From cinemas to cruises, the consumer-driven home and leisure sector was hit hard by lockdown restrictions. With economies reopening in a disjointed manner, some sub-sectors have rebounded quickly while others continue to struggle. Here, we look at how the pandemic is reshaping the industry and the implications for investors.
‘Fifteen Million Merits’, an episode of the Netflix series Black Mirror, portrays a dystopian society where people are required to pedal all day on indoor bikes and the only entertainment is reality TV.1 When entire countries locked down earlier in 2020, that world came within an inch of becoming reality.
It was hard on people, but also on the businesses that rely on customers being physically present to sell their services. This highlights how freedom of movement is essential to our leisure interests: eating out, having a drink with friends, gambling in a casino, enjoying the rides at a theme park, and, of course going, on holidays.
In these areas, which make up part of the broad consumer services industry, various subsectors and firms have fared differently as infection rates have ebbed and flowed and also because of the disjointed way social distancing restrictions have been eased. Some obvious winners and losers have emerged, while others have rebounded surprisingly quickly.
The enormous amount of stimulus injected into economies has muddied the waters for credit investors
The enormous amount of stimulus injected into economies by governments and central banks has muddied the waters for credit investors. Rather than company fundamentals, central bank policy is driving markets more than ever, making it more difficult to assess the underlying strength of many businesses.
The majority are high yield issuers or companies that were downgraded to high yield in March and early April as their leverage increased. Subsequently, valuations in the sector have recovered well after the initial market panic; in no small part because of stimulus measures rather than any substantive improvements in their financial performance. At times like these, investors would be well served by analysing companies beyond their valuation levels to unearth the more resilient sectors and business models.
“There is so much stimulus right now; everything is trading up, whether it should or not. The market doesn’t care. As a fundamental investor, in some cases, you may be proven right in the long run because you have a healthy scepticism and you can identify these issues,” says Paul Janowitz, Chicago-based senior credit analyst at Aviva Investors.
He highlights that, unsurprisingly, the hardest-hit sectors are energy, transport, and gaming, lodging and leisure.2 Looking at a year-to-date return profile doesn’t show the dramatic swings that occurred in the interim period, but looking at the period from the worst day for all bonds (March 23) to today makes the dramatic reversal very clear, as illustrated in Figure 1.
Figure 1: United States - BofA Merrill Lynch US High Yield Option-Adjusted Spread
Winners and losers
Cinemas have been among the businesses most challenged by lockdowns. Not only were they the first to shut and the last to reopen, but the five largest American studios, which produce 80 per cent of US movies, kept delaying the release of new films, making it more difficult for cinemas to open.
It is questionable whether the most leveraged actors may have to restructure over time
“It is questionable whether the most leveraged actors may have to restructure over time. For instance, American cinema operator AMC did debt exchanges and raised liquidity with more first-lien debt [where a borrower pledges assets to secure a loan]. In effect it is a default, even though it is out of court, because bondholders accepted a discount, which bought the company more time,” says Janowitz.3
At the other end of the spectrum, gardening, DIY and baking enjoyed a surge in popularity during lockdowns. It is therefore no surprise that home and gardening services – as well as retailers – have held up well in 2020, as the home became the centre of people’s lives.
“In the UK, non-food retailers with an element of gardening involved have done really well, and so has DIY,” says Shaniv Muttiah, senior credit research analyst at Aviva Investors.4
The fast rebounds
After dropping steeply in March and April, US homebuilding snapped back significantly once lockdowns eased, for similar reasons to those that supported DIY (see Figure 2).
“US mortgage rates were so low, and as a result of COVID with everyone stuck at home, people cared about their home a lot more. The trend was to move out of densely populated areas and into single-family suburban homes. People in the cities especially want to move now they don’t need to be in the city to work. Starting in May, we have seen sales pick up dramatically,” says Janowitz.
Figure 2: US new home sales
Another area that saw a quick rebound is gambling. However, not all firms fared equally, and business models played a large part in their resilience.
