NOBLE ROMAN’S UPDATED WRITE-UP

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THE COMPANY

Noble Roman’s, Inc. (NROM) is forty six years old as an Indiana Corporation, having operated, franchised and licensed versions of the “Noble Roman’s Pizza” brand. Founder and Chairman, Paul Mobley, formed NROM in 1972, still leads the company from a strategic standpoint, plays an active CFO and shareholder relations role, and his son, Scott, is President and CEO. Locations selling NROM Pizza today include 50 states plus D.C., Puerto Rico, the Bahamas, Italy, the Dominican Republic and Canada. While the company has operated and franchised stores with varying degrees of success over the years, the underlying reputation for serving a high quality product has been generally maintained. This is evidenced by the most recent commentary in social media (Yelp and Facebook) relative to the openings of Noble Roman’s Craft Pizza and Pub locations (NRCPP), the most recent incarnation of the brand.

Though customers of Noble Roman’s mostly remember the brand with the nostalgia of their youth, the long operating history has included a number of starts and stops. In particular, the six years ending in ‘17 were burdened by losses related to the unsuccessful effort to build a “Take ‘N Bake” version of Noble Roman’s, and the Company paid a predictable price for the failure. We describe below, when discussing the improved balance sheet, some of those costs.

THREE OPERATING SEGMENTS

Noble Roman’s today has three primary areas of focus, in order of current emphasis: (1) Expansion of a new generation of NRCPPs, which, following the successful openings of four company operated locations, has recently begun to award franchise rights. (2) Franchises-Licenses for “non-traditional” locations, primarily in convenience stores (often affiliated with gas stations) and entertainment facilities. (3) Licenses to sell Noble Roman’s products within grocery stores

“NOBLE ROMAN’S CRAFT PIZZA AND PUB” (NRCPP)

This is by far the most attractive expansion opportunity for the Company. The fast casual restaurant features two styles of crust, both thin and Deep Dish Sicilian, with their famous breadsticks served with spicy cheese sauce, specialty salads, four pasta dishes, all “designed to be fast, easy to prepare and delicious to eat.” New pizza oven technology provides bake times of only 2.5 minutes for the regular crust, 5.75 minutes for Sicilian, with the dough preparation room visible to customers.

The concept as we would describe it is: similar to Blaze, MOD, and so many other participants in the fast casual pizza segment, but “evolved” and “differentiated” in major ways. NRCPP serves personal size pies as well as family sized, serves traditional crust as well as Sicilian (for the same price), serves a limited number of salads, sandwiches, chicken wings, and desserts. Wine & Beer (including Craft Beers) is served at a modest but comfortable bar, where you can also dine. Half a dozen TV sets create a low key sports bar “vibe”.  Anecdotally, we have personally been to all four locations, several times to the first of them, and have been impressed with the quality of operations that has been taking place.  Social media commentary, including Yelp and Facebook, confirms our reaction, and the public’s view of The Brand seems to be a combination of nostalgia combined with admiration of the current updated approach. The hospitality quotient provided so far should presumably be replicable in the foreseeable future because the company operated stores, as well as initial franchised locations, will continue to be in NROM’s “back yard”. The first location (Westfield) opened  1/31/17. A second location (Whitestown) opened 11/17/17. The third location (Fishers) opened 1/18/18 and the fourth (Carmel) opened 5/29/18.  The Company has shown an ability to open these four stores, at budgeted cost, in only 3-4 months after lease signing. Naturally, the speed of future openings is dependent on lease negotiations, real estate variance requirements, and the configuration of the proposed site.

            UNIT LEVEL ECONOMICS OF NOBLE ROMAN’S CRAFT PIZZA & PUB

The locations are about 4,000 square feet, cost about $600,000 (including about $50,000 of pre-opening expenses). The targeted average annual volume has been $1.35M (26k/wk.) with a first year store level EBITDA of 22%. Cost of Goods combined with Labor (including fringe benefits) is expected to average no more than 50% of sales. These parameters provide an immediate 50% cash on cash return, allowing for a two year cash payback. The first four locations are collectively meeting, and sometimes (Westfield) individually exceeding all these targeted parameters on an annualized basis, though only the first (Westfield) has been open for more than one year. It is important to note that many successful restaurant franchisors project targeted cash on cash returns in year three much lower than shown above (and don’t include pre-opening expenses in their calculation), obviously far less attractive than the indicated fully loaded immediate returns of NRCPP. Since the company, as well as the first of the franchised locations, will be located near Indianapolis, pre-opening costs and initial opening inefficiencies should continue to be minimized.

