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Takeaway: Consensus BKW US & Canada same-restaurant sales estimates are very aggressive and Burger King's system remains "Too Big To Fix".

Burger King’s 3Q12 earnings per share beat consensus estimates by $0.02 but the myriad adjustments and one-time items muddied the waters.  The company has been cutting its way to improved profitability but history tells us that this, as a sole driver, is unsustainable.

The performance in sales trends is what carries most weight for the Burger King investment thesis.  On that metric, the outlook is uncertain.  In the U.S., two-year average trends accelerated by 100 basis points, sequentially, from 2Q12 to 3Q12.  The U.S. constitutes almost 60% of the store-base.  As the charts below highlight, consensus is expecting a sharp acceleration in trends during the first half of 2013.  Holding current two-year trends level suggests negative same-restaurant sales trends for 1H13. 

BKW: NOT A QUARTER ROYALE - bkw us

 

BKW: NOT A QUARTER ROYALE - bkw us canada consensus

Same-store sales slowed on a two-year average basis in Latin America and the Caribbean and Asia Pacific (18% of the store base); flat in Europe, the Middle East and Africa. 

Outlook for Burger King

The overall BK strategy, according to management, is based on 4 pillars: Image, Menu, Marketing Communications, and Operations.  Below, we outline some thoughts on these initiatives and the progress that was made on each during the third quarter.

Image

Remodeling the store base is the core focus of the “Image” initiative.  There was some good news in the quarter.  The number of Burger King stores in the USA needing to be remodeled is shrinking, but it needs to continue shrinking.  At the end of 3Q12, the system wide units had declined by 1% year-over-year and 0.2% sequentially.  Also, management announced that they received new commitments to re-image more than 350 restaurants in the United States and are on track to reach our target of having 40% of the US and Canada system on a modern image within three years.

The bad news, from our perspective, is that they did not disclose how many units were remodeled during the quarter.  The company outlined plans suggesting that almost 3,000 restaurants will be converted over the next three years.  The implication is that the Burger King system, in the United States and Canada, needs $350 million in capital every year for the next three years in order to complete the re-image program.

During the earnings call, management stated that its “analysis of remodels completed to date continues to reflect an average sales uplift of 10% to 15%, providing an attractive return to franchisees.”   Whether or not that target is achieved, even post-reimage Burger King store volume would be significantly below the competition.  

Hedgeye Conclusion:  We still believe that Burger King is “too big to fix”.

 

The Menu

Management stated that it is “seeing tangible results from the strategy to balance targeted promotions in premium limited time offerings.  This strategy is designed to shift our consumer profile and product mix, which we believe is key to driving positive, profitable growth for the BK system in the long-term … A key element of our strategy is to broaden the appeal of our advertising and bring a more diverse customer mix back into our restaurants. We saw further evidence of results on this front in our consumer segmentation data, which shows us that the change in marketing strategy has been successful and Burger King's mix of both women and customers age 50 or older increased.”

Hedgeye Conclusion:   Changing the menu at this point, and focusing significant amounts of resources and energy on it, is putting the cart before the horse.  It may require some attention to a degree, but is not going to lead Burger King to where shareholders want it to be.  Emil Brolick, at a lunch hosted by WEN at the outset of his tenure as CEO, stressed the importance of improving his company’s asset base over menu items for sustained market share gains.  We do not know any other QSR companies targeting customers 50 years of age and older and we think there is a reason why others are not focused on that demographic.

 

Marketing Communications

Management stated: “Our television advertising is increasingly focused on taste, which we think is a key differentiator for Burger King due to our flame-broiled grilling platform. This quarter, we used our advertising focused on limited time chicken offerings to create awareness around our broader chicken platform, including the Chicken Parmesan Sandwich, our new Popcorn Chicken, as well as wraps.”

Hedgeye Conclusion:  Burger King stepped up media spending in 2Q and 3Q to unsustainable levels.  We will see if the investment yields positive returns over the next few quarters but the current level of media spending will not continue. 

 

Operations

Management stated: “Speed of service slowed marginally with the introduction of our new products in early Q2 but has improved in the subsequent months, as coaches and crews in the restaurants accumulated experience with the new platforms and product builds. Our average speed of service is likely to remain somewhat higher than some of our peers due to our made-to-order service model, but we still have more work to do to reduce wait times and improve training in connection with the new product roll-outs.”

Hedgeye Conclusion:  Burger King’s service standards were significantly below the competitors before the introduction of new menu items.  Now, it seems, relative performance on those metrics is getting worse.  Adding complexity to the menu will likely impair any progress on this front.

Howard Penney

Managing Director

Rory Green

Analyst