Value Investors Club / RESTAURANT BRANDS INTL INC (QSR)

Description

QSR (Restaurant Brands International) was formed as a combination of THI and BKW completed in the

end of 2014, and presents a compelling, evolving, long-term opportunity. It is the third largest

restaurant company by sales and operates in over 100 countries through two separate brands. Burger

King is the world’s second largest fast food hamburger restaurant chain (14,372 locations, 99.6%

franchised) . Tim Horton’s is the leading Canadian quick service restaurant, known for coffee and baked

goods (4,671 locations 99.7% franchised)

Admittedly, the single most important variable in this combination is 3G. The 51% owners of the

combined entity, 3G Capital have built a solid record of imposing new efficient structures on top of

existing brands, with multiple success stories (most recently at BKW itself) of cost cutting, capex

management, capital allocation, and international expansion.

Since the merger closed in Dec 2014 the stock peaked at $45 only to roll back to $38, where it started

the year. Still not cheap compared to its peers, but with the initial excitement out of the stock we find

this level to be a very reasonable entry point, given what we expect to become another successful 3G

story. This view is particularly reinforced by the very confident performance in the most recent quarter.

As the new name and ticker suggest, the company is intended to become another one of 3G’s platform

businesses (like Kraft/Heinz and Inbev) designed to apply proven blueprints to multiple brands. It is

therefore crucial for the new entity to demonstrate the ability to support Tim Horton and Burger King

brands in the near term, before adding any new businesses to this international master franchise

structure.

The market currently values QSR at ~16.7x consensus ‘16 EBITDA, which is only marginally richer than

the other all-franchised peers (DNKN 16x, DPZ 15.5x). Given the 3G track record, the new company’s

vast scale and platform status, we feel the stock deserves a higher multiple, but holding the multiple at

current levels for now, upside to the stock price will need to be driven by improved profitability and

growth. Both are areas of expertise for management. Let’s see what 3G has done at BKW in the first 3

years of ownership.

1. Aggressive overhead cost cuts. Between its Zero Based Budget approach (where each year’s

budget is built from scratch rather than updating the previous year’s blueprint) and

refranchising they were able to shrink G&A by $178m (45%) in 3 years. This is where over 80% of

ebitda growth came from.

2. Less relevant for the QSR story, but just to illustrate management’s effectiveness, further margin

expansion was driven by refranchising 1,300 of company low-margin stores and shifting to an

asset-lite model. Lowering the capex requirement also dramatically improved FCF.

3. With the use of the master franchise agreements 3G accelerated international unit growth from

168 units (+3.7% y/y) to 710 (+12.9% y/y). Unit growth ramped up quickly starting with Brazil as

early as 2011, followed by 3 deals in ’12 (China, Russia, S Africa), and 3 more in ’13 (France,

India, Mexico) with more to come. The impact of these agreements is still being realized.

What can we expect from the new company? The management is not very forthcoming with projections

or specifics of its strategies, but after just 3 months of post-merger operations, the Q1 results reported

in the end of April provide us with some clues as to where the company is headed.

Same store sales came in higher than expected for both brands in every region, beating pretty much

every sell-side estimate. Burger King reported same store sales of +4.6% globally, and +6.9%

US/Canada. The Tim Horton comps were +5.3% globally with US at +8.9%. These were both brands’ best

numbers in several years. Clearly something is working right. Before the merger the market would have

been thrilled with 2-3% growth observed in 2014. These numbers look particularly surprising compared

to the disappointing results reported by some of the other operators in the space (CMG, DNKN, etc). For

what they’re worth, the upper ends of the sell side’s price target ranges for QSR ($48-50) are predicated

on much more modest SSS numbers (2-3% globally and 5-7% in the US).

G&A fell by $20m y/y, again surprising most analysts, with most savings coming from TH. Per

management commentary, its Zero-Based budgeting began to kick in with a 15% workforce reduction,

closure of its US headquarters and putting its Gulfstream 100 jet for sale. At the same time we were told

ZBB was only introduced in March, so we should see more savings going forward.

We also speculate that the company is somewhat restrained in its ability to brag about workforce

related cost saving, given the Canadian government’s and public’s vocal concerns in this area prior to

the merger approval last year.

