Paradise Inc, $PARF, Operates In A Consistently Profitable, Extremely Small Niche That It Has Dominated For Years

In Part 1 of this series I told you that I was starting a series of posts where I would be taking a look at a few nano caps, compare them to each other, and at the end decide which one, if any, would be the best buy right now.  The first article in this series was on BAB Systems Inc (BABB) which looked like a potentially good investment.  The second article in this series is going to be on Paradise Inc (PARF).

Introduction, History, Management Discussion, and Overview of Operations

Paradise began as a subsidiary of a different diversified corporation soon after World War 2, but very soon afterward candied fruit became the focus of its business.  Current ownership purchased the company in 1961 and the name Paradise Fruit Company was adopted in 1965.  It later changed its name to Paradise Inc after diversifying its operations a bit in the 90s.  Paradise Inc. is the leading producer of glace (candied) fruit which is a primary ingredient of fruit cakes sold to manufacturing bakers, institutional users and supermarkets for sale during the holiday seasons of Thanksgiving and Christmas. Paradise, Inc. consists of two business segments, fruit and molded plastics.  As of the most recent quarter the glace fruit segment makes up about 61% of all company sales with the plastics segment making up the remaining 39% of sales.

Candied Fruit Segment Description-Production of candied fruit which is a basic fruitcake ingredient and is sold to manufacturing bakers, institutional users, and retailers for use in home baking. Also, based on market conditions, the processing of frozen strawberry products for sale to commercial and institutional users such as preservers, dairies drink manufacturers, etc.  When PARF does sell these frozen strawberry products it is generally not a big part of its operations.  While there is no industry-wide data available, management estimates that the Company sold approximately 80% of all candied fruits and peels consumed in the U.S. during 2011. The Company knows of two major competitors; however, it estimates that neither of these has as large a share of the market as PARF’s.

Being the dominant company in your industry for years on end, owning an estimated 80% market share of the industry, and being in a niche business that makes it likely that you will not see many, if any new competitors in its market is an absolutely exceptional thing to find in any business.  This combination of characteristics is something I have been looking for in a company since I have started investing seriously and had not found it in any single company until now.

The demand for fruit cake materials is highly seasonal, with over 85% of sales in the glace fruits taking place in the months of September, October, and November.  In order to meet delivery requirements during this relatively short period, PARF must acquire the fruit and process it into candied fruit and peels for an estimated 10 months before this time period just to meet demand. This means that PARF has a massive build up in inventory in the quarter before the holiday months every year, and depletes its cash hoard to pay for the inventory that is needed to make sales in the last quarter of its fiscal year.  These very seasonal circumstances in the fruitcake industry makes the full year results of the company, generally which come out in March of every year, the only financial report of its fiscal year that shows how truly profitable PARF has been for the preceding trailing twelve month period.

Molded Plastic Segment Description-PARF produces plastic containers for its products and other molded plastics for sale to unaffiliated customers.  The molded plastics industry is very large and diverse, and PARF’s management has no estimate of its total size. Many products produced by PARF are materials for its own use in the packaging of candied fruits for sale at the retail level. Outside sales represent approximately 85% of PARF’s total plastics production at cost, and, in terms of the overall market, are insignificant.  In the plastics molding segment of business, sales to unaffiliated customers continue to strengthen. This trend began several years ago when management shifted its focus from the sale of high volume, low profit “generics” to higher technology value added custom applications.

PARF has only recently started to sell these types of packaged fruits as well which could become a bigger part of operations going forward.

Costs of goods sold have ranged between 71-75% of sales every year since 2003 and this year’s trailing twelve month COGS is coming in at 71.98%.  Despite an increase in the cost of raw materials within the fruit segment and increasing cost of resins within the Plastics segment, PARF has successfully maintained control over its production labor costs during the past year.  Management says that this can be traced directly to its previously disclosed decision and action to eliminate 15 full time positions, reduce executive and salary wages by 15% and 10%, respectively, and rescission of a 4% merit increase awarded to hourly workers. These actions remained in place throughout 2011 and have help reign in the cost of sales during this timeframe.

