MorningWord 8/25/14: Strange Brew – $BKW, $THI

by Dan August 25, 2014 9:46 am • Commentary

The WSJ is reporting that Burger King (BKW) is considering buying Tim Hortons (THI) despite having fairly similar market capitalizations.  While a deal would likely have strategic value in terms of broadening THI’s footprint globally, the primary interest by BKW is the ability to relocate their tax status to Canada. per WSJ:

By moving to a lower-tax jurisdiction, inversion deals enable companies to save money on foreign earnings and cash stowed abroad, and in some cases lower their overall corporate rate. Even though many of the headline-grabbing inversion deals of late have involved European companies, Canada has also been the focal point for a number of them, given its proximity and similarity to the U.S. Canada’s federal corporate tax rate was lowered to 15% in 2012.

While 2014 has had its share of high profile M&A (with some high profile fails), the inversion push has raised eyebrows in Washington, and not by the usual regulatory agencies like FTC, FCC etc, but by the IRS and Congress. I have no opinion on the regulatory merits of such a deal. Is it sad to see a fairly subpar American brand relocate to Canada?  Not at all from my perspective. Good riddance, the Whopper sucks. (CC thinks the Whopper is great but hasn’t had one in years because their fries suck) But what is interesting aside from the age old debate of Big Mac vs the Whopper, is the comparison of THI to Dunkin Donuts (DNKN).

THI as of Friday’s close had a $8.3 billion market cap, trading at 2.66x 2014 expected sales of $3.44 billion, and almost 21x 2014 earnings which are expected to grow 11% this year on a gross margin of about 39.5%.  Selling coffee is one of its largest appeals, as that high margin product is a profit machine for Tim Hortons just as it is for many other global restaurant chains.

One such chain is Dunkin Donuts. DNKN is a brand far more recognizable to U.S. investors, and sports a $4.5 billion market cap, trading at 6x 2014 expected sales and almost 25x 2014 earnings expected to grow 15% on a gross margin of 78%.

I suspect the large difference between sales and margin is owner operated vs franchised, but THI’s fairly obvious attraction is likely the “tax haven” that is Canada.  There have been no shortage of deals, discussed and considered in the healthcare space for the purpose of inversions, but I suspect that when this period’s m&a is looked back upon, the strategic deals will be far more likely to have succeeded than those for tax purposes.

While Walgreen’s opted not to pursue a relocation for tax purposes in its acquisition of Alliance Boots (which we suspect was the result of some U.S. government lobbying), the re-emergence of the tax inversion deal in the BKW / THI example could lead to a more rapid response from government regulators.  In the meantime, speculation is likely to increase in the options market about who the next target might be for tax inversion.  So far, the health care sector has been the area of focus, but we’ll be on the lookout for unusual activity in ADRs of foreign stocks that might indicate more tax inversion chatter.

Lastly, could the rush by U.S. companies to invert cause some unintended consequences within certain industry groups as certain tax targets like THI cause a flurry of M&A among the acquirers and acquired for strategic reasons?