Today I want to tell you about a little company called Noble Roman’s (NROM), a stock I recently researched with other members of my Special Opportunities Group—Peter Chase, Eric Hendey, Chaodan Zheng, and Rob Boling. On the surface, it’s a micro-cap pizza company trading for less than $1 that was nearly sent into bankruptcy after defending itself against frivolous lawsuits from its failed franchisees. However, on closer inspection, it’s a simple, sticky business model with high returns on capital and an underfollowed growth opportunity. I believe shares are worth at least $1.13, ~50% above recent prices.

For basic background info not covered here, see company presentation: http://www.nobleromans.com/pdfs/2012%20Presentation%20PDF.pdf

The Metrics

• Market cap: $14.64 mm
• EV: 20.09 mm
• P/B = 1.34
• P/E = 22.06
• EV/EBITDA = 6.20
• ROE = 12.27%

Company Background

• Began in 1972 as a small Indiana pizza operator
• In the 1980’s and 90’s phased out of the operating store business
• In the 1990’s and early 2000’s, the company morphed into a franchising and supply chain pizza business
• In 2008, the company was sued by many of their franchisees who accused Noble Roman’s of fraud as a result of the dramatic failure of most the of the franchises
  • The company spent  a couple million in legal payments company and is currently trying to recoup up to $5 mm in counterclaim payments.

The Business Segments

• Non-Traditional Locations (62% of revenue)
• Take-N-Bake (18% revenue)
• Traditional Locations (12%)
•  Other (8% of revenue). I won’t cover other as it is insignificant (consisting of some company owned stores for testing purposes)
  • As I describe the business segments, realize all of them have very few costs due to the licensing business model. I think it is therefore appropriate to try and best model out the revenue and assume a 35% operating margin. Note that operating margin has been very stable and generally higher (for five out of last 6 years) than this 35% figure so it should prove to be a bit conservative
• Non-Traditional Locations (62% of revenue), very sticky business
  • This is basically convenience stores/ gas stations. Noble Roman’s sells stores the equipment to make Noble Roman’s pizza (upfront fees) and NROM takes a % of sales as a royalty fee. This is a high margin segment for the locations and a great proposition for Noble Roman’s as well.
  • This is a very sticky business with essentially no costs. Once a location has the equipment, they have little incentive to switch. This makes the segment very easy to value
  • Below are the results from this segment (2012 full results estimated)

• Take and Bake Business (Grocery Stores): ~18% of Revenue, growing
• This is the company’s growth vertical. They started selling “take-n-bake” pizza to grocery store chains in September 2009. The Company has signed agreements for 1,206 grocery store locations to operate the take-n-bake pizza program and has opened take-n-bake pizza in approximately 945 of those locations.
• Again, the company has essentially no costs associated with this segment as they are licensing their brand. The company develops distribution agreements with grocery store distributors, sign licensing agreements with Grocery distributor customers, and service them through foodservice distributors
  • This clearly only has value to the extent that customers “value” the Noble Roman’s brand
  • Given their profitability and growth in number of grocery stores (see below), the NROM brand clearly has value
    • It is likely that this value is geographically bound

-The above numbers are only for operated stores. The number of “signed” stores is higher since there is a time delay between stores signed and operated. Still, the company has doubled the number of grocery stores operated from 2010 and this segment is now a significant driver of value.

• A key question in the valuation is how many grocery stores NROM can sign/year and when the growth will stop. I asked Ian Cassel this question. He is very knowledgeable on the company and wrote a great article on them here: http://seekingalpha.com/article/853531-noble-roman-s-inc-who-knew-pizza-could-be-so-profitable?source=yahoo
  • He said, “I think they had 10 distributors at YE 2011, and now have 13. So the question would be how many grocery stores do these 13 distributors represent? When I talked to the company a few months back (when they had 11 distributors), I think they represented 4000-5000 stores. So this would be a good starting point for guestimation”
  • This is an important and difficult estimate in the valuation, but I think this is a reasonable way to frame the scenarios
  • This is clearly a growth segment that should have a long runway given the existing relationships with grocery distributors

• Traditional Locations (~12% of revenue), has been in decline

• The traditional franchise locations have struggled recently. However, one would expect the worst locations to close over time and eventually for the company to be left with only the best locations. In either case, it is best not to be too optimistic when valuing this segment going forward, but at 12% of revenue, it is not a huge value driver.

