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The Casual Restaurant Bankruptcy Epidemic

We've examined the rise in bankruptcies among casual restaurant chains.

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Although we are starting to see some signs of a recovery across a number of consumer-related sectors, casual restaurant operators continue to struggle. Given that restaurants are traditionally a low-margin business due to high fixed costs--a successful stand-alone restaurant generates operating margins in the low single digits--it is not surprising to find individual operators increasingly file for bankruptcy protection. However, we believe that the threat of bankruptcy also spread to casual restaurant chains during the current economic downturn. Looking out over the past year, a number of small to midsized casual dining chains (loosely defined as those between 50 and 500 units) have filed for bankruptcy protection, a trend we expect to continue during 2010.

Among the most notable casual restaurant bankruptcies thus far have been Metromedia Restaurant Group (which shed 150 company-owned Bennigan's, 50 Steak and Ale, and 50 Ponderosa Steakhouse locations), Vicorp Restaurants (which closed 56 of the 400 Village Inn and Bakers Square restaurants), and G&R Acquisition (owner of 106 Max & Erma's and 53 Damon's Grill units). With the exception of Metromedia Restaurant Group, these bankruptcies were chapter 11 filings, meaning that the chains will continue to operate as they renegotiate their obligations with creditors, landlords, and other suppliers.

In this article, we examine some of the pressures facing casual restaurant operators and the alarming number of bankruptcy filings among casual dining restaurant chains. We've also taken a closer look at our coverage list to identify potential "at-risk" firms using Morningstar's proprietary Cash Flow CushionTM and determine whether investors should be concerned about their viability.

Why Are Casual Restaurants Struggling?
Key culprits for turmoil include increased price competition and cheaper alternatives, uninspiring menu innovations, lackluster service scores, poorly chosen restaurant locations, outdated facilities, and high fixed costs. Trading down to quick-service and fast-casual chains was a problem as macroeconomic pressures first came to light, but we believe trading out has become the more persistent issue as consumers turn to grocers and warehouse clubs for premade meals and other food staples. This has triggered aggressive price competition among casual restaurants, which is not a viable long-term option because of the inherent margin compression involved. Moreover, as consumers become accustomed to the lower price points, it may be more difficult to move them back up the pricing continuum when economic conditions stabilize.

For the most part, larger casual restaurant chains have been successful managing costs by closing unprofitable restaurants, minimizing capital expenditures, paring back staffing levels, and identifying new operating efficiencies. Easing commodity costs over the past six months has also helped to preserve margins. Still, these cost-containment strategies are only a temporary solution, and they may not be enough over the long haul unless unemployment levels and consumer confidence levels improve. Additionally, aggressive cost cutting can put brand equity at risk if consumers perceive a decline in a restaurant's level of quality.

Casual dining chains also face heavy fixed cost commitments such as debt obligations and lease payments, which are more difficult to reduce than day-to-day restaurant operating expenses. Although economies of scale are necessary for success in the restaurant business, firms that once relied on easy credit to expand their restaurant base or remodel older locations now find these fixed costs spread over a much smaller revenue base. With comparable-restaurant sales expected to be in negative territory for most casual restaurant concepts during fiscal 2010, these commitments become an increasing threat to long-term survival.

Credit Markets Remain Tight, with Few Signs of Easing in 2010
Over the past few months, the lending environment has improved, but credit markets still remain exceptionally tight for restaurant operators. There are fewer sources of capital, and several traditional lenders have curtailed their restaurant lending programs considerably (such as  GE Capital (GE) and  Bank of America (BAC)) or exited the market entirely (including CIT Group). In general, banks have become much more restrictive, with recent lending reflecting higher credit spreads, stricter covenants, shorter maturities, and higher transaction fees. Cash injection requirements are at an all-time high, with most lenders requiring a 20%-25% down payment before even considering a new loan in the restaurant space.

We anticipate that debt market liquidity will remain an issue for restaurant operators through 2010 and possibly beyond. High unemployment rates and low consumer confidence do not portend a near-term increase in casual restaurant spending, likely making lenders uneasy. According to lenders we have spoken with, the restaurant funding market will not stabilize until the consumer saving rate exceeds 8% (compared to 4.7% during November), household debt service ratios fall to about 10.5% (from 12.9% during the third quarter of 2009), and unemployment rates fall a couple of percentage points. As a result, we believe a number of smaller restaurant chains are at risk in 2010, even with some signs of stabilization in the broader economy.

While we have started to see credit markets thaw for larger chains due to a more favorable risk profile, smaller restaurant chains have been forced to seek alternative sources for funding. Private equity and other third-party funding might still be available for smaller restaurant operators, assuming they have demonstrated the ability to deliver EBITDA margins in the low-teen range (including corporate overhead expenses). Community and smaller banks also remain a somewhat viable source of funding. That said, we do not expect an immediate influx of sources of capital for casual restaurant chains, forcing restaurant operators to rely on their cash positions and free cash flow generation to satisfy financial commitments.

 

Assessing Bankruptcy Risk Using Morningstar's Cash Flow Cushion Ratio
Given our expectations for a continuation of tight credit market conditions during 2010, we've taken a closer look at the Cash-Flow CushionTM for each of the casual restaurant operators in our coverage universe to better identify the threat of financial distress. (For more information, please read through Brian Nelson's recent description of Morningstar's Cash Flow Cushion). The Cash Flow Cushion (CFC) ratio is a key component of Morningstar's new credit rating system, as it indicates how many times a company's internal cash generation plus total excess liquid cash will cover its debtlike contractual commitments over the next five years. In this regard, the CFC ratio can bring to light potential refinancing, operational, and liquidity risks inherent to the firm.

We have presented the CFC ratios for the casual restaurant chains we follow below. In general, the higher the ratio, the more likely the firm will be able fulfill their financial obligations over the next five years. Not surprisingly, larger firms like  Darden Restaurants (DRI),  Cheesecake Factory (CAKE), and  Brinker International (EAT) are near the top of the list, with cash flow cushions that should allow the firms to successfully navigate the economic downturn. If you include remaining availability under each firm's revolving credit facilities, these numbers look even more promising. On the other hand, a heavily leveraged company like  DineEquity (DIN) is more at risk because our cash flow projections fall short of the firm's expected cash commitments during the next five years. While a CFC ratio under 1 is certainly reason for concern, we do not necessarily believe bankruptcy is imminent for DineEquity (although refinancing or reorganization alternatives will have to be considered).

Despite still-restrictive credit markets, we believe restaurant operators with strong capital structures may be positioned to secure attractive financing. For example,  Texas Roadhouse (TXRH) was successful in securing attractive lending rates during the last economic downturn (partially explaining its solid CFC ratio), which was a key impetus in the firm's growth over the past five years. Given depressed real estate and equipment prices, taking advantage of lower interest rates could allow some firms to emerge from the current economic downturn in stronger financial health and eventually reaccelerate growth initiatives.

Final Thoughts
Given our expectations of rising commodity prices, wage rate inflation, and aggressive industry discounting, 2010 looks to be a challenging year for most casual restaurant firms. Unless there is a material improvement in restaurant traffic, we expect margins to remain under pressure throughout the year. With few financing alternatives, there will likely be additional bankruptcy filings from smaller casual restaurant chains. However, we believe most of the casual restaurant firms on our coverage list have a sufficient cash flow cushion to see their way through the current economic downturn.

R.J. Hottovy does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.