Description

Double digit FCF yield, high insider ownership, 40%+ ROE, 20% EBITDA margins, negative working capital, fifth of mkt cap in cash, recession resistant business, fat 7% yield, a growing business, and lastly a free growth option on China. What’s the catch – Singapore listed and a small cap to boot.

Food Junction is focused on food and beverage (F&B) service-management within food courts located in Singapore (14) and Malaysia (2). While the business will take a few paragraphs to explain, it is best to think of the company as a franchisor, collecting annual management fees from franchisees while additionally operating a handful of company owned units.

Food Junction leases space from landlords, and in turn franchises operations to stall owners. Food Junction has branded all of its food courts under the FJ name, with customers finding approximately 12-17 independently operated stalls within each FJ food court. The brand is very established in Singapore and carries a reputation for high quality, reasonable price, and exceptional cleanliness.

FJ makes the majority of its money from stall operators who pay the company a management fee based on a fixed percentage of sales, subject to minimum sales. The franchise fee differs between locations and stall type, but typically is in the range of 20-28% of sales. In return for the management fee, Food Junction handles the various operational aspects of operating the food stalls which includes cleaning, dishwashing, advertising and promotion, cash management, and general maintenance. Lastly, the operators gain access to lucrative locations in prominent malls, hospitals, education facilities that would otherwise be difficult to procure independently.

The company also operates 2 Food Square (FS) locations that are branded separately from Food Junction food courts. Food Squares bring a “homely” and comfortable dining experience to recently constructed Housing Development Board (HDB) estates. In the case of the Food Squares, FJ operates all of the stalls as opposed to sub-letting space to independent operators. The FS benefit from sharing a central kitchen within each location, while still offering a wide variety of banners from which customers can order distinct dishes. The FS are typically about one-third the size of a food court, but are open for longer hours (Eg. dinner) and have a higher proportion of takeaway traffic. However, FS only account for 10% of total revenue and are not central to the investment thesis.

Now that you know what the company does, let’s jump quickly into valuation. The company has a September year-end, with the LTM results incorporating the 2003 SARS period. Nonetheless, to be conservative, we will proceed using LTM numbers that are obviously depressed (which in part creates the opportunity).

($ Singapore millions)
2002 2003 2004F
Sales 44.0 46.7 49.6
EBITDA 11.1 9.7 10.8
% 25.2% 20.8% 21.8%
EBIT 7.6 7.9 8.7
% 18.4% 18.0% 17.5%
Net Income 6.2 6.6 7.2
FCF* 7.6 4.7 6.0
*Net income plus D&A, less working capital, less growth and maintenance capex, less deferred taxes

Shares Outstanding – 120 million
Share Price - .58
Mkt Cap - $69.6m
Cash less working capital*- $14.5m
EV – $55.1m
EV/LTM EBIT** – 7.0x
EV/2004F EBIT** – 6.3x
EV/LTM FCF – 11.7x
EV/2004F FCF – 9.2
*To avoid any theoretical arguments, I have gone the conservative route and backed out the negative working capital from the company’s cash balance
**Keep in mind tax rate in Singapore is ~21%, making the EBIT multiples that much more attractive versus US comps

As for actual FCF, this is a very cash generative business, and our forecast calls for $6.0 in FCF to be generated in 2004 (implies a 10.8% cash on cash yield). 2003 was a soft year for FCF generation because the FS were opened (capex and start-up losses) and EBITDA margins were depressed by SARS. We are well below analyst consensus numbers for revenue and profits for 2004F not because we actually think the company will miss, but because we like to err on the side of conservatism. With respect to analyst numbers, consensus net income figures are $8.0m in 2004 and $9.4m in 2005. With respect to FCF, analysts are calling for approximately $8m for each of 2004 and 2005. Using analyst numbers the FCF yield increases to 14.5%, but I would rather be conservative than be accused of being promotional.

As for additional details, I will proceed under the premise that the best defense is a good offense. I have tried to anticipate the various questions I will receive and have posted my answers below. Given the nature of VIC, I am sure I have not even brushed the surface, but here is my feeble attempt:

1) I still don’t understand why you think this is such a good business?

