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FAT BRANDS, INC. (FAT) – NEW RESEARCH COVERAGE ESTABLISHED

FAT BRANDS, INC. (FAT) – NEW RESEARCH COVERAGE ESTABLISHED

CONCLUSION

FAT BRANDS, INC. (FAT) has come a long way over the last several years. The company has established a multi-branded restaurant franchising company, now with over $700M of systemwide sales within the portfolio’s nine brands. The units are mostly within the fast casual segment of the restaurant industry, a generally good positioning within the post-Covid convenience driven consumer economy. The performance since becoming publicly owned three years ago has been sufficient to leverage the balance on acceptable terms and, in spite of the operating challenges within the last twelve months, fresh capital has been raised and an important acquisition doubled the company’s reach. Most recently, a merger with the corporate parent simplifies the situation and provides a $100M tax loss carryforward.

The company has guided to a doubling of the 2019 pre-Covid cash flow (EBITDA) generation once post-Covid normalization takes hold. Beyond that, $12M of current cash, an apparent ability to add to existing debt arrangements and potentially refinance or improve terms on current debt should allow for further acquisitions. Though, as Yogi Berra said “predictions are always difficult, especially about the future”, aside from the normal macro concerns, the performance of FAT will depend upon (1) continued reasonable performance, supported by the corporate team, of the existing portfolio, (2) the integration of the recent Johnny Rockets (JR) acquisition, including reduction of the previous JR G&A, as shown in our operating model below (3) future acquisitions generating an attractive return. While we cannot predict the timing of post-Covid “normalization”, we expect Fat Brands to continue on its growth path, especially if the current low interest rate environment prevails. The Enterprise Value of FAT, at about $180M is about 12x the post-Covid EBITDA potential, 30%-40% less than the valuation accorded larger publicly held pure franchising companies. As FAT demonstrates the performance of its current brands and the portfolio expands further, there is room for the valuation of FAT common stock to grow as well.

COMPANY BACKGROUND

FAT Brands, Inc. (FAT) has been publicly held since late 2017, with only about two million shares publicly outstanding. Though this is about to change, 81.5% of the shares issued have been owned by Fog Cutter Capital Group Inc. Management, led by CEO, Andrew Wiederhorn, has established a platform to support a portfolio of restaurant franchising companies. The object is to spread the administrative and promotional costs, as well as using best practices to improve and build the individual brands.

Per: The most recent Investor Presentation

The two largest contributors to current FAT revenues are the first and last acquisitions, Fatburger and Johnny Rockets.

In order of purchase: Fatburger was purchased by Fog Cutter in 2003, transferred to FAT prior to the IPO in October ‘17, Buffalo’s Café and Buffalo’s Express were purchased by Fog Cutter in 2011, transferred to FAT prior to the IPO, Ponderosa and Bonanza Steakhouses were purchased in October ’17 in conjunction with the IPO, Hurricane Grill & Wings was purchased in November ‘17, Yalla Mediterranean in December ‘18, Elevation Burger in June ‘19, and Johnny Rockets in September’20. In total, FAT’s portfolio today consists of over 700 franchised locations with systemwide sales over $700M. Each concept is described in detail below.

MANAGEMENT

The founder, CEO and President is 54 year old, Andrew Wiederhorn. He also founded Fog Cutter Capital Group, Inc. After earning a B.S. in Business Administration from USC in 1987, he founded and was CEO of Wilshire Financial Services Group and Wilshire Credit Corporation. He has served on numerous philanthropic Boards, the Citizens Crime Commission of Oregon, the Economic Development Council for Beverly Hills Chamber of Commerce. He was featured as Fatburger CEO in 2013 on “Undercover Boss”, still available and worth watching on youtube. We would be remiss not to mention that Wiederhorn pleaded guilty to filing a false tax return in 1998, by way of which he violated an ERISA statute. He paid a total of $4.6M in fines and fourteen months in federal prison in ’05-’06. Over two decades removed from this obviously unfortunate episode, based on his ability to raise approximately $150M from the capital markets, Wiederhorn seems to have overcome possible doubts about his personal integrity as well as the prospects for Fat Brands.

The CFO is 47 year old Rebecca Hershinger. After earning a Business Degree from Georgetown University and an MBA from Wharton, she studied at Oxford and was an analyst at JP Morgan Chase. With Fat Brands since 2018, she was previously CFO of a publicly traded global children’s media company.

The President of the Casual Dining Division is 64 year old Gregg Nettleton, with FAT since October ’17. Prior to that he was President and CEO of an international consulting firm. His restaurant experience includes Board Membership at Black Angus Steakhouses, Chief Marketing Officer at IHOP and Interim Chief Marketing Officer at Applebee’s.

The Chief Operating Officer of the Fast Casual Division since February 2020 is 36 year old Jacob Berchtold. He joined Fatburger in 2005, out of Arizona State University, as a restaurant manager and member of the new store opening team. He has served in a wide variety of operational management positions with Fatburger company and franchised locations, in China, S.E. Asia, the Middle East and North Africa.

The Senior VP of Finance is Ron Roe, previously with Fog Cutter Capital and Piper Jaffray.

The Chief Marketing and Chief Development Officers are Thayer and Taylor Wiederhorn,  respectively, both of whom have spent over 10 years with Fog Cutter Capital, Fatburger and Buffalo’s Café/Express.

The Board of Directors is headed by Chairman, Edward Rensi, former President of McDonald’s, USA. Other Board members include James Neuhauser of Stifel Nicolaus, Turtlerock Capital, Fifth and Co. and the Bank of New England: and Squire Junger of Knight Consulting and Arthur Anderson.