Other Valuation Considerations

• In June 2008 the company was sued by former franchise owners for Fraud. In December of 2010, a court issued a summary judgment in favor of Noble Roman’s and all appeals were rejected. Noble Romans’ countered sued claiming the franchise owners had breached their contracts and owe substantial damages. $3.6M for damages and $1.4M for legal expenses
  • This claim has been granted summary judgment but the final amounts are pending.
  • It’s unclear how much, if any, of this will be recovered. However, this only represents upside (and considerable upside relative to the approximate $15 mm mkt cap)
• Deferred Tax Assets
  • The company has over $9 mm in deferred tax assets that will keep it from paying taxes for ~4 years, a considerable source of value
• The company has plans to franchise stand alone take-n-bake stores. “Papa Murphy’s” has been quite successful with these types of stores with over 1000 nationwide. The company seems excited about this initiative. I think it is too early and speculative to factor this into the model, but its success would obviously provide upside.

Valuation: Three Scenarios, 10-year DCF

• I think the easiest way to approach this would typically be to look at the three segments. Non-traditional should be flat at worst, traditional location is going to continue to decline, and take-n-bake should grow. Given the current size of these segments, the overall effect should be net positive revenue growth. I think it is very hard to make a case to the contrary given how fast they are signing new grocery stores.
  • If we assume net positive revenue growth, then valuing them at a “no-growth” earnings power valuation should be conservative.
  • Taking estimated full year 2012 revenue of $7.46 mm and applying a 35% operating margin results in $2.61 mm. Normally, I would apply an ~40% tax rate to get to $1.56 mm in NOPAT, divide by a discount rate of ~10% to get to $15.60 mm in run rate earnings power value, subtract their $4.9 mm in debt and arrive at a value of ~$0.54/share.
    • However, because of the deferred tax assets, the 40% tax rate is not applicable for the first four years. Currently, EBIT = FCFF. However, looking at these unrealistically pessimistic assumptions shows the limited downside. Even in this scenario, downside is only 28%. That’s zero growth, no tax advantages, no legal payments, no benefit from new franchise concept. Now let’s look at a few more realistic scenarios that incorporate the tax advantages:

• Worst Case: $.72 (-6%)
  • 0 grocery stores per year added
  • Flat non-traditional stores
  • Precipitous 35% decline in franchise stores
  • No legal payout
• Base: $1.13 (46%)
  • 100 grocery stores added per year
  • Non-traditional stores growing at inflation (3%)
  • Franchise stores declining at 20% per year
  • $1M out of $5M in legal payout
• Best: $1.67 (116%)
  • 400 grocery stores added per year
  • Non-traditional stores growing at inflation (3%)
  • Franchise stores staying flat
  • $4M out of $5M in legal payout

I think the base case of $1.13 is pretty conservative and that anything less is a real bargain.

Why does the opportunity exist?

• The company trades for less than $1 and has a market cap < $20 mm
  • No research coverage, institutions prevented from buying
• The company does not screen well
  • P/E > 20, which does not look cheap at all. However, on a Market Cap/Lev FCF basis it is extremely cheap at         ~8X with growing FCF.
    • This is due to the deferred tax assets that will prevent it from paying taxes for ~4 years
• Company has been bogged down by frivolous lawsuits which have harmed results, threatened the existence of the company, and distracted management from growing their business
  • This is largely behind them and is now a potential catalyst (repayments) rather than a liability

Summary

• This is not a sexy stock. It’s a pizza franchising company. However, the main source of revenue (non traditional franchises) is very sticky, there is a strong growth vertical (take n bake), and it has some very valuable deferred tax assets. Even assuming no growth in grocery stores/year, the stock has very limited downside. I think fair value is at least $1.13 and that this is a very low risk bet that should handily outperform the market for patient investors.

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