Capital Markets

Sale-leaseback Plan Fuels Proxy Fight

Bucking the tide of the credit crunch, Luby's management battles a hedge-fund activist's push to sell off the restaurant chain's real estate.
David KatzJanuary 11, 2008

To own or rent? That’s the question facing the shareholders of Luby’s, a restaurant chain, at their annual meeting on January 15. Ensnarled in a bitterly contested proxy battle, senior management is fiercely resisting an equally fierce campaign by an activist hedge fund, Ramius Capital Group. Ramius’s goal: to get the company to sell all or part of its real estate and then lease it back.

The company says it would rather invest in its future — which includes the addition of 45 to 50 new restaurants to the 128-unit chain — than be saddled with stiff rents. What’s more, if an eatery’s fortunes head south, it could be costly and tough to get out of a lease.

On the rent side of the argument is Ramius, an activist investment adviser managing a $9.6 billion asset portfolio that includes a more than 6.5 percent stake in Luby’s. Ramius has nominated a slate of four board candidates that will pursue at least a partial sale-leaseback strategy. Arguing that the restaurant’s real estate is worth more than the business itself, Jeffrey Smith, Ramius’s managing partner, has called on Luby’s management to use the cash culled from a sale-leaseback to pay for a special dividend and a share buyback.

For its part, Luby’s leadership rejects Smith’s proposals outright, asserting that the company’s board, aided by outside advisers, carefully vetted sale-leaseback arrangements before Smith presented his plan. They have also argued that such a strategy would sacrifice the company’s long-term interests for a short-term gain “We believe that Ramius’s nominees will add nothing to the Luby’s Board, and will act as Ramius’s agents to pursue its misguided plan to sell and leaseback the company’s owned real estate, thereby depleting Luby’s assets and disrupting future profitable growth,” wrote chairman Gasper Mir and president and chief executive officer Christopher Pappas in an open letter to shareholders on January 10.

But in making that case, the company is going against the conventional wisdom about when sale-leasebacks are most desirable. In the currently intensifying credit crunch, it may be better for a company to sell off nonliquid assets like property and focus on its core strengths, says Benjamin Harris, head of U.S. principal investments at W.P. Carey, a firm that provides lease financing for corporations.

In contrast, demand for sale-leasebacks slackens sharply in booms like the one that preceded the current real-estate bust. When high-yield corporate bonds are in demand, share prices are rising, and banks are looking to lend, sale-leasebacks may seem a much less appealing way to raise capital.

Despite fears that property buyers’ appetite for deals might be plummeting, sale-leasebacks appear to be growing. “We’re seeing a big pickup in our volume” of such deals, says Harris, noting that in an economic climate like the present, “more and more companies look at alternative ways to raise capital, and sale-leasebacks are one of the avenues.” There are signs that the growth might be global: in December The Royal Bank of Scotland reportedly embarked on sale-leasebacks involving 62 of its branches.

Besides the allure of ready cash in a downturn, promoters tout the fact that sale-leasebacks give corporations the ability to write off rent as an expense for tax purposes. They also argue that renting can brighten the balance sheets of companies that — as Smith has charged Luby’s with doing — value their property below the price they could get for it in a sale-leaseback. Another selling point, particularly in these perilous times for real estate: they dump the risk of diving property values on to a third party, still permitting the company to control the operating side of its business.

Last summer, when Smith launched his initial move on Luby’s, capital — especially private-equity capital — was abundant. As a result, a sale-leaseback was only one form of funding the activist put on the table. In a July 30, 2007, letter to Luby’s president Pappas, Smith said the company should either put itself on the block or arrange a sale-leaseback on a “substantial” part of the real estate it owns, buy back stock, and issue a special dividend.

Smith said then that after he talked with a number of real estate and sale-leaseback experts, he felt that Luby’s real estate was worth between $206 million and $265 million in a sale-leaseback, before taxes. That represented between 91 percent and 117 percent of the company’s enterprise value, he said last summer.

Since then, Smith seems to have drawn in his sails a bit, no longer talking about an outright sale of the company. Instead of a sale-leaseback on the bulk of the chain’s units, he’s now proposing an assessment of individual units to gauge the appropriateness of a sale-leaseback for each one. (Smith did not respond to repeated requests for an interview for this story.)

In response to Smith’s pronouncements, Luby’s has consistently argued that the cost of rent would be excessive. Another key reason for spurning a big sale-leaseback is that it does not want to be locked into leases if changing conditions dictate that a restaurant should move, Rick Black, the company’s director of investor relations, told Inopportune highway construction, for instance, might make for a significant decline in customers for a certain unit, he suggested.

Since many of Luby’s restaurants are 20 years old or more, such changes might well happen, said Black. In that case, he added, “it’s very hard to get out of a lease — and very expensive.”