Description

Franchise Group (FRG)

Franchise Group, Inc. is a $1.7B market cap / ~$3B PF EV holding company with 100% stakes in a basket of niche, cash-generative, and mostly physical retail chains, skewing to lower socioeconomic demographics, that are either operating under a franchise model or have a store base that can, and will, be franchised.  They want to be the home of choice for franchisors within their lane seeking an exit, and in this regard seem to be gaining traction.  I believe the company’s most recent slide deck provides a very good overview of the FRG business model, as well as FRG’s six underlying concepts.  I’m not going to do a book report on RTO, discount furniture retailing with financing options, etc., so if the below sounds interesting enough, I’d suggest visiting each of the businesses websites.  And if you still care after that, each of the concepts have 2021 Franchise Disclosure Documents that aren’t too difficult to find (but email me at [email protected] if you’d like copies).

There's no special situations angle to FRG per se.  It just appears to me to be an inexpensive and well-run roll-up whose insiders have significant skin in the game.  They have a logical aversion to equity dilution and overpaying for assets, and generally run the business with an air of frugality.  I think the market will continue to pay increasing attention to the story and work its cost of capital down as the business continues to profitably grow via thoughtful M&A and integration, increased store counts, improved execution/cross-selling, and scaling corporate shared services.

At a recent $41.85, shares trade at 10.5x trailing adj. EPS of $3.99.  Management has guided to $5 in non-GAAP EPS for 2022 (+25% y/y earnings growth) putting shares at ~8.3x this year.  But this excludes any further M&A which I view as unlikely given a guide to ~2.5x leverage by the mid-year and the brisk cadence of deals of late.

CEO Brian Kahn directly owns over 18% of the company (worth over $300mm) directly while his hedge fund, Vintage Capital, owns an additional 12.5%.   He bought 757K shares personally from B Riley at $34.95 in Jan of 2021 and another 1mm shares at $36 in May 2021.   I'll let his introduction on the Q4 earnings call (hosted 2/23/22) serve as an overview of FRG's fruitful 2021:

2021 was another busy year for Franchise Group. Overall, my hat is off to the management teams of our current brands that combine to create impressive organic growth for FRG, but equally important allowing me and my team to devote the majority of our time and resources toward the M&A activity that continues to add diversification and scale to Franchise Group while also improving our cash flow and profitability.

[. . .] I love the scalability and the repeatability of the FRG model. We target great businesses with great management teams that have generated a lot of cash flow, and then we leverage our combined balance sheet in order to add new brands and transactions that are necessarily accretive to our earnings per share and dividends per share. So far, we've been able to rapidly delever our balance sheet through operational cash flow and the sale of non-core assets, which in turn has positioned FRG for additional accretive acquisitions.

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.

In 2021, FRG will have acquired PSP, Badcock, FFO and Sylvan Learning, using only debt financing and balance sheet cash to fund the purchases. But a combination of quickly delevering the balance sheet, combined with growing FRG's EBITDA, will leave us with under 2.5 turns of leverage after the sale of Badcock's real estate. We're seeing many opportunities in the M&A market to put our balance sheet back to work in transactions that would further diversify and enhance our cash flows. And we are pleased that the overall M&A environment is shifting back to our favor over the last couple of months.

The elevator pitch is as follows:

1. The stock is cheap at 10.5x trailing adjusted EPS, 8.4x management’s adj. EPS guide for 2022, and a 6% dividend yield.  Making some adjustments to the balance sheet to reflect the reality of a mid-year SLB transaction covering the Badcock RE portfolio, I peg FRG at 6.6x management's 2022 EBITDA guide of $450mm.  This is simply too cheap for a successful franchisor, even if its retail brands are #2 and #3 in its markets.

2. Since the company’s re-emergence as FRG from Liberty Tax, it has paid a steadily-increasing quarterly dividend, from a $1 run-rate in late 2019, to $2.50 currently (~45% CAGR).

3. Growing and high quality earnings.  Capital light streams of cash are stable so long as franchisees are able to make an economic profit– something a careful read of the franchises’ disclosure documents along with channel checks seems to indicate is the case here.  Franchised units wouldn’t keep growing if FRG weren’t doing something right; it opened 109 new franchise locations in 2021 and has backlog of 360 new locations at the end of the year (and growing).

4. Potential to significantly reduce capital intensity at Vitamin Shoppe over time as it engages in re-franchising efforts of 711 corporate-owned stores

5. A leadership team that seems to be thoughtful/creative in capital allocation decisions.  While Brian Kahn doesn’t have a perfect track record (Red Robin, RCII fiasco), I think FRG is proving itself in real time on being able to transact on, finance, and integrate acquisitions thoughtfully.  Some headlines: they sold Liberty Tax extremely well to a Canadian SPAC that’s now trading at CAD 2.50, NextPoint Financial, which made this gem of a filing yesterday.  They partially funded the $580mm acquisition of Badcock's through the sale of a portfolio of its receivables for $400mm just a few weeks after closing.  FFO’s 31 stores were bought out of BK after Vintage positioned itself as DIP lender in the Ch 11 proceedings.  FRG attempted to get a deal in the TUESQ situation as a DIP lender, but it looks like it ultimately became too hot a process.

6. Tight historical relationship with B. Riley gives me some confidence that access to deal flow and creative capital solutions will remain available.  I can’t help but wonder whether there’s something to do between BR’s Great American (involved in liquidations and reverse logistics), and American Freight given its reliance on scratch and dent inventory.

Prior to late 2019, FRG was known as Liberty Tax, and there are a few writeups covering that situation.  Essentially Vintage Capital, one of Liberty’s largest shareholders at the time with board representation, had a deal to buy RCII and planned to merge it with Liberty.  The RCII deal blew up and instead, Liberty Tax was merged into Buddy’s, an RTO chain already owned by Vintage.  This is all formally discussed in this press release: https://ir.franchisegrp.com/news-releases/news-release-details/liberty-tax-announces-series-strategic-transactions

From there it was a flurry of deals until Christmas (along with a name change to Franchise Group in November): the August 2019 acquisition of the Vitamin Shoppe; the acquisition of the outlet business of Sears Hometown & Outlet Stores that same month, and the December 2019 acquisition of American Freight / North American Freight.  It seems to me 2020 was mostly a digestion year, but things picked up again in 2021.  Pet Supplies Plus (pandemic great for installed base) was announced in January, Sylvan Learning was announced in September, and W.S. Badcock was announced in November.

A quick aside on Brian Kahn.  I met him at the RCII trial in Delaware, and thought he came off as thoughtful and a genuinely nice guy.  From testimony given, it seemed clear that Mitch Fadel at RCII, after screwing Vintage on a legal technicality (looking at you, Messrs. Wilson & Sonsini!) essentially borrowed the Kahn/Buddy’s playbook that had been discussed with the RCII side (as they were supposedly working in good faith toward a close).  Again, there have been some missteps, but ultimately I believe they know what it takes to keep their franchisees happy, while iterating on the portfolio, and cost/efficiency sides of things.

With regard to valuation, this might be too quirky to ever get full respect.   But it pays a nice and growing dividend, is well-run, and I don’t lose sleep over this given the insider ownership.

Catalyst

Continued creatively-financed, and thoughtful M&A

Continued dividend increases