Thoughts on value investing and related matters

An open letter to the CEO of Cracker Barrel

2011-12-13T23:44:00.004+05:30

Dear Ms. Cochran,

I am writing in response to your letter dated November 21^st 2011 to Cracker Barrel (CBRL) shareholders with respect to the ongoing proxy fight with Mr. Sardar Biglari, Chairman and CEO of Biglari Holdings.

CBRL and new store openings

On pg. 2 of your letter, you write: “Mr. Biglari says we shouldn’t be building new stores and we’re not getting a good return on our investment.”

The first part of your statement is indeed true. Sardar Biglari, in his second letter to CBRL shareholders, asks for a moratorium on new store openings. The second part of your statement, unfortunately, reflects a lack of understanding as to why Biglari wants that moratorium.

The question is not simply whether CBRL is getting a "good return" on investment in new store openings. Rather, it is whether opening new stores represents the best use of CBRL's capital, given the demonstrated and fairly prolonged deterioration in existing unit-level performance?

Given the severity of the deterioration, it is a virtual certainty that fixing the existing units will lead to the greatest increase in value. It is also an extremely reasonable proposition that efforts that are focused only on reviving the existing units are far more likely to succeed than those that are accompanied by the distraction of the effort to concurrently grow in size.

Secondly, as Biglari demonstrates, the market, then and now, is valuing the existing units at a price that is significantly less than the cost of building a new unit. Tack on the risk of execution, and it is clear as daylight that a significant share buyback is, on a risk-adjusted basis, by far the better use of CBRL’s capital when compared to a new store opening.

Indeed, if you are convinced that you can restore CBRL to it’s historical level of unit-level performance, a share buyback is the equivalent of a purchase of a dollar bills for 50 cents. CBRL can’t come close to matching those economics when opening a new store.

Biglari simply makes the rational assessment, based on the current situation at CBRL, that a share buyback is far preferable to a new store opening. Not only that, it is also likely the most optimal use of shareholders’ capital.

Clearly, the idea that Biglari says that CBRL is not getting a “good return” on investment in new stores is a straw man argument. Nevertheless, your response to this straw man argument is also flawed.

Appropriate evaluation of return on investment

While the idea of using return on invested capital (as opposed to simply equity) to determine the economic attractiveness of the investment is sound, using EBITDA in that calculation is not. Warren Buffett, in his 2000 letter to Berkshire shareholders, under the section titled ‘Full and Fair Reporting’ (pg. 17) says: “References to EBITDA make us shudder does management think the tooth fairy pays for capital expenditures?” (emphasis supplied)

CBRL’s pre-tax “owner’s earnings” on these new stores is EBITDA less an amount that fairly represents the amount of maintenance capital expenditures that need to be spent on those stores in order to maintain today’s level of sales. Those numbers, which will necessarily lead to a return on capital numbers lower than those you cited, will be a far more accurate representation of the returns that CBRL is achieving on those new stores. This Yogi Berra quote seems appropriate in the context of your calculation: “If you don’t know where you are going, you might not get there.”

Share repurchases

On pg. 2, somewhat incongruously under “Here is what we’re currently seeing”, you mention a “balanced approach to capital allocation” that includes increased return of capital to shareholders via, amongst other things, share repurchases.

In your most recent 10-K filed September 27^th 2011, the section talking about share repurchases (pg. 58) states: “In 2011 and 2010, the Company was authorized to repurchase shares to offset share dilution that results from the issuance of shares under its equity compensation plans.” (emphasis supplied)

This is not a repurchase that is a return of capital to shareholders. It is, quite simply, a mechanism to hide what was earlier taken away from them.

Intriguingly, on pg. 34 of the 10-K, the language for share repurchases for 2012 has changed. It reads: “Additionally, subject to a maximum amount of $65,000, we have been authorized by our Board of Directors to repurchase shares during 2012 at the discretion of management.” (emphasis supplied)

What are the odds that the change in language was precipitated by Biglari’s raising the issue of your options dilution hiding program, that was masquerading as a share repurchase program, as a serious concern in your initial discussions with him? Quite high, in my opinion.

Unfortunately, whilst that language changed, the criterion for repurchases, that they “be accretive to expected net income per share” is extraordinarily poor. It shows a serious lack of understanding as to how share repurchases add value to the shareholders that choose to hold on to their shares. If the value of the shares in relation to the price paid is not important when making the decision to repurchase shares, then what is?

Earnings guidance

In fact, the emphasis you lay on the impact of repurchases on “expected net income per share” is enough grounds for CBRL to put an end to the misguided practice of earnings guidance. The practice may please some analysts, but it does nothing for long-term shareholders. Indeed, it detracts, perhaps significantly, from long-term value creation.

Biglari on CBRL's board

Commenting on Biglari's second letter to CBRL shareholders, you write:” Indeed, in my view, his recent 11-page manifesto of all-things wrong with Cracker Barrel dating back to 2000 is both misdirected and misinformed.”

Au contraire, Biglari’s missive is based on facts and sound logic, qualities that would be a welcome addition to CBRL’s board. You may not want Biglari on the Board, but it’s plainly clear that CBRL’s shareholders need him on it.

Sincerely,

Ragupati Chandrasekaran

Investment background and philosophy

2011-11-01T21:55:00.007+05:30

The curtains were drawn on CGI's subscription business earlier in the year. In the spirit of reaching out to like-minded people, I'd like to post here a link to an interview of mine from last year that I did with my then-colleague Jeff Annello which goes into a fair amount of detail about my investment background and philosophy.

Many thanks to Jeff for making me think harder about certain things with his questions and for all of the patience during the multiple back-and-forth's! Not liking a career in software much, reading "The Intelligent Investor" on a friend's recommendation, having it change my life forever and more right here.

If this strikes a chord with you, and you'd like to talk, please email me.

Ragu

Thoughts on Gwalior Chemicals

2009-11-06T17:58:00.005+05:30

Gwalior Chemicals is an interesting special situation. Please see Ninad Kunder’s excellent blog for background.

Brief recap: The company entered into an agreement to sell their chemical business, on a cash and debt-free basis, to Lanxess in June, with the equity being valued at Rs.380 crores. The plan for the cash from the sale:

Consider a buy-back/dividend/some combination thereof for Rs.100 crores

Investment in a new power generation business and a specialty chemicals business. The company retained one plant in Ankleshwar for the latter.

The company announced on September 1, 2009 that the deal to sell the chemical business was completed. The company’s shares closed at Rs.96/share the day after this announcement. At that time, the company had a total of 246.8 lakh shares outstanding, with pre-tax cash from the deal worth Rs.380 crores (approx Rs. 154/share). Intriguing situation with what seemed like a fairly short-term and highly likely catalyst with a reasonable margin of safety.

Fast forward a couple of months. After a postponement or two of the board meeting to consider the dividend/buy-back, we finally got an announcement. No one-time dividend, which is a good thing as far as I am concerned. The buy-back, however, would be restricted to Rs.48.6 crores (because of legal restrictions that don’t permit the buy-back of more than 25% of the paid-up equity capital and free reserves of a company in any single financial year) for 40.5 lakh shares at Rs. 120/share. From talking to investor relations at the company, I gathered (since we don’t typically get a balance sheet every quarter down here) that the company’s cash receipt from the sale post-tax would be Rs.350 crores and that management would be tendering their shares as part of the buy-back offer so as to keep their percentage holdings the same post buy-back. Also, it turned out that a pre-tax amount of Rs.61.89 crores was being held in escrow subject to fulfillment of certain business targets as part of the Lanxess acquisition.

Given all of this, let’s take a look at some math here:

Public shareholdings: 98.8 lakhs (40%)

Promoter shareholdings: 148 lakhs (60%)

Assuming that management tenders enough shares to keep their percentage holding in the company the same, these are the likely numbers post buy-back:

Public shareholdings: 82.5 lakhs

Promoter shareholdings: 123.7 lakhs

So, the minimum percentage of public shares that are likely to be accepted in the buy-back (under the assumption that every shareholder tenders all of his/her shares) is 16.5% (16.3 lakh shares out of a possible 98.8 lakhs).

Optimistic and pessimistic scenarios re. the escrow amount, post buy-back:

The company receives all of the money that’s currently in escrow. This means that the company will have cash of Rs.301.4 crores and 206.3 lakh shares outstanding with a cash/share value of approximately Rs.146.

The company does not receive any of the money that’s currently in escrow. This means that the company will have cash of Rs.239.5 crores post buy-back (ignoring taxes on the escrow amount, the inclusion of which will increase the cash amount) for a cash/share value of approximately Rs.116.

Also, the company has no business operations at this point, with just land and buildings for the proposed specialty chemicals business at Ankleshwar. I don’t have a handle on what these might be worth, so consider this value an additional margin of safety.

The company’s shares closed today at Rs.90.4/share. In other words, an investor can buy a 1000 shares today for Rs.90,400. When the tender offer commences, he is guaranteed to have 165 shares redeemed by the company at Rs.120/share for a pre-tax gain of 32.7%, with the rest of the shares retaining a cash value of Rs.116/share under the pessimistic scenario outlined above.

Some quick math on what staff expenses might be under current conditions:

Staff cost for the quarter ended September 30, 2009: Rs.241.9 lakhs (2 months of operations before business was sold)

Staff cost for the quarter ended June 30,2009: Rs.304 lakhs, indicating a normal business staff cost of Rs.101.3 lakhs/month.

