Emulation is not going to get it done in the domestic QSR burger category for the same reason it did not work for Linens ‘n’ Things in retail. A thesis has been put forward over the last few days that the QSR burger industry is not a zero sum game. In this industry it is difficult to neatly delineate boundaries of competition or addressable markets but we are of the view that, if not a zero sum game, the niche of the burger industry that Burger King inhabits could possibly be shrinking. Recent commentary from Wendy’s CEO Emil Brolick supports this view.
BURGERS ‘N’ THINGS
Given the rapid growth of “better burger” category, or fast casual in general, it is easy to make blanket statements about the QSR industry because such proclamations are difficult to refute in the absence of definitive market share data. Justice Holdings took advantage of this in framing its narrative describing Burger King’s growth prospect, touting the strong expansion of the QSR industry over recent years. QSR is becoming more varied, however, both in terms of price point and product offerings. McDonald’s, Wendy’s, Burger King, and Taco Bell occupy a certain sector of the QSR industry; we think that the growth in that sector is stagnant and only differentiated concepts can achieve the level of growth that would justify the $16 per share price tag that is being attached to Burger King’s IPO. Just looking at the products Burger King is currently offering versus the McDonald’s menu highlights how little in the way of differentiation Burger King is bringing to the table. An article published last month by Advertising Age titled “Nothing Exciting About Burger King’s Menu Expansion” outlines this issue comprehensively. Discussing the “folly of emulation”, the author writes, “What was Linens ‘n’ Things’ strategy? Emulate the leader with similar stores and similar marketing strategies”. Burger King – a follower – emulating McDonald’s – a leader – is equally unwise.
There is a reason why McDonald’s has recently bought up billboards and radio air time in markets where Wendy’s tested breakfast; the competition in the segment of the market where those companies operate is fierce because of the difficult macro environment, growing ranks of competitors, and a consumer that demands not only a great product but a great overall experience too. We see it as highly unlikely that all four of the aforementioned QSR concepts are going to see positive same-store sales over the next few years absent a dramatic turnaround in the macro environment. We believe that in this small group, someone is winning and someone is losing. For that reason, making life difficult for your competitors – as McDonald’s does – is a winning strategy. Along the same lines, trying to emulate a better-positioned industry leader – as Burger King is doing – is unlikely to be effective.
This cut-throat environment is going to hamper the efforts of Wendy’s and Burger King to convince investors that their respective turnaround stories are in place. That’s bad news for two chains that need to attract billions of dollars in capital to restore severely depleted asset bases. Taco Bell’s slogan, “Think Outside the Bun”, underscores how much they compete with the burger companies. Both Yum Brands and McDonald’s have tremendous ammunition to spend. Both Taco Bell and McDonald’s have shown a willingness to lead with price and value to attract customers from other chains. McDonald’s has benefitted from the mismanagement of Wendy’s and Burger King and has recently squared up to Dunkin’ Donuts in its core geography of New England in a bid to steal some breakfast market share. Companies are hyper-competitive in their pursuit of consumers at the moment. Our view is that Burger King and, to a lesser extent Wendy’s, are facing a difficult battle to regain their prior statuses in the industry.
PICK YOUR SIDE(S)
Clearly our contention here is that a rising tide is not going to lift all boats in the domestic QSR burger industry. Burger King and Wendy’s are the two names that we would be most concerned about from an operational perspective over the next two-to-three years. Specifically, we think same-store sales growth could be weak at those concepts. This is suboptimal given that top line growth is needed to inspire confidence among investors, lenders and franchisees if the turnaround is not to turn into a protracted siege that can do long term damage to the brands.
Of course, given that “activist” investors are deeply involved with both Wendy’s and Burger King, adds another element to their stories. Weak operational performance may not lead to stock price weakness. Taking Burger King first, we believe that the $16 is a price tag that should give investors pause when considering an investment in the company. The implied valuation multiple, on an EV/EBIT basis, is 17x which makes Burger King the most expensive of the four companies (MCD, YUM, WEN, BKC). Our “Too Big To Fix” thesis contends that the issues at Burger King may be much more substantial than people realize.
Moving on to Wendy’s, the company is trading at a 26% discount to Burger King but at a 12% premium to McDonald’s. We think that represents a mispricing of the company’s fundamental outlook but investors’ expectations of Nelson Peltz’s possible next move. Given the sideways move in the stock over the past 3.5 years and the vast amount of capital needed to fix the asset base ($3.5 billion), it would not surprise us if Mr. Peltz was becoming a little anxious about Wendy’s future. Perhaps the changes that need to be brought around would be better implemented in the context of a public company, away from investor and analyst scrutiny? It would not be shocking if, in the not-too-distant future, we woke up to a rumor that Trian is shopping the company. The possibility of that happens, we believe, is helping to maintain that premium to McDonald’s which otherwise doesn’t seem to have any grounding in a fundamental comparison of the two companies.
Wendy’s CEO Emil Brolick’s recent comment on his company’s category was insightful: “we were hopeful that our February promotion of Dave's Hot 'N Juicy would help us regain our momentum, but unusually intense competitive couponing and discounting negatively impacted our sales growth.” This corroborates our view that the burger industry is, effectively, a zero sum game.