Description

Investment Overview: As a follow-up to Andreas’s 6-27-13 write-up on IRG, I thought it was timely to update the story given some meaningful developments and changes at the Company and the recent decline in the share price. The recent spade of news, without any insights from the Company to help investors digest it, has caused an information gap and allowed investors to believe that IRG was on a slippery slope, resulting in a period of emotional selling. I believe, this has created an opportunity for longer-term value investors to purchase the shares of this asset-light, high return business at an attractive price. For those investors who believe actions speak louder than words, especially when you allow your wallet to do the talking, the large and broad amount of insider purchases in recent days by management and the board, appears to be a clear statement that they agree with me relative to the Company’s prospects and the attractiveness of the stock.

After the recent news that IRG has ended its strategic review and will not be selling the Company, the hiring a very experienced new CEO, the return of the former founder of one of the restaurant brands and the reshuffling of the top executive overseeing some of its other brands, suggests management is for the first time in quite a while seriously focused on revitalizing its core franchise brands. My research in speaking with various sources, including many IRG franchisees, indicates that while challenging, many of the problems in the franchise network are fixable, with management having a high level of confidence this will occur. Additionally, since Andreas’s write-up, IRG has launched significant new initiatives in both manufacturing and retail distribution, which have begun to contribute to profitability and in the future should add significant earnings power to the Company’s financial results.

The true underlying earnings power of the company has been held down by a number of one-time and larger than normal operating expenses, including losses associated with temporarily owning and running certain locations awaiting re-franchise. Looking out 24 months, I believe IRG can generate EBITDA of $20 million or more on annual basis. The cash flows generated from the higher profitability and IRG’s asset light, high ROIC business model, gives the Company the ability to enhance shareholder value by continuing to pay down debt or begin paying a dividend. Management has stated that they are evaluating paying a dividend. Given the groundswell of activist investors, which now number over half of the shareholder base (including representation on the board) supporting such a move, I believe that within a short period of time, this will occur, which should be a catalyst for the stock. Base on my estimate of potential earnings power in about 24 months, the shares are selling at an EV/EBITDA multiple of less than 6x which is attractive both on an absolute basis as well as relative to other Canadian franchise/restaurant operators.

Key Updates & Investment Points: In his initial report on IRG, Andreas did an excellent job of describing the business, background, competition and the Company’s asset-light, high return, rich cash flow business model. I recommend it for anyone unfamiliar with the Company. Additionally, the following is a link to IRG’s shareholder presentation from its March 6, 2014 Annual Meeting:

http://imvescorweb.com/images//irg%20agm%202014_presentation%20and%20ceo%20notes.pdf

The following highlight some key investment points that build upon Andreas’s initial report and highlight some subsequent events:

Acquisition of Commensal spearheads an initiative to grow manufacturing revenues: In November 2013, IRG acquired the assets of Commensal L.P., including its manufacturing facility for $4.2 million. Commensal produces a line of fresh soups and frozen meals under its own brand which are sold in many of the major supermarkets in theQuebec region, including Wal-Mart. According to management, Commensal commands a market share of approximately 80% in the region. Revenues approximated $10 million at the time of purchase. However, unprofitable SKU’s were reduced, netting revenues of approximately $7 million. Given traditional EBITDA margins of ~15% for these types of businesses, this translates into an attractive EV/EBITDA valuation of ~4x or 0.6x sales.

Discussions with management indicate the game plan for Commensal is to leverage its manufacturing capabilities to: 1) lower the food costs of its franchisees on such products such as sauces and other ingredients (currently about $4-5 million) that they purchase from outside vendors and 2) produce internally (vs. using 3^rd part vendors) a growing line of branded food products offered at some of the Company’s restaurants for retail distribution. With Commensal’s manufacturing facilities running at only about one-quarter of capacity, they clearly have the ability to produce these items. For the nine months of FY 2014, manufacturing revenues were $3.6 million versus $0.3 million a year earlier and despite running at low capacity levels, the operations are now profitable. Management believes that Commensal’s revenues can grow to $25-$30 million in a few years, which given some incremental margin leverage would translate into an incremental $4-$5 million in overall EBITDA to the Company.

