Want Fries with that Bankruptcy?


Talk about a bad case of indigestion. In 1999, Albert J. DiMarco and three partners borrowed $15 million to open 41 Checkers & Rally's fast-food outlets across the Midwest. DiMarco certainly had the experience for the venture -- he was a former president of Checkers Drive-In Restaurants -- but he and his partners quickly found themselves overwhelmed by the $200,000 monthly payments.

This past January, just 14 months later, DiMarco shuttered his burger restaurants and filed for bankruptcy. "There was no cash left," explains DiMarco's attorney, H. Jeffrey Schwartz. "Leverage was the real issue."

DiMarco isn't the only fast-food franchisee going from the frying pan into the fire. Many in the industry are suffering from the one-two punch of slumping sales and soaring labor costs, and many big chains -- including Checkers, Taco Bell, Burger King, Hardee's, KFC, and Arby's -- have seen a growing number of their franchisees in financial trouble.

IN TOO DEEP. Fully one-quarter of Tricon Global Restaurants' 4,000 franchised Taco Bells units have defaulted or are about to default, estimates Raymond James Financial analyst Damon Brundage. And Diageo's Burger King isn't faring much better. Robert N. Hunziker, a vice-president for Atlanta-based National Restaurant Brokers, estimates that at least 15% of the chain's 7,800 franchised outlets in the U.S. are now in default on their loans.

While many in the fast-food industry are plagued by the same woes, those highly-leveraged franchisees that have seen sales slip are suffering most. Taco Bell and Burger King saw same-store sales fall 5% and 4%, respectively, last year. Labor costs have soared as much as 5% to 6% annually over the past few years, analysts estimate, thanks to the tight labor market that has driven up wages for even entry-level fast-food workers.

The current franchisee problems, however, go much deeper. Loans to open outlets of the top fast-food chains were easy to get in the mid '90s, and many franchisees took on much too much debt in a rush to expand. Then the growth needed to service those loans failed to appear as chains such as Burger King and Taco Bell faltered in their marketing efforts and dealt with management turnover.

McDonald's and Wendy's International, which were much more conservative in awarding franchises over the past decade, haven't been hit by a wave of defaults. But they are the exceptions. And fast-food chains' expansion is quickly reaching saturation: Last year, there were 1,171 people per fast-food outlet in the U.S., compared to 1,323 in 1990, according to Chicago food-industry consultant Technomic.

FINANCIAL JUGGLING. Some of the troubled franchisees are staving off default by recapitalizing their debt. San Diego-based Westwind Group, which owns 115 Burger Kings in the Northwest and Southeast, recently reduced its monthly debt payments by turning to lenders and refinancing payables, lowering interest rates, and extending the maturity dates of its loans. The eight-year-old Burger King operator also shuttered or sold 14 outlets and put its expansion plans on hold. "We eliminated some of our liabilities," says Michael Strauss, the group's chief executive. He's optimistic that new CEO John Dasburg, who came to Burger King in April, and better marketing will boost the brand. "At some point, we may want to buy more stores," he adds.

But for every operator like Westwind that stays afloat, another is trapped. "Many franchisees would love to walk away, [but] they can't because the debt on these stores is greater than their value," says Hunziker, who's trying to find buyers for 200 franchised Taco Bell and Burger King units that have been put on the block.

The franchisees' plight is now hitting the franchisors' bottom line. Louisville-based Tricon, which late last year saw two midsize Taco Bell franchisees file for bankruptcy, is diverting $75 million to $125 million this year to buy back some of the most troubled units. This is capital that Tricon could be using to repurchase shares, pay down its $2 billion debt, or renovate stores, says Lehman Brothers analyst Mitchell Speiser. He adds that if Tricon were using that money to buy shares, it would add just under 2 cents to his 2001 earnings-per-share estimate of $3.22. The company is working together with its financially troubled franchisees and banks to reorganize loans, reduce debt, and infuse equity. "Could additional bankruptcies happen? Potentially," says Dave Deno, Tricon's chief financial officer. "But our hope and plan is that we don't have any more bankruptcies."

LOAN GIVEAWAYS. The roots of the debt problem go back to around 1993, when lenders began offering securitized loans to fast-food franchisees. These loans were then packaged and sold as securities to investors such as insurance companies, a practice common in real estate and other industries. The major chains like Burger King and Taco Bell were doing well, and lenders, eager to enter the market for these securitized assets, were willing to grant loans to fast-food franchisees with little or no money down.

DiMarco and his partners borrowed nearly 100% of the cost of their Checkers & Rally's outlets. Over the past decade, there were deals that were done with "too much debt, not enough equity, and prices that were too high," says Dean Zuccarello, chief executive of the Cypress Group, an investment bank that specializes in the restaurant industry.

Consider the predicament of San Diego franchisee Karl James. He opened his first Taco Bell 11 years ago and expanded slowly, opening a new unit about every other year. But when Tricon announced in the mid '90s that it would sell thousands of its company-owned outlets, James quickly snapped up 46 units.

POWER CRUNCH. "Money was definitely easy to get," recalls James. "Lending was done based on the [high-volume] performance of the stores in the last 12 months." But sales promptly started eroding, and with labor costs and electricity prices soaring in California, cash flow dropped and James found himself unable to pay his bills. His business, Golden West Tacos, filed for bankruptcy last November.

The fallout is spreading to some lenders with heavy exposure to the fast-food business. Franchise Mortgage Acceptance Company (FMAC) stopped granting loans last September as it saw delinquencies rising. Bay View Capital had acquired FMAC in November, 1999, and viewed franchise lending as a business with "low incidence of default and high yields," says Douglas J. Wallis, Bay View's executive vice-president. But last year the secondary market for securitized loans dried up, and FMAC was left sitting on $350 million in fast-food franchisee loans. "We're getting out of the business by selling our franchise loans," says Wallis. As the industry found out, fast food and fast money don't go together very well. By Aixa M. Pascual in Atlanta


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