Whopper – Deliberate Practice – Dairy Queen 1997

Whopper Investments has started a weekly valuation practice series. The aim is to replicate the investment thesis of a successful investment. Whopper supplies two recent 10-Ks and the most recent 10-Q. The first challenge is to value Dairy Queen in 1997. My analysis of the company is below.

To value Dairy Queen in 1997, I used the same process I would typically use to value a company.

• First, I quickly browsed the last two 10-Ks to make sure I understand the business and what the main drivers and risks are. Also to get a high level understanding of the financials

Business : Dairy Queen is in the restaurant business but its really a franchisee. The company owns an operates 5,710 Dairy Queen stores. Only 34 of these stores are actually owned by the company. Most stores are located in small towns and suburbs.  Terms of a franchise are $30,000 initial fee, plus 4% of gross revenues on an ongoing basis. The franchisee model is in my opinion a vastly superior way of running a restaurant with high brand recognition. The company provides minimum amounts of financing to the stores.

In addition to the core business of Dairy Queen, the company also comprises of 420 Orange Julius stores, 60 KarmelKorn stores an 21 Golden Skillet restaurants. All these stores are franchisee operations and the company received a $15,000 start-up fee and receives approx 6% of gross sales. Interestingly, DQ also owns 60% of a staffing agency – Firststaff, Inc.

Senior Management has been with the company for an extremely long time – average tenure is around 20 years. Most senior managers are in their 50′s.

Risks: Given the nature of the business, the company’s main risk is competition. The number of franchise stores has increased over the last couple of years suggesting the stores are doing well and franchise operators are happy with their returns. Since the company doesn’t seem to provide much financial support for a franchisee the increase in number of stores is a big positive. The business is highly seasonal with second and third quarters providing a majority of profits (all qtrs are positive).

Dual share class limits voting rights of class A holders but entitles class A holders priority in distributions and liquidation preference. Class B may be converted to class A stock.

There is one legal proceeding related to the Sherman Anti-Trust Act. The court has certified classes in the case but the case is ongoing.

Financials:

1. Sales have increased over the last couple of years. 
2. Gross Margins are around 25%-35%. This indicates a good but not a great business. There is some risk of erosion of margins from competition. Consistent.
3. SG&A as a percent of Gross Margins ~40%. This suggests a very good but not great business. 
4. Net margins of 3%-5%. 
5. Net income consistently positive (no losses in 10 years) but increasing at a slower rate.
6. Number of shares outstanding have decreased from 26m in 1992 to 22m in 1996 thanks to an aggressive repurchase program.
7. Long-Term debt is only 3m. Current maturities of debt – $11m. The company has the earnings power to easily pay-off long-term debt.
8. After adjusting for treasury shares Total Liability / Total Shareholder Equity <0.8 suggesting a durable competitive advantage.
9. Cash – $38m.
10. Interest income has exceeded interest expense in each of the last three years.
11. Lease obligations are small (~3m-5m for the next four years) but rise to 14m in 2001 (not sure why??).

Given the pretty stable operations, I continued on with my process to value most company’s. (This process would not work for turnarounds, special situations or businesses that are changing in some material way).

• Second, I built out a quick model with conservative projections to calculate Enterprise Value and understand how the different pieces move

The operating model I built out looks like this:

The business is pretty straight-forward. Its been fairly stable the last few years so projecting financials should be in line with historical financials. The main assumptions are as follows:

1. Sales growth slows from 10% in 1996 to 3% a year by 1999. I think 3% is a conservative but accounts for small increases in number of stores and population growth. The number of stores is unlikely to increase a great deal in my opinion.
2. Operating margins are around 16.4%. This is a slight increase over the 15.5% the company achieved in the last three years but its in line with the historical average.
3. EBIT is projected at 14.8%. This is the peak of the last three years but in line with historical performance.

Using these projections for operating performance, I projected the enterprise value based on a DCF analysis. I did this using both the perpetuity and the multiples method.

The perpetuity method uses a discount rate of 8%. The 8% rate is used because the company’s pristine balance sheet and stable cash-flow generating business model suggest that would be the approximate rate at which it could raise capital. The rates at which the company has borrowed historically suggest 8% is in the ballpark of an appropriate discount rate. 

The multiples method uses a multiple of 7.5x. A stable business that generates cash-flows should be in the 6-8x range. Given the high ROIC, historical growth rate and asset-lite nature of the business, I would estimate a 7.5x multiple is pretty fair.

The calculation is as follows:

Using the assumptions described above, I would get an Enterprise Value of approx $750m.  At a 25% Margin of Safety the enterprise value or acquisition price should be approximately $560m.  I think given the nature of the business (stable) and risks it faces (low), the 25% MoS provides enough protection for unanticipated downturns.

The next step is to go through the checklist and check of that I hadn’t missed anything. In this case this was pretty straight-forward and after checking a couple of things and making some small adjustments (incorporated above)  it appears as though all boxes checked out.

Thus, I would guess Buffett purchased DQ for around $560m.

I am very interested to hear thoughts on the valuation and any questions. Feel free to comment below.