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August 3, 2011

Dear Fellow AltaRock Investors:

The first half of 2011 was surprisingly productive for us. We say "surprisingly because
we would not ordinarily expect to find so many interesting investment ideas after a near
doubling of the market averages in less than two year's time. Sometimes, however, the
average does not accurately reflect the totality. One epic example of this occurred in
1999 when the valuation of the average stock was blown into extreme bubble territory as
the world became increasingly hypnotized by stock markets in general and Internet
related equities in particular. Yet simultaneously the stocks of many great "old economy
businesses could be purchased at bargain basement prices. That there can be such a
huge discrepancy between the macro and the micro is, of course, the foundational wind
beneath our investment wings. t's why we so happily skip to work each day.

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
Comparison of $1 Million Investment
(as of 7/31/11)
Massey SP 500 LT T-Bond NASDAQ CPI

Year-to-date through July 31
AltaRock is up 17.6% net compared to a gain of 3.9% for
the S&P 500. While our short-term performance has been strong, we continue to
believe that our portfolio represents excellent long-term value. We have two powerful
forces working on our behalf over the long term: 1) discrepancies between market and
intrinsic value will eventually be rectified either by Mr. Market or private equity firms
unable to resist multi-million or billion dollar free lunches; and 2) the intrinsic value of the
companies we own continues to grow at a healthy rate with each passing day. We, of
course, cannot predict when the market will reward our hard work and patience, but we
are confident that eventually it will. As long-term investors in the AltaRock Fund, we feel
quite secure.

#1 Pdf Solutions
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Longer-term Results
x Since 2007 (the year of the previous market top), we have grown partner net
worth by 22.1% compared to a 4.7% loss for the S&P 500. This equates to a
compound annual growth rate of 5.7%, 710 basis points better than the market's
1.3% annual rate of loss.

x Since the inception of the AltaRock Fund on April 3, 2002 we have grown partner
net worth 94.3% as compared to a 36.5% gain for the S&P 500. This equates to
a compound annual growth rate of 7.4%, 400 basis points better than the
market's 3.4%. $1 million invested with us over this time is now worth $1.94
million versus $1.37 million had one invested in the S&P 500.

x Since 1999 (the end of the great stock market bubble) we have grown partner net
worth by 102.5% as compared to an 8.6% gain for the S&P 500. This equates to
a compound annual growth rate of 6.3%, 560 basis points better than the
market's 0.7%. $1 million invested with us over this time is now worth $2.02
million versus $1.09 million had one invested in the S&P 500.

x Since July 1989 (my inception as a portfolio manager), we have grown partner
net worth 1,103% versus 552% for the S&P 500. This equates to a compound
annual growth rate of 11.9%, 310 basis points better than the 8.9% generated by
the S&P 500. $1 million invested with us July 1, 1989 is now worth $12.03
million versus $6.52 million had one invested in the S&P 500.

You already know that we invest with the mindset of a long-term business owner, and
that we seek superior businesses with durable competitive advantages. You also know
that we expend great amounts of effort to truly understand investment candidates, both
qualitatively and quantitatively, so that we can be confident that our conclusions are
sound. Instead of rehashing through all the things that you already know, we thought it
would be more interesting if (in this letter) we highlighted three recent additions to The
AltaRock Conglomerate.

Domino's Pizza
In our incessant search for new investment ideas it is certainly not beneath us to
scrutinize the portfolios of other investors whom we respect. We pay particular attention
to intelligent, long-term, value-investors that really concentrate their portfolios, as we do,
in only their best ideas. Earlier in the year, we noticed that an investor we respect had
accumulated a large position in Domino's Pizza. After doing some cursory work we
became more intrigued than we expected by 1) the quality of the business, 2) its long-
term growth potential, and 3) its cheap valuation. In fact, as we peeled back the onion,
Domino's reminded us of YUM Brands, a splendid business we had extensively
researched in mid-2009. We never pulled the trigger on YUM because it wasn't cheap
enough to meet our return threshold. Domino's on the other hand appeared excessively
cheap so we quickly went into deep dive research mode.

My initial impression of Domino's Pizza was formed 25 years ago during my college
years in Charlottesville, Virginia. Up until recently, this was the last time I had any

Past performance is not necessarily indicative of future results. All investment programs have the potential for loss and
profit. Comparisons to the S&P 500 Index are for informational purposes only. Massey returns from 7/1/89 - 7/31/95 are
as co-manager of the Eureka Fund, from 8/1/95 - 4/2/02 as sole manager of Massey Capital Management and from
4/3/02 to the present as sole manager of the AltaRock Fund.


experience with the brand as a consumer. Back then, while I had always been satisfied
with the fast, prompt delivery, I found the pizza to be quite bland, largely due to crust that
more closely resembled cardboard than food. So the first thing we did to begin our
research was to order a bunch of Domino's pizzas to see if anything had changed.

