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RESTAURANT BRANDS (QSR), TEXAS ROADHOUSE (TXRH), BRINKER, INT’L (EAT) REPORT RESULTS — ALL THREE STOCKS ARE DOWN — WHAT’S GOING ON?

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RESTAURANT BRANDS (QSR), TEXAS ROADHOUSE (TXRH), BRINKER INT’L (EAT) REPORT RESULTS — ALL THREE STOCKS ARE DOWN — WHAT’S GOING ON?

Well regarded pure franchising Restaurant Brands, QSR, Best of Breed company operator, Texas Roadhouse, TXRH, mature professionally managed multi-chain company operator/franchisor, Brinker, Int’l.,(EAT) all reported their March quarters within the last 36 hours. What can we learn?

Before we start, because the news is not great and I recently seem to be consistently pessimistic (I would say “realistic”), you should know that I am not “talking my book”. I am neither long nor short two of the three companies discussed, and have a very modest short position in only one of them (which shall go nameless). All three stocks are down since they reported, QSR and EAT more modestly than TXRH, which is down about 10% this morning.

We are not going to provide extensive details, which you can read about elsewhere and which we will discuss in our full writeups to be posted within the next couple of weeks. We will provide just the pertinent highlights as we see them, and our conclusion.

Restaurant Brands (QSR), franchisor of Tim Horton’s, Burger King and Popeye’s, reported EPS down YTY, because of a higher tax rate. Actual Income Before Taxes was up, $302M versus $281M, but it should be noted that Other “Income” this year of $17M was $30M better than Other “Loss” a year ago of $13M. Let’s call it “flat” pretax income, by our simple adjustments. Everybody looks at comps and EBITDA by division here. Tim Horton’s delivered a negative comp of 0.6% in Q1, on top of a negative 0.3% in 2018. Price changes are not discussed relative to any of QSR’s three brands, so we can’t comment on traffic. Adjusted EBITDA at Tim Horton’s was $237M, down from $245M. Burger King had systemwide comps of 2.2% on top of 3.8% in ’18. BK’s Adjusted EBITDA was $222M vs. $214M in ’18. Popeye’s had a comp of 0.6% versus 3.2% in ’18. Adjusted EBITDA was $41M vs. $39M in ’18. The three brands, therefore, had total Adjusted EBITDA of $500M vs $498M a year earlier. Let’s call the results flat, and the bottom line is that, as we have predicted for some time, it will be very difficult to grow the EBITDA and EPS comparisons by more than mid single digits. Combining the “hard” results with the conference call commentary, there is very little happening that will accelerate the cash flow and earnings progress. Readers can refer to our previous commentary regarding QSR, , but, suffice to say: Tim Horton EBITDA growth, which grew from 2015 through 2017 largely by price increases imposed on the distribution chain, is not going to recur, especially in light of the lawsuits by franchisees. Burger King is a steady grower, especially overseas, but the G&A magic has already been imposed on this system so the easy money has been made. Popeye’s is the most rapid growth division, but is too small to move the total needle by much. The dividend of almost 4% supports the stock price, but it has seemed to us for a while that this “mid-single digit” grower is fully priced at 20x trailing EBITDA and 25x forward EPS. It should also be noted that much of the “free cash flow” has been used to buy back partnership interests from their parent, 3G, so this “return to shareholders” has primarily benefited 3G. From 12/31/16 to 12/31/18 the average weighted fully diluted shares outstanding has gone from 470M to 477M to 473M. There is substantial cash flow here, but a great deal of it has been used to buy back exchangeable Partnership interests from 3G. The long term debt was constant at $11.8B in ’18 over ’17 (after $3B was borrowed to buy back Berkshire’s Preferred), and “free cash flow” is not so “free” when debt is over five times trailing EBITDA. The Board of Directors preferred in ’18 to buy back stock from 3G (at 25x expected earnings and 20x trailing EBITDA) rather than reduce the debt. We agree that it seems sensible, from 3G’s standpoint, to lighten up. To be sure, there is a substantial dividend for common shareholders.

Texas Roadhouse (TXRH) is a simpler story. They are truly one of the premier operators in the full service casual dining space, consistently delivering same store sales growth as well as traffic gains. The most recent quarter was no exception, with an admirable comp of 5.2%, including 2.6% traffic. The monthly comps, though decelerating through the quarter were fine, up 7.2%, 4.7%, and 4% in January, Feb., and March. April to date is up 2.9% on top of 8.5% a year earlier. However: Income from Operations was down 6.8%, and diluted EPS was $.70 vs $.76. Restaurant margin (EBITDA) was down 128 bp to 17.9%, and the problem was labor, which cost 118 bp. The discouraging part for investors and analysts is that the Company has predicted ongoing wage pressure, and these guys are not about to disappoint customers by cutting labor.  An additional concern, though a lot smaller, is expected commodity inflation of 1-2% for all of ’19. There’s a lot more that could be detailed here, but the results at TXRH demonstrates what we’ve been saying for a while, that it takes more than even 3-4% comps (and now 5.2%) to leverage the higher costs of operations, labor in particular. We don’t know to what extent the Street will lower expectations for ’19 but at $54.37 at the moment (24.7x ’18 EPS) doesn’t seem like a bargain when it is hard to know when EPS growth will resume. FWIW, $54.37 is 14.5x Bloomberg’s estimate of TTM EBITDA.

