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Underwriting ValueInvestors’ dislike of bad news and uncertainty can cloud their collective judgment.When that happens, expect Jeffrey Altman to try to take advantage.

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ValueInvestor
June 30, 2013

The Leading Authority on Value Investing

INSIGHT
Inside this Issue
FEATURES

Underwriting Value

H

Investors’ dislike of bad news and uncertainty can cloud their collective judgment. When that happens, expect Jeffrey Altman to try to take advantage.
INVESTOR INSIGHT

is training under celebrated distressed investor Michael Price was put to an early test when Jeffrey Altman launched his own hedge fund in 2002. Equity markets were cratering and one-time darlings like Worldcom were going kaput. “We put ourselves out there as having the flexibility and expertise to manage through just that type of market,” he says. Altman’s Owl Creek Asset Management passed that test with flying colors and – now with $3.1 billion in assets – continues to deftly navigate volatile markets. His flagship fund has earned a net annualized 13.6% since 2002, vs. 5.9% for the Russell 3000. With a long/short mandate in both equity and credit, he’s finding mispriced value today in such areas as aerospace, telecom, See page 2 specialty finance and airlines.

Investor Insight: Owl Creek Ready to pounce on market mispricings and finding them today in Leap Wireless, Sprint, Japan Airlines and Spirit AeroSystems. PAGE 1 » Investor Insight: Brian Bythrow Seeing through the market’s skepticism to find value in CPI Aero, BofI Holding, Chefs’ Warehouse, Crimson Wine and Vocera. PAGE 1 » Uncovering Value: Cedar Fair Why this company’s stock may offer a smoother and calmer ride than its customers typically enjoy. PAGE 18 »

Owl Creek Asset Management

(l to r) Jeffrey Lee, Jeffrey Altman, Daniel Krueger Investment Focus: Securities across the capital structure of companies for which the market appears to be misinterpreting or overreacting to prominent news or events.

Uncovering Value: Fairfax After a period as “dead money,” is it time for a closer look at this highprofile insurer’s shares? PAGE 19 » Editors’ Letter On picking up something new from your investment toolbox. PAGE 20 »
INVESTMENT HIGHLIGHTS INVESTMENT SNAPSHOTS
BofI Holding Cedar Fair Chefs’ Warehouse CPI Aero Crimson Wine Group Fairfax Financial Japan Airlines Leap Wireless Spirit AeroSystems Sprint Vocera Communications

PAGE
17 18 13 16 14 19 8 7 5 9 15

Other companies in this issue:
Aiful, AIG, AT&T, Body Central, Boeing, Caesarstone, CommonWealth REIT, Dish Network, First Cash Financial, First Internet Bancorp, Forest Oil, InterLinks, Iron Mountain, Lorillard, MetLife, MusclePharm, National Research, Pep Boys, Six Flags, Verizon, Yahoo

*Please see the important information and additional disclosures at the end of the article.

I N V E S T O R I N S I G H T : Owl Creek

Investor Insight: Owl Creek
Owl Creek Asset Management’s Jeffrey Altman, Daniel Krueger and Jeffrey Lee describe why they find opportunity in binary-outcome situations, why there’s an Asian tilt to their non-U.S. investments, what they stopped doing after a tough 2011, and what they think the market is missing in Spirit AeroSystems, Sprint, Leap Wireless and Japan Airlines.
Since starting Owl Creek, you’ve been agnostic about investing in equity or credit, long or short. Why set it up that way? Jeffrey Altman: We try to be good at underwriting what something is worth, often in difficult and uncertain situations. When we find a real discrepancy between what we believe something is worth and where the market is pricing it, we want to take advantage of that regardless of where the security resides in the capital structure and regardless of whether we think it’s underpriced or overpriced. We gravitate toward event-driven situations where there is high-profile news that is thought to be value disruptive. The market often misprices the impact of that news, say by obsessing about a bad earnings report from a segment of the business that we don’t consider that important to the overall value case. Or by assuming the worst in a legal or regulatory situation where a deeper understanding of the details might indicate something less than total disaster. The market’s sentiment can swing too far in either direction and we’re trying to profit from the extremes. Are the companies that you target typically in extreme distress? JA: It’s not all we do, but a big part, especially on the credit side. There’s usually upheaval and uncertainty about the facts in distressed situations, so security prices can be all over the map. Also in bankruptcy situations you have investors like pension funds and banks that are indiscriminately dumping debt securities they can’t own because they’re now non-performing. In these types of cases, if you believe marketclearing prices don’t reflect the underlying risk, that’s a real opportunity. To give a classic example, as soon as Washington Mutual blew up during the financial crisis we were buying up and
June 30, 2013

