Call us old-fashioned, but we have great respect for the way things "ought to be." We believe buying shares of a company makes us part owners of that business. We believe that company management works for -- and should serve the best interests of -- shareholders. At least, that's the way things "ought" to be. And when incumbent management either can't (or won't) create value, we believe shareholders ought to attempt to exercise their rights as owners of the firm and push for change.

When change occurs, sometimes businesses that previously struggled suddenly bloom. Eddie Lampert merged dowdy old Kmart into Sears Holdings (NASDAQ:SHLD) with great success. Kirk Kerkorian tried (and ultimately failed) to do the same at General Motors (NYSE:GM) -- though investors who went along for the ride did all right. Hewlett Packard (NYSE:HPQ) under Carly Fiorina drifted for years before her 2005 ouster -- the stock's doubled since, and the business has revitalized.

Amazingly enough, some managements remain in power even after years of absolutely horrible performance. As we've lamented before, rapid share turnover among mutual funds and institutions means they're more likely to flee than fight. "Entrenched management? Let the next guy deal with it." But the next guy never does, which suits management just fine. In most cases, there's little the individual investor can do. Sometimes, though, an activist shareholder builds a stake significant enough to cause some trouble for management. If they have value creation on their minds, you could be staring at some serious investment gains.

We believe there's an opportunity of this very type with Friendly Ice Cream (AMEX:FRN), one of the first recommendations of our small-cap value service, Hidden Gems Pay Dirt. The people involved are real and fascinating. The drama is genuine, the ultimate outcome unknown. We also believe that investors have a tremendous real-life opportunity of improving value by making the following choice: Do they side with a management that has crushed a beloved brand and hundreds of millions of capital under its stewardship, or do they side with a team claiming dedication to cleaning up the mess?

The battleground
In 1935, brothers Prestley and Curtis Blake founded the original Friendly's ice cream shop in Springfield, Mass. They grew Friendly's from this one sandwich and ice cream joint into a chain of more than 500 outlets in 1979, when the Blakes sold to Hershey (NYSE:HSY) and retired. Hershey ran the chain until 1988, when current chairman/former CEO Donald Smith bought the company in a highly leveraged transaction under the banner of his firm The Restaurant Company (TRC). TRC took Friendly's public in 1997 in part to sell equity to help reduce outstanding debt.

Readers in the northeastern United States undoubtedly have eaten a signature Friendly's sundae or two (we've eaten a few ourselves). Or you've bought their ice cream at your local grocery. If you share the opinion of many of the Fools we've talked to, you probably sound something like this: "Great ice cream, not-so-great food, tired restaurants."

In 2001, McDonald's (NYSE:MCD) shares dropped as the company floundered without a coherent strategy. In just the same way, American icon Denny's (NASDAQ:DENN) went through a near-death experience before its current management team refocused strategy. Friendly's brand has value, in spite of a consistent lack of investment into the product.

Wearing the black hat
Friendly's performance has been dismal for a decade. While the 1997 IPO price was $18, it fell as low as $2 before climbing back to just over $11 at the time of our recommendation. (Woo-hoo! That's negative 5% annually for a decade!) Yet during this decade of value destruction, management -- particularly Smith -- made out quite well. Compensation has not been commensurate with performance. If it had, management would owe shareholders money.

At an operational level, Friendly's board of directors has hamstrung the company through its highly leveraged capital structure, compounded by an ineffective capital investment strategy. As the chart below shows, Friendly's has been dying a death of a thousand cuts:





















Capital Expenditures







Depreciation and Amortization**







Cash Interest







Cash Taxes







Total Cash







Total Debt







Average Interest Rate on Debt







Year-End Store Count







Amounts in millions.
*EBITDA = Earnings before interest taxes depreciation and amortization.
**Attributable solely to capital goods, not including amortization of intangibles.

You can see that revenues are slowly ebbing away. Since 2001, EBITDA has fallen by nearly 25%. At the end of 2006, Friendly's had a market value of $97 million (actual shareholder equity is negative), but also carried over $230 million in debt. Since IPO, Friendly's has spent roughly $237 million on cash interest and $240 million on capital expenditures -- money that's arguably been wasted. Yet Friendly's management bonus plan is based on EBITDA. In other words, their bonuses are paid before considering any progress on debt repayment from a declining profit pool. The progression goes like this: Pay management, then service debt, and shareholders get what's left over. Let's quote these figures again: Market cap of $97 million, $230 million in debt. It's unconscionable that any board would ignore that kind of capital structure and reward management for taking on absurd levels of debt.

