Chipotle Is the First, but Not the Last, in Coming Wave of Restaurant Activism

Editors' pick: Originally published Nov. 7.

Could an activist hedge fund drive Dunkin' Brands (DNKN) to put itself on the market?

At least one analyst following the fast-food donut and restaurant chain believes the answer is yes. John Gordon, restaurant analyst at Pacific Management Consulting, suggests that an activist at Dunkin' Brands could agitate for a sale of the chain, and that Yum! Brands (YUM) might be a possible buyer now that it has completed the separation of its China business. Yum!, the company behind Taco Bell, Kentucky Fried Chicken and Pizza Hut, completed the spinoff of its China unit on Nov. 1.

For Gordon, a Yum! acquisition of Dunkin' Brands would help boost the donut company's international growth. Yum! is already subject to an activist that is likely looking for more growth-oriented deal-making. And the restaurant chain has the infrastructure and expertise in place to help Dunkin' Brands expand its franchised model successfully.

"Dunkin' Brands hasn't been successful internationally," Gordon said. "Yum! would have the international infrastructure and business development expertise in place so it could slide Dunkin' Brands into its existing organization."

Dunkin' Brands currently has roughly 5,000 Baskin-Robbins and 3,000 Dunkin' Donuts locations outside of the U.S., which, as a group, haven't performed well lately, posting negative same-store sales for the past three quarters. Gordon noted that it opened 11 Dunkin' Donuts International locations in the third quarter, a low number signaling weakness.

Would Yum! be interested in making a major acquisition? It's a serious possibility. Yum! CFO David Gibbs told an investor conference on Oct. 11 that if there were an acquisition that the Louisville, Ky., company could make to "accelerate" its growth, it would "certainly be considered."

In addition, Greg Creed, Yum! CEO, told investors that the company has enough cash to pursue an acquisition despite its commitment to return $13.5 billion to shareholders between 2015 and 2019 in stock buybacks and dividend distributions. "If an opportunity arose, we've got plenty of liquidity and we've got plenty of cash to take advantage of it," Creed said at the conference.

In fact, Yum! had about $2.9 billion in cash as of September, up from $861 million in the same period last year, according to its October quarterly report. "The cash amount is way up, fueling the speculation that something could be done with it before it is dividended out or used to reduce debt," Gordon said.

Sharon Zackfia, restaurant analyst at William Blair, said that one positive aspect to a Yum!-Dunkin' Brands combination would be that there isn't much overlap when it comes to each company's businesses. "They are both franchised concepts and there would be little cannibalization of Dunkin' by Yum!'s KFC or Taco Bell," Zackfia said.

However, she noted that it would be easier to accelerate Dunkin' Brands' international operations if the company could improve its existing franchised locations first.

Alternatively, an activist could agitate to have Yum! acquire Subway, which is privately held and has over 44,000 locations inside the U.S. and outside. The sandwich retailer's co-founder, Fred DeLuca, passed away last year, leaving DeLuca's sister, Suzanne Greco, in charge. Gordon contends that Subway could be a target for acquisition in the months to come.

"The trouble with Subway is they overdeveloped stores in the U.S. and DeLuca's sister is running the place and she doesn't have the brand transformational skills," Gordon said. 

In response, a subway spokesman said that Greco grew up in the business and has served in many different roles, including sandwich artist and R&D, and is "leading the evolution of Subway." In addition, he added that Subway owners have "consistently said the brand is not for sale." 

Corvex Management's Keith Meister, a protégé of Carl Icahn, has been agitating at Yum! for some time. Meister initially pushed for a separation of the China business, and in 2015, Yum! added the activist manager to its board just as it said a decision was imminent on a strategic review it was working on. The insurgent manager owned 21 million shares, with a $1.7 billion value, as of its most recent positions filing in August. Meister, who is still on the board, could push for Yum! to acquire Dunkin' Brands, Subway or other fast-food chains to drive growth.

However, Zackfia said she was skeptical that Yum! would be interested in buying Subway, partly because with its numerous locations in the U.S. and abroad it may be too far along on the maturity curve for the KFC, Taco Bell and Pizza Hut owner. "Yum! would likely want something younger that they can grow," she said.

Another fast-food company that could become an M&A target in the months to come is Chipotle Mexican Grill (CMG) . The burrito chain is under pressure from activist investor Bill Ackman's Pershing Square Capital Management, which has a 9% stake.

One activist fund manager, who requested anonymity, told The Deal that he believed that Ackman could try to force a merger between Restaurant Brands International (QSR) , which owns Burger King and Tim Hortons, and Chipotle. In addition to Ackman's large Chipotle stake, the embattled insurgent fund has a 17% stake in Restaurant Brands and could be trying to drive growth at QSR and reap a premium on his investment in Chipotle.

In addition, a large swath of Chipotle's shareholders aren't happy with the company's performance and executive compensation, including CtW Investment Fund, an organization that advises pensions for unions that is seeking to have the company replace one of its co-founders with an independent director.

Feeling the heat, the burrito chain responded last month with a dizzying array of new initiatives targeted at igniting growth at the same time that it posted a disastrous third quarter. 

How would a deal work?

It is extremely unlikely that Restaurant Brands International will be a candidate for an activist-pressured takeover anytime soon. Private equity firm 3G Capital, co-founded by Alexandre Behring, controls Restaurant Brands International's exchangeable units that convert into about 43% of the voting interest in the company, a major impediment to any dissident-director election effort. 

But a Restaurant Brands acquisition of Chipotle would have problems as well. Gordon notes that QSR has accumulated a substantial amount of debt when it was formed to combine Burger King and Tim Hortons in 2014, and as a result it is likely to spend the next few years on developing its existing brands.

Instead of a deal, Ackman could pressure the burrito chain to shift its company-owned model into a franchised approach in a move that could drive a hike in capital distributions to shareholders. The idea is simply to sell company-owned stores to their operators or other interested parties to raise cash. Chipotle currently does not franchise and would have to establish the appropriate infrastructure, which includes setting up operational support systems, training and setting up of franchise advisory councils, as well as construction assistance. 

However, Zackfia noted that an activist wouldn't need to push Chipotle into franchising to raise cash for a hike in its capital distribution plan. "They have no existing debt so they wouldn't have to do franchising to raise [capital] to repurchase more shares," Zackfia said.

In addition, it would take significant time for Chipotle to shift to a franchising model, domestically, internationally or both. "There are systems and infrastructure that need to be set up to do franchising. It would take at least 12 months to do it," Zackfia said.

Still, Ackman could also be privately pressuring Chipotle to expand globally, beyond its 20 or so non-U.S. company-owned locations. Whether driven privately by Ackman or not, the burrito chain appears to be looking to do just that. It recently brought in a new managing director for its European business, Jim Slater, who previously worked at Costa Coffee. Chipotle co-CEO Montgomery Moran told analysts last month that "expanding ... in Europe holds a lot of promise" for the chain's future.

EDITOR'S NOTE: This article was originally published by The Deal, a sister publication of TheStreet that offers sophisticated insight and analysis on all types of deals, from inception to integration. Click here for a free trial.

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