STRATEGIC OVERVIEW

It is difficult for a relatively small publicly held company to build a portfolio of high quality restaurant brands, especially when there are hundreds of billions of dollars competing for attractive acquisitions. The process, of necessity, must focus on brands that seem troubled or are too small for multi-brand operators like Restaurant Brands (QSR, with Burger King, Tim Horton’s, Popeye’s), Yum Brands (YUM, with Taco Bell, KFC, Pizza Hut, Habit Burger), Bloomin’ Brands (BLMN) or privately held Inspire Brands (franchising Arby’s, Buffalo Wild Wings & Sonic). FAT, as a relatively small new competitor must deal with a lack of purchase currency: neither a large equity capitalization or inexpensive debt.

It is understandable therefore that Fat Brands, after going public in late 2017, with just a couple of brands, the most important of which was Fatburger (the first acquisition), has had to piece together a portfolio of brands too mature, not large enough, or not growing fast enough to attract a higher price from other bidders. It was on that basis that Hurricane, Ponderosa and Bonanza, Yalla and Elevation were acquired. By mid-2020, FAT had established an operating record good enough to monetize the existing royalty stream and raise capital at an acceptable interest rate to acquire Johnny Rockets (JR). JR has instantly become the “bookend” to Fatburger, between them providing the bulk of the current royalty stream and growth potential. As described further below, the post-Covid and post-JR cash flow  potential is expected to be at least a doubling of that in pre-Covid 2019. The currently liquid balance sheet plus further monetization of the royalty stream at an increasingly attractive interest rate, would allow for further acquisitions to build upon the newly enlarged base.

THE BRANDS

Fatburger – (The Last Great Hamburger Stand), was founded in Los Angeles, California in 1947. It serves a variety of freshly made-to-order, customizable, big, juicy, and tasty Fatburgers, Turkeyburgers, Chicken Sandwiches, Impossible™ Burgers, Veggieburgers, French fries, onion rings, soft-drinks and milkshakes. Fatburger has counted many celebrities and athletes as past franchisees and customers, and they believe this prestige has been a principal driver of the brand’s staying power. As of December 29, 2019, there were 163 franchised and sub-franchised Fatburger locations across eight states and 18 countries.

Per the most recent Fatburger Franchise Disclosure Document: it costs from $459K to $988K to begin operations, including the initial franchise fee of $50k. Current ongoing fees include 6%% royalty plus national ad fund of 1.9% within Los Angeles DMA or 0.95% outside of LA DMA, plus 2.0% local ads. Item 20, Page 60, shows 163 systemwide outlets (all franchised)  (79 domestic and 84 Int’l) at 12/31/19. The areas with US states with 5 or more locations are: CA (50), NV (15), WA (5), Canada (54), and China (5).  During fiscal 2019 the domestic system grew by 9 units.  

Buffalo’s Café  (and Buffalo’s Express) – Buffalo’s Café was established in Roswell, Georgia in 1985, Buffalo’s Cafe (Where Everyone is Family) is a family-themed casual dining concept known for its chicken wings and 13 distinctive homemade wing sauces, burgers, wraps, steaks, salads and other classic American cuisine. Featuring a full bar and table service, Buffalo’s Cafe affords friends and family the flexibility to enjoy an intimate dinner together or to casually watch sporting events. Beginning in 2011, Buffalo’s Express was developed and launched as a fast-casual, smaller footprint variant of Buffalo’s Cafe offering a limited version of the full menu with an emphasis on chicken wings, wraps and salads. Current Buffalo’s Express outlets are co-branded with Fatburger locations, providing  complementary concepts that share kitchen space and result in a higher average unit volume (compared to stand-alone Fatburger locations. As of December 29, 2019, there were 17 franchised Buffalo’s Cafe and 87 co-branded Fatburger / Buffalo’s Express locations globally.

Per the most recent Buffalo’s Cafe Franchise Disclosure Document: For Buffalo’s Cafe it costs from $407k to $1,009k, including the initial franchise fee of $50k, to begin operations. Current ongoing fees include 6% royalty plus 2.0% for the Creative Ad Fund, plus 2.0% local ads. Item 20, Page 60 shows 18 systemwide units (14 domestic) operating at 12/31/19, all franchised. The distribution of units is: GA (14) and Qatar (4). The system unit count was unchanged during ’19.

Relative to the co-branding of Buffalo’s Express within Fatburger outlets, it costs $36.5K to $88K to begin operations of a co-branded operation, plus the initial franchise fee of $25k. The ongoing fees are consistent with those paid by the Fatburger franchise partner. Per the FDD, “since 2012 Fatburger has permitted a total of 34 of its franchisees (in 87 locations) to also display the Buffalo’s Café marks, trade dress, and serve a limited menu relative to that described above.

Ponderosa & Bonanza Steakhouses – Ponderosa Steakhouse, founded in 1965, and Bonanza Steakhouse, founded in 1963, offer the quintessential American steakhouse experience, for which there is strong and growing demand in international markets, particularly in Asia and the Middle East. Ponderosa and Bonanza Steakhouses offer guests a high-quality buffet and broad array of affordably priced steak, chicken and seafood entrées. Buffets at Ponderosa and Bonanza Steakhouses feature a large variety of all you can eat salads, soups, appetizers, vegetables, breads, hot main courses and desserts. An additional variation of the brand, Bonanza Steak & BBQ, offers a full-service steakhouse with fresh farm-to-table salad bar and a menu showcase of USDA flame-grilled steaks and house-smoked BBQ, with contemporized interpretations of traditional American classics. As of December 29, 2019, there were 76 Ponderosa and 13 Bonanza restaurants operating under franchise and sub-franchise agreements in 16 states and five countries. There is not a current FDD for these brands, and the current stay at home economy is least promising for this portion of the FAT portfolio.

