Why Carl’s Jr. is a Bad Investment (Part III: Financials)
Posted By: The Rational Investor
Filed Under: Opinion on April 4, 2010
Now for the most boring but most important metric for deciding if Carl’s is a good investment. I can tell if I want to invest in something within 10 minutes of research by asking 5 questions:
1- Has the business been around more than 10 years?
2- Over the last 10 years has it consistently grown?
3- Over the next 10 years will its strategy and prospects continue to grow the business at the previous 10 years rates?
4- Would I trust the management with my life savings if it meant they would continue their growth rates over the next 10 years?
5- Is the market offering the company at a discount?
I don’t invest in the company unless I’m 90% confident in answering yes to all 5 of those questions. 60% of that confidence comes from looking at their financial sheets (6 minutes). 10% of that confidence comes from thinking about the world economy and its effects on the market they compete in (3 minutes). 30% comes from what I already know about them (i.e. their ads, products, target market, etc.)(1 minute).
This is a very conservative strategy, but it has resulted in an avg return of 10% yearly for me, including dividends, over the last 4 years. Mind you, this is during the Great Recession.
Imagine that you’re Jack looking to trade your aging cow for some food at the market. Three traders approach you. One offers you several wilted plants that are barely sprouting any beans. Even though the beans aren’t in the best shape, you think you’ll be able to fix them so that they grow more beans, hopefully somewhere within the average. In this scenario, buying several bad looking plants is better than buying just one good looking plant. The second offers you a boring looking plant with enough beans to get by with in the future without your cow. The third shows you some magic beans that he claims will grow into giant beanstalks that will offer you more beans than you can possibly imagine.
In terms of what you’re looking for, your best bet is #2. You’ll be fed longer with the stable plant than what your aging cow will last around for. With a bean plant, it is a lot easier to tell which is your best option. You can inspect the details simply with your eyes and everyone’s eyes work about the same if you aren’t blind. When it comes to inspecting the plants that are companies, it’s a bit more complicated. You look for clues in the financial data and try to draw the picture of what that plant looks like now and in the future.
Value
How do you evaluate the price you’re paying for the bean plant with regards to how much it will be able to feed you in the future? Market Cap tells me how much the trader thinks the plant is worth overall. P/E (Price/Earnings) is the trader telling me how many dollars other customers are willing to pay per bean the plant can eventually produce. For the shitty bean plants, this number is usually low because no one likes the current output of beans from these plants and expects the amount of beans they produce to continue to be low or even lower. For the average bean plant an average price of $12-$20 for each future bean. For magic beans, an extraordinary $40+/expected bean is paid out because other buyers are expecting high output from the magic beans in the future. The PEG tells me more about the correlation of the price per expected bean and the expected growth rate expected bean production. I don’t want to get into the boring details, but if this number is one, then the plant is priced correctly. If it’s lower than one, then there may be some value in it. If it’s higher than one, then the buyers may be over paying for it. Again, these are all inspection clues. Finally, and this is a gross oversimplification, the intrinsic value tells me the margin of safety for purchasing this plant/beans now vs sticking around with my cow. The higher this number, the bigger my margin of safety. I typically want this to be 25%+.
Interesting how all logos have the color red with either white and/or yellow
My job is to find a plant that meets the criteria of the average plant and buy it for the price of the shitty one. Starting with P/E, other bean plant buyers are willing to pay $13 for ea. bean Carl’s plant produces and $11 for ea. bean Jack In the Box produces. The expected rate of Jack’s plant’s output is higher than Carl’s which means the PEG will be much lower. Since its cheaper to get a bean out of Jack’s plant and is highly likely to produce faster output in the future compared to Carl’s, this pushes the plant’s PEG to a value of .7. So I get more beans at a better production rate (PE/G) for a better price (lower P/E). Moreover I can give myself a safety net by calculating the discounted cash flows of Carl’s vs. Jack. I have a higher margin of safety if I’m betting Jack over Carl’s.
Better value: Like their menu, you can buy Jack for less than Carl’s.
Profitability & Growth
McDonald's Da Illest Financials
The troubles and costs associated with maintaining the plant should be much less than benefits of getting fed by it. Simply put, costs for generating a bean should be a small fraction of the bean production. This is profit. In the plant world of fast food joints, profit margins are usually razor thin. In the plant world, debt is weeds that attempts to kill your plant. The more debt on a plant, the more likelihood it can die. EPS = Bean production per seed. Rev growth = Total Bean production growth rate.
The McDonald’s plant should be the plant that your plant aspires to be. Carl’s plant has a lot of weeds in comparison to the other plants ( high debt to equity), requires a lot of maintenance (low profit margin) and has a production rate that is all over the place (negative and flat). Jack requires a lot of maintenance, has an average number of weeds, but has a pretty consistent rate of production.
More profitable and more predictable: Jack’s plant is slightly better. It’s easier to predict the bean production rate, it doesnt require as much maintenance as Carl’s plant, and its production rate is more predictable.
Management
Let’s put a microscope on the plant and take a look at it’s eukaryote cell structure. How well are those mfs synhesizing food for the plant? Ok fine I’ll stop the plant analogy since it’s starting to confuse me now.
Click to view a better resolution
Jack’s return on equity is phenomenal compared to Carl’s. The same can be said for its ROIC. Jack doesn’t pay a dividend, which is an ok thing to me as long as it’s keeping that ROE high. Carl’s dividend is laughable and they shouldn’t even be paying one when they can’t turn a profit. Both companies reduced their shares outstanding. This brings more value since it reduces supply. The CGQ is a pct of how well the management has their checks and balances set up. Insider ownership is far greater in Carl’s which means the management are also shareholders.
Winner: Jack’s has a management that has proven to handle shareholder’s investment money better and has better governance set up.
Conclusion
Wendy’s should not buy Carl’s beca…Hey guess what everybody! This entire analysis is out of date! The investors of Aramark foods bought Carl’s instead! Hope you enjoyed my mediocre plant analogy and straightforward analysis though.
About the Author
The Rational Investor whirlwinds through streetverse at a crazy rate. He holds a G.E.D. in Illness.
