Michael Durante Western Reserve 2Q06 letter

Second Quarter 2006 July 18, 2006

100 Crescent Court • Suite 400 • Dallas, Texas 75201

YTDApr-06 May-06 Jun-06 2Q06 2006

WRHE Gross 0.7% -2.3% -0.2% -1.8% 7.0% 30.7%WRHE Class A, Net1 0.4% -1.9% -0.3% -1.7% 5.0% 20.5%WRHE Class B, Net1 0.4% -2.0% -0.3% -1.8% 5.2% 21.3%S&P 500 1.2% -3.1% 0.0% -1.9% 1.8% 14.3%NASDAQ Composite -0.7% -6.2% -0.3% -7.2% -1.5% 8.5%

1 Class A shares are subject to a one year lockup and a 20% performance fee; Class B shares are subject to a three year lockup and a 17% performance fee.

Inception to Date

“The Big Lie”

Dear Partners: The second quarter was a beating for stocks. Gains accumulated in the broader stock market during the year were wiped clean at one point and remain well off their highs. The S&P 500 recovered to close the quarter down 2%, while the NASDAQ closed down over 7%. Small cap stocks fell as much as 13% during the quarter, and highly speculative areas such as emerging markets and commodities fell by as much as 20% before recovering slightly. Western Reserve Hedged Equity declined 1.7% net for the second quarter. An indecisive Fed continues to offer cyclical economy bulls late-cycle hope and this has slowed the shift. But, we increasingly are seeing the quality rotation we have been anticipating emerge. Year-to-date, WRHE has gained 7% gross (5% net) versus 2% for the S&P 500 and a negative 1.5% for the NASDAQ. Net exposure has remained consistently half the market, and the Fund has made money both long and short. Since its 1/1/2004 inception, the Fund has gained 31% gross (21% net) versus the S&P’s 14% gain and NASDAQ’s 8%. We have exceeded our long-term goal of doubling market returns with half the exposure, and far better relative to the growthier areas of the market. Despite the unusually high correlation between stocks, our long positions have outperformed shorts by a ratio exceeding four to one. Yet, we cannot remember a time when we felt less satisfied with a performance stretch as we do now. There is significant power pent-up within the portfolio as institutions are frozen at the stick awaiting visibility from the Fed. We remain unsure as to why portfolio managers seek top-down assurances to execute. From the bottom up, quality is cheap, junk is expensive and seventeen rate hikes does not a new expansion make. This tired old

(214) 871-6720 Main • (214) 871-6713 Fax [email protected]

July 18, 2006

economy bull is drying-up as the massive Greenspan liquidity punchbowl is being hauled away from the party. The bull market in low quality is ending and the shake-out has finally begun. The portfolio’s long-side earnings growth (a key driver of long-term performance) has compounded at over 20% annually, so the portfolio is meaningfully underperforming earnings the past year. Rarely does this last for long. The flip side, of course, is that services stock valuations are disproportionately attractive. Because investors are paralyzed, the market is not paying for compound earnings right now, only paying up for transient momentum (trading). The portfolio’s services longs have earned well and we equate earnings accumulation to “stored value” in our low turnover portfolio. The businesses in which we invest are non-cyclical and their earnings tend to compound or “accumulate”. The E rarely stops compounding and only the P moves around from period to period. The P/E is as low as it gets historically for quality growth and services stocks. It’s time to buy them. We are equally excited by today’s short opportunities in over-owned areas which paradoxically are deeply cyclical despite seventeen straight rate hikes. This quarter’s letter discusses our intensive cash flow business model analysis a bit later. Our cash flow-based valuation methods are signaling a flood of materially overpriced low-quality businesses out there, which others should be short and likely will be as economic conditions become more obvious. Momentum is peaking for over-owned cyclicals, and their extended valuations have created short fodder. Many industrial/cyclical stocks are found in the Russell 2000 Value Index, a derivative chart of which is below and which depicts the incredible valuation expansion or “value” stock bubble we believe exists.

"Value" Stock Bubble

14

18

22

26

30

34

4Q95

2Q96

4Q96

2Q97

4Q97

2Q98

4Q98

2Q99

4Q99

2Q00

4Q00

2Q01

4Q01

2Q02

4Q02

2Q03

4Q03

2Q04

4Q04

2Q05

4Q05

2Q06

Russell 2000 Value Trailing P/E

High quality growth still trades at a material discount, and we are confident this will correct itself in due time. For the first time in many years, some blue-chip growth financials are cheap enough to merit our attention. I’m not talking about poorly managed, integration indigestion machines like regional banks, which do not grow and have no competitive advantage, but rather best-in-class companies such as American Express Company (AXP), Sallie Mae (SLM), Capital One Financial (COF), and Countrywide Financial (CFC) that are ripe for the picking. They are inexpensive and they grow. We are also seeing similarly compelling values in high growth

100 Crescent Court • Suite 400 • Dallas, Texas 75201 (214) 871-6720 Main • (214) 871-6713 Fax

[email protected]

