valueinvestorinsight issue 364

8/9/2019 ValueInvestorInsight Issue 364

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For a successful activist investor, Jeff

Smith exhibits little of the “us vs.

them” mentality you might expect.

“Management pursuing a different plan

than we propose doesn’t mean they’re

bad people or malicious,” he says. “It’s a

difference of opinion. The good thing is that

shareholders can decide which plan is bestfor the company.”

Smith’s instincts about what’s right for

companies have proven eminently sound.

Since launching his Starboard Value LP’s

activist strategy ten years ago, it has earned

a net annualized 16.2%, vs. 10.2% for the

Russell 2000.

Never wanting for good ideas, Smith

today is finding opportunity in such areas

as office supplies, paper products, software,

semiconductors and hair salons. See page 2

In discussing the “obscure and mundane”

companies they own, James Vanasek

and Don Noone of VN Capital know

they run the risk of listeners’ eyes glazing

over. “Let’s just say that talking about

rubber compounding and grain elevators

isn’t naturally as interesting to people as

Apple or Google,” says Vanasek.There has been nothing boring about

VN Capital’s returns, however, since the

firm opened for business in mid-2002. Over

that time it has earned a net annualized

11.5%, vs. 6.8% for the Russell 2000.

With a penchant for companies that

they expect to own for several years,

Vanasek and Noone see undiscovered

opportunity today in such eclectic areas as

rubber processing, helicopter equipment,

agricultural services and beer. See page 9

ValueInvestorINSIGHT

October 31, 2012

The Leading Authority on Value Investing

Critical PathSmall companies naturally try to move beyond what initially made them asuccess. It’s after they stumble that Starboard Value often finds opportunity.

Inside this IssueFEATURES

Investor Insight: Jeffrey Smith

Identifying unrecognized value andthe specific steps needed to unlock itin Office Depot, Progress Software,Wausau Paper and Regis. PAGE 2 »

Investor Insight: VN Capital

Searching well off the beaten pathfor mispriced value and finding it inAirBoss, Ceres, Breeze-Eastern and

Big Rock Brewery. PAGE 9 »

Strategy: Bestinver

How one of Europe’s foremostvalue investors is navigating today’sdifficult environment. PAGE 16»

Uncovering Value: Bulldog

What happens when a venerableactivist investor takes over the reinsof one of its targets. PAGE 19 »

Editors’ Letter

On investors’ preference for bonds

over equities; A timely parable fromWarren Buffett. PAGE 20 »

INVESTMENT HIGHLIGHTS

Other companies in this issue:

Acerinox, AOL, Escalade, Fiat, Fiat In-

dustrial, Firsthand Technology Value,

Imperial Holdings, Industrias Bachoco,

Integrated Device Technology, Myrexis,

Schindler, SGS, Ship Finance, SurMod-

ics, Thales, Yungtay Engineering

www.valueinvestorinsight.com

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

VN CapitalDon Noone (l ), James Vanasek (r )

Investment Focus: Seek off-the-beaten-path companies that due to neglect orcomplexity trade at prices unrepresentativeof their sustainable business prospects.

Coveting ObscurityInvestor demand for small, quirky companies has lessened since the financialcrisis, say Jim Vanasek and Don Noone – which suits them fine, by the way.

INVESTMENT SNAPSHOTS PAGE

AirBoss of America 11

Big Rock Brewery 14

Breeze-Eastern 13

Ceres Global 12

Exor 17

Office Depot 4

Progress Software 7

Regis 8

Special Opportunities Fund 19

Wausau Paper 6


Jeffrey SmithStarboard Value LP

Investment Focus: Seeks companies inwhich the market’s valuation reflects a lossof patience in money-losing growthinitiatives and/or bloated cost structures.


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October 31, 2012 www.valueinvestorinsight.com Value Investor Insight 2

Most of your portfolio companies fall in

the “good core business, failing growth

initiatives” camp. Why is that such fertile

investment ground for you?

Jeffrey Smith: If you think about the life-

cycle of a small company, it usually ini-

tially succeeds in a relatively small niche

where it delivers unique value and be-

comes a market leader. The business inevi-

tably starts to mature – producing strong

cash flow with a lower growth rate – andthe natural response from management is

to take some of the cash generated and to

invest it in new areas of potential growth.

Hopefully these new growth initiatives are

related to the core business and hopefully

the company can have some competitive

advantage. This pursuit of incremen-

tal growth is exactly what management

should be doing.

One of two things will happen. Ei-

ther the new initiatives work, everyone’s

happy, the stock has a high multiple andwe never find it, or the new growth initia-

tives are not working, the market becomes

disenchanted with the company because

earnings and cash flow are depressed and

that drives down the stock price. Those

are the situations we find attractive.

Once we’ve identified an attractive

situation, we engage with management in

order to try to get them to rein in spend-

ing on failing growth initiatives, refocus

on the good core business, improve cash

flow, and put in place a greater level of dis-cipline with respect to return on invested

capital – all of which is meant to make the

stock price go up.

Peter Feld: This dynamic plays out regu-

larly because of human nature. Most pub-

lic companies want to provide sharehold-

ers with compelling growth, and small-cap

companies in particular believe they need

to have even higher growth rates. Again,

when this occurs within the natural flow

of the business, it works well. But when

it’s unnatural and management is trying to

“create” the growth, that’s often a prob-

lem. A private-company owner after 18 to

24 months of getting little traction on a

new investment finds it pretty easy to pull

the plug – the money is coming out of his

or her own wallet and there’s not an ad-

equate return on investment. It’s different

with public companies, particularly when

there is little inside ownership. It’s just eas-

ier to perpetuate the hope that growth willmaterialize next quarter or next year than

it is to admit the investment may have

been a mistake, reassess the opportunity

and reduce costs.

Integrated Device Technology [IDTI],

a semiconductor company in our port-

folio, is a good example. A substantial

portion of its revenues and profits come

from semiconductor businesses where it

has dominant market shares, high gross

margins and very high operating mar-

gins. However, some of these are maturebusinesses in relatively mature markets.

To grow, the company has been investing

in new higher-growth areas with much

larger “addressable markets.” That’s actu-

ally a fairly common theme for companies

in which we invest. They’re not content

having a 40% share of a slowly growing

$500-million market. Instead, they prefer

to try to capture 1% of a $20-billion mar-

ket. In our experience, it’s more difficult

and takes much longer than companies

believe to capture a small market sharein a massive market, where there’s gener-

ally greater competition from much larger

players.

In IDT’s case, the company spends ap-

proximately 30% of revenue on R&D,

significantly more than most of its com-

petitors, yet it’s struggled to reinvigorate

its revenue growth. We have representa-

tives on the board and are working with

our fellow board members to apply a

better balance between growth and prof-

I N V E S T O R I N S I G H T : Jeffrey Smith

Investor Insight: Jeffrey SmithStarboard Value’s Jeffrey Smith, Peter Feld, Mark Mitchell, Gavin Molinelli, Tom Cusack and Jon Sagal describe wherethey spend the majority of their research time, how they assess whether an activist “path” is open, how they hedge risksand what they think the market is missing in Office Depot, Wausau Paper, Progress Software and Regis Corp.

Jeffrey Smith

Natural Inclination

Just two years into an investment banking

career at Societe Generale, Jeff Smith in

1996 got a call from his father asking for

help. His father’s company, The Fresh Juice

Co., had expanded its production capacity

too quickly and needed in short order to find

new avenues for growth to fill the capacity.

Fairly certain that investment banking

wasn’t for him anyway, Smith, then 24,

joined Fresh Juice as head of strategic

development and in less than two years

played a central role in building an East

Coast wholesale business, merging Fresh

Juice with the wholesale competitor it had

taken on, making two acquisitions that

significantly expanded national distribution,

and then selling the entire company to

Saratoga Beverage.

