With the lasting effects of COVID-19, the restaurant industry − besieged by loss of customers and staff, changing consumer preferences and even forced closings − needs reasons to believe there’s a way to effectively navigate this transition.
Grant Thornton Strategy & Transactions senior industry professionals Ryan Maupin and Eric Burgess evaluate what the past year has wrought in the industry and offer some ways to forge a path forward, including using the December 2020 stimulus bill tax provisions. Both Maupin and Burgess say it’s important to analyze what the particular pressure points for the restaurant industry were before the downturn. COVID-19 did not affect all industry sectors equally – far from it.
Past is prologue
Pre-COVID-19, the restaurant industry was facing several challenges. Among them, a trend among some states imposing mandatory minimum wage increases that were affecting restaurants’ bottom lines. Commodity prices in beef and seafood had risen, hurting restaurants specializing in those fares. Finally, the industry was oversaturated with concept restaurants of similar types and chains, with normal market forces already starting to identify the winners.
What COVID-19 has done, Maupin said, is magnify the effects of those trends in those subsectors of the restaurant industry.
It’s a mistake, though, to only see the effect of COVID-19 as accelerating existing problems in the restaurant industry, Burgess said. Even some poor-performing companies will survive if they happen to be in a sector that, overall, is doing well, such as fast food. These restaurants are actually outperforming historical results during COVID-19 restrictions and will likely fall back to pre-COVID-19 levels post-pandemic.
Hard choices for survival
The key to survival for a distressed restaurant company, big or small, is to start with the EBITDA performance within the company’s four-wall stores. For a restaurant chain, break down which portion of its footprint is performing or at least breaking even in cash flow. Same store sales performance is another key KPI to review closely. From there, management can determine which locations are profitable and salvageable.
“The earlier you can identify your top performing locations, the better. I tell that to clients regardless of retail or restaurant industries,” Maupin said.
For a bankruptcy proceeding, Maupin said a Chapter 11 procedure should not always be viewed as an end to the business, but as a way to take advantage of powerful legal tools that can lead to a business’s survival. First off, one of the biggest burdens for underperforming restaurants is executory contracts with its landlords. The Chapter 11 process allows for debtors to either renegotiate key terms of the lease (e.g. rent amounts) or reject the lease outright in the case, thus converting the unpaid obligation to a general unsecured claim.
If a sale of assets to maximize value is the ultimate goal in the process, getting unprofitable locations eliminated is essential. “No reasonable buyer is going to offer cash for a restaurant chain with half of its store base performing at negative EBITDA levels,” Maupin said. “There has to be an angle. That angle is taking those unprofitable leases out of the formula and reorganizing around a profitable store base.”
On a brighter note for the struggling industry, low interest rates and several record years of fundraising continue to fuel private equity interest and investment in M&A transactions. Burgess said buyers are interested not only in fast food chains that are doing well through COVID-19, but in casual and high-end restaurants which have been hit hard and may not be recovering as quickly, if at all.
What will matter, even with failing locations, is if a buyer can still envision making money, even long-term. Steps companies take in Chapter 11 also remove many encumbrances for private equity investors. Geography will have some impact as well, as corporate gatherings previously held in urban locations are on the decline, while many suburban locations are now outperforming those restaurants.
A key for evaluating which individual assets should be put up for sale is when, in early 2020, banks may start recalling debt on distressed companies. An examination of debt covenant performance will trigger these evaluations, as many banks are requiring that restaurants report monthly rather than quarterly.
While the prospects of salvaging distressed restaurant companies should be encouraging for many, particularly with recent reports of a COVID-19 vaccine, there are some trends that may be more permanent.
The use of third-party food delivery companies has helped many businesses survive the economic downturn. The dependency on these third-party arrangements has created its own dependency problems, in that the services are starting to charge more and dig deeper into a restaurant’s profit margin, Burgess said. The return of somewhat normal eating habits may give restaurants more negotiating leverage when they aren’t as dependent.
However, the impact of COVID-19 on casual dining, and particularly high-end dining, may be long-lasting. Burgess said the loss of business lunches at high-end restaurants has been crippling, as so much of their income was dependent on them. Many corporations cut sizable client entertainment expenses this year, and may have found business proceeding more or less normally, putting a question mark on reinstating them when face-to-face business interactions become normal again.
Operations of high-end dining establishments also depends more heavily on the talent of knowledgeable servers and expert chefs. The restaurant closures could have driven many in this field to leave the industry, thinning the pool of talent available.
What is the government’s role?
In March 2020, the Paycheck Protection Program (PPP), a centerpiece of the CARES Act stimulus package, was created to provide immediate relief for many, including the restaurant industry. However, the program got off to rocky start when, by April 3, the Small Business Administration announced that the $350 billion set aside for the program had been allocated. Revelations that larger corporate restaurant chains had squeezed out many small businesses led some to give back the money.
That said, restaurants seeking forgiveness for PPP loans may still face an issue over employee retention. Maupin said many restaurants taking out loans were in states or municipalities where lockdowns were imposed, making layoffs inevitable without the ability to bring in revenue. However, PPP loan forgiveness is predicated on retaining employees, and restaurants in those states may not qualify because the state or local rules forced them into a situation they didn’t anticipate.
In December 2020, restaurants received some good news with the approval of a new stimulus bill, which passed with overwhelming bipartisan support. There are number of stimulus bill provisions that will help restaurants, including another round of PPP funding and an advantageous revamp of the CARES Act’s employee retention credit.
The CARES Act created a 50% credit for employee retention for up to $10,000 in per-employee wages if the business was fully or partially suspended due to a government mandate or lost more than 50% in gross receipts in a quarter compared to the same quarter last year. The December 2020 stimulus legislation increases the credit to 70% per up to $10,000 in wages for each of the first two quarters of 2021, with an overall cap of $14,000 per employee. The gross receipts quarter comparison qualification is dropped from a 50% to a 20% reduction from the prior year’s quarter. Finally, the employee threshold for determining wage qualification was increased so that wages of employers with up to 500 full-time equivalent employees can qualify for the credit.
Furthermore, the stimulus bill reverses previous IRS guidance to allow taxpayers such as restaurants to fully deduct expenses even when they were paid for by forgiven PPP loans. In addition, the loan and loan forgiveness will remain excluded from taxable income. The PPP deduction fix will allow these to be claimed on a restaurant’s 2020 tax return.
One other encouraging stimulus bill provision for restaurants allows businesses to fully deduct meals “provided by a restaurant” in 2021 and 2022. The Tax Cuts and Jobs Act previously had removed an exception allowing some business meals to qualify for a 100% deduction, making it a uniform 50% deduction for all meals. The new stimulus bill not only restores the 100% deduction but appears to have expanded it to include any meal provided by a restaurant.
Negotiating the pathways to bring a restaurant business to stability and profitability sometimes can require skills and knowledge that are beyond the abilities of restaurant management. Professional advice can often be a productive way to navigate difficult assessments and procedures with an unbiased appraisal of the situation.