Another restaurant franchise deal, another securitization

Whole business securitizations have become enormously popular in the restaurant finance world. Name a restaurant franchise, and that company probably has securitization financing, including brands like Five Guys, Jack in the Box, Jersey Mike’s, Subway, and many, many others.

Securitization deal details

So we should not have been surprised by the report this week in Bloomberg that Pizza Hut’s new owners, LongRange Capital, are financing their $1.5 billion deal for most of the brand through a whole business securitization.

In a whole business securitization, a company pledges its income-generating assets to back bonds sold to investors. Those assets can be anything, and in this case they would be franchisee royalties and other fees, but these deals sometimes include other revenue, such as money generated by a franchise’s supply chain.

(Side note: Using supply chain revenue to guarantee the bonds is a bad idea in general, because then that incentivizes brands to make more money from that supply chain, which drives up costs for franchisees, but that’s also common right now.)

Securitizations are popular because they are structured in a way that provides more protections for bond investors, which lowers the interest rate.

Years ago we probably would not have thought much about this, because a lot of very successful restaurant chains – notably Domino’s – use this financing to great effect. But then we watched TGI Fridays, Hooters, and Fat Brands all file for bankruptcy with enormous loads of securitized debt. And now we think about this a lot.

Securitized debt may lower the cost of borrowing, but it also encourages companies to take on more debt than they really should. While debt is a necessary ingredient in many acquisitions, too much of it becomes an enormous burden, especially over the long term. It puts pressure on companies to grow the business, while limiting their options for doing so.

Pizza Hut challenges

And it is especially problematic when the company being burdened with this excessive debt has a need for investment and a long-term track record of weak sales, which brings us to Pizza Hut.

Yum Brands sold the chain in two parts. LongRange is spending $1.5 billion for Pizza Hut outside of China. Yum China is paying $1.2 billion for Pizza Hut in China. LongRange is paying a relative pittance for a chain with about 15,000 locations, but it won’t get access to that chain’s second biggest and arguably most important market.

That will put pressure on Pizza Hut to fix its U.S. market, and that is not remotely guaranteed.

Within the U.S., Pizza Hut has a long, storied history. But it has been in a steep decline. Consider this: The chain has closed more locations than it has opened in nine of the past 11 years, according to data from Restaurant Business sibling company Technomic.

Its unit volumes relative to its competitors are also weak. A typical Pizza Hut last year did $790,000, down $55,000 from the year before, and some $200,000 less than its nearest competitor. It is $610,000 per year less than Domino’s.

Pizza Hut can turn things around. During the Great Recession, some of us were wondering whether consumers lost their taste for pizza, and then Domino’s went on an absolute tear, going from troubled legacy brand to the sector’s dominant player.

But the pizza sector faces bigger questions this time around, as consumers shift delivery spending to third-party players. That has removed one of the pizza business’s biggest competitive advantages.

Brands can survive this, but only when they have the financial wherewithal to do so, because now those pizza chains will need to compete against the McDonald’s and the Taco Bells of the world for business. That’s not easy.

Pizza Hut could well turn things around and generate a strong return for its new owners, especially if they keep the amount of debt to a minimum. But take out too much, and it would more easily go in the other direction.