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The Battle with Cracker Barrel Old Country Store, Inc.

Sardar Biglari burst onto the investment scene in 2008 with his successful proxy fight for The Steak n Shake Company. While only 35 years old, he has assembled an outstanding investment record over the past sixteen years that is largely unknown and unappreciated. Biglari Holdings, Inc. (BH): Sardar Biglari - Bet The Jockey is a series of eight articles to investigate Biglari's investment results since inception, the strategies he has used to achieve these results, analyze his concentrated investment decisions and the likelihood that he can achieve outlier status and outperform the market over the long term. Part VI reviews Biglari's highly concentrated investment in Cracker Barrel Old Country Store, Inc. and his battle to join the company's Board of Directors.

Cracker Barrel Old Country Store, Inc (CBRL)

Working as a jobber for his grandfather's oil company in the 1960's, Danny Evins had witnessed the significant changes in the way people traveled, shopped and ate as a result of the new interstate highway system. Started during the Eisenhower administration, the system was a network of limited access freeways, highways and expressways that were originally planned as an important component of the national defense system. It quickly became an integral part of Americans' daily life driven by rising post-war affluence and rapidly expanding highway freight movements.

In 1969, Evins decided to capitalize on the significant traffic flow on the new Tennessee State Route 109 highway and opened the first Cracker Barrel restaurant in his hometown of Lebanon, Tennessee, 40 miles east of Nashville. He called the new store Cracker Barrel as a reference to the old-time country stores where people played checkers atop barrels used to carry crackers and other wares. The first store consisted of a gas station with a combination restaurant and gift shop. While McDonald's had already become entrenched in the highway food market, Evins intended to attract hungry motorists with the appeal of a home-style meal. Before being seated, visitors walked through the "country store" stocked with wares such as rock candy, marmalades and wooden toys. After the meal, a porch lined with rocking chairs awaited weary travelers.

The restaurant was an immediate hit and Evins began building Cracker Barrel stores throughout the region, gradually phasing out gasoline sales. By 1974 he owned a dozen restaurants and within five years of going public in 1981 there were 47 Cracker Barrel restaurants with net sales of $81 million. By the end of fiscal year 1991, Cracker Barrel operated over 100 stores almost all located along the interstate highways of the Southeast and Midwest. By 2001 there were 437 Cracker Barrel locations and today there are 613 company owned stores in 42 states.

On June 3, 2011, Biglari filed an initial statement of ownership with the SEC reporting a 9.7% ownership interest in Cracker Barrel. The 2,236,134 shares had been acquired for a total purchase price of $95,164,081, or an average cost of $42.56 per share. The filing also disclosed that The Lion Fund owned 140,100 shares representing 0.6% ownership stake. Over 90% of Biglari Holdings' investment portfolio was invested in Cracker Barrel.

In a 1965 letter to Buffett Partnership investors, Warren Buffett explained his thoughts on diversification. Buffett said, "We diversify substantially less than most investment operations. We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment. We have to work extremely hard to find just a very few attractive investment situations." From Buffett's perspective, it didn't make sense to put money in his twentieth best idea in the name of diversification.

Biglari was taking Buffett's investment philosophy to an extreme. At the same time, from his position as a business operator, a concentrated investment in a company he knew well, in an industry he understood, didn't look as crazy as if he was the investment manager of a mutual fund. As Biglari pointed out to Emil Lee from the Motley Fool, "Because of my double pronged viewpoint as a businessman and as a investor, I am able to concentrate our capital in a few positions."

Following the disclosure of his ownership stake, Biglari met with management and requested Board seats for himself and Phil Cooley. After numerous discussions the company offered him the opportunity to appoint two new independent directors, subject to qualification under Cracker Barrel's corporate governance guidelines. Biglari declined the offer and continued to push for his own seat. The Board formally declined Biglari's request in July citing significant business and legal concerns over conflicts of interest and governance, as well as uncertainty regarding Biglari's ultimate agenda.

In September 2011, Biglari submitted a formal notice under Cracker Barrel's bylaws to nominate himself to the company's Board of Directors at its upcoming annual meeting in December 2011. In a letter to shareholders, Biglari made his case to join the Board by highlighting three familiar themes. First, while Cracker Barrel represented an outstanding brand, the company had underperformed in recent years. In fiscal year 1998, Cracker Barrel, under its founder Danny Evins, achieved operating income of $164.9 million with 357 stores, or $462,000 of operating income per store. In 2011, Cracker Barrel produced operating income of $167.2 million with 603 stores, or $277,000 of operating income per store. By closing the productivity gap- realizing the additional $185,000 of operating income per store that the company was able to achieve in fiscal 1998- Cracker Barrel's 603 stores would earn an additional $110 million in operating profit.

