Value Investor May 2011

ValueInvestor
May 27, 2011

The Leading Authority on Value Investing

INSIGHT
F E AT U R E S

Impeccable Logic
They and the companies they invest in may not be particularly well known, but Dennis Delafield and Vince Sellecchia have built a record worthy of wide acclaim.

Inside this Issue
Investor Insight: Delafield Fund Roving off the beaten path to find value in such companies as Collective Brands, Albany International, Ferro PAGE 1 » and Checkpoint Systems. Investor Insight: Lloyd Khaner Looking for signs of unexpected recovery and finding them today in Sonic Corp., Cadence Design, OchZiff and Illinois Tool Works. PAGE 1 » Strategy: Real Estate In a sector where recovery has been fitful at best, two experts assess today’s opportunity set. PAGE 16 »

D

ennis Delafield's first job in 1957 was at a small investment firm in Florida, but it wasn't exactly the culmination of a life-long ambition. “They offered me a job and I needed one,” he says. “I didn't know a stock from a bond.” The career match couldn't have been better. Still going strong at 75, Delafield and partner Vincent Sellecchia now manage $2.2 billion for Tocqueville Asset Management, the bulk of which is in the Delafield Fund, which has earned a net annualized 11.6% over the past 15 years, vs. 6.5% for the S&P 500. Trafficking in “misunderstood and unloved” companies, they are finding opportunity today in such areas as shoes, anti-theft systems, industrial equipment See page 2 and chemicals.

INVESTOR INSIGHT

Dennis Delafield, Vincent Sellecchia Delafield Fund Investment Focus: Seek companies undergoing positive change whose share prices indicate the market is skeptical, or unaware, of their future prospects.

Uncovering Value: Skechers Is the market right in treating the trend-conscious shoe company as if PAGE 21 » it’s a one-hit wonder? Editors' Letter Advice for those trying to win at the Loser’s Game of investing. PAGE 22 »
INVESTMENT HIGHLIGHTS INVESTMENT SNAPSHOTS
Albany International Cadence Design Systems

Comeback Trails
Long-term investors spend considerable time trying to separate fact from fiction in corporate plans. For Lloyd Khaner, that’s proven to be time very well spent.
INVESTOR INSIGHT

PAGE 5 13 6 4 7 18 19 14 12 21 11

H

Lloyd Khaner Khaner Capital Investment Focus: Seeks companies requiring operational and strategic repair – after the turnaround has commenced but before the market appears to believe it.

e followed in his father's footsteps in the investment business, but Lloyd Khaner didn't go down exactly the same path. “My Dad was very much a cigar-butt, 50-cent-dollar kind of investor and very good at it,” he says. “That's not what I do.” Khaner has proven very good at what he does as well, focusing on high-quality companies that have lost their way and have first-class management leading the turnaround. Since he took full control of Khaner Capital's portfolio in 1997, it has earned a net annualized 11.1%, vs. 6.2% for the S&P 500. With companies in need of revival always in ready supply, he sees particular value today in fast food, software, asset manageSee page 9 ment and industrial products.
www.valueinvestorinsight.com

Checkpoint Systems Collective Brands Ferro Forest City Enterprises Henderson Land Illinois Tool Works Och-Ziff Capital Management Skechers Sonic Corp.

Other companies in this issue:
Campbell Soup, Celanese, Kennametal, Lennar, Plexus, School Specialty, Sears Holdings, Stanley Black & Decker, Starbucks, St. Joe, Tyco International, Weatherford, Xerox

I N V E S T O R I N S I G H T : Delafield Fund

Investor Insight: Delafield Fund
Dennis Delafield and Vincent Sellecchia of the Delafield Fund describe why their portfolio companies are hardly a glamorous lot, a key impetus to the “special situations” they typically pursue, why cash is more valuable than ever, and why they see mispriced value in Collective Brands, Albany International, Checkpoint Systems and Ferro.
You often remind your investors of your strategy in what strikes us as a refreshingly clear and succinct way. Can you repeat that for us here? Dennis Delafield: We’ve been at this for a long time, so we should be able to describe what we think is a logical approach to protecting our investors’ capital and making it grow. We search widely for stocks that are selling at prices which seem to be modest in relation to the underlying company’s intrinsic value. We meet with management, visit plants, talk to competitors and do all the groundwork necessary to understand the business and the people who direct the company’s future. We search for companies in which change can alter that future for the better. That can mean a change in management. It can mean a change in management’s attitude toward running the business, say by recognizing that 120% of the earnings come from 80% of the assets, so they should do something about that other 20% at some point. It can mean a new business opportunity that has yet to take off. It can mean a change in the dynamics of a company’s cash flow and how it’s to be used. If we perform our analysis correctly, the value added we bring is an earlier and better understanding of the companies in our portfolio than other investors might have. If the companies then begin to improve, their earnings should increase and they’re likely to earn a higher price/earnings multiple. Finally, we believe stock selection is much more relevant to successful investing than a total commitment to equities. As markets have gotten more volatile over the last 15 to 20 years, we’ve come to believe that the best hedge against volatility is to have cash on hand with
May 27, 2011

which to invest when stock prices seem unduly depressed. Your portfolio companies today are a pretty unglamorous and low-profile lot. Is that typical? DD: Our sweet spot tends to be in small and mid-size companies that often aren’t particularly well followed by Wall Street. It would be illogical for us to know or uncover something about Procter & Gamble or Texas Instruments before 100 smart analysts did. Vincent Sellecchia: Often businesses with high profiles or in sexy industries are the hardest to understand. They might be in a wide variety of disparate businesses. They might be in technology industries with very short product life cycles. It’s easier for us to get our arms around the basic industrial company in the heartland. We also tend to find more special situations in industries with higher cyclicality, which most often aren’t the most glamorous sectors of the economy. How companies both prepare for and respond to industry capacity utilization rates going from 100% to 30% and earnings falling off a cliff has a dramatic impact on their future prospects. If the down cycle makes entry points attractive, that can create excellent opportunities. Kennametal [KMT] is a classic example of the type of situation we find interesting. After a change in CEO, the company, which makes metal-cutting tools, went through an extensive restructuring of its business portfolio and manufacturing footprint to focus on its core competencies and on businesses generating free cash flow, while also paying down debt. All of that was poised to pay off when the economic crisis took revenues down 45%. We had an existing position and added to it, given the operating leverage
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Dennis Delafield, Vincent Sellecchia

Go With the Flow
When Dennis Delafield took his first investing job after graduating from Princeton in 1957, Dwight Eisenhower was president, the Dow Jones Industrial Average was around 500, and the average turnover on the New York Stock Exchange was less than one million shares a day. What’s remained relatively unchanged over that time, he says, is the basic analysis required to understand companies and their businesses. The biggest change: volatility, both in trading and in the economic system overall: “With all slack squeezed out of the system and individuals and governments levered to the hilt, for investors there’s much more of a premium now on being nimble, on being flexible, and on having plenty of reserves on hand when volatility hits.” Delafield today shares portfolio management responsibilities with Vincent Sellecchia, who joined what was then an independent Delafield Asset Management in 1980. (The firm is now part of Tocqueville Asset Management.) Both remain hands-on analysts, which they would have no other way. “Look, the business is fun because you learn something new every day,” Delafield says. “I can’t imagine giving that up.”
Value Investor Insight 2

I N V E S T O R I N S I G H T : Delafield Fund

we expected from the company as volumes eventually picked up. Our thesis went beyond just the cycle turning up again, it was more focused on what the company had done to make itself much more profitable. DD: One thing I’d add is that as brokerage firms have gone out of business or cut back on the number of companies they follow, it’s not as if we need to focus on tiny or new companies to find those that are relatively ignored. You can find plenty of established, decent-sized companies that just don’t get the attention from Wall Street that they once did. We haven’t yet heard any mention of business quality as a criterion. VS: We would love to own great businesses as much as the next guy, but the problem is finding them at the right price. We’re perfectly happy looking for the average company, where we think there’s something going on which the market hasn’t recognized that can make it better than average. You’re rewarded as much for that as for a good company becoming very good. We do make every effort to understand what edge the company has in facing competitive threats or maintaining pricing power. When that edge isn’t clear, you have to be very careful about the valuation you assign to the earnings and cash flow stream. But business quality, in and of itself, isn’t paramount to our decision to buy. You recently had nearly 25% of your assets in chemical companies. Is there ever a thematic element to your cyclical bets? DD: Everything we do is from the bottom up, so there are company-specific reasons we own each one of those positions, typically positive structural changes in the company or its markets that we believe are underway and that the market isn’t pricing in. Celanese [CE], for example, enjoys a substantial technology-driven cost advantage in its largest business, acetyl intermediates, which should transMay 27, 2011

late into meaningful margin improvement as industry utilization improves and incrementally higher-cost production comes on line. Its advanced engineered materials business is also poised for substantial growth as its primary end-market, auto manufacturing, recovers, and as the content of its products per automobile expands. Longer-term, we see significant potential in the company’s coal-to-ethanol technology, where just one of the giant plants they are planning to build in China could

Can you give a recent example? DD: We bought shares last quarter in Plexus Corp. [PLXS], a mid-tier electronics manufacturing services company with annual revenues of about $2 billion. The shares fell sharply after management lowered revenue and earnings expectations for the second half of its fiscal year, due largely to shortfalls in deliveries of complex new beverage dispensing machines the company is building for Coca-Cola. While they haven’t deployed as rapidly as expected, Coke continues to push the new systems and we think the delays are just short-term noise obscuring an overall long-term financial model for the business that remains intact – with 15% annual revenue growth, 10% gross margins, 5% operating margins and a high-teens return on invested capital. Given that we expect earnings power to be in excess of $3 per share in the next few years, the stock [recently trading at $37.20] still appears to us as a compelling value. Can you generalize about the time horizon for most of your investments? VS: We tend to do our work looking out two to three years, but our time horizon on any given holding is purely a function of what’s going on with the business and how the market is valuing it at any given moment. For example, we initially purchased Stanley Works several years ago and management has done a good job in managing the portfolio of businesses. More than a year ago they acquired Black & Decker in a stock deal, and despite the fact that the share price was substantially higher than when we initially set up our position, we increased our holdings because the deal made a good strategy fit with large cost synergies. Today, with Stanley Black & Decker [SWK] stock having moved higher yet since the deal [to a recent $73.50], it isn't what I'd consider cheap, but it is a sound holding especially if the company can come close to its 2015 goals of 15% operating margins on $15 billion in revenues. That translates to about $10 per share of earnings power.
Value Investor Insight 3

