The gist of the article is that managers of public companies focus too much on the expectations behind their stock price, and in turn “maximizing shareholder value.” [1] According to Martin, the causes stem from misaligned incentives and the business culture that has developed over the past 30 years. This focus on shareholders usually comes at the expense of customers and employees. “If you try to take care of shareholders, customers don’t benefit and, ironically, shareholders don’t get very far either.” When managers are working in the expectations market, they’re much more likely to make short term decisions that benefit only themselves and a (vocal) subset of shareholders—traders. This includes seemingly harmless activities like giving quarterly or annual earnings guidance, or for retailers reporting monthly same-store sales figures.

Martin proposes a few remedies to the problem, like improving board governance and eliminating both safe harbor provisions and stock-based compensation. These would go a long way to nudge corporate behavior in the right direction. But for managers who want to take it upon themselves, here’s my proposal: think of your company as a Dynamic Pie.

If you didn’t notice from the picture above, in this part of the post I’ll be discussing pie—the dessert, not the mathematical constant. The Dynamic Pie represents the value of a company to its customers—or in financial terms, its revenue. The size of the pie grows or shrinks over time depending on the amount of value received from customers. It then gets divided into three groups of stakeholders: Providers, Employees, and Owners.

The job of managers is twofold:

1. to grow the pie by delighting and growing the current base of customers; and
2. to divide the pie in a way that’s fair to all three groups.

Of course, the size of each group’s slice isn’t completely determined by managers. Each business is different—in some Providers will take the biggest slice (Wal-Mart), in others it’s Employees (Goldman Sachs) or Owners (Microsoft). The key is not that they are equal, but fair. Or, to be more precise, each group should be satisfied with their share given market circumstances.

Every stakeholder works to increase the size of the pie, because in most cases it’s in their best interest. If one group is being shortchanged in favor of another, they’ll end up focusing only on getting a bigger share, and not on customers. By taking care of customers and being fair to all stakeholders, the pie will grow and shareholder return should take care of itself.

Sears Holdings: Division of a Shrinking Pie

Sears Holdings is the company that owns Sears, Kmart, Land’s End, and other brands like Kenmore and Craftsman. It’s a good example of a business where the size of the pie is shrinking over time, primarily due to customers switching to competitors from under-maintained Sears or Kmart stores.[2] This is a difficult situation, as each group of stakeholders wants to maintain their share. If the pie’s getting smaller overall, it will come only at the cost of other stakeholders.

Although individually they don’t have much of a choice, employees don’t want to be laid off. Sears has 300,000+ associates, and you can’t meaningfully decrease their slice of the pie without consequences. There is value left in the huge amount of real estate that Sears leases, but again, you have to muscle it away from the lessors that provide it.[3]

Because it’s hard to maintain value for all share owners, Chairman Eddie Lampert has been focusing on a subdivision of the Owners slice: that of long-term shareholders. By buying-back a massive amount of shares over the past 6 years, the pie has shrunk further as some investors exit with their fixed slice, leaving remaining owners with a bigger share of a smaller pie.

For dying retailers, the decline is never linear—less customers, less employees, and poorer quality operations are all part of a negative feedback loop that accelerates over time. This is what has been happening to Sears recently. Now, all the investors who exited and “ate” their pie are looking much better off than those who stayed.

Getting it Right

In the article, Denning cites Johnson & Johnson, Proctor & Gamble, and Apple as exemplars. Costco and Starbucks are two more examples of companies that do a fantastic job of dividing and growing their value.

In Starbucks’ case, the Providers take the biggest slice by contributing the coffee beans, milk, paper products, real estate, etc. Though I’m not sure about the rest of their suppliers, I do know that Starbucks treats their coffee suppliers very well. Despite the fact that coffee is a commodity and can be had for the lowest possible price, Starbucks spends a little extra to ensure good working conditions for the farmers and good relationships with the communities involved. Baristas and other Starbucks partners receive full healthcare coverage, including part-time workers. Is this really necessary? Short-term, Starbucks could probably get away with cutting benefits (this was suggested to CEO Howard Shultz during the recession) to increase Owner’s share of the pie. But in the long run giving even the lowliest of partners a fair share will grow the pie for everyone involved.

