Description

SUMMARY

Anchored by its cash cow, the Carl’s Jr. restaurant brand, CKE Restaurants [NYSE: CKR] is in the middle of a dramatic turnaround of its chronically underperforming Hardee’s restaurant chain. Repeated positive same store sales and average unit volumes that are the highest in over four years have triggered a doubling of the stock from its lows earlier this year; however, I believe the Company is just hitting its stride and free cash flow is just starting to grow. If current trends continue, the stock could at least double from here.


BACKGROUND:

CKE Restaurants is the owner of the Carl’s Jr., Hardee’s, La Salsa Fresh Mexican Grill and Green Burrito restaurant chains – with over 3,200 total restaurants. Carl’s (founded 1956) and Hardee’s (1960) are quick-service restaurant chains primarily focused on burgers, chicken, fries and assorted fast food items. Both restaurants are a hybrid of fast-casual and quick-service and thus provide a higher level of service and higher price-points than McDonald's or Burger King. La Salsa is a Tex-Mex-style chain with 100 units based primarily in strip centers and other non-freestanding locations; and Green Burrito has a similar style, but is primarily co-branded within Carl’s Jr. stores.

UNIT COUNT (AS OF 11/3/03)
Carl’s Jr. Hardee’s La Salsa Other Total
Company - Operated 440 721 60 4 1,225
Franchised 563 1,413 40 17 2,033
Total 1,003 2,134 100 21 3,258

CKE's current CEO took over from a management team that had issued a tremendous amount of debt to acquire the failing Hardee’s chain and hundreds of its franchised restaurants. Over the past three years, current management has sold company-owned Hardee’s and Carl’s restaurants to franchisees, closed underperforming units, turned around the Hardee’s chain, and reduced debt [from over $700 million to under $400 million] by using the proceeds from asset sales and operating free cash flow.

I believe the stock is a great investment for several reasons:

• The stock trades at an EV/EBITDA ratio of 6.9X, a number that I think will go down dramatically over the next few years;
• The stock trades at less than 7X my projected free cash flow for next year – a number that I think may prove very conservative;
• CKE’s assets (land and buildings in prime locations) provide a significant margin of safety should the Hardee’s chain stumble;
• Carl’s Jr., CKE’s cash cow business, is a very successful chain with steady unit and same-store-sales growth, AUVs of about $1.1 million (over $1.3m when co-branded with Green Burrito), and high restaurant level margins of over 21%;
• Hardee’s new Thickburger menu appears to be a hit. I believe that current trends will continue; with the high operating leverage, incremental sales will drive rapid free cash flow growth;
• Management has a track record of over-delivering on its promises;
• Many things can go right that can boost free cash flow, including: lower beef and occupancy costs, continued product introductions, continued savvy advertising, growing recognition of Hardee’s new Thickburger menu, and more co-branded restaurants within Carl’s Jr. chain (and perhaps within the Hardee’s chain as well).
• The target market for both chains, 18-35 year old working males,


THE BRANDS

CARL’S JR.

Carl’s Jr. restaurants are located predominantly in the Western United States. They focus on burgers, chicken and a handful of premium offerings. About 20% of Carl’s Jr. restaurants are dual-branded with Green Burrito, and the company is expanding co-branding where appropriate. Sales come mainly from lunch and dinner (for company-operated restaurants, 88% of revenues come from the lunch and dinner segments).

HARDEE’S

Hardee’s restaurants are located predominantly in the Southeastern and Midwestern United States – offering quality food in generous portions at moderate prices. Historically a breakfast place (44% of revenues), Hardee’s restructured its lunch and dinner menu by cutting over 40 items and refocusing on large Angus beef Thickburgers and chicken sandwiches. (More on “The Hardee’s Revolution” is below.)

LA SALSA

The company acquired La Salsa on March 1, 2002 through the acquisition of the Santa Barbara Restaurant Group, Inc., or SBRG. The 100 restaurants are located mostly in California, and offer quality, fast-casual traditional Mexican food. While the company has focused primarily on turning around Hardee’s, it has also been tweaking the La Salsa menu, its brand and the overall value proposition; management is now preparing it to grow – primarily through franchising.


THE HARDEE’S REVOLUTION

The turnaround of Hardee’s has occurred in two phases. During the first phase started several years ago, the Company converted every Hardee’s to a new Star Hardee’s format; this included new signage, char-broilers (so burgers would be flame grilled, not fried), and a significantly spruced up physical plant that is bright and airy, similar in look and feel to Carl’s. In addition, the company instituted a new QSC (Quality, Service and Cleanliness) program, which it continues to push.

