March 23, 2005

ValuThe Leading Authority on Value Investing eInvestor INSIGHT

Big Misunderstandings Inside this Issue FEATURES Value investors generally seek cheap stocks and then try to understand why. David Einhorn asks why stocks might be mispriced, and then asks if they’re cheap. Investor Insight: David Einhorn Finding “special situations,” his aising money was a bit tough for now has some $3 billion in assets under bets on Freescale, M.D.C, Allied David Einhorn when he started management. Capital and more. PAGE 1 » Greenlight Capital in 1996, before Success has not diminished Einhorn’s R Investor Insight: John Lewis hedge funds were all the rage. “The indus- passion for finding mispriced securities Small-cap expert sees big oppor- try was not what it is today,” he says. and, as this issue’s interview makes clear, tunities in INVESTools, Boyds “Let’s just say people were not in big rush- holding management accountable to share- and eDiets.com. PAGE 1 » es to work with 27-year-old guys with no holders’ interests. See page 2 track record.” Behind the Numbers: LEAPS Starting small, Einhorn and his partner David Einhorn Whitney Tilson’s favorite invest- set up shop with a couple of computers in Greenlight Capital ment theme in years. PAGE 16 » 125 square feet of office space in New York Investment Focus: Seeks special City. Before long, Greenlight’s track record situations that might lead to general Uncovering Value: Nippon TV started to speak for itself. Today, after years investor misunderstanding – and mis- “You don’t see media companies of stellar returns, Einhorn is one of the pricing – of a company’s true value. trading at these levels.” PAGE 18 » Goes long or short based on the mag- hedge fund industry’s best-known and most nitude of difference between his esti- Of Sound Mind: Investor Nature successful investors. His company, from an mate of value and the market’s. People just can’t help but invest initial asset base of less than $1 million, with emotion. PAGE 19 »

Editors’ Letter Adopting Market Orphans Is the imperial CEO dead? Hold the applause for now. PAGE 20 » Some 5,000 companies have market values less than $250 million, and many are ignored by the investment community. That’s music to John Lewis’s ears. INVESTMENT HIGHLIGHTS

INVESTMENT SNAPSHOTS PAGE ohn Lewis’s timing couldn’t have been bet- ter for starting a value-oriented small-cap Allied Capital 7 Jhedge fund. He opened Osmium Partners Boyds Collection 13 in November 2002, just weeks after the begin- eDiets.com 14 ning of the current bull market, which has been Freescale Semiconductor 4 led by small-caps. “Everyone thought we were INVESTools 11 in the middle of a multi-year low and nothing Lanxess 9 was ever going to come back,” he says. “Value M.D.C. Holdings 5 was everywhere.” Osmium’s returns have far exceeded even Nippon Television 18 the rising small-cap tide, as Lewis applies his Renault 8 John Lewis “think like an owner” investing discipline Osmium Partners, LLC across an eclectic array of businesses, from Other companies in this issue: Investment Focus: With the eye of a investor education, to teddy bears, to online Anheuser-Busch, Bayer, Berkshire strategic corporate buyer, looks for com- diet programs. He leaves to others pursuit of Hathaway, Freddie Mac, Heartland panies ignored or shunned by the market Advisors, iVillage, KKR, Motorola, but with a sound core strategy and defen- the big-name glamour companies. “We focus New Century Financial, Nissan, sible niche. Many portfolio companies are on what we like to call two-stop-plane-ride STMicro, Tesco, Yahoo eventually bought out. companies.” he says. See page 10

www.valueinvestorinsight.com INTERVIEW: David Einhorn Investor Insight: David Einhorn

