|Shares Out. (in M):||45||P/E||25||n/a|
|Market Cap (in $M):||720||P/FCF||n/a||n/a|
|Net Debt (in $M):||208||EBIT||50||0|
|Borrow Cost:||General Collateral|
Let’s say I told you I had…
A company that operates in a hyper competitive and largely commoditized industry that is facing structural headwinds. This company has razor thin margins and is fairly capital intensive (DD&A = 50-100% of EBITDA).
This company is rarely adjusted EPS positive and has generated negative $75mm of FCF over the last 10 years. Meanwhile net operating losses have continued to grow over the last 5 years.
Debt markets aren’t overly fond of this business since the company could only raise senior secured debt in the Spring of 2015 (peak ZIRP) at 8%. ($200mm of debt on $150+mm of tangible PP&E)
This company highlights its 11-13% cash on cash investment opportunities, but cash on cash does not equal investment IRR, which is insufficient to cover the company’s cost of capital.
And this same company highlights their scale benefits but has yet to show any corporate G&A leverage and also downplays their ability to operate much better than the rest of the industry.
You'd say that sounds like a pretty bad business, right? Sure, but everything has a price. Meanwhile this business is...
Trading at 8x ebitda despite transaction comps in the 3-4x ebitda range.
Trading at ~6x book value despite private market valuations near replacement cost/book value.
Trading at a 25x NTM adjusted EPS.
In addition, these valuation metrics are based on peak earnings and unsustainably high margins. Why? This company has experienced record high margins the last two years, by a long shot, due to several unsustainable macro drivers - low gas prices helped drive strong traffic growth for the industry and key commodity input prices consequently collapsed driving gross margin expansion.
Despite all the negatives highlighted above, sentiment is extremely positive for this company and expectations are for all of these gains to hold and/or improve. All 4 analysts have buy ratings and the stock is repeatedly humped on idea sites (VIC, Seeking Alpha, Sumzero) using improper valuation comps, a misguided narrative on business quality, and as a “clever” derivative investment alongside a popular private equity group and celebrity hedge fund investor.
That seems like a pretty nice short set up to me!
Background on Carrols Restaurant Group (TAST)
Carrols is the largest franchisee of Burger Kings with 753 restaurants across 16 states at year-end 2016. It's a very simple story. The company buys, builds and operates Burger Kings. They don’t own the land or buildings either (will do sale leasebacks), just the operating business. For more details you should see the company’s recent ICR presentation. You wouldn’t think owning Burger Kings is a sexy business warranting strong growth multiples and tons of attention, but the TAST story has captured investors imaginations and the stock is loved by both hedge funds (own 17%) and retail investors/investment advisors (48%).
Bulls are excited about 4 main things:
Historical headline performance (SSS and ebitda margin expansion) that has exceeded the overall Burger King system
Strong financial momentum
A rollup strategy/valuation arbitrage game + a Right of First Refusal (ROFR) granted from BKC in 2012
3G’s involvement and turnaround of BKC and BKC’s 21% equity interest in Carrols.
Let’s dig a little deeper and visit some of these points.
This is not a high quality business. Even when adding back all one-time or unusual costs (impairments/lease charges, insurance proceeds, litigations adjustments, and acquisition costs (which are arguably very recurring), etc.), TAST has never been adjusted EPS profitable until the business inflected in 2015 (discussed later).
Source: Factset and company reports
The company has a cumulative 10-year FCF burn of $75mm.
Source: Factset and company reports
And the company recently said at ICR that their acquisitions are generating 20+% internal rate of return, fully capped and unlevered, and that remodel investments have cash on cash returns of 12-15%. Yet TAST’s ROIC (at record high margins) has peaked at 8% and was basically zero from 2012-2014. And this is despite over $285mm of capital spending the last 5 years. When asked how those returns can be verified since they clearly aren’t visible in the numbers, the CFO deflects and can’t provide a reasonable explanation - “you guys just can’t see all the numbers” is not an acceptable answer for me. (and no, it’s not accelerated depreciation)
Source: Factset and company reports
And NOLs continue to grow - hardly the sign of a profitable company.
