Description

Franchise Group is poised for a near-term earnings boost as elevated, but now normalizing, freight costs flow through its income statement; it also presents a compelling overall growth story in the longer term.  Concern about a potential recession’s impact on FRG’s “retail” exposure presents an attractive entry point for near term and longer term gains.  A dividend, which we believe is sustainable, and yields 9% at the current stock price, pays you while you wait.

FRG made headlines earlier this year with its nearly successful acquisition of Kohl’s.  Prior to that effort, CEO Brian Kahn and his team created a portfolio of franchised and franchise-able businesses with long growth runways.  Strong growth at several of the FRG businesses has been masked by financial statements in constant flux due to acquisitions and, more recently, extraordinary shipping expenses that severely impacted one FRG business in particular.  Adjusting for these unique supply chain costs, which appear to be subsiding, FRG is attractively priced on a no-growth scenario despite the fact there is meaningful growth expected across all lines of its business.

Company Overview

FRG is run by Brian Kahn, a seasoned private equity investor, who controls nearly 30% of FRG stock.  Since the creation of its platform in 2019 via merger of Buddy’s and Liberty Tax, FRG has been acquiring franchised and franchise-able businesses that generate steady cash flows with low cap-ex requirements.  Importantly, the acquisitions listed below have been completed largely with debt that has then been quickly repaid via post-closing non–core asset sales.  There was a $100mm equity raise in mid-2020, and the balance of the financing was variable rate debt. 

Business Segments

The Vitamin Shoppe (“TVS”)

TVS is the least franchised business in the FRG portfolio, but management intends to change this.  In January 2021, the first TVS store was franchised and the backlog stands at 12 stores as of 3/31/22.  

Margin improvement in recent years has been due, in part, to increased emphasis on private label products.  COVID accelerated the e-commerce platform development.

American Freight (“AF”)

The American Freight segment is a retail chain offering in-store and online access to furniture, mattresses, new and out-of-box home appliances and home accessories at discount prices. American Freight buys direct from manufacturers and sells direct in warehouse-style stores. 

American Freight also serves as a liquidation channel for major appliance vendors. American Freight operates specialty distribution centers that test every out-of-box appliance before it is offered for sale to customers. Customers typically are covered by the original manufacturer's warranty and are offered the opportunity to purchase a full suite of extended-service plans and services. 

AF is the only current business that FRG plans to grow via both corporate-owned locations and new franchises.  This, according to the CEO, is due to the compelling unit economics of the AF business.  Per the AF acquisition deck, the no-frill warehouse store opening capital expenditures approximate $215,000, 80% of which is starting inventory and the balance are pre-opening expenses.  Low operating costs are expected to result in 65% and 195% cash-on-cash ROIs in the first 12 and 24 months respectively.

COVID closings and re-openings coupled with stimulus payments, changing consumer behavior patterns, supply chain disruptions and inflation made the years 2020-2022 extraordinary for AF.  The latter of these impacts are still making their way through the AF financial statements.

Management pointed out that in the first half of 2021, and presumably continuing throughout the year, inventory shortages on certain high margin products had a significant impact on AF financial performance.  For example, “as-is” out of the box appliance revenue in Q1 2021 was down 30% because AF could not secure the inventory; “as-is” inventory was down 40% YoY.  Some of the demand was met with lower margin new appliances, but the impact on AF profitability was material.

By Q3 2021 management noted that AF was “well-inventoried” but with a sub-optimal mix and, as would be pointed out in subsequent quarters, at a cost of goods materially higher than was typical.  

In the Q2 2022 earnings call, Kahn quantified the staggering impact of inflation on the AF:

“Although American Freight is emphatically expected to be a material contributor to FRG's long-term growth, the impact of inflation this year is likely to result in approximately $100 million less EBITDA than what the current store base would be expected to generate in the steady state. American Freight is expected to generate approximately $200 million less revenue than planned. That revenue loss comes with roughly 30% EBITDA flow through, and additionally, the nearly $1 billion of revenue that American Freight will generate will come at a cost of over 500 basis points of excess freight. That math totals over $100 million of EBITDA impact at American Freight this year alone.”   -Brian Kahn, FRG CEO, Q2 2022 earnings call  

Importantly, Kahn went on the note that to avoid damaging the AF brand in its customers’ eyes, FRG had decided not to raise prices commensurate with the COGS increases and will instead take the margin hit until the high cost inventory has been sold.  Kahn noted that “it will likely take the rest of this year [2022] to sell the older higher cost inventory through our [FIFO] system.”

The good news is that Kahn also noted that costs were coming down, in some cases materially, and general market data appears to confirm that shipping costs from Asia have fallen dramatically.   

