Imvescor Restaurant Group (IRG.TO)

Summary

We focus on smaller companies with “Ft. Knox” balance sheets and large & sustainable free cash flow yields and we are typically seeking a mid-teens FCF yield or higher on an unleveraged basis.  The objective is for the sustainable FCF to eventually drive up the share price to a more reasonable valuation through share buybacks, debt reduction, dividends, or accretive acquisitions.  Obviously, it is important we have a management team that cares about shareholder value.  We focus on small and micro-cap stocks because there is a much better chance to find an attractive investment opportunity which is under-followed or undiscovered.

Imvescor Restaurant Group (IRG.TO) is a franchisor of four established Canadian restaurant brands located in Eastern Canada.

IRG’s restaurant brands include: (1) Pizza Delight, founded in 1968 with 95 restaurants in Atlantic Canada and Ontario; (2) Mikes, founded in 1967 with 81 Italian themed restaurants, primarily in Quebec; (3) Scores, founded in 1995, with 43 rotisserie family dining and takeout restaurants in Quebec; and (4) Baton Rouge, with 29 casual dining (bone ribs, steak, and seafood) restaurants in Quebec and Ontario.  IRG’s restaurant system has 248 restaurants, which are all franchised except for 8 corporate owned stores.  IRG’s restaurant system does about $400m in total sales per year.

Company Brands and Locations

IRG has about 42m shares outstanding and about 16m warrants with exercise price of 65 cents.  Assuming conversion of the warrants results in total diluted shares of 52m.  IRG net debt as of Q2 of FY13 was about $31m.  IRG’s recent price is $1.30 per share for a fully diluted market cap of about $68m and an EV of about $99m.

Over the past two years, under a new management team, IRG has been de-leveraged, costs have been reduced, operations improved, and several revenue growth opportunities are being pursued.  LTM adjusted EBITDA is $15.5m and we expect $16m+ for FY13, so IRG is trading at 6.2x adjusted EBITDA for FY13.  We expect IRG to generate FCF of about $11m in FY13 so IRG is trading at an 11% unleveraged FCF yield.  IRG’s net debt position - presently about $31m or 2x EBITDA - continues to decline from almost $65m in FY08 and IRG’s cash interest expense is declining rapidly as a result.

We think IRG has excellent growth opportunities for adjusted EBITDA and FCF over the next couple of years as indicated by six months FY13 results, with revenues up 15% and adjusted EBITDA up 40% over prior year (see Detailed Income Statements below).   We believe IRG could generate adjusted EBITDA of $18m+ in FY15 (and this could be conservative) and could trade for 10x adjusted EBITDA or $180m EV less $10m in net debt projected in FYE15, resulting in a share price of $3.30 per share, or 150% more than current price of $1.30 per share.

As a franchisor, IRG has an attractive asset-light business model with limited capital expenditures and working capital needs.  IRG was formerly a Canadian income trust called PDM Royalties Fund before its conversion in 2009 to a corporate structure due to changes in Canadian tax laws.  We believe PDM Royalties paid yearly dividends of $10m to $11m to its unit holders from 2006 to 2009 which highlights the cash-generative nature of the business model.

IRG’s adjusted EBITDA and FCF are both improving under CEO Denis Richard who joined in February 2011.  IRG was previously led by its largest shareholder and founder, Bernard Imbeault, who founded Pizza Delight in 1968 and added additional brand names over time.  In 2005, PDM Royalties purchased the Scores restaurant chain for $32m and in 2006 purchased the Baton Rouge chain for $44m.  These purchases saddled IRG with a large debt burden which, combined with poor management and the recession, strained the company’s capital structure.  Facing a default on convertible debt due in Dec 2011, IRG undertook a dilutive but necessary recapitalization led by Fairfax Financial (Prem Watsa) in Dec 2011, including $10m of 10% debentures and $15m of shares sold at about 45 to 50 cents (through a rights offering backed by Fairfax) plus 16m warrants exercisable at 65 cents.  Fairfax recently exited its entire position at a nice profit by selling all its common stock and warrants through GMP Securities, a Canadian brokerage firm.  Fairfax’s two representatives also left the IRG Board.  We believe the investment was a relatively small position for Fairfax and this was a factor in the exit.