            FRANCHISING OF NOBLE ROMAN’S CRAFT PIZZA AND PUB

While four locations in Indiana (the first of which is approaching its second anniversary) does not imply worldwide expansion opportunities, NROM management has many years of multi-unit operating, and franchising, experience and there are very few concepts in the restaurant industry that have generated the returns as described above. Average Unit Volumes (AUVs) could build further as the Indiana market is penetrated, or perhaps be cannibalized, but there has so far been no effort at delivery, introduction of a mobile app or many other typical operating and marketing initiatives. Greater Indianapolis alone could support at least 20 units, the State of Indiana many more, so an obviously unlimited growth runway is in place. The Company, operationally led by President and CEO, Scott Mobley, has done an admirable job of getting NRCPP off and running. Noble Roman’s brand is known, to varying degrees, in all 50 states, and could no doubt succeed in well run, properly situated locations almost anywhere, but Indiana and the immediately surrounding geography represent the most obvious expansion opportunities. It is noteworthy that well located non-traditional locations in C stores and hospitals do impressive enough volumes to inicate that NROM pizzas can attract customers far from Indianapolis but stores close to the home base are naturally the current priority.

The franchising strategy for NRCPPs is to sign single unit, experienced, operators close to home. Further away, only very well capitalized operators, fully committed (operationally, financially, psychologically) to building out markets, will be enrolled. Since an operating organization is in place at NROM that can support local franchisees in their startup phase, and multi-unit franchisees will pay non-refundable up front franchise fees that should more than offset support services, the franchising effort should contribute incremental profits and cash flow to NROM at even the earliest stage. The initial franchisee fee is $30,000 for a single unit, $25,000 for the second, $20,000 thereafter. Ongoing royalties are 5%, plus a 2% contribution to a creative fund.

The first franchisee has recently been signed, a highly regarded Indiana based Dairy Queen franchisee, Holly and Patrick O’Neil, who currently operate nineteen DQ locations. Since they have been expanding their number of DQ locations in recent years, they seem to have the financial and operating resources to open additional NRCPP locations if the first location is successful. The excellent reputation of Holly and Patrick (who has been head of the DQ franchise association) will no doubt be encouraging to other potential franchisees. They could also provide operating expertise to the NRCPP system. Nobody has all the answers and every successful franchisor has learned a great deal from their experienced franchise partners. Their first location will be in Lafayette, Indiana, a previously successful jurisdiction for Noble Roman’s, and should open by February, 2019.

NON-TRADITIONAL FRANCHISING

The company has franchised about 750 units, including convenience stores, travel plazas, entertainment venues, hospitals, most several Wal-Mart and Circle K locations.  A prototype counter top unit was introduced in early ’16 and has generated steady growth in the last 18-24 months. There is obviously a time lag from when a new license is signed to when a location opens for business. This steady source of revenues amounted to $4.5M in ’17, up from $4.4M in ’16. Revenues from this segment were down slightly YTY in Q1’18, up about the same in Q2, also flat for nine months. Though revenues have been flat for nine months, and openings and closings as described in the quarterly filings are lumped in with grocery store numbers, management indicates to us that non-traditional openings are increasing slightly quarter to quarter, from seven in Q1 to 8 in Q2 to 10 in Q3. Since signings have been going well in ’18, as reflected by “franchise fees and commissions in Q3” which increased from $58,000 in Q3’17 to $119,000 in Q3’18, an increase in royalty revenues can be expected in the future. It should be noted that while 13 non-traditional locations closed in the latest nine months, they were older low volume units and will not cost much in missed royalty income. It should also be understood that while a few units have opened within Circle Ks and WalMarts, those retail systems are difficult to quickly penetrate for a number of reasons and we expect independent operators to be the more predictable source of growth. Overall, the pace of signings within this segment, with tens of thousands of potential outlets throughout the country, has clearly picked up over the last eighteen months, and could be capable of, at least offsetting the current slippage in the grocery channel described below. The initial franchise fee is $7,500, except for $10,000 at hospitals. The ongoing royalty is 7% of sales, with no advertising contribution since customers in these locations are mostly on the premises for other reasons.

