Description

Executive Summary

Freshii is a $300m market cap, high-growth, Canadian fast-food chain that went public in January 2017 on the TSX under the symbol FRII. Freshii sells itself as a healthier alternative to the average fast food joint, with offerings like customizable bowls, salads, burritos, wraps and smoothies. The company is almost completely franchised with ~300 locations predominantly in Canada and the US.

We believe the risk-reward with this name is skewed heavily to the downside for the following reasons:

• Nosebleed valuations are pricing in near-perfect execution of company’s stated growth plan and should limit upside potential in the stock

• A significant portion (~20%) of near-term earnings is attributable to non-recurring, upfront fees that franchisees pay when opening a store ($30K per new store); this stream of earnings will become less significant as new store openings constitute a smaller proportion of the existing base of restaurants

• Significant execution risk due to Freshii’s extremely aggressive growth plan that envisions growing store count from 301 today to 825 by the end of 2019, an increase of >2.75x in the span of less than 3 years (+48 units avg. per quarter vs. +23 in Q1 ‘17)

• A highly replicable model with numerous regional competitors in the US will challenge growth

• Unit economics are less favorable than company indicates after factoring in owners’ costs

• Insiders took significant money off the table at the IPO and will likely continue to do so once the lock-up period expires

Potential catalysts for this short thesis to work out:

• Given the current valuation, we would expect the stock to face significant downward pressure on any quarterly misses on aggressive growth expansion targets

• Insiders’ lock-up period expires on July 30 which will pave the way for a secondary that will loosen the float

Valuation prices in near perfect execution

Regardless of how you slice it, Freshii trades at very high multiples in comparison to other peers in the space. On a 2017E basis, FRII trades at 13.5x revenue and 29.2x EBITDA, substantially higher than all highly franchised peers (see Table 2).

Table 1: Capitalization and Valuation

Table 2: Public Comparables

What makes FRII’s valuation even more egregious is the one-time nature of a significant portion of its earnings in the near-term. Freshii charges an upfront franchise fee of $30K for all new store openings. We estimate almost 20% or ~$4m in 2017 revenues (~150 new stores x $30K per store) will be attributable to these franchise fees, leaving ~$17m for royalties (based on consensus revenue estimates). Freshii only earns this fee one time for a store opening; given their one-time nature, this stream of earnings should not be valued at the same multiple as earnings from royalties. As openings become a smaller percentage of the existing store base, this source of revenue should become less material.

We believe this excessive valuation is being driven by two main factors:

1. Investors are pricing in successful execution of the company’s aggressive growth plans to almost triple their store base by the end of 2019

2. A constrained float with significant insider holdings and chunky institutional investors that bought in at the IPO

The inability of management to hit their significant growth targets would undoubtedly drive multiple compression. As we will show in the next section, management is promising unprecedented growth that is unlikely to be hit in the coming years. As such, we like the risk-reward here. Management must execute perfectly for Freshii to grow into its current valuation. On the flip side, any slip-ups should cause the halo surrounding the stock to disappear. The float dynamic should improve with a secondary sale which we believe is in the cards after the IPO lock-up expires on July 30. A revenue multiple compression alone, to bring Freshii in line with other premium highly franchised comps (~9x), would see a ~30% decrease in share price.

Potential investors should look to Zoe’s Kitchen (ZOES) as a case study of how quickly a stock deteriorates (down 60% in the last year) when a high growth story falls apart. ZOES is not a franchised business model, but it still illustrates the challenges and risks with executing an aggressive growth plan.

Growth plan is very aggressive and unlikely to come to fruition

Freshii’s unit growth up until this point has been impressive. They have grown from 70 units in 2013 to 278 units in 2016. It boasts that it was one of the fastest chains to reach 200 stores, taking them 11 years, ahead of McDonald’s, Subway and Domino’s. However, we believe that Freshii significantly benefited from a first-mover advantage in an underpenetrated Canadian market. We think the road ahead is much more difficult. To grow to 825 stores by 2019 requires a unit CAGR of ~44% over the next 3 years. Increasing your store base by such a large proportion every year becomes increasingly difficult.

Table 3: Freshii Unit Count and Forecast

If we compare this plan to historical execution by comps, we see this level of growth as nearly unprecedented. It took Wingstop ~5 years to double their store count from ~500 in 2011 to ~1,000 in 2016 (~15% CAGR). Domino’s international store count has grown from 4,835 stores in 2011 to 8,440 in 2016 (~12% CAGR). Chipotle tripled its store count from 227 to 704 units over 5 years from 2002 to 2007 (~25% CAGR). We deem Wingstop, Domino’s and Chiptole to be best-in-class growth stories that are challenging to replicate. We could go on with further examples, but the point is the same: Freshii’s growth goals are highly aggressive and not well supported by history.

