QSR: Taking Low-Risk Swings
Imagine you just signed a multi-million dollar deal with a new major league ball club. Before leaving the dugout for your first at bat, the manager looks you in the eyes and says, "Kid, if you don't crack a homer the team is finished. Everything rests on your shoulders now." With a big contract you'll be fine, but the team's owners desperately need a home-run.
Ok, not a realistic baseball scenario but investors are sometimes faced with such a dilemma. Turnarounds come to mind. A new, well-paid CEO is parachuted in and asked to hit a home-run to save the company. She visits investors and says something like "we need to make investments in our assets and marketing in order to grow." The previous management team is thrown under the bus and investors are asked to be patient. The risks are high but so are the potential returns.
A high-risk, high-return scenario isn't really attractive, especially if your investment philosophy is concerned with Buffett's first rule (i.e. don't lose money!!). If we wanted high-risk, high-return propositions, we'd go to the casino.
Instead, the investor, primarily concerned with loss avoidance, wants low-risk, high-return scenarios. Or, as Mohnish Pabrai describes, scenarios where "Heads I Win, Tails I Don't Lose Much."
Restaurant Brands (NYSE:QSR), in my view, is one such scenario. This article will first argue that investors should look at Free Cash Flow and not earnings, before concluding with an explanation of why the expansion strategy is relatively low risk for shareholders.
Free Cash Flow (Not Earnings)
Consider the following metrics which compares Restaurant Brands' Price-to-Free-Cash-Flow (P/FCF) and Price-To-Earnings (P/E) with McDonald's (NYSE:MCD), Starbucks (NASDAQ:SBUX) and Dunkin' Brands (NASDAQ:DNKN).
Restaurant Brands is far more expensive when using P/E than when using P/FCF.
The difference is quite large actually - much larger than its peers. One reason for the large difference is non-cash charges (i.e. waiting longer to pay suppliers) and adding back funny items such as stock compensation expense.
A second reason relates to depreciation and capital expenditures, which, in my view, is the item we should focus on.
In the past year, an important change occurred at RBI, specifically with Tim Hortons (TH). Much like management did with Burger King, they shifted TH development toward an even more capital light model. With respect to new TH restaurant development, the majority of capital outlays will now be the responsibility of existing and new franchisees.
This manifests itself in the large difference between depreciation and capital expenditures. The income statement, reflecting history, is depreciating assets at a rate of $180 million per year. In contrast, the cash flow statement, reflecting the present/future, is purchasing assets at a rate of $115 million per year (and falling).
In other words, far less cash is needed today to develop and open new stores than was required in the past. Much like with SG&A, the 3G inspired philosophy is setting a new standard for capital intensity in the restaurant sector. In my view, the lower capital outlays better reflect the business going forward, and is why free cash flow is a better metric than earnings (well, until time passes and the income statement reflects the new operating model).
Here's a theoretical look at the difference over the next two years
As a result, my estimate of 2016e P/FCF (after preferred dividend payment) is 18x, which looks much better than 2016e P/E at 25x.
Heads I win, Tails I Don't Lose Much
With that said, the more important part of the story is, in my view, the asymmetric nature of risk and reward - Restaurants Brands is potentially a "Heads I win, tails I don't lose much" situation.
For current shareholders, the growth strategy appears relatively low risk. Now that the majority of growth capital expenditures have been shifted to current and potential franchisees, the risk of management wasting shareholder cash on expensive initiatives is low.
Consider the following "Heads I Win' scenario.
Let's say they continue to spend around $100 million or so on capital expenditures for the next few years. The amount of free cash flow for shareholders might look like this.
Another way to look at it is, they are spending around $300 million to potentially generate $300 million more free cash flow dollars - not a bad return proposition.
If management strikes out - and many of us can envision the possibility that the TH expansion fails - they haven't really put that much shareholder capital at risk. Management isn't using a large amount of cash from the existing TH or BK businesses (i.e. shareholder capital) for, what some view as, a highly risky venture.
So "Tails I Don't Lose Much."
That's not to say failure wouldn't be bad for shareholders. It would, but at least it's not using a lot of capital for risky ventures. If they fail, shareholders are still left with two good businesses, which generate a lot of cash to (among other things) reduce debt on the balance sheet.
This suggests we have a potentially attractive risk-reward scenario. If the expansion of BK and TH continues to be successful, RBI can generate many more runs. If RBI strikes out, then they wait for their next chance to step up to the plate. Downside is contained and, most importantly, the ball club doesn't go under.
Heads I Win, Tails I Don't Lose Much. I hope.
Disclosure: I am/we are long QSR, DNKN.
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.