Circle of Competence

You’ve got Berkshire; the king, the original, the Mecca.  Investing in Berkshire Hathaway over the last 40 years has been like injecting rocket fuel into your portfolio, generating 20%+ returns since 1965 and, in the process, minting millionaires and loyal followers. However, nowadays Berkshire is getting so large that, by the laws of statistics, its returns have been and will continue to diminish.   You can’t compound $200 billion like $200 million.  The inevitable result?  Investors will go looking for its successor.

In that space you have some other players: Leucadia, Sears Holdings, Brookfield Asset Management, Fairfax Financial, Markel Corporation.  Each of those companies, in addition to others I haven’t mentioned, has been brought up in the conversation as to “Who’s the Next Berkshire?”  Each has provided serious returns for investors with manager(s) at the helm who think and act in the Berkshire mold, cultivating loyal long term investors who enjoy getting rich.

However, though I’ve looked closely at the words of Buffett’s progenies from Ian Cummings (Leucadia), to Prem Watsa (Fairfax), I can’t say I’ve ever read words as blatently Buffett as those written by Mr. Sardar Biglari, Chairman of Western Sizzlin’ Corporation, a $35mm holding company and restaurant franchiser who only recently was added to the NASDAQ stock exchange, under the ticker symbol WEST.

Before I give my rambling thoughts, I’ll first direct you to a couple wonderful sources of information already written by a few of my friends, George from Fat Pitch Financials, and Shane over at NoiseFreeInvesting.  They’ve both done legwork on Western Sizzlin’, and you should read up on their thoughts before continuing.  Once I’m finished, I’m confident you’ll believe that they are superior writers than I.  You would be correct.

Last year, George took a shot at Valuing Western Sizzlin’.   Then, a bit later on, George goes on to explain the reality of Western Sizzlin’s situation, in What is Western Sizzlin’, Really?.  Great work, and both articles serve as a primer for my thoughts on the company.
Second, Shane at Noisefreeinvesting, in November of last year, brought us through the history of WEST, explaining how and why they are where they are today, in Western Value: the Untold Story of Western Sizzlin’.  In addition, if you peruse through Shane’s writings, he covers some of Western Sizzlin’s major equity investments in more detail than I will go into: namely Steak N Shake and ITEX Corporation.

Those are the two places to start, regarding Western Sizzlin’.  Read ‘em and then continue on at your own peril.

*  *  *  *  *

Now that you’ve been able to soak up the wisdom imparted by Shane and George, I can continue.

Western Sizzlin’ came up as a straight restaurant operator and franchiser, struggling for a time up until 2002 when shareholders of the company ousted the CEO and replaced him with Jim Verney, who proceeded to pull the company from the brink of insolvency and move them forward in their business dealings.

By 2005, as Shane recounts in his article, Western Sizzlin’ saw one of its major shareholders, The Lion Fund LP, run by Sardar Biglari, begin to get active.  He pushed for board seats and a realignment of company values, enjoying success in this venture as he was named Chairman, placing his former professor and now partner, Phil Cooley, as Vice President.

The company we see today in Western Sizzlin’ is not your grandfather’s restaurant operator.   Beginning in 2005, Biglari began writing a Chairman’s Letter in the mold of Warren Buffett’s annual letter to Berkshire shareholders.  In these letters, of which there are now 3, Biglari makes it clear that Western Sizzlin’ will allocate its capital to the greenest possible pastures.  What was once a pure restaurant franchiser now has half of its market cap allocated to two stocks, Steak N Shake and ITEX, and one real estate property.

Let’s take a look at Western Sizzlin’ as it stands today, using my words interspersed with Mr. Biglari’s own thoughts on the company.

The General Operation

From the 2005 Letter:

“For every dollar spent, you can be sure your board accounts for 32 cents of it.  Plainly, then, we will treat your money the way we would treat our own.  Consequently, we will install a culture that cares about every expenditure.  We intend for the entire organization to exhibit and ethos of caring about is shareholders…an ethos that ensures that capital is allocated for obtainable positive results for the benefit of our franchisees, our customers, and ultimately, our shareholders.”