down its capital structure. By comparing the company’s financial statements to some bank regulatory filings, we were able to determine there probably was a $4.5 billion deposit that the holding company held in its own bank subsidiary. The question was whether that $4.5 billion would be an asset of the holding company, or would have to be transferred down to the bank subsidiary, which had just been taken over by the FDIC. Our conclusion was that there was a high probability it was an asset of the holding company, which would mean the senior holding-company debt that traded at less than 10 cents on the dollar could actually be worth par. Daniel Krueger: Another important question was who would be entitled to tax refunds resulting from the bank’s losses. The intuitive answer was that the operating bank generated the income and paid the taxes when times were good, and then suffered the losses that created the tax refunds when times were bad, so it should get any refunds. But the legal precedent said otherwise, that the IRS was obligated under the company’s Tax Sharing Agreement to pay out to the holding company first, which could then treat the bank like any other creditor in bankruptcy. If this were the case, that meant both the senior and subordinated bonds should be worth par. When this and the right to the $4.5 billion were settled in our favor, our holding-company debt did very well. Two points I’d make here: One, these types of answers don’t just fall in your lap, they require a non-trivial level of effort and expertise to uncover. Also, to the question of where we find opportunity, it’s often when there’s a binary nature to the outcomes. We’re comfortable working with probabilities and making decisions based on expected values, but in our experience most investors don’t like that. They’d rather take the risk of losing a
www.valueinvestorinsight.com

Jeffrey Lee, Jeffrey Altman, Daniel Krueger

On Credit
It’s not uncommon for the initial training of top stock investors to have been in debt rather than equity. Case in point: Jeffrey Altman founded Owl Creek Asset Management in 2002 after 13 years at what became Franklin Mutual Advisors, investing across companies’ capital structures in bankruptcy and other distressed situations. His co-portfolio managers, Daniel Krueger and Jeffrey Lee, also learned the business on the credit side first. Each is quick to point out the advantages of such training. “One key is how deep into the weeds you have to get in credit situations in order to understand the business and its capital structure,” says Altman. “It’s second-nature for us to do that on the equity side, where it’s obviously as important.” Says Krueger: “As credit investors, cash is king and there’s a hard catalyst of whether you get paid or not. We’re looking for similar situations on the equity side, where we’re focused clearly on how we’re going to get paid and don’t worry so much about near-term swings in the market.” The volatile nature of distressed credit investing also puts a premium on doing your own work, says Lee, as there’s much less conventional wisdom to tap. The transferable benefit, he says: “It makes you more comfortable going against the grain.”
Value Investor Insight 2

I N V E S T O R I N S I G H T : Owl Creek

greater amount of money gradually than a lesser amount potentially in one day. How systematic vs. opportunistic is your idea generation? JA: We do screens in the sense that if we’re in a period when the markets are doing really well or very poorly, we’ll look at what’s most and least in favor for ideas. This can lead us to favor an industry from time to time, but it depends why it’s cheap. If it’s politically motivated and backed by secular tailwinds, like healthcare in 2010, we’re more apt to get involved. If it’s an industry like steel or some other very cyclical business where we have a more difficult time underwriting the future, it’s not that we won’t ever get involved, but the price we’re willing to pay is much lower. Industries are often in a bad place for a good reason. That said, most of our ideas come from bottom-up work on companies and industries sparked by any number of things, from a headline to a conversation with another investor about a bankruptcy situation. We also often find other things to do by looking horizontally and vertically from names already in our portfolio. We’ll talk later about Sprint [S], but as an example, our research on it also gave us what we believe is actionable insight into Verizon, AT&T and Dish Network. Why did something like Yahoo [YHOO] attract your attention? Jeffrey Lee: We’ve owned Yahoo off and on for awhile, but we first got interested in it due to its stake in Alibaba Group, which in China is kind of like Amazon and eBay put together. We’ve had an office in Hong Kong since 2008 and if you were paying attention you could see that, even though Alibaba was private and there wasn’t much financial information, it was a tremendously valuable asset that wasn’t well reflected in Yahoo’s share price. We’ve had a lot of these cross-border situations in our portfolio, where there’s a U.S.-listed stock and the sell side spends 80-90% of its time on the U.S. business, even though
June 30, 2013

it may to our mind only represent 20-30% of the value of the company. Now that part of Yahoo’s Alibaba stake has been monetized, have you moved on? JA: Yahoo sold roughly half of its position back to Alibaba last year at what we considered a too-low valuation of $36 billion for the entire company. Alibaba’s value has continued to grow and we believe in an IPO fair value is at least $100 billion. If we’re right about that, Alibaba will have far more impact to the upside on Yahoo’s share price [now just over $25] than any tweaking of the business model in the U.S.

