TILSON GROWTH FUND, L.P.

2003 ANNUAL LETTER TO INVESTORS

T2 Partners LLC 145 E. 57th Street, Suite 1100 New York, NY 10022 Phone: (212) 386-7160 Fax: (240) 368-0299 info@T2PartnersLLC.com www.T2PartnersLLC.com

T2 PARTNERS LLC

Whitney R. Tilson phone: 212 386 7160 Managing Partner fax: 240 368 0299 WTilson@Tilsonfunds.com www.T2PartnersLLC.com

February 9, 2004 Dear Partner, The unaudited return for the Tilson Growth Fund through the end of 2003 versus major benchmarks (including reinvested dividends) is:

December

4th Quarter Full Year

Total Since

Inception

Annualized Since

Inception Tilson Growth Fund - gross -0.5% 9.5% 36.8% 68.5% 11.0% Tilson Growth Fund - net -0.4% 7.9% 29.4% 53.2% 8.9% S&P 500 5.3% 12.1% 28.6% -2.9% -0.6% Wilshire 4500 1.3% 12.8% 43.0% 21.7% 4.0% Dow 7.1% 13.3% 28.4% 25.7% 4.7% NASDAQ 2.2% 12.1% 50.0% -8.6% -1.8% Median Domestic General Stock Mutual Fund

4.9% 12.3% 29.6% 3.8% 0.8%

Notes: The Tilson Growth Fund was launched on 1/1/99. Its returns are after all fees. Gains and losses among private placements are only reflected in the returns since inception. The mutual fund data is from Morningstar and is published in the Sunday business section of The New York Times. While the net return to an investor who joined the fund at the beginning of 2003 was 29.4%, the vast majority of long-time investors earned a net return of 35.1% due to the fact that I earned no performance allocation in 2003 until the decline in 2002 was fully recouped (e.g., until the fund exceeded its high-water mark). It was exactly a year ago today, February 9, 2003, that our fund hit its nadir, down 5.9% for the year, on the heels of a dreadful 2002. I have no doubt that most funds would have seen an exodus of capital, but you, my partners, stuck with me. Since then, net of all fees, your capital accounts have risen by 53.2%. Thank you for providing me with a stable base of capital. It is a rare and precious asset in the money management business, as it allows me to make investments with a long-term perspective -- an enormous competitive advantage in an increasingly short-term-oriented market. This is a long letter that covers many topics, so if you wish to skim it, here is a list of the sections:

• Overview Page 2 • Performance Objectives Page 3 • Outlook Page 3 • Current Positioning Page 4

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• Cash Page 4 • Bearish Investments Page 5 • The Fund’s Seven Largest Long Positions Page 7 • Valuing Investments Page 9 • Tilson Offshore Fund Page 10 • Report on Tilson Capital Partners Page 11 • Conclusion Page 11 • Index of Appendices Page 12 • Appendix A: Investment Principles Page 13 • Appendix B: Email From a Reader on Investor Behavior Page 14 • Appendix C: Excerpt from 2003 Baupost Annual Letter on Cash Page 16 • Appendix D: Writings About the Fund’s Seven Largest Positions Page 18 • Appendix E: Writings About the Fund’s Other Holdings Page 39

Overview It was a good year for our fund -- and nearly every other fund as well. Consider the following:

• Small cap stocks had their best year ever, with the Russell 2000 rising 45%; • The Nasdaq rose 50%, its third best year ever; • All but one of the 87 industry groups in the Dow Jones U.S. Total Market Index rose last

year; • 92% of the stocks in the S&P 500 advanced, the most ever; • Of 5,999 stocks that were traded on the major exchanges for the entire year, 87%

increased in price, by an average of 90% and a median of 38%. In light of this broad-based rally -- it’s best not to forget that even turkeys can fly in hurricanes -- simply beating the S&P 500 is not much to crow about (although it does extend the fund’s streak to five years, every year since inception). Rather, I am most proud of the conservative, low-risk way in which our fund beat the market. The fund:

• Used no leverage and, in fact, ended the year with 15% cash (up to 27.4% today); • Held no speculative, on-the-verge-of-bankruptcy stocks that skyrocketed as the economy

rebounded, interest rates fell and debt investors threw low-cost capital at the riskiest companies;

• Hedged its long exposure with shorts (which accounted for at least 10% of the fund throughout the year), puts and credit-default swaps.

I have no plans to change my approach (summarized in Appendix A, Investment Principles), which is rooted in the following observation by Charlie Munger:

It is occasionally possible for a tortoise, content to assimilate proven insights of his best predecessors, to outrun hares which seek originality or don’t wish to be left out of some crowd folly which ignores the best work of the past. This happens as the tortoise stumbles on some particularly effective way to apply the best previous work, or simply avoids standard calamities. We try more to profit from always remembering the obvious than from grasping the esoteric. It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent. [Emphasis added.]

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Performance Objectives In every annual letter I repeat my performance objectives: My goal is to earn you at least 15% compounded annually, over an extended period, after all fees and performance allocation. (To make my lawyers happy, let me be clear that this is a goal, not a guarantee.) While a 15% annual return might not sound very exciting, it would quadruple your money over the next 10 years, while 7% annually -- about what I expect from the overall market for the next decade or two -- would only double your money. Of course, the fund’s performance will vary from year to year, depending on what the market does -- among other factors -- so I use another test as well: I would like to see the fund’s net returns beat the S&P 500 index by 5-10 percentage points annually, averaged over at least a few years. In its five years since inception, the fund has not met the first objective, but has met the second one, beating the S&P 500 index each year and by 9.5 percentage points on a compounded annual basis. Outlook In my January 9th column, A Scary Time for Stocks (www.fool.com/news/commentary/2004/commentary040109wt.htm), I wrote:

What does 2004 hold for investors? Before I answer that question, I want to share some of the wisest words ever spoken about investing, by (surprise!) Warren Buffett at the 1992 Berkshire Hathaway annual meeting:

If we find a company we like, the level of the market will not really impact our decisions...We spend essentially no time thinking about macroeconomic factors...We simply try to focus on businesses that we think we understand and where we like the price and management.

I agree with Buffett that one should have a bottoms-up approach to stock picking, but when it comes to managing my overall portfolio -- how much to have in cash vs. long positions vs. shorts/puts -- I think it’s important to have a general opinion regarding a few big factors, such as the economy, interest rates, and overall valuation levels in the stock market. So, without further ado, my opinion on these three factors is quite bearish. In contrast to the current cheery consensus, I think that the economy is not as strong as it appears, interest rates have nowhere to go but up, and high stock valuations already reflect a best-case scenario -- so there’s little upside and substantial downside.

I refer you to the rest of the article for further thoughts on these matters. In summary, I am quite certain that it will be far more difficult going forward to make money in the stock market than it has been over the past year, so I urge you to adjust your expectations for our fund accordingly. Stocks in general are not at all cheap, and even the ones we own are not as cheap as they once were, so there is less appreciation potential.

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Just because bargains are harder to find, however, doesn’t mean I’ve given up. Far from it. As usual, I continue to scour the investment universe for the rare unloved or unknown stocks that represent compelling investments. Sometimes months will go by and I won’t find any, and then I’ll find three in a week. The key is to be patient, yet also prepared to seize opportunities and invest a material amount of our capital, regardless of my view of the economy, stock market, interest rates, etc. Current Positioning For the reasons noted above, beginning in mid-2003 (too early it turns out, with the benefit of hindsight), I started to become increasingly concerned about high valuation levels -- both among the stocks in the fund, as well as the general market -- and began to trim the fund’s long positions and increase its bearish investments. Consequently, the fund today is the most conservatively positioned it has ever been, with 27.4% cash (excluding cash associated with short positions), 10.1% short and 9.4% invested in put and credit-default swap positions that are leveraged (meaning the economic exposure is substantially greater than 9.4%; see further discussion below in the section entitled, Bearish Investments). Cash While the fund’s cash position is near its highest level ever and I would of course prefer to be fully invested in a portfolio of 50-cent dollars, I do not feel a sense of urgency to invest this cash. Allow me to share with you some comments about cash with which I entirely agree, from Seth Klarman’s 2003 annual letter (Klarman is the author of Margin of Safety and has an exceptional long-term track record as the founder of the Baupost Group; at the time of his letter, Baupost held 57% cash):

Perhaps some of you will soon be asking why you are paying us a management fee to hold so much cash. Let us preempt you by saying that we are not. You are paying us to decide when to hold onto cash and when to invest it, to determine when the expected return from a prospective investment justifies the risk involved and when it does not.

Klarman later continues:

We have always believed that successful investing involved recognizing and correctly choosing among a series of tradeoffs. Cash (in the form of short-term U.S. treasury bills) is a way of safely doing nothing until compelling investment opportunity arises. It offers positive albeit very limited yield, complete safety of principal, and full and instant liquidity. A low positive return with virtually non-existent risk is not a bad proposition in the absence of better alternatives. Our view is that investors should choose to hold cash in the absence of compelling opportunity, not because they are making a top-down asset allocation into cash, but based on the result of a bottom-up search for bargains. Baupost will make the decision to hold cash, even if it becomes a very large percentage of partnership assets, until better opportunities arise. Every investment must be compared to the alternative of holding cash. If an investment is sufficiently better than cash -- offering a more than adequate return for the risk involved -- then it should be made. Note that the investment is made not because cash is bad, but because the investment is good. Exiting cash for any other reason involves dangerous thinking and greatly heightened risk.

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I have included the entire section on cash from Klarman’s letter in Appendix C. I’m especially happy to hold higher-than-usual levels of cash today because, while I try not to form opinions on such matters, I can’t help but be concerned about the overall economy and stock market. My friend Franz Heinsen of Heinsen Capital recently shared some wise thoughts on these matters:

While cash today generates interest income at an annual rate so insignificant that it’s best left unmentioned, it has a redeeming (and often overlooked) quality: it carries negligible risk of large, unexpected losses -- something that I can’t say today (at least not with a straight face) about many other kinds of assets, e.g., generously valued stocks. When interest rates are as low as they are today, it takes only a slight increase in them to wreak havoc with the financial situation of a stretched-out borrower. For example, an increase from, say, 5% to 6% per year increases a borrower’s monthly interest payments by a whopping 20%. Well, the United States of America, its government, and its people are all borrowing like there’s no tomorrow. Household debt, in particular, is growing at an alarming rate. What the ultimate consequences of this borrowing binge might be, no one really knows. But the risks and potential instability inherent in the present situation should be evident. For even the most rational, cool-headed person, when indebted to the hilt, will quickly become desperate in the face of even a mild financial setback. And desperate people do desperate things -- like, say, sell assets at any price to repay costlier debt to anxious lenders. A little setback here, a little setback there, and before your know it we could be facing an avalanche of desperate sellers. Having some cash in your portfolio (and an easily manageable level of personal debt) could provide a bit of cushion against it. You might want to think of a cash position as an insurance policy -- it seems unnecessary until you really, really need it.

