ValueInvestor - ValueWalk · Each E&P company in the portfolio today – EOG Resources [EOG],...

Ask Tim Hartch of Brown Brothers Harriman & Co. to describe a fa-vorite stock and the conversation

will go on for some time before there’s any mention of the share price and valuation. “We’re buying a business, not a model,” says Hartch.

This business-first approach has paid off handsomely for investors in the $20 bil-lion (assets) BBH Core Select strategy that Hartch has co-managed since 2005. Over that time, it has earned a net annualized 10.2%, vs. 7.1% for the S&P 500.

Though they’re finding bargains relative-ly hard to come by, Hartch and co-manager Michael Keller do see opportunity today in such areas as oil services, industrial lubri-cants, wireless technology, pharmaceuticals and seismic data. See page 2

As might be expected from someone who trained under investing icono-clasts such are Mario Gabelli and

Bob Robotti, Mario Cibelli isn’t one to bounce ideas off a network of hedge-fund buddies. “I’m an introvert when it comes to research,” he says. “I don’t think you can get true insights any other way.”

Cibelli’s independent streak has result-ed in outsized returns for his Marathon Partners L.P. investors. Since its launch in 1997, the fund has earned a net annualized 17.0%, vs. 7.3% for the S&P 500.

Targeting companies whose prospects are frequently under vociferous debate, he’s currently finding long-term upside in such areas as self-service kiosks, photo com-merce, money transfer, prepaid debit cards and prepaid gift cards. See page 10

ValueInvestorINSIGHT

December 30, 2013

The Leading Authority on Value Investing

Margins of SafetyValue investors can err by lowering their business-quality standards in order to get a bargain price. That’s not a mistake Tim Hartch is likely to make.

Inside this IssueFEATURES

Investor Insight: Brown BrothersCasting a wide net for resilient business models and finding them in Schlumberger, Fuchs Petrolub, TGS-Nopec and Sanofi. PAGE 1 »

Investor Insight: Mario CibelliLooking for winners in secularly changing markets and finding them in Outerwall, Shutterfly, Green Dot and Blackhawk Network. PAGE 1 »

Strategy: Michael PorterThe dean of competitive strategy has been thinking a lot about inves-tors and investing. PAGE 18 »

Uncovering Value: DreamA representative inexpensive idea from “the most overlooked stock market in the world.” PAGE 21 »

Editors’ LetterReflecting on the past year with a focus more on what’s gone wrong than what’s gone right. PAGE 22 » INVESTMENT HIGHLIGHTS

Other companies in this issue:Automatic Data Processing, Baxter, Bec-

ton, Dickinson, Bed Bath & Beyond, Dow

Chemical, EOG Resources, Facebook,

Microsoft, Nestle, Netflix, Novartis, Novo

Nordisk, Occidental Petroleum, Praxair,

Qualcomm, Sally Beauty, Southwestern

Energy, Twitter, Western Union

www.valueinvestorinsight.com

I N V E S T O R I N S I G H T

Mario CibelliCibelli Capital Management

Investment Focus: Seeks companies selling products that disrupt the competi-tive status quo, allowing strong growth regardless of economic conditions.

Disruptive BehaviorMario Cibelli’s favorite stocks have tended to produce a lot of controversy and volatility – and, in his hands, a long-term record of spectacular returns. INVESTMENT SNAPSHOTS PAGE

Blackhawk Network 16

Dream Unlimited 21

Fuchs Petrolub 7

Green Dot 15

Outerwall 12

Sanofi 6

Schlumberger 5

Shutterfly 14

TGS-Nopec 8


Brown Brothers Harriman & Co.(l to r) Tim Hartch, Regina Lombardi and Michael Keller

Investment Focus: Seek companies with sustainable positions in attractive markets when short-term or low-impact problems are overly discounted in the share price.

December 30, 2013 www.valueinvestorinsight.com Value Investor Insight 2

Part of the investor’s art is to narrow the field of play to situations in which you think you can win. How you do that?

Michael Keller: Our strategy at its most basic is one of ownership. We view our-selves as capital allocators, not traders, and therefore we see our role as making investments in businesses, not just finan-cial assets. We expect our returns over time to mainly be driven by the underly-ing cash flows generated by the business.

With that goes a high degree of selectiv-ity. We focus only on leading companies in attractive industries that sell essential products or services that loyal custom-ers cannot or will not do without. We want them to have strong and sustainable competitive positions that come through brand attributes, cost structure, intellec-tual property, routes to market and other factors. In terms of financial characteris-tics, they should earn high returns on capi-tal and produce strong free cash flow.

We run a concentrated portfolio – with 29 names at present in our Core Select strategy – and try to maintain a two-sided margin of safety, not only in the valua-tions, but also in the quality of the busi-nesses themselves. We’re driven by the value-generating and compounding at-tributes of the companies rather than just hoping we can buy at a low multiple and sell at a high multiple. That requires our controlling simultaneously for both price and business risk as best we can in every investment.

What are the “best” reasons high-quality companies trade at attractive valuations?

MK: We love those 80/20 situations where the amount of investor attention put on a particular area of a business or a specific issue exceeds its actual importance. Qual-comm [QCOM], for example, generates the majority of its pretax earnings from its

licensing portfolio, where we believe it has a very strong and sustainable position and the key secular trends are quite favorable. It also has a fine, well-run business selling chipsets and components used for wireless connectivity and application processing. By its nature the chip business is more competitive and cyclical, and therefore it can create periodic volatility in the stock. We have built our position over the last few quarters using that volatility.

Microsoft [MSFT] would be another technology example. It generates the sub-stantial majority of its profits through en-terprise-customer relationships, which are going increasingly from a transactional type of sale to an annuity or subscription type sale. But while the visibility and value of that profit pool in enterprise is growing, there’s still a lot of focus on peripheral ar-eas such as Internet search, Xbox, tablets and other more consumer-facing parts of the business. We believe that’s suppressing valuation.

Regina Lombardi: Another example would be when a company is making investments that enhance its long-term competitive position and this “investment cycle” has a negative impact on near-term earnings and cash flow. Bed Bath & Be-yond [BBBY] has been making substantial investments in areas such as e-commerce, information systems and data analytics – all focused on deepening customer loyalty that is already quite strong. Since we take an ownership view, we’re prepared to step in and invest when a jump in spending and short-term earnings pressure creates nega-tive sentiment.

Tim Hartch: Some opportunities arise just from the lack of a catalyst. If you focus on short-term returns, when there’s no cata-lyst to shift sentiment in the next three to six months you’re likely to pass. We don’t require a catalyst as long as we see the po-

I N V E S T O R I N S I G H T : Brown Brothers Harriman

Investor Insight: Brown BrothersTim Hartch, Michael Keller and Regina Lombardi of Brown Brothers Harriman & Co. describe what they consider the best reasons high-quality companies can get inexpensive, why they typically avoid turnarounds, why they don’t “ride their winners,” and why they believe Schlumberger, Sanofi, Fuchs Petrolub and TGS-Nopec Geophysical are mispriced.

T. Hartch, R. Lombardi, M. Keller

Going Global

It’s hard to imagine a successful U.S. money manager in recent years not at least contemplating a more international approach. Brown Brothers Harriman did just that in 2011 as it looked to define a global version of its large-cap Core Select strategy, to be co-managed by Tim Hartch and Regina Lombardi.

While the stock selection and valuation criteria would match the U.S. approach, Hartch and Lombardi still had many pro-cess and portfolio-management questions to answer. They added staff, but all within an existing research team based in New York. To take advantage of smaller-cap opportunities, they lowered the minimum market cap for the global strategy to $3 billion, from $5 billion in the U.S. To incre-mentally spread risk, they targeted a 30-40 stock portfolio rather than 25-30 in the U.S. They decided not to hedge currency exposure or to limit where they could in-vest, although the only non-U.S. stocks meeting their criteria since the global launch in 2012 have been in Europe.

Where are the best bargains? Hartch says the stocks his team targets are fairly pric-ey, regardless of geography. The global portfolio recently traded at 85% of esti-mated intrinsic value, vs. 88% in the U.S.


tential for attractive compounding of re-turns over a number of years.

Do you expressly avoid more-cyclical businesses?

TH: We are careful about cyclical compa-nies, but we don’t avoid them. For exam-ple, we own energy exploration and pro-duction companies, but only those with long-lived reserve bases and low finding and development costs. We believe those qualities shield them from some of the big swings in commodity prices that are in-evitable in the space. Each E&P company in the portfolio today – EOG Resources [EOG], Occidental Petroleum [OXY] and Southwestern Energy [SWN] – fits that profile.

For industrial companies serving cycli-cal end markets, we have to believe their products and services are truly essential and that they have loyal customers. A company like Praxair [PX] in industrial gases, for instance, has incredibly strong competitive positions in specific geograph-ic regions built through scale and distri-bution density. Its gases are critical to the end user, but make up a relatively small percentage of the input costs. It fits all of our criteria, even if its revenues and profits are impacted by macroeconomic cycles.

You avoid potential turnarounds. Why?

MK: The simple reason is that in so many cases they just don’t work out. Secular is-sues may prove to be insurmountable, or the strategic and operational changes re-quired are so profound that it’s hard to even state your thesis upfront. We need to have conviction on the current business model and why it can continue to generate sustainable value, rather than going after something really cheap in the hope man-agement can figure it out. That would be relaxing the required margin of safety in the business, which is not something we’re willing to do.

TH: I think that’s particularly dangerous in today’s environment. When the market has gone up a lot, the businesses trading

at lower multiples are likely to be the infe-rior ones that will get hit the hardest when the inevitable next downturn occurs. If anything, I’d argue that after a period in which equities have rallied dramatically, you want to raise the quality you look for in each business. That’s not trying to predict the next cycle or downturn, just recognizing that this is not 2002 or 2009. Valuations are relatively high.

Your domestic Core Select strategy targets market caps of $5 billion and above. Why that size?

TH: Part of it is that businesses with the durable qualities we’re looking for typi-cally tend to be larger cap. In addition, since the assets in the strategy have grown to more than $20 billion, we need to in-vest in companies with market caps over $5 billion in order to build the size posi-tions we’re looking for in a relatively con-centrated portfolio.

