Description

Midas is an example of what most of us on this site look for in a long: strong free-cash flow generating capability, first-class management team, very cheap (free-cash flow yield of over 13%!), and largely unknown, misunderstood, and ignored by Wall Street.

Midas History

Midas has a long history, first granting franchises for Midas shops in 1956. Initially the shops sold exhaust system replacements and added shocks, brakes, and alignment services over the following decades. Today there are 2,700 Midas shops worldwide with leading market shares in a number of auto aftermarket categories.

In the mid 1990’s the exhaust after-market industry began declining due to adoption of stainless steel mufflers, which significantly increased the life of an exhaust system from approximately 3 years to 9-10 years. This, of course, was negative for Midas because the company was still generating a large amount of its revenue from exhaust system replacements. Same-store sales began a long period of decline.

Seeing the “writing on the wall”, the company began offering new product categories (alignment, batteries, general maintenance, etc.) in the late 90’s in order to offset the declining exhaust system business. The difficulty in doing this, however, was that the individual Midas shops (franchisees) couldn’t hold the inventory required to offer all of the new products due to increased inventory costs as well as lack of physical space needed for all the new SKU’s. In order to alleviate this problem Midas decided that they would build out a large distribution network that could give the individual Midas shops just-in-time access to products. Prior to this decision the company had only a dozen distribution centers around the country that supplied weekly replenishment to the shops. The goal, going forward, was to build hundreds of distribution centers that could provide quick inventory replenishments to the franchisees – thus lifting the burden at the shops.

Unfortunately the strategy was flawed and could have eventually brought the company into bankruptcy. The distribution build-out was very costly and required the company to carry high levels of inventory and accounts receivable. Inventory on Midas’ balance sheet jumped from 96 days in 1998 to 212 days in 2002. Accounts receivable rose from 28 days to 56 days over the same period. The company took on a substantial amount of debt in order to finance their working capital needs. To make matters worse, they didn’t have the scale needed to be competitive and began losing a significant amount of money in distribution.

Alan Feldman takes over

Eventually the board of directors pushed out management and, in 2003, hired Alan Feldman – who most recently was President of McDonalds USA. Alan took over a company with declining same-store sales, that was heavily leveraged, working-capital intensive, and losing money because of an inefficient distribution network. Importantly, and critical to our analysis, all of these problems masked the profitability of a solid franchise/royalty business. Alan’s experience at McDonalds had taught him the attractiveness of a franchise model and the cash flow it can generate. Over the past year and a half he has done a fantastic job transforming the business to a new model, one that has franchise/royalties as its core. He studied AutoZone and realized that they already had in place a distribution network that could accommodate Midas’s requirements. So he worked out an agreement with AutoZone to have them take on Midas parts distribution in the U.S. (and did the same with Uni-Select in Canada). This enabled Midas to shut down its money-losing distribution centers and outsource the distribution function to AutoZone. By getting out of distribution the company was able to run with significantly lower inventory and accounts receivable. Inventory dropped from $129 million in the 3rd quarter of 2002 to only $12 million today. Accounts receivable dropped from over $60 million to $40 million over the same period. This freed up a tremendous amount of cash, which the company used to pay down debt – from $135 million at its peak at the end of 2002 to below $85 million today. Furthermore, once the balance sheet improved the company refinanced the remaining debt at much lower interest rates.

This was a major transformation for the company – one that sets them up for a strong future in my opinion. Today the company makes the vast amount of its money from the franchise fees it collects. Real Estate is the other major profit center of the company. The company owns the real estate for 250 of the franchised locations, which is a fairly valuable set of assets. The company also leases and then subleases back to the franchisees the real estate for the majority of the rest of the franchised locations.