I share Franz’s concerns about the indebtedness of American consumers and the potential deleterious impact on the economy and stock market, given that consumer spending accounts for roughly two-thirds of the nation’s economic activity. But these top-down concerns are not why our fund has so much cash. Rather, like Klarman, it is the consequence of what I’ve always done and always will do: a bottoms-up approach of buying really cheap stocks and selling fully valued ones. Bearish Investments The fund’s bearish investments were unprofitable in 2003, though I continue to expect that they will pay off in the future. And even if they don’t, I will not be too upset. I’ve made these investments to make money, but also view them as disaster insurance policies. Do you regret losing 100% of your “investment” if you purchase insurance on your home at the beginning of the year, and it doesn’t burn down? My strategy and tactics regarding making bearish bets have changed over the past 18 months or so. For the fund’s first three years, I invested only on the long side for a variety of reasons, discussed in my 2001 annual letter (www.tilsonfunds.com/private/letterannual01.html). Then, in

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2002 I shorted my first stock, Farmer Mac, after I became quite certain that it was a deeply flawed company trading at a ridiculously high valuation. (My opinion hasn’t changed, despite the stock’s significant drop, so this remains our largest short position -- see further discussion in Appendix E.) In late 2002 and 2003, I added a few more short positions, but recently scaled them back, replacing them with put positions. Allow me to explain why. Given my bearish views on the technology sector, I initially sought to short the most overvalued stocks in the sector -- classic examples are the Chinese internet stocks, Sina, Sohu, Netease and China.com. In July, they were trading at 35 times revenues, based partly on projections that in one year, they would be trading at “only” 35 times earnings. It was (and still is) clear to me that this was (and is) a speculative bubble, and that the odds that these barely profitable companies could grow earnings so rapidly were almost nil. Thus, I shorted a basket of these stocks -- 1% of the fund in each, for a total of a 4% position. Only a few weeks later, these stocks were trading at 45 times revenues and I was already down 25% or so on this investment. It finally dawned on me that once a stock becomes completely disconnected from any rational calculation of intrinsic value, there is no limit to how high it can go. What was to prevent these stocks from trading at 450 times revenues? In summary, I was short volatility, which is a very dangerous game. So-called 100-year storms seem to occur every few years in the financial markets, and investors who are short volatility can be put out of business in such situations -- just ask the Nobel laureates at Long Term Capital Management. I therefore decided to cover most of the fund’s shorts and today three short positions are only 10% of the fund. I still wanted to profit from the decline I expected in the frothiest, most overvalued sectors of the market, however, so I bought puts -- primarily on baskets of stocks such as the Nasdaq 100 (QQQ) and semiconductor companies (SMH). I would prefer to buy puts on individual companies, but the most overvalued stocks also tend to be quite volatile, which makes options on them very expensive. In contrast, the Nasdaq 100 has marched steadily upward for almost a year, so volatility is low and options -- even those that expire nearly two years from now in January 2006 -- are remarkably inexpensive. It is, of course, madness that at-the-money put options on the QQQ were expensive when the market bottomed last March and tech stocks were arguably cheap, and now they’re cheap when tech stocks are richly valued, but I’m happy to take advantage of this foolishness. For example, a couple of weeks ago I paid only $4.30/share for 87,600 January ‘06 puts (876 contracts) with an at-the-money $38 strike price, meaning that the Nasdaq 100 only has to fall 11% at some point in the next two years (even excluding the time value that might be remaining) for the investment to break even. The returns beyond that point increase rapidly. To understand the leverage in this position, let’s assume that instead of buying puts, I had instead shorted the QQQ, which was then trading at the strike price of $38. In this case, I would have had to invest $3,328,800 ($38 x 87,600 shares), investing nearly 10% of the fund and exposing it to unlimited losses on this amount. (Recall that I only invested $376,680 for the puts: $4.30 x 87,600.) If the QQQ falls to $30 by the end of two years, for instance, we would make $8/share on a short position (a 21% return), whereas by owning the puts, we would make the same $8, though we would have to subtract the $4.30 we paid for the options, yielding $3.70 of profit, or

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an 86% return. In short, by buying options we tie up 89% less capital and are not exposed to unlimited losses. The downside of options, of course, is that time is working against us. If the QQQ stays above $38 for the next two years and then plunges shortly thereafter, we would lose 100% of this put position, whereas if we maintained a short position, we would profit. In this case, I have chosen to use puts because I think two years is ample time for my investment thesis to play out -- and if I’m wrong, our losses will be relatively small and, more importantly, capped. The Fund’s Seven Largest Long Positions I have written at length about the fund’s largest holdings in previous letters (see Appendix D for extensive excerpts), so I will only share a few brief comments here (listed in descending order of size; all are 3.3% or larger positions): 1) Hallwood Realty Partners: In July 2003 Carl Icahn bid $100 per share for this real estate limited partnership, and he has since upped his bid to $132.50 -- and said he might be willing to bid more, subject to further due diligence. The stock closed Friday at $129.50. I think the company is likely to be sold for a $10-$20 premium to today’s price, so I have no interest in selling at this price, as I think there is still decent upside and little downside. 2) McDonald’s: On Friday, McDonald’s reported a 19.1% increase in January systemwide sales and comparable sales jumps of 13.4% in the U.S., 6.5% in Europe and 6.4% in Asia/Pacific, Middle East & Africa. While there were easy year-over-year comparisons, it is still amazing that a company of this size is generating such spectacular growth. When I bought this stock roughly a year ago at an average price of $14.68 (it closed Friday at $27.16), I conservatively estimated that the stock was worth in the mid-$20 range, but that it might take 1-3 years for the turnaround to take place, so I was prepared to be patient. The speed and magnitude of the turnaround have been wonderful surprises and have led me to increase my estimate of intrinsic value to the mid-$30 range, which is why I have yet to sell. While the U.S. operations are now humming along, the international operations still have tremendous room for improvement, so I think this will fuel continued good news for some time to come. 3) CKE Restaurants: I bought this stock at an average price of $3.49 roughly a year ago and everything I hoped would happen did happen, resulting in today’s price of $8.10. My friend David Eigen of Lego Capital and I did extensive scuttlebutt research, calling more than 30 Hardee’s restaurants around the country, which convinced us that the new Thickburger menu would be a home run -- and it has been, as January same-store sales were up 15.2%. Like McDonald’s, the year-over-year comparisons are easy right now and start to get harder, but I’m not starting to trim the position yet. David’s write-up on the company, which I assisted with, has all the details (see Appendix D). 4) Puts on the Nasdaq 100 (QQQ) and Semiconductor Holders Trust (SMH): In my October 2003 letter, I wrote the following:

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I have made a bearish bet on the Nasdaq 100, which is comprised largely of richly valued tech stocks…At first glance, my bearish bet on tech might appear to be a short-term market timing or hedging maneuver, but it’s not. I have made this bet for the exact same reason I have invested in every other position in the fund: because I think the odds are very favorable that we will make a lot of money. To make this argument, let me first draw your attention to a column I wrote three years ago, Peril and Prospects in Tech (www.fool.com/boringport/2000/boringport001009.htm), in which I analyzed six of the most popular tech stocks at the time: Cisco, Oracle, EMC, Sun, Nortel and Corning. I wrote:

The lowest P/E multiples among these six are 87 times trailing earnings and 64 times (very optimistic) estimated earnings for next year. Where, pray tell, is any margin of safety?… It is a virtual mathematical certainty that these six companies, as a group, cannot possibly grow into the enormous expectations built into their combined $1.2 trillion dollar valuation.

Even with the huge rally over the past year, those six stocks are down an average of 81% since then (the best performer, Cisco, is “only” down 63%). So where are we now? As I pointed out in today’s column, the Nasdaq 100’s trailing P/E ratio is 82 and the future P/E is 38 based on 2004 analysts’ estimates (which I believe are probably too high and certainly don’t factor in the fact that reported earnings will be hit hard if stock options are required to be expensed, which is likely). So, in summary, I will echo my conclusion from three years ago: I cannot predict when it will happen, so I’m prepared to be patient, but I believe it is a virtual mathematical certainty that the companies of the Nasdaq 100 cannot possibly grow into the enormous expectations built into their extreme valuation.

My prediction in October was a little early, but with the Nasdaq 100 today trading at 59 times trailing earnings and 38 times this year’s estimates, I have not changed my opinion that it is highly likely that the laws of valuation gravity will eventually catch up with these stocks -- and put options are a low-risk, leveraged way to profit from this. For further thoughts, see the following columns:

• Here We Go Again, 6/6/03 (www.fool.com/news/commentary/2003/commentary030606wt.htm)

• Am I Early or Wrong?, 10/31/03 (www.fool.com/news/commentary/2003/commentary031031wt.htm)

• How to Bet Against Tech, 11/7/03 (www.fool.com/news/commentary/2003/commentary031107wt.htm)

• A Scary Time for Stocks, 1/9/04 (www.fool.com/news/commentary/2004/commentary040109wt.htm)

5) Berkshire Hathaway: Berkshire’s earnings before realized investment gains through the first three quarters of 2003 soared 38.9%, driven by continued strong pricing in the insurance sector and superb execution across the board. Float grew 10.9% year-over-year, reaching a mind-

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boggling $43.8 billion -- and it was more than free, as Berkshire had a pre-tax underwriting profit of $1.1 billion in the first three quarters of 2003. The stock recently broke an all-time high of $90,000/share, but I think it’s worth six digits (how many stocks can you say that about?) so I’m holding. I think the market is still failing to appreciate the awesome power of a company with $72 billion of net worth, float of $43.8 billion, cash flow that is now roughly $2.5 billion per quarter, and Warren Buffett at the helm. 6) Cutter & Buck: Cutter & Buck has risen from the dead, rallying from a low of $2.84 last March to today’s price of $9.99. I played an instrumental role in this revival, leading a class action lawsuit against the company and helping negotiate a fair, quick settlement (see Appendix D for a detailed description). In its most recent quarter, Cutter & Buck’s sales fell 4.8%, but gross profit margins soared from 40.4% to 46.7%, resulting in ongoing wholesale business income before tax jumping 89.5%. With excellent management, $3.10/share in cash, no debt and on track to generate after-tax earnings of over $1/share this year (excluding one-time costs such as the settlement of the lawsuit), this stock remains cheap. 7) EVCI Career Colleges: This stock has been the all-time best performer for our fund and would currently be our largest position if I hadn’t aggressively trimmed it as it rose more than four times since I first purchased it at $2.12 last August (it hit a high of $9.49 recently and currently sits at $8.50). I describe the investment in a memo that I sent some friends in late September (see Appendix D). No matter what happens to the stock from this point forward, I’ve already sold $3.1 million, nearly two and a half times our original investment of $1.3 million, and we still have substantial potential further upside, mainly in the form of warrants. The beauty of this situation was that the fact that my investment increased the intrinsic value of the company -- the first time (but hopefully not the last) that this has been the case. Last summer, the stock price was depressed for two main reasons: 1) the company faced liquidity issues, as it wasn’t clear that it had enough cash on hand to meet near-term obligations; and 2) a large block of preferred stock was held by a tech-focused hedge fund, and investors were rightly concerned that when this stock converted to freely tradable common stock in the near future, the fund would start dumping the stock and crash the price. My first investment of $1 million in a direct transaction with the company helped take care of the first issue, as my cash improved the company’s financial position significantly. My second investment of $455,000 (both investments were split between the Tilson Growth and Offshore funds) was part of a transaction negotiated by the company whereby a large block of the preferred stock held by the hedge fund was transferred into friendly hands, thereby removing the risk of a flood of selling. The stock rose 21% to $2.96 on the day after this news was announced, and has never looked back. Valuing Investments An article last year in the Wall Street Journal reported that the Clinton Group, “one of the largest hedge-fund operators, has been accused by a recently departed employee of misstating the value of some bonds in its portfolio. Regulators are investigating.” Whether the employee’s accusations are true or not, this story highlights one of the dirty little secrets of the hedge fund

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world (and, to a lesser extent, the mutual fund world as well): that managers -- myself included -- have immense discretion in valuing certain illiquid positions. This, combined with strong financial incentives to overvalue, especially when year-end performance allocations are at stake, can lead to -- surprise! -- significant abuses. In my case, there are only a few small positions for which I have any discretion, as the great majority of our fund is invested in common, liquid stocks (which are simply valued at their closing price each day). To the extent I have any discretion, rest assured that I am very conservative in determining valuations. Allow me to give you some examples. Options Last spring I purchased call options expiring in January 2005 (long-term options like these are also known as LEAPS) on a number of different retail and restaurant stocks such as Home Depot and McDonald’s. While the underlying stocks are highly liquid, the long-dated, now-deep-in-the-money options we own are not and sometimes don’t trade for many days. In cases like these, the price I use at the end of each month is the last trade, if it is between the bid and the ask price; if not, then either the bid or the ask, whichever is closest to the last trade price. At the end of September, for example, the Home Depot Jan. 05 $20 call last traded at $13.00, but the bid-ask spread was $12.40-$12.60, so I marked this position down and valued it at $12.60. Conversely, on the same date the McDonald’s Jan. 05 $10 call last traded at $13.40, but the bid-ask spread was $13.50-$13.70, so I marked this position up and valued it at $13.50. (These have been spectacular investments for us, by the way. I purchased the Home Depot and McDonald’s calls for $6.40 and $5.70, respectively, and they closed last Friday at $16.40 and $17.10, up 156% and 200%.) Restricted Stock The initial EVCI stock that I purchased directly from the company was restricted, meaning that I could not sell it until the company filed a registration statement with the SEC and the SEC approved it (which took place in December). While the stock was restricted, I valued it at a 10% discount to the market price. Warrants As part of the same EVCI stock purchase, I also received warrants: five-year options to buy the stock with a strike price equal to the purchase price of the stock. Like any options, these warrants have both time value and in-the-money value, but to be conservative I have assigned no time value whatsoever to the warrants. Using the actual numbers, I purchased the stock at $2.12 per share, which is also the strike price of the warrants. It closed on Friday at $8.50, so each warrant is valued at $6.38 ($8.50 - $2.12). Tilson Offshore Fund The Tilson Offshore Fund, Ltd. launched on December 1, 2002 and has grown steadily to $5 million under management. The fund has 24 investors, based both in the U.S. (investing via IRA accounts) and overseas. I manage the two funds similarly, though the offshore fund has quite a bit more cash currently due to new investors.

