Away-from-home dining in the U.S. dropped significantly following the pandemic's onset, hitting several segments of the retail and food and beverage industries hard. Although these sectors have improved substantially since the depths of the economic shutdown in the spring of 2020, restaurants and bars continue to suffer from weak customer traffic and sales volumes. November data from the U.S. Department of Agriculture showed that the fall resurgence of COVID-19 erased some of the gains made since the spring (see chart 1). Despite a modest uptick in January, driven in part by the December stimulus package provisions, S&P Global Ratings expects demand to remain weak at least for the remainder of the winter as consumers continue to social distance (see chart 2). As a result, our outlook bias for restaurant ratings remains negative, and we're closely monitoring companies in the food and beverage sector heavily exposed to foodservice. Our outlook for foodservice distributors is more company-specific, with ratings stability expected for large players that we downgraded by one to two notches early in the pandemic. Still, we believe they'll continue to outperform the broader sector. The outlook for smaller, less diversified distributors that have less scale and financial flexibility remains negative. With the pandemic nearing its anniversary in the U.S., there are encouraging signs of stability, with the initial stages of a vaccine rollout underway and as the severe spike in cases following the holiday season start to ebb.

Here, we discuss the rating trends and outlook for the retail and consumer sectors most exposed to away-from-home dining and other off-premise food and beverage venues amid the pandemic.

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Performance Update And Credit Outlook

Restaurants

Most restaurants face a slow recovery but some QSRs have rebounded well.  Restaurants' credit quality on average has deteriorated dramatically relative to pre-pandemic conditions, which were tough to begin with due to increased competition from new concepts and grocers' prepared food offerings. In February 2020, one in 10 restaurant ratings were in the 'CCC' category, which implies there's a 50% likelihood the issuer will default. Currently, one in three restaurant ratings are in this category (see charts 3 and 4). The negative bias across restaurant ratings is more than two-thirds (see charts 5 and 6), reflecting the high level of uncertainty the sector faces until the pandemic is in check. Risk is concentrated in the casual dining sector, where all of our ratings have a negative outlook. On the other hand, about half of QSR ratings have a negative outlook. See table 5 in the appendix for the full list of restaurant ratings.

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We recently extended our timing assumption for widespread vaccination to the end of the third quarter from midyear. The delay in the vaccine rollout means that significant benefits for full-service restaurants won't appear until well into the second quarter. Even when there's widespread immunity, consumers may be wary to return to pre-pandemic behavior. They may also reconsider pre-pandemic dining habits after enjoying the reallocation of that portion of their budget to items such as electronics, décor, and home-improvement projects. Nevertheless, there's reason to expect some pent-up demand for dining out to materialize. On its second-quarter earnings call, casual diner Brinker International Inc. said lines were forming at reopened restaurants after shutdowns in California. Similarly, the company reported expectations of same-store sales growth in January in markets that were not subject to the most restrictive dine-in capacity.

After contracting by more than 20% in 2020, we expect sales in the casual dining segment to improve materially in 2021, but still be below 2019 levels by 5%-10%. Lower labor costs, larger order sizes, and slimmed-down menu options will somewhat alleviate pressure on margins, enabling some issuers to return to pre-pandemic profitability levels this year. Excluding debt issued to bolster liquidity, credit measures should return to 2019 levels over the next 12-18 months. Risks to our base case remain high due to the pandemic's course, new variants, and timing of the vaccine rollout. Similarly, restaurants face the prospect of an increase to the federal minimum wage, which they would be able to offset only partly with increased automation and technology.

On the other hand, QSRs on aggregate have fared relatively better due to their inherent suitability to social distancing and value offering in a weak economic environment. Performance varies across regions and brands. For instance, Yum! Brands Inc. reported ongoing pressure in mall, transportation hub, and airport locations. Three out of its four brands reported positive same-store sales in the U.S., while international results were weaker in the fourth quarter. McDonald's Corp. reported a similar dichotomy between domestic and international sales. In a preliminary sales report, Carrols Restaurant Group Inc. disclosed slightly negative comparables (comps) in the fourth quarter at its Burger King restaurants and comps of negative 12.9% at its Popeye's restaurants, as that brand laps the popular chicken sandwich.

