Don’t believe all the doom and gloom surrounding the restaurant industry. Despite slowing traffic across the industry, one firm is consistently improving profitability and creating shareholder value. Because the company aligns executive compensation with ROIC, we believe this firm can continue to outperform. Cracker Barrel Old Country Store (CBRL: $157/share) is this week’s Long Idea and also on March’s Most Attractive Stocks Model Portfolio.

Cracker Barrel’s Growing Profits

Over the past decade, Cracker Barrel Old Country Store has grown after-tax profit (NOPAT) by 4% compounded annually to $217 million in 2016. NOPAT has increased to $233 million over the last twelve months (TTM). Cracker Barrel’s NOPAT margin has improved from 6% in 2006 to 8% TTM, per Figure 1.

Figure 1: Cracker Barrel’s Profitability Since 2006

Cracker Barrel

Sources: New Constructs, LLC and company filings

In addition to NOPAT growth, Cracker Barrel has generated a cumulative $886 million (23% of market cap) in free cash flow (FCF) over the past five years. Throughout the company’s history it has improved its return on invested capital (ROIC) and currently earns a 14% ROIC. Cracker Barrel’s fundamentals impress across many metrics.

Executive Compensation Plan Is Aligned With Improving ROIC

Cracker Barrel’s executive compensation plan includes base salary, annual bonuses, and long-term stock-based compensation. 50% of long-term stock based compensation is tied to successful achievement of ROIC goals over a two-year performance period. Return on invested capital has been part of CBRL’s executive compensation plan since 2011.

The focus on return on invested capital helps ensure executives continue to be good stewards of capital. Per Figure 2, CBRL’s ROIC has improved from 8% in 2006 to its current 14%. Accordingly, Cracker Barrel has also grown economic earnings from $33 million in 2006 to $145 million in 2016, or 16% compounded annually. Over the last twelve months, economic earnings have increased to $157 million.

Figure 2: Improvements In Cracker Barrel’s ROIC

Cracker Barrel

Sources: New Constructs, LLC and company filings

We know from Figure 3 below that ROIC is directly correlated to changes in shareholder value. CBRL’s use of return on invested capital to measure performance ensures executives’ interests are aligned with shareholders’ interests.

Improving ROIC Correlated With Creating Shareholder Value

Per Figure 3, ROIC explains 83% of the changes in valuation for the 41 restaurant firms we cover. Despite Cracker Barrel’s 14% ROIC, well above the 9% average of the 41 restaurant firms, the firm’s stock trades at a discount to its peers as shown by its position below the trend line in Figure 3. Given the firm’s consistently high ROIC, profit growth and shareholder-friendly executive compensation incentives, one would think the stock would garner a premium valuation.

Figure 3: ROIC Explains 83% Of Valuation for Restaurant Firms

Cracker Barrel

Sources: New Constructs, LLC and company filings

High Profitability Gives Cracker Barrel A Competitive Advantage

In the highly competitive restaurant and retail industries, margins can be razor thin and price is often a firm’s most effective tool to attract customers. As a result, higher ROICs and margins can translate into competitive advantage. Per Figure 4, Cracker Barrel has the highest ROIC and one of the top margins versus peers, which include Denny’s Corporation (DENN), Darden Restaurant’s (DRI) Olive Garden and Longhorn Steakhouse, Red Robin (RRGB), Ruby Tuesday’s (RUBY), and Brinker International’s (EAT) Chili’s Bar and Grill, among others.

High margins allow Cracker Barrel to cut prices and still remain profitable. At the same time, higher margins allow Cracker Barrel to better withstand labor price pressures as minimum wages rise across the country. Less profitable firms face higher margin pressure in this environment and have less operational flexibility and resources to support growth.

Figure 4: Cracker Barrel’s Impressive Profitability

Cracker Barrel

Sources: New Constructs, LLC and company filings.

Bear Concerns Assume Restaurant Industry Is Failing

For years pundits have anointed fast casual restaurants as fast food and casual dining’s biggest competitor and the cause behind poor traffic in traditional restaurants. CBRL bears will tout the growth and success of fast casual dining along with rising labor costs in an effort to discount Cracker Barrel’s future potential. However, the bear case ignores Cracker Barrel’s resilient business model throughout the rise of fast casual and the firm’s prudent cost management.

2016 was reportedly a “bad year” for restaurants, as store traffic was down industry wide and for Cracker Barrel. Unlike the rest of the industry, however, Cracker Barrel has continued to grow sales in this challenging environment. In fact, same store restaurant sales have risen for 11 consecutive quarters. Restaurant sales comprised 80% of revenue in 2016. Same store retail sales, the remaining 20% of revenues, have increased in nine of the past 11 quarters. These sale increases come on the back of rising average check prices, which have grown for 11 consecutive quarters as well. While fewer customers are visiting Cracker Barrel, they’re spending more each time they enter the store.

While sales growth is important, profit growth remains most important to creating shareholder value. Through effective cost management, such as annual cost reduction efforts and process enhancements, Cracker Barrel has consistently improved its profit margins, as noted above. Other firms in the industry, such as prior Danger Zone pick, Zoe’s Kitchen (ZOES), blamed rising wages for slimming margins. ZOES is down 30% while the S&P is up nearly 10% since our report.

Per Figure 5, though, Cracker Barrel’s labor expenses, cost of goods sold, and general and administrative costs have all fallen as a percent of revenue since 2011. Most impressive is Cracker Barrel’s ability to manage labor costs while average hourly earnings in the food services industry are rising. From 2011 to 2016, average hourly earnings rose from $10.74 to $12.75, per the Bureau of Labor Statistics. Meanwhile, CBRL’s labor costs fell from 37% of revenue to 35% of revenue over the same time. Effective cost management enables Cracker Barrel to prosper while other firms fail.

Figure 5: Cracker Barrel’s Prudent Cost Management

Cracker Barrel

Sources: New Constructs, LLC and company filings.

Cracker Barrel’s valuation also undermines the bear arguments. Despite rising sales, margins, and profits, CBRL’s current valuation implies permanent profit decline, as we’ll show below.

Valuation Implies Significant Drop In Profits

CBRL is down 6% year-to-date while the S&P is up 5%, and shares are undervalued. At its current price of $157/share, CBRL has a price-to-economic book value (PEBV) ratio of 0.9. This ratio means the market expects Cracker Barrel’s NOPAT to permanently decline by 10%. This expectation seems rather pessimistic for a firm that has grown NOPAT by 4% compounded annually for the past decade.

If Cracker Barrel can maintain 2016 NOPAT margins of 8% and grow NOPAT by 3% compounded annually for the next decade, the stock is worth $199/share today – a 28% upside. This scenario assumes CBRL can grow revenue by consensus estimates in 2017 (1.5%) and 2018 (4.3%), and 3% each year thereafter. Given the

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