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At over 1,000 units and counting, Multi-Unit owner Guillermo Perales is bigger than 95% of all the franchise systems in the US.

How did he get so big?

How does he view his franchisor business partners?

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I wrote this article late in 2011. Given the recent lawsuit between Wendy's and DavCo, it is worth revisiting. This is a perennial issue, the contractually required upgrade.

"Remodels and upgrades are always a bone of contention between a franchisor and franchisee. Older units in a system rebel against a forced upgrade, sometimes correctly guessing that a fancier unit will not be profitable enough to pay for the upgrade and maintain a healthy return on investment.

So, it very surprising to see the new management of Burger King to encouraging this rebellion amongst its franchisees.

Burger King still owns and operates 1295 units, world-wide, mostly in the US and Canada. Before BKC was acquired by 3G, one of the due diligence concerns known to everyone in the restaurant sector was that Burger King units, both company and franchisee operated stores, were in need of remodel and store physical plant renewal, estimated then at $3B.

If all BKC company stores were remodeled at BKC's just updated cost of $200-300K per store it would require $3.2 billion, the "CAPEX" tab that needs to be funded. (This remodeling deficit itself was a partial legacy of the prior private equity owners, Bain Capital/Texas Pacific Group/GSCG PE group, which took Burger King public in 2006.)

3G has swept out the prior Burger King executive management clique, set up a loan program for franchisees, changed ad agencies and marketing thrust, and rolled out new products. Company EBITDA dollars are improved.

It would be reasonable to think that this improvement would find its way back to the corporate stores.

Especially with the NFA, the Burger King Franchisee Association, watching every move carefully. After all, if BKC doesn't think that all of its units ought to be upgraded, NFA will argue the same point on behalf of some of its members.

And we learned more about 3G's intentions for Burger King. On Thursday, November 10 2011, Burger King held its Q3 2011 earnings call and filed its 10Q with the SEC.

Company and debt tolerance conditions are apparently "favorable" enough for its PE owner that it is now working a $393M dividend payable back to 3G Capital, by December! Despite BKC needing $3 Billion to remodel, 3G wants return of capital first.

The wording from the fall 2011 10Q is below:

On October 19, 2011, the Board of Managers of BKCH approved a distribution to Parent and, subject to such distribution, the Board of Directors of Parent approved a return of capital distribution to the shareholders of Parent, including 3G, in the amount of $393.4 million, representing the net proceeds from the sale of the Discount Notes, payable by December 16, 2011, provided that the Board of Parent does not act to revoke its decision to declare the return of capital distribution prior to the payment date.

3G is taking the cash out, and not putting it towards remodelling or upgrading its corporate stores in North America. Time will tell if this strategy encourages compliance or dissent amongst the North American franchisees who are going to have to remodel."

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I was an expert for the BK franchisees in 2010 regarding the infamous $1 double cheese burger (DCB) legal action. For the record, the fully loaded cost then was about $1.17, and franchisees lost about 17 cents per DCB item then. The action settled, the court did not have the opportunity to rule on the main issues.

The BKW marketing approach is different now: not $1 double cheeseburger for months on end with no other new news, but only on selected weekends.

Based on confidential field operator commentary, I'd conclude that Burger King will be up in its December. But it's all a zero sum game: Competitor A temporarily takes share from Competitor B.

Burger King (BKW) is especially vulnerable to investor sentiment with its IPO this year, its rebuilding underway and new menu items introduced this summer that did generate some sales uplifts.

Concurrent with its 55th corporate anniversary, a "buy one get one (BOGO) Whopper deal for 55 cents is underway this weekend.

Franchisees just last week "voted" to extend it another weekend, December 13-16. Franchisees got the heavy sell and pressure to do it.

But, web reports are that some franchisees aren't honoring the BOGO offer.

This is an ultra low price point, the dream of marketing agencies everywhere who dream about low prices, and to take the cheap way out for their clients. This is a Burger King franchisee profit issue in that the additional Whopper has a backdoor cost of app. $.80, so the gross profit loss at first look is roughly about 25 cents per BOGO burger sold.

