Value Investing

Mittleman Brothers Investment Management 2015 Annual Letter

Mittleman Brothers Investment Management annual letter for the year ended December 31, 2015.

Mittleman Investment Management, LLC’s composite dropped 1.7% net of fees in the fourth quarter of 2015, versus a gain of 7.0% in the S&P 500 Total Return Index and a 3.6% advance in the Russell 2000 Total Return Index. Longer-term results for our composite through 12/31/15 are presented below:

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Mittleman Brothers Investment Management

Mittleman Brothers Investment Management - Performance Review

Our under-performance of the market indices in Q4 2015 marks the fourth consecutive quarter in which we under-performed both the S&P 500 and the Russell 2000, culminating in a full-year 2015 performance which was clearly a big step back for us. As shown above, Mittleman Brothers Investment Management's composite of all separately managed accounts dropped -21.9% net of fees, versus a 1.4% gain in the S&P 500, and a decline of -4.4% in the Russell 2000 index. But the market indices (market cap. weighted) masked the much weaker results of stocks in general last year. The S&P 500 equal weight index was -4.1%, the Russell 2000 equal weight index was -10.1%, and the median stock in the S&P 500 was off -22% from its 2015 high. So value-oriented investors like us, who eschewed the most popular large cap names (which appeared too highly valued) experienced a less benign market environment than what the indices portrayed. Momentum stocks beat value stocks during 2015, and beat ours quite badly.

Mittleman Brothers Investment Management

Market headwinds do not excuse Mittleman Brothers' poor results in 2015, and while “value stocks” being out of favor puts our lagging performance in some perspective, that does not fully explain it. I made some outright mistakes, too. The draw-down from our last interim performance peak on 8/30/14 has also been due to a deliberate shift away from what I found to be increasingly expensive U.S. stocks, into foreign and particularly emerging market names. Simultaneously, the U.S. Dollar was spiking higher, pressuring those markets and their local currencies. I also made an unforced error in allowing over-exposure to energy related situations much too early as energy prices collapsed, which weighed heavily on Mittleman Brothers' Q4 2014 and full year 2015 results.

Mittleman Brothers Investment Management - Portfolio Review

The shift towards foreign investments is nothing new for us, as Mittleman Brothers' unconstrained global approach has led us to do so from time to time, and this flexibility and wide scope has served us very well over the long term. Over the past 13 years, our international holdings have averaged 36% of the total portfolio, versus 60% today. And emerging markets exposure has averaged 23%, versus 51% today. Our last interim peak in foreign and EM exposure was in the first half of 2005, when international was 57% and emerging markets 41%. While our current positioning in foreign and emerging, versus domestic is at the high end of our historical range, it is not a departure from our normal strategy. Although the recent foreign exposure has been a detriment to our results over the past year and a half; it in no way diminishes my confidence that the vast majority of these foreign businesses will produce satisfying returns over our usual 3 to 5 year holding period. Some investments may take longer to work out, as we have experienced in the past, in foreign and domestic stocks, there have been a few occasions where waiting 6 to 10 years eventually achieved the expected rate of return, and those returns were well worth the wait.

As with our foreign investments, our energy-related stocks are in no way a departure from my historical discipline. In fact during the 13 years since our composite performance track record began on 12/31/02 we have closed out 5 of 8 energy-related investments at a profit (63% batting average) for a substantial net gain. If we end up exiting Pacific E&P and Gazprom at losses the track record in energy would drop to 5 of 10, but I don’t think that is likely to happen. The point here is simply to show that I did not suddenly mutate into a commodity price speculator, no more so than if I was buying banks (we own one, KB Financial in South Korea) would I consider myself engaging in interest rate speculation.

Commodity related businesses entail special risks, so we try to limit our exposure by only investing in proven low cost producers, usually with important infrastructure assets (pipelines) attached for balance sheet ballast in case the commodity price falls. Both of our current energy holdings, Pacific E&P and Gazprom, have those characteristics.

