Those of you who have followed me for a while may have noticed that I really like the franchised business model (you may also remember my promise to start writing more interesting blog titles... Whoops!). There's a reason- it's a really amazing business model. It costs nothing to grow (actually, new franchisees generally pay a franchising fee to start a franchise, so you get paid for letting them grow your business), the margins on incremental franchised revenues is almost 100% (almost all costs are fixed, so expanding your franchising rev. either through increased sales or new franchisees is basically pure profit), the cash flows are incredibly stable, and the ROIC is incredible. And that ignore quite possibly the best part of the franchise model- your franchisees are required to put a portion of sales to advertising, so other people pay to build up your own brand, which should increase brand value and attract new franchisees!
That's what attracted me to Pizza Inn (PZZI, Financial). I first stumbled on the idea from this write up on Value Investor's Club, which is excellent and well worth reading. However, the write up is over a year old and there have been some significant changes to the business since the write up, so I thought it worth posting my thoughts on it.
Pizza Inn operates the Pizza Inn brand. As of Dec. 26, there are 307 Pizza Inn units, of which 5 are company owned and 302 are franchised (76 of the 302 are international, the domestic units are mainly located in Texas and the South). There are three different types of Pizza Inns, buffets (sit down restaurants, much like CiCi's pizza if you have one by you- store count = 150 domestic and 14 intl.), Delco (think your typical pizza delivery joint, store count = 33 domestic and 50 intl.), and express (a location that would go in a food court. store count = 48 domestic and 9 intl.) On average, domestic buffet units do $700k in sales per year, delivery units do $225k, and express units do $80k (I took these numbers from what they did in 2010, but I also looked at their numbers going back through 2005, and they are consistent with these assumptions). On the international side, buffet units pull in $400k, delivery units $215k, and express units $170k.
Upfront note on this write up- my thoughts are all over the place on this company. I see tons of potential value here, as well as tons of potential downside, and this post may swing from very positive to very negative and back again quickly and repeatedly. Be prepared.
Anyway, back to the company. What's great about this idea is it's easy to model and figure out exactly what the company will be earning under different situations. The company has basically three divisions: food distribution (all franchisees are required to buy supplies from the company) and operating restaurants. The restaurant operations can be further divided into two segments: company owned and franchise owned.
Food Distribution
The Food Distribution segment is pretty interesting. Pizza Inn requires franchisees to buy basically all of their supplies from their food distribution arm, giving them a captive customer. The company then outsources all of the warehousing and delivery portions of the business to a third party (basically, all of the parts that would require capital investment). So all they do here is negotiate for and purchase ingredients. This is a win-win for all parties: the franchisees don’t have to worry about dealing with suppliers for food and Pizza Inn can use the combined purchasing power of all of their franchisees to negotiate volume discounts and then keep a portion of the saving.
Considering this business involved NO capital investment (they do need to own some inventory, but no PP&E or anything), it’s actually a pretty powerful segment. The business is a bit volatile and somewhat exposed to rising commodity prices, but the company has done a good job of adjusting the model so that they’re not as exposed (a huge rise in cheese prices caught them flat footed in 2007). This business earned $1.83m in operating income in 2010, $1.5m in 2009, $2.42m in 2008, and lost $50k in 2007 (that’s $50,000, so basically break even), and, through the first six months of 2011,it’s on pace to earn over $2m in operating income in 2011.
Franchising
So let's now look at the company's franchise business. Here's the company's royalty and franchise fee income for the past four years, as well as franchise expenses
I'm going to ignore the fee income and treat anything I get from it as gravy, because it requires new franchisees to open stores and can't be considered a completely consistent source of earnings. Royalty earnings have decreased in the past few years, but expenses have decreased as well. Almost all of the expenses are related to wages for servicing existing franchisees and selling new franchises, so the expenses can be scaled up and down to some extent.