MK: The other thing with larger com-panies is that we find a greater maturity in business processes, reporting, revenue recognition and global backend systems. That provides some comfort as an inves-tor that checks and balances are in place to avoid both mistakes and the obvious risk of having a small coterie of manage-ment getting creative with the numbers. The more transparency the better.

Describe how you build and maintain your “wish list” of potential ideas.

TH: We start with which businesses we want to own, according to the criteria Michael described. Our investment team is organized by sector, and a core respon-

sibility of each sector team is to conduct the due diligence and build the models necessary to identify companies we would own and the prices at which we would own them. The global list today consists of about 300 names, roughly balanced be-tween U.S. and non-U.S. companies.

Are there areas of focus in your due dili-gence you’d highlight?

MK: Management capability, broadly de-fined, is obviously very important to us as long-term owners of a business. We also think a lot about capital requirements and future capital productivity. You have to assume in almost every business that over time capital requirements will ultimately increase, or that margins will come under pressure due to competition. We’re in-tensely focused on how long and the ex-tent to which excess economic profits can be sustained. That’s not to imply there’s precision in that, but it’s just an incredibly important part of thinking through the modeling and building an iterative under-standing of a company.

We also spend a lot of time on under-standing customers – who they are, how they buy, when they buy, why they buy. How sensitive they are to price. How the product or service fits into their own cost structure. All of this is critically important in assessing the durability of the business and its cash flow.

You’ve moved a grand total of one idea, oil-services firm Schlumberger [SLB], off the wish list into your U.S. portfolio this year. What made it cheap enough to buy?

MK: We have a constructive point of view on long-term exploration and produc-tion spending globally and on long-term hydrocarbon prices, due to the fact that the incremental resource is getting harder to find and more difficult to extract. We believe Schlumberger will be a prime ben-eficiary of that, but earlier this year we felt that its share price reflected both a gen-eral malaise about weak demand in global energy markets and a specific concern about excess capacity in its U.S. pressure-


ON RESEARCH:

We spend a lot of time on

understanding customers to

assess the durability of the

business and its cash flow.


pumping business. The latter situation has weighed heavily on market sentiment, helping set up the opportunity for us.

More recently you bought into beauty-products distributor and retailer Sally Beauty [SBH] for your Global Core Select portfolio. What prompted that?

RL: This is a company we think has a lot going for it, including a very strong fran-chise supplying professional stylists, a loy-al and highly fragmented customer base, international growth opportunities and demographic-related tailwinds. However, a poorly executed shift in their marketing strategy on the retail side of their business and soft trends in some product categories led to earnings weakness over the summer. That knocked the stock down to a level we found interesting.

Describe generally how you approach valuation.

TH: It’s impossible to predict exactly how a business is going to look five or ten years from now, but if you have confidence in the competitive position, the sustainable qualities of the business and how manage-ment will execute over time, you can con-struct a reasonably conservative calcula-tion of intrinsic value based on discounted free cash flows, typically using an 8-10% discount rate. We’re willing to buy when shares are trading at 75% or less of esti-mated intrinsic value.

Our valuation discipline is absolute, so our cash position in today’s market has been increasing pretty meaningfully. It’s now about 13%, versus an average his-torically of closer to 5%.

How actively do you trade?

TH: Annual portfolio turnover has his-torically run between 10% and 30%. Position sizes do go up and down based on the relationship to intrinsic value, but fundamentally we follow the ownership principle that most of our return will be from the cash flows the companies gener-ate and distribute.

I went back to look at the Core Select portfolio when we spoke five years ago [VII, February 23, 2009]. We owned 29 businesses then and we own 29 today. Three have been acquired, but of the 26 that are still publicly traded, 16 are still in the portfolio. Most of the top-ten then – including Berkshire Hathaway, Waste Management, Nestle and Wal-Mart – are still meaningful positions. That highlights the ownership concept we have.

Can you give a recent example or two of where you adjusted position size relative to valuation?

MK: The shares of Baxter International [BAX] have moved around quite a bit over the last few years as a result of a number of things, including some manu-facturing glitches, some pension issues, an FDA approval delay for a key product, and heightened potential competition for its market-leading hemophilia treatment. None of those issues have materially changed our core thesis or our estimate of intrinsic value, so we have periodically taken advantage of the share-price move-ments to adjust our position size.

Our discipline for selling is that we typically start reducing a position when it hits 90% of estimated intrinsic value and we want to be out when it gets to 100%. An example we hated to part with recent-ly would be Automatic Data Processing [ADP]. It is a very tight fit with our crite-ria, with essential service offerings, a loyal customer base and consistently strong execution. But in keeping with our strict adherence to margin of safety with respect to valuation, we won’t “ride our winners” if they meet and then exceed our intrinsic value estimate, which was the case here.

Describe your broader investment thesis for Schlumberger [SLB].

MK: I mentioned our positive view on E&P spending and on energy prices. At the same time, with new hydrocarbon re-sources increasingly difficult to identify, access and extract, that should increase the service intensity of E&P activities world-wide. That creates a positive backdrop for the oil-services industry in general, and we believe particularly for Schlumberger as the biggest competitor with many attri-butes that we view as best in class.

The company’s services are clearly es-sential to its customers, which number around 4,000 worldwide and range in size from small E&Ps to multinational inte-grateds. What sets Schlumberger apart is the scale and quality of its research and de-velopment. Over the last five years it will have spent close to $5 billion on R&D, more than the next three competitors combined. That gives it not only accumu-lated knowledge, but also differentiated and proprietary products and capabili-ties – whether in seismic-acquisition tools, wireline equipment, completion fluids or any number of areas – that others don’t have. In our due diligence we’ve gathered a lot of positive feedback on Schlumberger and its ability to handle the most difficult and extensive projects.

We believe this backdrop can support significant top-line growth for many years. There’s also operating leverage, from scal-able inputs, scalable resources and the re-cent initiation of a multiyear program to improve profitability and capital efficien-cy. The goal is higher sustained margins by combining the selling of higher-value-add services with cost savings from consolidat-ing and streamlining a number of decen-tralized processes and operations.

Describe the extent to which you’re “con-structive” on energy prices?

MK: We use a marginal-cost framework for oil and gas, looking at the full cost structure of the marginal industry produc-er, who in theory becomes the price setter. We always think in ranges, so with respect


ON SELLING:

In keeping with our strict ad-

herence to margin of safety

with respect to valuation, we

won’t “ride our winners.”


to oil we believe a crude price in the mid- $90s per barrel is pretty close to the mar-ginal cost. With gas it’s harder to pinpoint – we think the all-in marginal cost could exceed $5 per Mcf, but in the intermediate term it’s probably lower than that due to the ramp of U.S.-based supply.

How does today’s share price of $90 com-pare to your estimate of intrinsic value?

MK: Assuming mid- to high-single digit top-line growth and some margin expan-sion, while also building in cyclical peaks and valleys and using an 8.5% weighted

average cost of capital, our estimate of in-trinsic value in the $110 to $120 range.

We were encouraged by the launch in July of a $10-billion share repurchase program, which is not insignificant for a $118-billion market-cap company. The balance sheet can support it, and it’s nice to see such an active shareholder-oriented maneuver on the back of the broad-based effort to improve profitability.

What are the notable risks?

MK: The industry-wide risks one always faces include a decline in E&P spending

driven by lower commodity costs, macro-driven risks around demand levels, and even the potential for association with a high-profile well problem like we’ve seen in the past. Specific to Schlumberger, we think about whether the spread of uncon-ventional drilling technologies around the world could foster an erosion in its tech-nology advantage. We’re comfortable that they will continue to do a good job of staying out ahead of the curve.

Could one describe drug giant Sanofi [SNY] as at least an after-the-fact turn-around story?

RL: We consider Sanofi less of a turn-around and more of a transformation. It was one of the earliest traditional phar-maceutical companies to face patent ex-piration on a number of its blockbuster drugs while having very little in the R&D pipeline to compensate. New management came in and since 2009 has reoriented the company around a platform of businesses that have competitive strengths and sus-tainable growth profiles. They bought out the balance of an animal-health business they had jointly owned. They expanded their vaccine franchise. They purchased Chattem to significantly expand their consumer over-the-counter business, and acquired Genzyme to establish a foothold in rare diseases and build a much stron-ger R&D presence in the U.S. The com-pany has now moved past a major “patent cliff” and has invested in a portfolio of businesses that should support sustainable growth.

Sanofi is a good example of what we look for in healthcare companies. The rev-enue streams are well diversified and focus on the treatment of either chronic condi-tions or preventative healthcare, which drives recurring revenues. The company operates in structurally attractive markets such as the treatment of diabetes, where it is the leading provider of long-acting insulin, Lantus. Diabetes represents about 20% of total revenues and a greater per-centage of profits. Not only is the inci-dence of diabetes on the rise due to rates of obesity and aging, but the barriers to


Schlumberger (NYSE: SLB)

Business: Provider of equipment, technol-ogy and end-to-end project management services to oil and gas exploration and production customers worldwide.

Share Information(@12/27/13):

Price 89.9052-Week Range 67.64 – 94.91Dividend Yield 1.4%Market Cap $118.39 billion

Financials (TTM): Revenue $44.86 billionOperating Profit Margin 18.4%Net Profit Margin 14.3%

Valuation Metrics(@12/27/13):

SLB S&P 500P/E (TTM) 18.7 19.0Forward P/E (Est.) 15.4 16.6EV/EBITDA (TTM) 10.1

Largest Institutional Owners(@9/30/13):

Company % OwnedVanguard 4.5%State Street 3.8%Dodge & Cox 2.8%BlackRock 2.5%Capital Research Global 2.4%

Short Interest (as of 11/29/13):

Shares Short/Float 1.1%

I N V E S T M E N T S N A P S H O T

SLB PRICE HISTORY

THE BOTTOM LINEAs the best-in-class competitor, the company should incrementally benefit as greater dif-ficulty in identifying and extracting oil and gas reserves increases the service intensity of E&P activity, says Michael Keller. Assuming mid- to high-single-digit revenue growth and some margin expansion, he estimates the shares’ intrinsic value at $110-120.

Sources: Company reports, other publicly available information

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entry for insulin therapy are very high, as capital intensity, scale economics and reg-ulatory expertise support an oligopolistic industry structure.

The company has been early to invest in product platforms and distribution in emerging markets, which now account for about one-third of total revenues. Many industry peers are playing catch up in fast-growing markets where Sanofi is already established.