MetLife [MET], where we could pay 7x earnings for one of the best insurance franchises out there. If interest rates normalize in the next three to five years – the upside/downside on that is in our favor – we think its value could double. Do you have a market-cap sweet spot on the equity side? JL: Most of our portfolio is in the $2 billion to $20 billion cap range. Less than that is difficult given the size of our fund and how concentrated we are. Greater than that, we tend to find less inefficiency. You appear to have an Asian tilt to your non-U.S. investments. Why? JL: We have a separate Asia-focused strategy, focusing primarily on China and Japan, and we have had a greater exposure to Asia than most New York-based firms. Part of that is that we’ve built our core competence there with investments in the region since 2004 and having a Hong Kong team since 2008. But it’s also a function of opportunity and inefficiency. The equity markets there tend to be very retaildriven and short-term focused, which is more apt to create the types of mispricing we try to take advantage of. JA: The volatility that you’ve seen in Japan over the last few weeks is consistent with that. That type of market can be enormously beneficial to us. How activist are you in your positions? JA: With distressed credit, you have to be active because the dynamics of the situation can be very fluid. On the equity side we’re sometimes in activist situations, but we prefer to take a back seat and let somebody else drive it. One example of that today is with CommonWealth REIT [CWH], where we believe Corvex is doing an excellent job in working to change an external-management structure at the company that we think is improper and severely value destructive. Whether investors have standValue Investor Insight 3

On Asia Interest: Part of that is we’ve invested in our core competence there. It’s also a function of opportunity and inefficiency.
You sold your AIG stake recently. Was that because the distressed part of the story had passed? JL: It’s one of the more crowded trades in insurance and we concluded the turnaround in its Chartis property/casualty business was going to be more difficult than we first expected. Given that, you wouldn’t get the same leverage on goingforward changes in pricing and interest rates that you would from other companies. There’s still potential for value creation at AIG, but the value gap had closed quite a bit and rather than go after the balance, we found better ideas elsewhere. JA: While the majority of our portfolio is event focused, sometimes we’ll find things we just think the market is missing. For insurers, the low interest-rate environment has been a big drag on portfolio returns. But if you look at where interest rates have been over the past 15 years, a 1.5% yield on the 10-year Treasury is not even in the range of normal. So rather than hold on to AIG, we’d rather own something like
www.valueinvestorinsight.com

I N V E S T O R I N S I G H T : Owl Creek

ing to call for a vote to replace the current board is now in arbitration, which hopefully will start the process of fixing things. How generally do you look at valuation? JL: It depends on the type of idea and the industry, but we are typically looking at normalized cash flows two to three years out and applying an appropriate multiple based on the quality of the business and the balance sheet. We’ll then look at the implied rate of return from today’s price to that normalized level. There’s no absolute return hurdle, but we often compare our equity ideas to those on the credit side, where the catalysts are usually quite firm. If incremental credit ideas have expected IRRs of 1213%, on the equity side we’d want something maybe 500 basis points above that. You’ve said you usually have a 9 to 18 month time horizon. Why that? JA: Over that period the dislocations we’re underwriting should be able to be righted or fixed. That doesn’t mean you shouldn’t own the business for five or ten years, but because of the types of situations we get involved in, if the value gap we see hasn’t narrowed in 9 to 18 months, we probably should be thinking about it differently. If we’re right, the accretion toward fair value is almost always steeper in the earliest stages and then it flattens out. We’re trying to capture the early move. Do you trade actively around positions? JA: It’s not a big part of what we do. But if our thinking on the outcomes and probabilities change, we react to that. That’s not so much trading around a position as it is updating our view as the facts change. People in the investment business have a hard time paying 20% more for something than they paid for it two weeks ago, or buying something back at $40 that they sold three months ago at $35. We don’t have a problem with that type of thing – we’re just reanalyzing probabilities and facts from today and acting on that.
June 30, 2013

As an example, we bought Boeing [BA] last year in the mid-$70s, before the battery problems, because we saw massive demand for airplanes over the next 15 to 20 years and we thought its upside was tremendously underwriteable because it’s one of only two global competitors. The stock kind of went nowhere for a while, even with the battery problems, but now it’s at $100 and we recently bought more. The long-term upside is still there, but the probability of it happening is higher and the cash flows from it are closer.

who historically has been quite outspoken on the negative impacts of menthol in cigarettes. That creates a very interesting asymmetry, when 90% of your cash flows come from a product that may be banned in the future. With the stock trading at alltime high valuations, we don’t think we’re paying at all for the option that the FDA acts against menthol. JL: If you look at how the sell side handles an issue like this, pretty much every firm lists this regulatory risk as a risk factor for Lorillard. But they never factor it into their target price. We can debate the right probabilities, but they’re essentially saying that the chance something bad happens is zero, which to us doesn’t make sense. JA: We’re also short the bonds here. You have 2020 bonds trading at around 4% yields. The company isn’t over-levered at all, but if the FDA acts against menthol and puts 90% of the cash flow in question, 4% is not the right yield for a 7-year piece of paper. Do you manage your equity portfolio to a given net exposure? JA: We’re generally in the 35-60% range. Over time we’ve found plenty to underwrite on the long and short side to stay mostly within that range and make good money without worrying that we’re over our skis with respect to a market bet. On the credit side, distressed opportunities tend to go in cycles. Where are we in the current one? JA: Default rates are currently low, but things can change quickly. In particular, interest rates going up will likely create a great deal of dislocation and stress that should provide us with a lot of opportunity on the credit side in the future, both short and long. DK: We run a concentrated portfolio in credit, with our top positions usually around 5% to 10% of assets. In any part of the cycle we can find things to do that
Value Investor Insight 4

