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ROBERT SCHERMER JR. - MERITAGE HOSPITALITY GROUP INC (MHG)
CEO Interview - published 04/11/2005

DOCUMENT # ABL605

ROBERT E. SCHERMER JR. is President and Chief Executive Officer of
Meritage Hospitality Group Inc. Mr. Schermer serves on the Pepsi
Advisory Board as well as the Board of Directors of Interstate
Communications Inc. Mr. Schermer is active in community affairs, through
philanthropic activities focused on the community's needy children. He
attended Hope College, majoring in Economics and Finance.

Sector: restaurants

TWST: Would you begin with an overview of Meritage?


Mr. Schermer First, I am pleased to have the opportunity to speak with
you today about our company. I would like to preface our interview
subject to our forward-looking statement disclosures which can be found
in our SEC Form 10-K. Meritage Hospitality Group in the nation's premier
publicly traded franchise operator engaged in the development and
operations of franchised restaurants. All of our restaurants are
operated pursuant to franchise agreements, in proven concepts with broad
customer appeal. Meritage is the nation's only publicly traded Wendy's
restaurant franchisee and the nation's only publicly traded O'Charley's
franchisee. We currently employ approximately 1,800 people and expect to
add 300 new positions this year.

TWST: Could you give us an overview of the strategy that you will follow
over the next several years


Mr. Schermer Over the next five years, we are focused on a multi-segment
'best of class' restaurant brands growth strategy aimed at internal unit
growth, which will expand sales from $53 million to $130 million. The
goal is profitable growth and outperforming the industry in operating
metrics while achieving segment diversification. We have made a
significant investment in training and infrastructure over the past 18
months preparing for our O'Charley's restaurant growth initiative.
Casual dining segment diversification helps guard against concentrated
commodity exposure such as the QSR segment is experiencing with beef
costs. Our strategy is to grow the business to $130 million over the
next 60 months, using a multi-brand, multi-segment strategy. In our next
12 ' 24 months, we forecast that the company will be approaching the $90
million sales benchmark. The real goal is growing profitability,
outperforming the industry in operating metrics and achieving segment
diversification.

TWST: Could you give us your take on current and future industry trends?


Mr. Schermer The food service industry is a $475 billion industry. I'll
grant you that for the typical investor, the business of selling food is
not terribly exciting. However, one should not underestimate the value
proposition in selling a basic need such as food. The two largest
segments of the industry are the $134 billion quick service restaurants
('QSR') and the $165 billion casual dining segment. Within these two
segments, the 200 largest multi-unit franchisees generate $17.9 billion
of sales annually, operating 16,600 units. The growth of large multi-
unit franchisees has evolved over the past two decades as franchisors
realized the cost efficiencies of utilizing multiple store development
agreements versus single unit deals with individual operators. At the
same time, growth capital from banks and finance companies have become
available to top tier brands. The emergence of these two forces has
created today's large, sophisticated multi-unit franchise operators.
Looking ahead, the QSR and casual dining segments have some very
compelling dynamics. Americans' desire for convenience and socializing
outside of the home has driven the percentage of food eaten away from
the home from 25% to almost 50% over the past 50 years. During the same
time, the premium restaurant's charge for a meal over the supermarket
has declined from a 93% premium to a 26% premium. 'Time' has become one
of the most valuable commodities in people's lives, and that has
transformed restaurants into consumer staples as opposed to a consumer
discretionary item. This growth in demand has fueled the evolution of
large segment brands. Recent consumer surveys demonstrate that nearly
half of American's believe restaurants are an important part of their
lifestyle.

TWST: What impact is the general economy likely to have on your
business?


Mr. Schermer The restaurant industry today is very healthy. For
investors, this is an asset class that has been very resilient overtime.
In theory, people will eat somewhere regardless of the local economic
climate. The restaurant industry competes for real estate locations with
many freestanding retail concepts such as drug stores and banks. The
industry's traditional capital resources are benchmarked to the 10 year
Treasury, so as interest rates move, so does the cost of growth capital
for the restaurant industry. We believe over the next 10 years, the
demographics for our two segments are outstanding. There has been a lot
written about the Baby Boomer and 'Generation Y' population waves in the
U.S. over the next few decades. The reality is this is a seismic
economic and social shift that is changing the US retail landscape. It
is well documented that the 'over 50s' crowd controls the vast majority
of wealth in the United States. These 77 million Boomers have the
highest 'food consumed away from home' of any generation in US history.
Following behind them is the eco-boom or Generation 'Y' ' sons and
daughters of the Boomers ' at 60 million strong. They rival the Boomers
in size and, soon, in purchasing clout. The growth in dual-income and
single parent households, combined with the Generation 'Y' trends,
creates compelling opportunity for us in the Wendy's and O'Charley's
restaurant brands. We believe the long-term prospects for the servicing
of these two segments are excellent. The barriers to entry of a single
restaurant unit can be relatively low. However, we believe critical mass
for a multi-unit franchisee to obtain optimal operating leverage is
between $75 - $100 million in sales ($1 billion in sales for a
franchisor). So we find ourselves in a growth industry with relatively
high capital barriers of entry to obtain scale.

