Wednesday, December 31, 2008

What's Steak 'N Shake worth anyway?

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

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, 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:

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,

Sunday, December 28, 2008

Steak 'N Shake: 2008 in review

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:

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:

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:

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,

Monday, December 22, 2008

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

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:

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,

Wednesday, December 17, 2008

Sellers on Premier's management issues

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,

Tuesday, December 16, 2008

Owner earnings calculation: An example

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:

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:

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,

Monday, December 15, 2008

Sachin Ramesh Tendulkar: Take a bow

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,

Thursday, December 11, 2008

Accounting for capital leases: An example

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,

Owner Earnings: What is it and Why it Counts

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:
Look for the beautifully written section titled 'Purchase-Price Accounting Adjustments and the "Cash Flow" Fallacy'.

Often wrong but seldom in doubt,

Monday, December 8, 2008

Accounting for capital leases vs operating leases: Balance sheet implications

I was going to write about Steak 'N Shake, but I figured a little accounting refresher was required in order to better understand its balance sheet. Companies lease a variety of things, from land and buildings to equipment, in order to maintain their operations. With leases come payment obligations. In the opinion of accountants, some of these obligations are "debt-like". They have therefore come up with a set of criteria to differentiate these "debt-like" cases from regular(operating) leases.    

In order for a lease to qualify as a capital lease, it is sufficient that any one of the following 4 conditions be met:

1. There is a transfer of ownership of the asset being leased at the end of the lease term.
2. There exists an option to purchase the asset at a "bargain price" at the end of the lease term.
3. The minimum present value of the lease payments is greater than 90% of the asset's current fair market value.
4. The lease term exceeds 75% of the asset's expected useful life.

Note that each of these conditions implies either outright ownership(1)/possibility of ownership(2) or virtual ownership((3) & (4)) of the asset in question. 

So, what happens when a lease is accounted for as a capital lease? Basically, the transaction is accounted for as though the asset was purchased with 100% debt. The assets and liabilities go up by the exact same amount. What is this amount? It is the present value of the lease payments(call this PVL). What is the discount rate that's appropriate to compute the PVL? Since the transaction is accounted for as being 100% debt financed, it makes sense to use the company's current cost of borrowing as the discount rate. Two possibilities present themselves now:

a. PVL, using the company's cost of borrowing, is less than the asset's current fair market value. In this case, the value of the asset and the liability on the balance sheet is the PVL.

b. PVL, using the company's cost of borrowing, is greater than the asset's current fair market value(FMV). In this case, the value of the asset and the liability on the balance sheet is the asset's current FMV. Also, a discount rate is calculated that makes the present value of the lease payments equal to the asset's current FMV. This discount rate is the imputed interest rate on the accounting "debt" that goes on the company's books.  

So far so good. At the inception of a capital lease, the assets and liabilities(pertaining to the lease in question) match exactly. As the lease progresses however, they diverge. The asset is depreciated (in a straight line, mostly) over the course of its useful life. As for the liability, remember that it is treated as debt and there is an imputed interest rate for that debt. The liability is reduced by the amount of "principal" repaid on that debt. Therefore, the asset is reduced by an amount, via depreciation, at a rate faster than the liability goes down. The two eventually converge to zero at the end of the lease. This is about as much as we need to understand about the change in assets and liabilities as the lease progresses.

When a lease is accounted for as an operating lease, there are no balance sheet entries at the inception of the lease. Thank god for small mercies.

In either case, there are implications for expenses, classifications of cash flows and so forth. We'll skip all of that for now. You're welcome.

Congratulations to everyone that made it to the end of this post. You will be receiving your free gift shortly.

Often wrong but seldom in doubt,

Thursday, December 4, 2008

Premier Exhibitions: The price isn't right

If you remember from the last post on Premier Exhibitions, the company had $17.481 million in cash and marketable securities as of Feb 29,2008 and no debt, with a healthy cash generating business to boot. The entire company is selling for $33.33 million today. What happened in the interim?

