Saturday, April 28, 2012

Biglari's Compensation Plan

So I understand that Biglari has pissed off a lot of people with renaming Steak N' Shake to Biglari Holdings and his hedge fund-like compensation package, which is of course unheard of for publicy listed restaurant companies. 

To be sure, Warren Buffett doesn't have anything like that, nor does the Tisch family or the folks at Leucadia and other value investing conglomerates.  I'm sure those folks would be opposed to Biglari's compensation plan too (as they are mostly opposed to the hedge fund structure in general; even though Buffett had one of his own early in his career).

Renaming to Biglari Holdings
First, let's look at this company name change for a second.  Yes, it seems so egotistical to name something for yourself.  I am one of those people that would have a problem putting my name on anything, but that's just me.  Some people name their fund companies after themselves, like Soros Fund Managment and others use another name, like Tiger (Greek Gods, mythical characters and highway signs are other sources of names).

I don't think there is anything inherently wrong with naming something after yourself, especially if you are going to change the business drastically into a holding company.  Of course, I would feel differently if Biglari changed the name (and store names) of Steak N' Shake to Biglari Burgers or some such and added new menu items like the Super Big Biglari Burger or Biglari Super Shakes etc... I would definitely roll my eyes on that (but then again, I live in NYC where at one point everything seemed to be named Trump, so maybe I am desensitized to super-egos).

But naming something to Biglari Holdings is partly meant to indicate that this company is no longer a burger restaurant and partly to indicate that this is now a jockey stock; not a burger company.

Also, when an ambitious, egotistical person puts their name on something, that can be a good thing.  They are going to really 'own' the business.  Nobody wants to put their name on something and see it flop; it's not good for their ego.  They are not going to rename something in their own name, do a big dividend recap and then let it go under.  Nobody wants to see their name on a $3.00 stock (OK, I heard someone say Trump again; I don't think Trump is a good analogy).

So even though there was a big uproar on the internet when this name change happened, I don't think it's a big deal.

Of course, Buffett did not rename Berkshire Hathway to Buffett Holdings to indicate a change in direction for the company.

I think part of the shock on this name change and compensation plan came from the fact that Buffett wouldn't do it this way.

I think some people were so happy that they found the next Warren Buffett, they really jumped on board emotionally as well as financially.  And when Biglari started doing things that Buffett wouldn't do, it was totally incomprehensible and unacceptable.

This is not to say that that's the only reason for the uproar.  But I think it contributed to the magnitude of it.

Compensation Plan
OK, I know this is going to be controversial and I will get hate mail for this but this compensation plan might actually be an interesting idea.  And I do know that both Buffett and Munger would not agree with me on this.

You have to think of this as a publicly listed hedge fund, not an industrial conglomerate.

Obviously, Biglari set up this compensation plan because he couldn't continue to run Lion Fund and SNS at the same time. He figured he will just put them together and run the whole thing like a hedge fund. 

If you look at it this way, this compensation plan is pretty normal and is actually better than deals you get in private equity and hedge funds.


First of all, Biglari's compensation plan doesn't have a catch up provision, meaning he only gets paid on growth above 6%.  So if book value grows 10%, he gets paid 25% of the 4% performance above the hurdle.  Hedge funds typically have some math in there so that even though they get paid nothing if they don't earn 6%, they will earn 20% of the total gain if they exceed the hurdle rate (so they will get paid 20% of 10%).

Also, Biglari is getting paid on book value growth which is after tax.  Hedge funds earn fees on pretax returns.  This is not as good as it sounds, though, because book value growth is after corporate taxes, but before any taxes stockholders will pay on dividends and capital gains.

But if BH focuses on growth and not dividend distribution, compounded returns may be taxed over time at the long term capital gains tax rate for the shareholders (when and if the sell).

So Why Is This Structure Interesting?
This may very well be innovative if it works out and I would be surprised if many hedge fund managers aren't looking at this carefully now.

One of the biggest issues in the hedge fund world has been the permanency of capital.  Investor funds rush into hedge funds (mutual funds too for that matter) in good times and then rush out in bad times.  I think Bill Ackman's first hedge fund blew up because of this; they invested in some illiquid, private equity-type deals and when redemptions came, they couldn't meet them.  That's probably why he is so focused on very large publicly listed corporations.

Private equity deals with this by having funds with fixed terms.  Oakmark (which I recently posted about) also has a lot of their funds as closed-end, fixed term funds.

This can be a problem too.  If you know you have to return capital in seven years, you might get into trouble if the market is not friendly at the time you have to liquidate.

Henry Kravis has mentioned how envious he is of Berkshire Hathaway's structure. 

The problem with these term funds is that they have to be out raising capital all the time; every time one of their large funds 'expire', their AUM goes down and they have to go out and raise capital for a new fund.

What about listed closed end funds?  Listed closed end funds are regulated under the Investment Company Act so is onerous to run and have many restrictions.

Some private equity structures are run as BDC's and there are a lot of those. But this has many restrictions too.

This capital problem is why guys like David Einhorn has set up Greenlight Capital Reinsurance (GLRE).  They set up an insurance company that will become permanent hedge fund clients of theirs.  Capital won't run away in bad times and rush in in good times.   (Of course, float can come and go according to insurance industry cycles and depending on well GLRE does).

So I think right now for hedge funds, this is the way to go to raise permanent capital.

What Biglari did was to convert this restaurant into a publicly listed hedge fund.  How can he get away with this as hedge funds are only to be sold to accredited investors and not the general public? 

Well, BH isn't actually a hedge fund.  It's a publicly listed corporation.  It only has a compensation package like a hedge fund and a capital allocator like a hedge fund.

