FRG - Franchise Group: Heads I Win; Tails I Win Big

2023-03-30 08:22:35 ET

Summary

• Franchise Group is undervalued relative to its current depressed earnings.
• Current earnings are depressed due to inventory problems. These are being addressed and should be solved by the end of 2023.
• Future normalized earnings are probably 40% higher than current depressed earnings.
• The company has been paying down debt used for recent acquisitions, buying back stock, and paying a high dividend.
• The company has received an unsolicited offer to be bought for $30 per share in cash.

Franchise Group ( FRG ) presents the kind of opportunity that I am fond of, with odds heavily on my side. The company is facing some temporary problems and the market punished the stock price with a 50% decline in more than one year. Once the company solves its inventory problems, the stock price should jump for a fairer price. Additionally, on the 20th of March, the company received an unsolicited offer from a third party to be bought for $30 per share. So, if the offer goes through, investors win, if does not go through, investors should win big.

Franchise Group Business Model and Transformation

Franchise Group is an owner and operator of franchised and franchisable businesses. They operate a diversified and growing portfolio of highly recognized brands. FRG asset-light business model is designed to generate consistent and recurring revenue plus strong operating margins, requiring limited maintenance capital expenditures. The company is active in M&A in order to grow their business, with a special focus on scalable businesses which generates high cashflows and can grow through own stores or by franchising. Currently the company operates 5 brands, The Vitamin Shoppe, Pet Supplies Plus, Badcock Home Furniture & more, American Freight, Buddy's Home Furnishings, and Sylvan Learning. At the end of 2022, FRG operated 3,029 locations, consisting of 1,401 company run stores 1,310 franchised locations and 318 dealer locations.

2021 was a transformative year for the company, with several acquisitions. FRG acquired Pet Supplies Plus, Badcock Home Furniture & more and Sylvan Learning and sold their Liberty Tax Business. The way the company financed all these purchases shows the management expertise in managing capital.

In March 2021, we acquired Pet Supplies Plus for $700 million financed with a new syndicated term loan that reduced our cost of capital significantly. 3 months later, we paid down approximately $182 million of that term loan with the cash proceeds from the Liberty Tax sale. And then in November, we financed the acquisition of Badcock Furniture entirely with a new $575 million term loan from our existing lenders and then 1 month later, sold non-core consumer credit receivables for $400 million that was used to pay down that debt. I'm happy to say that we now expect to pay off the remaining $175 million of the Badcock financing from the sale leaseback of Badcock's real estate within the next 90 days.

The way the company structures deals is in line with its founder and CEO Brian Khan background in private equity. The CEO has its skin in the game with a direct ownership of 4.2% of the company and 29% through a company called Vintage Capital Management, where he is one of the two partners. 2022 was supposed to be a great year for the company but an inventory problem at American Freight derailed the plans.

Inventory troubles

The company share price has declined about 50% since the beginning of 2022 due to a series of mounting issues.

FRG started to hint at problems in the 2nd quarter results call, when they revised their guidance of sales and EBITDA from $4.45 billion and $450 million to $4.3 billion and $390 million, respectively. The culprits were the inflationary pressure, weaker consumer demand and American Freight selling less $200 million than planned with a cost of $100 million in EBITDA. In the 3rd quarter the company revised their EBITDA guidance further down to $350 million. The company stressed the AF inventory problem and CEO admitted its execution problem.

While we can't control the environment, we absolutely can control our execution. We expect execution to be a net positive for FRG in all environments. Execution is my responsibility, and I don't expect to make the same mistake twice.

Specifically, we paid too much for the wrong mix of inventory, and that combination creates real consequences throughout the A freight system, including reduced profitability from heavily discounting or writing off slow moving and damaged inventory. This impact of discounting is compounded since our associates are commission-driven salespeople.

This mistake appears on the financial statements as lower revenues and gross margins. The cost of the mistake was paid by the excess realized in selling Badcock's real estate portfolio, but solving it is going to take time. In the 2022, results call the CFO hinted that 50% of the problem is addressed and that by year end the problem will be completely solved. The perfect storm hit the company and markets are too pessimistic about it.

Valuation

Although, FRG is facing some headwinds and temporary problems there is a lot of value at current share prices and depressed earnings.

At current prices of $26.8 even in the worst-case scenario the company is worth more than the current share price and current offer of $30. For the base case scenario, I basically used management guidance which was $4.4 billion in revenues and $355 million in EBITDA. In the worst-case scenario, the revenues were lowered by 5% and the operating margin used was the 2022 operating margin. For the best case, sales were increased by 3% and operating margin used was the 2022 operating margin adjusted for the impairments suffered in 2022. These 3 cases are the range of possibilities for 2023 results without growth, so the depreciation expense was kept constant and only maintenance capex was considered. Meanwhile, the normalized scenario is the results the company can achieve in the next two to three years. In this case, revenues increase by 15% when compared with the base case and operating margins climb to 8.2%. The 8.2% is basically the margin the company would achieve in 2022 if its American Freight brand had the same margin it had in 2021. Another difference in this scenario is the capital expenditures considered which includes all full value of 2022 capex, both maintenance and growth. In the base case scenario, the company upside is around 100% and only has to achieve the results it achieved last year, seems pretty likely.

Capital, Risks and Conclusions

The biggest risk on the table is a share price risk, not a business risk. The company pays a lofty dividend of $2.5 per share annually, and with the current problems it may be difficult to sustain that dividend if the company faces another unexpected headwind. On the Q&A for the 2022 results call, FRG hinted that it had around $225 million in free cash flow after freeing $100 million in working capital due to its high inventories. The dividend costs less than $100 million a year, so it should be safe, but the margin is not that wide. The company spent around $180 million last year buying back its own stock, which signals that management is fine with current cash levels. Only in a very pessimistic scenario should the company face real problems.

All in all, we have a severely depressed stock price because of temporary issues, which offers an opportunity to have a tremendous upside if the normalized scenario materializes, or good upside if the base scenario happens and a small upside of 12%, if the current unsolicited offer goes through, I don't think it will. While investors wait for the company business to improve, they receive a lofty dividend, around +9%. I believe the current setup on FRG is very good and that the odds are almost all on our side. Let's go!

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