Description

Introduction: Freshii (TSE: FRII / OTC: FRHHF) is Toronto-based healthy fast food chain with about 420 restaurants in 16 countries. Nearly all these stores are franchised. It also provides “grab and go” meals through third-party outlets. Freshii completed its IPO in January 2017 at C$11.50 / share. It now trades at about C$2.07 / US$1.63 per share so, clearly, something has gone wrong. Note: Even though Freshii’s primary listing is in Canada, it reports its financials in USD, so all financials are USD unless otherwise stated.

Summary: Looking for a consumer stock that hasn’t run to the moon and is even (sort of) in the health and wellness space? I present Freshii. This Canadian restaurant chain has had all sorts of problems in its four years as a public company…and then it was hit by the pandemic last year. So, why own it? Well, Freshii’s stock has been valued as if it’s going to go out of business, but there appears to be little danger of that because the company had $31.2 million (C$40 million) in cash on its balance sheet at the end of the last quarter (which is $0.98 / C$1.25 per share, or about 60% of the current stock price) but isn’t burning cash in about the most difficult market conditions imaginable. Net of cash, Freshii’s current EV is about $20 million, which is less than its revenue in both 2018 and 2019. A restaurant chain trading at less than 1x revenue is rather sad / pathetic. Freshii is exceedingly asset light as only operates two restaurants and franchises all the others. The number of stores has dropped over the past two years, but I think the store base will begin to grow again next year. I’m being quite safe (I think) and assuming upside of about 40% to $2.30 / C$2.93 over the next 12 months.

VIC: Freshii was written up on VIC as a short by TheSkeptic in June 2017 and as a long by ThatDu04 in June 2018. I suggest looking at both reports. The main thesis of the short report was that Freshii was overvalued, had benefitted from one-time franchise fees, would not be able to open as many stores as projected, and that its comparable sales growth was unsustainable. This thesis was right on the money and came with the stock near its all-time high. Freshii’s IPO turned about to be very well timed for the selling shareholders. The later, bullish report (which was published when Freshii was trading at more than 40% below its IPO price) was based on the idea that Freshii’s business had bottomed, was generally healthy, and had potential for many more stores. Unfortunately, Freshii’s results only worsened after that, and most investors abandoned it.

History / Background

Freshii was founded in 2005 in Toronto by 23-year old Matthew Corrin, who had borrowed C$250K from his parents to start the business. Corrin had no restaurant experience or even a business plan but thought there was an opportunity to create a fast food chain based on healthy food for millennials like him. Freshii was primarily a salad restaurant at first. Corrin continues to serve as CEO and controls the company through Class B super-voting stock, which gives him about 67% of the voting power. The chain expanded to Chicago two years after its founding and has since grown to more than 400 stores in 15 countries. All but two locations are franchised, and many of the franchisees are millennials. Freshii claims to have expanded to 100, 200, and 300 stores faster than such large fast food chains as McDonald’s, Domino’s. and Subway. This is not necessarily a good thing. The company’s January 2017 IPO was met with much fanfare, as it was priced above the high end of the projected range and valued the company at about C$400 million. Most of the proceeds from the IPO went to selling shareholders. Investors were excited about Freshii’s positive same-store sales growth and potential for many more stores as it had posted 16 consecutive quarters of positive same-store sales growth (including many quarters above 5%) at the time. Freshii was viewed as part of the big new trend towards healthy fast food.

Corrin often compares Freshii to Zara, the fast fashion chain that copies popular designs and sells them at lower prices, because it changes menu items frequently. Freshii sells food items like wraps, burritos, and salads and the average entrée item costs less than $10. Lunch is the most important daypart. The franchise fee is $30K and the build-out cost (including this fee) is about $260K. The start-up and operating costs of Freshii stores are lower than for other restaurants because there is no need for expensive equipment like ovens, grills, and freezers, and the stores are only about 1,200 square feet on average (some are much smaller). A Panera restaurant, for comparison, can cost $1 million or more. Freshii claims cash-on-cash returns to franchisees of 40%, but this is likely overstated as it ignores manager and owner compensation. Still, it has had great demand for new franchises. It expanded from 70 stores at the end of 2013 to more than 300 by early 2017. Freshii’s franchisees pay a royalty fee (for traditional stores) of 6.0% of gross weekly sales plus a fee of 1.5% of gross sales for advertising.

