Asset-light business models face an awful future

Restaurants spent too many years loading up on debt and dumping assets, and now those decisions are coming home to roost, says RB’s The Bottom Line.
Photograph by Jonathan Maze

the bottom line

Much of the restaurant industry has been built on a house of cards. The coronavirus could knock it down.

That house is largely in the form of asset-light business models that use tremendous amounts of debt throughout the process. For years, restaurant companies have unloaded assets and piled on debt. And they sold their restaurants to franchisees that themselves had loaded up on debt and sold off real estate.

The coronavirus pandemic threatens much of this. Suddenly, both sides of the franchising equation face months with drastically reduced revenues, followed by more months with an economy that is likely to be in the tank, even as federal assistance ends.

Jim Chanos, a noted short-seller and founder of hedge fund Kynikos Associates, said on CNBC this week that the pandemic shutdown “is going to expose a lot of business models,” and the asset-light model was his first target.

Franchisors have sold restaurants to franchisees, who took on a lot of debt to build new units, remodel existing units and buy up locations. A lot of these franchisees are backed by private-equity firms that use aggressive financing strategies that leave little room for error.

Many of these franchisors are also landlords. The companies lease the restaurants and then sublease them to the franchisees, adding a premium to generate some income. Chanos called this “double hidden leverage.”

Many franchisors themselves are highly leveraged. They took out tons of debt, in part to generate “shareholder value” by buying back stock.

Share buybacks in recent years were particularly problematic because they came when shares were trading at high levels, rather than when they were trading at low levels and could use the boost. Restaurant industry share prices have, as we all know, plunged over the past six weeks.

In other words, every level of the process is filled with debt. “It’s like triple leverage,” Chanos said. “Those business models I think are going to be exposed in 2020. It’s one of the dark sides of the buyback boom.”

On the whole, it’s a badly inefficient strategy that made the operating environment onerous, even when sales were good. A number of franchisees were facing major problems even before the coronavirus shutdown began.

NPC International, the largest franchisee for both Wendy’s and Pizza Hut, was teetering on the edge of bankruptcy.

Carrols Restaurant Group, Burger King’s largest franchisee, quickly slashed capital spending to hoard cash and pay down debt. Its credit rating was downgraded last month, before the world changed.

Put those two together, and the largest franchisees for three of the 12 largest restaurant chains in the U.S. were facing major problems.

(And, it must be noted, a fourth, Subway, has closed well over 2,000 units because franchisees were struggling. But that’s not due to excessive leverage, only weak sales. Yet it’s indicative of the operating environment many of these brands were operating under.)

Theoretically, many of these large-scale brands are more protected than others over the next few months. Burger King, after all, has its drive-thru, and restaurants with drive-thrus are in far better shape than restaurants without them. The same goes for Wendy’s, while Pizza Hut delivers pizza and therefore should see OK sales.

On top of that, these companies are more protected in a recessionary environment that is likely to be in place for some time, even after some of these restrictions are lifted.

But restaurant companies will also be discounting the hell out of their products to generate traffic in the aftermath. Many brands, especially Burger King, were discounting heavily already. It’s part of the reason the environment is so challenged.

Federal stimulus loans will help, but not completely, and the weak economy will remain a major question mark.

On top of this, franchisors themselves will be limited in their ability to help. Many of these brands face their own weakened financials. They are taking steps to help their operators, to be sure, but many of their strategies will ultimately be limited because of their own cash positions and debt levels.

And then, when it’s all done, the franchisors will have less cash, more debt, and a bunch of weakened operators, some of whom might not even make it out.

Here’s one notable statistic: A survey of more than 200 franchisors by franchise information firm FranData said they expect a franchisee attrition rate of 25%. Considering that many of the franchisors it surveyed are not restaurants, the real attrition rate for the industry is probably a lot higher.

Franchising in general is a great business model. But deploying that model to the hilt while getting rid of assets and loading everybody with an obscene amount of debt is a major problem that was bound to be corrected at some point. It’s just going to be corrected a lot more quickly now.

If the restaurant industry emerges from this period intent on slowing its demand to dump assets and overleveraging its business, it will be far better off in the long run.

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