ON BUSINESS QUALITY: You’re rewarded as much for an average company getting better as you are for a good company becoming very good.
eventually add $1 per share in earnings power. Right now in the U.S. you can only make industrial ethanol, not fuel ethanol, from coal. As more and more of the U.S. corn crop is used to make fuel ethanol, that may have to change. If it does, Celanese would be well positioned to benefit. Even with all that, while the stock has come up somewhat since we bought it, it’s still not at all expensive. On 2013 estimates, the shares trade at less than 9x earnings and around 5.5x EBITDA on an enterprise value basis. You mentioned markets becoming more volatile over the years. Is that a good thing for disciplined value investors? DD: Markets have always responded to fundamental surprises, positive and negative, in a company’s business. What’s relatively new is the volatility driven by the high-frequency traders, day traders and short-term oriented hedge funds reacting to whatever it is exactly that they react to. In either case, volatility can clearly create buying opportunities when we believe the reasons for the miss are temporary, not structural.
www.valueinvestorinsight.com

I N V E S T O R I N S I G H T : Delafield Fund

How rigid is your selling discipline? VS: We’ve always said we want to sell stocks when they’re fairly valued, but we’ll admit that determining that is as much art as science. There are no hard and fast rules, but in general we should be cutting back and moving on if the valuation appears to reflect whatever information we considered our edge at the outset. Tyco International [TYC] has been a good investment for us and we think the company has excellent growth prospects, but as the stock price has reflected that, we’ve reduced our position. We often find ourselves selling to more growth-oriented investors. DD: Our view on a position can also change as the situation warrants. We’ve invested successfully in oilfield-services company Weatherford International [WFT], for example, but have become increasingly concerned about its exposure in the Middle East and about what we consider to be a fairly levered balance sheet. As the stock hit post-crisis highs last quarter, we took money off the table. VS: Another example where we’ve responded to a changed situation is in School Specialty, Inc. [SCHS], which provides basic educational supplies to public schools. Management was doing the right things to improve the company’s operating profitability, but we sold the stock after concluding cuts in state and local education budgets were likely to be too much of a demand headwind for the foreseeable future. Turning to some of your favorite current ideas, describe the investment case for recently in-the-news shoe company Collective Brands [PSS]. VS: We got interested in the company, then called Payless ShoeSource, when Matthew Rubel came in as CEO after a very successful stint running Nike’s Cole Haan dress-shoe division. Starting with the 2007 acquisition of Stride Rite, he’s been transforming the company from what was a mostly domestic discount
May 27, 2011

shoe retailer to a more-diversified and international retailer and wholesaler. The anchor on performance is the domestic retail business, which serves the economy-minded consumer and accounts for nearly 60% of the company’s $3.4 billion in annual sales. Its target customers are still hurting economically, which is crimping demand and making it very difficult to pass through materials-cost increases. Higher fuel costs have also impacted customer spending, as did unusually cold and wet weather during the first quarter. All this was clear in the recently reported results, which caused the stock to sell off more than 15%.
INVESTMENT SNAPSHOT

Where we see value being created, however, is in the rest of the business. The international retail business generates $500 million in annual revenue, earns double-digit operating margins and continues to grow nicely. The Stride Rite retail operation in the U.S., which sells children’s shoes, has been refurbished and should breakeven this year as it continues to turn around after years of losses. The real gem, however, is the $700 million wholesale business, consisting primarily of the Saucony, Keds and Sperry brands that were part of Stride Rite. Each has gone through a top-to-bottom overhaul after being undermanaged by previ-

Collective Brands
(NYSE: PSS)

Valuation Metrics
(@5/26/11):

Business: Footwear retailer through Payless Shoe Source and Stride Rite stores and wholesaler through brands such as Keds, Saucony, Sperry and Top Sider. Share Information
(@5/26/11):

Trailing P/E Forward P/E Est.
(@3/31/11):

PSS 8.7 10.4

S&P 500 16.6 13.5

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

15.27
12.41 – 23.96 0.0% $939.5 million $3.37 billion 4.4% 2.8%

Company Primecap Mgmt Blum Capital Wells Fargo Vanguard Group State Street
Short Interest (as of 5/13/11):

% Owned 10.3% 5.9% 4.9% 4.8% 4.6% 17.6%
30 25 20 15 10 5 0

Revenue Operating Profit Margin Net Profit Margin
PSS PRICE HISTORY 30 25 20 15 10 5 0 2009

Shares Short/Float

2010

2011

THE BOTTOM LINE

Woes in the company’s domestic retail operations are obscuring important and building successes in its international and wholesale businesses, says Vince Sellecchia. After a very recent hit to the share price, he believes the risk/return equation for the company’s stock – trading at 4.5x forward EBITDA – has only gotten better.
Sources: Company reports, other publicly available information

www.valueinvestorinsight.com

Value Investor Insight 4

I N V E S T O R I N S I G H T : Delafield Fund

ous management. For Sperry, that has meant expanding the line beyond traditional boat shoes. For Saucony, it means reaffirming a commitment to product innovation. For Keds, it means capitalizing on the brand’s heritage in a similar way to what Nike has done with Converse. Last year the wholesale business grew 22% and we believe it can be a $1 billion business over time. We expect its operating margins to increase to 10% this year, up from 6% in 2010, and should reach the mid-teens as revenues expand. Is there anything to be done with the Payless retail business in the U.S.? VS: Positioning has always been an issue. The big competitors are discount stores like Wal-Mart and Kohl’s, so there’s always a question whether there’s space in the market for Payless to sell, say, $35 shoes rather than $20 ones. They’re putting some effort into that and doing things like expanding the offerings of higher-margin accessories, but this business won’t truly get back to normal until its economically challenged target consumer comes back. That should eventually happen and when it does, we’d expect the building strength of the other businesses to get more attention. With the stock trading at a recent $15.25, how are you looking at valuation? VS: Given the latest weakness in the Payless domestic business, we’re now expecting earnings for the 2011 fiscal year ending in January to come in around $1.10 per share, down from $1.73 in fiscal 2010. While earnings have fallen more than we previously expected, we think the more modest near-term outlook is fully reflected in the share price. The current enterprise value of $1.2 billion is only 4.5x estimated EBITDA for the coming fiscal year. Over time the business mix should improve as the wholesale business grows at a faster rate than Payless, which should have a positive impact on earnings and cash flow. Given the earnings turmoil,
May 27, 2011

this may not be for the faint of heart, but we have confidence in management's ability to deal with the near-term issues and believe the risk/return from today’s price is quite attractive. Describe the potential you see in one of your low-profile industrials, Albany International [AIN]. VS: The company’s main business, generating two-thirds of its nearly $1 billion in annual sales, is selling paper-machine clothing [PMC]. This includes the fabric and belts that move pulp through the paper-manufacturing process. Albany is
INVESTMENT SNAPSHOT

the largest supplier to this global market, with a 30% share, while its next closest competitors such as Xerium, which is publicly traded, and AstenJohnson, which is private, are no more than half as big. Most of the rest of the business is in making specialized doors used in industrial plants and in selling other products – like filters and winter-coat insulation – made using similar weaving technology to that used to make paper-machine clothing. Finally, there’s a small composites business – with less than $50 million in revenues – selling primarily carbon-reinforced products to aerospace manufacturers. I’ll come back to that later.

Albany International
(NYSE: AIN)

Valuation Metrics
(@5/26/11):

Business: Diversified manufacturer of paper-machine clothing, industrial door systems, engineered fabrics, engineered composites and insulation materials. Share Information
(@5/26/11):

Trailing P/E Forward P/E Est.
(@3/31/11):

AIN 17.0 12.6

S&P 500 16.6 13.5

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

26.50
15.00 – 28.08 1.9% $827.7 million $952.3 million 11.1% 5.1%

Company Wellington Mgmt Columbia Wanger Asset Mgmt Tocqueville Asset Mgmt Vanguard Group Times Square Capital
Short Interest (as of 5/13/11):

% Owned 7.8% 5.5% 5.1% 5.1% 4.9% 8.0%
40 35 30 25 20 15 10

Revenue Operating Profit Margin Net Profit Margin
AIN PRICE HISTORY 40 35 30 25 20 15 10 5 2009

Shares Short/Float

2010

2011

5

THE BOTTOM LINE

While the current 5.8x estimated EV/EBITDA multiple on the stock fairly values the company’s unexciting but profitable core businesses – primarily selling “machine clothing” to the paper industry – says Vince Sellecchia, he believes it ignores significant upside from a potential breakout business selling composites to aerospace manufacturers.
Sources: Company reports, other publicly available information

www.valueinvestorinsight.com

Value Investor Insight 5

I N V E S T O R I N S I G H T : Delafield Fund

Is manufacturing paper-machine clothing a decent business? VS: It’s driven by paper production, which is a consolidating and no-growth business in developed markets and a growing one – particularly in containerboard – in developing markets. Broadly speaking, paper production in Europe is expected to decline and in the U.S. is likely to be flat, but increased production in Asia and South America should offset that and cause the overall global market to modestly grow. While not exciting, it’s an excellent business for Albany, generating operating margins of around 25%. Competition in the business has become more rational as the industry has re-sized, and the company has done an excellent job shifting production capacity from the U.S. and Europe to Asia. The bulk of the spending on that capacity shift has been made, so we expect the PMC business to be a fairly reliable cash cow for years to come. Can we assume the composites business you mentioned provides some sizzle? VS: That’s the interesting part of the story. Albany composites are already being used in wheel struts on the new Boeing 787, but the most exciting potential is in providing composite-based parts to the Leap-X jet engine being developed for narrow-body planes by a joint venture between GE and the French company Snecma. There’s clearly a tremendous amount of uncertainty about what and when planes get launched and reengineered, as well as about the traction the Leap-X engine gets in any of those programs. But it’s not beyond reason to think composites could be a $300-plus million business for Albany within the next decade, with margins comparable to those in paper-machine clothing. How inexpensive do you consider the shares, now at $26.50? VS: The shares trade at 11.5x our 2012 earnings estimate of $2.30 per share. On the current enterprise value of $1.1 bilMay 27, 2011

lion, the multiple on our 2012 EBITDA estimate of $190 million is about 5.8x. Our view is that the current valuation reflects no upside for the composite business, which we think could have a great deal of upside. What do you think the market is missing in Checkpoint Systems [CKP]? DD: Checkpoint has two primary businesses. The first, accounting for about 75% of total expected revenues this year of $900 million, is selling anti-theft systems to retail stores. This includes the hard and soft tags that are affixed to merINVESTMENT SNAPSHOT

chandise, as well as a range of deactivation, detection and video-surveillance equipment. Two companies own the lion’s share of this business, Checkpoint and Sensormatic, a division of Tyco. Checkpoint’s is a radio-frequency-based system, while Sensormatic’s uses what is called acousto-magnetic technology. The second business is merchandise labeling, which includes everything from price tags to the Levi’s label that gets sewn onto your jeans. This has been a priority of CEO Rob van der Merwe’s since he joined the company from Paxar, a very successful label business he sold to Avery Dennison. He sees labeling as a logical

