Monro Muffler: Concerned With Management's Ability to Achieve Acquisition Growth

| About: Monro, Inc. (MNRO)
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Monro Muffler Brake (NASDAQ:MNRO) stock price tumbled more than 6% Monday after the company said they expect to earn somewhere between $1.54 to $1.56 in earnings per share in fiscal 2007 versus the $1.66 to $1.69 they thought they would earn for the fiscal year just a couple months ago.

Let me explain this a little further. This means after Monro has paid for the parts, labor, any marketing (selling), general overhead expenses, and even interest on outstanding loans and taxes to Uncle Sam, the company now expects to earn about $23.5 million in fiscal 2007, whereas a couple months ago they thought the figure would be closer to $25.5 million. On a per store basis (with the company having ~700 stores), this works out to about $33,700 in net (after tax) income per store in fiscal 2007 versus a previous expectation to make about $36,400 per store.

I should also offer a quick explanation about "fiscal years." The term fiscal simply means "of or pertaining to financial matters" (according to dictionary.com). For most companies, the financial (or fiscal) year is identical to the calendar year (January 1st - December 31st). However, some businesses have "seasons" that don't follow the traditional calendar.

So Monro's financial reporting period (we call a fiscal year) generally runs for 52 weeks (ended March 31st). But if you multiply 52 times 7 (days in a week) you only come up with 364 days. So over the course of 7 years, you've missed an entire week. Technically, I think Monro does it on "business days" (Monday through Friday/Saturday), so I am not sure if it is every 5 or 7 years. But conceptually, this is why every few years Monro needs to add a week (so a 53 week year), in order to "catch up." Fiscal 2007 happened to be one of those "catch up" years.

In the past, I understand most of the profits from the sale of goods and services dropped to the bottom (earnings) line when you had a "catch up year." However, one of the greatest challenges for every accountant is trying to figure out when the expense actually occurs. For example, in addition to the direct expenses (like labor and the actual part price), Monro might have with changing the oil or selling and installing a new tire, is that they may also have borrowed money to build the store. One form of financing (or borrowing) is for a company to sell bonds (basically big old IOUs).

Let's suppose Monro sold a $1,000 bond, where they pay interest of $30 every six months (so $60 a year, or a 6% annual interest rate). It would be pretty ridiculous for Monro to report the $30 interest expense only in the second and fourth quarter of every year (because that is when the interest expense was actually paid). So instead, the accountants "accrue" expenses, saying that even though the company hasn't actually sent the check, they really have about $15 of interest expense every quarter. The same "accrued expense" approach applies with taxes, employee wages (bonuses, stock option expenses), and even things like health insurance and workers' comp.

I am told that recent interpretations and accounting standards now require more expenses to be accrued or matched up to this extra week. So the "lift" companies see from the extra week is not as big of an increase as in past years because more expenses are being "accrued" along side the additional sales and gross profits.

Also, since you are making estimates with year end costs, sometimes you guess wrong. This is one of the main reasons why Monro had to lower their fiscal 2007 earnings guidance. If someone gets hurt on the job, employer's like Monro have to pay workers' compensation for things like lost wages (when the employee can not work), reimbursements for medical expenses, sometimes even "pain and suffering" expenses, and in extreme cases (in the event an employee gets killed on the job), benefits to the employees dependents (spouse and children) are required.

Usually a company will set aside a certain amount of insurance "reserves" to cover these expenses. And like I said, from time to time companies just guess wrong. So when Monro's management looked at the claims being made versus what they were putting aside (reserving), they decided it was not enough. So the company is taking a $0.07 (about $1 million after-tax) charge in the fourth quarter to "true up" the reserves for the higher workers compensation expenses.

In the release, management said the higher reserve relates to "new claims made in the fourth quarter of fiscal 2007 as well as unexpected adverse development of previous years' claims." When something like a workers' comp "true up" occurs, I don't get all that concerned. Most companies I have written investment research on over the years have guessed wrong at one time or another.