TWST: How would you describe the culture you have tried to build at the
company?


Mr. Schermer People are our greatest asset. In this business, it matters
how employees feel because how they feel ends up on the plate. We
operate much differently from the majority of our franchisor and brand
competitors with a de-centralized management structure. This structure
puts much more decision making control in the hands of store management;
then we reward them with performance-based compensation. Recruiting and
retention are paramount to successful growth. Our number one goal is
customer loyalty, number two ' employee loyalty and number three '
shareholder loyalty. We believe customer loyalty is earned by loyal
employees and we do not deserve shareholder loyalty without customer and
employee loyalty.

TWST: What will the expansion program look like in coming years?


Mr. Schermer: We've grown internally due to our strategy, which is a
risk-averse strategy. We would rather grow organically, or internally if
you will, as opposed to going outside and acquiring franchise units,
other Wendy's franchise units in other markets or O'Charley's units in
other markets from O'Charley's corporate. We built and opened a new
Wendy's restaurant on average every eight weeks for the past several
years, until we built out West Michigan with Wendy's. Then we
geographically ran out of trade areas. This led us to start
investigating casual dining opportunities and go through the brand
selection process . Today, we have about 18 months of investment behind
O'Charley's in terms of building infrastructure and hiring and training
employees. There is long lead time, much longer lead time in casual
dining than in QSR, for management training. Today, we are positioned to
roll out a unit every 90 days and would hope to accelerate that growth
once we get a base of nine or 10 units. During 2005, we started taking
advantage of a historically high real estate market for freestanding,
single tenant restaurant properties. The company began selling and
leasing back a tranche of our Wendy's real estate, using proceeds to pay
down long-term debt and build cash reserves for internally funding
O'Charley's growth. We expect sale proceeds to pay down approximately
$13 million in debt and increase cash reserves by $7 million. As a
result, in 2005, we will report a series of one-time debt extinguishment
charges associated with the accelerated debt pay down but also record
long-term deferred gains on our balance sheet which will be accounted
for as a reduction in rent expenses over the lease terms.

TWST: What are the goals that you have set for the company?


Mr. Schermer From a cumulative return to shareholders perspective over
the past six years, we have averaged 44% annual return or 24% compounded
return for our shareholders, which compares favorably in the industry.
We accomplished this through a rollout of Wendy's restaurants, opening a
unit every eight weeks. Today, we have positioned the company to
replicate this growth effort over the next five years with the
O'Charley's restaurants. We expect to maintain and accelerate our sales
growth from 15.8% over the last six years to 15% - 20% over the next
five years. We anticipate the flow-through of sales to cash earnings to
accelerate as O'Charley's is a higher margin business. Therefore, sales
and margins should be increasing as we approach the $90 - $100 million
sales benchmark. Over the next few years, we will be fully expensing new
store openings under the current GAAP rule, which previously allowed
pre-opening costs to be amortized over five to seven years. Investors
looking at us need to 'normalize' the cash earnings to get a fair
picture of a 'go forward' cash earnings model. Future cash earnings
could also get a measurable boost from the newly proposed restaurant
depreciation schedules changing from 39.5 years to 15 years. Two bills
lingering before legislators are looking to apply permanent 15-year
depreciation schedules for new restaurant construction, trimming nearly
25 years from the allowable term, thus reducing taxes payable. If
passed, this will have a very positive cash flow benefit for Meritage as
a high new unit growth franchisee. Another important pending legislation
is a proposal to modify the single business tax (SBT) in the State of
Michigan ' which is a unique tax to Michigan that penalizes labor
intense businesses and new capital investment. The Governor has
presented a proposal that dramatically shifts the SBT burden from an
employee tax to an income tax on corporate profit. We estimate this
would be a tremendous benefit, which would have immediate flow-through
to our bottom line. The proposal also includes incentives to encourage
new development with a personal property tax credit. I hope both of
these proposals will pass this year. What a refreshing, positive change
in the business climate that would be for us after Sarbanes-Oxley.

TWST: What is your view on the franchisor versus franchisee business
model?