Selling, general and administrative expenses have generally taken up between 18-20% of sales over the past decade but have started to come down a bit over the decade from a high of 20.33% in 2002 to the trailing twelve month period being only 18.14%.   This all leaves PARF’s trailing twelve month operating margin at 9.86% which is much improved and is its highest operating margin in the past decade.  Operating margin has actually been below 5% for most of the last decade so PARF has been able to double its operating margin in recent years.  It’s ROIC and ROE are a bit more volatile over the past decade but are both up over recent years and currently stand at 7.59% and 8.31% respectively over the trailing twelve month period.  My estimates of ROIC are 11.29% without goodwill and 11.09% with goodwill.  One thing of note and concern is that PARF’s cash conversion cycle has jumped dramatically as it stood at 160 days in its 2011 fiscal year and it now stands at 282 days in the trailing twelve month period.  This is most likely the buildup in inventory for the 2011 holiday season and may only be an aberration because of the seasonality of its business but it is something that definitely bears watching when PARF’s full annual report comes out.

PARF is pretty much a family owned and operated business as out of the top five executives four of them are related.  The only one who seems not to be related to anyone is the CFO and treasurer Jack M. Laskowitz.  Melvin S. Gordon who owns around 37% of PARF, and who is the current CEO, Chairman, and a director of the company, has been with PARF since the 1960s in various capacities.  His two sons, one daughter in law, and a cousin make up the remaining five member executive team.  The group of executives has done a pretty good job over the years of managing the company and expanding its operations into the plastic industry to become more diversified which has helped the company’s sales and profitability.  In total insiders own right around 41% total of PARF so outside of Mr. Melvin S. Gordon the other executives own very small percentages of the company.

As with BABB in my previous article, PARF also has excessive executive pay in my opinion.  Just the five executives in the company got paid including bonuses, in 2011 $1.551 million, or about 16% of PARF’s market cap, about 6% of revenues, and about 21% of gross profit.  While BABB’s executive pay is worse in relation to these benchmarks PARFs pay is still excessive in my opinion especially in relation to the company’s small size of around $10 million.

Valuations

These valuations were done by me, using my estimates and are not a recommendation to buy stock in any of the companies mentioned. Do your own homework.

Valuations were done using PARF’s 2011 10K and 2012 third quarter 10Q. All numbers are in thousands of US$, except per share information, unless otherwise noted.

Also remember that these valuations are not containing the full year’s number which generally come out in March of every year, and will show a much truer picture of how the company is operating.  The company’s operations are extremely seasonal and in the most recent quarter PARF had to use up nearly its entire cash hoard to buy inventory.  The cash should be at least partially replenished in the full year report and was standing near $7.8 million before they had to buy inventory.

Minimum Estimate of Value

EBIT Valuation

PARF has a trailing twelve month EBIT of 2,624.

5X, 8X, 11X, and 14X EBIT + cash and cash equivalents + short-term investments:

  • 5X2,624=13,120/520=$25.23 per share.
  • 8X2,624=20,992/520=$40.47 per share.
  • 11X2,624=28,864/520=$55.51 per share.
  • 14X2,624=36,736/520=$70.65 per share.

I would use the 5X EBIT estimate of intrinsic value as my minimum estimate of value for PARF.

Base Estimate of Value

Assets: Book Value: Reproduction Value:
Accounts Receivable 8,088 6,875
Inventories 11,664 5,832
Deferred Income Tax Asset 235 118
Prepaid Expenses & Other Current Assets 481 241
Total Current Assets 20,468 13,060
PP&E Net 4,037 2,624
Goodwill 413 0
Customer Base & Non-compete Agreement 471 236
Other Assets 233 0
Total Assets 25,622 15,920

Number of shares are 520

Reproduction Value:

  • 15,920/520=$30.62 per share.

High Estimate of Value

EBIT Valuation

PARF has a trailing twelve month EBIT of 2,624.

5X, 8X, 11X, and 14X EBIT + cash and cash equivalents + short-term investments:

  • 5X2,624=13,120/520=$25.23 per share.
  • 8X2,624=20,992/520=$40.47 per share.
  • 11X2,624=28,864/520=$55.51 per share.
  • 14X2,624=36,736/520=$70.65 per share.

This time I would use the 8X EBIT value of $40.47 per share and it would be my high estimate of value for PARF.

Relative Valuations

  • PARF’s P/E ratio is currently 6.9 with the industry average P/E standing at 16.7.  If PARF was selling at the industry average P/E it would be worth $48.40 per share.
  • PARF’s P/B ratio is currently 0.5 with the industry average P/B standing at 1.8.  If PARF was selling at the industry average P/B it would be worth $72.00 per share.
  • PARF’s TEV/EBIT is currently 5.02.
  • PARF’s EV/EBIT is currently 4.95.

