Francis Chou‘s Chou Associates Fund letter for the first half ended June 30, 2016.
Dear Unitholders of Chou Associates Fund,
The net asset value ("NAVPU" or "NAV") of a Series A unit of Chou Associates Fund at June 30, 2016 was $92.66 compared to $115.50 at December 31, 2015, a decrease of 19.8%, while the S&P 500 Total Return Index decreased 2.5% in Canadian dollars. In $US, a Series A unit of Chou Associates Fund was down 14.1% while the S&P 500 Total Return Index returned 3.8%.
The table shows our one-year, three-year, five-year, ten-year, 15-year, and 20-year annual compound rates of return.
Francis Chou - Factors Influencing the First Six-Month Results
Positive contributors to the Fund’s performance during the period ended June 30, 2016 included equity securities of Berkshire Hathaway Inc., MBIA Inc., Overstock.com, and the term loan of EXCO Resources Inc. Equities of Sears Holdings Corporation, Resolute Forest Products, Nokia Corporation, Citigroup Inc., and warrants of Wells Fargo & Company were negative contributors to the Fund’s performance during the same period. The US dollar depreciated against Canadian currency, which also negatively affected the Fund. The fund decreased its holdings of Berkshire Hathaway by 50% and increased its position in Sears Holdings Corporation by 60%, and significantly added to the term loan of EXCO Resources Inc.
New additions during the period include an equity stake in Valeant Pharmaceuticals International, the senior unsecured debt of EXCO Resources Inc. 8.5%, due April 2022, and debt securities of Westmoreland Coal Company 8.75%, due January 2022.
In 2015, we initiated the position in EXCO Resources second-lien term loan 12.5%, maturing in 2020. We liked this security because it met the criteria for investing in the Oil & Gas sector.
The criteria were that the security should be:
- First or second-lien loans or notes;
- Situations where the ability to add senior or issue pari-passu debt is significantly limited; and
- If the company restructures or goes into bankruptcy, the recovery value of the bond is greater than the current price of the bond.
We continue to add to the position and as at June 30, 2016, we owned $39.5 million worth of EXCO Resources second-lien term loan. This is one of the largest positions in the portfolio, comprising just below 10% of the assets of the Fund (at market value). We like this security because it is very senior in the capital structure and we believe that management is doing a great job in allocating capital in a tough environment. We also like the fact that the CEO, Mr. Wilder, has bought over $10 million worth of common stock in the open market and is required to purchase at least $23.5 million of additional shares prior to September 9, 2016. We strongly support EXCO's strategic plan as it continues to focus on three core objectives: restructuring the balance sheet to enhance capital structure and extend structural liquidity; transforming EXCO into the lowest cost producer; and optimizing and repositioning the portfolio. The three core objectives and the Company's recent progress are detailed below.
1. Restructuring the balance sheet to enhance capital structure and extend structural liquidity – The Company is focused on improving its capital structure and providing structural liquidity. As of June 30,
2016, EXCO had $246 million in liquidity. During the second quarter of 2016, EXCO reduced its indebtedness through the repurchase of $12 million in principal amount of senior unsecured notes due 2018 ("2018 Notes") and $12 million in principal amount of senior unsecured notes due 2022 ("2022 Notes"), utilizing $5 million in cash. These repurchases resulted in an estimated reduction in interest expense of approximately $2 million per year. In addition, EXCO's cash flows from operations, reduced capital programs and proceeds received from the sale of certain assets allowed the Company to reduce its indebtedness under its Credit Agreement by $11 million during the quarter.
On August 10, 2016, EXCO announced a cash tender offer to buy back $101.3 million of the 8.5% senior notes due 2022 at a discount of 40 cents on the dollar to the principal amount. This further reduces the Company’s indebtedness.
2. Transforming EXCO into the lowest cost producer – Lease operating expenses decreased by 11% compared to the prior quarter primarily due to the renegotiation of its saltwater disposal contracts, modifications to chemical programs and reduced workover activity. Since the fourth quarter of 2015, the Company has reduced its total workforce by 28%, including 20% of its general and administrative employees and 38% of its field employees. Since the fourth quarter of 2014, it has reduced its total workforce by 59%, including 58% of its general and administrative employees and 61% of its field employees. General and administrative expenses (excluding equity-based compensation and severance costs) have decreased 17% from the first quarter of 2016 primarily due to lower personnel costs.
3. Optimizing and repositioning the portfolio – The Company executed a series of non-core asset divestitures as part of its portfolio optimization initiative. In May 2016, the Company closed a sale of certain non-core undeveloped acreage in South Texas and its interests in four producing wells for $12 million. In July 2016, the Company closed a sale of its interests in shallow conventional assets located in Pennsylvania and retained an overriding royalty interest. EXCO's ability to reduce both capital and operating costs has improved well economics across its portfolio. The wells being drilled in 2016 are targeting rates of return in excess of 80% in the North Louisiana region and 30% in the East Texas region.
The company may need some time to achieve the three core objectives, but in the meantime, we are clipping coupons of 12.5% on a current price of about 60 cents on a dollar. That equates to a current yield of approximately 20%.
Valeant Pharmaceuticals International, Inc. (NYSE/TSX: VRX) is a multinational specialty pharmaceutical company that develops, manufactures and markets a broad range of pharmaceutical products primarily in the areas of dermatology, gastrointestinal disorders, eye health, neurology and branded generics. Major subsidiaries of the company include Salix Pharmaceuticals, a maker of gastrointestinal medicines, eye-care company Bausch & Lomb and skin-care company Medicis Pharmaceutical.
What jumps out initially when you first look at Valeant is how much debt it has relative to revenues, free cash flow and product pipelines ($31 billion of debt as of Q2 2016 relative to $10 billion of last twelvemonth revenue and approximately $5 billion of EBITDA2). There is no question that the company has a diversified array of drugs and it generates solid free cash flow, but it also carries an enormous level of debt on its balance sheet. This degree of leverage not only increases the risk for the investor, but may also give the impression that the company is extremely cheap when examining its price to earnings (P/E) ratio.
In the recent Q2 filing, Valeant released its management guidance for the 2016 Expected Adjusted Earnings Per Share (EPS) to be $6.60 – $7.00. For simplicity sake, let's assume its earnings for 2016 will be $7.00 per share and test the value based on that assumption. We will analyze the situation using a multiple of 14, which is the average P/E multiple a company on the Dow Jones Industrial Average has sold