In the US, the casino customers who have come back are spending more
In the US, 85 per cent of casinos had reopened by the middle of August. Because of social distancing measures, they had to cut their floor capacity to between 50 and 80 per cent. However, the customers who have come back are spending more. Of the casinos that reported Q2 results, earnings before interest, taxes, depreciation, and amortisation (EBITDA) were strong even though revenues were still down.
“As an example, Caesar’s is using its rewards base to target its most favoured clients. They are coming in and spending more; the volume might be down, but transactions are up. In some cases, we have seen the EBITDA margins do better than they did pre-COVID,” explains Janowitz.
This has been particularly true for regional players, where clients have returned in greater numbers than in destination resorts like Las Vegas. For instance, Q2 results of regional company Boyd Gaming were stronger than those of Las Vegas Strip casinos such as MGM Resorts International or Wynn Las Vegas.5,6,7 Being able to cater for local customers has been an advantage.
The European bond market is less focused on casinos, for which bond issuance is lower than in the US, and more so on lottery businesses and sports betting. Two countries dominate the industry: Italy, the largest market in Europe, and the UK.
These were very physical businesses, most customers using shops to place their bets and buy lottery tickets, and sales dropped significantly because of lockdowns. However, the sector is predominantly built on a franchise model: franchisees bore the brunt of the difficulties, while concessionaries benefitted from their variable cost base to maintain enough liquidity to withstand lockdowns. Luckily for investors, all the companies that had bonds outstanding were concessionaries, and business was quick to bounce back once restrictions were lifted.
COVID-19 accelerated longer-term trends that had begun to emerge before lockdowns
Yet COVID-19 also accelerated longer-term trends that had begun to emerge before lockdowns. In the UK, most betting companies like Ladbrokes or William Hill had begun closing shops, which were no longer viable after the minimum stake was reduced to two pounds. Across both countries, business is also increasingly moving online, an existing trend that has been given further momentum by the pandemic.8
“With virtual events, things like in-play betting where you can bet on different segments during a game, online betting gives a lot more options. So it is likely to grow going forward,” says Muttiah.
That will help them be more resilient if the virus continues to flare up locally, and they may join other businesses that held up well in the crisis.
Finding resilience
Although US theme parks had to shut during lockdowns, they have remained solvent, as most are able to break even at reduced occupancy rates.
There have been issues with flare-ups, but reopening with social distancing rules is generally expected not to be a problem
“There have been issues with flare-ups, particularly in the worst-case states like Florida, Arizona, Texas and California, but reopening with social distancing rules is generally expected not to be a problem,” says Janowitz.9
Companies and sectors with this kind of low breakeven point are proving more resilient than most, although in some areas, size is another factor.
In catering, for instance, business remains relatively secure in sectors such as healthcare, schools and oil and gas rigs, but there is a lot of uncertainty elsewhere. Catering in sports and entertainment venues has suffered, with no set date for crowds to begin attending events again, while office work and tertiary education may increasingly move online over the long term, reducing the need for onsite catering. According to Muttiah, this creates an opportunity for the bigger players.
“The pressure in-house operators face will accelerate the trend towards outsourcing. Companies with the strongest balance sheets – like Sodexho and Compass – could have the opportunity to seize that business. The smaller regional and niche players may lose out,” he says.
Restaurants and hotels have also shown low breakeven points and larger size to be an advantage, complemented by market positioning.
“There is no question larger companies with access to capital are benefitting in this environment. If we compare them to independent restaurants, they are much better off. That is part of the reason for the disconnect between main street and the market,” notes Janowitz.
Fast food and “quick service” restaurants have benefitted from drive-through and delivery services they could offer
In terms of market positioning, in the US and Europe alike, fast food and “quick service” restaurants like Burger King or Wagamama have benefitted from drive-through and delivery services they could offer.10
In contrast, premium dine-in restaurants have suffered. “They used to be business-related or travel-destination based. Let’s say there was a convention in Las Vegas and people across an industry were getting together; that is just not happening anymore,” says Janowitz.
