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ROGER’S MONTHLY COLUMN IN THE RESTAURANT FINANCE MONITOR – RESTAURANT BRANDS (QSR) “RETOOLS”

The following is the lion’s share of Roger’s monthly “Follow the Money” column for the Restaurant Finance Monitor.

RESTAURANT BRANDS (QSR) “RETOOLS”

Progress takes time in the real world and Jose’ Cil’s appointment as CEO at QSR in early 2019 is starting to bear fruit. Cil is an ex- bankruptcy lawyer who originally joined Burger King (BK) in ‘00 as an in-house counsel. With the exception of 10 months at Wal-Mart in ’10, he worked his way through worldwide and US operations at BK. Some historical context is necessary here. QSR, controlled by Brazilian 3G Capital, put BK and Tim Horton’s (TH) together in late 2014, creating a publicly held multi-branded “free cash flow”, “asset light”, franchisor. Popeye’s was added to the mix in 2017 and Firehouse Subs is about to become the fourth brand. While Popeye’s struck gold with their chicken sandwich, and there has been consistent systemwide unit growth at Burger King, Tim Horton’s has had well publicized friction (to be charitable) with their franchisees, and both chains’ same store sales have lagged their competition.

At the operational level over the last seven years, QSR demonstrated its platform’s administrative efficiency by closely controlling corporate G&A at both BK and TH, designed of course to maximize the cash flow for the franchisor. Setting aside (1) the widely known price increases (of food supplies, etc.) imposed on the TH franchise system, the wider profit margin providing a very large portion of the increase in TH operating income and (2) anecdotal reports that have circulated for years about less than ideal field support for BK franchisees.

The reported financials were muddied a bit between ’17 and ’18 as a change in accounting treatment took place and advertising fund contributions from franchisees were added to revenues as well as G&A expenses (mostly netting out). However, at Burger King, absolute dollars of G&A were down from ’15 to ’17 and virtually flat (up 0.2%) from ’18 through ’20. At Tim Horton’s, absolute G&A was down from ’15 through ’17, and down again from ’18 through ’20. During those same five years the systemwide units at Burger King grew steadily from 15,003 to 18,625. Even with the problems at TH, the number of systemwide units grew from 4,413 to 4,949. Therefore the systemwide units grew by 24% at Burger King and 12% at Tim Horton’s but dollars spent for G&A went down from 2015 through 2020. If you are not good to your franchise system, your franchise system will not be so good for you.

While QSR, the stock, has done “OK” since 2014, going from about $40 to $60, the free cash flow generated since 2015 has allowed for about $6.2 Billion of dividends and corporate purchase of (controlling parent) 3G’s partnership units. The long term debt, by the way, has gone from $8.5B at the end of ‘15 to over $12B today, so “free cash flow” largely benefited 3G Capital rather than the public.

Back at operations, in spite of Tim Horton’s selling an addictive product line and Burger King’s large number of drive-thru locations, results have lagged competitors throughout the pandemic. Average Unit Volumes the past eight quarters (according to Technomic) have been down 0.49% at BK, versus a positive 7.0% at McDonald’s, 5.5% at Wendy’s, and 7.5% at Jack in the Box. Tim Horton’s results have been worse, down 15.7% in ’20, only partially recovering in ’21. Current management, led by Jose’ Cil, obviously can’t change the past, but are acknowledging the shortfalls and taking steps. Cil acknowledged recently that “our drive-thru speed-of-service declined significantly” and he told analysts recently that “the company is increasing overhead spending for field operations and training specialists. We’re giving them better tools, investing in that from a technology standpoint.” Cil just hired Tom Curtis away from Domino’s to oversee BK operations, and other changes are no doubt in the works. Restaurant Brands may yet deliver on its potential.

STOCK MARKET INEFFICIENCY is more frequent than you think, with valuation disconnects taking place for no good fundamental reason. For example, we have periodically watched venture capital, private equity or even corporate strategic investors pay much higher valuations for a privately held company than could be obtained in the public marketplace.  This process, implemented by smart professionals, is due largely to the fact that the institution raised the capital for the express purpose of investing in the private marketplace, whether or not that is where the greatest value lies. It just so happens that private equity funds, while performing very well two or three decades ago, have not done nearly so well in recent years when they’ve had so much capital to put to use and so few bargains to pursue.

We have also watched IPOs (the latest “shiny objects”) get priced by their underwriters and then trade at much higher valuations than those accorded companies previously public. The pricing of IPOs is at last partly due to the fact that a previously privately owned situation has not yet shown themselves to be fallible.  The power point slide show always show charts sloping upward to the right, and management is predictably optimistic that this will always be the case.

As a result, though down from their highs, Sweetgreen (SG) is trading with an Enterprise Value over $3B, about ten times trailing SALES (growing units by about 20% per year) and the first nine months of ’21 showed NEGATIVE EBITDA of $107M, a GAAP loss of $49M, with no promise as to the timing of breakeven corporate performance.

Dutch Bros (BROS) is currently selling at 65-70x ’22 EBITDA. Portillo’s (PTLO), First Watch (FWRG), and Krispy Kreme (DNUT) are selling at an average of about 22x ’22 EBITDA. On the other hand, the average Enterprise Value for (reasonably well situated companies) Bloomin’ Brands (BLMN), Brinker (EAT), Chuy’s (CHUY), El Pollo Loco (LOCO), and Ruth’s Chris (RUTH) is about EIGHT TIMES TRAILING TWELVE MONTHS’ EBITDA. Take your pick.

Roger Lipton

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

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.