BAB (BABB): This Nano-Cap Franchisor of “Big Apple Bagel” Stores is the Smallest Stock I Know of That’s a Consistent Free Cash Flow Generator
This might turn out to be a shorter initial interest write-up than some, because there isn’t as much to talk about with this company. It’s pretty simple. The company is BAB (BABB). The “BAB” stands for Big Apple Bagel. This is the entity that franchises the actual stores (there are no company owned stores). Big Apple Bagel is a chain of bagel stores – mostly in the Midwest – that compete (generally unfavorably) with companies like Einstein Bros Bagels, Panera Bread, and Dunkin’ Donuts. The company owns certain other intellectual properties like: a brand of coffee (Brewster’s) served in its stores (which Andrew tells me is terrible, I haven’t had a chance to taste the coffee myself), “My Favorite Muffin” (a muffin concept similar to Big Apple Bagel), etc. But, the cash flows seem to come mainly from royalties paid to BABB by franchisees in proportion to the sales they make. Like other franchised businesses, the company also maintains a marketing fund that is paid for by franchisee contributions.
Why am I writing about this business? Because I think it may be literally the smallest stock I’m aware of that is a legitimate and decent business. The market cap is closer to $4 million than $5 million. Insiders own some stock. So, the float is even less. And the investment opportunity is limited no matter how willing you are to accumulate shares because there is a poison pill. No one can acquire more than 15% of the company’s shares no matter how patient they are. So, as of the time I’m writing this, that would mean that the biggest potential investment any outsider could make in this company would be about $650,000. Realistically, it’s unlikely any fund or outside investor could manage to put much more than half a million dollars into this stock. And it’s entirely possible management would not be happy to see even that much being put into this stock (since that’d be more than 10% of the share count).
So, this is a very, very limited investment opportunity. And yet: it is a real investment opportunity. This is a real business. You can travel the country eating at each of these franchised locations. You can call up the owners of the franchised stores and talk with them about the business. You can read 10-Ks on this company going back a couple decades. The company is an “over-the-counter” stock. But, it isn’t dark. It files with the SEC. That’s very unusual for a company with a market cap of less than $5 million. Public company costs are significant. This company would be making more money if it was private. Management costs are also significant here too. The CEO, general counsel, and CFO were paid: $250,000, $175,000, and $120,000 (respectively) last year. That adds up to $550,000.
They own 33% of the stock. I mention this because if we compare the value of the stock they own to the value of the salaries they draw – it’s true they are owners, but their position as managers may be more valuable to them. Take the CEO. He owns 20% of a stock with a total market cap of less than $5 million. So, he has wealth of less than $1 million in stock in the company. Meanwhile, he is paid $250,000 a year by the company. If we capitalize his salary at say 8 times – so, $2 million – his incentives should be titled a bit more toward keeping his job than compounding his wealth. And he is the biggest shareholder at the company.
This is also very, very unusual for a very, very small company. Tiny companies usually have very big shareholders who have way more invested in the future success of the business than they could reasonably get back in yearly salaries. That’s not the case here.
The business is obviously very free cash flow generative before we get to this corporate layer where you have public company costs, compensation of people who are also major shareholders, etc. It’s important to separate this stuff out to get a better feel for things like what a management led leveraged buyout would look like. What are the core economics of this business?
The company’s “cash flow from operations” basically converts directly to free cash flow. This is not unusual for a company like this. It’s basically just an entity that collects a perpetual royalty on already franchised stores. They do license (or franchise) additional stores sometimes. But, they don’t build company owned stores. They lease their headquarters. And they don’t have much in the way of equipment needs, etc. at HQ. So, CFFO basically equals FCF. Last year’s CFFO was $430,000. The year before was $390,000. Let’s call that $400,000.
At the end of last quarter, the company had 7.3 million shares outstanding. So, $400,000 in FCF divided by 7.3 million shares equals 5 cents a share in free cash flow. The stock trades at 60 cents a share. So, 12 times free cash flow. For a fast food franchisor – that’s cheap. It’s a little cheap for any stock really. You don’t find many stocks trading below 15 times truly free cash flow. To illustrate, 5 cents divided by 60 cents is an 8.3% free cash flow yield. The company’s current assets exceed its liabilities. A constant royalty stream on what’s basically a fast food business is a pretty safe form of free cash flow. And there are no securities senior to the common stock. So, getting a yield of more than 8% a year in BABB common stock seems a lot better protected than other ways of earning 8% a year.
