KSS - Franchise Group Is My #1 Recommendation - Here's Why

Summary

• Franchise Group: superbly managed, strong organic growth, moderate leverage, stellar M&A track record, huge buyback in place. I estimate a $5 dividend and $10+ FCF/share in 2024.
• The home furnishings segment, about 40% of the company's EBITDA, has been hit hard in 2022 by macroeconomic issues. The other business segments are growing nicely.
• Past M&A performance has earned the company access to third party financing. More M&A is likely coming as the company seeks to take advantage of the current distressed landscape.
• The stock is down ~35% as supply chain and other macro issues have hit the company's home furnishings segment hard in 2022, prompting a 13.5% cut to 2022 EBITDA guidance.
• FCF has been negative in 1H 2022, despite still strong EBITDA, due to a large build in working capital. This working capital build will reverse, and become a source of cash over the next 12 months.

Franchise Group ( FRG ) is my largest holding. I've written about it before, so if you want you can check it out, starting with my first article . Their Q2 2022 investor presentation may also be worth a look, as is the Q2 2022 earnings transcript .

FRG consists of health retailer The Vitamin Shoppe [TVS]; rent-to-own retailer Buddy's; warehouse-style appliance, mattress, and furniture retailer American Freight [AF]; pet store operator Pet Supplies Plus [PSP]; educational services company Sylvan Learning; and furniture retailer W.S. Badcock. Current management took the reins in 2019, and transformed the company from a troubled tax preparer into a growing, cash flowing retail powerhouse, through a series of spectacular acquisitions. EBITDA per share is up 3x as a result. The company has a policy of returning 25% of EBITDA to shareholders as dividends, and the dividend currently stands at $2.50, a yield of just under 8% as I write this. FRG is run by its excellent founder and CEO, Brian Kahn. Brian comes from a private equity background, and owns about 27% of the shares. He is well aligned with shareholders.

The company made a bold attempt to buy much larger Kohl's ( KSS ), receiving strong support from lenders. Ultimately Kohl's management rejected the $53/share offer , preferring their current $28 share price instead. FRG is almost certainly once again on the hunt for more acquisitions, but it has also authorized a $500 million buyback , enough to repurchase roughly 40% of the outstanding shares at the current price of ~$33.

2022 off to a rough start

FRG guided in December 2021 for 2022 EBITDA of $450 million and $5/share of non-GAAP EPS. While most business segments are on track, the discount home furnishings segment American Freight is suffering from cost inflation and a severe reduction in consumer demand, causing the company to reduce 2022 guidance to $390 million EBITDA and non-GAAP EPS to $4.

FCF/share has been ~($0.80) so far in 2022, despite the strong 1H EBITDA. This is largely due to a ~$150 million inventory build, up 22.5% from YE 2021. With flat working capital, FCF/share in the first six months would have been ~$2.70. While it's tempting to look through working capital fluctuations as short term and likely to reverse, it's nevertheless not a good look to run negative FCF.

The rational bear thesis

While general pessimism about inflation, the economy, and especially retailers, have all played a role in the recent share price decline at FRG, I want to start by spending some time stating the bear case aside from those factors.

1. Bears might be looking at 2H 2022 EBITDA guidance and annualizing for 2023. With $215 million so far, the new guidance implies $175 million in 2H. Annualizing this would imply $350M EBITDA in 2023, meaningfully lower than the already reduced $390 million now expected in 2022.
2. FCF has been negative so far in 2022 even with $215 million of EBITDA. This is due to the large build in working capital I referenced earlier.
3. Net debt is now $1.1 billion. Pro-forma for a bear view on 2023 EBITDA of $350 million, leverage would be 3.14x, which is above management's target of 2-3x. Bears might argue buybacks are off the table.
4. If things worsen from the bear thesis $350 million EBITDA, then even the dividend could be cut. The driver could be a big recession, or a serious setback in one of the non-home furnishings segments

Let's keep all this in mind as we plow ahead.

FRG is a growth business

15 months ago, FRG issued EBITDA guidance for 2021 of $315 million. Net debt was just under $1.1 billion, and there were 40 million shares. In the recent Q2 earnings press release , FRG lowered 2022 guidance to $390 million. Net debt is still $1.1 billion, and the share count has increased to 41 million.

I almost feel like I don't need to say anything more. The macro climate has been very hard on them, and they are cutting guidance, and everyone is disappointed about that. But $390 million is more than $315 million, so...

