Bagel maker Einstein Noah Restaurant Group (BAGL, Financial) announced that it started looking at a possible merger or sale of itself at the beginning of May, which sent its shares up more than 20 percent from $14 to $17.
Is there still upside should a bid come?
Yes, because things can be much improved if it falls into the right hands. In particular, Tim Hortons would be a good buyer for BAGL, and a merger would benefit both companies.
1. The company is transforming from a company-owned model to franchise model.
Einstein Noah owns and franchises restaurants primarily under Einstein Bros., Noah's and Manhattan Bagel brands. It gets about 90% of its revenue from company-owned restaurants. It is fair to say it is running a company-owned restaurant business. The management has been working to expand through a significant expansion of franchise and license restaurants, and looking to sell existing company-owned restaurants to prospective franchisees, even before the announcement. I think it is the right strategy for the company as the franchise model adds additional revenue without much capital commitment and additional expenses and is more capital efficient for expansion compared to the company-owned model. BAGL's business is similar as McDonald's, Tim Hortons, etc. If a big player like Tim Hortons with expertise in operating franchise restaurants acquires BAGL, it could speed up the transformation and improve return on capital quickly.
2. Scale and efficiency
Economics of scale is very important in the restaurant industry. If you look at operating margins of big vs. small players, it is obvious that big players enjoy better efficiency. Think about product supply for example. Say you have 100 stores in the west and 100 stores in the east, so you decide to have two manufacturing facilities to supply bagels, one for each region. Maybe when you expand to 500 or 1000 stores in each region, you still have those two manufacturing facilities, with some expansion probably. That is operation efficiency. Same thing goes with suppliers. Which one do you think you can get a better price if you buy 100 million bagels per year or 100,000 bagels per year? How about marketing? If you have 1,000 franchise stores and take 5% of sales from each store, you have more marketing budget than your competitor who only has 100 stores. A successful national marketing campaign can drive sales growth and improve brand awareness, which in turn leads to more stores and more marketing budget. In many ways a merger with successful integration can improve operation efficiency and margins and create value for shareholders.
3. Menu opportunity
If you look at the menu of Einstein Bros and compare it to McDonald's and Tim Hortons, you probably immediately know what I am talking about. If Tim Hortons can sell all their stuff in BAGL stores, it is reasonable to believe sales will grow higher. It also comes down to economics of scale again. Big players like McDonald's and Tim Hortons can spend tons of money on research and development and constantly supply improved offerings to the customers. McDonald's smoothies and iced drinks were very successful in the past few years after the financial crisis. Starbucks also got a boost when they put more stuff into their stores for sale. It is always good to sell more since fixed costs like lease or property depreciation are not going to increase along with incremental sales, and sales growth from new items can potentially contribute more to profits.
4. Store Locations
Now that is the reason I think BAGL is particularly a good buy for THI. THI dominates in Canada and has been trying to get into the U.S. market for a few years with limited success. Stores are concentrated in New York, Michigan and Ohio, mainly northeast and close to Canada. With 800 additional stores from BAGL, THI can immediately double its stores in the U.S. and reach markets where it has not yet established presence, for example, California and Florida. THI can even keep using the same brands — Einstein Bros., Noah's and Manhattan Bagel — as they are American and might be good for marketing and brand recognition in the U.S.
5. Greenlight Capital
Greenlight Capital (David Einhorn's hedge fund) is the majority holder of BAGL. Does it make sense for them to sell? Or are they just bumping up the share price? I doubt that $30 million market value increase would put a dent into the PnL of a $7 billion hedge fund. Greenlight probably really wants to do a deal and it makes sense for them to look for a strategic buyer and do a private transaction. Think about what would happen if they say they are going to sell in the open market or distribute it fund partners. In a private transaction, Greenlight avoids market impact of liquidation, and it can potentially get a better price from a strategic buyer also.
What is the upside potential then? Trailing twelve month EBITDA of BAGL is around $48 million, cash and debt were $9.6 million and $72.32 million as of last quarter. So we should expect 10% to 15% upside at least if it gets acquired at an 8 times EV/EBITDA multiple, and of course that also depends on the purchasing price. A reasonable deal price should be north of $20.
Let's take a look at another case — Ancestry (ACOM, Financial). Last month Bloomberg reported that Ancestry is weighing a sale and working with Frank Quattrone's Qatalyst Partners LLC to find buyers, "according to a person with knowledge of the situation." Shares of ACOM have since surged from $22 to $26 in a couple of days. Looking at stock chart, it is basically where it was a month ago before being crushed due to the cancellation of the fourth season of the NBC TV show, "Who Do You Think You Are." The show follows one of the celebrities in each episode as they embark on personal journeys of self-discovery to trace their family trees. It is a very good marketing strategy and contributed significantly to revenue growth of Ancestry in the past few years.
Company overview
ACOM's main business is operating Ancestry.com, a website that provides subscribers web-based services and content collection to research their family histories, build their family trees, collaborate with other subscribers, upload their own records and publish and share their stories. Ancestry's main revenue source is a monthly fee that it charges subscribers.