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Because the offshore fund has many more slots available (both funds are limited to 99 U.S. investors), it has a lower investment minimum for the time being of $200,000. Report on Tilson Capital Partners Tilson Capital Partners currently has $40 million under management: $35 million in the Tilson Growth Fund and the balance in the Tilson Offshore Fund. This is up more than 50% from the $26 million under management at the beginning of last year, as new investors continue to join the funds and many current investors have added to their accounts. As assets have grown, I have invested in additional analytical capacity. Most importantly, I want to thank Damien Smith, who does a spectacular job for us two days per week researching new investment ideas. In addition, another investment manager and I hired a number of summer interns, all of whom I want to acknowledge for their outstanding work: Arnaud Ajdler, Charles Kornblith, Rimmy Malhotra, Stefaan Marien and Chris Woolford. Conclusion Thank you for your continued confidence in me and the fund. As I’m sure you’re aware, nearly my entire net worth is invested in the fund (along with substantial investments from many close friends and family members), so we are in this together and I am fully committed to generating superior long-term returns for all of us. As always, I welcome your comments so please don’t hesitate to call me at (212) 348-0569. Sincerely yours, Whitney Tilson

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Index of Appendices

Appendix A: Investment Principles Page 13

Appendix B: Email From a Reader on Investor Behavior Page 14

Appendix C: Excerpt from 2003 Baupost Annual Letter on Cash Page 16

Appendix D: Writings About the Fund’s Seven Largest Long Positions

- Hallwood Realty Partners Page 18

- McDonald’s Page 19

- CKE Restaurants Page 22

- Puts on the Nasdaq 100 and Semiconductor Holders Trust Page 29

- Berkshire Hathaway Page 31

- Cutter & Buck Page 31

- EVCI Career Colleges Page 34

Appendix E: Writings About the Fund’s Other Holdings

- Farmer Mac (short) Page 39

- Boston Communications Group (short) Page 41

- Yum! Brands Page 43

- Office Depot Page 43

- Imperial Parking Page 44

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Appendix A

Investment Principles

1) I manage the fund as if it contained only my own money. That’s not too far off, as the majority of my personal net worth is in the fund and, in total, close family members and I account for a substantial fraction of the fund’s assets.

2) I seek to invest in high-quality businesses that I understand well at extremely attractive prices

-- generally at least a 50% discount to intrinsic value. 3) I prefer to invest with a long-term horizon (at least three years), which keeps turnover,

trading costs, and taxes low. I will, however, invest with a shorter horizon if I feel that the situation is attractive enough.

4) I don’t believe in diluting my best ideas with lesser ones, so the fund is concentrated in

approximately 20 stocks. Typically, the top five positions account for 50% of its invested assets, and the top 10, 80%. I consider the fund properly diversified, however. Currently, the top five investments (counting the QQQ and SMH puts as one investment) are 40% of total assets and 55% of invested assets, and the top 10 are 56% of total assets and 77% of invested assets.

5) I rarely, if ever, use leverage. 6) I pay little attention to the short-term gyrations of the market, other than to take advantage of

occasions when the stocks of companies I own or would like to own become significantly undervalued, in which case, I buy. Conversely, periods of overvaluation are opportunities to sell.

7) I neither take comfort from standing with the crowd nor pride in standing alone. Though I

tend to be a contrarian, that’s simply because I’ve found that the best opportunities lie in carefully buying high-quality companies that have fallen out of favor, whereas the greatest risks generally lie in buying the most popular companies in the hottest sectors.

8) I do not believe in market timing, so as long as I can find even a few highly attractive

investment opportunities, I anticipate that the fund will typically be fully or nearly fully invested. However, I am never in a hurry to invest the fund’s cash, and am willing to wait patiently until I find an opportunity so wonderful that I am trembling with greed (to borrow the title of one of my columns).

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Appendix B

Email From a Reader on Investor Behavior

One of my readers (who’s on the board of a company all value investors admire greatly -- I won’t say which to protect his identity) sent me this explanation of current investor behavior. I’m familiar with the pigeon experiment, but hadn’t made the connection he made. I think he’s exactly right:

Although it may run a little long, I do have a thought to share with respect to your January 4, 2004 piece, “A Scary Time for Stocks”. You write, “It’s mind boggling that so many investors are piling back into the same sectors that crushed them only a short time ago, like moths drawn to a flame.” Your observation made me think of classic behavioral research of the 50’s, which employed rats or pigeons to determine how thinking creatures react to certain situations. One such research project, “Pigeons at a Feeding Bar,” may offer some insight into this “moth-like” tendency of investors to return again and again to the same bad situation. In one stage of the research project, pigeons are first acclimated to a set pattern of food rewards, in which the pigeon “earns” his kernels by pecking a feeding bar until a unit of food is delivered (for example, the pattern might be for one kernel after every ten strikes of the bar). Subsequent to this particular pattern being established, food delivery is terminated altogether, allowing researchers to tabulate how long a pigeon will continue to hit the feeding bar before it realizes it has become fruitless to do so. The research revealed that pigeons are, as a group, remarkably consistent in the time which elapses until they realize that a formerly productive pattern has been replaced by a new, fruitless one. Once pigeons rationally discern the true pattern, they uniformly abandon the process in a predictable and timely manner. But what happens if no true pattern of reward ever exists in the first place? For example, what happens if instead of an established pattern of rewards, the feeding bar reward sequence is purely arbitrary, i.e. a random number table is used to set reward intervals? Under this scenario, the poor pigeons encounter a mind-spinning quandary: Although they see there are alluring rewards to be had in the system, they are unable to grasp how those rewards can be consistently earned. The amazing result: In random number versions of this experiment, even after the food delivery has been terminated altogether, pigeons return again and again, relentlessly hitting the bar until finally they drop from physical exhaustion. What relevance do pigeon studies of the 1950’s have to Wall Street behavior in 2004? Well, at the risk of overdrawing animal behavior to human behavior, investors repeatedly returning “to the flame” sure looks a lot like the behavior of lab pigeons in the second version of the experiment. And the reason appears to be the same: Both the investors and the pigeons are mesmerized by the tasty rewards they believe lie within the system, and both are similarly unable to divine a recognizable pattern as to how such rewards are “earned” at the “feeding bar”.

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Should investors’ inability to grasp a recognizable pattern really surprise us? Investors have watched in bewilderment as an entire investment hierarchy has thrown out basic accounting conventions and valuation metrics which have been in effect for nearly a century; they have seen initial public offerings soar to the stratosphere for companies with no comprehensible business model, no cash flow, and sometimes, even no revenue; and they continue to see CEO’s drive their companies into the ground while nevertheless receiving tens or hundreds of millions of dollars of stock options. Is it any wonder why investors are unable to identify a recognizable, dependable pattern as to how rewards are to be “earned” in this system? Researchers learned that pigeons, faced with alluring rewards but without recognized patterns as to how they are earned, essentially go mad, incessantly returning to “hit the bar” until they physically collapse. Sadly, in environments such as market bubbles, it seems this same stimulus-response mechanism can apply to human beings. Just as is the case with slot machines, lotteries and other forms of unskilled gambling, when investment returns take on the character of being arbitrary, unearned or random, human hope springs eternal – rendering many “investors” unable to resist the “feeding” bar. Can anything be done to stop this recurring insanity? As the lab pigeons showed us, the only real antidote for irrational investor behavior, is “rationality”, i.e., the ability to truly understand what is going on. In other words, the anecdote for “market bubbles” is rational pattern recognition, recognizing that the “valuations” of the securities they are snapping up have no basis in future earning power or any other objective economic measure, but instead have a basis in grossly unrealistic claims, promotions, hopes, and dreams. Is there any hope that the “irrational exuberance” bemoaned Alan Greenspan in December of 1996 will evolve into a saner set of investor behaviors? I’m not holding my breath. Human greed and wishful thinking, time tested as they are, suggest that most human investors will never be anything but “pigeons”.

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Appendix C Excerpt from 2003 Baupost Annual Letter on Cash Holding Cash in the Absence of Compelling Opportunity (This section reiterates and expands on ideas previously discussed in our June 30, 2003 letter.) Earlier we explained that cash and cash equivalents comprised approximately 57% of partnership assets at year-end. Perhaps some of you will soon be asking why you are paying us a management fee to hold so much cash. Let us preempt you by saying that we are not. You are paying us to decide when to hold onto cash and when to invest it, to determine when the expected return from a prospective investment justifies the risk involved and when it does not. In a short-term, relative-performance-oriented world, earning next to nothing on cash creates a compulsion to invest, even when all investment alternatives appear overvalued. Choosing their position, most investors prefer to hope that something expensive becomes even more expensive, especially when it has recently been doing exactly that. Holding cash, which they find barely tolerable when markets are falling, is anathema when markets are rising. The Japanese bond market is an extreme case. With Japanese overnight deposits paying literally nothing, investors moved out on the yield curve to pick up return. This past June, they accepted an annual yield of only 0.44% on the Japanese ten-year bond. By October, this bond had fallen from above par to below 90, yielding over 1.5%. Importantly, an investor lost (on a market to market basis) in four months more than twice the total return they would have earned if they had held onto that ludicrously mispriced bond for an entire decade. The summertime pricing of this bond can only be explained by the pressure of zero yield on cash, the globally despised investment alternative. Today's investors remain almost singlemindedly focused on relative performance, their results compared to the market's. Their behavior is understandable in an environment where, for most professional investors, short-term underperformance is often rewarded with client redemptions. This is especially the case since "long-term oriented" looks a lot like "being wrong" until proven otherwise. Since no one can know if it is your long-term orientation or your incompetence that is causing poor performance results, it is hard for disappointed clients to stay the course. Career risk for individual managers adds to the pressure. To avoid underperforming in a rising market, many professional investors have a mandate to remain fully invested. After three years of a grueling bear market, one might have thought investors would have developed an appreciation for an absolute return focus consistent with capital preservation, but old habits and ingrained tendencies die hard. If keeping up with an overvalued and rising market is your goal, cash is an unacceptable anchor to drag around. We have always believed that successful investing involved recognizing and correctly choosing among a series of tradeoffs. Cash (in the form of short-term U.S. treasury bills) is a way of safely doing nothing until compelling investment opportunity arises. It offers positive albeit very limited yield, complete safety of principal, and full and instant liquidity. A low positive return with virtually non-existent risk is not a bad proposition in the absence of better alternatives. Our view is that investors should choose to hold cash in the absence of compelling opportunity, not

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because they are making a top-down asset allocation into cash, but based on the result of a bottom-up search for bargains. Baupost will make the decision to hold cash, even if it becomes a very large percentage of partnership assets, until better opportunities arise. Every investment must be compared to the alternative of holding cash. If an investment is sufficiently better than cash--offering a more than adequate return for the risk involved--then it should be made. Note that the investment is made not because cash is bad, but because the investment is good. Exiting cash for any other reason involves dangerous thinking and greatly heightened risk. Many investors compare the current yield on cash (lousy) to the current yield on longer-term bonds or the dividend yield (or historic long-term expected total return) from stocks. Cash nearly always loses in this comparison, and investors feel quantitatively justified in doing what career and client pressures cause them to do anyway. It makes no difference how overvalued these alternatives may be in an absolute case. Investors' immediate problem is being too short-term oriented. One of the biggest challenges in investing is that the opportunity set available today is not the complete opportunity set that should be considered. Limiting your investment opportunity set to only the one immediately at hand would be like being required to choose your spouse from among the students you met in your high school homeroom. Indeed, for almost any time horizon, the opportunity set of tomorrow is a legitimate competitor for today's investment dollars. It is hard, perhaps impossible, to accurately predict the volume and attractiveness of future opportunities; but it would be foolish to ignore them as if they will not exist. It is one thing for a value investor to know that in the absence of opportunity you should hold cash. It is quite another to actually do it. It is particularly difficult to sit on your hands when others are probably speculating. We find that it is not a temptation to speculate that pulls at you, so much as a desire to be productive. Doing nothing is doing something, we have argued again and again; doing nothing means prospecting for potential investments and rejecting those that fail to meet one's criteria. But emotionally, doing nothing seems exactly like doing nothing; it feels uncomfortable, unproductive, unimaginative, uninspired and, probably for a while, underperforming. One's internal strains can be compounded by external pressures from clients, brokers and peers. If you want to know what it is like to truly stand alone, try holding a lot of cash. No one does it. No one knows anyone who does it. No one can readily comprehend why anyone would do it. Also, believing that better opportunities will arise in the future than exist today does not ensure that they will. Who can tell what investors will be willing to pay for securities tomorrow? Waiting for bargains to emerge may seem like a better strategy than overpaying for securities today, but tomorrow's valuations may still be higher still. Standing apart from the fully invested crowd for significant periods of time can be a grueling, humbling and even demoralizing experience.

