Noble Roman’s (OTCQB:NROM) ($2.48, market cap: $45 million) is a company that franchises two fast-food concepts: Noble Roman’s Pizza and Tuscano’s Italian Subs. You can see a bit more about what they do on the company's website. The company provides a perfect example of what I call operating accruals and why they are bad for companies. (Note–this is probably not the correct term. If there is a better term for what I discuss, please tell me.) By operating accruals, I mean that the business is operating in such a way that today's earnings are coming at the expense of poor earnings (or even losses) in the future. The obligations that go along with today’s earnings accrue in reality, but not on the financial statements. Accounting accruals are different but no less bad. Just google 'Sloan accrual anomaly,' and you can learn more about why accounting accruals can be bad.
I have thought about franchising from both the selling and buying sides. There are two benefits to franchising from the buyer’s side. The first benefit is that the franchisee gets training/products/a system. Otherwise it can be very hard to start anything from scratch. For example, a restaurant is not just about good food, but choosing the right kind of food and food that is high margin (has a high ratio of price to raw material and labor costs). (Watch Gordon Ramsey’s Kitchen Nightmares a few times, and you will get a feel for how important non-quality aspects of a restaurant’s food are.) Secondly, franchising gets you instant credibility and name recognition. It is for this reason that McDonald’s (NYSE:MCD) can charge more for its franchises than can other franchisors. It is this name recognition that helps the average McDonald’s franchise to achieve annual revenues of $1.9 million versus $500,000 for the average Noble Roman’s franchise (according to some estimates, although my estimates are significantly lower). Because of this extra name recognition McDonald’s can charge an initial franchise fee of $45,000 (plus 4% of ongoing sales) versus an initial franchise fee of $6,000 (plus 7% of sales on an ongoing basis) at Noble Roman’s.
The problem with Noble Roman’s is that it does not do any significant advertising. Its product is in a highly competitive industry and it is not differentiated from its competitors. The one advantage to choosing to franchise a Noble Roman’s concept is that it is cheap. While this is advantageous for the franchisees, it is not good for Noble Roman’s. The low capital requirements and low initial franchise frees likely draw many inexperienced and poor restaurant operators to the franchise.
Even worse, Noble Roman’s has tried to expand quickly by introducing a second level of franchising. Area developers pay the company for the right to develop franchises in a geographic area. They then receive a portion of the initial and ongoing franchise fees of new franchises in their area. This leads to what I call an operating accrual. Noble Roman’s reports strong earnings in the present, and by selling more areas to area developers it can grow its current earnings. But Noble Roman’s will receive a much smaller chunk of money from new franchises than it does from current franchises and it will still be responsible for training the new franchisees. And soon enough there will be no more area developer rights to sell. So the company is essentially giving up future revenue to gain revenue now. This type of strategy rarely works.
I am not the only one to criticize Noble Roman’s strategy. See the following article on the Franchise Blog, Kevin Murphy, a franchising lawyer widely known as Mr. Franchise, comments quite negatively on Noble Roman’s area developer strategy in an article on the Franchise Blog.
Let’s say that the whole area developer thing goes well and all the new franchises get built. Noble Roman’s signs over 30% of the initial franchise fee, and 2/7 of the continuing franchise fee of 7% of sales. Considering that the company has a timetable for its new franchises and the average franchise brings in $500,000 per year, I can do a simplified discounted cash flow analysis on the extra revenue from those franchises. Noble Roman’s will receive $4,200 of the initial franchise fee, and approximately $25,000 each year from each additional franchise (if you buy the $500,000 per year in sales, which I do not). See the attached Excel spreadsheet for four different valuations of the company using different assumptions. I discuss the assumptions and valuations below. I also discuss the assumptions of the different valuation models below.
First, for all the valuations I use earnings as a proxy for free cash flow. It is not that bad of an assumption considering that Noble Roman’s does not have much in the way of depreciating assets. I separately value new stores and existing stores. All the valuations use a discount rate of 10%, which is reasonable for a highly competitive business like fast food.
The first and rosiest valuation is as follows: For the existing stores, I assume that sales remain flat and that revenues remain at the same (high) level as they were in the most recent quarter. This gives us $2.8 million per year in FCF from present stores. For a terminal valuation, I use the book value. I assume that all new planned stores get built, and that they achieve $500,000 in sales in the first, as well as all subsequent years. For the terminal value of the new stores I use 5x the previous two years’ revenues. I also assume that the new franchises have zero cost for Noble Roman’s, and that Noble Roman’s cut of the sales goes straight to the bottom line. This analysis yields a value for the company of $146 million, or 220% of the company’s current market cap.
