CASE STUDY: GIFT CARD CAPITAL

Elliott Merck, senior vice-president and credit evaluator for Gift Card Capital Inc. (GCC), faced a critical decision. He had been presented with large credit requests from two mid-size, multi-unit restaurant companiesCasa Grande Brands Inc. (Casa Grande) and Domingo Grill Inc. (Domingo Grill). Both companies were requesting up to US$5 million¹ in cash advances, and both chains were in notable financial difficulty. In meeting with senior management from both companies, Merck could see that both organizations had taken the recessionary period as an opportunity to restructure their operations and finances; however, when looking through the financial statements for each company, he noticed that both chains had suffered significant losses in sales and had closed numerous stores. In short, neither company had been able to turn a profit for any of the past three years. Though Merck was accustomed to being a financier of last resort for many financially precarious hospitality organizations, it was unusual, even for him, to receive financing requests from such troubled companies. GCC was certainly used to taking calculated risks, but concentrating $10 million in financing into two troubled companies could either prove to be a highly lucrative investmentor the largest mistake of Mercks career.

THE STATE OF THE RESTAURANT INDUSTRY

The restaurant industry had long been the poster child of risky businesses, with popular media often citing the dubious statistic that 90 per cent of new restaurants fail within the first year. Despite empirical evidence that restaurant failure was no more common than that of other small businesses, the perception of riskiness was the primary reason why most restaurants carried little, if any, long-term debt. No one was willing to lend to them at a reasonable rate for fear that such businesses would not exist long enough to fully repay their loans. Any risk that did exist with restaurants was typically derived from the fundamental nature of the restaurant business. Restaurants generally (1) required relatively high levels of capital expenditures with little to no resale value and high fixed operating costs, such as labour and occupancy; (2) utilized highly perishable inventory that was exposed to highly variable commodity and raw material costs; and (3) operated on negative levels of working capital.

Large chains such as Applebees and Outback Steakhouse successfully defrayed much of the risk associated with restaurant operations by using their size to negotiate lower food costs from purveyors; developing sophisticated real estate purchasing and site selection, and menu development models; and implementing sophisticated information technology platforms. For example, Buffalo Wild Wings parent company, Inspire Brands, invested $20 million in a single year to improve its speed of service and collect more detailed customer information with mobile ordering and payment systems. Similarly, Chilis Grill & Bar parent, Brinker International, attributed its ability to weather volatility in commodity prices to a sophisticated supply chain management initiative that used technology and an entire information system team to connect suppliers with internal quality assurance, culinary, and marketing teams.⁶ Such costly technology investment and big-data-driven initiatives helped large chains to grow larger and take market share away from smaller chains and independent restaurants.

CASA GRANDE BRANDS INC.

The Casa Grande restaurant group owned and operated full-service casual-dining establishments under three brand concepts in 29 US states. The company owned 119 Casa Grande traditional restaurants, 66 brewery restaurants, and four caf restaurants, which operated under separate brand names. At its prime, Casa Grande was the seventh-largest Mexican casual-dining chain in the United States, as measured by sales. Casa Grandes menu prices were generally positioned at the lower end of casual dining restaurants. The average spend at Casa Grande, including beverages, was about $8 for lunch and $14 for dinner.

Casa Grande restaurants ranged in size from 5,0009,900 square feet (465920 square metres) and accommodated up to 230 dining seats and 70 bar seats. Each restaurant was staffed with one general manager, an assistant general manager, and two to four assistant managers, depending on the restaurants volume. Restaurant-level managers were measured on and rewarded for, their performance on budget and health and safety compliance, and their achievement of quality assurance goals, such as guest satisfaction, and adherence to brand standards.

Casa Grandes system-wide sales for the most recent year totalled $441 million, down from $589 million in the previous year, reflecting the corporate closure of underperforming stores. The average sales volume for units that had been open for at least one year was $2.1 million, which was down from the previous period. The company owned the real estate associated with 44 of its restaurants but leased either the building or the land associated with the remaining 141 sites. Managements most recently stated focus was to reduce debt, improve liquidity, and increase profitability.

DOMINGO GRILL INC.

Domingo Grill, a Florida-based company founded in 1992, operated 70 full-service casual-dining restaurants in the United States. The company operated in 10 US states, with the overwhelming majority of operations in the Southeast. The company owned the real estate associated with 12 of its restaurants and leased the land associated with the remaining sites. The average investment in a restaurant was $1.3 million. Domingo Grills restaurants targeted mostly couples, families, and senior citizens. The companys restaurants were known for their high-quality food, generous portions, diverse menus, and moderate prices. Dinner entree prices ranged from $8$19, and lunch items were priced at $9 or less.

Domingo Grill units that had been open for more than one year generated average annual sales of $2 million. Each of Domingo Grills restaurants employed 6070 people, including a general manager, kitchen manager, dining room manager, and one or two assistant managers, depending on store volume. Although much of the day-to-day operations were handled by unit-level managers, Domingo Grill centralized operational functions, such as purchasing, training, marketing, finance, and information technology.

In recent years, Domingo Grill had suffered from particularly poor timing, as the company reached the peak of its expansion plans just as a recession began. In January of the most recent year, creditors demanded a financial reorganization. By the end of September of the same year, Domingo Grill received an infusion of capital from four private investors. Due to the companys recent financial difficulties, the firm had no available lines of credit or other traditional means to raise operating capital.

