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.