Value Investing

Longleaf Partners Fund Down 20% In Q3 On Big Energy Bets

Longleaf Partners Fund commentary for the third quarter ended September 30, 2015.

H/T Dataroma

Longleaf Partners Fund was down 19.78% in the third quarter, trailing the S&P 500 Index’s 6.44% decline. Year-to-date (YTD) declines were 23.02% for the Fund versus 5.29% for the index. Only three times in the history of the Fund has quarterly performance been down more. Historically, performance rebounded strongly. Since its inception, the Fund has outperformed the index.

Longleaf Partners Fund

Over the last three months, several of our companies’ stocks suffered from the broad fears that China’s slower economic growth would negatively impact parts of their underlying businesses, but our energy investments continued to be a primary driver of underperformance. Oil prices fell more than 50% over the last year—something that has happened less than 2% of the time in the last 115 years.

Longleaf Partners Fund – Performance Contributors: Google, McDonald’s

The portfolio’s largest contributor during the quarter, Google, rose 17% on the back of strong operating results and an announced new corporate structure. The company’s core search and display business demonstrated healthy, accelerating organic revenue growth. The move to mobile search is helping Google, rather than hurting it as some bears had feared. YouTube is also performing well, as its average viewing session per user on a mobile device is over 40 minutes, up more than 50% year-over-year. Beginning in the fourth quarter, Alphabet Inc. will replace Google Inc. as the publicly-traded entity. Google will become a wholly-owned subsidiary of Alphabet, and all outstanding Google shares will convert into the same number of shares of Alphabet. This means the company will report two segments—the search and YouTube core business and all other business lines. Management believes the new structure will allow for more management scale and accountability as each Alphabet subsidiary will have its own CEO. Larry Page, Sergey Brin, and Ruth Porat will remain in their same roles as CEO and Co-Founder, Co-Founder, and Chief Financial Officer.

Longleaf Partners Fund

Another top contributor in the Fund, McDonald’s stock gained 5% in the quarter, demonstrating the resiliency we saw in 2008 when it was one of two stocks with a positive return in the Dow Jones. Since taking the helm of the company, CEO Steve Easterbrook has announced initial plans to reshape and turn around the business. Comparable store sales are showing broad signs of improvement in key international markets such as Germany and China. On the capital allocation front, the company continued to repurchase shares at a strong pace (7% annualized) and indicated that pace should continue. The company is also undergoing a review of its capital structure and working to re-franchise stores at attractive values.

Longleaf Partners Fund – Performance Detractors: Murphy Oil, Wynn Resorts, CONSOL Energy, Chesapeake, Level 3 Communications

As one of our energy holdings, Murphy Oil, an exploration and production company with a portfolio of global offshore and onshore assets, was a primary performance detractor, down 41% in the quarter, with approximately half of the impact coming from the equity we hold and the other half from the options. This happened despite beating estimates on production and operating cash flow (OCF) and raising production estimates for the rest of the year. Murphy management is focused on driving costs lower and shortening drill times while improving production efficiency to reduce capex to cash flow levels. Furthermore, after disappointing international drilling results in recent years, the company will not invest in higher risk, higher cost wells at this time; instead, management plans to focus rig commitments and to allocate capital to higher return opportunities near lower-risk existing infrastructure where the company has had prior exploration success. Murphy remains well capitalized with diverse cash flow sources and an investment grade rating. It also has non-core pieces that could be monetized to unlock value. CEO Roger Jenkins continues to repurchase shares at the company level and invest personally.

Longleaf Partners Fund

Wynn Resorts, the luxury gaming and hotel company with properties in the United States and Macau, was down 45% in the third quarter. Wynn Palace-Cotai is expected to open in March, and the company commenced site remediation for Wynn Everett-Boston, yet the stock price reflects no value for these assets before they generate revenues. While gross gaming revenue continues to decline in Macau, bears are extrapolating poor results forward and ignoring the potential for Wynn to gain market share next year upon the opening of Palace. The company sells for roughly our appraisal of its Las Vegas properties plus its Boston concession, after net debt. The stock price implies almost no value for Macau, even though the depressed market value of its 72% stake in Wynn Macau (down YTD from HKD 21.85 to HKD 8.78) is worth around $50 per Wynn share. Even bear case analysts project higher visitors and revenues in Macau over the next five years, but the uncertainty of the next 12 months translates into minimal value for Wynn’s Macau properties today.

