October 19, 2017

Still Finding Great Values

Opportunity Equity 3Q 2017 Letter

In the quarter, Opportunity Equity lost 0.44% (net of fees)1 relative to the S&P 500’s 4.48% gain. Given the Strategy outperformed by so much in the first half, advancing 20.04% versus the market’s 9.34% return, the underperformance doesn’t come as a surprise. Overall, the Strategy has outperformed 55% of quarters over its life. So we’ve done a little better than a coin toss on a quarterly basis. But during this time, the Strategy has compounded at 6.99% per year on average, beating the market’s 5.12% average annual return by over 30% annually. Opportunity may bounce around in the short term, but it has compounded much better over the long term. As the father of value investing, Benjamin Graham, said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Our approach focuses on weighing, not voting unlike most strategies these days. Two-thirds of this quarter’s underperformance can be attributed to two areas, specialty pharma/generics and airlines. Over the long term, we think the weighing machine will provide a much different assessment on these areas than the votes currently being tabulated.

The airlines lagged due to renewed competition and pricing fears, but they’ve already started to rebound as unit revenue guidance earlier this month positively surprised investors. While most focus on short-term industry trends, the bigger picture remains positive and dramatically different than history. Since the industry consolidated and management incentives changed to being based on returns on capital rather than growth, capacity (supply) growth has tracked GDP (demand) growth closely, free cash flow generation has been significant and consistent, and the companies have consistently paid down debt, bought back stock and paid dividends. Yet valuations don’t reflect any improvement.

Delta Airlines (DAL) has a 2.3% dividend yield and has grown the dividend at a 50% annual rate over the past 3 years. The company has shrunk its shares outstanding by 16% over the past 4 years and continues to buy back more stock. It has an investment grade balance sheet and continues to pay down more debt. We have confidence it will be profitable in the next recession, yet it trades at 9.5x next year’s earnings with a 13% free cash flow yield. We’ve owned the airlines for the better part of a decade and foresee owning them many years more with fundamentals like this.

The specialty pharma and generic investments, Valeant (VRX) and Endo Pharmaceuticals (ENDP), entered the portfolio more recently. We initially made the investments last year. We’ve been early/wrong so far, but remain optimistic about the upside potential. Valeant was one of our top performers in the second quarter after beating expectations and management guidance for the quarter. It’s pulled back from those highs for no apparent reason. Valeant’s core businesses (Bausch & Lomb, Salix, dermatology) are solid, but the company has too much debt. It’s already exceeded the debt pay down targets CEO Joe Papa set when he arrived last year. Valeant has a slew of products losing exclusivity. It will milk those products for cash to help it deleverage. The core business should grow and improve profits going forward. Cash from operations plus additional asset sales will help pay down debt. As that happens, we believe the valuation will improve from the current level of 4x earnings. We think the stock is worth at least double its current price.

Endo has some similarities. It too is highly levered (though not as levered as Valeant). Its businesses have faced more challenges. Generics pricing has been a headwind, but Endo was early in calling out the impact in 2017 and didn’t have to adjust down its outlook unlike competitors. It’s faced headwinds in the opioid pain part of the business and has been dealing with lingering legal liabilities due to vaginal mesh problems. We were pleased when the company settled the outstanding mesh liabilities, removing a significant uncertainty. But that settlement pushed out the net cash generation another year. In a market hyper-sensitive to the short term, this was viewed negatively. We are happy to be patient with a management team widely regarded as top notch. Analysts believe Endo will generate over $3 per share of free cash flow in 2018 and beyond. While most of it is going to mesh liabilities in 2018, after that most can be allocated in a manner to maximize shareholder value. As the generic environment improves and the company is able to allocate that capital effectively, the stock price should have significant upside from the current level in the $8s.

We added four new names in the quarter. One, Mallinckrodt PLC (MNK), operates in the specialty/generic space as well. We weren’t looking to add more exposure to the broad area, but headwinds have compressed valuations across the space. Mallinckrodt looks particularly interesting as it’s generating well over $7 per share in free cash flow with the stock in the mid $30s. It trades at this level mostly due to concerns about its main drug, Acthar, which it bought through its Quescor acquisition. It’s basically a monopoly product on which Qescor aggressively raised prices. The market believes those profits aren’t sustainable either due to increased competition or regulatory pressure. At this price, we believe the company is attractively valued even if it loses most of the Acthar profits to competition, which we think is possible, but not likely for several more years. In the interim, those profits will help the company pay down debt, buy back stock and pursue more deals to diversify the business. The company has a good track record on acquisitions thus far, but deploying capital to unattractive business development deals remains a risk going forward. Even given the Acthar risks, we think the stock is worth almost double its current price.

