Description

Checkers Drive-In Restaurants (CHKR) is a compelling value which is being obscured by the continuing fallout of a turnaround which began in 2000. CHKR trades at 8 times 2003’s depressed earnings and only 4.7 times 2002 FCF.

Checkers is a 1950s-style drive-in restaurant that was founded in 1986 in Mobile, AL. It offers a limited menu (hamburgers, hot dogs, French fries, and old-fashioned milkshakes) and emphasizes quick service and cheap food. Its format is unique in that it is a double drive-in with no inside seating. There is limited outside seating. There are 784 restaurants in the CHKR family, including the namesake restaurants located primarily in the Southeast and the Rally’s chain located primarily in the Midwest; 536 of these are franchisees and 248 are company-owned. CHKR doubled in size in 1999 when it bought Rally’s. This transaction loaded the balance sheet with debt, that, combined with major consolidation and operational issues, nearly caused the company to go bankrupt. Shortly after the purchase of Rally’s, Daniel J. Dorsch, a restaurant entrepreneur, was brought in as Chief Executive Officer & President to turn the franchise around. Dorsch’s vision for repairing the company involved a new emphasis on franchising that enabled him to repair the balance sheet.

Dorsch’s first move in this regard was to sell roughly 170 company-owned restaurants to a few major franchisees. He closed many unprofitable locations and refocused operations on what CHKR does best--getting reasonably priced food to the customer fast. These moves allowed him to reduce long-term debt and capital leases from $80.7 million at the beginning of 2000 to $30.9 million as of the end of fiscal 2002. Revenue has gone from $201 million in 2000 with a store base of 907, to $161 million in 2001 with a store base of 821, to $179 million in 2002 with the current store base of 784. The Company has recorded 11 straight quarters of positive earnings (excluding non-cash items) after accumulating losses for 11 straight quarters.

Cash flow has been so improved that recently CHKR has been buying back select units from franchisees. In 2002 FCF was $14.9 million. The debt/equity ratio at the end of 2002, including capital leases, was 51%, down from 61% in 2001. The strong cash flow has enabled the Company to announce a stock buyback of 1.3 million shares, which is roughly 10% of the 12,305 outstanding shares. Another positive here is tax loss carry forwards; CHKR does not expect to have to pay federal taxes until 2005.

So why, with all of these positive developments, has the stock price declined 60% from its April 2002 high of $14. Other than the obvious general market slide, there have been two primary factors. First, CKE Restaurants, a company which purchased a 10% stake in CHKR in 1996, has been unloading its position. CKE Restaurants sold half of its position in 2002 and has said it is going to sell the remainder as liquidity permits. Liquidity is not good in this name so with the negative general market backdrop and a large committed seller the share prices have been under pressure. The second factor in the declining share price is the distorted GAAP earnings. There have been all kinds of non-cash charges. Most of them recently have been related to the markdown of real estate from restaurant units that have been shut down but not sold. The units had been offered in the marketplace at the prices at which they were carried on the books and they were not selling. Earlier this month CHKR delayed its 4th quarter earnings (the issues included assessing recognition of deferred tax assets as well as a non-cash real estate write-down but were not material). In this environment of corporate malfeasance, just the sniff of impropriety had the expected result on the stock price, causing it to tumble from $6.50 down to $5.00. It has still not recovered despite the fact that earnings were released Thursday and the conference call clarified the issue.

Another important issue in this story is the fast food industry climate as well as competition/comparables. Clearly, the recent industry-wide price wars have made the operating environment tough. CHKR has not been immune. In the conference call Thursday, management lowered 2003 guidance from 80 cents to 65-75 cents (which does not include any share repurchases). But it reiterated several times that this guidance was conservative and included many negative assumptions including that the current price wars would continue. Even at the low end of current conservative guidance, CHKR trades at a forward-looking P/E of 8.2. In this environment CHKR has reduced its unit growth target for 2003 from 25 to 13 to 15. I think this prudence is a positive; but initially the market took it as a negative.

Another challenge for CHKR is the much larger Sonic Burger (SONC). This franchise has the most similar format with a few key differences. Both have no indoor dining; Sonic’s unique feature boasts bell hops delivering the food directly to you in your car instead of utilizing a drive-in. This is obviously a throw-back to the 1950s. Plus, while CHKR aims directly at the value segment, Sonic attempts to differentiate with good food quality and entertainment value. In contrast to CHKR, SONC has been one of the most successful fast food stocks out there in the last 5 years. It has risen almost four-fold, while growing revenues at 20% and aggressively expanding. SONC is a darling of the sector and now trades at 21X trailing earnings and 19X next years earnings. I personally found the product to be similar. CHKR offers slightly lower price while SONC provides broader choice. Both are very quick. I will admit I preferred the bell hop method; but not dramatically.

The key question here is whether SONC, expanding into CHKR’s territory, is going to eat its lunch. The relative pricing (19X versus 8X) suggests the market thinks so. Thus the potential opportunity.

Clearly, the CEO is a believer. He has bought well over 100.000 shares in the last year. He started buying as high as $11 and bought more as recently as 3/11/03.

Catalyst

Catalysts: insider buys; stock buy backs; FCF; Sonic is 3X; no more accounting issues