Parting Shots
Outback’s just-retired CFO, Bob Merritt, talks financial trends and new accounting rules.

By David Farkas

Bob Merritt surprised the industry on April 21 when he casually announced his retirement at the end of Outback Steakhouse’s first-quarter conference call. “No big deal,” the 53-year-old CFO huffed before offering an emotional explanation of why he was stepping down on May 27 after 15 years at the company.

“The recent lunacy over lease accounting took me over the breaking point,” Merritt complained, blaming accounting firms and regulators for creating a situation that wouldn’t get better “anytime soon.”

Several of the country’s largest restaurant companies have restated earnings to comply with new interpretations of lease-accounting rules.

Merritt’s departure ends an illustrious career at the financial helm of one of the industry’s most improbable growth stories—a steakhouse chain launched in 1988, when red-meat consumption was at its lowest point in the country’s history.

He joined Outback a year later, overseeing an IPO and two follow-ons in the early ’90s that raised some $68 million. Today, the 1,200-unit company has a market cap of $3.1 billion. A share of OSI was recently worth $42, $5 off its March 52-week high.

Merritt’s reputation remains large. “Bob’s legacy will be as the pre-eminent CFO in our industry over the past two decades,” says investor and former Brinker International CFO Jim Parish. SG Cowen’s Paul Westra, who has followed Outback since 1994, considers Merritt to be “the granddaddy” of CFOs.

Chain Leader caught up with the outspoken Merritt a month before his last day. We grilled him on financial trends including the recent changes in accounting rules that lead to his resignation.

From a perspective of 15 years in casual dining, where does the category stand today?

It’s going through a fundamental change. You now have four big players, and they are all net generators of cash. This is the first time in the history of casual dining that we have seen this. Until now, we’ve all been net users of cash. In the last few years, these companies have used the cash to eliminate or significantly reduce funded debt.

It’s also the most competitive environment and the worst cost environment. A competitive environment that restricts price increases and the cost of commodities, labor and construction to build new restaurants is a combination that makes it increasingly difficult to generate sufficient incremental returns to justify investments.

What are the implications?

There is an inflection point in the development of any restaurant concept. The cost to build the incremental restaurant escalates faster than the ability to raise prices. The consumer doesn’t care that the cost to open a restaurant in 2005 is 50 percent higher than the cost of the one five miles away that was built in 1995. They are not going to pay proportionately more to eat in the new unit. As a result, returns go down. At some point the incremental return doesn’t justify the incremental investment.

So the question is, given the environment, what will managements do with the excess cash? Will they do what they have historically done and continue to mindlessly expand these concepts well past this inflection point and destroy capital, or will they change and become more concerned about generating real shareholder value and how to grow it?

What’s your best guess as to what will happen?

One of the deficiencies of financial accounting as it exists today is that a company can grow [earnings per share] at the same time as it is destroying real capital. Our accounting systems don’t measure the cost of capital. In addition, when evaluating performance, we forget to adjust the nominal cost of capital for risk.

How many casual-dining companies have never closed a restaurant or shut down a failing concept? Because financial accounting lets you write these mistakes off of your balance sheet, we all seem to forget that we expended the capital.

Do you have any suggestions for fixing the problem?

When evaluating development, we need to do a better job of taking into account these hidden costs. A number of companies in this industry are destroying capital by continuing to grow even though incremental returns don’t exceed their risk-adjusted capital cost.

Care to name these companies?

I’d rather not. Some of my friends work there. They seem to be focused on growing earnings per share. To a certain extent, this is the result of having our stocks traded in the public markets, where EPS is the primary measurement used to value companies.

Speaking of public markets, you cited changes in lease-accounting and depreciation rules as your reason for retiring. What’s your problem with them?

I can see the argument. Maybe you should have consistency in measurement periods. That is not my problem. It is the crazy way the people who are responsible for overseeing financial reporting reacted to this. Once the consistency of measurement periods was identified as an issue by one of the accounting firms, the other firms seemed to try to outdo one another by bringing up other lease-accounting matters.

What should have been done?

If the accounting firm that first raised the issue of consistency of measurement periods had just gone to the [Financial Accounting Standards Board] to get clarification, a lot of the fire drill could have been avoided. Instead, it seems they jumped the gun, setting off the competition. What you had was this cluster f--k.

My problem was the lack of process. Some companies had to restate twice. How is that going to serve users of financial statements?

The biggest issue I have with the rules is that any obligation that lasts 25 to 30 years should be measured on a present-value basis. There is already precedent for this in accounting principles.

The way analysts cover companies has also changed post-Enron. How has that changed the way you manage expectations?

The most interesting evolution has been the fast-money movement and the movement away from long-term investors. You don’t hear much about it. Most of the sell side caters to fast money. It’s all about rapid data points. There’s a blind focus, for example, on same-store sales. Whereas management will tell you that [same-store sales] are an indicator of health, that is not what concerns us day to day. However, I understand the motivation for fast money. Long-term investors come in and hold the stock for 5 to 8 years. They are not going to make money off them.

What has been your reaction?

Increasingly, we moved away from playing the sell-side game to building a strong base of long-term shareholders. You target them and you run a company for long-term cash flow. You do your own shows. We cut way down on analysts meetings. We were seeing the same people over and over again, and they were all the fast-money guys. [The brokerage firms] used to treat management like they were important; now we’re just a piece of ground beef.

What’s the outlook for smaller casual-dining chains that want to raise capital?

It’s good, if you are willing to take on partners. We want to partner with companies that have two to three units and expansion capabilities. Private capital is probably more available today than, say, five to eight years ago.

I don’t know that raising capital is that big of an issue. Part of the change in casual dining is that you are now seeing more emerging new concepts developing within existing restaurant chains. Ten years ago these chains could have become public companies [on their own]. We became the source of capital and strategies they tapped into.

You have a reputation for bringing financial discipline to senior management. Any advice for CFOs?

My recommendation is to carefully pick who you work for. Everybody on the management team has to agree. It’s about having other senior management people who agree with your perspective. But if the CEO and COO want to build restaurants that don’t earn a good return, the CFO can’t change that.

That wasn’t the case at Outback.

They were smart enough to learn. [CEO Chris Sullivan] got it. It also depends on your objective. We decided we wanted to make something really big, and that required some discipline.

Were discussions painful nonetheless?

Of course the discussions are painful. Look, this is an industry dominated by entrepreneurs who believe there is never a downside. They look at a deal and assume that everything is going to work out perfectly.

Financial types always believe in a downside. We tend to plan to the downside. If the downside generates acceptable performance, then the upside will be great. That tends to result in our being viewed as more negative than entrepreneurs would like. So of course the conversations are difficult.

Do CFOs make good CEOs?

Historically, they haven’t had success in casual dining. My guess is, however, you’ll see that change now that the nature of the business is changing—that inflection point I mentioned. People capable of financial discipline will be more highly valued than in the past, as long as they understand and empathize with operators’ needs.

Would you consider a CEO slot, say, at a casual-dining chain in a turnaround situation?

Probably not, at this point in time. I’m not looking at anything. I want to do something important with my life, and that is to raise my kids.