Well, quite a few things and not all of them were good, to say the least. The company hired Bruce Eskowitz to be its CEO in September 2007. His agenda: Build Premier into a full-scale ticketing/merchandising business. The executive management team was revamped costing Premier a fortune, to put it mildly. The decision to run more shows independently (they had been partnering with JAM and LiveNation for most of their shows before) meant gross margins declined, from the mid 70's to the low 50's that they expect today. They bought MGR entertainment, an entertainment merchandising company, for $2.1 million (gross revenues of $9.1 million) in March 2008. In fiscal 2008, Premier made all of its money from 2 exhibitions(19% from Titanic and 81% from the hugely successful Bodies exhibitions). Earlier this year, in an ABC 20/20 episode, the origins of the bodies that were being used for display in the Bodies exhibitions were brought into question. There were claims that the bodies were those of tortured Chinese prisoners. Premier denied the charges and money was spent in legal expenses to handle these allegations. Ultimately, Premier resolved the issue by publishing a disclaimer to the effect that they couldn't completely guarantee the source of all the bodies that were on display.

Meanwhile, in an effort to diversify their revenue stream, Premier decided to add 3 more exhibitions: Dialogue in the Dark, Star Trek and Sports Immortals. There was a significant ramp-up in personnel costs as additional people were hired to handle this explosive growth ($2.535 million in the 1st qtr of fiscal 2008 vs $8.018 million(!) in the 1st qtr of fiscal 2009). They also signed a long term lease to display 3 of their exhibitions at the Luxor casino in Las Vegas, moving from the Tropicana. All of this expansion comes right smack in the middle of one of the worst recessions in the US in decades.

The aforementioned expenses have contributed to cash balances dwindling to $8.1 million at the end of the 2nd qtr of fiscal 2008, with Premier expecting to draw on their line of credit facility with Bank of America by the end of the year. Cash flows for the year have been extremely meager (about half a million from operations), with declining attendances at the exhibitions coupled with the outrageous rise in personnel expenses in the pursuit of "growth" being major contributors. After Premier reported a first quarter loss for fiscal 2009, dissatisfaction grew and Bruce Eskowitz was replaced by Arnie Geller, one of Premier's founders, as CEO in August 2008. The same Arnie Geller that had continued to be paid about $650,000 in salary after Eskowitz replaced him as CEO. He was, however, one of the company's founders and owned about 9% of the outstanding stock. Surely, he'd have the interests of the company's stockholders at heart.

Meanwhile, in the fall of 2007, a man I rate very highly, Mark Sellers, started building a position in Premier. Mark Sellers runs a hedge fund, Sellers Capital, and looks to invest in undervalued situations. On a completely unrelated note, it is interesting to see that Sellers looked at Steak 'N Shake as a potential investment before Sardar Biglari took charge there and decided not to pursue it as a potential catalyst was not visible. Look up and for articles/interviews by/with Sellers. He comes across as an extremely sensible, intelligent investment manager. It is clear(to me anyway) that Sellers understands investing the way it ought to be practised.

If he's that good, why don't you tell us his actual track record so we can judge for ourselves, eh? Sure.
Annualized net returns since inception (Aug 2003 through the end of Q3 2008): 19.86% vs 5.16% for the S&P 500. This, after his positions in the fund were down about 55% in Q3 of 2008. You heard that right. A lot of it was attributable to his biggest holding, Contango Oil and Gas, which declined precipitiously in Q3 as oil prices fell off the cliff. Knowledgeable observers feel Contango is undervalued at today's prices(likely atleast 2x) although I have no opinion there. His only other holding at the end of Q3: Premier Exhibitions.

Sellers now holds about 16% of Premier's stock(he is the company's largest shareholder), and as the business performance started deteriorating, he asked for 2 board seats and got them. It is likely he was instrumental in Arnie Geller returning as CEO.