Something of major note that is not included in any of the above valuations is that:

“The Company owns its plant facilities and other properties free and clear of any mortgage obligations.”

This means that PARF has some substantial hidden assets that are not fully on its books in the above valuations.  I found one set of links that showed PARF’s combined land, building, equipment, and properties were valued at a total of $6.6 million.

Being conservative I will use the link here where you can search for Paradise in the search bar, which shows a more conservative set of values for the property, land, equipment, and buildings valued at an estimated $5.41 million, or $10.40 per share.  This is probably a very low estimate and the combined value of the land, buildings, and equipments is most likely worth more than the $5.41 million.  Discounting this amount by 40% due to where the locations are at and for the overall sake of conservatism it still brings an extra $6.24 per share to the company’s valuations above.

This means the true valuations above should be: Minimum-$31.47 per share, Base-$36.86, and High-$46.71, making the company even more undervalued.

Valuation Thoughts

  • By my absolute minimum estimate of value PARF is undervalued by 36%.  By my base estimate of value PARF is undervalued by 46%.  With my high estimate of value PARF is undervalued by 53% and is a potential double from today share price at $20 per share.  Again, these valuations are not including any cash which will be at least partially replenished when the full year results come out and make PARF even more undervalued.
  • PARF is undervalued by every one of my estimates of intrinsic value and relative value.
  • PARF’s TEV/EBIT and EV/EBIT are both under 8 which is generally the threshold I like to buy under.
  • Again all of these valuations do not contain the full year’s results which are not out yet and will show a much truer picture of the company and its operations.

Customers Thoughts

PARF sells its products on its website, through Wal-Mart and Aqua Cal around the holiday seasons, smaller stores, some restaurants, and Amazon.  Wal-Mart and Aqua Cal both make up a substantial portion of all sales so if either decided not to reorder it would affect the company’s sales, profitability, and margins.

On Amazon, like everything else that is sold on the site, customers leave reviews and generally as you can see with this link, customers seem to think very highly of Paradise’s products.  After reading through all the reviews most people talked about the high quality of PARFs products, and how they couldn’t get glace fruit in their individual local stores even sometimes around the holidays, so they had to search online for them.  This could also be a potential opportunity for PARF because if there is more demand for their products that isn’t being fulfilled currently that could lead to higher sales if more people knew about them.

Some of the negative comments were about how the packaging of the product was poor and came partially crushed or even broken in some cases.  In a couple of extreme cases people said that their products came with ants, bug legs, and other bug parts inside of the products.

It is hard to tell whether this is PARF’s or Amazon’s fault but assuming at worst that it is PARF’s, this is a problem that they need to fix in the process of packaging the product and shipping it because as I talked about in my BABB article, customer reviews like this could lead to trouble in the future for the company if it were to continue to have these types of problems.

PARF has also made it to number 2 in the Top 20 Glace Fruit Sites.  Only one or two of the companies on this list look to be direct competitors with PARF as most of the other companies have operations in a lot of other areas and only do a small amount of business in the glace fruit area.

Catalysts

  • PARF becoming more known to people who like making fruit cakes would heighten their sales.

Pros

  • PARF is the leader in its industry by far, owning an estimated 80% of all sales in the glace food market.
  • PARF is in a very niche industry which should keep away competitors and its dominance intact.
  • PARF is substantially undervalued by all accounts.
  • PARF’s management team has done a very good job running the company over the years.
  • Customers generally seem to love the product.
  • There could be potential for a lot more sales if more people knew about PARF’s products as a lot of the customer reviews on Amazon stated that they struggled to find any glace fruit products in their local markets, sometimes even during the holiday season, and had to resort to looking online.
  • PARF has nearly $500K worth of non-compete agreements signed with people to keep them from competing with PARF.
  • PARF’s margins are overall pretty good and I will talk about that in the conclusion article.
  • PARF operates on some amount of float which I will also talk about in the finale article.
  • To boost the company’s margins PARF cut costs and payroll in recent years which has helped strengthen its margins.

