ROGER’S OCTOBER 15th COLUMN IN RESTAURANT FINANCE MONITOR

Macro-economic Developments cannot be ignored. Back in the day restaurant operators could maintain and even gain market share by attending to activities within their four walls and surrounding neighborhood. Worldwide economic trends, like today’s stagflation, were of small concern, but the times have changed. Household savings, as a percentage of discretionary income just made a new recent low of 3.5% (it was over 30% as Covid hit) and credit card debt hit a new high. Menu prices seem to be up about 8% in the last twelve months, and the latest indication from Chipotle is that their Q4 menu will be up in the mid-teens from Q4’21. Q2 conference call commentary indicated that traffic from lower income ($50-75k) customers has been challenged (“a bit”) but the higher end has been firm. There was minimal exploration of the trading down phenomenon, with much higher household expenses requiring an adjustment in other areas. Each operator must therefore attempt to anticipate which customers are at risk, and replaced by whom?  Higher priced restaurants have a particular problem. Who, for example, is going to trade down to STK (operated very well, with exceptionally attractive ROI and C/C returns, by The One Hospitality Group, STKS), with their average check per person of $114. For investment purposes in this environment, we prefer chains that have the possibility of gaining at least as many customers as they might lose. No matter the position on the price/value spectrum, to whatever extent the dining experience exceeds the grocery cost of that meal, Danny Meyer’s “hospitality” or the STK “vibe” had best justify the diner’s extra expenditure of time and money.

Tim Horton’s in China (THIL) came public on 9/28/22 by way of a $345M SPAC, (now THCH on Nasdaq) and is trading (on 10/12) at about $4.00, down from about $8.00 pre-merger. Units were sold at $10.00 on 1/19/21. The majority owner of THIL is Cartesian Capital Group, co-founder with THIL’s franchisor, Restaurant Brands, Int’l (QSR). The projected $1.3B valuation, at $10.00 was based on comparative growth rates and multiples of sales of peer growth companies, using 2026 as a benchmark year. THIL grew from 34 units at 12/31/20 to 390 system-wide stores at 12/31/21, 490 as of mid-year ’22, aiming for 2,753 locations by the end of 2026, very aggressive but modest relative to the size of the market. Important partnerships are in place, with: oil and convenience store giant-Sinopec, the German METRO hypermarket brand in China, investor in THIL and technology leader- Wumart, technology leader – Tencent Holdings, and China’s largest convenience store chain with 27,800 stores and 190M loyalty club members– Easy Joy. There are three Chinese Tim Horton prototypes: “Flagships” with over 150 sq. meters, “Classics” at 80-150sq. meters, and compact “Tim Go” at 20-80 sq.meters. The “target” AUV is $570k for the Classic and $250k at Tims Go. The target store EBITDA margin is 15-20% at Classics and 20-25% at Tims Go.  As of 12/31/21 there were 30 Flagships, 275 Classics” and 85 Tims Go. THIL has so far generated operating losses, $60M by GAAP measures in calendar ’21, with an Adjusted Corporate EBITDA of negative $14.7M. Adjusted store level EBITDA is expected to increase from 4.5% in ’21 to 9.0% in ’22 to 19.2% by ’26. Adjusted Company EBITDA will grow from a negative $14.7M in ’21 to negative $6.1M in ’22 to positive 15.5M in ’23 to $155.5M by ’26. In 2026, the Company EBITDA margin would be 13.1%, implying Company G&A of 6.1% at that point.  However: only about 100 locations have opened (at an unclear mid-’22 date), so the 343 projected ’22 openings will likely not be met. More important long term: in calendar ’21 (the last reported financials) virtually every expense line was higher than optimal. Marketing was 8%, G&A – 27%, CGS – 33%, Labor – 33%, Rental Expense – 23%, D&A – 12%, Pre-opening -13%, the last two added back to get to Adjusted Store Level EBITDA. Also concerning: Two major investment banking firms, B of A Securities and UBS resigned and/or were terminated as joint placement agents in the course of this transaction. As stated in the proxy material, both were “unwilling to be associated with the disclosure in this proxy/statement/prospectus or the underlying business or financial analysis related to the Business Combination”. We have no desire to play judge or jury in this situation, which is described on pages 89-91 and 115-128 of the proxy material. Though ’22 openings will likely miss estimates, thousands of Tim Horton locations will no doubt open in China, by 2026 and beyond.  There is enough financial muscle affiliated with THCH to open and market reasonably well-placed locations. However, our expectation regarding store level and corporate margins is not so optimistic. As noted above, virtually every expense category is running high, reductions possible to be sure, but to what degree is questionable, considering the very aggressive expansion rate. Important partnerships can provide hundreds, if not thousands, of easily accessible locations, but stores still have to be constructed, employees trained and customers convinced to spend their hard earned RMB at Tim Horton’s. To be sure, the current valuation, currently on the order of $200-300M, is a long way down from the starting valuation (at $10.00 per share) of $1.3B, and is obviously very modest relative to projected Corporate Adjusted EBITDA of $155M in 2026. However, based on what we know, 2026 projected store level Adjusted EBITDA margins of 19.2% and 13.1% at Corporate are a dream. Even if the 19.2% can be approached, only 6.1% of sales is left for G&A, unlikely with ongoing rapid unit growth. There are a lot of very inexpensive restaurant stocks. THCH is worth watching, but there is no rush to own it.