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Re: Leverage in the Market

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By howardroark
March 20, 2006

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The debt-financed buybacks are the most superficial of all these activities. In most cases the shares are not undervalued enough to satisfy the cost of capital + the risk inherent in the leverage.

Here's my unwarranted and probably ill-directed rant against the recent outbreak of the Liquid Lounge paradigm shift from the meaningful, specific to the vague generality -- excuse the bluntness. Debt-financed buybacks are neither good nor bad, but pundits make them so. I think it's rare time where you can make valuable statements about the attractiveness "most" share repurchases or capital structure decisions, or least the rare person who can review enough of them to come to an opinion worth saying. Corporate leverage is actually fairly tame these days. And for all the press about the second coming of the LBO barons, this ain't quite 1989.

In the spirit of the specific, here's my somewhat under-researched view on original (specific!) question about the soundness of CBRL's recap plan. Here are the details. They're borrowing $800m (with total capacity at $1.25b) senior-secured at LIBOR + 150 termed out seven years. They're using the $800 to Dutch-tender for their stock. And they're going to try to IPO Logan's by the fall. So has CBRL created an unduly risky capital structure that will threaten the stability of employees and scare away future shareholders? I really don't think so.

It's hard to predict what they'll get when they IPO Logan's, but I'm going assume around $300m after-tax. That reduces the amount of debt they're really taking on to $500m, and the interest on that will probably run $30 million or so a year. Obviously growth capex requirement will for the most part leave with Logan's.

So you're left with a stagnating CBRL chain with $200m in existing debt $500m in new debt -- maybe $40-$45m in annual interest expense. Cracker Barrel is running about $250 million in not-exactly-peak EBITDA and probably has around $30m or so in maintenance capex requirements. That's $220m against $40-$45m in interest expense -- you're talking 5-6X covered or 2.8X levered. The business is sputtering, especially the retail stores, but has actually been pretty damn consistent over time. I think don't think EBITDA margins have spent much time south of 10% in the two decades or so they've been public.

The kicker is that they still own over 70% of their 540 CBRL restaurants. What would people say about CBRL's leverage if instead of $700 million in debt, it simply leased all its stores, was debt-free, paid rent but not interest, and EBITDA margins were 8% instead of 10%? It's not quite the same, I admit -- debt matures and can covenant you to death, but when you're termed out seven years at 2.8X in a stable business it's not that different, either. Particularly because owning the real estate allows you to do sale leasebacks if times get volatile and trade your covenants for escalators. With real estate value very likely more than covering debt, the consistency of the business over long periods of time, and the inflow from Logan's conspire to make this a much more tamely leveraged situation than it seems, in my view.

That's doesn't mean that CBRL doesn't go down in a bonfire of the Piccadillies. But if it does, its prospective problems seems at least as likely to be permanent than volatility-driven, in which case the financing won't be the issue. Times are actually pretty crappy for them right now given their intuitively high exposure to gas prices and lower income consumers, neither of which have had the greatest run of things in recent years. Imagine a company like Ryan's hadn't taken on leverage to repurchase stock as it did, while still owning all its land and stores. Without the interest-deduction loophole and some lower cost financing of its real estate, the sub-par returns on its assets would have been even worse. And maybe they wouldn't feel the pressure that they do to finally stop building these $3.5 million boxes and performing endless remodels that are obviously not wanted by the world enough to offer decent returns to the people who are paying for the capital. I don't mean to ignore the many problems of Campeau-esque leverage, like its ability to destroy perfectly good businesses due to a little volatility, create warped incentives in management, and unfairly increase employee instability, but I think it can also be a significant net positive (and not just for shareholders) if balanced fairly. In this case, the plan seems reasonable enough to me.

But if you disagree, I personally think it's a lot more interesting to disagree about Cracker Barrel, than to disagree about 'the Cracker Barrels' of the world.' I don't want to go too far here. Who the hell am I to tell people what to talk about? And I'm usually up for a good 'stocks are too expensive' or 'is the housing bubble caused by the money illusion' conversation myself (if I'm good and liquored up). But man, if it doesn't seem like everyone wants to be an architect instead of a builder these days.


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