Costco is a similar example. Despite operating on razor-thin margins (stores aren’t allowed to mark merchandise up more than 14% above cost), Costco pays their employees above-average wages and insures 85% of them compared to less than 50% for other major retailers. “It’s not altruistic,” Costco founder Jim Sinegal said in a recent interview. “This is good business, hiring good people and paying them good wages and providing good jobs for them and opportunities for a career.”

Let’s look back at the Sears example for a moment—what if declining value is the only possibility? Even if Sears plowed money into improving their stores, they would be unlikely to out-compete the Wal-Marts and Targets of the world. An historic example of this can be seen in Berkshire Hathaway.

When Warren Buffett took control of Berkshire in the late 1960s, it was a declining textile mill with no hope for revival. Instead of trying to divide the shrinking pie amongst current stakeholders, Buffett decided to grow the pie by allocating cash to better businesses. Over time, this added new employees and providers to the overall company while the textile mill faded away. Owners were not forced to fight over a smaller and smaller piece, nor were they taking an unfair share from employees or providers.

Some situations are harder than others to fairly split the pie. Companies with competitive advantages have more leeway in how stakeholders are treated. But by making sure everyone “wins” by receiving a fair share, every contributor is more incentivized to grow the pie and delight customers. Now onto finding me some real pie… (My favorites—because I know you’re wondering—are apple, cherry, peach and pumpkin.)

[1] Listening to the comments of current business leaders and reading histories of past leaders, I’ve always been perplexed by the misguided focus on stock price and market expectations. Part of me thinks that they don’t have a fundamental understanding of the way the market and its participants work. With very few exceptions (for companies that require constant short-term financing, or those issuing or buying back stock), businesses and their leaders shouldn’t give a damn about the market price of their company.

As an investor and entrepreneur, my advice to all leaders is this: If the market or analysts “expect” you to grow sales by 20% next year, that’s their business—not yours. If you miss expectations by 2% or by 2 cents a share, they’re the ones to blame for missing estimates. Your job should be to focus on improving the long term value of the business for everyone involved. Most share “owners” these days are short-term holders or mindless algorithms anyway.

[2] Other Sears Holding’s brands and their online division are doing much better, but due to the relative size of the Sears/Kmart retail operations it drags the rest down with it.

[3] Yes, it’s true that lease agreements lock lessors in and give them little options. But this is just another example that shows the only way to extract value in a situation like this: by taking it from the other stakeholders. Real estate Providers aren’t getting their fair share because Sears pays much lower than market rent for their properties.

Animal species reside on a scale with “generalist” on one end and “specialist” on the other. Specialists can live only in a narrow range of conditions: diet, climate, camouflage, etc. Generalists are able to survive a wide variety of conditions and changes in the environment: food, climate, predators, etc.

Specialists thrive when conditions are just right. They fulfill a niche and are very effective at competing with other organisms. They have good mechanisms for coping with “known” risks. But when the specific conditions change, they are much more likely to go extinct. Generalists respond much better to changes/uncertainty. These species usually survive for very long periods because they deal with unanticipated risks better. They have very coarse behavior: eat any food available, survive in many climates, use a simple mechanism to defend a wide range of predators, etc. But unlike specialists they don’t maximize their current environment, because they don’t fill a niche where they could be more successful. It’s tough being a generalist—there’s more competition.

An environment with more competition breeds more specialists. Rainforests have huge diversity and competition, and therefore many specialist species.

Specialist examples: Orchid mantis (colorful mantis with appendages like leaves, thrives only on orchids and in tropics), sword-billed hummingbird (beak longer than body, co-evolved with flowers having very long corollas and difficult getting food elsewhere), koala (lives almost entirely on eucalyptus filling a niche that is toxic to most animals).

Generalist examples: Cockroach (survives in most climates, only needs water/moisture and a food source, only defense is responding to puffs of air), raccoon (wide diet, omnivore, lives in any area with trees, brush, or structures), rat (found everywhere in the world but the Artic, not picky eaters), horseshoe crab (wide diet on floor of sea bed, tolerates wide range of water temperature, can survive in low oxygen waters and out of water for extended periods; species over 360MYO).

Specialists & Generalists in Business

This model can be applied to many different areas.