July 18, 2006

technology services firms, and several of these investments were mentioned in our mid quarter update in May. Western Reserve Hedged Equity (unweighted) Long Short Small Cap <$1bil 46% 24% Mid Cap 39% 61% Large Cap >$10bil 15% 15%

As the above table shows, we tend to focus on small-mid capitalization, faster growing companies in our services verticals. Historically firms like AXP weren’t as appealing to us, as it typically commands a premium too high to warrant our attention. This is no longer the case. It is our largest long position and we think it can appreciate 50% in the next twelve to eighteen months. Express is among the most profitable firms in the world, sporting massive cash margins and return on invested capital while growing profits at three-to-four times (3x to 4x) the economy. Let’s start with AXP’s valuation, because it’s nonsensical. Given our estimate for over $9 billion in cash flow next year and an enterprise value (equity market value plus debt) of $84 billion, Express trades at only nine-times (9x) cash flow. If AXP were a bond (and the high recurring nature of its travel-related services (TRS) business is truly bond-like), the yield would be 11%. 11% or twice bond yields for a financial firm so entrenched in our global electronic payment system that it’s among the most recognized brands on the planet. Express is enormously profitable and its cash flow is growing at a double digit rate. Return on equity tops 32%, and we expect cash flow to grow at least 15% annually for the next several years. Low margin, highly cyclical companies like farm equipment makers, railroads and roofing shingle distributors trade at twice the multiples of AXP. A business like a railroad, which historically must spend 100% to 200% of EBITDA on requisite capital expenditures, currently fetches 14x to 16x EBITDA and 80x to 100x actual operating cash flow. AXP fetches 9x, more than a 50% discount to a railroad (90% on free cash flow). That’s perverse! It’s an opportunity, and we are quite confident it will correct itself.

American Express (AXP)

$100

$150

$200

$250

$300

$350

$400

$450

$500

$550

94A 95A 96A 97A 98A 99A 00A01A 02A 03A 04A 05A 06E 07E15%

17%

19%

21%

23%

25%

27%

Worldwide Billed Business $Billions

Share of US Purchase Volume

`

100 Crescent Court • Suite 400 • Dallas, Texas 75201

(214) 871-6720 Main • (214) 871-6713 Fax [email protected]

July 18, 2006

Express also has unloaded its lower value insurance business, the old IDS Financial, in the past year. All the lower quality distractions from the eighties have now been discarded. For the first time in decades, AXP is a pure play on electronic payments and arguably the very best electronic spend-centric investment to be had. Penetration of electronic payments remains low around the globe. We estimate that domestic consumer payment penetration by card accounts is only 35% and remains under 20% internationally. On the commercial-side, we estimate that penetration is less than 15% domestically among small businesses and de minimus globally. Express dominates both verticals. Express also has made a 180o turn from losing market share to bankcards (VISA, MasterCard) in the eighties and nineties to now taking market share following recent successful court victories. Bank issuers are now able to sell AXP branded card services and there is a market to be exploited in the more traditional banking customer channels. Express’ card accounts generate six-times (6x) the spend velocity of the typical bankcard account. Even an enviable Citibank (C) card portfolio churns only three-times (3x) the average. Traditional banks have a clear opportunity to leverage the American Express brand to their wealthiest clients. AXP doesn’t currently trade like a stock with high profitability, dominant market position in an expanding market, and profits growing in the high teens. We believe AXP should trade more in line with growing, spend-centric core transaction processors (versus credit-intensive issuers) like Global Payments (GPN), which trades at 20x cash flow or 2x AXP’s multiple. Valuations for the publicly traded financial transaction payment and processing peer group displayed in the below table are largely depressed as investors have shunned high recurring revenue, quality stocks in favor of more economically sensitive cyclicals and materials stocks (which we view as significantly overvalued). This is the most attractive this high quality stock group has been since the Y2K bug hysteria. The group trades at just 15x 2006 estimated cash earnings and a 1.0x price-earnings-to-growth ratio (PEG), and 14x and 1.0x respectively for the out year. Despite depressed peer valuations, AXP still trades at a meaty discount to this highly attractive and undervalued group of businesses.

Financial Payment and Processing Stocks EV/Cash

Flow 06E EV/Cash Flow 07E

PEG 06E

PEG 07E

Automatic Data ADP 15x 13x N/A 1.3x Alliance Data ADS* 15x 12x 0.4x 0.7x Checkfree CKFR* 15x 12x 0.4x 0.8x DealerTrack TRAK* 20x 15x 0.5x 0.5x eFunds EFD* 9x 7x 0.5x 0.5x Euronet Worldwide EEFT* 15x 12x 0.8x 0.6x First Data FDC* 13x 11x 2.0x 0.9x Global Payments GPN 20x 17x 1.4x 1.4x MasterCard MA* 9x 8x 0.7x 0.7x MoneyGram MGI 17x 15x 1.0x 1.5x Paychex PAYX 23x 20x 1.5x 1.7x Total Systems TSS 10x 10x N/A N/A Average 15x 14x 1.0x 1.0x American Express AXP 12x 10x 0.7x 0.7x

