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James Chanos

James Chanos

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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

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

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 management’s metric • Accounting issues

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 Buffett’s maxim

• The “Smart Guy Syndrome” (Take your pick!)


Cheap on Management’s Metric

• EBITDA…Arrgh! (Cable TV, Blockbuster)

• Ignore restructuring charges at your own peril
(Eastman Kodak)

• ‘Free’ cash flow…? (Tyco)

Accounting Issues

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

Current Value Traps

• Liquidating Trusts • Digital Distribution Destruction • Mis-Education • Nationalistic Commodity • China Bubble Fuel

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

– 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

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

– XTO purchase = expensive bet on natural gas •
XOM’s 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)

Digital Distribution Destruction: Video Games

Media retailers that were cheap…got 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

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 GME’s 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

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

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

– ITT’s 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 China’s fixed asset investment

– China’s 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

– 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’) – ‘It’s 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 Vale’s 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, People’s 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 China’s largest county lender - 30% of total loans, 40% of retail

• ABC’s relative exposure to rural China has increased in recent boom – Total loans up 74% since 2008, county loans up 100% • ABC’s 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

Thank You to the Value Investing Conference


This presentation is for informational purposes only; it does not constitutes a recommendation or endorsement from Kynikos Associates LP. If you wish to obtain further details about any information contained in this presentation, please contact us. Any decisions you make based on information from this presentation are your sole responsibility. The views expressed in the presentation were based upon the information available to Kynikos Associates LP at the time such views were presented. Changes, corrections, or additional information could cause such views to change. Kynikos Associates LP maintains a copyright on the presentation, aside from information, images, and materials contained within the presentation, which are the property of others and, hence, protected by their copyright.

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