Everyone, I'm Andrew Charles, TD Cowen's restaurant analyst. Today I'm joined by Mel Hope, the CFO of First Watch Restaurant Group.
Good morning.
First Watch is the category leader in the breakfast and brunch day part, differentiated by a limited menu with a focus on wellness and freshness, and one operating shift from 7:00 A.M. to 2:30 P.M. With nearly 600 U.S. locations and aspirations to reach at least 2,200 locations in the U.S., the concept has white space opportunity nearly quadrupled. Lastly, as we tee this off, I just want to mention that we really appreciate your participation in TD Cowen's Future of the Consumer Conference event. TD Cowen values the annual Extel , formerly II Investor Poll, that's now open for balloting. With that, we'd really be grateful for your recognition of a five-star vote for TD Cowen. So, Mel, with that shameless.
A little bit of commercial.
With that shameless plug out of the way, you know, maybe we can just start it off, you know, just would love to learn more about the 2025 sales guidance. What I think is unique about First Watch is that you have aspirations for flat to slightly positive traffic, which not many of your peers in the industry are aspiring for. What is giving you the confidence in returning to this performance?
Sure. Our traffic was under pressure almost all of last year and actually beginning last year, but about the third quarter we started to see things begin to turn, particularly our in-restaurant dining was turning. We also enjoyed an increase in our traffic associated with our third-party delivery, which has been for us something that's sort of been trying to find the right home. It's a new sales channel for us, but that has contributed more positively. We also know that we were bringing online more and more well-performing restaurants. I would say those things give us confidence that we're trending in the right direction. Since about the third quarter of last year, we've been trending more positively overall.
Moreover, I mean, Andrew, you've been following our story since before we went public, and you know that the company's bread and butter has been growing its customer base, growing traffic year over year over year. It's kind of part of our DNA to just continue to grow. Now we're marketing into some of that growth, and all of those things are healthy signs for us.
Awesome. Okay, that's a great overview. Before we go down to some of the exciting stuff that you mentioned, you know, traffic trends in April were the best they've been since 2023, but you called out that margins were off to a slower start this year. So, you know, as we think about the balance of the year, you know, how are you balancing the two dynamics of driving traffic but also doing so at a healthy margin?
Sure. Again, as you know, we tend to view pricing as something we need to be really careful about. Our typical cadence is to look at pricing early in the year and then again at mid-year if we have some course correction. Our margins have been under pressure. We've seen a lot of inflation in our four most popular commodities. As a result, we look at that inflation and we say, is it transitory or is it permanent? If it's permanent, then we take that under consideration when we make some adjustments to pricing. If it's transitory, we think it's our commitment to the customer to be sure that we're careful and that we're there every day with a value. We will take some margin hit, and we have.
We believe that most of the pressure that we're seeing in those four commodities, the eggs, avocados, bacon, and if I said pork, those commodity costs we think are more seasonal related or they're things that are beyond crop related, that sort of thing. We believe that they're transitory and that there will be a return to a more normal environment. Coffee was the commodity that I skipped over.
Okay, great. I want to dig in more in a little bit into the margin picture. Maybe first we recognize your ability and you're going on offense here. You know, what are some of the examples of the changes to the marketing strategy this year that are proving to be most effective? You did a lot last year that you tested, but this is the implementation this year.
That's right. It really goes back further than that. We've been really excited about just our data warehouse that we've been growing for the last few years. The company has different sorts of avenues that we capture customer information, either people on our app or logging into our Wi-Fi or their credit card tokenism. Over time, we've developed a pretty robust data set for our customers. Last year, we began to pilot some kind of a variety of different approaches, and they range from direct contact with those customers as well as social advertising, social media advertising, or connected TV advertising. We also did some geographic work, you know, around restaurants or around restaurant communities that would generate more visits, more transactions. Those pilots kind of gave us a set of things to which we would invest now.
