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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Is Delivery Killing Fast Casual Too? (Long Busted Narratives)

Zoe's Kitchen is Latest Restaurant Showing Signs of Trouble

Fast casual is supposed to be a bright spot for restaurants. But as the segment has grown in recent years, there are bound to be winners and losers. Zoe’s Kitchen Inc., a fast casual Mediterranean food chain with 250 locations in 20 states ($ZOES), is increasingly looking like the latter.

Last week the company reported sh*tty earnings. Comp restaurant sales declined by 2.3% despite rising prices pushed on to the consumer. The decline is attributable to the usual array of externalities (e.g., weather) but also location cannibalization. Apparently, the company’s growth strategy is pulling consumers from previously established locations. Moreover, the company noted “inflationary pressures in produce and freight costs, that are expected to impact cost of goods sold for the balance of the year.” Wages also increased 3.3%, an acceleration from the 2.9% realized in Q4 ‘17. Accordingly, adjusted EBITDA decreased 30.9%. The net loss for the quarter was $3.6mm or -$0.19/share. The company lowered guidance. The stock tumbled.

Before you get too excited, note that this is a debt-light company: it currently has a ‘22 $50mm revolving credit facility with JPMorganChase Bank NA, of which $16.5mm is outstanding (with $3.7mm of cash on hand, net debt is only $12.8mm). It also, believe it or not, has covenants — leverage and interest coverage, among others — and the company is in compliance as of April 16, 2018. It also plans to continue its expansion: in the sixteen weeks ended 4/16/18, the company opened 11 company-owned restaurants with a plan to open approximately 25 (inclusive) over the course of fiscal year ‘18. That said, it does intend to rationalize existing locations (and expects some impairment charges as a result), cut G&A and take other operational performance improvement measures to combat its negative trends. There’s a potential opportunity here for low-to-middle-market FAs and real estate advisors.

For our part, we found this bit intriguing (unedited):

We are definitely seen more competitive intrusion, more square footage growth in some of those smaller kind of mid to kind of large markets where we've been there for some time now that's a little bit of what we're seeing in those markets.

We've also seen more competitive catering competition as every ones ramped up catering. And also the value and discounting as we spoke to in the call, in the prepared remarks we've seen that $10 check with that single user kind of moving around and we think that's so from the new competition square footage growth, the value and discounting and then the delivery interruption, we've seen or felt that in many of our markets.

There’s a lot to unpack there. Clearly competition, as we noted upfront, is increasing in the $10-check size cohort of fast casual. Catering is always a competitive business for restaurants like this too. But, the point that really got out attention was that about delivery. The company says pointedly, “We also believe that disruption from delivery and discounting has created headwinds.” The company further states,

Digital comps were 26% positive in Q1 as we leverage improvements from last year's investments in web and mobile platforms to build greater convenience for our guests. Early in Q2, we relaunched and upgraded our loyalty program, which is expected to help drive traffic by making it easier and clearer for our guest to earn and redeem rewards. Delivery sales grew in both our non-catering and catering businesses by 155%. And we have a clear plan to build out the channel for more profitable growth in 2018.

The impact of mobile food ordering and the need for delivery cannot be overstated. Companies need to act fast to activate delivery capabilities that makes sense to a mobile consumer who, more and more, goes to Postmates, Caviar, UberEats and other food delivery services for discovery. This is precisely why Shake Shack ($SHAK) is now on Postmates and Chipotle Mexican Grill Inc. ($CMG) is now available on Doordash. Others, like privately-owned Panera Bread are taking a step farther by building out its own delivery infrastructure in an attempt to own all its data and deliver without owing a cut to a middleman. Query whether this is far too much dependence on the likelihood of people to go directly to Panera’s app when they’re hungry…?

It sounds like the Zoe folks are increasing their focus on delivery. The question is whether they can execute fast enough to offset in-store dining declines. And whether they can do it on their own.

More Pain in Casual Dining (Short Soggy Mozzarella Sticks)

RMH Franchise Holdings Inc. Files for Bankruptcy

In 🍟Casual Dining is a Hot Mess🍟, we wrote:

…don’t let the lull in restaurant activity fool you. As we’ve stated before, this is a space worth watching given intense competition and the rise of food delivery and meal kit services - both direct-to-consumer and in-grocery.

