Of Donuts, Debt, and Deals

Mundane fast-food chains and low-tech directories are getting loads of M&A interest. Why? They're cash cows that also hold the promise of big profits

Business news often is dominated by dramatic tales of dealmaking among high-powered companies in cutting-edge markets like media and technology. In the last few days, Google (GOOG ) has made headlines by pulling ahead of rival Microsoft (MSFT ) in the race to strike a new joint-venture agreement with Time Warner's AOL unit (TWX ) (see BW Online, 12/19/05, " Time Warner: Still Searching for Answers").

Those blockbuster deals obscure the bulk of merger-and-acquisition activity, though. For every Time Warner deal, countless others involve ordinary companies that sell ordinary goods and services. The last few months has seen a bull market in coffee and donuts. France's Pernod Ricard is selling its Dunkin' Donuts group, which includes the Baskin & Robbins ice-cream business, to a consortium of private-equity buyers for $2.4 billion (see BW Online, 12/15/05, "Want Fries With That M&A?").

CLASSIC EQUATION. And Wendy's International (WEN ) wants to sell up to 18% of its Canadian coffee-and-donut franchise, Tim Hortons, to the public. It's under shareholder pressure to spin off the entire unit (see BW Online, 10/13/05, "Tim Hortons' Power Play"). And Bear Stearns Merchant Banking, the private-equity affiliate of investment bank Bear Stearns (BSC ), has acquired a stake in Stuart Weitzman Holdings, the New York-based designer of women's shoes and handbags (see BW Online, 6/29/05, "Bear Sterns Tries on Shoes"). It also bought half of premium-jeans maker Seven For All Mankind.

Acquisitions for seemingly mundane services can be attention-getting. Sandwich-restaurant chain Quiznos is up for sale and could draw as much as $2 billion, reports say. Plus, telecom giant Verizon (VZ ) could get as much as $17 billion for its directories business (see BW Online, 12/6/05, "Yellow Fever, Courtesty of Verizon").

These deals are examples of classic private-equity plays. In each case, the outfit is generating a lot of cash. That's true, even if growth is slow, as is the case with the phone-directory business. Private-equity buyers load up these companies with debt, which can play a crucial role in generating profits for investors.

THANKS TO CONSUMERS. If a private-equity group puts, say, $20 million of its money into a $100 million deal and turns around and sells the business a few years later for $150 million, the investors have turned a $50 million profit on a $20 million investment. That's because the difference between the $20 million in their equity and the value of the $100 million transaction is funded by debt, and lenders don't benefit from the price appreciaton of the company when it's sold. "Many of the deals today are growth LBOs [leveraged buyouts]. The increase in the value of the enterprise accrues to the equity, not the debt," says investment banker Adam Sokoloff, co-head of the financial sponsors group at Jefferies & Co.

Such deals are particularly attractive these days, especially in the restaurant sector. Banks traditionally allow private-equity firms to borrow three times to five times as much operating earnings generated by a target company. But lenders are currently letting them borrow as much as eight times the operating earnings of the companies they buy, Sokoloff says. This increased borrowing ability, or leverage, boosts the total return on the money invested.

Why are banks willing to allow that much leverage? One factor: a robust consumer sector, according to investment banker Jeff Williams of Jeff Williams & Co. Consumer spending has been bolstered by a strong housing market, low inflation and borrowing rates, and healthy increases in spending power.

Even modest increases in rates and a spike in energy prices have failed to hurt the consumer sector. A lot of people are pouring their discretionary income into eating out and shopping for clothes.

HOT-GROWTH PROSPECTS. The margins on some of these consumer businesses can be very high. "The margin on a cup of diner coffee is about 50%. Starbucks margins are off the charts, and that's before you add 75 cents for a shot of vanilla syrup," Williams says. That's why banks are willing to let buyers borrow so much money as part of a transaction.

Some of these companies also boast big growth potential. The Tim Hortons chain "is like a cult" in Canada, Sokoloff says. But it barely has any profile in the U.S. And sandwich chain Quiznos is experiencing dramatic growth in the U.S.

Still, risks abound. Verizon's directory business generates plenty of cash now, but it's subject to enormous technological change as the Internet transforms the industry. For now, it appears that yellow-page ads are still a great tool for local businesses, though.

NO LETUP. As private-equity players clamor for action, the price of target companies is on the rise. The investors can afford to pay higher prices because banks are tolerating so much debt as part of the transaction. And an enormous amount of money is chasing a relatively few good deals.

The party won't end any time soon. Consumers have weathered the threat of rising rates, wobbly house prices, and a spike in energy costs. Given that the Federal Reserve has signaled it may be approaching the end of the tightening cycle, and with energy costs possibly leveling off, it's even possible that consumer spending will strengthen. This means the bull market for ordinary, everyday consumer goods such as donuts and coffee is likely to continue.

READER COMMENTS

Rosenbush is a senior writer at BusinessWeek Online in New York
Edited by Beth Belton

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