We believe the normalization of these costs, even if other recessionary pressures persist, will lead to a meaningful improvement in AF financial performance in the relatively near term.

In addition to cost normalization, we also expect accelerating growth in AF store count.  In Q2 2021 management noted that they had executed four AF franchise area development agreements with a total commitment of 16 stores in multiple markets.  The Company expects additional franchise growth in AF and other lines of business as the inventory problems subside and construction material and labor costs normalize.

Pet Supplies Plus (“PSP”)

The Pet Supplies Plus segment is a leading omnichannel retail chain and franchisor of pet supplies and services. Pet Supplies Plus has a diversified revenue model consisting of Company-owned store revenue, franchise royalties and revenue generated by the wholesale distribution of products to its franchisees. 

As with AF, PSP offers compelling until level economics.  In the PSP acquisition investor slide deck, FRG highlights a 2 to 3-year payback on an initial investment of $500k; $185k unit level annual contribution to PSP from a franchise unit and $250k per corporate location.  

The number of franchise locations has grown by 25% since 2020 and the franchise backlog at the end of June, 2022 was 230 stores.  In addition to historical positive same store comps which we expect to continue, the unit economics indicate considerable EBITDA growth embedded in the PSP franchise backlog.

In addition to continued new market growth, the recent acquisition of Wag N’ Wash offers existing franchisees the opportunity to develop a new complementary concept within their market to generate incremental profit.

Badcock

The Badcock segment is a specialty retailer of furniture, appliances, bedding, electronics, home office equipment, accessories and seasonal items in a showroom format. Additionally, Badcock offers multiple and flexible payment solutions and credit options through its consumer financing services.  Based on the 6/25/22 reconciliation of EBITDA to Adjusted EBITDA in the 10Q, the six month “income from operations” likely includes either consumer finance results and/or gain on sale leaseback of certain Badcock properties earlier this year.  Regardless, it is not representative of the current earning power of the business FRG will manage going forward.

FRG will shift Badcock’s consumer financing business to third-party vendors in the near future.  In the interim, the FRG balance sheet reflects non-recourse debt associated with the sale of certain Badcock customer accounts receivable.  As described by FRG’s CFO on the Q2 2022 earnings call:

“We are still in the process of transitioning consumer finance (inaudible) Badcock from in-house to third-party partners and have excluded the noncore results of the finance business from adjusted EBITDA and non-GAAP EPS. While we can't pro forma the income statement for consumer lending, the balance sheet continues to reflect securitization debt and accounts receivables despite most of the receivables having been sold to third parties. Once we discontinue originating customer loans, we believe that securitized receivables will be accounted for as a sale and the related assets and liabilities will no longer be reported on our balance sheet.”  - Eric F. Seeton, FRG CFO 8/4/22

Neglecting to eliminate this “debt” from the FRG leverage calculation leads to the perception that FRG’s leverage ratio is nearly 1 turn in excess of the high end of its optimum range.  Moreover, this “debt” comprises 98% of the current maturities at the end of Q2 2022.

It should be noted that the Badcock purchase by FRG was a remarkable acquisition and speaks to the dealmaking ability of Kahn and his team.  On 11/22/21 FRG paid $580 million cash for W.S. Badcock Corporation.  FRG then promptly sold $400mm of receivables to B. Riley (in a similar transaction to the follow-on A/R sale recently completed); completed the sale-leaseback of all three W.S. Badcock Corporation (“Badcock”) distribution centers for gross proceeds of approximately $150 million to affiliates of Oak Street Real Estate Capital; and completed the sale-leaseback of 35 retail W.S. Badcock Corporation (“Badcock”) locations for gross proceeds of approximately $94 million.  In sum, Badcock paid no net cash for Badcock’s remaining $60mm pro forma LTM EBITDA.

Buddy’s 

The Buddy's segment is a specialty retailer of high quality, name brand consumer electronics, residential furniture, appliances and household accessories through rent-to-own agreements. 

The Buddy's segment is a specialty retailer of name brand consumer electronic, residential furniture, appliances and household accessories through rent-to-own agreements. The rental transaction allows customers the use of high-quality products under flexible rental purchase agreements without long-term obligations.

Sylvan

The Sylvan Learning segment is an established and growing franchisor of supplemental education for Pre-K-12 students and families in the U.S. and Canada. Sylvan addresses the full range of student needs with a broad variety of academic curriculums delivered in an omnichannel format. The Sylvan platform provides franchisees with the ability to provide a range of services, including on premises, virtually, at a satellite location, and in the home. 

There is documented learning loss/missed learning in K-12 students as a result of the home schooling required during COVID lockdowns.  It is likely that the need for remedial services, like Sylvan, to help close this gap will provide a tailwind for Sylvan in the years to come.