Investors themselves can be put on the specialist/generalist scale. The most specialized investors focus only on narrow segments of the market or certain types of securities. They can be very successful during certain time periods but in the long run are usually disrupted by a changing investment landscape or black-swan-like event. The most generalized investors use very coarse, unchanging rules and are truly “go anywhere”, willing to buy or sell any type of security around the world. They may underperform or lag behind their specialized brethren in the short term but will likely do well in the long run when averaged out over many different environments. Most investors (including Warren Buffett) lie somewhere in between these two extremes. Specialists include investors in certain industries like Sam Zell (real estate) and Ron Burkle (retail), or in certain situations like Jim Chanos (shorting) and David Tepper (distressed). True generalists are more rare, but include great investors like Ben Graham and Seth Klarman.

A more interesting application is to the competitive business world. Like in the animal kingdom, generalists are rare and are usually much bigger than the specialists. They include big multinationals like Johnson & Johnson, Wal-Mart, Coca-Cola, and Proctor & Gamble. Also included are conglomerates that may hold many diversified specialists like General Electric or Berkshire Hathaway. Specialists are businesses that focus on a local niche whether in geography or product space. Because many specialists can dominate their niche, they’re usually protected by moats and thus have high returns.

This is what I call the Specialist’s Dilemma. The stronger your competitive position, the more vulnerable you are to eventually being disrupted and replaced.

Let me explain further. Out of the universe of companies that have strong competitive moats, many of them have advantages originating from the niches they occupy. (Which can lead to barriers like economies of scale, brand attachment driven by habit, and being ahead on the learning curve.) These advantages are durable only as long as the niche itself remains viable. In other words, the more specialized a company’s dominance is, the stronger its advantages are — but the higher the odds of the niche itself eventually disappearing. Not disappearing due to competitors within the industry, but due to the niche being completely destroyed and replaced by something else. The timing of when this happens partially depends on the “clockspeed” of innovation within the industry (more on that in my last post).

Just something to think about if you’re a long term investor or business manager.

The following is a simplified chart/timeline of innovations in the computer industry:

Consumers purchase computer systems, with new innovations or shifts in one component (processors or operating systems) driving innovation in computer design and vice versa. Other components like storage and display also drove innovation but were less important in this context. Most of the above innovations are technical, with the exception of the commodity PC makers (Dell, Compaq, etc.) which were an innovation in business model.

After money was transferred from consumers to computer makers, it went primarily to chip makers and OS developers. Because suppliers like Intel and Microsoft had strong competitive advantages, they had strong bargaining power, and therefore received and kept most of the value.

Retail Industry

The progression of innovation doesn’t just apply to industries as technical and complex as computers. Below is another timeline (dates are approximate) of the progression of the retail industry:

As you can see, the speed of innovation in retail is much slower than the computer industry (but still faster than other businesses, like consumer staples). Innovations and shifts in the retail industry were driven by both (1) prior retail innovations, like discount retailers combining the variety store model with the grocery model of low margin/high turnover; and (2) outside-industry innovations, like railroad transportation leading to nationwide chains, free rural postal delivery leading to mail-order catalogues, and the internet leading to online retail.

If you’ve got any suggestions or critiques of the above charts, let me know in the comments or through email. I tried to get all the facts right for a simplified version of the timelines, but may have missed something.

The hefty valuation, along with the youth of the company (2.5 years) and the reported operating loss may lead observers and the media to cry “bubble.” While I think that $25 billion is a very rich valuation and wouldn’t pay that amount if it went public today, I think people in general underestimate the potential of Groupon’s business model. In other words, they were probably right to turn down Google’s offer of $6 billion (even if they don’t cash out during the offering).

Before going into Groupon’s business model and competitive advantages, here’s a quick run down of some of their customer statistics from the S-1:

In the above equation, those 5 metrics are multiplied to arrive at Groupon’s net revenue amount (the amount Groupon gets to keep after giving merchants their cut). So in the first quarter they made $270 million before expenses.

First the market, then the moat

Before Groupon and all the other deal sites began, local businesses had many lackluster options for advertising their product. They could send coupons in the mail; pay for ads in a local newspaper; pay for outdoor advertising; or pay for online advertising via Google, local news sites, etc. Most of these options (Google less so) are what Seth Godin calls interruption marketing. They are made to interrupt what you are normally trying to do. And because of that, people usually don’t like them, and they have a very low hit-rate in acquiring customers.

