Quarterly Letters

Roumell

Quarterly Update

July 31, 2008

Performance Summary

  Annualized as of 6/30/08
  2Q 2008 YTD 1 Year 3 Year 5 Year 7 Year Since
Inception
(1/1/99)
Total Return
Since Inception
(1/1/99)
Roumell Equity -7.68% -12.57% -23.17% 0.11% 8.72% 6.19% 11.16% 173.28%
S&P 500 -2.73% -11.91% -13.12% 4.41% 7.59% 2.46% 2.08% 21.65%
Russell 2000 0.58% -9.38% -16.21% 3.78% 10.29% 5.63% 6.65% 84.32%
Russell 2000 Value -3.55% -9.85% -21.64% 1.39% 10.01% 7.71% 9.13% 129.40%
Roumell Balanced (Net) -4.89% -8.91% -19.82% -0.05% 7.17% 5.50% 8.01% 107.91%
Thomson US Balanced Index -1.20% -7.10% -6.48% 4.03% 5.90% 3.33% 3.26% 35.63%
Please refer to performance disclosures at end of document.

Roumell Asset Management, LLC has prepared and presented this report in compliance with the Global Investment Performance Standards (GIPS®). Ashland Partners & Co. LLP, our independent verifier, completed its examination of the composite performance returns for the period of 1999 (inception) through March 31, 2008. Please refer to the annual disclosure presentations at end of this document.

Where Do We Go from Here? We Have a Plan.

The economy continues to weaken as housing takes yet another leg down, while energy prices climb and consumer anxiety seems to grow daily. Large companies often viewed as “safe” have dropped dramatically this year, joining their already fallen smaller brethren. As of this writing, GE is down 28%; Bank of America is down 55%; Microsoft is down 27%; AIG is down 65%; and, of course, Fannie Mae is down 82%. Bear market? Absolutely.

Here are some thoughts we want to share with our clients:


  1. It is our belief that the preponderance of unrealized losses showing up on current statements is due to mark-to-market issues as opposed to permanent impairment of capital issues. In other words, we own well-capitalized companies—most, exceptionally so—that may be exposed to an economic slowdown, but not to real company degradation, in our opinion. It is highly possible, for instance, that Fannie Mae and other highly leveraged financial institutions may emerge as weaker companies having experienced actual capital impairment to their balance sheets, but at the same time highly probable that Whirlpool and Toyota Industries, though currently selling fewer goods, will be fine. Similarly, The Washington Post Company, owner of Kaplan Education, Cable One, and six different television stations in addition to its newspaper (which accounts for less than 10% of our valuation of the company), possesses a pristine balance sheet, a board that includes Warren Buffett and Tom Gayner, and a $1 billion overfunded pension and should be just fine as well. Thus, mark-to-market is far easier to live with than is the capital impairment associated with so many financial institutions.


  2. Some of our top holdings’ businesses are doing exceptionally well. KVH Industries rolled out a new broadband antenna last year for its marine market and it is being well received. The company recently purchased additional satellite capacity in order to respond to demand. Further, KVH’s fiberoptic gyros are now being purchased by Kongsberg, the leading remote weaponry system manufacturer in a growing market. Similarly, OPNET Technologies’ mission-critical network monitoring software is being well received. We have spoken with several of OPNET’s customers (45 of the Fortune 50 use OPNET products) and can attest to their deep satisfaction with OPNET’s products, their intention to increase their use of OPNET’s products, and their respect for the company’s engineering capabilities and service-oriented culture. We have sat down with both companies’ CEOs this year and have a very high level of comfort in these individuals’ talent, integrity, and business acumen. We’ve purchased more KVH and OPNET stock this year. Recently, we noted that Tejon Ranch entered into an agreement with California’s leading environmentalists to allow it to pursue large land entitlements with their blessings in exchange for Tejon’s contributing land for conservation purposes. Tejon’s planned-community proposal, Centennial, is certainly negatively affected by the housing market. However, Tejon has many things going on that are creating value; i.e., increased oil drilling and aggregate revenue, a growing industrial park, and the opportunity to monetize conservation land. The above three companies are all top holdings. They are all cash rich, debt free, and managed by people with meaningful equity stakes. In the case of KVH and OPNET, current managers are also the founders of the business. The Cohen brothers, in fact, own nearly 40% of OPNET’s stock.


  3. We are sometimes asked, “Why didn’t you sell?” We have sold many securities, responding to what we believe were material events affecting valuation. We sold virtually all of our financial holdings in the 4th quarter of 2007. As we reported in last quarter’s letter, the shares of these companies have fallen significantly since our sales and we have not been interested in buying them back even at seemingly depressed prices. In last quarter’s letter we discussed the essence of the financials’ business model—leverage—and stated that the risks were quite high (particularly in this environment), and as a result had decided to exit. Thus, we do not hesitate to sell when we believe there is an absence of a value proposition.


