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Probability of default spikes for US restaurants amid coronavirus shutdowns

The chances that U.S. restaurants will default jumped in recent weeks as social distancing causes people to slash spending at eateries and the coronavirus pandemic keeps most dining rooms closed.

S&P Global Market Intelligence's median one-year market signal probability of default rose to above 30% for U.S. restaurants in April before dropping to about 24% as of May 18. That is up from less than 5% in the opening months of 2020 before the coronavirus pandemic upended the U.S. economy. The figures represent the odds that a company will default on its debt within the next year based on fluctuations in the company's share price and other country and industry-related risks.

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Gaming and casual dining chain Dave & Buster's Entertainment Inc., Outback Steakhouse parent Bloomin' Brands Inc. and The Cheesecake Factory Inc. are among the largest publicly traded U.S. restaurant companies most likely to default, according to Market Intelligence data.

The odds of default for retailers and auto companies also rose in recent months because of the fallout from the global pandemic. Still, U.S. restaurants are being hit particularly hard by widespread stay-at-home guidelines and business closures, which contributed to a near-50% drop year over year in spending at restaurants and bars during April.

READ MORE: Sign up for our weekly coronavirus newsletter here, and read our latest coverage on the crisis here.

While the odds of default for restaurants generally have risen from lows in January or February, different segments of the industry are seeing different trends, BTIG analyst Peter Saleh said in an interview.

"The quick-service space, which is highly franchised, I think their odds are fairly low," Saleh said, adding the odds of default are likely higher in the casual dining segment. "With that said, we've been writing and saying that we think a lot of the brands will be cash flow neutral by the end of May."

Quick-service restaurants like McDonald's Corp. and Yum! Brands Inc.'s Taco Bell rely heavily on franchisees, a structure that allows them to collect royalties from independent operators who bear most of the costs of doing business. These chains also built more robust drive-thru operations than casual dining chains, which became even more important as dining rooms were forced to close in response to coronavirus but take away orders were still allowed. McDonald's odds of defaulting within the next year as of May 18 was 8.4%, while Yum! Brands' had a 14.8% chance of default.

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The restaurant companies with the highest one-year probability of default scores as of May 18 were Dave & Buster's at 53.5%, Bloomin' Brands at 36.1% and The Cheesecake Factory at 28.8%. The largest U.S. companies least likely to default included Wingstop Inc. at 1.1%, Papa John's International Inc. at 3.3% and Chipotle Mexican Grill Inc. at 3.6%.

Sales trends for Dave & Buster's were already under pressure prior to the pandemic, and risks to its business include fewer customer visits, cannibalization of new units on same-store sales and labor cost pressures, William Blair analyst Sharon Zackfia said in a May 6 note. The chain closed all of its restaurants in March. Zackfia predicted the company's same-store sales will drop 58% in the second quarter and 30% in the third given an expected "prolonged recovery with likely capacity restrictions."

Bloomin' Brands, meanwhile, is seeing sales improvements as its restaurants reopen but will also face profitability challenges amid the need for staff to run dine-in operations with lower sales volumes, Gordon Haskett Research Advisors analyst Jeff Farmer said in a May 8 note.

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Casual dining restaurants were already investing in delivery capabilities to keep up with rising demand for delivery orders, but the strain of coronavirus forced these companies to get even more creative with their off-premise business and more open to partnering with third-party delivery companies. Loans to full-service restaurants may be more of a credit risk to U.S. banks relative to limited-service restaurants.

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While third-party delivery companies are benefiting from increased demand for their services, they have also come under more scrutiny as cities seek to limit the fees they charge restaurants for ushering food to customers.

Some restaurants across the industry are reporting improving trends in their sales even as they acknowledge a full recovery remains elusive and uncertain, which could help explain why the probability of default began to ease in May.

Bankruptcy is not a risk for most quick-service and limited-service restaurants, while dine-in businesses such as smaller chains and mom-and-pop restaurants are at greater risk, said Erik Herrmann, partner and head of the restaurant investment group at CapitalSpring.

"Those are chains that are primarily casual dining businesses that were hanging on by a thread before and this was just kind of the final blow," Herrmann said in an interview. "Their earnings have already been squeezed because customers stopped coming to them, and now they have to shut down their dining rooms."