Description

Investment Overview: In June 2020 Readern highlighted MTY as an oversold and misunderstood multi-brand Canadian restaurant franchise operator, who aided by its two core brands, Papa Murphys and Cold Stone Creamery, would be able to successfully navigate through the pandemic. Since his report, the company’s operating profitability and cash flow have held up well during the last few quarters. Also, the health of MTY’s network appears to weathered the storm well with the overwhelming majority of franchisees in good health and the shares have significantly rebounded from fire sale pandemic fear levels. However, I believe MTY still represents an attractive long-term investment opportunity as a result of: 1) a significant COVID recovery valuation gap that continues to exist vs. US-traded industry comp’s due to the slow rollout of vaccinations in Canada, resulting in prolonged lockdowns, and 2) the company is positioned well in what is likely to be a more favorable post-pandemic industry environment to compound profitability and cash flow an attractive 15%-20% rate over the next 5 years. 

From a fundamental perspective, the company’s two major premium banners, Papa Murphys and Cold Stone Creamery (56% of system sales in the last quarter), have been among the strongest brands in the fast-casual industry during the pandemic (comping up 20%+) and should be valued at par with the multiple of these comp’s (20x-25x EBITDA & 25x-35x P/E). Additionally, MTY entered the pandemic in a much-improved state from an organic growth perspective, which should position the company for a quick and strong post-pandemic rebound. Steps taken by management prior to the pandemic to revitalize organic growth resulted in fourth consecutive quarters of improved same-store sales thru Q1-FY20, with the biggest improvement in the US, while Canada posted positive same-store sales growth for the 10th consecutive quarter. Maybe most importantly, with an estimated 15%-20% of Canadian restaurants projected to close during the pandemic, the industry environment in the next few years is likely to be less competitive and a target-rich environment for MTY to resume its historic M&A earnings accretive growth strategy. 

As illustrated in the below chart, the shares of MTY have significantly underperformed US-based restaurant stocks; we believe due simply to the delayed timing of lockdowns in Canada versus the US. Despite the rebound from pandemic fears lows, the shares of MTY are still modestly below pre-pandemic levels, while most US-traded restaurant stocks (especially pizza brands) are trading at premiums of +10%-40%. Additionally, MTY trades at only about a 10x multiple of pandemic depressed trailing 12-month FCF, ~11x pre-pandemic EBITDA, and ~15x pre-pandemic EPS power, which as illustrated in the following table, are well below other US restaurant comp’s as well as the company’s historic multiple trading ranges. 

The following table also underscores the rebound in profitability that most US restaurant companies are seeing with lockdowns in states being eased and people are eager to return to dining at restaurants. On average profitability in FY22, the first full year of reopening’s, is expected to be ~28% higher than 2019 pre-pandemic levels. While somewhat delayed relative to its US peers due to longer-lasting Canadian lockdowns, we believe the same dynamics will drive MTY’s profitability to levels in excess of pre-pandemic levels. This earnings power was illustrated in Q3 FY20 when Canadian lockdowns were briefly eased. In Q3 FY20 with system sales rebounding to ~85% of pre-pandemic levels, EBITDA grew +4% y/y to an annual run rate of ~$174 million, operating EPS grew on a y/y basis to $0.93 or $3.72 on an annualized basis and FCF jumped to over $6/share annualized. With FY21 being a transition year when lockdowns ease in the 2nd half, we believe in FY22 MTY could see its EBITDA rebound above pre-pandemic levels of ~$175 million and with M&A grow to $240 million in 3 years. 

Using MTY’s pre-pandemic average historical multiple of 17x (which we believe could re-rate higher), equates to ~$100 share price in about 12 months, (about 2x current levels) and ~$150 (about 3x current levels) in 3 years. 