12/30/12 (YE2012) NOLs of $7mm
12/29/13 (YE2013) NOLs of $16mm
12/28/14 (YE2014) NOLs of $32mm
1/3/16 (YE2015) NOLs of $51mm
Carrols has no QSR magic.
Bulls love to point to two TAST investor slides (6 & 12) which show 1) outperformance vs. the Burger King system and 2) significant margin expansion in acquired units. Bulls cling to the belief that TAST is a materially better operator than other Burger King operators and that TAST has the secret sauce to extract more value from Burger King boxes than others.
The reality is that while TAST is a solid operator, they are no better than most BK operators and TAST management often down plays their operating “benefit”. On the 2Q16 call they were asked about how they were able to put up better comps than BKC and the CEO said “I'm not sure that we're doing anything terribly different. I think you have to look at this thing geographically. And it might very well be that the markets in which we operate are trending a bit better than some of the other geographic parts of the BURGER KING system.”
Humble? Doubtful. When reviewing other information that TAST provides its clear to see TAST is just buying their outperformance. The company’s comp growth is a function of heavy remodel investment (to Burger King’s 20/20 store) which drives a 10-15% sales uplift per unit. If TAST remodels 15% of their units a year and those units experience a 12% uplift, that adds to 2% comp outperformance (15% * 12% = 2%) above and beyond normal Burger King performance. These investments also drive ebitda margin expansion (since the investment and consequential depreciation is ignored), but it's questionable if they have a positive NPV (discussed later).
More importantly, if TAST was such a great operator, shouldn’t we be seeing leverage on the corporate cost line?
Source: Company reports
In addition, you can see that in that at times TAST’s legacy stores (the ones not getting a big “uplift”) actually underperformed BK systemwide store base- both SSS and margins. Note TAST margins are not directly comparable to BK co-owned stores due to TAST allocating costs to corporate level - 5-6% of sales. Only directionally helpful.
Source: Citi initiation report
TAST’s ROFR is not that important
While bulls love to highlight TAST’s right of first refusal in acquiring additional Burger Kings (in 20 states) as a key competitive advantage and value creating opportunity, in reality their ROFR is fairly immaterial. Not only does management downplay its significance, but 70% of 2014 acquisitions, 40% of 2015 acquisitions, 61% of 2016 acquisitions, and 100% of 2017 acquisitions have been TAST *not* using its ROFR. In addition, TAST pays $0.2mm quarterly (for 5 years) to have this ROFR - so it does have an explicit and tangible value that is materially lower than bulls like to discuss.
So what happened in 2015 then?!
TAST business took off in 2015 as store level cash flow margins improved 400 bps and total company ebitda margins improved 360 bps. Bulls attribute this to 3G BKC success + winning remodel concept + TAST operating excellence, but I’d argue the largest tailwinds, by far, were macro drivers that TAST and QSR did not control - lower gasoline prices drove strength in low-end consumer (driving traffic and opex leverage) and lower commodity input costs (beef) drove gross margin expansion.
As you can see below, traffic inflected positively in a big way in 2015 (and starting 2H14) - consistent with the great restaurant boom of 2015 that got investors so excited and is currently unwinding. Reasons for current restaurant weakness include stalling wages, rising living costs (health care), continued price increases by restaurants and record spread between grocery store food pricing vs. restaurants.
Even after aggressive price increases in 2014 and declining traffic, TAST has continued to push price to offset cost inflation below the gross profit line. Current comp is being driven by ticket as traffic has turned negative again. How long will pricing hold in this hyper competitive industry?
As you can see below, price increases and falling COGS have driven over 100% of margin expansion in 2016 (and ~60% of margin expansion in 2017).
This situation was not unique to Burger King and even Wendy’s has seen record store level ebitda margins driven by lower food COGS.
Is this sustainable? Unlikely given the hyper competitive nature of the industry. And TAST talks about heavier promotional activity and an “intense competitive environment which has caused most of QSR to continue using aggressive price-pointed offers, meal bundles, and aggressive discounting to drive traffic.”
To summarize, 2015 and 2016 were the perfect storm of juiced comps, plummeting raws and increase in pricing,which drove margins to record and unsustainably high levels. Expectations are for gains to hold (or improve), but the risk is clearly skewed down.
