Upcoming Earnings Release
Restaurant Brands International Inc. (NYSE:QSR) is scheduled to report its 16Q3 earnings Monday, October 24h before the market opens with a conference call at 8:30AM EST. Of the 15 sell side analysts providing estimates, the consensus for revenue and EPS at $1,066M (Range $485M-$528M) and $0.41 (Range $0.37-$0.43), respectively are virtually unchanged since revenues were lowered modestly and EPS were raised modestly following the Q2 report. Similarly, Q4 and FY17 estimates have changed little in the past 3 months. According to Bloomberg, the mean target price is $48 (range $35-$54) which is up $2 since the Q2 report. We would avoid the stock at this valuation. The same store sales comparisons (an all important metric for investors) are slowing as strong year ago numbers are lapped, unlikely to surprise strongly on the upside. Moreover, the stock is trading at about twice the rate of growth in earnings and 20x trailing EBITDA, fully valued compared to its peer group, and nobody considers either Burger King or Tim Horton's to be "best of breed". While a stock buyback has been authorized, the stock is far from a bargain, and the balance sheet is already leveraged. We think the stock offers more downside than upside, at least over the short to intermediate term. Longer term, these brands are here to stay, but how fast they grow is problematic.
Restaurant Brands International was created in December 2014 from the merger of then Burger King Worldwide (BKW) and Tim Hortons International (THI). Headquartered in Oakville, Ontario, the company is the operator and franchisor of approximately 19,500 Burger King (BK) and Tim Horton (TH) brand restaurants generating system-wide sales of over $23B in about 100 countries. Both brands are virtually 100% franchised and are operated as independent segments from their traditional headquarters (BK in Miami, FL and TH in Oakville, Ontario) to preserve their respective heritages and prominent community profiles.
BK is the second largest burger chain by locations, after McDonald's (NYSE:MCD), and third largest by sales, after Wendy's. The menu features its signature flame-grilled hamburgers, chicken and other specialty sandwiches, french fries, desserts and beverages. The system generates approximately $17B in sales from approximately 15,100 units (about 48% in the US). The principal source of the BK segment revenues are franchise royalties (normally 4.5% in the US) and fees, since the chain is nearly 100% franchised. The remaining revenues derive from the 12% of properties leased or subleased to franchisees and from sales at 52 company units.
Tim Hortons quick service restaurants have a menu that includes premium blend coffee, tea, espresso-based hot and cold specialty drinks, fresh baked goods, (donuts, cookies, muffins, pastries), grilled paninis, sandwiches, wraps and soups. It generates about $6B in system-wide sales from about 4,400 units (about 80% in Canada). The TH segment generates revenue from sales of supplies and equipment and packaged products to retailers; from property revenues from the 80% of properties leased or subleased to franchisees; from franchise royalties and fees; and from sales at 24 company restaurants.
While BK's supply operations are largely outsourced to approved third parties (procured in the US by a purchasing entity jointly managed with franchisees), TH operates a significant supply system to procure, store and distribute raw materials, and supplies to most of its Canadian restaurants (US units are supplied by a third party distributors). It operates 2 roasting facilities for blending coffee for its Canadian and US restaurants (and retail), and it operates facilities for the manufacture of icings and fills for its products, though all donuts are purchased from a third party supplier. TH has a variety of franchise agreements which largely reflect the extent of its ownership interest in franchised locations. Franchisees who lease land and/or buildings from the company typically pay a royalty rate of 3%-5% plus rent of 8.5% to 10.5% of sales. Where the premises is owned by the franchisee or is subleased from TH or leased from a third party, the royalty rate is higher; and where the franchisee essentially operates a fully outfitted company property (i.e. includes equipment, signage and trade fixtures), a rate of about 20% covers royalties and rent.
There are currently three major shareholders (3G Capital Partners, with a 42.7% vote, Berkshire Hathaway with an 11.6% vote, and William Ackman's Pershing Capital with a 7.4% vote). Since 3G is a long term oriented international activist fund specializing in consumer brands, they are not likely to exit soon so the stock does not reflect the overhang typical with an activist investor holding an outsized stake. Indeed, its past (and continuing) role in turning around BK may prove prologue as to how the TH acquisition will play out, and thus, key to understanding the company.
