TEXT-S&P revises Cara Operations outlook to negative from stable

Thu Nov 8, 2012 4:58pm EST
 
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Overview
     -- We are revising our outlook on Cara Operations Ltd. to negative from 
stable, in view of the company's elevated leverage brought about by reduced 
earnings from franchise operations.
     -- At the same time, we are affirming our 'BB-' long-term corporate 
credit rating on the company.
     -- We believe that Cara's earnings will remain under pressure from weak 
same-restaurant-sales and lower earnings from conversions.
     -- The negative outlook reflects our concerns that Cara's weaker 
profitability might increase its already high debt leverage, potentially 
affecting its compliance with tight financial covenants ahead of the maturity 
of its revolving credit facility in December 2013.

Rating Action
On Nov. 8, 2012, Standard & Poor's Ratings Services revised its outlook on 
Cara Operations Ltd. to negative from stable. At the same time, Standard & 
Poor's affirmed its ratings on the company, including its 'BB-' long-term 
corporate credit rating on Cara.

We base the outlook revision on our view of the company's higher debt levels, 
elevated leverage, and weak interest coverage brought about by reduced 
earnings from franchise operations amid weaker restaurant-level performance. 
We believe that Cara's earnings will remain under pressure from weak 
same-restaurant-sales performance in its core Ontario market, while earnings 
from conversions wane and new franchise stores--predominantly in western 
Canada--begin to contribute more meaningfully in 2013.

Rationale
The ratings on Cara reflect what Standard & Poor's views as the company's 
aggressive financial risk profile, with high debt leverage and thin cash flow 
coverage. That said, we believe the company has a fair business risk profile, 
with a relatively attractive portfolio of restaurant banners in Canada. The 
privately held company does not release its financial statements publicly.

Cara is a 129-year-old, family-owned company that operates and franchises five 
restaurant brands in Canada. It has narrowed its focus meaningfully in recent 
years, selling noncore holdings and shifting the strategic and operating 
position for its remaining restaurant brands. Cara emphasizes a franchise 
model for its new locations and for lower-check brands, maintains corporate 
ownership of some restaurants in higher-check brands, while centralizing key 
support functions.

The company's aggressive financial risk profile is characterized by high debt 
leverage and thin cash flow coverage, with debt to EBITDA likely to exceed 7x 
through 2012 and 2013 along with EBITDA interest coverage of below 2x, both 
fully adjusted to capitalize operating leases. We believe that subleases lower 
net leverage to about 5x by providing a modest buffer for default risk, but 
Cara's credit metrics are still high for our 'BB' rating category. We add 
about C$400 million of pro forma capitalized operating leases to the company's 
debt load, but subleases to franchisees account for about two-thirds of the 
adjustment, thereby providing a buffer in the default risk associated with 
this obligation. The credit risk embedded in the combined portfolio of 
subleases appears moderate, given the low degree of franchisee concentration 
and low historical franchisee financial default.

Cara's key financial risk, in our view, is the company's weak cash flow 
coverage, particularly given the recent changes in its business model. We 
believe that Cara's cash flow protection could be at risk because of weaker 
franchise earnings from a modest decline in same-restaurant-sales, and as 
franchise conversion gains incorporated into adjusted EBITDA decline through 
2014. Nevertheless, Cara's reported EBITDA interest coverage should remain 
consistent at 2.5x-3.0x in the next several years, which we believe should 
translate into modest discretionary cash flow in 2013 and 2014 after 
accounting for lower capital expenditures and steady dividends. We believe 
that a greater preponderance of franchises should improve Cara's returns on 
capital along with lower, more stable earnings and lower capital intensity, 
albeit while ceding some control and earnings to franchisees. The financial 
benefits of the transition to a more centralized business model are muted, 
however, considering that Cara's overhead costs remain high compared with some 
of its heavily franchised U.S. peers.

We view Cara's business risk profile as fair, supported by the good market 
position of its brands in the competitive, fragmented, and cyclical restaurant 
industry. Cara operates four of the top 10 full-service restaurant chains in 
Canada and the fourth-largest quick-service hamburger chain, thereby covering 
a broad spectrum of market segments. On the other hand, the diversity of its 
operations is weak, with more than two-thirds of its restaurants in Ontario. 
This concentration in Ontario is a key driver of Cara's recent weaker 
performance, with soft economic conditions leading to a modest decline in 
same-restaurant-sales. Moreover, we believe that the cash flow and adjusted 
EBITDA benefits from franchise conversions will decline to a negligible amount 
by 2014 as the company converts corporate stores to franchise operations. On 
the other hand, we believe that Cara has good growth prospects in 
faster-growing western Canada where its banners have lower penetration. 
Moreover, the company's growth strategy should benefit from strong national 
brand awareness and low capital intensity because of the concentration of 
growth within the entirely franchised Harvey's and Swiss Chalet banners.

Liquidity
We view Cara's liquidity as less than adequate, with only a small amount of 
cash on hand as of July 3, 2012, and an estimated C$39 million available on 
its C$175 million revolving credit facility due 2013, access to which could 
get constrained by tight financial covenants. We incorporate the following 
expectations into our assessment of Cara's liquidity:
     -- Liquidity sources will cover uses by only about 0.7x in the next 12 
months, taking into account the refinancing requirement for its revolving 
credit facility in December 2013;
     -- Fairly stable operating earnings, some working-capital relief from 
franchise conversions, and lower capital expenditures contribute to modest 
discretionary cash flow in the next year; and
     -- The company's relationships with banks, standing in capital markets, 
and ability to withstand low-probability adversities is uncertain.

Recovery analysis
We rate Cara's C$200 million senior secured second-lien notes due 2015 'BB-' 
(the same as the corporate credit rating on the company), with a '4' recovery 
rating, reflecting our expectation of average (30%-50%) recovery in a default 
scenario.

Outlook
The negative outlook reflects our concerns that Cara's weaker profitability 
could increase its already high debt leverage, potentially affecting its 
compliance with tight financial covenants ahead of the maturity of its 
revolving credit facility in December 2013. We could lower the ratings if 
persistently weak earnings in 2013 increase fully adjusted leverage 
meaningfully above 7x as the company continues to shift its business model, 
with the attendant risks for cost reductions and operational disruptions. 
Moreover, downward pressure on the rating would likely ensue from reported 
EBITDA interest coverage below 2x, which we believe would indicate a 
discretionary cash burn and higher prospective debt service costs.

On the other hand, we could revise the outlook to stable if earnings rebound, 
lowering fully adjusted debt leverage to about 6.0x and supporting adequate 
liquidity. In addition, we expect a scenario of ratings stability and 
improving earnings should translate into about 3.5x reported interest coverage 
and potentially contribute to debt reduction from discretionary cash flow.

Related Criteria And Research
     -- Key Credit Factors: Business And Financial Risks In The Restaurant 
Industry, Dec. 4, 2008
     -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008

Ratings List
Cara Operations Ltd.

Outlook Revised
                           To                From
Corporate credit rating    BB-/Negative/--   BB-/Stable/--

Ratings Affirmed
Senior secured debt        BB-
Recovery rating            4


Complete ratings information is available to subscribers of RatingsDirect on 
the Global Credit Portal at www.globalcreditportal.com. All ratings affected 
by this rating action can be found on Standard & Poor's public Web site at 
www.standardandpoors.com. Use the Ratings search box located in the left 
column.