FRGAP - Franchise Group: An Analysis Of The $30 Takeout Potential

2023-04-20 13:03:31 ET

Summary

• A $30 unsolicited nonbinding offer was made over a month ago. There's since been some news through filings that we'll cover.
• Investors have been wondering if CEO Brian Kahn was involved with the bid. The recent filings show he wasn't.
• Yet they show that Kahn is now negotiating with this group.
• In this article I'll take a look at the buyout scenario and discuss why I think the FRGAP preferred shares offer a better way to play.

Franchise Group ( FRG ) has seen a lot of speculation over the last month regarding an unsolicited non-binding offer to acquire the company for $30.00 per share. The day before the announcement the stock closed at $22.75 meaning the offer was at a 31.9% premium. The stock has drifted upwards since then and is at $27.59 as of writing.

Since the announcement on March 20, 2023 there's been some news which helps to clarify the situation. One of the key questions investors seemed curious about is whether this offer came from CEO Brian Kahn himself who owns 40.2% of the outstanding common stock. A 13d filing from Kahn on April 17 revealed that he was not behind the offer. But they seem to be negotiating with the parties that did.

The filing revealed that part of the offer conditions included " management rolling over its equity stake in the Issuer. " It seems that management is not interested in selling out themselves, but are interested in a potential transaction. Here are some of the details with Kahn represented as the Reporting Persons:

"The Reporting Persons have determined that they wish to discuss the Proposed Transaction with the Bidder and may negotiate with the Bidder (and other interested parties, including the Issuer) with respect to their participation in, and take other actions in furtherance of, that or any other Acquisition Transaction. Following the making of this determination, the Reporting Persons solicited and received the consent of the Special Committee (as defined below) to pursue discussions, negotiations and actions in connection with any proposed Acquisition Transaction so long as the Reporting Persons kept the Special Committee and its counsel reasonably informed regarding any such discussions, negotiations and actions. In connection therewith, the Reporting Persons informed the Special Committee that should any Acquisition Transaction proposal be received by the Issuer, the Reporting Persons would consider engaging in discussions with any bidder that makes such a proposal, should there be a role for the Reporting Persons in connection with any such alternative Acquisition Transaction. In furtherance of the foregoing and subject to any contractual or other applicable limitations, the Reporting Persons intend to engage in discussions and negotiations with third parties regarding an Acquisition Transaction, including the Bidder, potential sources of financing and certain of the existing lenders to the Issuer."

A special committee made up of independent members of the board formed to consider and evaluate a proposal. Notably this committee has retained its own counsel and financial advisor to help create clear separation from Kahn's interests - this is a good sign for minority shareholders. And a recent market purchase from independent director Gary Rich shows interest from the board themselves.

Additionally, the filing indicates that if Kahn and this bidder work together, the final offer would be subject to majority shareholder approval. Essentially if the committee recommends a deal, shareholders outside of Kahn's interest would be making the final vote.

I take all of this to mean that a deal is at least being investigated. Kahn is openly communicating that and the company is building the structure necessary to complete a deal in a way that's equitable to all owners. Yet even with this additional information, we still don't know who the bidder is nor do we have any sense of where this ultimately is going to go. Everything is non-binding and exploratory.

The filing suggested that a transaction could include " the acquisition of additional securities of the Issuer, a merger or other extraordinary transaction involving the Issuer, the delisting of the Common Stock from NASDAQ, and the Common Stock becoming eligible for termination of registration pursuant to Section 12(g)(4) of the Securities Exchange Act of 1934, as amended. "

A take-private transaction seems likely if the bidder and Kahn work together on a deal. That represents an interesting opportunity.

Buyout Scenario and the Preferred Shares

Let's consider some outcomes here. It's possible that the deal moves forward with the already announced $30 price per share which alone represents upside for the common. Some are speculating that an even higher buyout price is likely to be negotiated. I've constructed a table to give some reference points about possible returns in certain buyout scenarios. As part of my assumptions I included two quarters of dividend payments.

At the $30 price target and assuming some time passing we can see that translates to a 13% return. Clearly there's potential for greater returns if a higher price is negotiated. But what I find interesting is the preferred shares in relation to this potential transaction: FRGAP.

