Steak n Shake Company Quietly Shifting to Berkshire Hathaway Business Model

The Steak n Shake Company (SNS), an operator of 485 burger and shake focused casual dining restaurants in 21 states, has recently been quietly transformed by a new management team into a small Berkshire Hathaway type holding company. The move is very Warren Buffett-esque, with a 1-for-20 reverse stock split aimed at boosting the share price to well above normal levels (above $300 currently) and a bid to buy an insurance company among the noteworthy actions taken thus far.

What I find almost as interesting as the moves made by new CEO Sardar Biglari (a former hedge fund manager who has gained control of the firm and inserted himself into the top management slot) is the fact that this move has largely gone unnoticed by the financial media. Granted, Steak n Shake is a small cap regional restaurant chain ($450 million equity value) but the exact same strategy undertaken by Sears Holdings chairman Eddie Lampert garnered huge amounts of press.

Clearly Sears and Kmart are larger, more well known U.S. brands, but there seems to be a lot of interest from investors for any company trying to mimic the holding company business model that Buffett has perfected for decades. As a result, I would have thought Steak n Shake would have gotten some more attention.

Essentially, Biglari is using similar methods Lampert used when he took control of Kmart and later purchased Sears. Steak n Shake has dramatically cut costs, reduced capital expenditures, and will add to its store base going forward solely via franchising new locations, rather than building them with shareholder capital. The results have been impressive so far. During 2009, the first full year under new management, Steak n Shake's free cash flow soared from negative $20 million to positive $31 million.

Biglari has made it clear that he plans to deploy the company's capital into the best investment opportunities going forward, and that likely does not include heavy investments into the core Steak n Shake business. He has announced plans to rename the company Biglari Holdings (an odd choice if you ask me) and recently offered to acquire a property and casualty insurance company (the Warren Buffett comparison is worth noting here) but was rebuffed by Fremont Michigan InsuraCorp.

In the short term, Biglari and his fellow shareholders have reaped the benefits of his shift from a capital intensive negative free cash flow restaurant business to a more lean and efficient holding company. The stock has more than doubled from the $144 price ($7.20 pre-split) it fetched on the day Biglari took over.

The larger question remains how well this young former hedge fund manager can further deploy Steak n Shake's operating profits in the future. At more than $300 per share, the stock trades for 1.6 times tangible book value of around $196, versus about 1.9 times for Berkshire Hathaway.

In my view, any price over 1.5 times tangible book value for an unproven concept and management team is too much to pay. However, given the results thus far it should come as no surprise that investors are willing to shell out more for the stock than they were previously, despite a lot of uncertainty over Steak n Shake's future. Count me as one who will be interested in monitoring the situation going forward but would only take a flier on Biglari if the price to do so got cheaper.

Full Disclosure: No position in Steak n Shake at the time of writing, but positions may change at any time

Apple iPad is Nice, Probably Not a Game Changer Yet

After seeing Apple's unveiling of the new iPad tablet yesterday my overall conclusion is that the product is very solid and will probably find a niche with certain users, but it hardly seems to be the game changer for old media that many had hoped for.

Essentially the iPad is a thin, light-weight, extremely mobile device that can be described as a supersized iPhone or a thin netbook computer. You can surf the web, check email, play iTunes, and download iPhone-like apps customized for the device.

The real issue I see is that the iPad is not all that different than a netbook or iPhone, other than its physical design. The only unique feature of the iPad seems to be a new e-book store. In addition to buying songs, movies, and television shows from iTunes you will be able to buy e-books from an e-book store, modeled after the iPhone app store and the iTunes media store. Think thin netbook combined with an Amazon Kindle.

The clear loser here is Amazon, whose Kindle overnight gets a strong competitor. The clear winners were supposed to be the content publishers, including magazine and newspaper companies, not just book publishers. On that end, I think the expanded distribution of e-books will be good for those publishers, but the gains for newspapers and magazines is less apparent.

The problem those publishers face today is that most are giving away their content on the web and the advertising revenue they earn from web visitors pales in comparison to the subscription revenue they used to collect. Some have been able to charge for web content (Wall Street Journal) and others are starting to put pay walls on their sites (New York Times) but with so many free news sources on the web, it will be hard for most publishers to convince consumers to pay a monthly fee for their content.