Greenlight Capital’s David Einhorn explains how to look for market mispricings, what situations drive Greenlight to activism, and what he thinks the market is missing in David Einhorn Freescale Semiconductor, M.D.C. Holdings, Allied Capital, France’s Renault and Accidental Investor Germany’s Lanxess. Growing up in Milwaukee and going to You’ve said your investing style differs a particularly good view of what the college at Cornell University, David somewhat from that of traditional prospective performance of the busi- Einhorn never expected to become a value investors. How so? ness is likely to be. It may be due to professional investor. “I studied govern- ment at Cornell, and expected to get a David Einhorn: We take the traditional how the performance had been report- PhD and teach,” he says. But graduate value investor’s process and just flip it ed when a now-independent business programs in his field of choice, eco- around a little bit. The traditional was part of a larger company. It may be nomics, had few, if any, places for value investor asks “Is this cheap?” that strategies or capabilities have those without extensive undergraduate and then “Why is it cheap?” We start changed in ways that aren’t immediate- economics training, so Einhorn joined by identifying a reason something ly apparent. DLJ as an investment banker. Not liking might be mispriced, and then if we find We also find opportunities when it much after two years, he interviewed in 1993 for a hedge-fund analyst posi- a reason why something is likely mis- there is a large upheaval or rejection of tion and the rest is history. “I worked for priced, then we make a determination a particular company – or sometimes some very smart people, who actually whether it’s cheap. an entire industry – for reasons that are took the time to help and train me,” he obviously just plain old cyclical or oth- says. “I was very, very fortunate to find Explain the distinction. erwise based on what the investment that situation.” DE: If you’re looking for something fashion of the moment is. that’s cheap, you’ll probably do a vari- An example: Investors in retail com- ety of screens – on price-to-sales, price- panies are very focused on monthly think it’s mispriced, where we have a to-earnings, price-to-book, whatever – comparable-store sales, particularly good understanding of why it’s mis- to identify stocks that appear to be during the holiday season. It seems like priced, where we think the mispricing inexpensive. Once you have that list, at least every other year, particularly in is very large and the overall risk is very then you start to research if there are January, we’re able to find a retailer that small, we take an outsized position to good reasons the stocks deserve to be we really like that had negative compa- make sure we give ourselves the chance cheap, or if maybe there’s an invest- rable-store sales during Christmas and to be well compensated for getting it ment opportunity because they’re the stock trades down to seven or eight right. cheap without a good reason. We think times earnings. The company has a You’ve also developed a reputation as that’s the way most value investors clean balance sheet and it’s a nice ongo- somewhat of an activist investor. Is approach it. ing franchise. We have no idea how the that part of your strategy? We never do screens like that. We next Christmas will go, but if it goes start by identifying situations in which okay, the earnings will be higher and we DE: Activism for us is Plan B. In cases there is a reason why something might will then get a much better multiple on where we’ve been activists, we’ve gen- be misunderstood or mispriced, why those earnings. We’ve been through that erally been passive investors for a good it’s likely investors will not have cor- before with Circuit City and Foot period of time first. But while it isn’t rectly figured out what’s going on. Locker. our goal, when something goes serious- Then we do the more traditional work ly awry, we won’t hesitate to try to You tend to make a few very big invest- to confirm whether, in fact, there’s an effect change when we feel it better ment bets, why? attractive investment to make. protects the interest of the partnership DE: We believe in constructing the than exiting. So you’re often looking for special sit- portfolio so that we put our biggest Look at a few of the situations for uations – a spin-off, or a post-bank- amount of money in our highest-con- which we’re most known for being ruptcy, say, where mispricings can be viction idea, and then we view the active: Mercer International we held for common? other ideas relative to that. We find five or six years before we had our proxy DE: Basically, yes. It happens routinely things that we think are exceptional fight. MI Developments we held for more [in such situations] that the historical only occasionally. So if we find some- than a year before we felt they went off performance of a company doesn’t give thing that is really set up, where we course and we had to start trying to

March 23, 2005 www.valueinvestorinsight.com Value Investor Insight 2 INTERVIEW: David Einhorn

