Bronte Capital Amalthea Fund letter to investors for the month ended February 29, 2016.
Bronte Capital Amalthea Fund had a good month in a stressful market. Our performance is usually good in a weakly downward market and it was during February (+1.8%).
The market recovered fairly rapidly in the last week in February (and the first week of March). We usually do poorly during rapid market spikes, however in February the market spike did not hurt us and left us with positive results for the month.
Prior to the spike we benefited from a well-received earnings report from Rolls Royce and later in the month Herbalife reported results which we thought were merely adequate but which the market liked. Meanwhile our short position in Valeant worked well as Valeant stock continued to erode. We discuss all of these below.
The market surge in the first week of March has been less kind to us. We normally don’t report positive intra-month performance but negative intra-month performance warrants a mention. We are down a low single-digit percentage during the first week of March our worst relative week for many months.
We are not worried about being down a few percent in early March – but it does take the shine off an excellent February. For reasons described at the end of this letter we think our early March losses will be reversed.
Bronte Capital Amalthea Fund – Rolls Royce
Rolls Royce, the maker of jet engines, was one of the most problematic stocks in our portfolio. We have discussed this at length in previous letters.
They have the most fuel-efficient jet engine on the market (the Trent XWB) for the most fuel-efficient plane on the market (the Airbus A350). This plane should sell a lot of copies (especially if the oil price rises).
If the plane sells a lot of copies Rolls Royce should make a lot of money on maintenance over the next thirty or so years.
However there has been some difficulty in Rolls Royce getting to the “promised land”. The company has incorrectly estimated cash usage and has considerable capital expenditures in ramping up production. We have been uncertain as to whether Rolls Royce can meet those capital expenditures without tapping equity markets for more money.
Rolls reported results that were uneventful. They cut their dividend (as expected) but the management seemed sanguine about their capital needs. The stock rose from just above 5GBP per share to just above 7GBP per share.
Bronte Capital Amalthea Fund – The Herbalife results
We have done some study of Herbalife’s European business. The business model is a very long way from the business model described by Herbalife’s main critic. The pattern on the ground is not even to mention the “business opportunity” until the customer has had a notable change in body shape from the weight loss routine.
Recruitments in this business are lower but retention is much higher and the average recruit does better. This is a stable growing business.
This regime has been in place in much of Europe for some time. And the numbers show it – volume points (a good measure of sales volume) in Europe rose 15 percent. This was the best for any region other than China.
The business methods in Europe are being transitioned over the globe. As this happens we expect short-term volume falls in countries which are disrupted, followed by long term stable growth.
The volume falls in transitioning markets were a feature of late 2014 and were the main reason why the stock was weak in the second half of 2014.
In most countries the transition is now over a year old and growth should be resuming. And it did resume – and the market was pleased.
We were less pleased.
We expected growth in volume points in the transitioned countries to be higher. We were particularly disappointed with the US result where volume points remained at minus 7 percent year on year and were dead flat in the fourth quarter versus the fourth quarter of last year.
Unless this growth comes our eventual target for the stock lowers to about $80 (it trades at about $55 currently).
We think European type growth might come to the rest of the world – but we would prefer seeing it before we believe it. If the European growth globalises then Herbalife will wind up above $200 per share. That is not our base case – but very strong upside is possible here.
The FTC settlement
The big news in the results however was new language in the 10-K filing about them being in discussions with the FTC to settle outstanding issues.
Herbalife made several changes to their business model after the short-seller attack on the company. We expect the company to settle with the FTC for a fine and for provisions making permanent the new company rules. How big the fine is is an open question but
anything less than $100 million will be a big victory for longs in the company provided it does not come with substantial changes in the way the business operates today.
After month end on Herbalife
After month end Herbalife put out a truly shocking correction to their results where they indicated the number of new active distributors was grossly overstated. They claimed this was due to a coding error in their (mostly laudable) Oracle database system. Here is the mea-culpa as in the SEC filing:
On March 1, 2016, Herbalife Ltd. (the “Company”) identified errant information regarding the Company’s new “Active New Member” metric that was provided on certain of the Company’s 2015 earnings calls, as outlined in greater detail in the tables below. The Company began tracking this non-financial metric in 2015 in connection with certain marketing plan changes and discussed it for the first time on its second quarter 2015 earnings call. However, database scripting errors led to both (i) the errant inclusion of additional categories of data in calculating the metric for parts of 2015 which were not included in the 2014 and prior period calculations and (ii) quarterly aggregation issues which created variances from period-to-period depending on when the greatest level of activity occurred during the relevant period. The Company did not discover these errors earlier because it had limited visibility into the likely rate of change in this metric upon its first use. The Company has taken corrective action regarding these issues. No information regarding this non-financial metric has been included in any of the Company’s periodic reports filed with the Securities and Exchange Commission and the errors do not impact the Company’s historical consolidated financial statements.
Some of the changes were ugly. For instance global active new members excluding China went from 16.7 percent to 3.0 percent growth.
We have agonized about this error. Nobody likes mistakes, but they are twice as painful for companies operating under exacting public scrutiny. It was sloppy but we have – on balance – decided we believe the honest -error explanation. And it did not affect reported earnings numbers or cash balances.
It is worth explaining why we believe the sloppy error explanation when we so readily conclude that other companies’ misstated accounts are fraudulent.
Double-entry accounting is a beautifully self-correcting system. If you want to fake your earnings you are overstating your revenue or understating your expenses. This means that pretty rapidly your balance sheet will show cash