June 30, 2010

ValuThe Leading Authority on eInvestorINSIGHT

Prime Properties Inside this Issue FEATURES “We're paid for results, not activity,” says Pacifica Capital's Steve Leonard, who's done a great job producing the former, without generating much of the latter. Investor Insight: Jerry Senser Seeking out mispriced companies fter 20 years investing in and man- INVESTOR INSIGHT with identifiable catalysts for change, aging commercial real estate, Steve such as ConocoPhillips, Textron, ALeonard in 1998 turned his invest- Sanofi and Credit Suisse. PAGE 1 » ing attention to equities, focusing on busi- nesses with strong brands and market posi- Investor Insight: Steve Leonard Patiently waiting for big bargains tions that had “more control of their des- like those found so far in Energizer tinies through market cycles than I could Holdings, , R.G. ever find in real estate,” he says. Barry and Starbucks. PAGE 1 » Leonard's skills have certainly translated well. Since his Pacifica Capital Investments Strategy: Momentum starting taking outside money in 1998, it Can understanding how and why has earned for investors a net annualized share-price momentum occurs be of help to value investors? PAGE 16 » 12.2%, vs. 1.8% for the S&P 500. Sticking to a narrow range of industries Steve Leonard Uncovering Value Pacifica Capital Investments and typically holding no more than 10 As Joel Greenblatt’s “magic formula” positions at a time, Leonard today is find- Investment Focus: Seeks high-quality goes global, in what stocks is it find- ing opportunity in property/casualty insur- companies at those rare moments when ing opportunity today? PAGE 18 » market, industry or company issues have ance, financial services, consumer prod- made their stocks cheap enough to buy. ucts, coffee retail and slippers. See page 2 Editors' Letter When you’re better off paying little attention to your gut instincts; Mark Twain on speculation. PAGE 19 » Pacifica Capital Investments INVESTMENT HIGHLIGHTS PO Box 710 • 5119 El Mirlo • Rancho Santa Fe, CA 92067 858-354-7180 • www.pacificacapital.net INVESTMENT SNAPSHOTS PAGE ConocoPhillips 5 Performance Comparison Credit Suisse 8 PCI vs S&P 500 %'". Energizer Holdings 12 299.6% d %"". n Fairfax Financial 11

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m 24.3% u ". C '". Other companies in this issue: #++* #+++ $""" $""# $""$ $""% $""& $""' $""( $"") $""* $""+ American Express, AstraZeneca, Berkshire *9 months only Year Hathaway, Capital One, CGI Group, , Hewlett-Packard, *PCI performance for each year is an Internal Rate of Return measurement for that year. 1998 is a partial year. IRR is a weightedreturn that InterDigital, Jamba Juice, Kroger, Markel, accounts for contributions and withdrawals during the period. The S&P 500 return measures the change from the start of the period to the end of the period, assuming no contributions and/or withdrawals and includes dividends. The “Total” is for the entire period, compounded annu- Medicis, Nintendo, Office Depot, OPAP, ally. PCI results are shown net of all fees, including management fees, brokerage fees and custodial expenses, and reflect the reinvestment of all PepsiCo, Pfizer, Redecard, Sembcorp dividends and earnings. Results for individual accounts are varied and will vary in the future. Past performance is not a guarantee or indicator of future results, and investors should not assume that investments made on their behalf by PCI will be profitable, and may, in fact, result in a Marine, Sohu.com, Takeda Pharmaceutical, loss. Investors also should not assume that PCI’s results will outperform the S&P 500 Index or other broad market indexes in the future. TomTom, United Internet, Wells Fargo

www.valueinvestorinsight.com INVESTOR INSIGHT: Steve Leonard

Investor Insight: Steve Leonard

Steve Leonard and Kari Pemberton of Pacifica Capital Investments explain why their concentrated focus is a risk miti- gator, the low-risk bets they're making with what would otherwise be idle cash, why new financial regulation may not hurt incumbent leaders, and why they hold big stakes in Fairfax Financial, Energizer, R.G. Barry and Starbucks.

