Case Problems

2007 II Case Problem (November 8-10, 2007)
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2007 I Case Problem
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2005 Case Problem
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2004 Case Problem
Crystal Restaurant Holdings, Inc.
February 11, 2004

Introduction

Julie Morgan turns off her cell phone and earns a (temporary) reprieve from her most
recent contentious phone call with a member of her Board of Directors. Two weeks ago,
Morgan was named interim CEO of Crystal Restaurant Holdings, Inc., a once high-flying
operator of restaurant chains. After a disastrous 2003, Crystal is highly leveraged and in
the midst of a liquidity crisis. Decisions made by former CEO Matt LeFleur badly
crippled one of Crystal’s two remaining restaurant chains and, shortly after the release of
preliminary financial results for Q4 2003, LeFleur resigned as CEO under pressure from
the other members of Crystal’s Board of Directors and various other stakeholders.
Late last summer, Crystal defaulted on various covenants in its credit facility with its
senior lender, First Capital Bank, and at that time, LeFleur promised an imminent
turnaround of the business. Due to the promised turnaround, additional financial support
of Viceroy Capital (a 20% shareholder of Crystal’s) and a few other concessions, First
Capital agreed to waive the default and set new covenants.

However, given the continued decline of the business, Crystal soon thereafter failed
to meet the revised Q4 2003 EBITDA covenant. While First Capital agreed to a short
term forbearance through March 31, 2004 in return for a $5 million reserve against
availability, Jim Mack, Crystal’s CFO, has expressed to Morgan his expectation that
Crystal will likely default on certain Q1 2004 covenants as well and that, even with
LeFleur’s resignation, First Capital would not further extend the forbearance period.
Exacerbating the problem, Morgan expects Crystal to finish Q1 2004 with only $3
million of cash and, after applying the $5 million reserve, no availability under its
revolver. Thus, without additional “rescue” financing and a solution for First Capital,
Morgan is concerned that Crystal will be unable to meet the April 15th interest payment
of $8.75 million on its $175 million of Senior Notes due 2007. Morgan needs your help
to develop a viable restructuring solution that will immediately restore the confidence of
the banks and Crystal’s various other stakeholders and find the required liquidity.

Business Description

Crystal was once regarded as one of the best-managed restaurant operators in the
industry. Starting from a base of only ten franchised Sandwich Hut restaurants in 1988,
the charismatic LeFleur had, within ten years, expanded Crystal’s operations to include
six separate restaurant chains with a total of 447 stores. Crystal grew via the leveraged
acquisition and subsequent expansion of each of its chains. By 1997, sales exceeded $900
million and the Company generated over $125 million of EBITDA. Crystal’s 1995 initial
public offering made LeFleur rich and shareholders were rewarded with annual returns in
excess of 20%.

In recent years, however, same store sales and operating margins suffered steep
declines. Management reacted by selling four of the restaurant chains and using the sale
proceeds to retire debt and fund required debt interest payments. Now, Crystal operates
only two chains, both separate subsidiaries: Bleachers, a sports bar/brewpub concept; and
Tuscany, which features Italian food.

In 2003, while Crystal still generated sales of $453 million, its EBITDA declined to
$16 million, or only 3.5% of sales. Initiatives to stimulate same store sales growth and
margin improvements failed and, in an effort to conserve cash, management deferred
much-needed restaurant refurbishment and refreshment capital expenditures. The public
market and equity analysts have expressed concerns about the Company’s strategies and
liquidity; Crystal’s stock price recently declined to $1.00 per share and the Senior Notes
were recently quoted at 50% of face value.

Description of Tuscany

Tuscany is Crystal’s largest chain. The first Tuscany opened in Los Angeles in 1987
and the chain has always enjoyed a strong presence in the western United States, with its largest
concentration of units in Arizona and California. In 1996, Tuscany Restaurant, Inc., a
direct subsidiary of Crystal, acquired Tuscany for cash from Paolo Luciano, Tuscany’s
founder. Following the acquisition, in an effort to build a national brand, Crystal
aggressively grew Tuscany by expanding into Florida, Texas and Ohio. At the end of
2003, Crystal operated 115 Tuscany restaurants.

