Conoco Phillips Analysis

Let us look at Conoco again after the rumors that Warren Buffett is doing something with the stock. We will key off our analysis from FY08 Q2 report as well as FY07 annual report.

Let us look at the proven reserves and the estimated cash flows from proven reserves. Conoco provides an estimate using 2007 year-end prices and costs (adjusted only for existing contractual changes), appropriate statutory tax rates and a prescribed 10 percent discount factor. It also assumes continuation of year-end economic conditions. The calculation is based on estimates of proved reserves, which are revised over time as new data become available. The future cash flows has been trending up primarily because of the increase in crude prices. It has jumped from 51 billion to 67 billion dollars from 2006 to 2007.

In Q2 conference call, the management said that there wont be any more major acquisitions in the near future as it won't provide additional value to share holders. Also ,at the end of Q2, the book value was close to $62/share. Of this, $20 billion came from the Lukoil investment. This has fallen somewhat since the Russian invasion of Georgia and also the subsequent oil price drop. It is likely that oil prices will remain high in the future as there are no significant new discoveries to offset depleting oil fields. COP is also in talks with Petrobras to do some joint venture in some areas ( specifics not known ). The company is also spending significant amount of cash to buy back shares.

The oil prices have since jumped up by about 15% since the end of 2007. This has led to the decline in usage of oil in the US by about 3% year over year. COP has also allocated about $10 billion to buy back its shares. This combined with the increase in gas prices lead one to believe that book value of COP will keep increasing at a steady pace through this year and next.

From a price to cashflow as well as price to book perspective, COP looks more attractive compared to the other oil majors at this point in time.

BRKA Q2 Analysis

Berkshire Hathaway filed its Q2 earnings on 08/08/08. I was hoping Berkshire to report headline grabbing mark to market losses with derivatives. This would have opened a buying opportunity for me. However, it turns out that Berkshire had less mark to market losses.

Let us look at the balance sheets to see how Berkshire did.

The shareholders equity took a small drop (2.3%) compared to December 31st. Berkshire's stock holdings have taken a mark to market drop of abotu 5.5 billion in the six month period which have since recovered. In the first six months of the year, 26.7 billion of fixed income securities were bought along with 5.5 billion of equity securities. ( 11.9 billion dollar worth of securities were sold as well ) Overall, in the first six months, 19.4 billion dollars were deployed.

Let us look at the cash flow from operations. This declined to 4.99 billion from 7.43 billion from the corresponding period last year. It is a 33% drop, primarily attributable to the reinsurance market slump.

Interestingly, the interest, dividend and other investment income came in at 2.4 billion for the first six months at par with last year. This should increase in the coming years because of the large investment in the fixed income category.

Insurance underwriting gain declined this year compared to last year. The decline was across all insurance sectors with the exception of Berkshire Hathaway Primary Group. BHAC, the monoline insurer is now operational in 49 states. This sector is expected to be lumpy in earnings and very few reinsurance contracts were written in the first six months of the year.

Utilities section continues to do well with earnings fallling slightly for the quarter but up for the first six months.

Manufacturing, service and retailing continues to do wel in a tough environment. The total revenues jumped up to 17.49 billion from 14.98 billion thanks to the Marmon/TTI acquisition. Earnings also increased by 11.5%. The general trend in manufacturing/retail is that revenues are up but income is down. This is a trend across all businesses as we see increased inflation but that can't be passed on to consumers.

Finance and financial products also declined somewhat compared to the prior year. Manufactured housing, furniture/transportation leasing hasnt fallen off a cliff but are down nominally.

In general, going by strict quantitative analysis, the IV is around 142K/A share. However, IV is also the potential cash that can be taken out of the business in its life time. With this calculation, under normal economic conditions, the IV will be closer to 150-160K/share.

Sardar Biglari letter

http://www.western-sizzlin.com/pdfs/Chairmans%20Letter%202007.pdf

A great letter in the Warren Buffett mould:


1
WESTERN SIZZLIN CORPORATION
To the Shareholders of Western Sizzlin Corporation:
In 2007 Western continued its evolution as a holding company in order to
maximize intrinsic business value on a per share basis.1 To achieve our objective, we
have made the conscious decision to be in the business of acquiring other businesses. To
describe our performance accurately, we must begin this year’s report with a few
comments about accounting because, depending on the percentage of voting stock
owned by Western in other businesses, under generally accepted accounting principles
(GAAP) three major categories are used for reporting our results.
GAAP dictates that we consolidate the financial statements (including income
statement and balance sheet) of businesses in which we own more than 50%. Western
Sizzlin Franchise Corp. (“WSFC”), 100% owned by Western, is an example.
Consequently, we fully record all the sales, expenses, assets, and liabilities of WSFC.
Businesses in which we own between 20% and 50% impact our income statement
in a different manner, termed the equity method of accounting. Their earnings are posted
as a single item on our consolidated income statement. For example, we have a 50% joint
venture in a Wood Grill Buffet restaurant; yet on the income statement, you will notice
just a one-line entry of our portion of profits or losses. Unlike businesses in which we
own the majority of shares, the revenues and expenses are not itemized on Western’s
consolidated income statement since we do not own the stipulated 50% plus of Wood
Grill Buffet.
Then we possess holdings in which our ownership is under 20%. GAAP
prescribes that Western cannot enter the earnings of such investees on its income
statement, and that only dividends received should be listed on it. In past years, such
investments did not affect Western’s income statement (unless shares were sold).
However, last year we decided to transfer most of our marketable securities to an
investment partnership, Western Acquisitions, L.P., in which we have limited partners
investing alongside us. Because of the limited partners, the partnership is deemed an
investment company, and accounting rules further stipulate that fluctuations of the
market price of our holdings are applied to earnings every quarter. Thus, the actual
earnings of our investees are not incorporated in our income statement; rather, the
market value changes, either up or down, are identified as part of our “earnings.” And,
to complicate matters even more, stocks that we hold outside the partnership are treated
differently; here, changes in market value affect our net worth but do not appear on the
income statement unless the shares are sold.
We have provided the abridged outline of accounting rules because Western
owns portions of businesses ranging from less than 1% of the voting stock to 100%. This
view is particularly important to positions in which ownership is less than 20% because
1 Intrinsic value is computed by taking all future cash flows into and out of a business
and then discounting the resultant number at an appropriate interest rate.
2
investees’ earnings are not recorded in our operating earnings, even though the unstated
amount may exceed listed figures. Consequently, our approach to GAAP earnings is
simple: We ignore them. Phil Cooley, Vice Chairman and my partner, and I make our
own assessment of the value of Western by accounting for all cash flows, whether we
own 1% or 100% of another concern, to arrive at Western’s “economic earnings.” It is
our ownership of our holdings and therefore our claim on cash flows that are relevant.
Accordingly, we account for the cash flows of businesses we own in whole and in part to
compute Western’s total cash flows. Our claim on the unaccounted cash flows from noncontrolled
businesses and their subsequent use is of great import to us. The growth of the
aggregate cash flows of the businesses we own — both controlled and non-controlled —
will signify the growth in Western’s intrinsic value. Our view, we warn you, is
unconventional. Then, again, our mindset is geared to pay attention to what counts and
not to how the numbers are counted under GAAP.
While we do not disclose our estimated values of the businesses we own in whole
or in part, we do provide the information you require so that you can construct your
own appraisals. We arrive at our personal valuations independent of the accounting
values for wholly-owned businesses or for the values the market places on our partiallyowned
ones. Stock market values at times are capricious, and we caution anyone about
equating them with intrinsic values.
We operate under a highly decentralized management structure with financial
decisions centralized only at the holding company. The returns on invested capital from
the operating businesses combined with my capital allocation work produces Western’s
overall return which, according to our criterion, must exceed the S&P 500 Index. Over
time, we are focused on seeking a rate of growth in Western’s business value that
surpasses the total return measured by the S&P. I am confident that the operating
businesses we own will deliver good-to-great returns on capital; my responsibility is to
reinvest the surplus cash in a manner that improves overall corporate results.
Western Sizzlin Franchise Corp.
Our largest wholly-owned subsidiary, WSFC, which franchises and operates 117
restaurants, is our main source of operating earnings.
Years Ended December 31,
2007 2006
Income from restaurant and franchise operations ...................................... $ 507,773 $ 572,210
Plus: Depreciation and amortization expense ........................................... 1,063,017 1,057,492
Plus: Claims settlement and legal fees associated with lawsuit ................ 741,287 289,109
Income from restaurant and franchise operations (excluding depreciation
and amortization expense and expenses associated with the lawsuit) ........ $ 2,312,077
$ 1,918,811
In 2007, our restaurant and franchise operations did well as profits increased by
20%. The major contribution to this heightened performance stemmed from our 50%
joint venture in Wood Grill Buffet. However, same-store sales decreased by
approximately 1% for both franchise and company-operated restaurants. While we seek
improvement in comparable sales, our approach is not simply to escalate sales at any cost
$
$
3
but to do so profitably. We want to attain increases in same-store sales through boosts in
guest traffic rather than by inflating menu prices. Thus, our focus is on understanding
customer value — by providing enticing offerings that will engender a lasting and
profitable relationship.
In 2006 and 2007 we cut unnecessary expenditures without curtailing the
services we provide our franchisees. For example, we moved offices from a venue in
which a number of offices were vacant to one that is more appropriate to our needs and,
best of all, will save us annually around $74,000 in rent. Moreover, we have trimmed a
number of like expenses to become more productive. Yet while we continue to fight
costs to save wisely, we have concurrently pursued investments in our core business to
expand franchised openings. Although these expenditures increase our operating costs,
in our mind, they are a form of investment that should supplement our long-term cash
flows. As a corollary, we must ensure the health of the existing franchise system.
Total capital expenditures for company-operated stores were $35,493 in 2007,
and in 2008 we expect them to approximate $50,000. We view these outlays as expenses
to maintain operations even though they do not appear on the income statement.
As I wrote in previous letters, lawsuits have plagued our company. In the 2005
letter I had deemed certain legal costs a one-time expense, but in last year’s letter I wrote,
“I was wrong. Shortly after the [2005] letter we were slapped with another lawsuit.” This
litigation has cost us nearly a painful $1 million. As an investor, when I see the term
“one-time” expense repeat every few years, I no longer designate it as “one-time,” but as
“habitual.” In our case, the recent significant legal liabilities stemmed from past years
when WSFC’s former management made the unsound decision to lease properties under
unfavorable terms. Because of the failures to recognize and remedy past problems, I
have made the decision to become more involved and to that end have assembled the
appropriate legal counsel. As for future exposure to litigation, we now have only one
more sublet arrangement (expiring later in the year), and we are assiduously working
through any issues to avoid future liabilities. Consequently, by the end of the year we no
longer will need to report the expense line “subleased restaurant property expenses.”
In my view, we are displaying signs of progress. We are pleased that in December
2007 a new franchisee started an updated yet still traditional Western Sizzlin concept with
a smaller footprint. This Parkersburg, West Virginia store is expected to generate sales of
approximately $3 million in its first year of operation. The unit economics are very
attractive with a sales-to-investment ratio of 1.5:1. In addition, a newly recruited
franchisee in California later in the year will introduce the first Wood Grill Buffet there.
Whether the store is a Wood Grill Buffet or a Western Sizzlin, we are happy with the unit
economics for a franchisee. Because we have proven concepts, our key task is to
encourage potential operators to learn that these outlets are accessible and lucrative. (Call
Jerry Plunkett at 540-345-3195
if you’re interested in becoming a restaurateur
representing our brands.)
We entered into a joint venture in 2005 to build a single Wood Grill Buffet
restaurant of 12,600 square feet, seating 400, located in Harrisonburg, Virginia. This
venture has been exceptional mainly because of our partner in the project, W.E. Proffitt,
who because he knows how to run a buffet concept to perfection, lives up to his name by
producing exceptional profits. W.E. has day-to-day operating responsibility for the
business. The decision to team up with W.E. was easy, given his success at his other
4
restaurant located in Charlottesville, Virginia, which is also generating around $5 million
in revenue.
Below is the result for the Wood Grill joint venture for 2007:
Year Ended
December 31, 2007
(unaudited)
Statement of Operations Data:
Total revenues ............................................................................. $ 4,960,695
Food............................................................................................ 2,110,602
Labor........................................................................................... 1,502,077
Marketing.................................................................................... 204,374
General and administrative .......................................................... 404,106
Depreciation and amortization ..................................................... 200,869
Interest ........................................................................................ 223,574
Earnings (loss)............................................................................. $ 315,031
In partnering with W.E., we formed a jointly-owned entity that borrowed $3.3
million with each partner contributing $300,000 in capital for a total investment of $3.9
million, which includes land and building. Western also guaranteed 50% of the bank
loan. Last year, earnings before interest, depreciation, and amortization but after capital
expenditures were $726,479. The return on invested capital was 18.6% with a free cash
flow2 return on equity capital of 83.8%.
Needless to say, we like the unit economics of Wood Grill, and as evidenced by
our experience, we think it can make an effective operator a healthy stream of income.
It’s a concept based on the sound premise of delivering great values to consumers, whose
patronage in turn delivers great returns to the owners.
Mustang Capital
We are in the process of purchasing 51% of Mustang Capital for $1,173,000.
John Linnartz is the founder and managing partner of Mustang, an investment
management firm with approximately $55 million in client assets. (For sharp-eyed
readers, we are technically purchasing a 50.5% limited partnership interest in Mustang
Capital Advisors and a 51% membership interest in Mustang Capital Management, which
owns a 1% interest in Mustang Capital Advisors as its general partner.) Western plans to
pay a total purchase price of $300,000 in cash and $873,000 of Western’s common
stock, priced at $16 per share.
I met John a few years ago at a Christmas party held by an accounting firm
servicing our respective investment companies. As two value investors, John and I
naturally gravitated to a corner to discuss pink sheet stocks. His knowledge is impressive;
as a sample, I gave him a few facts about a certain stock, and he identified the company
simply through my sketchy data.
2 Free cash flow represents earnings plus depreciation and amortization minus capital