How has your background in real estate cess has a lot to do with timing when you informed your stock-investing strategy? get in and when you get out. Being disci- plined about that is obviously as impor- Steve Leonard: The success we had in tant in stock investing. The time to buy is real estate came from having a deep when earnings are below their sustainable understanding of the market, focusing level and you have to pay a relatively only on what we really knew, paying very lower multiple on those earnings. The close attention to supply and demand, time to sell is when earnings are above and being exceedingly careful about the normal and the market is paying dearly prices we’d pay. That mindset translates for that. It sounds simple, but people directly to how we invest in common don’t tend to do that. stocks. Steve Leonard We’ll rarely invest outside of industries You’ve described much of your time being we know extremely well, which tend to spent “patiently waiting” for the right Picking His Spots be consumer goods, retail, restaurants, price to buy. What tends to make that banks and companies. Our best happen? Steve Leonard earned his stripes as a early investment by far was Starbucks value investor long before turning to equi- [SBUX], which we knew first-hand from SL: Much of our research and analysis ty investing full-time through Pacifica the real estate business had tremendous involves identifying companies we’re will- Capital in 1998. In 1982, his real estate growth potential. Landlords gave them ing to buy and the prices at which we’ll firm started buying and developing prop- favorable locations and rents because of buy them. If the market isn’t offering up erties in Los Angeles at a recession- all the traffic they drew, and you could those companies at those prices, we sit induced low point in the market. By 1988 figure out fairly easily the economics at and wait. Clients sometimes get anxious he had sold his L.A. holdings and took his the store level and the long runway they about that, but we try to remind them we buy-low, sell-high strategy to Denver, a had to expand. When we know business- get paid for results, not activity. market reeling from an extended decline in es that well, we’re confident in making One clear reason prices get attractive is energy prices. First buying up existing them big positions – we generally aren’t when the whole market is panicking. In properties and then teaming with Apollo invested in more than 10 stocks at a time. late 2008 and early 2009 you could have Real Estate Advisors to build new ones, Having seen what capital flowing into thrown darts – almost everything was a Leonard did some 100 deals in Denver a business can do to supply and ultimate- good buy. That gave us the opportunity over ten years prior to selling out to three ly to returns, we focus on companies with to buy American Express, ADP [ADP], different real estate investment trusts. “It's strong brands, leading market positions Wells Fargo [WFC] and U.S. Bancorp always nice to sell to people hungry to do and what we think are sustainable com- [USB]. These were all examples of great deals with other people's money,” he says. petitive advantages. A great example in franchises with clear challenges from the our portfolio today would be American crisis, to which we thought the market With a history of adroitly picking his spots Express [AXP], which we think is one of was overreacting. to invest, how does Leonard view the cur- the most valuable brands there is. We also Industries can also have issues from rent equity opportunity set? “With individ- stick to businesses we don’t expect to time to time that mark down stocks, usu- ual stocks, 10% of the time they’re cheap change dramatically over the years. ally having to do with an oversupply of enough to buy, 10% of the time they’re Going out for coffee, for example, proba- capital driving down returns. That hap- bly isn’t going to be replaced by a new pens with fairly cyclical regularity in expensive enough to sell, and the rest of technology or some other activity. People property/casualty insurance, for example, the time you should just hold them if you are still going to want slippers, of which which we’ve tried to take advantage of own them and avoid them if you don't. The another of our holdings, R.G. Barry many times over the years. overall market is like that as well. We're [DFZ], is a leading provider. Then there are obviously company- not at the top or the bottom, which means For the most part, commercial real specific issues. R.G. Barry went through a we're mostly patiently waiting at the estate is a commodity business and suc- painful transition from a manufacturer moment.”