The second phase grew out of two revelations generated by its success with the Carl’s Jr. concept: first, it is impossible and unprofitable to compete with McDonalds and Burger King on price – especially while keeping quality. Second, outside of the West Coast where both Carl’s Jr. and the privately held In N’ Out Burger chain both compete, there was a gaping hole in the market for a thick, high-quality burger in the quick service restaurant (QSR) sector. For meat lovers – a large portion of whom are working males in the 18-35 year age demographic – there was simply no provider of such a quality offering in Hardee’s markets in the Mid-West and Southeast. Quite simply, there was a significant void between the typical QSR burger offering, including Wendy’s, and the Friday’s and Applebee’s fast casual offering.

After extensive research and test marketing, CKE made a bold bet: while they could depend to some degree on the steady cash flows from their successful breakfast menu, they eliminated 40 items from the lunch and dinner menu, which had become a hodgepodge of junk food. The new menu has been built around the “Thickburgers,” which are Angus beef and come in 1/3, ½ and 2/3 pound sizes with all the “fixins,” including fresh tomato, lettuce, etc. The Company launched a test market with over 80 restaurants in the fall of 2002; the initial success spurred a quick vote in early 2003 by franchisees to agree to roll out the new menu to all restaurants within the next year. At this point, 100% of company-owned and 97% of franchised restaurants have the new menu.

In summary, in repositioning Hardee’s and starting the “Revolution,” the company has done the following:

• Renovated and re-branded the Hardee’s stores (completed at all company-owned stores and nearly all franchised units);
• Drastically changed the lunch and dinner menu (done at all company-owned stores and at 97% of franchised restaurants);
• Sold numerous restaurants to franchisees;
• Closed underperforming restaurants;
• Pared debt from well over $700mm two years ago to under $400mm today, including lease obligations;
• Re-focused Hardee’s on food quality, speed and accuracy of service, as well as cleanliness and employee attitude;
• Launched highly successful Hardee’s commercials.

The Hardee’s menu changes or “Revolution” is the crux of this investment thesis. It repositioned the restaurant to bring in people with regular paychecks – young males aged 18-35 – vs. teenagers and the elderly. It is focused on quality and value instead of cheap prices – a battle Hardee’s was losing (and will always lose) to McDonalds and Burger King. In addition, Hardee’s now targets the same demographic as Carl’s Jr. – a demographic that management understands well and knows how to target. Overall, the Hardee’s Revolution is a truly brilliant move that is already paying off in a big way. Take a look at Hardee’s same store sales since last November, which are the highest since 1999:


Hardee’s YTD Period 11 Period 10 Period 9 Period 8
FY 2004 +1.3% +6.4% +5.7% +7.7% +6.5%
FY 2003 -1.6% -5.6% -2.8% -3.6% -4.1%


SCUTTLEBUTT RESEARCH

Back in late January and again in the late spring, a fellow investor and I called over 30 Hardee’s restaurants in six markets, visited two in Omaha, NE and Daytona, FL and spoke with one of their largest franchisees, who owns over 100 restaurants in several markets from Illinois down to Alabama. We heard a very consistent message: that the converted restaurants:

• Experience a brief mild sales decline post-revolution as, for example, patrons who came in for fried chicken discover that Hardee’s doesn’t serve it anymore. Since the average price points are higher, Hardee’s lost many of its most price-sensitive (and least profitable) customers.
• Get very positive feedback and word-of-mouth advertising regarding the new menu.
• Clearly benefit[ed] from a carefully planned marketing campaign that include[d] coupon-ing as well as television advertising.
• Incur modest training costs, hurting margins in the short-term,
• Benefit from a better overall work environment – morale is higher because employees are proud of the food they’re serving, and there’s less menu complexity, resulting in less chaos, fewer errors and less waste;
• Smell much better. For example, customers no longer smell fried chicken as they bite into their burgers, nor do they smell “fast food” on their clothes as they walk out;
• Have significantly higher restaurant level margins – though high beef prices and short-term labor training costs are currently offsetting this benefit; and
• In some areas have 30-40% increases in same-store sales (SSS).