So, an estimate of current staff costs works out to Rs. 39.3 lakhs on a monthly basis. This costs approximately .19Rs/share post buy-back. Not material at this point.

Risks:

Since not all of the shares tendered are likely to be accepted in the tender offer, the chief risk here is that you’ll end up owning shares of a company that possesses a fair amount of operational risk as they make investments in 2 new businesses. The question then is whether the discount to cash is sufficiently compelling in order for this to be a risk worth taking.

Management’s impressed me so far with the offer to only buy-back shares at this point. Given that they will be tendering shares in the buy-back, the fact that they are not offering more than Rs.120/share is noteworthy. They certainly don’t seem greedy for a fat payoff and also look pretty rational with their capital allocation decision to buyback stock up to the maximum permissible limit. Also, their ownership percentage (60%) is sufficiently high to ensure that they’ll be plenty motivated to make the new business operations work. We’ll see how this situation plays out.

Disclosure: Long Gwalior Chemicals at the time of this writing. This is my first, and so far, only individual equity purchase in India, so please consider yourself suitably warned before you reach any conclusions as to the attractiveness of this idea based on this post.

Ragu

Working at CGI, going to Las Vegas and more

2009-10-13T13:05:00.002+05:30

This post has been a few months in the making. Apologies for not updating all of you sooner. As some of you know already, I’ve been working at CGI for a few months now. Thanks to link who, unwittingly, set the ball rolling in this regard by posting a link to one of my blog posts on CGI’s forums. Tom, one of the co-founders of CGI, and I spoke a few times after that. As I’d expected, our investing philosophies matched. I'd been a CGI subscriber since late last year, so I’d had the chance to evaluate their integrity and ability. Both top-notch. So, when Tom offered me the chance to work on their value portfolios, I knew the right answer was yes. It’s a rare group of people that’s blessed with integrity, intelligence, passion and humility. I consider myself extremely fortunate to be working with just such a group here and doing what I love doing.

If you liked reading my blog and are interested in small-cap value opportunities, I believe the chances are good that you’ll find (deep) value in a subscription to CGI Growth and Value Focus. Please email me if you do make the decision to subscribe, so that the appropriate discount, for being a reader of this blog, can be applied to your subscription. While we’ve had a few blog readers subscribe to CGI already, I hope to see many more.

I will also be traveling to Las Vegas for CGI’s second subscriber conference from the 23^rd of Oct through the 25^th. While you run the risk of meeting me, consider the rewards of meeting Tom, Jeff, Jason and Shane. Of course, you will also have the chance to listen to our excellent selection of keynote speakers and talk value investing with like-minded investors all weekend long. I look forward to being there, even if it's a long way from out here in Chennai, and I hope you’ll join us too.

Finally, a note on what happens to this blog. I have positions in common with the CGI portfolios. You’ll need to subscribe to see what they are! Therefore, commentary on those positions through this blog is going to be very limited, if at all. It's highly likely that I'll comment on my Indian equity holdings from time to time. Thanks to everyone that’s been a regular reader, and especially to Andy, link and Larry for keeping me on my toes.

For folks that aren't in Chennai and are not planning to make a trip anytime soon, I hope we can stay in touch, most preferably through CGI or via email. However, if you do live in Chennai or are visiting sometime, drop me a line if you'd like to meet up. I've already had the pleasure of meeting a regular reader of this blog in person, and I hope to be able to add many more to that list over time.

Ragu

A compensation policy worth studying

2009-06-16T16:22:00.005+05:30

A number of corporate compensation policies tie executive compensation to the level of profits achieved in the year, with no attention being paid to the amount of capital that was employed to attain those profits. With retained earnings essentially free under such a scheme, executives rarely feel compelled to achieve a reasonable rate of return on capital employed. As Charlie Munger says often, incentives matter. A lot. And then some.

On that note, one of the exhibits that Western filed with it’s latest 10-Q is the employment agreement with Robert Moore, the new President of Western Sizzlin Franchise Corporation. It’s a rationally designed compensation policy that specifies, amongst other things:

a. The normal levels of cash flows expected from the business for which Mr.Moore gets no extra credit. In this case, the amount is $2.3 million annually.

b. The definition of cash flows that will be used to determine the bonus allocation, which is computed as EBITDA less capital expenditures.

c. Any exceptions to the cash flow calculation above, which includes severance payment obligations to the prior President, Jim Verney.

An item to note is the cash flow metric upon which the bonus calculation is made. The capital expenditures necessary to maintain the business’ current levels of profitability are charged against EBITDA so that the cash flow so computed is truly pre-tax “owner’s earnings”. The use of EBITDA also suggests that debt is going to be rarely used, if at all, in Western’s restaurant business. It also makes good business sense to ignore expenses in the cash flow metric calculation that are not a result of decisions made by Mr. Moore.

The most important part of the compensation policy though is the charge that is applicable to incremental capital that is reinvested in the business for growth. The compensation policy provides for a charge of 20% on any incremental capital investment. This implies that if a bonus were paid out to Mr.Moore, the pre-tax return on incrementally invested capital to Western will necessarily have been above 20%. However, it is not clear if Mr.Moore’s compensation will be penalized if the pre-tax incremental ROIC were to be below 20% i.e. does the charge for incremental capital carry over to the next year’s bonus calculation if the pre-tax hurdle of 20% is not met this year? If that were the case, this would be a truly symmetric proposition. One that provides for a reasonable payout in case the additional investment is economically attractive and a penalty otherwise. This structure encourages the investigation of potentially attractive reinvestment opportunities. The penalty, if it does exist, would act as a deterrent against actual reinvestment of significant amounts of capital except for situations where the odds highly favour the possibility of realization of an attractive rate of return on capital employed.

If you are looking for a “’til death parts us” type of security (or even otherwise), one of the first things to look at is the structure of the compensation policy. What truly counts is how the compensation amount was arrived at, not the actual dollar amount of compensation. A sensibly designed compensation policy is unlikely to come up with compensation that is not commensurate with the underlying business results.

The structure of the compensation policy can also provide a clue (often a very big one) into the way management thinks about business, the business' owners and the importance it places on capital allocation. On the basis of Mr.Moore’s compensation policy, amongst other things, it’s reasonable to expect that shareholders of Western are likely to do well over the course of the next few decades. Subject, of course, to the caveat that their holdings be acquired at sensible prices and that Sardar stays in charge of allocating capital.

Disclosure: Added to my Western position at $7/share earlier this year.

--Ragu

Steak 'N Shake on the mend

2009-04-26T21:05:00.005+05:30

Steak ‘N Shake reported fiscal 2009 2nd quarter earnings on Friday. Guest traffic increased by 7.8%. However, the discounting in effect meant that guests were, on average, paying 5.4% less for a meal leading to a same store sales increase of 2.4%.

First 2 quarters of fiscal 2009:

Cash flows from operations before changes in working capital and other assets and excluding gain on sale of property = $18.239 million (1) Note: Corrected amount now ignores the change in other assets of $2.098 million. Thanks Larry.

Maintenance capital expenditures = $2.612 million (2)

Owner earnings = (1) – (2) – Non-cash stock compensation expense – principal payments on capital lease obligations = $11.278 million (a)

Owner earnings estimate for the first quarter (12 weeks) = $ .658 million.

Therefore, owner earnings estimate for the second quarter (16 weeks) = $10.62 million.

The dramatic improvement in owner earnings this quarter has been driven by the improved sales, the significant cost control measures in effect and the closure/refranchising of stores through fiscal 2008 and the first quarter of fiscal 2009. As a percentage of sales, these are some expense numbers for this quarter:

Cost of sales: 24.1% compared to 24.9% in fiscal 2008

Restaurant operating costs: 53.7% compared to 55.7% in fiscal 2008

G&A expenses: 5.7% compared to 8.3% in fiscal 2008(the 2008 numbers are skewed by one-time severance expenses though)

Marketing expenses: 5.2% compared to 4.7% in fiscal 2008 as the company continues to spend money to get guest traffic moving in the right direction.

Looking at the balance sheet, long-term debt stands at $12.034 million ($11.957 million at the end of the last quarter). Borrowings against the line of credit stand at $17 million ($19.84 million at the end of the last quarter). Cash and equivalents of about $35 million have to be balanced against the obligation of $31.5 million of (mostly cash) accrued expenses. Still, with the assets held for sale and the potential cash generation from the business for the rest of the year, the balance sheet looks in very good shape such that the odds on further expensive sale-leaseback transactions, like the ones of last year, or distress sales of owned properties, ought to be fairly low.

A couple of properties were sold during the quarter for proceeds of $1.534 million and a gain of $47,000. This leaves 31 properties available for sale, currently carried on the books for $21.055 million.

It’s hard not to be impressed with these results. Granted that a quarter does not an investment thesis make, but given how precipitous the decline has been in owner earnings over the past few quarters, this is an extremely impressive turn-around. And in such short order too. I have fairly high expectations of Sardar Biglari but it’s reasonable to say that my expectations have been easily surpassed and then some. In my opinion, this is more than likely just the beginning of what could be a very special turn-around. While the price has run up recently, the risk/reward equation is still pretty attractive for the long-term oriented shareholder.

Steak ‘N Shake also held its Annual Meeting for shareholders this past Friday. Please see Jeff’s excellent set of notes from the AM here. Much appreciated Jeff.