Brinker International (EAT) reported Q3 (ending March) with somewhat of a “mixed bag”. The headline indicated that EPS, excluding special items, was up 16.7% to $1.26 vs $1.08. Comp sales for Chili’s was up 2.9% (company) and 2.0% (franchised). Maggiano’s was up 0.4%. Operating Income was 8.4% of Revenues, down 50 bp from 8.9%. Restaurant margin (EBITDA) was 14.3%, down from 16.1% but, excluding the effect of a sale-leaseback transaction, would have been flat YTY. (However, the higher rent is a cash charge vs. depreciation which is non-cash, so the true cash EBITDA margin was truly 180 bp lower). Chili’s results are the main driver of results, and, aside from the sale-leaseback penalty, it was pointed out that: “cost of sales increased due to unfavorable  menu mix, and commodity pricing, partially offset by menu pricing, also partially offset by a decrease in restaurant labor from lower incentive compensation, which in turn was partially offset by higher wages.” So: CGS was up, wages were up, restaurant labor (hours?) was down, and there was less incentive compensation. That doesn’t sound like the industry wide wage increase is abating, and commodity costs are up, which we also heard at Texas Roadhouse. While it is admirable that comps were up again at Chili’s, with traffic up as well, it should be noted that the gain in after tax EPS was entirely due to a lower tax rate and far fewer shares outstanding. Income Before Taxes was $55.5M, down from $58.9M. Adjusted for an Other Gain of $3.5M this year versus a $2.7M loss, the comparison would be $52.0M of Adjusted Pretax Operating Income vs. $61.6M. The number of fully diluted shares was 38.1M vs. 46.0M. From a financial engineering standpoint, EAT chose to do a sale-leaseback transaction, paying higher “rent” vs. non-cash depreciation of the stores in return for retiring a large number of shares. From an operating standpoint, even with flat EBITDA at the store level, we see that same store sales (and traffic) gains of 2 or 3% are not sufficient to overcome higher labor (and other) expenses.

The Bottom Line:

The above capsulized reports show that the operating challenges have not abated, and will not likely relent in the foreseeable future. Restaurant Brands’ results show how ten years of low interest rates have allowed financially astute executives to assemble a portfolio of franchised brands, but mature (Tim Horton’s and Burger King) chains can only be financially engineered to a certain point, especially in a difficult environment. Texas Roadhouse and Brinker results show how operators ranging from a Best of Breed growth company  to relatively mature brands are similarly challenged.

Broader than the Restaurant Industry: There are something like 20M individuals employed in the hospitality industries, including restaurants, retail and lodging and this is a material portion of the entire US workforce. The wage increases that are so evident to us will inevitably start to affect the national averages, and the next step will be price increases. Operators of restaurants and retail stores and lodging will not allow their margins to deteriorate indefinitely. All those surcharges such as baggage fees at airlines, “facility” charges at hotels, and miscellaneous add-ons with car rentals (that add 25-30% to the quote), will increasingly be joined by higher menu prices. It’s not a question of “if”, rather “when”.

Roger Lipton

 

RESTAURANT BRANDS-(QSR)-WEAKENS AFTER KRAFT HEINZ (KHC) DISAPPOINTS-WHY?

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RESTAURANT BRANDS  (QSR) WEAKENS AFTER KRAFT HEINZ (KHC) DISAPPOINTS – WHY?

It is not a coincidence that QSR stock was uncharacteristically weak, in a strong market, on Friday, as Kraft Heinz (KHC) was “taken out and shot”, down 25% on the day.

Both KHC and QSR are heavily owned by 3G, a Brazilian based holding company. It should be noted that Warren Buffet’s Berkshire Hathaway owns 22% of KHC, with a much smaller (3.3%) holding of QSR. Berkshire cashed out $3 billion of preferred stock in QSR a little over a year ago.

An extensive article in the weekend edition of the Wall Street Journal described how 3G “became the standard bearer for zero-base budgeting (ZBB), the accounting practice invented in the 1960s that 3G perfected and popularized, first with its acquisitions of Brazilian beer companies, and then globally. It requires justifying every expense each year, no matter how small, rather than using the prior year’s budget as a starting point”.

Quoting 3G co-founder, Jorge Paulo Lemann, the WSJ reported: “I’m a terrified dinosaur. I’ve been living in this cozy world of old brands and big volumes. You could just focus on being very efficient and you’d be OK.  All of a sudden we are being disrupted in all ways. We bought brands and we thought they would last forever. Now, we have to totally adjust to new demands from clients”.

The WSJ followed Lemann’s comments by saying: “The results are exposing the limits of 3G’s hyperfocus on a financial strategy to manage the companies, while not putting enough toward marketing, research and development.”

Relative to Restaurant Brands:

Later in the same article: “3G shook up the restaurant industry with the purchase of Burger King in 2010, followed by acquisitions of Tim Hortons and Popeyes. Cost cuts led to higher margins, and RBI stock price soared. Restaurant Brands wasn’t keeping up with change to the industry and consumer tastes, said Jeremy Scott, an analyst with Mizuho Securities, USA. Competitors such as McDonald’s, Starbucks, and Panera moved to remodel their restaurants, adopt technologies including self-service kiosks and emphasize fresh ingredients. The firm was forced to pour money last year into restaurant remodeling, introducing new espresso drinks (at Tim Horton’s) and simplifying menus. It is also modernizing Popeye’s cash registers to more easily track what customers are buying.”

Duncan Fulton, chief corporate officer for RBI (QSR) said the company is not only focused on cost-cutting but has invested to grow the number of restaurants at its chains.”

WSJ continued: “It’s preferred measure of profitability, adjusted earnings before interest, taxes, D&A, grew 2.6% in the fourth quarter of 2018, the slowest growth the company has reported since BK’s merger with TH. Mizuho’s Mr. Scott said he expects the high spending to continue for another two years as RBI races to catch up, putting pressure on profits.”