On time horizon: If the value gap we see hasn’t narrowed in 9 to 18 months, we probably should think about it differently.
That made the stock more attractive even though the price was higher. How does shorting fit into your strategy? JA: We short specific situations in order to generate alpha. If it provides some hedging against another part of the portfolio or against market risk, that’s good, but it’s not the original intention. We’re underwriting a specific negative change we believe will occur in the valuation of a company in the next 9 to 12 months. Why is cigarette company Lorillard [LO] a representative current example on the short side? JA: There are two main parts to the thesis. The first has to do with the competitive environment, which we believe is intensifying as volumes shrink and more people quit smoking. On top of that for Lorillard is the fact that 90% of its business comes from menthol cigarettes, which are the only flavored cigarettes not already banned by the FDA and the FDA is still looking carefully at whether to ban them. Then in February the FDA named as its new head of tobacco regulation someone
www.valueinvestorinsight.com

I N V E S T O R I N S I G H T : Owl Creek

we’re excited about. That said, while you have to be careful what you wish for, typically the more volatility and tumult out there the better. Describe your experience with the credit securities of Japan’s Aiful? DK: Aiful is a consumer-finance company that got hit by a Supreme Court ruling in Japan several years ago that found it and its competitors to be liable for overcharging on micro consumer loans. That sent the entire industry into serious financial distress and pushed most of the small and medium-sized players into bankruptcy. With Aiful, our first bet was on liquidity, that the company had the financial flexibility – both from its ongoing cash flow and from its ability to use unencumbered assets on its balance sheet as enticement to push out bank-debt maturities – to pay off its shorter-term paper at par, even though the market was pricing its one-year bonds at 35 cents on the dollar. That first bet has worked out nicely. Today we own that bank debt of Aiful that originally got extended to 2014, which now trades in the low-80s cents on the dollar. Now it’s a valuation bet in that we believe the existing collateral base and the remaining operating business will support this bank debt at par. The market has been consistently cynical about the company’s ability to dig itself out of its hole – we think the odds are still in our favor that it will. Back to equities, describe your investment case for aircraft-equipment manufacturer Spirit AeroSystems [SPR]. JL: Spirit used to be owned by Boeing and remains one of its largest suppliers, manufacturing things like fuselages, wing assemblies and engine compartments. The company was bought out in 2005 by the private-equity firm Onex, and then came public again in 2006. As Onex prepared it for the IPO, they wanted to create a sort of growth story that included Spirit’s diversification away from Boeing. That resulted in two contracts – one with Airbus and
June 30, 2013

the other with Gulfstream – that until recently the market assumed were fine, but in the third quarter of last year management announced a $590 million charge to earnings saying that the contracts over their lives would be materially less profitable. The stock went from $25 to $15 and we got involved shortly thereafter. A couple of things here are interesting to us. The first is that while the Airbus and Gulfstream contracts may be unprofitable from start to finish, on a cash-flow basis looking forward from today we actually think they’re breakeven to slightly positive. In these types of contracts, which
INVESTMENT SNAPSHOT

have already been running for five or six years, you make a lot of investment upfront and generate cash flow in the outer years. We think the market is still implying very negative future values for these contracts when in fact that isn’t the case. The biggest source of uncertainty, though, has to do with the Boeing contract itself. When Spirit was spun out, it was given a perpetual-supply agreement by Boeing, which meant that for all of Boeing’s then-existing platforms – which didn’t yet include the 787 – Spirit would be the sole supplier of its specific parts for the life of those platforms. Pricing was

Spirit AeroSystems
(NYSE: SPR)

Valuation Metrics
(@6/28/13):

Business: Designs and manufactures fuselage, propulsion and wing systems primarily for original equipment manufacturers serving the commercial aviation industry. Share Information
(@6/28/13):

P/E (TTM) Forward P/E (Est.) EV/EBITDA (TTM)
(@3/31/13):

SPR Russell 2000 72.3 59.1 8.6 17.3 25.2

Largest Institutional Owners

Price 21.48
52-Week Range Dividend Yield Market Cap 13.96 – 25.87 0.0% $3.09 billion $5.57 billion (-0.1%) 0.8%

Financials (TTM):
Revenue Operating Profit Margin Net Profit Margin
SPR PRICE HISTORY 30 30
25 25

Company Scopia Capital Orbis Holdings Vanguard Group BlackRock Artisan Partners
Short Interest (as of 5/31/13):

