MTY FOOD GROUP INC MTY
May 12, 2011 - 11:01am EST by
opco
2011 2012
Price: 15.00 EPS $0.81 $1.06
Shares Out. (in M): 19 P/E 17.9x 13.7x
Market Cap (in $M): 287 P/FCF 14.2x 11.0x
Net Debt (in $M): -3 EBIT 22 27
TEV ($): 284 TEV/EBIT 13.1x 10.7x

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Description

MTY Food Group trades at a meaningful discount to today's intrinsic value, and I expect the company's profits to continue compounding at a high rate for several years.  The stock not only has high growth potential, but is cheap on trailing cash flow which provides a substantial margin of safety.  MTY's cash flow is high quality as it is basically a recurring cash flow stream from franchisees.  The market capitalization is $287 million and the company has $10 million of cash pro forma for two small acquisitions which close by June.  The company has $6 million of debt.  The company generated net income of $15 million in 2010 and over $20 million of free cash flow.  Free cash flow is much higher than net income as there is minimal maintenance capex but the company has $4 million of non-cash amortization.  Free cash flow tends to be, with slight deviations plus or minus, net income + amortization, which I denote in the last row of the table below.  Ex-cash, one is creating the equity position at 11.0x 2011 FCF.  

The P/E and P/FCF multiples above are ex-cash.  Most market participants view the company as trading at 18.6x 2010 EPS, but this does not take into account the cash on the balance sheet, the earnings power of the recently announced acquisitions, the large difference between net income and FCF, the high earnings growth, and a return on equity of around 30%.  The ROE takes 2010 FCF and divides it by non-cash assets including intangibles, as there is no net debt.  MTY trades at 9.0x 2011 EBITDA and 9.4x 2011 EBITDA less capex.  Capex was $1.2 million in 2010 and is often offset by disposals.    

$ in million CAD, except per share amounts

Share price $15.00
Shares 19
Market cap $287
PF cash 10
Debt 6
Min int 0.3
Enterprise value $284
 
 
 
2010 P/E 18.6x
2010 P/E ex-cash 17.9x
2011 P/FCF ex-cash 11.0x
 
 
 
Lease commitments @ face $218
Conserv. PV of lease commitments      176
Annual lease expense 35
Adjusted TEV / EBITDAR 6.9x         

 

                               2003      2004      2005      2006      2007      2008      2009      2010      2011E

Sales                      $11.5     $15.5     $18.6     $22.0     $30.5     $34.2     $51.5     $66.9      $88.3     

   growth                               35%       20%      18%        39%      12%       51%      30%        32%       

EBITDA                      2.9        4.9        7.1         9.2         14.2       15.7      21.4      25.8        31.3         

   margin                   25%     32%       38%       42%        46%      46%      42%      39%        36%       

Net income                 1.6        2.9        4.3         5.8           9.2        9.9       12.3      15.4        20.2         

   growth                               85%       46%       36%        58%        8%       24%      26%        31%        

Net income + amort    1.9        3.4         4.7        6.8          11.0       12.4      16.1      19.5        25.1 

   growth                               75%       41%       43%        62%       13%      29%      21%        28%        

Same store sales growth                      4.0%     4.8%       3.3%      1.7%     (1.8)%    (0.3)%      1%

 

Founded over 25 years ago by the current CEO and largest shareholder, Stanley Ma, MTY is a leading franchisor of quick service food concepts in Canada.  Stanley arrived in Canada from Hong Kong when he was 18 and he started his first restaurant called Le Paradis du Pacifique in Laval, Quebec when he was 29.  The company now has 28 different concepts, and they include Thai Express, Taco Time, Country Style, the Canadian branches of Yogen Fruz, Tiki Ming, Kim Chi, Tandoori, Cultures (salads/sandwiches), Sukiyaki, Veggirama, Frankx Supreme (hot dogs, fries, burgers), Sushi Shop, Koya Japan, Villa Madina Mediterranean Cuisine, Vie & Nam, Vanelli's (Italian), Au Vieux Duluth Express, La Cremiere, the Canadian rights to TCBY, Panini, Croissant Plus, Tutti Frutti, Groupe Valentine, Caferama, Chick n' Chick, O' burger, Sushi-Taxi, and Jugo Juice.  MTY has 1,886 locations (pro forma), over 1,700 of which are franchised and the remaining are company owned stores.  The top 5 banners are Country Style, Taco Time, Sushi Shops, Thai Express, and Vanelli's as of 2010.  Roughly half of system sales are in shopping malls and food courts, 40% are in street front locations, and 10% consist of non-traditional locations.  Despite the company's growth, MTY is not a large company and generated only $67 million of sales in 2010 and had system wide sales of $462 million.