  4. We own several small capitalization companies that have suffered significantly given the dramatic sell-off in smaller company shares. To underscore the depth of this disfavor, look no further than Tollgrade, TLGD: it trades at less than its current assets minus all its liabilities. Or InFocus, INFS, which trades at less than its net cash. Given the exceptional capital structures of these companies, and the absence of any value being ascribed to their businesses, we have elected to hold these securities and believe value will ultimately be realized at better prices. Collectively, such investments represent less than 5% of total account value.


  5. We, like so many others, are pessimistic about the U.S. economy, housing, and the stress on consumers. Our job, however, is to select investments that we believe are priced incorrectly given underlying value. We realize we must live with mark-to-market dislocations in the short term, and our clients should similarly accept this fact. We view the market as being in a valley of sorts—not knowing with any precision where the bottom is—where we will collect pieces of businesses that should allow us to prosper within perhaps the next two or three years, and maybe quite handsomely at that. We will, no doubt, not pick the bottom. For instance, recently we purchased Gaylord Entertainment, owner of four fabulous large hotel convention assets, after its shares had fallen by 50%. Our purchase price was equivalent to 65% of the cost the company paid to build these assets (not accounting for any brand/company value), yet Gaylord’s shares dropped 25% farther after our purchase. However, the shares quickly rebounded after Texas billionaire Robert Rowling’s TRT Holdings, which operates, among other companies, the Omni hotel chain, announced it added to its position in Gaylord and is now Gaylord’s largest shareholder.


  6. Cash is still, by far, our largest holding at about 25% (with another 15% in bond funds), and we will look to deploy it opportunistically.


  7. As we have said many times before, we are, ourselves, among our firm’s largest clients. In fact, the firm’s main actors will continue to have 100% of their assets invested here and nowhere else. This may sound typical, but it’s not. A recent study showed that 46% of domestic stock funds surveyed had zero manager investment, and up to 70% of balanced funds had no manager participation.


  8. Times are tough, but so are we. We continue to visit our portfolio companies and explore potential new investment opportunities. We remain cautious and continue to wrestle with the dynamic between price and value. We remain committed, believe that our opportunity set grows daily, and will be judicious in deploying capital. We have been hit by market forces and a slowing economy, as well as our own underestimate of the severity of certain economic stresses, such as those discussed in the past three letters. However, we will move on by staying focused on the future and the potential opportunities being presented to us today.

Our Three Top Purchases

Belo Corp., BLC. Belo Corp. owns and operates twenty television stations reaching more than 14% of total U.S. TV households. The stations are positioned in fifteen demographically attractive, growing markets with a strong concentration in Texas, Arizona, and the Northwest. Thirteen of the twenty stations are major network affiliates with a fairly even distribution among ABC, CBS, and NBC. All but one of the thirteen network affiliates are ranked either first or second in audience share in their respective markets, an extremely important metric to local ad buyers. The Dealey/Decherd family has run Belo since 1920 and still maintains about a 17% economic shareholder interest in the company. In February 2008, Belo spun off its newspaper business, A. H. Belo.

There are two issues facing local broadcast stations: first, and far more important in our mind, is the secular issue of stations competing for advertising dollars against cable and Internet options, and second is the normal cyclical one of an overall drop in advertising revenue in a weakening economy. The secular changes in media distribution have been going on for decades, with various new media being introduced into the marketplace: radio, television, cable, and now the Internet have each delivered a new, and important, avenue to advertisers in their quest to reach buyers, voters, and particular constituencies.

What is noteworthy to us in this continuously fractured marketplace is that overall television viewing continues to rise and the networks and their local affiliates continue to deliver the largest viewing audiences to advertisers. Thus, a 30-second spot advertisement in Dallas at Belo’s ABC station cost more five years ago than it did ten years ago, and costs more today than it did five years ago. Further, Belo’s revenues have grown 3% per annum organically over the past five years. We would readily agree that the micro-targeting abilities of cable and Internet options are very valuable to certain advertising needs. However, mass marketing—network television and its local affiliates’ value—remains vital to many advertising campaigns. For instance, 35% of the dollars that the top five television advertisers spent in 2007 went to local broadcasters; expanding to the top 100, the affiliates’ share is 22%. Additionally, well over 50% of this year’s presidential candidates’ advertising budgets will be spent on network television. In fact, The Washington Post Company, one of our holdings, appears to understand the value of local affiliates, as it recently announced the purchase of the NBC affiliate in Miami, Florida, creating a duopoly with the ABC affiliate it already owns. The cyclical issues facing all advertising options are just that—cyclical.