After subtracting expenses, the franchise royalty business alone generated operating income of $1.79m last year and between $1.75-2.16m in the past four years. Pretty consistent, and franchise royalties have actually increased slightly in the first six months of fiscal 2011. Let's assume this business can continue to earn $1.8m per year going forward.
Company Owned Stores
The company has recently begun opening company owned stores in an effort to fuel more growth. Personally, I think this is a bad decision- I'd rather the company focus on higher margin, higher ROIC franchising than the lower margin more risky business of owning and operating restaurants. These restaurants have also been money losers- the company doesn't back out the breakdown of their company, but they do breakdown the profit of their franchise + company owned stores. Backing out the profit earned by the franchise business shows operating income losses between $300-400k in each of the past four years for the company owned stores, and they're on pace to do it again this year. In other words, the company has used up more than all of the franchise fee income (important: NOT royalty income, just the income they've received from signing franchise agreements) they've earned in the past four years to fund losses in this segment.
Hidden Value
That's where the hidden value to the company comes in. If they simply shut down the company owned stores, operating income would increase by $300-400k annually. But imagine these two scenarios- what if the company 1) turned the stores around, or 2) sold them to franchisees.
In the most likely scenario, if the company turned the stores around to $42,000 in operating income per store (which would assume ~6% ebit margins on $700,000 in sale), this would result in $200,000 in operating income, or a $500k-600k increase in operating income! This doesn't seem too far fetched, as most of the company owned stores are new (restaurants take a while to ramp up to full sales rate and generally generate losses in their first six months - one year) and the company just closed a money losing store whose lease expense was too onerous.
Alternative 2 would be even more interesting. Most sales of company owned stores to franchisees involve 1) cash payment for the store, 2) a franchising fee, and 3) the royalty stream for ongoing sales. While the stores may not fetch a huge premium given the losses the stores are currently generating, they would certainly be worth something, and the franchising fees would result in at least $110k in cash. Given the restaurants combined should generate ~$3.5m in annual revenue, they would also generate ~$140k in royalty revenue each year if sold to franchisees.
There is another source of hidden revenue here- the company waived all first year royalty fees and reduced second year royalty fees to 2% for franchises opened in the past year. This is just a great strategic move- it’s a great way to get new franchisees to join the system, who will eventually pay that franchisee fee. This program resulted in 8 new buffet units and $131k in lost royalty in the first six months of 2011. Once these units start paying their royalties, this will result in an additional ~$250k in annual royalty revenue, and all of it should fall directly to the bottom line.
Valuation
We already decided that the distribution business would do $2m in operating income this year. If we add the $250k in waived royalties (which they will start earning within the next year), the royalty business will earn another $2m. That’s $4m in operating income from two businesses that involve NO capital investment. The highest corporate overhead has been in the last four years was $1.8m in 2007 (it’s on pace for ~$1.6m this year), so subtracting that out I get $2.2m in operating income. Given the low level of investment involved with these two lines, I think a multiple of 10x EBIT is reasonable, if not conservative. That would give Pizza Inn an EV of $22m versus a current EV of ~$16.5m.
In addition, we’ve assigned no value to the five company owned stores or any potential franchising fees that we will receive from either (1) new franchisees or (2) current franchisees renewing their contract. Franchise fees have averaged $285k in the past four years (they had a bad year in 2009, coming in at 94k, the other three years were actually much higher). I’ll leave it to you to decide how much value to give to these two segments, but there is clearly value here as well.
The bad news
Unfortunately, there is significant risk to the idea. The chain has been shrinking pretty rapidly. Here's a look at the total number of units at fiscal year end.
So the company basically lost 25% of its units since 2003. Clearly, that's not good for business, and continued franchisee loss / unit closure is definitely the biggest risk to this investment. In addition, same store sales have been on a downward trend, coming in down -2.6% in the most recent quarter.