Diminishing returns on new investment
TAST used to say they’d experience a 12-15% sales uplift on remodels, but that fell to 10-12% and has now fallen further to 8-10%. Meanwhile, remodel costs continue to rise. In 2016 remodel costs were estimated at $480k/unit. In 2015 they were $400k. And earlier remodel costs were ~$300k. TAST says its cash on cash returns have only fallen from ~15% to 12-13%, but simple economics would argue returns have fallen much further.
More importantly, using cash on cash returns metrics as a proxy for IRR is about as useful as using EBITDA multiples to comp capital intensive companies to capital light businesses, something TAST bulls love to do.
The basic restructuring model is as follows: 10% sales uplift on $1.2mm AUV = $120k of incremental sales * 40% incremental margin = $48k of cash on a $400k investment, or a 12% cash on cash return. But if that $400k investment is depreciated over 20 years, the $48k falls to $28k and the return falls into the mid single digits. Hardly high enough to cover the TAST’s high cost of capital - senior secured debt in 2015 cost them 8%! And what happens to this “return” as sales upflift decreases and cost increases as it has been?
Bulls love to value TAST in a steady state maintenance capex environment using maintenance capex of $12-25k/unit/year (in perpetuity), while real DD&A per unit is closer to $60-65k/year, and increasing each year. Why is it increasing? Burger King requires major remodels every 20 years ($400-500k, or $20-25k/year of D&A), fresh ups every 7-10 years (~$100k, or $10k/year of D&A) and regular maintenance of $10-12k/year, which excludes frequent yet viewed as one-time upgrade requests (for POS equipment, kitchen equipment, or anything). Adding all this up and TAST’s reported DD&A is representative of recurring capex. Thus, EPS mirrors full-cycle FCF and is the most important valuation metric for this company, not EBITDA less some theoretical maintenance capex.
Raymond James recently raised their TAST target to $17 and their assumptions used to justify their target get more and more stretched each time (using lofty 2019/2020 assumptions). For example, RJ uses 1k stores (vs 753 at year end), 2% annual comp growth and 9.6% total company margins (inline with peak 2016 margins) to get to ~$140mm of EBITDA (vs ~$90mm currently) and $200mm of net debt (similar to current net debt). How is TAST going to grow stores 30% and ebitda 50+% all within FCF? They’ve never been able to do that and there is no reason to think that changes.
In addition to the lofty multiples (adjusted EPS multiple = ~25x NTM, adjusted ebitda multiple = 8x, and 6x BV), TAST is trading at an EV/unit of $1.25mm - for Burger Kings that often trade $200-600k (ex land and building - comparable to TAST).
The CEO and VP were sellers this past November/December 2016 at $14 (CEO sold ~$350k of stock). But being intellectually honest, their position sizes have continued to grow over the last few years - both in absolute shares and dollar value since the stock has appreciated, so I don’t see any material positives or negatives in insider sales.
Recent Results: 3Q miss and lower, expectations high for 2017.
TAST missed and lowered with 3Q results. Sales, EBITDA and EPS all fell short and sales, EBITDA and comp guidance were all lowered. Meanwhile capex was taken higher to account for higher costs. While the stock sold off to below $10, it has consequently rallied back over 60% back and to near all-time highs. Part of this was a function of the company saying they expected their 4Q16 comp to beat recently lowered expectations - which would still put them at the very bottom end of their prior guidance!
Meanwhile 2017 expectations of ~2% comp growth, continued M&A driven sales growth, and 20 bps of adjusted EBITDA margin expansion look aggressive. The company reports Thursday (March 2nd) in the morning and will give 2017 guidance.
What is TAST worth?
15x 2017 Consensus Adj EPS of $0.63 = $9.50/share. And 15x is arguably high for a no organic growth business.
At 6.5x Street NTM EBITDA of $100mm, that’s $9.80/share of EPS. 6.5x is 2.5 turns higher than private market values and within historical valuation range
At 3x book value of $2.80/share, that’s $8.40/share.
Base case downside of $9-10/share, down 40% from current levels.