After mid-single-digit declines in 2020, we expect QSR toplines on average to return to or slightly exceed 2019 levels this year, as the sector continues to benefit from off-premise operations through the first half of the year. Lower costs and higher efficiencies associated with take-out and drive-thru service in 2020 supported margin improvement for some issuers, which could reverse as dine-in service returns in the second half of 2021. Franchisors' profitability will remain insulated from rising costs that franchisees could face this year, namely a higher minimum wage and higher commodity costs. In our base case, we assume these risks don't hurt profits too much, resulting in modest margin improvement for most issuers in 2021. We think many will likely be able to restore their credit metrics to pre-pandemic levels by the second quarter of this year.

Foodservice distributors

Foodservice distributors still face an uneven recovery though overall performance has been better than expected, financial flexibility for large distributors is solid, and we believe demand will improve, absent adverse pandemic-related developments.  We lowered our ratings on foodservice distributors by one to two notches at the onset of the pandemic to account for the significant expected performance deterioration that materialized in the second quarter of 2020. This trend has continued to varying degrees through today.

Table 1

There is still uncertainty about the trajectory of the virus, as demonstrated by the tightening of restrictions on food away-from-home establishments in many jurisdictions this winter. Virus mutations could pose a threat, especially if they render the virus more contagious, virulent, or vaccine-resistant.

That said, we have become more optimistic about the sectors' prospects, especially for larger distributors such as Sysco Corp., US Foods Inc., and Performance Food Group Inc. (PFG). Starting in January, several large U.S. states and municipalities eased COVID-19-related restrictions or expressed a willingness to do so. Vaccine rollouts should further bolster the relaxation of dining restrictions and act as a shot in the arm to hesitant restaurant patrons. While still low, the National Restaurant Association's Restaurant Performance Index has rebounded from its first-half lows. Importantly, although the current situation index fell in December due to restrictions that pushed same-store sales down to their lowest since May, the expectations index, which measures restaurant operators' six-month outlook, improved to 102.4 from 100.0 in November and about 97.0 at the pandemic trough in the spring of 2020 (see chart 7).

Chart 7

We think large distributors with significant scale and financial flexibility to weather the pandemic storm are gaining market share at the expense of smaller rivals that may struggle to serve clients. Sysco has disclosed that it won $1.5 billion net new business since the start of the pandemic, while US Foods claims $500 million.

Moreover, the Center for Disease Control recently issued new guidelines, and urged elementary and secondary schools to reopen safely, and as soon as possible, but perhaps at low levels (as little as one day a week). While schools comprise a very small amount of rated distributor sales, it's possible an increase in school re-openings could facilitate some adult workers returning to the office, subject to employer-reopening policies. This could lead to increased demand for breakfast and lunch at city restaurants that still see low numbers of office workers.

Foodservice distributor performance has generally been better than our base case expectations. It's true that credit metrics are weak on a trailing-12-month basis, in part due to the inclusion of the extremely poor quarter ended June 2020 (marginally positive to negative EBITDA), which included dramatically lower demand, operational disruptions, inventory charge-offs, and excess receivable reserves. In our opinion, the subsequent two quarters (ended September 2020 and December 2020) are a better proxy for ongoing subpar conditions, especially since the September quarter was above expectations due to better weather months (outdoor dining) and increased carryout and delivery, whereas the December quarter faced much tougher dining restrictions.

Chart 8 shows annualized adjusted leverage for select foodservice distributors as of the six months ended December of 2020. Annualized leverage is clearly higher than pro forma pre-pandemic levels by at least one to two turns or more, though we expect generally stable levels over the next six months (with EBITDA improvement constrained by higher adjusted debt levels as issuers reinvest in working capital to service reopening restaurants) followed by clear improvement by mid-2022.

Chart 8

In addition to potential adverse virus mutation, economic stagflation--though not incorporated in our base case economic forecast--is a risk. While extraordinary government intervention, including transfer payments, mortgage foreclosure, and rent eviction moratoriums have dampened the damaging lockdown effects, the economy could remain in a weakened state, especially if many small businesses--including restaurants--fail. There could be significant inflation across the economy following extraordinary fiscal and monetary policies that could exacerbate economic hardships.