But it is the second "charge" that gives me a little more pause for concern. Specifically, the part where management said they now expect to lose between $0.09 to $0.10 per share from the company's recently acquired Pro Care stores versus their last indication to lose about $0.05 a share.

Keep in mind, shortly after Monro announced the acquisition of Pro Care's 75 stores (in Ohio and Pennsylvania) out of bankruptcy back in April 2006, management said they felt Pro Care would add about $33 million to $35 million in revenues (for 11 months in fiscal 2007) and be anywhere from break even to a loss of $0.05 (about three-fourths of a million bucks).

Management said they expected fiscal 2007 to be a year of rebuilding for the group of Pro Care stores, but when they got into fiscal 2008, they expected Pro Care to run double digit comparable store sales increases and positively contribute to earnings in fiscal 2008 and beyond. In the press release, CEO Robert Gross said:

I am very disappointed by the slower than expected progress made in the ProCare business over the course of the year, even with the significant improvement in comparable store sales from the declines of over 30% we inherited when we purchased ProCare out of bankruptcy. However, we continue to gain traction in the ProCare operations and are on track to report 8% growth in comparable store sales for these stores for March, and positive comparable store sales for these stores for our fourth quarter.

I should also point out that the company's fiscal 2007 guidance EXCLUDES a ~$1.7 million after-tax one-time impairment charge related to an equity investment made in Strauss Discount Auto. These were the "Pep Boys" type stores that Monro took an initial equity investment and was going to acquire (the remaining 80% or so). But profits started to fall apart at Strauss, and Monro decided to walk from the deal, and had to take a write down in their initial equity investment.

As I have discussed in previous notes, Monro is not "greenfielding" (building new) stores. Instead, they are pursuing an acquisition growth strategy. Something that I think is prudent. With superior systems and processes, and a struggling and over bayed service repair market, I think Monro should be able to acquire stores (sometimes even out of bankruptcy court like with Pro Care) for "pennies on the dollar." And then put in the "Monro" systems and processes, and over a pretty short order, bring break-even to loss stores up to the company average of $30,000 to $40,000 in net income (after spreading the corporate and parts wholesaling costs out to the stores).

But now we are seeing some signs that it might not be as easy to acquire and implement improvements. With Strauss the company actually had to walk from their initial acquisition plans. And now they are seeing "slower than expected progress" with the Pro Care acquisition. It clearly casts some doubt on management's ability to execute an acquisition growth strategy. These problems worry me a lot more than a difficult market backdrop.

Having said that, management announced fiscal 2008 guidance to be in the range of $1.85 to $1.95. Management (at least in the press release) seemed to base the fiscal 2008 guidance on improving core business trends. Specifically, Mr. Gross said:

We are experiencing solid company-wide sales trends, store traffic and product demand and we expect to continue this positive momentum as we enter fiscal 2008.

So the company's core business continues to gain steam as evidenced by expectations for a pretty strong fiscal 2008, despite some of the hiccups in fiscal 2007. And Mr. Gross deserves a considerable amount of credit for turning around Monro's profitability when he stepped into the job in 1999, and I understand he did something similar at his previous employer; Tops Appliance City. I think Mr. Gross is a turnaround expert, and so it would probably be premature to run at the first sign of trouble.

Nonetheless, when I removed Monro from the autoretailstocks index on March 14, 2007 (just a couple weeks ago), it was simply because Monro's stock price was pretty close to what I felt the "net present value" of Monro's 2012 earnings were worth. With Pep Boys (who replaced Monro in the top ten index), the announcement of a new CEO (Jeff Rachor) simply presented the opportunity for returns to be generated that the market was not anticipating (whereas with Monro most investors seemed to recognize the solid execution capability of management).

But given some of the concerns popping up with the company's last two acquisitions, I think the bar gets raised a bit (meaning an even lower stock price would be needed) in order to make the shares look attractive again.

MNRO 1-yr chart:

MNRO 1-yr chart