Below is my analysis of Dairy Queen, our first company for Deliberate Practice (see instructions for deliberate practice here). Remember, this is just my analysis- it is neither right nor wrong, and reasonable people can differ on valuation!
I also want to highlight that there was plenty of excellent analysis in the comments section- probably my two favorite came from this comment by “red” and a bit of value.
So let’s start with what I think Buffett saw in DQ.
Buffett has famously said that he’d like to invest in businesses that could be run by a monkey… because at some point, they will be.
I think Buffett saw a business that had, to some extent, been run by a monkey, but was still able to grow faster than inflation with extremely high returns on capital and returns on incremental capital.
Let’s start with the first part- the business, despite its high returns on capital, was not run as well as it could be. Let me refine my “monkey” comment here. Was management terrible? No, not at all- but they were hindered in a way by the structure of legacy contracts. So I think Buffett definitely saw opportunity for improvement.
Some examples:
The company also had a strange territoral/sub-franchisee set up were 124 franchises (or about 2% of the DQ franchises) paid zero royalty. And the franchisees contributed vastly different rates to their advertising fund (3-6%), so the opportunity exists to increase these too.
So 1) I think Buffett saw a business that, while well run, had a lot of room for incremental improvement with zero investment required. Another data point: MCD’s margins at the time were actually slightly higher than Dairy Queen’s, despite 70% of MCD’s revenue coming from low margin company owned stores (versus barely any for DQ until 1996). While a big piece of that could be due to DQ producing some of the products retail sold, I can help but think that margins should be higher simply given the structure of their business. Again, another area for huge incremental improvement w/ no invested capital.
2) I think Buffett saw a business that, even without the levers mentioned above, would be able to grow faster than inflation with almost no invested capital. Given DQ’s brand name, I don’t think it’s unreasonable to believe that they should at least be able to raise prices with inflation. Combine that with unit growth of 1% annually (DQ was a mature brand, but it still had some room to expand and our population is growing! Compare DQ’s 6k units MCD’s (at the time) 11k+ units, and you can see there is room to grow a bit) and DQ should be able to grow at least 1% above inflation for a long, long time.
3) Of course, those facts are nice and all… but let’s not kid ourselves. What really attracted Buffett to the business was this (click the image to enlarge).
That’s pretty impressive growth- revenues and operating income have both grown at a very consistent clip over the past ten years.
But the beauty of this chart requires a bit of adjustment.
After you back out intangibles and excess cash, I can’t come up with an invested capital number over $45m from the period from 1992-1996. That means that pre-tax ROIC has consistently been over 100%.
Also of note- In 1992, I peg DQ corporate average revenue per store (which I’m defining as total revenues / total systemwide stores) at $49k per stare. In 1995 (which I use because it’s the last comparable year, before DQ bought their corporate owned stores), revenue per store came in at over $60k. So, over that (admittedly short) time frame, revenue increased 20% per store and 25% overall. B operating income only increased 10% overall and not even 10% per store (operating income per store went from ~$7,900 to ~$8,400 by my estimate). Why the lag- is it possible that there’s actually some upside to the current operating income numbers????
Finally, let’s not forget that DQ mentions they are being sued by some of their franchisees. Many of you may dismiss that lawsuit. And it’s true: there’s probably no way DQ loses that lawsuit.
But at the same time, every franchiser has learned, at one time or another, that their health and happiness depends on the health and happiness of the franchisees. And if the franchisees are suing… well, that’s not good.
So I know I just through a bunch of data out there. So let’s sum it up.
I think Buffett saw a business that was a consistent cash flow generator that would, at worse, be able to grow faster than inflation with little incremental capital invested. In addition, there was plenty of upside from 1) legacy contracts rolling off or 2) tighter cost controls / improved margins or 3) just improvement to franchise relationship or more effective management.
Many of you have compared Buffett buying the company to buying an inflation protected bond. But in this case, I think Buffett thought he was buying an inflation protected growing bond with upside potential, possibly even huge upside potential. It was literally heads, I win- tails, I win more! Buffett could buy the business at a fair price based on present operations and get all of the potential upside for free. And, given DQs strong brand name, simple business model, and proven history, there wasn’t really any potential downside- especially w/ a capital allocator like Buffett deploying the gobs of free cash flow.
So let’s talk valuation here. We’ll approach this from two angles.
