QUIC RESEARCH REPORT Consumers & Healthcare Restaurant Brands International (TSX:QSR) Stock Pitch A Company as Rich as its Dark Roast Coffee Daniel Morris Julie Vincent Jon Allion Simon Rezene Michael Benzinger Introduction In December 2014, Burger King acquired Tim Hortons in a $12 billion acquisition to create Restaurant Brands International, the third largest quick service restaurant chain in the world. With the recent volatility one of our largest holdings, Valeant, has experienced, we believe that shifting a portion of our position into Restaurant Brands International would position us better to capitalize on a highly attractive company in the coming years. Summary - The combined company is in a position to expand globally, while cutting costs at the same time. This will grow revenues and increase margins, which has already seen some success - 3G Capital s Zero-Based Budgeting technique has historically been successful at Burger King and Anheuser-Busch and we are confident it can be implemented at Restaurant Brands International - Additional deals are a catalyst for long-term value creation, and with shares trading at a discount to peers, share buybacks and increased dividends can provide near-term value - We propose adding Restaurant Brands International as a core holding to our Canadian portfolio, with an implied return of 26.8% QUIC Research Reports focus on emerging investment themes that affect current portfolio companies and companies under coverage. The information in this document is for EDUCATIONAL and NON-COMMERCIAL use only and is not intended to constitute specific legal, accounting, financial or tax advice for any individual. In no event will QUIC, its members or directors, or Queen s University be liable to you or anyone else for any loss or damages whatsoever (including direct, indirect, special, incidental, consequential, exemplary or punitive damages) resulting from the use of this document, or reliance on the information or content found within this document. The information may not be reproduced or republished in any part without the prior written consent of QUIC and Queen s University. QUIC is not in the business of advising or holding themselves out as being in the business of advising. Many factors may affect the applicability of any statement or comment that appear in our documents to an individual's particular circumstances. Queen s University 2016
Table of Contents Introduction 1 Quick Service Restaurant Industry Overview 3 Company Overview 4 Investment Thesis I: Global Expansion Set to Drive Topline Growth 5 Investment Thesis II: Cost Reduction Leading to Margin Expansion 6 Investment Thesis III: Strong Balance Sheet 7 Catalysts and Risks 8 Valuation 9 References 12
Quick Service Restaurant Industry Overview Over the past year, quick service restaurants (QSRs) have performed extremely well. In 2015, they outperformed the S&P 500 by approximately 6% as a result of scale advantages and increased ticket consumption. The three largest QSR companies in the United States are McDonald s, YUM! Brands and Restaurant Brands International. McDonald s is the largest chain, which opened its first store in 1948. They have approximately 36,000 store world wide, of which 80% are franchised. They have significantly expanded their menu to include healthier options, but still heavily promote their dollar menu which features burgers and fries. YUM! Brands is the second largest retailer and owns brands such as KFC, Pizza Hut and Taco Bell. The company has approximately 40,000 restaurants in over 120 countries around the world. YUM! has been focusing its corporate strategy on expanding in China, where it sees the largest growth potential in the coming years. Restaurant Brands International is the third largest company and is the result of a merger of the American-based Burger King Chain and the Canadian-based Tim Hortons chain. It is currently looking to expand Tim Hortons into the United states as well as continue expanding Burger King into Asian countries. Other players in the industry include Subway, A&W and Starbucks. On a macro scale, there are three key trends QSR