We also initiated small positions in a couple of retailers, namely Foot Locker (FL) and American Eagle Outfitters (AEO). Retailer shares have suffered as it’s now widely believed Amazon will kill malls and the retailers living within. That may be true over the long term, but valuations have reached a level (numerous 10%+ free cash flow yields) where there could be some attractive investment opportunities. We believe both Foot Locker and American Eagle have more sustainable businesses than many retailers and at current levels, the market is discounting a more dire situation than is likely to occur.
Foot Locker trades in the low $30s or less than 8x what it is expected to earn in 2018. It has a 4% dividend yield and has grown the dividend over 70% in the past 5 years. The company has consistently generated returns on capital of 15% or greater during that time. It has a strong balance sheet with net cash and all its stores remain profitable. It’s been hit over Amazon concerns after the announcement of Amazon’s new partnership with Nike, Foot Locker’s biggest supplier. The majority of Foot Locker’s business is in premium-priced sneakers for sneaker enthusiasts, mostly boys aged 12-25. Nike benefits from this market segmentation. These products are not part of the partnership. We think Foot Locker’s business is more defensible than the market is currently suggesting, as the current price implies perpetual declines. The company halted its share repurchase program earlier this year when it saw weakness in the business, but has gotten more aggressive again with the stock at these levels, shrinking the shares substantially in only a couple months. While we fully acknowledge risks to retailers, we think there is an opportunity here for a trade. The stock could easily double with improving trends. We will watch the developments closely.

Additionally, we initiated a small position in the Internet real estate company RedFin (RDFN) on the IPO. We think the company is extremely well positioned for the long term, and we rolled forward our small Genworth option position. We exited Halozyme (HALO) and Seagate (STX) to fund new purchases.

We continue to talk to people who suggest there aren’t great values in the market. We disagree! Our problem has been what to sell to fund new names, rather than finding new things to buy. Opportunity has a forward P/E of 14.3x, a deep discount to the market’s 19.7x multiple. Yet we expect it to generate better long-term earnings growth than the market. If these numbers are right, it will be very difficult for Opportunity not to outperform. We remain excited about the significant embedded value we see in the Strategy.

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Strategy Highlights

During the third quarter of 2017, Opportunity Equity returned 0.44% (net of fees).1 In comparison, the Strategy’s unmanaged benchmark, the S&P 500 Index, returned 4.48%.

Using a three-factor performance attribution model, security selection, interaction effects and allocation effects contributed to the Strategy’s underperformance. Quotient Technology Inc. (QUOT), Apple Inc. C100 1/18, Restoration Hardware Holdings, Inc. (RH), OneMain Holding Inc. (OMF), and MGIC Investment Corp. (MTG) were the largest contributors to performance, while Valeant Pharmaceuticals International Inc. (VRX), Intrexon Corp. (XON), United Continental Holdings (UAL), Endo Pharmaceuticals Holding Inc. (ENDP), and Platform Specialty Products Corp. (PAH) were the largest detractors.

Relative to the index, the Strategy was overweight the Financials, Consumer Discretionary, Health Care, Industrials, and Materials sectors on average during the quarter. With zero allocation to Utilities, Consumer Staples, Telecommunications, and Energy, the Strategy was dramatically underweight these groups and more moderately underweight the Information Technology and Real Estate sectors. In terms of sector allocation, the overweight position in the Consumer Discretionary sector, which underperformed the index, detracted the most from the Strategy’s relative performance. On the other hand, the underweight in Consumer Staples, which underperformed the index, contributed the most to relative performance.

We added five positions and eliminated three positions during the quarter, ending the quarter with 37 holdings where the top 10 represented 45.75% of total assets compared to 19.11% for the index, highlighting the Opportunity’s meaningful active share of around 99.89%.

