Biglari Succinctly Criticizes Cracker Barrel’s Strategic Plan in Pursuit of Board Seat

As an investor looking for attractive places to allocate your capital, one of the biggest things you can try to avoid are companies where the management team takes actions that do little to maximize shareholder value. Oftentimes these same managers have very little “skin the the game” (stock ownership in their own company), giving them little reason to care about the stock price.

The operating performance of restaurant chain Cracker Barrel (CBRL) over the last decade or so has been dismal, which has led Sardar Biglari, CEO of Biglari Holdings (BH) to amass a 10% stake in the company and seek a board seat at next month’s annual meeting. This week Biglari wrote a letter to CBRL shareholders explaining why he wants on the board and what his ideas are for value creation. The letter is very well written and highlights issues that are all too common with public companies. Time and time again decisions seem to be made without much financial analysis. The end result is wasted shareholder capital and value destruction for equity holders.

You can read the entire letter to CBRL shareholders here, but I think it is important to cherry pick a few of Biglari’s points, as they apply to many companies, not just CBRL. Below are some direct quotes from the letter (in italics), followed by some of my thoughts.

“Cracker Barrel’s performance during Founder Danny Evins’ era was stellar. However, since Michael Woodhouse became Chairman and CEO, the underlying store-level operating performance has been deteriorating. Instead of restoring the formerly successful store-level performance, Mr. Woodhouse has spent over $600 million in capital over the past seven years while over the same time span operating profit declined.”

Biglari provides the hard data that shows 2005 revenues of $2.2 billion and operating income of $169 million, versus 2011 revenues of $2.4 billion and opearting income of $167 million. Indeed, the current management team has spent $615 million on capital expenditures since 2005, which has grown revenue by 10% (entirely from new store openings) but failed to add a single dollar of profit to the company. Biglari uses this data to argue the company should not be wasting money on building new stores today (the company’s current plan is to spend $50 million on them in 2012). All too often management thinks the best thing to do is to get bigger, even when doing so adds nothing to the bottom line.

“After all, it is easy to spend money to open new units. The trick and triumph are to achieve unit profit both sufficient and sustainable without a diminution of performance in existing stores. The principal reason unit-level performance has been dismal is that unit-level customer traffic has been declining. On this important measure, customer traffic has been consistently negative in each of the past seven years. There are currently about 960 customers, on average, that go through each unit per day, nearly 190 fewer than seven years ago.”

Again, Biglari provides traffic data that shows a 15% decline in customer traffic per existing unit since 2005. This is yet more evidence that opening new stores is a waste of money and is destroying shareholder value. It is clear that even ignoring new store cannibalization (which certainly exists at least to some minor extent), traffic at existing stores is falling. Why then open new stores?

“Mr. Woodhouse in essence has produced the same level of profit with 603 stores that Mr. Evins did with 357 stores. If Mr. Woodhouse could have simply returned the Company to the productive level achieved in fiscal 1998, there would be an additional $110 million in operating profit, and we estimate $1 billion added in market value or the doubling of the current stock price.”

Biglari shows operating profit per store of $462,000 in 1998 (357 stores), $319,000 in 2005 (529 stores), and $277,000 in 2011 (603 stores). He concludes that new store expansion should be halted and management should work on getting the existing store base back to the level of profitability that existed more than a decade ago. It seems so simple, but management is clearly clueless, which is why Biglari is seeking a board seat as the company’s largest shareholder.

“When determining where to direct capital, management should evlaute all options and then place capital based on the highest return after compensating for relevant risks. The math is simple: The cost of a new unit including land, building, and pre-opening expenses is between $3.5 million to $4.7 million. Cracker Barrel’s current market value is about $1 billion. With 608 units, the market value per store is $1.6 million.”