June 30, 2010 www.valueinvestorinsight.com Value Investor Insight 2 INVESTOR INSIGHT: Steve Leonard model to one like Nike where it out- [BRK-A]. Those are still our three largest tent basis to book value than it has been sourced product manufacturing to Asia. positions, by the way. in recent years, when you would expect The market dumped the stock, but we When we shifted our real estate busi- the premium to have expanded because thought the strength of the brands and ness to Denver in the late 1980s, a large the company’s value is more tied to oper- the ultimate soundness of the strategy investor of ours from L.A. asked whether ating businesses than investments. That made it a great turnaround opportunity. we were nervous about having all our tells me that the premium for him has In Starbucks’ case, they overexpanded eggs in one basket in Denver. It’s obvious- rationally gone down as he’s aged. But and they overpaid to buy back stock, ly a fair question, but when I thought he’s not gone yet, and I still believe he and hurting returns and the stock price. We about the alternatives – investing in real of Fairfax are two of the best got back in again at what we thought was estate in places like Dallas or Baltimore or capital allocators in the world. a bargain price as they recognized the investing in other projects in Denver out- error of their ways on the operational side side of what we knew – diversifying just Are any more macro themes informing and also started better allocating capital. made no sense. If I have the majority of your strategy today?

Any brand-new examples of the market SL: We typically only own U.S.-based offering up an opportunity to buy? ON : firms, but we’re unlikely to invest in com- It would be better if he were panies that don’t have at least the poten- SL: Yes, Goldman Sachs [GS]. The SEC tial to have a strong presence in emerging allegations against it and the regulatory 50, but he’s not gone yet and markets. In Asia and elsewhere, you don’t uncertainty around the industry certainly is still one of the best capital have the unfavorable demographics and don’t make Goldman more valuable to potentially damaging economic policies us, but chances are the market is overre- allocators in the world. that are likely to constrain growth in the acting to the tangible damage of penalties U.S. and other developed countries. or regulatory change. Our read on the We’re also very concerned about the history of businesses that come in for our portfolio in the three or four posi- unsustainable debt levels across-the- greater regulation is that it’s more likely tions which I understand the best and in board in the U.S. and most developed to entrench the existing market leaders at which I have the most confidence, I don’t countries, and how government responses the expense of new competition. We also consider that risky. to that problem are likely to result in high think people are ignoring the fact that When I had 100% of my net worth in inflation and interest rates over time. even if Goldman has to divest or spin off Denver real estate, I was worried about a That makes us more leery than ever of something, it should get comparable meteor hitting Denver. When I had more companies with too much debt, that are value in return. It’s not like something’s than 50% of my portfolio in Starbucks, I overly dependent on leverage financing to going to be taken from them. worried about things like studies coming fund capital expenditures, and that don’t One thing I should point out here is out showing coffee causes cancer. The have pricing power. that the very best opportunities are in point with both is that I couldn’t really Pension-fund obligations are also very finding a Starbucks in 1996 or a Chipotle think of anything else that could go badly scary to us. The future costs of pension a few years ago, where there’s a great con- wrong. We want that to be the case with plans are almost always understated, cept that is just beginning to grow and the all of the businesses we own. while the future investment returns are market hasn’t fully caught on. Then, overstated. We were interested not long because there’s so much growth in front How do you think about the risk of ago in Kroger [KR], the grocery chain, of it, it’s not so much about waiting for Warren Buffett being unable to run until concluding what a big problem its the rock-bottom price. Those ideas are Berkshire? pension fund was. the hardest to find, but they’re the best. SL: It would be better if he were 50 rather How much cash are you holding today? Some highly concentrated funds fared than almost 80. Our feeling is that the poorly when the crisis hit. How did your company has a tremendous number of SL: Including the variable-rate preferred portfolio weather the storm? well-run businesses that will continue to stock we’ve been buying, it’s around 35% generate attractive returns long after he’s of our portfolios. We don’t actively try to SL: We ended up being down around gone. If no one can reinvest the cash flow time the market, but our cash naturally 14% in 2008, and in fact, our smallest, like he has, which is likely, they’ll proba- goes up when we sell our least-favorite lower-conviction ideas did the worst. Our bly start paying a decent dividend, which positions that have gone up a lot and it three biggest positions going into the cri- may attract a lot of new owners to the goes down when we’re finding a lot to sis were cash – which got as high as 60% shares. buy. Over the past several months we’ve of our portfolios in 2007 – Fairfax The reality is that Berkshire’s share raised some cash as some of our stocks Financial [FFH] and price has never been as close on a consis- went up dramatically.

