Description

Morgan’s Foods (MRFD) is a franchisee of Yum Brands restaurants that owns 56 of the 97 units it operates.  MRFD trades at 6x LTM EBITDA and has significant hidden real estate assets.  This stock is trading at fifty cents on the dollar.

I’m sure everyone knows what KFC and Taco Bell do, so I’ll try to keep this write up brief and to the point. 

$37.2 million of debt is mortgage related.

In F’07 (2/07) MRFD generated $10.3 million of EBITDA, so EV/EBITDA is 6.1x.  I expect F’08 operating results will be fairly similar to F’07.  MRFD also has a NOL of $2.5 million, which I have not valued.  6x seems pretty cheap and a steady slow growing restaurant stock probably deserves to trade at 7x EBITDA, which would put the stock around $16 based on F'08 EBITDA of $11 million, so it appears relatively cheap with decent upside just based on the operating results.  Some microcap restaurant comp multiples that appear the closest matches in terms of size are: CASA 6x, BYBI 8x, WSZL 11x, STRZ 12x, BUCA 14x, BOBS 9x.

Asset value provides the real upside (and margin of safety) via the potential for MRFD to monetize its real estate holdings. Book value of land and buildings is $30.7 million.  In addition to the 56 owned restaurants, there are 23 units where the land is leased and the buildings are owned.  I assume that these could also be monetized, albeit at much less attractive terms, which could add a few dollars per share to my valuation below, but I am not including these in the analysis.  Backing into the book value for the 23 land leased/building owned units is probably just over $8 million, so the book value of the 56 owned is approximately $22-23 million.  I believe the market value is far greater than that.

The company explored a sale/leaseback transaction of 10 properties in F’05, but ended up not following through.  In F’06 MRFD did complete a sale/leaseback on one unit for $985 thousand with cash proceeds of $967 thousand and a deferred gain of $377 thousand.  This transaction closed 2 years ago, so in all likelihood valuations have improved in that time.

There are a couple of ways to value the owned restaurants.  If we assume that MRFD’s income is evenly distributed throughout its restaurants and we know that 58% of MRFD’s units are owned, then we can estimate that the owned units generated $5.9m of EBITDA.   Assuming $2 million of maintenance capex, the owned units capex would be $1.2 million.  EBITDA – capex for the owned units is $4.8 million, which per store is equal to approximately $86 thousand.  I have not disaggregated corporate overhead from these EBITDA estimates because there is not enough disclosure to do so, so the per store economics are probably slightly better than this, so the real value of each unit could be higher, but for the sake of conservatism we can use these numbers.  Fast food restaurant cap rates are currently about 6.5%, so a restaurant's private market value is in the $1.3 million range based on this metric.  6.5% is historically a low cap rate, so there is a risk of reversion to the mean as rates rise, but there is still a window of opportunity now to monetize these.  Another way of approaching it is that the median price per square foot to acquire a fast food restaurant is currently about $500 and KFC’s on average are about 2200 square feet, so $1.1 million is also a reasonable value per store.  In my due diligence, I discussed these estimates with sale/leaseback experts and they agreed that they are conservative and reasonable.

Furthermore, from a replacement value perspective, YUM’s franchising website, http://www.yumfranchises.com/fran_process/worksheet.asp, indicates that ‘ground up’ construction of a KFC/TB unit could cost between $875 thousand and $1.355 million and the real estate could cost up to $1.4 million, so if you get aggressive an owned unit could cost $2.75 million to build from scratch.  Granted, these ‘2n1’ units are more valuable and costlier to build than the single concept unit, but 19 of MRFD’s 97 restaurants are ‘2n1’ units and it provides a basic idea of the cost of a new build, as well as, the potential for upside to the $1.1-1.3 million estimate of restaurant value.

If restaurants were sold in a sale/leaseback transaction for $1.1-1.3 million each, then the gross proceeds would be between $61.6-72.8 million.  If the $23 million book value estimate for the 56 owned stores is correct then the per store book value is roughly $410 thousand, which results in a gain on sale of $690-890 thousand per unit, taxed at 40%, which yields after tax proceeds of $46.1-52.9 million.  On a per share basis this is $15.91-18.23.

Rents for the units under operating leases range between $19 thousand and $95 thousand. I assume that the new rent for restaurants that would be leased back is about $80 thousand because new leases would probably be more expensive than MRFD’s current average.  Therefore, the incremental rent expense would be $4.48 million for running these restaurants under an operating lease. 

The EV adjusted for the net proceeds from the sale of the property would be $9.9-16.6 million.  EBITDA adjusted for the incremental rent expense would be $5.8 million, which means that following a sale/leaseback of all owned units MRFD would be trading at 1.7-2.9x EBITDA.  If the stock were to trade at 7x EBITDA following a sale/leaseback transaction, it would be worth about $19 to $22 per share.

Although the impact of a sale/leaseback would dramatically lower EBITDA due to higher rent expense, it would be basically offset by the decrease in interest expense, which was $3.9 million in F’07, so there would be minimal impact on net income.  The cost of their debt also seems very high considering it is backed by real estate, at 8.3-10.6%, so at the very least I think they should pursue a refinancing, but I also think this makes a sale/leaseback an interesting form of financing for the company.

Leonard Sapir-Stein, CEO, is 68 years old and owns 29% of the shares outstanding, so I would expect that he might be interested in an exit strategy that creates a lot of shareholder value, but then again I don’t want to underestimate the allure of working at a KFC well into one’s golden years.  Furthermore, officers and directors of the company own 43% of the stock.  It is also worth mentioning that two funds have been steadily accumulating the stock and now own over 10% each, so that could create a catalyst, as well.  Personally, I’m a little tired of all the LBO rumors these days, but I really do think an MBO is a distinct possibility, in conjunction with or in lieu of a sale/leaseback.

Risks:

1) Potential management intransigence to monetize real estate assets or inability to monetize them.

2)  Increased capex requirements.  MRFD’s commitments for restaurant improvements in the next few years are slightly higher than they have been in past years.

3)  Illiquidity, which I would describe more as a drawback than a risk.

4) http://www.youtube.com/watch?v=k5BjaVulOsQ

(This is not a MRFD franchise by the way.)

Catalyst