Burger King-Tim Hortons Cross-Border Merger Much More Than Tax Inversion

After many years of cost-cutting measures, Burger King Worldwide (NYSE:BKW) spent big cash, as the burger chain merged with the Canadian multinational fast-casual restaurant chain, Tim Hortons (NYSE: THI). On August 26, Tim Hortons and Burger King Worldwide entered into an agreement under which the two recognized companies joined hands to create the World’s third largest quick service restaurant company. ^[1] With a combined system sales of $23 billion, the new company now has over 18,000 restaurants in around 100 countries, headquartered out of Canada, where corporate taxes are lower as compared to the U.S.  3G capital, the majority stake holder of Burger King will continue to own majority shares (51%) of the new company. The new company will be listed on the Toronto Stock Exchange, as well as on the New York Stock Exchange.

Burger King has received commitments for $12.5 billion of deal financing to fund the cash portion of the transaction, with $9.5 billion debt financing package led by JP Morgan (NYSE: JPM) and Wells Fargo (NYSE: WFC). Warren Buffett, CEO of Berkshire Hathaway, is providing roughly 25% of the deal financing ($3 billion) by taking preferred shares in the combined company.

Known for its coffee and doughnuts, Tim Hortons, is Canada’s largest fast food service with 4,546 system-wide restaurants spread mainly across Canada and the U.S. ^[2] The company’s reported a 9% increase in net revenues year-over-year (y-o-y) in Q2 2014, while the same store sales growth was 2.6% in Canada and 5.9% in the U.S. ^[3]

On the other hand, Burger King has been reporting rather unimpressive results for the last couple of quarters. In Q2 2014, the company’s total reported revenues declined by 6% due to tremendous slump in company-operated revenues, driven by net re-franchising of 360 company-owned restaurants during 2013 and increased competition in the industry. (see Burger King’s Q2 Earnings: Revenues Decline As Breakfast Battle Intensifies; International Expansion To Accelerate)

We have a price estimate of $28 for Burger King, which is about 13% below the current market price. Before the merger announcement, the company’s stock was trading close to $26.

See full analysis for Burger King

Headquarter Shift to Canada to Benefit Burger King

The merger is being looked upon as a tax inversion strategy by Burger King, as the parent company’s headquarters are relocated to Ontario, Canada. Inversion will allow Burger King to transfer its money overseas to the parent company in Canada without paying additional U.S. taxes, but rather paying the lesser tax to the Canadian government. Canada’s federal tax rate of 15%, combined with Ontario’s corporate taxes of 11.5%, results in a combined tax rate of 26.5%. ^[4] It will benefit the American company in tax savings, as it can use the saved money to reinvest in the businesses or to fund the dividends and share buybacks.

According to the company’s annual report of 2013, the U.S. and Canada together accounts for 58% of the company’s net EBITDA. The remaining 42% comes from other geographical segments. Assuming that this geographical percentage allocation is the same for net income, the company’s foreign profits come to around $98.15 million. This profit is taxed again at U.S. corporate tax rate of 35%, which amounts to $34.35 million in taxes. This value excludes the profits from Canada, including which the value can go slightly higher. This is a huge amount which the company might save as a result of its headquarters relocation to a tax-favorable location.

A wave of tax inversion cases this year, mostly involving the health care companies, has raised a concern in the U.S., and the country’s government is preparing for tax rule changes to curb the tax inversion practice.

Merger with Tim Hortons to Boost Burger King’s Top-line Performance

Burger King has a lot of positives to take out from this deal. Merger with Tim Hortons provides Burger King with everything from incremental revenues to expansion scope, from tax savings to better menu resources. Even though it might not be enough to outpace the industry leaders, it might put them in a better position to shrink the gap. Moreover, this deal fits perfectly with the company’s new business model, where the American company focuses more on international expansion.

