The Retail Food Group Limited (ASX: RFG) share price has collapsed 30% in the past few days, following the Fairfax media allegations of underpaid workers and franchisees being pushed to breaking point. The company is now priced at 9x last year's profit and will have a 10% dividend yield if dividends are maintained.
12.6% of the company's shares were sold short as of last Thursday, according to ASIC. This is a considerable amount and usually indicates that short-sellers have scented blood – the only company I've seen buck expectations once it's been that heavily shorted is Flight Centre Travel Group Ltd (ASX: FLT). Plenty of others like Quintis Ltd (ASX: QIN), Slater & Gordon Limited (ASX: SGH) and Myer Holdings Ltd (ASX:MYR) have gone into terminal decline.
Retail Food Group confirmed last Thursday that it was still forecasting 6% in underlying Net Profit After Tax (NPAT) growth in the current financial year.
In my opinion, there are 3 possible ways this whole scenario shakes out:
- Fairfax media has exaggerated the allegations. This is technically possible, and Retail Food Group has stated that they believe the allegations are inaccurate. Investors are best advised to form their own opinion. However, if the accusations are mostly false or confined to a small handful of franchises, then in my opinion Retail Food Group shares are likely quite cheap. Domestic franchises account for less than half of the Group's earnings (see chart below), although if you consider that much of the coffee and commercial sales likely go to domestic franchises, then the impact is potentially higher.
- The accusations are true and management pretends that they are not. This is also possible and Retail Food wouldn't be the first management team to sweep problems under the rug. I pointed out a few months ago that domestic franchise operations had been mediocre, and this was one of the key reasons I sold:
Given years of consistent performance and apparent transaction value and same-store sales growth, the decline in Domestic Franchise EBITDA as well as a total 'net outlet decline' of 14 stores was a warning sign to me. Retail Food Group commissioned 210 new stores in financial year 2017, so to have a net outlet decline of 14 stores (not shown) suggests that actually 224 stores closed down. To me, that suggested trouble behind the scenes, and I am inclined to believe the Fairfax media allegations. If this is the case and management is ignoring the elephant in the room, Retail Food's results are likely to get substantially worse from here, and the dividend yield and low price may prove misleading. The company also carries an uncomfortably high amount of debt, if earnings are declining.
I personally do believe that Retail Food Group has been under-investing in its franchises – this is something I've griped about for years, even as a shareholder. If you look at the Donut King results in 2017, following the introduction of the 'Royal' range of donuts, you can see what the recent focus on franchise innovation does for the results:
"Donut King continued to be the stand-out performer, recording FY17 SSS and ATV of +4.7% and +2.7% respectively."
Finally, the last possibility is:
- The accusations are true and management responds proactively. Companies can make mistakes, and quite often, even companies that have been hit with unfair and incorrect smear campaigns will 'overreact' on the positive side, going out of their way to fix possible concerns and repair their reputation. Retail Food Group's response has been very muted and in my opinion, it doesn't appear to see anything that needs fixing.More than anything, that is my biggest concern here, and the concern is magnified by the degree to which Retail Food Group is withholding information about the 'health' of its franchisee base.Fairfax media asked a list of questions at the AGM and Retail Food has not published any meaningful response.
- If management were truly responding proactively I would expect maybe some sort of nationwide audit into employee underpayment, similar to what Domino's Pizza Enterprises Ltd. (ASX: DMP) initiated. I would also expect a detailed explanation of how many franchises are behind on their payments, how many franchises are up for sale, and so on. Following that, if there was a problem, I would also expect some sort of arrangements made to provide financial relief for franchisees – even if it's just letting them out of their contracts early, or donating to a franchisee protection organisation like Franchise Redress.
This won't fix the problem, but it may help set the business on a more sustainable footing, as well as helping repair its brand image. I would be gravely concerned if, as a result of these allegations, Retail Food Group came to be seen as 'the enemy' by its franchisees, so I think pro-activity is the only viable choice for management.
It's tough to know exactly which outcome is the case, and until shareholders know how seriously (or otherwise) the company is treating the allegations, I would be inclined to avoid Retail Food Group for the time being.
