Winchell’s Leaves Bad Taste With Investors : Plunge in Market Value Sparks Lawsuits

When Denny’s Inc. sold a 58% interest in its venerable Winchell’s Donut Houses to the public in December, 1986, investors flocked to pay $18 a share and get in on the ground floor.

Within nine months, Winchell’s sales nose-dived, cash distributions to investors were chopped sharply and the market value of shares in the publicly traded limited partnership plunged to below $4.

“Disaster” is a word often used by observers to describe what happened to the 40-year-old doughnut business after its $90-million spinoff.

But while Winchell’s investors were losing their shirts in the market, managers who presided over its problems in 1987 made big profits by selling the company’s La Mirada-based parent, Denny’s.

The fortunates included a number of the firm’s top executives and its investment banker, Merrill Lynch Capital Markets, which had been instrumental in taking Denny’s private in a leveraged buyout in January, 1985. Now the Denny’s insiders, who did so well last year, are being sued by several Winchell’s investors, who didn’t do well at all.

Winchell’s investors have filed eight class-action suits since mid-December--in federal courts in Los Angeles and New York and in Delaware state court--against Denny’s, its former top officers and directors, and 85 underwriters for the Winchell’s public offering.

Among other allegations, the suits claim that the prospectus for the offering misled the public about the condition and prospects of the more than 700 Winchell’s Donut Houses.

Merrill Lynch, which was a 30% owner of Denny’s and a manager of the Winchell’s underwriting, is a major target of the class-action suits. Also named as a defendant is its co-manager, Dean Witter Reynolds.

Winchell’s, the nation’s second-largest doughnut chain, was founded in 1948 by Verne H. Winchell. Starting with a single store in Temple City, he expanded his business into hundreds of outlets. In 1968, he sold the company--in exchange for stock--to Denny’s and became chairman of that firm.

Denny’s subsequent spinoff of Winchell’s in 1986 did not exactly come as a bolt from the heavens. As long ago as 1974, only six years after acquiring Winchell’s, Denny’s was talking about spinning off the doughnut business.

In a statement that year, Chairman Winchell said the board was studying whether to split the firm into two publicly traded entities.

Ten years later, Denny’s management disclosed in a proxy statement that in May, 1984, management had considered “disposing of” Winchell’s because of a “slowdown in (its) growth.” The proxy blamed the slowdown on “high real estate costs and saturation of its primary market.”

The disclosure--made Dec. 21, 1984--appears considerably different in tone from the discussion of Winchell’s condition and outlook in the December, 1986, prospectus.

The proxy recounted that Vern O. Curtis, then Denny’s president and chief executive, and other senior management met with Merrill Lynch to look into the idea of selling Winchell’s. Instead, the investment bankers suggested selling Denny’s as a whole to a group consisting of management, Merrill Lynch and various financial institutions.

A special committee made up of outside directors and Chairman Winchell, who by this time had retired from active management, negotiated with Merrill Lynch, the proxy said. The committee, whose independent financial adviser was Dean Witter, recommended approval of the offer of $45 a share. That figure later was reduced to $43 at Merrill Lynch’s request, and the deal was concluded.

The investment firm had three representatives on Denny’s board until last September, when the company was sold to TW Services of New York, a restaurant and vending machine operator, for $220 million cash and the assumption of $640 million in debt.

Merrill Lynch reportedly made about $50 million in profit on its Denny’s investment.

In the Winchell’s lawsuits, defendants’ answers are expected to be filed soon. The cases are being consolidated in the Delaware state and federal courts, lawyers explained.

Spokesmen for defendants Merrill Lynch and Dean Witter have declined to comment on the allegations. Ted Edelman, New York attorney for Denny’s and the individual defendants, said he expects to file an answer denying the allegations.

Meanwhile, TW Services has its hands full with the staggering problems of running a chain of aging doughnut stores whose 42% control it inherited, along with the restaurants that it prized: the 1,200 Denny’s coffee shops (the nation’s largest such chain) and 1,000 El Pollo Loco Mexican-style chicken restaurants.

Restaurant analysts believe that New York-based TW Services would like nothing better than to sell the doughnut business and relieve itself of that headache.