OUR READ:

We have written extensively over the last year or so (you can use the “Search” function on our Home Page) about the slowdown in earnings and EBITDA growth at QSR. The largest contributor to overall corporate EBITDA growth, from 2015-2017, was the improvement at Tim Horton’s. This was not only the result of ZBB inspired cost cutting, but price increases of supplies sold to the TH system, which has resulted in major lawsuits from the franchise community. We have predicted that the lawsuits will be settled, but the tactics are history not to be repeated.  The cost cutting referred to above no doubt also took place at Burger King, Tim Horton’s in turn, and have already been implemented at the most recently acquired Popeye’s. The unit growth is real, especially at Burger King and Popeye’s, less so at Tim Horton’s, but the “catchup” in systemwide support will absorb most of the increased royalties, and the “magic” at TH is no longer. We believe Mizuho’s Jeremy Scott is correct in his analysis.

Furthermore: as we have pointed out in the past, a great deal of QSR’s free cash flow (about $900M over the last two years) has been paid out to 41% owner, 3G, buying back stock at about 19x trailing “adjusted” EBITDA and over 20x forward earnings per share, hardly a bargain price. Obviously, the Board of Directors, with all but two members categorized as independent, thought a $550M stock buyback in ’18 was more important than reducing debt.  The debt, net of cash, of $11 billion was unchanged in the last twelve months, in spite of $2B of “adjusted EBITDA”.

One final, call it “cautionary”, note. Perhaps an analyst with more legal background than our own, familiar with governance standards in Canada (where QSR is domiciled), can explain why 3G’s ownership is in the form of “Partnership Exchangeable Units”. There must be an advantage for 3G, unlikely to help common shareholders, or this structure wouldn’t be in place. Whether this issue is material or not, full transparency is always a positive. As Ronald Reagan put it: “TBV”  😊

Roger Lipton

RESTAURANT BRANDS REPORTS Q4 – BEATS BY $.01 “ADJUSTED” – THE DEVIL IS IN THE DETAILS

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RESTAURANT BRANDS REPORTS FOURTH QUARTER RESULTS – BEATS BY $.01 “ADJUSTED” – THE DEVIL IS IN THE DETAILS

CONCLUSION:

Restaurant Brands is here to stay (not surprisingly), but the operating details of this situation reflect a great deal of financial engineering rather than predictable, above average,  long term operating progress. The unit growth at Burger King will continue, but the profitability “levers” are largely played out. Tim Horton’s has serious franchisee tension still to be dealt with, and we are sure that peace will be made. However, the improvement in franchisor margins at Horton’s, (which the franchisees claim was largely at their expense) will not be duplicated. Popeye’s is no doubt the best growth vehicle within this brand portfolio, but their scale is not large enough to move the overall corporate profitability or cash flow by much. The bottom line is that the earnings and cash flow of this situation are unlikely to grow by more than mid single digits in the near future, having grown by even less than that in calendar ’18. The cash generation may well be used to reduce the $11B of net debt, but that hasn’t been the case in the last two years.  The dividend, yielding 3.2% currently, is secure, but the stock is no bargain at 23x ’19 earnings, and about 20x trailing EBITDA.

THE RESULTS:

Restaurant Brands (QSR), one of the highest visibility “asset light”, “free cash flow” multi-brand franchisors, with Tim Horton’s, Burger King, and Popeye’s, and they reported their ’18 yearend result this morning. We have written many times on this situation, which readers can access through the “Search” function on our home page. With that background, the highlights of the fourth quarter report follow. Readers should know that the fourth quarter sales were reported in mid-January, and QSR ran up about 10%, from $57 to $63 on something of a relief rally. Today’s report filled in the accompanying profit numbers.

Refreshing our memory of the comps, Tim Horton’s had Q4 and calendar ’18 comps of 1.9% and 0.6% respectively. Burger King had comps of 1.7% and 2.0% respectively. Popeye’s had comps of 0.2% and 1.6% respectively.  Traffic has not been described but can be assumed to be two or three points less than the same store sales.

Unit growth was better. Tim Horton’s net unit growth was 2.1% and 2.1% respectively. Burger King was 6.1% and 6.1%, Popeye’s was 7.3% and 7.3%.

The reported GAAP (remember General Accepted Accounting Principles?) earnings per share are a bit confusing because of a change in accounting “Standards”. In Q4, Diluted EPS was $0.64 (New Standard) and $0.68 (Previous Standard) vs. $1.59 (Previous). The twelve months were $2.42 (New) and $2.49 (Previous) vs $2.54 (Previous). Setting aside the Q4 quarterly adjusted large fluctuation, the year, on a GAAP basis was down, on either standard.

Investors are very interested these days in EBITDA, so that was provided, by segment, on an “adjusted” basis, and adjusted EPS was provided as well.

Tim Horton’s had adjusted EBITDA, in Q4 of $297M (New Standard) and $295M (Previous Standard) vs. $304M (Previous). That’s down. For the year, TH had segment EBITDA of $1,127M (New) and $1,128 (Previous) vs $1,136M (Previous). That’s down. Burger King, in Q4 had adjusted EBITDA of $247M (New) and $265M (Previous) vs $265M (Previous). That’s flat to down. For the year, BK had $928M (New) and $950M (Previous) vs $903M (Previous). That’s up 2.7% and 5.2% respectively. Popeye’s, for Q4, had adjusted EBITDA of $37M (New) and $42M (Previous) vs. $37M (Previous). That’s flat to down. For the year, Popeye’s had adjusted EBITDA of $157M (New) and $169M (Previous) vs. $107M (Previous). That’s up sharply, 47-58%, but we will come back to this, in the next paragraph. Adding up the segment EBITDA, total Q4 was $581 (New) and $602M (Previous) vs. $606M (Previous). That’s down. Total calendar adjusted EBITDA was $2,212M (New) and $2,247 (Previous) vs $2,146 (Previous). That’s up 3.0-4.7%.