Tuscany restaurants feature Italian entrées served in a relaxed dining atmosphere
patterned off the courtyard of a rustic Italian Villa. Each restaurant features a glass
covered, two-story stucco-walled dining courtyard laced with cypress trees that include a
central fountain and barrels of tomatoes, olives and various types of pasta. An open
kitchen with a prominently located flame grill visible to patrons occupies one corner of
each restaurant, allowing customers to watch as food is prepared fresh each day. A
separate bar area serves as a lounge for guests awaiting seating. The restaurants generally
average approximately 6,000 square feet and have dining room seating for approximately
180 customers and bar seating for approximately 25 additional customers.

Menu items are comprised of traditional Italian fare. The menu includes Italian-style
appetizers such as stuffed mushrooms and bruschetta, entrées such as gourmet pizzas,
pastas and lasagnas served with various homemade sauces and unique desserts including
tiramisu and gelato. Entrée price points vary from $5.99 to $8.99 for lunch and $7.99 to
$15.99 for dinner, the mid-range of casual dining. Most menu items are prepared fresh
on-site using high-quality ingredients. The freshness of its food and unique signature
menu items such as Italian sausage and pizzels are Tuscany’s primary points of menu
differentiation. The chain is also known for its extensive selection of Italian wines.
Alcoholic beverages account for approximately 15% of sales.

Description of Bleachers

Bleachers restaurants are concentrated primarily in Florida, Virginia, Maryland and
Colorado. Its restaurants have an all-American appeal as a combination brewpub and
sports bar. Each restaurant has a rustic wood and brick interior with a glass encased 450-
600 square feet microbrewery which separates the bar area from the dining room. Staff
encourage patrons to tour the microbrewery before and after meals. Sports-related
programming is broadcast on televisions visible from every seat in the dining area and
bar. The restaurants generally average approximately 7,000 square feet and have dining
room seating for approximately 190 customers and bar seating for approximately 50
additional customers. In 1997, Bleachers Restaurant, Inc., a direct subsidiary of Crystal,
acquired for cash and stock the fifteen-year old chain from its founders. While most of
Bleachers’ shareholders cashed out, James Andrews believed in the equity story of the
combined companies and took virtually all of his consideration in the form of Crystal’s
stock and obtained a Board seat. Today, Andrews is understandably bitter about the
performance of Crystal’s stock price and was instrumental in the removal of LeFleur as
the CEO.

Although initially concentrated in Florida, after the acquisition, LeFleur aggressively
grew Bleachers by targeting college-focused markets in Virginia, Maryland and
Colorado, and to a lesser extent, other eastern states. At the end of 2003, Crystal operated
60 Bleachers restaurants. Immediately after its acquisition, Bleachers was Crystal’s
engine for both same store sales and unit growth. But in 2002, a switch in beef suppliers
caused a temporary decline in meat quality and some loyal customers abandoned the
chain. Bleachers lost its momentum and same-store sales began to decline. To reverse this
decline, against the advice of his management team, LeFleur approved a dramatic menu
change at Bleachers, which was implemented in early 2003. The change involved
substituting more expensive entrées for lower priced items, thereby gravitating
Bleachers’ menu from the middle to the high-end of the casual dining market.

The results proved devastating. Customers were confused by the higher prices and
removal of many of their favorite selections from the menu. Furthermore, restaurant staff
struggled with the overnight “flip” of virtually the entire menu. This created quality,
service and efficiency issues. Many of the remaining core customers were alienated and
began to defect. Cash flow plummeted and management was forced to defer previously
planned capital expenditures. As a result of the Company’s liquidity concerns, only the
most critical capital expenditures were permitted. To raise cash, management commenced
a series of sale/leaseback transactions on owned Bleachers units. Also, in an attempt to
improve customer counts and to stimulate gross sales, management implemented heavy
buy-one-get-one free promotions (BOGOs). Although customer counts and gross sales
stabilized in the latter half of 2003, the cost of the BOGOs ate up almost all of the chain’s
2003 profits.

