Berkshire Ruminations

Monday, May 22, 2006

My take on the Burger King IPO

Over the past few months, one could not help but hear about the IPO of BKC, but the general sentiment was mixed. This seemed strange to me, since generally the bulls are out in force for a large IPO such as this, so I did a little investigating. A little investigating is all that I needed, it turns out, because this stock looks like a loser all around.

I have no doubt Burger King is a good company. It has enormous brand equity, the second largest market share among burger joints, and, I feel, a pretty flipping good product. Pun intended. But the new company, the one that now trades shares on the NYSE, has been stripped down to pad the wallets of the consortium of private equity folks that took it private in 2002. Not to mention a CEO that just split and a struggling burger market.

The biggest red flag, or should I say “proof”, that this proposition is a loser for individuals is the $367 million dividend the owners paid themselves, financed by $350 million in debt, immediately before the IPO. This could be justified if it is true that the consortium contributed a like amount of equity themselves since the buyout, but what it leaves is a dangerously overleveraged firm in an unfavorable market.

I say unfavorable because burgers seem to be losing popularity in favor of other foods such as subs (Subway) and tacos (Taco Bell). Such was the momentum behind the overwhelmingly successful IPO of the legitimately stellar business Chipotle. Given that Chipotle had whetted appetites of investors for big fast food IPOs, this was a logical time for the consortium to cash out.

So lets review. The Burger King owners take out a $350 million loan and pay themselves roughly a $350 million dividend, then take the company public to raise $350 million in equity capital, which they purport to use to repay the loan. Translation: $350 in, then out, then back in, then back out. So absolutely no value has been added to the firm through this offering, it has all gone to the original owners. The icing on the cake for them is that they emerge from this with the 75% of the company that was not sold in the IPO.

The right reason to take a firm public is to raise capital. Good firms can usually do this rather inexpensively. The wrong reason to take a firm public is to cash out, or sometimes pawn-off, a mediocre business on to the unsuspecting public.

Friday, May 19, 2006

Permanent Holding - Part 2

Walgreens is still hovering around $40/share. Should we buy? Consider the following.

Two things happened in 2005 that hurt sales and increased costs, yet the company thrived nonetheless. The first is Hurricane Katrina, which cost the company about $55 million in addition to the lost sales at the 74 locations that were temporarily or permanently closed. The second is substantial costs in preparation for the launch of Medicare Part D. The company spent a great deal educating both its employees and seniors about the upcoming changes.

But Medicare Part D will benefit Walgreens tremendously as the program takes off. First of all, many more seniors will be filling prescriptions simply because they now have prescription drug coverage, whereas they did not before. According to the Kaiser Family Foundation, the 28% of Medicare recipients without prescription drug coverage spent 42% less on prescriptions than their covered counterparts. Should these individuals get coverage, it stands to reason their spending will increase significantly.

Second, as Walgreens management points out in the 2005 Annual Report, these new beneficiaries should be indifferent among pharmacies since their copay will be the same at every retail location. This is when Walgreen’s competitive advantage – outstanding convenience and location – will generate value. I expect that most new pharmacy patients will gravitate towards Walgreens over its competitors.

So is Walgreens still cheap? Let’s look at the financials. The company, which has no debt, has maintained a return on equity in excess of 15% as far back as I can calculate (at least ten years). So these equity shareholders, who supply capital at a cost much less than 15%, are getting a healthy, consistent and reliable return.

Same-store sales have increased in every category for the last two years, contributing to a growth in gross margins as well. Margins are up to 27.9% in 2005, from 27.2% and 27.1% in 2004 and 2003 respectively.

So when we calculate owner earnings for this company, I think we can have great confidence that optimistic projections are attainable. But it will take those optimistic projections to come up with an intrinsic value in the ballpark of the current $40 stock price.

Thursday, May 11, 2006

Overstock CEO Loco

I bought a few years back and doubled my money in about three months. I bailed immediately because I could tell the sudden runup in price was not justified. Boy am I glad I did, because to agonize over what is going on at that company today is more that I am willing to undertake.

What originally attracted me to the stock was the legitimate Buffettness of it. The now-loco CEO Patrick Byrne is the son of Jack Byrne, the longtime head of GEICO and close friend of Mr. Buffett’s. The company seemed to be managed in a Berkshire type fashion, complete with an owners’ manual and straightforward, from-the-hip commentary from the management. It also seemed to be reasonably cheap. Although it wasn’t profitable, it was gaining ground quickly and was considerably cheaper than its closest peer, on a price-to-revenue basis.

Well, it now seems that all those good things mentioned above have dissolved, except for Patrick still being Jack Byrne’s son – so far as I know he hasn’t disowned him yet.