expenditures.
5
The next time I saw John was last year in New York at Western’s annual meeting,
as he then was one of our largest shareholders. Several months later he asked for a
meeting and broached the idea of Western’s purchasing his business, a proposition I
immediately embraced. To John, price was not the primary factor; rather, he wanted a
good home for his business and also wished to continue running it. His investment
record, founded on a very stable client base, is phenomenal. He will continue to operate
his business as before.
We believe that other money managers like John would find Western an ideal
solution to monetize a portion of their business, establish a succession plan, and be part
of a public company without being saddled with all the drawbacks: e.g., meeting with
analysts, regulatory filings, press interviews, and so on. Furthermore, they could
continue to run their business as they had before we purchased them. Phil and I are
excited about the prospects of working with John, and we expect that Western
stockholders will be equally excited about the value added from this acquisition. If you
plan to attend the annual meeting, be sure to say hello to him.
(Mustang, through its funds and its managed accounts, held approximately 7.2%
of Western's common stock. However, at the closing of the transaction, Mustang’s funds
will distribute Western’s stock to their limited partners.)
Friendly Ice Cream Corp.
In my letter to you last year, I wrote concerning our plans for one of our then
largest equity positions, Friendly Ice Cream Corp. Shortly after writing you on June 8,
2007, a week later, the company agreed to be purchased by Sun Capital Partners, a
private equity firm, amounting to $15.50 per share or $337 million (which included the
assumption of debt). Because of Massachusetts law, which requires the affirmative vote
of the holders of not less than two-thirds of the outstanding stock to approve such a
transaction, Sun indicated privately to us that unless we contractually agreed to the offer,
it would not buy Friendly. Because the price reflected full value and it was the right
decision for all shareholders, we concurred with the transaction.
Friendly was a fascinating situation for Phil and me. It epitomized our love for
great businessmen like Friendly’s co-founder, S. Prestley Blake. Moreover, we were not
the only ones who thought Friendly’s situation was thought-provoking. Harvard
Business School made our proxy fight and Prestley’s lawsuit with Friendly’s top
leadership the subject of a case study. Professors V.G. Narayanan and Fabrizio Ferri
along with Senior Researcher James Weber wrote an extraordinary study, adhering to the
facts with admirable accuracy. You may order a copy of the case by visiting
http://harvardbusinessonline.hbsp.harvard.edu. I will refrain from recounting much of
what you can read in the case.
We started purchasing the stock for Western in July 2007, accumulating 531,318
shares by the end of 2007 at an average price of $8.54. This purchase price in relation to
the buyout amount was approximately 82%.
6
The Steak n Shake Company
Around the time Friendly announced its intentions to sell, we began investing in
another restaurant chain that like Friendly boasted an iconic brand but had also fallen on
hard times: Steak n Shake.
The company was started in 1934 by A. H. “Gus” Belt. In the years since its
founder passed away in 1954, the ownership has changed hands three times. Luckily for
the business, in 1981 E.W. “Ed” Kelley sealed the contract to purchase the company and
began to grow it. Over the next two decades under Kelley, the chain snowballed into a
great restaurant company. Unfortunately, Kelley’s decline in health in 1998 reduced his
role in the firm, and the health of the company began to deteriorate. For the next ten
years, the company increased its top line but failed to create shareholder value for the
capital that it retained in the business.
Observing that the firm’s predicament had culminated in lowering its stock price,
I allotted capital from Western to purchase shares amounting to 5.4% of Steak n Shake.
The ownership reported in our public filings, however, is 13.2% because of The Lion
Fund, L.P. and other shareholders who are acting in concert with Western. Consequently,
our group represents the largest stock ownership in the company. Members of the group
consist of a couple of Ed Kelley’s former business partners, one of whom includes the
former Vice Chair of the company, S. Sue Aramian, Mr. Kelley’s right hand person.
On August 13, 2007, Phil and I traveled to the company’s headquarters in
Indianapolis, scheduled to visit with Peter Dunn, then CEO, and Jeff Blade, CFO. Thirty
minutes before our meeting, we read on the wire that Mr. Dunn had resigned. Alan
Gilman, at the time chairman of the board, was appointed interim CEO. Consequently,
we met only with Messrs. Gilman and Blade, and by the end of the meeting we asked for
two board seats to help restore and unlock the value inherent within the company. After
several months during which the desired results were not forthcoming, we initiated a
proxy contest. In addition to mailing letters to shareholders, we set up the website
enhancesteaknshake.com to communicate with all stakeholders.
Of course, a proxy fight is only a prelude to improving the performance of a
company. The proxy contest accomplishes a change in the boardroom, which alters the
dynamics of the leadership in a company. To us it was the last resort, but one that we felt
forced to take; Steak n Shake’s former leadership had lost sight of its purpose.
In proxy contests, several proxy advisory firms are in business to advise
institutional investors on how to vote. Phil and I received the backing of all major
advisory firms: Institutional Shareholder Services, Glass Lewis & Co., Proxy
Governance, Inc., and Egan-Jones Proxy Services. The net effect at the annual meeting
on March 7, 2008 was that these recommendations along with the support of
shareholders eventuated in our winning two board seats in a landside with 74% of the
votes cast in our favor.
Steak n Shake’s intrinsic value per share has been declining. While the economy
provides a difficult environment for restaurants, the company’s performance is
unacceptable. What attracted us to Steak n Shake was the power of the brand, its real
estate, and the chain’s ability to generate substantial cash inflows. Even though Steak n
Shake has experienced larger operating shortfalls than I anticipated when I began
7
purchasing the stock, its problems Phil and I believe are fixable. Thus, we believe in the
company’s long-term prospects.
The former management’s revenue strategy in the new millennium — to grow
top line without achieving the proper return on invested capital — was fallacious. Theirs
was a case of opening stores without the proper management systems and operational
capabilities in place to execute effectively, a mistake culminating in low returns on
invested capital. Nevertheless, we think that the situation can be remedied if the
principles, objectives, and alterations we have in mind are implemented.
The primary objective of Steak n Shake’s board and management must center on
intelligent ways to maximize the intrinsic business value of the company on a per share
basis. This long-term view will keep leadership disciplined to create value on an
enduring basis. Otherwise, it is easy to become myopic — with detrimental results. It is a
requisite to begin to implement certain strategic initiatives to create substantial and
sustainable shareholder value. The reasons underlying these imperatives are that the
record clearly shows, in quantifiable terms, that during the last ten years approximately
$566 million in capital has been spent, yet operating profit declined and negative
shareholder returns were produced!
Steak n Shake has exemplified the antithesis of a value-based strategy, proving
that sales growth is not tantamount to value growth. Growth at a competitive
disadvantage — when cost of capital exceeds return on capital — destroys shareholder
wealth. The decision to plow money back into low-return investments has resulted in the
detrimental effect of lowering the price of the stock. A larger company has been created
with more company-operated restaurants, but shareholders have been denied the
opportunity to reinvest their capital elsewhere in more remunerative opportunities. In our
proxy contest, we advocated that a moratorium be placed on new store openings.
We continue to espouse the notion that the company focus on the generation of
free cash flow and the judicious reinvestment of capital, a policy intended to maximize
the value per share of the company. It can no longer allocate capital without considering
opportunity cost. If intrinsic value per share increases, the stock price will eventually
follow suit.
In pursuit of optimizing free cash flow, the uppermost levels of leadership must
constantly review projects and eliminate the unnecessary ones to curtail nonessential
spending. Equally important is to take the savings from excess spending and reinvest
Steak n Shake’s Capital Allocation Record
($ in thousands)
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 10 Yr.
Change
Revenues $295,944 $350,879 $408,686 $445,191 $459,014 $499,104 $553,692 $606,912 $638,822 $654,142 $358,198
Growth per Yr. – 18.6% 16.5% 8.9% 3.1% 8.7% 10.9% 9.6% 5.3% 2.4% –
Pre-tax Profit $ 32,850 $ 30,602 $ 33,204 $ 32,366 $ 36,044 $ 32,424 $ 42,438 $ 44,444 $ 42,292 $ 14,871 ($17,979)
Growth per Yr. – (6.8%) 8.5% (2.5%) 11.4% (10.0%) 30.9% 4.7% (4.8%) (64.8%) –
% of Revenues 11.1% 8.7% 8.1% 7.3% 7.9% 6.5% 7.7% 7.3% 6.6% 2.3% (8.8%)
Capital
Expenditures
$ 51,430
$ 66,974
$ 75,765
$ 39,910
$ 41,351
$ 30,707
$ 46,278
$ 63,622
$ 80,840
$ 68,643
Cumulative Capital Expenditures (10 Year Period): $565,520
Source: As Reported in SEC filings
8
those funds prudently. Complying with the maxim to save wisely and invest sensibly is
imperative to turn Steak n Shake around. But turnarounds cannot turn without
management’s reducing unnecessary overhead. General and administrative (“G&A”)
spending must be limited to appropriate levels. The reduction in G&A should become
part of the corporate culture at Steak n Shake to conserve resources and to distribute
them productively.
Towards that end, just returning to past G&A levels — on a per unit basis —
would save the company around $15 million annually. Bottom line: Steak n Shake like
WSFC is in the penny-profit business. We continue to believe that a great deal of money
has yet to be saved at Steak n Shake’s headquarters and at the store level.
In altering the corporate culture, we must select an entrepreneurial CEO who will
be relentless in fighting costs, who will concentrate on the customer by leading
employees and franchisees to champion a common standard of quality, service, and
cleanliness. The culture of the organization should revolve around capitalizing on the
mental prowess of entrepreneurs. With the right leadership team, the company can
become more nimble and inventive as it adheres to principles and practices placing a
premium on individual performance.
The CEO must be a vigorous leader willing to instigate grassroots searches to
improve operations. Steak n Shake must adapt to the very sharpest ideas and practices
pervasive in the marketplace. Borrowing or emulating the most effective industry
methods is essential to molding a profitable restaurant chain. As Wal-Mart founder Sam
Walton once said, “Most everything I’ve done I’ve copied from someone else.” At Steak
n Shake, we can learn a great deal from other highly resourceful retail and restaurant
businesses.
We want Steak n Shake to be best-in-class in product, in menu, in customer
metrics, and in financial returns. Every day, roughly a quarter of a million people go
through Steak n Shake restaurants; the quality of their overall experience will ultimately
determine whether they will increase or decrease their number of visits. The pleased
guests will certainly spread the good word that their listeners ought to visit frequently,
whereas the displeased guests can hugely damage future traffic. An organization that is a
standout for its employees, franchisees, and customers will ultimately be a standout for
stockholders.
Current plans must focus on turning around operations with unit economics that
are attractive for the company and its franchisees. Over the longer term the company
should strategically zero in on growth through franchising. Franchising represents a
strategy of disciplined unit growth by leveraging the brand with market penetration in a
manner that begets low-risk revenue and high-return cash flows. Such a long-range plan
would yield numerous benefits: It would allow management to concentrate on propelling
the value of the brand by allotting more resources to development of better products,
improved quality control, shrewder marketing practices — all resulting in better overall
productivity, resource allocation, high returns on capital, and significant free cash flow.
