valueinvestorinsight issue 364
TRANSCRIPT
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8/9/2019 ValueInvestorInsight Issue 364
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For a successful activist investor, Jeff
Smith exhibits little of the “us vs.
them” mentality you might expect.
“Management pursuing a different plan
than we propose doesn’t mean they’re
bad people or malicious,” he says. “It’s a
difference of opinion. The good thing is that
shareholders can decide which plan is bestfor the company.”
Smith’s instincts about what’s right for
companies have proven eminently sound.
Since launching his Starboard Value LP’s
activist strategy ten years ago, it has earned
a net annualized 16.2%, vs. 10.2% for the
Russell 2000.
Never wanting for good ideas, Smith
today is finding opportunity in such areas
as office supplies, paper products, software,
semiconductors and hair salons. See page 2
In discussing the “obscure and mundane”
companies they own, James Vanasek
and Don Noone of VN Capital know
they run the risk of listeners’ eyes glazing
over. “Let’s just say that talking about
rubber compounding and grain elevators
isn’t naturally as interesting to people as
Apple or Google,” says Vanasek.There has been nothing boring about
VN Capital’s returns, however, since the
firm opened for business in mid-2002. Over
that time it has earned a net annualized
11.5%, vs. 6.8% for the Russell 2000.
With a penchant for companies that
they expect to own for several years,
Vanasek and Noone see undiscovered
opportunity today in such eclectic areas as
rubber processing, helicopter equipment,
agricultural services and beer. See page 9
ValueInvestorINSIGHT
October 31, 2012
The Leading Authority on Value Investing
Critical PathSmall companies naturally try to move beyond what initially made them asuccess. It’s after they stumble that Starboard Value often finds opportunity.
Inside this IssueFEATURES
Investor Insight: Jeffrey Smith
Identifying unrecognized value andthe specific steps needed to unlock itin Office Depot, Progress Software,Wausau Paper and Regis. PAGE 2 »
Investor Insight: VN Capital
Searching well off the beaten pathfor mispriced value and finding it inAirBoss, Ceres, Breeze-Eastern and
Big Rock Brewery. PAGE 9 »
Strategy: Bestinver
How one of Europe’s foremostvalue investors is navigating today’sdifficult environment. PAGE 16»
Uncovering Value: Bulldog
What happens when a venerableactivist investor takes over the reinsof one of its targets. PAGE 19 »
Editors’ Letter
On investors’ preference for bonds
over equities; A timely parable fromWarren Buffett. PAGE 20 »
INVESTMENT HIGHLIGHTS
Other companies in this issue:
Acerinox, AOL, Escalade, Fiat, Fiat In-
dustrial, Firsthand Technology Value,
Imperial Holdings, Industrias Bachoco,
Integrated Device Technology, Myrexis,
Schindler, SGS, Ship Finance, SurMod-
ics, Thales, Yungtay Engineering
www.valueinvestorinsight.com
I N V E S T O R I N S I G H T
VN CapitalDon Noone (l ), James Vanasek (r )
Investment Focus: Seek off-the-beaten-path companies that due to neglect orcomplexity trade at prices unrepresentativeof their sustainable business prospects.
Coveting ObscurityInvestor demand for small, quirky companies has lessened since the financialcrisis, say Jim Vanasek and Don Noone – which suits them fine, by the way.
INVESTMENT SNAPSHOTS PAGE
AirBoss of America 11
Big Rock Brewery 14
Breeze-Eastern 13
Ceres Global 12
Exor 17
Office Depot 4
Progress Software 7
Regis 8
Special Opportunities Fund 19
Wausau Paper 6
I N V E S T O R I N S I G H T
Jeffrey SmithStarboard Value LP
Investment Focus: Seeks companies inwhich the market’s valuation reflects a lossof patience in money-losing growthinitiatives and/or bloated cost structures.
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Most of your portfolio companies fall in
the “good core business, failing growth
initiatives” camp. Why is that such fertile
investment ground for you?
Jeffrey Smith: If you think about the life-
cycle of a small company, it usually ini-
tially succeeds in a relatively small niche
where it delivers unique value and be-
comes a market leader. The business inevi-
tably starts to mature – producing strong
cash flow with a lower growth rate – andthe natural response from management is
to take some of the cash generated and to
invest it in new areas of potential growth.
Hopefully these new growth initiatives are
related to the core business and hopefully
the company can have some competitive
advantage. This pursuit of incremen-
tal growth is exactly what management
should be doing.
One of two things will happen. Ei-
ther the new initiatives work, everyone’s
happy, the stock has a high multiple andwe never find it, or the new growth initia-
tives are not working, the market becomes
disenchanted with the company because
earnings and cash flow are depressed and
that drives down the stock price. Those
are the situations we find attractive.
Once we’ve identified an attractive
situation, we engage with management in
order to try to get them to rein in spend-
ing on failing growth initiatives, refocus
on the good core business, improve cash
flow, and put in place a greater level of dis-cipline with respect to return on invested
capital – all of which is meant to make the
stock price go up.
Peter Feld: This dynamic plays out regu-
larly because of human nature. Most pub-
lic companies want to provide sharehold-
ers with compelling growth, and small-cap
companies in particular believe they need
to have even higher growth rates. Again,
when this occurs within the natural flow
of the business, it works well. But when
it’s unnatural and management is trying to
“create” the growth, that’s often a prob-
lem. A private-company owner after 18 to
24 months of getting little traction on a
new investment finds it pretty easy to pull
the plug – the money is coming out of his
or her own wallet and there’s not an ad-
equate return on investment. It’s different
with public companies, particularly when
there is little inside ownership. It’s just eas-
ier to perpetuate the hope that growth willmaterialize next quarter or next year than
it is to admit the investment may have
been a mistake, reassess the opportunity
and reduce costs.
Integrated Device Technology [IDTI],
a semiconductor company in our port-
folio, is a good example. A substantial
portion of its revenues and profits come
from semiconductor businesses where it
has dominant market shares, high gross
margins and very high operating mar-
gins. However, some of these are maturebusinesses in relatively mature markets.
To grow, the company has been investing
in new higher-growth areas with much
larger “addressable markets.” That’s actu-
ally a fairly common theme for companies
in which we invest. They’re not content
having a 40% share of a slowly growing
$500-million market. Instead, they prefer
to try to capture 1% of a $20-billion mar-
ket. In our experience, it’s more difficult
and takes much longer than companies
believe to capture a small market sharein a massive market, where there’s gener-
ally greater competition from much larger
players.
In IDT’s case, the company spends ap-
proximately 30% of revenue on R&D,
significantly more than most of its com-
petitors, yet it’s struggled to reinvigorate
its revenue growth. We have representa-
tives on the board and are working with
our fellow board members to apply a
better balance between growth and prof-
I N V E S T O R I N S I G H T : Jeffrey Smith
Investor Insight: Jeffrey SmithStarboard Value’s Jeffrey Smith, Peter Feld, Mark Mitchell, Gavin Molinelli, Tom Cusack and Jon Sagal describe wherethey spend the majority of their research time, how they assess whether an activist “path” is open, how they hedge risksand what they think the market is missing in Office Depot, Wausau Paper, Progress Software and Regis Corp.
Jeffrey Smith
Natural Inclination
Just two years into an investment banking
career at Societe Generale, Jeff Smith in
1996 got a call from his father asking for
help. His father’s company, The Fresh Juice
Co., had expanded its production capacity
too quickly and needed in short order to find
new avenues for growth to fill the capacity.
Fairly certain that investment banking
wasn’t for him anyway, Smith, then 24,
joined Fresh Juice as head of strategic
development and in less than two years
played a central role in building an East
Coast wholesale business, merging Fresh
Juice with the wholesale competitor it had
taken on, making two acquisitions that
significantly expanded national distribution,
and then selling the entire company to
Saratoga Beverage.
Now CEO of Starboard Value LP and 14
years into an investment career focused
on activism, Smith considers that earlyexperience in his father’s business as
less a wake-up call than it was an af-
firmation. “I wouldn’t say my Fresh Juice
Co. experience made me want to be an
activist investor,” he says, “but it did
highlight my natural inclination. Trying to
clearly see the issues, identify solutions to
fix them and then work within the system to
get those solutions implemented is exactly
what our kind of investing is all about.”
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I N V E S T O R I N S I G H T : Jeffrey Smith
itability. The company has put out oper-
ating-margin targets that are significantly
higher than what it has done historically
and that are more in line with its peers.