CURRENT STRATEGY

Hardee’s main focus is to build on its current momentum by:

• Increasing the brand profile as the “premium burger destination for the ‘young hungry guy’” – through creative in-store and TV-based advertising;
• Reducing discounting and couponing associated with the new menu;
• Introducing new burger-based combinations – chili burgers, bacon cheeseburgers, bun-free lettuce wrapped burgers [for Atkins dieters], etc. – that will continue to draw attention. In a recent press release, CKE boasted that a Hardee’s manager in the midwest lost 40 pounds in a few months by eating a 2/3 pound Thickburger with bacon every day by taking off the bun!; and
• Continuing to focus on restaurant fundamentals ( “QSC”);


NEW PRODUCTS & ADVERTISING

CKE has done a remarkable job developing new products and advertising them cleverly. Regarding the former, I have never seen a company focus so well on one thing (burgers), yet present it in so many different ways – ways that keep same store comps increasing on a regular basis. In the last few months at Carl’s Jr. alone, the company introduced the Six Dollar Burger (for $3.95), Guacamole Bacon Six Dollar Burger, Western Bacon Six Dollar Burger, Bacon Cheese Six Dollar Burger and Chili Cheese Six Dollar Burger. The latest innovation, wrapping the Hardee’s Thickburger in lettuce rather than a bun, targets the millions of Atkins dieters. The company has won awards for product innovation and I suspect this will continue.

The advertising is outstanding as well, focusing on CKE’s target customer: the hungry working class guy who loves a great burger and is willing and able to pay $3 to $5 for it. CKE faced a tremendous challenge with Hardee’s awful image, and did an unbelievable job re-launching the brand. The Thickburger ads were priceless as they went through three stages – from self-deprecation to outright promotion. In the latest promotion for Carl’s Jr., the company partnered with Hugh Hefner to introduce five new types of Six Dollar Burgers. In it, Hefner talks about his love of variety as he is flanked by a bunch of Playboy Bunnies.


MANAGEMENT

CKR has an incredibly competent senior management team. Andy Puzder, the president and CEO, has been involved with CKR for almost 20 years and combines a methodical and patient nature with a willingness to make big decisions. He has delivered on every promise he has made and, as discussed above, has shown an unusual flair for creative products and advertising. He has also been an intelligent capital allocator.


RESTAURANT METRICS

The following table captures the key operating metrics of Carl’s and Hardee’s. One can easily see the vast difference -- and the benefit to CKE should Hardee’s metrics improve to anything close to Carl’s Jr’s.


General Information Carl’s Jr. Hardee’s
Systemwide Sales (FY 2003) $1.1 billion $1.8 billion
Co. Owned Sales (FY 2003) $507 million $562 million
YTD Co. Owned Sales (40 wks. FY04) $401 million $446 million
Q3 Co. Owned Sales (12 wks. FY04) $121 million (up 6.3%) $140 million (up 6%)
Average Unit Volumes (AUV) $1.16 million (1.3m with G.B.) $761 thousand
Average Guest Check $5.53 (up 7.6% over FY2003) $4.38 (up 9% over FY 2003)
Operating Costs Breakdown et al.
Food and Packaging 28.5% 31.2%
Restaurant Level Margin 21.1% 11.9% (up 50 bps over Q2’04)
Net Franchising Income $17.4 million $25.1 million
Net Change in Co.- Stores vs. YE** 03 1 (10)
Net Change in Franch. Stores vs. YE 03 21 (111)
Net Diff. in Co. Sales vs. Q3-03** $7.1 million (up 6.3%) $7.9 million (up 6.0%)
Net Change in Franch. Fees vs. Q3-03* $5.6 million (up 13.9%) $1.1 million (up 6.9%)
* Franchise fees are based on a % of revenue equivalent to 3.6% for Hardee’s and 3.7% for Carl’s Jr.
* *YE = year-end; Q3-03 = 3rd Quarter of Fiscal 2003. [Fiscal 2003 ended on January 31, 2003.]


FINANCIAL METRICS

Balance Sheet (as of 11/3/03)
Cash $25 million
Bank Debt $0 drawn ($150m 3-yr. revolving credit facility, $25m term loan)
Sr. Subordinated Notes $200 million – 9.125%
Convertible Debt-new $105 million – new convert debt at 4% (convert at $8.89 / share)
Convertible Debt-old $22 million – remaining on old convert offering
Capitalized Leases $67 million
Net Debt $370 million
Market Cap $371 million – 60.5m shares diluted pre convert at $6.13 Enterprise Value $741 million

Other Assets
Land Value at Book $150 million
Net PP&E $553 million
NOL’s - Federal $83.4 million
NOL’s – State $71.5 million