GROCERY STORE LICENSING

Noble Roman’s has licensed, by way of a supply agreement, sales of its products to just over 2,000 grocery stores. The licensed grocery store must purchase proprietary ingredients through a Noble Roman’s approved distributor. The deli department of the grocery store then assembles the products and displays them using Noble Roman’s point of sale marketing materials. The distributors collect for Noble Roman’s a fee in lieu of royalty as they sell ingredients to the grocery stores and remit this amount within ten days of each month end. While the number of grocery stores under license expanded steadily for several years, especially until the end of 2016, the labor requirement within the grocery deli departments has limited further growth, and the improving economy has reduced the number of budget driven pizza consumers, so license revenues from this segment has contracted in the last two years. It is unknown how many of the 2000+ grocery locations are currently offering product, especially since stores sometimes are removed and then later return. NROM management has explored the possibility of assembling the pies at the distribution level, reducing the labor requirement at the individual grocery store, but a solution has not yet been developed.  With two other far more profitable and promising areas for corporate growth, NROM management is concentrating efforts elsewhere. Royalties and fees from grocery store distribution was $1.8M in calendar 2017, down from $2.1M in ’16. In the first nine months of ’18, grocery fees were down a more modest 12.5% to $1,151k from 1,316k, though seasonally slow Q3 was down 27%. While this division’s income has slipped in the last two years, the economy seems to be slowing once again, which would make deli-workers more available and consumers more interested in a take and bake product.

THE BALANCE SHEET – SUBSTANTIALLY IMPROVED

During ’15, ’16 and early ’17, as the Take ‘n Bake version was winding down, and the NRCPP version was incubating, the Company was carrying short term debt with an interest rate over 20%, especially burdensome when the company was still reporting operating losses from termination of the Take ‘N Bake adventure. $2.4M was raised in late 2016 and early 2017 in the form of 10% debentures, maturing in December 2019 and January 2010, convertible at $0.50/share, with 2.4M warrants @ $1.00 attached. It is worth noting that both Paul Mobley, Chairman, and Marcel Herbst, Director, participated in this private placement. While the terms of the convertible debt were not pretty, it was a lot better than what had been in place. More importantly, in September ’17 the Company put in place $4.5M of conventional bank debt, maturing in September 2022, at an interest rate of LIBOR plus 4.25%. Additionally, a $1.6M Development Line of credit facility was established to fund three new company operated locations.  Each tranche of the Development Line is repaid starting four months after being drawn, on a seven year amortization schedule. As described earlier, the rapid cash on cash returns from the new locations are easily capable of servicing the Development Line and generating excess cash as well. Overall, the new financing arrangements have provided NROM with adequate financial flexibility, allowing steady further development of NRCPP locations, building a franchise operation, also further developing the two other segments. Calendar 2018 results will have benefited from about $500k of cash interest savings YTY. It is also important to note that NROM has a Deferred Tax Asset on their balance sheet of $5.6M, sheltering about $20M of pretax earnings. In the nine month report, the Company indicated its plan to extend the maturity date of the 10% convertible (at $0.50) bond, (with warrants at $1.00/share attached), which has $2M still outstanding, three years until 2023.

Q3’18 CONTINUES TO DEMONSTRATE EXPANSION OF CORPORATE EARNINGS AND CASH FLOW POWER

Operating results over the years, including the last few, have been burdened with lots of unattractive moving parts. While the apparent EBITDA has been about $3M annually in each of the last several years, the actual free cash flow was inhibited due to expenses necessary to wind up the aborted Take ‘N Bake operation, exorbitant interest charges, and legal expenses associated with license fee collection. However, since late ’17, without Take N’ Bake and the exorbitant interest charges, the EBITDA more closely resembles free cash flow. While recent reported results have still been complicated by writeoffs of old receivables and associated legal expenses, as well as non-cash changes in the value of derivatives, a $3.7M change in calendar ’17 in  the value of the deferred tax asset, EBITDA (Operating Income plus D&A plus non-cash writeoffs plus interest) in the trailing twelve months ending 9/30/18 was over $3M. Since legal fees should come down now that the two active lawsuits were settled, the “run rate” of annual EBITDA by 12/31/18 could be over $3.5M.