Hurricane Grill & Wings – Founded in Fort Pierce, Florida in 1995, Hurricane Grill & Wings is a tropical beach themed casual dining restaurant known for its fresh, jumbo, chicken wings, 35 signature sauces, burgers, bowls, tacos, salads and sides. Featuring a full bar and table service, Hurricane Grill & Wings’ laid-back, casual, atmosphere affords family and friends the flexibility to enjoy dining experiences together regardless of the occasion. The acquisition of Hurricane Grill & Wings has been complementary to FAT Brands existing portfolio chicken wing brands, Buffalo’s Cafe and Buffalo’s Express. As of December 29, 2019, there were 51 franchised Hurricane Grill & Wings and 2 franchised Hurricane BTWs (Hurricane’s fast-casual burgers, tacos & wings concept), across eight states.

Per the most recent Franchise Disclosure Document, dealing with domestic units: It costs from $491k to $1,088k to begin operations, including the initial franchise fee of $50k. Current ongoing fees include 6% royalty, plus 2% to nat’l ad fund, plus 2% spent on local ads. Item 20, page 63, shows 51 domestic units or int’l), all franchised plus 1 affiliated unit in FL operating at 12/31/19. The states with 2 or more locations are: AL (2), FL (36), and NY (9). During calendar 2019, the system declined by 6 units. Relative to the Hurricane BTW franchise, it varies from the above by the fact that the cost to begin operation ranges from $260k to $521k, including the $5k initial franchise fee.

Yalla Mediterranean – Founded in 2014, Yalla Mediterranean is a Los Angeles-based restaurant chain specializing in authentic, healthful, Mediterranean cuisine with an environmental conscience and focus on sustainability. The word “yalla” which means “let’s go” is embraced in every aspect of Yalla Mediterranean’s culture. Yalla offers wraps, plates, and bowls in a fast-casual setting, with cuisine prepared fresh daily using, GMO-free, local ingredients for a menu that includes vegetarian, vegan, gluten-free and dairy-free options. The brand demonstrates its commitment to the environment by using responsibly sourced proteins and utensils, bowls and serving trays made from compostable materials. Also featured are an on-tap selections of craft beers and fine wines. Originally acquired as company operated, two restaurants had been franchised as of December 29, 2019, with the intention of franchising the remaining five existing Yalla locations to franchisees and expand the business through additional franchising.

Per the most recent Yalla Franchise Disclosure Document: If a current company store is being purchased, the franchise will pay Fat Brands from $500k to $700k, depending on the existing location, which will include assets and initial franchise fee ($50k). Stores to be constructed will cost $525k to $988k, including the $50k initial franchisee fee, to open. Current ongoing fees include 6% royalty plus 2.0% to the National Ad Fund, plus 2.0% for local ads.  Per the most recent Franchise Disclosure, Item 20, Page 57 shows 7 systemwide units, unchanged in the last two years, with the 2 stores moving from company to franchisee during 2019. All locations are in California.

Elevation Burger – Established in Northern Virginia in 2002, Elevation Burger is a fast-casual burger, fries, and shakes chain that provides its customers with healthier, “elevated” food options. Serving grass-fed beef, organic chicken, and French fries cooked using a proprietary olive oil-based frying method, Elevation maintains environmentally-friendly operating practices including responsible sourcing of ingredients, robust recycling programs intended to reduce carbon footprint, and store décor constructed of eco-friendly materials. Ownership of the Elevation Burger brand aligns with our the corporate mission of providing fresh, authentic and tasty products, complementing the Fatburger brand. As of December 29, 2019, there were 45 franchised Elevation Burger locations across nine states and four countries.

Per the most recent EB Franchise Disclosure Document: It costs from $459k to $988k to begin operations, including the initial franchise fee of $50k. Current ongoing fees include 6% royalty plus 1.5% national ads plus 2% local ads.  Per the most recent Franchise Disclosure, Item 20, Page 60 shows 48 total systemwide units (27 domestic + 19 int’l franchised) + 2 Affiliates operating at 12/31/19. There are at least 2 units operating in: ME (4), MD (5), MI (2), NY (4), PA (5), VA (4) (US Total of 27), Bahrain (3), Kuwait (8), Qatar (4), UAE (3) (Int’l Total of 19). The two Affiliated units are in VA. The total number of units declined by 4 in fiscal 2019.

Johnny Rockets – Founded in 1986 by Ronn Teitelbaum in Los Angeles, originally a 20 stool counter operation on Melrose Avenue, presenting a 1940s vintage style malt shop. The first unit, featuring jukeboxes, red-vinyl booths and chrome counters, opened with fans such as Bob Hope and Elizabeth Taylor. The chain grew to 200 locations by 2007 when it was acquired by RedZone Capital. By 2013, when Sun Capital Partners bought it, there were 300 locations in 30 states and 16 countries, including more than a dozen in amusement parks and cruise ships. They typically offer lunch and dinner, featuring made to order burgers, crispy fries, chili, hand-spun shakes and malts, plus sandwiches and other items. Today, under FAT’s ownership there are 322 locations operated by 129 franchisees, having reported 2019 systemwide sales of $316M. The average royalty in 2019 was 4.3%.

