Meritage Hospitality Group (MHGU) operates 344 restaurants in 16 states and is the largest franchisee of Wendy's (WEN) restaurants, notes Doug Gerlach, editor of SmallCap Informer.
More than just a quick service restaurant operator, Meritage Hospitality gained an edge by acquiring underperforming Wendy's restaurants and “re-imaging” them to bring them up to present-day standards. These new units tend to perform much better than restaurants with the older architecture and décor.
Sales growth since 2011 has been an annualized 23.1%. EPS growth has been less consistent, but has expanded at an annual rate of 18.1%. Profits fell in 2019 due to additional depreciation charges booked in the year and an increase in wages due to labor conditions.
In the second quarter ended June 30, 2021, sales grew 21.0% to $147.3 million and EPS grew 25.0% to $0.80. Q2 of 2020 showed more or less “normal” levels of sales for the company, so recent results were not due to a recovery from weakness.
The company saw major declines in Q1 2020 due to mandated closures, but re-opened stores with drive-through operations and no indoor dining and saw good results for the year over 2019.
Wendy’s launched its new breakfast in early 2020, about 10 days before the pandemic caused stores to shut down. Meritage estimates that 7% to 8% of sales in 2020 were generated by breakfast, but that 80% of its core customer base has not yet tried the new items.
Meritage’s has an agreement to build 50 new Wendy’s restaurants by the end of 2025. Wendy’s recommended that franchisees put construction plans on hold in 2020, but Meritage returned to its aggressive building pace in 2021 and expects to add 20 new restaurants and re-image 30 this year.
Wendy’s limits each franchisee to no more than 400 restaurants, and Meritage will soon reach that figure. As a result, in August 2021, Meritage announced an agreement to build 50 new Taco John’s restaurants by 2026, with exclusive options to develop an additional 150 restaurants.
Taco John’s operates and franchises 400 restaurants in 23 states, primarily in the Midwest and Mountain regions of the U.S., so this agreement would expand Taco John’s footprint significantly and into states not previously served.
If you don’t know Taco John’s, you may have heard of its trademarked “Taco Tuesday” marketing phrase. The company actively works to protect this mark from use by other Mexican restaurants. As of 2018, Taco John’s ranked eighth by revenues among Mexican chains in the U.S.
Meritage estimates that it will invest $100 million in the 50-store Taco John’s development agreement through cash and borrowing. Management guides to full-year fiscal 2021 sales growth of 10%-15%, and net earnings growth of 20%-30%. We project growth at 14% for sales and EPS through 2025, providing a good margin of safety.
Meritage is currently trading at a P/E ratio of 8.1, which is on the low end of its traditional range. If the P/E reaches 11.3 and EPS reach $5.26, a future high price of $59 would be reached. (Some future P/E expansion could be achieved if the company continues to grow.)
A price drop of 20% suggests a downside price of $17. From the current price of $22.13, the reward/risk ratio is 8.4-to-1 and a potential 22.5% annual total return could be earned.
