Description

Thesis

QSR is a rare combination of 1) a growing, high quality/predictable business that requires minimal expenditures to grow, 2) a talented, incented management team with a strong track record and 3) the ability to reinvest cash into high return opportunities (M&A).  This is a proven winning formula that 3G has used to compound equity at high rates for decades, and is likely to continue at QSR.

Specifically, QSR’s FCF/share could compound at >20% due to a growth algorithm consisting of 6-8% revenue growth (2-3% comps, 4-5% unit growth), 8-10% EBIT growth (due to high incremental margins and strong cost control), which drives 14-18% FCF growth (due to interest expense leverage) before capital allocation.  If QSR simply maintains leverage and repurchases shares, FCF/share would grow ~20%, however the more likely scenario is that QSR continues to invest their cash into high ROIC M&A (as they have with Tim Horton’s and Popeyes), leading to well over 20% annualized FCF/share growth.

Assuming some multiple compression, QSR’s stock could compound at 20%+ for the foreseeable future with call options on 1) greater upside via transformational M&A, 2) if management’s upside AuV or unit growth come to fruition or 3) no multiple compression.

QSR and 3G Background:

QSR is a roll-up of (you guessed it) quick service restaurant franchisors, consisting of Tim Horton’s (50% of EBITDA), the dominant coffee franchise in Canada, and Burger King which can be split into BK US (25% of EBITDA) and BK International (25% of EBITDA).  In addition, QSR recently acquired Popeyes Louisiana Kitchen (PLKI), which will contribute ~10% of EBITDA.  ~80% of QSR EBITDA is derived from franchise fees (QSR owns negligible stores), and 20% is via the procurement and distribution operations at Tim Hortons.

Although 3G Capital needs no introduction to VIC members, a brief discussion of their model is helpful to understand QSR’s strategy going forward.

Much is made of 3G’s (in)famous cost cutting focus including the now popular buzzword “zero based budgeting”, but cost cutting is simply one byproduct of 3G’s over-arching model.  3G’s real model is to pair 1) talented, young, ambitious personnel with 2) extremely powerful financial incentives and 3) strong business models that can withstand change.  Cutting costs is a major tactic, but 3G operators are incented to grow FCF using all levers at their disposal and have been successful growing the topline via launching new products, entering new geographies and improving marketing.

The model has its critics, but it has proven successful over multiple decades, in multiple industries, in multiple geographies, with multiple management teams, throughout varied macro conditions which should give investors comfort the model is sustainable. We believe 3G’s prior large investments in Lojas Americanas (1993-2013), ALL (1996-2013), ABInbev (1989-current), QSR (2010-current) and Kraft-Heinz (2013-current) have all compounded at 20% or above, in some cases for 20-30 years, one of the most enviable track records on the planet.

M&A is a natural fit for this strategy, since 3G can acquire a business that others have worked for decades to put into a strong competitive position, but are sub-optimally run.  To give some examples of how replicable this model is using public data, 3-4 years after the merger 3G-backed companies increased EBITDA-capex at Budweiser by >80%, Modelo by >60% and Heinz by >50%.

Specific to QSR, they increased Burger King EBITDA-Capex by >100% and Tim Hortons by >60% (despite material FX headwinds).  Since the initial purchase of Burger King in 2010, it could be estimated that 3G Capital may have generated over 10x their initial investment - a 40% IRR over seven years.

QSR’s Growth Algorithm

The potential drivers for QSR to compound FCF at ~15% before any capital allocation are as follows:  6-8% revenue growth of which 2-3% comes from comps and 4-5% is unit expansion.

2-3% Comps:

Comps are influenced by a variety of macro factors that ebb and flow and are difficult to predict in any given quarter, but population growth (1%) + inflation growth (2-3%) is a reasonable starting point for a mature business like QSR.  In the prior 3 years, constant currency same-store sales have averaged 2.7%.

QSR management will cite that average unit volumes at BK are ~$1.3M vs. MCD at >$2M, and MCD took significant share from BKW in the decade prior to 3G while BK was mismanaged.  QSR management has launched a number of initiatives to address this gap, and in fact has increased AUVs from $1.1M at the time of the acquisition.  We don’t assume this gap continues to close, but it would provide nice upside to comps.

Of course, offsetting QSR’s market share initiatives will be ongoing consumer trends away from unhealthy foods, notably at BK US (25% of EBITDA), however we believe this trend will continue to play out slowly.

4-5% unit expansion:

Though BK US is fully penetrated, we believe 75% of QSR’s remaining business remains underpenetrated, notably BK Int’l and TH Int’l.

BK Int’l:

We have spoken to franchisees or former BK employees that have insight into a large portion of BK Int’l markets.  They were generally supportive that BK is underpenetrated, that new units generate attractive ROICs and that 10% unit growth is feasible.