How It Went Wrong

Freshii’s plans started to come apart soon after its 2017 IPO. At the time, it projected that it would have about 825 stores, systemwide sales of $355-$365 million, and adjusted EBITDA of $20-$22 million in 2019. Soon after, it backed off on these goals and, ultimately, didn’t even come close to achieving them. In 2019, Freshii had $184 million in systemwide sales and adjusted EBITDA of $5.8 million ($1 million less than in 2016), and it closed the year with just 470 stores. Freshii continued to sign up new franchisees in 2017 and 2018, but the productivity of its restaurants began to falter, turning negative in the second half of 2018. Its same-store sales growth fell to negative 1.2% in 2018 from positive 5.5% in 2017, and its systemwide average unit volume (AUV) dropped 10% (to $457K from $507). AUVs were around $600K at the time of the IPO. Freshii began to close some underperforming locations in 2018. Then, its results worsened in 2019, as it suffered a same-store sales decline of 2.7% and its systemwide AUV fell to just $427K. At this low level, Freshii’s AUVs were like those of weakening Subway, which has closed a few thousand stores over the past few years. Corrin’s credibility has taken a big hit after he over-promised and under-delivered. In November 2018, Freshii stopped providing an outlook to investors and the small number of analysts who still follow this microcap stock.

Freshii, like so many other retailers and restaurant chains, grew too quickly and could not sustain its early growth. While the trend towards healthy eating is real, Freshii is hardly alone in trying to benefit from it. Direct competitors include Sweetgreen, Saladworks, Just Salad, Fresh & Co., Chop’t, Just Salad, and Grabbagreen. Sweetgreen is quite a bit smaller than Freshii in terms of units, but it was valued at $1.6 billion in 2019. Then, there are a seemingly infinite number of broader competitors, like Chipotle and Panera, as well as grocery stores, convenience stores, single location restaurants, and non-traditional competitors like Farmer’s Fridge. Aside from the intense competition, Freshii has struggled with inconsistent food quality and rising operating costs for franchisees. Freshii swaps food items in and out frequently but, clearly, not all of them have been winners. One downside is being almost entirely franchised is that some franchisees are certain to be financially and operationally weaker than others. Freshii hurt itself by entering too many markets and expanding too quickly in some areas. Its international stores, which are in such far-flung places as Ecuador, Australia, and Kuwait, have been much less productive than those in North America. Some international stores have been closed. While it continued to open more franchised locations than it closed, 30 franchised locations shuttered in 2018, and then another 36 closed in 2019. Meanwhile, the number of company-owned stores has fallen from five in 2019 to just two at present.

Freshii viewed 2019 as a reset year, but it has been forced to reset again in 2020 due to the pandemic. Like most others, Freshii’s sales plummeted when the virus spread in North America in the second half of March. At one point in April, as many as 50% of its restaurants were closed. Freshii reported its Q1 results very late and did not hold a conference call. By the end of Q2, more than 80% of its global stores had reopened and its results, while horrible, had started to recover. Freshii also got serious about closing locations which were not expected to be viable during or after the pandemic. After closing eight stores in Q1, Freshii (working with its franchise partners) closed 40 locations in Q2. Then, in Q3, another 13 franchised stores and one company-owned store were closed. A disproportionate number of the stores that closed were international locations. Of the North America stores that have closed, Freshii has said that some of them might reopen if better franchise partners can be found and if rents can be reduced. Net of openings, Freshii’s global store base dropped to 420 stores at the end of Q3 from 470 at the end of 2019.

Freshii has cut costs during the pandemic, including headcount reductions at its corporate headquarters. It helped its franchisees by delaying royalty payments when the stores were closed and working with them to reduce rent. Freshii also committed $1 million in additional funding for marketing and growth programs to help the franchisees. The company hasn’t done a lot of traditional advertising (like TV) in the past.