Now, the actual dividend yield does not perfectly match the free cash flow yield as I’ve calculated it. But, it’s very close. BAB paid out about $360,000 in dividends in 2018 and about $440,000 in dividends in 2019. If we average the two, we get about $400,000 a year in dividends. If we divide that into the 7.3 million shares outstanding – we get an expected dividend of about 5 cents. A 5 cent dividend on a 60 cent stock is an 8% yield.
Again, this yield is well protected in some sense. It’s certainly not rock solid. But, compared to other things you can buy that will pay you 8% in cash on your purchase price this year – this is a financially solid entity you’re buying into. For example, cash on hand is $1.1 million using unrestricted cash only and $1.5 million including restricted cash. That’s 15 cents to 21 cents a share in cash. That is not – however – what I’d call net cash necessarily. The company does have some liabilities. But, current assets exceed total liabilities by $400,000. There is, therefore, no reasonable argument to be made that the company has less than 5 cents a share in truly surplus cash. And it probably has a lot closer to 15 cents a share.
Why?
Because the company’s liabilities are really cheap, safe, and slow to run-off forms of liabilities. The single biggest liability is the marketing fund. The company has received cash from franchisees to be put toward marketing that it hasn’t yet put toward marketing. This is a liability. And we could take the restricted cash and net it against this number. I’d consider that fair. That would leave just the unrestricted cash of 15 cents a share. The only other forms of liabilities are an operating lease liability and accrued expenses. These are normal expenses that are paid in cash from each year’s cash flows before we get to the “cash flows from operations” number.
So, if I’m being honest, here’s what I think we have here.
Stock price is 60 cents a share.
Net cash is 15 cents a share.
Free cash flow is 5 cents a share.
So, when you buy this security – you have 25% of the price you are paying immediately backed by cash on hand. Plus, you get an 8% annual yield paid out to you in dividends. Or, if you prefer using the “enterprise value” approach – we have free cash flow / enterprise value of 11%. It’s actually 12%, because I rounded down the free cash flow figure I’ve been giving you. Whatever it is, we’re talking about a free cash flow yield / dividend yield of over 8% on the market cap and over 10% on the enterprise value. If you prefer using EV/EBIT – it’s about 5 times.
We are also talking about a business that is very, very small relative to the costs of being a public company. For example, the company paid $60,000 for its audit last year. I know of a few public companies that pay $40,000 or less. And this company is an SEC filing stock even though it’s very, very small even by OTC standards. I don’t know how much could be saved in total by not being a public company.
I think it’s difficult to model out what this company would look like if its 20% owner (the CEO) simply became a 100% owner. But, it’d look different. My guess is that he could – in the long run – extract far more cash from BAB, if he borrowed enough money (like $3-4 million or more) to take the company private and then eliminated public company costs, etc. and drew his earnings as an owner (paid himself out 100% of the company’s dividends) rather than drawing a salary and being just a 20% owner.
However, there would be risks with doing something like that. One, I don’t know that you could borrow enough money to buy outsider shareholders out. Two, there are enough outside shareholders to present reputational problems, etc. if you did this. You might actually have to pay a decent premium to take the company private. Three, this business could deteriorate – and you might not want to put debt on it.
However, I do want to point out that taking this company private is probably easier than it looks. Take the market cap. Yes, it’s $4.4 million. However, two insiders – the CEO and the general counsel – own a third of the shares. So, the real “float” needed to buy out everyone other than the CEO and general counsel (if they were the team-up taking the company private) is only $2.9 million. Call it $3 million. The company definitely has $1 million in truly surplus cash on hand. It actually has $1.5 million in the bank. You can borrow dollar for dollar against truly surplus cash. That leaves $2 million you have to borrow. Free cash flow has been $400,000 lately. So, that’s borrowing 5 times debt to free cash flow (not EBITDA). And, remember, that’s without injecting any more equity. The top people at the company have been drawing $150,000 to $250,000 a year. Presumably, they have some savings. Now, yes, you’d have to pay a premium to get agreement from shareholders overall. But, this thing does seem to be trading at a price below where a going private transaction would make sense.
