- We seek to focus on the facts.
- The situation is far from intractable, if a mindset of compromise is adopted by all parties.
- We provide tangible, shareholder-friendly solutions to the biggest challenges at BH.
Overview of the BH proxy battle: While Groveland Capital makes very valid points regarding the circumvention of the incentive agreement and the egregious nature of the licensing agreement, they failed to recognize the operational and investment success of Mr. Biglari and Biglari Holdings since he’s assumed the helm. And while Mr. Biglari has done a great job operationally and with capital allocation, he and the board have neglected to address the circumvention of the incentive agreement and egregious nature of the licensing agreement.
As we will explain, shareholders (i.e owners) are being punished because of the distrust created by Mr. Biglari and the board in their end around of the $10m bonus cap, along with the growing off-sheet liability associated with the licensing agreement. If we understand the licensing agreement correctly, the potential royalty payment liability could be a staggering $700m or more if Mr. Biglari is ousted years down the road. Additionally, Mr. Biglari has contended that Groveland Capital is trying to take over the company with just .17% ownership stake, yet their position represents about 10% of one of their investment vehicles- not a small percentage*. In contrast, Mr. Biglari has effectively turned his 1.5% ownership stake** (worth about $13m) into performance fee compensation totaling $75.3m since taking over.
* Per their call with shareholders on 4/2/15
** Form 4’s filed 2/11/15
As we will show, under the current incentive and licensing agreements, Mr. Biglari can continue to perform fabulously over the next several years, BUT it won’t translate into shareholders’ success because of the escalating nature of the licensing agreement liability.
Combine that with the distrust in Mr. Biglari and the board over the circumvention of the incentive agreement, and you have a company set up to make the CEO and capital allocator rich at the expense of shareholders, even while he can claim continued operational and investment success. Unfortunately, success alone cannot dig shareholders out from the hole that the licensing agreement and distrust creates. It’s not by coincidence that the market has discounted BH stock since the introduction of the licensing agreement and the circumvention of the incentive agreement. It is in the interests of both parties to reach an agreement and make concessions for the benefit of the remaining 98% of the owners.
We began buying stock in Biglari Holdings (BH, Financial) in the summer of 2014 when we felt it had become too cheap, despite the well-deserved overhang and uncertainty created by some of Mr. Biglari and the board’s actions. Stocks like BH become cheap in an expensive market for a reason: we think it’s due to the recent treatment of shareholders-- not Mr. Biglari’s operational and investment performance. In fact, as an operator and capital allocator, Mr. Biglari has been outstanding. Unfortunately, board decisions regarding the incentive agreement and the license agreement have created a persistent cloud over the stock price.
We have been keen observers of the recent proxy battle for control over the BH board. Like any disagreement, both sides make valid arguments while conveniently ignoring plainly obvious facts detrimental to their cases. This article attempts to provide some clarity on the issues we felt each side has either misrepresented or ignored, as well as some potential solutions to ensure everyone wins. (In full disclosure, we own approximately twice as many shares as the challenger Groveland Capital. While we have temporarily voted our shares by mail, we will be attending the meeting in person and are prepared to re-vote based on what we uncover leading up to the meeting.)
Issue #1: Operating Income/Steak and Shake Performance
Either because of poor analysis or simply ignoring the economic facts of BH, Groveland has taken operating income straight from the published financials and compared Mr. Biglari’s tenure with the previous management’s. That is unequivocally the wrong way to analyze BH’s operating income. The company’s numbers have a few major distinctions worth taking into account and backing out to analyze what’s truly happening economically.
To set the record straight, Steak n’ Shake’s (SNS) sales increases under Mr. Biglari were accomplished through the same four walls, meaning BH did not build extra stores to increase sales. Same store sales started to climb almost immediately after Mr. Biglari’s arrival and continue to this day, a remarkable achievement given the very little capital expenditure for maintenance or new stores. By spreading store-level fixed costs across more revenue per store, Mr. Biglari was also able to quite effectively increase free cash flow* for the parent company. This increased cash flow was achieved despite recent turnaround investments at Maxim and very large franchising investments since 2011.