Going forward, the company is poised for a great deal of organic growth across multiple segments. PSP just had its best EBITDA quarter ever. The segment has a 230 store backlog of franchisees, which would increase the store count by more than 35% above the 644 stores they operated at YE 2021. The company has identified a goal to exceed 1650 stores over time. PSP is on track for $105 million EBITDA in 2022. Extrapolating that to 1650 stores would take PSP EBITDA to $260 million.

Probably the biggest organic driver will be American Freight, which is currently the most challenged segment. AF is actually a superb business, but it operates in the low end home furnishings space, which is extremely challenged right now. AF is on track for $40 million of EBITDA in 2022, well below the triple digits management probably expected at the beginning of the year, and this is almost certainly the primary driver of the guidance cut. Here's what CEO Brian Kahn had to say about it during the Q2 2022 earnings call :

Product and freight costs within our home furnishing businesses are reducing margins. And food and energy inflation is taking a larger share of our lower income customer's wallet, which is reducing transaction volumes. This combination is meaningful. Although American Freight is emphatically expected to be a material contributor to FRG's long term growth, the impact of inflation this year is likely to result in approximately $100 million less EBITDA than what the current store base would be expected to generate in the steady state... we've got 370 stores going to 1300 stores ... (Emphasis mine)

This implies a steady state EBITDA for AF of $140 million based on the current 370 store count. However, that store count is expected to grow materially. A simple extrapolation suggests that EBITDA at AF may exceed $400 million at some point.

Adding in the other segments, it's clear the current configuration of FRG has the potential to exceed $1 billion of EBITDA over time through basic block and tackle operations. It's definitely a growth business, even without M&A.

A light at the end of the tunnel

FRG consists three home furnishings segments, of which AF is the largest, and three other non home furnishings segments. The three in the "other" category are headed for a record year in 2022, on pace for $270 million of the $390 million EBITDA guidance, and they are expected to grow into 2023 and beyond.

But what about home furnishings? CEO Brian Kahn had this to say on the Q2 2022 earnings call:

American Freight is expected to generate approximately $200 million less revenue than planned, that revenue loss comes with roughly 30% EBITDA... the nearly $1 billion of revenue that American Freight will generate will come at a cost of over 500 basis points of excess... The math totals over $100 million of EBITDA impact at American Freight this year alone... we're just not going to increase prices, we're going to eat the cost increases that we have embedded in the inventory now.

In that statement, we learn that the company believes the $110 million EBITDA hit at AF is split, with roughly $60 million due to lower revenue, and $50 million due to high costs that the company is electing not to pass on to the consumer.

While demand is not yet recovering, there are some good signs on costs:

The primary difference between the business climate today and the one we shared after the first quarter is that freight costs and home furnishing product costs have peaked. We're now ordering new inventory at lower product costs, and lower incoming freight costs. Some cost reductions are more material than others but generally we're headed in the right direction... supply and demand imbalance for products and human capital are both correcting in our favor, and we expect this trend to continue...

We see costs coming down and in some cases, very significantly. We have one of our larger and better vendors, decreasing prices, product costs 30% to 40% in major categories.

A full reset to normal prices would yield a $50 million EBITDA improvement at AF, even without a return to normal consumer demand, and this process appears to have at least begun. If it has, then FCF will begin to benefit immediately. However, whatever cost savings they may see now, they will not impact 2022 EBITDA due to the company's FIFO accounting. Kahn makes indirect reference to this:

It will likely take the rest of this year to sell the older higher cost inventory through our system...

I don't want to get into the details of FIFO accounting here, but lower costs today mean increased FCF now, and then both increased EBITDA and FCF once the high cost inventory is sold. This is a subtle point, but an important one. 2023 EBITDA guidance will benefit from whatever cost savings they are seeing right now. 2022 EBITDA guidance will not.

Is American Freight recession resistant?

It might very well be. The reason is that in a recession, costs go down, and middle class consumers tend to become customers at discount stores like AF. This is why discount businesses are recession resistant. It's not applicable now because costs are up, and the middle class is not distressed. Only low end consumers are being squeezed. Here's what Kahn had to say during the Q2 2022 earnings call :

What you would typically see is in a recession, you would see the lower income customer, everybody, the jobless rate going up, unemployment is increasing. So you have a trade down, the higher income customer now becomes your customer and the lower income customer who you may lose is replaced, that's not really what's happening now. We're not seeing unemployment go up. What we're seeing is the low income customer having their wallet squeezed... the higher income customer, he or she is not losing their job. So they don't need to trade down.

