|Shares Out. (in M):||25||P/E||17.3x||15.4x|
|Market Cap (in $M):||411||P/FCF||14.4x||12.5x|
|Net Debt (in $M):||46||EBIT||41||45|
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VIC is not as fun on a 90 day lag and I miss being able to contribute on the comment board. I hope you will consider me for reactivation. I’m going to write up Popeyes, which has been written up several times on this site. While the situation has not changed a huge amount since those write-ups, I think the investment is still compelling and I’m going to try to provide a little more detail.
AFC Enterprises (AFCE)
Market Cap: $400 million
Net Debt: $46 million
Estimated 2012 Operating Income: ~$45 million
AFC Enterprises franchises and operates Popeyes Louisiana Kitchen, which sells juicy bone-in fried chicken of the “spicy” and “non-spicy” variety. Often this delectable chicken is served with a cylinder of golden lard called a “biscuit.” AFC is primarily a franchising business, with about 2000 franchised restaurants in its system versus 40 company-operated restaurants. Thus, this is essentially a brand royalty business that can grow with minimal capital investment. While AFC’s valuation does not seem especially cheap at 10x operating income, the company has excellent growth opportunities, particularly in domestic markets.
How we got here – A neglected brand
AFC Enterprises is an Atlanta-based company that was once a restaurant conglomerate that, in addition to Popeyes, owned Church’s Chicken, Chesapeake Bagel Bakery, Cinnabon, Seattle’s Best Coffee, and Torrefacione Italia. After several bouts with debt problems, shareholder lawsuits, and a slew of acquisitions and dispositions, the company was dismantled and centered around Popeyes with 1) the 2004 sale of Church’s to a private equity firm for $386 million, 2) the sale of Cinnabon to Focus Brands for $21 million, and 3) the sale of Seattle’s Best to Starbucks for $72 million. The combined proceeds of $479 million were used to repay some debt, repurchase shares and pay a $350 million special dividend in 2005. The company’s founder and CEO, Frank Belatti, announced his retirement the same month as the dividend.
After AFC was downsized there was a tremendous amount of turnover at the management and board level. Belatti’s replacement, Ken Keymer, lasted less than two years as CEO. AFC then embarked on a lengthy executive search that ended in late 2007, when board member Cheryl Bachelder was named CEO. Most of the board members from the period before the Church’s sale had left the company, and AFC had operated without a permanent CEO for almost a year. Popeyes was truly a neglected orphan.
A bonafide, finger-lickin’ good business
Before I address Ms. Bachelder’s successes as CEO, I want to talk a little bit about why I think Popeyes is a good business. As you probably know, franchising is a very stable, high-margin business where all of the costs of operating restaurants are borne by the franchisee. Popeyes’ franchisees pay 5% of their sales as a royalty to AFC and contribute an additional 4% of sales into local and national advertising funds. Franchisees must finance all store re-images and remodels, and their contracts typically specify how frequently such remodels must be done.
The Popeyes brand and concept are excellent. Popeyes has the best product in a defensible, mature niche with only one national competitor, KFC. Bone-in fried chicken is not at risk of competitive entry from existing quick-service chains and the space is mature enough that new entrants are not so common. Additionally, the store-level economics of bone-in friend chicken restaurants are strong for franchisees with low labor costs and a simple menu – with very few proteins and sides – that changes infrequently.
AFC Enterprises’ CEO Cheryl Bachelder has been particularly impressive and her story is worth mentioning. Ms. Bachelders restaurant experience began at Domino’s Pizza, where she was mentored by founder Tom Monaghan, a legendary operator who ran the business for 38 years before selling to Bain Capital for over a billion dollars. (Domino’s is, if nothing else, a business based on operational efficiency). From Domino’s, Ms. Bachelder moved to KFC where she was named President and Chief Concept Officer in 2001.
While Ms. Bachelder had some early successes at KFC, the chain began to suffer in 2002 and 2003 with the rest of the quick service industry. She also endured a nasty public spat with an animal rights group and a private battle with cancer. After her resignation in 2003, Ms. Bachelder quietly stepped away from the restaurant industry to focus on her family and health. She joined AFCE’s board in late 2006 and was tabbed by her fellow board members to fill the company’s CEO vacancy the following year.
Cheryl Bachelder brings to Popeyes the intense focus on operations so crucial to success in the foodservice industry. She also brings perspective as a board member, vast experience (including running Popeyes’ largest competitor), and importantly, something to prove. With hindsight it is clear that 2003 was a remarkably tough year for domestic quick service restaurants – McDonald’s shares, for example, traded below $13 for the first time since the early 1990s. Bachelder did not get a fair shot during her tenure at KFC and Popeyes is her chance to prove herself.
Since Ms. Bachelder became CEO, AFC has exhibited the kind of operational focus we love to see in our portfolio companies. For the first time in the company’s history, AFC is collecting profit/loss statements from franchisees. The company now gets operating data from over half of the system’s restaurants. This treasure trove of information helps management promote best practices among the franchise base that will improve store-level economics for franchisees. Other simple changes such as timing drive-thru transactions and carefully monitoring customer satisfaction have already begun to improve guest experiences and help franchisees run more profitable, higher traffic restaurants.