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Appendix D Writings About the Fund’s Seven Largest Long Positions (Listed in descending order of size)

1) Hallwood Realty Partners From September 2002 letter I have steadily purchased the shares of an obscure real estate company for more than 18 months because its stock has been trading at a substantial discount to its intrinsic value, due in large part to dishonest management. However, an activist shareholder has waged a long legal campaign to effectively remove management and gain control of the company, which would undoubtedly unleash tremendous shareholder value. I have been following the case closely and have twice attended closing courtroom arguments, so I was not surprised when the activist investor recently won a huge legal victory. Before the news of this victory had spread, I increased our position significantly. Almost immediately thereafter the stock rose by more than 50%. It is now the fund’s largest position. Given the recent legal victory, my estimation of the company’s intrinsic value has risen -- and the timetable for realizing that value has become clearer -- so I still believe the stock is significantly undervalued and have no plans to sell it. From January 2003 letter Most of January’s losses were due to an 18.5% decline in the stock of the real estate company that was our largest position. The drop was triggered by an announcement by an investment fund that is the largest outside shareholder that it is winding down its operations and has hired an investment bank to sell its stake in the company. Some investors apparently viewed these developments as bad news and sold in a panic -- only a few motivated sellers can trigger a plunge in such an illiquid stock -- but my view is precisely the opposite. There are two catalysts that will unleash the value of this stock, which is trading at roughly half of its conservatively calculated intrinsic value: a victory in the shareholder lawsuit against management or a settlement of the litigation. I believe that both of these outcomes are more likely if another company becomes the largest outside shareholder. The most likely bidders, in my opinion, are large real estate enterprises that seek to own the entire company. Given this desire, the most likely strategy for a bidder to pursue, I believe, is to reach a legal settlement with management and then make an offer to buy all of the shares (including ours, of course), not just the block for sale. I don’t know exactly what price the company might fetch -- to some extent, that will depend on the terms of the settlement with management -- but my calculations show an intrinsic value of $130 - $165/share (the stock is today under $70). The investment bankers appear to share my confidence because they agreed to a fee arrangement whereby they will receive a flat fee plus “an incentive fee of 10% of the value of aggregate consideration in excess of $100.” I don’t think the investment bankers would have accepted the $100 benchmark unless they were very confident they could sell the block for substantially more than this amount.

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From July 2003 letter The main driver of last month’s performance was a 27% increase in our largest position, Hallwood Realty Partners (HRY), the real estate limited partnership I’ve discussed in previous letters. Carl Icahn bid $100 per share for the company earlier this year and last month upped his bid to $132.50 -- and said he might be willing to bid more, subject to further due diligence. The stock closed today at $130.50. I have no interest in selling at this price, as I think there is still significant upside and little downside. 2) McDonald’s I published this article last October, which captures my thinking on McDonald’s: CEO of the Year: McDonald’s Cantalupo

Whitney Tilson nominates McDonald’s Jim Cantalupo as CEO of the Year for turning around a fast-food giant that skeptics had written off as dead. How did Cantalupo achieve the near-impossible? He adopted the right strategy and acted urgently to carry it out. By Whitney Tilson Published on the Motley Fool web site, 10/17/03 (www.fool.com/news/commentary/2003/commentary031017wt.htm) Longtime McDonald’s (NYSE: MCD) executive Jim Cantalupo came out of retirement last December to try to turn around a sagging business that appeared to be -- and in many ways was -- but a shadow of its glorious former self. By engineering a remarkable turnaround in an extremely short period of time, Cantalupo gets my vote for CEO of the year. With McDonald’s currently doing very well -- last week, it reported that total systemwide sales increased 11.1% in September (6.0% in constant currencies) and U.S. same-store comps were up a fabulous 10.0% -- it’s easy to forget how bad the company’s results were, and the contempt hurled its way by investors and the media. Let me refresh your memory. When McDonald’s chose to hire the insider Cantalupo, it was viewed as proof that the company’s bureaucratic, inbred culture would continue. A Reuters article at the time summarized the conventional wisdom:

Jim Cantalupo is taking the reins of the world’s largest restaurant company as its markets mature, competition balloons and consumers become more selective in what they eat...Investors have come to see McDonald’s as a slow-moving monolith facing market saturation, increased competition, changing tastes in the U.S. fast-food market -- its largest with some 13,000 restaurants -- and a host of problems overseas where troubled economies hamper growth...The clock is ticking for Cantalupo, who steps into the hot seat in the wake of seven earnings declines in the past eight quarters.

TheStreet.com’s (Nasdaq: TSCM) Jim Cramer was even more blunt:

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There can be no fixing of McDonald’s because there is no McDonald’s. The company itself can’t control its franchises. The franchises used to be the source of so much growth and so much profit, but now the franchises can’t be reined in and they can’t be fixed. McDonald’s has become a rogue operation...What can McDonald’s do to save itself? Nothing at this point, nothing.

Nor were investors mollified by Cantalupo’s strategy to turn the company around: On the day of his first conference call with investors in January, the stock fell 5% as one analyst wrote, “This does not seem like a new era from McDonald’s, but instead a continuation of the (disappointing) recent past.” Shortly thereafter, Cramer wrote in another article, “McDonald’s still doesn’t get it...This ‘change’ is just the same old evolution; nothing revolutionary here. In fact, the company is still in massive denial about what is happening. It doesn’t recognize that there is a crisis...The orchard is rotten.” Yet today, less than 10 months later, sales have surged, the stock is up sharply, and the company’s worst critics are singing a different tune altogether. Last week, Cramer wrote: “I thought I would never write this but the turn is palpable. The company has really gotten its act together...Who knows, maybe you really can change these big companies with change at the top. That’s certainly what happened here.” So what exactly did Cantalupo do to fix McDonald’s? Two things: He adopted the right strategy and -- this is where he really earns kudos -- acted urgently to carry it out. Strategy As I discussed in my last column, like many long-standing, high-growth companies, McDonald’s began to saturate its core markets yet failed to recognize this and slow its growth. Consequently, new restaurants performed poorly and cannibalized established ones, margins and returns on capital fell, and the stock followed. McDonald’s compounded this mistake by engaging in an insane price war with Burger King and failing to take care of the basics that made the company great: tasty food, clean restaurants, quick service, and consistency across the chain. In addition, it pursued new restaurant concepts that proved to be little more than expensive distractions. Cantalupo deserves credit for recognizing the problems and taking appropriate actions: scaling back growth and slashing capital expenditures, winding down the price war, putting non-core concepts on the block, reemphasizing the basics, etc. But I’m not hailing Cantalupo as CEO of the Year for adopting the right strategy -- the basics were obvious to nearly everyone. The real challenge was actually carrying out the strategy. Execution How many times have you seen a CEO announce a new strategy that appears to be exactly right for turning around a declining business, but then nothing happens and the company continues to fade? I see it happen all the time, generally for three reasons: The company’s problems are so intractable that even the best-laid plans can’t save it; the CEO is just telling the investment community what it wants to hear but isn’t really committed to change; and/or the culture is so ingrained and the bureaucracy so entrenched that the company successfully resists the CEO’s attempts to change it.

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When I was evaluating McDonald’s before purchasing the stock shortly after Cantalupo took over, there was little doubt in my mind that the company remained one of the world’s great businesses. It had a powerful brand, high margins, huge cash flows, and a worldwide presence. Despite horrible mismanagement, McDonald’s was consistently pounding out nearly $3 billion of operating cash flow. In short, it was a classic case of what Warren Buffett once spoke about: “Invest in a company any idiot can run because sooner or later any idiot is going to run it.” Nor did I doubt Cantalupo’s sincerity. The key for me boiled down to the following question: Could Cantalupo overcome the challenges posed by McDonald’s infamous bureaucracy and angry franchisees? Interview with a franchisee I stumbled upon the answer almost by accident, when a friend introduced me to a McDonald’s franchisee. To summarize his comments, he couldn’t heap enough scorn on the company’s prior management and its bureaucracy but, conversely, couldn’t praise Cantalupo enough. Here are some of the highlights of what he told me:

• Franchisees had become more and more disgruntled, in part due to the perception that the company had stopped listening to them. Cantalupo was taking rapid action to address this issue, by holding frequent urgent meetings with franchisees nationwide, often bypassing the corporate bureaucracy.

• The company had been cannibalizing itself. When I asked which of his competitors

worried him most, he snorted and said, “The only competition I worry about is McDonald’s. I have one store that competes with Burger King, Wendy’s (NYSE: WEN), and Popeye’s on adjacent corners and I outsell all of them put together. But I get hurt if McDonald’s opens another restaurant nearby -- it can cost me $500,000 in annual sales.” He said that Cantalupo understood this problem and was slowing down new store growth.

• McDonald’s “Made for You” system (in which food was cooked to order rather

than made in advance and put in bins) was a disaster because it slowed service. The key, the franchisee argued, was to reinstall bins but only use them during peak times when the product is moving so quickly that the customer will get a fresh, hot burger even if it’s not made to order (this would, of course, cut service time dramatically). He believed that the company would soon allow him to proceed with this plan.

• In its reckless pursuit of growth, the company had abandoned its rigorous “full field”

evaluation standards of franchisees, so cleanliness, quality, and consistency were slipping. He said Cantalupo was restoring “full field” evaluations across the system and removing bad franchisees.

Overall, he was extremely optimistic about the sensible, rapid, forceful changes Cantalupo was making and concluded our conversation by saying, “If I had $5 million right now, I’d invest every penny in McDonald’s stock.” With this unique window on the inner workings of the company, I became more convinced than ever that the stock was a steal and nearly doubled my position shortly thereafter.

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A turnaround triumph Turning around a large global company that has been plagued by years of mismanagement and an inbred bureaucracy is an enormous challenge and generally takes years to accomplish -- witness Lou Gerstner at IBM (NYSE: IBM) in the mid-1990s. I was therefore expecting that it would take at least one to two years and possibly longer before the impact of Cantalupo’s changes would be felt. Yet in less than a year McDonald’s has made tremendous progress and appears to have built real momentum. That’s not to say the final story has been written here, regarding either the company or Cantalupo. The turnaround is still young and it’s possible that McDonald’s is simply benefiting from easy comps and two hit new products (salads and McGriddles), which were developed under previous management. I think, however, that a far more robust turnaround is under way, and the company and stock will provide at least another year or two of pleasant surprises -- which is why I have yet to sell any of my shares even after they’ve nearly doubled off their lows. Whitney Tilson is a longtime guest columnist for The Motley Fool. He owned shares of McDonald’s at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. The Motley Fool is investors writing for investors. 3) CKE Restaurants [I assisted my friend David Eigen of Lego Capital in drafting this write-up, which he posted on the ValueInvestorsClub.com web site on 12/23/03.] SUMMARY Anchored by its cash cow, the Carl’s Jr. restaurant brand, CKE Restaurants [NYSE: CKR] is in the middle of a dramatic turnaround of its chronically underperforming Hardee’s restaurant chain. Repeated positive same store sales and average unit volumes that are the highest in over four years have triggered a doubling of the stock from its lows earlier this year; however, I believe the Company is just hitting its stride and free cash flow is just starting to grow. If current trends continue, the stock could at least double from here. BACKGROUND CKE Restaurants is the owner of the Carl’s Jr., Hardee’s, La Salsa Fresh Mexican Grill and Green Burrito restaurant chains – with over 3,200 total restaurants. Carl’s (founded 1956) and Hardee’s (1960) are quick-service restaurant chains primarily focused on burgers, chicken, fries and assorted fast food items. Both restaurants are a hybrid of fast-casual and quick-service and thus provide a higher level of service and higher price-points than McDonald’s or Burger King. La Salsa is a Tex-Mex-style chain with 100 units based primarily in strip centers and other non-

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freestanding locations; and Green Burrito has a similar style, but is primarily co-branded within Carl’s Jr. stores. UNIT COUNT (AS OF 11/3/03) Carl’s Jr. Hardee’s La Salsa Other Total Company - Operated 440 721 60 4 1,225 Franchised 563 1,413 40 17 2,033 Total 1,003 2,134 100 21 3,258 CKE’s current CEO took over from a management team that had issued a tremendous amount of debt to acquire the failing Hardee’s chain and hundreds of its franchised restaurants. Over the past three years, current management has sold company-owned Hardee’s and Carl’s restaurants to franchisees, closed underperforming units, turned around the Hardee’s chain, and reduced debt [from over $700 million to under $400 million] by using the proceeds from asset sales and operating free cash flow. I believe the stock is a great investment for several reasons:

• The stock trades at an EV/EBITDA ratio of 6.9X, a number that I think will go down dramatically over the next few years;

• The stock trades at less than 7X my projected free cash flow for next year – a number that I think may prove very conservative;

• CKE’s assets (land and buildings in prime locations) provide a significant margin of safety should the Hardee’s chain stumble;

• Carl’s Jr., CKE’s cash cow business, is a very successful chain with steady unit and same-store-sales growth, AUVs of about $1.1 million (over $1.3m when co-branded with Green Burrito), and high restaurant level margins of over 21%;

• Hardee’s new Thickburger menu appears to be a hit. I believe that current trends will continue; with the high operating leverage, incremental sales will drive rapid free cash flow growth;

• Management has a track record of over-delivering on its promises; • Many things can go right that can boost free cash flow, including: lower beef and

occupancy costs, continued product introductions, continued savvy advertising, growing recognition of Hardee’s new Thickburger menu, and more co-brand restaurants within Carl’s Jr. chain (and perhaps within the Hardee’s chain as well);

• The target market for both chains, 18-35 year old working males. THE BRANDS CARL’S JR. Carl’s Jr. restaurants are located predominantly in the Western United States. They focus on burgers, chicken and a handful of premium offerings. About 20% of Carl’s Jr. restaurants are dual-branded with Green Burrito, and the company is expanding co-branding where appropriate. Sales come mainly from lunch and dinner (for company-operated restaurants, 88% of revenues come from the lunch and dinner segments).