Thus, the company should be in the franchising and real estate businesses for the cogent
reason of maximizing return on capital while concurrently minimizing cost of capital —
a powerful combination that would lead to creating value for all shareholders.
9
Improvement of store-level profitability, growth through franchising, reduction
of corporate G&A, focus on generation of free cash flow, share repurchases, pay-forperformance
compensation, a more effective governance board — these are strategies we
have in mind to enhance the value of the company. Western’s 5.4% equity interest in
Steak n Shake represents about $33 million of revenue, larger than WSFC’s entire
restaurant and franchise operations. Consequently, we are working with the board so we
can become more involved with the company, effect necessary changes, and invite in the
right CEO.
Thus far, the investment result has been dismal. But we think that it will improve.
ITEX Corp.
ITEX is in the business of barter, functioning as the clearinghouse for
approximately 24,000 member clients through a franchise network. Barter is the oldest
form of commerce, so we are going back a few thousand years with this concept. Instead
of businesses bartering directly with each other, ITEX provides a marketplace for its
member clients to purchase goods and services from one another utilizing trade credits,
which are administered through ITEX’s bookkeeping system. Thus, ITEX manages the
marketplace and acts as a third-party record-keeper, charging its members a percentagebased
transaction fee as well as an association fee.
By now you may wonder why one would use ITEX when ages ago a convenient
medium of exchange had been invented, money. ITEX has in essence an alternative
monetary system using its own unique currency. ITEX’s exchange, or bartering, can be
another source of revenue for most businesses, particularly those with excess inventory
or capacity. Instead of unused products lying fallow and services remaining
unproductive, bartering opens the door for firms in like situations to work with one
another. Thus, it’s an effective way to enter new markets or reach clients who otherwise
may not have paid cash. I myself have been using barter services since I was 13 years
old. ITEX helped me launch my early ventures. In fact, years ago I paid for office rent
and obtained office furniture all through the barter exchange. At our operations in
WSFC, we have been utilizing the bartering program since early 2007.
ITEX’s business is attractive to us because, as a franchise system like WSFC, it
generates stable cash flows and pleasing returns on capital. Initially, we sought to
purchase the entire business, making an unsolicited tender offer at an exchange ratio of
.06623 shares of Western common stock for each outstanding share of ITEX’s common
stock. While we believe the value of ITEX would be enhanced as a wholly-owned
subsidiary of Western, for reasons such as elimination of redundant public company
costs and potential revenue sources, ITEX management vehemently opposed the
transaction. Nonetheless, we proceeded, and we thought we probably would have
succeeded if we upped our offer, a move which we vehemently opposed (for reasons we
explain in the next section). But the shareholders who did wish to tender their stock were
given the opportunity to do so as we revised the offer and in the process increased our
ownership by 5% of the company. We had previously purchased 4% in the open market
with cash. Therefore, we currently own approximately 9% of the company and are its
largest outside shareholder, a position that leaves us quite comfortable.
10
Stock Issuance
Because our goal is to maximize the value per share of Western, we are
concerned both with the numerator, intrinsic business value, as well as the denominator,
the number of shares. When considering a share issuance in purchasing a business, we
follow a basic policy: We will issue shares only when we receive as much or more
intrinsic value on a per share basis. What concerns us is not whether an acquisition is
accretive to earnings per share but whether it adds to intrinsic value per share.
In negotiated acquisitions, the price paid often is so high that any potential
benefit to the buyer is negated. In our analysis we have found that acquisitions
predicated on cost savings usually have a more successful outcome than do ones based
on revenue generation. Unfortunately, synergy often has been used as a pleasant word in
mergers and acquisitions to justify a premium when in fact synergy did not exist. A
significant premium, incidentally, is not necessarily a concern if it can be defended. We
do not look for acquisitions on the basis of synergy; rather, we seek to capture the value
of non-integration. Non-integration has value, and as a holding company we plan to
capture that value in allowing acquirees to retain their autonomy. The cost is lack of
synergy, which we believe is overrated, whereas non-integration is underrated.
Acquisition Goals
We will continue to seek ownership in businesses in their entirety as well as in
part. When purchasing a controlling interest, we will do so only at a sensible price. While
we remain flexible in structure, our basic criteria for a business acquisition are that the
acquiree comes with intelligent management who has historically produced healthy cash
flows and earned high returns on invested capital. Therefore, we are not interested in
somewhat chancy new ventures, as promising as they may appear to be.
If the principals in a business are interested in becoming a part of Western
companies, we would welcome hearing from them.
Western Real Estate
Western purchased 23.5 acres of land in San Antonio through Western Real
Estate, L.P. on December 13, 2007 for $3.75 million. The property is near an 800-acre
mixed-use development, The Rim, in one of the most robust and fastest growing areas of
the city. We knew that all 23.5 acres were not usable, but after the due diligence we
received reliable data and was in a position to offer a price and close on the transaction
expeditiously. The price was favorable in relation to the property’s potential usability.
We received attractive financing from our friends at Wachovia Bank. They have
provided a $2.6 million note at prime minus 50 basis points, which at the date of this
letter stood at 4.5%. We are delighted with the after-tax carrying cost of around 2.8%.
Thus far, we have not accepted outside money for Western Real Estate, L.P. although
certain parties remain interested.
The entitlement process began as soon as we purchased the property; of course,
this process will increase our costs but eventually should lead to sufficient cash flows
when compared to our total investment. There is value in converting non-income
producing real estate to one that is producing. With many of our investments, but
11
particularly with real estate development, it pays to follow Benjamin Franklin’s advice:
“He that can have patience can have what he will.”
NASDAQ Listing
Earlier this year, on February 25, 2008, Western’s shares were listed on the
NASDAQ Capital Markets and now trade under the symbol WEST. Our decision to list
on NASDAQ was driven by our desire to reduce the transaction costs for our
shareholders.
Over the long haul, the most investors can earn from a stock is equal to the
profits achieved by the business less transaction costs, namely the commissions charged
by brokerage firms and the net spreads realized by market-makers. We attempt to attract
long-term shareholders who seek to profit in concert with the business and not from the
faulty reasoning of their co-shareholders on the value of the company. Irrespective of
the exchange on which the stock is listed, we have connected with the right shareholder
base. Phil and I have been pleased by the quality of our shareholders — savvy long-term
business owners. Because we view Western as a medium through which shareholders, not
the company, own the assets and claim the profits, we are ultimately concerned about the
pre-tax return of our shareholders.
The legal and listing fees in connection with our presence on NASDAQ were
approximately $90,000 and expensed in the first quarter, 2008. We expect that this
amount is far less than the long term savings on our shareholders’ transactions. Clearly,
we are not income statement driven, but rather we are concerned with the long-term
economic consequences of our decisions for our shareholders.
Board of Directors
In 2007 we added two new board members: Kenneth R. Cooper and Martin S.
Fridson. Ken, a real estate attorney who has been a trusted friend, is also able to proffer
valuable assistance with Western’s real estate transactions. Marty is the master when it
comes to the junk bond market. Marty and Phil knew each other over the years, at one
point serving simultaneously on a non-profit board. I first learned of Marty when I was
an undergraduate student in Phil’s investment class because Phil required his entire class
to read Fridson’s book Financial Statement Analysis. Last fall, Phil and I visited with
Marty about his joining Western’s board, and shortly thereafter he enthusiastically
agreed. While I enjoy all of Marty’s writings, I recommend your reading his latest,
Unwarranted Intrusions: The Case Against Government Intervention in the Marketplace,
one of my favorite volumes from 2007.
Rights Offering Redux
Last year I offered an explanation of the use of a rights offering, which you can
read by accessing the letter on our website.
In 2007, as in 2006, we initiated a rights offering. We raised $7.6 million in 2007
and $4.2 million in 2006. In both years Western did not hire an investment banker to
assist with the rights offering. As I mentioned in last year’s letter, flotation costs (namely
issuing expenses, e.g., legal, printing, accounting, and numerous smaller associated
outlays) would be quite low in 2007. Actually, expenses were remarkably low at 1.3% of
issuance, resulting in net proceeds of $7.5 million.
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Phil and I are puzzled why more companies do not initiate rights offerings
because it is an excellent method to raise equity capital and minimize costs. (No
investment banker fees perhaps!) When boards and management review their alternatives
in equity financing, they invariably opt to sell discounted shares to outside parties along
with paying high underwriting fees — the effects of both are to the detriment of their
shareholders’ net worth. Not only are flotation costs much lower in rights offerings than
they are in most other forms of equity offerings, but they are a quite equitable method
and provide all shareholders equal terms.
* * *
As the former CEO of Coca-Cola, Roberto Goizueta once articulated, “We, in
business, do have a calling. We have a calling to reward the confidence of those who
have hired us — and to build something lasting and good in the process.” This is our
guide as we attempt to grow Western’s value in many dimensions. We seek to utilize all
available options to create value. We have a strong balance sheet and plan to conduct our
affairs in a manner to maintain extreme flexibility. We are willing to trade near term
performance to maximize long-term value and in the process strengthen Western.
However, we should warn you that our methods will produce erratic results but ones we
believe will be above par in the long haul. If volatility in operating performance
unnerves you, then Western’s stock is not for you.
Annual Meeting
Our annual meeting will be on Wednesday, July 9, 2008, in New York City at the
St. Regis Hotel. Annual meetings represent ideal times to communicate with a number of
shareholders simultaneously. The bulk of the meeting will center on answering your
questions. We will begin at 1:30 pm and continue until all your questions are answered.
To be fair to all shareholders as well as to be efficient with our time, the annual
forum is a surrogate for one-on-one communication. While we cannot respond to
individual inquiries throughout the year, we will gladly spend as many hours as
necessary to answer shareholder questions at the annual meeting.
We have attempted to set forth our principles in this as well as in past letters and
hold annual meetings that are informative. I find our annual letters and annual meetings
to be practicable media to attract like-minded shareholders who embrace the
multidirectional nature of Western’s future. Because the management of most companies
is consumed by quarterly computations and pursue targeted, preconceived results, they
attract shareholders with similar time horizons and expectations. We, on the other hand,
think in terms of decades. Of course, quarterly and annual performances are important to
us but not at the expense of generating higher long-term value. Our approach may be
unconventional, but we find it to be more productive and sensible than conventional
methods.
We look forward to welcoming you on July 9th.
Sardar Biglari
June 10, 2008 Chairman of the Board

