Trouble Hits Castle Harlan Restaurant Chain

Castle Harlan Inc. has run into trouble with one of its restaurant investments, as rising fuel costs and the home mortgage crisis have families tightening their belts.

The product of an early 2006 merger, Perkins & Marie Callender’s Inc. generated less revenue than expected in the third quarter of last year, and, with a heavier debt load, its cash flow has slowed precipitously, according to ratings agency Standard & Poor’s.

Third-quarter comparable sales fell 0.3 percent at Perkins restaurants, and 2.5 percent at Marie Callender’s restaurants, while overall revenue dropped from $134.2 million in the third quarter of 2006 to $131.3 million in the third quarter of 2007, ended Oct. 7, according to financial statements. The company registered free operating cash flows of negative $15.4 million over the 12 months ending Oct. 7, according to S&P.

Last month, S&P lowered the Memphis-based company’s rating from B- to CCC+, noting that profits have been lower than anticipated since Perkins Bakery and Restaurants and Marie Callender’s Bakery and Restaurants merged in May 2006. (In the last 25 years, more than a quarter of all companies rated ‘CCC+’ or below defaulted on their debt within a year of attaining the rating, according to the ratings agency.)

The new rating affects about $303 million of long-term debt as of Oct. 7. According to the S&P report, there’s a “distinct possibility” that without increasing cash flow or decreasing debt, “the company will breach the financial covenants of its senior secured credit in fiscal 2008.” The debt-to-EBITDA ratio stood at about 7.4 times as of Oct. 7.

In 1999 Castle Harlan invested $150 million in the Wilshire Restaurant Group, which owned all of the outstanding common stock of Marie Callender Pie Shops Inc., the owner, operator, and franchisor of Marie Callender’s Restaurant and Bakery, based in Mission Viejo, Calif. Six years later, Castle Harlan acquired the holding company of Perkins Restaurant & Bakery for $245 million.

Combining the two restaurant chains involved a stock-for-stock exchange valued at about $440 million. The deal closed in May 2006, bringing the number of restaurants in the newly formed company to more than 600.

But the merger carried a high price tag. As of Oct. 7, with just $5.5 million in cash, and $13.5 million available on its five-year revolving credit facility of $40 million, the company had barely adequate liquidity, according to the S&P report. It also has a seven-year term credit facility not to exceed $100 million.

“The company thought they could grow their profitability and they’re doing okay,” said Charles Pinson-Rose, an analyst for S&P. “It’s just that they’re not doing as well as they thought they’d be doing when they consummated the merger.”

Perkins & Marie Callender’s is one of several restaurant companies owned by buyout shops in precarious financial condition. In November, S&P branded six buyout-backed restaurant companies as “weakest links”–companies most at risk of defaulting on their debt. They include Uno Restaurant Holdings Corp. owned by Centre Partners, and Sbarro Inc. owned by MidOcean Partners.

In a phone interview in March, David Pittaway, senior managing director at New York-based Castle Harlan, said his firm likes restaurants as investments because they provide steady and predictable cash flow. “Your customers pay you cash and you pay your suppliers on time,” he said. “Those are nice, attractive characteristics.”

In that same interview Pittaway observed that most buyout firms didn’t begin investing in restaurant chains until the early part of this decade. Castle Harlan, by contrast, acquired its first restaurant more than a decade earlier with the purchase of Chicago-based Morton’s The Steakhouses in 1988. It bought seven more restaurant businesses in the years that followed, and still holds four. Pittaway could not be reached to comment on the recent S&P downgrading of Perkins and Marie Callender’s.

In addition to Perkins and Marie Callender’s, Castle Harlan restaurant holdings include Bravo Development Inc., Columbus, Ohio, and Caribbean Restaurants, the exclusive Burger King franchisee in Puerto Rico. It maintains a small stake in Morton’s Restaurant Group, now a publicly-traded company.

The firm’s $1.2 billion fourth fund closed in 2003. Since 1987 it has made 48 acquisitions valued at more than $9 billion.