On June 13th of this year, a form SC-13D was filed with the SEC announcing that successful value investor Sardar Biglari had bought 9.7% of Cracker Barrel Old Country Store, Inc (NASDAQ: CBRL), making his fund the company’s largest shareholder (note, included in the original 9.7% calculation were put options Biglari wrote, which subsequently expired, making his current ownership ~9.3%) .
Two months passed before more details were made public. On August 23rd, Biglari filed an amended SC-13D including an exhibit containing a letter to the CEO of CBRL. In the letter, Biglari accused the company of failing to meet SEC mandates to disclose details about its operating segments (in this case, restaurants and gift shops). Here are some highlights (emphasis added):
I think we have established as fact that you identify the businesses separately, measure them separately, and manage them separately. But you fail in fully reporting them separately. Admittedly, it is conceivable that you just founder in performing a full evaluation of the two segments and thus have failed to report them in accordance with the rule. Doing so would be a sin of bad judgment, bad business, and bad accounting. …
As the largest owner, a professional investor, and an experienced operator, I assure you that disaggregating the financial data of the retail business from the restaurant business is imperative and integral to conducting robust investment analysis. As investors, we must utilize the data concerning the relative profitability of the two operating segments to gain better understanding of the performance of the entire Company and to more accurately estimate its intrinsic value. …
When we spoke on August 10, I said that I would require more details on the retail business, such as its direct labor costs, to gauge its performance. In turn, you offered me the opportunity to review inside information. While I absolutely would need data to evaluate the pair of business segments properly and consequently judge the effectiveness of management, I believe the right thing to do is to treat all shareholders equally. Thus, I declined your offer on the basis that I would possess the same advantage as insiders but leave all other stockholders at an informational disadvantage. Such is not the way we operate and such is not the way we want the management of Cracker Barrel to operate.
In the final analysis, you are either not properly measuring the restaurant and retail businesses, and thus you are not properly managing them, or you are measuring/managing them properly but failing to report both operating segments to your owners.
Subsequent to this letter, Biglari announced he and his right-hand man, Philip Cooley, are seeking a seat on the Board. The company unanimously rejected making these appointments, so he has taken the case to shareholders in a proxy fight (see his activist website EnhanceCrackerBarrel.com) that will not resolve until the annual meeting in December. Additionally, on September 23 the company instituted a poison pill to prevent Biglari from purchasing more than 10% of the company (should anyone purchase more than 10%, the poison pill is enacted, diluting existing shareholders other than the >10% holder). Biglari’s response is here.
Ok, if you’ve read this far, you are up to date with the activity that has been made public to date. From reviewing Biglari’s filings, it seems he made his purchases in the $45 range. On October 4th the stock was trading around $38, or 15% less. I respect Biglari’s investing style and I have followed his moves closely, so when I see an opportunity to buy into one of his targets significantly below his purchase price, I like to take a closer look.
Let’s take a look at CBRL’s historical operating performance.
Cracker Barrel Old Country Store, Inc - Historical Returns, 1998 - 2011
Here we see that the company’s return on equity jumped in 2007 relative to its other metrics which remained in a long-term, relatively lackluster, range in the high single digits. As we’ll see in a second, this is the result not of superior performance (otherwise we would see some improvements across metrics), but rather due to the company’s use of debt to fund share repurchases (increasing leverage and decreasing equity). Here’s the company’s capital structure historically.
Cracker Barrel Old Country Store, Inc - Capital Structure, 1998 - 2011
In 2006, the company took on approximately $700 million more in debt in order to repurchase 16.75 million shares at $42 (as part of its strategic review). This was about 1/3 of the company’s shares outstanding. In 2007, they reduced shares outstanding by another 7.25 million, or 23%.
Cracker Barrel Old Country Store, Inc - Shares Outstanding, 1998 - 2011
What Biglari seems to be pointing out with his activism is that the company’s lack of disclosure about its business segments is indicative of the company’s culture not being focused on the right metrics. In the past, when Biglari has taken over a company he has focused on adding value from improving the operations, not from tinkering with the balance sheet. Here is an important chart:
Cracker Barrel Old Country Store, Inc - Revenues, 1998 - 2011
What this chart shows is that the company’s aggregate revenues from 2003 – 2011 have been relatively flat, rising only 10.7%. Over the same period, the company has increased the number of stores by 25.6%. Translation: sales per store have fallen over the period. Let’s take a look at free cash flows.
Cracker Barrel Old Country Store, Inc - Free Cash Flows, 1998 - 2011
Looking through the company’s historical performance, we see stagnancy and decline. If you look past the balance sheet management, the company has done nothing to improve actual operating performance, with margins essentially holding steady, revenues declining and returns that are mediocre at best. Biglari has successfully turned around several other restaurant businesses and it is clear that he sees the same operational inefficiencies in CBRL that he has seen in his other targets.
Since my portfolio is not large enough to take stakes sufficient in size to push through change, I am left to value companies on the assumption that necessary change will not occur (this is a rebuttable starting point, but there would have to be especially strong evidence to suggest that change was occurring) and so I tend to use a mixture of historical margins an my own estimates based on what management has been doing recently. In valuing CBRL, I started with estimates of growth in store count and then then estimates in the change in sales per store over the next five years. This allowed me to forecast future aggregate revenues, which I used in calculating EBIT (and ultimately free cash flows) using a mixture of average historical margins and estimates of future savings. In CBRL’s case, I find that the company is overvalued at its current price, which as noted above is 15% less than Biglari paid.
Does this mean that Biglari has made a mistake? Certainly not. Biglari is in the enviable position of running a sizable portfolio that affords him the ability to take large positions that demand management action. So Biglari, unlike myself, is capable of forecasting what the company should be capable of doing, and then forcing it to do so. This means his valuations are drastically different from my own; his are based on potential performance, whereas mine are based on actual performance should Biglari be unable to force the change he desires.
For Biglari, it is completely rational to take the approach he has, and I believe it is also completely rational for other small investors (like myself) to avoid a company like CBRL given our inability to force through the necessary changes. For us, an investment hinges on Biglari’s success as an activist, which is simply too great a risk unless the company is undervalued even on historical performance (which is not the case with CBRL).
Lesson? The value of a business depends on who is running the company and the strategy employed. Learn more about this concept in Value: The Four Cornerstones of Corporate Finance (which I reviewed here).
On a side note, I would encourage you to read Sardar Biglari’s shareholder letters. He is clearly brilliant and is the closest to a young Buffett as I have seen.
What do you think of CBRL? Leave your thoughts in the comments below.
Author Disclosure: No position.