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Tuesday, July 6, 1999

An Investment Opinion
by Warren Gump

A Hardee Proposition?

The up-and-down saga of CKE Restaurants (NYSE: CKR) continues. At this point, unfortunately, the downs seem to be handily outweighing the ups. Like many other companies that rise on high expectations about the future, this October 1997 Daily Double turned into a June 1999 Daily Trouble. Obviously, perceptions about the firm have changed quite drastically in a relatively short period of time. I've always been attracted to beaten down stocks and have been a fan of Hardee's breakfasts for years. For that reason, I decided to once again look over the company after the recent news of disappointing earnings.

The company gained favor in the mid-1990's after William Foley came in and rejuvenated the struggling Carl's Jr. chain. In the spring of 1997, CKE management announced that it was going to acquire long-neglected Hardee's, the nation's fourth largest burger chain. This turnaround would be a much more significant endeavor since Hardee's system-wide sales were almost five times those of Carl's Jr.

At the time the acquisition was announced, it seemed like a stroke of brilliance. Hardee's management had not created a cohesive image and most people didn't think of the chain for anything other than its excellent breakfast menu. Thanks to years of lackluster performance, CKE would be able to scoop up the chain at what seemed like a bargain-basement price. By implementing similar changes used at Carl's Jr., namely operational and marketing savvy, Hardee's could be turned around and CKE shareholders would reap a tidy profit.

To gain more control over the chain, CKE acquired numerous previously franchised Hardee's restaurants, including those of its then-largest franchisee, Advantica Restaurant Group (Nasdaq: DINE). CKE now owns about 50% of the Hardee's chain, up from roughly 25% at the time of the acquisition. This increased ownership was expected to result in increased corporate control, and enable operations to be run more consistently.

After taking the reins of Hardee's, CKE quickly implemented scheduling changes, menu refinement, and better procurement that helped boost restaurant level margins, even as same-store sales continued to decline. It also developed plans to find the best way to revitalize the chain. Test efforts included a dual branding that offered Hardee's breakfast items along with Carl's lunch and dinner menus. Another try was a concept known as Star Hardee's, which offered many of Hardee's traditional items along with charbroiled burgers from Carl Jr.'s menu. Beyond menu changes, the company remodeled these restaurants, added limited table service, and installed all-you-can-drink beverage centers. Based on positive results, the company and franchisees decided to convert everything to Star Hardee's by the end of fiscal 2002.

In the midst of these turnaround efforts, CKE hoped to stem the declining same-store sales that have been battering Hardee's for five years. While cost controls can boost profits, the key to long-term success is the ability to increase sales. As recently as January, the company publicly stated it expected that Hardee's would finally show positive same-store sales in the first quarter of fiscal 2000 (almost two years after taking the helm of the brand). As it turned out, however, sales for the chain actually declined 4.8% during that period. Yikes!

Hoping to put a positive spin on those results, CKE noted that excluding the 557 units acquired from Advantica, Hardee's actually enjoyed positive same-store sales of 0.5%. I don't really think it's fair to exclude 20% of the chain to get an indication of the company's overall health. If we were to do that, perhaps we should also exclude the results from the roughly 325 restaurants converted into Star Hardee's that experienced 8%-10% sales improvements in the first quarter. That would once again put comp-sales well into negative territory. Making the sales struggles more painful for CKE is the fact that it owns all of the former Advantica units.

Certainly, the improvement in sales at the converted Star Hardee's is good news. The strength of that indicator, however, is yet to be seen. One would expect for sales to rise modestly at a restaurant that has been remodeled and supported with a new advertising campaign. A key barometer to measure that success is how well those units perform after the excitement of being new wears off. While it is really too early to get any data on this front, the line in the previous paragraph about sales results in the first quarter isn't all that promising. In January, after only 190 units had been converted to Star Hardee's, the company announced that sales at converted units were averaging "at least 10% above pre-conversion levels." Movement from "at least 10%" down to 8%-10% is not the direction an investor would like to see.

Adding insult to injury, while getting ready to gear up for the big Star Hardee's conversion effort, results at stalwart Carl's Jr. are starting to stumble. Carl Jr.'s 14-quarter streak of comparable sales gains was brought to an end by a 1.3% decline in the quarter that ended in January. That negative trend accelerated in the first quarter of this year, when comp-sales fell 4.8%. On a positive note, Taco Bueno, the company's third (and by far smallest) chain, is still reporting excellent results.

From a financial standpoint, CKE is moderately leveraged with $555 million in debt and $604 million in equity. Earlier this year, the company completed a new refinancing plan that should give it ample capital to proceed with its growth plans over the next couple of years. At an average of $140,000-$150,000, the cost of converting a Hardee's to Star Hardee's starts to add up pretty quickly. Due to these high capital expenditures, the company will likely be challenged to have positive free cash flow in the near term.

Trading at only 11.4 times First Call's fiscal 2000 consensus earnings per share (EPS) estimate of $1.38, CKE might look quite attractive to a value investor. Of course, the caveat is that you need to believe that the company will actually achieve those estimates. From a projected 19% year-over-year EPS decline in Q2, analysts look for a slight increase in Q3 results and a 32% jump in Q4 earnings. Going out further, they see at least 20% improvements every quarter in fiscal 2001.

At the risk of being too conservative, I have to say that I'm quite leery that the company will achieve those expectations. Hardee's problems are still not eradicated and the challenges facing Carl's Jr. will likely stick around given the strong negative trends of the past three quarters. Seeing a sharp, sudden positive change of fortune at these two chains in the next six months would surprise me.

As a consumer who really enjoys Hardee's breakfasts, I hope that CKE does find a way to successfully reinvigorate Hardee's. So far, however, neither the financial performance nor the operational changes at Star Hardee's have really impressed me. Even though CKE looks cheap, I have no desire to plunk my money down into the stock. I want to see solid signs that consumers are once again embracing the Hardee's concept. In addition to improvements in chain-wide comparable sales, I also want to see data showing that converted Star Hardee's units continue to show sales growth after their "honeymoon" reopening periods. Beyond Hardee's, the company will also need to show that it can maintain and expand on the impressive progress made at Carl's Jr. over the past five years. Without those signs, I'm sticking to the sidelines on this stock.

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