A Saturday with Warren

I personally thought this year's Berkshire Hathaway annual report was one of the best. Perhaps welcoming thousands of new shareholders to the fold got Warren Buffett's creativity flowing?

Whatever the reason, it was a treat to read. But since most people have better things to do on a Saturday, here are some of my favorite excerpts (with minimal commentary) in case you want the abridged version.

On inverting and country music:

Long ago, Charlie (Munger) laid out his strongest ambition: “All I want to know is where I’m going to die, so I’ll never go there.” That bit of wisdom was inspired by Jacobi, the great Prussian mathematician, who counseled “Invert, always invert” as an aid to solving difficult problems. (I can report as well that this inversion approach works on a less lofty level: Sing a country song in reverse, and you will quickly recover your car, house and wife.)

Attention tech investors - industry growth doesn't guarantee a good investment:

Charlie and I avoid businesses whose futures we can’t evaluate, no matter how exciting their products may be. In the past, it required no brilliance for people to foresee the fabulous growth that awaited such industries as autos (in 1910), aircraft (in 1930) and television sets (in 1950). But the future then also included competitive dynamics that would decimate almost all of the companies entering those industries. Even the survivors tended to come away bleeding.

Just because Charlie and I can clearly see dramatic growth ahead for an industry does not mean we can judge what its profit margins and returns on capital will be as a host of competitors battle for supremacy. At Berkshire we will stick with businesses whose profit picture for decades to come seems reasonably predictable. Even then, we will make plenty of mistakes.

Berkshire wants long-term investors, not short-term stock jockeys (but we split the stock anyway):

We make no attempt to woo Wall Street. Investors who buy and sell based upon media or analyst commentary are not for us. Instead we want partners who join us at Berkshire because they wish to make a long-term investment in a business they themselves understand and because it’s one that follows policies with which they concur. If Charlie and I were to go into a small venture with a few partners, we would seek individuals in sync with us, knowing that common goals and a shared destiny make for a happy business “marriage” between owners and managers. Scaling up to giant size doesn’t change that truth.

Capital-intensive businesses aren't ideal (but they're OK if you're drowning in capital):

In earlier days, Charlie and I shunned capital-intensive businesses such as public utilities. Indeed, the best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow. We are fortunate to own a number of such businesses, and we would love to buy more. Anticipating, however, that Berkshire will generate ever-increasing amounts of cash, we are today quite willing to enter businesses that regularly require large capital expenditures. We expect only that these businesses have reasonable expectations of earning decent returns on the incremental sums they invest.

NetJets was a mistake (so, goodbye, Rich Santulli):

NetJets’ business operation, however, has been another story. In the eleven years that we have owned the company, it has recorded an aggregate pre-tax loss of $157 million. Moreover, the company’s debt has soared from $102 million at the time of purchase to $1.9 billion in April of last year. Without Berkshire’s guarantee of
this debt, NetJets would have been out of business. It’s clear that I failed you in letting NetJets descend into this condition. But, luckily, I have been bailed out.

On cohabitation and (the idiotic) cash-for-clunkers program:

People thought it was good news a few years back when housing starts – the supply side of the picture – were running about two million annually. But household formations – the demand side – only amounted to about 1.2 million. After a few years of such imbalances, the country unsurprisingly ended up with far too many houses.

There were three ways to cure this overhang: (1) blow up a lot of houses, a tactic similar to the destruction of autos that occurred with the “cash-for-clunkers” program; (2) speed up household formations by, say, encouraging teenagers to cohabitate, a program not likely to suffer from a lack of volunteers or; (3) reduce new housing starts to a number far below the rate of household formations.

Government creates distortions in the mortgage market (and everywhere else):

The residential mortgage market is shaped by government rules that are expressed by FHA, Freddie Mac and Fannie Mae. Their lending standards are all-powerful because the mortgages they insure can typically be securitized and turned into what, in effect, is an obligation of the U.S. government. Currently buyers of conventional site-built homes who qualify for these guarantees can obtain a 30-year loan at about 51⁄4%. In addition, these are mortgages that have recently been purchased in massive amounts by the Federal Reserve, an action that also helped to keep rates at bargain-basement levels.

What happens when Ben takes his finger off the scale?

It pays to back up a truck when people get stupid (and boy did they get stupid):

We told you last year that very unusual conditions then existed in the corporate and municipal bond markets and that these securities were ridiculously cheap relative to U.S. Treasuries. We backed this view with some purchases, but I should have done far more. Big opportunities come infrequently. When it’s raining gold, reach for a bucket, not a thimble.

