Meritage Hospitality (MHGU) — A Substantially Undervalued Microcap
Meritage Hospitality (MHGU) is the only publicly traded Wendy’s franchisor. At its most recent price of $2 per share, I believe it is substantially undervalued on a variety of metrics and offers investors willing to tear through their (admittedly complex) financial statements a relatively lopsided risk reward opportunity (at least 200% upside with limited long-term downside risk).
What do they do?
Meritage operates restaurants. Specifically, they operate 69 Wendy’s franchises (49 in Michigan, 20 in Florida), 3 O’Charley’s restaurants, and 1 Twisted Rooster restaurant. They also own an interest in a development property known as Lighthouse Point that owns 900 acres on the island of Eleuthera in the Bahamas.
First, towards the end of 2006, Meritage engaged in a “going private” transaction in order to avoid the costs of complying with Sarbanes Oxley (the company, which is ~75% owned by insiders, also functions like a partnership and stated several times that they didn’t like the level of disclosure required by being a public company. They felt like it gave them a competitive disadvantage in pursuing sensitive real estate deals like the Bahamas partnership, so the delisting also allows them to be more private).
To do this, they engaged in a 1 for 300 reverse stock split, then paid anyone who didn’t have one full share after the split $5.25 per share (well above the current share price!). They then re-split the stock 300 for 1 to get shareholders back to their original share count. By doing this, they reduced the number of shareholders below 300. They then delisted from national stock exchanges and moved their listing to the OTCQX, which the company describes as a “premium listing service intended to set apart a select group of issuers that the OTC Markets deems worthy of heightened consideration by investors.”
At the time of the delisting, the company was substantially levered. Over the past few years, they have engaged in sale-leaseback transactions for the real estate under many of their Wendy’s properties (for those of you unfamiliar, a sale leaseback transaction involves the sale of real estate to a third party who immediately leases the property back to you under a relatively long term lease. This allows a company to unlock their real estate’s value while continuing to operate their business). Meritage then used the proceeds of the sale-leasebacks to pay down debt; remember this — it’ll come into play later.
More recently, they purchased the 20 underperforming Wendy’s in Florida in order to diversify their business away from the weak Michigan market and, through a series of transactions, acquired a 92.25% interest in an LLC that owns a 50% stake (so, effectively, Meritage owns ~46%) in a large Bahamas development property.
For such a small company, Meritage has an incredibly complicated capital structure. However, I believe this capital structure is what has led to the valuation discount and what gives investors a chance to earn outsized returns by investing in the company.
In this section, I’ll look at the company on three metrics: book value, comparable transactions/sum of the parts and earnings power. On each of those metrics, I’ll show that the company is substantially undervalued. Finally, I’ll discuss some of the “bonus goodies” associated with Meritage, including the company’s Bermuda property, which I will not include in the valuation but instead treat as a “lottery” ticket that would act as an added bonus if the company realizes value from it.
On first look, the company’s balance sheet isn’t pretty. They’re substantially levered, with $12.4 million of debt versus equity of under $1.5 million. Further, equity consists of two classes of preferred stock and common stock. The par value of the preferred equals $5.3 million, so on first glance it looks like the company doesn’t even have enough equity for the common to have any value.
However, looking deeper into their books, this is not the case. The company carries a $12 million liability entitled “deferred gain.” This liability stems from the sale/leaseback transactions mentioned earlier. When the company sold their properties, rather than recognizing all of the gains at once (and thus paying taxes on the gains), they put a “deferred gain” liability on the books. Much like a company that sells a bond at a premium and then amortizes that premium against interest expense over the life of the bond, Meritage applies this gain as a reduction of rent over the life of the lease, resulting in higher profits in later periods (and thus deferring the taxes until they report those higher profits).
This “deferred gain” liability has NO economic substance and will never result in a cash outflow for the company. Therefore, you can effectively wipe it off the books and transfer it to equity. Doing so results in an equity value of $13.5 million. After taking out the $5.3 million par value of the preferreds, this would leave $8.2 million of value leftover for the common shares. With 5.5 million shares outstanding, this would leave per share value of ~$1.50.
