Description

I am recommending to short shares of Steak N Shake (SNS) which currently trade at $12.19.  At the current price, I believe that Steak N Shake is priced well ahead of fundamentals and that the combination of weak consumer spending, poor brand name, a saturated casual restaurant market, and a potential rise in commodity and labor costs in 2011 will result in continued pressure in Steak N Shake margins. I believe that somewhere between $6 and $8 represents a fair price for Steak N Shake given no more than $0.50-$0.60 of earnings power by 2011, and possibly closer to $0.20 if some of the events below play out.

This short thesis (described in more detail below) is predicated on the belief that casual restaurants will continue to come under the perfect storm of an oversupply of restaurants, weaker demand from consumers, and potential labor and commodity cost increases over the next two years.  We believe this will result in lower than expected revenue growth and operating margins, a lower return on capital, and a lower earnings multiple in the market.  We also believe that consumer's spending decisions will become more value driven with the relationship between food quality and price being the key determinant to the success of a restaurant.  Quick service restaurants will continue to move up the value chain offering higher quality foods such as angus burgers, salads, and premium chicken dishes forcing casual restaurants to compete on price.  Therefore, over the next few years, we believe that only the strongest casual restaurants that offer the best quality to value combination will succeed in growing the top line and reaching normalized operating margins.  We do not believe that Steak N Shake has the brand or food quality to value necessary to compete in this environment and will therefore be forced to lower prices over an extended period of time, preventing the company from achieving normalized operating margins over the next few years.

Description:

Steak N Shake operates 415 restaurants and franchises 73 restaurants in 21 states.  Steak N Shake is known for its steak burgers, milk shakes, and its appeal as a classic looking community diner.  Restaurants offer full-service dining with counter and dining room seating (about 60% sales), a drive-thru window (30%), and carryout service (10%). Most restaurants remain open for 24 hours per day, 7 days per week and support customer traffic for breakfast (about 5% sales), lunch (35%), dinner (45%-50), and late night (10%-15%). The average check for a restaurant is somewhere between $6.75 and $7.35 per person.  The restaurants are located primarily in stand-alone buildings and have an average size of about 4,000 square feet. Of the Company's 415 operated restaurants, it owns the land and buildings of 145 of those restaurants.

History:

In 2007, two activist shareholders, HBK and Lion Funds bought significant stakes in Steak N Shake in the mid teens. Both investors believed that Steak N Shake was being managed poorly on costs and that the Company had a significant amount of value tied up in its real estate. Shortly after HBK surfaced, the fund sold its stock (we believe because of liquidity needs). Lion Fund continued to hold its stock and in February of 2008 filed a definitive proxy seeking board seats.  Lion Fund won the board seats and Sardar Biglari (head of Lion Fund) ultimately became Chairman and then CEO of Steak N Shake. Mr. Biglari has done his best to cut costs at the Company in the face of declining same store sales, mostly in the G&A line, and reduced capex by over 75%.  Although we recognize some improvements in the cost structure, Steak N Shake has now become more of a holding company for Mr. Biglari and his investors. We expect that Steak N Shake will look to do acquisitions to leverage its G&A costs over the next few years.

Short Thesis:

Oversupply of restaurants - Over the last three years, the rise in new restaurant openings against weaker demand has created a large supply imbalance in the restaurant industry.  This was only exacerbated last year with a challenging macro environment. Although restaurants have begun the process of closing underperforming restaurants to reduce supply, restaurant demand continues to fall faster than the decline in supply. With the pullback in consumer spending and shift downward to lower priced alternatives, we believe that the supply imbalance has been greater in the casual restaurant space. We believe this will cause pricing to continue to come under pressure as an increased number of restaurants compete for a cash-strapped consumer.

Weak consumer spending - Record levels of consumer leverage since early 2000 and high unemployment should continue to drive savings rates higher over the next few years. With a limited number of dollars to spend, food quality to value becomes a more important factor in making the decision to dine out.

Competition - Quick Service and specialty burger restaurants, which have ranged in the $5 average check have begun offering higher quality options in the $6 to $7 range to draw in more customers.  At the same time chains like "five guys", who sell premium quality burgers in the $7-$8 range have begun expanding into new markets.  Meanwhile, casual restaurants, which have ranged in the $12-$16 average check, have begun to offer deals in the $10-$12 range to stimulate customer demand.  We believe that the combination of quick service restaurants moving up in price with higher quality offerings, new entrants into the specialty burger market, and casual restaurants moving down in price, will continue to weigh on customer demand at Steak N Shake.

Commodity Costs - A primary reason why restaurants have been able to maintain decent margins in the face of declining same store sales has been the large drop in food costs (commodity prices) over the last year.   Food costs typically account for 25% of revenue.  The most important commodities for Steak N Shake are wheat, beef, milk, eggs, and oil.  Most restaurants have been able to lock in new contracts at some point in the last six months and should have favorable costs until those contracts roll off sometime in 2010.  However, we believe that once those contracts roll off, with continued pressure on the top line, restaurant margins could come under significant pressure. We believe that lower commodity costs in 2009 and half way into 2010 may be saving Steak N Shake up to $0.10 of EPS per year.  Assuming we are correct that commodity costs will continue to rise into 2010, we could see an approximate $0.8-$0.12 headwind in 2011 earnings.