A lot has changed; the pizza is actually very good, now. In fact, we soon learned that
following extensive polling and consumer focus group activities in 2009, management
decided that something needed to change. Evidently, we were not the only people that
liked the service, but not the pizza. So in 2010 the company made meaningful
alterations to its pizza crust, tomato sauce, and associated ingredients. You may have
noticed last year's TV advertising campaign announcing the new, improved pizza. On a
personal note, my family has been in search of good pizza on the North Shore of Boston
for many years. Like most places in America, there is no shortage of pizza joints within
driving distance of our home. Despite all the options, we have had a surprisingly hard
time finding pizza that all four of us liked. don't want to overstate the case here or
generalize from our personal experience, but Domino's has now become our family's
favorite pizza. I never would have guessed this result, which I suppose is why we
haven't even considered trying Domino's in the 18 years that we have lived here. Based
upon the consistent and sizeable uptick in sales following the introduction of the new
pizza, it is evident that many people feel as we do that Domino's pizza is now, not just
improved, but actually among the better pizza products on the market. There were other
positive surprises from our personal taste tests: we learned that Domino's sells chicken,
sandwiches and desserts, all of which we found to be both tasty and affordable.

While good tasting food is important, it is hardly enough to qualify a restaurant operation
as a great business. In fact, while many restaurants have great food, most are not
businesses that will stand the test of time. This is because when people go out for lunch
or dinner they are often looking for something new, something different, something
exciting.and price is often merely a secondary consideration. Consequently, new
competition, that people are all too willing to try, is sprouting up every day, while older,
once popular restaurants go out of business.

While restauranting is a notoriously poor business, some eateries like McDonald's, Taco
Bell, KFC, and Domino's Pizza can prove to be exceptions to the rule. This is because
when people go to one of these establishments they are not looking for new and
exciting; they are looking for consistently good-tasting food, delivered fast, and at a low
price. The secret to long-term success in this notable subset of the restaurant business
is the size and scale to drive down unit product costs, which allows prices to be kept low
even while considerable resources are spent on consumer brand advertising and
product development. Restaurant businesses that can successfully combine these
elements are hard to compete with. Said another way.a brand is a promise, and when
that promise resonates with consumers and is backed by economies of scale and good
management that consistently executes on the promise, the result can be astoundingly
good and very long lasting financial returns.

With no seats in most stores Domino's is primarily focused on the delivery business. In
the USA, 47% of the industry's $11 billion in delivery sales are split among three
companies: Domino's is number one with a 20% share, while Pizza Hut and Papa John's
together hold 27%. The other 53% is largely made up of mom and pop operators and
small regional chains.



Domino's, which was founded over 50 years ago, has indeed stood the test of time. Its
base of nearly 5,000 domestic stores is efficiently serviced by 19 company-owned
commissary/supply chain facilities. The company has been steadily and solidly
profitable with operating margins ranging between 11-15% since 1999 (as far as the
publicly available information goes back). Return on invested capital has averaged 27%
and operating profits have grown at a 6% compound annual rate over the previous
decade. The business has held up remarkably well in each of the past two recessions.
The chain's economic resiliency has been further proven by its extraordinary and steady
success in the depressed economies of the UK and Ireland where same store sales
have grown 10%, 8%, and 12% in 2008, 2009 and 2010. Importantly, the business is
also a good one for the franchisees who put up most of the capital and who own and run
most of the store base. Franchisee return on invested capital averages 20-30% in the
United States. We believe the international franchisees enjoy even better returns since
almost every market outside of North America is far from saturation. International
franchisees continue to eagerly open more stores every year.

The US business can be described as mature, yet steady. t's reasonable to expect it to
grow long term, but probably no faster than GDP. The exciting part of the Domino's
story is its international growth potential. Pizza is a business that translates very well
across the globe; in fact Domino's international division will soon have more stores than
its US division. In the US, the parent company owns and operates the commissary and
distribution operations as well as about 10% of the store base. It is also responsible for
franchisee selection, product development and advertising. The International
operations, however, are largely in the hands of various Master Franchisees who own
and operate the commissary and distribution operations as well as various percentages
of the stores in their geographic area of control. They are also responsible for
franchisee selection, advertising, and product development. The result of this set-up is
that Domino's collects approximately 3% of each international store's sales, which is less
than the 5% it collects from its domestic franchisees. This international royalty income,
net of all costs associated with the international division, has been steadily growing for
many years and now represents 35% of Domino's total corporate profit.

Domino's has done a fabulous job of picking strong international partners. In fact, we
would argue that the international operations are Domino's crown jewel not just for their
promise, but also for what they have delivered thus far. These are very high quality
businesses in their own right. Taken together the international business has generated
positive same store sales for 17 ! years. International revenue has compounded at an
11% rate over the last decade and at 12% over the last five years. It has a number one
delivery share position in the UK (623 stores), Mexico (584 stores), Australia (431
stores), India (377 stores), France (182 stores), and Turkey (192 stores). It has a
number two delivery share position in South Korea (346 stores), and Taiwan (137
stores). While the international business is already substantial, it's far from saturation.
We figure if 300 million Americans can support 5,000 successful Domino's Pizza delivery
stores, surely the other 6.4 billion earthlings can support another 15,000 stores. We see
no reason why the international business can't continue to grow at double digit rates for
at least another ten years, and even then, the world should be able to support thousands
more Domino's Pizza stores.