Gazprom’s net debt is only 1.3x the $23B in EBITDA it should produce in 2016, so that is very modest financial leverage. Gazprom’s dividend yield is 5.4% at current price, and we have already been paid about $0.48 per ADR in dividends over the past 18 months since we started buying the stock. They own a huge pipeline network, one that if spun-off into a separate public entity would be highly likely to trade at a much higher valuation than Gazprom’s current price of $3.59 implies, a TEV/EBITDA multiple of only 3x. My estimate of fair value is $7.00 (5x EBITDA) which is 100% upside from current price of $3.59, but less than our average cost of $7.39. That is due to the steep decline in the Russian Ruble, which is tightly correlated to the price of oil. Should energy prices mean-revert at some point in the future, the upside would be much greater. The Ruble should benefit from the removal of economic sanctions on Russia, a more likely prospect now as the big guns have gone quiet in Eastern Ukraine since Putin’s trip to the U.N. last September. There is talk of the well-regarded ex-finance minister Alexei Kudrin rejoining the government in some capacity, which would be a welcome injection of competence. I would expect that before the World Cup takes place in Moscow in 2018, we’ll see a much better economic environment in Russia, with sentiment and valuations vastly improved. Gazprom is hosting an investor day in New York on Feb. 1st where we hope to hear more about the prospect of a pipeline company spin-off, which they’ve mentioned only tentatively in the past.

Mittleman Brothers' other energy company, Pacific Exploration & Production (PRE CN), is in a much more precarious position, and the source of our greatest loss in 2015, and my biggest mistake in some time. When the stock ran up from $2.00 to $5.25 in May 2015 on news of a takeover offer at CAD $6.50 ./ USD 5.40 per share in cash by their largest shareholder, ALFA Group of Mexico, and a private equity firm (EIG/Harbour Energy) in partnership with management, I should have just sold it all then. Instead I held on to almost all of our shares and voted them against the deal. We own about 2% of the shares outstanding. A Venezuelan billionaire named Alejandro Betancourt bought 20% of Pacific E&P’s stock in the open market in May 2015 for about $5.00 per share ($300M) and led a proxy battle to scuttle the deal, which is what happened. But the continuing decline in the price of oil afterwards has severely impaired their cash flow, and they now stand on the verge of a debt default and possible bankruptcy. With the stock at only $0.58 per share now, and their bonds at $13; there is a real risk we may lose our entire investment in this stock, or what little remains of it now. All hope is not lost, though, as the largest shareholders ALFA Group (20%), Betancourt (20%), and a more recent investor, Trafigura Beheer (10%) have deep enough pockets to put together some kind of bridge financing if they are so inclined. Other more highly leveraged energy companies like Chesapeake Energy (CHK) have successfully executed swaps of unsecured debt in exchange for a lower face value amount of newly issued senior secured notes, thus reducing total debt outstanding. One could imagine Pacific E&P doing something similar if they do not close on intended sales of their pipelines and other infrastructure assets in the very near term.

EIG/Harbour Energy is now trying to get control Pacific E&P by buying their bonds (they would need 80%) and then forcing the company into a bankruptcy to swap their debt for new equity, which would wipe out existing shareholders. But their new approach seems likely to fail given an investment firm based in the UK called Ashmore Group controls 40% of the bonds and is standing against EIG/Harbours’ new back-door tactic. At their CAD$6.50 /USD 5.40 offer last year, the value of PRE CN’s total share count was $1.7B, plus about $5B in net debt, for a $6.7B total enterprise value, or 4.5x the $1.5 bil. in EBITDA estimated for 2015. But this new offer, just to the bond holders, would pay bond holders about twenty cents on the dollar, and offer no compensation to equity holders, implying a TEV of only $1.8B, less than 2x the now reduced estimate of $1B in EBITDA for 2017, and obviously much less than the 4.5x multiple ($6.7B) at which they valued it last May.

We have been through a few distressed and/or bankruptcy situations over the years, like buying Carmike Cinemas (CKEC) bonds in late 2000 / early 2001 when the company was in bankruptcy. The bonds traded down from our initial purchase of $27 to $17, before ultimately recovering to par ($100), although we sold around $70. The stock survived the ordeal completely intact, which is very rare in Chapter 11 cases. A more recent Ch11 situation occurred with Mittleman Brothers' investment in GSI Group (GSIG), which made lasers primarily. We bought an initial 2.5% position in 2007 at $10 (before subsequent 1 for 3 reverse split). The company filed Ch11 in 2009 on a technical debt default issue (failure to file quarterly reports on time), not really a solvency or liquidity issue. We dramatically increased the position to a 10% weighting while the stock was well below $1.00, and filed a 13G in early 2010. The equity survived the bankruptcy due to a large shareholder (Stephen Bershad) backstopping a rights offering in support of a more favorable reorganization plan. We participated in the rights offering, and so what began as a disastrous investment (from $10 to $0.60 into Ch11) became one of our biggest winners as the stock rebounded quickly and we made nearly 4x our investment thanks to having averaged down so significantly near the lows.

