Restaurants feel sting of surging costs, debt

When you serve 1.1 million eggs a week, even a tiny price increase can pinch. So when egg prices tripled for casual-dining restaurant chains Bakers Square and the Village Inn over the past two years, the result was especially painful. Pricier eggs and other foods added $9 million in annual costs. This month, the chains’ owner, Denver-based Vicorp Restaurants Inc., filed for bankruptcy-court protection.

Vicorp won’t be the last. The $558 billion restaurant industry is hitting rough times, squeezed by many of the same woes hitting other sectors of the economy: tightfisted consumers, scarce credit and surging commodity prices. Adding to the pressure is a big jump in the minimum wage starting this summer, which will boost wages by 12 percent in some states.

That’s sent the industry into its worst slump in decades. Many chains have scaled back expansion plans or cut costs by skimping on things like extra sauce and free sour cream. Some are shuttering sites and laying off workers. Private-equity firms, which plunged into the business earlier this decade using gobs of borrowed money, are now especially vulnerable as those debts come due.

This week’s earnings results, despite some glimmers of good news, paint a sobering picture. McDonald’s Corp., the world’s largest restaurant chain, saw U.S. sales at restaurants open at least 13 months fall 0.8 percent in March, the first decline in monthly same-store sales in five years. Brinker International Inc., parent of Chili’s, says it lost $38.8 million in its latest quarter. Analysts expect that when Cheesecake Factory Inc. reports first-quarter earnings on Thursday, same-store sales will have dipped and profit will have been pressured by spikes in the cost of dairy products, a key component of the chain’s 30 cheesecakes. Restaurants will be watching closely next week, when the first government tax-rebate checks go out, hoping people use that cash to eat out.

The slowdown has broad implications for the economy. The industry employs 13.1 million people, making it the nation’s third-largest employer, behind the U.S. government and the health-care industry, according to the National Restaurant Association, a trade group. Many of those jobs are held by the poor and immigrants who have few other options for work.

Vicorp and Buffets Holdings Inc., which owns the Ryan’s Steakhouse chain and filed for bankruptcy-court protection in January, together are closing about 110 restaurants and cutting 4,300 jobs. Both companies say more cuts could be in the offing.

For consumers, the closing of their neighborhood restaurants may be one of the most visible signs of a slowing economy. The chains anchor strip malls and highway exits, busy street corners and suburban downtowns. Trying to ingratiate themselves with the community, many restaurants fill their lobbies with local high-school pennants and yearbook photos or sponsor little-league teams.

Almost all segments are struggling. Some midpriced chains, including Ruby Tuesday Inc., are battling persistent same-store sales declines. Metromedia Restaurant Group, which owns Bennigan’s and Steak and Ale, recently hired a restructuring lawyer after it violated several agreements in its lending deal with GE Capital, according to people familiar with the company. Representatives for Metromedia and GE Capital declined to comment. Higher-end operators such as Ruth’s Chris, Morton’s and McCormick & Schmick’s all posted declining same-store sales in the fourth quarter of the year. Overall, big fast-food chains have fared much better, in part because they’ve lured customers from sit-down restaurants.

Moody’s Investors Service has downgraded seven prominent national and regional chains, including Landry’s Restaurants and the parent of Pizzeria Uno, to its lowest liquidity rating – the most restaurants to be given this rating at once since it was created in 2002. One in five companies that winds up on this list ultimately defaults. Representatives for Landry’s and Pizzeria Uno declined to comment.

At Vicorp – which owns 400-plus Village Inn and Bakers Square restaurants in cities like Chicago, Denver and Phoenix – chief executive Ken Keymer is trying to adapt and wring out costs one ounce at a time.

His company launched a study last October that weighed rivals’ portions of hash browns and french fries and determined they were mostly smaller. Managers also examined diners’ leftovers to see what went uneaten. As a result, Mr. Keymer decided to cut as much as an ounce from each serving of hash browns and french fries. The projected annual savings: more than $500,000.

Vicorp is now studying whether to reduce the number of sugar packets at each table. It is also analyzing the size of its pie slices, trying smaller “taster slices” at certain restaurants. And it is keeping a closer eye on overtime, holding field meetings with managers every Monday to discuss labor costs.

“It’s not a good situation at all for restaurants. It truly is the worst I have seen in my 30 years in it,” says the 60-year-old Mr. Keymer, a balding, stocky U.S. Naval Academy graduate who was previously president of Popeye’s Chicken and Sonic Corp., the burger chain.

The company, which started in 1958 as the Village Inn Pancake House in Denver, grew into a midsize chain and a strong regional player. It saw conditions turn in 2006. Same-store sales at both Village Inn and Bakers Square declined, and a slight profit in 2005 turned to growing losses the next two years. Through the first nine months of 2007, Vicorp had a loss of $20.9 million on sales of $336 million. Vicorp’s debt-to-equity level ballooned from four times to 10 times on its $127 million in public debt.