A focus on expanding the Company’s branded retail products represents a significant growth opportunity: Historically, IRG has offered a select few of its food products (mostly its pizza sauce) for distribution in major retailers in the region. Beginning in 2013, under the direction of the Company’s former CEO, Denis Richard, IRG began to significantly expand the amount of products that it was offering to retailers. Recent product additions include Mike’s pulled pork andBaton Rouge ribs products, with other products in the pipeline for retail distribution. An exclusive distribution agreement with one major retailer has ended and is being significantly expanded including multiple retailers and geographic expansion. In fiscal 2014 (October), retail royalty sales should be ~$7 million, which compares with $4.1 million/$1.9 million in Fiscal 2013/12, representing significant growth. Given the expanded product line and distribution, sales in future period have the potential to advance significantly from current levels. With contribution margins running 80%-90%, these sales have begun to have a meaningful impact on IRG’s financials.

Drama in the executive ranks and the board room adds to investor uncertainty and selling pressure: During the last 18 months there have been so many changes to the senior management team and the Board of Directors at IRG, that one needs a score card to keep up with them. As Andreas mentioned, IRG appointed Denis Richard as CEO in February 2011 to replace the founder of the company. Mr. Richard was instrumental in repositioning the Company from a financial perspective and putting it on strong footing. He also championed IRG’s retail and manufacturing growth initiatives. In June 2013, Mr. Richard left the Company, rejoined in January 2014, and subsequently left again in July 2014. During this time, IRG changed CFO’s and the composition of the Board of Directors. In 2013, activist investor, Arnaud Ajdler, Managing Partner of Engine Capital Management, took a significant stake in the Company and in July became a board member. In January 2014, three board members were replaced with experienced executives. With another activist investor, with a significant position in the stock, urging the Company publically to review its dividend policy, IRG announced in April 2014 that it had begun a process to review its strategic alternatives, including the sale of the Company. Following on the heels of the July 2014 departure of CEO, Richard, on September 8^th, IRG announced, in tandem with a somewhat mixed Q3 earnings report, that the Company: has concluded its strategic review (without consummating a favorable sale of the Company), would evaluate initiating a dividend policy (but not actually do it at this time) and the appointment of a well experienced new CEO.

All this news was dropped on the market, without a conference call to help investors interpret the information while inquiries from the investment community received a response to wait a couple of weeks for the new CEO to get up to speed. Thus, with all this drama going on the natural tendency of investors is to think the worst (i.e. the Company is on a slippery slope), which has led to a lot of emotional/forced selling. It is also noteworthy that following the recent turmoil in the share price, Crescendo Partners announced that they had increased their stake in the Company to about 10%, marking another activist investor taking a healthy position in the shares.

So, what is my take on this drama? While I clearly don’t know all the in’s and out’s of what had transpired over the last 18 months, I have had insights from people in and around the Company regarding the situation. My understanding is that Mr. Richard’s skill set in financial re-engineering and deal making was helpful to get IRG back on strong financial footing and in positioning some of the growth initiatives in manufacturing and retail. However, he did not have a strong skill set from an operating perspective to interface with the franchisees and work with them on improving their businesses. I also understand that he may have been a reason why some potential parties looking at IRG as an acquisition target, could not get comfortable enough to offer favorable deal terms.

In my opinion, the appointment of Frank Hennessey as IRG’s new President & CEO, along with some other changes in the senior management ranks is a sign that the Company is now serious on improving the health and growth prospects of the franchise network. Mr. Hennessey brings to IRG a very impressive and diverse background and skill set in the franchise restaurant business in all areas of operations. I believe this focus was sorely missing from the top of IRG’s management team over the last couple of years. As part of his initial assessment of the Company, he is out in the field visiting stores and meeting with many of the major franchisees.

So, does this mean an acquisition is now off the table? I would guess, maybe for the time being, that is the case. However, if IRG can strengthen the health of its franchise network, stem the decline in the number of franchisees and begin to show some same store growth, a potential acquisition will not only be easier, but should be at higher prices. Noteworthy, we believe that an acquisition is still the desired exit path for the activist interests on the board and within the shareholder ranks.

Insider Buying; Management votes with its wallet: I am a big believer in following insider transactions, especially purchases. The recent large and diverse amount of recent insider purchases by different members of the management team and Board of Directors was one of the factors that got me excited about re-visiting the stock and is a key part of the investment thesis. The following table shows the number of insider purchases that have taken place by this group since the September 8^th news was dropped on the markets:

Among the group of insider purchases, the transactions that stand out, not just by their large size, are those by Peter Mammas. As one of the founders of Baton Rouge, who returned to IRG to head up this division in 2013, he purchase 275,000 shares in September of last year, and subsequently sold them in the summer of this year, at much higher prices, after the strategic review was announced. As someone with intimate knowledge of the business and a good feel for what is happening inside the Company (and a good track record for timing his transactions), I view this as a very clear vote of confidence in the outlook for the business and the attractiveness of the stock.

