Friendlys Icecream

May 29, 2007

How did sleepy old Friendlys (FRN) restaurants land in the middle of a dramatic take-over battle? Here’s the “back-story” as I understand it:

Blake versus Smith: Founded in the 1930’s, the company was sold to Hershey’s, then spun off again. One of the founders (S Prestley Blake) owns over 10% of the latest version of the corporation, but has no part in management; indeed, he’s suing management. Meanwhile, Donald N. Smith, Chairman, who also owns over 10% has run Friendlys as part of a nearly unchanged 5-person board for about a decade.

Blake has accused Smith of mismanaging the company; e.g., trading in a $3 million aircraft for a more expensive $8 million one, running an office from Chicago when Friendlys has no restaurants in Illinois, paying staff at that office who do not do much for Friendlys (referred to as “FODs” — “friends of Don” by an employee in court testimony), and so on. These are all accusations, I do not claim them to be facts. Also, Smith has an interest in another company (“TRC”) that has various deals with Friendlys, and Blake accuses Smith of constructing these related-party deals for his own and TRC’s benefit, and not in the interest of Friendlys.

Blake also complains that Friendlys has taken on very expensive debt, and he has offered to lend the company $50 million at 2% over a specified floating benchmark rate, to pay off costly debt. The company responds that the pre-payment penalties would make that a bad idea.

Enter Biglari: Sardar Biglari runs the LionFund, and recently took over another restaurant chain (Western Sizzlin) in a hostile bid. Sometime in 2006, Biglari targeted Friendlys. Like Blake, he too criticizes the debt levels and management performance. (According to Yahoo Finance, in the last 3 years, FRN has had a cumulative near-zero cash-flow, a cumulative loss, and it has had negative net tangible assets. On the other hand, there have been profitable years, and the restaurants have a good reputation with customers.)

Management offered Sardar Biglari first one seat, then two, on an expanded board, but only if he agreed to conditions that would keep him in check for the next three years. This seems like an obvious attempt to buy time. Why would Biglari just sit on the board and nod? He rejected their offer. On March 6th, 2007, Biglari wrote a letter asking shareholders to vote him and an associate (Cooley) as directors at the next annual meeting. Biglari has billboards in Wilbraham, MA and Springfield, MA saying “Vote Biglari and Cooley”, and pointing people to his website.

Perhaps seeing the inevitability of Biglari winning two seats, Friendlys put out a March 7th press release (i.e. the very next day), indicating that they had “…retained Goldman Sachs & Co., as financial adviser, and Weil, Gotshal & Manges LLP, as legal adviser, to assist the Board of Directors in exploring strategic alternatives to enhance shareholder value,...” Then, they postponed the annual meeting!

Friendlys’ website says: “The Friendly Ice Cream Corporation shareholder meeting originally proposed to be scheduled for May 9, 2007 has been postponed due to the previously disclosed alternative strategic review being conducted by the company’s Board. When the Board sets the date for a rescheduled meeting of the shareholders, the new date and time will be posted here.”

Ownership pattern/Proxy fight: From Friendly’s site, I got the following ownership figures (as of May 21, 2007):

  • Biglari Capital Corporation: 14.6%
  • S Prestley Blake: 13.1% [Founder, now suing Friendlys and Donald Smith]
  • Donald N. Smith: 12.2%
  • Kevin G. Douglas: 10.4% (Not sure who he is)
  • Various mutual funds (approx): 23%

With this ownership pattern, and with the possible backing of a few big mutual funds, Biglari appears to be an almost certain winner if there’s a proxy fight. So, it appears that current management is in its final days. Their only hope in not being forced out, is to get an offer that Biglari cannot refuse. If this happens, current shareholders win too.

Who’s the bad guy?: Is Biglari really trying to get rid of mediocre managers who have a poor record, or is he pouncing on a company that hit a temporary bad patch? Friendlys did have net income in some recent years, but a large loss in one year wiped out the cumulative numbers. Friendlys management says Biglari wants to use their company’s free cash fkow to finance other ventures, not investing in the restaurants. Answering this would require more details, and I’ll defer that for now.

Is FRN a buy?: What if no suitors are found? Even if Biglari gets the company, it may take a while, and some court battles; in the meanwhile, fundamentals could deteriorate (particularly with management focusing on this battle, rather than on running the company); the company he finally gets may be in a worse state than it is today. The stock has jumped since Biglari got into the stock. From $8 before Sept 2006, it is $14 today. Having risen so much, is the good news already reflected in the stock-price? This too would require more details, and I’ll defer that to a future post.


Netflix/Blockbuster: bird’s eye view

May 11, 2007

I recently started to look at Netflix (NFLX) as an investment. My summary is that it’s a really interesting story, they’re a well-run company, but in a market fraught with uncertainity.

NFLX pioneered a channel that took business away from Blockbuster BBI. Finally, in the last quarter of 2006, BBI started to fight back, undercutting NFLX, causing it problems. NFLX has a clear and simple model, but BBI is adapting theirs rapidly and NFLX may be forced to react. To figure the value of NFLX, it is becoming more imperative to understand BBI than to understand NFLX itself. While NFLX executes well, its medium-term future depends more on what BBI will do and how NFLX can counter them.

Don’t shrug off BBI’s undercutting, saying they’re losing money. Price wars can get irrational, particularly when a competitor is fighting for its existence. Areas of research:

  • How much does BBI lose per TA customer? Estimates range from $2 to $42 per month; the truth is probably somewhere in between those numbers.
  • Next, what can BBI do to change those numbers? BBI’s management are obviously thinking hard about how they can use their loss-leader to make profit on something other than popcorn sales.
  • If BBI cannot sustain the current level of loss-leadership in TA, can they tweak it to reduce their losses, while still undercutting NFLX just enough to do real harm?
  • Finally, even if BBI fails after a few years of fighting hard, might that be a few years too many for NFLX?

In the longer term, the channel is threatened by downloading.When it comes to downloading, other players like cable and ISPs will also want in on the game. One can anticipate another fight, (say) six years down the road.

Therefore, what we have is this: NFLX is a well-run company, in a market that’s in flux, with a competitor that’s desperate; and, the future, instead of ending in a winner, morphs into a different fight. In summary, from a bird’s eye view, NFLX looks like a good company, but in a business that may not be too profitable in the medium-term and has little long-term visibility.

And yet…, it’s all so interesting. It’s seductive for an investor to want to rise up to the intellectual challenge of predicting a winner. That challenge, after all, is why so many people like investing. Despite thinking that it’s unpredictable, I too am drawn to the story, and will probably look more closely. I’ll resist the urge to bet any money just yet.