Source: Burger King 10-K SEC filing 2013, Tim Hortons 10-K SEC filing 2013

• Tim Hortons To Bolster Burger King’s Breakfast Menu

Although Tim Hortons has a strong brand appeal and unmatchable foothold in Canada, it struggled to have a major impact in the U.S. On the other hand, Burger King has been facing a lot of competitive activity in the States from the emerging fast-casual segment, as well as in the breakfast segment. Burger King serves the Starbuck’s owned Seattle’s Best coffee to compete against McDonald’s McCafe. ^[5] In a market where coffee is a vital breakfast item, Burger King plans on expanding this segment to match the brand appeal of McDonald’s McCafe and Starbucks’ coffee. This merger could provide both the entities a major platform to strengthen their weak points.

Tim Hortons has more versatile food offerings for the breakfast segment that can help Burger king compete against the likes of  McDonald’s(NYSE:MCD), Dunkin’ Brands (NASDAQ: DNKN) and Starbucks (NASDAQ: SBUX). Tim Hortons has more than double the number of McDonald’s restaurants in Canada, with better system-wide sales as well. ^[6] Also, the company has over 70% share of baked goods market in Canada and more than 75% of Canadian coffee market, much ahead of Starbucks and McDonald’s. ^[7] Tim Hortons’ dominance in Canada can provide more exposure to Burger King in the breakfast market. Moreover, Tim Hortons could provide Burger King with improved quality of coffee and innovative food items to strengthen its dominance in the breakfast and coffee segment.

• Better Revenue Stream with International Expansion

Tim Hortons reported more than $3 billion in net revenues in 2013 at a steady growth rate and is consistent in its margins. However, it has struggled in the U.S., where food giants such as McDonald’s, Yum Brands, Dunkin’ Donuts and Starbucks have unmatchable dominance. On the Other hand, Burger King has accelerated its international expansion over the last couple of years, as it is witnessing sluggish growth in the domestic market. As mentioned before, the new company will have combined system-wide sales of $23 billion, with a prominent growth potential, to compete against the fast-food giants McDonald’s. McDonald’s reported around $28 billion net revenues in the fiscal 2013. The merger will not only provide a boost to the revenue growth, but help them in penetrating the Canadian market. Burger King has more than 7,000 restaurants in the U.S., leaving them with a little expansion growth in the domestic market. With around 280 restaurants in Canada, Burger King might look to expand its customer base in that region.

• Better Resources to Compete Against Fast-Casual Restaurants

The fast-casual segment is a fresh and rapidly growing concept, appealing to the health-conscious consumers. Brands such as Chipotle Mexican Grill (NYSE:CMG), Panera Bread, Qdoba Mexican Grill and Baja Fresh are considered as the top restaurants in this category. Regional burger chains in the U.S. such as In-N-Out Burgers, Five Guys, Shake Shack are stealing a small portion of market share as well. According to the NPD group, the fast-casual segment saw an 8% rise in the guest count in the 12 month-period ended in November 2013, whereas traffic count was flat for quick service restaurants. ((Fast casual leads traffic growth again, NPD group))

Tim Hortons innovative menu items, well-established coffee and food offerings and dominance in Canada, might help Burger King in off-setting the damage done to its revenue growth by the competitive activity. Also, the brand appeal of Tim Hortons might lay a smooth platform for Burger King to regain the lost customer traffic.

Overall, it is a blockbuster deal for Burger King in terms of growth opportunities, apart from tax saving strategy. It would be interesting to see how the combined company performs in the July-September quarter this year.

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1. World’s third largest quick service restaurant company launched with two iconic and independent brands [↩]
2. Tim Hortons Q2 2014, 10-Q SEC filing [↩]
3. Tim Hortons Earnings call transcript, Q2 2014 [↩]
4. Is Canada becoming a corporate tax haven? [↩]
5. Burger King serves Seattle Best Coffee [↩]
6. List of countries with McDonald’s restaurants [↩]
7. Can Tim Hortons fight off McDonald’s attack? [↩]