When we began looking at the company its stock price appeared to be very cheap as a
result Mr. Market's nervous anticipation of how 2011 results would stack up against the
exceptionally good results from 2010, which was boosted considerably by the roll-out of


the newly improved pizza. In fact, when we began looking at the company,
management had already indicated that first quarter domestic same store sales would
be negative. Undeterred by negative short-term results, we believed the business was
excessively cheap trading at nearly a 10% yield on our estimates of 2011 free cash flow.
And regardless of what 2011 might bring, our extensive work gave us great confidence
that longer-term domestic profits could grow at 2% per year, while the international
business could easily sustain a 10% rate of growth. If correct, this meant that the entire
business would grow operating profits at 5-6% per year, which would further translate
into an 8% growth rate in earnings per share as operating profits leveraged over the
fixed interest expenses of the company's debt. The combination of a nearly 10% free
cash flow yield and an 8% growth rate would generate a 19% annual rate of return for
us, if we were to buy the entire company at its then valuation of $17 per share or $1
billion. This is a fabulous return for such a high quality business.

Some may argue that Domino's balance sheet is excessively leveraged a topic
understandably much on the collective minds of investors following a near meltdown of
the financial system in recent years. We, however, feel comfortable with the debt level
given the fact that the business requires little, if any, additional capital to run, and has
proven to be highly resilient in the toughest of times. For the sake of argument and to be
extra conservative, let's assume that it became necessary to take the interest coverage
ratio (the number of times operating income covers interest expense) from its current
three times up to five times. This would require the diversion of the next four years of
free cash flow to debt repayment. This seemingly excessive change would lower our
annual rate of return from 19% down to 16% - a number still in excess of our 15% hurdle
rate. As an aside, we think it's possible, if not probable that the next several years will
resemble the post WWII years when the Federal Reserve engaged in financial
repression to assist in the repayment of excessive debt in the economy. This is exactly
what quantitative easing is intended to accomplish by keeping interest rates very low
while inflating away the value of debt. Such an environment may benefit levered entities
like Domino's that produce relatively low priced goods that sell well even during tougher
times. They can both take advantage of cheap debt capital, while simultaneously
benefiting from an inflationary tailwind to their earnings growth. Of course, we have not
incorporated such a factor into our model.

mportant to us, Domino's is run by people who treat shareholders as respected
partners. Domino's management team, led by Patrick Doyle, has a 4% economic
interest in the business equating to a little over $60 million. Including share
repurchases, dividends and a special one-time dividend in 2007, this management team
has returned 123% of free cash flow to shareholders since its 2004 initial public offering.
In addition to rationally buying in the stock at bargain prices, they have also bought in
the company's bonds when they've traded at a discount (sometimes substantial) to par.
This kind of activity can further reinforce, sometimes quite meaningfully, the economics
of being a partial, long-term owner in a great enterprise.

We believe Domino's clearly has the staying power that we seek in a business. t's
gained an enviable position in the value based meal delivery business not only in the
USA but in 70 other countries and counting. Its position is reinforced by scale
economics in dough manufacturing and supply distribution. Additionally, each year,
Domino's and its global franchisees spend a large and growing amount of money
(estimated at $600 million in 2011) building the brand in the minds of consumers. While
these things, when combined with a cheap valuation, are more than enough for

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Domino's to be a part of the AltaRock Conglomerate, there is one additional factor that
while impossible to quantify, we find adds additional appeal to the investment..and that
is the rapid advance of web-based ordering through computers, smart-phones, and
tablets. This has the appearance of being perhaps more meaningful than one might
expect, and fortunately we are paying nothing extra for it.

Several international master franchisees have seen consistent and lasting acceleration
in their businesses from the rollout of mobile applications for the iPhone and Android
phone systems. If you think about it, pizza delivery restaurants are the rare eating-place
whose customers have historically ordered without being able to look at a menu. The
web, increasingly accessible anywhere, places not only a menu, but also a quick and
easy-to-use electronic ordering apparatus in every consumer's hands. This is beginning
to result in higher ticket orders for Domino's as people add on chicken, desserts, etc.
that before they did not think of or perhaps even know about. This method of ordering is
also measurably improving customer satisfaction scores and brand loyalty statistics,
while also lowering labor costs and error rates since there is less need for humans to
take phone orders. International master franchisees were the first to enthusiastically get
behind this phenomenon and several of them now have upwards of 50% of their orders
coming in over the web/mobile web, compared to 25% in the US. The US division just
recently rolled out an iPhone app and is currently working on one for the Android
system. For the time being this is something that is quite hard for mom and pop pizza
restaurants to adopt due to the large cost involved relative to their meager sales base.
Perhaps this additional advantage when added to the already considerable existing
ones, will assist the big three (Domino's, Pizza Hut, and Papa John's) in further
consolidating the US and global marketplace.

