DC Advisory
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We are all stunned, investors, operators, analysts, bankers, alike. Our lives, professionally and otherwise are seriously changed, if not forever, then definitely over the next year or two.

You’ve no doubt already read a number of excellent articles and heard podcasts outlining steps  that operators should be taking, including: cash conservation, focus on off premise sales wherever possible, talk to your bankers and landlords (who are financing your premises), communicate with your employees (and ex-employees) as much as possible to be prepared for the startup. We disagree with the suggestion that it will be difficult to restart if you close down completely. Your current staff, if you treat them humanely as they leave, will be anxious to get back and they haven’ t forgotten how to cook, serve, or manage.

I haven’t written anything in the last week or so because my primary focus is on the financial side of things, and it is impossible to know what that aspect looks like. We don’t know when or how renewed activity is going to take place. We know there will be a great deal of damage to balance sheets but can’t measure it. Stock prices have come down from a relatively  modest 20% (in the rare case of Domino’s) to a more typical 75-80% at the lows of last week. Yesterday and today we have seen huge “dead cat” bounces, over 100% in the case of Red Robin (from $5 to $12), for example, but it is still down from $24 three weeks ago and $36 six weeks ago. In most cases, the prices at the moment, still down over 50% from just a few weeks ago, are efficiently valuing the huge uncertainties ahead.

My observation is that the restaurant industry participants most affected long term but probably not yet adequately discounted by their stock price, is that group that took the greatest opportunity to leverage themselves to the hilt. That is the pure franchisors, living off “free cash flow”, and leveraging themselves to the hilt in the process. Private equity investors and activists have blessed the “asset light” model and this has been a catalyst in the process. If current management of the publicly held company won’t engineer the balance sheet appropriately, there have been hundreds of millions of dollars with private equity firms, with leverage on top of that, that will be happy to help. It has been a productive formula for a long time. We have written many times about the fact that franchise royalties are not “free cash flow”, that support has to be provided to the system to keep it modern and relevant. We have pointed out that funds used to repurchase hundreds of millions (and more) of stock could have been, at least partly, used for new product development, and a myriad of other operating needs.

Just a few examples of heavily indebted pure franchisors are: Wendy’s (with debt at 4.8x trailing twelve month Adjusted EBITDA), Dunkin’ Brands (4.8x), Yum Brands (4.7x), Restaurant Brands (4.5x), Jack in the Box (4.2), Dine Brands (4.3x). Of course the  multiple of debt vs. TRAILING TWELVE MONTH EBITDA has become irrelevant. We can’t even imagine what the EBITDA is going to be the next twelve months, the twelve months after that, or beyond.

What we can imagine is that the franchisee, when he or she re-opens their stores, is that royalty payments are going to be the farthest thing from a priority. Rents have to be renegotiated, suppliers and employees have to be paid if product is going to move through the facility, utilities and insurance can’t be stretched too far, trash  must be picked up, etc.etc. Sales will likely be strong compared to the last few months, after the cabin fever breaks, but it is reasonable to assume that social distancing will be in place, enforced or not. You get the picture.

With the above in mind,publicly and privately held franchisors had best evaluate their own levels of corporate overhead, since all that free cash flow has turned out to be not so automatic. This brings us back to the billions of dollars of loans that have to be repaid somehow, probably with fewer stores and lower sales. No doubt more than a few franchised stores will close and I wouldn’t count on many newly built locations. For example, that $11B of net debt at Restaurant Brands (QSR) may have to be stretched out, and I don’t think they will be buying any more stock back from 3G. (FWIW, I currently have no position in QSR.)

Since I promised to point out some opportunities, I would most seriously consider operators with little or no debt, a small physical store footprint, an ability to provide off-premise service, and historically strong store level economics. Valuations aside, chains that meet that general outline include, Starbucks, Domino’s and WIngstop.

As a last word, on an optimistic note: The restaurant industry has been over-stored for years, with new locations still being built. That issue is solved. Rents, which have only gone up, will be far more negotiable. Labor will be more available, for not much more than the minimum wage. In short, survivors could have an easier time, even though a difficult transition is ahead, and people have to eat, after all.

The sun is still rising in the east, and we’ve had a good run. Stay healthy, and we’ll figure something out.

Roger Lipton