Zombies Among Us

Recent hits in popular cinema and literature have brought renewed attention to vampires (the “Twilight” series, among others) and zombies (everything from George Romero’s films to the amazing Jane Austen homage -- or parody -- entitled Pride and Prejudice and Zombies). Recent economic cycles and financial market trends have brought a different sort of vampire and zombie to life in the restaurant industry and other consumer-facing businesses. I’ve spoken a bit about some of the vampires in past columns, and may resurrect the topic soon, but today’s subject is Zombies.

I had a couple of conversations recently with a former client and potential future client, which brought my attention to this topic. One of these companies can be accurately characterized as a Zombie right now; the other is in danger of becoming one, because of some decisions being made around it, over which the company’s management has little or no influence. Bear with me while I explain.

Variously referred to as the Living Dead or Walking Dead, Zombies in films are generally depicted as beings who are dead, but don’t realize it, and continue to inhabit their environment and consume from the living (sometimes consuming the living) until they’re finally destroyed. While they continue exist, they may be portrayed as threatening or relatively harmless, perhaps even humorous, but they are in a terminal condition -- you don’t recover from being a Zombie, and eventually you perish.

So what makes a company a Zombie? Many things, but it all comes down to arithmetic, and specifically the arithmetic of costs and obligations, as influenced by an economic cycle; let’s walk through an example, using fairly simple, but representative, numbers.

Company X was producing some $120 million a year in sales in 2005; its EBITDA (that favorite measure of investors) was just under $12 million a year. Its founders received an offer too good to refuse, and sold the business for almost $100 million. The new owners put in $35 million and borrowed the rest.

The $65 million in debt was split into two pieces -- a senior, or bank loan, piece of $35 million, and a subordinated piece of $30 million. The bank’s interest rate was 9%, and the subordinated debt carried a cash interest rate of 12%, plus 2% a year in non-cash interest which was added to the $30 million note, plus an initial 10% ownership position -- all pretty standard for 2005-6. Adding it all up, the company was paying some $3.1 million/year in senior interest, plus $3.6 million per year in subordinated interest, leaving about $5.3 million/year, of which $3.5 million/year was initially earmarked for debt repayment, leaving very little development (menu, new stores, whatever) from the annual cash flows.

The new owners saw an opportunity to improve margins by applying their prior experience as investors in many businesses -- they planned to renegotiate supply contracts (food, power, insurance, outside services, and the like) for a combined annual savings of some $2 million, and apply those savings to more rapid debt repayment, as well as some growth investment.

Unfortunately, the world changed. Like many restaurant companies, this company saw its sales slip by 3% in 2007, 10% in 2008, and a further 8% in 2009, as its customer base was hit by the mortgage reset problems which rolled across many US markets. Despite owner’s and management’s attention to cost controls, the combined 20% drop in revenues over three years brought about a sizable drop in EBITDA, leaving the company with just under $6.5 million/year in annual cash flows -- not enough to cover interest, principal, and essential reinvestment.

Because of issues I’ve discussed before, the lenders didn’t take a hard line, forcing the borrower and its owners to recapitalize; in any event, the markets were so frozen for a time that no recapitalization was practical. Instead, the lenders repeatedly charged fees for amendments (logical from their standpoint, but further depleting cash); additionally, the sub debt converted a part of its interest from cash pay to “Payment-in-Kind” (meaning that interest due was instead converted to additional debts due at some future date), which relieved some of the cash pressure, but saddled the company with a larger, more permanent (and less refinanceable) debt burden.

At the end of this process, the company was dragging around such a sizable debt burden that the debt exceeded the likely value of the company. However, the lenders were unwilling to force a sale (because it would trigger a bankruptcy, and cause the lender to take a loss), and the investors were certainly willing to try waiting out the cycle -- after all, if your lender won’t force you to sell, there’s always the possibility that next year might be much better, right?

So we have a Zombie -- a company which perpetually underinvests in its own maintenance and upkeep, can’t invest in developing new products, promoting by discounting (if at all) and essentially living on the economic fringes of its market -- and, by doing so, robbing the rest of its competitors of some small portion of their potential traffic, all in a usually unsuccessful attempt to stay alive just long enough for the “rising economic tide that lifts all boats”.

Look around: what Zombies do you see? And how might the rest of the industry benefit if they were put out of their misery (and ours)? For that matter, how might the lender and investor communities benefit? After inflicting some specific pain on a few lenders and investors (who would suffer real losses by writing off their loans and investments), the rest of the community would see a healthier industry into which new investment might be placed and expect a reasonable return. Instead, the zombies drag us all down.

On that cheery note -- stay tuned for more on the world of franchising next time!