Ever since Burger King aquired Tim Hortons in 2014, the fast food conglomerate has swiftly expanded its locations around the world (mainly in Middle East and North America). Just this month, the limited partnership announced a joint venture in Mexico to develop and grow the Tims brand in the country. Daniel Schwartz, CEO of Restaurant Brands International believes that Mexico has a thriving coffee market and the managemnet is optimistic of the outlook.
Currently trading at $50.02, QSR has some potential upside, assuming the compnay keeps up with its current operating margin (37.58%), which is well above industry average (14.75%), and maintains its steady growth by expanding into profitable markets and making smart acquisitions. (I will discuss this in the next post.)
Now, let's jump into the valuation part. I first created a trailing 12 months spreadsheet using RBI's last annual report (with a 12/31 year end) and two 10 Qs from 9/30 2015 and 2016 respectively. The numbers I arrived are as follows: $4.1 billion in Revenue (Sales and franchise and property) and $1.5 billion in Operating Income (note. this is calculated using the adj operating income for 2015 10K). I then calculated the debt value of operating leases and made adjustment to operating income as well as the book value of Debt. Since operating leases are essentially obligated commitments, it's more prudent to treat it as a tax deducted financial expense such as interest expense rather than operating expense. The numbers I arrived are as follows: Adj Operating Income: $1.2 billion. Restated BV of Debt: $9.7B. Using the computed numbers as my base year Revenue and Operating Income, I then proceeded to build a DCF model. The first assumption I need to make is the revenue growth rate for RBI's 1-5 yrs of operation (after yr 6 I assume the company will converge to a growth rate equal to the risk-free rate. I have four numbers to pick from, the 5.5% comparable sales growth and 9.8% system wide sales growth from RBI's recent 10K, the 7.16% U.S Restaurant/Dining average revenue growth and the 16.47% Global Restaurant/Dining average revenue growth. I decided to use the more conservative number, which is the comparable sales growth of 5.5%, here but I did perform a sensitivity analysis afterwards.
The second assumptions I need to make is the target operating margin, namely, the terminal year operating margin. Here, I assume that as a mature company competing in a saturated market. RBI will have a operating margin similar to that of the industry average, which is 14.75% in the U.S and 17.38% globally. However, given RBI's current margin and its position as a cost-effectiev leader in the industry, it's likely they will sustain this competitive advantage and maintain its high margin cost structure. It is for this reason that I performed a sensitivity analysis using higher operating margins in conjunction with different numbers of revenue growth to simulate the upside and downside cases.
Next, I started calulating the cost of equity using risk free rate of 1.82% (Canadian government 10-year bonds bench mark rate), the industry average leveraged beta of 0.76 and Expectcted Risk Premium of 5.69% (using prof. Damodaran blog's data). The cost of equity I computed is 6.14%. Using the 3.75% default spread based on RBI's B+ S&P debt rating, I computed the pre-tax cost of debt as 5.57%. This brought me to my final step -- computing WACC. The market value of Equity is roughly $10B (using Google Finance latest outstanding shares and stock price). As for the market value of Debt, I obtained it from RBI's last 10K report (p.54, under the contractual commitments and obligation section). It is approximately $16 billion. Using the statutory (marginal) tax rate of 26.5%, I arrived at the final number: 4.88%. The graph below shows how I arrived at the present value of future cash flows.
After summing up the all the present value of future cash flows, the enterprise value I computed is roughly $20.7 billion. Subtracting debt and adding back cash, I got the Value of Equity at around $12.4 billion. One thing to note here is that I subtracted the value of option, the logic behind this is that options effectively decrease the owners holding in the company since more equity is given away. Thus, the final value per share I arrived is $50.20, which is roughly the price at which QSR is currently trading.
From the two-way table above, we can see that operating margin has a more significant effect on the value of RBI's share than revenue growth. In an upside case where RBI maintains its operating margin of 20% and grows at a pace roughly in line with industry average, the stock has a 11%-137% upside. In a downside case, which we can hedge by buying protective put option, QSR might drop 5%-30%.
In sum, QSR's potential upside outweighs its downside. However, it is pertinent to factor in the success or failure of Tim Horton's joint venture in Mexico in our valuation. RBI's press releases and its first 10 Q in 2017 might indicate if the company successfully captures the Mexican market.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: This study is conducted primarily on the purpose of practising building models and applying what I've learned from Prof. Damodaran's blog and website to a real-life company. Ever since I arrived in Canada, Tim Hortons has been part of my everyday life and I think, at least in Canada, Tim Hortons possess a brand image, or what Buffet called "moat" that other fast food retailers find hard to surpass.