These are cumulative perpetual preferreds with a par value of $25 and pay out $1.88 in annual dividends. Right now the preferreds are trading at $22.00 which implies an annual dividend yield of 8.5%. Compared to a universe of over 600 preferreds this is above the 7.78% average dividend yield.

If we turn to the prospectus for the preferreds we can discover that they retain conversion rights in the case of a delisting event or change of control. Series A Preferred stock is given the right to convert shares into common stock. This conversion per share is calculated at the lesser of these two options:

1. The quotient obtained by dividing (1) the sum of the $25.00 per share liquidation preference plus the amount of any accumulated and unpaid dividends to, but not including, the Delisting Event Conversion Date or Change of Control Conversion Date, as applicable (unless the Delisting Event Conversion Date or Change of Control Conversion Date, as applicable is after a record date for a Series A Preferred Stock dividend payment and prior to the corresponding Series A Preferred Stock dividend payment date, in which case no additional amount for such accumulated and unpaid dividend will be included in this sum) by (2) the Common Stock Price (as defined herein); and

2. 1.9608 (i.e., the Share Cap), subject to certain adjustments.

Looking at scenario two we can multiply the current stock price of $27.59 by the 1.96x share cap to estimate value per preferred share at $54.08 on the high end. This scenario is very unlikely. Instead we are looking at scenario one where the value of the preferreds is really gauged around par value and any upcoming dividends.

We can use this information to estimate what might happen to the preferreds in a buyout situation. With the same assumptions we would see two quarters of dividends on the preferreds totaling $0.94 which we can add to par value of $25.00. That gives us a takeout value for FRGAP at $25.94 compared to the current $22.00 price (17.9%).

What this means is that if the deal goes through at the current $30 price tag there is actually more upside for the preferred shares than there are for the common. Not only that, the preferreds come with more downside support if a deal does not go through. As we noted earlier FRG was trading around $23 before the unsolicited offer was made. Comparing that to where FRGAP was just before the announcement gives us some sense of potential downside on the news.

Personally, I wouldn't expect a deal breaking announcement to cause as much pressure on the preferred shares as they seem to be trading more related to their yield.

To put some context on the relative safety of the preferred in the capital stack we can look at some metrics as of their most recent 10k .

We can see that preferred equity of $45 million is covered over eight times by stock equity. Cash on hand at $81 million nearly covers the value of the preferreds twice over. With 4.5 million shares of FRGAP outstanding and $1.88 annual dividend that comes to $8 million owed on the preferreds each year. That seems well covered by current assets.

And in a worst-case scenario the company pays out $2.50 per share on the common which amounts to $87.25 million a year that could be cut. Any amount saved on the common dividend would help strengthen the position of the preferreds.

Investor Takeaways

It looks to me like a deal is shaping up at Franchise Group to enable some sort of transaction involving Kahn and whoever the original bidder was. At this point though nothing is guaranteed and the common stock price reflects that uncertainty. If we assume a takeout at the current $30 per share pricing then the return potential is higher today for the preferreds. And even in a situation where a deal does not go through, owners of FRGAP can collect on the above-average 8.5% yield which seems supported by the underlying fundamentals.

Preferred owners are given exposure to the possible deal through the conversion rights. Relative safety is offered by moving up in the capital stack from the common. And if one believes that a buyout price on the common is likely to go higher, then by all means it may end up a better opportunity. Be mindful of the risk of a dividend cut here though as net income was negative last year mostly due to interest expense on their debt. This is another overhang on the common if the deal does not materialize.

As it stands I believe the preferreds are clearly a better way to capitalize on Franchise Group's current situation. With market uncertainty continuing to loom and a tightening credit cycle pressuring business, I prefer to have additional security in my investments these days. It's not often you get that security, more return potential, and less downside risk all at the same time. That's what FRGAP is offering vis a vis FRG .

Risks

• The major risk is what happens with this unsolicited offer. If a deal is taken off the table then there could be price pressure on both the common and preferreds.

• A sizable amount of debt comes before the preferreds. Debt-to-equity overall is high at 4.35x and the impacts of this are coming through on the income statement already as interest expenses eat up operating profits. In a tightening credit cycle this is important to watch.

• While I focused on a take-private transaction it may not be what happens. The negotiations between Kahn and the bidder may evolve into some other type of transaction like a stock merger with another company. This would materially change the impact on the preferred shares. Folks who are interested should read the preferred prospectus to wrap your head around the details.

For further details see: