Tuesday, December 13, 2011

An open letter to the CEO of Cracker Barrel

Dear Ms. Cochran,

I am writing in response to your letter dated November 21st 2011 to Cracker Barrel (CBRL) shareholders with respect to the ongoing proxy fight with Mr. Sardar Biglari, Chairman and CEO of Biglari Holdings.

CBRL and new store openings

On pg. 2 of your letter, you write: “Mr. Biglari says we shouldn’t be building new stores and we’re not getting a good return on our investment.”

The first part of your statement is indeed true. Sardar Biglari, in his second letter to CBRL shareholders, asks for a moratorium on new store openings. The second part of your statement, unfortunately, reflects a lack of understanding as to why Biglari wants that moratorium.

The question is not simply whether CBRL is getting a "good return" on investment in new store openings. Rather, it is whether opening new stores represents the best use of CBRL's capital, given the demonstrated and fairly prolonged deterioration in existing unit-level performance?

Given the severity of the deterioration, it is a virtual certainty that fixing the existing units will lead to the greatest increase in value. It is also an extremely reasonable proposition that efforts that are focused only on reviving the existing units are far more likely to succeed than those that are accompanied by the distraction of the effort to concurrently grow in size.

Secondly, as Biglari demonstrates, the market, then and now, is valuing the existing units at a price that is significantly less than the cost of building a new unit. Tack on the risk of execution, and it is clear as daylight that a significant share buyback is, on a risk-adjusted basis, by far the better use of CBRL’s capital when compared to a new store opening.

Indeed, if you are convinced that you can restore CBRL to it’s historical level of unit-level performance, a share buyback is the equivalent of a purchase of a dollar bills for 50 cents. CBRL can’t come close to matching those economics when opening a new store.

Biglari simply makes the rational assessment, based on the current situation at CBRL, that a share buyback is far preferable to a new store opening. Not only that, it is also likely the most optimal use of shareholders’ capital.

Clearly, the idea that Biglari says that CBRL is not getting a “good return” on investment in new stores is a straw man argument. Nevertheless, your response to this straw man argument is also flawed.

Appropriate evaluation of return on investment

While the idea of using return on invested capital (as opposed to simply equity) to determine the economic attractiveness of the investment is sound, using EBITDA in that calculation is not. Warren Buffett, in his 2000 letter to Berkshire shareholders, under the section titled ‘Full and Fair Reporting’ (pg. 17) says: “References to EBITDA make us shudder does management think the tooth fairy pays for capital expenditures?” (emphasis supplied)

CBRL’s pre-tax “owner’s earnings” on these new stores is EBITDA less an amount that fairly represents the amount of maintenance capital expenditures that need to be spent on those stores in order to maintain today’s level of sales. Those numbers, which will necessarily lead to a return on capital numbers lower than those you cited, will be a far more accurate representation of the returns that CBRL is achieving on those new stores. This Yogi Berra quote seems appropriate in the context of your calculation: “If you don’t know where you are going, you might not get there.”

Share repurchases

On pg. 2, somewhat incongruously under “Here is what we’re currently seeing”, you mention a “balanced approach to capital allocation” that includes increased return of capital to shareholders via, amongst other things, share repurchases.

In your most recent 10-K filed September 27th 2011, the section talking about share repurchases (pg. 58) states: “In 2011 and 2010, the Company was authorized to repurchase shares to offset share dilution that results from the issuance of shares under its equity compensation plans.(emphasis supplied)

This is not a repurchase that is a return of capital to shareholders. It is, quite simply, a mechanism to hide what was earlier taken away from them.

Intriguingly, on pg. 34 of the 10-K, the language for share repurchases for 2012 has changed. It reads: “Additionally, subject to a maximum amount of $65,000, we have been authorized by our Board of Directors to repurchase shares during 2012 at the discretion of management.(emphasis supplied)

What are the odds that the change in language was precipitated by Biglari’s raising the issue of your options dilution hiding program, that was masquerading as a share repurchase program, as a serious concern in your initial discussions with him? Quite high, in my opinion.

Unfortunately, whilst that language changed, the criterion for repurchases, that they “be accretive to expected net income per share” is extraordinarily poor. It shows a serious lack of understanding as to how share repurchases add value to the shareholders that choose to hold on to their shares. If the value of the shares in relation to the price paid is not important when making the decision to repurchase shares, then what is?

Earnings guidance

In fact, the emphasis you lay on the impact of repurchases on “expected net income per share” is enough grounds for CBRL to put an end to the misguided practice of earnings guidance. The practice may please some analysts, but it does nothing for long-term shareholders. Indeed, it detracts, perhaps significantly, from long-term value creation.

Biglari on CBRL's board

Commenting on Biglari's second letter to CBRL shareholders, you write:” Indeed, in my view, his recent 11-page manifesto of all-things wrong with Cracker Barrel dating back to 2000 is both misdirected and misinformed.”

Au contraire, Biglari’s missive is based on facts and sound logic, qualities that would be a welcome addition to CBRL’s board. You may not want Biglari on the Board, but it’s plainly clear that CBRL’s shareholders need him on it.


Ragupati Chandrasekaran