A Closer Look at Income Opportunity in 2Q 2015 – Higher Cash Flows at a Lower Price

Market Commentary

The Income Opportunity Strategy ended the second quarter of this year down -0.28% (year-to-date, net of fees).¹ Shortly after the fourth quarter of 2014, which was among the Strategy’s weaker quarters, we wrote about how we were optimistic for the portfolio’s prospects given the dividend changes declared by portfolio companies. The same analysis today yields equally encouraging results, as does a more in-depth look at two of the holdings behind the second quarter’s weak performance.

During the quarter, 18 equities in the Strategy announced dividend changes, with 11 increases and seven decreases. If we exclude the companies with variable dividend payouts and only look at companies setting dividends they intend to maintain for the foreseeable future, there were nine increases and five decreases. Two of the dividend increases were among the top ten holdings, and the nine companies increasing the dividend represented 18% of the portfolio while the five reductions represented 4% of the portfolio as of quarter-end. Interestingly enough, two of the Strategy’s top ten holdings — American Realty Capital Properties (ARCP) and Fortress Transportation and Infrastructure Investors (FTAI) — do not even pay a dividend today, though we expect each to declare one by the end of this year. We think this bodes well for the Strategy’s ability to continue to accomplish its goal – a high level of income while preserving the potential for capital appreciation.

Unfortunately, owning securities that we think are likely to appreciate meaningfully in value means they can do the opposite. This quarter, two of the Strategy’s top ten holdings combined to contribute almost 40% of the Strategy’s decline. New Media (NEWM), the largest position in Income Opportunity, lost almost a quarter of its value even as it hiked the dividend by 10%. The company is the largest publicly traded collection of community newspapers in the country, and it is buying small newspapers at EV/EBITDA multiples of 3-5x. New Media then uses its centralized infrastructure to reduce costs at the community newspapers, which has so far resulted in meaningful cost savings and a lower multiple net of synergies than implied by the reported purchase price. Investors dumped the shares during the first quarter on concerns that revenues are falling more rapidly than the company highlights in its presentations. We are aware that New Media operates in a secularly challenged business, and we understand the revenue trajectory too. However, we believe these concerns are overly discounted in the current valuation. The company is likely to be generating $3.00 in annualized free cash flow per share by the end of this year, which provides a nice cushion for the $1.32 annualized dividend while also providing capital to acquire additional newspapers. With the stock ending the second quarter at $17.93, investors reap a free cash flow yield over 16% and a dividend yield of 7.4%. Needless to say, we believe the stock is worth significantly more than $17.93.

The other significant detractor was American Realty Capital Properties (ARCP), which is the largest publicly traded triple-net-lease REIT. The company owns a national portfolio of real estate requiring tenants to pay for the top expenses associated with commercial real estate ownership: taxes, insurance and maintenance. The company previously had an aggressive management team that misstated some headline cash flow numbers closely followed by analysts. That management team has since left, along with most of the board. The company suspended the dividend in December to review the depth of the fraud along with broader corporate strategy and capital allocation policies. We bought shares after the initial misstatement came to light and the stock plummeted, partially because a $4.00 share price decline seemed excessive in light of a $0.04 misstatement. While shares appreciated into the end of Q1 2015, they have since come back down as the company is taking time to formulate its strategy and new dividend policy; a sharp spike in rates has also weighed on the shares of many REITs. We think that the company has high quality assets, and that the stock can trade at a similar cash flow multiple as other triple-net-lease REITs if management can behave like teams at other triple-net-lease REITs. If this were to happen, we believe the stock could provide a total return of as much as 50%.

We remain optimistic about the strategy and welcome your questions and comments.

Strategy Highlights

During the second quarter of 2015, the Income Opportunity Strategy returned -5.13% (net of fees). In comparison, the Strategy’s unmanaged benchmarks, the BofA Merrill Lynch US High Yield Master II Index and the S&P500 returned -0.05% and 0.28%, respectively.

The Strategy initiated six positions and eliminated eleven during the quarter, ending the quarter with 61 holdings.

Top Contributors

Fortress Transportation and Infrastructure Investors LLC was up 6.65% during the quarter. The Strategy bought Fortress Transportation on the IPO in May. The company is comprised of a portfolio of transportation-related equipment and businesses accumulated by Fortress Investment Group. The company disclosed in its prospectus that it intends to pay a $0.33 dividend (though the first will be pro-rated for one half of a quarter), implying a yield of 7.3% at quarter-end, with Fortress targeting 10% annualized dividend growth.
Qiwi PLC rebounded in the first quarter, rising 17.68%. First quarter results came in above Street expectations on EPS and sales growth with the company reiterating guidance for sales and profit growth of between 12% and 16% for 2015. The company also reinstated a dividend of $0.25, implying an annualized gross yield of 2.9%. During the quarter, Qiwi announced a partnership with Beeline, launching a co-branded e-wallet, similar to its partnership with Megafon announced earlier this year. The company completed its acquisition of money remittance companies Contact and Rapida.
Triangle Capital Corp. was up 5.32% during the quarter supported by Q1 performance. Triangle beat estimates with NII per share of $0.54 vs. consensus of $0.51. Non-recurring fees on heavy repayments drove the earnings beat, though the company indicated that lending activity should increase through the remainder of 2015. In May, Triangle announced a quarterly cash dividend of $0.54 per share along with a supplemental dividend of $0.05, implying an annualized dividend yield of 10.1%.

Top Detractors

New Media Investment Group ended the first quarter down -23.97%, despite its improving performance. Investors appeared concerned that top-line growth would disappoint in a secularly challenged business. For the second straight quarter, the company announced a $0.03 rise in the quarterly dividend bringing the total quarterly dividend to $0.33, implying an annualized dividend yield of 7.4%. During the quarter, the company announced the acquisition of The Columbus Dispatch.
The REITs American Realty Capital Properties Inc. and Altisource Residential Corp. declined -17.46% and -14.48% over the quarter, respectively. American Realty continued to build out its Board with new, independent members in the wake of an accounting scandal. Glenn J. Rufrano, new CEO, is expected to announce a business plan along with its dividend policy in August. Fellow REIT Altisource transferred a significant portion of its mortgage servicing away from Ocwen (OCN), which reduced risk but slowed the ability to profit from progress on distressed loans. In June, Altisource announced that CEO Ashish Pandey would step down and be replaced by George Ellison, who joined the company as President in March. The dividend was maintained at $0.55, implying an annualized dividend yield of 13.1%.

¹For important information about Income Opportunity Strategy performance, please click on the Income Opportunity Composite Performance Disclosure. Past performance is no guarantee of future results.

Contact LMM 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.

All investments are subject to risk, including possible loss of principal.

The views expressed in this report reflect those of the LMM LLC (LMM) strategy’s portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and LMM 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.