Berkshire Hathaway Q1 Analysis

In this article, we examine Berkshire Hathaway's Q1 numbers and try to put an intrinisic value around the business. First, we will look at Berkshire's performance relative to SP500. Secondly, we will look at the strength of operating businesses. Then we will take a look at new investments. Lastly, we will take a look at overall outlook for the business.

The SP500 index dropped by about 7% in Q1 of 08. Compared to this, Berkshire's share holder equity dropped by 1.2% in the same period. So Berkshire handily out performed SP500 in Q1.

Let us next look at the operating businesses and cash flow. The insurance premiums earned declined by half - this is primarily because of the decline in premiums in the Berkshire Hathaway ReInsurance Group. Overall, there was a 22% drop in revenue. In the utilities sector, there was a slight gain in the mid american unit. In the finance/financial products sector, there was a mark to market loss of 1.6 billion. It is unlikely that this loss will be realized as the losses are on a logn term PUT option that is unlikely to be paid out. Taking this out, the Q1 earnings are roughly comparable to Q1 of last year.

Of all the businesses reported, Berkshire Hathaway Reinsurance Group has reduced the number of policies it is underwriting which contributes to the decline in revenue. Other operating companies have continues to do well in the face of a tough economy. Not writing insurance policies when the pricing environment is not right is a good way to operate the business. So, this points to good underwriting practices.

Then, the last piece of the puzzle is investments. From the balance sheet, the cash flow from operating activities declined to 3.3 billion from 4.6 billion for the quarter. On the other hand, 10.5 billion dollars were deployed in fixed income securities in the quarter. 1.5 billion was spent on equities. 4.8 billion was deployed to acquire Marmon group with further capital outlays in the future. Cash and cash equivalents declined by about 9 billion dollars in the first quarter. It declined by about 10.5 billion on a year over year basis. With another six billion pledged for the Wrigley deal, the 30 billion dollar barrier is close to being broken. If the bear market is prolonged as Buffett thinks, it is likely that more investment opportunties will arise for Berkshire and money will be deployed.

The IV of the company is 147K per my estimates as of end of Q1. It should be around 155-160K range as of now because of the stock market rebound. If the stock drops, it should provide a great entry point this year.


In case of a dip in the markets next week, it may present a great buying opportunity for a company which will continue to grow in the 10% range in the long term.

Berkshire Hathaway FY2007 Analysis

Berkshire Hathaway (BRK) reported its yearly earning on Friday, 29th of February. The comapny did well, advancing its book value by 11% compared to 2006 and beating SP500 handily. SP500 returned 5.5% in the same period. Berkshire has beaten SP500 for three years in a row now.

Some special notes from Buffett's letter:
Return on invested capital on See's candy - 200+%
Return on capital in Flight Safet - 27%
Return on capital in Microsoft - ~100%.

See's candy is a better business than Google or Microsoft, though a lot smaller in scale :-). Microsoft's profit margins and return on capital likely will continue to erode.

The other point of interest is the value of stocks owned by Berkshire is now 75 billion dollars. There are several that will do well in the next three-five years, some probably by a huge margin. In the mean time, they will kick in dividends to Berkshire in the range of a billion+ dollars a year. The stock portfolio will be at 95 billion with just 8% return in the next three years.

Warren Buffett has invested about 27 billion dollars in the last two years. All the free cash generated in the last two years has been deployed and will continue to get deployed in the next two-three years. I expect the free cash on the balance sheet to decline on a year over year basis in the next two-three years. The way cash is generated, even if the cash is deployed in the last three year's pace, we are looking a total of around 65 billion dollar investment from 2005-2010 inclusive. If one gets a return on capital of 10%, ( 10.8% is Berkshire historical record ), one an look at earnings going up by about 30%. Meanwhile the stock portfolio should also increase by about 25-30% excluding dividends.

I put my intrinsic value between 148-156K for berkshire at the end of 2007. It should be possible for the IV to go north of 200K by the end of 2010. This is a conservative estimate and the actual returns could be much higher.

CarMax KMX Analysis

KMX is mostly a used car dealer with attention to quality, no haggle pricing and low prices. It offers to remove the hassle in used car buying. I checked out the carmax.com website and the prices for the cars I saw were cheaper than the ones available with the dealer. KMX also has four new car selling facilities. Given the mix of new vs old cars ( 30-70 ) as well the expansion plans of KMX, it is likely that KMX will continue to see volumes of scale as it expands.

KMX was spun off from circuit city stores in 2002 as an independent entity, KMX was founded in 2002 in Virginia and currently has 81 stores in the country with most stores in Florida, Texas followed by California. Florida and California are hit heavily by the falling house prices and the general economy continues to cool off with impact on consumers. Let us see how this impacts KMX. The new car sales dipped in 2007 ( 11%) where as the used car sales went up (20+%). As the economy cools, it will be interesting to see how the mix changes in the first couple of quarters for KMX.

KMX has another revenue stream through auto financing operations. The company provides the following guidelines for 2008.

Fiscal 2008 Expectations
The fiscal 2008 expectations discussed below are based on historical and current trends in our business and should be read in conjunction with “Risk Factors,” in Part I, Item 1A of this Form 10-K.

Fiscal 2008 Sales. We currently anticipate comparable store used unit growth for fiscal 2008 in the range of 3% to 9%. We also expect wholesale unit sales growth to be consistent with our total used unit sales increase. Total revenues are expected to climb by between 14% and 20%, reflecting our expectations for comparable store used unit growth, new store openings, a modest increase in used vehicle average selling price, and a continued decline in our new vehicle sales.

Fiscal 2008 Earnings Per Share. We currently anticipate fiscal 2008 earnings per share in the range of $1.03 to $1.14, representing EPS growth in the range of 12% to 24%. We expect modest improvement in both used vehicle and wholesale gross profits per unit in fiscal 2008, as we continue to refine and improve our car-buying processes.

We expect CAF income to increase modestly, but at a pace slower than anticipated sales growth, primarily reflecting the challenging comparison created by the $13.0 million of favorable CAF items reported in fiscal 2007. The CAF gain percentage is anticipated to be slightly above the midpoint of our normalized 3.5% to 4.5% range in fiscal 2008, assuming no significant change in the interest rate environment.


The stock is not cheap but has potential for further growth in a vast market. The price to cash flow and P/E are somewhat high and the growth will be low this year. The ROA and ROE are not very high compared to other established businesses. While the concept clearly holds potential, the bet here is nation wide expansion of KMX over a period of time will increase efficiencies and EPS.

Valueline expects the company to post reduced margins over the next few quarters but do well over the long term as KMX is one of the finest companies in this category. Value line expects double digit bottom line growth for the next three-five years.

Microsoft and Yahoo! Merger

Microsoft is trying to buy Yahoo! at a price of $31/share. Barrons analyzed this deal and said the price Microsoft is paying is low when compared to the Acquantive acquisition. Henry Blodget, the former internet analyst has this to say about this deal in his blog.

"The first problem with Microsoft's online services division is the name: Microsoft's online services division. MSN, Windows Live, Office Live, MSNBC.com, aQuantive...we'd feel better about the company's chances if it could begin by settling on a brand (or at least a couple of brands).As for last quarter...Online revenue jumped 38% to $863 million, for an overall annual run-rate of a respectable $3.4 billion. Of that, $623 million was advertising ($2.5 billion run rate), making Microsoft's ad business one-seventh of Google's size and about one-third of Yahoo's size.Of the advertising business, which also grew 38% year over year, $112 million came from the aQuantive acquisition. Excluding this, the division's ad revenue grew 24% vs. 25% last quarter. This means Microsoft almost certainly lost more share to Google in the quarter, but may have picked up a small amount against Yahoo.Most importantly, despite the acquisition of profitable aQuantive, Microsoft's online business is still burning money--$800 million a year (after factoring out some non-cash charges). This is an improvement vs. Q207, when it was losing $1 billion a year, but it's still horrible. Even walloped AOL is still printing money. Microsoft's online successes, such as they are, won't be taken seriously until the company is running a large, organically growing, profitable business."