* Free cash flow defined as Operating Income minus Purchase of Property, Plant and Equipment
Second, because of accounting rules, Mr. Biglari’s performance fees related to investments were included in SG&A expense, but the associated gains in investments were not. Groveland recognized the performance fee expenses, but none of the investment gains that go with it. Backing out those expenses pushes the 2009-2014 operating income up by approximately +$25m ($227m vs. $220m with prior management). More importantly, because very little cap ex for new stores was utilized and depreciation charges were significantly greater than capex, free cash flow was virtually identical to operating income at approximately $226m. This compares to previous management which created negative free cash flow of approximately $111m*. Yes, the old regime spent approximately $331m on PPE in the six years ending September 30th, 2008 and earned just $220.3m in operating income. The free cash flow difference between the two management periods is a whopping $336.6m. Great job, Mr. Biglari and team!
* $220.3m of operating income for the six years ending August 2008 per Groveland Capital's proxy materials minus the $331m of Purchase of PPE for the six years ending September 30th, 2008.
Lastly, except for rising beef prices, the only substantial increase in SG&A is attributable to the investment in SNS franchising. If one backs out more than $40m in franchising start up costs in what could partially be counted as a capital expenditure investment, the operating income and free cash flow numbers are fantastic. Large scale franchising may or may not work, but Mr. Biglari deserves credit for halting the low return on investment (ROI) new store development of the old regime in favor of a likely higher ROI franchising strategy. It’s an investment worth making and can be discontinued immediately if it proves to be a failure. There are numerous franchise models which have been very effective, so success is not a low probability event. More recently, Warren-Buffett-darlings 3G have been phenomenally successful migrating Burger King to a predominantly franchise-only, high ROIC business.
Similar to 3G, Mr. Biglari has done an exceptional job wringing out expenses at SNS using zero based budgeting and treating all expenses as variable. Despite rising costs of beef, SNS has actually lowered the overall check per customer while still increasing total sales. SNS is providing significantly more value to customers while at the same time earning improved free cash flow via increased customer traffic all through the same four walls. As a result of operational improvements, low capex and working capital improvements, SNS alone has provided more than $300m in cash flow to be used for more attractive investment opportunities. It’s hard to argue that Mr. Biglari has done anything wrong operationally when it comes to SNS. Mr. Biglari and his team deserve a lot of credit.
Solution to Issue #1:
Compared to the alternatives, no one is better suited to operating SNS than Mr. Biglari. We see no reason to make any changes on this front.
Issue #2: Investment and Stock Price Performance
Groveland made note of the poor stock price performance of BH. They were correct in stating that recent stock price performance has lagged. However, they conveniently looked at 1, 3, and 5 year time periods, but failed to look slightly farther back since Mr. Biglari took over as CEO on August 5, 2008. Had they looked at the whole data set, they’d see that BH’s stock has significantly outperformed the S&P 500 Index by 175% from August 6, 2008 to March 6, 2015*.
* March 11, 2015 Letter to Shareholders of Biglari Holdings Inc.
Groveland also failed to recognize Mr. Biglari’s exceptional investment record. Starting from just $1.6m of cash on the books, Mr. Biglari has applied his capital allocation skills to a combination of free cash flow from operations, low cost debt and rights offerings, to grow cash and investments to over $900m today*. This represents an overall return on investments of 364.3% vs. 133.9% from August 2009 to December 31st 2014**. His latest hedging of approximately 25% of Cracker Barrel (CBRL) shares at nearly fair intrinsic value prices is another clever move to build the coffers up for the next available investment opportunity. Although his portfolio concentration is not for the faint of heart, it’s hard to argue with his results.
* Our estimation based on gains in Cracker Barrel since December 31st, 2014.
** March 11, 2015 Letter to Shareholders of Biglari Holdings Inc.
As a side note, if you want to see terrific analysis and proposals for a floundering business, go to http://www.enhancecrackerbarrel.com/. There you will find several letters from Mr. Biglari to CBRL shareholders and management dating back to 2011 outlining the problems and proposed solutions. Despite much initial resistance, CRBL management eventually adopted many of Mr. Biglari’s proposals, and the company and stock have since performed extraordinarily well. We also take it as a good sign that Mr. Biglari’s agitation for change at CRBL has slowed to a halt since they started implementing many of his suggestions.
Solution to Issue #2:
Given his track record of capital allocation, we are comfortable with Mr. Biglari having full control of investment decisions.