We also like the company’s low rela-tive exposure to significant healthcare-cost pressures in third-party-pay markets like the United States. Even where there is higher exposure, as in diabetes, we believe it is mitigated by how critical insulin ther-apy is to the treatment of the disease, and how relatively inexpensive it is relative to

the costs associated with not treating the disease.

How inexpensive do you consider the shares at a recent €76.50?

RL: We are more conservative than man-agement in terms of our revenue and oper-ating-profit growth assumptions, and as is the case for all pharmaceutical companies, we assume modest terminal growth rates in our valuation. With those assumptions our current intrinsic value estimate is in the €95 to €100 per share range.

As Tim mentioned earlier, we are not looking for an imminent catalyst. We do expect over time for the company’s growth businesses to begin to more than offset declines in the legacy franchise. We

also expect management to increasingly return capital to shareholders, primarily in the form of dividends.

What attracted you to under-the-radar in-dustrial Fuchs Petrolub [FPE:GR]?

TH: When we started our global strategy and expanded our research effort more broadly overseas, we knew there were a number of consumer and healthcare busi-nesses that we wanted to own, but we weren’t sure how many energy and indus-trial companies we would find that fit our criteria. We’ve actually been pleasantly surprised by the number of companies in those industries that do fit. Fuchs Petrolub is a good example of that.

Fuchs is a family-controlled German company that is the #1 independent devel-oper, producer and distributor of automo-tive and industrial lubricants. It supplies more than 10,000 products to 100,000 customers globally. Europe is its largest market, but it is also big in North America and Asia.

This is not a commodity chemicals business, but one deeply committed to innovation and R&D and creating spe-cialty lubricants that are customized for its clients. Its salespeople are technically well trained and are often on site at cus-tomer plants helping solve problems. To give some examples of what they do: they make engine oil for buses that run on liq-uefied natural gas; they sell fire-resistant hydraulic fluids for underground mining; they provide special lubricants for wind turbines. Most of their products are cus-tomer specific and help increase reliability, save energy or reduce emissions.

The biggest lubricant manufactur-ers are all large integrated oil-and-gas or chemicals producers. They tend to be fo-cused on commodity products and find it less economically feasible to produce and distribute these types of niche products to a fragmented customer base. That’s a com-petitive barrier to entry for Fuchs, which has developed extremely strong customer loyalty and has benefitted from pricing power. We estimate the annual customer retention rate on the 75% of the business


Sanofi(Paris: SAN:FP)

Business: Global producer of prescription pharmaceuticals, vaccines, animal health products and OTC drugs. Large pharmaceu-tical focus on the treatment of diabetes.

Share Information(@12/27/13, Exchange Rate: $1 = €0.727):

Price €76.5452-Week Range €65.91 – €87.03Dividend Yield 3.6%Market Cap €101.83 billion

Financials (TTM): Revenue €31.32 billionOperating Margin 18.2%Net Profit Margin 9.4%

Valuation Metrics(Current Price vs. TTM):

SAN:FP CACP/E 29.7 14.2


SAN:FP PRICE HISTORY

THE BOTTOM LINEThe market is not giving the company sufficient credit for having reoriented itself around a more diverse platform of businesses that have competitive strengths and sustainable growth profiles, says Regina Lombardi. Even after tempering management’s revenue and profit growth assumptions, she arrives an intrinsic value estimate of €95-100 per share.


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that goes direct to the end-use customer – as opposed to through distributors – is almost 98%.

Is Fuchs’ financial performance similarly impressive?

TH: EBIT margins above 15% and net margins at 11% or so lead the industry, and are very attractive for this type of business. The company also generates extremely high returns on capital – the return on invested capital was 30% last year if you include goodwill and intan-gibles in the capital base, and 40% if you don’t. One reason it’s so high is the lack of capital intensity. They’re primarily buy-ing base oils and additives from others, adding value through creating unique for-

mulations to serve customer needs. If they build a facility in China or Latin America, it costs tens of millions of dollars, not hundreds of millions.

What are the key growth drivers?

TH: Management would say underly-ing growth in the industry is 4-6% annu-ally. Per-capita use of specialty lubricants is increasing broadly as countries adopt stricter environmental standards, and par-ticularly so in developing markets where companies are also increasingly manufac-turing more specialized products. Fuchs was aggressive during and after the 2008-2009 crisis in investing to expand its foot-print in places like China, India and even Russia.

How vulnerable is the company to volatile input costs?

TH: Base oils are a significant input cost, so if they rise in price that’s a problem for Fuchs if it’s unable to pass those higher costs through. Historically, though, that hasn’t been a problem, which you can see in its gross margins being relatively consis-tent over time. That reflects the company’s competitive position and its good relation-ships with its customers.

One counter-cyclical element to Fuchs’ business is that in most recessions, base-oil prices decline. That happened in 2008-2009, and helped on the margin front as sales volumes declined. Lower base-oil prices during recessions also reduce work-ing capital and boost free cash flow.

How does your estimate of intrinsic value compare with current share price of just over €62?

TH: On a pure multiple basis the stock doesn’t appear obviously cheap or expen-sive, trading at 20-21x trailing earnings and maybe 10x EBITDA on an enterprise value basis. But this is a case where the discount we see from intrinsic value comes from the company’s ability to compound earnings over time and generate high re-turns from a competitively advantaged business. Assuming mid-single-digit rev-enue growth – in line with guidance and history – and an ability to maintain a very high ROIC, we arrive at an intrinsic value estimate of €75-80 per share.

Is the Fuchs family likely to remain firmly in control?

TH: Yes, they own about 50% of the vot-ing shares and 30% of the overall econom-ic interest. Stefan Fuchs is the Chairman of the Executive Board, in his mid-40s and actively involved in managing the compa-ny. We often like family-owned businesses in terms of their long-term perspective and focus on shareholder value. What you have to watch out for is complacency and an unwillingness to change and bring in new people as necessary. In this case Ste-


Fuchs Petrolub (Xetra: FPE:GR)

Business: German-based producer and refiner of industrial and automotive lubricants, polishing products and hydraulic and biode-gradable oils sold worldwide.

Share Information(@12/27/13, Exchange Rate: $1 = €0.727):

Price €62.3952-Week Range €48.72 – €63.61Dividend Yield 2.1%Market Cap €4.76 billion

Financials (Through 9/30, annualized): Revenue €1.84 billionEBIT Margin 17.2%Net Profit Margin 12.0%


FPE:GR DAXP/E 20.7 16.3


FPE:GR PRICE HISTORY

THE BOTTOM LINETim Hartch believes the company’s focus on innovation has helped it build a unique, sustainable global franchise that will benefit from greater use of speciality lubricants as industrializing economies grow and mature. Assuming revenue growth in line with history and continued high ROIC, he pegs estimated intrinsic value at €75-80 per share.


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fan Fuchs and others in top management have aggressively transformed the compa-ny over the past decade and show no signs of letting up.

Turning to a relatively rare commodity – a stock trading fairly near its 52-week low – describe your interest in TGS-Nopec Geo-physical [TGS:NO].

TH: TGS is a leading provider of multi-client geoscientific data that global oil and gas companies use to identify and plan their exploration and drilling activities. The biggest part of the business is offshore seismic, with traditional strength in the Gulf of Mexico and the North Sea. They use an asset-light business model, mean-ing they don’t own vessels but instead con-

tract whatever capacity they need from vessel owners and competitors on a proj-ect basis. They occasionally fund projects on their own, but over 90% of what they do is for identified clients who pre-fund a meaningful portion of the projects.

We like that this is have-to-have infor-mation. A deepwater offshore well can cost as much as $150 million to $250 mil-lion to drill, and one of the best ways to de-risk that investment is by having very good seismic information on the basin be-ing explored. It’s critical data that can dra-matically increase the likelihood of success at a very small percentage of the total cost. As exploration shifts to more difficult-to-access areas, as Michael described earlier, the relative value of what TGS provides increases even further.

How does TGS-Nopec differentiate itself competitively?

TH: There are a number of industry par-ticipants, but TGS is one of the few that focuses exclusively on multi-client proj-ects. Multi-client data is much cheaper for customers and TGS retains ownership of the data, helping it build up deep ex-pertise in specific geographic regions. The company is also recognized for its ability to take raw seismic data and create useful and actionable information from it. We’ve spoken with several of their 300 E&P cus-tomers and they get very high marks for their in-house processing capabilities.

The processing expertise combined with the big data library allows them to generate their own ideas for potential projects. Historically for every dollar in-vested in seismic data, they’ve generated $2 to $2.50 in revenue back.

So why the weakness in the share price, which at 155 Norwegian kroner is down 33% in the past nine months?

TH: That’s a reminder of the fact that this is a project business in a cyclical indus-try. They’ve had some permitting issues both in Australia and onshore in the U.S., which affected the timing of some big projects. They’ve also postponed or can-celled projects where they were not able to line up sufficient pre-funding or where the prospective returns due to price competi-tion were too low. As management low-ered guidance, the market really punished the stock.

The current market price implies that the amount of capital TGS is able to in-vest each year stagnates, and that the company’s return on investment declines dramatically over time. Given the favor-able backdrop we’ve described for global E&P activity and spending and the inher-ent strengths in TGS’s approach, we think that’s exceedingly pessimistic. If we in-stead assume capital invested grows at a modest rate and that they can continue to earn close to $2 on every dollar invested, our estimate of intrinsic value is 200 to 250 kroner per share.

TGS-Nopec (Oslo: TGS:NO)

Business: Collects and sells multi-client geoscience data, primarily covering under-water oil and gas fields, to global energy exploration and production companies.

Share Information(@12/27/13, Exchange Rate: $1 = NOK 6.145):

Price NOK 155.3052-Week Range NOK 138.90 – NOK 231.00Dividend Yield 5.1%Market Cap NOK 16.08 billion

Financials (Through 9/30, annualized): Revenue $816.1 millionEBIT Margin 43.6%Net Profit Margin 30.2%


TGS:NO OBXP/E 9.6 15.3


TGS:NO PRICE HISTORY

THE BOTTOM LINEGiven the strengths in its business model and the positive backdrop for spending in its in-dustry, Tim Hartch believes the market is too pessimistic about the company’s prospects. Assuming modest growth in capital invested and continued solid returns on that invest-ment, he arrives at an intrinsic value estimate at least 30% above today’s share price.