I am sure it started earlier in life, but Patrick Byrne’s hysteria culminated last year in his “jihad” against naked shortsellers. Yes, he actually called it jihad. Shortsellers severely depressed the price of overstock stock, he said, and did so through the unethical and often illegal practice of naked-shorting. This means the shares that were being shorted were not even borrowed – they didn’t exist at all. Apparently this is possible because of structural inefficiencies in the stock exchanges. It is not something that I really understand, nor have any desire to understand to the extent that I would want to do such a thing myself.

So the stock price crashes, and Patrick was probably somewhat correct as to why. But his response was just, well, crazy. I mean really crazy, crazy in a Tom Cruise crazy kind of way. Instead of welcoming the drop in price as an opportunity to buy shares for himself, or better yet for his company, he sued one of the firms accused of the naked shorting. In fact, he did buy quite a few shares for himself, so why is he whining? He then announces that he is declaring “jihad” against them, claiming that the crash in overstock stock was caused not just by naked shortselling, but by a conspiracy coordinated by the "Sith Lord." Ok, Pat, now you are starting to lose me.

In an interview in December, he was able to divert conversation away from Overstock's disappointing holiday sales by suggesting he had, among other things, herion and a dead body in the trunk of his car. Later in that interview he verbally attacked Mark Cuban, who successfully shorted Overstock shares.

In March Patrick issued a press release entitled “ to Gradient Analytics and Rocker Partners: Where's the Countersuit You Threatened?”, the text of which is hilariously unprofessional.

Today, he released a press release reading “ Celebrates Receipt of SEC Subpoena.” I can’t help but think that such a preoccupation with such an inconsequential problem can’t be good for the company.

Moreover, blaming others for a fall in your own stock price, no matter how justified, is just tacky. Did it not occur to Patrick that, despite escalating sales, earnings remained negative? Is it not possible that folks were just losing faith in the prospects of the company? If he were truly to follow in his father’s footsteps, Pat Byrne would either brush off the stock’s fall and start buying, or own up to his failure to put up better numbers – since better numbers logically would serve to dissuade short sellers anyway.

Wednesday, May 03, 2006

Small-Cap Profile: Varsity Group, Inc.

This is a company that recently underwent an operational restructuring that I am confident will prove much more profitable to the firm. The firm started out as selling college textbooks over the internet and employing college students to promote the company on campus. This was at the height of the dot-com bubble and the company targeted any and every university in the country – including mine – but could never penetrate the market. This industry was and is extremely competitive and the firm did fairly poorly. Varsity Group today, however, has identified an altogether different niche, one that will afford them competitive advantages that would have never been possible under the old business model.

Today, the company contracts with private high schools to provide all the textbooks for the school. The key to this model is contracting. Once the company contracts with the school, the individuals purchasing the books or uniforms have little to no buyer power. This is not to say, however, that the company can ignore potential competition, but only that it will be protected by temporary barriers to entry.

The most exciting benefit from the change in business model is the new customer base. As opposed to the stereotypical “starving-college-student,” to which the company previously marketed its product, the company now is selling to affluent parents, parents rich enough to send their kids to private school in the first place. The typical private high school student will visit the school bookstore with his parents, often buying more than he needs, including every accessory that strikes his fancy. It is a highly price-insensitive clientele. This, of course, compares favorably to the college student I often see so strapped for cash that he will forego buying textbooks altogether.

Additionally, just last year Varsity Group began selling uniforms, through its acquisition of a private uniform provider, with great success. Sales of uniforms are equally as profitable as sales of books, so the company can maintain its strong margins while adding to its product mix. More importantly, though, the company will be able to increase sales per school by providing more than just books.

The Varsity Group annual report is presented clearly and comprehensively. I especially like and appreciate how the company presents its financial statements. Varsity presents each source of revenue and expense separately. This makes it really easy to see how profitable each revenue stream is, and where the growth in total sales is coming from.

It is apparent from a glance at the company’s income statements since its IPO in 1999 that this model is dynamite, as its earnings have exploded, from zero around the time of the change in 2002, to over $12 million in 2005, all on the original $88 million of paid-in-capital. The company has yet to use debt financing, and founder and former CEO Eric Kuhn retains 8% of the outstanding shares. The current P/E of only 8 will get your attention, but a DCF valuation with conservative assumptions yields an intrinsic value high above the current price of $5. For this reason I think there is a considerable margin of safety in and investment in this company.

I own quite a bit of this stock. Bought it back in February at $3.85.

Monday, May 01, 2006

Annual Meeting

I am traveling with seven students to the annual meeting this weekend in Omaha. We would love to meet any readers of this blog that may be in attendance as well. We should arrive Friday afternoon around 5:00, and plan to attend the Borsheim's reception Friday night. After the meeting on Saturday we will be attending the NFM BBQ. I can be reached via email at