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.
Quarterly Results
Set forth below are our results through March 31st and for the year 2014:
| Third Point | ||
| 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.
Petrochemical Under?Earning
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.
Figure 1:2
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 isolate the portion of Performance Materials EBITDA that is actually generated by assets within the segment. The ~ $ 800 million estimate represents our “best guess” as to what segment EBITDA would have been without any upstream subsidization into products like propylene oxide, polyurethanes, epoxies, chlorinated organics, and oxygenated solvents.
At the top of the Dow “bottom?up” bar graph, we have also highlighted $700 million of under?earning related to chlor?alkali. We show it separately to account for two significant structural deficiencies in Dow’s footprint: i) the suboptimal use of ethylene that is being combined with chlorine in the production of EDC, and ii) Dow’s chlorohydrin propylene
3 See Footnote 2 for Petchem EBITDA composition. We estimate that non?service cost related pension expenses included in reported EBITDA amount to ~$400 million for Dow and $20 million for LYB in 2013; pension adjustments have not been included. Source: Company filings, Third Point estimates.
4 Bottom?up EBITDA calculated using 2013 industry avg margin, with adjustments for both Dow and LYB where relevant. Actual 2013 feedslate mixes used for NAM ethylene and 100% naphtha for RoW (ex?ME). Source: Third Point estimates, IHS, The Hodson Report, company data.
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oxide production process, which consumes caustic and consequently causes Dow to lose a meaningful portion of its merchant caustic potential. We do not believe this lost ECU margin is clawed back further downstream where propylene oxide is consumed in products such as polyurethanes. In both cases, Dow is hamstrung by excess chlorine capacity and its desire to supply downstream derivative products with subsidized raw materials.
Importantly, when we replicate the same bottom?up analysis for Lyondell (i.e. what Lyondell could earn vs. what it actually earns), the difference between our estimate and Lyondell’s actual EBITDA is negligible. This result reflects a management team that is focused on being the lowest cost commodity petrochemical producer and a clear strategy that is driven by upstream profit maximization.
In Figure 3, we see that Dow has ~20% greater sales than Lyondell, which is consistent with Dow’s larger upstream capacity and presence in downstream derivatives. However, the downstream businesses require significant headcount, facilities, R&D, and SG&A. Dow’s headcount is ~2.5 times more than Lyondell’s, which is not a reflection of poor efficiency, but rather that Dow is engaged in numerous downstream derivatives that Lyondell is not. Yet, the incremental sales and headcount do not generate additional profits as illustrated below:
Figure 3:5, 6
This is the underlying problem with Dow’s strategy: many upstream petrochemical molecules do not gain incremental EBITDA as they move downstream, often through 3 or 4 business units, before they are sold to the end?customer. In fact, our under?earning analysis suggests that Dow’s commitment to the downstream integrated strategy has actually created a significant drag on upstream profitability.
5 LYB headcount excludes ~500 employees assumed for the Refining segment. Dow headcount excludes ~12,000 employees in Electronic & Functional Materials and Coatings & Infrastructure, and ~8,000 in Agricultural Sciences. Source: Company filings, press releases, Third Point.
6 See Footnote 2 for segments contributing to EBITDA. Figure 3 EBITDA excludes JVs in order to be consistent with associated revenue and headcount.
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Unconvincing Integrated Strategy
Figure 4 is the visual representation of what Dow’s management describes as taking low cost inputs and using value?add innovation to make differentiated downstream products. This, in our opinion, is the essence of why Dow’s strategy is flawed – none of ethylene, propylene, or chlorine provides any product differentiation or specialization in packaging, coatings, or food & nutrition products:
Figure 4:7
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Equity Position: IHI Corporation (“IHI”)
IHI is a mid?cap Japanese conglomerate exposed to three big themes: commercial aerospace, automotive fuel efficiency, and Abenomics?led real estate reflation in Tokyo.
Over the past few years, Third Point has successfully invested in numerous companies in the commercial aerospace sector. While air travel has grown historically at ~2x GDP, increasing fuel costs – which account for roughly 40% of cash operating costs for airlines – are driving the decision to upgrade to new, more fuel?efficient planes. A substantial increase in air travel by new fliers in emerging markets is also expected to drive demand for new aircraft in coming decades. Today, emerging market?focused airlines account for more than 2/3 of global aircraft orders while representing only 1/4 of the global fleet.
As the leading Japanese jet engine manufacturer, IHI partners with engine OEMs like GE, Pratt & Whitney, and Rolls Royce to design engine platforms to power best?selling airplanes like the A320, A320neo, B787, B777, and B777X. IHI’s focus on quality, safety, and on?time delivery has resulted in it consistently increasing its share of key engine programs in new airliners. We believe we are investing in IHI at an attractive price because the market assigns an undeserved conglomerate discount to it.
In one of its two key segments – aerospace and defense – IHI’s margins will expand as its commercial installed engine base grows, driven by spare parts sales which will provide the company with a long?tailed, high?quality, dollar?denominated annuity stream. We expect IHI’s spare parts business to grow volumes by over 10% annually for the next few years while achieving average annual price increases of 5% in dollar terms on a predominantly yen?denominated cost base. With spare parts incremental margins of well over 50%, IHI’s jet engines business’ earnings are set to grow dramatically despite significant R&D investments in new platforms.