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This business probably has a wider range of potential outcomes than is usual for us, and the share price is likely to be volatile. But we’re focused on the com-pany’s ability to reinvest in high-return opportunities over the next ten years, not the next ten months. In the meantime, the stock pays a nice dividend of over 5%, which management has indicated a strong desire to maintain. Given that the business is generating cash and there’s $187 mil-lion of net cash on the balance sheet, that should be possible.

Did you take away any lessons from your investment in now-private Dell?

TH: Dell has a loyal enterprise customer base for whom many of its products and services are truly essential, but we mis-judged the structural challenges of the personal-computer market. We accept that not every business can fire on all cyl-inders at all times, but in the case of Dell

our takeaway is that secular pressures can mount quickly and with enough severity that it can be difficult to effectively and ex-peditiously re-center around more attrac-tive opportunities. Our experience with Dell reinforces the importance of judging changes in industry structure correctly.

The contrast in market sentiment between now and when we spoke five years ago is pretty striking. How would you describe your own sentiment toward the market between then and now?

TH: We fundamentally believe owning high-quality businesses over a long time is a great way to protect and grow capital, but we can’t help but be more cautious today. While much in the macroeconomic environment has improved, big challenges certainly remain. Government debt is ex-tremely high. The Fed’s balance sheet has ballooned. We see the government playing a bigger role in the economy, particularly

in financial services and healthcare, which creates uncertainty and we believe limits capital formation and investment.

Another big challenge today is valua-tion. Five years ago our Core Select port-folio overall traded at 55-60% of estimat-ed intrinsic value. Today that number is in high-80% range, which is about as high as it’s ever been.

Some of the most interesting oppor-tunities we’re finding today are in energy and industrials, serving cyclical markets, but we’re not making them the biggest positions even though they’re the most at-tractively valued. We’ve left room to make them larger positions at more attractive prices if the macro picture worsens.

We view our approach – disciplined on valuation and emphasizing resilient busi-nesses – as particularly well-suited for the current environment. After a market rally like we’ve had over the past five years, that double margin of safety is likely to be very important. VII

http://www.amazon.com/The-Art-Value-Investing-Investors/dp/0470479779

http://www.valueinvestorinsight.com/pdfs/Art_of_Value_Investing.PDF


Describe the two distinct types of oppor-tunities you’ve targeted since you started your fund sixteen years ago.

Mario Cibelli: Everything in the portfolio is either a core investment or an opportu-nistic investment.

Core investments are in companies we know as well as anyone on the outside can, where we believe the product or ser-vice offered is disruptive to the competi-tive status quo in a way that will allow the business to gain market share and grow strongly regardless of the economic situ-ation. These are 10% to 20% positions that we expect to own for a number of years and where we’ve built a productive dialogue with management and credibility with the board. Examples of our core in-vestments over the years include Netflix, Expedia, 1-800-Contacts, Coinstar (now Outerwall) and Shutterfly.

Our opportunistic investments target more serially inefficient areas that other hedge funds often target, such as spinoffs, rights offerings, tracking stocks, low-float securities and restructurings. These are usually 1% to 10% positions where we might move faster and haven’t necessarily built a full relationship with management. One of the companies we’ll speak about later is Blackhawk Network Holdings [HAWK], a recent carve-out from Safeway that many investors won’t touch because Safeway still owns most of the company and could bring the rest to market some time soon. We love situations where the valuation is compressed due to a short-term liquidity concern.

We’ll also be opportunistic around dra-matic responses to earnings misses or other short-term events. A little over a year ago when Western Union [WU] shares fell by a third in a few days after a poor earnings report, we did some relatively quick work and concluded the market was overreact-ing to cyclical issues and perceived-to-be

negative competitive dynamics. We were comfortable that the business had higher barriers to entry than many imagined and thought at a share price of $12-13 our downside was minimal. [Note: After fall-ing to $12 in early November 2012, WU shares now trade at $17.20.]

It takes a great deal of time and energy for us to develop core positions and it’s obviously something that can’t be forced.

We don’t know how to make gold, we can only find it with lots of digging. It only makes sense that if while we’re digging we find some silver, we should try to mine that as well. That’s what our opportunis-tic investments do, allow us to find return while our core ideas are in various stages of development.

With respect to core ideas, can you gener-alize about the characteristics of a success-fully disruptive company?

MC: We actually have a simple diagram of the anatomy of a disruptive leader. It’s a triangle, at the top of which is the word “brand” because brand always matters. Companies that take the time and effort to build great brands are tremendously advantaged over those that are overly focused on price to draw customers in. We haven’t had the opportunity to own Amazon.com yet, but it’s a great example of how much brand matters. For a high percentage of its customers, a competitor would have to dramatically beat Amazon

on price – which is very difficult, by the way – for them to try something else.

On the lower right of the triangle we put technical expertise. Companies need a base of engineers, product designers, coders and others who are highly skilled in translating great ideas into workable products and services across multiple plat-forms. That type of expertise is a unique asset, and tends to be concentrated in Sili-con Valley.

The last leg of the triangle is an in-herent difficulty about the business that makes it challenging to perfect. Over and over again we’ve seen skeptics of these disruptive businesses assume there are no barriers to entry and that returns will be commoditized away. Companies like Net-flix, Shutterfly and Pandora have years of problem solving behind them already when new entrants come to play. This plus the inherent advantages that come with scale explain why these businesses often become winner-take-all or at least winner-take-most.

At the center of our diagram we put management. Inherent in betting on any fast-changing business is an important lev-el of reliance on the people making deci-sions about strategy, marketing, products and technology. We will not make a core investment without clear insight – through regular personal interaction – into who is making those decisions and how they’re making them. It’s easier said than done, but you simply have to get very comfort-able that smart things are being done ev-ery day.

Not to put too fine a point on it, but we could imagine that at the time you find them interesting, many value investors wouldn’t touch your core ideas with a ten-foot pole.

MC: Value investing tends to be focused on current earnings, while growth invest-

Investor Insight: Mario Cibelli Mario Cibelli of Cibelli Capital Management explains how he identifies disruptive business models, which “serially inef-ficient” special situations tend to most often attract his attention, why high short interests in his holdings don’t bother him, and what he thinks the market is missing in Outerwall, Shutterfly, Green Dot and Blackhawk Network Holdings.

I N V E S T O R I N S I G H T : Mario Cibelli

TRAITS OF “DISRUPTERS”:

They have brands and unique

technical expertise, while

the difficulty of the business

makes it hard to perfect.


ing is more about what a company is go-ing to earn in the future. A value inves-tor might say, “It’s speculation to try to figure out what Netflix is going to earn,” but to me trying to figure out how com-panies can grow to much higher levels of earnings is just another form of investing. We’re equally comfortable doing both.

We’re not venture-capital investors. Our more growth-oriented names are established companies with pre-existing business models. We’re making detailed and we think reasonable assumptions about how the next three to five years will play out and we’re focused on paying low multiples of future earnings. Value inves-tors are slow to believe, but there are ex-ceptional people who are competent, ag-gressive and creative enough to challenge the status quo. We were early in Expedia, and saw up close how it really changed the way people travel. That left a mark on me.

I would stress our value roots in all of this. I use Twitter [TWTR] and actu-ally find it to be a great research tool, but would I pay the current price? Absolutely not. Did we buy Facebook [FB] at the IPO? No, but after it fell over 40% from the IPO price, was trading at 6-7x for-ward EBITDA and seemed to have latent revenue growth potential that was outra-geously high, we did take a small position. With the stock having almost tripled from the bottom, we never got beyond that small share stake.

Our strategy requires an investor base that understands our returns can be vola-tile. We had great returns owning Netflix over the years, but twice it got crushed, down at least 35% in a short period of time. When that happens I don’t neces-sarily assume the market’s right and I’m wrong. We’ve gotten to the point where our investors understand that as well, which is very valuable. It allows us to view the world much differently than the aver-age hedge fund.

How do you get to know your companies “as well as anyone on the outside can?”

MC: There’s no secret to that. If you’re looking to take a 1-2% position, your time

is probably best spent on identifying the few things that matter the most and trying to figure out if you have a differentiated view. But when you’re looking to take a 10% or even 20% position, everything matters, including little, nuanced, tidbits of information that most people wouldn’t have an interest in. Why is it that Netflix sends you the first movie in your queue at a much higher rate than Blockbuster did?

Why do they turn DVDs around faster at their distribution centers? How come Shutterfly’s competitors force consumers to create a new book if they just want the same book in a different size? Why could Redbox’s kiosk deliver a movie DVD so much faster than the one from Blockbust-er Express? Little things like that matter. In aggregate, they begin to paint a picture of the competitive dynamics that many can’t see. Just reading the 10-K and listen-ing to earnings calls isn’t enough.

This extends to the conversations we have with management. We ask very de-tailed questions on every aspect of the business. I’ve found that the best CEOs of these disruptive-type businesses are the ones who aren’t turning to someone else to fill in the detail. They know exactly what’s going on and why. That gives us more conviction that the right decisions are being made.

The focus on detail also extends to how we build our models. Some businesses lend themselves more easily to this than others, but we essentially want to model the business similarly to how the company does. So for Outerwall [OUTR], we’re not just modeling the Redbox business on revenue and some assumptions on growth and margins. We’re going down to the in-dividual kiosk level to understand how ex-

actly it works, how much it costs and how much it earns. In doing all that we learned a lot about why Redbox was eating the competition’s lunch and why it was likely to be the one dominant DVD-rental-kiosk company.

Describe your valuation discipline.

MC: We create multiyear earnings and cash flow models and assign what we con-sider to be reasonable multiples on the out years’ earnings. Our goal is to have at least a 20% IRR from today’s price.

We’re striving for realism in the mod-els, but we also like to leave free options for upside surprises. With Shutterfly, for example, we’re modeling a level of rev-enue growth that is lower than historical levels and less than we really expect going forward. We also think it’s likely to buy the #2 player, Snapfish, at some point, but we’re not modeling that. If we can bank on lower numbers and still be happy, we love to do that.

Given the concentration of your portfolio, in what ways do you try to hedge various exposures?