The results so far have been impressive. Popeyes’ domestic same-store sales have been positive for three years in a row and outperformed the fried chicken segment as well as overall QSR in each of those three years. Average unit volumes are over $1.1 million and restaurant pre-rent operating margins are just under 20%. This has all been achieved without meaningful capital investment into the system. Management is excited about the potential of the new “Louisiana kitchen” brand image and indeed new openings have been performing very well. Last year’s new restaurants are generating about $1.5 million AUV while the 2010 vintage is still holding up well at $1.3 million. Over the next three years the entire franchise system will be freshened and remodeled, with 600 happening this year. This should provide a meaningful sales boost to the system.
Earnings will grow
Popeyes has 1,587 domestic franchises, 408 international franchises and 40 domestic company-operated restaurants. International growth has been plugging along reasonably well with particular strength in Turkey. The international franchise base has grown by about 20% over the past three years. The best growth opportunity for Popeyes, however, is here at home.
Popeyes only has about 1,600 domestic restaurants (versus over 5,000 for KFC) and their geographic footprint is very uneven. There are less than 10 (ten!) Popeyes restaurants in each of these states: North Carolina, Minnesota, Massachusetts, Washington, Oregon, Kansas and Kentucky. There is an excellent opportunity for Popeyes to meaningfully grow its domestic franchised restaurant base over the next few years. Management believes it can double the number of Popeyes franchises in the US and while they are generally non-promotional, they are publicly guiding for 15% annualized earnings per share growth over the next 5 years.
A large impediment to Popeyes’ growth aspiration is to finding capable franchisees with access to adequate financing. The lending environment for franchises is still weak, and it is downright crappy for new operators. Despite this headwind, Popeyes franchisees opened 73 domestic restaurants in 2011, the 3rd most franchise openings of any QSR concept (behind MCD and BKC). 75% of new domestic restaurants were opened by existing franchisees. This indicates the confidence that existing franchisees have in the future of the brand, but it might also show that new franchisees are still having trouble getting financing. Management expects a larger number of domestic openings in 2012, and I expect the lending environment to gradually improve for new small businesses.
One opportunity the company has to kickstart its domestic growth is to selectively invest in company-operated restaurants in underserved markets when the returns are attractive. A perfect example is Popeyes’ recent foray into Indianapolis. This was a good market for Popeyes franchises until the local franchisee was shut down for tax evasion. AFC was not happy with the new franchisee prospects, or their ability to open several restaurants at once successfully, so the company is taking on the project itself and opening 7 to 9 restaurants in the market this year. Indianapolis is a little bit of a unique situation for the company because management knows the market well (the president was a former Dominos franchisee in Indianapolis), so we will not see huge system-wide investment in company-operated restaurants. Still, I’m happy that management is thinking opportunistically about some of their underserved markets. QSR franchises are pretty fungible, so AFC can flip the Indianapolis restaurants to franchisees once they are up and running smoothly.
So what is it worth?
AFC should generate about $50 million in EBITDA this year with minimal maintenance capex requirements (at most $3 million to $4 million). Franchise businesses deserve a high multiple, and indeed Ackman’s recent Burger King presentation advocates a 13x to 16x EBITDA minus capex multiple. This would imply a stock price of $22.50 to $28.15.
The way I look at it, I’m buying a good, stable business at 10x EBITDA minus capex. Not super cheap, but I think just on the back of domestic growth we’ll see meaningful earnings growth at about 15% a year. While we wait for the system to grow, Popeyes management is allocating most of its free cash flow to share repurchases (it repurchased $22 million last year).
Each new opening comes into the system at $1.5 million AUV either replacing a ~$700k AUV closing or adding a net unit. This year Popeyes management expects 135 to 155 new openings (both domestic and international) with net openings of 60 to 100. While doubling the domestic restaurant base would provide bonanza growth, even modest unit growth results in meaningful earnings increases. Every 100 new domestic restaurants should contribute about $8.5 million in first year fees and royalties with minimal incremental cost. It is also worth pointing out that as the system grows, the advertising fund becomes larger and more effective. Every week that Popeyes uses national TV advertising, they see an 8% sales lift. Much of the advertising cost is paid by franchisees so as the system grows, TV dollars multiply.
In my write-up I’ve paid scant attention to the international segment, which I think is a cheap call-option in this situation. KFC’s success overseas shows the potential for bone-in chicken concepts in international markets. This takes years of investment and good franchisee partners, but AFC has seen some success, particularly in South Korea and Turkey, its two largest markets. Popeyes is currently in 25 countries and continues to enter new markets. Given AFC’s underleveraged balance sheet, this makes for a great LBO candidate. A private equity fund with experience building out international franchise businesses could really hit a home run with Popeyes. Someone like 3G, who bought Burger King, could buy Popeyes at a healthy premium to market and still get the domestic business at a discount. The international business would be gravy and has huge long-term potential.
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