So, am I excited about this opportunity?
Not really.
Why not?
Well, it’s really only going to pay me dividends. I would never be able to influence capital allocation – there’s a poison pill with 15% threshold – so, you can’t keep cash in the entity. A franchise system that built up cash inside it and eventually did other stuff with that (while being publicly traded) could be more efficient than almost any other vehicle for the right capital allocators. Is current management the right capital allocators?
I don’t think so. I think they’ll just pay out the free cash flow in dividends. Receiving all cash in dividends is a very sure way of making money. But, it’s not the most efficient way.
If this thing gets recapitalized at some point – borrowing against its stream of future royalites – I suspect it’ll be to go private, not to reward the outside shareholders with more dividends or some buybacks or acquisitions of other stuff. So, the fact there is net cash here and no leverage is definitely a big plus for the value of the corporation. But, it may not be something outside shareholders can ever benefit from given management is entrenched with the poison pill.
This leaves just a dividend stream.
And while it’s a good dividend stream – this is not something like Pinelawn Cemetery (PLWN) or even something like Mills Music Trust (MMTRS). This company is subject to intense competition.
Big Apple Bagel locations face much rougher competition now than they did 20 years ago. Einstein Bagel and Panera are much more likely to be sited close to some of the franchisees that are producing a lot of the free cash flow here.
If we assume the median franchised location does about $350,000 a year in sales and the company gets a 5% of sales royalty fee – that’s a little less than $18,000 from the median franchised store. The mean sales from a store has to be more like $450,000 and up. But, it’s very possible the mean could be that high while the median was more along the lines I suggested if the very top stores do over $1 million a year in sales.
The cushion here for the franchisee – if they only own/operate one location – is very slim. When I add together the marketing fund, the royalties taken by corporate, and then factor in what’s likely to be left for the franchisee to draw as a salary, it doesn’t leave more than they’d make working a full-time job managing someone else’s store or doing a lot of other jobs. And that’s more along the lines of the “median” franchisee. It’s likely that the bottom half of franchisees are closer to the edge financially than that.
That’s typical of franchise systems. And I don’t see anything here to suggest that the resiliency of the remaining Big Apple Bagel locations is a lot worse than other franchised businesses. However, in places where Big Apple Bagel is up against the likes of Einstein Brothers and Panera – it’s very clear that franchisees aren’t putting in as much capital as those companies do. So, the Big Apple Bagel locations are older than the locations of competing chains in the same area. They don’t get much support or direction from BAB Inc. I didn’t hear negative things from franchisees. But, I did hear they have a lot of freedom compared to other franchise systems and they’re mostly on their own. Some are successful. Others less so. But, the way these stores work – franchisees really don’t have the capital on hand to refurbish and upgrade stores. And it shows. Stores look old. Equipment tends to be cheaper. This is a small system. The entire Big Apple Bagel franchise system generates only $33 million a year. Think about that. That’s less than $650,000 a week spread over 72 franchised locations. We’re talking an average (mean) of $9,000 a week in sales per store. It’s enough to make a living. But, it’s not enough – at the franchisee level – to actually retain capital and compound wealth through reinvestment.
So, my concern is not that BAB Inc. isn’t doing well financially. It is. My concern also isn’t that franchisees are doing all that badly. I’ve seen much, much worse economics for the franchisees than what I’m seeing with a Big Apple Bagel. My concern is that if and when competition intensifies from the siting of locations of better known, more national, and better funded competitors – these Big Apple Bagel franchisees won’t be able to put more money into their stores.
The stores will age further over time. They will fall further behind.
Is this risk more than offset by the high dividend yield, the excellent balance sheet, the surplus cash, etc.?
Maybe.
There’s a reason other franchise systems trade for many, many times higher multiples than BAB does. I can’t deny the stock is cheap. But, I am not sure of the long-term competitive position of the franchised locations that provide all the free cash flow here.
Geoff’s Initial Interest: 50%
Geoff’s Re-visit Price: 35 cents a share