Category: Stocks

In the search of Goode value we must be willing to take necessary risks. We must be willing to bet on struggling companies, sometimes with bad management, sometimes in struggling industries. We must never combine those three, however. Most important of all, we must shun excessive debt like the plague. While I prefer to avoid companies with significant debt, in cases in which the company has consistent earnings and the ability to maintain those earnings (because of strong brands or monopoly status), debt is forgivable.

For companies with tough competition and little competitive advantage, debt is a very, very bad idea. Two great cases in point are Movie Gallery (MOVI) and General Motors (GM). Both companies have historically strong brands and decent business models. They are both extraordinarily cheap. If they had less debt they would be great companies to buy. Saddled with debt, however, they lack the ability to survive their cut-throat industries.

Movie Gallery is a great example of stupid management harming a company. The company’s stock traded as high as $30 in 2005; it now trades at $0.55. Movie Gallery runs a chain of video rental stores. They have historically been profitable. However, early in 2005 the company took on much debt to buy Hollywood Video. The company now has a market cap of $17 million and debt of $1.1 billion. The company’s bankruptcy is imminent. I would argue that the movie rental business is one of the best businesses to be in. People like watching movies, new movies cost a lot to see at movie theaters, and the competition (satellite and cable movies on demand) are not that great.

While Netflix (NFLX) has made it harder for bricks and mortar stores, I feel its impact has been drastically over-rated. I subscribe to the Netflix service, but there are plenty of people who do not. A bricks and mortar store can do good business because those that rent more infrequently will never subscribe to a Netflix-type service. Therefore, I think that Movie Gallery’s two chains, Movie Gallery and Hollywood Video, will still be around in one form or another fifteen years from now. The problem is that the debt of the current company will prevent it from responding to challenges. Bankruptcy is therefore almost certain

General Motors faces much the same problem. Unfortunately for the careless investor, their full debt his hidden in details in their financial statements about their union contracts and the number of retirees for whom they provide pensions. Some have estimated that GM will have to pay out over $70 billion in pensions and health care benefits to its current and future retirees. For a company that has consistently lost a few billion dollars per year over the last few years, this is a problem. In addition to its debt, GM has too many brands, too much production capacity, an unfavorable union contract, and shrinking sales. Without such a sizable debt, GM would stand a chance of restructuring and saving its stockholders. As it stands, it has no room to maneuver. Unless it can become highly profitable within a year or at most two years, it will go bankrupt.

So does debt matter for stock returns? Yes, at least according to this study (scroll down on the page to which I link to download the PDF). While the data are from the UK, the results are logical and should apply in the USA as well. While the correlation of debt ratio with stock returns is lower than the correlation of P/E with stock returns, there is still a definite negative correlation: the stock of those companies with the least debt did the best. The 30% of companies with the lowest debt showed a consistent advantage over those with higher debt. Those companies had leverage ratios of under 20%, meaning that total debt represented less than 20% of enterprise value. For comparison, MOVI has a leverage ratio of 99%, while GM has a leverage ratio of 96%.

Disclosure: I have no interest in any company mentioned. Since I wrote this article last spring both GM and MOVI have seen their stocks decline. MOVI looks like it is about to enter bankruptcy. I have a disclosure policy.

TSR Inc. [[tsri]] just announced a stock buyback of about 6.7% of its shares outstanding. This may come as a surprise to some investors. It is not a surprise to me, however. I was the one who recommended it, in a letter (pdf) that I sent to TSR directors back in late June 2007. TSR is a tiny computer staffing firm with a highly under-leveraged balance sheet (they have a lot of cash).

Did my actions directly cause the stock buyback? Probably not. The directors were not afraid of an investor with less than 0.5% of the shares outstanding in his possession. But it certainly did not hurt that I wrote and suggested that the company buy back stock (for a good reason, I might add). Perhaps that was just the push the directors needed to get them thinking about ways to deal with TSR’s cash hoard.

Perhaps TSR will take my other advice and declassify its board of directors. If not, I may not just sit back and wait. I might even try to get that on the next proxy ballot myself.

