Beware: The Global Value Trap!

Value Investing Conference

October 17, 2011

James Chanos Kynikos Associates

Classic Short Selling Themes

Booms that go bust Consumer fads Technological obsolescence Structurally-flawed accounting Selling $1.00 for $2.00 Value traps
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Value Stocks: Definitive Traits

Predictable, consistent cash flow Defensive and/or defensible business Not dependent on superior management Low/reasonable valuation Margin of safety using many metrics Reliable, transparent financial statements
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Value Traps: Some Common Characteristics

Cyclical and/or overly dependent on one product Hindsight drives expectations Marquis management and/or famous investor(s) Appears cheap using managements metric Accounting issues
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Cyclical and/or Single Product

Cycles sometimes become secular (Steel, Autos)

Fad does not equal sustainable value (Coleco,

Salton, Renewable Energy)

Illegal does not equal value (Online Poker)

Hindsight Drives Perceived Value

Technological obsolescence (Minicomputers,

Eastman Kodak, Video Rental)

Rapid prior growth Law of Large Numbers

(Telecom Build-Out)

Marquis Management and/or Famous Investor(s)

New CEO as a savior - ignoring Buffetts maxim

(Conseco)

The Smart Guy Syndrome (Take your pick!)

Cheap on Managements Metric

EBITDAArrgh! (Cable TV, Blockbuster)

Ignore restructuring charges at your own peril

(Eastman Kodak)

Free cash flow? (Tyco)

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Accounting Issues

Confusing disclosure (Bally Total Fitness) Nonsensical GAAP (Subprime lenders) Growth by acquisition (Tyco, Roll-ups) Fair value (Level 3 assets)
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Current Value Traps

Liquidating Trusts Digital Distribution Destruction Mis-Education Nationalistic Commodity China Bubble Fuel
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Liquidating Trusts: Integrated Oil Companies (IOCs)

Dead hand of government falls on new discoveries

Brazil - only the government benefits from offshore development Russia IOCs forced to sell assets to state champions US - Arctic permitting grinds to a crawl
Costs climb while oil production stagnates

Finding and development $22/boe in 2010 from $5/boe in 2000* Production $15/boe in 2010 from $5/boe in 2000* IOC liquids production declined in 2Q11
IOCs switch to natural gas despite plummeting prices

Sub-$4 natural gas is the new normal in the US thanks to the shale
revolution

Race to secure land leases means uneconomical drilling continues

Slow liquidation via cash return strategies
*Source: DB, Global Integrated Oils, October 2011 11

ExxonMobil (NYSE: XOM): Slow Value Leak?

Capital and exploration costs consistently higher than expectations

In 2006, upstream capital expenditure was $16bn; by 2010 it had reached

$27bn

Guided 2011 capital expenditure climbs to $37bn versus $32bn last year Guided 2012-15 capital expenditure of ~$35bn/yr versus prior estimate of
~$28bn

XTO purchase = expensive bet on natural gas

XOMs reserve replacement ratios (RRR) are not as good as they look

2010 RRR of 212% - 55% without the XTO purchase 2009 RRR of 230% - 82% if the definition had not been broadened
XOM borrows to keep its buybacks going

FCF after capex, acquisitions, dividends and buybacks is regularly negative $3.0bn in 2008, ($19.8bn) in 2009, $3.6bn in 2010, ($0.6bn) in 1H11 XOM goes from net cash of $25bn (4Q07) to net debt of $6bn (2Q11)
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Digital Distribution Destruction: Video Games

Media retailers that were cheapgot cheaper Music HMV Forward P/E of 7.5x before bottoming at 1.8x in June 2011 Multiple unsuccessful diversification attempts to offset music declines Movies Blockbuster Forward P/E of 4.1x before declaring bankruptcy in September 2010 Unsuccessfully competed against DVD-by-mail service and online digital distribution Video games undergoing digital transition Digital distribution is still constrained by large file sizes and slow download speeds Evolution of devices such as smartphones and tablet PCs changing the gaming industry Packaged games pressured by growth in casual, mobile and social network games
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Gamestop (NYSE: GME): Next Video Game Victim?

Looks cheap at first glance

Forward P/E 8.2x versus 10.6x average forward P/E over last 5 years Over $3 TTM FCF/share as of end of FQ2 2011 Used games facing increasing competition and margin pressure
NPD data: packaged games shrink while digital games grow

Software sales were -9% YTD September 2011; -5% in 2010 and -10% in 2009 Digital game estimated sales growth of 23% in 2010
2014 expectations indicate GMEs digital opportunity is overstated

2/3 of digital revenues to come from mature PC games 88% of expected revenues from physical games, hardware and accessories
Digital transition adds incremental risk to GME

Improving quality of low-priced digital games threatens traditional $60 price point Game publishers are increasingly direct competitors Fewer trade-ins to maintain used game business
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Mis-Education: For-Profit Colleges

Stocks trading at cheap valuations

Forward P/E multiples range from 7.8x to 13.2x* Trading at large discounts to 5 year average forward P/E multiples (11.1x 27.8x*)

Returns on assets comparable to best companies (Google, Microsoft, CocaCola, Apple)

Business model under increasing pressure

Product sold not bought marketers not educators Traditionally high churn rates create enrollment issues running out of
prospects?

