Restaurant stocks face another headwind with Biden minimum wage plan: Alpha Tactics

The combination of a raised minimum wage and elimination of a tip credit for servers could be another blow to the low-margin restaurant industry reeling from COVID-19.

But publicly traded restaurants showed no sign concern, even as President Joe Biden signed an executive order directing the Office of Personnel Management to develop recommendations to increase the minimum wage for federal employees and contractors to $15 per hour.

The vast majority of the stocks posted gains for the week.

Biden's move was a first step in a push to increase the overall federal minimum wage, which covers most American workers, up to $15/hour from $7.25/hour, where it has stayed since July 2009. That hike is part of Biden’s $1.9T COVID-19 relief plan.

Along with the boost in minimum wage, the new administration would eliminate the tip credit, which allows tipped service workers to be paid below minimum wage, as long as the minimum wage is reached when tips are included. There are 43 states that allow the tip credit and the minimum wage can be as low as $2.12/hour in Nebraska, with many states at $2.13.

At a time when so many restaurants are still prevented from serving indoors or have a reduction in capacity enforced, and even those fully open seeing a large drop in foot traffic, an increase in labor costs could smash margins.

The industry has an average profit margin of 5%-6% and 86% of restaurants have reported an average drop in sales of 36% during the pandemic, according to the National Restaurant Association.

TGI Friday’s CEO Ray Blanchette told CNBC that Biden’s plan would create more inequality in compensation within restaurants, and would translate into fewer hours and higher menu prices.

“In the front of the house, where we spend a lot of hours, we would clearly be cutting back hours if something that dramatic happened,” Blanchette said “And we’d have to materially raise prices, which doesn’t feel like that would be right.”

Proponents of the move say that many businesses shirk their responsibility to bring wages up to minimum if tips fall short.

The Restaurant Workers of America is in favor of keeping the tip credit and also believes a correlating hike in menu prices and drop in traffic would occur, citing a study in the Bay Area, which has no tip credit, showing “for every dollar that the minimum wage is increased, the chance of a restaurant closing goes up by as much as 14 percent.”

Evercore Co-CEO Ralph Schlosstein came out in favor of the higher minimum wage this week, telling Bloomberg that it is “a bit of a blunt instrument, but I do think we need a blunt instrument to at least start to swing that balance back in the direction of people who work.”

Since the stocks of the major chains not only survived the predictions of pandemic disaster, some that were quick to redeploy resources thrived, it’s perhaps not surprising these stocks held strong last week in spite of the minimum wage move.

Among 14 of the largest publicly traded restaurant stocks, just 2 closed down for the week, Red Robin (NASDAQ:RRGB) off 4% and Wendy’s (NASDAQ:WEN) -3.7%.

Brinker (NYSE:EAT), which operates Chili’s, was the top performer, up 6.5%, followed by Chipotle (NYSE:CMG), up 6.3%, and Dine Brands (NYSE:DIN), which owns Applebee’s and IHOP, up 5.2%.

Bigger names McDonald’s (NYSE:MCD), up 1.7%, and Yum! (NYSE:YUM), up 0.4%, had more modest gains.

There is also the possibility that investors believe a rise in the minimum wage is a political longshot.

GOP Senator Roy Blunt has already said that the hike is one item on Biden’s agenda that’s not happening.

But as long as the White House is pushing for the move, and also increasing regulations to stop the spread of COVID, it could give investors the excuse to cash in on the recent gains.

Among top performers in the last month, Bloomin’ Brands (NASDAQ:BLMN) is overbought according to a relative strength index above 70, as is Ruth’s Chris (NASDAQ:RUTH) and Papa John’s (NASDAQ:PZZA).

Looking to ETFs, there isn’t a dedicated restaurant fund. But one preferred representative, the passive Invesco Dynamic Leisure and Entertainment ETF (NYSEARCA:PEJ) has boosted its restaurant allocation since the pandemic.

Restaurants went from making up 16.6% of the portfolio in April 2020 to 26.6% at the end of October (during the same time the ETF moved to streaming with movies and entertainment the top sectors and airlines, the previous top sector at 22.1% in April, disappearing completely).

PEJ’s restaurant holdings are Yum! at 4.4%, Yum China (NYSE:YUMC), 4.3%, McDonald’s, 4.3%, Bloomin’, 3%, Brinker, 2.85%, and Texas Roadhouse (NASDAQ:TXRH), at 2.4%.

PEJ is currently in overbought territory with an RSI of 72.32. And its price is now more than 30% above its 200-day simple moving average for the first time in its history.

Seeking Alpha contributor BOOX Research writes that PEJ "has underperformed its industry index benchmark consistently over the past decade" and the "concentrated portfolio of only 30 holdings ends up excluding many important stocks".

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