By Alex Gavrish, Etalon Investment Research; and author of “Wall Street Back To Basics

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Activist hedge fund stake

Many investors follow activist investors and copy them, investing in the same companies. There is even a mutual fund called 13D Activist Fund that offers investors exposure to shareholder activism as an investment strategy. Overall, activist investors’ targets are certainly an interesting niche to focus on where attractive investment opportunities can be found. However, it might be not so easy to replicate activists and achieve similar performance. Even though the interests of activists and other shareholders are aligned, and both have as a main objective to see the value of their investment go up, the field is not without conflicts of interests. An interesting case that illustrates this is a recently-announced activist hedge fund investment in Bob Evans Farms Inc (NASDAQ:BOBE).

On September 24th, Sandell Asset Management filed a 13D form with the SEC disclosing a 5.1% stake in shares of Bob Evans Farms Inc (NASDAQ:BOBE), an owner and operator of a full-service, family-dining restaurant chain under the Bob Evans brand name. Bob Evans Farms Inc (NASDAQ:BOBE) Farms operates 560 restaurants mostly in the Midwest, mid-Atlantic, and Southeast regions in the United States. In addition to restaurants, Bob Evans Farms produces and distributes a line of food products and convenience food items under the Bob Evans Farms Inc (NASDAQ:BOBE), Owens, and Country Creek brand names. Later, the hedge fund firm disclosed that its stake was increased and it presently owns 6.5% of the company’s shares.

Bob Evans Farms: activist proposals

The proposal outlined three ideas for enhancing shareholder value: spin-off or disposal of a packaged foods division, extracting value from company-owned real estate via sale-leaseback transactions, and subsequent repurchase of shares. Spin-off or disposal of a packaged foods operation could unlock value because this business is presently “buried” inside a restaurant company while when valued on its own it can command a higher valuation which would be comparable to other packaged food companies. A sale-leaseback transaction is a “standard” financial transaction which is often implemented by many similar companies and would provide significant proceeds. The transaction would be similar to leveraging a balance sheet by raising additional debt. The share buyback idea probably does not need an explanation – if done at an attractive price, it will increase shareholder value in the long-term.

Share price paid by activist

Based on a reported cost of the position, the hedge fund group paid $47.2 million for its stake, which consists of about 1 million shares and options to acquire an additional 0.39 million shares. The cost of options was not disclosed in the filing. By allocating approximately 10% of the total cost to options, we can calculate the cost of shares to the hedge fund. If about $42.4 million or 90% of the invested amount was put to work through an outright stock holding position, the cost of these shares for hedge fund should be about $42.09 per share. Options have an exercise price of $55 per share and expire in March 2014. In a December 6th 2013 SEC filing the activist hedge fund disclosed that it increased its holding by purchasing an additional 0.336 million shares at an average price of $52.03. Overall, without accounting for shares that might be purchased by exercising option contracts, the fund owns about 1.34 million shares or 5.1% of total shares outstanding with an average cost of $44.57 per share.

Valuation and upside potential

As of January 16th, 2014 close, Bob Evans Farms Inc (NASDAQ:BOBE) had a market capitalization of $1,264 million and an enterprise value of $1,578 million. During the first 6 months of fiscal 2014 (May-October 2013), the company generated $662 million in revenues, operating income of $21 million ($33.4 million if adjusted for impairment of assets held for sale), net income of $14.5 million and an EBITDA of $70 million. On an annualized basis, company share are valued at an EV/EBITDA multiple of x11.2. Reasonable, but not an especially attractive valuation.

Management responded to activists by stating that the company will not undertake pure financial engineering tactics that place the company’s ability to deliver long-term shareholder value at unnecessary risk. The overall response that the company provided to activist proposals seems to be adequate and balanced: the sale-leaseback is a plain financial engineering transaction in which company borrows funds at a specific rate, which, according to the company’s Board, is unattractive compared to other financing options available. In addition to this, such a transaction would put the company in a position where it will have less flexibility to make operational changes. On January 2nd, 2014, the company reported that it entered into a $750 million revolving credit facility which is the less restrictive financing option available and allows the company to borrow funds as required.

Regarding second proposal to sell or spin-off company’s Bob Evans Farms Inc (NASDAQ:BOBE) Foods division, management and board believes that in light of recent investments of more than $100 million in an acquisition and plant expansion, separating its foods business will not allow it to deliver on growth potential and realize synergies of combining restaurant and food businesses and achieve brand enhancement. This seems reasonable as BEF Foods division had an annual revenue of $349 million which is only 26% of the company’s total revenues, so it seems to make more sense to grow this business more before separating it through a spin-off or sale transaction.

Regarding the third proposal to repurchase shares, one can see that Bob Evans Farms repurchased $70 million worth of shares in FY 2012, $63 million in FY 2013 and $75 million so far in first 6 months of FY 2014. Current share authorization provides the possibility to repurchase $150 million worth of shares until the end of FY 2014. One can hardly accuse company that it is not willing to return cash to shareholders. In addition to buybacks, Bob Evans Farms pays a quarterly dividend of $0.31 per share which provides an annual dividend yield of 2.6%.

The company has significant capital investment plans for fiscal 2014 in a range of $175 to $200 million, and later plans to allocate more free cash flow to share repurchases and dividends, and reduce capital expenditures to maintenance levels. In the near future though, the company might be relatively limited in the amount of funds available for return to shareholders. Sandell Asset Management took an extreme step recently and pursued a litigation against Bob Evans Farms Inc (NASDAQ:BOBE) in an attempt to restore rights to shareholders. Regardless of the outcome of litigation it might be indicative that no quick and large returns will be available to shareholders. If an activist hedge fund will be disappointed to hold onto its position and decides to sell its stake, this will put an extra pressure on the company’s share price. Individual investors will probably do better by waiting on the sidelines, at least for the end of fiscal year 2014, or until company executes on its capital expenditures program. Once it is completed, there will be more clarity on the upside potential for long-term, patient investors.