Top 10 Investor Questions: How Will The U.S. Restaurant Industry Fare In The Continuing Slow-Growth Economy?
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March 27, 2012
Top 10 Investor Questions: How
Will The U.S. Restaurant Industry
Fare In The Continuing
Slow-Growth Economy?
Primary Credit Analyst:
Charles Pinson-Rose, New York (1) 212-438-4944; charles_pinson-rose@standardandpoors.com
Table Of Contents
What is our forecast for the economy and consumer spending in 2012 as it
relates to the U.S. restaurant sector?
How does this forecast translate into expectations for sector credit
quality?
What is your opinion of operators with large international operations?
Will any particular subsector of the restaurant industry outperform the
rest of the sector?
What are the major threats to the restaurant industry's credit quality?
Are there any opportunities for the restaurant industry?
How many restaurant companies are owned by private equity and what
are the future rating implications?
What is the likelihood of downgrades and defaults in 2012?
What is the industry's refinancing risk over the next several years?
What is the credit rating breakdown for the sector?
www.standardandpoors.com/ratingsdirect 1
951411 | 301674531Top 10 Investor Questions: How Will The U.S.
Restaurant Industry Fare In The Continuing
Slow-Growth Economy?
It is a volatile time for industries that depend on consumer discretionary spending, such as the U.S. restaurant
industry. While the economy continues its slow recovery after coming out of the Great Recession, high oil and
commodity prices still pose a threat to consumer spending levels. Standard & Poor's Ratings Services here answers
what it views as the top 10 investor questions regarding the future performance and credit quality of U.S. restaurant
companies.
What is our forecast for the economy and consumer spending in 2012 as it relates
to the U.S. restaurant sector?
We expect slow economic expansion in the U.S. in 2012, slight improvement in the unemployment rate, and modest
growth in spending on food away from home. However, we do not expect this to translate to an improved operating
environment for the restaurant industry. We forecast growth in the industry should be in the low-single-digit
percentage area, at about 1.5% to 2.5%, which is near Standard & Poor's overall economic growth expectation.
How does this forecast translate into expectations for sector credit quality?
Even with the current difficult operating environment--and factoring in continued cost inflation, which we think will
likely be particularly acute for beef and dairy products--we still anticipate that the industry will have relatively flat
profits and stable credit ratings for the current year. This is evident in our outlook distribution of U.S. restaurant
companies: Twenty-nine of the 32 we rate have stable rating outlooks.
What is your opinion of operators with large international operations?
We expect large quick-service operators with international operations as a growth vehicle to outperform peers
limited to domestic operations. Many emerging markets are still experiencing meaningful economic growth, and
many developed markets outside the U.S. don't have enough restaurants to meet the demand. However, there are
only a limited number of companies that have international operations to take advantage of this opportunity. Most
notably, McDonald's Corp. (rated 'A' with a stable rating outlook and an 'A-1' short-term rating) and Yum! Brands
Inc. (BBB/Stable/--) have such operations and have experienced continued new unit growth and positive same-stores
sales internationally. We expect this to continue in the near term and anticipate that international restaurant growth
will enhance both companies' market position and profitability.
Burger King Corp. (B/Stable/--) and Domino's Inc. (not rated) also have seen significant growth in their respective
international operations, but their international businesses are relatively small as compared with their domestic
operations. Nonetheless, we anticipate continued growth and, over time, expect international growth to play an
increasingly important role in future profit growth for both Burger King and Domino's.
Standard & Poors | RatingsDirect on the Global Credit Portal | March 27, 2012 2
951411 | 301674531Top 10 Investor Questions: How Will The U.S. Restaurant Industry Fare In The Continuing Slow-Growth
Economy?
Will any particular subsector of the restaurant industry outperform the rest of the
sector?
In general, we expect quick-service restaurants to outperform the casual-dining subsector in 2012, as a result of
relatively lower price points and convenience, but the difference will be relatively narrow. We expect relatively flat
growth among casual dining operators, and low-single-digit growth for quick-service operators. In 2011, there was
an improvement in operating performance at some larger casual-dining operators, namely Brinker International Inc.
(BBB-/Stable/--) and OSI Restaurant Partners LLC (B-/Stable/--), but this was after several years of negative sales and
relatively poor performance. We expect that trend to moderate in 2012.
