FOOL ON THE HILL
An Investment Opinion by Louis Corrigan
Einstein's Genius in Question
Last week, this column made the hardly controversial point that business models often matter a great deal in any company's success or failure. In turning to
franchisors, I suggested that looking at a firm's business model might reveal the inherent risks of an investment. The demise of one-time highflyer Jiffy Lube, the oil
change company that grew by financing its franchisees, suggested that there might be significant risks for any firm adopting the franchisor-as-lender model to grow
its system. The examples at hand were the related fast-growing franchise cousins BOSTON MARKET (Nasdaq:BOST) and EINSTEIN-NOAH BAGELS
(Nasdaq:ENBX) , both of which have left investors with some painful heartburn over the past year despite these companies' success at opening new stores and
building strong consumer brands. Since the "Chicken" owns a majority stake in the "Bagel," it's worth focusing first on the latter. Are we looking at an overly
criticized genius, or should we prepare for the stock to be hit with more flooding?
One of the great things about the online world is that when you're wrong, you're likely to get corrected in short order. Last week, I argued that Einstein's "corporate
expenses dwarf the [firm's] royalty payments." This would be significant because while the company has been reporting solid earnings, the majority of its revenue
comes from one-time initial franchise fees and interest income on the money Einstein has loaned its area developers. Excluding those interest payments as simply
necessary to service the company's own $125 million in long-term debt, royalties from franchisees become the main source of recurring operating revenue and thus
the key for determining the Bagel's long-term prospects. But relying on the company's consolidated statement of income, I had made some rough calculations that
proved wrong given the more clearly delineated data under "royalties and franchise-related fees" in its latest SEC filing. "WallSt2001," a poster to our Einstein
message folder on AOL, was quick to provide the proper numbers and to make the bullish case for Einstein.
Comparing Einstein's 112-day first quarter to its 84-day second quarter, this poster highlighted some important signs of improvement once you back out first
quarter revenues and expenses related to company-owned stores the franchisor has now sold. Excluding these stores, total revenue fell 9.2% to $13.3 million
during the second quarter, but total continuing expenses dropped 41.6% to $5.13 million. Royalties were sliced just 6.5% to $3.95 million. That means these
franchisee payments are still a ways from covering expenses. Yet the trend definitely appears to be a long investor's friend. "WallSt2001" also provided other
bullish arguments based on earnings.
For one thing, the consensus third quarter earnings estimate of eight analysts covering Einstein is $0.16, a 6.7% increase over last quarter's results. That suggests
26.8% annualized earnings growth. For comparison, the analysts put year-over-year growth at 32% based on the consensus $0.62 per share estimate for FY97
and the FY98 estimate of $0.82 (range $0.75 to $0.85). Compared to trailing earnings of $0.58 per share, those numbers also point to 26% annualized growth
over the next six quarters. At the stock's recent price of $10 5/16, those numbers suggest an attractive PEG ratio of .68. With three analysts estimating five-year
growth of 35%, the YPEG fair value based on FY98 estimates is about $29. Assuming Wall Street is right, Einstein appears wildly undervalued based on the
standard measures for valuing growth stocks based on earnings.
The real question is whether earnings are an even vaguely adequate means for valuing Einstein-Noah. More than doubling its system this year to over 500 retail
stores, all of them owned and operated now by five area developers, the company has grown system-wide revenue 149% in the last year, from $58.7 million in the
first half of 1996 to $146.4 million for the first half of this year. The overall system, though, is still losing money: $1.3 million in 1995, $40.6 million last year, and
perhaps more this year. Einstein's latest quarterly filing argues that "the Company does not consider these start-up losses to be a meaningful financial measure during
this rapid expansion phase" when "new stores constitute a significant percentage of the store base." The problem is that this "phase" is expected to last 3 to 4 years
"from the time significant development commences in an area developer's markets." So system losses could continue for 2 to 3 more years.
These losses are being financed largely by Einstein, which requires that the area developers put up just 20% of the money needed to build new stores. By the end
of the second quarter, Einstein had loaned the developers $259.2 million. Much of the franchisees' contributions have come from Bagel Store Development
Funding, a firm partially owned by Einstein insiders and managed by the company. As of July 13, it had loaned the developers $89.5 million. Einstein's loans are
secured by the stores themselves, since the firm can ultimately convert its loans into a 70% equity stake in the area developers. Plus, Einstein charges the
developers a profitable 9.5% for the revolving loans, despite having obtained $125 million of the cash by selling 7.5% convertible subordinated debentures in May
and receiving much of the rest through the sale of stock.
The financing challenge is twofold. With no reserve for loan defaults, Einstein is banking on the continued financial health of it developers. But every rapidly growing
chain inevitably needs to close or relocate stores from time to time. In the past, the cost of doing so has run from $60,000 to $400,000 for each company-owned
store and $260,000 to $520,000 for developer-owned stores, or roughly in the $240,000 to $625,000 range of what it costs to develop a new store. A large
number of store closings could put a real damper on new store openings. At the same time, while the company has recently said it planned to slow the pace of new
store openings next year, Einstein's latest filing reiterates the fact that it anticipates "a continuing need for additional capital" as it moves toward 615 to 665 stores by
year-end and up to perhaps 1,500 over the next 2 1/2 years. Finding a financially reasonable way to raise the needed capital would seem to be a challenge if not a
problem.
