Description

CKE Restaurants (CKR): From a recent high of $17.15 down to its current $12.01 price, the opportunity for capital appreciation is greater than ever. Management has a great strategy going forward and many investors simply are missing the longer-term picture by focusing on monthly same store sales data and mad cow scares. For further detail on the basic CKR story, review a previous posting by me dated December 23, 2003 when the stock was at $6.13.

The opportunity for long-term price appreciation are as follows:

- Strength of Carl’s Jr.: Carl’s Jr., the company’s incredibly successful West Coast burger chain continues to turn in great same store sales and provides a great model for Hardee’s. If you allocate general and administrative costs accordingly, Carl’s alone should generate $73mm in pre-tax income and roughly $47.3mm in net income. (The current debt is associated with Hardee’s so we assume no interest expense. Note that the company owns significant real estate under both its Hardee’s and Carl’s Jr. restaurants.) For a restaurant chain of the caliber of Carl’s, we estimate the multiple would be at least 12 times, implying a market cap of $567mm. If you divide by the pre-convert number of shares into the market cap, you arrive at $9.10. If you assign a 15x multiple, a fair multiple when comparing to (CY2005) MCD’s current 16.5x, JBX’s 14.2x, WEN’s 21.5 and YUM’s 18.6x, you arrive at an $11.38 price. In other words, you are essentially getting Hardee’s nearly for free.
- Conversion of Hardee’s into an East Coast version of Carl’s Jr.: There is no question that Hardee’s continues to evolve into Carl’s. This includes look and feel, service levels, menu items, etc. With over $1.2 million of Carl’s Jr.’s $1.4 million AUV coming from lunch and dinner, Hardee’s clearly has major sales expansion possibilities as it currently does only a bit over $500,000 at lunch and dinner.
- Shorter Drive-Thru Times: The company has spent considerable time and effort improving its drive-thru times and order accuracy for both Carl’s and Hardee’s. But we think results could be most dramatic at Hardee’s as the restaurants come off the lower sales base. This may be one of the biggest hidden gems in the story. Increased order accuracy improves the customer experience and trust in the drive-thru. There is no worse PR than individual experiences of people driving away without a coffee stirrer or with pickles on the cheeseburger when you ordered a plain chicken sandwich. But most importantly is time. Lower times per drive-thru order create shorter, faster-moving lines that invite passers-by to get on line and typically spend more. In other words, it has a positive returns effect on sales. How many times have you skipped a line because you saw it was too long? The math is quite attractive for Hardee’s alone:
- Average guest check = $4.70
- Drive-thru = 59% of sales
- Potential time savings – industry rule of thumb is that 10 seconds can create an extra one hour of sales per day (roughly 5% increase). If we extrapolate that:
- Current AUV annualized is about $900,000
- Daily sales = $2,465
- 59% is drive thru = $1455 per day in drive-thru
- Avg. guest check is $4.50
- Number of transactions per day = 323
- Number of transactions per week = 2,261
- A 5% improvement in sales due to improved service = 113 additional customers or $509 per week in additional sales. This translates into an additional $26,477 in annual sales or about a 3% comp comtribution.
- A 5% addition to sales with a 30% cost of food and minimal if any additional operating costs equals an additional $18.534 in profit per restaurant. There currently are 677 company owned and operated stores. This equals additional pre-tax profit of $12.4mm. Of course, a 10% improvement in sales over time would be double the profitability.
- And remember, that I am not giving effect to the typically higher average check nor am I giving effect to the higher sales base that occurs over several years – which creates compounding returns. That is all gravy. But, let’s just say that an average of an extra 20 cents per order is added –as is implied by one study and another $600,000 is added to pre-tax profit
- Here are the effects of service on customer decisions - as per a Starbucks Harvard Business School Case Study from 2003:
- # of visits for an unsatisfied customer = 3.9 times
- # of visits for a satisfied customer = 4.3 times
- # of visits for a highly satisfied customer = 7.2 times
- The average ticket also moves up from $3.88 to $4.06 to $4.42 respectively!
- The average customer life goes from 1.1 years to 4.4 years up to 8.3 years respectively!
- New Menu Items: The Hardee’s menu was gutted when the move to the Carl’s format was initiated a bit over two years ago. Management has been slowly adding back items, including new chicken sandwiches, a pork breakfast biscuit and more expensive milk shakes (coupled with a great ad campaign!). Other future items that will help sales include a line of salads. These items have higher margins and higher price points – contributing more gross margin dollars. These additional menu items are required for Hardee’s to nix the veto vote (wherein one person in a group forces everyone to go to a different restaurant for lack of something she/he likes) and get its average-unit-volumes (AUVs) above $1 million by CY2008 from the current $900,000, which would require 4% same store comps over the next three years. Historically, Hardee’s has done over $1 million AUV’s and its largest franchisee currently generates greater than $1 million AUV’s, though that comes through having more menu items that corporate owned stores do not have at this point. Also, Hardee’s should get a boost to its AUV from replacing its underperforming stores with new stores in better locations.
- Co-branding of Green Burrito with Hardee’s: In the fall, Hardee’s will start testing a Southeastern version of Green Burrito, the successful Tex-Mex restaurant chain that is fully owned and integrated into CKR. The company continues to grow its presence within its Carl Jr.’s restaurants. Known as Red Burrito for Hardee’s, a roll-out to over a half dozen restaurants starts this fall. The success of co-branding at Carl’s Jr. and other chains (Yum! Brands, Baskin Robbins/Dunkin Donuts, etc.) should add value to Hardee’s over the next few years. The AUV’s for dual-branded stores typically are 20% higher than normal company averages.
- Creative advertising and product promotions: The company continues to generate wildly successful PR and product advertising. It is working well toward their efforts to establish Hardee’s as a leading, “cool” burger chain for hungry young males. To see the recent Paris Hilton ads or the recent ad for the new milk shakes, go to www.Hardee’s.com. Make sure to view the spoof that someone else created but the company has posted on their site. It sits right below the Paris ads.
- Solid Management: Let us just say one thing about management. They are very conservative in their management of the business. We have heard several people question whether they are too promotional. Our belief is that management simply is leveraging the free press they are getting as they rebuild the brand. They did not expect special interest groups to create a stir about Paris Hilton in a bikini or the negative health effects of a 1400 calorie Monster burger. Management is solid and intelligently opportunistic and continues to focus on maximizing shareholders’ returns as they continue to de-lever the balance sheet and return excess cash in the form of dividends and share buybacks.
- Store Remodels: Store remodels have tested well and are being rolled out for Carl’s. Hardee’s remodels will start this fall. We estimate that there is a less-than three-year payback on these remodels.
- Growing AUV’s: Annualized AUV’s for Hardee’s now are roughly $900,000 and growing albeit more slowly pending additional product launches. Management successfully has increased these AUVs from roughly $750,000 AUV’s in 2002.
- Return of franchisees: The re-emergence of Hardee’s as a viable brand will foster the return of franchisees. Previous management so alienated past and potential franchisees that the company has only been shrinking the base of franchised restaurants. Now that the menu and system has been revamped and sales are growing, we expect franchisees to start opening a minimum of 30-40 restaurants per year starting in CY2006.

