Want Fries With That M&A?


The restaurant sector has been serving up sizzling deals as large companies slim down to their most famous brands. McDonald's (MCD) is planning an IPO for Chipotle, its popular quick-serve burrito subsidiary (see BW Online, 11/28/05, "Chipotle's Jalape?o of an IPO"). French liquor group Pernod Ricard announced in mid-December that it's selling its Dunkin' Donuts chain to a consortium, including Bain Capital, Thomas H. Lee Partners, and Carlyle Group, for a reported $2.4 billion.

And there could be more items on the sector's M&A menu. In July, Wendy's International (WEN) said it would dispose of 15% to 18% of coffee and doughnut chain Tim Hortons via an IPO. Upping the stakes on Dec. 13, billionaire shareholder Nelson Peltz sent Wendy's stock soaring when he suggested spinning off all of Tim Hortons to refocus the company's business on the hamburger chain.

Amid all the deal news, how should investors react? BusinessWeek Online reporter Alex Halperin spoke with Dennis Milton, restaurant industry analyst for Standard & Poor's Equity Research Group, about the value of core brands, the industry's strong prospects, and the hidden value of fast-food real estate. Edited excerpts of their conversation follow:

(Note: Dennis Milton is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed.)

Why are these deals happening now?

It all begins with McDonald's. A couple years ago, McDonald's [executives] decided that they were going to focus on their core brand and slow expansion down, and they've had a lot of success at improving their business and their profitability. Chipotle is a very attractive brand that they own, but [compared] to McDonald's it's very small, so they just decided this isn't a core asset anymore.

[Pernod's planned sale of] Dunkin' Donuts is really the byproduct of a company trying to focus on core assets, too. It was owned by Pernod and originally by Allied Domecq. Those are both spirits companies, and they decided there's a lot of interest from private-equity firms to actually purchase these assets and brands and turn them around. We saw that with Burger King, too. About two years ago, [Burger King was] purchased the same way.

With Wendy's, some shareholders voiced the opinion that the company was undervalued. Tim Hortons has been an excellent growth concept for the last decade, and people felt like they weren't getting credit for it in Wendy's stock, so they pushed for a breakup. Wendy's has been hurt by McDonald's success. So it's really two factors there -- trying to unlock the shareholder value, but also to focus on your core brand.

Why do private-equity groups find these brands so attractive?

It's hard to say relative to other industries. A lot of times it's because they're available. But some of [the restaurants] haven't been doing very well over the last few years, but still have a strong brand name, so they feel they can build around that [to make it] a classic turnaround story.

With Dunkin' Donuts, I think it's just one that was available. It's an attractive property. It's got strong growth prospects, and people just wanted to buy it. With McDonald's, there are a couple of shareholders who have been agitating to split that business up to unlock their real estate, because a lot of these restaurants have very successful real estate, but it's still on their books. The book value is low, and they're trying to get credit for the value.

What do you think of the prices they're going for?

With Wendy's, you've seen a 25% runup in the price of the company's stock. It's up 7% [Dec. 13] because an investor was pressing for a complete spinoff of Tim Hortons and more franchising efforts of the main brand, and people are really attracted to what these shareholders are saying.

On the other hand, the stock's up 25% this year, and the underlying performance of the company has been pretty poor. I currently have a sell recommendation on Wendy's. I think the runup in the shares has been too much. It overstates the valuation of the company.

Should we expect to see similar deals in the restaurant industry?

You might see some more deals with companies trying to narrow the focus and, as a result, get rid of their weaker brands. As for the real estate, there aren't a whole lot of restaurant companies who actually own their real estate. McDonald's is the main one. It owns a lot of real estate of its franchisees, too. Most restaurant chains lease, so they don't have that on their balance sheets.

Are there any brands that you see as particularly attractive or available?

Nothing really comes to mind. A lot of it has been done already. When you take a look at the Burger Kings and the Dunkin' Donuts, this is the tail end of a trend that's been going on for 10 or 15 years.

A lot of these brands have already been spun off by larger conglomerates. What you may see going forward is the Burger Kings and the Dunkin' Donuts, after being held by the private-equity firms, may look to go public.

Is this a reflection of public sentiment about the restaurant industry, either casual dining or fast food?

The restaurant industry's long-term fundamentals look pretty attractive. People sense that there are growth prospects in it and are willing to pay for them. In the U.S., you have an aging population that is wealthier, that is looking to eat out. You have a lot of dual-income households where there's not enough time to cook, so people are dining out more and more. As a percentage of overall meals, dining out has been increasing for several decades, and it looks to continue that way.

Are there any opportunities you see for investors?

I believe that Applebee's (APPB) is undervalued. There have been some difficult customer-traffic trends this year, given the price of gas and the hurricanes. The economy in the Midwest has been struggling a little bit, so you see the traffic patterns are off a little this year, but I think it has hit the stocks disproportionately.

I have a 5-STARS [strong buy] recommendation on Applebee's and 4-STARS [buy] recommendations on Outback Steakhouse (OSI) and Rare Hospitality (RARE).


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