If you are too lazy to read my letter, here is my strongest reason for a buyback (which would reduce the company’s cash): “We of course do not need an academic study to prove the obvious point that the key driver of shareholder value is the ability of the company to provide a return on investment. A 5% yield in treasury securities that comprise the majority of a company’s equity is ipso facto inadequate for any corporation.”

Disclosure: I am long TSRI. I have a disclosure policy that generally does nothing until an unhappy reader writes it a letter.

Sometimes a large investor makes their presence known and it becomes fairly obvious who is causing a stock to move. This is particularly true in microcaps. So when the price of Noble Roman’s (OTC BB: NROM) stock jumped up 46% a week ago, it was not too hard to figure out that it was largely because of one large individual investor buying a chunk (although my initial guess was completely wrong). How do I know? He just filed a form 13G with the SEC, indicating that he now owns 10% of Noble Roman’s.

That buyer was none other than Robert P. Stiller, chairman of the board of Green Mountain Coffee [[gmcr]] (and for those old hippies out there, founder of E-Z Wider). Bob has owned the stock of Noble Roman’s since early in the spring of 2007. See his 13G filing on March 6, 2007, where he stated that he owns 1,000,000 shares. He increased that earlier this month to just under 2,000,000 shares. Green Mountain has a $900 million market cap. What does Bob want with a $40 million pizza company? And should anybody follow his example? That is the $4 million dollar question (for Bob at least).

So far, Bob has not done well on his Noble Roman’s investment. His average price on the earlier purchases in February and March 2007 was probably around $4.15. At a recent stock price of $2.40, he has lost 43%.

Microcaps will often see random individuals that buy large stakes. Sometimes the large investors are right, sometimes not. In this case, like with others, only time will tell.

Disclosure: I am short NROM. I have a disclosure policy.

A good executive knows when to take the blame: when his or her management or lack thereof causes a serious problem. Bad executives like to find scapegoats. That is exactly what Paul Mobley of Noble Roman’s (OTC BB: NROM) did in an article with Daniel Lee of the Indianapolis Star (see also the reader comments on the article). In describing the company’s expansion troubles, he placed blame for failed franchises fully on the franchisees, claiming that “Some of the franchises we sold didn’t have very much business or being-your-own-boss experience.” His comments make it seem like he was surprised. He should not be surprised: what does he expect when Noble Roman’s has such low requirements for franchisees? People who probably shouldn’t be franchisees (or who would need lots of help and training to succeed) choose Noble Roman’s over other franchisers solely because its fees are lower. Noble Roman’s then fails to provide proper support and training and the franchisees fail.

With about 1,000 franchisees, one would think that Noble Roman’s has some idea how to select and train franchisees. It is incredibly easy to select only experienced and well-financed franchisees. But Noble Roman’s executives do not appear to care about the success of their franchisees or even about the ultimate success of the company. All they seem to care about is “growing” as quickly as possible, even if most of the company’s growth is not real (over the last year, 90 Noble Roman’s franchisees opened, but 38 franchisees closed). (Noble Roman’s franchise closure rate of about 3.7% is fully one percentage point higher than the industry average of 2.7%.) And if Noble Roman’s were to be more selective and were to take the time to train its franchisees, it would not be quite so exciting as a “growth” company. Of course, to anyone who has looked at the company’s financial statements and seen how 24% of the company’s royalties are from one-time initial franchise or area developer fees, it is obvious that Noble Roman’s is not a growth company (number from the most recent 10Q).

Potential franchisees would do well to keep this in mind and avoid companies like Noble Roman’s whose sole selling point is their low franchise fees and requirements.

Disclosure: I am short NROM. I have a disclosure policy that has been franchised successfully in 87 galaxies.

Noble Roman’s (OTC BB: NROM.ob, $2.48, market cap: $45 million) is a company that franchises two fast-food concepts: Noble Roman’s Pizza and Tuscano’s Italian Subs. You can see a bit more about what they do on their website. The company provides a perfect example of what I call operating accruals and why they are bad for companies. (Note–this is probably not the correct term. If there is a better term for what I discuss, please tell me.) By operating accruals, I mean that the business is operating in such as way that earnings today are coming at the expense of poor earnings (or even losses) in the future. The obligations that go along with today’s earnings accrue in reality, but not on the financial statements. Accounting accruals are different but no less bad. Just google ‘Sloan accrual anomaly‘ and you can learn more about why accounting accruals can be bad.

