Street Capitalist: Event Driven Value Investments

Given the poor performance of Steak n Shake (SNS) it should be no wonder that some shareholders are disgruntled. Below is a letter to the company, by H. Kevin Byun of Denali Investors. He suggests a number of appropriate methods for the company to pursue in order to create shareholder value.

The Steak ‘n Shake Company
500 Century Building
36 South Pennsylvania Street
Indianapolis, Indiana 46204
March 19, 2008

To the Board of Directors:

The purpose of this letter is three-fold:

1. Request timing for when the company By-Laws will be reverted.

2. Understand the Board’s stance on share repurchases as a capital allocation opportunity.

3. Request an articulated and detailed turnaround plan.

Ultimately, my sincere hope is that actions taken by the directors will compel shareholders to vote for the reelection of returning directors at next year’s annual meeting. A prompt response and addressing the three issues above will surely be integral to that decision.

In my previous letter to last year’s board on February 7, 2008, I stated that to date, board actions were perhaps having the unintended consequences of increasing shareholder discontent and decreasing support for board-led initiatives. The recent proxy vote provided confirmation. By a count of 15.65m to 5.45m, a super majority of 74% of voting shareholders selected the GOLD opposition proxy. Importantly, the top four proxy advisory service firms in the country also all advised shareholders to vote for the GOLD proxy.

In moving forward, a regression back to previous patterns of insular behavior would only further the case against the seven returning directors.

What prompted the writing of this letter is that, to my dismay, we are already seeing signs that previous patterns of hazardous thinking still permeate the seven returning directors. In a press release dated March 12, 2008, the Company announced that Wayne Kelley is assuming the role of Interim CEO and Chairman, and Jeff Blade the role of Interim President. Not only are both receiving substantial pay raises, but Mr. Blade will also receive an additional lump sum payment of $150,000, in addition to his pre-existing lump sum grants, in the event of any of three listed occurrences. I was utterly shocked to see that the first occurrence listed in press release reads “On the date the Board appoints him [Blade] to be permanent President and CEO.”

It appears that the culmination of seven months of work by the special committee and spending fulsome amounts on Merrill Lynch as an advisor has only produced one specific name associated with the role of permanent CEO - the current CFO. The fact that Mr. Blade is being considered by the returning directors as a viable candidate for permanent CEO, a role that requires an executive that can affect an operational turnaround, is truly alarming. This is no way a commentary on Mr. Blade’s ability as CFO.

In order to begin repairing the reputation of returning directors, do directors disagree with the following?

1. Reversion of the Company By-Laws. Namely, the reversion of Article IV (Meetings of Shareholders), Section 3 (Special Meetings), which allows shareholders to call special meetings, from the recently amended 80%, back to the original 25%.

Indeed, Steak ‘n Shake shareholders, along with every proxy advisory firm, were dismayed that the previous board decided to amend the By-Laws in an attempt to avoid accountability. A reversion to the original 25%, in addition to future By-Law changes requiring a shareholder vote, would make the clear and positive statement that the Board is operating within a shareholder friendly framework. Conversely, failing to revert the By-Laws sends an equally clear signal that the Board still does not take seriously its fiduciary duty. It behooves directors to revert the By-Laws promptly.

Exhibit I: The Excerpt of Original Steak ‘n Shake By-Laws dated March 2006:

Article IV Meetings of Shareholders
Section 3. Special Meetings. Special meetings of the shareholders for any purpose or purposes, unless otherwise prescribed by statute or by the Articles of Incorporation, may be called by the Board of Directors or the Chairman and shall be called by the Chairman or the Secretary at the request in writing of a majority of the Board of Directors, or at the request in writing of shareholders holding of record not less than one-fourth of all the shares outstanding and entitled by the Articles of Incorporation to vote on the business for which the meeting is being called.

In the Board’s proxy statement dated February 8, 2008, the special committee comprised of Messrs. Risk, Wilhelm and Williamson had “analyzed the outcome of various alternative future scenarios, including executing the company’s current strategic plan, modifying the strategic plan, increasing growth through more aggressive franchising, pursuing a leveraged recapitalization through a sale/leaseback of company-owned real estate and selling the company to a third party - either a strategic or private buyer.”