We’ve put a lot of money to work during the chaos of the last two years. It’s been an ideal period for investors: A climate of fear is their best friend. Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance. In the end, what counts in investing is what you pay for a business – through the purchase of a small piece of it in the stock market – and what that business earns in the succeeding decade or two.

The buck stops (or should) at the CEO's desk (and the boardroom):

It’s my job to keep Berkshire far away from such (leverage and/or counterparty risk) problems. Charlie and I believe that a CEO must not delegate risk control. It’s simply too important.... If Berkshire ever gets in trouble, it will be my fault. It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.

In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other employment. And if he fails at it – with the government thereupon required to step in with funds or guarantees – the financial consequences for him and his board should be severe.

It has not been shareholders who have botched the operations of some of our country’s largest financial institutions. Yet they have borne the burden, with 90% or more of the value of their holdings wiped out in most cases of failure. Collectively, they have lost more than $500 billion in just the four largest financial fiascos of the last two years. To say these owners have been “bailed-out” is to make a mockery of the term.

We (unlike most of corporate America) hate to issue stock (but we did it anyway):

Charlie and I enjoy issuing Berkshire stock about as much as we relish prepping for a colonoscopy.... The reason for our distaste is simple. If we wouldn’t dream of selling Berkshire in its entirety at the current market price, why in the world should we “sell” a significant part of the company at that same inadequate price by issuing our stock in a merger?

In stock deals, intrinsic value matters on both sides of the equation:

In evaluating a stock-for-stock offer, shareholders of the target company quite understandably focus on the market price of the acquirer’s shares that are to be given them. But they also expect the transaction to deliver them the intrinsic value of their own shares – the ones they are giving up. If shares of a prospective acquirer are selling below their intrinsic value, it’s impossible for that buyer to make a sensible deal in an all-stock deal. You simply can’t exchange an undervalued stock for a fully-valued one without hurting your shareholders.

Imagine, if you will, Company A and Company B, of equal size and both with businesses intrinsically worth $100 per share. Both of their stocks, however, sell for $80 per share. The CEO of A, long on confidence and short on smarts, offers 1 and 1⁄4 shares of A for each share of B, correctly telling his directors that B is worth $100 per share. He will neglect to explain, though, that what he is giving will cost his shareholders $125 in intrinsic value. If the directors are mathematically challenged as well, and a deal is therefore completed, the shareholders of B will end up owning 55.6% of A & B’s combined assets and A’s shareholders will own 44.4%.

Not everyone at A, it should be noted, is a loser from this nonsensical transaction. Its CEO now runs a company twice as large as his original domain, in a world where size tends to correlate with both prestige and compensation.

If an acquirer’s stock is overvalued, it’s a different story: Using it as a currency works to the acquirer’s advantage. That’s why bubbles in various areas of the stock market have invariably led to serial issuances of stock by sly promoters. Going by the market value of their stock, they can afford to overpay because they are, in effect, using counterfeit money. Periodically, many air-for-assets acquisitions have taken place, the late 1960s having been a particularly obscene period for such chicanery. Indeed, certain large companies were built in this way. (No one involved, of course, ever publicly acknowledges the reality of what is going on, though there is plenty of private snickering.)

Buffett "loves" investment bankers (Salomon taught him well):

I have been in dozens of board meetings in which acquisitions have been deliberated, often with the directors being instructed by high-priced investment bankers (are there any other kind?). Invariably, the bankers give the board a detailed assessment of the value of the company being purchased, with emphasis on why it is worth far more than its market price. In more than fifty years of board memberships, however, never have I heard the investment bankers (or management!) discuss the true value of what is being given. When a deal involved the issuance of the acquirer’s stock, they simply used market value to measure the cost. They did this even though they would have argued that the acquirer’s stock price was woefully inadequate – absolutely no indicator of its real value – had a takeover bid for the acquirer instead been the subject up for discussion.

When stock is the currency being contemplated in an acquisition and when directors are hearing from an advisor, it appears to me that there is only one way to get a rational and balanced discussion. Directors should hire a second advisor to make the case against the proposed acquisition, with its fee contingent on the deal not going through. Absent this drastic remedy, our recommendation in respect to the use of advisors remains: “Don’t ask the barber whether you need a haircut.”

But not all bankers are stupid (or overpaid):

We (Berkshire) owned stock in a large well-run bank that for decades had been statutorily prevented from acquisitions. Eventually, the law was changed and our bank immediately began looking for possible purchases. Its managers – fine people and able bankers – not unexpectedly began to behave like teenage boys who had just discovered girls.