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HARDEE’S Hardee’s restaurants are located predominantly in the Southeastern and Midwestern United States – offering quality food in generous portions at moderate prices. Historically a breakfast place (44% of revenues), Hardee’s restructured its lunch and dinner menu by cutting over 40 items and refocusing on large Angus beef Thickburgers and chicken sandwiches. (More on “The Hardee’s Revolution” is below.) LA SALSA The company acquired La Salsa on March 1, 2002 through the acquisition of the Santa Barbara Restaurant Group, Inc., or SBRG. The 100 restaurants are located mostly in California, and offer quality, fast-casual traditional Mexican food. While the company has focused primarily on turning around Hardee’s, it has also been tweaking the La Salsa menu, its brand and the overall value proposition; management is now preparing it to grow – primarily through franchising. THE HARDEE’S REVOLUTION The turnaround of Hardee’s has occurred in two phases. During the first phase started several years ago, the Company converted every Hardee’s to a new Star Hardee’s format; this included new signage, char-broilers (so burgers would be flame grilled, not fried), and a significantly spruced up physical plant that is bright and airy, similar in look and feel to Carl’s. In addition, the company instituted a new QSC (Quality, Service and Cleanliness) program, which it continues to push. The second phase grew out of two revelations generated by its success with the Carl’s Jr. concept: first, it is impossible and unprofitable to compete with McDonalds and Burger King on price – especially while keeping quality. Second, outside of the West Coast where both Carl’s Jr. and the privately held In N’ Out Burger chain both compete, there was a gaping hole in the market for a thick, high-quality burger in the quick service restaurant (QSR) sector. For meat lovers – a large portion of whom are working males in the 18-35 year age demographic – there was simply no provider of such a quality offering in Hardee’s markets in the Mid-West and Southeast. Quite simply, there was a significant void between the typical QSR burger offering, including Wendy’s, and the Friday’s and Applebee’s fast casual offering. After extensive research and test marketing, CKE made a bold bet: while they could depend to some degree on the steady cash flows from their successful breakfast menu, they eliminated 40 items from the lunch and dinner menu, which had become a hodgepodge of junk food. The new menu has been built around the “Thickburgers,” which are Angus beef and come in 1/3, ½ and 2/3 pound sizes with all the “fixins,” including fresh tomato, lettuce, etc. The Company launched a test market with over 80 restaurants in the fall of 2002; the initial success spurred a quick vote in early 2003 by franchisees to agree to roll out the new menu to all restaurants within the next year. At this point, 100% of company-owned and 97% of franchised restaurants have the new menu. In summary, in repositioning Hardee’s and starting the “Revolution,” the company has done the following:

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• Renovated and re-branded the Hardee’s stores (completed at all company-owned stores and nearly all franchised units);

• Drastically changed the lunch and dinner menu (done at all company-owned stores and at 97% of franchised restaurants);

• Sold numerous restaurants to franchisees; • Closed underperforming restaurants; • Pared debt from well over $700mm two years ago to under $400mm today, including

lease obligations; • Re-focused Hardee’s on food quality, speed and accuracy of service, as well as

cleanliness and employee attitude; • Launched highly successful Hardee’s commercials.

The Hardee’s menu changes or “Revolution” is the crux of this investment thesis. It repositioned the restaurant to bring in people with regular paychecks – young males aged 18-35 – vs. teenagers and the elderly. It is focused on quality and value instead of cheap prices – a battle Hardee’s was losing (and will always lose) to McDonalds and Burger King. In addition, Hardee’s now targets the same demographic as Carl’s Jr. – a demographic that management understands well and knows how to target. Overall, the Hardee’s Revolution is a truly brilliant move that is already paying off in a big way. Take a look at Hardee’s same store sales since last November, which are the highest since 1999: Hardee’s YTD Period 11 Period 10 Period 9 Period 8 FY 2004 +1.3% +6.4% +5.7% +7.7% +6.5% FY 2003 -1.6% -5.6% -2.8% -3.6% -4.1% SCUTTLEBUTT RESEARCH Back in late January and again in the late spring, a fellow investor and I called over 30 Hardee’s restaurants in six markets, visited two in Omaha, NE and Daytona, FL and spoke with one of their largest franchisees, who owns over 100 restaurants in several markets from Illinois down to Alabama. We heard a very consistent message -- that the converted restaurants:

• Experience a brief mild sales decline post-revolution as, for example, patrons who came in for fried chicken discover that Hardee’s doesn’t serve it anymore. Since the average price points are higher, Hardee’s lost many of its most price-sensitive (and least profitable) customers;

• Get very positive feedback and word-of-mouth advertising regarding the new menu; • Clearly benefit[ed] from a carefully planned marketing campaign that include[d]

couponing as well as television advertising; • Incur modest training costs, hurting margins in the short-term; • Benefit from a better overall work environment – morale is higher because employees are

proud of the food they’re serving, and there’s less menu complexity, resulting in less chaos, fewer errors and less waste;

• Smell much better. For example, customers no longer smell fried chicken as they bite into their burgers, nor do they smell “fast food” on their clothes as they walk out;

• Have significantly higher restaurant level margins – though high beef prices and short-term labor training costs are currently offsetting this benefit; and

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• In some areas have 30-40% increases in same-store sales (SSS). CURRENT STRATEGY Hardee’s main focus is to build on its current momentum by:

• Increasing the brand profile as the “premium burger destination for the ‘young hungry guy’” – through creative in-store and TV-based advertising;

• Reducing discounting and couponing associated with the new menu; • Introducing new burger-based combinations – chili burgers, bacon cheeseburgers, bun-

free lettuce wrapped burgers [for Atkins dieters], etc. – that will continue to draw attention. In a recent press release, CKE boasted that a Hardee’s manager in the midwest lost 40 pounds in a few months by eating a 2/3 pound Thickburger with bacon every day by taking off the bun!; and

• Continuing to focus on restaurant fundamentals ( “QSC”). NEW PRODUCTS & ADVERTISING CKE has done a remarkable job developing new products and advertising them cleverly. Regarding the former, I have never seen a company focus so well on one thing (burgers), yet present it in so many different ways – ways that keep same store comps increasing on a regular basis. In the last few months at Carl’s Jr. alone, the company introduced the Six Dollar Burger (for $3.95), Guacamole Bacon Six Dollar Burger, Western Bacon Six Dollar Burger, Bacon Cheese Six Dollar Burger and Chili Cheese Six Dollar Burger. The latest innovation, wrapping the Hardee’s Thickburger in lettuce rather than a bun, targets the millions of Atkins dieters. The company has won awards for product innovation and I suspect this will continue. The advertising is outstanding as well, focusing on CKE’s target customer: the hungry working class guy who loves a great burger and is willing and able to pay $3 to $5 for it. CKE faced a tremendous challenge with Hardee’s awful image, and did an unbelievable job re-launching the brand. The Thickburger ads were priceless as they went through three stages – from self-deprecation to outright promotion. In the latest promotion for Carl’s Jr., the company partnered with Hugh Hefner to introduce five new types of Six Dollar Burgers. In it, Hefner talks about his love of variety as he is flanked by a bunch of Playboy Bunnies. MANAGEMENT CKR has an incredibly competent senior management team. Andy Puzder, the president and CEO, has been involved with CKR for almost 20 years and combines a methodical and patient nature with a willingness to make big decisions. He has delivered on every promise he has made and, as discussed above, has shown an unusual flair for creative products and advertising. He has also been an intelligent capital allocator.

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RESTAURANT METRICS The following table captures the key operating metrics of Carl’s and Hardee’s. One can easily see the vast difference -- and the benefit to CKE should Hardee’s metrics improve to anything close to Carl’s Jr’s. General Information Carl’s Jr. Hardee’s Systemwide Sales (FY 2003) $1.1 billion $1.8 billion Co. Owned Sales (FY 2003) $507 million $562 million YTD Co. Owned Sales (40 wks. FY04) $401 million $446 million Q3 Co. Owned Sales (12 wks. FY04) $121M (+6.3%) $140M (+6%) Average Unit Volumes (AUV) $1.16M ($1.3M with G.B.) $761K Average Guest Check $5.53 (+7.6% YOY) $4.38 (+9%) Operating Costs Breakdown et al. Food and Packaging 28.5% 31.2% Restaurant Level Margin 21.1% 11.9% (+50

bps over Q2’04) Net Franchising Income $17.4 million $25.1 million Net Change in Co. Stores vs. YE** 03 1 (10) Net Change in Franch. Stores vs. YE 03 21 (111) Net Diff. in Co. Sales vs. Q3-03** $7.1M (+6.3%) $7.9M (+6.0%) Net Change in Franch. Fees vs. Q3-03* $5.6M (+13.9%) $1.1M (+6.9%) * Franchise fees are based on a % of revenue equivalent to 3.6% for Hardee’s and 3.7% for Carl’s Jr. ** YE = year-end; Q3-03 = 3rd Quarter of Fiscal 2003. [Fiscal 2003 ended on January 31, 2003.] FINANCIAL METRICS Balance Sheet (as of 11/3/03) Cash $25 million Bank Debt $0 drawn ($150m 3-yr. revolving credit

facility, $25m term loan) Sr. Subordinated Notes $200 million – 9.125% Convertible Debt-new $105 million – new convert debt at 4% (convert

at $8.89/share) Convertible Debt-old $22 million – remaining on old convert offering Capitalized Leases $67 million Net Debt $370 million Market Cap $371 million – 60.5m shares diluted pre convert

at $6.13 Enterprise Value $741 million Other Assets Land Value at Book $150 million Net PP&E $553 million NOL’s - Federal $83.4 million NOL’s – State $71.5 million Current Income and Cash Flow Related Numbers Restaurants have a great deal of operating leverage due to significant fixed costs such as land, building and equipment acquisition costs and maintenance. In addition, a substantial fraction of

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labor and general occupancy costs are also fixed. The last major cost, food, is largely variable (“food and packaging” equaled about 30% of CKE’s company-operated restaurant revenues last quarter). Thus, over 60% of any same store sales increase drops straight to the (pre-tax) bottom line. First, look at the current business through the end of the 3rd quarter of fiscal 2004: TTM Ebitda = $107.7 million Net Debt / Ebitda = 3.4X EV / TTM Ebitda = 6.9X Ebitda coverage [over int. exp.] = 2.6X (107.7m/41.6m) EV / [TTM Ebitda – TTM Capex] = 19.2X (capex has declined

dramatically) While CKE’s stock may not appear to be particularly cheap at first glance, we must make certain assumptions going forward: First, we conservatively assume that neither chain has any net unit decline nor growth; second, we assume that Carl’s same store sales grow by 3% and Hardee’s same store sales grow by 5%. Third, we assume that food and packaging and marginal labor costs are 40% of sales (food and packaging are at 28.5% and 31.2% at Carl’s and Hardee’s respectively. (For both chains, these assumptions are at or below recent levels.) The result would be as follows: Annualized Q3 FY 2004 Ebitda = $109.9 million Carl’s Ebitda growth* + $9.3 million (add’l co. net of

$8.7m + fr. fees of $600k) Hardee’s Ebitda growth* + $18.5 million (add’l co. net of