Investment Company Act (ICA)?
How can this entity get around the Investment Company Act?   If the ICA is a pain in the butt, why don't people just set up a company like BRK, LUK, L and just do what they want?

Because even if you don't register as an Investment Company, you will be considered one if you look like one.  How do they determine if you look like one?  I think if more than 50% of your total assets is in investment securities and/or 90% of income is dividend and investment income or some such, you will be deemed an investment company.

BRK is not an investment company because it owns a large amount of wholly owned businesses.  Way back before they owned a lot of that, their investments were made either via Blue Chip Stamps or the insurance segment.  Obviously, insurance companies don't fall under the ICA, but are regulated as insurance companies. 

Loews too is not an investment company because their large holdings are consolidated; the large holdings are not investment securities but are consolidated subsidiaries.

Leucadia also looks like an investment business, but they too own a large amount of wholly owned businesses and consolidate some large holdings.

Biglari Holdings, too, would have to be careful going forward like the above companies to stay out of the ICA.  The fact that SNS is a wholly owned operating business gives Biglari some room, and this is probably another reason why Biglari wants an insurance company; not only to get the float, but to have an entity that can buy and hold investment securities without turning BH into an investment company.

So anyway, I know many people won't agree with me on this including many of my heros.  But I have to say that this is an interesting experiment.  Biglari gets a BRK, LUK, L-like structure (operating business and cash flows into investment securities) with a hedge fund-like compensation structure.

I have to say that I have never been against the hedge fund incentive compensation structure.  I know there was a lot of debate on that in the past few years all over the internet.  But for me, my view was always that if someone wants to pay 4%/50% management/incentive fee, let them pay it.  What matters at the end of the day is net performance to the investor.  If the manager earns 50%/year over time, then maybe the high fees are worth it.

I would rather pay that high fee than pay an equity mutual fund manager 1.5%/year with no incentive fee to underperform the S&P 500 index  (In fact, those mutual fund fees for underperformance and all those front-loads / back-end loads / 12b-1 fees and what not bother me way, way more than hedge fund/private equity fund fees).

So that's where I'm coming from and in this Occupy Wall Street age, I know this is not a common view, and that's OK.

BH's compensation plan is horrible and egregious for a restaurant chain or normal operating business or compared to other, older investment conglomerates like BRK, but not at all as a hedge fund (or private equity fund). 

If BH works out, I wouldn't be surprised if we see other hedge fund operators try to do something simliar.  If that happens, then Biglari would have turned out to be a pioneer.  (Although, again, I understand that most of the value investing community would not necessarily see that as a good thing).

Wednesday, April 25, 2012

OAK: Oaktree Capital Management IPO

Oaktree Capital Managment had their IPO recently (April 12?); the stock was offered at $43.00/share but is now trading at $39.41 (today's close).   The price range for the offering was $43-46 so it came it at the lower end, and the planned 10,295,841 share offering was reduced to 7,888,864 shares (excluding the shares sold by current shareholders).  All of the proceeds are to be used to buy out existing shareholders (or partnership units).

I'm not going to go into the details here because Oaktree is a bit complicated like all of these publicly listed hedge fund/private equity fund management firms, but I'll cut and paste (snip function on Windows 7) a bunch of interesting looking charts from the prospectus and also take a stab at valuing OAK.  (OK, it was co-lead by Goldman Sachs and Morgan Stanley if you must know.  They earned fees of $17,781,635 on this deal that comes to a gross spread of 7%.  I guess Oaktree doesn't have the negotiating power of a Facebook... A $380 million offering is not worth a discount).

Oaktree is very interesting because it is founded and run by Howard Marks, who is just about the best in the business with respect to fixed income investing.  He specializes in distressed debt and has a great track record.

He has also written what I think is one of the best investment books out there today; The Most Important Thing:  Uncommon Sense for the Thoughtful Investor.   Buffett's blurb on the cover says, "This is that rarity, a useful book".

Other people who wrote blurbs on the back cover are Joel Greenblatt, Jeremy Grantham, Seth Klarman and John Bogle.    That tells you Marks has written a pretty good book, and it is a really great book.

I have been reading his letters to investors for years (I'm not an investor in his funds, but read it when it floats around on the internet), and he is one of those people who are no nonsense and spot on.

Some basics are that they have $75 billion in assets under management as of December 2011, has 650 employees in 13 offices around the world and it was founded in 1995.

The asset breakdown by strategy is:

Distressed debt:  32%
Corporate debt:  28%
Control investing:  23%
Convertibles:  10%
Real estate:  6%
Listed equities: 1%

Anyway, here are some interesting charts from the prospectus.

The Alternative Asset Management Business
Like all the other alternative asset managers, the prospectus describes the industry and it's bright prospects.

This may disagree with Buffett's views that he doesn't think any hedge fund, after fees, will outperform the S&P 500 index over 10 years (he made a bet with someone on that; this bet is still ongoing so there is no winner yet).
The graph below shows that alternative investments have outperformed traditional investments over the past ten years.

This, and similar graphs are used by alternative managers to raise capital.  It is not surprising that these alternatives have beaten the S&P 500 index over the past decade, as the past decade has been pretty bad for stocks and hedge funds tend to do well in volatile markets.

This graph also worries me a little bit.   I always worry when pensions rush into any certain asset class.  This is totally understandable given that we've had TWO big bear markets where the S&P 500 index went down 50% in the past decade; it's been a high risk, no return market.  People want returns.  They don't want 50% bear markets and flat returns.   Also, many pensions assume an 8% return on plan assets and if they don't achieve it, they may have to contribute cash to it causing a hit to earnings. 

They would much rather reallocate the pension funds away from stocks and bonds (low return assets) into alternative assets which promise such high returns.

This sort of thing *always* cause trouble.  