These are all steps in the right direction.
On what size companies do you focus?
JS: We mostly focus on companies around
$1 billion in market cap. The situations
that fit our strategy are pervasive among
smaller-cap companies, where there’s
a significant focus on growth with less
discipline on return on invested capital.
We also have to own enough stock to be
able to influence management if neces-
sary, which has historically meant owning
smaller-cap companies.
Does every idea you pursue have an activ-
ist agenda?
JS: We believe every company in our port-
folio is undervalued, we have an alterna-
tive plan to unlock value that is within
our control, and we have a path to imple-
ment the plan. By “path” we mean that
we believe we could win a proxy contest
if it becomes necessary. The overwhelming
majority of the time a contest isn’t neces-sary, either because value is unlocked on
its own or because management and the
board choose to work with us to create
value. To make sure we have the best
chance of success in all situations, howev-
er, we remain prepared to run a contest to
replace directors. This way we will either
create value with the company’s coopera-
tion or, if the company won’t work with
us, we’re prepared to ask shareholders for
support to implement change.
What ideas fall outside the “good core
business, failing growth initiative” profile?
JS: Many of our investments fit that pro-
file but not all of them. One related type of
idea we also pursue is when a company is
so focused on growing the top line that it
spends inefficiently without an acceptable
return on that spend. These inflated costs
can be on things like research and devel-
opment, infrastructure, advertising and
general and administrative costs, to name
a few. Spending gets so out of line that
the company ends up significantly under-
earning. Office Depot [ODP], which we’ll
discuss in more detail later, is an example
of this.
How do you generate ideas?
PF: There are two primary sources. One
is generating ideas internally, mostly using
a variety of investment screens that have
value as a key piece, but we also screen
for financial metrics that may show symp-
toms of the types of situations we look for.
Say revenues have been flat for the past
three years, but operating expenses have
increased in each of those years. We also
typically look for companies that are un-
derperforming on any number of profit-ability or productivity measures, against
peers and against their own history. Be-
cause they’re under-earning, many of the
companies that interest us look expensive
based on current numbers, but are actu-
ally undervalued relative to the pro-forma
earnings that can be generated if our plan
is implemented.
We also find ideas from outside sources
such as more traditional investment firms
that invest in a similar universe. When
they find themselves in a problematic in-vestment, they typically have only two
choices – sell their position or just contin-
ue to hold and hope. Neither of these are
particularly good choices if they feel the
company is undervalued and underper-
forming. We provide a third option. Share
the idea with us, let us do our work on it,
and if it fits our criteria maybe we can get
involved and help to unlock value for the
benefit of all shareholders. Many of these
types of relationships started when these
firms were investors in companies we were
involved with in the past and they bene-
fited from our involvement and the value
we created.
Where do you focus first in research?
PF: Since we often suggest that companies
refocus on their core business, the major
ity of our research time is spent on deter
mining the health and sustainability o
that business. We need to fully stress test
our assumptions on the core business –
that’s where something could go wrong if
it were going to go wrong.
Next we analyze the company’s exist
ing plan compared to ours. We need to
determine if our plan can create significantly more value on a risk-adjusted ba
sis than the status quo. If along the way
management is able to prove us wrong
and succeed with their existing plan, that
works out well for us too, as value wil
significantly increase as their execution
improves.
How do you judge whether your activist
path is open?
PF: This involves an analysis of the com-pany’s corporate-governance mechanics
Where are they incorporated? Do they
have a staggered board? Is there a dual-
class ownership structure or large blocks
of shares which may be problematic?
What anti-takeover provisions exist?
These are just some of the many technica
items we analyze.
In addition, we conduct a more quali
tative analysis of the existing shareholder
base. The performance of the stock is a
key barometer of the collective satisfaction or frustration of shareholders, bu
we also use our experience and contacts
with a large number of investors to gauge
the relative difficulty of a potential proxy
contest.
How generally does Starboard approach
valuation?
PF: We develop upside price targets solely
based on pro-forma cash flow and asset
ON RESEARCH FOCUS:
We often suggest refocusing
on a core business, so most
of our time is spent on its
health and sustainability.
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I N V E S T O R I N S I G H T : Jeffrey Smith
value assuming we are able to implement
our alternative plan. Our plan focuses on
actions that are within the company’s con-
trol, such as reducing costs, exiting mon-
ey-losing businesses and selling assets that
don’t produce cash flow but have value to
a buyer.
We put equal emphasis on the down-
side price measurement. Where could the
stock go if our plan is not implemented or
if we are not able to gain influence? That
can mean putting a historically low mul-
tiple on the depressed expected EBITDA.
However, our preference is to buy as close
as possible to some proxy of balance sheet
value, such as tangible book value or liq-
uidation value. [Note: In Starboard’s high-
profile engagement with AOL, for exam-ple, an important element of the potential
downside protection came from the esti-
mated value of the company’s intellectual-
property portfolio.] In general, our target
upside should be a multiple of our target
downside.
JS: The downside price is also extremely
important in how we size positions. We
usually own 15 to 25 companies at a
time, roughly half of which are lead po-
sitions where we’ve filed a 13D, and therest are what we call seed positions, where
we have a plan and a path laid out, but
the valuation isn’t quite what we want
to see before owning a full position. We
limit each position to a maximum risk,
measured in basis points, to our downside
price. In other words, if a stock went to its
downside price, we don’t expect the fund
to lose any more than the maximum risk
for that particular position.
You’ve taken big profits on your AOLstake. Would you say that the activist play
there is over?
JS: Due at least in part to our pressure,
suggestions and proxy contest, AOL suc-
cessfully sold a portion of its intellectual
property for over $1 billion, committed to
improve the profitability of the display-ad-
vertising business, and said it would return
$1 billion of cash to shareholders. This
unlocked a great deal of value and was an
enormous success for all AOL sharehold-
ers, including us. While the changes so far
have been meaningful, the company has
done very few of the hard things around
shrinking its cost base that we thought
were also necessary. But given the value
that was unlocked, AOL shareholders
decided to give the board more time to
improve the operational execution, which
has been reflected in the stock price.
[Note: At a recent $35.50, AOL’s shares
have nearly doubled since early April and
have almost tripled since Starboard’s ini-
tial purchases.] So while we still have a
plan to unlock value, at today’s price our
other criteria are no longer met and we do
not currently have a position.
What attracted your attention in office-
supply retailer Office Depot?
JS: There are quite a few things that have
us excited about Office Depot. The compa
ny has a hidden asset in its Mexican joint
venture which, we believe, may be worth
close to the entire market cap of the com
pany. On top of that, there is $11 billion
of annual revenue that we don’t believe is
efficiently managed from a profitability
standpoint. Operating margins are less
Office Depot(NYSE: ODP)
Business: Provider of office supplies andservices sold through company-ownedstores and online, as well as to businesscustomers through an in-house sales force.
Share Information(@10/30/12):
Price 2.3952-Week Range 1.51 - 3.81Dividend Yield 0.0%Market Cap $681.5 million
Financials (TTM): Revenue $11.19 billionOperating Profit Margin 1.0%Net Profit Margin 1.0%
Valuation Metrics(@10/30/12):
ODP Russell 2000Trailing P/E 8.4 31.3Forward P/E Est. 29.9 15.3
Largest Institutional Owners(@6/30/12):
Company % OwnedThornburg Inv Mgmt 6.9%Putnam Inv Mgmt 6.9%BlackRock 6.2%
Vanguard Group 5.2%AllianceBernstein 4.9%
Short Interest (as of 10/15/12):
Shares Short/Float 15.9%
I N V E S T M E N T S N A P S H O T
ODP PRICE HISTORY10
8
6
4
2
02010 2011 2012
10
8
6
4
2
0
THE BOTTOM LINE
The market has weighed in unfavorably on the company’s performance, says Jeff Smith,who has proposed a detailed plan for improving profitability to at least near peer levels.The stock today trades at an EV/EBITDA multiple, assuming his low to high cases forannual EBITDA improvement occur, of 1.3x on the low case and 0.7x on the high.
Sources: Company reports, other publicly available information
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I N V E S T O R I N S I G H T : Jeffrey Smith
than 1%, while the margins of the largest
competitor, Staples, are above 6%. Some
argue that’s a function of the size dispar-
ity between Staples and Office Depot. But
OfficeMax is the smallest competitor and
it’s significantly more profitable than Of-
fice Depot. We think there are significant
ways to improve profitability at Office
Depot based on changes fully within the
control of management and the board.
