In the 1990s, Midas (NYSE:MDS) nearly became the modern day equivalent of a buggy whip, typewriter, or slide projector maker -- rendered irrelevant by technology. Oh, sure, the advances in auto exhaust technology aren't the kinds of things that sear into the consciousness of most consumers, or investors for that matter, but there you go. Midas nearly dried up, and everything its management did at the time seemed to achieve little more than to help the process of extinction along. In effect, everything Midas touched turned not to gold, but to quicksand.
Then in 2003, Midas' board tossed out the executive team and brought in new blood -- a franchising expert, Alan Feldman. Feldman, previously president of McDonald's (NYSE:MCD) USA, isn't a magician -- he cannot roll back the technological advancements that provide so much challenge to Midas, but his team has reformed and revitalized the company, and while it was once stumbling toward bankruptcy, its structure now looks a little bit like McDonald's, and a little bit like Amazon.com (NASDAQ:AMZN) -- a low-cost, high-service participant in a commodity business. No, I'm serious. Midas' stock has rallied on its reversal of fortune, though I believe not enough.
Let's go to the videotape
Midas is not a young company, having been around since the 1950s. It started as an exhaust system company, selling replacement mufflers. Though Midas added brake service, shocks, and other parts, its identity, marketing, and mainstay were focused on its mufflers -- its retail stores sold Midas-produced and branded equipment. Pity poor Midas, then, when in the 1990s car companies began migrating to stainless steel mufflers from aluminum.
Suddenly a car component that previously needed to be replaced every two to three years could last, in some cases, more than a decade -- longer than most people owned their cars. So, even though Midas had diversified its revenue stream to some extent, the elongated replacement cycle had the effect of blowing a big hole in Midas' revenue stream, with revenues dropping by 40% between 1996 and 2001.
So the obvious solution (said in a tone that suggests that it was obviously not the solution) in the late 1990s was to diversify even more. But Midas stores aren't set up to be cure-all repair shops; the amount of inventory they'd have to maintain would be overwhelming. So the company elected to set up a complex distribution network to supply Midas franchisees with products that customers weren't buying, with scores of local distribution points that would serve clusters of franchises. What's the inevitable result of this? You bet: The amount of working capital required to run the Midas network soared, with inventories rising to exceed 200 days' worth in 2002, with receivables similarly ballooning. The end result was a company that had a depleted core exhaust system business distending itself to try to maintain numerous other revenue streams, in car maintenance components in which it had a much lower credibility. Yick.
Enter Feldman
When Alan Feldman took the reins, he saw a franchise system trying to do too many things, all the while drowning under an unwieldy support network. Midas undertook yet another major restructuring, this time undoing the "fixes" that had been put into place in the late 1990s. In 2003 the company shuttered 77 Parts Warehouse quick-delivery locations, choosing instead to outsource its parts supply to AutoZone (NYSE:AZO), which had a robust distribution network in place. Midas trimmed its production horns, maintaining only the Midas brand mufflers in-house.
The new team also set some audacious goals: to increase systemwide sales 40%, and to double what it calls "dealer profits," while focusing on three services: exhaust, brakes, and maintenance. What has taken place, of course, is that revenues have dropped substantially from 2003 to 2004 -- but the revenues that Midas shed were the same ones that required it to have a stifling, expensive inventory buildup. What's left behind is the company's legacy businesses, and a franchise system that has already enjoyed the benefits of addition by subtraction. We love these kinds of situations, companies that fail to show up on screens anywhere simply because they have declining revenues, even though the revenues they're shedding were the most unhealthy part of their businesses. Recentexamples here include Kmart (NASDAQ:KMRT), Lone Star Steakhouse (NASDAQ:STAR), Denny's (OTCBB: DNYY.OB), and J.C. Penney (NYSE:JCP).
From a valuation perspective, the company doesn't appear particularly cheap if you focus on reported earnings, because, well, it doesn't have any. Back out charges related to restructuring and I figure that the stock would be trading at a P/E of about 24. Ah, but the details offer a different picture entirely. Midas has about $41 million in built up losses from the past that it can apply to future profits to keep from paying tax, which should last for about three years. Further, Midas' free cash flow is substantially higher than its earnings, and should remain so for an extended period of time. The company has substantial depreciating assets from pre-restructuring (on top of others that it has already written down) that will account for some $12 million annually in earnings reductions. Check Midas' capital expenditures, though, and you see something else: The company's new model is very capital-light, with expenditures in the past year of $1.1 million. That's a mismatch, and it means that there is a great deal of economic gain that is accruing to Midas that is not reflected in its earnings number. Numbers as reported will only improve as the company sheds the drag of its money-losing manufacturing component.
Does any of this mean that Midas is going to trade at $100 next year? No, absolutely not. This is still a slow-growth business. Midas is still a brand name with power, and its network, now that it's not drowning under its own weight, has the opportunity to spin off gobs of free cash for use in deleveraging, buying back shares, and expanding the Midas network. The latter is easier to do now that AutoZone is providing the backbone. What it does mean is that I believe that the negative growth and reported losses in the recent past have obscured the full nature of the economic renaissance at Midas. This isn't going to be a rapid-growth company, in all likelihood. But at present valuation, I don't suspect that it needs to be.
Bill Mann is the editor for Stocks 2005. He can't for the life of him figure out what Dear Henry's problem is. He owns shares in Denny's and McDonald's. Interested in hearing about other companies that are ignored or misunderstood by Wall Street? Give yourself a subscription to Philip Durell's Inside Value newsletter. Afree trialis but a click away.
