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).

Conclusion
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.

Cracker Barrel / Biglari Holdings

To continue the story, Biglari Holdings (BH) bought 1.05 million more Cracker Barrel (CBRL) shares in January for $54 million.

So that sort of changes the composition of the balance sheet.  At the end of December 2011, BH had cash and investments of:

Cash:             $115 million
Investments:  $119 million

So the above transactions changes that to:
Cash:              $61 million
Investments:  $173 million

So that's a pretty big position now in CBRL.  In my last post, I thought BH is worth around $580 million as is, but may be worth $840 million as margins at the restaurant (SNS) improves.   So either way you look at it, CBRL is a pretty big position for BH.   (I ignore small changes in the stock price of CBRL for now).

Partly because of that, I spent some time at the SEC website reading through the filings at both companies; CBRL and BH.  The back and forth during the proxy contest last year is very interesting with both sides making interesting points and both sides having good presentations.

Whatever you think of either side, it's really interesting and educational to see what each side has to say.  All of this stuff is available at the SEC website for corporate filings, and the respective corporate investor relations websites.   Biglari set up a website specifically for his CBRL proxy contest and it makes for very good reading. 

It is accessible at the following website:

http://www.enhancecrackerbarrel.com/

You can read all of Biglari's points in his letter to CBRL shareholders.  It is well written and easy to understand.  Again, I don't worry too much about who is right or wrong.  One learns from listening to both sides.

Unprofitable Capex
Anyway, one interesting point Biglari makes is that CBRL has spent a lot of money building new stores that increased revenues but hasn't really been profitable:

This is a very good point.  This is similar to Ed Lampert's point about capex in the retail industry and really cut down on capex.  In that case, so far, it doesn't look like it's working too well.  But let's not let one or two situations influence our decision.  I too tend to believe that corporations tend to spend money by 'inertia'.    There are a lot of motives that drive companies to spend or to grow at the expense of profitability.  (Some older blue chip firms obsessed with market share is a typical example).


Bad Traffic
CBRL has had some pretty horrible traffic trends in the past few years.  Below is a table from Biglari's letter:

I don't think you can blame the economy for this as the economy was in a boom during 2005 - 2007. I too wonder about expanding stores when trends aren't favorable.  Many retailers will keep opening stores even if it cannibalized their existing base if they think they can get more profit dollars from the market.  But in CBRL's case, as is shown in the above table, this expansion in the face of declining traffic trends has not led to increased profits.


Store Profitability
We already know from the above that profits per store is down; sales are up and operating income is flat, so obviously profit per store is down.

Biglari makes the case that this downtrend began when Evins retired and the current CEO Woodhouse took over.

I think the basic story of CBRL, as Biglari states in the above cut-and-paste text from his letter, is that if CBRL can stop building new stores for the sake of building new stores and focus on store profitability, it can really increase shareholder value.  Biglari says that if they can get per store profit back to the old levels, that would double the value of CBRL.

Incentive plan

So why is CBRL so bent on building new stores and expanding?  They have mentioned over the years that they target 1000 stores nationally.  Maybe this is what it's about.  They did have a goal of growing their store base by 5%/year but at some point they decided to slow that down.  I think they are going to start picking up again (plan to spend $50 million this year on new stores).

Biglari mentions that the CEO got a bonus for achieving a hurdle of $90 million in operating profits in 2011, but points out that this hurdle is way too low as the company hasn't had operating profits below $90 million in years (see table below).   There isn't any mention of margins or growth.

I also notice in the proxy that the long term incentive is based on "achieving long term revenue growth and profitability over performance period" (as well as stock price performance).

It doesn't say, "achieving long term revenue and profit growth", but revenue growth and profitability, which might explain why CBRL keeps spending money to open stores even when it doesn't contribute to earnings growth; as long as they are profitable, it doesn't matter. They need to grow revenues.

So on the issue of growing stores without growing profits, Biglari has a good point and the reason might have something to do with this long term incentive plan.

Operating Margins

OK, so let's get back to store profitability.  I will actually just look at the overall operating margin of CBRL over the years.  Below is the sales, operating income and operating margin of CBRL since 1994.

So you will notice that operating margins have been trending down starting with a big drop in 1999 (same store sales trend were down back then and they acquired Logan's Roadhouse in February 1999 which probably accounts for some of the margin drop too.  They have since sold Logan's). 

Between 1994 and 1998, CBRL seemed to earn operating margins of 10-14%.  Biglari mentioned above the year 1998.  Operating margin in that year was 12.52%.  If CBRL can earn a 12.52% operating margin, that would be an EPS of:

$2.4 billion sales (in 2011) x 12.52% = $300 million in operating income, less $51 million interest expense (assuming same capital structure) for a pretax profit of $249 million.  With a 27% tax rate that is net income of $182 million.  With 22.9 million shares outstanding, that's an EPS of around $8.00/share.