Strategy Problems

I have thought about franchising from both the selling and buying sides. There are two benefits to franchising from the buyer’s side. The first benefit is that the franchisee gets training / products / a system. Otherwise it can be very hard to start anything from scratch. For example, a restaurant is not just about good food, but choosing the right kind of food and food that is high margin (has a high ratio of price to raw material and labor costs) . (Watch Gordon Ramsey’s Kitchen Nightmares a few times and you will get a feel for how important non-quality aspects of a restaurant’s food are.) Secondly, franchising gets you instant credibility and name recognition. It is for this reason that McDonald’s can charge more for its franchises than can other franchisors. It is this name recognition that helps the average McDonald’s franchise to achieve annual revenues of $1.9 million versus $500,000 for the average Noble Roman’s franchise (according to some estimates, although my estimates are significantly lower). Because of this extra name recognition McDonald’s can charge an initial franchise fee of $45,000 (plus 4% of ongoing sales) versus an initial franchise fee of $6,000 (plus 7% of sales on an ongoing basis) at Noble Roman’s.

The problem with Noble Roman’s is that it does not do any significant advertising. Its product is in a highly competitive industry and it is not differentiated from its competitors. The one advantage to choosing to franchise a Noble Roman’s concept is that it is cheap. While this is advantageous for the franchisees, it is not good for Noble Roman’s. The low capital requirements and low initial franchise frees likely draw many inexperienced and poor restaurant operators to the franchise.

Even worse, Noble Roman’s has tried to expand quickly by introducing a second level of franchising. Area developers pay the company for the right to develop franchises in a geographic area. They then receive a portion of the initial and ongoing franchise fees of new franchises in their area. This leads to what I call an operating accrual. Noble Roman’s reports strong earnings in the present and by selling more areas to area developers it can grow its current earnings. But Noble Roman’s will receive a much smaller chunk of money from new franchises than it does from current franchises and it will still be responsible for training the new franchisees. And soon enough there will be no more area developer rights to sell. So the company is essentially giving up future revenue to gain revenue now. This type of strategy rarely works.

I am not the only one to criticize Noble Roman’s strategy. See the following article on the Franchise Blog, where Kevin Murphy, a franchising lawyer widely known as Mr. Franchise, comments quite negatively on Noble Roman’s area developer strategy.

Valuation

Let’s say that the whole area developer thing goes well and all the new franchises get built. Noble Roman’s signs over 30% of the initial franchise fee and 2/7 of the continuing franchise fee of 7% of sales. Considering that the company has a timetable for its new franchises and the average franchise brings in $500,000 per year, I can do a simplified discounted cash flow analysis on the extra revenue from those franchises. Noble Roman’s will receive $4,200 of the initial franchise fee and approximately $25,000 each year from each additional franchise (if you buy the $500,000 per year in sales, which I do not). See the attached Excel spreadsheet for four different valuations of the company using different assumptions. I discuss the assumptions and valuations below. I discuss below the assumptions of the different valuation models.

First, for all the valuations I use earnings as a proxy for free cash flow. It is not that bad of an assumption considering that Noble Roman’s does not have much in the way of depreciating assets. I separately value new stores and existing stores. All the valuations use a discount rate of 10%, which is reasonable for a highly competitive business like fast food.

The first and rosiest valuation is as follows: For the existing stores, I assume that sales remain flat and that revenues remain at the same (high) level as they were in the most recent quarter. This gives us $2.8 million per year in FCF from present stores. For a terminal valuation I use book value. I assume that all new planned stores get built and that they achieve $500,000 in sales in the first and all subsequent years. For the terminal value of the new stores I use 5x the previous two years’ revenues. I also assume that the new franchises have zero cost for Noble Roman’s and that Noble Roman’s cut of the sales goes straight to the bottom line. This analysis yields a value for the company of $146 million, or 220% of the company’s current market cap.

One problem with the first valuation is that a lot of the current revenues (that I have modeled as existing stores) come from area developer fees and initial franchise fees. Eventually there will be no more areas to develop and initial franchise fees are accounted for in my model in the new store valuation. Subtracting out those revenues from the current store revenues leaves a current annualized profit run rate of only $256,000. This lowers the valuation to about $100 million, or about 121% above the current market price (this is shown on the second worksheet of the valuation spreadsheet).

