Restaurant Brands International: What’s The Secret Sauce?

Restaurant Brands International (RBI) is a conglomerate of QSR (quick-service restaurant) brands. Some of the world’s most prominent investors have spent billions assembling it over the last decade.

RBI’s roots go back to 2010 when 3G Capital took Burger King private for $4B. Two years later, Burger King merged with Bill Ackman’s SPAC, Justice Holdings. In 2014 Burger King bought Tim Horton’s for $11.3B and became Restaurant Brands International. Warren Buffett’s Berkshire Hathaway bought $3B of preferred shares to help finance that deal.

Leveraged 7.5x, it was essentially a public LBO. Under 3G’s leadership the business gushed cash and quickly de-levered. By 2017 3G was back on the prowl and purchased Popeyes for $1.8B in cash.

Curiously, in 2005 Bill Ackman had urged Wendy’s to spin off Tim Horton’s to unlock shareholder value. Nine years later, Ackman cheered when Burger King bought Tim Horton’s. He was one of its largest shareholders.

This begs the question: why did Tim Horton’s add value to RBI but detract value from Wendy’s? What’s RBI’s secret sauce?

RBI’s Secret Sauce

There are limited synergies to owning multiple QSR brands, as Bill Ackman pointed out in 2005. Brands need their own marketing and product development teams to preserve their unique qualities. RBI’s key insight has been to decentralize branding and operations while centralizing new restaurant development in order to leverage 3G’s unique financial expertise and relationships with investors around the world.

Source: May 2019 Investor Day Presentation

Although 3G has a reputation as a ruthless cost cutter (which isn’t undeserved), it’s not RBI’s focus. Their rationale for buying Burger King, Tim Horton’s, and Popeye’s was international growth. 3G’s strategy is to buy iconic brands with large, untapped addressable markets, and use their international connections and financial expertise to rapidly expand. RBI’s growth is particularly valuable because franchisees — not RBI — put up capital for new restaurants. It’s capital-light growth at its finest.

Though relationships and financial expertise might not sound like a durable competitive advantage, it’s better than you might think. It’s one thing to find one person who wants to open one Burger King. It’s another thing to find investors in 100 different countries with the capital and expertise to open hundreds of stores in a matter of years.

3G’s founders hail from Brazil, so they started expanding there. RBI leveraged 3G’s relationships with investors and financial prowess to structure a unique master franchise joint venture (JV).

The JV’s deep pockets combined with 3G’s operational know-how and Burger King’s iconic brand allowed RBI to expand in Brazil at an unprecedented pace.

Growth was fast, but profitable. Revenue (the basis for RBI’s royalties) grew at a 45% CAGR. Adjusted EBITDA compounded at a 66%. Average restaurant sales (ARS), the most important driver of franchisee profitability, are $1.1M, only 25% below the BK America’s ARS. The Brazilian master franchise JV served as a template for expansion elsewhere. Since then RBI has re-run their Brazilian playbook in 100 different countries using three different brands. Expansion has accelerated ever since.

RBI’s growth carried high incremental margins which allowed it to rapidly de-lever. This gave them room to borrow against new purchases and led to the acquisition of Tim Horton’s and later Popeye’s. Like Burger King, RBI selected these for their iconic brands and international potential. Current leverage is about 5x, which is manageable and lower than peers. Another brand acquisition could be possible.

Popeye’s in particular has lots of growth potential. 65% of Americans have yet to try the brand, so there’s an untapped market at home. Abroad, KFC has proven how well fried chicken sells. In China alone there are 11,484 KFCs to Popeye’s 121. Popeyes only has 4% of KFC’s international stores. Popeye’s Louisiana heritage helps differentiate it from KFC and while its spicy flavors complement tastes in many emerging markets.

Forward Returns

In Bill Ackman’s words, RBI “has a highly-scalable and replicable operating strategy.” The strategy has been a home run so far, but how much runway do they have left?

RBI’s growth is a function of new unit growth plus same store sales growth. Management plans to grow from 27,000 restaurants to 40,000 in 8 to 10 years. That works out to a 4-5% unit growth CAGR. They also expect same store sales to grow 2-3%. Combined, they’re targeting 6-8% system wide annual sales growth.

One way I value companies is to ask what price I could pay to earn a 15% CAGR over 5-years (i.e. a double) while using reasonable assumptions.

Management has a creditable plan to grow sales at 7% annually. A 7% growth rate discounted at 10% suggests a 35x multiple, which is pricing for perfection. Instead I assume a 4% terminal growth rate, which is about half of management’s new unit growth target before counting same store sales growth. This suggests RBI’s terminal multiple should be 17.3x.

RBI pays a $2.08 annual dividend, which represents 80% of their adjusted net income. Actual distributable earnings are likely closer to 85-90% of net income, but 80% is more conservative.

All together these assumptions suggest buying at 15.1x earnings will produce a 15% CAGR for five years. This price gives no value to 3G’s capital allocation skills, which could bring a new brand into the fold someday.