CONSOL Energy fell 55% in the quarter after disappointing revenue and earnings on weaker-than-expected thermal coal production and negative natural gas differentials versus the New York Mercantile Exchange. Management is adjusting to lower commodity prices with cost controls and took steps to recognize the value of CONSOL’s coal assets by offering shares in the master limited partnership (MLP) CNX Coal, which generated $200 million in proceeds. We filed a 13-D during the quarter to discuss with third parties as well as management and the board a potential monetization or separation of the valuable Marcellus and Utica gas assets. We believe these assets alone are worth demonstrably more than CONSOL’s total equity capitalization. They are unique, low cost reserves given the company’s fee ownership of many acres. CONSOL is exploring monetization paths for all of its assets, including thermal coal, metallurgical coal, pipelines, and the Baltimore port terminal.

One of the largest producers of natural gas, natural gas liquids, and oil in the U.S., Chesapeake Energy declined 34% in the quarter. In line with our exposure, about 60% of the impact came from the options we own and the remainder from the common equity. Concerns remain over the company’s liquidity profile, but management made major strides to improve realizations by successfully renegotiating two contracts with pipeline operator Williams that reduces transportation costs. Additionally, on October 1 the company announced the renewal of its $4 billion credit facility. Comparable asset sales in overlapping basins, such as Encana’s sale of Haynesville assets, further confirmed our appraisal of Chesapeake. The company’s shares remain more heavily discounted than its peers, yet CEO Doug Lawler is keenly focused on realizing value for shareholders even in this depressed energy price environment. Further reducing costs, including the recently announced 15% headcount reduction, coupled with asset divestitures, should lead to a stock price more in line with intrinsic value, which we appraise at twice the current price assuming the underlying commodity prices remain depressed.

Longleaf Partners Fund 4

Fiber and networking company Level 3 Communications declined 17% as concerns about near term top-line growth rates outweighed improvement in margins and free cash flow (FCF) generation. During the quarter, the company reported organic revenue growth across North America and EMEA (Europe, Middle East, and Africa) in line with expectations, while Latin America, which represents approximately 10% of consolidated revenue, had weaker growth mainly due to currency. The integration of tw telecom remains on track with synergy realizations ahead of schedule. Level 3 already has achieved approximately $115 million of annualized run-rate EBITDA synergies, and the company should achieve 70% or $140 million of its annualized synergy target by the end of the first quarter of 2016. FCF growth at Level 3 is ramping up and, we believe, marching toward explosive FCF growth on a per share basis in the next few years as a result of the business’ strong incremental margins, the aforementioned tw telecom synergies, and continued debt reduction and refinancing. During the quarter, major bond rating agencies upgraded approximately $11 billion of the company’s rated debt and credit commitments, further proof of Level 3’s improving business and financial profile. We bought two new positions in the Fund during the quarter. Weakness in global agricultural markets provided an opportunity to purchase DuPont, a science-based company in agriculture, safety, high-performance materials, nutrition, electronics & communications, and industrial bioscience. With corn and soybean prices down significantly, less acreage is being planted worldwide. This lowers demand for DuPont Pioneer’s seeds and crop protection products that make up 50% of the value of the company. The company has spun off non-core units and accelerated cost reductions. After quarter end, CEO Ellen Kullman resigned. Interim CEO and board member Ed Breen has a great track record rationalizing and realizing value of business segments in his prior jobs.

We also initiated a position via options in National Oilwell Varco, the leading global provider of equipment used in offshore and land drilling. Fear of a prolonged downturn in deep water rig orders is more than accounted for in the current price and is giving us an opportunity to invest in a high-quality franchise during a cyclical trough. The company holds a dominant market position due to its scale, trusted brands, and large installed base of equipment. Shareholders are benefitting from a 5% dividend yield while waiting for the rig building cycle to resume. Additionally, CEO Clay Williams is a strong capital allocator who we believe should continue to build value through share repurchases and acquisitions of distressed companies.