However, this second valuation assumes over-optimistically that each new franchise will generate $500,000 annually in revenue. A 5% cut of this gives Noble Roman’s $25,000 per franchise per year. Rather than using estimates, I should use actual royalties received from current franchises to estimate what the average franchise gets in revenues and gives to Noble Roman’s in royalties. In the most recent 10Q, Noble Roman’s breaks down its royalties into the various types, including area developer royalties and initial franchise fees. For the most recent quarter continuing royalties totaled $2.044 million. Multiply that by four to get the annual run rate (because pizza is not seasonal) and we get $8.18 million annually in royalties from 1,033 franchises. This averages out to $7,920 per franchise per year. Multiply that by 14.3x (the inverse of the royalty rate of 7%) and we get average revenues of $113,143. For the new franchises under the area developers Noble Roman’s only gets 5% of revenues, so we can expect Noble Roman’s to receive $5,650 in revenue for each new franchise per year.

One important note–a lot of the current and new franchises are dual-concepts–a Tuscano’s Subs franchise and a Noble Roman’s franchise. Even though these are usually within the same restaurant they are counted as two franchises, which explains the low per-franchise revenues. Still, $230,000 sales per restaurant is horrid. Now, I will be charitable and assume that the new franchises produce 50% more revenues than the current stores. But even with this rosy assumption, the valuation of Noble Roman’s falls dramatically. The company is then fairly valued at $42 million, 7% less than its current valuation.

What is worse is that even this valuation involves optimistic assumptions. It assumes that current franchises do not close. It assumes that all the proposed stores get built (which the management just admitted will not happen). It assumes that revenues are 50% greater at new stores than at existing stores. It does not account for the discount that multiple-franchise stores get (saving $2000 on the initial franchise fee). It does not account for the extra training costs (however small) that each new franchise entails. If only half of the projected 868 new franchises are built and new franchises have only as much revenues as old franchises, then the company’s stock should fall 47% to a market cap of $28 million.

Disgruntled Franchisees

Another problem I see with Noble Roman’s, though I cannot quantify it, is that there are a few very disgruntled franchisees out there. The reason I can tell this is by looking at all the negative posts about Noble Roman’s on the Yahoo! stock message boards. Those boards are usually not informative, but in this case they are. Normally, most negative posts on such boards are written by short sellers. But judging from the short interest in NROM, it appears that I am the only one who has sold the company’s stock short. So that means that Noble Roman’s really annoyed a few people. I should add that this is only icing on the cake for my case against Noble Roman’s: I never put much weight on such subjective information. In the case of these ‘disgruntled franchisees’, it could be all the work of one lunatic who may not have even been a franchisee and may just hold a personal grudge against Noble Roman’s management.

Conclusion

All in all, things do not look good for Noble Roman’s stock or for its business. In my realistic scenario, the company is priced at over twice its intrinsic value. In a worst-case scenario most of the new franchises will never be sold, the area development agreements will flop, and Noble Roman’s will struggle to earn $1 million per year. In this scenario the company’s stock price could easily fall 75%. Considering management’s past failures to expand Noble Roman’s, the company’s lack of advertising and product differentiation, and the untested strategy of going with area developers, I think it likely that Noble Roman’s will fall far short of achieving its goals for growth.

Lessons

While I do love bashing companies, there is a broader purpose to the above analysis. I wanted to show how a cogent analysis of financial statements and business decisions can help an investor avoid problems. I knew months ago that Noble Roman’s would never build all the new stores they planned to build. I knew that the company’s current earnings were inflated by non-recurring charges (area developer fees and initial franchise fees). I knew all of this just by thinking hard about its business and looking in depth at its financial statements. I did not need any inside information. Yet still I knew enough to avoid the company’s stock and even to take a large short position in the stock.

Many companies are willing to cut corners to improve current earnings. Whether this involves accounting tricks (such as inappropriately capitalizing expenses) or poor business decisions (such as not re-investing enough money in the business to maintain earnings), the individual investor would be wise to beware.

Disclosure: I am short NROM. See my disclosure policy.