Mexican Restaurants, Inc – CASA

Mexican Restaurants, Inc. owns and operates 52 Mexican (surprised?) restaurants in Texas, Oklahoma and Louisiana, and operates another 13 via franchisees. The company’s brands include Casa Olé, Crazy Jose’s, Mission Burrito, Monterey’s Little Mexico and Tortuga Mexican kitchen.

MR delisted from the NASDAQ in early 2011 after running into problems caused by over-expansion, excess debt and weak consumer spending. Since then, the company has closed unprofitable restaurants, paid off debt and sought to improve operating efficiency. These efforts are paying off and the company returned to profitability this year.

The market has yet to appreciate the company’s turnaround. MR trades at rarely-seen ratios and multiples. On a twelve trailing month basis, the company’s enterprise value to adjusted EBITDA ratio is 1.46. (I have adjusted EBITDA to account for one-time expenses like restaurant closings and losses on assets sold.) The company’s market capitalization is $3.82 million versus common book equity of $10.30 million. Free cash flow yield is 33.4%. Here’s a look at the company’s results for the past few years. EBITDA and operating income are adjusted for one-time items. Net income is not.

Revenues troughed in 2010, rebounding slightly since. Revenues are unlikely to regain previous highs any time soon, as the company has shut down multiple poorly-performing locations since 2008. The company reported a small profit over the twelve trailing months for the first time since 2007, earning $0.28 million or 6.5 cents per share. The company had a total of $3.8 million in federal tax credit carryforwards and net operating loss carryforwards which will shield the company from federal taxation for years to come.

The company’s reported trailing profit understates earnings power due to a few one-time items that affected MR in the past year. In the four trailing quarters, the company recorded an asset impairment of $471,730 related to two under-performing owned restaurants. The company also recorded a loss on the sale of equipment of $26,017, a restaurant closing expense of $9,491 and a bad debt charge of $150,426. MR did not experience any bad debt losses in the previous two years, so I think it is safe to label this expense a one-time item. These one-time items sum to $657,664.

Due to the company’s large loss carryforwards, these items can be added to the bottom line without accounting for federal tax. Assuming these figures are reasonable, Mexican Restaurants’ adjusted trailing net income is $0.94 million, or 21.6 cents per share. Evidence for this much higher adjusted net income figure is provided by free cash flow, which totaled 29.4 cents per share over the same time period.

As the company has made operational headway, it has also progressed in deleveraging its balance sheet. MR has a line of credit with Wells Fargo and has remaining obligations related to lease settlements on closed restaurants. Since 2008, the company has reduced these debt and obligation balances from $8.10 million to $2.14 million. The company’s line of credit current has a balance of $2.00 million and expires in mid-2013. MR is in negotiations with Wells Fargo to extend the credit line. Once the company finishes up the debt reduction process, substantial cash flow will be freed to reward shareholders via investments in new restaurants or dividends and share repurchases.

There is a wrinkle in the company’s capital structure. In 2011, the company sold 800,000 shares of preferred stock to officers at $1.25 per share, as well as 125,000 warrants. These preferred shares are convertible into common stock on a 1 to 1 basis and bear interest at 8%. Interest on these shares accrues in the form of additional shares until May 15, 2013. I have included these shares in diluted shares outstanding. The warrants were issued with a strike price of $2.00. Since insiders already owned a majority of shares outstanding, this transaction had the effect of solidifying management’s control over the company.

Mexican Restaurants, Inc. trades infrequently and at a large bid/ask spread, currently $0.75/$1.00. At the price mid-point of $0.875, the company’s pro-forma P/E is 4.05 and price to free cash flow is 3.82. If the company can continue to improve operating margins and extend its line of credit, investors may be looking at an extremely cheap stock.

It should be noted that MR, like many retail and restaurant operators, has large off-balance sheet operating lease obligations. Many of these leases are noncancelable.  In ordinary environments this may not be an issue, but a steep economic downturn could leave the company scrambling to make rent. Many companies have been done in by lease payment obligations. Mid-market Mexican restaurants are not as economically sensitive as say, a jewelry store or classy steakhouse, but they still depend on consumers opening their wallets for a discretionary purchase. Quality of management is a risk as well. One hopes the company’s insiders were chastened by the disastrous over-expansion of the mid 2000s, but the possibility remains that history will repeat itself.

Disclosure: No position.

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8 Responses to Mexican Restaurants, Inc – CASA

  1. DTEJD1997 says:

    HEY!

    You stole my TOP SECRET idea & investment! (hahaha just kidding).

    I attended the latest annual meeting. Management was flabbergasted that an outside shareholder would show up. They said there hasn’t been outsider at the annual meeting in 7 years. Once they got over their shock, they were very friendly and answered most of my questions.

    I would like to point out a few things you might have missed and not touched upon.

    A). The stock has briefly sold as little as $.20/share. Several thousand shares crossed at BELOW $.30/share. I bought in below $.50/share. I wish I could get many, many times my holdings, but the price has moved up substantially and the bid/ask is very hard to work with.

    At a price of under $.50/share, the company would have a market cap of UNDER $2 million. The have 57 company owned locations. They also have a handful of franchisees.

    B). The book value may be UNDERSTATED. I strongly suspect that a lot of locations have capital equipment that has been fully depreciated, but yet has a few years of useful life left. For example, industrial ovens, grease traps, venting hoods, etc. I have been to many of their locations. I have conversed with managers, busboys, and other workers. They are generally in good spirits and say that the restaurants are generally well maintained.

    C). The company released earnings yesterday, and they were an improvement over the year ago period.

    D). I have been to company HQ and they have a fairly modest location. Not much money is being wasted, near as I can tell.