However, in a note following the segment breakdown, the company says “since RBI’s consolidated results include Popeye’s starting in Q2 of 2017 (post acquisition), RBI’s consolidated year over year results…are favorably impacted by the inclusion of a full year of Popeye’s in 2018 and only a partial year in 2017.”

While we cannot know what Popeye’s organic annual change in EBITDA was, it seems reasonable that an “adjustment” to the $50-$62M apparent increase in PLKI’s annual EBITDA would have largely wiped out the increase in adjusted EBITDA for the company as a whole.

It’s possible that our interpretation of the above is misguided, but, at best, QSR’s EBITDA is growing year to year at a very modest rate. If we are right, it is growing hardly at all.

Moving on, net unit growth is steady, most importantly at Burger King, their most well established worldwide brand, with 17,796 locations, up 6.1% in ‘18. Popeye’s is growing nicely, up 7.3% on a smaller base of 3,102 units. Tim Horton’s continues to grow, at a 2.1% rate in ‘18, on a base 4,846 restaurants, in spite of the well publicized franchisee unrest. Clearly, unit growth, internationally in particular, is the largest opportunity for improved profitability and cash flow. The potential for growth at Tim Horton’s in China was emphasized, with an objective of 1,500 units over ten years, the growth led by an affiliate of QSR. Ongoing growth in Brazil is also predictable, also led by a QSR affiliate, in this case publicly traded in Brazil. The same Brazilian affiliate is leading the growth there of Popeye’s.

The conference call consisted of the Company reiterating their dedication to building profitable sales for each of their franchise systems. Analysts questioned management about the unit level profitability, and the company continues to claim that franchisee profitability improved in ’18 vs. ’17. Various questioners seemed skeptical, citing wage increases as a continuing burden. Since comp sales are up 2.0% at best, and traffic (while not disclosed) is likely down, virtually every publicly held company has reported that profit margins are suffering under these conditions and it is unclear why Burger King, Tim Horton’s or Popeye’s would be an exception.

The Company adhered closely to their mantra of building top line sales for each of their franchise systems, which truly does solve all other issues. As referenced above, while one could question their assertion of improved franchise profitability, we can’t doubt the Company dedication to improved future sales. Loyalty programs, digital ordering, renovations, and other operating initiatives are important elements in maintaining market share, at the very least, and hopefully building it.

In terms of “capital allocation”, reference was made to ongoing “delevering” of the balance sheet. This is an important objective since net debt is 5.1x the adjusted EBITDA of 2.1B. However, the free cash flow of $1.1B was a lot less, after dividends and $550M of repurchased exchange units from their 3G affiliate. Furthermore, there has yet to be any “delevering”, since net debt is still $11.8B, virtually unchanged from a year earlier, still at a year end high after calendar ’17 capital allocations to dividends, another $500M plus repurchase from 3G, and redeeming Warren Buffet’s $3B of preferred stock.

CONCLUSION: Provided at the beginning of this article

Roger Lipton

ASSET LIGHT FRANCHISING – COMPLAINTS FROM FRANCHISEES – LET’S CLEAR THE AIR!!

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ASSET LIGHT FRANCHISING – COMPLAINTS FROM FRANCHISEES – LET’S CLEAR THE AIR!!

The long term investment appeal of well established franchising companies is accepted by the investment community. Most of the prominent franchisors’ equities sell at price to trailing twelve month EBITDA multiples in the mid to high teens (Denny’s (DENN), Dine Brands (DIN), Dunkin’ Brands (DNKN), Pollo Loco (LOCO), McDonald’s (MCD), Restaurant Brands (QSR), Wendy’s (WEN), even higher in a couple of instances Domino’s (DPZ), Shake Shack (SHAK), Wingstop (WING), lower in a number of “challenged” situations like Jack in the Box (JACK), Red Robin (RRGB), Brinker (EAT), Fiesta Rest. (FRGI).

The attraction of asset light franchisors revolves around the presumably free cash flow for franchisors, a steady stream of royalty income unburdened by capital expenditures to build stores. The operating leverage is at the store level.  Franchisees are responsible for building the stores, then controlling food costs, labor, rent and all the other operating line items. Franchisors receive the royalty stream and have the obligation of supporting the system with brand development, site selection advice, marketing support, and operating supervision. These supporting functions, it should be noted, are optional to a degree, and we have written extensively about system support sometimes being short changed by corporate priorities such as major stock buybacks.

THE CURRENT WORD, IN THE FIELD, AS WE HEAR IT

We acknowledge that in every franchise system there will be some operators less satisfied than others. In the same way, customer reviews on Yelp or Facebook are more frequently written by critics. Bad news is more noteworthy and more customers are inclined to criticize than applaud, so we have to listen to the complaints but dig further for the reality. With that in mind, we hear the following from franchisees of various restaurant systems:

“I’ve been in this business for thirty years, and I’ve never seen it this bad. Everyone is making money but me; the landlords, the franchisor, the banks. My margins have been killed, and I’m up against my lending convenants”.

“All the franchisors want to do is build sales to build their royalties. The dollar deals are trading people down. My franchisor doesn’t care about my margins. I can’t maintain my margins, especially with the increasing cost of labor, let alone build it”.