They soon focused on a much smaller bank, also well-run and having similar financial characteristics in such areas as return on equity, interest margin, loan quality, etc. Our bank sold at a modest price (that’s why we had bought into it), hovering near book value and possessing a very low price/earnings ratio. Alongside, though, the small-bank owner was being wooed by other large banks in the state and was holding out for a price close to three times book value. Moreover, he wanted stock, not cash.

Naturally, our fellows caved in and agreed to this value-destroying deal. “We need to show that we are in the hunt. Besides, it’s only a small deal,” they said, as if only major harm to shareholders would have been a legitimate reason for holding back. Charlie’s reaction at the time: “Are we supposed to applaud because the dog that fouls our lawn is a Chihuahua rather than a Saint Bernard?”

The seller of the smaller bank – no fool – then delivered one final demand in his negotiations. “After the merger,” he in effect said, perhaps using words that were phrased more diplomatically than these, “I’m going to be a large shareholder of your bank, and it will represent a huge portion of my net worth. You have to promise me, therefore, that you’ll never again do a deal this dumb.”

Yes, the merger went through. The owner of the small bank became richer, we became poorer, and the managers of the big bank – newly bigger – lived happily ever after.

Buffett's attempt to justify the Burlington deal rang hollow. Given the highlighted line above, one could even accuse the Oracle of hypocrisy, especially since he believes Berkshire shares are slightly undervalued. So the premium paid to BNI was even higher then we thought?

Nonetheless, this is a worthy addition to the Berkshire letter library. Buffett has a true gift for presenting difficult concepts and framing issues in a unique way. Whether its quoting country music lyrics or offering a window into many a boardroom, Buffett is both entertaining and educational whether you're a amateur or a seasoned veteran. And he doesn't pull his punches. When you're a billionaire, you don't have to.


Disclosure: No positions.

Dr Pepper Follow-up

Dr Pepper Snapple (DPS) delivered on its promises today. DPS worked fast, immediately paying down debt to its target of $2.55 billion.

Here is the press release (highlights added):

DR PEPPER SNAPPLE GROUP COMPLETES LICENSING OF CERTAIN BRANDS TO PEPSICO

• Receives one-time cash payment of $900 million
• Reduces total outstanding debt obligations to $2.55 billion

Plano, TX, February 26, 2010 – Dr Pepper Snapple Group, Inc. (NYSE: DPS) today announced that it has completed the licensing of certain brands to PepsiCo, Inc. following PepsiCo's acquisitions of The Pepsi Bottling Group, Inc. (PBG) and PepsiAmericas, Inc. (PAS). As part of the transaction, DPS received a one-time cash payment of $900 million before taxes and other related fees and expenses.

The company used a portion of these proceeds to reduce its total debt obligations to $2.55 billion, in-line with its target capital structure of approximately 2.25 times total debt to EBITDA after certain adjustments.

“Having achieved our capital structure target less than two years after going public, and with a focus on growing the business organically, we are now committed to returning excess cash to shareholders over time,” said Larry Young, DPS president and CEO. “We’re excited to be working with PepsiCo and are confident in our continuing ability to generate strong cash flows.”

Under the new licensing agreements, PepsiCo will distribute Dr Pepper, Crush and Schweppes in the U.S. territories where these brands were formerly distributed by PBG and PAS. The same will apply for Dr Pepper, Crush, Schweppes, Vernors and Sussex in Canada, and Squirt and Canada Dry in Mexico. The new agreements will have an initial term of 20 years, with 20-year renewal periods, and will require PepsiCo to meet certain performance conditions.

Additionally, in U.S. territories where it has a manufacturing and distribution footprint, DPS will shortly begin selling certain owned and licensed brands, including Sunkist soda, Squirt, Vernors and Hawaiian Punch, that were previously distributed by PBG and PAS.

The one-time cash payment of $900 million will be recorded as deferred revenue and recognized as net sales over the estimated 25 year life of the customer relationship.

Validation like this usually takes longer than 24 hours!

Disclosure: Long DPS

Dr Pepper Wins Again & Again

Have I mentioned Dr Pepper Snapple Group (DPS) on this blog before? OK, once or twice. There wouldn't be a need for this crusade if anyone else seemed to be paying attention. Honestly, it seems like Crocs (CROX), a maker of plastic shoes, gets more press.

Despite relative obscurity, DPS is a serial winner. The stock was up 11% yesterday thanks to a combination of earnings and the Coca-Cola (KO)/Coca-Cola Enterprises (CCE) deal.

And yet, it's still cheap.

Dr Pepper hit the jackpot when Pepsi bought its largest bottlers (PBG and PAS). The deal triggered a change of control clause in DPS' bottling agreements with those companies. As a result, Dr Pepper renegotiated the deals and extracted $900 million from their new parent Pepsico (PEP). Dr Pepper was also able to reclaim some brands for their internal bottling operations.