Recession?

FRG believes it has assembled a group of businesses that will perform well, as a whole, through the business cycle.  Management believes that in a “normal” recession, i.e. one in which supply chain costs have not exploded, certain FRG business will be recession-resistant.  FRG provides the following historical context to support this view. Liberty Tax is no longer in the portfolio.

Valuation

Here is the pro forma 2021 performance of the businesses, assuming a full year of results for each business:

Given the impacts to the business year to date, particularly the supply chain impact on American Freight, FRG management lowered it’s 2022 EBITDA guidance from $450mm to $390mm in the Q2 2022 earnings call:

Historically, management has stated a target leverage ratio, through cycles, of 2x-3x, so even at the updated guidance, they are within their target, assuming you properly eliminate the securitized A/R debt (as discussed above).  

Let’s assume that the revised guidance is still too optimistic.  Here is a look at EBITDA of roughly $350mm for 2022, or a 10% further guide down with the biggest hit at the home furnishings businesses.

Even in this scenario, and despite a significant inventory buildup in H1 2022 (as discussed above), we believe the dividend can be sustained:

Debt

Significantly, the two term loans have no principal payments due prior to maturity (earliest March 2026) and the vast majority of the “current maturities” on the 6/25/22 balance sheet are non-recourse and are related to the aforementioned Badcock accounts receivable sales.  Thus, there are no material cash current maturities, despite what a cursory look at the most recent balance sheet would indicate.  

The recent sale of Badcock A/R may be used to pay down the ABL revolver, thereby increasing capacity for stock buybacks, dividends and other purposes.  In addition, on 8/22/22, FRG’s lenders increased their revolving credit facility commitments from $250 million to $400 million.

FRG is permitted to pay dividends under the ABL based on the following conditions, with which it is currently in compliance, particularly given a paydown of the ABL from the recent (October 2022) A/R transaction with B. Riley.:

Outlook for 2023

Looking ahead to 2023, assuming (i) the already subsiding freight costs revert to normal for AF and the other home furnishing-related businesses, and (ii) modest growth at the remaining businesses (note the respective franchise backlogs), we could conservatively see the following:

Note also that Q1 is historically the strongest quarter for businesses other than TVS and PSP.

Valuation Summary

Here is the outlook for a possible FRG share price at various FCF multiples on projected 2023 FCF per share, with potential share price returns excluding dividends (currently $2.50 per year):

One can debate whether certain segments deserve different multiples, but directionally, we believe the stock is too cheap at 5x aggregate FCF.  

Stock buyback

In May 2022, FRG approved a $500mm stock buyback program.  As Brian Kahn pointed out in the Q2 2022 earnings call, 

“...we authorized a $500 million buyback over the next few years. We did not intend to do a [10b5-1]. We want to be strategic about when and how much we acquire. Certainly it is something that -- just to say we've not had an open window, still don't have an open window. We didn't have an open window because of the Kohl's transaction, and then we got into the quiet period. So we haven't had any window yet to speak of. But look, we will -- we now have the ability to weigh buying more of our existing businesses against buying other businesses. That's not a tool that we've had in the toolbox for. We have it now. We're very excited about that, and I don't think anybody knows our business is better than we do. Which is a good thing. So I think we'll be opportunistic as we can be” - Brian Kahn 8/4/22

We expect the company will report on 11/3/22 having made re-purchases in Q2 prior to the blackout period; we also expect they will resume buybacks shortly after Q3 2022 earnings are announced given the current stock price levels.  As shown above, FRG has the capacity for buybacks even given the revised 2022 outlook.

Dividend outlook

As shown above, we believe the current dividend is sustainable, even with a haircut to the revised guidance, given the relief to AF costs among other line items.  In addition, as set forth in the March 10, 2021 earnings call, Brian Kahn laid out his view on the dividend.

We all know Mike Tyson’s quote about a plan and a punch in the mouth, but we believe FRG will work hard to ensure a flat dividend at least, if not an increase in the quarters to come.

Business outlook summary

Why is it cheap?

• Fears of a potential recession’s impact on “retail” businesses
• Apparent leverage: misunderstanding of treatment of securitized Badcock accounts receivable
• Cash flow uncertainty and potential for dividend cut as a result
• Poor home furnishing business performance masks strong growth in non-home furnishing businesses 
• Temporary and subsiding COGS impact for American Freight in particular
  

Catalyst

• Resumed buy-back post Q3 2022 earnings

• Re-affirmation of $2.50 dividend, or possibly increased amount

• Elimination of Badcock A/R accounting which makes leverage look too high

• Normalization of American Freight costs 

• Potential for acquisition of a new business

• Refinancing of term debt

• Franchise backlogs converted to franchises