Where to for RFG

A few items that I think are worth considering for those looking at the company.

Price Support

I believe that between 2.90-3.00 should offer some reasonable price support given that this was previously significant resistance and often previous resistance levels become good support levels from my experience. So there is a potential trade there looking for the potential bounce off support.

Management Response

The response management recently put out was certainly better than their initial response and while I think there was room to improve on this response it was a step in the right direction, with Fairfax continuing their barrage against the company and politicians seemingly taking advantage of the low hanging fruit to try and grandstand silence really wasn’t an option. Would have ideally liked to see some hard figures in respect to performances of franchises and some more solid information about exactly what they were doing.

Store Closures

The explanation for the drop in Pizza Caper outlets was rationalization of trading corporate outlets. Of concern is that I can’t imagine that they would have closed profitable outlets and this is a business that generates profits from the wholesale side of things as well. The thing is if RFG cannot justify keeping these stores open and you would have to think that they are considering the loss in profits from wholesale as well then what chance do ordinary franchisees have given they make nothing from wholesale. Also the fact they didn’t or weren’t able to get these outlets to new franchisee’s speaks volumes.

Intangible Assets and Goodwill

I think that there is serious possibilities there will be more writedowns of goodwill. In their recent results excluding the restatement of previous accounts there was a 5.2m asset impairment. My concerns stem from how the 650m of goodwill and intangible assets are seemingly being valued. Their accounts put growth in the Donut King, Brumby’s and Michel’s at 2.5% per year between years 2-5 and thereafter 2%. However actual growth from these 3 brands were -6% last year. These 3 brands represent 248m of goodwill and intangible value on their balance sheet which may prove too high based on their assumptions.

A table below shows the actual growth in FY17, their stated growth rates used in intangible calculations as well as the extent of goodwill and intangibles in the business.

	Column 1	Column 2	Column 3	Column 4	Column 5
0		FY2017 Growth	RFG Assumptions (Years 2-5)	Goodwill (m)	Intangibles (m)
1	Bakery Divison	-6.0%	2.5%	76,864	171,900
2	QSR	-10.9%	3.0%	25,092	47,424
3	Coffee	0.9%	3.0%	65,367	166,424

Another thing I noted was that the business is getting close to their net assets being greater than their market capitalization. I know when this happened with Billabong in their recent results that they were required to mark down the value of their brands in spite of the fact they felt it wouldn’t impact on the recoverable value of the intangibles. It related to AASB 136 which in paragraph 12 (d) states that the external sources for indicating assets may be impaired is if the carrying amount of the net assets of the entity is more than its market capitalization. (http://www.aasb.gov.au/admin/file/content102/c3/AASB136_07-04_ERDRjun10_07-09.pdf)

I am not an accountant so am unsure of the full implications of this on the company and whether they would be able to get around having to do any impairments if net assets did exceed market cap. If there is any accountants on hotcopper that could shed some light on this for us all it would be good.

Based on the current shares on issue and the net assets per the FY17 accounts my estimate is that they would have a market cap below net assets at $2.54. However this doesn’t factor in the increase in net assets from the underwritten dividend either so would likely be higher now.

Why are the intangibles Important

If the company does have to write down assets then it debt load comes into question. RFG is a business with negative net tangible assets so which its EBITDA margins are impressive (around 80%) of the bakery franchise segment the banks might get a bit uneasy about not having enough tangible security within the business and may pressure RFG into raising equity if they get close to debt covenants. In their financial statements it doesn’t state what those covenants are only mentions that they are within covenants and their gearing ratio for the purpose of these covenants is 34.7%.

If the company was forced into raising equity at current prices that would be highly dilutive given the recent share price falls.

The Fairfax connection

I usually don’t buy the shorter are out to get us mentality however the timing of the articles from Fairfax being just before closing their books for the half seems suspicious. Also articles in regards to the previous CEO seemed rather personal and their eagerness to publish another story so quickly without getting the full story details from the so called 300 other past and current franchisees seems counter-intuitive. There is a significant short position in the company at 12.5% and I do wonder whether there has been information passed along or encouragement to write these stories. December is also a period where volumes are a bit lighter due to the holiday season so it would be easier to move the price at this time of year.

Investment Case

I still see too many risks with this company to support the case for a long term investment for myself and there are quite a few things that would need to turn around to improve this. However as I said earlier from a technical point of view it seems oversold so could be a bounce in the short term.