value investor may 2011

8/3/2019 Value Investor May 2011

1/23

He followed in his father's footsteps

in the investment business, but

Lloyd Khaner didn't go down

exactly the same path. My Dad was very

much a cigar-butt, 50-cent-dollar kind of

investor and very good at it, he says.

That's not what I do.

Khaner has proven very good at what hedoes as well, focusing on high-quality com-

panies that have lost their way and have

first-class management leading the turn-

around. Since he took full control of Khaner

Capital's portfolio in 1997, it has earned a

net annualized 11.1%, vs. 6.2% for the

S&P 500.

With companies in need of revival always

in ready supply, he sees particular value

today in fast food, software, asset manage-

ment and industrial products. See page 9

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

Lloyd KhanerKhaner Capital

Investment Focus: Seeks companiesrequiring operational and strategic repair after the turnaround has commenced butbefore the market appears to believe it.

ValueInvestorMay 27, 201

Impeccable LogicThey and the companies they invest in may not be particularly well known, butDennis Delafield and Vince Sellecchia have built a record worthy of wide acclaim.

Inside this IssueFEATURES

Investor Insight: Delafield FundRoving off the beaten path to findvalue in such companies as CollectiveBrands, Albany International, Ferroand Checkpoint Systems. PAGE 1

Investor Insight: Lloyd Khaner

Looking for signs of unexpectedrecovery and finding them today inSonic Corp., Cadence Design, Och-Ziff and Illinois Tool Works.PAGE 1

Strategy: Real Estate

In a sector where recovery has beenfitful at best, two experts assesstodays opportunity set. PAGE 16

Uncovering Value: Skechers

Is the market right in treating thetrend-conscious shoe company as ifits a one-hit wonder? PAGE 21

Editors' Letter

Advice for those trying to win at theLosers Game of investing. PAGE 22

INVESTMENT HIGHLIGHTS

Other companies in this issue:

Campbell Soup,Celanese,Kennametal,

Lennar,Plexus, School Specialty, Sears

Holdings,Stanley Black & Decker,

Starbucks,St. Joe, Tyco International,

Weatherford,Xerox

Comeback TrailsLong-term investors spend considerable time trying to separate fact from fictionin corporate plans. For Lloyd Khaner, thats proven to be time very well spent.

The Leading Authority on Value Investing

INSIGHT

INVESTMENT SNAPSHOTS PAGE

Albany International 5

Cadence Design Systems 13

Checkpoint Systems 6

Collective Brands 4

Ferro 7

Forest City Enterprises 18

Henderson Land 19

Illinois Tool Works 14

Och-Ziff Capital Management 12

Skechers 21

Sonic Corp. 11

Dennis Delafield's first job in 1957

was at a small investment firm in

Florida, but it wasn't exactly the

culmination of a life-long ambition. They

offered me a job and I needed one, he

says. I didn't know a stock from a bond.

The career match couldn't have been

better. Still going strong at 75, Delafieldand partner Vincent Sellecchia now man-

age $2.2 billion for Tocqueville Asset

Management, the bulk of which is in the

Delafield Fund, which has earned a net

annualized 11.6% over the past 15 years,

vs. 6.5% for the S&P 500.

Trafficking in misunderstood and

unloved companies, they are finding

opportunity today in such areas as shoes,

anti-theft systems, industrial equipment

and chemicals. See page 2

www.valueinvestorinsight.com


Dennis Delafield, Vincent SellecchiaDelafield Fund

Investment Focus: Seek companiesundergoing positive change whose shareprices indicate the market is skeptical, orunaware, of their future prospects.
http://www.valueinvestorinsight.com/http://www.valueinvestorinsight.com/


2/23

I N V E S T O R I N S I G H T : Delafield Fund

Value Investor Insight 2May 27, 2011 www.valueinvestorinsight.com

Investor Insight: Delafield FundDennis Delafield and Vincent Sellecchia of the Delafield Fund describe why their portfolio companies are hardly a glam-orous lot, a key impetus to the special situations they typically pursue, why cash is more valuable than ever, and whythey see mispriced value in Collective Brands, Albany International, Checkpoint Systems and Ferro.

You often remind your investors of your

strategy in what strikes us as a refreshing-

ly clear and succinct way. Can you repeat

that for us here?

Dennis Delafield: Weve been at this for a

long time, so we should be able to

describe what we think is a logical

approach to protecting our investors

capital and making it grow.

We search widely for stocks that are

selling at prices which seem to be modestin relation to the underlying companys

intrinsic value.

We meet with management, visit

plants, talk to competitors and do all the

groundwork necessary to understand the

business and the people who direct the

companys future.

We search for companies in which

change can alter that future for the better.

That can mean a change in management.

It can mean a change in managements

attitude toward running the business, sayby recognizing that 120% of the earnings

come from 80% of the assets, so they

should do something about that other

20% at some point. It can mean a new

business opportunity that has yet to take

off. It can mean a change in the dynamics

of a companys cash flow and how its to

be used.

If we perform our analysis correctly,

the value added we bring is an earlier and

better understanding of the companies in

our portfolio than other investors mighthave. If the companies then begin to

improve, their earnings should increase

and theyre likely to earn a higher

price/earnings multiple.

Finally, we believe stock selection is

much more relevant to successful invest-

ing than a total commitment to equities.

As markets have gotten more volatile

over the last 15 to 20 years, weve come

to believe that the best hedge against

volatility is to have cash on hand with

which to invest when stock prices seem

unduly depressed.

Your portfolio companies today are a

pretty unglamorous and low-profile lot.

Is that typical?

DD: Our sweet spot tends to be in small

and mid-size companies that often arent

particularly well followed by Wall Street.

It would be illogical for us to know or

uncover something about Procter &Gamble or Texas Instruments before 100

smart analysts did.

Vincent Sellecchia: Often businesses with

high profiles or in sexy industries are the

hardest to understand. They might be in a

wide variety of disparate businesses. They

might be in technology industries with

very short product life cycles. Its easier

for us to get our arms around the basic

industrial company in the heartland.

We also tend to find more special situ-ations in industries with higher cyclicality,

which most often arent the most glam-

orous sectors of the economy. How com-

panies both prepare for and respond to

industry capacity utilization rates going

from 100% to 30% and earnings falling

off a cliff has a dramatic impact on their

future prospects. If the down cycle makes

entry points attractive, that can create

excellent opportunities.

Kennametal [KMT] is a classic exam-

ple of the type of situation we find inter-esting. After a change in CEO, the com-

pany, which makes metal-cutting tools,

went through an extensive restructuring

of its business portfolio and manufactur-

ing footprint to focus on its core compe-

tencies and on businesses generating free

cash flow, while also paying down debt.

All of that was poised to pay off when

the economic crisis took revenues down

45%. We had an existing position and

added to it, given the operating leverage

Dennis Delafield, Vincent Sellecchia

Go With the Flow

When Dennis Delafield took his first

investing job after graduating from

Princeton in 1957, Dwight Eisenhower

was president, the Dow Jones Industrial

Average was around 500, and the aver-

age turnover on the New York Stock

Exchange was less than one million

shares a day. Whats remained relatively

unchanged over that time, he says, is the

basic analysis required to understand

companies and their businesses. The

biggest change: volatility, both in trading

and in the economic system overall: With

all slack squeezed out of the system and

individuals and governments levered to

the hilt, for investors theres much more of

a premium now on being nimble, on being

flexible, and on having plenty of reserves

on hand when volatility hits.

Delafield today shares portfolio manage-

ment responsibilities with Vincent

Sellecchia, who joined what was then an

independent Delafield Asset Management

in 1980. (The firm is now part of

Tocqueville Asset Management.) Both

remain hands-on analysts, which they

would have no other way. Look, the busi-

ness is fun because you learn something

new every day, Delafield says. I cant

imagine giving that up.


