Selling SAUC

Why I am reducing my shares

Published on:
June 24, 2019
Last Update:

Written by

Noam Ganel is the voice behind Pen & Paper, a value-oriented stock research publication. He  serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Analyst Credential (CFA).

This week I sold 10,000 shares of Diversified Restaurant Holdings (SAUC on Nasdaq) at $0.73 per share. As I type these words, two days after my first stock sell in 2019, SAUC climbed to $1.03. So not only did I lose money since as my cost basis was $1.40 per share, but also I lost $2,500 by trading on Tuesday instead of Thursday.

I have zero regrets. I sold the shares because I was wrong in buying shares in SAUC in the first place. In this week's essay I explain why.

The lure of SAUC's historical price

Between 2013 and 2018, SAUC traded as low as $2 and as high as $4. So when I bought the stock at $1.40, I assumed that price was low enough to serve as a margin of safety. I was wrong. A closer look at the publicly available financial statements would reveal that SAUC in 2018 was not the same company it was in 2016. This was because 26 of Dave and Buster's restaurants were no longer part of the company.

Score: Noam: 0. Mr. Market: 1.

Ignoring the market capitalization

I did not factor in SAUC's minuscule market capitalization of $25 million. Mistake number two. Companies with less than $100 million in market capitalization are riskier than larger capitalized companies. This is because it is tougher for pygmy companies to obtain debt or equity financing without diluting shareholders. Another risk is that small cap stock is usually off the radar screen of larger capitalized stock. So, unless the market readjusts the small cap stock valuation, the investor has no exit strategy.

As a rule, if a billion in market capitalization is selling at 10 times the earnings per share, then 25 million in market capitalization stock, given the risks detailed above, should sell at no more than 4 times the earnings the per share. But I had not discounted for size.

Score: Noam: 0. Mr. Market: 2.

Buying the stock at par

SAUC owns 64 franchises of Buffalo Wild Wings. I estimated that the value of each franchise was $2.5 million. This value was based on how much it would cost to build and open a Buffalo Wild Wings franchise and based on the price franchises were selling in the market place.

So, the replacement cost was $160 million. With total liabilities of $118 million I estimated equity to be $40 million or $1.38 per share. I paid about par of the net asset value which dear valuation. Purchasing the equity at 50% - 80% would be sensible according to Marty Whitman, founder of Third Avenue Management. But not only did I disappoint one of the masters of value investing, I overlooked the right of the balance sheet.

Score: Noam: 0. Mr. Market: 3.


SAUC's right of the balance sheet

"The company cannot conclude that it is probable that it will secure a credit facility," warned management on page 29 of its latest 10-k filing. "This raises substantial doubt that the company's ability to continue as a going concern."

SAUC may not be a company a year from today. Management had agreed to debt covenants that raise two problems. The first problem is that SAUC's debt is variable. It is based on LIBOR plus a margin that depends on the company's leverage ratios. This condition is a two-edged sword because as operations deteriorate, the cost of capital will increase. The combination of two will tarnish earnings.

The hidden liabilities are the second problem. When SAUC spanned off Bagger Dave's it continued to guarantee the leases. In the event Bagger Dave's decided to give the keys back to lenders, SAUC will be liable for the rent. This is like selling your home and then guaranteeing tax authorities that if the buyer is not able to pay the appropriate taxes, they can come after you.

Score: Noam: 0. Mr. Market: 4.

Management      

SAUC’s senior management is invested in the company but lacks disclosure to shareholders. Michael Ansley owns 2.2 million shares, Jason Curtis 1.1 million shares and David Bruke owns 580 thousand shares. Together, the shares represent about 20% of the available stock. Yet they are not reporting enough about the company operations.

To understand the performance of the restaurant business, you need to understand more than revenue and profit trends. All shareholders of a company should know what the guest satisfaction is, what the hourly compensation costs are and how the cost of food affects margins. But management provides none of this information.

Other industries, such as the airline industry, share information on a granular level (read my recent purchase of Hawaiian Airlines as example). It was a mistake to buy shares in a company that does not value transparency.

Score: Noam: 0. Mr. Market: 5.

***

In A Senseless Market Capitalization for Diversified Restaurant Holdings link, I wrote that:

"Animal Spirits may explain why an investor would prefer to franchise a Buffalo Wild Wings restaurant as opposed to simply purchasing Diversified Restaurants Holdings stocks."

I was positive that Mr. Market was wrong and that I was right. That I was wrong is obvious and not worthwhile to further mention. What is important, though, using the game of tennis as an analogy, is to highlight that all the mistakes were unforced errors.

The 5 mistakes highlighted above were not due to unforeseen changes in industry or by remarkable performance of competition. Investing in SAUC was a mistake that could have easily been avoided.

As a resolution I began this month to spend an extra 10 hours reviewing an “unforced error” checklist. During this review, I answer questions such as: Does the company have variable or fixed rate debt? Is management sharing with shareholders how they evaluate business performance? For every dollar of retained earnings over the past year, has management increased the value of the company? Hopefully, going forward, this will improve my scorecard against Mr. Market.