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Can Bill Ackman Restore BKW as the Worldwide Burger King?

We are unimpressed with Burger King Worldwide (BKW) as an investment.  Burger KING?  Not from where we’re standing!  More like Burger Dethroned!  Wendy’s (WEN) now generates more revenue than BKW.  BKW is selling off 278 of its corporate-owned restaurants to Carrols Restaurant Group, Inc (TAST).  The bad news is that this transaction will exacerbate BKW’s revenue gap between McDonald’s (MCD), Wendy’s and Burger King.  The good news is that these restaurants were some of the weaker performing restaurants in the system and it will reduce losses by $4M annually.  Also this transaction will convert ~$45M of net tangible assets into $12.4M in cash and $54M in convertible preferred stock in Carrols.

 
Source: Company Q1 Press Releases

At least BKW announced in the S-1 filings that it is not planning on paying divvies.  I sure hope that the management keeps their word on this, because BKW will need every penny to pay down its $3.2B in outstanding bonded debt and loans.  Despite the fact that the weighted-average coupon paid on this debt exceeds 7%, BKW’s outstanding debt is trading at a weighted average 3% discount to face value.  At least the company won’t see any big debt maturities until 2016, when it will see nearly $1.8B in maturities from secured term loans and interest rate caps.  We believe that it will be at least able to refinance its outstanding debt.

 
Source: Justice Holding/Burger King Worldwide Amended S-1 Form Financial Statement Notes

We think the only purpose of the Private Equity firms investing in BKW was to see which firm could suck out the most cash flows and value from Burger King.  Diageo sold Burger King to the Goldman, Bain and TPG consortium for $1.5B in 2002.   The PE firms invested only $210 million of their own money; the rest was borrowed.  BKW’s new owners immediately began taking out tens of millions of dollars in fees. Four years later, this consortium took Burger King’s stock public in 2006. But, first, the investors sucked out a $448 million dividend from the company. In all, according to The Wall Street Journal, “the firms received $511 million in dividend, fees, expense reimbursements and interest” — while still retaining a 76 percent stake.

In 2010 the PE firms sold Burger King to 3G Capital for $3.26B.  It appears that 3G larded $1.8B in additional debt on to BKW’s balance sheet and then paid out 110% of BKW’s 2011 free cash flows as a dividend ($393M).  With regards to the $1.41B Justice Holdings is investing in BKW, that money is going directly and exclusively to 3G.  BKW is not getting a penny of it.

The financial engineering of the PEs has enabled a $1.5B investment in BKW in 2002 to be worth $4.96B 10 years later.  The PEs also paid themselves ~$1B in dividends, which makes the PE stake worth $5.96B. An investment in BKW in 2002 when the Diageo sale of BKW was announced to July 3rd, 2012 would have generated a Compounded Annual Growth Rate of 14.74% over this 10 year period.  BKW’s revenues have only increased by 60% cumulative during this time period and had shown erratic revenue and cash flow performance during this time period.  The financial engineering forced BKW to increase its bonded debt and loans outstanding from $1.3B in 2002 to $3.2B in 2012.  Despite these gimmicks, an investment in McDonald’s common stock on June 30th, 2002 would have outperformed an investment in BKW during this time period and would not have relied on complex financial engineering and a rapid increase in outstanding debt.

 
Source: Morningstar Direct and Joe Nocera’s New York Times Article on BKW

In conclusion, we recommend that investors avoid investing in BKW until we see greater clarity with regards to the firm’s performance.  We believe that the Q2 earnings release will potentially provide investors with greater clarity with regards to BKW’s operating and financial performance.  However, in our opinion, Burger King is going to need many years and much more capital investment in order to be able to just merely compete with fellow fast-food also-ran Wendy’s, much less the fast-food industry’s leader McDonalds.  We find that paying 25 times estimated 2012 free cash flows from business operations is too high a price, especially when ~63% of the company’s assets are acquisition related intangible assets and goodwill and the company has $3.2B in outstanding principal debt.  About 12% of the company’s pro forma Q1 revenue has to be used simply to pay bond interest expense and we believe that will hurt BKW’s ability to turn itself around.  Furthermore one-third of BKW’s Q1 free cash flows from business operations were due to amortization of deferred financing costs on original issue discount (zero-coupon) bonds.

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