RBD - Restaurant Brands

[POSSUM THE CAT]

SNOOPY may be it is the other way round. They possibly have a lot they want to sell.

[gregrday]

Hey guys, latest RBD analysis up at http://gregnz.wordpress.com.

Let me know what you think, whether I have made any errors etc. Note, I havent tried to separate out the different components of RBD, but essentially am treating Starbucks and Pizza Hut as slow going concerns. I also havent factored in any remaining growth from the KFC refurbishment program, instead treating that as an additional margin of safety.

cheers
Greg

[gregrday]

Hi Snoopy

Its actually pretty easy to get RBD at a $5 valuation, without using any crazy growth multipliers. Dropping the cost-of-capital from 7.7% to 7% and decreasing the required reinvestment rate to 20% gets you pretty close. My own feeling (although I haven't looked deeply into it) is that the WACC could be dropped a bit, since RBD have some crazy cheap (4.7%) bank loans. Can RBD sustain operations at a 20% (or $6million) reinvestment rate? And as mentioned above, there is probably still a bit of upside in the KFC refurbishment program which has yet to filter through.

The big question is, are people going to continue eating deep fried chicken at the same rate? I can't really see why not. Maybe I need to ditch MHI and get back to RBD...? :-)

cheers
Greg

[Snoopy]

Hey guys, latest RBD analysis up at http://gregnz.wordpress.com.

Let me know what you think, whether I have made any errors etc. Note, I havent tried to separate out the different components of RBD, but essentially am treating Starbucks and Pizza Hut as slow going concerns. I also havent factored in any remaining growth from the KFC refurbishment program, instead treating that as an additional margin of safety.

Interesting your treatment of commercial leases as a kind of debt. For those of us with memories longer than your spreadsheet, RBD used to own most of their properties and sold them off. Some argued at the time it was smoke and mirrors and virtually profit neutral, with the new rent payments offsetting the depreciation and amortization on the once owned properties. Of course all of this was before John Key's depreciation tax reforms. I guess you are arguing that it was really a 'debt neutral' exercise as well, and you may have a point.

The property sell off was done IIRC with RBD signing 10 years leases with a right of renewal. That meant potential property buyers could confidently bid with a guaranteed income stream. I have often wondered if that income stream represented real 'market value'. By that I mean if RBD moved out of those properties would the new hapless property owner stand any chance of signing another tenant at the same rent rate? Would be interested to find out what happened to those properties that RBD has since moved out of!

But if any of those properties were sold 'rent high', you might argue that getting rid of them was actually a very smart move from a debt perspective.

SNOOPY

[Snoopy]

I also havent factored in any remaining growth from the KFC refurbishment program, instead treating that as an additional margin of safety.

I guess the key point in your analysis Greg is whether RBD can continue generating that $20m of free cash flow every year. People continuing to eat the same amount of fried chicken as they do now is one prerequisite. The other is that costs continue to be contained. IMO and somewhat perversely, the longer as the NZ economy remains weak, the better for KFC (sorry RBD) shareholders!

CEO Russel One 'l' Creedy is on record as saying he would like to sell Starbucks and reinvest that money into KFC. One thing you haven't put into your analysis I believe are the one off fees to open a new KFC store and ongoing franchising fees on every store payable every decade or so. Creedy has also shown interest in starting up a new restaurant chain, an exercise which is sure to be cashflow negative until it builds to a critical mass in five years or so. I agree that any 'extra growth' from the KFC refurbishment is a bonus, but I am not sure if that isn't balanced out by the negative cashflow effects that I am talked about at teh opening of this paragraph.

SNOOPY

[Snoopy]

Dropping the cost-of-capital from 7.7% to 7% and decreasing the required reinvestment rate to 20% gets you pretty close. My own feeling (although I haven't looked deeply into it) is that the WACC could be dropped a bit, since RBD have some crazy cheap (4.7%) bank loans.

If the RBD cost of capital is less than the RBD earnings yield, can you not make a case for a valuation of RBD to be as high as you like?

SNOOPY

[gregrday]

Yes, the 20m free-cash-flow is critical. Anything that drops it below this would obviously affect the valuation. It should be noted that they havent actually ever achieved that, although they have come close. So, going up a level, RBD need to a) control costs and b) control capital expenditures, and c) continue to sell lots of chicken.

