Nobody knows how the current social distancing and mandated bar and restaurant restrictions will impact the wider foodservice industry as many restaurants pivot to off-premises-only operations or close down, but the leading restaurant analysts are zeroing in on what the coronavirus scare means for individual restaurants and investors in the space.
As Wells Fargo analysts Jon Tower and William Miller note with an iceberg analogy, the most disconcerting thing at the moment is not the financials analysts see, but what lies beneath the visible surface.
Below are excerpts of the most recent COVID-19 reports from Jefferies, Wells Fargo, Cowen, BTIG and Morgan Stanley on the topic. These kinds of reports are heavy on jargon, so we’ve edited them down to include the most relevant information for restaurant operators.
Jefferies – Rob Dickerson, Matt Fishbein, Ashish Mago
Given frenzied food-at-home buying and near-term foodservice declines expected given COVID-19, we’ve quantified the potential uptick in food-at-home purchases in the U.S., dimensionalized potential risks and benefits for our coverage, rank-ordered our coverage given pantry-loading category and retail channel positioning, and updated our valuation/yield analysis, all of which point to a more attractive setup for U.S.-based food names.
Analysis suggests food-at-home could see incremental $90bn in retail dollars March through May. If food-at-home were to increase to 70% of total U.S. food retail sales from March to May this year (from a pre-COVID-19 50% level), we estimate an incremental ~$90bn in food-at-home revenues. Food-at-home peaked at ~56% of total U.S. food retail sales during the 2009 Great Recession, which was financially based, not virally-driven. And given the shift to at-home food purchases seems much more than a week-long pantry load, we foresee an ongoing top line tailwind in the near term for many companies under our coverage (assuming supply chains keep up).
Wells Fargo – Jon Tower, William Miller
While we believe most restaurants under our coverage will survive this turbulent time, we find it challenging to “pick a bottom” for stocks as fears may overwhelm reality in the near-term and therefore drive equity prices well below intrinsic values. Some companies under our coverage may trip covenants due to sales and profits contraction, but based on our conversations, we believe most corporates will have the ability to negotiate new terms with lenders (albeit at a higher financial burden) and keep the current entity intact. However, we are less confident in the financial health of the franchisee community. Until we gain greater clarity on the depth and duration of the sales declines, we recommend investors keep powder dry, pivot to names with what we believe to be solid balance sheets and the ability to drive sales in this environment due to the heavy delivery or off-premise mix (i.e., CMG, 1; MCD, 1; DPZ, 2) or have greater exposure to markets where the virus appears to have already peaked (i.e., YUM, 2, with China exposure).
· Recent industry data suggests daily yr/yr traffic declines of 30-50% across markets and we see the potential for mandatory nationwide dine-in closures. OpenTable has offered a daily report on traffic trends across states and major cities across the globe that suggests traffic declines have accelerated over the past week. Further, as of writing, Ohio and Illinois have officially suspended dine-in service indefinitely with both markets permitting curbside pick-up and drive-thru services. In this scenario, we see eater-tainment (i.e., PLAY), fine dining (i.e., DRI’s Eddie V’s and Capital Grill, BLMN’s Fleming’s) and those companies that have not aggressively pursued the off-premise sales channel (i.e., TXRH and DRI) as most at risk of losing sales during this temporary closure period. Alternatively, pizza concepts (i.e., DPZ) and quick-service operators with a heavy drive-thru sales presence (i.e., MCD, WEN, JACK, Taco Bell, Burger King) may all see modest sales lift during this period.
· Leverage for the sector is well above that seen heading into the financial crisis of ’08-’09, but it is important to note that debt structures are different, too. Many companies have turned to securitization vehicles when issuing debt financing. Based on our conversations and work, these vehicles can typically handle more stress to the model before tripping cash trapping relative to traditional financing vehicles. Within our coverage universe, DNKN, DPZ, JACK, QSR, WEN, WING and YUM all use a form of this financing in some fashion. In this note, we’ve aggregated leverage levels across the sector as well as detailed the contractual obligations for each name under coverage per the annual filings. Our sentiment barometer demonstrates that those stocks with heavy debt loads and a primarily company-owned model have paid the heaviest toll to date, with RRGB, EAT and PLAY near the bottom of the list and near the worst performance in the sector over the past month.