Cons

  • PARF’s business is very seasonal and requires a lot of lead time so if demand drops for fruitcake during the holiday season the company’s results would be highly affected.
  • PARF’s management and executive pay is a bit excessive in my mind.
  • A few customers have had some nasty problems with PARF’s products being delivered to them broken or with bug parts being in the product.
  • PARF is highly dependent on Wal-Mart and Aqua Cal (Sales to these two companies make up between 20 and 25% of sales in recent years) purchasing their products for sale around the holiday season so if either one didn’t reorder it would affect PARF’s results.
  • So far in the trailing twelve month period there has been a 120 day jump in the cash conversion cycles which is alarming.  Hopefully this is just due to the lead up in having the buy inventory for sale during the holiday season and will not be a problem after full year results come out.

Conclusion

Paradise looks like a fantastic company to own right now.  It is undervalued substantially and owns a conservatively estimated $5.4 million with of property and land that partially protects the downside of buying into PARF.  It has dominated its market for years and continues to do so.  Being in a very niche market and industry that it is dominating, it is unlikely that someone would come in and try to compete with them.  PARF has generally good to very good margins and its operations are partially supported by float.  The continued dominance and good to very good margins lead me to believe that the company also has at least a small moat as well or at the very least being in this extreme niche market has helped it to gain moat like qualities due to lack of competition.  I will talk about margins and float in depth in the conclusion piece of this series of posts.  PARF’s customers seem to love its products and since a lot of them complain that they cannot find glace fruit products in their local markets PARF might be able to capitalize on this with  through more advertising and advertising to a wider audience that they sell their products online.

PARF does have some negatives as well with what is in my opinion excessive executive pay, heavy reliance on two customers, some previous problems with its packaging, and it’s very seasonal market but up to this point PARF looks like a very exceptional company to invest in as the positives far outweigh the negatives in my opinion.

Next up in this now shortened series is the conclusion.

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BAB Systems Inc, $BABB, Owner of Big Apple Bagels and My Favorite Muffin Is Undervalued But Has A Glaring Issue

This is the beginning of my series on nano-cap companies.  Specifically in this series I will be turning my analytical eye towards companies with market caps of $10 million and under to see if I can find any good companies to buy in this very small and relatively unfollowed area of the market. Over the next several articles I will introduce each company, talk about its operations, pros and cons, valuations, etc. At the end of each article I will state my overall opinion of the company and whether or not I think the company would be a good potential investment.  At the end of this series I will go over and compare all of the companies’ margins, floats, the pros and cons of buying into each company, and valuations to determine which one(s), if any, I have decided to buy and state why I have decided to buy into at this time.  I hope you enjoy this series on nano cap companies.

Introduction And Overview

The company I will be talking about in this article is BAB Systems Inc, (BABB) a very small and unfollowed $4.4 million market cap that is traded on the OTC market, company based in Deerfield, Illinois which is the parent company and franchise owner of My Favorite Muffin, Sweet Duet Frozen Yogurt & Gourmet Muffins, and Big Apple Bagels stores.  BABB also sells Brewster’s Coffee at its restaurants. As of August 31, 2012 BABB had 97 franchise units and 6 licensed units in operation in 24 states and zero owned stores after selling the only one last year. BABB’s revenues are derived primarily from the ongoing royalties paid to it by its franchisees and from receipt of initial franchise fees. BABB also gets income from the sale of its trademark bagels, muffins and coffee through nontraditional channels of distribution including to Mrs. Fields Famous Brands (Mrs. Fields), Kohr Bros. Frozen Custard, Braeda Cafe, Kaleidoscoops, Green Beans Coffee, Sodexo and through direct home delivery of specialty muffin gift baskets and coffee.  Below are descriptions of the different operating segments taken from BABB’s annual and quarterly reports.

Big Apple Bagels

BAB franchised stores daily bake a variety of fresh bagels and offer up to 11 varieties of
cream cheese spreads.   Stores also offer a variety of breakfast and lunch bagel sandwiches, salads, soups, various dessert items, fruit smoothies, gourmet coffees and other beverages.

My Favorite Muffin

MFM franchised stores daily bake 20 to 25 varieties of muffins from over 250 recipes,
plus a variety of bagels. They also serve gourmet coffees, beverages and, at My Favorite Muffin and Bagel Cafe locations, a variety of bagel sandwiches and related products.

Brewster’s Coffee

Although the Company doesn’t have, or actively market, Brewster’s stand-alone
franchises, Brewster’s coffee products are sold in most of the franchised units.