% Owned 15.5% 5.7% 4.6% 4.1% 4.1% 2.0%

Shares Short/Float

30 25 20 15 10
1.0 0.8 0.6 0.4 0.2 0.0

Clo
1.0 0.8 0.6 0.4 0.2 0.0

20 20 15 15 10 10

2011

2012

2013

THE BOTTOM LINE

The market appears overly pessimistic about the ongoing negotiation of the company’s supply contract with Boeing, says Jeffrey Lee. If the contract renews with no change in pricing – which he considers a more than reasonable likely outcome – he values this contract and another with Boeing at $35 per share, a 60%-plus premium to today’s price.
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 : Owl Creek

set for several years, a period that went through the end of May this year. The issue now is that the pricing side of the contract is being renegotiated and Boeing has said across the board to its suppliers to expect double-digit price decreases. As a result, the market is worried Spirit is going to take a big pricing hit going forward, which would obviously be a big deal given than 85% of Spirit’s revenue comes from Boeing. But this situation is unique. No one else has ever made the parts Spirit supplies to Boeing, and by contract Spirit will remain the sole-source supplier. That puts Boeing in a much different negotiating position than normal. While the full contract details haven’t been disclosed, the summary information that has been released indicates that if an agreement can’t be reached on price, the default is to operate under the terms of the previous contract. That would be a very good result for Spirit. With a perpetual-supply contract, could Spirit even play hardball? JL: Spirit actually says they think the pricing should go up. We’ve asked ourselves how aggressive they should be given Boeing’s size and clout. Boeing could just say, “If you push too hard we’ll take our business elsewhere and you can wear yourself out in court coming after us.” We think that’s an unrealistic threat. There isn’t any capacity in the industry to replace Spirit and there would be a huge disruption in Boeing’s deliveries if it pulled the business. We don’t know how aggressive Spirit will be, but the bargaining position is clearly in its favor and we’d expect pricing at the very least to stay as it is. Our worstcase scenario is that Spirit has to give back something like 2-3%, which would knock $4-6 off our per-share fair value. How do you arrive at that fair value for Spirit, now trading at $21.50? JL: The three pieces of the business are the Boeing legacy contract, a newer program for Boeing’s 787 platform, and the deals with Gulfstream and Airbus. We think the
June 30, 2013

legacy contract, using a 6x EBITDA multiple on current numbers, is worth around $30 per share. The 787 business – based on current orders but with a demandgrowth path going out 30 years – is worth another $5 or so per share using the same 6x EBITDA multiple. That gets you to around $35 per share, ascribing no value to the Airbus and Gulfstream contracts. We don’t really believe those contracts are worth zero, and that Spirit could sell them as a way to create incremental value.

On leap wireless: This is a credit-type idea, where what matters most is the capital structure, asset base and liquidity profile.
When do you expect news on the Boeing contract? JL: It could happen as early as next quarter, but Spirit in March named a new CEO – known as a very tough negotiator from his time at Lockheed Martin, by the way – so there could be some delay as he gets fully up to speed. We don’t expect it to drag on forever, but it’s not a negative for Spirit if it does. Why do you believe market pessimism toward Leap Wireless [LEAP] is overdone? DK: We like buying cheap out-of-themoney options, and in the case of Leap Wireless stock we think we’re getting an in-the-money option at a very cheap price. The equity market value is around $530 million, which is a sliver of the total enterprise value because the company is levered at 7:1. That makes this more of a credittype idea to us, where what matters most is the capital structure, asset base and liquidity profile. Nine out of ten people you talk to about Leap will focus primarily on the operational side of the business, where the outlook isn’t rosy. The company made
www.valueinvestorinsight.com

its name offering cheap pre-paid wireless plans to customers who couldn’t afford contract plans with the big carriers. That’s resulted in very expensive customer churn, while at the same time second-tier competitors like Sprint and T-Mobile have gotten more aggressive on price and in offering unlimited-use plans. That’s all hurt Leap, and given the industry changes underway it’s probably not going to get any easier. Our focus is not on the income statement, but on the more than four billion megahertz pops in wireless PCS and AWS1 spectrum that the company owns. Valuing this is very much an imprecise science – deal comps have been all over the map – but as we go market by market, spectrum-type by spectrum-type, we arrive at a range of possible current values for the company that is very asymmetrically weighted toward the upside. Not just decent upside, but multiples of the current share price, for scarce assets that should only become more valuable over time. How big is the risk that the company goes under before that upside is realized? DK: That’s clearly a risk in any company this levered, but we think the liquidity profile is adequate to keep that at bay for some time. The operations are just turning free-cash-flow positive, the company has more than $900 million in cash on hand and, more importantly, Leap recently refinanced a lot of its debt so that there aren’t any serious maturities until 2019. The long-term nature of the option makes it that much more appealing. If Leap did go into bankruptcy, while not our first-choice outcome, a credible argument could be made that it would accelerate the ultimate sale of the assets to the highest bidder. Then we fall back on our bottom-up valuation work and if we’re right, we could make a lot of money even in a bankruptcy. Now at $6.75, what kind of value are you ascribing to the shares? DK: When we do the detailed work market by market, our base-case value comes
Value Investor Insight 6

