Description

Friendly Ice Cream Corporation is a New England based restaurant chain that provides full service casual dining for families. The Company is best known for its ice cream and sells its ice cream products to retail stores. The Company enjoys strong brand awareness in the Northeast. In 2000, the Company completed a debt for equity swap necessitated by a failed leveraged buyout. Following the restructuring, management did an excellent job further reducing debt. Poor operating results have driven the stock almost 60% lower from its 52-week high of $19.30 to the mid $8’s range. The stock has also likely faced technical pressure due to year end tax selling. The factors driving the weak operating results are most likely temporary. The Company also has significant franchise growth potential. It also has a very defensible niche as the only casual dining chain focused on the ice cream space and many prime northeast locations where it is hard to put a competing box. While the real estate alone probably does not cover the stock price, it is a hidden asset of the company. At these prices, FRN represents a very attractive value investment at 6x depressed EBITDA. Since the Company is highly levered (net debt of 4.6x projected 2004 EBITDA, market capitalization of only $65m) the returns to equity from an operating turnaround could be substantial. The Company’s stock could trade at $15-17 with only marginally improved operating performance and continued franchising.

The Company’s recent deterioration in performance has been driven by a variety of factors: 1) cooler weather, 2) higher oil prices, 3) higher cream prices and 4) heavy competition in the retail segment. These factors should prove temporary and/or cyclical. Cooler weather results in less traffic at FRN due to lower ice cream sales. The Company reported particularly weak results over the summer and at lunch and dinner meals when ice cream is most often consumed. Clearly, the Company cannot control the weather or this risk. However, there is no reason to assume weather should be a permanent negative factor. Higher oil prices have hurt the Company (as well as its peers in the lower price full service segment) as more middle income families stay home as opposed to driving for dinner. The price of oil has begun to subside since it reached its $50+ peak. Cream, an important cost of goods sold in ice cream production, traded at extremely high levels this year (almost doubling). The price of cream has already begun to moderate, declining almost 16% recently. The Company could not pass on the cost of higher cream prices in the retail segment due to intense super market competition. Historically, cream prices have had high volatility. The recent price decreases and lack of a discernable long-term rationale for why cream prices should remain at such levels indicate that cream prices should fall from their highs. While competition in the retail segment is unlikely to abate, lower cream prices will enhance margins and FRN has introduced some promising new products (including ice cream cakes and healthier versions of its best selling ice cream flavors).

FRN also has great upside with franchising. While FRN has reported poor results at Company owned restaurants, franchises have continued to perform extremely well. For the most recent quarter and year-to-date, comparable store revenues for Company owned stores are negative 1.7% and negative .9%. But for franchises, comparable store revenue is tracking up 2.7% for both the most recent quarter and year-to-date. Franchises have reported 14 consecutive quarters of positive comparable store revenue growth. Franchising has many advantages for the Company, including: 1) an immediate source of liquidity once stores are sold, 2) a revenue stream from licensing and food service that has high margins and requires minimal capital costs and most importantly 3) expansion into new states with no capital costs. The Company selects its franchisees very carefully and almost always sells restaurants as part of larger development deals. For example, the Company’s Florida franchises have been particularly successful because the brand has high awareness from North Eastern transplants. Combined with the hot weather and a very strong local area developer, you could over time develop Florida into an area that rivals the North East in importance to the company. If someone wants to buy a Company restaurant, they must commit to spend capital to develop more restaurants within a given region. The positive impact on EBITDA on franchising will increase over time as the franchise base grows and the franchisee themselves take a lead role in developing new stores.

The Company is currently projecting $45-50m of EBITDA in 2004, down from its earlier guidance of $50-55m. In 2003, the Company posted $56m in EBITDA and in 2002 the Company did $61m. It does not take aggressive assumptions in terms of margin improvement and franchise related growth (the Company has a stated goal of adding 20-25 franchisees per year over the next few years) to return to a $60m EBITDA run rate (an over 25% improvement from the mid-point of 2004 current guidance). The table below summarized projected EBITDA under a variety of scenarios.

New Franchises
15 20 25 30
EBIT Margin Inc. EBITDA
.25% 55.1 55.5 56.0 56.4
.50% 56.7 57.1 57.5 57.9
.75% 58.2 58.6 59.1 59.5
1.00% 59.8 60.2 60.6 61.1


The free cash flow yield on $60m of EBITDA is also a very compelling 18.5%. This yield is derived from the following analysis: $60m EBITDA less $20m capital expenditures less $20m interest expense less $8m cash taxes (assumes 40% rate, D&A of $20m)= $12m free cash flow. $12m FCF divided by 7.7m shares outstanding $1.55 per share. Based on the current share price of $8.40, the indicated yield is 18.5%.

Catalyst

1) improved operating results due to lower commodity prices, 2) franchise led growth and 3) deleveraging. Due to its capital structure, if the Company were to hit $60m in EBITDA again, the stock price could more than double assuming no multiple expansion. The stock could hit $15-$17 per share with a return to more normalized operating margins and continued franchise growth. The Company clearly faces risk relating to high food input prices (cream, vanilla, chicken) as well as general economic conditions. Continued poor operating performance could also force the Company to slow further its plans to refurbish all Company owned stores, which could hurt customer traffic. The Company is also highly levered and has recently violated covenants. The liquidity risk is partially mitigated, however, by a recent refinancing. The bulk of the Company’s debt ($175m of 8.375% high yield notes) is due in 2012. The Company also has no borrowing on its revolving credit facility for which it recently received covenant waivers.