The National Restaurant Association’s Restaurant Performance Index for March dropped to its lowest level since the Index began in 2002. The 95.0 reading was down from 101.9 in February, with 100 being the separator between expansion and contraction. The RPI is equally weighted between the Current Situation Index (93.1) and the Expectations Index (97.0). The Expectations Index is usually the higher of the two and measures operators 6-month outlook, but it is telling that this figure is still below 100 looking out to September.

Coming into 2020, there was a growing chasm between the valuations of many restaurant brands that get significant franchise royalty revenues and their franchisee operating counterparts. Franchisee valuations have lagged as margins have been squeezed by factors including costly third-party delivery services. Perhaps these costs will be abated once this subindustry experiences some consolidation like Uber’s recently announced attempted takeover of Grubhub. Or maybe this will further squeeze the bottom line for restaurant operators as these delivery companies compete less. Either way, franchisors clipping royalties off the top of revenues have been protected, and their asset lite approach has streamlined operations. However, the success of this business model is premised on the idea that operator margins may be squeezed but their revenues will not materially decline. The demand shock created by COVID has burst the bubble on this investment thesis, which has brought down valuations for franchisors and operators alike. It will be interesting to see going forward how this impacts the separation between brand and operator as franchisees have long bemoaned expensive capex requirements that are a use of cash and may increase revenues and profits in unequal measure.

Restaurants with significant leverage (debt or other fixed costs such as rent not tied to a % of sales) are likely to fare worse than others. Brand may also play an increased role as consumers seek to “support local.” Stay-at-home orders have seen grocery bills increase and restaurant trips confined to takeout. In certain areas, restrictions have been eased including Nashville, where retail and restaurant businesses are allowed to open at 50% capacity as part of Phase One of the city’s reopening plan. While government’s allowing restaurants to reopen is the first step to returning to normalcy, there are many more steps to go. First, restaurants must be willing to reopen amidst concerns about staffing and profitability. For restaurants to be willing to open, they must believe customers will be willing to return as well.

Despite now being allowed to open, not all restaurants will opt to flip the switch and open their doors.  There is a myriad of potential reasons, but we will highlight a couple key issues. First is labor. In April, 20.5 million jobs were lost, and 5.5 million of these were in food services. Rehiring at this scale doesn’t happen overnight. Also, the CARES Act signed on March 27th increased unemployment benefits by $600 per week through the end of July. For an employee making $10/hour in Tennessee, they would be eligible for a total of $800/week in benefits from unemployment between state and federal.  While unemployment originally would have only replaced half of the worker’s $400/week wage, they would now be receiving double. This significantly impairs the ability of restaurant owners to compel staff to return.

This presents a problem for employers who are required to restore employment under the terms of the PPP to make loans forgivable. On May 3rd, the Treasury Department issued guidance that if businesses could document a rejected written offer, this employee will be excluded from the forgiveness calculation. Receiving unemployment benefits requires people to be “actively searching” for a job. While this has historically been only minimally enforceable, the PPP loans will cause written documentation to be provided to the government that people are ineligible for unemployment, which may increase compliance. But this will strain labor relations as many will view themselves as underpaid.

An effective pay cut is not the only thing that would keep staff away from work. Even management-level employees are not necessarily eager to return to work with the potential health and safety risks. While staying below full capacity is likely safer than reopening all at once, the risk is certainly not eliminated. People have been strongly encouraged or required to wear masks in public, but masks will be decidedly less prevalent in between bites of a meal.

Finally, restaurant owners have to perform their own cost benefit analysis as to whether it makes sense to reopen, just like they had to determine whether or not to offer takeout or close entirely. Certain overhead expenses like rent are considered a cost of doing business, except for some companies who opted to forego rent payments. Many expenses, however, are variable such as food costs. If restaurant owners decide to reopen their doors, they will have to pay for inventory, bring back workers, and incur the majority of their typical expenses. Incorrectly projecting consumer behavior can lead to spoilage. On the other hand, people returning to their favorite restaurants expecting their favorite menu item may deal a blow to reputation if items aren’t properly stocked. For many, reopening will not make sense if revenues are only 25-50%.

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