I N V E S T O R I N S I G H T : Owl Creek

to about $20 per share. That represents a 62-cent blended value per megahertz pop in spectrum and values the subscriber base assuming a less than two-year average life and $19 in net profit per month per user. But because transaction valuations have been so volatile, you have to look at a very broad range of potential outcomes. We have analyses that create the stock in the $60s and $70s, all the way down to zero. But you can’t do worse than zero, so it’s the asymmetry of this security that makes it so interesting. Figuratively speaking, if we roll the “spectrum-valuation” die and it hits on
INVESTMENT SNAPSHOT

one of the upside cases, we should make multiples of our money. Plus, given the company’s liquidity, we get to roll that die multiple times. That’s important given how sensitive the equity value is to slight changes in what the spectrum is worth – every 10 cents in incremental spectrum value is worth roughly Leap’s entire equity market cap today. We’re curious how you’re sizing a position like this. JA: Given the leverage involved and the asymmetry we see in potential outcomes,

it’s not a large position. The upside is so high that we don’t need a big position in order for it to have a very beneficial impact on the portfolio. What do you think the market is missing in Japan Airlines [9201:JP]? JL: Japan Airlines for most of the past two decades was a bloated, overleveraged company that was run as a quasi-governmental entity focused more on status than on profitability. As its financial condition worsened it didn’t invest adequately in its planes, its service suffered, and it eventually went bankrupt in early 2010. We got involved at the company’s IPO last September as it re-emerged from bankruptcy, having actually done through the process everything you would want a company to do. It cut headcount by 35%, in a country where layoffs rarely happen. It cut the number of routes by nearly 30%, ending unprofitable service to markets that had been served as kind of a public service. It decreased the number of plane models in the fleet from seven to four. Employee work rules were amended to be more flexible, and even pension liabilities were significantly reduced. So at the IPO you had an airline with no net debt and a market-leading cost position. Its costs declined from ¥13.8 per available seat kilometer in 2009 to ¥11.4 in 2012. At ANA, its only other big competitor in Japan, that metric in 2012 was ¥12.9 per Close seat kilometer. The IPO, at ¥3,790 per share, did poorly out of the gate, and only as more institutional and international investors have come into the stock have things picked up. But we still think the story is misunderstood. People question the sustainability of JAL’s high-teens operating margins and seem to fear it will lapse back into its freespending and inefficient ways. Why do you disagree? JL: With respect to margins, while they’re certainly high for an airline, they are not at all out of line with what you would expect from a duopoly competitor with a strucValue Investor Insight 7

Leap Wireless
(Nasdaq: LEAP)

Valuation Metrics
(@6/28/13):

Business: Owns and operates a digital wireless network providing phone and data services under the Cricket brand to some five million customers in the United States. Share Information
(@6/28/13):

LEAP Russell 2000 P/E (TTM) n/a 59.1 Forward P/E (Est.) n/a 17.3 EV/EBITDA (TTM) 6.1
Largest Institutional Owners
(@3/31/13):

Price 6.73
52-Week Range Dividend Yield Market Cap 4.28 – 8.16 0.0% $532.0 million $3.11 billion (-1.6%) (-6.5%)

Financials (TTM):
Revenue Operating Profit Margin Net Profit Margin
LEAP PRICE HISTORY 20 20 15 15 10 10 5 0

Company MHR Fund Mgmt Capital Research Global Inv Paulson & Co BlackRock Vanguard Group
Short Interest (as of 5/31/13):

% Owned 29.8% 10.8% 9.9% 6.8% 4.8% 70.1%
20 15 10 5 0
1.0 0.8 0.6 0.4 0.2 0.0

Shares Short/Float

5

0

2011

2012

2013

THE BOTTOM LINE

While most investors focus on the company’s less-than-rosy operational outlook, Daniel Krueger considers its scarce wireless-spectrum assets to be of far greater importance. Using a range of potential values for those assets that are “very asymmetrically weighted toward the upside,” he arrives at a base-case company value of $20 per share.
Sources: Company reports, other publicly available information

June 30, 2013

www.valueinvestorinsight.com

I N V E S T O R I N S I G H T : Owl Creek

tural cost advantage. As for management’s discipline, we’ve spent a lot of time with the people running the company and have been extremely impressed. The bankruptcy process really shut the door on the old culture and if you listen to management today talk about capital allocation and its focus on return on investment, there’s no difference from what you’d hear at a bestof-breed U.S. company. Is there any new competition for JAL on the horizon? JL: Some low-cost carriers are just starting to emerge in Japan. While it’s something to keep an eye on, these new players are still tiny and focused on smaller markets. We don’t see it as a large threat to JAL,
INVESTMENT SNAPSHOT

but it is another thing the market seems to worry about. With the shares now at ¥5,100, how are you looking at valuation? JL: We actually think this is the cheapest large-cap stock in Japan, trading at around 5.5x our estimated forward earnings of ¥926 per share. But because there’s no net debt, P/E is not really the best metric. We’re looking at it more on enterprise value to EBITDAR (earnings before interest, taxes, depreciation, amortization and aircraft-lease costs), where the stock is trading at only 2.1x on our go-forward numbers. That includes an adjustment for net operating loss carryforwards that will negate taxes over the next six or seven