Regardless, as owners we feel very comfortable that we will be sitting back collecting a
growing hoard of cash as the business and particularly the international business
continues to grow for a very long time. Domino's Pizza has already proven to be hugely
successful in many different cultures and is run by proven owner-operators that are
financially motivated to continue to grow the business and further widen its competitive
moat all across the world. We acquired our position in Domino's in early March at prices
between $17.37 and $17.81.

Mohawk Industries
We're always investigating areas of pain hoping to find cheap, overlooked securities.
Investors notoriously over-extrapolate current conditions. For this reason, anything
related to housing could potentially be interesting to us, if we can accurately determine
that it is cheap, safe and well-run for the benefit of long-term shareholders. You may
recognize Mohawk as a former AltaRock holding. We purchased Mohawk in late-2002
through early-2003 at prices ranging from $46 - $51. We liquidated the position from
mid-2005 through early-2006 at prices ranging from $83 - $91. Today, off 50% from its
all-time high, Mohawk is clearly unloved on Wall Street. Despite the fact that the size
and scope of the business have been meaningfully enlarged through acquisitions and
organic market share gains, we can again purchase the entire business for less than $4
billion. These facts convinced us to roll up our analytical sleeves to reacquaint ourselves
with the business's competitive position, its leadership, and its valuation.

Mohawk began many decades ago as a manufacturer of carpeting for residential and
commercial customers. The company was largely built via acquisition during the 1980's
and 1990's. With increased size from each acquisition came increased scale and


additional opportunities for savings via vertical integration. However, the most important
advantage was the reaching of a critical tipping point that enabled the company to forgo
third parties and bring its distribution in-house. We believe that economies of scale and
scope in distribution remain the most important and durable advantages of this franchise

Mohawk's distribution platform allows it to efficiently service a diversified base of 25,000
retailers, most of whom are small mom and pop flooring dealers. Its largest customer,
Home Depot, is less than 5% of sales a level that has remained largely unchanged for
a long time. Flooring is one of the few home improvement categories that the large
home center chains have been unable to consolidate. Understanding why is the key to
understanding Mohawk's competitive advantage.

If you wanted to build your own deck or shed at home, you'd likely go to either Home
Depot or Lowe's for the best selection of relevant materials at the lowest prices. You'd
make your selections, cart them to the nearest checkout register, pay, and then load
them into your pick-up truck for transport back home. This is how most of retail works:
they stock the inventory; you buy it and take it home. All things being equal, the retailer
with the most efficient supply chain will gain market share by offering low prices that
can't be matched by its less efficient competitors.

Flooring, however, is different in that you purchase it by viewing samples, and instead of
taking it with you, most flooring is delivered at a later date, often to be professionally
installed. Retailers do not keep most flooring in stock because it's uneconomical.
Carpet in particular takes up lots of space and most of the myriad of potential selections
turn very slowly. As a result of flooring's atypical supply chain, the manufacturer is in the
catbird's seat and the retail side of the marketplace maintains its fragmentation. Thanks
to Mohawk, Joe's Flooring Shop can compete with Home Depot and Lowe's by offering
an equally wide selection of products while also competing successfully on price. And
when it comes to service, there is a good chance that Joe has got an entrepreneurial
spark that the big box chains will always find hard to replicate. So while Home Depot
and Lowe's typically represent a huge percentage of most of their vendors' sales, these
massive retail chains remain only a small part of Mohawk's business. In fact, Mohawk is
far more important to all of its retailers (including Home Depot and Lowe's) than any
retailer is to Mohawk.

Soft surfaces (carpet and rugs) still constitute around 60% of US flooring sales, but have
been slowly losing share to hard surfaces like tile, wood, and laminate. Wanting
exposure to the non-carpet side of the business, Mohawk, in 2000, established a hard
surface sales team to sell other manufacturer's products through its distribution
infrastructure to its 25,000 retail customers. Eventually, Mohawk sought to vertically
integrate into this area by acquiring leading hard surface manufacturers. In 2002 it spent
$1.8 billion to buy Dal-Tile, the dominant tile company in North America. In 2005 it spent
$2.6 billion to buy Unilin, a leading laminate supplier in Europe and North America. In
2007 it purchased the manufacturing assets of Columbia Wood (price undisclosed but
certainly less than $100 million), a US hardwood-flooring manufacturer.

Today, Mohawk controls approximately 22% of the United States flooring market. The
number two player, Shaw Industries (a unit of Berkshire Hathaway) controls about 21%.
These two companies effectively operate a flooring duopoly; the next largest competitor
is only one fourth the size of Mohawk. Due to the economics of flooring distribution, we


don't see this basic industry structure changing much over time. This makes Mohawk a
particularly appealing long-term investment if it can be purchased at a cheap price.

