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MTY is an operator of franchise restaurant banners in the US and Canada. MTY has an outstanding multi-decade track record of growing earnings and has done so at high rates of return. Being a restaurant franchisor is an attractive proposition as there is typically minimal capital required to grow (as most of the cost are borne by the individual franchisees) and the industry is largely recession-proof (spend on food is very resilient through cycles). However, the industry is highly competitive with an long list of new entrants and strong incumbents. In order to sustain long term success and growth, companies must possess durable competitive advantages. Most of the largest restaurant operators fall in the camp of brand-builders. The risk to that strategy is a shift in consumer preferences or a deterioration in the brand quality. MTY has a different recipe for success. Instead of building and growing one brand, MTY operates a diversified portfolio of brands and focuses primarily on growth through acquisitions. Unlike single-brand operators, MTY is diversified across formats, cuisines, and geographies. It also buys more mature brands that have demonstrated durability. It relies on the combination of attractively priced acquisitions and effective cost cutting to grow at attractive rates of return. This strategy is less exposed to changes in consumer trends, and in some ways easier to underwrite for investors.

A little background on the company. MTY was founded in 1997 by Stanley Ma and became a pureplay restaurant franchisor in June 2003. Since 2005, the company has grown system sales, revenue, and unlevered free cash flow at 24%, 24%, and 25% p.a., respectively. Through 44 acquisitions over the last two decades, the company grew from a handful of brands to over 80 banners and 6.7K stores in the US and Canada. Over this time, the company spent a total of $1.1B and generated ~$130M in UFCF. This equals to an average 12% return on invested capital, and roughly double those levels on an equity basis as the company has taken on a modest level of debt over time. 

The key to MTY’s impressive track record is its focus on disciplined acquisitions and efficient operations. This means the company typically waits patiently for assets that are attractively priced, which are usually businesses that are at the mature phase of their lifecycle, where growth has slowed but sales are stable and predictable. These brands typically trade at lower multiples than sexier targets that are earlier in their lifecycles. MTY purchases these brands, and then leverages its increased scale to improve efficiency. Cost savings are mainly achieved in procurement, rent, and corporate staff. Over time, the MTY team has gained an enormous amount of experience in purchasing assets as well as integrating them within their system. While the formula itself isn’t rocket science, doing it consistently takes strong execution combined with an unusual degree of focus on long-term value generation.  

Behind the scenes is Stanley who stepped back from the day-to-day operations in 2018 but still oversees the company’s acquisition strategy  and serves as  Chairman of the company’s board. Despite being away from the executive role, he remains devoted to MTY. He and his wife own close to 20% of the shares outstanding. Stanley is the one who instilled the important values of frugality and discipline at the company, which are essential for its business strategy. For example, as the CEO of a multi-billion-dollar public company, he had only taken a modest salary of ~CAD$400K (and no bonus) per year prior to his retirement. Even now, he continues to frequent the food court stalls owned by the company because of their good value, in addition to the goal of staying close to the business. The new CEO, Eric Lefebvre, shares a lot of the same values and long-term orientation. Eric has been working at the company for over a decade and has a compensation structure that is almost entirely contingent on stock performance over the next 10 years. Since taking over, he has achieved impressive results in maintaining the existing portfolio, integrating new acquisitions, and guiding the company through the challenges of the COVID-19 pandemic.

MTY trades at 11x FCF, which we believe is a significant discount for a high-quality business with sustainable double digit growth potential. Other posts have previously detailed MTY’s background and track record in depth, so we encourage you to read those to get up to speed. Instead of posting a similar writeup that simply reiterates the facts that support the thesis, below we discuss three common pushbacks we hear from bears.

1. MTY teams are weak operators 

MTY specializes in buying more mature restaurant brands at attractive valuations.. The company prefers to target relatively stable concepts and rarely pursues rapidly growing, trendy brands, which typically trade at high valuations. The market has questioned MTY’s health by focusing on the company’s same store sales and store count myopically. However, It is incomplete to look only at organic growth at the portfolio level and extrapolate the operational capabilities of the company, without accounting for the quality of the brand at the time of acquisition and the price paid for the asset. In fact, after examining its track record, it is evident that the acquired brands’ performance pre-merger is almost always in line with its performance post-merger. This suggests that instead being weak operators that are unable to grow organically, MTY is choosing to own assets that in many cases are more mature and have less impressive rates of the growth. 

