October 24, 2018
Rolling Realized Value into New Ideas
Opportunity Equity 3Q 2018 Letter
Opportunity Equity had a good quarter, rising 10.76% (net of fees)1 compared to a gain of 7.71% for the S&P 500. Year-to-date through the third quarter we were up 23.06% versus the market’s 10.56%, although we have given back a chunk of that in the correction that got going in early October.
We bought five new names and sold four in the quarter. We also exercised soon-to-expire warrants on JP Morgan, retaining the same weighting in the stock that we had in the warrants. The two biggest contributors to our results were specialty pharmaceutical stocks Endo International (ENDP) and Mallinckrodt (MNK), which rose 78.45% and 57.10% respectively. Mr. Market has been realizing all year that these two stocks were just too cheap, with Endo rising 125% year-to-date. Mallinckrodt is up a more modest 20%. It has more than doubled from its low in May of $11.65, which was under 2x its expected earnings for 2018. They are still quite inexpensive: Endo trades at 6.7x this year’s estimated earnings; Mallinckrodt at 4x.
Our purchases were Avon Products (AVP), Eventbrite (EB), Newell Brands (NWL), NXP Semiconductors (NXPI), and Qualcomm (QCOMM). We sold Foot Locker (FL), MGIC Investment (MTG), Platform Specialty Products (PAH), and Wayfair (W). Foot Locker and Wayfair reached what we considered fair value or close to it. The other two were sold because we thought the funds could be more productively employed in what we judged were even more undervalued names. Avon, as probably everyone knows, sells beauty and other products through a direct sales force. The company has disposed of its US-based business and now sells principally in emerging markets. The senior management team is almost entirely new in the past year or so. We think their strategic plan, announced at an investor day in late September, is sound. The stock hit an all-time low of $1.37 in the third quarter. We think it is easily worth $3 and potentially multiples of that if the plan works. Eventbrite went public at what we thought was an attractive valuation and it has done very well since. The company provides an online platform that allows users to plan events. It also sells tickets. We like the management team and especially the CFO, Randy Befumo, whom we know quite well since he used to work for us. Newell is a consumer products company that has done nothing but go down the past two years. It was over $50 in 2017 and now trades at under $20. It trades at just over 7x this year’s estimated earnings, has a 5% yield, is selling non-core assets to reduce debt and is buying back stock. We think it is worth at least 50% more than the current price. NXP and Qualcomm were slated to merge, but the deal was cancelled when Chinese regulatory authorities would not approve it. Both companies have significant operations in China. Subsequent to the deal’s falling apart both companies announced dramatic share repurchase programs, each amounting to around 30% of the outstanding shares, a move we think is exactly right as the companies are, in our judgment, worth up to twice the current price in a few years and have ample cash to retire shares at these bargain prices.
As always, we appreciate your confidence and if you have any questions please feel free to contact us directly and we will be happy to answer them.
Bill Miller, CFA
Strategy Highlights by Christina Siegel, CFA
During the third quarter of 2018, Opportunity Equity returned 10.76% (net of fees)1 versus the S&P 500 Index’s 7.71%.
Using a three-factor performance attribution model, allocation and interaction effects contributed to the Strategy’s outperformance, which was partially offset by selection effects. Endo International plc (ENDP), Mallinckrodt plc (MNK), Amazon.com Inc. (AMZN), Stitch Fix Inc. (SFIX) and United Continental Holdings (UAL) were the largest contributors to performance, while Flexion Therapeutics (FLXN), Facebook Inc. (FB), Pulte Group Inc. (PHM), Lennar Corp. (LEN) and Teva Pharmaceutical (TEVA) were the largest detractors.
Relative to the Index, Opportunity was overweight the Consumer Discretionary, Financials, Health Care, Industrials, and Communication Services on average during the quarter. With zero allocation to Energy, Materials, Real Estate and Utilities, the Strategy was dramatically underweight these groups and more moderately underweight the Information Technology and Consumer Staples sector. In terms of sector allocation, the underweight position in the Information Technology sector, which outperformed the Index, detracted the most from Opportunity’s relative performance. On the other hand, the overweight in Health Care, which outperformed the Index, contributed the most to relative performance.
We added five positions and eliminated four positions during the quarter, ending the quarter with 38 holdings where the top 10 represented 42.4% of total assets compared to 21.9% for the Index, highlighting Opportunity’s meaningful active share of around 96%.
