Burger King IPO: Is Its Private-Equity Backing a Red Flag?

Back in early April, my colleague Chad Fraser warned that investors should be wary of the upcoming Burger King IPO. Well, today (June 20th) Burger King Worldwide (NYSE: BKW) began publicly trading. As of 3:00 PM, the stock has managed to sustain a small 3.5% gain after having briefly jumped as much as 11.9% during the first half-hour of trading this morning.

To be perfectly accurate, Burger King has not returned to the public markets via an IPO, but instead has undergone a reverse merger with a special purpose acquisition company (SPAC) called Justice Holdings (OTC Markets: JSTUF), which canceled its London listing and re-listed on the New York Stock Exchange under the Burger King moniker. Justice Holdings last traded on the OTC “grey market” yesterday at a price of $14.50, which is the price being used as the IPO-equivalent offering price to judge the performance of Burger King on its first day of trading:

Source: Bloomberg

Anyway, Justice Holdings is now history and BKW is the surviving entity.

Burger King is an Expensive Stock

The question is whether owning this burger-chain’s stock is a good investment going forward? The answer is probably not. Keep in mind that Burger King was taken private in October 2010 at an equity valuation of $3.3 billion and an enterprise value (including debt) of $4.0 billion. Compare those numbers to BKW’s current equity valuation of $5.1 billion (350 million shares outstanding * $14.50 opening stock price) and an enterprise value of $8.2 billion (total debt is $3.1 billion). In other words, the company’s current enterprise value is more than double what it was less than two years ago and its debt load has increased more than four-fold, from $700 million to $3.2 billion!

On an enterprise value (EV) to earnings before interest, taxes, depreciation, and amortization (EBITDA) multiples basis, the company was taken private at 9 times EBITDA. You can calculate this yourself by reading page 40 of the Burger King prospectus and finding fiscal 2010 EBITDA was $444.6 million. Divide the $4.0 billion enterprise value by $444.6 million EBITDA yields a multiple of 9.0. To determine the company’s current EV-to-EBITDA multiple, divide its 2011 EBITDA of $498.9 million into the company’s current $8.2 billion enterprise value and you get a multiple of 16.4, which is 83% higher than its “take private” EBITDA multiple of 9.0.

Burger King’s Operational Performance is Mediocre

Private equity firm 3G Capital – which took Burger King private in 2010 and still owns a 71% interest in the new public company – would argue that today’s higher multiple is justified because it has spent time improving Burger King’s operations and competitive positioning. Hogwash! 3G Capital has only owned the company for 20 months; that is not enough time to turn the company around. As a Morningstar analyst commented:

This is a pretty quick turnaround to be going public again, especially when a lot of their fundamentals still seem to be lagging a number of their competitors.

It’s true that the company’s first-quarter 2012 EBITDA of $118.1 million is up 19% from last year’s $99.0 million, but EBITDA has declined sequentially for the past two quarters (page 10) and the $118.1 million number excludes $9 million in higher interest expenses caused by the $2.3 billion increase in debt. Furthermore, the improved EBITDA was due primarily to cost cutting and selling stores to franchisees, not growing the business. A better reflection of business performance is same-restaurant sales growth, which has only started to improve during the last three months, but one quarter of improved sales performance is nowhere near as convincing as a full-year’s improvement would be. The fact that 3G Capital and Justice Holdings weren’t willing to wait for a full year of same-restaurant sales improvement is a bit disconcerting. Another red flag: Wendy’s (NasdaqGS: WEN) recently leap-frogged over Burger King to become the second-largest U.S. burger chain after McDonald’s (NYSE: MCD).

Burger King is Loaded with Debt

About the only thing 3G Capital appears to have done during its short tenure as private owner is borrow $2.3 billion in order to pay itself a huge dividend of $3,931 per share in 2011 (see pages 37-38 of prospectus). I’m not impressed by the company’s new summer menu, and don’t get me started on the disgusting bacon sundae which has been called a “monstrosity” and an “abomination.” Early promises by 3G Capital to spend $500,000 per store revamping Burger King restaurants have been all but abandoned.

Cutting costs to the bone for a short-term earnings spike and loading up on debt in order to pay special dividends before going public are common practices among private-equity backed IPOs. In fact, Burger King itself has played this game more than once, each time going public at a higher valuation on IPO hype despite sagging fundamentals and then taken private again after disappointing performance causes the stock price to decline below the IPO price.

No wonder many investors shy away from investing in private-equity backed IPOs! But I’m an optimistic fellow so let me leave you with a couple reasons why Burger King may not perform too poorly.

Academic Research Says Don’t Short Burger King

First, 3G Capital continues to own 71% of the company, which provides the private-equity firm with plenty of financial incentive to make Burger King a success. Hedge fund manager Bill Ackman personally owns 1% of Burger King and his Pershing Square funds own 11%. Burger King’s stock won’t go down in earnest until you see 3G and Pershing Square unload their significant stock holdings in follow-on public offerings.

Second, academic studies have found that private-equity backed IPOs outperform. A 2006 Harvard Business School study concluded:

Critics complain that buyout firms suck out profits rather than improve the firms they acquire, making these companies weakened goods when the IPO is launched. IPO investors suffer when these crippled companies fail in the market. But conventional wisdom has it wrong.

Reverse LBOs appear to consistently outperform other IPOs and the stock market as a whole. The positive returns appear to be economically and statistically meaningful. Moreover, there is no evidence of a deterioration of returns over time, despite the growth of the buyout market: RLBOs performed strongly in the late 1980s, the mid-1990s, and the 2000s.

The one exception involves “quick flips,” where the private equity firm buys and sells the company within a one-year period. Quick-flip IPOs underperform the S&P 500 by 5% over the following three years. 3G Capital’s 20-month flip of Burger King is pretty darn quick, but it doesn’t qualify under the Harvard study’s 12-month definition, so there is still hope.

Similar studies of private-equity backed IPOs in other countries, including the U.K., Germany, and Australia have also concluded that investor fear of underperformance is “invalid.”

My takeaway from the academic research, as well as from Burger King’s prospectus, is that Burger King is an expensive stock whose turnaround is uncertain, but I wouldn’t bet against it as long as 3G Capital and Pershing Squire remain significant shareholders.