Third quarter results showed revenues increasing substantially from the addition of NRCPP locations. Up front Franchise Fees and Commissions more than doubled to $119,000 from $58,000 in Q3’17. Royalties and fees from non-traditional locations was flat at $1.2M while fees from grocery stores were down $124,000 to $311,000. The most important line item was the Revenues from Craft Pizza and Pubs, increasing from $457,000 to $1.309M, reflecting the four stores now opened. Equally important was that restaurant expenses of NRCPPs amounted to $1,048,566 or 80.1% of sales, providing store level EBITDA of 19.9%. A year ago, Westfield was the only store opened and had store level EBITDA of 24.0%. The lower margin this year is a function of three relatively immature locations, still reflecting opening inefficiencies. Annualizing the third quarter revenues would indicate an average yearly revenue level just above $1.3M for the four stores now open, but the third quarter is a seasonally slow quarter reflecting typical back to school consumer spending. Also, in spite of some indeterminate amount of cannibalization, the full year should annualize at or above $1.35M. The company stated that they expect the store level margin to improve from the nine month level, as higher seasonal volume combined with operating efficiency from the newest locations kicks in. It seems that the targeted 22% store level EBITDA is achievable, which at $1.35M generates $297,000 and provides a two year cash payback on the $600,000 investment with includes pre-opening expense.

Operating income in Q3 was $714k, in the same range as the last two quarters Adding back $125k of depreciation provides EBITDA of $839k. Below the Operating Income line, interest expense was down sharply to $173k from $601k a year earlier. There was a non-cash adjustment of the valuation of receivables (70% of which was capitalized legal expenses) of $1,296k, relating to two receivables that have been contested in court for over two years. This non-cash item resulted in a GAAP loss after taxes of $562k. This level of earnings and EBITDA is typical of the last four quarters. As indicated above, there seems to be a current annualized level of EBITDA comfortably over $3.0M to build upon.

The Company indicated its plan to open a fifth store in the near future but there is not yet an indication of a lease being signed. We think the probability is high of a new location in early ’19, perhaps another store by late ’19, which would allow for a contribution of at least five store-years for calendar ’19. If we conservatively assume 5 store years for ’19 (versus 4 stores open currently), this would be a total targeted EBITDA addition of $297k on the current run rate from one more store, but it is possible that lower legal expenses and more efficiency from the three newest locations could improve upon that. This ballpark possibility excludes possible benefit (e.g.non-traditional locations) or penalty (e.g.grocery locations) from the other activities. Most important: these numbers do not include any contribution from NRCPP franchising. Ten franchised locations, for example would generate $250-$300,000 up front, and, $675,000 annually of franchise royalties at the targeted volume. There is obviously a long runway for growth here, if operating results do not disappoint.

THE CURRENT BALANCE SHEET AND ENTERPRISE VALUE

There is currently about $7.0M of total debt, and about 21.6M shares currently outstanding. The debt consists of $5.0M bank debt, including the current portion, and $2.0M of convertible debt (at $0.50/share). Between now and late 2019/early 2020, the $2.0M of convertible debt will either turn into 4.0M new shares, be extended in maturity (if bond holders agree), or be refinanced (likely at less than the current 10% interest rate), one of which we believe will be practical, considering the successful development of NRCPP locations.  There are 2.4M warrants, that were attached to the convertible debentures, at $1.00 per share, which would obviously bring in $2.4M of equity if exercised. There are about 1M additional shares due to various options and warrants, which would bring in roughly $500k if exercised. In total therefore, about 27M shares would be outstanding, fully diluted, but that would have brought in over $5M of equity, obviously reducing the current $7M of current debt very substantially. We can therefore consider that the total enterprise value of NROM is something like ($0.45/share x 27M shares) plus $2M of remaining debt after cash generated from exercise of all options and warrants, or a total enterprise value of just over $14M.

CONCLUSION

We need not make precise projections in terms of cash flow and earnings, other than presenting the rough parameters above. Our statistical template at the beginning of this descriptive article assumes only a continuation of the four company operated stores that are in place, maintenance of the other two operating segments, and no surprises, positive or negative. Substantial progress has been made over the last two years, both operationally and in terms of balance sheet restructuring. The stock is obviously cheap statistically, with an enterprise value of about 4x the current rate of annualized EBITDA. There would normally be a great deal of private equity interest at this kind of a valuation, but this is a very small deal in today’s environment and management has no desire to change ownership at anywhere near the current valuation. This is especially so, as the company seems to be “cleaned up and just arriving at the party”. Time will obviously tell as to what extent this management team capitalizes on the current opportunity, but it seems like the necessary pieces are in place to take this reincarnated brand a great deal further. Noble Roman’s is an infant compared to some of the more mature participants in the fast casual pizza segment such as Blaze or MOD  but seems equipped to compete effectively.

Roger Lipton

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