*Other Western Reserve Hedged Equity long positions as of June 30, 2006 Source: Western Reserve estimates; Baseline


[email protected]

July 18, 2006

Once the marathon Fed tightening and coming economic slowdown is fully digested by investors, high quality financial and transaction processing stocks will catch the normal “bid” from those rotating out of low quality stock groups. 12x 2007E cash earnings (still under 1x PEG) gets one to $85 or more than 50% upside from current levels in AXP. We still like Capital One (COF) as well. At 10x cash flow, COF grows at 2x-3x the typical regional bank, posts 30% higher profitability (ROE), and trades at a 40% discount. Absurd! It’s the most valuable all purpose bank in the country in our view – #4 in credit cards, #2 in small business cards (AXP is #1), #2 in non captive auto finance, #3 bank in New York City, and #10 in deposits nationwide. COF has earned profits exceeding $12 billion since going public in 1994. It still grows earnings at multiples of the economy and other finance companies.

Capital One Financial (COF)

$0.50 $0.64 $0.77 $0.93$1.32

$1.72$2.24

$2.91

$3.93

$4.92

$6.21$6.73

$8.00

$9.00

94A 95A 96A 97A 98A 99A 00A 01A 02A 03A 04A 05A 06E 07E

Earnings Per Share

The above chart for COF says it all. COF’s EPS has grown 1,600% since the IPO in 1994 and the stock is up about 1,500%. No multiple expansion is a total rip-off in our view and the current 40% discount to peers is a joke, but that’s our kind of stock. All E and too cheap to make sense! We would like to see other investors give COF credit for phenomenal growth and consistency, but financials haven’t led the stock market in over ten years, and we wouldn’t be as excited if prices weren’t this ridiculously low. We are satisfied with just accumulating earnings as performance. A classic compound earnings-driven Western Reserve investment, COF has never posted a down year and never less than 10% growth in a given year. Compound earnings is the eighth wonder of the world. “What’s in your wallet?” COF is in ours!

Capital One versus Regional Banks P/Book P/E 06E P/E 07E PEG 07E AmSouth Bancorp ASO 2.5x 14x 13x 2.0x BB&T BBT 2.0x 15x 14x 2.0x Compass Bancshares CBSS 2.8x 18x 17x 1.8x Commerce Bancorp CBH 2.4x 19x 17x 2.0x M&T Bank MTB 2.2x 16x 15x 1.6x Zions Bancorporation ZION 1.9x 15x 14x 1.5x Average 2.4x 16x 14x 1.9x Capital One Financial COF 1.7x 12x 10x 0.8x Source: Western Reserve estimates; Baseline


[email protected]

July 18, 2006

The Big Lie… Years ago, television commercials warned kids about cocaine abuse in powerful ads labeling the drug as “The Big Lie.” Fortunately, cocaine’s recreational popularity appears to have waned since those days, and we suspect the ads played a role in educating against the downside of abuse. Appealing to an audience constantly interested in a good elixir, Wall Street’s use of an arbitrary accounting convention called EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) is the newest revival of an old school valuation drug. And it’s every bit the same canard that has gotten investors in over their heads before. EBITDA has become so widely used as a valuation metric by analysts and portfolio managers that we liken it to the Internet mania’s price-to-sales binge-use. We all know what a bender that turned out to be. Why EBITDA? Because it makes the valuations of old economy industries like industrials and materials appear much less expensive than they really are. Like a popular drug, it makes one feel falsely confident. Put plainly, EBITDA is agreeable to the eye and necessary to fuel the current bubble in traditional “value” stocks. Beyond that, it’s a ruse. EBITDA doesn’t come anywhere close to actual cash flow for many businesses, most notably business which are asset or capital intensive (high capital expenditures or “CapEx”). It ignores large obligatory operational expenses related to running a business, namely investing in the very inputs necessary to operate the business day-to-day.

Examples of items ignored by standard EBITDA analysis….

• Inventory for merchandizing firms • Receivables management for sales-finance driven businesses e.g. durables • Depreciable equipment in manufacturing • Off-balance “rents” such as real estate occupancy or operating system leases • Certain benefits and compensation for professional services firms

All are examples of real operating costs which GAAP (Generally Accepted Accounting Principles) and EBITDA often ignore, and dismissing them when valuing a business is precarious. It’s akin to analyzing your household budget and ignoring the mortgage, grocery and electric bill. Wall Street analysts and portfolio mangers use EBITDA routinely without qualifying its use. Among the finer business evaluators, Warren Buffet once defined EBITDA as “earnings before all the important expenses.” His long-time partner, Charlie Munger, once referred to EBITDA in more colorful language which we are reluctant to reprint in mixed company, but it started with the letters bull…. Evaluating actual cash flow is a better way to measure how profitable a business really is. It sure works at home, however confrontational it may be. Why, then, is it so unpopular a measure for


[email protected]

