The only moderately dramatic conclusion ...
"Good Things Come to Boys Who Wait" - Christina Aguilera, Pop Star
Newsflash: A company’s stock is worth the value of all its discounted future cash flows until the demise of the company or the demise of time, whichever comes first. And in every instant, the market evaluates all available information impacting earnings, inflation, and real interest rates and adjusts its prediction of a stock’s future cash flows accordingly. And if the market is right, the stock should never, ever appreciate in price (in real terms … although shouldn’t this holds true for the nominal price as well??? Maybe someone has a thought on this).
But as this chart of the S&P500 can attest, stocks clearly do appreciate. And they appreciate in real terms. An investor paying ~100 for the S&P in the late 1870s was buying the market 90% undervalued compared to its current real high around 1,000.
Concessional Aside: There are problems with using such a long-term chart of the S&P. There is survivorship bias, which over the course of 130 years would have a significant impact. Also, such a chart bolts together the S&P500 (b. 1957), the S&P90 (b. 1918), the DJIA (b. 1896), and whatever the hell was in existence before that. Perhaps this? Anyway, just ignore all this and my argument will be that much stronger.
So it appears the market was wrong in 1879 when it valued itself at 100. In the truest sense of investing, if you ever buy any stock with goal of making money, the market must be wrong.
In a perfect world, the instant after you purchase, the market would immediately realize the error of its ways and reprice the stock to its intrinsic value while you pocket a massive profit. Then you could buy the yacht, the car, theloft, and the significant other you’ve always dreamed of, have brunch with the queen, fly to the moon, eat all the Toblerone and Clodhoppers you want, fall asleep on a bed of imported animal skins and call it a day.
Then, if you got bored, you could simply find another significantly underpriced stock tomorrow and do it all over again. Wouldn’t it be great if this happened to you!?! If only you could find that stock. You’d be rich! You’d be King.
Unfortunately, the allure of quick wealth drives a lot of people’s investment decisions. Everyone wants a stock that will triple in 3 months. Even more unfortunate is the fact that this very rarely happens with stocks. Usually (and this is especially true for the retail investor), you buy a stock, it trades up or down some 10% and you sell it in 3 months, horribly disappointed it didn’t make all your decadent dreams come true. Sometimes you buy a stock, it plummets in value and you end up bankrupt and living on the streets with your dog.
Homelessness Activist Aside: btw, ever notice how people treat a homeless person’s dog better than the homeless person!?!? They will literally step over the homeless person to pet the dog. Did anyone stop to consider that maybe the dog was a lazy bum that dragged the homeless person to the sewer? I don’t mind animals, but it seems our priorities are a little out of sorts.
Every once in a while, much to your delight, you buy a stock and remain patient, and the stock appreciates continuously over time (normal market fluctuations notwithstanding), until such point as you can boast of a pretty impressive return. This point, of course, usually comes moments before you die of old age, leaving the substantial sum to your lazy, spoiled grandchildren who spent much of their adolescence pretending to love you just to get in on the will and splurge in 6 days what took you 60 years to build. Hey, at least you had a pretty impressive return.
Take Becton Dickinson (NYSE:BDX).
In 1984, it traded at a low around $1.60 and over the next 26 years it appreciated fairly consistently to its current price of about $70. Clearly, in 1984, the market severely underestimated BDX’s future cash flows. Except the market didn’t realize it immediately. Instead (and I’m simplifying here) in the next quarter, BDX earned a bit more than the market anticipated and, almost grudgingly, the market adjusted its price a little higher. But obviously not high enough because in the next quarter, BDX again earned a bit more than expected, and again the market adjusted its price a little higher. And on it continued, quarter after quarter, year after year, BDX kept earning more than the market anticipated, and the market never fully adjusted its expectations correctly. Then 26 years later the market looks back and says, “God damn we undervalued that stock!”
Think of the market as a nasty substitute teacher. It never gives stocks full credit, especially not for returns to be earned in the distant future. The great investors always give full credit where it is deserved.
Hot-Stock-Tip Aside: If you were to build the perfect value investment for the 21st century from scratch, that investment would look like BDX. Hopefully I will have an opportunity to cover it in the future.
Franchising For Dummies (like me)
You all probably know how franchising works, so I won’t draw this out. Most franchises are service companies like restaurants or convenience stores or fitness centers. I’ll use a fast food restaurant as an example, you know, because this blog’s about fast food franchises.
Say a restaurant owner develops a locally or regionally successful service proposition or concept or banner and say he trademarks the brand and other aspects of its concept like specific products and equipment and even operational standards that he’s used to become successful. Now say, like any perfectly greedy businessman, he sees an opportunity for the concept to excel in many other regions. He has 2 choices: build new locations with his own capital and own and operate them outright … or find partners willing to invest their capital and operate the new locations on his behalf (known as franchising).
Additional Non-sexist aside: I tried to write that paragraph gender-neutral, but screwed it up so many times that I decided to forget it.
There are benefits and pitfalls to either strategy. If you own outright, you have better control of operations at each location (in theory) and you don’t have to split your profits with any partner. If you franchise, you have lower capital requirements and administrative costs and you have a prideful owner at each location, caring for the restaurant in a way some bum employee never would.