Per the most recent JR Franchise Disclosure Document, dealing with domestic units: It costs from $597k to $1,189k to begin operations, including the initial franchise fee of $50k. Current ongoing fees include 6% royalty, plus 2% to a marketing fund, plus 2% spent on local ads. Item 20, page 51, shows 175 domestic units (not including cruise ships or int’l) (162 F + 13 C ) operating at 12/31/19. The US states with 5 or more units are in CA (30), CT (5), FL (14), GA (6), MD (8), NV (12), NJ (6), NY (10), PA (5), RI (5) and TX (5). During calendar 2019, the domestic system declined by 22 units (20F + 2C). Internationally: SEC filings show 177 int’l units as of 9/30/20, with the heaviest concentration in Chile, Korea, Brazil and Mexico, with units also operating in over twenty five other countries.

THE BALANCE SHEET

The company raised a total of $49M ($40M of “M-2” plus $9M of “Series B”, below) in the third quarter, which funded the Johnny Rockets acquisition and provided a $12M unrestricted cash cushion going forward. In addition to the cash, as of 9/30/20, there were current assets of $31.2M almost exactly matching $31.8M of current liabilities, long term debt, net of $1.6M current portion amounting to $78.4M. There was also (net of offering costs, OID, etc.) $13M of Preferred Stock (not including $13M to be issued in Q4 in conjunction with the Fog Cutter transaction, discussed below), along with $12.7M of equity. The long term debt is obviously substantial relative to the historical trailing EBITDA, but a great deal of it was incurred to purchase Johnny Rockets, with a cushion for a future purchase. Relative to the post-Covid expectation, including Johnny Rockets, of EBITDA in the range of $15-16M, the long term debt to EBITDA ratio drops in half to a more tolerable 5.2x. The table below shows that the weighted average interest rate on the Series 2020 notes is 8.75%. Management has noted their intention to refinance these notes at a lower interest rate in H1’21.

THE MOST RECENT TRANSACTION – MERGING FAT BRANDS WITH PARENT, FOG CUTTER

The Company announced in late 2020 a plan to merge with Fog Cutter Capital. FAT is now the surviving Company and individual shareholders of Fog Cutter own common shares of FAT with the total outstanding unchanged. Presumably to offset the elimination of the $38M receivable from Fog Cutter, each share of FAT common shareholders received .232 shares of FAT Brands’ 8.25% Series B Cumulative Preferred Stock (FATBP) which have recently been trading in the area of $16/share. The company has not yet filed information relative to the post-merger balance sheet.

The most important advantages of this transaction are (1) Fog Cutter no longer has to own over 80% of FAT to maintain its $100M tax loss carryforward, so FAT can use its stock for acquisitions (2) FAT gets the use of the tax loss carryforward  (3) The public float of FAT increases to 46% of the fully diluted shares (4) Intercompany balance sheet items are eliminated.

THE ENLARGED POST-COVID PLATFORM

It is clear now that 2020 was a lost year in terms of revenues, earnings, and cash flow progress for most restaurant companies. In spite of that, Fat Brands made meaningful progress, building on their base of brands with the Johnny Rockets acquisition as well as positioning the balance sheet for long term growth. Though we cannot predict at what point normalized post-Covid operations will be in place, our exercise is to take the 2019 platform, breaking the royalty stream down by brand, and then project forward in a reasonable fashion to the post-Covid earning and cash flow power of the FAT franchise portfolio.  In addition to the numbers shown below, it is worth noting that a total of 57 new locations  have opened across the portfolio in the first nine months of 2020, up from 52 in 2019, plus six ghost kitchens. We have, however, projected forward to a post-Covid environment assuming no growth in units or same store sales.

By definition, the projections cannot be precise, either numerically or within a timeframe. However, we have pieced together the model just below from SEC filings and investor presentations, with relevant assumptions indicated by footnotes. Our model indicates that the company conclusion that pro forma EBITDA, post-Covid with the inclusion of Johnny Rockets, could double or more from the $6.7M ($7.7M Adjusted) in calendar 2019 appears reasonable. Our most important assumptions are that the most important segments, namely Fatburger, Hurricane Grill and Johnny Rockets don’t deteriorate from their 2019 results and the G&A from Johnny Rockets can be cut from $11.9M to $6.1M annually.

 CONCLUSION : Provided at the beginning of this report

 

SUN CAPITAL PARTNERS HAS HAD ENOUGH WITH THE RESTAURANT INDUSTRY – WHAT CAN WE LEARN?

SUN CAPITAL PARTNERS HAS HAD ENOUGH WITH THE RESTAURANT INDUSTRY – WHAT CAN WE LEARN?

It is 17 years since Sun Capital Partners, a multi-billion dollar private equity firm made their first investment, buying Bruegger’s Bagels, within the restaurant industry. Seventeen years can be viewed as pretty much a complete cycle in terms of up and downs. With only one material restaurant chain left in their portfolio, they have announced their departure from our favorite industry. We’re here to learn, so we spent an unexpectedly long time reconstructing the important elements of thirteen transactions. We stand to be corrected if we’ve missed anything material, but we’re not the library of congress (for $100 annually) and we do our best. At the end of this piece, we will summarize the bottom line.

Bought – Company

2003 – Bruegger’s

2005 – Souper Salad

2005 – Garden Fresh

2006 – Real Mex Restaurants

2006 – Fazoli’s

2007 – Restaurants Unlimited

2007 – Friendly’s Ice Cream

2007 – Boston Market

2008 – Smokey Bones

2008 – Timothy’s Coffee

2010 – Captain D’s

2010 – Bar Louie’s

2013 – Johnny Rocket’s

Let’s look at these deals in chronological order from the time they were initiated.

