CKR - Circling the Clouds in a Cessna Citation X

Back on May 3, I posted my concerns about the level of G&A spending at CKR, highlighting the fact that although the company's system-wide store count had declined by 8% since 2002, G&A per store had grown nearly 40%. On May 15, I pointed out that CKR's aggressive capital spending over the past 2 years has not led to incremental returns for shareholders and said that management needed to change its long-term unit growth strategy in order to reverse declining returns. It turns out I am not the only one with these concerns as Ramius LLC (owns 3.6% of CKR's shares) sent a letter today to Andrew Puzder, CEO of CKR, in which it calls for the company to:

1. Significantly Reduce Operating Costs
2. Shrink the Capital Spending Plan to Improve Free Cash Flow

My letter to management, however, would not have been as nice. First, I would have spent more time pointing out that senior management is significantly overpaid. Please refer to my posting from May 12 for more details about my frustration with management's recent bonuses relative to company performance, but I can't help but reiterate the point that in FY08 despite a nearly $600 million decline in the company's market value, the CEO still made $6.2 million (down only slightly from the $6.8 million he made the prior year). The Board pretty much made excuses (they called them material events ) about why CKR did not hit the targeted income for management to receive a bonus so in the end, they received their money while shareholders did not.

More importantly, it would have been easy to show that the company's senior executives fly around the country in a Cessna Citation X. They justify the expense of the plane due to the vast number of restaurants around the country. Not! I can name several restaurant companies that are significantly bigger than CKR and the senior executives fly commercial. As the Ramius letter suggests the company should consolidate its headquarter operations in California. If management did this, I would guess that most of the flights on the Cessna Citation X would stop! The hourly cost of flying a private jet has increased 100% over the past two years and management continues to abuse shareholders money.

Although I agree with all of the initiatives outlined in the letter and think that reducing both operating costs and capital expenditures are necessary to improve operating margins (which fell 170 bps in FY08) and to increase returns on incremental invested capital, I do not think this one letter will spur any immediate changes or even cause management to miss a step as it my understanding that CKR management does not listen to its shareholders. Ramius LLC points to this very point in its letter, saying we have repeatedly stated in conversations with you and with the senior management team, we believe there is currently a substantial opportunity to improve shareholder value at CKE. If management were to get its heads out of the sands, well, then, maybe things would be different...

Significantly Reduce Operating Costs
There is substantial opportunity to drastically reduce overhead costs at CKE. The Company currently operates three headquarter facilities, one of which occupies some of the most valuable real estate in the U.S., west of the Pacific Coast Highway in Carpinteria, California. Two of the three facilities are located less than 100 miles apart. Given the close proximity of the Company's two offices in California, one in Carpinteria and one in Anaheim, it is prudent for CKE to consolidate both offices into a lower cost facility as well as to simultaneously explore the feasibility of combining all locations into one facility. In addition to consolidating offices, there is an opportunity to meaningfully reduce general and administrative expenses ( G&A ) per store. As you can see in the table below, since 2001 the absolute level of G&A has remained almost unchanged yet the store count has been reduced by almost 20%. This has created a substantial increase in G&A per store from $38,400 in 2001 to $46,700 in 2008, an increase of 22%.

The Company was able to maintain a positive trend in lowering G&A in proportion to store count from FY2000 to FY2004 with G&A being reduced by $39.8 million and store count decreasing by 16%. However, since FY2004, while store count dropped by an additional 5%, G&A actually rose by $36.6 million.

From FY2000 to FY2004, the Company on average reduced G&A by $2.5 million for every 1% reduction in store count. The average G&A per store achieved by FY2004 was $33,100. By applying the FY2004 average G&A cost per store to the current store count, excluding any additional necessary public costs such as FAS123, the Company would operate at a G&A of $102.0 million, or $42.1 million lower than the current amount.

Our analysis indicates that CKE's G&A costs as a percentage of total revenues, company owned revenues, and on a per employee basis are out of line with competitors in the QSR industry and clearly demonstrate an opportunity for improvement.

Shrink the Capital Spending Plan to Improve Free Cash Flow
In light of the current economic outlook, the Company's $145 million capital spending plan for FY2009 is too aggressive and unwarranted. The Company is expected to generate $155 million of EBITDA based on analysts' 2009 consensus estimates and has roughly $50 million in annual interest expense and cash taxes, thereby producing $105 million in cash flow from operations excluding working capital adjustments. A capital plan of $145 million would yield a $40 million free cash flow deficit which we believe is unacceptable given the current environment and balance sheet leverage. Furthermore, we fail to see the rationale for such a large capital spending plan since the Company has failed to achieve a measurable increase in returns on investment from past spending.

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