“The franchisor is putting pressure on me to sell, even though I’ve always been considered a good operator, with high performance scores. I’m up to date on my development agreement, but they want somebody else to take me out, and the new buyer will agree to what I consider to be a ridiculously aggressive development contract”.

“The franchisor has replaced experienced long term field support with lower priced (and inexperienced) younger people. They’re cutting corporate overhead, but these kids, who never ran a store, are telling me to how to control costs.””

“I’m doing my best with the development objectives, but it is almost impossible to build stores with today’s economics. Rents are too high, labor costs are killing me, and I can’t raise prices in this promotional environment”.

“As if things aren’t tough enough, I’m being nickeled and dimed with demand for higher advertising contributions and fees on services (including software) that I thought would be provided”.

The valuations provided to the publicly held companies do not reflect the situation as described by the admittedly anonymous franchisees. The commentators quoted above don’t want to aggravate their franchisor, and we don’t want to be unfair or misleading to particular companies by relying on just a few conversations, though they do support one another. For the most part, franchisees are strongly discouraged from talking to the press or investment community. The companies will say that “competitive” issues require some secrecy, but there are few secrets in this industry.

The optimistic view, as represented by the valuations in the marketplace, is that the comments above are not typical or representative of the health of the subject franchise systems. Allow me to provide a short story which leads to a suggestion.

A SHORT STORY

Twenty six years ago, in 1992, IHOP had just come public. I was a sell side analyst, thought the numbers were interesting and the stock was reasonably priced. The company, led by the now deceased CEO Kim Herzer, invited me to attend their franchisee convention, which I did. I obviously had the opportunity to interface with many franchisees and it was clear that, while all was not perfect, the franchisor was providing a great deal of support that was embraced by an enthusiastic franchise community. IHOP stock tripled over several years for me and my clients who owned millions of shares. I attended several more of their annual conventions and maintain some of those relationships to this day. Obviously, the conviction I gained from their open attitude was critical to the success of the investment. I should add, that many of those buyers in 1992 owned the stock for many years, not living and dying on quarterly reports.

THE SUGGESTION

As you are no doubt by now anticipating, my suggestion to publicly held franchising companies: open up your franchisee conventions to the investment community. The companies may quickly respond that lenders are already invited to franchise conventions, but franchisees are unlikely to express their system oriented concerns when they are making a pitch to a potential lender. Companies may also respond that their lawyers think it would be a bad idea, not consistent with full disclosure and analysts would be getting “inside information”. Let’s not allow the lawyers to provide “cover”. A good lawyer will provide a solution to the problem, not just provide the pitfalls. Analysts attending a franchise convention are not being told what sales or profits are going to be. Attending a franchise convention is  a “channel check”, no more than talking to a supplier or customer of a manufacturing company, which any decent analyst will do.

The anecdotal critical comments, as described above, have likely been heard by others, but may be atypical of most restaurant franchising companies. There are no secrets in this business. One of the investment appeals of this industry is its transparency. Notable news is going to leak out anyway. The objective of any publicly held company is to build stock ownership by well informed investors. Investment analysts pride themselves on their ability to “build a mosaic”, enhance the information provided in quarterly reports, SEC filings, and conference calls, with “channel checks”. What channel check would be more pertinent than meeting the franchisees of a company that is dependent on franchisee success? Putting it another way, and taking the highest valuation relative to EBITDA as an example: Wingstop (WING) is a company I have the highest regard for. However, you could call it irresponsible to pay almost fifty times trailing EBITDA for Wingstop stock (and I haven’t) if I couldn’t talk to franchisees of my own choosing?

There’s no particular need to invite this writer if I’m not considered influential enough. I have not spoken to these analysts on this subject, but qualified industry followers such as David Palmer, Nicole Reagan, Matt DiFrisco, David Tarantino, Jeff Bernstein, Andy Barish, Bob Derrington, Mark Kalinowski, Michal Halen, Gary Occhiogrosso, Howard Penney, Jonathan Maze, Nicholas Upton, John Hamburger and John Gordon provide the beginning of an invitation list.  I rest my case.

Roger Lipton

BILL ACKMAN, WITH 41% OF ASSETS IN QSR, CMG AND SBUX COMBINED, IS STILL NOT WELL POSITIONED

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BILL ACKMAN, WITH 41% OF ASSETS IN QSR, CMG & SBUX COMBINED, IS STILL NOT WELL POSITIONED

We wrote an article on October 11th, discussing the three major positions in Bill Ackman’s Pershing Square Capital portfolio, within our knowledge base, that comprise a massive 41% of his $8.3 billion portfolio.

At the close of business, October 11th, Restaurant Brands (QSR) was $56.26, Chipotle (CMG) was $434.06, and Starbucks (SBUX) was $54.87. Our conclusion on October 11th was that he should switch his QSR immediately into McDonald’s (then at $163.98), sell his CMG to take advantage of the huge move since new management has been installed, and hold his SBUX (which has moved up nicely).

We have no reason to think that he has made any moves in the last several weeks, but Restaurant Brands, McDonald’s and Chipotle have all reported third quarter results. Starbucks reports tonight.

From the close of business October 11th to last night’s closing price, Restaurant Brands, at 53.06 was down 5.7%, or $85M on the $1.5B position. McDonald’s, at $178.42 was up 8.8%, so would have made Ackman’s Pershing Square Capital a profit of $132M. Chipotle closed at $465 so Ackman would have foregone a profit of 7.1% or $63M on his $900M investment.