Often wrong but seldom in doubt,

Ragu

Notes:

(a). The actual amount of non-cash stock compensation expense is lower than the amount used in the calculation which clubs that expense and deferred rent expense together in one line item. The 10-Q should provide the breakdown but this works as an estimate.

Sellers Capital offered buy-out at Premier

2009-04-20T07:43:00.005+05:30

See the press release here. First, the title. It's blatantly misleading. This is not an offer for the RMS Titanic Inc., a wholly-owned subsidiary of Premier. Second, the value of the offer as it relates to the Titanic business of Premier is not $40 million. It's $25 million for the rights to exhibit the Titanic over a "multi-year" period and $15 million for Sellers Capital's 16.3% stake in the company(@$3/share). Third, far as I can tell, Contango Oil and Gas(MCF) has no beneficial interest in Premier. Fourth, you can't pay off the largest shareholder and expect to get all board and executive positions in return. The board of directors is not Sellers Capital's to sell. I'll stop here.

Later in the day, Premier issued a press release clarifying the offer. To summarize:

a. Premier gets $25 million over a five-year period, in installments of $5 million each, in exchange for the rights to exhibit the Titanic. Premier also gets an undisclosed percentage of merchandising/television revenues. This also means that Premier keeps the Titanic assets, both the ones that are owned outright and the ones currently under adjudication.

b. Sellers Capital is being offered $3/share to give up their stake in Premier.

c. Michael Harris, the principal of Wlm Inc, is asking for 3 board seats and control of all executive positions. This is in addition to 1 million shares and an undisclosed number of options.

It is not clear whether the offers to Premier and Sellers Capital are tied in any way. The offer to manage the Titanic assets is intriguing.

The good:

--------

Quite clearly, there is a lot to like about a $5 million royalty payment every year for the next 5 years. No costs, no capital investment. So long as Wlm Inc. is good for the money, this is a deal worth considering.

It seems like Premier would give up the exhibition at the Luxor in Las Vegas (there are no exclusions in the offer). This would take the associated annual lease payments, amounting to $3.3 million currently, off Premier's hands.

Also, it's worth noting that the offer to manage the Titanic assets comes from one of the co-founders of the RMS Titanic Inc who runs a Titanic attraction in Orlando. Therefore, it's reasonable to believe that the payments being offered to Premier are not extravagant. I'd suggest that this offer goes to show just how profitable the operation of the Titanic exhibits alone currently is or is likely to be as we approach the 100th anniversary of it's sinking in 2012.

The bad:

-------

The 1 million shares (at what price anyway?) represent about 3.4% of the 29.2 million shares outstanding as of January 5, 2009. This disregards about 4.3 million options that were out of the money as of that date. The effect of the dilution is worse if you consider the shares undervalued as of today and the effect of the "undisclosed" number of options that Harris is seeking.

The other problem with the Titanic offer is that the $5 million payment for the first year is likely not enough to offset the revenue hole caused by the lack of exhibition days later this year. G&A expenses alone were at $6.4 million for the most recent quarter. This means further dilution if Premier were to raise additional capital.

As for the offer to buy-out Sellers Capital, it's worth remembering that in addition to running a hedge fund, Sellers is Premier's Chairman. Fiduciary responsibility would quite clearly dictate that he not seriously consider any offer that is not being offered to all shareholders. Based on my estimation of Sellers' character, I'd expect that the buy-out offer will be rejected.

For those curious about Michael Harris, he is one of the co-founders of the RMS Titanic Inc. and was terminated from his employment for "misappropriating" $70,000 of the company's funds. See the note on page 10 in the 2004 10-K. Much more colourful personality and character insights can be gleaned from a Google search.

Often wrong but seldom in doubt,

Ragu

Mark Sellers' first conference call as Premier's Chairman

2009-03-13T07:57:00.004+05:30

Now that I am sufficiently recovered (I think) from listening in on Mark Sellers' first conference call as Chairman of Premier, here's the link to the transcript of the same.

Things are in much worse shape at Premier than I'd envisioned (I was pessimistic before the call). As I'd posted elsewhere, I was certainly wrong in my assessment that prior management was running the company terribly. The truth is that that they were hardly running the company at all. I still cannot believe some of the stuff that Sellers mentioned in that call. I'll bet Sellers wasn't prepared for most of it either. The single most damaging piece of information to come out of that call was the lack of scheduled exhibition days for later this year. This implies that capital will need to be raised (although there was no indication of just how much would need to be raised) with the options ranked in the following order:

(a). Selling a portion of the business. I'd guess Sellers was referring to the Titanic (and it's associated assets) here.

(b). Raising debt capital.

(c). Raising equity capital. The question here is the amount of dilution that might occur under this scenario.

If none of this works out, Sellers mentioned that they'd look to sell the entire company. Clearly, though, this is his least preferred option. The interim CEO, Chris Davino, spoke for a bit about the problems at Premier and how they were approaching it. I liked the guy. He was brutally honest and realistic about the situation. As would be obvious in a situation like this, they are looking to get to cash-flow neutral as a first step. I find it interesting though that Chris has been appointed for a period to last between 4-6 months. That, quite possibly, gives us an upper bound on management's estimate for Premier to get back to at least not bleeding cash.

On the good news front(there is some), Sellers was quite clear that Premier wouldn't provide earnings guidance any more. If every CEO in the corporate world were to make the same decision, long-term shareholders, in aggregate, would be wealthier than they would be otherwise. This decision alone is indicative of Sellers' clear understanding of the true nature of most businesses(even if their managements would like you to believe otherwise) and his gumption in standing up for what he believes in. In this otherwise sordid affair to date, I couldn't be happier than to be associated with a manager like Mark Sellers.

The company has some serious issues to work through. Quite clearly, I made a mistake in making the decision to buy Premier. There was at least one issue that, if I'd picked up on it, would've given me serious qualms about buying into Premier. I'll have more to say about that in another post. The outcome of the investment may still be alright from here, but that'll have been despite my process, not because of it.

Often wrong but seldom in doubt,

Ragu

Examining Steak 'N Shake's debt covenants

2009-03-10T13:18:00.003+05:30

There have been some suggestions that Steak ‘N Shake is likely to be in violation of it's debt covenants that were amended in November 2008. The amendments were brought on by the violation of the original debt covenants that were in place as prior management essentially ran the place down. I was initially drawn to Steak 'N Shake in early 2008 for the following reasons: The owned real estate, carried on the books at historical cost, that would likely provide protection against a permanent loss of capital, the healthy cash flows from an established restaurant brand in the relatively recent past and, last but not the least, Sardar asking for board seats for himself and Phil to help fix the terrible capital allocation policies and operational inefficiencies. In the midst of all this, I neglected to look at the debt covenants that SNS was then pushing up against. Since I am not particularly keen on making the same mistake again(in the same security, no less), we'll take a look at how things stand today as far as the revised covenants go.

There are 2 covenants that need to be met, one relating to the balance sheet and one related to the debt servicing ability of the company’s business operations.

The debt covenants related to SNS’ line of credit issuer, Fifth Third Bank, is here.

Here’s how the ratios relating to the covenants for Fifth Third look as of Dec 17, 2008:

Ratio	Actual	Required
Total liabilities/ Total Tangible Net Worth	.89	<= (1-1.1)
Fixed charge coverage ratio	1.25(1)(2)	>=(.7-1)

The debt covenants related to SNS’ Senior Notes issuer, Prudential, is here.

Here’s how the ratios relating to the covenants for Prudential look as of Dec 17, 2008:

Ratio	Actual	Required
Total liabilities/ Total Tangible Net Worth	.89	<= (1-1.1)
Fixed charge coverage ratio	1.84(1)(3)	>=(.7-1)

The required ratios for the fixed coverage ratio increase every quarter ending with a required range of not less than between (1-1.2) for the last quarter of fiscal 2009. The examination of this ratio changes into a rolling 4-quarter test after the end of the last quarter of fiscal 2009, which effectively means that the clock has started ticking beginning the first quarter of fiscal 2009, the numbers for which can be seen above.

Overall, the numbers look ok for now, with trouble not looking imminent in the near term. Especially so when you consider that the 1st and 4th quarters are traditionally the slowest for Steak ‘N Shake. I’d expect to see the debt paid down by the asset sales (the long-term debt of about $11.5 million costs an exorbitant 9%), so this should be less relevant going forward.

Often wrong but seldom in doubt,

Ragu

Notes to calculations:

1. The numerator in the fixed charge coverage ratio calculation works out to $12,136,000.
2. The denominator in the fixed charge coverage ratio calculation works out to $9,684,000.
3. The denominator in the fixed charge coverage ratio calculation works out to $6,602,000.

Brief thoughts on Buffett's letter to shareholders

2009-03-06T11:50:00.002+05:30

Well, really brief actually: Buy Berkshire.

What were you expecting? I've only read it the 3 times so far. A's going for $72,400/share at this time.

Often wrong but seldom in doubt,

Ragu

A look at Western's purchase of Mustang Capital

2009-03-04T12:08:00.005+05:30

Western agreed to purchase a 51% interest in Mustang Capital Advisors in the first quarter of 2008. Here are the numbers for Mustang from 2006 through 2008. All amounts are in dollars.