So distressed and bankruptcy situations don’t necessarily mean all is lost. But it usually does mean that for equity holders, so Pacific E&P could be a GSI Group style turnaround, or it could also be a complete loss, like we experienced with both RH Donnelley in a 2008 bankruptcy and Spectrum Brands (SPB) which filed in 2009. Both were large positions for us in 2008, and both went to $0 in 2008 / 2009. But those horrible losses didn’t prevent the rest of the portfolio from recovering, as we gained 151% in 2009. Similarly in 2003, we gained 83% after losing 100% in insurance company Mutual Risk Management (MM), which went from A- rated and $9 per share to $0 in 2002 after losses incurred due to 9/11 were not reimbursed by some of their reinsurance companies. So if Pacific E&P is destined to be a loss, however painful, we have overcome worse.

Mittleman Brothers Investment Management - Performance Contributors & Detractors

The three biggest contributors to Mittleman Brothers' performance for the full year 2015 were Sberbank of Russia (SBRCY): $3.87 to $5.79 (+50.4% incl. dividend), ABS-CBN Holdings PDR (ABSP PM): $1.04 to $1.34 (+36.1% incl. dividend), and Bouygues SA (EN FP): $36.28 to $39.71 (+27.2% incl. dividend). Ironically, all foreign companies (Russia, The Philippines, and France).

The three most impactful detractors from our full year 2015 performance were Pacific Exploration & Production (formerly Pacific Rubiales) (PRE:CN): $6.19 to $1.24 (-76.2%), and CTC Media (CTCM): $4.87 to $1.85 (-60.3% incl. dividend), and TV Azteca (AZTECACP MM): $0.42 to $0.14 (-66.7% incl. dividend). The slightly smaller percentage decline from CTC Media was more impactful than the slightly larger percentage decline from TV Azteca due to the larger portfolio weighting in CTC Media. Also, all three are foreign companies (Colombia, Russia, and Mexico).

Next week you will receive an updated version of “What We Own, and Why” covering all 20 of Mittleman Brothers' holdings, whereas the last one only profiled the top ten holdings. I think these one page profiles are helpful in conveying the quality of the businesses in which we’ve invested and the rationale behind the investment thesis. So rather than go over all of that with those stocks mentioned above, I will just touch on them briefly here now.

Sberbank, the largest bank in Russia by far, rebounded nicely in 2015 but at $5.79 remains well below our average cost of $8.39. An article in The New York Times this morning noted that agricultural exports from Russia hit $20B last year, topping exports of weapons for the first time, helping to sustain their sizable current account surplus. The country is the least leveraged in the G-20 (except for Saudi Arabia) and Sberbank is actually a well-run bank, well capitalized, and reaping efficiencies from closing branches and moving customers online. I think fair value is at least $10 (+73%), which would be 12.5x the $0.80 in EPS they should produce in 2016, and 1.7x their book value of $5.88. Any gain in the Ruble from here (RUB/USD 76) would boost that fair value target.

ABS-CBN Corp. is a major media conglomerate in The Philippines which we started buying in Q2 2014. Our average cost is $0.89 (PHP 39), current price is $1.34, estimated fair value = $1.75 (+32%) = TEV/EBITDA multiple of 8.5x $200M in EBITDA, market cap to Free Cash Flow multiple of 21x $70M. ABS-CBN is the largest television broadcaster (44% audience share) and content producer in The Philippines, with operations in radio, cable & satellite TV, and movie production. In 2013, ABS-CBN began investing in a new mobile phone services business and the costs of that start-up have been depressing profits and free cash flow and will continue to do so over the intermediate term. But the family of Oscar M. Lopez, the Harvard grad who founded the company in 1956 and still owns 56% of the stock, has got an excellent track record, so we expect those costs to pay off in the future. 2016 is also an election year in The Philippines, so ad spending should get a boost.

