Why Tim Hortons is not buying Burger King?Yvan Allaire | Financial Post
Although smaller than Burger King, Tim Hortons (TI) is more profitable and better managed than Burger King. Their stock market valuation is comparable. Why then is it not Tim Hortons that is trying to buy Burger King?
TI becomes a target of hedge funds
One must recall that in early 2013, two activist funds (Scout Capital Management and Highfields Capital, two hedge funds) started circling around TI. The two funds, which, at the time, held respectively 7% and 4% of TI’s shares, wanted to be heard by management and the board of directors.The managers of the two funds said and wrote that although TI was extremely well managed and enjoyed tremendous commercial success, its stock was lagging in performance. TI could create a lot more shareholder value if it implemented their recommendations. Essentially, the two hedge funds contended that TI’s board of directors lacked financial savvy, was not conversant enough with the tricks of financial engineering. So, they urged the board of TI to:
- increase the company’s indebtedness in order to buy back a large number of its shares;
- stop (or slow down) the company’s expansion in the United States;
- spin-off its real estate holdings in an exchange listed “real estate investment trust” (REIT);
- tie executive compensation to earnings per share and total shareholder return (TSR);
- bring in new board members drawn from the financial community.
These measures, the hedge funds asserted, would increase earnings per share and the return on equity of TI and would, ipso facto, boost its share price. In what has to be an iconic statement about what differentiates financial capitalism from industrial capitalism, a hedge fund wrote:
“In fact, we would argue that the earnings growth created through this [financial engineering] approach would be far superior (at much lower execution risk) than attempting to drive growth through continuing to invest in the U.S. market at sub‑par returns.” [Letter sent by HIGHFIELDS CAPITAL MANAGEMENT to Tim Hortons on March 21, 2013.]
At first, TI’s senior management and board of directors were underwhelmed with these recommendations and politely dismissed the two activist funds. But, these funds did not give up and, it seems, finally succeeded in convincing the board that their recommendations were sound (except for the REIT gambit).
So, TI added two board members from the financial community; then, on August 8, 2013, the company announced that the board of directors had approved $900 million in new debt to buy back a billion dollars-worth of shares of TI over the next twelve months.
The results of these financial moves are captured in the following table:
In eighteen months, TI was transformed from a company with little leverage (debt-to-debt plus equity of 26.4%) into a highly leveraged company (77.3%). Shareholders’ equity has melted away, shrinking from $1.2 billion to $384 million (given that any buyback of shares at a market price higher than the book value of the shares triggers a reduction in equity equivalent to the difference between the two amounts).
TI’s stock price increased from $55 in July 2013 to $62 at the end of 2013, a 13% gain, just in time for some funds to sell their holdings at a profit; but the market quickly realized that, with its new capital structure and financial strategy, TI would have to slow down its growth in the United States, which caused the share price to drop back to $58 in July 2014.
Therefore, in the short term, the stock market reacted as predicted by the hedge funds, but in the longer term, because this financially engineered growth in earnings could not be sustained, the stock returned to its intrinsic value.
The TI of December 2012, with its very low leverage, could have considered making a bid for Burger King. However, the TI of July 2014 no longer had the financial flexibility and buffer to consider a Burger King transaction. So-called “activist” hedge funds, all too often, propose stratagems that work well for their funds’ performance but hamper the development of industrial firms and inflict considerable damage unto targeted companies.
Should TI really consider buying Burger King?
If TI still had the financial wherewithal, should it have bid to buy Burger King? After all, TI needs no “financial inversion” to benefit from the favourable Canadian corporate income tax regime, which is touted as a rationale for the transaction. (Some observers believe that another reason for transferring Burger King’s legal head office to Canada is to sooth Investment Canada, which will have to approve the transaction and assess whether it brings “tangible benefits for Canada.”)
Well, let’s remember that between 1995 and 2005, TI was part of the Wendy’s International Group (Wendy’s being a direct competitor of McDonald’s and Burger King). In 2005, some activist funds, including the omnipresent Bill Ackman (Pershing Square – which holds almost 11% of the Burger King shares), made the case forcefully that Wendy’s should spin-off Tim Hortons by listing it on the stock market.
In a letter addressed to Wendy’s senior management, Ackman, who, at the time, held 9.9% of its shares, wrote:
“We believe that many Wendy’s shareholders and members of the Wall Street research analyst community have frequently questioned the benefits of having Tim Hortons under the same corporate structure as Wendy’s given the minimal synergies that exist between the two companies. (…) As such, we believe that as long as Tim Hortons is owned under the Wendy’s corporate umbrella, the Company will trade at a depressed valuation.” [Letter by W. Ackman to the Chairman, CEO and President of Wendy’s International, dated July 11, 2005.]
In other words, it is a bad idea to merge two such disparate entities as Wendy’s (or Burger King) and Tim Hortons into one and the same company.
It would not be surprising if, a few years hence, some activist hedge funds make the case that Tim Hortons should again be spun off from Burger King. Maybe once the benefits of tax inversion become less significant…
(The opinions expressed in this article are those of the author.)