And there is no right answer. Some of the most successful restaurant chains in the world are privately held, some of them are franchised. Most restaurant chains can’t even make up their minds which is better. YUM! Brands (KFC, Pizza Hut, A&W), MacDonald’s, Burger King, and Wendy’s/Arby’s all corporately own and operate up to 30% of their stores, franchising the remainder.
But all of the companies do franchise and they make cash in a few ways:
1) the all-important royalty fees (usually 4-5% of a franchisees gross revenue)
2) the just-as-important, but lesser known, product sales and
3) initial franchise fees.
In exchange for use of the trademarked concept, the franchisee pays to the franchisor a percentage of sales. BUT the franchisee is also usually contractually obligated to buy certain products from the franchisor (like coffee beans in the case of Starbucks or Tim Hortons), on which the franchisor also earns a spread. This is a cute trick that adds major earnings power for Tim Horton’s and, as it turns out, MTY. The franchisor also collects a decent up-front fee when it opens a new franchise (from $20K to $100K in the restaurant biz). It doesn’t account for much as a percentage of total revenue, but it’s basically free money.
Keys to the Game … or in this case, the Franchise
Two key metrics for franchises are shown below. The first is Revenue per $ system sales (REVPSS) shows how much the franchisor is able to squeeze out of their franchisees. It’s obvious that the 4% royalty fee is only one component of revenue for a solid franchise. The second is Profit margin … well, if you don’t know why that’s important you need to find a new hobby.
|Franchise||Revenue per $ System Sales||Profit Margin|
|MTY Food Group||13%||24%|
You can see MTY ranks near the top of the list for both.
Other important factors include:
- Location of Stores – duh!
- Brand recognition – this of course draws customers and also helps draw a higher quality franchisee
- Geographic Diversification
- Brand Diversification – important for 3 reasons: 1) the more banners a company owns, the more it can withstand a decline in any one brand 2) Appeal to different market segments and tastes 3) Crowd out competitors
- Strong franchisees
Number 5 is of particular importance. A franchisor must screen vigorously for good partners. A bad partner will impact profitability and sully the banner’s image. Also, the franchisor must ensure the franchisee makes money by developing a reasonable royalty structure and proper support functions. A franchisor will have a hard time finding good partners if they don’t’ expect to make money.
What’s the Scenario!?!
"I often remind our analysts that 100% of the information you have about a company represents the past, and 100% of a stock's valuation depends on the future." – Bill Miller, Chief Investment Officer, Legg Mason Capital Management
The obvious answer to why MTY’s P/E is just 14x is that the market doesn’t expect MTY will grow at nearly the same rates in the future. And it’s a fair expectation. One thing about growing by acquisition is that it becomes harder and harder to make acquisitions that will move the EPS needle. That and there are less companies out there to buy. Sooner or later, growth has to slow down.
But what growth would MTY have to maintain to justify its current price? And what growth would it have to maintain to warrant an investment? I’m glad you asked ……
|SCEN 1||SCEN 2||SCEN 3||SCEN 4|
|New Store Growth||3%||0%||3%||3%|
|Total Growth, System Sales||16%||3%||16%||16%|
|Revenue per system sales||13%||13%||10%||13% - 10%|
|Profit Margin||20%||20%||10%||23% - 16%|
|EPS, 15-year CAGR||13%||0%||7%||10%|
|Same-store Sales growth||3%|
|Growth in Shares||2.8%|
|Length, 1st stage||15 Years|
Here we are with my familiar two stage model, which calculates the intrinsic value of a stock based on its future free cash flow. In the first stage, I estimate growth in total system sales for the entire group, based on three components: same-store sales growth, new store growth, and acquisition growth. New stores are expansions of existing banners. Acquisition growth results from the purchase of new banners.
In each scenario, I assume same-store sales will grow at 3%, below the average for limited-service restaurants in Canada in the past 10 years. I also assume the number of shares outstanding will grow 2.8% per year, which is the average over the past 8 years. This is conservative as MTY has made a point not to issue new shares in recent years.
Here I assume MTY will grow by adding its own new stores at a mild 3% per year. Profit margin is reduced to 20% in year 1 and remains there for 15 years. REVPSS remains at the current 13% well into the future. I assume acquisition growth is 10%. MTY looks very attractive.
Here I assume the company will not build any new stores and it will not acquire any new banners. It maintains its current new stores and they grow at 3%. Profit margin and REVPSS as per Scenario 1. Stock doesn’t look very attractive.
This is scenario 1 with the twist that profit margin is cut in half to 10% and REVPSS is cut to 10%. Stock looks fairly priced.
This is scenario 1 with the twist that profit margin and REVPSS taper down overtime as new acquisitions are made. Profit margin declines from the current 23% to 16% by the end of year 15 and REVPSS declines from 13% to 10%. Again, the stock looks attractive.
