Editors' Note: This article discusses micro-cap stocks. Please be aware of the risks associated with these stocks.
U-Swirl (OTCQB:SWRL) is a company I have been following ever since I published an article on Rocky Mountain Chocolate Factory (RMCF) earlier this year, which holds a 57 percent stake in the company. Considering U-Swirl's remarkable turnaround over the last several years, it is very surprising to me that I happen to be one of the first Seeking Alpha contributors to write an article on the company. I believe that this lack of coverage is the main reason why this company is so undervalued and why its growth potential has been ignored by most investors. I hope to change that with this article.
Business History and Overview
U-Swirl's story begins in late 2005 when the company attempted to own and operate EVOS "healthy fast food" franchises. The company eventually opened two EVOS locations; however, after experiencing continued operating losses, the company decided to diversify into another healthy fast food concept and acquired the worldwide rights to U-Swirl Frozen Yogurt in September 2008.
As the years progressed, U-Swirl continued to diversify its operations by acquiring in January 2013 six Aspen Leaf stores and the franchise rights to Aspen Leaf Yogurt and Yogurtini self-serve frozen yogurt chains from RMCF. And more recently, in October 2013, U-Swirl continued gobbling up its competitors with the acquisition of the franchise rights to 11 self-serve frozen yogurt stores from Josie's Frozen Yogurt.
As of October 15, 2013, U-Swirl had 12 company-owned stores and 77 franchised stores for a total of 89 stores operating in 26 different states (this includes nine stores that were opened after the quarter ended).
Every store has the same basic self-serve concept. Customers serve themselves, allowing U-Swirl to benefit from lower labor costs, and pay by the ounce instead of by the cup size. Similar to a coffee shop hangout, locations are furnished with couches and tables and patio seating.
Enormous Growth Potential
U-Swirl has experienced tremendous growth since the company entered the frozen yogurt business. Since 2009, the company has seen more than a tenfold increase in its store count, and its revenues have grown by more than 250 percent to $4.7 million for the most recent 12 month period. While this growth has been impressive to say the least, the company still has plenty of potential.
So how large can U-Swirl become? This is what we must figure out before investing in this stock. According to market research firm IBISWorld, in the five years leading up to 2012, the frozen-yogurt industry grew by an average of 3.7 percent per year to $760 million in annual sales. IBISWorld projects that the frozen yogurt industry will grow slightly faster over the next five years as the economy continues improving and consumers become even more health-conscious. By 2017, the entire U.S. frozen-yogurt industry, including both franchises and individual stores, is expected to bring in over $930 million in sales annually.
Now that we have an idea of how large this industry is, the next step is to find out how many U-Swirl stores could eventually be opened. In the most recent 10-K, management estimates that this number is around 3,000 stores worldwide, however, I believe this estimate is overly optimistic. The best way to get an idea of U-Swirls growth potential is to look at some of its competitors:
TCBY ~ 600 locations
Menchie's ~ 350 locations
Orange Leaf ~ 300 locations
Pinkberry ~ 250 locations
Yogurtland ~ 245 locations
Sweet Frog ~ 200 locations
Note: These are the latest worldwide store numbers for each company.
The largest frozen yogurt companies have on average about 320 stores worldwide, and I believe that this is U-Swirl's long-term potential as well. Furthermore, the frozen yogurt industry has reached a saturation point, and in many parts of the country consolidation has begun. This leads me to believe that most of U-Swirl's growth will come from acquisitions. This can be a very smart growth strategy, as long as the company does not end up overpaying.
Diversifying the Business with U-Swirl-n-Go Store Franchises
Recently, the company also began offering U-Swirl-n-Go Store franchises, which are "mini-stores" that can be installed within non-traditional locations, such as convenience stores, airports, hotels and other mass gathering areas. They will be very similar to the traditional U-Swirl stores, except they will not offer seating for customers.
While we will have to wait until next quarter to find out how many of them are in operation, we do know that the initial investment for these franchises is substantially less, or approximately 80 percent lower even when including the $20,000 initial franchise fee. Furthermore, royalty fees are not based on a percentage of sales, but instead they will be a flat $10,000 per year. The company will also collect a monthly fee of $150 to support national and regional advertising efforts.
In my opinion, this is another great opportunity for U-Swirl to expand its footprint in the frozen yogurt industry. Again, there is little information about this business segment at the moment, so estimating its growth potential is difficult, but not impossible. A company offering a similar concept, and one I have written about before, is Jamba Inc. (JMBA) which offers "JambaGo." As of July 2013, JambaGo was offered at 636 locations and the company's management expects to serve approximately 1,500 locations by the end of fiscal 2013.
This should give us a rough idea of how many U-Swirl-n-Go Store franchises there could eventually be. In fact, if the company ended up opening just 100 of these mini-stores, it would bring in approximately $1 million in before tax profits. This alone would make the stock a bargain at the current price.
A Remarkable Turnaround Most Investors Have Missed
In January 2013, RMCF acquired a controlling equity interest in U-Swirl. As a result, U-Swirl has been deemed to have been acquired by RMCF. As the accounting acquirer, RMCF will consolidate U-Swirl's results of operations in its financial statements. This acquisition also forced U-Swirl to change its fiscal year-end to February (it used to be December).