1) Many of you have (correctly) noted that high grade corporate bonds (the type Berkshire would issue) would carry a cost of 8-8.5% at the time Buffett bought them. Given the steady, “bond like” nature of DQ’s cash flows, it’s pretty simple to picture an “LBO” scenario and value the business as a levered bond.
If you take their last 10-Q, operating income was coming in at $60m per year, and the company had ~$45m in excess cash. So if we applied the “LBO” scenario to DQ, we’d get a value of (($60m / 8.5%) + $45m) = just over $750m.
As a side note, the 8-8.5% cost of capital equates to ~12x EBIT multiple, which is actually a bit lower what I believe Buffett uses to value Berkshire’s businesses (see slide 13 of this presentation for Whitney Tilson’s estimate of BRK’s op. business muliple)
2. This is a bit cheating… but I’ve linked to this Ackman presentation on Burger King before. If you look at slide 49, he shows that the median ebitda – capex multiple of a QSR business if 15.6x, with a range of 13x-16x. Given depreciation = capex, it’s reasonable to use Dairy Queen’s EBIT for this analysis (side note- actually, this may be conservative. operating income includes both depreciation and amortization, and it looks like the company has ~$3m in amort. expense per year. feel free to add that back if you want). And given Dairy Queen has almost NO lower multiple owned restaurants, while many of the comps listed own a good percentage of their units, it’s fair to think DQ deserves to be at the high side of that analysis. But if we just use a 15x multiple, then Buffett picked up a business worth ($60m x 15 + 45m) = $945m.
Some of you may argue that those multiples are too high. But I would counter that those are quite fair prices for buying a wonderful business with inflation protection and a lot of upside levers (growth, cost cutting, margin expansion, legacy contract turnover) that require no investment.
So using those values give a range of $750m-945m. With 22.5m shares outstanding, that equates to $33.33 – 42.00 per share. This is what I consider a fair value for the company to be… not what I would personally want to buy at. I would, of course, want to buy with a margin of safety!
I will post the post mortem, as well as next week’s deliberate practice information, tomorrow.
I also want to highlight that there was plenty of excellent analysis in the comments section- probably my two favorite came from this comment by “red” and a bit of value.
So let’s start with what I think Buffett saw in DQ.
Buffett has famously said that he’d like to invest in businesses that could be run by a monkey… because at some point, they will be.
I think Buffett saw a business that had, to some extent, been run by a monkey, but was still able to grow faster than inflation with extremely high returns on capital and returns on incremental capital.
Let’s start with the first part- the business, despite its high returns on capital, was not run as well as it could be. Let me refine my “monkey” comment here. Was management terrible? No, not at all- but they were hindered in a way by the structure of legacy contracts. So I think Buffett definitely saw opportunity for improvement.
Some examples:
All direct franchisees pay some fees to the Company, and at November 30, 1996, 2,861 of the 3,903 stores franchised by the Company in the United States and Canada were paying a continuing franchise service fee of 4% or more.That’s over 25% of franchisees who are paying less than the going rate for a franchise (4%). That’s an area for huge incremental improvement that would cost absolutely nothing.
The company also had a strange territoral/sub-franchisee set up were 124 franchises (or about 2% of the DQ franchises) paid zero royalty. And the franchisees contributed vastly different rates to their advertising fund (3-6%), so the opportunity exists to increase these too.
So 1) I think Buffett saw a business that, while well run, had a lot of room for incremental improvement with zero investment required. Another data point: MCD’s margins at the time were actually slightly higher than Dairy Queen’s, despite 70% of MCD’s revenue coming from low margin company owned stores (versus barely any for DQ until 1996). While a big piece of that could be due to DQ producing some of the products retail sold, I can help but think that margins should be higher simply given the structure of their business. Again, another area for huge incremental improvement w/ no invested capital.
2) I think Buffett saw a business that, even without the levers mentioned above, would be able to grow faster than inflation with almost no invested capital. Given DQ’s brand name, I don’t think it’s unreasonable to believe that they should at least be able to raise prices with inflation. Combine that with unit growth of 1% annually (DQ was a mature brand, but it still had some room to expand and our population is growing! Compare DQ’s 6k units MCD’s (at the time) 11k+ units, and you can see there is room to grow a bit) and DQ should be able to grow at least 1% above inflation for a long, long time.
