Value Investors Club / CKE Restaurants (CKR)

Description

CKE Restaurants (NYSE: CKR)
CKE Restaurants (CKR) provides the opportunity to invest in a quality asset rich business with highly capable management at a point in time when the market is inappropriately focused on short-term issues yet the company, the Board, and key franchisees are buying into the long-term opportunity – literally. In the last year:
• the company has bought back over 20% of its fully diluted share count at an average cost 20% above today’s price,
• a key board member’s investment fund has purchased 1.6 million shares at an average price 25% above today’s current price,
• the CEO (who owns over 3% of the company) recently purchased stock in the open market for the first time in years, and
• key franchisees have paid over $50 million to buy in over 100 company-owned units, have agreed to over $20 million in remodeling investment for those units, and have also agreed to commit over $50 million in capital to open over 40 new units in the coming years (total capital commitment from franchisees of close to $120 million and the company is only halfway through its re-franchising efforts).

In total, “insiders” have committed to the company or returned to shareholders $400 million at a point in time when the public markets have chopped almost 40% or $500 million+ off of the market capitalization of the company from June highs (admittedly, this high was attained at a point in time when the consumer was presumably a lot stronger, gas prices were significantly lower, and rumors of a Yum Brand bid for CKR in the high 20s and private equity offers for the company in the low 20s surfaced). As described in detail below, we believe at current levels, an investment in CKR represents very attractive risk/reward with approximately 10% downside and over 50% upside in the next year.

[See earlier CKR VIC posts for a more detailed discussion of the history of the company and CKE’s acquisition of Hardee’s]. CKE Restaurants owns, operates and franchises quick service restaurants under the Carl’s Jr. and Hardee’s brand names. CKR is best known for its Carl’s Jr. restaurants located in the Western US with a concentration in California. Carl’s has distinguished itself through its focus on quality, service and cleanliness and a menu geared toward young hungry men. It’s “$6 service” mantra encompasses this focus and has moved the company away from pure quick service competition on price to more of a fast casual dining experience. CKR has taken the Carl’s strategy to Hardee’s and over the past several years has successfully turned around a brand that was left for dead years ago, augmenting Hardee’s dominant breakfast menu with the traditional Carl’s Thickburger lunch and dinner offerings. We estimate that while the improving Hardee’s represents 60% of the current store base, it currently generates less than 30% of total company operating income.

At today’s prices, CKR trades at approximately 6x forward ev/ebitda (a multiple not seen over a sustained period of time since the company levered up to acquire Hardee’s over eight years ago), approximately 10x pre-expansion free cash flow, and 14x earnings. We consider these prices extremely cheap relative to the long term potential of the company (if the multiple on this year’s ebitda stays constant, even with the re-franchising headwind, we believe ebitda will grow 30% over the next 2 years resulting in 30% share appreciation), to comps (that trade generally three turns above CKR – each turn of next year’s ebitda equates to 23% appreciation), to recent industry strategic deals (typically done at low double-digit ebitda multiples, 9x next years ebitda would equate to $24 per share or 66% upside) and to longer-dated private equity deals (closer to 8x ev/ebitda, which would equate to $21 per share or 45% upside). In the last five months two strategic deals have been announced – DRI’s acquisition of RARE at over 10x forward ebitda and IHOP’s acquisition of APPB for 9x forward ebitda – and Triarc is rumored to be bidding at least 9.5x forward ebitda for Wendy’s. The average multiple of these deals would equate to approximately $25.50 for CKR or 75% above today’s stock price.

Importantly, downside is protected by substantial company-owned real estate on Hardee’s units which if backed out of the current enterprise value, one is paying only 6x next year’s estimated Carl’s ebitda for the entire company’s valuation and paying nothing for the improving Hardee’s operations or growing franchise income stream. The math on the real estate is as follows: the company has about $150 million of land on its books (the vast majority of which is real estate for Hardee’s company-owned units), half of which was appraised at over $200 million over eight years ago when Carl’s levered up to acquired Hardee’s. If one assumes that the land (pro forma for currently re-franchised units) is worth what it was over eight years ago that would equate to $340 million in total land value with no credit given for appreciation over those years or the value of the buildings that CKR owns on top of the real estate. So, essentially the market is valuing Carl’s (one of the industry’s leading QSRs) at three to four and a half multiple turns below its comps and the vastly improved Hardee’s franchise at just the underlying value of owned land. Downside is also protected by insiders that own over 10% of the company and who are incented to maximize shareholder value over time (and have delivered in the past). It is our belief that once the credit markets stabilize and, if the public markets do not recognize the inherent value in the company, the company will explore going private and can be financed in a rational private equity environment at a deal price of over $20 per share. The company generates strong free cash flow, is asset rich and could look to securitize its real estate, restaurant operations, distribution business and franchise income stream.

