2010 q4 letter khrom capital

41 Madison Ave., 29th FLNew York, NY 10010

T: [email protected]

January 17, 2011

Dear Partner:

In 2010, our Partnership returned 23.8%, or 18.6% net of fees and expenses. More importantly, this gain came with minimal risk exposure. During the year our fund was strictly invested in undervalued securities and about 20% of its assets were held in cash.

S&P 500 Index K.I., before fees K.I., after fees 2

2008 1 -32.3% -32.6% -32.6%

2009 23.5% 91.9% 82.9%

2010 12.8% 23.8% 18.6%

Total Return -6.1% 60.8% 46.2%

Annualized -2.3% 18.9% 14.8%

1 Since the fund’s inception date of March 20082 After fees return is calculated by the performance of an initial investment at the fund’s inception, after subtracting expenses and performance fee allocations, net of any loss carryforwards. Note that each individual Partner’s returns will vary depending on when they make capital contributions to the Partnership.

It brings me pleasure that regardless of when Partners invested, they achieved good returns. As of year-end 2010, capital invested at our fund’s inception in 2008 earned a total return of 46.2%, after all fees and expenses, or 14.8% annualized; fresh capital invested at the start of 2009 earned a total return of 95.9%, after all fees and expenses, or 40.0% annualized.

When our Partnership commenced, I stressed that we must not focus on short-term results–do not stare at the quarterly, or even yearly, numbers. Our investment strategy requires an outlook of at least three to five years. This is owed to the fact that we buy undervalued securities that in the short-run may get cheaper. I can never predict at what price the most panicked seller will sell. I know only what certain investments are roughly worth and that once all the noise clears–however many years that may take–a dollar will not continue to sell for fifty cents.

I thank Partners for their consistent long-term perspective. Finishing our third year, Partners now have the data they can use to judge our Partnership’s performance versus the available alternatives.

New Investments

The new significant investments we made in the 4th quarter of 2010 were Universal Corporation and Full House Resorts.

-1 Khrom Capital Management LLC

www.khromcapital.com

Universal Corporation

Cigarette smokers may soon become a relic. According to a recent report by Citigroup analysts, given the current decline in tobacco consumption, they predict the last smoker will put out his cigarette in the year 2050. That is not good news for the cigarette makers, and it is especially bad for companies–like Universal Corporation–that sell these guys the tobacco leaves.

Universal is the largest tobacco leaf exporter/importer in the world, conducting business in more than thirty countries. The company is the middleman between the farmers that grow the tobacco and the big cigarette manufacturers–Phillip Morris, British Tobacco, Japan Tobacco, etc–that buy it.

Universal is a dominant distributor in the tobacco leaf market; its only other major competitor is Alliance One. Together, these two companies roughly split 70% of all the worldwide business for freely auctioned tobacco. That is quite a position of strength. It is threatened, however, by two big overhangs.

The first, as mentioned above, is the decline of tobacco sales and governments’ increased use of force against the freedom to purchase the product. The second is a problem specific only to Universal Corporation and Alliance One: the possible extinction of the middleman.

Japan Tobacco, the world’s third largest cigarette manufacturer, announced in 2009 that they will begin to purchase some of their tobacco directly from farmers and buy facilities to do their own leaf processing. In other words, they want to do themselves what companies like Universal used to do for them. Was this news Universal’s killer or just a scarecrow in the tobacco field?

Japan Tobacco’s announcement was important but it was not the kick off of a new industry trend; it simply moved to the position all the big manufacturers were already in. Phillip Morris and British Tobacco have had internal leaf operations, to varying degrees, for a long time. Japan Tobacco, recently worried about the security of its leaf supply, decided it prudent to also have at least some direct involvement with farmers. Manufacturers do not want to be completely dependent on middlemen for the one key ingredient to their product.

How do we know, however, that the cigarette makers will not march towards the eradication of any intermediary between them and the farmers? The fact that middleman Universal works hard for its money. (Do not get distracted by the sudden urge to hum Donna Summer’s song in your head.) In the United States–which accounts for less than 5% of the worldwide market–tobacco is grown by large-scale, commercial farmers. Given such a setup, it makes sense for cigarette manufacturers to buy directly from farmers.

However, elsewhere in the world, tobacco procurement is a complicated and fragmented process. Universal deals with 30,000 tobacco farmers in Brazil. In Africa, where farmers tend to work very small plots of land, the company deals with over 100,000 farmers. Universal needs to have its agronomers and technicians on the ground to assist these small farmers with growing tobacco, and in certain areas, actually provides the seeds and fertilizer. To get to the places with no infrastructure, Universal provides its employees with motor bikes. In these remote places, Universal has had to setup its own generators with laptops and satellite links.

Complications remain even once crop is obtained from disintegrated and inaccessible farmers. Like oranges, tobacco leaves are perishable. They must be processed promptly after harvesting or risk spoilage. To accommodate for this, Universal’s leaf processing facilities are located around the globe where tobacco is grown.