Checkpoint Systems
(NYSE: CKP)

Valuation Metrics
(@5/26/11):

Business: Manufacturer of closed-circuit TV security systems and radio-frequency electronic tagging and detection systems used primarily by retailers to deter theft. Share Information
(@5/26/11):

Trailing P/E Forward P/E Est.
(@3/31/11):

CKP 48.9 14.9

S&P 500 16.6 13.5

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

17.64
16.07 – 23.00 0.0% $707.1 million $831.7 million 5.0% 1.7%

Company Highlander Capital Shapiro Capital Earnest Partners Tocqueville Asset Mgmt Invesco
Short Interest (as of 5/13/11):

% Owned 24.2% 12.6% 7.2% 5.7% 5.3% 4.3%
30 25 20 15 10 5

Revenue Operating Profit Margin Net Profit Margin
CKP PRICE HISTORY 30 25 20 15 10 5

Shares Short/Float

2009

2010

2011

THE BOTTOM LINE

The company’s market position and anti-theft technology make it well-positioned to prosper as retail sales recover in developed markets and expand in emerging ones, says Dennis Delafield. Trading at less than 8x his estimate of the company’s pershare earnings power, he says, the stock today offers “highly compelling value.”
Sources: Company reports, other publicly available information

www.valueinvestorinsight.com

Value Investor Insight 6

I N V E S T O R I N S I G H T : Delafield Fund

strategic extension of the core business and has made no secret he wants it to be a $300-400 million revenue business in the near future. After a recent acquisition, it could generate sales of around $250 million this year. Is the business driven by retail sales? DD: Predominantly, which is why earnings have been soft in the last few years. They benefit when apparel and drugstore sales are strong, when stores are opening or refurbished, and when retailers in general are investing in new technology. Margins have disappointed for two years, which the company has partly attributed to expenses related to new-product introductions, but also is a function of a mix shift to lower-margin systems as customers look to economize. Despite the short-term cyclicality, we believe it’s logical to assume theft will continue to be a problem for retailers and that the sale of systems to prevent it will remain a good business in the future. It will be that much better when retail spending around the world picks up. We also can imagine that labels, anti-theft tags and the radio-frequency identification [RFID] tags used for inventory control will eventually merge in some way. Given that Checkpoint’s tag technology is already radio-frequency based, it should be a key player as that happens. What upside do you see in the shares, now trading at around $17.60? DD: The company’s goal is to get EBIT margins within the next couple of years to at least 10%, which we believe is realistic. On today’s revenue base, that would translate into $1.60 per share in earnings, but with growth over the next five years or so, it’s not unreasonable to expect earnings of closer to $2.25 per share. We don’t really work with target prices, but if earnings come through as we expect, today’s share price is likely to offer highly compelling value. The business may not bounce back right away, but this is a well-managed company with a sustainable franchise and a wonderful balMay 27, 2011

ance sheet. They, and we, can certainly withstand another tough quarter or two. Describe your interest in diversified industrial supplier Ferro [FOE]. DD: Ferro produces specialty materials and chemicals used in a wide variety of manufacturing processes worldwide. Its products include things like glazers, frits, enamels, pigments, plastics and solar-cell pastes. This was a classic example of a company that had lost its way, through overexpansion, sticking with bad businesses for too long, and inattention to cost control.
INVESTMENT SNAPSHOT

The CEO since 2005, Jim Kirsch, overhauled all aspects of the business – selling divisions, closing plants, replacing top managers, revamping sales efforts – just in time for the economic crisis to hit. Only after raising capital in a large and dilutive secondary offering in the fall of 2009 – in which we significantly increased our position – did the company have the financial breathing room for the restructuring to start paying off. Since then, each division of the company has shown progressive operating improvement. The story now primary revolves around the company’s most-profitable business, selling conductive pastes to the

Ferro Corp.
(NYSE: FOE)

Valuation Metrics
(@5/26/11):

Business: Global producer of industrial chemicals and specialty materials used in a wide range of manufactured products, from wall coverings to solar cells. Share Information
(@5/26/11):

Trailing P/E Forward P/E Est.
(@3/31/11):

FOE 38.3 9.5

S&P 500 16.6 13.5

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

12.45
6.68 – 17.84 0.0% $1.08 billion $2.18 billion 8.8% 1.3%

Company Gamco Inv Lord, Abbett & Co TIAA-CREF Vanguard Group BlackRock
Short Interest (as of 5/13/11):

% Owned 11.6% 6.4% 5.5% 5.4% 5.0% 5.7%
25 20 15 10 5 0

Revenue Operating Profit Margin Net Profit Margin
FOE PRICE HISTORY 25 20 15 10 5 0

Shares Short/Float

2009

2010

2011

THE BOTTOM LINE

Concern over near-term prospects for the company’s solar-energy-related businesses has caused the market to misprice – by valuing the shares at only 4.5x estimated 2012 EBITDA on an enterprise value basis – the longer-term prospects for those same businesses and others in the company’s revived portfolio, says Dennis Delafield.
Sources: Company reports, other publicly available information

www.valueinvestorinsight.com

Value Investor Insight 7

I N V E S T O R I N S I G H T : Delafield Fund

solar-cell industry. Ferro and Dupont are the two primary global producers of this paste, and the business has taken off in the past several years along with spending on solar-energy technology. Of the $196 million in EBIT we expect Ferro to earn this year, nearly $130 million of it will come from the solar business. The stock has been under pressure as investors are increasingly concerned about governments’ commitment worldwide to solar energy. For the time being, solar is only economically viable as a power source with government subsidies, which have been cut back – or threatened to be – in countries that have to-date been the greatest solar proponents, including Germany, Spain and Italy. Is that concern being overdone? DD: In the short-term, we have no idea. But over time we believe solar energy – especially as costs to produce it continue to decline – will compete well against other sources of clean energy that governments around the world will continue to want to promote. There are only so many places you can put up wind turbines, for example. There are also significant issues in getting at all the new shale natural gas reserves, which may both inhibit supply more than expected and put upward pressure on prices from historically low levels. The shares, at just under $12.50, are down some 30% in the past seven weeks. How are you looking today at valuation? DD: At today’s price, the company’s enterprise value is $1.35 billion. We’re estimating that with continued improvement in the non-solar businesses and some modest upturn in solar revenues, EBITDA next year can approach $300 million. That means EV/EBITDA on our 2012 estimate is only 4.5x. At what point would you consider a company like this to be fully priced? DD: The company’s operations have been vastly improved, it should have no net debt by the end of next year, and we have
May 27, 2011

great confidence in management. Would it be fully priced at 7x EBITDA? That’s probably close. How, if at all, are your views on today’s macroeconomic environment reflected in your portfolio? DD: We’re not macro people, but you cannot be investing other people’s money

unusual number of serious things to worry about. That all makes its way into the portfolio by our assessing the impact all of these things could have on each company we own and fully understanding the downside. We also think there are so many imponderables out there that it’s important to have a significant cash cushion in case something goes wrong. How big is that cushion today? DD: When I was first starting out in the business, you could be more or less fully invested all the time. If there was a downturn in the industrial sector, you could sell the utilities you owned that were doing well to buy the beaten-down industrials. In today’s market, everything goes up and down at the same time, so you don’t have stocks going up to sell in order to buy the bargains. The best way to take advantage of a big market correction, then, is to have cash. In a normal time, we’ll keep around 10% cash on hand for liquidity purposes. Given the state of the world today, we’re closer to 20%. We’ll miss some profits when valuations are running high and we’re raising cash. That’s just not something we’ve ever worried about. VII

ON CASH: When everything goes up and down at the same time, the best way to take advantage of a correction is to have cash.
without thinking about the state of the world, much of which is unsettling. Think about the U.S. government’s debt level and what happens if interest rates increase? Think about housing values, the unemployment rate and the price of gasoline and what that means for consumer purchasing power. What’s going to happen in the Middle East? What’s going to happen in Japan? What’s going to happen with the U.S. dollar? There are an

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Value Investor Insight 8

I N V E S T O R I N S I G H T : Lloyd Khaner

Investor Insight: Lloyd Khaner
Lloyd Khaner of Khaner Capital explains the primary impediments to company turnarounds, why investing in the Jack in the Box restaurant chain was a pivotal experience, whether his long-time gold bullishness is intact, and what he thinks the market is missing in Sonic Corp., Cadence Design, Och-Ziff Capital Management and Illinois Tool Works.
You joined your father’s investment firm in 1991, when it was focused mostly on deep-value “cigar butts.” Why did you gravitate toward a somewhat different value orientation? Lloyd Khaner: There are many ways to succeed in this business, but my focus from early on has always been on companies that had proven, thriving businesses that for some reason have hit a wall. It could be they got caught up in growth for growth’s sake and lost control of quality or operating discipline. It could be that success had blinded them to changes in their markets that required bolder strategic or business-model adjustments. But at the core are valuable competitive strengths that often, but not always, require new management to bring back into focus. It’s not a question of creating something brand new from scratch, which is inherently risky, but more about getting back to basics. If it works, the payoffs can be much better over time than the 50-cent dollar going to a 80-cent dollar. One big influence for me was investing in the Jack in the Box restaurant chain in the early 1990s. I was the first person from the buy-side or sell-side to visit the company after an E. coli outbreak at their restaurants had killed four customers and made hundreds more sick. On the plane out to San Diego, I sat next to a woman with her baby who saw all the Jack in the Box material I was reading and asked if I was with the company. She explained how she preferred Burger King, but because her husband was a Jack in the Box fan, they’d switch off between one and the other. I asked what she thought about the E. coli problem and, with her baby on her lap, she said she understood it was an accident and that they were still eating there as often as before. The immediate realization was
May 27, 2011

that this company had an opportunity to come back, reputation-wise, but more broadly, it hit home for me that in this country you can make bad mistakes, but if you own up to them and make clear what you’re doing to make it right again, you can have another chance. There was obviously more to buying the stock than that, but the company ended up doing the right things and the business came back better than ever. I owned it for eight years, buying around $4 and selling above $20. I took away two key lessons from that. The first is that it takes a lot to kill a strong, established franchise even if a company loses its way. Think IBM. Think McDonald’s. The second is that the right management can make all the difference in whether the business comes back. The strength of the franchise and the quality of management are what I spend most of my time on (see box). What about Warren Buffett’s famous quote about which reputation remains intact if a great manager meets a bad business? LK: While we’re very managementfocused, we’re also very clear on the fact that nobody’s going to turn around a bad company in a bad industry. One thing my father taught me at a young age was not to fall in love with companies or the people running them. You look for companies that, despite current challenges, have proven business models, true value propositions, rational competition and a strong balance sheet. Jim Keyes, who turned around 7-Eleven and is the type of CEO we’d follow almost anywhere, took over Blockbuster and ran into a dying industry, an over-leveraged company and a financial crisis. I don’t care how good he is, that was not going to be turned around.
www.valueinvestorinsight.com