So, around the time of Q2 earnings, the situation at Premier was:
a. Largest shareholder on the Board of Directors pushing for cost control, a focus on return on invested capital and better corporate governance.
b. Second largest shareholder and one of the founders returning as CEO.
c. Trial for the salvage award moving forward as Premier had submitted revised covenants to the court in the event that they were to be granted an "in-specie" award.

Things were looking up, right? Right. A week or so before Q2 earnings, Sellers announced that he was shutting his fund down and would be liquidating his positions. Bummer. Except Sellers wouldn't allow redemptions from his fund(to prevent forced selling) and he expected to wind his fund down over a period of 2 or more years in order to get sensible prices for his holdings. Good on him for doing the right thing. As always, it's a good thing to associate yourself with people of the highest integrity. I'll post more thoughts on Sellers shutting his fund down, and the perils of managing other people's money, later.

Back to Premier. Even though the Sellers news wasn't bad, all things considered, the stock continued to decline. Q2 earnings were announced(not good, of course, given the economic conditions), and in the conference call, management announced that they'd not provide guidance for earnings any more. In general, I consider that an extremely bullish signal. I don't believe that there is any value added from providing earnings estimates and investors waiting with bated breath to see if a company hit/missed/exceeded earnings expectations for each quarter. The earnings guidance practice is a colossal waste of resources, both on the company's side and on the investor's side of the fence. Not every one feels the same way, of course, and the stock continued to decline relentlessly from that point on.

As the stock cratered, Sellers Capital asked for the resignation of Arnie Geller on November 4, citing a variety of reasons, none of which would entice anyone to buy the stock, mind you.
You can read the SEC filing here:

Sellers also proposed that he'd be the non-executive chairman(without pay) after Arnie Geller's departure, overseeing the turnaround. There was no response from Premier. On November 21, Sellers Capital made official their choices for the 4 board seats that would be opening up:
Guess who I'll be voting for?

Premier sells for $33.33 million today. What are you getting for that price?

$46 million in fair value for the Titanic artifacts that are owned free and clear.
A free option on the outcome of the salvage award trial which is worth anywhere between $0-$110 million, an option with an extremely high probability of working out based on comments made by the US government in the trial.
The underlying low capex, high ROIC business for free.

The challenging economic conditions, entrenched shareholder unfriendly board/management, the yet to be determined result of the capital expenditures at Vegas and the new exhibitions all represent risks here. The price at this point though is sufficiently compelling that the risk/reward equation is heavily skewed in favour of the equity investor.

Often wrong but seldom in doubt,

Friday, November 28, 2008

Introducing Premier Exhibitions

Remember the trips to the exhibition when you were young?(yay!). Remember the trips to the museum?(Honey, we have visitors. We ought to take them to the museum, it'd be so educational). Combine the two into one experience and you've got Premier Exhibition's business.

Premier's a kind of a hybrid pick. It's a part special situation, part (possibly) long-term hold. Let's look at the special situation part first. Premier's most significant asset is its fully owned subsidiary, RMS Titanic Inc. ( The RMS Titanic Inc. is valuable because it is the only entity in the world that is allowed to look for and recover items from the sunk Titanic. See the FAQ on their website for more detail. They have recovered about 5500 artifacts from the Titanic so far which are extremely valuable. Just how valuable are they to Premier? You'll be sorry you asked. The answer to the question of how valuable the artifacts are depends on who has legal ownership of the items.

1. Of the 5500 artifacts, Premier has the title to 1800 artifacts, free and clear, awarded to it by a French court. This ownership is not in dispute and Premier estimates the fair value of these artifacts at $46 million.

2. Premier has "salvor-in-possession" status for the rest of the artifacts. What does this mean? This means that Premier essentially is the custodian of the artifacts until a decision is made regarding their ultimate destiny. Following a court order last October, Premier moved the courts for a "salvage award" last December. What's a salvage award, you ask? It's compensation for the act of salvaging property from a vessel in peril. 

