Capital Markets

Table Stakes

As the casual-dining industry suffers one of its worst downturns, CFOs are in the kitchen and feeling the heat.
Edward TeachDecember 1, 2008

Chuck Sonsteby has worked in the restaurant business for most of his professional life. He began while in college, interning for the company that owned the fast-food chain Long John Silver’s. Today, at 55, Sonsteby is executive vice president and CFO of one of the country’s largest casual-dining companies — Brinker International, the Dallas-based operator of the Chili’s Grill & Bar, Maggiano’s Little Italy, and On the Border Mexican Grill & Cantina restaurant chains.

“I love the industry,” says Sonsteby. “It’s a combination of everything: manufacturing in the back and value-added retail in the front, along with entertainment. And it’s a great people business.” But while Sonsteby’s enthusiasm is alive and well, the same can’t be said for the industry he loves. “I don’t think anyone has ever seen anything like this,” he says. “These are truly historic times.”

In a bad way, that is. As the economy slides deeper into recession, casual full-service restaurants, which were among the first businesses to feel the tremors of impending collapse, are hungry for customers. Brinker’s same-store sales, the key metric for the casual-dining industry, declined across its brands in the latest quarter. Practically everyone else’s same-store sales have dropped too, according to Technomic, a Chicago-based restaurant consultancy. Applebee’s, Outback Steakhouse, Ruby Tuesday, P.F. Chang’s Chinese Bistro — these and other chains have seen a dramatic falloff in their “guest counts” during 2008, not to mention their profits and stock prices.

Some chains have called it quits. In July, the parent company of Bennigan’s and Steak and Ale filed for Chapter 7, closing hundreds of company-owned restaurants and dismissing thousands of employees. Startling for its size and suddenness — many workers found out the bad news when they showed up for work and found the doors locked — the liquidation signaled just how bad the economics of the casual-dining industry have become.

Indeed, while the U.S. economy shrank in the third quarter of 2008, the casual-dining industry (which analysts position between fast-food and fast-casual chains on the low end and fine-dining restaurants on the high end) has been in a recession for many months. “We saw a downturn in consumer sentiment in February 2006,” says Sonsteby, “and we’ve been in a downturn in traffic for quite some time.” Technomic dates the restaurant recession back to the third quarter of 2007, based on overall same-store growth rates for publicly held chains, says president Ron Paul.

For many restaurant finance chiefs, weathering the current economic climate will be the challenge of their professional lives. “Times like these are when CFOs get called to the test,” says Andrew Green, assistant professor of finance at Wofford College in Spartanburg, South Carolina, who was CFO from 2001 to 2005 of Denny’s Corp., a family-restaurant chain.

These times are about to get even worse: consumer confidence is sagging and unemployment is rising. In the third quarter of 2008, for the first time in 17 years, growth in U.S. consumer spending turned negative, according to the U.S. Department of Commerce. A recent Technomic study reports that more than a third of consumers are eating dinners out less frequently than a year ago.

Meanwhile, skyrocketing food and energy prices over the past two years have only recently started to moderate. Larger outlays for wheat, corn, soybeans, and cheese have eaten into profit margins, while steeper fuel costs have taken bigger bites out of the bottom lines for restaurateurs and consumers alike. Labor costs have risen, too. No wonder the phrase “perfect storm” has found currency among industry analysts. “I’ve never seen a time when the consumer was strained this much, when all the commodity prices were up, when every single input was unfavorable,” says Brad Ludington, a restaurant analyst at KeyBanc Capital Markets in Cleveland.

Too Much of Everything

As the tide of consumer spending recedes, the weaknesses of the casual-dining sector have been exposed. Foremost among them is overexpansion, fueled in the past few years by cheap credit. The consensus among analysts is that there are simply too many restaurants, which Paul attributes to a prevailing “take-the-hill mentality.” As chains sized up new locations they rarely worried whether a Red Lobster or Ruby Tuesday was already next door; the thinking was “our concept is good, our food is better,” says Paul. “For a while, it seemed to work, but you couldn’t support 4 or 5 percent growth per unit when demand was rising only 1, 2, or maybe 3 percent.”

As chains piled on top of each other they all began to look alike to consumers. Asked why they patronized one restaurant versus another on a given night, many focus group participants answered that “the line was shorter.” No loyalty was being built up, says Paul. “Restaurants were look-alikes in terms of menu, pricing, and even TV commercials — consumers couldn’t remember which chain did which commercial. Restaurants became bland and tired, the decor packages were kind of ‘been there, done that.’ The customers grew up, but the concepts didn’t.”

But other things were changing. “Prepared foods from supermarkets and other retailers have gotten infinitely better,” says Paul. “The consumer now realizes that the salmon you pick up at Whole Foods is really pretty good” — and less than half the price of a casual restaurant’s seafood entrée. Wine and soft drinks are a lot cheaper at the supermarket, too. Combine those options with concern about the cost of gas and babysitting and it’s no surprise that more people are dining at home on Saturday night.