As we've looked at that, we've applied them to certain markets. Every restaurant in the system is getting some sort of marketing support, but we're emphasizing it in certain markets where we're really trying to drive traffic with that more direct contact. We've also expanded our data set with external data that's available to us, which allows us to tailor the contacts with customers for those whose data is not in our systems but may have already expressed either an interest in the day part or an affinity for breakfast. We can help, you know, with our approaches to them, you know, kind of tailor that so that they have a reason to visit First Watch.
Yeah. I mean, when I think about this, I think of it as more kind of, I don't want to say griller or grassroots, but it's very targeted in terms of what you're doing. I guess the question is that with 600 stores now and visibility at 2,200, is TV advertising something in the long term that you have your eye on, or is that more just now, we got the strategy right now and this will evolve over time?
I think the strategy that we have now will evolve over time. You know, we'll see. But, you know, even as traditional media has evolved, I think the way people consume media now, consume advertising now, is evolving just as fast, if not faster. I'd hate to speak for whether or not, you know, broad-based media advertising would be in our future. For us, it'd be pretty inefficient right now. We'd be advertising in a lot of markets where we don't currently have restaurants. We'll be there eventually, but right now there'd be a fair amount of inefficiency associated with a broad-based program.
Makes sense. Absolutely. Okay. How would you describe the efforts with marketing 2025? Is this more increasing the level of ad spend, or is it more just changing methods to improve, you know, your return on ad spend?
A little bit of both. I mean, we're definitely spending more on marketing now or allocating more of our G&A dollars than we have in the past toward marketing. There has been an uptick in spend, but it's also more targeting and I think, you know, more optimizing either what we've done in the past or bringing on some of these new means that we've piloted last year and said, hey, we believe that's going to work.
Great. You talked a little bit ago about the challenges last year with third-party delivery. You know, great to see, you know, mid-teens traffic increases in one Q after that big headwind last year. You know, what details can you provide on the partnerships with the third-party delivery platforms that's led to this kind of rebound that you're seeing?
One thing to take you back on is that, you know, prior to COVID, we did not have a third-party delivery program. It has been relatively new for us, and we are still proudest of our in-dining room experience. I mean, the service at a First Watch, the in-dining room experience is really our, you know, where we have cut our teeth. We have had a lot to learn over the course of the last four years or so. What we have done, you know, in terms of changing, it is really kind of optimizing the relationship overall. There is some cost associated with it, but it is also behavior. It is also having a better relationship, being a better partner with our delivery partners so that they adjust both their marketing and the emphasis on our brand and that we understand each other better.
In terms of details, what we're really trying to do there is to do it the right way for us to be a good partner, to understand their principles and for them to understand us more. And that's paid some immediate dividends.
Yeah. Okay. Let me transition now to marketing. Excuse me, margins, excuse me. We started the conversation, there were some margin surprises in Q1 results that you guys were very forthcoming about. You know, how would you rank order what weighed on margins the most in Q1 versus, you know, which of the headwinds you would classify as kind of transitory versus not transitory?
Without question, the biggest factor was the inflation and what we experienced in those commodities I mentioned earlier. I think between that, we had some higher healthcare costs during the period. We've been promoting enrollment in our healthcare programs. Then we had some higher healthcare claims, which also were unplanned for in our world. The biggest driver has been that cost. The other thing that you saw in our first quarter margins is really the large number of newer restaurants. If you think about a First Watch restaurant, their first 120, 150 days or so, they have juvenile margins. We're trying to get every restaurant, you know, to a full margin, which is generally somewhere between 18%-20%, maybe a little bit higher than that.
In the early periods, those new restaurants have large crews, they have a little bit more waste, and they're operating with more juvenile margins. We had, I think it was 33 or so restaurants opened before the end of the first quarter, between the fourth quarter and the first quarter of this year. Many of the ones that opened in the fourth quarter of last year were open toward the end of the quarter. The most juvenile margin periods were all in that time. Because of that large number of restaurants, not only that, they're very high revenue restaurants. They kind of over-index against the overall margin. As a consequence, just with that large group going through, there was some impact to the margin just by having a large number of new restaurants that are doing quite well, but they're growing to maturity.