Describe the basic elements of the plan.
Gavin Molinelli: One important compo-
nent is getting costs in line with the busi-
ness reality and with competition. From
2007 to 2011 the total number of stores
declined by 108 and annual revenue de-clined by $4 billion, but general and ad-
ministrative expenses actually increased.
Advertising expenses as a percentage of
revenue are significantly higher than they
are at both Staples and OfficeMax, and
the advertising-expense ratio has been
increasing. So Office Depot spends at the
highest rate but has the lowest return on
that spend.
We believe the company can dramati-
cally improve the economics of its North
American stores by downsizing to smallerstore formats. Management has said that
the new 5,000-square-foot format it has
tested can retain up to 90% of total store
sales from the existing 24,000-square-
foot-format, while at the same time signif-
icantly reducing occupancy costs, improv-
ing labor utility, and reducing inventory
investment. With roughly 45% of North
American leases up in the next three years
– and 67% up within the next five – that’s
a huge opportunity.
We have also defined a number of op-erating initiatives to improve profitability.
The company can significantly increase
the mix of higher-margin services – such
as copy and print services, security solu-
tions and shipping – in its North Ameri-
can retail division. It can improve gross
margins through more direct sourcing of
private-label products. It can lower the
number of SKUs to reduce inventory and
procurement expenses. Its Business Solu-
tions division in North America can take
several steps to get its performance more
in line with the competition. Those are
just some of our ideas.
The company’s response?
JS: The company has been very cordial
and professional, but we really don’t
know whether they’ll be willing to make
the changes we’ve proposed. We are pre-
pared to work with them or to appeal to
the shareholders to ensure the appropriate
changes are made.
The stock popped after Starboard’s inter-
est became public, but at a recent $2.40 is
still down 75% from its post-crash high.
What do you think it’s more reasonably
worth?
GM: We try to avoid talking publiclyabout what we think a company may be
worth. Our target prices are quite conser-
vative, in that they’re based only on what
we believe the financials would look like if
our plan is implemented. We discuss why
we believe the stock is undervalued and
how the operational performance can be
significantly improved through the execu-
tion of an alternative plan for the busi-
ness. Shareholders can then determine the
full value of the stock based on their own
assumptions.In Office Depot’s case, we’ve outlined a
low case and high case, assuming annual
EBITDA improvement of $275 million to
$540 million. This range would indicate
a doubling or almost tripling of current
EBITDA. We’ve also assumed that Office
Depot de Mexico, the 50/50 joint venture
between Office Depot and publicly traded
Grupo Gigante, is a non-core asset with
substantial hidden value of $500 to $700
million. At today’s price, the pro-forma
EV/EBITDA multiple is 1.3x on our low
case, and only 0.7x on our high case.
Is the big risk that secular challenges in
the office-supply market, primarily from
online competition, overwhelm everything
else you’re counting on here?
GM: The office-supply-store industry has
been challenged by online competition
We believe the current valuation more
than fully discounts the threats from the
outside as long as the company begins to
follow an alternative plan. We think la
menting about the online competition has
gone too far. The service level and qual-
ity you can provide by having a physica
store can be a huge advantage over onlinecompetitors. The company needs to start
playing to its strengths while running the
business as effectively and efficiently as
possible.
Next steps?
JS: We’ll continue to have conversations
with the company. As those conversation
continue and time passes, we’re fully cog-
nizant of our choices as we approach the
nomination deadline in January. OfficeDepot has a single-class board, which pro
vides full flexibility for any shareholder
looking to promote board changes should
they be necessary.
Describe the public case you’ve made for
changes at Wausau Paper [WPP].
Jon Sagal: Wausau is a paper-products
manufacturer operating in two segments
The tissue business makes paper towels
and toilet paper for the away-from-homemarket, while the paper segment makes
specialty and technical papers for a num
ber of applications, from industrial tape
backings to fire-resistant paper to micro-
wave-popcorn bags.
The tissue business is an excellent ra-
zor/razor blade type of business. Wausau
has developed very strong distributor re-
lationships, and once a distributor has its
dispensers in the office-building or schoo
bathroom, they don’t get replaced easily
ON ODP NEXT STEPS:
We’re fully cognizant of our
choice as we approach the
board-of-directors nomina-
tion deadline in January.
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I N V E S T O R I N S I G H T : Jeffrey Smith
or quickly. Given the required number and
frequency of deliveries, market shares tend
to be very high in any given geographic re-
gion. Wausau has also built a strong pres-
ence in the green, sustainable market with
its 100%-recycled products. As a result of
all of this, it consistently earns high mar-
gins – 20% EBITDA margins or better –
and has shown better growth than most
other tissue manufacturers.
The company has exited part of its
paper business – the more commoditized
printing and writing lines – since we first
got involved. The remaining technical-
paper business generates only minimal,
if any, profits on a significant portion of
overall revenues.
Wausau is making a huge capital invest-
ment in its tissue business. Have you been
on board with that?
Jon Sagal: This is a $425 million market-
cap company and the plant it is about to
complete is the centerpiece of a $220 mil-
lion investment – that’s almost $4.50 per
share in capital spending for a stock cur-
rently trading around $8.50. That said,
the new plant will use less raw material
and energy for every ton of output and has
a much lower marginal cost of operation
It’s also flexible in producing different tis
sue qualities, including new products that
should allow Wausau to compete in new
higher-end segments of the market with a
100%-recycled premium product.
How are you looking at valuation with
the shares trading today at around $8.65?
Jon Sagal: The stock still trades at a mul-
tiple that is more reflective of a commod
ity paper business than it is a best-in-clas
specialty-tissue business. Other tissue
businesses trade at 7-8x EBITDA and
Wausau’s is among the best tissue assets
out there. On trailing 12-month numbers
– not even our pro-forma numbers – thestock today trades at only 5x enterprise
value to EBITDA.
PF: While we can’t say a lot about our
current interactions with management
and the board, one item of note is that we
recently amended our 13D to disclose tha
we’d increased our ownership here to over
14% of the shares outstanding.
Is Progress Software [PRGS] another refo-
cus-on-the-core-business idea?
Tom Cusack: Yes. The company’s core
business is a product called OpenEdge
which is an application development plat
form that is used by independent software
vendors to develop software. The custom
er base is more than 1,500 independen
vendors, which pay Progress a percentage
of all license and maintenance revenue
they earn on products they’ve developed
over decades using OpenEdge. It’s costly
and difficult for existing customers to remove OpenEdge from their products, so
this business is extremely sticky, has very
high margins and generates a stream of at-
tractive cash flow for the company.
As growth in the OpenEdge business
began to slow, Progress began using the
cash flow from it to make acquisitions in
high-growth software areas such as Busi
ness Process Management [BPM] and
Complex Event Processing [CEP]. Most of
these acquisitions were unrelated to their
Wausau Paper(NYSE: WPP)
Business: Producer of specialty papers forindustrial, commercial and consumer use,as well as a broad line of “away from home”towel and tissue products.
Share Information(@10/30/12):
Price 8.6352-Week Range 6.85 - 9.92Dividend Yield 1.4%Market Cap $425.6 million
Financials (TTM): Revenue $1.05 billionOperating Profit Margin 3.1%Net Profit Margin (-2.4%)
Valuation Metrics(@10/30/12):
WPP Russell 2000Trailing P/E n/a 31.3Forward P/E Est. 20.5 15.3
Largest Institutional Owners(@6/30/12):
Company % OwnedStarboard Value 9.3%Dimensional Fund Adv 5.4%Wilmington Trust 5.4%
T. Rowe Price 5.3%Vanguard Group 5.3%
Short Interest (as of 10/15/12):
Shares Short/Float 3.9%
I N V E S T M E N T S N A P S H O T
WPP PRICE HISTORY12
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THE BOTTOM LINE
The company’s stock trades at a multiple reflective of a commodity paper business ratherthan of the specialty tissue business on which Starboard Value believes Wausau shouldfocus. On trailing-12-month numbers, says Jon Sagal, the shares trade at an EV/EBITDAmultiple of only 5x, while more-comparable tissue businesses trade at closer to 7-8x.
