An 'Extinction Event' for America's Independent Restaurants

By Berna Barshay

Wednesday, July 1, 2020

Things are getting worse, not better for America’s mom and pop restaurants…

In yesterday’s Empire Financial Daily, I shared a chart of the year-over-year change in seated diners utilizing a reservation in Houston, with data courtesy of reservation app OpenTable.

The chart showed that after six weeks of steady improvement upon reopening, reservations fell back dramatically when the city emerged as a COVID-19 hot zone.

The greater U.S. looks a lot like Houston, although with a lower peak recovery…

It’s possible that this is just a blip, but as I wrote yesterday, even if restaurants are open, people won’t dine in if they have safety concerns.

Public health experts are cautious on the current safety of indoor dining…

As I was flipping channels last night, I happened to catch Ashish Jha, the head of the Harvard Global Health Institute, warn viewers that “we should get rid of indoor large gatherings, including bars and probably restaurants at this point.” Asked if he would recommend that consumers in states allowing indoor dining not partake in it, he responded…

There may be a few places, Vermont where the number of cases is so low across the state that it might be safe… But would I do it in any of the hot spots? Absolutely not… mostly the answer is no, not right now. I don’t think it’s safe. Certainly, in hot places, the 12 states or so where things are really bad, I think there is no way you can justify that.

Dr. Jha’s comments came the same day that Dr. Anthony Fauci, director of the National Institute of Allergy and Infectious Diseases, testified to a Senate Committee that bars should be closed. Before going on to make the dire prediction that U.S. daily COVID-19 cases could soar to 100,000 per day, Fauci cautioned, “Congregation at a bar, inside, is bad news. We really got to stop that right now.”

Privately, many doctors around the country are giving their patients the same advice: avoid indoor dining.

These comments from the medical community may render any local regulatory decisions moot. If enough of the dining public listens to what doctors are telling them, restaurants won’t fill up.

While these warnings won’t last forever, most restaurants don’t have much time…

Permanent closure notices are already flooding in.

Some of New York’s most renowned restaurants – such as Gotham Bar & Grill and Charlie Palmer’s Aureole – have already made their temporary shutdown permanent. Both Michelin-starred restaurants had been in business for more than 30 years.

The story is the same around the country, with iconic restaurants such as Charleston’s McCrady’s, Austin’s Threadgill’s, and San Francisco’s Locanda all announcing permanent closures.

For many restaurants, things won’t get better until tourism returns. Even if New York City finally brings back indoor dining, the hundreds of restaurants in Times Square are all endangered with Broadway closed through year-end and foreign tourists nowhere to be found.

It’s the same story at tourist centers around the country, and for bars and restaurants adjacent to major sports arenas.

In an industry where 80% of entrepreneurs will fail within five years, it’s heartbreaking to see decades of work and livelihoods go up in flames for the talented, hardworking folks who had managed to defy the odds prior to the pandemic.

Even in areas where the virus hasn’t been as widespread, restaurants have struggled…

The Atlantic did a deep dive last month into the troubles plaguing the restaurant industry. Appropriately titled “An Extinction Event for America’s Restaurants,” the article recounted the troubles facing Tulsa, Oklahoma restaurateur Elliott Nelson, who owns 20 restaurants and is contemplating a bankruptcy filing…

Over the past 15 years, Nelson has built a diverse collection of restaurants, from a classic Irish pub to a three-story Mexican cantina, that helped breathe new life into the city’s downtown.

When he reopened most of his establishments on May 4, he was optimistic. Oklahoma’s shutdown, announced on April 1, hadn’t been as strict or encompassing as California’s or New York’s, and the combination of big, open restaurants; a young clientele; and perfect spring weather led him to believe that people would come back quicker than media reports were suggesting.

But few diners have returned, Nelson told me, not even to his 4,000-square-foot outdoor beer garden. Revenue is down 81% from the same period last year. “It’s a post-apocalyptic, Walking Dead vibe,” he said.

Adding to the huge drop in revenue is the expense of keeping his restaurants safe: temperature checks and health questionnaires for employees, single-use tableware and condiments, personal protective equipment ($12,000 in masks for his staff to date), plus more labor to implement the new policies. “So even though we’re not serving as many people, we need more employees,” he said.

“The simple math I’ve run says that it will take two years of normal sales to balance the hit we took in those four weeks.” Hence, the bankruptcy talk.

Is help on the way for America’s beleaguered restaurants?

As I described back in May, many restaurateurs have proven nimble and creative in confronting these challenges. Some high-end, white-tablecloth establishments – like Chicago’s three-Michelin-starred Alinea – have simplified their offerings, lowered prices, and pivoted to takeout-friendly fare.

