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Whitney Tilson October 2011 Shareholder Letter

 

Whitney R. Tilson and Glenn H. Tongue phone: 212 386 7160 Managing Partners fax: 240 368 0299 www.T2PartnersLLC.com

November 1, 2011

Dear Partner,

Our fund rose 7.0% in October vs. 10.9% for the S&P 500, 9.7% for the Dow and 11.2% for the Nasdaq. Year to date, it’s down 24.5% vs. +1.3% for the S&P 500, 5.5% for the Dow and 1.9% for the Nasdaq. Our fund’s performance during the month was roughly in line with what we would expect given that it is nearly 70% net long.

Our long book outpaced the market in October, led by SanDisk (25.6%), Citigroup (23.3%), J.C. Penney (19.8%), Goldman Sachs (15.9%), Howard Hughes Corp. (14.0%), Dell (11.8%), and Berkshire Hathaway (9.5%). The only loser of note was Iridium warrants, which fell 11.8%.

Our short book offset nearly half of our gains on the long side due to Ethan Allen (45.5%), Boyd Gaming (32.2%), Philips-Van Heusen (27.8%), Nokia (18.9%), and Salesforce.com (16.5%). There were two winners of note on the short side, Green Mountain Coffee Roasters (-30.0%), which tumbled after the presentation by Greenlight Capital’s David Einhorn at the Value Investing Congress (see: http://valueinvestingletter.com/david-einhorns-presentation-from-the- 7th-annual-new-york-value-investing-congress.html), and First Solar (-21.3%).

Tax Estimates Please email or call Kelli at [email protected] or (212) 386-7160 if you would like to receive your tax estimates as of the end of October, which will be available in mid to late November.

Netflix We established a position in Netflix near the end of the month on the day the stock crashed 35%. Given our unsuccessful timing of being short this stock – a highly frustrating experience – it wasn’t easy to overcome the emotional baggage and think about Netflix with a fresh perspective, but we’ve concluded that it’s an excellent company and that the market has over-reacted to all of the recent negative news, thereby providing us the chance to own it at a cheap price.

Netflix today reminds us of BP 16 months ago (which was a huge winner for us): the company, its CEO and the stock are all universally hated right now, with endless headlines of furious customers and shareholders. We love situations like this – as long as we’re convinced that there’s a good company and a cheap stock once you cut through all of the noise.

And we do think Netflix is a good company – something we acknowledged when we were short it, but didn’t fully appreciate at the time. Once we did – we think it’s an excellent company – we covered. Here’s what we wrote in our article, Why We Covered Our Netflix Short, published on Feb. 9, 2011 (posted at: http://valueinvestingletter.com/why-we-covered-our-netflix-short.html):

The GM Building, 767 Fifth Avenue, 18th Floor, New York, NY 10153

…while we acknowledged in our December article that Netflix ?offers a useful, attractively- priced service to customers, is growing like wildfire, is very well managed, and has a strong balance sheet,? we now believe that it is an even better business than we gave it credit for. The company has enormous momentum and substantial optionality (for example, international growth), and management is executing superbly.

Obviously the momentum has been broken due in large part to management not executing superbly, but we still think it’s an excellent company – and credit Reed Hastings for quickly acknowledging and fixing the Qwikster mistake.

We were short it primarily because of the extreme valuation of the stock – but now that it’s down nearly 75% from its peak less than four months ago, we think it’s downright cheap. Attached in Appendix A is an article that captures many of the reasons we’re bullish, which concludes:

And one of the reasons everyone thought Reed Hastings was a genius, by the way, was Reed Hastings’ demonstrated willingness and ability to suffer short-term pain in exchange for presumed long-term gain.

How did everyone learn that about Reed Hastings?

They learned that back in early 2004, when Reed Hastings slashed Netflix’s prices and ramped up marketing spending to compete with a new DVD service from Blockbuster that many people thought was going to destroy Netflix.

Reed Hastings’ price cuts and spending increases did not go over well with Netflix’s shareholders. In fact, as you can see in the chart below, Netflix’s stock fell even more then than it has now: 75%+

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But Reed Hastings was right. The company that was supposed to kill him, Blockbuster, went bust. And Netflix’s stock went on to soar 30X from the 2005 low.

