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.


  1. "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"

    Ragu, I am missing something here. Are u saying that in hindsight this was not a good investment on your part ?


  2. ragu, your formula of total invested capital, at least as it as it relates west's restaurant operations, doesnt yield the sames numbers as this definition:

    and there's a simplified, abbreviated formula i generally use which is: equity, plus long term debt, plus other LT liabilities, LESS cash & cash equivalents & marketable securities = total invested capital in operations that is roughly right, if not always to the 2nd decimal point.

    and Income from restaurant and franchise operations according to west's 2007 shareholder letter was $507,773 for 2007 & $572,210 for 2006, Plus: Depreciation and amortization expense of $1,063,217 & $1,057,492 respectively, Plus: Claims settlement and legal fees associated with lawsuit of $741,287 & & 289,109 respectively, giving an ADJUSTED Income from restaurant and franchise operations (excluding depreciation
    and amortization expense and expenses associated with the lawsuit) of $2,312,077 for 2007 & $1,918,811 for 2006.


    i am not able to square your numbers to the ones sardar gives.

    and your ROIC seems to be understated because your calculations of total invested operating capital appears to be over stated.

    can you help me here?

    i enjoy your blog & feel a kinmanship with your investing sensibilities but am unable to reconcile a few things in your table above.


  3. Qleap,

    If you own a business for any significant period of time, say a couple of decades or more, your compounded annual returns will more than likely match the long-run return on invested capital in the business(assuming little to no leverage and a price paid in the neighbourhood of the capital invested in the business at the time of purchase) over that time period. If your hurdle rate i.e. opportunity cost for your capital, is say 15% after-tax, then clearly Western's restaurant operations' ROIC numbers will fall well short of expectations. Unless, you have a good(which Sardar already is) to great(which Sardar is highly likely to be, in my opinion) capital allocator who takes the cash from the restaurant operations and redeploys it into high return opportunities in the securities markets or elsewhere.

    So, in summary, to answer your question: I wouldn't be interested in owning a piece of Western's restaurant operations(based on the ROIC numbers) for the long-term unless there was a skilled capital allocator in charge of allocating the cash flows from those restaurant operations. In my opinion, we do have one. That makes Western, at a minimum, certainly worth examining.


  4. Ragu,

    Thanks for the elaborate, clear reply!


  5. link,

    Thanks for your kind words re. the blog. Re. the difference between the numbers in the table above and Sardar's numbers:
    (a). Sardar includes Western's equity in the JV in his numbers. I broke out the JV numbers to illustrate the difference in the economic characteristics of the JV and the rest of Western's restaurant operations.
    (b). My numbers adjust the income from the restaurant ops downwards to account for maintenance capex. This gives us an estimate of the cash generated from the operations, which is the numerator in the ROIC calculations.

    As for the invested capital calculations, your method is conceptually equivalent to the method I use. I like looking at the assets side of the balance sheet to come up with an estimate because it forces me to think about whether the asset is question really ought to count as part of the business' invested capital. For e.g. in 2005, there were a couple of items related to income tax and insurance receivables that aren't really relevant to the calculation of capital invested in the business. As for the difference in the numbers between your method and my calculations, I expect that much of the difference will be explained by noting that I don't amortize the franchise royalty contracts(what we otherwise call goodwill) while the balance sheet numbers reflect the amortized amount(see end of Note 2 in the original post). I thought about this for a while. In the end, I decided to go with the non-amortized amount. Couple of reasons:
    1. The amount of goodwill and franchise royalty contracts(non-amortized) on the balance sheet is so high relative to tangible assets that it is reasonable to believe that much of the earnings from the company-owned stores have been "bought" over time. The return on tangible net worth in this case did not seem like a reasonable measure of what Western could do, if they decided to build a store on their own. We'll know more in the next couple of years with their wholly owned Wood Grill Buffet type restaurants.
    2. Given the declining count of the company-owned and franchised stores over the past few years, it seemed prudent to see the numbers in my table as more representative of the "normal" ROIC. Perhaps Sardar will revive the franchising, but I'd rather not pay up for that possibility in the absence of any information to indicate that this is highly likely to happen.

    Hope this clarifies.


  6. thnx, ragu, for the explanation. i enetered your no.'s in xl then ran my table beside yours & our results vary by very little...a max of 2% in 2005. the 9 months for 2008, however, i'm getting an annualized roic of 13%. the differenece is that i use the Total income (loss) from restaurant and franchise ops no. of $208,505 from wests 10Q, & also add back the 1x expenses of $ 250,000 & $355,00 that you cite in notes (a) & (b) but dont appear to add back.

    and, yes, wests franchising base has been in a steady, if slow decline. but i have some confidence that their new good grill buffet concept is going to be successful from both a high return & a growth standpoint. and we will have to see if jim verneys replacement plus some of the other new blood sardar has hired in operational capacities will revitalize things there.


  7. Qleap,



    You are right that I don't add back the numbers that I cite in notes (a) and (b). If I were to be consistent with the numbers from prior years, I shouldn't be really be adding back (b) because that amount represents the increase in sub-leased property expenses as compared to last year. I don't mind adding (a) back. That gives us a pre-tax ROIC of 9.8%. I left the notes in there as an explanation of why the cash flows look like they have fallen off a cliff. They have fallen, just not quite as dramatically as the numbers seem to indicate at first glance.


  8. "If I were to be consistent with the numbers from prior years, I shouldn't be really be adding back (b) because that amount represents the increase in sub-leased property expenses as compared to last year."

    yes, ragu, but it looks like a 1x increase to the sublease expense. as it says in the 10Q:

    "Subleased properties include net costs associated with subleasing former Company-operated restaurants and maintenance of vacant premises. These expenses increased by $335,000 and $355,000 for the three and nine months ended September 30, 2008 versus the prior year’s comparable periods. The increases were largely attributable to repairs and maintenance to subleased properties undertaken by the Company in anticipation of surrendering possession to the landlord in October and November of 2008. Inflationary increases in costs associated with vacant properties also contributed to the increases in subleased properties expense. Current subleasing arrangements, and the related master lease, are scheduled to expire by the end of 2008."

    thus, if you want to see what the underlying business cash flows look like non recurring charges should be added back. and the 10Q paragraph quoted above suggests your note (b) that "Sub-leased property expenses increased by $355,000 for the first 9 months of 2008 as compared to 2007." is a 1x r&m expense prior to relinquishing the leases in oct and nov.

    your extreme coservatism makes mine look like a case of bleeding liberalism, ragu!