The first quarter of 2020 is in the books, and though continued economic expansion was looking increasingly weak at the end of the past decade, few would have guessed a day of reckoning was about to be unleashed by a global pandemic. The coronavirus has been wreaking havoc on countless lives, and one of the hardest-hit areas has been the restaurant industry.
Restaurants aren't just a popular sector, though. The industry provides a foundation for small businesses and entrepreneurship that employ millions of people. COVID-19 has quickly undone a great deal of progress on that front. According to research group Black Box Intelligence, comparable-store sales (or "comps" from here on out, a combination of foot traffic and average guest ticket size) collapsed 28% in March relative to a year ago. Most of those declines occurred in the second half of the month, so the worst is likely yet to come in April and May as the economy remains in shelter-in-place mode.
For owners of small dining establishments reading this, hang in there. Adapt to the changing trends (delivery and online ordering) that are sure to emerge once the dust settles. Better times will eventually come back around.
But for restaurant investors, the unprecedented response to coronavirus has exposed those chains that were ready for industry disruption, and those that were certainly not. The news is overwhelmingly gloomy right now, but history says the time to start buying up the highest-quality restaurant stocks is now.
A long downward trend
First, it needs to be acknowledged that, though coronavirus ended up being the catalyst that caused everything to come undone, all was not great with the restaurant industry. According to data compiled by the U.S. Census Bureau, consumer spending on dining out started to exceed spending at grocery stores in 2019. That may have been a foreboding omen of what was to come, or it might be an indicator of long-term consumer trends shifting (more work and play, less time at home). That's a debate that will likely continue for a long time.
But what is clear is that to capitalize on the move toward having someone else do the cooking, restaurants started opening up at a torrid pace. For the first five years following the Great Recession, that was just fine as the American consumer rebounded, but starting in 2015, something changed. According to Black Box Intelligence, foot traffic at the average restaurant started to decline. Though comps continued to increase at times, that was due primarily to menu price increases.
New stores were opening up faster than existing ones could be filled. Five years running, the long downward trend was never going to end well with an increasing number of establishments willing to accept lower profit margins, some of them (like Domino's Pizza (NYSE:DPZ) -- which has thus far been successful in its bid) playing a dangerous game of chicken with peers as they raced to open more restaurants in a bid for market share rather than actual bottom-line returns.
I never thought the industry would get bludgeoned like it is right now, but by the end of December, signs that the industry was nearing some sort of breaking point were emerging. As Warren Buffett has said, "Only when the tide goes out do you discover who's been swimming naked." And many large brands like Cheesecake Factory (NASDAQ:CAKE) and Dave & Buster's Entertainment (NASDAQ:PLAY) for example, were indeed swimming naked with little in the way of liquidity. Suffice it to say, some companies will not be expanding their real estate footprint again any time soon, and others may need to start right-sizing their operations by closing some stores.
Hitting the reset button
The good news is, as we head deeper into 2020 and then start lapping these horrific stats in 2021, restaurant chains will be able to begin growing again using the current situation as a new base to work from. Some of those chains will emerge with deep scars and debt that needs to be repaid, but the best of the best will be in better shape than ever before. Long-term owners of Chipotle Mexican Grill (NYSE:CMG) know a thing or two about hitting reset. After reported cases of food-borne illness traced back to some stores in 2015 and then again in 2018, the chain saw many of its patrons leave.
But since then, at least until the current economic crisis, the company was able to work off of a new base as it rebuilt trust with its guests and invested in new digital sales capabilities. A balance sheet that ended 2019 with $881 million in cash and investments and zero debt made that possible, and 2019 comps grew 11.1% over the 2018 trough. Though it will face challenging times again along with the rest of the industry, Chipotle stock is doing quite well at the moment.
For restaurant stock investors, the last few years provide a valuable lesson. If a brand is expanding while its existing store base is in decline, and if this expansion leaves the company with little to no liquidity for when the economy pulls back, take heed and find the exit. Restaurant stocks will survive the coronavirus crisis, but the best bets are on those that were prepared for the economic shock before it occurred, not those that are nearly out of cash.