I am not convinced the iPad solves this problem. The content companies will build apps for the iPad, just as they did for the iPhone, but the core issue is the same; will people pay for the content when there are other free options? If the answer is yes, then the publishers will get stronger going forward. If not, nothing will change.

If you put your content on the iPad for free, that is no different than the free web site people are using to access your content. If people are not willing to pay to use your web site today, why would they be willing to pay for an iPhone or iPad app with the same content?

Even after seeing the iPad in action, I think the content game is unchanged. If you truly have valuable content that is unique and in strong demand (Wall Street Journal), you can make good money with online content. If not, people will simply go to free news sites and your profits will evaporate as subscription revenue continues to decline.

Where does this leave Apple stock? They will likely sell a good number of iPads going forward so the product is certainly an incremental positive for the company and the stock. Believe it or not, the shares have been treading water for a while now, and therefore are not overly expensive. At $207 per share Apple sports a P/E ratio of about 18x based on $11-$12 of earnings power this year. Add in the $27 per share ($25 billion) of cash that is wasting away on their balance sheet and you can see that the stock is not super-cheap but is not overly expensive by any means.

Full Disclosure: Peridot Capital was long shares of Apple at the time of writing, but positions may change at any time

Glass-Steagal Act Should Not Be Core of Financial Regulatory Reform

There has been a lot of talk lately about the repeal of Glass-Steagal in the 1990's and the potential that such a move contributed greatly to the financial crisis. Glass-Steagal, originally passed in 1933, had many parts to it but it is most widely known to have disallowed commercial banks that gathered customer deposits and gave out loans from also being investment banks that would underwrite securities and trade for their own account.

The logic of Glass-Steagal makes sense; banks should not use depositor or government capital to fund internal hedge funds. Should the enormous risks the trading desks take turn sour, it puts customers' deposits in jeopardy and reduces the amount of lending the firm can do. Not to mention the fact that cheap government funding is given to banks to boost lending and the economy, not to generate trading profits for the firm's partners.

Despite the soundness of the law, those who maintain that the repeal of Glass-Steagal was a leading contributor to the financial crisis are off base. Why? Because most of the casualties of the financial crisis were not banks at the time. Off the top of my head I can name AIG, Fannie Mae, Freddie Mac, Lehman Brothers, Bear Stearns, and Merrill Lynch.

None of those firms were commercial banks but they lost the most money. Those losses came from poor mortgage underwriting, poor insurance underwriting, and extreme leverage ratios of up to 40-to-1. More effective government regulation surely could have helped prevent such monumental downfalls (minimum underwriting standards and leverage limits to name a couple), but a combination business model of commercial and investment banking was not the culprit by any stretch of the imagination.

Now there were commercial banks that failed or nearly did during the recent crisis. Wachovia and Citigroup are the two big ones. But again, Glass-Steagal would not have prevented this. Citigroup was hampered by its leverage and significant holdings in mortgage backed securities, CDOs, and SIVs. Wachovia failed after it acquired a California-based mortgage lender that pioneered interest-only, pick-a-payment, and option ARM mortgage products. Such poor, undocumented, mortgage underwriting doomed them from the start, not investment banking (Wachovia did little, if any).

I am all for better regulation of the financial services sector, but many of the ideas floating around do not really address the core issues the industry faces. Not only that, existing regulators and laws easily allow for better regulation, without further changes, even though modern products such as credit default swaps and futures contracts clearly need to be regulated going forward.

Market Is Pricing In 35% Profit Growth in 2010

A theme of mine in recent weeks, as well as for 2010, is that the stock market has risen 70% from the March lows and has begun to price in the current consensus forecast of $75 in S&P 500 earnings, which would be a 35% increase from 2009. As a result, I think the Wall Street strategist consensus of a 10 -15% market gain this year seems overly optimistic. It is far more likely that earnings come in below $75 than above that level.. not a good risk-reward trade off.

Last evening we got the first big earnings report from the fourth quarter (Intel), they blew away the numbers (40 cents vs 30 cent estimate) and the stock is down this morning. JPM reported a decent number this morning (beat on earnings, light on sales) and it is down too. Whenever you see stocks not go up on good news, it is typically a clear sign that the markets have priced in the good news.