Will they make it up on volume? We'll see. This is classical economic price/supply/demand test. A big issue is product mix, whether tradeups can occur and how many additional customers that come in.

Loss leader tactics aren't "wrong" per se but the effectiveness depends. In store, we saw the new digital menu boards prominently featuring the $.55 offer, which doesn't seem quite right to maximize tradeups.

But there was considerable Burger King discussion in 2010 that the Whopper should be not be discounted, it was their legacy flagship product. Perhaps not now. What does the research say?

This is another reminder that publicly traded restaurants, particularly those with no or few company operated units (Burger King is selling stores worldwide and will soon be near zero company stores) will forever and ever be tempted to do low priced offers. The investment community rewards comparable sales; franchisee profits aren't reported or much often discussed.

These restaurants will be playing a zero sum game for some time.

McDonald's (MCD) weak same store sales results for October announced Friday threatened to take down the entire restaurant space stock platform.

One of the problems is MCD reports by calendar month. But not every month has the same number of weekdays and weekends each year, and MCD missed a Saturday and a Sunday this year.

This could be fixed. Fiscal year formats of 13 periods of 28 days have been standard for 30 years plus in this space and could so be adopted. Every back office system in the world has such flexibility.

I suspect the problem is getting franchisee reporting lined up. It's a change and will cost something. But we expect such systems from the QSR industry pioneer. And less stress on the publicly traded company is good for all.

To be sure, McDonald's was weak (-1.8% worldwide). Weaker than most expected. Wendy's (WEN) same day reported +2.7% system same store sales and Burger King (BKW) and its franchisee Carrols (TAST) reported a strong plus 6.2%, and an 'OK trend' thus far in October. 

What was of greater concern were the MCD sales components: With some analysts projecting an embedded 3% price increase in the U.S., either customer traffic was almost 5% lower or product mix shifted lower.

McDonald's sales momentum deterioration in the U.S. and Europe was the most pronounced. APMEA (Asia Pacific/Middle East/Africa) was -2.4% vs. the rest of world, had poor Japanese trends and bouncing Australian results, and has been weak or negative for some time.

McDonald's does not disclose results by nation, but we can tell by the process of elimination that the MCD powerhouse markets of France and Germany had to be down big time as MCD reported the U.K. was up.

Finally, while the same store sales metric is commonly understood in the business press, comparing to one prior year is not really the best measurement. It misses cumulative history.

McDonald's was down versus 2011, but still up versus 2010, 2009, 2008, and all years back to 2003. In fact, versus 2002, U.S. MCD same store sales is up cumulatively 55.4% coming into FY-12. Wendy's and Burger King do not have the same advantage.

Additionally, reporting same store sales on a five year compound average growth basis could be more meaningful.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

We had to guess after his investigations of Wendy’s (WEN) in 2007 and McDonald’s (MCD) in 2008 that Bill Ackman would reappear in the restaurant space. He did Wednesday, with a full throated presentation as to why Burger King was right up his alley.

Investors must be hopeful and Bill was that today. In fact, we think Bill has the bug and wants to run restaurants. It gets in the blood.
Looking at the numbers and the presentation, several points are noteworthy.
 
Sales lift assumptions after remodel very optimistic: Ackman assumptions call for a 10-17% average sales unit (AUV) sales lift after the BKC remodels, based on a $250K to 300K remodel. A Burger King costs around $2 million, so this might be best characterized as a “medium remodel” with hopefully both interior, equipment, exterior and drive thru upgrades.
 
The problem is no one in the QSR space has achieved that. MCD gets double digit SSS bumps with a scrape and rebuild, but that is not what we are talking. Jack in the Box (JACK) has done a nice job of remodeling, but reported low/minimal lifts in 2010/2011, for example. The norm is single digits. Is that 10-17% to be achieved every year?
 
BKC versus MCD: head to head competition: doable? Bill mentioned that BKC could be more nimble around “bloated” MCD and have a restaurant wherever MCD did. He displayed a chart laying out the MCD North American AUV of $2.4M, WEN of $1.4M and BKC of $1.15 million.
 