Year	2008(9 months)	2007	2006
Operating income (Management fee income less operating expenses)	282,524 (376,698 annualized)	234,070	148,346
Net portfolio income	-	3,006,532	1,541,847
Portfolio income, net of minority interests	-	613,063	374,591
Assets in portfolio @ end of year	-	13,629,075	10,824,470
Minority interest in assets	-	12,672,954	10,279,485

Source for numbers above and calculations below:

Mustang Capital's financials
Purchase Term Sheet

There are 2 sources of income for Mustang:
a. The management fee income that accrues from providing investment advice to third parties.
b. The performance incentive (20% allocation) for beating a hurdle rate of 4% on the actively managed funds, the size of which is reflected by the row titled ‘Minority interest in assets’ in the table above. The estimated returns for 2006 and 2007(assuming no deposits/withdrawals during the year) look pretty good at 16.6% and 27.78%. 2008 has been difficult, with the equity portfolio down $347,132 on a cost basis of $6,348,528 as of Sept 30, 2008. I'd expect that the decline has continued through the rest of the year.

The segment that provides the management fee income has been growing nicely, as can be seen from the numbers above. The portfolio income, dependent as it is on market values for the securities held, is a little harder to evaluate. Let’s assume that John Linnartz, the fund manager at Mustang, and the managers that will succeed him, are able to invest the assets at 6% in perpetuity. We’ll also make the assumption that the capital invested in the funds remains the same i.e. all returns are distributed to the investors in the funds. The portfolio income is therefore 20% of the excess spread (6%-4% = 2%) on a capital of approximately $12.6 million (the incentive allocation is only on the minority interest in the funds). This works out to $50,400 annually. The value of this income stream in perpetuity, discounted at an opportunity cost of 15%, is $336,000.

There is also about $1 million in capital in the funds that belongs to the general/limited partners in the funds (essentially John). Let’s say that this was worth “book” value at the end of 2007 i.e. 1 million.

So, at the end of 2007:
Mustang’s value = Book value of capital of general/limited partners + Value of the actively managed funds + Value of the management fee income stream
= $ 1 million + $336,000 + Value of the management fee income stream

Western’s purchase price, for a 51% interest in Mustang = $ 1.173 million ($300, 000 in cash + rest in Western stock)

Implied value of Mustang based on Western’s purchase price = $2.3 million

Value of the management fee income stream (inferred from value of Mustang above) = $2.3 million - $1.336 million = .96 million

Implied multiple on 2006 operating earnings (lowest of the 3 years) = 6.5
Implied multiple on estimated 2008 operating earnings (highest of the 3 years) = 3.4

For a business with little on-going capital expenditure requirements, these are great multiples on what can reasonably be expected to be recurrent earnings, if you are the buyer. When you factor in the conservativeness of the assumptions (6% returns on managed funds, payout of all returns), this seems like a steal for Western. A few possibilities that lend themselves as possible explanations are:
1. I am missing something in my valuation (always possible).
2. The assumptions underlying the valuation of the managed funds are not as conservative as I think they are.
3. John’s estimate of the value of Western’s stock was higher than it was trading for at the time of purchase ($16/share). In fact, I’d go as far as to speculate that without Western’s stock comprising a majority of the purchase price that this deal wouldn’t have gone through for the price that it apparently did.

Often wrong but seldom in doubt,

Ragu

Evaluating Western Sizzlin's restaurant operations under Sardar

2009-02-27T08:07:00.008+05:30

Sardar was appointed to Western’s board in November of 2005 and was elected Chairman in March 2006. Here’s the 2005 shareholder letter:
http://www.western-sizzlin.com/pdfs/Chairmans%20Letter.pdf

Excerpts from the letter:
“Our 2005 return on capital was dismal. The five company-owned stores achieved same-store sales growth of .33%. The franchise system achieved same-store sales growth of .25%. While same-store sales are not the only, preferred, or most important figure, we do like to see the figures climb as long as profits keep pace and the capital that generated those gains results in a healthy return on invested capital. The more important factor is the cash return on invested capital.” (emphasis supplied).

Let’s look at the cash return on invested capital from just before and since Sardar has gotten control. All amounts are in dollars.

Year	2008 (9 months)	2007	2006	2005
Income from operations	57,920	350,257	733,122	1,426,119
D&A	786,676	1,063,017	1,057,492	1,072,334
Lawsuit/claims settlement expense (1)	162,820	741,287	289,109	201,000
Gain on claims (1)	-	-	-	(1,166,683)
Maintenance capital expenditures	(22,505) (30,006 annualized)	(35,493)	(492,107)	(312,532)
Pre-tax cash from operations	984,911 (1,292,728 annual) (4)	2,119,068	1,587,606	1,220,238
Invested capital at the start of the year (2) (3)	15,706,703	16,388,887	16,885,941	17,907,831
Pre-tax cash ROIC (4)	8.23%	12.92%	9.4%	6.81%

Note the numbers for 2005. The business was earning a pre-tax return of 6.81% on invested capital with debt financing a part of that capital at 10%. Little wonder then that Sardar moved to pay down the debt first. The improvement in return on invested capital was achieved despite overall revenues declining from about $19.3 million in 2005 to $17.25 million in 2007(they declined further in 2008). The boost to cash flows came from reducing expenses from about $19.11 million in 2005 to about $16.2 million in 2007 and from slashing capital expenditures to what is essentially a bare minimum maintenance level. The invested capital in the business was lowered as well as Western went from a working capital surplus of about $2 million in 2005 to a working capital deficit of about $1.6 million in 2007. Of course, none of these improvements can go on forever. It’s reasonable to assume that this is about as well as the company owned stores and the franchises will do, for now.

A note on the 2008 numbers. These are skewed by a couple of items:
a. The departure of Jim Verney from Western Sizzlin Franchise Corp. resulted in severance expense of $250,000.
b. Sub-leased property expenses increased by $355,000 for the first 9 months of 2008 as compared to 2007. These lease arrangements will cease at the end of 2008. I won’t miss them.

Contrast these operations with the joint venture Wood Grill Buffet in Harrisonburg. The cash return on invested capital ($3.9 million) in 2007 for that restaurant amounted to 18.6%. These are very good numbers in absolute terms and about 1.5 times better than the rest of Western’s restaurant operations in 2007, on a pre-tax basis. Interestingly, from the figures presented by Sardar on pg. 4 of the 2007 letter, the tax expense on the joint venture’s pre-tax income of $315,063 in 2007 amount to a piddling $62. For the first 9 months of 2008, there was an income tax benefit of $6,683. This makes me wary of using after-tax numbers for the JV and I am surprised that Sardar used them in his presentation in the 2007 letter.

Here's how the cash ROIC numbers look for the JV. All amounts are in dollars.

Year	2008 (9 months)	2007
Pre-tax earnings	294,488	315,063
Interest	160,421	223,574
D&A	152,131	200,869
Maintenance capital expenditures	(17,864) (estimated from information on JV operations from fiscal 2008 3rd qtr 10-Q)	(12,995)
Pre-tax cash from operations	589,176 (785,568 annualized)	726,511
Invested capital at the start of the year (5)	3,678,571	3,534,960
Pre-tax cash ROIC	21.36%	20.55%
Cash distribution to Western	150,000	-

Here are Western’s cash flows as they pertain to the JV:

Late 2005: Cash outlay of $300,000.
No cash flows in 2006 and 2007.
3rd quarter of 2008: Cash receipt of $150,000 with decent prospects for cash flows ahead. I’d take this deal every day of the week and thrice on Sundays. Of course, given the amount of leverage involved, it’s hard to imagine scaling on these returns on equity.

From the numbers above, it is clear that Sardar is walking the talk at Western. Admittedly, the bar wasn’t set very high (understatement) when he got control but it’s good to see progress nonetheless. What is also clear is that the restaurant operations (excluding the JV) aren’t worth owning on a long-term basis unless the cash from those operations are redeployed into (much) higher return opportunities elsewhere.

Often wrong but seldom in doubt,
Ragu

Notes to calculations:

1. Cash flows were adjusted for one-time gains/losses. Sardar makes the same adjustments when presenting restaurant operations’ performance in the 2007 letter: http://www.western-sizzlin.com/pdfs/Chairmans%20Letter%202007.pdf (pg 2).

2. Invested capital in restaurant operations was calculated as the total of all assets that were financed by either debt or equity, less cash, marketable securities, equity in the joint venture and all non-interest bearing current liabilities. This means tax and insurance receivables were ignored as were accounts payable (financed by suppliers) and accrued expenses. Also, franchise royalty contracts (what essentially amounts to goodwill when franchises are reacquired by the company) were not amortized for the purposes of calculation of invested capital.

3. Western’s operating leases weren’t converted to their debt equivalents for the calculation of invested capital.

4. 4th quarter pre-tax operating income was assumed to be the same as 1st quarter pre-tax operating income, before lawsuit charges. These 2 quarters are relatively weak as compared to the 2nd and 3rd quarters.

5. Cash was included in the calculation of invested capital since, unlike at Western, there are really no redeployment opportunities in the JV. Regardless, it is clear that this JV has highly-desirable economics.

Management changes at Premier

2009-02-06T16:40:00.003+05:30

A couple of weeks after Sellers Capital delivered sufficient shareholder consents to elect their nominees to Premier's board, Premier acknowledged their election:

http://www.sec.gov/Archives/edgar/data/796764/000095015209000924/l35343ae8vk.htm

Arnie Geller has been terminated as CEO, although he is still on the board, a position that leaves me feeling uncomfortable. Sellers will serve as non-executive chairman without compensation, as promised. One of the elected directors, Christopher Davino, will serve as Interim President and CEO, for a period of between 4-6 months. He comes from XRoads Solutions Group, a corporate restructuring management consulting company. Meanwhile, the newly constituted audit committee will continue to investigate the Sarbanes Oxley violation allegations, allegations that were withheld from Sellers Capital at the time that it discussed bringing back Geller as CEO for a second term.