Groupon sells what Godin calls permission marketing. People want Groupon to send them daily emails, even if they don’t bother with 95% of them. This “permission” asset that Groupon owns is very valuable. It is not only the huge email list alone that is valuable, but the fact that the people on the other end look forward to Groupon offers (even if they don’t come in the form of daily deals in the future).

Felix Salmon has a good article going into more detail on the value of the “collective buying” model to consumers.

The absence of a well-run permission marketer in the local advertising space (a HUGE market) was an enormous opportunity. It was a form of entrepreneurial arbitrage — find the gap, and close the spread before everyone else catches on. But filling an unmet market opportunity, even if you’re the first mover, doesn’t necessarily mean your profits are protected from assault by competitors.

No company, outside of one with government contracts, has a competitive moat right off the bat. But as Groupon grew to fill-in the market opportunity, it grew its barriers to entry along the way:

• Trust & habit — similar, though not as strong, is why people continue to use Google despite many low-barrier alternatives. This is the initial, fundamental reason for Groupon’s success. As long as they keep their customers happy (and don’t screw anything up), people will keep using what their familiar with and trust. That will also be the one they tell their friends about.
• Initial network effects – the more people that use the service, the better discounts Groupon can get because they can better guarantee a certain amount of people will buy. The group buying aspect provides a kind of mini-economies-of-scale for local businesses. If they have a certain amount of fixed costs, the more customers they can bring in the door (even at little or no variable profit) the better.
• Long-run network effects – local businesses want to sell/advertise their product with the company with the biggest customer base (email distribution, popularity, trust). This is the key advantage. Because Groupon already has a dominant market share, local businesses will seek them more than anyone else. This also leads to a feedback loop—the bigger and better quality Groupon’s “deal” base is, the better they can serve their customers. Combined with trust/habit, these network effects allow Groupon to capture a significant amount of consumer’s attention and time. That attention is obviously very valuable to local businesses around the world. It is much more valuable than say an ad in the newspaper, yellow pages, or on the side of the road.

Groupon also has a funding source in the form of float. It receives the cash from selling a Groupon in an average of 8 days, but waits an average of 79 days to pay merchants their share. This is mainly due to a policy of paying merchants 1/3 five days after their debut, 1/3 thirty after, and the remainder in 60 days. As of March, this amounted to total float of $268mm (payables – receivables). This float has funded most of their recent cash needs in excess of non-growth profit.

All the above also applies to LivingSocial, Groupon’s largest competitor. Past a certain point, customers will get “deal fatigue”. No one wants to receive and sort through 20 daily email offers, or to browse 20 different deal sites. People have a limited amount of “mindshare” to devote to things like this. But at the same time, despite the above competitive advantages, people will still subscribe and solicit other deal sites. This business model is well designed for an oligopoly between Groupon, LivingSocial, and maybe a few other smaller players (Gilt, Travelzoo, etc.).

Not all growth is free

Here is a quote from a blog post today on Forbes: “…investors would be wise to mind the gap between dazzling revenues what it costs to get them.” These are probably the thoughts, at first glance, of many observers.

But if Groupon cut its advertising to nothing, there wouldn’t be a mass customer exodus. In fact, I would guess that growth wouldn’t even slow that much — at this point, it seems that a good portion of obtaining new subscribers would be organic (spread by word-of-mouth). It was certainly smart to spend as much on marketing as possible at first in order to grow market share, for the reasons stated in the above section.

So a certain percentage of marketing spend could be classified as “maintenance expenditures”, which would be the amount they would have to spend to maintain the current customer base. I have no guess as to what that number is, but it’s a lot smaller than their total marketing spend in the 1st quarter of $208mm. To arrive at an adjusted figure (they call it “Adjusted CSOI”) Groupon adds back $180mm of that amount. This would mean it costs them $28mm a quarter to maintain the current customer base. Seems reasonable to me.

Using $28mm in maintenance marketing, Groupon’s first quarter steady-state operating income was $63mm.

