MTY Food Group,
Papa Murphy's acquisition.
SHAREHOLDERS
April 15, 2019
SHARE PRICE: $55 CAD
MARKET CAP: $1,39B CAD
1. INTRODUCTION
Last thursday, April 11 2019, MTY released its 2019 first quarter results while at the same time announcing it was acquiring the U.S. based raw pizza chain Papa Murphy’s (FRESH). I’ve wrote about the Q1 results here, and now I’m taking a quick look at the acquisition. The company has also released a quick presentation on the merger.
2. BUSINESS OVERVIEW
2.1. COMPANY PRESENTATION
Papa Murphy’s is a typical franchising business, but their product made me scratch my head: They sell raw pizzas in their stores. Yes, you’ve heard me right. Raw Pizzas. They use the best and freshest ingredients to prepare the pizza in front of the customer and then the customer takes it home. They are the fifth largest pizza player in the U.S..
I must say that this isn’t a concept that makes me go “WOW, how come no one has ever thought of that?”. Well, no one has ever thought of that probably because it isn’t that good of an idea. But hey, it has its following so who am I to be criticising.
Whether I like the concept or not, that’s not why we’re here. We’re here to figure out if this acquisition has some merit to it or if Stanley Ma has lost it after all these years.
The thing is, with this acquisition MTY is aiming at further diversification and consolidation of its U.S. operations. The “dine in” and delivery niche has become hugely popular as of lately mostly due to the ever increasing delivery apps. If going to a mall and buying a raw pizza only to drive home, turn on the oven and wait for it to cook doesn’t seem that good of an idea, the delivery apps can give a huge boost to this company’s sales.
On another note, the first thing that comes to one’s mind is the possibility for these guys to be able to fit a pizza oven in every store, immediately becoming a whole different business. But because they sell raw food, people can use Electronic Benefit Transfer (food stamps) to buy their products. The minute they bake the pizza, people will no longer be able to use the food stamps.
I’m not sure how much this exchange between food stamps and cooked pizza would impact their sales, but I think Stanley Ma and Eric Lefebvre are surely doing the math.
2.2. MANAGEMENT TEAM
The management team, namely the CEO Weldon and the CFO Nik Rupp are newcomers to the company and they’re the ones responsible for the turnaround process we’ve been witnessing recently.
3. HISTORICAL CONTEXT
3.1. LONG TERM CHART
Unfortunately Papa Murphy’s share price shows an historical negative trend. After the merger was announced, the stock price soared by more than 30%, obviously because that was the premium MTY payed for the whole company.
3.2. SALES - OPERATING INCOME - OPERATING MARGIN
There are a couple of things I’d like to comment here. The first is that although the revenue figure had been rising up until 2017, the operating margin was declining at a fast pace and the company even reported a loss in 2017.
The second thing is that there was a big drop in revenue in 2018 because the new management decided to re-franchise some of the company-owned stores that were dragging performance.
Just so we can put this into perspective, let’s compare Papa Murphy’s operating margin to MTY’s.
Clearly MTY is able to run a much leaner and profitable operation than Papa Murphy’s. But for the readers that are thinking that MTY has bought a lousy business, you should try to look at it this way:
MTY is famous for being a roll-up. Its core business is not the food business. Its core business is the M&A business. It buys smaller, less profitable businesses and integrates them on its successful platform, managing to create high levels of synergies (centralization of operations, centralization of food processing, etc, etc), making them much more profitable after just a short period of time.
3.3. STORE COUNT
As I was saying, the company had been growing the number of stores up until 2016 to the detriment of profitability. In 2017 the new management decided to shift its strategy and start to close down unprofitable stores and re-franchise its company-owned stores.
In 2018 we’ve continued to see the same strategy being followed.
The readers might be asking, if the company-owned stores bring in much more cash, why are they closing them? Well, we’ve seen the same happening when I wrote the McDonald’s analysis.
The franchising model is a much less capital intensive, scalable business and it has much higher margins. That’s why a lot of these franchisors are aiming for just a few company-owned stores where they can test things before implementing them system-wide.
3.4. COMPARABLE SALES
This is where Mr. Market drew his line and why MTY’s share price has declined 8% on the news of the merger (today it’s up 3% already). The same-store-sales, one of the most used metrics to analyse a retail franchising business, have been negative for the last 3 years.
But again, I would look at it differently. Ever since the new management team was put in place, they’ve been able to reverse this trend and in the last quarter of 2018, the SSS were “just” -1,3%. Although this is still a negative number, the trend is positive.
3.5. NET INCOME, NET MARGIN
Net Income has been highly erratic and the company even reported a net loss of $1,8M in 2017.
Fortunately in 2018 the management team was quick to lower its operating costs, especially the huge SG&A expenses the company has.
I would say that we’ll be seeing these costs lower even more when the company is fully integrated into MTY’s platform.
3.6. CASH FLOW
As always, I like to see whether the company is really generating cash or not. I would argue that YES, the company is making a lot more cash than what one might’ve thought if he were to look at the income statement alone.
Looking at the cash-flows statement further reinforces my point that this new management team is taking all the right measures. It is amazing how much cash the company has spent in 2016 alone. It it wasn’t for that, we could say that the company has generated positive free-cash-flow for the last seven years.
3.7. PRICE RATIOS
MTY has agreed to pay $190M USD for Papa Murphy’s, including $82M of debt in an all cash transaction funded by MTY’s cash in hand and existing credit facility. This means MTY is paying a 30% premium to Papa Murphy’s last price before the announcement of the acquisition was made.
MTY is buying it, before synergies, at an EV/EBITDA of 8,5x and a Price/FCF of 12.
Just so we can get a means of comparison, let’s take a look at prior acquisitions MTY has made.
MTY itself is now trading at 11x EV/EBITDA and a Price/FCF of 15. If we compare this to the other acquisitions, we could eventually say that they are buying it cheap.
I think MTY’s plan is to keep re-franchising Papa Murphy’s company-owned stores until they get near to the percentage of MTY’s company-owned stores which is 99%. This way, they’d re-franchise around 91 stores. At an average price of $120.000 per store, that would amount to $11,7M. One could even argue that this is cash on hand, effectively lowering the multiples for which MTY has bought Papa Murphy’s.
4. OVERVIEW AND CONCLUSION
4.1. OVERVIEW
First of all, I think that the MTY shareholders – like me – should be happy that the company is still finding targets to acquire. Due to its increasing size, MTY’s biggest risk is not finding good companies to buy.
Second of all, Stanley Ma has retired from the day-to-day operations so he could spend more time doing acquisitions. This is what he has been doing for the last couple of decades and what has made MTY a 200 bagger.
When these smaller chains and concepts are merged with the well oiled MTY’s operating machine, they can improve almost every operating metric you can think of, from buying the raw food for much lower prices to the renegotiation of the rents or the lowering of the corporate overhead.
MTY has been wanting to grow its footprint in the U.S. and it is doing it with success. The investment thesis is intact. Investors just need to sit back, relax and let the management team and board of directors work their magic as they’ve been doing in a masterful manner.
4.2. CONCLUSION
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