Dal-Tile gives Mohawk a dominant position in the North American tile business with a
35% market share. It is five times larger than the nearest competitor and continues to
take additional market share. Similar to carpeting, tile is often purchased from
showroom samples and installed later. Mohawk sells tile through its existing distribution
network to the same 25,000 retailers who sell its carpeting products. However, it also
sells tile through Dal-Tile's separate distribution system, which includes 250
warehouse/showrooms across the United States. Customers come into these
showrooms with their architects, builders, or professional installers to view and order
from Dal-Tile's vast selection of tile. No other company has a similar vertically integrated
distribution system, which is a very distinct advantage. Wrestling market share away
from Dal-Tile will be very tough.

Unilin gives Mohawk a manufacturing presence in the laminate category and via the
most innovative company in the business. Most other laminate companies around the
world pay royalties to Unilin to utilize its patented Quick-Step installation system which
allows laminate flooring to be easily and quickly assembled by snapping it into place.
Unilin also gives Mohawk a beachhead in Europe where two thirds of Unilin's business is

There is no doubt that current business is poor across most housing related industries.
The markets that Mohawk serves have lost 35-40% of their volume from peak (2007) to
trough (2010?). Other signs of industry distress include five years of falling home prices.
Additionally, Lowe's and Home Depot, two exceptional businesses with a virtual duopoly
in most home improvement product categories have seen their same store sales fall for
nearly five years. Their returns on invested capital have fallen into the single digits,
despite massive competitive advantages and few worthy competitors. Also, consider the
chart below which plots private residential fixed investment as a percent of GDP. t's
worse than it's EVER been in the post-war era, including when mortgage rates spiked
through 17% in the early 1980's.

1947 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011




Private Residential Fixed Investment as a % of GDP (64 yr avg. 4.7%)
PRFI as % of GDP
72' 78'


Given recent trends, investors are understandably less than enthused about the sector.
Beyond the decline in Mohawk's shares there is plenty of evidence of extreme
pessimism. CNBC recently penned an article entitled: US Housing Crisis Now Worse
Than Great Depression. If you Google "housing depression, you will find thousands of
entries. While there is little doubt that this is a housing depression, it's clearly closer to
the bottom than the top. House price declines have slowed and appear to be bottoming
out. Housing is now more affordable than it's been in at least 40 years (as far as data
goes back). US and world populations continue to grow; these additional people will
need a roof over their heads and a floor under their feet. Floors wear out and need to be
replaced. Yesterday's excess housing inventory continues to be worked down.
Consumers continue to de-lever. The marketplace is healing.

Meanwhile Mohawk, even in this extremely depressed environment is generating
operating margins in the 6% to 7.5% range and we estimate it will earn around $3.70 in
free cash flow this year. That you can acquire this very high quality company, which
requires little additional capital to grow, for less than 7x very depressed EBITDA, is quite
remarkable. We are confident that Mohawk will be doing a lot better in the future than it
is today, a view that we are paying nothing for since everyone else seems to think things
will never get better. Perhaps these are the same people that thought house prices
would never go down, or that Mohawk at $103 in June 2007 was a sound investment.

t's important to mention, too, that during normal times only about 20% of Mohawk's
sales comes from new residential construction. This part of the business has now
shrunk to less than 10% of sales. Normally 55% of Mohawk's business is residential
flooring replacement, while the remaining 25% comes from commercial customers, split
between new construction and replacement flooring.

Jeff Lorberbaum, whose family owns 16% ($600 million) of the equity, ably leads
Mohawk. We love it when management has a big stake in the future of the business,
especially if we think they are smart, ethical, and focused on protecting and growing the
competitive moat surrounding the enterprise. We believe that is definitely true when it
comes to Jeff and his team. One of the reasons we decided to sell our position in 2005,
in addition to the valuation and our fears of a housing bubble, was due to management's
eagerness to grow Mohawk into hard surface flooring categories through what we
believed were large, overly-expensive acquisitions. Today we feel a lot better about this
issue since 1) management, as the largest shareholder, has experienced both
psychological and financial pain from these past decisions; 2) they continue to own 16%
of the company which keeps our interests well aligned; and 3) we like the businesses
they bought, it was the prices they paid, with which we had a problem. Thanks to the
collapse in Mohawk's stock price we aren't paying the same high prices that other
shareholders paid for these acquired businesses; in fact, we can now buy the entire
company for less than it paid for Dal-Tile and Unilin, two fine businesses with bright

We like this investment a great deal. We own a super business with a durable
competitive position. t's very cheap on extremely depressed earnings which will recover
before too long and certainly before most believe. Not only will earnings eventually
recover based on cyclical and secular certainties, the company will most likely continue
to take share in its North American tile, laminate, wood, and carpet segments. Mohawk
also has several exciting international opportunities. It recently formed a joint venture in
China with one of the leading manufacturers in the Chinese tile market. In contrast to


the US where Dal-Tile has accumulated a dominant 35% share position, the Chinese tile
business is still very fragmented with the largest player having only a 2% share. Also of
note is that the Chinese tile market is 30 times larger than its US counterpart. In Mexico,
Dal-Tile currently has less than a 10% share in a market that equals America's in size. It
is in the process of opening an additional domestic plant near Mexico City that will
significantly expand its tile offerings while also improving its servicing capabilities. Unilin
has sold into the Russian market for several years out of its European manufacturing
operations, but just recently opened a domestic plant to better serve this large, growing
market. Lastly, we reiterate that Mohawk is run by owner-operators who are passionately
focused on its long-term success and who have enormous skin in the game. Based on
very reasonable assumptions, we believe we will earn between 16-18% compounded
annually through 2021. Our cost basis is just under $58.

