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BAB Systems Inc. Is Undervalued but Has a Glaring Issue

March 04, 2013 | About:
This is the beginning of my series on nano-cap companies. Specifically in this series I will be turning my analytical eye towards companies with market caps of $10 million and under to see if I can find any good companies to buy in this very small and relatively un-followed area of the market.

Over the next several articles I will introduce each company, talk about its operations, pros and cons, valuations, etc. At the end of each article I will state my overall opinion of the company and whether or not I think the company would be a good potential investment. At the end of this series I will go over and compare all of the companies’ margins, floats, the pros and cons of buying into each company, and valuations to determine which one(s), if any, I have decided to buy and state why I have decided to buy into at this time.

Introduction and Overview

The company I will be talking about in this article is BAB Systems Inc. (BABB), a very small and un-followed $4.4 million market cap that is traded on the OTC market, and based in Deerfield, Ill., which is the parent company and franchise owner of My Favorite Muffin, Sweet Duet Frozen Yogurt & Gourmet Muffins, and Big Apple Bagels stores. BABB also sells Brewster's Coffee at its restaurants.

As of Aug. 31, 2012, BABB had 97 franchise units and six licensed units in operation in 24 states and zero owned stores after selling the only one last year. BABB's revenues are derived primarily from the ongoing royalties paid to it by its franchisees and from receipt of initial franchise fees. BABB also gets income from the sale of its trademark bagels, muffins and coffee through nontraditional channels of distribution including to Mrs. Fields Famous Brands (Mrs. Fields), Kohr Bros. Frozen Custard, Braeda Cafe, Kaleidoscoops, Green Beans Coffee, Sodexo and through direct home delivery of specialty muffin gift baskets and coffee. Below are descriptions of the different operating segments taken from BABB's annual and quarterly reports.

Big Apple Bagels

BAB franchised stores daily bake a variety of fresh bagels and offer up to 11 varieties of cream cheese spreads. Stores also offer a variety of breakfast and lunch bagel sandwiches, salads, soups, various dessert items, fruit smoothies, gourmet coffees and other beverages.

My Favorite Muffin

MFM franchised stores daily bake 20 to 25 varieties of muffins from over 250 recipes, and a variety of bagels. They also serve gourmet coffees, beverages and, at My Favorite Muffin and Bagel Cafe locations, a variety of bagel sandwiches and related products.

Brewster's Coffee

Although the Company doesn't have, or actively market, Brewster's stand-alone franchises, Brewster's coffee products are sold in most of the franchised units.

Sweet Duet Frozen Yogurt

On May 7, 2012, the company issued a press release announcing the launch of its new franchise concept, SweetDuet Frozen Yogurt & Gourmet Muffins, which it is preparing to roll out this year. While BAB will be offering franchises in all 50 states, its initial development focus is targeted for the Midwest, specifically Illinois, Michigan, Wisconsin and Ohio. As part of its introductory development plan, BAB will be donating 10% of the initial franchise fee from its first 50 units to the Cystic Fibrosis Foundation, of which BAB is a corporate sponsor. SweetDuet, as its name implies, is a fusion concept, pairing self-serve frozen yogurt with BAB’s exclusive line of My Favorite Muffin gourmet muffins, broadening the shop’s offering and therefore differentiating itself from the numerous frozen yogurt outlets already populating the market. SweetDuet Frozen Yogurt & Gourmet Muffins shops will also include BAB’s Brewster’s Coffee and a streamlined breakfast menu. The concept is designed to work in 1600 square feet of space. The SweetDuet concept will be included as part of the Systems franchise operating and financial information.

Typically each of these restaurants seat around 30 people.

Operations and Management Discussion

Currently BABB's is pretty much a holding company operation now that it does not directly run any of its restaurants and it derives its revenue from collecting royalty fees from its franchisees (5% of net sales.) Initial franchise fees when a new store opens ($25,000 for a franchisee's first "full production" Big Apple Bagels or My Favorite Muffin. Fee for subsequent stores opened by franchisees is $20,000). Big Apple Bagel and My Favorite Muffin franchisees also contribute 3% of net sales towards advertising and marketing to BABB.