BRUEGGER’S

Bruegger’s Bagels, founded by our friend Nord Brue and originally based in Burlington, VT was acquired by Sun Capital in 2003 when sales and profits were declining. In the course of the next eight years management, led by CEO, Jim Greco, reduced the Company’s cost base, remodeled nearly all locations, introduced new product lines, and increased store count through the opening of new Company–operated and franchised units as well as  add–on acquisitions. Separately, Sun Capital had bought Canadian based Timothy’s Coffee in March, 2008 (with 106 franchised Timothy’s, 47 mmmuffins, 13 Michel’s Baguette’s) for a reported $100M. In November, 2009, Sun sold Timothy’s to Green Mountain Coffee for $167MM but, immediately prior to that sale, Sun sold the franchised operations of Timothy’s to Bruegger’s. Between the purchase of Bruegger’s in 2003 and 2011, when Bruegger’s and the franchised locations of Timothy’s were sold to Group Le Duff SA, a French company, sales were reported to have grown by 76% from 2003 while EBITDA more than doubled.

Bruegger’s was a very successful investment by Sun Capital, making a reported 13x their investment for a 35 percent annualized internal rate of return. We don’t know whether the reported gain on Timothy’s was included in this calculation, but Bruegger’s/Timothy’s was all very good news.

Postscript: In 2017 Group Le Duff sold Bruegger’s to Caribou Coffee, owned by JAB Holding Co., owner of Panera Bread, Einstein Noah Bagels, Peet’s Coffee, and others including Green Mountain Coffee, which had bought Timothy’s from Bruegger’s in 2009.

SOUPER SALAD

In 1978, the first Souper Salad (SS) was opened by Ray Barshick in Houston, Texas. It was acquired, with about 91 locations, by Sun Capital in 2005. In 2007 Souper Salad added  Grandy’s (with one company store, 4 franchised stores managed by the company and 67 franchised locations, bought out of Spectrum Restaurant Group’s bankruptcy). By the middle of 2008 SS had grown to 151 stores in 17 states. In 2009, the company began selling franchises. However, coming out of the 2008-09 recession, the SS chain had shrunk to 80 units by the end of 2010. In 2011, the parent company filed Chapter 11 bankruptcy and 25 more locations were sold. LNC Ventures, owned by Dan and Jackie Hernandez, bought SS out of bankruptcy in 2012. In the course of 2011, Souper Salad had also disposed of the 65 unit Grandy’s chain, selling to Sun portfolio company, Captain D’s.

Postscript: By late 2013, the SS chain was down to 45 locations. In 2014, SS, with 37 locations, was sold by LNC to Brix Holdings, LLC., based in Dallas.[5][6] After the acquisition, Dan Hernandez remained president of Souper Salad until 2016. [7] Grandy’s, still a sister concept to Captain D’s, has not helped anyone in a long time, shrinking from 72 units in 2007 to 38 locations in 2019 and only 27 units by August, 2020.

There doesn’t seem to be any obvious way that Sun Capital could have made any money on this investment.

GARDEN FRESH

Garden Fresh, founded in 1978 in San Diego, CA, amounted to 97 company operated soup and salad restaurants operated as Souplantation and Sweet Tomatoes when purchased for $198M by Sun Capital in 2005. By 2012, when top management was changed, there were a larger total of 118 locations. In October, 2016, now with 123 locations, Garden Fresh declared bankruptcy. It was purchased out of bankruptcy by Cerberus Capital Management in January, 2017.

We have no knowledge of the operational results or balance sheet changes at Garden Fresh while under the ownership of Sun Capital, so dividends paid out of recapitalizations or cash flow from operations, as well as annual fees could have mitigated the losses on this situation, but it was likely not a great investment success.

REAL MEX  RESTAURANTS

Sun Capital bough Real Mex from Bruckmann, Rosser, Sherrill & Co., reportedly for $359M, in August 21, 2006. There were 200 company-owned restaurants operating in more than a dozen States. The primary concepts were: El Torito, El Torito Grill, Chevys Fresh Mex and Acapulco. However, as the economy weakened by late ’08, Sun Capital’s leverage required them to swap majority control for a reduction in the debt burden. My mid-2010, however, Sun Capital was once again majority owner (70%), of the restaurant portfolio, by way of a debt for equity swap, with Real Mex consisting of 183 operated locations plus 26 Chevy’s franchised units.

The situation obviously deteriorated quickly from mid-2010 to late-2011, when Real Mex entered bankruptcy.  A group of noteholders had the winning bid to acquire the assets in the bankruptcy auction.

There does not seem to be any obvious way that Sun Capital succeeded with this investment.

FAZOLI’S

Fazoli’s, with 319 locations, 179 of which were franchised, was bought by Sun Capital in 2006. The plan was to revitalize the menu, improve the food quality and variety, upgrade the décor, refine the marketing and reduce costs. The Company was sold in 2015 to Sentinel Capital Partners (owner of Checkers, Rally’s, Newks, and TGI Friday’s), at which point the Fazoli’s system consisted of 213 locations, 89 of which were franchised.

Since Fazoli’s shrunk by a third in size while owned by Sun, it would be logical to assume that they didn’t do well with it. However, reports are that Sun Capital made three times their investment over nine years of ownership. This was a function of Fazoli’s  poor management prior to Sun’s purchase, therefore a modest purchase price, cash flow improvements while owned by Sun Capital and a more full valuation at sale.

