Casual Dining is a Hot Mess. Part VI. (Short Franchisees).

We’ve previously written about Kona Grill Inc. ($KONA) and Luby’s Inc. ($LUB) here. Indeed, we marked the former’s now-inevitable descent into bankruptcy as far back as April 2018. Subsequently, we’ve followed each quarter with interest only to witness the conflagration get bigger and bigger along the way. This sucker is certainly headed into bankruptcy.

Here is what’s new: Kona hired an Alvarez & Marsal Managing Director as its CEO — its fifth CEO in less than a year. It publicly indicated that it may have to file for bankruptcy. And Nasdaq delisted it. Stick a fork in it.

Likewise, we first highlighted Luby’s in July 2018. In a follow-up in January, we wrote:

And then there is Luby’s Inc. ($LUB). We featured the chain back in July, highlighting continued overall same store sales and total sales decreases. We did note, however, that the company has the advantage of owning a lot of its locations and that asset sales, therefore, could help buy the company time and assuage lender concerns. Real estate sales have, in fact, been a significant part of the company’s strategy. And so the lenders haven’t been its problem. Activist shareholders have been.

But that’s not entirely the full picture. We also noted that the company’s numbers “suck.” Which begs the question: now that another quarter has gone by, has anything changed?

On the performance side, not particularly.

Same store sales decreased 3.3%. Restaurant sales were down 12.1% (offset slightly by culinary contract services sales). Every single restaurant brand performed poorly: Luby’s Cafeterias were down 6.1%, Cheeseburger in Paradise (TERRIBLE name) down 76%, F*cked-ruckers…uh, Fuddruckers, was down 19%, and combo locations were down 7%. Basically this was an absolute bloodbath. Fuddruckers same-store sales were -5.3%. Analysts don’t even bother covering the stock. The company trades at $1.50/share at the time of this writing.

But things have changed a bit on the cost side. The company has closed 27 underperforming restaurants and sold $34.7mm in assets. It has also moved forward with its plans to refranchise many company-owned Fuddruckers, converting five units to franchisors who are clearly gluttons for punishment. The company has also engaged in food and operating cost cutting initiatives. Who is helping them out with this? Duh…the new CEO and Alvarez & Marsal’s “performance improvement” group! 

PETITION Note: we always find “PI” projects spearheaded by divisions out of large turnaround advisory firms to be interesting beasts. Imagine the conversations behind closed doors:

PI Managing Director: “Yeah, bro, we just took $0.2mm of SG&A out of the business and we believe there is more room to run there once we beat up the supply chain a bit, postpone repairs and maintenance, adjust employee hours, and make food cuts.”

Restructuring Managing Director: “Food cuts, huh?”

PI Managing Director: “Yeah, we DEFINITELY wouldn’t recommend you eat there.”

Restructuring Managing Director: “Got it. So, uh, this is obviously a bit delicate but, uh, here’s the real question: how can you guys continue to take SOME costs out of the business and look like heroes…without…uh…improving performance…you know…TOO MUCH?”

Boisterous bro-tastic laughs, winks and secret handshakes ensue.

Now, sure, sure, that’s cynical AF and not at all fair here: we’re not at all saying that anyone is doing anything untoward here. Yet, we wouldn’t be surprised, however, if conversations such as these happen though. Just saying.

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🍟Casual Dining Continues to = a Hot Mess🍟

Luby's & Steak N Shake Look Stressed (Short Soggy Mac N’ Cheese)

We’ve previously covered this topic in “🍟Casual Dining is a Hot Mess🍟” and “More Pain in Casual Dining (Short Soggy Mozzarella Sticks).” Recall that, back in April, Bertucci’s Holdings Inc. filed for bankruptcy and said the following in its First Day Declaration:

"With the rise in popularity of quick-casual restaurants and oversaturation of the restaurant industry as a whole, Bertucci’s – and the casual family dining sector in general – has been affected by a prolonged negative operating trend in an ever increasing competitive price environment. Consumers have more options than ever for spending discretionary income, and their preferences continue to shift towards cheaper, faster alternatives. Since 2011, Bertucci’s has experienced a year-over-year decline in sales and revenue."

Unfortunately for those in the space, those themes persist.

On Monday, Luby’s Inc. ($LUB) — the owner and operator of 160 restaurants (86 Luby’s Cafeteria, 67 Fuddruckers and 7 Cheeseburger in Paradise) reported Q3 earnings and they were totally on trend. While the company reported positive same-store sales at Luby’s Cafeteria — its largest brand — the company’s financial results nevertheless cratered on account of increased costs (in food, labor and operating expense) without a corresponding acceleration in sales (via either increased prices or guest traffic). The company’s overall same store sales decreased 0.9%, its total sales decreased 3.1%.