3/23Value Investor Insight 3May 27, 2011 www.valueinvestorinsight.com


we expected from the company as vol-

umes eventually picked up. Our thesis

went beyond just the cycle turning up

again, it was more focused on what the

company had done to make itself much

more profitable.

DD: One thing Id add is that as broker-

age firms have gone out of business or cut

back on the number of companies they

follow, its not as if we need to focus on

tiny or new companies to find those that

are relatively ignored. You can find plen-

ty of established, decent-sized companies

that just dont get the attention from Wall

Street that they once did.

We havent yet heard any mention of

business quality as a criterion.

VS: We would love to own great business-

es as much as the next guy, but the prob-

lem is finding them at the right price.

Were perfectly happy looking for the

average company, where we think theres

something going on which the market

hasnt recognized that can make it better

than average. Youre rewarded as much

for that as for a good company becoming

very good.

We do make every effort to understandwhat edge the company has in facing

competitive threats or maintaining pric-

ing power. When that edge isnt clear, you

have to be very careful about the valua-

tion you assign to the earnings and cash

flow stream. But business quality, in and

of itself, isnt paramount to our decision

to buy.

You recently had nearly 25% of your

assets in chemical companies. Is there ever

a thematic element to your cyclical bets?

DD: Everything we do is from the bottom

up, so there are company-specific reasons

we own each one of those positions, typ-

ically positive structural changes in the

company or its markets that we believe

are underway and that the market isnt

pricing in. Celanese [CE], for example,

enjoys a substantial technology-driven

cost advantage in its largest business,

acetyl intermediates, which should trans-

late into meaningful margin improvement

as industry utilization improves and

incrementally higher-cost production

comes on line. Its advanced engineered

materials business is also poised for sub-

stantial growth as its primary end-mar-

ket, auto manufacturing, recovers, and as

the content of its products per automobile

expands.

Longer-term, we see significant poten-

tial in the companys coal-to-ethanol tech-

nology, where just one of the giant plants

they are planning to build in China could

eventually add $1 per share in earnings

power. Right now in the U.S. you can

only make industrial ethanol, not fuel

ethanol, from coal. As more and more of

the U.S. corn crop is used to make fuel

ethanol, that may have to change. If it

does, Celanese would be well positionedto benefit.

Even with all that, while the stock has

come up somewhat since we bought it, its

still not at all expensive. On 2013 esti-

mates, the shares trade at less than 9x

earnings and around 5.5x EBITDA on an

enterprise value basis.

You mentioned markets becoming more

volatile over the years. Is that a good

thing for disciplined value investors?

DD: Markets have always responded to

fundamental surprises, positive and nega-

tive, in a companys business. Whats rel-

atively new is the volatility driven by the

high-frequency traders, day traders and

short-term oriented hedge funds reacting

to whatever it is exactly that they react to.

In either case, volatility can clearly create

buying opportunities when we believe the

reasons for the miss are temporary, not

structural.

Can you give a recent example?

DD: We bought shares last quarter in

Plexus Corp. [PLXS], a mid-tier electron

ics manufacturing services company with

annual revenues of about $2 billion. The

shares fell sharply after managemen

lowered revenue and earnings expecta

tions for the second half of its fiscal year

due largely to shortfalls in deliveries o

complex new beverage dispensing

machines the company is building for

Coca-Cola. While they havent deployed

as rapidly as expected, Coke continues to

push the new systems and we think the

delays are just short-term noise obscur

ing an overall long-term financial mode

for the business that remains intact

with 15% annual revenue growth, 10%gross margins, 5% operating margin

and a high-teens return on invested capi

tal. Given that we expect earnings power

to be in excess of $3 per share in the nex

few years, the stock [recently trading a

$37.20] still appears to us as a com

pelling value.

Can you generalize about the time hori-

zon for most of your investments?

VS: We tend to do our work looking outwo to three years, but our time horizon

on any given holding is purely a function

of whats going on with the business and

how the market is valuing it at any given

moment. For example, we initially pur

chased Stanley Works several years ago

and management has done a good job in

managing the portfolio of businesses

More than a year ago they acquired Black

& Decker in a stock deal, and despite the

fact that the share price was substantially

higher than when we initially set up ourposition, we increased our holding

because the deal made a good strategy fi

with large cost synergies. Today, with

Stanley Black & Decker [SWK] stock

having moved higher yet since the deal [to

a recent $73.50], it isn't what I'd consid

er cheap, but it is a sound holding espe

cially if the company can come close to it

2015 goals of 15% operating margins on

$15 billion in revenues. That translates to

about $10 per share of earnings power.

ON BUSINESS QUALITY:

Youre rewarded as much for

an average company getting

better as you are for a good

company becoming very good.




How rigid is your selling discipline?

VS: Weve always said we want to sell

stocks when theyre fairly valued, but

well admit that determining that is as

much art as science. There are no hard

and fast rules, but in general we should be

cutting back and moving on if the valua-

tion appears to reflect whatever informa-

tion we considered our edge at the outset.

Tyco International [TYC] has been a

good investment for us and we think the

company has excellent growth prospects,

but as the stock price has reflected that,

weve reduced our position. We often find

ourselves selling to more growth-oriented

investors.

DD: Our view on a position can alsochange as the situation warrants. Weve

invested successfully in oilfield-services

company Weatherford International

[WFT], for example, but have become

increasingly concerned about its exposure

in the Middle East and about what we

consider to be a fairly levered balance

sheet. As the stock hit post-crisis highs

last quarter, we took money off the table.

VS: Another example where weve

responded to a changed situation is inSchool Specialty, Inc. [SCHS], which pro-

vides basic educational supplies to public

schools. Management was doing the right

things to improve the companys operat-

ing profitability, but we sold the stock

after concluding cuts in state and local

education budgets were likely to be too

much of a demand headwind for the fore-

seeable future.

Turning to some of your favorite current

ideas, describe the investment case forrecently in-the-news shoe company

Collective Brands [PSS].

VS: We got interested in the company,

then called Payless ShoeSource, when

Matthew Rubel came in as CEO after a

very successful stint running Nikes Cole

Haan dress-shoe division. Starting with

the 2007 acquisition of Stride Rite, hes

been transforming the company from

what was a mostly domestic discount

shoe retailer to a more-diversified and

international retailer and wholesaler.

The anchor on performance is the

domestic retail business, which serves the

economy-minded consumer and accounts

for nearly 60% of the companys $3.4 bil-

lion in annual sales. Its target customers

are still hurting economically, which is

crimping demand and making it very dif-

ficult to pass through materials-cost

increases. Higher fuel costs have also

impacted customer spending, as did

unusually cold and wet weather during

the first quarter. All this was clear in the

recently reported results, which caused

the stock to sell off more than 15%.

Where we see value being created

however, is in the rest of the business. The

international retail business generate

$500 million in annual revenue, earn

double-digit operating margins and con

tinues to grow nicely. The Stride Rite

retail operation in the U.S., which sell

childrens shoes, has been refurbished and

should breakeven this year as it continue

to turn around after years of losses.

The real gem, however, is the $700

million wholesale business, consisting pri

marily of the Saucony, Keds and Sperry

brands that were part of Stride Rite. Each

has gone through a top-to-bottom over

haul after being undermanaged by previ

Collective Brands(NYSE: PSS)

Business: Footwear retailer throughPayless Shoe Source and Stride Rite storesand wholesaler through brands such asKeds, Saucony, Sperry and Top Sider.

