Burger King's (BKW) come a long way since its first little outlet in Miami in 1954. The chain's famous flame-grilled cooking process has been the key plank of its innovative food presentation and cooking, which has moved it up to being the world's second largest hamburger chain.
In 2010, it was acquired by the private equity firm, 3G Capital, to be returned to the market again in June 2012. While it was an absence of just 20 months the company that has returned is not the same. Burger King is transformed and it has big plans for itself and its investors.
The most important change that is taking place is a transition to franchisee model. It is also modernizing its stores and expanding its menu to take on rivals like McDonald's (NYSE:MCD) and Wendy's (NASDAQ:WEN) and looking for more international exposure. In short, it is taking a holistic approach to strengthen its foothold in the Quick Service Restaurant (NYSE:QSR) market.
The franchisee model
In this model, franchisees manage the day to day restaurant operations, incur costs, and earn sales revenue. The profits also remain with them. The franchiser receives a royalty on the sales. This is a win-win situation for both parties.
Franchisees are best positioned to understand the local tastes and preferences and have their own business models to maximize sales. And freed from cumbersome operational duties, the franchisers pour all their resources into giving overall directions to the franchisees and chalk out strategies for promoting their brand.
So the franchisees, who are local restaurateurs, get a national brand, which they can leverage to earn big profits and the franchisers get low-risk steady stream of cash flow. McDonald's and Wendy's both have successful franchisee models. Now Burger King has decided to join the club. It transitioned to a 99% franchised model by the end of the second quarter. This move will have both long-term and immediate impacts.
Cracking the code
Immediate benefit of the franchisee model would be an improvement in profitability and cash position. This is exactly what happened in the second quarter. Burger King's expenses declined by 65% during the quarter and profits jumped 30% over the second quarter of 2012.
Meanwhile, cash generated by operating activities improved from $36.9 million to $130.2 million in the current second quarter. Given that low cash generation has been a sore point with investors especially in view of Burger King's heavy debt load of $3 billion, this is a big development.
From a longer term perspective, the company will now be able to focus on solid brand building. Management has a dual intent - to increase international exposure and grow domestic sales in the face of cut-throat competition.
Testing waters across the globe
Over the last few years, Burger King has been eyeing markets abroad, especially ones with growing middle class population. During the second quarter, it signed new master franchise and development agreements in Mexico, Canada, and Pakistan and entered into a new development agreement in Germany. These new markets can provide added avenues for growth.
The company is experiencing good sales in most of its existing foreign markets. Trends are especially strong in Asia-Pacific, where comps grew by 3.9% in the second quarter. This surprised analysts, who had predicted 0.7% decline. The EMEA region saw comps growth of 2.9%, ahead of the 2.5% expected by analysts.
Currently, growing domestic sales is the biggest challenge for all QSRs as Americans continue to remain cost conscious and reluctant regarding any discretionary spending. So, all fast food chains are consolidating their strengths.
McDonald's is experimenting with an extension of its dollar menu in some test markets. This is a tiered menu with items priced between $1 and $2 and is called "Dollar Menu & More". It includes items like Southwest Burger, Bacon Hot 'N Spicy McChicken, and more. Besides, promoting its dollar menu, McDonald's is also trying to grow traffic through new premium offerings, its emphasis on breakfast items, and restaurant modernization.
Wendy's is doing up its restaurants in a big way and has also strengthened its value proposition by adding six solid items at the $0.99 price point. It has a tiered 'Right Price Right Size' menu with items priced between $1 and $2.The chain made big news when it launched its Pretzel Bacon Cheeseburger in July. This has been a huge hit. Analysts are predicting that Wendy's will increase total sales by a solid 5.5% in the third quarter. Ever since the arrival of this burger, Wendy's stock has also been on fire. It has added over $1 billion in market capitalization already.
An eye for an eye
Burger King is not taking the beating hands down. It, in turn, is throwing an equally big challenge to its competitors. It has gone for a complete menu offensive and it pursuing its restaurant modernization program with full gusto.
The chain has added lots of new items this year. In March, there was the Spring-menu with nine new items and in May there was the Summer-menu with 13 new items. The company is offering premium items like Rib Sandwich, Carolina BBQ Favorites, Turkey Burger, Buffalo Chicken Strips, and more.
However, items that are resonating most with customers are the $1.25 Whopper Jr, $0.50 ice-cream cone, and $1 frozen lemonade. The Mix & Match 2 for $5 Special, targeting the everyday customer looking for more value for money, has also struck a chord. So, the company has decided to focus more on its value menu promotions and go for fewer but more impacting premium product launches in the second half.
The balanced menu launches would help to build more excitement around the premium offerings, and the emphasis on value items would attract more traffic.
Burger King is modernizing its restaurants in order to improve its brand perception. Through the end of 2012, it completed re-imaging 19% of its restaurants in the U.S. and Canada. Now the company is on track to meet its target of re-imaging 40% by 2015.
The renovated restaurants are seeing 10% to 15% more traffic than the old restaurants. As the proportion of re-imaged restaurants increase, the overall comparative same store sales numbers are likely to move up.
From the above, we can conclude that Burger King has taken the right steps but it is very important to look at the company's latest quarterly numbers and key investment metrics to evaluate its progress and attractiveness.
In the recently concluded second quarter, Burger King's reported adjusted earnings of $0.21 per share compared to $0.19 expected by analysts. Reported revenue was down 48.5% to $278.3 million as the company shifted to a franchisee model. In constant currency terms and excluding the impact of franchising, revenue increased by 1.2%.
System-wide same-store sales were up 0.4%, ahead of the 0.2% projected by analysts. In the U.S. and Canada, same-store sales were down 0.5%. This is an improvement over the 3% drop in the first quarter and better than the 0.8% decline expected by analysts.
Meanwhile, we find that ever since it has returned to the market, the stock has appreciated by 25%. It has a forward P/E ratio of 21.5 times, which is lower than the current P/E ratio of 46 times. This implies that the market expects the company to grow its profitability and post better earnings in future. Its forward P/E is in line with the industry average and contains upside potential.
While it is clear that things are looking up for Burger King, investors need to keep in mind that even the best laid plans can fail. I would urge investors to keep an eye on a few things to avert losses. First of all, any further debt issue can be risky. The company already has a sizable debt burden. Next, although Burger King has chosen its franchisees painstakingly, as with any big transition, we need to see whether the latter have adequate controls in place and whether they are diluting the brand.
Then there is the minimum wages bill. If this is passed and the wage rate of $9/hour is established, it would raise costs of franchisees. Although this will not directly affect Burger King, this can have an indirect impact. If margins of franchisees get compromised the company may find it difficult to get willing partners to fuel its future development plans. Finally, we need to keep an eye on the competition. If peers like McDonald's and Wendy's manage to erode Burger King's market share, it can have a big impact on future sales and profits.
Burger King is consolidating its strengths. It is boosting sales through store modernization and lowering costs by adopting a system-wide franchisee model. It is also increasing promotions of value menu to attract more customers and looking to grow internationally. While risks definitely remain, the company looks poised for a bright future ahead.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.