years. We believe fair value for the stock is closer to 4.5x to 5x EV/EBITDAR, which would translate into a share price of ¥7,300 to ¥8,700. How does the yen’s volatility impact company earnings? JL: A weaker yen is probably a modest negative, because it translates into higher fuel costs. The flip side is that there are more business travelers today going to Japan than there have been in a long time and, if the government is successful in reflating the economy, that’s going to lead to more domestic travelers as well. In such a high-fixed-cost business, small increases in load factors can help offset a lot of that fuel-cost impact. A plus we haven’t yet mentioned is the dividend. The current yield is 3.7% and management has said it plans to increase the payout ratio on net income in the near future. If and when that happens, you’re looking at a 5.5% or so yield on today’s share price if the payout ratio increases from 20% to 30%, which we think is likely. Turning to an idea very much in the news, what’s your take on Sprint? JL: We got involved with Sprint soon after Softbank made its initial acquisition offer at the end of last year. Sprint’s stock price Close reacted and then found a stable level of around $5.50 to $6 per share, where we thought it was very attractive. Because of our presence in Asia, we’ve followed Softbank’s history in Japan, where it bought the #3 wireless provider several years ago from Vodafone and dramatically improved its market position, profits and profitability. It did that by investing in building the most technologically innovative network. It spent heavily on marketing, rebranding the company under the Softbank name, and bought early exclusivity for the iPhone. It also offered better pricing for higher levels of usage, which was very attractive to customers in what had been more of a premium-priced market.
Value Investor Insight 8

Japan Airlines
(Tokyo: 9201:JP)

Business: Passenger and freight air-transportation services; company came public again in 2012 after emerging from Japan’s equivalent of Chapter 11 bankruptcy. Share Information
(@6/28/13, Exchange Rate: $1 = ¥99.130):

Financials (2012):
Revenue Operating Profit Margin Net Profit Margin
Valuation Metrics
(@6/28/13):

¥1.24 trillion 15.8% 13.9%

Price ¥5,100
52-Week Range Dividend Yield Market Cap
JAL PRICE HISTORY 6000 5000 4000 3000 2000 1000
0

¥3,210 – ¥5,490 3.7% ¥924.90 billion

9201:JP S&P 500 P/E (TTM) 5.4 18.4

6000

6000 5000 4000 3000 2000 1000

5000

4000

3000

2000

1000

0

2011

2012

2013

0

THE BOTTOM LINE

Calling it “the cheapest large-cap stock in Japan,” Jeffrey Lee says the company’s competitive cost advantage and its management’s newfound capital-allocation discipline is worthy of far more respect from the market. At what he considers a more reasonable valuation of 4.5x to 5x EV/EBITDAR, the shares would trade at ¥7,300 to ¥8,700 per share.
Sources: Company reports, other publicly available information

June 30, 2013

www.valueinvestorinsight.com

I N V E S T O R I N S I G H T : Owl Creek

Our basic thesis is that Softbank can do the same with Sprint, which is a clear laggard in the U.S. It’s the #3 player, saddled with too much debt and struggling with inefficient and less-capable network technology that delivers a competitively inferior product. With 50 million subscribers, it has EBITDA margins of 18-19%. Verizon’s wireless EBITDA margins are almost 50%, AT&T’s about 43% and even T-Mobile’s – with less subscribers than Sprint – are close to 30%. Softbank is basically saying we bring the capital and knowhow to intelligently invest in the network, bring down the
INVESTMENT SNAPSHOT

cost base, and reinvigorate the relationship with the U.S. wireless customer. In a scale business like this, its success in doing that would have a significant impact on Sprint’s ultimate profitability. Is this a longer-term bet than you would usually make? JA: Yes, but with that said, we expected the market over a shorter period of time to understand the potential upside of a combination better than it originally did after Softbank’s announcement. Dish Network coming in with a higher bid served to ac-

celerate that a bit, but we still see plenty of skepticism built into the share price. What upside do you see from today’s price of around $7? JL: Softbank responded to the Dish bid by improving its offer, putting up more cash upfront for Sprint shareholders. That means you’re creating the ongoing shares at a price of about $4.80. We’re basically saying that if the new Sprint can increase revenues at a 3% annual rate through 2016 and match T-Mobile’s 29% EBITDA margins, at a 6x multiple that would be worth $11 per share. With a 33% margin, which is not at all unreasonable, the stock would be worth $14 per share. How are you looking “horizontally and vertically” from this idea? JA: We think the pro-forma Sprint will be a much stronger competitor. We don’t expect it to initially compete on price, instead focusing on the cost side and competing through a better technology platform and network. If they do it right, especially in urban areas, Sprint’s network will be more capable than either AT&T’s or Verizon’s to deliver things like data and streaming video. Ultimately we think Sprint’s rise as a competitor is a negative for AT&T and Verizon, so we have small short positions in each. Another potential negative for Close AT&T is if it sees the need to do something dramatic, like bid for Dish, which we don’t think the market would view positively. But that would be a positive for Dish – we’ve also got a long position in it. Talk about a recent mistake or two and why they happened. JA: Iron Mountain [IRM, recent price $26.60] hasn’t financially been a mistake, but it’s a good example of what can go wrong. We understood the secular issues facing the company, but we underwrote with a high probability that it would get approval to convert to a real estate investment trust and expected that to create value. Adjusted for the dividend, we got
1.0 0.8 0.6 0.4 0.2 0.0