In addition, MCD has ~3x the international locations as BK, implying BK is underpenetrated vs. their best comp.  Of note, MCD is adding ~700 units internationally (similar to BK’s goal), a signal that another rational, well-informed competitor sees continued growth.

TH:

Over the last few years, TH has been growing units at 4-5%, mainly via US and Canada, which seems like a reasonable starting point.

In addition, a key initiative at QSR is to grow TH internationally, similar to the initiative that accelerated BK international growth following the BK acquisition.  This initiative has been slow to ramp (the first international JV deals were signed in 2016), but Dunkin’ Donuts, TH’s best comp, operates 3,500 international units vs. 130 for TH, which leaves a lot of potential for THI.   

Popeyes:

Though not a near-term driver, Popeyes is also significantly underpenetrated and should extend QSR’s ability to grow units for a very long time.

Popeyes currently operates 2,700 units whereas KFC, their best comp, has >20,000, again providing a long run-way of growth for the outer years should TH/BK start to slow.

8-11% EBIT growth:

As a franchisor, QSR requires very little incremental expenditure to grow revenue which leads to high incremental margins.

In addition, as you would imagine QSR is very focused on keeping or reducing opex.  For example, despite owning BK for almost 7 years, BK SG&A was flat YoY in 2016 driving ~100% incremental margins.

In total, EBIT should grow 200-300 bps higher than revenue growth.  14-18% FCF growth

Given QSR’s sizeable interest expense, 8-11% EBIT growth translates into 14-18% FCF growth.   

Capital Allocation:

If QSR simply uses FCF to buyback shares, they would buy 4-5% of their shares outstanding per year assuming a 20-25x FCF multiple.  Added to the 14-18% FCF growth, this would result in 18-23% FCF/Share growth.  If instead QSR pursues M&A (details discussed below), it could add >10% to EPS per year, for a total FCF/share growth rate of 24-28%.   

M&A

Given the attractive M&A economics and strong track record of buying / improving assets it is reasonable to conclude that QSR will try to use FCF (and incremental leverage) to continue to roll-up the QSR industry.  The questions are a) how much capital can they deploy on and b) what are potential returns on M&A?

Capital Deployed: By the end of 2018, we estimate QSR could have ~$10B of M&A capacity vs. a TAM of ~$200B of publicly-traded targets ($100B excluding MCD).

Returns on M&A:  If you use the TH and PLKI acquisitions as templates (acquired at 12-15x NOPAT), $10B of M&A would add ~$1.00 of FCF/share, or 40% accretive to Consensus 2018 EPS estimates.  Assuming 3 years to realize the accretion, this would add >10% to QSR’s FCF/Share growth rate.

Management and Incentives

QSR is led by CEO Daniel Schwartz (a former 3G hedge fund analyst) and CFO Josh Kobza (former Blackstone private equity), though we understand 3G’s Chairman Alex Behring is highly engaged as well.  References on Daniel/Josh have been stellar, and their track record speaks for itself.

Since comp is mainly paid in stock, the entire 3G team is highly incented to continue compounding shareholder value.  For example, if QSR stock were to reach $80 in two years (a 20% CAGR), Daniel’s option package would increase by ~$85M and Josh’s would increase by $30M.

Valuation

Adjusting for the expected refi of QSR’s cap structure in December 2017 and including the PLKI accretion, QSR is valued at ~20x 2018 FCF assuming no future capital deployment, ~20% below fully-franchised restaurant peers who on average have inferior topline growth potential, inferior capital allocation opportunities and inferior managers and just a 10% premium to the S&P 500.

If FCF/share can compound at >20%, and if QSR’s multiple remains at 20x, QSR’s stock price should CAGR at a similar rate for the foreseeable future.

Key Risks

QSR’s entire model is levered to revenue growth via comps and unit growth.

As for comps, QSR is on the wrong end of health/wellness trends and BK US (again, just 25% of EBITDA) comps have recently turned negative, though lapping difficult comparisons (two year stack still +1-5%).  There is a chance these comps do not inflect positive, and BK Int’l eventually follows.

As for unit growth, our checks were positive on the next few years, but at some point the world will run out of demand for Burger Kings and Tim Hortons.

We assumed continued, but greatly reduced, margin expansion at Tim Hortons, which has not been explicitly guided to or “proveable” from a bottoms-up basis.

At some point, QSR will run out of acquisition targets and the rate of FCF/share growth  will resemble the organic growth outlined above.

Franchised restaurant multiples seem frothy, perhaps because investors associate them with bond-like predictability in a low interest rate environment.  Our valuation assumes material multiple compression from today’s level, but in a scenario where topline growth disappoints, QSR’s multiple may compress below the 20x we underwrite.

Disclosure:

We and our affiliates are long QSR and may buy additional shares or sell some or all of our securities, at any time. We have no obligation to inform anybody of any changes in our views of QSR. This is not a recommendation to buy or sell securities. Our research should not be taken for certainty. Please conduct your own research and reach your own conclusion.

Catalyst

Earnings.  M&A.