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This morning’s release by Restaurant Brands International relating to initiatives at Tim Horton’s, its now admittedly troubled subsidiary that contributes about half of its corporate EBITDA tells us a lot about the prospects for the RBI over the next few years. The now well publicized lawsuits by the franchisees has obviously gotten the attention of their parent company. RBI management acknowledged today that “some things could have been handled better, but management has changed……in an effort to bolster that relationship….and it’s just going to be a matter of time to prove out that this is a new day, and there’s a very sincere interest in working collaboratively with all the franchisees”.

Recall that Tim Horton’s is the largest contributor to RBI’s cash flow and earnings, and the distribution margins, along with G&A efficiencies at TH have been major contributors to the overall corporate progress. To be precise, thecost of sales” at TH distribution has gone from 99.2% in 2014, on a straight line, to 83.3% in 2015 to 78.0% in 2016, 76.6% in 2017, finally up ticking modestly to 77.9% (up 160 bp YTY) in Q1’18. (Might the franchisee complaints have anything to do with the recent uptick?). At the same time, TH segment G&A went from 4.6% in ’14, to 3.2% in 2015, to 2.6% in 2016 with a modest uptick in calendar ’17 to 2.9%. In just the last two years ending 12/31/17: total corporate adjusted EBITDA, grew $480M, up 28.8%. The Tim Horton segment grew $229M, representing 47.7% of the total increase (up 11.8% in ’16, slowed to 5.9% growth in ’17, and decreased 5.0% in Q1’18). Burger King contributed $143.6M of the two-year increase (29.9% of the corporate total) and Popeye’s contributed $106.9M, all of it in ’17.  The improvement in CGS at TH contributed $122M of that. G&A efficiencies at TH contributed another $5.9M.  So the better distribution margin and G&A “efficiencies” accounted for 127.9M or 55.8% of the two year EBITDA improvement at Tim Horton’s.

The first quarter of Q1’18 showed total corporate adjusted EBITDA up by 12.2% or $54.5M. That included an increase of $27.0M at BK, or 14.4%, a contribution of $38.5M from Popeye’s versus nothing a year earlier, and a decrease of $11.0M at TH with non-recurring adjustments (to be discussed later) flowing through TH’s first quarter results.

The lawsuits will be settled at some point, there may or may not be monetary damages applied to QSR, but that will be one time in nature, easy to overlook by investors. Especially in light of the operating initiatives outlined just today, including delivery, advertising of all day breakfast and a new kids menu, roll out of a new loyalty program, profit margins and EBITDA at TH will be very difficult to improve from the current level and could even come down.

Summarizing the entire situation, RBI management is very smart, but they are not magicians. Popeye’s has a great deal of potential, but corporate efficiencies may be more difficult to employ here, especially considering the history at Tim Horton’s and Popeye’s is too small to move the corporate needle by much. Even though Burger King’s contribution could continue to grow at a 15-20% rate (not without their own set of challenges), TH will be hard pressed to grow from here. There is an increasingly aggressive competitor called Starbucks, Dunkin’ Donuts is not going away and McDonald’s does all day breakfast and all three have a head start against the latest programs at Tim Horton’s. We view QSR as an adequately leveraged (and valued) single digit growth company over the next several years.

Company Overview  

Restaurant Brands International was created in December 2014 from the merger of then Burger King Worldwide (BKW) and Tim Hortons International (THI).  Early in 2017, Popeye’s Louisiana Kitchen was added to the portfolio. Headquartered in Oakville, Ontario, the company is now the operator and franchisor of over 24,000 Burger King (BK), Tim Horton (TH), and Popeye’s (PLKI) brand restaurants generating system-wide sales of over $29B in over 100 countries.  All three brands are virtually 100% franchised and are operated as independent segments from their traditional headquarters (BK in Miami, FL, TH in Oakville, Ontario, and Popeye’s in Atlanta, GA.) to preserve their respective heritages.

