2009-11-18 15:07:04 -

Fitch Ratings expects sales trends for U.S. restaurants to improve modestly during the second half of 2010, therefore the outlook for Fitch's universe of coverage remains stable heading into next year. Due to continued weakness in consumer discretionary spending, same-store sales (SSS) trends for the restaurant industry remain negative and near-term visibility is limited. Nonetheless, Fitch believes personal consumption and consequently restaurant traffic could improve as the economy continues to recover and unemployment peaks during 2010. In the meantime, the maintenance of market share, by offering compelling values along with variety and high quality food and service, will remain a key priority for the industry.

"Adequate liquidity and positive free-cash flow should contribute to a stable credit environment for the large

chain restaurants in 2010," said Carla Norfleet Taylor, Director at Fitch. "We believe growing weakness in quick-service restaurant traffic is signaling a bottoming for the industry. Despite significant discounting by some casual dining chains, sales trends for the quick-service segment have held up better over the course of the recession. Consumers remain attracted to the lower relative prices, additional premium food offerings and convenience that the quick service segment provides," she added.

Easing commodity costs, better labor management and aggressive general and administrative expense reductions enabled the industry to mitigate cash flow declines in 2009, despite growing pressure on SSS. With the exception of McDonald's Corporation, which continues to lead the industry in profitability, credit profiles were further supported by more conservative financial strategies. Reduced capital expenditures, particularly within casual dining and among highly leveraged firms, and less spending on share repurchases helped preserve liquidity and fostered debt reduction.

Fitch believes controlling cost will outweigh aggressive expense reductions in 2010, given that some of the reductions implemented in 2009 cannot be sustained. Despite modest potential commodity cost inflation, restaurants will likely maintain the currently cautious stance on pricing as consumer spending remains weak and the environment continues to be extremely competitive. Discounting within the casual dining segment is expected to continue until there are better indications that consumer spending has improved. Ongoing promotional activity without sustained improvement in traffic could pressure operating margins and cash flow in the coming year.

Fitch continues to view the quick-service restaurant (QSR) segment as better positioned to withstand the currently difficult consumer environment. As previously mentioned, there is a high level of discounting by many casual dining chains but quick-service providers continue to have lower relative prices, are offering more premium food items and will continue to benefit from their convenience platform.

Fitch's current baseline 2010 macroeconomic assumptions, regarding unemployment and growth in personal consumption expenditures, provide support for a possible inflection point in industry-wide SSS performance during 2010. Modest improvement could occur in the later half of 2010 as the broader economy continues to recover and consumers regain confidence. Nevertheless, Fitch does not expect a rapid upturn in SSS growth due to the potential longer tail nature of the economic recovery.

Fitch expects unemployment to peak in 2010, averaging approximately 10.2% for the year, and then decline modestly in 2011. Personal consumption is projected to turn mildly positive at 0.3% in 2010, after declining by an estimated 1.1% in 2009, and then increase to 1.8% in 2011. Growth in personal consumption will remain below levels experienced prior to the beginning of the recession in December 2007.

The ratings of the firms in Fitch's universe reflect each company's unique cash flow generation characteristics and their ongoing financial strategy. Liquidity is currently not a concern for any of these companies. All of them generate positive FCF (defined as cash flow from operations less capital expenditures and dividend) and should have minimal challenges refinancing or repaying near-term maturities. Stable to moderate increases in rent adjusted leverage, defined as total debt plus eight times gross rent expense divided by earnings before interest, taxes, depreciation, amortization and gross rent expense (EBITDAR), is not expected to have negative rating implications.

The ratings and Outlooks for Fitch's universe of restaurant companies are as follows.

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

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

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

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

Negative QSR Traffic Could Signal Bottom for Industry Despite Limited Near-Term Same-Store Sales Visibility.

The current environment for restaurant sales is characterized as having limited near-term visibility. SSS trends have not shown broad signs of improvement even though U.S. GDP turned strongly positive during the third quarter of 2009. The National Restaurant Association reports that industry traffic has contracted since September 2007, and expectations remain dismal for most operators. Companies that have provided fiscal 2010 sales and earnings guidance have wide spans of expectations or in some cases have opted out of providing SSS guidance at all. Fitch expects more clarity in SSS prospects and potential improvement in trends as the year progresses and consumers feel more confident about their personal financial conditions and the overall U.S. economy.