retailers will experience. First, the QSR industry is expected to experience SSS growth in the 2-3% range. Companies who are able to create strong organic growth, will most likely outperform their peers. Second, food costs are expected to decline and wage costs are expected to continue growing. Companies will begin looking to follow a 3G cost cutting model, to ensure that bottom line profitability is maximized. Last, it is expected that casual dining SSS growth will remain flat, with more individuals opting for fast food options. With new, healthier menus, customers are more inclined to try QSR restaurants. Continued capital deployment from large QSR companies will incentivize shareholders to invest, and should support strong performance over the coming year. EXHIBIT 1 SSS Growth Casual Dining vs. Fast Food 7% 6% 5% 4% 3% 2% 1% 0% (1.0%) (2.0%) (3.0%) 1Q12 3Q12 1Q13 3Q13 1Q14 3Q14 1Q15 3Q15 1Q16E Source: RBC Capital Markets QSR CASUAL 3
Restaurant Brands International Company Overview Restaurant Brands International (TSX:QSR) was formed in December 2014 through the $12 billion acquisition of Tim Hortons by Burger King. Combined sales of the company are ~$23 billion, ranking third behind McDonald s and YUM! Brands (who owns Taco Bell, and Kentucky Fried Chicken among many others). The Company operates ~19,000 restaurants in over 100 countries, the majority of which are franchised. Tim Hortons is based out of Oakville, Ontario and Burger King is based out of Miami, Florida; the two divisions are being operated separately, as Tim Hortons is led by CEO Marc Caira (and has been since 2013) while Burger King is managed by CEO Daniel Schwartz, whom will take on the role as the group CEO of the new company. EXHIBIT 2 Geographic Locations (2014) Canada 21% United States 42% opportunities to expand Tim Hortons (Burger King operates in 98 countries). Burger King s solid relationships with franchisors will benefit the growth strategy set out for Tim Hortons. Burger King was founded in 1954 and generates revenue from three categories: franchise revenues, property income, and retail sales. Tim Hortons was founded in 1964, and operates the largest quick service restaurant chain in Canada (by system wide sales and number of locations). Tim Hortons accounts for 75% of caffeinated beverages and 76% of brewed coffee served in Canada, and by doing so, has become an iconic Canadian business. 3G Capital, a Brazilian investment firm, was a leading player behind the merger and their zerobased budgeting strategy has been successfully implemented at Anheuser-Busch and Burger King 3G owns 51% of pro-forma shares. Berkshire Hathaway has also committed $3B in a form of preferred equity financing, however they will not participate in Restaurant Brand International s daily business operations. Internat ional QSR is fairly well diversified geographically, with 37% Source: Company Reports EXHIBIT 3 Global Sales ($B) $87.8 $43.6 $23.6 $19.8 $10.0 $9.8 $8.9 MCD YUM QSR Subway Wendy's Dunkin Domino's Source: Company Reports
Franchise and Property Revenues ($MM) QUIC Research Repor t Investment Thesis I: Global Expansion Set to Drive Topline Growth After Burger King was taken private by 3G Capital, a Brazilian Private Equity firm, the company has undergone significant expansion efforts to increase its store count in markets outside of Canada and the United States. Through a master franchise joint venture (MFJV) structure, the company has sold off more than 1,200 company-owned stores to franchisees in 2009, resulting in 99% of system wide restaurants currently being operated by franchisees and licensees. This expansion model has allowed Burger King to transfer business-level decisions to local operators and financing partners who have extensive knowledge of their respective markets. By granting local operators licensing rights, QSR has been able to pursue long term unit growth outside of its domestic markets (1.4% YoY in 2010, versus 5.4% YoY in 2014) and drive sales through rent, royalty and licensing fees. Prior to 3G s involvement, the store count totalled 12,078 and has since expanded to 14,372 by the end of 