If You Liked the Pre-Cendant HFS, You May Love U.S. Franchise

For those of you wondering if I have it in my heart to ever write anything remotely positive: I put in a call to Ken Londoner, who runs Red Coat Capital, a money management firm in New York's Midtown.

This is a guy who tries to traffic in the names not well traveled. He's so far out that rather than have his offices in some trendy hedge fund grotto on Wall Street or Park Avenue, he chooses a building on not-so-trendy Third Avenue, which is heavily populated by consulates of developing countries I never heard of.

I'm asking him about what he likes, especially in the lodging area, which is an area in which he claims some expertise. He goes over a few names, none with much conviction, then starts talking about U.S. Franchise Systems (USFS Quote).

Never heard of it, but I listen and then he delivers the magic line that snares my attention: "This is HFS all over again. They have taken the purity of the HFS model, the model that excited Wall Street so much, and replicated it in the segment where HFS started -- hotel franchising."

HFS, of course, evolved into Cendant (CD Quote). And USF's CEO, Mike Leven, helped Cendant CEO Henry Silverman set up the original HFS model. One thing led to another. Leven, who ran Days Inn years earlier, left. Ran Holiday Inn for a handful of years, before striking out on his own three years ago to start USF (now with a $338 million market cap). "This is a needle in a haystack" of investments, Londoner is saying. "Growth rates are exceptional."

He continues ticking off attributes: Big investors include the Pritzker family, which runs Hyatt (Hyatt's prez is on the board) and other investors and board members, including a recent stake by money management firm Gilder Gagnon Howe, are considered among Wall Street's smartest. "I'm convinced it will be bigger than I originally thought it would be," he says. What's more, he tells me that despite owning the stock for a year he has been buying more shares while they have been rising.

Hey, Ken, fine, I say, but nothing is that good. Why, CFO Neal Aronson, a former LBO guy, is Leven's nephew, for goodness sake. (Red flag No. 1.) He and Leven control most of the voting stock. (Red flag No. 2) and Leven is on the board of Starwood Hotels & Resorts Worldwide (HOT Quote), whose CEO Barry Sternlicht is on his board. (Red flag No. 3!) "C'mon, Ken, doesn't any of this concern you?," I say. "These are the very reasons you'd short a company." (Londoner loves to short overhyped companies.)

Londoner, who made a bundle on HFS while co-managing a few funds for J. & W. Seligman, agrees, but says the difference here is track record -- Leven's track record, which in lodging circles is said to be extraordinary if not legendary.

So, I call Aronson, who makes no excuses for being Leven's nephew. Says the voting stock is tightly controlled to prevent an unwanted takeover, which very well might have happened when the stock recently slid along with the entire lodging group. It's now at 18 1/4. (Baby with the bath water kind of situation, Londoner says.) Aronson goes on to say that he and Leven have 99% of their net worth tied up in USF's stock, so they have the most to lose if the company doesn't do well. (Yeah, but didn't Silverman have much of his net worth tied up in Cendant?!)

So, then I ask: If this company is such a hot property why haven't I ever heard of it, and why has there been so little written about it? Aronson says that's because the company only became profitable three quarters ago, and only a few analysts follow it.

He goes on to tell me how the company, which franchises Microtel Inn & Suites, Hawthorn Suites and Best Inns & Suites, was started three years ago in somebody's basement with just 12 people. Today it has 150 employees and more than 1,000 units, with a fairly simply business model: Selling franchises to its hotels in return for a fee that generates what amounts to an annuity-like stream of income.

The franchisors, many of whom have been involved with Leven at other chains, are responsible for finding the capital to build, maintain and even market the properties. USF kicks in some additional marketing dollars. The end result, Aronson tells me, is profit margins in the range of 80% to 90%. "For every incremental royalty dollar into our system, 80% to 90% falls to the bottom line," he says. "We have the margins and profitability of a software company."

What makes them so high? Aronson attributes to the need for little overhead. This year the company plans to add 200 hotels and five employees, "so my overhead remains fixed" while revenue and profits grow. Aronson adds the company could make acquisitions. USF currently has $11 million in cash and no debt.

Ah, but Neal, there's gotta be risk. Every company has risk. "Our risk is timing," he says. "Were a backlog business." He says 700 new franchise licenses have currently been approved, "but all of those hotels haven't opened yet and it's very hard to predict when they will open." If they don't open as quickly as Wall Street expects, he says there could be a quarterly disappointment. There's also the interest-rate risk: Franchisees need to borrow money to build hotels. "Interest rates rising 200 basis points aren't a problem," he says. "Three-hundred to 400 basis points hurts us badly."

Londoner isn't worried. Thinking back to HFS, he says, "This is lightening striking twice." For his sake, he had better hope his thesis is well grounded.

It's always something (case study time): In the year or two that this column has been tracking CKE Restaurants (CKR Quote), every quarterly disappointment has been dismissed by the company as unrelated to the fundamentals of its business. Falling topline sales a year ago, never a good sign at a restaurant company, were dismissed as a quarterly aberration.

Comp store sales down? Oh, sorry, bad weather.

Now, the company is warning that first-quarter earnings will be below expectations. And, for the first time, it cites sluggishness at both Hardee's as well as its Carl's Jr. chain in California. Carl's Jr. had been the one bright spot.

The excuse? Can't blame the weather any more, so CKE is digging deep and is blaming the integration of Hardee's and Carl's Jr., and the remodeling of its restaurants -- neither of which are new! (A spokeswoman told my assistant Mark Martinez that the company was too optimistic about how 557 newly acquired stores from Advantica would perform; seems they had more problems than the company had expected.)

Trying to downplay the issue, CEO Bill Foley said, "We seem to be hitting a plateau for a while...."

Translation: Biz stinks.

But don't ever expect Foley to come right out and say it. This is the same guy who last year pulled down more than $1.2 mil in salary and bonus from Hardee's, while raking in another $2.5 mil, give or take a few hundred thou, as CEO of Fidelity National Financial (FNF Quote), a title insurance company.

What's a title insurance exec doing running a fast food chain?

In the past, when asked, the company has said Foley hires good people to run the day-to-day operations. Perhaps in theory, but that's not what the numbers seem to be saying.

That double-dip role should've been the clue to investors from the get-go.

Lernahooligan alert: Reader M.K. thinks I oughta consider changing the name "Lernahoulians" to "Lernahooligans." Agreed.