Carrols Restaurant Group (TAST): America’s Biggest Burger King Franchisee Comes with “Rights of First Refusal”
Guest write-up by Vetle Forsland
Overview
Carrols Restaurant Group (TAST) is the largest Burger King franchisee in the US. They are currently operating 753 Burger King restaurants on the east coast of North America, in 16 different states. That accounts for about 10.2 % of all Burger King locations in the USA.
Carrols was founded in 1960. At the time, they were operating an independent burger chain. In 1976, they started converting those stores to Burger King locations, and they became a franchisee. In the 1990s they were already one of the nation’s largest Burger King franchisees. Later, Carrols bought the Pollo Tropical and Taco Cabana brands, which accounted for about 50 % of the company’s revenue in the 2000s. In 2012, Carrols spun off the two latter businesses to Fiesta Restaurant Group, and Fiesta’s market cap is currently around $520 million vs Carrols’ $450 million. The spin-off took place shortly after 3G capital took control of Burger King’s owner, Restaurant Brands International (QSR). A part of 3G’s plan was to give more power to franchisees, as these businesses in the past were capped to a certain amount of Burger King locations, leaving BK restaurants fragmented and underperforming, as a result of little to no economies of scale.
Since the spin-off, Carrols has put significantly more focus on expanding their business and acquiring other Burger King locations. Most notably, they acquired 278 restaurants from QSR in 2012. Sales have increased 23 % annually on average since the spin-off, versus a 1 % decrease a year from 2000-2011. Additionally, the number of restaurants has increased around 24 % since 2012, compared to a 1.4 % decrease in locations in the 11-year period before the spin-off (Carrols had an IPO in 2004, so store counts before 2000 are non-existent/very difficult to find).
The 2012 acquisition of nearly 300 restaurants from QSR was financed through debt and preferred stock issued to QSR. So, Burger King’s owner basically bought a 21 % equity stake in Carrols. Executive officers and directors also own 5 % of the company, so 26 % of Carrols is owned by insiders. The 2012 deal included a preapproval by Burger King for Carrols to expand to 1,000 restaurants in “Rights of First Refusal” states, and the ability to expand beyond this region with Burger King’s approval. Carrols therefore has Rights of First Refusal in 20 states on the East Coast, paving the way for more acquisitions in the near future. 21 % of Carrols’ restaurants today are in North Carolina, 17 % of them are in New York, and 31 % are in Indiana, Ohio and Michigan. So, 69 % of their restaurants are in 5 states, diversifying their revenue but at the same time making the company vulnerable to potential economic downtrends on the east coast.
Durability
Restaurants have been around for hundreds of years, and serves as an important part of modern culture and our society today. There is no need to analyze whether or not we will be eating out in 20, 50 or 100 years into the future in the same manner as you can speculate whether people will be driving trucks in 20 years or not. However, the fast food industry’s golden days may be over. Fast casual food has been on the rise since the beginning of the century – this shares similarities to fast food, but is healthier and tastier. It’s more expensive though. And, the over-whelming amounts of fast food chains you find in virtually all major cities today, and on the roads of America, won’t disappear anytime soon. For now, I think it’s safe to say that while there are alternatives on the rise, fast food chains are still maintaining their strong position in the restaurant industry.
The durability of Carrols is basically equal to the durability of the Burger King brand. Burger King is, with 15,700+ locations worldwide, the second biggest hamburger chain in the world, only beaten by McDonalds. In 1957, Burger King introduced the “Whopper”, which has been a signature product and a popular burger sandwich ever since. It’s difficult to see what exactly might cause Burger King to fail. The company has performed well in the past decade, with strong same-store sales and consistent growth figures. I think that both Burger King and Carrols are durable businesses, and Carrols’ future performance will be dependent on the quality of the company, not the durability of the Burger King brand, because of its strength.
Quality
Carrols is a company that will focus on acquiring underperforming Burger Kings and then make them better performing. So the quality of their business model relies on the management’s ability to buy Burger King locations for a good price, and making them more efficient. The price they are paying for those restaurants is a vital part of Carrols’s ROI. But first, I will look at today’s EBITDA margins and predict what they may be a few years from now.
EBITDA margins for Carrols have on average been 8.2 %. Since the spin-off, margins have been lower – closer to 5.2 %. The past years’ numbers are heavily offset by the acquisitions of underperforming restaurants in 2012, 2014 and 2015 though. Since their whole business model revolves around getting margins for acquired restaurants up, it makes no sense to use the 5 % figure. Instead, we can calculate what a “mature” EBITDA margin may be.