Lloyd Khaner

Betting on the Jockeys
Having earned a Masters degree in dramatic writing from New York University and spent time on a screenwriting fellowship at Amblin Entertainment, Steven Spielberg's former production company, Lloyd Khaner knows a thing or two about character development. Thus he's quick to describe the profile of what he considers the ideal turnaround chief executive: “It's usually a first-time CEO, between 48 and 52. They have 25 to 30 years of experience, but have never had a #1 spot before. They're seeking out a challenge, have everything to prove and, while they've surely done very well financially, they probably haven't yet had that huge payday, which they badly want.” Khaner considers his best source of ideas to be the database of some 500 executives he's compiled since entering the business in 1991, made up of what he considers first-class CEOs as well as their current or former top lieutenants. He's automatically pinged when anyone on the list takes a new position, joins a board or otherwise makes news. “It's not fool-proof, but people who have had success reliably put themselves in positions to continue to succeed,” he says. “We're often happy to go along for the ride.”
Value Investor Insight 9

I N V E S T O R I N S I G H T : Lloyd Khaner

Timing would seem to be of paramount importance in betting on turnarounds. How do you think about that? LK: We actually categorize turnarounds as one-year, three-year or five-year turnarounds, primarily as a discipline to avoid buying too early. The time needed to get a company back on track is usually a function of how long the business has been struggling, how healthy the balance sheet is, how demoralized the culture has become and how healthy the industry is. In a one-year turnaround, for example, the problems have relatively recently surfaced, the balance sheet is still solid and the industry is in pretty good shape. In something like that we’re prepared to invest fairly quickly and may exit fairly quickly as well. Is Starbucks [SBUX] a recent example? LK: This is one that, in retrospect, we didn’t pull the trigger on quickly enough. When the stock got below $10 two years ago, it was just too early for me because the plan to fix things wasn’t yet clear, and if that plan included shutting down the growth engine and even pulling back – which I thought was necessary – I wanted to see evidence of that actually happening before buying in. By the time I was convinced they were on the right track the stock was already up 50%, but the good news is I recognized the upside was much higher than a share price of $15. Store experiences have been improved, there are more value-priced menu options, the Via instant-coffee line has been a big hit, and the international growth opportunity, particularly in China, is tremendous. They’ve taken the McDonald’s turnaround playbook, which has played out over several years, and are really only in year two. [Note: Starbucks shares recently traded around $36.50.] Are you much slower to buy into the more arduous turnarounds? LK: Three-year to five-year turnarounds almost always require a deep infusion of outside management talent, a change in culture, an overhaul of the cost structure
May 27, 2011

and some fairly dramatic shifts in operational execution. We want to identify these potential turnarounds early, but it’s often only after a year or two of careful study that we’re ready to act. Depending on the situation, we want to see tangible evidence – say, an increase in gross margins, declining inventory levels or reduced operating expenses – that the turnaround is working. If we believe the shares can double or triple if we’re right – which isn’t a stretch if earnings and valuations are starting from particularly depressed levels – we

is valuing Xerox as if it were another Kodak, which we don’t at all believe will prove to be the case. What are the primary reasons companies don’t turn? LK: The first one is too much debt, which acts like an anchor on companies that have to be so focused on keeping themselves afloat that they can’t or don’t do the operational things necessary to get back on track. The second is a dying industry, which you can’t overcome. There may be shortterm investment opportunity at times when an industry is in decline, but that’s not the type of thing I typically want to invest in. When we spoke five years ago [VII, April 28, 2006] you identified Campbell Soup [CPB] as a long-term turnaround, but the stock is trading only marginally higher than it was then. Have you given up on that one? LK: We actually did OK on the stock when it ran up a bit in late 2006, early 2007, but we haven’t owned it for some time. We concluded that soup, which is still the dominant part of the company, just isn’t as popular as it once was as a convenient meal. There are so many alternatives and Campbell’s hasn’t come up with answers on the product side that have resonated enough with consumers to make a big difference. I don’t know what would make me interested again. The truth is they’d probably be better off as part of a bigger company, but that’s not something I’d want to bet on. How did the potential revival of drive-in restaurant chain Sonic [SONC] get on your radar screen? LK: I’ve paid attention to the company since the 1990s, after management at Jack in the Box told me they considered Sonic the gold standard in the industry for product innovation and operating excellence. It has more than 3,500 restaurants, 87% of which are franchised, with the largest concentration in the south cenValue Investor Insight 10

ON TIMING: If we believe the shares can double or triple, we have no problem leaving the first bump in the price on the table.
have no problem leaving the first bump in the stock price on the table. We’re helped by the fact that once the market has given up on a company, it can be quite slow to embrace it again. How would you characterize your timing on Xerox [XRX]? LK: This is a case where we sat out the classic turnaround phase, executed by previous CEO Anne Mulcahy, but started getting interested when the company acquired business-process outsourcing leader Affiliated Computer Services 18 months ago. We believe ACS is an excellent business and that the acquisition fundamentally changes the character of Xerox to something that is far more interesting than a company fighting against an inexorable decline in black-and-white printing. We bought six months ago and the stock has done nothing, but we believe the catalyst will be 15-20% earnings growth over the next couple of years, which will allow them to pay down debt and buy back stock. At 8x next year’s estimated earnings [based on a recent share price of just under $10], the market
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I N V E S T O R I N S I G H T : Lloyd Khaner

tral and southeastern U.S. They’re known for having better-quality food, car-hop service, a wide beverage selection – nearly 40% of sales come from drinks – and for a willingness to customize any combination of food or drink on their menu. If you want Sprite and root beer and milk mixed together with crushed M&Ms, they’ll do it. The stock was always too expensive until Sonic fell into the classic growth-forgrowth’s-sake trap, which resulted in kind of an across the board breakdown in operational control, product innovation, marketing effectiveness and, ultimately, profitability. Over the past three years the
INVESTMENT SNAPSHOT

company has endured the pain of repairing the damage. Describe the key elements of the turnaround plan. LK: They stopped all new unit development, closed poorly performing units, increased base pay for company-owned store managers and stressed store cleanliness and efficiency everywhere. Research and development for product innovation has been increased and they’ve again started to roll out exciting new products, like a Spicy BBQ Burger, 6inch all-beef hot dogs with ample top-

Sonic Corp.
(Nasdaq: SONC)

Valuation Metrics
(@5/26/11):

Business: Operator or franchisor of more than 3,500 quick-service drive-in restaurants located primarily in the south central and southeastern United States. Share Information
(@5/26/11):

Trailing P/E Forward P/E Est.

SONC 26.1 21.7

Russell 2000 49.5 22.5

pings for only $1.99, and a new Double Stuf Oreo ice cream dessert that I can attest is fantastic. They have also carefully rethought pricing and now have a “laddered” menu with more of a value component to go with traditional premium items. This gives the customer more options and should help generate both new and repeat visits. I’d add that the general environment in the quick-service restaurant industry for passing on food and packaging cost increases is better today than it has been in years, with fewer players willing to be the price spoiler in a rising-cost environment. We believe the turnaround inflection point here is upon us. Last quarter comp sales at company-owned stores went positive for the first time in three years, and the company came out soon after the earnings call to say comp sales growth was accelerating and would probably reach 4-6% this year. The stock responded nicely to that news, rising 13% on the day of the announcement. Now trading around $11.50, what upside do you see in the shares from here? LK: Assuming that comp sales grow 35% annually over the next three years and that operating leverage kicks in as revenues rise faster than costs and the company benefits from a unique ascending royalty-rate system – in which the percentage royalty paid by franchisees increases as sales rise – we expect annual bottom-line growth in excess of 20% through 2013. By then we’re estimating $1 in earnings per share and, because the franchise model requires little in the way of capital spending, $1.35 in free cash flow per share. What’s that worth? I think an 18x multiple on 2013 EPS is more than reasonable, which would result in a share price of $18. Now that store-level service has stabilized and is improving, we think there’s a good chance the company can re-engage on unit growth and that they’re far from saturating their potential markets. If unit growth re-accelerates, the multiple could be even higher.
Value Investor Insight 11

Largest Institutional Owners
(@3/31/11):

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

11.49
7.28 – 11.86 0.0% $710.1 million $543.8 million 15.3% 5.0%

Company Fidelity Mgmt & Research Wellington Mgmt Invesco Dreman Value Mgmt Deustche Bank
Short Interest (as of 5/13/11):

% Owned 14.6% 9.5% 8.0% 5.8% 4.9% 12.9%
20

Revenue Operating Profit Margin Net Profit Margin
SONC PRICE HISTORY 20

Shares Short/Float

15

15

10

10

5 2009 2010 2011

5

THE BOTTOM LINE

The market is underestimating the scope and speed of the company’s broad-based turnaround after it fell into a growth-for-growth’s-sake trap, says Lloyd Khaner. Assuming solid comp-store sales growth and significant operating leverage, he expects $1 in estimated 2013 EPS to warrant a target share price of $18 within two years.
Sources: Company reports, other publicly available information