The foundation of the business is an extensive collection of historical records (over 10 billion now) including historical census data, military records, immigration records, family histories, etc. The company spent years and millions in acquiring all the records worldwide and having them digitized, indexed and put online. They face no competition in the online family history service business since no other competitors have such an offering, and it is unlikely that anyone would ever want to build the same thing again from scratch. The website and user interface was pretty good when I tried their service last year. You can try their 14-day trial. For someone that is very interested in researching family history and tracing their family tree, the service may actually be cost efficient. With a niche market and a smart marketing strategy (Who Do You Think You Are), the company was able to grow revenue rapidly since 2009.
A few things worth noting:
1) Spectrum Equity V L.P. has been unloading shares since the IPO. It has decreased share holdings from 55% to 28% in three years.
2) Growth is slowing in the U.S. In the first quarter of 2012, the impact of fewer viewers of NBC's show caused the growth rate for revenues to decrease compared to 1Q 2011. And now without the show, can the company still grow its subscriber base?
3) Revenue is concentrated in the U.S. and UK, where baby boomers are facing tighter personal spending budgets. Can the company make significant progress in other markets to drive growth?
4) The company is active on an acquisition front, and recently acquired We're Related LLC and Archives.com.
5) Shares have been heavily shorted despite the company has 100 million share repurchasing program. As of June 15, 7.8 million shares were shorted, about 30% of total float. One can smell the war between the company and short-sellers from far away.
Who would be the buyer? Would Google or Facebook be interested as some analysts suggested? Not very likely. Both giants are more interested in far-reaching businesses that target the broad market. And they are more into free ad-based models than the fee-based model that ACOM operates.
Would private equity be interested? Maybe. They would certainly be more interested when it was 20% cheaper. The company does not have issue of capital or operation. And also if another private equity firm buys it from Spectrum Equity, they would need to be confident that they have considerably better understanding of the business and industry than the seller.
At the time of finalizing this post, ACOM popped 15% to $31 in after market due to rumors of buyout talks with PE firms. It was definitely worth looking into after the May drop and probably still worth analyzing as an ongoing business even now. But I would not participate now at these levels as one should not expect much upside any more.
Disclosure: Long BAGL
Is there still upside should a bid come?
Yes, because things can be much improved if it falls into the right hands. In particular, Tim Hortons would be a good buyer for BAGL, and a merger would benefit both companies.
| Company | BAGL | MCD | THI | SBUX | PNRA |
| EV/Sales | 0.82 | 3.68 | 2.94 | 2.91 | 2.08 |
| EV/EBITDA | 7.23 | 10.21 | 12.46 | 16.81 | 12.45 |
| EBIT Margin | 6.71% | 30.76% | 19.54% | 12.84% | 12.36% |
1. The company is transforming from a company-owned model to franchise model.
Einstein Noah owns and franchises restaurants primarily under Einstein Bros., Noah's and Manhattan Bagel brands. It gets about 90% of its revenue from company-owned restaurants. It is fair to say it is running a company-owned restaurant business. The management has been working to expand through a significant expansion of franchise and license restaurants, and looking to sell existing company-owned restaurants to prospective franchisees, even before the announcement. I think it is the right strategy for the company as the franchise model adds additional revenue without much capital commitment and additional expenses and is more capital efficient for expansion compared to the company-owned model. BAGL's business is similar as McDonald's, Tim Hortons, etc. If a big player like Tim Hortons with expertise in operating franchise restaurants acquires BAGL, it could speed up the transformation and improve return on capital quickly.
2. Scale and efficiency
Economics of scale is very important in the restaurant industry. If you look at operating margins of big vs. small players, it is obvious that big players enjoy better efficiency. Think about product supply for example. Say you have 100 stores in the west and 100 stores in the east, so you decide to have two manufacturing facilities to supply bagels, one for each region. Maybe when you expand to 500 or 1000 stores in each region, you still have those two manufacturing facilities, with some expansion probably. That is operation efficiency. Same thing goes with suppliers. Which one do you think you can get a better price if you buy 100 million bagels per year or 100,000 bagels per year? How about marketing? If you have 1,000 franchise stores and take 5% of sales from each store, you have more marketing budget than your competitor who only has 100 stores. A successful national marketing campaign can drive sales growth and improve brand awareness, which in turn leads to more stores and more marketing budget. In many ways a merger with successful integration can improve operation efficiency and margins and create value for shareholders.
3. Menu opportunity
If you look at the menu of Einstein Bros and compare it to McDonald's and Tim Hortons, you probably immediately know what I am talking about. If Tim Hortons can sell all their stuff in BAGL stores, it is reasonable to believe sales will grow higher. It also comes down to economics of scale again. Big players like McDonald's and Tim Hortons can spend tons of money on research and development and constantly supply improved offerings to the customers. McDonald's smoothies and iced drinks were very successful in the past few years after the financial crisis. Starbucks also got a boost when they put more stuff into their stores for sale. It is always good to sell more since fixed costs like lease or property depreciation are not going to increase along with incremental sales, and sales growth from new items can potentially contribute more to profits.