Restaurant Makeovers

But the restaurant chains are fighting back. “This is the time we really have to perform,” says Sonsteby. As consumers scale back, he says, “their expectations become higher because their dollars are more precious, so we have to make sure everybody gets a fantastic experience.”

That experience begins with appearances. Despite the credit crunch (see “On the Financing Menu, Limited Choices” at the end of this article), a number of chains have recently spent millions to “reimage” or refresh the look of their restaurants. “The exterior is your billboard, your drive-by,” explains Sonsteby. “It’s important.” Brinker reimaged 73 Chili’s restaurants in fiscal 2008, at a cost of about $250,000 each. “We’re putting in glass, making them much brighter and lighter,” says Sonsteby. “It’s really helped customer traffic.”

Ruby Tuesday, a chain of American-style restaurants based in Maryville, Tennessee, completed a nationwide reimaging last spring, according to CFO Margie Duffy. The company recognized three years ago that “the bar/grill segment was becoming commoditized,” she says, and that a makeover was necessary. Accordingly, the chain recently said goodbye to the old Ruby Tuesday, spending $65 million to replace Tiffany-style lamps, polished brass, and antiques at more than 600 company-owned restaurants with colorful lighting fixtures, earth tones, and custom artwork. Since Ruby Tuesday had halted its expansion plans a year ago (because of industry overbuilding) and finished its remodeling program this spring, the company’s modest capital needs are unaffected by the credit crunch, says Duffy.

Ruby Tuesday is also shifting its advertising emphasis to value, says Duffy. A hamburger is now a dollar cheaper, at $5.99. The chain is also tailoring promotions to local markets; in parts of Florida, for example, it promotes early-bird dinner specials. And the company is emphasizing the freshness and quality of its ingredients and a rededication to service. As a result, Duffy can cite internal surveys showing that Ruby Tuesday has attained its highest-ever levels of customer satisfaction.

The restaurant, in short, has pulled out all the stops — to little avail. For the first quarter of fiscal 2009 (ended September 2), Ruby Tuesday reported that same-restaurant sales had dropped 10.8 percent and 7.9 percent at company-owned and domestic franchise restaurants, respectively, compared with declines of 4.8 percent and 2.9 percent for the same quarter a year ago. Earnings were down to a penny a share, compared with 21 cents last year. The company continues to pay down debt with the free cash flow it generates, so its best bet may be to keep its restaurants shipshape and wait for the economic tide to turn.

Please Don’t Wait to Be Seated

When might that be? Mark Basham, a restaurant analyst at Standard & Poor’s, predicts aggregate 2008 sales for full-service restaurants will total $181 billion, and traffic will be down 3 percent from last year. For 2009 he forecasts flat sales of $180 billion, with an average menu price increase of 4.2 percent. Paul of Technomic thinks the casual-dining industry is near or at the bottom. Still, he adds, it’s not time to start thinking about five-year plans. “The long term is next month,” he says.

“Normally in our industry, whenever we see a sudden shock — the Iraq war, 9/11 — it takes consumers between 60 and 90 days to get back to their normal routines,” says Sonsteby. “What we have today is almost a continual series of crises,” marked by extreme volatility in the Dow and S&P 500. Sonsteby thinks a semblance of stability will have to be restored to the financial and equity markets “before that 60-to-90-day period starts.” (In early November, the Dow Jones Industrial Average was 32 percent off its 2008 peak. At the same time, Brinker’s stock traded around $9, down 60 percent from its high of $23.86 in May. The company’s revenues of $984.4 million for the first quarter of fiscal 2009 were 6.7 percent below revenues for the same period last year, in part because of the sale and closing of restaurants.)

Many chains will try to lure customers with various promotions and limited-time specials, accepting the risk that they will condition diners to lower prices. In the meantime, finance chiefs are stepping up to the stove. “If my marketing people are telling me sales are going to be bad, what can I do with the rest of the P&L to combat that?” asks Andrew Green. “How can I keep our stock price up?” Restaurant CFOs “have to look creatively at the expense side, purchase food products more effectively, and be more efficient with their labor,” he says.

The challenge is to take costs out without affecting the customer experience. Chains might increase the pack size of restaurant goods and make fewer deliveries, for example. Or they might install utility-management programs that can cut energy costs by, for instance, monitoring when deep fryers and hood vents are left on after hours.

Health Benefits

As restaurants wrestle with food prices, societal concerns about health and weight control could help them out. Chains are leery of reducing portion sizes; offering “healthy” menu items may give them a way to do so without alienating customers. “Health and wellness is certainly going to give our industry an opportunity to evaluate how we construct a meal,” says Sonsteby. “To offer more vegetables, perhaps less protein, but highlight it as such. I’d be reluctant to reduce portions on standard menu items, but I’d look for additional offerings that would appeal to folks along health and wellness lines that do have smaller portions and maybe carry a lower price as well. We are definitely evaluating those kinds of things.”