On yesterday's earnings call, DPS management said they expect to close the deal by the end of February. So, like, tomorrow!

That's $900 million... cash... tomorrow.

Dr Pepper has approximately 256 million shares outstanding. At $32 a share, the current market value is just $8 billion. So the $900 million payment (did I mention that already?) is pretty significant in both absolute and relative terms.

What does DPS plan to do with the money? Debt repayments, share repurchases, and dividends. (Is that a song?)

On top of this windfall, Dr Pepper Snapple generated operating cash of $865 million in 2009. Of this, $312 million was spent on capital expenditures, approximately half of which were new investments (as opposed to maintenance capex). The remaining cash flow was spent on voluntary debt prepayments of $550 million.

How's that for straightforward capital allocation? (550 + 312 = 862) Not a coincidence.

At year-end 2009, Dr Pepper Snapple had $2.955 billion of debt outstanding. The company's target debt level is approximately $2.5 billion. So with the Pepsi payment, the company will immediately reach its debt target and have $400 - $500 million cash remaining. As in, like, tomorrow.

It is not surprising then that the company announced an increase in its share repurchase plan to $1 billion. Only 3 months ago, DPS announced its first ever buyback plan ($200 million) and its first dividend (15 cents a quarter). So in just 3 months since the first buyback announcement, the board became so confident in the company's cash generation that it increased the authorization by $800 million?!? Astounding.

Far from a publicity stunt, management announced that the repurchases will begin once the debt target has been met. Again, so like, tomorrow! Ok, Monday.

The excess Pepsi money ($400 - $500 million) will probably be allocated to share repurchases immediately. The same is probably true for all excess cash flow going forward. In short, cash previously dedicated to debt payments will now go towards share repurchases. This is not a bogus buyback (the norm) that simply offsets stock option dilution. Rather, it is a concerted effort to return cash to shareholders. Lot's of it.

Most companies in this situation would find some reason to throw it away on an expensive acquisition (here read Dell/Perot). But DPS (as I've been saying over and over again) is not "most companies".

When asked about possible acquisitions on the conference call, one company official (can't remember which one) put the issue to rest seemingly forever. Our growth is going to be "organic, not from M&A" (a pretty close paraphrase). He said that the company may buy some small distributors, but that any such transaction would be tiny. He may have even called it a "rounding error". Again, straightforward... and shareholder friendly!

So here is how DPS' free cash flow will probably being allocated into the near future.

$700 million in free cash flow (a conservative 2010 estimate)

$150 million in discretionary capex
$150 million in dividends
$400+ million in share repurchases

The $700 million free cash flow estimate could be low as interest expense will be dramatically lower going forward. The company has lowered its average interest rate to around 5%. And don't forget over $1 billion of debt repayments. That's as of, like, tomorrow.

The Pepsi money means that the current share repurchase plan could be completed in just 12 months. But it gets even better. That always seems to be the case with this company!

Dr Pepper Snapple Group's bottling agreement with CCE is "very similar" to the one that it had with the Pepsi bottlers. The Coca-Cola buyout of CCE's North American assets will presumably trigger the same change of control clause that is typical in such deals.

Does that mean another $900 million (or more) payment for DPS? I wouldn't be surprised.

My $40 price target is looking VERY low.

It's time someone (besides this lonely investor) started counting the cash at DPS.

Disclosure: Yes, the author STILL owns DPS shares.

KO: 49% is a Solution No More

In October 1996, Fortune magazine ran a cover story entitled: HOW COKE IS KICKING PEPSI'S CAN. In it the authors portray a Coca-Cola management that's very satisfied with itself. The cola wars are over. They've won. Case closed.

Of Pepsico (PEP), Roberto Goizueta said, "As they've become less relevant, I don't need to look at them very much anymore." Pretty smug for a man described as reserved, aristocratic, and cerebral. Nonetheless, the swagger seemed appropriate given Coke's performance. The anecdotes set forth by Fortune show KO was outmaneuvering PEP on every front.

And there was an element of vindication and payback! As the article says:

Coke has had a vendetta against (then Pepsi CEO) Enrico ever since he gloated about the New Coke debacle a decade ago in his memoir, The Other Guy Blinked: How Pepsi Won the Cola Wars. Says Goizueta, seeming both vindicated and vindictive: "It appears that the company that claimed to have won the cola wars is now raising the white flag."

While PepsiCo's CEO Roger Enrico and his beverage chief Craig Weatherup did sound defensive in the article, neither was willing to admit defeat, much less to offer a surrender.