protect value there. In all these cases, the Can you give an example? for a long time, and there have been a day we bought the shares we had no plan lot of times when the CEO has said or to be anything other than passive, happy DE: New Century Financial was a good done things that got under our skin. investors. example of this for us on the long side. The natural reaction would be to just Back in late 2002 there was a lot of sell the stock and move on, but if we Are there sectors or businesses you concern about exposure they retained had reacted in that emotional way, it tend to avoid? from residuals they had on their bal- would have cost us a lot of money. If DE: Some areas lend themselves better ance sheet. When we plugged through you sell when you’re angry, you can to our types of analysis than others. It’s imagine everybody else who sells that very hard for us to figure out what way reaches the point of exasperation brands are worth, for example. It’s also ON CONTROLLING EMOTION: at exactly the same time. That’s the hard for us to figure out what future kind of thing that creates at least a scientific developments are worth. We When management makes us trading bottom. Better to sit on it for tend to stay away from those kinds of angry, we put the file in a some time, and even if you still hate things. But at the right price, we’ll con- what the company’s doing, you’re sider anything. drawer for a while and just probably going to get a better chance to get out. Many value investors avoid financial don’t do anything. We try not to stocks, fearful that they’re more sub- sell just because we’re angry. Let’s talk about your largest position, ject to being black boxes? Does that Freescale Semiconductor (FSL). concern you? DE: Freescale is a classic example of DE: We generally like financials, which the math we concluded that there was the type of situation that interests us. lend themselves very well to our kinds not significant risk to the residual val- This is the semiconductor division that of analysis on both the long and short ues and the market was not giving came out of Motorola last year, and if sides. We don’t think they’re so “black- them credit for their origination plat- you look at the historical performance boxy.” We’ve done well over the years form. As a result, people just had their over time before the spin-off, it’s truly in property/casualty insurance compa- analysis wrong, which made for a very ugly. In 2003, they lost $300 million in nies, for example. It’s a lot of work, good investment opportunity. operating income. In 2002, they lost but you can get the statutory filings, $1.5 billion. In 2001, they lost $1.9 Does instinct play much of a role in and you can look at the claims experi- billion. Even at the peak of the bubble, your decision-making process? ence, and you can look at the loss when things were good, they made only reserves and how they have been devel- DE: Sometimes. As our positions have $200 million in operating profit. oping over time. Maybe a lot of gotten larger, we often find ourselves in So if you look at that, and average investors don’t take the time to do this situations where we can’t trade out of through a cycle, we can understand or don’t know exactly what they’re positions quickly. There have been why you wouldn’t want to own the looking for, but we’re pretty comfort- cases where we own, say, one million shares. One Wall Street analyst actual- able estimating how the reserves shares and we think we want to sell, ly went out of his way to put an under- should look. Sometimes we can find but we can only sell 25,000 shares perform on the stock before the IPO something that is unusually conserva- right away. You could say “why both- even happened. That was actually good tively reserved, or aggressively er, it’s only 25,000 shares.” But our news for us, because The New York reserved, and we can make an invest- feeling is that’s silly – it might only Times picked up on the report and it ment accordingly. help solve 2.5% of the problem, but ran on the front page of the business It's similar with companies that do a the problem is now 2.5% smaller than section the day they were trying to lot of securitizations. We can get the it was. We also find that as you begin price the deal, which helped lower the securitization data, and see the prepay- to exit a position, sometimes the stom- price of the IPO. ments and loss experience on a pool- ach tells us whether we want to keep The catch in all of this is that the by-pool or securitization-by-securitiza- going, accelerate, or whether it isn’t business as run under Motorola was tion basis. We can see how companies really necessary. very different from the business as it’s are actually doing versus their assump- Another thing we do is when man- run independently. With whatever tions or versus what the market thinks, agement really makes us angry, we put global technology and wireless ambi- and sometimes we can find a real dis- the file in a drawer for a while and just tions Motorola had, they were having connect. If we do, there's often a real don’t do anything. We try not to sell Freescale invest in all sorts of capital opportunity to make a good invest- just because we’re angry. We have a and R&D projects that probably didn’t ment, either long or short. large position in a company we’ve had have positive returns, or if they did,