From the previous analysis, we know that restaurant companies trade at around 16.5x p/e, so applying that we get a CBRL value of $132/share.   That's 150% higher than the current price of around $53/share.

But wait a minute.  How the heck does a company with sub 7% operating margins suddenly improve that to 12.5%?  That might seem quite a stretch.  The restaurant environment too is very different from what it was in the late 90s.  Surely there is much more competition.  Also, consumers are still pressed, unemployment high and food and energy inflation continue to put pressure on margins.  So it would be unrealistic to expect such a huge increase in operating margins over a short period of time.

Let's do the same exercise at 10% operating margins.  If CBRL achieves a 10% margin (which still might be aggressive), then the value of CBRL might rise to: 

$2.4 billion sales x 10% = $240 million operating income, less $51 million interest expense = $189 million pretax income x (1 - 27% tax rate) = $138 million net divided by 22.9 million shares outstanding is $6/share.  $6 per share x 16.5x typical restaurant p/e ratio is still $99/share.  Pretty much a double.   [ If the value of CBRL doubles, then the total value of BH can be up to $700/share (that includes the improvement in SNS too ]

For another sanity check, I jotted down some operating margin levels from some listed restaurant companies to see if 10-12% operating margins are reasonable or possible.

It's difficult to compare since the business models are so different.  I tried to include companies that mostly owned their restaurants versus the franchise model like YUM brands or DIN (the old IHOP) which have drastically different models.

Anyway, just from looking at this, it seems that most restaurants have suffered declining margins over the years.  Of course, higher costs and high unemployment has really been a negative factor in the sector.  But looking at the table, it doesn't seem to me that 8-10% margins is impossible.  Again, we are talking about a big change in direction so margins can change dramatically in that case (as opposed to the same management just making minor tweaks here and there).

Off the top of my head, I remember other recent situations where companies got used to growing for the sake of growing and lost sight of what was important.  They stopped or slowed expansion to refocus their operations and boosted their margins.

The ones that come to mind are McDonald's and Starbucks.  Both of them have grown for many, many years and came to a point where they decided growth wasn't adding value to shareholders, and that focusing on improving operations at their store base was the right thing to do.  Walmart too, by the way, came to that conclusion recently although I don't see margin improvement there yet.

Anyway, here is a table of what happened to operating margins at McDonald's and Starbucks:

So McDonald's got stuck in the early 2000s, and decided to focus more on profitability instead of growth.  Their margins went from the teens to over 30%.  It's important to remember that MCD was facing a crowded market that was overly competitive ($1.00 menus etc...) and many thought that MCD has gone as far as it can go and that there wasn't much they can do.  SBUX too was in a simliar situation.  They had gone as far as they can go and saturated their stores (and markets with stores) with all kinds of products and there wasn't much more they can do to increase profits.  SBUX too, has done well by refocusing, recently hitting operating margins that are far higher than in their best years between 2004 and 2007.

So rethinking strategy and reallocating capital *can* make drastic changes, even at companies where  few people imagined anything can change much.

This is not to suggest that CBRL can make 30% operating margins or anything like that.  MCD and SBUX are both drastically different businesses.

But what I think it's important to remember is that things *can* change and slowing or stopping expansion to improve operations *can* work to boost margins.

Of course, this doesn't mean it's easy.

I just wanted to point out that it can happen and work, even when the rest of the sector continues to suffer (MCD improves while Wendy's, Burger King etc.. continue to not do too well etc...).

Biglari's Track Record

This is a "by the way", but this was included in one of Biglari's letters to CBRL shareholders.

These are his big recent transactions; it seems that he has done well.

Conclusion
I am no expert on the restaurant industry, so I wouldn't be surprised if some restaurant industry veterans looked at CBRL and laughed at the notion that it can improve operations and make more money.

But *if* they can make some changes, especially cutting back on growing while they suffer declining traffic and other things (like MCD and SBUX did), they may be able to boost margins.  If they do, this can certainly lead to a doubling or at least a higher stock price.

If that happened, from the above analysis, BH stock too can be worth as much as $700/share (CBRL doubles in price and SNS gets to 8.5% operating margin for the year, and then valuing that business at 16.5x p/e).

Again, this is if things go well at CBRL (and continues to go well at SNS).  I think there is a reasonable chance that both go well, but many things can obviously go wrong.  BH is not a Berkshire Hathaway or a Coca-Cola.  It is a small, concentrated investment dependent on the actions of a single person.   So many things can go wrong here. 

This is something that I will watch closely with interest.  Biglari continues to buy shares even as he lost the proxy contest, so it will be interesting how this plays out going forward.   I do think the pressure is on, though, at CBRL and sometimes that's all that is needed to make some positive changes (it was encouraging that the shareholders voted down the poison pill, at least).

Stay tuned.