There’s always a “but”…

Groupon’s model and growth story aren’t a perfect fairy tale. There is certainly a “fad” element to Groupon (but the same could be said for Facebook, and Facebook has a more difficult job of converting attention to money). As Andrew Mason mentioned is his S-1 letter to investors, there will be bumps along the way. That’s inevitable for a company only 30 months old, no matter what its size.

Groupon is not unassailable. Although they have a moat, it’s definitely not as big as the moat around Google, Apple, or Facebook. In going back to the “oligopoly” argument — even if this is the case, LivingSocial has similar advantages and could potentially outdo Groupon in terms of service and efficiently acquiring customers. I’ve been a customer of both for a while now and recently it seems LivingSocial has done an excellent job. Regardless of whether it’s Groupon or LivingSocial on top — and LivingSocial has a long way to go at ~10% market share vs. 70-80% for Groupon — the business model is a powerful one that will continue to produce large amounts of profit for years to come (until it is inevitably disrupted at some point in time by another business model).

It was a very good letter overall, with Buffett providing his usual wisdom and wit. This year, he didn’t have to review the basics as he did in 2009 for the new Burlington Northern shareholders, so there was even more wisdom about Buffett’s methodologies and Berkshire’s businesses than usual.

He spends some time in the letter talking about Berkshire’s culture, which is an extremely important yet overlooked part of their past and future success. It is this culture that will allow Buffett to continue to “run” the company for many years after his death. That’s what Berkshire shareholders and the media should focus on instead of worrying so much about succession.

One thing is clear: Buffett may not run the companies that Berkshire owns, but he knows the numbers cold. Of course, that’s always been the case. For every kind of business, he knows the metrics that matter most and the determinants that drive success over time. Sometimes, he even knows it better than the managers themselves (and he’s a much better manager than he’d like to admit in his letters).

For investors, one of the most insightful parts of both Buffett’s letters and annual meetings is how he thinks about and evaluates businesses. In this letter, he didn’t disappoint by providing more insight on how he evaluates Berkshire’s holdings. GEICO was one specific example. The value of policyholders for many insurance companies is zero or even less than zero — these companies are worth tangible book value and no more. But GEICO, according to Buffett’s evaluation, has an extremely valuable base of policyholders: worth about $14 billion, or 97% of annual premium volume.

Number-wise, Buffett provided his estimate of the normalized earnings power of Berkshire’s operations — which at $17 billion, is higher than the reported amount in 2010. These earnings alone would give Berkshire a current pre-tax yield of over 8%, and that doesn’t include any new investments or future gains on their $158 billion in investments.

This valuation compares very favorably to many large-caps in the S&P 500. I think Berkshire is worth at least $100 per “B” share, if not more if Buffett can continue to deploy capital into good, growing businesses.

You can see the above comments in addition to commentary from other Berkshire shareholders in this WSJ blog post: “Here is What People Are Saying About Buffett’s Letter“

Braewick Holdings LP owns shares in Berkshire Hathaway. We reserve the right to buy or sell them at any time.

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Wal-Mart is often listed as a cheap large-cap, but is owned by surprisingly few value investors. One reason is that it’s big and well scrutinized and hence its price is more “efficient.”  This is partly true, and you won’t get stellar returns investing in Wal-Mart. But it is a cheap, well-managed company that returns cash to shareholders and should fare well under a number of different macro scenarios.

Competitive Advantages

The U.S. stores division of Wal-Mart (about 3/4 of pre-tax profit) has significant competitive advantages. To consumers, Wal-Mart’s brand represents one thing: low prices. Customers in the vicinity of a Wal-Mart remain loyal because they can be certain that they will have the lowest prices. And as long as Wal-Mart doesn’t slack off in the service and facility departments, there will be no good reason for customers to switch.

Wal-Mart can have the lowest prices because of their (1) efficient operations and (2) economies of scale. Operationally, expenses are lower because of their non-unionized workforce and other shrewd cost management (shrinkage, inbound logistics, etc.). This penny-pinching mentality has been ingrained in the company since it was founded by Sam Walton. The biggest cost advantages are from Wal-Mart’s economies of scale. The most obvious consequence is purchasing power—Wal-Mart can buy products at lower prices because they can purchase in such enormous quantities. But the biggest and most un-replicable scale advantage is geographic concentration. Wal-Mart has a “hub and spoke” system of a distribution centers with 100-150 stores around them, all within about a day’s drive. Because of this concentration, costs can be distributed over a larger base of potential customers: distribution, advertising, regional management, etc. Wal-Mart also has some of the most technologically advanced merchandise and logistics systems in the world. This is something that smaller or more spread-out retailers can’t match.