In a bear case scenario thinks can get ugly quickly. TAST has high operating and financial leverage and there is significant downside to what I’d argue are “normal” margins. A 200 bps decline in 2017 store-level cash flow margins from a 2016 peak of 15.3% would result in 2017 EBITDA of ~$80mm and adjusted EPS of just $0.20/share. And that’s using the company’s current 0% tax bracket (thanks to NOLs). At a normal 35% tax rate, EPS falls to the $0.10-0.15/share range and turns negative if margins fall further.
Is the company going to give up 200 bps of margin in 2017? It is definitely possible given this is just 40% of the 500+bps gained over the last two years. Also, with declining traffic, an inability to continue to push pricing in a competitive environment, an inability to leverage other costs (wage pressures continuing), and no COGS tailwind, margin declines could happen much faster than expected. 20x $0.20 of EPS, 1.5 BV, or 5.5x EBITDA multiple on $70mm of EBITDA = $4 stock price in a bear case scenario.
Timing on this idea is uncertain. Valuation and expectations provide a margin of safety on the short side, but the timing of when margins will revert - either driven by pricing cuts, traffic declines, rising COGS, or negative operating leverage on opex is uncertain.
|Entry||03/01/2017 02:37 PM|
You state that margin expansion has been achieved through commodity input prices (which is true) which is characterized as being unsustainable. Can you elaborate on that point? Beef production plummeted in 2014-2015 which resulted in unsustainably high prices which, in my opinion, seem to be normalizing as the herd repopulates.
I think the point on the debt is perhaps a little misleading.. the 8% notes represented a meaningful reduction from the 11.25% notes prior to that. While that's not a great interest rate, it is a step in the right direction and emblematic of the fact that the credit profile of this company is improving. Their revolver was also upsized a year ago and has much better pricing at ~L+275.
I don't think anyone is arguing that this is a "great" business (or even "good" for that matter!), but an 8x multiple on EBITDA does not seem to be overly aggressive. I think two other risks to the short position here are 1) contribution from the recent batch of acquired restaurants in coming quarters and 2) CapEx falling off since they're over the hump on the 20/20 remodeling. Also, the price target seems predicated on multiple compression without a well defined catalyst to get there - I'm struggling to understand why this should trade a 5.5x EBITDA?
Enjoyed your research and look forward to any additional thoughts you have, thank you!
|Subject||Re: Few items|
|Entry||03/01/2017 03:56 PM|
Thanks for the questions and the comments.
Re beef, completely agree and I'm not arguing beef prices or COGS will rise. What I am arguing is that unit economics have improved to an above normal level and its natural for an efficient and competitive industry to compete those excess earnings away, often via price. When beef prices were rising, the industry was increasing pricing and they haven't given any back, yet. With traffic declining for the entire industry, increased competition, and lower pricing elsewhere (grocery stores), price competition will likely get worse and weigh on margins - normalizing what I view as unsustinably high margins.
Re debt, you can see it either way. Yes it was an improvement (reduction in rate, etc), but i'm looking at it in conjunction with equity value so I still view the rate as very high for an asset heavy company that is emblematic of low business quality - whereas equity valuation suggests the opposite. So debt yields 8% but equity has an earnings yield of 3-4% in a best case scenario? Where's the equity risk premium here? This is the exact opposite of an idea like NXST which raises debt at 4-6% and has a FCF to equity yield of 17-20%.
We agree that TAST isn't a high quality business yet it has a 20% ROE on 2016 numbers and even higher on 2017. Granted that's assisted by healthy leverage and also "adjusted", but do fast food operators generate sustainable 20% ROEs? I doubt it.
Re ebitda, maybe we'll have to agree to disagree. I strongly disagree with looking at TAST's ebitda multiple in isolation. EBITDA multiples tell you nothing about what the real economic earnings are to equity holders. 8x ebitda for one company in the restaurant industry might be 12x earnings/fcf, but 8x TAST is 25x earnings. TAST's ebitda multiple is not comparable to other restaraunts that have various mixes of franchise vs owned units, etc.