FJ’s standard lease with a landlord is for 6 years, and includes one rent revision at the end of the third year. The standard lease with a stall operator is for two years, upon which the agreement is renegotiated (typically upwards in FJ’s favor). Given that rent is the largest component of costs, FJ benefits from positive leverage when rates with stall operators are renegotiated.

The average food court requires $2.5m of capex to set up, of which stall operators cover about 60% (net cost of $1.0m to FJ). Historical sales have averaged around $1.4m per food court and EBITDA margins on the food court business over the past two years haven been ~42%. Assuming a food court reaches mature margins and sales in year 3, the pre-tax IRR on a six year lease is 40% (payback is 1.5-2.5 years depending on the time it takes to reach maturity).

In the event that FC renews the lease for another six years, the pre-tax IRR moves up to 43%. The renovation costs associated with renewing a lease are typically 75% of the original investment, with stall operators again picking up 60% of the tab. Both the 6 year and 12 year IRR calculations ignore working capital, which is conservative since the company has a negative working capital dynamic.

With respect to working capital, total revenue generated by the stall operators are collected daily. A tally is carried out on revenue against sales receipts and a penalty is imposed if there is more than 1% leakage. The amount of management fees attributable to FJ are computed at month-end and the balance refunded to the stall operators in the second week of the following month. Hence, the stall operators provide FJ with a negative working capital float and FJ has zero financing/bad debt risk.

Even with excess cash on the balance sheet, the company has generated 40%+ ROE’s over the last three years and margins are top quartile on a global basis. As discussed previously the company is very cash generative and can easily support and grow dividends without drawing upon the large cash cushion. I realize VIC members may want to get into a lengthy discussion regarding whether one should capitalize the leases and treat as debt (commensurately reducing ROE and net cash), but our quantitative analysis was focused on future cash generation as opposed to mental masturbation regarding the company’s theoretically correct performance metrics.


2) Why do landlords not enter this business directly?

Upon establishment, FJ originally had to try and convince landlords of the concept. However, the situation has now developed to the point that landlords actually seek out FJ to manage food courts - FJ presently has 24% of the market compared to nothing 10 years ago. In fact, FJ no longer needs to compete in tenders, and is often able to negotiate first right of refusal on any new locations opened by existing landlords.

To sum it up, landlords do not want to deal with many different mom and pop operators, and prefer dealing directly with FJ. Moreover FJ maximizes the productivity of Food Courts by adeptly managing the product mix and ensuring a high standard of cleanliness. As an isolated example, there are 17,000 eateries in Singapore, yet FJ’s 200+ stalls account for over half of the “A” rated eateries as determined by the Singapore National Environment Agency (health and safety board).


3) Why do operators need FJ.

As with a typical franchise/franchisee relationship, FJ provides guidance on basic selling techniques, store design, quality assurance, etc. But most importantly, FJ allows the stall owners (who are typically not actually operating the stalls – as with many successful franchisee businesses it is not atypical for an individual to own multiple stalls) to operate as relatively silent partners. For example, FJ has set up closed circuit TV’s in every food court to allow FJ management to monitor movements and supervise operations. Not only does this allow FJ to ensure a high standard of conduct and cleanliness, it allows them to monitor every till real-time and keep pilferage to a minimum. As an additional example, it is worth noting that bathroom faucets are monitored and employees are subject to a $100 fine if the leave the washroom without washing their hands (I can only assume they would probably cane somebody if they ever caught them spitting in the food). Essentially FJ management realize that the devil is in the details, and they run a very tight operational organization.

With respect to the design and aesthetics of the operations, interested parties can visit www.foodjunction.com.sg to view pictures of each location. As an aside, there has historically been greater demand for new stalls by operators/investors than the company can meet, which is qualitative evidence that this is a win-win situation.


4) OK, you convinced me this business deserves to exist, but what does management do with the cash?

The pay regular and special dividends. Dividends have been consistently increased over the past three years and there is no reason to suggest the increases will abate (mgmnt confirmed this to us). The stock currently has a trailing dividend yield a little shy of 7.0%, and one can expect the yield to increase to between 7.5-8.0% for 2004 based on current market prices.