July 18, 2006

investors? The fact that EBITDA is just easier to calculate seems too veneer to be believable. We suspect there is another reason… EBITDA aficionados attest that it’s a means of measuring cash flow on the quick. The measure excludes the significant factor of changes in working capital notwithstanding. Cash is king because it shows "true" profitability and a company's ability to continue operations. Many investment mistakes made at the end of the dotcom era mirror the recommendations Wall Street is currently making based upon seemingly palatable multiples of EBITDA. History does repeat itself. Western Reserve’s research team applies a cash flow matching model across all long and short investments. It’s a model taught to every rookie Federal Reserve bank examiner. While the model was designed for credit analysis, we think it’s not applied often enough to equity investing. As the greatest old economy bull in a generation ages, we thought it might be timely to lay out the financial statement analysis which drives the pure cash flow-driven stock selection we employ. We scrutinize cash flows in an effort to reduce the following risks presented by the use of conventional accounting:

i) Flexibility in GAAP for reporting profits can be used to widen the differences between reported profits and cash flow

ii) In some instances the requirements of GAAP result in misleading operating cash flow and profit reporting

iii) Unusual cash receipts and payments can lead to unsustainable fundamentals The key metric we utilize when evaluating the true profitability of a business is the “cash conversion rate”, typically operating cash flow-to-EBITDA. This ratio is akin to truth serum when evaluating the quality of a business, especially relative to GAAP and EBITDA measurements of valuation. Examples of Western Reserve’s cash flow intensive growth stock analysis:

1. Acquisitions: For acquisition-intensive strategies (a.k.a. “roll-ups”), treat acquisitions the same as “replacement” CapEx and not “growth” CapEx

Firms that rely upon voluminous and rapid-fire acquisitions to maintain GAAP EPS growth (via purchase accounting treatment) are more commonly referred to as “roll-ups”. Roll-ups are quite popular again among investors. Purchase accounting under GAAP allows firms to record the cash flow impact below the operating line (see ii above). However, for these firms, acquisitions are the operations of the business.


[email protected]

July 18, 2006

Roofing Materials Distributor A – Operating Cash Flow v. EBITDA 2005 Net Income $18 mil Add: Depreciation & Amortization 11 EBITDA 29 Change in Receivables 24 Change in Inventory <33> Change in Payables 16 Accrued Expenses <1> Other Assets -0- Other Liabilities 1 Capital Expenses <5> Acquisitions <280> Operating Cash Flow <248>

EV/EBITDA 11x EV/Operating Cash Flow Negative

Cash Conversion Rate Negative (Increase) Decrease in Debt 197 Stock Issuance 52 Cash Flow from Financings 249 Acquisition Goodwill-to-Book Equity 105% Debt-to-Capital 60% Debt-to-Tangible Equity Negative

Source: SEC filings; Western Reserve estimates

The truth is that “Roofing Materials Distribution Firm A” must spend excessively for accounting–based profit growth. Acquisitions are an expensive business strategy and thus there is no real cash flow conversion from the business without collapsing the growth model. This is where the valuation risk lies for investors. Investors place high multiples on “roll-ups” based upon the sustainability of growth, itself a cash destroyer. The paradox is that to create a profit, the firm must stop growing and thus the valuation must correct to the significantly lower growth rate. Risk of overpaying is substantial.

History shows that product or distribution-based acquisitions incur real cash costs which are almost never economically as scalable as CapEx related to organic growth initiatives. EBITDA and cash flow will be miles apart in these strategies. This is why the majority of “roll-ups” are eventually “blow-ups”. Investors ignore the cash flow and balance sheet deterioration until at some point the firm runs out of accounting-based growth because acquirable properties become either too scarce and/or pricing gets too competitive. These firms often suffer from rising debt leverage, low cash support and integration-related problems and mishaps.

“Auto Parts Distributor B” also must spend excessively for accounting–based profit growth. Their business is inventory intensive and they need to buy-up junkyards in order to find more inventory of used auto parts. The inventory intensity itself is a major drain on working capital and thus the business itself converts a mere 10% of EBITDA into above the line operating cash flow. As a result, the GAAP operating cash flow multiple is an eye-popping 180x at market. Add the costs of acquisitions into the fray and Firm B must fund significant and continual real operating cash flow shortfalls by issuing stock and debt. The risk, obviously, of over-paying for this stock is high. In fact, the valuation of this stock at market is fantastical and due simply to poor business model analysis and accounting research on Wall Street.


[email protected]

July 18, 2006

Auto Parts Distributor B – Operating Cash Flow v. EBITDA 1Q06 Net Income $12 mil Add: Depreciation & Amortization 3 EBITDA 15 Change in Receivables <2> Change in Inventory <14> Other Assets and Liabilities, net 5 GAAP Operating Cash Flow 4 Capital Expenses <9> Acquisitions <29> Operating Cash Flow <37>

EV/EBITDA (annualized) 18x EV/GAAP Operating Cash Flow 180x

EV/Operating Cash Flow Negative Cash Flow Conversion Rate Negative EBITDA Yield 6% Operating Cash Flow Yield Negative Cash Flow from Financings 37


The “roll-up” strategy is a classic example of serial operating cash outflow covered by financings. Relying on financings to cover the strategy’s need to constantly spend to meet accounting-based profit growth is precarious. Paying multiples for the stocks based upon GAAP and EBITDA is foolhardy. Many fund managers have become interested in “roll-ups” again largely because they appear to have non-economically correlated GAAP EPS growth. We are seeing elevated valuations, particular for industrial and materials industry “roll-ups” at present. On a balance sheet note, “roll-ups” tend to have a negative tangible net worth and a high level of debt. This makes the balance sheet very high risk and vulnerable to any integration mistakes and/or an economic downturn. These models are very much on a “treadmill” in our view. Beware!

