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Restaurants on the Ropes

Restaurants on the Ropes
Rick Newman
On Friday June 12, 2009, 11:05 am EDT

When Americans get stressed out, one thing they do is eat. But apparently not enough.

The dismal economy has punished retailers, with companies like Circuit City and Linens 'n Things going extinct and dozens of others losing money. Now it's hitting their cousins in the restaurant industry, too. The Bennigan's and Steak & Ale chains were early casualties, going belly up last summer. This year, with Americans cutting back on spending, sales at restaurants could fall by 10 percent or more. Analysts don't expect widespread closures, but some chains are likely to close unprofitable outlets, cut back on service, and look for other ways to reduce costs.

As in retail, companies that help people save money will weather the storm better than others. Chains like McDonald's, Pizza Hut, and Olive Garden, which offer ample portions at value prices, should do OK and maybe even pick up market share. It helps if they've been run conservatively, with low borrowing costs and cash held for a rainy day.

Other eateries are in a pickle. Fancy restaurants that had long waits a few years ago are now begging for customers and offering sales. Midpriced casual dining outlets are losing customers to cheaper fast-food joints. Even some dollar-menu franchises are suffering if they're overdependent on mall traffic or clustered in regions where the economy is weakest. A key factor is debt: With sales down everywhere, many companies that borrowed heavily to remodel, expand, or buy other franchises now find that interest payments gobble up a nerve-wracking amount of cash flow.

Since debt is such an important menu item, we scoured data from ratings agency Standard & Poor's to gauge which well-known restaurants are facing tough challenges. The following list represents companies that meet two criteria: They have a credit rating of B or lower, and S&P assigns them a negative outlook. Landing on this list doesn't mean the company is likely to declare bankruptcy or close its doors. But these firms are vulnerable to deteriorating economic and financial conditions. And the negative outlook means there's a chance S&P could downgrade the company's rating over the next six to 24 months. Here's our watch list:

Perkins Restaurant and Bakery. Company accountants could probably use some of the comfort food on the menu at this diner-style franchise, which has about 500 locations, mostly in the Midwest. Like other restaurants, Perkins has been able to cut food costs since they soared in 2007. But revenue has fallen, and the parent firm lost $9.7 million in the first quarter. S&P says the firm's liquidity position is "tenuous." With market share of just 8 percent, Perkins is more vulnerable to a lousy economy that competitors like Denny's (22 percent market share) and IHOP (19 percent). Perkins also owns the Marie Callender's Restaurant and Bakery chain, which suffers from similar financial burdens. Plus, Marie Callender is based in hard-hit California, which has been hammered by the housing bust.

A company spokesperson says Perkins has cut expenses by $7.3 million to help shore up its finances, delayed some remodeling, and called a halt to expansion.

El Torito. Slumping sales and steep debt are an unappetizing combo, especially in California, where this chain is based. The parent firm, Real Mex Restaurants, has bought time by extending a key credit line until next January. But S&P has questioned whether the company, owned by a group of private-equity firms, will have the cash flow to comply with loan terms over the next two years. Real Mex also owns Chevy's, the Acapulco chain, the more upscale El Torito Grill, and several other eateries. All are facing the same woes.

Real Mex says that cost-cutting has helped sustain earnings, and it recently hired a new CEO to help turn things around. The company also announced plans recently to issue new debt that would help cover a major payment due to lenders next year. If that offering is successful, it would indicate investors' confidence in the chain.

Sbarro. Many of this pizza chain's 1,070 outlets are in malls, where traffic is down and spenders are stingy. That contributed to a $5.7 million loss in the first quarter, more than double the red ink from a year ago. Interest payments on debt gobble up much of the company's cash flow, leaving little margin for error. The company is especially vulnerable to any rises in food or commodity costs and to competition that could force prices down. With about 40 percent of sales coming during the Christmas season, the company will need strong December results at a time of high unemployment and weak spending. A Sbarro executive declined to comment on the company's financial prospects.

Captain D's Seafood Kitchen. This chain's thrifty appeal--"sit-down food at fast-food prices"--hits the right note during lean times. And aggressive cost-cutting has helped offset falling sales. But debt is still too high, compared with the company's earnings. Parent company Sagittarius Brands got some relief last year from lenders who agreed to relax certain financial requirements. But the old terms go back into effect in 2010, and S&P doesn't think the firm, which operates nearly 600 restaurants across the south, will be able to meet them. A breach could trigger higher borrowing costs or give lenders the right to call in their loans. The California-based Del Tacos chain, which Sagittarius bought in 2006, is under similar pressure. The company didn't respond to calls seeking comment.

Krispy Kreme. The famed doughnut chain got too chubby over the last 15 years, and it's been closing unprofitable stores to help reverse several years of steep losses. Revenue has plunged since 2005, but cutbacks helped the company turn a $1.9 million profit in the latest quarter. Lenders have provided a breather by easing some of their requirements over the last two years. The temporary reprieve expires in 2011. By then, the company hopes that streamlining, profitable new overseas stores, and other measures will have strengthened its finances.

Spokesman Brian Little points out that Krispy Kreme has cut its debt by nearly 40 percent and has a $21 million cash cushion. The recession, he adds, isn't as daunting to Krispy Kreme as to other food chains: "We sell an affordable indulgence consumers will purchase when they can't afford to treat themselves or their families to other luxuries."

Mastro's. These elegant steakhouses may be among the nation's best, but they're also clustered in Arizona and southern California, where housing woes have char-broiled the economy. With just 7 outlets (including two Ocean Club restaurants), Mastro's lacks the scale and geographic diversity of bigger chains like Morton's and McCormick & Schmick's. Sales have fallen along with customers' net worth and corporate expense budgets, and Mastro's cash flow is likely to get worse before the double-cut porterhouse ($68.50) comes back into style.

To cope, Mastro's is scaling back expansion plans, and may only open four new restaurants by 2012, fewer than half its original target. "Returns to investors will be impaired," says CEO Tom Heymann, "but doing this will improve our cash flow and still allow us to grow and meet our commitments to the banks." And refrain from adding burgers and hot dogs to the menu.

Restaurants on the Ropes - Yahoo! Finance
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