16.8m + fr. fees of $1.7m) Next year’s projected Ebitda = $137.7 million % Ebitda growth = 25.3% * the Ebitda growth figures are based on a percent of annualized Q3 FY2004 co. sales and franchise royalty revenues respectively. This Ebitda should translate into $53.7 million of free cash flow, using the following assumptions: Ebitda = $137.7 million Subtract:Capex(assuming all maint.) = ($42.0) million (7% over

annualized Q3) Interest payments (estimated) = ($38.0) million Facility Action Charges–cash costs = ($3.0) million Cash Taxes (state and local) = ($1.0) million Free Cash Flow (FCF) = $53.7 million I think it’s reasonable to assume that CKE will use most of this cash flow to retire debt; thus, in one year, net debt could be down under $320 million and the EV (assuming today’s share price) should be approaching $690 million. Thus, future valuation metrics will be as follows: Future Net Debt/Future Ebitda = 2.3X Future EV/Future Ebitda = 5.0X Future EV/Future Ebitda–$42mm capex]= 7.2X Total Number of Fully Diluted Shares (pre-convert) = 60.5 million Free cash flow = $53.7 million

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Free Cash Flow per Share = $0.89 Current Stock Price = $6.13 (close as of 12.22.03) Multiple to expected FY 2005 (ending 1/31/05) = 6.9X UPSIDE POTENTIAL I believe that a number of factors could drive even better performance for CKE over time:

• Beef costs are at historically very high levels. If they return to more normal levels, Hardee’s and Carl’s would benefit quickly;

• Hardee’s SSS could increase at a faster rate and/or the company could start franchising again;

• Green Burrito could be added to Hardee’s, which would bring AUV’s up substantially; • La Salsa’s performance could improve and growth in franchises and associated royalties

would thus increase. RISKS

• Hardee’s Thickburger menu could prove to be a flash in the pan and/or competitors could roll out competing products that steal sales;

• The economy could worsen, driving customers to less expensive restaurant chains; • Beef costs may remain high or go even higher. Based on cattle numbers on farms, the

company estimates that prices should come down by summer 2004; • Insurance, electric and other occupancy costs may continue to rise; • Franchisee problems, especially at Hardee’s. In the latest 10Q, the company disclosed

that a franchisee owning 33 restaurants had filed for chapter 11 bankruptcy protection and had rejected the leases on 15 restaurants that the company had guaranteed. On the recent conference call Puzder stated that the problem stemmed from over-leverage by the franchisee and not from any problems with the store sales levels.

CATALYSTS 1. Continued success of the Hardee’s revolution: if same store sales continue as they have in the

last five periods, then Hardee’s Ebitda and free cash flow will grow dramatically, which would also likely drive multiple expansion;

2. Debt upgrade would lower company’s borrowing costs and thus increase earnings; 3. Buyback of the 9.125% debt and its refinancing at a lower cost of capital; 4. Continued pay-down of debt; 5. Growth at Carl’s and La Salsa. 4) Puts on the Nasdaq 100 (QQQ) and Semiconductor Holders Trust (SMH) Excerpt from Am I Early or Wrong?, 10/31/03 (www.fool.com/news/commentary/2003/commentary031031wt.htm) My concerns are twofold. First, I think there’s a strong possibility that the recent signs of recovery are driven by temporary factors, mainly booming consumer demand fueled by

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increasing debt, tax rebates, and the like. Second, with stocks priced for perfection, there’s an unattractive dynamic: If the economy continues to surge, stocks will likely be flat to up modestly, given that this scenario is already built into prices. But if there are economic setbacks, look out below! Techie bear I’m especially bearing on tech stocks, as the underlying fundamentals are poor, yet the valuations are extreme. Consider the following valuation comparison between the 30 companies in the Dow Jones Industrial Average and the 100 companies in the Nasdaq 100: Dow Nasdaq 100 P/E (trailing) 21.0 81.7 P/E (operating) 18.2 42.7 P/E (future) 18.4 37.8 P/CF 8.5 21.8 P/S 1.1 3.6 P/B 3.6 4.5 Dividend yield 2.2% 0.2% Notes: P/E: price to earnings ratio; P/CF: price to cash flow; P/S: price to sales; P/B: price to book Source: Merrill Lynch report by Chief U.S. Strategist Richard Bernstein, 10/27/03 Maybe such a valuation discrepancy could be justified if earnings in the tech sector (which accounts for 64% of the Nasdaq 100) were poised to soar, far exceeding estimates, and companies in the sector were of exceptionally high quality. But I don’t believe either of these statements is true. Regarding the latter, it should be obvious by now that tech stocks should trade at a discount to most other sectors given the tech sector’s hugely volatile earnings and short product life cycles. In the recent Barron’s article, Buffett wondered why leading tech companies traded at much higher valuations than top pharmaceutical companies when “drugs are a better business in the aggregate than technology.” Then Buffett answered his own question, quoting the legendary Ben Graham: “Companies with mystery are worth more than those without mystery.” But what about near-term fundamentals? Might earnings continue to soar in the tech sector, justifying today’s prices? Not likely says Fred Hickey, author of The High-Tech Strategist newsletter, which has been uncannily accurate for years (incidentally, it’s the only newsletter I subscribe to -- with the exception of Motley Fool Hidden Gems). Earlier this month, Hickey wrote:

In general, tech earnings will look good in Q3 thanks to the massive stimulus from the government (tax rebates, low interest rates, massive money supply growth, and huge government spending)... Component suppliers to the PC and cell phone manufacturers are booming thanks to optimistic sales forecasts and related inventory build activity... The result will be one of the greatest inventory overstockings of all time. The impact (bust) will not be felt until later in Q4 and in 2004.

Hickey is especially bearish on Intel’s (Nasdaq: INTC) prospects due to the impending rollout in scale of Advanced Micro Devices’s (NYSE: AMD) new 64-bit chips:

While supporters high-five themselves as Intel has been able to hold the line on ASPs and regain some market share during the lull leading up to the deluge of AMD64 shipments

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coming next year, they are completely missing the big picture. Intel’s position in the marketplace has never been more threatened.

Hickey concludes with a stark warning:

Tech stock investing is extraordinarily risky... Today’s crop of tech investors sees all of the potential rewards and none of the risks. They do not understand that today’s tech leaders are very vulnerable... Another comeuppance is in the offing, and this time I think it will culminate in a sharp crash. Investors believe they learned a lesson in the 2000-2002 collapse. They believe that if they sold at the first sign of trouble...they could have avoided the damage. This time, all the retail investors...and all the wise-guy hedge fund and mutual fund traders plan to sell and get out first. The problem will be finding buyers.

5) Berkshire Hathaway I haven’t written about Berkshire recently, but would refer you to the cover story in the August, 11, 2003 Barron’s entitled: “Warren Buffett’s Still-Golden Touch: The wizard of Omaha’s magic is alive and well. Amazingly, Berkshire Hathaway’s best days might still lie ahead.” It’s on the web at http://webreprints.djreprints.com/836640857069.html 6) Cutter & Buck From June 2003 letter In past columns and letters I’ve written about some of our fund’s largest holdings -- in many cases, household name companies -- so in this letter I’d like to introduce you to Cutter & Buck, a tiny company (market cap: $59 million) that is the #2 brand of golf clothing. (You may have seen the company’s logo recently on the shirt of Annika Sorenstam, the top-ranked women’s golfer, who recently attracted a great deal of attention by playing in a men’s PGA tour event.) The stock was our biggest winner during the quarter and in June, up 54% and 27%, respectively (and it’s up another 9% in July already), though it is only the 6th largest position in both the Tilson Growth Fund and Tilson Offshore Fund. The reason for focusing on this relatively small holding is that I played a role in the positive developments that triggered the recent increase in the stock price by leading -- and successfully resolving -- a class action lawsuit against the company. This was the first time I have ever been involved, either personally or professionally, in a lawsuit. But before I tell you about the litigation, allow me to give you some background. I invested in Cutter & Buck in January 2002 after doing extensive research on the golf industry, including attending its annual convention, meeting with management teams, and so forth. At the time, there was widespread distress across the entire industry due to excess capacity that built up during the boom years of the late 1990s, combined with the economic downturn. I like investing in good companies whose stocks are beaten down due to industry-wide (and hopefully temporary) problems, and thought I had found such a situation in Cutter & Buck for three reasons:

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1) I thought that the economy couldn’t get worse, excess capacity was exiting the industry and the inventory overhang was dissipating. 2) My research led me to believe that Cutter & Buck was the class of the golf apparel industry. During the 1990s, it had grown rapidly and consistently at more than 30% per year, with high margins and good returns on equity. Even after the downturn hit, the company still had a healthy balance sheet, strong distribution channel, widely admired management, high-quality products and a well-known and respected brand. 3) By nearly any metric, the stock appeared to be very cheap. At $6.66/share, it was trading at a 24% discount to book value of $8.75 and only a 2% premium to liquidation value of $6.55 (current assets minus all liabilities). Despite the woes of the industry, Cutter & Buck was profitable (albeit barely so) and was generating robust free cash flows, due mainly to inventory reductions. Only a year earlier, Cutter & Buck had earnings of $1.10/share, so I figured that within a few years, at least $1/share of earnings -- and a $10-$15 stock price -- was not unrealistic. So what happened? In short, Murphy’s Law kicked in with full force. The economy got worse and the golf industry did even more poorly, remaining awash in inventory. Cutter & Buck’s sales and margins fell and the company began to lose money (it has reported losses in five of the six quarters since I invested). Making matters worse, the company’s founders both resigned suddenly, leaving the company under the leadership of an interim CEO, Board Chair Fran Conley. Not surprisingly, the stock did poorly, falling steadily to just above $4 by August of 2002. But the worst was yet to come. While reviewing Cutter & Buck’s historical financial statements, Conley discovered some unusual transactions. She immediately investigated and discovered that previous management, to make its numbers at the end of fiscal year 2000, had shipped $5.8 million of inventory (representing roughly 5% of company sales) to three distributors, with side deals that committed Cutter & Buck to take back the merchandise if it didn’t sell. The existence of such side deals made these consignment sales, which cannot be booked as revenue under GAAP. However, these deals were hidden from the company and its auditors (as was the unsold merchandise when it was eventually returned to the company), so the end result was that Cutter & Buck reported artificially high sales and profits in 2000 (and correspondingly lower sales and profits in fiscal year 2001). The fallout from the discovery and disclosure of the accounting irregularities was immediate and potentially devastating for Cutter & Buck: the company’s auditor, Ernst & Young, reported that it believed “there is a material weakness in the Company’s internal controls and operations;” the SEC began an investigation; the NASDAQ placed the stock on warning for possible delisting; and the stock fell as much as 30% on the day all of this news was released, eventually closing at $3.44, down 14%. With much of my investment thesis in tatters, I was sorely tempted to sell, but didn’t for the following reasons:

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1) I liked Fran Conley, a turnaround specialist, and felt that she was doing exactly the right things to deal with the crisis and fix the company. 2) Cutter & Buck’s brand and market position remained strong and its core operations were still profitable. 3) This was a relatively benign accounting scandal that had merely shifted sales and profits between two years. There appeared to be no impact on the company’s current financial situation. 4) With others dumping the stock in a panic, the stock had become preposterously cheap. At $3.44, the stock was trading at a 57% discount to book value and a 45% discount to liquidation value. I was prepared to wait out the storm, but one wild card was making me nervous: as is the case whenever a company announces accounting irregularities, various class action law firms had filed suit and were trolling for plaintiffs. In general, I am against such lawsuits, but that wasn’t the issue at hand: It was clear to me that Cutter & Buck would be sued and that, in the hands of the wrong lead plaintiff or law firm, the result could have been a long, expensive, distracting legal wrangle that would not have been in the best interests of the aggrieved shareholders or the company. Thus, to protect our interests, I began to consider attempting to become the lead plaintiff -- but only if the cost to me would be minimal in terms of money and, far more importantly, time. After careful due diligence, I decided to proceed, chose to work with Milberg, Weiss, the nation’s leading class action firm, applied to become the lead plaintiff, and was chosen. True to its word, Milberg, Weiss did all of the work (I scarcely lifted a finger), and in May we spent a day negotiating with the company and its lawyers in a court-ordered mediation session. We ended up striking a deal whereby the company will pay at least $4 million to shareholders that were harmed (it could be as much as $7 million if Cutter & Buck is successful in its lawsuit against its directors’ and officers’ liability insurance carrier, which is trying to rescind coverage). I think this amount is fair compensation to shareholders, yet is also affordable for the company, which has over $15 million of net cash. Importantly, it allows the company to put this sorry chapter in its history behind it and focus on returning to profitability, which I believe it is on its way to doing. Having closed down its unprofitable operations, improved it internal controls, dealt with the lawsuits and SEC investigation (which ended with no fines or penalties), I think Cutter & Buck will do well going forward, especially if the economy in general -- and the golf industry in particular -- improve. I suspect that very few people say this after being involved in litigation, but I am pleased with my decision to become the lead plaintiff (though I certainly hope that this is a once-in-a-lifetime pleasure). I protected our interests, both as shareholders harmed by the past accounting missteps (our share of the $4 million will be nearly $100,000) and also as current owners of Cutter & Buck (witness the stock’s performance since the settlement was announced), yet it consumed very little of my time and I learned a great deal.