I am glad though that this consent solicitation is over and we have management in place that Sellers chose. I haven't always found myself nodding in agreement with Sellers during the consent solicitation process but the outcome, which was critical, turned out alright. It is vital for Sellers to address the looming liquidity issues with shareholders. Previous management had said that they'd be ok till the middle of 2009. Their available line of credit, down from $10 million to $7.1 million at the end of the last quarter, goes down with deteriorating operational performance.

The change in management will lead to a much greater focus on better aligning costs with declining attendances, better corporate governance and more transparent and conservative accounting. Sellers, in my opinion, has essentially staked his legacy on this position. We'll see how it pans out for him and the rest of Premier's shareholders.

Often wrong but seldom in doubt,

Ragu

Steak 'N Shake Q1 2009 results

2009-01-29T11:38:00.009+05:30

[Note to Andy and everyone else that's reading this: Based on Andy's comment, I fixed the section that describes the adjustments needed to arrive at operational cash flows that are attributable to owner earnings and the corresponding errors in calculation. I figured it'd be easier to fix it here rather than have people drill down the comments section to see the errors. Thanks Andy! I'll leave the original section in as a comment, as an example of how not to describe the required adjustments.]

The 10-Q is here:
http://www.sec.gov/Archives/edgar/data/93859/000009385909000008/form10q1q2009.htm

SNS reported an operational loss, before taxes, of $5.981 million. This number includes depreciation charges of $7.392 million. The actual maintenance capex for this quarter: $1.974 million. This discrepancy implies that GAAP earnings will understate the economic earnings of this business.

Adjustments to reported net income to arrive at operational cash flows that are attributable to owner earnings:

Net income: -($3.44 million)

Add back depreciation: +$7.392 million

Add back increased provision for income taxes: +$.733 million

Add back asset impairments and provision for restaurant closings: +$.176 million

Subtract gain on sale of property: -($.59 million). Correction(thanks to Andy again!): -($.059 million)

Subtract cash that resulted from changes in other assets: -($1.104 million)

Items that weren't included in the adjustment to net income: Stock compensation expense and changes in working capital. Adjusted cash flow from operations amounts to $3.698 million. With maintenance capex at $1.974 million, we get an owner earnings estimate of $1.724 million.

The sharp-eyed reader will note that we are ignoring one other cash outflow that should lower this estimate. Remember that in our evaluation of SNS' balance sheet, we only considered interest-bearing debt as long-term debt. The capital lease obligations, while still a liability, wasn't really considered as debt. From our discussion on accounting for capital leases, remember that we agreed to postpone implications of capital lease accounting on classification of cash flows. Not any longer. When a company has debt on it's books, the cash flows relating to that debt are classified as follows:

Interest payments are considered part of operations and are classified as cash flows from operations.

Principal repayments are classified as cash flows from financing activities.

Since the capital leases are accounted for as debt, the principal repayments on this debt are accounted for as financing cash outflows. If we don't consider the capital lease obligations as debt, consistency demands that we factor in the principal repayments on the lease obligations as a recurring claim against owner earnings. The principal repayments, on the long-term debt and the capital lease obligations, are broken out under the section titled 'Financing Activities' in the statement of cash flows. The payments for the lease obligations for this quarter amounted to $1.066 million. This reduces our owner's earnings estimate for this quarter to $.658 million.

There's another reason that we ought to account for the principal payments on the lease obligations as operational cash flows. The success of SNS as an investment is dependent on Sardar Biglari fixing two things: operations and capital allocation, with much of the value creation likely to be derived from capital allocation. To determine the effect of capital allocation, we'd need a realistic estimate of the capital that will be available for Sardar to allocate. Based on the numbers above, it's clear that there isn't much capital left at present to allocate outside of business operations. This is likely to change as Sardar and co. continue the business turnaround.

With that detour into accounting issues complete, we'll turn our focus onto the balance sheet at the end of Q1. Cash amounting to $11.351 million was received as tax refunds. There was a prepayment on the Prudential Senior Note in the amount of $4.476 million. The borrowings at the end of the quarter were:

Line of credit in the amount of $19.84 million @ 4.1%

Long-term debt in the amount of $11.957 million @ 9%

Against this, we have assets held for sale on the books at $23.24 million and cash and equivalents of $25.636 million. It's reasonable to expect, based on the above, that SNS is a fair chance to be debt-free by the end of the fiscal year.

On to earnings. These were skewed by a couple of items. The prepayment of a portion of the long-term debt resulted in a penalty of $506,000. Assuming that the prepayment happened at the start of the quarter, the interest savings would've amounted to $100,710. So, interest expense is likely overstated by around $405,000, at the very least. Marketing expenses were higher by $1.542 million this quarter compared to the same quarter in fiscal 2008. Management indicates that this was by design although I'd doubt that this is a permanent increase. I suspect we'll see this expense, as a percentage of sales, trend down once sales stabilize.

All things considered, this was a pretty good quarter. Based on Sardar's estimates on Investor Day, I expect that we haven't seen the full benefits of the envisioned cost savings. There's still a lot of work to do with reversing the guest traffic and same store sales trends, but the signs from this quarter are encouraging.

Often wrong but seldom in doubt,

Ragu

Premier's shareholders need to act now

2009-01-13T07:23:00.007+05:30

3rd quarter results at Premier were dismal, and that's putting it mildly. Attendances were down big, revenues suffered and Premier reported a net loss of $1.8 million for this quarter. All of this after recognizing $4 million in revenue from an option pickup by a third party to co-host the Bodies exhibitions. As Sellers pointed out in a press release once the results came out, taking out this non-recurring revenue and focusing exclusively on ticket sales would cause gross margins to come in at 9.1%. This compares with gross margins of 47.3% from the same quarter last year. Terrible by any measure. The accounting is also very aggressive, too aggressive for my own comfort. I'd have expected the revenue to be recognized over the period for which the option to co-host the exhibitions is effective(between 12-18 months, I believe).

The balance sheet continues to deteriorate as well. We are down to $4.709 million in cash. The $4 million payment from the option pickup is reflected in Accounts Receivable at the time of the end of the 3rd quarter($8.212 million). This is essentially a wash with what's owed as reflected by Accounts Payable at the end of the 3rd quarter($8.38 million). It also looks like we'll be getting back about $3.271 million in taxes previously paid. The $10 million line of credit that was available at the start of the quarter through Bank of America has now been cut to $7.1 million based on the deterioration in the operating results. At this rate of cash burn, we are looking at a quarter or two more of operations before capital needs to be raised. All of this cheerful news is available in the latest 10-Q:

http://www.sec.gov/Archives/edgar/data/796764/000119312509004043/d10q.htm

On the salvage award trial, things have progressed some with both Premier and the U.S. Govt submitting their changes to the revised covenants. As of Nov. 18, it looks like it's in the Court's hands to decide. I ran across this interesting article with respect to the case:

http://hamptonroads.com/2008/11/judge-decide-fate-5500-titanic-artifacts-soon

Looks like Sellers' fairly outspoken plan to monetize the Titanic assets have caused the judge some serious reservations. Sellers was rebuked by Premier as well. I suspect that this, as well as Premier's deteriorating financial condition, may play a part in the timing of the judge's decision. We'll see.

If the 3rd quarter results don't cheer you enough, the conference call to discuss them ought to. After what was essentially a regurgitation of the details in the press release, Geller talked about how Sellers didn't have a specific plan for turning the company around and why shareholders should vote for incumbent management instead(no good reason). He then ended the call without allowing for questions. If not for anything else, he needs to go just for this blatant disregard for corporate governance.

Post this conference call, Sellers Capital made this filing that pretty much destroys(not that this needed much destroying) any little credibility that management might have had remaining:

http://www.sec.gov/Archives/edgar/data/796764/000095015209000197/l35069adfan14a.htm

Quoting the relevant section:

"We also question how the Special Committee can allow serious and unfounded allegations to be made against Sellers Capital and our representatives, particularly after having offered to give us control of the company’s board as part of a settlement, which the Special Committee offered us in return for little more than full releases from liability for its members. " (emphasis mine)

This is no good and a serious indication that Geller and co.'s biggest troubles might begin once the proxy contest is over.

If you are a shareholder, I'd recommend that you call your brokerage or the Altman Group at 1-866-828-6934 and vote your shares in favour of Sellers Capital's slate of nominated directors now. Risk has been ratcheted up in my opinion, given what's come out in the public domain re. management's character and intentions. Shareholders need to act urgently to give themselves every chance of preserving, let alone enhancing, their original investment.