Sources: Company reports, other publicly available information
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I N V E S T O R I N S I G H T : Jeffrey Smith
core business and had limited synergies
with their other products. So at the time
we got involved last year, there were about
15 different product lines spread across
three reporting segments and our view
was that the company was suffering from
a serious lack of operational focus. Many
of the acquired businesses were growing
revenue 20-30% per year but were losing
money, obscuring the value of the core
OpenEdge business. We asked the com-
pany to streamline product lines, reduce
excess costs and consider separating the
money-losing growth businesses from the
mature core business.
Earlier this year, in April, the com-
pany announced a new strategic plan to
increase shareholder value that was very
much in line with our and other share-
holders’ suggestions. They agreed to di-
vest 10 non-core product lines, committed
by fiscal 2013 to a 35% operating margin
target – up from today’s 10% – and an-
nounced a plan to buy back $350 million
worth of stock, which is about 30% of the
float. Once that restructuring is complete
– the company has already announced the
sale of 80% of its non-core businesses –
we expect Progress to be a much more
profitable company.
Does the just-announced departure o
CEO Jay Bhatt, after less than a year on
the job, disrupt things?
JS: The stock price went down 15% on
the news because the market fears the un
known. The risk at that point was execu
tion, and the individual who was supposed
to execute left. Jay said he was leaving to
take his dream job, which turned out to
be CEO of the private education-software
company Blackboard. We don’t believe
this changes the company’s resolve to go
forward with its restructuring plan.
Now at $19.30, how inexpensive do you
consider Progress shares?
TC: The stock trades at less than 4.5x
what we believe EBITDA should be over
the next year or two. This excludes the
proceeds from the non-core assets that
have not yet been sold, so if you include
the estimated proceeds for those, the mul
tiple is even lower. We think 4.5x EBITDA
for an extremely stable business, with high
recurring revenue and the potential to
generate 35% or higher EBITDA margins
represents a very compelling value. [Note
The EV/EBITDA multiple for comparablesoftware firms today is 6-8x.]
How much further does your engagement
with hair-salon operator Regis [RGS] have
to play out?
JS: For Regis, we concluded the company’
core North American salon business was
capable of generating consistent free cash
flow and a high return on capital, but the
market wasn’t recognizing it because there
was a bloated cost structure and a varietyof non-core businesses obscuring the value
of the core business. We won a proxy con
test and got three directors elected to the
board in October of last year.
In our original plan, we identified four
assets that we recommended selling as
well as roughly $100 million in annua
cost cuts. Two of the non-core businesses
have been sold, the Hair Club for Men
and Women hair-restoration centers – the
deal for which is not yet closed – and a
Progress Software(Nasdaq: PRGS)
Business: Develops and markets systemsused by commercial and governmentalcustomers worldwide for the development,deployment and integration of software.
Share Information(@10/30/12):
Price 19.3052-Week Range 17.01 - 24.76Dividend Yield 0.0%Market Cap $1.23 billion
Financials (TTM): Revenue $484.4 millionOperating Profit Margin 12.7%Net Profit Margin 4.7%
Valuation Metrics(@10/30/12):
PRGS Russell 2000Trailing P/E 55.5 31.3Forward P/E Est. 14.7 15.3
Largest Institutional Owners(@6/30/12):
Company % OwnedT. Rowe Price 7.4%Starboard Value 7.2%Fidelity Mgmt & Research 6.4%
Perkins Inv Mgmt 6.0%Praesidium Inv Mgmt 5.7%
Short Interest (as of 10/15/12):
Shares Short/Float 2.1%
I N V E S T M E N T S N A P S H O T
PRGS PRICE HISTORY35
30
25
20
152010 2011 2012
35
30
25
20
15
THE BOTTOM LINE
The company’s announced strategic overhaul involving the divestiture of product linesand setting of new profitability goals is sound, says Tom Cusack, so the story now restson execution. On what he believes the company can earn within the next year or two, thestock trades at a 4.5x EV/EBITDA multiple, far below software-company peers.
Sources: Company reports, other publicly available information
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I N V E S T O R I N S I G H T : Jeffrey Smith
minority ownership stake in Provalliance,
a French salon chain. That leaves two as-
sets remaining that we consider non-core,
a U.K. salon business and a 50% interestin a chain of cosmetology schools called
Empire Education Group.
The bulk of the story now is about
execution. We’re very supportive of the
new CEO, Dan Hanrahan, who joined
the company in July from Royal Carib-
bean’s Celebrity Cruises, where he was
CEO. Dan had been successful in turning
around Celebrity Cruises by significantly
improving the service experience in order
to drive an increase in return rates.
At $16, the stock is back to where it was
when you won the proxy contest a year
ago. How are you looking at valuation?
JS: It comes down to how successfully the
operational and efficiency initiatives are
executed. Dan will be active both on the
cost side as well as on improving the in-sa-
lon experience, which had been neglected.
Stylists were trained on how to cut hair,
but not on how to treat their customers as
guests – how to greet them, the right ques-
tions to ask to make sure they’re happy,
how to follow up and improve the chances
they come back for their next haircut. This
is all just good service execution and it
needs to be put in place in order for same
store sales to stabilize and start growing
again. The company has a great deal o
operating leverage, which should produce
tremendous shareholder value when the
execution improves.
You recently sold out of your position in
healthcare company SurModics [SRDX]
Another happy story, but why sell now?
JS: Our plan for SurModics was relatively
simple: sell the money-losing pharmaceu
tical business and re-focus on the excellen
core business selling coatings for catheters
and other medical devices. The company
was amenable to our plan, allowed us tojoin the board and hired a banker to sel
off the pharmaceutical business. After that
business was sold, operating margins im
proved to 35% from less than 10%. Why
sell now? The stock is currently almos
twice where it was when we entered and
the company has made the changes we
had set out in our plan.
One could argue that sentiment toward
activist investors is as positive as it’s ever
been. Why do you think that is?
JS: Shareholders are becoming more in
terested in how they can create alpha in
their portfolios and are happy to suppor
other shareholders whose interests are di
rectly aligned with theirs to create positive
change at companies. There is growing
sentiment that a shareholder perspective
in the boardroom is helpful, which was
not the case 25 years ago. I’d like to think
we’ve moved past the corporate-raider
phase and that most activism today isdone professionally with the interests o
all shareholders in mind.
Companies have also increasingly real
ized how unproductive it is to resist share
holder input. When activists show up
management for the most part behaves re
sponsibly and respectfully. That results in
healthy, constructive dialogue about how
a company should operate. That type of
dialogue is absolutely in the best interest
of all shareholders.
Regis Corp.(NYSE: RGS)
Business: Owns, operates and franchises
more than 12,500 hair-care salons servingmen, women and children; brands includeSupercuts, SmartStyle and Cost Cutters.
Share Information(@10/30/12):
Price 16.0052-Week Range 15.02 - 19.59Dividend Yield 1.5%Market Cap $916.5 million
Financials (TTM): Revenue $2.25 billion
Operating Profit Margin 4.6%
Net Profit Margin (-4.2%)
Valuation Metrics(@10/30/12):
RGS Russell 2000Trailing P/E n/a 31.3Forward P/E Est. 17.6 15.3
Largest Institutional Owners(@6/30/12):
Company % OwnedFidelity Mgmt & Research 11.0%Birch Run Capital 10.4%
Dimensional Fund Adv 7.7%Robeco Inv Mgmt 6.5%FranklinTempleton 6.1%
Short Interest (as of 10/15/12):
Shares Short/Float 21.1%
I N V E S T M E N T S N A P S H O T
RGS PRICE HISTORY25
20
15
102010 2011 2012
25
20
15
10
THE BOTTOM LINE
Jeff Smith believes the company is taking the steps necessary to refocus on its coreNorth American salon business and he is “very supportive” of the new CEO’s efforts toimprove the customer experience. Given the company’s operating leverage, a return tosame-store sales growth should produce “tremendous” shareholder value, he says.
Sources: Company reports, other publicly available information
VII
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Your target company typically operates
well off the beaten path. Can you gener-
alize about the companies and businesses
you find most interesting?
James Vanasek: We focus primarily on
companies in the U.S. and Canada with
market caps of $500 million or less and
that operate in odd-ballish kinds of busi-
nesses where they have strong positions
in relatively small niches. Investors run-
ning larger funds can’t put enough moneyto work in them. Wall Street tends to ig-
nore them because they have good bal-
ance sheets and cash flow and don’t need
investment-banking services. Our basic
premise is that there’s a higher likelihood
these types of companies will be mispriced.
