Mexican Restaurants, Inc - CASA

Mexican Restaurants, Inc. owns and operates 52 Mexican (surprised?) restaurants in Texas, Oklahoma and Louisiana, and operates another 13 via franchisees. The company's brands include Casa Olé, Crazy Jose's, Mission Burrito, Monterey's Little Mexico and Tortuga Mexican kitchen.

MR delisted from the NASDAQ in early 2011 after running into problems caused by over-expansion, excess debt and weak consumer spending. Since then, the company has closed unprofitable restaurants, paid off debt and sought to improve operating efficiency. These efforts are paying off and the company returned to profitability this year.

The market has yet to appreciate the company's turnaround. MR trades at rarely-seen ratios and multiples. On a twelve trailing month basis, the company's enterprise value to adjusted EBITDA ratio is 1.46. (I have adjusted EBITDA to account for one-time expenses like restaurant closings and losses on assets sold.) The company's market capitalization is $3.82 million versus common book equity of $10.30 million. Free cash flow yield is 33.4%. Here's a look at the company's results for the past few years. EBITDA and operating income are adjusted for one-time items. Net income is not.

Revenues troughed in 2010, rebounding slightly since. Revenues are unlikely to regain previous highs any time soon, as the company has shut down multiple poorly-performing locations since 2008. The company reported a small profit over the twelve trailing months for the first time since 2007, earning $0.28 million or 6.5 cents per share. The company had a total of $3.8 million in federal tax credit carryforwards and net operating loss carryforwards which will shield the company from federal taxation for years to come.

The company's reported trailing profit understates earnings power due to a few one-time items that affected MR in the past year. In the four trailing quarters, the company recorded an asset impairment of $471,730 related to two under-performing owned restaurants. The company also recorded a loss on the sale of equipment of $26,017, a restaurant closing expense of $9,491 and a bad debt charge of $150,426. MR did not experience any bad debt losses in the previous two years, so I think it is safe to label this expense a one-time item. These one-time items sum to $657,664.

Due to the company's large loss carryforwards, these items can be added to the bottom line without accounting for federal tax. Assuming these figures are reasonable, Mexican Restaurants' adjusted trailing net income is $0.94 million, or 21.6 cents per share. Evidence for this much higher adjusted net income figure is provided by free cash flow, which totaled 29.4 cents per share over the same time period.

As the company has made operational headway, it has also progressed in deleveraging its balance sheet. MR has a line of credit with Wells Fargo and has remaining obligations related to lease settlements on closed restaurants. Since 2008, the company has reduced these debt and obligation balances from $8.10 million to $2.14 million. The company's line of credit current has a balance of $2.00 million and expires in mid-2013. MR is in negotiations with Wells Fargo to extend the credit line. Once the company finishes up the debt reduction process, substantial cash flow will be freed to reward shareholders via investments in new restaurants or dividends and share repurchases.

There is a wrinkle in the company's capital structure. In 2011, the company sold 800,000 shares of preferred stock to officers at $1.25 per share, as well as 125,000 warrants. These preferred shares are convertible into common stock on a 1 to 1 basis and bear interest at 8%. Interest on these shares accrues in the form of additional shares until May 15, 2013. I have included these shares in diluted shares outstanding. The warrants were issued with a strike price of $2.00. Since insiders already owned a majority of shares outstanding, this transaction had the effect of solidifying management's control over the company.

Mexican Restaurants, Inc. trades infrequently and at a large bid/ask spread, currently $0.75/$1.00. At the price mid-point of $0.875, the company's pro-forma P/E is 4.05 and price to free cash flow is 3.82. If the company can continue to improve operating margins and extend its line of credit, investors may be looking at an extremely cheap stock.

It should be noted that MR, like many retail and restaurant operators, has large off-balance sheet operating lease obligations. Many of these leases are noncancelable. In ordinary environments this may not be an issue, but a steep economic downturn could leave the company scrambling to make rent. Many companies have been done in by lease payment obligations. Mid-market Mexican restaurants are not as economically sensitive as say, a jewelry store or classy steakhouse, but they still depend on consumers opening their wallets for a discretionary purchase. Quality of management is a risk as well. One hopes the company's insiders were chastened by the disastrous over-expansion of the mid 2000s, but the possibility remains that history will repeat itself.

Disclosure: No position.