Despite a cautious market outlook short term, there are still good investments out there. I will share a couple in coming weeks to halt the post-holiday lull in postings on this site.

Second Tier Smart Phone Makers Likely To Struggle With Profitability

When shares of Palm (PALM) were trading in the mid single digits I was quite bullish on the company's stock simply because a revamped product line and a private equity capital infusion would likely serve to keep the company afloat and give it a chance to reverse a declining sales trend. We now find ourselves in round two of the story. Palm and the other second tier device companies are trying to grab market share in a rapidly growing smart phone market but the Blackberry and iPhone are unlikely to give up their leadership positions.

With a market growing so rapidly (3-5 years from now pretty much everyone is likely to have a smart phone device) selling devices is one thing, but making good money on them is quite another. Last week Palm reported that it shipped nearly 800,000 phones in the latest quarter, but the company lost a whopping $50 million in the process. Gross margins are only around 25-27% despite about 80% of sales coming from the new Pre and Pixi phones.

That does not leave much room for profitability when second tier firms have to spend so much on marketing to be noticed by a consumer who may be focused on the iPhone or Blackberry. The introduction of a Google phone into the mobile market (rumored to be early next year) will only make it harder for second tier players. In fact, Palm stressed on their conference call last Thursday evening that they are focused on gaining market share, not margins, so there is little reason to expect them to even care about profits in the short to intermediate term.

To me this makes the investment merit of companies like Palm a lot less attractive. I would add a company like Motorola (MOT) to this list too. Sure they have the new Droid phone, but the competitive landscape is so crowded that sustainable profitability seems difficult. Again, a rapidly growing market can lift all boats in terms of device sales, but future stock price performance will be based on profits, not sales, now that the market believes (correctly) that Palm and Motorola will survive to compete in the marketplace.

At Peridot Capital I was a buyer of Palm early in 2009 but pared back the position a lot as the stock rose into the mid teens. Now that the story has played out I will be less bullish on the shares unless they can reach sustainable profitability. And I do not think the prospects for Motorola are any more promising.

Full Disclosure: Peridot Capital has just a small long position in Palm and no position in Motorola at the time of writing, although positions may change at any time.

Devon Energy An Unlikely Merger Partner in 2010

About a month ago I wrote about Devon Energy's (DVN) plan to focus on North American on-shore energy exploration by disposing of its off-shore and international properties in 2010. Essentially the company has too many properties to drill for oil and natural gas and not enough capital resources to fund all of the potential projects. By selling off their international and off-shore properties Devon can reduce debt and focus its future exploration efforts on the very promising on-shore acreage they have, boosting shareholder value in the process.

Despite the restructuring plan announcement just last month, Devon's name is being thrown around as a possible M&A partner now that XTO Energy has been gobbled up by Exxon. I find it unlikely that in light of the deal announced this week that Devon would all of the sudden scrap its 2010 asset disposition plan and instead entertain buyout offers from larger energy players.

Judging from Devon's stated strategy it does seem that they share Exxon's bullish stance on North American on-shore shale properties. After all, they are selling other assets to focus their company on those plays going forward. As a result, it seems to me that Devon already owns enough attractive assets that it prefers to go it alone and build a leading North American energy producer.

Now surely a larger company with less attractive assets may covet a company like Devon, but I do not believe given the firm's recent strategy announcement that it feels like it needs to partner with a larger firm to create shareholder value from those assets. Of course the company would need to strongly consider any significant premium they may be offered for the entire company, but in terms of companies positioned to benefit from doing a larger M&A deal, Devon Energy does not seem to fit that mold.

Like Chesapeake, which I mentioned yesterday, Peridot Capital is also invested in Devon, but again not necessarily for the prospects of a takeover. Rather, the company already has plenty of assets (and after their asset disposition plan is complete, ample capital) to boost their stock price significantly long term. Unless a large energy company has both an interest in the assets that Devon is putting up for sale, as well as a desire to boost its on-shore shale exposure, I believe it is unlike that Devon agrees to a takeover anytime soon.