5) You are asking me to invest outside of the USA, home of the tightest corporate governance in the world.

Also home of Tyco, Worldcom, Enron… OK, more seriously, there is only one class of stock, and founders/management/BOD own approximately half the company.

FJ’s Chairman and CEO is Fu Che-Yen. Fu was one of the founders of the company back in 1993. He became managing member in early 2000 so that the prior managing director (Quek) could concentrate on his other businesses. Fu is currently 55 years old, but was independently wealthy by the age of 38 due to astute property dealings in Australia. The guy is a workaholic who realizes that this is a business where execution and vision require equal attention. We love CEO’s that are already rich but work because they love what they do. Couple that with high inside ownership and you should be able to put your fears at ease.

As for our stamp of approval, we have been in touch with the company. The only thing we don’t believe in stock buybacks. That being said, they explicitly stated that they are committed to creating value for shareholders, with dividends being the primary driver. Oh yeah, the company issues no stock options and annual bonuses are dependent on hitting quantifiable performance targets.


6) Ah, I got you. I see from Bloomberg that one of the founders recently dumped stock. Why should I buy when this guy is selling?

This is a rather lengthy story, but if you are still with me and interested I will refer you to page 77 of the IPO prospectus. Approximately five years ago Quek, the founder with the largest shareholding (~25%), wanted to go into China. The other founders/shareholders said too risky, too early, no way. So Quek went into a JV on his own independent of FJ. Needless to say Quek and his partner lost money for five years and the operation has just started to turn a profit.

When FJ went public, the IPO prospectus stated that if FJ ever wanted to into China, FJ would negotiate with Quek on an arms-length basis to purchase his interest in the Chinese JV. In the event that no agreement is reached, Quek would have to resign from the board and would no longer receive access to the company’s management or financial statements.

Earlier this year, after seeing that Quek had finally tweaked the concept enough to make money in China, FJ approached him regarding a buyout. Quek said OK, but his partner said “I didn’t slave away at this for five years just to sell as the going is getting good”. To sum up, FJ didn’t want a JV with Quek’s current partner and no deal was reached. As such, Quek was given one week to dispose of his holdings and resign from the board. His holdings are now below 5%, and he was able to reduce his holdings at an average discount of 5%.


7) This company is too illiquid for me to buy.

Webster’s defines liquidity as “Available cash or the capacity to obtain it on demand”. Quek was able to sell ~25% of the company on less than a week’s notice, and the buyers are reportedly still looking for size. That is good enough for us.

As for obtaining the stock, the average daily volume YTD according to Bloomberg is 475,000 shares. This implies daily turnover in USD of just over $150,000. We had no trouble building a position without driving up the price, and in full disclosure our avg cost is right around current prices.


8) Singapore is a small country, how are these guys going to grow?

As noted above, Quek is making money with the concept in China. FJ has already opened two facilities in Malaysia, has publicly stated it is going into China, and is also kicking around the idea of Thailand.

FJ management is well known in Asia and is typically sought after for expansion opportunities. It is worth noting that the historical pace of growth reflects management’s conservative attitude as opposed to a dearth of opportunities. As an example, the Malaysian expansion came about after FJ was approached by landlords to run the food courts, as opposed to having to cold call for new locations. Similarly the company was recently invited to Indonesia to evaluate some opportunities, which may or may not be interesting. All in all, we would rather the company grow slowly and ensure that every location is profitable from the start (current mandate for new locations) rather than grow for the sake of growth.

We believe that management will on average open 2 new food courts per year, growing sales/profits by 5-10% each year. Granted this isn’t gangbusters growth, but we are content receiving a steadily growing cash dividend each year that already offers an attractive current yield. The CEO stated recently in an interview that “I would rather we stay on the safe route here and earn less. It’s safer and guaranteed. If we just earn 10%, 10%, 10% the company can still grow”.


9) I have read China is going to have a hard landing and I think all of Asia is going to go down with it?