Issue #3: Incentive Agreement
By moving BH assets into the Lion Fund, Mr. Biglari and the board found a way to questionably circumvent without shareholder approval the 2010 incentive agreement that capped the 0 and 25%* performance fee compensation model at $10m per year. Shareholders have every right to be upset. Is Mr. Biglari likely worth hedge fund fees? Yes, however the shareholders (read: true owners) in 2010 pushed back and were not willing to pay their CEO anything more than the $10m bonus cap for growth in book value, hence the 2010 Incentive Agreement. We are big fans of the 0 and 25% pay-for-performance model and think it’s appropriate for BH, however, it’s the collective owners of the business who ultimately decide. They demanded a compromise in 2010, only to be circumvented in 2013 with the buyback of Biglari Capital and the transfer of Biglari Holdings capital into the Lion Fund.
* Zero management fees and 25% of the profits above a 6% hurdle
One of the key issues is that the capital in BH is permanent, whereas with a hedge fund the capital can be pulled at some future date if the investor is unhappy. Granted, other publicly traded firms (mostly in reinsurance) use a hedge-fund-like structure more egregious than the 0 and 25% model, but for whatever reason their shareholders do not disapprove of the fees. BH shareholders plainly did; an agreement is an agreement. In that regard, Mr. Biglari and the board have not earned the complete trust of shareholders because they conveniently found a way to nullify the $10m imposed cap, all without shareholder approval.
As Charlie Munger (Trades, Portfolio) says, the best way to build a reputation is to actually deserve it - be trustworthy and do what you say you’re going to do. Outperformance with investments as well as a great operational turnaround doesn’t give Mr. Biglari and the board the right to circumvent the previous compensation agreement. Warren Buffett (Trades, Portfolio) always says that he hires people who are 1. intelligent, 2. energetic and 3. have high integrity. Without the third, the first two can kill you. Mr. Biglari clearly has the first two, and has a chance to prove once and for all the third right now. The good news is that he and the board can change people’s perceptions by adopting a humble attitude of compromise. Don’t forget that Mr. Buffett and Mr. Munger were both investigated by the SEC early on due to the tangled ownership structures of Blue Chip Stamps and Wesco. Hope is not lost!
Solution to Issue #3:
A simple compromise would be to align the compensation plan similar to what Mr. Buffett has implemented for Ted Weschler and Todd Combs at Berkshire Hathaway. BH shareholders would be quite intelligent to give Mr. Biglari the same treatment Mr. Buffett is giving his top investment lieutenants. To refresh, they receive 10% of the gains above the S&P 500 averaged out over several years. In addition, they receive a base salary equal to about .1% of their assets under management. On a $1B portfolio, they will receive $1m in base pay, plus 10% of any outperformance against the S&P 500, subject to clawback provisions.
For permanent capital like that of BH’s assets, aligning with this Buffett-designed compensation plan would be a great solution for both sides. Additionally, Mr. Biglari and the board would begin to repair the BH brand and mend the distrust of shareholders. If Mr. Biglari and the board want to continue to fight for the 0 and 25% plan, they can put it to shareholder vote to see what the “bosses” think. The owners should have the final say on what they’re paying the steward of their capital.
It appears Biglari Capital manages approximately $60.4m of outside capital, this is capital not associated with Biglari Holdings*. By moving assets to the Lion Fund he and the board have executed an end-around for Biglari Capital to capture approximately $700m of BH’s permanent capital, already a boon to his bank account in the form of 0 and 25% fees the past two years totaling $45.1m. (This does not include the $25.2m of fees paid under the $10m cap agreement from 2010 to 2013.)
* Note 5 of the BH 2013 Annual Report
When confronted with a moral dilemma, we always ask, what would Mr. Buffett do in this situation? The prudent and gentlemanly resolution is for Mr. Biglari, the board and the remaining 98% of owners to find a balance between the $10m cap plan and the 0 and 25% model. Mr. Biglari should earn more than $10m per year if he’s creating significantly more wealth for shareholders - something in between a $10m cap and the 0 and 25% model seems fair. We would even venture to say that the 0 and 25% uncapped model is acceptable if the below proposed solutions were adopted. Our guess is that shareholders do not mind paying Biglari a fair sum for his performance, but they clearly do not like when he and the board skirt the prior agreement. It’s time both sides to reconcile and at a minimum, split the difference with an assist from Mr. Buffett!
