FPA Capital Fund commentary for the first quarter ended March 31, 2016.
Dear fellow shareholders,
After five quarters of disappointing performance, FPA Capital Fund’s results in the first quarter of 2016 were in line with our benchmark, the Russell 2500 (0.15% Fund return vs. 0.39% benchmark return). The quarter was significantly more volatile than the March 31st figures suggest. Halfway through the quarter, as of February 12th, the FPA Capital Fund’s performance was -11.77%. Then we made up for the FPA Capital Fund’s shortfall in the second half of the quarter.
The events of the quarter played to the strengths of our strategy. Our high cash balance and significant energy investments, which had recently been liabilities, turned into assets. Because our flexible mandate allows us to patiently build cash until opportunities appear, we had funds available to invest at a time when leveraged market participants were liquidating their energy positions at fire-sale prices. Our long-term time horizon gives us the luxury of not having to perfectly time the bottom. When we see a dislocation between price and value, we can take a view and let time work for us, not against us.
Obviously, we don’t put too much emphasis on how we performed in the second half of a given quarter. What really matters to us—and to you, as our fellow shareholders—is long-term performance. As frustrated as we are with our underperformance over the past five years, we’d like to point out that the underperformance occurred during a five-quarter period from Q4 2014 to Q4 2015. That’s a short period of time for a strategy with an average holding period of 28 quarters. While past performance does not guarantee future results, some historical context is also helpful. In the FPA Capital Fund’s almost 32-year history, we experienced five years of performance worse than -3%: 1990, 2000, 2002, 2008 and 2015. Robust performance followed the drawdowns in 1990, 2000, 2002 and 2008: the average cumulative 3-year performance following each of those years was 98.01%.
In this quarter’s letter, we will discuss our technology investments and provide an update on our education-related names in the portfolio commentary section. In the market commentary section, we will reiterate our energy thesis and provide a quick update on our energy-related investments.
FPA Capital Fund – Portfolio commentary
Our two largest industry allocations remain technology (24.9%) and energy (23.5%). We discuss below our three largest technology investments: Western Digital Corporation (Nasdaq: WDC), Arris International plc (Nasdaq: ARRS), and InterDigital, Inc. (Nasdaq: IDCC). Collectively, these investments accounted for 15.7% of portfolio weighting at the end of the first quarter.
Western Digital Corporation:
Western Digital designs, develops, manufactures, and sells hard disk drives (HDDs), and increasingly, solid-state drives (SSDs). The company’s hard disk drives are used in desktop and notebook computers, enterprise applications, and consumer electronic applications. Among the most profitable product areas for WDC is in the enterprise drive segment. Overall, WDC’s market share in the HDD industry is roughly 44%. During the last several years, the HDD industry has consolidated substantially, and the top three companies now control nearly 100% of the market. Furthermore, WDC’s vertically integrated business model makes it the lowest-cost producer of disk drives. It is also important to note that WDC management has done a superb job of returning the firm’s strong and consistent free cash flow to shareholders via buybacks and dividends. WDC also recently made a series of bold moves that could become gamechangers for the industry.
The company received approval from the Ministry of Commerce of the People’s Republic of China (MOFCOM) to fully integrate the Chinese assets from its acquisition of Hitachi’s disk drive business. We believe the combination could add more than $2.40 to EPS3 (using current share count), given the possible savings of more than $400 million a year in operating expenses, and $250 million in the cost of goods sold.
WDC also announced a deal to acquire SanDisk (Nasdaq: SNDK) for approximately $19 billion in cash and stock, catapulting the company into a leadership position in SSDs. The move gives the company a very competitive offering and should put to rest fears that WDC could be cut out of the drive business by SSD players.
A quick summary of our evaluation of potential best-case and worst-case scenarios is shown below:
- Downside ($55 per share): $18 billion of revenue and $4.8 billion of EBITDA4. Assumes $650 million of MOFCOM synergies, $500 million of SNDK synergies (up to $1.1 billion over the long term), offset by 6% decline in the core business. Using an 8x multiple on owner earnings5 implies a stock value of $55 per share.
- Upside ($138 per share): $18.9 billion of revenue and $5.2 billion of EBITDA. Assumes $650 million of MOFCOM synergies and $700 million of SNDK synergies (up to $1.1 billion over the long term). Using a 14x multiple on owners’ earnings implies a stock value of $138 per share.
Western Digital has been in our portfolio since early 2007. The investment is a good example of how we scale up and down our position size over time.
Arris International plc:
Arris provides cable operators with communication systems that make it possible for users to consume bandwidth. When customers demand faster internet speeds and more bandwidth to watch movies or upload pictures, the internet providers have to upgrade their infrastructure. This is where ARRS comes in, because it provides the hardware and software needed for expanding network capacity.
We initially invested in Arris in November 2010, and we more than doubled our investment in 2013 after they acquired Motorola Home from Google. This acquisition transformed ARRS into one of the market leaders in all aspects of the cable infrastructure market, with No. 1 market share in cable modem termination systems, No. 1 in cable modem shipments, and a close No. 2 to Cisco in set-top boxes. We thought ARRS got a good deal by buying from a motivated seller, and we had great confidence in the management team’s ability to integrate this very large acquisition. This thesis largely played out, and the stock price tripled from November 2010 to March 2014.
We started buying again at a time when four of the company’s five largest customers—Time Warner, Comcast, Charter and AT&T—were involved in M&A talks. The uncertainty over consolidation forced those companies to rein in big spending, slowing orders at ARRS. We consider this a short-term issue because the level of competition is stronger than ever, between both the traditional players and newcomers such as Amazon and Netflix. In addition, Arris’s products help these companies differentiate themselves, and there is a major replacement cycle around the corner. We believe the future is bright for Arris.
Arris sells a great number of products to a global customer base of corporate giants, and we believe there is tremendous growth ahead for Arris in the foreseeable future. Arris’s largest customers are running out of network capacity, so their CapEx plans should remain elevated.
In April 2015, Arris announced