We do believe American Freight is recession resistant... unfortunately, it's not a recession . I think in a good old fashioned recession, you'll see American Freight perform very well... it's the best unit economics of all the brands that we have, right now. (Emphasis mine.)

A quick word about net debt

FRG has net debt of $1,112 million, as can be seen on page 21 of the company's Q2 2022 earnings presentation . This kind of thing is not normally a source of confusion, but in this case it has caused some. The reason is that FRG sold receivables acquired during the Badcock acquisition, some of which are still being counted, for now, as debt for accounting purposes.

I'm not going to get into the weeds on it here, but ultimately the company will complete the transition to third party customer finance vendors Fortiva and America First Financial, and the issue will go away. In the meantime, the company has provided the correct net debt, adjusted for this issue, in the earnings deck I linked above. CFO Eric Seeton had this to say on the Q2 2022 earnings call :

We are still in the process of transitioning consumer finance at Badcock from in-house to third party partners... the balance sheet continues to reflect securitization debt and accounts receivable despite most of the receivables having been sold to third parties. Once we discontinue originating customer loans... the related assets and liabilities will no longer be reported on our balance sheet.

The company is expecting the issue to be cleared up by YE 2022. Timing aside, the issue will certainly be cleared up eventually, and the correct net debt number is $1,112 million.

Answering the rational bear thesis

The rational bear thesis is inherently short term in nature. If we believe in the growth inherent in the business segments, and the quality of management, one could argue that's much more important than what EBITDA might be over the next 12 months. Fair enough, but I think it should be answered anyway.

I've already made the point that the higher costs facing AF have led to a big build in inventory, resulting in negative FCF in 1H 2022. Just having the same number of units at a higher price point will do that. And then these higher costs, along with reduced consumer demand for discount furniture, is responsible for a roughly $100 million reduction in EBITDA in 2022, with about half the effect attributable to each.

On the recent call, Brian said that home furnishings costs, both product and shipping, were coming down, and in particular even referenced one of their "larger and better vendors" cutting costs 30-40%. But although the lower costs will begin benefitting FCF right away, the lower costs won't impact EBITDA until 2023 due to the company's FIFO accounting.

This already challenges one of the main "rational bear" thesis points: using annualized 2H 2022 EBITDA as the basis for estimating 2023 EBITDA. Although the lower costs they are already seeing right now will be an important boost to 2023 EBITDA, they aren't included in 2022 EBITDA at all.

A second point is that FRG is a seasonal business, with 2H slower than 1H. And finally, the non home furnishings segments are all growing right now, and are expected to continue that growth in 2023 and beyond. So for three clear cut reasons, simply annualizing 2H 2022 is not the right starting point to estimate 2023 EBITDA.

Here's some arithmetic. Non-home furnishings in 2023 will be $285 million EBITDA. With no reduction in cost inflation, and no improvement in consumer demand, Buddy's and Badcock come in at ~$60 million between them, and AF is running at $40 million. Take away $10 million of corporate and we are at $375 million. If half the cost increases facing AF abate for 2023, EBITDA is at $400 million, while in a full recovery, including a rebound in consumer demand to normal pre-pandemic levels, the number is $140 million at AF and ~$100 million at Badcock and Buddy's, resulting in 2023 EBITDA of $515 million. My base case for 2023, not including M&A, is in that range, $400 to $500 million, with the latter only possible in a robust recovery, while the former is more likely if things just limp along at the current level.

I've also argued that at least some of the inventory build is going to be a source of FCF in 2H 2022. This combination means that there will be plenty of cash for buybacks. Even at $400 million 2023 EBITDA guidance, and assuming 3x leverage, there's $100 million available from the balance sheet, plus any FCF not used for the dividend. The total available is likely to be at least $200 million, or enough to buy 15% of the outstanding shares by YE 2022 at the current price.

And it could easily be well above that. If EBITDA guidance is $450 million, and if they were willing to go to 3.3x leverage, then the entire $500 million repurchase authorization would be available. That's enough to buy 15 million shares, or ~40% of the total share count at the current price, though of course buying back shares in such a large quantity won't be possible without having a big impact on the share price.

So the bear thesis, the rational bear thesis, is not just short term, I think it's also wrong. About EBITDA, about leverage, and about whether a share repurchase can be executed. Only if conditions get materially worse would any of these be an issue. And it's not at all clear that a recession would be a negative for FRG. Their discount brands might actually benefit in a recession, as indeed Kahn has suggested.