March 23, 2005 www.valueinvestorinsight.com Value Investor Insight 3 INTERVIEW: David Einhorn

only in the context of the broader A lot of value investors would look at led to a valuation very different from Motorola empire. Freescale and say this is a fast-moving any other semiconductor company out So what's happening now, as a technology business, where it’s difficult there. At the IPO price ($13) we paid stand-alone, Freescale isn't going to to predict cash flows three years from less than one times revenue, on an make those investments at the same now, let alone further out. How have enterprise value basis, for this compa- level they would have under Motorola. you gotten comfortable with that? ny. That was a 50% discount to As a result, we're going to have much STMicro or Texas Instruments. So you less depreciation going forward, caus- DE: A few ways. As I mentioned, we’re really had to view this as the worst ing the margins to go up. Not a lot has comfortable in understanding the company around in order to feel there to go right for the profits to grow at a financial dynamics of the company, was a lot of risk in the shares. very rapid clip for the next couple of that they’re likely to have prospective The future leverage is in wireless, years, just because of a change in the results that are much better than his- where the technology does move fast, business model. torical results. We also understand why but they also have a lot of business people might look at this company and besides wireless. The biggest portion of When companies get spun out you also not be attracted to it, which at the IPO revenues comes from the auto business, often see overhead come down as fat gets cut by managers with more of a INVESTMENT SNAPHOT stake in the bottom line. Freescale Semiconductor Financials (TTM): DE: We have SG&A coming down a (NYSE: FSL) Revenue $5.72 billion modest amount in our model and Operating Profit Margin 4.6% they’ve announced some headcount Business: Spun-off from Motorola in July, Net Profit Margin 3.7% reductions. But we don't think that's a 2004, designs and manufactures embed- Valuation Metrics: very big part of the story. ded semiconductors for use primarily in the automotive, wireless, consumer and net- (Current Price vs. TTM) What is another big part of the story FSL S&P 500 working markets. is the possibility they could actually P/E 16.1 20.4 win new customers that didn’t want to Share Information P/CF 7.2 12.8 (@3/22/05): buy from them as a part of Motorola, Largest Institutional Owners: but who would be happy to buy from Price 17.05 (@ 12/31/04) them as an independent company. If 52-Week Range 12.06 – 19.67 Company % Owned Dividend Yield 0.0% you’re a big cellular phone company, Greenlight Capital 15.9% Market Cap $6.84 billion you now have a new supplier option Fidelity Mgmt & Research 14.9% that you didn’t consider before. As it Short Interest: Wellington Mgmt 9.1% happens, Freescale’s wireless technolo- (@3/8/05) Dodge & Cox 8.1% gy is quite competitive, and it looks Shares Short/Float 1.4% Capital Research and Mgmt. 5.0% like they’ll be able to gain quite a bit of market share over the next couple of FSL PRICE HISTORY 20 20 years. Have there been any big new wireless wins yet? DE: They have not really diversified 15 15 the revenues in that segment outside of holdover Motorola business. But we’re actually more confident that they’re going to gain extra market share in 10 10 wireless than we were the day of the 2002 2003 2004 2005 IPO. There are a lot of signs that Freescale’s technology is really quite THE BOTTOM LINE competitive and competitors like An independent Freescale will operate much differently than it did under Motorola – in STMicro have had a lot of bad news in capital spending, in R&D spending, and in its ability to win business from Motorola their own wireless technology portfo- competitors in the booming wireless industry. Given his expectation that margins will increase dramatically, David Einhorn believes the shares are “very inexpensive” at an lios. But it does take a while to win enterprise value (market cap less net cash) of 110% of sales. new designs and then have it actually show up as revenues and profits. Sources: Company reports, other publicly available information

March 23, 2005 www.valueinvestorinsight.com Value Investor Insight 4 INTERVIEW: David Einhorn

