It Will Take Years for the Restaurant Industry to Recover

Rabobank’s 2022 target stems from two main detractors: lower contributions from foodservice growth (price and unit growth, which accounted for nearly 90 percent of foodservice expansion over the last five to 10 years), and a likely protracted economic recovery, notwithstanding the surprising quick jobs recovery outlined in May by the Bureau of Labor Statistics, when restaurants gained 1.4 million jobs.

What also needs to be considered is how the speed of recovery won’t track uniform across all sectors.

U.S. restaurant sales increased at a consistent compounded annual growth rate (CAGR) over the last five, 10, 20 years (5.3, 5, and 4.9 percent, respectively) compared to a steady deceleration in food retail trends (2.7, 2.9, and 4.9 percent).

This growth, though, was not one-size-fits-all. And those divergences are poised to only accelerate as restaurants emerge from COVID-19 lockdowns.

To put this in perspective, limited-service restaurant sales increased at a 6.9 percent CAGR over the last three years. That’s nearly twice the rate (3.6 percent) of full-service venues. Rabobank expects this to widen as counter-service sales lift 3.5 percent over the next three years versus a decline of 2.5 percent for sit-down brands.

The reason: The standard drivers of quick-service growth—demographics, convenience, behavior trends, improving quality—will not only remain in play in a post-COVID-19 landscape, but will be further augmented by a higher number of full-service closures, permanent dine-in constraints/changes, lingering health-and-safety concerns and a slower recovery during periods of low or no economic growth. Additionally, older, more wary consumers typically over-index to full-service restaurants.

Nearly two-thirds of independent restaurants are full service (versus 15 percent for chained/franchised). It’s a segment more at risk of permanent closure than any other. The Independent Restaurant Coalition said in June that 85 percent of independents could close without direct aid, which would strike a severe blow to the industry. Independents generate about $760 billion in sales and employ 11 million people. The Coalition warned independents were more in danger of permanently going out of business due to the pandemic because consumer spending at these establishments has been disproportionately affected and they lack the same access to capital markets.

“Mass failure may also destabilize the commercial real estate market if these restaurants cannot pay rent, which could also incite a spillover effect in the larger economy,” it wrote in a report released by Compass Lexecon.

The Coalition added independent restaurant revenues dropped more than 70 percent in the final two weeks of March and are still 60 percent lower compared to last year. At least 4.5 million of the roughly six million jobs lost in the food and drink industry came from independent brands.

Generally, independents have lower margins and access to less relief on rent and other fixed costs. They also entered COVID-19 with underdeveloped off-premises business and higher levels of financial stress.

A post-COVID-19 survey of small businesses by the National Bureau of Economic Research showed only 30 percent of restaurants expected to remain open by the end of the year if the current disruption lasted even four months. That was last among all retail/consumer sectors.

Rabobank, even with the CARES Act in consideration, projects as many as 50,000 to 60,000 independent restaurant closures, or 15–20 percent of the entire field. Looking at the bigger picture, it would slice 8–10 percent of all restaurants in the next 12 months.

Where the investments are headed

Coming into COVID-19, off-premises sales increased nearly four times faster than dine-in business, accounting for about 80 percent of restaurants’ U.S. dollar sales growth over the last three years. Many chains have seen their numbers triple in recent weeks.

Rabobank said the trend should strengthen meaningfully after the crisis as consumers become comfortable with off-premises options given the extended trials during lockdowns, the continued growth of delivery platforms, the expansion of operators’ off-premises capabilities, and the evolution of kitchen and packaging capabilities to narrow the gap between the carryout/delivery and on-premises experience.

In other terms, it won’t boil down to customers fearing dining in, and thus ordering takeout or delivery (like it has for months). They’ll tap the option because of trends that were already surging, such as convenience. Only now, the adoption rate will be much higher and the consumer far more comfortable with the service.

A lot of restaurants, so far at least, appear to be holding off-premises sales gains as dine-in business rebounds. This has been true of Bloomin’ Brands, Darden, and Chipotle. The latter of which said it’s sticking in the 70–80 percent range.

This, coupled with the ongoing strength of quick-service off-premises sales, leads Rabobank to project off-premises will account for more than 100 percent of restaurant sales growth over the next three years.

What’s going to happen to the restaurant landscape?

On the topic of growth, the count of U.S. restaurants and bars increased at a 2.2 and 2.5 percent CAGR over the last there and five years, respectively. Roughly 45,000 new restaurants (net of permanent closures) opened in the last three years—more than in any other comparable period over the last 25-plus. It’s something that was leading many pundits to suggest a course correction, like the one that flooded retail, was in the works already. There were just too many restaurants, too many choices, and too few customers.

In a story about the sudden proliferation of bankruptcies in the foodservice sector, Dave Bennett, CEO of Mirus Restaurant Solutions, previously told FSR the industry could be headed for a 15 percent reduction over the next few years, or the elimination of roughly 100,000 restaurant sites. Darren Tristano, CEO of Foodservice Results, also said earlier oversaturation was leading to declining traffic. In turn, restaurants started to raise prices to remain viable. Those who couldn’t found themselves “on the bubble.”

What did this course correction project to? Bennet explained it as a split into two industries: retail focused and convenience, where the food is brought to you.

