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,

Tuesday, March 10, 2009

Examining Steak 'N Shake's debt covenants

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’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’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,

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.

Friday, March 6, 2009

Brief thoughts on Buffett's letter to shareholders

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,

Wednesday, March 4, 2009

A look at Western's purchase of Mustang Capital

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:
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,

Friday, February 27, 2009

Evaluating Western Sizzlin's restaurant operations under Sardar

Sardar was appointed to Western’s board in November of 2005 and was elected Chairman in March 2006. Here’s the 2005 shareholder letter:

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) 162,820 741,287 289,109201,000
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 294,488315,063
Interest 160,421223,574
D&A 152,131200,869
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 ROIC21.36% 20.55%
Cash distribution to Western150,000-

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,

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: (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.

Friday, February 6, 2009

Management changes at Premier

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

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,

Thursday, January 29, 2009

Steak 'N Shake Q1 2009 results

[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:

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,