3rd Quarter Letter from GB Investments!

Here is the link for the 3rd Quarter Letter from GB Investments!

Public Corporations - Capital - Generation and Allocation

To create wealth in businesses (Public corporations), business should be able to generate and allocate (deploy) capital efficiently. In this article, I would like to highlight the ways in which businesses can generate and allocate capital. Although each category deserves an entire article on its own, this is just a highlight!

Capital Generation:

There are essentially 3 ways public corporations can generate capital.

1. Internal generation (Profits)
2. Issue stocks (Take money from investors)
3. Issue bonds (Borrow money from investors)

Lets take a look at each in detail with their advantages and disadvantages.

1. Internal generation (Profits):

Profits are generated when the company sells products/services above their costs after all taxes are paid. To continue to make a profit, the products/services of the company have to be needed or desired by the customers who are able and willing to pay more than the costs incurred to make it.

Advantage vs money from investors: 

Limited risk and dilution of ownership.

Disadvantage vs money from investors:

Limited ability in generation relative to their products/services sales

2. Issue stocks:

When the business needs more cash than their own ability to generate, they can sell stocks to investors.

Advantages:

Business can and should do that when their stock is richly valued by the investors and deploy them into attractive opportunities.

Disadvantages: 

Dilution of ownership for the existing shareholders.

3. Issue bonds

When the business needs cash more than their own ability to generate, they can borrow money from investors.

Advantages:

No ownership dilution for existing investors.
Lower cost of capital.
Interest expense is tax deductible.

Disadvantages: 

Increased risk as the need to pay interest on the bonds.

Capital Allocation:

There are essentially 5 things public corporations can do with each dollar (Capital) generated: 

1. Reinvest in the business 
2. Acquire other businesses or assets 
3. Pay down debt 
4. Pay dividends and
5. Buy back shares 

Lets take a look at each in detail and where each of them could be valuable and rational when they are applied.

1. Reinvest in the business

If the opportunity to get a return on invested capital is high, the business is best served by reinvesting in their products/services. This is by far the best option to increase the net worth of the business and shareholders.

2. Acquire other businesses or assets

If the opportunity to reinvest in their business where they can get high return on capital is not available, the next best option is to buy other businesses in same industry to achieve better economics and grow; or even other assets or businesses in unrelated industries (usually done by holding companies). Obvious disadvantage of this approach is usually companies tend to get 'diworsified'. 

3. Pay down debt 

If the opportunity is not available to reinvest in existing businesses or acquire other businesses, paying down debt makes the company debt free and less risky as a corporation. Disadvantage is that the business loses the low cost of capital and tax advantages.

4. Pay dividends

If the opportunity to reinvest/acquisition is not available and there is not a lot of debt, returning cash back to shareholders via dividends is a good idea. The disadvantages are double taxation(tax on the company level profits, dividend tax on the investor level) and value not accruing at the company level.

5. Buy back shares 

If the opportunity to reinvest/acquisition is not available and there is not a lot of debt on their books, returning cash back to shareholders via buying back shares is a better idea when their shares are selling in the market for cheap multiples or attractive valuation relative to their cash flows. This will increase the existing shareholders' ownership and earnings per share in the company and no double taxation as in the dividend distribution. The value may not be great if the company is buying back their shares at any (high multiples) price.


Disclosure: Gobinath Balasubramanian is a Registered Investment Advisor Representative for GB Investments LLC (RIA).

Follow up: Owner Operated Business - Biglari Holdings (NYSE: BH) - Excellent Entry Point??

This is a follow up to my investment idea that I wrote in 2013. This article outlines some of the developments in the last 3 years. I think the opportunity is even more compelling today than in 2013.

Business:

Biglari Holdings Inc. is a diversified holding company engaged in a range of business activities. The Company, along with its subsidiaries, is engaged in investment management and the franchising/operating of restaurants. As a capital allocating vehicle, it is also in the business of owning other businesses in whole and in part. The company assets are:

Steak n Shake restaurants (417 owned, 144 franchised) (100%)

Western sizzlin restaurants (4 owned, 66 franchised) (100%)

Maxim Brands (100%)

First Guard Insurance (100%)

Biglari Holdings (42%) - $315M in worth

Cracker Barrel restaurants (621 owned, 0 franchised) (~20%) - $700M in worth

Insignia Systems (20%) - Board member - $6M in worth

Air T Inc(10%) - $5.8M in worth

Unico American Corporation (~10%) - $6M in worth

CCA Industries (~10%) – Board member - $2.3M in worth

ITEX Corporation (~8.4%) - $1M in worth

Situation & Valuation:

Currently the company is selling in the market for ~$750M ($370/share) (Enterprise value of $960M), which has a look through operating earnings/cash flow of more than $85M & likely growing at a reasonable clip for years. The company is in excellent financial condition by both ample cash on the balance sheet & credit facility. There is a lot of flexibility with the capital structure; they can issue cheap interest bonds, buyback stocks and they can issue stocks when they are priced high to acquire other companies wholly or in part. There is a huge opportunity of franchising SNS both domestically & abroad. Recently the company is working with partners in middle eastern countries on its franchising efforts as it has a potential of achieving high returns on invested capital. In the last 5 years, the company's franchised restaurants(SNS) grew from 71 to 144. 

Market Cap – $750M

Net Debt – $210M

Enterprise Value - $960M

Investments/Marketable securities - $815M

For an example, Cracker Barrel Restaurant stake alone worth $700M in the market today compared to the Biglari Holdings market cap of $750M. You get everything else for almost free, adjusted for debt at Steak and Shake. Each Steak and Shake restaurant unit costs between $1.5M to $2.5M to build out. On average, each unit does $1.8M in revenue and $90K in profits per year. 

Management:

Sardar Biglari is the Chairman & CEO of Biglari Holdings, solely responsible for capital allocation decisions. He was a hedge fund manager with over 20% annual return for 8 years just before he took a control position in Steak ‘n Shake. He is very smart and exhibited tremendous skills in operation and capital allocation. Phil Cooley (Vice Chairman) is a sounding board to the CEO and also was his business school professor at Trinity University. CEO is incentivized properly to increase the per share value/book value of the company. Sardar Biglari controls more than 50% of the company using his personal funds, shareholders equity and limited partners from his hedge fund.

Catalyst:

There is no catalyst/situation/timeline to unlock the value of this business. Current value is its own catalyst, and an efficient way of deploying capital in the right business will increase the value of the company immensely. When value gets higher due to the combination of retaining earnings, investment in right areas/subsidiaries will ultimately unlock the value in their shares over time.

Reasons Why Opportunity Exists:

Complicated holding company structure, no analyst coverage, no guidance from the management on the quarterly/annual results from the company, unconventional CEO pay structure, high share price & low liquidity.

Risks:

Aggressive/confident CEO can run into a situation where he bets the company on a single acquisition by taking on excess debt, although it is highly unlikely.

Public market participants late to realize or appreciate this opportunity.

Final Comment:      

The company is a wonderful platform for owning companies in part or full to increase the net worth of any investor. CEO Sardar Biglari is being young (39 yrs) & unconventional is great asset to the company.  

Disclosure: I/partnerships managed by me own shares of this company.

2015 Portfolio Performance

My portfolio value decreased by 8.2% as of 31st Dec 2015 since the beginning of Jan 2015. Overall, 2015 was a lousy year for my portfolio both absolutely and also relative to the S&P performance (+1.9%). There were few costly mistakes (at least it appears so) by investing early in the Indian banks and Iconix brands lead to the poor investment returns. 

Any one year performance of quoted prices of the businesses in the portfolio is irrelevant, what relevant is the underlying business performance. All the businesses in the portfolio had a decent performance given the industry conditions, all have reinvested their profits, paying out dividends and buying back their shares where they are appropriate.

Major contributors for the performance were,

Infinite Computer Solutions (+54.5%)

PBF Energy (+28.6%)

Major detractors were,

Iconix brands (-55%)

Jammu and Kashmir Bank (-39%)

South Indian Bank (-32%)

Here are the top 10 holdings in my portfolio for 2016. You may have noticed some of the investment write ups and my reasons for the below holdings in this blog. The portfolio companies for 2016 are more or less the same; solid, have favorable prospects, cheap and diversified. I expect the returns for 2016 should be better than 2015 although one year performance is too short to measure any success/failure in the investment business.

The holdings below are all have a durable businesses, have large opportunity to grow both revenues and profits, run by competent managers and priced cheaply relative to their assets and current/future earnings.

COF, GM, JPM, PNC & WFC warrants (18.7%)

Infinite Computer Solutions (8.3%)

Jammu and Kashmir Bank (7.1%)

South Indian Bank (6.8%)

Fairfax Financial (6.4%)

Gap Inc (6%)

Leucadia National (4.5%)

Iconix Brands (4%)

MFC Industrial Ltd (3.8%)

PBF Energy (3.7%)

As always, feel free to contact me if you have any questions.