MC: We’ll ideally have 75-80% of our to-tal assets in our top 10 investments, and I’m not averse to individual positions get-ting into the low-20% range. Both Shutter-fly and Outerwall were at that level earlier this year at the same time, though they’re not that high at the moment. I know a lot of people couldn’t sleep at night with 20% positions, but it’s the way I’ve done things since the beginning and I’m very comfort-able with it. For me, it all comes down to how well we know the company. You can still be surprised sometimes, but knowl-edge is power when it comes to position sizing.

We’re strongly long-biased and don’t manage to any net exposure, but we do some outright shorting, some paired trades and some sector-based hedging. We short-ed Blockbuster, for example, when Netf-lix was a core position. We have shorted American Greetings, before it went pri-vate, against our long in Shutterfly. If we


ON OUTSIZED POSITIONS:

A lot of people couldn’t sleep

at night with 20% positions,

but that’s just the way I’ve

done it since the beginning.


have a high exposure to a sector, we might offset a portion of that by going short an appropriate ETF or basket of securities.

How do you think about the high levels of short interest that exist in many of your top positions?

MC: By the nature of what we do, there’s often a lot of controversy around our names. We have gone against some of the very best minds on Wall Street on our longs, and the answer I always give when investors ask about it is that we and the shorts can both be right. There are very smart investors out there who do a great job pinpointing which quarter to be short. I’m not good at that and I find it intel-lectually unappealing, but it can work for “right-now” investors who are focused on what’s reflected in the share price today. I knew I wanted to own Netflix for a long time and had success in doing just that. The managers who shorted it before the stock collapsed a few times over that same period had success doing that. We both did our jobs.

You recommended Netflix in VII on Octo-ber 31, 2006 at just under $28 per share – one of the great calls ever. How well did you ride it on the way up?

MC: I’d like to say we still own every share we did then, but the fact is we sold down our position to nothing just prior to the Qwikster debacle. We did purchase shares again in the summer of 2012 in the $60s and we continue to have a tail-end position today. Reed Hastings is a brilliant CEO, but now everyone else seems to think that as well and the stock [at around $365] seems aggressively priced with a lot of rosy assumptions built in.

We don’t have hard-and-fast rules, but we’re shooting for a high IRR and if that becomes uninteresting we start selling. We don’t want to be a slave to the model ei-ther. If the IRR falls to 15% and we’ve built conservative assumptions in, we might say that 15% is still pretty good and there’s no rush to sell. It is very difficult to continue to get things right with compa-

nies that take off like Netflix. In retrospect we sold a lot of shares too soon.

Outerwall has gone in many people’s eyes from disrupter to disruptee. Why are you still bullish on it?

MC: This is a controversial name because 80% of the business today comes from Redbox and many assume DVDs are going away. We don’t disagree that the DVD-rental business is in secular decline, but we think the trajectory of that decline will be very different from what people expect.

Redbox has a low, disruptive price. A rental costs maybe $1.20 per night versus the cheapest alternative, video on demand [VOD], where the cost is usually $4.99 to $5.99. One way we think about the slope of the decline curve is by asking what would happen if Redbox disappeared and nothing replaced it. There’s no way that lost business would translate into VOD viewing on close to a one-for-one basis. You’ll take a chance on a movie for $1.20, but you’re much less likely to at $4.99 or $5.99, let alone at the price of seeing it in the theater. Clearly, there is a price at which the conversion to digital is slowed.


Outerwall (Nasdaq: OUTR)

Business: Provider of self-service kiosks located in or near third-party retail locations and offering two primary services: coin redemption and movie/videogame rental.





OUTR Russell 2000P/E (TTM) 11.0 87.2Forward P/E (Est.) 12.3 29.1EV/EBITDA (TTM) 5.4


Company % OwnedJANA Partners 10.0%Vanguard 7.2%Fine Capital 6.2%Artisan Partners 5.5%BlackRock 5.5%




OUTR PRICE HISTORY

THE BOTTOM LINEMario Cibelli believes the market is misjudging the extent and pace of the decline in the company’s lucrative DVD-rental business as well as the extent and pace of the rise in its electronics-recycling franchise. At what he considers a reasonable 9x his 2014 estimate of free cash flow prior to growth capital spending, the shares would trade around $100.


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Anyone expecting Redbox to disap-pear fast ought to look at the company’s Coinstar coin-counting business, which has been in harvest mode for six or seven years. The secular trend there is movement to a cashless society, but the company has been very smart about retooling the busi-ness to maintain revenue and earnings. They’ve increased prices but have also come up with new promotions like allow-ing people to count their coins for free if they put the money on a gift card, the issuer of which pays Coinstar. There are intelligent ways to stretch out the lives of these types of things.

We were happy that the company an-nounced earlier this month that it was pulling back on its development concepts in coffee, food and photos, while also cutting overhead costs and payroll. The goal is to maximize free cash flow from the existing businesses while investing in a new one that we think has tremendous potential.

Describe the new concept, ecoATM.

MC: The business is electronics-recycling kiosks, where you basically trade in your old mobile devices and tablets for cash on the spot. Outerwall bought the remaining 75% of ecoATM that it didn’t own over the summer.

What the company has figured out is how to collect large volumes of cast-off devices, delivering them to middlemen who may resell them in emerging markets or strip them for parts. Just in the U.S., 600 million new mobile phones were bought in the past year, which you can safely assume pushed a previous device out. There are a variety of things you can do with your old phone, including trad-ing it in, selling it on eBay or tossing it in the trash. The ecoATM alternative offers a quick and painless way to get cash to sell-ers and to get increasingly valuable used equipment to buyers.

This is not a simple thing to automate. You have to build in safeguards against people turning in stolen phones. You have to recognize a broken phone and pay less for it. But the company has had ecoATM

kiosks up and running now for nearly five years and they’re working well. Annual revenues so far are $100,000 to $120,000 per kiosk, resulting in 15- to 20-month paybacks. From 1,000 kiosks today, man-agement thinks the potential just in the U.S. could be as high as 10,000 units.

How are you thinking about valuation with the shares at a recent $66? MC: We believe the company next year will earn around $325 million in free cash flow, roughly $11 per share, prior to growth capital spending at ecoATM. As a

first pass, putting even a 9x multiple on that gets you to a share price of $100.

Coming at it another way, assume the coin-counting business is worth a little more than 6x EBITDA, or $600 million, and that ecoATM appreciates to twice what Outerwall paid for it last summer, or $700 million. If the company over the next three years earns the $600 million in net free cash flow, after growth capex, we expect, the implied enterprise value of the Redbox business will fall to $525 million. That’s on a business earning roughly $400 million in EBITDA per year right now. We think that protects us on the downside, with a nice option on ecoATM ultimately being worth significantly more than we’ve marked it.

We’re guessing the 35% short interest doesn’t concern you.

MC: My guess is that the hedge fund man-agers who are short the stock haven’t pur-chased or rented a physical DVD in years, so they assume no one else does either. But for a lot of people in this country, saving

money will remain very much in vogue. The busiest Redbox in the world is in Horizon City, Texas, at a Walgreens out-side of El Paso. People in places outside of New York and San Francisco will be renting low-priced DVDs for a long time.

Your bull case for Shutterfly [VII, Septem-ber 30, 2010] has played out fairly well. Why do you think it still has plenty of room to run?

MC: The more time we spend with the photo-commerce business – photo books, cards, stationery and other personalized products that visually preserve memories – the more convinced we are that there will not be a #2 player of substance after Shutterfly. When you remove traditional barriers to expansion like the need to open physical stores, companies with the right combination of scale and expertise can basically own a whole market. We think that’s what Shutterfly is in the pro-cess of doing.

The company has best-in-class manu-facturing, soon to be done at three prima-ry U.S. sites. Its marketing spending – now including TV, radio and print as well as online – dwarfs that of competitors. It in-vests far more in product innovation than others, resulting in a significant number of new products in recent years. What they don’t develop in house they go out and buy. Earlier this year, for example, they bought a company called ThisLife, which is going to be their cloud-based platform for photo and video organization, stor-ing and sharing. All of this drives growth and scale that just widens the gap between Shutterfly and the next-best player.

Is there a next-best player?

MC: The primary competitors are Snap-fish, owned by Hewlett-Packard, and American Greetings’ Cardstore.com. I consider them perfect competitors, ap-pearing ferocious enough in name to ward off new competition, but actually so soft as to make for easy kill. Snapfish, the most direct competitor, seems lost inside H-P and I really can’t imagine it ever thriving


ON PHOTO COMMERCE:

The more time we spend with

the business, the more con-

vinced we are there will not

be a #2 player of substance.


there. It’s very likely Shutterfly will buy Snapfish sometime in the next few years, although the price it would pay probably goes down every year H-P holds onto it. Shutterfly is small and focused on doing a single thing very right. H-P is as unfocused as they come.

What about the threat that Facebook, es-pecially after buying Instagram, decides to compete more directly with Shutterfly?

MC: This is a commonly voiced threat, reflecting both the concern that all pho-tos are going digital, and that Facebook

will leverage its position as a repository for photos to take on Shutterfly in photo commerce.

To the first point, one important con-clusion we’ve made is that there are lots of different kinds of photos, and no single entity can effectively serve all the needs for these varied photos. Shutterfly exists to create, assemble and store in a variety of different formats the photos you want to keep forever. The digital lifestyle is not going to do away with that.

To the second point, as Facebook shareholders we would be extremely dis-appointed at the company’s lack of vision

if it decided to compete directly with Shut-terfly. They would fail miserably. It’s not in their DNA – they know social media and ad targeting and know nothing about e-commerce, manufacturing, marketing and distribution of physical goods. It would be like trying to make a fish climb a tree.

What upside do you see in Shutterfly shares from today’s price of $51.60?

MC: We’re modeling 17% or so annual top-line growth over the next three years, with operating leverage taking EBITDA margins from the high-teens to low-20s. At 10-11x EBITDA on an enterprise value basis on our 2016 estimates, we arrive at a target price of $75 to $80 per share. As I mentioned earlier, we’re assuming a rate of growth they may well exceed.

I’m fairly convinced the end game here is that Amazon will acquire Shutterfly one day. Whether that happens or not, there are years of natural domestic and interna-tional growth ahead before the potential of the existing businesses is met. There’s also a truly outstanding CEO, Jeff House-nbold, who is probably going to develop or acquire other great products or services I can’t even imagine. All in, it’s a pretty powerful story in a low-growth economy.