Now CEO of Starboard Value LP and 14

years into an investment career focused

on activism, Smith considers that earlyexperience in his father’s business as

less a wake-up call than it was an af-

firmation. “I wouldn’t say my Fresh Juice

Co. experience made me want to be an

activist investor,” he says, “but it did

highlight my natural inclination. Trying to

clearly see the issues, identify solutions to

fix them and then work within the system to

get those solutions implemented is exactly

what our kind of investing is all about.”


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itability. The company has put out oper-

ating-margin targets that are significantly

higher than what it has done historically

and that are more in line with its peers.

These are all steps in the right direction.

On what size companies do you focus?

JS: We mostly focus on companies around

$1 billion in market cap. The situations

that fit our strategy are pervasive among

smaller-cap companies, where there’s

a significant focus on growth with less

discipline on return on invested capital.

We also have to own enough stock to be

able to influence management if neces-

sary, which has historically meant owning

smaller-cap companies.

Does every idea you pursue have an activ-

ist agenda?

JS: We believe every company in our port-

folio is undervalued, we have an alterna-

tive plan to unlock value that is within

our control, and we have a path to imple-

ment the plan. By “path” we mean that

we believe we could win a proxy contest

if it becomes necessary. The overwhelming

majority of the time a contest isn’t neces-sary, either because value is unlocked on

its own or because management and the

board choose to work with us to create

value. To make sure we have the best

chance of success in all situations, howev-

er, we remain prepared to run a contest to

replace directors. This way we will either

create value with the company’s coopera-

tion or, if the company won’t work with

us, we’re prepared to ask shareholders for

support to implement change.

What ideas fall outside the “good core

business, failing growth initiative” profile?

JS: Many of our investments fit that pro-

file but not all of them. One related type of

idea we also pursue is when a company is

so focused on growing the top line that it

spends inefficiently without an acceptable

return on that spend. These inflated costs

can be on things like research and devel-

opment, infrastructure, advertising and

general and administrative costs, to name

a few. Spending gets so out of line that

the company ends up significantly under-

earning. Office Depot [ODP], which we’ll

discuss in more detail later, is an example

of this.

How do you generate ideas?

PF: There are two primary sources. One

is generating ideas internally, mostly using

a variety of investment screens that have

value as a key piece, but we also screen

for financial metrics that may show symp-

toms of the types of situations we look for.

Say revenues have been flat for the past

three years, but operating expenses have

increased in each of those years. We also

typically look for companies that are un-

derperforming on any number of profit-ability or productivity measures, against

peers and against their own history. Be-

cause they’re under-earning, many of the

companies that interest us look expensive

based on current numbers, but are actu-

ally undervalued relative to the pro-forma

earnings that can be generated if our plan

is implemented.

We also find ideas from outside sources

such as more traditional investment firms

that invest in a similar universe. When

they find themselves in a problematic in-vestment, they typically have only two

choices – sell their position or just contin-

ue to hold and hope. Neither of these are

particularly good choices if they feel the

company is undervalued and underper-

forming. We provide a third option. Share

the idea with us, let us do our work on it,

and if it fits our criteria maybe we can get

involved and help to unlock value for the

benefit of all shareholders. Many of these

types of relationships started when these

firms were investors in companies we were

involved with in the past and they bene-

fited from our involvement and the value

we created.

Where do you focus first in research?

PF: Since we often suggest that companies

refocus on their core business, the major

ity of our research time is spent on deter

mining the health and sustainability o

that business. We need to fully stress test

our assumptions on the core business –

that’s where something could go wrong if

it were going to go wrong.

Next we analyze the company’s exist

ing plan compared to ours. We need to

determine if our plan can create significantly more value on a risk-adjusted ba

sis than the status quo. If along the way

management is able to prove us wrong

and succeed with their existing plan, that

works out well for us too, as value wil

significantly increase as their execution

improves.

How do you judge whether your activist

path is open?

PF: This involves an analysis of the com-pany’s corporate-governance mechanics

Where are they incorporated? Do they

have a staggered board? Is there a dual-

class ownership structure or large blocks

of shares which may be problematic?

What anti-takeover provisions exist?

These are just some of the many technica

items we analyze.

In addition, we conduct a more quali

tative analysis of the existing shareholder

base. The performance of the stock is a

key barometer of the collective satisfaction or frustration of shareholders, bu

we also use our experience and contacts

with a large number of investors to gauge

the relative difficulty of a potential proxy

contest.

How generally does Starboard approach

valuation?

PF: We develop upside price targets solely

based on pro-forma cash flow and asset

ON RESEARCH FOCUS:

We often suggest refocusing

on a core business, so most

of our time is spent on its

health and sustainability.


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value assuming we are able to implement

our alternative plan. Our plan focuses on

actions that are within the company’s con-

trol, such as reducing costs, exiting mon-

ey-losing businesses and selling assets that

don’t produce cash flow but have value to

a buyer.

We put equal emphasis on the down-

side price measurement. Where could the

stock go if our plan is not implemented or

if we are not able to gain influence? That

can mean putting a historically low mul-

tiple on the depressed expected EBITDA.

However, our preference is to buy as close

as possible to some proxy of balance sheet

value, such as tangible book value or liq-

uidation value. [Note: In Starboard’s high-

profile engagement with AOL, for exam-ple, an important element of the potential

downside protection came from the esti-

mated value of the company’s intellectual-

property portfolio.] In general, our target

upside should be a multiple of our target

downside.

JS: The downside price is also extremely

important in how we size positions. We

usually own 15 to 25 companies at a

time, roughly half of which are lead po-

sitions where we’ve filed a 13D, and therest are what we call seed positions, where

we have a plan and a path laid out, but

the valuation isn’t quite what we want

to see before owning a full position. We

limit each position to a maximum risk,

measured in basis points, to our downside

price. In other words, if a stock went to its

downside price, we don’t expect the fund

to lose any more than the maximum risk

for that particular position.

You’ve taken big profits on your AOLstake. Would you say that the activist play

there is over?

JS: Due at least in part to our pressure,

suggestions and proxy contest, AOL suc-

cessfully sold a portion of its intellectual

property for over $1 billion, committed to

improve the profitability of the display-ad-

vertising business, and said it would return

$1 billion of cash to shareholders. This

unlocked a great deal of value and was an

enormous success for all AOL sharehold-

ers, including us. While the changes so far

have been meaningful, the company has

done very few of the hard things around

shrinking its cost base that we thought

were also necessary. But given the value

that was unlocked, AOL shareholders

decided to give the board more time to

improve the operational execution, which

has been reflected in the stock price.

[Note: At a recent $35.50, AOL’s shares

have nearly doubled since early April and

have almost tripled since Starboard’s ini-

tial purchases.] So while we still have a

plan to unlock value, at today’s price our

other criteria are no longer met and we do

not currently have a position.

What attracted your attention in office-

supply retailer Office Depot?

JS: There are quite a few things that have

us excited about Office Depot. The compa

ny has a hidden asset in its Mexican joint

venture which, we believe, may be worth

close to the entire market cap of the com

pany. On top of that, there is $11 billion

of annual revenue that we don’t believe is

efficiently managed from a profitability

standpoint. Operating margins are less

Office Depot(NYSE: ODP)

Business: Provider of office supplies andservices sold through company-ownedstores and online, as well as to businesscustomers through an in-house sales force.

Share Information(@10/30/12):

Price 2.3952-Week Range 1.51 - 3.81Dividend Yield 0.0%Market Cap $681.5 million

Financials (TTM): Revenue $11.19 billionOperating Profit Margin 1.0%Net Profit Margin 1.0%

Valuation Metrics(@10/30/12):

ODP Russell 2000Trailing P/E 8.4 31.3Forward P/E Est. 29.9 15.3

Largest Institutional Owners(@6/30/12):

Company % OwnedThornburg Inv Mgmt 6.9%Putnam Inv Mgmt 6.9%BlackRock 6.2%

Vanguard Group 5.2%AllianceBernstein 4.9%

Short Interest (as of 10/15/12):

Shares Short/Float 15.9%

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

ODP PRICE HISTORY10

8

6

4

2

02010 2011 2012

10

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4

2

0

THE BOTTOM LINE

The market has weighed in unfavorably on the company’s performance, says Jeff Smith,who has proposed a detailed plan for improving profitability to at least near peer levels.The stock today trades at an EV/EBITDA multiple, assuming his low to high cases forannual EBITDA improvement occur, of 1.3x on the low case and 0.7x on the high.