Some restaurants have turned into supermarkets, and others have gone into the meal kit business. For every scrappy success story, dozens of others won’t be able to make rent on just takeout, delivery, and limited outdoor dining.

According to The Atlantic, food-service employees made up more than 60% of early unemployment claims, yet restaurants have received less than 9% of overall small-business loans.

Independent restaurants may find some relief through a second chance at Paycheck Protection Program (“PPP”) funds. The deadline for applying for PPP was yesterday, yet the program expired with $130 billion leftover from its $670 billion in funding. It is surprising that anything was left over, given the original rush to apply and frustration of many small businesses that were initially shut out.

Last night, the Senate unanimously voted to extend the application period for five weeks to August 8. The change still needs to pass the House and President Donald Trump still needs to sign it, but it seems to have enough bipartisan support.

For the PPP program to offer a true lifeline, it needs changes to its structure and borrowing requirements…

I laid out the case in my original Empire Financial Daily discussing independent restaurants. Already, some necessary modifications have happened, such as extending the loan utilization period from eight weeks to 24 and reducing the amount required for payroll from 75% to 60%. I suspect most restaurateurs would like the flexibility to spend more than 40% of funds on rent.

And further small-business-friendly modifications may be on the way. Last night, the Wall Street Journal outlined one such development…

Sens. Kevin Cramer (R., N.D.) and Kyrsten Sinema (D., Ariz.) have introduced legislation that would forgive all loans under $150,000. The amount was selected because it would encompass 85% of all PPP loans but only about 26% of the program’s total dollars.

The White House also seems to be on board with steering the remaining $130 billion to small businesses in the hardest-hit industries, including restaurants. Treasury Secretary Steve Mnuchin testified to a House panel yesterday…

There appears to be bipartisan support in the Senate to repurpose the $130 billion for PPP, extending it to businesses that are most hard-hit, that have a requirement that their revenues have dropped significantly, things like restaurants and hotels and others where it is critical to get people back to work.

Mnuchin indicated willingness to work with Congress to make sure the remaining funds end up at small businesses.

Democrats have proposed a few ways to ensure this happens. The Journal reports…

Senate Democrats have proposed legislation that would allow small businesses to take out a second PPP loan if they have 100 or fewer employees. Previously the program was generally open to companies with 500 or fewer workers.

To qualify under the Democratic proposal, businesses would have to demonstrate a revenue loss of 50% or more because of the pandemic and have already spent an initial PPP loan or be on pace to do so.

With the reclosings and reopening delays, restaurants and other small businesses will need help for more than a few more months…

According to a survey from the National Federation of Independent Business, 47% of businesses that took PPP money and/or funds from the Small Business Administration’s disaster loan program expect to need additional financial support over the next year.

With 16 million employees working in the restaurant industry, the government should provide ample funds to keep independent restaurants afloat until things go back to normal.

Avoiding financial collapse at the airlines was deemed strategic, even though the industry employs only 1 million people. Airlines that go bankrupt generally get restructured in Chapter 11 and maintain continuous operations with a headcount pared down at the margins. Restaurants that hit the wall, on the other hand, liquidate and fire every single employee.

Within the next few weeks, we should get a sense of how strategic the Federal government determines restaurants and other small businesses to be.

With greater access to funds in the capital markets, chain restaurants win…

Like it or not, fast food, or quick service restaurants (“QSRs”), are the winners here. As I wrote in the May 21 Empire Financial Daily

The QSR business model can easily accommodate social distancing with minor operational tweaks.

The QSRs are built to withstand a pandemic. No one goes to McDonald’s or Taco Bell for the atmosphere. You eat there for the speed, convenience, bang for the buck, and consistency of product.

Many QSRs already operate drive-thrus, which are perfect for a contactless world. Several of the largest QSRs – including McDonald’s, Domino’s Pizza (DPZ), Starbucks (SBUX), and Dunkin’ Brands (DNKN) – have been investing heavily in their apps for several years, long before the current pandemic.

A well-tested app with a large user base makes for a near-seamless transition from ordering at the counter to ordering ahead for low-touch pick up.

These companies’ ability to tap the capital markets and access all-time-low interest rates only serve to reinforce their competitive advantages over mom and pop restaurants.

QSRs also see a margin bump as takeout and drive-thru replace dine-in and reduce labor costs.

It shouldn’t be a shock that QSRs are doubling down on drive-thrus and online ordering. Starbucks (SBUX), which for years marketed itself as a “third place” – a home away from home and the workplace – announced it will build urban locations designed specifically for takeout. Chipotle Mexican Grill (CMG) is looking to expand the number of locations with a drive-thru, cleverly nicknamed “Chipotlanes.”

