Bernstein Sr. Analyst Danilo Gargiulo joins Yahoo Finance Live to discuss November jobs report data, how restaurants are grappling with macroeconomic headwinds, and how rising interest rates will influence growth in the restaurant sector.

Video Transcript

- The restaurant sector is grappling with rising interest rates, but our next guest says while the pace and the space should not face significant impacts, companies like Restaurant Brands and Domino's will be the most sensitive. Bernstein senior analyst Danilo Gargiulo joins us now. Danilo, great to have you here with us this morning. When you think about the space more broadly and how it can continue to weather some of the headwinds, what do you look for in a company that could perhaps outperform?

DANILO GARGIULO: Good morning, and thank you for having me. Look, I feel the macro environment is particularly challenging for the average restaurant today. You have commodities that have been elevated throughout 2022 expected to remain elevated in 2023, maybe with some kind of benefit toward kind of the middle of the year. Labor has increased by about 10%, depending on the concept, and we are expecting labor to continue to be elevated.

And therefore, we are expecting companies that can maintain high margins to be relatively better positioned going forward. Essentially, companies that have kind of a resilient brand power and a resilient ability to maintain their margin power to be better positioned coming into 2023 because of the kind of challenging forward profitability across the stores in the United States, and even internationally. So to me, the biggest kind of tailwinds are going to be on companies that are able to maintain their growth profile in the long run, as well, despite the macro challenges that we are seeing today.

- Danilo, you wrote a really interesting note recently looking at the effect of rising interest rates on restaurants. And this, I have to be honest, restaurants and interest rates, I don't usually think of them as the first sector I would think of as being affected. But of course, you know, if you're a franchisee and you want to open new restaurants, you're probably taking on debt, for example. So walk us through how the restaurant industry writ large is going to be impacted by these rising interest rates, how it has been impacted, and how much of a problem it is going to be for them.

DANILO GARGIULO: Yeah, no, that's a great question. I-- we had a ton of interest from investor asking exactly how interest rates are impacting or are going to be impacting restaurants. It actually takes place in two forms. You mentioned the franchisees.

Clearly, from a franchisee standpoint, it's about the unit growth. Having access to capital, having access to financing is fundamental to maintain their growth algorithm. This is, of course, also knock-on effect on the franchisors, so the likes of, you know, the Domino's, the McDonald's of the world who are relying on a unit growth algorithm for them to continue to expand their sales internationally, because of course, from an EPS standpoint, they are highly dependent on the top line expanding. And so it has a dual effect on both the franchisees and franchisors.

I would say on top of the unit growth, typically the kind of average franchisor has also used kind of the low interest rate environment to fuel some of their EPS algorithm through share repurchases and dividends. And so we were trying to model out and trying to see, over a long period of time, whether this impact of higher interest rates will actually influence the decisions of the companies, both from a kind of capital allocation priority, as well as their ability to continue to fuel the unit growth going forward. And frankly, I was very surprised with the results that we noticed in the data.

You know, I was expecting, just like many of the investors that were asking us this question, I was expecting some material impact on the compounding growth of companies in higher interest rates. But in reality, we-- kind of the data doesn't tell us so. And so it kind of made us wonder why this dynamic was not playing out as per our expectations. And we think there is a couple of reasons behind the scenes.

First of all, companies in the sector-- in the sector-- restaurant sector have long maturity of debt. Typically, about 90% of our covered companies have debt that is maturing three years out or more. About-- sorry, that was 80%. 90% of the debt is fixed, which means basically the kind of cash flow profile for this company is pretty much set for the next-- for the foreseeable future. So they have a longer window of time to readjust their algorithm going forward.

- That's really interesting. Danilo, within the food services landscape, Food Services and Drinking Place added 62,000 jobs during this most recent month, in the month of November. And when we think about the pace of hiring, as well as how all of these businesses are going to need to be able to keep margins and able to get through a challenging economic environment, you know, what do you look towards for them to be able to maintain those margins, while also still needing people, needing workers in order to make sure that they can service all of the customers that they are either bringing into in-- in service or in-person eating capacity, or delivering to, in some cases?

DANILO GARGIULO: Yeah. So if I can decompose your question into kind of expectations on labor and why kind of the added labor is essentially like a potential tailwind for restaurant, but at the same time, you know, it may not be sufficient for restaurant. I want to say, look, right now, the major response that restaurants have kind of adopted toward the tight labor market for restaurants has been essentially wage increases. And restaurants have been kind of the hardest hit sector in the United States during the pandemic, but it's also been the lowest sector to recover during the same time frame. It's also a sector that has seen the highest quit rate compared to any other sector.

And so we are expecting that this is something that has some specific roots in the restaurant industry. It's not necessarily shared across the broader environment. In particular, what I mean by that is the pandemic has really taken a toll on the workers. The workers in the restaurant space have been pretty hard hit during the past 20 years by kind of low wages, working conditions that were poor, lack of flexibility. All these dynamics were actually being reflected upon by the workers during the pandemic. And so the quit rate has been particularly elevated for restaurants.

The immediate reaction from a restaurant standpoint has been increasing the wages, because clearly this is the easiest way for any company to attract talent. But we don't think that this is going to be sufficient, in particular since the restaurant space has the highest proportion of millennial and Gen Z being part of their workforce. And because we know that this generation is much more value-oriented compared to any other generations, we are expecting additional investments that restaurants will be taking in the form of higher benefits, in the form of better security in kind of-- better security and safety in restaurants, as well as additional investments when it comes to career pathing inside the restaurant chains.

And so clear examples of how this is reshaping as we speak, a Starbucks has launched a transformation, which is also focused on reigniting the labor workforce through more flexibility of schedules, as well as a better career path inside Starbucks. Chipotle has always prided itself for offering opportunities for essentially creating jobs for their own people, or essentially like a upward movement for their workers. Somebody working in a store could become a VP of a region, eventually could go into headquarters, as well. We've seen the same dynamics with Darden.

- Yeah.

DANILO GARGIULO: Domino's share-- 95% of their franchisees are coming from the store itself. So there are many more venues outside of wages.

- Danilo, we've got to leave the conversation there today, but thank you so much for joining us and really breaking down the food sector segment. That's Bernstein senior analyst Danilo Gargiulo. Appreciate it.