FRG in 2024: FCF $10+/share, $5 dividend

We are obviously not in a normal environment now, and while it looks to be getting better in 2023, at this point my guess is it will not be all the way back to normal by the beginning of 2023. But some time in 2023 it probably will happen, and 2024 is likely to be a normal year. My estimate in that case is $800 million EBITDA, $10 of FCF, and a $5 dividend. No heroic assumptions are required.

To get there, we start with $600 million EBITDA on an organic basis, with no M&A. It breaks down as about half in home furnishings and half for non home furnishings.

On home furnishings, the big delta will of course be AF. At 370 stores, normalized EBITDA is $140 million, a full $100 million above the 2022 level. This just comps back to 2019 levels. By 2024 I will start at the $140 million normalized number, adjust for increased store count, and apply a 2% annual CAGR on a per store basis. It works out to $160 million.

The company has guided to Badcock at $60 million of EBITDA as a normal year before being acquired. But Badcock was almost certainly not optimally managed. I won't go into details here, but basically Badcock managed to sell itself to FRG for $580 million, and FRG was then able to sell Badcock receivables and real estate for $660 million in less than a year, netting $80 million cash before taxes, and of course they still own the business itself. It's hard for me to imagine Badcock management ran a tight ship.

So operational improvements to the $60 million are likely achievable. In addition, FRG has called out meaningful synergies to be realized after 2022. I have Badcock at $110 million EBITDA in 2024. Buddy's is likely to benefit from a return to normal too, plus it's also growing store count meaningfully. Call it $25 million, up from $18 million in 2022, or $295 million in total for home furnishings.

TVS has been growing really fast, but we probably shouldn't expect more of that from here. I have them at $150 million in 2024, only up a few percent from current levels. PSP is a fast grower, with a big ramp in the store count, increasing private label brands, and the new Wag N' Wash launch. PSP likely gets close to $150 million as a result, up from ~$105 million in 2022. And then a growing Sylvan hits maybe $15 million, so $315 million for non home furnishing.

Take away $10 million corporate EBITDA and we are at $600 million in 2024. This works out to about $8.50 FCF/share at the current 41 million shares, but with no M&A or buybacks leverage would be really low, barely over 1x. Some M&A or buybacks seem inevitable.

Given Kahn's track record, averaging two acquisitions a year prior to 2022, it's a safe bet they will be making some acquisitions over the next two and a half years. There's no way to know for sure, but I'll pencil in $200 million of EBITDA at 6x, which actually seems conservative to me.

I think some near term buybacks are quite likely. Assuming $175 million of buybacks at $40, the share count becomes 37 million, and leverage moves to 2.5x. The dividend would be $5, and FCF/share would be just under $11.

Valuation

I put a conservative 12x FCF multiple on $10 a share of 2024 FCF. As an aside, the 12 multiple is much less than the company deserves, but I am not confident the market will be rational about this as soon as 2024. Anyway, that's a $120 price target. To this we can add ~$10 of dividends between now and YE 2024, to get $130. Discount this back to the present at 10% and the valuation today is $102.

Risks to the thesis

Probably the biggest risks at FRG are short term in nature. We have already seen the company lower guidance once, and it's certainly possible they might have to do it again. Inflation is still a factor, and supply chain issues, while improving, remain a thorn in the side of many retailers. Management has argued that a recession might actually help some business segments, but it's possible that this is wrong, and that a recession could lead to another leg down in EBITDA.

If they are forced to lower EBITDA guidance again on the Q3 2022 earnings call, then the stock might take a hit. If the troubles they are experiencing in 2022 persist or worsen in 2023, then it's possible EBITDA will be lower in 2022 than in 2023, absent M&A.

All this adds up to some risk over the near term. The stock price might decline, or at least not recover, until demand returns to normal level and supply chain issues subside. And if EBITDA is challenged, it might make it harder for the company to repurchase shares, or they might have to forgo engaging in accretive M&A. I don't expect any of this as a base case, but it's certainly possible.

Conclusion

FRG is a superbly managed business with strong organic EBITDA growth prospects for years to come. The company is executing on a roll-up strategy of franchised and franchise-able businesses, and their M&A track record so far is stellar. An EBITDA/share CAGR of 20% or more over the next ten years seems plausible if the company can execute on both organic growth and acquisitions, even as the company pays out a quarter of EBITDA each year as a dividend. Remarkably, the stock can be bought at just over 3x my base case 2024 FCF estimate. The price is absurd, and the stock should be bought.

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