Sources: Company reports, other publicly available information


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than 1%, while the margins of the largest

competitor, Staples, are above 6%. Some

argue that’s a function of the size dispar-

ity between Staples and Office Depot. But

OfficeMax is the smallest competitor and

it’s significantly more profitable than Of-

fice Depot. We think there are significant

ways to improve profitability at Office

Depot based on changes fully within the

control of management and the board.

Describe the basic elements of the plan.

Gavin Molinelli: One important compo-

nent is getting costs in line with the busi-

ness reality and with competition. From

2007 to 2011 the total number of stores

declined by 108 and annual revenue de-clined by $4 billion, but general and ad-

ministrative expenses actually increased.

Advertising expenses as a percentage of

revenue are significantly higher than they

are at both Staples and OfficeMax, and

the advertising-expense ratio has been

increasing. So Office Depot spends at the

highest rate but has the lowest return on

that spend.

We believe the company can dramati-

cally improve the economics of its North

American stores by downsizing to smallerstore formats. Management has said that

the new 5,000-square-foot format it has

tested can retain up to 90% of total store

sales from the existing 24,000-square-

foot-format, while at the same time signif-

icantly reducing occupancy costs, improv-

ing labor utility, and reducing inventory

investment. With roughly 45% of North

American leases up in the next three years

– and 67% up within the next five – that’s

a huge opportunity.

We have also defined a number of op-erating initiatives to improve profitability.

The company can significantly increase

the mix of higher-margin services – such

as copy and print services, security solu-

tions and shipping – in its North Ameri-

can retail division. It can improve gross

margins through more direct sourcing of

private-label products. It can lower the

number of SKUs to reduce inventory and

procurement expenses. Its Business Solu-

tions division in North America can take

several steps to get its performance more

in line with the competition. Those are

just some of our ideas.

The company’s response?

JS: The company has been very cordial

and professional, but we really don’t

know whether they’ll be willing to make

the changes we’ve proposed. We are pre-

pared to work with them or to appeal to

the shareholders to ensure the appropriate

changes are made.

The stock popped after Starboard’s inter-

est became public, but at a recent $2.40 is

still down 75% from its post-crash high.

What do you think it’s more reasonably

worth?

GM: We try to avoid talking publiclyabout what we think a company may be

worth. Our target prices are quite conser-

vative, in that they’re based only on what

we believe the financials would look like if

our plan is implemented. We discuss why

we believe the stock is undervalued and

how the operational performance can be

significantly improved through the execu-

tion of an alternative plan for the busi-

ness. Shareholders can then determine the

full value of the stock based on their own

assumptions.In Office Depot’s case, we’ve outlined a

low case and high case, assuming annual

EBITDA improvement of $275 million to

$540 million. This range would indicate

a doubling or almost tripling of current

EBITDA. We’ve also assumed that Office

Depot de Mexico, the 50/50 joint venture

between Office Depot and publicly traded

Grupo Gigante, is a non-core asset with

substantial hidden value of $500 to $700

million. At today’s price, the pro-forma

EV/EBITDA multiple is 1.3x on our low

case, and only 0.7x on our high case.

Is the big risk that secular challenges in

the office-supply market, primarily from

online competition, overwhelm everything

else you’re counting on here?

GM: The office-supply-store industry has

been challenged by online competition

We believe the current valuation more

than fully discounts the threats from the

outside as long as the company begins to

follow an alternative plan. We think la

menting about the online competition has

gone too far. The service level and qual-

ity you can provide by having a physica

store can be a huge advantage over onlinecompetitors. The company needs to start

playing to its strengths while running the

business as effectively and efficiently as

possible.

Next steps?

JS: We’ll continue to have conversations

with the company. As those conversation

continue and time passes, we’re fully cog-

nizant of our choices as we approach the

nomination deadline in January. OfficeDepot has a single-class board, which pro

vides full flexibility for any shareholder

looking to promote board changes should

they be necessary.

Describe the public case you’ve made for

changes at Wausau Paper [WPP].

Jon Sagal: Wausau is a paper-products

manufacturer operating in two segments

The tissue business makes paper towels

and toilet paper for the away-from-homemarket, while the paper segment makes

specialty and technical papers for a num

ber of applications, from industrial tape

backings to fire-resistant paper to micro-

wave-popcorn bags.

The tissue business is an excellent ra-

zor/razor blade type of business. Wausau

has developed very strong distributor re-

lationships, and once a distributor has its

dispensers in the office-building or schoo

bathroom, they don’t get replaced easily

ON ODP NEXT STEPS:

We’re fully cognizant of our

choice as we approach the

board-of-directors nomina-

tion deadline in January.


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or quickly. Given the required number and

frequency of deliveries, market shares tend

to be very high in any given geographic re-

gion. Wausau has also built a strong pres-

ence in the green, sustainable market with

its 100%-recycled products. As a result of

all of this, it consistently earns high mar-

gins – 20% EBITDA margins or better –

and has shown better growth than most

other tissue manufacturers.

The company has exited part of its

paper business – the more commoditized

printing and writing lines – since we first

got involved. The remaining technical-

paper business generates only minimal,

if any, profits on a significant portion of

overall revenues.

Wausau is making a huge capital invest-

ment in its tissue business. Have you been

on board with that?

Jon Sagal: This is a $425 million market-

cap company and the plant it is about to

complete is the centerpiece of a $220 mil-

lion investment – that’s almost $4.50 per

share in capital spending for a stock cur-

rently trading around $8.50. That said,

the new plant will use less raw material

and energy for every ton of output and has

a much lower marginal cost of operation

It’s also flexible in producing different tis

sue qualities, including new products that

should allow Wausau to compete in new

higher-end segments of the market with a

100%-recycled premium product.

How are you looking at valuation with

the shares trading today at around $8.65?

Jon Sagal: The stock still trades at a mul-

tiple that is more reflective of a commod

ity paper business than it is a best-in-clas

specialty-tissue business. Other tissue

businesses trade at 7-8x EBITDA and

Wausau’s is among the best tissue assets

out there. On trailing 12-month numbers

– not even our pro-forma numbers – thestock today trades at only 5x enterprise

value to EBITDA.

PF: While we can’t say a lot about our

current interactions with management

and the board, one item of note is that we

recently amended our 13D to disclose tha

we’d increased our ownership here to over

14% of the shares outstanding.

Is Progress Software [PRGS] another refo-

cus-on-the-core-business idea?

Tom Cusack: Yes. The company’s core

business is a product called OpenEdge

which is an application development plat

form that is used by independent software

vendors to develop software. The custom

er base is more than 1,500 independen

vendors, which pay Progress a percentage

of all license and maintenance revenue

they earn on products they’ve developed

over decades using OpenEdge. It’s costly

and difficult for existing customers to remove OpenEdge from their products, so

this business is extremely sticky, has very

high margins and generates a stream of at-

tractive cash flow for the company.

As growth in the OpenEdge business

began to slow, Progress began using the

cash flow from it to make acquisitions in

high-growth software areas such as Busi

ness Process Management [BPM] and

Complex Event Processing [CEP]. Most of

these acquisitions were unrelated to their

Wausau Paper(NYSE: WPP)

Business: Producer of specialty papers forindustrial, commercial and consumer use,as well as a broad line of “away from home”towel and tissue products.