BK is the second largest burger chain by locations (after McDonald’s), 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.  In 2017, the system generated a little over $20B in sales from approximately 16,800 units (about 48% in the US).   The principal sources 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 BK locations leased or subleased to franchisees and from sales at 52 company units. QSR does not discuss the development costs of a new Burger King, but the largest franchisee, Carrols Restaurant Group (TAST) does. As described by TAST in their 10K, the initial cost of franchisee fee, equipment, signage & other interior costs is approximately $400,000. Additionally, their cost of land ranges from $500k to 900k and the cost of building and site improvements generally ranges from $850k to 1,025k. Using the midpoint of these numbers, the total development cost would be $2,037,000 – a fairly high total cost for a unit that averages $1.3 million. In spite of a sales/investment ratio (fully capitalized) well below the long accepted 1:1 objective, the Burger King system continues to thrive.  We attribute TAST operating success and BKs continuing unit development to the fact that many units were built years ago (with lower development costs), the long term operating success of the system that attracts build-to-suit development, and of course the very low interest rate environment of the past decade. It is also worth noting that QSR does not indicate how many units are “traditional” versus “non-traditional” such as kiosks, food courts, etc. We suggest that not too many units in the US in particular, are built from the ground up these days, and fewer still will be built if interest rates rise. Of course, in any event, BKs primary expansion will be overseas from this point forward.

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 $6.7B in system-wide sales from about 4,700 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.

Popeyes Louisiana Kitchen, Inc. (PLKI), QSR’s most recently completed acquisition, develops, operates and franchises over 2,700 quick service restaurants with system-wide sales in 2016 of $3.4B in 48 states, D.C., and 25 foreign countries.  Popeyes specializes in strongly flavored Louisiana-style offerings, particularly chicken, but also fried shrimp, red beans and other regional specialties. PLKI is nearly entirely franchised (98% of system’s units).  The US stores averaged about 2.7k square feet with AUV’s of $1.4M in 2016.  US franchisees generated EBITDAR of $340K on average (23% margin).  From 2008 through 2016, comps averaged 3.2% (though slowing in 2016, and further in 2017), which was the major factor in the 4.9% CAGR in the AUV’s and EBITDAR margin expansion of over 500bps (along with new store performance).  In 2016 revenues were $268.9M ($108.3M company stores, $154.8M from franchise royalties & fees, $5.8M rent from franchised restaurants), EBIT at $74.5M (27.7% margin), EBITDA of $84.6 (31.5% margin) with free cash flow of $56.0M (20.8% margin).  Aside from the strong financial track record, QSR said Popeyes leadership position in the chicken QSR category (26.5% market share in 2016, up from 25.5 in 2015) fits well in its brand portfolio.  Also attractive, obviously is the “asset light” highly franchised structure, with further growth potential, especially overseas.

3G Restaurant Brands Holdings LP (3G RBH), with 43.6% voting rights, provides 3G effective control of QSR.  3G is an international activist fund specializing in consumer brands and a frequent partner with Berkshire Hathaway, which provided $3B to finance the TH acquisition in the form of 9% preferred equity, redeemed in late ‘17.  The 3G playbook is to acquire and fix up mature brands (e.g. Anheuser-Busch InBev SA/NV (Euronext Brussels: ABI) and The Kraft Heinz Co (NYSE: KHC), but unlike most activist investors, 3G is a patient investor, with an investment horizon measured in years.  In order to judge QSR’s future, including incorporation of PLKI, it’s worthwhile to understand 3G’s historical initiatives in turning around BK and TH.

