I’ve owned BreitBurn Energy Partners (BBEP) both personally and through Braewick Holdings LP for the past year and a half. The following is a clip from my letter to partners explaining our investment in the company:

* * *

BreitBurn is an oil and gas production company structured as an MLP (see my July 2009 letter for a similar discussion of Linn Energy, another MLP). BreitBurn’s business model is fairly simple: their only job is to extract and sell oil and gas from wells they own throughout the U.S. These are wells they have acquired—they don’t take the risk of exploring or drilling for new wells. Basically, BreitBurn is like a portfolio of interest-only bonds—assets (petroleum in the ground) that pay interest (production revenue minus extraction and administration costs) until the bond is paid off (reserves are depleted). Here’s a quick summary of BreitBurn’s goal from their 10-K:

“Our objective is to manage our oil and gas producing properties for the purpose of generating cash flow and making distributions to our unitholders.”

Because BreitBurn wants fairly steady cash flow to fund their distributions, much of their oil and gas production is hedged. That level of hedged production is immune from fluctuations in energy prices. By the summer of 2008 when prices were high, they had managed to hedge about 70-80% of production for three years out. So when energy prices (and the stock market) subsequently collapsed that fall, BreitBurn’s cash flow remained mostly unharmed. However, as with many of the MLPs, Lehman Brothers was both counterparty to their hedges and a large owner of the stock. The “perfect storm” of falling energy prices, a crashing stock market, and Lehman’s liquidation caused BreitBurn’s unit price to fall from over $20 in the summer to under $6 in December.

Continue reading… »

In November of last year, I wrote “The Restaurant Investor” about Steak n Shake, Sardar Biglari, and what it takes for a restaurant to succeed. In the article, I mentioned that Steak n Shake (now Biglari Holdings) was on solid financial footing and that Biglari would likely start pursuing a holding-company strategy by investing excess cash flow into better opportunities. While this did happen, a few other “revelations” came up over the past six months that changed my view on the company. Anyone who follows BH already knows what I’m talking about, but below I’ve included my thoughts on the situation from my most recent letter to investors:

* * *

Most everyone has heard of the “Type A” and “Type B” personality classifications. In Dan Pink’s book Drive, he adapts MIT management professor Douglas McGregor’s ideas to put forth two more classifications: Type X and Type I. Type X behavior is fueled by extrinsic motivation—external rewards like money and recognition. Type I behavior is fueled by intrinsic motivation—the inherent satisfaction of the activity itself. “I don’t mean to say that Type X people always neglect the inherent enjoyment of what they do, or that Type I people resist any outside goodies of any kind,” Pink says. “But for Type X’s, the main motivator is external rewards. Any deeper satisfaction is welcome, but secondary. For Type I’s, the main motivator is the freedom, challenge, and purpose of the undertaking itself. Any other gains are welcome, but mainly as a bonus.”

Pink lists some well-known examples of both types: Warren Buffett, Oprah Winfrey, and Bruce Springsteen are Type I’s. Donald Trump, Jack Welch, and Simon Cowell are Type X’s. So it’s clear that both personalities can be successful. People can also change over time. But Type I’s almost always outperform in the long run. They’re also the people you want working for you.

On April 30, Biglari Holdings announced that its new compensation agreement with CEO Sardar Biglari would provide him with 25% of the gain in Book Value over an annual hurdle rate of 5%. So if the Book Value of the company went up 13%, Biglari would receive 2% of the company’s equity. At its current size, that amounts to around $7 million, including his regular salary.

Continue reading… »

Claude Bébéar is the founder and former CEO of the insurance company AXA. I believe the AXA group is currently the third largest insurance company in the world (just behind Allianz and Generali Group). Bébéar built AXA through mergers and acquisitions, most notably the Drouot Group and the American insurer Equitable. More can be found about AXA at Wikipedia.

The following are some excerpts from a great interview of Bébéar done by Michael Villette (mentioned in Malcolm Gladwell’s essay “The Sure Thing”). In the interview, Villette’s goal was to test the common belief that Bébéar took more risks than others (both in business and insurance), was a business innovator, and took advantage of others using insider “industry” information.

MV: Explain to me how starting in 1981 you managed to carry out an uninterrupted sequence of acquisitions in France and then in other countries. I would like an explanation with no magic, with facts and figures.

CB: There’s no magic in any of it, nothing extraordinary. The first coup was Drouot, which we bought at a bargain price, because of the panic after the left won the elections.

On the Drouot acquisition:

… the result: we acquired for 250 million francs a company that was valued at 5 billion francs four years later. . . .

MV: Why was Drouot worth so little to start with and so much later?

