Breaking away from thedramaof the market is difficult,but it is in times of great turmoil when the best opportunities can be found. Q3 presented Wanger Investment Management, Inc. with opportunities to purchase companies with great assets at discount prices. Two new investments added to the portfolio are Energy Solutions (ES) and Allied Defense Group (ADG). These companies share important common attributes: limited exposure to business cycles, strong ability to generate cash, and unique assets capable of producing a high ROE. In addition, both companies are poised to benefit from important longer term trends: ES will take advantage of the growth of the nuclear industry and ADG will benefit from the transition to lighter, more mobile militaries around the world.

Since its IPO on 11/15/2007, ES has traded at an average PE of 22. We like the company but not that much. ES’s Clive, Utah low level radioactive disposal site is the only site that the majority of nuclear materials users can use for disposal. Low level nuclear waste (Class A to be specific) includes everything from the lab coat a radiologist might wear to the dirt under the site of a former nuclear power station. ES is almost the only game in town, with 82 of the 104 operating nuclear power plants in the US having “life of plant” contracts with ES for the disposal of their Class A waste. Margins on disposal are an impressive 50%, so the growth comes by driving more waste into their dump. Each nuclear plant must have a fund set up at its inception for decommissioning at the end of life and ES’s central growth strategy has involved figuring out how to tap these funds. For example, ES was awarded the contracts to fully decommission 2 large reactors in Zion, IL. As part of this strategy ES has asked the Nuclear Regulatory Commission (NRC) to allow the trust funds to be used for partial decommissioning (“large component removal”). While this change in regulation is expected, it hasn’t occurred fast enough to generate the expected revenue in 2008, causing analysts to talk down 2008 EPS, thereby setting up 2009 to be a record year. Such attractive margins and limited capacity have attracted the interest of other waste-handling companies, but the barriers to entry are impressive. Valhi (VHI) subsidiary, WCS, has been working for more than ten years to obtain a permit for a similar site in Texas, but continues to run up against a series of challenges. The regulatory delay,along with the market conditions, caused the stock price to fall by 64% YTD (as of 9/30/08), bringing the current PE down to 11, and providing an opportunity to buy.

ADG is not an obvious buy at first glance. ADG is a failed military roll-up that expects to complete the sale of its remaining non-ammunitions business by the end of 2008. Looking at the company more closely, ADG’s remaining subsidiary, MECAR SA, produces differentiates munitions, with a solid back log, a tested management team, a deeply rich customer base and almost no debt. The munitions business currently has a $190 million backlog with a 10% EBIDTA margin. The backlog will be realized over a 12-14 month period and continues to build. Given the current market cap of $50 million we estimate that this firm is conservatively trading at 2.6x 2009 EBITDA. The backlog is real and securitized with deposits. The largest customer in the backlog is the Saudi Arabian government which primarily uses 90mm rounds in its tanks and mortars, of which ADG is the only manufacturer. Other customers include the governments of Morocco, Bahrain, Tunisia, Kuwait, and Jordan. ADG also has advanced 105mm round technology that allows the smaller shell to perform similarly to the 120mm round, which is the current standard in the US military. The militaryís goal to build a lighter and faster army has led them to realize that the 120 mm guns are too heavy. As a result, the smaller 105mm round weapons have been designated by the military for use in the General Dynamics Stryker vehicle an exciting development for ADG. In addition, ADG formed a joint venture with the much larger Alliant Technologies to redistribute each otherís products. We believe the JV could be a first step towards an eventual buyout of ADG. We also like that the tangible PPE assets of ADGís MECAR unit in Belgium externally appraised at 10-15m Euros limits the downside. By completing the sale of the GMS unit, ADG is now out from under a series of bad financing deals that almost brought this great, small company down. We expect ADG will continue to grow or be purchased.

While these markets continue to be challenging, we at Wanger still see tremendous opportunities.

James L. Cahn