When Enrico is told about Goizueta's disparaging remark--that Pepsi has become "less relevant"--he folds his arms across his burly chest, stares at the coffee table in front of him, and pauses. Smiling slyly, he says, "Good."

Weatherup went even further, saying (of Coke), "Their Achilles' heel is their own arrogance, and it eventually will be their downfall. I hope I'm around to see it."

The word "arrogance" must have been directed at Doug Ivester. The heir apparent to Goizueta, Ivester clearly believed his sharp elbows were a virtue. Of Weatherup, he said, "Craig is a nice guy." And as Fortune pointed out: Ivester is not a nice guy.

He is, in fact, the man responsible for Coke's ungentlemanly swagger of late. An intense, uncharismatic ex-accountant, he tells customers, "I want all your business." He urges managers to play by the rule of Ray Kroc, the founder of McDonald's (another PepsiCo nemesis): "What do you do when your competitor is drowning? Get a live hose and stick it in his mouth." Tenacious and unequivocal, Ivester, 49, is Goizueta's co-strategist and the senior executive in charge of operations and marketing. Says Goizueta: "Doug has the nerve of a night prowler."

As as Fortune correctly pointed out, "Unless he gets run over by a Pepsi delivery truck, Ivester will be Coca-Cola's next CEO." And for 3 short years (1997-2000), he was.

Besides his tough image, Ivester is portrayed as a financial genius... with an "ability to analyze arcane problems, concoct clever solutions, and maximize returns on investment".

One such clever solution has favored the industry for years.

As chief financial officer in 1986, Ivester devised the financial underpinnings of "the 49% solution." This innovative deal turned out to be the bedrock of Coke's global strategy, not to mention a potent stimulus to its stock price. Here's how it worked: Coke bought a bunch of U.S. bottlers that weren't performing well and combined them with its own bottling network, calling the new outfit Coca-Cola Enterprises (CCE). Then it spun CCE off to the public but kept 49% of the stock and the right to throw its weight around. Simultaneously -- here's the magic -- Coke washed billions of dollars in debt and a low-return, capital-hungry business off its books.

For nearly 25 years, Coca-Cola benefited from having effective control of its largest bottlers, while not having to consolidate these "low-return, capital-hungry" businesses onto its pristine balance sheet. And investors willingly ignored this slight of hand, basking in the glow of earnings growth.

Whether the ownership level triggers a GAAP consolidation or not, Coca-Cola and its bottlers are connected at the hip. Unfortunately for KO, as separate companies, the bottlers didn't always fall in line. In today's world, the "49% solution" looks more like an accounting gimmick than a strategy. Effective control wasn't absolute.

That said, PepsiCo spent years trying to duplicate Coca-Cola's 49% structure. The strung together bottlers, spun them off, and held large "minority" stakes. They implicitly bought into the belief that bottling needed to be controlled, but separate. Pepsi clearly believed that KO was deriving some benefit from the arrangement.

Investment bankers were all too happy to oblige. How often have you seen companies spin-off their dreaded slow-growth businesses? But was all the asset shifting creating anything? Was it worthwhile? The debate dies a cold, carbonated death in August when Pepsico acquired Pepsi Bottling Group (PBG) and PepsiAmericas (PAS). In one swift move, it reversed itself after years of following Coca-Cola's structural lead. In short, Pepsico began thinking for itself.

It became an industry leader, rather than a follower. The question became, would KO confirm this new direction? Today they did. In a huge $15 billion affirmation.

The partial purchase of Coca-Cola Enterprises (CCE) by Coca-Cola confirms that the Age of Ivester is truly over. And if I may interject, a hearty "Congratulations" to LSV Asset Management for buying a huge CCE stake recently. Wish I'd followed... one can never have too much sugar water in the portfolio.

The 49% Solution lived after Doug Invester left Coca-Cola, but it is dead, or dying, now. Ironically, it was Ivester who said, "I look at the business like a chessboard... You always need to be seeing three, four, five moves ahead. Otherwise, your first move can prove fatal." I doubt he saw this coming.

Perhaps checkers would be a better analogy. In 1996, Coca-Cola declared victory and yelled "king me". Any investor who heeded the call has paid dearly. Since 1996-1997, KO shares have been dead money (ex dividends). Pepsico has more than doubled. Craig Weatherup should be proud. (He led the PBG spin-off and then left in 2003.)

Today, Coke is still larger than Pepsico, but it is a humbler company. Despite all the talk about live hoses and drowning, both companies are doing just fine. That said, neither is particularly cheap. Their market values are either side of $100 billion and their free cash flow multiples hover around 20 times.

