Thursday, 6 February 2014

Careful when riding coat-tails

Most of my time when looking at investments is spent rejecting ideas. Personally, I prefer reading other peoples ideas from various blogs, SumZero, VIC, BeyondProxy instead of running screens (notorious coat-tail-rider), so every idea I come across is written from another investors point of view - which has its positives and negatives. The positive is that you learn a lot, there are lots of smart investors willing to share their wisdom - how to look at a certain business, things you should be concerned about. The negative is that every investor has different concerns, a different investment philosophy, and will only provide what they feel is the most relevant information. Doing your own work is crucial, no matter who's tail you plan on riding. Two ideas which I'd been working on recently can serve as good examples:

#1) Comparing Apples vs. Oranges - Imvescor Restaurant Group:
This was an idea initially posted on VIC in June 2013 when the stock was at $1.30, with a $3.30 target (available to guests). More recently a couple of write-ups popped up on SumZero with $4.30 & $4.50 targets (members only), the stock is trading at $1.90, so despite rising +45% over the last six months, it was still of interest. The investment thesis goes something like this:
  1. Franchisor business model - stable earnings with high free cash flow generation.
  2. Strong market share in key markets - #1 position in Atlantic Canada and #2 in Quebec, with 240 total restaurants concentrated in Eastern Canada.
  3. Attractive valuation - trading at ~7.7x EBITDA, whereas comps range from 8.5x to 13.9x. Absolute valuation of 9.9x FCF is also attractive given the low capital intensity.
  4. Catalysts - resumption of dividends, new products, activist investors.
At this point I was pretty excited and started to do some due diligence. 

Being a Canadian and not knowing any of these eastern franchises, my first question was obviously how have these franchises fared over time?

The answer was not great. Overall the top two brands have lost 51 locations out of 222 over the last decade, 47 of these were in their respective dominant market. Over the same period Boston Pizza, previously focused on the West Coast added some 90+ restaurants in Eastern Canada alone. While disappointing, I thought this probably explains the cheapness.

Moving onto cheapness I wanted to answer 3 questions:

1. How does the current valuation compare to its historical valuation? 

Not very cheap, the company's current EV of ~C$110mln is close to its historical peak in 2008. The company does boast a retail division now with ~$4mln in royalties, but has lost 20 odd locations since. Overall EBITDA is pretty close to the 2008 rate of ~$18 mln. But hey, just because it's been cheap in the past doesn't mean its not cheap now.

2. How does it compare with its competitors?

This is where the whole "Apples vs. Oranges" rant comes in. The VIC write-up lists four comps, three of which are unit trust - A&W, Boston Pizza, and Pizza Pizza - the writer did explicitly flag this, but let me continue. What is the problem here? 

The problem is that with Imvescor, you have 3 different business models: i) the good franchising business including retail sales; ii) not so great the company owned restaurants which are acquired from struggling franchisees; and iii) not so great manufacturing operations. All three reports treat all the businesses equally and slap a 10x EBITDA multiple or a 6% dividend yield to get their target prices. This means you're paying $70 mln for the two not so great businesses. To provide some perspective, the 10 company owned restaurants were acquired for $2.5 mln and the company currently has $1.5 mln in manufacturing sales + a recently acquired facility for $4mln. I find it tough to get $70 mln worth of value there. 

3) What is it worth on a sum-of-the-parts basis?

Well lets say we assign a 10x mult. to the royalty business for $130mln, and 4x for the company owned restaurants for $12mln, and 4x for manufacturing, which we will assume does $4mln in EBITDA after recent acquisition, for another $16mln. Adjust for the debt and fully diluted cash and share count, you get $2.53/sh. Still attractive compared to its $1.90 price, but our safety margin is now much narrower than say compared to $4.50 in value. Now you start thinking about the fact that the company's two mature franchises have closed 51 locations over the last decade, the multi-brand strategy is clearly struggling to compete against national franchises, and that competition is actually intensifying - well that margin of safety is pretty much gone. 

Imvescor is cheap, but would I want to hold on to it for 10 years against the competition? Definitely not.

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