Fixing the franchise operations will be challenging, but is doable: The major issue/challenge facing IRG at this time is revitalizing the health of its franchise network. Due to the financial troubles the Company endured under IRG’s founder and during Mr. Richard’s tenure, the franchise network was somewhat neglected. While the world was changing, concepts got stale, menu’s were not refreshed with new ideas and the look of its stores got stuck in the past. In addition, the company has not kept up with new technologies like on-line ordering, while customers and competitors around them were adopting them. Mr. Richard’s skill set as a financier and deal maker was not the type to be constantly meeting with franchisees and responding to their needs with innovative ideas and programs. As a result, as illustrated in the following table, both same store sales (SSS) trends and the number of new stores in the IRG network has suffered.

The insights I have received in speaking with various individuals around the Company and within the franchise network, coupled with some recent changes with certain of the brands leads me to believe that IRG’s problems, while challenging, are fixable given a fair amount of focus and some time (6-12 months). The insights I have heard from various franchisees is that the food offerings have a favorable reputation for flavor, quality and value and the brand remains good. However, an equally strong message was that corporate has fallen behind in such things as effectively utilizing  marketing/advertising, introducing fresh menu concepts, passing on savings and implementing technology.

I will point to two examples within the IRG organization to show that the combination of a new brand leader managing a brand and a fair amount of focus can have a notable impact on financial results. Within the Baton Rouge brand, the 2013 return of the founder of the organization, Peter Mammas, had a notable impact on the results from these operations. When he arrived, Baton Rougewas clearly the most troubled brand within the IRG network. Following a number of changes during the last 12 months, y/y revenues improved from comps in the -7% to -8% range to -0.4% in the last quarter, with the number of company owned locations declining from 11 to 6. I understand that Baton Rouse has begun to show positive comps in the last few weeks, which I believe should continue over the next quarter or two. Another brand having problems in 2013 was Mike’s. In response, Gina Michaud was appointed brand leader in September 2013. Following her appointment, she was successful in reducing y/y revenue declines from the -3% to -4% range to the point where it is also not showing positive comps, with a reduction in the number of company owned locations from 5-6 to 3 last quarter. Thus, the significant turnaround at these two formerly troubled brands shows that the Company’s problems in its franchise network are fixable.

Currently Score’s is one of the most underperforming brands within the IRG family. However, Gina Michaud (who was instrumental in Mike’s turnaround) was appointed brand manager of Score’s as well in June of this year. Indications that I have received is that she is very optimistic about the potential for a turnaround here as well and has already had a notable impact (including updating a menu that had not changed in many years and responding to competitive promotions). Insights received from some insiders believe SSS could be comping close to flat by the end of the calendar year. If successful, this would mark another big reversal within the IRG brand portfolio and give investors confidence that the overall franchise business could get on a growth path. I believe it is possible that Mr. Hennessey may choose to bring in new experienced managers to oversee some of the other brands and work in key positions that directly impact franchisee sales.

Thus, the bottom line is that while investors are concerned about the health of IRG’s brands, I believe they are fixable given the proper leadership. Given the negative investment sentiment regarding the health of the Company’s franchise network, any success management has in either stabilizing some of the negative trends in its franchise brands or beginning to show SSS growth would likely have a meaningful impact on the stock price and begin to turn sentiment more favorable.

Current results weighed down by some extraordinary operating costs: IRG’s results over the last couple of quarters have been weighed down by some one-time reorganization costs as well as some above normal operating costs. In addition to the one time reorganization costs of $2.5million in FY 2013, the Company’s operating costs include such items as lease exit costs, legal fees and franchise support costs. To a large degree, these costs are tied directly to the health of IRG’s franchisee organization and tend to vary with the number of company owned restaurants. For example, excluding the reorganization costs, these expenses increased by approximately $1.5 million in FY 2013 compared with the prior year. This appears to be tied to the increase in the number of company owned restaurants during this period. The number of company owned stores peaked at 11 in Q2/Q3 of fiscal 2013 and currently has declined to 6 in Q3 (July) of this year (with Baton Rouge and Mike’s showing the most improvement). With the number of company owned restaurants beginning to decline in FY 2014, this should bode well for a reduction in these costs.