· When thinking about the industry: similar to an iceberg, it’s not the financials we can see (publicly-traded franchisors) that may cause the most trouble for the industry, but what lies beneath (franchisee financial health, specifically leverage). Based on our previous conversations with Wells Fargo Restaurant Finance group, franchisee leverage levels are high relative to history (~6x, lease adjusted on average, or about 0.5x higher than 5 years ago) and store-level cash flows have been under pressure (modest top-line growth and rising labor pressures). Further, with many newer franchisees choosing to lease rather than own real estate, franchisee ability to sustain financial stress during an economic downturn may be more limited. Should the environment materially worsen we would anticipate franchisors stepping-in with measures to alleviate store-level cash flow pressures, including temporary royalty or rent abatement, but given the financial health of the franchisee community, we would expect the rate of closures or consolidation to be higher than during prior periods of financial stress. Lastly, we would note that even during the financial crisis of 2008-2009, industry net unit growth remained in positive territory. We would expect greater closures this time should this contraction be protracted.
· Thinking beyond the current moment is challenging, in our view. However, we do think this crisis could permanently alter the foodservice landscape in the following manners: (1) further expansion of delivery and off-premise as well as the industry expediting drive-thru renovations, (2) growth of digital sales and loyalty programs (both allow for greater 1-1 communication and incentives when consumer attention may be pulled away from traditional media), (3) growth of contactless payment (digital will help fuel this, in our view), and (4) likely lower average debt levels going forward for operators, including franchisees, which may alter future private equity ownership mix across the industry in our view. Further, we see those concepts that survive the current crisis as potentially thriving in the aftermath as there will likely be less well-capitalized concepts in the market.
Cowen – Kevin Kopelman
Risks to the companies in our sector include risks and uncertainties associated with the global economic environment and consumer spending, as well as general competition given the fragmented and low-barriers-to-entry nature of the industry. Restaurant sales are sensitive to changes in disposable income and job growth, while costs are subject to fluctuations in commodity prices as well as labor from minimum wage increases and other benefits, namely health care. Execution flaws and the departure of certain key executives may negatively affect performance and financial results. Legal, regulatory, political, currency, and economic risks, as well as changes in consumer tastes, may affect the ability to conduct business in both domestic and international markets.
Severe Impact to Store Traffic Likely Across the Entire Consumer Discretionary Sector:
Cowen expects broad store and mall closures at discretionary retailers and/or severe limitations to traffic as social distancing policies are implemented for the welfare of society, employees, and customers as the nation works together to flatten the curve. Most significant risk to mall-based retailers we cover including LB, AEO, M, JCP, JWN, GPS, TPR, & CPRI. While retailers with robust e-commerce capabilities will be better positioned, store closures will be detrimental to financial results and also compound stress in an already declining traffic environment for mall retailers. We do expect traffic in Asia to decline substantially in 1H20, and, as the virus affects Europe and the U.S., global traffic could be down even further, impairing sales across the retail landscape.
■ Retail EPS Impact and Sensitivity: Every lost week of traffic would yield approximately a negative 1-2% headwind to comp store sales and hurt EPS by 2% or greater. Every month of closures would hurt revenues by 8% or more and EPS by 12% or more. The earnings sensitivity varies depending on fixed vs. variable costs, partial eCommerce re-capture from store closures, and the percentage of store base closed. Many retailers including LULU, ANF, URBN, & LE will close until March 27-29. Closures may or may not go longer depending on CDC guidelines for social distancing and the progress the country makes in flattening the curve of infection.