Sprint

Valuation Metrics
(@6/28/13):

(NYSE: S)

Business: Third-largest phone services provider in the U.S.; recently agreed after bidding competition to merger/investment proposal from Japan’s Softbank. Share Information
(@6/28/13):

P/E Forward P/E EV/EBITDA (TTM)
(@3/31/13):

S S&P 500 n/a 18.4 n/a 14.6 7.1

Largest Institutional Owners

Price 7.02
52-Week Range Dividend Yield Market Cap 3.15 – 7.50 0.0% $21.19 billion $35.40 billion 2.4% (-11.6%)

Financials (TTM):
Revenue Operating Profit Margin Net Profit Margin
S PRICE HISTORY 8 8
7

Company Dodge & Cox Capital Research Global Inv Paulson & Co Vanguard Group State Street
Short Interest (as of 5/31/13):

% Owned 11.6% 7.7% 7.7% 5.3% 4.8% 1.7%
8 7 6 5 4 3

Shares Short/Float

7 6 5 4 3 2 2011 2012 2013

6

5

4

3

2

2

THE BOTTOM LINE

Jeffrey Lee believes the recent deal with Softbank brings the capital and knowhow to allow the company to intelligently invest in its network, bring down costs and reinvigorate its relationship with the U.S. wireless customer. Assuming 3% annual revenue growth and improved margins to match T-Mobile’s, he believes the shares could be worth $11.
Sources: Company reports, other publicly available information

June 30, 2013

www.valueinvestorinsight.com

Value Investor Insight 9

I N V E S T O R I N S I G H T : Owl Creek

in last summer in the high-$20s per share and thought after a conversion it would be worth in the low-$40s. JL: As the market priced in the REIT conversion, the stock went to the high-$30s and we sold half our position because the risk/reward had changed. Then the company announced that the IRS conversion decision had been delayed and was under more serious question than expected. Our range of outcomes hasn’t changed – mid$20s stock price if the approval doesn’t happen and low-$40s if it does – but the probabilities have. We still own it because the expected value is high enough, but it’s no longer a big position. Your financial pain in Forest Oil [FST] has been more real. What happened there? JA: Our mistake here was not adequately recognizing the mismatch between the company being highly leveraged and at the

same time having a business model that required heavy spending on exploration to uncover the value we saw in the assets. That created a negative feedback loop that has killed the stock. [Editor’s Note: From the mid-$20s in the summer of 2011, FST shares now trade at just over $4.] We do believe the company is doing the right things to address its problems. They’ve sold a considerable number of assets, pushed out debt maturities, and in April signed a joint venture with Schlumberger that will accelerate development of Forest’s Eagle Ford shale assets. The market still is skeptical, but especially as the cash flow from the new JV kicks in, we think that will change and can result in a much, much higher stock price. Do you have any macro views reflected in your portfolio today? JA: We use our macro outlook more to inform where we should be looking. Today

that leads us to be cautious on China, to be ready to act in Europe, and to be bullish on Japan and the U.S. When and how any of that leads to specific investment ideas is totally based on our work on the ground. We went through a period of relatively bad performance on the equity side in 2011 and into 2012. Part of it was that anything and everything that could have gone wrong with our portfolio companies did go wrong. But that was compounded by the fact that we were probably doing too many things on the macro side, trying to hedge the portfolio more than we needed to. Where we’ve made money over time is on our ability to underwrite individual investments in both credit and equity. The probability of those working has historically been high. Sometimes you need to be reminded not to mess that up by doing things where your probability of success isn’t as high. VII

Disclosure
The foregoing is a reprint of an article that appeared in Value Investor Insight’s June 30, 2013 issue. It is being provided to you solely for general informational purposes. Owl Creek Asset Management, L.P. (“Owl Creek”) makes no representations as to the accuracy or completeness of the foregoing information. Past performance is not indicative of future results. This material is not and should not be construed as an offer or recommendation to buy or sell any security, nor should information contained herein be relied upon as investment advice. The information herein is not intended to provide, and should not be relied upon for, accounting, legal or tax advice or investment recommendations. Opinions and information included herein are as of the date indicated, and are subject to change. Discussions herein represent assessments and views at such specific point in time and are not intended to be construed as an indication of the performance or experience of any investor. Furthermore, such information is not intended to be and should not be construed as a forecast of future events, or a guarantee of future results. Owl Creek may currently or in the future buy, sell, cover, eliminate or otherwise change the form of investments in the positions discussed herein for any reason. It is not known and there can be no guarantee that any of these investments will be profitable. The foregoing may contain forward-looking statements. By their nature, forward-looking statements involve risks and uncertainties because they relate to events and depend on circumstances that may or may not occur in the future. Future results may vary from the views and statements expressed or implied herein, and possibly to a material degree. Owl Creek assumes no obligation to update the information included herein. Distribution of this information to any person other than the person to whom this information was originally delivered is unauthorized and any reproduction of these materials, in whole or in part, or the disclosure of any of its contents is prohibited.

June 30, 2013

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Value Investor Insight 10

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