CB: It’s just like Equitable. People study the issues very poorly. They look at things superficially. Drouot was a company with a very good business that had done some stupid things in real estate. It was taken over hastily by Bouygues. Bouygues knew nothing about the profession of insurance, so he stuck with thinking like a financial analyst, that is, in the short term. He said to himself: “Oh, there’s a hole in this business, it’s terrible!” He didn’t see the value of the underlying business. We bought at a very low price because it seemed to be a company practically on the skids, but since we were insurance professionals, we restored the business immediately, we increased premiums, and so on, and the business took off very quickly. When we bought it, it was losing 200 million. The following year, the budget was balanced, and the third year it earned 200 million.

On the Equitable acquisition:

Continue reading… »

Instead of further examining where Apple’s current (and future) products fit in on the “innovation scale,” in Part II I want to talk about Apple as an investment, and where its products fit in in terms of investment value.

Apple has been a fantastic investment over the past decade. In fact, since April 2003 when they launched the iTunes store (and iPod sales took off), a dollar invested in Apple would be worth over $40 today – an annualized return of almost 70%. That’s a return that would make most venture capitalists blush. Not bad for a company founded 27 years prior.

One more statistic: even if Apple stock had gone nowhere from its IPO in 1980 up to 2003, its annual return over the three decades since going public would be 13%, which still beats the S&P 500 by over 3%. In other words, almost all of Apple’s current value (~$230 billion) was created over the last seven years.

Where did that value come from? For the seven years ending 2009, sales grew from $5.7bb to $42.9bb. Over 70% of that growth came from new products: the iPod, the iPhone, media sales, and other related peripherals. On a net profit basis, even more than 70% of Apple’s growth came from new products (segment margins aren’t disclosed, but overall margins have hugely increased and most of that likely came from new products). Aside from the storied brand name, Apple is basically a startup that was funded with the cash and income from their struggling Macintosh business.

Apple and the Red Queen Run the Hedonic Treadmill

“…it takes all the running you can do, to keep in the same place.” – The Red Queen, Lewis Carroll’s “Through the Looking-Glass”

So, clearly, the law of large numbers comes into effect when looking at Apple’s future growth prospects. To double revenues, Apple would have to sell an extra $43 billion a year in products – that’s over 68 million iPhones or 32 million Macs every year.

Continue reading… »

Apple is an incredibly creative, innovative company, and is usually at the top of people’s minds when it comes to new consumer technologies. So for the rest of this post, I’ll examine if and why Apple’s products are disruptive.

Disruptive Portable Music?

Before MP3 players, the only real option for portable music was a CD player. The first MP3 players were introduced in 1998, and had very low capacities. They could hold at most one or two CDs worth of music. In 2000, Creative released its NOMAD Jukebox, which had a capacity of around 1,200 songs. However, it was expensive and had limited usability.

The first generation iPod (5GB) was released in 2001 and could hold an average of 1,000 songs, or about 79 CDs at an equivalent quality. The cost of music (content) was low at first: consumers who already had a CD collection could transfer their songs to the iPod, or download them from the (usually illegal) filesharing programs on the internet.

The total cost per portable song for an iPod 1G was $1.48 or $0.39 if users converted old songs. This compares favorably to a CD player’s $1.95 cost per song (assuming someone can carry around a maximum of 10 CDs without it becoming too much of a burden – see notes for details). Despite this ability to carry more music for an incrementally cheaper cost, like earlier players the high total cost of the device—and the lack of convenience to use its capacity—confined sales to “fist adopters” and high-end users who were willing to convert their old music collection.

So at first, the iPod was a sustaining innovation relative to other portable music devices. Although it wasn’t made by a current industry leader, it was a breakthrough improvement upon other portable music devices and the performance metrics that customers valued (quality, capacity, cost per portable song, etc.).

Continue reading… »

Although the phrase disruptive innovation is used often, it is best described by Clayton Christensen in his books “The Innovator’s Dilemma” and “The Innovator’s Solution.” Most new technologies are sustaining—they improve the performance of current products along dimensions that the market already values. Rarer disruptive innovations result in products that are worse than current offerings in the near-term, but offer a different value proposition and are directed toward a different set of customers.

There are two types of disruptive innovations: new-market and low-end. New-market disruptions create a new value network (the context in which customers and firms within an industry define what attributes are most important), with different performance attributes. They usually serve customers who would normally not be using the product at all (i.e. personal computers, Bloomberg terminals). Low-end disruptions attack the least-profitable and most overserved customers along attributes that the market currently values (i.e. discount retailing, steel minimills). Both types of disruption eventually end up overtaking or completely replacing current offerings as their performance improves.

There are also two types of sustaining innovations: incremental and breakthrough. Most sustaining innovations are simple, incremental year-to-year improvements. Others are dramatic, breakthrough advances that surpass all current offerings (i.e. contact lenses replacing glasses, airliners replacing other long-distance travel). Many people confuse the terms disruptive and breakthrough. Christensen further distinguishes them by pointing out that disruptive innovations usually do not entail technological breakthroughs. Instead, they package current technologies into a disruptive business model.

Continue reading… »