My Take: I see tons of potential value here. While the rapid loss of units was scary, the company seems like they are on the verge of halting that loss and begin gaining units, which could drive tremendous bottom line growth. However, I recently made a promise to myself that I would stop looking so much at the upside and start looking much more deeply into the downside (something I think I did a poor job of with GAXC, but we will see how that plays out), and there is a lot of downside here as well. While it seems like the decline in units has slowed, it could easily reaccelerate, and the decline in SSS is not a good sign. Unfortunately, I don’t have an answer for those problems, so the downside here makes it a pass for me, but investors looking for a solid turnaround story should give the company a second look.
Originally posted here
That's what attracted me to Pizza Inn (PZZI, Financial). I first stumbled on the idea from this write up on Value Investor's Club, which is excellent and well worth reading. However, the write up is over a year old and there have been some significant changes to the business since the write up, so I thought it worth posting my thoughts on it.
Pizza Inn operates the Pizza Inn brand. As of Dec. 26, there are 307 Pizza Inn units, of which 5 are company owned and 302 are franchised (76 of the 302 are international, the domestic units are mainly located in Texas and the South). There are three different types of Pizza Inns, buffets (sit down restaurants, much like CiCi's pizza if you have one by you- store count = 150 domestic and 14 intl.), Delco (think your typical pizza delivery joint, store count = 33 domestic and 50 intl.), and express (a location that would go in a food court. store count = 48 domestic and 9 intl.) On average, domestic buffet units do $700k in sales per year, delivery units do $225k, and express units do $80k (I took these numbers from what they did in 2010, but I also looked at their numbers going back through 2005, and they are consistent with these assumptions). On the international side, buffet units pull in $400k, delivery units $215k, and express units $170k.
Upfront note on this write up- my thoughts are all over the place on this company. I see tons of potential value here, as well as tons of potential downside, and this post may swing from very positive to very negative and back again quickly and repeatedly. Be prepared.
Anyway, back to the company. What's great about this idea is it's easy to model and figure out exactly what the company will be earning under different situations. The company has basically three divisions: food distribution (all franchisees are required to buy supplies from the company) and operating restaurants. The restaurant operations can be further divided into two segments: company owned and franchise owned.
Food Distribution
The Food Distribution segment is pretty interesting. Pizza Inn requires franchisees to buy basically all of their supplies from their food distribution arm, giving them a captive customer. The company then outsources all of the warehousing and delivery portions of the business to a third party (basically, all of the parts that would require capital investment). So all they do here is negotiate for and purchase ingredients. This is a win-win for all parties: the franchisees don’t have to worry about dealing with suppliers for food and Pizza Inn can use the combined purchasing power of all of their franchisees to negotiate volume discounts and then keep a portion of the saving.
Considering this business involved NO capital investment (they do need to own some inventory, but no PP&E or anything), it’s actually a pretty powerful segment. The business is a bit volatile and somewhat exposed to rising commodity prices, but the company has done a good job of adjusting the model so that they’re not as exposed (a huge rise in cheese prices caught them flat footed in 2007). This business earned $1.83m in operating income in 2010, $1.5m in 2009, $2.42m in 2008, and lost $50k in 2007 (that’s $50,000, so basically break even), and, through the first six months of 2011,it’s on pace to earn over $2m in operating income in 2011.
Franchising
So let's now look at the company's franchise business. Here's the company's royalty and franchise fee income for the past four years, as well as franchise expenses
| 2010 | 2009 | 2008 | 2007 | |
| Royalties | 3,740 | 4,086 | 4,489 | 4,386 |
| Fee | 327 | 94 | 481 | 236 |
| Expenses | 1,950 | 1,929 | 2,538 | 2,633 |
After subtracting expenses, the franchise royalty business alone generated operating income of $1.79m last year and between $1.75-2.16m in the past four years. Pretty consistent, and franchise royalties have actually increased slightly in the first six months of fiscal 2011. Let's assume this business can continue to earn $1.8m per year going forward.