Since BABB does not currently directly operate any restaurants, and BABB just does corporate back office work for the whole company, locates new franchisees and franchise locations, markets the company and sits back to collect fees from the franchisees, of course one would expect BABB to have absolutely exceptional margins.

The company does have some pretty good TTM margins: gross margin at 96.2%, operating margin at 17.9%, ROE of 15.51% and an ROIC of 14.51%. However the company's operating margin, ROE and ROIC could potentially double if payroll and payroll-related expenses could be halved from their extremely high current levels (which is probably a bit optimistic and I will talk about that more below) and didn't amount to more than $1 million, or about 25% of the company's entire market cap, and about one-third of its enterprise value.

If payroll and payroll-related expenses which totaled about $1.4 million for the entirety of 2011, 53% of BABB's gross profit, (or an incredible $100,000 per employee at a $4.4 million market cap company) could be cut in half that would add 9 cents to BABB's EPS, which would almost triple current EPS. Cutting payroll expenses by half is just an estimate of what the company could do and may be a bit optimistic but BABB management should certainly be able to get close to halving payroll if it really wanted to become a more efficient company.

That 9 cents per share extra could be put towards growing the company further, paying an even bigger dividend (current dividend yield is 3.31%), or my favorite option, buying back shares outstanding since I am finding BABB to be undervalued currently and which I will talk about later.

Just the top three executives of the company made nearly $700,000 in 2011, not including the also generous options that have been given in the past, are still being given, and can still be exercised for even higher compensation for the three main executives of BABB. Company insiders do own about 38% of BABB but that is down from a few years ago where insiders owned 48% of BABB.

At Nov. 30, 2011, there were 360,400 of unexercised options that were not included in the computation of dilutive EPS because their impact would be anti-dilutive due to the market price of the common stock being higher than the option prices. At Nov. 30, 2010, there were 368,373 unexercised options that were not included in diluted EPS because their impact would be antidilutive due to the market price of the common stock being higher than the option prices.

Executive pay has also been rising in most recent years even as the number of total restaurants franchised and owned has dropped from 129 total restaurants in 2007 down to 103 total restaurants. Since BABB no longer operates any of its restaurants the drop in number of total restaurants has also dropped royalty income, operating income and total company value. Again, executive pay has continued to rise in recent years as this has been going on.

On top of all of this the CEO Michael G. Evans, is on BABB's compensation committee which never looks good, especially in this case due to the high executive pay in comparison to the overall size of the company.

Also of note as it pertains to how the company operates is that as I talked about above the company receives 3% of net sales towards marketing and advertising for the restaurants. This amount for several years now at year end has stayed consistently in the $300,000 a year range in unused advertising and marketing funds that the company could be putting towards better use than just sitting in company accounts waiting to be used.

Management could also be getting a bit sidetracked with opening up its new restaurant concept Sweetduet Frozen Yogurt as well and may be better served concentrating on and improving its already established Big Apple Bagel and My Favorite Muffin restaurants.

Valuations

This section will illustrate why I think management could be doing a much better job, especially when it comes to their own pay, and putting some of that money to better use for shareholders.

These valuations were done by me, using my estimates and are not a recommendation to buy stock in any of the companies mentioned. Do your own homework.

Valuations were done using BABB's 2011 10K and 2012 third quarter 10Q. All numbers are in thousands of US dollars, except per-share information, unless otherwise noted.

Cash and NOL Valuation (Absolute Minimum Valuation)

  • BABB has $1,239 in cash (17 cents per share) + total net operating loss carry forwards of $5,857, discounted 50% which I will talk about later to $2,928 (40 cents a share)= a total valuation of 57 cents per share.
EBIT, Cash and NOL Valuation

Cash, cash equivalents and short term investments are 1,239

Total current liabilities are 822

Number of shares are 7,266

Cash and cash equivalents + short-term investments - total current liabilities =

  • 1239-822=417/7266=$0.06 in net cash per share.
BABB has a trailing twelve month EBIT of 504.