Often wrong but seldom in doubt,

Ragu

Getting uglier at Premier

2009-01-04T07:45:00.002+05:30

Incumbent management filed a consent revocation statement on Dec 29:

http://www.sec.gov/Archives/edgar/data/796764/000095014408009605/x17112pre14a.htm

As expected, this inspires no confidence in management at all. The section below, in particular, is galling:

Sellers’ Solicitation, If Successful, Could Trigger The Company’s Change of Control Severance Agreements. The employment contracts of Messrs. Geller and Thomas Zaller, Vice President of Operations, contain a “Change in Control” provision, whereby if during the term of their employment, three of the four members of the Board of Directors, a majority as of the effective date of the Agreement (February 4, 2002 as amended), no longer comprise a majority of the Board, a “Change of Control” will occur. In the event that Mr. Geller’s or Mr. Zaller’s employment is subsequently terminated, each would be entitled to a lump-sum cash payment of 299% of his current salary. Messrs. Geller and Zaller’s compensation is currently $705,737 and $273,000, respectively. This would result in a combined payment of approximately $2.9 million in the event that the employment of both of them is terminated. According to the terms of Mr. Geller’s agreement, he can elect to receive compensation in the form of the Company’s common stock at a price equal to 50% of the closing bid price as quoted on the NASDAQ Stock Market as of the date of election. If he should so elect, based on the closing price of the Company’s common stock on December 22, 2008, he could receive up to 2,827,000 shares of common stock, thereby diluting the interests of the Company’s shareholders. These agreements have been in place for several years. As a result, if Mr. Geller or Mr. Zaller were to successfully assert that a change of control preceded his termination, the Company would become obligated to pay him the foregoing compensation.

The argument for Geller and co. keeping their jobs is that their dismissal would cost the company money. Clearly, shareholders ought to let them keep their jobs and save the $2.9 million in payments while they continue to mismanage the company and cause erosion in value. No kidding.

One other interesting nugget from that filing:

The Company is also aware that there have been discussions between Mr. Geller and his counsel and representatives of Sellers Capital and its counsel in regard to a settlement of this matter, but no resolution has been reached as of the date hereof. (emphasis mine)

Maybe, just maybe, Geller will see that Sellers is odds on to get his slate of directors nominated and go away on his own.

Couple of days later, Sellers Capital filed their response to the Consent Revocation Statement:

http://www.sec.gov/Archives/edgar/data/796764/000095015208010882/l35000adfan14a.htm

Clearly, incumbent management is not only lacking in competence, but is also bereft of rectitude. Geller's settlement with the SEC in response to potential violation of securities laws in 2004 is particularly disturbing. At this point, the sooner the CEO and his cronies go, the better off all other shareholders will be.

Often wrong but seldom in doubt,

Ragu

Steak 'N Shake fiscal 2009 Q1 owner earnings: A guesstimate

2009-01-01T07:05:00.005+05:30

From the most recently filed 8-K, same store sales were off 1.4% as compared to fiscal 2008 Q1. Assuming this translates to a similar decline in overall sales, we can project revenues of $134.4865 million for Q1.

G&A expenses for fiscal 2007 were $57.525 million. Sardar had mentioned in his first letter to shareholders as CEO of SNS that G&A would likely be $20 million lower than fiscal 2007 levels. This implies G&A expenses for fiscal 2009 of $37.525 million, giving us a quarterly estimate of $9.3813 million.

I will assume that other expenses remain at 2008 levels (except that there will be no pre-opening costs given the moratorium on new store openings by the company). This might overstate expenses as my understanding is that commodity costs have eased up a bit from 2008 levels. I also expect restaurant operating costs to be lower than 2008 levels given the initiatives there, but since I don't have an estimate we'll stick to using 2008 numbers.

Excluding depreciation, other costs and expenses(cost of sales, restaurant operating costs, marketing, interest and rent) add up to 90% of sales. Given that there will be no new store openings, all capex will be maintenance.

To get an estimate of maintenance capex in 2008: Total capex was $31.443 million. 9 new stores were opened at an estimated cost of $2-2.5 million per store. If we assumed an average of $2.25 million per new store opened, growth capex works out to $20.25 million. This gives us a maintenance capex estimate of $11.193 million. The quarterly number works out to $2.7983 million.

So, total costs and expenses work out to: G&A expenses + 90% of sales + maintenance capex

= $9.3813 million + 90% of $134.4865 million + $2.7983 million

= $133.2175 million

There's also this pesky little line item, Other Income, net that has shown a loss of .3% of sales for the last couple of years. Assuming this continues to be the case, we'll see a loss of about $.4035 million for this quarter. There is no explanation of what this line item represents(as far as I can tell). I hope the forthcoming 10-Q contains an explanation.

So, owner earnings estimate for Q1 2009 comes in at $1.2691 million. There's one other adjustment we'd need to consider. Remember that SNS essentially swapped one type of debt(line of credit) for another with the sale-leaseback of 11 properties for $14.817 million with the interest rate going from 4.94% to 8.27%. This causes an additional expense of $.7198 million compared to fiscal 2008(roughly). Revised owner earnings estimate is now $.5493 million.

Given that this calculation doesn't include the effects of easing commodity costs and the effects of cost cutting initiatives in restaurant operations, I'd suggest that there is a reasonable possibility of SNS being in the black on an owner earnings basis for Q1.

Often wrong but seldom in doubt,

Ragu

What's Steak 'N Shake worth anyway?

2008-12-31T11:38:00.005+05:30

Let's look at the latest annual report for fiscal 2008:

http://www.sec.gov/Archives/edgar/data/93859/000009385908000078/form10k2008.htm

Under the section titled 'Franchising':

We also take advantage of opportunities to refranchise certain Company-owned restaurants that are typically located in tertiary markets. (emphasis mine)

Under the section titled 'Subsequent Events':

On November 26, 2008, we refranchised seven restaurants to an existing franchisee. We received proceeds of $2,660 in conjunction with this transaction. (emphasis mine)

The latest refranchising values each of the seven restaurants at an average of $380K/restaurant. The company owned 415 restaurants after the refranchising. Using the numbers from the refranchising yields a value of $157.7 million for the entire chain (415 restaurants * 380K/restaurant). But, wait. The refranchised restaurants more than likely came from tertiary markets(as opposed to primary/secondary markets), as per the language in the 10-K. So, $157.7 million seems to be a rock-bottom valuation based on the most recent transactions. The fact that these restaurants went to an existing franchisee is also encouraging. This bodes well for future refranchising efforts as well as the stated aim of growth through franchising. From http://www.steaknshake.com/franchise/benefits.asp, the goal is to have 1000 SNS units(currently 490) in operation throughout the US.

There's more though. In fiscal 2008, SNS sold and leased back 11 company-owned restaurants for $15.993 million. This values each of those properties at an average of $1.4539 million. Going as far back as 2004, the lowest value I can see for a property that was sold and leased back was $600K. These numbers suggest that the restaurants that SNS refranchised were more than likely not owned, but rather leased. The 1st quarter's 10-Q for fiscal 2009 should confirm it either way. We'll need to look at the total number of operating and capital leases still on SNS' books and see if they went down by the amount of restaurants refranchised (i.e. 7), given that Sardar has said there will be no more new store openings for the foreseeable future.

Update on March 5th 2009: Actually, it'd be easier and less convoluted to just look at how many Company-owned and operated restaurants there were in the 4th quarter of 2008 as compared to the 1st quarter of 2009. It turns out that the number of Company-owned and operated restaurants is exactly the same in both quarters(146). This makes it clear that the 7 refranchised restaurants were indeed leased at the time of the refranchising.

If the refranchised restaurants were indeed leased, the value of $157.7 million for the entire chain would need to be revised upwards on two counts:

Inclusion of restaurants from primary and secondary markets that are presumably more profitable.

Inclusion of 146 restaurant properties that are owned that are likely worth somewhere between $87.6 million(at $600K/property based on the sale-leaseback transaction in 2004) and $212.6 million(at $1.4536 million/property based on the sale-leaseback transaction in fiscal 2008).

How much is the company selling for today? $166.82 million. Based on the numbers above, I believe the price today not only discounts the future under Sardar, but is also discounting the present.

Qualitative factors: Management under Sardar that is highly ethical and shareholder friendly, and obsessively focused on cash flows and returns on invested capital.

Quantitatively cheap as can be seen from the numbers above. It's hard to see a permanent loss of capital from these levels unless the decline in sales continues unabated. Thankfully, there is a glimmer of hope in this filing about sales in the 1st quarter of fiscal 2009:

http://www.sec.gov/Archives/edgar/data/93859/000009385908000082/form8k122208.htm

Although guest traffic and same-store sales were down(.9% and 1.4% respectively) compared to last year, the declines are both marginal and a significant improvement from last year's comparables(down 9.5% and 13.3% respectively). Although this is only the second full quarter under Sardar, the sales decline needed to be arrested quickly. Looks like excellent progress, given the environment we are in. We'll see if this was enough to generate positive free cash flow for the quarter. The trend in guest traffic will be worth keeping an eye on as we go along.

In the meantime, as Charlie Munger is fond of saying, you sit on your rear and wait while Sardar does his thing.

Often wrong but seldom in doubt,

Ragu

Steak 'N Shake: 2008 in review

2008-12-28T09:45:00.005+05:30

After Sardar asked for 2 board seats at the end of fiscal 2007, SNS management explored various "strategic" alternatives, including a sale of the company. I believe bids came in although management rejected all of them as being insufficient. Meanwhile, operations continued to deteriorate through the first quarter prompting a second, and more detailed letter, from Sardar:

http://www.western-sizzlin.com/pdfs/Second%20Letter%20to%20Shareholders%20of%20the%20Steak%20n%20Shake%20Company.pdf

SNS was going to post an operating loss for the first quarter. Sardar outlined his vision for the future of SNS: Moving away from a majority company-owned stores model to a majority franchisees-owned stores model i.e. a translation from a capex-heavy and risk-abundant model to a capex-light and risk-light model. Sardar also made it clear that he was going to seek to replace the majority of the board at a special shareholder meeting following the Annual Meeting.