- Endo International plc (ENDP) increased 78.5% over the quarter. Endo gained over the quarter after announcing strong 2Q results. Revenues came in at $714.7M above consensus of $697.7M driven by strong performance in the branded segments with Xiaflex sales up 27% year-over-year (YoY) and earnings per share (EPS) coming in at $0.76, far ahead of the $0.54 expected. The company raised full year revenue guidance to $2.75-2.85B from $2.6-2.8B. The company also announced that it had entered into an exclusive licensing agreement with Nevakar Inc. for development of five differentiated sterile injectable products in the U.S. and Canada. The company also benefited from the FDA issuing a Federal Register notice proposing that Vasopressin be left off the 503 Bulks list. The final decision is expected by December 31st.
- Mallinckrodt plc (MNK) had a strong quarter rising 57.1%. The company announced 2Q revenues of $632M ahead of consensus of $621M and EPS of $1.78, beating expectations for $1.48. Acthar revenue came in ahead of expectations at $293M versus $260M, while management reiterated that Acthar would achieve at least $1B in sales this year. The company raised full year net sales growth to +4-7% up from +3-6% and raised adjusted EPS to $6.50-6.90 from $6.00-6.50. Over the quarter, MNK received a complete response letter from the FDA related to its new drug application for Stannsoporfin to treat severe jaundice in newborns. The FDA granted the company Fast Track designation for its Phase III trial of inhaled Xeon for post cardiac arrest patients.
- Amazon.com Inc. (AMZN) climbed higher over the quarter returning 17.8%. The company had another strong Prime Day, adding the most prime members in one day and seeing record sales across many of its devices. Small and medium sized businesses sold more than $1B on Prime Day. The company reported 2Q results with revenue of $52.9B versus $53.4B expected, but reported generally accepted accounting principle (GAAP) EPS of $5.07 compared to $2.49 consensus on strong margin improvement. Amazon Web Services (AWS) had 49% revenue growth along with 26.9% margins. The company guided for 3Q net revenue of $54-$57.5B versus consensus of $58.1B with operating income of $1.4-2.4B ahead of consensus of $1.2B. The company hosted a device event where they released a plethora of new devices, as well as new capabilities and use cases for Alexa. At this event the company also announced their strategic initiative with ADT. It was also reported that AMZN is considering opening as many as 3,000 Amazon Go stores over the next few years with about 50 slated for 2019.
- Flexion Therapeutics Inc. (FLXN) declined 27.6% over the quarter. The company announced 2Q results with sales of $3.8M below consensus of $4.3B, with operating expenses slightly below consensus at $44.1M versus expectations of $45.1M coming in with lower R&D expenses than expected. The company stated that 60% of target accounts have either purchased or received samples of Zilretta and >55% of ordering accounts have placed reorders. The company received a dedicated Q-code in the third quarter with expectations of receiving a J-code in January. Over the quarter, the company announced that the Zilretta study met its primary endpoints in patients with osteoarthritis knee pain and Type 2 diabetes.
- Facebook Inc. (FB) declined 15.4% over the quarter. The company reported 2Q results with revenues and EPS of $13.2B and $1.74, respectively, compared to consensus of $13.3B and $1.71. The company saw engagement of 65.8% below consensus of 66.1% with daily active users (DAUs) growing 2% Quarter-over-Quarter and monthly active users (MAUs) growing 11% YoY to 2.234B. The company guided to high-single digit deceleration in revenue growth rates in both 3Q and 4Q while also stating that expenses will grow at a faster rate than revenue growth in 2019 leading operating margins to trend towards the mid-30s compared to their current operating margins in the mid-40s. Later in the quarter, the company announced that it had discovered a security breach that affected almost 50 million accounts, but had fixed the breach.
- Pulte Group Inc. (PHM) declined 13.6% over the quarter. The company reported 2Q EPS of $0.97 above consensus of $0.75 however, new orders declined 1% far below the 8% growth expected as the company has focused on pricing over pace. The company raised its 3Q and 4Q gross margin guidance to 24-24.5% and 23.8-24.3%, respectively from 23-23.5% in 3Q previously, while also raising full year 2018 operating cash flow guidance to $900M-1.1B from $700-900M previously. Pulte was further pressured as new home sales dropped to a 9-month low in August.
View our 3Q Infographic and read our 3Q 2018 Market Highlights for a recap on what drove market performance.
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. Content may not be reprinted, republished or used in any manner without written consent from Miller Value Partners.
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