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<DAILY TROUBLE>
Friday, November 27, 1998
Schlotzsky's Inc.
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Phone: 512-236-3600
Price (11/25/98): $9 1/4
HOW DID IT FIND TROUBLE?
Walk into a Schlotzsky's and order one of the signature subs or sourdough bread pizzas. If something doesn't smell right, you take it back -- you ask them to make it right. That is exactly what the company had to re-serve earlier this year when it announced that an accounting faux pas would force the company to restate fiscal 1997 results.
The aggressive accounting seemed innocent enough. It was simply a case of recording income from its turnkey units at the time of transfer to the franchisee, rather than have it properly amortized as the company engaged in a leaseback transaction with a REIT. While the sum involved was relatively minor -- the move did not affect cash flow and bumped down fiscal 1997 earnings about a dime a share -- the company that could dish out no wrongs was suddenly suspect.
As class action lawsuits piled on like layers of cold cuts, investors quickly forgot the fast-growing upscale sub shop they were once enamored with. The shareholders took a beating.
BUSINESS DESCRIPTION
As of the end of September, Texas-based Schlotzsky's franchised 736 namesake quick service restaurants. The counter service eatery is a bit more upscale than its two largest competitors, privately held Subway and Blimpie <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: BLM)") else Response.Write("(AMEX: BLM)") end if %>, complete with a liquor license to go along with its freshly made submarine sandwiches and pizzas. Plans for the current quarter call for 35-40 new unit openings.
The company's restaurants are in 38 states and 16 foreign countries.
FINANCIAL FACTS
Income Statement
12-month sales: $35.8 million
12-month income: $5.7 million
12-month EPS: $0.73
Profit Margin: 15.9%
Market Cap: $70.3 million
Balance Sheet
Cash: $7.6 million
Current Assets: $40.3 million
Current Liabilities: $5.7 million
Long-term Debt: $6.2 million
Ratios
Price-to-earnings: 12.7
Price-to-sales: 1.96
HOW COULD YOU HAVE SEEN IT COMING?
A lot of Schlotzsky's success has come from its Turnkey Program. As the name suggests, the company builds the unit and then simply sells the completed restaurant to the franchisee (with one of the more thorough training systems in the industry). So, in essence, all the educated franchise owner has to do is turn the key.
The program is interesting in that Schlotzsky's is not trying to make a mint on the sale. Nope. As a matter of fact, so far this year the company has spent more on purchasing and development costs than it has taken in from the eventual buyers. Why do this then? Like the old razor and blades analogy -- or the far more current Iomega <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IOM)") else Response.Write("(NYSE: IOM)") end if %> drive and disks theory -- Schlotzsky's is more than happy to swallow the turnkey expenses knowing it is lining up franchising royalties based on future sales in perpetuity.
Oddly enough, that is exactly where the company tripped up, and those who had chased the shares higher based on tasty eats and 40% annual sales growth (and 30% earnings per share gains) suffered the cruel indigestion.
Fair warning is often hard to find, but there was one such window to bolt here. Some got nervous when the company announced a delay in filing its annual 10-K statement. At the time, Coopers & Lybrand was auditing the financials, and even at a distance it was apparent that they probably didn't like what they saw given the filing extension. That was on Friday, April 3. The company did not make the official announcement until the close of trading the following Monday. However, apart from the restatement shocker that came shortly after the company's stock hit an all-time high of $24 1/8 on the eve of April Fool's Day (fittingly enough), someone combing the financials might have seen that earnings would have come under pressure anyway as general & administrative expenses, as well as depreciation and amortization, were growing at a much faster rate than both sales and earnings.
WHERE TO FROM HERE?
The upside, and there is an upside, is that the concept seems to be performing quite well. For the September quarter, average weekly sales at the individual units rose 12% to $10,000 -- after rising 10% the year before.
With earnings projected at $0.84 a share this year, each of the five analysts covering the company expect the sandwich maker to earn at least a buck a share next year. The $1.05 a share average estimate represents a healthy 25% rise, and even this year's financial performance looks solid when one considers a secondary share offering the company carried out a year ago. That is why the company was smart in announcing a 380,000 share buyback in September as the stock fell into single digits. After all, they had just sold those shares at a much higher price.
The company has also taken steps to change the Turnkey Program. Rather than depend on REITs, which demand guarantees that the company must amortize for as long as 20 years, it is trying to finance the franchises in-house -- providing attractive borrowing rates and assuring clean revenue recognition, yet another selling point to the potential franchisee.
Today, trading barely above book value and running a successful franchise program seems to justify a higher share price. The unit growth continues at a steady clip and that is what ultimately fills the Schlotzsky's income statement with franchise royalties. So, your order is ready and there's no need to hold your nose this time.
-Rick Aristotle Munarriz
([email protected])
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