Smaller subsectors, such as fine dining and quick casual, have performed well, and we expect this good performance
to continue in both subsectors, though we rate very few issuers in these spaces. We anticipate that fine dining will
benefit from increased spending by businesses and wealthy individuals. Meanwhile, we expect quick casual will take
some market share from quick-service and casual-dining operators, since the quick-casual subsector generally offers
compelling quality of products at price points between quick-service and casual-dining operators. The small market
share gains by quick-casual restaurants will likely lead to more robust growth in that subsector, in the
mid-single-digit area by our estimate.
In general, we believe that company-specific factors will have an important impact on issuers' individual overall
performance given stagnant economic conditions. An operator's ability to offer compelling quality at reasonable
price points and a positive customer experience will play an important roll in its ability to grow sales. Considering
our economists' slow-growth forecast for consumer spending, the only way for restaurants to grow sales and offset
cost inflation, in our view, will be to take market share from competitors. Thus, we expect the stronger operators to
continue to perform well, while the weaker operators without compelling offerings will continue to struggle.
What are the major threats to the restaurant industry's credit quality?
Greater than currently anticipated energy and food cost inflation is probably the most viable threat. Higher gasoline
prices would likely mean lower discretionary spending for many restaurant customers and inhibit restaurant
operator's ability to raise prices to counteract the food cost increases. In this case, sales would grow slower we are
now forecasting, and margin contraction could be meaningful. Credit quality deterioration could be significant.
In addition, credit market conditions have become seemingly more borrower friendly in early 2012 relative to the
second half of 2011. This could signal greater leveraged buyout activity and possibly dividend recapitalizations. In
either case, the increased use of leverage could lead us to lower ratings on restaurant issuers.
Are there any opportunities for the restaurant industry?
Generally, eating outside the home is correlated to discretionary spending. Moreover, many restaurants operators
provide convenience for busy working individuals. Thus, greater-than-anticipated job growth could lead to
meaningful increases in demand and sales growth in the industry. However, we view such a magnitude of job
growth and discretionary spending as a low probability in 2012 and, thus, we foresee limited performance upside in
the industry as a whole.
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951411 | 301674531Top 10 Investor Questions: How Will The U.S. Restaurant Industry Fare In The Continuing Slow-Growth
Economy?
How many restaurant companies are owned by private equity and what are the
future rating implications?
Of the 32 U.S. restaurant companies that we publically rate, private equity owns 21. We rated most of these
privately held restaurant companies are rated in the 'B' category and have "highly leveraged" financial risk profiles
(see "Business Risk/Financial Risk Matrix Expanded," May 27, 2009. In most cases, the financial risk is a result of
very aggressive financial policies of the private-equity ownership, which used considerable amounts of debt to
purchase the company. In most situations we see little rating upside.
Again, we do not forecast meaningful profit growth and credit ratio enhancement in much of the industry over the
near term in general. Also, if a private-equity owned company deleverages over time after its initial purchase, we
would expect the owners to seek to monetize their initial equity investment with a dividend or sale of the company.
In either case, the company's debt burden would likely increase as a result of a total recapitalization or additional
debt issuances. Therefore, our assessment of the owner's financial policy as very aggressive could inhibit a positive
rating action, even with performance and temporary credit ratio improvement.
What is the likelihood of downgrades and defaults in 2012?
While we assess a large number of restaurant companies' financial risk profiles as "highly leveraged," we only have
one company with an issuer credit rating in the 'CCC' rating category: Mastro's Restaurants LLC
(CCC/Negative/--). Currently, there are no 'B-' issuer credit ratings with a negative outlook. Recently, Buffets Inc.
(no longer rated) and Real Mex Restaurants Inc. (D/--/--) filed for Chapter 11 bankruptcy protection. These highly
leveraged companies struggled to keep their customers and market share, given weak economic conditions, and
could not sustain their capital structures.
Over the next year, considering our base-case performance scenario for the industry, we do not see an uptick in
defaults amongst rated issuers. Nonetheless, if consumer spending weakens because of higher gasoline prices, or if
cost pressures are more intense than we are now contemplating, there could be greater credit quality deterioration
among lower-rated restaurant companies than we currently anticipate.
What is the industry's refinancing risk over the next several years?
