Lakewood Capital Management letter to investors for the second quarter ended June 30, 2016 obtained by ValueWalk- below is an excerpt discussing their short positions.
In the quarter ended June 30, 2016, the fund recorded a net gain of 1.3%. At quarter end, the fund’s equity exposure was 77.7% long and 37.9% short for a net equity exposure of 39.8%. In addition, the fund was 3.7% long and 0.2% short fixed income securities for a net fixed income exposure of 3.5%.1 capital and the top ten positions constituted 38.8% of equity capital.
Review of the Quarter
The fund generated a net gain of 1.3% in the quarter. Long equity positions generated a +2% return on capital, hedged long equity positions generated a +10% return on capital, short equity positions generated a -1% return on capital and fixed income positions generated a +8% return on capital.
Lakewood Capital on short positions
Below, I briefly discuss our views on our short positions in two Australian banks and Core Laboratories.
Lakewood Capital – Australian Banks (Short)
The fund is short Australia’s two largest banks, Westpac Banking Corporation and Commonwealth Bank of Australia. While many global banks currently trade at depressed valuations, the stock prices of Australia’s largest banks have roughly doubled in the past five years as profits and returns have remained strong. We believe investors are running the risk of applying peak earnings multiples to peak earnings performance just as nearly non-existent loan losses look set to increase.
Investors in Australian banks are attracted to a highly consolidated market with strong returns on equity (ROEs) and attractive dividend yields of 6% (based on high payout ratios of 80% to 85% of earnings). However, the high returns generated by the Australian banks are largely the result of the tremendous amount of leverage they are willing to employ. In fact, unlevered returns on assets for Westpac and Commonwealth are roughly 1.0%, which is almost identical to the average for JP Morgan, Wells Fargo and Citigroup. Yet, while Citigroup (a core long position for Lakewood) runs the bank with assets to equity at 10x, the Australian banks are operating at 18x assets to equity. The result is that Westpac and Commonwealth generate 16% to 18% ROEs and trade at around 2.5x tangible book while Citigroup trades at just 70% of tangible book.
We also think the Australian banks are vulnerable to an increasingly shaky local housing market. Australian residential mortgage lending makes up roughly 60% of total loans at Westpac and Commonwealth. The Australian housing market has been incredibly strong since the start of 2008, with overall home prices in the country up 45%, while prices in Sydney and Melbourne are up even more at 72% and 55%, respectively. By comparison, U.S. home prices are flat over the same period. Consequently, affordability has become stretched (among the worst in the world), and a speculative environment has emerged reminiscent of other recent housing bubbles (amazingly, auctions of individual homes are broadcast live on TV). The banks are at the epicenter of this behavior, with interest-only loans representing around 40% of new business, and investment properties accounting for over 50% of new loan originations in recent periods at Westpac. Importantly, we are now seeing a strong supply response that could lead to sharp declines in home prices in the coming quarters. Crane counts in key markets along with housing starts and housing completions are all hitting all-time highs. We think the market will struggle to absorb all of this new supply due to slowing population growth, flat to declining rents and decreased international buying (particularly out of China). Despite these risks, loan loss reserves at Westpac and Commonwealth are extraordinarily low at just 0.5% of their gross loan balances. By contrast, Citigroup has reserved 1.9% of its gross loan balance for losses (3.5x greater than the Australian banks). Moreover, the loan to deposit ratios at Westpac and Commonwealth average approximately 125% (Citigroup’s is just 70%), highlighting the Australian banks’ heavy reliance on short-term (and largely offshore) funding markets.
With the turn in the Australian housing market likely soon upon us, we think investors will regret paying a multiple of 2.5x book value for banks that may be vulnerable to significant write-downs. Current loan loss provisions booked through the income statement at Westpac and Commonwealth would need to more than double simply to be comparable to the current impairment expenses at large U.S. banks today, and that excludes the one-time boost needed to match their overall stock of allowances. Provisions would likely be even higher than the current U.S. run-rate if the Australian housing market experiences a serious downturn. Utilizing a conservative scenario where provisions simply rise to the current U.S. run-rate, earnings would fall by 15% for these banks. With increased losses, lower earnings and thin capital levels, we believe these stocks could soon trade more like their global peers. At 10x this revised earnings level, Westpac and Commonwealth would be worth 40% less than the current share prices but would still trade at 1.5x book value, well above most other global banks. If the Australian housing market runs into more serious problems as we suspect could be the case, further downside in these stocks would be likely.
Core Laboratories (Short)
Earlier this year, we initiated a short position in Core Laboratories, a $5 billion market capitalization oil services company, and we added to our position during the quarter. We suspect investors in Core Labs believe they own a “safe,” high quality business that is experiencing temporary cyclical pressures, allowing them to participate in meaningful upside when oil prices eventually recover. Remarkably, this optimism has kept the stock at roughly the same price as October 2014 when oil prices were almost double current levels and Core Labs’ 2016 earnings were expected to be four times greater than current 2016 forecasts. Although you wouldn’t know it by looking at the stock price, times are tough at Core Labs – so tough in fact, the company recently completed a surprise $200 million equity offering to ensure that it would not trip any debt covenants. At 60x EBIT and 80x earnings, investors are paying a steep price in anticipation of catching the rebound. We believe the pressures facing Core Labs are not going away anytime soon and investors are highly likely to be disappointed in the coming quarters.
Core Labs’ largest segment and crown jewel is its reservoir description business. The company takes rock and fluid samples and analyzes them for customers to quantify the level of hydrocarbons, measure how quickly those hydrocarbons can flow and determine the mix of oil, gas and water in the reservoir. The business has historically grown at reasonable rates with solid EBITDA margins. The next largest segment is production enhancement, a business largely driven by the sale of perforating guns and charges that are used to blast through well casings. The segment is highly dependent on North American shale activity and saw strong growth until 2015. This business