For an industry bargain, investors should head to Dr Pepper Snapple Group (DPS) with its paltry $8 billion market value. The company generates $650 to $750 million a year in free cash flow. Debt repayments are largely complete and the stock repurchase plan has been increased to $1 billion, or 12% of the outstanding shares. Today's earnings release was a thing of beauty.

Could this be the next beverage buyout?

Absolutely.


Disclosure: Author owns DPS shares.

BKS Speaks Volumes

As expected, the Barnes & Noble Board of Directors (Read the Riggio family) has spurned Ron Burkle's (Yucaipa) attempt to raise his BKS stake without triggering a poison pill. The letter to Burkle says a lot more than "No".

The letter reads:

Dear Mr. Burkle:

The Board of Directors has carefully considered your letter of January 28, 2010 requesting that you and your affiliated funds be allowed to collectively acquire 37% of Barnes & Noble’s outstanding shares without triggering Barnes & Noble’s Shareholder Rights Plan.

The Shareholder Rights Plan was adopted last November in response to a rapid accumulation of a significant portion of Barnes & Noble’s outstanding common stock, and is intended to protect our shareholders from actions that are inconsistent with their best interests. The Board has determined by unanimous vote that acceding to your request would not be in the best interests of all Barnes & Noble’s shareholders.

As you have expressed concern regarding the “free and fair exercise of the shareholder franchise,” we would remind you that Barnes & Noble previously announced its intention to submit the Shareholder Rights Plan for shareholder ratification within 12 months of its adoption.

The Board also would like to correct a misstatement contained in your letter regarding the total stock holdings of the Riggio family and other Company insiders. Please be advised that, excluding options that are not votable, Barnes & Noble’s directors, management and other executive officers currently hold approximately 31% of the Company’s outstanding stock.

The Board has also considered your question regarding Excluded Shares under the Shareholder Rights Plan. While the Board does not believe the analysis of the Shareholder Rights Plan reflected in your letter is correct, in order to eliminate any ambiguity the Board has adopted an amendment to the Rights Agreement regarding Excluded Shares. This amendment is contained in a Form 8-K being filed today with the Securities and Exchange Commission.

Finally, the Board is unanimous in its view that there is absolutely no basis whatsoever for the allegations made in your letter.

Yours truly,

Barnes & Noble Board of Directors

This letter is an embarrassment. It leaves no illusions as to whose interests the BKS board is serving. Perhaps this is why there's no press release touting it. The Barnes & Noble board is working against outside shareholders, while claiming the opposite.

The directors are protecting us "from actions that are inconsistent with (our) best interests." How's that for paternalism? This is a smokescreen.

The Riggio's want the benefits of a publicly traded company AND of their own private fiefdom. Where is the outrage? With 31 percent of the vote, who are the Riggio's to say who can and can't own shares in BKS (and at what level). The intellectual arrogance is staggering.

The entire letter is difficult to read. There is the inherent presumption that outside shareholders are morons, incapable of critical thought. Do we really need to fear a "rapid accumulation of a significant portion of Barnes & Noble’s outstanding common stock"?

God forbid. Isn't that what we WANT?

The Barnes & Noble board unanimously decided that the Burke request "would not be in the best interests of all Barnes & Noble’s shareholders." Huh? How do they write this garbage with a straight face?!?

The word "ALL" is glaringly apparent. Show me ONE outside shareholder who thinks Burkle shouldn't be allowed to buy more stock!

This painfully inclusive language attempts to hides the obvious. Only insiders are disadvantaged by the Burkle move. And they aren't ordinary shareholders. Outsiders can't force the company into incestuous transactions. We aren't entitled to multimillion dollar pay packages. We must be "content" with dividends and capital gains. Plebes.

Despite an over-sized yield, capital gains are scarce. See the connection? It would be nice if management spent more time on the business of the business. Instead they are manning the barricades against their own shareholders.

The dichotomy between inside and outside shareholders is precisely what Burkle pointed out. Far from refuting his claims, the management of Barnes & Noble has proven them in six short paragraphs. BKS' leadership has indicted themselves.

The language twisting reminds me of Bill Clinton debating the meaning of the word "is". Funny. Bill Clinton is Ron Burkle's pal and a former Yucaipa partner/consultant. Maybe it's time to bring him back to play word games with the Riggio's. Neither has any shame.

At least the Riggio's are hiding behind their board. They are the one's protecting the little children from the evil Yucaipa. But they'll let us pretend to drive daddy's car sometime this year when we get to vote on that shareholder rights plan. Hurray!

I wonder how the Riggio's (with 30+ percent of outstanding shares) will vote? Yucaipa seems to be the only institutional shareholder that isn't asleep at the Barnes & Noble wheel. Most institutional voting is on autopilot anyway. If they vote at all, they vote with management. This lazy approach is a comfort to lackluster boards (and the managers they hire) everywhere.

