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Burger King will need time to digest Tim Hortons

Valuations are rich for the burger chain, but it holds potential for momentum investors.

Catherine Multon 25 September, 2014 | 6:00PM
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Should investors who are hungry for Tim Hortons THI be buyers of Burger King? Investing directly in the iconic Canadian coffee chain will no longer be possible once it merges with Burger King Worldwide Inc. BKW.

Announced on Aug. 26, Burger King's US$11-billion takeover deal will create the third-largest fast-food chain in the world, with US$23 billion in annual sales and 18,000 outlets. 3G Capital, the Brazilian investment firm that holds a majority ownership of Burger King, will own 51% of the new combined company, Burger King minority shareholders 27% and Tim Hortons shareholders 22%. Tim Hortons shareholders must vote to accept the offer and it must pass regulatory scrutiny in both countries before the deal can close.

Shares of both Tim Hortons and Burger King surged about 20% in the first trading session after the merger announcement, an indication that the market perceived the deal to be beneficial to both companies. Though the two brands will operate independently of each other, having a much larger corporate parent to draw on is viewed as a competitive advantage. Also, there are potential tax savings for the combined entity. By locating the new company's headquarters in Canada, Burger King may be able to ease its U.S. tax burden through an arrangement known as tax inversion.

Of the two merging companies, Tim Hortons has been by far the more attractive investment, particularly for those income-seeking investors looking for stocks with growing dividends. Over the past five years, Tim's fiscal-year dividend has grown at an annualized rate of 29%. Furthermore, the dividend is expected to grow by another 10% in the coming four quarters. The buyout premium was the cherry on top for dividend growth investors in Tim Hortons, who were already more than satisfied to hold the stock long-term for the consistent hikes in dividends.

By contrast, Burger King appears to be a far less appetizing investment. Relative to the U.S. consumer-discretionary sector, its valuations are high. For example, the price-earnings ratio on the earnings per share estimate is 27.6 times versus 17 for the sector. Price-to-book, price-to-sales and price-to-cash-flow ratios are also well in excess of peers at 7.4 times, 11 times and 26.2 times respectively, versus three times, 1.2 times and 11.8 times for the sector. Accordingly, value-oriented investors should have no interest in owning Burger King stock.

The balance sheet does not impress either. Burger King's level of debt to equity is high at 1.9 times relative to 0.5 times for the sector, and its cash flow to debt is very low at 0.1 times compared to 0.5 times for the sector.

However, thanks to growth and momentum metrics, Burger King's future seems more promising. Its return on equity and growth of book value are estimated at 26.9% and 19.5%, respectively, versus 17% and 13.2% for its peer group.

Burger King's quarterly earnings momentum values (last, current and next quarters) are higher -- 6.9%, 4.2% and 7.5% -- than the sector's 1.1%, 1.4% and 1.6%, respectively, for the same periods. However, the estimated earnings growth in the coming year, which is 17.9% compared to 15.2% for the sector, will recede to 12.6 % against 16.3% for the sector in the following year.

As a result, Burger King should be on the radar for aggressive growth and momentum-oriented investors. But in order for these investors to consider buying the stock, it will need to greatly improve in the earnings surprises department; in the most recently reported quarter, Burger King reported lower earnings than what was expected by the analyst community.

The acquisition of Tim Hortons is likely to contribute to Burger King's future earnings growth. In the meantime, however, investors should hold off on investing in the new company.

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Catherine Multon

Catherine Multon  Catherine Multon is a contributing writer for Morningstar Canada.

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