Looks like we spoke to soon about a lull. Earlier this week RMH Franchise Holdings Inc.filed for bankruptcy in the District of Delaware. If you’ve never heard of RMH Franchise Holdings Inc., have no fear. You haven’t. Nor had we. But it is...

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The (Hard) Business of Eating

Long VC Subsidies & Facebook's Copying Skills

Generally speaking, there are four categories in the dining space. First, there are the QSRs (quick service restaurants). Your run-of-the-mill fast food spots fall into this space. For the most part, these guys are doing okay: McDonald's ($MCD) and Wendy's ($WEN), for instance, have both seen great stock performance in the TTM. Second, there's the fast casual space. Competition here is fast and furious covering all manner of ethnicities and varieties. Chipotle ($CMG) and Panera Bread are probably the two best known representatives of this category. The former has gotten SMOKED and the latter got taken private. Generally speaking, there'll be some shakeout here, but the category as a whole has been holding its own. Third, there's the fine dining space. This is a tough space to play in but there are clear cut winners and losers (Le Cirque, see below): not a lot of chains fall in to this category. And, finally, there is the casual dining category. Here is where there's been a ton of shakeout. This past week, for instance, Ruby Tuesday Inc. ($RT) - the ubiquitous casual dining restaurant loosely associated with bad New Jersey strip malls - got bailed out...uh, taken private by NRD Capital at a fraction of its once $30/share price. (There was some assumed debt, too, to be fair). Moreover, Romano's Macaroni Grill filed for chapter 11 bankruptcy. In RMG's bankruptcy papers, the company's Chief Restructuring Officer said the following, "The Debtors’ operations and financial performance have been adversely affected by a number of economic factors, but perhaps most notably by an overall downturn for the casual dining industry. The preferences of such customers have shifted to cheaper, faster alternatives. On the other end of the spectrum, there is a trend among younger customers to spend their disposable income at non-chain “experience-driven” restaurants, even if slightly more expensive." No. Bueno. See below for a more in-depth (and slightly repetitive summary) of this particular bankruptcy filing. 

Unfortunately, the restaurant world received some other (slightly under-the-radar) bad news this past week: UberEATS, Uber's food delivery service, reportedly generated 10% of the company's total global bookings in Q2 - which, extrapolated, equates to $3b in gross sales for the year. That's a lot of food delivery to a lot of people sitting at home doing the "Netflix-and-chill" thing instead of the eat-microwaved-mozzarella-sticks-at-the-local-Ruby-Tuesday-thing. Of course, this is attributable to Softbank and other venture capitalists who are subsidizing this money-losing endeavor: UberEATS is unprofitable in 75% of the cities it services. On the other hand, do you know what IS profitable? Facebook ($FB). Yeah, Facebook is profitable. And Facebook is going after this space too; it released its plans to get into the online food ordering business earlier this week. And many suspect that this may be a precursor to a foray into food delivery as well. Why? Perhaps Mark Zuckerberg saw Cowen's prediction that US food delivery would grow 79% in the next several years. Delivery or not, anything that helps make online food ordering easier and more mainstream is an obvious headwind to the casual dining spots. Given that this area is already troubled and many casual dining spots have already fallen victim to bankruptcy, there don't seem to be many indications of a near-term reversal of fortune. Headwinds for the casual dining space correlate to tailwinds for restructuring professionals. Sick? Yeah. Sad? Sure. But true. 

Caspar the Friendly (Non-)Restaurant

Walk through the streets of Manhattan these days and you are bound to see a lot of “for rent” signs taped to the windows of empty commercial spaces. In Captain Obvious fashion, Crain’s New York last week noted that Amazon is affecting a lot of mom-and-pop brick-and-mortar: revenue is down due to the online competition and rents in New York, despite tons of vacancy, remain unsustainable for many business owners. 

It’s rather simple: online retailing is eating up brick and mortar and there aren’t enough Bonobos, Birchbox and Warby Parker showrooms to fill the gap. After expanding to seemingly every corner of the City, banks are in contraction mode: there are now a number of shuttered Capital One and Chase locations in the City. And restaurants? We’ve covered that in detail: forget about it. Art galleries? Mwahahahahaha.  