MTY vs S&P 600 Restaurant Index (February 2020-May 2021)

Favorable Investments Characteristics Underscore Our Positive Viewpoint: There are a number of characteristics of MTY that we find appealing, including:

• An asset-light, high return, strong cash flow business model: With the majority of revenues derived from royalties from its base of franchisees, the company’s pre-pandemic EBITDA margin has averaged about 33% over the prior 5-year period and its FCF/revenue ratio has averaged roughly 24%. An average EBITDA to FCF conversion of about 75% underscores MTY’s strong cash generation capabilities. With future growth likely to be driven primarily from growth in its franchise base and some scaling benefits, we believe these high financial returns are sustainable in the future.

• A proven accretive M&A growth strategy: M&A is in MTY’s DNA and it has been a hallmark of the company’s growth. While organic growth has averaged in the low-to-mid single digits over the last decade, as illustrated in the below charts, MTY has used targeted M&A to significantly grow the company’s number of locations and system sales at a very healthy rate in the pre-pandemic period through FY19. With M&A under the direction of company founder Stanley Ma, we believe the post-pandemic industry environment will provide a number of attractive future growth opportunities for the company to resume this growth (this point is discussed further below). 

• A track record of strong growth in profitability and cash flow: One of the key attributes we favor in an investment is a company that has demonstrated a financial track record of success over an extended time period. As highlighted below, MTY has an outstanding track record of growth in profitability and intrinsic value over a 15+ year period. Noteworthy, in the pre-pandemic 10-year period, MTY has growth EBITDA, EPS, FCF & book value at a CAGR of 21%, 18%, 21% & 23% respectively. While these metrics are backward-looking, they highlight the proven health and strength of MTY’s business model, which gives us confidence in the ability to record strong future growth.

• An excellent owner-operator management team with a history of accomplishment and strong capital allocation: Founder Stanley Ma has been MTY’s Chairman since 1997 and was the architect of creating and growing the company’s brand profile over the last 20+ years. After a recently announced stock sale for estate planning purposes, he will continue to be the company’s largest shareholder, with a 16.2% oneship position. In 2018 he gave up the CEO title to Eric Lefebvre. While Stanley Ma will continue to focus on potential growth-oriented M&A, Eric Lefebvre has added a focus on organic growth that has proven successful. Under Eric Lefebvre’s leadership, the company’s internal operations were restructured, and at the franchisee level new marketing initiatives were launched, improved customer interaction training was instituted, new offerings were implemented and certain brands were relaunched. This has resulted in an improvement in overall organic growth from both the Canadian and US operations all through FY19 and early FY20 leading up to the beginning of the pandemic. The renewed strength of the company’s brand portfolio has shown itself well during the challenges posed by the pandemic and gives us confidence that organic growth will resume in the post-pandemic period. Finally, MTY has a history of strong capital allocation, using its high cash flows to make accretive acquisitions and repurchase shares while paying a healthy dividend to shareholders.

MTY Entered The Pandemic In A Strengthened Position Which Bodes Well For A Quick Post Pandemic Recovery: It is important to emphasize that MTY had a lot of strength going into the pandemic with both its two major brands, Papa Murphys and Cold Stone Creamery, reinvigorated and the company’s portfolio of smaller brands updated and refreshed, which has both helped the company maintain a healthy level of system sales thru the pandemic and bodes well for a quick recovery in the post-pandemic recovery period. Since being named CEO in November 2018, one of the major priorities of Eric Lefebvre has been regaining organic growth, which a major portion of his compensation is tied to achieving. Under his leadership, the company’s internal operations were restructured, and at the franchisee level new marketing initiatives were launched, improved customer interaction training was instituted, new offerings were implemented and certain brands were relaunched. As illustrated below, in the pre-pandemic period leading up to Q1-FY20 (February 2020) MTY reported four consecutive quarters of improved same-store sales with Canada posting positive same-store sales growth for 10 consecutive quarters. The company’s momentum continued further into FY20, with CEO Lefebvre stating the first two weeks in March, were the two best weeks in the company’s history.

