!"#$%&'()*$+#,-+./)001))233)14556,7.)1-,#-+/)846#-)9:;)<)*/)=->-+"?/)@!)32A2; B-"-CD&,-E)AFG<AHH<FF32))))

August 3, 2011

Dear Fellow AltaRock Investors:

we would not ordinarily expect to find so many interesting investment ideas after a near doubling of the market avaverage 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 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. why we so happily skip to work each day.

$0$1,000,000$2,000,000$3,000,000$4,000,000$5,000,000$6,000,000$7,000,000$8,000,000$9,000,000

$10,000,000$11,000,000$12,000,000$13,000,000

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 31st 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. m

arket f

olly

PDFaid.Com#1 Pdf Solutions

2

Longer-term Results 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 1.3% annual rate of loss.1

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

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 500.1

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

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 500.1

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 500.1 1

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.

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 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,

splendid business we had extensively researched in mid-2009enough 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 Pizza was formed 25 years ago during my college years in Charlottesville, Virginia. Up until recently, this was the last time I had any

1 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. m

arket f

olly

3

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 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

, 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

favorite pizza. I never would have guessed this result, which I suppose is why we

upon the consistent and sizeable uptick in sales following the introduction of the new pizza now, not just improved, but actually among the better pizza products on the market. There were other

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

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, KF 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 ele rand 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.

primarily focused on the delivery business. In the USA, 47% of the industry 11 billion in delivery sales are split among three

together hold 27%. The other 53% is largely made up of mom and pop operators and small regional chains. m

arket f

olly

4

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.

s 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 nable to expect it to grow long term, but probably no faster than GDP. The story is its international growth potential. Pizza is a business that translates very well across the globe; in fact 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

lects 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 total corporate profit.

strong international partners. In fact, we would argue that the international operations are 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 bu far from saturation. We figure if 300 million Americans can support 5,000 stores, surely the other 6.4 billion earthlings can support another 15,000 stores. We see

double digit rates for at least another ten years, and even then, the world should be able to support thousands

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

arket f

olly

5

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

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 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 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. 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

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.

respected partners. 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 bonds when 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.

s clearly has the staying power that 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,

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 m

arket f

olly

6

he AltaRock Conglomerate, there is one additional factor that while impossible to quantify, we find adds additional appeal to the investmentis 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 . This is beginning to result in higher ticket orders 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 onesconsolidating 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. 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 March at prices between $17.37 and $17.81. Mohawk Industries

es. 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 th Mohawk began many decades ago as a manufacturer of carpeting for residential and commercial customers. The company

With increased size from each acquisition came increased scale and mark

et folly

7

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 today.

ice 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 Moh If you wanted to build your own deck or shed at homeDepot or Lowe s for the best selection of relevant materials at the lowest pricesmake 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

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. uneconomical. Carpet in particular takes up lots of space and most of the myriad of potential selections turn very slowly. atypical supply chain, the manufacturer is in the

marketplace maintains its fragmentation. Thanks to 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 these massive retail chains remain only a small part of Mohawk 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

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 m

arket f

olly

8

. 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-warehouse/showrooms across the United States. Customers come into these showrooms with their architects, builders, or professional installers to view and order from Dal- 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 business is done. 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

in the post-war era, including when mortgage rates spiked through 17

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

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

PRFI

as

% o

f GDP

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

PRFI as % of GDP

50'

55'

59'64'

69'

72' 78'

82'

86'

91'

94'00'

75'70'67'

61' 80'!"#

$%#

&'#

&!#

&(#

mark

et folly

9

Given recent trends, investors are understandably less than enthused about the sector. of extreme

pessimism. CNBC recently penned an article entitled: US Housing Crisis Now Worse Than Great Depression. If you Google !"#$%&'()*+,*$$%"&, you will find thousands of entries. While there is little doubt that this is a housing depression, 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 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. 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.

important to mention, too, that during normal times only about 20% of Mohasales comes from new residential construction. This part of the business has now shrunk to less than 10% of sales. Normally 55% 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, 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

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 futures. We like this investment a great deal. We own a super business with a durable competitive 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 m

arket f

olly

10

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 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 insider by virtue of its building a 10% ownership position in

stock. As we looked further into it we became highly intrigued, because it turns out that the private equity firm, Berkshire Partners, knows 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. largest shareholder until 2006 when it finally exited its position. Even after its financial exit, Berkshire maintained a seat on the board of directors through May 2010. In November 2010 Berkshire disclosed that it had accumulated a 9% position in

accumulate the stock. This information, once again, inspired us to roll up our sleeves and get to work. At first we were skeptical because w jority 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-

ke these as much, but we do acknowledge their existence. However, more than anything else, we just had to know

After a month or so of investigation, here is what we have learned and come to believe

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. 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 r s, J.C. , Target and Wal-Mart. It also sells to virtually every department store in North America. All of these retailers believe m

arket f

olly

11

that they need to offer Gymboree (recently taken private Baby Gap, Old Navy, etc.

ubiquitous new moms coming back to the store. and that is priced just above 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-to the power of this brand. Several yearWal-Mart. However, in 2000 Target approached the company and asked if the two might -brand named Just

, available only at Target. The offering was a huge success that did not escape the notice of Wal- -Mart launched a sub-brand called , available only at Wal-Mart. Sometime in 2008 Wal-Mart, which by then had

-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 Many apparel stocks have increasingly apparent that 2011 will be a poor year, especially for those companies offering cotton-

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

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 prior year guess. During these times, demand exceeds supply and industry prices and profits benefit accordingly.

mark

et folly

12

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 +"$%-%.*/0 affect supply as large profits coerce farmers to plant more cotton. Meanwhile high prices &*'1-%.*/0 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

a inevitable bad years, you value a farm based upon the long-term net cash flow you

So while 2011

reflects on the value of the business franchise and the cash that we expect it to generate for us as owners.

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. were done m

arket f

olly

13

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 Historically, 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 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 acco 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 baby product (ages 0-24 monththrough age seven. (Incidentally, after age seven, the business becomes more fashion

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 apparel business where its sand 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 ) 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 bretail 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 2 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 , in fact, even today s in many consumer

focus groups. 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, r cry from 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 wholessales were coming from its own 150 outlet storescould 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 m

arket f

olly

14

strategy that evidently had and 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 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

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

ting and new OshKosh licensees. Heretofore This will change going forward.

More recently, on June 22, 2011 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. Iits stores. These brands were so overwhelmingly successful that Bonnie Togs

management soon thereafter with a concept of launching a 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. , 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

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

In April we added 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 and need the next size. We believe the largely nondiscretionary explains why the company was able to sail untouched through the most recent recession, while most m

arket f

olly

15

other large declines in sales and earnings. Furthermore we feel very content with the 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 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 !!!

mark

et folly