I think this is also one of the reasons why equities remain reasonably valued:  there is an ongoing reallocation out of equities into alternatives.  People just don't want stocks.

Anyway, this has nothing to do with OAK, so let's go on.

Assets Under Management

Like other hedge funds and private equity funds, OAK has really grown their assets under management (AUM) dramatically in the past decade.  As usual, my primary concern would be if they can perform just as well with $80 billion in AUM as they did when they managed $20-30 billion.   Size really cuts down on the choice of investments.   Some of this is tempered by going global; when the universe is expanded, so should the opportunities.  But still, it gets tougher to get high returns with higher amount of capital.   I don't think there is a way around that.


The returns on their distressed debt strategy has been pretty stellar.  The gross internal rate of return on their closed-end funds (not to be confused with publicly listed, perpetually discount-traded, poorly performing closed-end funds) was +19.4% and +22.9% for the distressed debt strategy.  These are nice returns, but that's to be somewhat expected as it is a distressed strategy where equity-like returns are expected (in this case, it's way better than equity-like returns!).

One thing I should mention is that these IRR's are a little different and not directly comparable to other hedge fund, mutual fund returns.   I think these IRR's are calculated on capital actually employed.  This means that if you raise a $1 billion fund, the investors don't have to put up the capital until you call it.  And you don't have to call it until you find an investment.  So if the $1 billion is not deployed in the first year or first few months or whatever, that doesn't affect your IRR.

Once you invest it, then the IRR calculation starts.  But if you are a hedge fund and you raise $1 billion, then your performance is going to be tracked on day one.  If you own only cash, then you made zero return on day one.  If you do nothing for a year, this will negatively impact your annual returns.  This is the same with mutual funds.

For private equity and many of these 'closed end' funds with terms, that is not the case.  Obviously, the IRR will be much higher than with other types of funds as you are not penalized for the cash or undeployed/uncalled capital.

The following is a composite return chart of the high yield bond strategy.  Since 1986, the strategy has returned 1069% versus 776% for the benchmark.   So that's 10.3%/year since vs 9.1% for the benchmark index.

Here is the return on specific funds compared to the default rates of non-investment grade debt at the time of the launch.
You will notice that the funds launched in bad times have the highest returns versus funds that were launched when defaults were at a low point.  Oaktree understands this very well so tries to adjust their capital raising to be counter-cyclical; raise more money in bad times when prices are cheap, and less in good times when prices are high. 

Below is a graph that shows how they deployed very little capital in good times while the private equity industry was falling over themselves buying stuff up, and then when things blew up, Oaktree stepped in to buy and private equity fund capital deployment plunged.

This really illustrates the counter-cyclical nature of Oaktree.  They act when prices are low and their performance is improved by that.  They clearly don't follow the crowd.  We can see with these figures that Oaktree really walks the talk; they do what they say they will do (and what Marks says investors should do in his book).

The following is the breakdown of revenues since 2000:

So you can see that like other similar listed hedge funds and private equity funds, the three pillars of revenue are management fees, incentive fees and investment income.

So What is OAK Worth?
As usual, here's the tough part.  What the heck is this thing worth?  We know that the value of Oaktree comes from the three sources of revenue shown above. 

So OAK is worth the sum value of these three parts:  some stable revenue/income based on management fees, the assets they own on their balance sheet which is cash, treasuries and investments in their own funds (and some other assets, but most of the assets are financial assets), and the option value of the incentive income.

The ownership structure is complex and the financial statements can be quite confusing.  So I will ignore all the confusion and assume that only one class of  stock is outstanding and that represents the equity in the whole firm. 

According to this simplification, OAK would have 148,524,215 shares outstanding (never mind if it's class A or class B or whatever class.  I think this is what will be outstanding if all the partnership units, class B and others is converted to class A, which is the listed class).

The financial statements are confusing too because accounting rules force them to consolidate assets in certain of their funds even if that doesn't make much sense.  And then the balance sheet/income statement shown with consolidated fund assets/liabilities and income/expense shown separately is confusing too as OAK does own shares in some of their funds which shows up in the portion of assets on the balance sheet in the "assets of consolidated funds" (which would include assets that actually is owned by OAK).

So Oakmark has a separate table somewhere else that shows segment income statement and balance sheet which sorts all of this stuff out and puts what Oakmark owns in the operating segment.

OK, that's kind of confusing, I know.

Anyway, let's take this one piece at a time.

Fee-Related Earnings
Fee-related earnings (FRE) is a convenient measure that shows us what the business will earn on a steady-state basis with no investment returns or incentive fee income.  It's basically the management fee revenue minus compensation and benefit expense (excluding bonuses tied to incentive fees) and general and administrative expense.  

If you are running an asset management firm, this would be a key indicator.  Basically, you want to be able to cover all of your fixed cost with management fees, and if you can make positive earnings, that's even better.  This leaves the incentive fee income and investment income as bonuses, or icing on the cake.  You don't ever want to be in a position where you have to make good returns and earn incentive fees just to cover expenses (or depend on investment gains on from your balance sheet). 

The FRE for the past five years were:

             FRE  ($mn)
2007      $119
2008      $256
2009      $290
2010      $375
2011      $315

Over the past five years, FRE averaged $271 million and for the last three, it was $326 million. So what is normal here?  This is the problem with valuing businesses.  FRE and AUM has grown in the past few years, but is that because of the financial crisis and many great opportunities, or is the AUM trending upwards on a secular basis for the long term? 

If this growth is secular, then using $326 million as a base-case FRE figure would be fine.  If current AUM is bloated due to the financial crisis and extraordinary opportunities that arose in the past couple of years, then it may not be. 