All these considerations mentioned remain compelling. However, there is no mention of opportunistic share repurchases as an option when shares are available at such a massive discount today.

A manager who consistently turns his back on repurchases, when these clearly are in the interests of owners, reveals more than he knows of his motivations. No matter how often or how eloquently he mouths some public relations-inspired phrase such as “maximizing shareholder wealth” (this season’s favorite), the market correctly discounts assets lodged with him. His heart is not listening to his mouth – and, after a while, neither will the market.

- Warren Buffett, 1984 Berkshire Hathaway Annual Report

What is the Board’s view of share repurchases?

To be perfectly clear, this is not to advocate share repurchases at any price. Indeed, were the share price currently $100 per share for example, share repurchases would be an inarguably improper use of capital.

Unfortunately, it is not without irony that at a time in which share repurchases would be the most effective, the Company does not have a repurchase authorization in place.

A knowledgeable Board recognizes excess capital can be directed in several ways, including: 1) dividends, 2) debt reduction, 3) share repurchases. Since the relative characteristics of dividends (tax consequences and transaction costs) and debt reduction (Company is not over levered) are fairly straightforward, the discussion will focus on share repurchases as the most attractive, given the severely discounted share price.

If I may be so bold, I would like to present the following case:

2. Implementation of an Opportunistic Share Repurchase Program. At the current share price, rather than use incremental capital to open one new company-owned store dollar for dollar, the same amount of capital through a share repurchase effectively buys the equivalent of 2.5 to 4 existing stores.

The recent share price, as low as $7.46 per share, offers a tremendous discount to the intrinsic value of the Company. At $7.46 per share, the Company is trading at only 0.7x of book value. Many shareholders believe this price represents a discount to intrinsic value of 60% to 75%, which implies a return profile of 150% to 300%. Clearly, the market is offering the Board an incredible opportunity to repurchase shares at a truly massive discount.

The previous Share Repurchase Authorization in effect from November 16, 2005 to November 16, 2007, was authorized to repurchase up to 3,000,000 shares. During those two years, only 20,400 shares were repurchased, or a total of $312,000, at an average cost of $15.29 per share (see Addendum I for more details). For reasons that cannot be explained, the previous Board allowed the program to expire.

The companies in which we have our largest investments have all engaged in significant stock repurchases at times when wide discrepancies existed between price and value. As shareholders, we find this encouraging and rewarding… By making repurchases when a company’s market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management’s domain but that do nothing for (or even harm) shareholders. Seeing this, shareholders and potential shareholders increase their estimates of future returns from the business

- Warren Buffett, 1984 Berkshire Hathaway Annual Report

Tremendous Cash Flow Masked by Growth Capital Expenditures

As the Board knows fully well, the Company generates significant cash flow. However, for the past decade, the Company has directed capital almost wholly into expansion. Growth, in the pursuit of top line numbers and without regard to the returns on incremental capital, is an inefficient use of capital. In reality, growth, depending on the returns on incremental capital, can be 1) value creating, 2) value neutral, or 3) value destroying.

(click the image for a larger version)

The Capex figures above include both maintenance capex (MCX) and growth capex (GCX). A fair proxy for MCX is Depreciation and Amortization (D&A). D&A for the past decade was as follows:

(click the image for a larger version)

As one can see, the Company, in reality, generates significant free cash flow were it not for burning capital to fund growth for growth’s sake.

During 1998, adjusted FCF was $24.1m. From 1999 to 2007, the Company pumped in $300m in growth capex, an average of $33.3m annually. During the same period, adjusted FCF totaled $236m, an average of $26.2m annually. This means that the $300m in growth capex resulted in only $17m in total incremental FCF from 1999 to 2007, implying a yield of only 5.7%.

However, each share repurchased at today’s price is the economic equivalent of buying a fractional ownership in each and every SNS restaurant at a 60% to 75% discount. To state again, the incremental dollar spent cutting the ribbon at one new company-owned store, spent instead for a share repurchase, buys the economic equivalent of cutting the ribbons at 2.5 to 4 existing stores. Compared to the returns from an incremental dollar of growth capex, share repurchases instead are an excellent and much higher return use of free cash flow at this time.

