S&P: Steak n Shake Inc. Downgraded To 'B-' On Note Issuance, Outlook Stable; New Debt Rated
We assigned our 'B+' issue-level rating to the company's senior secured revolving credit facility. The recovery rating assigned to the revolving credit facility is '1', indicating our expectation for very high (90% to 100%) recovery for lenders in the event of a payment default or bankruptcy We assigned a 'B-' issue-level rating to the company's senior secured note offering. The recovery rating is '4', indicating our expectation for average recovery in the event of default, at the higher end of the 30% to 50% range.
The downgrade reflects weakened credit metrics, including adjusted leverage in the mid - to high-5x range, and a more aggressive financial policy following the proposed $400 million note issuance. The company anticipates using the note issuance proceeds and balance sheet cash to refinance the existing $204 million in term loan debt and to fund a $230 million dividend to Biglari Holdings (not rated), the public holding and parent company for Steak n Shake. Following the note issuance, we expect limited deleveraging and forecast adjusted leverage will remain in the mid - to high-5x range for the next 12 to 18 months.
Our assessment of the Steak n Shake's business risk considers the company's niche in the limited-service hamburger segment of the quick-service restaurant (QSR) industry. We believe the company's position as a geographically-concentrated, smaller operator limits its ability to compete with significantly larger, better capitalized QSRs. Furthermore, our assessment considers that 70% of restaurants are owned and operated by Steak n Shake, resulting in lower margins and more potential earnings volatility versus highly franchised peers. We also believe the company's business model exposes operating performance to commodity prices given its limited ability to pass higher costs to the consumer and the relatively small franchisee base. However, successful franchise growth over the long term could mitigate these risks in our opinion. Despite weak performance in the second quarter of 2016, we think the company will leverage its value-pricing model to drive customer traffic and expect a modest improvement in 2016 performance. Considering this, our base-case forecast scenario assumes:
U. S. economic growth of about 2% in 2016 followed by GDP growth of 2.3% in 2017 with consumer spending growth of about 3% in both years;Projected same restaurant sales growth of about 3% in 2016 followed by growth of about 2% in 2017 and thereafter with the company's value menu offerings driving growth; Estimated annual restaurant growth about 30 units, with growth primarily in the company's franchise base. Operating costs decline modestly, as percentage of sales, on improved operating leverage, cost saving initiatives, and reduced franchise investment spending partially offset by the effects of inflation; Low - to mid-double-digit capital spending annually to fund general restaurant maintenance, restaurant growth initiatives, and franchise growth plans; and Modest free operating cash flow with cash generation used partially for debt repayment but primarily for distributions to Biglari Holdings Inc., as the parent entity. Our forecast scenario would lead to the following credit ratios:Adjusted debt to EBITDA of 5.8x for fiscal 2016 and 5.6x for fiscal 2017; andFunds from operations (FFO) to debt of 9% in 2016 and 8% 2017. We forecast adjusted leverage will remain in the mid - to high-5x for the next 12 to 18 months, a significant deterioration from the mid-4x range prior to the proposed $400 million note recapitalization. We view the increase in leverage as a change in the company's financial policy and see an increase in the company's financial risk. Moreover, we expect limited future deleveraging and expect most of the company's free operating cash flow generation used for distributions to Biglari Holdings Inc.
Steak n Shake is a wholly owned subsidiary of Biglari Holdings Inc., a public company. Currently, Steak n Shake accounts for more than 95% of sales and almost all of Biglari's EBITDA. Biglari Holdings has no significant debt. As such, credit measures have been generally comparable for both entities and we view the credit profiles for the two entities as synonymous. Biglari's strategy has been to reinvest cash generated by its operating subsidiaries into acquisitions of other businesses. We believe the company will maintain leverage in the mid - to high-5x range.
The stable outlook on Steak n Shake incorporates our expectation that performance will continue to improve modestly in the coming 12 to 18 months because of positive same-store sales, unit expansion, and modest margin gains. However, we see the deleveraging potential as limited and we expect adjusted leverage to remain in the mid - to high-5x range.
We would lower the rating if significantly weak operating performance and/or an increase in operating costs result in negative free operating cash flow, leading us to believe the company's liquidity was diminishing and the capital structure was trending towards an unsustainable level. This could happen for example if same-restaurant sales were consistently negative and profit margins eroded by more than 200 bps, resulting in an EBITDA decline in excess of 15% or more. Under this scenario, adjusted interest coverage would be 2x, and liquidity would erode because of negative free operating cash flow.
Although an upgrade is unlikely over the next year given our view of the company's financial policy and its limited near-term operational upside, we could raise our rating on a successful and rapid franchise expansion, favorable commodity price (especially for beef), better-than-expected restaurant cost management and a sustained mid-single-digit same-restaurant sales growth resulting in mid-single-digit increase in sales growth, margins expanding by 150 bps, and EBITDA growth of 20% or more. Under this scenario, adjusted debt leverage would decline to below 5x on a sustained basis. Moreover, lower leverage would be supported by a financial policy to maintain leverage to those indicated levels on a sustained basis.