But Frank L. Salizzoni, chairman and chief executive of the food services firm, maintained in a recent interview that the company does not intend to sell Winchell’s anytime soon. “We have advised the employees we are going to turn it around and make it a better company,” he said, later adding a qualification, “at least over the near run.”

“It stretches my imagination too far to think they could turn it around,” says Ward Paul Lindenmayer, a vice president and senior research analyst for Sutro & Co., San Francisco. He said he has seen no real improvement developing.

And analyst James J. Murren of Cyrus J. Lawrence, Morgan Grenfell Inc., New York, observing that Winchell’s stores “are old, tired and need a face lift at least,” said a turnaround “is not going to happen right away.” He added, “I’m sure TW Services would love to get rid of it if they could.”

By contrast, he said, “Denny’s is in much better shape,” and TW Services plans to spend about $66 million this year to renovate Denny’s coffee shops.

Focus on Language

However, despite the spinoff of a majority interest in the doughnut business, the prosperous-looking Denny’s and its “poor relation” remain yoked together like Siamese twins.

After getting rid of the Denny’s-Winchell’s top management, TW Services moved its president, Jerome J. Richardson, to the Denny’s “compound” in La Mirada to oversee both operations.

However, the lawsuits have cast a certain grimness over the compound, pointed up by a reluctance of present management to discuss the problems at Winchell’s.

While differing in some respects, the suits generally focus on language in the Winchell’s prospectus that allegedly presented a much rosier view of the company than was warranted by the facts.

For instance, among the allegedly misleading information cited by one of three class-action suits on file in U.S. District Court in Los Angeles are the following:

- That Winchell’s retail store sales declined to $168.5 million in 1986 from $182.9 million in 1985 “primarily” because of the sale of 93 “underperforming” doughnut houses in a “planned withdrawal” from certain unprofitable markets.

- That a declining number of customers over a five-year period was offset by increased per-customer purchases of doughnuts and other products, and average annual sales per store increased to $220,000 in 1986 from $184,000 in 1982 because of price increases.

- That the company believed that the decline in customer traffic was primarily because of increased competition from independent doughnut shops, convenience stores and others.

The prospectus, according to the suit, attempts to give the impression that the sale of the 93 underperforming doughnut houses solved the problem of declining sales.

There is no disclosure in the prospectus, the suit said, that weakening sales might continue.

In fact, the complaint said, “a serious erosion” of Winchell’s sales began as early as 1985 and “has continued to the present time at a dramatic rate” despite the sale of the 93 stores.

Winchell’s failure to disclose any sales erosion beyond the 93 underperforming stores sold in 1986 “creates the impression that Winchell’s took the steps necessary to halt the retail sales decline,” the suit says. The net effect of the prospectus, it adds, is “to give the impression that Winchell’s has a rosy future and that its problems are behind it.”

Another suit, filed in Delaware Chancery Court, alleges that the market price of Winchell’s shares was artificially inflated because of omissions and misrepresentations in the prospectus.

The suit notes statements in the proxy regarding efforts designed to increase Winchell’s sales and an intent to distribute “all available cash flow” to purchasers of the partnership interests.

(The partnership shares were sold with an indicated 10% yield, making it an attractive income-oriented investment.)

“In fact,” the suit goes on, “less than six months after the offering it was disclosed that the company had anticipated a sales decline representing a continuation of the pattern of the previous year. It was then revealed that the cash flow was about half the levels the company had generated in recent years.

Costly Promotion

“It was also disclosed that not only were sales soft but profits were seriously impacted by a coffee promotion,” the suit says. (According to analyst Lindenmayer, Winchell’s for years had an annual promotion in which, for 99 cents, a customer got a cup of coffee and a mug that he could take home. Last year, Lindenmayer said, the company added a provision that a refill would cost 25 cents instead of the previous 60 cents. The promotion turned out to be extremely costly for the company because of strong demand for the refills at a time coffee commodity prices were high, he said.)

By November, 1987, the suit says, Merrill Lynch knew that Winchell’s per-store sales were falling at an accelerated rate and that cash flow had declined sharply. As a result, the cash distribution to limited partners was cut for the third quarter to 15 cents from 45 cents, the suit noted.

Last month, Winchell’s reported a $11.5-million net loss for 1987 and said it would make no cash payout at all for the fourth quarter.