The second key business in IHI’s portfolio that offers both growth and high returns is vehicular turbochargers. In this business, IHI is a global #3 (after Borgwarner and Honeywell). IHI’s superior engineering capabilities and willingness to develop bespoke solutions for auto OEMs has led it to outgrow the industry and gain market share. As the internal combustion engine faces increasingly stringent government mandates for reduced fuel consumption and CO2 emissions, we expect widespread turbocharger adoption, enabling IHI to grow topline in the high teens while closing some of the margin gap to its main competitors. We also expect growth emanating from Chinese demand thanks to IHI’s strong relationships with European OEMs like Volkswagen, Fiat, and Daimler.
While these two segments account for two?thirds of IHI’s earnings, the company is involved in many other engineering businesses – from the manufacturing of boilers and turbines to
LNG terminals and tanks – which impact its market perception disproportionately. Throughout the years, the results from these many small businesses have ranged from acceptable to horrible, thus explaining the conglomerate discount applied by the market. IHI is also regarded warily by investors because management shocked investors in 2007 with an announcement of large cost overruns in its energy division. Nearly half of the company’s market cap was wiped out. This prompted management change and an increased focus on project risk management and capital allocation, including deconsolidating its shipbuilding operation. We think the changes have been positive and the company should no longer be punished for 2007’s mistakes.
Finally, IHI has another significant asset – valuable non?core real estate. The company owns a large land bank in Toyosu, a central district of Tokyo located in the vicinity of the 2020 Tokyo Olympic village. The company also owns large office buildings and retail facilities built on the land and is in the process of further development work. IHI listed the book value of its real estate to be ¥ 252 billion as of March 2013. Third Point commissioned two independent appraisals of the land bank and buildings and concluded the value to be closer to ¥350 billion, or over 50% of IHI’s current market capitalization.
Should management decide to spin off the property into a separate company that could achieve substantial financial leverage for redevelopment purposes (hotels, condos, and office buildings in Toyosu and a modern logistic park in Koto ward), the company would realize enormous value for shareholders. As property values rise and rental income increases, IHI will be able to reduce its participation in the listed real estate company and reinvest in its jet engines and turbochargers segments.
We see the intrinsic value of IHI at more than ¥1000 per share, well above where the stock trades today. IHI’s path to value could be substantially streamlined if management were to choose to increase its focus on its high return segments and continue its move away from the suboptimal conglomerate structure of the past.
SoftBank Corp. (“SoftBank”) Update
Following its strong rally at year?end, SoftBank shares pulled back 15% during Q1 2014. We believe this pullback was due to technical trading and that SoftBank’s fundamentals are stronger than when we initiated the position during the fourth quarter of 2013.
SoftBank has continued to demonstrate significant value growth in key drivers across each of its underlying businesses. The Japanese wireless segment successfully navigated the temporary impact of NTT’s iPhone offering and seasonal promotional activity in March 2014, while consensus valuations for Alibaba Group have grown from $120 billion to $171
LNG terminals and tanks – which impact its market perception disproportionately. Throughout the years, the results from these many small businesses have ranged from acceptable to horrible, thus explaining the conglomerate discount applied by the market. IHI is also regarded warily by investors because management shocked investors in 2007 with an announcement of large cost overruns in its energy division. Nearly half of the company’s market cap was wiped out. This prompted management change and an increased focus on project risk management and capital allocation, including deconsolidating its shipbuilding operation. We think the changes have been positive and the company should no longer be punished for 2007’s mistakes.
Finally, IHI has another significant asset – valuable non?core real estate. The company owns a large land bank in Toyosu, a central district of Tokyo located in the vicinity of the 2020 Tokyo Olympic village. The company also owns large office buildings and retail facilities built on the land and is in the process of further development work. IHI listed the book value of its real estate to be ¥ 252 billion as of March 2013. Third Point commissioned two independent appraisals of the land bank and buildings and concluded the value to be closer to ¥350 billion, or over 50% of IHI’s current market capitalization.
Should management decide to spin off the property into a separate company that could achieve substantial financial leverage for redevelopment purposes (hotels, condos, and office buildings in Toyosu and a modern logistic park in Koto ward), the company would realize enormous value for shareholders. As property values rise and rental income increases, IHI will be able to reduce its participation in the listed real estate company and reinvest in its jet engines and turbochargers segments.
We see the intrinsic value of IHI at more than ¥1000 per share, well above where the stock trades today. IHI’s path to value could be substantially streamlined if management were to choose to increase its focus on its high return segments and continue its move away from the suboptimal conglomerate structure of the past.
SoftBank Corp. (“SoftBank”) Update
Following its strong rally at year?end, SoftBank shares pulled back 15% during Q1 2014. We believe this pullback was due to technical trading and that SoftBank’s fundamentals are stronger than when we initiated the position during the fourth quarter of 2013.
SoftBank has continued to demonstrate significant value growth in key drivers across each of its underlying businesses. The Japanese wireless segment successfully navigated the temporary impact of NTT’s iPhone offering and seasonal promotional activity in March 2014, while consensus valuations for Alibaba Group have grown from $120 billion to $171
Dan Loeb Letter To Shareholders Third-Point-Q1-2014-Investor-Letter-TPOI