Within MTY’s brand portfolio, the two largest premier brands, Papa Murphys and Cold Stone Creamery have been among the star performers during the pandemic. Prior to the pandemic, MTY worked hard to revitalize and re-establish both brands in the marketplace. Their efforts paid off during the pandemic as once stores reopen after a brief network close, both brands were among the strongest growers. Papa Murphys and Cold Stone Creamery (56% of system sales in the last quarter), have been among the strongest brands in the fast-casual industry during the pandemic (comping up 20%+) and should be valued at par with the multiple of these comp’s (20x-25x EBITDA & 25x-35x P/E).  This strength during the pandemic is highlighted in the charts below. 

New Franchisee Additions Likely Beginning In 2H FY21: The strength in both brands bodes well for future growth in both banners in the post-pandemic period. In addition, some of the company’s other brands have also been showing very strong growth. Some of the strongest growth had been within the company’s sushi banners. We understand some of these brands had been comping up +50% y/y, with the Sushi Shop brand recently rising to MTY’s 5th largest banner. The momentum that some of the company’s major brands are seeing should position MTY for a rebound in growth in the number of locations in 2H of FY21 and into early FY22. Noteworthy, management has indicated that they have had discussions with a number of people regarding opening up new franchises, and have recently signed 20 new Cold Stone locations to open beginning in 2H of FY21.

Q3 FY20 Financial Rebound Tied To Reopening’s Illustrates The Resiliency Of The Business & MTY’s Earnings Power Post Pandemic: MTY’s system sales trends in FY20 during the pandemic have tracked commensurate with store openings/closing trends associated with local and provincial lock-downs tied to virus infection rates in Canada and the US. The charts below show the trend of infections and deaths in Canada since the beginning of the pandemic in February/March 2020. 

Source: https://www.worldometers.info/coronavirus/country/canada/#graph-cases-daily

Q2 marked the low point for system sales when all store locations were initially closed in the early days of the pandemic when virus cases and deaths surged.

Beginning in the Summer of 2020 when virus cases dropped notably leaving to an easing of lockdowns and government restrictions on indoor dining rooms reopening, MTY saw their system sales improve meaningfully week-to-week. The reopening’s of stores and indoor dining in Q3 translated into a significant rebound in system sales, profitability, and cash flow. MTY’s strong rebound in Q3 (ended August) system sales and profitability illustrate the resiliency in the company’s brands and the pent-up desire of consumers to return to restaurants. In Q3 FY20 with system sales rebounding to ~85% of pre-pandemic levels, EBITDA grew +4% y/y to an annual run rate of ~$174 million, operating EPS grew on a y/y basis to $0.93 vs. $0.91, or $3.72 on an annualized basis and FCF jumped to over $6/share annualized. 

We believe the quick and notable financial rebound and results in Q3 illustrates the resiliency in MTY’s business and illustrates the near-term earnings power of the company in a post-pandemic environment. The increase in system sales during this period also shows the appetite and pent-up demand that Canadian consumers, similar to what we have seen in the US, have to return to restaurants. So clearly the biggest factor that drove the Q3 rebound in profitability was the ability of MTY to reopen its restaurant locations and increase its total operating weeks. Thus, Q3 provides investors evidence that MTY’s overall business and profitability will rebound relatively quickly once lockdowns and restrictions are eased.

Now In The 3nd Phase Of Canadian Lockdowns; Recovery Stalled: However, with a spike in infections beginning again in the September/October time frame, Canada began the 2nd wave of government-imposed dining restrictions and lockdowns in the Fall, with more strict measures beginning on December 16th and continued thru Q1 FY21 (February). Some provinces eased restrictions temporarily in March, only to reinstate them in April. These on/off/on restrictions in Canada contrast with what has been a general easing in most states in the US, with indoor dining opening restrictions being reduced or eliminated in many states. US restaurant operators have noted a significant increase in demand when indoor dining restrictions are eased.

