Burger King’s Earnings Preview: Prices Hike & International Expansion To Drive Q2 Results [Part 2]

BKW: Burger King Worldwide logo
BKW
Burger King Worldwide

Burger King Worldwide (NYSE:BKW) is scheduled to release its Q2 2014 earnings on August 1. [1] Burger King has been reporting improved comparable store sales across all four regions for the last three quarters, with a 2% growth in comparable store sales in its first fiscal quarter. The reported net income increased by almost 70% to $60.4 million from last year’s figures of $35.8 million, whereas the total reported revenues declined 26.5% to reach $240.9 million due to the net re-franchising of 327 company-owned restaurants over the trailing 12-month period. Neglecting the impact of the global re-franchising transactions and currency movements, the system-wide sales increased 6.2% year-over-year due to net restaurant growth and global same-store sales growth. ((Burger King Worldwide: Q1 2014 earnings))

In our previous article, we discussed how the increased competitive activity in the restaurant industry might have impacted Burger King’s performance in the second quarter. [2] This article discusses company’s international expansion plans, the pros and cons of its fully franchised business model and also, how the prices hike by the company on conventional menu items might drive overall profitability in the second quarter.

We have a price estimate of $28 for Burger King, which is about 5% above the current market price.

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See full analysis for Burger King

Burger King’s 100% Franchised Model Raise Margins

Burger King re-franchised almost all of its company-operated restaurants during 2013, bringing its business model to nearly 99% franchised and by the end of 2013, the company was left with only 52 company-operated restaurants. The advantage of the franchised model is that the company does not have to incur operating costs and can enjoy the royalties paid by the franchises. The margins for this type of model are very high, as the company’s EBITDA margins for the franchise restaurants rose to 69% in 2013 from 67% in 2012. [3] With the company’s plan to expand further in lucrative and developing markets, these margins might further grow. Trefis estimates the margins for this segment to widen up to 71% by the end of 2014. [4]

However, this model comes with number of disadvantages and risks such as

  • Limited influence over the operations, marketing and advertising decisions and ownership of the franchised restaurants
  • Inability to participate in strategic initiatives such as investment initiatives in re-imaging and remodeling
  • Negative impact of franchise’s bankruptcy on the company’s revenue from that restaurant, as the franchisee agreement can be cancelled in case of bankruptcy with no further royalty payments
  • Reduction in royalty rate by franchises in times of difficult economic conditions

McDonald’s, Starbucks and Wendy’s have more company-operated stores, giving them an advantage in terms of independence in operational initiatives and marketing decisions.

Comparable Sales Might Improve

In the first quarter, the restaurant industry faced severe winter in North America which acted as a dampener for most of fast-food restaurants. However, in Q1 2014, comparable sales for Burger King grew 2% primarily driven by fewer but eye-catching menu items and simplification of in-restaurant operations, offsetting the impact of decreased customer count due to harsh weather. This improved the overall sales as compared to the previous three quarters. Comparable sales or same-store sales is an important measure to gauge a restaurant’s performance since it only includes restaurants that are open for more than a year and excludes the effect of currency fluctuation.

The foremost reason for improved comparable store sales was the increase in system comparable sales in the Europe, the Middle East and Latin America, which are typically Burger King’s low sales regions, but were not impacted by weather. Burger King clearly saw the differences between the markets that were affected by weather and those that were not. Burger King is trying to differentiate through re-imaging its outlets and if they continue to attract customers through menu optimization, we could see enhanced comparable store sales in the coming few quarters.

Price Hike Due To Rising Commodity Costs To Boost Top-line Growth

The commodity prices have been on an upsurge since the onset of this year, threatening every top restaurant chain in the industry. The price of Ground Chuck 100% beef rose to $3.85 per pound in May 2014, up 11% year-over-year, whereas pork prices grew 19% over the same period with prices hovering over $6 per pound for sliced bacon. [5] On the other hand, the price of Arabica coffee beans has surged almost 100% from a level of 106 cents per pound to around 220 cents in mid April, due to tight supply as a result of a prolonged drought in Brazil, followed by recent floods. [6] Beef and other meat items are the major raw material for Burger King and the rising coffee prices might affect its Seattle’ Best coffee segment.

  • Slight Increase In Average Spend Per Customer Visit

Rising input costs forced the company to raise its menu prices, but not by much. The company’s competitors have raised their menu prices which might force the company to further raise the price of its conventional meals. The prices hike will increase the average spend per customer visit for the company and give an additional boost to revenue growth in franchised restaurants. The more the revenue they generate, the more the royalty income the company receives.

  • Price Hike Might Decrease Customer Count

Since the company is passing on the rising commodity costs to the customers, the franchisees might have experienced reduced customer traffic due to a decline in customer demand. This might negatively affect the overall sales for the franchisees.

  • Lower Input Costs To Drive Margins

Despite rising commodity costs, Burger King is likely to incur lower cost of sales as the company has hedged most of its core supply needs for the fiscal year 2014. On account of price rises and lower input costs, we expect Burger King’s to expand its margins this quarter.

Expansion to New Lucrative Markets

The company’s major focus is on expanding its brand presence around the globe. According to our valuation, Franchise Royalty contributes 74% to the company’s share price and it further increased as Burger King set up 676 franchise stores over the past one year, out of which 496 were set up in Europe, the Middle East and Latin America. In 2014, the company plans to further expand internationally and also to enter France and India.

Burger King completed its global re-franchising initiative in the first quarter, with only 52 of its outlets operated by the company by the end of Q1 2014. At the end of first quarter, the company’s total store count reached 13,677. Although the re-franchising led to a decrease in overall revenues, it was more than offset by a greater reduction in expenses, widening their adjusted EBITDA margin by 22 percentage points.

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Notes:
  1. Burger King Worldwide: Q2 earnings result []
  2. Burger King’s Earnings Preview: Part 1 []
  3. []
  4. Burger King: 10-K report FY 2013 []
  5. Bureau of Labor Statistics []
  6. Coffee futures, July contract, 2014 []