May 27, 2011

www.valueinvestorinsight.com

I N V E S T O R I N S I G H T : Lloyd Khaner

It’s interesting that the long-time CEO, Cliff Hudson, led the turnaround. Is that unusual? LK: It can certainly happen. People like Cliff, who has been Sonic’s CEO since 1995, don’t like losing and can bring a real fire to getting things back on track. It’s important to note, though, that he did over the last three years name a new head of company-owned stores, a new head of marketing and a new head of information technology. Some new blood is often important in refreshing and refocusing the overall leadership. What’s the investment case for one of your non-turnaround ideas, Och-Ziff Capital Management [OZM]? LK: Och-Ziff is one of the largest institutional alternative asset managers, with approximately $29 billion in assets under management. For clients around the world, it operates four primary investment funds that employ a wide variety of strategies, including convertible and derivative arbitrage, fixed income, long/short equity, merger arbitrage and structured credit. The company runs truly “hedged” funds that typically have 120-130% long exposure offset with an 80-90% short exposure. Based on their strategy and backed up by strong historical performance, they offer the kind of “I can sleep at night” investment options that large institutions often crave. For that, they are paid on a traditional hedge fund scale, earning an average 1.75% management fee and 20% of annual appreciation as an incentive fee. That all makes for a highly scalable and profitable business. As assets grow, expenses don’t at all grow commensurately once you reach critical mass, which Och-Ziff reached a long time ago. Based on “economic income,” which excludes non-cash charges from the reorganization it did prior to going public in 2007, the company’s operating margins are in the mid-50% range and we believe are likely headed over 60% for the year ending in December.
May 27, 2011

This may provoke an admittedly selfserving answer, but what makes you optimistic about the future of the hedge fund business? LK: As evidenced by their performance, hedge funds by and large protected investors much better during the financial crisis than non-hedged asset managers. In a world that financial-market-wise is not going to be a safe place for some time, we believe managers like Och-Ziff will prove to be a magnet for institutional assets. Their funds were down far less than the market in 2008, more than made up any losses in 2009 and, importantly, they
INVESTMENT SNAPSHOT

never put up any “gates” to client withdrawals when the crisis was at its worst. In general we’ve heard from clients that the company was highly transparent and responsive throughout the crisis, a reputation you want to have when managing other people’s money. Another factor in favor of alternative managers is the fact that institutions have been sitting on very large fixed-income allocations that are going to have to be redeployed. With interest rates and the prospects for capital appreciation so low, pension funds and other similar institutions will have a hard time meeting obligations with too much fixed income.

Och-Ziff Capital Management
(NYSE: OZM)

Valuation Metrics
(@5/26/11):

Business: Investment manager offering a range of hedge funds focused on credit, equity, special situations, convertible and merger arbitrage, and private investments. Share Information
(@5/26/11):

Trailing P/E Forward P/E Est.
(@3/31/11):

OZM n/a 9.9

S&P 500 16.6 13.5

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

14.59
11.74 – 17.56 3.6% $1.41 billion $953.5 million 51.3% (-31.6%)

Company Bank of NY Mellon T. Rowe Price Thornburg Inv Mgmt HSBC Holdings Century Capital
Short Interest (as of 5/13/11):

% Owned 3.1% 2.8% 2.6% 2.3% 2.3% 5.1%
25 20 15 10 5 0

Revenue Operating Profit Margin Net Profit Margin
OZM PRICE HISTORY 25 20 15 10 5 0

Shares Short/Float

2009

2010

2011

THE BOTTOM LINE

Lloyd Khaner believes the company will be a prime beneficiary as institutional investors seek greater stability of returns and reallocate low-potential fixed-income holdings to alternative asset managers. The shares currently trade at 55% of his $27 target price, and he estimates they’ll earn a dividend yield on this year’s company earnings of 8.5%.
Sources: Company reports, other publicly available information

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Value Investor Insight 12

I N V E S T O R I N S I G H T : Lloyd Khaner

Inflows have been positive – hitting $2.7 billion last year for OZM – and while it’s impossible to be precise about timing, we believe money could come in at a much faster clip over the next couple of years. Ultimately, there’s no reason why the company can’t manage more than twice the assets it currently does. With the shares at recent $14.60 – down more than 50% from the 2007 IPO – how are you looking at valuation? LK: Wall Street assigns different multiples to alternative asset managers’ management-fee and incentive-fee streams. The management fees might earn a 19x multiple, while the more volatile incentive fees earn more like 9x. In OZM’s case, we believe the resulting blended multiple of around 13x is unfair, because its incentive fees won’t be as volatile as those of other publicly traded alternative managers, most of which are private equity firms. So using a more reasonable 15x multiple on our 2012 EPS estimate of just over $1.80, we get a target price of more than $27. On top of that, because OZM is a master limited partnership, it has to pay out a high percentage of its earnings as a distribution to shareholders. Assuming an 85% payout, the dividend yield on our 2011 estimate is 8.5%, and on our 2012 estimate is 10.3%. The biggest risks? LK: There is some risk that the hedge fund compensation model comes under attack, but the company says they’ve had more pushback on management fees, which are a much lower percentage of total revenue, than on incentive fees. In general, if people are satisfied with their returns, they have tended to let people get paid what they’re paid. There is also a risk that the tax rate on “carried interest” is increased, which would affect the earnings available to shareholders. I don’t have a crystal ball on this issue, but those affected are likely to have up to a 10-year transition period to implement any change. It’s obviously something we’re keeping our eye on.
May 27, 2011

Another thing I’d add is that the alignment of Och-Ziff’s partners here with those of shareholders is the best I’ve ever seen in my career. The 19 partners take no salary or bonus, participating in the company’s success in the same way we do, as shareholders receiving distributions and benefiting from any appreciation in the stock price. From hedge funds to software, describe your investment case for Cadence Design Systems [CDNS]. LK: Cadence is a leading global supplier of electronic design automation (EDA)
INVESTMENT SNAPSHOT

software. EDA software helps companies like Texas Instruments, Intel and Samsung design and manufacture computer chips and printed circuit boards, allowing them to see in advance things like how prospective new chips will perform, whether they’ll be compatible within systems, and how much power they’ll use. This helps save time and money in the product-development process, which is critical in an environment where the technology has to constantly evolve to meet the needs of end-product computer and smartphone manufacturers. We started tracking the company in 2007 when Lip-Bu Tan came off the

Cadence Design Systems
(Nasdaq: CDNS)

Valuation Metrics
(@5/26/11):

Business: Global supplier of software and design tools that help engineers plan, lay out, simulate and verify designs of a wide variety of semiconductors. Share Information
(@5/26/11):

Trailing P/E Forward P/E Est.
(@3/31/11):

CDNS 19.8 26.0

Russell 2000 49.5 22.5

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

10.64
5.58 – 11.07 0.0% $2.86 billion $980.1 million 2.2% 14.8%

Company Dodge & Cox T. Rowe Price Wellington Mgmt Vanguard Group State Street Corp
Short Interest (as of 5/13/11):

% Owned 16.5% 4.9% 4.8% 4.7% 2.8% 9.2%
12 10 8 6 4 2

Revenue Operating Profit Margin Net Profit Margin
CDNS PRICE HISTORY 12 10 8 6 4 2

Shares Short/Float

2009

2010

2011

THE BOTTOM LINE

Having implemented a new revenue model, cut costs, and tailored R&D more to customer needs, the company is well-positioned to benefit from what Lloyd Khaner expects to be a positive mobile-device-driven cycle for semiconductors. At 13.5x his 2012 earnings estimate, the shares within 12 to 18 months would trade around $17.
Sources: Company reports, other publicly available information

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Value Investor Insight 13

I N V E S T O R I N S I G H T : Lloyd Khaner

board to run the company and began cutting operating expenses, refocusing R&D based on closer customer contact, and moving the revenue model to subscription-based payments over a contract life rather than one-time upfront payments. We didn’t buy in until last year, though, when we saw bookings start to grow again after a painful decline prompted mainly by the revenue-model switch. In general, in a business where labor is the largest expense, operating leverage is very high. On top of that here we have costs having been cut and customers successfully migrated to higher-margin subscription contracts. As a result, we think margins are set to take off if revenues grow at the 10-15% annual rate we expect. Management believes, and we agree, that this should eventually be a 2530% operating-margin business. What’s driving revenue growth? LK: The semiconductor industry is clearly volatile, but we think there’s a strong tailwind for the business from the current upturn in global technology spending and the explosive growth in mobile devices. We consider Cadence a “picks and shovels” way to play that growth – it provides tools that semiconductor product manufacturers desperately need, but it has less technology risk because they can stay device and end-market agnostic. Is industry competition rational? LK: The EDA industry has consolidated into an oligopoly led by Cadence, Synopsys, Mentor Graphics and Magma Design. Pricing is more likely to remain rational as a result of consolidation and the fact that the shift to subscriptionbased revenue takes away some of the quarter-to-quarter jockeying to sign new business by making unprofitable price concessions. How inexpensive are the shares at a recent $10.65? LK: We value the shares based on free cash flow, which is higher than net
May 27, 2011

income because depreciation and amortization charges are roughly double capital expenditures. From 56 cents per share in 2010, we estimate Cadence can earn 90 cents to $1 in free cash flow this year and $1.25 in 2012. Based on peer and historical multiples, we believe 13.5x the 2012 number is reasonable, which would produce a share price in the next 12 to 18 months of around $17. The main risk short-term is that the semiconductor industry takes a turn for the worse. But we wouldn’t expect that to change the long-term demand picture for Cadence, and are comfortable the company can ride out any industry volatility. It
INVESTMENT SNAPSHOT

should have almost $800 million in cash on the balance sheet by the end of this year, while debt – most of which is in outof-the-money convertible shares – should only be around $600 million. What do you think the market is missing in Illinois Tool Works [ITW]? LK: This has always been a good company, but we believe is about to prove it’s a great company. It’s a multinational manufacturer of a wide range of industrial products and equipment, with 800 operating companies aggregated into eight reportable segments: Transportation,

Illinois Tool Works
(NYSE: ITW)

Valuation Metrics
(@5/26/11):

Business: Broadly diversified manufacturer of industrial products, systems and equipment, operating through more than 800 decentralized business units worldwide. Share Information
(@5/26/11):

Trailing P/E Forward P/E Est.
(@3/31/11):

ITW 15.8 14.5

S&P 500 16.6 13.5

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

56.99
40.33 – 58.79 2.4% $28.5 billion $16.52 billion 15.1% 11.0%

Company Northern Trust State Farm Vanguard Group Wellington Mgmt State Street Corp
Short Interest (as of 5/13/11):

% Owned 8.8% 4.5% 3.8% 3.5% 3.4% 2.4%
60 50 40 30 20

Revenue Operating Profit Margin Net Profit Margin
ITW PRICE HISTORY 60 50 40 30 20 2009

Shares Short/Float

2010

2011

THE BOTTOM LINE

Having aggressively restructured itself during the economic crisis – including making new investments – the company is poised to “blow through” new records for revenues, margins and earnings per share over the next few years, says Lloyd Khaner. At 15x his 2012 per-share earnings estimate of $5, his target price for the shares is $75.
Sources: Company reports, other publicly available information