Share Information(@5/26/11):

Price 15.2752-Week Range 12.41 23.96Dividend Yield 0.0%Market Cap $939.5 million

Financials (TTM):

Revenue $3.37 billionOperating Profit Margin 4.4%Net Profit Margin 2.8%

THE BOTTOM LINE

Woes in the companys domestic retail operations are obscuring important and build-ing successes in its international and wholesale businesses, says Vince Sellecchia.After a very recent hit to the share price, he believes the risk/return equation for thecompanys stock trading at 4.5x forward EBITDA has only gotten better.

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

PSS PRICE HISTORY

Sources: Company reports, other publicly available information

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02009 2010 2011

Valuation Metrics(@5/26/11):

PSS S&P 500

Trailing P/E 8.7 16.6Forward P/E Est. 10.4 13.5

Largest Institutional Owners(@3/31/11):

Company % Owned

Primecap Mgmt 10.3%Blum Capital 5.9%Wells Fargo 4.9%

Vanguard Group 4.8%State Street 4.6%

Short Interest (as of 5/13/11):

Shares Short/Float 17.6%

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0




ous management. For Sperry, that has

meant expanding the line beyond tradi-

tional boat shoes. For Saucony, it means

reaffirming a commitment to product

innovation. For Keds, it means capitaliz-

ing on the brands heritage in a similar

way to what Nike has done with

Converse.

Last year the wholesale business grew

22% and we believe it can be a $1 billion

business over time. We expect its operat-

ing margins to increase to 10% this year,

up from 6% in 2010, and should reach

the mid-teens as revenues expand.

Is there anything to be done with the

Payless retail business in the U.S.?

VS: Positioning has always been an issue.The big competitors are discount stores

like Wal-Mart and Kohls, so theres

always a question whether theres space

in the market for Payless to sell, say, $35

shoes rather than $20 ones. Theyre put-

ting some effort into that and doing

things like expanding the offerings of

higher-margin accessories, but this busi-

ness wont truly get back to normal until

its economically challenged target con-

sumer comes back. That should eventual-

ly happen and when it does, wed expectthe building strength of the other busi-

nesses to get more attention.

With the stock trading at a recent $15.25,

how are you looking at valuation?

VS: Given the latest weakness in the

Payless domestic business, were now

expecting earnings for the 2011 fiscal

year ending in January to come in

around $1.10 per share, down from

$1.73 in fiscal 2010. While earnings havefallen more than we previously expected,

we think the more modest near-term out-

look is fully reflected in the share price.

The current enterprise value of $1.2 bil-

lion is only 4.5x estimated EBITDA for

the coming fiscal year.

Over time the business mix should

improve as the wholesale business grows

at a faster rate than Payless, which should

have a positive impact on earnings and

cash flow. Given the earnings turmoil,

this may not be for the faint of heart, but

we have confidence in management's

ability to deal with the near-term issues

and believe the risk/return from todays

price is quite attractive.

Describe the potential you see in one of

your low-profile industrials, Albany

International [AIN].

VS: The companys main business, gener-

ating two-thirds of its nearly $1 billion in

annual sales, is selling paper-machine

clothing [PMC]. This includes the fabric

and belts that move pulp through the

paper-manufacturing process. Albany is

the largest supplier to this global market

with a 30% share, while its next closes

competitors such as Xerium, which i

publicly traded, and AstenJohnson

which is private, are no more than half a

big. Most of the rest of the business is in

making specialized doors used in industri

al plants and in selling other products

like filters and winter-coat insulation

made using similar weaving technology to

that used to make paper-machine cloth

ing. Finally, theres a small composite

business with less than $50 million in

revenues selling primarily carbon-rein

forced products to aerospace manufactur

ers. Ill come back to that later.

Albany International(NYSE: AIN)

Business: Diversified manufacturer ofpaper-machine clothing, industrial door sys-tems, engineered fabrics, engineered com-posites and insulation materials.



Financials (TTM):

Revenue $952.3 millionOperating Profit Margin 11.1%Net Profit Margin 5.1%

THE BOTTOM LINE

While the current 5.8x estimated EV/EBITDA multiple on the stock fairly values the com-panys unexciting but profitable core businesses primarily selling machine clothing tothe paper industry says Vince Sellecchia, he believes it ignores significant upside froma potential breakout business selling composites to aerospace manufacturers.


AIN PRICE HISTORY


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AIN S&P 500



Company % Owned

Wellington Mgmt 7.8%Columbia Wanger Asset Mgmt 5.5%Tocqueville Asset Mgmt 5.1%

Vanguard Group 5.1%Times Square Capital 4.9%



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Is manufacturing paper-machine clothing

a decent business?

VS: Its driven by paper production,

which is a consolidating and no-growth

business in developed markets and a

growing one particularly in container-

board in developing markets. Broadly

speaking, paper production in Europe is

expected to decline and in the U.S. is like-

ly to be flat, but increased production in

Asia and South America should offset

that and cause the overall global market

to modestly grow.

While not exciting, its an excellent

business for Albany, generating operating

margins of around 25%. Competition in

the business has become more rational as

the industry has re-sized, and the compa-ny has done an excellent job shifting pro-

duction capacity from the U.S. and

Europe to Asia. The bulk of the spending

on that capacity shift has been made, so

we expect the PMC business to be a fair-

ly reliable cash cow for years to come.

Can we assume the composites business

you mentioned provides some sizzle?

VS: Thats the interesting part of the

story. Albany composites are alreadybeing used in wheel struts on the new

Boeing 787, but the most exciting poten-

tial is in providing composite-based parts

to the Leap-X jet engine being developed

for narrow-body planes by a joint venture

between GE and the French company

Snecma. Theres clearly a tremendous

amount of uncertainty about what and

when planes get launched and reengi-

neered, as well as about the traction the

Leap-X engine gets in any of those pro-

grams. But its not beyond reason to thinkcomposites could be a $300-plus million

business for Albany within the next

decade, with margins comparable to

those in paper-machine clothing.

How inexpensive do you consider the

shares, now at $26.50?

VS: The shares trade at 11.5x our 2012

earnings estimate of $2.30 per share. On

the current enterprise value of $1.1 bil-

lion, the multiple on our 2012 EBITDA

estimate of $190 million is about 5.8x.

Our view is that the current valuation

reflects no upside for the composite busi-

ness, which we think could have a great

deal of upside.

What do you think the market is missing

in Checkpoint Systems [CKP]?

DD: Checkpoint has two primary busi-

nesses. The first, accounting for about

75% of total expected revenues this year

of $900 million, is selling anti-theft sys-

tems to retail stores. This includes the

hard and soft tags that are affixed to mer-

chandise, as well as a range of deactiva

tion, detection and video-surveillance

equipment. Two companies own the

lions share of this business, Checkpoin

and Sensormatic, a division of Tyco

Checkpoints is a radio-frequency-based

system, while Sensormatics uses what i

called acousto-magnetic technology.

The second business is merchandise

labeling, which includes everything from

price tags to the Levis label that gets

sewn onto your jeans. This has been a pri

ority of CEO Rob van der Merwes since

he joined the company from Paxar, a very

successful label business he sold to Avery

Dennison. He sees labeling as a logica

Checkpoint Systems(NYSE: CKP)

Business: Manufacturer of closed-circuitTV security systems and radio-frequencyelectronic tagging and detection systemsused primarily by retailers to deter theft.



Financials (TTM):


THE BOTTOM LINE

The companys market position and anti-theft technology make it well-positioned toprosper as retail sales recover in developed markets and expand in emerging ones,says Dennis Delafield. Trading at less than 8x his estimate of the companys per-share earnings power, he says, the stock today offers highly compelling value.


