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Feeding Frenzy Fading: Appetite For Restaurant Debt Wanes As Winners And Losers Emerge

Feeding Frenzy Fading: Appetite For Restaurant Debt Wanes As Winners And Losers Emerge

While U.S. brick-and-mortar retailers face accelerating profit pressure amid the shift to digital sales, the domestic restaurant ratings landscape has performed well in recent years. However, we believe that rosy picture is rapidly changing for many rated operators and franchisees in 2019.

There were no rated restaurant defaults in 2017 or 2018, and S&P Global Ratings saw elevated restaurant new issuer and acquisition volume over the past 18 months. Both corporate debt and whole business securitization issuance from restaurants ticked up, the latter an attractive option given the bankruptcy remote entities that are generally part of the structure. We also note positive rating actions this year on Bloomin' Brands Inc., Carrols Restaurant Group Inc., and Restaurant Brands International Inc. amid better performance at brands including Outback Steakhouse and Burger King Corp. as well as increased scale at Carrols.

This year, though, the pace of new restaurant issuers is drastically slower and loan pricing higher. Whole business securitization demand has been slower than 2018, though could pick up. Overall, we believe challenges including higher minimum wages and delivery cost pressures will continue to weigh on the quick service restaurant (QSR) subsector, while changing millennial dining preferences will pressure casual dining without success from new menu and promotional efforts. The bulk of our restaurant ratings are in these two subsectors.

Table 1

2019 Restaurant Rating Actions
Date Description Event Type
Jan. 11, 2019 P.F. Chang's China Bistro Inc. ratings placed on CreditWatch positive on agreement to be acquired by TriArtisan M&A
Jan. 28, 2019 Wok Holdings Inc. rated 'B' on acquisition by TriArtisan and Paulson, outlook stable; debt rated 'B' New issuer
Feb. 21, 2019 Carrols Restaurant Group ratings placed on CreditWatch positive on merger with Cambridge Franchise Holdings M&A
Feb. 22, 2019 PHD Group Holdings LLC outlook revised to stable from negative on improving performance; ratings affirmed Operating performance
March 1, 2019 Nathan's Famous Inc. rating raised to 'B' on improved cash flow and credit metrics; outlook stable Operating performance
March 12, 2019 Bloomin' Brands Inc. outlook revised to stable from negative on improving performance; ratings affirmed Operating performance
March 18, 2019 Restaurant Brands International Inc. upgraded to 'BB-' on improved performance; outlook positive Operating performance
March 21, 2019 Carrols Restaurant Group Inc. upgraded to 'B' on improved operating scale and performance; outlook stable M&A
April 5, 2019 McDonald's Corp. 'BBB+' rating affirmed on improved liquidity assessment; outlook stable Other
April 15, 2019 Big Jack Holdings L.P. outlook revised to stable on improving performance and credit metrics; ratings affirmed Operating performance
April 18, 2019 NPC International downgraded to 'CCC+' on soft operating performance and reduced covenant headroom; outlook negative Operating performance
M&A--Mergers and acquisitions.

Restaurant issuers (about 30 entities) now represent about one-quarter of S&P Global Ratings' retail sector ratings. There were about a dozen new restaurant issuers last year, all of which were initially rated 'B' or 'B-', and many of which are regional QSR operators. In some cases, acquirers are attempting to turn around underperforming units from brands such as Taco Bell Corp., Burger King, and Popeyes to juice EBITDA margins. Brand rollups are in vogue for both operators and franchisors. Inspire Brands Inc. (formerly Arby's Restaurant Group) purchased Sonic Corp. for $2.3 billion toward the end of 2018, less than a year after its Buffalo Wild Wings acquisition.

