Kansas Pizza Hut Franchisee Struggles Under Debt

By Michael Hooper

The world's largest Pizza Hut franchisee is struggling under a mountain of debt, weak operating trends, and rising costs for food, labor and wages, according to Moody's Investor Services.

NPC International, of Leawood, Kan., operates 1,232 Pizza Hut restaurants and 391 Wendy's restaurants. Eldridge Industries, owner of Security Benefit in Topeka, is owner of NPC International. Sometimes Eldridge Industries and Security Benefit will invest in a deal together, such as the Los Angeles Dodgers, but Security Benefit does not own any equity or bonds in NPC International, said Joe Wittrock, chief investment officer with Security Benefit.

On Sept. 13, 2019, Moody's Investor Service downgraded the corporate debt of NPC International to junk status, Caa1-PD from B3-PD. Moody's additionally downgraded the company's first lien senior secured revolving credit facility and first lien senior secured term loan to B3 from B2, as well as the company's 2nd lien senior secured term loan to Caa3 from Caa2. The rating outlook is negative.

The downgrade to Caa1 reflects NPC's continued weak operating performance with persistent cost and margin pressure, said Adam McLaren, Moody's senior analyst. High leverage and weak interest coverage, along with elevated capital expenditure requirements have pressured the company's liquidity. For the last 12-month period ended June 25, 2019, NPC's debt-to-EBITDA was high at over 7 times, with the expectation of remaining elevated over the next 12-18 months given the challenging operating environment with pressured same-store sales and labor and margin headwinds (EBITA is Earnings Before Interest Taxes and Amortization).

Moody's said the downgrade reflects NPC's high leverage and modest interest coverage driven by weaker operating trends and cost inflation related in part to labor, wages, commodities, and pricing. Given NPC's high level of capital investment, including re-locations, new units, and remodel initiatives, it is expected that free cash flow will be constrained and liquidity to be weak. 

Moody's rating also considers NPC's limited product offering, concentrated day-part in lunch and dinner and limited geographic diversity. The rating is supported by NPC's multiple brands, meaningful scale within the Pizza Hut and Wendy's franchise system, new advertising partnerships, and dedicated brand management. The company benefits from the support of its financial sponsor, including $50 million of incremental term loan borrowings and $18 million of capital injection thus far in 2019 which provide additional liquidity to enable the company to continue to invest in remodels and re-locations, although NPC will require additional future liquidity to continue to invest at such high levels (inclusive of growth capex).

The negative outlook reflects Moody's view that the company will continue to face margin pressure over the next 12-18 months, which will weigh on operating performance and credit metrics, while investing heavily in remodels, new units, and re-locations continue to constrain liquidity. Performance improvement coupled with additional equity injections from its sponsor or other forms of liquidity could help stabilize the company's outlook, Moody's said.

David Tangeman, a Houston accountant, said investors led by Eldridge Industries paid $1.2 billion for NPC International in late 2017. The year before it was sold, NPC International's EBITA was $127.6 million. Normally, a sale like this would be around 5 to 7 times EBITA, but this sale was closer to 9 times EBITA.

"They overpaid for it," said Tangeman, adding that NPC International was saddled with about $740 million in debt after the deal. He noted investors kicked in $17.5 million through equity plus a new $50 million loan in August.

Pizza Hut was founded in 1958 in Wichita by brothers Dan and Frank Carney. In 1977, Pizza Hut was sold to PepsiCo (NYSE: PEP). Then PepsiCo spun off its restaurant business, including KFC, to Yum Brands (NYSE: YUM) in 1997.

In an interview with Bloomberg Sept. 9, 2019, Todd Boehly, chairman of Eldridge Industries, was asked how he is going to salvage NPC International.

Boehly said, "Right now we're very aligned with Yum. We've got a great relationship with Yum. Yum cares deeply about Pizza Hut, we care deeply about Pizza Hut. There's no magic bullet that's going to change the fact it's been underperforming. It's performed worse than we originally anticipated. But that doesn't change our long term view of what the opportunity is with Pizza Hut. It's a tremendous brand that goes back 50-60 years. If you look at what Pizza Hut stands for people, high quality pizza, great food, great memories. We need to figure out how to make it more mobile, make it easier to get. And compete in a world where convenience is the No. 1 driver, not just quality of food."

Boehly said his strategy is to align with Yum to outperform the historical performance at NPC International.

NPC International was founded by Gene Bicknell of Kansas. But a lot has changed in the pizza business since he owned it. Some of the locations of Pizza Huts were good when they started but now are not in the ideal locations.

While Pizza Hut is growing in the international markets, the restaurants are losing sales in the US.

"In the U.S., system sales declined 2% with same-store sales declining 3% and a 1% net new unit decline. Coming off a solid second quarter, the Pizza Hut U.S. business decelerated in Q3 as changes to our value offerings helped franchisee margins, but had a negative impact on transactions," David Gibbs, Yum CFO and COO, said during third quarter earnings call, according to Seeking Alpha transcripts. "In addition, our previously announced plans to accelerate the transition to a modern delivery asset base in the U.S., while restructuring and upgrading our franchisee base also took a toll on performance. While we strongly believe that these are the right strategies to build the business for the longer term, these moves will introduce some uncertainty in the business performance over the short term, as we expect results to continue to be choppy. We caution, we could see a continuation of soft sales and unit contraction throughout 2020 in the Pizza Hut U.S. business."

Editor's note: Michael Hooper owns stock in PepsiCo (NYSE: PEP)