This is something that I see all the time with public companies that require large upfront investments to expand their unit base (restaurants, hotels, casinos, etc). It drives me crazy. In the case of CBRL the market is valuing each store at $1.6 million but management is choosing to spend tens of millions per year on new units at a cost of no less than $3.5 million each. Opening a new unit results in an immediate loss of $1.9 million for shareholders, or 54% of the investment! No wonder the stock has been in the tank. Conversely, if the company uses their capital to repurchase stock (essentially buying back their own stores at $1.6 million each), and then improves the profitability of those stores, the stock price will go the other way. Investors should always be wary of companies that spend “X” to build a new unit when the market is valuing their company at less than “X” per unit. Getting bigger for bigger’s sake without looking at the returns on invested capital is a sure-fire way to destroy shareholder value.

So why on earth does the CBRL management team seem to not care about deteriorating store-level operating performance or their poor returns from new store expansion? Well, in addition to the fact that management hardly owns any stock, Biglari points to their compensation system as a culprit:

“We believe in excellent pay for performance. But the Board has designed a flawed compensation system, one with a low bar for achievement. For 2011, executive officers were eligible to receive a bonus of up to 200% of target (target being median reflected by our peer group) if operating income met or exceeded $90 million. To put in context the absurdity of the $90 million bonus target, Cracker Barrel has not had operating income below $90 million in any year since 1994! Why would a Board set eligibility at a level unseen in nearly 20 years?”

Of course, the answer is it ensures they can collect maximum bonuses without showing any job competence. In this case operating income can decline by nearly 50% and they still collect a 200% bonus. It is not surprising then, that CBRL’s operating income has actually declined over the last seven years, despite new store growth. Management has no incentive to reverse that trend because they only own a little bit of stock in the company and they get their bonus regardless of what happens.

It’s not hard to see why Biglari Holdings has taken a 10% stake in CBRL and Mr. Biglari is trying to get on the board of directors. If he is successful, there is no doubt that taking even some of his advice would get the stock moving again, as corporate financial results would have no where to go but up. Also not surprising is the effort CBRL management is putting forth to defeat his election (if only they put that much time into improving the company!). To give you an idea of how much they value their shareholders, Biglari ends his letter with this final observation:

“I hope to see you at the annual meeting, a gathering for shareholders to learn more about the Company. Annual meetings represent another window into the culture of the organization shaped by top leadership. Unfortunately, even on this mark, the Board sends the wrong message: Cracker Barrel has chosen to hold its upcoming annual meeting during Christmas week on December 20, 2011. While we will attend the meeting regardless of date or time, it is not the way shareholders should be treated. It is time to change the ethos of the Company to one that cares about shareholders and respects their money and their time.”

Now, as a shareholder of Biglari Holdings this letter and proxy fight is a material development in which I have a keen interest. However, even if you are not in the same boat, I think it highlights important lessons for all investors who are trying to identify superior investment opportunities. Beware of companies like CBRL whose management teams seem to make one mistake after another. They usually claim to want to maximize shareholder value, but oftentimes take actions that ensure the opposite. Be especially wary of companies that have a desire to expand their unit base, at a huge cost, even when the public markets will ensure such capital investments never return a profit to shareholders.

Full Disclosure: Long shares of Biglari Holdings at the time of writing, but positions may change at any time

SodaStream: A Great Short, Once Every Store Is Fully Stocked

There has been a lot of speculation lately about the health of the IPO market and whether it is signaling that the bull market that has seen the S&P 500 index double since early 2009 is in its late stages. Whether it be hot U.S. technology and internet IPOs (watch LinkedIn today as an example) or wannabes in China and India, there is no doubt that many of these new issues are overheated. One of the more interesting ones in my view is SodaStream (SODA), the maker of carbonation systems used to make your own soda and flavored water at home. If you have perused a Bed, Bath, and Beyond or Williams Sonoma lately, you have probably seen their display. What once would have been reserved for the pages of SkyMall in your airline’s seat compartment has now apparently gone mainstream in the U.S. and the company is pushing into new markets all across the globe. You can now buy a SodaStream soda maker at 40,000 retail outlets in 40 countries.