Second, the company had spent $615 million in capital expenditures over the past seven years including the addition of 99 new restaurants. Net operating income had actually declined by $1.6 million during the period. Biglari felt the company should stop spending capital for new restaurants, focus on improving existing operations and return cash to shareholders through stock repurchases.

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Finally, Biglari believed the principal reason driving the deterioration in unit-level performance was the decline in customer traffic in 25 of the last 28 quarters. In 2005, 1,150 customers, on average, visited a Cracker Barrel restaurant on a daily basis. By 2011, that number had declined to 960, nearly 160 fewer than seven years ago. If management could have maintained traffic/per unit, then there would have been an additional 40 million customer visits per year through out the entire chain. With an average check of $9.22, that would result in an additional $370 million of annual revenue. Biglari felt that driving customer traffic profitably to existing stores and leveraging fixed restaurant-level costs was the best approach to maximize shareholder value.

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Biglari's Buy Analysis

Based upon Biglari's average purchase price of $42.56 for his 9.7% stake, Cracker Barrel's total market capitalization was $972,111,853. Net funded debt totaled $497,992,000 at July 29, 2011, indicating a total enterprise value for the company of $1,470,104,000. An analysis of Cracker Barrel's adjusted free cash flow is detailed below.

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While Cracker Barrel was selling at an 11.5x multiple of existing adjusted free cash flows, Biglari felt that the company's intrinsic value significantly exceeded its current market value. The hidden asset that made Cracker Barrel such a compelling investment opportunity was the significant operating leverage it possessed as a result of its sizable investment in real estate over the years. Unlike many chains that rent their restaurant locations from third party developers, Cracker Barrel owned 404 restaurants free and clear, 85% of which were located on highly desirable interstate freeway locations. Conservatively assuming the typical restaurant was valued at $2,500,000, (for comparative purposes, on July 1, 2009, Cracker Barrel announced the closing of a sale-leaseback transaction on 15 store locations. The transaction produced aggregate gross proceeds of $45.2 million or roughly $3 million per store). Cracker Barrel's real estate represented approximately two-thirds of the company's enterprise value, or $1 billion.

Operating leverage measures a company's fixed versus variable costs. The greater proportion of fixed costs, the greater the operating leverage. Like financial leverage, operating leverage magnifies results, making gains look better and losses look worse. Over the past seven years, the company's operating leverage worked against it as customer traffic declined and operating profits stalled. Biglari realized that even a small improvement in operating results could lead to a meaningful growth in profits. A 10% improvement in operating profit per store would result in an additional $12,500,000 in net profit for the company, an increase of 14.6%. If the company was successful in improving results to 1998 levels, or $462,000 operating profit per store, net profits would increase by $83,500,000, or almost double the current figure. At this level of performance, the company would be selling at a 6.95x multiple of adjusted free cash flows.

Of course the hard part would be improving results.

On December 20, 2011, after a contentious proxy fight, Cracker Barrel announced that Biglari received just 6.6 million votes out of a total 18.9 million votes cast and was denied a seat on the Board. Shareholders did vote against the company's recently instituted shareholders rights plan that effectively limited anyone from acquiring more than 10% of the company's shares.

Biglari's response to the vote was to buy more stock. From January 3-5, 2012, he acquired 417,597 shares at a total cost of $21.2 million. He would continue buying shares over the ensuing six months, raising his stake to 3,869,965 shares at a total cost of $188,177,121, or an average cost per share of $48.63. The Lion Fund continued to hold 140,100 shares at an average cost of $43.28. Biglari now controlled 17.3% of the company.

Cracker Barrel's management earned high marks in their response to Biglari's criticism and his quest for a Board seat. On August 1, 2011, the company named Sandra B. Cochran, the company's current President and Chief Operating Officer, as its new Chief Executive Officer. In November 2011, Cochran unveiled the company's strategic plan for 2012 and beyond focused on six key initiatives designed to capitalize on the brand, accelerate improvements in the business model and maximize shareholder returns. Specifically the six initiatives included:

  • New marketing messaging- a new advertising agency and a new ad campaign.
  • Refined menu and pricing- implement new lunch specials at a $5.99 price point driving customer traffic.
  • Enhanced restaurant operating platform- improve guest satisfaction and enhance speed of service.
  • Innovative tactics driving retail sales growth- introduction of new retail items to drive results.
  • Focused cost reduction- initiatives to capture increased efficiencies in labor and transportation management.
  • Balanced approach to capital allocation- reinvest in the business through prudent new store growth and increase return of capital to shareholders through increased dividend and share repurchase programs.

