April 17, 2008 To: Re: All Limited Partners First Quarter 2008, Letter to Partners Dear Partners: Please find below material information regarding Denali Investors funds. Performance Denali Investors S&P 500 (Total Return) 2008 Q1 Performance 6.6% 9.9% 2008 Year-to-Date Performance* 6.6% 9.9% Total Return Since Inception** 8.2% 13.8% Annualized Return Since Inception** 18.6% 30.1% * Through March 31, 2008. ** Return from inception November 2007 The S&P 500 records worst start to a year in its history was the headline of a Financial Times article on February 6 th, 2008. As investors, we should be thrilled. In this environment we will find tremendous opportunity, that of a low-risk and high-reward nature. The market seems willing to offer us increasingly attractive situations, and we are willing to wait for them. In fact, there is a good chance the best is still to come. Default rates and bankruptcies are creeping, but still well below the historic average. Corporate profitability is receding, but still well above the historic average. In the US, homeowners pulled out $1 trillion from their homes each year over the past few years and simply spent it (US GDP is $14 trillion). Today, home prices are still more than double the average real price in the history of the US. If prices revert to the mean, this implies home prices must fall by half or inflation must eat away the value. Either way, the result is the same. Any reasons themselves are less interesting than the bargains they create. Like a kid in a candy store, our favorite pieces of candy may become available at big discounts, or perhaps be given away for free. Mr. Market can be a generous fellow. As we look ahead, we should remember the following: 1
Your best money is made in bear markets; you just don t know it at the time. The only people who pick bottoms are liars. General Comments This section provides an update on our special situation investments. Special situations include misunderstood and mispriced companies, spin-offs, restructurings, bankruptcies, distressed securities, distressed bonds, merger arbitrage, etc. The advantage of allocating capital to these special situations is two fold: 1) The risk reward ratio can be highly favorable. In many cases, a special situation unlocks preexisting value that has been embedded or ignored by the market. 2) The unlocking of value is not correlated to the stock market, but rather through company level actions and outcomes. Special Situation 1: Spin-Out From Q4 2007: In this situation, Parent Co. (PCo) will spin out Subsidiary Co. (SCo) to shareholders. PCo owns over 80% of SCo, which is already public. PCo trades at $10 per share. The value of the spun out shares is $5 per share. Hence you are getting the PCo business for $5 per share. When one does the math, it becomes apparent that a fair valuation for the PCo stub is over $8 per share, which represents 60% upside. Again, the gain results from the spin out of SCo shares, and is an unlocking of pre-existing value rather than a creation of new value. UPDATE: In the first quarter, the investment has generally been unremarkable in that the price has been mostly flat. This investment will be given more time to develop. Special Situation 2: Value Activist From Q4 2007: In this situation, the Company (Co) is trading at a price that is far below its intrinsic value. Co is at $10 per share. There are three main drivers of embedded value in this situation. 1) Given an incredibly valuable real estate portfolio, there is about $10 per share in real estate value available for sale-leaseback. 2) The company owns almost all company units and can refranchise the majority for $10 15 per share. The residual royalties for just the refranchising alone are worth about $0.50 per year, or say $5 in conservative present value. 3) Operations are substandard and have much room for improvement. The changes that will take place at the operating level are of material importance and will be led by a highly successful team (not the previous 2
management team). Incremental margin expansion creates additional value, but let s assume this results in $0 value if not successful to $5 if there is some value created. The combined results unlock and create value in the range of $20 35 per share. UPDATE: The proxy contest was successful, and two Board seats were won. I have been engaged in a productive dialogue with the Board and the probability shareholder friendly steps will be made this year is favorable. However, in the interim, the share price has traded down with the sector, which is less a concern and more an opportunity. Special Situation 3: Restructuring From Q4 2007: In this situation, the Company (Co) is undergoing material structural changes. Co has three main businesses and has sold two of them. Co trades at $10 per share and the company will return, via a special dividend, $7 to shareholders. After the fact, Co will still have $2.50 per share in net cash. This means you pay $0.50 for the remaining business. At $0.50, this implies a price of only 1 2x EV/EBITDA. But there is more. Not only do you get the business at only 1-2x EBITDA, you also get $12 per share in NOLs. A conservative present value calculation yields $3-4 per share. Therefore, you are getting paid $2.50-3.50 to take the business! UPDATE: This investment has played out in text-book fashion. The special dividend returned half of the share