We think IRG is a high quality franchise business with four solid restaurant brands that was simply over-extended during the recession.  We believe CEO Richard is driving a strong turnaround in IRG’s business and capital structure.  IRG has reduced net debt to about $31m as of April 2013 from $65m in 2008.  IRG remains focused on reducing its net debt position.

We had planned to post this idea earlier but we were surprised on June 21, 2013 when IRG issued a press release stating that CEO Denis Richard would step aside as President and CEO of the company.  We were very disappointed to hear this and, in fact, had previously listed Richard’s departure as a risk factor (see below).  Candidly, we are not completely certain what transpired, although there may have been hard feelings between Richard and the founding family as well as some franchisees.  Our sense is that there is at least a chance that sufficient shareholders may insist on the return of Richard.  We are told he was instrumental in helping to place the shares which Fairfax sold, as well as in architecting the turnaround.  In our opinion, it would be a major positive if Richard were to be reinstated but by no means are we certain this will happen.  Even without Richard, we think an investment in IRG could do well over the next couple of years, however, we would very strongly prefer that he return and continue executing his playbook from the last few years.  We will have to see what happens here.

IRG’s franchise business model is driven by royalties on restaurant system sales and supply chain revenues earned on product purchased by franchisees.  IRG has limited expenses, limited capital expenditures and limited working capital needs.  ROIC is well over 100% because working capital is negative and PPE is negligible.  IRG earns royalties of 4% to 6% on system restaurant sales, depending .on the restaurant chain, with an average of about 4.5% for six months of FY13.  IRG also receives advertising revenues of about 3% of restaurant system sales.  IRG’s expenses include advertising - basically a pass-through of advertising revenues - and general and administrative expenses.  Capital expenditures have been around $1m per year or less.

IRG’s franchise business model makes it more stable and less subject to cost pressures and volatility than for the owners of the restaurants.  It also makes IRG a highly-cash generative business.  For six months of FY13, IRG generated adjusted EBITDA of $7.6m versus $5.4m in prior year.  We believe IRG’s adjusted EBITDA for FY13 will be $16m+ with capital expenditures of $1m or less and limited working capital needs.  IRG has an NOL so does not pay cash taxes.  We believe IRG’s cash interest expense for FY13 will be about $4m.  We believe IRG’s FCF for FY13 will be roughly $11m, reflecting adjusted EBITDA of $16m less $4m in cash interest and $1m capital expenditures.

Importantly, we believe IRG has good prospects for growth in revenues, adjusted EBITDA, and FCF in FY14 and FY15.  CEO Richard has streamlined operations and reduced costs.  There are several key drivers (and potential drivers) of improved results: 

1)                          Increased royalty revenues from retail sales under IRG’s well-known brand names in grocery stores in Eastern Canada.  In November 2012, Baton Rouge brand ribs started selling in retail grocery locations and have succeeded beyond management expectations.  Mikes brand pizzas, pepperonis, and sauces are also generating significant retail royalty revenues.  Management estimates there are as many as 25 additional branded products it may be able to sell in grocery stores, thus leveraging its restaurant brands in retail grocery stores in Eastern Canada.  Management expects to introduce several new retail products in Q3 and Q4 of FY13 which could drive meaningful gains in revenues, adjusted EBITDA, and FCF;

2)                          Increased supply chain revenues due to improved food purchasing terms negotiated for franchisees and also due to more stringent purchasing compliance for suppliers and franchisees;

3)                          Reduced cash interest expense due to lower debt levels and lower interest rates is helping to increase adjusted earnings and FCF; and

4)                          Potential increases in restaurants, currently 248 units, which management believes can be expanded in several ways, including: (i) geographic expansion of the Baton Rouge brand (currently 29 units) on a national basis to as many as 60 units; (ii) smaller footprint formats for Scores brand and Baton Rouge brand to allow entry into smaller markets, and (iii) co-branding opportunities between Pizza Delight and Scores brands.

We believe IRG can generate adjusted EBITDA of $18m+ in FY15 and that IRG could trade for 10x adjusted EBITDA or $180m EV less $10m in net debt at FYE15, resulting in a share price of $3.30 per share, or 150% more than current price of $1.30 per share.