Management's reaction was swift and a vivid illustration of the depths that they would sink to in order to keep their jobs: The company's by-laws were amended such that 80% of shareholder votes would be needed in order to call a special meeting, up from the original 25%. This caused significant consternation amongst Sardar's camp, as one might imagine. The proxy fight was now on in full force. Sardar and Phil won support from the major proxy advisory services, and in early March, were decisively voted on to SNS' board.

Things didn't end here though. The atmosphere within the board was hardly congenial. The CFO at that time, Jeffrey Blade, was appointed interim Chairman, when the obvious choice would have been Sardar. It took 3 long months, and further operational deterioration, until things took a turn for the better when Sardar was appointed Chairman in June. After a fruitless search for a new CEO, Sardar himself was appointed CEO in August. So, how did things go operationally this year?

Q1 results:

---------

The company posted an operating loss of $2.415 million before taxes with same store sales declining a whopping 9.5% and guest traffic declining 13.3%. Given how dismal new store openings had proved over the last decade, management also considered it prudent to open 4 more new restaurants! 4 restaurants were refranchised and 2 new franchised restaurants were also opened. Owner earnings estimates for the quarter came in at a piddling $1.987 million.

Q2 results:

---------

The company posted an operating loss of $5.112 million before taxes with same store sales declining 6.3% and guest traffic declining 8.8%. Unimaginably, in the face of all of this operational decline, management continued on it's merry spending spree, opening 5 more restaurants in Q2. The company also refranchised 4 of it's owned restaurants. Alarmingly, the company reported that it was in violation of covenants with respect to it's debt agreements and that some covenants had to be reworked in order to enable SNS to be in compliance with them. Although SNS had the assets to cover the debt, this wasn't good news at all.

Q3 results:

---------

Sardar had been appointed Chairman just prior to the end of this quarter. The company posted an operating loss of $16.179 million before taxes with non-cash restaurant impairment charges of about $14 million. The noose was also being tightened wrt the line of credit facility. SNS entered into a sale-leaseback transaction for 10 of it's owned stores for $14.817 million and used pretty much all of the proceeds to pay down the line of credit to $9.18 million. This was essentially a financing transaction, a swap of one type of debt to another, more expensive type of debt. The interest on the line of credit facility was 4.94%. The imputed interest on the sale-leaseback transaction was 8.27% (lease payment of $1.226 million for these leased-back properties in fiscal 2009 divided by the total proceeds of $14.817 million). Clearly, this was a transaction best avoided, if possible. I suspect that with operations deteriorating fast, the lenders pushed hard and Sardar had no choice in this matter.

The 10-Q also indicated that SNS had been granted a current quarter waiver of covenants wrt to both the Senior Notes as well as the Line of Credit facility. SNS was also prohibited from making cash dividends as well as share repurchases. SNS would also be required to secure their Senior Notes borrowings with real estate assets effective November 21,2008. SNS was basically being told what to do by their creditors as a result of operational deterioration, and one suspects, the freeze-up in the credit markets.

Prior to the announcement of Q4 results, Sardar wrote his first letter to shareholders as CEO of SNS:

http://www.sec.gov/Archives/edgar/data/93859/000009385908000070/exhibit99_1.htm

Plenty of discussion about cost cutting with G&A expected to be $20 million lower from 2007 levels. SNS was also expecting a $16 million(!) refund from taxes that were paid in 2006. SNS also expected to pay down the Senior Notes.

There was an interesting comment about hiring an experienced restauranteur, Dennis Roberts, formerly at Friendly's (Western's first stock investment under Sardar), to help with improving operations. Roberts had been granted 50,000 stock options of SNS as part of his offer of employment at a strike price of $10 effective Sept 29, 2008. Closing price of SNS stock on Sept 29, 2008: $8.59. You heard that right. Sardar had hired Roberts to work at SNS with an options agreement where the stock price was lower than the strike price of the options. Although there exists a remote possibility that there is a precedence for this occurence, I suspect this is a first and one that Sardar deserves credit for.

Q4 results:

---------

This was Sardar's first full quarter in charge of SNS. The company reported an operating loss of $11 million before taxes with same store sales declining by 7.4%. The operating loss came back of $6.366 million in charges associated with the restructuring that Sardar alluded to in his last letter.

Estimated owner earnings for fiscal 2008 was $14.13 million, compared to $16.644 million in fiscal 2007. Just like the 2007 estimate, the 2008 estimate also included certain one-time charges. The difference with the 2008 charges were that one could be reasonably confident that these charges would be non-recurring, given their nature and also given that Sardar was now in control. The addition of the non-recurring expenses increases the estimate of owner earnings in fiscal 2008 to $15.885 million, still significantly off from the highs of about $35 million in fiscal 2005.

Sardar had also announced an SNS investor day for November 11th, a day after the results for the 4th quarter had been posted. Notes from that day are available here:

http://seekingalpha.com/article/106523-notes-from-steak-n-shake-s-investor-day?source=article_lb_author

A more detailed, and brilliant, set of notes came from a service I subscribe to. All I can say is that I wish all current and prospective SNS shareholders could read it. I was disappointed to not be able to make it to that investor day but I suspect there will be plenty of chances in the next few decades to see Sardar at SNS/WEST annual meetings.

Warren Buffett has often said that he looks for three qualities in evaluating a person: integrity, passion and intelligence. In my admittedly subjective opinion, Sardar ranks very highly in all 3 categories.

He has a tough job turning SNS around but I'll say this: Underestimate Sardar Biglari at your own cost of opportunity.

Disclosure: Long Sardar(SNS & WEST).

Often wrong but seldom in doubt,

Ragu

A lesson in value-destroying "growth": Presented by former Steak 'N Shake management

2008-12-22T13:28:00.010+05:30

Number of Steak 'N Shake restaurants in 1998: 233 company owned and 51 franchised

Number of Steak 'N Shake restaurants in 2007: 435 company owned and 56 franchised

Revenues at the end of 1998: $312.552 million with franchise fees accounting for $3.355 million

Revenues at the end of 2007: $654.142 million with franchise fees accounting for $3.726 million

Sales grew at a compounded rate of 8.55% for those 9 years. What about profits?

Reported earnings for 1998: $11.225 million

Reported earnings for 2007: $11.808 million

That's right. Earnings grew(if that's the right term here) over the same period at a compounded rate of about half a percent per annum. To achieve this tremendous result, management spent more than $500 million in capital over that period. Little wonder then that shareholders were the ones left holding the bag as management embarked on a value destruction spree. Shareholders would have instead been much better off if management had simply paid out all of the owner earnings as dividends during this period.

As management continued down this path of destruction, Sardar Biglari, the Chairman and CEO of Western Sizzlin, began buying shares of Steak 'N Shake. After buying about 7% of the stock, Sardar wrote his first letter to SNS shareholders in October 2007 announcing his intention to nominate Western's vice-chairman Dr.Phil Cooley and himself for election to SNS' board at the 2008 Annual meeting:

http://www.western-sizzlin.com/pdfs/Letter%20to%20the%20Shareholders%20of%20Steak%20n%20Shake.pdf

This is how SNS' balance sheet looked at the end of 2007:

A line of credit that had been drawn upon to the tune of $27.185 million.

Long term debt of $16.522 million.

Against this debt, we had:

Assets Held for Sale valued on the books at $18.571 million.

Property and Equipment valued on the books at $492.61 million.

Remember our discussion on capital lease accounting? You'll see that SNS' balance sheet has a liability line item called Obligation under Leases to the tune of $139.493 million. So, the book value of SNS' property and equipment was closer to $353.117 million(492.61 - 139.493). Debt looked reasonable relative to assets on the book at this point.

We also had $16.644 million in owner earnings for 2007(there were quite a few one-time charges in that calculation that weren't added back, so these earnings are likely understated if Sardar were to get control), down precipitously from about $35 million in 2005. Sardar had mentioned a possible $12 million in savings from bringing G&A expenses down to prior levels. Nevertheless, the business operations were in serious decline as is clear from the numbers above. Having demonstrated it's ineptitude on the capital allocation front, management had turned it's sights to operational ineptitude over the last couple of years. Consequently, SNS was selling for about $303.9 million a week after the 2007 10-k was filed, for less than the value of Property and Equipment on it's books.

So, the situation at the end of 2007 was: A restaurant "brand" that had been around since 1934 being decimated by management incompetence, primarily on the capital allocation front, and more recently, on the operational front. An extremely shareholder friendly group led by Sardar that was looking for two seats on the board to fix the capital allocation and operational issues. If Sardar and Phil Cooley were elected to SNS' board, things were likely to get better, albeit over time. We'll see what actually happened in 2008 next.

Often wrong but seldom in doubt,

Ragu

Sellers on Premier's management issues

2008-12-17T16:10:00.003+05:30

http://www.sec.gov/Archives/edgar/data/796764/000095015208010212/l34728cprrn14a.htm

Must read for all current and prospective Premier shareholders. Warning: Current shareholders may experience loss of sleep the night of reading this(I did).