CEO Stanley Ma is intensely focused on return on capital, and has successfully grown the company both organically and through highly accretive acquisitions.  He owns over 25% of the stock which has a current market value over $70 million.  Stanley's compensation was $390,000 in 2009.  The CFO Claude St. Pierre has been with the company for over 20 years, took $140,000 of compensation in 2009, and owns stock which has a market value over $7 million.  The management team is a quiet, hard working team which does not do conference calls or presentations, though they are happy to meet with investors.  Stanley is funding the growth with internally generated cash flow - MTY has net cash and there are no stock options.  The accounting is clean - there are no non-recurring items to back out.  The CEO has not sold a single share in the last ten years and has two children who work in the business.

Compounder

From 2003 to 2010, the company compounded sales and net income at a 29% and 39% CAGR, respectively.  In 2003 the company generated $11.5 million in revenues and $1.6 million of net income.  In 2005, the company generated $18.6 million in revenues and $4.3 million of net income.  And in 2010, the company generated $66.9 million in revenues and $15.4 million of net income.  FCF is higher than net income due to non-cash amortization associated with the amortization of franchise rights and other intangibles. 

2011 revenue growth is driven by having a full year of results from the food processing and distribution businesses which were acquired in 2010, and by the acquisitions of Sushi Taxi (to close by 5/31/11, 12 stores, $8.5 million of system wide sales) and Jugo Juice (to close by 6/30/11, 133 outlets, $36.4 million of system wide sales in 2010).

The components of MTY revenue growth are same store sales growth, opening new locations of existing concepts, creating new concepts, and acquisitions.  Let's quickly discuss each.

Same store sales.   Same store sales growth was 4% in 2005, 4.8% in 2006, 3.3% in 2007, 1.7% in 2008, -1.8% in 2009, -0.3% in 2010.  Same store sales growth on a quarterly basis in 2010 was -1.2%, -1.15%, -0.24%, and then 2.03%.  This last quarter same store sales growth was -0.4% due to weakness in Country Style.  Given the cheap price paid for Country Style, the acquisition was very NPV positive but it is a drag on same store metrics.  MTY is not negatively impacted by food and labor inflation, as MTY is getting a cut of the sales.  Obviously franchisee economics have to be attractive in order to sustain current cash flows and grow, and franchisee economics are addressed later.

New locations.  One of the attractions of a franchisor model is that the incremental expense and capital required to franchise out existing concepts is incredibly low.  Imagine your portfolio being filled with new inflation protected bonds with a negligible acquisition cost.  MTY has stated that they will open 85 new stores in 2011 (probably 70 net new stores), which contributes 4-5% revenue growth.  With comparable same store sales growth of 1-2% (just inflation), the company can easily grow 5-6% organically without adding new concepts.  The company does not spend significant capital recruiting new franchisees.  It participates in 1-2 trade shows each year and spends some minimal marketing on the internet.  About 15% of new locations are from existing franchisees, and the bulk of the remaining new locations result from prospective franchisees learning about MTY via word of mouth.  MTY has built a reputation in Canada for having a successful portfolio of concepts, particularly within Canada's Asian community.    

New concepts.  Many of the company's existing concepts were internally created.  Tandoori, an Indian concept created in 2008, now has about 30 locations.  The cost of creating a new concept is a few hundred thousand dollars, and MTY has a team which focuses on rolling out new designs, menus, and concepts.  MTY's team is constantly monitoring competitors and searching for new concepts.        

Acquisitions.  MTY has been deploying almost all of its FCF into acquisitions.  My analysis of the acquisitions reveals that they are highly accretive.  This is not akin to a large cap technology firm which has to make acquisitions simply to maintain its current cash flows - the acquisition spend is not maintenance capex.  The company is very experienced in acquisitions and is acquiring franchisors for between 4-5x pro forma EBITDA.  Pro forma for cost savings, not revenue growth.  Since franchisors have minimal capex, 4-5x EBITDA translates into 6-7x after-tax unlevered free cash flow.  When a company can acquire free cash flow at a 13% yield which arguably should be priced at a 6-7% yield, value compounds quickly.  And this 13% yield can grow rapidly if the concept is successful and more franchisee locations can be opened.  The company tries to avoid auction processes and has disciplined valuation parameters.  Fortunately for MTY, the Canadian market for these deals is less efficient than in the United States.  Many of the acquisitions were not auctions but were situations where MTY approached or was approached by a smaller franchisor.  MTY benefits from the fact that most of its competitors are not acquiring disparate concepts.  Once MTY acquires a franchisor, it can cut out many of the corporate costs such as accounting, finance, and marketing.  When a franchisor is acquired, MTY can allocate a meaningful proportion of the purchase price to intangible franchisor rights, which are amortized over less than 10 years and provide a nice tax shield.      

The company has had success with acquiring good concepts and franchising more locations.  For example, MTY acquired 6 Thai Express franchise locations in 2004 for $289,000.  There are now 140 locations.  MTY acquired 62 Sushi Shop locations from 2004-2007, now there are 110 units.  Cultures was purchased at 27 stores and is now at 63 stores.    

Unit Economics for Franchisees

MTY partners with its franchisees and considers the franchisees its customers.  The economics for MTY are obviously compelling, but the economics of the franchisees are also attractive.    