3) Of course, those facts are nice and all… but let’s not kid ourselves. What really attracted Buffett to the business was this (click the image to enlarge).
That’s pretty impressive growth- revenues and operating income have both grown at a very consistent clip over the past ten years.
But the beauty of this chart requires a bit of adjustment.
After you back out intangibles and excess cash, I can’t come up with an invested capital number over $45m from the period from 1992-1996. That means that pre-tax ROIC has consistently been over 100%.
Also of note- In 1992, I peg DQ corporate average revenue per store (which I’m defining as total revenues / total systemwide stores) at $49k per stare. In 1995 (which I use because it’s the last comparable year, before DQ bought their corporate owned stores), revenue per store came in at over $60k. So, over that (admittedly short) time frame, revenue increased 20% per store and 25% overall. B operating income only increased 10% overall and not even 10% per store (operating income per store went from ~$7,900 to ~$8,400 by my estimate). Why the lag- is it possible that there’s actually some upside to the current operating income numbers????
Finally, let’s not forget that DQ mentions they are being sued by some of their franchisees. Many of you may dismiss that lawsuit. And it’s true: there’s probably no way DQ loses that lawsuit.
But at the same time, every franchiser has learned, at one time or another, that their health and happiness depends on the health and happiness of the franchisees. And if the franchisees are suing… well, that’s not good.
So I know I just through a bunch of data out there. So let’s sum it up.
I think Buffett saw a business that was a consistent cash flow generator that would, at worse, be able to grow faster than inflation with little incremental capital invested. In addition, there was plenty of upside from 1) legacy contracts rolling off or 2) tighter cost controls / improved margins or 3) just improvement to franchise relationship or more effective management.
Many of you have compared Buffett buying the company to buying an inflation protected bond. But in this case, I think Buffett thought he was buying an inflation protected growing bond with upside potential, possibly even huge upside potential. It was literally heads, I win- tails, I win more! Buffett could buy the business at a fair price based on present operations and get all of the potential upside for free. And, given DQs strong brand name, simple business model, and proven history, there wasn’t really any potential downside- especially w/ a capital allocator like Buffett deploying the gobs of free cash flow.
So let’s talk valuation here. We’ll approach this from two angles.
1) Many of you have (correctly) noted that high grade corporate bonds (the type Berkshire would issue) would carry a cost of 8-8.5% at the time Buffett bought them. Given the steady, “bond like” nature of DQ’s cash flows, it’s pretty simple to picture an “LBO” scenario and value the business as a levered bond.
If you take their last 10-Q, operating income was coming in at $60m per year, and the company had ~$45m in excess cash. So if we applied the “LBO” scenario to DQ, we’d get a value of (($60m / 8.5%) + $45m) = just over $750m.
As a side note, the 8-8.5% cost of capital equates to ~12x EBIT multiple, which is actually a bit lower what I believe Buffett uses to value Berkshire’s businesses (see slide 13 of this presentation for Whitney Tilson’s estimate of BRK’s op. business muliple)
2. This is a bit cheating… but I’ve linked to this Ackman presentation on Burger King before. If you look at slide 49, he shows that the median ebitda – capex multiple of a QSR business if 15.6x, with a range of 13x-16x. Given depreciation = capex, it’s reasonable to use Dairy Queen’s EBIT for this analysis (side note- actually, this may be conservative. operating income includes both depreciation and amortization, and it looks like the company has ~$3m in amort. expense per year. feel free to add that back if you want). And given Dairy Queen has almost NO lower multiple owned restaurants, while many of the comps listed own a good percentage of their units, it’s fair to think DQ deserves to be at the high side of that analysis. But if we just use a 15x multiple, then Buffett picked up a business worth ($60m x 15 + 45m) = $945m.
Some of you may argue that those multiples are too high. But I would counter that those are quite fair prices for buying a wonderful business with inflation protection and a lot of upside levers (growth, cost cutting, margin expansion, legacy contract turnover) that require no investment.
So using those values give a range of $750m-945m. With 22.5m shares outstanding, that equates to $33.33 – 42.00 per share. This is what I consider a fair value for the company to be… not what I would personally want to buy at. I would, of course, want to buy with a margin of safety!
I will post the post mortem, as well as next week’s deliberate practice information, tomorrow.