My thoughts on reading this ranged from wow to Wow(not the good kind of Wow). I knew going in that the quality of management was iffy here, but I had no idea that things were this bad. Good thing they have such valuable assets, eh?

Often wrong but seldom in doubt,
Ragu

Owner earnings calculation: An example

2008-12-16T09:27:00.004+05:30

After a brief diversion into the world of cricket, we are back to regularly scheduled programming. My voice may be gone completely after the cricket yesterday, but I am luckily still able to type.

Let's look at Steak 'N Shake's numbers for fiscal 2005 and see if we can come up with an estimate for owner earnings. Steak 'N Shake is a chain of Quick Service Restaurants, originally established in 1934.

The 10-K for fiscal 2005 is here:

http://www.sec.gov/Archives/edgar/data/93859/000009385905000091/form10-k2005.htm

For fiscal 2005, the company reported $30.222 million in GAAP earnings. Let's look at the statement of cash flows under Operating Activities to see which non-cash charges need adjusting.

Depreciation and amortization charges of $26.945 million will be added back. We will subtract maintenance capex(yet to be determined) to offset this.

A charge for provision of deferred income taxes(beyond my ability to explain this well and perhaps even comprehend completely) of $1.769 million will be added back.

Provision for restaurant closings of $1.4 million. What does this amount represent? The company states that it decided to close 2 underperforming restaurants in fiscal 2005. The $1.4 million represents represents the difference between the carrying value of the assets on the balance sheet and the undiscounted future cash flows that would have accrued from keeping the assets in operation. The answer to whether this non-cash charge should be added back is subjective. In general, asset write-downs reflect poorly on management's capital allocation abilities. On the other hand, these assets will be sold (the 10-K says so) for cash that may be deployed effectively elsewhere. Given that there was a bigger write-down in fiscal 2003 for $5.2 million, I am loathe to give management the benefit of doubt re. the deployment of cash from the asset sales. In fact, management is more than likely destroying value by retaining all the earnings of this business. More on that later. On balance, this charge is still a balance sheet impairment and so we'll add these charges back to reported earnings. I won't quibble however if this charge wasn't added back.

Non-cash stock compensation expense amounted to $1.798 million. I consider this a true "economic" expense(try withholding it in future periods from the people who were going to receive it and see how many want to continue to work there), so this amount won't be added back either.

There was a loss on disposal of property amounting to $.65 million. Again, this is a balance sheet impairment and is unlikely to have a material effect on earnings. We'll add this amount back.

The adjustments from non-cash charges to earnings of $30.222 million are as follows:

Depreciation and amortization: + $26.945 million

Provision for deferred taxes: +$1.769 million

Provision for restaurant closings: +$1.4 million

Loss on disposal of property: +$.65 million

This gets us to $60.986 million in cash flows prior to maintenance capex. How do we estimate maintenance capex? Let's look in the 10-K for some clues.

The Investing Activities section of the cash flow statement tells us that $63.622 million was spent in capital expenditures for fiscal 2005. The growth capex for this business comes from opening new restaurants. From the 10-K, we know that 19 new restaurants were opened in 2005. The 10-K also tells us that the company expects to open 26 new open restaurants in fiscal 2006 at an average cost of $2 million. Aha! Perhaps the 2004 10-K will tell us how much, on an average, the new restaurants that were opened in fiscal 2005 were expected to cost. Here's the link to the 2004 10-K:

http://www.sec.gov/Archives/edgar/data/93859/000009385904000049/form10k.txt

Sure enough, under the section titled Liquidity and Capital Resources, we find that the average cost of the new restaurants to be opened in fiscal 2005 were expected to be $2 million. We now have an estimate of growth capex (19 new restaurants * $2 million = $38 million). Therefore, an estimate of maintenance capex is $25.622 million (63.622-38).

We can now come up with an estimate of owner earnings: $60.986 million - $25.622 million = $35.364 million. This is about 17% higher than the reported GAAP earnings of $30.322 million. Additional adjustments are possible in this case, but this works as an illustration of how to get to a first estimate of owner earnings.

Often wrong but seldom in doubt,

Ragu

Sachin Ramesh Tendulkar: Take a bow

2008-12-15T18:17:00.004+05:30

Train tickets to Chepauk and back: Rs. 10

Tickets to the D stand by the sight-screen: Rs. 125

Food inside the stadium: Rs. 200

Watching cricket in a stadium for the first time, with my cricket fanatic uncle in tow, and seeing Tendulkar make a match-winning 100 in a 4th innings chase for the first time ever: Priceless

Sehwag clearly set up the platform for a victory push but it was a joy to watch Tendulkar see it through to the very end.

Exhausted from chanting "Saachin, Saachin" all day but deliriously happy nonetheless,

Ragu

Accounting for capital leases: An example

2008-12-11T17:01:00.009+05:30

For the reader that wanted an illustration of the balance sheet changes during the life of a capital lease, here goes:

Assume a company leases(capital lease) a tractor for a period of 5 years, beginning today. The fair market value of the tractor today is $15000. The annual lease payments amount to $4000. The company's long-term cost of borrowing is 10%. Also assume that the asset will be fully depreciated on a straight line over the lease period i.e. annual depreciation will be ($15000/5 = $3000).

The present value of the lease payments based on the company's long-term borrowing rate of 10% = $15,164.35

Since this is greater than the current FMV of $15000, the asset and liabilities side of the balance sheet will go up by the current FMV (it is not reasonable to capitalize an asset at a value greater than its current FMV).

Assets (A): +$15,000

Liabilities(L): +$15,000 (this is considered long-term debt)

The next step is to compute an interest rate for this "debt" as the company's long-term rate of borrowing didn't fit(too low). This is the rate for which the present value of the lease payments equals the asset's current FMV. It turns out that this rate is 10.42%(the TI BA II Plus calculator is of some use after all).

How do the balance sheet entries change as we progress through the lease? Remember the annual depreciation on the asset is $3000. So, the carrying value of the asset on the books is reduced by $3000 annually over 5 years until it reaches zero.

The liability goes down by the amount of "principal" repaid on this debt. If you run an amortizing calculator on a loan amount of $15000 at an interest rate of 10.42% over 5 years, you will get an amortization schedule that looks like this:

Year Principal payment Interest payment Principal balance
1 2436.51 1563 12563.49
2 2690.39 1309.12 9873.1
3 2970.73 1028.78 6902.37
4 3280.28 719.23 3622.09
5 3622.09 377.42 0

So, here's how the carrying values of the asset and liability for this lease look at year-end as the lease progresses:

Remember that at lease inception they are both carried on the books at $15000.

Year Asset's book value Liability's book value
1 $12000 $12563.49
2 $9000 $9873.1
3 $6000 $6902.37
4 $3000 $3622.09
5 $0 $0

Hope this was helpful. Feel free to ask if any of this is unclear.

Often wrong but seldom in doubt,
Ragu

Owner Earnings: What is it and Why it Counts

2008-12-11T07:10:00.004+05:30

Remember the very first thing that we were told in any good book on common stock investing: When you buy the common stock of a company you become a part owner in the underlying business. As owners evaluating the earnings power of a company, our focus should be on the earnings that are available to the owners every year. This is simply the amount of cash that can be taken out of the business every year and distributed to the owners without affecting the current operations/profitability of the business. How do you get this amount?

Start with the reported GAAP earnings:
a. Add back depreciation, amortization and certain non-cash charges.
b. Subtract maintenance capital expenditures.
c. Undo the effects of one-time items.

Note on (a): The question of which non-cash charges to add back to earnings is subjective. The one non-cash charge that I feel strongly about and would not consider adding back to GAAP earnings is stock compensation expense.

Also, note that we ignore changes in working capital in the calculation of owner earnings. Growth in operational cash flow powered by a significant change in working capital is not likely to be sustainable(there are limits to how quickly you can collect payments from people that owe you and how much you can put off paying people that you owe money to). So, while positive changes in working capital management is welcome, the nature of these improvements is such that they are not recurrent enough to warrant their inclusion in the calculation of owner earnings.

Update: On reflection, while it may be prudent to ignore positive changes in working capital, cases where sales growth necessitates increased working capital investment require different treatment. In such cases, it'd be worthwhile to charge for the increase in working capital(higher levels of inventories, for e.g.) to arrive at an owner earnings estimate.

There are two types of capital expenditures:
a. Maintenance capex which is needed in order to maintain current profitability. e.g. replacement of old equipment/worn-out buildings. Estimation of this amount is the tricky part.
b. Growth capex which is spent for growth. e.g. building a new factory to enable additional sales.

In general, companies do not provide a breakdown of the two types of capex. They are invariably lumped together under the Statement of cash flows under the Investing Activities section as Additions of Property and Equipment. It is necessary though to guesstimate the maintenance capital expenditures, for otherwise it is not possible to come up with an estimate of owner earnings. A reasonable question to ask at this point is: Why do we need maintenance capex estimates when depreciation is intended to fulfill that very purpose? Simply because depreciation is based on historical costs which may/may not be relevant today. If depreciation is much smaller than maintenance capex, GAAP earnings vastly overstate the earnings power of the company in question.

Warren Buffett first introduced the concept of Owner Earnings in his 1986 letter to shareholders. I'd highly encourage readers to read it: http://www.berkshirehathaway.com/letters/1986.html.
Look for the beautifully written section titled 'Purchase-Price Accounting Adjustments and the "Cash Flow" Fallacy'.

Often wrong but seldom in doubt,
Ragu