Let's say you want to open a franchise location.  You pay MTY a one-time franchise fee of $30,000.  You then purchase equipment for about $80,000, and you spend approximately $200,000 in leasehold improvements so that the location you lease is outfitted for the concept.  So total startup costs are $310,000. 

An average street front location should be able to generate $600,000 in sales (the top-grossing location does around $2 million).  Cost of goods sold is around 33% of sales, labor is 28%, 5% royalties to MTY, 2% advertising paid into a fund which is dedicated to advertising and does not flow into MTY revenues, rent is around $84,000, and after insurance, utilities, taxes, a franchise location should produce over $44,000 of net income.  When you add back depreciation and include the salary of the franchisee, a franchisee who works at the location should be able to generate $100,000 to $150,000 of cash flow for himself (after corporate taxes, before personal taxes).  Some of the best franchisees are making $300,000 to $500,000 per location.  Most banks in Canada will finance 50-75% of the leasehold improvements and equipment at the Canadian prime rate + 300 bps, or about 6% today.    

Sample economics for a store-front location
 
Initial franchise fee    $30,000
Equipment 80,000
Leaseholds 200,000
Total investment $310,000
   
Revenues $600,000
Cost of good sold 198,000
Labor 168,000 
Royalties 30,000 
Advertising 12,000
Rent 84,000 
Insurance 5,000
Utilities 12,000
Repairs 3,000 
Depreciation 31,000 
Pre-tax income 57,000
   margin 9.5% 
Taxes 12,540 
Net income $44,460 
   margin  7.4% 
   
Net income $44,460
Depreciation 31,000 
Salary 40,000 
FCF to owner $115,460 
  

This FCF to owner is before personal taxes and assumes the owner works in the business.  At the end of 10 years, the owner will need to spend about $100,000 to upgrade his store.  Let's therefore penalize the FCF to owner by a theoretical $10,000 per year allocation to this future investment to arrive at a "lifecycle" annual FCF to owner.  This lifecycle FCF to owner is $105,460.  Excluding the owner operator's salary, the lifecycle FCF to owner is $65,460, or a 21% unlevered return on the original investment of $310,000.            

What happens when a franchisee defaults on his royalty payments?  MTY controls the lease as MTY enters into the lease with the landlord and then sublets to the franchisee.  MTY is a better credit than the franchisee, so MTY is able to secure better rental rates for the franchisee.  MTY controls the lease so that it has power over the franchisee.  For example, if an unruly franchisee stops paying royalties to MTY or violates quality control standards, MTY can kick the franchisee out of the location and replace him with a better operator.  The new operator often benefits from not having to spend on the leasehold improvements as the location is already built out.  If MTY feels that the location is untenable and does not offer it to a better operator, it can terminate the lease and work out an arrangement with the landlord.  While MTY technically is on the hook for the remaining lease term, MTY as a practical matter usually just pays a few months rent at worst while the landlord finds a new tenant.  MTY does not have any vacant locations.            

Economics for MTY

MTY collects the initial franchise fee of $25,000 to $35,000, and then takes 5% royalties.  MTY mandates that all its franchisees order from various distributors approved by MTY.  MTY gets a commission from these distributors.  MTY basically takes in the equivalent of 10% of a franchisee's sales between the royalty, commissions, and other fees/services/products.

The $67 million in 2010 revenues roughly break out as $23 million in royalties, $23 million in food commissions and other fees/services/products, $3 million in initial franchise fees, $9 million in turnkey revenues, and $9 million from company owned stores.  Turnkey revenues are payments from the franchisee to MTY for building out the store.  Most franchisees hire their own contractors to build the store, but some franchisees pay MTY to build it out.  Turnkey revenues are done at just a 7% margin, so MTY does not generate much cash flow from turnkey projects.  MTY is not lending to the franchisee. 

The company's primary expenses are the 100 or so people at corporate (offices in Montreal, Calgary, and Toronto), as well as the expenses related to company owned stores.  MTY does not own the real estate related to company owned stores.   

Keep in mind that MTY does not run leasing through the income statement.  From a cash flow perspective, MTY is collecting rents from the franchisees and then paying rents to the landlord.  These always offset each other unless there are lease defaults/breakage costs, in which case these costs are reflected in the income statement. 

Geographic expansion

MTY has entered into master franchisee agreements with master franchisees of certain concepts in the Middle East.

The United States presents a large, attractive opportunity.  The company is likely to test 1-2 banners in the U.S. and build from there.  I have visited food courts and malls across North America, and it is clear to me that many of the concepts would succeed in the U.S.  To do this, MTY would open a few company owned stores and then franchise concepts out once some minimal brand identity has been established.  The United States is a competitive market, but MTY has competed very well in the most competitive locations in Canada, such as popular food courts and malls in Toronto.      

Questions/Concerns

How has MTY grown so quickly?  Have others grown like this?  Other concepts have not been growing as quickly as MTY.  MTY does a superior job of attracting franchisees through its reputation, and MTY is taking share from other competitors. 