At the same time, prices for eggs, wheat and vegetables were spiking, causing what Mr. Keymer called “Carter-esque inflation hits.” The price of a bushel of wheat on the Chicago Board of Trade, for example, has risen to the mid $8 range from about $5 a year ago. To keep up, Vicorp boosted its menu prices across the board last spring, summer, fall and again this year.

Like many restaurant chains, Vicorp was a target of private-equity investors earlier this decade, which loaded it up with debt the company later couldn’t cover. Flush with cash in the past few years, private-equity funds saw restaurants as relatively cheap investments that could potentially be turned around quickly by a management change or new menu concept.

“You tweak a menu, fix its distribution chain and then promote it right and you can make a dramatic impact on a chain’s finances,” says Vince Lambiase, a former Denny’s executive who is now a managing director at the turnaround firm BBK Inc.

But with a few exceptions, it hasn’t happened that way.

Last year, for example, OSI Restaurant Partners Inc., which owns Outback Steakhouse and Fleming’s Prime Steakhouse & Wine Bar, went private in a $3.5 billion deal led by the private-equity firms Bain Capital Partners and Catterton Management Co. as well as a group of company founders and management.

Even before the buyout, Outback was struggling with falling same-store sales. For most of the year, OSI’s bonds traded around 60 cents, a danger sign to many investors. The bonds, due 2015, were trading this week at about 74 cents, which Wachovia high-yield bond analyst Bryan Hunt characterized as “still distressed … but investors have a little more confidence.”

Analysts say OSI – along with many other chains – is vulnerable to coming state and federal minimum-wage hikes. On July 24, the federal minimum wage jumps to $6.55 an hour. That is a 12 percent hike in 21 states with the lowest minimum wages, mostly Southern states such as Virginia and Texas. Outback has 82 sites in Texas and Virginia. A spokesman for OSI says it has already planned for the wage hikes.

Dirk Montgomery, chief financial officer of OSI, says the company hasn’t had trouble making debt payments and is not in danger of filing for bankruptcy protection. He says he thinks the financial structure of the company allows for “ample room to weather the storm.”

Outback is fighting to bring back customers by pushing coupons and adding a cheaper daily special, such as a sirloin medley with spinach that starts at $11.99. To cut costs, it has reduced the amount of sauce it serves on dishes like its coconut shrimp.

After the recession of the early 1990s, restaurants rebounded quickly. Midpriced sit-down restaurants were booming as chains expanded beyond metropolitan areas and into suburbs or smaller towns. Bar-and-grill chains such as Applebee’s and Chili’s became a hit with middle-class consumers by offering oversized salads, chicken platters and margaritas at locations that were closer to people’s homes than downtown restaurants.

Restaurant analysts say they don’t expect a swift rebound this time. Part of the reason is the leveling off of women entering the work force and an increase in the quality of prepared food offerings at grocery stores, both of which have led consumers to eat more at home. And with many consumers looking to cut back, casual dining is one of the first things to go.

Restaurants overexpanded in recent years, too. There were 524,286 eating and drinking places in the U.S. in 2006 – a 45 percent increase from 1990, according to the National Restaurant Association. The U.S. population rose 20 percent during that period, according to census figures.

In part because of the glut, overall same-store sales at about 70 restaurant chains were flat or down in the fourth quarter, says Wachovia Capital Markets. Dips are rare in a business that has seen growth in all but two of the past 26 years, according to Wachovia.

“The people I counted on … they’re eating out less,” says Ruby Tuesday CEO and founder Sandy Beall. The company’s same-store sales have declined for four straight quarters at franchised locations and for seven consecutive quarters at company-owned restaurants. The company’s shares closed at $7.35 in 4 p.m. composite trading on the New York Stock Exchange, down from $27.59 a year ago.

To boost sales and set the company apart from its casual-dining competitors, Ruby Tuesday is spending at least $50 million on remodeling, with 668 of its 721 company-owned locations getting a new look. It is replacing its decor of Tiffany lamps and roller skates with custom artwork and leatherlike upholstered furniture. Servers are wearing black pants instead of jeans.

The company has changed some of its food suppliers to trim costs. It saved $800,000 on broccoli by using a different supplier, and another $500,000 by switching mashed-potato suppliers. Ruby Tuesday is installing a new frying-oil filtration system to reduce the amount of cooking oil the company uses, a move Mr. Beall estimates will save $2 million a year.

Smaller franchisees are also hurting. Gerald and Jimmie Sue Farmer own a Ponderosa restaurant, part of privately held Metromedia. The Farmers have managed the Crown Point, Ind., site since 1989 and bought it six years ago. Sales were down 4.5 percent last year over 2006. Food now accounts for more than 40 percent of total costs, up from 36.5 percent five years ago.

“We just hit a brick wall with bills,” Mr. Farmer says. The couple cashed out some of their retirement savings and asked a food supplier for an extension to help pay the January bill.

To cover their costs, the Farmers added a 35-cent surcharge for sour cream. They raised the price of steak entrees by $1. And they stopped offering cherry cobbler, replacing it with less-expensive apple cobbler.

The couple admits the financial squeeze is taking its toll on them. “You have to pretend to smile,” says Mrs. Farmer.