5X, 8X, 11X, and 14X EBIT + cash and cash equivalents + short-term investments+$2,928 in NOL's, or $0.40 per share:

  • 5X504=2520+1239=3759/7266=$0.52 per share+$0.40 in NOL's=$0.92 per share.
  • 8X504=4032+1239=5271/7266=$0.73 per share+$0.40 in NOL's=$1.13 per share.
  • 11X504=5544+1239=6783/7266=$0.93 per share+$0.40 in NOL's=$1.33 per share.
  • 14X504=7056+1239=8295/7266=$1.14 per share+$0.40 in NOL's=$1.54 per share.
Right now BABB's operations at 5X EBIT are only adding 2,520 (35 cents per share) to its overall valuation due to overall restaurant count dropping and now only collecting royalty, license, and franchise fees but even at that valuation BABB is selling at a 35% discount to today’s share price of 60 cents a share. I chose to discount the NOL’s by 50% in the above valuations for conservatism because a lot of these NOL’s will take years to accrue to BABB.

Relative Valuations

  • BABB's P/E is currently 9 with the industry average being 17.9. With BABB's current share price of 60 cents per share, if it was selling at the industry average P/E it would be worth $1.20 per share.
  • BABB's P/B is currently 1.4 with the industry average being 3.7. With BABB's current share price of 60 cents per share, if it was selling at the industry average P/B it would be worth $1.58 per share.
  • BABB's TEV/EBIT is 7.07 and its EV/EBIT is 6.58. Both of which are under 8 which is generally what I like to see in companies I think about buying into.
Valuation Thoughts

  • BABB's, which is currently selling at 60 cents per share, is undervalued by every one of my estimates of intrinsic value and relative value estimates when compared to its industry.
  • BABB has $153,000 in total debt, or only 2 cents per share so even subtracting the company’s debt it is still undervalued.
  • By my absolute minimum estimate of value BABB valued about fairly right now but that only includes cash and NOL’s. Adding in BABB's operations into the valuation makes BABB undervalued by 35% currently.
Customer Reviews

As I have been researching and writing this article one thing has continued to bother me and not made very much sense about BABB. The restaurant count dropping has been a bit perplexing to me as the company has been profitable every year since 2002 except for 2009, and I would not have thought that bagel sales would have suffered a massive drop during the recession, so the restaurant count dropping in 2007 from 129 total restaurants to now only having 103 total restaurants (or a drop in total restaurant count of 20%) has continued to bug me as the process of researching this company has gone on. I have not eaten at any of BABB's restaurants before as the closest one of its restaurants are a six hour drive away from me so I decided to find customer reviews online to help me get a bit of perspective on how the franchise restaurants are generally thought of by its customers.

After reading through dozens of customer reviews from different franchise locations I think that I am able to come to some conclusions about what its customers think about Big Apple Bagel restaurants and think that I have found the answer to the dropping restaurant count problem that has been bothering me.

  • Generally customers only think that the food is average to good.
  • Generally people think that the bagel/sandwich products are overpriced.
  • A lot of people think that competitors have better bagels in their respective local areas.
  • More than a few people mentioned that they only went there because of coupon promotions (buy 1 get 1 half off or free on bagel sandwiches.)
  • More than a few people who said they went there only because of the coupons said that even with the coupon they thought the products were overpriced.
  • The biggest overall concern that I saw stated over and over again from customer visits to multiple different franchise locations was that customer service was rated at best ok to absolutely horrible.
Through my studies of many different companies in many different industries I have learned many things that can help and hurt the company’s sales and profitability. One of the biggest things that can help or hurt a company, especially in today’s world where people can write things like customer reviews on the internet for everyone to see, is customer service or the lack thereof. I think that one of the reasons Amazon has been such a huge success is due to its customer service which is exceptional and one of the best I have ever dealt with. The reverse can also happen if you have a reputation for poor customer service and can lead to customers not coming back to your stores and restaurants. Combine the poor customer service with products that the customers think are overpriced (even with buy 1 get 1 free coupons) and the combination of these two things may be why restaurant count has dropped by 20% in recent years. Maybe the restaurants are losing customers, sales, and the franchise locations are becoming unprofitable leading the franchisees to close restaurants. There is not really a mention of why the restaurant count has dropped in BABB’s annual reports and to this point I have not been able to talk with company IR and have not had my phone calls returned to get these questions answered so for now this is my best guess as to why the number of restaurants have dropped in recent years.