Carrols divides all of their locations into two parts: Acquired restaurants and legacy restaurants. Legacy restaurants are all restaurants that have been owned for more than 3 years, and acquired restaurants have drastically lower EBITDA margins than legacy restaurants. In 2013, right after Carrols bought 278 Burger Kings from QSR, acquired restaurants had an EBITDA margin of 5.9 %, compared to 14.4 % for legacy restaurants. According to the company, they managed to increase margins from 5.9 % to 7.2 % in one year. Carrols acquired 120 additional restaurants in 2014 and 55 restaurants in 2015. In 2016, legacy restaurants had an EBITDA margin of 15.9 % versus 12.1 % for acquired restaurants. Carrols’ margins overall for 2016 were 8.8 %. Most likely, Carrols will have higher margins once it reaches maturity.
As of today, 233 restaurants are acquired, while 520 locations are legacy restaurants – so 30% of all the locations are recently acquired (past three years), according to the company, and 70 % are legacy restaurants.
70 % of all restaurants have an EBITDA margin of 16 %. The remaining 30 % of all restaurants have a margin of 12 %. On average, Carrols’ restaurant level EBITDA is 14.8 %.
That’s before a margin expansion for the acquired restaurants.
70 % of all restaurants have an EBITDA margin of 16 %, and the remaining acquired restaurants (30 % of all restaurants) has a margin of 15 %. The average here is 15.7 %.
Therefore, when the business has matured, Carrols’ restaurant level EBITDA margin will have increased from about 14.8 % to 15.7 %. Carrols’ average EBITDA margin is around 8.2 %. So by adding the 0.9 % increase, we get a 9.1 % normal EBITDA margin.
If Carrols manages to increase margins for the acquired restaurants from around 12 % today to closer to 15 % in the future, that will result in an overall increase in EBITDA margin from 8.2 % to 9.1 % (this is conservative in my opinion, as it doesn’t take other acquisition expenses into account).
Is Carrols Overpaying for Their Restaurants?
In the past, Carrols’ return on capital has been good, with ROE hovering around 50 % as well as 35-40 % in EBITDA/NTA. However, future returns will be decided by whether or not Carrols can get a good deal on the restaurants they buy.
The purchase price for 278 restaurants and Right of First Refusal from QSR in 2012 was a 28.9 % equity ownership interest in TAST and a net cash purchase price of $74.537 million. The preferred stocks QSR received were at the time worth $57.711 million, but it has increased in value to $114.680 million today. This is in reality money Carrols could have earned on their own shares, so the price increase should be accounted for. The acquired restaurants had $174.3 million in sales in 2012, resulting in an EV/Sales of 0.43 ($74.537/$174.3). Adjusted for the 2016 share price and sales the restaurants had in 2014, we get an EV/Sales of 0.45 ($131.506/$290.945).
Carrols paid $52.200 million in cash for 123 restaurants in 2014, but this included $15.955 million in land and building, which they planned to sell. This equals an EV/Sales of 1.07 ($36.245/$33.982). While TAST seemingly overpaid for these restaurants, Carrols managed to bring sales up to $144.6 million in 2016, decreasing the EV/Sales multiple to 0.35 ($36.245/$144.6).
In 2015, the company purchased 55 restaurants for $52.750 million, or $30.136 million excluding the land and buildings cost. $30.136/$70.4 = 0.428 in EV/Sales. However, these sales will probably grow more in the future like the previous acquisitions did, because of efficiency and economies of scale.
So, the purchase price (adjusted for share price and sales increases and land and buildings costs) for all 456 restaurants is: ($131.506+$36.245+$30.136)/($290.945+$144.6+$70.4) = $197.887/$505.945 = 0.39 in EV/Sales.
By applying a normalized 9.1 % EBITDA margin, that $505.945 millions in sales can also be converted to $46.041 million in EBITDA, resulting in an EV/EBITDA multiple of 4.3 ($197.887/$46.041). In my opinion, these are three great acquisitions that have added a lot of value to Carrols. The company as a whole is trading at 8 times EV/Normalized EBITDA (and 8.5 “real” EV/EBITDA) and 0.72 EV/Sales. At the same time, peers are trading at around 9x EBITDA and 0.80x Sales. Seems like three good deals to me, and it is promising for future acquisitions.
Management
Carrols is a bet on the management. You as a shareholder are handicapped, as all capital allocation decisions are done by executives – they’re not paying dividends and they’re not buying back shares. So it’s important to feel comfortable with the people at the top in this company. I do. CEO Daniel Accordino has been with Carrols for 43 years and has been the CEO since Fiesta Restaurant Group was spun off in 2012. Furthermore, CFO Paul Flanders has 19 years of experience with the company. As previously mentioned, executives own about 5 % of the company, so it’s safe to say that they have faith in Carrols. Regional managers average 27 years of experience, and district managers average 19 years of experience. So, very experienced individuals will help and support new restaurants improve margins on a restaurant level.