2. Capitalized Expenses: Capitalizing operating expenses is often always a red flag

Beware of material expense accruals and unusually large charges through the investing section of the cash flow statement! Capitalizing operating costs often are reported either as a build-up of accruals, which result in cash outflows of working capital (changes in assets or future liabilities) in operating cash flow or large cash outflows in the investing section of the cash flow statement. Thus, they are erroneously ignored by EBITDA calculations and missed by many analysts and portfolio managers.

Western Reserve adjusts operating cash flow to remove capitalized operating expenses. Examples include capitalized software development costs, product warranties and other future liability reserves, capitalized interest and even certain stock-based compensation strategies. We see only one benefit to capitalizing clear operational related costs - to overstate the reported profitability of the business. And therein lays the valuation risk.


[email protected]

July 18, 2006

Recreational Vehicle Maker C – Operating Cash Flow v. EBITDA 1Q06 Net Income $11 mil Add: Depreciation & Amortization 14 EBITDA 25 Change in Receivables 18 Change in Inventory <18> Change in Payables 1 Accrued Expenses <71> Other Assets and Liabilities, net 1 Less Capital Expenses <14> Investment in Off-Balance Sheet Finance Sub

11

Operating Cash Flow <47> EV/EBITDA 19x

EV/Operating Cash Flow Negative Cash Flow Conversion Rate Negative Stock Issuance <16> Debt Issuance 62 Cash Flow from Financings 51 EBITDA Yield 5% Operating Cash Flow Yield Negative


“Recreational Vehicle Maker C” accrues warranties (future liabilities) despite having to fund the reserve at the time of sale. The effect is to substantially overstate the profitability of the business per GAAP and EBITDA metrics. The firm “pays” for this perpetual cash flow short-fall through financings. Actual debt is understated as well due to the use of an off-balance sheet financing structure. The cash conversion rate is negative due to the need to finance the working capital deficiency and thus the valuation risk of the stock is high. Levered sales-finance models like this can quickly disintegrate into bankruptcy on any fundamental mishaps. Western Reserve either shorts or avoids such business models as a standard practice due to the inherent business model risks.

Companies that capitalize expenses generally must fund such cash outflows below the operating line, most commonly through constant financings. Financing repetitive working capital shortfalls overstates profitability and increases the risk to already overstated fundamentals in a downturn. Most problems are not uncovered until a fundamental problem arises and this explains the rapid “melt-down” in stocks of companies which employ aggressive expense capitalization techniques.

3. Working Capital: Some sources and uses of cash related to working capital-intensive industries are properly reported in the operating section of the cash flow statement, but ignored by EBITDA. Others are not picked-up by traditional financial statements entirely due to off-balance sheet accounting techniques such as unconsolidated joint ventures and leases

EBITDA can be a materially inaccurate measure of operating cash flow for asset-intensive and people-intensive industries. For the asset-intensive business model, changes in working capital related to the management of such key assets and liabilities as inventory, receivables, payables, etc. are too critical to ignore, yet both GAAP and EBITDA do just that. Some firms use off-balance sheet financing


[email protected]

July 18, 2006

arrangements to manage such working capital-intensive assets and liabilities. Receivables securitization is one of the more common techniques as are off-balance sheet leases for occupancy (real estate) and operating systems (technology). If continual cash outflow in working capital related items is present, then a company may have fundamental issues related to revenue recognition that need to be explored with management. For example, “channel stuffing” is a technique used to record sales on the income statement by redirecting receivables to other potentially inappropriate parts of the balance sheet. A thorough reconciliation of working capital from period to period usually can pick-up on this. Conversely, unusual cash inflows in working capital related assets and liabilities can indicate off-balance sheet ventures and financing structures. In either case, EBITDA ignores working capital and thus is wholly inadequate a measure of cash flow and profitability.