where they have leading market share We think that the shares are worth a DE: The way we approach it, there is and continue to announce positive lot more than $17, without much risk, plenty of history that shows that design wins. That’s a relatively stable and that’s really all we have to figure through the cycle this business is still business, with model production runs out today. going to have a premium return on that last for years. We also see in the equity. It doesn’t have to be in the high You’re a long-time holder of M.D.C. auto business that there is a nice secu- 30s that they’re getting now, but on an Holdings (MDC). Few sectors elicit as lar trend of more electronic compo- average basis – even if you assume much controversy in the value commu- nents in cars. So even though there may some rough years coming – it’s going to nity as homebuilders do today. Some not be a lot of unit growth in cars on a earn a very acceptable return on equity, are comfortable with the industry global basis, every year there are more and, in MDC’s case, with relatively low dynamics and have made a fortune in electronics, from satellite radios to financial leverage. the past few years. Others are con- power windows to steering to brakes Then look at what average earnings vinced this is a bubble. What’s your and these guys are selling some pretty can be expected to be through the view as it relates to MDC, currently basic microcontrollers into that cycle. If one wanted to take a very pes- trading around $72? demand. simistic view, assume that earnings At a recent $17 a share, how do you INVESTMENT SNAPHOT think about Freescale’s valuation today? M.D.C. Holdings Financials (TTM): (NYSE: MDC) Revenue $4.01 billion DE: Because we’re looking for margins Operating Profit Margin 15.9% Business: Builder of mostly mid-priced to improve dramatically over the com- Net Profit Margin 9.8% homes in major U.S. markets, including ing years as this plays out, we’re Arizona, California, Florida, Nevada and Valuation Metrics: inclined to look at the relevant valua- Texas. Subsidiaries also provide home (Current Price vs. TTM) tion on a price-to-sales basis. They mortgage lending and title agency services. MDC S&P 500 have over $2 per share in net cash, so P/E 8.2 20.4 Share Information P/CF 7.2 12.8 that’s an enterprise value of about $6 (@3/22/05): billion, which is only 110% of sales. Price 71.75 Largest Institutional Owners: For a business of this sort, we believe 52-Week Range 43.13 – 81.11 (@ 12/31/04) this is very inexpensive. Dividend Yield 0.8% Company % Owned Market Cap $3.11 billion Do you have a target price? Greenlight Capital 9.7% Barclays Bank Plc 6.1% Short Interest: DE: No. That’s another general rule we Aronson + Partners 5.1% (@3/8/05) have here. We hate to make any invest- Wasatch Advisors 4.4% Shares Short/Float 6.6% ment decisions that we don’t have to Axa 3.5% make today, because we’ll have more information later. A lot of people will MDC PRICE HISTORY ask “If you buy a stock at $10, do you 100 100 have a price at which you’ll sell it?” And the answer is really no. All we 80 80 have to know today is do we want to buy or own it at $10, because that’s the 60 60 price that’s available in the market today. By the time it gets to $20, there 40 40 will be lots of new information and we can assess what we want to do at $20 20 20 when it gets there. We try not to clutter 2002 2003 2004 2005 our heads with things that aren’t avail- able for us to evaluate today. We just THE BOTTOM LINE believe today that it’s worth well more Even with an inevitable cooling of the housing market, David Einhorn expects this than $10. excellent operator to generate strong earnings and return on equity deserving of a So with Freescale a target price is market multiple. If that happens, even at 2/3 current per share net earnings, he esti- just not something we have to figure mates MDC would be worth signficantly more than the current $72 per share. out right now, and I’m not just saying that to be cute. We really don’t know. Sources: Company reports, other publicly available information

March 23, 2005 www.valueinvestorinsight.com Value Investor Insight 5 INTERVIEW: David Einhorn

through the cycle from here might DE: I wasn’t suggesting $6 was the In the old days, if you built the house average 2/3 the present level. This is a trough earnings, but the mid-cycle first and couldn’t find a buyer, you had cyclical growth company with very earnings. Clearly you could come to a to cut the price until someone would good returns on equity. We don’t see trough number that is considerably take it off your hands. So in a cyclical why it shouldn’t be worth at least a less, though we would expect MDC to trough, you wound up losing money. I market multiple on the mid-cycle earn- remain solidly profitable at the trough. think the industry has changed to the ings. So MDC today earns around $9 But the homebuilding industry is a very point that the next trough will be high- per share. 2/3 of that is $6. At a mar- different industry now than it was 10 er than the last one 14 or 15 years ago. ket multiple the shares would be much or 15 years ago. The fundamental dif- The market is not giving it credit for a higher. We think that if there is a cycli- ference: Back then if you wanted change in its business model, hence the cal earnings decline, the multiple will somebody to buy a house you had to stock is mispriced. expand and the shares will continue to build it first so they could look at it Independent of one’s general view, do very well instead of shrinking. and decide if they wanted to buy it. what’s special about MDC? That’s been our analysis the last sev- Companies have gotten much better in eral years, and the funny thing has their risk management today. They DE: We believe they are simply better been that instead of shrinking, each build a model house, and then have operators. They are very disciplined in year the earnings have continued to some good computer programs to show their land selection, very effective in grow. The average cycle earnings keep the customer how they can customize their construction, and very good at proving to be higher than we would it, and visualize how the house will pricing their product. They have the have thought a few years ago, and the actually look before it is constructed. highest operating margins and the low- value of company keeps growing. So the customer is comfortable com- est financial leverage. The CEO owns mitting before construction. an enormous amount of stock, so Isn’t the key question here not just they’ve taken the risk of capital very average cycle earnings, but trough So you’d argue that things really are seriously. This company went just earnings? Go back to the last housing different this time? about to the verge of collapse at the downturn, and MDC actually lost DE: The industry has gone from “build bottom of the last down cycle, so money for four consecutive years, from it and then find a buyer” to “find a they’ve seen what can happen if they 1988 to 1991. Could things go back to buyer and then build it.” That has don’t do a good job. We think they being as bad as they were? changed the risk profile dramatically. learned from that.