Other than in the second half of 2011, credit market conditions have been relatively favorable over the past couple
of years. Many restaurant companies have issued debt and have longer-term maturities. Thus, there is not a
meaningful amount of debt maturating in 2012 and 2013. Moreover, current market conditions seem relatively
borrower friendly, and we expect most restaurant companies to able to address refinancing needs if necessary.
Beginning in 2014 and in subsequent years, however, there are more meaningful maturities in the sector. Therefore,
if credit market conditions weaken materially in 2013 and 2014, and financing options dry up for speculative-grade
restaurant issuers (those rated 'BB+' or lower), there could be a negative impact on ratings of companies that need to
refinance their debt maturities.
Standard & Poors | RatingsDirect on the Global Credit Portal | March 27, 2012 4
951411 | 301674531Top 10 Investor Questions: How Will The U.S. Restaurant Industry Fare In The Continuing Slow-Growth
Economy?
What is the credit rating breakdown for the sector?
We rate most U.S. restaurant companies at the speculative-grade level, and there is a vast preponderance of issuer
credit ratings in the 'B' rating category (including 'B+', 'B', and 'B-' rated issuers) with 25 of 32 publicly rated issuers
with a rating in that category. Currently, there is only one in the 'CCC' rating category and none in the 'BB'
category. Of the five investment-grade ratings, we have two in the 'A' category and three in the 'BBB' category. We
do not expect that this will change materially over time.
We consider the restaurant industry risk profile as weak because of the highly competitive nature of the sector,
restaurant operators' inability to fully pass along cost increases, and the industry's vulnerability to weak economic
conditions. Moreover, many restaurant operators lack diversity and are concentrated geographically. Consequently,
we view most restaurant issuers' business risk profiles as either "weak" or "vulnerable," which often leads to ratings
in the 'B' category. Also, many restaurant issuers are privately owned and the owners used large amounts of debt to
purchase the companies. Their very aggressive financial policies usually result in "highly leveraged" financial risk
profiles, which also often leads to ratings in the 'B' category.
We do not see the rating breakdown changing materially over the near-to-intermediate term. If private-equity
activity increases in the restaurant sector, we would expect new issuers to have considerable debt burdens, and we
would most likely rate them in the 'B' category. Therefore, we expect the percentage of sector ratings in the 'B'
category to increase over time before it decreases.
U.S. Restaurant Company Ratings
Issuer Rating
McDonald's Corp. A/Stable/A-1
Starbucks Corp. A-/Stable/A-2
Darden Restaurants Inc. BBB/Stable/A-2
Yum! Brands Inc. BBB/Stable/--
Brinker International Inc. BBB-/Stable/--
Dunkin' Brands Inc. B+/Stable/--
The Wendy's Company B+/Stable/--
Il Fornaio (America) Corp. B+/Stable/--
Denny's Corp. B+/Stable/--
DineEquity Inc. B/Stable/--
Landry's Inc. B/Stable/--
Burger King Corp. B/Stable/--
Fertitta Morton's Restaurants Inc. B/Stable/--
Focus Brands Inc. B/Stable/--
Fiesta Restaurant Group Inc. B/Stable/--
California Pizza Kitchen Inc. B/Stable/--
Fogo de Chao Churrascaria Holdings LLC B/Stable/--
Steak n Shake Operations Inc. B/Stable/--
BHI Exchange Inc. B/Stable/--
Sagittarius Restaurants LLC B/Stable/--
HoA Restaurant Group LLC B/Stable/--
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951411 | 301674531Top 10 Investor Questions: How Will The U.S. Restaurant Industry Fare In The Continuing Slow-Growth
Economy?
U.S. Restaurant Company Ratings (cont.)
NPC International Inc. B/Negative/--
Dave & Buster's Inc. B-/Stable/--
CKE Restaurants Inc. B-/Stable/--
Logan's Roadhouse Inc. B-/Stable/--
El Pollo Loco Inc. B-/Stable/--
Sizzling Platter LLC B-/Stable/--
Caribbean Restaurants LLC B-/Stable/--
OSI Restaurant Partners LLC B-/Stable/--
Sbarro LLC B-/Stable/--
Mastro's Restaurants LLC CCC/Negative/--
Real Mex Restaurants Inc. D/--/--
Standard & Poors | RatingsDirect on the Global Credit Portal | March 27, 2012 6
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