Figure 3: US restaurant industry same store sales growth
“In Europe, it is very focused on UK data. Half the restaurants haven’t opened following the easing of lockdown, and we continue to see a lot of restructuring and liquidations,” adds Muttiah.11
As shown in Figure 4, bricks and mortar restaurants’ difficulties significantly benefitted delivery companies like Door Dash or Just Eat, although in the UK Deliveroo suffered from the sector’s ongoing price war.12,13
Figure 4: US monthly meal delivery sales by company
Similarly, with the suspension of business travel, economy and mid-scale lodgings businesses with a focus on leisure have fared much better than luxury hotels.
“We have focused in the US on a leisure hospitality company called Choice. We also looked at Marriott and Hyatt, which are premium, full-service hotels, but they are burning cash and Choice is starting to turn a profit, so there is a difference in terms of cash flow,” explains Janowitz.14
Economy and mid-scale players have also benefitted from occupancy by essential workers
Economy and mid-scale players have also benefitted from occupancy by essential workers – government employees, construction workers or nurses, for example – who had to isolate from their families.
In addition, their breakevens are lower than luxury hotels’ because they don’t cost as much to run. “In the US, hospitality companies focused on the low end have a breakeven around 30 per cent occupancy, whereas full-service hotels need 45 per cent plus. Occupancy hit a low of 23 per cent for mid-scale hotels, and sometimes as low as five per cent for full-service hotels. They have now trended back up to around 50 per cent, but even at 50 per cent the full-service hotels are just breaking even at best,” notes Janowitz.
Companies with a franchise model add another benefit, in that franchisors bear less cost and therefore tend to have the liquidity to survive longer periods of low occupancy.
“Franchise businesses like InterContinental Hotels Group have done relatively well so far; they have sufficient liquidity to withstand at least another 12 months if this were to continue. Non-franchise businesses like Whitbread or Radisson Hospitality AB had to raise equity, either public or private, to sustain themselves,” explains Muttiah.15,16,17
A low cost base provides franchisors with a buffer, particularly if they have a diversified network. However, despite often qualifying for government support, franchisees are more exposed, which may eventually impact the franchise owners.
Franchise owners are all stressing the positives, but franchisees are struggling
“Franchise owners are all stressing the positives, but franchisees are struggling. There was a case for example with Yum Brands. On July 1, NPC International, Yum Brands’ largest Pizza Hut US franchisee with over a thousand Pizza Hut restaurants, filed for bankruptcy, so obviously Yum Brands will not receive royalties from them. That is happening, but it has not affected bond prices at all,” adds Janowitz.18
The leveraged vaccine play
A final sector attracting investor attention is cruise operators, which have suffered significantly from the pandemic-induced restrictions. Having been forbidden to operate, they are unable to generate revenues, while having to refund clients whose trip was cancelled and paying for ship maintenance, which can typically cost half a million dollars a month – per ship.
Cruise operators had to raise cash, which they mostly did in the form of secure bonds
“These companies had to raise cash, which they mostly did in the form of secure bonds, meaning without revenue and cash flow investors have to depend on asset values. Of course, when a ship is new, the company can say it is worth $500 million or $1 billion, but the valuation may not be there in a situation where nobody can operate and you have to get rid of your ships. They cost so much just to maintain,” says Janowitz.19,20
Yet if a vaccine is someday announced, these “bottom of the barrel” bonds could bounce the hardest, so it may be tempting to take some exposure to a smaller operator – that will burn less cash in maintenance – with long liquidity. Janowitz calls this a leveraged vaccine play.
It is a complex proposition, however. To hedge against a downside scenario, investors need to analyse whether the company has sufficient liquidity to pay out a large coupon for long enough that would cover them in case of a default.
“They are all first or second-lien guaranteed bonds, all based on the supposed book value. That is the only way you can get comfortable if you are investing. You have to assume the company will restructure in a downside scenario, not get rid of any of the ships, then come out of bankruptcy and just keep going, and the first liens will get reinstated,” explains Janowitz.
Making all these assumptions requires optimism and, as in every segment of the home and leisure sector in these uncertain times, detailed fundamental analysis on the companies.