Sometimes obscurity alone is enough
for the stocks of such companies to be un-
dervalued, but there’s often also something
else going on. Occasionally the broader
industry is under pressure for cyclical rea-
sons or due to some exogenous event, likea regulatory change. The company itself
may also be undergoing a restructuring
or building a new business, both of which
may take more effort to understand and
require more patience than the small-cap
manager with 150 names can muster.
You’ve owned oil-tanker and drilling-rig
lessor Ship Finance International [SFL]
since 2004. What about it has kept your
interest?
Don Noone: There are three fundamental
reasons we think Ship Finance is misunder-
stood and mispriced. The first is that it has
this crazy lease-finance accounting that is
difficult to understand and distorts share-
holder equity, cash flow and net income
– throwing off all the high-level metrics a
stock analyst typically uses. The second
is that it’s treated as a high-risk business
heavily subject to spot tanker-lease prices
– which are currently cyclically depressed
– when in fact the business model is
primarily based on long-term contracts,
and the company has diversified, with
40% of revenues coming from the leasing
of offshore drilling rigs. Finally, for rea-
sons we don’t understand, people seem to
look at the large share ownership in the
company of John Fredriksen, a Norwei-
gian billionaire with a long history in the
tanker business, as a negative. We actually
think he has an impeccable record of do-
ing right by all shareholders and think hisassociation with the company gives it ac-
cess to investment opportunities at a low
point in the cycle.
What’s representative here of our typical
holding is that some level of misunder-
standing is conspiring to keep the stock
from trading at what we think is full
value. As Jim said, that may result from
neglect, or from time horizon, but it can
be even more compelling when our view
is that the market’s fundamental analysis
is just wrong.
Ship Finance is at more than $1 billion in
market cap, but has the average company
in your portfolio gotten even smaller since
we last spoke [VII , April 30, 2008]?
JV: We haven’t consciously decided to pur-
sue smaller companies, but since the finan-
cial crisis we’ve noticed more risk aver-
sion among investors when it comes to
less-liquid smaller-cap names. For almost
anything under $200 million in marketcap, the number of people willing to invest
dries up fairly dramatically, so it’s no
surprise we’re finding better opportunities
at that size.
We saw a graph recently showing how
aggregate hedge fund assets had shifted to-
ward large-cap stocks. Now close to 50%
of all assets are in market caps of more
than $10 billion, up from around 35% in
2002. Small caps, defined as less than $2
billion, went over the same period from
I N V E S T O R I N S I G H T : VN Capital
Investor Insight: VN Capital James Vanasek and Don Noone of VN Capital explain how they unearth ideas that are typically well out of plain sightwhat virtues they see in portfolio inactivity, the lesson they learned from getting frustrated by management, and why theysee unrecognized value in AirBoss of America, Breeze-Eastern, Big Rock Brewery and Ceres Global Ag Corp.
Don Noone, James Vanasek
Serendipity over Screens
It’s a safe bet that most viewers of reality
show Man vs. Wild , in which the show’s
star is dropped into the wild to fend for
himself, don’t come away with investment
ideas. But as the protagonist was hoisted
to safety by helicopter, VN Capital’s James
Vanasek wondered if making the equip-
ment that lifted people out of danger might
be a good business. One thing led to an-
other and he’d found a new core position
– a firm called Breeze-Eastern that made
just such equipment – for his portfolio.
In seeking out quirky small-cap ideas, Va-
nasek and partner Don Noone rely more
on serendipity than computer screens.
“There’s nothing systematic we can do to
find, say, a new idea every three weeks,”
he says. For another recent idea, Vanasek
would have ignored a news item on Ce-
res Global Ag Corp.’s purchase of grain
elevators, except that some of the el-evators had been separated from malting
businesses, which he’d found interesting
years earlier in researching craft beer. That
prompted him to look at grain elevators,
whose economics had similarities with the
cement business, in which he’d invested
successfully in the past. “You don’t know
when enough things will pull together that
say, ‘Here’s an idea,’” he says, “but if you
uncover enough rocks, it does happen.”
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I N V E S T O R I N S I G H T : VN Capital
nearly 30% of assets to closer to 15%.
It’s safe to assume that shift is even more
pronounced away from the smallest-cap
stocks, which is good for us.
You’ve described your idea generation as
much more organic than systematic [see
box, p. 10]. Is there any process to how
you flag potential ideas?
JV: We don’t find screening helpful,
primarily because our type of company
may have less accessible public data, which
means it won’t show up in a standard
database or that the data for it will be
incorrect or out of date.
We do spend a fair amount of time main-
taining a list of companies with quirky,odd businesses that we like and market
caps under $500 million. Most of the
time they’re fairly valued or overvalued,
but we’ve programmed our Bloomberg
to alert us if something happens and the
valuation drops to a pre-defined level at
which we’d want to look at it.
It’s kind of a bizarre conversation to
have, but we actively discuss what isn’t
being talked about. Maybe an industry
is at a low point in its cycle, where our
favorite company would be one that isstill making money and looking to expand
while competitors are losing money and
retrenching. If a commodity is trading at a
multi-year low, we’ll look at the producers
of the commodity who may be suffering.
If a commodity is at an all-time high, we’ll
look at companies that use the commodity
as a raw material and are getting hurt as
a result. This all becomes a starting point
and then we wander around from there.
Give an example of where your counter-cyclical bent is pointing you today?
JV: We’ve been thinking about the casino
business, which was hit hard by the finan-
cial crisis and is far from having recovered.
If you’re a supplier to the North American
gaming industry, you’re still looking at a
fairly bleak demand outlook as few new
casinos are being built and existing ones
are stretching out replacement cycles. We
haven’t made any conclusions yet, but
there are some good little companies that
supply products to the gaming industry
that have been worth a look.
You’ve said your portfolio management at
times in recent years has been character-
ized by “conspicuous inactivity.” Is that a
habit, or a reflection of the environment?
DN: It’s both. We’re constitutionally set
up to be inactive, following the War-
ren Buffett idea that you should always
judge how you’re doing in any given year
relative to if you’d done nothing. As long
as we’ve made good decisions and our
investment cases are intact, that creates a
bias for inactivity. We can go long stretch-
es without adding a new name to the port-
folio. Our latest addition was AirBoss of
America [BOS:CN] this year, which wasour first new name since 2010.
As the financial crisis hit, we also made
an active decision to be more inactive. Our
basic view was that the crisis was more of
a financial panic than a true crumbling of
the foundations of the global economy. So
we looked at our portfolio and concluded
that if you had to run and hide while the
panic raged, where would you go? We
had a big position in a beer company in
Canada, Big Rock Brewery [BR:CN], and
Canadians drink a lot of beer. We owneda chicken company in Mexico, Indus-
trias Bachoco [IBA], and Mexicans eat a
lot of chicken. Even with Ship Finance,
while oil demand is variable, the demand
for the transportation and drilling of it is
fairly steady. We concluded we had the
type of portfolio you would want to run
to, so other than selling off a couple hold-
ings that were extremely economically
sensitive, we mostly just hunkered down
with what we had.
Did the crisis prompt any changes in how
you do things?
JV: It really hasn’t. We’ve tried to be very
conservative both in how we run our
management company and how we run
our fund, which was certainly vindicated
as once-hot hedge funds crashed and
burned after the crisis. It’s common in
this business for managers who have had
some success to develop an outsized view
of their actual skill. One benefit of our
partnership is that we keep each other
grounded so that doesn’t happen.
DN: I also don’t think you can underesti
mate the importance of having an inves
tor base that allows you to stick to yourstrategy. We were down more than 40%
in 2008, but our investors knew what we
owned and why we owned it and were
confident we’d react to the selloff in a
way that would benefit the portfolio in the
long run. We wouldn’t have been able to
come back as strongly as we did in 2009
and 2010 without that confidence.
Some managers responded to the crisis
by running less-concentrated portfolios
but you still own around 10 positions aa time. Why?
JV: Our investors hire us to manage a
concentrated portfolio of obscure smal
companies. They don’t need us to diversify
for them. We’re going to have volatility
in our returns, but we’re clearly of the
mind that concentrating on a small number
of ideas that we know inside and out is
one of the best ways to have a shot at
outperforming the market over time.
