Description

Midas Revisited

Midas Inc (NYSE: MDS) is an undervalued franchisor of auto service shops that has recently completed a multi-part restructuring process. The idea was originally written up in October 2004 by roy915 who gave an excellent analysis of the transformation that was underway. Despite the completion of much heavy lifting, and a clearer path to growth in the future, the company trades at virtually the same price it did more than a year ago. Midas’ high quality revenue streams create tremendous business stability, but the company trades at only 11.7x fully taxed FCF.

Historical Recap

Historically the Midas business was dominated by exhaust (muffler replacement) and brake repair. These two categories accounted for well over 50% of the combined revenues of a typical franchisee. Franchisees were generally mechanics or service technicians who decided they wanted to go into business for themselves, and the operations were relatively simple. The business model required relatively few SKUs and muffler replacement required a modest skill-set. Cars came in making a distinctive noise, the problem was obvious, and the fix was the same for virtually every car (replace the muffler or replace the brakes).

During the 1990s, muffler lives were extended dramatically by the introduction of stainless steel and the replacement business began a precipitous decline. This was especially damaging to Midas corporate as they previously earned the bulk of their money from manufacturing replacement mufflers and selling them at significant margin to their franchisees. In the words of an old franchisee “Times changed and you can’t just sell a $10 pipe for $100 anymore; people won’t let you rip them off like that.” The manufacturing business had significant fixed costs, which in the face of an irreversible revenue decline led to a precipitous fall in profits. The former Midas management team began a disastrous foray into offering all sorts of new auto parts where they would supply the inventory to franchisees (who were unable to store additional SKUs due to the space constraints they faced in their retail location). Even well executed, this strategy would have led to massive working capital expansion. However, this too was botched. Franchisees were unhappy with poor parts supply and a declining exhaust business, and Midas corporate faced financial distress due to increase leverage and poor execution.

Business Transformation

Alan Feldman, former head of McDonald’s USA, took over Midas in 2003 and led a dramatic change in corporate strategy. He realized that the company would never be successful as a sub-scale distributor of auto parts, and that the manufacturing business which had once contributed the bulk of Midas’s profits would never return to profitability. Midas has spent the last two years transforming the structure of the company, and that process is now virtually complete. The manufacturing business has finally been exited (Midas now has a long-term supply agreement with Arvin), stemming the cash drag from that operation. The parts distribution has been outsourced to Autozone which can supply parts more effectively and cheaply than Midas ever could.

In 2006 for the first time, Midas’ business is comprised of two high quality revenue streams: royalty revenue from more than 2,600 franchisees and rental revenue from their 230 owned locations. As management has worked to exit unprofitable business lines, they have focused on initiatives that will grow their royalty revenue stream. These initiatives are discussed below, but the empirical evidence is that they are working: after several years of negative same-store sales, Midas has posted ten consecutive quarters of positive comps (coinciding with the start of the Feldman era). The goal of Midas through their new initiatives is to generate 4% comps which on a fixed cost base at corporate would leverage nicely into per share earnings gains.

Business Initiatives

- As a headwind, Midas shops still face exhaust declines. Exhaust today comprises slightly less than 15% of their business and is declining at approximately 7-8% a year. This will reduce comps by 1% annually.
- Brakes: This category grows organically at 3% to 5% annually (driven by age of cars on the road, total miles driven and modest pricing). They are #1 nationally with a 5% market share and have historically grown faster than the market in brakes, especially when they advertise behind it. Brakes comprise 42% of their business, and with growth at 5%, it would contribute over 2% to comps annually. Brakes grew at 7.5% for Midas in 2004, though in 2005 it has been more of a market rate as they have shifted advertising to highlight maintenance services.
- Tires: Midas has a new agreement with Bridgestone/Firestone who inventories the tires for them and delivers them on a just-in-time basis to the franchisees. The economics to the franchisees are far superior to previous Midas tire initiatives; they account for 3.5% of system sales today up from zero 18 months ago. If they can get to one tire per shop per day over the next few years, this would add 1% to comps annually.
- Maintenance: they currently have ½ of 1% of the maintenance market, accounting for $140m in system revenues today. They never trained franchisees around this, no standards of operation, marketing, ability to track customer history, etc. They have put all of that in place and the segment is up 20% over the last two years. Midas should be able to double their current volume over the next five years with the current effort. If they do even half that, it would add 1% annually to comps.
- Fleet: there are 13m light trucks and cars that are part of small fleets (think plumbing companies, etc.); Midas has zero share of that service business today because they haven’t had the systems to do fleet reporting. This effort has been supported by sales teams from corporate as it requires more sophisticated selling than simply handing out flyers by a franchisee. If they could achieve 1% share, it would be significant, but this is one aspect of the plan that I put at lower probability due to the difficulty of execution.
- Conversions: A revitalized national Midas brand is becoming increasingly attractive to independents who are having a difficult time competing. Midas has spent considerable effort laying the groundwork for flag conversions, and that strategy has begun to bear fruit as the first announcement of a conversion was made this past month. While it is small (three units, plus the opening of two additional Midas units), it seems to have generated a significant buzz in the independent community and is one clear avenue Midas can grow its franchisee base in the future.

Comps of 4% would generate an incremental $2.3m of EBIT off a base of $29m, or 8% growth.

Valuation

Midas has 16.38m shares fully diluted, and the stock trades at $18.30 giving it a market cap of $300m. Midas has very modest leverage against its stable royalty and real estate cash flow streams. Corporate debt is $65m and finance lease obligations total another $36m for $101m in total debt versus EBITDA (2006) of approximately $41 million.

The company has two other assets of value. Midas has extensive NOLs which have a PV of approximately $30 million. Additionally, they have a chain of corporate owned stores in Florida which they have targeted for re-franchising in the near future. These generate $25 million in revenues and if operating at breakeven could be sold for $5 million. They would then generate $1m annually in franchise fees which would be roughly 500k in net income (fully taxed). The Florida operations, therefore, represent $10 million in latent asset value.

Midas will generate $29 million in EBIT this year (which assumes very modest – 2% comp -- growth over 2005, but does contemplate the elimination of the money losing mfr business, etc.), and free cash flow breaks down as follows:

EBIT: $29m
Interest Expense: (8.5)
Other Income: 1.0
Taxes @ 38% (8.2)
Net Income: 13.3

Depreciation 12.0
CAPX (3.0)
Free Cash Flow 22.3m

If you fully tax the cash flows and deduct the NOL and Florida operations from the equity cap (which is more realistic than looking at an untaxed “gross” free cash flow figure), you have 260m / 22.3 = 11.66x. Midas is a pure franchise royalty and real estate revenue company which will begin to grow its earnings unencumbered by low quality businesses. Additionally, management has publicly stated that they have no use for the free cash flow that the company generates and will use substantially all of it to repurchase stock (and will also therefore maximize the value of the NOL by using the current cash the shield generates). Aggressive share buybacks with modest comp growth will generate per share free cash glow gains well into the double digits.

One final word on share repurchases. The company began buying back stock this year with a modest effort ($7.2m through the first nine months), but was buying stock at $23 and intends to continue buying stock at these levels. Their covenants restrict them to 60% of LTM EBITDA minus CAPX. After 2006, that amount will be 60% x ($41m - $3m) = $22.8m. So they will be able to use 100% of their free cash flow to repurchase shares, something I would expect them to start doing this year.

Catalyst

- Clean financials for first time
- Accelerated share repurchase program