Even once the tobacco crop is finally purchased and processed, it does not become a simple buy and sale of a commodity product–like corn or soybeans. The combinations of colors, qualities and types of tobacco number in the thousands. U.S. flue-cured tobacco, for example, has different smoking characteristics than Tanzanian flue-cured tobacco. Cigarette manufacturers serve a customer base with very diverse taste preferences.



Various taste require various tobacco. Manufacturers usually purchase only the specific grades within a crop that they need for their different blends of flavor. This creates the dilemma of a farmer who wants to sell his entire harvest but a manufacturer who only wants to buy parts of it. This is where Universal steps in.

Universal adds the most value for its customers by providing a clearinghouse for the various grades of tobacco found in every crop. Universal contracts with a farmer and agrees to buy their entire crop; then it allows the manufacturers to pick the grade of tobacco they desire; Universal then sells the remains to its broad base of customers. This model has and will continue to reduce the costs and risks for Universal’s customers.

Universal provides all the above and it barely asks for anything in return. Its profits are not a significant part of the cost of a cigarette. The cost of leaf tobacco in a pack of cigarettes is less than 10 cents, and Universal’s profit before taxes on that is less than a penny.

Universal is almost a century old and it should stick around for a bit more. If such a company does not face extinction, then it should not trade at 6x to 7x net income–especially when a big chunk of those profits are paid out in quarterly dividends. Cigarette manufacturers trade at above 13x net income, so investors understand that an overall decline in tobacco sales (which actually rose in emerging countries) will not be rapid. Once the smoke around Universal clears, it should not stay this cheap for long.

(As an aside, Alliance One–Universal’s competitor mentioned above–has begun to look like a good investment for us to allocate capital. Its current CEO was just replaced with Mark Kehaya. Mr. Kehaya comes from Meriturn Capital, a restructuring and turnaround firm. That is exactly what over-leveraged Alliance One needs: for its huge cash flows to go towards the pay down of its large debts or the purchase of its undervalued shares. This may serve as a catalyst for a company that almost no investors follow.)

Full House Resorts

Casinos are a preferred form of entertainment for many people. (I, for one, am an avid fan of poker.) In 2009, consumers spent more on commercial casino gambling than they did on movie tickets, outdoor equipment, and even candy–combined. And in a survey done by VP Communications, people are getting their dollar’s worth: 73% thought that an evening out at a casino was an excellent value for their money compared to other entertainment options.

Being a casino owner can be just as much fun, but with more profits. In general, the business is not at risk of technology obsolescence, substitute products, or the passing of a fad. Better yet, depending on the specific property, there might not even be the threat of competition.

Full House Resorts is a small company that owns one tiny casino and has a contract to manage two others. What first pops about this company is that its Director and large shareholder is Lee Iacocca, the businessman famous for his revival of the Chrysler Corporation in the 1980s. Named by Portfolio as the 18th greatest CEO of all time, Mr. Iacocca’s roots in a company usually sprout a shareholder-friendly management team.

Full House is not much when you first look at it. It owns a small casino in little town Fallon, Nevada that produces $2 to $3 million EBITDA a year. Its other asset is a an expiring contract to manage a Delaware casino, from which it earns about $5 million a year.

Full House does not have the sound of a ringing jackpot and that may be why no investors have rushed to claim the prize. The pot has recently grown, however, so investors may want to take a second look. In August 2009, FireKeepers casino finally opened in Michigan. GEM is the casino’s manager and is entitled to 26% of the casino’s income; Full House Resorts owns 50% of GEM. In short, after the slicing and dicing, Full House has started to earn about $11m a year of net income from FireKeepers.

Within 50 miles of FireKeepers, there are 1.1 million adults and no competing casinos. Stretch out a bit further, and there are 5.1 million adults within a one to two hour drive. There is only one smaller casino within a 100-mile driving radius. If you are hesitant to conclude those are enticing economics, this anecdote may help: to market the opening of FireKeepers, Full House’s management put up a pylon sign



on the freeway and mailed out 50,000 player cards. That is it. And it was enough to generate over $300 million in revenue and have 500,000 players signed up in the casino’s first year.

Full House sells for less than the sum of its assets. Its Stockman’s casino, at a conservative 3x to 5x EBITDA multiple (casinos currently sell for 5x to 10x), puts its value at $6 to $15 million. Full House’s contract to manage the Delaware casino expires next year, but the company is set to receive $5 million before that happens. Full House’s contract to manage the new FireKeepers expires at the end of 2016. (Federal law prohibits management contracts on Native American tribal casinos to exceed seven years.) $11 million a year in net income for the next six years is about $45 to $50 million in present value. Add that together and you arrive at a conservative $56 to $70 million valuation for Full House. Yet, at the time of our investment, Full House’s market cap was $35 million, net of cash.