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7) EVCI Career Colleges Below are notes that I sent to some friends on 9/26/03 (the stock closed at $2.37 that day). They are based on a document originally written by my friend Guy Spier of Aquamarine Fund. The Deal and Rationale Tilson Capital Partners and Aquamarine Fund participated in a PIPE (Private Investment in Public Equity) for EVCI Career Colleges (EVCI) on August 1, 2003. Each invested $1 million into EVCI at a price of $2.12/share, receiving 471,698 shares, along with 117,925 warrants (good for five years; strike price: $2.12; the company can call them after three years if the stock price is above $5) (the Tilson shares were split between Tilson Growth Fund and Tilson Offshore Fund). At the time, these shares (not counting the warrants) represented 14.55% of the fully diluted shares outstanding (7.27% each), based on 6,488,072 shares of Common Stock outstanding as of May 1, 2003 (with the Series B conversion (see below), the share count will soon be 9.5 million shares). The deal offered us the opportunity to invest in one of New York’s oldest post-secondary colleges (it was founded in 1888) at a low multiple of what we believe is the company’s current earnings power. We believe these earnings are likely to increase substantially over the next few years. As the company gets through the factors contributing to a low valuation, both the earnings growth and a valuation expansion should result on an exit (either through an outright sale of the company, or through redistribution of the shares on the open market) at a multiple of the current value of the investment. Background and Discussion EVCI was a minor darling of the Internet boom age; when it went public, the company’s business plan was to deliver distance education to both corporate workforces as well as handicapped and students unable to get to a campus. At its height, the company’s shares had gone from a $12 IPO price to a high of $40. The company had signed deals with Bell Atlantic and @Home Network to provide access, and with leading corporate customers for their educational services, including names such as Citibank, AIG and Merrill Lynch. As the dot-com bubble broke, along with EVCI’s business model, the existing management decided to focus on Interboro College, which they had acquired in January 2000 during the boom (its campus is at 450 W. 56th Street, corner of 10th Avenue). At the time of acquisition, Interboro, while highly profitable, was on the verge of losing its educational license as a result of fraudulent practices by the former owner. Since 2000, the management of EVCI have dramatically grown enrollment, revenues and profitability at the main Interboro campus, as well as opening an extension center in Flushing, Queens and two new college sites on 9/30/02 in Yonkers and Washington Heights. EVCI had net income (before accreted value of warrants and undeclared dividends on the Series B preferred stock, which is going away -- see below) of $1.148 million in Q1 03 and a small $33,000 loss in Q2 (business is seasonally strongest in Q1 and Q4 as enrollment is low during the summer), a total of $1.114 million, up sharply from a mere $154,000 in the first half of 2002.

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EVCI has a unique niche in the for-profit secondary education sector: All other for-profit colleges require the student to supplement educational grants from state and federal sources with their own money (begged, borrowed or earned) in order to pay the tuition fees. EVCI keeps its fees low enough to enable students to pay the fees from grant money alone, without requiring supplemental funds. This means that EVCI can provide secondary education to those students in the New York City area who would be incapable of getting a loan. These are students who, even if they were able to get a loan, would have such high default rates as to disqualify EVCI and its students from benefiting from federal loan assistance programs or federal and state student grant programs. In providing a secondary education to low income and underprivileged students, EVCI provides, at a profit, a very welcomed and valuable service to the community. There are significant barriers to entry: for example, a new competitor can’t get Pell or TAP funding for two years. EVCI’s management team appears to be eminently suited to the job of executing the company’s business plan: The Chairman, Dr. Arol Buntzman, and the CEO, John McGrath, were responsible for the profitable and rapid growth of the Extension Centers of Mercy College. They bring with them the prior and successful experience of running a similar, though much larger institution than EVCI. Concerns/Due Diligence A profitable and growing post-secondary educational establishment does not come cheaply without its own fair share of issues and concerns: 1. Insider control/Insider salary Arol Buntzman is paid an annual salary of $300,000 per year (down from $345,500 plus a bonus of $14,437 last year, though he officially cut his time to three days/week; he claims -- and I believe him -- that he continues to effectively work full time). This is a lot for such a small company, but it is what it is. He says that independent compensation experts hired by the board have confirmed his belief that his pay is fair and reasonable, given salaries in the sector, his experience, and what other companies might pay him (given how hot the sector is, he’s probably right). McGrath’s salary in 2002 was $207,083 and I believe this has risen to about $250,000 now, reflecting the fact that he took over the CEO role when Buntzman went to part-time. Richard Goldenberg, CFO, was paid $158,750 plus a bonus of $6,667 in 2002. Worse than the salaries, at the end of last year the Board, in lieu of cash bonuses, which the company could ill afford, instead gave significant option grants (with the stock well below $1) to the top three execs (in the proxy, under Long Term Compensation Awards: Common Stock Underlying Options, it listed 330,000 for Buntzman, 130,000 for McGrath, and 40,000 for Goldenberg -- that’s 500,000 options which quickly became in the money). Guy and I raised a real stink about this and have received assurances from Buntzman (and all four independent board members -- a majority of the seven) that this will not happen again.

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Finally, Buntzman controls the company with around 22% of the shares outstanding, so you’d better get comfortable with him. Having spent a great deal of time with him and checking him out thoroughly (most importantly, from a friend who has been on the board of EVCI for a number of years), I am. I believe he has high integrity and is intelligent and rational. He realizes that much larger amounts of money than his annual salary will be made through achieving an excellent valuation in the public markets, so I believe he will deal fairly with shareholders and not issue excessive options going forward. 2. Share/warrant issuance EVCI has issued a very large number of options and warrants (beyond those given the management), causing the share count to soar to 9.5 million shares. In fairness to the company, many of these were issued by the company after the dot-com bubble broke -- though at much higher prices than today -- in a bid to keep itself alive while the management refocused its efforts on EVCI, but this would be an eyesore to any investor evaluating the company. Most importantly, however, the company has no further plans to issue any shares and warrants beyond the investment Guy and I made. As evidence of management’s intentions, there were other investors clamoring to invest in the PIPE deal Guy and I did, but the company decided they did not want any more dilution than was absolutely necessary, so they limited the PIPE to $2 million. 3. Debt/Payables overhang The company has a number of payments that it needs to make to third parties before it can fully apply its cash to funding expansion. These sums include: - $2.12 million which is still payable to the former owner of Interboro (the company was purchased from him on the basis of a lump sum plus an earnout). - $1.79 million in accrued dividends on the company’s series B convertible preferred (this does not appear on the balance sheet). - $1.46 million in notes payable. The good news is that these are manageable sums (much of it is not due immediately; some of the timing is subject to negotiation), especially given the $2 million Guy and I invested, plus $1 million of debt the company recently received. But these debts may delay aggressive implementation of expansion plans for EVCI. As they are paid off, this will be one of the catalysts to an improved valuation. 4. New York State – potential cut in TAP funding The state of New York, like other states in this economic environment, is going through fiscal hardship with very difficult budget discussions in Albany. There remains the danger that TAP might be reduced in future years, which could have (to use the cliché) “a material adverse impact” on EVCI, though the lawyer/lobbyist we hired to investigate this matter assured us of the strong political support for the TAP program. As evidence of this, a few months ago, New York state ended up not cutting TAP funding at all (despite the budget crisis), but is holding back 30% of payments for an extra six months. This is a relatively minor inconvenience for EVCI.

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5. Liquidity of the investment Over the past 30 days, the average daily trading volume is only 59,000 shares -- and some of this liquidity may be a result of Amaranth, the Series B holder, dumping. Series B Years ago, during the bubble days, a $1B hedge fund, Amaranth Capital, invested more than $10M in a $13M round of Series B preferred stock, which is coming due now. One condition, however, is that they cannot own more than 9.9% of the stock outstanding, so they’ve been converting and dumping stock for months, because otherwise they would forfeit any shares above 9.9% upon mandatory conversion at this time. The bottom line now is that: 1) EVCI must pay Amaranth the $1.79 million in dividends, though the timing is subject to negotiation -- the Series B governing document allows EVCI to pay this based on its ability to pay, so Amaranth can’t force immediate payment. Most likely, EVCI will pay some now and give them a note for the rest and pay it off over the next year or two (which it should have no trouble doing). 2) EVCI and Amaranth both want to have nothing more to do with each other (it’s an insignificant investment for Amaranth and Buntzman has been playing hardball with them, using a very favorable (to EVCI) Series B governing document). Thus, today, Amaranth agreed with Buntzman to sell its shares (freely tradable, common stock, unlike the as-yet-to-be registered stock Guy and I bought) for $2.20, worth approximately $2.5 million. Buntzman is now looking for friendly, long-term oriented, ideally value-added investors to take this slug. He does not anticipate trouble finding takers. He has promised up to $750,000 to someone who wanted to participate in the PIPE, so there may only be $1.75 million available. Here’s the latest on the Series B, from the Q2 10Q: NOTE 5 - PREFERRED STOCK Our Series B preferred stock was initially convertible into shares of our common stock at $13.50 per share. On September 22, 2001, the conversion price was reset to $6.75 in accordance with the provisions of the Series B preferred that required the reset to the lower of the initial conversion price and the current market price, but not less than 50% of the initial conversion price. As a result of our issuance of additional common stock for less than $6.75 per share and common stock purchase warrants that are exercisable below $6.75 per share, the conversion price has been adjusted to $5.24 as of September 5, 2002. On May 13, 2003, 25,000 Series B preferred shares were converted into 477,100 shares of common stock at $5.24 per share. In September 2003, the conversion price will reset to the lower of $6.75 and the then current market price of our common stock, but not lower than $3.375. At June 30, 2003, cumulative undeclared dividends on our Series B preferred amount to approximately $1,586,000.

(Note that the Series B dividend rose by a final $199,000 I believe, so the total now owed is $1.79 million.) Conclusion Guy and I believe that the hair on this story will go away with time, and as this happen the company will achieve better recognition and a markedly better valuation in the market place. It

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will also help that there’s no overhang/selling pressure from the Series B -- and no further accrual of dividends will also boost EPS. You will have to make your own estimates of earnings and cash flows, but I believe this will be a very profitable investment. Due diligence interviews conducted: Various meetings and phone conversations with - Arol Buntzman (Chairman) - John McGrath (CEO of EVCI) - Stephen Adolphus (President of Interboro) - Richard Goldenberg (CFO of EVCI). - Conversations with four of EVCI’s board members. - Visits to two of the campuses (Manhattan and Flushing) and to the corporate head office. - Various conversations with Harold Iselin of Crouch and White in Albany regarding TAP funding and relations between the company and the State Education Department

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Appendix E Writings About the Fund’s Other Holdings (Listed in descending order of size) 1) Farmer Mac (short) From August 2003 letter With Farmer Mac hovering around $30, up from $22 a few months ago, it is once again a trembling-with-greed shorting opportunity so I’m very comfortable holding a substantial short position (5.4% of the fund as of this date). Recent results from the company have reinforced my opinion on the fundamentals (they’re ghastly) and where the stock will end up (zero). As for a catalyst, the Senate Ag Committee, which oversees Farmer Mac, asked the General Accounting Office on June 26th of last year to address:

“(1) the financial stability of Farmer Mac; (2) its corporate governance; (3) its compensation policy, including the granting of stock options; (4) its investment practices and strategy; (5) the non-voting status of its Class C stock; and (6) its fulfillment of its Congressionally-established mission. We ask that this report provide potential legislative or regulatory recommendations to address any shortcomings found in these areas.”

15 months have passed, so I expect the GAO report soon, and believe that it will confirm my analysis of Farmer Mac. From September 2003 letter There was major news this week regarding another large short position, Farmer Mac. You may recall that in last month’s letter I wrote:

With Farmer Mac hovering around $30, up from $22 a few months ago, it is once again a trembling-with-greed shorting opportunity so I’m very comfortable holding a substantial short position (5.4% of the fund as of this date). Recent results from the company have reinforced my opinion on the fundamentals (they’re ghastly) and where the stock will end up (zero). As for a catalyst, the Senate Ag Committee, which oversees Farmer Mac, asked the General Accounting Office on June 26th of last year to address:

“(1) the financial stability of Farmer Mac; (2) its corporate governance; (3) its compensation policy, including the granting of stock options; (4) its investment practices and strategy; (5) the non-voting status of its Class C stock; and (6) its fulfillment of its Congressionally-established mission. We ask that this report provide potential legislative or regulatory recommendations to address any shortcomings found in these areas.”

15 months have passed, so I expect the GAO report soon, and believe that it will confirm my analysis of Farmer Mac.