Under the radar are the ghost restaurants that are quietly undermining the commercial real estate market and contributing to the over-supply of space. Wait, what? Ghost restaurants? Picture this: you're on billable hour 26 for the day and you're hungry. You go on Seamless and find a restaurant with glossy food-porn photos and reasonable prices. You order and 35 minutes later you're indulging in your tasty delights while questioning the meaning of life.

A week later, you've got 20 minutes free from the office and your significant other suggests going out to eat. You say, "I know a great restaurant with awesome food. Let's go." You look for an address but you can't find one. Because there isn't one. The place you ordered from has no physical presence whatsoever or, alternatively, is just a kitchen with no seating space. Now you're rubbing your belly and really having an existential crisis. WTF.  

With sky-high rents and quick turnover the norm, companies like the Green Summit Group are coming up with varying and unique restaurant concepts, locating themselves online only (or, at best, securing a small commercial space with no seating), skipping the long-term onerous lease with commercial landlords, partnering with commercial kitchens, and using Seamless and Grubhub for distribution.

This model promotes improvisation. One benefit of avoiding an actual storefront is the ability to test different food concepts and pivot menus if there are lower-than-anticipated sales. Rebranding is remarkably easy: just a new name, some different food porn photos, and an update to Seamless. To the extent that one company is running different concepts - say, Middle Eastern and Greek - it can also cross-pollinate by offering the exact same menu items per "restaurant" and sharing ingredients in the kitchen. This limits the need to source new ingredients or engage in extensive food prep training for each and every concept. 

It is questionable how sustainable these experiments are long-term. You can read more about some of the cons - loss of alcohol-related sales, no walk-ins, logistics complications - here. The fact is, though, that this represents yet another headwind confronting established restaurant companies. And that potentially means EVEN MORE restaurant bankruptcies in the near future. 

Mmmmm...Food

The media is feeding us a confusing narrative.  

On one hand, restaurants should be benefiting from recent low gas prices and food deflation - with meat, chicken, and egg prices, in particular, depressed.  

Depressed food prices are not inuring to the benefit of restaurants...or grocers.

One the other hand, we've seen that restaurant chains are suffering from increased rent, healthcare and employment costs and, thus, more than a dozen restaurants have filed for Chapter 11 or 7 this year alone. While there are some outliers, e.g., Olive Garden, traffic at restaurants has fallen in 10 of the last 11 months (this includes the once-hyped fast casual segment, which is experiencing a customer count decline so far in 2016). And a U.S. Labor Department regulation increasing overtime pay for managers may still take effect and potentially make matters worse - despite a recent 11th hour injunction issued by a Texas District Court judge halting, at least temporarily, the December 1 effective date. 

Some argue that grocers are benefitting from the restaurants' pain. Are they? The numbers reflect that grocers' margins and stock prices are also taking a hit from this wave of food deflation. A number of publicly-traded grocers like Sprouts Farmers Market, Smart & Final Stores Inc., and Kroger Co. have lowered full-year '16 guidance. WholeFoods reported its first annual comparable sales decline since 2009. Randalls, Jewel-Osco, H-E-B, Albertsons and even WholeFoods are slashing prices like crazy in a race to the bottom. And others have fallen victim to bankruptcy - A&P (the second time), Fresh & Easy (the second time), Haggen, Fairway, Garden of Eden - or been bailed out.

Much of this is just natural competition. Discounters like Family Dollar and big box stores like Target and Walmart are sacrificing margin in exchange for foot traffic. Indeed, Dollar General reported lower comp-store sales this week and a 10% decrease in its bottom line (and initiated a wholesale marketing process of various rental properties). WholeFoods and KMart are aiming to offer food to lower scale markets. Amazon Fresh, Munchery, Maple, Blue Apron, Zakara Life, Caviar (owned by Square and on the market), Hello Fresh, UberEats, and a seemingly endless array of other app-based food distribution and/or delivery services are also complicating matters. With free introductory experiences, consumers can have at least a week's worth of food subsidized by Silicon Valley: this isn't helping grocers in major markets.