In order to better explain the magnitude of the benefit of share repurchases, the amount allocated to growth capex from 2005 to 2007 was approximately $125m. Assuming an average repurchase price of $15 per share, the Company could have repurchased up to 8.3m shares, reduced the share count by up to 30%, and increased EPS by over 40%. At the recent price of $7.46, the effectiveness and benefits of repurchases should be fully apparent and too meaningful to ignore. Notwithstanding the circular nature that a growth capex shift to repurchases affects future cash flow, one should concede that a repurchase at the current share price would yield more than the 5.7% return from growth capex.

I would greatly appreciate if the Board would communicate additional views of the case presented above, be they corrective or opposing, that I may have overlooked as well as the Board’s current position on share repurchases.

3. An Articulated and Detailed Turnaround Plan.
This is fairly straightforward. A plan should be provided to shareholders promptly.

In conclusion, it is my opinion that shareholders deserve a Board of Directors that understands and will act to address the following:

1. By-Law reversion is a necessary event and a forthright Board would act as soon as possible.

2. A Share Repurchase Authorization, available when shares are severely undervalued, is one opportunistic use of cash flow that creates significant value.

3. An articulated and detailed turnaround plan is critical to the entire process.

These are vital steps in reversing the loss of confidence and building trust among shareholders.

Again, not taking these steps sends the signal that the returning directors still continue to ignore: 1) fundamental principles of corporate governance; and 2) advantageous capital allocation opportunities.

As a concerned shareholder, I sincerely hope the Board takes these steps and rebuilds shareholder confidence, or steps down to make room for those that will. Shareholders should rightfully hold the seven returning directors responsible for continued deterioration of value, but would much rather wish to have a strong case to vote for the reelection of directors.

I appreciate the time you have afforded me and I look forward to your response on these important matters.

Regards,

H. Kevin Byun

With today’s news regarding the Bear Stearns buyout, the markets were certainly volatile, with some large sell-offs for Lehman Brothers (LEH) and MF Global (MF). I was more interested in the performance of the credit default swaps that are held in the portfolios of Odyssey Re (ORH) and Fairfax Financial Limited (FFH). So far things are looking good and we should see both of these companies thrive as a result of the current turmoil.

Thanks to Barminov from the MSN BRK Board for posting these figures:

I would also suggest that you visit Nick Nejad’s blog, Rational Angle to see more information pertaining to the credit default swap portfolio held by FFH, and a nice graphic of their price movements.

thanks to Eric for posting this:

Ajit Jain’s Prepared Remarks to the U.S. House Financial Services Committee (March 12, 2008)
http://www.berkshirehathaway.com//ajit0308dc.pdf
(around 20 minutes video among 6 hours in total) :
From 05h04 to 05h11 Prepared Remarks by Ajit Jain
Q&A session :
From 05h29 to 05h47: Ajit Jain. Note: I also recommend you watching until the end of video (Moody’s)
http://financialserv.edgeboss.net/wmedia/financialserv/hearing031208.wvx
Municipal Bond Turmoil: Impact on Cities, Towns, and States
http://www.house.gov/apps/list/hearing/financialsvcs_dem/hr031208.shtml

Source: BRKNEWS http://groups.yahoo.com/group/brknews/

One of my smaller investments is in a special situation at Steak N Shake. Steak N Shake (SNS) is a struggling casual dining chain which specializes in steakburgers. Through corporate change, I felt that the company could engage in a number of value creating opportunities, such as a sale leaseback transaction, or the refranchising of company owned restaurants. Both of these seemed to indicate a 55% upside to my initial investment ($11 per share).

With the company now trading at about $8 per share there seems to be quite a bit of fear. One of the walls that stood in the way of the company’s value was their stubborn and entrenched management. Part of my investment was my faith in Sardar Biglari of Western Sizzlin and The Lion Fund to enact change. Biglari has a keen insight on what to do with struggling casual dining chains, and so far has been quite effective with the takeover of Western Sizzlin and an investment in Friendly’s (a company taken private by Sun Capital).

