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Restaurant Stocks Are Rallying -- Here's Why You Should Avoid Them

By Rich Duprey – Oct 9, 2020 at 8:54AM

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They're no longer the tasty investment they were just a few months ago.

The restaurant industry is in trouble. Although the stocks of many chains have rallied during the pandemic, with the S&P 400 Restaurant index is up 90% from the industry low point in March, many restaurants are still hurting.

Ruby Tuesday just declared bankruptcy, following in the footsteps of Chuck E. Cheese parent CEC Entertainment, California Pizza Kitchen, and the biggest franchisee of Wendy's (WEN 1.20%) and Pizza Hut, NPC International.

Empty outdoor restaurant dining area

Image source: Getty Images.

Yet even for restaurant operators that have seen their stocks more than triple in value since March, including Olive Garden owner Darden Restaurants (DRI 1.37%), Chili's parent Brinker International (EAT -1.22%), and IHOP owner Dine Brands (DIN -0.64%), investors might want to think twice about trying to ride them any higher.

There remain dark clouds on the horizon that would make an investment in even these recovering restaurant stocks a risky bet.

Tight quarters

While many restaurants were able to survive through COVID-19 disruption by falling back on takeout and delivery, it was outdoor seating and loosening restrictions on in-restaurant dining that really helped the industry gain traction again. Tents in restaurant parking lots popped up overnight like mushrooms sprouting, and sidewalk seating helped chains expand upon the capacity limitations many cities and states imposed on indoor dining.

Darden president and CEO Gene Lee had told analysts early on that social distancing mandates were a high hurdle to get over: "[O]nce you're past 25% occupancy," he said, "the six-foot restriction on social distancing trumps any other restriction there is, because you can't get to 50% [capacity]." The company was fortunate that its Longhorn Steakhouse chain was essentially one big room where seating could be rearranged as needed. But Olive Garden's built-in booths and family dining aesthetic made distancing more difficult, and it was experimenting with glass dividers.

Fiscal first-quarter sales were still down significantly with revenue dropping 28% for the three-month period ending Aug. 30 as same-restaurant sales fell 29% year over year. Darden is still financially stable, and it reinstated a quarterly dividend, but many other chains may not be so fortunate.

Winter is coming

The outdoor dining option that many restaurants enjoyed during warmer months is about to come to an end. Cool fall weather will give way to cold winter weather and storms that will make outdoor seating an impossibility for chains operating in the affected regions. That means restaurants will be at the mercy of their indoor seating capabilities and the capacity constraints of 25% to 50%. That means the boost to sales the restaurants received from their dining rooms reopening may collapse once again.

John Cywinski, Applebee's chain president at Dine Brands, said in July that its dining rooms represented 85% of the restaurant's business pre-COVID-19, and despite 97% of the locations reopening, 64% of its sales last quarter came from dining rooms. 

Certainly, business has improved as the pandemic progressed, and in the last week of July, Applebee's comps were down about 16%, a better result than the 37% decline experienced at the beginning of June. Yet as colder temperatures settle in, these numbers are likely to deteriorate once more.

Drive-by benefits

Casual dining restaurants could be the worst hit, while fast-food chains may be able to persevere. Where takeout and delivery have come to comprise far larger proportions of casual dining chains' revenue -- Applebee's has seen off-premise sales grow to 36% of the total, while they reached 45% for Darden -- quick-service outlets like McDonald's (MCD 0.63%) and Wendy's were built around takeout.

McDonald's, for example, typically sees its drive-thru windows account for two-thirds of its sales, but during the pandemic, they represented over 90% of the total. The importance of drive-thru has not been lost on chains straddling the fast food and casual dining concepts.

Chipotle Mexican Grill (CMG -0.51%) says over 60% of the restaurants it opens this year will have a Chipotlane drive-thru option, while 70% will have them next year. Shake Shack (SHAK -2.60%) says drive-thru windows will be an essential part of its business going forward with windows from drive-thru or walk-up getting punched into the walls of its restaurants wherever possible.

Even with outdoor seating allowed, restaurants were unable to fully recapture sales, and as that option diminishes for many chains, the strong recovery their stocks experienced may fade. While buying shares of casual restaurant chains has paid off handsomely for investors in 2020, the industry may have reached its near-term peak, and investors should consider locking in their existing gains before winter weather -- and a possible resurgence of COVID-19 -- sends restaurant stocks sliding for a second time this year. 

Rich Duprey has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Chipotle Mexican Grill. The Motley Fool has a disclosure policy.

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