Summary
Hand-wringing abounds over recent impairment charges being absorbed by restaurant companies. The concerns are overwrought. In fact, the current round of write-downs will serve to strengthen survivors as the economy eventually recovers.
Analysis
Writing off or devaluing existing depreciable assets have no negative cash flow implications and will increase EPS calculations in the future. Removing even “hard” assets from the balance sheet has a negligible impact on most restaurant companies due to the nature of the industry’s traditional capital structure. Companies should take advantage of current economic conditions to strip undervalued assets from their balance sheets.
Consider the composition of typical restaurant company longer-term assets. They can be generally sorted into one of three categories: land, furniture/fixtures/equipment (“FF&E”), or goodwill. In each case, write-offs have minimal impact on a true valuation of the enterprise. In the case of goodwill, the asset is essentially meaningless. An acquisition for more than the book value of the acquired assets (thus requiring a computation of goodwill) is neither uncommon nor necessarily ill-advised; savvy buyers will price their bids on projections of future cash flow, which has nothing to do with book value. Booking goodwill serves no purpose except as an attempt to quantify brand equity. It’s a plug number with no real ongoing value. Writing off goodwill cleans up a misleading datum created purely by an accounting convention and has no significant impact on the company.
FF&E assets are also virtually worthless in valuing a restaurant company. Restaurant equipment depreciates dramatically upon its initial use. No matter the depreciation schedule (typically between one and ten years, depending on the specific piece of equipment), the depreciated value of equipment carried on a company’s books is almost always overstated; the true market value of such assets is typically far below its balance sheet entry, especially when the equipment is relatively new.
For equipment which is fully depreciated, amortized charges drop off operating statements, boosting profitability metrics. However, restaurant equipment is typically pretty much shot by the time it reaches the end of its depreciable life and needs to be replaced anyway. Investors examining companies with fully depreciated equipment on their books should anticipate significant expenditures for replacement in the near term.
The previous two paragraphs addressing equipment holds equally true for furniture and fixtures. In fact, many concepts find themselves replacing those components prior to the end of their “book” life as they recognize the need to update or freshen their concept.
Land assets are a somewhat different animal. Typically carried on the ledger at acquisition cost, it is the one asset class whose value is often understated, due to the fact that most (though not all) land actually appreciates over time. For this reason, owned real estate is often utilized as a financing vehicle through sale/leasebacks. The baggage attached to such transactions, however, is significant: more on that subject in a forthcoming analysis. Suffice it to say at this point that impairing or writing off fee simple land assets avoids the negative implications of sale/leasebacks and has no significant effect on the true value of the enterprise.
Companies which absorb impairment charges now are lowering their asset base and, by extension, reducing their ongoing depreciation/amortization expenses moving forward. This will ultimately result in improved EPS, which will lever up as the economy recovers and sales volumes normalize. The sales effect will be amplified by a contraction of supply as many concepts are shuttered during the downturn.
Restaurant operators are well advised to use the current crisis to write off as many of their assets as possible. This will skew some ratio calculations, to be sure, but unless there are specific debt covenants to be considered (and these should be negotiable with a proper explanation of the reasons for a recasting of asset values), any negative perceptions of such a strategy will be lost in the current macro environment. The resultant revisions will help focus investors on what really matters – cash flow – and will prepare companies for a more pronounced earnings upside during the inevitable recovery.