Regulatory scrutiny of industry continues

Program Integrity Rules implemented (incentive compensation, state

authorization, misrepresentation accountability)

Gainful employment rules still have teeth Congressional support is waning

*Source: Based on Bloomberg estimates for APOL, BPI, CECO, COCO, DV, EDMC, ESI, STRA 15

ITT Educational Services (NYSE: ESI): PEAK Earnings?

Looks cheap at first glance

Forward P/E 7.8x*, EBIT margins over 35% Cash conversion over 140% (FCF/Net Income)
Structural earnings issues

ITTs programs are considered expensive even in the for-profit universe New student growth has been negative for three consecutive quarters
PEAKS Private Student Loan Program raises questions and enhances free cash flow

PEAKS is an off balance sheet entity used to finance student debt ITT guarantees PEAKS debt - not consolidated on its balance sheet PEAKS reserve rate appears below historical industry default rates Next tranche of PEAKS necessary to maintain student lending

Regulatory pressure is increasing

2009 2-year Cohort Default Rate rose 83% year over year (22.4% from 12.2%) Securities and Exchange Commission has inquired about PEAKS
*Source: Based on Bloomberg estimates 16

Nationalistic Commodity: Iron Ore Countries for Sale

Leveraged to Chinese growth Growth in iron ore demand is driven by Chinas fixed asset investment
boom

Chinas share of global iron ore consumption is 59% (June 2011) up from
52% (June 2008)*

Iron ore extraction becoming more costly Major growth projects lie in increasingly difficult to access geographical
locations

Enormous investment in rail, port and energy facilities required to access

new projects

Governments use companies as extension of public policy Exploit the industry as a source of revenue and taxes Capital deployment at the suggestion of government officials
*Source: Macquarie, October 2011 17

Vale (NYSE: VALE): China or Bust?

Cyclical peak creates impression of value Forward P/E 5.1x*, operating cash flow margin over 45% $160/ton iron ore price more than 5x 30-year historical average Capital expenditure inflation is soaring 2011 budget of $24B; up 85% over 2010 Questionable capital allocation VALE Navy 12 Chinamax 400k dead weight ton very large ore carriers (VLOCs) Its not our policy to make money in freight. Jose Carlos Martins, Vale Executive Officer of Marketing, Sales and Strategy Enormous exposure to uncertain Chinese demand growth China accounted for 43% of Vales iron ore sales in 2010, up from 29% in 2008 Reliance on continued fixed asset investment growth in China Brazilian Government influence on strategic decision-making Key driver of economy - iron ore exports accounted for 17% of total exports in 2010* Recent resignation of CEO Agnelli amid rumored tensions with newly elected government
*Source: Based on Bloomberg estimates 18

China Bubble Fuel: Chinese State Banks

Record lending spree now three years strong Massive 2009 stimulus 14% of GDP fueled largely by RMB 9.6 trillion in official lending Banks lent another RMB 8.0 trillion in 2010 on track to lend another RMB 7.0 trillion in 2011 Off-balance sheet lending by the banks adding fuel to the fire Off-balance sheet lending by largest banks increased by over RMB 6.7 trillion since 2008 CBRC growing concern push to bring loans back on balance sheet Underground lending may be the most significant risk of all Estimated at RMB 4 trillion, 10% of GDP Unsustainably high lending rates in Wenzhou - proxy for China at large? LGFVs: A restructuring waiting to happen RMB 10.7 trillion in LGFV lending as of 2010 Official estimates are that RMB 2-3 trillion are impaired Big 4 banks maintain RMB 1.4 trillion in AMC bonds on their balance sheets as of June 2011, representing 50% of their tangible book value
*Source: Based on China Banking Regulatory Commission, Peoples Bank of China, National Audit Office, Credit Suisse, Sanford Bernstein, company filings 19

Agricultural Bank of China (HKEX: 1288): Leveraged to Frontier Expansion?

Agricultural Bank of China (ABC) apparent value at risk P/E ratio of 6.3 for 2011, P/BV ratio of 1.5x Profit headwinds reserve releases ending? ABC is Chinas largest county lender - 30% of total loans, 40% of retail
loans

ABCs relative exposure to rural China has increased in recent boom Total loans up 74% since 2008, county loans up 100% ABCs current county credit quality understates riskiness of rural lending NPL ratio of 2%, compared to pre-restructuring level of 32% Reserve coverage of 210% could prove inadequate ABC maintains a material LGFV loan exposure 10% of total loans 90% of tangible book value
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Thank You to the Value Investing Conference

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