As expected, 
Tim Hortons THI and Burger King entered into a definitive merger agreement on Aug. 26 to create the third-largest global quick-service restaurant chain behind McDonald's MCD and Yum Brands YUM. Tim Hortons shareholders will receive $65.50 per share in cash and 0.8025 common shares of the new company, which works out to $89.32 per share in total consideration. On completion, 3G Capital will own 51% of the shares, with Burger King and Tim Hortons shareholders owning 27% and 22%, respectively. The new company will be headquartered in Canada, with both brands continuing to operate independently.
Though much attention has been given to the tax implications, we share management's view that growth strategies (namely, using 3G's master franchise joint-venture network to accelerate Tim Hortons' unit growth) and other shared-service benefits are the transaction's primary motivation.
We are raising our fair value estimates for Tim Hortons to $90 and believe that Tim Hortons' shareholders are receiving more than a fair price. In our view, the partnership can help enhance Tim Hortons' narrow moat, and we believe the combined company warrants a premium to industry averages because of its strong long-term cash-flow potential. Over the next decade, we see an opportunity for 30,000 system-wide units (implying mid-single-digit annual growth), low- to mid-single-digit comparable-store sales (backed by new margin-improving items across multiple menus), and operating margin expansion (with adjusted operating margins growing to at least the low-30% range from 28% today).
We also believe this partnership will better position both companies to compete with struggling industry leader McDonald's and to weather an evolving restaurant industry highlighted by the increased popularity of fast-casual concepts and the rapid retail and wholesale growth of specialty coffee players like Starbucks SBUX and Dunkin Brands DNKN.
Berkshire Hathaway's role
Burger King will fund the US$15.5 billion deal through US$9.5 billion in debt and US$3 billion in preferred equity financing from Berkshire Hathaway BRK.B. Though the deal does involve 3G Capital -- the Brazilian private-equity firm that owns about 70% of Burger King and joined Berkshire in a joint purchase of Heinz last year -- it looks like Warren Buffett is acting purely as a financier in this transaction. We are encouraged to see Berkshire, which closed out the second quarter of 2014 with more than US$55 billion in cash on its books, putting some cash to work, even if it is only US$3 billion. It is also interesting to see Buffett teaming up again with 3G Capital, with our expectation being that Berkshire will continue to look for innovative ways to put its excess capital to work.
Tough industry for moats, but Tim Hortons has dug one
Nonexistent switching costs, intense competition and low barriers to entry make it extremely difficult for restaurant operators to create an advantage. But we believe Tim Hortons' dominant brand, a cohesive franchisee system and a highly scalable business model, particularly in its core Canadian markets, have earned it a narrow moat that can be improved by merging with Burger King. Tim Hortons is Canada's leading quick-service restaurant (QSR) chain by a wide margin, with a 27% share of Canada's $23 billion QSR marketplace (including 42% of all QSR transactions and 75% of QSR caffeinated beverage sales). On a unit basis, Tim Hortons' 3,600 locations across Canada represent a sizable lead over the next-largest chains: Subway (2,700 units), McDonald's (1,425) and Starbucks (1,400). This leadership not only makes Tim Hortons one of the best-known brands in Canada, but also provides its franchisees with access to prime retail real estate, meaningful bargaining clout with suppliers and significant advertising scale.
Burger King's global reach (with a meaningful presence in the U.S., Latin America and Europe) can help strengthen Tim Hortons' brand outside of Canada. We also see an opportunity for the chains to collaborate on new margin-improving items across multiple menu segments while reducing purchasing, advertising and overhead expenses.
We also consider a heavily franchised business model to be a key advantage. Approximately 99% of Tim Hortons' restaurants are operated by franchisees, providing the firm with an annuity-like stream of rent and royalty payments, even during difficult economic times. Additionally, the firm's vertically integrated supply chain business provides a reliable revenue source by distributing roasted coffee beans and other food products to franchisees.
We're also encouraged by Tim Hortons' focus on increasing the number of items per order and other bundling/combo meal promotions to increase sales, and we share management's view that there are opportunities to increase beverage pricing in Canada, particularly among more specialized drinks. Given the company's market share in Canada, even a modest uptick in the average check could add a few percentage points to same-store sales trends.
In the U.S., productivity is a key objective for Tim Hortons, with goals of improving average unit volume in key markets (including Buffalo, Detroit, Columbus, Flint, Dayton and Rochester), paring back stores in unprofitable markets, and embracing new restaurant formats and franchisee development structures to accelerate its brand presence. Similar to its Canada segment, management's five-year plan in the U.S. hinges on expanding menu items (with a particular emphasis on breakfast), increasing the average check size, further rollout of the café/bake shop format (which has already had a positive impact on same-store sales trends, while also reducing building and equipment costs), and additional drive-through capacity. The company also announced that it is pursuing agreements in several new markets.
Although we view management's target of $50 million in operating profit from its U.S. segment by 2018 as ambitious, we expect a material improvement over the next several years as productivity initiatives gain traction.
Even well-run restaurant operators like Tim Hortons are susceptible to cyclical and competitive headwinds such as uneven consumer spending patterns, aggressive industry promotional activity and increasing competition from larger players like McDonald's and Starbucks. We believe these pressures have been pronounced the past few years, where same-restaurant traffic trends have been sluggish and same-store sales growth have been instead driven by menu price increases and an increase in the average ticket size (via larger cup sizes, specialty coffee offerings and an expanded food menu). We see few signs that competition will abate in the decade to come, but Tim Hortons' five-year plan can certainly help it defend market share over the medium term.
Still plenty of risk for this pair of restaurants
Even though both boards have approved the merger, our uncertainty rating remains high until the deal closes, expected in late 2014 or early 2015, for several reasons:
- Though we are optimistic about the combined company, it will face a competitive marketplace, with chains increasingly vying for market share on the basis of price and product differentiation.
- The combined company could saturate its more penetrated markets sooner than expected.
- The company might not be able to develop the scale advantages of its competitors, including Starbucks, McDonald's, Dunkin' Brands and others.
- Volatility in credit markets could impede franchisees' abilities to add locations, purchase equipment or renovate or repair properties.
Who will rule the kingdom?
When the Burger King-Tim Hortons merger is completed, Alex Behring, executive chairman of Burger King and managing partner at 3G Capital, will oversee the company as executive chairman and director, with Marc Caira becoming vice chairman of the combined company and remaining Tim Hortons CEO. Daniel Schwartz will become group CEO of the new company but maintain his role as CEO of the Burger King brand. Because of the similarities between Burger King's "menu/marketing communications/image/operations" strategic vision and Tim Hortons' five-year plan, which emphasizes guest experience investments; increased use of technology as a throughput and marketing tool; international expansion; and channel diversification, as well as the commitment from both management teams to continue paying a dividend, we plan to maintain our Standard equity stewardship rating.
