An Interesting Income Play – BAB Inc.

BAB Inc. (symbol BABB.ob) is a tiny company whose stock pays a high return with relatively low risk. BAB franchises restaurants under two brands: Big Apple Bagels and My Favorite Muffin. All stores in its system are franchised; none are company owned. The company earns its income from the franchise fees paid by stores, so income goes up and down with sales. So long as the individual franchisees stay in business, BAB will get its fee. This removes most of the ups and downs of the profits at the individual stores from affecting the BAB revenue stream in a major way.

I will get back to describing BAB’s business in a moment, but first, I want to explain the key to the stock. As I write this, BAB is selling for 56 cents. That’s right, it’s another of those penny stocks that I like. BAB pays a regular dividend of 4 cents. In each of the last two years, however, BAB also paid a special dividend of 2 cents. Even if one ignores the special dividend, the rate of return is just over 7%. If the special is repeated this year, the rate of return goes almost to 11%. Even better, a big chunk of the dividend is tax free since it is return of capital. Last year, about 78% was tax free and the remainder was a qualified dividend taxable, at most, at 15%. This is an extraordinarily high return for an income play.

So given the high return, the big question is how likely is it that the dividend can continue. The company has paid dividends at this level for the last three years. Through the recession and the anemic recovery that followed it, BAB has been paying out this dividend. Prior to the recession, the dividend was twice as high. As the economy improves, the profitability of the franchises should also improve. This should give the company more revenue and a better chance to keep the dividend. In short, there seems to be nothing on the horizon that represents a threat to the dividend.

There are two downsides to BAB. First, the spread between the bid and asked is usually large, a problem not uncommon with penny stocks. This could make it hard to get in and out in the short term. In my view, this means that BAB is not a stock to be bought for a short term investment. Buy it only if you want a long or mid-term investment that pays a high return. It is particularly suited to taxable accounts rather than IRA’s because of the tax advantaged structure of the dividend.

Second, BAB is a tiny company and could hit a problem that would affect it severely just due to its small size. That is a risk that cannot be avoided with any small stock.

On the whole, I think this stock is worth purchase for a nice after tax return.

UPDATE: When I first posted this, I failed to mention that the technicals on the stock are quite good as well. We have a golden cross today which is a frequent sign of an impending breakout move. In addition, we have already seen volume today which is ten times the 90 day average volume, another good sign.

DISCLOSURE: I am long BAB. Given the small size of the company, you should satisfy yourself through investigation that it meets your investment criteria.