Biglari makes it clear that he will treat his shareholders’ capital with every care, and he will treat his fellow shareholders as partners in a business venture, much like Buffett treats his own at Berkshire.  In the this particular letter, Biglari even quotes Buffett flat out regarding investing capital for growth.  Biglari is not bashful in using Buffett’s thinking for the benefit of WEST shareholders.

The Restaurant Business

In the letter, and in his activities since, Biglari accents the necessary emphasis on restaurant franchising rather than operation.  Indeed, Bill Ackman did the same three years ago in pushing McDonald’s to improve its operations by focusing on franchising and free cash flow generation.

Here are Biglari’s thoughts on franchising from the 2007 letter, recently issued:

“Over the longer term the company should strategically zero in on growth through franchising. Franchising represents a strategy of disciplined unit growth by leveraging the brand with market penetration in a manner that begets low-risk revenue and high-return cash flows. Such a long-range plan would yield numerous benefits: It would allow management to concentrate on propelling the value of the brand by allotting more resources to development of better products, improved quality control, shrewder marketing practices — all resulting in better overall productivity, resource allocation, high returns on capital, and significant free cash flow.Thus, the company should be in the franchising and real estate businesses for the cogent reason of maximizing return on capital while concurrently minimizing cost of capital — a powerful combination that would lead to creating value for all shareholders.”

Thus, business plan #1 for WEST is now restaurant franchising.  At the end of 2002, there were 17 company owned and 215 franchised restaurants.  Today, they operate a mere 5 restaurants in addition to 117 franchisees.  As you can see, the operation has been scaled down to manageable and profitable operation, one that is now part of Western Sizzlin’, rather than all of it.

The Investments

Sardar continues to run his hedge fund, the Lion Fund LP, with its major investment being Western Sizzlin’.  Coming from this background, it comes as no surprise that much of WEST’s business today is in a major securities operation.  The holding company structure allows Western Investments LP, the investment partnership subsidiary of Western Sizzlin’, flexibility to invest in marketable securities of any kind.  Biglari has made it clear that this operation will be heavily concentrated in a few securities.  So far, there have been three major investments:

#1 began in 2006 and commenced in 2007, namely Friendly Ice Cream Corporation.  In the continuing theme of activism, Biglari issued a rights offering to Western Sizzlin’ shareholders in 2006, using the new capital to purchase a large stake in Friendly’s.  Now, living in the Northeast I am a huge fan of the company’s ice cream, but as it were, the business itself had been struggling for years with cash flow mis-allocation, a perfect situation for Biglari to get involved in.

Here is a synopsis of Biglari’s thesis on Friendly’s, pulled from an interview with the Motley Fool in 2007:

“Biglari: Though I do not wish to share the details of my thesis for a number of reasons, I can tell you that as a value investor, I am looking for situations in which the consensus is incomplete or even erroneous.

Here is a company founded 72 years ago by two friendly brothers selling ice cream quite profitably. Up until very recently, [it] was controlled by a board [with a culture] that was the antithesis of the culture developed by the brothers. When I first examined the company, I was struck by the board’s unfriendliness toward shareholder interests, illustrated by a poison pill, a poison put, a classified board, onerous provisions in the bylaws, to name a few. Yet beneath the dark clouds of poor governance and a leveraged balance sheet was a company producing a well-known brand, generating great cash inflows, combined with a terrific real estate portfolio — all adding up to substantial upside potential.

When we entered the stock, our intention was not to sell the company. But when we were presented with a rather attractive price, we took it, because doing so was in the best interests of all the stockholders. We could have vetoed the deal, and the shareholders, in all likelihood, would have elected us to the board. But a buyer was found willing to buy the entire company for $15.50 per share, which, incidentally, fully values the stock. We do not believe that every company should be put up for sale or even sold unless the price reflects its full value, as it did with Friendly.”

After trying to work quietly with management (unsuccessfully), Biglari went active and started a proxy battle, beginning a website: www.enhancefriendlys.com.   The company resisted, but much to Biglari’s pleasure, in 2007 the company was bought out for a price 82% above what WEST paid,  realizing a profit of about $3.7mm for shareholders.