Similarly, in light of last year’s political backlash against tax-inversion motivated deals, it appears the

company continues to downplay the tax optimization component of its strategy. Nonetheless, the nicely

improved rate of 22% effective tax vs. last year’s 27.5% shouldn’t be ignored

Finally the company raised its dividend from 9c to 10c.

These results look like a sign of management’s very serious commitment. Setting the bar this high

indicates the team’s confidence in its plan, and we should expect similar pace of progress in the future

quarters. There were questions regarding TH’s distribution business, which had been speculated to be

the next area of optimization. While no specific plans were revealed, management indicated that

nothing is off the table. It seems that the manufacturing and physical distribution (trucks/warehousing)

parts of the distribution business (as opposed to the supply chain management piece) could garner

some attention.

Beyond cost cutting, we should also start hearing more on unit development at BK, the weakest point of

the Q1 report. With only 15 units opened so far in 2015 we expect a ramp up towards the 2nd half,

similar to the pattern observed last year. Unit openings drive more EBITDA leverage in a franchise

framework (as compared to the same store sales growth), and hence a healthy pace of expansion is key.

To this end, TH’s international expansion is the more exciting value creation avenue for the company in

the medium/long term. While the timing is not clear, and most analysts assume a cautious stance on

this, using BKW as the blueprint again, its first contracts began shaping up in just 8 months of 3G

ownership, so it’s not unreasonable to expect a similar time line this time around.

To be fair, there are still many unanswered questions about receptiveness of the international markets

to TH’s product. But DNKN's 3,000+ international stores indicate there’s substantial international

interest in coffee/baked goods offering. And to further counter skeptics managements recalled in recent

comments its successful experience with introducing BK to France and India. That effort was met with

justifiable initial skepticism regarding demand for burgers and fries among the French and Indian

consumers. By teaming up with thoughtfully chosen local partners and developing creative product

alternatives, the BK team was able to prove the skeptics wrong.

Again, the timing of TH’s international expansion is tough to predict, but in the meantime we expect to

hear something soon regarding TH’s more attainable US development.

To summarize we are witnessing a very confident start to what should be a series of further successful

steps on multiple fronts. Given our confidence in QSR’s management, backed by its track record and

already implemented strong initial steps, we are comfortable expecting a repeat success in Q2,

potentially to be rewarded by multiple expansion.

And for the really long term we go back to the platform business thesis. We don’t expect any new

acquisitions until the model proves itself. But looking for the next brand to be added to the platform,

Dairy Queen, owned by Berkshire Hathaway (a large holder of QSR common and preferred stock) has

been suggested. 99% franchised with some international presence DQ looks like a great fit with the QSR

model.

Risks

Valuation vs. peers, while no longer at its March 2015 highs, still makes QSR relatively rich, and the stock

is likely to get hurt in case of any potential Q2 missteps.

Such missteps can include SSS not sustained and dropping below 2-3%, slowing pace of G&A cost cuts

and prolonged lack of any JV / franchise agreement announcements.

TH’s foreign strategy may get slowed down with typical problems facing any internationally expanding

US business (problems with supply chain, operations, limited brand awareness, etc.). While a reasonable

concern, we expect BK’s playbook to be very helpful in anticipating these issues.

Conclusion

With the multiple avenues of growth, an efficiency driven platform model, management’s track record,

and a very healthy start, we find QSR to be a compelling medium-to-long-term story with reasonable

near and mid-term risks.

As the market is still trying to size up the new company two quarters after the merger, the price declines

over the past couple of months present attractive entry point.

Disclosure:

I do not hold a position of employment, directorship, or consultancy with the issuer.

I and/or others I advise hold a material investment in the issuer's securities.

This investment may change at any time.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Continued SSS strength and pace of cost cuts in q2

Announcements of international master franchise agreements for THI.

Additional BKW JV announcements.

New efficiency measures for the TH’s distribution business

show sort by

			2015	2016
Price:	38.17	EPS	.95	1.18
Shares Out. (in M):	467	P/E	40	32
Market Cap (in $M):	17,714	P/FCF	32	25
Net Debt (in $M):	11,200	EBIT	1,331	1,503
TEV (in $M):	28,950	TEV/EBIT	21.7	19.25