RESTAURANTS UNLIMITED

Sun Capital purchased Restaurants Unlimited (RU) in March, 2007. RU, based in Boca Raton, FL, founded by Rich Komen, operated 29 restaurants in total when acquired under names including Palisade, Cutters Bayhouse, Scott’s, Ryan’s Grill and Fondi Pizzeria. Only months later, in July 2007, Sun added Pacific Coast Restaurants (PCR), operating 27 restaurants under the names of Stanford’s, Newport Bay, Manzana, Newport Seafood Grill and others. In July, 2019, Restaurants Unlimited, at that point down to 35 restaurants in six states, filed for bankruptcy. Landry’s bought RU out of bankruptcy for a reported $37M. Multi-brande, multi-unit restaurant, geographically dispersed chains are difficult to manage.

There is no apparent way that Sun Capital could have done well with this investment.

FRIENDLY’S ICE CREAM

In August, 2007, Sun Capital purchased the publicly held Friendly’s Ice Cream Corporation (FIC) for $337M of equity plus $175M of long term debt. At that point there were a total of 515 locations systemwide, plus a distribution system of over 4,000 supermarkets and retail locations. Just four years later, in 2011, FIC filed for bankruptcy protection, at the time with $297M in debt and announcing plans to close 63 of its just under 500 locations and indicating over 7,000 retail points of distribution. It came out of bankruptcy with Sun Capital maintaining ownership while erasing a $75M loan. In 2016, Dean Foods bought FIC’s manufacturing and retail distribution business for $155M. In December 2018, Sun Capital bought back a dozen FIC locations across Massachusetts. Early in 2020, with only 138 locations remaining, FIC filed for bankruptcy once more. FIC has now sold it’s assets for $2M to an investor group affiliated with BRIX Holdings LLC, a Dallas franchising company that owns Red Mango, Smoothie Factory, RedBrick Pizza and Souper Salad (Remember them?). The deal will apparently keep most Friendly’s locations open but cover only a small fraction of the $89 million in secured debt.

We cannot judge the bottom line result of this investment, since we don’t know how the balance sheet was managed during the course of Sun Capital’s ownership, including the sale of the distribution business for $155M in late 2018 to Dean Foods, who happened to declare bankruptcy less than a year later.

BOSTON MARKET

We actively followed publicly held, rapidly growing, unit level profit challenged, Boston Market (BM) in the 1990s. Stock market darling BM raised a lot of capital inexpensively, some of which financed franchisees, grew to over 1,100 systemwide units, then went bankrupt. McDonald’s purchased it out of bankruptcy in 2000 for $173.5M. Sun Capital took it off MCD’s hands in 2007, purchase terms unknown, with 630 locations systemwide. Sun Capital was rumored to put BM up for sale in 2017, seeking $400M, but not to be.  In July, 2019, 45 restaurants were closed, bringing the unit count down close to 400. Engage Brands (owner of Pizza Hut, Checker’s & Rally’s) bought Boston Market (down to 390 stores) from Sun Capital in 2019.

Terms of the purchase from McDonald’s and the sale to Engage Brands were not disclosed but there is no apparent way that Sun could have been successful with this investment.

SMOKEY BONES

Originated by Darden Restaurants in Orlando, FL in 1999, Smokey Bones (SB) was grown to a peak of 128 locations, reduced to 73 locations when Sun Capital bought it from Darden in early 2008. The purchase price was reported to be $80M. As of August, 2015, 66 locations were operating. There have been a number of top management changes within the last 13 years, the most recent of which was the appointment of well regarded James O’Reilly (previously with Long John Silver’s, Sonic Corp, YUM and Pepsico) as CEO in November, 2019. At that point, there were 61 locations in 16 states. Smokey Bones remains under the ownership of Sun Capital. Most recently, James O’Reilly announced the opening of 122 Virtual Restaurants, delivery-only, working out of SB’s ghost kitchen in Chicago and the existing 61 restaurants, featuring a limited menu of burgers and wings.

This investment remains a work in progress.

TIMOTHY’S COFFEE

In March, 2008, when purchased by Sun Capital, Timothy’s Coffees of the World (TC), an operator of a retail chain of 166 store, 70% within Ontario, was an operator of Timothy’s, mmmuffins, and Michel’s Baguette. Timothy’s was also a wholesale distributor of single serve coffee and tea products. Purchase terms were not disclosed. In November, 2009, Sun sold Timothy’s to Green Mountain Coffee Roaster’s for a reported $157M in cash. Immediately prior to the sale, Sun Capital’s Bruegger’s bought the Canadian franchised locations (for an undisclosed price), which remained with Bruegger’s until its sale to Group Le Duff in 2011.

Timothy’s was no doubt a very successful transaction, since it was purchased and sold in a short 20 months, and the franchised Timothy’s that were transferred to Bruegger’s may have also made a tangible contribution to the EBITDA at Bruegger’s which was later monetized.

CAPTAIN D’S

Captain D’s (CD), originated in 1969, and built under the ownership of Shoney’s, was comprised of 539 locations across 25 states when Sun Capital bought it in 2010. Captain D’s, in turn, acquired Grandy’s in 2011 from bankrupt Spectrum. Grandy’s has not helped anyone in a long time, shrinking from 72 units in 2007 to 65 locations when CD purchased it in 2011, to 38 locations in 2019 and 27 units by August, 2020 (long after Sun’s departure from CD), still a sister concept of Captain D’s. Sun sold CD in December, 2013 (with 521 restaurants systemwide, fewer than the 539 when purchased in 2010) to Centre Partners. Through a combination of initiatives EBITDA had reportedly gone from $12M to $25.5M over less than four years of Sun’s ownership and Sun made 8x their investment, a stunning 105% internal annualized rate of return. Ain’t leverage grand ?