Company Owned Stores
The company has recently begun opening company owned stores in an effort to fuel more growth. Personally, I think this is a bad decision- I'd rather the company focus on higher margin, higher ROIC franchising than the lower margin more risky business of owning and operating restaurants. These restaurants have also been money losers- the company doesn't back out the breakdown of their company, but they do breakdown the profit of their franchise + company owned stores. Backing out the profit earned by the franchise business shows operating income losses between $300-400k in each of the past four years for the company owned stores, and they're on pace to do it again this year. In other words, the company has used up more than all of the franchise fee income (important: NOT royalty income, just the income they've received from signing franchise agreements) they've earned in the past four years to fund losses in this segment.
Hidden Value
That's where the hidden value to the company comes in. If they simply shut down the company owned stores, operating income would increase by $300-400k annually. But imagine these two scenarios- what if the company 1) turned the stores around, or 2) sold them to franchisees.
In the most likely scenario, if the company turned the stores around to $42,000 in operating income per store (which would assume ~6% ebit margins on $700,000 in sale), this would result in $200,000 in operating income, or a $500k-600k increase in operating income! This doesn't seem too far fetched, as most of the company owned stores are new (restaurants take a while to ramp up to full sales rate and generally generate losses in their first six months - one year) and the company just closed a money losing store whose lease expense was too onerous.
Alternative 2 would be even more interesting. Most sales of company owned stores to franchisees involve 1) cash payment for the store, 2) a franchising fee, and 3) the royalty stream for ongoing sales. While the stores may not fetch a huge premium given the losses the stores are currently generating, they would certainly be worth something, and the franchising fees would result in at least $110k in cash. Given the restaurants combined should generate ~$3.5m in annual revenue, they would also generate ~$140k in royalty revenue each year if sold to franchisees.
There is another source of hidden revenue here- the company waived all first year royalty fees and reduced second year royalty fees to 2% for franchises opened in the past year. This is just a great strategic move- it’s a great way to get new franchisees to join the system, who will eventually pay that franchisee fee. This program resulted in 8 new buffet units and $131k in lost royalty in the first six months of 2011. Once these units start paying their royalties, this will result in an additional ~$250k in annual royalty revenue, and all of it should fall directly to the bottom line.
Valuation
We already decided that the distribution business would do $2m in operating income this year. If we add the $250k in waived royalties (which they will start earning within the next year), the royalty business will earn another $2m. That’s $4m in operating income from two businesses that involve NO capital investment. The highest corporate overhead has been in the last four years was $1.8m in 2007 (it’s on pace for ~$1.6m this year), so subtracting that out I get $2.2m in operating income. Given the low level of investment involved with these two lines, I think a multiple of 10x EBIT is reasonable, if not conservative. That would give Pizza Inn an EV of $22m versus a current EV of ~$16.5m.
In addition, we’ve assigned no value to the five company owned stores or any potential franchising fees that we will receive from either (1) new franchisees or (2) current franchisees renewing their contract. Franchise fees have averaged $285k in the past four years (they had a bad year in 2009, coming in at 94k, the other three years were actually much higher). I’ll leave it to you to decide how much value to give to these two segments, but there is clearly value here as well.
The bad news
Unfortunately, there is significant risk to the idea. The chain has been shrinking pretty rapidly. Here's a look at the total number of units at fiscal year end.
| 2010 | 2009 | 2008 | 2007 | 2006 | 2005 | 2004 | 2003 |
| 312 | 316 | 323 | 353 | 375 | 398 | 405 | 414 |
My Take: I see tons of potential value here. While the rapid loss of units was scary, the company seems like they are on the verge of halting that loss and begin gaining units, which could drive tremendous bottom line growth. However, I recently made a promise to myself that I would stop looking so much at the upside and start looking much more deeply into the downside (something I think I did a poor job of with GAXC, but we will see how that plays out), and there is a lot of downside here as well. While it seems like the decline in units has slowed, it could easily reaccelerate, and the decline in SSS is not a good sign. Unfortunately, I don’t have an answer for those problems, so the downside here makes it a pass for me, but investors looking for a solid turnaround story should give the company a second look.
Originally posted here