We believe the stock has been driven to its recent lows as a result of tax loss selling, massive turnover in its shareholder base (in the mid 20s there was a good amount of deal speculation in the stock and once the credit environment changed, those shareholders bailed), and the significant headwinds that have pressured results in 2007 – namely, commodity cost, one time distribution costs (80 bps of headwind in Q1 alone), workers comp settlement (150 bps of headwind in Q2), minimum wage increases as well as the optical headwind of re-franchising which trades higher margin/higher free cash flow converting ebitda (that is less sensitive over the long-term to rising commodity/wage costs) for lower absolute ebitda dollars. For example, 2007 ebitda drops from 175 million in 2006 to 159 million driven by a combination of re-franchising and margin headwinds before growing to $186 million in 2008. Moreover, comps on the Carl’s side have been going against very difficult year over year comps and investors seem worried about the long-term impact of high gas prices on the business (in recent history, we believe high gas prices have actually helped the business as consumers trade down from casual dining to higher end quick service).

On commodity costs, we believe that over the long-term these cost headwinds have proved to be a timing issue rather than a permanent margin compressor. CKR is one of the higher priced quick service operators and generally follows rather than leads the industry in price increases. This year, commodity costs increased precipitously just after CKR took price to offset minimum wage increases. As a result, CKR waited until recent months to take two separate 2% price increases. These price increases have not had an impact on traffic and we believe that commodity costs are more of a timing issue because the company has a history of pricing power that sticks even when commodity costs return to more normal levels. Our channel checks and commentary from the company suggests that just as the current price increases are taking effect, key commodity costs (namely beef and pork) are easing. As a result, we believe CKE will benefit from essentially a 4% comp boost (potentially more as we are not certain when the minimum wage price increase was taken) heading into the end of this year and next year. According to the company, they have not had this sort of pricing tailwind for years. Industry experts and the company have discussed the fact that 2%+ comps generally lead to margin expansion – with a 4% pricing boost heading into next year, commodity cost relief, and the absence of 1x costs margins should logically improve even without giving credit for other strings that the company can pull (discussed below). Indeed, easier comps, rolling price benefits, and easing commodity costs could prove to be a significant catalyst in early 2008. It is worth noting, that the company will also have a significantly lower share count heading into the 4th quarter due to its aggressive repurchase and beginning of next year. We believe the 4th Quarter will show the first indications of this inflection point.

Another catalyst for the stock will be new unit growth. For the first time in years, CKE is growing both its Carl’s and Hardee’s brands, achieving strong returns and doing so through a lower capital intensity model, i.e., greater franchising commitments for new units. This coupled with continued Hardee’s momentum, remodels, dual branding of Mexican concepts within stores (Hardee’s is seeing a 10% lift to same store sales comps with newly dual-branded units), and breakfast and late night growth at Carl’s should help drive the company toward its stated near term goals of $1.6 million+ AUVs (average unit volumes) at Carl’s and $1 million + AUVs at Hardee’s. The company does a very good job of laying out returns for remodels, dual branding, and new units in recent presentations. It is worth noting though that despite the significant improvements made to date at the Hardee’s brand, its average unit volumes ($910K) are still the lowest of peers and its margins still trail Carl’s by five hundred basis points. Closing half of the margin gap between Hardee’s and Carl’s would equate to over 25% of incremental market value. Notably, at 30% of the Hardee’s stores that are above $1 million in AUVs, margins are actually higher than Carl’s peers.

Based on conservative margin relief on commodities, moderate G&A leverage, price increases rolling forward, unit growth expectations, and without giving the company credit for the returns outlined on its significant capital plan for remodels and dual-branding, leads to Carl’s ebitda of $132 million and Hardee’s ebitda of 54 million. 9x Carl’s ebitda and 7.5x Hardee’s ebitda yields a value of approximately $23 per share or 60% above today’s prices. Based on next year’s ebitda, the company is levered at close to 1.75x ebitda (pro forma for share repurchases) while management has been comfortable with 5x leverage as a public company in less certain times. As discussed above, we believe that currently the stock is well protected by a depressed Carl’s Jr. multiple plus the value of the underlying real estate on Hardee’s, but if one assumes that CKE gets minimal margin relief on commodities, no G&A leverage, and only half of price increases roll forward (again without giving the company credit for the returns outlined on its capital plan), at 6x forward ebitda there would only be approximately 10% downside from here.

Catalysts:
• Items the public market focuses on: easing comps, the effects of re-franchising on ebitda almost completely finished by end of 2007 so that absolute ebitda grows again in 2008 and increasing analyst estimates for next year (which are significantly below us on an ebitda and eps basis – a welcome change from CKE’s recent past)
• Operational: Tailwinds of recent price increases, commodity cost relief, Hardee’s continued margin improvement, return to total company new unit growth and benefits of significant capital plan
• Corporate Structure: Significant share repurchase rolling forward and shrinking the capital base and transformation of company model to less capital intensive, higher return franchise model
• Strategic: Private Equity or Strategic Transaction

Catalyst

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			2007	2008
Price:	14.50	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	900	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT