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Pencils Fund Purchase: Mexican Restaurants

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By pencils2
November 10, 2006

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Pencils Fund Purchase: Mexican Restaurants

Price Paid: 10.62

Shares Purchased: 17

Date Purchased: 11/8/06

Commission: 6.95

Business

Mexican Restaurants engages in the operation and franchising of Mexican-theme restaurants. It operates under several names, including Casa Ole, Monterey's Tex-Mex Cafe, Monterey's Little Mexico, Tortuga Coastal Cantina, La Se�orita, and Crazy Jose's. The company currently has 80 company operated restaurants, 19 franchised restaurants, and 1 licensed restaurant. The restaurants are primarily located in Texas, but are also located in Michigan, Louisiana, and Oklahoma. Mexican Restaurants was founded in 1947.

Financials

Some quick financials:

Market Cap                           35.11M 
Enterprise Value                     39.50M 
Employ­ees                            3,171 
Shares Outstanding                   3.40M 
Float                                790.51K 
% Held by Insiders                   74.38% 
% Held by Institutions               41.80% 
Qtrly Earnings Growth (yoy)          100.40% 
Qtrly Rev Growth (yoy)               5.90%  
Revenue (ttm)                        83.46M 
Gross Margin (ttm)                   17.56%  
EBITDA (ttm)                         7.45M 
Profit Margin (ttm)                  3.49% 
Oper Margins (ttm)                   5.32%  
Net Income (ttm)                     3.49M 
EPS (ttm)                            0.794 
P/E (ttm)                            13.38
P/S (ttm)                            0.43 
Total Cash (mrq)                     637.35K  
Total Debt (mrq)                     4.00M

This is a small company, as you can see, but it is one that I think has a good future. They've had a steady debt-reduction program as of late, and they're on track to be rid of it soon. They've been able to pay off the debt without diminishing too much of their cash position, which is something I always like to see. They are strengthening the balance sheet every quarter. Why do I like the future of this micro cap? One of the large reasons is because David Nierenberg, who is considered one of the greatest investors in small businesses, owns 35.5% of the business through his D3 Family Fund, making him the largest shareholder. David has a very good track record, and he's been invested in Mexican Restaurants for approximately two years now, and is one of the directors.

Last year, Mexican Restaurants was affected by Hurricane Rita, and YOY revenues have hardly budged. But, net income doubled, margins increased, they were able to keep costs down. I find this very impressive, it gives me confidence that management knows how to bring in net income. What's interesting to note is that last year's October 2005 quarter was not a good one because of the hurricane, and because this year has been a relatively weak hurricane season, we should see a nice increase in the EPS when they release their 3Q earnings.

I love seeing that high insider ownership number (74.38%). This gives insiders the motivation to do everything they can do to continue expanding and strengthening the company. There are no analysts following the company, which I find a good sign, especially considering they have a P/E of 13, have strong potential, and are strengthening their financials (primarily margins and the balance sheet right now). What I really like with this micro cap is that the cash flow produced from business activities is increasing very strongly, they aren't relying on the bank for expansion. But the fact that cash flow produced from the business has nearly tripled over the past three years is something I find very pleasing. It is very assuring to know that a company's business is very strong and producing enough to "get by" with.

Overall, the financials are very strong and improving every quarter. Since this wasn't a strong hurricane year, they'll be able to really continue strengthening the balance sheet and other aspects of the company without lots of worry. Management knows what needs to be done to expand, and they've done it consistently over the past years. The market hasn't really noticed it yet, which explains the low P/E and very low volume (I was afraid I'd have to wait awhile to open even a small position!). As long as the company keeps doing what it's been doing, the market will notice it eventually.

What to Look For / Risks

-- Expansion - What Mexican Restaurants has been doing is buying out its franchisees and expanding its current businesses. What I want them to do is continue expanding at a slow, reasonable pace, adding ten new stores a year is what I'd like to be the maximum expansion. This is because, even though they are strengthening the balance sheet, that they aren't fully prepared to take on heavy expansion. I think management knows this, so I'm not too concerned. But, heavy expansion is something that will wipe out any company if they aren't ready for it.

-- Hurricanes - Hurricanes are, to me, the greatest risk. The company suffered damages last year because of Hurricane Rita, but has recovered nicely from it. They have a good amount of stores in the Gulf Coast region, so it's another thing to keep a close eye on. As I mentioned before, they will have a time without having to worry about hurricanes since this has been a weak hurricane season (so far), so they'll have another good three quarters to strengthen financials and "get ready." But it'll be key to keep an eye on hurricane movements, because this is the other main risk and thing that could really hurt the company.

-- Competition - The restaurant industry is very competitive, but Mexican Restaurants has a good niche, because there aren't really any "McDonalds of Mexican food" out there. These guys also have lots of experience, as they are coming up on their 60 year anniversary next year, so they definitely know how to run a business. I really like how management has run the company; slow and steady expansion, strengthening financials every quarter, and now they've got David Nierenberg on board to help them out (and he knows what small businesses need). I think they can handle the competition, because this simply is a well-run company in an interesting niche.

Valuation

As I mentioned, the EPS should expect a nice boost this quarter, because last year's 3Q was weak because of Hurricane Rita. I think 15% annual growth of the EPS is conservative, takes into account risks, and the strategy of management's expansion style. This would mean just under a double of the EPS in five years, and I think that is very reasonable and more than likely to happen with the current management team. I think Mexican Restaurants will still be relatively unknown then, so I'll put a P/E of 15 as what people will be pricing the stock in five years. This is a pretty conservative estimate, but I'll keep it as my most expected estimate. Let's see how it turns out:

.79 * (1.15^5) * 15 = 23.83

For my everything-goes-great scenario, I'm going to say 18% annual growth and a P/E of 17:

.79 * (1.18^5) * 17 = 30.72

For my doomsday scenario, let's say 11% annual growth and a P/E of 10:

.79 * (1.11^5) * 10 = 13.31

I think this is a safe investment in the micro cap area, because the stock is very conservatively priced today, and as the market starts to notice it, the price will rise. But having a P/E of 13 while General Electric, one of the largest corporations in America, has a P/E of 21.66 just doesn't seem right. When the market notices Mexican Restaurants, I expect to see very satisfying returns from the stock.

Conclusion

This has got to be one of my favorite stocks now, after doing some in-depth research into it. Management's commitment, the strengthening financials, good expansion rate, and the experience and niche of the business is simply something I can't resist. I expect to be an owner of this company for many years to come.

Best,

David K


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