Not surprisingly, SodaStream stock has been roaring since its late 2010 IPO. After reporting strong first quarter earnings, SODA soared 23% or $10, to close at $54 per share on Wednesday. That huge move higher gave the company a market valuation of over $1 billion. Crazy? Probably, but let’s not underestimate how many retail locations globally SodaStream may be able to get its product stocked in. That is why I say this might be a great short opportunity, but not quite yet. As long as SodaStream is signing up new retailers, they will likely be able to post some impressive sales numbers simply from initial inventory stocking.

However, the long-term viability of the business model will depend on how many units those retailers are able to sell, and how many buyers actually continue to use the product regularly (SodaStream gets 50% of its revenue from consumables — CO2 refills and flavor mixes). Getting soda makers out the door of your manufacturing factory is one thing, building a loyal customer base for years to come is quite another. How many kitchen appliances get used once or twice and then find gather dust in the back of the pantry? Can’t you picture a SodaStream home soda maker in such a situation?

So how many soda makers are consumers actually buying? Not that many, even though the company reported unit sales of 592,000 for the first quarter of 2011. With 40,000 retail outlets peddling the product, that rate of sales equates to about 1 soda maker sold per week, per retail location. At that sell-through rate, it is easy to see that constant restocking really won’t be required. Given that this product has a ways to go before I’m convinced it will become a mainstay in consumer kitchens worldwide, I will be monitoring the situation closely. As SodaStream expands into new countries and signs on new retail distributors, I have no doubt they can grow sales substantially initially, but the thing to watch is how many potential retail outlets there are, and how fast they penetrate those markets. Once the SodaStream product line has found its way onto most retail shelves, it will have a much tougher time performing well and keeping that shelf space.

With a market value already exceeding $1 billion (for comparison’s sake, the third largest soda company in the world, Dr Pepper Snapple, is worth about $9 billion), SodaStream’s stock could easily reach nosebleed territory and make for a great short once the initial stocking sales momentum calms down. I don’t know if I would call this a fad (are they really that popular to begin with?) but I think in a year or two from now the fizz will have flattened tremendously. Time will tell.

Full Disclosure: No positions in the stocks mentioned at the time of writing, but positions may change at any time

Biglari Holdings: You Can’t Be Serious!

This week marked the first time in my investing career that I have felt the need to write to the management team of a publicly traded company. Not only that, but I even surprised myself a little bit by actually going ahead and doing it. After reading a corporate press release from Biglari Holdings on Tuesday morning, I was absolutely irate. What could make me so upset that I actually wrote a two page letter and mailed it off to the CEO, despite the fact that collectively my clients and I own about 0.005% of the company’s stock?

Biglari Holdings announced this week that it was planning to reverse split its stock (which was already trading above $450 per share) 1-for-15, which would send the price up to nearly $7,000 per share and reduce the total shares outstanding to less than 100,000. The end result (other than an insanely expensive stock) is that anyone with fewer than 15 shares of the company (again, nearly $7,000 worth) would be forced to accept cash in return for liquidating their investment. That’s right, the company was forcing its smaller shareholders to sell and they had no say in the matter. At least if you own stock in a company that has agreed to a merger you can vote “yes” or “no” to the deal.

To my knowledge, I don’t know of any other company that has ever had the audacity to force its shareholders to sell all of their stock. And since all but two of my clients who are invested in Biglari Holdings own fewer than 15 shares (myself included) I just had to speak up, even though it clearly won’t matter to the company what I think. Still, if there was ever a time that small shareholders should complain to management, I have to think this would be that time.

Rather than post the letter on this blog, I chose to submit it for publication on a larger site (Seeking Alpha) with the hope that other upset shareholders might join me in voicing their discontent. A copy of the letter can be read here: An Open Letter to Sardar Biglari, CEO of Biglari Holdings.