Capital Investment

Wal-Mart has turned their inventory at a faster rate for each of the past 7 years. This is due to better inventory management and logistics, which have allowed Wal-Mart to decrease their inventory per square foot to around $35, giving them an inventory turnover of 12x. This compares to turnover of 13-14x for Costco and 9x for Wal-Mart a decade ago. Return on inventory (margins * turnover) is at an all-time high. This, along with a slightly higher payables period, has turned working capital into a source of capital instead of a use of it.

Recent pre-tax ROIIC (return on incremental invested capital) is about 20% for the entire company, which includes lower-returning international acquisitions. Figures aren’t broken out perfectly, but I estimate that ROIIC for the Wal-Mart Stores division is around 30% with the International and Sam’s Club divisions at 10% and 14%, respectively. These returns once again reflect Wal-Mart’s advantages in the U.S. and their troubles replicating those advantages overseas.

Valuation

Though the price has been up over the past 3 months, free cash flow yield on equity is still around 6-7%, most of which is returned to shareholders through dividends (2.2% yield) and share buybacks (2-3% a year).  Current valuation is also lower than historic multiples. In fact, earlier this summer when shares hit $48, trailing EV/EBIT was 8.6x, the cheapest multiple Wal-Mart has traded at since 1985.

$55 * 3,636.5m shares + $37.8b net debt = $237 billion EV
Trailing EBIT = $24.8b; EV/EBIT = 9.6x

Sum of parts valuation:

$33b – Walmex stake (Market value of $48b, 68.5% stake)
$30b – Other International (10x pre-tax FCF)
$14b – Sam’s Club (11x pre-tax, vs. 10x for BJ and 13x for COST)
$240b – Wal-Mart Stores (15x pre-tax)
($38b) – Net debt
$279b equity value ($77/share)

Growth

U.S. stores are still being reformatted and converted into Supercenters: the percentage of stores in the Supercenter format is 74% versus 28% a decade ago. Also, the Neighborhood Market (NM) concept, which is basically a stripped-down grocery store, is still slowly being rolled out. Both should take share from lower-end grocery stores, and grow square footage 3-4%/year with another 1-2%/year growth in sales per square foot.

As for location growth, it’s hard to picture that many more Wal-Marts in the U.S. But there is still some opportunity here. In their home state of Arkansas, there is one Wal-Mart store for every 32,000 people. With NM’s that number could probably go lower, but that’s just about saturated. A bigger state like Texas has about 66,000 people per store which I figure is a reasonable goal for other areas. To push California to that figure, they’d have to open around 400 stores. To push other states to that level would add another 900. Wal-Mart has historically had trouble with major metropolitan areas like NYC, but that may change as they experiment with NM’s and smaller store formats.

Most new growth for the overall company will come from the International division. Within International, organic growth in emerging markets (South America and China) offers the best opportunities. The biggest segment is Wal-Mart Mexico (Walmex), which now includes Central America, with 2,122 stores. Walmex’s operating income has more than doubled over the past 5 years to $2 billion, and is growing 13% a year.

The biggest risk here is achieving low return on investment in new markets, primarily in growth through acquisitions. They haven’t done well in that regard over the past 5 years, the reason being they have no real advantages in starting or acquiring new companies far from their dominant U.S. business. They recently made an expensive offer for Massmart, a dominant South African discounter, and are bidding on a retailer in Indonesia. Hopefully they will be more disciplined in the future regarding expansion into new areas overseas.

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Number of U.S. Wal-Mart Stores:

Returns on capital investments: (return on inventory = EBIT margin * inventory turnover)

Invested Capital as a % of Sales: (You can see the more efficient use of working capital over time as well as the spike in fixed assets as they expanded rapidly outside their normal geographic area in the ’90s.)

Historic End of Year and Low EV/EBIT: (Notice that, despite outstanding growth and financial performance, how cheap Wal-Mart was pre-1986.)