As we found more discounted opportunities in the third quarter, we sold Franklin Resources and Vivendi. We hope to partner again with CEO Greg Johnson if Franklin Resources’ large and broad global distribution network becomes significantly undervalued again. French media company Vivendi returned 4% since we purchased it in the third quarter last year. In that time, Chairman Vincent Bolloré sold non-core businesses SFR and GVT and returned capital to shareholders via special dividends.

Despite our frustration over recent returns, we believe that the positive fundamentals of the companies we own will be reflected in their stock prices. The Fund has three categories of companies that we see driving returns. Roughly 60% of the portfolio is a collection of what we feel are industry leading businesses that have the competitive strength and management leadership to compound value per share at a potentially high rate. Based on our appraisals, as a group this category of holdings sells for below 65 cents on the dollar and, on average, less than 12X after-tax free cash flow (real cash P/E). Prospects for these holdings’ value growth, especially as a diversified basket, are greatly enhanced due to their combinations of pricing power and gross profit royalty status. Their managements’ track records and ownership alignment suggest strongly that these steadily growing free cash flow streams should be reinvested to build even more corporate value.

In our opinion, this group includes the best global digital fiber network in Level 3 Communications, the highest-quality global conglomerate in CK Hutchison, the world’s number one insurance and risk broker in Aon, the world’s largest and superior search engine in Google, the world’s best delivery network in FedEx, the best U.S. cable channel company with HGTV and Food Network (via Scripps Networks), the world’s most compelling real estate company in Cheung Kong Property, the world’s best casino developer and operator in Wynn, and the most dominant worldwide cement oligopolist in LafargeHolcim. These companies are among those that offer a combination of competitive advantages, business safety, balance sheet strength, and glaring undervaluation that gets lost in the focus on the few names that have hurt recent results. As the largest portion of the Fund, however, it is this group of holdings that we look to as the primary long-term driver of potential future outperformance.

The second category of holdings includes companies being led through transitions by strong partners who are focused on growing and unlocking values by highlighting their competitive business segments and/or reinvesting substantial cash in high-return opportunities. McDonald’s has discussed capitalizing on its increasingly valuable real estate and becoming a fee company; in our view, CNH Industrial should eventually become a pure-play agricultural equipment company, second only to Deere; Philips is heading toward becoming a leading healthcare company; and DuPont has multiple ways to refocus and improve. This group comprises about one-quarter of the portfolio and we feel should drive performance when the gap between price and value closes as our management partners lead these transitions.

The third category contains our energy holdings which, as a bucket, are down over 60% year-to-date (YTD), constituting a bona fide crash rather than a mere bear market. The momentum-driven heavy selling and shorting of this “crash bucket” has gotten so out of hand that we feel the companies’ recovery is a large part of our significant potential future return. Even though qualitatively Wynn is in the first category above, its severe undervaluation positions it similarly to our energy investments for a big near-term recovery. To be clear, we do not think these stocks will do well simply because they are down. We believe their long-term fundamentals under the stewardship of their capable leaders should drive prices as contrasted to the short-term perceptions. In the case of our energy holdings, we are not reliant on an energy rebound to move the stocks higher, as our appraisals are over twice the current stock levels based on current depressed commodity futures pricing. Should oil and gas prices move back to their much higher marginal cost of production, the values of these stocks would be materially more. These energy holdings represent less than 10% of the Fund, and while we put them in their own group, they share many of the same compelling attributes described in the second category above.

Although we cannot predict short-term prices, we believe the Partners Fund has reached an attractive level for long-term investors to add capital. The Fund’s price-to-value (P/V) ratio is in the low-60s%, and the sharp uptick in global market volatility, which has now reached its highest level since 2011, has been a precursor to strong Fund returns in the past. While a useful data point, this historic performance is not the basis for our confidence in returns going forward. The competitiveness of our businesses, our extremely capable management partners, and the attractive margin of safety in our companies’ stock prices make us highly confident that the companies we own can perform well and reward your patience and ours.