By Jeff McConnell | 11-08-99 | 12:00 AM | Email Article
Contrarian investing, by definition, is about going against the crowd, finding beaten-up stocks the rest of the market intensely dislikes and hoping they turn their fortunes. It's a strategy that can be extremely rewarding--to the ego as well as the wallet--when it works. But it can also be a very risky proposition. Many times, the market has good reasons for turning its back on a company.
Jeff McConnell, CFA, is an analyst with Morningstar.com.

CKE Restaurants CKR might be a perfect example. The company owns and operates a variety of restaurant chains, including Carl's Jr., Hardee's, and Taco Bueno. CKE's stock certainly fits the contrarian bill: Over the past year, it's lost about two thirds of its value, and it currently trades at rock-bottom price multiples across the board. That's helped garner the company a valuation grade of A. The company looks good on other measures as well, earning grades of B or better in growth, profitability, and financial health.

But despite its cheap price tag, CKE has provided investors with plenty of reasons to stay away.

The company's strategy had long been to focus on running its flagship (and original) chain, Carl's Jr., and make occasional equity investments in other restaurants. But in 1997, the company decided to take a huge step, purchasing the Hardee's chain. (Because CKE's fiscal year ends in January, the original purchase showed up in its 1998 results.) CKE followed that up by buying Flagstar Enterprises, a huge Hardee's franchiser, in fiscal 1999.

Since then, CKE has focused its energies on turning that struggling chain around, pouring money into Hardee's over the past couple of years. The company's plan is to convert all of its Hardee's reastaurants into so-called "Star Hardee's." The changes--things like remodeling the restaurants and adding limited wait service--will have the effect of making Hardee's look and feel a lot like the company's successful Carl's Jr. chain. (The star refers to the Carl's Jr. logo, which will be featured on the signs of the converted Hardee's restaurants.) To that end, CKE has dramatically upped its capital spending in the past two years. The ambitious plan has also required the company to take on a lot more debt.

That's where the trouble begins. Since the end of CKE's fiscal 1997, the company's long-term debt has skyrocketed, climbing from about $34 million to almost $600 million. And the firm hasn't produced very strong cash flows in the past few years. (CKE's cash flow in 1999 was inflated by a big increase in the company's accounts payable.) Thus, CKE's interest coverage has fallen dramatically, reducing the company's room for error. And that isn't likely to get better anytime soon: As of August 1999 (CKE's second quarter), the firm had converted only 16% of its Hardee's restaurants to the new format.

That combination of a big (and rising) debt burden and slow cash flow should rattle even the most steel-nerved contrarian, especially considering all the spending the firm has planned. CKE has made a huge bet on Hardee's--the chain accounted for 60% of the company's 1999 revenues. Thus, the long-term prospects of this firm hinge on how successful CKE's management is in turning its troubled chain around, and investors in this company must have faith in management's ability to do that.

Unfortunately, some of management's recent activities have cast doubts.

First, Carl Karcher, the company's founder, contributed to the downward pressure on the stock in August when he was forced to sell a bunch of it to meet a margin call. Karcher had been buying CKE stock on margin (meaning he borrowed cash from a brokerage firm to make the purchase), and when the stock continued to fall, the broker called its loan back, forcing Karcher to sell.

The company's follow-up to that bizarre situation was to announce a share repurchase (wherein a firm buys its own stock on the open market), which is normally good news. However, CKE's method of choice was to loan the firm's senior management $10 million, which the executives could then use to buy the shares themselves. That's a questionable tactic, since it's often hard for an outsider to determine the terms of the loan. In addition, in many cases in the past, companies have forgiven such loans when the value of the stock fell.

When shareholders voiced their concerns, CKE rescinded the loan offer and opted for a more-traditional buyback of up to almost 10% of the firm's outstanding shares. Even that seems an odd move, though--this company is hardly flush with cash, and they should be using what they have for restaurant remodeling and debt servicing.

The best contrarian plays are those that have little risk of bankruptcy--companies that the market, for whatever reason, hates but that have the capacity to hang around long enough to turn their fortunes. When the risk of bankruptcy exists, an investor must have a lot of faith in management's capacity to engineer a comeback.

With CKE, the risk of going belly-up is a real one. Should the Hardee's turnaround stall, CKE could be left with a huge debt load and not much in the way of cash flows to meet interest payments. True, if CKE's management is able to revive Hardee's, this will be a very successful investment.

But if they can't, there's a strong possibility of ending up with nothing--and then it won't matter how cheap this stock was when investors bought it.
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Jeff McConnell does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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