Okay. Okay. Earlier you mentioned that, you know, you're evaluating price, you know, twice a year as the historical cadence. You know, as we approach the next time where you typically take price, you know, how are you thinking about it?
No different. Our thinking is that, you know, the crop-related inflation that we see out there, you know, we would not expect that to recur. That would be transitory. We think that there, you know, we're having a good experience in terms of avian influenza not surging like it did last year several times, which means that there should be some abatement in overall egg prices as long as there's no, you know, no lift in that area. We are taking most of the inflationary costs unrelated to tariffs, whatever those might be, as mostly transitory. As we sit down, we'll begin to think about which of that we think is more permanent.
Okay. Very good. Let's spend a minute on the commodities, you know, that we've been talking about throughout the conversation. You know, beginning in early March, the spot wholesale egg market fell dramatically. You know, I like the fact that you're embedding commodity inflation persisting for the majority of the year. You've talked about how your eggs come from, you know, more mature birds, you know, larger eggs, of course. You know, how long does it usually take or would you expect it to be until you see the benefit to spot markets, you know, prevail within your own business?
At the current trajectory in terms of the flocks replenishing, and I should say we are really finicky about our eggs. I mean, our shell-in eggs are extra large or large, cage-free, pasteurized eggs. The number of birds that actually can lay those kinds of eggs is a subset of the full flock. Until we can get to those mature birds, we have to be, you know, we're getting a good bit of the market that's out there in our own restaurants. I think that, you know, our expectation is that in the second half of the year, at the present trajectory, there may, you know, the flocks may be more, you know, at least closer to kind of full U.S. flock. We should, you know, we should see some sort of abatement there.
That's certainly what we're, you know, that's certainly what the latest information is that we're thinking. I have learned to be conservative about this in the last couple of years. We have had resurgence of avian influenza for the last three years, and it's becoming more and more profound. We have taken a pretty conservative approach at trying to consider it in our own projections.
Yeah. It's a good plug for 10:30 in the morning to talk about how thin you are with eggs, by the way. We're peak brunch hour right now, so that's great. Okay, super. Maybe we just touch on the other commodities as well. So outside of eggs, you know, coffee, bacon, avocados, obviously very inflationary so far this year. You know, how are you thinking about, you know, inflation for these being transitory versus reaching a new run rate level?
Right. Each of those, or at least coffee and avocados, were more crop-related. And so, you know, the expectation is that there to be a more normal, you know, normal cycle on those. Coffee is, excuse me, pork has been pretty unpredictable. It's kind of running countercyclical right now. There's probably smarter people to talk about pork than I do. I would just say that of those three, we do expect that there is a more normal climate out there and nothing that we're seeing in those three commodities would be a permanent type shift in the market. It's certainly displaced right now and has been, but I think we should see that return to some sort of normalcy.
Yep. This question kind of straddles sales and margins, but I want to talk more about the surprise and delight program you started following the 4Q annual conference. So I guess can you share with the group, you know, what that is? And my question is, would you expect this program to persist at the current level it did in 1Q or have you been trying to dial it back a bit?
It really relates to a couple of things. One, and neither of which are things that we do not do every year. They took more attention because the effect of them was somewhat exaggerated because of the cost of commodities. Two things that we did. One, we had a little bit of a pep rally for our managers and they said, "Look, hey, look, when Andrew comes to the restaurant, Andrew's a regular customer, maybe the right thing to do is to say, you know, have you tried this new juice that we've come out? We fresh juiced our, you know, our kale this morning. Why do you not try our new kale tonic or something like that?" That is kind of our version of a loyalty program.
We don't have a loyalty program, but for a manager to go to a regular customer or a regular customer's family and to give them a complimentary side or something like that to encourage them to return, I think that makes a statement. It's a long-term investment. I think even you, cynical as you are, might be impressed by that. Our managers embraced that in the first period. We don't try to throttle it. We, you know, we help them to, you know, use it a little bit more judiciously. We encourage, I mean, we encourage that and always have. That's not a new thing that our managers have been able to do, but we did encourage it. I think it's a good time to help us develop loyalty.