Let us look at the latest numbers from Q2 of 2008. The numbers thus far in 08 is 1.5 billion in revenue with 500 million dollar loss. Yahoo! on the other hand had revenues of ~7 billion with approximate profit of 660 million. Combining the two entities by themselves would result in about 10 billion in revenue with about 340 million in loss. This is without adding any cost saving, talent loss and special incentive packages to retain executives and employees. If one billion is cut from costs it will result in about 600 million in profits. This is not including the increase in cost structure to retain key employees and managers.

This compares to 16 billion in revenues and 4 billion in net income at Google. As can be seen, from the business stand point, Google is ahead and continues to pull ahead as Microhoo! gets bogged down in getting the merger to work.

Retailers - DDS, COST and SHLD

In the article on retailers, we examined the price/cashflow situation of several retailers. We did miss a few retailers and in this segment, we will look at DDS, COST and SHLD.

DDS - Dillards is a very cheap stock with a price/cash flow of around 4.5. Dillards has been hit by intense competition in the retail sector. With EBIT margin of around 2% and with low ROE, ROA ratios, Dillards main asset is property, plant and equipment. Dillard's equity is more or less the same in the past several years and the property value is most likely understated. A buyout by the likes of Lampert can help unlock the value in this company.

COST - Costco boasts of having Charlie Munger on the board of directors and is indeed a quality company. As is the case with Wesco Financial, costco is not cheap with a price to cash flow of about 15. It has done well compared to other retailers returning about 25% for the year and is overpriced compared to its business fundamentals. There are better bargains out there compared to Costco.

SHLD - SHLD should trade at a premium given that Eddie Lampert is allocating capital for the company. The company generares ample cash to the tune of about 800 million - 1 billion a year and the book value/price is very attractive at current prices. Barron's valued the company at close to $300/share. Even applying a healthy 50% margin of safety to that value will value the company at $150/share.

The current retail environment is offering some great bargains and a prudent investor can make a boatload of money by exploiting the current environment to the maximum.

Lowes vs Home Depot - part 2

In prior articles, we have looked at home improvement retailers - Lowes and Home Depot respectively. Let us compare the two again, based on most recently ended quarter.

Lowes currently sports a P/E of 11, market cap of 32.6 billion, price/cash flow of 6.91 and is trading close to its 52 week low at 22.11.

Home Depot currently sports a P/E of close to 11, market cap of 55.5 billion, price/cash flow of 8.29. Home Depot has better yield than Lowes at the moment.

In the most recent quarter, home depot's margins declined by 2% points from 11.3% to 9.3%. By comparison, Lowes gross margin declined by 1.42 bais points in the same quarter. Similarly, Lowes sales increased whereas Home Depot's sales declined. ( 3% increase to 3.5% decline )

Home Depot's outstanding shares decliend by 11.4%, helped by the sale of HD Supply. Lowes outstanding shares declined by 3.5% in the same period. Home Depot's book value per share is 9.64$/share where as Lowes is 10.9$/share. Clearly, buying back shares after selling Home Supply unit hasnt added more value to the book for Home Depot as the current share price for HD is around $28 where as it is $22 for Lowes.

Home Depot increased its square footage by 5.5% where as Lowes increased its square footage by 11%. Yahoo! quotes a PEG of 0.69 for Lowes and 0.99 for HD.

Lowes has advantage over HD regarding ROE, ROA and price/cash flow ratios. Lowes seems to be a better alternative to HD from both price and business point of view at this point in time.

Overview of Retail Stocks from Cash Flow Perspective

In this segment, we will look at the retailers and see which ones offer the best value from the cash flow perspective. The last week has been pretty brutal on retail stocks and it has hurt several retailers in particular. This survey looks at some ( not all ) retailers of interest to the author. The author has positions in some of the retailers noted below.

AEO - American Eagle Outfitters
Price to cashflow is around 9. ( taking out the cash in the balance sheet ) Price to free cash flow this year is 4.8%. Even without increasing cash flow, this company can payout dividends, buy out shares at a better rate than US treasury bonds. The company has zero debt and it is likely that it will grow free cash flow at a decent rate making it a far more interesting buy than the treasury bond over the next five years.

ANF - Abercrombie and Fitch
Also offers a low price to cashflow ratio of about 9 after taking out the cash from the balane sheet. The company carries little debt but the price to free cash flow yield is around 3.8%. The dividend yield in ANF is less than that of AEO.

GPS - Gap
Gap offers price to cashflow ratio of about 9 and a free cash flow yield of about 5.8%. This is significantly better than AEO and treasury bonds. However, Gap's cash flow hasnt altered a whole lot since 1999.

LTD - Limited
Limited's cash flow has also been stagnant for a few years and free cash flow has been somewhat low compared to other peers this year. Analysts are expecting a turn around in the coming years. However, this year, the stock has taken a hit.

CHS - Chico's Fas Inc
Chico's is cheap and the stock price has fallen off dramatically in the last two yearsbecause of declining sales. Still, JOSB and AEO offer better bargains at this moment.

JOSB - Joseph A Bank
Josb offers a very attractive price to cash flow ratio of 6.38. The company does have some debt but price to free cash flow yield is around 9%. Even taking last years figures, it yeilds a figure of about 6%. Looks like a good buy at these prices.

BBY - Best Buy
Best buy also looks interesting at these prices. However, it seems as though best buy is getting serious competition from WMT and friends.

BBBY - Bed Bath and Beyond
This is not as cheap as some of the others in this list. Also, we looked at this in some detail in this blog.

KSS - Kohl's Corporation
Kohl's is a growth story. It cant be compared to the other retailers in the same way.

WMT - Walmart
WMT offers a price to cash flow ratio of 9. The price to free cash flow yield is 2.1%. While this is hardly spectacular, the company spends a huge amount of money on capex in foreign contries.

TGT - Target
Target is somewhat more expensive than Walmart. This is mainly because of the same store sales have been doing better at Target than Walmart.

JCP - J.C Penney
Looks cheap - cheaper than WMT from a cash flow perspective at this moment. The company has spent a lot of money on Capex this year - hopefully this should show in the coming years.

M - Macy's
Macy's had a decline in cash flow and free cash flow this year. This could turn around in the coming years. In that case, this is a turn around play.

LOW - Lowes
Lowes offers price to cash flow of 7.47. It also yields 2.5% on free cash flow. Incidentally, lowes expects to increase both cash flow and free cash flow this year compared to last.

HD - Home Depot
More expensive than Lowes from a cash flow perspective but better from a free cash flow perspective. However, HD's use of capital and growth are both being questioned by share holders.

One can also play the ETF XRT to play the entire sector.

Microsoft Analysis

Microsoft released its quarterly report recently which beat the analyst estimates. It caused the stock to pop - we look in this section to see if Microsoft has further upside for the next couple of years.

Microsoft is expected to earn 1.81$/share in FY08 and $2.06 in FY09. The uncertainty with the EU has declined significantly after the recent deal. At a low end, Microsoft can trade at $36 - $41.2. At the high end Microsoft can fetch between $40 - $50 at the high end in the next two years.

Let us analyze each of Microsoft's businesses by segment in the latest quarter as reported.

Client: 80 cents of income for $1 of revenue.
Server: 33 cents of income for $1 of revenue.
Online: -39 cents of income for $1 of revenue.
Microsoft Business Division: 65 cents of income from $1 of revenue.
Entertainment and Devices: 8.5 cents of income from $1 of revenue.
Separately, -7.3 cents per dollar is spent on corporate level activity.

This table shows the usefulness of various Microsoft divisions. Windows client is by far the most profitable group followed by Microsoft Business Division. This is followed by Server and Tools. Entertainment and Devices and Online are losing money/marginally profitable as is corporate level activity.

Microsoft's strength is its windows (client,server) and office franchises. These businesses should continue to drive Microsoft for the next five-ten years. As the spending in corporate level activity shows, there is room for improvement in capital allocation. One can also expect stock buy backs to offset further stock dilution. On a positive note, the company is returning capital to the investors in the form of dividends which will allow the shareholders to deploy it in a more meaningful fashion.

However, for the next two years, the downturn in housing and financial sectors would continue to propel technology stocks. This should help Microsoft attain further peaks in its stock price.

Berkshire Hathaway Q3 Analysis

In this blog, we have analyzed Berkshire quarterly reports for quite some time. We will take a look at Berkshire Q3 earnings and take a look at few areas.