THE DECISION

Merck looked at Casa Grandes and Domingo Grills financial statements and sighed. Based on an initial look at each companys unit-level economics, neither company looked promising. The income statements and balance sheets were not much help either, as both companies had several unusual line items that complicated Mercks analysis. Nevertheless, he forged ahead, as he would soon need to respond to these companies cash requests.

REQUIRED:

1. For both firms, calculate the ratios as shown in the template:

Casa Domingo Industry average current year prior year current year prior year 21.3 Turnover Inventory turnover AR turnover Fixed asset turnover Total asset turnover 1.7 1.1 0.7 Credit risk ratios Liquidity ratios Current ratio Quick ratio CFO/current liabilities Coverage EBITDA/interest expense CFO/debt Interest expense/sales Capital structure Debt/capitalization Debt/assets Shareholders' Equity/assets 60.0% EXHIBIT 1: INCOME STATEMENT FOR CASA GRANDE BRANDS INC. (US$ THOUSANDS) Total revenue Current year $ 441.588 S Prior year Two years prior 589,379 $ 650,261 Store operating expenses Food & beverage Labour & benefits Occupancy & other Total 125,190 149,140 118,281 392,611 168,222 191,034 156,517 515,773 189,363 207,091 162,433 558,887 Other operating expenses Depreciation and amortization General & administrative Asset impairment Operating income (loss) 14,861 26,580 45,994 (38,458) 19,639 31,011 49,110 (26,154) 23,140 36,976 58,485 (27,227) 35,305 22,651 38,262 23,773 Interest expense Other losses and charges Gain on debt extinguishment Loss before income taxes Income tax expense (benefit) Net loss 31,050 26,458 (32,912) (63,054) 375 (63,429) S (84,110) 11,150 (95,260) S (89,262) (23,528) (65,734) S EXHIBIT 2: BALANCE SHEET FOR CASA GRANDE BRANDS INC. (US$ THOUSANDS) Current year Prior year Two years prior Three years prior $ Assets Cash and cash equivalents Accounts receivable Inventories Prepaid expenses and other Total current assets 636 $ 5,087 5,283 2.129 13.135 10,537 S 10.723 5,870 2,928 39,795 402 7,621 9,418 3,535 20,976 9,097 252,870 Premises and equipment, net Goodwill, net Deferred income tax benefit Other assets Total assets 11,620 28,670 306,295 S 292,765 34.920 11,620 29,193 399,556 s 315,793 72,012 18.900 44,000 471,681 $ S 656,596 $ Liabilities and shareholders' equity Current liabilities Accounts payable Accrued liabilities Income taxes payable Total current liabilities 11,509 $ 54,292 15,766 $ 64,265 33.773 113,804 16,568 64,567 30.164 111,299 100,839 Long-term debt Other long-term liabilities Total liabilities 199,869 2143 302,851 215,828 3,111 332,743 194541 5,024 310,864 Shareholders' equity (deficit): Common stock Additional paid-in capital Retained earnings (accumulated deficit) Treasury stock at cost Total shareholders' equity (deficit) Total liabilities & shareholders' equity (deficit) 405 154,637 (58,118) (93,480) 3,444 306,295 S 405 146,139 5311 (86,042) 65,813 398,556 S 405 147,809 100,571 (87.968) 160.817 471,681 S EXHIBIT 3: INCOME STATEMENT FOR DOMINGO GRILL BRANDS INC. (US$ THOUSANDS) Current year $ 140,924 $ Prior year Two years prior 158,982 $ 168,055 Total revenues Store operating expenses Food & beverage Labour & benefits Occupancy & other Total 47,439 47,860 34,691 129,990 55,066 51,817 38,057 144,940 59,112 54,059 41,750 154,921 Other operating expenses Depreciation & amortization General & administrative Asset impairment Operating income (loss) 7,460 6,956 6,713 (10,195) 8,991 9.106 13,529 (17,584) 10,297 11,754 3,066 (11,983) Interest expense Loss before income tax 2.289 (12,484) 3,810 (21,394) 3,655 (15,638) Income tax (benefit) Net loss (1,241) (11,243) S 49 (21,443) S 1,818 (17,450) S EXHIBIT 4: BALANCE SHEET FOR DOMINGO GRILL BRANDS INC. (US$ THOUSANDS) Current year Prior year Two years prior Three years prior $ Assets Curent assets Cash & cash equivalents Accounts receivable Income tax receivable Inventory Prepaid expenses Total current assets 2,956 $ 337 741 1,163 2,196 7393 3.193 $ 475 17 1,305 2,628 7,618 1,592 1,512 2.253 1,462 2,080 8,899 1,622 71,926 Net property, plant & equipment Intangible assets Other assets Total assets 60,824 1,890 1,197 71,304 S 1,935 1.875 87,204 2,105 2120 100,328 S S 83,354 S 105,312 Liabilities & shareholders' equity Current liabilities: Accounts payable Accrued expenses Total current liabilities $ 3,630 $ 8,893 12,523 1,603 $ 9,285 10,888 741 8.818 9,559 Long-term debt Total liabilities 47,996 60,519 56,938 67,826 53,798 63,357 Shareholders' equity Common stock Additional paid-in capital Retained deficit Total shareholders' equity Total liabilities & shareholders' equity 877 55,953 (46,045) 10,785 71,304 S 291 50,039 (34,802) 15,528 83,354 S 291 50,039 (13,359) 36,971 100,328 S