Financials (TTM): Revenue $1.05 billionOperating Profit Margin 3.1%Net Profit Margin (-2.4%)


WPP Russell 2000Trailing P/E n/a 31.3Forward P/E Est. 20.5 15.3


Company % OwnedStarboard Value 9.3%Dimensional Fund Adv 5.4%Wilmington Trust 5.4%

T. Rowe Price 5.3%Vanguard Group 5.3%




WPP PRICE HISTORY12

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THE BOTTOM LINE

The company’s stock trades at a multiple reflective of a commodity paper business ratherthan of the specialty tissue business on which Starboard Value believes Wausau shouldfocus. On trailing-12-month numbers, says Jon Sagal, the shares trade at an EV/EBITDAmultiple of only 5x, while more-comparable tissue businesses trade at closer to 7-8x.



7/21



core business and had limited synergies

with their other products. So at the time

we got involved last year, there were about

15 different product lines spread across

three reporting segments and our view

was that the company was suffering from

a serious lack of operational focus. Many

of the acquired businesses were growing

revenue 20-30% per year but were losing

money, obscuring the value of the core

OpenEdge business. We asked the com-

pany to streamline product lines, reduce

excess costs and consider separating the

money-losing growth businesses from the

mature core business.

Earlier this year, in April, the com-

pany announced a new strategic plan to

increase shareholder value that was very

much in line with our and other share-

holders’ suggestions. They agreed to di-

vest 10 non-core product lines, committed

by fiscal 2013 to a 35% operating margin

target – up from today’s 10% – and an-

nounced a plan to buy back $350 million

worth of stock, which is about 30% of the

float. Once that restructuring is complete

– the company has already announced the

sale of 80% of its non-core businesses –

we expect Progress to be a much more

profitable company.

Does the just-announced departure o

CEO Jay Bhatt, after less than a year on

the job, disrupt things?

JS: The stock price went down 15% on

the news because the market fears the un

known. The risk at that point was execu

tion, and the individual who was supposed

to execute left. Jay said he was leaving to

take his dream job, which turned out to

be CEO of the private education-software

company Blackboard. We don’t believe

this changes the company’s resolve to go

forward with its restructuring plan.

Now at $19.30, how inexpensive do you

consider Progress shares?

TC: The stock trades at less than 4.5x

what we believe EBITDA should be over

the next year or two. This excludes the

proceeds from the non-core assets that

have not yet been sold, so if you include

the estimated proceeds for those, the mul

tiple is even lower. We think 4.5x EBITDA

for an extremely stable business, with high

recurring revenue and the potential to

generate 35% or higher EBITDA margins

represents a very compelling value. [Note

The EV/EBITDA multiple for comparablesoftware firms today is 6-8x.]

How much further does your engagement

with hair-salon operator Regis [RGS] have

to play out?

JS: For Regis, we concluded the company’

core North American salon business was

capable of generating consistent free cash

flow and a high return on capital, but the

market wasn’t recognizing it because there

was a bloated cost structure and a varietyof non-core businesses obscuring the value

of the core business. We won a proxy con

test and got three directors elected to the

board in October of last year.

In our original plan, we identified four

assets that we recommended selling as

well as roughly $100 million in annua

cost cuts. Two of the non-core businesses

have been sold, the Hair Club for Men

and Women hair-restoration centers – the

deal for which is not yet closed – and a

Progress Software(Nasdaq: PRGS)

Business: Develops and markets systemsused by commercial and governmentalcustomers worldwide for the development,deployment and integration of software.


Price 19.3052-Week Range 17.01 - 24.76Dividend Yield 0.0%Market Cap $1.23 billion

Financials (TTM): Revenue $484.4 millionOperating Profit Margin 12.7%Net Profit Margin 4.7%


PRGS Russell 2000Trailing P/E 55.5 31.3Forward P/E Est. 14.7 15.3


Company % OwnedT. Rowe Price 7.4%Starboard Value 7.2%Fidelity Mgmt & Research 6.4%

Perkins Inv Mgmt 6.0%Praesidium Inv Mgmt 5.7%




PRGS PRICE HISTORY35

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THE BOTTOM LINE

The company’s announced strategic overhaul involving the divestiture of product linesand setting of new profitability goals is sound, says Tom Cusack, so the story now restson execution. On what he believes the company can earn within the next year or two, thestock trades at a 4.5x EV/EBITDA multiple, far below software-company peers.



8/21



minority ownership stake in Provalliance,

a French salon chain. That leaves two as-

sets remaining that we consider non-core,

a U.K. salon business and a 50% interestin a chain of cosmetology schools called

Empire Education Group.

The bulk of the story now is about

execution. We’re very supportive of the

new CEO, Dan Hanrahan, who joined

the company in July from Royal Carib-

bean’s Celebrity Cruises, where he was

CEO. Dan had been successful in turning

around Celebrity Cruises by significantly

improving the service experience in order

to drive an increase in return rates.

At $16, the stock is back to where it was

when you won the proxy contest a year

ago. How are you looking at valuation?

JS: It comes down to how successfully the

operational and efficiency initiatives are

executed. Dan will be active both on the

cost side as well as on improving the in-sa-

lon experience, which had been neglected.

Stylists were trained on how to cut hair,

but not on how to treat their customers as

guests – how to greet them, the right ques-

tions to ask to make sure they’re happy,

how to follow up and improve the chances

they come back for their next haircut. This

is all just good service execution and it

needs to be put in place in order for same

store sales to stabilize and start growing

again. The company has a great deal o

operating leverage, which should produce

tremendous shareholder value when the

execution improves.

You recently sold out of your position in

healthcare company SurModics [SRDX]

Another happy story, but why sell now?

JS: Our plan for SurModics was relatively

simple: sell the money-losing pharmaceu

tical business and re-focus on the excellen

core business selling coatings for catheters

and other medical devices. The company

was amenable to our plan, allowed us tojoin the board and hired a banker to sel

off the pharmaceutical business. After that

business was sold, operating margins im

proved to 35% from less than 10%. Why

sell now? The stock is currently almos

twice where it was when we entered and

the company has made the changes we

had set out in our plan.

One could argue that sentiment toward

activist investors is as positive as it’s ever

been. Why do you think that is?

JS: Shareholders are becoming more in

terested in how they can create alpha in

their portfolios and are happy to suppor

other shareholders whose interests are di

rectly aligned with theirs to create positive

change at companies. There is growing

sentiment that a shareholder perspective

in the boardroom is helpful, which was

not the case 25 years ago. I’d like to think

we’ve moved past the corporate-raider

phase and that most activism today isdone professionally with the interests o

all shareholders in mind.

Companies have also increasingly real

ized how unproductive it is to resist share

holder input. When activists show up

management for the most part behaves re

sponsibly and respectfully. That results in

healthy, constructive dialogue about how

a company should operate. That type of

dialogue is absolutely in the best interest

of all shareholders.

Regis Corp.(NYSE: RGS)

Business: Owns, operates and franchises

more than 12,500 hair-care salons servingmen, women and children; brands includeSupercuts, SmartStyle and Cost Cutters.



Financials (TTM): Revenue $2.25 billion

Operating Profit Margin 4.6%

Net Profit Margin (-4.2%)


RGS Russell 2000Trailing P/E n/a 31.3Forward P/E Est. 17.6 15.3


Company % OwnedFidelity Mgmt & Research 11.0%Birch Run Capital 10.4%

Dimensional Fund Adv 7.7%Robeco Inv Mgmt 6.5%FranklinTempleton 6.1%




RGS PRICE HISTORY25

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THE BOTTOM LINE

Jeff Smith believes the company is taking the steps necessary to refocus on its coreNorth American salon business and he is “very supportive” of the new CEO’s efforts toimprove the customer experience. Given the company’s operating leverage, a return tosame-store sales growth should produce “tremendous” shareholder value, he says.


VII


9/21


Your target company typically operates

well off the beaten path. Can you gener-

alize about the companies and businesses

you find most interesting?

James Vanasek: We focus primarily on

companies in the U.S. and Canada with

market caps of $500 million or less and

that operate in odd-ballish kinds of busi-

nesses where they have strong positions

in relatively small niches. Investors run-

ning larger funds can’t put enough moneyto work in them. Wall Street tends to ig-

nore them because they have good bal-

ance sheets and cash flow and don’t need

investment-banking services. Our basic

premise is that there’s a higher likelihood

these types of companies will be mispriced.