June 30, 2010 www.valueinvestorinsight.com Value Investor Insight 3 INVESTOR INSIGHT: Steve Leonard

What are some examples of positions business is an average-return business. mary operations are in property/casualty you’ve sold recently and why? What makes Fairfax exceptional is Prem insurance in the U.S. and Canada, the Watsa, who as CEO and Chief Investment OdysseyRe global reinsurance business SL: We sold the last of our Markel [MKL] Officer has an unsurpassed record of and – after the recent acquisition of shares just for valuation reasons. The making investment decisions over the Zenith National – in workers’ compensa- share price relative to book value got high past 25 years. He’s outperformed in both tion insurance in the U.S. We like that enough that we decided there was no good fixed income and equities, increasing they’re expanding in emerging markets, reason to own it over something like book value by more than 20% annually including the purchase of wholly owned Fairfax, which has more upside and better over that time. That’s a significant and subsidiaries and minority investments in management. The market also kind of sustainable competitive advantage. We’d places like India, China, Singapore, Hong bailed us out of our Office Depot [ODP] think differently if Watsa were not there, Kong, Poland, Jordan and Brazil. position. We originally liked the stock even more so than if Warren Buffett were because it was a solid #2 in selling office not at Berkshire Hathaway. The investment portfolio was smartly supplies, which we consider an attractive positioned to profit from the crisis. How business,. But the more experience we had How well run are Fairfax’s insurance would you describe its make up today? with management overpromising and businesses, which provide all the float? underperforming, we were happy to get SL: He basically redeployed much of the out as the share price came back this year. SL: For businesses the company has portfolio into corporate bonds, municipal It’s not on our potential-buy list any more. owned for any period of time, it does very bonds – mostly those insured by well in terms of underwriting. The pri- Berkshire Hathaway – and global equities What variable-rate preferreds are you buying? INVESTMENT SNAPSHOT

Kari Pemberton: With money-market Fairfax Financial returns at historic lows, we think we’re (: FFH:CN) able to get much better yields without Business: with primary Financials (Year-end 2009) taking on much interest-rate or credit risk operating subsidiaries involved in proper- Revenue $6.64 billion ty/casualty insurance and reinsurance in Pre-Tax Profit Margin 18.2% by buying the variable-rate preferred Canada, the U.S. and Asia. Net Profit Margin 12.9% shares of companies like Goldman Sachs, Share Information Morgan Stanley and Bank of America. (@6/29/10, Exchange Rate: $1 = C$1.05): Valuation Metrics Goldman Sachs’ D shares, for example, (Current Price vs. TTM): have a par value – the price at which Price C$390.82 FFH S&P 500 they’d be redeemed – of $25 per share, 52-Week Range C$281.33 – C$417.35 Dividend Yield 2.6% P/E 6.0 17.8 but can be bought today for around Market Cap C$8.39 billion $18.75, resulting in a current yield of 5.3%. The shares have a yield floor of FFH PRICE HISTORY 4%, and if interest rates rise – which we 500 500 view as matter of when and not if – the rate goes up tied to 3-month LIBOR. So 400 400 we’re protected against rising interest rates, are earning a nice tax-advantaged 300 300 yield, and think over time there’s a very good chance of capital appreciation from 200 200 today’s depressed prices. The risk is that the companies go out of business, which we just don’t see happening to a Goldman 100 2008 2009 2010 100 or a Morgan Stanley. THE BOTTOM LINE Describe the investment case for your If CEO Prem Watsa continued to increase book value at the 20%-plus annual rate largest stock position, Fairfax Financial. he’s done so over the past 25 years, “I could put all my money in this and go home,” says Steve Leonard. Even if book increases at closer to 15% per year and the share SL: This idea is 90% about management. multiple increases to 1.25x from today’s 1x, “It’s still unlikely I’d be a seller,” he says. Unless you touch the consumer directly – Sources: Company reports, other publicly available information like a Geico, for example – the insurance