2014, signalling 3G s agenda of accelerating unit store growth abroad to drive sales over the medium term. Tim Hortons, on the contrary, has had less success in international markets, but is focused on increasing unit growth in key U.S. markets. Tim Hortons has begun to adopt Burger King s master franchising model through local partnerships to ensure offerings and marketing efforts are sensitive to local preferences. In 2015, Tim Hortons added 69 net new outlets worldwide, taking the total count to 174 net new openings for the year. As part of the expansion strategy, Tim Hortons is focusing on new menu innovations by experimenting with different day parts, seasonal offerings, new lunch items and increasing drive-through capacity to appeal to an increasing number of consumers and alleviate competitive pressures. With an increased number of franchised stores in the United States, Tim Hortons will create an increased stream of rent and royalty fees, thereby driving overall topline growth for QSR. While QSR can expected increased competition in international geographic markets, it is well poised to withstand these pressures due to their adaptive business strategy. In addition, QSR s expansion structure can allow the company to leverage its existing relationships with financing partners such as Groupe Bertrand of France to add to its brand portfolio in the long term. EXHIBIT 4 Company-Wide Franchise and Property Revenue Growth $3,000 $2,500 $2,000 $1,500 Source: Company Reports $1,000 2014 2015 2016E 2017E 2018E 2019E 5
Adj. SG&A Expenses ($MM) QUIC Research Repor t Investment Thesis II: Cost Reduction Leading to Margin Expansion Since 3G s takeover of Burger King in 2010, the company has seen sharp declines in expenses, totalling $178 million over the course of 2010-2013. 3G has implemented significant cost reducing efforts to improve Burger King s growth in earnings, and over the last four years, has improved the company s EBITDA margin to 70.6% in 2014, up from 18.9% in 2010. The move to a nearly fully franchised business has allowed the company to become a less capital intensive business, with lower corporate overhead. By eliminating companyowned stores and transferring operating costs to franchisees, QSR has been able to free up cash and focus on de-levering, improving store layouts and menus, and engaging in shareholder value creating activity. In addition to the new fully franchised model, 3G has employed a company-wide Zero Based Budgeting (ZBB) process, which requires corporate managers to justify their spending plans each year. The combination of the ZBB plan with nearly a 20% reduction in headquarter staff has began to yield lower corporate costs for QSR. Within QSR s first year, the company saw $107 million in the reduction of G&A expenses due to the ZBB plan. At Tim Hortons, management s cost optimization efforts have led to a reduction in G&A expenses of approximately 16.8% on a YoY basis over the course of 2015 With QSR s focus on a U.S. expansion for Tim Hortons and increasing international unit store growth for Burger King, we are confident that QSR will continue to prioritize cost savings. Due to the company s size, it can continue to leverage this advantage in negotiations with suppliers and ensure they maintain a reduced cost base. This will ultimately allow management to focus on key strategic issues pertaining to store layouts, offerings and marketing efforts that will translate to increased franchise level returns and drive margin expansion. EXHIBIT 5 Burger King SG&A Expense Decline $400 14.3% 16.0% $300 $345 11.6% 10.3% 12.0% 8.8% 8.6% $200 $100 $206 $169 $133 $108 8.0% 4.0% $0 2010 2011 2012 2013 2014 0.0% Source: Company Reports Adj. SG&A Expenses Adj. SG&A Rate 6
