Franchise Finance Perspectives

Compilation of Answers to Topical Questions

What will the restaurant franchisee community’s balance sheet look like when the industry re-opens?

• While the franchisees’ cash will be severely depleted, the extent of depletion will depend on the extent of how much funding the operator receives from the government’s paycheck protection program claimed through the SBA. Notably, most operators have kept their store managers on the payroll while eliminating many/most of their line workers.
• Each brand has their own pre-opening procedures, requiring operators to get current with things like rent backlog, pay backlog & accrued wages, inventory & supplies and deferred lender payments. Notably, it is unlikely that operators will receive rent or interest abatement.
• Resultantly, re-opening costs are likely to range between $15k to $100k per store. The SBA loans will not cover all of these costs nor will their business interruption policies.
• While borrowers with low leverage levels and/or personal cash reserves will be OK, existing senior lenders are unlikely to cover the gap for highly leveraged operators because of regulations.
• As a rough rule-of-thumb, 25% of franchisees have leverage levels (senior debt/enterprise value) under 25%; 25% with 25% – 50% leverage; 25% with 50% – 75% leverage; and 25% over 75% leverage. Currently, lower valuations (& EV) translate into higher leverage levels.

What did this event teach us about the adequacy of the industry’s balance sheet?

• This is a cash flow business and the balance sheet rarely plays a role in past lending decisions.
• With 10% cash flow margins, there is not much room to service debt, shareholder returns and capex.
• The key is how fast can AUVs return to normal levels because this is how cash levels will be replenished. It can be as fast as 3 months for QSR with FSR likely to take 6-12 months.
• In hindsight, there may have been inadequate attention to balance sheets.

Would it be beneficial for all operators to maintain dedicated revolvers? How would you calculate the appropriate size of the revolver?

• Banks are often unwilling to lend additional funds into a deteriorating situation.
• All-the-same, revolvers could be a good thing for the industry for times just like this.
• It is notable that lenders would count the undrawn revolver towards the borrower’s overall leverage level. In other words, the amount of the revolver would have to off-set the total amount of the senior debt. In essence, a revolver would require a greater amount of equity in the borrower’s capital structure.
• Ideally, the size of the revolver would equal 6 months of cash flow, equivalent to a ½ turn of EBITDA.

Should operators consider incorporating higher equity levels?

• Highly leveraged borrowers are less likely to obtain relief from additional debt bridge financing. They are also less likely to contribute their own equity to bridge the shortfall given the risk of throwing good money after bad money.
• On the other hand, operators with large equity positions are more likely to have access to additional debt bridge financing. Also, they are more likely to invest additional equity to protect their original equity investment.
• Ultimately, much depends on how stores are currently valued given current business conditions. As current valuations will certainly suffer from uncertainty and a smaller buyer pool, highly leveraged operators are more prone to fire sales.

How does this all play out?

• A higher level of independent closures probably equates to a lower level of franchise closures.
• This situation highlights the value of a large, franchised system which brings to bear considerable resources in terms of best practices/operational expertise and marketing for their franchisees.
• Going forward valuations are likely to reflect how the sales of each brand fared during this event.
• Distressed buyers will likely be represented by existing franchisees with lower leverage levels and from private equity.
• Also, it is possible that franchisors will reverse their asset-light model by acquiring distressed stores (particularly from troublesome franchisees) – buying low, turning-around operations and then selling high.
• Real estate cap rates could ultimately suffer depending on the extent of store closures, particularly as it relates to mall locations if consumers remain skittish about gathering in larger venues.

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• Health and Price/Money conversation increased during the workweek as people celebrated World Health Day by sharing their favorite quarantine exercises and mentioned donations made by celebrities.
• During the workweek, the nation’s emotions have shifted towards grieving those lost and wishing for a speedy recovery for those infected. Emotional conversation has increased the most for the Northeast and Midwest.

Chili’s – RR Executive Summary

Chili’s is the 4th largest casual player by domestic sales (behind Olive Garden, Applebee’s & Buffalo Wild Wings) and is positioned as a great place to hang-out with family & friends by offering good value, bold food innovation, and a great bar atmosphere to go with a convenient off-premise digital order platform. This overlays Chili’s historical core brand equity as a sit-down Southwest (Tex-Mex) chain that specializes in burgers, ribs, sizzling fajitas & margaritas. Strong everyday value is driving higher frequency among its core customers and is expected to increase the frequency among its lighter users. Its margin friendly 3 for $10 offer (high-teens mix) works well at lunch, dinner as well as for take-out and other everyday value platforms include: $25 meal for 2 (share an app & dessert to go with 2 entrees); $8 lunch combos; and $5 margarita of the month (easy way to drive new news). Food items are rotated onto these value platforms to keep things fresh and helps the brand avoid dependence on operationally complex LTOs every 6-8 weeks. A significant shift in marketing spend from traditional to digital reflects: a focus on reaching a younger demo; a better tie-in to its digital order platform & loyalty program; and an effort to leverage a more cost-effective marketing channel. Notably, Chili’s is now spending (on a national basis) more on digital than tradition TV. Success in leveraging its 6MM+ loyalty and 2.6MM email databases facilitates 1-to-1 marketing and it is notable that its My Chili’s Reward members drive 20% of total guest checks. Fiscal 2Q20 off-premise growth of +31% y/y increased the mix of this channel to 17% and its digital ordering platforms drive 2/3s of off-premise sales, benefitting operations & marketing. Having said all this, it is notable that its AUV significantly under-performs the segment average, revealing the brand’s sales challenges since the onset of the Great Recession as Chili’s struggled to balance the tension between a need for greater value to drive traffic and the need for a higher check (which under-performs by double-digits). Resultantly, its labor margins have been trending-up and now represents a system worst as sales have failed to keep pace with wage rate inflation & higher manager bonuses. A system low EBITDAR margin challenges franchisee willingness to make very necessary capex investments to modernize facilities and explains corporate’s move to further increase its ownership of system stores (76% at the end of FY19). In conclusion, while Chili’s re-positioning has started the ball rolling, it will take a longer track record of comp out-performance for its store-level unit economics to catch-up to the segment average.