We estimate that despite a recent slowing in growth at Hardee’s, the company is trading at 7.5 times this year’s free cash flow after the cost of a number of remodels – which should be accretive. However, the operating leverage kicks in significantly as AUV’s reach the $1 million mark at Hardee’s. Assuming sales continue to slowly grow at 2% at Carl’s, which they have exceeded for over three years straight, then the company currently is trading at what may be as low as 6.5 times free cash flow on a pre-tax basis two years out. The company has net operating loss carryforwards (NOL) that protect them from taxes for the next several years. On an after-tax basis (which would not kick-in until the 2008 fiscal year at the earliest), this means a multiple of roughly 7.2x free cash flow. However you analyze it, if one assumes that management has the right strategy, this stock is cheap.

For a bit of additional clarity on how to think about this prospect, look at it from this perspective:
- today, the fully diluted market cap is $890mm
- total debt – post conversion is $132mm
- EV – $1.001B
- EV/Free Cash Flow after maintenance capex = 8.5x
- Look forward to January 2007 and think of the valuation:
- Assuming no growth as discussed above, the company will have generated approximately $160-180mm in free cash over the 1.5 year period.
- The new EV will be about $850mm and the EV/FCF will be about 7x
- The new market cap/FCF (assuming the company buys back the equivalent stock and keeps the currently healthy amount of debt) will be about 6x.

Of course, if growth returns – as we think it will – then we are grossly underestimating our figures. A $1mm AUV at Hardee’s means the stock is trading at less than 6x F2008 (which starts less than 1.5 years from now)

In the end, the quick-service restaurant business is a very tough business. It is very execution oriented and you must trust that management is on top of every last detail. We know that management here is doing that. Their methodical approach to raising the service levels at Hardee’s yet another notch before a further rollout of additional menu items will prove prescient and shows their dedication to quality of execution.

What about the Risks?

1. Execution risk at Hardee’s. Management must continue to fill out the menu and drive sales growth without over-reaching and alienating their customer base
2. High Oil Prices (consumer driven)
3. Higher fixed costs – heating costs, etc.
4. Encroachment from MCD, Wendy’s, Burger King

Catalyst

1. The turnaround at Hardee’s continues returning sales to historical levels of over $1mm AUVs
2. The addition of Red Burrito to Hardee’s stores accelerates AUV growth.
3. Sloughing off of under-performing stores and replacing with newer better performing stores will increase AUVs
4. The re-branding effort continues apace
5. Margin growth due to decreasing food costs and operating leverage
6. Resurging sales growth at Hardee’s
7. Return of franchisees
8. Conversion of convertible debt to shares – simplifying the cap structure
9. Associated spike in free cash flow
10. Fulfillment of current share buyback and perhaps an extension of that buyback