Given its tiny market cap and problems, Bay and Wall Street interest in Freshii has declined precipitously. There were no sellside participants on the Q2 call, and only one (from Canaccord) on the Q3 call. There were typically questions from six analysts on the calls back in the glory days of 2017.

Growth Plans / Opportunities

Corrin (now 38) probably would have been forced out by activists by now if he didn’t have voting control. He admits that the company tried to do many things at once and lost focus. As it is, Corrin has said many times that Freshii is a lifetime job for him and he is committed to fixing it. There are reasons to believe it can be done. Freshii is in no danger of falling into financial distress since it only spent a fraction of its IPO cash and has generated free cash flow even during the pandemic.

Clearly, the priority must be to improve same-store sales and raise the AUV. Freshii grew too fast and didn’t always have the best franchise partners (despite only accepting a very small percentage of applicants). Since the beginning of 2020, it has transferred 10 stores in attractive locations from weaker franchisees to stronger franchisees. Other stores in locations viewed as non-viable after the pandemic have been closed. It will help in the short- and long-term that weaker stores and franchisees have been eliminated.

Freshii has long tried to build a second daypart and began testing dinner items in 2019. The chain has always been very lunch-oriented (60%+ of sales). To attract more consistent traffic at other times, Freshii introduced Plates, a new dinner menu, in 2020. Dinner, historically, has accounted for less than 20% of sales. Plates began as a test in Vancouver-area stores in mid-2020 and has since expanded across Canada. If the concept works, it could greatly improve the economics of the stores and lift the low AUVs. The Plates dinners cost about C$13.99, which is well above the cost of lunch items. Freshii has noted that its average check is increasing, even during the pandemic. The firm has also put more emphasis on its breakfast menu (yogurt and stuff) in the last couple of years. It started selling coffee across its fleet in 2018. Breakfast sales, though, are minimal (less than 10% of sales).

Freshii rolled out a new app in the U.S. and Canada in October 2020, which should boost sales over time. Freshii’s previous app (released in the dark ages of 2016) was way below standard. It was not great for data collection, and it was not driving sales. The new one has a loyalty program called “Veggie Points” (which sounds like something a mother would love her children to have) and should allow for a lot more data collection. More than 90% of Freshii’s stores have made the necessary POS upgrades. Freshii has also expanded its partnerships with DoorDash, SkiptheDishes, and Uber Eats during the pandemic such that 90% of its locations in the U.S. and Canada now have delivery. Freshii has offered delivery for years, but only in select locations due to the cost. It has little choice but to expand it now since the pandemic is hurting its sales in major cities like Toronto and Chicago that are normally dependent on office workers. Sales at the drive-up suburban locations (which account for about 1/3 of the total) are bouncing back quicker than sales at the urban stores.

Freshii is testing a new operating model in some stores with less complexity and fewer menu items. If it works, it could allow for the elimination of lower-margin items, reduce overall costs, and help with franchise profitability. Also, Freshii has rolled out better chicken items which should increase check sizes.

Freshii is building its CPG (consumer packaged goods) operations (called “Freshii Foods”), which it began in late-2017. The company sells “grab and go” items through a few hundred points of distribution, including Walmart stores in Ontario (100 locations), Hudson News, Gateway Newsstands, and Shell stations (200 locations) in Ontario. In July 2020, its food became available at 23 ONroute rest stops in Ontario. Some of these deals are presently limited to Ontario but could expand. Freshii also sells packaged food on hundreds of weekly Air Canada flights, and this business was reportedly growing prior to the pandemic. It also does catering / lunch boxes through its stores. Over time, it could develop into less of a traditional restaurant chain and more of CPG and “ghost kitchen” company. The economics of these types of operations are favorable given the low fixed costs.

Freshii could expand the number of its stores in “non-traditional” places like airports, college campuses, and retailers. It has master franchise agreements with companies like Aramark, Sodexo, SSP America, and Compass Group, that specialize in these places. Freshii has locations inside Walgreens stores in Chicago, Miami, and Philadelphia, and on about 15 college campuses. In 2015, the company opened outlets in a few Target stores, but this collaboration was ended in 2017. Freshii currently has about 40 non-traditional stores.