With the current share price around $2, the $1.50 share price would imply decent downside to today’s price. As you’ve probably already guessed, there’s one more item on their book that needs adjusting — goodwill. Goodwill, of course, is the excess price paid for acquisitions that must be tested annually for impairment. The company carries a bit over $4.4 million in goodwill on its balance sheet. The question becomes — is this the right amount for goodwill? In their financial footnotes, Meritage notes the fair value of goodwill “significantly exceeded the carrying value” after performing a discounted cash flow (DCF) using 12% weighted average cost of capital (WACC) and a 5.5x multiple to terminal EBITDA. Now we have to ask, how much more is good will worth?
Interestingly, the company used to provide us with something resembling an answer. Specifically, in their 2009 financial statements, the goodwill footnote read “The 2009 test indicated that the fair value of goodwill exceeded the carrying value by approximately 600%. The fair value was calculated using the discounted cash flow approach with a discount rate equal to the weighted average cost of capital of 10.51% and a multiple of 6.0 times earnings before interest, taxes, depreciation and amortization.”
Clearly, this year’s test is more difficult than last year’s. Given the improvement in capital markets over the past year, it’s strange that the company would make their goodwill test more stringent this year. However, I don’t think last year’s test was unreasonable, and the company provided us an interesting tidbit in it — using those assumptions, management had the value of goodwill exceeded carrying value by 600%. Using that number, their goodwill is actually worth ~$31 million versus a current carrying value of $4.4 million. This $26.6 million increase in value would imply equity value of $40.1 million and results in a per share value of $6.32 for the common.
Comparable Transactions/Sum of the Parts
So you may be thinking, “All of that sounds nice, but it feels like financial sleight of hand to me. Is book value really understating equity value by almost $40 million??” Well, let’s look at it from a different approach. In this section, we will break down the value of Meritage’s land holdings and restaurants and see how much the company is worth on a sum-of-the-parts basis.
Let’s start with their land value. The company owns the land and building for 14 of their Wendy’s and 2 of their casual dining restaurants (they also own the building but lease the land for one more of their casual dining restaurants). Clearly, these have some value, but how much? In this write up of Wendy’s, the author takes the average of 31 sales and/or for-sale listings and pegs the average price at $1.42 million. It’s not noted whether these sales are outright sales of the building or part of a sale leaseback transaction, and Wendy’s is a better credit than Meritage, so let’s apply a 33% discount to this figure. Doing so results in a value of $950k per location, and would give Meritage land and property value of $15.2 million (note: I’m applying the same rate to the 14 Wendy’s locations and 2 casual dining locations, and giving no value to the owned building to arrive at this number).
Is that $950k number reasonable? If anything, it’s too conservative — the company has averaged about $1.4 million for their properties when they engage in the sale leaseback transactions, consistent with the number mentioned in the write up. If we apply that value, the companies land is worth $22.4 million. Let’s use these two numbers as our range: $15.2 million on the low end, $22.4 million on the high.
Now how about the company’s Wendy’s franchises? As noted by Wendy’s in their 10-K (see note two, page 84), the company sold 2 restaurants to franchisees for $2.3 million in 2010 and 12 restaurants for $5 million in 2009, for an average over the two-year period of $521k per restaurant. That actually jives well with what we’ve seen from sales at other fast food restaurants. Jack in the Box, for example, sold hundreds of company-owned units (both Jack in the Box and Qdoba) between 2004 to 2009 for an average price of $640k, plus they made the new owners pay a franchise fee after making the purchase! Burger King sold 180 units over the past three to four years at an average price of $416k per unit, and Sonic sold 227 units for an average of $519k. Looking at just pure cost to produce, including the franchisee fee (which Wendy’s like to call the “technical assistance fee”) of 25k, it costs $275k to $625k to open a Wendy’s. All of these number point towards a range of $450k to $550k for a fast food or Wendy’s unit. Meritage owns 69 units, so using that range gives a value of $31 million to $38 million.