Portland restaurateur Naomi Pomeroy, an alum of both Top Chef Masters and Iron Chef, sees a fast-food future. As she warned in the Atlantic article…

People don’t understand that if we don’t figure this out, the result will be the homogenization of our foodscape. Choosing between Subway and Papa John’s – that’s what we should be afraid of.

Given the tailwinds for QSRs, here’s one stock to put on your radar…

In a restaurant landscape that strongly favors QSRs, investors may want to consider the giant of the industry, McDonald’s (MCD).

While McDonald’s will have to contend with the rolling beef shortages plaguing the nation, and may suffer a lingering hit to its breakfast business as offices are slow to reopen, it’s hard to bet on fast food without betting on the inventor and global behemoth of the category.

McDonald’s is well-positioned with a high penetration of units with drive-thrus and an excellent online ordering app. The stock yields nearly 3% and its valuation is less overheated than many of its publicly traded fast-food peers.

In today’s mailbag, another reader reacts to Friday’s Empire Financial Daily on higher ed… and the essay on Kanye West and Gap sparks a question…

Do you trust your state and local governments to only open businesses that are safe, or are you seeking a second opinion from your doctors or ones in the media? Have you been eating fast food more frequently? Which chains are your favorite? Share your thoughts at [email protected].

“Dear Berna, thank you for asking about college students and online learning. I have 19-year old triplets who are all very bright and have ADD and dyslexia. The boys also have dysgraphia. Coming home for online learning was very difficult for everyone. They had just tasted their independence and had to come home from college. One accepted academic coaching and support and did well after taking 3 extra weeks to finish. She was very sad missing her friends and graduation. One was angry and frustrated, saying it was all the worst and none of the best parts of college. The third is not going back to his big college because despite a very high IQ, he could not focus on computer learning.

“The quality and structure of our educational system has many issues. Teachers and students were not ready for online learning. Some will never be, given their brain structure. Some kids will do better to take the year off than do online learning. Poor families with no access to computers or tutoring fell apart, losing free breakfast, lunch, support, and structure. It is, again, the poor and people of color that have suffered and lost 6 months of education.

“Our children are the most important investment we could make. But our society is very short-sighted. Please read some of Art Rolnick’s (former Minneapolis Federal Reserve chief) research on how $1 invested in quality education for 3-year-olds saves $7 in lowering drop-out rates, juvenile delinquency, welfare dependence, etc. Thank you for your work.” – Sloane D.

Berna comment: Thank you for your thoughtful comments, Sloane. It’s a tragedy that the shift to online learning has only amplified the existing injustices in our society. I hope we can get back to in-person learning in the fall, as the current situation only increases societal inequality in so many ways.

“I’ve just joined Empire Financial Research – very pleased to be doing so. One question: Is any chain clothing retailer a good value investment going forward? I have a hard time believing that – with the increasing consolidation of goods and services on Amazon. The question: Should I have such a retail stock in my portfolio?” – Tim W.

Berna comment: Tim, as far as clothing chain retailers go, you’re right that this is a difficult operating environment. Due to fashion cycles and branding, certain apparel companies can, however, buck the trend of a shrinking pie by taking market share…

For example, athleisure retailer Lululemon Athletica (LULU) is up 33% this year (versus the S&P 500 Index down 4%) and hit an all-time high at the beginning of June. It’s certainly not a value investment, considering the high price-to-earnings (P/E) multiple, but it has been a huge winner this year.

Clothing retail isn’t a great business… but as with most topics in investing, there’s no rule to follow here that doesn’t have notable exceptions.

Looking more broadly at legacy brick-and-mortar retail businesses, both home-improvement chains Home Depot (HD) and Lowe’s (LOW) have substantially outperformed the S&P 500 this year. And as I wrote in the June 12 Empire Financial Daily, discount retailers Walmart (WMT) and Target (TGT) will likely come out of this pandemic stronger, as they’ve proven their e-commerce chops and benefit greatly from their omnichannel business models.


Berna Barshay
July 1, 2020

Whitney Tilson
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About Whitney Tilson

Prior to creating Empire Financial Research, Whitney Tilson founded and ran Kase Capital Management, which managed three value-oriented hedge funds and two mutual funds. Starting out of his bedroom with only $1 million, Tilson grew assets under management to more than $200 million.

Tilson graduated magna cum laude from Harvard College with a bachelor’s degree in government in 1989. After college, he helped Wendy Kopp launch Teach for America and then spent two years as a consultant at the Boston Consulting Group. He earned his MBA from Harvard Business School in 1994, where he graduated in the top 5% of his class and was named a Baker Scholar.

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