- Burger King has bet hard on the franchise model.
- Franchise revenues made up over 90% of total revenues in the last quarter.
- The margins look great.
Burger King (BKW) has been shifting their company to focus on franchising and eliminate running stores themselves. The new strategy has dramatically improved their profitability, and their gains are being reflected in a substantially higher share price. I don't recommend Burger King as a replacement to McDonald's (NYSE:MCD), but I do think a small position in BK is great for diversification benefits. Looking at the last two years, MCD has been fairly flat. It has paid a solid dividend, and there are still good arguments for it as an investment, but the other companies have delivered fairly solid returns. Check out the chart over the last two years:
Burger King has done fairly well. The P/E (TTM) of 42.15 should scare investors a bit. I love the franchising model as a source of revenue generation, but the dividend yield isn't going to make this a solid investment without growth. However, the company's net income has been expanding dramatically. Since 2011 it went from $88 million to $233 million. In short, the margins on operating a Burger King just aren't that good compared to the margins on having other people operate them. I'll admit that 2 years ago I wouldn't have predicted that BKW would be able to grow net income this fast. I would've been very concerned that they wouldn't have been able to unload their restaurants in attractive deals. However, that thesis has been proven wrong. Their company restaurant revenues were only $18.3 million last year, down from $52.7 million the year before.
The company's EV/EBITDA ratio was 17.09 last week. After the run up regarding the Buffett / Hortons news the ratio has gone to 19.39. For comparison, MCD was 10.23, Jack in the Box (NASDAQ:JACK) was at 10.85, and Wendy's (NASDAQ:WEN) was at 11.95. At 17.09 I could stomach the premium. Now, I'm not so sure.
As of 2014 Q2 ending, the company is reporting an increase in sales by franchisee locations that have experienced the Burger King remodel. The company had remodeled 30% of locations as of the start of the year and is aiming to hit 50% by the end of 2015. Based on the 2,200 stores that have been completed, the expected increase in sales per store is between 10 and 15%. This is great for Burger King. Being in a royalty business the increased costs of goods sold isn't passed on. Sure, they may miss out on some gains in operating margins at the business level, but they have their own leverage from some costs that are largely fixed.
One of the benefits of Burger King's model in diversifying exposure to the restaurant industry is that their earnings will not fluctuate as rapidly with changes in the cost of food. Yes, long term it will impact them. If the franchisees are unable to turn a profit the system won't last indefinitely, but the short term spikes in EPS from changes to operating margins when food costs can easily fluctuate by a hundred and fifty basis points, as happened this quarter to several restaurants, can be handled easily by Burger King's model.
The operating structure changed from managing restaurants to running a franchise operation, but the capital structure isn't static either. Burger King's CFO has said they will be monitoring the situation and may implement changes to their capital structure. I'd really like to see the company change the capital structure. The company may not have control over how fast they can sign up franchises, but they do have some very steady operating margins now and a very powerful sales force with strongly motivated management. Given the reliability of their operating margins and the very low interest rates in the market, I would favor a significant increase in the amount of debt funding the company uses. I think the cash flow is stable enough to easily handle using more debt and less equity. With a lower WACC (weighted average cost of capital) the value to the shareholders would be significantly increased.
Impact on EPS of possible debt restructuring
Based on the company's tax rate and the debt financing acquired by other restaurants, I think Burger King would be looking at an after tax cost of debt below 2%. I attempted to check for trading information on BKW's debt, but Morningstar did not have it. I consider MCD to be a tiny bit less risky. Their bonds for June 11th, 2029, are trading at a yield to maturity of 2.24%. If BKW can issue debt near that rate, the after tax rate will be under 2%.
If I'm right, then the company would be increasing EPS as long as shares were purchased with a P/E ratio below 50. That potentially gives the shares some room to run just on capital restructuring.* The limit on that run up could still come from the shorter term borrowings to achieve such a low rate.
On the other hand, if the company wanted to use longer term debt so it could safely repurchase more shares, the growth in revenues from one quarter to the next could benefit from the financial leverage. The PEG ratio is actually very attractive for a company that could be benefiting from an improvement in their financial structure. The PEG ratio for BKW is only 1.72.** For McDonald's it is 2.73, though of course McDonald's does deserve its own premiums for its massive size and steady dividend.
BKW's shift to franchising has dramatically improved results. The company seems more focused now on growing its operations and adding value to the shareholder. The company has had a strong run up in price, but I believe they could still have some room to run on growth in franchise locations and improving the capital structure. I wouldn't suggest them as a replacement for McDonald's, but I like them as a complement to other exposure. I do think the company might outperform McDonald's over the next few years, but I think the risks in a large position are simply too great to justify in terms of risk adjusted returns. ***I'm bullish on the stock.
*Update: I originally authored this piece before the news about Warren Buffett or Hortons broke. It wasn't published because I had poorly designed a part of the analysis and the article needed improvement. That was my fault. The price spike that occurred over the last few days caused me to do further revisions. My theory of the company being able to run up closer to a P/E ratio of 50 was written when the P/E ratio was 36, rather than 42. If the company does pull an inversion and acquire a lower tax rate by moving the profits to Canada, it would reduce the benefit of using debt but increase the future values of EPS.
**The peg ratio as of market close on August 27th, 2014 is 2.00.
***My bullish stance was at a price of $26.82. I am now only moderately bullish. Further, my position that the company was set to outperform MCD was also based on the previous price of $26.82.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from either Yahoo Finance or the SEC database. If either of these sources contained faulty information, it could be incorporated in our analysis. The analyst holds a diversified portfolio including mutual funds or index funds which may include a small long exposure to the stock. The author does not eat at Burger King.