June 30, 2010 www.valueinvestorinsight.com Value Investor Insight 4 INVESTOR INSIGHT: Steve Leonard

in late 2008 and early 2009. He’s more What potential do you see in Energizer these types of consumer products recently put some hedges on the equity Holdings [ENR]. expands. As they leverage existing inter- holdings, which would indicate he’s less national distribution and manufacturing than enthusiastic about near-term SL: The company has a portfolio of most- infrastructure, they should be able to prospects for the market. ly #1 and #2 brands in stable consumable increase long-term sustainable margins. product categories that aren’t prone to They also have margin upside from con- The shares have roughly doubled over the significant private-label competition. tinuing to integrate operations of the past three years, to around C$390. How That includes Energizer and Eveready many acquisitions they’ve done over the do you look at the upside from here? batteries, Schick razors, Playtex feminine- years to build up the brand portfolio. care products, Wet Ones hand wipes and SL: The shares currently trade right Hawaiian Tropic suntan lotions. With the shares trading just under $51, to around book value. So if Prem Watsa can The story here is fairly simple. They what extent is the market missing the increase book value at the 20% annual have leading brands in attractive cate- potential you see? rate of the last 25 years over the next 25 gories with excellent potential for inter- years, I could put all my money in this national growth as disposable incomes KP: With a top line growing in the mid- and go home. I don’t think that’s likely, rise around the world and demand for single digits and long-term net margins given that the business is bigger and that they have in that book value more good- INVESTMENT SNAPSHOT will, on which it’s harder to earn that kind of return. But it’s not unreasonable Energizer Holdings (NYSE: ENR) to expect he can earn 15% annually. It’s Valuation Metrics (@6/29/10): also not unreasonable to expect the mar- Business: Global manufacturer and mar- keter of branded battery, shaving, skin-care, ENR S&P 500 ket will eventually wake up and pay at infant-care and feminine-care products. Key Trailing P/E 10.8 17.8 least 1.25x book for a company with this brands: Energizer, Schick and Playtex. Forward P/E Est. 9.6 13.1 type of track record. Even if that hap- Share Information Largest Institutional Owners pened, it’s still unlikely I’d be a seller. (@6/29/10): (@3/31/10): An added kicker here that we like is Price 50.93 Company % Owned that the company regularly increases its 52-Week Range 50.80 – 69.11 Fidelity Mgmt & Research 7.6% dividend, most recently by 25% in Dividend Yield 0.0% Vanguard Group 3.4% January to C$10 per share. That’s just Market Cap $3.57 billion Atlantic Inv Mgmt 3.4% another example of how they treat share- Financials (TTM): Wellington Mgmt 2.8% holders right. Revenue $4.19 billion Bank of NY Mellon 2.6% Operating Profit Margin 16.7% Short Interest (as of 6/15/10): What are the biggest risks? Net Profit Margin 7.7% Shares Short/Float 5.2%

SL: We worry somewhat about inflation, ENR PRICE HISTORY although the negative of future claims 120 120 being higher than what has been reserved 100 100 is probably more or less offset by the pos- itive of increased yield on the fixed- 80 80 income portfolio as he reinvests. With any insurance company, there are 60 60 always underwriting risks from earth- quakes, hurricanes and asbestos-type liti- 40 40 gation, but as with Berkshire Hathaway, 20 20 we’re confident they’ve structured their 2008 2009 2010 exposures to never take on more risk than they can handle. THE BOTTOM LINE Probably the biggest challenge would The company’s share price doesn’t reflect the strength of its brands, its international be if something happened to Prem Watsa. growth potential and its opportunities to increase margins, says Steve Leonard. Based He’s still relatively young and has built a on his discounted-cash-flow model or by applying a more reasonable multiple to his competent team around him, but we’d $5.75 per share estimate of sustainable earnings, the fair share value is closer to $80. certainly lighten up on our position with- Sources: Company reports, other publicly available information out him.

