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The Steak n Shake Takeover Battle

Sardar Biglari burst onto the investment scene in 2008 with his successful proxy fight for The Steak n Shake Company. While only 35 years old, he has assembled an outstanding investment record over the past sixteen years that is largely unknown and unappreciated. Biglari Holdings, Inc (BH): Sardar Biglari - Bet The Jockey is a series of eight articles to investigate Biglari's investment results since inception, the strategies he has used to achieve these results, analyze his concentrated investment decisions and the likelihood that he can achieve outlier status and outperform the market over the long term. Part II in this series reviewed the Friendly Ice Cream proxy fight. Part III revisits the Steak n Shake takeover battle.

The Steak n Shake Company

Fresh off his successful fight with Friendly Ice Cream Corporation, Sardar Biglari quickly set his sights on another iconic brand that was experiencing financial challenges. On March 22, 2007, he made his first purchase of 25,000 shares in Steak n Shake Company and continued to acquire stock throughout the summer. On July 30, 2007, Biglari filed an initial statement of ownership with the SEC reporting a 5.8% ownership interest and by June, 2008, Biglari and his related interests would ultimately hold 13.2% of the company.

Much like Friendly, Steak n Shake boasted an iconic brand that had fallen on hard times. An American legacy, Steak n Shake was the fourth oldest restaurant chain in the country behind A & W, White Castle and Krystal. Through the financial ups and downs of its history, the Steak n Shake brand remained strong. The company was started in 1934 by Gus Belt in Normal, Illinois. Looking for a way to make his Shell gas station more attractive to motorists, as well as a way to supplement his income, Belt hit upon the idea of running a small restaurant in conjunction with the gas business. The "steak" in Steak n Shake referred to the restaurant's hallmark sandwich, the steakburger, which was made with real cuts of T-bone, fillet, strip steak and sirloin, ground up, formed into patties and grilled in a unique carefully choreographed method that seared in the juices and crisped the exterior.

The restaurant was a hit and Belt opened a second walk-in store in Bloomington, Illinois. A third and fourth store soon followed and by the end of the 1930's the chain operated eight locations. By 1943, there were fifteen Steak n Shakes with most located in Illinois. In the late 1940's, the company opened its first St. Louis store and by 1954, the company opened ten highly successful restaurants in the city. The St. Louis expansion was financed by a public stock offering, but the Belts continued to own a controlling interest in the chain. After Belt's death in 1954, his wife Edith took over the company. Over a period of fifteen years, she expanded the store base from twenty-one to fifty-one, but kept the Steak n Shake formula unchanged. In 1969, she sold her controlling interest in the company to Longchamps, a New York restaurant chain, for $17 million.

Only three years after Longchamps acquired the company, they were accused of negligence by dissident shareholders and sold their interest to the Franklin Corporation, a holding company run by Robert Cronin. Cronin's leadership would span ten years, when the company was sold again to Ed W. Kelly. The 1990's ushered in a new era of growth for Steak n Shake. The chain, which contained slightly more than 100 units at the beginning of the decade, more than tripled in size over the next ten years. Part of the growth stemmed from a franchise campaign, which the company launched in 1991. Unfortunately, Kelly's health declined in 1998 and he began playing a significantly less active role in the firm.

While Steak n Shake had a relatively pristine history of profitability, reporting only one annual operating loss since the mid-eighties, profits peaked in 2005 and trended down over the next three years. In 2008, the company reported a pre-tax loss of $34.7 million on a 6.7% decline in sales. Customer traffic and same store sales had been consistently trending down since the fourth quarter of 2005:

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Corporate-level expenses had gotten out of hand as an ivory-tower mentality developed among management and unit economics deteriorated as a result of weak management systems and operational capabilities. Trapped by the inertia of their past success, Steak n Shake management was paralyzed to react and continued its unabated pursuit of growth through the addition of new stores and markets. In a letter to management, Biglari pointed out that this growth came at a heavy cost. Over the nine-year period ending in 2008, a total of $478 million in capital expenditures were spent in maintaining and expanding the chain, while sales grew just $259 million. This meant that for every dollar of sales growth, Steak n Shake invested $1.84.

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On August 13, 2007, Biglari and Phil Cooley traveled to Steak n Shake's headquarters in Indianapolis to meet with Alan Gilman, Chairman of the Board, and top management to discuss the business, operations and future plans of the company. Biglari had hoped that management would be open to his suggestions and supportive of his desire for two seats on the Board. He was the third largest shareholder of Steak n Shake at the time, holding more shares than all executive officers and directors combined. Unfortunately the meeting did not go as planned and he was denied representation and otherwise rebuffed from any involvement with the company. To management, he was viewed as a nuisance, one that if ignored would hopefully go away. Later that month, the board hired Merrill Lynch & Co. as a financial advisor to help examine "potential opportunities" in an effort to sell the company and advise a special committee on a strategic plan that included simplifying initiatives, focusing on field leadership and critically reviewing the company's cost structure.

Biglari launched a proxy contest in October 2007 after attempts to discuss directorships with the existing Board became fruitless. The proxy battle was bruising. In a shareholder letter, Biglari pressed claims that the company was handicapped by a "lack of leadership, lack of execution and lack of strategic direction from headquarters". Biglari felt that the company wasted millions of dollars building new restaurants and instead should have focused on franchising, improving profits at existing locations and cutting costs. The Board countered that Biglari was nothing but a corporate raider, only interested in Steak n Shake to pursue short-term profits at the expense of the company.

On March 7, 2008, after months of back and forth between Biglari and incumbent management, Biglari won the most important victory of his life when 74% of shareholders voted to replace current leadership with Biglari and Cooley. At the young age of thirty, Biglari had successfully launched his second hostile Board takeover of a public company.