As mentioned earlier, Fitch continues to view the QSR segment as better positioned to withstand prolonged weakness in consumer discretionary spending. The QSR segment has held up better than full service dining during most of the economic downturn. Casual dining chains, including Chili's, Applebee's and Ruby Tuesday, started posting negative sales comparisons in mid-to-late 2006 while U.S. SSS growth for QSR companies did not start to decelerate until 2009. Although regional concepts like Jack in the Box, Inc. and Sonic, which have units concentrated in areas with above average unemployment, begin posting negative SSS performance in 2008, U.S. sales comparisons for national chains, like YUM and Burger King did not turn negative until 2009. Fitch attributes declining traffic trends for the QSR segment to rising unemployment and increased price competition, given the high level of discounting and promotions in casual dining; but believes broad-based weakening among QSR sale performance could signal a bottoming for the industry.

QSR chains are continuing to emphasize their value menus but are also providing customers with more choices, such as McDonald's Angus Third Pounders and extensive beverage offerings. Other examples include Burger King's barbell menu which offers indulgent items like Steakhouse burgers and value offerings like the $1 Quarter Pound Double Cheeseburger.

International SSS growth for global chains such as McDonald's and YUM is expected to continue to support their world-wide operating performance in 2010, given limited competition from casual dining chains outside of the U.S.

The multitude of promotional activity within casual dining is helping some of these companies drive traffic, albeit at a cost. Mix shift towards promotional items is negatively impacting SSS performance and restaurant level profitability. Higher margin alcoholic beverages and desserts have not been able to offset discounted entrees because consumers generally order less of these if they are watching their pocket books. Fitch expects SSS trends for casual dining restaurants to remain more negative than QSR companies in the near term but once again anticipates that an inflection point for industry-wide SSS performance can occur during 2010. An example of how competitive the casual dining segment has gotten is Applebee's '2 for $20' offer, where two diners get one appetizer and two entree's, and Chili's subsequent $20 '3 for 2' promotion, which offers two guests one appetizer along with 2 entrees and a dessert to share. For competitive reasons, neither company will disclose the tenure of these promotions.

As of Oct. 23, 2009, the USDA is forecasting a 3.5%-4.0% increase in food-away-from-home prices, on par with the projected increase for 2009.
Fitch anticipates that these estimates could be revised down due to a continued high level of discounting in the full-service dining segment, particularly during the beginning of 2010. As previously mentioned, restaurants are likely to take a cautious stance on pricing until consumer spending shows clear signs of improving.

SSS performance for Darden was noticeably weaker during the fiscal first quarter ended Aug. 30, 2009, given the company's position against discounting. While consumers might appreciate temporary savings, current industry practices could definitely have potential negative longer-term consequences relating to brand image. Darden plans to continue to emphasize value with offerings such as Endless Shrimp at Red Lobster and Never Ending Pasta at Olive Garden but is not expected to lower prices.

Margin Risk Could Return Due to Modest Potential Commodity Cost Inflation and Continued Promotional Activity in the Near-Term.

Overall, industry margins held up better than Fitch had originally anticipated in 2009. Nonetheless, slowing sales combined with a lagging benefit from easing commodity cost or inefficient labor management caused some firms, such as Burger King, to experience margin contraction during 2009. In addition, as previously mentioned, casual dining chains, including Brinker (which operates Chili's) and Ruby Tuesday, appear to be experiencing lower restaurant level profitability due to less profitable food promotions.

While many companies expect to experience commodity cost deflation during the last quarter of calendar 2009, lower protein production and an improved global macroeconomic environment could result in modest commodity cost inflation in 2010. The outlook for individual companies will depend on each restaurant's exposure to various commodities and the timing of contract expirations. McDonald's expect flat costs in both the U.S. and Europe for its basket of commodities in 2010. Unlike other restaurants, Fitch believes McDonald's will benefit from its extensive procurement and massive supply chain infrastructure even if there is modest commodity inflation for certain agricultural products.