Farm Equipment Maker D – Operating Cash Flow v. EBITDA 2005 Net Income $32 mil Add: Depreciation & Amortization 106 EBITDA 138 Change in Receivables 104 Change in Inventory <42> Change in Payables 40 Accrued Expenses <45> Other Assets and Liabilities, net <39> Less Capital Expenses <23> Transfer of Receivables to Off-Balance Sheet Entity <109> Operating Cash Flow <40>

EV/EBITDA 16x EV/Operating Cash Flow Negative

Cash Flow Conversion Rate Negative EBITDA Yield 6% Operating Cash Flow Yield Negative Off-Balance Sheet Commitments 652 GAAP Debt 848 Adjusted Total Debt 1500 GAAP Debt-to-Tangible Equity 1.7x Adjusted Debt-to-Tangible Equity 3.0x


“Farm Equipment Maker D” accrues operating expenses but must fund the reserve for such future liabilities at the time of sale. However, the more glaring standout is that the company funds almost 80% of GAAP operating cash flow by transferring assets to off-balance sheet structures, which are partially owned and thus unconsolidated. They are financings nonetheless and materially alter the real operating cash flow statement when factored-in. The effect is to substantially understate leverage in the business (by two times) and reliance on financings to meet working capital shortfalls. The cash conversion rate is negative as a result. This is a highly “strained” business model in our analysis and the use of EBITDA is nonsensical in evaluating profits and cash flow.

Be particularly aware of off-balance sheet financing arrangements as they decrease accounts receivable and lower indicated debt levels, thereby artificially increasing operating cash flow under GAAP. Western Reserve “unwinds” such off-balance sheet transactions by adjusting balance sheet items to increase receivables and short-term debt. Many of these “arrangements”


[email protected]

July 18, 2006

are structured as joint ventures and treated as unconsolidated subsidiaries for accounting purposes. Thus, they are easily missed by analysts and portfolio managers. Over valuation can be quite alarming and common due to the understatement of leverage and business risk.

GAAP and EBITDA also materially understate CapEx for asset-intensive firms through the use of off-balance sheet structures for such operational costs as occupancy (real estate), technology utilization leases, and others. Western Reserve strips out the impact of operating leases from our cash flow analysis and adds back off-balance sheet commitments into debt and enterprise value.

Satellite Television Network E – Operating Cash Flow v. EBITDA 2005 Net Income $1515 Add: Depreciation & Amortization 798 EBITDA 2313 Change in Receivables <4> Change in Inventory 80 Change in Payables <7> Accrued Expenses 151 Other Assets and Liabilities, net 219 Deferred Taxes <540> Less Capital Expenses <1506> Cash Flow pre Leases 268 Change in Off-Balance Sheet Leases <192> Operating Cash Flow 76

EV/EBITDA 8x EV/Operating Cash Flow 67x

Cash Flow Conversion Rate 11% EBITDA Yield 13% Operating Cash Flow Yield 1%


The fact is that “Satellite T.V. Network E” is highly CapEx intensive and converts only 11% of its EBITDA into operating cash flow after adjusting for off-balance sheet satellite leases. So, it’s not a very profitable business after all. The actual cash yield on the investment is only 1% at market. Valuing EBITDA for a business like this is highly inaccurate and the risk of overpaying substantial. Yet, almost every analyst following the stock focuses on EBITDA for valuation, even though it really trades at 67x actual cash flow.

Using EBITDA as a substitute for cash flow even among “clean” accounting for asset-intensive industries is problematic as it leads to overvaluation risk. Western Reserve will very rarely be long an asset-intensive firm, but we often find short candidates among these business models due to the heightened execution risk to such capital intensive business models and the higher likelihood for overvaluation due to accounting convention overstatement of profitability. These types of stocks tend to get overvalued towards the end of long, strong economic runs.

This is the traditional “value” stock bubble now ongoing…


[email protected]

July 18, 2006

Railroad F – Operating Cash Flow v. EBITDA 2005 Net Income $1026 mil Add: Depreciation & Amortization 1175 EBITDA 2201 Change in Receivables <201> Change in Inventory <22> Change in Payables 224 Other Assets 12 Other Liabilities 138 Less Capital Expenses <2169> Operating Cash Flow 183

EV/EBITDA 14x EV/Operating Cash Flow 169x

Cash Flow Conversion Rate 8% EBITDA Yield 7% Operating Cash Flow Yield <1%


The reality is that “Railroad F” converts a mere 8% of its EBITDA into operating cash flow. So, using the cash flow standard, it’s not a “good” business. The actual cash yield on the investment is under 1% at market. Valuing EBITDA for a severely asset-intensive firm like a railroad is inane, and paying 169x operating cash flow sounds like an Internet multiple to us. “Only 14x EBITDA” says the sell-side brokerage firm analyst. 169x actual cash flow…ridiculous!

4. Stock Options: EBITDA and other cash flow substitutes do not adequately capture the true operating costs for firms that substitute stock options for cash compensation across a high percentage of their employees

While motivating employees with stock ownership has positive attributes for investors, it does overstate the profitability of a business under the current accounting conventions used by Wall Street. Two items not found in EBITDA must be reconciled to get an accurate picture of cash profits - deferred tax liabilities and stock repurchases in the open market. The latter negatively impacts cash flow per share metrics and is the most common miss by analysts and portfolio managers.