Morningstar had the following summary for Berkshire after Q3 in the article titled "Berkshire Puts Some Capital to Work"

On the investment side, it appears Berkshire put roughly $11 billion of its cash hoard to work in equity securities this year. This isn't overly surprising given the tumult in the markets, and chairman Warren Buffett's excellent track record of deftly deploying capital in times of financial stress. In spite of this, though, Berkshire still has more than $40 billion of cash on its balance sheet. While we recognize that roughly $10 billion is required for insurance regulatory purposes, Berkshire still has about $30 billion available for additional investment. We suspect that over time, this will be deployed into business acquisitions or situations requiring an injection of liquidity.





Since this article does an adequate job of summarizing the quarter for Berkshire, we will look at the areas this report doesnt cover.





The book value grew by 3.98% from Q2 to Q3 and by 10.9% for the first nine months of the year. So the stock is clearly on its way to better SP500 in book value growth for the year. Having beaten SP500 in four of the past six years in book value growth alone, (business value growth is greater ) looks like this is another year where Berkshire is going to out perform SP500.



The other metric to look at is operating cash flow. Last year, this came in at 10.195 billion dollars. This year in the first three quarters, this is at 11.351 billion dollars. The run rate is about 40% higher than last year. This excludes gains from investments which is a huge part of Berkshire's cash flow.



Despite investing heavily in equities in the quarter ( and the year ), the gushing cash flow continued to add to the liquidity of the balance sheet.

The intrinsic value of BRK A share is now in the 147 - 152K range when conservatively valued in my opinion. This should grow to 153-158K range by end of this year.

RDN Analysis

Radian operates in the following businesses:


Mortgage insurance business provides credit protection for mortgage lenders and other financial services companies on residential mortgage assets through traditional mortgage insurance as well as other mortgage-backed structured products.

Financial guaranty business insures and reinsures credit-based risks and provides synthetic credit protection on various asset classes through credit default swaps.


Financial services business consists mainly of our ownership interests in Credit-Based Asset Servicing and Securitization LLC (“C-BASS”)—a mortgage investment and servicing firm specializing in credit-sensitive, residential mortgage assets and residential mortgage-backed securities—and in Sherman Financial Services Group LLC (“Sherman”)—a consumer asset and servicing firm specializing in credit card and bankruptcy-plan consumer assets.

In 2006, MI provided 49% of revenue, Financial Guarantee 23% and Financial Services 28% of revenue respectively.

Following the collapse of the subprime market and the scandal with rating subprime debt a lot of the banks and insurers have taken a huge hit to their balance sheets. In this analysis, we look to see if Radian has a future and is an investment at these prices.

In the quarter ending June 30th, each of the above segments contributed to income as follows:
Mortgage Insurance: -28.2 million
Financial Guarantee: 22 million
Financial Services: 27.3 million

The company reported a profit overall despite a negative mortgage insurance segment.

Interestingly enough, MTG also reported a profit in this quarter. But MTG reported a loss in Q3 and issued the following guidance regarding FY08.
MTG is providing the following guidance for the remainder of 2007 and the full year 2008:

•2007 Fourth Quarter paid losses approximating $270 to $290 million
• 2008 paid losses approximating $1.2 to $1.5 billion

This is the worst case loss of 1.8 billion with a shareholders equity of 4 billion for MTG.

Let us now look at Radian Q3. In the business call on 9/5/07, management offered the following scenarios for book value from 2007 through 2010. Book value of $46.9 in 07, $49 in 08, $54 in 09 and $59 in 10.

The Q3 book value came in less than what management predicted at $42.86.

From Q3 onwards, the company will only have two lines of business, mortgage insurance and financial services. In both these sectors, the company took a loss by valuing the derivatives to the mark to market criteria. Excluding this, the loss in the MI division was about 200 million. Financial Services had a slight profit. The company booked a large loss in Q3 and wrote off all of CBass investment. The company also thinks it can pay off the mortgage liability from the reserves and has adequate capitalization.

The stock holder equity was 2.2 billion in the MI division and 1.3 billion in financial services division.

Now let us look at two scenarios. The first one is the normal case as outlined by the company. This involves about 10% loss in the bubble states such as California and Texas. This is also the worst case envisioned by some other independent groups as well. The stress case involves taking 20% loss in these states and the company should do fine in this case. The reduction in book value in Q3 came in as management had expected except for the mark to market of derivatives. In the worst case, one can expect the book value to go to $30 in this scenario.

In the second scenario, we can expect the losses to continue till end of 2008 and mid 2009 at the current rate and another write off of 1 billion from the book value. This should still leave 2.1 billion in book value about 3 times the current market price for the stock. Even writing off the entire mortgage insurance business off still leaves a value of around ~$19/share in Radian.

The great risk for the company is downgrading of its credit from AA to a lower grade by SP and Moody's. In this case, the business may be harmed beyond repair. In the conference call, management was confident that it will be able to maintain its rating.

This stock has high uncertainty and low risk built in. A patient investor may be rewarded handsomely for holding on to this asset.

Four pillars of Tech

The four pillars of tech according to Kramer are:

1. RIMM
2. AMZN
3. GOOG and
4. AAPL

Let us look at each of these to see if they offer good bargains at current prices.

1. RIMM carries a P/E of 76, PEG of 1.56, Price to cash flow of 90.

2. AMZN carries a P/E of 124, PEG of 3.54 and price to cash flow of 42.

3. GOOG carries a P/E of 50, PEG of 1.22 and price to cash flow of 46.

4. AAPL carries a P/E 49, PEG of 2 and price to cash flow of 32.

AAPL is the cheapest from the P/E and P/CF point of view. Google is the cheapest by PEG point of view.

From a discounted cash flow point of view, none of the stocks look cheap and each of them look quite expensive. In the long term, the value is likely to catch up with price - this can happen through stagnant or declining share price.

HOG (Harley Davidson) Analysis

Harley Davidson (HOG) is the iconic American motor cycle manufacturer. It is more than a brand in many ways - many people tattoo HOG on their bodies. It is difficult to find many companies that people are willing to tattoo on their bodies. Of late, HOG stock price has declined because of stagnant or slightly declining year over year sales. Let us analyze the stock in further detail in the rest of this blog. HOG embodies a lifestyle and in some sense beyond a brand.

HOG has a P/E of ~12 and price to cash flow of about 13. Price to book value is about 4. The dividend yield for the stock is about 2%. While the stock is undoubtedly cheap as it is very difficult to replicate the Harley brand for the market cap of the company which is about 13 billion. While the intangibles add significantly to Harley's book value, let us see if the company is a buy at the current prices.

First let us analyze Harley. The number of outstanding shares has been declining by about 1.6% per year for the last ten years. The EPS has grown by about 20% per year for the past ten years - which is clearly not sustainable.

Let us look at the cash flows and return on equity to see how HOG looks like from this perspective. The cash flow from operations for the last five years have been respectively - 936, 970, 960, 762 and 998 million dollars respectively. The free cash flow has varied from 708 million to 782 million respectively. The return on equity has varied from 29% to 39% of late.

The company's YoY sales in the US has declined by about 5% and the company is hoping to expand internationally further. Like other consumer staples such as Coke and Pepsi, HOG will probably see more revenue and profits internationally in the future.

The stock looks cheap compared to its historic P/E of about 19. Even given the stagnant cash flows, the company is returning money to the share holders in the form of dividends and share buy backs. HOG is a good long term buy but may not see immediate upside.

Proctor and Gamble Analysis

PG ( Proctor and Gamble ) is in the consumer staples business. It was the best performing dow jones stocks for the recently ended quarter. Let us quickly take a look at the financials to see if it is a buy at current prices. With a P/E of 23 and Price/Cash flow of close to 18, the stock doesnt appear cheap at current prices. Let us take a deeper look at the numbers to see how things look like.

The company bought Gillette recently, which has helped its cashflow and net margins. The EPS has grown at the rate of 9% a year for the past ten years and is likely to grow at that rate in the future.

The business is doing well on all fronts as noted in the company's 10-Q:

Net sales fiscal year to date increased 14 percent to $57.20 billion behind 11 percent volume growth, including an additional three months of Gillette results during the current fiscal year to date period versus the comparable year ago period. Organic volume grew five percent with broad-based growth across the business. Every reportable segment delivered year-on-year organic volume growth driven by product initiatives including Tide Simple Pleasures, Febreze Noticeables, Pantene Color Expressions, Olay Regenerist and Definity and the Head & Shoulders and Herbal Essences restages. Price increases taken across several segments added one percent to sales growth while favorable foreign exchange trends had a positive two percent impact. Product mix had no net impact on sales growth as the favorable mix impact from the additional period of Gillette results was offset by disproportionate growth in developing regions, where unit selling prices are below the Company average. Organic sales increased six percent fiscal year to date.