Captain D’s was an obvious grand slam home run. It’s interesting that Centre Partners “flipped” Captain D’s (with the similar 530 stores systemwide) five years later, saying “We are very proud of our successful investment in Captain D’s”. Only in America (worldwide, actually) with zero percent interest rates.

BAR LOUIE’S

Bar Louie’s (BL), started in Chicago in 1991, was purchased by Sun Capital in June, 2010. At that point there were 36 company operated and 8 franchised units systemwide. We have no knowledge of the operating history in the ten years since purchase, but no doubt a great deal of debt was in place, typical of private equity ownership, as the chain was expanded from 36 to 110 company operated locations, providing a substantial burden on corporate cash flow. Even before the pandemic, the traffic declines at shopping malls, where many of the 110 corporate units were located, penalized sales and profits.  In early 2020, after closing 38 of its 134 locations restaurants and arranging to sell its remaining locations to lenders, Bar Louie’s filed for chapter II bankruptcy protection. Creditors were apparently owed $110M.  On April 27, 2020 the court approved the sale to secured lender, GE Capital affiliate, Antares Capital LP and the chain emerged from bankruptcy in early June.

There is no indication that Sun Capital emerged with any post-bankrupt equity but there might have been at least a  partial recovery of capital in a recap while owned.

JOHNNY ROCKET’S

Johnny Rockets, founded in 1986 by Ronn Teitelbaum, consisted of 300 locations, almost all franchised, in June, 2013 when purchased by Sun Capital, reportedly for about $80M. It’s interesting that Sun Capital bought it from RedZone Capital (backed by billionaire Dan Snyder, owner of the Washington Redskins football team) who had bought it in 2007 from Centre Partners/Apax Partners. Earlier in 2020, after seven years of ownership, Sun Capital sold JR (with 325 stores, including 9 company operated) to publicly traded FAT Brands (FAT) for $25M.

Based on the $80M or thereabouts that Sun Capital paid for Johnny Rockets, and the $25M that Sun Capital received, it seems likely that this deal didn’t provide a great outcome for Sun’s investors.

THE BOTTOM LINE

Bruegger’s – a grand slam home run – supposedly 13x their investment

Souper Salad – not good

Garden Fresh – not good

Real Mex – not good

Fazoli’s – a reported 3x return

Restaurants Unlimited – not good

Friendly’s – not great, might have gotten out whole

Boston Market – not bankrupt, but not good

Smokey Bones – work in progress

Timothy’s Coffee – an apparent grand slam, especially over only 20 months

Captain D’s – a grand slam home run – supposedly 8x their investment

Bar Louie’s – not good

Johnny Rockets – can’t make much if you receive a third of what you pay

SUMMARY

Three out of the twelve closed out positions were grand slam successes (Bruegger’s, Captain D’s and Timothy’s), and one (Fazoli’s) was a triple, so that offsets the losses on the majority of the portfolio. Losses for both the sponsor and limited partners  can also be mitigated somewhat by fees for the sponsor and recapitalizations that can benefit both.

Two of the concepts, Garden Fresh and Souper Salad were concepts that just got old, so reinvention was a huge challenge. Real Mex and Restaurants Unlimited were always going to hard to monetize: multiple brands spread over many geographies. With Boston Market they should have called me.  (I think there could still be some potential there. The product used to be good and bone-in chicken serves today’s off-premise customer because it travels so well ! Look how well El Pollo Loco has survived the pandemic.) Back to Sun Capital: They might have gotten out of Friendly’s “whole”, largely by stripping and selling the distribution business for $155M. Fazoli’s worked out because the chain had been so poorly run by the previous owner. Johnny Rockets’ franchise operation might have worked, given more time, with good management, but Sun paid a full price in 2013 and ran out of patience after this year’s pandemic.

It is especially noteworthy that the three or four most successful investments were franchising situations; Bruegger’s, Timothy’s & Captain D’s & Fazoli’s. Franchise systems have to be supported by reinvesting some of that supposedly free cash flow, but at least the balance sheet leverage predictably employed by the private equity sponsors won’t kill you if the economy turns down for a year or two.

CONCLUSION

Don’t give up on the restaurant industry as an investment, just because Sun Capital has had enough. From what we have read Karp/Reilly, Catterton, Roark, Bruckmann/Rosser/Sherrill and others have had better batting averages. I guarantee that there are lots of strong concepts incubating that are equipped to please the public who will always be interested in good food prepared away from home. For our readership that is perhaps managing a small number of privately owned restaurants: consider that a restaurant generating $100k annually pretax is more challenging day to day but financially equivalent to $20M invested in presumably safe short term US Treasury securities. It’s best to protect that cash flow because you may not be able to easily find $20M after taxes.

Roger Lipton

FAT BRANDS INC. (FAT) TO ACQUIRE PRIVATELY HELD JOHNNY ROCKETS – WHY AND HOW??

FAT BRANDS INC. (FAT) TO ACQUIRE PRIVATELY HELD JOHNNY ROCKETS – WHY NAD HOW, AND WHAT IS THE OUTLOOK?