I would add that the stocks we owneven though they’re small and less liquid
don’t gyrate that much in price. Ship
Finance can be an exception because it’s
treated as more cyclical than we think
it really is, but most of our companies
are just kind of plodding along in niche
markets where we put a premium on high
and stable market shares.
DN: Industrias Bachoco, for instance, is
in a cyclical business, but its stock price
ON INACTIVITY:
We follow Warren Buffett’s
idea that you should always
judge how you’re doing rela-
tive to if you’d done nothing.
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I N V E S T O R I N S I G H T : VN Capital
doesn’t move all over the place because
it just keeps executing, chunking out a
consistent return on equity and adding a
point or two of market share every year.
You never know how long you’ll own
something, but I could see this in our port-
folio five or ten years from now as the com-
pany continues to expand its product and
geographic footprint. It wouldn’t at all sur-
prise us to see it mentioned up there with
Tyson Foods or Pilgrim’s Pride one day.
AirBoss of America would seem to qualify
as the type of “obscure and mundane”
company on which you focus. Why is it a
good investment today?
DN: The company’s headquarters is in themiddle of nowhere in northern Ontario,
consisting of a few guys set up in the con-
verted project house of a new develop-
ment that ran into financial trouble. But
it’s a substantial business, the biggest part
of which is in rubber compounding, where
it’s the second-largest player in North
America. They basically take different rub-
bers and mix them in these giant kettles to
produce compound rubbers that meet cus-
tomer specifications for things like hard-
ness, flexibility and weather protection.It’s not a great business because it can be
cyclical and low-margin, but it’s also rela-
tively insulated because there aren’t many
companies that have the expertise to do
this and the capital costs to get started
are high. The primary customers are tire
manufacturers and equipment suppliers to
the mining and coal industries.
JV: The other main business, in which Air-
Boss is the world’s largest supplier, is pro-
ducing protective boots and gloves for usein dealing with chemical, biological, ra-
diological and nuclear [CBRN] contami-
nation. Most of the customers for this type
of protective gear are military and there’s
an attractive replacement profile, as the
gear has to be replaced once it’s been used
in an actual contamination. We’re skepti-
cal of synergies, but this is a case where the
company applied its sophisticated knowl-
edge of rubber properties and compound-
ing to make what appears to be a better
mousetrap in CBRN protective gear. This
business today generates roughly the same
level of annual operating earnings as the
compounding business, around $11 mil-
lion, on about one-third of the revenues.
One thing that sealed it for us was
spending time with management. We’re
sitting in this converted house and they’re
describing how the company got started
after buying a tire plant from Uniroyal
for $1, and then signing up Uniroyal as
its first compounding customer. They got
into the CBRN business initially by tak-
ing over a government testing lab, beating
out much bigger defense-company suitors
because they played up the fact that they
were Canadian and had extensive rubber
knowledge. We like that kind of contrariannature and scrappiness.
To the extent the two businesses are
cyclical, where are we in the cycles?
DN: China’s slowing down and the impact
that’s had on the mining business has hur
them. At the same time, sales to military
customers are also in what we expect to
be a temporary down cycle. Both of those
things have put pressure on the stock.
With the shares trading today at C$4.55
how are you looking at valuation?
DN: Net income last year, which we con-
sider a modestly good year, was C$13 mil
lion, while free cash flow was more than
C$22 million. At today’s market value
then, the stock on trailing numbers goesfor an 8x P/E and less than 5x cash flow.
AirBoss of America(Toronto: BOS:CN)
Business: Develops, manufactures andsells rubber compounds as well as specialtyrubber-based protective gear used in de-fense and industrial applications.
Share Information(@10/30/12, Exchange Rate: $1 = C$1.00):
Price C$4.5552-Week Range C$4.20 – C$5.92Dividend Yield 4.4%Market Cap C$104.6 million
Financials (TTM): Revenue $271.4 millionEBITDA Margin 6.6%Net Profit Margin 3.0%
Valuation Metrics(Current Price vs. TTM):
BOS:CN Russell 2000P/E 8.0 31.3
I N V E S T M E N T S N A P S H O T
BOS PRICE HISTORY
9
8
7
6
5
42010 2011 2012
9
8
7
6
5
4
THE BOTTOM LINE
Worried about cyclical pressures in the company’s traditional rubber-compounding busi-ness, the market doesn’t appear to appreciate the higher growth and profitability of itsincreasingly important protective-gear business, says Don Noone. At only 12x “a goodyear’s” C$15 million in profit, he says, the company’s shares would trade at around C$8.
Sources: Company reports, other publicly available information
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I N V E S T O R I N S I G H T : VN Capital
We try not to make overly aggressive
valuation assumptions, but we don’t be-
lieve a company like this should trade for
8x earnings. It should reliably generate
C$10-15 million in annual profit, earn-
ing an 8-10% return on assets and a 15%
return on equity. You could see earnings
spike as it wins big CBRN contracts, and
the overall profitability profile should
improve as the protective-gear business
accounts for a greater share of total rev-
enues. While you could argue all that’s
worth at least a market multiple, even at
12x a good year’s C$15 million in profit,
the shares would be around C$8.
JV: We also believe we’re getting free op-
tion value, in the unfortunate event thata large-scale accident or attack increased
demand for protective gear. As the pri-
mary supplier out there, AirBoss would
substantially benefit.
So why is a Canadian company in the rub-
ber business named AirBoss of America?
DN: I actually have no idea. We said the
companies we invest in tend to be quirky.
A perfect transition to Ceres Global Ag[CRP:CN], a closed-end fund on its way
to becoming a grain-elevator company.
JV: The backstory here is that Ceres was
formed in late 2007 by Front Street Capital
to invest in the then-hot agricultural com-
modity boom. Within a year those mar-
kets crashed as the recession hit and man-
agement shifted focus to hard assets with
the purchase of a dozen privately held
grain elevators from a Minnesota-based
hedge fund manager, Whitebox Advisors.In 2011, Ceres announced it was going to
run off its investment portfolio and rein-
vest the cash into similar operating assets.
As we studied grain elevators, we
concluded the business was similar to that
of the cement business, where we’ve in-
vested with some success before. There are
high fixed-cost assets, with a good that is
fairly low in value but bulky and expensive
to transport. That allows cement compa-
nies to have natural monopolies near their
plants because it’s a lot cheaper to buy ce-
ment from the guy who’s 10 miles away
than 200 miles away. The same thing
applies with grain elevators, but kind of
in reverse. If you’re a farmer, it’s a lot
cheaper and easier to transport your grain
to the elevator that is very close than one
that’s far away. In these situations it comes
down to what you pay for the fixed as-
sets – the lower the price, the higher your
return. In Ceres’ case, we believe we were
able to buy those fixed assets for free.
Walk through that math given today’s
C$5.80 share price.
JV: The current market cap is around
C$83 million. Using year-end Marchnumbers, reflecting a full harvest season,
Ceres had around C$40 million in cash
and run-off investments. It owned C$160
million worth of grain in its elevators
against which it had C$80 million of debt
At the fund level there was also another
C$40 million in debt. So for less than C$5
million at today’s price, you’re getting the
grain-elevator assets and the profits they
generate. It recent years those profits have
been as high as C$12 million, with an av
erage of around C$8 million. Discount
that average annuity at 10%, and that’s
C$80 million in value right there.
Is there any reason to be more optimistic
about the elevator business?
JV: One significant thing happened in thethird quarter of this year, which is that the
Ceres Global Ag Corp.(Toronto: CRP:CN)
Business: Provider of agricultural grain stor-age and supply-chain management servicesthrough a network of storage facilities in thenorthern United States and Canada.
Share Information(@10/30/12, Exchange Rate: $1 = C$1.00):
Price C$5.7852-Week Range C$4.20 – C$7.24Dividend Yield 0.0%Market Cap C$83.2 million
Financials (FY ending March 2012): Revenue C$184.4 millionOperating Profit Margin 2.7%Net Profit Margin (-0.7%)
Valuation Metrics(Current Price vs. TTM):
CRP:CN Russell 2000P/E n/a 31.3
I N V E S T M E N T S N A P S H O T
CRP PRICE HISTORY
10
9
8
7
6
5
42010 2011 2012
10
9
8
7
6
5
4
THE BOTTOM LINE
As the company transitions from a failed strategy as a closed-end investment fund, themarket is almost entirely ignoring the value of what will be its ongoing business of manag-ing grain elevators, says Jim Vanasek. If that business ultimately earns a 10x multiple onits average profit in recent years, he says, the share price would nearly double.