Prior to the 2003 menu change, Bleachers was primarily a quality burger and
sandwich chain. Its most popular draw was an extensive lineup of signature charbroiled
burgers. The 2003 menu change had the effect of dropping the lower priced options from
these categories and replacing them with more varied entrées including New York steaks,
seafood steaks, crab legs and stir-fried entrées. Entrée price points vary from $6.50 to
$11.00 for lunch and $14.00 to $20.00 for dinner, which is at the high end of the casual
dining range. Beer also plays a prominent part in Bleachers’ menu. At any one time,
Bleachers brews four Company brands on the premises, two all-season brands and two
seasonal brands that were rotated on and off the menu every three months. Bleachers’
beer is featured prominently in its advertising messages. In fact, the chain does not offer
national beer brands on its menu, and its only other alcoholic beverage is wine. Alcohol
accounts for approximately 15% of sales.

Restaurant Management

As explained to Morgan by Gary Bull, the Company’s President, Crystal’s strategy
had been to develop and manage a portfolio of niche restaurant concepts with significant
growth potential. The Company had executed this strategy by allowing individual chains
to operate autonomously with high-level oversight from a corporate organization that
provided shared services. Management believed this decentralized structure fostered
entrepreneurial management of its chains, stimulating a better understanding of customer
preferences and tighter controls on operations. Shared corporate functions included
accounting, human resources, legal, menu development, MIS, and treasury.
Historically, each of Crystal’s chains had its own President and management team.
However, Bleacher’s President was terminated concurrent with LeFleur’s resignation.
Concurrent with Morgan’s appointment to Interim CEO, Bull was promoted from
President of Tuscany to President of Crystal. The management teams for both of
Crystal’s chains now report directly to Bull. However, daily management functions such
as financial analysis, marketing, operations and real estate continue to reside at the chain
level.

At both chains, a Restaurant General Manager (RGM) and an Assistant Restaurant
General Manager share daily responsibility for restaurant operations. RGMs report
directly to Area Supervisors who are each responsible for six to eight restaurants.
Tuscany has seventeen Area Supervisors; Bleachers has nine. Each chain also has a
Director of Operations who is ultimately responsible for overall restaurant operations.
Managers at all levels participate in a bonus program that is tied to achieving budgeted
profitability for their particular restaurant(s).

Although the chains have similar MIS systems, Bull previously enacted several
manual reporting tools unique to Tuscany that became integral to the chain’s restaurant
management. The first was the introduction of daily store P&L reporting. While
Tuscany’s point of sale and accounting system commonly generated restaurant level
P&Ls at the end of each month, Bull had noticed that Tuscany RGMs often could not
explain the root cause of variances and other performance anomalies. In response, Bull
required RGMs to generate Excel spreadsheet-based manual P&Ls on a daily basis and
report these results to Tuscany’s VP of Finance on a weekly basis. Within a few months
of the kick-off of this program, restaurant GMs began to report weekly financial
information that reconciled almost exactly with monthly totals generated by the
accounting system. More importantly, the negative variance of actual food cost to
theoretical food cost improved. Although Bleachers’ management had considered the
creation of similar reports, the distraction caused by the 2003 menu flip prevented any
attempt at implementation.

Marketing

Crystal stimulates customer traffic at both chains through a combination of direct
mail, print, radio and television advertising. The advertising vehicles employed depend
upon the “media efficiency” of each designated market area (DMA). Media efficient
DMAs are those where the aggregate sales of restaurants within the broadcast area are
sufficient to support an effective electronic media advertising campaign at a cost of 5% of
sales or less. If a DMA is not media efficient, advertising is limited to direct mail and
print advertising. DMA-wide marketing expenditures are allocated to stores within a
DMA on a straight-line basis ($ expenditures/# of stores) with minor adjustments.
Although Tuscany and Bleachers restaurants could sometimes be found in the same
DMA, Crystal never conducts joint marketing programs between the brands.