Bouygues SA, the French construction and telecom conglomerate, was purchased initially in early 2012, a time of extreme pessimism about Europe in general, France in particular under a President-elect Hollande, and Bouygues’ struggling mobile phone service, a unit which had provided a third of profits, then reduced to EBITDA break-even in a savage price war. The stock dropped sharply during Mittleman Brothers' first 6 months of ownership, we doubled the weighting; then sold half for about an 80% gain in 2014 and exited the last of the position in the first trading days of this year. It was an excellent total return, aided by the dividend yield of 8% when we started buying it.

Pacific Exploration & Production was covered above, and more color will be provided in “What We Own, and Why” coming out next week. In brief, the stock has been reduced to option value, and reasonably so, given the current price of oil. Whether that option will expire in the short term or the long term will be determined in the next few weeks by the outcome of talks with their banks, note holders, and three major shareholders.

CTC Media shareholders approved the sale of its remaining 20% stake in their Russian TV network, by a narrow 54% (just above the 50% needed). Mittleman Brothers voted our 8% stake against it, wanting to retain at least that sliver of value for what it could be worth in the future. If the U.S. Office of Foreign Assets Control (“OFAC”) approves the deal, we will be cashed out of our CTCM position at just over $2.00 per share, realizing a loss versus our average cost of $3.55. As I mentioned in the “What We Own, and Why” summary on CTCM, I was clearly mistaken on both the resilience of the business in the face of sanctions, and my handicapping of the event risk. We could have doubled or tripled our money on this investment if it had worked out in the way I had imagined, but the resulting loss (if OFAC gives the deal a green light) is 44% (from $3.55 to $2.00), a bit less when including two $0.175 per share dividends received on 12/26/14 and 3/31/15, reducing the loss to about 38%. Painful, yes; but not the end of the world.

TV Azteca, the second largest television broadcaster in Mexico, with an estimated 25% market share, has been down because of very depressed profit margins. 2015 was also a down year in Mexican TV ad sales, with leader Televisa reporting -9% and Azteca -10% for the first 9 months of 2015, largely due to absence of the 2014 World Cup. The company is investing in new businesses (wholesale fiber optic telecom services) in Colombia and Peru, the start-up costs of which have dragged down their EBITDA margin from 39% in 2011 to 17% over trailing 12 months. Part of that margin compression was due to the MXN peso weakening severely against the USD as the company has a significant portion of costs in USD. The company is run by a Mexican billionaire, Ricardo Salinas, who has a well-deserved reputation for being not very nice to minority shareholders. Yet we have invested with other not so nice controlling shareholders like Carl Icahn and Ron Perelman and usually have made great returns doing so. TV Azteca reminds me a bit of another small cap family-controlled Mexican media company we owned in the past, Grupo Radio Centro, which used to trade on the NYSE as an ADR (symbol was RC), the largest radio station group in Mexico. In 2002 that stock dropped from $8 (Mittleman Brothers' average cost was around $7.50) to close out the year at $1.95 (-75%). We sold the last of it about 5 years later in 2007 at $15, with sizable cash dividends received along the way. TV Azteca has similar rebound potential, which I’ll describe in detail in the profile piece next week. TV Azteca’s stock (MXN 2.05 / USD 0.11) trades at 5.7x EBITDA est. of $180M for 2016, other Spanish language broadcasters like Atresmedia (A3M SM EUR 8.71) which is the Antena 3 TV channel in Spain, and Hemisphere Media (HMTV $14.40) which is WAPA-TV in Puerto Rico, both trade at 10x EBITDA.

Looking at the portfolio in its currently diminished state can be depressing if one is prone to mindless extrapolation in lieu of rational analysis. With 19 of the 20 names down since most recent purchases, the scene in the rear-view mirror is not too pretty. Yet, looking back upon Mittleman Brothers Investment Management's hideous performance in 2008 (-64.3%) from 12/31/08, that picture was even uglier, with no discernible signs that things were about to turn around in 2009 (+150.9%). Looking back even further at the year ending 12/31/02, while predating Mittleman Brothers' verified track record, I can say anecdotally it was about -17% in 2002. Almost every one of the names were down. And yet in 2003 we were +82.6%, and almost every loser from 2002 became a winner in 2003. Did those businesses change so much during that one year? Of course not, but the perception did.