Catalysts

  • If management decided to cut payroll expenses and put that money towards much better use the share price would no doubt rise.
  • Gaining more franchisees would up sales and profitability which would make the share price rise.
Pros

  • BABB is at minimum fairly valued, and undervalued sometimes substantially with my other intrinsic and relative valuations.
  • BABB’s margins are pretty good overall.
  • Insiders own around 38% of BABB.
  • If BABB’s management decided to cut payroll expenses it would raise EPS and overall profitability of BABB, potentially substantially depending on how much they decided to cut payroll.
Cons

  • BABB’s restaurant count has dropped by 20% since 2007 which has lowered the amount of royalty fees collected, thus lowering sales and profitability for the overall company.
  • Management’s pay is excessive in my view taking up 53% of gross margin. Last year overall payroll and payroll expenses amounted to $1.4 million dollars with the company only having a $4.4 million market cap. Stated another way payroll and payroll expenses make up 32% of the companies entire market cap.
  • Just the top three executives of BABB made around $700,000 last year, not including options, or 16% of the entire market cap.
  • BABB’s margins could be a lot higher if management cut payroll expenses.
  • A few years ago insiders owned 48% of the company and now only own 38%.
  • At the very least the company is perceived to not have very good customer service.
  • Several reviewers online also thought the products sold at BAB restaurants were overpriced, even when they had a buy 1 get 1 half off or fee coupon.
Conclusion

I will save in-depth talk about margins, float and the other normal things I talk about in my articles for the conclusion piece in the series of posts but my overall investment thesis is very simple with this company: BABB is at worst fairly valued when only counting cash and NOL’s and is undervalued by a substantial margin (about 35%) when including its operations. If management were to cut payroll and other payroll expenses, especially executive pay and options, and put that money (potentially as much as 9 cents per share if they were to halve payroll expenses) towards improving company operations and/or expanding the number of franchises, paying a higher dividend, or buying back shares the company could potentially appreciate by even more.

In my opinion management could be doing a much better job helping this company expand and to improve operations, especially the customer service side of things. I do not think that BABB is necessarily a buy and hold forever company like some of the other companies I own, but I do think that BABB could grow its restaurant count, become more profitable, and turn into a much more attractive company to own, and potentially turn into a buyout candidate. Payroll expenses taking up 53% of gross profit is absolutely insane, and if BABB decides to cut some corporate excess andwaste and puts that money to much better use for shareholders and the overall company, BABB could potentially double or triple from today’s current share price of 60 cents per share.

I still have a few more companies to write articles about before making a definite buy decision or not about BABB, but overall it looks like a potential investment opportunity at this point, especially if management would cut payroll expenses and put that money towards much better use for shareholders.

The next article in this series will be about Paradise Fruit Company Inc. (PARF).

About the author:

Jason Rivera
I have been investing for about 4 years and really only dedicating myself to it since February of 2012. Self taught from books, websites, blogs, etc. Value investor and special situations investor, hoping to emulate and mix the philosophies of Warren Buffett, Benjamin Graham, Seth Klarman, and Joel Greenblatt. Aspiring to build my own "personal" MBA through the knowledge I am gaining.

If you like my work feel free to visit my blog at http://vijourney.wordpress.com/ where I write about various investing topics, post my articles, list my goals, and where I have posted my investing philosophy.

If you have any comments, questions, or potential job opportunities for me please contact me through Guru Focus, through my blog above, through twitter @JMRiv1986 or at jmriv1986@gmail.com

Visit Jason Rivera's Website


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