Mr. Schermer We have not had the opportunity to speak much with the
investment community short of SEC filings and press releases. We do not
have any analysts who follow our stock. Many investors pass over our
company simply because of our lack of liquidity. I think our stock
trades 1,900 shares per day on the American Stock Exchange. That said, I
hear often two distinct misperceptions about our business. First, the
franchisor versus franchisee business model misconception, and second,
not understanding the imbedded equity value inherent in real estate
development and franchise ownership. First, assuming we are talking
about a quality brand, the average new restaurant unit will earn, inside
of the four walls, between 2 times to 4 times greater cash earnings
(depending on QSR or casual segment) than a franchise fee, which is
typically 4% of sales. Therefore, a franchisor will always earn more
money and create more value for its shareholders owning and operating a
good restaurant than franchising one. The general issues that drive many
companies into franchising typically revolves around limited human
resources, limited financial resources and the desire to achieve brand
scale and a national footprint. Scale creates operating leverage and
benefits all units in a brand, particularly compared to independent
restaurant operators. Second, our multi-segment, multi-concept strategy
decreases commodity and economic risk while increasing growth
opportunities. We selected the best of class brands in two of the
strongest industry segments, which both have innovative and distinctive
menus focused on high quality food. There is inherent leverage in
Meritage by virtue of the size of our shareholder base compared to our
franchisor's shareholder base. Wendy's International will have to build
19 new Wendy's restaurants to equal the value we create in building one
new Wendy's restaurants. In this case, the law of small number rewards
the multi-unit franchisees. We own a retail real estate portfolio that
more closely resembles a restaurant REIT model than a franchisor model
such as Wendy's International that owns 11% of the Wendy's systems' real
estate. We have an inherent leverage from the law of small numbers in
value creation for the shareholder.

TWST: Do you think that investors have a good idea of what you are
trying to accomplish?


Mr. Schermer I was hired as the CEO six years ago; the company has been
public since the mid-1980s. Today, the management of the company owns
43% of the company, and has steadily increased ownership over the years.
We encourage significant ownership by management with a sizable portion
of key employees' net worth invested in this company. We believe this
keeps management focused on the long-term wealth creation and
progressive growth of the business rather than short-term stock
volatility. Management has been consistent long-term buyers. My
philosophy is that the business exists ultimately to pay its
shareholders dividends. Simply stated, that means earn more cash than we
pay out in expenses, then return some money to shareholders and reinvest
some back in the business to grow. With the reduced tax burden for
holders of dividend paying stock, future investors have greater
incentive to buy and hold dividend paying growth stocks than previous
generations of investors. The art of the dividend proposition is to have
both the ability and the willingness to pay dividends. We have just
started paying a cash dividend through the use of special dividends. We
hope that will mature into a regular dividend policy as we achieve
greater scale in the next several years. The willingness is certainly
there as evidenced by management's increasing ownership of the business.

TWST: Are acquisitions likely to play a role in your future growth?


Mr. Schermer First of all, our Board will always strive to maximize
shareholder value. The art of maximizing shareholder value is always up
for debate. Over the past six years, we have followed a strategy which
you could describe as risk-averse by relying solely on internal new unit
growth. We have preferred to build new restaurants rather than acquire
existing restaurant portfolios, which tend to have a lot of deferred cap
ex and varying management cultures. In our business model, when we build
a new freestanding restaurant, we create value or imbedded shareholder
equity, as the industry terms it ' measured in two values; first is the
real estate value and second is the business value created in each new
restaurant unit. In our Wendy's franchise model, we create approximately
$500,000 of real estate value (the difference between wholesale
development cost and retail sales value), and a business value of
approximately $550,000 (5.5 times cash flow after rent). In our
O'Charley's model, we multiply these numbers by two, given the
proportionately larger size of the investment and sales. These imbedded
equity values are not reflected in financial statements and are only
realized by selling the real estate or the business value of a
restaurant unit. Given our current experience in real estate sale-
leasebacks and current market rates for multi-unit franchise
transactions, I believe these values are conservative in today's market.
A sum of the parts valuation suggests our stock trades at a hefty
discount to the underlying intrinsic value of our businesses. As it
relates to acquisitions, we would need to see a clear strategic value or
major real estate opportunity in order to justify an acquisition. TWT:
What are the two or three reasons would you give potential long-term
investors to take a look at Meritage?

Mr. Schermer Why Meritage Hospitality Group? This is a simple business
with relatively few moving parts and long product life cycles. We have a
talented and experienced management team that has proven it can execute
the development and operations of high new unit expansion. Our six-year
cumulative return to shareholders of 44% annually speaks to this. The
restaurant industry is healthy. The QSR and casual dining segments are
outpacing the economy, supported by very strong future demographics. We
have an inherent real estate and business value leverage compared to our
brand franchisors by virtue of the multi-unit franchisee business model
and our real estate ownership. Because of our unique position, being one
of the few multi-unit public franchisees, and possessing the 'best of
class' brands in the two strongest industry segments, the inherent
leverage of our multi-unit franchise model will provide improving
operated margins. We are a hybrid with characteristics of a real estate
REIT and operating characteristics of a de-centralized restaurant
company that has a high likelihood of replicating our historical returns
through price appreciation and yield. This recipe should provide an
interesting dessert for an investor's appetite in the food service
industry.

TWST: Thank you (TJM)


ROBERT E. SCHERMER JR.
 CEO
 Meritage Hospitality Group Inc.
 1971 East Beltline Avenue, NE
 Suite 200
 Grand Rapids, MI 49525
 (616) 776-2600
 (616) 776-2776 ' FAX
 www.meritagehospitality.com

Copyright 2005 The Wall Street Transcript Corporation
All Rights Reserved


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