So let's just use the figure in between and call FRE $300 million per year.   The other big question is what multiple you put on this.   I will use a conservative figure (what I consider conservative, of course, may be silly to others; anyone can use their own multiple).   I will use a figure of 10x this pretax figure.  10x is a 10% pretax coupon and that is very reasonable in this environment. 

At 10x the pretax income, the value of the FRE flow comes to $3 billion.  With 149 million shares outstanding, this is worth $20/share

Their management fees for funds is 1.48% for closed end, 0.47% of open end and the overall (including Evergreen funds) management fee is 1.11%. 

So if they maintain AUM at current levels and expenses remain the same, they can earn $315 million (same as 2011) on an ongoing basis.  I do think that management fees will actually go up going forward as increasing expenses in the past few years are due to expanding the business (international etc...).  If this is the case, AUM may rise.  If it doesn't work out, we can expect expenses to come down. 

(Actually, FRE is taxed at the corporate level at OAK so after tax and per share FRE can be found at in the prospectus (but only for 2009-2011).  After-tax FRE per class A share were $1.30, $1.75 and $1.47 in 2009, 2010 and 2011. Put a 14x p/e on that and you get $18.20 - $24.50/share value.  The average for the three years was $1.50.  At 14x $1.50, you get $21/share in value.  But it's the same valuation (10x pretax = 14x after tax etc...).  

Balance Sheet Value
OAK owns cash, treasuries and investments in their limited partnerships (funds) among other things.  They also have debt and other liabilities.  One quick way to measure their balance sheet value is to look at the tangible book value per share listed in the prospectus.  That's $7.44/share proforma after the offering.  This is a quick proxy because most of the assets at OAK is in financial assets such as the above. 

Of course, this may be double counting to some extent if there are assets used in the asset management business itself.  To prevent that (and I don't know the details of 'other assets' and total liabilities), we can just be very conservative and add up the cash, treasuries and investments and subtract total liabilities so that we can be sure we don't include assets that help generate income other than investment income. 

Here's the balance sheet summary from the "Segment Statements of Financial Condition":

Cash and cash equivalents:                                       $297 million
U.S. Treasury and government agency securities:   $382 million
Investments in limited partnerships at equity:          $1,159 million
Total investments and cash:                                     $1,838 million

Total liabilities:                                                      $ 960 million
Net cash and investments:                                   $ 878 million

With 149 shares outstanding, that comes to around $5.90/share.  So that's only off by $1.50 or so from the tangible book value per share.  I don't know exactly what the difference is as the balance sheet asset items listed on the Segment Statement of Financial Condition doesn't add up to the Total assets figure (only the financial assets are itemized). 

So let's just say that $5.90/share in net cash and investments is conservative as the asset side really does include only the financial assets and we deducted all liabilities from that. 

Incentive Fee Income
So what does that leave?  The last piece of the valuation puzzle is basically the incentive fee income.  Incentive fee is generally 20% at Oakmark and 40% to 55% of that is allocated (when earned) to incentive fee-linked bonuses.  So what is left over to Oakmark after paying bonuses on that is somewhere between 9% and 12% of fund returns.

There are a lot of ways to look at this but let's look at the first, simplest one.  Incentive fees are obviously lumpy, so let's just look at the average incentive fee income for the past five years: 

                              net of incentive compensation (bonus)
2007   $332           $254
2008   $174           $109
2009   $175           $109 
2010   $413           $254
2011   $304           $125

The average is $280 million through this period.  It would be $170 million after incentive based compensation.   

How do we value this?  Just using 10x pretax income, that would value the incentive fee stream at $1.7 billion, or $11.40/share.  But one important point is that the incentive fees earned are booked using a more stringent standards than other funds; there are accrued incentive fees that are not on the balance sheet and does not pass through the income statement. 

Apparently, this is a choice by management so as to reduce the volatility of earnings (by booking earnings on accrued incentive fees, this may cause volatility as market declines can force a reversal of these accrued fees). 

So we would have to add back the balance of accrued incentive fees (net of associated incentive compensation (we can get the same result simply by adding incentive income to incentive created instead of just using incentive income). 

The balance of accrued incentive income (net of bonuses) was $1 billion at December end 2011.  So that $1 billion comes to $6.71/share

So the incentive fee stream (including accrued incentive fees) comes to $18.10/share.  

Of course, there is a problem with just using the average incentive income for that past five years as incentive creating AUM has grown from $15 billion in 2007 to $36 billion.   I suppose it is conservative in that sense. 

Just as a sanity check, let's look at it another way.  Incentive fee, or carried interest is sort of like having a direct equity interest in the funds (except that you don't have to participate on the downside). 

As we said above, we know that incentive fees are 20% and 40%-55% of that is paid out as performance bonuses to employees, so what is left to OAK is something like 9-12% of the fund returns (assuming they can earn more than 8%). 

So another way to look at this is to assume that OAK owns 9% of the incentive fee generating AUM.  That figure is $36 billion at December-end 2011.  9% of that (to be conservative, I will use the lower portion of 9-12%) is $3.2 billion.  That comes to $21.50/share.   Of course, this is just a rough estimate.  The good thing about this approach is that you don't have to make any assumptions about investment returns.  The bad is that it doesn't take into account the fact that OAK will earn no incentive fee if they return 7% (or anything lower than the preferred return rate of 8%). 

As another cross-check, let's just say that the funds earn 10% gross returns.  That would generate $3.6 billion in profits at the funds and an incentive fee of $720 million and net of incentive compensation $324 million.  Slap on a 10x multiple on that pretax number and you get $3.2 billion or $21.50/share

So we come to the same valuation as the above.  