Sweet Duet Frozen Yogurt

On May 7, 2012 the Company issued a press release announcing the launch of its new franchise concept, SweetDuet Frozen Yogurt & Gourmet Muffins, which it is preparing to roll out this year. While BAB will be offering franchises in all 50 states, its initial development focus is targeted for the Midwest, specifically Illinois, Michigan, Wisconsin and Ohio. As part of its introductory development plan, BAB will be donating 10% of the initial franchise fee from its first 50 units to the Cystic Fibrosis Foundation, of which BAB is a corporate sponsor.  SweetDuet, as its name implies, is a fusion concept, pairing self-serve frozen yogurt with BAB’s exclusive line of My Favorite Muffin gourmet muffins, broadening the shop’s offering and therefore differentiating itself from the numerous frozen yogurt outlets already populating the market. SweetDuet Frozen Yogurt & Gourmet Muffins shops will also include BAB’s. Brewster’s Coffee and a streamlined breakfast menu. The concept is designed to work in 1600 square feet of space.  The SweetDuet concept will be included as part of the Systems franchise operating and financial information.

Typically all of these restaurants seat around 30 people.

Operations And Management Discussion

Currently BABB’s is pretty much a holding company operation now that it does not directly run any of its restaurants and it derives its revenue from collecting royalty fees from its franchisees (5% of net sales.)  Initial franchise fees when a new store opens ($25,000 for a franchisees first “Full production” Big Apple Bagels or My Favorite Muffin.  Fee for subsequent stores opened by franchisees is $20,000.)  Big Apple Bagel and My Favorite Muffin franchisees also contribute 3% of net sales towards advertising and marketing to BABB.

Since BABB does not currently directly operate any restaurants, and BABB just does corporate back office work for the whole company, locates new franchisees and franchise locations, markets the company, and sits back to collect fees from the franchisees of course you would expect BABB to have absolutely exceptional margins.

The company does have some pretty good TTM margins: Gross margin at 96.2%, operating margin at 17.9%, ROE of 15.51%, and an ROIC of 14.51%.  However the companies operating margin, ROE, and ROIC could potentially double if payroll and payroll related expenses could be halved from their extremely high current levels (Which is probably a bit optimistic and I will talk about more below) and didn’t amount to more than $1 million, or about 25% of the companies entire market cap, and about 1/3 of its enterprise value.

If payroll and payroll related expenses which totaled about $1.4 million for the entirety of 2011, 53% of BABB’s gross profit, (Or an incredible $100,000 per employee at a $4.4 million market cap company) could be cut in half that would add 9 cents to BABB’s EPS, which would almost triple current EPS.  Cutting payroll expenses by half is just an estimate of what the company could do and may be a bit optimistic but BABB management should certainly be able to get close to halving payroll if it really wanted to become a more efficient company.  That 9 cents per share extra could be put towards growing the company further, paying an even bigger dividend (current dividend yield is 3.31%), or my favorite option, buying back shares outstanding since I am finding BABB to be undervalued currently and which I will talk about later.  Just the top three executives of the company made nearly $700,000 in 2011, not including the also generous options that have been given in the past, are still being given, and can still be exercised for even higher compensation for the three main executives of BABB.  Company insiders do own about 38% of BABB but that is down from a few years ago where insiders owned 48% of BABB.

At November 30, 2011 there are 360,400 of unexercised options that are not included in the computation of dilutive EPS because their impact would be antidilutive due to the market price of the common stock being higher than the option prices.  At November 30, 2010 there were 368,373 unexercised options that were not included in diluted EPS because their impact would be antidilutive due to the market price of the common stock being higher than the option prices.

Executive pay has also been rising in most recent years even as the number of total restaurants franchised and owned has dropped from 129 total restaurants in 2007 down to 103 total restaurants.  Since BABB no longer operates any of its restaurants the drop in number of total restaurants has also dropped royalty income, operating income and total company value.  Again, executive pay has continued to rise in recent years as this has been going on.

On top of all of this the CEO Mr. Michael G. Evans, is on BABB’s compensation committee which never looks good, especially in this case due to the high executive pay in comparison to the overall size of the company.