As a result of the latest round of Canadian lockdowns, MTY saw its Q1 FY21 overall system sales decline about 15% q/q, but were still up notably from Q2 when more locations were closed. Highlighting the difference, the lockdowns and easing of US restrictions have had on MTY’s business, in Q1 Canadian franchise revenues were down about 50% y/y while US franchise revenues were only down 3% y/y. This highlights more evidence of a quick rebound in MTY’s Canadian and overall systems sales when restrictions are eased.

Increased Vaccinations Will Drive A Recovery & Will Be A Catalyst to The Share Price: It is somewhat unclear exactly when lockdowns and Canadian government imposed dining restrictions will ease, but will likely be influenced by infection and hospitalization levels. As illustrated in the following news story, vaccination rates in Canada will be a key driver of reopening’s and have trailed the US and Western European vaccination levels. 

https://www.wsj.com/articles/as-the-u-s-vaccinates-millions-for-covid-19-most-canadians-are-still-waiting-11617905495?mod=searchresults_pos1&page=1

The following table, which may surprise many readers, shows how far Canada is behind the US and most Western European countries in vaccination rates and underscores why Canadian restaurant company earnings have remained depressed relative to the sharp rebound that companies in other countries (like the US) have experienced. We believe Canada will experience the same rebound in restaurant traffic and profitability when lockdowns are eased and the shares will rebound to pre-pandemic new highs as we have seen in the US.

https://www.cnn.com/interactive/2021/health/global-covid-vaccinations/

The good news is that vaccination rates in Canada have begun to accelerate and recent government expectations are that most people should be able to get a vaccination, if they want, by the end of June. 

Source: https://health-infobase.canada.ca/covid-19/vaccination-coverage/

This increase in vaccination levels will be the catalyst to begin the chain reaction in re-openings, increased restaurant traffic, and higher profitability that will change investor sentiment and fuel the share price of Canadian restaurant shares, including MTY, higher as we have seen in other countries. 

The Post-Pandemic Industry Environment; Less Competition & A Target Rich M&A Landscape: The overall post-pandemic industry landscape for strong survivors like MTY should be more favorable than the past few years. One major outcome is that the overall restaurant industry is likely to get less competitive. Various industry sources speculate that the pandemic could result in the elimination of roughly 10,000 restaurants or 15%-25% of the industry (mostly independents) in Canada. Information from Canadian food wholesalers suggests the true final number when all is said and done could even be higher. Additionally, we understand that many independent restaurants still operationally are struggling financially and are having challenges in the current environment getting financing and insurance. This is significant as in recent years there has been a growing oversaturation of restaurants in the country and the pandemic may have accelerated in a brief period what was likely to be a natural consolidation in the market. We have heard from sources that in the 4 years prior to the pandemic the number of new full-service restaurants in Canada had been growing at about +15% annually with restaurants per capita in Canada well above US levels. Noteworthy, this oversaturation in Canada has been weighing heavily on same-store sales growth across the industry. 

A side note benefit to the closing of many restaurants in Canada due to the pandemic is related to real estate. With many new vacancies due to restaurant closures, MTY has some leverage with landlords to garner more favorable leases and now has the ability to gain access to key locations that were previously unavailable.

The second important factor relative to the post-pandemic industry environment which will benefit MTY is with a number of restaurant brands impacted by the financial toll of the pandemic it is likely that many will be forced to merge or sell themselves to financially stronger organizations like MTY to continue to operate and prosper. With its balance sheet strength, including a healthy amount of liquidity as well as access to the debt and capital markets, MTY is in a prime position to take advantage of the opportunity. M&A has been, and will likely continue to be a key part of the company’s DNA and growth strategy. Under the direction of MTY’s Chairman & President Stanley Ma, who is spearheading current efforts, MTY has a history of making accretive growth-oriented acquisitions over the last 15 years. Also, we sense that the company may also use the post-pandemic environment to divest some poorly performing or not well-positioned brands to increase the overall profitability of its portfolio and growth prospects.