June 30, 2010 www.valueinvestorinsight.com Value Investor Insight 5 INVESTOR INSIGHT: Steve Leonard

increasing to 9-10% (from 7.4% in the out of line. New management was products for companies such as Levi’s and latest fiscal year), we believe the compa- addressing the problem, but it wasn’t Nautica. ny’s sustainable earnings per share is at fixed without a painful transition that The company is now focused primari- least $5.75. So on a normalized basis, the almost put the company under. They ly on product design, marketing and dis- shares trade at less than 9x earnings. came out of that and as we’ve gotten to tribution and the business generates In our experience, that’s a surprisingly know management and the business over excellent free cash flow, which manage- low multiple for a company with the time, the more we like them both. ment has used to start paying a dividend quality of brands this has. Even a 15x The basic business is slippers – Barry and to build up more than $4 per share in multiple would not be overly aggressive, has around 35% of the U.S. soft-slipper net cash on the balance sheet. The overall which would result in a share price in the market, selling under a variety of brand return on invested capital this year should mid-$80s if we’re right about earnings. names, the most prominent of which is be around 25%. Our discounted-cash-flow model, using Dearfoams. They’ve also taken advantage conservative assumptions, isn’t far off of a strong marketing and distribution Is this a growth story? that, putting fair value in the high-$70s. system to expand into harder-soled “après anything” footwear under the SL: We’re modeling roughly 5% annual What has the market concerned? Terrasoles brand, and to sell licensed growth, but there are a few ways it could

SL: The company has a bit more debt INVESTMENT SNAPSHOT leverage than we would typically like, which is one reason this isn’t yet a large R.G. Barry (Nasdaq: DFZ)) position for us. But most of the debt is at Valuation Metrics (@6/29/10): fixed rates for a reasonable period of Business: Developer and marketer of “accessories” footwear, including slippers DFZ Nasdaq time, while the cash generated by the and shoes sold under such brand names Trailing P/E 11.5 13.0 business is allowing them to steadily as Dearfoams, Terrasoles and Superga. Forward P/E Est. 11.5 14.9 reduce the overall debt level. Share Information Largest Institutional Owners There’s also some concern the con- (@6/29/10): (@3/31/10): sumable battery business is only going to Price 11.25 Company % Owned be so-so, which is legitimate as people 52-Week Range 6.48 – 12.00 Pacifica Capital 10.6% use more rechargeable batteries. Our Dividend Yield 1.7% Dalton, Greiner, Hartman, Maher & Co 5.0% feeling is that will be more of a devel- Market Cap $122.4 million Wellington Mgmt 4.0% oped-country phenomenon, which is Financials (TTM): Dimensional Fund Adv 3.4% likely to be offset by emerging-market Revenue $124.4 million Schneider Capital 3.0% growth for traditional batteries. Given Operating Profit Margin 13.3% Short Interest (as of 6/15/10): the diversity of the overall product port- Net Profit Margin 8.6% Shares Short/Float 0.4% folio, we don’t see rechargeable batteries as a big problem. DFZ PRICE HISTORY Another potential market concern we 15 15 actually consider a plus is the fact that management doesn’t spend a lot of time 12 12 and money selling itself to Wall Street. They avoid things like conference calls 9 9 and investor confabs. That might make the stock a bit more volatile, but we like 6 6 that the priority is more on running a suc- cessful business than holding the hands of 3 3 investors. 2008 2009 2010