Most large restaurant chains have sophisticated purchasing organizations and use forward buying to control their food prices. Brinker has done so for years and currently contracts for about 85 percent of its goods, says Sonsteby. Not that money is always saved: the recent escalation and sudden fall in prices for items like wheat, corn, and soybean oil resulted in spot prices being lower than contracted prices, he says.

Uno Chicago Grill, owned by privately held Uno Restaurant Holdings Corp., uses forward contracts for about 80 percent of its cheese and 50 percent of its wheat, says senior vice president and CFO Louie Psallidas. “We don’t buy all at once; you never know all the facts on any given day,” he says. “There are more forecasts out there than you can shake a stick at.” Psallidas is unperturbed if forward buying should wind up costing more than spot purchases. “It gives you certainty,” he says. “At the end of the year, nobody ever criticizes you for buying insurance when the building doesn’t burn down.”

There are other ways to keep tabs on food costs while finding opportunities to generate more revenue. For example, restaurants hire consulting firms like Technomic to make sure their prices are in line with their competitors’. The restaurant business is still a penny business, says Paul, because of the huge number of transactions: “An extra dime on a cup of coffee can add up over the year.”

KeyBanc’s Ludington notes that chains are rolling out “theoretical food-cost systems,” software that enables individual restaurants to compare customer traffic and order volumes going back several years. Brinker, for one, has “a pretty sophisticated [information systems] model,” allows Sonsteby. “Every day we can tell what all of our restaurants sold for lunch and dinner yesterday versus last year, down to the check-level detail — how many chicken sandwiches, how many burgers.”

Brinker managers can also explore “check interdependencies” — which items on Chili’s menu are likely to be ordered in tandem, like fajitas and margaritas — and product mix (the overall combination of items ordered). “There is a lot of science to constructing a menu,” says Sonsteby. “You have to make sure you have certain items that have a good ‘return to net.’” (The average check per Chili’s guest last year was $12.93.)

Menu science and cost-cutting aside, you have to maintain optimism above all, adds Sonsteby — even if most of the news about the restaurant industry and the economy is bad news. Despite the consumer pullback, “I think people see [dining out] as more of a necessity than a luxury, particularly at our price points,” he says. “I keep telling people that this is when careers get made, this is when companies get made. A lot of folks have their heads down; they’re worried about making it to tomorrow. I say, keep your heads up and look forward, try to see what’s over the horizon. It’s a great opportunity here.”

Edward Teach is articles editor of CFO.

On the Financing Menu, Limited Choices

While one rap against casual dining chains is that they all look alike, financing an extreme makeover won’t be easy. “The capital markets right now are essentially closed to even a lot of investment-grade companies,” says Chuck Sonsteby, CFO of Brinker International. “And anyone in the high-yield space can’t get money from anyone.” Financing for new restaurants, typically offered by midmarket lenders such as GE Capital Markets, Wells Fargo, and Bank of America, has slowed to a trickle, say analysts.

Money for refinancing debt is just as scarce. Restaurant chains that leveraged up when credit was easy could find the going especially tough in coming months. By some estimates as many as 10,000 restaurants of all kinds could close in the next 12 to 18 months, says Brad Ludington, a restaurant analyst at KeyBanc Capital Markets. Ron Paul, president of Technomic, forecasts 1,000 closures in the casual-dining sector in the 12 months following June 30, 2008. Bankruptcies in 2008 are running at least twice the rate for last year, he adds.

Uno Chicago Grill, a 206-restaurant chain controlled by private-equity firm Centre Partners, raised eyebrows in August for deferring a $7.1 million interest payment through a 30-day grace period while it attempted to renegotiate its $142 million in senior secured debt. The recapitalization fell through and Uno paid up, but Standard & Poor’s downgraded the company’s credit rating to D. Today it stands at CCC with a negative outlook, but CFO Louie Psallidas insists the chain is in no danger of going bankrupt. “Everyone in our space is being downgraded and watched carefully,” he says. “It doesn’t change anything we do on a day-to-day basis.” New Uno franchisees will seek financing from local community banks, he adds: “We don’t need a bond rating to access capital.”

As restaurants become insolvent, Chapter 7 liquidations like Bennigan’s may become more common, thanks to the disappearance of debtor-in-possession financing. “There’s been a change in debtor-in-possession financing markets,” comments Sonsteby. “It used to be people would enter into bankruptcy one day and emerge the next with lender financing that allowed them to reject the bad leases and move down the road. But debtor-in-possession financing is really not available anymore.”

All may not be bleak, points out John Hamburger, president of the Restaurant Finance Monitor newsletter. “Restaurants are financed in many different ways,” he says. “Developers finance them, and there’s a fairly decent sale-leaseback market. And there are still some private-equity funds sniffing around the business.”

Restaurant credit was tightening long before the financial crisis erupted, Hamburger says. “You can’t blame the credit slowdown on the crisis; you have to blame it on the fundamentals.” — E.T.

The Natl. Restaurant Association's Performance Index fell below 100 for the 13th straight month.

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