The real bottom line is not Einstein's reported earnings but whether the individual stores can turn a decent profit. At this point, it's difficult to answer this question
without plugging in a host of assumptions and reading between the lines of the financial reports. Despite the fact that 77 stores had been opened more than a year as
of April 21, the company does not provide same store sales data, presumably because many of those stores are from the comparably strong Noah's chain acquired
in February 1996 and might create overly optimistic expectations. Still, if you take the $76.5 million system income reported for the first quarter, divide it by the
112 days in the quarter and then by the 354 average number of stores open during the quarter and then multiple that per-day per-store sales figure of $1,928 by
365 days, you arrive at annualized sales of about $704,000 per store. Using the same method for the 84-day second quarter and adjusting for the 451 average
store count, you get $1,846 revenues per day per store or about $674,000 in annualized sales per store. Given that most of these stores are less than a year old,
Merrill Lynch's forecast that Einstein's stores will do $690,000 in sales this year and $720,000 per store next year seems reasonable.
Assuming they will, what kind of cash flow will these stores need to cover the costs of being franchisees, most of which Einstein records as revenue? If the $259.2
million in loans to developers as of July 13 simply paid for the 487 stores then opened, each store owes Einstein about $532,000. Since the developers are not yet
paying off principal, interest payments on their adjustable-rate loans, recently at 9.5%, would cost them $50,540 per year. Royalty payments vary between 6% of
net revenues for the company's founding stores and 5% for the stores opened in new markets over the past 18 months. Assuming 5.5% royalties on $720,000 in
annual revenue, the royalty payment per store amounts to $39,600, meaning that $90,140 or about 12.5% of annual sales go to Einstein.
On top of that, each store must contribute 2% of sales to national advertising and 4% of sales for local advertising, though Einstein itself doesn't see this money.
That adds another $43,200 in costs for a total of $133,200. On average, then, each individual store needs to report at least 18.5% in margins to cover these costs.
Assuming that happens and that Einstein hits Merrill's per-store revenue target for FY98 on just 650 stores, then the company would record $468 million in sales,
good for $25.7 million in royalties. That would be a 50% increase over the $17.2 million royalty run-rate reported in the second quarter, suggesting royalties could
grow at an annualized rate of 31% over the next six quarters. If that happens, the royalties that now fall just 23% short of expenses would likely exceed them.
If that happens, Einstein will also look like a genius and today's stock price will look cheap. Still, such an outcome depends on a number of assumptions. Plus,
Einstein's filings show it has in the past sold 118 stores for $59.7 million, or $506,000 a piece, roughly the start-up cost of a new store. Assuming the company can
expand to 640 stores using its $70.2 million in cash, the chain would then be valued, on a similar basis, at just $324 million, substantially below its post-expansion
enterprise value of $491 million, assuming the shares trade around $11. Also, Einstein only has the right to convert its debt into a 70% ownership interest in its
stores.
Then there's the example of Bruegger's Bagel, the now extraordinarily troubled bagel franchise that QUALITY DINING (Nasdaq:QDIN) acquired in June 1996
for over $140 million. Quality spent $38 million through its Bagel Acquisition Company to purchase and try to re-sell 48 retail stores. When that failed and Quality
finally moved to consolidate those store operations into its overall financial statements, the result was a reduction in royalty revenue but also a substantial loss in
Quality's book value since the underlying assets -- the bagel stores -- weren't worth as much as the company had paid for them. In the end, Quality took a $185
million write-down charge plus a $15.5 million charge to close stores. In the recently announced deal allowing Bruegger's founders to take back the business,
Quality expects to receive just about $45 million, $26 million of that in Quality stock based on a price of $6 per share. When the deal was announced in August,
Bruegger's had 476 retail bagel stores, 317 owned by franchisees and 159 by Quality. In the second quarter, Quality reported $18.6 million in revenues from its
159 company-owned stores, suggesting annual sales of about $509,000 per store, significantly less than the typical Einstein store.
Is the downfall of Bruegger's a cautionary tale for Einstein investors, or perhaps a sign that Einstein is on the way to winning the bagel wars? From most accounts,
Quality badly mismanaged Bruegger's rapid expansion. Plus, while there are risks in Einstein's franchisor-as-lender model, there are also advantages to cultivating a
handful of area developers rather than hundreds of individual franchisees. The decreasing number of these developers are presumably in better financial condition
overall than your mom-and-pop franchisee, so they are better able to weather any short-term troubles. Still, Bruegger's is a bagel franchise about three-quarters as
large as Einstein will be by year end. And it's in the process of being sold for about a tenth of Einstein's probable enterprise value a few months from now, assuming
Einstein stock just stays around $11 per share.
It's too early to tell whether Einstein's stores can actually make enough money to support the company's financial obligations, or how much more time the company
can buy in new financing commitments. If its plan works, the stock could rise substantially from here. But with the company's high-wire financing act, the risk still
seems great that the Bagel could just as easily end up as toast. The company will report results the last week of October. Einstein's spokesperson Gary Gerdemann
said the company's earnings reports and press releases can be obtained at that time via fax by calling 1-800-321-3768. Next week, we'll look at the Chicken. |