IRG’s revenues and adjusted EBITDA are nicely diversified across four established restaurant brands, as indicated below:

Company EBIT by Brand

A brief summary of IRG’s restaurant brands is as follows:

Scores

Scores Restaurants are rotisserie restaurants that offer chicken and ribs and operate in the family/mid-scale dining and takeout and delivery segment mainly in Quebec (8m population).  Management believes Scores has significant revenue growth potential through improvements in sales reporting and food cost management. 

Scores brand value proposition is: “Great tasting and generous Rotisserie & Ribs served quickly with a convenient soup, salad, and fruit bar where you always get a great deal more”.

Scores is differentiated from its competitors because of its Soup, Salad, and Fruit Bar.  Scores has strong loyalty levels and is #2 for chicken in Quebec behind St. Hubert.  Scores recent improvement in sales performance in sales is related to a refocus on marketing.

Management is testing a smaller Scores concept offering with similar menu items in a fast casual service model.  This smaller concept requires a reduced initial investment as well as lower labor and overhead costs.  This would provide the ability to open in smaller markets.

Pizza Delight

Pizza Delight is a dominant player in the Atlantic Provinces (2m population) and is concentrated in smaller cities and secondary markets where they compete primarily with mid-scale, local independently owned family restaurants.

Pizza Delight brand value proposition is: “Crave-able pizzas, oven-baked pastas, salads and don-airs served with our hometown hospitality and value through channels suited to consumers’ needs”.

Pizza Delight has a market dominance of Atlantic Provinces built over its 43-year history.  Pizza Delight has had a consistent financial track record and has achieved management’s financial contribution targets.  Pizza Delight has had resilient sales and cash flows through the recession, even while competitors entered the market.

Pizza Delight is currently testing co-branding with Scores concept to offer additional choice of selected items, including chicken, soup, salad, and fruit bar.  This would provide an opportunity to grow sales in existing Pizza Delight markets where a Scores restaurant would typically not be in operation.

Mikes

Mikes or Trattoria di Mikes is a family-style restaurant brand that serves Italian-inspired dishes and operates in the casual dining, takeout, and delivery segment.  Mikes is a strong Quebec (8m population) brand that management is focused on returning to its core offering.

Mikes brand value proposition is: “An affordable family style restaurant that consistently serves Hot Italian Subs, Pizza, and Pasta that people crave”.

Mikes has the strongest presences for the Italian based segment in Quebec at more than twice the locations of two closest peers.  However, management believes Mikes faces renovation program initiatives to address relevance and competition.

Mikes has a strong retail presence as the dominant restaurant provider in the retail frozen pizza sector with five SKU’s in the top 50 frozen retail pizza.

Mikes is testing numerous enhancements including signature and premium subs and pizzas.  Selected Mikes locations may be switched to other concepts.  In 2014, Mikes will examine an express concept.

Baton Rouge

Baton Rouge is a casual dining restaurant chain specializing in bone ribs, steak, and seafood.  Baton Rouge operates in the Provinces of Quebec, Ontario, and Alberta.  Baton Rouge offers significant geographical growth potential and the most attractive revenue potential to franchisees.

Baton Rouge value proposition is: “An adult, urban experience that makes every dining occasion special featuring high quality, generous portions, and great tasting Ribs, Steaks, Seafood, and Cocktails”.

Management believes Baton Rouge has the potential to expand nationally and has market footholds to take advantages of growing the brand’s image, with the potential to reach 60 units across Canada.

Baton Rouge is entering a renovation phase with a more modern look and the first renovation will be completed this year.  Baton Rouge has a new executive chef with a mandate to introduce menu re-engineering initiatives and broaden the appeal of the brand.  A smaller footprint format is being developed to open in smaller and suburban markets.

Restaurant Count Opportunity

There are currently 242 franchised and 8 corporate locations in the IRG restaurant network.  During FY11 and FY12, IRG closed 14 restaurants and the company pruned the restaurant network and focused on improved cash flows.  Management believes the operational initiatives are substantially complete and its focus has returned to growth.  Management believes there are significant opportunities for restaurant expansion.  IRG believes there is an opportunity for up to 100 smaller format fast casual or “Scores Express” restaurants across Canada and 30 additional Baton Rouge restaurants.

