Fitch: Weakening Economy Will Challenge U.S. Restaurants in 2008 but Credit Outlook Stable

CHICAGO-- (BUSINESS WIRE) -- Fitch Ratings expects that the slowing U.S economy and growing pressure on consumer discretionary income will constrain sales growth for the entire restaurant industry in 2008. Weak same restaurant sales (SRS) performance for the casual dining segment is continuing and SRS growth for less economically sensitive quick-service restaurants (QSR) is expected to decelerate but remain positive.

Rising labor and food costs will continue to force the industry to adjust to a higher level of inflation than experienced in the past. In addition, greater competition for fewer dollars could reduce the willingness of many restaurants to be more aggressive with pricing. Stronger industry participants are attempting to offset margin pressure with more profitable products or further expansion into less competitive and faster growing international markets.

Despite slower overall revenue growth, Fitch anticipates that 2008 will be a quieter year for restaurant bondholders. Shareholder activism, debt-financed share repurchases and leveraged buy out risk is expected to be less pervasive. Board of directors and management teams are likely to focus more on navigating through a difficult operating environment and less on returning cash to shareholders.

BROAD-BASED PERFORMANCE CHALLENGES

Over the past couple of years, there was operating divergence in the restaurant industry. Sales performance in the QSR segment outperformed other segments of the restaurant industry because fast food chains did a better job responding to changing consumer preferences and due to growing pressure on consumer discretionary income. As a result, consumers traded down to better values on fast casual and quick service restaurant menus. In 2008, however, Fitch expects the economic slowdown and reduced consumer spending to pressure revenue growth for the entire restaurant industry. Weaker overall revenue growth combined with food and labor cost inflation will make 2008 a very challenging year. Same restaurant sales (SRS) performance for the casual dining industry is entering a third year of sluggish growth and slower sales comparisons are also expected in the QSR segment.

Despite easier SRS comparisons for most casual dining concepts, top line pressure will continue due to competitive pricing as restaurants increase the level of discounting in order to drive traffic. Average check price could be pressured as consumers pull back on higher margin alcoholic beverages and appetizers. Casual diners, such as Red Lobster and Ruby Tuesday's, which have refined their menus to offer better values or to attract more upscale clientele could find that these strategies will become challenged as the macroeconomic slowdown deepens. In general, consumers dine out less frequently during tougher economic environments.

Quick service operators continue to prepare for more discerning customers. Burger King has launched a value breakfast menu and intends to add a $1 double cheeseburger to compete with McDonald's and Wendy's iconic value burgers. McDonald's premium and specialty coffee strategy could steal market share from premium priced Starbuck's beverages.

Inflation will continue to be a concern for the restaurant industry. Labor costs could rise for many companies as the industry absorbs multi-year increases in the minimum wage. Food and beverage costs, particularly for dairy and proteins, remain elevated and packaging costs have impacted some QSR companies. Nonetheless, Fitch anticipates that restaurants will generally be less likely to significantly raise menu prices in 2008 because they do not want to risk losing market share.

COMPETITION TO LIMIT PRICING

Fitch believes lower levels of price increases will occur in 2008 due to more competition. In 2008, the USDA projects food away from home prices to increase 2.5%-3.5%, down from the 3%-4% expected in 2007. Over the three years ended 2006, consumer price inflation (CPI) for food away from home increased at an average annual rate of 3.1%. In 2007, the restaurant industry successfully passed along a portion of their higher input costs to customers. As consumers continue to pull back on discretionary spending, however, restaurant companies will be more concerned with driving traffic versus raising prices.

Increased competition is evidence by the recent up-tick in promotional activity within the industry. Starbucks, the world's dominant coffee retailer, launched its first national television advertising campaign in order to increase traffic and respond to market encroachment by McDonald's and Dunkin Donuts in the coffee space. With increased competition and less consumer spending, revenue growth will be more dependent on robust traffic trends and higher margin products.

FOCUS ON HIGHER MARGIN PRODUCTS AND TRAFFIC DRIVERS

Over the past couple of years, healthier menu items including salads, fruit options and those with zero grams of trans fat were developed in order to help drive traffic and combat negative health and obesity perceptions in the QSR industry. McDonald's and Wendy's both rolled out increased salad varieties and fruit options. Wendy's, YUM! Brand's Kentucky Fried Chicken (KFC) and Darden among many others announced the use of zero or minimum amounts of trans fat frying oils in their menus.