A recent event may cause Full House’s cheap valuation to become noticeable. The company–after it built up cash while others acquired casinos at high multiples–decided to purchase a casino in Rising Sun, Indiana.

Grand Victoria is a 300 acre property with a casino, 18 hole golf course and hotel. It was built in 1996 for a total cost of $200 million. Full House acquired it for $43 million. The price equates to 5x the property’s EBITDA. Why so cheap? First, the property was owned by the Pritzker family; internal feuding has led them to divest many of their assets. Second, the price was rockbottom because neighboring Ohio just legalized the opening of four casinos–one of which will be a $400 million development within a 50 minute drive of Grand Victoria.

U.S. states are in dire need of revenues, so they have allowed more casinos to open. This harms the competitive barrier to entry that many existing casinos enjoy. The impairment of a protective moat and its ruin, however, should not be confused as the same thing. Casino licenses are still rare, hard and slow to get.

The Ohio casino is set to open in 2012 and it will take a chunk of Grand Victoria’s business. The factors to not forget, however, are that 5.1 million adults live within a 100-mile radius; of those, some prefer Grand Victoria’s relaxing rural environment to Ohio’s urban casino. Grand Victoria will lose customers, but its variable cost structure should allow it to adjust to decreased revenues.

Whatever may happen with Grand Victoria–and Full House bought it a price that factors in only the bad–our Partnership received it for about nothing. Full House’s other three assets should produce about what we paid for the company, leaving Grand Victoria as a freebie. (Plus, there is the possibility that Full House gets another casino management contract and/or the FireKeepers contract gets renewed in 2016.)

Currently, not many investors are aware or follow Full House Resorts. Once the acquisition of Grand Victoria is completed, Full House’s 12-month’s earnings should land somewhere around $0.90 per share. At our entry price of around $2.95 a share, that is 3x earnings. Once that multiple becomes clear, other investors will want to pay more than quarters to pull the handle on Full House.

Investments To Which We Said Goodbye

The investments in which we held significant capital and fully exited during the year are listed below. A large part of what has led to our fund’s investment performance is a lack of any significant realized losses. Methodical due diligence and buying cheap has certainly helped put the odds in our favor. Investment losses, however, are part of the trade and there will certainly be some in the future.

Closed Security L/S Avg. Entry Price

Avg. Exit Price

IRR Comments

Ansell L $9.77 $11.67 +49% It produces a range of protective products people wear, from surgical gloves to LifeStyle condoms. Demand is inelastic and not hampered by hard times; primarily brand name–not price–determine buying decisions. The brand and earnings power of this company were selling for too cheap.



Closed Security L/S Avg. Entry Price

Avg. Exit Price

IRR Comments

Arctic Cat L $8.48 $9.95 +245% One of the top brand name manufacturers for snowmobiles and ATVs. See 2010 Q3 letter for more detail.

Bristow L $20.98 $36.77 +63% Provides helicopter transportation to and from offshore oil/gas rigs. See May 2009 letter to Partners for the investment thesis.

Capital Southwest L $89.75 $103.64 +35% It is a business development company (a/k/a private equity firm). Capital Southwest was trading below what its underlying businesses were worth. Furthermore, Capital Southwest had a phenomenal fifty year investment track record.

Care Investment Trust L $6.81 $8.24 +38% A REIT, holding healthcare related real estate. See May 2009 letter to Partners for the investment thesis. Care got acquired by Tiptree Financial for $9/share. We also collected some big dividends before that occurred.

Innophos Holdings L $20.24 $26.44 +453% The company produces specialty phosphates. There was huge uncertainty around what the company can earn in the future; volatile prices for phosphate rock caused great earnings disparity in previous years. It was selling for too cheap, however, given any reasonable range of the company’s earnings power.

New England Realty L $53.94 $65.02 +35% A publicly traded partnership that owns residential real estate in the Greater Boston area. See 2010 Q2 letter for greater detail.

Sycamore Networks L $19.26 $19.14 -3% A company that was selling for a bit less than the huge pile of cash that it held. We sold once I realized I could not determine when the company would stop burning cash and finally turn its operations profitable. Right after we sold, the company turned profitable and the stock soared.

United PanAm Financial

L $2.93 $4.11 +241% A provider of subprime auto financing. See 2010 Q2 letter for the thorough investment writeup. The company was just acquired for $7.05/share. There is no doubt I sold our investment too early. This is not simply because the share price went higher. Rather, looking back, the evidence was there for me to see that the company was still undervalued at our sale price.

* * *

My entire net worth continues to be invested in the Partnership, right alongside yours. Benjamin Graham correctly stated that “[t]he underlying principles of sound investment should not alter from decade to decade...” We remain steadfast in digging for treasure primarily where others say there is none to be found.

Yours truly,

Eric E. Khrom Managing Partner



2010 q4 letter khrom capital

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