With a deal in place to acquire
Burger King (
BKC
)
for a tidy $24 a share, investors are handed the opportunity to
quickly assess how its rivals are valued. Any rivals selling at a
sharp discount to Burger King's price are likely to see renewed
investor interest as the M&A action heats up in the sector.
[Read:
How Investors Should Handle the M&A Frenzy
]
Private equity (PE) firms like to buy underperforming companies. In
recent years, Burger King has seen
McDonald's (
MCD
)
and
Yum Brands (
YUM
)
pull away in terms of same-store sales growth and sharply rising
cash flow
. Those companies are likely too large and too healthy to be of
real interest to these
turnaround
specialists. For that matter,
Chipotle Mexican Grill (
CMG
)
is far too healthy -- and richly valued -- to hold any appeal. [
More on Chipotle -- and why you should short it
]
So I decided to take a look at three major chains that are
underperforming and have major room for improvement.
A fair deal
Burger King is being acquired for about 11 times trailing cash flow
-- a fair multiple when you offset the company's strong brand, yet
slightly weaker operating metrics than rival McDonald's, which
trades for about 13 times trailing cash flow. The
buyout
is a bit unusual in that Burger King is not in distress and
performing only slightly below expectations.
Rival
Wendy's/Arby's Group (
WEN
)
has often been considered the most logical buyout candidate, thanks
to its very weak results in terms of gross and operating profit
margins. Wendy's has been a moderate underperformer while Arby's
has been a severe underperformer. Presumably, a PE firm could come
in and shake things up to bring the Wendy's and Arby's chains up to
snuff. The trouble with that logic is that Nelson Peltz, a major
shareholder, has already been working diligently to improve results
without any success. PE firms may question whether they can do any
better.
But if Wendy's/Arby's could once again operate as well as its
peers, then shares would be quite undervalued at these levels. As
the table below notes, Wendy's
enterprise value
is less than its annual sales (or said another way, the shares have
an EV/sales ratio below one), while McDonald's trades for more than
four times sales and Burger King trades for about 1.5 times sales.
That gap is explained away by profit margins. If Wendy's/Arby's
could boost margins up to the peer group, then every dollar of
sales it generates would be more highly valued by investors
(pushing up the EV/sales ratio).
Figures
(in $M) |
McDonald's
|
Burger King
|
Wendy's/Arby's
|
Denny's
|
DineEquity
|
| Sales |
$22,745 |
$2,502 |
$3,581 |
$608 |
$1,414 |
| Price/Sales |
4.0 |
1.4 |
0.9 |
0.8 |
1.5 |
| Gross Profits |
$8,792 |
$887 |
$852 |
$221 |
$447 |
| Gross Margin |
38.7% |
35.5% |
23.8% |
36.4% |
31.7% |
|
Operating Margin
|
30.1% |
13.3% |
3.1%
|
11.9% |
2.6%
|
| Net Profits |
$4,551 |
$186 |
$4 |
$42 |
$9 |
|
Free Cash Flow
|
$1,563 |
$126 |
$165 |
$15 |
$118
|
|
EPS
|
$4.11 |
$1.38 |
$0.01 |
$0.42 |
$0.54 |
|
P/E
|
18.2 |
17.4 |
274.1 |
6.5 |
66.9 |
| Free Cash Flow/Share |
$1.41 |
$0.93 |
$0.35 |
$0.15 |
$6.97
|
| Enterprise Value |
$91,550 |
$3,729 |
$3,204 |
$497 |
$2,170 |
| EV/EBITDA |
13.4 |
11.2 |
28.6 |
6.9 |
59.3 |
The cheapest stock in the group
Perhaps the real bargain for PE firms would be
Denny's (Nasdaq: DENN)
, which I recently recommended. [Read:
Five Beaten-Down Stocks with +100% Upside
Potential
]
Shares are out of favor right now thanks to a severe contraction in
sales. Sales should stabilize by year-end, but even at these
depressed levels, Denny's profit metrics appear solid. Gross and
operating profit margins are on par with Burger King and would
likely be nicely higher if and when sales rebound. Most
importantly, shares trade for less than seven times EBITDA, on an
enterprise value basis. PE firms can presume that EBITDA can rise
sharply as the
economy
improves, so they can offer to pay up to nine or 10 times trailing
EBITDA under the assumption that the forward EBITDA multiples would
be well lower.
As I noted in my recommendation of Denny's a few weeks ago, shares
likely have significant upside down the road, so it's unclear that
a PE firm would be able to get shares below $4. Then again, they
may not be inclined to pay above that figure in light of the
still-slumping sales. So Denny's may not come into play until
results start to stabilize and turn up.
A turnaround play
DineEquity (
DIN
)
, which operate the Applebee's and International House of Pancakes
(IHOP) franchises, is not seen as a clear rival to the burger
chains. But like Burger King, it is seen as a typical PE target and
that's helping push shares up +7% on Thursday. DineEquity throws
off large amounts of cash flow, which PE firms love to see when
they look to load up their targets with debt.
The company is already sitting on more than $1.6 billion in debt,
so there are limits to how much more debt it can take on, but
annual free cash flow of more than $100 million compared to a
market value
of around $600 million implies that a PE firm could pay a +20% to
+30% premium for DineEquity, keep it private for three or four
years while paying off some debt with that free cash flow and then
bring those restaurant chains public again once sales are on the
upswing and investors see them as growth vehicles.
Action to Take -->
Wendy's/Arby's has acknowledged receiving buyout interest in the
recent past, though it's unclear that any PE firm could swoop in
while Nelson Peltz is in control. If there is a PE value to be
unlocked, he's got first dibs, though he has yet to make any such
move in that direction. Denny's looks like the most clear-cut
acquisition candidate, and as soon as sales stabilize, perhaps in a
quarter or two, then shares could heat up.
-- David Sterman
David Sterman started his career in equity research at Smith
Barney, culminating in a position as Senior Analyst covering
European banks. David has also served as Director of Research at
Individual Investor and a Managing Editor at TheStreet.com. Read
More...
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.