Labor Costs - On July 24, 2009 minimum wage increased to $7.25 per hour from $6.55, completing the last increase of three specified increases starting in 2007. Although we don't believe that Steak N Shake will see much of an impact from the increase to $7.25 since we believe that most of its workers earn slightly higher than minimum wage, we do believe that there is a substantial risk that President Obama will follow through on past promises to increase the minimum wage to $9.50 by 2011. If that were to happen, we believe that Steak N Shake's margins would be severely impacted.  Typically, labor costs, which include benefits accounts for between 25% and 30% of sales. Two thirds of Steak N Shake's 20,000 employees are part-time hourly employees. Assuming that 21% of Steak N Shakes employees (approximately 10 per restaurant), working 30 hours per week, make $8 per hour, compared to the $7.25 minimum wage, and their pay rises to $10 per hour with the increase in minimum wage going to $9.50, that would impact Steak N Shakes labor costs by approximately $13 million per year, or approximately $0.30 of EPS. A rise in the minimum wage to $9.50 per hour, coupled with an increase in commodity costs, could almost wipe out Steak N Shakes 2011 earnings.

Real Estate - The primary reason for bulls to be excited over Steak N Shake lies in its company owned real estate. However, the value of this real estate has significantly deteriorated since 2007 when the activist investors decided to take an investment.  Steak N Shake owns the land and building of 145 of its restaurants. The most value that Steak N Shake could get with this real estate would be in a sale leaseback transaction.  Put simply, a sale leaseback is a transaction is a transaction where the owner of the property (Steak N Shake) would sell the property to a buyer, and then lease it back over an extended period of time. Usually this amounts to a 10 or 15 year lease with at least two 5 year extensions.  For the property, the buyer receives a fixed amount of rent every year based on the sales that the property produces. The buyer values the property both based on the cash flow it receives (in this case from Steak N Shake) as well as the value of the property, location, and ability to rent it out to another company after the contract is up with Steak N Shake.  Since Steak N Shake restaurants are mostly stand alone units and B locations predominantly in the mid west, we believe that a rent of about 8% to the buyer and a cap rate of about 7.5% would have been an acceptable value in 2007. At a $1.5 million revenue per unit, and 145 units, that translates into a 2007 value of about $232 million for the real estate.  The important thing about a sale leaseback transaction is that it only makes sense for the buyer to buy the property if it is confident that the Steak N Shake unit would be profitable. Although this was certainly the case in 2007, we question whether the underlying restaurant would have enough profitability to sustain the 8%+ rent per year, which would equate to $17 million in extra costs.  However, even if it did, in this market, where a number of casual restaurants are looking to unload property, we believe the appropriate cap rate would be closer to 8.5% or possibly 9%. At that value, Steak N Shake's real estate would be worth under $200 million, or less than half of its current enterprise value.  If Steak N Shake did do a sale leaseback in this market, we believe the rent costs would significantly hurt its profitability, and EPS would be impacted by about $0.40 per share.  We believe that the most likely scenario is that Steak N Shake merely sells the property in underperforming locations as it moves back to its core market.  In that scenario, we believe that each property (without the revenue per year to the buyer) is worth no more than $1.5 million.

Valuation:

At $12.19, Steak N Shake has a $351 million market cap and $464 million enterprise value. According to analyst estimates for 2010, Steak and Shake trades at 26.5x 2010 earnings of $0.46 and 7.5x EBITDA of $62 million. This compares to a 2010 earnings multiple of 13x for casual diners and 10.4x for family diners as well as a 6x 2010 EBITDA multiple for casual diners and 7.0x for family diners. Although we believe that Steak N Shake 2010 earnings may be able to meet or even slightly exceed analyst estimates because of declining commodity costs and vigilant cost control by management, we believe that earnings will stagnate or possible decline after 2010. Overall, we think it will be extremely difficult for Steak N Shake to manage over $0.60 of earnings before 2012 as the company struggles to maintain price and margins in the face of increasing competition from quick service and casual restaurants, rising commodity costs, and a struggling consumer.

The following Income Statement model only assumes a small hit to pricing, commodity, and labor costs. We believe that if the events described above take place, Steak N Shake earnings for 2011 would be materially lower.

 Risks

Primary risks in the short term include the company beating estimates over the next few quarters as commodity costs remain low and the company is more diligent on G&A costs

Steak N Shake being able to maintain or increase price with new offerings

Significant rebound in consumer spending

Higher than expected value for the Company's real estate

Catalyst

Realization that 2011 earnings will be less than expected as revenue stagnates from a lack of consumer income, an oversupply of casual restaurants, increased pricing pressure, and lower margins as commodity and labor costs rise