Summing the Parts
So putting those pieces together, we have: 

Management fee value per share:          $20.00
Net cash and investments per share:        $6.90
Incentive fee value per share:                $21.50
Total value per share:                          $48.40

(I used $21.50 because two approaches converged on that number and it makes more sense since it uses the more recent AUM number). 

So with the current price at $39 or so, OAK appears to be trading at a discount of 20%.  This is a really simple analysis and I may be missing something (or a lot!), but I think this sums up the gist of the value in OAK.  You can use your own multiples to see what you come up with.

As a final sanity check, I thought about looking at the adjusted net income per share of OAK over time and distributions per share.  But I realized it may not be that meaningful as although adjusted net income is a very good measure of the economics of the operating business given the complexity and non-cash expenses, it doesn't include accrued incentives so understates earnings.  

The above approach allows us to plug in our own numbers and multiples on each piece of the value so I am more comfortable with this sort of analysis rather than slapping a multiple on a single earnings figure, particularly when it's so easy to separate out the value pieces. 

Anyway, this is just a quick look at this thing.  I will keep an eye on it but am in no rush to go out and buy OAK at this point.  As usual, I am concerned about the rapid growth in AUM and what it will do to prospective returns on their funds and whether they will do as well internationally.  One well known thing, at least until recently, is the legal clarity and structure in distressed situations in the U.S. versus other countries. I remember distressed investors having trouble in Japan, for example, since there wasn't a clear legal route to value realization like there was in the U.S. 

I can be confident in the honesty and integrity of the folks at OAK.  I would never worry about that. Their philosophy and approach too makes a lot of sense and I would be very comfortable with that. Read the beginning of the prospectus; it is well worth reading to get a feel for who these people are. 

And obviously, Howard Mark's book is also pretty much a must read for value investors and you will get a feel for how this firm is run. 

Tuesday, April 24, 2012

Biglari Holdings Annual Meeting

So I did something unusual and went to an annual meeting last week.  I am usually not interested in annual meetings as they seem to be sort of love fests or promotional events and most of them seem to be rubber stamp events with no real substance.  Of course, the glaring exception is the Berkshire Hathaway (BRK) annual meeting.

I have been following Biglari Holdings (BH) recently and heard that he sits there and answers shareholders' questions for four or five hours.  I thought this would be an interesting event to attend.   So I did and it was interesting.

I didn't take detailed notes like BRK shareholders do, trying to capture every question and answer.  I just jotted down things I heard that I thought were interesting and here it is.

First of all, I should mention that this took place at the St. Regis Hotel in midtown and started at 1:00 pm and went on until a little before 6:00 pm.

Here are some random notes (some of it is off the top of my head so it may be off):

Intrinsic Value Growth Goal of 15%/year
BH seeks to grow intrinsic value by 15%/year.  This was mentioned in the annual report, but I don't know if that is before or after his incentive compensation.  It's not that important to me as this is just a number that people have to come up with; high enough to be interesting but not so high as to be silly.

Value of Activism
One chart Biglari showed at the beginning of the annual meeting was what happens to an investment if bought for 50 cents on the dollar and comparing that to what happens to this investment if they can participate on the board of a company and help it grow value to $2.00.  Now you are talking about turning $0.50 into $2.00 instead of $1.00. 

So if they can buy $1.00 of assets for $0.50, the return in 5 years would be 15%/year.  But if they can participate in value enhancement to get the value up to $2.00, that would boost the return to 32%/year instead of 15%/year.

A key point is that even if the activism doesn't work out, they should do well.

SNS Doing Well
Biglari announced at the annual meeting that SNS had same store sales and traffic growth of 4.8% and 5.2% in the first quarter of 2012 continuing the trend in improvement.   The Signature store in Times Square is doing very well.  He showed a video of the opening and a couple of clips when the Steak N' Shake Signature store was featured on the Letterman show.  Letterman did spend a lot of time talking about how it was an important thing in his early life to be able to go to the SNS on his bicycle to get shakes.

Sales are doing well at the Times Square store but he said that they do need some work on operations; there is room for improvement.   Someone asked him what lesson he learned or is learning from the Time Square store and he said they need more space (the Time Square store is only 1300 or 1400 square feet; it's a nice store but tiny).

He also said that SNS is the only national hamburger chain (or national fast food chain, not sure which one he said) that offers an organic hamburger, even though it's just in one store (Times Square).  He did say it is selling well and they are working on getting it to more stores.

Why Not Sell/Lease Back or Spin Off the SNS Real Estate?
Someone mentioned that SNS owns the land under many stores; why not sell the real estate and lease it back or split/spin off the real estate?   This would free up capital and improve returns. 

Biglari's response was that if you sell the real estate, you lose optionality.  When you own the real estate, you have choice.  When you sell the real estate, the landlord can raise rent or decide it can be more profitable as something other than an SNS restaurant.  You lose control.  If you own the real estate, rent can't rise and a landlord can't kick you out.

He said the cost of a sale-leaseback would be 8%, so after taxes and expenses, they would have to earn 10% with the proceeds of a sale-leaseback for it to make sense.

Biglari mentioned that they actually went backwards; they BOUGHT real estate recently.  They bought $9 million of real estate and lowered rent expense by $900,000 for a 10% return.

He also mentioned that a lot of this financial engineering stuff is done by managements that can't or don't turn around the operations.  They shuffle assets but things don't improve because they don't turn the operations around.  So turning the operations around is more important than financial engineering.

Why Not Refranchise Stores to Free Up Capital and Boost Returns?
Someone asked why BH wouldn't want to sell and refranchise SNS restaurants.  Biglari had an interesting response.  He said they are working on franchising the business, but it is taking time because they want to do it right.  They don't want to sign up a bunch of franchisees and open up a bunch of stores only to have to close them.  They want to do it right and that takes time. They want to find the right partners, set up the infrastructure and systems etc...

