Roger Lipton

CoreLife Eatery— A Brand on the Move
CoreLife Eatery— A Brand on the Move

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Well regarded pure franchising Restaurant Brands Int’l (QSR), best of breed company operator, Texas Roadhouse (TXRH), and the mature, professionally managed, multi-chain operator and franchisor, Brinker International, (EAT) all reported their March quarter within the last 36 hours. What can we learn?

Before we start, because the news is not great, and recently I seem to be consistently pessimistic (I would say "realistic"), you should know that I am not "talking my book." I am neither long nor short two of the three companies, and have a very modest short position in only one of them (which shall go nameless). All three stocks are down since they reported, QSR and EAT more modestly than TXRH, which is down about 10% this morning.

Here are the pertinent highlights as we see them, and our conclusion.

Restaurant Brands Int’l (QSR), franchisor of Tim Horton’s, Burger King and Popeye’s, reported earnings per share down year-to-year, because of a higher tax rate. Actual income before taxes was up $302 million versus $281 million. It should be noted that Other Income this year of $17 million was $30 million better than "Other Loss" a year ago of $13 million. Let’s call it "flat" pretax income, by our simple adjustments.

Everyone looks at comps and EBITDA by division here. Tim Horton’s delivered a negative comp of 0.6% in the quarter, on top of a negative 0.3% a year ago. Price changes are not discussed relative to any of QSR’s three brands, so we can’t comment on traffic. Adjusted EBITDA at Tim Horton’s was $237 million, down from $245 million. Burger King had positive systemwide comps of 2.2% on top of 3.8% a year ago. BK’s adjusted EBITDA was $222 million vs. $214 million in 2018. Popeye’s had positive comps of 0.6% versus 3.2% in 2018. Adjusted EBITDA was $41 million vs. $39 million in 2018.

The three brands, therefore, had total adjusted EBITDA of $500 million vs $498 million a year earlier. The bottom line is this: It is very difficult to grow the EBITDA and EPS comparisons by more than mid-single digits. Combining the "hard" results with the conference call commentary, there is very little happening that will accelerate cash flow and earnings. Suffice to say: Tim Horton EBITDA growth, which grew from 2015 through 2017 largely by price increases imposed on the distribution chain, is not going to recur, especially in light of the lawsuits by franchisees. Burger King is a steady grower, especially overseas, but the G&A magic has already been imposed on this system, so the easy money has been made. Popeye’s is the most rapid growth division, but is too small to move the total needle by much. The dividend of almost 4% supports the stock price, but it has seemed to us for a while that this "mid-single digit" grower is fully priced at 20x trailing EBITDA and 25x forward EPS.

It should also be noted that much of the "free cash flow" has been used to buy back partnership interests from their parent, 3G, so this "return to shareholders" has primarily benefited 3G. From 12/31/16 to 12/31/18 the average weighted fully diluted shares outstanding has gone from 470 million to 477 million to 473 million. There is substantial cash flow here, but a great deal of it has been used to buy back exchangeable partnership interests from 3G. The long term debt was constant at $11.8 billion in 2018 versus 2017 (after $3 billion was borrowed to buy back Berkshire Hathaway’s Preferred Stock), and "free cash flow" is not so "free" when debt is over 5x trailing EBITDA. The Board of Directors preferred in 2018 to buy back stock from 3G (at 25x expected earnings and 20x trailing EBITDA) rather than reduce the debt. We agree that it seems sensible, from 3G’s standpoint, to lighten up. To be sure, there is a substantial dividend for common shareholders.

Texas Roadhouse (TXRH) is a simpler story. They are truly one of the premier operators in the full service casual dining space, consistently delivering same store sales growth as well as traffic gains. The most recent quarter was no exception, with an admirable comp sales gain of 5.2%, including 2.6% in traffic. The monthly comps, though decelerating through the quarter were fine, up 7.2%, 4.7%, and 4% in January, February and March. April to date is up 2.9% on top of 8.5% a year earlier.