During the proxy fight with Steak N Shake, Biglari mentioned Friendly’s often as an indicator of his prior success. Interestingly enough, a few days ago I ran across some new developments at Friendly’s in the Wall Street Journal:

To drive earnings growth, Sun obsesses over costs. One trick is pooling Sun-owned companies’ purchasing power for everything from health-care benefits to food. Friendly’s management has slashed about $1.6 million in expenses, including $50,000 for office supplies and $40,000 for UPS freight costs. Now, it’s looking to offset record commodity prices by gaining buying leverage on dairy and poultry. “One of the bigger opportunities could be in cheese,” says a delighted George Condos, Friendly’s CEO.

Some of these ideas seem really obvious and could probably also be implemented at Steak N Shake, especially considering the company’s steady rise in expenditures. In the last ten years, Steak N Shake has spent $566 million in capital with nothing to show for it except a decline in operating profits and negative shareholder returns. In 1998 the company’s stock price traded as high a $18.75 but now is at a mere $8.00, an almost 60% decline.

It is not as if the current entrenched management seemed open to pursuing opportunities for value, they instead focused on the wasteful implementation of grilled chicken sandwiches which costed an average of $30,000 per restaurant with nothing to show for it. In one of their recent conference calls they spent much of their time discussing the speed of their milkshake machines instead of addressing some of the problems like rising costs and same store sale declines.
But with the recent election results, that all might change:

Nominee Votes For Votes Withheld

Sardar Biglari 15,645,868 42,360
Philip L. Cooley 15,645,574 42,654
James Williamson 5,452,242 1,541,030
Alan B. Gilman 5,447,374 1,545,898

Clearly, Biglari and his former college professor Philip L. Cooley won by a landslide. However, Ted Evanoff of the Indianapolis Star makes a slight error

Although the two dissidents joined the board, they received fewer votes than any re-elected incumbent and trailed Risk by a wide margin. Risk, 79, has been a company director since 1971. Shareholders representing 17.9 million shares of stock voted for Risk, while 15.6 million shares each were voted in favor of Biglari and Cooley.

This insinuates that Bilgari and Cooley were competing against Risk, when that was not the case. Looking at the text on my gold proxy card, it is explicitly written that:

The Committtee intends to use this proxy to vote (i) “FOR” Mesrs. Biglari and Cooley and (ii) “FOR” the candidates who have been nominated by the Company to serve as directors other than Alan b. Gilman and James Williamson, Jr.

It seems clear that while Risk may have received a large number of votes, it is irrelevant. The sole intention of Biglari and Cooley was to replace Gilman and Williamson, Jr., not J. Fred Risk.

With any luck, Biglari will be able to execute some opportunities for shareholder value. I think one of the best ways would be a major franchising initiative, so that management can extricate themselves from having to operate restaurants, and focus more on strategy. In 2005 Alan Gilman asserted that he would accelerate the company’s franchising initiative, but it is painfully clear that today SNS has the same amount of franchises as it did in 2001. In addition, Steak N Shake seems to have a distorted approach to franchising, franchises make up only about 10% of the company’s restaurants, this is almost the opposite of a number of other franchise chains which adopt an approach of 80% franchises, 20% company owned.

In the Wall Street Journal article, one thing that stood out to me was Sun Capital’s views on maximizing the value of real estate:

“Now don’t get me wrong, casual dining is in the dumps and we’ve got our hands full,” Mr. Leder says of Smokey Bones. “But I’ll take a $220 million-revenue chain of restaurants for free all day long.”

Now, at current levels, SNS is not trading at levels which are equal to the potential cash that would be reaped from a sale-leaseback transaction (roughly $5.43 per share) but if you add the cash from a potential refranchising, you would come out to an extra $11.47 per share. Some critics say that SNS has had a decline in same store sales, which would make the franchises unattractive, but Applebees also reported declines in same store sales and successfully refranchised a number of locations. As a whole, this exceeds what the market perceives Steak N Shake’s value to be, making it an attractive bargain.

Other activities could be share repurchases - Biglari details how the $20 million spent to create 9 new restaurants could be better used at repurchasing shares. He also seems intent on making management act more like owners of the company by altering the compensation arrangement to adequately pay based on performance.

