Tuesday, December 13, 2011

An open letter to the CEO of Cracker Barrel

Dear Ms. Cochran,

I am writing in response to your letter dated November 21st 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 27th 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.


Ragupati Chandrasekaran

Friday, November 6, 2009

Thoughts on Gwalior Chemicals

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.


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.


Tuesday, October 13, 2009

Working at CGI, going to Las Vegas and more

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 23rd of Oct through the 25th. 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.


Tuesday, June 16, 2009

A compensation policy worth studying

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.


Sunday, April 26, 2009

Steak 'N Shake on the mend

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)
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,

(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.

Monday, April 20, 2009

Sellers Capital offered buy-out at Premier

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,

Friday, March 13, 2009

Mark Sellers' first conference call as Premier's Chairman

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,