In June 2008, Biglari was named Chairman of Steak n Shake and he added the Chief Executive Officer title in August. With his latest victory, Biglari had graduated from his role as a corporate raider to one of business leader. He would now get the opportunity to implement his aggressive turnaround plans to revive a struggling brand. While he didn't lack for confidence, the market was still skeptical given his age and limited restaurant operating experience.

The current state of the economy also proved to be a significant challenge. Lehman Brothers Holdings, Inc. filed for bankruptcy in September 2008 and Shake n Shake's stock dropped 61% during Biglari's first three months on the job. Undeterred, Biglari quickly moved to announce a moratorium on opening new company owned restaurants and dropped plans to build twenty new locations. He called for cutting general and administrative expenses by $20 million in fiscal 2009 while operating costs of existing restaurants would be cut $8 million. In addition, fourteen restaurants were closed and hours were curtailed at an additional 125 locations. Biglari spent $400,000 on a tax study that identified depreciation related savings resulting in $16 million in tax savings dating back to 2006.

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Biglari's Buy Analysis

The similarities between Friendly and Steak n Shake were not lost on Biglari. Both companies enjoyed a long colorful history and powerful brand recognition in their established markets. They each had the potential to expand through franchising on a broader national level but had posted weak financial results. Biglari felt that Steak n Shake's problems were largely self-inflicted and that key fundamentals such as leverage, interest coverage and operating cash flow had not deteriorated to the point that it was too late to make changes.

Biglari first started acquiring stock in The Steak n Shake Company at $16.78, yielding a market capitalization of $468,281,558. Net funded debt totaled $27,436,000 at December 20, 2006, indicating a total enterprise value for the company of $495,717,557. An analysis of Steak n Shake's adjusted free cash flow and EBITDA is detailed below.

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Assuming Biglari was successful in returning the company to normalized cash flows comparable to the 2005-2006 period, Steak n Shake was selling at a 9.65x multiple of adjusted free cash flow calculation and a 6.95x multiple of EBITDA.

Biglari planned to reorganize Steak n Shake into a holding company structure similar to Western Sizzlin. Financial and capital allocation decisions would be centralized at the holding company level while management of the operating businesses would be decentralized at the business unit level. Steak n Shake's most important business activity was restaurant operations but any incremental capital that could not be redeployed into the core business would be channeled back to the parent for reallocation to other unrelated businesses or investments. The sole focus would be on the generation of free cash flow and maximizing cash and equity investments through improved earnings and the judicious reinvestment of capital.

The most controversial aspect of Biglari's plan was the significant reduction in capital expenditures in an effort to build cash to fund additional investment opportunities at the holding company level. From 1999 to 2008 the company averaged $55 million, or 9% of total revenues, in capital expenditures per year. Biglari's proposal assumed maintenance capital expenditures of just $5 million, or just $12,000 per company owned restaurant. Restaurant experts and financial advisors warned the move carried heavy risks. Juelene Beck, a former top executive at Burger King and Dunkin Donuts suggested, "Cutting back on capital expenditures can work for a few years, but there are long term risks. Just remaining a player in the hyper-competitive chain restaurant business requires investment". Financial analysts compared the strategy to Eddie Lampert's efforts to maximize cash flow at Sears Holding Company (SHLD) that later led to disastrous same store sales results.

Biglari as CEO

Biglari worked to reposition the Steak n Shake brand as a low cost value leader by aggressively marketing such programs as 4 meals under $4, ½ Price Happy Hour, Kids Eat Free and $3.99 All You Can Eat Pancakes. He felt that growing same store sales at existing restaurants was superior to opening new units and that same store sales could be grown through increases in customer traffic, increases in the average check, or a combination of both.

Results were immediate with increased customer traffic and same store sales.

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Same store sales increased 4.1%, 7.5% and 4.2% in 2009, 2010 and 2011, respectively, under Biglari's leadership, reversing a four-year slide. The number of customer visits to Steak n Shake increased from 85 million in 2008 to 105 million in 2011, all through the same stores. Biglari felt that increasing customer traffic by building new units was not a management accomplishment, but boosting customer traffic profitably through existing stores and leveraging fixed restaurant costs enhanced value more than any other concept.

Investors' initial concerns regarding Biglari starving Steak n Shake for its cash while under-investing in the business were unfounded. Once operations were stabilized, he increased maintenance capital expenditures from $5.7 million in 2009 to $13 million in 2011. Profits quickly rebounded and trended up with the improved sales results.

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Nation's Restaurant News, a top industry trade magazine, honors five outstanding multi-unit foodservice executives each year with its Golden Chain Award recognizing the recipients' strong leadership and innovation. In July 2010, Sardar Biglari was recognized as a 2010 Golden Chain winner along with restaurant industry veterans, Fred DeLuca, Founder of Subway Restaurants, Sally Smith, President & CEO of Buffalo Wild Wings, Kevin Reddy, President & CEO of Noodles & Co. and Elie Maalouf, President & CEO, HMSHost Corporation.

"For over 30 years, NRN's Golden Chain winners have represented the best in foodservice. They are leaders whose recent accomplishments and career achievements have benefited the restaurant industry as well as consumers around the world," said NRN publisher Randall Friendman. "Our class of 2010 continues this outstanding tradition of restaurant leadership." After less than two years on the job, Biglari was acknowledged along with long time restaurant industry pioneers for his work at Steak n Shake. He would no longer be considered a corporate raider with limited restaurant experience.

With Steak n Shake's operations largely restructured, Biglari turned his sights to investing the company's growing excess cash. On August 28, 2009 he bought 400 shares of Fremont Michigan Insuracorp, Inc. at $18.825.

Source: Biglari Holdings, Inc: Sardar Biglari - Bet The Jockey Part III