CKP PRICE HISTORY


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CKP S&P 500



Company % Owned

Highlander Capital 24.2%

Shapiro Capital 12.6%Earnest Partners 7.2%

Tocqueville Asset Mgmt 5.7%Invesco 5.3%



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7/23



strategic extension of the core business

and has made no secret he wants it to be

a $300-400 million revenue business in

the near future. After a recent acquisition,

it could generate sales of around $250

million this year.

Is the business driven by retail sales?

DD: Predominantly, which is why earn-

ings have been soft in the last few years.

They benefit when apparel and drugstore

sales are strong, when stores are opening

or refurbished, and when retailers in gen-

eral are investing in new technology.

Margins have disappointed for two years,

which the company has partly attributed

to expenses related to new-product intro-

ductions, but also is a function of a mixshift to lower-margin systems as cus-

tomers look to economize.

Despite the short-term cyclicality, we

believe its logical to assume theft will

continue to be a problem for retailers and

that the sale of systems to prevent it will

remain a good business in the future. It

will be that much better when retail

spending around the world picks up. We

also can imagine that labels, anti-theft

tags and the radio-frequency identifica-

tion [RFID] tags used for inventory con-trol will eventually merge in some way.

Given that Checkpoints tag technology is

already radio-frequency based, it should

be a key player as that happens.

What upside do you see in the shares,

now trading at around $17.60?

DD: The companys goal is to get EBIT

margins within the next couple of years to

at least 10%, which we believe is realistic.

On todays revenue base, that wouldtranslate into $1.60 per share in earnings,

but with growth over the next five years

or so, its not unreasonable to expect

earnings of closer to $2.25 per share.

We dont really work with target

prices, but if earnings come through as we

expect, todays share price is likely to offer

highly compelling value. The business

may not bounce back right away, but this

is a well-managed company with a sus-

tainable franchise and a wonderful bal-

ance sheet. They, and we, can certainly

withstand another tough quarter or two.

Describe your interest in diversified

industrial supplier Ferro [FOE].

DD: Ferro produces specialty materials

and chemicals used in a wide variety of

manufacturing processes worldwide. Its

products include things like glazers, frits,

enamels, pigments, plastics and solar-cell

pastes.

This was a classic example of a compa-

ny that had lost its way, through overex-

pansion, sticking with bad businesses for

too long, and inattention to cost control.

The CEO since 2005, Jim Kirsch, over

hauled all aspects of the business selling

divisions, closing plants, replacing top

managers, revamping sales efforts just in

time for the economic crisis to hit. Only

after raising capital in a large and dilutive

secondary offering in the fall of 2009 in

which we significantly increased our posi

tion did the company have the financia

breathing room for the restructuring to

start paying off. Since then, each division

of the company has shown progressive

operating improvement.

The story now primary revolve

around the companys most-profitable

business, selling conductive pastes to the

Ferro Corp.(NYSE: FOE)

Business: Global producer of industrialchemicals and specialty materials used in awide range of manufactured products, fromwall coverings to solar cells.


Price 12.4552-Week Range 6.68 17.84Dividend Yield 0.0%Market Cap $1.08 billion

Financials (TTM):


THE BOTTOM LINE

Concern over near-term prospects for the companys solar-energy-related businesseshas caused the market to misprice by valuing the shares at only 4.5x estimated2012 EBITDA on an enterprise value basis the longer-term prospects for thosesame businesses and others in the companys revived portfolio, says Dennis Delafield.


FOE PRICE HISTORY


25

20

15

10

5

02009 2010 2011


FOE S&P 500



Company % Owned

Gamco Inv 11.6%Lord, Abbett & Co 6.4%TIAA-CREF 5.5%

Vanguard Group 5.4%BlackRock 5.0%



25

20

15

10

5

0


8/23



solar-cell industry. Ferro and Dupont are

the two primary global producers of this

paste, and the business has taken off in

the past several years along with spending

on solar-energy technology. Of the $196

million in EBIT we expect Ferro to earn

this year, nearly $130 million of it will

come from the solar business.

The stock has been under pressure as

investors are increasingly concerned

about governments commitment world-

wide to solar energy. For the time being,

solar is only economically viable as a

power source with government subsidies,

which have been cut back or threatened

to be in countries that have to-date been

the greatest solar proponents, including

Germany, Spain and Italy.

Is that concern being overdone?

DD: In the short-term, we have no idea.

But over time we believe solar energy

especially as costs to produce it continue

to decline will compete well against

other sources of clean energy that govern-

ments around the world will continue to

want to promote. There are only so many

places you can put up wind turbines, for

example. There are also significant issues

in getting at all the new shale natural gasreserves, which may both inhibit supply

more than expected and put upward pres-

sure on prices from historically low levels.

The shares, at just under $12.50, are

down some 30% in the past seven weeks.

How are you looking today at valuation?

DD: At todays price, the companys

enterprise value is $1.35 billion. Were

estimating that with continued improve-

ment in the non-solar businesses andsome modest upturn in solar revenues,

EBITDA next year can approach $300

million. That means EV/EBITDA on our

2012 estimate is only 4.5x.

At what point would you consider a com-

pany like this to be fully priced?

DD: The companys operations have been

vastly improved, it should have no net

debt by the end of next year, and we have

great confidence in management. Would

it be fully priced at 7x EBITDA? Thats

probably close.

How, if at all, are your views on todays

macroeconomic environment reflected in

your portfolio?

DD: Were not macro people, but you

cannot be investing other peoples money

without thinking about the state of the

world, much of which is unsettling.

Think about the U.S. governments debt

level and what happens if interest rates

increase? Think about housing values,

the unemployment rate and the price of

gasoline and what that means for con-

sumer purchasing power. Whats going to

happen in the Middle East? Whats going

to happen in Japan? Whats going to hap-pen with the U.S. dollar? There are an

unusual number of serious things to

worry about.

That all makes its way into the portfo

lio by our assessing the impact all of these

things could have on each company we

own and fully understanding the down

side. We also think there are so many

imponderables out there that its impor

tant to have a significant cash cushion in

case something goes wrong.

How big is that cushion today?

DD: When I was first starting out in the

business, you could be more or less fully

invested all the time. If there was a down

turn in the industrial sector, you could sel

the utilities you owned that were doing

well to buy the beaten-down industrialsIn todays market, everything goes up and

down at the same time, so you dont have

stocks going up to sell in order to buy the

bargains. The best way to take advantage

of a big market correction, then, is to

have cash. In a normal time, well keep

around 10% cash on hand for liquidity

purposes. Given the state of the world

today, were closer to 20%.

Well miss some profits when valua

tions are running high and were raising

cash. Thats just not something weve eveworried about. VII

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9/23

I N V E S T O R I N S I G H T : Lloyd Khaner


Investor Insight: Lloyd KhanerLloyd Khaner of Khaner Capital explains the primary impediments to company turnarounds, why investing in the Jackin the Box restaurant chain was a pivotal experience, whether his long-time gold bullishness is intact, and what he thinksthe market is missing in Sonic Corp., Cadence Design, Och-Ziff Capital Management and Illinois Tool Works.

You joined your fathers investment firm

in 1991, when it was focused mostly on

deep-value cigar butts. Why did you

gravitate toward a somewhat different

value orientation?

Lloyd Khaner: There are many ways to

succeed in this business, but my focus

from early on has always been on compa-

nies that had proven, thriving businesses

that for some reason have hit a wall. It

could be they got caught up in growthfor growths sake and lost control of

quality or operating discipline. It could

be that success had blinded them to

changes in their markets that required

bolder strategic or business-model

adjustments. But at the core are valuable

competitive strengths that often, but not

always, require new management to

bring back into focus. Its not a question

of creating something brand new from

scratch, which is inherently risky, but

more about getting back to basics. If itworks, the payoffs can be much better

over time than the 50-cent dollar going

to a 80-cent dollar.