Analysts tend to stop above the operating line when evaluating firms with high stock-based compensation. Since we are dealing with share count issues with stock-based compensation (share count dilution) in the first place, per share operating metrics are critical. If the number of fully diluted shares is not declining for a firm with a broad stock-based compensation strategy despite an aggressive stock repurchase program, then one should be concerned. Significant cash flow per share dilution likely is taking place as economic value is being transferred to employees (funded below the operating line) at the expense of public stockholders. The effect is doubly problematic because not only is cash flow per share (economic value) being destroyed; the impact below the operating line also overstates the above-the-line growth rates used by Wall Street to discount the valuation. This leads to serious overvaluation risk for investors.


[email protected]

July 18, 2006

Professional Services Firm G – Operating Cash Flow v. EBITDA* FY06 Net Income $26 mil Add: Depreciation & Amortization 1 EBITDA 27 Change in Deferred Taxes 22 Adjusted EBITDA* 49 Change in Membership Fees <6> Change in Deferred Revenue 9 Less Capital Expenses <4> Purchase of Treasury Stock <44> Operating Cash Flow 2

EV/Adjusted EBITDA* 18x EV/Operating Cash Flow 438x

Cash Flow Conversion Rate 4% Adjusted EBITDA Yield 6% Operating Cash Flow Yield 0% GAAP EPS $1.30 Adjusted EBITDA Per Share $2.45 Operating Cash Flow Per Share $0.10 Cash Flow Dilution Per Share >90% GAAP EPS Growth Rate +19% Cash Flow Per Share Growth Rate Negative Change in Common Shares FD +5%


*Sell-side analysts use Net Income plus Depreciation, Amortization and Deferred Taxes for a cash flow substitute.

“Professional Services Firm G” converts an astonishingly low 4% of its adjusted EBITDA* into real operating cash flow. This creates a nightmarishly overvalued stock at 438x actual cash flow. In effect, firms using options in lieu of cash compensation have exacerbated operating costs for their staff because buying-back stock at inflated market prices to battle share creep from vesting is a colossal destroyer of cash. Investors and analysts are missing this aspect of stock-based compensation. There is no mistake in cash flow per share metrics. This may be the biggest “miss” from a lack of detailed cash flow statement analysis by Wall Street today.

From a conventional accounting perspective, the effect of many stock-based compensation-centric financial models is that material levels of actual staff expense, a clear operating cost, is capitalized and thus ignored on the income statement. The cash costs show up in the cash flow statement below the operating line upon option vesting in the financing section of the cash flow statement at a future date. These firms prove to be less profitable than indicated by GAAP and EBITDA metrics. Professional services and technology firms are most at risk to this type of capitalized operating expense issue.

Obviously, using actual cash flow is a better measure of how much real profit a company is able to generate and should be inherent to stock valuation. Nevertheless, it’s not widely practiced by Wall Street, which is more prone to momentum investing and applying false valuation measures to propel investing trends in the short run.

EBITDA is an accounting gimmick used to dress-up a firm’s earnings or to dilute the valuation. Western Reserve’s research team employs a cash flow matching model which adjusts real operating costs such as replacement CapEx and changes in working capital intensive asset and liabilities back into profit calculations. The resultant measure of profitability can adequately discount how much cash a company can consistently generate over time. As is common in all


[email protected]

July 18, 2006

cycles in the stock market, investors ignore cash flow and both over value “hot” sectors and miss clues that indicate whether or not a company is truly making money or not. The current old economy stock boom is not dissimilar and will unwind in the same manner as past booms.

Despite our clear focus on growth, our concept of ‘firm value’ is linked inextricably to a measurement of true operating cash flow, largely because we do not believe we will be adept at timing the sustainability of valuation gimmicks and “new paradigms” in the market. We believe that real earnings drive stocks over time (e.g. see Capital One). The wholesale use of EBITDA and other trivialized cash flow substitutes in valuing stocks today is as counterfactual as the use of other relative valuation methodologies so spuriously applied during the dotcom era.

Despite a pretty fair licking this spring, old economy stocks remain excessively valued in our view. Portfolio managers again are in denial of the oversized bet they have on their books at the top of the economic cycle. A railroad should not be bought at 14x a wildly inaccurate profit measure such as EBITDA, when in a downturn it will fetch three-times (3x). What’s remarkable is that the rails still make virtually no cash profits even at a point in time when capacity is maxed out and profit fundamentals are absolutely stellar.

The stock market usually leads the economy by three-to-six months. Clearly, the second quarter for stocks raises the caution flag on the economy. Terrific balance sheets on both the commercial and consumer sides of the economy will soften the coming downturn, but a leadership change in stocks will be necessary to maintain positive market direction. Regardless, we see compelling opportunities both long and short amidst this anxious and aging old economy led market.

Old school EBITDA, like ‘new age’ price-to-sales, is baloney. EBITDA enthusiasts have been warned.

