A Turnaround, with Warts
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By mklein9
March 19, 2007

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There are a lot of restaurant experts on this board. Here's an interesting opportunity that would be useful to get some input on: New Word Restaurant Group (NWRG.PK), which owns Einstein Brothers and Noah's Bagels and Manhattan Bagels. The big wart? It is 95% owned by a hedge fund (Greenlight Capital, i.e. David Einhorn of recent NEW fame) which has installed its own CEO and board. But the 10-K seems written with the thoroughness of a company trying to become real again. I do have a small stake in NWRG.PK, so am not entirely unbiased here.

The 10-K is unusually complete with 5 years of financial results shown and a good description of how they are improving the business. They are carefully measuring how customers react to experimental changes. Underperforming locations are being closed, to the tune of about 4% of existing locations in the past year (which is the main reason revenues have been flat yet comparable store sales are increasing modestly). NWRG has been profitable only in the last 2 quarters but operating income has been positive for a few years now (the high interest expenses are the problem). Long term debt was restructured in 2006 from mostly 13% interest rate (yikes) to a bit over 10% (semi-yikes).

Beyond that, there are more warts. NWRG has a large negative book value due to long term debt of $170 million. The due dates of those notes are far enough out that they feel that operational cash flow will meet interest expenses and pay off the notes, but that's a risk. Even so, an earnings yield calculation, Greenblatt-style, shows pre-tax earnings yield in the range of 16% based on the latest quarter's results. Not impossibly cheap right now, but that operating income appears to be growing over time through additional cost savings, more dollars per customer visit, and additional store openings in profitable areas (all of which they have been doing already, so they seem to know how).

Another wart: the volume is very, very low. On a typical day only a few hundred shares trade, so only a few thousand dollars. I have probed a bit and it looks like it is possible to trade a few thousand shares a day without too much trouble, but with potentially LARGE slippage (bid-ask spread is sometimes $2). I have not tried selling shares.

I have taken a small initial position in NWRG.PK, and I am not sure if I should add to it or not. The trading volume is a problem, and the 95% ownership and total control by Greenlight is a problem (or not). However, it looks like there is a real business here that is utterly ignored by investors at large, and there is an assumption that could be made that Greenlight is building the business to sell it at a higher price later. On the other hand, it appears that Greenlight got most of its shares at something around $0.60 and the stock is now already at $10.

If that is the case, what is a reasonable price for NWRG? Revenues are roughly $400 million. The last quarter's net margins were 6% but those were the highest in a long time and it is difficult to find a normalized earnings figure, I think, except that they are clearly increasing. Interest expenses alone are nearly 5% of revenues, and there are as yet no taxes being paid. While debt is so high, any cash flow will be going to debt repayment and moderate store growth (capex).

If we make a simplistic assumption of 3% net margins, and a multiple of 12, that would be a market cap of $150 million. Current market cap is $106 million. That's not much of a discount, but I think those are fairly conservative assumptions.

Or, we could look at it as operating income vs. enterprise value, as Greenblatt does. A 3% net margin assumption plus 5% interest expenses means operating margin would be roughly 8% ($32 million) vs. an enterprise value of about $275 million today. (Operating margin was 13% in the latest quarter.)

5% net margin and a growth rate of 5-7% should command a P/E of maybe 15; that implies a market cap of $300 million. That would be at the top end and assumes that they are making good progress on debt repayment (which by itself will improve earnings substantially). Under these assumptions operating margins would be 10% and a reasonable multiplier to get to enterprise value is probably 10, so an enterprise value of $400 million seems appropriate. With debt at $160 million, that's a market cap target of $240 million. That's about 2.5x today's share price.

What would be others' views on this? Straightforward valuations seem to show a pretty good discount, but the 95% ownership of Greenlight and the current large negative book value are certainly potential issues. It also currently trades on the Pink Sheets, although reading the 10-K I think disclosure is very good. Board and management are *not* very diverse; for now Greenlight seems to want it that way.

On the positive side, the latest 10-K has an impressive looking table on page 32 under the "Current Restaurant Base" heading that, to me (not a restaurant expert) shows a strong 3-year trend of closing poorly performing restaurants and increasing well-performing restaurants, i.e. a strong trend of increasing margins even as revenue is flat and number of stores is falling. The growth in top-performing stores looks impressive to me.


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