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Contra Guys: Why Restaurant Brands could be in for ‘some major indigestion’

Restaurant Brands International Inc. agreed to buy Popeyes Louisiana Kitchen Inc. for about $1.8 billion in March.

Luke Sharrett/Bloomberg

About a year ago, Benj attended the annual general meeting for the Female Health Company (FHCO-Q), an outfit that is the global leader in female condoms.

Part of the potential of this investment that we wrote about last year was the possibility that FHCO would be acquired, which Benj talked about with the company's chief executive officer O.B. Parrish, who was open to the idea. Alas, a transaction did emerge but with a wannabee outfit with zero revenues called Aspen Park Pharmaceuticals. Unhappy with the deal, Benj sold for $1.04 (U.S.), taking a 32-cent loss.

One particularly interesting aspect of the trip was the Popeyes Louisiana Kitchen gathering that was occurring at the hotel where Benj was staying. There were about 1,200 people and they seemed like happy franchisees and employees. This was definitely a group that was pulling together to propel their company ahead.

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Might unity be derailed? In February, Restaurant Brands International Inc. (QSR-N) swooped in to buy PLKI in a $1.8-billion deal that was recently completed. This company is the mother ship of Burger King and the same outfit that purchased Tim Hortons in 2014, a change of ownership that is proving particularly tempestuous as franchisees rebel against QSR's practices. Recently, they formed the Great White North Franchisee Association to air their lengthy list of grievances. Their list is too long to repeat here, but suffice it to say that they are very dissatisfied and have stated that they feel that the Tim's brand is being "destroyed." Ron Joyce, co-founder of Canada's iconic doughnut chain stated, "The head office has been decimated."

Is QSR a buy? Critical to QSR's operations is the leadership of the gents from 3G Capital, a Brazilian group that prides itself on efficiency. At both Tim's and Burger King there is no question that this dramatically reduced expenses and improved the bottom line. But one has to wonder if it is a case of trading short-term gain for long-term pain.

Some pretty smart investors like the stock. Joel Greenblatt of hedge fund Gotham Capital owns a piece, as well as Bill Ackman of Pershing Square Capital Management. This gent named Warren Buffett also possesses a chunk and he is considered to be a wizened hand in the stock world. They have watched QSR jump about 75 per cent since the beginning of 2016. Revenues that were $1.2-billion in 2014 should reach $4.5-billion this year. Net income of about $152-million in 2014 paled compared to the robust $636-million tally of 2016. There is almost $1.5-billion in the kitty. What's not to like?

Our wariness of this stock stems from a number of factors. The debt load is about $9-billion, which is very fat. Goodwill is almost $4.7-billion and in all likelihood, some of this will be written off. The book value is less than $10 so, at around $56 per share, the stock trades at a very hefty premium.

But one major concern, as alluded to before, is the dissatisfaction of franchisees as evidenced by the thrust back from the Tims' people. One has to wonder if their unhappiness and questions about operations and quality will cause some devoted customers to shop in other places. Certainly there are a myriad of options. QSR's devotion to slashing could work immediately, but what will it do to the brands that people love?

Will QSR follow their normal efficiency blueprint with Popeyes or perhaps will they decide the time has come to change their line of attack? This chain has over 2,600 restaurants and (now former) CEO Cheryl Bachelder stated that the "high trust partnership that we enjoy with our franchise owners" was a motivating factor for QSR to do the deal. Given the operational DNA of Restaurant Brands, one wonders if that relationship will be quickly eroded. And if The Sailor Man's franchisees are eating their spinach, they might be tough to deal with.

Scarfing down Popeyes so soon after Tims could prove to be too big a mouthful, especially since much of the top brass at Popeyes has either chosen to leave or is being shown the door. Changes in the way consumers eat at restaurants could also diminish profitability since none of the QSR brands is known for healthy food. At the end of the day, our feeling is that owners of this stock could be in line for some major indigestion. Evidently, Mr. Greenblatt, Mr. Ackman and Mr. Buffett disagree with us, pretty formidable competition on reasons to diverge from our view.

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Benj Gallander and Ben Stadelmann are co-editors of Contra the Heard Investment Letter.

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