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BEHIND THE NEWS: Why diner chain whets the appetite of the buyout crowd

July 16, 2007

The Steak n Shake Co. may not be delighting diners these days, if slumping sales are any indication. But you can bet the privateequity crowd is salivating.

Investment pros say the Dallas-based investment group that recently amassed a big stake in Steak n Shake surely isn't alone in hungering to take the Indianapolis-based diner chain private.

"Some ... funds make their money by identifying underperforming companies that have intrinsic value which can be unlocked," Motley Fool columnist Timothy Otte wrote recently.

"In ... restaurant companies, that usually means a good brand that has lost its way. Steak n Shake fits that description to a T."

Investors have been abuzz about Steak n Shake's future since the Dallas investors disclosed in a regulatory filing late last month that they had amassed nearly 10 percent of the company and wanted to explore an acquisition or other "potential transactions to maximize shareholder value."

In the filing, the hedge fund HBK Investments and the private equity firm Lone Star Funds said they did not plan to pursue a transaction unless the company's board supported it.

Don't put a lot of stock in the friendly tone. As Otte observed in his column, "Once those 'discussions' get under way, the gloves have a way of coming off."

And there surely are other investment groups with an eye on Steak n Shake that wouldn't be so genteel.

What's the allure? The same traits that have fueled a spate of going-private deals in the restaurant industry the past two years-stable cash flows, low debt, lots of real estate, and lots of upside if new owners are able to pull off a turnaround.

Indeed, the restaurant industry has seen better days. Myriad factors, including overbuilding, have depressed results at many chains. At the same time, skyhigh gas prices have taken a big bite out of diners' disposable income.

Steak n Shake feels the pain. The 490-restaurant chain has reported seven straight quarters of declining same-store sales.

Chains agreeing to go private in the past year include Champps, Outback Steakhouse and Lone Star Steakhouse. The latter steakhouse was purchased by Lone Star Funds-the same outfit that's part of the Steak n Shake investment group.

Many others are feeling investor heat. Among the chains that recently said they would consider sales are Applebee's and Wendy's.

Steak n Shake CEO Peter Dunn and an official with the Dallas-based investment group did not return calls.

During a conference call with analysts in May, Dunn sounded hellbent on fixing what ails the 73-year-old chain.

"We are determined to shape our own destiny by optimizing the design and execution of the Steak n Shake business model based on new research," he said.

The pressure is on. After the Dallas group disclosed its stake, Steak n Shake shares surged 16 percent, reaching $17.13. The stock has retreated only slightly since-a sign that investors are hopeful the group's overture will propel the company into play.

Steak n Shake "certainly hasn't commented, but as a public company, its board has a fiduciary duty to review whatever is in the best interests of shareholders," said Michael Gallo, an analyst with CL King in New York.

Analysts say investment firms would be drawn to Steak n Shake in part because it carries only modest debt-about $43 million. That's appealing because such buyers typically ratchet up debt of firms they acquire, minimizing their out-of-pocket expense.

Further, Steak n Shake owns about one-third of its locations. Selling sites, then leasing them back, is another means of accessing millions of dollars. Florida-based Sun Capital Partners took a page from that playbook after it bought Fishers-based Marsh Supermarkets Inc. last year.

And the biggest opportunity of all, analysts say, may be to boost the performance of the company, thereby swelling profit.

"I don't think anyone-including the current management team-would dispute the fact that the last year's results have been disappointing," Gallo said. "Clearly, they have to do better."

Understandably, investors are restless. Even with the recent runup in the shares, they're off 4 percent this year. And they've fallen 20 percent since topping $21 in April 2006.

Investors who've rushed into the stock in recent weeks could be rewarded, even if a buyout never happens. One way to keep activist investors at bay, analysts said, is to pay shareholders a special dividend-a cash distribution Steak n Shake could fund by taking on debt.

What path will Steak n Shake take? It's hard to say. Worth noting: Dunn is no stranger to private-equity circles. The last company he led-Borden Foods-was owned by the New York-based investment powerhouse Kohlberg Kravis & Roberts. He left after KKR sold the business in pieces and cashed out its investment.
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