This acquisition philosophy has two major benefits. First, the less sexy brands that MTY targets generally have fewer potential suiters allowing MTY to purchase them at more attractive valuations. Second, the fact that most of the concepts are mature in their lifecycles is a positive for the predictability of the outcome of the restaurants longer term. Studies have been done at several universities that show that within the restaurant industry, annual survival rates improve materially beyond the initial phase of rapid elimination. By buying businesses later in their lifecycles, MTY reduces its risk of impairment.

2. Portfolio is in terminal decline / this is a melting ice cube

Note: Adj existing brand store count takes into account the lower productivity level of stores closed (relative to those that remain open) 

It is valid that organic growth pre-COVID had been negative for several years. The reason for this decline is primarily because the company’s strategy is not reliant on organic growth. Stanley has always gravitated towards generating value through acquisitions, in combination with strong discipline around cost minimization post-acquisition. While it hasn’t produced the strongest topline growth from its concepts, it has generated strong returns on capital. We think this was driven primarily by Stanley’s natural orientation towards finding good deals, rather than a systematic review of the ROI from organic versus inorganic opportunities. In other words, we do not believe the organic growth from the last 5 years before COVID were the output of a management team that has attempted to optimize this aspect of the business. 

Since taking over, Eric has made significant changes to the company’s strategic priorities by focusing on improving organic growth and he generated some positive early trends prior to the pandemic. Unfortunately, the period for investors to evaluate his success was cut short due to COVID so it is difficult to use those data points to draw firm conclusions. 

But unlike a short-term initiative, Eric likely has fundamentally shifted the way the company views organic growth and its importance going forward. For example, he has publicly announced the goal of hitting 2-6% organic FCF growth per annum before COVID. Executives are now explicitly compensated on a single metric - organic growth in EBITDA, which is a material pivot for an organization that did not previously have performance-based incentives for most of its employees. This shift in priority has propelled the company to refresh its portfolio, with a focus on brands that are deteriorating. Diagnostics were run on each brand and those with issues were identified and bolstered by rebranding consultants and turnaround specialists. Technological tools have been installed to better improve data collection and analysis (e.g. franchisee store-level management system) as well as better serve its customers (e.g. loyalty programs and online ordering). Some of these initiatives are already bearing fruit. For example, the accelerated rollout of online ordering and delivery has helped sustain sales for many brands, as digital sales have grown to become a meaningful part of the business. This was a necessary development particularly during COVID. Other initiatives, like data-driven support for franchisees, require longer time frame to evaluate. It is however logical that at least at a high level the company should be able to harvest the value of its scale beyond cost synergies and towards revenue synergies as well. 

Importantly, a turnaround in organic growth is not necessary for MTY shares to generate teens returns but provide upside optionality if successful.

3. Franchisees are unprofitable

Another argument from bears is that since MTY owns a large portfolio with many brands that are in a mature/declining part of its lifecycle that the health of the underlying franchisees is very weak. This is not true. 

The company targets a normalized 30% return on capital for new franchisees and a 5-year payback period - their franchisees generally hit these targets. While brand-level franchisee data is not available for every brand, we can look at key brands to verify these figures. 

Take Papa Murphy’s as an example - approximately two thirds of its franchisees earn a reasonable (or better) yield on their investment with one third earning a 40-50% pre-tax return on capital, while another one third earns ~15-20% pre-tax return. The last one third earns a low single-digit return. In absolute dollars, the average franchisee invests about $400K on a store and makes $90K pre-tax or $120K pre-tax including the compensation for the store manager (which is often the owner). This equates to a 30% return on capital, and a much higher return on equity as on average 60% of the investment is funded with debt.  

Summary

Lastly as a reminder, MTY is currently trading at a high single-digit earnings yield with tons of dry powder to deploy in a proven and underappreciate acquisition strategy with high returns. We expect that these acquisitions will continue to generate double digit growth for the company in the future. There is further upside optionality should Eric's operational turnaround prove to be successful. Overall, this is an investment that we believe will yield strong long-term returns with limited downside risk.