There's two ways a salvor can be compensated:
a. In cash, based on the Blackwell factors (you can look these up, if you are interested. I now know more maritime salvage law terms than I ever wanted to know, which was nothing).
b. "In-specie" which means that the salvor gets ownership of the recovered property with an attached set of covenants that they must agree to abide by.  

Once Premier moved the courts for a salvage award, the US government joined the case as a "friend of the court". Outside of Premier, the US government is the most interested party in the Titanic wreck site. The US government believes that an "in-specie" award with the necessary covenants is one possible appropriate mechanism of compensating Premier (, p4). As of September 15 of 2008, Premier had submitted revised covenants that it would adhere to if it were granted ownership of these artifacts via an "in-specie" award. There isn't a date set for the court's ruling on this matter, but it looks like Premier is virtually certain to be granted an "in-specie" award, subject to reaching an agreement wrt to the covenants with the US government.
Premier's estimate of the fair value of these artifacts: > $100 million. See Premier's investor presentation from earlier this year for fair value estimates of the artifacts they own and the artifacts that are currently being adjudicated on by the court: (p7)

To summarize:
Fair value of artifacts owned free and clear: $46 million (carried at cost of $3 million on Premier's books)
Fair value of artifacts that are currently under adjudication: > 100 million

The cash flows from operations for the business for the last 5 years (in millions, 2004-2008) : ($1.577), (.051), 2.13, 11.476, 17.142. Premier had 17.481 million in cash and marketable securities as of Feb 29,2008 and no debt, compared to cash and marketable securities of $547,000 as of Feb 28,2004.

How much is the entire company selling for today? How about $20.17 million? Intrigued? You ought to be. 

Disclosure: Long Premier at prices much higher than today's. Let's leave it at that while I go see my therapist about that purchase.

Often wrong but seldom in doubt,

Friday, November 21, 2008

The fear behind Berkshire's free fall

I ought to have talked about it in the post about Berkshire's valuation. The reason is simple: Any time you believe there is a discrepancy between price and value for a particular security, it pays to understand why the discrepancy arose. Once you do, you can then make a reasonable assessment of whether the discrepancy is real or imagined. 

Over the last couple of days, there have been reports on Bloomberg and other sources that the cost of insuring Berkshire's debt has almost tripled over the last couple of months from 140 basis points to 415 basis points i.e. the cost of protecting a 100$ of debt owed by Berkshire went from $1.40 to $4.15. 

Median for Baa3 rated debt(lowest level of investment grade debt) was 348 basis points, compared to Berkshire's 415. If there's a more obvious illustration of irrational fear in the credit markets, I'd like to see it. Someone's going to make a ton of money shorting the Berkshire CDS' at these prices, perhaps more than someone thats just buying the equity. 

The fear(caused by the rising cost of Berkshire's debt protection) is that Berkshire will lose its AAA credit rating which would be an obvious blow to their insurance business, especially the super-cat business. Much as the rating agencies have behaved abominably during the real estate bubble, I'd seriously doubt a downgrade of Berkshire is in the works. Never say never I suppose, but lets see why fears of a credit downgrade are overblown.

The apparent(because I cant know for sure) reason for the surge in cost protection of Berkshire's debt is the equity index put options that have been written by Berkshire in the last few years. Lets forget the accounting for a minute and look at the economics of the transaction. 

1. Berkshire was paid $4.85 billion upfront in premiums for the put options.
2. The put options were written at market values for 4 stock indexes, 3 of them foreign over various times in the last 5 years.
3. Each of the contracts has a term ranging from 15-20 years.
 4. The options are European-style(which combined with the timeframe makes the transaction virtually risk-free for Berkshire), which means that they cannot be exercised except on the date of expiration.
5. The notional exposure on these contracts at the end of Q3 of 2008 was $37.042 billion.

