Dan Loeb Letter To Shareholders
First Quarter 2014 Investor Letter
Review and Outlook
Harsh winter weather caused the economy and corporate earnings to falter in the first quarter of this year, a seasonal phenomenon we expect will dissipate this spring. This weakness was exacerbated by new Fed Chair Janet Yellen’s statements shifting the market’s expectations of the timing of the Fed’s first rate hike. Four months into 2014, it now seems evident that investment performance will require a combination of good stock selection, patience, and deft trading.
Looking back, perhaps our optimism at the beginning of the year was misplaced. First, certain sectors were clearly exhibiting bubblelicious valuations. Looking at the bigger picture, it is evident in hindsight that at least for the first part of the year, we were toiling against somewhat of a “Lose/Lose” backdrop. On one hand, if growth did not accelerate then the market appeared fairly valued (at best) given 2013’s significant re?rating. On the flip side, if growth did accelerate, the timing of the Fed’s change in monetary policy would hang over the market.
Taking a look at the current landscape, the decline in overinflated sectors, though painful in the short term, is healthy in our view. We have seen an equally painful reversion to the mean on many popular trades. Consensus positions entering this year – long Japan, long momentum, and short bonds – have all underperformed, while value and emerging markets have accelerated. This reversion has created a violent bout of deleveraging, particularly among hedge fund holders, creating chances to add to our portfolio at attractive levels.
Despite its challenging start, it appears as we begin May that the U.S. economy is beginning to accelerate from the low levels of Q1. As a result, perhaps 2014 will be the year where one should not “Sell in May and go away”. Nevertheless, it is important to keep in mind that by this Fall, we will have had negative real interest rates in the U.S. for a longer consecutive period than at any other time – even after the Great Depression. As tapering ends, most likely in October, and the discussion shifts to an impending first rate hike (probably around the time when unemployment is approaching 6% and inflation is ticking higher), we will have to buckle our seatbelts for an inevitably more volatile environment.
Set forth below are our results through March 31st and for the year 2014:
|Offshore Fund Ltd.||S&P 500|
|2014 Year?to?Date Performance*||3.3%||1.8%|
|Annualized Return Since Inception*||17.9%||7.3%|
*Through March 31, 2014. ** Return from inception, December 1996 for TP Offshore Fund Ltd. and S&P 500.
Our performance in the first quarter was buoyed by corporate credit and mortgage investments, which provided roughly half of our returns despite being only roughly 25% of our exposure.
The funds are hard closed to all investors and not currently accepting new capital.
Select Portfolio Positions
Equity Position Update: The Dow Chemical Company (“Dow”)
Since we disclosed our stake in January, Dow’s management has taken several shareholder? friendly actions including increasing the company’s dividend, approving a $4.5 billion buyback to address the impending conversion of the Warren Buffett/KIA preferred securities, and committing to more portfolio divestitures. Management’s level of shareholder engagement has also risen notably, demonstrating an admirable and strong commitment to addressing long?standing concerns.
We also applaud Dow’s recently stated initiative to increase transparency. Shareholders have long called for the company to increase disclosure, improve the clarity of their reporting, and clearly identify underlying business drivers. On Dow’s first quarter earnings call, management suggested it could simplify the portfolio reporting structure by re? classifying (or removing) the Feedstocks & Energy segment. In our view, simply joining the Feedstocks & Energy and Performance Plastics segments would not effectively increase transparency. Instead, the priority should be to implement a consistent, market?based transfer pricing methodology across and within all segments so shareholders can clearly understand each business unit’s underlying profitability. Further, to be consistent with its peers, all of Dow’s petrochemical capacities need to be disclosed in detail so that shareholders can more easily benchmark performance versus competitors. All shareholders eagerly anticipate progress on these important initiatives.
Despite the positive steps taken, we still believe Dow is under?earning its potential in its petrochemical businesses, a concern that management has yet to adequately address. To quantify the extent of under?earning, we sought to compare Dow’s capacity and profits
relative to peers and industry average margins. The result of this carefully researched analysis led us to conclude that Dow’s integrated strategy does not maximize profits.
Dow’s management has yet to address the crux of Third Point’s case for increasing value: curing under?earning in the Petrochemical businesses. This under?earning is clear when one compares Dow to its largest North American petchem peer, LyondellBasell (“Lyondell”). Dow has ~30% more North American ethylene capacity, triple the Middle Eastern ethylene capacity, and more North American derivatives capacity than Lyondell, yet the two companies generate the same amount of EBITDA in their respective petrochemical businesses.1 Additionally, Dow engages in multiple downstream businesses in its Performance Materials segment that Lyondell does not.
This discrepancy is difficult for the market to identify, because Dow does not disclose any of its capacities. Therefore, to identify the magnitude of under?earning, we did our own bottom?up analysis examining: i) the capacities for the petrochemicals Dow produces, ii) average 2013 industry margins for those capacities, and iii) the actual 2013 feedslate mixes by plant (where applicable). The result of this bottom?up analysis shows a meaningful gap between what Dow’s capacities indicate potential EBITDA should be and the amount of EBITDA actually generated:
1 Dow’s petrochemical business includes the Feedstocks & Energy, Performance Plastics, and Performance Materials segments. LYB’s petrochemical business includes all segments except Refining and Technology.
2 Dow’s Petchem EBITDA includes all Feedstocks & Energy, Performance Plastics, and Performance Materials. We allocate corporate expense to Dow’s 2013 segment EBITDA based on an estimate of Dow’s Petchem % of total employees. LYB Petchem EBITDA includes all segments except Refining and Technology. LYB allocates corporate expense to segment EBITDA. Both Dow and LYB 2013 EBITDA has been adjusted to include an estimate of JV EBITDA in excess of equity income. Source: Company filings, Third Point estimates. Capacity data: IHS, company filings, Third Point
We estimate the under?earning to be at least $2.5 billion, which we believe is the result of a strategy focused more on selling downstream products than on maximizing profits.
In this analysis, we have incorporated Dow?specific adjustments where using industry average margin or effective capacity may be overly optimistic. These adjustments include assuming a significant discount to spot pricing for European merchant ethylene volume, and low capacity utilization in both Argentine ethylene and Canadian polyethylene. Additionally, while the Performance Materials segment (where capacities and spreads do not exist) reported $ 1.5 billion of EBITDA in 2013, we have only assumed ~$800 million in our estimate. Since Dow moves numerous self?sourced inputs at cost, a portion of this segment’s EBITDA is transferred from upstream assets in the form of a raw material subsidy. The lack of disclosure and inconsistent transfer pricing make it difficult to