As for selling/refranchising stores, Biglari says that there is so much room for improvement in the existing, owned store base that it makes no sense to refranchise at this time.  For example, the average sales now is around $1.6 million.  If there is a clear path to get that to $2.0 million, then it makes much more sense to work on getting that to $2.0 million rather than selling the store and franchising it.

If sales moves up to $2.0 million from $1.6 million, Bigari says that they can earn conservatively a 40% incremental margin.  That means the $400,000 increase in sales per restaurant would increase pretax profits by $160,000/store. 

If the store were franchised, they would earn 5.5% royalty on sales.  So at the current $1.6 million, BH would earn $88,000 in royalty fees.  He said that at best, the franchise business would have a margin of 50%, so that implies pretax profits of only $44,000.

(He didn't mention what the cash generated from the sale of the restaurant sale would earn, so this may not be apples to apples (because we don't know what price the restaurant would fetch either)).

Anyway, it is an interesting response and compelling as it does seem that there is nice returns to be earned going forward in the existing restaurant base.

I have mixed feelings about franchising as I personally tend to think that the best businesses are owned (Starbucks, Chipotle Mexican Grill) and franchised operations are 'trashy' (YUM Brands U.S. operations and countless others; MCD being the notable exception that has really gotten the franchising thing down to perfection)).

In any case, at this point I don't have any strong feelings about whether any of this financial engineering is a good idea or not.  Biglari seemed really passionate and serious about turning SNS into a great business; better products, lower prices etc...  

(Just as a note, he said maintenance capex for SNS in 2011 was $6 million and won't change much in 2012)

Cracker Barrel
Not surprisingly, he made some comments about Cracker Barrel.   Most of the comments were similar to what he said in his letters to CBRL shareholders.

He offered two examples of the waste and mismanagement at CBRL.  He said that he spends a lot of money on billboards.  I forgot why he knows this, but he said that CBRL spends $1,400 per billboard per month (that's what I think he said, but again, this is off the top of my head so I may be wrong), and he said that is way too high a price.  He said that he pays for a lot of billboards so knows the market and this level is just way too high.

He also mentioned that CBRL restaurants have a separate bathroom for employees.  He said this is incredibly wasteful as space is very important in the restaurant business.  Why do employees need their own bathroom?

He said this is just two examples and he is sure there are many, many more.  But he will need access to information to find more waste and that can only be done by getting on the board.

He insisted that he is at CBRL for the long term and is not there for a quick profit, and that contrary to claims by the CBRL board (that don't stock in CBRL), BH's interest is aligned with the shareholders of CBRL.  BH owns so much CBRL, how can the interest not be aligned?

He said more than once, as if speaking to the CBRL moles in the audience that he is not going to go away.  It may take years and he will be there.  One failed proxy contest is not going to make him go away.  What's right will prevail.

Anyway, Biglari really seemed determined and serious about this.

Questions were asked about the opportunity cost of owning so much CBRL without making much headway in terms of getting board seats.  He said that they are long term investors and they are concentrated investors. This is the way they work. 

If you look back to what Biglari said in the beginning about the difference between turning $0.50 into $1.00 and $2.00, having it turn to $1.00 is not bad at all.  So BH will presumably do well even if nothing happens on the proxy contest.

He reiterated the value that can be realized at CBRL if they can get store productivity back up to where it was when the founder ran it. 

Biglari sent a letter to CBRL shareholders on the day of the annual meeting and he said that CBRL should be able to grow traffic by at least 3%/year and should be able to target 5%.  Someone asked where that number came from.  The answer was that after years of traffic declines, it shouldn't be too difficult to turn traffic around.  He mentioned SNS.   He mentioned that it was getting harder for SNS to grow traffic as they have been growing for many quarters in a row.  But after declining for so long, Biglari insists that it won't take much to turn it around a modest amount.

Incentive Compensation
So someone stepped up to the microphone and asked Biglari about his compensation.  He said that if Biglari cared about the shareholders, why not reduce his $900,000 salary and incentive compensation and use it to invest and enhance value for shareholders?

Biglari mentioned that the compensation was overwhelmingly approved by shareholders.  He said that if he didn't like the compensation package, he shouldn't own BH stock.  Biglari asked that if you invested in a hedge fund, would you ask the hedge fund manager to lower his management and incentive fees?  (my comment:  a lot of investors *are* actually asking hedge funds, private equity funds etc... to lower fees!).

But I understand Biglari's point. 

At some point, Biglari said that this is an unintelligent question so he doesn't want to respond any more to it or some such thing (I'm pretty sure "unintelligent" was the word he actually used).  Of course, Biglari is not known for, say, the folksy charm, wit and humor of Warren Buffett.  I thought to myself, hmmm...   I would not answer a shareholder question like that even if I did think it wasn't the best question (you know what he's gonna say).

Of course, it only took seconds for someone to notice the 'hypocrisy' of the comment "if you don't like it, don't own the stock".  So someone jumped up and said, hey, that's not a stupid question and you can't tell people not to own the stock when BH also owns shares in CBRL and complains about compensation there.  Why not just sell CBRL stock if you don't like it? 

I knew this sort of question would come right when Biglari said "if you don't like it...". 

But Biglari's response made sense too.  This is different because you are looking at a compensation package at BH that is based on results.   If BH doesn't succeed and make money for shareholders, it will cease to exist.

At CBRL, management is failing and trailing the industry on many measures.  The complaint against CBRL is not so much the compensation but the (non) performance of the business.

So that is a fair distinction; he's not trying to get on the board of CBRL to cut compensation (even though that may be part of the plan), but to create value for shareholders by improving the operations of the business. 

I agree with Biglari that this is a different thing altogether. 

