“If I had $10,000 to invest, I would focus on smaller companies because there would be a greater chance that something was overlooked in that arena. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money.I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that. But you can’t compound $100 million or $1 billion at anything remotely like that rate.”
So, we love to find micro-cap companies that have minimal capital requirements and high rates of return. A company that we have recently found that fits the bill is the franchisor BAB Inc, (BABB).
When you think of quick serve restaurants (QSR) many of the more famous names come to mind. What does not come high on that list is Big Apple Bagels since it has only roughly 100 franchises throughout the US. BABB owns Big Apple Bagels, My Favorite Muffins and and Sweet Duet. The franchisor has less revenue than 2005, however, royalty revenues have been quite steady the past couple of years. Management owns a majority of the company and smartly decided to cut salaries and expenses to manage the decline. Since the company has 0 analyst coverage and goes under the radar due to its $6 million market cap, the market has not fully priced in the impact of a recently signed master franchisor agreement. We believe that the company’s current franchise base is stable and royalty revenues should continue, while the master franchise agreement has minimum guarantees of store growth of 30% of current stores over the next 10 years. BABB has also enlisted the help of refreshing their brand and marketing which should help current stores gather more sales as well as gaining interest franchisee interest. BABB is trading at nearly half of their closest competitor’s multiple of royalty EBITDA indicating the market is not pricing in any franchise growth. Investors are paid 5% in dividends - that can be mostly taxed as capital distributions - while the market takes its time in seeing the true value of BABB.
It is no surprise that QSRs have been going the way of total franchise models ditching the company owned operations due to the capital light, high cash flow and ability to grow quickly. Operational risk is reduced and cash can be deployed in highly accretive ways or it can be handed directly back to investors. BAB’s owner operators figured this out in 2010 and has been operating a full franchise model since that period and gives a majority of their cash back to investors. The only problem is revenues are less than years past. What we have noticed is that franchise closings the last two years has been very low at 1-3 stores or 1-3% of total franchises and during 2009 7 stores were closed equaling a 6.7% closing rate. These numbers indicate that the current franchise lineup is unlikely to close or not renew their franchise agreement and royalty revenues should be stable. In other words there is limited downside.
Other bagel QSRs like Einstein Noah Restaurant (BAGL) have similar operations and can give us an idea of what a bagel QSR could be worth. BAGL is shifting to focus less on company owned operations, yet has significantly more debt than BABB with roughly 35% of it’s market cap in long-term debt. BABB, on the other hand, has 8% of its market cap in cash and virtually no long-term debt.
BAGL’s sum of the parts valuation indicates that the franchise businesses are worth roughly 8x royalty EBITDA. BABB on the other hand, is trading for ~4.5x royalty EBITDA. We acknowledge that BAGL is larger than BABB and has more liquidity, so we should expect a discount, however, a nearly 50% discount would only be warranted if BABB had no growth going forward. We feel the market is overlooking two important factors that will lead to growth of the franchise making the large discount unwarranted. We would say that BABB’s royalty revenues could be worth 6x EBITDA which includes an illiquidity discount. With a 6x multiple, BABB’s enterprise value would be $11 million instead of the current $5.15 million today. Indicating upside of >100%.
(Source: Our Calculations)
To achieve this higher multiple we will outline the two important drivers of the company’s franchise growth. First, BAB partnered with marketing agency Streng/MSI to help modernize their marketing program, which could help improve the profile of the BAB franchise brands. The websites of the franchises, as well as the social media pages, are a significant improvement. It will take time for the marketing to help promote the franchises and the franchise opportunity. BABB also recently announced at the beginning of May this year a new master franchise agreement with Mont Royal General Trading, LLC in Dubai to expand Big Apple Bagels and other franchises throughout the Middle East. The market clearly does not take this growth into perspective since there are guaranteed minimum number of stores that must be opened in the next three and tend years.
Let’s see what impact this master agreement would have on BABB. The new agreement stipulates that Mont Royal must open at least 9 BAB franchises in the next three years and at least 30 franchises in the next ten years. Currently, BAB franchises receive roughly $17,500 in royalty revenues per store, but that is at 5% of franchise sales. The agreement states that the international franchise royalty fees with Mont Royal will be at 3% of sales, so if we adjust gross sales slightly downward to adjust for currency differences, our estimate for royalty revenue per store is ~$10,000. So if we specifically look three years out and put a similar 6 times multiple on royalty EBITDA, excluding licensing fee, and discounting those cash flows 10% we estimate the current value of that stream of income at $570,000 or $0.08 a share.
Our total conservative estimate of intrinsic value would be:
$1.53 + $0.08 = $1.61
BAB Inc, currently trades for $0.82 a share, so there is a huge margin of safety. Investors have the benefit of receiving a 5% stream of cash while they wait for the market to realize the company’s true value. We say stream of cash since the income is not necessarily taxed as a dividend and is mostly earmarked as a capital distribution. Income given as a capital distribution is significantly beneficial to long-term shareholders since distributions defer taxes. What happens is instead of getting taxed for each distribution, the distributions lower the shareholder’s cost basis. So, when an investor sells the capital gains will be larger and thus a larger sum to tax on. Taxes are then deferred until the sale of shares. It makes sense that this decision was made since the CEO is the largest shareholder and the board/management team own a significant portion of BABB.
Management’s decision to take pay cuts and further reduce salaries is another indication that management is focused on the long-term value and is aligned with minority shareholders.
Royalty cash streams from franchisees could continue to decline. This could then impair the company’s ability to pay a capital distribution. We think that this risk is mitigated by the stickiness inherent in the franchise model. Also, the franchise closing and non-renewal rates have been in the 1-3% range over the last few years and only 7% in the worst recession in many years. We can take comfort in the fact that the CEO is majority owner and the capital distribution is roughly $60,000 or 30% of his salary and will take the appropriate steps to continue receiving this distribution as well as growing it.
BABB could have trouble growing in the US and the recent master franchising agreement could lead to unprofitable franchises. This could be possible but even if the minimum franchises from the master agreement are opened and not successful, the current valuation has this baked into the price.
BABB is a micro-cap company with very little trading volume, so one must use limit orders and be ready to hold onto the long-term. This risk is mitigated by the large capital distribution.
Positive results from the new opened franchises in the Middle East as well as positive performance from the marketing campaign would further reduce the value gap.
Investors with smaller capital to invest should heed Warren Buffett (Trades, Portfolio)’s advice and invest in small-cap and micro-caps where there are greater opportunities. BAB Inc, is a micro-cap with solid cash generation capacity that is trading at a very large discount. Investors get a dollar for fifty cents and have the optionality for larger growth. Illiquidity should not be a problem since BABB’s 5% capital distribution provides plenty of value while they wait for Mr. Market to understand the company’s true intrinsic value.