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Franchised group (NASDAQ: FRG) owns and operates branded retail businesses ideal for franchising. The company uses company-owned stores to refine business processes. It licenses its concepts to franchisees who are start new stores or buy stores that the company has already established. In addition, the company is looking for retail brands that can be franchised and benefit from FRG’s operating capabilities.

We believe FRG is an excellent choice for dividends and capital appreciation due to its attractive valuation, 6.4% dividend yield and free cash flow. We believe the series of acquisitions through fiscal 2021 have significantly increased their cash-generating potential, and therefore give it an estimated fair value of $78.

franchise group

E2022

E2023

E2024

Price/sales ratio

0.4

0.4

0.3

Price/earnings ratio

8.5

7.4

6.4

EV/EBITDA

8.8

8.2

7.8

Existing business

FRG currently owns the following branded businesses: The Vitamin Shoppe, Pet Supplies Plus, Buddy’s Home Furnishings, Badcock & More, Sylvan Learning and American Freight.

Subsidiary company

Revenue ($millions)

Franchisee / Owned company

vitamin store

1,172.7

1 / 711

American freight

988.9

5 / 367

Pet Supplies More

1,120.5

374 / 602

Buddy’s Furnishing

64.4

276 / 313

Forest learning

38.2

713 / 719

badcock and more

907.1

315 / 383

FRG revenue by industry

RFA turnover by activity (FRG Investor Day 2022)

The Vitamin Shoppe is an omnichannel retailer specializing in wellness and lifestyle products. It brings in just over $1 billion in sales annually, making it the second-largest wellness retailer in the United States. Wellness has an exceptionally large potential total addressable market (TAM) of $50 billion. In fiscal 2021, the various private labels increased to 26% of sales. As counterintuitive as it may seem, cosmetics and other beauty products see a boost during recessions, a phenomenon called the “lipstick effect”. This helps make this business economically resilient.

Pet Supplies Plus is a leading franchisor and operator of pet stores offering grooming products, toys, food and other pet supplies.. An estimated 62% of Pet Supplies Plus’ sales come from high-frequency drug and pet food restocking sales, making it a recession-proof business. The pet industry has an estimated TAM of $75 billion, and Pet Supplies Plus is the third largest pet care retailer in the United States. The acquisition of Pet Supplies Plus in March 2021 was the primary driver of revenue growth in 2021, increasing FRG revenue by $917 million.

American Freight is an “as is” furniture, appliance and mattress retail outlet benefiting from a merger with Sears Outlet. The furniture industry has a TAM of nearly $500 billion, which leaves plenty of room for expansion. American Freight is the industry leader in discount home appliances in the United States with the #1 market share. For the very value-conscious market segment, consumer durables are purchased on the basis of need (the need to be replaced), not as truly discretionary expenditure; therefore, American Freight is more recession-proof than most consumer durables.

Buddy’s Home Furnishings is a hire-purchase furniture store, with operations similar to American Freight, to be the 3rd largest rent-to-own store in the United States. The rent-to-own market targets so-called “subprime” buyers; these are consumers whose credit rating may not meet the financing needs of other furniture stores. Although the total addressable market is not as large as the traditional furniture and retail markets, 34% of the US population has a “subprime” credit rating, which means Buddy’s still has a significant addressable market. potential.

Badcock & more is a mid-priced furniture store, with all locations in 8 southeastern states, with most locations in Florida. Being one of the most recent acquisitions, Badcock & more is set to see expansion into the rest of the US now that it has educational support from the RFA – although those plans have not yet been released to the community. investors. The entire purchase price of Badcock & More will be covered by a sale and leaseback of commercial real estate, totaling $175 million. Additionally, the acquisition added $102 million in revenue to FRG.

Sylvan is a franchised tutoring service, offering a range of services for remedial students to advanced students. Sylvan is focused on in-center tutoring but offers remote, home and satellite location services for students. The total addressable market for education services is $20 billion and growing.

Strategy and Valuation

FRG’s new brand acquisition strategy focuses on the following investment profile: small capitalization business, high product margin, significant free cash generation, consumer contact and difficult to replicate online. These new companies are acquired by the holding company and rely on common policies and scale to develop the franchise business. This strategy allows franchise management to focus exclusively on growth in the target market rather than having capacity limitations. Home office costs are thus shared among several branded companies, improving efficiency and reducing costs.

System-Wide Revenue RFA

FRG system-wide revenue (FRG Investor Day 2021)

Brands that are fully franchised produce enough free cash and only spend 1.5-2.0% of their cash flow on capital expenditures and try to maintain conservative leverage at 2-3x (net debt/ EBITDA). FRG will expand to a 4x margin for an opportunistic acquisition that offers the ability to quickly generate profits and free cash.

This strategy allows FRG to trade cash for additional cash flow growth, allowing them to quickly deleverage after a large acquisition. Through 2021, FRG has opened 109 new locations and increased its backlog to 360 planned locations, with 54% of all locations (planned and currently open) held by independent franchisees.

FRG primarily funds acquisitions and sustaining transactions through operating cash flow, although as previously stated they will extend leverage if there is a significant opportunity. The leverage ratio for fiscal 2021 is 5.5x (total debt / EBITDA) mainly due to 3 significant acquisitions in 2021. However, with the increase in cash flow associated with these activities, we expect the ratio of leverage will be reduced to around 4.1x by the end of FY2022.

The E2022 price/cash flow ratio is 5.9.

E2022

E2023

E2024

Cash flow ($ millions)

$274.0

$314.8

$334.2

Cash flow / Action

$6.67

$7.66

$8.13

Price / Cash Flow

5.86

5.11

4.81

Our estimated fair value for FRG is $78.

Estimated PER: 13.0

Estimated EPS 2024: $6.00

Normalized earnings power increases to $6.00 by FY2024 after most recent acquisitions.

Therefore, 13 times $6.00 = $78.

Risk

While FRG’s acquisition strategy focuses on recession-proof business models, consumer spending behavior is often volatile and preferences change. A severe recession will negatively affect FRG’s operations.

Since FRG is primarily a franchisor, individual stores or groups expose FRG to brand risks, such as poor customer experience and lack of franchisee execution talent. Retail also presents risks related to competition from other physical retailers and online retailers.

Conclusion

We believe FRG is an excellent choice for dividends and capital appreciation. Fiscal 2021 acquisitions have significantly increased earnings potential, and much of the acquired business is recession-proof, which may prove useful in maintaining dividend yield in the event of an economic downturn.

Management is strong and we believe the customer base and total addressable markets for businesses are strong even though consumer spending is expected to decline.