Retail Branded Product Opportunity

Sales of retail branded products for IRG are distributed to grocery and wholesale retailers such as Loblaws, Sobeys, Costco, and Walmart.  Mikes brand pizza has been very successful, having five SKU’s in the top 50 in Quebec.  Also, IRG has the number one retail Rosee sauce in the province of Quebec.  These products have been growing rapidly and are highly profitable, allowing IRG to add incremental royalty dollars to its bottom line.  Management has identified over 25 new products which have the potential to be launched.  Management expects to launch several new retail products in Q3 and Q4 of FY13.  Retail sales allow IRG to leverage its restaurant brand names into the retail grocery industry.  In November 2012, the Baton Rouge rib concept was launched and has been very successful to date.

Retail Branded Product revenues and profits were a key driver of IRG’s improved revenues and adjusted EBITDA for 6 months of FY13 versus prior year.  Retail royalties less retail expenses grew to $2.1m for six months of FY13 versus $0.7m in prior year.  We expect this strong growth in retail royalties to continue in FY13 as well as in FY14 and FY15.

Financial Results for Q2 of FY13

Q2 revenue was $13.9m or up 18% versus $11.8m in prior year and Q2 adjusted EBITDA increased 20% to $3.6m versus $3.0m in prior year, as results increased primarily due to increased supply chain revenue and increased retail royalties and reduced general and administrative and franchise support expenses (excluding increased general and administrative expenses to support additional company-owned restaurants). (See Detailed Income Statements).

Six months revenue was $26.5m or up 15% versus $23.1m in prior year and six months adjusted EBITDA increased 40% to $7.6m versus $5.4m in prior year, with the improvements due to the same factors described above.  Six months of FY13 adjusted net earnings, which exclude non-recurring and non-operating items, were $3.7m versus $1.8m in prior year, and LTM adjusted net earnings were about $7.5m.

Strong Franchise Business Model which is Highly Cash Generative

As a franchisor, IRG has a very stable, high quality business model driven by royalty revenues and supply chain revenues on underlying restaurant system sales.  IRG has a highly cash generative business model which is asset-light with limited capital expenditures and working capital needs.  IRG has a high return on invested capital (ROIC) business model with over 100% ROIC based on EBIT as compared to the sum of net PPE plus net working capital.  Net working capital is actually negative given the lack of current assets in IRG’s business model.  Even modest growth in IRG’s high margin revenues could generate significant gains in adjusted EBITDA and FCF from current levels.

Strong Competitive Position Diversified Across Four Restaurant Brands

We think IRG has a strong competitive position in the restaurant industry throughout key markets in Eastern Canada.  Quebec (8m) and Atlantic Canada (2m) have a population of about 10m between them and IRG has strong positions in both markets.  IRG’s restaurant brands have operated in these Eastern Canada markets for many years and have well-established customer bases. Management is seeking to further strengthen its competitive position through increased emphasis on value-oriented products and smaller restaurant formats which would enable IRG brands to enter smaller markets.  Importantly, IRG’s revenues and adjusted EBITDA are well-diversified across four established restaurants brands in Eastern Canada, which reduces risk and gives management more alternatives for overall restaurant unit and brand growth.

Solid Turnaround and Momentum by New Management Team Since Early 2011

We believe CEO Denis Richard has executed an impressive turnaround since joining in February 2011 and we hope he somehow returns.  Even without Richard, we believe there is good momentum in IRG’s turnaround.  IRG’s balance sheet has been recapitalized, with debt greatly reduced, operating and overhead expenses reduced, restaurant operations upgraded, and promising new sources of revenue growth, such as retail licensing, have been initiated.  We believe IRG’s stronger balance sheet and liquidity will enable management to increase its focus on improving operations and growing revenues over the next couple of years.  For six months of FY13, revenues increased 15% over prior year and adjusted EBITDA increased almost 40% over prior year driven by cost reductions in corporate overhead and increased revenue from retail licensing and supply chain management.

Solid Balance Sheet and Expected Steady Reduction in Net Debt Position.

