Restaurant Anthology – Part 2

I find myself writing the phrase “a sign of the times” a lot recently to describe negative trends that have emerged that in the past, I would have described as daunting, but today, are merely commonplace or the standard against the backdrop of today’s difficult economic environment, particularly as it relates to restaurant operators. Such “signs of the times” would include severe traffic declines, rising prices to offset higher costs at the expense of traffic and the flip side, discounting at the expense of profitability, margin-crushing commodity costs, higher management turnover, an increased number of companies at risk of defaulting on debt covenants and increased leverage within the industry. Unfortunately, all of these “signs” and trends continued to be relevant over the last two weeks.

For more details regarding any of the following highlights, please refer to the relevant postings over the past two weeks, which are sorted by date on the portal.
  • An increased number of companies at risk of defaulting on debt covenants - On July 20th, I published a list of 13 restaurant transactions that have taken place over the past three years and asked the question; how many companies on this list will need to raise equity or file bankruptcy in the next 12-18 months? Last week, the WSJ highlighted some of the companies on the list. According to the WSJ, the parent of Uno Chicago Grill was expected to skip a bond payment as it tried to negotiate more financial breathing room. The issues at Uno are a common theme in restaurant land – UNO is being squeezed by declining customer counts, rising food costs and an overleveraged balance sheet. The article also cited that Chevy’s Fresh Mex, Perkins and Marie Callender's chains are in talks with their lenders - posted August 13.
  • Increased leverage within the industry – I just don’t understand the reasoning behind the capital allocation decision to borrow money to buy back stock. RRGB’s board recently authorized an additional $50 million share repurchase effective through 2010. The company’s lowered new unit growth for FY09 will free up additional cash, but I would not like to see RRGB offset this shareholder-friendly capital allocation decision by then borrowing money to buy back more stock than it should – posted August 19.

    YUM’s cash flow story is changing with the company’s debt levels increasing to keep up with increased cash burn (in the last 12 months, YUM has burned through $1.4 billion in cash and its interest expense has increased 8%). Additionally, YUM has been allocating more cash toward capital spending (up 13% in the last year), which increases YUM’s risk profile and drives lower incremental returns for shareholders. YUM’s capital spending needs are growing and that will come at the expense of the share repurchase program. The question that remains is if interest expense in up 8% (due to higher debt levels to buy back stock) and the share count has only declined by 2%, how is that accretive to shareholders? – posted August 14.
  • Other Company-Specific Highlights:

    YUM – I recently reviewed YUM’s proxy and the metrics used to determine how management gets paid. Including the leverage factor, EPS growth of at least 10% can account for more than 50% of the bonus. System sales growth and system net new restaurant builds (easily achieved by accelerating capital spending, which has been steadily increasing for YUM) collectively account for another 40%. There is no incentive for management to improve the operating performance of the company. In light of the poor operating performance in the U.S., it is very clear why management wants to leverage the balance sheet and reduce the share count by 8% - posted August 21.
  • MCD – As of 2Q08, MCD said specialty coffees is in more than 1,600 restaurants (up from 1,300 in 1Q08). If we assume the company accelerates the conversion process in 2H08 and converts 1,200 stores, the total number of McDonald’s stores with the ability to sell specialty coffee in the U.S. would be 2,800, which is only 25% of the system. Management has set expectations for a national launch for the specialty coffee program in mid-2009, but if only 25% of the store base has the ability to sell specialty coffee, how can the company justify spending the marketing dollars in 2009? More importantly, will the franchise system embrace the move? – posted August 15.
  • CKR - CKR posted solid period 7 same-store sales growth at both Carl’s Jr. and Hardee’s, up 4.2% and 1.4%, respectively, closing out 2Q up 3.8% at Carl’s Jr. and up 3.3% at Hardee’s. Both concepts experienced sequentially better 2-year average trends in 2Q from 1Q (100 bp improvement at Carl’s Jr. and 250 bps better Hardee’s). CKR also provided restaurant operating cost guidance for 2Q and expects restaurant operating margins to be up 20-50 bps year-over-year. The company is facing an easy comparison from last year when restaurant margins fell 300 bps (primarily as a result of higher food costs), but margins growing YOY is favorable, nonetheless, as CKR’s margins have declined for the last 6 quarters – posted August 20.
  • LDG – During my career as an analyst and an investment banker, I spent a lot of time looking at real estate transactions for a number of different companies. In most cases, the business model was better off owning the real estate, as it provided a level of stability to earnings. I will go as far to say that selling a company’s real estate portfolio is about as effective in creating shareholder value as an activist shareholder telling a company to use leverage to buy back stock! I guess if Bill Ackman can prove to the world that LDG’s real estate can add incremental value, it will validate his other consumer holdings. Selling a company’s undervalued real estate creates an enormous tax burden, which limits the cash available to maximize value for shareholders. I truly believe that Bill Ackman knows this, and I have yet to see a structure from him that would get around the tax issue completely – posted August 18.
  • GMCR – The bull case for GMCR is compelling but the case for demand destruction is even greater. Taken together, the combination of Keurig brewers, patented K-cups and Green Mountain specialty coffee has provided the company with strong top line growth. However, the K-cup -razor/razor blade model is a long way from generating the type of revenues needed to drive overall profitability. This is already showing up in the company's consolidated results with 3Q08 gross profit margins declining to 36% from 41% last year – posted August 12.
Restaurant Transactions Over the Past Three Years
YUM Compensation