Several members of the sell-side have updated numbers for the recently announced acquisitions. Given those were so large, and not part of the ROFR, hard to think TAST got a steal of a deal and that it would be that accretive to earnings. And sure capex might fall (see -$75mm of FCF last 10 years), but we'll see how ebitda and earnings fair.
And re my target, not sure where the 5.5x is coming from. If I put 6.5x on consensus of ~$100mm, i get to $10 stock price. But my bet is that earnings and ebitda both decline (sooner than later. when? not 100% sure, but likely sooner than later) which will result in both lower numbers AND multiple compression.
I got increasingly bearish writing this up, so would love to hear more ideas where I'm wrong.
|Subject||Re: Re: Few items|
|Entry||03/01/2017 05:25 PM|
To the contrary, QSR and fast casual competitors have been talking about a more promotional environment for a few quarters now, so a lot of pricing is already getting passed back. I tend to agree with you that TAST is an undifferentiated franchisee that should be valued at 3.5x-4.0x that franchisees generally transact at, but as long as the public markets turns a blind eye to rational valuation (TAST has traded at 7x+ EBITDA for the past 5 years), this doesn't feel like an actionable short because TAST can just continue to play the multiple arbitrage game to your detriment.
|Subject||Re: Re: Re: Few items|
|Entry||03/01/2017 05:48 PM|
Agree that this isn't your typical "actionable" short given zero visibility into trigger or catalyst, but valuation and expectations make it an attractive risk reward.
I see TAST below 7x NTM for most of 2016, maybe Factset has errors there.
I don't think your comment goes to the contrary, several of the quotes i put in were actually from 2Q, not 3Q. TAST hasn't reported 4Q yet but the real bet is that it gets worse in 2017 as more people battle for traffic. Also, the mutiple arbitrage game gets materially harder the larger they get.
Thanks for the comments, you highlight the biggest risk imo.
|Entry||03/01/2017 06:46 PM|
Can you name one $100m EBITDA restaurant franchisee that was acquired in a transaction for 3x EBITDA?
|Subject||Re: Transaction Comps|
|Entry||03/01/2017 08:58 PM|
Unfortunately I do not have a comprehensive restaurant M&A database, so if you're looking for downside beyond my 6.5x consensus target (bottom end of their normal trading range) or the 5.5x bear scenario, I can't help.
|Subject||Re: Re: Transaction Comps|
|Entry||03/02/2017 08:55 AM|
no position. i spoke with someone in P/E that has been involved with a number of franchisee transactions. he said 6-7x is typical, with 8x reserved for a special, sizable, and diversified one. perhaps Carrols qualifies for that. perhaps not. but 3-4x is not market.
|Subject||Re: Re: Re: Transaction Comps|
|Entry||03/02/2017 10:00 AM|
Another miss and lower. Despite the SSS beat (largely pre announced), sales missed and ebitda missed by 10%. EPS of $0.04 missed consensus of $0.11 and full year adjusted EPS came in at $0.40 – so 40x earnings at $16. While comp guidance of 2-4% was above consensus of 1.6% (see section re buying comp growth), sales were inline and ebitda of $90-100mm was a good bit below consensus of $102mm. Given they guided to flat G&A, this means store level cash flow margins are compressing and EPS estimates will come down even further than EBITDA decreases. They attributed a majority of the declining unit economics on wage inflation and said pricing still up 2-3% in 2017. Weather has definitely helped them this winter (in 4Q traffic was +0.2%, which is a nice reversal) but 1Q guide of flat to negative is not good (granted on a tough comp) and makes guidance back half loaded – never good.
Despite ~8% unit growth via M&A in 2015 and 2016, and spending significantly above cash flow in in 2016, absolute adjusted ebitda was basically flat yoy in the 4th quarter (adjusting for the $4mm for last year’s extra week) and guidance has margins starting to retrace. And this is all with positive comps. Could get ugly if comps turn negative.
Bulls will also like the decreased capex guidance, but $95mm of ebitda - $18.5mm of interest - ~$5mm of cash taxes (20% rate) - $65mm capex (midpoint, they’ve generally come in high end or above here) = $6.5mm of FCF during a “low” capex and harvest cash year. If I give them $12mm for additional non-recurring capex and round up we are talking $20mm of FCF, or just $0.40-$0.45 (2.5-3% yield) meanwhile margins and unit economics are declining and zero organic growth, just a debt fueled M&A arbitrage valuation game.