I do not believe it is realistic to expect that these costs will be completely eliminated, as there will likely always be some issues within the franchise network that needs to be addressed. Additionally, discussions with management suggest the likelihood that in the short term the Company will provide financial incentives to its franchisee network to make capital improvements (i.e. re-modeling, etc.) that will likely flow through franchise support expenses. Nonetheless, I believe it is fair to assume that as the health of the network improves, these total costs will decline, especially lease exit costs and legal fees. Assuming some ongoing franchise support costs and more moderate legal fees (and excluding the one time reorganization costs of $2.5 million in FY 2013), I would estimate operating expense reductions of approximately $1.5 million from FY 2013 levels when the health of the franchise network is restored.

Company owned stores negatively impacting results and represent a potential boost to profitability when repatriated back into the franchise network: As Andreas noted in his original report on IRG, after joining the Company in February 2011, CEO Richard was instrumental in resurrecting a seriously financially troubled company and helping to stabilize the health of its franchise network. While a lot of progress has been made, there is still more work that needs to be done in this regard. The years of underinvestment and lack of focus on the franchise network by the former CEO resulted in a handful of restaurants that were financially unstable. In such cases, IRG assumes ownership of the restaurant, makes any necessary investments and changes to nurse the operations back into shape with a goal of returning them back into the franchise ownership network.

During the interim period, while IRG assumes ownership of these restaurants, they are accounted for as company owned stores. Unlike the accounting for franchise royalty income in IRG’s traditional business, all income and costs associated with company owned stores flow through the Company’s income statement. Company owned stores impact IRG’s financials in two ways; the net impact of their profit/loss on operating profits and the potential loss of royalty income. Considering the fact that these company owned stores are either unprofitable or producing substandard returns, even a small number can have a meaningful impact on IRG’s operating results, returns and profitability.

In FY 2014, IRG began breaking out the financial impact on its operations of the company owned stores. For the nine moths of the year, the 6-7 company owned stores, lost $1.3 million on an operating income basis, which translates into a run rate of about $1.8 million annually. Relative to the loss of franchise royalty income, I have modeled the average number of company owned stores for each restaurant chain in FY 2014, along with their respective average revenue and royalty rate to arrive at an approximate figure. My calculations show the loss of franchise royalties from these company owned locations to be an additional ~$0.6 million. Given the nature of these revenues, they fall right to operating profits. So, I estimate the total financial impact (both real and unrealized) impact on IRG’s profitability from company owned stores to be ~$2.4 million in FY 2014. I believe that most, if not all of this amount will be returned to IRG’s earnings power in the 24 month period, making my $20 million EBITDA number potentially conservative.

Relative to FY 2013 EBIT of $13.95 million (excluding the reorganization costs), highlights that these company owned stores represent a meaningful drag on IRG’s current profitability. That said, it is probably unrealistic to expect that all company owned restaurants will be eliminated and to add this all back into the Company’s profitability. However, this does underscore the fact that the underlying earnings power of the Company is currently understated and represent a potential uplift to future results when these locations are repatriated back into the franchise network.

Earnings power understated and should approximate $20 million in the near future: Currently, I believe underlying earning power of IRG is being understated by a number of factors. The combination of the Company’s retail and manufacturing initiatives provide significant high profit growth opportunities over the next few years as these operations are expanded. In addition, there is a significant amount of earnings leverage tied to any progress management has in reviving the health of its franchisee network. If management is successful in this initiative, some of the Company’s expenses, such as lease exit costs, legal fees and franchise support costs, should revert back to more normalized levels. Also, as previously described, as the number of company owned store continue to decline, this should have a positive impact on both decreasing the losses from these locations on IRG’s operations and increasing royalties if they come back into the franchise network. Finally, I believe IRG’s overall cost structure is too heavy relative to the Company’s size. I suspect there is a layer of potential operating cost reductions tied to headcount reductions as well as facilities consolidation (i.e. Moncton and Montreal).

In FY 2014 (October), IRG’s reported EBITDA should approximate $15.5 million. However, as previously discussed, there were a number of both operational issues (poor weather in the northeast, a problem transitioning to a new food distributor, a fire at a Baton Rouge location, inadequate response to competitive promotions, etc.) and extraordinary costs that pressured these results. While each investor can make there own assumptions as to how many of these extraordinary costs are above normal operating levels, I would conservatively estimate about $1.5 million. Note that I am not assuming a complete elimination of either the lease exit costs, legal fees and franchise support costs that are included in the reported P&L or the company owned store losses. From this base of estimated EBITDA of ~$17 million, I believe that earnings power could approximate $20 million over the next 24 months, as IRG’s manufacturing and retail growth initiatives kick in, corporate costs are reduced and some progress is made in revitalizing the heath of the network.