Are you comfortable with the runway for growth?  Yes, I believe that MTY can continue to grow at a nice pace in Canada.  My conversations and visits have confirmed that the concepts are by no means saturated.  MTY has over 1,800 locations and has the ability to grow to 3,500 locations over the next several years just within Canada based on my analysis of market share, penetration, and saturation in Canada's main provinces.  Also, there are still plenty of less efficient, independent mom-and-pop operators in Canada.    

Do you trust management's ability to deploy capital at rates higher than their cost of capital?  Management is extremely focused on return on capital and has a very specific way of analyzing the NPV created by making acquisitions.  MTY avoids acquisitions where the math is unattractive.        

Why hasn't MTY expanded in the United States?  Stanley is very conservative and prefers to continue growing in Canada for now.  But he has his eyes on the United States and will eventually expand 1-2 of his banners there to test the markets.    

$218 million in undiscounted lease commitments are obligations of the company.  Of this amount, $205 million is sub-leased for what MTY calls a "net" commitment of $14 million.  Nonetheless, MTY is ultimately on the hook for all leases.  The average maturity of the lease book is 7 years and annual lease expense is $35 million.  MTY currently has no vacant locations where it is paying rent and does not own any real estate.  MTY, unlike some franchisors, does not make a spread on the rent.  Even in the 2008-2009 downturn, the lease commitments did not cause problems and the franchisee economics were still attractive.  I have focused on the franchisee economics in detail to get comfortable with the lease exposure.          

Why have the margins come down in 2009 and 2010?  The decline in margin is due to negative same store comps during the recession and the acquisition of Country Style in May of 2009, with Country Style being the primary reason.  2010 margins are lower than 2009 since 2010 had a full year of Country Style results.  Country Style is the largest acquisition MTY has made and was a great acquisition at below 4x estimated EBITDA.  Given Country Style's size, MTY has maintained County Style's corporate infrastructure for now.  Over time, MTY will likely rationalize some of Country Style's overhead.  MTY is trying to drive higher volumes by combining certain existing Country Style locations with other concepts.  The weakness in Country Style same store sales growth was demonstrated last quarter and that is something to monitor.       

The growth has been impressive, but does MTY have a real moat?  I attended a franchisee trade show recently in Canada and MTY clearly stood out as having the most diverse and comprehensive portfolio of concepts.  MTY's focus on traditional quick service fare and ethnic fare make it extremely popular with franchisees.  Because of MTY's purchasing scale (MTY gets bulk discounts for its franchisees due to the ordering of food, supplies), menus, and efficient system, MTY's franchisee economics are competitive.  Also, MTY has a highly professional team which works with franchisees to select the right concepts and locations.  MTY has a great training program for franchisees.  And MTY has the experience and intellectual capital to constantly tweak concepts to ensure they remain competitive.  If a certain concept loses its edge, MTY can eventually phase in a new, stronger concept.  As a franchisee making a large initial investment, one feels comfortable working with MTY.    

Is this story too dependent on Stanley?  Stanley has certainly played the dominant role in the company's success, but I feel the CFO, marketing officer, business development officer, and franchising head are all strong players who understand the successful template Stanley has built.  That being said, the story is more compelling with Stanley at the helm.  Stanley is about 60 years old and in good health.  He does not want to retire anytime soon and has large growth ambitions.   

Who are their competitors?  MTY essentially competes directly with all quick service restaurants.  These include McDonald's, Subway, Quiznos, Opa!, and a host of other medium sized and small operators.

Valuation

My estimate of current intrinsic value is $25, or 67% higher than today's valuation.  This is based on assuming that future cash flow is reinvested into accretive acquisitions (at 7x EBITDA instead of 4-5x EBITDA) and I keep margins flat for several years and then have a slight uptick back towards 2009 levels.  My model assumes that it takes one decade for the sales to double, and then the company grows at just 2%, or inflation.  I use an 8% unlevered cost of equity in my analysis.  Sales have doubled since 2003, but I reduce the growth rate as MTY cannot grow at a high rate forever.  Like all concepts, MTY will hit a wall at some point, but I believe they can comfortably reach 3,500 locations. 

For a more conservative case, let's assume MTY cannot source new acquisitions and that the company runs out of new concepts and fewer franchisees approach MTY.  A high quality, inflation-protected royalty stream like this should trade a 6.5% yield.  The company should generate $25 million of FCF in 2011 which at a 6.5% yield implies $385 million of value.  Pro forma for two recently announced transactions, the company will have $10 million of cash at the end of Q2, and around $20 million at the end of 2011.  This yields a value at the end of 2011 of $405 million, over 40% higher than today's value.  When I look at the stock market, TIPS yields, real interest rates over time, and high yield bond yields, I feel comfortable that a 6.5% inflation-protected yield is the right "price" for the risk.  Additionally, I like the CAD exposure.  

Catalyst

Continued growth of existing concepts and the creation of new concepts.  Resuming the long term trend of same stores growth.

Improvement of Country Style and reduction in Country Style corporate costs.      

MTY would make for a strong acquisition candidate given its abundant, recurring free cash flow. 

