Ivy Sector Insights – Consumer discretionary
Commentary as of June 29, 2020
Restaurants are one segment of the consumer discretionary sector hardest hit by the COVID-19 pandemic. What are we seeing within this industry?
When looking at the broad restaurant category, we tend to focus on the two segments: Quick Service Restaurants (QSRs) and Casual Diners. QSRs are what we traditionally consider fast food establishments, like McDonald's, Inc., Domino’s Pizza, Inc. and Wingstop, Inc. This segment has done incredibly well during the pandemic despite the initial period of lockdown and shelter-in-place orders. This is largely due to its drive-thru and delivery orientation. Consumers are looking for value offerings and a safe interaction experience, which are conducive to these types of businesses, so it’s not surprising many QSRs have produced sales that are either positive or only slightly negative.
However, it's important to determine whether QSRs recent near-term outperformance is related to the fact that nearly all dining rooms across the U.S. have been closed or have had severe capacity constraints. Both Domino’s and Wingstop have acknowledged their peak sales levels aren't sustainable as alternative dining options open back up.
We believe a large number of QSRs operators will survive the current economic environment given strong sales and operational advantages. Publicly traded QSRs, like McDonald’s, Yum! Brands, Inc. and The Wendy's Company are franchisors that rely on royalties and see no benefit to changes in the restaurant cost structure. Strong operational performance is likely temporary.
The other segment we focus on is Casual Diners. These are chain restaurants like Olive Garden, Texas Roadhouse and Chili's where you sit down and the server takes your order. Unlike the typical QSRs franchisor model, Casual Diners are restaurant groups that typically own their locations and may benefit from potential margin and capital investment structures.
The category historically has been oversaturated and struggled for growth. These chains typically face a number of operational challenges: too many locations, wage and food costs and underdeveloped pickup/delivery offerings that didn't fully utilize kitchen capacity.
Casual Diners were hit hard early on in the pandemic as dining rooms were shut down for months on end. Sales were down more than 80% almost overnight. Businesses don't prepare for these types of events, and restaurants in particular are high fixed-cost businesses with rent and basic labor costs. Many Casual Diners won't generate positive cash flows until achieving 85% – 90% of pre-COVID-19 sales, so even when restaurants are allowed to open at 50% capacity levels, the ability to generate the necessary profits is likely to be limited. We believe as much as 20% of these restaurant groups, mostly smaller, independent operators, are unlikely to survive the current economic environment.
However, times could be changing for the category. The reduction in supply could be a major windfall to the Casual Diners that survive the crisis. Unlike the typical QSRs franchisor model, Casual Diners are restaurant groups that typically own their locations and may benefit from potential margin and capital investment structures. The need to cut cost during the pandemic has allowed these restaurants to simplify their menus and remove high-cost, low-margin products, leading to the opportunity of increased profitability.
Many Casual Diners have substantially grown their carry-out capabilities during the crisis simply to survive. Furthermore, companies should be able to build new locations on better sites at lower costs as real estate begins to open up. We believe these factors make Casual Diners more appealing than QSRs, particularly as we look past this current environment.
The cruise lines segment is another area that was heavily impacted by the pandemic. Is there upside potential here or are the risks too high?
Many investors think that cruise lines offer significant upside potential right now. We believe there are some serious risk factors to consider. First, some cruise lines had to raise equity capital in order to make it through the pandemic. This materially dilutes shareholder equity, which ultimately limits upside potential.
In addition, the industry is extremely high risk as long as we're in this health crisis. There were a number of COVID-19 outbreaks on cruise lines earlier in the year when infection rates were significantly lower than they are now. The thought of thousands of people being quarantined on a boat for extended time periods, coupled with the potential for domestic and international ports to be forced to shut down to prevent further disease spread would be a potential disaster to these companies.
One possible solution would be for cruise lines to offer shorter excursions – two or three day cruises – to lower the potential risk of contagion. However, that option also presents a number of challenges. Short cruises wouldn't necessarily reduce the risk of spreading the infection; it would simply reduce the risk of infected persons showing symptoms during the cruise. A shorter cruise also would negatively impact the amount of time and money spent while on board, sinking profits. Lastly, many customers may not want to spend their vacation dollars on a brief cruise.
Another concern is the high number of sailing credits that have been issued to passengers who had booked cruises that were eventually cancelled this year. When these passengers do return to cruises, they will spend against the credits, limiting any additional cash coming through the door. That creates bridging internal costs, capital expenditures and debt servicing headwinds in the near term.
Finally, look at the history of some cruise lines during the recessionary conditions. Carnival Cruises didn't recover its 2007 operating losses until 2016, while Royal Caribbean took seven years to recover its operating losses.
We believe people will eventually return to cruises. However, as long as COVID-19 cases remain high, cruise lines are not likely to return to normal operations for the foreseeable future, leading to a category that is burdened with supply and high debt.
When consumers think about casinos, destinations like Las Vegas typically are top of mind. Are investors underestimating how well regional casinos that are within easy driving distance could fare during this crisis?
In this COVID-19 era, we believe consumers are less likely to travel by plane and are even less likely to travel without their children. In addition, concerts, movie theaters and sporting events are all closed. We think this creates opportunities for regional casinos and the high energy, local entertainment experience offered to consumers.
Due to social distancing guidelines, nearly all casinos have shut down the buffets, which are typically loss leaders, as well as other low-margin offerings. Fewer slot machines are open to play than before the pandemic, which means less wear and tear on equipment. Casinos also are operating fewer table games right now, so that they don't have to pay as many dealers. Many casinos have pared back on marketing and promotional spending, and people are still coming to play since there is little else to do.
While casinos are highly levered, they have adequate access to liquidity and capital markets and have control over their cost structures. Many states are highly dependent on gaming revenue taxes. The large open-room designs of these businesses allow for high capacity limits. We believe these conditions could create tailwinds for regional casinos to perform to the positive on the other side of the pandemic.
Past performance is no guarantee of future results. The opinions expressed are those of Ivy Investments and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.
Risk Factors: Investment return and principal will fluctuate, and it is possible to lose money by investing. Securities of companies within specific industries or sectors of the economy may periodically perform differently than the overall market.
The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. In addition, the impact of infectious illnesses in emerging market countries may be greater due to generally less established healthcare systems. Public health crises caused by the COVID-19 outbreak may exacerbate other pre-existing political, social and economic risks in certain countries or globally. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.