The company noted:

“…the current competitive restaurant environment is making it difficult for our brand and the mature brands of many others to gain significant traction. We've been faced with the environment for quite some time, which has been a large drag on our financial results and our company valuation.

The challenge of rising costs, flattish-to-down sales, and a sustained debt balance are restricting the company's overall financial performance.”

Like many other chains, therefore, Luby’s is rationalizing its store count. The company previously committed to shedding at least 14 of its owned locations to the tune of an estimated $25mm in proceeds; it is accelerating its efforts in an attempt to generate an additional $20mm in proceeds. The use of proceeds is to pay down the company’s $44.2mm of debt. The company also announced that it hired Cowen ($COWN) to assist it with a potential restructuring of its Wells Fargo-agented ($WFC) credit facility. That hire was a requirement to a July 12-dated financial covenant default waiver (expiration August 10) provided by the company’s lenders.

This company does have one advantage over several distressed competitors: it owns a lot of its locations (in addition to its franchise business; a separate licensee operates an additional 36 Fuddruckers locations). The question therefore becomes whether the company’s lenders will provide the company with enough latitude (via continued waivers or otherwise) to sell enough locations to generate proceeds to pay down or “reduce [its] outstanding debt to near zero.” If patience wears thin or buyers balk at purchasing locations that later may become subject to a fraudulent conveyance attack, this may be yet another casual dining chain to find itself in bankruptcy. The stock, which has been range-bound for about a year, trades as follows:

*****

Likewise, Steak ‘n Shake is also beginning to look stressed — at least as far as its senior secured term loan goes. The casual dining restaurant company has somewhere between 580 and 616 locations, approximately 2/3 of which are company-owned. According to Reorg Research, it also has a group of lenders who are agitating given (i) under-budget revenues, (ii) liquidity concerns, and (iii) lower loan trading levels. Per Reorg:

The lenders’ move to organize comes as Steak ‘n Shake has shifted its focus from company-owned locations to franchise opportunities in the face of declining revenue, same-store sales and customer traffic as well as increased costs. A wholly owned subsidiary of Biglari Holdings, Steak ‘n Shake is a casual restaurant chain primarily located primarily in the Midwest and South United States; the chain is known for its steak burgers and milkshakes. Biglari says that unlike company-operated locations, franchises have “continued to progress profitably.” “Franchising is a business that not only produces cash instead of consuming it, but concomitantly reduces operating risk,” the 2017 chairman’s letter says.

Even so, 415 of the total 616 Steak ‘n Shake locations are company-operated and creditors are pushing the company to bring in operational advisors, sources say. The company’s $220 million term loan due in 2019, which according to the Biglari 10-Q had $185.3 million outstanding as of March 31, has dipped to the 86/88 context, according to a trading desk. The term loan, which matures March 19, 2021, is secured by first-priority security interests in substantially all the assets of Steak ‘n Shake, although is not guaranteed by Biglari Holdings.

The company has been struggling for years. Per Restaurant Business:

Same-store sales fell 0.4% in 2016 and another 1.8% in 2017. Traffic last year fell 4.4%.

The decline in traffic wiped out the chain’s profits. Operating earnings per location declined from $83,300 in 2016 to just $1,000 in 2017.

Part of the issue may be the company’s geography-agnostic “consistent pricing strategy” which keeps prices static across the board — regardless of whether a location is in a higher cost region. This strategy has franchisees in an uproar which, obviously, could curtail efforts to switch from an owner-owned model to a franchisee model. Indeed, a franchisee is suing. Per Restaurant Business:

For franchisees that operate 173 of the 585 U.S. locations and have to pay for royalties on top of other costs, the traffic declines risk sending many locations into financial losses. In addition, rising minimum wages in many markets, along with competition for labor, could put further pressure on that profitability.

Steaks of Virginia, the franchisee that filed the lawsuit last week, claimed it was losing money at all nine of its locations.

Curious. Apparently the company’s reliance on higher traffic to generate profits didn’t come to fruition. Insert lawsuit here. Insert lender agitation here. Insert questionable business model shift here.

In a February shareholder letter, Biglari Holdings Chairman Sardar Biglari channeled his inner-Adam Neumann (of WeWork), stating:

We do not just sell burgers and shakes; we also sell an experience.

And if by “experience” he means getting shot, being on the receiving end of an armed robbery or getting beat up by an employee…well, sure, points for originality? 👍😬

Given all of the above and the perfect storm that has clouded the casual dining space (i.e., too many restaurants, the rise of food delivery and meal kit services, the popularity of prepared foods at grocers), lender activity at this early stage seems prudent.