FAT BRANDS INC (FAT), led by CEO, Andrew Wiederhorn, has assembled a group of internationally franchised brands, some better known than others but all of them challenged to varying degrees in recent years. The theory is to leverage operating expertise, marketing power, purchasing scale and administrative costs over independent brands, using an asset light franchising approach (zero company operated locations). Wiederhorn is the controlling shareholder of Fog Cutter Capital Group, Inc., which owns 81% of the common stock of FAT.

The liberal use of debt and preferred stock, as outlined just below, has allowed for the current ownership of:

Fatburger, a burger chain, founded in Los Angeles in 1947, now 168 locations, including 101 co-branded

Buffalo’s, casual dining, wings and classic American platters, GA founded in 1985, now 18 locations

Ponderosa & Bonanza steakhouse, founded in 1960s, now 83 locations

Hurricane Grill & Wings, casual dining, chicken wings, FL  founding in 1995, now 49 locations

Yalla, fast casual, healthy Mediterranean, now 7 locations

Elevation Burger, fast casual with grass fed and organic burgers, 2002 founding, now 41 locations

Systemwide sales in 2019 of these 366 locations (@ 6/30/20) was $395M.

BALANCE SHEET DISCUSSION:

As of 12/31/2019 shareholders’ equity was $5.4M (including goodwill and intangible assets of $55M). Preferred A stock obligation amounted to $15.3M. The current portion of long term debt was $24.5M and the remaining long term portion was $5.2M. Due from affiliates was $26M. The current ratio consisted of $10.5M of current assets and $45.6M of current liabilities.

By 6/30/2020, the balance sheet reflected shareholders’ equity of negative $3.5M (including goodwill and intangible assets of $37M). The Preferred A stock amounted to $15.5M. The current portion of long term debt was reduced to $661k, with the long term portion amounting to $43.9M. Due from affiliates was $34.7M. The current ratio had improved to reflect $10M of current assets against a much reduced $21M of current liabilities. The previous Long Term Debt had been replaced by a face amount of $40M of “Securitization Notes”, netting $37.3M after expenses and discounts, to be repaid from royalties as received. The blended average cash interest rate is 7.75%, which reduces the total weighted average cash cost of debt to 8.49%, decreasing annual interest expense by almost $2M per year.  There is also an “Accordion” feature, allowing for additional acquisition related borrowing.

Post the second quarter, on 7/13/20 FAT raised $8.2M from the sale of 8.25% Series B Preferred Shares and warrants exercisable at $5.00/share. Subsequent to this offering FAT entered into an Agreement to redeem and cancel the remaining Series A Preferred shares. The result was equity increased by $15M, with insiders converting $3M of Series A and accrued dividends into Series B Preferred. Also retired was warrants, exercisable at $7.20, to acquire 554,065 shares.

A VERY QUICK OPERATIONAL LOOK

The first half of calendar ’20 is obviously distorted by the effects of the Coronavirus Pandemic, and the Adjusted EBITDA was a negative $361k. More importantly, the Adjusted EBITDA in calendar ’19 was $7.7M. The Company’s recent presentation talks about 41 additional Fatburger locations since acquisition, integration of Elevation Burger onto the the Fatburger operating platform, a turnaround in Hurricane Grill, from a negative 4.7% comp prior to acquisition to +6.4% in calendar ’19, including +8.3% in Q4’19. The overall portfolio store count has increased from 286 in calendar 2017 to 374 by 12/19 (including acquisitions). Most importantly, demonstrating the efficiency of the multi-brand platform, Total Costs and Expenses as a % of Revenues has come down from 97.7% in ’17 to 62.4% in ’19. It is on this basis that the Company raised $40M with their Securitization and, most recently in Q3, the additional $8.2M.

THE JOHNNY ROCKETS DEAL

This “iconic brand”, as FAT management now terms it, has over 300 locations, spread over 129 individual franchise owners, which will bring the FAT portfolio to over 700 units in total. The new systemwide expectation of over $700M implies that the Johnny Rockets locations are expected to annualize at something like $1M per store. The purchase price is $25M, which will paid for by cash on hand plus the Accordion feature of the recent securitization. FAT management stated that they expect this acquisition to allow them to double their current (in calendar ’19) Adjusted EBITDA of $7.7M. The brief audio “conference call”, with no Q&A, described how FAT can leverage their operating platform with new purchasing power of $250M annually (about 30% or so of $700M), marketing (produced and booked internally at FAT), virtual restaurant offerings, dual branding and FAT’s knowledge of “the burger business”.

WHY WOULD SUN CAPITAL SELL ?

It is reasonable that Johnny Rockets, which is, indeed, a well known brand, could be reincarnated, even if reduced in size after the pandemic, under the right leadership. However, if it is so promising, why would Sun Capital let it go for $25M, especially when FAT management says it is capable of generating $7 or $8M of EBITDA.

Our guess is that Johnny Rockets is generating no more than a couple of million dollars for Sun Capital, perhaps not much more than breaking even. Sun bought it from RedZone Capital in 2013, who had bought it in 2007. After thirteen years in private equity hands, you can bet that the energy provided by early management is long gone. It is “just a name” to Sun Capital, to be bought and sold, and the $25M can be applied elsewhere. Private equity firms always have liquidity concerns as well, so that might come into play here. If Johnny Rockets is breaking even to earning perhaps $2M for Sun Capital, Fat Brands could probably “adjust” that to a current million or two, and believe they can leverage that over a couple of years to six or seven million of EBITDA. Even if it takes longer, and amounts to only $5M, it would be a worthwhile ROI for FAT. A lot more than their cost of capital. So…..the seller is tired…..and the buyer is optimistic….and liquid enough….and that’s how deals get done.

Let’s watch.

Roger Lipton