Meritage Considers Going Private

July 8, 2005
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GRAND RAPIDS — Citing the high cost of Sarbanes-Oxley compliance, Meritage Hospitality Group’s board of directors has appointed a special committee of independent directors to look at the plausibility of the company going private and the alternatives that move would encompass.

Meritage is the only publicly traded Wendy’s franchisee and O’Charley’s restaurant franchisee in the country. The company has more than 5.3 million common shares outstanding, which are held by approximately 1,200 shareholders.

In the board’s view, the company’s current stock price is not representative of the underlying value and earnings potential, which is often a factor of a smaller listed company like Meritage, said James Saalfeld, Meritage vice president.

The company’s stock was trading at $5.28 on the American Stock Exchange (AMEX) as of Thursday. Saalfeld declined to comment on what the board thinks the stock price should be.

“Secondly is the cost of the new Sarbanes-Oxley Act provisions and what will be the SEC reporting requirements going forward,” Saalfeld said. He said SEC financial reporting is something Meritage has done since its incorporation in 1986 and is not by itself what triggered the review. “It’s things like this Section 404 compliance, which is just an incredibly costly undertaking and it just makes a smaller company like ours question whether the cost that goes into that is going to be returned to shareholders or not.”

Section 404 mandates that public companies evaluate and annually report on the effectiveness of their internal controls over financial reporting and that an independent auditor substantiate the effectiveness. It is intended to strengthen corporate controls to prevent fraud and its negative financial impact on a company.

Large companies with fiscal years ending after Dec. 15, 2004, had to issue their first Section 404 report along with their Form 10K in March.

Small public companies with fiscal years ending after July 15, 2005, must begin issuing a report on the effectiveness of internal controls in every annual report to come. So if a company’s fiscal year ended, say, last month, it has another year before it has to file Section 404 reports.

Meritage has yet to go through the process of preparing a Section 404 report. The company’s fiscal year ends Nov. 27. The company would not have to complete its first Section 404 audit until the end of fiscal 2006.

That’s why they’re looking at the going-private issue now, because they would have to get going on the 404 process later this year and continue through next year, Saalfeld said.

“We’ve had our own estimates done in talking with our auditors and other accounting firms. I don’t have a specific figure, but it would be an extremely costly undertaking,” he said.

“I’d estimate it would increase our current cost for outside auditing fees by at least three times what they currently are, and that doesn’t even factor in the other costs of time and resources it will take internally to go through the process.”

The committee will explore whether delisting from AMEX could maximize shareholder value since the company would no longer have to file financial reports with the Securities and Exchange Commission (SEC) and thus could avoid the costs imposed by Sarbanes-Oxley Section 404 compliance, which the board feels will disproportionately affect smaller publicly traded companies like Meritage.

The special committee also will look at the possibility of delisting from AMEX and relisting Meritage’s common shares on a quotation service such as the Pink Sheets. Companies that list their shares on a quotation service don’t have to be registered with the SEC and have no obligations to file audits or other material information with the SEC.

The special committee may recommend that Meritage retain its public company status, Saalfeld said. He expects the special committee will recommend a course of action within the next two or three months.

In a study published in February, risk and control assessment consultants ARC Morgan mined data from the filings of 280 companies to try to determine just what Sarbanes-Oxley Section 404 compliance was costing them. Some 87 percent of the companies analyzed had annual revenues of less than $2 billion. Meritage reported $53.3 million in sales for fiscal 2004.

The consultants concluded that “Section 404 has cost many companies significantly more than widely anticipated,” and said the study indicated that smaller companies are incurring higher costs than larger companies as a percentage of sales.

“To put an average fee against the dollar value of sales using the $1 million for $1 billion analogy, our findings indicate for smaller companies (less than $2 billion) it is closer to an average cost of $1.8 million for $1 billion in sales,” the consultant reported.

However, they note that the figure does not take into account either the increase in external audit fees or management’s time and internal resource time. When those expenses are factored in, “these numbers will more than likely bring the average cost of first year compliance to around $3 million to $3.2 million per $1 billion in sales for companies with less than $2 billion in sales.”    

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