Our advice, less than three weeks ago, to Ackman can definitely be considered “theoretical” in terms of the practical ability to switch $1.5B positions instantly, or sell $900M worth of Chipotle on the spur of the moment, and Ackman’s positions are established on the basis of long term prospects. Acknowledging that three weeks doesn’t “make a season” or prove a thesis, Ackman’s portfolio would be ($132M+85M-$63M) a cool $154M better off, or 4.5% of the $3.4B in these three positions, especially costly when all hedge fund managers are fighting for every basis point in a difficult market environment.

Our points here are (1) too many multi-billion hedge funds, and other institutions are playing hunches rather than making well informed long term judgements. This is a function of not enough really attractive reward/risk investment propositions when trillions of dollars of capital are competing to generate “alpha” after nine years of a bull market (2) there is too much emphasis on short term performance, trying to “game” the monthly comps for example,  rather than evaluate long term strategic positioning (3) in too many cases, the self confidence of multi-billion dollar money managers is unjustified. They are very smart, hard working, in many cases have become very rich (which breeds inflated egos), and can’t be expected to know as much they should about every industry. Rather than make Bill Ackman an undeserved particular example: Eddie Lampert, still a billionaire, had no chance whatsoever to turn around Sears based on his strategies, and there were lots of highly experienced retailers that could have told him so. It has taken ten years to play out, but it was clear to many of us years ago that the brilliant and successful Lampert was wasting enormous time and money on Sears.

If we were speaking with Ackman today, we would suggest that it’s not too late to adjust the portfolio. The last three weeks are history.  Let’s see what happens over the longer term.

Roger Lipton

RESTAURANT BRANDS (QSR) REPORTS Q2 – LACKLUSTER QUARTER – OUR TAKE

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RESTAURANT BRANDS (QSR) REPORTS Q2 – LACKLUSTER QUARTER – OUR TAKE

Restaurant Brands reported Q2 earnings this morning and disappointed the investment community, primarily because of softer sales (by a couple of points) at Burger King than expected and EBITDA comparisons that were anywhere from flat to up 6%, depending on the “standard” employed. The stock was trading down several percent as the conference call was being conducted, recovering to be down just slightly at the opening.

In summary: Comp sales at TH were flat, BK was up 1.8%, Popeye’s was up 2.9%. Net restaurant growth was up 3.0%, 6.4% and 7.5% respectively.  There are two “standards” of reporting here, as discussed below. On the “new” versus “previous” standard, Adjusted EBITDA was down 1.1%, up 1.8% and down 5.4% respectively. Total Adjusted EBITA, Net Income, and Adjusted Diluted Earnings Per Share were virtually flat YTY. On the “previous” standard versus “previous”, Adjusted EBITDA was up 2.7%, up 7.0%, up 28.0% respectively, up 6.0% overall. We discuss the differences further below.

 The Conference Call:

Management, CEO Daniel Schwartz, started off the call by saying that “we plan to provide more details than we historically have on initiatives across each of our brands”.

There was, predictably, substantial discussion by management about the continued growth at Burger King, the effort to generate renewed growth at Tim Horton’s as a result of the “Winning Together” program, and worldwide expansion of the Popeye’s brand.  There was major emphasis on the improved communication with the Tim Horton’s franchise community. Over 1/3 of the franchise network have agreed to renovate their stores in ’18 and ’19, with QSR helping to finance that investment.  Supply chain margins at Tim Horton’s improved from Q1 to Q2, as a result of seasonal sales influences. Management indicated that profits and EBITDA at Tim Horton’s should improve in the second half as the price adjustments in the supply chain, and the introduction of Espresso (when equipment was sold to franchisees), about a year ago are lapped.

We have no doubt that a major effort is being made to repair the relationship with the TH franchise community. Peace will be made, because it will be in everyone’s interest, but the profit growth in the supply chain in the future will be far less than in the past.

In terms of management’s guidance for overall future growth of profits and EBITDA, management declined to provide an objective, maintaining that their objective is unit growth, sales growth, and profit growth at each brand.

The question was asked about menu price increases, but management declined to quantify that. Menu prices have obviously been increased, so traffic would be something like a couple of points less than the comps indicate.

When asked about the profitability at the franchisee level, management declined to be specific but said that profitability is up at all three brands.

When asked about the TH performance, country by country, management talked about softness in the US (being countered by renovations, etc.), differences by each market, and long term optimism about each, but nothing more specific.

In reference to supply chain margin at Horton’s, and the $100M capex there over ’18 and mostly ’19, management said that the current structure is good, and should be more efficient in the future with new distribution centers in Alberta and BC. Management declined to provide specific objectives in terms of improved profitability, for franchisees or QSR.

TWO STANDARDS OF REPORTING

It has to do with revenue recognition, as described in the following note from the first quarter’s 10Q filing:

 Note 4. Revenue Recognition

Revenue from Contracts with Customers

We transitioned to FASB Accounting Standards Codification (“ASC”) Topic 606, Revenue From Contracts with Customers(“ASC 606”), from ASC Topic 605,Revenue Recognition and ASC Subtopic 952-605, Franchisors – Revenue Recognition(together, the “Previous Standards”) on January 1, 2018 using the modified retrospective transition method. Our Financial Statements reflect the application of ASC 606 guidance beginning in 2018, while our consolidated financial statements for prior periods were prepared under the guidance of Previous Standards. The$249.8 million cumulative effect of our transition to ASC 606 is reflected as an adjustment to January 1, 2018 Shareholders’ equity.

Our transition to ASC 606 represents a change in accounting principle. ASC 606 eliminates industry-specific guidance and provides a single revenue recognition model for recognizing revenue from contracts with customers. The core principle of ASC 606 is that a reporting entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the reporting entity expects to be entitled for the exchange of those goods or services.

