Jack in the Box
Long John Silver’s
Rating Guidelines for Franchise Loan Securitizations
Fitch IBCA Restaurant Concept Tiers
America’s Favorite Chicken (Popeye’s/Church’s)
Houlihan’s Little Caesar’s
Key Borrower and Loan Factors
Fixed-Charge Coverage Ratio FCCR is the key measure of leverage and the primary factor in estimating conditional expected default fre- quency for a franchise loan. FCCR is the ratio of free cash flow from opera- tions to fixed charges, such as lease expense and debt service. Free cash flow, the numerator of FCCR, is gener- ally calculated as the sum of pretax op- erating income, interest, depreciation, amortization, and rent. In addition, cer- tain nonrecurring charges and a fixed amount of discretionary corporate over- head may be added back. Fitch IBCA carefully reviews the comparability of addbacks for FCCR calculations and requires that issuers disclose their com- putation and any assumptions made in calculating this ratio.
As a benchmark for measuring the proximity of a loan to default, the FCCR captures the absolute level of cash flow and the cost structure and operating leverage of the business. Cash flow volatility is captured by the relationship among FCCR and the other loan factors. For example, a loan to a franchise location affiliated with a strong concept will exhibit less cash flow volatility than a loan to a franchise with the same FCCR but a weaker brand affiliation. Thus, a loan to a tier 1 concept should require a smaller debt service cushion than a loan to an other- wise comparable tier 2 concept to ex-
hibit the same likelihood of default and the same recovery value in a default. For acquired or less seasoned units, Fitch IBCA will compare pro forma FCCRs to actual FCCRs for similar units operated by the borrower in adja- cent locations and/or comparable units operated by competing franchisees in the territory. In some instances, issuers may need to provide additional histori- cal revenue and cost information to ver- ify the economic viability of a certain location over time.
Concept Strength Concept strength tiering is a proxy for measuring brand loyalty or estimating the economic viability and sustainabil- ity of the brand concept. For default and recovery analysis, the concept tier- ing of brand associations is based on revenues, market share, marketing ac- tivity and brand support, capital, in- stalled base, geographic dominance, market coverage, and regional market penetration. Concept viability corre- sponds to the economic influence of brand equity on revenues and cash flow (i.e. franchise or enterprise value) and to the effect of brand loyalty on con- sumer demand (i.e. price inelasticity).
The research for classifying concepts according to tiers focuses on the fran- chisor’s investment in brand equity as a capital stock and on installed base and location as the key asset. Fitch IBCA’s concept tiering acknowledges the tradeoff between national geographic coverage/diversification and regional
market dominance as a positive exter- nality. In establishing or modifying con- cept tiers, Fitch IBCA uses concept analyses that are based on comparable store economics according to standard metropolitan statistical areas (MSAs). The tables above and on page 5 present examples of Fitch IBCA’s concept tier- ing for restaurant and energy concepts.
Fitch IBCA performs in-depth industry economic analysis to adapt the existing criteria and model implementation to new industries. The industry analysis employed incorporates a comprehen- sive survey of industry structure, dy- namics, and trends. The Fitch IBCA corporate rating group is consulted on a continual basis to monitor the financial strength and performance of the con- cepts seen in pools. Fitch IBCA contin- ues to adapt the LDRM to a broader range of assets beyond restaurant and energy loans.
Units Under Management and Operator Experience Units under management and operator experience are borrower characteristics that act as proxies for cost structure advantages, operating leverage (econo- mies of scale), and operator viability. Highly experienced borrowers with a large critical mass of established loca- tions are generally expected to benefit from economies of scale and, hence, be less susceptible to revenue or cost vola- tility than a smaller or less experienced borrower. Acquisition loans should be extended to large, experienced borrow-
Fitch IBCA, Inc.