Description

MTY

Company background

MTY is a Canadian company that operates and franchises quick service restaurants under multiple banners.

Founded in 1979, by its current CEO Stanley Ma, MTY has grown into one of the largest restaurants groups in Canada, operating from more than 5500 locations, with about 98% of the location franchised and the remaining 2% directly operated by MTY.

Over the past 5 years, MTY has compounded revenue at 20% at a ROE>20%. Most of this growth has been the result of a disciplined M&A strategy. Last year, MTY executed its largest ever acquisition, Kahala Brands. Kahala Brands is a US company and thus opens up the prospect for MTY to replicate its business model in the US.

Unit economics

Please refer to the previous VIC report published in 2011 for further background on MTY’s unit economics.

Business model

There are four important concepts to understand when it comes to MTY’s business model

1)      Unlike most food groups, MTY is not focused on maximising LFL growth. Instead, MTY behaves much more like a capital allocator than an operator. MTY must decide between.

a)        Investing in restaurants/Marketing to improve LFL sales

b)        Opening new restaurants.

c)        Acquiring new franchisors.

Very often, improving LFL growth from say, -1% to 3% will provide a lower return on capital than acquiring new franchisors at a ROE of 20%. Over the past 5 years and 10 years LFL sales has been roughly -1% and 0% respectively.

The sell side has a tendency to be overly focused on LFL growth and this creates an opportunity for investors that understand that capital allocation process.

2)       MTY will often close more restaurants than they open and while this would be a problem in most companies, and is certainly something that sell side analysts focus on, MTY’s large number of banners means that it is able to constantly manage its portfolio of brands by closing underperforming restaurants and opening much better performing restaurants. The result of this is that although restaurant numbers may decrease year over year, the actual revenue from restaurant increases.

3)       MTY is not overly reliant on any one banner and so is less sensitive to changes in trends.

4)       MTY’s underlying business should perform well in a recession as the company will be in a strong position to acquire franchisors at a depressed valued.

Runway

For any compounder stock like MTY, the runway left must be a key question.

Over the past 10 years, MTY has completed an average of 3 transactions per year. Over the past 3 years, the average systems sales of acquired companies has been $52m excluding Kahala brands, and $125m including Kahala brands. In terms of number of restaurants, these acquisitions averaged about 58 locations excluding Kahala Brands and 332 including Kahala brands.

Canadian market

We estimate that MTY has roughly 15% market share of Canada’s chain restaurant operators market. Looking at a more granular breakdown of chain restaurants in Canada, we estimate that there are potentially around 60 restaurant groups (of a similar size to its previous acquisition) that MTY could acquire.

United States market

We estimate that MTY has less than 1% market share of  US chain restaurant operators market. Looking at a more granular breakdown of chain restaurants in the US, we estimate that there are potentially around 600 restaurant groups (of a similar size to its previous acquisition) that MTY could acquire.

We believe this leaves a lot of runway for MTY to execute its playbook.

Acquisition multiples

Another key metric to follow in any rollup strategy is the acquisition multiple payed. While, MTY does not disclose the EBITDA or earnings of acquired companies, it does disclose the system sales. While the price to system sales has been quite volatile over the past 10 years, the range has been stable, indicating that that MTY has been able to remain price disciplined even after increasing revenue 7 fold over the past decade.

Valuation

MTY currently trades at a forward P/FCF ratio of aroud 14. For a company that should be able to compound free cashflow  at 15% to 20%, we think the valuation is too low. Since MTY’s P/FCF has always been relatively low, we don’t anticipate much of the returns to come from an expansion of P/FCF but rather from a growth of FCF. The low P/FCF should however provide downside protection.

As a point of reference, it’s worth noting that other large restaurant groups, trade at around 20 times P/E while having significantly lower growth potential.

Why are the shares undervalued?

Because the timing of acquisitions are uncertain, sell side analysts do not forecast growth from acquisition and instead focus on organic growth and like for like sales. For this reason, the P/FCF does not fully reflect the value that management will create from future acquisitions.

Debt 

 Net debt has recently increased due to the Kahala Brands acquisition and currently stands at $187m. Net debt/EBITDA of 1.9 is significantly below its covenant of 3.5.  Although net debt/EBITDA is higher than it has ever been, we think that the debt level is manageable given the diversified source of revenue (around 60 banners), high margins, low cyclicality and low capex requirement. Furthermore, we think that, if prudent, taking advantage of cheap financing (<5% interest rate) does make sense when the company can invest the proceeds at a ROIC greater than 15%.   The company would be negatively impacted by a rise of interest rate. 

Management

CEO and founder Stanley Ma owns 23% of the shares outstanding. Although Stanley’s salary is a relatively modest CAD 385k, he has not sold any shares over the past 10 years. The company does not issue any significant amount of  stock options or bonuses.

Risks

The main risk is that management loses its price discipline. While we think this risk is very small given management’s track record, Stanley Ma is 70 years old and so a change of management could change the thesis.

Catalyst

Further acquisitions. Company averages 3 a year.