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2012 Q3 Letter KCM

2012 Q3 Letter KCM

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Published by: SheerazRaza on Oct 15, 2012
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Khrom Capital Management LLCwww.khromcapital.com
41 Madison Ave, 31st FLNew York, NY 10010T: 646.202.2618F: 646.349.3530info@khromcapital.com
October 14, 2012Dear Partners:In the third quarter of 2012, our Partnership returned 8.9% net of fees and expenses. As of September30th, our year to date net return is 27.8%. On average, we held 17% of our assets in cash throughoutthis year.
S&P 500
K.I.F., gross K.I.F., net
(31.1%) (32.6%) (32.6%)2009 26.5% 91.9% 82.9%2010 15.1% 23.8% 18.6%2011 2.1% 22.8% 18.0%2012 YTD 16.4% 35.4% 27.8%
Annualized Return 3.9% 23.8% 18.8% 
Please refer to the disclosure at the end of this letter.
 There’s No Such Thing As a Free…Drug
Free options are one investment bucket to which we allocate capital. Derma Sciences (mentioned in our2011 Q4 letter) owns a drug that accelerates the healing of diabetic foot ulcers. The drug should soonenter the final stages of the FDA approval process. Statistically, it has a 55% chance of making it tomarket. (Anecdotally, the odds are even higher.) Upon final FDA approval, the drug should be wortharound $1 billion. We purchased Derma Sciences when it was valued at $80 million.Our attraction to the investment was that the market seemed to pay no attention to Derma Sciences’two other business segments, one of which was growing rapidly. Those segments alone, plus the cash,
Khrom Capital Management LLCwww.khromcapital.com
 were worth around $80 million. That effectively provided us the option on the potential blockbusterdrug for free. We recently exited the investment, which generated a 64% IRR. Derma Sciences is still undervalued:the drug alone has an expected value in the hundreds of millions, yet the company’s marketcapitalization today is only $140 million. However, we sold because at today’s valuation, there isdownside should the drug not be approved. Though Derma Sciences is clearly still a bet with a positiveexpected value, it no longer fits into our free options bucket.
Getting Paid to Wait for the J-Curve
 Vistaprint is a new investment for our fund. Robert Keane, founder and current CEO, started with theidea to cheaply produce business cards for companies too small to order large quantities. Through thecreation of printing technologies designed for low volume orders, Vistaprint significantly reduced thecost for a box of 250 business cards. The cheap prices they were able to offer small businesses enabled Vistaprint to rapidly grow from $0 to over $1 billion in annual revenues. Today, business cards account for only 30% of Vistaprint’s sales. The company has expanded its low- volume concept to sell a wide range of customizable, printed marketing materials in small quantities andat cheap prices–from brochures and signage to customized apparel and stationary. In addition, thecompany now targets consumers as well as small businesses, with products such as wedding invitationsand photo books. Vistaprint is a scale business. Every increment of growth increases their competitive advantage. Vistaprint has grown to currently process 76,000 orders per day. The more individual print jobsreceived in a time period, the more efficiently it can be aggregated and scaled over a fixed expense base.No competitor receives as many daily orders as Vistaprint, allowing the company to become theindustry’s lowest cost producer. It now only takes Vistaprint 13 seconds–down from 60 seconds a few years ago–to produce a box of cards. That amounts to a fraction of the labor that traditional printersutilize. With every new customer, Vistaprint can scale its investments to further improve its products andmanufacturing. For example, the $129 million that the company spent on technology and developmentlast year–a sum greater than the
of most competitors–came out to only $5 per order for Vistaprint. The feedback loop this creates is obvious: more customers lead to greater scale, whichallows better products and pricing, which leads to more customers. Vistaprint develops a similar edge with the cost of acquiring customers, i.e., their advertising. Forexample, no competitors have the size to justify the national TV ads that Vistaprint recently launched. The new TV commercials are part of Vistaprint’s efforts to target customers that still do theirpurchases offline. A large amount of small businesses still buy at the local print shop–a source that is interminal decline
Local print shops cannot effectively compete pricewise with their online counterparts.
Khrom Capital Management LLCwww.khromcapital.com
 This causes the local shop to suffer from a negative feedback loop: as their sales shrink, there are lessrevenues to spread over their fixed expenses, which eventually leaves the shop with only red ink. Since2004, over one-third of commercial printers have gone out of business. The printing world willcontinue to exist; it will just be a smaller market with probably fewer competitors.Robert Keane wants to accelerate Vistaprint’s acquisition of market share. Many companies will try toinvest smoothly over time with no burden on currently reported income. Keane’s priorities, himself being a substantial owner of Vistaprint’s stock, are long-term. Vistaprint has decided to trade-off near-term earnings in favor of upfront investments that should increase customer retention, lowerproduction costs, improve product quality, create new products, and expand the business beyondNorth America and Europe. Should improvement in these metrics lead to the growth that Keaneexpects, Vistaprint will be worth multiples of what we paid.In the interim, the currently depressed earnings have created uncertainty for many investors, which ledto an attractive price for us to buy Vistaprint. We have no naïve misconceptions about growth; it ishighly challenging and hard to predict. It may not deliver in spades like Keane expects. But what wethink the market fails to realize is that at Vistaprint’s current stock price, we are not paying for thegrowth. Vistaprint already 
14 million customers; it already 
a profitable business with a competitiveadvantage. The recent contraction in earnings was not caused by a decline in customers, sales, or grossprofit margins. It was derived from a substantial increase in employees.
In the past year, Vistaprinthired almost 1,000 new employees–a 30% increase in just one year. We venture to assume thissubstantial increase in employees is not needed to service the revenues that Vistaprint already generates.Back out these incremental investments in headcount and adjust advertising to maintenance levels, and we purchased Vistaprint at a single-digit multiple of free cash flow. While the price we are paying does not give Vistaprint any credit for growth, we are taking on a risk related to the company’s growth strategy. Vistaprint’s new investments could mask our ability to detectany deterioration in the economics of the core business. In the short-term, an unplanned decline in acompany’s competitive position produces the same effect on an income statement as a plannedinvestment aimed at widening its moat. It requires careful forensic accounting and investigativescuttlebutt to distinguish between the two.Guiding the company through this landscape of risk and opportunity is a manager whose judgment wehave found ample reason to trust. Robert Keane has an impressive track record, having built Vistaprintinto a truly wonderful business, with a return on equity that has averaged over 21% for the past sevenyears. He is exceptional with collecting and interpreting data, a key skill given the centrality of data-driven marketing to Vistaprint’s business, and he personally owns a substantial amount of stock. Keanerecently raised the hurdle at which he can exercise his stock options to $75 a share (more than doubleour purchase price), and the company has redesigned its executive compensation structure to ensure
Excluding advertising, ~75% of Vistaprint’s expense increase was due to payroll.

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