Description

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:

1. Historical headline performance (SSS and ebitda margin expansion) that has exceeded the overall Burger King system

2. Strong financial momentum

3. A rollup strategy/valuation arbitrage game + a Right of First Refusal (ROFR) granted from BKC in 2012

4. 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?

Current Valuation

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).

Insider sales

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.

Catalyst

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.

Risks:

• Low end consumer strength remains - QSR industry is able to hold pricing and traffic.
• Burger King has some product homeruns and the brand gains momentum.
• Commodity costs fall further
• Leverage on G&A materialize
• Market comps TAST to other restaurants on EBITDA basis (wrong), so multiple keeps expanding as the company does valuation accretive (but not value creative) M&A.