What does this all mean in the end? For starters, we are likely to see continued stress and distress in both the restaurant and grocery space. As we get there, there will likely be job losses  - at the highest levels of management and beyond - and additional technological advancement.  Touchscreens are likely to proliferate and, where possible, broader-based automation deployed. To point, McDonalds this week announced the launch of its touchscreen self-service ordering kiosks in its 14,000 locations. While MCD's CEO Steve Easterbrook indicated that this would not reduce costs/jobs - merely alter them - do we really believe that? So he proposes to pay workers more to effectively do less? Not with Eatsas of the world expanding - now at 5 locations. 

The space has come a long way and there are more drastic changes in store.

Are Progressives Bankrupting Restaurants?

According to the CEO of Garden Fresh Restaurant Intermediate Holdings (GFRIH), they are.  

This past week, John Morberg filed an affidavit in support of the chapter 11 bankruptcy filing of GFRIH, the holding company to restaurant brands Souplantation and Fresh Tomatoes. This family of restaurants includes 123 locations, 17 central kitchens and 2 distribution centers. All in, the company has 5500 employees, the majority of which work in the restaurants located in California, Texas and Florida.  

In addition to having approximately $135mm of funded debt, the company experienced increasing cash flow pressure which, according to Morberg, triggered the bankruptcy. Chief among the causes for this pressure was "declining sales consistent with the declines experienced in the entire restaurant industry." Morberg, here, is clearly referencing a string of recent restaurant bankruptcies including Cosi, Fox & Hound, Logan's Roadhouse, Don Pablo's, Zio Restaurants, Buffetts, and Champps. Cheap gasoline was supposed to translate into bigger consumer spending. Not so for these restaurants, apparently. 

Still, Morberg's explanation for the bankruptcy went a step farther. He noted that cash flow pressures also came from increased workers' compensation costs, annual rent increases, minimum wage increases in the markets they serve, and higher health benefit costs -- a damning assessment of popular progressive initiatives making the rounds this campaign season. And certainly not a minor statement to make in a sworn declaration.  

It's unlikely that this is the last restaurant bankruptcy in the near term. Will the next one also delineate progressive policies as a root cause? It seems likely.

Discounted Crackly-Crust Flatbread...

"All Sorrows Are Less With Bread" - Miguel de Cervantes Saavedra

If crackly-crust flatbread and Squagels (yes, this exists...and it is what it sounds like) are on your Christmas wish-list this year, you may be in luck: the once high-flying Cosi Inc. could be yours via bankruptcy sale.

For those familiar with Cosi In NYC, the downfall of the fast casual chain is particularly surprising. Once upon a time, blockbusting lunch lines for Cosi were a regular occurrence. As they waited, people jostled for access to the excess baked crackly-crust bread the bakers regularly dispensed. In certain locations, the competition for the excess was so fierce that the bakers resorted to placing the pieces in a small metal bowl on the counter - the fast casual equivalent of a home owner lazily putting a basket of Halloween candy on the doorstep for trick-or-treaters. Never mind hygiene: 126,292 other people put their hands into that bowl between the hours of 12 and 2. Yech.  

Here are the stats:

• 107 stores in 3 countries (but most in the US).
• 1555 employees (many of whom will now be losing their jobs)
• $7.5mm of (gulp, maybe) secured debt (which will position the lenders to own the business)
• $3mm in net losses in Q2 '16 (hence why we're talking about bankruptcy in the first place).

The court filings contain a choice quote: "The deteriorating sales are at least partially due to macro-economic issues as the restaurant industry as a whole and the fast casual sector in particular are experiencing decreasing sales trends." So much to unpack here. First, what happened to the notion that the "gasoline windfall" would lead to greater consumer spending? Second, aren't millennials spending more on food and experiences than on physical goods? Third, how does this purported trend affect the likes of Panera Bread, Chipotle, and a whole host of other fast casual upstarts? Sadly, the filings don't substantiate this statement. Curious.  

Winners:

• the original founders who blew out after the I.P.O. (yes, this thing is publicly-traded).

Losers:

• the senior secured lenders - they'll either get pennies on the dollar or 78 rubber-chicken-serving fast casual locations facing (unsubstantiated) headwinds; and
• the former CEO - the (public) filings go out of their way to note that he failed miserably to acknowledge the decline in the business and effectively turn it around (ouch). 
• employees - many are losing there jobs with little to no advanced notice.  
• shareholders - unlikely to see any recovery for their position.  

Thoughts, comments or questions? Note the comment section below.