But even after cutting its third-quarter cash distribution by two-thirds, Winchell’s was talking optimistically. In a Nov. 2 press release reporting a $3-million loss for the quarter, the company noted that it had reached an agreement to distribute its doughnuts in 7-Eleven stores in Los Angeles.

“We are very excited by the potential for increased sales and profits,” Donald L. Pierce, then chief executive of both Winchell’s and Denny’s, said at the time. Pierce resigned in late January, and less than three weeks later, Winchell’s reported an $8.6-million loss for the fourth quarter and the $11.5-million loss for the full year.

When TW Services bought Denny’s last year from the private owners, it apparently wasn’t thinking much about Winchell’s. And the lawsuits that might have called attention to the problems had not yet been filed.

Noting that previous management did little with the old doughnut chain, analyst Murren of Cyrus J. Lawrence says: “It (Winchell’s) was not very meaningful in Denny’s scheme and a pimple (to) TW Services.”

That was not far off the mark, judging from a recent comment by Chairman Salizzoni of TW Services. Asked in a telephone interview if his firm knew the scope of Winchell’s problems when it bought Denny’s, he said:

“We knew up to the point of closing our deal (last September). We saw the numbers trending downward. They accelerated as they moved into the second half and the last quarter.”

But, he said, “we didn’t anticipate and I don’t think the management of Denny’s anticipated” how bad Winchell’s would wind up at year-end.

Earnings Decline Seen

Salizzoni said his firm was primarily buying Denny’s for its coffee shops and El Pollo Loco restaurants, adding: “We didn’t spend a lot of time focusing on Winchell’s.”

TW Services has said its first-quarter earnings might decline as much as 22% because of the seasonal nature of its food and vending service businesses, “particularly Denny’s.”

However, the executive added: “We are very optimistic about Denny’s. We couldn’t be more optimistic. We will do very well for the full year.”

Analysts, too, generally see a much brighter outlook for Denny’s coffee shop business than for Winchell’s.

And both Lindenmayer and Murren said they believe that Winchell’s suffered even more than Denny’s by a failure of Denny’s recent private ownership to spend enough on upkeep of retail properties.

Lindenmayer also says that, in his opinion, both Denny’s and Winchell’s suffered from a decision two decades ago to concentrate on company-owned outlets rather than on franchising. Although the company increased franchising efforts in recent times, he said, only about 10% of the doughnut shops are franchise operations.

An East Coast chain, Dunkin Donuts, which leads Winchell’s as the biggest national doughnut house operator, is almost 100% franchised, Lindenmayer said, and the average sales volume for each Dunkin Donuts outlet is almost twice as high as Winchell’s.

Didn’t Expect Disaster

Murren speculated that other doughnut chains, particularly Dunkin Donuts, might be interested in acquiring Winchell’s. When Winchell’s went public 15 months ago, Lindenmayer reflected recently, analysts knew that its average store volume was “under some pressure.” But as an income-oriented investment, Wall Streeters generally saw it as one of the better master limited partnerships.

“They didn’t expect it to burn up the track,” he said, “but they expected it to continue as it had. The same management people were around. There was no reason to expect it was going to be a disaster. But it had problems from the second they got out of the box.”

Besides a continuing drop in average volumes, he said, its problems included getting caught in higher-than-expected commodity market prices for coffee, as well as the “total bomb” of a coffee mug promotion. Customer counts and average store volumes got worse last fall, Lindenmayer said.

To cap it off, the company reported taking a $2.6-million charge in the fourth quarter to increase workers’ compensation reserves and a $3.2-million provision for closing 45 “poorly performing” stores.

Last week, Salizzoni of TW Services was taking a wait-and-see attitude when asked for details about what his people could do to solve Winchell’s problems.

“All we’ve done so far is put in a new president, (James C.) Verney,” he said. “Jim really has to get into that operation. He has to see what the problems are and see what we can do to improve the operating profits and the bottom line.”

Analyst Lindenmayer says: “Their choices are fix it, sell it or close it. If it loses money long enough, they conceivably could close it. I imagine they would rather sell it. My guess is, TW Services will get rid of it as soon as possible--either sell it to someone else or to (the previous) management.”