Shutting shop on Retail Food Group

Retail Food Group has been kind to long-term shareholders. Those that bought in the IPO in 2006 have earned 21% a year, before dividends. With an impressive track record, it may come as a surprise that we're downgrading the stock to Sell. Why the change of heart?

Retail Food Group has built a $1.22bn business through a 'roll-up' strategy, buying in the same industry to increase the market share and earnings of the acquiring entity. Thus far, it's been successful. Fifteen acquisitions have been made to date without a sniff of a setback.

Added scale has brought other opportunities too, allowing an additional earnings stream supplying roasted coffee beans to its growing list of cafe and bakery franchises. But history suggests roll-ups often end badly. Think ABC Learning and Slater and Gordon. That's not to say RFG will go the way of these duds, but the risks are increasing.

In the early years, roll-ups work but there's a finite supply of high-quality businesses to purchase. Inevitably, the number of sensible targets diminishes and the focus turns to bigger acquisitions, with higher risks. This is where Retail Food Group finds itself today.

With operating earnings (before depreciation & amortisation) of $132m, to move the needle the company must make a purchase of upwards of $100m. RFG's 2014 purchase of Gloria Jeans for $180m and last year's acquisition of Hudson Pacific for $88m are two cases in point.

But it's not just about size. A good business and a sensible price are the important prerequisites for a successful acquisition, and the two don't often align. As the pace of acquisitions increase, the pool of high-quality opportunities diminishes and the price at which they're available goes up. In the face of pressure to keep growing, it takes managerial skill to not overpay.  

Skin in the game

Tony Alford, who founded Retail Food Group in 1989 and has been chief executive ever since, stood down in July last year. This is a significant change. The risk in a roll-up strategy run by a major shareholder is far lower than one run by a hired gun on a performance rights package.

New chief executive Andre Nell has been with Retail Food Group since 2007, so he probably understands the culture and businesses well. We have no reason to believe he isn't a great manager. But it's hard to replace the level of care that comes with a big shareholding. We all wash our own cars, but no one washes a rental.

There are also several other factors that concern us. The company's fortune depends on the success of the underlying franchisees. No surprises here. But the reliance on franchisees is compounded by the company's large wholesale division – the one that sells beans to Gloria Jeans for example. Instead of adding diversification, it magnifies the operating results of the franchisees. Good results for the franchisees mean both divisions fare well but in poor years the double-up dynamic quickly reverses.

Right now, headline results indicate the franchise business is stable. But Retail Food Group continues to increase the amount of loan support to franchisees, and more than half the company's receivables are past 90 days due. That's a big red flag.

There is also the 'marketing' fund, discussed in Retail Food Group: Result 2016 and which is used for a lot more than marketing. Last time we checked, cushioning franchisees from a supplier failure isn't marketing.

These facts don't sit well with us and, with 19 other businesses on our Buy List, we prefer to stick to those we are comfortable with. SELL.