Full Disclosure: Peridot Capital was long both Chesapeake Energy and Devon Energy at the time of writing, but positions may change at any time.

Chesapeake Energy Unlikely Next Energy Merger Partner

On Monday I showed data on the mid-sized energy firms that could be next in line to be acquired on the heals of ExxonMobil's (XOM) $31 billion buyout of XTO Energy (XTO). Today I wanted share my personal view that I do not believe natural giant Chesapeake Energy (CHK) will be next in line to be gobbled up if indeed the XTO deal sets off a domino effect in the industry.

For those who do not follow Chesapeake, they are one of the largest independent natural gas producers in the United States and the most gas-heavy exploration and production firm on the short list of possible buyouts going forward (about 90% of the present value of CHK's reserves are natural gas).

A lot has changed for Chesapeake over the last 18 months. Back in July 2008 natural gas prices were a lot higher than today and Chesapeake, as the largest leaseholder of gas-producing acreage, was busy inking exploration partnerships for its massive shale properties. Big energy companies were eager to gain access to vast gas reserves and Chesapeake was interested in sharing some of the development costs to reduce their growth financing needs.

Shares of Chesapeake Energy peaked at $74 each in July 2008. The company's  co-founder and CEO, Aubrey McClendon, had been aggressively buying the stock on the way up, signaling his optimism over the company's future prospects. At the peak, McClendon owned 5.2% of the company and those 34 million shares were worth a whopping $2.5 billion. Things could not have looked better.

Amazingly, within 5 months the tide had completely shifted. Natural gas prices began to decline as the financial crisis and subsequent recession began to rear their ugly heads. As the economy weakened demand for natural gas would drop and Chesapeake's profits would take a hit. Then in December 2008 the stock started to drop a lot faster than its peer group. Rumors began to swirl that there was a large seller of the stock and that it might in fact be the company's CEO. Chesapeake shares hit rock bottom around $10 each in December, down about 85% in just 5 months.

As rumors continued to run rampant about what was happening the company issued a press release informing investors that in fact McClendon had been issued a margin call by his brokerage firm and was forced to sell 93% of his holdings in the company. It turned out that McClendon had been using margin (borrowed money) to build up his stake over the years.

If that seemed reckless, despite his optimism about Chesapeake's future, it turned out to be even more reckless given that he did not seem to hedge any of his massive margined stake even when the stock peaked and was worth billions of dollars.

Given the events that had transpired and how shocking they were, one can certainly understand why the stock began to lag the natural gas sector. After all, if McClendon could be so careless with his own money, who knew what he might do with shareholders' capital. The stock did rebound from a panicked low of $10 to the 20's in subsequent months, but it continued to lag behind its rivals; companies that carried a lot less baggage.

After such an embarrassment, McClendon vowed to slowly rebuild his stake over time, but he has yet to do so. He still owns 2.4 million shares of Chesapeake (a 0.4% stake) worth nearly $60 million but that has to feel like nothing compared to what he once had. And that is why I doubt Chesapeake will be the next natural gas company to be sold.

While it is pure speculation on my part, I do not believe that McClendon, who co-founded Chesapeake with Tom Ward (who now runs SandRidge Energy), would be extremely anxious to sell the company after he allowed $2.5 billion of equity to disappear within a matter of months. McClendon remains CEO and shows a lot of passion about continuing to grow the company himself.

In my view, the only motivation for him to sell at this point in the natural gas cycle would be to lessen his work load and cash out financially. While $60 million may seem like a lot to you and me, it may not be an attractive option for McClendon (or even $70 or $80 million if he accepted a premium) considering that he owned a 5%, $2.5 billion stake as recently as mid 2008. Furthermore, with natural gas prices in the tank lately it would be a reasonable argument to claim that it would not be in the best interests of shareholders to sell now either.

More likely I would bet that McClendon does in fact want to build up his stake again (maybe not back to 5% but somewhere above his current 0.4%), sell at a time when the natural gas market is a bit more favorable, and really cash in on the company he has built from nothing over the last two decades.

As a result, I really do not expect Chesapeake Energy to be sold in the near term (say the next 3-6 months at least). It just does not seem to be something McClendon would entertain given where we are right now in the natural gas cycle and what he has been through over the last couple of years.