Expansion into the United States.

Inflation causing investors to pursue inflation-protected assets.  

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    Description

    MTY Food Group trades at a meaningful discount to today's intrinsic value, and I expect the company's profits to continue compounding at a high rate for several years.  The stock not only has high growth potential, but is cheap on trailing cash flow which provides a substantial margin of safety.  MTY's cash flow is high quality as it is basically a recurring cash flow stream from franchisees.  The market capitalization is $287 million and the company has $10 million of cash pro forma for two small acquisitions which close by June.  The company has $6 million of debt.  The company generated net income of $15 million in 2010 and over $20 million of free cash flow.  Free cash flow is much higher than net income as there is minimal maintenance capex but the company has $4 million of non-cash amortization.  Free cash flow tends to be, with slight deviations plus or minus, net income + amortization, which I denote in the last row of the table below.  Ex-cash, one is creating the equity position at 11.0x 2011 FCF.  

    The P/E and P/FCF multiples above are ex-cash.  Most market participants view the company as trading at 18.6x 2010 EPS, but this does not take into account the cash on the balance sheet, the earnings power of the recently announced acquisitions, the large difference between net income and FCF, the high earnings growth, and a return on equity of around 30%.  The ROE takes 2010 FCF and divides it by non-cash assets including intangibles, as there is no net debt.  MTY trades at 9.0x 2011 EBITDA and 9.4x 2011 EBITDA less capex.  Capex was $1.2 million in 2010 and is often offset by disposals.    

    $ in million CAD, except per share amounts

    Share price $15.00
    Shares 19
    Market cap $287
    PF cash 10
    Debt 6
    Min int 0.3
    Enterprise value $284
     
     
     
    2010 P/E 18.6x
    2010 P/E ex-cash 17.9x
    2011 P/FCF ex-cash 11.0x
     
     
     
    Lease commitments @ face $218
    Conserv. PV of lease commitments      176
    Annual lease expense 35
    Adjusted TEV / EBITDAR 6.9x         

     

                                   2003      2004      2005      2006      2007      2008      2009      2010      2011E

    Sales                      $11.5     $15.5     $18.6     $22.0     $30.5     $34.2     $51.5     $66.9      $88.3     

       growth                               35%       20%      18%        39%      12%       51%      30%        32%       

    EBITDA                      2.9        4.9        7.1         9.2         14.2       15.7      21.4      25.8        31.3         

       margin                   25%     32%       38%       42%        46%      46%      42%      39%        36%       

    Net income                 1.6        2.9        4.3         5.8           9.2        9.9       12.3      15.4        20.2         

       growth                               85%       46%       36%        58%        8%       24%      26%        31%        

    Net income + amort    1.9        3.4         4.7        6.8          11.0       12.4      16.1      19.5        25.1 

       growth                               75%       41%       43%        62%       13%      29%      21%        28%        

    Same store sales growth                      4.0%     4.8%       3.3%      1.7%     (1.8)%    (0.3)%      1%

     

    Founded over 25 years ago by the current CEO and largest shareholder, Stanley Ma, MTY is a leading franchisor of quick service food concepts in Canada.  Stanley arrived in Canada from Hong Kong when he was 18 and he started his first restaurant called Le Paradis du Pacifique in Laval, Quebec when he was 29.  The company now has 28 different concepts, and they include Thai Express, Taco Time, Country Style, the Canadian branches of Yogen Fruz, Tiki Ming, Kim Chi, Tandoori, Cultures (salads/sandwiches), Sukiyaki, Veggirama, Frankx Supreme (hot dogs, fries, burgers), Sushi Shop, Koya Japan, Villa Madina Mediterranean Cuisine, Vie & Nam, Vanelli's (Italian), Au Vieux Duluth Express, La Cremiere, the Canadian rights to TCBY, Panini, Croissant Plus, Tutti Frutti, Groupe Valentine, Caferama, Chick n' Chick, O' burger, Sushi-Taxi, and Jugo Juice.  MTY has 1,886 locations (pro forma), over 1,700 of which are franchised and the remaining are company owned stores.  The top 5 banners are Country Style, Taco Time, Sushi Shops, Thai Express, and Vanelli's as of 2010.  Roughly half of system sales are in shopping malls and food courts, 40% are in street front locations, and 10% consist of non-traditional locations.  Despite the company's growth, MTY is not a large company and generated only $67 million of sales in 2010 and had system wide sales of $462 million.

    CEO Stanley Ma is intensely focused on return on capital, and has successfully grown the company both organically and through highly accretive acquisitions.  He owns over 25% of the stock which has a current market value over $70 million.  Stanley's compensation was $390,000 in 2009.  The CFO Claude St. Pierre has been with the company for over 20 years, took $140,000 of compensation in 2009, and owns stock which has a market value over $7 million.  The management team is a quiet, hard working team which does not do conference calls or presentations, though they are happy to meet with investors.  Stanley is funding the growth with internally generated cash flow - MTY has net cash and there are no stock options.  The accounting is clean - there are no non-recurring items to back out.  The CEO has not sold a single share in the last ten years and has two children who work in the business.