Sources: Company reports, other publicly available information
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I N V E S T O R I N S I G H T : VN Capital
Canadian Wheat Board officially lost its
monopoly to purchase Canadian wheat.
That opens up a significant new base of
potential customers for Ceres’s assets,
many of which are located in the U.S near
the Canadian border. The business will
continue to fluctuate somewhat based
on weather and crop yields, but the new
demand should have a positive long-term
impact on both capacity and pricing.
Another upside we see here is that as
the non-elevator portfolio is sold off, there
will be no need for Ceres to maintain its
closed-end fund structure. Savings related
to that could add another C$2 million or
so annually to the bottom line.
Describe the turnaround you’re betting onat Breeze-Eastern [BZC].
JV: The company’s core business is making
hoist and hook equipment used in
helicopter search-and-rescue missions.
It has roughly 60% of that global
market, in which it operates basically in a
duopoly with a division of Goodrich Corp.
The customer base is primarily military,
though there are commercial end-user
applications as well.
This is equipment that absolutely hasto work, in the worst environments and
operating conditions. As a $100,000 item
in a $23 million helicopter, it’s not the
type of thing where the manufacturer will
play hardball over price. There’s usually
good visibility on future cash flows, be-
cause once you’re on a platform you’re on
it until the helicopter is no longer made,
and because there’s a healthy stream of
replacement-parts business. From a bar-
rier-to-entry standpoint, this also isn’t an
area where you’d expect a price-cuttingChinese competitor to come in and take
business.
Breeze-Eastern starting in the 1990s
took the plentiful cash generated by this
core business to invest in becoming a more
diversified defense supplier. They bought
a bunch of companies, paid too much for
them, loaded up on debt and then didn’t
manage it all well, basically running the
company into the ground. That eventually
led in 2007 to a special capital raise that
resulted in the two biggest shareholders,
Tinicum Capital and Wynnefield Capital,
controlling more than 50% of the shares.
They brought in a new management team
to sort out the mess and go back to basics.
DN: While all this is getting underway,
the financial crisis hits. The company was
also saddled with large legacy contracts
for supplying hooks and winches in cargo
airplanes that left them holding the bag
on significant engineering-cost overruns.
So while the turnaround has been going
on for some time now, the financial results
haven’t really shown it.
We think that’s about to change. The
company has consolidated its manufactur
ing into new facilities and has spent mos
of the upfront engineering costs for new
projects coming on stream over the next
decade. Signed new projects alone will add
$10 to $20 million in annual revenues, de
pending on the year, to a current revenue
base of around $80 million.
How do you see that translating into share
upside from today’s $8 price.
DN: The core business in the past has
earned as much as $15 million in net prof
Breeze-Eastern(NYSE: BZC)
Business: Manufacture, sale and servicingof hoists, winches, hooks and other liftingand restraining devices utilized primarily incommercial and military aviation markets.
Share Information(@10/30/12):
Price 8.0052-Week Range 5.77 - 9.86Dividend Yield 0.0%Market Cap $75.9 million
Financials (TTM): Revenue $81.1 millionOperating Profit Margin 11.1%Net Profit Margin 2.9%
Valuation Metrics(@10/30/12):
BZC Russell 2000Trailing P/E 33.1 31.3Forward P/E Est. n/a 15.3
Largest Institutional Owners(@6/30/12):
Company % OwnedTinicum Capital 34.8%Wynnefield Capital 22.3%T. Rowe Price 6.7%
Dimensional Fund Adv 3.5%Kennedy Capital 0.7%
Short Interest (as of 10/15/12):
Shares Short/Float 0.1%
I N V E S T M E N T S N A P S H O T
BZC PRICE HISTORY
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10
8
6
42010 2011 2012
12
10
8
6
4
THE BOTTOM LINE
The company’s long road back to focusing on its strong core business – made longer bythe recession and a number of unprofitable legacy contracts – is finally about to pay off,says Don Noone. At a market multiple on what he considers a conservative $10-12 mil-lion estimate of normalized earnings, the stock would roughly double from today’s price.
Sources: Company reports, other publicly available information
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I N V E S T O R I N S I G H T : VN Capital
it. That’s been depressed in recent years,
but we think we’re being conservative in
assuming they get back to the $10-12 mil-
lion annual range. That means the stock to-
day trades at only 7-8x more normal earn-
ings. A private buyer for a business with
this type of predictability and profitability
would pay significantly more than that. We
feel good when we can model out a double
in the stock price over the next few years,
which is pretty much where we are here.
Does the recent sale of top-competitor
Goodrich to United Technologies pose
any risks?
JV: The competitor was already a tiny di-
vision of a very large company and nowit’s part of an even larger firm. People are
worried that now Sikorsky, which is also
owned by United Technologies, will stop
buying from Breeze. Sikorsky is run quite
independently, so we think that concern is
overblown. Probably more likely is that
Sikorsky’s competitors will now think twice
about buying from Goodrich, which could
incrementally benefit Breeze in the end.
Has your case for Big Rock Brewery been
slower to materialize than you expected?
DN: The thesis is still fully intact. Big Rock
has the best reputation and brands in the
craft-beer business in the Alberta province
of Canada, which is booming with the ex-
pansion of the energy business there. The
area is importing oil workers from around
the world, mostly men making good mon-
ey during the biggest beer-consuming pe-
riods of their lives. The company is grow-
ing and making good money, but it is true
that they haven’t really made it sing yet.
Why not?
DN: There have been some fits and starts
with management. The founder, Ed Mc-
Nally, was slow to let go of control and
kind of let the company drift in the past
couple of years. But early this year he
named a new CEO, Bob Sartor, who we
believe is a world-class operator. He has
articulated a clear plan and is injecting
new energy and ambition into the business.
His first focus, which we believe is right,
is on product innovation. For Labatt or
Molson drinkers, you need to graduate
them into the craft-beer market. For the
beer nerd, you need to provide them with
new, exciting and flavorful brews. That all
requires pushing the envelope with new
products, which Big Rock hadn’t been do-
ing. It has now launched a number of new
and seasonal beers, one of which, a Scot-
tish heavy ale, is already being introduced
into the full-time product stable.
On the operational side, Sartor is shift-
ing marketing spending away from what
he calls “trinkets and trash” – things like
coasters and key chains – toward more
on-premise events like beer tastings. Tofree up production capacity that was gen-
erating very little if no profit, he’s winding
down the production of private-label beer
He also plans to cut at least C$1 million
in annual expenses, not insignificant for a
company that’s been earning C$6-8 mil-
lion per year.
The last piece of the plan involves geo-
graphic expansion, focused on neighbor
ing British Columbia. The idea would be
to translate, through acquisition or build
ing a new brewery, the success Big Rock
has had in one vibrant market to another.
At today’s C$13.95, how cheap do you
consider the shares?
DN: If the product and operating initia
tives prove successful, we believe the company should earn at least C$10 million per
Big Rock Brewery(Toronto: BR:CN)
Business: Produces, markets and distributesa line of premium craft beers and alcoholiccider, sold primarily in and around its homeprovince of Alberta, Canada.
Share Information(@10/30/12, Exchange Rate: $1 = C$1.00):
Price C$13.9052-Week Range C$11.50 – C$14.50Dividend Yield 5.8%Market Cap C$84.3 million
Financials (TTM): Revenue C$46.6 millionOperating Profit Margin 10.7%Net Profit Margin 8.0%
Valuation Metrics(Current Price vs. TTM):
BR:CN Russell 2000P/E 22.4 31.3
I N V E S T M E N T S N A P S H O T
BR PRICE HISTORY
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14
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THE BOTTOM LINE
A new CEO’s injection of “energy and ambition” should unearth latent value in the com-pany’s core brewing franchise, says Don Noone. At 12x the C$10 million in annual profithe believes the company should earn, the shares would be 50% above today’s price. Theprice of options on successful geographic expansion and/or an eventual buyout: free.
Sources: Company reports, other publicly available information
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I N V E S T O R I N S I G H T : VN Capital
year. It was making that much in the mid-
2000s, so we don’t consider that a stretch.
Put even a 12x multiple on that and you’ve
got almost 50% upside from today’s price.
You then have an option on successful
geographic expansion, as well as on Mol-
son or Labatt swooping in over the next
couple of years to buy some craft-brew
credibility that almost all big brewers have
had a tough time creating. As you wait for
some of those things to play out, there’s a
very healthy dividend yield, which on to-
day’s price is just below 6%.