The problem is that the US MCD AUV is even higher, at almost $2.9M, per my look at the recent 10K.  MCD European AUVs are even higher. So there is an even greater MCD v. BKC gap, about 2.5X.
 
MCD has a six dayparts/day business while BKC just rolled out a “catchup” new menu burst just Monday and is still working core dayparts.
 
This isn’t Ackman’s fault of course, but it is 2012, not 2002 or even 1992. The world is filling up with restaurants, and the competition isn’t standing still.
 
Flawed M&A comps:  During the 2010 acquisition, it was conservatively estimated that there was a $2 billion or more BKC facility conditions backlog. Selling company stores and getting to a 100% royalty income stream concept is a nice idea, but how do you get there in 2012?
 
There has to be the credit or cash generated from operations for franchisees to build and remodel.
 
Bill listed reasonable comparables of Dunkin Brands (DNKN) and Tim Horton’s (THI) as justification for the 10-16X EV/EBITDA multiple he hoped to support.
 
The problem is, the Dunkin Donuts or Tim Horton’s box costs around $500K to build, not $2 million.   
 
(Historical note: Burger King did achieve$121M better free cash flow in 2011 v. 2010 (adjusted EBITDA-CAPEX) but also cut CAPEX $75M to partially get there.)
 
Ackman is making a lot of assumptions, but the numbers don't appear to be supporting his story.

NFA Website

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Website Grade for NFA, by Hubspot
. The Website Grade for www.nfabk.org!

The Burger King franchisee association, called the National Franchisee Association, has been fighting with the BK franchisor about the appropriateness of being mandated to sell loss leaders.

There are a number of interesting legal, marketing, and practical issues behind this dispute.

But how is the NFA communicating to the public a savvy view of their dispute?  

The answer is they are not: nothing appears on their website, which Hubspot only gives a grade of 74/100.  Do we presume that behind the closed paywall, the NFA is doing a bang up job of explaining the litigation to their franchisees?  How does a franchisee explain to the public that they cannot afford to sell the $1 double?  Who is helping them with their communication problem?

There is no doubt that at the top level of the NFA there are smart, experienced, and thoughtful business leaders.  But it appears from their website that they they don't believe  it is their job to market their message to public.

Given the recent change of control at BK, the franchisees are going to need a more sophisticated communication channel from the NFA, especially as those renewals come  up.  Is the NFA leadership up to this challenge, I wonder?

"Few people realize that the top private equity firms, such as Blackstone Group, Carlyle Group, and Kohlberg Kravis Roberts, have become the nation's largest employers through the businesses they own. 

Using leveraged buyouts that load their acquired companies with loans, private equity firms have generated more than $1 trillion in new debt-which will come due just when these businesses are least likely to be able to pay it off.", so begins Josh Kosman's book, "The Buy Out of America."

Kosman's book is an important book for franchisees to read and understand.

For example, today's, September 1st 2010, announcement that Burger King is looking to sell itself caused the stock to rise, is confirmation of Kosman's analysis.

"The Burger King stock was surging by 16.1% to $19.10 in premarket trading Wednesday. The status of the talks is unclear but one interested firm was 3i Group, a British private-equity firm, the Journal says, citing people familiar with the matter."

According to Kosman, we can predict that certain companies will have trouble refinancing their debt.  We obtain that the information in a report by Moody's showing which companies are indebted, by how much, and when the debt is due.

According to that Moody's report, "Burger King Corporation owes US$ 666.2 million in Bank Credit Facility, rated Ba2, and due 06/30/12."

So in less than two years, Burger King is going to have refinance over $650 million of debt - when it's own market share has decreased, and it seems to be a death struggle with its franchisees, NFA, over the ability of the franchisor to dictate money losing value meals to its franchisees.

I recommend that every association leader, executive, board member in the Burger King franchisee association read Kosman's excellent book to prepare for what might happen to the Burger King system. 

We will have more on this story, and hopefully the NFA website will also contain updates for its members.


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