We are now almost six months into the COVID era which has affected restaurants like no other in the post World War Two period. The most advanced national mitigation strategy at the moment is to avoid people at any cost. There is no doubt the US will eventually have a vaccine but science and distribution thru the supply chain —and easing of lapsed guest fears—will take time.
There is more restaurant restructuring to come. One day last week, we were greeted with the news of the California Pizza Kitchen Chapter 11 and Pret closing up the Chicago and Boston markets. More will follow. On the independent restaurant side, estimates run from 30% to 70% of sites that will ultimately go dark. While painful, these actions will contribute to eventual industry improvement.
To be sure, there are some good things underway. On the positive side, we should have a pretty good idea now what is going on. US restaurant sales are driven by fear right now. There is some excellent free research that is documenting consumer sentiment. We didn’t have this level of knowledge so quickly in prior years. Also, the initial shock of COVID has been absorbed and some instances of very good management underway can be seen.
Rent and Debt Leverage Must be Improved For A Solid Recovery
Restaurant rents and debt service (principal and interest) were a problem for many restaurant operators pre COVID-19. Rent cost per square foot and some brand and many franchisee debts to EBITDA ratios steadily crept up year after year after the 2008 great recession. No expenses are as fixed as these are in the restaurant cost structure. I’m convinced that the restaurant industry must improve the rent and debt cost ratios for a sustainable recovery platform to be built post-COVID-19.
Some operators owned their real estate and were protected from rent increases. But most brands did not enjoy legacy rents. Rent/CAMS expense of 12-15% of sales for many units of these brands was common in 2019. The problem over time, in lease strategy, is that landlords asked for a fixed dollar amount plus rent overages. As some landlord reps mentioned during the Restaurant Finance Monitor’s Zoom webinars this summer: “our investors don’t expect us to invest in our restaurant tenant’s variability. That why we need fixed rent.” This has become a very difficult situation, with restaurants and landlords at an impasse in many situations.
How to Solve this impasse? Let supply and demand take its course. These days there is no shame in closing restaurants. Last quarter, both McDonalds and Dunkin Brands announced store closings, 200 in McDonald’s US, and 800 in US Dunkin Brands (450 unit closings were preannounced as part of the Speedway gas station kiosk turnover). This took guts by both CEOs who are at risk of getting hammered by investors who seem to only understand the growth of “stores open” counts. Another situation playing out this week is the Matchbox casual dining chain Chapter 11 playing out in DC, with the strategy to renegotiate leases or close units if an agreement with landlords cannot be reached. 
Timing is everything. If a brand is over-stored, this might be the time to “de-store” with customer demand weak anyway for a time. Kudos go to Dunkin CEO Dave Hoffmann and team who worked with franchisees to prune the system to allow for more efficient economics in support of future growth.
Debt: another foundational issue that has to be solved
In the area of heavy debt, the real risk for some brands and franchisees exists where store economics have collapsed and efforts to build take out sales or utilize drive-thru sales units aren’t possible. Some brands with declining store margins were hit by dual requirements to build new units and remodel at the same time. This is best seen in the July Chapter 11 filing of NPC, the 1700 unit Pizza Hut and 380 unit Wendy’s franchisee.  The NPC Pizza Hut units were in decline as was the brand in the US since 2011. NPC went through multiple leveraged buyouts which added debt. NPC funded its Wendy’s acquisition with more debt over the 2013-2017 timeframe. Two private equity firms bought NPC in 2018 with more debt.
One side benefit from COVID is that restaurant M&A deals will likely be of lower dollar value, with lower base EBITDA dollar values going forward. That will produce less strain on acquisition debt and debt service.
One franchise space solution is that the franchisor must assume more control over franchisee’s M&A actions. This standard is expressly or implied in virtually all franchise agreements. YUM would have had several opportunities to weigh in. The other is for the franchisor to ease up on requiring both remodeling and new units at the same time. To be sure, the franchisee should provide annual business plans, with cash flow and new unit/remodel actual ROI results for analysis and learning.
Management Bright Spots
In listening to the publicly traded company earning calls, there were many instances noted of very appropriate management tactics and attitudes noted. For example, many restaurants have put a halt to new company units and required new franchisee unit development, preferring instead to focus on maintenance CAPEX, curbside, and pickup lane projects. Almost universally, share buyback projects were suspended. Some brands, like Shake Shak, have conceptualized their first drive-thru renderings. These are all positive developments.
About the author: John A. Gordon has 47 years in chain restaurant operations, financial analysis, and management consulting roles. He founded Pacific Management Consulting Group in 2003 to work restaurant operations, financial analysis, and strategy consulting engagements. He is a Master Analyst, Financial Forensics (MAFF), who specializes in brand financial analysis reviews, and dispute resolution. He can be reached anytime at 858 874 6626 (office) or email, email@example.com.
 Matchbox Food Group Declares Bankruptcy, Restaurant Business Online, August 3 2020.
 NPC International’s Bankruptcy Should Be a Wake Up Call for Franchises, Restaurant Business Online, Jonathan Maze, July 1 2020.