Explain in more detail your long-time THE BOTTOM LINE interest in R.G. Barry. After accounting for net cash on the balance sheet and for future pension obligations, the company’s shares trade for only 11x Steve Leonard’s 80 to 85 cent estimate of SL: This is a company I came across six sustainable per share earnings. “For a steady, high-return-on-capital business with a or seven years ago, at a time when it was great balance sheet and excellent management, that’s just too low,” he says. having significant problems primarily Sources: Company reports, other publicly available information because its manufacturing costs were way

June 30, 2010 www.valueinvestorinsight.com Value Investor Insight 6 INVESTOR INSIGHT: Steve Leonard

come in better than that. Wal-Mart has it’s all about the brand and customer loy- national markets, where people thought asked Barry to supply it in its stores out- alty. People don’t just say, “Let’s go for a Starbucks would have a hard time com- side the U.S., but that’s in the early stages cup of coffee.” They say, “Let’s go for peting against traditional coffeehouses, so we don’t have a clear sense how that Starbucks.” You know the #1 in an indus- but where they continue to show impres- will go. Management also sees untapped try has a pretty good business when you sive growth. We also see a great deal of potential in expanding both its licensing can’t even identify a #2. upside from many of their external-prod- and private-label businesses. Finally, the ucts businesses, including their new Via company has announced it’s in the mar- The operational improvement certainly instant coffee, other packaged retail prod- ket for the right acquisition, possibly in doesn’t appear to have been missed by the ucts, and a food-services initiative under an area – like sandals, for example – that market. Why are you content to hold the way with Sysco. They’ve also recently offers some seasonal diversification. shares today? decided to do more franchising of stores, which requires less capital and should At $11.25, how cheap do you consider SL: We think this is more than just a turn- generate excellent returns. the shares? around and that Starbucks still has Overall, we think the company can impressive growth opportunities ahead. grow revenues at around 10% annually, SL: We expect the existing business to The primary growth driver will be inter- with profits growing faster than that as earn a net margin of up to 8% and pro- duce sustainable profits of 80 to 85 cents INVESTMENT SNAPSHOT per share. After netting out the cash and adding back maybe $2 per share in pen- Starbucks (Nasdaq: SBUX) sion obligations – which I know I said we Valuation Metrics (@6/29/10): dislike, but which we at least feel we can Business: Global owner or licensor of more than 16,000 coffeehouses in over 50 coun- SBUX Nasdaq quantify and take out in valuing the busi- tries. Also sells branded beverage and food Trailing P/E 25.0 13.0 ness – the shares currently trade for only products through third-party retail outlets. Forward P/E Est. 20.3 14.9 about 11x normal earnings. For a steady, Share Information Largest Institutional Owners high-return-on-capital business with a (@6/29/10): (@3/31/10): great balance sheet and excellent manage- Price 25.01 Company % Owned ment, we believe that’s just too low. 52-Week Range 12.76 – 28.50 Fidelity Mgmt & Research 10.5% One reason for the low multiple may Dividend Yield 1.5% T. Rowe Price 5.6% be that Barry still isn’t well-followed or Market Cap $18.63 billion Capital World Inv 5.1% well-known, but a low Wall Street profile Financials (TTM): Vanguard Group 3.6% has never been a particular concern to us. Revenue $10.08 billion State Street Corp 3.3% That’s rarely a permanent problem as Operating Profit Margin 11.0% Short Interest (as of 6/15/10): long as a company continues to execute Net Profit Margin 7.5% Shares Short/Float 3.1% and build value. The biggest risk we see is that manage- SBUX PRICE HISTORY ment gets impatient and pays too much 30 30 for an acquisition or buys something that 25 25 isn’t a good fit. That’s always possible, but such a lack of discipline would cer- 20 20 tainly contradict our experience with them to date. 15 15

You mentioned your early success with 10 10 Starbucks. Why is it back to a large hold- 5 5 ing today? 2008 2009 2010