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Value Investor Insight 14

I N V E S T O R I N S I G H T : Lloyd Khaner

Industrial Packaging, Power Systems and Electronics, Polymers and Fluids, Food Equipment, Construction Products, Decorative Surfaces, and All Other (which includes a thriving Test and Measurement business). It operates in 57 countries, with 48% of revenues coming from North America, 32% from Europe, the Middle East and Africa, and 20% from Asia Pacific and everywhere else. While most companies fought to survive during the crisis of 2008-09, ITW aggressively restructured itself through cost-cutting, divesting underperforming operations, expanding through acquisition in higher-growth and higher-margin end-markets and geographies, and buying back its undervalued stock. Revenues increased more than 10% in 2010, even though one key end-market – U.S. residential and commercial construction – was still very weak. As the global economy continues to mend, we expect the company to set records for revenues, margins and earnings over the next couple of years. What assumptions are you making about profitability? LK: We’re assuming 10-15% annual growth in revenues, split roughly between organic growth and acquisitions. With that growth and the permanent removal of costs in the restructuring, we think operating margins can top 18% by 2012. From earnings of $3.08 per share in 2010, we’re estimating $4 this year and $5 next year. How does that translate into potential upside for the shares, now at around $57? LK: Given the 10%-plus revenue growth and 20%-plus EPS growth we’re expecting, we consider a 15x earnings multiple to be conservative. Applying that to our 2012 earnings estimate, our price target a year out is around $75. That assumes no big stock buyback plans or a dividend increase, both of which are certainly on the table as management looks to allocate the $1.5 billion or so in free cash flow ITW will generate this year.
May 27, 2011

We’ve seen ITW show up on the ubiquitous “potential Berkshire Hathaway acquisition” lists that get published from time to time. Why do you think that is? LK: The main reason is probably that it’s a superb return-on-invested-capital company that often doesn’t get the respect it deserves from the market. It’s ROIC averages 15-17% during cyclical upturns, even though that number gets hit by high levels of goodwill from the company having done so many acquisitions over time.

I’d mention that I prefer to hedge using put options rather than shorting. Options have their challenges because the pricing can be volatile – premiums for the most part are too high now – and because you have to get the timing right, but we like to know how much we can lose if we’re wrong, which isn’t the case in shorting. You also last time touted the virtues of gold, which has turned out pretty well. What’s your take on it now? LK: We still own it, but have cut back. I still consider gold a good long-term hedge against inflation and geopolitical risk, but I would not be surprised, in an improving global economy where the dollar stops depreciating, if gold prices stayed where they were or corrected, maybe significantly. Until 2009, gold regularly had intrayear corrections of 20% or more two or three times a year – it is, after all, a commodity. Now we’ve had two years without a significant correction and, shortterm, we might be due for one. You write a column for Minyanville.com called “Lloyd’s Wall of Worry.” Why? LK: I’ve actually gone through the basic process for 20 years, identifying the major things I believe are worrying equity markets worldwide, such as QE II going away, rising oil prices or sovereign debt problems. It’s my way of putting somewhat of a macro overlay on my 100% company-focused investing. This is hardly scientific, but I’ve found that when I can list more than 20 fundamental market concerns, that high level of worry is usually priced into the market and it’s proven to be a good time to be looking for value. If I can identify no more than 10 big concerns, the market is overly complacent. So what’s the “Wall of Worry” indicator saying today? LK: My latest list has 20 items. There’s plenty to worry about – which may explain why I’m finding quite a few values out there. VII
Value Investor Insight 15

ON GOLD: We still own it, but we’ve had two years without a significant price correction and we might be due for one.
A better reason to me is that the company follows the highly decentralized Berkshire operating model and does an excellent job of identifying accretive acquisitions. No one has or will ask me, but I’d argue that ITW CEO David Speer, who started at the company in 1978, would actually make a great choice as the next person to run Berkshire’s operations. When we last spoke in 2006, you were betting against mortgage originators, saying “it’s not going to be pretty as housing prices and/or the economy go south.” Nice call – any similar insights today? LK: It’s not as much of a sector-wide bet, but we do believe certain retailers that have no real unique selling proposition and have too many stores that are too big – we call them “commodity retailers” – are going to get their lunch eaten longterm by online retailers and by specialty and discount stores. Real estate values propped the stocks up for some time, but that hasn’t proven to be as valuable as people once thought. It’s not the only one we see in this boat, but it’s hard for us to see how Sears [SHLD], for example, is going to be successful over time.
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S T R A T E G Y : Real Estate

Rebuilding
The recovery in most global real estate markets has been fitful at best. For Third Avenue Funds' Michael Winer and Jason Wolf that spells selective investment opportunity – leavened with a heavy dose of caution.
INVESTOR INSIGHT

Michael Winer, Jason Wolf Third Avenue Management On U.S. housing: “Are we going toward a model in which you need 20% down to purchase a home? If so … the housing market is likely to continue to suffer.”

Editors’ Note: Even for the boom-andbust real estate business in which he’s plied his trade for the past 25 years, Michael Winer admits to some surprise at the ferocity of the recent downturn. “It was brutal for about a year,” he says. “There was no good news and companies that a year prior seemed to be wellmanaged and well-financed had their securities priced as if they were near bankruptcy.” With most residential and commercial real estate markets having only tentatively begun the recovery process, we asked Winer and co-portfolio manager Jason Wolf – who oversee $5.5 billion in real estate-related investments for Third Avenue Management – for insight on where they’re finding opportunity today … and where they aren’t. The storm clouds for real estate were gathering when we last spoke [VII, August 31, 2007]. How do you think your strategy weathered the ultimate deluge? Michael Winer: Nothing has caused us to question the fundamental aspects of our strategy. We focus on development-oriented real estate operating companies
May 27, 2011

that create value, as opposed to most real estate investment trusts [REITs] that buy properties and then try to make money on the spread between financing costs and the assets’ yields. While no part of the market was spared, companies with high development exposure took particularly big hits as the perceived value of the projects declined sharply. Companies with, say, 50% debt to total assets based on value before the crisis suddenly were perceived to have 80% leverage as those values got marked down. When credit markets shut down, that was bad news for the stocks of companies we owned like ProLogis [PLD] and Forest City Enterprises [FCE-A]. I believe we did a good job of staying focused on companies’ balance sheets, the long-term value of the assets they owned and on consistent, recurring cash flows, which don’t just disappear overnight. We had some pretty decent cash reserves in late 2008 and early 2009 – around 18% of the portfolio, because we had prepared for heavier investor redemptions than we got – and put it to work as security prices were so depressed. We invested heavily in the unsecured convertible notes of U.S. REITs, for example, which were trading at 30, 40 or 50 cents on the dollar, and a year later were typically able to sell them at par. We had gotten out of ProLogis common stock, but bought back in as the share price got as low as $2 – we recently sold it above $14. Even after enduring tremendous pain with our investment in Forest City, we participated in its equity raise at $6.60 per share and we still think the stock is undervalued today at $19. You’ve written about some process and portfolio-management changes sparked by the crisis. Describe those. MW: In general, we’ve taken a more active view on adjusting position sizes so they best reflect our level of conviction
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and return expectations. We’re not at all becoming market timers, but we’re much less apt today to let a 5% position through appreciation become an 8% position unless its prospective return has commensurately improved as well. We’ve also scaled back the maximum position size we’re comfortable with to 8-9% of the portfolio, from 12-13% or higher before the crisis. Jason Wolf: Another important change we’ve made is to develop a well-maintained list of companies we would want to own at the right price. Because of the suddenness of the crisis, there were so many securities on sale that we were a bit paralyzed in trying to analyze them all. We’ve made the investment to stay current about on-deck ideas so we can act more quickly when opportunities present themselves. This has already proven helpful, as a year ago we were able to buy some REITs – such as Unibail and Klepierre, both based in France – when their stocks dropped like stones due to the European debt crisis. Given how quickly the shares came back, we probably would have missed out on those before. You’ve started selling out-of-the-money put options on some of the stocks on your prospect list. What’s behind that? JW: When markets are volatile and option premiums are high, we can essentially pick the price at which we’d buy a stock that’s trading at a discount to our estimate of net asset value and receive a nice premium for agreeing to buy it at that lower price in the future. We can only do this when we have a relatively high cash balance to cover purchases we might have to make – today cash is around 22% of the portfolio – and we see it as sort of a win-win proposition. If the options expire out-of-the-money, the premium we earn is an attractive yield on cash that is otherwise earning close to
Value Investor Insight 16

S T R A T E G Y : Real Estate

zero. If the shares are put to us, we’re paying less than our “buy price” after netting the premiums against the strike price. The risk, of course, is that an exogenous event – like fraud, a natural disaster or a major market dislocation – could cause us to have to buy a stock at a premium to the market price. Our view is that we already assume those types of risks with every security we own, which we go to great lengths to mitigate by focusing on margin of safety and rocksolid balance sheets. Does your current cash level reflect caution about today’s environment? MW: We consider having 10% cash to be fully invested, so the answer is yes. We’re seeing more selling opportunities than buying opportunities, so we’re unapologetic about holding cash as dry powder. I mentioned that commercial REITs aren’t typically our focus, but we’ll own them if the prices are right. That is not at all the case today in our view, as they’re trading in the U.S. in particular at all-time high multiples of cash flows and all-time low implied cap rates. They just seem priced for perfection right now. When we last spoke you were wary of U.S. homebuilders, saying “I just don’t know where the bottom is yet.” Is that still true? MW: The news every month on U.S. housing isn’t encouraging, but we think we’ve seen the bottom and long-term we’re bullish. Homebuilders by and large have written down their land inventories to appropriate levels, as evidenced by the fact that they’re earning 18-20% gross margins on the homes they’re selling today. Operating margins are still skinny, but there’s a lot of leverage there once they are able to spread selling, general and administrative costs over a larger base of sold homes. We're confident that there will ultimately have to be a greater number of homes built in the U.S., given positive household formation, low levels of current housing starts and obsolescence of existing stock.
May 27, 2011