■ The Health of the U.S. Consumer: U.S. consumer spending may rapidly decline given the vast personal and professional uncertainty and related declining consumer confidence. Other risk factors which will drive lower consumer spending and income include: stock market weakness and negative wealth effect, rising unemployment, wage pressure and additional healthcare costs. Businesses which are not well capitalized, over-levered, or highly reliant upon cash flows and working capital are at risk as closures negatively impact revenues and profitability. Severe retail traffic declines and temporary store closures are evolving risk factors that depend on uncertain variables like the geographic spread of the virus and the timing of containment/eradication solutions.
■ Traffic and Consumer Confidence Risk: Impact to EPS will depend upon duration and scale of traffic declines. Each percentage point of annual traffic decline may lead to a greater percentage decline to EPS based on negative leverage from fixed costs such as occupancy and labor. If the sector experiences overall annual traffic declines of 10% this could yield 15% or more downside to EPS.
■ Broadlines: Longer-Term Supply Chain Risk, Medium Term Upside Likely as Customers Stock Up–Social distancing is driving US consumers to stock up on essentials and groceries as we estimate traffic is increasing 20% or higher at consumer staples retailers. Further, we believe WMT and TGT’s curbside pick-up and delivery capabilities will resonate strongly with consumers in this time of social distancing, and should contribute comp growth. We expect grocery, personal care, and household essentials to be in significant demand for the next few weeks if not longer–this will benefit WMT, TGT, COST, GO, and others.
BTIG – Peter Saleh
While we expect restaurant sales to be materially impacted, especially in regions with the greatest number of coronavirus cases such as Seattle, San Francisco and New York, we do believe restaurant operators especially quick-service can cut operating costs while getting abatements on royalties, rent and advertising.
We do expect casual-dining operators to feel the brunt of this sales decline the longer the social distancing and virus concerns persist, however, we note that most full-service operators do not have meaningful exposure to major metropolitan areas currently hardest hit by this virus, rather their exposure is mostly in suburban markets.
According to our industry contacts including Bikky (Private), a customer relationship management company which aggregates data from POS, delivery and loyalty programs, NYC quick-service operators are down 20%-30% in the past week with full-service restaurants down greater than 30%. In the Mid-Atlantic, and Chicago, no change in trends so far. However, in the San Francisco Bay area and Seattle, sales are down anywhere from 50%-90%. While we are not surprised by these data points, we believe these declines are transitory and expect sales to rebound quickly when consumers return to their daily lives.
▪ Restaurant Chain Sales Account for 19% of U.S. Food Consumption: Food away from home (a category that encompasses a lot of venues) accounts for a slight majority (54%) of U.S. consumers’ food spending with full- and limited-service restaurants accounting for 73% of this spending. Chain restaurants account for a slight minority (about 47%) of all restaurants, which equates to chain restaurants accounting for nearly 19% of all food consumption domestically. While we expect consumers will pull back on restaurant visits as they socially distance themselves, we expect consumers to shift their consumption to delivery, drive-thru and pick-up rather than completely abandoning restaurants for an extended period of time.
▪ Breaking Down Restaurant Sales: In quick-service, approximately 70% of sales are generated through the drive-thru with a low-to-mid-single digit mix from delivery, somewhat insulating them from the coming sales decline associated with social distancing. We believe it is likely that many quick-service operators opt to close their dining rooms, reducing costs and potential virus transmission, while still serving customers through the drive-thru, which will likely be preferred.
▪ Saving Franchisees and Employees–First Order of Business: We believe in certain instances, including those franchisees with the steepest sales declines could get royalty abatements, material reductions in rent (especially McDonald’s [MCD, Buy, $240 PT]) franchisees) and or dramatic cuts in advertising contribution in an effort to support cash flows in the near-term. We estimate that franchisee pay a low- to mid-teens percent of sales for rent (if applicable), royalty and advertising combined. We believe a reduction in these three costs coupled with the closure of dining rooms (lower operating costs) could go a long-way in aiding franchisee cash flows in the near term.
Morgan Stanley – Chetan Ahya – Chief Global Economist
With economic activity disrupted and capital markets dislocated, investors have been debating if Covid-19 could derail the global cycle. Given the sharp drops in global asset markets recently, the coronavirus could deliver a sizable impact to global growth in the first half of the year. However some clear perspective on the outlook for the full year is warranted.