Commodity food processors

Food processors, particularly meatpackers, have shifted sales to retail and are benefitting from the rebound in QSR demand, but commodity input costs are now turning higher. 

Table 2

Meatpackers and other commodity food processors continue to offset lost foodservice sales with higher retail sales while further benefitting from the rebound in QSR demand that took hold midway through last year. As such, they face relatively better prospects despite an uneven recovery in away-from-home dining. Moreover, protein's share of restaurant consumption is higher at QSRs than casual dining locations because on-the-go meals primarily consist of protein sandwiches and sides (see chart 9). Casual dining meals, on the other hand, include beverages and additional courses that have less meat content. According to a recent working paper published by the USDA this past December, potato- and chicken-based products historically have made up more than twice the share of consumption at QSRs than casual dining locations. Other proteins like cheese, beef, and pork also have higher consumption rates at QSRs compared with casual dining. Given the still-strong retail demand for protein offerings as well as the higher share of protein consumption at QSRs, which continue to rebound, we believe meatpackers and other commodity food providers will likely continue to see sales volumes steadily rebound next year.

Chart 9

Although the topline outlook is relatively more favorable for protein producers, the sector remains exposed to commodity pricing and margin volatility. In fact, we believe the sector's operating margins face a difficult comparison to last year, which benefitted significantly from the supply chain dislocation that occurred at the pandemic's onset. Temporary plant shutdowns due to COVID-19 workforce outbreaks, coupled with strong livestock production in anticipation of better exports sales, led to significant livestock supplies at farms and historically low animal costs for the sector. As a result, beef and pork packing cut-out margins spiked to record highs last year, despite an unprecedented run-up in COVID-19-related operating costs to ensure workforce safety at plants. Although these one-time pandemic-related costs will be lower next year, cut-out margins too will likely trend toward historical averages. Moreover, the USDA projects higher feed costs after last year's smaller-than-expected corn and soybean harvests to result in much smaller ending stocks. In short, despite less pressure on topline performance given the sector's ability to offset casual dining sales with higher QSR and retail volumes, higher input cost inflation tempers the operating outlook for meatpackers and other commodity food producers.

Beverages

Both nonalcoholic and alcoholic beverage companies have benefitted from strong retail demand, but companies with a higher mix of on-premise sales face credit challenges. 

Table 3

Despite the economic shutdowns and away-from-home dining restrictions have had on restaurants and bars, the beverage sector has performed better than our initial expectations. This was certainly the case for U.S.-based alcoholic beverage companies where the exposure to on-premise sales is much lower than in other regions (on-premise sales are about 20% in the U.S. compared with much higher rates from 50% to as much as 80% in other areas). Not only are off-premise sales much more prevalent in the U.S., they continue to grow at a healthy clip domestically, underpinned by strong growth for seltzers, which have reversed share losses in the ready-to-drink category of alcoholic beverages (see chart 10). Moreover, premium prices continue to support the healthy mid-single-digit sales growth for spirits and premium wines. Although the better-than-expected off-premise performance cannot fully offset lost on-premise sales, particularly for companies with more sales exposure outside the U.S., the U.S. sector has been able to reduce advertising and promotional spending to cash flow until the on-premise channels fully reopen, which could occur by the second half of this year. Given this background, we already have begun to return our rating outlooks for some U.S. issuers to stable after revising them to negative at the pandemic's onset. This was the case for Constellation Brands Inc., which maintained strong high-single-digit beer sales growth coupled with debt repayment from its wind divestitures, leading us to return our rating outlook on the company to stable.

Chart 10

Most, but not all, nonalcoholic beverage companies have also leveraged their strong retail exposure to offset lost foodservice demand (see chart 11). Beverage peers PepsiCo Inc. and Keurig Dr. Pepper Inc. (KDP) continue to perform well in the stay-at-home environment, whereas The Coca-Cola Co.'s (Coke) credit metrics--which were already tight for the rating--weakened because away-from-home venues previously generated almost 50% of profits.