Given its asset-light model, Freshii could get a lot larger without any significant new expense. If any or all these efforts succeed, Freshii should be able to open many more stores. While the competition is high, there are lots of millennials looking for fresh food.

Share Buybacks

Freshii established a normal course issuer bid (NCIB) in 2018 and repurchased 528K shares at an average cost $1.96 (C$2.59) per share, which is above the current price. It renewed the NCIB in 2019 and was authorized to repurchase up to 10% of the shares, but it suspended buybacks during the pandemic. Given the low stock price, I think it would make sense to continue buybacks after the current crisis. However, the trading volume is already low, so fewer shares could also scare away potential institutional investors.

Historical and Projected Income Statement

The near-term outlook is poor due to the resurgence of the virus over the past few months. Hopefully, the business gets back to normal in 2022.

Earnings

I expect Freshii to return to positive EPS and produce about $6 million in EBITDA in 2022. While that may sound unimpressive, Freshii’s current EV is only $20 million. If my estimate is correct, then Freshii is trading at less than 4x forward EBITDA.

Balance Sheet

Aside from the cash left over from its IPO, Freshii has very little in the way of assets of liabilities. It had $31.2 million in cash at the end of the last quarter, nearly identical to its equity of $31.3 million. For better or worse, it has hoarded much its IPO proceeds.

Cash Flow Statement

Freshii has consistently generated positive operating and free cash flow despite its struggles and the pandemic.

Ratios

Freshii was trading at about 2x revenue and book value as recently as 2019. It traded at less than 1x revenue and just over book value (which is cash) for much of the past year due to the pandemic and its downsizing.

I expect FRII to go back into store growth mode next year.

Valuation

Freshii has about $0.98 / C$1.25 in cash and isn’t burning cash. The stock is trading at $1.63 / C$2.07 so if I back out the cash, the price is $0.65 / C$0.83, giving it an EV of $20.2 million / C$25.9 million. I estimate 2022 EBITDA at $6 million. At 7x EBITDA, this implies a stock price of $2.30 / C$2.93, or upside of about 40%. This is a very conservative valuation – even mediocre restaurant companies usually trade above 10x EBITDA. Freshii itself used to trade at more than 20x EBITDA. Moreover, my estimates for 2022 appear to be very safe. I am only assuming that 2022 EBITDA gets back to the 2019 level, but (1) 2019 was not a strong year for the company, (2) Freshii has since closed its worst-performing units, and (3) I’m not giving much credit at all for the new initiatives. Another way to look at it is that this valuation only values Freshii at only about 0.22x my estimate of 2022 systemwide sales. There have been several restaurant chains that have been acquired for 1x+ systemwide sales in recent years. Admittedly, most of them were doing better than Freshii, but even some weaker chains have sold for more. Papa Murphy’s (which was struggling badly) sold for about 0.23x systemwide sales of about $800 million in 2019. In 2018, Jamba Juice (which wasn’t performing all that well, either) sold for 0.4x its systemwide sales of about $500 million. So, I think there is 40% upside in Freshii’ stock price even if its business doesn’t improve that much and its valuation remains depressed. If it does execute better, its EBITDA would be higher than I assume, and it would likely get a much more attractive valuation. Realistically, I don’t think it should be that hard to get to $4-$5 in the next year or two.

Acquisition Candidate?

Freshii would probably be an acquisition candidate…if not for the super-voting stock. It would seem to be a prime candidate to be acquired by a larger restaurant company or private equity. Freshii has not done well as an independent public company but still seems viable and serves a fast-growing part of the restaurant industry. If Corrin cannot turn it around, he might be amenable to a sale. I suppose there’s some possibility that the management takes it private, but that could occur at an unfavorable valuation for shareholders.

Summary

Freshii has been all but forgotten by investors and is very cheap. It isn’t the next CMG or WING, but it is a decent value play and should still benefit from consumers’ interest in healthy fast food. Even if results remain disappointing, the cash on the balance sheet should prevent bankruptcy. The risk/reward looks very favorable. I’m putting a 12-month valuation of $2.30 / C$2.93 on it for now. However, given the asset-light, low overhead model, it could go a lot higher if the growth initiatives pay off.

Catalyst

end of the pandemic, improved SSS, share buybacks