With most of Western Sizzlin’s investment capital tied up in Steak N Shake, Biglari seems extremely committed to making changes which will enhance value for shareholders and I believe the market’s current sentiments are of no indication of the true value of this business. The ultimate factor in a special situation is the time required for it to take place, with the bylaws change it will require 80% of the company’s stockholders to call a special meeting and replace the rest of the board. This means that we will either have to wait another year for some major changes to occur, or, Biglari will diplomatically persuade management to change their course with his new board seats. With large institutional investors such as MSD Capital and HBK Investments, I think they will have to start listening and change their course.

With domestic equity markets in the US in trouble, under fire by the credit crisis, inflation, and recession fears - it might be time to find a safe haven. Like in the old days, sometimes the frontier is the best place to be. One of the problems with even emerging markets, is that they are heavily invested by foreigners, if something goes wrong in the US, you can see a contraction in the markets elsewhere. For example, during August, a dip in the S&P 500 registered in a dip in the iShares MSCI Brazil Index (EWZ)

This seems to refute the idea of decoupling, although perhaps what it really shows is that market participants inadvertently create correlations based on positions and the use of margin. Still, compared to the S&P 500, Brazil’s stock market index is performing better than the S&P 500, its performance is still negative YTD and not entirely completely unrelated.

Example:

Bob runs a hedge fund with securities all over the globe and employs a hefty use of leverage. If his positions in the United States begin to tank, he will be forced to meet his margin call by selling some of his profitable securities, in this case, Brazilian equities. If there are more participants, like Bob, we can expect the same kind of reactions, causing a market drawdown like we saw in the graph pictured above.

It is precisely this kind of accidental-correlation which makes emerging markets a particularly dicy place to invest during periods of increased volatility. This is where frontier markets come in. They are still relatively new to most investors, and those who do invest in them typically have longer term views on their directions. This makes for markets where there are greater inefficiencies to exploit.

In my previous post (Looking for the Next Bull Market? Ask the UN) I described a method of using development indicators as a means for predicting how well certain countries will advance, and how that generally for tells of greater market returns.

Below are some new insights on evaluating investments in frontier markets. On monday, the Financial Times featured an interview with Slim Feriani a managing director at Progressive Asset Management, Here (subscription required).

In one of the first questions he’s asked about corruption, and how sensitive he is to corruption in frontier markets. It is easy to see his rationale, a lot of developing nations are viewed to be highly corrupt, some rightfully so. But what Feriani says is interesting:

We see it as being the other way round. Investing in the stock markets of many frontier countries helps improve governance and visibility. We saw a similar thing in the late 1990s early 2000s in Russia where corporate managements tuned into the fact that the best way to improve their lots was to adopt Western best practice in terms of corporate governance and to be rewarded by higher stock market valuations.

So the increase in foreign capital seems to fight against corruption, because the entrepreneurs of these countries know that by making their nation a good place to invest, they will attract more money and capital so that their businesses can expand and grow. The real risk underscored here, which needs to be taken into account would be political risk — instability would be the greatest factor for a nation’s markets to go south.

Feriani uses a simple framework for investigating possible investments:

At the top-down level we assess individual markets at both the macro and corporate level within a framework of “Quality, Growth, Valuation and Change”. Hence, political stability falls under our assessment of “Change”. Rather than just manage our investment sitting at our desks here in London we place a lot of emphasis on travelling to the markets we invest in.

Frontier markets are everywhere, but Feriani gives us his choices for where be believes the best opportunities are:

Regarding liquidity and transparency things vary from country to country but to sum up the Middle East typically has very liquid markets while sub Saharan Africa is more difficult. Transparency is not perfect in either but rapid improvements are taking place – the influence of foreign investment is helping foster this process.

At this stage, we believe the Middle East & Africa are among the most attractive regional frontier opportunities. They currently account for half of our of our frontier markets fund.
The case for investments in the Middle East is a strong one. The influx of petrodollars and relatively high levels of unemployment, large early-20s population, and prior bad experiences with a decline in oil prices means that many Middle Eastern nations will seek greater domestic investment in order to build new industries and create jobs.