Why is Lennar [LEN] one of your key bets on a cyclical rebound? MW: Like everyone else, Lennar has struggled in the downturn, but we expect it to be one of the most-profitable builders as conditions improve. They have smart management, great land assets on the books at low values – either from writedowns or from opportunistic acquisitions in recent years at bargain prices – and plenty of cash to ride out current conditions. On top of that, the company has recreated its former distressed-real-estate business under the Rialto Capital banner. We were actually an original shareholder in LNR Property Corp., the similar business that was spun out of Lennar in 1997 and run very successfully by Jeffrey Krasnoff, who founded Rialto with Lennar’s backing. He’s buying portfolios of distressed mortgages from failed banks and the FDIC and we expect that he’ll again create meaningful value for Lennar shareholders. JW: The big unknowns, of course, are what’s going to happen to Fannie Mae and Freddie Mac and what the new mortgage model in the U.S. is going to look like. Are we going toward a model in which you need a 20% downpayment to purchase a home? If so – and I’m making no value judgment at all – the housing market is likely to suffer for another couple of years. That’s a real wildcard, which is another reason we like Lennar’s stake in Rialto, as a nice counterbalance against a prolonged bottom in the housing market. You’ve been through the wringer with long-time holding Forest City Enterprises. What is your take on the company’s prospects today? JW: Forest City to us is the quintessential real estate development company, which over 40 years has created value through a wide variety of large-scale, income-producing commercial, retail and residential projects, often as part of complicated urban-development projects.
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There are two knocks on the company today from the market’s perspective. The first is that there’s uncertainty over some remaining big development projects and how well they’ll get operationally up to speed. One is 8 Spruce Street, a 76-story apartment complex designed by Frank Gehry, which will be the tallest residential building in New York City. The project is scheduled to be completed this year, offers great views and will even have a new public school built on the ground floor. At the end of the day when it’s stabilized, it will probably be worth about the $950 million they paid to build it. They usually do better, but it’s hardly a disaster and one day, given the notoriously tight Manhattan rental market, 8 Spruce Street will be worth a lot more than that. Another development underway is a $1.3 billion retail mall development in Yonkers, NY called Westchester’s Ridge Hill. The retail environment has improved considerably over the past six months and they’ve signed some key tenants, including Lord & Taylor, Dick’s Sporting Goods, Whole Foods and National Amusements, for a large cineplex. Ridge Hill opens in phases over the next two years and if the economy remains reasonably healthy, we believe can surprise on the upside in terms of rents and occupancy rates. MW: The other big knock on Forest City is that it’s perceived to have a relatively high debt load, based on its overall debt to total assets. But we think those concerns are overblown if you look more closely at the type of debt the company has. For one, the vast majority of it is in single-property, non-recourse-to-the-parent mortgage loans. This significantly reduces risk – if a troubled property has a $100 million mortgage and is only worth $60 million, with a non-recourse loan you really only owe $60 million because you can hand the keys back. In addition, of the $750 million of corporate-level liabilities, some $470 million of that is in convertible debt that is all inthe-money. As long as the stock stays above $14 or so, that debt will be turned into equity over time.
Value Investor Insight 17

S T R A T E G Y : Real Estate

Is the development pipeline fairly empty after those two projects are stabilized? JW: As those two projects become operational, the company’s development assets as a percentage of total assets goes to less than 10%. That to us signals phase one of the recovery, and that’s all we’re counting on in finding the stock attractive today. But we also believe there will be a phase two, as they put their 8,600-acre land bank across the country to good use and continue to be the preferred developer for transformative urban projects. The company was recently chosen for the Pier 70 project in San Francisco, encompassINVESTMENT SNAPSHOT

ing commercial development, historic preservation and the creation of waterfront open space. That’s the type of complex project Forest City does very well. With the shares at $18.90, how are you looking at valuation? JW: In valuing companies we typically use what we think are very conservative cap rates on each component part of net operating income to arrive at gross asset value, then subtract all liabilities to arrive at net asset value. We’re interested when the shares trade at least at a 20% discount to that conservative estimate,

although we’ll accept less of a discount if the growth potential is high. In Forest City’s case, we value separately the income-producing properties, the development portfolio, the land bank, and some other hotel and military-housing assets. For the income properties, we assume 7% cap rates on current net operating income for the retail, office and residential portfolios. For the hotel and military assets, we use an even higher cap rate of 9%. For the development portfolio and the land assets, we use book value less 10%. When you add it all up, including cash, and subtract the debt, we estimate NAV at $22-23 per share. MW: If we applied the current implied cap rates on comparable publicly traded REITs – which we believe are somewhat overvalued – to Forest City’s income-producing properties, the NAV would be closer to $30 per share. The upside to that, which we believe is likely, is if the development portfolio and the land bank prove to be worth far more over time than the book value minus 10% we’ve assumed. Your portfolio has been weighted toward international stocks for some time. Do you still find more opportunity outside the U.S. than in it? JW: North America represents just over 30% of the portfolio today. We’re seeing a disconnect between market fundamentals and valuations, in that the mostdeveloped real estate public-security markets like the U.S. and the U.K. generally have fair to high valuations paired with anemic real estate fundamentals, while in the developing world, primarily Asia exJapan, you have great demand, supply and cash flow fundamentals, but investors appear hesitant to bid up stock prices. As value investors, we’re just finding better pricing in Asia. Describe why Henderson Land [12:HK] is a prime example. JW: The company was founded in Hong Kong in 1976 by Lee Shau Kee [#28 on Forbes’ list of the world’s richest people]
Value Investor Insight 18

Forest City Enterprises
(NYSE: FCE-A)

Valuation Metrics
(@5/26/11):

Business: Commercial and residential real estate development, with specialty in urban renewal projects done in concert with municipal or regional governments. Share Information
(@5/26/11):

Trailing P/E Forward P/E Est.
(@3/31/11):

FCE-A 62.2 n/a

S&P 500 16.6 13.5

Largest Institutional Owners

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

18.92
10.80 – 19.42 0.0% $3.16 billion $1.18 billion 22.2% 5.0%

Company Third Avenue Mgmt Horizon Asset Mgmt Morgan Stanley Inv Mgmt Wellington Mgmt Cohen & Steers
Short Interest (as of 5/13/11):

% Owned 13.3% 9.0% 8.1% 7.8% 7.8% 6.8%
50 40 30 20 10 0

Revenue Operating Profit Margin Net Profit Margin
FCE-A PRICE HISTORY 50 40 30 20 10 0

Shares Short/Float

2009

2010

2011

THE BOTTOM LINE

Concern about near-term prospects for soon-to-be-completed development projects in and around New York City is unduly penalizing the company’s stock, says Michael Winer. If he applies the current implied capitalization rates on comparable publicly traded REITs to the company’s assets, its net asset value would be closer to $30.
Sources: Company reports, other publicly available information

May 27, 2011

www.valueinvestorinsight.com

S T R A T E G Y : Real Estate

and consists of income-producing properties primarily in Hong Kong, real estate development projects in Hong Kong and mainland China, and stakes in separate publicly traded companies such as Hong Kong & China Gas. The income-property portfolio, encompassing some 15 million square feet of owned space, is benefiting from high demand and relatively constrained supply in Hong Kong, particularly in the retail and office sectors. That has translated into excellent cash flow growth from this segment, averaging 10% annually over the past six years. The development business is sort of a catch-all for a giant portfolio of raw land, farmland, entitled land, unsold or unfinished office property, and several urban redevelopment projects. Henderson is unique in not participating in public auctions for land, which has resulted in it accumulating over the years particularly low-cost assets. Two of the publicly traded stakes the company owns are in small-cap real estate companies, Hong Kong Ferry and Miramar Hotel & Investment. The most valuable is its 40% holding in Hong Kong & China Gas, one of Asia’s largest and most-profitable natural gas distributors which also owns two-thirds of Towngas China, a public gas utility operating in 17 provinces in mainland China. The Hong Kong & China Gas stake alone, at current market prices, is worth 55 billion Hong Kong dollars, 45% of Henderson’s entire market cap. With government policy having helped fuel the real estate boom in China, isn’t one concern that it will act aggressively to rein it in? JW: That is clearly a primary reason investors appear so cautious, regardless of the fundamentals. Our view is that based on the company’s actual portfolio makeup, that generic risk is overstated in Henderson’s case. Its commercial assets on the mainland are in high-quality urban office and retail properties that haven’t shown the pricing excesses you do see in “tier-1” city residential properties. At the
May 27, 2011

same time, its residential holdings tend to be located in second- and third-tier Chinese cities, which haven’t seen house prices go parabolic and which will continue to benefit from strong demand as the flight from country to city continues. Henderson also actively sells properties when it believes the time is right. It has been selling residential properties in Hong Kong, for example, which will probably lead to a banner profitability year in 2011 if that pace continues. Walk through your sum-of-the-parts valuation of the company’s stock, now trading at HK$51.75. JW: The net operating income for the income-producing properties is around 2.1 billion Hong Kong dollars. We value
INVESTMENT SNAPSHOT

that cash flow at a 5% cap rate, which sounds low, but is actually conservative for the Hong Kong market. That results in a value for that piece of HK$42 billion. We value separately the company’s 35% equity interest in Hong Kong’s International Finance Center, which we consider one of the highest-quality real estate projects in the world. Using only book value, that’s worth just under HK$21 billion. We assign a HK$78 billion value to the development assets, a 16% premium to book value, mostly because of the very low farmland and raw land prices on the books. The portfolio of stock holdings are worth another HK$55 billion, a discount to actual market values due to potential liquidity issues if they tried to sell their stakes.

