In restaurants, debates are raging about delivery and meatless alternatives and what is the impact upon sales, comps and earnings. What is said by some is “it is incremental”.  The first question what is incremental, and to whom?  Restaurant fundamentals talk is so numbers intensive now, it is easy for investors to get confused by the array of numbers.    

One recent example of this is the debate underway within the restaurant space is whether delivery is contributing new customers.  Some restaurant operators and 3^rd party delivery providers passionately claim that delivery is incremental (e.g., see Restaurant Business piece by Peter Romeo [1] but yet others claim that it can’t be (e.g., Dominos (DPZ) CEO Rich Allison noting the industry is still producing negative traffic despite all the delivery business claimed[2])  Another most recent incrementality question involves meat alternatives (e.g., meatless); hit rates have jumped up to the mid-single digits in many operators and one study reported a 18% April traffic bump at Burger King in its St. Louis meatless trial, but is it incremental?

So, what does incremental really mean?  Incremental means verifiably additional and it applies to revenues, operating expenses and capital expenditures in our business. Most of the debates on “incrementality” fall in the revenue and marketing analysis area. Incremental can refer to additional revenue net of cannibalization and other mix shifts but ideally, in my expanded view, it is that revenue that offsets all the associated costs and capital outlays…so it is truly free cash flow positive. [3]

One very important question to sort out initially about incrementality of anything; is it recurring, showing up period after period, or is it one time in nature?  Sometimes, when a new concept or product platform is implemented, we simply won’t know what the implementation cycle will be. For example, if meatless burgers are added at White Castle, will there be a sales bump sustained? This is why test markets and control markets are necessary. There will always be uncertainty and hence “excitement” in retail and restaurants, and we won’t know the answer at once. Operators, analysts, investors and observers should be cautious while a new product or concept is being proven.

One trap that restaurants and their ad agencies fall into is not having on site customer research customer data to determine actual incrementality and using hit rate or sales mix results as a proxy for marketing success.   Even McDonald’s (MCD) with their global reach of their marketing and G&A budgets does not have instant guest survey feedback. [4]   The hit rate[5] is a customer interest indicator, but it does not guarantee the guests powering the hit rate are new and additional; many times, they are existing guests and are cannibalized from other menu offerings.

Incrementality Tests:  Based on many years of my own experience in restaurants revenue, expense and CAPEX analysis, here are some observations on tests for incrementality worth thinking about:    

• Regarding a new product platform or new concept, revenue incrementality does not typically result right away. It takes time for guest realization and habits to change.  On the other hand, a marketing promotional LTO event may have an earlier sales bump but has much faster revenue erosion.
• For the minimum revenue analysis required, comparison to the overall company business trend as well as the peer restaurant company as a whole is needed to detect incrementality. The best example is delivery: if the delivery sales mix is 6% but your brand has flat sales in total, it is not likely the delivery is incremental. But it also does not mean that delivery should be abandoned too soon. It means more has to be done. Conversely, if peer companies sales are flat and your brand is up 5%, with delivery sales mix of 6% and few other factors are at play, it seems likely there is incrementality.  
• If one must struggle to see it……If very positive sales or traffic results are material and seen clearly, that is great. If the results are almost hidden or must be manipulated to be seen, that is a sign the incrementality is not there.
• Expenses: as a standard, a 50% restaurant profit flow through is assumed. That means for every $1 in incremental revenue, there is $.50 of incremental expense. That has been assumed and proven for decades in restaurants. But as you know, new product platforms and concepts are a bit inefficient with training and startup costs at the onset. I recommend thinking about lower than 50% profit flow through in the trial period but then approaching or exceeding 50% later, depending on the labor, COGS and ticket/mix intensity of the new platform.     
• CAPEX: plan for it.  But the amount will vary great based on the concept or revenue platform in use.  Typically, there will be a burst of CAPEX at the beginning and then a falloff until a new wave of investment for the next sales platform or concept is required.      

[1]  Peter Romeo piece, https://www.restaurantbusinessonline.com/financing/delivery-growing-becoming-incremental-profitable-process

[2]   Dominos (DPZ) Q1 2019 Earnings Call, April 24 2019.

[3]   With other things invariably underway affecting the P&L, the value of a test and control can be seen to isolate the effects.  Then, the store level P&L must be slightly modified to add back depreciation expense and subtract marketing expense (if not directly allocated to the store) and capital spending associated with the new product or concept.   

[4]   For example, McDonald’s (MCD) noted during their all-day breakfast rollout in 2017 that they needed several months to assess and read customer behavior.

[5]   Number of food units or entrees sold divided by total food units or entrees sold. This is close to but not exactly the same as the menu mix, which is traditionally percentage of sales mix.