We now have a value of $45.2million to $60.4 million for the land and Wendy’s side of the business. With $12.4 million in debt (they, like most restaurant companies, are substantially working capital negative, so I give them no value for their $1.8 million in cash to be conservative) and $5.3 million in preferreds, this implies value of the common stock between $27.5 million and $42.6 million, or per-share value of $5 to $7.75. The $6.32 per share value arrived at by looking at the book value fits squarely in the middle of this valuation, which makes both valuations feel reasonable.
Let’s now look at the company from an earnings basis. The company reported operating income of just under $3 million this year. Adding back their depreciation and amortization of $1.42 million and subtracting the reduction of expenses from their deferred gains on sales (mentioned above) of $820k yields EBITDA of $3.58 million (this number includes $250k of pre-opening expense. Some analysts prefer to exclude this number, which would result in EBITDA of $3.83 million. I view openings as a way of life for restaurants and prefer to keep the expense included to be more conservative).
However, I believe that their Wendy’s operations earn SUBSTANTIALLY more than this and that the earnings power of these Wendy’s are being held back by their O’Charley’s units, which are bleeding red. The company no longer breaks out the results of their Wendy’s versus O’Charley’s divisions, but I can back this claim up with two facts. 1) the company has decided to close all of their O’Charley’s, noting that the brand could never gain a following in their markets and that they will spend $900k transitioning from O’Charley’s to their new Twisted Rooster brand. A company Meritage’s size does not make this decision and spend that amount of money lightly. 2) Meritage notes that their new Twisted Rooster concept did $63k in sales per week versus $34k at the O’Charley’s it replaced. Restaurants generally take six months or so to reach a steady level of sales, as word of mouth spreads and consumers gain awareness of the new location, so for a brand new brand to almost double the sales of a restaurant that had been in operation for over five years speaks wonders to how poorly that location was performing.
So how much were the O’Charley’s losing? Again, it’s difficult to estimate because Meritage no longer breaks out their financial results by division/brand. However, they do break out revenue run rates, and their O’Charley’s have revenue run rates of $1.7 million per year.
O’Charley’s is a publically traded company (CHUX), and their corporate restaurants do $2.4 million in revenue per restaurant with a 6% EBITDA margin. Given most of the costs of running a restaurant are fixed, the fact Meritage needs to pay a franchise fee as a percentage of sales, and their significantly lower revenue rate, it’s no stretch to model the O’Charley’s units averaging ~$250k in EBITDA loss per unit. If you look at Meritage’s filing before going private, you can confirm similar numbers — the O’Charleys units were on revenue run rates of $1.86 million per year and losing $293k in EBITDA per year. Given that at that time they were actually on higher revenue rates and losing more than we are estimating, it’s very generous to estimate EBITDA losses of $250k per units. Since one O’Charley’s was open for only half a year, the O’Charley’s division lost ~$875k in EBITDA last year. Adding this back to the $3.83 million in EBITDA would yield $4.7 million in EBITDA for the Wendy’s division. Using a range of 5.5x to 6x ebitda multiple (the numbers from this year and last year’s goodwill tests) would give an EV of $25.9 million to $28.2 million.
While this is slightly below the $31 to $38 million of value estimated above, it’s not that far out of that range, and given we are assigning all corporate overhead from the real estate and O’Charley’s to the Wendy’s division and the fact that they’re only a year into the (so far successful) turnaround of their Florida division (30% of their units), the numbers are probably too conservative. But they do broadly back up our valuation of the Wendy’s units in section two.
So far, we’ve stumbled upon a valuation in the $5-7.75 range, settling on $6.32 as our midpoint. However, we’ve yet to discuss some of the bonus goodies that you pick up in the company.
First, the Twisted Rooster chain. I’d argue just shutting down the O’Charley’s should reveal some of the value hidden in Meritage. However, they’ve done one better by opening Twisted Rooster. The chain has enjoyed great reviews in its limited time so far (look at their urbanspoon reviews here, or this review here), and $63k per week value implies a revenue run rate of well over $3.2 million, which is very impressive and could even improve, given most restaurants begin to increase sales as word of mouth about them spreads.