One big influence for me was invest-

ing in the Jack in the Box restaurant

chain in the early 1990s. I was the first

person from the buy-side or sell-side to

visit the company after an E. coli out-

break at their restaurants had killed four

customers and made hundreds more sick.

On the plane out to San Diego, I sat next

to a woman with her baby who saw allthe Jack in the Box material I was read-

ing and asked if I was with the company.

She explained how she preferred Burger

King, but because her husband was a

Jack in the Box fan, theyd switch off

between one and the other. I asked what

she thought about the E. coli problem

and, with her baby on her lap, she said

she understood it was an accident and

that they were still eating there as often

as before. The immediate realization was

that this company had an opportunity to

come back, reputation-wise, but more

broadly, it hit home for me that in this

country you can make bad mistakes, but

if you own up to them and make clear

what youre doing to make it right again,

you can have another chance. There was

obviously more to buying the stock than

that, but the company ended up doing

the right things and the business came

back better than ever. I owned it for eight

years, buying around $4 and sellingabove $20.

I took away two key lessons from that.

The first is that it takes a lot to kill a

strong, established franchise even if a

company loses its way. Think IBM. Think

McDonalds. The second is that the right

management can make all the difference

in whether the business comes back. The

strength of the franchise and the quality

of management are what I spend most of

my time on (see box).

What about Warren Buffetts famous

quote about which reputation remains

intact if a great manager meets a bad

business?

LK: While were very management-

focused, were also very clear on the fact

that nobodys going to turn around a bad

company in a bad industry. One thing my

father taught me at a young age was not

to fall in love with companies or the peo-

ple running them. You look for compa-nies that, despite current challenges, have

proven business models, true value

propositions, rational competition and a

strong balance sheet. Jim Keyes, who

turned around 7-Eleven and is the type of

CEO wed follow almost anywhere, took

over Blockbuster and ran into a dying

industry, an over-leveraged company and

a financial crisis. I dont care how good

he is, that was not going to be turned

around.

Lloyd Khaner

Betting on the Jockeys

Having earned a Masters degree in dra-

matic writing from New York University

and spent time on a screenwriting fellow-

ship at Amblin Entertainment, Steven

Spielberg's former production company,

Lloyd Khaner knows a thing or two about

character development. Thus he's quick to

describe the profile of what he considers

the ideal turnaround chief executive: It's

usually a first-time CEO, between 48 and

52. They have 25 to 30 years of experi-

ence, but have never had a #1 spot

before. They're seeking out a challenge,

have everything to prove and, while

they've surely done very well financially,

they probably haven't yet had that huge

payday, which they badly want.

Khaner considers his best source of ideas

to be the database of some 500 execu-

tives he's compiled since entering thebusiness in 1991, made up of what he

considers first-class CEOs as well as their

current or former top lieutenants. He's

automatically pinged when anyone on the

list takes a new position, joins a board or

otherwise makes news. It's not fool-proof,

but people who have had success reliably

put themselves in positions to continue to

succeed, he says. We're often happy to

go along for the ride.


10/23

Timing would seem to be of paramount

importance in betting on turnarounds.

How do you think about that?

LK: We actually categorize turnarounds

as one-year, three-year or five-year turn-

arounds, primarily as a discipline to avoid

buying too early. The time needed to get

a company back on track is usually a

function of how long the business has

been struggling, how healthy the balance

sheet is, how demoralized the culture has

become and how healthy the industry is.

In a one-year turnaround, for example,

the problems have relatively recently sur-

faced, the balance sheet is still solid and

the industry is in pretty good shape. In

something like that were prepared to

invest fairly quickly and may exit fairly

quickly as well.

Is Starbucks [SBUX] a recent example?

LK: This is one that, in retrospect, we

didnt pull the trigger on quickly enough.

When the stock got below $10 two years

ago, it was just too early for me because

the plan to fix things wasnt yet clear, and

if that plan included shutting down the

growth engine and even pulling back

which I thought was necessary I wanted

to see evidence of that actually happeningbefore buying in. By the time I was con-

vinced they were on the right track the

stock was already up 50%, but the good

news is I recognized the upside was much

higher than a share price of $15. Store

experiences have been improved, there

are more value-priced menu options, the

Via instant-coffee line has been a big hit,

and the international growth opportunity,

particularly in China, is tremendous.

Theyve taken the McDonalds turn-

around playbook, which has played outover several years, and are really only in

year two. [Note: Starbucks shares recent-

ly traded around $36.50.]

Are you much slower to buy into the

more arduous turnarounds?

LK: Three-year to five-year turnarounds

almost always require a deep infusion of

outside management talent, a change in

culture, an overhaul of the cost structure

and some fairly dramatic shifts in opera-

tional execution. We want to identify

these potential turnarounds early, but its

often only after a year or two of careful

study that were ready to act. Depending

on the situation, we want to see tangible

evidence say, an increase in gross mar-

gins, declining inventory levels or reduced

operating expenses that the turnaround

is working.

If we believe the shares can double or

triple if were right which isnt a stretch

if earnings and valuations are starting

from particularly depressed levels we

have no problem leaving the first bump in

the stock price on the table. Were helped

by the fact that once the market has given

up on a company, it can be quite slow to

embrace it again.

How would you characterize your timingon Xerox [XRX]?

LK: This is a case where we sat out the

classic turnaround phase, executed by

previous CEO Anne Mulcahy, but started

getting interested when the company

acquired business-process outsourcing

leader Affiliated Computer Services 18

months ago. We believe ACS is an excel-

lent business and that the acquisition fun-

damentally changes the character of

Xerox to something that is far more inter-esting than a company fighting against an

inexorable decline in black-and-white

printing.

We bought six months ago and the

stock has done nothing, but we believe

the catalyst will be 15-20% earnings

growth over the next couple of years,

which will allow them to pay down debt

and buy back stock. At 8x next years

estimated earnings [based on a recent

share price of just under $10], the market

is valuing Xerox as if it were anothe

Kodak, which we dont at all believe wil

prove to be the case.

What are the primary reasons companies

dont turn?

LK: The first one is too much debt, which

acts like an anchor on companies tha

have to be so focused on keeping them

selves afloat that they cant or dont do

the operational things necessary to ge

back on track.

The second is a dying industry, which

you cant overcome. There may be short

term investment opportunity at time

when an industry is in decline, but thats

not the type of thing I typically want to

invest in.

When we spoke five years ago [VII, Apri

28, 2006] you identified Campbell Soup

[CPB] as a long-term turnaround, but the

stock is trading only marginally higher

than it was then. Have you given up on

that one?

LK: We actually did OK on the stock

when it ran up a bit in late 2006, early

2007, but we havent owned it for some

time. We concluded that soup, which is

still the dominant part of the companyjust isnt as popular as it once was as a

convenient meal. There are so many alter

natives and Campbells hasnt come up

with answers on the product side tha

have resonated enough with consumers to

make a big difference. I dont know wha

would make me interested again. The

truth is theyd probably be better off as

part of a bigger company, but thats no

something Id want to bet on.

How did the potential revival of drive-inrestaurant chain Sonic [SONC] get on

your radar screen?

LK: Ive paid attention to the company

since the 1990s, after management a

Jack in the Box told me they considered

Sonic the gold standard in the industry

for product innovation and operating

excellence. It has more than 3,500 restau

rants, 87% of which are franchised, with

the largest concentration in the south cen



ON TIMING:

If we believe the shares can

double or triple, we have no

problem leaving the first bump

in the price on the table.


11/23

tral and southeastern U.S. Theyre known

for having better-quality food, car-hop

service, a wide beverage selection near-

ly 40% of sales come from drinks and

for a willingness to customize any combi-

nation of food or drink on their menu. If

you want Sprite and root beer and milk

mixed together with crushed M&Ms,

theyll do it.