One problem with the first valuation is that a lot of the current revenues (that I have modeled as existing stores) come from area developer fees and initial franchise fees. Eventually there will be no more areas to develop and initial franchise fees are accounted for in my model in the new store valuation. Subtracting out those revenues from the current store revenues leaves a current annualized profit run rate of only $256,000. This lowers the valuation to about $100 million, or about 121% above the current market price (this is shown on the second worksheet of the valuation spreadsheet).
However, this second valuation assumes over-optimistically that each new franchise will generate $500,000 annually in revenue. A 5% cut of this gives Noble Roman’s $25,000 per franchise per year. Rather than using estimates, I should use actual royalties received from current franchises to estimate what the average franchise gets in revenues, and then gives to Noble Roman’s in royalties. In the most recent 10Q, Noble Roman’s breaks down its royalties into the various types, including area developer royalties and initial franchise fees. For the most recent quarter continuing royalties totaled $2.044 million. Multiply that by four to get the annual run rate (because pizza is not seasonal), and we get $8.18 million annually in royalties from 1,033 franchises. This averages out to $7,920 per franchise per year. Multiply that by 14.3x (the inverse of the royalty rate of 7%), and we get average revenues of $113,143. For the new franchises under the area developers Noble Roman’s only gets 5% of revenues, so we can expect Noble Roman’s to receive $5,650 in revenue for each new franchise per year.
One important note–a lot of the current and new franchises are dual-concepts–a Tuscano’s Subs franchise and a Noble Roman’s franchise. Even though these are usually within the same restaurant they are counted as two franchises, which explains the low per-franchise revenues. Still, $230,000 sales per restaurant is horrid. Now, I will be charitable and assume that the new franchises produce 50% more revenues than the current stores. But even with this rosy assumption, the valuation of Noble Roman’s falls dramatically. The company is then fairly valued at $42 million, 7% less than its current valuation.
What is worse is that even this valuation involves optimistic assumptions. It assumes that current franchises do not close. It assumes that all the proposed stores get built (which the management just admitted will not happen). It assumes that revenues are 50% greater at new stores than at existing stores. It does not account for the discount that multiple-franchise stores get (saving $2000 on the initial franchise fee). It does not account for the extra training costs (however small) that each new franchise entails. If only half of the projected 868 new franchises are built and new franchises have only as much revenues as old franchises, then the company’s stock should fall 47% to a market cap of $28 million.
Another problem I see with Noble Roman’s, though I cannot quantify it, is that there are a few very disgruntled franchisees out there. The reason I can tell this is by looking at all the negative posts about Noble Roman’s on the Yahoo! stock message boards. Those boards are usually not informative, but in this case they are. Normally, most negative posts on such boards are written by short sellers. But judging from the short interest in NROM.OB, it appears that I am the only one who has sold the company’s stock short. So that means that Noble Roman’s really annoyed a few people. I should add that this is only icing on the cake for my case against Noble Roman’s: I never put much weight on such subjective information. In the case of these ‘disgruntled franchisees,’ it could all be the work of one lunatic who may not have even been a franchisee, and may just hold a personal grudge against Noble Roman’s management.
All in all, things do not look good for Noble Roman’s stock or for its business. In my realistic scenario, the company is priced at over twice its intrinsic value. In a worst-case scenario most of the new franchises will never be sold, the area development agreements will flop, and Noble Roman’s will struggle to earn $1 million per year. In this scenario, the company’s stock price could easily fall 75%. Considering management’s past failures to expand Noble Roman’s, the company’s lack of advertising and product differentiation, and the untested strategy of going with area developers, I think it likely that Noble Roman’s will fall far short of achieving its goals for growth.
While I do love bashing companies, there is a broader purpose to the above analysis. I wanted to show how a cogent analysis of financial statements and business decisions can help an investor avoid problems. I knew months ago that Noble Roman’s would never build all the new stores they planned to build. I knew that the company’s current earnings were inflated by non-recurring charges (area developer fees and initial franchise fees). I knew all of this just by thinking hard about its business, and taking an in-depth look at its financial statements. I did not need any inside information. Yet, I still knew enough to avoid the company’s stock, and to even take a large short position in the stock.
Many companies are willing to cut corners to improve current earnings. Whether this involves accounting tricks (such as inappropriately capitalizing expenses) or poor business decisions (such as not re-investing enough money in the business to maintain earnings), the individual investor would be wise to beware.
Disclosure: I am short NROM.OB.