Burger King – For at least a decade before 2010, management and franchisees had been in growing conflict over repeated failures to revive the brand. The conflict peaked with a franchisee lawsuit charging management with driving system sales with promotions (specifically $1 Double Cheeseburgers) that were good for royalties but costly for franchisees.  Into this poisonous atmosphere, 3G 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 inserted itself in operations, staffing key executive positions with partners from a deep bench of proven managers from other investments.  It instituted cost controls centered on zero-based budgeting (every budget item must be justified afresh each year).  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 included 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. 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.  Management also attacked overhead bloat, again using the zero-based budgeting which requires justification of both historical and incremental expenses.  The payoff was a reduction in G&A from $356M in 2010 to about $160M by 2015 and 2016. The dramatic reduction in G&A, while improving profitability at the franchisor level, has not been without controversy, however. Some franchisees feel that support has been compromised along with the reduction of expenditures on behalf of the franchise system. The response of the franchisor has predictably been something like “in every large system some franchisees are happier than others, but our priority continues to be the profitability and financial health of every franchisee”.

Additionally, the company accelerated a refranchising initiative that had been under way, becoming virtually 100% franchised by 2013 (from 89% at acquisition in 2010).   Importantly, the 1,200+ refranchised units were placed with the system’s strongest hands, such as Carrol’s Restaurant Group (NASDAQ: TAST), BK’s largest franchisor and an exceptional operator.  As of year-end 2017, only 26 company stores remained, which the company has intended 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.  At the end of 2017, we estimate over 70% 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. They usually pay discounted upfront fees and royalty rates (vs the usual 5% rate) based on the characteristics 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 the company’s operational control over sub-franchisees is weaker than with direct franchisees.  QSR believes it protects against these risks by entering agreements with experienced, well-capitalized partners supported by strong management teams.

So far, results at Burger King have been impressive. The unit growth rate has more than tripled in the 8 years since the acquisition vs the preceding 6 years—from 1.5% CAGR, to 6.5% unit growth in ’17.  (In validation of the MFJV strategy, the international MFJV’s have generated most of BK’s 3,800+ unit growth since acquisition, notably: Brazil >600 in 2017, up from <150 in 2011, China >650 units in 2017, up from <90 in 2012 and Russia >400 units in 2017, up from <90 in 2012.) There has been an increase over six years in AUV’s from $1M to $1.4M and a 30% increase in profitability (according to management).

Tim Hortons  At the time of the December 2014 merger, the TH brand did have its challenges, but overall performance was strong.  In the five 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 Q1’13, 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 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 during 2017, 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 concluded MFJV agreements with partners in Mexico, Great Britain and the Philippines.

The company has focused on G&A which, at $78.9M, was down 15.4% in 2016 over 2015, the first full year of operation under new management, then rose back to $91.0M in 2017.  (The reductions may be more significant when compared with the pre-acquisition G&A levels, > $150M USD, but it isn’t clear this is an apples-to-apples comparison.)  While TH’s capital-intensive supply chain operations seem ripe for management overhaul, nothing on that front has been reported yet.  While management disclosed that though it will be maintaining capital incentives to remodel stores, which it deems an important priority, it seems this is aimed more at the smaller franchisees.  Separately it has announced it will be reducing capital support for new stores, principally the leased and subleased locations.  This shift to a more asset-light corporate structure is consistent with its strategy for seeking out larger, well-capitalized MFJV partners to drive growth.

As of the end of 2017, with only 3 full years of TH ownership under its belt, the results were promising, but have proved to be controversial. This “progress” at the franchisor level has apparently not been shared at the franchisee level, at least as described in a number of lawsuits filed by something like half of the Canadian franchisee base, and US franchisees as well. They claim that, while their sales progress has stalled, QSR has raised the price of supplies and food, contracting franchise margins further. Additionally, the franchisee lawsuit claims that advertising contributions have been “misallocated” somehow to reduce corporate overhead. Since most of the improvement from 2015 through 2017 within the TH operating results came from “distribution” and to some lesser extent G&A efficiencies, the strained relationship with franchisees is obviously a material development. While management may claim that they went through similar “growing pains” after acquiring Burger King, there was not a similar distribution segment, and BK has built sales more successfully than TH, which takes the sting out of higher costs. As strong as MCD has been vs. BK, SBUX is an even more powerful dominant competitor in the coffee segment.

