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Dow Jones & Company, Inc. Reproduced with permission of copyright owner. Further reproduction or distribution is prohibited without permission.Restaurant chains worried about breaking covenants in their debt agreements are inviting their lenders to the table to talk, as the dining industry faces another challenging year.
The renegotiated terms are coming at a cost, with restaurant operators taking on higher interest rates and, in most cases, tighter restrictions on how they can spend their cash. But their moves are aimed at avoiding more-severe penalties associated with violating covenants, which can ratchet up payments even more or funnel nearly all free cash flow into paying down debt.
Covenants contained in debt agreements generally set out conditions a company must observe to stay on the good side of its lender, such as how much free cash it must generate in relation to its debt. They are designed to reflect the risk of lending to a particular company.
O'Charley's Inc., which operates 370 casual-dining restaurants, amended its revolving credit facility in December to include looser covenants, higher interest payments and a gradual reduction in the amount available to borrow. While the chain didn't anticipate violating its covenants, the outlook for the restaurant industry and consumer spending was so uncertain that it decided to play safe.
"From our standpoint, seeking a waiver after the fact has the gun pointed in the wrong direction," said O'Charley's Chief Financial Officer Lawrence Hyatt, in an interview.
The new terms also required the company to dedicate a portion of its cash flow to paying down its debt. While that limits its freedom to spend, O'Charley's was already taking measures to economize by cutting capital spending, freezing wages and cutting overtime.
"We would be doing that if we had a bank amendment -- or if we didn't -- because in this environment that's the prudent thing to do," Mr. Hyatt said.
Many other chains are already saving their cash through the downturn, but investors have grown concerned that some chains may not be able to take advantage of an eventual economic recovery if their spending is controlled by banks.
With tighter purse strings, restaurants may be limited in their ability to reward shareholders through such moves as paying special dividends or buying back stock. Strategic moves like remodeling stores, expanding into new markets or testing new concepts could also take a backseat to paying back lenders.
"Cash flow was always thought to be the board of directors' discretion," says Oppenhiemer & Co. restaurant analyst Matthew DiFrisco, "but it could become the bank's discretion."
Over the past year, debt worries have weighed on the stocks of restaurant companies that investors feared might breach a covenant. O'Charley's stock has fallen roughly 80% over the past year; shares of Benihana Inc., a small casual-dining chain that renegotiated terms of its loan in November, have declined around 80% during the same period. Meanwhile, Cheesecake Factory Inc., which earlier this month renegotiated its revolving credit facility, loosening one covenant, has seen its shares drop about 60%. Those declines compare with a 35% drop in the Russell 2000 index of small stocks.
To be sure, these companies have had their own struggles to achieve sales growth. Food, gasoline and other raw-materials costs have been difficult to control, which has eroded earnings.
Some analysts think fears about covenant violations in the industry are excessive, since many restaurant chains have suceeded in restructuring their debt.
While a restaurant chain's performance may have deteriorated to the point where its risk profile is elevated, most publicly traded chains still generate enough cash flow to avoid the more serious lapse of missing interest payments. Mr. Hyatt of O'Charley's emphasized the company was never at risk of missing an interest payment.
"In many cases, the market is discounting it too much," Raymond James & Co. restaurant analyst Bryan Elliot said. "Bankers today are struggling with loans that aren't paying at all, but these loans are paying."
"Things would have to get significantly worse" before most restaurant chains' ability to make debt payments would be called into questions, he added.
As a result, lenders generally have been amenable to reworking debt terms. "Lenders want to get repaid, and if they believe they're going to get repaid, they're willing to work with companies to make adjustments," Robert Bielinski, head of the restaurant finance group at CIT Group Inc.
Among publicly held restaurant companies, Ruth's Hospitality Group Inc. was among the most recent to bring its lender back to the table. The operator of the Ruth's Chris Steakhouse chain said it would probably violate a covenant in its senior credit facility after suffering through double-digit declines in same-store sales for several months and failing to finalize a sale-leaseback of its corporate headquarters.
The stock sank 33% following last month's announcement, closing at $1.41, and is currently trading above $1.50. Ruth's said it hopes to renegotiate covenant terms in the coming weeks. Mr. Elliot, the Raymond James analyst, expects the company to achieve that goal, based on its visibility for generating cash this year, as well as the track record other companies have had. Also, the sale-leaseback of its headquarters, while hung up by a lack of financing, could be completed by late February, and proceeds are expected to help pay down debt.
Ruth's executives declined to comment.
Credit: By Paul Ziobro
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