Thanks for the additional color rhubarb. One additional point I’d make is a lot of these deals are not comparable. A lot of franchisee’s own their own land and/or buildings, so willing to pay higher ebitda multiple to acquire those assets. TAST does not own ANY of that. TAST is also already fairly levered, so less opportunity to juice equity returns. Regardless,
6.5x 2017 of $95 = $8.40 stock price. (assuming $20mm for 43 box January acquisition in guidance, so $240 PF net debt)
7.5x 2017 on $95 = $10.50
So even in a blue sky PE takeout scenario TAST is still very overvalued. More misses and lowers + fading interest re playing alongside 3G (as attention turns to popeyes?) = valuation normalization. We’ll see, that’s the bet.
|Subject||Re: Re: Re: Transaction Comps|
|Entry||03/02/2017 10:02 AM|
Why are franchisees willing to sell to Carrols at 3.5x-4.0x pre-synergy EBITDA then if 6-7x is typical? Seems like 3-4x is market for Burger King franchises. See Page 12. http://files.shareholder.com/downloads/TAST/3993281881x0x923487/A538B97C-68E5-4F28-A125-19EEA4538C5E/Carrols_January_2016_Investor_Presentation.PDF
There are few benefits to scale for franchisees in terms of market positioning, because for the most part the franchisor dictates your supply chain and brand imaging, so your product is almost completely undifferentiated from the 10 unit franchisee that they pay 3.5x-4x for. I can't fathom why a larger, similarly concentrated, franchisee should trade at almost a 100% premium.
We are highly dependent on the Burger King system and our ability to renew our franchise agreements with BKC. The failure to renew our franchise agreements or Burger King's failure to compete effectively would materially adversely affect our results of operations.
Due to the nature of franchising and our agreements with BKC, our success is, to a large extent, directly related to the success of the Burger King system including its financial condition, advertising programs, new products, overall quality of operations and the successful and consistent operation of Burger King restaurants owned by other franchisees. We cannot assure you that Burger King will be able to compete effectively with other restaurants. As a result, any failure of Burger King to compete effectively would likely have a material adverse effect on our operating results.
Under each of our franchise agreements with BKC, we are required to comply with operational programs established by BKC. For example, our franchise agreements with BKC require that our restaurants comply with specified design criteria. In addition, BKC generally has the right to require us during the tenth year of a franchise agreement to remodel our restaurants to conform to the then-current image of Burger King, which may require the expenditure of considerable funds. In addition we may not be able to avoid adopting menu price discount promotions or permanent menu price decreases instituted by BKC that may be unprofitable.
|Subject||Re: Transaction Comps|
|Entry||03/02/2017 10:19 AM|
rjm59, tough to find examples like that when the 3rd largest franchisee in the country (TAST) reported $90mm in EBITDA last year.
|Subject||Re: Re: Transaction Comps|
|Entry||03/02/2017 12:11 PM|
Yes, I agree it's very, very tough to find examples because no restaurant company at scale has sold for 3-4x EBITDA in a going private transaction in the last 30 years. If you know any that are for sale at 3x EBITDA, I would love to buy the whole company.
|Subject||Re: Re: Re: Transaction Comps|
|Entry||03/02/2017 02:47 PM|
What are we talking about? Franchisors or franchisees? The only two franchisees that could have $100mm+ EBITDA (like you asked below) today are Flynn and NPC. Flynn is still family-controlled and NPC last transacted in 2011, when it was a much smaller business. It should go without saying that franchisors, who enjoy control over brand, pricing, supply chain, marketing, royalty stream, among many many other structural advantages, deserve a much higher multiple to franchisees. Franchisors (most of the publicly traded restaurants) are not comparable businesses to TAST.
|Subject||Re: Re: Re: Re: Transaction Comps|
|Entry||03/03/2017 05:07 AM|
Btw to clarify when I said 6-7x that was for a sizable deal with 100 or 200 franchisees. I suspect 3.5x-4x is what you pay if you're buying an individual unit.