Sometimes obscurity alone is enough

for the stocks of such companies to be un-

dervalued, but there’s often also something

else going on. Occasionally the broader

industry is under pressure for cyclical rea-

sons or due to some exogenous event, likea regulatory change. The company itself

may also be undergoing a restructuring

or building a new business, both of which

may take more effort to understand and

require more patience than the small-cap

manager with 150 names can muster.

You’ve owned oil-tanker and drilling-rig

lessor Ship Finance International [SFL]

since 2004. What about it has kept your

interest?

Don Noone: There are three fundamental

reasons we think Ship Finance is misunder-

stood and mispriced. The first is that it has

this crazy lease-finance accounting that is

difficult to understand and distorts share-

holder equity, cash flow and net income

– throwing off all the high-level metrics a

stock analyst typically uses. The second

is that it’s treated as a high-risk business

heavily subject to spot tanker-lease prices

– which are currently cyclically depressed

– when in fact the business model is

primarily based on long-term contracts,

and the company has diversified, with

40% of revenues coming from the leasing

of offshore drilling rigs. Finally, for rea-

sons we don’t understand, people seem to

look at the large share ownership in the

company of John Fredriksen, a Norwei-

gian billionaire with a long history in the

tanker business, as a negative. We actually

think he has an impeccable record of do-

ing right by all shareholders and think hisassociation with the company gives it ac-

cess to investment opportunities at a low

point in the cycle.

What’s representative here of our typical

holding is that some level of misunder-

standing is conspiring to keep the stock

from trading at what we think is full

value. As Jim said, that may result from

neglect, or from time horizon, but it can

be even more compelling when our view

is that the market’s fundamental analysis

is just wrong.

Ship Finance is at more than $1 billion in

market cap, but has the average company

in your portfolio gotten even smaller since

we last spoke [VII , April 30, 2008]?

JV: We haven’t consciously decided to pur-

sue smaller companies, but since the finan-

cial crisis we’ve noticed more risk aver-

sion among investors when it comes to

less-liquid smaller-cap names. For almost

anything under $200 million in marketcap, the number of people willing to invest

dries up fairly dramatically, so it’s no

surprise we’re finding better opportunities

at that size.

We saw a graph recently showing how

aggregate hedge fund assets had shifted to-

ward large-cap stocks. Now close to 50%

of all assets are in market caps of more

than $10 billion, up from around 35% in

2002. Small caps, defined as less than $2

billion, went over the same period from

I N V E S T O R I N S I G H T : VN Capital

Investor Insight: VN Capital James Vanasek and Don Noone of VN Capital explain how they unearth ideas that are typically well out of plain sightwhat virtues they see in portfolio inactivity, the lesson they learned from getting frustrated by management, and why theysee unrecognized value in AirBoss of America, Breeze-Eastern, Big Rock Brewery and Ceres Global Ag Corp.

Don Noone, James Vanasek

Serendipity over Screens

It’s a safe bet that most viewers of reality

show Man vs. Wild , in which the show’s

star is dropped into the wild to fend for

himself, don’t come away with investment

ideas. But as the protagonist was hoisted

to safety by helicopter, VN Capital’s James

Vanasek wondered if making the equip-

ment that lifted people out of danger might

be a good business. One thing led to an-

other and he’d found a new core position

– a firm called Breeze-Eastern that made

just such equipment – for his portfolio.

In seeking out quirky small-cap ideas, Va-

nasek and partner Don Noone rely more

on serendipity than computer screens.

“There’s nothing systematic we can do to

find, say, a new idea every three weeks,”

he says. For another recent idea, Vanasek

would have ignored a news item on Ce-

res Global Ag Corp.’s purchase of grain

elevators, except that some of the el-evators had been separated from malting

businesses, which he’d found interesting

years earlier in researching craft beer. That

prompted him to look at grain elevators,

whose economics had similarities with the

cement business, in which he’d invested

successfully in the past. “You don’t know

when enough things will pull together that

say, ‘Here’s an idea,’” he says, “but if you

uncover enough rocks, it does happen.”


10/21



nearly 30% of assets to closer to 15%.

It’s safe to assume that shift is even more

pronounced away from the smallest-cap

stocks, which is good for us.

You’ve described your idea generation as

much more organic than systematic [see

box, p. 10]. Is there any process to how

you flag potential ideas?

JV: We don’t find screening helpful,

primarily because our type of company

may have less accessible public data, which

means it won’t show up in a standard

database or that the data for it will be

incorrect or out of date.

We do spend a fair amount of time main-

taining a list of companies with quirky,odd businesses that we like and market

caps under $500 million. Most of the

time they’re fairly valued or overvalued,

but we’ve programmed our Bloomberg

to alert us if something happens and the

valuation drops to a pre-defined level at

which we’d want to look at it.

It’s kind of a bizarre conversation to

have, but we actively discuss what isn’t

being talked about. Maybe an industry

is at a low point in its cycle, where our

favorite company would be one that isstill making money and looking to expand

while competitors are losing money and

retrenching. If a commodity is trading at a

multi-year low, we’ll look at the producers

of the commodity who may be suffering.

If a commodity is at an all-time high, we’ll

look at companies that use the commodity

as a raw material and are getting hurt as

a result. This all becomes a starting point

and then we wander around from there.

Give an example of where your counter-cyclical bent is pointing you today?

JV: We’ve been thinking about the casino

business, which was hit hard by the finan-

cial crisis and is far from having recovered.

If you’re a supplier to the North American

gaming industry, you’re still looking at a

fairly bleak demand outlook as few new

casinos are being built and existing ones

are stretching out replacement cycles. We

haven’t made any conclusions yet, but

there are some good little companies that

supply products to the gaming industry

that have been worth a look.

You’ve said your portfolio management at

times in recent years has been character-

ized by “conspicuous inactivity.” Is that a

habit, or a reflection of the environment?

DN: It’s both. We’re constitutionally set

up to be inactive, following the War-

ren Buffett idea that you should always

judge how you’re doing in any given year

relative to if you’d done nothing. As long

as we’ve made good decisions and our

investment cases are intact, that creates a

bias for inactivity. We can go long stretch-

es without adding a new name to the port-

folio. Our latest addition was AirBoss of

America [BOS:CN] this year, which wasour first new name since 2010.

As the financial crisis hit, we also made

an active decision to be more inactive. Our

basic view was that the crisis was more of

a financial panic than a true crumbling of

the foundations of the global economy. So

we looked at our portfolio and concluded

that if you had to run and hide while the

panic raged, where would you go? We

had a big position in a beer company in

Canada, Big Rock Brewery [BR:CN], and

Canadians drink a lot of beer. We owneda chicken company in Mexico, Indus-

trias Bachoco [IBA], and Mexicans eat a

lot of chicken. Even with Ship Finance,

while oil demand is variable, the demand

for the transportation and drilling of it is

fairly steady. We concluded we had the

type of portfolio you would want to run

to, so other than selling off a couple hold-

ings that were extremely economically

sensitive, we mostly just hunkered down

with what we had.

Did the crisis prompt any changes in how

you do things?

JV: It really hasn’t. We’ve tried to be very

conservative both in how we run our

management company and how we run

our fund, which was certainly vindicated

as once-hot hedge funds crashed and

burned after the crisis. It’s common in

this business for managers who have had

some success to develop an outsized view

of their actual skill. One benefit of our

partnership is that we keep each other

grounded so that doesn’t happen.

DN: I also don’t think you can underesti

mate the importance of having an inves

tor base that allows you to stick to yourstrategy. We were down more than 40%

in 2008, but our investors knew what we

owned and why we owned it and were

confident we’d react to the selloff in a

way that would benefit the portfolio in the

long run. We wouldn’t have been able to

come back as strongly as we did in 2009

and 2010 without that confidence.

Some managers responded to the crisis

by running less-concentrated portfolios

but you still own around 10 positions aa time. Why?