Top Contributors

  • Quotient Technology Inc. ended the quarter up 36.09% after announcing 2nd quarter results that had revenues of $74.4m and EBITDA of $13m which beat estimates of $73.7M and $9.6m, respectively. Transactions were up 48% YoY and flat QoQ. The company announced that Mir Aamir, current President and COO, would become CEO effective September 1st as the CEO and Founder, Steven Boal would become Executive Chairman. The company increased 2017 guidance due to the acquisition of Crisp, which closed on 6/1/17.
  • The Apple Inc. C100 1/18 calls climbed in the third quarter ending the period up 20.20%. The company announced positive third quarter results with revenues and gross margin coming in at the upper end of guidance ($45.4B vs. $43.5B-$45.5B guide and 38.5% vs. 37.5%-38.5% guide). iPhone shipments were above consensus at 41.03M vs. 40.7M and the company provided guidance ahead of consensus for the 4th quarter with revenues of $49B-$52B (vs. $49.2B). The company held its annual hardware launch event in September unveiling three new iPhones, the Apple Watch Series 3 with cellular connectivity and 4K Apple TV.
  • RH finished the quarter up 8.99%. The company soared after posting Q2 EPS of $0.65 and revenues of $615.33M, both easily surpassing analyst estimates of $0.47 and $606.34M, respectively. The beat was driven by gross margins of 34.1%, sales growth of 13.9%, and comp growth of 7%. The company raised FY 2017 guidance where they see EPS from $2.43 to $2.67, up significantly from $1.67 to $1.94. The company also expects full-year FCF of $400M, which is meaningfully higher than estimates. The company also announced the completion of its $700M buyback program and CEO Gary Friedman personally purchased another $2M in RH shares during September.

Top Detractors

  • Valeant Pharmaceuticals International Inc. declined 17.17% over the quarter. The company reported 2Q results which beat consensus on revenue and adjusted EBITDA due to their two largest business lines (Bausch + Lomb and Salix) growing 8% on a combined basis (revenue of $2.23B vs. $2.21B and adjusted EBITDA of $951M vs. $903M). The company paid down $811M of senior secured term loans following the closure of the sale of Dendreon and redeemed the remaining $500M outstanding principal of the 6.75% Senior Notes due 2018 using cash on hand. The company launched their SILIQ injection in the US which is used to treat psoriasis in adult patients and submitted a New Drug Application to the FDA for IDP-118, a topical lotion to treat plaque psoriasis.
  • Intrexon Corp. ended the quarter down 21.09%. The company announced 2Q results which missed on the topline but beat on the bottom line. Revenue came in at $54M compared to consensus of $57M but non-GAAP EPS came in at -$0.16 compared to consensus of -$0.22. The company continues to anticipate the commercial launch of the Arctic Apple in the US in the fall of 2017 and the AquaBounty Salmon is now available in Canadian markets. Through its exclusive licensing collaboration with Oragenics Inc. (OGEN), the company announced that they have started their Phase 2 clinical trial of AG013, an oral rinsing solution designed to treat oral mucositis in patients undergoing chemo-radiation for the treatment of head and neck cancer. During the quarter, Randal Kirk, CEO, led multiple insider purchases and bought $2.5M worth of stock.
  • United Continental Holdings Inc. declined 19.09% over the quarter. The company disclosed 2Q results which beat estimates but disappointed on 3Q guidance. Second quarter adjusted EPS was $2.75 ahead of consensus of $2.68. The company guided for 3Q PRASM of -1% to +1% y/y and raised CAPEX for 2017 and 2018. Later in the quarter, the company updated its Q3 outlook lowering PRASM to -3% to -5% (previously -1% to +1%), as well as pretax margin to 8% to 10% (previously 12.5% to 14.5%). UAL raised expectations for fuel price per gallon to $1.72 to $1.77 (previously $1.56 to $1.61). The company cited Hurricane Harvey and geopolitical tensions as reasoning for the lower guidance.

1For important additional information on Opportunity Equity strategy performance, please click on the Opportunity Equity GIPS Composite Disclosure. This additional information applies to such performance for all time periods. Past performance is no guarantee of future results.

Contact Miller Value Partners to obtain information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to Strategy performance.

The views expressed in this report reflect those of the Miller Value Partners strategy’s portfolio manager(s) as of the date published. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.

©2017 Miller Value Partners, LLC

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