4. Store Locations
Now that is the reason I think BAGL is particularly a good buy for THI. THI dominates in Canada and has been trying to get into the U.S. market for a few years with limited success. Stores are concentrated in New York, Michigan and Ohio, mainly northeast and close to Canada. With 800 additional stores from BAGL, THI can immediately double its stores in the U.S. and reach markets where it has not yet established presence, for example, California and Florida. THI can even keep using the same brands — Einstein Bros., Noah's and Manhattan Bagel — as they are American and might be good for marketing and brand recognition in the U.S.
5. Greenlight Capital
Greenlight Capital (David Einhorn's hedge fund) is the majority holder of BAGL. Does it make sense for them to sell? Or are they just bumping up the share price? I doubt that $30 million market value increase would put a dent into the PnL of a $7 billion hedge fund. Greenlight probably really wants to do a deal and it makes sense for them to look for a strategic buyer and do a private transaction. Think about what would happen if they say they are going to sell in the open market or distribute it fund partners. In a private transaction, Greenlight avoids market impact of liquidation, and it can potentially get a better price from a strategic buyer also.
What is the upside potential then? Trailing twelve month EBITDA of BAGL is around $48 million, cash and debt were $9.6 million and $72.32 million as of last quarter. So we should expect 10% to 15% upside at least if it gets acquired at an 8 times EV/EBITDA multiple, and of course that also depends on the purchasing price. A reasonable deal price should be north of $20.
| EV/EBITDA Multiple | 8 | 9 | 10 | 11 |
| EV | $322.64m | $370.81m | $418.98m | $467.15m |
| Price per share | $19.10 | $21.90 | $24.80 | $27.60 |
Let's take a look at another case — Ancestry (ACOM, Financial). Last month Bloomberg reported that Ancestry is weighing a sale and working with Frank Quattrone's Qatalyst Partners LLC to find buyers, "according to a person with knowledge of the situation." Shares of ACOM have since surged from $22 to $26 in a couple of days. Looking at stock chart, it is basically where it was a month ago before being crushed due to the cancellation of the fourth season of the NBC TV show, "Who Do You Think You Are." The show follows one of the celebrities in each episode as they embark on personal journeys of self-discovery to trace their family trees. It is a very good marketing strategy and contributed significantly to revenue growth of Ancestry in the past few years.
Company overview
ACOM's main business is operating Ancestry.com, a website that provides subscribers web-based services and content collection to research their family histories, build their family trees, collaborate with other subscribers, upload their own records and publish and share their stories. Ancestry's main revenue source is a monthly fee that it charges subscribers.
The foundation of the business is an extensive collection of historical records (over 10 billion now) including historical census data, military records, immigration records, family histories, etc. The company spent years and millions in acquiring all the records worldwide and having them digitized, indexed and put online. They face no competition in the online family history service business since no other competitors have such an offering, and it is unlikely that anyone would ever want to build the same thing again from scratch. The website and user interface was pretty good when I tried their service last year. You can try their 14-day trial. For someone that is very interested in researching family history and tracing their family tree, the service may actually be cost efficient. With a niche market and a smart marketing strategy (Who Do You Think You Are), the company was able to grow revenue rapidly since 2009.
A few things worth noting:
1) Spectrum Equity V L.P. has been unloading shares since the IPO. It has decreased share holdings from 55% to 28% in three years.
2) Growth is slowing in the U.S. In the first quarter of 2012, the impact of fewer viewers of NBC's show caused the growth rate for revenues to decrease compared to 1Q 2011. And now without the show, can the company still grow its subscriber base?
3) Revenue is concentrated in the U.S. and UK, where baby boomers are facing tighter personal spending budgets. Can the company make significant progress in other markets to drive growth?
4) The company is active on an acquisition front, and recently acquired We're Related LLC and Archives.com.
5) Shares have been heavily shorted despite the company has 100 million share repurchasing program. As of June 15, 7.8 million shares were shorted, about 30% of total float. One can smell the war between the company and short-sellers from far away.
Who would be the buyer? Would Google or Facebook be interested as some analysts suggested? Not very likely. Both giants are more interested in far-reaching businesses that target the broad market. And they are more into free ad-based models than the fee-based model that ACOM operates.
Would private equity be interested? Maybe. They would certainly be more interested when it was 20% cheaper. The company does not have issue of capital or operation. And also if another private equity firm buys it from Spectrum Equity, they would need to be confident that they have considerably better understanding of the business and industry than the seller.
At the time of finalizing this post, ACOM popped 15% to $31 in after market due to rumors of buyout talks with PE firms. It was definitely worth looking into after the May drop and probably still worth analyzing as an ongoing business even now. But I would not participate now at these levels as one should not expect much upside any more.
Disclosure: Long BAGL