This is not to say that people shouldn't complain about what bothers them.  They could bring it up and leave it up to other shareholders.

Other Things
Someone asked him what he's learned from other financiers taking over businesses and trying to run them. What has he learned from watching Eddie Lampert, for example?  His answer was that he learned that retail is a hard business.

He went on to talk about how the restaurant business is full of horrible operators that make really bad decisions all the time.  He made it sound like an easy business to do well for that reason.

He talked about Sam Walton and Walmart and about Henry Singleton/Teledyne and knew the important metrics of his management tenure (book value growth, sales, earnings or whatever it was... he just threw out a bunch of numbers off the top of his head).

It is clear that Biglari loves business and is deeply passionate about it.  He is no fool.   You can tell he is a voracious reader and knows what he is talking about.  He seemed to answer questions well.  I didn't have any problems with anything he said that I remember.

He doesn't have any of the charm that you see from a Buffett, of course.  There aren't many of those.  He does have this intensity about him, though, which give you the feeling that Biglari will be spectacularly successful or flop miserably.  But my sense is that he won't flop miserably.

He does have an incredibly arrogant vibe about him. He is definitely not the warm and friendly type.  But you know, that's OK.  When I look at investments, I look for people who are passionate about succeeding, works hard and loves to do what they do; I'm not looking for friends.  I really did get that sense from him after watching him for five hours.  He is there for the money, of course. But it seems to me that he really loves it too (unlike many highly paid people I've known on Wall Street over the years).

I think this is an interesting situation.  I understand many people don't like Biglari for many reasons but I think it would be a mistake to write him off.  I think there is a bit more substance there than people seem to think.

But then again, I could be totally wrong!  If I am, I apologize in advance.

Thursday, April 5, 2012

JPM Annual Report 2011

JPM posted their 2011 annual report last night and as usual it's a great read.  It's probably the best annual report written out there (other than Warren Buffett's).

I know a lot of people are skeptical of what corporate executives say.  They say, "you actually believe what these CEOs tell you?!". 

Good point.  But what I tend to do is to not categorize people by their titles and automatically accept or reject what they say because they are CEOs or bankers.  I know that much of the American public simply do not trust CEOs; we've had Enron, Worldcom not to mention the recent Lehman, AIG, Bear Stearns and many other corporate scandals.  How can we trust corporations and their CEOs?

For me, since I spend so much time reading and following businesses, I tend to think that I know who I can listen to and trust and who to not trust at all.

Warren Buffett and Jamie Dimon are two people that you *can* trust and believe.

When Buffett said U.S. stocks were expensive and people expecting double digit returns from the stock market are dreaming back in the late nineties, people said he was over the hill and didn't know what he was talking about; he just doesn't get it.  Of course he was right  (note what he has been saying recently about gold, and what people have been saying about Buffett).

Back in 2008 when everybody thought that capitalism was over and investors were in a state of total panic, he told people to buy American stocks because he is.  Again, people laughed at him.  People actually told me that Buffett is just talking his book; he is losing so much money in the stock market that he is just trying to talk the market up to save himself.

Well, people who said that just don't know Buffett.  I've read his reports going back to the 1950s and he never says anything to try to move markets.  He says what he believes and more often than not, he is right.

When the economy really started to fall apart, Buffett was on live television telling the public that we are in fact in a recession. He said never mind the economic data and what people say; he sees numbers from his many businesses and we are definitely in a recession.   He did not sugarcoat then either.  He called it like it is.  He saw awful numbers and said so.  When people talked about green shoots, he said then too that he saw no green shoots.

This is the same with Jamie Dimon.  He is no slick salesman.  All throughout the mid 2000s, he kept saying how credit spreads were too thin, people weren't getting paid for the risk they were taking and there is a lot of bad stuff out there that can hurt a lot of people.

When things imploded, he said on public television that things are "horrible".  He didn't sugarcoat anything.  He tells it like it is, and I can imagine that it is a nightmare for his public relations and legal people.

So these guys aren't promoters who are just talking positive all the time to push their agendas.

Having said all that, let's get back to Dimon's letter to shareholders.

I don't mean this to be a summary or anything like that.  He covers a lot of important topics and I recommend anyone interested in business to read it.

I will just make some comments on things that grabbed me.

Normalized Earnings
JPM earned $19 billion in 2011 and had a return on tangible equity of 15%.  He points out the many headwinds that the world economy faced in 2011 and yet JPM did reasonably well; we had the European crisis, U.S. government debt credit downgrade, Japan earthquake and tsunami etc...

And he reiiterated that JPM should have earned $23-24 billion in 2011, and that the difference with what they actually earned ($19 billion) were the high costs in mortgage and mortgage-related issues.

This means that this $23-24 billion earnings figure doesn't take into account any growth in assets or normalization of interest rates or anything like that. 

As I said before, that would come to $6.30/share in EPS, and it's not a stretch at all to see JPM stock trading up over $60 (10x earnings). 

Regulatory Confusion
He spends a lot of time talking about the complicated regulations being negotiated and going into effect.  Bank critics say that banks are trying to push back and prevent regulation but Dimon points out that this is not true.  Dimon wants more regulation in many areas, but he wants GOOD and meaningful regulation.  Not bad knee-jerk regulations with unintended consequences.

I don't expect the business press to understand what Dimon is trying to say, but I totally agree with it.  What Dimon wants is not more or less, but just better regulation.   He is not against it at all.

Future of Investment Banking
He does talk about the future of investment banking (it is not dead, but is in fact a growth business) and growth potential for JPM in many areas.  He also explains the role of investment banks in fund raising and in market-making (this business is not understood well at all by the public so it's good that he took the time to explain it).