    Compounder

    From 2003 to 2010, the company compounded sales and net income at a 29% and 39% CAGR, respectively.  In 2003 the company generated $11.5 million in revenues and $1.6 million of net income.  In 2005, the company generated $18.6 million in revenues and $4.3 million of net income.  And in 2010, the company generated $66.9 million in revenues and $15.4 million of net income.  FCF is higher than net income due to non-cash amortization associated with the amortization of franchise rights and other intangibles. 

    2011 revenue growth is driven by having a full year of results from the food processing and distribution businesses which were acquired in 2010, and by the acquisitions of Sushi Taxi (to close by 5/31/11, 12 stores, $8.5 million of system wide sales) and Jugo Juice (to close by 6/30/11, 133 outlets, $36.4 million of system wide sales in 2010).

    The components of MTY revenue growth are same store sales growth, opening new locations of existing concepts, creating new concepts, and acquisitions.  Let's quickly discuss each.

    Same store sales.   Same store sales growth was 4% in 2005, 4.8% in 2006, 3.3% in 2007, 1.7% in 2008, -1.8% in 2009, -0.3% in 2010.  Same store sales growth on a quarterly basis in 2010 was -1.2%, -1.15%, -0.24%, and then 2.03%.  This last quarter same store sales growth was -0.4% due to weakness in Country Style.  Given the cheap price paid for Country Style, the acquisition was very NPV positive but it is a drag on same store metrics.  MTY is not negatively impacted by food and labor inflation, as MTY is getting a cut of the sales.  Obviously franchisee economics have to be attractive in order to sustain current cash flows and grow, and franchisee economics are addressed later.

    New locations.  One of the attractions of a franchisor model is that the incremental expense and capital required to franchise out existing concepts is incredibly low.  Imagine your portfolio being filled with new inflation protected bonds with a negligible acquisition cost.  MTY has stated that they will open 85 new stores in 2011 (probably 70 net new stores), which contributes 4-5% revenue growth.  With comparable same store sales growth of 1-2% (just inflation), the company can easily grow 5-6% organically without adding new concepts.  The company does not spend significant capital recruiting new franchisees.  It participates in 1-2 trade shows each year and spends some minimal marketing on the internet.  About 15% of new locations are from existing franchisees, and the bulk of the remaining new locations result from prospective franchisees learning about MTY via word of mouth.  MTY has built a reputation in Canada for having a successful portfolio of concepts, particularly within Canada's Asian community.    

    New concepts.  Many of the company's existing concepts were internally created.  Tandoori, an Indian concept created in 2008, now has about 30 locations.  The cost of creating a new concept is a few hundred thousand dollars, and MTY has a team which focuses on rolling out new designs, menus, and concepts.  MTY's team is constantly monitoring competitors and searching for new concepts.        

    Acquisitions.  MTY has been deploying almost all of its FCF into acquisitions.  My analysis of the acquisitions reveals that they are highly accretive.  This is not akin to a large cap technology firm which has to make acquisitions simply to maintain its current cash flows - the acquisition spend is not maintenance capex.  The company is very experienced in acquisitions and is acquiring franchisors for between 4-5x pro forma EBITDA.  Pro forma for cost savings, not revenue growth.  Since franchisors have minimal capex, 4-5x EBITDA translates into 6-7x after-tax unlevered free cash flow.  When a company can acquire free cash flow at a 13% yield which arguably should be priced at a 6-7% yield, value compounds quickly.  And this 13% yield can grow rapidly if the concept is successful and more franchisee locations can be opened.  The company tries to avoid auction processes and has disciplined valuation parameters.  Fortunately for MTY, the Canadian market for these deals is less efficient than in the United States.  Many of the acquisitions were not auctions but were situations where MTY approached or was approached by a smaller franchisor.  MTY benefits from the fact that most of its competitors are not acquiring disparate concepts.  Once MTY acquires a franchisor, it can cut out many of the corporate costs such as accounting, finance, and marketing.  When a franchisor is acquired, MTY can allocate a meaningful proportion of the purchase price to intangible franchisor rights, which are amortized over less than 10 years and provide a nice tax shield.      

    The company has had success with acquiring good concepts and franchising more locations.  For example, MTY acquired 6 Thai Express franchise locations in 2004 for $289,000.  There are now 140 locations.  MTY acquired 62 Sushi Shop locations from 2004-2007, now there are 110 units.  Cultures was purchased at 27 stores and is now at 63 stores.    

    Unit Economics for Franchisees

    MTY partners with its franchisees and considers the franchisees its customers.  The economics for MTY are obviously compelling, but the economics of the franchisees are also attractive.    

    Let's say you want to open a franchise location.  You pay MTY a one-time franchise fee of $30,000.  You then purchase equipment for about $80,000, and you spend approximately $200,000 in leasehold improvements so that the location you lease is outfitted for the concept.  So total startup costs are $310,000. 