Turning to a financial-services idea, de-scribe your thesis for Green Dot [GDOT].

MC: We’ve been a bit light on financials over time, but with all the industry chang-es in the past few years, more companies in the sector have been making it into the portfolio.

Green Dot offers pre-paid debit cards, under its own brand or those of large retail partners like Wal-Mart, which es-sentially provide the equivalent of check-ing-account services to non-banked or un-derbanked individuals. You can have your paycheck directly deposited to the card, use it to withdraw cash at ATMs and use it to make purchases through the Master-Card and Visa payment networks. There are a ton of different use profiles, but if you attach it to your payroll and stay within the ATM network, the fees to the


Shutterfly (Nasdaq: SFLY)

Business: Provider of a range of online and offline products and services focused on the reproduction, organization, sharing and preservation of personal photographs.



Financials (TTM): Revenue $724.6 millionOperating Profit Margin 2.6%Net Profit Margin 2.6%


SFLY Russell 2000P/E (TTM) 108.2 87.2Forward P/E (Est.) 156.4 29.1EV/EBITDA (TTM) n/a


Company % OwnedWells Fargo 11.6%Columbia Wanger Asset Mgmt 6.7%AllianceBernstein 6.4%BlackRock 5.4%Vanguard 5.4%




SFLY PRICE HISTORY

THE BOTTOM LINEThe company has built an increasingly unassailable position in photo-related commerce that has many years of strong natural domestic and international growth ahead of it, says Mario Cibelli. At 10-11x his 2016 estimate of EBITDA on an enterprise value basis, he arrives at a target price for the stock of $75-80, roughly 50% above today’s level.


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end user are very low compared to a full-service bank checking account. That posi-tions the company well in what is likely to remain a job-challenged, low-growth economy with more and more people stretching to make ends meet.

We’re very impressed by the founder and CEO, Steve Streit. There’s an excel-lent video on the web of him and Michael Moritz of Sequoia Capital, an early back-er, in which they talk about leadership and the development of the business. Steve St-reit is a unique personality and is passion-ate in his desire to deliver high-function-ing financial services at low cost to people

who don’t have access to them. I appreci-ate that and think this focus will provide a long-term tailwind for the company.

The stock has been volatile, to say the least, over the past 18 months. What are the primary culprits?

MC: In July of last year the stock was down around 60% in one day, from $23 to $9. The company took down expecta-tions across the board due both to a neces-sary tightening of its approval procedures and to the threat of new competition, par-ticularly from the rollout of the Bluebird

debit card from American Express. The market seemed to assume the gig was up for Green Dot.

It turns out Green Dot had more brand value in its demographic than the mar-ket expected and that American Express’ success in the market wasn’t such a slam dunk. As the company proved it was still able to grow through all that, the stock came back nicely and now trades above where it was before the collapse.

Isn’t American Express still coming?

MC: Yes. They have a new debit card coming out with even lower fees. That’s a concern, but I don’t believe this ver-sion will be any more successful than the last. The American Express brand doesn’t mean much in this target market, and it’s a negative that Amex isn’t accepted nearly as broadly as MasterCard and Visa. In my humble opinion, it’s kind of a misguided effort on their part. If they really want to be in this market, their best strategy by far would be to try to buy Green Dot.

Is this one of the many areas of specialty finance that faces increased regulation?

MC: That seems to be a market concern. The Consumer Financial Protection Bu-reau is looking at prepaid products, and that could result in greater compliance and regulatory burdens. My view is that Green Dot is both the scale player and the class operator, so any changes that hurt it will decimate its competitors and ultimately help it consolidate its market position.

At just under $25, how inexpensive do you consider the shares?

MC: Backing out cash on the balance sheet, the stock trades at roughly 18x 2014 estimated earnings and about 8x next year’s EV/EBITDA.

This is a difficult one to model because there are so many different user profiles for the company’s cards. One good indi-cator of the potential value here is that Total System Services paid $1.4 billion earlier this year for debit-card competitor


Green Dot (NYSE: GDOT)

Business: Bank holding company focused primarily on branded consumer prepaid debit cards, prepaid card-reloading ser-vices and mobile bank accounts.


Price 24.8252-Week Range 11.85 – 26.61Dividend Yield 0.0%Market Cap $927.1 million

Financials (TTM): Revenue $576.0 millionOperating Profit Margin 11.1%Net Profit Margin 7.5%


GDOT Russell 2000P/E (TTM) 25.4 87.2Forward P/E (Est.) 17.4 29.1EV/EBITDA (TTM) 6.4


Company % OwnedScff Mgmt 7.6%Fidelity Mgmt & Research 5.6%QVT Financial 3.7%Harvest Capital 3.5%Opus Capital 3.4%




GDOT PRICE HISTORY

THE BOTTOM LINEThe company’s well-developed franchise in providing high-functioning financial services at low cost to consumers who haven’t had traditional access to them is a long-term tail-wind in a tepid economy, says Mario Cibelli. At the EBITDA multiple at which an inferior competitor was bought earlier this year, he says, the shares would trade around $45.


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NetSpend Holdings. NetSpend is much smaller than Green Dot and isn’t nearly as high quality, with distribution at pawn-shops, check-cashing firms and payday lenders, and with a reliance on fees for services such as overdrafts that Green Dot doesn’t offer. At the 14-15x EBITDA that NetSpend went for, Green Dot shares would be worth something around $45.

What do you consider the key risks?

MC: The Wal-Mart contract, which ac-counts for a significant chunk of total revenue, comes up for renewal in 2015. Wal-Mart is clearly a tough negotiator, but offsetting that somewhat is that this partnership appears to be working very well even as the environment becomes increasingly complex and regulated. Wal-Mart knows it needs a strong and commit-ted long-term partner in this business. It won’t necessarily just go with the best rev share offered.

From debit cards to gift cards, describe why you’re high on Blackhawk Network Holdings’ prospects.

MC: Carve-outs and spin-outs are always worth a close look. Blackhawk is a really nice business that has been trapped inside a mediocre grocery chain. It essentially runs a marketplace for branded gift cards in supermarkets, assembling cards from retailers like Home Depot and Cheesecake Factory and iTunes and then packaging them together for display at grocery-store partners.

Retailers like gift cards because the money loaded on has to be spent with them, and if it isn’t, they keep it anyway. Grocery stores like the high margins on items that take up little selling space. The numbers vary, but for every $100 loaded on a card, roughly $92 goes to the card sponsor, $5-6 goes to the grocery store and $2-3 goes to Blackhawk.

Company revenues this year should be $1.1 billion, up from $245 million in 2007, and it’s still a growth business. People like giving gift cards because they’re less im-personal than a check or cash. Blackhawk

is still expanding its grocery distribution and is constantly working to place big-ger and better displays with more cards. There’s significant potential to expand in other retail channels and internationally. The company has also made some inter-esting add-on acquisitions, most recently of a firm called IntelliSpend, which offers prepaid spending cards as part of corpo-rate employee-incentive programs. Over-all, we’re expecting top-line growth at least in the high teens over the next three years.

Is digital competition a threat?

MC: There are several start-ups focused on creating non-card-based solutions. While digital solutions will evolve, I believe this is a classic case of finding a solution for a non-problem. These gift cards are sold more than bought – putting them right in front of people and making them easy and convenient to load generates much higher sales than would occur otherwise. It also seems to me that even if more gift cards were sold digitally, it would still make sense for an intermediary like Blackhawk to exist, minimizing the need for multiple, non-scale, direct connections between the various partners.

Blackhawk Network Holdings (Nasdaq: HAWK)

Business: Provider of a distribution plat-form and network that primarily supports prepaid gift cards is offered by a wide vari-ety of retail partners in the United States.





HAWK Russell 2000P/E (TTM) 32.0 87.2Forward P/E (Est.) 18.5 29.1EV/EBITDA (TTM) 13.7


Company % OwnedColumbia Wanger Asset Mgmt 17.3%Lazard Asset Mgmt 8.2%Capital World Inv 7.6%First Investors Mgmt 6.4%Vanguard 4.7%




HAWK PRICE HISTORY

THE BOTTOM LINEBenefitting from expanded distribution for its gift-card programs in both existing and new retail channels, Mario Cibelli believes the company can increase its earnings at a mid-20% annualized rate over the next three years. His target price for the shares is $44, which is roughly today’s forward multiple applied to his estimate of 2016 EBITDA.


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The shares, now at $25.70, are up just over 10% from the April IPO. What po-tential do you see from here?

MC: With margin expansion on top of our estimated revenue growth, we’re model-ing mid-20% annualized earnings growth over the next three years. That may lag a bit this year because of new expenses af-ter going public, but should pick up from there. Our target price three years out is $44, which is roughly today’s forward multiple applied to our 2016 EBITDA es-timate of more than $215 million.

Has Safeway announced any plans for the remaining 80% stake its still owns in Blackhawk?

MC: Jana Partners is currently pushing Safeway to unlock shareholder value and I would imagine monetizing Blackhawk is on their list of recommendations. But we’re focused on Blackhawk’s earnings power three years out – if we’re right

about that, we should be fine regardless of what Safeway decides to do.

Can you let us in on any brand-new dis-coveries of disruptive business models?

MC: We pay attention to private compa-nies in businesses we’re interested in, that might have management we know, or that are backed by particularly smart VC firms. We even invest in a few. One we’ve funded recently that is still private is a company called FlexWage, which offers a turnkey solution that allows employers to advance to employees accrued but not yet paid wages. It essentially takes the loan out of payday lending, letting low-wage earners get paid between payroll cycles. FlexWage is trying to sell it as a benefit to employees, provided at very low per-transaction fees, that will tie them more closely to their em-ployer and help reduce turnover. It’s still early stage, but it’s something we find very interesting that could impact the entire payday-lending space.

What do you look back on as your most annoying mistakes?

MC: It’s difficult to balance price disci-pline against compelling business models. What really got me off my butt on Netflix was when the stock in 2004 went from the low-$30s to $9. If it only went to $15, maybe I wouldn’t have bought it. More recently we did a lot of work on Pandora and Zipcar, but didn’t buy much before we thought the prices got away from us. You can make decisions that look smart in the short term but end up being pen-ny wise and pound foolish. Sometimes it makes sense to push harder on valuation if you’ve found something capable of grow-ing at high rates over a long time. That’s something we always struggle with.