Rolling 10-Year Annualized Stock Returns:

Braewick Holdings LP currently owns shares in Wal-Mart Stores (WMT). We reserve the right to buy or sell shares at any time.

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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.

When BreitBurn appeared on my radar in November, it seemed like the perfect example of a simple, profitable company that was being sold off by non-economic sellers. So despite all the market noise, what were units of BreitBurn really worth?

The above valuation of asset value is a simplistic method of obtaining the market value of oil and gas reserves that BreitBurn owns. The hybrid price of oil/gas was $35 a barrel at the time, which translated into an equity value of around $17 per unit. (Though, had BreitBurn actually liquidated and sold its reserves, it would take a haircut due to the time value of extracting the reserves over a period of years.) Distributable cash flow (profits that can be freely distributed to unitholders) totaled $2.70 per unit, $2.08 of which was actually distributed in the form of a dividend. So at a price of $6 per unit, we were purchasing BreitBurn at a yield of over 30%. This was clearly an asset with a large margin of safety.

We continued to purchase BreitBurn through the next quarter. Even with their hedges in place, cash flow did drop going into 2009 as demand for oil and gas continued to languish. Because of falling energy prices and asset values, BreitBurn’s lenders decided to redetermine their borrowing base (the amount of debt the company is allowed to have in relation to oil/gas reserves). Although BreitBurn was still in the “safe” zone, it was a hectic economic period with little liquidity, and management made the choice to temporarily eliminate the $2.08 distribution. This was a prudent decision, as they could instead pay down debt with their cash flow and eliminate the risk of having to raise new equity or refinance at a bad rate. It’s always better to be safe than sorry. This was one of the many excellent decisions that managers Hal Washburn and Randy Breitenbach made over the past few years.

On April 20, 2009, after the announcement of the dividend cut, BreitBurn’s stock price collapsed again under $6, and gave us another opportunity to buy more units. Our total average cost was $5.90. Over the course of the year, the price moved up steadily with the market. On February 8 of this year, they announced the reinstatement of the distribution at $1.50 per unit. “Yield” investors bought back in, pushing the share price to its current level of around $15 (a 10% yield). We sold a quarter of our position at $14, but BreitBurn remains one of our largest investments.

Braewick Holdings LP currently has a long position in BreitBurn Energy (BBEP). We reserve the right to buy or sell shares at any time.

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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.

In and of itself, this compensation agreement isn’t inherently bad. It’s a typical “pay for performance” scheme that many private investment funds use, including our own. (In fact, Biglari’s hurdle is slightly more generous than ours, but thankfully I haven’t had any complaints—yet.) I won’t delve into the more technical reasons I dislike the agreement—other than to say that a public company is not comparable to a private investment fund for a variety of reasons. I think the bigger implications are with the revelation of Type X behavior and how it affects the culture and future strategy of the company.

Type X behavior is fairly common among the CEOs of public companies. So it’s obviously not a disaster. In this particular case however, I think it permanently damages reputation. Aside from Warren Buffett’s history of good deeds, it gives people (shareholders, company managers, etc.) comfort that he isn’t in it for the money and is on equal financial footing with other partners. The strategy of Biglari Holdings is also that of “growth through opportunistic acquisitions.” Acquiring companies when you have a reputation for selfishness and hostility can be a difficult undertaking. Also, regarding the people already working for Biglari Holdings, this behavior may have the effect of changing company culture for the worse.

Braewick Holdings LP still has a long position in Biglari Holdings (BH). We reserve the right buy or sell shares in BH at any time.

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:

The entire financial press thought the company was done for, and Wall Street was expecting a bankruptcy at any moment.  … I went to New York, I took a look, I talked with the management, and I said to myself: “This one too has a fantastic business.” So I had to see how big the financial hole was, in comparison with the value of the business. We studied the company for five months, something no one else was doing. We made a bet on a sure thing. . . .

What’s marvelous in this story is that when we did the deal, the head of the company said to me: “Claude, now you know more about the company than I do.” And it was true. We had studied it thoroughly. To do deals like that, you have to be in a profession you know, do a very thorough study, and have the ability to make quick decisions. These were the advantages we had over the others. There was no miracle.

