We have written extensively about FAT Brands over the last several years, which can be accessed by way of the SEARCH function our Home Page.
FAT Brands reported results for Q1’23. There was significant fundamental progress, though non-cash and/or non-recurring expenses, as well as ongoing interest costs require a look beneath the surface. The top line, as represented by same store sales, systemwide sales, store growth, and Adjusted EBITDA are moving higher, largely because of unit growth within the 2,300 stores representing seventeen brands.
Per the Company website:
The GAAP net loss of $32.1M, equal to $1.95 per diluted share, is eye-catching, to be sure. Adjusted EBITDA, however was $19.2M up 27% from Q1’22, continuing the quarterly progress shown in calendar ’22. Trailing twelmve month is now $92.9M, not far from the $100M Adjusted EBITDA post-Covid company objective, with a $150M longer term goal as the 1,000 store development pipeline is implemented. Included in the results: Royalties were up by 7.6% in Q1, Factory Revenues were up by 12.0%. G&A, excluding the increase in litigation expense (discussed below), was down 5.2%.
THE TWO MOST IMPORTANT CONCERNS: BALANCE SHEET LIQUIDITY AND LITIGATION EXPENSE
Of note is the fact that $21.3M of the $32.1M GAAP loss was non-cash and/or non-recurring: $7.1M of D&A, $1.1M of non-cash compensation, $5.0M of non-cash loan fees and interest, and $7.7M of litigation expense, discussed below. Also within the $32.1M GAAP loss was $30M of interest expense ($25M in cash), as a result of the billion dollars worth of long term royalty securitization, remaining current in terms of debt service. With the Q1’23 (seasonally low) indicated negative cash flow of about $15M (if we assume legal fees at $2M/qtr), balance sheet liquidity is a natural concern. However, as stated in the recent 10Q: “The Company had $46.2 million of unrestricted cash at March 26, 2023 and plans on the combination of cash flows from operations, cash on hand and $48.5 million of issued but not sold aggregate principal amount of fixed rate secured notes to be sufficient to cover any working capital requirements for the next twelve months from the date of this report.”
As discussed below, the expected unit and royalty growth should steadily improve operating earnings, presumably turning free cash flow positive before the financial flexibility runs it course. In addition, as discussed below, a “liquidity event” could well come into play within the next year or so,
We are not equipped to judge the validity, or predict the outcome of the legal issues in play, and we refer our readers to the discussion in the most recent quarterly 10Q and annual 10K SEC filings. The lawsuits relate largely to Andrew Wiederhorn as an individual, who has recently stepped down as CEO. As he said on the most recent conference call: “to remove the distraction of the personal investigation regarding matters from several years ago before our merger with Fog Cutter”.
Per the latest 10Q “This lawsuit (editor’s note: one of them) does not assert any claims against the Company. However, subject to certain limitations, we are obligated to indemnify our current and former directors in connection with defense costs for the lawsuit and any related litigation, which may exceed coverage provided under our insurance policies…”
It is apparently on this basis, as well as one of the lawsuits that includes the Company as a plaintiff, that the Company is incurring the referenced legal expenses, and management has stated an expectation that insurance will provide some portion of relief. While investors should give legal concerns their due, franchisees, as we personally observed at their seventeen brand franchisee convention last August, seemed unconcerned with this subject, viewing the Wiederhorn family with respect and even affection.
MORE RESULTS – TOPLINE GROWTH HELPS A LOT
There is no question that the new interest rate environment has challenged the Company in terms of managing their balance sheet. They had hoped to refinance much of their debt, currently at an overall interest rate of about 7% with an improvement of 200 basis points or more, but that will obviously be delayed. The good news is that the businesses seem to be prospering, with every indication that sustained growth is ahead. As pointed out above, Royalties were up by 7.6% in Q1, Factory Revenues were up by 12.0%. G&A, excluding the increase in litigation expense, was down 5.2%.
Forty one units opened during the first quarter, forty five to open in the second quarter, one hundred seventy five in all of ’23, up 25% from ’22. The development pipeline of approximating 1,000 units can be expected to add $50 or more to Adjusted EBITDA, building Adjusted EBITDA to a total of $150M, with the vast majority of incremental EBITDA becoming free cash flow.
STRATEGIC PRIORITIES, INCLUDING A LIQUIDITY EVENT
A casual analysis of this highly leveraged company might result in concern about the long term viability. A billion dollars of debt and large current losses are ample negative signposts.
However, well positioned growing franchised restaurant brands have value, selling at five to fifteen times EBITDA (sometimes even more), depending on performance and positioning. As the above charts suggest, cash flow should build steadily, from new units and higher royalties, Twin Peaks, in particular, being the “golden goose”. Additionally, higher utilization of the dough manufacturing facility could provide $10-$15M of incremental EBITDA within the next twelve to twenty four months. Twin Peaks just opened its 100th unit, is showing AUV’s of $6M, and is growing its system by 15-20 units per year. Reference has been made to Twin Peaks’ current EBITDA run rate approximating $40M, with the dough manufacturing facility at about $15M. Twin Peaks has grown by 40% in just two years, with the potential to double from here in 4-5 years. The manufacturing facility, running at only about 40% of capacity, could be generating $25M of Adjusted EBITDA or more in two years.
Notwithstanding the current interest rate environment and the legal situation (which does not seem to be affecting operations), free cash flow, now and in the future, is dependent on topline growth, which is fortunately moving in the right direction. The current liquidity seems to be sufficient for the next year, and for the long term if the projected growth takes place. An “ace in the hole” is a liquidity event, with the sale of some portion of one of their brands or the dough manufacturing facility. The FAT Brands stock, now worth about $100M, represents an equity “stub” or“option” on the Company, the value above and beyond the billion dollars of debt. The Enterprise Value is therefore about 11x the current rounded $100M ($92.9 on a TTM basis) of Adjusted EBITDA, less than some pure franchising peers that sell for a multiple in the high teens. If FAT is generating something like $150M of Adjusted EBITDA in five years, the Enterprise Value could be 15-20x, or $2.2-3.0B. If there are still 16 million shares, with similar debt, the common stock could be worth $1.2-2.0B, or $75-125 per share. More conservatively, if free cash flow of $50M were to represent a hefty 10% free cash flow yield, the stock would sell at $30 per share or $60 with a 5% free cash flow yield.
Investors can make their own assumptions in terms of operating projections and more stock/debt being issued (which we view as likely), but the upside is still surprisingly substantial. Relative to risk, the current lenders seem comfortable, even willing to lend more to “help out”. The fact remains that the upside for FAT is an order of magnitude larger than the $6/share at risk.