Biglari Exchange Offer Signals Inflated Stock Price of Warren Buffet Follower

Biglari Holdings (BH), in the company’s first major move since changing its corporate name from Steak ‘n Shake (read my last post about Biglari and Steak ‘n Shake), has chosen an uncommon method for completing its next public market transaction. Rather than use the company’s cash to acquire a minority stake in Advance Auto Parts (AAP), Biglari has offered to exchange shares of his own stock for shares in AAP at a ratio of 0.1179. Such a move is rare, but more importantly, it signals to investors that Biglari feels that his stock is at least fully valued and at most overvalued. Otherwise, he would have preferred to use cash rather than stock to invest in AAP. Smart capital allocators such as Biglari only have a reason to dilute their ownership stake if they are using prime currency. In this case, BH shares at nearly $400 each were certainly on the expensive side, at nearly two times book value.

Unfortunately, the market has reacted appropriately to this move by shedding nearly 10% from Biglari Holdings’ market value. Trading down into the mid 350’s, the exchange offer to Advance Auto Parts shareholders went from being an attractive option (originally representing a premium of about $1 per share) to being very unattractive (about a $3 per share discount). The markets in general are quite smart and they appear to have sniffed out Biglari’s intention of swapping an expensive stock for a cheaper one.

Why he did not opt to make this offer privately to one or a handful of existing AAP shareholders is baffling. By going public with the offer, he essentially ensured that his stock would get hit hard and reduce any interest in his exchange offer. Of course, the more Biglari makes headlines the more investors might start to read up on him and decide to invest in his company. That exposure could result in a fairly quick rebound in the stock price of Biglari Holdings, prompting more offers like this one.

Full Disclosure: No position in AAP or BH at the time of writing, but positions may change at any time

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

Anheuser-Busch InBev Update: Nine Months Following BusinessWeek Recommendation

Back in December I was fortunate enough to be chosen by the editors to provide BusinessWeek magazine a value stock idea for their annual investment guide issue. My selection, beer giant Anheuser-Busch InBev, was controversial at the time due to the just-completed buyout of A-B by Belgium’s InBev, but despite how disappointed many were with the deal (especially in St. Louis where I resided for ten years) the stock of the combined company was too cheap for me to ignore.

Nearly nine months later I figured I would publish an update to that investment idea given that many people read the BusinessWeek issue and some surely wound up purchasing the stock. Shares of Anheuser-Busch InBev (AHBIF) have more than doubled in value (+119%) since the issue hit newsstands, soaring from $21 per share to a current $46 quote.


The reasons for such a large move have turned out to be the very same arguments I made when I made the pick; the stock was deeply oversold after millions of new shares were sold to finance the A-B deal, and profit margins have increased smartly thanks to the synergies captured from the merger.

The company recently reported financial results for the first half of 2009. While revenue rose only 3% (the beer market is fairly mature in most parts of the world), normalized EBITDA rose 22% thanks to margin expansion. In fact, gross margin rose from 50% to nearly 53%, and EBITDA margins rose from under 30% to over 36%. Simply put, thus far the company has succeeded in hitting its post-merger operating goals.

The doubling of the share price has increased the equity market value of A-B InBev to $73 billion. Combined with $53 billion in net debt (much of which was borrowed to buy A-B and will be repaid in coming years with free cash flow), the stock’s enterprise value sits at $126 billion, or 9.8 times current run-rate cash flow. My valuation model back in December pegged a fair value price for the company at 10 times cash flow, so the stock now appears close to fair value of ~$47 per share.

As a result, Anheuser-Busch InBev stock is no longer dirt cheap. For investors who own large positions, it may be wise to consider paring it back. I have not sold it completely for my clients because there remains decent upside over the long term as the firm’s massive debt load is repaid. Every dollar of debt that is repaid (assuming constant operating cash flow) will translate into more value for equity holders.