If they looked at starting up another franchise, I would get out completely. I'm not convinced they have expertise in that area, when all that has currently happened is the successful turn around of 1 of their brands.

But in any case, at the moment, I think RBD looks a bit undervalued. Pity I have no cash... damn tax!

[gregrday]

"If the RBD cost of capital is less than the RBD earnings yield, can you not make a case for a valuation of RBD to be as high as you like?"
(oops, missed the reply with quote button)

I'm not sure about this, the earnings yield is NP/enterprise value? So as valuation goes up, earnings yield comes down? I might be misunderstanding...

I also looked at the latest PWC cost-of-capital report (which I should have used since it came out in June), which has the WACC for RBD at 7.4%, rather than the 7.7% I used. So that would push the forecast price up even further... So my fair value estimate is around $3.5, which I wish I had worked out before selling at $2.35... :-) Be interesting to see how it plays out, now I've got a number to aim at!

[gregrday]

No, I believe its the Greg effect, where I buy some shares and then they drop 10%. I have an amazing ability to influence markets...
I should set up a reverse-Greg fund, which sells when I buy, and buys when I sell.

However, I still believe RBD is undervalued, unless theres some actual news...

cheers
Greg

[Snoopy]

Snoopy wrote:
"If the RBD cost of capital is less than the RBD earnings yield, can you not make a case for a valuation of RBD to be as high as you like?"

I'm not sure about this, the earnings yield is NP/enterprise value? So as valuation goes up, earnings yield comes down? I might be misunderstanding...

I also looked at the latest PWC cost-of-capital report (which I should have used since it came out in June), which has the WACC for RBD at 7.4%, rather than the 7.7% I used. So that would push the forecast price up even further... So my fair value estimate is around $3.5, which I wish I had worked out before selling at $2.35... :-) Be interesting to see how it plays out, now I've got a number to aim at!

Gregr, I think my comment was slightly screwed up. What I was trying to say in an overly twisted way is that I think there are some issues regarding the appropriate discount rate that should be used to value RBD.

In an extreme situation it would be possible to have a discount rate greater than the earnings growth rate. With the benefit of hindsight, this is what has happened with RBD. I would argue that five years ago RBD was a $12.5m per year profit company given normal business conditions. I would equally argue today that RBD is a $25m per year profit company. That is very roughly a 15% compounding growth rate of 'underlying earnings' over 5 years. As long as the PWC discount rate for RBD was under 15% over those 5 years (and I think it was, let's make it 10%), then when we work out the present value of that underlying earnings growth pattern from a 2006 perspective then an interesting thing happens:

2006: $12.5m
2007: $12.5m x (1.15/1.1)= $13.0m
2008: $12.5m x (1.15/1.1)^2 = $13.6m
2009: $12.5m x (1.15/1.1)^3 = $14.2m
2010: $12.5m x (1.15/1.1)^4 = $14.9m
2011: $12.5m x (1.15/1.1)^5 = $15.6m

What we have here is an increasing earnings number every year, even though these future earnings are being discounted back to 2006 dollars. If this trajectory were to continue you could argue that the PV of Restaurant Brands earnings (from a 2006 perspective) can be as high as you like by just looking out into the future far enough. Obviously this is not possible, so there is some fantasy going on within this calculation somewhere. But the average earnings growth of 15% that I used is not the fantasy, because this is the actual growth rate achieved in this period (we know this with the benefit of hindsight). That means something else must be wrong, and the only thing in that equation not based on fact is the discount rate. The discount rate must be higher than the earnings growth rate to obtain a convergent share valuation.

Of course the other thing that must happen foir this farcical divergent valuation to be true is that earnings must keep growing at above 10% indefinitely. Clearly this also is unlikely, although we may get an average 10%+ growth rate for 10 years, and 10 years is 'indefintely' for some investors. I used the 10% average discount rate for ease of calculation but in reality I think the PWC discount rate for RBD over that period would have been less. That means my example as presented is conservative.

The point I am trying to make ( I think! )is that the PWC discount rate for RBD can never have been as low as they suggested. The whole basis for their calculation cannot be right, even if the actual mathematics they used to calculate that figure contains no computational errors. This is why I take these discount rates very cynically.

SNOOPY