Table 2

New Restaurant Issuers, 2018-2019
Date Company Description
Jan. 5, 2018 IRB Holding Corp. Inspire Brands buys Sonic.
Jan. 18, 2018 Tacala LLC Taco Bell franchisee.
Feb. 28, 2018 Quidditch Acquisition Inc. Apollo buys Qdoba.
March 2, 2018 K-MAC Holdings Corp. Taco Bell franchisee.
March 13, 2018 Fogo de Chao Inc. Rhone Capital acquisition.
May 14, 2018 Miller's Ale House Inc. Dividend recapitalization.
June 6, 2018 Flynn Restaurant Group LLC Applebee's, Taco Bell, and Panera franchisee.
June 14, 2018 Dhanani Group Inc. Burger King, Popeyes, and Le Madeleine operator.
Aug. 6, 2018 Del Frisco's Restaurant Group Inc. Purchases Barteca for $325 million.
Oct. 29, 2018 GPS Hospitality Holding Co. LLC Burger King, Popeyes franchisee.
Dec. 3, 2018 Bojangles Private equity purchase.
Jan. 11, 2019 Wok Holdings Inc. Private equity acquisition of P.F. Chang's.

Restaurant Party Ending

From 2010-2016, there was about one restaurant default per year, including Sbarro LLC, Mastro's Restaurants LLC, and Logan’s Roadhouse Inc. In our view, the lack of defaults in 2017 and 2018 was anomalous. Given the combination of heightened competitive pressure muting comparable sales and private equity piling on debt to the sector, we expect defaults to return in the next 1-2 years.

Already, cracks are showing across our rated restaurant universe. We lowered the rating on Burger BossCo Intermediate Inc. (parent of Checkers Holdings Inc.) to 'CCC+' with a negative outlook in December 2018 on increased risk of a covenant breach. We similarly downgraded U.S.-based Pizza Hut Holdings LLC and The Wendy's Co. franchisee NPC International Inc. to 'CCC+' with a negative outlook in April 2019 amid weak performance and negative free cash flow, which in our view raised the risk of a revolver covenant breach. And Del Frisco's Restaurant Group Inc. (B-/Stable/--), a new issuer in August 2018, said by December amid activist pressure that it is exploring a possible sale. It recently announced private equity firm L Catterton will purchase it for $650 million.

Challenges among unrated restaurant peers are also growing, with Taco Bueno, Kona Grill, the parent of the Palm, Bertucci's, and the owner of Chevy's Fresh Mex all filing for bankruptcy in the past year.

Steak n Shake Inc. (CCC/Negative/--) remains the lowest-rated restaurant in our portfolio, given the downgrade last June on a potential restructuring. The table below demonstrates the inherent pressure on many rated restaurant names in the hypercompetitive space, including on profitability and market share.

Table 3

S&P Global Ratings' Business Risk/Financial Risk Matrix For Restaurants
--Business Risk Profile-- --Financial Risk Profile--
Minimal (1) Modest (2) Intermediate (3) Significant (4) Aggressive (5) Highly Leveraged (6)
Excellent (1)
Strong (2) Starbucks Corp. (BBB+/Stable) McDonald's Corp. (BBB+/Stable) Yum! Brands Inc. (BB/Stable)
Satisfactory (3) Darden Restaurants Inc. (BBB/Stable) Brinker International (BB+/Stable) Restaurant Brands International Inc. (BB-/Positive)
Fair (4) Bloomin' Brands Inc. (BB/Stable) The Wendy's Co.(B/Stable)
Golden Nugget Inc.(B/Stable)
IRB Holding Corp.(B/Stable)
Weak (5) Fogo De Chao (B/Stable)
Flynn Restaurant Group L.P. (B/Stable)
Dhanani Group Inc. (B/Stable)
Bojangles’ Inc. (B/Stable)
Wok Holdings Inc. (B/Stable)
Nathan's Famous Inc. (B/Stable)
Carrols Restaurant Group Inc. (B/Stable)
Big Jack Holdings L.P. (B/Stable)
GPS Hospitality Holding Co. LLC (B-/Stable)
PHD Group Holdings LLC (B-/Stable)
Del Frisco’s Restaurant Group Inc. (B-/Stable)
K-MAC Holdings Corp. (B-/Stable)
Tacala LLC (B-/Stable)
California Pizza Kitchen Inc. (B-/Negative)
CEC Entertainment Inc. (B-/Watch Positive)
Red Lobster Intermediate Holdings LLC (B-/Negative)
Vulnerable (6) Quidditch Acquisition Co. (B-/Stable)
Millers Ale House Inc. (B-/Stable)
Steak n Shake Inc. (CCC/Negative)

Given expectations for continued volatile equity and credit markets, and the changing tide in the restaurant category this year, it is not surprising that sponsor monetization and exit activity is increasing. CEC Entertainment Inc., parent of the Chuck E. Cheese's and Peter Piper Pizza brands, intends to go public again later this year. Centerbridge Partners L.P. sold P.F. Chang's China Bistro Inc.'s parent to two other private equity sponsors in January. Recent media reports said that Onex Partners-backed Big Jack Holdings L.P. is weighing a sale.