We believe the selling in Belo’s stock has been overdone and that local station owners have a lot going for them. In addition to the media statistics noted earlier, we believe Belo will have opportunities to monetize its soon-to-be excess spectrum. Television stations will completely transition their signals from analog to digital in February 2009. By transmitting a compressed digital signal, the local affiliates will be in possession of excess high-quality, low-bandwidth spectrum that they can utilize to (1) expand their programming by adding a channel(s), (2) offer a mobile signal delivered to handheld devices that could open the door to targeted advertising, or (3) simply lease to wireless carriers. In the meantime, Belo has been able to supplement its advertising revenue with growing incremental retransmission fees from carriage agreements with local cable operators.

Finally, we purchased our Belo shares at a very deep discount to what the Hearst Corporation recently offered to pay for the 30% of Hearst Argyle, HTV, it didn’t already own. Belo and Hearst Argyle are very similar companies, each having about $750 million in annual revenue. Averaging several metrics that Hearst was willing to pay (HTV’s board turned them down) results in a $20 Belo share price. Moreover, in his 2007 annual report, Warren Buffett lamented passing up an opportunity years ago to buy Fort Worth’s NBC station that he values today at 11x pretax income. Applying the same analysis to Belo also results in a $20 stock price. We paid an average price of roughly $9.80 after the shares had fallen from $20 (though the shares have dropped much farther), which equates to an 8% free cash flow yield and 12x earnings even after accounting for a 20% drop in profit. We went to Dallas in the second quarter and visited directly with Belo management and confirmed our judgment that this is a superior management team possessing strong assets and the ability to manage them.

A. H. Belo Corp., AHC. A. H. Belo publishes three daily newspapers: the Dallas Morning News, the Providence Journal, and the Press-Enterprise (Riverside, Calif.), along with several smaller weeklies. AHC, as noted, was part of Belo Corp. prior to its spin-off earlier this year. As is the case with BLC, the Dealey/Decherd family maintains a significant economic shareholder interest in the company. In addition to its newspaper operations, AHC owns hard assets primarily composed of (1) a 50% interest in a joint venture with BLC that owns the company’s downtown Dallas headquarters of both operations and (2) significant undeveloped contiguous land in the area surrounding the headquarters. AHC also owns outright a brand-new packaging facility in South Dallas (that we visited), a printing facility in Plano, and the newsroom and printing facilities of both the Providence and Riverside papers.

The investment proposition for AHC is that we own hard assets equating to our purchase price with a free option on a newspaper company. First, unlike most publicly-traded newspaper companies, AHC is debt free. Second, as indicated above, AHC is a 50% joint owner (along with BLC) in a significant amount of downtown Dallas real estate—completely unlevered. This real estate is adjacent to a piece of property the city of Dallas recently purchased with the intent to build a hotel to buttress its downtown convention center. In fact, the company owns its real estate outright (printing and editorial properties) in each of its markets. We sat down with Robert Decherd (third-generation owner of the Dallas Morning News) and believe he is proactively moving the company into the digital age. He is strengthening AHC’s own Internet content while partnering with Yahoo! and other Internet portals that seek to leverage AHC’s local sales force on their behalf. Interesting still, we effectively paid about 0.20x sales (2007 sales of $738 million) for our AHC shares. Long Island’s Newsday, with roughly $500 million in revenue, was purchased earlier this year for $650 million, or roughly 1.3x revenue. Again, we believe we have a free option on a right-sized and profitable newspaper operation, as we do not believe the creation of good local content—be it paper or Web-based—will go unnoticed in local markets.

Pfizer Inc., PFE. Pfizer is the world’s largest fully integrated pharmaceutical company. Currently, the market is concerned with both the impact of Lipitor, Pfizer’s hit cholesterol medication that comprises 25% of sales, coming off patent in what now appears to be November 2011, and the belief that the company has an anemic new product pipeline. PFE stock has accordingly been sold off to historic trough valuation levels with shares trading near $18, a split-adjusted price not seen since late 1997.

Our investment thesis regarding Pfizer is straightforward: we own a blue chip pharmaceutical company wherein we paid roughly 7.5x current earnings, or just over 2x revenue, for a company currently possessing 30% net margins and an 11% free cash flow yield. To boot, we receive a 7.5% dividend yield (the dividend was increased in February of this year for the 41st year in a row). In our minds, one of two things happens over the next three years: (1) the company converts its pipeline into income-producing drugs to replace Lipitor or (2) in the absence of the above, the company leverages its world-class distribution system (real shoe leather on the worldwide streets) and either enters into joint ventures or purchases promising drugs. Pfizer’s pristine balance sheet provides the company with real options given its $11 billion in net cash.