Below is what I and my colleagues on the firm’s economics team see as the three most likely outcomes for the impact of the coronavirus outbreak on global growth. In our base case scenario, new cases and disruption may continue near-term, but global policymakers will likely use easing measures and rate cuts to help mitigate the impact. Assuming new cases peak by April/May, global growth could pick up in the third quarter, as the disruption fades and is supported by accommodative monetary and fiscal policies.
To set the backdrop: Coming into the year, my colleagues and I saw a growing evidence of a global economy on the mend after a tough 18 months. Headline Purchasing Manager Indices (PMIs) had bottomed out, and new-order survey data showed improvement as of October. Global trade was growing again in December, after contracting for six months. Despite lingering skepticism, we thought these data points supported our thesis of a global recovery taking hold in the first quarter of 2020.
The outbreak of COVID-19 has certainly changed that near-term narrative. Considering the weak starting point for global growth and still nascent recovery, this untimely disruption to economic activity will likely slow global growth this quarter.
The key question now: Could this exogenous, transitory shock fundamentally challenge the growth cycle? For now, we don’t think so. Indeed, throughout this expansion cycle, the global economy has weathered a series of shocks, each in turn giving way to a mini-cycle in global growth that has helped to extend the greater expansion by interrupting a stage of overexuberance that may have led to overheated growth and an end to the expansion.
Still, given the uncertainty of the outbreak, we see three possible scenarios ahead. At the current juncture, the second scenario is our base case.
Scenario No.1 – Containment by End of March: The virus outbreak is contained by end-March and production disruption is limited to the first quarter. Policymakers in China and Asia move to provide meaningful fiscal and monetary support, with China expanding its fiscal deficit by 1.2 percentage points, keeping it high for the second year running. Global growth dips to an annualized rate of 2.5% in the first quarter, down from 2.9% in the fourth quarter, 2019, but recovers meaningfully from the second quarter onward. Global growth dips to an annualized rate of 2.6% in the first quarter, down from 3.0% in the fourth quarter, 2019, but recovers meaningfully from the second quarter onward.
Scenario #2 – Escalation in new geographies, disruption extends into the second quarter: In this scenario, new cases continue to rise in other parts of the world, before peaking by April / May. The disruption extends into the second quarter, affecting corporate profitability in select sectors, risking the emergence of corporate credit risks. If the dislocations in asset markets also persist into the second quarter, a sharp tightening in financial conditions may mark a tipping point, exacerbating the impact on growth via weaker corporate confidence, falling capital expenditures and cutbacks in hiring.
In response, policymakers around the world would step up easing measures, with fiscal policy in Asia and Europe and monetary policy in the U.S. doing the heavy lifting. Global central banks will also ease, taking the global weighted average policy rate to a new all-time low. The fiscal response across key developed and emerging economies will also kick in. In aggregate, the cyclically adjusted primary fiscal deficit for China and the G4 nations (U.S., euro area, Japan and UK) widens to 5.1% of GDP in 2020, from 4.1% in 2019, a level not seen since 2011. In this scenario, global growth averages just 2.3% in the first half of 2020, but starts to pick up in the third quarter.
Scenario #3 – Persisting into the third quarter, escalating recession risks: The outbreak’s global disruption continues to spread into the third quarter, encompassing all the large economies. China faces a renewed rise in new cases as it restarts production. The extended disruption to economic activity damages corporate profitability and brings about a rise in corporate credit risks and significant tightening in financial conditions, which exacerbate the slowdown in global growth. While there should be a rebound in growth from the fourth quarter, given that the slowdown would extend into three quarters in this scenario, it would mean that the global economy will enter into recession in this scenario. We project full-year global GDP growth of 2.1% (i.e., below the recession threshold of 2.5%). All of the G3 economies—the U.S., euro area and Japan—would also have moved into technical recession territory (i.e., two quarters of sequential contraction).
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