Chart 11

PepsiCo is enjoying solid demand overall, thanks to its significant snack portfolio (over 50% of sales) and under-indexing to hard-hit away-from-home establishments. PepsiCo recently said it would de-emphasize acquisitions since it has strengthened its brand portfolio and won't repurchase any more shares following the year-to-date $100 million buybacks to preserve its credit rating. We indicated last year that there's little room from a ratings perspective for PepsiCo to undertake additional moderate-size acquisitions or increase share repurchases because its financial policies have become more aggressive over the past 12 to 24 months and due to the uncertainty pertaining to the coronavirus. Like PepsiCo, KDP is also seeing good demand for its soft drink and coffee products, resulting in mid-single digit reported sales growth and solid margins.

Coke was hit much harder than PepsiCo and KDP because of its high market share in away-from-home venues; reported sales fell by almost 30% in the June 2020 quarter before steadying in the negative 5% to negative 10% range. We believe Coke will end 2020 with around 3.5x leverage whereas the company needs to reduce adjusted leverage to below 3x on a sustained basis by 2021 or risk a downgrade. Given our view for potentially improving away-from-home demand, Coke's stock-keeping-unit rationalization program and its strategic transformation to a more networked organization, we believe it can still reach leverage below 3x by the end of 2021. However, resolution of Coke's long-standing dispute with the IRS over transfer pricing seems to be entering its later stages. If the company doesn't win on appeal, and clear negative outcomes materialize with respect to very large retroactive tax liabilities and prospective tax payments, we would reconsider the earnings power of the business post-pandemic. We would also assess Coke's willingness to take other actions to maintain the rating, including asset disposals and a reduction of its very large dividend, the latter of which we don't currently factor into the rating.

Cost Cutting And Tapping Liquidity Helped Stabilize Operations

Foodservice distributors

Excluding the quarter ended June 2020, foodservice distributor cost-cutting initiatives have generally proven effective at limiting the impact of fixed-cost deleveraging on profit margin percentage. Nevertheless, excluding outperforming PFG, the negative impact of lower demand on absolute adjusted EBITDA has been more pronounced, with around 30%-50% deterioration, and for smaller distributors such as Chefs' Warehouse, breakeven adjusted EBITDA.

At the pandemic's onset, foodservice distributors generally indicated their cost structures were 75% variable and 25% fixed. Gross profit has proven quite variable with margin percentage down only modestly; this slight weakening as a percentage of sales has largely been due to a higher mix of lower margin business (e.g., chain and QSR) and delivery/takeout orders that often exclude higher margin items, such as beverages and desserts. Absolute gross margin dollars are nevertheless down considerably. In response to the pandemic, distributors enacted layoffs and temporary furloughs--which mainly hurt drivers and warehouse workers--while also cutting nonessential expenditures such as travel. Large distributors have also implemented restructurings, which should drive operating efficiencies in an upswing. For example, Sysco Corp. has consolidated its operating entity structure, reducing the number of operating regions to 31 from 76 while US Foods Inc. has moved from six regions to four, which we think will lower managerial costs. Notwithstanding these initiatives, reduced topline performance, restructuring costs, and COVID-related inefficiencies and expenses hurt the sectors' already thin adjusted EBITDA margin (low- to mid-single digit percentage) by 100 to 200 basis points or more (see chart 12).

Chart 12

However, we believe large distributors have at least adequate liquidity to fund operations--including rebuilding working capital--and win business in a food away-from-home recovery. Sizable debt issuances added to cash balances and pushed-out debt maturities such that large distributors will likely be able to weather a prolonged period of lower industry demand. Similarly, the alcoholic beverage sector successfully tapped a combination of committed bank lines and term loans for liquidity, significantly cutting discretionary salary and travel expense while spending less on advertising, promotions, and capital expenditures. The cost cutting enabled companies to maintain stable EBITDA and cash flow. The free operating conversion to EBITDA has remain relatively flat, and we're now seeing companies signal plans to repay outstanding bank loans with built-up cash balances. Companies like Molson Coors Beverage Co. and Constellation Brands Inc. both indicated their intentions to repay term loan balances in the coming quarters as they continue to keep leverage within in targeted ranges.