Our investment ideas are sourced in various manners, one of which is by regularly
reviewing insider buying activity. Earlier in the year we noticed that a private equity firm
had become a Carter's insider by virtue of its building a 10% ownership position in
Carter's stock. As we looked further into it we became highly intrigued, because it turns
out that the private equity firm, Berkshire Partners, knows Carter's intimately. In 2001
Berkshire (not to be confused with Berkshire Hathaway) led a management buyout of
the firm from its prior owner. As a result, it became the majority owner of the company
from 2001 through 2004. Carter's went public in 2003 and Berkshire remained Carter's
largest shareholder until 2006 when it finally exited its position. Even after its financial
exit, Berkshire maintained a seat on the company's board of directors through May
2010. In November 2010 Berkshire disclosed that it had accumulated a 9% position in
Carter's in the open market. Subsequent to this initial filing Berkshire continued to
accumulate the stock. This information, once again, inspired us to roll up our sleeves
and get to work.

At first we were skeptical because we don't believe that the overwhelming majority of
apparel companies have the kind of sustainable advantages that we seek in our
companies. But we also have learned to pay attention when people who may know
more than we do are placing multi-million dollar bets. Additionally, it is always possible
that a company can become so cheap that it is a great investment, even without long-
lasting competitive advantages. We don't tend to like these as much, but we do
acknowledge their existence. However, more than anything else, we just had to know
what was going through Berkshire's collective mind.

After a month or so of investigation, here is what we have learned and come to believe
about Carter's business. Carter's is the dominant brand in North America for outfitting
0-24 month-old babies, having 30% market share in this, its core segment. This makes
it six times the size of its largest competitor. The Carter's brand has been serving new
moms and their babies for 145 years. We believe this is a brand that mothers,
grandmothers, and great-grandmothers associate with the magic of bringing life into the
world. We believe that this powerful emotional brand association often gets passed
down from one generation to the next.

Available in over 15,000 US retail stores, the brand has a very unique and ubiquitous
presence in the market. It is virtually alone as the main branded offering of most
multipurpose retailers like Sears, Kohl's, J.C. Penney's, Target and Wal-Mart. It also
sells to virtually every department store in North America. All of these retailers believe

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that they need to offer Carter's in order to compete against specialty stores like
Gymboree (recently taken private by Bain Capital), Children's Place, Baby Gap, Old
Navy, etc. While all of Carter's retail customers carry their own private label offerings,
it's the ubiquitous Carter's brand that keeps new moms coming back to the store.
Carter's is a very affordable brand that is priced just above most stores' private label
offerings. When mothers, grandmothers, and friends are shopping for baby clothes at
these stores, they are faced with the choice of buying private label or for a dollar or two
more they can purchase the dominant baby brand that most every mom recognizes, and
which has been associated with cute little babies for 145 years.

Wal-Mart's experience with Carter's really caught our attention and, we believe, speaks
to the power of this brand. Several years ago Carter's did not sell to either Target or
Wal-Mart. However, in 2000 Target approached the company and asked if the two
might find a way to work together. n 2001 Carter's launched a sub-brand named Just
One You, by Carter's, available only at Target. The offering was a huge success that
did not escape the notice of Wal-Mart and sure enough in 2003 Carter's and Wal-Mart
launched a sub-brand called Child of Mine, by Carter's, available only at Wal-Mart.
Sometime in 2008 Wal-Mart, which by then had become Carter's largest customer,
decided to deemphasize Carter's and to give more weight to its private label baby
goods. nterestingly, while Carter's Wal-Mart business declined by about 50%,
increases at its other wholesale accounts, especially Target, more than made up for this
decline. Tellingly, in 2010 Wal-Mart announced that it would reverse course to once
again re-emphasize the Carter's brand in its baby section.

Many apparel stocks have taken a big hit in the past year as it's become increasingly
apparent that 2011 will be a poor year, especially for those companies offering cotton-
based products, like Carter's. For various reasons cotton prices have run into the
stratosphere, far out of line with any historical pattern, and far worse than anyone could
have envisioned in their worst nightmares (see chart below).

Apparel companies can often have volatile earnings as a result of their unusually long
supply chains. Today most apparel is hand-stitched in various Asian nations wherever
cheap, skilled labor can be found. Because of the time needed to first design, then
source raw materials, then hand make the garments, and then finally ship them half way
around the world, many US apparel companies are forced to place orders up to a year in
advance. This means that they have to guess how much demand will exist for their
products a year from today. This exercise is all the more risky for fashion apparel
companies because what's fashionable can and does change, sometimes abruptly.
Every so often the industry faces a 2008/9 type of market where demand comes in far
below expectations. The result of this miscalculation is very low industry profits as
companies are forced to liquidate excess inventory. Then there are the good years like
2010 where demand turns out to be much higher than the industry's collective prior year
guess. During these times, demand exceeds supply and industry prices and profits
benefit accordingly.