Although the easy money has already been made, I think the stock will do fairly well longer term as the company de-levers its balance sheet and further integrates the two beer giants into one company. Translation: the stock is no longer a screaming buy, but rather a very solid hold.

Full Disclosure: Clients of Peridot Capital were long shares of AHBIF at the time of writing, but positions may change at any time

“Buy and Hold” Doesn’t Work If You Completely Ignore Valuation

The current bear market resulted in the first negative ten-year period for the U.S. stock market in a long time. This has prompted many people to declare that the investment strategy of buying and holding stocks for the long term (“buy and “hold” for short) is all of the sudden “dead” or no longer viable.

Personally, I find this death pronouncement a bit odd. Just because stocks went nowhere from 1999-2008 means that investing in stocks for ten years is flawed generally? Since when does one instance of something not working render the entire concept flawed? I don’t think a 100 percent success rate is required for one to declare it a viable strategy.

The reason “buy and hold” became popular is because, over long periods of time, stock prices mimic corporate earnings, which have risen over business cycles since the beginning of our economy. Legendary fund manager Peter Lynch continually reminds people that it is no coincidence that over decades the gains in the U.S. stock market are practically identical to the gains in corporate earnings (stock ownership represents a proportional share in profits generated by the firm).

The key point here is that the relationship only holds over long periods of time. In any given year, there is virtually no correlation between earnings growth rates and equity market gains. That is why “buy and hold” is a widely accepted investment strategy. If you invest over the long term, the odds are extremely high that earnings and stock prices will rise, and do so at higher rates than other investment alternatives.

I bring this up today because a former CEO of Coca Cola was a guest host on CNBC this morning. He and the CNBC gang discussed the fact that shares of Coke are actually down over the last ten years (since this person left the CEO post), as the chart below shows.

The CNBC commentators were quick to point out that Coke’s earnings have more than doubled over the past decade, but the stock has actually lost value. Does this example support the idea that “buy and hold” is a flawed strategy, or is there something else at work here?

The latter. Coke stock carried a P/E ratio above 50 back in the late 1990’s, during the blue chip bull market. Even when earnings grow dramatically, if P/E ratios are in nose bleed territory, “buy and hold” may not work, as was the case with Coke.

As a result, “buy and hold” does not work blindly. If you dramatically overpay for a stock, there is a good chance that you won’t make any money, even over an entire decade. From my perspective, this does not mean that “buy and hold” is dead (the long term relationship between earnings and stock prices is unchanged), it simply means that valuation is important in determining future stock price returns (statistics show it is the most important, in fact).

The take away from this discussion is that “buy and hold” investors are likely to do very well over the long term, as long as they don’t grossly overpay for an asset. The U.S. stock market in the late 1990’s was more expensive, on a valuation basis, than at any other time in its history. Buyers during that time can’t be saved from their own poor decision of paying too much for a stock, even by a proven long term investment strategy. Unfortunately, most non-professional individual investors don’t focus on valuation when picking stocks for their portfolios, and often pay the price as a result.

Full Disclosure: No position in Coca Cola at the time of writing, but positions may change at any time

Amazon Shares Look Expensive, Long Term Future Returns Appear Limited

In November of 2004 I wrote a piece entitled “Sleepless in Seattle” which postulated that shares of Starbucks (SBUX) were trading at such a high valuation (forward P/E of 48) that even if the company grew handsomely over the following few years, the stock’s performance was likely to be unimpressive. I projected an aggressive three-year average annual earnings growth rate of 20% and a P/E of 40 by 2007. I warned investors that even if those aggressive assumptions were attained, Starbucks stock would only gain 6% per year over that three year period.

The analysis proved quite accurate. Starbucks continued to grow its profits nicely, but the stock’s valuation came back down to earth. After three years had passed, Starbucks stock was actually trading 12% lower than it was when I wrote the original piece.