price and the ex-dividend stock price has moved up by about 1/3 since then. I was somewhat surprised at how quickly value has been recognized. The stock is still cheap and continues to be monitored. Special Situation 4: Negative Stub Pair Trade From Q4 2007: In this situation, the Parent Co. (PCo) trades at $10 per share. PCo, however, owns $20 per share in a majority controlled and publicly traded subsidiary, SCo. If we assume PCo (ex SCo value) is worth absolutely nothing, this implies PCo stock, due to SCo value, is worth $20! In order to unlock value, management is pursuing a sale of its largest PCo segment, which has been losing money. The chairman owns a very large stake in the PCo and has recently revealed a very large stake in the SCo. My sense is that the SCo stake was taken to maintain control in the event of a spinout of SCo. The unfolding of these events will unlock the tremendous embedded value in PCo. As such, we are long PCo and short SCo in order to earn the collapsing spread. UPDATE: The PCo did sell its large, money losing division during the quarter. Once the market understands the forward metrics versus the rear-view mirror database numbers, the spread should collapse further. In addition, a tax-free spin out would be a tremendous catalyst. During the quarter, we took a net long position in PCo. 3
Special Situation 5: Buy One, Get Three Free In this situation, the Company trades at $10 per share and has two businesses that contribute similarly to cash flow. At the current price, 1) the first business is at half price, 2) the second business is free, and 3) liquidation value for the combined company is a double. So in a worst case scenario, one gets a double on the investment. Also, if an event, which has a material chance of occurring, actually does occur, the remaining business is then created at a negative enterprise value. To be clear, this means we would be paid (not pay) to take the business, which happens to be a consistent, profitable business at that. Special Situation 6: Heads We Win, Tails We Don t Lose In this situation, the Company traded at $10 per share. Due to a potentially troublesome merger obligation, the company traded down to bankruptcy levels. Unencumbered, the upside was five to ten-fold. The insurance of a position in the target company provided a natural and cheap hedge in the event of an unfavorable ruling. During the quarter, the deal broke and the stock has moved materially since then. In this market, a favorable deal outcome would not get full credit anyway, so there was no harming in waiting. The Company is still cheap. Investing in these special situations goes back to the core of our investment framework. This is especially relevant in the current environment, one in which many are concerned about subprime and recession. These examples should help demonstrate that Denali's results will be determined by the outcome of these individual opportunities, not the noise in the overall stock market. Ironically, it is more like gambling, and less like investing, to put money blindly into broader indexes. Again, it is not the short term performance of the stock market or the fund that matters to us. The only reason Denali was started was to provide absolute returns and beat the market over the long term. I believe these types of investments position us very well to do just that. Website Update I have posted letters and documents to the site so that you may refer to them at your discretion. To view, please visit www.denaliinvestors.com. The user id is "mister" and the password is "market". A Special Thanks to Our Investors 4
Denali Investors is fortunate to 1) be extremely selective in the manner we make investments, and 2) have partners with a long-term value perspective in combination with outstanding professional and personal character. The firm is lucky, and rare, in this regard. One of the most important differences is that our investor base understands that a stock at a 75% discount to intrinsic value can change to a 70% or 80% discount, simply due to short-term noise. The short-term 20% move from the entry point is understood as largely meaningless and that the eventual realization of intrinsic value is our focus. It is a true pleasure to go to work everyday on your behalf. I thank you for your trust and support. And thank you for the referrals! Next Opening Openings for both the Accredited and Offshore Fund are on a monthly basis and for the upcoming quarter are: May 1, June 1, and July 1. Existing partners of either fund can add assets in increments of $50,000 at each opening. The minimum initial investment for DIAF is $100,000. To invest in the fund one must be an accredited investor as defined by the SEC. The next opening is on the 1 st of each month. The minimum initial investment for the DIOL is $100,000. To invest in the Offshore Fund, one must be a non-us accredited offshore investor or tax-exempt account such as IRAs. The next opening is on the 1 st of each month. Please note that all new assets received are subject to the two-year lockup period. Funds received by May 1, 2008, for example, will be open for redemption on May 1, 2010. Recommended Timetable if Considering a Subscription Subscribing assets into a partnership is fairly simple, but does require some lead time. Our professional associates at Citi are very knowledgeable and can help facilitate with the finer points of the transfer and subscription process. Please allow at least a one-month window to provide ample time. 5