This is an issue today as valuations have crept higher for growth companies. We’re watching a number of terrific businesses and waiting for the right entry prices. In the meantime, we’re finding a lot do on the opportunistic side of the portfolio. VII

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Editor’s Note: Harvard Business School Professor Michael Porter needs no intro-duction to any serious student of busi-ness. His seminal work on the competitive dynamics that determine industry profit-ability and on the strategies companies can employ to positively impact their competitive positions – laid out initially in the books Competitive Strategy and Competitive Advantage – revolutionized managerial thinking. So articulate was his framework for thinking about strat-egy and competition that it passed quickly into accepted wisdom. As he recently told Fortune, “The highest compliment, I’ve come to understand, is, ‘Oh, that’s obvi-ous.’ I used to take that as criticism, but now I understand that’s the goal – to take a complex problem and make it seem clear and obvious.”

Now 66 and busier than ever writing, teaching and advising, Porter continues to take on a succession of massively com-plex problems, from reviving inner cities, to making countries more competitive, to transforming the value of healthcare de-livery. We caught up with him recently to discuss his latest thinking on competitive dynamics and corporate strategy. To our

surprise, he also had plenty on his mind about investing in general, and value in-vesting in particular.

Your “five forces” framework for analyz-ing industries – Threat of New Entrants, Bargaining Power of Buyers, Threat of Substitutes, Bargaining Power of Suppli-ers, Rivalry Among Firms – is an impor-tant part of many fundamental investors’ research process. Has your thinking on it evolved over the years?

Michael Porter: While the original frame-work was introduced many years ago, in 2008 I wrote an article in the Harvard Business Review that reexamined and re-flected on the application of the concept over time. My basic conclusion is that the five forces are still the five forces. There have been various nominations for a sixth force, such as technology or the influence of government, but my view is that those are best understood in terms of how they affect the five fundamental forces that ul-timately drive the division of value among industry participants. For example, gov-ernment policy can raise barriers to entry or lower barriers to entry. New technol-ogy can intensify the rivalry among firms or decrease it.

Industry structure is profoundly rel-evant to investment analysis, but too much of the analysis looks at industries in a simplistic way, say whether the industry is growing or shrinking, or whether it’s a down cycle or an up cycle. The fundamen-tal investor that uses the five forces to un-derstand what determines the fundamen-tal economic value creation in an industry and how it is changing gains a huge edge.

Do you think your strategy prescriptions for creating competitive advantage have equally stood the test of time?

MP: My original work looked at the broad positioning choices in an industry – low

costs, differentiation, broad or narrow set of customers. Over time, I deepened the principles for thinking about creating a unique and sustainable position, start-ing with the value chain. That was partly motivated by the #1 question I had got-ten about the generic strategies, which is, “Can’t you be both low-cost and differen-tiated at the same time?” This conundrum let to the distinction between operational effectiveness and strategic positioning. Operational effectiveness is about assimi-lating best practices. Strategic position-ing is about making choices and tradeoffs about what customers a company is going to serve, the particular needs it is trying to meet, and ultimately the value proposition of a company relative to competitors.

I have been focused on the timeless, un-varying fundamentals that underlie com-petition. There’s no question that condi-tions change and that change is relentless and impacts industries and companies. But I have always tried to understand the principles that never change, and use them to understand the consequences of change and the implications for companies and managers in setting direction. Those prin-ciples have stood the test of time.

Broadly speaking, would you say the rate of change in industry structures and com-petitive positions has increased?

MP: We don’t have any real proof, but the general feeling is that things are chang-ing faster. I believe that everyone always thinks that their period of history is one where things are changing faster.

Information technology, however, has clearly been a big disrupter and a speed accelerator. I would also say the aggres-siveness with which management is shut-ting things down and cutting costs has definitely gone up over the last 10 or 20 years. That is partly due to the fact that capital markets are more transparent and investors are more demanding. But on

Without peer as an expert on industry dynamics and competitive strategy, Harvard Business School’s Michael Porter has also been thinking a lot about investors and investing – not all of which is particularly flattering.

S T R AT E GY: Michael Porter

Fundamental Purpose


Michael PorterHarvard Business School

On investors’ role: “Directing capital to companies that can use it productively is ultimately the most profound benefit investors can have on society.”


many other dimensions of competition, I’m not so sure the rate of change is that much faster.

Every year or two over the past 20 years somebody has written an article say-ing strategy is no longer relevant because the world is changing too quickly and the imperative is to stay one step ahead by changing feverishly. I don’t know many CEOs who actually believe this. Just about every company I’ve ever come in contact with recognizes it needs a strategy. It needs to understand who it is and how it’s going to create distinctive value. That’s what allows companies and managers to make choices about how to deal with all the trends, versus just imitate the next guy.

Elaborate on your earlier comment that investors’ industry analysis can often be simplistic.

MP: Industry trends and today’s growth rates are easy to see. What’s more subtle is to understand how the five forces are changing, and what that means for where the overall value lies.

For example, a very important trend working its way through many manu-facturing industries is that products with embedded sensors are getting “smart” and “connected” to manufacturers and users via the Internet. Smart connected prod-ucts can have a variety of impacts up and down the value chain. For example, by transforming the nature of after-sale ser-vice, where there is a shift toward more preventative and efficient maintenance versus a traditional break-and-fix model. But the trend is neither good nor bad. It all depends on how it’s going to impact the five forces in a particular industry. Does it impact barriers to entry? Does it create switching costs for the customer? Does it create new business models focused on selling the use of the product rather than the product itself, rebalancing customer power? Taking the trends and then work-ing them through the five-forces frame-work is where the insight comes.

Another example is that an industry doesn’t have to be growing to be interest-ing. A year or two ago investor enthusiasm

for the printing industry was non-existent because print is being substituted for by electronic media. But declining industries can be highly profitable if capacity leaves the market and barriers to entry rise. De-mand can hold up in less-price-sensitive segments. I’m not making the case for ev-eryone to run out and buy printing com-panies. But if you look deeply enough, you may have even greater economic op-portunities in some declining industries than you do in growth industries where

everyone is rushing to get in. Look at the stock price of R.R. Donnelley [RRD] over the past year.

You mentioned that investors have be-come more demanding. Do you consider that an unalloyed good?

MP: Net-net, I would say capital mar-kets have made it harder for companies to actually have a strategy and make the investments that address the true funda-mentals of their industry structure and their competitive position. We’ve seen a rise in gaming around guidance and deliv-ering quarterly earnings surprises. There’s also a tendency for investors to latch on to one company that seems to be doing well and push for everyone else in the indus-try to imitate it. Analysts tend to evalu-ate competitors on the same metrics even though different metrics are appropriate for different strategies. All of this encour-ages convergence, which is the enemy of strategy. The worst mistake in strategy is for a company to compete with rivals on all the same things.

Given all your work with companies and industries, are there any secular trends you’d suggest investors examine?

MP: In the U.S. economy, the single big-gest opportunity that will have ripple ef-fects across many industries is the new en-ergy situation. This is certainly not a secret and has already had significant impact on oil and gas producing regions and on the railroads and pipelines that transport all the new production. The next-order ef-fects, which are just beginning, will be on industries where oil and gas are important feedstocks or inputs, such as in chemicals and plastics where U.S. production now has a competitive advantage where it has had a disadvantage. Further down the line, other energy-intensive industries and companies will benefit.

Another area on which I spend a lot of my time today is around the idea of cre-ating shared value. This gets at the rela-tionship between business and important societal issues such as health, education, poverty and the environment. Historically companies have addressed social issues through corporate philanthropy, which is detached from the business and, some would say, spends shareholders’ money. More recently, corporate responsibility initiatives have led to much reporting and focus on reducing social harms – again, tangential to the business.

But the real power of a business in so-ciety is in being a business – meeting needs at a profit. We’re just starting to under-stand that the worrisome societal prob-lems we face represent the greatest busi-ness opportunities.

The pharmaceutical industry is a great example. It was built largely to serve a half billion people living primarily in rich countries with established healthcare systems and relatively high incomes. But another 6.5 billion people are out there whose needs are largely unmet. Compa-nies like Novartis and Novo Nordisk are starting to address those 6.5 billion people profitably with new kinds of products, pricing models and distribution systems. The potential to create shared value is huge and applicable to virtually every in-dustry and sector.

Can you give some other examples of companies creating shared value?

ON SHARED VALUE:

We’re starting to understand

that worrisome societal prob-

lems represent the greatest

business opportunities.



MP: Becton, Dickinson is a medical-device company whose recent growth is being driven by addressing public health needs – like risks from needle-stick infections – working collaboratively with govern-ments and non-governmental organiza-tions to do so. Dow Chemical created a “Breakthroughs to World Challenges” program, tasking each of its business units to find business solutions to a range of global problems. One big hit was the development of Omega-9 canola and sun-flower seeds that produce cooking oil with no trans fats and low saturated fats. The seeds yield for farmers twice the oil per hectare than soybeans, and the oils have longer shelf and usage lives for customers. It’s also become one of Dow Chemical’s biggest-selling product lines. This is creat-ing shared value.

It’s crucial for every enterprise to un-derstand its fundamental purpose in so-ciety. Lately we’ve been saying that our fundamental purpose is to make money – maximize shareholder value. But this definition of purpose is uninspiring and even risky. Companies also define purpose in terms of the product they produce. But purpose ought to be about the fundamen-tal needs in society a company meets. If Nestle thinks of itself as just a food com-pany, it might think that the goal is to get people to eat more. But if Nestle thinks of itself as a nutrition company, it has aligned its purpose around meeting a fundamental societal need. That opens up optionality and opportunity for Nestle to differenti-ate itself and innovate in ways that create shared value.

You’re helping to lead a multi-year Har-vard initiative on U.S. competitiveness. What would you highlight as key insights from that effort so far?

MP: This starts with the definition of competitiveness. In our definition, the United States is competitive to the degree that companies operating here can com-pete successfully in global markets while simultaneously maintaining and increas-ing wages and living standards for the average American. If business succeeds by

cutting jobs and incomes, the U.S. is not truly competitive. We’re finding that the U.S. has serious structural competitiveness problems, which leads us to believe that the country is likely to face slow economic and job growth for years to come.

Everyone seems to understand the mac-roeconomic problems we face. But our work suggests that we also have a number of serious microeconomic problems that are just as important.