Due to this fiscal year-end date change, most finance websites have not properly updated the company's financial statements, which make it seem as if the company is still unprofitable. This is part of the reason why most investors have missed out on this company's impressive turnaround over the last several years.
Note: Fiscal year 2013 only accounts for the first eight months of the year, since the company's fiscal year now ends in February.
As can be clearly seen from the table above, the company went from having negative $2.9 million in free cash flow during 2009 to positive $339,390 during the most recent eight month period of 2013. This is a very impressive turnaround for such a small company; however, it should come as no surprise to anyone who understands how a franchise business model works.
On average, it costs a franchisee around $400,000 to build a store, not including the cost of the real-estate. In other words, the franchisee does the capital intensive work of buying the land and building the store, all U-Swirl has to do is collect the $25,000 initial franchise fee (which goes straight to the balance sheet and improves its financial health) and a 3 to 5 percent royalty once the store is up and running. This makes the company's financial performance more stable and predictable. As the company continues expanding its franchise business, its profitability should improve further, since all it has to do is collect money from franchisees.
Ulderico Conte is U-Swirl's CEO and has been the company's interim CFO since 2011. While I would like to see these two roles separated, considering how small the company currently is, it should not be a problem for now. Mr. Conte, along with Henry Cartwright (the CMO) and Terry Cartwright (the COO), also happen to be the co-founders. This is a good thing because research has shown that some of the best companies in the world are those that are still run by their founders. This is because founders simply care more. Their companies are their life's work, so they are more likely to embrace long-term strategies.
I also like the fact that insiders (including RMCF) own more than 75 percent of the shares outstanding. This means insiders have "skin-in-the-game" and their interests are clearly aligned with other shareholders.
And finally, it is nice to see that the top executives do not pay themselves too much. For example, during 2011 and 2012, key executive compensation (three persons) totaled only $371,384 and $403,491, respectively. This is very reasonable considering the size of the company.
Undervalued Stock with a Short-Term Catalyst
I believe that U-Swirl's current valuation does not justify the company's long-term earnings power and growth potential. For example, U-Swirl's market capitalization is currently only $13.7 million. In addition, the company has a healthy balance sheet with less than $1 million of debt and $676,691 in cash - giving it an enterprise value of just under $14 million. During the most recent eight months, the company generated $339,390 in free cash flow, and I estimate it will generate approximately $620,000 for the full fiscal year. This gives us a forward free cash flow yield of 4.4 percent. It is also important to mention that this estimate does not even take into account the free cash flow that will be generated from the new U-Swirl-n-Go Store franchises.
Not only is this stock attractively priced, there is also a short-term catalyst that will push the shares higher. As of this writing, the stock was trading under $1, which prevents most institutional investors (even the small ones) from making an investment. However, the demand for the shares should increase considerably once the stock price goes above $1. In this particular situation, demand does not have to go up much for it to have a dramatic effect on the stock price. This is because U-Swirl has a tiny float of only 4.2 million shares available to the public. The rest of the shares, or about 11 million of them, are held by insiders who have no plans on selling them any time soon - which also protects the downside. U-Swirl's stock price has already gone up more than 220 percent over the last 12 months, and I expect at least 100 percent more upside by year's end. Overall, I believe this stock presents the ideal asymmetrical trade; huge upside potential, with limited downside risk.
Risks to Consider Before Investing
There are numerous risks with an investment like this. Possibly the greatest risk is the fact that U-Swirl possesses no competitive advantage (or economic moat). In this business there is simply no customer loyalty or switching costs. It does not take very much effort to drive, or even walk, from one yogurt store to another. Even worse, this industry is highly competitive, and many of U-Swirl's competitors have existed longer and have greater capital resources. There are also constantly new companies entering this industry, since entry is relatively easy. All of this will make it difficult for U-Swirl to succeed in the long-run.
Another potential risk is management's strategy of growing the company through acquisitions. So far it has worked out well, however, if they make an acquisition which they end up overpaying for, it could destroy shareholder value and adversely affect the stock price.
The frozen yogurt business is also subject to seasonal fluctuations. Generally, companies in this industry experience decreased sales during the winter months and higher sales during the summer months. This kind of fluctuation in sales can be tough on a small company such as this. Although, the company is trying to address the seasonal fluctuations in sales by converting some company-owned stores into co-branded RMCF and U-Swirl stores, as demand for gourmet chocolate products is stronger during the fall, winter and spring seasons.
The final risk we must consider is the company's financial health. While as of this moment the company has a healthy balance sheet with plenty of cash and a manageable amount of debt, there is no guarantee that this will continue. The company might be forced to sell more stock (causing dilution) and taking on more debt (increasing risk). These are just some of the risks we should consider before investing in this stock.
Summary and Conclusion
U-Swirl is a small, underfollowed company with huge growth potential over the next few years. The stock presents the perfect asymmetrical trade; little downside risk because insider own majority of the shares, and enormous upside due to the small float and likely increase in demand for the shares once the stock price goes above $1. Overall, I believe this is the ideal stock for investors who can handle the short-term volatility without panicking.