What’s something you’ve been selling re-
cently and why?
JV: We spoke last time about Escalade[ESCA], which has this mish-mash of busi-
nesses, some of which are good, like ping-
pong tables and archery products, and
others which aren’t so good, like paper
shredders and letter openers. Our thesis
was that better managing the portfolio of
businesses – getting rid of underperformers
and investing in those doing well – would
result in a much more profitable company.
It hasn’t been a disaster investment for us,
but after years of one step forward, two
steps back, we’ve decided to move on.
DN: We’ve tried to speak constructively to
the board, to get them to focus for each
piece of the business on where they’re
earning a return on capital and where they
aren’t. That strikes us as common sense,
but there just hasn’t been adequate will at
the board level to do that.
Speaking of another idea we discussed last
time, it would appear you sold cigarette-
paper maker Schweitzer-Maudit [SWM]
way too early. What happened?
DN: There’s a good lesson there. What at-tracted us to it was that there was a strong
underlying business, but it was poorly
managed. Dealing with management was
so frustrating that it discombobulated us
and we concluded the situation couldn’t
be fixed. In fact, we should have stepped
back and recognized that the attractive-
ness of the business would outlast man-
agement. Within a year of the old CEO
leaving, the stock went from the low-teen
to $40 [split adjusted]. We had the conver
sation at $7 about whether to take a much
bigger position and pound the table more
with management, we just didn’t do it.
We asked last time what advice your men-
tor in the business, Joseph Reich of Reich
& Tang, had been offering up. He had sug
gested maintaining plenty of liquidity, and
you added, “Having been through some
really bad markets before, he doesn’t think
this one is over yet.” Pretty good advice in
April 2008. What’s he counseling today?
JV: He usually focuses on how we’re run-
ning the business, such as whether we’re
sticking to our discipline or how we’retreating clients. One piece of advice he did
give us recently was that while we should
selectively try to work with our companies
to create value, we shouldn’t start think-
ing we’re investment bankers with 45
different ideas for the company to imple-
ment. The message was to be careful not
to get out of our competence zone, which
is always good to be reminded of. VII
http://www.valueinvestingcongress.com/landing/s13/vii/10.26.12_ad.php?utm_source=VII&utm_medium=A&utm_content=SAVE800&utm_campaign=S13VIIA&ocode=S13VIIA
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Editor’s Note: The distant observer might
imagine a siege mentality among European
investment managers, clinging for dear life
as the fate of the European Union hangs
in the balance. The view from the inside asdescribed by Bestinver’s Francisco Garcia
Parames, however, is very different. One of
Europe’s foremost investors – his flagship
Bestinfond has returned a net annualized
15.7% since inception in 1993, vs. 8.5% for
its mixed Spanish and global benchmark
– Garcia Parames oversees €5.5 billion
in assets from his Madrid home base.
We recently caught up with him and co-
portfolio managers Fernando Bernad and
Alvaro Guzman to see how they’re navi-
gating today’s difficult investing environ-ment. Cautious? Yes. Fearful? Not at all.
It’s been an eventful few years since we
last spoke [VII , November 26, 2008].
Have you called any of your core value-in-
vesting tenets into question in the interim?
Francisco Garcia Parames: The core of
what we do, investing with a long-term
horizon in stocks that are inexpensive
relative to their normalized free cash flow,
has not changed and most certainly will
not change in the future. But that doesn’t
mean you don’t evolve as an investor. For
example, while I wouldn’t attribute this
directly to the crisis, we have moved more
from a pure Benjamin Graham style of
value investing to one closer to Phil Fisher
and Warren Buffett, in the sense that we’re
putting even more weight on the qual-
ity of the business. I don’t know, maybe
when you’re younger you just care about
getting things that are cheap and making
money fast. But as you become old you seethat buying companies with high and sus-
tainable returns on capital at reasonable
prices tends to work a little bit better.
The second adjustment we’ve made is to
concentrate more. In our global portfolio
we used to have 100-120 stocks, but
now we have around 50. With the top 15
stocks, we cover 70% of the portfolio.
The more concentrated you are, the more
sure you have to be about everything – the
barriers to entry, the leverage, the down-
side. Every stock in which we hold a largeposition has to be very safe by its nature.
Has it gotten harder to estimate normal-
ized free cash flow in Europe?
Alvaro Guzman: When you look at our
average stock, we’re not making a huge
effort to predict earnings. A typical busi-
ness would be like that of Schindler Hold-
ing [SCHN:SW], the elevator company,
which has barriers to entry and is difficult
to copy. We’re comfortable in a case likethis in assuming 1-2% volume growth and
flat-to-1% pricing growth translating into
4-5% annual EBITDA growth. We don’t
have to be more aggressive than that for
almost all of our holdings.
I’d distinguish between cyclical stocks
with barriers to entry and those without
them. When market shares are stable,
if the size of the pie goes up and down,
you have historical data points that al-
low you to normalize. We own French
defense contractor and aerospace firm
Thales [HO:FP]. It is clearly impacted by
changes in defense budgets, but its mar-
gins have also suffered from a number of
poorly negotiated contracts under prior
management. The new CEO has put or
der to the way the company accounts
for costs and negotiates contracts, so we
expect EBIT margins to increase from
6% to an 8% normalized level, which
is still below the 10% earned by peers
Just making that assumption allows us
to find the stock quite undervalued. Ifdefense spending also eventually comes
back to normal levels, which it is likely to
do, that would be icing on the cake.
Contrast that with businesses in which
there are no competitive barriers and
market shares can vary greatly from one
year to the next. These are usually more
purely commodity businesses that, absent
clear low-cost leadership, are difficult to
normalize and we’re not very interested in
What macro views are informing your investing today?
FGP: Sometimes we can add more value
on this front than others, and I would say
today is a difficult time. Much of how
things play out in Europe will depend on
politicians making decisions, which we
consider almost impossible to forecast.
We do spend a lot of effort trying to un
derstand how China will grow. Given that
its growth is based on savings and produc
tivity improvement, we’re still positive onthe sustainability of its economic expan
sion. Even as China slows down, if you
look at the absolute growth in its forecast
ed GDP relative to the expected GDP pull
back in vulnerable European countries
there’s no comparison. Overly focusing on
what is going on in Spain and even what is
going on in Europe is losing the right
perspective from our point of view.
That’s why we own global companies
Acerinox [ACX:SM] is a stainless-stee
With a painful economic contraction at home and the European economic union in trouble, Bestinver’s FranciscoGarcia Parames would be forgiven for having a downbeat investment outlook. Such, however, is not the case.
S T R A T E G Y : Bestinver
Eye of the Storm
I N V E S T O R I N S I G H T
Bestinver Asset Management(l to r ) Alvaro Guzman, Fernando Bernad andFrancisco Garcia Parames
On perspective: “Overly focusing onwhat is going on in Spain and even whatis going on in Europe is losing the rightperspective from our point of view.”
Funds People
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company based in Spain, but it just set up
a 600,000-ton-capacity plant in Malaysia
to serve Asian countries outside of China
– that’s a market of 600 million people.
Despite what’s going on in Europe, this
company has been growing 5-6% per year
for several years.
Do you still have your own analyst in
Shanghai?
FGP: Yes, he’s been there four years. This
forces us to go there, to learn. If you
invest in almost any sector in the world you
have to know what’s going on in China,
both for companies that want to sell there
and to know what competition may come
from there.We’re also learning about Chinese
stocks and while we haven’t yet invested in
mainland China, we have invested in a Tai-
wanese company called Yungtay Engineer-
ing [1507:TT], which is very active in Chi-
na. It’s an elevator company, an industry
we know very well from investing in Euro-
pean companies like Schindler and Kone.
We are comfortable with its corporate
governance, and feel it provides good ad-
ditional exposure to an industry we like in
a part of the world that is growing.
Has the geographic mix of your portfolio
been shifting?
Fernando Bernad: In putting more
emphasis on truly global companies, we
have over the last couple of years reduced
our exposure to the euro zone. In terms of
the underlying economic exposure of the
companies we own – which we calculate
by looking at both revenues and EBITDA
– our euro zone exposure today is 42%,down from 54% two years ago. Our next
biggest exposures are 20% in emerging
markets (up from 14% in 2010), 17% in
N