The following letter was sent to the Board of Directors of Steak ‘n Shake (SNS) on March 18th, 2008.
The Steak ‘n Shake Company
500 Century Building
36 South Pennsylvania Street
Indianapolis, Indiana 46204
March 19, 2008
c/o Geoffrey Ballotti
c/o Sardar Biglari
c/o Dr. Philip Cooley
c/o Wayne L. Kelley
c/o Charles E. Lanham
c/o Ruth J. Person
c/o J. Fred Risk
c/o Dr. John W. Ryan
c/o Steven M. Schmidt
c/o Edward W. Wilhelm
cc: David C. Milne
cc: Jeffrey A. Blade
To the Board of Directors:
The purpose of this letter is three-fold:
1. Request timing for when the company By-Laws will be reverted.
2. Understand the Board’s stance on share repurchases as a capital allocation opportunity.
3. Request an articulated and detailed turnaround plan.
Ultimately, my sincere hope is that actions taken by the directors will compel shareholders to vote for the reelection of returning directors at next year’s annual meeting. A prompt response and addressing the three issues above will surely be integral to that decision.
In my previous letter to last year’s board on February 7, 2008, I stated that to date, board actions were perhaps having the unintended consequences of increasing shareholder discontent and decreasing support for board-led initiatives. The recent proxy vote provided confirmation. By a count of 15.65m to 5.45m, a super majority of 74% of voting shareholders selected the GOLD opposition proxy. Importantly, the top four proxy advisory service firms in the country also all advised shareholders to vote for the GOLD proxy.
In moving forward, a regression back to previous patterns of insular behavior would only further the case against the seven returning directors.
What prompted the writing of this letter is that, to my dismay, we are already seeing signs that previous patterns of hazardous thinking still permeate the seven returning directors. In a press release dated March 12, 2008, the Company announced that Wayne Kelley is assuming the role of Interim CEO and Chairman, and Jeff Blade the role of Interim President. Not only are both receiving substantial pay raises, but Mr. Blade will also receive an additional lump sum payment of $150,000, in addition to his pre-existing lump sum grants, in the event of any of three listed occurrences. I was utterly shocked to see that the first occurrence listed in press release reads “On the date the Board appoints him [Blade] to be permanent President and CEO.”
It appears that the culmination of seven months of work by the special committee and spending fulsome amounts on Merrill Lynch (MER) as an advisor has only produced one specific name associated with the role of permanent CEO - the current CFO. The fact that Mr. Blade is being considered by the returning directors as a viable candidate for permanent CEO, a role that requires an executive that can affect an operational turnaround, is truly alarming. This is in no way a commentary on Mr. Blade’s ability as CFO.
In order to begin repairing the reputation of returning directors, do directors disagree with the following?
1. Reversion of the Company By-Laws. Namely, the reversion of Article IV (Meetings of Shareholders), Section 3 (Special Meetings), which allows shareholders to call special meetings, from the recently amended 80%, back to the original 25%.
Indeed, Steak ‘n Shake shareholders, along with every proxy advisory firm, were dismayed that the previous board decided to amend the By-Laws in an attempt to avoid accountability. A reversion to the original 25%, in addition to future By-Law changes requiring a shareholder vote, would make the clear and positive statement that the Board is operating within a shareholder friendly framework. Conversely, failing to revert the By-Laws sends an equally clear signal that the Board still does not take seriously its fiduciary duty. It behooves directors to revert the By-Laws promptly.
Exhibit I: The Excerpt of Original Steak ‘n Shake By-Laws dated March 2006:
Article IV Meetings of Shareholders
Section 3. Special Meetings. Special meetings of the shareholders for any purpose or purposes, unless otherwise prescribed by statute or by the Articles of Incorporation, may be called by the Board of Directors or the Chairman and shall be called by the Chairman or the Secretary at the request in writing of a majority of the Board of Directors, or at the request in writing of shareholders holding of record not less than one-fourth of all the shares outstanding and entitled by the Articles of Incorporation to vote on the business for which the meeting is being called.