Mittleman Brothers Investment Management - Macro-Economic Concerns

Investors are bombarded by useless noise and uninformed advice and are too often distracted if not paralyzed by it all; the macro-economic concerns of the day. I remember in the early 1990s, once a week the money supply numbers would be released (M1, M2, M3, etc) and that was a major weekly signpost, it moved markets, and was much discussed on FNN and CNBC. It was believed money supply growth predicted economic growth and thus stock prices. Eventually people figured out it was not quite true (credit growth, much more so than money growth, was key) and the indicator eventually fell out of favor. Imagine how many people wasted mental energy considering such things and ended up selling something prematurely because some pundit scared them over an adverse trend in the money supply figures? Are these same people today selling their ETFs when the China PMI index comes in weaker then consensus expectations? Or when the price of oil goes down?

The concerns about China are not unfounded, but if China’s GDP only grows at 4% over the next 10 years instead of 8% as it has been most recently, should we avoid investing there? In Japan, GDP grew 10.2% per year on average from 1961-1970, and the stock market there gained 8.2% annually. From 1971 to 1980 GDP grew 4.5% per year, but stocks gained 15.9% p.a.

And rather than weaken, the Japanese Yen strengthened dramatically during the 1970s, from JPY/USD 360 to 240, a 50% gain against the USD, despite the much slower growth rate, and despite Japan being a huge importer of oil during a time of rising oil prices. So despite a GDP growth rate that was less than half of what it was in the prior decade, stock market returns nearly doubled the rate of the prior decade, and the currency gained 50%. Now China is a different situation, with more debt as a percentage of GDP than Japan had in the 1970s, and an over-extended banking industry. But while China’s bank assets to GDP ratio is huge at around 300%, China is lower on that ratio than France or the UK, with presumably better growth prospects to help them grow through it. The consensus thinking about China’s currency just a few years ago was that it was horribly undervalued and needed to be allowed to rise, and that the Chinese gov’t was manipulating the currency to keep it cheaper at 6.50 CNY/USD in 2011. Now we are told it’s apparently very overvalued and needs a significant drop to restore competitiveness, currently at 6.58 CNY/USD.

I am not making any macro-economic predictions here, I’m just saying that those who hesitate to invest due to apprehensions about these macro issues are likely succumbing to the paralyzing noise and volatility that can make even the proven long term investor more short term oriented, without even realizing it. We all know about Mr. Market, that manic-depressive business man who Ben Graham described as offering to buy or sell shares in his business at widely disparate prices from one day to the next based on his mood of the moment. Ben Graham and Warren Buffett advised us to take advantage of Mr. Market when the price he offers is attractive, and ignore him when it’s not. Outstanding advice, and yet so many let Mr. Market’s offers guide them, thus substituting their best judgment for the dictates of his mental illness.

There is another character out there, to be more ignored than taken advantage of; and that is Mr. Macro. Mr. Macro reads everything worth reading and knows every macro-economic indicator worth tracking, including the price of tea in China, and where the unsustainable imbalances are, and he plans to grab that next big asymmetric risk/reward payoff so The Big Short II will be about him. He even goes to Davos. He speaks of new normals, zero bounds, contagion, contango, unintended consequences, risk premia, risk parity, risk-on/risk-off, Abenomics, QE, BRICs, PIIGS, Grexit, Brexit, and Mr. Macro is the one who whispers in your ear at each sell-off, “Don’t do it… It’s different this time…” For long-term value-oriented investors like us, Mr. Macro is to be ignored with extreme prejudice. Because, as history has proved, opportunities for successful investment outcomes exist in even the most hostile macro environments imaginable. And we think we own a bunch of them right now.

$1,000,000 invested with us on 12/31/02 grew to an interim peak of $3,500,400 on 05/31/07 (+250.04% in 4 years and 5 months). Then it fell to $801,300 on 02/28/09 (-77.11% in 1 year and 9 months) before rising to a new interim peak of $11,144,100 on 08/31/14 (+1,290.75% in 5 years and 6 months). Then declined again to $7,641,300 by 12/31/15 (-31.43% in 1 year and 4 months). A 16.9% CAGR over 13 years, vs. 8.9% for the S&P 500. You will receive Mittleman Brothers Investment Management's revised “What We Own, and Why” summary in the next few days, which shows just how well we’re positioned to get to our next interim peak.


Christopher P. Mittleman

Managing Partner, Chief Investment Officer

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