Burger King Worldwide Inc. (NYSE: BKW) has announced on August 26, 2014, the acquisition of Tim Hortons Inc. (NYSE: THI) in a merger that will create the world’s third-largest quick service restaurant. The legal headquarter of the combined entity will be relocated in Canada, which rises new concerns about the trend of tax inversion deals which regards U.S. companies.

The transaction is valued C$ 12.5 billion (US$ 11.4 billion), a price that includes a 30% premium over the Tim Hortons unaffected market value.

Transaction Drivers

It was initially believed that the main transaction driver was the tax inversion made available by moving the combined company’s headquarters to Canada. Indeed the American corporate tax rate of 39% is significantly higher than Canada’s 26% rate. Burger King executives however defended that the deal had significant strategic drivers and that the tax advantage was minimal as Burger King currently only pays a 27% tax rate. Proof of their motivations appeared when they announced that they would go through with the acquisition despite the new tax regulations enacted by the Treasury Department on September 22^nd.

The deal is the logical continuation of Burger King’s recent trajectory. Since its acquisition by 3G Capital in 2010, Burger King has expanded notably into China, Russia and Brazil, and opened a significant number of restaurants in its established markets. However sustaining the growth trajectory and stock price appreciation with a single brand has become increasingly complicated, which is why Burger King has such strong interest in Tim Hortons. The new combined company would become the third largest fast food company behind giants McDonalds and Yum! Brands (KFC, Pizza Hut) and would be well-diversified in its offering, ranging from burgers and fries to coffee and sweets.

Burger King plans to leverage its worldwide network to internationalize the overly Canadian Tim Hortons, while inspiring its operations from the exceptional market penetration Tim Hortons has displayed in Canada recently. By keeping the Burger King and Tim Hortons brands separate, the combined company would had a strong breakfast franchise to its burger brand, creating a good mix of restaurant offering. Finally, Burger King executives have argued that significant cost-cutting opportunities were possible at Tim Hortons, given its low profit margin of 25% relative to competitors (Dunkin Donuts is at 50%).

Transaction Terms and Structure

The value of the transaction is of approximately C$ 12.5 billion (US$ 11.4 billion) that will be paid by Burger King to Tim Hortons shareholders.

Under the terms of the transaction, each Tim Hortons shareholder will have the option to choose between three forms of payment. The first one is the default choice, according to which each Tim Horton shareholder will receive, for each share, C$ 65.50 in cash and 0.8025 common shares of the new company. Considering the unaffected stock price of Burger King on August 22, the total value received for each share of Tim Hortons is C$ 89.32. The second option is to receive C$ 88.50 in cash. The third option is to receive 3.0879 common shares in the new company for a total value of c$ 91.66.

Upon completion of the transaction, each of the shares of Burger King will be converted in 0.99 of a share of the new combined entity and in 0.01 of a unit of a newly formed Ontario limited partnership controlled by the newco. Burger King shareholders will be given the option to select whether they prefer to receive common shares of the new combined entity or partnership units (that will be converted with a 1:1 ratio into common shares of the newco, but it will not be possible to convert them during the first year following the closing of the transaction. They have the same voting rights as common stock). 3G Capital, which is the main shareholder of Burger King with approximately 70% of its capital, has committed to receive only partnership units. After the transaction will be completed, 3G Capital will own around 51% of the new combined entity.

The market reacted very positively to the announcement of the transaction and on August 26 Burger King closed at 19.5% up ($32.40) and Tim Hortons closed 19% up (C$74.72), compared to the unaffected stock prices of August 22. Compared to Tim Hortons closing price on August 22, Burger King is going to pay a premium of approximately 30%.

The proposed transaction has already passed the antitrust controls and on October 28, Canada’s Competition Bureau announced that Burger King’s plan to buy Tim Hortons does not pose a competitive threat to the fast food industry due to the large number of competitors.

