Arbitrage Opportunity: Western Sizzlin/Steak 'n Shake Pair Trade 15 comments
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Western Sizzlin - the sizzle is gone, at least in terms of
valuation.
Western Sizzlin (WEST) is a holding company
engaged in restaurant operation and security investment. Sardar
Biglari's Lion Fund took over the ailing company a couple of years back
and applied the early Warren Buffet partnership blueprint to it to such
an extent that one has to cringe at times: Sardar's annual reports are
written using the exact same style and language as the original. Same
can also be said about his annual reports for the Lion Fund. I guess
that has to be booked under marketing.
On the
upside so far he's made a good investment. After acquiring Western
Sizzlin (which trades on the nasdaq as WEST) he designed two rights
offerings to increase available cash in the company. He then invested
the proceeds of the first offering in a single stock (Friendly's) and
was able to almost double the investment through activism which
resulted in the sale of the company. Later investments were less
successful: AppleBee's didn't return much at all.
On the downside his latest investment in SNS which used the
proceeds from the second rights offering and the Friendly's trade has
been catastrophic. The losses thus far accumulate to $8.7M - more than
45% on the original investment. This is then where investing in only
one stock comes back to bite you.
WEST's
restaurant business overall is slightly declining. They're losing
franchisees at a modest clip, same store sales are trending slightly
down. Q4 numbers aren't out yet - so one can only guess how the overall
decline in the restaurant business will affect WEST.
The market has been very inefficient in valuing WEST. The first
obstacle is that earnings are clouded by amortization of franchise
contracts - so free cash flow is much higher than earnings. Secondly
investors don't seem to be precisely following the dilutive impact of
the right offerings that are occurring. Finally - and this is where
copying Buffett has benefited valuations - many folks believe Sardar to
be something like the next Warren Buffett and his presence alone is
worth a good premium. Personally I tend to be more skeptical - the guy
is around 30 and we don't have a meaningful investment record to talk
about.
So let's look at what has happened in
terms of value per share over time. Conservative cost management and
debt reduction has helped the core business. Core business creates
about $1.5-$2M per year in free cash flow - provided no capex occurs
(which Sardar has driven towards 0 - but how sustainable is that?).
Given the shrinking franchise base it doesn't deserve a stellar
multiple. Add in the current economical uncertainties and I'll still
give you a 10-13x on it - say around $20M overall. That business hasn't
changed that much though some improvements have occurred through cost
savings. So I'll take the $20M as constant from 2006-2007.
But increasingly WEST is becoming an investment
company as well, plus share count has increased - so let's look at all
the non operating assets plus the operations per share:
3/2006:
$20M Business
$1.7M Cash
and equivalents
-$1.1M Debt
-$548k Deferred
income taxes
875k Stock outstanding
---
$23 / share; stock price $13
12/2006:
$20M Business
$2.3M Cash and equivalents
$6.5M Investments in securities
-$850k Debt
-$700k Deferred income taxes
1.8M Stock
outstanding
---
$15 / share; stock price
$8.50
9/2007:
$20M Business
$610k Cash and equivalents
$12.54 Investment in
securities
-$1.46M Minority interest
-$730k
Debt
-$560k Deferred income taxes
1.8M Stock
outstanding
---
$17 / share; stock price
$17
3/2007:
$20M Business
$610k Cash and equivalents
$7.65M Capital raised in
offering
$12.54 Investment in securities - $1.63M loss on
SNS options - $7.0M loss on SNS position
-$1.46 Minority
interest
-$730k Debt
$2.5 Deferred income taxes
(including credit for the SNS losses)
2.7M Stock
outstanding
--
$12 / share; stock price $16
The declining value per share shouldn't surprise too
much - the rights offerings have always been priced very low and thus
drove down per share value. But over the last 9 months there is a real
loss due to the disastrous SNS investment, and a drastic increase in
price/value lately.
Biglari's lion fund and WEST
have taken a sizable SNS position together. They are again taking an
activist position and have received 2 seats on the board during the
annual meeting. However it's not clear how quickly value can be created
given that they still don't have a majority on the board.
Biglari's lion fund owns 34.6% of WEST and about 4% in
SNS. Fund redemptions in the lion fund can only be requested once a
year: 3/15th. For the yearly performance of the lion fund things
probably don't look that bad: WEST was undervalued 12/06 and very
overvalued 12/07 and it's one of the largest positions. But I'm sure
investors have been following developments as the redemption option
came closer. It will be interesting to see if significant redemptions
came in.
WEST has delayed filing their 10-k,
filing for an extension today. According to the CFO the 10-k should be
out end of this week. It will not look good since WEST had a $1.6M loss
on expired SNS options in Q4. This is also the first financial report
which will show significant unrealized losses on SNS holdings.
Sardar has been buying assets issuing WEST stock (he
has a bid out for ITEX and just purchased a partnership largely using
shares). As follower of Buffett this is a clear sign that he believes
the WEST stock to be overvalued.
Disclosure: At this point I have taken a short
position on WEST and I'm long SNS. This pair should be a good setup for
the coming months.
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This article has 15 comments:
Capex was slashed on the restaurant portion of WEST because it didn't boost the companies ROE-in that sense, you would want to allocate funds elsewhere.
The situation at SNS is one of great interest, and with 2 seats on the board, they should be able to do a great deal of good, especially with the mandate that they got from shareholders when they were elected (something like 75% of the vote). I like you am long SNS, and think that it will fare quite well for Biglari, and in turn, WEST and all others that are involved in the matter.
Also note that Sardar started to purchase assets using shares precisely when WEST shares became overvalued according to my model.
WEST simply doesn't have the cash to buy ITEX at a bargain price. I would imagine that credit drying up would complicate things of this nature, as the debt load that would have to be brought on to acquire ITEX would be pretty large. This is also something that could hold back expansion in the future.