Now, thanks to the stumbles of the past few months, everyone thinks Reed Hastings is a bonehead again.

And maybe, this time, Reed Hastings will turn out to be a bonehead.

But this observer, anyway, is not going to be betting against him. Especially because Reed Hastings has already demonstrated his ability to bet the company and be right. And because Netflix’s future — streaming over the Internet instead of cable networks — already looks to be a pretty good and pretty big business.

In addition to the points in the article, we’d add the following:

• With 23.8 million subscribers (excluding 1.5 million international ones) and a market cap of $4.4 billion, Netflix is being valued at $186/subscriber, a very low figure relative to other media companies.

• Its shrunken market cap means that Netflix would be a bite-sized acquisition for any number of much larger companies like Apple ($376B market cap), Google ($192B), Amazon ($97B), Comcast ($64B), or Disney ($65B). We don’t think an acquisition is likely, but it probably puts a floor under the stock.

• By all accounts, streaming usage is growing very rapidly – 30-40% annually we’d estimate. It seems likely that Netflix will get the lion’s share of this because there are no meaningful competitors. A key pillar of our short thesis last year was the rapid emergence of numerous competitors, but it just hasn’t happened. Hulu Plus, which is owned in part by Comcast and Disney, just passed the one million paying subscriber mark, not even 5% of Netflix’s level. Amazon is offering free streaming videos to Amazon Prime members and boasted in its recent earnings release of a library of ?more than 12,000 movies and TV shows from partners such as CBS, FOX, PBS, NBCUniversal, Sony, Warner Bros., and many more,? but Netflix in its earnings release said ?we have not seen much usage of Amazon Prime in our research.? If Comcast, Disney or Amazon wanted to get serious about this nascent market, it would be much easier and less costly just to buy Netflix.

• This is a really rough number, but we think Netflix should eventually be able to earn $5-6 of contribution profit per customer per month (a bit less than half of average revenue of approximately $12.50) if – and this is a big if – it can grow its subscriber base meaningfully over time. This translates into $1.3-$1.7 billion of contribution profit (again, excluding Netflix’s nascent international operations).

• We think Netflix was smart to raise its price – our only critique is how Reed Hastings communicated it. Had he done a better job explaining it, perhaps fewer customers would be so furious. It might not be too late to send out a letter like this one:

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Dear Netflix subscribers,

I understand that many of you are upset by our recent price increase. We didn’t want to do it, but it was necessary. Allow me to explain…

For many years, we had only the DVD-by-mail service and made a reasonable profit charging $9.99/month (for our basic plan). We knew, however, that the future lay in streaming: it’s obviously far better to click a few buttons and watch a movie immediately rather than have to wait for it to come in the mail and then have to mail it back.

But streaming developed slowly thanks to technological barriers (which thankfully are falling rapidly) and the difficulty of licensing content (which remains difficult and expensive). In the early days of our streaming service, it wasn’t a great product: few of our customers had the internet bandwidth to download movies quickly and in high definition, and our content library was very limited. Thus, we gave it away to all of our subscribers, and this worked beautifully for a number of years: millions of our existing subscribers began using streaming and millions more signed up for Netflix to access our convenient streaming library of over 15,000 titles.

But the overwhelming popularity of our streaming service created a dilemma: our subscribers wanted more and more streaming content, but unlike DVDs, where we can simply buy a DVD and send it again and again to our customers, with streaming the law requires that we negotiate licensing deals with the content owners. Not surprisingly, seeing our millions of customers and understanding that streaming is the future, they began to demand higher and higher prices for their content. We don’t begrudge them, but this dramatically increases our costs if we want to make available to our subscribers the most popular movies and TV shows (which we do!). Meanwhile, the costs to provide our DVD-by-mail service certainly weren’t going down. Thus, we had no choice but to charge separately for our two services.

I think $7.99/month for unlimited streaming or unlimited DVD rentals is a bargain – we just can’t afford to provide both for that price. I hope you understand.