This is a relatively recession resistant business. Food courts occupy a unique slot of being cheaper than restaurants, yet more expensive than Singapore hawkers (outside food markets). The FJ formula is akin to an upscale food court where you have a host/hostess and high quality food at reasonable prices. During a recession restaurant patrons will downgrade to the food courts, while during boom times people will move up from hawkers or brown bags. The company performed admirably during the last Asian crisis, as between FY1998-2001 tunover grew by a CAGR of 23% and earnings by a CAGR of 40%. We believe there is no legitimate reason to suggest a future economic slowdown will have a demonstrably different impact.

Similarly, a secular trend working in the company’s favor is the rising participation of females in the workforce, which has grown from 39% in 1995 to 44% in 2002.


10) What about the Singapore currency.

You can either hedge out the currency or simply go long the SGD. For what it is worth Dr. Marc Faber has been pounding the table on going long the SGD during the past two or three issues of his Gloom, Boom & Doom newsletter. Faber is a member of Barron’s round table and is a lot smarter than the writer of this idea. Needless to say we went long the SGD for this investment.


11) OK, I buy that this is a good business but I don’t like that these guys operate their own stalls. If they really understood capital allocation they would not operate any stalls.

FJ operates about 20% of the stalls in its Food Courts. Originally FJ franchised almost all of its stores. However, early on it realized that the drink and dessert stalls had attractive economics because they required a de minimis amount of capital and had the highest margins of all their stalls. As such FJ now operates virtually all of the drink and dessert stalls in FJ locations. Quite simply while this brings down the group ROE, it maximizes cash flow and allows the company to earn a rate of return well in excess of its cost of capital (I can run through the numbers if any VIC members want me to go through the exercise).

As for the Food Squares, they are a small portion of the overall business and allow the company to gain experience at running stalls themselves. For the record, mgnt has told us explicitly that they will not be opening up any additional FS outlets. However, mgmnt believes that a modified FS concept may be a solution to FJ’s concerns that local Chinese operators are untrustworthy and irresponsible (Quek’s experience). In the event that FJ’s Chinese expansion necessitates greater supervision of operations, the company now has experience to draw upon. That being said, management is very capital disciplined and recently closed down a Food Square after only four months when they realized it was not going to be profitable.


12) Your numbers show an improvement in results from 2003. Why should I believe you?

2003 was not a great year for the business due to a number of factors. Firstly, the startup costs of the FS business had a negative EBIT impact of $1.5m on a company that only did $8.5m in EBIT total. Assuming the business gets to breakeven in 2004, you pick up 17% growth in EBIT off the bat. When mgmnt originally signed the FS leases they negotiated the flexibility to terminate the FS leases with a one-month notice and no penalty. As such investors can expect the company to exit the business quickly if profitability does not improve.

The second major contributor to the earnings improvement will be a full recovery from SARS. During 2003 FJ’s food court in the Singapore SARS hospital was closed for two months, and traffic only recovered by 50% once the hospital was reopened to the public. Similarly another nearby food court saw revenue contract 30% in April-May. The remaining food courts in Singapore all suffered declines of 5-10% during April-May. While one cannot quantify the exact benefit, our math suggests investors should expect a low to mid single digit revenue rebound solely from this factor.

Lastly, there were no net new food courts added last year, while this year will benefit from a full year’s contribution from the Harbourfront location (only 7.5 mnths last year) as well as Funan (nothing last year – 10 mnths this year).


13) Yeah this is a good biz with good mgmnt, but it trades in Singapore and so deserves a correspondingly lower multiple?

We are bottoms-up global value investors and evaluate each investment on a case by case basis. We obviously believe Food Junction trades at a material discount to its intrinsic value and we have not focused on comps. Nonetheless, as a comparison the Singapore Times Index (STI) currently trades at 17x earnings (according to Bloomberg). Moreover, readers should keep in mind that Singapore is a very progressive Asian nation, not a basket case like Indonesia or the Philippines.

Catalyst

- Near-term earnings improvement due to recovery from SARS
- Cautious growth in China
- Continued expansion in Malaysia
- Defensive business if Asia goes into a downturn
- Increase in the dividend
- 7% yield