Burger King Worldwide is paying a royal premium to acquire Canada's Tim Hortons. It will probably take much more than tax loopholes to make the deal pay off.
The burger chain announced Tuesday it would acquire Tim Hortons for about $85.70 per share, valuing the company at roughly $11 billion. A person familiar with the matter said Burger King approached Tim Hortons multiple times before they reached a deal—and it appears the ultimate terms are generous.
According to Dealogic, the price represents a 57 percent premium to the trailing one-month price of Tim Hortons shares. That compares with an average premium of 30 percent for other deals completed so far this year in North America, Dealogic said.
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Contrary to what many observers have speculated, Burger King won't be able to justify much of that premium through tax advantages—at least not anytime soon. The deal has drawn attention because it is structured as a so-called tax inversion, where the new company will be domiciled in Canada rather than the U.S. Canada's corporate tax rate is somewhat lower than in the U.S.
But while Burger King is a U.S. company currently, its effective tax rate is at a level in the high 20s, similar to levels paid in Canada. It's always possible that rate would have drifted toward the standard 35 percent tax rate over time, but the move to Canada will effectively keep the rate in the same ballpark.
Indeed, Burger King said on a call with investors Tuesday that it doesn't expect the "tax rate to change materially" and it doesn't anticipate any "meaningful tax savings" from the deal.
And the deal financing isn't exactly cheap. As part of the deal, Warren Buffett's Berkshire Hathaway will provide $3 billion in exchange for preferred shares in the new company. The coupon on those shares: a hefty 9 percent. Burger King also expects the debt for the deal to have a junk rating, indicating higher borrowing costs.
Burger King isn't relying much on cost cuts, which companies often cite to justify hefty acquisition premiums. Asked about potential cost savings on the investor call, Burger King said "this transaction isn't about synergies" but that it will boost earnings in the "medium to long term."
The real key to squeezing more profits from Tim Hortons may actually be adding more restaurants outside of Canada—something the company has done at a fairly slow pace so far.
Burger King has a much broader international footprint and can probably convince more franchisees overseas to open Tim Hortons restaurants. The key to that approach is that Burger King collects a percentage of each restaurant's revenue. In the U.S., for instance, most new Burger King franchisees pay the company a royalty of 4.5 percent of sales, according to recent company filings.
Even if new Tim Hortons restaurants only perform modestly in their early years, Burger King can still make a handsome profit. That will also give the parent company cash that allows it to service the hefty debt load it takes on in the transaction.
While international expansion carries plenty of risk, Burger King parent 3G Capital has plenty of experience with global companies. Burger King along with beer giant Anheuser-Busch InBev, have both shown a significant improvement in margins under the stewardship of the investment firm.
Investors who hang onto shares in the new company should be careful not to expect immediate gratification.