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March 23, 2005 www.valueinvestorinsight.com Value Investor Insight 6 INTERVIEW: David Einhorn

The risk of course is if there is mas- the last three years, Allied has earned misleading disclosure about the 2003 sive collapse in housing. We just don’t hundreds of millions less than analysts transaction. Allied justified the secret think it’s going to happen, certainly not initially estimated. deals by saying that there had been an on a national basis. There’s not a lot of oral agreement between the two com- Describe some of the regulatory issues history of national deflation in hous- panies. From our perspective, the only involving Allied. ing. And you don’t need ongoing price reason companies have “oral agree- increases for MDC to make great DE: Last year, it came out that in 2000 ments” is because they don't want returns. Allied had shifted problem loans off its someone to find out what they are up own balance sheet to its largest invest- to. It seems to us the acknowledgement Another controversial holding of yours ment, Business Loan Express, and in of an “oral agreement” is tantamount is Allied Capital (ALD), on which 2003 had taken back the same loans, to an admission of fraud. Now there is you’ve been negative for nearly three which had by then defaulted, at full some pretty significant regulatory years. The stock has hardly budged. value. There was no disclosure about review as to what Allied and Business Has your investment thesis changed the 2000 transfer and minimal and Loan Express have been doing. We are over time?

DE: Our original claim, which we still INVESTMENT SNAPHOT believe, is that the company has inflat- ed its balance sheet by mis-marking Allied Capital Financials (TTM): (NYSE: ALD) various portfolio holdings, and inflated Revenue $367.1 million Operating Profit Margin 55.0% its income statement by taking in a Business: Provides debt and equity Net Profit Margin 68.0% bunch of income from what amounts investment capital to small and mid-market to related parties. They’re an invest- companies. Also invests in high-yield com- Valuation Metrics: ment company, so they don’t consoli- mercial mortgage-backed securities and (Current Price vs. TTM) collateralized debt obligations. ALD S&P 500 date investments they control, and can P/E 13.6 20.4 treat from an accounting perspective Share Information P/CF 13.7 12.8 non-arm's-length agreements as if (@3/22/05): they’re arm’s length. That has a posi- Price 25.54 Largest Institutional Owners: (@ 12/31/04) tive impact on their reported results. 52-Week Range 21.60 – 30.72 Dividend Yield 8.8% Company % Owned We also thought the company had Market Cap $3.41 billion Capital Research and Mgmt 5.7% come through the recession with a Goldman Sachs 2.8% portfolio of risky mezzanine loans to Short Interest: Robert E. Torray & Co 2.2% middle-market companies and had rec- (@3/8/05) Torray Corp. 1.9% Shares Short/Float 11.4% ognized almost no losses during that Kayne Anderson Rudnick 1.5% period. Our thinking has been that this will eventually adjust itself, and the ALD PRICE HISTORY shares would go down. 35 35 We’re three years later and we’re not in a substantially different place. The 30 30 company has been extremely effective at what I would call fooling some of 25 25 the people all of the time. Instead of addressing at face value the things we 20 20 have criticized them for, they have made a series of false and misleading 15 15 statements that distract investors from 2002 2003 2004 2005 their ongoing, serious problems. They have figured out they have a core con- THE BOTTOM LINE stituency of shareholders that are per- As a business development company making loans and other investments in private fectly happy to hear them on their companies, Allied has discretion in valuing its investment portfolio and income from terms and focus on their quarterly dis- related companies. David Einhorn believes reported company results have misstated tributions. the health and viability of ALD’s investment companies. Should ongoing regulatory The company has changed some of inquiries validate his thesis, he believes the shares will fall sharply. its accounting, and has begun to recog- Sources: Company reports, other publicly available information nize some of the portfolio losses. Over