Issue #4 - Licensing Agreement
Simply put, the licensing deal is beyond egregious and completely unnecessary. The shareholders and the stock price can thrive even with a 0 and 25% incentive agreement, however, the licensing agreement as we understand it will always be a noose around the neck of shareholders and the stock price.
Consider this. The deal is for 2.5% of revenue from SNS (and any other Biglari branded revenues) for a period of 5 years minimum and a maximum time measured from the date of the license agreement* to a triggering event, plus an additional 3 years. What does that add up to? Today, if he were disposed, that deal would cost the company approximately $20m per year for 5 years, or $100m on a business with about $765m in revenue, or approximately 13% of revenue. That does not include the golden parachute payout estimated to be about $20m today**.
* January 2013
** 299% of average pay, 2014 Annual Report
As a worst case scenario, let’s assume 17 more years pass and a triggering event occurs right before the license agreement expires in 2033. The total amount of years of royalty payments the company is on the hook for would be 19 years from the date of the agreement, plus the additional 3 years, for a total of 22 years. Next assume SNS revenues grew 3% per year over those 17 years. Revenues would grow from $765m in 2014 to about $1.3B in that time, meaning the annual royalty payment would be about $32m (2.5% of $1.26B) for a period of 22 years. That sums up to $695m in royalty payments on a $1.3B revenue business, or 55% of revenue. As time goes by, the licensing agreement becomes a potential off-sheet liability that severely impedes the value of the business and the stock price. We don’t know of any other deal like it and quite frankly we hope we are wrong in our understanding of it. He will have been paid handsomely with base pay and performance fees along the way and should not receive additional monies for the Biglari name that would likely not be used upon his departure. We realize the agreement was written with the intention of never having to execute on it, but there is absolutely no reason for holding owners of the company ransom so that Mr. Biglari can protect his job. If he continues to perform under a fair pay-for-performance compensation plan, his role will be secure and he doesn’t need a licensing agreement. His golden parachute of 299% of his average compensation is already in place and more than sufficient.
We’d like to emphasize this important point: As the incentive and licensing agreements are aligned today, Mr. Biglari will continue to get rich off his efforts while shareholders will languish. With Mr. Biglari making many times his 1.5% ownership in performance fees (which grow as BH’s assets grow), as well as a potential $695m royalty payment based on increases in sales from Biglari branded revenues, he is not incentivized to focus on increasing the share price and benefiting owners. His bread is buttered from performance fees and the potential royalty payment, not from his small 1.5% ownership stake. Plainly put, in this perverse arrangement he’s incentivized to grow assets and to grow sales. Those aren’t necessarily the metrics a discerning owner wants their managers to optimize.
To put these numbers into context, he has earned about $75m in salary and bonuses (from BH and/or BH capital) since taking over and would be owed approximately $120m* if he was relieved of his duties today (vs. his 1.5% ownership totalling $13m). The performance fees and potential royalty payments only get bigger as the assets and sales grow. Shareholders can live and thrive with the pay-for-performance fees, even the 0 and 25% uncapped, but will die by the royalty payments.
* Royalty payments and golden parachute severance payments
Solution to Issue #4:
We can appreciate that Mr. Biglari is looking to keep control of the company while he is building it, but the measures in place today are not the long term answer. There is a sensible solution that can be reached to avoid creating the lingering cloud over the stock price and perpetually angry shareholders. The board and Mr. Biglari need to do the right thing and eliminate the licensing agreement once and for all.
Issue #5: BH’s Ownership of Its Own Shares in The Lion Fund
Shareholders are frustrated with Mr. Biglari’s purchasing of BH’s shares in the Lion Fund for his own benefit rather than retiring the shares to treasury for BH’s benefit as they are clearly undervalued.
This is a problem for two reasons:
1. Mr. Biglari has the potential to earn fees on capital that he really shouldn’t be able to.
2. Mr. Biglari can vote many more shares than his own 1.5% ownership interest would allow, giving him disproportionate voting power.
Solution to Issue #5:
There should be a plan to retire the shares held in the Lion Fund at a sensible price based on average tender offer premiums. In the meantime, BH’s percentage ownership of their own BH’s shares in TLF should be voted in exact proportion to how all of the remaining votes are cast for the upcoming meeting. This would give the remaining 98% owners of BH the equal representation to shares they own in TLF, rather than give Mr. Biglari the ability to vote the shares as he sees fit.
