That Tim Hortons Deal
Burgers and coffee: It's not the worst thing in the world, but it probably wouldn't be your first choice for a meal either, right?
That's how I feel about the merger between Burger King and Tim Hortons, which was engineered by Brazilian private equity firm 3G Capital with some financing help from Warren Buffett's Berkshire Hathaway Inc. 1 There are some tasty parts, and some less so. This week marks the two-year anniversary of the deal, which created the fast-food company now called Restaurant Brands International Inc. After analyzing the transaction, Gadfly has decided that it's meh -- the midpoint of five ratings given to mergers we review. 2
Buying Tim Hortons -- a Canadian chain of coffee-and-doughnut shops named after a hockey player, of course -- was technically a tax-inversion deal that left the combined company headquartered in Oakville, Ontario. But the biggest motivation wasn't taxes. It was that 3G saw an opportunity to do what they do best: gut overhead and operating costs at Tim Hortons, like they had already done at Burger King. 3 Timmy's profit margins paled in comparison to Dunkin' Brands Group Inc.
But where does Restaurant Brands go from here? The margin expansion has driven profit and created value, except that strategy has an expiration. Eventually the operations hit peak efficiency, at which point in order to keep growing you need to bring in more customers, open more restaurants (franchises) or make another big acquisition. And organic growth isn't looking that impressive at the moment.
Revenue growth may not be as much of a concern for private equity owners like 3G that concentrate on maximizing the bottom line and cash flows. Still, Restaurant Brands is a public company and for public investors, growth potential can be important -- especially when they're considering whether to invest at this stage.
Burger King is facing the same challenges as its U.S. rivals: keeping customers loyal when other fast, cheap options are plentiful and many consumers are on a health kick. While competitors have taken advantage of low food costs to introduce less-bad-for-you options, Burger King doubled down on, well, the opposite. Case in point: the Whopperrito, Mac n' Cheetos and chili cheese dogs. That's actually not a bad idea since people don't go to McDonald's and Burger King for salads. However, it also means constantly having to introduce new menu items that will get people's attention.
It's been two years and Tim Hortons' geographic profile outside of North America hasn't changed meaningfully yet, even though bringing the coffee shops to other countries where Burger King has franchise partners was a major goal. Progress on this has been slow, which in part may have to do with the Tim Hortons name being less recognizable than, say, Starbucks, as well as cultural differences, such as tea being more popular than coffee in some international markets. Just ask Yum! Brands Inc., the owner of KFC, Pizza Hut and Taco Bell that spun off its China operations this year: It's not always easy bringing a Western brand to other parts of the world. For one, the menu and message have to be adapted for the local market, which takes time and isn't cheap.
Restaurant Brands signed a development agreement in June for Tim Hortons in Minneapolis, following agreements in Columbus, Cincinnati and Indianapolis. As for outside the U.S., the chain is also coming to the Philippines, which management says has "an affinity for coffee and donuts." It's going to take time for these investments to translate into profit growth for shareholders.
So while this merger has juiced earnings and lifted the stock, the cost-reduction benefits may start to wane and top-line growth hasn't yet hit its stride.
Berkshire provided $3 billion of preferred equity financing and got a warrant allowing it to purchase about 4 percent of Restaurant Brands outstanding common stock. Buffett and 3G had also teamed up to acquire H.J. Heinz in 2013, which they later merged with Kraft Foods.
In rating the merger, Gadfly took into account the margin improvement at Tim Hortons, the slow pace of international growth, Burger King's performance in the U.S. and current food trends.
Data used for "3G's Margin Magic" chart: First Burger King bar shows average operating margin for 10 quarters leading up to the LBO by 3G Capital. Second bar shows average operating margin after being taken public again in 2012 through the second quarter of 2014 (excludes third quarter of that year because of significant non-recurring operating expenses related to the Tim Hortons merger). Tim Hortons bar shows average operating margin for 10 quarters leading up to Burger King merger. Restaurant Brands bar shows combined company's average operating margin since merger.
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