But that's not all. Corporate governance at Friendly's has been circumspect. We believe the board has seemed remarkably compliant. So incensed was Prestley Blake that he has pursued legal action against Friendly's and Smith. Before you dismiss Blake as a frustrated former owner who no longer controls his baby, consider that he's filed charges on behalf of Friendly's, meaning that it's the company that will receive any awarded damages. Blake charges that Smith and the Friendly's board breached their fiduciary duty to shareholders and misappropriated corporate assets.

Here's where it gets messy: Through TRC, Chairman Smith also controlled Perkins Family Restaurants -- a notably larger share (around 70%) than of Friendly's (around 9%). Given that Smith stood to benefit more from performance at Perkins rather than Friendly's, Blake asserts that related-party deals were tilted in favor of Perkins. Deals like the disproportionate sharing of a corporate aircraft. Or that Friendly's, with no presence in Illinois, unreasonably shared expenses for Smith's Illinois office when his primary residence was in Chicago (Friendly's is headquartered in Massachusetts). Or that joint food purchases for Friendly's and Perkins resulted in higher costs to Friendly's and were designed to subsidize TRC.

In 2002, a special committee of the board appointed Friendly's general counsel (and former associate general counsel for TRC) to investigate Blake's allegations. The investigator's findings essentially dismissed the allegations. Blake pressed on legally, and last year a judge agreed, throwing out the findings of the so-called "independent" board members on the basis that they were not sufficiently independent. These board members included one former Perkins director and another who'd been invited to consult at Perkins/TRC for a $5,000 daily stipend.

To summarize, we've got an over-leveraged, moribund ice cream restaurant/distributor with a spitting mad founder and management that seems -- at best -- to have failed its obligations to shareholders. Generally, we urge avoiding such a mess. So why are we bringing Friendly's to your attention today? We thought you'd never ask.

And in this corner ...
Meet Sardar Biglari, chairman and CEO of Biglari Capital, general partner of The Lion Fund, and the chairman of Western Sizzlin (OTC BB: WSZL), a chain of steak and buffet restaurants with a stagnant history similar to Friendly's. Similar, that is, until Biglari bought enough shares to get himself onto the board as chairman. Biglari freed the executive management of Western Sizzlin to run the operating business, while he took over capital allocation decisions. And what he did with that capital -- along with some financing and his own money -- was buy just shy of 15% of Friendly's.

It's hard not to make the comparison to Buffett's creeping takeover of Berkshire Hathaway in the 1960s. Biglari's group is now the single largest Friendly's shareholder and, in September 2006, sought board representation, calling for two of its six seats. Friendly's responded, first with a condition-laden offer of one seat, then with an offer for two seats, but with the restriction that Biglari's group would be prohibited from non-board-approved proxy solicitations (making him a "kept man"). Biglari countered acceptance if Friendly's would declassify its board (requiring the entire board be elected annually, rather than the current staggered three-year terms that entrench directors and detract from value). This time, Friendly's balked at the terms.

There's a proxy fight coming, Fools. While there's no apparent connection between Biglari and Blake (who controls about 13.1% of total shares), it's not unreasonable to suggest they have common cause against Smith and the incumbent directors, as do other significant long-term shareholders. At Friendly's upcoming annual meeting, Biglari will run himself and his Western Sizzlin vice chairman, Philip Cooley, against two directors up for election. We think he'll win, and then we can gauge the remaining board members' enthusiasm for working with an activist major shareholder. At the very least, we expect Biglari to fight for his stated goals of revamping the capital structure, franchising out the company-owned stores, and containing costs (including management compensation).

The Foolish bottom line
Having significant investors taking these types of public stands is good for all shareholders (yes, even you, Chairman Smith). Should Biglari's group be successful at gaining board seats, they'll still be in the minority -- at least for a year. Should the existing board resist Biglari's proposed changes, we'd not be surprised by a second proxy fight in 2008 running a second set of alternate directors.

As for us, we're both shareholders of Friendly's. When we receive the appropriate proxy documents from both Friendly's and the Biglari Group in the coming weeks, we'll vote our shares for change that we think will enhance shareholder value. In short, we'll vote for Biglari and Cooley and against any company-proffered slate of directors.

Berkshire Hathaway is a Motley Fool Inside Value recommendation.

Jim Gillies and Bill Mann both own shares of Western Sizzlin and Berkshire Hathaway. Bill also holds shares of McDonald's and Denny's. Jim and Bill also have purchased token shares in Friendly Ice Cream for the purpose of attending the company's upcoming annual meeting. The Motley Fool has given both Jim and Bill permission to buy the shares on the condition that any gains will be donated to charity. The Fool has a disclosure policy.