I would submit that any potential acquirer looking at IRG, would be able to find even greater earning power by eliminating: duplicate senior management and headcount (~$1-2 million), facilities consolidation (~$1 million), better volume purchase discounts (maybe $1-2 million) and increase shareholder value by using IRG’s manufacturing to reduce their outside food purchase costs and distribute a greater assortment of products through the Company’s retail network. Thus, a potential acquirer could see earnings power well north of $20 million, which could translate into a meaningfully accretive acquisition for its shareholders.

A dividend is very likely in the near future and should be a catalyst for the stock: Like many of the Company’s Canadian franchise peers, IRG has a high FCF business model. However, as illustrated in the table below, unlike its public peers, IRG does not currently return cash to its shareholders via a dividend. This has been an issue with investors for some time now, given that the Company is well beyond its financial restructuring of a couple of years ago, and has been generating a healthy amount of cash over the last few years. It has become more of an issue, following the termination of its strategic review, without finding an adequate acquisition partner.

The high return rich free cash flow model associated with IRG’s franchise model provides adequate cash to allow the Company to pay a regular dividend. IRG has generated an average of about $9.5-$10.0 million in FCF (operating cash flow minus cap-ex.) on an annual basis over the last two years and through the first nine months of FY 2014. Assuming a dividend yield comparable with its peers of about 5.5% (or $0.10-$0.12 per share), would translate into an annual payment of about $4.3 million (assuming the 42.7 million shares before warrants), representing a payout ratio of 43%-45% on free cash flow. Note, this payout ratio would still be well below the level of most of IRG’s peers in the industry. Thus, this would give management the flexibility to continue to pay down debt or increase the payout ratio in the future closer to its peers as some of the Company’s growth initiatives become more fruitful and/or if management is successful in revitalizing the growth of its franchise network.

I believe that while management has stated that they are evaluating paying a dividend, recent pressure from activist investors both on the board (Arnaud Ajdler), as well as those with significant holdings, such as Crescendo Partners and ADW Capital Management (both of which have written letters to IRG’s board in support of a dividend) will pressure the Board of Directors to institute a dividend policy in the near future. I am personally aware of shareholders with total holding in excess of 50% of the Company’s stock that are strongly in support of a dividend policy. I believe instituting a dividend would be viewed by investors as a strong vote of confidence by the board relative to the Company’s prospects. As many of the members of management and the board have done so by acquiring shares in the open market, this will be another powerful sign where actions speak louder than words.

Attractive valuation on both an absolute and relative basis: The shares of IRG have been pretty volatile in the last couple of months, tied to the drama in the management ranks and board room and the recent news flow. After increasing on the news of the strategic review, the shares are off ~30% from June levels and are trading about 15% below where they were prior to the beginning of the review. Notable was the decline in the share price following the news on September 8^th regarding the end of the strategic review (without a sale or dividend announcement), the announcement of a new CEO and some mixed news in the Company’s Q3 (July) earnings report. The recent stream of news, without any insights from the Company to help investors digest the news, was very poorly handled by IRG. This has, in my opinion, caused an information gap and allowed investors to believe that IRG was on a slippery slope, resulting in a period of emotional selling by some investors. I believe this has created an opportunity for longer-term value investors to purchase the shares of this asset-light, high return business at an attractive price.

As underscored by the valuation comparison table below (based on Cap-IQ reported numbers and consensus forecasts), I believe, the shares of IRG currently sell at an attractive price on both an absolute and relative basis. Based on trailing 12-month results (which contain some higher than normal costs) the shares are trading at an EV/EBITDA multiple of only 6.8x and a FCF/EV yield of about 8%. These valuations are significantly below the Company’s Canadian public peers and suggest there is significant appreciation potential in the share price as this valuation gap is narrowed.

Risks:

• Failure to revitalize and grow the Company’s franchise sales
• Franchisees who leave the organization or fail to re-new franchise agreements
• Competition from other restaurant rivals could negatively impact royalties
• Weak economic conditions in northeast Canada
• Adverse weather

Catalyst

• The announcement of a dividend
• Management articulating its strategic plan and adopting a more investor friendly communication policy
• Any signs of progress in improving same store sales at the Company's brands
• Additional growth from the Company's manufacturing and retail growth initiatives