Earlier this week, S&P 500 downgraded the credit rating of NPC International, a giant franchisee of Wendy’s and Pizza Hut.
The agency downgraded NPC’s bond rating to “CCC+” from “B” and gave the company a negative outlook. A CCC+ rating means that the agency believes its financial commitments “appear to be unsustainable in the long term.”
S&P said it expects NPC’s operating performance “will remain challenged for the next 12 months, resulting in sustained, very weak credit metrics and negative free cash flow exacerbated by high capital expenditures for remodels and modest unit growth.”
A lower credit rating for a large operator like NPC is only the latest warning sign for the franchise business. Even large-scale franchisees find themselves facing growing operating pressure amid tightening profit margins and growing demands for remodels and unit development.
Traffic and sales have stagnated and many brands are relying heavily on discounts to get customers to come in the doors. They’ve done this even as labor costs skyrocket.
Operators are also on the hook for remodels and technology additions, and they’re the ones paying the fees to third-party delivery companies franchisors are so eager to write deals with.
Concern about the disconnect between franchise brands and store operations last year led famous short seller Jim Chanos to bet against franchise stocks such as Restaurant Brands International and Dunkin’.
There has been growing evidence of more challenging margin performance at franchised brands. Jack in the Box operators are suing their brand and calling for a leadership change in part because more of them are struggling financially. McDonald’s operators formed a franchise association largely because of diminishing cash flow.
And even large-scale operators are seeing margins thin. Carrols Restaurant Group, a big Burger King operator, noted that its margins deteriorated last year due largely to its brand’s discount strategy—though, to be fair, the company has since doubled down on Burger King by agreeing to operate an additional 500 units. It also started buying up Popeyes, owned by the same parent company, Restaurant Brands International.
But few franchisees are as large or extensive as NPC, which is one of the largest restaurant operators of any kind in the U.S., with more than 1,200 restaurants. It is massive.
In this instance, S&P is looking at NPC’s operating performance and its demands for remodels and store growth.
Wendy’s same-store sales have generally performed consistently well in recent years, but that changed, to a degree, late in 2018. Same-store sales declined 0.2% in the third quarter and were up 0.2% in the fourth quarter.
Same-store sales have been weak at Pizza Hut for years, though they increased 1% in both the third and fourth quarters.
S&P believes the company has an “elevated risk” of breaching financial requirements in its debt agreements, “given our projection for negative free operating cash flow and anticipated reliance on the revolver to fund capital expenditures.”
If a big operator like NPC faces a credit downgrade, what is the business like for the small franchisee?