Risk-Assessing Aside: In this model, scenario 2 is the most risky. Could things potentially turn out even worse for MTY? Sure, there is always a chance, but in this case I think it’s a small one. MTY’s diversification both in banners and geography, its low leverage, its high margins, and its experienced management are all solid mitigants to potential disaster in the future.
I Hope MTY is Hungry
So Scenario 1 makes MTY look like a screaming buy. But scenario 1 suggests the company will grow EPS 13% per year over 15 years. And that requires system sales growth of 16% per year over 15 years. This does not sound like an easy task.
But with same-store sales growing at 3% per year and new store growth equaling a mild 3% also, MTY need only grow through acquisition at 10% per year. Compared to previous years, that doesn’t sound like a staggering achievement.
|Growth in System Sales via Acquisition||58%||13%||33%||28%|
The question that should be on everyone’s mind is this: are there enough franchises out there to buy? Remember in Part 1 of this delicious story, I said there were 11,488 branded chain stores in Canada. Well, at 1,570 stores, MTY is already 10% of the industry. Then there’s McDonald’s (1,500 stores), Starbucks (1,000), and the Canadian colossus Tim Horton’s (3,000). That’s 62% of the industry in just 4 names. I doubt MTY is getting their hands on any of those stores.
All is not lost, though. There are still plenty of names out there and, being the aberrantly curious person that I am, I took some time and came up with a few names.
|Stores||System Sales (mil)|
|New York Fries||210||$84|
If MTY were to acquire all of these banners, it would triple its number of stores and increase its system sales by almost 5 times. Even if it grew acquisitions 10% per year, it would take MTY over 12 years to acquire all of those stores. And there’s a nice thing the economy will do during that time: it will grow! There will be more people eating more food in more places 12 years from now than there were today. I’ll bet my life on it. And that will require more fast food joints. So I imagine there will be additional stores available for acquisition. And probably spaceships and teleportation too.
And that list is hardly exhaustive. There are surely many Canadian franchise rights up for grabs. For instance, there is Prizm Income Fund, the largest franchisee of YUM! ‘s KFC and Pizza Hut banners in Canada (about 450 stores in total). Prizm is a dying fund that’s cut its distribution several times as its unit price collapsed from $15 to $0.65 during the financial crisis. KFC and Pizza Hut could soon be on the market in Canada.
If MTY wanted to go slightly out of its comfort zone into full-service, it could take a run at CARA Corporation, the privately-held restaurant operator of well-known names Harvey’s, Swiss Chalet, Kelsey’s, Milestone’s, and Montana’s and its 750 some stores.
Then MTY could step way outside the lines and pick-up Fabutan and its 150 stores or Popeye’s Supplements and its 65 locations or any other franchise you could possibly think of. Remember the more outside the lines they go, the more risky things get.
Sounds Too Good to Be True … Almost
If you ever participated in the merger or acquisition of a company, no matter the size, you know it’s rarely a smooth process. One reason I like MTY’s business model is that the acquisition process is less cumbersome than most. For the bulk of acquisitions, the franchisees are already in place, running their stores as proud owners are apt to do. MTY likely makes a few administrative changes, maybe closes a store here or there, maybe makes some product changes … but there isn’t the massive undertaking of integration that goes on in other deals.
Still, the most ominous risk (besides not being able to acquire enough businesses to satisfy the multiple) is that of a poor acquisition. MTY might run out of strong brands and, consumed by the need to grow, acquire something struggling in hopes of a turnaround. And the turnaround might be unsuccessful and prove to be a waste of precious cash. MTY might start ratcheting up its acquisitions, looking for larger and larger competitors to consume. Then complexity becomes an issue: sort of like taking two trains apart and having to put them back together as one, instead of just hitching another container to the train. The bigger the acquisition, the bigger the potential indigestion (think AOL Time Warner). Or maybe MTY, again running out of available banners, ventures into markets in which it has limited expertise. Stanley Ma has spent a good chunk of his life running restaurtants. What does he know about tanning beds or hair salons?
Informative Aside: Let the record show that I know absolutely nothing about tanning salons … on the record.
Food for Thought, MTY Food Group for Profit
For the stock to really move from here, MTY has some pretty big orders to fill. Growth may be hard to come by at points along the way as less and less acquisitions are available to them. They may have to look for growth outside their borders or push for more organic growth in their existing brands. And, of course, there are the inherent risks of an acquisition-based strategy.
Still, as I’ve noted, MTY covers all the fundamental bases. Its management has shown it understands the value of its free cash and how its careful deployment can lead to fantastic growth. Its brand diversification, low debt, and industry (people will always need to eat after all) minimize potential downside. It may not be the most undervalued stock, but it certainly has the potential to make its owners very satisfied.
After loading the blog with bad eating puns, this would be the part where I make a reference to being famished from all the food and eating references I’ve made. And far be it from me to disappoint! I’m off to Taco Time. And if you happen to see me halfway through a tray of 4 hard tacos and two large mexi-fries, remember, I’m not a glutton, I’m a fervent supporter of my business.
Disclosure: I got anxious and bought MTY the day it was added to the TSX. And I’m about breakeven as of today thanks to a strong earnings report for Q2.
Disclosure: Long MTY ... damn right.