The stock was always too expensive

until Sonic fell into the classic growth-for-

growths-sake trap, which resulted in

kind of an across the board breakdown in

operational control, product innovation,

marketing effectiveness and, ultimately,

profitability. Over the past three years the

company has endured the pain of repair-

ing the damage.

Describe the key elements of the turn-

around plan.

LK: They stopped all new unit develop-

ment, closed poorly performing units,

increased base pay for company-owned

store managers and stressed store cleanli-

ness and efficiency everywhere.

Research and development for product

innovation has been increased and

theyve again started to roll out exciting

new products, like a Spicy BBQ Burger, 6-

inch all-beef hot dogs with ample top-

pings for only $1.99, and a new Double

Stuf Oreo ice cream dessert that I can

attest is fantastic.

They have also carefully rethough

pricing and now have a laddered menu

with more of a value component to go

with traditional premium items. Thi

gives the customer more options and

should help generate both new and repea

visits. Id add that the general environ

ment in the quick-service restauran

industry for passing on food and packag

ing cost increases is better today than i

has been in years, with fewer players will

ing to be the price spoiler in a rising-cos

environment.

We believe the turnaround inflection

point here is upon us. Last quarter comp

sales at company-owned stores went positive for the first time in three years, and

the company came out soon after the

earnings call to say comp sales growth

was accelerating and would probably

reach 4-6% this year.

The stock responded nicely to that news

rising 13% on the day of the announce-

ment. Now trading around $11.50, what

upside do you see in the shares from here?

LK: Assuming that comp sales grow 35% annually over the next three year

and that operating leverage kicks in a

revenues rise faster than costs and the

company benefits from a unique ascend

ing royalty-rate system in which the per

centage royalty paid by franchisee

increases as sales rise we expect annua

bottom-line growth in excess of 20%

through 2013. By then were estimating

$1 in earnings per share and, because the

franchise model requires little in the way

of capital spending, $1.35 in free cashflow per share.

Whats that worth? I think an 18x

multiple on 2013 EPS is more than rea

sonable, which would result in a share

price of $18. Now that store-level service

has stabilized and is improving, we think

theres a good chance the company can

re-engage on unit growth and that theyre

far from saturating their potential mar

kets. If unit growth re-accelerates, the

multiple could be even higher.



Sonic Corp.(Nasdaq: SONC)

Business: Operator or franchisor of morethan 3,500 quick-service drive-in restau-rants located primarily in the south centraland southeastern United States.



Financials (TTM):


THE BOTTOM LINE

The market is underestimating the scope and speed of the companys broad-basedturnaround after it fell into a growth-for-growths-sake trap, says Lloyd Khaner.Assuming solid comp-store sales growth and significant operating leverage, he expects$1 in estimated 2013 EPS to warrant a target share price of $18 within two years.


SONC PRICE HISTORY


20

15

10

52009 2010 2011


SONC Russell 2000



Company % Owned

Fidelity Mgmt & Research 14.6%

Wellington Mgmt 9.5%Invesco 8.0%

Dreman Value Mgmt 5.8%Deustche Bank 4.9%



20

15

10

5




Its interesting that the long-time CEO,

Cliff Hudson, led the turnaround. Is that

unusual?

LK: It can certainly happen. People like

Cliff, who has been Sonics CEO since

1995, dont like losing and can bring a

real fire to getting things back on track.

Its important to note, though, that he did

over the last three years name a new head

of company-owned stores, a new head of

marketing and a new head of information

technology. Some new blood is often

important in refreshing and refocusing

the overall leadership.

Whats the investment case for one of

your non-turnaround ideas, Och-Ziff

Capital Management [OZM]?

LK: Och-Ziff is one of the largest institu-

tional alternative asset managers, with

approximately $29 billion in assets under

management. For clients around the

world, it operates four primary invest-

ment funds that employ a wide variety of

strategies, including convertible and

derivative arbitrage, fixed income,

long/short equity, merger arbitrage and

structured credit.

The company runs truly hedgedfunds that typically have 120-130% long

exposure offset with an 80-90% short

exposure. Based on their strategy and

backed up by strong historical perform-

ance, they offer the kind of I can sleep at

night investment options that large insti-

tutions often crave. For that, they are

paid on a traditional hedge fund scale,

earning an average 1.75% management

fee and 20% of annual appreciation as an

incentive fee.

That all makes for a highly scalableand profitable business. As assets grow,

expenses dont at all grow commensurate-

ly once you reach critical mass, which

Och-Ziff reached a long time ago. Based

on economic income, which excludes

non-cash charges from the reorganization

it did prior to going public in 2007, the

companys operating margins are in the

mid-50% range and we believe are likely

headed over 60% for the year ending in

December.

This may provoke an admittedly self-

serving answer, but what makes you opti-

mistic about the future of the hedge fund

business?

LK: As evidenced by their performance,

hedge funds by and large protected

investors much better during the financial

crisis than non-hedged asset managers. In

a world that financial-market-wise is not

going to be a safe place for some time, we

believe managers like Och-Ziff will prove

to be a magnet for institutional assets.

Their funds were down far less than the

market in 2008, more than made up any

losses in 2009 and, importantly, they

never put up any gates to client with

drawals when the crisis was at its worst

In general weve heard from clients tha

the company was highly transparent and

responsive throughout the crisis, a repu

tation you want to have when managing

other peoples money.

Another factor in favor of alternative

managers is the fact that institutions have

been sitting on very large fixed-income

allocations that are going to have to be

redeployed. With interest rates and the

prospects for capital appreciation so low

pension funds and other similar institu

tions will have a hard time meeting obli

gations with too much fixed income.

Och-Ziff Capital Management(NYSE: OZM)

Business: Investment manager offering arange of hedge funds focused on credit,equity, special situations, convertible andmerger arbitrage, and private investments.



Financials (TTM):

Revenue $953.5 millionOperating Profit Margin 51.3%Net Profit Margin (-31.6%)

THE BOTTOM LINE

Lloyd Khaner believes the company will be a prime beneficiary as institutional investorsseek greater stability of returns and reallocate low-potential fixed-income holdings toalternative asset managers. The shares currently trade at 55% of his $27 target price,and he estimates theyll earn a dividend yield on this years company earnings of 8.5%.


OZM PRICE HISTORY


25

20

15

10

5

02009 2010 2011


OZM S&P 500

Trailing P/E n/a 16.6Forward P/E Est. 9.9 13.5


Company % Owned

Bank of NY Mellon 3.1%T. Rowe Price 2.8%Thornburg Inv Mgmt 2.6%

HSBC Holdings 2.3%Century Capital 2.3%



25

20

15

10

5

0


13/23

Inflows have been positive hitting

$2.7 billion last year for OZM and

while its impossible to be precise about

timing, we believe money could come in

at a much faster clip over the next couple

of years. Ultimately, theres no reason

why the company cant manage more

than twice the assets it currently does.

With the shares at recent $14.60 down

more than 50% from the 2007 IPO

how are you looking at valuation?

LK: Wall Street assigns different multiples

to alternative asset managers manage-

ment-fee and incentive-fee streams. The

management fees might earn a 19x multi-

ple, while the more volatile incentive fees

earn more like 9x. In OZMs case, webelieve the resulting blended multiple of

around 13x is unfair, because its incentive

fees wont be as volatile as those of other

publicly traded alternative managers,

most of which are private equity firms.

So using a more reasonable 15x multi-

ple on our 2012 EPS estimate of just over

$1.80, we get a target price of more than

$27. On top of that, because OZM is a

master limited partnership, it has to pay

out a high percentage of its earnings as a

distribution to shareholders. Assuming an85% payout, the dividend yield on our

2011 estimate is 8.5%, and on our 2012

estimate is 10.3%.