March 23, 2005 www.valueinvestorinsight.com Value Investor Insight 7 INTERVIEW: David Einhorn

optimistic that the government will get calls it a “dividend.” Instead of mini- outcome. Either the government in its to the bottom of what’s transpired here mizing it, they aim to maximize it. So investigations will come to agree with and that eventually things should be their investment policy, essentially, is our perspective, or it won’t. satisfactorily resolved for us. to sell their winners to maximize their Based on what you said earlier, we’re distributions, and let their losers carry Are you still uncovering new informa- guessing you won’t say what you think on into the portfolio into future years. tion to support your view on Allied? Allied is worth. They have “educated” their investors DE: We don’t have anything that isn’t that for Allied such taxes, I mean “dis- DE: Let’s just say sufficiently enough available to the general public. A lot of tributions,” are a good thing. Allied’s less than the current price to make this their portfolio companies are private, investors have bought it. all worthwhile. The last three years so there’s no financial information one Then they say, “Look, we have all haven’t really been fun and games here. way or the other. But we keep close these realized gains that prove what Some European investments have track of the news on the companies in good investors we are.” recently caught your eye. Tell us first their portfolio. A number have gone What’s the catalyst for you here? The about Renault? bankrupt, so we’ve been able to review federal investigations? the bankruptcy filings and compare the DE: Renault is free. Absolutely free. histories of these companies with how DE: That seems to be the most likely How can you be against that? Allied has historically reported on them. We’ve learned a lot about the INVESTMENT SNAPHOT general accounting practices there, and it seems to us there are some very sig- Renault SA nificant issues. We have found compa- (PARIS: RNO) nies that went bankrupt where it’s clear Business: Global car and truck manufac- Financials (Full-year 2004): they’ve been in deterioration for four turer based in France, operating primarily Revenue €40.7 billion ($53.8 billion) or five years, and then shortly before under the Renault brand. Also owns large Operating Profit Margin 5.3% the bankruptcy Allied belatedly takes consumer/commercial finance operation. Net Profit Margin 8.7% the first impairment. Share Information Valuation Metrics: The company has done a good job (@3/22/05, Exchange Rate: $1 = .7570 euro): (Current Price vs. TTM) from a PR perspective of making the Price €68.05 ($89.89) RNO CAC debate about what they’re doing a per- 52-Week Range €53.20 – €70.40 P/E 5.1 14.5 sonal one, about how they are this nice Dividend Yield 2.1% company that through good people and Market Cap €19.4 billion ($25.6 billion) hard work supports the individual investor and pays healthy dividends. You know, it’s not actually a divi- RNO PRICE HISTORY 80 80 dend Allied pays. A dividend in a com- pany is profit earned that isn’t required 70 70 for the ongoing growth of the business 60 60 and can be distributed to shareholders. Allied is quite different. It is a type of 50 50 investment company called a business 40 40 development company. It is governed by the same tax regime as mutual 30 30 funds, which means they don’t pay tax 20 20 at the fund level, but they distribute the 2002 2003 2004 2005 taxable income to their investors. Mutual funds understand that investors don’t want taxable distribu- THE BOTTOM LINE tions, so each year they sell their losers At today’s prices, Renault owns minority equity interests worth around €16 billion in to get their tax losses and let their win- Nissan and €3 billion in Volvo. The value of the profitable auto finance business is ners ride, which is the efficient thing to roughly equal to total debt. The result, says David Einhorn: “The car and truck busi- do from a tax perspective. ness, which made about €2 billion last year, is free.” Allied takes that taxable distribu- Sources: Company reports, other publicly available information tion, breaks it into four equal parts and