Sure enough, the GAO released its report -- a hefty 123 pages (on the web at www.gao.gov/new.items/d04116.pdf) -- after the close on Thursday. I am very pleased with the report, as it emphatically confirms nearly every element of my short thesis, including:

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• Increasing credit risk due to inadequate reserving • Flawed risk models and management systems • Improper accounting when calculating reserves • Liquidity risks • Doubt that the Department of Treasury would cover losses on Agricultural Mortgage

Backed Securities (AMBS) held in Farmer Mac’s portfolio • Little evidence that Farmer Mac is fulfilling its Congressionally-mandated mission • Weaknesses in regulatory oversight of the company • Poor corporate governance practices

Here is one example of the many damning statements in the GAO report:

Guidance from financial regulators indicates rapid growth of programs or assets is thought to be an increased risk factor. Many financial institution failures of past decades were blamed, in part, on unchecked growth particularly in new and innovative products with complicated risk characteristics. The rapid growth of the standby agreements could result in increased funding liquidity risk to Farmer Mac because Farmer Mac’s commitment under these agreements differ from its off-balance sheet AMBS…Going forward, if the rapid growth of standby agreements continue, at a time when either the agricultural sector is severely depressed or interest rates are adversely changing, Farmer Mac could be required to purchase large amounts of impaired or defaulted loans under the standby agreements, thus subjecting Farmer Mac to increased funding liquidity risks and the potential for reduced earnings. Additionally, because of its rapid growth and recent implementation, there is limited historical information to project the number of loans covered by standby agreements that Farmer Mac may need to purchase in the future. As a result, management has limited quantitative data on which to base risk management and other operating decisions.

This sentence did not appear in the GAO’s report by accident: “Many financial institution failures of past decades were blamed, in part, on unchecked growth particularly in new and innovative products with complicated risk characteristics.” The GAO is warning that Farmer Mac’s reckless expansion of its Long-Term Standby Purchase Commitment Program (loans covered by LTSPCs grew from zero in 1998 to $2.7 billion only four years later) could result in a total failure of the company (which had a mere $203 million of total equity as of 6/30/03). So how did the stock react on Friday? It rose 10% to $29.36, largely I believe because few investors have bothered to read the lengthy GAO report and instead skimmed Farmer Mac’s press release (biz.yahoo.com/prnews/031016/dcth055_1.html), which is masterful in its duplicity. Its title was “GAO Finds Improved Financial Condition With Increased Mission Activities at Farmer Mac” and the rest of the release continued in the same vein, quoting the GAO report selectively and out of context, concluding with Farmer Mac’s CEO saying: “The Report makes it clear that there are no significant issues with respect to Farmer Mac’s financial stability, corporate governance, executive compensation, or investment practices, and that Farmer Mac has increased its mission-related activities. We appreciate GAO’s recommendations

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to Farmer Mac and in those areas in which we need to improve, we either are doing so or plan to.” What a total crock! While I can’t predict what Farmer Mac’s stock price will do in the short term, I remain confident of the end game. As Ben Graham famously said, “In the short run, the market is a voting machine but in the long run it is a weighing machine.” I think Farmer Mac stock will eventually go to zero because the stock and company are worthless. Why? Because I believe that, properly calculated, the company’s liabilities today substantially exceed its assets, and its earnings power (again, properly calculated) has always been and will always be nil. 2) Boston Communications Group (short) From September 2003 letter In the United States, most people with cell phones receive a bill at the end of each month, but many with poor credit histories don’t qualify for such plans and must pay in advance for their usage via prepaid calling plans. BCGI specializes in helping wireless carriers offer such plans by providing subscriber management, payment services, billing and customer care. BCGI serves approximately 70 wireless carriers and resellers, including five of the top six national carriers. The company has grown rapidly in recent times, has high margins, $3.27/share in cash and no debt. So why am I short this stock? Simple: this company has one of the worst business models I’ve ever seen and, not coincidentally, I think it will soon lose its largest customer, which accounts for more than 50% of its revenues. Let’s say, for example, that a wireless carrier decides to enter the prepaid market. Rather than making a large, upfront investment in billing software, customer service centers, etc., the carrier can instead conduct a trial by outsourcing all of these functions to BCGI, so it typically signs a two-year contract. At the end of the contract, one of two things will generally happen: either the trial was a failure, in which case the carrier pulls the plug and BCGI loses the customer, or it was a success, in which case the carrier will often choose to save a lot of money over time by making the investment to bring its billing software, customer service and so forth in house -- and BCGI loses the customer. The important insight is that BCGI is likely to lose its biggest customers within a couple of years, no matter what! Indeed, this is precisely what happened in late 2000, when the company lost AT&T Wireless as a customer, triggering a collapse of the stock from almost $30 to nearly $6. This is one terrible business model. When I began shorting the stock in May, I believed that the catalyst for the collapse of the stock would be the loss or unfavorable renegotiation of the contract with Verizon Wireless, which accounts for 51% of BCGI’s sales. Put yourself in Verizon’s shoes: even if you liked the prepaid business (which is only marginally profitable due to high costs and subscriber churn rates), why would you pay BCGI’s exorbitant fees on a long-term basis? (BCGI’s gross margins in its core billing and transaction processing services are a fat 76%.) Instead, wouldn’t it make much more sense to buy largely off-the-shelf technology and bring the services in-house, which would save a lot of money and also ensure a direct connection with your customers? At the very least, wouldn’t you use your size and BCGI’s dependence on your business to renegotiate much lower rates (which would crush BCGI’s margins)? Any sensible company would of course do this, especially one like Verizon trying to cope with increasing competition and stagnant sales.

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Confirming my analysis, I had heard rumors (which I was unable to independently substantiate) that Verizon had already made the decision to bring BCGI’s services in-house and cancel the contract, but had not yet informed BCGI of this because it first wanted to make sure its in-house systems were fully up to speed. If these rumors proved to be true, then it would be icing on the cake as far as I was concerned. So I started shorting the stock in June at $15.48 and it started to climb on no news other than a rising market. I shorted more as it rose, and it eventually peaked at over $22 just before the company announced Q2 earnings on July 16th. It was no fun seeing the stock rise nearly 50%, but my patience was rewarded. In the Q2 press release, the company confessed:

As the Company has stated in its public disclosures, its contract with Verizon Wireless is scheduled, according to its terms, to be renegotiated in 2003. The Company is currently in contract discussions with Verizon Wireless. The terms and conditions, including the length of the contract and pricing have not yet been determined. Verizon Wireless has also requested that bcgi provide support services to assist Verizon Wireless in testing its own internal prepaid platform in 2004 which could potentially displace prepay services currently being provided by bcgi. [emphasis added] None of the Company’s contracts are exclusive and its carrier customers have and continue to use and/or test competing products in certain markets. The Company believes bcgi’s real-time transaction processing and support solutions best meet the technology, functionality and profitability goals of its carriers today, and in the future.

While the company did its best to put a brave face on matters -- gee, what a shocker given the massive insider selling -- this information convinced me that the rumor was true and BCGI had, in fact, lost the Verizon business. Others apparently came to the same conclusion as the stock plunged nearly 40% the next day to under $13. Skipping forward to last week, the company reported Q3 earnings after the close on Wednesday. There was no sequential subscriber growth -- an obvious disappoint to the growth junkies who own this stock -- and the company noted that:

We continue to support Verizon Wireless’ prepaid business with new features and technological enhancements. At the same time, we remain focused on further diversifying our business and believe we are well positioned for new customer opportunities [emphasis added], as well as new product introductions that leverage our core competencies and assets.

Sounds to me like they’re finally acknowledging the writing on the wall. Not surprisingly, the stock has plunged 18% in the two days since then to close on Friday at $9.30. I’m not covering yet, however. I think once it’s confirmed that BCGI has lost the Verizon contract, BCGI will no longer be profitable and the stock will trade at only a slight premium to cash, so my price target is perhaps $5 (though I may start covering before it gets there).

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3) Yum! Brands From February 2003 letter Yum! is in many way similar to Office Depot: both companies have excellent management and returns on capital, generate a great deal of cash, and have well-positioned businesses in a saturated North American market that generate cash to invest in vast, high-margin growth opportunities overseas. And both stocks are trading at about 11-12 times this year’s earnings estimates, which I believe are conservative. Here is an excerpt from my recent column:

[Yum!] is the most diversified company in the QSR sector, with three major brands: Pizza Hut, Taco Bell, and KFC. (It also recently acquired Long John Silver’s and A&W.) This is both a blessing and a curse: Diversification smoothes earnings, but it also means one chain is typically encountering some sort of weakness, giving investors a reason to shun the stock. In the five years since PepsiCo (NYSE: PEP) spun off Yum! (formerly Tricon), it has made tremendous progress. It completed a refranchising program that reduced the percentage of company-owned restaurants from 47% in 1994 to 21% today; the restaurant operating margin has grown from 13.5% to 15.8%; ongoing operating EPS has risen 20% annually; ROIC has jumped from 12% to 18%; and the company has paid down debt from $3.5 billion to $2.4 billion. Yum! has adopted the sensible strategy of opening no net new units in the saturated U.S. market; instead, it’s focusing on converting existing restaurants to “multibrand” units (e.g., KFC and Taco Bell sharing the same building) and pursing 5% to 6% annual net-unit growth overseas, which offers great promise. For example, KFC is the No. 1 brand in China, and Pizza Hut’s best market is Korea.

Unlike nearly every other company in the quick-serve restaurant sector, Yum! has not guided estimates down because its international business continues to boom and because it does not sell many burgers -- and is therefore somewhat insulated from burger price war. I expect Yum! to continue to grow earnings at a low-double-digit rate and that its earnings multiple will expand over time as the sector returns to favor -- both of which should drive substantial stock appreciation from today’s depressed levels. 4) Office Depot From February 2003 letter I first purchased Office Depot’s stock at $8 in January, 2001 based on my belief that the new CEO, Bruce Nelson, would correct the serious strategic and operational mistakes of his predecessor and turn the company around. Nelson delivered on everything I’d hoped for -- and more. Over the past two years, Office Depot has generated over $1 billion of free cash flow (its market cap today is $3.7 billion) and improved its balance sheet from a net debt position of $600 million to net cash of $455 million today. Inventory turns have increased from four to six, days sales outstanding have fallen from 60 days to 48, and operating margins in its three main businesses have increased sharply, as the following table shows:

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N. Amer. Retail N. Amer. Biz Svcs International 2000 3.3% 4.9% 12.0% 2001 5.3 7.7 14.3 2002 7.2 9.3 12.9* * International margins were dampened in 2002 by spending to expand into new countries and unfavorable currency shifts. As evidence of the turnaround became apparent, the stock more than doubled in 2001, making it one of the three best performing stocks in the S&P 500 that year. By early 2002, I felt the stock was approaching fair value, so I sold the fund’s stake for $17. Since then, the company has continued to improve its performance, yet the stock has fallen below $12 due to general stock market weakness, poor same-store sales in its North American retail stores (-4% in Q4 and -2% for 2002), and lower-than-expected guidance for 2003 (EPS of $1.03-$1.07, up 5-10% from 2002’s $0.98). Nelson lamented at an investment conference last week that Wall Street analysts and investors seem to fixate on same-store sales in Office Depot’s North American retail stores. I’m delighted that they do so, as it causes the stock to become undervalued. Fortunately, Nelson has the good sense to ignore this faulty thinking. He said that he could drive positive same-store sales by building new stores or refurbishing existing ones, but that he is not convinced (nor am I) that this would yield high returns on incremental capital. Instead, he is milking the saturated North American retail market for cash and plowing it into Office Depot’s higher-margin growth areas: North American Business Services and its international operations. While the stock is up nearly 50% from the price at which I first bought it, the company’s intrinsic value has risen substantially as well, so the stock is nearly as cheap -- and much safer -- than it was two years ago. I believe that we are only in the middle innings of Office Depot’s turnaround and that the company will continue to grow and improve its performance over the next few years, especially if the economy improves at all. Nelson noted that white-collar employment and new business formation are the two key macroeconomic drivers of Office Depot’s business. Both of these metrics have suffered recently, making the company’s strong performance even more remarkable. Imagine how well the company will do without such a stiff headwind. 5) Imperial Parking From January 2004 letter Imperial Parking, a company in which we held nearly a 5% ownership stake, announced last week that it is being acquired for $26/share, only a slight premium to market, but 30% above where the stock was trading a few months ago when Imperial announced that it was in play. It is with some sadness that I say goodbye to this stock, one that I first purchased in May 2000 at $12.63. It performed very well for us during a period of substantial market decline. While some other shareholders have complained to me that the price was too low, the economic downturn affected Imperial more than I’d expected, so I think the price is fair and I welcome the cash given my concerns about this market.