Quality Dining must regroup or face defeat in 'battle of the bagel chains.' - Quality Dining Inc - Editorial

Recent developments in the bagel segment, especially at Mishawaka, Ind.-based Quality Dining Inc., demonstrate just how important it is for operators to have access to capital if they want to stay out front in a highly competitive growth segment of the restaurant industry.

It was just about a year ago when Quality Dining jumped into the bagel wars in a big way with its acquisition of the Burlington, Vt.-based Bruegger's Corp. in a deal that cost it about $110 million. Quality Dining, as a Burger King and Chili's franchisee, already was recognized as one of the industry's best operations companies with a glowing future.

True, there are some industry analysts questioning the wisdom of Quality Dining's previous acquisition of the Spageddies and Grady's units from Brinker International. Early on, many of them expressed concern that the company might be spreading itself too thin to handle the commitment needed for a really aggressive Bruegger's expansion.

Bruegger's, at the time, however, was rolling along as the undisputed leader in the bagel cafe competition with 275 units and a plan to bring its total number to about 500 within a year. And Quality Dining's operations at its Burger King, Grady's and Chili's franchises were producing strong cash flow that would help finance the bagel expansion.

Despite the growing competition Bruegger's was still far out front, and as the chain's chief executive, Stephen Finn, remarked when news of the pending acquisition broke: "We still are viewing our competitors through the rear-view mirror, and our job is to make sure that they don't get in under our windshield."

Coming up quickly, though, was the Einstein/Noah Bagel Corp., which at that time had about 100 units. The chain, hammered together with the funding, management and real-estate connections of Boston Chicken Inc. of Golden, Colo. was thundering along the expansion road. It now has more than 320 units, expects to end the year with more than 600 and plans to go on adding about 300 or more units a year for the foreseeable future.

Last year Einstein/Noah went to the capital markets to raise a total of $86 million in an initial public stock sale and then quickly followed that with a secondary offering within just a few months, which brought an additional $89 million for a total of $175 million in its first year. A private-equity affiliate also invested $70 million more in common equity. It also has an open and untapped line of credit with Boston Chicken, which recently announced it would be doing a $200 million debt issue, and some of that would be available for Einstein/Noah.

So Einstein/Noah is flush with cash for its growth and media marketing programs. Its stock also is doing somewhat better trading at about $9 above its 52week low of $19, while Quality Dining stock is only about 65 cents above its 52week low of $10.25. Quality Dining stock started dropping as analysts began questioning its ability to keep ahead of the aggressive expansion of the fastgrowing Einstein/Noah group. The falling stock took away the ability to go back to the public markets to raise additional funds.

And the doubt took on added dimensions when Bruegger's founders Nordahl Brue and Michael Dressel, resigned from the board because of their own concern about Quality Dining's commitment and ability to finance the necessary growth for the bagel chain. Now Brue and Dressel are back on the board, and it appears that they are working out their differences. Meanwhile, Quality Dining reported that it is launching a refranchising program to be funded by a $35 million loan to an affiliate company.

The affiliate will acquire certain franchisee territory that has not demonstrated the required development. And -- taking some lessons from Boston Chicken -- it will finance additional development with loans that would be convertible to ultimate ownership by Quality Dining.

There are other scenarios that could play out, according to the Securities and Exchange Commission statement filed by the original Bruegger's group. For instance, some of the other Quality Dining concepts could be sold, or Bruegger's could be spun off as a separate company with stock in the bagel chain going to existing Quality Dining shareholders. Quality Dining's top officer, Daniel Fitzpatrick, says those other scenarios are not in the cards at this point. And the company also recently instituted a "poison pill" provision to make it difficult for an outside firm to raid Quality Dining.

Quality Dining isn't the only company in the segment running into problems.

It was the lack of capital financing that scuttled Chicago-based BAB Holdings Inc.'s plan to acquire the Chesapeake Bagel chain of McLean, Va. And once-high-flying Manhattan Bagel Co. of Eatontown, N.J., lost its access to the public markets when its stock took a tumble after it reported that it had discovered accounting irregularities in one of its West Coast acquisitions.

However, the battle for bagel dominance clearly is being fought by the two giants. Right now Quality Dining is searching for the funding vehicle to fill out some of its thinly stretched markets. It will be interesting to follow the money and the path that it takes as both Einstein/Noah and Quality Dining try to keep their financial war chests as well as their restaurants filled to capacity.

It's obvious that Quality Dining either has to sell off assets or come up with some other major funding vehicle for its Bruegger's expansion. Otherwise, the bagel segment will wind up as a one-horse race with a somewhat familiar chicken in the saddle.

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