March 23, 2005 www.valueinvestorinsight.com Value Investor Insight 8 INTERVIEW: David Einhorn

Define free. investor, you’re not going to be inter- lot of mediocre businesses and a couple ested in Renault. A plain vanilla value that are actually good. DE: Renault has a market value of €19 investor won’t be comfortable because The thesis is that at a time when the billion today. But they own about €16 of the valuation of Nissan. But, if you stocks of U.S. basic materials and billion worth of Nissan, and they own do what we do, which is hedge out the chemicals companies are trading at €3 billion of Volvo. They still have €2.5 Nissan and Volvo stakes, you get the high multiples on next year’s profits billion of debt, which is covered by the Renault business at a price we like to that assume lots of price increases, this value of the finance subsidiary that gen- pay. One day the discrepancy should is a company trading at a low multiple erates €290 in after-tax income and has resolve itself. of this year’s profits that don’t assume a €1.7 billion book value. a lot of price increases. Lanxess is trad- Your final stock, Lanxess, is a recent So you’re left with the Renault car ing at only around 5x EBITDA on German spinoff of Bayer AG. What’s and truck business, which generated 2005 estimates. the thesis here? EBIT in 2004 of €2 billion, for free. Everyone hates this company DE: Lanxess is a hodgepodge of busi- because it’s a bunch of businesses Bayer What’s the catch? nesses in chemicals and plastics and didn’t want and has low margins. So it DE: The catch is there are no natural rubbers. As in most spinoffs, there are trades at a lower-than-average multiple owners for this. If you’re a growth a few absolute dogs in their portfolio, a on the lower-than-average margin. But we think there’s a real opportunity here for management to reengineer the port- INVESTMENT SNAPHOT folio – close businesses that are a drag, Lanxess AG maybe reallocate capital among busi- (Frankfurt: LXS) nesses. It’s very much like Freescale in

Business: Recent spin-off from Germany’s Financials (Est. full-year 2004, prior to spin-off): that you could wind up with a much Bayer AG, portfolio of businesses focused Revenue €6.7 billion ($8.8 billion) better multiple on much higher profits. primarily on global manufacture of chemi- Operating Profit Margin 1.5% If that were to come to pass we’ll have cals, synthetics and plastics. Net Profit Margin (0.2%) a very good investment result. Share Information Valuation Metrics: Looking at the available financial and (@3/22/05, Exchange Rate: $1 = .7570 euro): (Current Price vs. TTM) strategic information on Lanxess, Price €16.11 ($21.28) LXS DAX which isn’t very enlightening, how do 52-Week Range €13.63 – €17.95 P/E n/a 16.1 Dividend Yield n/a you analyze the individual businesses? Market Cap €1.2 billion ($1.6 billion) DE: This is too opaque to have a strong view about the individual businesses. You have to bet on whether you think LXS PRICE HISTORY the people they put in charge are capa- 20 20 ble of reconfiguring the portfolio in a way likely to create value for share- 15 15 holders. They brought in a CFO who had a similar successful experience at 10 10 Aventis. Our subjective judgment from hearing management present and 5 5 speaking to them on the telephone tells us it’s a worthwhile bet. 0 0 2004 2005 Any parting advice or thoughts? DE: Maybe one thing I didn’t mention earlier. We try not to have many invest- THE BOTTOM LINE ing “rules,” but there is one that has While U.S. chemicals stocks have “high multiples and assume strong industry price served us well: If we decide we were increases,” says David Einhorn, LXS trades at only 5x estimated 2005 EBITDA, assum- wrong about something, in terms of ing little or no price increases. As the portfolio of businesses is reengineered in com- ing years, he sees significant upside from higher profits earning a much better multiple. why we did it, we exit, period. We never invent new reasons to continue with a position when the original rea- Sources: Company reports, other publicly available information sons are no longer available. VII

March 23, 2005 www.valueinvestorinsight.com Value Investor Insight 9