Both chains also regularly employ BOGOs and other special offers as an additional
inducement to visit restaurants. BOGO coupons are delivered to customers via newspaper
freestanding inserts or direct mail. The cost of the coupons themselves is captured as a
DMA-wide marketing expenditure. However, the actual food cost of the redeemed
BOGO coupons is captured at the individual store level by Crystal’s point of sale system.
All spending and creative decisions involving advertising, BOGOs and other special
offers are made by the chain Presidents (now just Bull) and the VPs of Marketing. RGMs
also have an annual local store-marketing budget that can be used for local store
promotions. Popular promotional ideas include after work specials and community
involvement initiatives.

Financial Performance

Crystal’s financial performance has declined for the past several years. Management
believes the steady erosion of Crystal’s sales base is the root cause of Crystal’s woes. It
has been three years since either chain has registered positive same store sales trends.
EBITDA margins steadily declined due to the combination of shrinking sales with
relatively fixed costs. And while proceeds from sale transactions allowed the Company to
pare balance sheet debt to approximately one-half of its peak level, by the end of 2003,
Crystal’s operating margins had fallen to one-third of previous levels, resulting in
debt/EBITDA of 14x.

Bleachers’ profit decline was particularly dramatic. While Tuscany offset gradually
falling sales with across-the-board expense reductions, Bleachers’ sales decrease was too
steep. Even radical measures such as the closure and consolidation of Bleachers’
Jacksonville headquarters into Crystal’s corporate offices were insufficient to stave off
margin erosion.

Although management expected sales decreases from the disposition of entire
restaurant chains, the decline in same store sales of retained locations was unexpected
and is a major source of frustration. Management views the reversal of this trend as
Crystal’s biggest opportunity for improvement. Finance department studies show that up
to 40% of incremental non-BOGO sales flow through to restaurant level EBITDA.
Unfortunately, both chains have struggled to find the optimal method for driving such
growth. While management blames the terrorist events of 9/11 and the economic
recession, the fact remains that neither chain matched industry growth rates. Though
heavy BOGOs at Bleachers drove gross sales growth during several months of 2003, the
strategy proved extremely expensive.

Tuscany was directly impacted by aggressive expansion in the Italian dining market
by Olive Garden and Romano’s Macaroni Grill, as well as the explosion of competing
fast casual concepts such as Panera Bread, Fazoli’s and Pasta Pomodoro. And while
competitive expansion is not as apparent in Bleachers’ markets, many casual dining
competitors recently strengthened their existing locations via remodeling and re-imaging.
Early 2003’s ill-fated repositioning of Bleachers’ menu was Crystal’s only response
to such challenges. Beyond that, neither chain offered much in recent years to excite
customers. The last new store opening for either chain was in 2000. Because of Crystal’s
financial woes, only bare maintenance has been performed at existing restaurants. The
lack of capital investment is obvious enough that customer focus groups often note that
Crystal’s restaurants look dated when compared to its competitors. Many in the
management team feel that growth through new restaurants is key. To stimulate growth,
Tuscany considered expanding into the fast casual market during 2002 and opened two
successful “Tuscany Express” prototype restaurants within existing Tuscany stores.
Crystal estimates that Tuscany Express units cost $250,000 and offer a three-year
payback period, substantially lower than the minimum $1 million initial investment
required to open a new Tuscany or Bleachers location. However, the crisis at Bleachers
consumed Corporate’s attention and the program was shelved. Morgan and Mack,
Crystal’s CFO, know that new store growth under the Company’s existing capital
structure is not feasible. Compounding the lack of growth, Crystal has never remodeled
or re-imaged any stores at either chain.

Unfortunately, Crystal’s balance sheet reflects the impact of recent losses. The
Company has only $3.5 million in cash on hand and essentially no other current assets
since sales are largely cash or credit card-based and perishable inventory levels are kept
to a minimum. Crystal has kept its main food vendor within the 15-day terms specified in
its supply contract and relations between the two companies are strong. However,
secondary vendors, wary of Crystal’s financial condition, are starting to demand cash in
advance of shipments and the provision of services. Accrued liabilities consist primarily
of payroll, rent, sales and real estate taxes and interest. Property, plant and equipment
consists primarily of owned restaurants, restaurant leasehold improvements and
equipment, and Crystal’s headquarters building in St. Louis.