Burger King For a least a decade prior to 2010, BK management and franchisees had been in growing conflict over repeated failures to revive the brand and sales momentum. The conflict crescendoed with a franchisee lawsuit charging management with driving system sales with promotions (specifically $1 Double Cheeseburgers) that were good for royalties but costly money losers for franchisees. Into this poisonous atmosphere, 3G Capital stepped up to acquire the company. The fund, which had been instrumental in assembling global beer behemoth AB InBev, also had established a reputation as a long term investor that achieved strong returns by turning around flagging brands, often with aggressive cost cutting and management changes.
When 3G acquired the company in October 2010, it promptly installed partners onto the board and also inserted itself in operations, staffing key executive positions with partners and from a deep bench of proven managers drawn from other investee companies. It moved quickly to restore trust with the franchisee community by giving them a larger voice in the decision-making process and by making franchisee profitability a top priority. This includes simplifying the menu and eliminating money-losing promotions. To this end, new menu introductions and LTO's aim more for flavor variations on legacy standards (e.g. "Angry Whopper") than additions that are more operationally challenging to execute. Management has, however, attempted to fill gaps in the core menu with added or improved items such as salads, chicken strips, beverages and desserts. These additions aim to broaden brand appeal beyond its traditional young male customer to include women and seniors. In its own operations, management attacked overhead bloat, installing zero-based budgeting, which requires justification of all expenses, not just incremental ones. The payoff was a reduction in G&A from $356M in 2010 to about $200M by 2012.
Additionally, the company accelerated a refranchising initiative, that had been already under way, becoming virtually 100% franchised by 2013 (from 89% at acquisition in 2010). As such, only 52 company stores in the Miami area remain, which the company intends to retain principally for test purposes. The new management also launched a store re-imaging initiative of the US and Canadian stores. The company provides incentives, principally in royalty and advertising fund relief, to accelerate the pace of remodeling. According to management, the remodels cost about $300K per unit and drive a 10%-14% sales lift. As of 2015, 50% of the stores have been remodeled.
Finally, it launched a strong international push, particularly into under-penetrated regions. In a departure from BK's traditional franchise agreements, the company aims to accelerate international growth through master franchise joint ventures (MFJVs) and master development agreements with experienced local partners. The structure of these agreements varies significantly, but in general local partners are granted exclusive regional rights to develop or sub-franchise units. The partners commit to aggressive development targets, and franchisee support requirements. They usually pay discounted upfront fees and royalty rates (vs the usual 5% rate) based on the facts and circumstances of each market. The partners make substantial upfront equity contributions, while the company usually obtains a meaningful minority stake in the MFJV's with little or no capital contribution. Of course, this enhanced growth comes with financial and brand risks, principally because operational control over sub-franchisees is even weaker than over direct franchisees. It believes it protects against these risks by entering agreements with well-capitalized partners supported by strong management teams.
So far, results have been impressive. The unit growth rate has doubled in the 6.5 years since the acquisition vs. the preceding 6 years-from 1.5% CAGR, or 171/year, to 3.3% CAGR, or 438/year. (In validation of the MFJV strategy, the international MFJV's have generated most of BK's 2,800+ unit growth since acquisition, notably: Brazil >500 now, up from <150 in 2011, China >450 units now, up from <90 in 2012 and Russia >350 units now, up from <90 in 2012.) Presumably franchisees are happier, helped, no doubt, by an increase in AUV's from $1M to $1.3M and a 30% increase in profitability (according to management). BK EBITDA (adjusted to eliminate non-cash incentive compensation, refranchising gains or losses & one-time expenses, but not FX impacts) increased to nearly $760M in 2015 from $136M in 2004 and by our estimates, segment free cash flows averaged $348M in the 6 years through 2015 (when it reached $488.9M) vs. an average of $86.7M in the six years prior to acquisition.