While the U.S. retains core strengths in things like entrepreneurship, innovation, science and higher education, we’ve let some of the basics slide. We need to sim-plify and streamline regulation affecting business to focus on outcomes rather than impose costly reporting, compliance and delays. Our legal system is inflicting high costs on U.S. businesses, as is our health-care system. Roads, bridges and ports are in disrepair, and our communications and energy infrastructure does not match the world’s best.

The corporate tax system is disastrous for U.S. competitiveness, with the highest statutory rates in the OECD and disincen-tives to repatriate foreign profits back to the U.S. At the same time, the system has so many complex exclusions and deduc-tions that the U.S. ends up collecting low-er taxes than many other countries.

Our public-education system, crucial to the ability of workers to compete and to maintain their incomes, continues to fall further behind, especially with respect to middle-level skills involving some techni-cal training. Overall, skill development is broken, leading to unfilled jobs and high unemployment. What troubles us is that the U.S. has not been willing and able to reach consensus, pass legislation, and ad-dress any of these problems in decades.

In the same way companies need to define their purpose, you’ve said the same thing about investors. Explain that.

MP: I believe the fundamental purpose of investing is to deploy capital to pro-ductive uses in the real economy. It’s the ability of businesses to use capital well to meet needs at a profit and grow that cre-ates all the wealth in society. Government and NGOs don’t create wealth, they uti-lize taxes and donations to meet societal needs. Directing capital to companies that can use it productively to create economic value, and thus wealth, is ultimately the most profound benefit investors can have on society.

Beyond allocating capital, investors also play a vital role in monitoring what companies are doing, pushing for trans-parency, and intervening to catalyze change if the capital employed isn’t gen-erating the economic value it should. All of this raises the fundamental wealth that is being created, and this kind of wealth creation does not come at the expense of other investors.

The concern is that it seems like the vast majority of energy and effort in in-vesting has become about other things. It’s about indexing. It’s about momentum. It’s about program trading to capitalize on tiny movements in share prices. It’s about locating your servers closer to the exchange so you can trade in and out a little faster. I’m all for price discovery and liquidity, but improvements here have di-minishing returns for fundamental wealth creation. One investor’s gain is often an-other investor’s loss.

As more investors walk away from fundamental investing, the need and the opportunity grows for value investors who focus on understanding companies, industries and competition. Such investors can do well for themselves, for their own investors, and for society. This is creating shared value. I’d like to see more inves-tors with that sense of purpose, and more rules, regulations and incentives put in place that lead investing in these direc-tions rather than those that create limited societal returns. VII


ON ECONOMIC VALUE:

The concern is that it seems

the vast majority of energy

and effort in investing has

become about other things.


U N C O V E R I N G VA L U E : Dream Unlimited

Horizon Kinetics LLC’s Murray Stahl considers Canada “the most overlooked stock market in the world.” One of his favorite representative examples of this phenomenon: recent Dundee Corp. spinoff Dream Unlimited.

Marathon Partners’ Mario Cibelli in his interview in this issue reiterates the opportunity many savvy investors see in newly public business units that have been hived off from a corporate parent. Given the typical structural dynamics of such events and the incremental upside expect-ed from having an independent manage-ment and board focused only on the busi-ness at hand, “Carve outs and spin outs are always worth a close look,” he says.

Murray Stahl of Horizon Kinetics LLC [VII, May 31, 2013] has taken just such a look at Dream Unlimited, a Canadian real estate company spun off in May by Dundee Corp. Dundee’s billionaire founder Ned Goodman felt the legacy assets of Dundee Realty, which now make up Dream, were not being properly valued within a hold-ing company structure, prompting the spin out at around C$12.50 per share. Though the shares have performed well, rising to a recent C$17.20, Stahl argues that Dream’s assets are still far from properly valued.

Dream is active in two primary areas, residential development and commercial real estate asset management. Its land-and-housing division owns more than 9,000 acres of undeveloped land in resource-rich western Canada, is an active developer of large master-planned residential commu-nities and owns a leading homebuilder in Saskatchewan. Its urban-development unit is a large condo developer in and around Toronto and co-owns Toronto’s Distillery Historic District, an up-and-coming 13-acre pedestrian-only village dedicated to arts, culture and entertainment. Its resort division owns and operates the Arapahoe Basin ski area in Colorado and holds an interest in California’s Bear Valley Moun-tain Resort.

The company also manages approxi-mately C$9.6 billion in commercial real estate, comprising over 56 million square feet and primarily including the assets of three other publicly traded Dundee off-spring: Dundee Industrial REIT (Canadi-

an light-industrial properties), Dundee In-ternational REIT (commercial properties in Europe) and Dundee REIT (Canadian office properties). As the active asset man-ager, Dream collects management fees as well as performance fees based on the ac-tive buying and selling of portfolio assets. The terms of the spinoff essentially con-firm that Dream will be able to maintain these management contracts in perpetuity, notes Stahl.

What’s that all worth? Stahl says he doesn’t need to go through a property-by-property assessment of current valuations,

but is focused instead on two primary stores of value. He believes the asset-man-agement fee-revenue stream is worth at least 10% of total assets managed, justify-ing 75% of Dream’s current C$1.3 billion market cap. He also cites the 9,000 acres of undeveloped western Canadian land, which the company has publicly stated it believes will generate C$4 billion in earn-ings over the next 20 years. “If they get anything remotely close to that number, discounted back to the present, everything else I’m buying today will turn out to be free,” he says. VII

Unfulfilled Dream

Dream Unlimited (Toronto: DRM:CN)

Business: Diversified Canadian real estate company focused primarily on residential housing development and commercial-property asset management.

Share Information(@12/27/13, Exchange Rate: $1 = C$1.071):

Price C$17.1752-Week Range C$9.54 – C$17.64Dividend Yield 2.9%Market Cap C$1.30 billion

Financials (Through 9/30, annualized): Revenue C$479.4 millionEBIT Margin 24.2%Net Profit Margin 24.2%


DRM:CN Russell 2000P/E n/a 87.2


THE BOTTOM LINEThe market is mispricing both the income-producing and developmental assets of this well-managed recent spinoff, says Murray Stahl. If the company realizes “anything close” to the earnings it expects from just one store of value – yet-to-be-developed Western Canadian land – “everything else I’m buying today will turn out to be free,” he says.


DRM:CN PRICE HISTORY

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E D I T O R S ’ L E T T E R

As readers, we’ve never gotten a great deal out of investment-oriented pub-lications’ “How did we do this year?” types of stories. While we appreciate the effort to be accountable for what’s ap-peared in their pages, there tends to be a lot of back-slapping over great calls, the recitation of which doesn’t provide a tre-mendous amount of value after the fact.

We regularly track how the stocks rec-ommended in VII perform, specifically the “focus” ideas in interviews that are accompanied by Investment Snapshots, as well as the one-off ideas in Uncovering Value, Uncovering Risk or A Fresh Look features. The challenge is defining a time frame over which to look. Most of those we interview credibly cite their ability to look beyond the short-term focus of most investors as a competitive advantage, so rating their ideas after a year or less seems unproductive and a bit unfair.

But as the end of the year is a good time to reflect, we’re happy to do so – but with a twist, focusing more on what has so far gone wrong than right. Not that a lot didn’t go right: Had you invested $10,000 in each of the 122 ideas mentioned in depth in VII over the past 12 months

($1,220,000), your portfolio as of Decem-ber 26 would have $43,000 more than one that had invested the same amounts in the Russell 3000. That represents an 18.8% gain, vs. 15.3% for the market. (In com-paring this to the market’s 2013 perfor-mance, remember that the ideas tracked only contribute for the time held, which for the ideas in our November issue, for example, amounted to just one month.) No fewer than five stocks – Quiksilver, Manpower, Crosstex Energy, iGate and Leap Wireless – more than doubled.

Were there commonalities among the handful of unsuccessful ideas so far? Two stand out. Bottom fishing among gold miners, namely Coeur Mining and Allied Nevada Gold, has decidedly not worked out. Nor, unsurprisingly, have most of the short ideas recommended, most promi-nently Herbalife, German utility RWE and Vera Bradley. In a horrible year for short-sellers, kudos go to Solas Capital’s Tucker Golden for his negative thesis on Krispy Kreme Doughnuts in our August issue – its shares have fallen 14% over a period in which the market is up more than 12%.

While many ideas recommended at-tracted high-profile activist investments

during the year, those cited before the activist went public, such as Air Products and Oil States International, performed far better than those mentioned after the activist angle became well known, such as Agrium and Ashland.

Timing has also been an issue with technology companies Internap Network Services and Symantec. While both have seen their shares fall since being men-tioned, the investment cases for each rests on business transformations that haven’t yet borne the fruit that their recommend-ers expect. Each was a “time arbitrage” idea for which insufficient time has passed to accurately judge success or failure.

One idea from our pages for which time has been relatively unkind: British grocery giant Tesco PLC. It has been recommend-ed three times in the past two years, most recently in our September issue, and the share price has essentially gone nowhere. Maybe our pointing it out now is a sign that the tide is about to turn.

Here’s wishing you all a happy, peace-ful and prosperous 2014! VII

Taking Stock

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Value Investor Insight and SuperInvestor Insight are published at www.valueinvestorinsight.com (the “Site”) by Value Investor Media, Inc. Use of this newsletter and its content is governed by the Site Terms of Use described in detail at www.valueinvestorinsight.com/misc/termsofuse. For your convenience, a summary of certain key policies, disclosures and disclaimers is reproduced below. This summary is meant in no way to limit or otherwise circumscribe the full scope and effect of the complete Terms of Use.

No Investment AdviceThis newsletter is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. This newsletter is distributed for informational purposes only and should not be construed as investment advice or a recom-mendation to sell or buy any security or other investment, or undertake any investment strategy. It does not constitute a general or personal recommendation or take into account the particular investment objectives, financ ial situations, or needs of individual investors. The price and value of securities referred to in this newsletter will fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of all of the original capital invested in a security discussed in this newsletter may occur. Certain transactions, including those involving futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors.

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It is the policy of T2 Partners Management, LP and all Related Persons to allow a full trading day to elapse after the publication of this newsletter before purchases or sales are made of any securities or financial instruments discussed herein as Investment Snapshots.

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