Today, shares of online retailer (AMZN) remind me of Starbucks back in 2004. Despite a cratering stock market and weak retail market, Amazon stock has been quite resilient. After a strong fourth quarter earnings report (released yesterday after the close of trading), the stock is up $7 today to $57 per share. Profits at Amazon for 2008 came in at $1.49 per share, which gives the stock a P/E of 38, which is very high, even for a strong franchise like Amazon.

I decided to do the same exercise with Amazon. I wanted to make assumptions that were both reasonable but also fairly aggressive. I decided that an average earnings growth rate of 15% over the next five years fits that mold. Projecting the P/E in January of 2014 is not easy, but given that Amazon’s growth rate should slow as the company gets larger, I think a 20 P/E ratio is reasonable given where other retailers trade (less than 15x). By 2014, Amazon’s growth rate should be more in-line with other retailers similar in size, so I chose 20 to be higher than average, but not in nosebleed territory like the current 38 P/E.

After some simple number crunching, we can determine that Amazon would earn $3 per share in 2013 in this scenario. Twenty times that figure gets us a share price of $60, versus today’s quote of $57. Even if the company hits these assumptions, shareholders will make a total return of 5% (only 1% per year!) over the next five years. I would be willing to bet the S&P 500 index far outpaces that rate over that time.

Obviously these assumptions could prove inaccurate, but I think this exercise is helpful in illustrating how hard it is for stocks that trade at lofty valuations to generate strong returns over the long term.

There is one interesting thing about Amazon’s business that I think is worth pointing out. You may recall that one of the bullish arguments for an online retailer like Amazon was that they could have a lower cost structure by eliminating the expenses associated with renting and operating large brick and mortar storefronts. Having a 100% online presence was supposed to result in higher profit margins, and therefore investors could justify paying more for Amazon’s stock.

It seems that argument has not been realized. Amazon’s operating margins in 2008 were 4.3%. If we look at brick and mortar retailers that are similar in business line and/or size, we find that Amazon’s margins are actually lower than their offline competitors. Here is a sample list: Kohls (KSS) 9.9%, JC Penney (JCP) 7.6%, Macy’s (M) 7.2%, Target (TGT) 7.8%, and Best Buy (BBY) 4.6%.

Maybe online retailers have to spend more on research and development and call center staff than offline stores do, thereby cutting into the margin advantage. Amazon also offers free shipping on orders of $25 or more, which many say they could eliminate to boost profits. Maybe so, but sales would be affected to some degree if they did that, not to mention customer loyalty.

Nonetheless, to me these statistics help make the case that a 38 P/E for Amazon is way too high. As a result, returns to Amazon shareholders over the next several years could very well be unimpressive, just as was the case with Starbucks five years ago.

Full Disclosure: Peridot Capital was long Best Buy and Target at the time of writing, but positions may change at any time

Anheuser-Busch InBev Poised To Rebound After 85% Collapse

As you may have already read in Business Week’s 2009 Investment Outlook issue (dated 12/29-1/5), I highlighted the recently formed Anheuser-Busch InBev (AHBIF) as a potentially attractive bargain pick. Despite various other mergers failing to get done in the current credit environment, Belgium’s InBev paid $52 billion in cash to acquire Anheuser-Busch. Fearing that borrowing the money to get the deal done would prove overly aggressive, InBev’s stock simply cratered in the months leading up to the deal, and shortly after it was completed.

In addition to the plan to borrow the entire $52 billion, InBev’s plan to repay $10 billion of that loan right away via a rights offering proved much more ominous than once thought. With InBev’s stock price collapsing (the stock peaked at US$95 and fell all the way to US$14), the number of new shares needed to be sold to raise $10 billion of capital greatly increased. In fact, InBev sold about 1 billion new shares which was far greater than the 600 million shares outstanding before the buyout. All of the sudden, InBev shareholders were diluted by more than 60%, which was a main reason why the bottom fell out of the stock shortly after the buyout was completed.