Highly competitive and regionalized US market

Historically, Canada has been Freshii’s home base and stronghold, comprising ~45% of its 301 units at the end of Q1. The US represents the next bastion of growth (~38% of units) with the rest of the world playing a smaller role (~17% of units). Management has guided to 80% of new openings in North American and traditional units, with the bulk of the openings shifting to the US after 2017. This is unsurprising as the market in Canada appears to have become more saturated in recent years.

A cursory (non-exhaustive) look at the US competition yields the following results:

Table 4: US Salad Chains

Aside from its long-time Chicago stronghold, Freshii faces significant competition in almost all its key markets. The offerings across these chains are similar and largely substitutable. We observe that Freshii has wisely kept a minimal presence in large East Coast cities such as New York, Philadelphia, and Washington DC, presumably due to the fierce existing competition. Instead, they have focused on Chicago (~30 units) and select other markets (e.g. Portland, Miami, Houston, Dallas, Boston, Detroit) as well as targeting high traffic locations like airports and universities. It is important to note that Freshii’s units in Chicago were under a Master Franchisee Agreement which they bought back recently for ~US$5m at an estimated 10x EBITDA multiple (~30 stores at $500k AUV and 3% incremental royalty).

We estimate that 15% of the company’s US units are located in Target department stores, hardly a desirable platform given TGT’s recent announcement that they expect SSS to decline LSD in FY17, as well as the broader challenges being faced by the US retail sector. Freshii’s presence in California is largely centered around its partnership with Target which suggests they have not been able to gain traction in more traditional locations in that competitive market.

We also noticed that Freshii’s churn rate (defined as stores closed/relocated per year as a % of average store count) is substantially higher than its peers. We have a limited data set, but 10 or ~4.4% of Freshii stores were closed in 2016 out of an average of 228 stores (178 BOP, 278 EOP). This compares to 1.6% for Denny’s, 0.7% for Wingstop and 0.6% for Sonic. We think this is a warning sign and a potential indicator of marginal franchisee profitability or growing too quickly.

For these reasons, we believe the perceived white space in the US is substantially smaller than the company projects. This should materialize in lower than expected growth towards the back half of 2018, when dependency on US growth increases.

Unit economics are overstated

To the franchisee, Freshii offers an affordable cash build-out cost of $260K and resulting cash-on-cash returns >40% in year 2 of operations after a 6% royalty. In an initiating report, CIBC breaks down their estimates for average unit economics

Table 5: Store Economics

One item that is clearly missing from these calculations are owners’ costs (i.e. the franchisee paying his or her own salary, or a store manager instead). If we peg those at $50K, then the cash-on-cash returns drop to 20%. To make matters worse, minimum wages in Ontario, Canada are expected to rise >30% from $11.40 to $15 over the next 18 months. Adding 30% to CIBC labour cost estimates and assuming no price increases, we see cash on cash returns drop to ~5%. We estimate that >20% of Freshii stores are in Ontario. We are seeing similar trends in the US with 19 states expected to raise their minimum wage in 2017. Increasing labor costs will place broad-based pressure on franchisee economics.

Shareholder dynamics and impending unlock

Freshii runs a capital-light business model that requires minimal expenditures to grow as franchisees soak up the costs to open new stores. With ambitious growth plans (and execution risk) to triple their store base in a few years we think investors should be skeptical when existing shareholders sell a third of their shares for proceeds of C$86 million. With those same selling shareholders holding ~50% of shares post-IPO, we expect the probability of a secondary is high after the lock-up expiry on July 30. If they were willing to sell at C$11.50, they should be happy selling shares at a 15% premium to the IPO price. This should have the dual effect of loosening the float and putting downward pressure on the share price.

Table 6: IPO Summary

Table 7: Selling Shareholders

Conclusion

• Expensive Valuation: Freshii trades at an excessive valuation when compared to peers

• Aggressive Growth: Company is trying to sell a growth plan that will be very difficult to achieve

• High Competition: Numerous salad chains in the US all vying for the same whitespace

• Churn: Freshii has higher unit churn than public competitors

• Marginal Economics: Cash on cash returns are significantly lower than the company advertises

• Insider Selling: Shareholders sold significant stake at IPO and will likely continue to do so after the lock-up period expires at the end of July

Risks to Short Thesis

• Freshii ends up exceeding its aggressive growth store opening targets, unhampered by competition

• Float kept tight even after lock-up expiry

• Greater than expected public market appetite to soak up secondary sales

Catalyst

• Quarterly misses on store growth targets

• IPO lock-up expiry on July 30, 2017