JV: Our investors hire us to manage a

concentrated portfolio of obscure smal

companies. They don’t need us to diversify

for them. We’re going to have volatility

in our returns, but we’re clearly of the

mind that concentrating on a small number

of ideas that we know inside and out is

one of the best ways to have a shot at

outperforming the market over time.

I would add that the stocks we owneven though they’re small and less liquid

don’t gyrate that much in price. Ship

Finance can be an exception because it’s

treated as more cyclical than we think

it really is, but most of our companies

are just kind of plodding along in niche

markets where we put a premium on high

and stable market shares.

DN: Industrias Bachoco, for instance, is

in a cyclical business, but its stock price

ON INACTIVITY:

We follow Warren Buffett’s

idea that you should always

judge how you’re doing rela-

tive to if you’d done nothing.


11/21



doesn’t move all over the place because

it just keeps executing, chunking out a

consistent return on equity and adding a

point or two of market share every year.

You never know how long you’ll own

something, but I could see this in our port-

folio five or ten years from now as the com-

pany continues to expand its product and

geographic footprint. It wouldn’t at all sur-

prise us to see it mentioned up there with

Tyson Foods or Pilgrim’s Pride one day.

AirBoss of America would seem to qualify

as the type of “obscure and mundane”

company on which you focus. Why is it a

good investment today?

DN: The company’s headquarters is in themiddle of nowhere in northern Ontario,

consisting of a few guys set up in the con-

verted project house of a new develop-

ment that ran into financial trouble. But

it’s a substantial business, the biggest part

of which is in rubber compounding, where

it’s the second-largest player in North

America. They basically take different rub-

bers and mix them in these giant kettles to

produce compound rubbers that meet cus-

tomer specifications for things like hard-

ness, flexibility and weather protection.It’s not a great business because it can be

cyclical and low-margin, but it’s also rela-

tively insulated because there aren’t many

companies that have the expertise to do

this and the capital costs to get started

are high. The primary customers are tire

manufacturers and equipment suppliers to

the mining and coal industries.

JV: The other main business, in which Air-

Boss is the world’s largest supplier, is pro-

ducing protective boots and gloves for usein dealing with chemical, biological, ra-

diological and nuclear [CBRN] contami-

nation. Most of the customers for this type

of protective gear are military and there’s

an attractive replacement profile, as the

gear has to be replaced once it’s been used

in an actual contamination. We’re skepti-

cal of synergies, but this is a case where the

company applied its sophisticated knowl-

edge of rubber properties and compound-

ing to make what appears to be a better

mousetrap in CBRN protective gear. This

business today generates roughly the same

level of annual operating earnings as the

compounding business, around $11 mil-

lion, on about one-third of the revenues.

One thing that sealed it for us was

spending time with management. We’re

sitting in this converted house and they’re

describing how the company got started

after buying a tire plant from Uniroyal

for $1, and then signing up Uniroyal as

its first compounding customer. They got

into the CBRN business initially by tak-

ing over a government testing lab, beating

out much bigger defense-company suitors

because they played up the fact that they

were Canadian and had extensive rubber

knowledge. We like that kind of contrariannature and scrappiness.

To the extent the two businesses are

cyclical, where are we in the cycles?

DN: China’s slowing down and the impact

that’s had on the mining business has hur

them. At the same time, sales to military

customers are also in what we expect to

be a temporary down cycle. Both of those

things have put pressure on the stock.

With the shares trading today at C$4.55

how are you looking at valuation?

DN: Net income last year, which we con-

sider a modestly good year, was C$13 mil

lion, while free cash flow was more than

C$22 million. At today’s market value

then, the stock on trailing numbers goesfor an 8x P/E and less than 5x cash flow.

AirBoss of America(Toronto: BOS:CN)

Business: Develops, manufactures andsells rubber compounds as well as specialtyrubber-based protective gear used in de-fense and industrial applications.

Share Information(@10/30/12, Exchange Rate: $1 = C$1.00):

Price C$4.5552-Week Range C$4.20 – C$5.92Dividend Yield 4.4%Market Cap C$104.6 million

Financials (TTM): Revenue $271.4 millionEBITDA Margin 6.6%Net Profit Margin 3.0%

Valuation Metrics(Current Price vs. TTM):

BOS:CN Russell 2000P/E 8.0 31.3


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THE BOTTOM LINE

Worried about cyclical pressures in the company’s traditional rubber-compounding busi-ness, the market doesn’t appear to appreciate the higher growth and profitability of itsincreasingly important protective-gear business, says Don Noone. At only 12x “a goodyear’s” C$15 million in profit, he says, the company’s shares would trade at around C$8.



12/21



We try not to make overly aggressive

valuation assumptions, but we don’t be-

lieve a company like this should trade for

8x earnings. It should reliably generate

C$10-15 million in annual profit, earn-

ing an 8-10% return on assets and a 15%

return on equity. You could see earnings

spike as it wins big CBRN contracts, and

the overall profitability profile should

improve as the protective-gear business

accounts for a greater share of total rev-

enues. While you could argue all that’s

worth at least a market multiple, even at

12x a good year’s C$15 million in profit,

the shares would be around C$8.

JV: We also believe we’re getting free op-

tion value, in the unfortunate event thata large-scale accident or attack increased

demand for protective gear. As the pri-

mary supplier out there, AirBoss would

substantially benefit.

So why is a Canadian company in the rub-

ber business named AirBoss of America?

DN: I actually have no idea. We said the

companies we invest in tend to be quirky.

A perfect transition to Ceres Global Ag[CRP:CN], a closed-end fund on its way

to becoming a grain-elevator company.

JV: The backstory here is that Ceres was

formed in late 2007 by Front Street Capital

to invest in the then-hot agricultural com-

modity boom. Within a year those mar-

kets crashed as the recession hit and man-

agement shifted focus to hard assets with

the purchase of a dozen privately held

grain elevators from a Minnesota-based

hedge fund manager, Whitebox Advisors.In 2011, Ceres announced it was going to

run off its investment portfolio and rein-

vest the cash into similar operating assets.

As we studied grain elevators, we

concluded the business was similar to that

of the cement business, where we’ve in-

vested with some success before. There are

high fixed-cost assets, with a good that is

fairly low in value but bulky and expensive

to transport. That allows cement compa-

nies to have natural monopolies near their

plants because it’s a lot cheaper to buy ce-

ment from the guy who’s 10 miles away

than 200 miles away. The same thing

applies with grain elevators, but kind of

in reverse. If you’re a farmer, it’s a lot

cheaper and easier to transport your grain

to the elevator that is very close than one

that’s far away. In these situations it comes

down to what you pay for the fixed as-

sets – the lower the price, the higher your

return. In Ceres’ case, we believe we were

able to buy those fixed assets for free.

Walk through that math given today’s

C$5.80 share price.

JV: The current market cap is around

C$83 million. Using year-end Marchnumbers, reflecting a full harvest season,

Ceres had around C$40 million in cash

and run-off investments. It owned C$160

million worth of grain in its elevators

against which it had C$80 million of debt

At the fund level there was also another

C$40 million in debt. So for less than C$5

million at today’s price, you’re getting the

grain-elevator assets and the profits they

generate. It recent years those profits have

been as high as C$12 million, with an av

erage of around C$8 million. Discount

that average annuity at 10%, and that’s

C$80 million in value right there.

Is there any reason to be more optimistic

about the elevator business?

JV: One significant thing happened in thethird quarter of this year, which is that the

Ceres Global Ag Corp.(Toronto: CRP:CN)

Business: Provider of agricultural grain stor-age and supply-chain management servicesthrough a network of storage facilities in thenorthern United States and Canada.



Financials (FY ending March 2012): Revenue C$184.4 millionOperating Profit Margin 2.7%Net Profit Margin (-0.7%)


CRP:CN Russell 2000P/E n/a 31.3


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THE BOTTOM LINE

As the company transitions from a failed strategy as a closed-end investment fund, themarket is almost entirely ignoring the value of what will be its ongoing business of manag-ing grain elevators, says Jim Vanasek. If that business ultimately earns a 10x multiple onits average profit in recent years, he says, the share price would nearly double.