#2, after Friendly’s, is the current and ongoing saga at Steak N Shake (SNS), another investment in the vein of Friendly’s.  Steak N Shake is a restaurant operator who has realized strong cash inflows but misappropriated cash outflows since 1998, resulting in negative 10 year shareholder value and a big waste of time and money.   Sure, sales doubled from their prior levels, but the company generated lower free cash flow in 2007 than 1998.  Seeing this, Biglari began purchasing shares last year at levels more than double what they are today.  After a campaign that reflected his efforts at Friendly’s, early this year Biglari was successful in getting himself and Phil Cooley elected to the board at SNS.  In fact, the shareholders of SNS voted 74% in Biglari’s favor, an overwhelming vote of confidence.

Here is a portion of Biglari’s thoughts on SNS:

“Improvement of store-level profitability, growth through franchising, reduction of corporate G&A, focus on generation of free cash flow, share repurchases, pay-forperformance compensation, a more effective governance board — these are strategies we have in mind to enhance the value of the company. Western’s 5.4% equity interest in Steak n Shake represents about $33 million of revenue, larger than WSFC’s entire restaurant and franchise operations. Consequently, we are working with the board so we can become more involved with the company, effect necessary changes, and invite in the right CEO.
Thus far, the investment result has been dismal. But we think that it will improve.”

Steak N Shake is a deeply undervalued company right now. As a WEST shareholder, I take comfort in the fact that Biglari is using himself as a catalyst for postive change at the company.  The wonderful thing is that not only is the company cheap, but its problems easily fixable.  Reduction of G+A expenses to prior levels, a moratorium on capital spending, and an increase in franchising operations would yield free cash flow easily north of $50mm.  With the ability to generate north of $50mm in free cash flow on a normalized basis, their current market cap of ~$175mm seems pedestrian.   The value of WEST’s investment in SNS stands at $13.8mm as of Q1, but it’ll be worth much more in the future.

#3 is a smaller investment, to the tune of about $900,000 invested  in ITEX Corporation, a company engaged in a cashless barterting business.  Having looked at their financials, a couple of things stand out with ITEX: strong cash flow and high returns on capital.   Biglari attempted to purchase the whole company for .06623 shares of WEST per share of ITEX, but ITEX management fought hard for a better price that Biglari refused to pay.  The net result is that Western Investments LP now owns 9% of ITEX.

You may be thinking that Biglari’s unwillingness to up his price is a mark, however I believe the opposite;  Biglari’s fiduciary responsiblity is the the shareholders of Western Sizzlin’, not ITEX.  Indeed, the price he offered to pay was probably not realistic for ITEX shareholders.  In fact, if I was presented with the price Biglari offered, I’d have turned it down, too.  But the tender offer did allow WEST to purchase a large block of shares in a well run company with terrific economics, at a reasonable price.  I’ll take it.

The Other Stuff

There are three other pieces of business that WEST is engaged in, which I’ll discuss briefly.

The first is an interest in Mustang Capital Partners, a new investment that Sardar details in the 2007 letter:

“I met John a few years ago at a Christmas party held by an accounting firm servicing our respective investment companies. As two value investors, John and I naturally gravitated to a corner to discuss pink sheet stocks. His knowledge is impressive; as a sample, I gave him a few facts about a certain stock, and he identified the company simply through my sketchy data.

The next time I saw John was last year in New York at Western’s annual meeting, as he then was one of our largest shareholders. Several months later he asked for a meeting and broached the idea of Western’s purchasing his business, a proposition I immediately embraced. To John, price was not the primary factor; rather, he wanted a good home for his business and also wished to continue running it. His investment record, founded on a very stable client base, is phenomenal. He will continue to operate his business as before.”

In my opinion, this interest represents a saavy investment.  Thought I haven’t seen the audited record of Mustang, it must be a good one for Sardar to invest in the General Partner.  What this means is that WEST will reap a 51% interest in the general partner’s allocation at Mustang.  Hedge fund operation is an extremely attractive business model, with much upside and little downside, so I believe this will provide WEST shareholders with value creation for years to come.

The 2nd part of “other stuff” is a $3.8mm investment in Real Estate.  Once again, Sardar does a great job discussing this in the recent letter:

“Western purchased 23.5 acres of land in San Antonio through Western Real Estate, L.P. on December 13, 2007 for $3.75 million. The property is near an 800-acre mixed-use development, The Rim, in one of the most robust and fastest growing areas of the city. We knew that all 23.5 acres were not usable, but after the due diligence we received reliable data and was in a position to offer a price and close on the transaction expeditiously. The price was favorable in relation to the property’s potential usability.”

