The first deep value pink sheet I invested in was Meritage Hospitality (MHGU). I did a very, very detailed write up on it last April which ultimately won second in the gurufocus value idea contest. However, given it’s been almost a year since I researched them in detail (outside of this brief earnings update), and I feel like I’m much better at dealing with micro-caps now, I felt it was time to revisit post Q1 results.
First, I think it’s instructive to read management’s letter for 2011. There are some very interesting tidbits in there.
Let’s start with the obvious: catalyst. Specifically,
Our near term operating strategy is to keep our G & A costs at the low end of the industry range, and leverage our highly efficient operating platform. Our four year growth target is 150 restaurants across diverse U.S. markets. We believe this will allow the Company to continue building intrinsic value and position Meritage for common share dividend distributions in 2012.I’ll discuss how big the dividend could be later. But dividends can serve as huge catalysts for these microcap companies. They remind investors that the stock represents a piece of a profitable and cash generating business, not a pure speculation. Personally, I’d rather the company use their cash to buy more underperforming stores and pay down debt, but I won’t argue if this is the route they choose to go.
Now let’s talk strategy. Management’s plan is pretty simple. They buy underperforming stores that need an upgrade/face lift (but whose owners can’t afford to pay for one), put the stores on their management platform (which cuts costs; MHGU apparently has one of the most efficient platforms in the industry), and make the investment in a face lift for the stores (which spurs a huge sales increases and generates solid ROI). Most of the purchases are done with a generous amount of seller financing, allowing MHGU to really lever the improvements.
Here’s how management describes it
We believe that many of the smaller legacy Wendy’s franchisees, now at retirement ages, are not properly positioned to make the capital reinvestment and effectively complete the construction requirements of “Image Activation,” a system-wide upgrade estimated to cost between $500,000 and $750,000 per restaurant. The result is a major consolidation opportunity within the Wendy’s franchisee system for “next generation” franchise operators with scalable operating platforms and development capabilities.So let’s now dive a bit into valuation. Carrols Group (symbol: TAST) has been in the news recently as they aim to buy a big chunk of Burger King restaurants, spin off their own brands, and become a pure play Burger King franchiser. Here’s a really nice article describing their strategy from the WSJ.
Anything jump out at you???
How bout the second to last paragraph, where a restaurant analyst estimates the cost to buy a single Burger King franchise at $600-800k?
That’s actually higher than the valuation per franchise I used in my first article, where I used company unit sales from Wendy’s, Jack in the Box, Burger King, and Sonic to estimate a per unit value of $450-550k. Of course, my valuation was based on sales in 2009+2010, a significantly worse operating environment than today’s, so it would make sense if valuations had slightly expanded.
Meritage currently owns 86 Wendy’s restaurants. Using my absolute low valuation of $450k per unit implies an overall value of $38.7m, and the midpoint of $600k equates to a value of $51.6m. Meritage had about $20m in debt as of their last balance sheet (they haven’t filed a Q1 balance sheet yet, but I doubt it’s changed much), which leaves us equity value of $18.7-31.6m. Backing out $5.3m in preferred equity value, the common is worth somewhere between $13.2-26.3m.
That’s a per share value of $2.40 to $4.78 without including the value of their Twisted Rooster restaurants, their real estate (likely over $15m), or any optionality from their Bahamas JV.
Do I think that number is too aggressive???
Most of their Wendy’s were under-performing units acquired through somewhat distressed sales or are located in relative economic disaster zones.
But I don’t think those numbers are that aggressive. The right number is probably very close to that low end, if not above it. And again, that estimate excludes a lot of potential value from the rest of their business.
Also remember that, until 2010, the company included the following in their footnotes
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 amortizationNow, goodwill is up significantly since then, so the footnote would no longer apply exactly. But I think it just goes to reaffirm that these Wendy’s franchises are worth much, much more than they are on the books for.
So now let’s try and figure out how big a potential dividend could be. Management’s forecast calls for EBITDA of ~$6.25m this year. Interest costs should run about $1.5m this year. Depreciation should equal about $1.8m (these are very rough estimates, given the significant growth in their store base, it’s difficult to get an exact number).
If we assume that maintaince capex = depreciation (a very conservative estimate in the restaurant business, actual maintaince capex is normally well below depreciation), and then deduct $430k for preferred dividends and another $500k for taxes (don’t know why they are paying taxes, given their NOLs, but they have paid some in each of the last two years), we end up with excess cash flow to common of just over $2m.
This $2m represents completely free cash flow. They can do whatever they want with it- buy new stores, pay down debt, or dividend it out. With 5.5m shares out, that represents over $0.36 per share.
If they chose to payout 40% of this free cash flow, that’s a dividend of just under $0.15 per share. MHGU’s last price is $1.75- that’s an over 8% potential yield!
Granted, there were quite a few assumptions in there. Feel free to play around with them yourself.
But I think the moral of the story holds no matter how you look at it- MHGU offers asset value significantly in excess of today’s stock price with a strong catalyst for value realization within the next year in the form of a huge dividend.