• Note that the price increase only affected subscribers who were getting both the streaming and DVD services (they were paying $9.99 and now have to pay $7.99 for each service or $15.98, a 60% price increase). Streaming-only and DVD-only customers didn’t see a price hike and these subscriber numbers are growing quickly, especially the streaming- only, which is the future of the company. Based on the company’s guidance and our own estimates, we think that the number of streaming-only customers will rise 29% from 9.9 million at the end of Q3 to 12.8 million at the end of Q4, due to both new subscribers as well as current streaming and DVD customers dropping the DVD portion. The net result is that the total number of subscribers will remain roughly flat in Q4, but the mix will shift to more streaming and fewer DVD customers (who will be far more profitable, thanks to the price hike). We think these trends bode well for the company over time.

In summary, the question for Netflix (and its shareholders) is whether the company gets back into a virtuous cycle, whereby more and more streaming subscribers lead to more money to pay for better content, which in turn drives even more subscribers. Thus, the key number to watch over the next year is the number of streaming subscribers, not profits or total subscribers (though DVD subscribers are also important, as this business is a cash cow that can fund the growth of the streaming business).

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We believe that the anger many Netflix customers feel will fade as they realize that the company offers two great services at very reasonable price points, and that robust subscriber growth will resume in 2012.

Finally, as background:

• Our original article on Why We’re Short Netflix, published on Dec. 16, 2010, is posted at: http://valueinvestingletter.com/why-were-short-netflix.html

• Reed Hastings’s response on Dec. 20, 2010, Cover Your Short Position. Now., is posted at: http://seekingalpha.com/article/242653-netflix-ceo-reed-hastings-responds-to-whitney- tilson-cover-your-short-position-now

• Our article on Why We Covered Our Netflix Short, published on Feb. 9, 2011, is posted at: http://valueinvestingletter.com/why-we-covered-our-netflix-short.html

Wall St. Transcript Interview Attached is Appendix B is an interview Whitney did recently with The Wall Street Transcript, in which he discussed a number of topics, including many of our favorite positions.

Conclusion Thank you for your continued confidence in us and the fund. As always, we welcome your comments or questions, so please don’t hesitate to call us at (212) 386-7160.

Sincerely yours,

Whitney Tilson and Glenn Tongue

The unaudited return for the T2 Accredited Fund versus major benchmarks (including reinvested dividends) is:

October Year-to-Date Since Inception T2 Accredited Fund – net 7.0% -24.5% 115.2% S&P 500 10.9% 1.3% 28.1% Dow 9.7% 5.5% 74.7% NASDAQ 11.2% 1.9% 27.2% Past performance is not indicative of future results. Please refer to the disclosure section at the end of this letter. The T2 Accredited Fund was launched on 1/1/99.

Note: Returns in 2001, 2003, and 2009 reflect the benefit of the high-water mark, assuming an investor at inception.

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Appendix A

Sorry, But This Netflix Collapse Is Overdone

Henry Blodget | Oct. 25, 2011, 10:40 AM http://www.businessinsider.com/netflix-collapse-overdone-2011-10#ixzz1btT0T83C

Four months ago, no one could get enough of Netflix. Everyone raved about how brilliant CEO Reed Hastings was, how Netflix was disrupting the television business, and how Netflix stock was going straight to the moon. And in mid-July, on the back of all this euphoria, the stock hit an all-time high of ~$300 a share.

And now, three months later, the stock is trading at $75, down 75%. Ouch.

Not surprisingly, analysts are slamming the barn door after the horse is gone, frantically slashing price targets and downgrading the stock. Everyone’s piling on and raving about how stupid the company is. And suddenly sobered-up analysts are saying there’s still more downside ahead. And maybe there is.

Maybe Netflix will just keep right on collapsing until it hits zero. But maybe, just maybe, the collapse and backlash is already overdone.

Here are some points in favor of that latter view.

• Netflix appears to be just going through a product transition. Product transitions are often hell on margins and stock prices. But Netflix’s product transition is not about some

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new, future product that no one knows much about. Netflix’s new product, streaming, is already off to a very encouraging start. And it’s also, obviously, the future of content distribution.

• It’s not Reed Hastings’ fault all those magazines put him on their covers a couple of years ago. This is always a death-curse, and Reed is only the latest executive to get clobbered by it. But the good ones pick themselves up and climb back to the top. (Remember 1999, when Jeff Bezos was named “Man of the Year”? Oof. But look at Jeff now.)