    An average street front location should be able to generate $600,000 in sales (the top-grossing location does around $2 million).  Cost of goods sold is around 33% of sales, labor is 28%, 5% royalties to MTY, 2% advertising paid into a fund which is dedicated to advertising and does not flow into MTY revenues, rent is around $84,000, and after insurance, utilities, taxes, a franchise location should produce over $44,000 of net income.  When you add back depreciation and include the salary of the franchisee, a franchisee who works at the location should be able to generate $100,000 to $150,000 of cash flow for himself (after corporate taxes, before personal taxes).  Some of the best franchisees are making $300,000 to $500,000 per location.  Most banks in Canada will finance 50-75% of the leasehold improvements and equipment at the Canadian prime rate + 300 bps, or about 6% today.    

    Sample economics for a store-front location
     
    Initial franchise fee    $30,000
    Equipment 80,000
    Leaseholds 200,000
    Total investment $310,000
       
    Revenues $600,000
    Cost of good sold 198,000
    Labor 168,000 
    Royalties 30,000 
    Advertising 12,000
    Rent 84,000 
    Insurance 5,000
    Utilities 12,000
    Repairs 3,000 
    Depreciation 31,000 
    Pre-tax income 57,000
       margin 9.5% 
    Taxes 12,540 
    Net income $44,460 
       margin  7.4% 
       
    Net income $44,460
    Depreciation 31,000 
    Salary 40,000 
    FCF to owner $115,460 
      

    This FCF to owner is before personal taxes and assumes the owner works in the business.  At the end of 10 years, the owner will need to spend about $100,000 to upgrade his store.  Let's therefore penalize the FCF to owner by a theoretical $10,000 per year allocation to this future investment to arrive at a "lifecycle" annual FCF to owner.  This lifecycle FCF to owner is $105,460.  Excluding the owner operator's salary, the lifecycle FCF to owner is $65,460, or a 21% unlevered return on the original investment of $310,000.            

    What happens when a franchisee defaults on his royalty payments?  MTY controls the lease as MTY enters into the lease with the landlord and then sublets to the franchisee.  MTY is a better credit than the franchisee, so MTY is able to secure better rental rates for the franchisee.  MTY controls the lease so that it has power over the franchisee.  For example, if an unruly franchisee stops paying royalties to MTY or violates quality control standards, MTY can kick the franchisee out of the location and replace him with a better operator.  The new operator often benefits from not having to spend on the leasehold improvements as the location is already built out.  If MTY feels that the location is untenable and does not offer it to a better operator, it can terminate the lease and work out an arrangement with the landlord.  While MTY technically is on the hook for the remaining lease term, MTY as a practical matter usually just pays a few months rent at worst while the landlord finds a new tenant.  MTY does not have any vacant locations.            

    Economics for MTY

    MTY collects the initial franchise fee of $25,000 to $35,000, and then takes 5% royalties.  MTY mandates that all its franchisees order from various distributors approved by MTY.  MTY gets a commission from these distributors.  MTY basically takes in the equivalent of 10% of a franchisee's sales between the royalty, commissions, and other fees/services/products.

    The $67 million in 2010 revenues roughly break out as $23 million in royalties, $23 million in food commissions and other fees/services/products, $3 million in initial franchise fees, $9 million in turnkey revenues, and $9 million from company owned stores.  Turnkey revenues are payments from the franchisee to MTY for building out the store.  Most franchisees hire their own contractors to build the store, but some franchisees pay MTY to build it out.  Turnkey revenues are done at just a 7% margin, so MTY does not generate much cash flow from turnkey projects.  MTY is not lending to the franchisee. 

    The company's primary expenses are the 100 or so people at corporate (offices in Montreal, Calgary, and Toronto), as well as the expenses related to company owned stores.  MTY does not own the real estate related to company owned stores.   

    Keep in mind that MTY does not run leasing through the income statement.  From a cash flow perspective, MTY is collecting rents from the franchisees and then paying rents to the landlord.  These always offset each other unless there are lease defaults/breakage costs, in which case these costs are reflected in the income statement. 

    Geographic expansion

    MTY has entered into master franchisee agreements with master franchisees of certain concepts in the Middle East.

    The United States presents a large, attractive opportunity.  The company is likely to test 1-2 banners in the U.S. and build from there.  I have visited food courts and malls across North America, and it is clear to me that many of the concepts would succeed in the U.S.  To do this, MTY would open a few company owned stores and then franchise concepts out once some minimal brand identity has been established.  The United States is a competitive market, but MTY has competed very well in the most competitive locations in Canada, such as popular food courts and malls in Toronto.      

    Questions/Concerns

    How has MTY grown so quickly?  Have others grown like this?  Other concepts have not been growing as quickly as MTY.  MTY does a superior job of attracting franchisees through its reputation, and MTY is taking share from other competitors. 