However, the acquisition still requires the approval by Tim Hortons shareholders (they will vote on December 9) and is subject to a review under the Investment Canada Act. The deal does not require the approval of Burger King shareholders since 3G Capital (owning 70% of Burger King) has already approved the deal. The final approval by the Canadian Government is expected before Christmas.

The shares of the newco will be traded on the New York Stock Exchange and the Toronto Stock Exchange whereas units of the new partnership will be traded only on the Toronto Stock Exchange. The new global company will be headquartered in Canada.

JP Morgan, Wells Fargo and other banks have committed to finance C$ 9.5 billion of debt; Berkshire Hathaway has committed C$ 3 billion of preferred equity financing with 9% coupon (only financing source, no participation in the management of the business). The coupon that burger King is going to pay to Berkshire Hathaway seems high compared to the current yield on corporate junk bond around 5.27% (the rating of the newco is B+, as stated on September 15 by S&P). However, in order to get the deal done with the amount of debt that 3G Capital put on the company, Mr. Buffet was actually the best option. The reason is that Burger King is a highly indebted company that, with nearly $ 3 billion of debt in its balance sheet, is paying interest rates between 10% and 11% on roughly $1.3 billion of its debt. Therefore, a coupon of 9% on the C$ 3 billion financing by Berkshire Hathaway is a step down in interest payments on new debt. Finally, by structuring Mr. Buffett’s piece of financing as preferred equity, the newco will avoid to write additional C$ 3 billion of debt on its balance sheet.

Lazard, J.P. Morgan and Wells Fargo served as financial advisors to Burger King. Citi and RBC Capital Markets served as financial advisors to Tim Hortons. The deal is expected to close at the end of the year or at the beginning of 2015.

Industry Overview

Both Burger King and Tim Hortons are pure-play fast food services companies, operating in different segments. Tim Hortons is known for their freshly brewed coffee and doughnuts while Burger King for their infamous flame-grilled burgers. The global fast-food market in 2013 amounted to a whopping $635 bln, a 4% year-over-year increase. Over the last 5 years the industry grew at a CAGR of 5,3%. The global market is very fragmented, stretching through different food segments: burgers, asian, bakery and chicken being the most significant ones. The major players include McDonald’s, KFC, Subway, Burger King, Wendy’s and Pizza Hut.

The burger joints’ dominance in the fast food industry seems to be far from over, yet increasing awareness of health risks associated with a fat- and sugar-based diet pushes people to veer towards more healthy choices. And apparently this change does not have to entail a compromise on the speed of the service. That is due to a recent proliferation of local healthy fast-food chains like Tender Greens, with 20 locations in California or Veggie Grill with 25 places on the West Coast, both offering meals that are both healthy and convenient. The acclaimed market players like Panera Bread with over 1800 locations worldwide are also gaining traction.

The big names, in fear of diminishing sales, have also conformed to this trend by including ‘streamlined’ items in their menu. McDonald’s offers salads with low-fat dressing, Subway 9-Grain Wheat Bread, Burger King a Whopper Jr. without mayo. That however, does not even compare to the selection of foods found in the healthy fast-food chains. Diners can order a variety of meals ranging from brussels sprout salads and kale smoothies to vegan sandwiches stuffed with organic ingredients, everything served with the same speed as in McDonald’s.

Well, in that light even a grilled non-mayo burger coupled with a doughnut or coffee doesn’t seem like a guilty pleasure worth the money and Burger King’s strategy seems contradictory to the ongoing trends. Nevertheless, fast-food industry is a huge one and the sales of the combined companies represent merely a 3.6% in the global market. The analysts seem to be unanimous – there’s a lot of potential for Burger King to exploit in this deal and the tiny fraction that healthy chains make up for so far should not stand in the way.

---

To contact the authors:

Costantino Brizzi                         costantino.brizzi@studbocconi.it

Isabella Diplotti                            isabella.diplotti@studbocconi.it

Michał Ozimski                           michal.ozimski@studbocconi.it

Hugues Coruzzi                           hugues.coruzzi@studbocconi.it