On what constitutes a “good deal”:

MV: If I understand you correctly, correct me if I’m wrong, to do a good deal, you take advantage of a moment of vulnerability of the other party (which doesn’t mean you treat him badly, you can be elegant) and you play on the asymmetry of information.

CB: Absolutely.

MV: You’re not against that interpretation?

CB: No, not at all. You know, in a company, there’s the objective and the subjective. In addition, a company can be worth something for me, considering the business I’m in, considering the know-how I have, and for the next businessman it could be a catastrophe, a millstone. We were just talking about Bouygues: he bought an insurance company by chance, he realized it was not his kind of business, and boom. He went away. It was a good decision by a company head.

On taking insurance risks:

We took small risks in the area of reinsurance, but not on a large scale. It’s easy to do reinsurance. You can sign up to whatever you want. We didn’t want to buy shares in a reinsurer but to learn the business ourselves.

On whether is made his money by being an “innovator”:

MV: In writing the history of major businessmen, to explain their careers, it is often said that they were innovators. And you? You never present yourself as an innovator?

CB: In France, the inventor of modern automobile insurance was a man named Jacques Vandier. He was the head of Macif. He really invented new criteria. I have to admit that I never invented anything. What I was able to do was to recognize the weakness of other companies and exploit that weakness. That is, when opportunities came up, I dared to do what other’s didn’t, but without taking considerable risks. This was simply because facing me were timorous people, bureaucrats, notables.

On his interest in business:

Your last question is why I’m not richer than I am? The explanation is simple. First, I’m the son of civil servants, my parents were teachers, I was more tempted by business and power in business than by wealth. Second, I joined a mutual company where, normally, you’re not supposed to get rich. . . . Later, I started to get wealthy when stock options became legal in France. . . .

You know, it’s never entertaining to manage a company. What’s entertaining is to make progress, to try to do better than the others, to do things that the other’s don’t do. That’s the entrepreneurial spirit.

Claude Bébéar is very much a value investor (protecting himself from risk and uncertainty) whether he calls it that or not. Definitely no Warren Buffett, but an interesting story nonetheless.

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.

Of course, investors aren’t counting on Apple’s revenue doubling anytime soon, and the law of large numbers just means it’s more difficult for them to grow, not that it’s impossible. But to me, the more relevant model to use for Apple’s future growth is that of the Red Queen Effect.

In Lewis Carroll’s follow up to “Alice in Wonderland,” Alice comes across the Red Queen (not to be confused with the more popular Queen of Hearts) and for no reason at all they both begin to run. Alice notices that, despite their tireless efforts, they have remained in the same spot. The Queen informs her that she must keep running just to stay put (see the above quote).

In biology, the Red Queen’s race is translated into the principle that “for an evolutionary system, continuing development is needed just in order to maintain its fitness relative to the systems it is co-evolving with.” I think the Red Queen effect is an apt analogy for Apple’s current situation. Here’s why:

• Most of Apple’s growth in sales over the past 2 years has been from the iPhone (68% of growth to be exact).  The iPhone was launched in 2007, and most of these sales have been to new iPhone users. Certainly there are much more non-iPhone users to “convert,” but at some point most iPhone purchases will come from current users who are upgrading. This has already happened with the iPod – as seen in the chart above with iPod unit sales tapering off lately.
• Most future growth will have to come from new iPhone users, iPad sales, and any new products that Apple introduces.
• To justify Apple’s current valuation, the company must consistently come out with new (and popular) products to both maintain and grow profits. In other words, they have to keep running just to stay in the same place.

The one part of Apple’s business that isn’t susceptible to the Red Queen effect is their share of media/app sales through the iTunes & App store. Because of their closed system (disregarding the downside to this model), Apple controls and gets a cut of almost every application and piece of media consumed on their devices.

The iPod/iPhone/iPad act as mobile “delivering devices” for entertainment and productivity applications. If Apple can maintain their closed system – and Clayton Christensen’s prediction continues to be wrong – their share of content distribution will continue to rake in profits.

But as an investment, I don’t think there’s much of a margin of safety if Apple stops “running” and a new product launch fails. Investor’s high expectations have put Apple on a Hedonic Treadmill of sorts that only a fall in price can cure.