15.1x earnings works out to $40 per share, about 25% below today’s $53 price.

Note that RBI has 469M diluted shares outstanding, including 216 partnership units that are exchangeable 1:1 into common shares.

Gaining From Disorder

Although the pandemic has cast a cloud of uncertainty over the economy, RBI looks poised to emerge stronger from it.

Before the pandemic, two-thirds of RBI’s business was already drive-thru or carry-out. That’s kept it open for business. Burger King’s largest franchisee, Carrol’s Restaurant Group, reported that sales rose 3% year-over-year for the week ended June 7th. Sales bottomed at -34% the week of March 29. This demonstrates how resilient the QSR industry is. Consumers trade down to fast food and consider it an affordable luxury during tough times.

Tim Horton’s sales have fared the worst because of their large breakfast business. Breakfast and coffee are routine-driven, which normally makes for a loyal customer base. Most of Tim’s customers visit 4+ times per week. But routines have changed and so have Tim’s sales patterns. On the flip side, Popeyes sales are strong. Families, tired of cooking, are increasingly turning to delivery or carry-out for variety. These sales tend to carry an above-average check size. RBI’s diversification make its cash flows even more robust than peers.

The pandemic accelerated years of digital adoption into a number of weeks. RBI has been able to surf this wave because it invested in apps and (outsourced) delivery years ago. In May, RBI reported that digital represents 9% of sales at Burger King, 15% at Popeyes, and 30% at Tim Horton’s.

Tim Horton’s digital capabilities are particularly advanced. Last year Tim’s rolled out a loyalty program that 20% of Canadians enrolled in. 50% of Tim’s sales now come through this program. The loyalty rollout has created a 3% headwind to same store sales growth, but ought to drive incremental sales in the future.

Apps allow RBI to interact directly with customers. They’re not intermediated by Google, Facebook, TV ads, or billboards. Loyalty programs give RBI data about a customer’s exact preferences, allowing them to customize promotions.

The pandemic will likely slow RBI’s expansion plans, but only temporarily. Opportunities in real estate could set up RBI’s growth for the years to come. Traffic is the most critical variable to a restaurant’s success, and nothing drives traffic better than a convenient location.

In 2009 Tim Horton’s CEO spoke about his experience during the 1991 recession:

All of a sudden, real estate that maybe the year before we couldn’t afford to look at becomes available to us at attractive prices. And the other thing that happens is, there are a lot of people that are displaced from their jobs, all of a sudden want to take a greater control of their lives, decide to apply and become Tim Hortons franchisees. And if you go back to the early 90s, we had a tremendous influx of new store owners who were very strong operators, people that wanted to again take control of their lives and own their own business.

RBI’s CEO spoke in May about his experience coming out of the financial crisis:

I was in Europe with Burger King back in 2010 about 10 years ago a kind of at the height of the economic crisis and these were some of the best years we had with in Western Europe with many of our developing partners because there was a tremendous opportunities, the resilience of our business and our brands the strength of our investment model and returns on capital as well as opportunities that exist from a real estate stand point so we feel very confident long term.

RBI’s ability to serve affordable food while enabling social distancing, produce consistent cash flows, and capitalize on its technologic advantage position it to emerge stronger from this crisis.

RBI’s greatest challenge may be labor costs. Usually recessions ease wage inflation, but the extra $600 per week in employment benefits mean laborers can earn more on welfare than in a kitchen. The extra $600 is scheduled to roll off in July, but once you give someone something, it’s difficult to take it away. Charlie Munger calls it Deprival Super-reaction Syndrome and Daniel Kahneman calls it loss aversion.

For example, in 2008 the FDIC increased its insurance limit from $100k to $250k. The increase was scheduled to roll off in 2014, but in 2010 Obama made it permanent. If unemployment benefits continue to exceed minimum wage, franchisees will need to increase wages. That will pressure margins and reduce appetite for new unit growth.

Summary

Bill Ackman has described RBI as a “high-quality, capital-light, growing annuity that generates high-margin brand royalty fees.” It is squarely in replication mode, with a proven strategy and ability to execute. It has a large addressable market and requires almost no capital to grow. It is relatively non cyclical and run by managers with skin in the game and proven capital allocation skills. 3G owns 32% of RBI and employees, excluding officers, own 5%. Most importantly, RBI’s business model is simple, easy to understand, and not subject to disruption.

That’s not to say the QSR industry isn’t competitive. It is fiercely competitive. Brands battle constantly for traffic via promotions and new menu items. They must balance novelty to drive traffic against a simplicity to drive efficiency.

The good news is that, while competitive, the industry’s market share is relatively fixed. McDonald’s, Burger King, and Wendy’s have been the big three for a long time. New concepts come and go, but few attain the critical mass necessary to challenge the incumbents. While menu novelty is important, tweaking a chicken sandwich doesn’t require costly R&D.

RBI has many of the qualities I look for in an investment and trades 25% above where I’d get interested in buying. It traded below $40 a few weeks ago and may very well again in the coming months.

Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.

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