Henderson Land
(Hong Kong: 12:HK)

Business: Develops and operates commercial, retail and residential real estate properties, primarily in Hong Kong and second-tier cities in mainland China. Share Information
(@5/26/11, Exchange Rate: $1 = HK$7.78):

Financials (2010)

Revenue Operating Profit Margin Reported NAV/Share
Valuation Metrics
(Current Price vs. TTM):

HK$7.09 billion 36.2% HK$73.09

Price
52-Week Range Dividend Yield Market Cap

HK$51.75
HK$43.10 – HK$61.50 1.9% HK$121.5 billion P/E 12:HK 7.1 S&P 500 16.6

HENDERSON LAND PRICE HISTORY 80 70 60 50 40 30 20 2009 2010 2011

80 70 60 50 40 30 20

THE BOTTOM LINE

There’s a disconnect between the company’s current valuation and the supply/demand and cash flow characteristics of its properties and markets, says Jason Wolf. Based on what he believes are conservative sum-of-the-parts assumptions, he pegs the net asset value of the company’s shares at HK$70, 35% above today’s price.
Sources: Company reports, other publicly available information

www.valueinvestorinsight.com

Value Investor Insight 19

S T R A T E G Y : Real Estate

Add in another HK$14 billion for various other assets and cash, subtract HK$51 billion in liabilities, and we arrive at a net asset value for the company of HK$160 billion, or HK$70 per share. If you strip out the actual value of the Hong Kong & China Gas stake, we believe we’re buying the real estate at a 50% discount to net asset value. One technical issue weighing on the stock is a “bonus warrant” the company issued to shareholders last year, allowing it for twelve months to buy newly issued shares at HK$58 per share. That has not surprisingly put a lid on the share price, since no new investor would want to pay more than that when current investors have that option, which expires in June. An interesting twist of late is that Lee Shau Kee, apparently trying to send a message about his confidence in the company, recently exercised his right to buy shares for HK$58 each, even though the stock was then trading around HK$53. We certainly wouldn’t do that, but it rein-

forces our belief that investor sentiment on this stock is way too negative. How should investors fearful of inflation think about investing in real estate? MW: Well-leased and well-located real estate should be a hedge against inflation. Rents in such cases should follow the inflation trend and to the extent you’ve locked in long-term fixed-rate debt financing, most of that inflation falls to the bottom line. Most of the companies we own continue to refinance their debt at low rates with extended maturities, which should serve them quite well if we get into an inflationary period. We have to ask about your take on the drama at Florida real estate company St. Joe [JOE], in which you were once the largest shareholder. MW: We no longer own St. Joe shares. While [Greenlight Capital’s] David

Einhorn has some valid arguments to the contrary, we do believe the long-term value is there. We think the new airport is going to be a tremendous asset for northwest Florida and that the market will eventually recover. But there’s no question it’s a terrible market right now, and more importantly, with [Fairholme Fund’s] Bruce Berkowitz taking over as chairman and overhauling the board and management, we don’t know what the business plan will be and who’s going to execute it. As long as that’s the case, we’ll choose to be on the sidelines. Is this a case where the ultimate payoff is just too far off, even for you? MW: I wouldn’t say that. If new management articulates a plan that we trust will realize the value in the company, we’d be happy to buy back in, maybe even at today’s price [of $21.70]. If the potential upside is big enough, we don’t mind waiting for years to get at it. VII

May 27, 2011

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Value Investor Insight 20

U N C O V E R I N G V A L U E : Skechers

Best Foot Forward
After nearly 20 years in business, trend-conscious shoe company Skechers has built a nicely profitable and well-diversified franchise. So why is the market treating it as a troubled one-hit wonder?
Such is the nature of dynamic economies – and fickle investors – that even the strongest bull markets bypass certain stocks entirely. Lists of stocks hitting new lows may shrink, but they never dry up completely. Fashion-forward shoe company Skechers finds itself among this unhappy cohort today. Since topping out near $45 a year ago, its stock now sits at a recent $17.70 after the company reported three straight quarters of unexpectedly high inventories and unexpectedly low earnings. The culprit: a rapidly cooling market for so-called “toning” sneakers, thicksoled shoes with rounded heels that had taken off in popularity when Skechers entered the market in 2009 with its lowerpriced Shape-Ups line. As claimed benefits ranging from reduced cellulite to improved circulation have come under increased scrutiny, toning shoes day in the sun appears to have passed. Though hardly good news for Skechers – toning shoes accounted for an estimated 20% of the company's 2010 revenues of $2 billion – David Kessler of Robotti & Co. believes the decimation of its share price has been overdone. “The market's reaction implies the company is a one-trick pony, but it's not,” he says. While capable of creating its own product hits, such as the Twinkle Toes line of kids' shoes, Skechers bread-andbutter has been quickly adapting others’ trendy products into stylish footwear sold at mid-tier prices. It spends heavily on celebrity-endorsed advertising and then takes full advantage of its strong distribution network of independent retailers and nearly 300 company-owned stores. In the ten years before toning shoes came along, the company increased revenues at an 8% annual clip, earned consistent gross margins in the low-40% range and averaged 13% returns on equity. Looking forward, Kessler believes 68% average annual top-line growth in the
May 27, 2011

rest of the business – from international expansion and opening 25-30 new U.S. stores per year – will offset the decline in toning-shoe revenue, which he does not think will go entirely away. He expects marketing spending to be maintained at a high 9% of revenues, but believes operating margins can increase to around 8%, driven by operating leverage and savings from a new distribution center opening this year. Add it all up and he estimates the company can earn $2 per share within the next two to three years.
INVESTMENT SNAPSHOT

The potential stock upside? Shoe companies such as Nike, Deckers and Wolverine trade today at 18-20x earnings, but even at 13-15x his estimate of “normal” EPS – plus more than $2 per share in net cash on the balance sheet – Skechers' shares would be worth closer to $30. “The next couple of quarters may not be pretty,” says Kessler. “But once the inventory issues are resolved and attention shifts back to the core business, it’s highly unlikely the shares will be such a bargain.” VII

Skechers
(NYSE: SKX)

Business: U.S. designer and marketer of casual footwear sold through independent retailers and company-owned stores. Share Information (@5/26/11):

Valuation Metrics
(@5/26/11):

Trailing P/E Forward P/E Est.
(@5/26/11):

SKX 9.4 16.7

S&P 500 16.6 13.5

Price
52-Week Range Dividend Yield Market Cap
Financials (TTM):

17.70
17.41 – 44.90 0.0% $881.3 million $1.99 billion 6.5% 4.6%

Largest Institutional Owners

Company Wellington Mgmt Cadian Capital Perkins Inv Mgmt
Short Interest (as of 5/13/11):

% Owned 7.2% 6.3% 5.6% 16.7%
50 40 30 20 10 0

Revenue Operating Profit Margin Net Profit Margin
SKX PRICE HISTORY 50 40 30 20 10 0

Shares Short/Float

2009

2010

2011

THE BOTTOM LINE

With solid revenue growth in the rest of its business offsetting fading toning-shoe sales, the company can earn $2 in EPS in the next two to three years, says David Kessler. Applying a less-than-market multiple to that, the shares would be worth closer to $30.
Sources: Company reports, other publicly available information

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Value Investor Insight 21

EDITORS’ LETTER

Winning a Loser’s Game
Oaktree Capital Chairman Howard Marks often credits a 1975 article in The Financial Analysts Journal as a key contributor to his investment thinking. In the article, titled “The Loser's Game,” investing legend Charles Ellis argued that increased competition among highly skilled professional investors had turned investing from a Winner's Game, in which the aggressive, deliberate actions of a privileged view could generate consistent outsized returns, to a Loser's Game, where the emphasis must shift toward making fewer mistakes than others. The numbers made a good case for passive investing, he wrote, but citing his own experience and the work of scientist Simon Ramo, historian Admiral Samuel Elliot Morrison and professional golf instructor Tommy Armour, Ellis does offer some specific advice (which we've condensed here) to those determined to try to win the Loser's Game:
Be sure you are playing your own game. Know your policies very well and play according to them all the time. Admiral Morrison says: “Impose upon the enemy the time and place and conditions for fighting Value Investor Insight™ is published monthly at www.valueinvestorinsight.com (the “Site”), by Value Investor Media, Inc. Chairman and Co-Editor-in-Chief, Whitney Tilson; President and Co-Editor-in-Chief, John Heins. Annual subscription price: $349.
©2011 by Value Investor Media, Inc. All rights reserved. All Site content is protected by U.S. and international copyright laws and is the property of VIM and any third-party providers of such content. The U.S. Copyright Act imposes liability of up to $150,000 for each act of willful infringement of a copyright.

preferred by oneself.” Simon Ramo suggests: “Give the other fellow as many opportunities as possible to make mistakes, and he will do so.” Keep it simple. Tommy Armour says, “Play the shot you've got the greatest chance of playing well.” Ramo says: “Every game boils down to doing the things you do best, and doing them over and over again.” Armour again: “Simplicity, concentration and economy of time and effort have been the distinguishing feature of great players’ methods, while others lost their way to glory by wandering in a maze of details.” Concentrate on your defenses. The competition in making purchase decisions is too good. Concentrate on selling instead. In a Winner's Game, 90 percent of all research effort should be spent on making purchase decisions; in a Loser's Game, most researchers should spend most of their time making sell decisions. Almost all of the really big trouble that you're going to experience in the next year is in your portfolio right now; if you could reduce some of those really big problems, you might come out a winner in the Loser's Game.

The Most Most Important Thing Speaking of Howard Marks, in his latest investor missive he responds to those wanting the Cliffs Notes version of his new book by further narrowing the field of “most-important” things on which investors should focus:
Especially since the publication of my book, people have been asking me for the secret to risk control. If I had to identify a single key to consistently successful investing, I'd say it's “cheapness.” Buying at low prices relative to intrinsic value (rigorously and conservatively derived) holds the key to earning dependably high returns, limiting risk and minimizing losses. It's not the only thing that matters – obviously – but it's something for which there is no substitute. Without doing the above, “investing” moves closer to “speculating,” a much less dependable activity.

Hear, hear.

John Heins Co-Editor-in-Chief

Whitney Tilson Co-Editor-in-Chief

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Value Investor Insight and SuperInvestor Insight are published at www.valueinvestorinsight.com (the “Site”) by Value Investor Media, Inc. Use of this newsletter and its content is governed by the Site Terms of Use described in detail at www.valueinvestorinsight.com/misc/termsofuse. For your convenience, a summary of certain key policies, disclosures and disclaimers is reproduced below. This summary is meant in no way to limit or otherwise circumscribe the full scope and effect of the complete Terms of Use. No Investment Advice This newsletter is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. This newsletter is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. It does not constitute a general or personal recommendation or take into account the particular investment objectives, financ ial situations, or needs of individual investors. The price and value of securities referred to in this newsletter will fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of all of the original capital invested in a security discussed in this newsletter may occur. Certain transactions, including those involving futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors. Disclaimers There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth in this newsletter. Value Investor Media will not be liable to you or anyone else for any loss or injury resulting directly or indirectly from the use of the information contained in this newsletter, caused in whole or in part by its negligence in compiling, interpreting, reporting or delivering the content in this newsletter. Related Persons Value Investor Media’s officers, directors, employees and/or principals (collectively “Related Persons”) may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated in this newsletter. Whitney Tilson, Chairman of Value Investor Media, is also a principal of T2 Partners Management, LP, a registered investment adviser. T2Partners Management, LP may purchase or sell securities and financial instruments discussed in this newsletter on behalf of certain accounts it manages. It is the policy of T2 Partners Management, LP and all Related Persons to allow a full trading day to elapse after the publication of this newsletter before purchases or sales are made of any securities or financial instruments discussed herein as Investment Snapshots. Compensation Value Investor Media, Inc. receives compensation in connection with the publication of this newsletter only in the form of subscription fees charged to subscribers and reproduction or re-dissemination fees charged to subscribers or others interested in the newsletter content.

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