We Expect A Rapid Rebound In System Sales & Profitability Post-Pandemic: Looking forward, we expect that similar to what occurred in Q3 FY20, MTY will see a quick rebound in its system sales once lockdowns in Canada are eased with restaurants and indoor dining opening across the company network. In Q3 FY20, the company’s EBITDA bounced back to a run rate of $174 million, which approximated its pre-pandemic run rate, despite some restrictions that were in place in both the US and Canada. Given the pace of vaccinations in both countries continuing, we believe (excluding M&A growth) it is likely that MTY could get back to reporting this same level of EBITDA by Q4 FY21 (November). Given the recovery that we have seen among leading US QSR/casual restaurant companies, where FY22 revenue forecasts exceed pre-pandemic FY19 revenues, we expect the same will be true (albeit a little delayed due to Canadian reopening timetables) for MTY. Additionally, we believe there is a good possibility that MTY will find accretive M&A candidates, which will further increase its overall system sales growth.

With FY21 being a transition year when lockdowns ease in the 2nd half, we believe in FY22 MTY could see its EBITDA rebound above pre-pandemic levels of ~$175 million and with M&A grow to $240 million in 3 years.

Current Valuation Below Comp’s & Historical Range, A Case For A Re-Rating Higher Can Be Made: MTY trades at only about a 9x multiple of pandemic depressed trailing 12-month FCF and `13x pre-pandemic EBITDA, which is both well below other US restaurant comp’s as well as its pre-pandemic historic multiple trading range, which averaged ~17x. (illustrated in the following chart).  

As illustrated in the first table in the report, on consensus forecasts, which are below our estimates, MTY trades at a significant discount to a comp group average of US-traded casual restaurant stocks on FY22 EBITDA and a P/E basis.

A case could be made that MTY’s multiple should expand above its historical average and re-rate higher due to the combination of: 

• The improved quality and growth prospects of its two largest brands, Papa Murphys and Cold Stone Creamery (56% of system sales in the last quarter), which should be valued at levels closer to premium restaurant brand comps (20x-25x EBITDA & 25x-35x P/E);

• The improvement that MTY demonstrated in revitalizing its SRS growth going into the pandemic, which should continue once Canadian government imposed lockdowns are eased and the entire network is reopened. 

• A more favorable overall competitive industry climate post-pandemic given the elimination of roughly 10,000 restaurants or 15%-25% of the industry (mostly independents) in Canada.

Significant Upside Potential of 3-4x In The Next 3-5 Years: With FY21 being a transition year when lockdowns ease in the 2nd half, we believe in FY22 MTY could see its EBITDA rebound above pre-pandemic levels of ~$175 million and with M&A growing to $240 million in 3 years. Using MTY’s pre-pandemic average historical multiple of 17x (which we believe could re-rate higher), equates to ~$100 share price in about 12 months, (about ~67% upside from current levels) and ~$150 (about 2.5x current levels) in 3 years. 

Conversely, using a FCF multiple analysis illustrates similar upside opportunity in the shares. We believe MTY can earn between $5-$6 in FCF/share in 2021 and grow that number 15-20% over time. Using a FCF multiple of ~15x-20x, which compares with industry comp’s, shows that MTY is worth between $75-$100/share in the near time. In 5 years, we think MTY will earn north of $10/share and be worth between $150-$200/share, which equates to a 20%+ IRR over the next 5 years. 

Catalyst

• Increased vaccination rates in Canada.
• The easing of government-imposed lockdowns and restrictions in various provinces in Canada.
• Full reopenings of MTY brand locations in Canada.
• Reports of increased restaurant traffic and reservations in Canada.
• MTY reporting quarterly results during a period of full re-openings which should highlight the company's earnings power and strong cash flow dynamics.
• Increased SRS.
• MTY announcing accretive acquisitions.