Monro Muffler Brake, Inc. (NASDAQ:MNRO) has grown to 1,000 stores primarily through acquisitions. In March of 2013, shares traded for about 40. Today, the price has pushed beyond the $73 level. This impressive price surge overestimates the value of future business growth by as much as 20%.
The Pep Boys Comparison
Comparing Monro to Pep Boys (NYSE:PBY) offers the first clue that price has outpaced value. Carl Icahn formalized the acquisition of PBY last December for just over $1 billion, or $18 per share. PBY is more than twice the size of MNRO. While MNRO will exceed $950 million in sales when its fiscal year closes this month, PBY had nearly $2.1 billion in revenues for 2015. Icahn's purchase represents an EBITDA multiple of 11.67 and an EV/EBITDA multiple of 13.08. In contrast, MNRO trades at 14.44x EBITDA and 16.90 EV/EBITDA. Applying a 12 multiple to EBITDA implies the stock is 20% overvalued.
Growing faster than they've ever grown before
CEO John Van Heel touted an ambitious plan during the January 26 conference call:
Our 5-year plan remains unchanged and continues to call for on average 15% annual top line growth, including 10% growth through acquisitions, 3% comp and a 2% increase from greenfield stores.
In a highly competitive environment where inflation runs below 2% and consumer whims are subject to the variances in weather, comp sales will not grow faster than the economy - 3% is a stretch. Acquisitions will clearly have to carry the load. MNRO has a solid acquisition track record. They integrate stores well and margins and earnings have responded accordingly. However, Monro has grown revenue below 10% for the past four years. Running up the score by 15% annually for five years into the future sounds like a moonshot by comparison.
The only way to grow: reinvesting capital effectively
In evaluating investments, my primary question is the following: Can the company earn a return on capital that exceeds its cost of capital by a margin sufficient to achieve the growth necessary to sustain its value?
FY 2016 return on capital will be around 11% for MNRO.
|Est'd FY 2016 EBIT (1-t)||78,374|
|Return on Capital||10.86%|
Returns on capital have been declining at MNRO:
Given these trends, how will MNRO hit 15% revenue growth going forward? Let's start with the base FY 2016 estimate shown above and use a forecast return on capital of 11%.
Since 3% of growth will come from comp sales, it is the 12% growth needed from acquisitions and "greenfield" stores that deserve our attention.
Indeed, CEO Van Heel outlined some progress they've made negotiating new purchases:
With more than 10 NDAs currently signed, we remain very optimistic about the attractive acquisition opportunities we see in the marketplace... These NDAs represent chains of between 5 and 40 stores located within our 25 state footprint.
Let's work backward. A return on capital of 11% implies that for every dollar the company invests, it will yield 11 cents in operating income less taxes. Assuming a 35% tax rate implies an operating income level of 17 cents. An operating margin of 12.65% translates into $1.34 of revenues. Therefore, every dollar of investment generates $1.34 in revenue.
If forecast revenue needs to increase by $143 million to slightly less than $1.1 billion to hit the 15% target, MNRO will have to invest about $107 million. In FY 2016, MNRO had approximately $109 million in operating cash flow. This amount was mostly sufficient to pay $20 million in dividends, $48 million in acquisitions and $38 million in capital improvements.
An acquisition and construction budget of $107 million will require only between $20 and $30 million in additional long term debt. This is a very manageable amount of leverage. I have presented below a discounted cash flow analysis that utilizes the aforementioned sales-to-capital ratio of 1.35.
Unfortunately, the 11% return on capital is merely sufficient to justify a price around $60 per share.
Discounted cash flow projection
Explanation of assumptions
The CEO's revenue growth target of 15% for five consecutive years was utilized. The growth trails off for the following five years.
An operating margin of 15% was employed instead of 12.65%. The reason for the additional margin is the result of the exercise I went through to capitalize operating leases. MNRO has capital lease obligations on the balance sheet and I added the operating leases to both sides of the balance sheet. The amortization of the asset is shown as a benefit to EBIT.
The cost of capital employed as a discount rate is 6.76%. This was derived from a leveraged beta of .85 for equity and 5.38% for the cost of debt.
Debt cost is calculated as follows:
|Long Term Debt||1.75%||$127,359|
Balance sheet with adjustment for operating leases:
Disclosure: I am/we are short MNRO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Your feedback and comments are welcome. I enjoy a healthy dialogue as a process of seeking good investments. The information provided has been accumulated from publicly available sources including press releases, earnings call transcripts and SEC filings. Any interpretations or inferences are those of the author. You should conduct your own due diligence before you invest.