There are a lot of complexities these days relative to accounting treatment, and many companies are reporting all kind of “adjusted” results. Our comments here could be considered cynical, but we don’t see other franchising companies changing their “standard”, reporting both ways, and the net effect here of the “New Standard” was A REDUCTION OF SHAREHOLDER’S EQUITY OF $249.8 MILLION ON 12/31/17. As analysts would say, there are a lot of “puts and takes”, but the bottom line is that shareholder’s equity is materially less than had been reported.

 Conclusion:

Restaurant Brands, International (QSR) is a strong company, to be admired from many standpoints. We stand by our previous discussions which have pointed out that the financial engineering of the past will not be possible in the future. The company is already levered up pretty fully, though they could be tempted by the availability of Papa John’s.  The reduction of G&A at Burger King, and especially at Tim Horton’s, combined with the supply chain “efficiencies” (price increases to franchisees) will not be possible going forward. The growth rate of profits and EBITDA will obviously be lower in the next several years than has been produced in the past.

RESTAURANT BRANDS – THE BULL VS. BEAR CASE – THE LAWYERS GO TO WORK!

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RESTAURANT BRANDS, INC. – (QSR) – THREE WELL KNOWN BRANDS, THE LAWYERS GO TO WORK!

WE PRESENT BOTH THE BULL AND THE BEAR CASES

BACKGROUND

Restaurant Brands, Inc. (QSR) – is a relatively “pure” franchising companies, owning three well known brands, Burger King, Tim Horton’s, and recently purchased Popeye’s Louisiana Kitchen. The largest cash flow generator (55% of total EBITDA) in the last twelve months has been Tim Horton’s, a 75 year old Canadian based brand named after the legendary hockey player. Burger King generated the balance, since Popeye’s was acquired at the very end of Q1’17. As of 3/31/17 there were 4,644 systemwide TH units (up 4.6% YTY), 15,768 BK locations (up 5.1% YTY) and 2,743 PLK stores (up 5.8% YTY). All three chains are virtually 100% franchised.

We published a rather full description of QSR at www.rogerlipton.com in April, which we suggest you peruse, though we did not update the writeup to reflect Q1’17 results.  We deal here with the implications of the recently filed Tim Horton’s franchisee class action lawsuit, as it may affect future growth in earnings, cash flow, and the valuation of QSR. This is especially so since TH generates 55% of trailing twelve month EBITDA for the Company as a whole.  Suffice to say, regarding Q1’17, that results were “in line”, sales trends were sluggish again, just as in Q4’16 (and reflecting industry wide trends), unit growth was steady, the company was enthusiastic about growing the Popeye’s footprint on a worldwide basis, and improving the operating margins at PLK as they had done at BK and TH. An accelerated pace of pace of expansion at PLK is also expected to improve the overall net unit growth for QSR. However, “Business as usual”, as described during Q`17 may become a footnote, as further details and eventual “disposition” of the TH franchisee litigation takes place.

Over the last two years, the Company has gained credibility not only by the strong operating results, largely driven by improved operating margins at TH, but from Berkshire Hathaway’s purchase of $3 billion of a 9% Preferred stock (with warrants attached to buy about 3.5% of QSR for $.01/share) which helped finance the Tim Horton’s acquisition. Other major shareholders are 3G Capital, the Brazilian private equity firm that purchased Burger King in 2010, which still controls 42.5% of the shareholder vote through “Partnership Exchangeable Units” as well as Berkshire’s 12.9% voting rights, and William Ackman’s Pershing Square Funds with 43M shares representing 18.3% of the common shares and 8.4% of the vote. Ackman’s interest derives mostly from the public vehicle he helped create that purchased Burger King from 3G Capital, as well as 1 million open market shares purchased in early 2016.

Based on the operating record of 3G and then QSR, the investment attractiveness of “asset light” free cash flow generating franchise companies, and perhaps the “affiliation” with Warren Buffet, QSR has attained an enviable valuation. There are currently nineteen sell side restaurant analysts that cover the stock, according to Bloomberg. Eleven currently rank QSR a BUY, eight say HOLD, none say SELL. Target prices for the analysts that say buy range from $60 to $70/share.

THE DEBATE BEGINS!

THE BULL CASE

On June 14, 2017, Oppenheimer & Co, Inc.’s restaurant analyst upgraded QSR to “Outperform”, with a $70.00 price target. The key points cited were:

  • EPS upside from consensus ’18 estimates ($2.70 vs. $2.42 consensus) largely based on redemption of the Berkshire 9% Preferred. No operational improvement is assumed.
  • Accelerated growth, and improved margins at Popeye’s, maintaining and perhaps improving the overall growth in earnings and cash flow for QSR.
  • Possibility of same store sales improvement at all three brands, vs. current industry malaise.
  • Free Cash Flow Yield of 5.5% based on ’18 estimates, vs. peers at 4.5%.
  • P/E multiple of 21x based on new above consensus $2.72. The price target of $70. Is based on a 4.5% FCF yield and 26x P/E, modestly higher than peers, slightly lower than QSR’s history.

In summary, this latest upgrade reflects the assumption that the historical success of management in improving margins at Burger King, and most recently Tim Horton’s will continue, and be augmented by similar success at Popeye’s.