Growth
Carrols grows through acquisitions of BK restaurants, and same-store sales growth (which has in the past been in line with inflation at 2 %). Carrols has Right of First Refusal and pre-approval rights on all restaurants in 20 states up until they run 1,000 BK restaurants in total. So, Carrols can acquire another 242 restaurants before they reach the 1,000 store threshold. After 1,000 restaurants, they are in the open market with every other franchisee. The total number of BK restaurants owned by Carrols grew by 7.4 % from 2013-2016, and 24.3 % if we include the 2012 acquisition – but this is misleading, as Carrols probably won’t make another mega acquisition like that again. Furthermore, Carrols grew their number of restaurants by 1.4 % from 2000-2011. I think it’s reasonable with a yearly restaurant growth of 5.8 % over the next 5 years, that they will reach 1,000 restaurants in total.
Sales have grown 6.5 % annually since 2000, 10.3 % over the past decade and 23.3 % since the spin-off in 2012. As you can see, growth rates are heavily skewed by the 55 % sales growth in 2012 alone. And as previously mentioned, Carrols won’t repeat the major acquisition that was completed in 2012. But to be fair, the company has focused a lot more on growth since the spin-off, although their growth rate will most likely slow down after they hit 1,000 restaurants.
We can probably assume around 6-7 % growth in sales over the next 5 years, while same-store sales will grow by 2 %. Additionally, the company will be able to grow around 5 % after this, if the management’s mindset prevails. In total, Carrols is positioned to grow sales by 8-9 % over the next 5 years, and around 7 % for the next decade and beyond.
Value
In the valuation part of the write-up, I will look at what TAST might be worth after 5 years of growth.
Sales per restaurant has steadily grown at a 2.3 % rate in the past decade, and if this growth continues for five more years, Carrols’ sales per restaurant will be around $1.457 million. It is reasonable to assume that Carrols will have 1,000 restaurants in 5 years, and more restaurants will add to the per restaurant sales in the form of economies of scale. Therefore, we can assume that Carrols will have $1.457 billion in revenue in half a decade and 9.1 % CAGR – very much in line with the past.
I already discussed Carrols’ future EBITDA margin, and concluded that it would probably be around 9.1 %. It’s a conservative figure for a number of reasons. But it’s also the best figure to use, as margins were inflated in 2015 and 2016 due to lower gasoline costs and commodity prices. This is why my normal EBITDA margin prediction isn’t that much higher than margins in 2016 (8.8 %). Using a 9.1 % margin, Carrols can expect $132.587 million in EBITDA.
What is a fair multiple for the business as a whole? As earlier mentioned 9x EV/EBITDA seems like a reasonable multiple to me. Peers like Meritage, Diversified Restaurant Group and Heartland are trading in that ballpark – and I would say that Carrols is an above average franchisee. It’s not necessarily an above average business, and it’s certainly not an above average growing franchisor/restaurant (like Cheesecake), but as a franchisee, they outperform most peers. Nine times $132.587 million equals an enterprise value of $1.193 billion. If we subtract $283.009 million in debt (I added average debt per restaurant to the 242 new restaurants) we get an equity value of $910.274 million.
There are 36.160 million shares outstanding, but QSR owns 9 400 preferred shares. So, realistically, there are 45.560 million shares outstanding, giving TAST an intrinsic value of $19.98 in 5 years. TAST shares are liquid and the price has been hovering around $12.20 to $13.20 today, which means that TAST will potentially return 8.6% – 10.4% annually for the next 5 years. It’s worth noting that we get almost identical results ($19.69) by using an EV/Sales multiple of 0.81. Carrols is a riskier stock than most other businesses out there, so I’d say it makes TAST fairly valued for now, as the SP 500 will most likely generate similar returns in the near future.
I won’t seriously consider TAST before the share price drops by a noticeable amounts.
Risks
Carrols has a lot of debt. But, the question is whether or not they can handle it. Net debt/EBITDA is 2.57, which most people considered fine for a highly predictable restaurant business (like a Burger King operator). Carrols is not overleveraged on a relative basis by any means. So debt isn’t a big risk, nor do they have more debt than most competitors.
Another risk is their profitability. They usually have negative free cash flow, including in 2016, when they had negative $31.811 million in FCF. The question is whether or not Carrols will have the same expenses when it’s a more mature business. They won’t – but they have a huge gap to fill. Right now, Carrols is spending all of their income on acquisitions and growth, so I think FCF will be very different a decade from now, after acquisition costs are cut drastically and their restaurants have higher margins.
One of the prime risks with all franchisees, is whether the brand they’re operating with is durable. Burger King may take a major hit in the future. Although it hasn’t happened to Carrols in the past, any irreparable harm to the BK brand will undoubtedly hurt Carrols as a business, as well as QSR. So it’s something to be aware of. For now, I believe Burger King has one of the strongest fast food brand names in the world.