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.

Buyback Champion at a reasonable price?? - Gap Inc

GAP, Inc (GPS)

Highlights:

Asset Light Business: The Company has a net equity of $2.6 billion, produces $1.4 billion in annual free cash flow with a Return on Equity of more than 50% with a modest financial leverage.

Great Brand image: The Company owns brands like Gap, Banana Republic, Old Navy, Athleta, and Intermix.

Emerging Market Growth: The Company has franchise agreements and huge growth plans in emerging markets, especially in China. They are likely to fuel the revenues and cash flow growth.

Management: Incentivized/long tenured management in place to take advantage of the opportunities. Fisher Family owns more than 26% of the shares outstanding.

Market Price: The Company is selling in the market for 8 times of their current annual free cash flow which translates into 12% initial free cash flow yield.

Stock Buyback: The Company bought back more than 55% of their shares outstanding in past 10 years and 35% in past 5 years.

Dividend: The current dividend yield is about 3.3% with ~30% payout ratio.

Business profile:

Gap Inc. is a leading global apparel retail company which offers apparel, accessories, and personal care products for men, women, and children under the Gap, Banana Republic, Old Navy, Piperlime, Athleta, and Intermix brands. Portfolio of distinct brands across multiple channels and geographies gives them a competitive advantage in the global retail marketplace. In January 2015, The Company announced their decision to close the Piperlime brand due to the return on capital employed not being sufficient.

Revenue distribution by Geography and Brands ($ millions):

	2014	2013	2012
United States	$12,672	$12,531	$12,194
Canada	$1,137	$1,128	$1,095
Europe	$917	$891	$870
Asia	$1,502	$1,397	$1,310
Other	$207	$201	$182

	2014	2013	2012
GAP	$6,165	$6,351	$6,254
Old Navy	$6,619	$6,257	$6,112
Banana Republic	$2,992	$2,868	$2,890
Athleta, Intermix	$729	$672	$395

Selected historical Financials ($ millions):

	2014	2013	2012	2011	2010
Net sales	$16,435	$16,148	$15,651	$14,549	$14,664
Net income	$1,262	$1,280	$1,135	$833	$1,204
Total assets	$7,690	$7,849	$7,470	$7,422	$7,065
Stockholders’ equity	$2,983	$3,062	$2,894	$2,755	$4,080
Total long-term debt	$1,332	$1,369	$1,246	$1,606	$ —
Weighted-average number of shares	435	461	482	529	636
Cash dividends paid	$383	$321	$240	$236	$252
Earnings per share	$2.90	$2.78	$2.35	$1.57	$1.89
Operating Cash flow	2,129	1,705	1,936	1,363	1,744
Cash used for purchases of property and equipment	$714	$670	$659	$548	$557
Free cash flow	$1,415	$1,035	$1,277	$815	$1,187
Number of Company-operated store locations	3,280	3,164	3,095	3,036	3,068
Number of franchise store locations	429	375	312	227	178
Total number of store locations	3,709	3,539	3,407	3,263	3,246

The company has been growing revenues and profits nicely. The company is great at allocating capital by going through franchising business model in emerging markets, which essentially reduces the capital at risk. The number of franchised stores has been growing at 25% for the last 4 years. Online sales have been growing at double digits. They also have used their free cash flow to buy back their shares aggressively as the shares have been selling cheaply for last few years. The Company has bought back more than 55% of their shares outstanding in last 10 years and 35% in last 5 years. The shares outstanding are currently at 410 million as of June 2015. As of August 1^st, the company has $695 million authorized for share re-purchases.

Management & Partners:

Arthur Peck, 59, Director and Chief Executive Officer since February 2015 after Glenn Murphy; President, Growth, Innovation, and Digital division from November 2012 to January 2015; President, Gap North America from February 2011 to November 2012; Executive Vice President of Strategy and Operations from May 2005 to February 2011; President, Gap Inc. Outlet from October 2008 to February 2011;

Fisher family collectively owns about 107,500,000 (26%) of the shares outstanding. With their large ownership, as the famous saying goes ‘They eat their own cooking’. Eddie Lampert (Sears Holdings chairman) used to own 5% of the company and sold out as the share prices appreciated last year. Now, he is starting to buy again as the shares are in bargain territory. He owns more than 2 million shares now.

Valuation ($M):

Market Cap	11,400	Market Cap/ FCF	8.1
Net Debt	0	Interest Expense	75
Enterprise Value	11,400	Enterprise Value / EBITDA	4.6
EBIDTA	2,460	P/E	9.80
FCF	1,400	Interest Coverage	32.80

The company has ample cash interest coverage ratio (33 times) and it trades for 8 times the free cash flow.

Major shareholders:

Shareholders	No of Shares	Percentage
Fisher Core Holdings LP	107,500,000	26.22%
Vanguard Group, Inc.	16,283,881	3.97%
Goldman Sachs Asset Management, L.P.	14,089,987	3.44%
J.P. Morgan Investment Management Inc	11,305,884	2.76%
State Street Corp	10,773,611	2.63%
Glenview Capital Management LLC	5,994,495	1.46%
ESL Investments	2,057,403	0.50%

Potential Risks:

Ø  Miss on the fashion trends in one or more of their brands may threaten their free cash flow generation in short term.

Ø  Management/leaders of divisions leaving for better opportunities may cause temporary transition issue within the management.

Conclusion:

The company is a great cash flow machine relative to their assets and equity. Free cash flows are used to pay dividends and repurchase the shares as they don’t need lot of reinvestment in their assets to grow further. The company’s shares are selling in the market for 8 times the free cash flow, which yields about 12% shareholder return initially. The buyer of shares at these prices ($28/share) will be rewarded greatly in the long term ownership of this business.

Disclosure:

I / partnerships that I manage own shares of Gap Inc. This is not a recommendation to buy or sell above mentioned securities. Please conduct your own research to make any investment decisions.