Steve Leonard of Pacifica Capital Investments focuses on finding high-quality companies trading at attractive prices. He currently finds opportunities in property/casualty insurance, financial services, consumer products, coffee retail and slippers. Leonard typically holds no more than 10 concentrated positions and relies on deep industry knowledge to identify companies with strong brands and durable competitive advantages. While patiently waiting for bargains, Leonard has utilized cash reserves and variable-rate preferred stocks to earn returns. He remains focused on companies that can benefit from emerging markets growth while avoiding those saddled with too much debt or pension obligations.

1. ValueInvestor
June 30, 2010
The Leading Authority on Value Investing
INSIGHT
Prime Properties Inside this Issue
F E AT U R E S
“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
A
fter 20 years investing in and man- INVESTOR INSIGHT with identifiable catalysts for change,
aging commercial real estate, Steve such as ConocoPhillips, Textron,
Leonard 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, Fairfax Financial, 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
and typically holding no more than 10 Pacifica Capital Investments
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%
Cumulative, Compound
%"". Fairfax Financial 11
PCI
$'". R.G. Barry 13
$"". S&P
Return
Sanofi-Aventis 7
#'".
Starbucks 14
#"".
Textron 6
'".
24.3%
".
'".
Other companies in this issue:
+ "" "# "$ "% "& "' "( ") "* "+
+* #+
+
$" $" $" $" $" $" $" $" $" $"
#+ American Express, AstraZeneca, Berkshire
*9 months only
Year Hathaway, Capital One, CGI Group,
Goldman Sachs, 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

2. I N V E S T O R I N S I G H T : 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 insurance 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-
expensive enough to sell, and the rest of
bly isn’t going to be replaced by a new pens with fairly cyclical regularity in
the time you should just hold them if you
technology or some other activity. People property/casualty insurance, for example,
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

3. I N V E S T O R I N S I G H T : 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 Prem Watsa 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 WARREN BUFFETT: firms, but we’re unlikely to invest in com-
panies that don’t have at least the poten-
It would be better if he were
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 have the unfavorable demographics and
is still one of the best capital
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 Berkshire Hathaway price has never been as close on a consis- went up dramatically.
June 30, 2010 www.valueinvestorinsight.com Value Investor Insight 3

4. I N V E S T O R I N S I G H T : 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
(Toronto: FFH:CN)
returns at historic lows, we think we’re
able to get much better yields without Business: Holding company with primary Financials (Year-end 2009)
operating subsidiaries involved in proper- Revenue $6.64 billion
taking on much interest-rate or credit risk
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. Valuation Metrics
(@6/29/10, Exchange Rate: $1 = C$1.05):
Goldman Sachs’ D shares, for example, (Current Price vs. TTM):
have a par value – the price at which Price C$390.82
52-Week Range C$281.33 – C$417.35 FFH S&P 500
they’d be redeemed – of $25 per share,
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
100 100
we just don’t see happening to a Goldman 2008 2009 2010
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

5. I N V E S T O R I N S I G H T : 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) Valuation Metrics
to expect he can earn 15% annually. It’s
Business: Global manufacturer and mar- (@6/29/10):
also not unreasonable to expect the mar-
keter of branded battery, shaving, skin-care, ENR S&P 500
ket will eventually wake up and pay at Trailing P/E 10.8 17.8
infant-care and feminine-care products. Key
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- Wellington Mgmt 2.8%
Financials (TTM):
holders right. Bank of NY Mellon 2.6%
Revenue $4.19 billion
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
120 120
although the negative of future claims
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-
40 40
quakes, hurricanes and asbestos-type liti-
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

6. I N V E S T O R I N S I G H T : 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)) Valuation Metrics
position for us. But most of the debt is at
Business: Developer and marketer of (@6/29/10):
fixed rates for a reasonable period of
“accessories” footwear, including slippers DFZ Nasdaq
time, while the cash generated by the Trailing P/E 11.5 13.0
and shoes sold under such brand names
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 Dimensional Fund Adv 3.4%
Financials (TTM):
likely to be offset by emerging-market Schneider Capital 3.0%
Revenue $124.4 million
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
15 15
Another potential market concern we
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

7. I N V E S T O R I N S I G H T : 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) Valuation Metrics
sion obligations – which I know I said we
Business: Global owner or licensor of more (@6/29/10):
dislike, but which we at least feel we can
than 16,000 coffeehouses in over 50 coun- SBUX Nasdaq
quantify and take out in valuing the busi- Trailing P/E 25.0 13.0
tries. Also sells branded beverage and food
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 Vanguard Group 3.6%
Financials (TTM):
has never been a particular concern to us. State Street Corp 3.3%
Revenue $10.08 billion
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
30 30
ment gets impatient and pays too much
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
10 10
You mentioned your early success with
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

8. I N V E S T O R I N S I G H T : 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
June 30, 2010 www.valueinvestorinsight.com Value Investor Insight 8

9. 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