In the Board’s proxy statement dated February 8, 2008, the special committee comprised of Messrs. Risk, Wilhelm and Williamson had “analyzed the outcome of various alternative future scenarios, including executing the company’s current strategic plan, modifying the strategic plan, increasing growth through more aggressive franchising, pursuing a leveraged recapitalization through a sale/leaseback of company-owned real estate and selling the company to a third party - either a strategic or private buyer.”
All these considerations mentioned remain compelling. However, there is no mention of opportunistic share repurchases as an option when shares are available at such a massive discount today.
A manager who consistently turns his back on repurchases, when these clearly are in the interests of owners, reveals more than he knows of his motivations. No matter how often or how eloquently he mouths some public relations-inspired phrase such as “maximizing shareholder wealth” (this season’s favorite), the market correctly discounts assets lodged with him. His heart is not listening to his mouth – and, after a while, neither will the market.
- Warren Buffett, 1984 Berkshire Hathaway Annual Report
What is the Board’s view of share repurchases?
To be perfectly clear, this is not to advocate share repurchases at any price. Indeed, were the share price currently $100 per share for example, share repurchases would be an inarguably improper use of capital.
Unfortunately, it is not without irony that at a time in which share repurchases would be the most effective, the Company does not have a repurchase authorization in place.
A knowledgeable Board recognizes excess capital can be directed in several ways, including: 1) dividends, 2) debt reduction, 3) share repurchases. Since the relative characteristics of dividends (tax consequences and transaction costs) and debt reduction (Company is not over levered) are fairly straightforward, the discussion will focus on share repurchases as the most attractive, given the severely discounted share price.
If I may be so bold, I would like to present the following case:
2. Implementation of an Opportunistic Share Repurchase Program. At the current share price, rather than use incremental capital to open one new company-owned store dollar for dollar, the same amount of capital through a share repurchase effectively buys the equivalent of 2.5 to 4 existing stores.
The recent share price, as low as $7.46 per share, offers a tremendous discount to the intrinsic value of the Company. At $7.46 per share, the Company is trading at only 0.7x of book value. Many shareholders believe this price represents a discount to intrinsic value of 60% to 75%, which implies a return profile of 150% to 300%. Clearly, the market is offering the Board an incredible opportunity to repurchase shares at a truly massive discount.
The previous Share Repurchase Authorization in effect from November 16, 2005 to November 16, 2007, was authorized to repurchase up to 3,000,000 shares. During those two years, only 20,400 shares were repurchased, or a total of $312,000, at an average cost of $15.29 per share (see Addendum I for more details). For reasons that cannot be explained, the previous Board allowed the program to expire.
The companies in which we have our largest investments have all engaged in significant stock repurchases at times when wide discrepancies existed between price and value. As shareholders, we find this encouraging and rewarding… By making repurchases when a company’s market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management’s domain but that do nothing for (or even harm) shareholders. Seeing this, shareholders and potential shareholders increase their estimates of future returns from the business
- Warren Buffett, 1984 Berkshire Hathaway Annual Report
Tremendous Cash Flow Masked by Growth Capital Expenditures
As the Board knows fully well, the Company generates significant cash flow. However, for the past decade, the Company has directed capital almost wholly into expansion. Growth, in the pursuit of top line numbers and without regard to the returns on incremental capital, is an inefficient use of capital. In reality, growth, depending on the returns on incremental capital, can be 1) value creating, 2) value neutral, or 3) value destroying.
Total capital expenditures in the past decade were as follows:
Exhibit II: Capex, 1998 – 2007
As a result, the Company’s cash generating ability has been masked due to growth capex and Free Cash Flow (NYSE:FCF) has actually been negative in aggregate during this time.
Exhibit III: Free Cash Flow, 1998 – 2007
The Capex figures above include both maintenance capex [MCX] and growth capex [GCX]. A fair proxy for MCX is Depreciation and Amortization [D&A]. D&A for the past decade was as follows:
Exhibit IV: Depreciation & Amortization, 1998 – 2007
We can now better determine how much capital has been directed into “growth” as well as determine a truer sense of cash flow, an Adjusted Free Cash Flow [FCF]:
Exhibit V: Growth Capex and Adjusted Free Cash Flow, 1998 – 2007
As one can see, the Company, in reality, generates significant free cash flow were it not for burning capital to fund growth for growth’s sake.