McClendon is usually outspoken on quarterly conference calls, so perhaps he will even address the M&A landscape and his current thinking on the company's fourth quarter earnings call in early February. If he does, I will be sure to keep you all posted.

All of that said, Peridot Capital continues to invest in the company. I believe it has excellent leverage to the future of the natural gas market, which will likely turn around sometime in the not-too-distant future as currently low prices discourage gas production. I am just not banking on a blockbuster merger anytime soon.

Full Disclosure: Peridot Capital was long shares of CHK at the time of writing, but positions may change at any time

Will ExxonMobil-XTO Spark Energy M&A Boom Like 1998-2001?

I have decided this will be "energy week" on the blog. I have a total four posts in mind including yesterday's about Exxon's decision to buy XTO Energy. I have reiterated what many people have said, that Exxon may have started a chain reaction of rather large energy mergers. Is there a precedent for such a run on quality energy assets? Absolutely.

Consider the period from 1998 to 2001, the last large energy consolidation. Large energy companies have a history of "me-too" transactions in order to avoid falling behind the competition in terms of size and scope of energy producing properties. Take a look at how many mega mergers were announced between 1998 and 2001:

• Exxon buys Mobil

• Conoco buys Phillips

• BP buys Amoco

• Chevron buys Texaco

Many energy industry insiders are thinking we could see a repeat of this now that Exxon Mobil, a conservative deal maker (they have not done a large deal since Mobil), has gotten the ball rolling.

So which targets are most likely to be gobbled up first? Interestingly, I have more of a strong view on which firms likely will not be sold in the short term. More details on those later this week.

Exxon Buy of XTO Could Start Energy M&A Domino Effect

I love Monday mornings for the sole reason that they are often very exciting from a merger announcement prospective. Many have expected lots of merger and acquisition activity in the energy sector but until today there was very little going on there. With this morning's announcement that ExxonMobil (XOM) is buying XTO Energy (XTO) it appears that the long anticipated trend of consolidation in mid-sized North American energy companies (most notably the unconventional natural gas producers) may be under way.

Exxon is paying a 25% premium for XTO Energy, one of the five companies always rumored to be on the short list of possible major oil company targets. Exxon is a conservative dealmaker so the fact that they are shelling out $31 billion ($41 billion including debt assumption) for XTO shows that they not only liked what they saw and the price they got. Other leading oil giants (think the likes of BP and Shell) are likely scrambling to draft their own plans to follow suit to ensure they do not get stuck with inferior growth properties. The majors are lacking an excess of replacement fields for the huge amounts of energy they produce each year, so a large acquisition is really the best way to secure future growth opportunities in a very competitive energy market.

So who might be next? I have compiled a list of the obvious targets, including valuations, to show you exactly why Exxon likely chose XTO (it was the cheapest company in the group), what other firms are likely going to have their tires kicked in coming months, and which of the remaining independent firms may be most attractive from a price tag perspective. Exxon is paying 6.6x trailing cash flow for XTO, so we can expect that to be the yardstick off of which future deal negotiations will be based.

Full Disclosure: Peridot Capital was long Chesapeake and Devon at the time of writing (yeah, unfortunately no XTO) but positions may change at any time.

Housing Market Stabilizing, As Long As Tax Credit Expiration in 2010 Does Not Halt Buying

For some reason I have not updated my long running home inventory chart in recent months, so I figured I would show the most recent data from the National Association of Realtors. As I have long discussed on this blog, inventories are the crucial part to the story because a balancing of longer term supply and demand is the only thing that will halt the home price decline for good.

As you can see below, inventories really took a turn for the better during the recently ended prime selling season (the data here is as of October 2009). The first-time homebuyer tax credit definitely played a big role in that, so the question going forward is "what happens when the extension of the credit expires in 1H 2010?"

I think sales will certainly slip at that point, but if the economy is growing, monthly job gains come to fruition by then, and consumer confidence is reasonable, there is a good chance inventories might not see another large spike higher. In that case, I believe we will see home prices stable in 2010. Long term, home owners should expect historically normal appreciation, which means about 3% annually.