    E). The company now only has $2MM in debt. That gives an enterprise value of say $6.5MM. That is a little more than $100k per company owned location. They also have a revenue stream from franchisees. There is absolutely NO WAY that you could outfit their locations for anything even remotely approaching $100k per location. You couldn’t do it for $200k even…

    F). Assets are only worth what they can earn or be sold for….and earnings are starting to turn around. In the early 2000’s they earned as much as $1/share. The stock trade for above $10/share at one point. They have shuttered bad locations. They are opening a new location in Pasadena. It appears they might own the land underneath it, as they got a mortgage on it.

    G). They have some small “orphan” brands. How much would the two location “Tortuga” chain be worth to a 3rd party buyer? $50k? $250k? $500K, $1,000,000? My guess would be somewhere between $400k and $600k. If they could sell these smaller brands, they could pay off the debt easily. Heck, they could start paying a dividend. They could tell the banks to “take a hike”. They have two other smaller brands that they might be able to sell, Crazy Jose and Mission Burritos. These could easily be worth a couple million a piece.

    H). I have patronized eight of their locations. Some are better than others…Nobody would mistake this for gourmet food, but it is OK. They have a lot of potential for improvement and better sales & profit.

    I). There is TREMENDOUS sales leverage. If they could NET 3% on their sales, you would be looking at profits of about $.60/share.

    If you are patient and can snag shares on the cheap, I am hard pressed to think of a “cheaper” public company.

    Nice catch, as this is pretty far off most investor’s radar scopes!

    • otcadventures says:

      Way to get in a lot cheap than the company is now! I agree that the company’s asset replacement value is far, far higher than where it trades. Good to know that management is friendly to outside shareholders….that is not the case with many controlled companies.

      I definitely think the company can increase its value even if it implements just a few of the ideas you outlined. Even if they don’t, the deleveraging process should result in significant value creation for shareholders.

      You seem to have a nose for these situations as well!

    • Kevin says:

      Book value is not understated. Whatever fully-depreciatd equipment that they are still using is more than offset by the undepreciated stuff. Restaurants are going out of business left & right. There’s no way they could sell their used equipment for anything close to the carrying value. I’d probably trim 75% off of PP&E to estimate a liquidation value.

      I haven’t read any reports yet….do they break out the mix of profitable vs. unprofitable locations?

      • Nice find, I like this one. I’d agree to haircut the PP&E. 75% still gets you to about $9m in PP&E and about $8m in equity, I’d probably haircut it a little more, but even 50% still leaves you around $5m vs. a diluted market cap of about $4.3m. From the way they’re approaching the new restaurant, it looks like they have a preference to own the properties, anyone have an idea how many of these locations the real estate is owned? Though its clear they’ve leased a lot of them due to the related closure charges being taken, it seems like they’ve still got some low margin stores, could those still be open b/c the real estate is owned and thus there’s a lower profitability hurdle?

        When I add the cash back, counting the cash I’m getting to a EV of about $5.6m on TTM FCF of about $1.22m for about a 22% FCF/EV & 28% FCF/Equity. I don’t see any reason why Wells wouldn’t re-up on this.

        Has anyone spoken to the company yet? Is there opportunity to close a few more underperformers?

        • Nevermind the real estate question, from the company’s last filed 10k:
          “All of the Company-owned restaurant sites are leased.”

          • DTEJD1997 says:

            They might own one location.

            It is being built in Pasadena TX, replacing an older location.

            As to book value…I still say it is understated. How could you open a function restaurant for $100K? There is no way that you could, no way that you could even come close. I have personally been to about a dozen of their locations…I am sure they could sell off their restaurants for more than a $100k per location.

            If a lot of the equipment is carried on the books for $0, or very close to it, I bet you COULD get more than it’s carrying value in a liquidation sale. If a brand new commercial range venting system is $10k, could they sell a heavily used one for $1k? What if that is being carried at 0 or $500?

            Yes, restaurants go out of business all the time. Yes, it is a difficult business. Prime example of that is that they are earning low returns on capital invested.

            That could change going forward. They don’t have to earn a lot more on sales to have a big effect on the bottom line.

            If they can earn 1% more on sales, that will translate to about $.20/share in earnings. In the not too distant past, they were earning close to a $1/share. I don’t think they’ll get back to that, but there is NO reason why they can’t earn $.50/share per year. That is only a 2.5% NET on sales. Remember, they have a lot less debt, so that will lower interest expenses tremendously.

            Debt is at about $2MM. They way they are going, they can almost just pay it off and be done with the banks. Even if Wells won’t re-up, what bank wouldn’t loan them $2MM on sales of $70MM, positive net earnings and positive cash flow?

  2. I agree on the debt. In the 5 years prior to going dark capex was more or less in line with D&A, some years more, some years less, but it doesn’t suggest that these are undervalued, also leasehold improvements are really only of value to Mexican Restaurants. I guess my biggest buggaboo with the asset value argument is that estimated replacement cost of one particular franchise probably isn’t the best way to value to all the stores stores (though it may provide some semblance of margin of safety), its earnings power. My one concern about the business is that even by going to 72ish stores to 52ish, with sales declining modestly from 72m in 2010 to 66m in the TTM operating margins haven’t improved as much as I’d expect. They clearly terminated a number of leases, I wonder how many are “dark” that they’re still paying rent on. Lease obligations are scheduled to stair-step down about $1.3m in 2013, perhaps those are some dark stores rolling off. If that’s the case, it should materially improve the outlook for next year.

  3. Pingback: Update, Learning a Language in 22 Hours and Links from Geoff Gannon, Student of Value, Distressed Debt Investing, Valuewalk, OTC Adventures, and Others. | Value Investing Journey

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