Creditor Issues

The Company’s primary source of liquidity has been its $50 million revolver with
First Capital, of which $45 million remains outstanding with the balance subject to
reserve. The revolver currently carries an interest rate of LIBOR + 4.0% with interest
payable monthly. The revolver is secured by all of the assets of the Company, including
owned real estate, intangibles (including brand names), leaseholds, restaurant FF&E,
inventory, and receivables.

In late summer 2003, the Company faced pending covenant violations under the
revolver for Q3 2003 and an $8.75 million coupon payment on October 15th. After
reassurances from LeFleur and his management team of an imminent turnaround of the
business and extensive negotiations, First Capital agreed to waive the covenant violations
in consideration of: (a) a $20 million reduction of the revolver (from $70 million to $50
million), (b) a 50 basis point increase in the interest rate (to LIBOR + 4.0%), (c)
perfection of all its security interests in the Company’s leaseholds, (d) a new covenant
limiting capital expenditures, (e) a new restricted payments covenant, specifically
prohibiting the Company from repurchasing or redeeming any debt securities junior to
the revolver without First Capital’s prior approval, (f) revised EBITDA covenants, and
(g) a new investment of $10 million structured junior to First Capital to help fund the
coupon payment. In connection with the negotiations, First Capital required an appraisal
of Crystal’s owned real estate, FF&E, and the Tuscany and Bleachers brand names
(attached as an exhibit).

In connection with the First Capital negotiations in summer 2003, Viceroy Capital (a
20% shareholder of the Company) invested $10 million in the form of a second lien term
loan. The new investment was secured by all of the assets of the Company, but junior in
right of payment to the First Capital revolver. The loan was structured senior to the
Senior Notes. According to Jim Mack, Crystal’s CFO, LeFleur’s strong assertions of an
imminent turnaround were instrumental in convincing Viceroy Capital to invest the $10
million.

Unfortunately, Crystal soon thereafter failed to meet the revised Q4 2003 EBITDA
covenant under the amended First Capital revolver, placing the facility in default. This
time, after insisting that a $5 million reserve be placed on the revolver, thereby
effectively restricting availability on the revolver to $45 million, First Capital only agreed
to forbear from exercising available remedies until March 31, 2004.

Crystal’s other funded debt consists of $175 million of remaining Senior Notes due in
October 2007 with interest due semi-annually at an annual rate of 10%. The Senior Notes
are unsecured and were issued by Crystal Restaurant Holdings, Inc., the parent company
of the restaurant operating subsidiaries. The Senior Notes were initially held primarily by
high yield funds and insurance companies. However, several hedge funds have recently
established sizable positions in the Senior Notes at a substantial discount to face value.
While a semi-annual interest payment of $8.75 million is due on April 15th, Crystal has a
thirty-day grace period within which to cure any payment default.

In addition to funded debt, Crystal has operating leases for restaurants and kitchen
equipment with terms that vary from less than one year to twenty years. All but 15 of
Crystal’s 175 restaurant locations are leased, with an aggregate of approximately $250
million of remaining lease payments. All chain leases are obligations of their respective
operating subsidiary (see the corporate structure exhibit for clarification). In connection
with a sale and leaseback transaction, the Company and Bleachers Restaurant, Inc.
entered into a master lease agreement with Corporate Realty, Inc. that covers 20
Bleachers locations. All but a handful of Bleachers and Tuscany leases are generally at or
slightly below market lease rates. Previously, as Crystal closed locations with remaining
lease terms, it was able to “buy-out” the remaining lease obligations via a lump-sum
payment to the landlord averaging 30% of the value of the remaining lease payments.

The Current Situation

With the need for liquidity critical and employee morale sinking, Morgan knows she
needs to act quickly. The Company has recently lost several key employees, and Morgan
has heard rumors of other potential key resignations in the near term. Morgan has
retained your team as restructuring advisors to provide much needed assistance and
advice.

The first issue is to deal with the immediate need for liquidity. Finance has just
completed the second draft of a thirteen-week cash flow forecast indicating that Crystal
requires additional funds to meet the upcoming April 15th interest payment. Moreover,
the current forbearance agreement with First Capital expires on March 31, 2004.
Management also prepared a set of projections that were given to Morgan upon