Tim Hortons At the time of the merger, the TH brand did have its challenges, but overall performance was strong. In the 5 years before the merger, system units grew at a 5% annual pace, while quarterly same store sales (20Q's) averaged 3.1% in Canada and 4.1% in the US, turning negative only once, in 13Q1, and then only modestly (-0.3% Can & -0.5% US). Meanwhile, operating margins were consistently around 20% and free cash flows averaged around $300M, with average FCF margins ~11.0%. The company's challenges were (and are) to protect the brand's Canadian dominance (>40% traffic share), particularly from the encroachments of Starbucks (NASDAQ:SBUX), to expand in the US where it has struggled to gain critical mass, and to exploit the large untapped opportunity it sees on other continents (~1% system units are located outside North America). In Canada, management's principal focus is on solidifying its lunch and breakfast dayparts and improving its coffee business. In the US it closed 27 underperforming stores in New York and Maine to concentrate instead on building density in priority markets in the Midwest. To that end, it has signed development area agreements with partners in the Cincinnati and Columbus, Ohio DMAs and the state of Minnesota. Internationally, it also recently concluded MFJV agreements with partners in Great Britain and the Philippines.
The company has also begun to focus on G&A, with targeted corporate personnel cutbacks reported to date. While TH's capital intensive supply chain operations seem a ripe target for management overhaul, nothing on that front has been reported yet. However, in its 16Q2 conference call, management disclosed that though it will be maintaining capital incentives to remodel stores, which it deems an important initiative, it will be reducing capital support for new stores. This change may signal a more general transfer of real estate financing responsibilities to franchisees, as is the practice at BK, which could give a powerful lift to free cash flows over time.
Though still early days, the results are promising. Revenues have declined modestly due to store closings, but 2015EBITDA (adjusted for one-time expenses and non-cash incentive compensation), at $906.7M, was up 14.4% from $792.4M in 2013, the last full year prior to the merger. More impressive, free cash flow, at $598.5M in 2015, was up 68.2% over 2013's $355.8M.
Restaurant Brands International Consolidated On a consolidated basis, QSR's T12M EBITDA to16Q2 was $1.578B, up 16.1% from the 12M ended14Q2. T12M cash from operations at $1.2B was flat with 14Q2, while FCF was up modestly due to lower cap ex in the last 12 months. As a result of the TH acquisition, QSR is more leveraged than is the norm for "pure play" franchisors. The ratios of total debt to EBITDA and lease-adjusted debt to EBITDAR were 5.5X and 5.9X, respectively. Moreover, the TH acquisition was partially financed by $3B of preferred shares with a 9% dividend issued to Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), the impact of which is not included in the cash flows and leverage figures above. If they were, free cash flows would be reduced by the $270M annual dividend requirement and the ratios of total debt including preferred equity to EBITDA and lease-adjusted debt including preferred equity to EBITDAR would be 7.4X and 7.5X, respectively.
In its 16Q2 the company missed estimates on revenues but exceeded expectations on earnings. The revenue miss was caused by a rare negative -0.8% comp by BK's US stores, which compared unfavorably with sector peers, particularly MCD's 3.1% comps. Though management proclaimed satisfaction with its relatively long-running strategy involving its 2 for $10 Whopper Meal value offer and premium offerings (Grilled Dogs, Chicken Fries Rings and Mac n' Cheetos), it said had made some unspecified strategy changes , though it provided no insight on how well they were doing. Meanwhile, overall unit growth YOY was 3.8% (BK 3.9%, TH 3.3%) and TH's comps and revenues were modestly below expectations. Though US comps at 5.9% (vs 2.3% Canada) were slower than LY's 7%, they held up better in a generally softening market than Dunkin's (NASDAQ:DNKN) 0.5% comps and compared favorably with SBUX's 6% comps (also 7% LY). They were driven by strength in beverages, breakfast sandwiches and impactful introductions such as Oreo and Mocha Cappuccino. Below the top line, strong expense control led to a 510bp improvement in adjusted EBITDA margin and a 1,180bp improvement in operating margin which drove YOY growth of net income and EPS by 23.1% and 36.7%, respectively, a result that beat estimates by over 18%. The company was non-committal about plans for its growing cash balance (up $240M YTD and generated by $517M FCF less $260M preferred & regular dividends and $35M debt repayment and plus $18M favorable FX), though it pointed out that it had announced a new $300M share repurchase authorization that morning. This may be significant in that, in the past 5years, QSR or predecessor BKW expended only $7M (in 2013) for share repurchases.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in QSR over 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.