Restaurant Brands International Consolidated On a consolidated basis, QSR’s EBIT in 2016, at $1.666.7M was up about 90% over a pro-forma $875.6M USD for 2014 (i.e. assuming TH was owned the entire year), driving 1,950bps of operating margin expansion to 40.2% from 20.7%. Calendar year 2017 showed a further increase of 4.1% to $1.735M.

As a result of its acquisition strategy, QSR is leveraged at the top of the range for peer “pure play” franchisors. Total net debt at 3/31/17 of $11.4B was about 5.1X adjusted TTM EBITDA of $2.25M versus 4-5X more typically for its franchising peers. The current dividend, yielding 2.86% requires over $500M of the free cash flow and management has allocated C700M over the next four years to help TH franchisees with re-imaging stores.

QSR: Current Developments – Per Q1’18 Corporate Release and Conference Call

“Adjusted Diluted” earnings, on a “New Standard” were $0.66 vs. $0.67 a year earlier, which is the number that seems to be carried by analysts and the reporting services. GAAP earnings, reported on a “Previous Standard” were $0.66 vs $0.36. The difference in “Standards” relate (among other things) to franchise agreement amortization, amortization of deferred financing costs and debt issuance costs, reflection of advertising fund contributions and expenses, supply chain related revenues at TH, and foreign exchange impact. Forgive us for presenting these technical features of the reporting approach, but this is an unusually complex financial structure, obviously requiring these various methods of disclosure.

In any event, the “organic” EBITDA for Q1’18 was up 5.0%, including Popeye’s, driven primarily by an increase in revenues at BK and PLK, partially offset by a decrease in supply chain related revenues at TH. A breakdown of Adjusted EBITDA by Segment is roughly as follows: Tim Horton’s was down 4.3% to $250M, Burger King was up 14.4% to $215M and Popeye’s was up $80% to $40M.  We’ve “mixed and matched” these numbers between the “adjusted New and Previous Standards”, but, in spite of the reporting complexity, we have confidence that the direction and order of magnitude is indicative of the operating trends. More simplistically, comps were down 0.3% at TH, up 3.8% at BK, and up 3.2% at PLK. Systemwide sales growth was up 2.1% at TH, up 11.3% at BK and up 10.9% at PLK.

Per the conference call: Tim Horton’s reported flat sales in Canada and softness in the US. Early in the call, management addressed the tension in the TH franchise system, describing the press as mischaracterizing RBI intentions, citing inaccurate information that “usually reflect a purposely negative tone dictated by a group of dissident franchisees”. Changes have been made in communication strategy, both with the press and the franchisees, which will presumably bear fruit over time. First quarter sales at TH reflected softness in coffee sales, partially offset by breakfast foods. The results of some new lunch products are encouraging.  A new Brand President at TH, Alex Macedo, previously President of Burger King, North America, is leading the effort. A “Winning Together” plan has been put in place, based on restaurant experience, product excellence and brand communications. A new TH restaurant design, called the Welcome Image has been put in place at 10 locations, with an encouraging customer response. Management “admittedly should have done more of this in the past……we are confident that this plan will help us achieve long term sustainable comparable sales growth for TIMs.”

We won’t dwell here on the Burger King discussion. Delivery and technology applications are among the current programs. Suffice to say that results within this segment continue to be fine and the positive prospects are undiminished.

Popeye’s is focusing on delivery and technology as well, and international franchising is a major focus, Brazil being the first master agreement. With EBITDA of $40M in Q1’18 out of close to $500M for RBI in total, substantial improvement within this segment will not affect short to intermediate term overall results in a major way.

The single largest “elephant in the room”, supply chain margins at TH, was addressed when the question was asked relative to the Q1’18 decline at TH in supply chain revenues. Management responded that “we passed on some supply chain savings to our franchisees through a reduction in pricing in the second half of last year. We continued to maintain this pricing for franchisees, so margins in the first quarter of 2018 are relatively consistent sequentially with the margins from the second half of last year. Looking ahead…. we expect the organic growth profile at TIM’s to improve throughout the year.” Maybe.

Our conclusion regarding the prospects for QSR is provided at the beginning of this article.