Initiating Coverage of Freshii at “2”

With the JAB Holdings acquisition of Panera Bread Company having closed this week, we have decided to add a new company to our coverage universe.

Freshii is a fast casual chain focused on healthy food that offers a variety of dishes such as bowls, wraps, burritos, salads, and soups. The chain’s first location opened in 2005 and after years of fast growth currently has over 300 locations globally, with 99% owned and operated by franchisees. Unit growth continues to be torrid, with over 150 units expected to be opened in 2017 alone and >800 system-wide locations expected to be in operation by the end of 2019.

Freshii went public in January 2017, selling shares at $11.50 (CAD) on the Toronto stock exchange. Investors can buy the Canadian listed shares under the symbol FRII.TO or opt for the U.S. dollar denominated over-the-counter stock trading under the symbol FRHHF. The stock soared in the early days post-IPO (peaking at over $15 CAD) and has since dropped by roughly 30%.

Perhaps the most interesting thing about Freshii’s business model is their focus on keeping build-out costs extremely low for franchisees. The company targets an initial cost of $260,000 in local currency to build a new location and that includes the franchise fee. Such a low cost is relatively unheard-of in the restaurant sector (A typical Chipotle unit costs 3-4x as much to build, for instance). This low cost is attainable because of the company’s goal of offering only the freshest, most healthy food offerings. As a result, a Freshii location does not require any ovens, grills, fryers, freezers, or microwaves. Such limited equipment requirements makes it very easy for franchisees to open relatively small units for a lot less money than competitors. This is clearly a unique competitive advantage.

While Freshii appears to be a unique concept, the chain does face challenges. The food offerings, while creative and healthy, are likely most suited for a younger, more urban customer. That niche market will limit the company’s ability to blanket the world with units and generate high per-unit sales. In fact, the average Freshii location produced less than $500,000 in revenue in 2016. Those economics can work fine due to the low start-up costs, but it does mean that high volumes are not the goal here. As a result, location selection will be the key to the chain’s success. Overbuilding and/or choosing locations lacking the core target customer are likely to be problems for franchisees.

Another challenge for Freshii will simply be the pressures that come with being a young public company. Management has already guided investors to more than 800 locations globally by the end of 2019, but it is equally important to open high quality, profitable locations as it is to “hit the numbers” for public investors who grade you every three months. The risk here, of course, is that they step on the gas to hit their targets for new unit openings and in return become less rigorous in their process for green-lighting proposals from franchisees.

Shortly after the IPO, when Freshii stock was trading well above the initial price, the shares did not seem to offer much value to investors. For instance, at the end of the first quarter there were roughly 300 locations open. At a build-out cost of $260,000 each, that would imply roughly $80 million of hard assets, versus a company that was valued at $450 million at its peak shortly after the IPO. Such a disconnect, which afforded most of the company’s value to units not yet in existence, would have garnered a “1” rating from us. However, the recent stock price decline has brought things closer to reality.

We are initiating coverage of Freshii with a neutral “2” rating based on the belief that the concept is unique and clearly has a place in the market. It remains unclear how large that market is, and whether the chain can maintain its early success as it grows larger over time, but the low build-out cost should attract plenty of interested franchisees.

At current prices, the market is valuing Freshii at $250 million USD. The company is guiding investors to 2019 system-wide sales of $285 million USD, on which they expect to earn EBITDA of $16 million USD. While ~15x EV/EBITDA based on 2019 estimates is not cheap (hence no “3” rating), we no longer think the company’s valuation is excessive given their growth aspirations. We think after several more quarters of publicly filed financial statements are released, it will be a little easier to gauge sustainable profitability levels and therefore get a better handle on the valuation.

At the very least, Freshii is a new, exciting concept with lots of potential within certain customer demographics.  It should certainly be on dining stock investors’ radars, and therefore we are pleased to begin coverage today.