Also of note as it pertains to how the company operates is that as I talked about above the company receives 3% of net sales towards marketing and advertising for the restaurants.  This amount for several years now at year end has stayed consistently in the $300,000 a year range in unused advertising and marketing funds that the company could be putting towards better use than just sitting in company accounts waiting to be used.

Management could also be getting a bit sidetracked with opening up its new restaurant concept Sweetduet Frozen Yogurt as well and may be better served concentrating on and improving its already established Big Apple Bagel and My Favorite Muffin restaurants.

Valuations

This section will illustrate why I think management could be doing a much better job, especially when it comes to their own pay, and putting some of that money to better use for shareholders.

These valuations were done by me, using my estimates and are not a recommendation to buy stock in any of the companies mentioned. Do your own homework.

Valuations were done using BABB’s 2011 10K and 2012 third quarter 10Q. All numbers are in thousands of US$, except per share information, unless otherwise noted.

Cash and NOL Valuation (Absolute Minimum Valuation)

  • BABB has 1,239 in cash (17 cents per share) + total net operating loss carry forwards of $5,857, discounted 50% which I will talk about later to $2,928 (40 cents a share)= a total valuation of 57 cents per share.

EBIT, Cash, and NOL Valuation

Cash, cash equivalents, and short term investments are 1,239

Total current liabilities are 822

Number of shares are 7,266

Cash and cash equivalents + short-term investments – total current liabilities=

  • 1239-822=417/7266=$0.06 in net cash per share.

BABB has a trailing twelve month EBIT of 504.

5X, 8X, 11X, and 14X EBIT + cash and cash equivalents + short-term investments+$2,928 in NOL’s, or $0.40 per share:

  • 5X504=2520+1239=3759/7266=$0.52 per share+$0.40 in NOL’s=$0.92 per share.
  • 8X504=4032+1239=5271/7266=$0.73 per share+$0.40 in NOL’s=$1.13 per share.
  • 11X504=5544+1239=6783/7266=$0.93 per share+$0.40 in NOL’s=$1.33 per share.
  • 14X504=7056+1239=8295/7266=$1.14 per share+$0.40 in NOL’s=$1.54 per share.

Right now BABB’s operations at 5X EBIT are only adding 2,520 (35 cents per share) to its overall valuation due to overall restaurant count dropping and now only collecting royalty, license, and franchise fees but even at that valuation BABB is selling at a 35% discount to today’s share price of 60 cents a share.    I chose to discount the NOL’s by 50% in the above valuations for conservatism because a lot of these NOL’s will take years to accrue to BABB.

Relative Valuations

  • BABB’s P/E is currently 9 with the industry average being 17.9. With BABB’s current share price of 60 cents per share, if it was selling at the industry average P/E it would be worth $1.20 per share.
  • BABB’s P/B is currently 1.4 with the industry average being 3.7.  With BABB’s current share price of 60 cents per share, if it was selling at the industry average P/B it would be worth $1.58 per share.
  • BABB’s TEV/EBIT is 7.07 and its EV/EBIT is 6.58.  Both of which are under 8 which is generally what I like to see in companies I think about buying into.

Valuation Thoughts

  • BABB’s, which is currently selling at 60 cents per share, is undervalued by every one of my estimates of intrinsic value and relative value estimates when compared to its industry.
  • BABB has $153,000 in total debt, or only 2 cents per share so even subtracting the company’s debt it is still undervalued.
  • By my absolute minimum estimate of value BABB valued about fairly right now but that only includes cash and NOL’s.  Adding in BABB’s operations into the valuation makes BABB undervalued by 35% currently.

Customer Reviews

As I have been researching and writing this article one thing has continued to bother me and not made very much sense about BABB.  The restaurant count dropping has been a bit perplexing to me as the company has been profitable every year since 2002 except for 2009, and I would not have thought that bagel sales would have suffered a massive drop during the recession, so the restaurant count dropping in 2007 from 129 total restaurants to now only having 103 total restaurants (Or a drop in total restaurant count of 20%) has continued to bug me as the process of researching this company has gone on.  I have not eaten at any of BABB’s restaurants before as the closest one of its restaurants are a six hour drive away from me so I decided to find customer reviews online to help me get a bit of perspective on how the franchise restaurants are generally thought of by its customers. After reading through dozens of customer reviews from different franchise locations I think that I am able to come to some conclusions about what its customers think about Big Apple Bagel restaurants and think that I have found the answer to the dropping restaurant count problem that has been bothering me.

