Restaurant Franchise Investments Require Detailed Due Diligence

Includes: DIN, QSR
by: John Gordon


Recent Businessweek article on Burger King Lacks Detail.

Much More Franchisor Investor Due Diligence Necessary.

Commonly Used Metrics Must be Parsed.

This week, Bloomberg Businessweek has a detailed cover story about Burger King's (BKW) leadership.

It's not much of a useful analytical piece. The piece did not move the market, the Bloomberg editorial standard (but BKW earnings are later this week). Deep analytics must not sell anymore in our time-starved span of attention. The piece is Wall Street personality and issue focused. Businessweek seemed more intent to send a warm kiss to the largest Burger King shareholder, Bill Ackman, who is quoted. Ackman's Pershing Square is a 10.9% BKW holder, the largest single institutional or individual shareholder. Bill needed a warm kiss; he had a very bad week last week, personally over-promising and under-delivering on his anti-Herbalife pitch.

Franchised Restaurant companies require a lot more investor due diligence, on both the equity and bond investor side, and on the franchisee side. First, franchisors don't release their franchisee financials results other than same store sales. 100% franchisors like DineEquity (NYSE:DIN), Burger King and Tim Hortons (THI) don't release a single franchise operations number. Popeyes (PLKI) alone of the publicly traded group releases franchisee EBITDAR - EBITDA less rent. Some limited clues may be possible from the 10Q/10K statements and the franchisors' Franchise Disclosure Document that details unit opens/closes. The 10Qs/10Ks don't detail why units open or close, but the FDD broadly classifies closings into categories.

The same store sales metric is more visible. But focus to it in isolation as Businessweek tried (Burger King's same store sales exceeded McDonald's) is flawed: a .5% same store sales gain on a $2.7 million sales base yields a much more healthy picture than 2.0% on $1.0M store AUV base. Actually, both comps and unit opens/closings need to be examined together, it's very possible to open a lot of stores but realize negative same store sales trends (Five Guys, Smashburger are best recent examples, experiencing both conditions).

Positive same store sales are nice, but are they profitable sales (might not be if discounting is involved) and are they high enough (restaurants need about 2% growth per year typically to cover inflation).

Bad debt expense, the value of franchise royalties not paid to the franchisor and eventually aged and reported, is also a poor, lagging metric. Once bad debt expense is posted, it's really late in the business cycle, the franchise model problem is very intense, the horse is out of the barn.

Franchisees don't talk much - they are afraid to and told not to, and are constrained from communicating via franchise agreements. More research and due diligence is needed. Consider the 3G Capital and Fortress experience, their astoundingly bad 2012 Quiznos investment ($350 million investor group loss and counting).

Getting franchisee EBITDA is great (it is possible, but you have to dig and hire the right people) but it's only half of the story. Restaurants are capital expenditure (MUTF:CAPEX) intense and some measure of after tax, after debt service, after loan amortization economic gain or loss number is needed.

As usual, business analysis is not what you read on the cuff - it's not what you expect, it's what you inspect.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.