Issue #6: Corporate Governance
Plainly put, any board that allows the circumvention of the 2010 compensation agreement along with the addition of the egregious licensing agreement without shareholder approval clearly needs at a minimum more checks and balances, and a genuine shake-up at a maximum. This board has simply not been held accountable and needs some opposing viewpoints and healthy debate in the boardroom. Given the uncomfortable position the board has been thrust into during this proxy battle, it is likely they would actually welcome independent directors that will speak on behalf of the shareholders concerned over the above issues. That is likely a better outcome than a larger activist shareholders getting involved and really turning the screws.
Solution to Issue #6:
Mr. Biglari and the board should reach an agreement before the annual meeting by electing two of Groveland’s most qualified nominees to the board. We welcome an expanded and more independent and healthy board of directors while still allowing Mr. Biglari to flourish as an operator and capital allocator.
Conclusion:
Compromise is the only sustainable path forward for Mr. Biglari, the board and the remaining 98% owners of Biglari Holdings. Even if Mr. Biglari wins this battle against Groveland, there will assuredly be more battles in his future. The war will not end until a compromise files down the burrs. As a result of the six issues named above, especially the licensing agreement, the stock will deserve a perennially low-multiple. And because it will be cheap, it will be a magnet for activists with more capital and better qualified board candidates than the proxy battle that Groveland recently mounted. Circling like sharks, these activists will easily gain the support of bigger institutional owners as well as the proxy voting services, not to mention smaller shareholders. If Mr. Biglari and the board is at all concerned with their reputations, their quality of life, and the ability to simply focus on growing BH’s per-share intrinsic value without being bogged down in proxy fights, he and the board would be well advised to find a solution now and not let this become a perpetually festering battle for control over the company.
We believe the preferred solution would be for Mr. Biglari, the board and the remaining 98% of the owners to reach the following compromises:
Keep Mr. Biglari in full control of operations and capital allocation as Chairman and CEO. His track record is proof that he is the best option for BH.
Adopt a more shareholder-friendly compensation agreement for Mr. Biglari with our suggestion being the Buffett lieutenant model at a minimum. (If points 3-5 below were resolved in a shareholder friendly manner we believe shareholders would likely agree with the 0 and 25% uncapped pay-for-performance model. That would be a long-term solution for all parties and a win-win in our book!)
Eliminate the licensing agreement once and for all.
Vote BH-owned shares in the Lion Fund in exact proportion to the remaining votes cast. BH then buys back the BH-owned shares held in the Lion Fund at an agreed upon price based on some average premiums granted in a typical tender offer.
Add two truly independent directors from the Groveland slate of nominees prior to the board meeting.
With these proposed solutions, Mr. Biglari and the board can remain in control of the company. A compromise on the compensation plan and elimination of the licensing agreement will remove much of the uncertainty and make shareholders happy with a more fairly valued stock price. With two dissident board members as balance, there will be healthy debate in the board room and fair representation of all owners of BH going forward.
In a perfect world, we would love to be owners of BH for many decades. We think Mr. Biglari has the potential to be a great long-term partner. However, that is simply not the case today given his and the board’s treatment of BH shareholders (i.e. owners) regarding the incentive agreement and licensing agreement. This non-shareholder friendly sentiment is proven by the annual turnover in BH shareholders. Based on average trading activity, shareholders turn over BH stock ownership about 100% every year versus less than 5% for Berkshire Hathaway. As Mr. Buffett says, “You get the shareholders you deserve.” Once the board makes these owner-friendly changes to go along with the great operational and investment performance of Mr. Biglari, long-term-oriented shareholders will return to BH stock.
Today we are owners simply because it is attractively priced and significantly undervalued. If Mr. Biglari and the board do the right thing for shareholders with an added touch of humility, we are inclined to make this a permanent holding in our portfolios for years to come. We imagine many fellow shareholders would agree and want to share in the success of Mr. Biglari’s continued operational and investment compounding. We’d be cheering him on!
We welcome contact from both Nick Swenson of Groveland Capital and Mr. Biglari as well as larger shareholders (Mr. Gabelli included), and look forward to attending the meeting in person this Thursday.
Onward and upward!
Sincerely and with all due respect,
Lonnie J. Rush & Jacob L. Taylor
aka Shareholders for Compromise