Beverages

Nonalcoholic beverage manufacturers responded to the pandemic by cutting nonessential costs including travel and advertising, despite having to spend on COVID-19-related prevention measures and absorbing some inefficiencies, though the level of topline stress proved fleeting with the exception of The Coca-Cola Co., which is over-indexed to the away-from-home channel. Heavy commercial paper issuers sold sizable amounts of debt to reduce commercial paper borrowings, add to cash, and in the case of PepsiCo Inc., fund previously announced acquisitions.

Food processors

Although meatpackers may not be benefitting from the cost-cutting tailwinds as much as the foodservice, e-, and beverage companies because of higher COVID-related operating costs, they nonetheless have maintained leverage within expectations given their higher-than-expected margins. Given the sector's history of earnings volatility, companies typically target somewhat low leverage (low 2x debt to EBITDA for most rated issuers). The favorable margin performance last year enabled companies to operate near target levels and, despite our expectation for modest margin pressure next year, we don't expect leverage to be a primary pressure for the sector.

Companies Are Still Adapting To Accelerated Secular Changes

We continue to believe that consumers will return to dining-out habits eventually. The question is when. Until consumers feel comfortable returning to dining rooms, restaurants will keep leaning on off-premise operations, which in some cases has doubled as a percentage of sales relative to pre-pandemic levels. New products, such as Popeye's chicken sandwich, and new concepts or formats--such as IRB Holding Corp.'s (Inspire) Buffalo Wild Wings "GO" model, and Bloomin’ Brands Inc.'s virtual brand "Tender Shack," will be required to supplement soft dine-in sales. Restaurants will also need to respond to the secular shift toward working from home and the implications this has for the breakfast daypart.

Restaurant Brands International Inc.'s reported fourth quarter systemwide sales at Tim Hortons and Burger King that illustrate the continued softness in breakfast and late night sales (see table 4).

Table 4

A silver lining for larger restaurant chains could be increased share because smaller, independent restaurants may not survive the winter. Reports estimate 15%-35% of mom-and-pop restaurants could close permanently when the pandemic subsides. This leaves desirable real estate and share for the taking by larger, better-capitalized restaurant chains.

Foodservice distributors

Foodservice distributors still face risks ahead, depending on the virus' trajectory combined with how related public policy and consumer habits evolve. Several distributors have indicated in cities where relaxation of restrictions occur, there's a large improvement in demand. We believe large foodservice distributors have been adapting to the pandemic and should gain market share in the eventual food away-from-home recovery. This is because larger distributors are aiding restaurants with menu selection, grab-and-go set-ups, digital tools, and most importantly, higher market share.

Beverages

We believe nonalcoholic beverage manufacturers have been repositioning some products to improve their portfolios. In the case of Coke, it's in the process of pruning its portfolio to weed out slower moving, lower-return brands. PepsiCo conversely has invested heavily in acquiring new brands (including energy drinks) and expanded geographically (e.g., Africa) to enhance its position in higher growth areas.

Food processors

For meat and commodity food processors, we believe a larger retail mix could be temporary, primarily because the sector's foodservice sales skew more heavily toward QSRs, which is rebounding. Although other branded processed food offerings are likely to continue to see a secular shift to increased online sales, we don't expect this trend will be as prevalent for meat and commodity food processors as for packaged food companies given a significant share of their product mix remains in the fresh or refrigerated segment. Still, new concepts being introduced by the restaurant channel will provide an innovation platform for food processors to develop foodservice offerings that will supplement the sector's soft dine-in sales.

S&P Global Ratings believes there remains high, albeit moderating, uncertainty about the evolution of the coronavirus pandemic and its economic effects. Vaccine production is ramping up and rollouts are gathering pace around the world. Widespread immunization, which will help pave the way for a return to more normal levels of social and economic activity, looks to be achievable by most developed economies by the end of the third quarter. However, some emerging markets may only be able to achieve widespread immunization by year-end or later. We use these assumptions about vaccine timing in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Appendix

Table 5