Summary

We realize that the past year has been particularly difficult. Although our equity returns were a cumulative 30% for 2005 and 2006, returns for 2007 and year-to-date 2008 through June 30 are a cumulative -20%. A poor twelve months not only obviously affects one-year returns, but also has a significant impact on three- and five-year returns. Value investors particularly seem to be out of favor of late. For example, after beating the S&P 500 for fifteen years in a row, Bill Miller’s Legg Mason Value Trust is down about 32% as of this writing, after being down almost 7% in 2007. Dodge & Cox Stock Fund, which incepted January 1965, is down about 19%. The list goes on…

The purchases this quarter reflect our belief that real value is being created in this marketplace. We do not believe we need to live with the substantial risks that lie in leveraged financial models. We would rather take advantage of companies with strong balance sheets and solid real assets and live with the consequences of an undefined economic slowdown while feeling confident in the assets themselves. We will continue to deploy cash very cautiously and seek instances where we believe there is a substantial spread between underlying value and current market price.

For our clients, we have posted a complete listing of our holdings that describes each company and the rationale behind each purchase on our Web site (www.roumellasset.com). Please contact us either by phone or email if you would like the user name and password to access this document or, alternatively, if you would like a printed copy.

Disclosure: The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients and the reader should not assume that investments in the securities identified and discussed were or will be profitable. The top three securities purchased in the quarter are based on the largest absolute dollar purchases made in the quarter.

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ROUMELL ASSET MANAGEMENT, LLC
EQUITY COMPOSITE
ANNUAL DISCLOSURE PRESENTATION

  Total Firm Composite Assets Annual Performance Results
Year Assets USD Number of Composite S&P Russell Russell Composite
End (millions) (millions) Accounts Net 500 2000 2000 Value Dispersion
2007 270 178 549 -7.67% 5.49% -1.57% -9.78 2.68
2006 280 176 458 16.89% 15.79% 18.37% 23.48% 2.18%
2005 199 111 312 12.38% 4.91% 4.55% 4.71% 2.59%
2004 123 47 125 20.18% 10.88% 18.33% 22.25% 2.69%
2003 66 15 46 32.13% 28.69% 47.25% 46.03% 4.04%
2002 41 8 44 -10.15% -22.10% -20.48% -11.43% 4.33%
2001 31 5 30 32.76% -11.89% 2.49% 14.02% 6.33%
2000 19 2 12 7.97% -9.10% -3.02% 22.83% 4.05%
1999 16 2 9 26.02% 21.04% 21.26% -1.49% 3.92%

 

Equity Composite contains fully discretionary equity accounts and for comparison purposes is measured against the S&P 500, Russell 2000, and Russell 2000 Value Indices. The S&P 500 Index is used for comparative purposes only and is not meant to be indicative of the Equity Composite performance. In presentations shown prior to March 31, 2005, the composite was also compared against the Nasdaq Index. The benchmark was eliminated since it did not represent the strategy of the composite.

Roumell Asset Management, LLC has prepared and presented this report in compliance with the Global Investment Performance Standards (GIPS®).

Roumell Asset Management, LLC is an independent registered investment adviser. The firm maintains a complete list and description of composites, which is available upon request.

Results are based on fully discretionary accounts under management, including those accounts no longer with the firm. Past performance is not indicative of future results.

The U.S. Dollar is the currency used to express performance. Returns are presented net of management fees and include the reinvestment of all income. Net of fee performance was calculated using actual management fees. Net returns are reduced by all fees and transaction costs incurred. Wrap fee accounts pay a fee based on a percentage of assets under management. Other than brokerage commissions, this fee includes investment management, portfolio monitoring, consulting services, and in some cases, custodial services. As of December 31, 2006 and 2007, wrap fee accounts made up 33% and 36% of the composite, respectively. Wrap fee schedules are provided by independent wrap sponsors and are available upon request from each respective wrap sponsor. Returns include the effect of foreign currency exchange rates. Exchange rate source utilized by the portfolios within the composite may vary. Composite performance is presented net of foreign withholding taxes. Withholding taxes may vary according to the investor’s domicile.