Because of the spike in cotton prices and the consequently overly optimistic
assumptions about demand, 2011 profits are likely to suffer. A year ago when orders
were being placed, business was very good and the industry was optimistic. Nobody
could have foreseen that apparel inflation would accelerate so quickly due largely to an
unpredictable and unprecedented jump in cotton prices. Nevertheless, the good news
about cotton and most other commodities is that high prices are normally self-correcting.
This is because high prices positively affect supply as large profits coerce farmers to
plant more cotton. Meanwhile high prices negatively impact consumer demand as
people buy fewer cotton-based products when they suddenly become more expensive.
In fact, both of these effects already appear to be happening, which has caused cotton
prices to fall 50% in recent days.

As far as we are concerned all of this is short-term noise. As Warren Buffett likes to say
(we are paraphrasing), "when you buy a farm you don't focus exclusively on the
inevitable bad years, you value a farm based upon the long-term net cash flow you
expect it to generate. Companies and their stock prices are no different. So while 2011
may well be a terrible year for Carter's, we frankly don't care because it in no way
reflects on the value of the business franchise and the cash that we expect it to generate
for us as owners.

Carter's management team has done a fabulous job for a long time and is led by Michael
Casey who has been with the company for 18 years. Over the last 15 years this team
has grown sales and operating income at annual rates of 13% and 18%, respectively.
Over the last five years, which includes the worst recession since the Great Depression,
they have grown sales and income at annual rates of 9% and 11%, respectively. Return
on equity over this period has averaged 21%. Importantly, the management team has
been a long-term holder of the stock with a current 3% economic interest amounting to
over $60 million. Their actions and words are those of owner-operators properly focused
on continuing to build a lasting enterprise. We feel safe with them running part of our
conglomerate, and believe that they will create a lot of wealth for us.

We made our purchases in April and May at an average price of $29.70. We estimate
that we bought the firm at about 10x its current earnings power. f Carter's were done


growing its market presence, then we would effectively be earning a 10% yield plus
whatever growth rate we might tack on based on our best estimate of future real GDP
growth. While this may equate to a respectable double-digit return, it would be below
our 15% hurdle rate. Fortunately, we do not believe Carter's is finished growing.

Historically, Carter's has always had outlet stores in places like New Hampshire to give
the brand distribution in geographic areas where it was not as accessible. In recent
years the company began experimenting with opening Carter's branded stores in more
densely populated areas. These stores have been wildly successful with some paying
back their investment in less than one year. The management team has understandably
decided to grow this side of the business more aggressively from its current base of 130
locations to 300-400 over the next several years. The risk here, which management is
well aware of, is the potential cannibalization of its crown jewel, the wholesale business,
which currently accounts for two thirds of the company's profits. There are several
positives, however, to also consider: 1) the company spends very little on consumer
advertising and these stores, in addition to being highly productive, act as massive
billboards to further enhance the appeal of the brand. This could have a favorable
impact on overall market share. 2) Most wholesale accounts focus on Carter's baby
product (ages 0-24 months), but Carter's has impressive product offerings that extend
through age seven. (Incidentally, after age seven, the business becomes more fashion
driven as kids themselves begin to influence the purchase decision. Carter's wants no
part of this more risky, fashion driven business.) Having the ability to display its entire
product line in a convenient, beautiful, well-branded environment should help the
company expand its market share in the 2-7 year-old children's apparel business where
its share is much lower. As Carter's own retail stores have success with this age group
and as consumers become more aware that the brand extends beyond the baby years,
perhaps wholesale accounts will have more economic incentive to expand their own
selection of Carter's product. 3) We are always looking for analogies to learn from and
in this case we see that Polo/Ralph Lauren has been able to very successfully expand
its retail store presence while simultaneously growing its global wholesale business.
The bottom line is that we believe Carter's will gain incremental market share through its
retail store expansion strategy and we trust management to execute with care given its
large ownership position and its long successful track record.