The biggest risks?

LK: There is some risk that the hedge

fund compensation model comes under

attack, but the company says theyve had

more pushback on management fees,

which are a much lower percentage of

total revenue, than on incentive fees. Ingeneral, if people are satisfied with their

returns, they have tended to let people get

paid what theyre paid.

There is also a risk that the tax rate on

carried interest is increased, which

would affect the earnings available to

shareholders. I dont have a crystal ball

on this issue, but those affected are likely

to have up to a 10-year transition period

to implement any change. Its obviously

something were keeping our eye on.

Another thing Id add is that the align-

ment of Och-Ziffs partners here with

those of shareholders is the best Ive ever

seen in my career. The 19 partners take

no salary or bonus, participating in the

companys success in the same way we

do, as shareholders receiving distribu-

tions and benefiting from any apprecia-

tion in the stock price.

From hedge funds to software, describe

your investment case for Cadence Design

Systems [CDNS].

LK: Cadence is a leading global supplier

of electronic design automation (EDA)

software. EDA software helps companie

like Texas Instruments, Intel and

Samsung design and manufacture com

puter chips and printed circuit boards

allowing them to see in advance things

like how prospective new chips will per

form, whether theyll be compatible with

in systems, and how much power theyl

use. This helps save time and money in

the product-development process, which

is critical in an environment where the

technology has to constantly evolve to

meet the needs of end-product computer

and smartphone manufacturers.

We started tracking the company in

2007 when Lip-Bu Tan came off the

Value Investor Insight 13May 27, 2011


www.valueinvestorinsight.com

Cadence Design Systems(Nasdaq: CDNS)

Business: Global supplier of software anddesign tools that help engineers plan, layout, simulate and verify designs of a widevariety of semiconductors.



Financials (TTM):


THE BOTTOM LINE

Having implemented a new revenue model, cut costs, and tailored R&D more to cus-tomer needs, the company is well-positioned to benefit from what Lloyd Khanerexpects to be a positive mobile-device-driven cycle for semiconductors. At 13.5x his2012 earnings estimate, the shares within 12 to 18 months would trade around $17.


CDNS PRICE HISTORY


12

10

8

6

4

22009 2010 2011


CDNS Russell 2000



Company % Owned

Dodge & Cox 16.5%T. Rowe Price 4.9%Wellington Mgmt 4.8%

Vanguard Group 4.7%State Street Corp 2.8%



12

10

8

6

4

2


14/23

board to run the company and began cut-

ting operating expenses, refocusing R&D

based on closer customer contact, and

moving the revenue model to subscrip-

tion-based payments over a contract life

rather than one-time upfront payments.

We didnt buy in until last year, though,

when we saw bookings start to grow

again after a painful decline prompted

mainly by the revenue-model switch.

In general, in a business where labor is

the largest expense, operating leverage is

very high. On top of that here we have

costs having been cut and customers suc-

cessfully migrated to higher-margin sub-

scription contracts. As a result, we think

margins are set to take off if revenues

grow at the 10-15% annual rate we

expect. Management believes, and weagree, that this should eventually be a 25-

30% operating-margin business.

Whats driving revenue growth?

LK: The semiconductor industry is clear-

ly volatile, but we think theres a strong

tailwind for the business from the current

upturn in global technology spending and

the explosive growth in mobile devices.

We consider Cadence a picks and shov-

els way to play that growth it providestools that semiconductor product manu-

facturers desperately need, but it has less

technology risk because they can stay

device and end-market agnostic.

Is industry competition rational?

LK: The EDA industry has consolidated

into an oligopoly led by Cadence,

Synopsys, Mentor Graphics and Magma

Design. Pricing is more likely to remain

rational as a result of consolidation andthe fact that the shift to subscription-

based revenue takes away some of the

quarter-to-quarter jockeying to sign new

business by making unprofitable price

concessions.

How inexpensive are the shares at a

recent $10.65?

LK: We value the shares based on free

cash flow, which is higher than net

income because depreciation and amorti-

zation charges are roughly double capital

expenditures. From 56 cents per share in

2010, we estimate Cadence can earn 90

cents to $1 in free cash flow this year and

$1.25 in 2012. Based on peer and histor-

ical multiples, we believe 13.5x the 2012

number is reasonable, which would pro-

duce a share price in the next 12 to 18

months of around $17.

The main risk short-term is that the

semiconductor industry takes a turn for

the worse. But we wouldnt expect that to

change the long-term demand picture for

Cadence, and are comfortable the compa-

ny can ride out any industry volatility. It

should have almost $800 million in cash

on the balance sheet by the end of this

year, while debt most of which is in out

of-the-money convertible shares should

only be around $600 million.

What do you think the market is missing

in Illinois Tool Works [ITW]?

LK: This has always been a good compa

ny, but we believe is about to prove its a

great company. Its a multinational manu

facturer of a wide range of industria

products and equipment, with 800 oper

ating companies aggregated into eigh

reportable segments: Transportation



Illinois Tool Works(NYSE: ITW)

Business: Broadly diversified manufacturerof industrial products, systems and equip-ment, operating through more than 800decentralized business units worldwide.



Financials (TTM):


THE BOTTOM LINE

Having aggressively restructured itself during the economic crisis including makingnew investments the company is poised to blow through new records for rev-enues, margins and earnings per share over the next few years, says Lloyd Khaner. At15x his 2012 per-share earnings estimate of $5, his target price for the shares is $75.


ITW PRICE HISTORY


60

50

40

30

202009 2010 2011


ITW S&P 500



Company % Owned

Northern Trust 8.8%State Farm 4.5%Vanguard Group 3.8%

Wellington Mgmt 3.5%State Street Corp 3.4%



60

50

40

30

20


15/23

Industrial Packaging, Power Systems and

Electronics, Polymers and Fluids, Food

Equipment, Construction Products,

Decorative Surfaces, and All Other

(which includes a thriving Test and

Measurement business). It operates in 57

countries, with 48% of revenues coming

from North America, 32% from Europe,

the Middle East and Africa, and 20%

from Asia Pacific and everywhere else.

While most companies fought to sur-

vive during the crisis of 2008-09, ITW

aggressively restructured itself through

cost-cutting, divesting underperforming

operations, expanding through acquisi-

tion in higher-growth and higher-margin

end-markets and geographies, and buy-

ing back its undervalued stock. Revenues

increased more than 10% in 2010, eventhough one key end-market U.S. resi-

dential and commercial construction

was still very weak. As the global econo-

my continues to mend, we expect the

company to set records for revenues,

margins and earnings over the next cou-

ple of years.

What assumptions are you making about

profitability?

LK: Were assuming 10-15% annualgrowth in revenues, split roughly between

organic growth and acquisitions. With

that growth and the permanent removal

of costs in the restructuring, we think

operating margins can top 18% by 2012.

From earnings of $3.08 per share in

2010, were estimating $4 this year and

$5 next year.

How does that translate into potential

upside for the shares, now at around $57?

LK: Given the 10%-plus revenue growth

and 20%-plus EPS growth were expect-

ing, we consider a 15x earnings multiple

to be conservative. Applying that to our

2012 earnings estimate, our price target a

year out is around $75. That assumes no

big stock buyback plans or a dividend

increase, both of which are certainly on

the table as management looks to allocate

the $1.5 billion or so in free cash flow

ITW will generate this year.

Weve seen ITW show up on the ubiqui-

tous potential Berkshire Hathaway

acquisition lists that get published from

time to time. Why do you think that is?