    Are you comfortable with the runway for growth?  Yes, I believe that MTY can continue to grow at a nice pace in Canada.  My conversations and visits have confirmed that the concepts are by no means saturated.  MTY has over 1,800 locations and has the ability to grow to 3,500 locations over the next several years just within Canada based on my analysis of market share, penetration, and saturation in Canada's main provinces.  Also, there are still plenty of less efficient, independent mom-and-pop operators in Canada.    

    Do you trust management's ability to deploy capital at rates higher than their cost of capital?  Management is extremely focused on return on capital and has a very specific way of analyzing the NPV created by making acquisitions.  MTY avoids acquisitions where the math is unattractive.        

    Why hasn't MTY expanded in the United States?  Stanley is very conservative and prefers to continue growing in Canada for now.  But he has his eyes on the United States and will eventually expand 1-2 of his banners there to test the markets.    

    $218 million in undiscounted lease commitments are obligations of the company.  Of this amount, $205 million is sub-leased for what MTY calls a "net" commitment of $14 million.  Nonetheless, MTY is ultimately on the hook for all leases.  The average maturity of the lease book is 7 years and annual lease expense is $35 million.  MTY currently has no vacant locations where it is paying rent and does not own any real estate.  MTY, unlike some franchisors, does not make a spread on the rent.  Even in the 2008-2009 downturn, the lease commitments did not cause problems and the franchisee economics were still attractive.  I have focused on the franchisee economics in detail to get comfortable with the lease exposure.          

    Why have the margins come down in 2009 and 2010?  The decline in margin is due to negative same store comps during the recession and the acquisition of Country Style in May of 2009, with Country Style being the primary reason.  2010 margins are lower than 2009 since 2010 had a full year of Country Style results.  Country Style is the largest acquisition MTY has made and was a great acquisition at below 4x estimated EBITDA.  Given Country Style's size, MTY has maintained County Style's corporate infrastructure for now.  Over time, MTY will likely rationalize some of Country Style's overhead.  MTY is trying to drive higher volumes by combining certain existing Country Style locations with other concepts.  The weakness in Country Style same store sales growth was demonstrated last quarter and that is something to monitor.       

    The growth has been impressive, but does MTY have a real moat?  I attended a franchisee trade show recently in Canada and MTY clearly stood out as having the most diverse and comprehensive portfolio of concepts.  MTY's focus on traditional quick service fare and ethnic fare make it extremely popular with franchisees.  Because of MTY's purchasing scale (MTY gets bulk discounts for its franchisees due to the ordering of food, supplies), menus, and efficient system, MTY's franchisee economics are competitive.  Also, MTY has a highly professional team which works with franchisees to select the right concepts and locations.  MTY has a great training program for franchisees.  And MTY has the experience and intellectual capital to constantly tweak concepts to ensure they remain competitive.  If a certain concept loses its edge, MTY can eventually phase in a new, stronger concept.  As a franchisee making a large initial investment, one feels comfortable working with MTY.    

    Is this story too dependent on Stanley?  Stanley has certainly played the dominant role in the company's success, but I feel the CFO, marketing officer, business development officer, and franchising head are all strong players who understand the successful template Stanley has built.  That being said, the story is more compelling with Stanley at the helm.  Stanley is about 60 years old and in good health.  He does not want to retire anytime soon and has large growth ambitions.   

    Who are their competitors?  MTY essentially competes directly with all quick service restaurants.  These include McDonald's, Subway, Quiznos, Opa!, and a host of other medium sized and small operators.

    Valuation

    My estimate of current intrinsic value is $25, or 67% higher than today's valuation.  This is based on assuming that future cash flow is reinvested into accretive acquisitions (at 7x EBITDA instead of 4-5x EBITDA) and I keep margins flat for several years and then have a slight uptick back towards 2009 levels.  My model assumes that it takes one decade for the sales to double, and then the company grows at just 2%, or inflation.  I use an 8% unlevered cost of equity in my analysis.  Sales have doubled since 2003, but I reduce the growth rate as MTY cannot grow at a high rate forever.  Like all concepts, MTY will hit a wall at some point, but I believe they can comfortably reach 3,500 locations. 

    For a more conservative case, let's assume MTY cannot source new acquisitions and that the company runs out of new concepts and fewer franchisees approach MTY.  A high quality, inflation-protected royalty stream like this should trade a 6.5% yield.  The company should generate $25 million of FCF in 2011 which at a 6.5% yield implies $385 million of value.  Pro forma for two recently announced transactions, the company will have $10 million of cash at the end of Q2, and around $20 million at the end of 2011.  This yields a value at the end of 2011 of $405 million, over 40% higher than today's value.  When I look at the stock market, TIPS yields, real interest rates over time, and high yield bond yields, I feel comfortable that a 6.5% inflation-protected yield is the right "price" for the risk.  Additionally, I like the CAD exposure.  

    Catalyst

    Continued growth of existing concepts and the creation of new concepts.  Resuming the long term trend of same stores growth.

    Improvement of Country Style and reduction in Country Style corporate costs.      

    MTY would make for a strong acquisition candidate given its abundant, recurring free cash flow. 

    Expansion into the United States.

    Inflation causing investors to pursue inflation-protected assets.  

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