With survival on the line, restaurants may rethink financing

Companies that make it through a near-death experience may be more conservative financially, but don’t expect them to abandon risks altogether.
Photo illustration by RB

This is the fifth story in a five-part series examining the long-term impact of the coronavirus pandemic on the restaurant industry.

As Cousins Subs devises its annual plans each year, company executives consider its risk tolerance and plan for the prospect of an unexpectedly large decline in same-store sales—maybe 5% or 10%. “But never 30%,” said Christine Specht, CEO of the 100-unit Milwaukee-based sandwich chain.

Expect that to change across the industry.

Wounded by the coronavirus shutdown, restaurant companies appear likely to get more conservative in their financial structures. Cash reserves will become more important than ever. Lending seems likely to get stingy. Franchisors will be stricter on the financial risk of their franchisees, while avoiding the megafranchisees that have become commonplace over the past decade.

In short, the industry could make sure it’s better prepared the next time around.  

“I would imagine businesses or restaurants will have a greater amount of cash reserves,” Specht said. “In the event something like this happens and sales take a nosedive, eating into cash, businesses that have an excess amount of debt and little cash flow will find themselves in real trouble.”

Brands get conservative

For much of the past two decades, restaurant companies driven by financiers have taken on an increasing amount of risk.

Many restaurants have shed assets, selling off real estate and leasing it back while loading up on debt to pay dividends or, if they are publicly traded, to buy back shares.

Private equity-owned chains in particular have lived on the edge this way, using readily available cheap debt to load up companies with leverage.

That left many companies with weak balance sheets even before the coronavirus began: Well over a dozen full-service restaurant chains had been operating under the cloud of bankruptcy as of mid-March.

Many of these companies will go away or be badly stripped of underperforming locations. Already, a number of casual-dining chains have had to take drastic steps: CraftWorks Holdings, the owner of Logan’s Roadhouse and Old Chicago operating in bankruptcy, has shuttered its locations and may struggle to emerge.

FoodFirst Global Restaurants, the owner of Bravo Fresh Italian and Brio Italian Mediterranean, filed for debt protection and is working to decide whether it can sell itself or simply liquidate.

In a recent survey by the National Bureau of Economic Research, operators only gave themselves a 15% chance of survival in a six-month crisis. They gave themselves a 30% chance in a three-month crisis.

On the other hand, there are some examples of cash-rich businesses that could expect to thrive coming out of the shutdown. One such company: Chipotle Mexican Grill, which has no debt and $900 million, even though it only recently emerged from a multiyear sales collapse brought about by food safety concerns.

To be sure, few expected anything like the coronavirus shutdown. That could reduce operators’ appetite for risk, certainly for a while.

“Generally, there’s a wide spectrum of folks more aggressive and less aggressive than others,” said Ashish Seth, who heads restaurant investment banking with BMO Capital Markets. “Nobody was planning for a multimonth, complete shutdown of restaurants. They just never thought this would be possible.”

Certainly in the short-term, restaurants will have little choice but to operate more conservatively. Many are draining cash reserves, after all, and they will need to preserve their funds as the specter of the coronavirus and a potential resurgence loom.

“I think they’re going to have to be more conservative,” said Jim Ilaria, president and CEO of Uno Restaurants. “We could have a flare-up a year from now. We’re not out of the woods yet. Anyone taking on a significant amount of debt besides [Paycheck Protection Program] loans does do at great risk.”

How long do restaurateurs expect to survive?

Source: National Bureau of Economic Research

Expect franchisors to change their strategies

The franchise sector in particular could be up for massive changes as franchisors rethink their strategies.

Many financially aggressive companies are franchisees, which over the past decade have amassed large numbers of restaurants and heavy capital cost requirements, using huge amounts of debt.

That might have been on its way toward changing even before this happened, given growing challenges with some large-scale franchisees. NPC International, the largest franchisee for Pizza Hut and Wendy’s, has been teetering on the edge of bankruptcy.

Big Burger King operator Carrols Restaurants, meanwhile, was facing debt problems of its own. It cut costs to pay down debt only to be dealt a massive blow to its cash flow when the coronavirus hit.

John Gordon, a restaurant consultant out of San Diego, believes franchisors are far more likely to limit franchisees in the post-coronavirus world. The days of the massive single-brand franchisee are likely gone.

He noted that Taco Bell tries to keep its franchisees to fewer than 250 locations. “Expect to see more of that, and directly proportional to the amount of blood on the floor,” Gordon said. “They have gotten too big.”

That could force other changes. Franchisees themselves may shift to more brands with fewer locations apiece. But brands may be less likely to sell corporate stores to franchisees, period—at least those that hadn’t already taken this step.

That’s because many brands are left with little ability to support their own stores after years of selling them to franchisees. Those that didn’t may look at that and adopt a different strategy, Gordon said.

“Franchisors don’t have the capability to solve problems anymore because of asset-light [strategies],” he said. “They have no staff. They couldn’t take over a cluster of franchisees that have problems.”

“Expect to see more [franchisors limiting the size of franchisees], and directly proportional to the amount of blood on the floor. They have gotten too big.” —John Gordon, restaurant consultant

But risk won’t completely vanish

To be sure, it may be naive to suggest that restaurants will abandon the strategies they used to grow rapidly after the Great Recession. And private-equity firms in particular seem unlikely to get religion on their financial strategies, even after a massive shutdown like this.

Operating a business, after all, requires some risk-taking. That will never go away. “We’re never not going to take risks or invest,” Specht of Cousins said. “We need to do that for a lot of reasons.”

Much will depend on private equity. Such firms typically operate with the riskiest of credit profiles, bingeing on debt, pushing out expansion and remodels and keeping declining restaurants alive.

Many of these firms see opportunity in a weakened industry and could pick up chains on the cheap and return to those riskier strategies.

Or they could decide that it’s too risky in the near term and largely avoid such investments. “It will be interesting to see what private equity does,” Ilaria of Uno said. “Cheap debt and private equity fueled a lot of the expansion of chains over the last 10 years.”

That cheap debt will still be around. The lenders? Maybe not. Some banks had been slowing their lending to restaurants heading into the shutdown, which could intensify that exodus, meaning financing will be harder to come by. Loan terms seem likely to get stricter, which in and of itself would make for a financially conservative industry.

“We’re never not going to take risks or invest. We need to do that for a lot of reasons.” —Christine Specht, Cousins Subs

And landlords might take a second look at their prospective tenants, too, even as they grow eager to fill empty spaces.

“We could be more reticent to take a flyer on a restaurant that didn’t have a track record already,” said Jeff Brand, founder of Brand Partners, a small, Dallas-based landlord for a handful of shopping centers and a real estate broker. “After having gone through this, it does make you want to look at how much they’re carrying on the balance sheet in terms of cash on hand.”

To be sure, the restaurant industry itself is not going away. It will always feature a lot of risk. Yet many believe that the shakeout that results from the pandemic shutdown could be good for the industry long term, promoting better balance sheets and financial strategies. Those that are left will be in a stronger position.

It’s just going to take a while to get there.

“I am hopeful that with all this pain and anguish we’re going through that this is one of the good things that come out of it,” Gordon said. “We’ll have a more rational perspective.”

How the coronavirus will change the restaurant industry

Sunday: Why the coronavirus shutdown will upend delivery services for good

Monday: Shakeout and takeout usher in new realities for full-service chains

Tuesday: Will mom and pops survive this?

Wednesday: How the coronavirus will change menus

Today: With survival on the line, expect restaurants to plan for the impossible

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