The success of this real estate venture is yet to be seen.  Personally, I have absolutely no knowledge of the real estate market, so I cannot judge the real estate venture with any competence.  This is a “trust Sardar” moment for shareholders, and we’ll have to keep a close eye on its ultimate success or failure.  He brought on a real estate attorney, Ken Cooper, to the board in 2007, whom I assume will oversee or consult for this operation.

Lastly, WEST has an interest in a joint restaurant operating venture for a restautant called Wood Grill.  The JV is with a man named W.E. Profitt.  While he does sound like a Dr. Seuss character, Biglari thinks highly of the fellow.  I do too, after seeing the numbers being generated by the JV in 2007: 83% return on equity and a cool 18% ROIC.  WEST put in $300,000 last year, and the company produced EBIDA-capex of $726,479, 50% of which belongs to WEST.  Those are some beautiful economics.

What’s this jumbalaya worth?

OK, Jeff you’ve been rambling on for a day and half about this holding company with a bunch of uncorrelated investments.  But you call yourself a value investor, so What’s the value!?

If you’ll please, I’ll give it a shot: Here is the link to my various valuations based on TTM, Q1, and SNS returning to $20/share: link.

These are the numbers I’ve produced.  You’ve got restaurant operations and franchising, which includes the JV for Wood Grill, in the numbers on the left side.  Adding back non-cash charges like D+A, and non-recurring lawsuit charges, putting it on an annualized basis and a reasonable 10X FCF multiple, we arrive at a value of $20mm or so for the restaurant business.   Considering the economics there,  I think it is a reasonable valuation.  Capital expenditures are very, very little.

Note 5/15/08:  I altered the valuation numbers a little bit, in my own mind.  One thing I missed (secured debt on their real estate holding), and one thing I changed (methodology for valuing the cash flows of the restaurant operation).  I was not satisfied with my valuation based on TTM numbers vs. just 1Q ‘08, but I was able to figure it out enough to provide reasonably accurate numbers.  The updated spreadsheet is included in the link:

On the right side, you’ve got the market value of SNS and ITEX at the end of Q1, the market value of their real estate, and cash.  Taking out debt and the minority interests in the securities and real estate operations, total value comes to $36.7mm, exceeding the current market cap by a small percentage.

It’s not that cheap, Jeff…

I know, I know, why would I buy a business for what it’s worth?  A couple of reasons:

1.  This assumes no premium for Biglari’s investing acumen and future value creation.  This assumes a stagnant restuarant operation, cash being worth cash, and the marketable securities being worth their current price.   Imagine Berkshire in 1970 being worth it’s book value.  While I’m not saying Biglari will find returns as high as Berkshire, I think he and his team will create value way above and beyond the average company over the next 20 years.  The market places a value of zero on this possibility.

2. As I mentioned, the market value of WEST’s investments in Steak n Shake and ITEX are shown at market value.  I’ve studied SNS, and since become a shareholder myself independent of WEST, and I believe it to be deeply undervalued.  With a catalyst apparent (Biglari and Cooley), the company can realize its value within a few years, a value which I place at multiples of its current market price.  If this does indeed occur, WEST is worth much more than the market is placing on it, even without a premium for future successful investments.

3. This is a train I’m getting on early.  I’d like to be partners with Mr. Biglari for the forseeable future, and at this price, I can do so for free.  No incentive allocation, no premium, nothin’.

Conclusion

The team of Biglari and Cooley are acting in the manner of Buffett + Munger.  These are lofty comparisons, but the correct mindset, and the results up to this point flesh out that thesis.  I don’t think that WEST can compound at 21% for 40 years, but I think way above average returns can be had at these prices.  WEST is small and agile, Biglari can go anywhere and invest in anything with a small amount of capital, thus even though Buffett may be a far superior investor, he is constrained in ways Biglari is not.

With minimal downside, I’d like to think investors can put their money in WEST and it compound at an attractive rate for years to come.

Disclosure: If you didn’t notice, I hold positions in WEST and SNS.

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