The annual composite dispersion presented is an asset-weighted standard deviation calculated for the accounts in the composite the entire year. Dispersion calculations are greater as a result of managing accounts on a client relationship basis. Securities are bought based on the combined value of all portfolios of a client relationship and then allocated to one account within a client relationship. Therefore, accounts within a client relationship will hold different securities. The result is greater dispersion amongst accounts. Additional information regarding the policies for calculating and reporting returns is available upon request.

The investment management fee schedule for the composite is as follows: For Direct Portfolio Management Services: 1.75% on the first $200,000, 1.50% on the next $300,000, and 1.00% on assets over $500,000; For Sub-Adviser Services: determined by adviser; For Wrap Fee Services: determined by sponsor. Actual investment advisory fees incurred by clients may vary.

The Equity Composite was created January 1, 1999. Roumell Asset Management, LLC’s compliance with the GIPS® standards has been verified for the period January 1, 1999 through March 31, 2008 by Ashland Partners & Company LLP. In addition, a performance examination was conducted on the Equity Composite beginning January 1, 1999. A copy of the verification report is available upon request.






ROUMELL ASSET MANAGEMENT, LLC
BALANCED COMPOSITE
ANNUAL DISCLOSURE PRESENTATION

  Total Firm Composite Assets Annual Performance Results
Year Assets USD Number of Composite Thomson US Balanced Composite
End (millions) (millions) Accounts Net Mutual Fund Dispersion
2007 270 75 154 -7.58% 5.76% 3.71%
2006 280 87 158 14.00% 10.47% 3.69%
2005 199 73 142 8.56% 4.22% 2.67%
2004 123 66 119 16.48% 7.79% 3.82%
2003 66 42 100 28.26% 18.60% 3.94%
2002 41 27 79 -9.70% -11.36% 3.77%
2001 31 17 39 21.18% -4.19% 4.75%
2000 19 10 23 8.47% 1.95% 4.53%
1999 16 9 22 12.53% 8.35% 2.63%

Balanced Compositecontains fully discretionary balanced accounts (consisting of equity, fixed income, and cash investments) and for comparison purposes is measured against the Thomson US Balanced Mutual Fund Index. In presentations shown prior to March 31, 2006, the composite was also compared against the Lipper Balanced Index. Additionally, in presentations prior to December 2006, the composite was measured against the Vanguard Balanced Index Fund. The Thomson US Balanced Mutual Fund Index is a blend of over 500 balanced mutual funds and is therefore deemed to more accurately reflect the strategy of the composite.

Roumell Asset Management, LLC has prepared and presented this report in compliance with the Global Investment Performance Standards (GIPS®).

Roumell Asset Management, LLC is an independent registered investment adviser. The firm maintains a complete list and description of composites, which is available upon request.

Results are based on fully discretionary accounts under management, including those accounts no longer with the firm. Past performance is not indicative of future results.

The U.S. Dollar is the currency used to express performance. Returns are presented net of management fees and include the reinvestment of all income. Net of fee performance was calculated using actual management fees. Net returns are reduced by all fees and transaction costs incurred. Wrap fee accounts pay a fee based on a percentage of assets under management. Other than brokerage commissions, this fee includes investment management, portfolio monitoring, consulting services, and in some cases, custodial services. As of December 31, 2007, there are no wrap fee accounts in the composite. As of December 31, 2006, wrap fee accounts made up less than 1% of the composite. Wrap fee schedules are provided by independent wrap sponsors and are available upon request from each respective wrap sponsor. Returns include the effect of foreign currency exchange rates. Exchange rate source utilized by the portfolios within the composite may vary. Composite performance is presented net of foreign withholding taxes. Withholding taxes may vary according to the investor’s domicile.

The annual composite dispersion presented is an asset-weighted standard deviation calculated for the accounts in the composite the entire year. Dispersion calculations are greater as a result of managing accounts on a client relationship basis. Securities are bought based on the combined value of all portfolios of a client relationship and then allocated to one account within a client relationship. Therefore, accounts within a client relationship will hold different securities. The result is greater dispersion amongst accounts. Additional information regarding the policies for calculating and reporting returns is available upon request.

The investment management fee schedule for the composite is as follows: For Direct Portfolio Management Services: 1.75% on the first $200,000, 1.50% on the next $300,000, and 1.00% on assets over $500,000; For Sub-Adviser Services: determined by adviser; For Wrap Fee Services: determined by sponsor. Actual investment advisory fees incurred by clients may vary.

The Balanced Composite was created January 1, 1999. Roumell Asset Management, LLC’s compliance with the GIPS® standards has been verified for the period January 1, 1999 through March 31, 2008 by Ashland Partners & Company LLP. In addition, a performance examination was conducted on the Balanced Composite beginning January 1, 1999. A copy of the verification report is available upon request.

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