In some ways, a butcher is similar to a surgeon. In some ways, they are very different; one uses a cleaver while the other typically opts for a scalpel. We view some of the cost cutting practices of private equity players in the restaurant space as analogous to surgeons operating with cleavers. The risk of things going awry tends to be quite high and the equity holders are typically left with the corpse.
Heinz dominated the headlines on Valentine’s Day when it was revealed that 3G Capital and Warren Buffett’s Berkshire Hathaway was buying the ketchup maker for $23 billion. 3G Capital will be in charge of operations, according to media reports, and this is being interpreted as some to mean that heavy cost-cutting at HNZ is soon to come. The reasoning behind this concern is that servicing the debt and dividend payments may leave inadequate cash flow to cover other obligations.
We were interested to read, in this past weekend’s edition of The Wall Street Journal, that comparisons are being made between 3G Capital’s takeover of Burger King in 2010 and last week’s much larger Heinz acquisition.
Cut Costs First, Ask Questions Later
We recently spoke with a Burger King franchisee that told us, “management are sitting on pickle buckets” when we asked for his perspective on the cost-cutting that had occurred at BKW on the corporate level. Some of the anecdotes about Burger King in the WSJ article on HNZ were fascinating and confirmative of our prior thoughts on BKW and its IPO.
Here are a couple of highlights, as far as BKW is concerned, from the WSJ article on HNZ:
“A few weeks after taking over, the firms’ management team fired about half of the 600 employees at the company’s Miami headquarters, got rid of the building’s executive wing and made employees get permission to make color printouts”
“One large Burger King franchisee said that so many managers at the corporate headquarters have been laid off that there is no one to call when there is a problem. Meetings are conducted via webcast as a way to save money.”
The practices being employed by Burger King managers, according to the article, are said by former Burger King executives to have been inspired by consultant Bob Fifer’s book, “Double Your Profits in 6 Months or Less”. One of the book’s chapters is called, “Cut Costs First, Ask Questions Later”.
Bootstrapping Unlikely To Work Over Long-Run
It’s important to acknowledge Burger King’s response to the implication that costs had been cut too much. Spokesman Miguel Piedra is quoted as saying that corporate headcount had been slashed to enable an increase in the number of field managers within the company. Time will tell whether or not these cuts have been overly aggressive: we think they have been.
One key aspect of the “turnaround” has been new menu items that have been touted as bringing in incremental customers. While this may be true, we question the sustainability of the means implemented by management. No R&D was required in producing these new menu items as the offerings were taken straight from the McDonald’s menu. This has also been seen in the new coffee and beverage initiative which required little-to-no capex. Management’s strategy seems to be to compete head-on with McDonald’s. We don’t believe franchisees are excited about this from a profitability standpoint and we would bet against Burger King bootstrapping its way to success. Low budget, short-term attempts are unlikely to offer sustainable profitability to the franchisee community. We think there is a high risk of investors being disappointed with FY13 results when all is said and done.
At this point, operating costs at Burger King have been cut dramatically and investors responded positively to its 4Q12 earnings report on Friday. We continue to believe, as stated on our Best Ideas call on February 11th, that BKW shares represents an attractive opportunity on the short side. The company was not “fixed” in the 18 months that it was private. We believe that the franchisee base is under duress as the butchering of the corporate cost structure, while beneficial over the short run, could result in issues down the road.
For precedent, look no further than Wendy’s. The company has been starved of capital that has led to “cardiac arrest” for its shareholders as its equity value has flat-lined since the crash in late 2008.