LK: The main reason is probably that its

a superb return-on-invested-capital com-

pany that often doesnt get the respect it

deserves from the market. Its ROIC aver-

ages 15-17% during cyclical upturns,

even though that number gets hit by high

levels of goodwill from the company hav-

ing done so many acquisitions over time.

A better reason to me is that the com-

pany follows the highly decentralized

Berkshire operating model and does an

excellent job of identifying accretive

acquisitions. No one has or will ask me,

but Id argue that ITW CEO David Speer,

who started at the company in 1978,would actually make a great choice as the

next person to run Berkshires operations.

When we last spoke in 2006, you were

betting against mortgage originators, say-

ing its not going to be pretty as housing

prices and/or the economy go south.

Nice call any similar insights today?

LK: Its not as much of a sector-wide bet,

but we do believe certain retailers that

have no real unique selling propositionand have too many stores that are too big

we call them commodity retailers

are going to get their lunch eaten long-

term by online retailers and by specialty

and discount stores. Real estate values

propped the stocks up for some time, but

that hasnt proven to be as valuable as

people once thought. Its not the only one

we see in this boat, but its hard for us to

see how Sears [SHLD], for example, is

going to be successful over time.

Id mention that I prefer to hedge using

put options rather than shorting. Option

have their challenges because the pricing

can be volatile premiums for the mos

part are too high now and because you

have to get the timing right, but we like to

know how much we can lose if were

wrong, which isnt the case in shorting.

You also last time touted the virtues o

gold, which has turned out pretty well

Whats your take on it now?

LK: We still own it, but have cut back.

still consider gold a good long-term hedge

against inflation and geopolitical risk, bu

I would not be surprised, in an improving

global economy where the dollar stop

depreciating, if gold prices stayed wherethey were or corrected, maybe significant

ly. Until 2009, gold regularly had intra

year corrections of 20% or more two o

three times a year it is, after all, a com

modity. Now weve had two years with

out a significant correction and, short

term, we might be due for one.

You write a column for Minyanville.com

called Lloyds Wall of Worry. Why?

LK: Ive actually gone through the basicprocess for 20 years, identifying the

major things I believe are worrying equi

ty markets worldwide, such as QE I

going away, rising oil prices or sovereign

debt problems. Its my way of putting

somewhat of a macro overlay on my

100% company-focused investing.

This is hardly scientific, but Ive found

that when I can list more than 20 funda

mental market concerns, that high level o

worry is usually priced into the marke

and its proven to be a good time to belooking for value. If I can identify no

more than 10 big concerns, the market is

overly complacent.

So whats the Wall of Worry indicator

saying today?

LK: My latest list has 20 items. There

plenty to worry about which may

explain why Im finding quite a few val

ues out there. VII



ON GOLD:

We still own it, but weve had

two years without a significant

price correction and we might

be due for one.


16/23

Editors Note: Even for the boom-and-

bust real estate business in which hes

plied his trade for the past 25 years,

Michael Winer admits to some surprise

at the ferocity of the recent downturn.

It was brutal for about a year, he says.There was no good news and compa-

nies that a year prior seemed to be well-

managed and well-financed had their

securities priced as if they were near

bankruptcy. With most residential and

commercial real estate markets having

only tentatively begun the recovery

process, we asked Winer and co-portfolio

manager Jason Wolf who oversee $5.5

billion in real estate-related investments

for Third Avenue Management for

insight on where theyre finding opportu-nity today and where they arent.

The storm clouds for real estate were

gathering when we last spoke [VII, August

31, 2007]. How do you think your strate-

gy weathered the ultimate deluge?

Michael Winer: Nothing has caused us to

question the fundamental aspects of our

strategy. We focus on development-ori-

ented real estate operating companies

that create value, as opposed to most real

estate investment trusts [REITs] that buy

properties and then try to make money on

the spread between financing costs and

the assets yields. While no part of the

market was spared, companies with high

development exposure took particularly

big hits as the perceived value of the proj-

ects declined sharply. Companies with,

say, 50% debt to total assets based on

value before the crisis suddenly were per-

ceived to have 80% leverage as those val-

ues got marked down. When credit mar-kets shut down, that was bad news for

the stocks of companies we owned like

ProLogis [PLD] and Forest City

Enterprises [FCE-A].

I believe we did a good job of staying

focused on companies balance sheets, the

long-term value of the assets they owned

and on consistent, recurring cash flows,

which dont just disappear overnight. We

had some pretty decent cash reserves in

late 2008 and early 2009 around 18%

of the portfolio, because we had preparedfor heavier investor redemptions than we

got and put it to work as security prices

were so depressed. We invested heavily in

the unsecured convertible notes of U.S.

REITs, for example, which were trading

at 30, 40 or 50 cents on the dollar, and a

year later were typically able to sell them

at par. We had gotten out of ProLogis

common stock, but bought back in as the

share price got as low as $2 we recently

sold it above $14. Even after enduring

tremendous pain with our investment inForest City, we participated in its equity

raise at $6.60 per share and we still think

the stock is undervalued today at $19.

Youve written about some process and

portfolio-management changes sparked

by the crisis. Describe those.

MW: In general, weve taken a more

active view on adjusting position sizes so

they best reflect our level of conviction

and return expectations. Were not at al

becoming market timers, but were much

less apt today to let a 5% position

through appreciation become an 8%

position unless its prospective return ha

commensurately improved as well. Wev

also scaled back the maximum position

size were comfortable with to 8-9% o

the portfolio, from 12-13% or higher

before the crisis.

Jason Wolf: Another important change

weve made is to develop a well-main-tained list of companies we would want to

own at the right price. Because of the sud

denness of the crisis, there were so many

securities on sale that we were a bit para

lyzed in trying to analyze them all. Weve

made the investment to stay current abou

on-deck ideas so we can act more quickly

when opportunities present themselves

This has already proven helpful, as a yea

ago we were able to buy some REITs

such as Unibail and Klepierre, both based

in France when their stocks dropped likestones due to the European debt crisis

Given how quickly the shares came back

we probably would have missed out on

those before.

Youve started selling out-of-the-money

put options on some of the stocks on your

prospect list. Whats behind that?

JW: When markets are volatile and option

premiums are high, we can essentially pick

the price at which wed buy a stock thatstrading at a discount to our estimate of ne

asset value and receive a nice premium fo

agreeing to buy it at that lower price in the

future. We can only do this when we have

a relatively high cash balance to cover

purchases we might have to make today

cash is around 22% of the portfolio and

we see it as sort of a win-win proposition

If the options expire out-of-the-money, the

premium we earn is an attractive yield on

cash that is otherwise earning close to

RebuildingThe recovery in most global real estate markets has been fitful at best. For Third Avenue Funds' Michael Winerand Jason Wolf that spells selective investment opportunity leavened with a heavy dose of caution.

S T RAT E GY: Real Estate



Michael Winer, Jason WolfThird Avenue Management

On U.S. housing: Are we going towarda model in which you need 20% down topurchase a home? If so the housingmarket is likely to continue to suffer.


17/23

zero. If the shares are put to us, were pay-

ing less than our buy price after netting

the premiums against the strike price.

The risk, of course, is that an exoge-

nous event like fraud, a natural disaster

or a major market dislocation could

cause us to have to buy a stock at a pre-

mium to the market price. Our view is

that we already assume those types of

risks with every security we own, which

we go to great lengths to mitigate by

focusing on margin of safety and rock-

solid balance sheets.

Does your current cash level reflect cau-

tion about todays environment?

MW: We consider having 10% cash to be

fully invested, so the answer is yes. Wereseeing more selling opportunities than

buying opportunities, so were unapolo-

getic about holding cash as dry powder.

I mentioned that commercial REITs

arent typically our focus, but well own

them if the prices are right. That is not at

all the case today in our v

value investor may 2011

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