The recapitalization transaction with Fairfax plus incremental FCF generation has significantly de-risked IRG’s balance sheet.  For several years, IRG was burdened by close to $65m+ in debt and very high cost interest expense and financing fees.  The recapitalization with Fairfax and a subsequent refinancing with GE Capital in August 2012 have dramatically lowered IRG’s net debt and interest expense, with net debt of $31m as of April 2013 or about 2x LTM EBITDA. 

While we are generally not fans of any debt on our small and micro-cap investments, we believe IRG’s stable and cash generative business model should handle this net debt level comfortably.  Further, IRG’s cash interest expense has been sharply reduced and we expect much lower interest expense in FY13.  Six months of FY13 interest expense was $1.7m versus $2.8m in prior year or a reduction of 39%, which will also increase FCF.  We believe IRG will further deleverage its balance sheet and net debt could reach $10m or less by FYE15.

Attractive Valuation For a Franchisor Business Model

We believe a high ROIC, stable business franchise business model like IRG’s with limited capital expenditure and working capital requirements should trade at a premium multiple.  We think IRG’s valuation of 6.2x adjusted EBITDA for FY13 and an 11% unleveraged FCF for FY13 are relatively cheap compared to other franchisor trading and acquisition multiples. For example, there are several franchising companies that trade at EBITDA multiples of 10x or higher (see Comparable Public Companies). 

We believe as IRG executes on its business model and de-leverages, there is a strong likelihood the company could be recognized with a more appropriate multiple, closer to 10x adjusted EBITDA.  Adjusted net earnings, which exclude non-recurring or non-operating items, are about $7.5m on an LTM basis.  IRG is trading at under 10x LTM adjusted net earnings, which we believe is cheap for a franchisor business.  

Excellent Opportunities for Growth in Adjusted EBITDA and FCF

We think IRG has excellent opportunities to grow adjusted EBITDA and FCF through FY15 as a result of additional cost management programs, revenue growth through retail brand licensing programs in grocery stores, revenue growth through improved supply chain management programs, and revenue growth through new restaurants.  New restaurant opportunities include: i) geographic expansion of Baton Rouge, ii) smaller units which allow existing brands to enter smaller markets, and iii) co-branded restaurants.  We also expect FCF to benefit significantly as IRG’s net debt position declines further and cash interest expense on its net debt is reduced.  

Attractive Upside Potential

IRG generated adjusted EBITDA in FY12 of about $14m versus $12m in prior year.  In FY12, FCF was about $9m (cash from operations less capital expenditures).  We believe IRG can grow adjusted EBITDA and FCF through FY15.  Six months adjusted EBITDA for FY13 increased close to 40% over prior year.

We believe IRG can achieve adjusted EBITDA of $18m+ in FY15 and that net debt can be reduced to $10m or less.  Based on adjusted EBITDA of $18m+ in FY15, IRG could trade for 10x adjusted EBITDA or $180m EV and market cap of $170m or close to $3.30 per share, more than 150% higher than current price of $1.30 per share. 

Potential for Share Repurchase or Dividends

IRG does not currently have a share repurchase program in place but we believe management might consider one if accretive acquisitions are not available.  We believe accretive acquisitions are the preferred choice of management and we think the company is looking at selected opportunities.  We believe IRG is well aware of the current depressed relative valuation of its stock and is taking this into consideration when evaluating potential acquisitions.  We believe that if IRG’s share price remains depressed and management is unable to find attractively priced acquisitions, a major share-repurchase program and/or a major dividend program is a solid back-up plan.

Conclusion and Target Price

Based on 10x our adjusted EBITDA est. of $18m+ for FY15 less our estimated $10m net debt at FYE15, we believe IRG could trade for an EV of about $180m or $3.30 per share or more versus $1.30 per share today (+150%), assuming IRG continues to execute and its franchise restaurant business model performs as strongly as we expect.  IRG has four well-established restaurant brands with solid competitive positions in Eastern Canada and a very high ROIC, high FCF generative business model.  We would not be surprised to see a strategic or private equity firm seek to acquire the company.  We also believe there is a chance that IRG could significantly exceed our adjusted EBITDA and FCF projections for FY14 and FY15.

**Includes 1.7m options to purchase common shares with exercise price of 67 cents which vest over five years.

*** General Financial is a holding company for Bernard Imbeault’s family.