During 1998, adjusted FCF was $24.1m. From 1999 to 2007, the Company pumped in $300m in growth capex, an average of $33.3m annually. During the same period, adjusted FCF totaled $236m, an average of $26.2m annually. This means that the $300m in growth capex resulted in only $17m in total incremental FCF from 1999 to 2007, implying a yield of only 5.7%.
However, each share repurchased at today’s price is the economic equivalent of buying a fractional ownership in each and every SNS restaurant at a 60% to 75% discount. To state again, the incremental dollar spent cutting the ribbon at one new company-owned store, spent instead for a share repurchase, buys the economic equivalent of cutting the ribbons at 2.5 to 4 existing stores. Compared to the returns from an incremental dollar of growth capex, share repurchases instead are an excellent and much higher return use of free cash flow at this time.
In order to better explain the magnitude of the benefit of share repurchases, the amount allocated to growth capex from 2005 to 2007 was approximately $125m. Assuming an average repurchase price of $15 per share, the Company could have repurchased up to 8.3m shares, reduced the share count by up to 30%, and increased EPS by over 40%.
At the recent price of $7.46, the effectiveness and benefits of repurchases should be fully apparent and too meaningful to ignore. Notwithstanding the circular nature that a growth capex shift to repurchases affects future cash flow, one should concede that a repurchase at the current share price would yield more than the 5.7% return from growth capex.
I would greatly appreciate if the Board would communicate additional views of the case presented above, be they corrective or opposing, that I may have overlooked as well as the Board’s current position on share repurchases.
3. An Articulated and Detailed Turnaround Plan. This is fairly straightforward. A plan should be provided to shareholders promptly.
In conclusion, it is my opinion that shareholders deserve a Board of Directors that understands and will act to address the following:
1. By-Law reversion is a necessary event and a forthright Board would act as soon as possible.
2. A Share Repurchase Authorization, available when shares are severely undervalued, is one opportunistic use of cash flow that creates significant value.
3. An articulated and detailed turnaround plan is critical to the entire process.
These are vital steps in reversing the loss of confidence and building trust among shareholders.
Again, not taking these steps sends the signal that the returning directors still continue to ignore: 1) fundamental principles of corporate governance; and 2) advantageous capital allocation opportunities.
As a concerned shareholder, I sincerely hope the Board takes these steps and rebuilds shareholder confidence, or steps down to make room for those that will. Shareholders should rightfully hold the seven returning directors responsible for continued deterioration of value, but would much rather wish to have a strong case to vote for the reelection of directors.
I appreciate the time you have afforded me and I look forward to your response on these important matters.
H. Kevin Byun
Excerpts from SEC Filings Related to the Share Repurchase Authorization Expired November 16, 2007
November 17, 2005 - Excerpt from an 8-K SEC Filing, filed by SNS.
Share Repurchase Authorization
On November 16, 2005, the Companys[sic] Board of Directors authorized the repurchase of up to three million shares of common stock over the next two years. The Companys[sic] repurchase of its common stock is subject to market conditions and managements discretion.
August 14, 2006 - Excerpt from a 10-Q SEC Filing, filed by SNS.
During the current quarter, we repurchased a total of 20,400 shares of the common stock as under our share repurchase program. We used cash generated from operations to purchase the shares for $312. This is the first time that we repurchased stock through this program which was approved by the Board of Directors in fiscal 2005. Additional share purchases, if any, will be made in such amounts and at such times as deemed appropriate based upon prevailing market and business conditions.
December 10, 2007 - Excerpt from a 10-K SEC Filing, filed by SNS.
The following table presents a summary of share repurchases made by us:
There were no further repurchases of shares subsequent to year-end through the expiration of the program on November 16, 2007.
January 28, 2008 - Excerpt from a 10-K SEC Filing, filed by SNS.
ITEM 2. Unregistered Sales Of Equity Securities And Use Of Proceeds
The publicly announced share repurchase program approved by our Board of Directors expired on November 16, 2007. We did not make any share repurchases during the first quarter of fiscal 2008 prior to the expiration of the program.