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Looking for hospitality’s ‘silver lining’

While investor sentiment in the hospitality industry appears to be low, a shakeout of capacity could be just the thing that the strong brands need in order to thrive…

The potential upside:

The pandemic has acted as a catalyst for change across most industries. For hospitality, it has had a marked impact on capacity in the sector, with more sites leaving the sector than joining it. There is, however, the chance of mothballed units returning to the market, we cover this possibility below.

Capacity reduction:

Recently, at Restaurant Group’s interim results, the company presented research to analysts that showed restaurant capacity down c20% since pre-pandemic times in the independent and casual dining restaurant segments.

This figure is similar to the number that Alix Partners reported in its CGA Market Recovery Monitor for August, which showed capacity in the casual dining segment down 18.8% in June 2022 compared to March 2020. These figures agreeing suggests that they might be in the right ballpark

At the same time, volumes for the survivors are well down on 2019 levels, perhaps by mid teen figures. Combined, this could mean a volume reduction of perhaps 30% plus. Effectively 70% as many people may be going to 80% of the former number of restaurants.
 
The ‘silver lining’:

The pandemic gave rise to this sharp correction by creating an extreme business environment where barely economically feasible units closed much faster than they would have in more ordinary times.

However, this shakeout of capacity could prove to be an overcorrection. Let’s say, as an aspirational product, spending in restaurants runs at 1.25x GDP growth. Long term GDP growth may be 2%. So, leisure volume growth should be 2.5%. Clearly, at the moment, it isn’t.

In the scenario of an overcorrection, trade would seek to return to the long-term trend of demand growth. A return to trend could give rise to blistering like-for-like sales if demand were to materially outstrip supply. We expect the winners to win. The hospitality industry is currently at the nadir of the chart below:

This period of exceptional like-for-likes could see good operators being valued on high PE ratios, despite the overall picture just being the industry returning to the long-term trend. This means investors could be facing a moment of opportunity before the return to trend begins.

A quote from Graeme Smith, MD & Head of Corporate Finance Advisory, AlixPartners: “while the fundamental, longer-term outlook for the sector is strong, a higher degree of volatility will likely return…Operators are experiencing massive cost increases…This inevitably means more closures and churn, but significant market share opportunities for the best businesses and brands.”

A word from the Devil’s advocate:

There are a number of assumptions being made here. None of them are crazy but, for the sector to enjoy mega-growth, they might all need to come right. Any very rapid growth would likely lead to increased capacity and any mothballed units could be brought back online.

The decline in volumes could be a sign of structural change within the industry. Langton estimates that delivery has trebled and then lost a third, meaning that it is still above 2019 levels. If it continues to stay above these levels then the long-term trend growth for volumes in casual dining restaurants might be lower than expected, leading to less punchy catch-up like-for-likes. But of course, the delivery food needs to be cooked somewhere, most obviously in restaurants.

There is no certainty and no guarantee as to timing. With an ongoing consumer squeeze and falling real incomes, consumers could keep shy of non-essential spending such as dining out. This might make a return to trend protracted and dampen future like-for-likes.

The ONS shows the squeeze on real incomes with the following quote: “growth in total and regular pay fell in real terms (adjusted for inflation) on the year in May to July 2022, at 2.6% for total pay and 2.8% for regular pay; this is slightly smaller than the record fall we saw last month (3.0%), but still remains among the largest falls in growth since comparable records began in 2001.”

However, some very good operators are opening profitable units into a smaller market with less competition. This could be challenging in the short term but, over the medium and longer term, it could be very rewarding indeed. Investors will be keeping an eye out for the starting gun – like-for-like figures that signal the reversion to trend.

Contact – James Brumby – +44(0)20 7374 4588
james.brumby@langtoncapital.co.uk