THE BEAR CASE

One June 2, Grant’s Interest Rate Observer, provided a “bearish analysis” (their term) on QSR common stock. The quotes are as stated by Grant. We have not confirmed every number, but have spot checked to confirm that they are at least generally correct. The key points cited were:

  • After paying top dollar for BK, TH, and PLKI, QSR is highly leveraged with debts of $12 Billion, representing 6.1 times trailing pro forma EBITDA.
  • TH (representing 55% of QSR’s total EBITDA) generates revenues from franchisees in the form of royalties (3-5% of sales), rents (as high as 10% of store sales), and, most concerning at this juncture, a markup on sales of food, paper, and other consumable supplies.
  • Grant spoke to TH franchisees that claimed prices had been raised substantially on required purchases from TH parent. In fact, over the 24 months from Q1’15 to Q1’17, margins on those sales increased from 13.3% to 23.7%. For the five years under previous ownership, gross margins on those sales ranged between 11.9% and 14%.
  • Franchisees further complained that the required 3.5% contribution to the national marketing fund had been used by TH parent for “non-marketing endeavors” contending that the company is “misdirecting advertising funds”. Grant’s points out that G&A expense at TH, after declining in 2016, rose in Q1’17 to $25.1M, up from $16.2M in Q1’16, “after franchises started raising issues with the advertising fund”. FYI, Total G&A for TH during calendar 2016 declined to $78.9M from $93.2M in ’15.
  • TH franchisees complained to Grant’s that TH inspections have become unnecessarily harsh and provide a pressure to report profit margins that are inflated. As Grant’s writer Lorenz relates: “Three franchisees tell me that RBI rejects P&L statements if profit margins are too low. 129 TH franchisees responded to an anonymous online survey in Alberta. They reported an average 6.29% operating margin, roughly half the 13-14% margin that the company claims that franchisees earn company-wide.”
  • Grant’s points out that the low tax rate of 2016, at 20.3%, as a result of QSR’s Canadian domicile, is cited as a “risk factor” in the annual 10-K report, saying that ‘Future changes in U.S and non U.S. tax laws could materially affect the Company’. Grant’s implication, obviously, is that the tax rate is more likely to go up than down.
  • Franchisees told Grant’s that the “Great White North” franchisee group has engaged a Toronto law firm to represent a case they were building against QSR.
  • Grant’s related that “the recruiting site, Glassdoor.com had 31 reviews from Restaurant Brand (QSR) employees that gives the Company 1.8 out of a possible five starts. ‘RBI has cut costs to the bone by getting rid of all the professionals…..and hiring kids’ says a comment dated March 24. ‘Turnover rate is at nearly 50%….there is no meritocracy and process goes out the window. Decisions are made by a couple of key decision makers usually based on cost, not what’s best….they have destroyed not only the corporation but the many small franchisees….in the Burger King brand….the same thing at Tim Horton’s. Popeye’s is next.’”

Grant’s concludes: “The criticism seems not to accord with the fancy RBI multiple.”.

JUNE 19TH BLOOMBERG HEADLINE READ: “TIM HORTONS’ FRANCHISEES FILE LAUNCH $500M CLASS-ACTION LAWSUIT AGAINST RESTAURANT BRANDS, INC.

To quote portions of the release: Franchisees claim their costs have increased but they haven’t been allowed to raise prices to recoup their costs. “Since the acquisition, RBI has used various strategies to extract more money out of the TH franchise system at the expense of the franchisees” Among the allegations is that the parent company is misusing the millions of dollars that franchisees pay for marketing. (3.5% of franchisee sales). The claim says that “RBI has funneled this money to itself, TDL(?), and the individual defendants at the wrongful expense of the franchisees”.

The Company responded by saying “it is very disappointing that a few restaurant owners have opted to take actions against us when our focus remains on protecting and enhancing the brand. We vehemently disagree with and deny all allegations….we remain committed to working together with our restaurant owners to ensure the incredible TH brand continues to be strong for many years to come.”

Grant’s at the very least proved to be accurate in terms of describing the disaffection of Tim Horton’s franchisees. Above we have provided the bull and bear cases. In terms of making a contribution to the debate, however, we should at least summarize the potential financial impact of the suggested “misallocation” of advertising funds to “other purposes” as well as the higher markup on supplies provided by TH to franchisees.

A FEW FINANCIAL FACTS

According to the 2016 10K, total revenues from the TH segment were $3001M, up 1.4% from $2957M. The segment income for Tim Horton’s was $1,072M, an increase of $165M from 907M in calendar ’15. SG&A expenses were down about $14M, from $93.2M to $78.9M. Cost of goods was 78.0% versus 83.3% in ’15. Had the cost of goods, on $2,112M of sales to franchisees been 83.3% in ’16, segment income would have been $112M lower. Summarizing, $126M, or 76% of the $165M improvement at TH in ’16 came from the combination of improvement in supply chain margin and a reduction in G&A. At a 20% tax rate, the effect would be $100M or $0.43/share.

OUR CONCLUSION

We are not trying to take sides in this debate. The only reason our bear case description is longer is because the bull case is pretty well entrenched and well known by the investment community. Cynics, in this case “Grant’s”, always have the burden of proof, at least at the beginning, so we provide more details regarding their argument. Notwithstanding the red flags provided by Grant’s,  QSR is a strong company and no doubt will grow further through the years. We have no way to know to what extent the franchisee complaints are valid, but certainly such a dramatic increase in margins from sales to franchisees is worthy of explanation. There are always some franchisees that are less happy than others. The lawsuit will play out over time. We do suggest, however, that this “cloud” over the division that provides 55% of trailing EBITDA will not enhance the valuation in the short run. It is probably safe to say that the next $0.43 of earnings contribution from lower G&A and better supply chain margins will not be so easily achieved. Whether or not the franchisee claims are valid, no doubt the low hanging fruit has already been picked in terms of improving the earnings contribution from Tim Horton’s.