While the dilution certainly was much more than anyone expected, the business prospects for the combined company have not really changed, which is at the heart of why I think there is a good chance they can actually pay back the loans successfully. Beer sales worldwide are not going to be dramatically affected by the global recession and lower commodity prices could even help boost margins as input costs decline.

Through the first nine months of 2008, Anheuser-Busch was on pace for annual EBITDA of about $3.9 billion, with InBev tacking on another 5 billion euros. That comes to nearly 7.5 billion euros of annual EBITDA before accounting for any cost synergies. Assuming the A-B portion could see an improvement in profitability due to cost cuts, there is reason to think the combined company could have annual EBITDA of more than 8 billion euros. To see how I get to that number, I have included the following chart:

Comparable large, dominant, global beverage brands fetch about 10 times cash flow in the public markets so an enterprise value of 80 billion euro is not an unreasonable valuation in my eyes. The catch, of course, is the tremendous debt load InBev took on to become the most dominant beer company in the world.

The companies had more than $7 billion in net debt before the transaction. Even after 20% of the $52 billion load is repaid with proceeds from the new stock sale, Anheuser-Busch InBev remains saddled with about 40 billion euro of net debt, which accounts for half of the projected enterprise value of the company. At the current point in time, that translates into a little more than $24 per AHBIF share. After rising from a low of $14 in recent weeks, the stock trades in the low 20’s already.

Is there any upside left then? Well, leverage works both ways. If you take on too much debt and your cash flow sinks, you might be left holding the bag. On the other hand, if your cash flow is strong, you can repay debt fairly quickly. There is no doubt that 40 billion euros of debt sounds like a huge number, but it is more reasonable if you are bringing in 8 billion euro of EBITDA annually.

Now, it is true that all of that money cannot go toward the debt (which would wipe it out in five years), due to ongoing capital expenditure requirements. That said, Anheuser-Busch reinvests about 20% of its cash flow into the business, so they were on pace to have free cash flow of $3 billion in 2008 after reinvesting $750 million back into the business. InBev was even bigger than A-B before the merger, so free cash flow should be immense.

Assuming AHBIF reinvests 20% of operating cash flow into the business and uses the remaining 80% to repay debt, the current 40 billion euro debt load could be reduced by half within several years. At current prices, AHBIF stock could return more than 50% in 3 years, which equates to a 15% average annual return.

I have ignored taxes in this example, but fortunately the company’s interest expense will wipe out much of their taxable income. To offset that variable, I also did not factor in any proceeds from asset divestitures that are likely to be completed to help with the deleveraging process. Anheuser’s entertainment division (think Busch Gardens, etc) as well as their packaging division are often rumored to potentially be on the selling block. Proceeds would be used for interest and debt payments. As a result, while the numbers I have used will not prove to be exact, a net debt to EBITDA ratio of 5:1, while high, seems manageable given the strength of the combined company’s business.

Note: Anheuser-Busch InBev stock trades on the Brussels exchange and recently fetched about 16 euros. Investors without access to international exchanges can buy the stock over the counter under the symbol AHBIF for around 23 dollars, but currency fluctuations will impact the dollar price, which is based on the euro quote and the prevailing exchange rate.

Full Disclosure: Peridot was long shares of Anheuser-Busch InBev at the time of writing, but positions may change at any time

Chad’s Stock Idea for the Annual Business Week Investment Outlook Issue

The annual Business Week Investment Outlook issue (dated 12/29-1/5) is out and I was asked to contribute a bargain investment idea from the currently depressed market. My pick (on page 58) was Anheuser-Busch InBev. I am on vacation through 12/27 but I will write about this newly created beer giant in more detail when I return. For those of you who do not have access to the magazine, I made a PDF file:

Business Week Investment Outlook – 12-29-08 (Page 58)