As of Nov. 10, 2009, the USDA is projecting an average increase of 9% in beef prices during 2010, while chicken prices are forecasted to rise by about 1%. Wheat costs are expected to decline nearly 30% while dairy prices are projected to increase about 30%. Egg prices are forecasted to move up a modest 3%. On balance, the USDA's outlook suggests a modest increase in agricultural prices for this mix of food in 2010. Fitch anticipates that even slight commodity inflation could negatively impact margins if a high level of promotional activity continues and there is no sustained improvement in SSS.

Wage inflation is not expected to be a major issue in 2010, given that the final phase of the federal minimum wage increase to $7.25 per hour was implemented in 2009. Furthermore, due to the currently high unemployment rate and the large pool of available restaurant staff, there should be little upward pressure on wages. The biggest uncertainty regarding U.S. labor is potentially higher costs associated with U.S.

Health Care Reform. According to the National Restaurant Association, the restaurant industry employs approximately 13 million people and is one of the largest private-sector employers in the U.S. As mentioned earlier, overall cost containment will remain a high priority for the industry.

Credit Profiles of Large Chain Restaurants Remain Stable.

Fitch believes prolonged uncertainty related to SSS growth will cause the higher than normal degree of financial discipline within the restaurant industry to continue into 2010. Although financial risk moderated in 2009 and credit availability continues to improve, Fitch does not expect debt-financed share repurchases or acquisitions to accelerate for the industry.

Credit statistics for the large chain restaurants in Fitch's universe are projected to remain relatively stable or experience only slight deterioration during 2010, if the sales environment does not improve during the later half of the year as Fitch anticipates. None of these companies have bank revolvers expiring in 2010 and near-term maturities are manageable. Modest debt reduction is expected for Darden and Burger King, but debt levels are projected to remain relatively stable for McDonald's and YUM. Since all of these companies generate free cash flow and significant debt reduction is not anticipated, share repurchases could occur at varying levels. Nonetheless, companies are expected to exercise caution if the sales environment remains challenging.

Key Issuer Level Rating Drivers.

McDonald's Corporation - Fitch affirmed McDonald's ratings and Stable Outlook on Sept. 30, 2009. Ratings reflect the company's geographically diverse revenue base, substantial cash flow generation and stable royalty stream. Industry-leading margins and SSS performance further strengthen the company's credit profile. Fitch believes operating performance will continue to guide the company's financial strategy.
McDonald's credit statistics are projected to remain relatively stable in 2010.

Darden Restaurants, Inc. - Fitch affirmed Darden's ratings and revised the Outlook to Stable from Negative on Sept. 11, 2009. Darden's credit statistics have remained stable, despite weak SSS trends. Fitch expects Olive Garden and Red Lobster to maintain their long-term competitiveness, despite a heightened level of discounting by casual dining competitors. SSS are projected to remain negative in fiscal 2010, which ends May 2010, but credit statistics are expected to be relatively stable due to modest debt reduction.

YUM! Brands, Inc. - Fitch affirmed YUM's ratings and Stable Outlook on July 9, 2009. Recent trends in U.S. SSS performance have been negative but operating income and cash flow remain strong. Substantial international new unit expansion during a period of weaker SSS growth is considered aggressive but Fitch's concerns are partially alleviated by the fact that this development is funded with internally generated cash flow.

Burger King Corporation - Fitch affirmed Burger King's ratings and revised its Outlook to Stable from Positive on Oct. 30, 2009, because SSS growth decelerated and margins contracted more than Fitch had anticipated. Fitch does not expect a slight weakening in Burger King's credit statistics to have further negative rating implications, given that there is room in the current ratings.

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Fitch RatingsCarla Norfleet Taylor, CFA, +1-312-368-3195 (Chicago)Wesley
E. Moultrie II, CPA, +1-312-368-3186 (Chicago)Judy M. Rossetti,
CFA, CPA, +1-312-368-2077 (Chicago)Christopher M. Collins,
+1-312-368-3196 (Chicago)Cindy Stoller, +1-212-908-0526 (Media
Relations, New York) cindy.stoller@fitchratings.com : mailto:cindy.stoller@fitchratings.com