Investing in hidden potentialInvesting in hidden potential

Steve

Activist shareholders scour the restaurant market for what they believe are companies that have not reached their full potential and are therefore undervalued.


Sometimes you know their names — William Ackman and Sardar Biglari are two that have grabbed headlines dogging several restaurant concerns over the years — and other times they fly under the radar.


In some cases they decide that management is ineffective at operating the company, and in others they believe there is hidden value on the balance sheet that is not reflected in the stock price. For restaurant companies this latter assessment typically reflects sentiments toward real estate holdings. 


In the mid-2000s there was a wave of activism that forced a number of restaurant managements to rethink their strategies in order to avoid having activists take a position in their companies. One of the most notable brands subjected to the scrutiny of activist investors at that time was Outback Steakhouse. Ultimately, that scrutiny contributed to the company going private in mid-2007.


Today’s activists are hunting for restaurant stocks that have underperformed the market or their competitors where they believe a change in either financial or operating strategies could be catalysts for improved performance. Some have landed on restaurant companies in part because of their strong cash flow and real estate holdings. 


Biglari’s overtures to Cracker Barrel Old Country Store have been well documented. Three other instructive examples are O’Charley’s, Ruby Tuesday and J. Alexander’s, each an established concept in the recession-battered casual-dining segment with substantial real estate holdings. 


O’Charley’s was recently acquired by Fidelity National Financial, headed by William Foley, an industry veteran with a history of buying and improving underperforming brands. Given the sequence of events at O’Charley’s, I can’t help but think its sale was heavily influenced by the outside investors who gained seats on the board several years ago.


Crescendo Partners first announced their investment in O’Charley’s in late 2007. Approximately three years later, Greg Burns, who had been with the company essentially since its inception, first as chief financial officer and then as chief executive, resigned. Within a year, Larry Hyatt, the company’s CFO, resigned. This action was probably not initiated by the investor group, but certainly could have reflected a desire by Hyatt to join a larger, more stable company with stronger sales performance.


In the fall of 2011, the company did a sale/leaseback, demonstrating the underlying value of its assets as well as lowering combined interest and rent expense in a typical financial-
engineering action. Earlier this year the company was sold.


More recently, activist investors have had Ruby Tuesday, where I once served as vice president of finance, in their crosshairs. Becker Drapkin Management and Carlson Capital staked their position by investing in Ruby Tuesday in early 2011 and gained board representation in the middle of that year. 


Since then, the company said it would undertake a sale/leaseback program; the CFO resigned; and Sandy Beall, the founder and CEO, announced his retirement. Soon after, three longtime directors resigned, one of whom, James Haslam, was the lead outside director. The final script has not yet been written for Ruby Tuesday, but additional changes could be in the offing, and if it follows the same path as O’Charley’s, a sale is highly likely.


The third recent example is J. Alexander’s, where the activist Privet Fund announced its investment late last year and earlier this year sought board representation. Although it wasn’t made public at the time, J. Alexander’s had consulted with an investment bank in September 2011 to explore interest by potential acquirers.


At about the same time the company had an initial conversation with Privet, it engaged the investment bank to formally consider strategic alternatives, including the sale of the company. The company successfully rebuffed Privet’s attempt for board representation and agreed to be acquired by Fidelity National Financial, the same firm that bought O’Charley’s earlier this summer. 


J. Alexander’s has long been viewed as an attractive acquisition candidate and was the subject of at least one public overture — O’Charley’s offered to buy the company in 1999, perhaps explaining Fidelity National’s interest — and one other informal inquiry several years ago, of which I am aware.


Privet’s involvement cannot be cited as the reason for the sale of the company because management had been exploring a possible sale before Privet’s position was public. However, one can assume that the sense of urgency to agree to a transaction was much greater than it otherwise would have been.


Activist investors in restaurant stocks have a very good record of being catalysts for change. Those changes have not always been positive in the eyes of senior management, but the impact on shareholders is less obvious.


Outback’s shareholders probably benefited because the company went private shortly before the recession hit full throttle in 2008. But in other cases the change may have been more tumultuous, possibly leading to deteriorating performance prior to the hoped-for improvement.


A company’s value will vary, either in the public market or at the time of sale, depending on where a company is in that process. Good or bad, change is inevitable when activist investors get involved. Managements need to accept that change, and investors need to anticipate it and the impact of any related actions on valuation. 

Steve Rockwell has 30 years of experience in the restaurant industry, including as a restaurant analyst, finance executive, investor and consultant. He is a partner in Results Thru Strategy, a consulting firm based in Charlotte, N.C., and can be reached at [email protected].