Jack in the Box – RR Executive Summary

While Jack in the Box is a regional system with ~70% of its stores located in California & Texas, the brand enjoys leading QSR hamburger share in 8 of its major markets. The chain’s menu is known for variety and innovation with 4 strong dayparts, including late-night which benefits from 24/7 drive-thru access. The primary idea is that Jack’s menu addresses various cravings throughout the day, including munchies at night. As value seeking consumers represent half of Jack’s customer mix (the other half seek “craveable & indulgent” menu items only available at Jack), the goal is to restore traffic losses attributed to: its 2016 decision to raise the price ceiling on its 2 tacos deal (notably tacos are unique to QSR burger chains and work well with Hispanic customers); and a steady stream of price increases designed to help offset rising costs. To this end, Jack has made great progress towards increasing its value focus with nearly 100% of its 2019 promotions representing price point value up from 50% during 2018. The chain has found success with combo promotions up to the $4.99 price point and unique snack & side offerings at prices of $1 – $4 with the lower priced snacks & sides appealing to the value seekers while driving incremental add-on sales from its more premium customers (without causing trade-down). Going forward sales should benefit from the chain’s new value equation to go with operational improvements and faster service speeds. In any case, operators have expressed strong dissatisfaction that flattish AUV growth has not kept-up with significant cost inflation over the last 4 years (the franchisee EBITDAR margin has declined by -3.2% over the last 3 years making it difficult to keep-up with the high rents often charged by the franchisor as landlord). Notably, a lack of sufficient top-line growth has been particularly challenging on the 15% of system stores with AUVs under $1MM (55% from Texas) and 17% with AUVs from $1MM to $1.25MM. In conclusion, while Jack in the Box may have strengthened its very important value positioning, the chain must still make progress in driving sales out-performance sufficient to at least offset the speed of cost inflation (particularly on the West Coast) and this may require developing a more clear distinction for its core burger and chicken menu in a crowded field of QSR+ and better burger players.

Jimmy John’s – RR Executive Summary

Jimmy John’s ongoing brand refresh is moving it away from a singular focus on the pursuit of simplicity (around its core speed, freshness & food quality attributes) towards: menu innovation; new tech to enhance the guest experience; and a marketing revamp which seeks to better leverage its “Freaky Fresh! Freaky Fast!” message. The brand’s “Freaky Fast” core equity reflects that JJ is the only national sub chain offering in-house delivery to go with 30 second sandwich make times with a strict 5-minute delivery radius limit and the goal is to highlight this advantage among unhappy consumers of 3rd party delivery aggregators. JJ’s freshness and quality core equity is distinguished by: freshness as a function of speed; all-natural meats with no added hormones, artificial ingredients or preservatives; bread freshly baked every 4 hours; daily in-house slicing of all veggies (sourced locally), cheeses & meats; lettuce cut into exactly 3/32 of an inch for optimum freshness; and tuna salad made from scratch with Hellmann’s mayo. The chain offers good value with price points starting at $3, with a $5.69 mid-tier Original option and a $6.89 premium Favorites option and its new Freaky Fast Rewards program is appropriate for a loyal customer base with a high frequency rate who originate a lot of digital orders online. Having said all this, it is notable that annual comps have been negative for 6 of the last 7 years, reflecting: JJ’s relatively high average check in a world of heightened QSR discounting that has been aggravated by past menu price increases; higher competition from sandwich chains around food quality & service including competition from c-store chains; increased competition from quality, pre-made grab & go sandwiches at the grocery stores; nearly infinite restaurant delivery options for consumers with the onset of 3rd party aggregators; cannibalization from new development; the lack of a CMO until 2018; the lack of cost effective national advertising; and consumers’ growing appetite for breakfast throughout the day – a menu category not offered by Jimmy John’s. In any case, while JJ’s store-level EBITDAR margin is at a system low, it outperforms the segment average which suggests that JJ’s in-house delivery program is net accretive to the system’s profitability. In conclusion, Jimmy John’s has a very defensible positioning around its speedy, in-house delivery and it looks like the chain stands to benefit from relevant tweaks which are being implemented as part of its ongoing turn-around.