• Netflix’s streaming business, its future, is already at a ~$2 billion revenue run-rate, with 21 million subscribers paying $8/month. This shows that consumers are excited about Netflix’s streaming product. The company isn’t betting itself on some future product that everyone might hate.

• At $75 a share, Netflix’s market cap is $4 billion, or 2X the revenue of its product of the future. Assuming one values the DVD business at zero — and it’s worth more than zero — this suggests that the market is valuing Netflix’s streaming business at 2X run- rate revenue. That seems like a pretty low valuation for a company and product that should have good growth prospects going forward.

• Netflix’s streaming business, after all, is similar to HBO’s business in many key ways: Like HBO, Netflix offers consumers a wide selection of on-demand content for about $10-$15 a month (HBO often costs more, depending on your cable system). Like Netflix, HBO started out with second-run movies, and then eventually began developing its own proprietary content (it seems reasonable to assume that Netflix will increase its commitment to this). Like Netflix, HBO has amassed 20+ million U.S. subscribers: HBO had about 28 million earlier this year, Netflix has 21 million (streaming). Like Netflix, HBO has a multi-billion dollar business: HBO generated about $3.5 billion in revenue in 2010, according to one estimate; Netflix’s streaming business is already generating $2 billion of run-rate revenue.

• Netflix may well prove to be a much better business than HBO, because it won’t be beholden to the cable operators for distribution. Netflix can sell a subscription to anyone with an Internet connection — and it can sell it directly, with its own pricing and customer relationship. HBO can only sell a subscription through a cable or satellite provider, and the cable or satellite provider generally controls the relationship. Netflix, meanwhile, is becoming easier and easier to use on TV sets, which is where HBO lives. Consumers love ease-of-use and convenience, and the fact that Netflix has amassed 21 million subscribers while being relatively hard to use with a TV is remarkable.

• To believe that Netflix is worth less than 2X the current revenue of its streaming business, you have to believe that content providers will always be able to sock it to Netflix whenever Netflix posts a few dollars of profit. But this doesn’t seem a reasonable assumption. Netflix can already write content providers massive checks that content providers can’t get from anyone else in the streaming business. The content providers all believe Netflix needs their content, but it doesn’t need it — all it needs is some content. Some content providers should always be willing to take Netflix’s money, especially as its subscriber base increases. And Netflix’s leverage will likely increase as

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the company develops more proprietary content and becomes even less dependent on any one content provider. And here’s a final point to consider.

Not your average schmo. Right now, everyone has concluded that Reed Hastings is obviously a bonehead. Reed Hastings blew it by raising prices on the DVD business. Reed Hastings blew it by hatching a plan to separate the DVD and streaming businesses. Reed Hastings blew it by failing to foresee how pissed-off his customers would get and how much his content costs would skyrocket. And so on. But, three months ago, let us recall, everyone thought exactly the opposite: They thought Reed Hastings was a genius. And one of the reasons everyone thought Reed Hastings was a genius, by the way, was Reed Hastings’ demonstrated willingness and ability to suffer short-term pain in exchange for presumed long-term gain.

How did everyone learn that about Reed Hastings? They learned that back in early 2004, when Reed Hastings slashed Netflix’s prices and ramped up marketing spending to compete with a new DVD service from Blockbuster that many people thought was going to destroy Netflix.

Reed Hastings’ price cuts and spending increases did not go over well with Netflix’s shareholders. In fact, as you can see in the chart below, Netflix’s stock fell even more then than it has now: 75%+

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But Reed Hastings was right. The company that was supposed to kill him, Blockbuster, went bust. And Netflix’s stock went on to soar 30X from the 2005 low. Now, thanks to the stumbles of the past few months, everyone thinks Reed Hastings is a bonehead again. And maybe, this time, Reed Hastings will turn out to be a bonehead.

But this observer, anyway, is not going to be betting against him. Especially because Reed Hastings has already demonstrated his ability to bet the company and be right. And because Netflix’s future — streaming over the Internet instead of cable networks — already looks to be a pretty good and pretty big business.