Meritage plans on switching all of their O’Charley’s to Twisted Roosters this year, and if they all enjoy this level of success, it could drive a large increase in profits. They could also begin to gain some economies of scale as they can share advertising costs across four units instead of one, which could further increase sales, but this added gain would likely be marginal.
Second, new purchases of Wendy’s. In the subsequent events note, Meritage notes they purchased six more underperforming Wendy’s in the Jacksonville market on March 15. Given their success in turning around the first batch of Jacksonville underperforming stores they purchased last year, these six new Wendy’s could drive decent incremental profit if they can turn them around. They’ve also entered a non-binding agreement to purchase eight restaurants in Atlanta, but this deal hasn’t been completed yet. If both go through, it would add 14 units and ~$15 million in annual revenue to the company. As they are adding underperforming units for little cost (a little over $200k per unit for the Jacksonville units, and no disclosure yet for the Atlanta units), this is a low-risk way for the company to increase value.
If successful (and historically, they’ve done a good job of turning units around), they can almost triple their investment. If not, they use a healthy chunk of seller financing to make these purchases, and they won’t lose much on their investment.
(Note: some of you may wonder if the $200k per unit would make more sense for valuing the company’s own Wendy’s unit. The answer: NO! These units are running at significantly lower revenue rates than an average franchise and losing money, which allows Meritage to acquire the units on the cheap.)
Third, improvement in Wendy’s in general. The Wendy’s franchise has been somewhat underperforming for several years, but since their merger with Arby’s (and Nelson Peltz + management team), the franchise has been improving. The pending sale of the Arby’s unit should allow management to focus on the Wendy’s division. While several initiatives could drive improvement in Wendy’s, the one that stands out is the roll out of a nationwide breakfast menu. While this has been tried before, it’s generally been on a very shoe-string basis. Breakfast represents 15-20% of sales at most fast food restaurants, and given these sales would leverage the fixed assets already in place, they will come at relatively high margins and could drive significant increase in profits across the chain. I’ve heard good reviews about Wendy’s breakfast so far, so as it rolls out nationwide this year, it could greatly improve both brand image and profits.
Finally, the Bahamas property. I’ve intentionally avoided mentioning this so far because the company has provided very little detail on the property as of yet, and the venture is somewhat speculative. But it represents a significant “lottery ticket” if the company can realize any value from it. This property consists of 760 acres of “ocean front” real estate in the Bahamas that Meritage plans to either sell or develop into a resort community. In their 2009 10-K, the company noted they had placed the property for sale with a real estate broker with an ask price of $33 million. The partnership that owns the property has total liabilities of $12 million, which would leave $21 million if the property is sold for its asking price.
Meritage has ~46% stake in the partnership, which would result in just under $10 million for Meritage if the sale goes through at ask price (for reference, that’s just less than the company’s current market cap). Of course, it’s difficult to estimate exactly what this development is worth, and in today’s real estate market a developmental property like this probably deserves a substantial discount from ask price. Still, even with a discount applied, the land is clearly worth something and could possibly add a substantial amount of value to the company.
So, in sum, an investor willing to dig through Meritage’s statements is getting the company at a substantial discount to its fair value on a variety of metrics. Unlike many of these microcap deep value situations, investors are also getting the company with a variety of catalysts: The closure of the O’Charleys alone should improve the bottom line, to say nothing of the possible continued success of the Twisted Rooster concept or turnaround of the new Wendy’s units — not to mention general improvement in the Wendy’s chain. Of course, a sale of the Bahamas development would unlock substantial value and would drive a significant increase in share price.
While all of those catalysts are nice, ultimately investors should be happy to invest in a substantially undervalued situation, sit back, and relax as the company drives towards its stated goal of 150 Wendy’s units by 2015. At that point, it could be big enough to attract some analyst interest, resume paying a dividend (it regularly paid a dividend before going private), or repurchase shares (it has an open but unused share repurchase program).
Disclosure- Long MHGU