So, what does Berkshire's bet mean? Simplifying for a minute (assume that the puts were written on one stock index and there's 13.5 years left on that contract, which is the average weighted remaining life on the contracts put together):

Market price of the index on the day the contracts were written: X
Market price of the index on the day the contracts expire(13.5 years from today): Y

If Y is less than X, Berkshire is liable to pay the difference to the put holder at the time of expiry of the contract, otherwise the puts expire worthless. Think about it: What are the odds that the indexes will be lower 15 years from now(approximately) than their peak, of say, last year? Free money for Berkshire, if you ask me. Add to it the fact that Berkshire gets to invest that $4.85 billion in a time of extreme financial turbulence. Brilliant timing. And the $37.042 billion in notional exposure? Thats the amount Berkshire is liable for, if all of the indexes on which these contracts are written against were trading at zero at the expiration date of these contracts. Lets just say we will have bigger problems than worrying about Berkshire's solvency if that eventuality came to pass.

Remember when I said to forget about the accounting for a minute? Well, that minute has passed and its time to understand why you see headlines in the financial media such as: "Berkshire Hathaway reports record 77 percent drop in quarterly profits".

As the market continues to decline:
1. The value of the puts(as estimated by Black-Scholes) decline. The current estimated fair value of the puts must be entered on Berkshire's books. This causes reported book value to decline.
2. The change in the value of the puts must also be applied to earnings. This means that, when the value of the puts decline, reported earnings take a hit, even though no cash payments have been made from Berkshire. This essentially renders reported GAAP earnings meaningless for analysis. The reverse is also true. When markets turn around, Berkshire will report "profits" from these contracts even though no cash payments will have accrued to Berkshire during that period. You can also expect the financial media to go ga-ga over these reported numbers and praise WEB's genius at that time. 

I hope this explains the fear behind Berkshire's drop and the irrationality of the fear. 

As WEB has said(paraphrasing): "To put up runs on the scoreboard, one must look at what's happening on the playing field, not whats happening on the scoreboard". 

On the scoreboard: Declining quoted prices for Berkshire's equity holdings, the "losing" put positions etc.

On the playing field(since the 3rd quarter only, Berkshire's been deploying plenty of cash since the end of last year): Berkshire buying 10% yielding preferreds in GE and GS(with an equity kicker to boot), MidAmerican buying CEG for a fraction of what it was worth at the start of this year, and the ability to buy billions of dollars of worth of securities at depressed prices with 2 of the greatest investing minds of all time allocating capital. 

I'd suggest what's happening on the playing field today will have a far greater impact on Berkshire's future net worth than what's being reported on the scoreboard. 

I'll say this again: At $77500 an A share and $2620 for the B's, Berkshire is stunningly cheap.

The obvious question from folks reading this then is: Why aren't you buying it? 
Two reasons:
1. I am fully invested at this point.
2. None of my other holdings are selling at prices close to where I would consider selling them. They aren't selling at prices close to where I bought them either, but thats another story for another day.

Often wrong but seldom in doubt,

Thursday, November 20, 2008

Buyback to commence at Western Sizzlin

At the end of the 3rd quarter of 2008, the company had $745,000 of cash and equivalents available. The operating cash flows from restaurant operations(without any adjustments) for the first 9 months of 2008 were at $1.15 million. It will be interesting to see how many shares(out of the authorized 500,000) they do end up buying back. They've also terminated the offer to Jack in the Box shareholders to tender their shares in exchange for shares in Western. I am happy with both of these developments.

Why is this interesting? Two reasons:
1. I am long WEST.
2. Sardar Biglari is the Chairman of Western. 

Who's Sardar Biglari, you ask?
Read this for an excellent primer on Western Sizzlin and how Sardar Biglari got to be its Chairman:

I believe the commencement of the buyback at WEST is a fairly telling indication of Sardar's estimate of its intrinsic value and the discount to that value that today's price represents. More thoughts on Western and its biggest investment(Steak 'N Shake) later.

Disclosure: Long WEST, at prices about 35% higher than today's (shares closed at $7.99 each, before the buyback announcement).

Often wrong but seldom in doubt,