Investment Thesis III: Cash Rich Balance Sheet Restaurant Brands International has a cash rich balance sheet, an industry leading free cash flow yield and strives to create shareholder value through capital deployment. The combined company now operates seamlessly, and is using its joint assets to help expand and adapt to new consumer preferences. We see it as being the top QSR company poised for strong growth in 2016 and 2017. With the help of 3G, Tim Horton s is beginning to transition to a more capital-light model, which was successfully achieved at Burger-King a few years back. Once fully transitioned, FCF will significantly increase at Tim Horton s, which is expected to contribute to an FCF which is 2x larger than the level achieved previously. Cash on the companies balance sheet will be used to make capital investments which improve and reimage its restaurants, to retire preferred shares and to make strategic acquisitions should they be appropriate. deleveraging while still being able to pay out a steady dividend. The leverage ratio is expected to be approximately 3.83x by the end of 2016, compared with 5.46x immediately following the merger. Management has indicated that QSR will increase its dividend every quarter for the next two years and attempt to reach a target payout ratio of 30% by the end of 2017. They also have stated they plan on repurchasing shares and ensuring that all strategic goals maximize shareholder value. Compared to its peers, QSR is more financially stable and has been able to create more shareholder value. We expect this trend to increase in the coming year, making Restaurant Brands International out top choice among quick service restaurants. Pre-merger, both companies had very strong balance sheets with little debt. Going forward, Restaurant Brands International hopes to continue EXHIBIT 6 Free Cash Flow Yields of Major Retailers 4.4% 4.2% 3.9% 3.0% 2.5% 2.1% QSR MCD YUM! DNKN DPZ WEN Source: Bloomberg 7
Catalysts & Risks Catalysts 1. Low Overhead Costs from Merged Entity: Lowered costs from the combined company of Burger King and Tim Hortons have led to many benefits across the board. Most notably, overhead costs have decreased significantly for both Burger King and Tim Hortons, currently at $10,000 and $16,000 per system restaurant. Meanwhile, Wendy s, McDonald s and YUM! Brands possess overhead costs per system restaurant of $40,000, $36,000 and $63,000 respectively. 2. 3G Involvement and Opportunity for Future Global Deals: 3G Capital has had a history of making similar follow-up investments in other sectors it has entered. The possibility for 3G to reshape and consolidate the global fast food landscape would add additional scale benefits for Restaurant Brands International. 3. Tim Hortons U.S. Development Agreement: On October 8 th 2015, Restaurant Brands International announced the signing of a development agreement for Tim Hortons in Cincinnati. QSR intends to build more than 150 chains across the region in the upcoming decade, while also looking towards other areas for international expansion. Risks 1. Burger King SSS Contraction: Burger King witnessed same store sales (SSS) growth contract throughout all four quarters of 2014. The decline is now having effects on EPS, lowering the multiple by significant amounts. The company is attempting to mitigate the downturn by changing food options in stores. 2. Competition in the Fast Food Industry: Burger King has experienced increased competition in recent years, leading to the company lowering prices for hamburger meals. New threats posed by fast food names like Chipotle and Shake Shack have also cut into the companies revenues. Meanwhile, brands such as Starbucks, Dunkin Donuts and McDonald s continue to be key players in the industry. 3. Cost Savings and Synergies: Many believe that cost reductions from the combined company of Tim Hortons and Burger King have been fully experienced. Synergies are also expected to diminish in the future, leading to lower increased revenues in upcoming years. The combined effect has led to sell-side analysts cutting EPS estimates for 2016 and beyond. 8
