In the early part of this decade, CKE Restaurants, operator of Carl’s Jr. and Hardee restaurants, ran into financial trouble because of quality control issues at their franchisees. Having cleaned up past problems and looking to put the quick service operator in a better position to expand the brand(s) and sales growth, CKE chief executive officer Andrew F. Puzder announced in April 2007 the Company’s strategic launch of its re-franchising program.
To date, the Company has sold 224 restaurants to franchisees and secured commitments for 105 new franchise restaurants under development agreements for those markets. Digging through the 10-Q regulatory filing for the second-quarter ended August 11, however, I unearthed a tocsin that could signal trouble around the next bend for CKE stakeholders:
- We enter into sublease agreements with franchisees but remained principally liable for the lease obligations. We account for the sublease payments received as franchising rental income in franchised and licensed restaurants and other revenue, and the payments on the leases as rental expense in franchised and licensed restaurants and other expense, in our accompanying Condensed Consolidated Statements of Income. Franchisees may, from time to time, experience financial hardship and may cease payment on their sublease obligations to us.
In other words, CKE is subsidizing restaurant operating costs — such as paper products, food, and other supplies sold to its franchisees — and which it subsequently records as income on its own income statement, by guaranteeing loan obligations held by its franchisees. As of August 11, the present value of the exposure to CKE from franchisees characterized “as under financial hardship” was $1.17 million, of which only $112,000 was reserved as estimated liability for closed restaurants in CKE’s accompanying balance sheet.
Rising beef, dairy and other commodity prices could prove to be the least of CKE’s worries in the long-term.