13/21



Canadian Wheat Board officially lost its

monopoly to purchase Canadian wheat.

That opens up a significant new base of

potential customers for Ceres’s assets,

many of which are located in the U.S near

the Canadian border. The business will

continue to fluctuate somewhat based

on weather and crop yields, but the new

demand should have a positive long-term

impact on both capacity and pricing.

Another upside we see here is that as

the non-elevator portfolio is sold off, there

will be no need for Ceres to maintain its

closed-end fund structure. Savings related

to that could add another C$2 million or

so annually to the bottom line.

Describe the turnaround you’re betting onat Breeze-Eastern [BZC].

JV: The company’s core business is making

hoist and hook equipment used in

helicopter search-and-rescue missions.

It has roughly 60% of that global

market, in which it operates basically in a

duopoly with a division of Goodrich Corp.

The customer base is primarily military,

though there are commercial end-user

applications as well.

This is equipment that absolutely hasto work, in the worst environments and

operating conditions. As a $100,000 item

in a $23 million helicopter, it’s not the

type of thing where the manufacturer will

play hardball over price. There’s usually

good visibility on future cash flows, be-

cause once you’re on a platform you’re on

it until the helicopter is no longer made,

and because there’s a healthy stream of

replacement-parts business. From a bar-

rier-to-entry standpoint, this also isn’t an

area where you’d expect a price-cuttingChinese competitor to come in and take

business.

Breeze-Eastern starting in the 1990s

took the plentiful cash generated by this

core business to invest in becoming a more

diversified defense supplier. They bought

a bunch of companies, paid too much for

them, loaded up on debt and then didn’t

manage it all well, basically running the

company into the ground. That eventually

led in 2007 to a special capital raise that

resulted in the two biggest shareholders,

Tinicum Capital and Wynnefield Capital,

controlling more than 50% of the shares.

They brought in a new management team

to sort out the mess and go back to basics.

DN: While all this is getting underway,

the financial crisis hits. The company was

also saddled with large legacy contracts

for supplying hooks and winches in cargo

airplanes that left them holding the bag

on significant engineering-cost overruns.

So while the turnaround has been going

on for some time now, the financial results

haven’t really shown it.

We think that’s about to change. The

company has consolidated its manufactur

ing into new facilities and has spent mos

of the upfront engineering costs for new

projects coming on stream over the next

decade. Signed new projects alone will add

$10 to $20 million in annual revenues, de

pending on the year, to a current revenue

base of around $80 million.

How do you see that translating into share

upside from today’s $8 price.

DN: The core business in the past has

earned as much as $15 million in net prof

Breeze-Eastern(NYSE: BZC)

Business: Manufacture, sale and servicingof hoists, winches, hooks and other liftingand restraining devices utilized primarily incommercial and military aviation markets.



Financials (TTM): Revenue $81.1 millionOperating Profit Margin 11.1%Net Profit Margin 2.9%


BZC Russell 2000Trailing P/E 33.1 31.3Forward P/E Est. n/a 15.3


Company % OwnedTinicum Capital 34.8%Wynnefield Capital 22.3%T. Rowe Price 6.7%

Dimensional Fund Adv 3.5%Kennedy Capital 0.7%




BZC PRICE HISTORY

12

10

8

6

42010 2011 2012

12

10

8

6

4

THE BOTTOM LINE

The company’s long road back to focusing on its strong core business – made longer bythe recession and a number of unprofitable legacy contracts – is finally about to pay off,says Don Noone. At a market multiple on what he considers a conservative $10-12 mil-lion estimate of normalized earnings, the stock would roughly double from today’s price.



14/21



it. That’s been depressed in recent years,

but we think we’re being conservative in

assuming they get back to the $10-12 mil-

lion annual range. That means the stock to-

day trades at only 7-8x more normal earn-

ings. A private buyer for a business with

this type of predictability and profitability

would pay significantly more than that. We

feel good when we can model out a double

in the stock price over the next few years,

which is pretty much where we are here.

Does the recent sale of top-competitor

Goodrich to United Technologies pose

any risks?

JV: The competitor was already a tiny di-

vision of a very large company and nowit’s part of an even larger firm. People are

worried that now Sikorsky, which is also

owned by United Technologies, will stop

buying from Breeze. Sikorsky is run quite

independently, so we think that concern is

overblown. Probably more likely is that

Sikorsky’s competitors will now think twice

about buying from Goodrich, which could

incrementally benefit Breeze in the end.

Has your case for Big Rock Brewery been

slower to materialize than you expected?

DN: The thesis is still fully intact. Big Rock

has the best reputation and brands in the

craft-beer business in the Alberta province

of Canada, which is booming with the ex-

pansion of the energy business there. The

area is importing oil workers from around

the world, mostly men making good mon-

ey during the biggest beer-consuming pe-

riods of their lives. The company is grow-

ing and making good money, but it is true

that they haven’t really made it sing yet.

Why not?

DN: There have been some fits and starts

with management. The founder, Ed Mc-

Nally, was slow to let go of control and

kind of let the company drift in the past

couple of years. But early this year he

named a new CEO, Bob Sartor, who we

believe is a world-class operator. He has

articulated a clear plan and is injecting

new energy and ambition into the business.

His first focus, which we believe is right,

is on product innovation. For Labatt or

Molson drinkers, you need to graduate

them into the craft-beer market. For the

beer nerd, you need to provide them with

new, exciting and flavorful brews. That all

requires pushing the envelope with new

products, which Big Rock hadn’t been do-

ing. It has now launched a number of new

and seasonal beers, one of which, a Scot-

tish heavy ale, is already being introduced

into the full-time product stable.

On the operational side, Sartor is shift-

ing marketing spending away from what

he calls “trinkets and trash” – things like

coasters and key chains – toward more

on-premise events like beer tastings. Tofree up production capacity that was gen-

erating very little if no profit, he’s winding

down the production of private-label beer

He also plans to cut at least C$1 million

in annual expenses, not insignificant for a

company that’s been earning C$6-8 mil-

lion per year.

The last piece of the plan involves geo-

graphic expansion, focused on neighbor

ing British Columbia. The idea would be

to translate, through acquisition or build

ing a new brewery, the success Big Rock

has had in one vibrant market to another.

At today’s C$13.95, how cheap do you

consider the shares?

DN: If the product and operating initia

tives prove successful, we believe the company should earn at least C$10 million per

Big Rock Brewery(Toronto: BR:CN)

Business: Produces, markets and distributesa line of premium craft beers and alcoholiccider, sold primarily in and around its homeprovince of Alberta, Canada.



Financials (TTM): Revenue C$46.6 millionOperating Profit Margin 10.7%Net Profit Margin 8.0%


BR:CN Russell 2000P/E 22.4 31.3


BR PRICE HISTORY

18

16

14

12

102010 2011 2012

18

16

14

12

10

THE BOTTOM LINE

A new CEO’s injection of “energy and ambition” should unearth latent value in the com-pany’s core brewing franchise, says Don Noone. At 12x the C$10 million in annual profithe believes the company should earn, the shares would be 50% above today’s price. Theprice of options on successful geographic expansion and/or an eventual buyout: free.



15/21



year. It was making that much in the mid-

2000s, so we don’t consider that a stretch.

Put even a 12x multiple on that and you’ve

got almost 50% upside from today’s price.

You then have an option on successful

geographic expansion, as well as on Mol-

son or Labatt swooping in over the next

couple of years to buy some craft-brew

credibility that almost all big brewers have

had a tough time creating. As you wait for

some of those things to play out, there’s a

very healthy dividend yield, which on to-

day’s price is just below 6%.

What’s something you’ve been selling re-

cently and why?

JV: We spoke last time about Escalade[ESCA], which has this mish-mash of busi-

nesses, some of which are good, like ping-

pong tables and archery products, and

others which aren’t so good, like paper

shredders and letter openers. Our thesis

was that better managing the portfolio of

businesses – getting rid of underperformers

and investing in those doing well – would

result in a much more profitable company.