Additionally, the per share growth has been impressive partly because of the accretive nature of Gillette's business.

Net earnings increased 19 percent to $8.07 billion behind organic sales growth, the impacts from the addition of Gillette, including financing and other acquisition-related expenses, and profit margin expansion. Diluted net earnings per share were $2.37, up 13 percent versus the prior year. Earnings per share growth lagged net earnings growth due to a net increase in the weighted average shares outstanding in the current year to date period (incremental shares issued in conjunction with the Gillette acquisition on October 1, 2005, net of share repurchases, primarily under the Gillette repurchase program).

The fastest growing business segment was health care products. The gillette razors and blade segment is growing impressively in the developing countries.

Overall, PG is a great business. The current price levels are a bit too high - the right time to buy this was during the summer months during the peak of the credit crisis.

Bed Bath and Beyond (BBBY) Analysis

In this blog, we have looked at retailers such as Walmart, American Eagle and Joseph A Bank. Let us analyze another specialty retailer, BBBY and see if it is a good investment opportunity at this time.



BBBY is a retailer specializing in bedding, bath and kitchen products. It also sells electronics, electrical equipment ( kitchen electrics ), furniture, wall and home decor. It targets the rich to upper middle class customer and competes with a slew of other retailers in this space. Its closest competitors are Target ( which targets the middle class customer ) and Linen and Things. In each of the segments it operates in, there are a slew of speciality retailers that compete for the same business.



Let us look at the latest 10-Q report and past reports to see how BBBY stacks up against some of the other retailers. In the most recent quarter, BBBY saw increase of sales (~11%) through store expansion and through the acquisition of buy buy BABY. Meanwhile, the gross profit margin declined because of rising inventory costs and selling, general and administrative cost went up. The result was a decline in operating profit margins to 9.9% from 10.7% from the same period a year ago. Does the declining profit margins show a fiercer competitive environment? Let us look at the profit margins for the past five years to figure this out.

The operating income for the past five years are as shown below with a compound annual growth rate of 7%.

639.3
792.4
879.2
889.4
895.0 (expected for this year )

The operating margin has declined sharply this year and last compared to the previous two years to the 2003 levels. This is a bit early to say if this is because of fiercer competition. The reduction in margins could also be because of the decline in the housing market. However, this should have been more pronounced in 2007 as opposed to 2006 which is not the case.

The company has decided to buy back about a billion dollar worth of shares in December 2006 and the total number of outstanding shares has declined in the most recent quarter by about 7 million compared to the same period a year ago. The company has about 20 million shares outstanding (options) and about 6 million shares in restricted stock. While many of the options are under water at the moment, the addition of close to 9% of additional shares can dilute the impact of buy back.

On a positive note, the company carries no debt and is funding its expansion through operating cash flow.

From a cash flow perspective, there are cheaper alternatives such as Walmart and Target and a slew of other retailers noted earlier in this blog such as AEO and JOSB.

While the company is healthy, the impact of housing slow down and competitive pressures is not fully clear at the moment. It is our view that there are other retailers that offer a better discount to intrinsic value than BBBY.

Infosys Q1 Analysis

In this blog, we have looked at Indian outsourcer, Infosys quite a few times. We found Infosys to be the best run of the Indian outsourcers with solid management. In the first six months of the year, the Indian currency appreciated by about 10% against the US dollar. This appreciation was partly precipitated by the Indian central bank keen to cut inflationary pressures. The exchange rate of the Indian currency is artificially maintained as the currency is not freely traded. This is similar to the way the Chinese government maintains its peg against the US dollar.

The problem for Indian companies that are exported focussed is that it increases their cost of operations. While some of the cost can be passed on to the customers, it will not be possible to pass on all the costs to the customers. In addition, Infosys and other Indian companies are facing increase in operating costs with wages increasing at double digit rates of 15%. This impact is probably not fully felt yet and show up further in the coming year. The wage increase is expected to be about 15% in the coming year as well.

The operating income margin in Q1 of 2006 for Infosys was 25.75%. The operating margin in Q1 of 2007 was 24.67%. In general, the business did well, with revenues and profits growing strongly. As usual, the stock market looks at future prospects as opposed to past results. Infosys is expected to continue to do well with growth in the 28-31% range for FY2008.

Other points of note is attrition rate of 4% in the quarter and 10% new employees in Q1 alone. Infosys expects to pay new employees higher wages compared to the ones hired before. Infosys now employs about 75000 people world wide. The increase in cost will increasingly be felt in the next couple of years which is reflected in the stock price.

The company has a strong balance sheet with about $1.6 billion in cash. The company is run well and this is reflected in the stock price. However, we feel that the company is fairly valued at current price levels.

Value vs Growth

We are looking at this again after a short gap. Given the disaster in the financial sector and the dominance of financials in the value fund, the value fund hasnt done too badly.

The chart below shows how value, blend (sp500) and growth compare in the large cap arena. The chart below shows the iShares ETFs - IVE, IVV and IVW.
The top stocks in IVE (value etf) are:
AT&T,
GE,
Citigroup,
BAC,
JP Morgan Chase,
Conoco Phillips

The top five stocks in IVW ( growth ETF) are:
Exxon Mobil,
Proctor and Gamble,
Cisco Systems,
Johnson and Johnson and
AIG

The difference between value and growth is not wide with iShares ETFs.


http://finance.yahoo.com/q/bc?t=6m&s=IVE&l=on&z=m&q=l&c=ivv%2Civw

The second chart compares the vanguard funds in the same category. The vanguard funds of interest are VTV, VV and VUG respectively. The mix of stocks in vanguard funds is different than the iShares funds - so the difference in performance is also different. As an example, Berkshire is in vanguard growth fund but not in the value fund. Comparing to iShares ETFs, the stocks and their weights are also different.


The top holdings in VUG are:

Microsoft,
Proctor and Gamble
Johnson and Johnson
Cisco
Intel

The top holdings in VTV are:

Exxon Mobil,
GE,
A&T,
Citigroup and
Bank of America

http://finance.yahoo.com/q/bc?t=6m&s=VTV&l=on&z=m&q=l&c=vv%2Cvug

While the companies in both the lists are good, citigroup and BAC may have to take some charges on the buy out transactions still pending for which commitments are made. While this is a good time to buy - it may be in the doldrums for some time.

The differentiation of stocks to value and growth is quite arbitrary and one should do ones due diligence before selecting one sector over the other. It also depends on which funds one selects and what cost advantages an ETF or a bunch of ETFs provide over the other.

Jos A. Bank Clothiers (JOSB) revisited

Now that all the retailers are in a funk thanks to the subprime mess as well as the Walmart warning, let us look at this section again.

We have looked at JOSB before in this blog and noted that P/E contraction was a major risk to both JOSB and Chico FAS. True enough, even though the sales have done well, people have been dumping JOSB as well as other retailers enmasse creating an opportunity.

Let us look at JOSB business and macro factors first. Jos. A. Bank Clothiers, Inc. is a nationwide retailer of classic men’s clothing through conventional retail stores and catalog and Internet direct marketing. What are the factors that can go right and what are the factors that can go wrong for JOSB?

Things going right:
1. Good job market - always a plus for JOSB. It is unlikely this will falter given the strong growth in emerging markets, europe and Japan. The U.S export growth continues to grow and the dollar will probably decline further if there is a rate cut. This bodes well for JOSB.

This not going well:
1. The housing market. A bunch of ARMs are scheduled to be reset next year - this can cause problems to JOSB and other retails if it impacts the US consumer abnormally.

If the job growth continues and the ARM resets occur in an orderly way - the consumer mix for JOSB is going to determine how well it will do.

For this, let us look at the financial statements.

First cash flows - JOSB has a price to cash flow ratio 0f 7. What this means is that the business can pay out the entire capital back in seven years if nothing is reinvested in the business. However, a part of the capital will have to be reinvested to keep the business going. Another part to look at is the sustainability of the cash flow. Let us look at the balance sheets to gain further insight into these factors.

First let us look at the free cash flow growth. It has been far for uniform - in fiscal 2002 and 2004, the company had negative cash flows. The company is excpected to have free cash flows of ~40 million this fiscal year. So the cash flows are not even meaning some dependency on the economic cycles are present.

Let us look at the latest 10-Q for more details. The company is planning to add more stores this year to expand the number of stores from 366 to close to 500. The company would put the store expansion plans on hold if there is a chance to lose money on the investment or if it is very risky. As noted by other retailers, the sales havent fallen off the cliff yet but people are expecting catastrophe to hit when the ARMs reset.

JOSB looks attractive at this price, with book value of approximately $12/share - it is definitely selling below its intrinsic value and can offer some good upside if the ARM reset doesnt hobble the economy badly. Note: please see the disclaimer part of this blog.