It’s not all that different from what Rabobank envisions. The rate of expansion accelerated meaningfully, from growth of 1.7 to 1.8 percent over the last 20 years, as operators jumped in to take advantage of decades-low unemployment levels, rising discretionary incomes, favorable demographics, and multiplying delivery and ordering options, which totaled more than a third of overall foodservice sales growth in the last three to five years.

But this benefited some more than others. A “zero-sum game” as Bennett called it, where one concept’s growth potential came at the expense of somebody else’s. Rising rents in retail malls and high-traffic areas, such as the urban locations so many fast casuals gravitated toward when prices dropped, put the industry at an inflection point pre-COVID-19. These brands were suddenly strapped with expensive leases, declining guest counts, and high costs (mostly jump-started by wage pressure). Also, there was an abundance of inexpensive money dipped into by restaurants out of the financial crisis. And as interest rates climbed back, those same parties had to write debt at a higher interest rate.

Which leads us to the post-coronavirus world. Rabobank said the pandemic’s weight will likely impair the restaurant industry’s long-running expansion cycle. The company believes the pace of new restaurant openings will fall back to long-term averages, shaving 40–60 basis points from the future outlook.

Some reasons why:

New consumer habits and regulatory requirements will discourage potential new entrants. While it’s too early to understand what COVID-19-fueled changes will stick, there’s little doubt heightened safety concerns over public gatherings, increased telecommuting, less corporate travel, and a greater shift to off-premises consumption will linger. Many additional state- and city-wide rules and regulations will also pressure potential new restaurants and make it harder for current restaurants to reopen, even as restrictions are eased or lifted.

This could lead to, as other reports have suggested, the big chains getting bigger out of COVID-19.

Permanent closures will rise steeply, much worse than past economic recessions. During the Great Recession, only 5,000 net new restaurants were added between 2007 and 2010, compared to nearly 25,000 in the three-year period before the crisis. As explored earlier, the financial downturn spurred future growth due to lowered barriers to entry, like rent, but it didn’t happen amid the heart of the problem.

Rabobank predicts a much greater rate of attrition from COVID-19, including a recession on the heels. Noted earlier, 15–20 percent of all restaurants are at risk, particularly independents and small chain/franchisees.

Elevated operating cost pressure EBITDA and cash flows. This will heighten if the currently mandated capacity reductions and safety-related procedures become a lasting part of restaurants’ operating procedures. Most independent and smaller operators were likely generating single-digit EBITDA margins before facing additional/elevated operating costs from coronavirus disruptions. This will make it even harder for current operators to stay open and attract new ones.

Growth capital becomes scares for independents and smaller franchisees (less than 10 units). Banks could demand a higher rate of returns in light of potentially higher operating and bankruptcy risk.

Larger competitors scale back expansion expenditures as they look to build up cash reserves, reduce leverage, and ramp up investments behind off-premises capabilities. Rabobank said strengthening the balance sheet with greater financial flexibility will likely remain the top priority well beyond 2020/2021, closely followed by further investments to improve off-premises and digital capabilities. For some, this could relegate expansion plans to the backburner. For others, like Chipotle, which wants to broaden its drive-thru footprint, it might present a landlord-friendly dynamic to grow the aspects of its business best suited for a post COVID-19 world.

More M&A, bankruptcies?

Rabobank said M&A opportunities are ready to accelerate as COVID-19-driven sales deterioration, along with economic recession, spur the pace of exit and consolidation in an already highly fragmented industry. Nearly half a dozen relatively high-profile closures/bankruptcies have already occurred since mid-March.

Rabobank added the pace could quicken as temporary lifelines, like the CAREs Act, expire and weaker restaurants run into even more stringent liquidity return hurdles to stay in business. Sellers’ motivation could be further enhanced by an uncertain future tax outlook due to potential changes in the political environment and/or the necessity if paying for the recent stimulus measures.

Here’s another sign to keep an eye on: Large publicly traded restaurant companies have raised significant cash (new issuance and/or drawdown on existing credit lines) since COVID-19 landed. In some cases, it’s come in far excess of their near- to intermediate-term cash needs. In fact, Rabobank said, aggregator cash holdings by 25 of the largest public brands have more than doubled, from $9.4 billion pre-virus to nearly $20 billion in mid-May. Each of these chains now carries more cash than before coronavirus struck.

Rabobank believes this recent cash build-up is not just a defensive strategy intended to improve liquidity and project balance-sheet strength. It also could signal a more aggressive M&A stance, as foodservice sales recovery takes hold and economic recession brings acquisition multiples down to attractive levels.

Dollars will be up for grabs in a less saturated industry, leading larger and stronger brands to go after new customers.

Restaurants focused on off-premises and value-oriented service will have a chance to quickly expand through “bolt-on” acquisitions. Companies with deep or patented technology, and logistical capabilities for online sales and delivery will be attractive. So will those with innovative concepts, like ghost kitchens.

A more moderate sales growth outlook and limited balance sheet flexibility may reduce sellers’ expectations, too, eliciting greater interest from both strategic and private-equity buyers. “Though the companies/brands likely to be available would potentially be most at risk from a more challenging operating environment, we believe that even some of the more desirable targets will attract opportunistic buyers as acquisition multiples return to attractive levels,” Rabobank said.

To put in plainly, the industry is in line for significant changes. The dynamics might never look the same. Like with any major change event, winners and losers will emerge based on their relative positioning and how fast they adapt to new norms.