There is another element to this story to which we assign little to no value, but that may,
in fact, turn out to be worth a lot. In 2005 Carter's bought OshKosh B'Gosh for $312
million. OshKosh has been selling branded kids clothing since 1895. It targets the same
age group with a current skew toward ages 2-8 with its more rugged Americana, denim
heritage. Twenty years ago OshKosh was actually a larger business than Carter's and,
in fact, even today it's a more recognized brand than Carter's in many consumer
survey's and focus groups. Despite OshKosh's strong brand recognition, management
has had a tough time gaining the kind of traction it envisioned when it purchased the
company. While OshKosh operating profits of $136MM since the acquisition are far
better than the losses prior to purchase, it's still a far cry from management's long-term
goals for OshKosh. By 2005, prior mismanagement of the brand and an ill-advised effort
to maintain domestic (high-cost) sourcing had resulted in the loss of much of OshKosh's
wholesale business. Consequently, when Carter's acquired the business, over 70% of
sales were coming from its own 150 outlet stores. Carter's management believed it
could copy the Carter's playbook by moving sourcing offshore, which would
simultaneously improve the quality of the product while lowering its cost. It was believed
that this would enable the brand to regain its business with wholesale accounts a


strategy that evidently had and continues to have the support of many of Carter's largest
wholesale partners. Unfortunately the product design has thus far not been good enough
to gain traction with these retailers. Management, undaunted, still holds great hope for
this brand and a year ago brought in an entirely separate management and design team
to double down behind its conviction. Additionally, as with the Carter's brand,
management has begun testing OshKosh branded stores in more densely populated
areas. The recent test stores have been putting up good results.

One of the only other bright spots thus far with the OshKosh brand has been its
international franchisee business, which really was nothing more than an afterthought
when Carter's bought the firm. Today, its international partners own and operate 162
freestanding OshKosh branded stores in over 40 countries outside the US. Additionally
there are shops-within-a-shop at 781 international department stores. The company
collects royalties on these sales that net of related expenses equated to 7% of the total
company's operating income in 2010. In early 2011 the company hired an executive
away from Disney to head up its brand new international division. The initial focus has
been on growing the number of licensing relationships around the world while also
introducing the Carter's brand to existing and new OshKosh licensees. Heretofore
Carter's had not done much internationally. This will change going forward.

More recently, on June 22, 2011, Carter's announced an agreement to buy Bonnie Togs,
its largest international licensee with operations solely in Canada. While we are highly
skeptical of most acquisitions, we find this one to be very interesting. Bonnie Togs, a
small company with $100 million in revenue, was until 2007, a kids retail store selling
various brands, including its own. In 2007 it began selling Carter's and OshKosh in all of
its stores. These brands were so overwhelmingly successful that Bonnie Togs
approached Carter's management soon thereafter with a concept of launching a Carter's
branded store and an OshKosh branded store side by side, with interior wall openings
such that customers could flow back and forth as they do inside select Gap/Gap Kids
combo stores. Carter's figured, if nothing more, this would be an interesting and
potentially educational experiment. It gave Bonnie Togs the green light. Today, Bonnie
Togs has 22 of these stores and plans to open another 80 as fast as reasonably
possible. While the company has yet to release the return-on-invested-capital figures
that these stores generate, we are confident that they are fairly strong. Bonnie Togs
today generates even better operating margins than Carter's, which is quite a feat.
Moreover, we doubt this management team would bother buying a licensee in a small
market like Canada, unless these stores were putting up some highly intriguing
numbers. We believe that they want to get as close a look at this opportunity as
possible. If this double store concept is for real, it surely could work in many other
markets, not just in Canada. While this could add considerably to our investment
results, our investment case is quite compelling based solely on our expectations for the
Carter's brand.

In April we added Carter's to the AltaRock Conglomerate. We are excited to be getting a
great brand with a dominant, niche position at a great price. This business is unique
when compared to most apparel firms as a result of its uniquely ubiquitous presence in
over 15,000 retail stores across the United States. We believe there is strong evidence
that this is an unusually powerful brand with staying power. The other nice thing about it
is that babies quickly outgrow their Carter's outfits and need the next size. We believe
the largely nondiscretionary nature of many Carter's purchases explains why the
company was able to sail untouched through the most recent recession, while most


other apparel company's experienced large declines in sales and earnings. Furthermore
we feel very content with the quality of the Carter's management team and its owner-
operator mentality. Our financial expectations are that operating margins will contract
significantly this year as management has decided that it is in the best long-term interest
of the brand to gradually adjust pricing, instead of passing along 100% of the 15-25%
increase in garment costs. Over time, we fully expect margins to recover back to their
2010 level of 14% and perhaps edge higher as the more profitable retail division
becomes a larger portion of the business. Overall we expect earnings to grow at 6%
annual rate over the next ten years, which will produce a compound annual 15% rate of
return for us over the period.

Conclusion - Yes we're finally done!
It is our hope that by going through the above examples in some detail, we have been
able to shed even more light on our investment operation. Of course, what we choose to
own in our portfolio will change as time passes and prices fluctuate, but our philosophy,
strategy, process, discipline, and passion will never change. It is these that we will
constantly bring to bear as we navigate a world of ever-shifting opportunities and
hazards. We have great confidence that we will do very well over the long haul, which is
why we continue to have all of our investable assets alongside yours in the AltaRock
Fund. We thank you for your profound confidence and trust in us; we will forever work
hard to deserve it.

We encourage you to call us with any questions, comments or investment ideas. In the
meantime, we will look forward to updating you on our continued progress sometime in
early 2012.!

The best to you and your family,

Mark T. Massey, CFA


Click here to read an excellent summary of AltaRock's investing principles