However, Income from Operations was down 6.8% and diluted earnings per share was $.70 versus $.76. EBITDA was down 128 basis points to 17.9%, and the problem was labor, which cost 118 basis points. The discouraging part for investors and analysts is that the company has predicted ongoing wage pressure, and these guys are not about to disappoint customers by cutting labor.  An additional concern, though a lot smaller, is expected commodity inflation of 1-2% for all of 2019. There’s a lot more that could be detailed here, but the results at TXRH demonstrates what we’ve been saying for a while, that it takes more than even 3-4% comps (and now 5.2%) to leverage the higher costs of operations, labor in particular. We don’t know to what extent the Street will lower expectations for 2019 but with the stock trading at $54.37 at the moment (24.7x 2018 EPS), it doesn’t seem like a bargain when it is hard to know when earnings growth will resume.

Brinker International (EAT) reported Q3 (ending March) with somewhat of a "mixed bag." The headline indicated that earnings per share, excluding special items, was up 16.7% to $1.26 versus $1.08. Comp sales for Chili’s were up 2.9% (company) and 2.0% (franchised). Maggiano’s was up 0.4%. Operating Income was 8.4% of revenues, down 50 basis points from 8.9%.

Restaurant margin (EBITDA) was 14.3%, down from 16.1% but, excluding the effect of a sale-leaseback transaction, would have been flat year-to-year. (However, the higher rent is a cash charge versus depreciation, which is non-cash, so the true cash EBITDA margin was truly 180 basis points lower).

Chili’s results are the main driver and aside from the sale-leaseback penalty, it was pointed out that: "cost of sales increased due to unfavorable  menu mix, and commodity pricing, partially offset by menu pricing, also partially offset by a decrease in restaurant labor from lower incentive compensation, which in turn was partially offset by higher wages."

So: cost of good was up, wages were up, restaurant labor (hours?) was down, and there was less incentive compensation. That doesn’t sound like the industry wide wage increase is abating, and commodity costs are up, which we also heard at Texas Roadhouse. While it is admirable that comps were up again at Chili’s, with traffic up as well, it should be noted that the gain in after tax earnings per share was entirely due to a lower tax rate and far fewer shares outstanding. Income Before Taxes was $55.5 million, down from $58.9 million. Adjusted for an Other Gain of $3.5 million this year versus a $2.7 million loss last year, the comparison would be $52.0 million of Adjusted Pretax Operating Income versus $61.6 million. The number of fully diluted shares was $38.1 million versus $46.0 million. From a financial engineering standpoint, EAT chose to do a sale-leaseback transaction, paying higher "rent" versus non-cash depreciation of the stores in return for retiring a large number of shares. From an operating standpoint, even with flat EBITDA at the store level, we see that same store sales (and traffic) gains of 2 or 3% are not sufficient to overcome higher labor and other expenses.

The Bottom Line:

The above reports show that the operating challenges in the restaurant industry have not abated, and will not likely relent in the foreseeable future. Restaurant Brands’ results show how ten years of low interest rates have allowed financially astute executives at this company to assemble a portfolio of franchised brands. However, the mature Tim Horton’s and Burger King can only be financially engineered to a certain point, especially in a difficult operating environment. Texas Roadhouse and Brinker results show how operators ranging from a best of breed growth company to relatively mature brands are similarly challenged.

Broader than the Restaurant Industry: There are something like 20 million individuals employed in the hospitality industries, including restaurants, retail and lodging and this is a material portion of the entire US workforce. The wage increases that are so evident to us will inevitably start to affect the national averages, and the next step will be price increases. Operators of restaurants and retail stores and lodging will not allow their margins to deteriorate indefinitely. All those surcharges such as baggage fees at airlines, "facility" charges at hotels, and miscellaneous add-ons with car rentals (that add 25-30% to the quote), will increasingly be joined by higher menu prices.

It’s not a question of if, rather when.

Roger Lipton


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