Overall, we expect restaurant mergers and acquisitions (M&A) will also decline this year, with less franchisee consolidation amid unit cost erosion from rising minimum wages and moderate food cost inflation.

2019 Sector Outlook: Rising Cost Pressures To Take Bite Out Of Earnings

We expect continued pressure on the lower-income demographic this year to hinder QSR performance, as low unemployment and slowly improving wages trickle slowly. As a result, we expect a continued focus on loyalty and customer experience amid casual dining and QSR players. We are slightly positive on QSR performance, expect turnaround potential in casual dining, and remain cautious on the fast-casual sector that we now view as overbuilt.

Despite some improving brands, we believe increased prepared food offerings and in-house restaurants from grocery stores, the rise of food halls, and shifting millennial dining habits are among challenges for restaurant industry sales in the coming year. A new normal is unfolding, with U.S. restaurant sales increasing only 3.6% last year versus a compound annual growth rate of 6.4% between 1970 and 2019, according to the National Restaurant Association.

Most concerning to us is that industry traffic hit a nine-year low with a 4% reduction in February, while check averages hit a 10-year high, according to U.S. restaurant industry benchmarker MillerPulse. The company's founder believes price increases are unsustainable given negative industry traffic since 2015, which we agree with, as many challenged operators try to pass on rising operating and delivery costs to boost top-line results.

Overall, we expect remodeling growth to slow after years of capital spending on both back- and front-facing technology investment, especially in the casual dining space. We believe international expansion is often more attractive than domestic unit growth for many rated players, and expect operating margin pressure to continue as delivery costs rise from both third-party and in-house options, and promotions remain in place to improve traffic.

We view the food cost outlook as relatively benign as the protein deflation of 2018 shifts to modest inflation in the second half of 2019. We expect these prices to rise given swine fever in China crimping global pork supply. We remain cautious about productivity enhancements to absorb the 3%-4% minimum wage inflation we expect in the coming year. This is a crucial driver given that, by our estimates, labor accounts for almost one-third of cost of sales for restaurants; it's closer to about 10% in our traditional retail space.

Lastly, we will continue to closely monitor refranchising efforts that McDonald's Corp., Wendy's, and other major players undertook in recent years. The approach passes costs on to the franchise operators, improving margins and free cash flow generation at the franchisor level. But in our view, in some cases it causes potential for strife if mom-and-pop owners feel they shoulder too much expense to execute on the major transformations of QSRs.

According to Euromonitor International, spending on U.S. consumer food services reached $587 billion in 2018, of which off-premise sales (delivery and to-go) represented 48.6%, or $286 billion. Off-premise sales are an increasingly important source of transaction growth for the industry, which has struggled with tepid customer traffic for years. We believe this segment will continue to outpace the growth of dine-in sales as consumer demand for convenience increases and more consumer activity, such as online shopping and streaming entertainment, occurs at home.

Within our coverage list, most restaurant companies have elected to partner with third-party delivery providers and aggregators, which can quickly expand their customer reach, but at the cost of very high commission rates. We believe third-party delivery orders tend to have higher average checks than in-restaurant purchases and are largely incremental, but ultimately they are negligibly profitable due to high commission costs.

We expect restaurant operators will spend more of their marketing budget dollars to direct customers to their brand-specific mobile applications, as we believe take rates are lower for these orders. Bucking the industry trend, Bloomin’ Brands Inc. fulfills delivery in-house at over 550 locations across its Outback Steakhouse and Carrabba's Italian Grill concepts, as it seeks more control over the customer experience and more flexibility to adjust the operating model.

This report does not constitute a rating action.

Primary Credit Analyst:Diya G Iyer, New York (1) 212-438-4001;
Secondary Contact:Declan Gargan, CFA, Boston 857-383-5686;

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