"Housing is getting better - there, I said it"
OK, so this is where I'm sure a lot of naysayers will come out and say, no way!  Impossible!  Dimon says in the annual report that housing is actually getting better.  Buffett too, on CNBC recently, said that if he could he would love to buy a bundle of hundreds or thousands of homes as they are very reasonably valued with prospects of good returns.  It just doesn't make sense for him to buy one house at a time. 

And as I said at the beginning, Buffett and Dimon are not the kind of people to say things they don't mean or believe.  So here is the greatest investor of all time saying that single family homes are great investments now.   He has also been calling for a turn in the housing market.

Keep in mind that neither of these people are calling for another housing bubble or for housing prices to go up 20%/year for many years or anything like that.

Here are some of the facts that Dimon threw out there which is not that different from what Buffett and some other 'smart' investors have been saying recently (Buffett admitted in the Berkshire Hathaway annual report that he called for a bottoming in the housing market before and was wrong about the timing, but he still thinks it will come (it's also important to note that Buffett's investment style doesn't require him to be right on timing such things):

  • The U.S. is adding 3 million people per year since the crisis began four years ago
  • The U.S. will add 30 million people in the next ten years
  • This growing population creates the need for 1.2 million new housing units per year, but household formations have been half of that in the past four years; household formations will eventually return to 1.2 million as the employment situation improves
  • Job conditions are improving slowly
  • 845,000 housing units were built annually in the past four years.  Destruction from demolition, disaster and dilapidation averaged 250,000 per year
  • Total housing inventory is 2.7 million, down from peak of 4.4 million in May 2007; it would take only six months to sell all of this at existing sales rate, down from 12 months two years ago
  • Shadow inventory is declining after peaking in 2009;  mortgages 90+ day delinquent and in foreclosure was 5.1 million but now down to 3.9 million and could be 3 million in twelve months
  • Housing is at all time high level of affordability due to low house prices and low mortgage rates
  • It is now cheaper to buy than to rent in half of the markets in America; this has not been true in more than 15 years
  • Household debt service ratio is lowest since 1994

Dimon ends the section saying "More jobs, more households, more Americans, good value - it's just a matter of time".

Ignore Macro?
So I tell people to ignore macro concerns and yet I seem pretty interested in the U.S. housing market.  Well, I am interested in the housing market as it is a key component in getting the U.S. economy back on track.  So I pay attention to what people say, particularly people I trust and who have been right before and are *not* known as forecasters.  

But having said that, I don't base any of my investments on what people say.  For example, when I hear Buffett say that housing will bottom eventually, I don't go out and buy housing stocks or anything like that at all.

My investment decisions are based on price/valuation and what a company will eventually earn in a more "normal" environment.  I don't care when that "normal" environment comes; people go wrong when they try to predict when that would be.

I don't ever want to be in a position where I pile into housing stocks, for example, because I expect a turn in the housing market over the next year and then I lose a lot of money because the turn doesn't come. 

What's the difference between that and what I try to do?

JPM is a great example.  JPM would do really great if the housing market *did* turn.  They have really expanded their footprint with the Wamu purchase and are growing branches all over the place.  They have many more mortgage bankers than before. 

So if housing picked up, JPM (as well as WFC which has also increased it's footprint across the country) would get some pretty hefty upside to revenues and profits.

But the key issue for me is that even if the housing market did *not* recover at all, it is making tons of money and the stock is pretty cheap.  A housing market recovery would be a bonus.  A stronger U.S. economy would be a bonus.

Keep in mind how JPM has done in an awful environment. Here's a graph that I post all the time; it was also in the annual report so here it is again:

So in the worst economic environment since the great depression, JPM managed to make money throughout and has even increased tangible book value per share by more than 12%/year in this turbulent five year period.

Imagine what they could do in a more "normal" environment.

So JPM is a good investment that makes money even without a recovery in the housing market; even if it continues to muddle along the bottom, JPM can make money.

Contrast that with some favored 'macro' trades out there; there are housing, construction and material stocks (like USG) that are losing money and has been losing money forever.  The scenario is that they can make tons of money *if* the housing market turns (if not, they can go bust no too far in the future).

Why would you do that if you can get something that is making money now and will make more in a recovery and you can get it for so cheap?    And you don't have to cross your fingers and hope for a quick recovery in housing.   You can just be comfortable that things will turn eventually and things will be fine. If it doesn't come you are still doing OK.

Why Would You Own the Stock?
OK, so I digressed quite a bit.  The last part of the letter to shareholders is a section with this title.  He goes on to say that banks stocks are depressed for many reasons but Dimon feels that most of those reasons will go away; the economy will recover, interest rates will normalize etc...

And he goes on to explain why JPM stock is such a great buy at tangible book value.

He says (and like I said last fall):

   "Our tangible book value per share is a good, very conservative measure of shareholder value"

And he explains how stock repurchases at tangible book value would be accretive to both earnings per share and tangible book value per share.

He does believe that tangible book value is a conservative measure and that JPM itself is worth far more than that.

As I said before, 1.5x to 2.0x tangible book is not a stretch at all.  Dimon has said that JPM should be able to earn at least 15% return on tangible book.  Earnings in a not-so-good year of 2011 would have been 19% return on tangible book excluding the legacy mortgage expenses, so return on tangible book of over 20% is not a stretch and in that case 2.0x tangible book value per share is not at all unreasonable for JPM stock.

Anyway, the letter to shareholders is almost 40 pages long so is a bit long, but it is definitely worth the read for anyone interested in stocks, investing, business etc...

Also, I do like JPM stock but keep in mind that it is a financial stock and it can be volatile.  If Europe implodes or the economy takes a turn for the worse, of course the stock price can go down and can go down in some cases quite dramatically.