  • Generally customers only think that the food is average to good.
  • Generally people think that the bagel/sandwich products are overpriced.
  • A lot of people think that competitors have better bagels in their respective local areas.
  • More than a few people mentioned that they only went there because of coupon promotions (buy 1 get 1 half off or free on bagel sandwiches.)
  • More than a few people who said they went there only because of the coupons said that even with the coupon they thought the products were overpriced.
  • The biggest overall concern that I saw stated over and over again from customer visits to multiple different franchise locations was that customer service was rated at best ok to absolutely horrible.

Through my studies of many different companies in many different industries I have learned many things that can help and hurt the company’s sales and profitability.  One of the biggest things that can help or hurt a company, especially in today’s world where people can write things like customer reviews on the internet for everyone to see, is customer service or the lack thereof.  I think that one of the reasons Amazon has been such a huge success is due to its customer service which is exceptional and one of the best I have ever dealt with.  The reverse can also happen if you have a reputation for poor customer service and can lead to customers not coming back to your stores and restaurants.  Combine the poor customer service with products that the customers think are overpriced (even with buy 1 get 1 free coupons) and the combination of these two things may be why restaurant count has dropped by 20% in recent years.  Maybe the restaurants are losing customers, sales, and the franchise locations are becoming unprofitable leading the franchisees to close restaurants.  There is not really a mention of why the restaurant count has dropped in BABB’s annual reports and to this point I have not been able to talk with company IR and have not had my phone calls returned to get these questions answered so for now this is my best guess as to why the number of restaurants have dropped in recent years.

Catalysts

  • If management decided to cut payroll expenses and put that money towards much better use the share price would no doubt rise.
  • Gaining more franchisees would up sales and profitability which would make the share price rise.

Pros

  • BABB is at minimum fairly valued, and undervalued sometimes substantially with my other intrinsic and relative valuations.
  • BABB’s margins are pretty good overall.
  • Insiders own around 38% of BABB.
  • If BABB’s management decided to cut payroll expenses it would raise EPS and overall profitability of BABB, potentially substantially depending on how much they decided to cut payroll.

Cons

  • BABB’s restaurant count has dropped by 20% since 2007 which has lowered the amount of royalty fees collected, thus lowering sales and profitability for the overall company.
  • Management’s pay is excessive in my view taking up 53% of gross margin.  Last year overall payroll and payroll expenses amounted to $1.4 million dollars with the company only having a $4.4 million market cap.  Stated another way payroll and payroll expenses make up 32% of the companies entire market cap.
  • Just the top three executives of BABB made around $700,000 last year, not including options, or 16% of the entire market cap.
  • BABB’s margins could be a lot higher if management cut payroll expenses.
  • A few years ago insiders owned 48% of the company and now only own 38%.
  • At the very least the company is perceived to not have very good customer service.
  • Several reviewers online also thought the products sold at BAB restaurants were overpriced, even when they had a buy 1 get 1 half off or fee coupon.

Conclusion

I will save in depth talk about margins, float, and the other normal things I talk about in my articles for the conclusion piece in the series of posts but my overall investment thesis is very simple with this company: BABB is at worst fairly valued when only counting cash and NOL’s and is undervalued by a substantial margin (about 35%) when including its operations.  If management were to cut payroll and other payroll expenses, especially executive pay and options, and put that money (Potentially as much as 9 cents per share if they were to halve payroll expenses) towards improving company operations and/or expanding the number of franchises, paying a higher dividend, or buying back shares the company could potentially appreciate by even more.

In my opinion management could be doing a much better job helping this company expand and to improve operations, especially the customer service side of things.  I do not think that BABB is necessarily a buy and hold forever company like some of the other companies I own, but I do think that BABB could grow its restaurant count, become more profitable, and turn into a much more attractive company to own, and potentially turn into a buyout candidate.  Payroll expenses taking up 53% of gross profit is absolutely insane, and if BABB decides to cut some corporate excess/waste and put that money to much better use for shareholders and the overall company, BABB could potentially double or triple from today’s current share price of 60 cents per share.

I still have a few more companies to write articles about before making a definite buy decision or not about BABB, but overall it looks like a potential investment opportunity at this point, especially if management would cut payroll expenses and put that money towards much better use for shareholders.

The next article in this series will be about Paradise Fruit Company Inc (PARF).