The Ratio In the last quarterly letter, we considered the issue of volatility. Appendix A of this letter contains the next part of the discussion and deals with the spectrum of risk-reward relationships. As always, should you have any questions or follow up, please feel free to contact me anytime at or kbyun@denaliinvestors.com. Respectfully, kbyun@denaliinvestors.com 6
Appendix A: The Ratio The existence of investment opportunities with The Ratio stands in direct contrast to the classic risk-reward model. In the previous two investor letters from Q3 and Q4 2007, we established: 1) Conclusion: Cheap stocks have lower volatility (beta) and higher expected returns and expensive stocks have higher volatility (beta) and lower expected returns. 2) Conclusion: If a stock is cheap (measured against intrinsic value), high volatility can produce low risk and high expected returns 3) Risk: A permanent loss of capital, not short term price movements or beta In the previous letter (Q4 2007), we established that risk is not beta, but rather the permanent loss of capital. When defined in this manner, the risk-reward relationship is actually negatively correlated, meaning the risk-reward relationship line moves down and to the right. Return = Reward Risk = Permanent Loss That said, let us consider scenarios that falls into three broad categories below. Category 1: Category 2: Category 3: Downside > Upside, (i.e. win $10 or lose $20 with equal probability) Downside ~ Upside, (i.e. win $10 or lose $10 with equal probability) Downside < Upside, (i.e. win $20 or lose $10 with equal probability) 7
Visually: 1. Risk* > Reward 2. Risk* = Reward 3. Risk* < Reward * Risk = permanent loss of capital, not volatility (beta) These three categories capture most situations (in stocks as well as in life). Put simply: Category 1: Bad Deals (Expensive) Category 2: Fair Deals (Fair) Category 3: Good Deals (Cheap) The Ratio I consider an investment attractive if there is at least a 5 to 1 ratio of upside to downside. This means that if an investment could fall 20% in price (permanently), then we would require at least 100% upside potential. If an investment could fall just 1% in price (permanently), then we would require at least 5% upside potential. Category 3 Good Deals By sticking with opportunities that have an attractive ratio within Category 3, we are putting ourselves in a great position to earn outsized returns. Efficient market followers would have you believe, incorrectly, that good deals in the stock market do not exist. If the price of already interesting opportunities fall further and the fundamentals have not changed, then the lower price provides an even more attractive opportunity. In the extreme case of Category 3, there is no downside, and there is just upside. That is a ratio that is tough to beat and these situations do not come around often. How is this possible? Well, at times the market is so pessimistic or decoupled from reality, companies will trade at valuations far below 8
the most conservative liquidation values. In this case, the stock might trade down in the interim, but the investor is very secure even in a terminal scenario for the company. Category 1 Bad Deals This group has more downside than upside. It is a good place to look for shorts. It is an uphill battle given one is fighting the average annual gain of the market. However, if one can apply The Ratio to grossly overvalued stocks with catalysts, then we have found an attractive potential investment. Category 2 Fair Deals Most stocks fall in Category 2. This group contains stocks that are not compelling, as they are already close to intrinsic value. This is not to say they are not great companies. They might very well be excellent companies, but being a great company does not always mean being a great investment. People invest in Category 2 for many reasons, sometimes for no other reason than they are required to by their fund s institutional mandate. Based on the discussion above, we can summarize: Conclusion: A potential investment is worth considering if it has The Ratio, which is upside to downside ratio of at least 5 to 1. The idea of The Ratio is not new and has been encoded in one form or another in the thoughts of value investors past and present: Benjamin Graham called it a Margin of Safety. Warren Buffett said Rule #1 - Don t lose money. Rule #2 - Don t forget Rule #1. Marty Whitman said Safe and cheap. Mohnish Pabrai said Heads I win, tails I don t lose much. Mark Sellers said Worry about downside, and upside will take care of itself. This is value investing s biggest open secret. It is the concept that makes investing quite simple, but not easy. 9
In summary, in the Q3 2007, Q4 2007, and Q1 2008 letters, we have established several important conclusions: 1) Conclusion: Cheap stocks have lower volatility (beta) and higher expected returns and expensive stocks have higher volatility (beta) and lower expected returns. 2) Conclusion: If a stock is cheap (measured against intrinsic value), high volatility can produce low risk and high expected returns 3) Risk: A permanent loss of capital, not short term price movements or beta 4) Conclusion: A potential investment is worth considering if it has The Ratio, which is upside to downside ratio of at least 5 to 1. 10