Valuation Comparable Companies Analysis Company Name Market Enterprise EV / EBITDA Price / Earnings Net Debt / EBITDA 2015 EBITDA FCF Dividend Cap ($MM) Value ($MM) LTM 2016E 2017E 2016E 2017E 2016E 2017E Margin Yield Yield McDonald's Corp. $108,480 $124,018 13.9x 14.1x 13.5x 23.9x 21.8x 1.8x 1.7x 3.4% 3.0% 3.0% Starbucks Corporation $89,133 $89,905 nmf 17.1x 15.2x 31.8x 27.5x 0.1x 23.1x 0.1% 2.4% - Yum! Brands, Inc. $31,502 $33,858 12.1x 12.2x 11.4x 22.4x 19.8x 0.9x 0.8x 2.1% 3.3% 2.5% Chipotle Mexican Grill, Inc. $14,965 $14,006 14.2x 15.2x 14.6x 31.0x 29.3x (1.0x) (1.0x) 2.0% 2.8% 0.0% Domino's Pizza, Inc. $6,080 $7,575 18.6x 17.6x 15.9x 32.4x 27.5x 3.5x 3.1x 2.0% 2.6% 1.1% Dunkin' Brands Group, Inc. $3,946 $6,117 15.3x 14.6x 13.8x 22.3x 19.5x 5.2x 4.9x 5.2% 7.5% 2.5% Mean $42,351 $45,913 14.8x 15.2x 14.0x 27.3x 24.2x 1.7x 5.4x 2.5% 3.6% 1.8% Median $23,234 $23,932 14.2x 14.9x 14.2x 27.5x 24.7x 1.3x 2.4x 2.1% 2.9% 2.5% Restaurant Brands International Inc. $8,222 $16,035 15.2x 9.7x 9.1x 34.8x 30.1x 4.8x 4.4x 4.8% 7.3% 1.4% Restaurant Brands is trading at a premium on a Price/Earnings and EBITDA margin basis. From a FCF Yield and EV/EBITDA standpoint the company is undervalued, with figures far more attractive than its peers. Net Debt/EBITDA is extremely high for the company, representing an area for investors to be mindful of. EXHIBIT 7 Analyst Target Prices Scotia Bank $69.00 QUIC $64.11 RBC $60.72 Credit Suisse $59.34 Cowen $57.96 Stephens $57.96 Consensus $55.20 UBS $55.20 Source: Capital IQ $50.00 $55.00 $60.00 $65.00 $70.00 9
Terminal Growth (%) QUIC Research Repor t Valuation We value Restaurant Brands International using comparable companies and a discounted cash flow model analyses. Cost of equity is derived by using a 10-year treasury yield of 2.85% and an above average market risk premium to account for the expansion risk. The cost of debt was calculated using the weighted average yield of QSR s debt. WACC Calculation Risk-Free Rate 2.85% Market Risk Premium 9.00% Levered Beta 0.63 Cost of Equity 8.54% Combined, the WACC is 7.29%. We assumed a 2.00% terminal growth rate due to global expansion and the increased synergies of the combined company that are expected to have a profound effect over the next decade. Our target share price implies a total return of 24.2% (capital gain of 22.8% and a dividend yield of 1.4%). Share Price Calculation PV of UFCF 4,193 Terminal Year Growth Rate 2.00% Discount Rate 7.29% PV of Terminal Value 16,578 Enterprise Value 20,770 Cost of Debt 8.25% Tax Rate 23.00% After Tax Cost of Debt 6.35% Enterprise Value 20,770 Less: Total Debt 8,788 Plus: Cash and Cash Equivalen 976 Implied Equity Value 12,957 Capital Structure Debt 57.10% Equity 42.90% Total: 100.00% WACC 7.29% Shares Outstanding 202.4 Implied Share Price $64.02 Current Price $51.56 Target Price $64.02 Dividend Yield 1.4% Total Return 24.2% Discount Rate (%) 65 6.22% 6.72% 7.22% 7.72% 8.22% 1.00% $67.66 $58.73 $51.26 $44.94 $39.51 1.50% $77.19 $66.48 $57.68 $50.32 $44.09 2.00% $88.97 $75.88 $65.32 $56.65 $49.40 2.50% $103.93 $87.50 $74.59 $64.19 $55.64 3.00% $123.53 $102.25 $86.05 $73.33 $63.08 10
Appendix: Discounted Cash Flow Historical Projections 2012 2013 2014 2015 2016E 2017E 2018E 2019E Revenue $1,970 $1,146 $1,197 $3,707 $4,018 $4,177 $4,226 $4,519 Revenue Growth % (41.8%) 4.5% 209.7% 8.4% 4.0% 1.2% 6.9% Operating Income (EBIT) $383 $522 $1,382 $1,332 $1,357 $1,465 $1,600 $1,737 Operating Income Margin Growth 36% 165% -4% 2% 8% 9% 9% Less: Taxes ($101) ($144) ($145) ($306) ($312) ($337) ($368) ($400) Net Operating Profits after Tax $282 $378 1,236 $1,026 $1,045 $1,128 $1,232 $1,337 Plus: Depreciation and Amortization $18 $11 $14 $203 $185 $192 $200 $200 % Revenue 0.9% 1.0% 1.2% 5.5% 4.6% 4.6% 4.7% 4.4% Plus: Stock-Based Compensation $12 $15 $26 $46 $40 $40 $40 $40 % Revenue 0.6% 1.3% 2.2% 1.2% 1.0% 1.0% 0.9% 0.9% Changes in Operating Assets and Liabilities ($151) ($93) ($37) ($157) ($50) ($74) ($23) ($202) % Revenue 8% 8.1% 3.1% 4.2% 1.2% 1.8% 0.5% 4.5% Less: Capital Expenditures ($39) ($25) ($70) ($178) ($190) ($210) ($230) ($250) % Revenue 2.0% 2.2% 5.9% 4.8% 4.7% 5.0% 5.4% 5.5% Unlevered Free Cash Flow $123 $286 ($1169) $938 $1,030 $1,077 $1,219 $1,126 Discount Period 1 2 3 4 Discount Factor 95.90% 91.98% 88.21% 84.60% Present Value of Unlevered Cash Flows $988 $990 $1,075 $ 1,139 11
References 1. Bloomberg 2. Capital IQ 3. Company Reports 4. Evercore ISI 5. IBIS World 6. Jefferies 7. JP Morgan 8. Morgan Stanley 9. RBC Capital Markets 10. Scotiabank Global Banking and Markets 12