SL: We bought back in about 18 months THE BOTTOM LINE ago at the height of the crisis, when it was The company's operating turnaround is well underway, but Steve Leonard also sees becoming clear how important it was for upside from the potential of10%-plus annual profit growth. While he might start trim- the company to moderate growth, close ming his position at a 25% higher share price, he'd be in no hurry to get out. “You don't underperforming stores and refocus on come across global brand franchises with this kind of growth every day,” he says. maintaining what we consider to be a Sources: Company reports, other publicly available information truly unique customer experience. Again,

June 30, 2010 www.valueinvestorinsight.com Value Investor Insight 7 INVESTOR INSIGHT: Steve Leonard

the store base matures and they leverage margin growth. We also like that they when you go into a Starbucks you’ll see existing infrastructure in the U.S. and started paying a dividend, which we up to 20 people in line or sitting down. At internationally. expect to grow over time. Jamba Juice, you’ll maybe see two. We might start trimming if the stock We’ve heard for some time about U.S. rose another 25% from today’s price, but In the end, your investing strategy is pret- competitors like McDonald’s and Dunkin I wouldn’t be in a big hurry to get out. ty simple. Why is it so hard to get right? Donuts going more directly after You don’t come across global brand fran- Starbucks. Is that a concern? chises with this kind of growth upside SL: It’s true that figuring out what you every day. should do as an investor isn’t that diffi- SL: If those efforts have had an impact cult. You can read all Warren Buffett has on Starbucks, I haven’t seen any evidence Describe a recent mistake. written or said over the years, for exam- of it. I don’t think it’s the same customer ple, and basically emulate that. The hard or the same experience when you’re talk- SL: Our mistakes are usually a result of part is to have the discipline and the ing about going to McDonald’s or to overestimating the strength of a brand or patience to execute. Starbucks for a cup of coffee. the competence of management. We did The bottom line is that to be a good both with Jamba Juice [JMBA], the investor you need to only buy when it’s At a recent $25, the shares have more smoothie company. Its strategy to buy emotionally the hardest, only sell when than tripled from their crisis lows. How back successful franchises and make them it’s emotionally the hardest, and do pret- far are you from starting to trim your company-owned turned out to be badly ty much nothing while waiting for market position? timed and poorly executed, destroying a extremes to offer opportunities to do lot of value. New management seems to either. That’s all incredibly hard. You SL: We still have 10% of our portfolios have the company back on track, but as often don’t know you’ve been right until in Starbucks and, while I wouldn’t buy at the price came back we were more than months or even years later. Most people this price, I’m very comfortable holding happy to get out. It just wasn’t the type of need more immediate gratification than and taking advantage of the revenue and franchise we want to be investing in – value investing typically offers up. VII

Disclosure

Performance results provided herein are the aggregate of all fully discretionary accounts managed by PCI, including those accounts no longer with PCI, and include the performance of the accounts of PCI’s principals (which do not incur management fees) and certain other accounts that have reduced management fees. Minimal leverage and short selling has been used since inception for the PCI managed accounts; the effects of such leverage and short selling on PCI’s performance figures have been nominal. In addition, it is not likely that the relative performance of PCI’s managed accounts will exceed the performance of the broader stock market (as measured by the S&P 500 or other broad market indexes) by as large a margin as has occurred to date. The stock market faced an unprecedented decline in the year 2008, which strongly impacted the performance of the S&P 500 Index during the time period shown. In addition, PCI’s per- formance during the year 2000 was significantly enhanced by the strong performance of one large position in its accounts under man- agement. The 12/31/09 total ending balance for all accounts was approximately $191 million and approximately $41 million was in accounts of PCI principals (Leonard family and PCI accounts). Total number of individual accounts was 250 as of 12/31/09.

The investment objective of PCI’s managed accounts is capital appreciation. PCI’s strategy is to concentrate its investments in a limited number of positions with certain positions representing an intentionally large size in the accounts. This concentration is likely to result in greater volatility than the overall market as measured by the S&P 500 Index, which is made up of 500 large companies. In addition, PCI’s strategy is to “hold for the long term” which reduces trading costs.

June 30, 2010 www.valueinvestorinsight.com Value Investor Insight 8