The "vote" logic is so circular I'm getting dizzy. The poison pill is blocking Yucaipa and protecting the Riggio's entrenched management. The Riggio-controlled board instituted the poison pill to block anyone from gaining enough shares to force change. So the "intended" vote is a foregone conclusion. And therefore the "free and fair" vote is a straw man argument. The Riggio's have eliminated their only competition. The shareholder rights plan will pass and the Barnes & Noble board will wear it as a badge of honor.

Yucaipa bad. Riggio good. Gotta keep it easy for us simple folk.

"Our" board pats us collectively on the head and says there is "absolutely no basis whatsoever for the allegations made in (Burkle's) letter." What a relief. For a minute there, I thought these guys might not be looking out for me. Yes, sarcasm intended.

Dear BKS Board,

Not all your shareholders are stupid or asleep!

On a good day, some of us even read books.

Sincerely,

The Lonely Value Investor

Rarely has open contempt for outside shareholders been on such vivid display. If only more people were paying attention.



Disclosure: The author owns BKS shares.

BKS: Let the Fireworks Begin

Lonely Value has been long and wrong on Barnes & Noble (BKS), but that may be about to change.

This afternoon billionaire Ron Burkle sent a letter to the BKS board of directors and, by extension, to the Riggio family, controlling shareholders of the company. In the letter, Burkle's company (Yucaipa) expresses a desire to increase its current 18.7% stake to 37%, effectively matching the Riggio ownership level. This would trigger a 20% poison pill. So Burkle is asking the board to allow such a move without the trigger.

The Yucaipa letter reads (in part):

My name is Ron Burkle and through my Yucaipa investment funds I am a significant shareholder in Barnes & Noble. We believe Barnes & Noble is currently undervalued, and have therefore bought approximately 19% of the outstanding Barnes & Noble common stock in open market purchases. I was surprised to find that, even though I spoke with Leonard Riggio prior to our purchasing any shares to make sure he understood our views and concerns as an investor, the Company has reacted to our stock purchases by implementing a poison pill prohibiting us (or any other non-Riggio shareholder) from acquiring stock ownership above a 20% threshold.

The fact that the Riggio family and other Company insiders own over 37% of the outstanding stock, and that over the past 3 years Len was allowed to increase his personal stake by approximately 10% of the outstanding stock (to over 30% of the outstanding shares), in my view shows that the Board and its Chairman endorse two sets of rules: one for the Riggio family, and one for the rest of the Company’s shareholders. I believe the poison pill allows Len and other Company insiders to exert effective control over the shareholder franchise, while at the same time Len has taken a great deal of money off the table by selling his textbook business to the Company, thereby reducing the Company’s liquidity and burdening the Company and its shareholders with significant debt to finance that purchase.

We believe having over 37% of the Company shares in the hands of the Riggio family and other insiders, coupled with the 20% ownership limitation enforced on other shareholders under the poison pill, has a coercive effect on the Company’s other shareholders and gives the Riggio family a preclusive advantage in any proxy contest. This has the effect of placing de facto control of the Company in the Riggio’s hands, despite their owning much less than a majority of the Company’s shares.

We believe the poison pill is counterproductive, unnecessary, and inappropriately impairs the free and fair exercise of the shareholder franchise. Put simply, we believe it hurts the share price and inappropriately penalizes Barnes & Noble’s “non-Riggio” shareholders. We also firmly believe that by implementing the poison pill but nonetheless allowing Len Riggio and other insiders to own over 37% of the stock, the Board is sending a message to the other shareholders and the investing community that Barnes & Noble is a company controlled and operated for the benefit of selected insiders.

In short, if the Riggio's can own 37%, then why not Yucaipa? The poison pill is a sham, protecting only shareholders named Riggio. Kudos to Burkle on impeccable logic.

Lonely Value recommended BKS shares back in November and also mentioned the growing ownership of Yucaipa. Until today, this rising ownership stake hadn't garnered much outside attention. Nevertheless, it could be a major positive catalyst for outside shareholders.

Not surprisingly, the Riggio family takes a "contrary" view.

On November 17, 2009, the Company's board conveniently announced a poison pill, euphemistically referred to as a "shareholder rights plan", and (as with all such moves) said it was:

"intended to protect the Company and its stockholders from efforts to obtain control of the Company that are inconsistent with the best interests of the Company and its stockholders."

Really? Aren't all poison pills designed to protect incumbent managers? Left unsaid in the press release - the Riggio family's past actions are "inconsistent" with those very same stockholder interests. Given the company's performance, management's defensiveness is understandable. They may even have a genuine inferiority complex.