In 2008, Fitch expects restaurants to launch more profitable products focused more on added variety. Many of these products will be limited time offers, which create buzz and help drive traffic, and will not replace the permanent menu items. The QSR segment will continue to focus on faster growing breakfast, coffee and premium sandwich products. Burger King recently announced the segments first Value Breakfast Menu which has ten items starting at $1.00 each. As the first to establish a solid QSR breakfast menu, McDonald's has added a larger premium sausage burrito option called the McSkillet and has plans to add to a chicken biscuit offering to its breakfast options in 2008. Dunkin Donuts is now distributing a smaller 12 ounce version of its packaged coffee through the retail grocery channel. Fitch anticipates that breakfast efforts at YUM! Brand's Taco Bell could be put on the backburner due to competitive pressure and continued efforts to revitalize the brand in the U.S.

McDonald's expansion into high margin specialty coffees is intended to capture more of the $30 billion U.S. coffee market while further enhancing the company's overall snack options. The snack wrap options rolled out in 2007 will be complemented over the next couple of years with a variety of lattes and cappuccinos which are expected to function as snacks. Menu items catered towards snacking will help drive the late night meals day part. Wendy's recently announced that phase two of its strategic growth plan will include introducing products to re-energize its late night business and capture snacking opportunities. Burger King is currently expanding its day part traffic by extending hours of operations across its system.

CREDIT OUTLOOK GENERALLY STABLE

Credit risk is the primary concern of bondholders; however, Fitch expects less market liquidity and more levered balance sheets to make the event driven credit risk experienced over the past couple of years to be less prevalent in 2008. During 2007, shareholder activism was rampant, restaurants incurred more debt and future discretionary cash flows were committed to equity holders in the form of multiple year share repurchase programs.

In 2007, credit rating activity was abundant. The level of downgrades outpaced upgrades three-to-one. Fitch downgraded Brinker International, Inc. (Brinker) and YUM!Brands, Inc. (YUM) because of debt-financed share repurchase and Darden Restaurants, Inc. (Darden) because of its debt-financed acquisition of RARE Hospitality International, Inc. Burger King Corporation was upgraded due to significant improvement in the company's credit profile and financial flexibility during the previous twelve months.

Going into 2008, Fitch views the credit outlook for the restaurant industry as generally stable despite a weakening economy and growing pressure on consumer spending. Food price inflation, high gasoline prices and lofty winter heating bills will reduce discretionary income. Credit statistics could weaken modestly due to lower top line growth and potential margin pressure but Fitch does not anticipate a large number of additional rating downgrades. The Ratings Outlook for Fitch's universe of coverage is currently stable.

FEWER LEVERAGED TRANSACTIONS

Due to more restrictive lending and slowing commercial real estate activity, aggressive debt-financed acquisitions, share repurchase programs and one-time dividend payouts are expected to be less prevalent in 2008. Increased use of change of control, ratings-based coupon-step up provisions and material adverse change clauses are likely to increase capital structure discipline in the restaurant industry. These structural forms of bondholder protection should also reduce shareholder activism in the industry. Sale-leaseback activity could also slow due to weaker property valuations.

Acquisition activity in 2006 and 2007 was fueled by the availability of various forms of financing. In addition to conventional bank facilities and unsecured bond issuance; secured forms of financing included securitization of royalty based franchised fees and intellectual brand property. As such, demand was strong and acquisition multiples averaged a healthy 10 times(x)-12x cash flows. In 2008, a reduced number of qualified acquirers and slower revenue growth will prolong the sales process and could reduce acquisition multiples in the restaurant industry.

Restaurants currently for sale include; Wendy's and Brinker's Romano Macaroni Grill. A recent lowering of acquisition multiples indicates that the current supply of restaurants for sale could be exceeding demand. Potential acquirers of Wendy's International, Inc. (Wendy's) have lowered bids for the nationally recognized chain and IHOP acquired Applebee's International, Inc. (Applebee's), the largest casual dining restaurant in terms of units, at a below market rate of approximately 9x. Sun Capital Partners, Inc. is estimated to have paid mid-to-high single digit multiples for its recent purchase of Boston Market from McDonald's and Smokey Bones Barbeque & Grill from Darden.

Following is a list of Fitch-rated issuers and their current Issuer Default Ratings (IDRs) in the U.S. Restaurant Sector:

--McDonald's Corporation ('A'; Outlook Stable);

--Brinker International, Inc. ('BBB-'; Outlook Stable);

--Burger King Corporation ('BB-'; Outlook Stable);

--Darden Restaurants Inc., ('BBB'; Outlook Stable);

--YUM! Brands Inc., ('BBB-'; Outlook Stable);

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.

Fitch Ratings, Chicago

Carla Norfleet Taylor, CFA, +1-312-368-3195

Wesley E. Moultrie II, CPA, +1-312-368-3186

Judi M. Rossetti, CFA/CPA, +1-312-368-2077

Media Relations, New York

Brian Bertsch, +1-212-908-0549