It hasn’t been a disaster investment for us,

but after years of one step forward, two

steps back, we’ve decided to move on.

DN: We’ve tried to speak constructively to

the board, to get them to focus for each

piece of the business on where they’re

earning a return on capital and where they

aren’t. That strikes us as common sense,

but there just hasn’t been adequate will at

the board level to do that.

Speaking of another idea we discussed last

time, it would appear you sold cigarette-

paper maker Schweitzer-Maudit [SWM]

way too early. What happened?

DN: There’s a good lesson there. What at-tracted us to it was that there was a strong

underlying business, but it was poorly

managed. Dealing with management was

so frustrating that it discombobulated us

and we concluded the situation couldn’t

be fixed. In fact, we should have stepped

back and recognized that the attractive-

ness of the business would outlast man-

agement. Within a year of the old CEO

leaving, the stock went from the low-teen

to $40 [split adjusted]. We had the conver

sation at $7 about whether to take a much

bigger position and pound the table more

with management, we just didn’t do it.

We asked last time what advice your men-

tor in the business, Joseph Reich of Reich

& Tang, had been offering up. He had sug

gested maintaining plenty of liquidity, and

you added, “Having been through some

really bad markets before, he doesn’t think

this one is over yet.” Pretty good advice in

April 2008. What’s he counseling today?

JV: He usually focuses on how we’re run-

ning the business, such as whether we’re

sticking to our discipline or how we’retreating clients. One piece of advice he did

give us recently was that while we should

selectively try to work with our companies

to create value, we shouldn’t start think-

ing we’re investment bankers with 45

different ideas for the company to imple-

ment. The message was to be careful not

to get out of our competence zone, which

is always good to be reminded of. VII

http://www.valueinvestingcongress.com/landing/s13/vii/10.26.12_ad.php?utm_source=VII&utm_medium=A&utm_content=SAVE800&utm_campaign=S13VIIA&ocode=S13VIIA


16/21


Editor’s Note: The distant observer might

imagine a siege mentality among European

investment managers, clinging for dear life

as the fate of the European Union hangs

in the balance. The view from the inside asdescribed by Bestinver’s Francisco Garcia

Parames, however, is very different. One of

Europe’s foremost investors – his flagship

Bestinfond has returned a net annualized

15.7% since inception in 1993, vs. 8.5% for

its mixed Spanish and global benchmark

– Garcia Parames oversees €5.5 billion

in assets from his Madrid home base.

We recently caught up with him and co-

portfolio managers Fernando Bernad and

Alvaro Guzman to see how they’re navi-

gating today’s difficult investing environ-ment. Cautious? Yes. Fearful? Not at all.

It’s been an eventful few years since we

last spoke [VII , November 26, 2008].

Have you called any of your core value-in-

vesting tenets into question in the interim?

Francisco Garcia Parames: The core of

what we do, investing with a long-term

horizon in stocks that are inexpensive

relative to their normalized free cash flow,

has not changed and most certainly will

not change in the future. But that doesn’t

mean you don’t evolve as an investor. For

example, while I wouldn’t attribute this

directly to the crisis, we have moved more

from a pure Benjamin Graham style of

value investing to one closer to Phil Fisher

and Warren Buffett, in the sense that we’re

putting even more weight on the qual-

ity of the business. I don’t know, maybe

when you’re younger you just care about

getting things that are cheap and making

money fast. But as you become old you seethat buying companies with high and sus-

tainable returns on capital at reasonable

prices tends to work a little bit better.

The second adjustment we’ve made is to

concentrate more. In our global portfolio

we used to have 100-120 stocks, but

now we have around 50. With the top 15

stocks, we cover 70% of the portfolio.

The more concentrated you are, the more

sure you have to be about everything – the

barriers to entry, the leverage, the down-

side. Every stock in which we hold a largeposition has to be very safe by its nature.

Has it gotten harder to estimate normal-

ized free cash flow in Europe?

Alvaro Guzman: When you look at our

average stock, we’re not making a huge

effort to predict earnings. A typical busi-

ness would be like that of Schindler Hold-

ing [SCHN:SW], the elevator company,

which has barriers to entry and is difficult

to copy. We’re comfortable in a case likethis in assuming 1-2% volume growth and

flat-to-1% pricing growth translating into

4-5% annual EBITDA growth. We don’t

have to be more aggressive than that for

almost all of our holdings.

I’d distinguish between cyclical stocks

with barriers to entry and those without

them. When market shares are stable,

if the size of the pie goes up and down,

you have historical data points that al-

low you to normalize. We own French

defense contractor and aerospace firm

Thales [HO:FP]. It is clearly impacted by

changes in defense budgets, but its mar-

gins have also suffered from a number of

poorly negotiated contracts under prior

management. The new CEO has put or

der to the way the company accounts

for costs and negotiates contracts, so we

expect EBIT margins to increase from

6% to an 8% normalized level, which

is still below the 10% earned by peers

Just making that assumption allows us

to find the stock quite undervalued. Ifdefense spending also eventually comes

back to normal levels, which it is likely to

do, that would be icing on the cake.

Contrast that with businesses in which

there are no competitive barriers and

market shares can vary greatly from one

year to the next. These are usually more

purely commodity businesses that, absent

clear low-cost leadership, are difficult to

normalize and we’re not very interested in

What macro views are informing your investing today?

FGP: Sometimes we can add more value

on this front than others, and I would say

today is a difficult time. Much of how

things play out in Europe will depend on

politicians making decisions, which we

consider almost impossible to forecast.

We do spend a lot of effort trying to un

derstand how China will grow. Given that

its growth is based on savings and produc

tivity improvement, we’re still positive onthe sustainability of its economic expan

sion. Even as China slows down, if you

look at the absolute growth in its forecast

ed GDP relative to the expected GDP pull

back in vulnerable European countries

there’s no comparison. Overly focusing on

what is going on in Spain and even what is

going on in Europe is losing the right

perspective from our point of view.

That’s why we own global companies

Acerinox [ACX:SM] is a stainless-stee

With a painful economic contraction at home and the European economic union in trouble, Bestinver’s FranciscoGarcia Parames would be forgiven for having a downbeat investment outlook. Such, however, is not the case.

S T R A T E G Y : Bestinver

Eye of the Storm


Bestinver Asset Management(l to r ) Alvaro Guzman, Fernando Bernad andFrancisco Garcia Parames

On perspective: “Overly focusing onwhat is going on in Spain and even whatis going on in Europe is losing the rightperspective from our point of view.”

Funds People


17/21


company based in Spain, but it just set up

a 600,000-ton-capacity plant in Malaysia

to serve Asian countries outside of China

– that’s a market of 600 million people.

Despite what’s going on in Europe, this

company has been growing 5-6% per year

for several years.

Do you still have your own analyst in

Shanghai?

FGP: Yes, he’s been there four years. This

forces us to go there, to learn. If you

invest in almost any sector in the world you

have to know what’s going on in China,

both for companies that want to sell there

and to know what competition may come

from there.We’re also learning about Chinese

stocks and while we haven’t yet invested in

mainland China, we have invested in a Tai-

wanese company called Yungtay Engineer-

ing [1507:TT], which is very active in Chi-

na. It’s an elevator company, an industry

we know very well from investing in Euro-

pean companies like Schindler and Kone.

We are comfortable with its corporate

governance, and feel it provides good ad-

ditional exposure to an industry we like in

a part of the world that is growing.

Has the geographic mix of your portfolio

been shifting?

Fernando Bernad: In putting more

emphasis on truly global companies, we

have over the last couple of years reduced

our exposure to the euro zone. In terms of

the underlying economic exposure of the

companies we own – which we calculate

by looking at both revenues and EBITDA

– our euro zone exposure today is 42%,down from 54% two years ago. Our next

biggest exposures are 20% in emerging

markets (up from 14% in 2010), 17% in

N

valueinvestorinsight issue 364

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