Regards,

Michael P. Durante Managing Partner


[email protected]

July 18, 2006

LongShortTotal (Gross) Total Class A (Net)2

Total Class B (Net)2

LongShortTotal (Gross) Total Class A (Net)2

Total Class B (Net)2

Jan-06 Feb-06 Mar-06 Apr-06 May-06 Jun-06 YTDWRHE Gross 4.7% 2.7% 1.3% 0.7% -2.3% -0.2% 7.0%WRHE Class A Net 3.6% 2.1% 1.0% 0.4% -1.9% -0.3% 5.0%WRHE Class B Net 3.8% 2.1% 1.0% 0.4% -2.0% -0.3% 5.2%S&P 500 2.5% 0.0% 1.1% 1.2% -3.1% 0.0% 1.8%NASDAQ 4.6% -1.1% 2.6% -0.7% -6.2% -0.3% -1.5%

Jun-06 May-06 Apr-06 Mar-06 Feb-06 Jan-06 Dec-05 Nov-05 Oct-05 Sep-05 Aug-05 Jul-05 TTMInception To Date3

WRHE Gross -0.2% -2.3% 0.7% 1.3% 2.7% 4.7% 3.3% 0.9% -3.9% -1.9% -5.1% 2.7% 2.4% 30.7%WRHE Class A Net -0.3% -1.9% 0.4% 1.0% 2.1% 3.6% 2.5% 0.6% -3.2% -1.6% -4.2% 2.1% 0.8% 20.5%WRHE Class B Net -0.3% -2.0% 0.4% 1.0% 2.1% 3.8% 2.6% 0.6% -3.4% -1.7% -4.3% 2.1% 0.8% 21.3%S&P 500 0.0% -3.1% 1.2% 1.1% 0.0% 2.5% -0.1% 3.5% -1.8% 0.7% -1.1% 3.6% 6.6% 14.3%NASDAQ -0.3% -6.2% -0.7% 2.6% -1.1% 4.6% -1.2% 5.3% -1.5% 0.0% -1.5% 6.2% 5.6% 8.5%

Sector Long Short Gross NetBusiness Services 13% 3% 17% 10% American Express LongConsumer 0% 5% 5% -5% Capital One FinancialFinancial Institutions 14% 1% 16% 13% Alliance DataFinancial Services 24% 10% 35% 14% SLM Corp.Healthcare 2% 0% 3% 2% MasterCardIndustrial 2% 9% 11% -7%Technology 5% 3% 8% 2%Technology Services 23% 2% 24% 21% Long ShortReal Estate 14% 3% 17% 12% Top 5 40% 13%

98% 36% 134% 62% 64% 21%

Percent of Capital

Largest Long Positions1

Top 10 Positions

Euronet Worldwide

Top 5 Winners YTD1

ShortAlliance Data CNET Networks

L-3 CommunicationsCybersource

0.8% 60%

Fleetwood

Trammell Crow Co. AdministaffLazard Ltd. AO Smith Corp.

Trailing Twelve Months Comparative Returns2

Composition by Sector (% of Capital) Key Positions

2.4% 140%0.8% 60%

7.6% 100%-5.1% 40%

-1.8% 62%

Trailing Twelve Months (TTM)

Performance Average Exposure1

81 -1.8% 134%-1.7% 62%

47 -3.5% 98%34 1.7% 36%

Year to Date Comparative Returns2

Summary for the Quarter EndedJune 30, 2006

Western Reserve Hedged Equity, LP

Quarter EndedJune 30, 2006

Positions1 Performance Ending Exposure1

Western Reserve Hedged Equity, LP Cumulative Performance Since Inception (Gross)

-9%

-5%

-1%

4%

8%

12%

16%

20%

24%

28%

32%

Dec Feb Apr Jun

Aug OctDec Feb Apr Ju

nAug Oct

Dec Feb Apr Jun

Western ReserveS&P 500NASDAQ

1 Fr2

eely tradable securities. Immaterial position sizes omitted.Class A shares are subject to a one year lock-up and a 20% performance fee; Class B shares are subject to a three year lock-up and a 17% performance fee.

3 Western Reserve Hedged Equity, LP's inception date is January 1, 2004.

Please be advised that the past performance of Western Reserve Hedged Equity, LP (the “Fund) is not necessarily indicative of future results. Depending on the timing of a person’s investment in one of the Funds, actual investment returns in the Fund may vary from the returns stated herein. Performance results are estimated, based on both audited and unaudited results, net of management and performance fees and operating expenses. Such performance results assume that a partner invested in the Fund at the inception of the Fund and has not made additional contributions or withdrawals. There is no assurance that at any time the securities held by the Fund will be securities which comprise any of the indices listed above, and the Fund may have substantial cash balances and investments in relatively illiquid securities at any time when compared to the securities comprising a listed index. This report is provided for informational purposes only and is not authorized for use as an offer of sale or a solicitation of an offer to purchase investments in the Fund or any affiliated entity. This report is qualified in its entirety by the more complete information contained in the Fund’s Confidential Private Placement Memorandum and related subscription materials. This report is confidential and may not be reproduced for any purpose. Western Reserve Capital Management, LP serves as the Fund’s investment manager. Its Form ADV Part II and Privacy Policy are available to investors upon request.


[email protected]

Michael Durante Western Reserve 2Q06 letter

Business

Transcript of Michael Durante Western Reserve 2Q06 letter