Description

Carrols Restaurant Group (TAST)

Carrols Restaurant Group, with 717 locations, is the largest operator of Burger King locations in the world. The company has a unique, mutually reinforcing culture that couples strong operating discipline with outstanding capital allocation. The operating discipline manifests itself in system-leading operating margins and same store sales comps. The capital allocation skills are evident in the company’s history of M&A, unit growth, a successful spinoff, and the ongoing relationship with Burger King that features a unique right of first refusal to purchase hundreds of Burger King locations on the East Coast.

Taken together, the operating skill and the capital allocation opportunity create a long runway for profitable growth that is still early, and still underappreciated by investors. The stock, currently trading at $14, should appreciate above $20 within a year with reasonable assumptions. Further growth above $20 will only be a matter of continued execution of a well-established plan.

Company History

Carrols was founded in the 1960s and operated a chain of burger restaurants under its own brand until the 1970s, when it converted to Burger King. The company added units through the late 1990s when Burger King became a built-out concept in the United States. Then, the company bought the Taco Cabana Mexican chain in Texas and Oklahoma, and the Pollo Tropical Caribbean chain in Florida. Both chains were small and represented an opportunity for Carrols to deploy its free cash flow from Burger King operations into unit growth for its newer chains. In 2012, Carrols spun these concepts out into Fiesta Restaurant Group (FRGI), a company that reached nearly $2 billion in market cap in early 2015 before falling along with other small cap stocks in the second half of the year. While the stock has been choppy recently, FRGI continues to put up impressive performance.

The spinoff of FRGI came shortly after 3G Capital took control of Burger King. The change in strategy at QSR presented a new growth opportunity for Carrols: consolidation of the fragmented Burger King store base. In the past, Burger King enforced a cap on the number of locations any one company could control. While this rule has long since been eliminated, it left the store base highly fragmented, with the median franchisee owning fewer than 10 units. 3G, whose plans called for strong operations and rapid store renovations, needed bigger, stronger owners. Carrols was their solution.

In 2012, 3G bought a stake in Carrols and transferred to the company ownership of 278 units. The company still operates 246 of those units; the rest were structurally unprofitable and have been closed as the leases and franchise agreements expired.

Subsequently, Carrols raised further capital through a stock sale and increases in the company’s bond capacity and line of credit. They have been deploying this capital by purchasing additional locations and by remodeling restaurants. Both uses of capital are attractive: remodels deliver low double digit IRRs, and acquisitions are often done at 5X EBITDA. Post close, Carrols can often increase EBITDA margins by hundreds of bps, bringing their purchase multiple lower by one to two turns.

Key Metrics

Store Count: Currently 717. Pre-authorized by Burger King to grow to 1,000 units. The company acquired 123 locations in 2014, 55 locations in 2015, and 12 YTD in 2016. The company has increased its line of credit in 2016 with a stated goal of further unit acquisition, so there’s basis to believe the pace of M&A will increase in 2016 over 2015.

Store remodeling: 430 locations have been upgraded to the current 20/20 format. An additional 85 to 95 will be remodeled in 2016, which will fulfill the company’s commitment to remodel at least 450 units by December 31, 2016. After 2016, the pace of remodels will slow, and the company will swing to free cash flow positive. The company anticipates using much of this cash flow for further store acquisitions.

EBITDA margins: The company reports EBITDA margins by store cohort. Stores owned before 2012 are referred to as legacy units. The legacy units have been managed well and are the company’s highest margin units. They have averaged 14% four-wall EBITDA margins over the last few years, though in 2015 they set a new recent high at 16.7% in the fourth quarter.

The 2012 cohort, purchased from Burger King corporate, were very low margin units and the company has spent the last few years improving their performance. EBITDA margin at these stores was just 3.0% in 2013. Now, that figure is at 13.5%, putting them within range of the average at Carrols legacy stores. The experienced regional managers (average experience: 27 years!) who led this effort can now be redeployed to new stores as they are acquired.

The 2014 and 2015 cohorts, purchased from other franchisees, were better performing units that required less improvement.

EBITDA margins are heavily influenced by beef costs. Beef spiked to multi-year highs in 2014 and 2015, before peaking in the middle of last year. As beef costs continue to decline, the company will have very easy margin comps through the balance of 2016.

Average unit volume

As the company has put up solid SSS, remodeled restaurants, and benefited from new menu items and promotions from Burger King, Carrols has put up impressive SSS performance. The all-units AUV number has been dragged down by acquired restaurants, which do less volume that Carrols units, but looking at the figures on a cohort basis shows ongoing improvement throughout the store base.

Valuation

The future valuation of Carrols will depend most heavily on the pace of store acquisition. If the company can buy approximately 100 units per year at the prices they have achieved in recent years, they will generate considerable value for shareholders. Presented below is a simple model of equity value at different store counts. A few notes on assumptions:

• The company is already at 9% EBITDA margins on a 2015 store base that averaged fewer than 700 units and with high beef costs early in the year. So we believe the 9.00% figure presented in the 800 unit column to be conservative.

• Through 1000 stores, we have assumed $50 million in additional debt per 100 stores. Beyond the 1000 store threshold, as EBITDA levels grow, we assume that increments of $50 million in additional debt will only be necessary per 200 stores. We believe both estimates are conservative, especially as store remodeling costs trail off in 2017.

• We have used an EBITDA multiple of 9 to 11 in all scenarios, in line with the EBITDA multiples of many QSR and fast casual restaurant companies. We give no premium valuation for the company’s strong operational history and their lower risk store growth strategy, compared to restaurant concepts that must build new stores.

• We treat the Burger King preferred stock on a fully converted basis.

• The company is guiding to 2016 EBITDA of $80 to $90 million, but this guidance does not anticipate any new stores beyond the current 717. So our assumption of $94 million at 800 stores represents a lower per store estimate than the company’s.

Management and Alignment

QSR International, the 3G controlled owner of Burger King, owns 21% of the equity through their Series A Preferred stock convertible into 9.4 million common shares. The remaining executive officers and directors own 5.3.% of the shares. CEO Accordino has been with Carrols for 43 years, and the CFO Flanders is a comparative rookie with 19 years of experience with the company. Regional managers average 27 years of experience, and district managers average 19 years of experience.

Risks

• The most important, and unquantifiable risk, the potential for a Chipotle-style pathogen scare that does irreparable harm to the brand. This hasn’t happened before to TAST but it is an ever-present risk for a QSR brand.

• Labor costs could turn unfavorable. While this would hurt COGS and EBITDA margins, it could benefit TAST as smaller BK operators would be hurt more, creating the opportunity for accelerated store acquisitions. Additionally, if Burger King workers can demand more pay, so should most other low skill workers, and such workers have a high marginal propensity to spend. TAST would likely benefit from higher revenue comps on a lagging basis from any rise in labor costs, though this would be only a partial offset.

Catalyst

Strong margin performance in 2016 due to falling beef costs. Ongoing store acquisitions.