Description

AFC Enterprises (AFCE) represents an opportunity to invest in an event-driven, undervalued, underfollowed company with strong secular trends and a management motivated to create shareholder value.

AFCE develops, operates and franchises quick service restaurants (QSR) for three major concepts: Popeyes Chicken, Church’s Chicken, and Cinnabon.

After several quarters of significant underperformance due to weak comp trends and the Company’s delisting in August 2003, AFCE now stands at the beginning stages of several upcoming catalysts which will unlock value. These catalysts include the potential for substantial asset sales, a NASDAQ relisting, sell-side coverage, a share buyback, a special dividend, cost cutting efforts and improving comp trends.

AFCE recently announced they have retained Bear Stearns to explore strategic alternatives for both its Churchs and Cinnabon brands. Church’s sells Southern fried chicken and is the third largest chicken QSR brand in the world. Church’s represents 37% of AFCE sales. Cinnabon, representing 15% of total company sales, is a cinnamon roll bakery located primarily in high traffic venues such as shopping malls, aiports and train stations.

After several meetings with management, it is clear that selling both brands, focusing the Company’s time and attention on improving Popeyes and returning cash to shareholders creates the greatest value. Both management and its board clearly have an invested interest to create value for equity holders - not only is the CEO the fourth largest shareholder with over 1 million shares, Freeman Spogli (the largest shareholder and a Los Angeles-based private equity firm) owns 27% and has three boards seats.

With strong employment trends, competitive pricing abating and easy year-over-year comps, QSR stocks have seen strong performance since the first quarter of 2003, with returns of over 40%. AFCE has significantly underperformed the rest of the sector during this period as a result of the Company’s financial restatement which resulted in a NASDAQ delisting (currently trades on pink sheets) in August of 2003. This resulted in an extensive audit, an SEC review and a restatement of its 10Ks and 10Qs for fiscal years 2001 to 2003. This not only consumed management’s time, but has stunted franchise growth, investor interest and sell side support.

These restatements, related to quarter-end adjustments to reserve, asset and accrual accounts on the books of the Company, were determined as appropriate after consultation with the Company’s new independent auditors KPMG in March 2003. The restatements triggered a lengthy audit committee investigation which caused a delay in the SEC filings. The audit committee concluded that the there was no evidence that AFCE used improper accounting treatment to manipulate reported earnings or that there was wrongdoing on the part of the Company.

Since then, the Company has filed all necessary SEC documents and is now considered current. This allows management to actively pursue the sale of franchisees, the main driver of growth for the business, which they have been unable to do since failing to meet the filing requirements in time. This also allows management to file for relisting, expected to occur by mid-summer, which should improve liquidity and investor awareness.

In addition, comps have continued to improve with Q1:04 blended same store sales up 3.0% - with a 6.2% comp improvement at Churchs, 4.4% at Cinnabons, and 1.1% at Popeyes. Management also increased its full year blended comp guidance to 1.5% - 2.5% from 1.0% - 2.0%. The primary factor leading to the increase in guidance was\s Church's performance. AFC now expects Church's FY04 comp growth to be up 2.0% - 3.0% versus previous expectations of 1.0% - 2.0%. Management’s comp guidance appears very conservative given the first quarter results, the easy upcoming comps and management’s continued focus on menu improvement and price increases.

Given the sale of Churchs and Cinnabon, the pro forma capital structure would leave AFCE with no debt, approximately $10 in cash per share and a singular focus on one brand, Popeyes. With a new brand president (Ken Keymer from Sonic Corporation), the opportunity to substantially grow its franchisee base, the potential for modest price increases, new menu offerings and easy comps, Popeyes is now in a position to see significant leverage in what has been an very undermanaged asset.
Popeyes Same-Store Sales:
1Q03 2Q03 3Q03 4Q03 1Q04
-2.5 -2.1 -2.7 -4.1 1.1

Summary of Thesis/Catalysts:
• Sale of Church’s and Cinnabon
• NASDAQ relisting expected by midsummer
• Share buyback and/or special dividend
• Institutional investor awareness/support – most “plain vanilla” funds cannot own stocks on the pink sheets; relisting should result in increased liquidity and demand.
• Management roadshow
• Sell-side support - currently there are 5 analysts who cover AFCE (and only 1 actively), all have sells or neutrals; models are stale, sentiment is negative
• Comp improvement at Popeyes which should substantially increase depressed margins and EBITDA

Risks:
• Inability to sell Church’s and/or Cinnabon at an attractive valuation
• Delay in NASDAQ relisting
• Commodity costs - Chicken costs are anticipated to increase for the rest of the year which will pressure margins for both chicken brands, but should be mitigated through menu price increases

Current Valuation:
Current Price: $21.00
Shares Outstanding: 28.8
Market Cap: $605mm
Net Debt: $111
Aggregate Value: $716mm
EV/ FY04 EBITDA: 6.0x

Pro Forma Valuation:
$mm

Sale Proceeds:
EBITDA Mult Value Value per Share
Cinnabon $6.0 8.0x $48.0 $1.67
Churchs $56.0 8.0x $448.0 $15.56
Total $62.0 $496.0 $17.22

After Tax Proceeds: $422mm
AT Proceeds Per Share: $14.64

Pro Forma Multiples:
Current Price: $21.00
Shares Outstanding: 28.8
Market Cap: $605mm
Net Cash: $311mm
Aggregate Value: $294
---------------------------------
Popeyes ’04 EBITDA: $59mm
Popeyes ’05 EBITDA: $65mm
EV/ FY04 EBITDA: 5.0x
EV/FY05 EBITDA: 4.5x

Comparable Company Analysis:
EV/’04 EBITDA EV/ ’05 EBITDA
Large Cap:
MCD McDonald’s 8.8x 8.4x
WEN Wendy’s 7.0x 6.4x
YUM Yum Brands 8.1x 7.5x

Small Cap:
SONC Sonic 10.7x 9.4x
CKR CKE Restaraunts 9.0x 8.1x
Average 8.7x 8.0x


Pro Forma Price Target:
$mm
Popeyes ’05 EBITDA: $65
EBITDA Multiple: 7.0x
Implied Aggregate Value: $455
Pro Forma Net Cash $210
Market Cap $665
Pro Forma Shares 24.0
Implied AFCE Share Price $28
Upside to Current 32%

This assumes a successful sale of both Churchs and Cinnabon for a reasonable price (8.0x this year’s EBITDA); moderate, but not aggressive growth for Popeyes, a discount EBITDA multiple to its closest comps SONC and CKR (small cap QSR) and the use of cash proceeds to pay down existing debt (will have no debt) and buyback shares ($100mm). Clearly, an underleveraged balance sheet with $200mm + of cash is not the most optimal capital structure, paying a special dividend or buying back more stock would only enhance shareholder value.

Catalyst

• Sale of Church’s and Cinnabon
• NASDAQ relisting expected by midsummer
• Share buyback and/or special dividend
• Institutional investor awareness/support – most “plain vanilla” funds cannot own stocks on the pink sheets; relisting should result in increased liquidity and demand.
• Management roadshow
• Sell-side support - currently there are 5 analysts who cover AFCE (and only 1 actively), all have sells or neutrals; models are stale, sentiment is negative
• Comp improvement at Popeyes which should substantially increase depressed margins and EBITDA