It appeared the company had taken a page from Biglari's playbook.

Final Analysis

In November 2012, Cracker Barrel shareholders rejected a second proxy bid by Biglari and Phil Cooley to join the Board. They also voted in favor of a poison pill resolution that was adopted in April that basically limited ownership in the company at 20%. Results showed that Biglari was soundly beaten with 70% of voting shares cast for the company's Board nominees, while 65% voted in support of the poison pill rights plan. Given Biglari's 17.5% ownership stake, he was successful in convincing only 13.5% of independent shareholders to support his bid for a Board seat.

Immediately after the vote, the media speculated Biglari might walk away from the fight. On December 18, 2012, he answered that speculation with a Securities and Exchange Commission 13D filing disclosing he had acquired an additional 568,557 Cracker Barrel shares. Biglari Holdings, Inc. now held 4,597,694 shares. Combined with The Lion Fund's 140,100 shares, Biglari now controlled 19.9999% of the company's shares, or just 6 shares shy of the 20% ownership threshold. His total cost of $250.1 million represents an average purchase price per share of $52.79.

Since the announcement of Biglari's ownership stake in June 2011, Cracker Barrel's long time Chief Executive Officer retired and six of the company's nine Directors have moved off the Board. Financial results exceeded analyst's projections and earnings guidance was increased in November 2011, February 2012, May 2012 and February 2013. In April 2012, Cracker Barrel announced a 60% increase in its quarterly dividend (Biglari Holdings will receive $9.2 million in annual dividends on its investment). In addition, Cochran provided earnings guidance targeting annual total shareholder returns of 15%-18%, built on sales growth of 5%, operating income growth of 8%-10% and earnings per share gains of 12%-15%, over the next three years.

More importantly, after seven years of decline, customer traffic trends finally turned positive.

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Cracker Barrel started to unleash the hidden power of its operating leverage in fiscal year 2012 (FYE August 3rd) with sales were up 6%, operating income up 12.2% and net income up 20.9%. The company reported net income of $103.1 million compared to $85.2 million the previous year. Management provided guidance for fiscal year end 2013 calls for adjusted net income to be between $106.5 and $111.3 million.

The $60 Million Decision

In a February 15, 2013, letter to shareholders, Cracker Barrel confirmed that it had attempted to purchase Biglari's stake in the company at current market prices (the closing price on the day of the offer was $65.35). Management explained that, "it was in the best interests of the company for Biglari to exit, avoiding the expense and distraction of a third proxy fight and allowing management to move forward uninterrupted in the fulfillment of its business plans."

To some, the offer may have been tempting. It would allow Biglari to claim victory. He could monetize his $59.5 million in gains and avoid the discount associated with block trades necessary to unwind his investment. It would represent the most significant financial gain of his career.

Steak n Shake's Board of Directors at one time had misjudged Biglari as, "nothing more than a corporate raider, only interested in Steak n Shake to pursue short-term profits at the expense of the company." Cracker Barrel had now misjudged Biglari as well. One day after the offer, Biglari responded, saying he had no interest in exiting his position and reiterated his commitment to own the stock for the long run. From his perspective, the company was in the early innings of a nine inning game with much greater value to be realized.

Less than two weeks later, Cracker Barrel reported second quarter 2013 results that significantly exceeded analyst estimates and management increased earnings guidance for the balance of the year. The stock jumped $5.80 the day of the announcement and trended up another $5.74 to $78.49 as of March 11, 2013. Biglari's gain had now grown to $121.7 million. His decision to hold the stock resulted in a $62.2 million gain for his shareholders in less than four weeks.

Sardar Biglari realized he did not have the financial capacity to make a bid to buy Cracker Barrel as he had with Fremont Michigan InsuraCorp, but he realized that by acquiring a meaningful position to become a dominant shareholder, he would have the power to influence corporate policies and create positive changes. Although Biglari did not win a seat on the Board, he was successful in changing the course of the company's operations in a manner that a passive investor could never realize.

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Source: Biglari Holdings, Inc: Sardar Biglari - Bet The Jockey Part VI