Too bad they think outside BKS shareholders are stupid enough to swallow this "we're protecting you" line of reasoning.

Many will say that Barnes & Noble is a dying company, a dinosaur. Recent news out of the company has given cold comfort to those who believe differently. As this article is being written, CNBC is loudly regurgitating all the reasons to hate BKS shares. It's a tired old song abut a changing landscape, etc.

Translation: Amazon, Amazon, Amazon.

Hello! That is exactly WHY Barnes & Noble is so cheap (and attractive). Whatever happened to "buy low" or "buy when others are fearful"?

Ron Burkle didn't get where he is by listening to the crowd. Barnes & Noble is an under-managed (profitable) company in a fragmented industry. There is room for a physical alternative to Amazon.com (AMZN). Brick and mortar isn't dead. And BKS may be unique among its peers. It has the financial strength to survive. The possible demise of Borders Group (BGP) only makes the competitive landscape all the more intriguing.

Enter Yucaipa: They should throw the full corporate governance book at Barnes & Noble and its entrenched interests. Outside shareholders have little to fear from Burkle and Co. Current management has shown that they don't have our best interests at heart. Past actions speak volumes. The company's leadership under the Riggio's is hardly one to write home about.

This may be the start of beautiful new chapter for Barnes & Noble. I can't wait to read it.


Disclosure: Author owns BKS shares.

AMZN's Rose Colored Glasses

Do you remember those guys in high school who could get away with anything because they were popular? I do. And I'm not bitter about it. Really! I'M NOT.

Well, Amazon.com (AMZN) is so popular that they can get away with anything... and they know it.

How else can you explain the most recent quarterly earnings report?

Here are the first couple of lines in the release:

Operating cash flow was $3.29 billion in 2009, compared with $1.70 billion in 2008. Free cash flow increased 114% to $2.92 billion in 2009, compared with $1.36 billion in 2008.

Common shares outstanding plus shares underlying stock-based awards outstanding totaled 461 million on December 31, 2009, compared with 446 million a year ago.

With a $55 billion market value (round numbers please), Amazon is trading at a very reasonable 19 times free cash flow. Given their torrid growth, this is downright cheap. Heck, I've been wrong about Amazon! They aren't overvalued. My bad.

But wait just a minute. 2009 reported earnings are $902 million. For a backward-looking price-to-earnings multiple of 61.

Major differences between cash flow and reported earnings is a huge red flag... or it used to be. Do we have a difference set of rules for Amazon?

Net income is up 39.8 percent year-over-year, but operating cash flow is up 94 percent? And free cash flow is up 114%? With each successive number, the burden of proof gets higher. Is that red flag going up yet?

What accounts for the differences? Huge increases in current liabilities that may (or may not) be temporary. Accounts payable increased $1.8 billion alone. String out one big supplier to the tune of $1.8 billion and (whammo) you triple your "free" cash flow... until the bill comes due.

Profit and free cash flow should be pretty close at Amazon, especially since depreciation and capex match up pretty closely. In fact, they are almost identical.

2009 Depreciation of fixed assets, including internal-use software and website development, and other amortization = $378 million

2009 Purchases of fixed assets, including internal-use software and website development = $373 million

This $5 million difference isn't material.

At the very least, the deviation in net profit and free cash flow are cause for further investigation. Is anyone doing it?

Given Amazon's growth, one should expect free cash flow to trail profits because of rising receivables and inventories. In fact, they did rise and have been for several years. Increases in inventories and accounts receivable used $531 million and $481 million respectively in 2009, a $1 billion hit to reported free cash flow. This makes the huge reported gain in free cash flow year-over-year all the more suspect.

Why is Amazon touting these (misleading-at-best) numbers in LINE 1 of the release? Because they assume nobody is going to dig deeper and be skeptical.

Did anyone even read the report? (Be among the few, the proud... here's the link.)

No, people saw that headline about revenue growth (SALES UP 42%) and fell in love all over again. Oh, and don't forget the buyback.

CNBC is gushing over the buyback! $2 billion.

But what about the increase in shares outstanding mentioned above? Year-over-year shares outstanding are up 16 million shares, probably due to employee stock options.

The current market value of those dilutive shares? $2 billion.

You can't make this stuff up.

So did Amazon shareholders get the benefit of any of the $900 million in profits last year? It's a philosophical question. Rhetorical really.

I say "no". Yes, the stock is up. Everyone loves Amazon. But I thought these kinds of earnings releases died with the Internet Bubble. Apparently not.

For those of you who are long Amazon, keep those rose-colored glasses on. You'll need 'em if you read the earnings release.

Disclosure: No position.