By freeing themselves from the distribution business, the company is now able to focus on getting system-wide sales up. The goal is to get system-wide sales to $1.4 billion from today’s $1 billion. The way they are doing this is through four initiatives:
(1) Renewed focus on brakes
(2) Begin selling tires (they recently entered into a relationship with Bridgestone/Firestone)
(3) Provide maintenance services at shops
(4) Fleet management (will be the only national player offering this service to small/medium size companies)

These initiates are already working: exhausts are only 19% of system-wide sales today – down from 33% in the late 90’s. Further, same-store sales, which had declined in 6 out of the 7 years from 1996-2002 have now risen for six straight quarters – and the new programs are not even fully rolled out yet.


I feel that this new focus should provide meaningful growth for the company over the next 5 years – although in order for this investment to work we only need to see a small amount of growth going forward (see below).




Valuation

While Midas has interesting growth prospects going forward, the most attractive part is that the company has cash earnings that are significantly higher than reported earnings (for most companies it’s the other way around).

There are a couple of reasons for this. The first has to do with Midas’ $40 million in tax NOL’s. These are a result of losses in the past and essentially mean that the company won’t be paying cash taxes for at least the next 3- 4 years! The second reason has to do with a very large mismatch between depreciation and capital expenditures. Depreciation will run at about $12.5 million per year while capital expenditures will run at only $2.5 million. The reasons for the higher depreciation go back to the IT build-out that the company put in place in anticipation for all the new distribution centers. While the company did shut down it’s distribution sites it kept the IT systems and will be depreciating them for some time without having a corresponding capital expenditure outlay. This cap-ex/depreciation “mismatch” will remain going forward.

In addition, Midas still manufactures exhaust systems and loses money doing so. My estimate is that they lose anywhere between $5 million and $8 million annually in manufacturing mufflers. I believe that the company will eventually shut down this business or sell it and cut out the losses associated with it. While there would be a cost to shutting down, the company says that the lower warranty cost and inventory would offset this cost.

I expect Midas to earn $13.9 million or $.86/share in 2005. At a stock price of $17.30 it would seem that the stock is fair value at best. But, as stated before, the company generates significantly more cash income per share because of tax NOL’s and cap-ex/depreciation differential. If we add back the tax expense (which, again, is not a cash outflow due to the NOL’s) then earnings are closer to $22.5 million. We can then add back the cap-ex/depreciation mismatch of $10 million to get to a cash-flow number of $32.5 million (I’m excluding further working capital reductions which will likely continue). Also, I think that they will shut down manufacturing of exhausts, which would add (at the low end of my estimate) an additional $5 million in cash flow annually – bringing cash flow to $37.5 million. There are 16.2 million shares outstanding so cash-flow/share could be as high as $2.32 next year by my estimates. This gives the stock an extremely attractive free cash-flow yield of 13.4%. Of course I don’t know when they would shut down manufacturing of exhausts so the timing of generating $2.32 in cash flow is uncertain – but I suspect this will be very soon.

I think that the company will use the cash flow to buy back a significant amount of shares over the next few years (something that I am strongly pushing them to do). My modeling assumes that cash flow will grow in the low to mid-single digits over the next few years (roughly in-line with GDP – not a heroic assumption). Assuming the company uses free cash flow to buy back shares then the cash flow per share should be about $3.15 per share by the end of 2007. If the stock were to sell at a free cash flow yield of 6-8% (versus roughly only 5% for the market today) then it will be selling for somewhere between $39 and $52 per share by that point – or a compounded annualized return of 31% to 45% based on today’s stock price. Note – make your own assumptions on what the free-cash flow yield could be at that point to get to your own valuation target– this is how I am looking at it today (also, remember that the NOL’s don’t go on forever). The downside is somewhat protected as the real estate on the company’s balance alone is worth about $7.50 per share (based on some real estate sales the company has done recently) and could be monetized if needed. Given, then, that the downside is much higher than $7.50 (closer to $13.00 in my opinion) the risk/reward is very attractive.

Catalyst

Share buybacks, closing of exhaust business, convergence of cash flow per share and reported earnings per share