One of the most difficult aspects for individual investors is actually being able to invest in frontier markets. They seem relatively closed off from us and aren’t available to most. However, Feriani also mentioned a number of products that someone who has access to the AIM exchange in london could purchase:

…our fund Advance Frontier Markets Fund (a closed-end fund) trades on the Alternative Investment Markets of the London Stock Exchange and can be purchased through your stockbroker. Our fund also qualifies for PEPs and ISAs thanks to its secondary listing on the Channel Islands Stock Exchange. The Bloomberg ticker for the ordinary shares and warrants is AFMF LN and AFMW LN. There’s no minimum investment and therefore anyone could invest as much or as little as they wish.

…On the exchange traded funds front, Deutsche Bank has been the first mover with its x-trackers ETF range (XSFR LN is its Bloomberg ticker). However, it has been around for only 4 weeks (i.e., small and not properly tested yet) and is limited to only the 30 largest and most liquid stocks in the largest and most liquid frontier markets. We believe the more diversification the better and safer, particularly in this space.

Now, the company I’m about to discuss is not based in one of these frontier markets, or does most of its business in these markets. Instead, it has operations that are geographically diverse and would be able to profit from increases in infrastructure activity in some of these markets. I think it is attractive, especially because I’m not entirely a fan of just investing in an index, I’d rather find a good business.

What I like to do is combine this macro perspectives with my value investing side, and one idea I’ve seen to take advantage of these trends through an undervalued company is KHD Humboldt Wedag International Ltd. (KHD).

Here is a description of the company:

During the year ended December 31, 2006, KHD focused on its industrial plant engineering and equipment supply business for the cement, coal and minerals processing industries and was engaged in the supplying technologies, equipment and engineering services for cement, coal and minerals processing, as well as designing and building plants that produce clinker, cement, clean coal and minerals, such as copper, gold and diamonds.

With many investors expecting a recession in the United States, a company like KHD which receives much of its revenues through the construction of cement plants is extremely beneficial. These plants are critical for emerging and frontier markets. Take a look at the places where the derive much of their cement plant revenue:

The 60 cement plants in the US seems like a big number, but they have already been built. The fact that KHD has operations in Europe, South Africa, the Middle East, and Eastern Europe means that some of its revenue sources will be able to withstand a US downturn. The Coal plant business also shows significant activity outside of the United States, with only 6 built while the vast majority are being built in Europe and China.
See Below:

According to KHD, they feel that demand for cement will almost double from 1,758 million tonnes in 2003 to 2,347 million tonnes in 2015. Such activity would mean increased economic activity and they outline some of the main areas. Specifically, North Africa/ Middle East for infrastructure and export opportunities. Eastern Europe for the replacement of old technology, infrastructure projects, and the the recovery of Soviet Union stagnation. Russia/Eastern Europe, Middle East, and Asia made up 90% of KHD’s order intake in Q2-2007 which again affirms the idea that they should be able to weather a US downturn well.

Financials

KHD is growing quickly, for the past three years KHD’s revenues have steadily inclined, marked by a jump in 2006-2007 by an 88% increase from $143 million to $270 million.

EBIT (Earnings Before Interest and Taxes) also grew quickly during this period, surging 150% from $14 million to $35 million.

In addition, KHD owns royalty interests in an iron ore mine with an increase in earnings from 2006 to 2007 by an increase in iron ore prices. With the current M&A environment with iron ore, we can reasonably expect prices to rise and the value of the mine to rise with it, making it an attractive asset.

KHD maintains a significant amount of cash, currently $9 per share, with virtually no debt. The company is extremely well equipped to deal with any downturn in credit markets and instead can self-finance many of its own operations. Management seems to always place their focus on creating shareholder value, which means that we shouldn’t worry about a waste of this surplus cash, I’m relatively sure that it will be deployed well.

With adjusted 2007 net earnings of $52M and an EV of about $453M, KHD trades at a multiple of 8.7X when its current growth rate warrants a significantly higher multiple of 15X-18X, meaning a per-share valuation of $41.37 to $50.00 or 72% to 108% higher than current levels.

At this point in time, the sell-off by the market for KHD seems unwarranted, and has priced KHD at an exceptionally undervalued level, which remains very attractive. I can speculate that some of this is due to the lack of news from the company, however they have released a statement saying that they have no real idea regarding the recent sell-off.