We also, in terms of delighting our customers, we also increased the portion size on one of our most popular entrees. We doubled the portion of bacon on what we call the Tri-Fecta. We doubled it right at the time when pork prices spiked and customers continue to enjoy that. Those are permanent changes. I think in an ordinary time, those sorts of changes that we make do not draw a lot of attention. They were part of a pool of things that we do constantly to help stretch out our lead in hospitality and customer service. I think it is the right thing to do for our guests. I do not expect it to abate some, even though we may be, you know, we want to be careful about doing the right things for our customers.
Okay. It's a good segue to my next question. I mean, was the portion investment in the Tri-Fecta, was that kind of a one-off or is this, you know, more to come as you evaluate, you know, doing this to other items as well?
In that case, it was in any case like that, it's generally because we see an opportunity or see something that we feel like we need to do as opposed to a part of a program to continue to do that.
Okay. Got it. Okay. Touch really quickly on development. You know, one of the hallmarks of the First Watch story is a long-term algorithm that calls for 10% plus net restaurant growth, which is, you know, amongst the highest in the full-service category. Can you talk about what gives you confidence in your pace of growth?
Sure. First of all, our pipeline. I mean, I'd say, again, looking backwards, we've invested more and more in terms of talented people. We put more people in markets. We develop more relationships with commercial developers in more and more markets. Over time, we know we've got a lot of green space and the ability to grow to over 2,200 restaurants in the system. As I look at the pipeline and our development team who are constantly, look, I approve, I'm part of the team that approves every site. You know, this year is for us pretty much spoken for because we start, you know, 18, 24 months in advance trying to bring a project to maturity. The projects that we're looking at now and are approving now will open next year or even the year following.
Our development team led by Eric Hartman, they are very thoughtful and data-driven about the timeline to get to an opening. I think because of the, you know, as a consequence or a reward for their diligence on the upfront, you know, it's a pretty predictable range that we have overall on projects coming to maturity.
Yep. Mel, do you want to spend a minute as well just talking about what you're seeing with the new store economics? I thought you shared some pretty compelling data points in the last call around the performance you're seeing with new stores.
In the new store?
Like you're seeing your, yeah.
Yeah, new stores are opening up. They're about 10% higher than their system average. We underwrite them to get to about $2.6 million in AUVs by their third year of operations with a restaurant-level operating profit about 18%-20%, which generally pencils out to something like 30%-35% cash-on-cash return. Most of the restaurants now are ahead of that $2.6 million pace. They're opening up at real sterling volumes and they're growing rapidly. As we continue to open the restaurants, improve our site selection, it's a nimble group of people. There's not as much first-generation space out there, but there's a lot of second-generation space as brands have decided to walk on leases that are attractive to us and, you know, particularly a lot of freestanding units that are more billboard sites for us.
As we've moved into new territories, we have really seen those take off. Those AUVs of those restaurants are very exciting.
Yep. Okay, great. Kind of good segue on the development side. You know, certainly not looking for a year, but, you know, what is the bridge to ultimately becoming free cash flow profitable? And the question we get a lot from investors is, can you reach free cash flow profitability while doing the 10%+ in restaurant growth?
Sure. I think, I don't know if people look at this, but I think of free cash flow prior to investment in CapEx. We've already been that. We fund our new restaurants as well as investments we made in the legacy fleet and in terms of keeping them current and repair and maintenance and that sort of thing. We fund that out of our operating cash. We borrow as we have done strategic acquisitions. We bought a number of our franchisee restaurants in. Years ago, we bought one or two brands that we converted to First Watch Restaurants. We currently are funding our growth with operating cash and only borrowing for those strategic acquisitions. I think we'd like to try and stick to that principle.