Current Income and Cash Flow Related Numbers

Restaurants have a great deal of operating leverage due to significant fixed costs such as land, building and equipment acquisition costs and maintenance. In addition, a substantial fraction of labor and general occupancy costs are also fixed. The last major cost, food, is largely variable (“food and packaging” equaled about 30% of CKE’s company-operated restaurant revenues last quarter). Thus, over 60% of any same store sales increase drops straight to the (pre-tax) bottom line. First, look at the current business through the end of the 3rd quarter of fiscal 2004:

TTM Ebitda = $107.7 million
Net Debt / Ebitda = 3.4X
EV / TTM Ebitda = 6.9X
Ebitda coverage [over int. exp.] = 2.6X (107.7m/41.6m)
EV / [TTM Ebitda – TTM Capex] = 19.2X (capex has declined dramatically)

While CKE’s stock may not appear to be particularly cheap at first glance, we must make certain assumptions going forward: First, we conservatively assume that neither chain has any net unit decline nor growth; second, we assume that Carl’s same store sales grow by 3% and Hardee’s same store sales grow by 5%. Third, we assume that food and packaging and marginal labor costs are 40% of sales (food and packaging are at 28.5 and 31.2% at Carl’s and Hardee’s respectively. (For both chains, these assumptions are at or below recent levels.) The result would be as follows:

Annualized Q3 FY 2004 Ebitda = $109.9 million
Carl’s Ebitda growth* + $ 9.3 million (add’l co. net of $8.7m + fr. fees of $600k)
Hardee’s Ebitda growth* + $ 18.5 million (add’l co. net of 16.8m + fr. fees of $1.7m)
Next year’s projected Ebitda = $137.7 million
% Ebitda growth = 25.3%
*the Ebitda growth figures are based on a percent of annualized Q3 FY2004 co. sales and franchise royalty revenues respectively.

This Ebitda should translate into $53.7 million of free cash flow, using the following assumptions:

Ebitda = $137.7 million
Subtract: Capex (assuming all maintenance) = ($ 42.0) million (7% over annualized Q3)
Interest payments (estimated) = ($ 38.0) million
Facility Action Charges – cash costs = ($ 3.0) million
Cash Taxes (state and local) = ($ 1.0) million
Free Cash Flow (FCF) = $ 53.7 million

I think it’s reasonable to assume that CKE will use most of this cash flow to retire debt; thus, in one year, net debt could be down under $320 million and the EV (assuming today’s share price) should be approaching $690 million. Thus, future valuation metrics will be as follows:

Future Net Debt / Future Ebitda = 2.3X
Future EV / Future Ebitda = 5.0X
Future EV / Future Ebitda – $42mm capex] = 7.2X
Total Number of Fully Diluted Shares (pre-convert) = 60.5 million
Free cash flow = $53.7 million
Free Cash Flow per Share = $ .89
Current Stock Price = $6.13 (close as of 12.22.03)
Multiple to expected FY 2005 (ending 1/31/05) = 6.9X

UPSIDE POTENTIAL

I believe that a number of factors could drive even better performance for CKE over time:

• Beef costs are at historically very high levels. If they return to more normal levels, Hardee’s and Carl’s would benefit quickly;
• Hardee’s SSS could increase at a faster rate and/or the company could start franchising again;
• Green Burrito could be added to Hardee’s, which would bring AUV’s up substantially;
• La Salsa’s performance could improve and growth in franchises and associated royalties would thus increase.


RISKS

• Hardee’s Thickburger menu could prove to be a flash in the pan and/or competitors could roll out competing products that steal sales;
• The economy could worsen, driving customers to less expensive restaurant chains;
• Beef costs may remain high or go even higher. Based on cattle numbers on farms, the company estimates that prices should come down by summer 2004;
• Insurance, electric and other occupancy costs may continue to rise;
• Franchisee problems, especially at Hardee’s. In the latest 10Q, the company disclosed that a franchisee owning 33 restaurants had filed for chapter 11 bankruptcy protection and had rejected the leases on 15 restaurants that the company had guaranteed. On the recent conference call Puzder stated that the problem stemmed from over-leverage by the franchisee and not from any problems with the store sales levels.

Catalyst

1. Continued success of the Hardee’s revolution: if same store sales continue as they have in the last five periods, then Hardee’s Ebitda and free cash flow will grow dramatically, which would also likely drive multiple expansion;
2. Debt upgrade would lower company’s borrowing costs and thus increase earnings;
3. Buyback of the 9.125% debt and its refinancing at a lower cost of capital;
4. Continued pay-down of debt;
5. Growth at Carl’s and La Salsa.