It is true that value guys frown on diluting shares, but I could imagine it be defended when you are getting a better deal-just look at the earnings and C/F that ITEX has...
Do you have a link to where Buffett talks of the mistake of issuing shares to expand?
Why are you not long ITEX? Wouldn't that help the arbitrage out?
Anyway in my view Sardar knew that SNS will take longer to get resolved than he thought last year. He needed to prevent fund redemptions in the Lion Fund to avoid having to exit SNS at a huge loss. So miraculously the thinly traded WEST stock hit a high of a completely unjustified $18 just before the end of the year, in time to save the year for the lion fund - and WEST announces the ITEX tender offer using this inflated currency.
Buying assets issuing overvalued stock is a nice way to generate value so I don't blame him. But it does seem like he's playing his shareholders a bit at the moment - delaying the bad 07 numbers until the last moment etc. I've actually owned WEST for some time last year when the market didn't correctly price the rights offering - and sold end of last year. I've been trying to short WEST since those days - but only recently found shares (thanks to the nasdaq listing).
With regards to your comments on ITEX/SNS value: ITEX is immaterial. I don't know what SNS's value is - which is precisely why I was suggesting the pair trade. Given the current stock price of SNS, WEST was trading too high at $16 so either SNS moves up, or WEST moves down or a combination of the two. Seems to be working so far.
From the 2007 AR: "Finally, I made an even worse mistake when I said “yes” to Dexter, a shoe business I bought in 1993 for $433 million in Berkshire stock (25,203 shares of A). What I had assessed as durable competitive advantage vanished within a few years. But that’s just the beginning: By using Berkshire stock, I compounded this error hugely. That move made the cost to Berkshire shareholders not $400 million, but rather $3.5 billion. In essence, I gave away 1.6% of a wonderful business – one now valued at $220 billion
– to buy a worthless business."
Re: Siglari, I'm still not sure what to make of him. I don't know anything about the performance of the Lion fund. He did a good job with Friendly's, but that's just one data point. The options thing is a sign of either excessive risk-taking or immaturity.
And if you'll allow a pet peeve, he is a crappy writer but fancies himself a great one. A lot of ten cent words and dimestore Buffetisms.
Generally, he seems intelligent but also overconfident, and that can be a very, very dangerous combo for an investor.
Would you say that it is a fair to reason that Buffett is upset at trading stock for dexter due to the fact that dexter was a bad investment? Had it preformed well, and become worth more than the 3.5 billion in 2007, would it be safe to say that the shareholders would have been better off?
I agree w your core business valuation of about 2M of CF*10X of 20M
But as of 12/07 the co has marketable securities booked at $16M and about $4M in real estate, less 2M of debt. The $16M I presume is mostly SNS marked to market.
So seems to me, correct me if I'm wrong, you're buying an operating business at about 10X, w no capex, so that is 10% pure cash flow yield. Not dirt cheap, not 5X, but cheap enough considering the rest of the mart and the fact that most managers can't allocate capital very well. You're also getting the securities/real estate at about even, 20M (so that's 20M + 20M = 40M market cap, about even). On top of that, you're getting a guy who seems to have a nose for value, i.e. ITEX which is trading at about 8X CF. He bought Mustang and Mustang's boss seemed to speak fondly of Biglari. I like Biglari's style bc it's simple (get CF) and yet he seems to find decent co's out there, i.e. ITEX.
I am a bit bothered by the stock issuances. But, not really. Like I said, despite the dilution the valuation is reasonable. And if he's going to sell stock to buy ITEX, which is like I said trading at about 8X w no capex to speak of, and growing, and synergistic w WEST as he claims, I'm OK w using stock to buy the co.
Also, this is a small co w an almost unlimited investment universe for him to invest in.
Again, correct me if I'm wrong, but if SNS doubles, then the securities double to $32M, which is almost the value of the co right now.
Big surprise based on this post, I am long WEST.
Here is some performance data for the Lion Fund (in % gain):
2000: 50.8
2001: 30.4
2002: (10.1)
2003: 28.0
2004: 8.4
2005: 21.3
2000 through 2002 were fairly impressive, while 2003 through 2005 were somewhat disappointing (relative to the market). I don't have data for 2006 or 2007, but imagine it would be heavily weighted by FRN and SNS results.
Disclosures: I have been long WEST the last few years and have been long SNS for nearly a year having recently doubled my position for ~$7.50 a share.
I'd be hesitant though to say that the operating business is still worth $20M. Will be interesting to see the revenue numbers for q1.
I think I sort of see what you're doing and it seems you're assuming that for SNS price=value. I am not disagreeing w your way of looking at it, I'm probably wrong but I'm just assuming, agreeing w Biglari, that it seems sensible that there's a decent amount of value in SNS that could be freed up, ie just by making capex=depreciation for that co, that's about $30M in cash per year, saved. Whether thats a sensible figure I have no idea. So I'm not too concerned with short-term price fluctuations in SNS stock. NI has declined for that co too but I assume (bad to do that, I know) that has something to do w poor expense mgmt by the directors, though that could just be Biglari brainwashing me.
Again, this is just smoke, but the other thing is...if Biglari wanted to make a push, to oust the directors, etc, he needed a big chunk of stock, hence the dilution etc etc. Why he had to go after SNS and not some smaller cap'd co doesnt really make sense though
He prolly went after steak n shake because they own a ton of real estate and also own/operate the majority of their restaurants-he is making a push to sell off real estate and re franchise like crazy.
My personal valuation of SNS comes to roughly 38 bucks a share (which I know is high when compared to other people out there,most get to the low 30s). Though, this is provided that he gets his way with the company.
His 2006 letter to shareholders talks about GULP and SNS seems like the perfect company for it.