Okay. Very good. A couple of questions that we also get from investors. You know, would love to know, what are you observing in the breakfast category in 2025? You know, the discretionary nature of the category seemed to be a headwind to sales in 2024, but you're seeing the traffic, you know, seeing a nice rebound there so far this year. You know, do you attribute it to, you know, a better category that you're seeing in breakfast or has this been driven by some of your more idiosyncratic drivers?
I think there's a number of things that have gone on with breakfast. I mean, you can see the customer has made some sort of a shift. You know, maybe it's they're managing their wallets. They're not trading down into fast food because you can see that those, you know, the fast food guys are saying their breakfast occasions are off too. I think a couple of things have gone on. One, I think it's not the value proposition that it was years ago. There's more entrance into the space right now, but many of them are franchise models. We're a company-owned model. The pricing that we've seen out there has made it less attractive as a, you know, as a cost occasion, which is why we have the opportunity to communicate a lot with customers and show our value proposition.
It's also why I'm optimistic about our philosophy on pricing because as we continue to maintain our, you know, our favorable value proposition and favorable menu pricing for like items, I think we become an option for customers who are, you know, seeking something a little bit more special.
Yeah. Okay. You've started talking more about speed of service in recent quarters. You know, would love to have you frame up the progress that you've made so far and the key drivers there, as well as looking ahead at the opportunities to continue on this.
Sure. Dan Jones is our Chief Operating Officer and I know you've met Dan before. One of the things that Dan brought to the company in terms of operations was a real focus on operating data and measuring and racking and stacking and communicating it to our managers who, by the way, are a competitive bunch of people and don't like to look different from their friends around the corner. One of the things that we did just in terms of the data capture is to actually report it. I mean, it's not novel, but oftentimes you'll find that what my dad used to say, if you aim for nothing, you're sure to hit it. We gave people a target and people started to emphasize that. They started to focus on it and then they trained on how to do it better.
We also, with the introduction of our KDS systems in the back of the house, that allowed us to align more with the production line, with the service line out front and allowed us to measure more from the time that we take an order to the time it's served. The addition of the data and then feeding it back and emphasizing it to our teams, those I think really made a compelling change in the operations. Kudos to Dan for making that important to our operators.
Yeah. Looking ahead, you know, you've identified some key opportunities that have really helped lead. I mean, what are the further opportunities here? Because I mean, I think you guys do a good job of making sure it's an efficient experience for the guests without being pushy by any means.
Sure. Yeah. The hard work of restaurants, and I've been in this business for a long time, is it comes in managing the, you know, just the basis points. I mean, it comes in little things. You know, from time to time, we visit the choreography and the service of the restaurant. We visit the location of things in the back of the house or whether or not we need larger make lines or do you need a separate area for where takeout and delivery is very popular. Do you need to have, you know, modifications for things like that? Most of those things come along and again, it's shaving basis points. It's constantly training.
It's making sure that as we get so many new people into the company, you know, when we have now 15,000 employees, give or take a thousand, okay, the turnover of new employees, of people who come into the company, having them better trained, having them better ready to go, those sorts of things are the emphasis that we have now in order to continue to shave those basis points and to introduce new items in the restaurant without disrupting or tarnishing the experience of the customers.
Awesome. In the last minute or so we have left, you know, Mel, I'd just love your read on the broader consumer. You know, there's been a lot of news flow so far this year. It's definitely created noise, you know, within your business, but certainly you guys have shown that you've shown progress off the rebound from 2024. So I'm curious, you know, how you see the current stand of the consumer.
I generally look to you guys for those kind of comments, I have to say. I think the customer is fragile. I mean, there's no question about what people are looking for, a little bit more certainty right now. There is, you know, consistency would I think bolster some of the, you know, some of the consumer confidence in the near term and the long term. I think our customer is affected by that. I think your investor is probably affected by that. I think every company out there right now is managing through a consumer environment. It's a little bit more fragile than we're used to and people could use a little bit more comfort.
Awesome. I hate to end it on that note, but you know, I just want to say, Mel, thank you so much for joining us in the [call] .
[I'm excited for you.]
Yeah, exactly. There we go. Thank you, everybody.
Thank you.