Mittleman Investment Management Q2 2016 letter some interesting positions including Rallye where the hedge fund takes issue with Muddy Waters
The three biggest contributors to our Q2 2016 performance were Sberbank of Russia (SBRCY): $6.94 to $8.73 (+25.8%), CMIC Holdings (2309 JP): $12.62 to $15.32 (+21.7% with dividend), and Rallye SA (RAL FP): $17.37 to $17.24 (+7.4% with dividend).
The three most impactful detractors from our Q2 2016 performance were Revlon (REV): $36.41 to $32.18 (-11.6%), Intralot SA (INLOT GA): $1.29 to $1.00 (-22.5%), and ABS-CBN Holdings (ABSP PM): $1.24 to $1.01 (-17.8% with dividend).
After strong out-performance in Q1, our portfolio dropped slightly in Q2 while the market indices gained ground, narrowing our lead year-to-date. Yet, we believe our holdings remain remarkably undervalued, with 70%+ upside potential to fair value.
After a 20% gain in Q1, Sberbank of Russia gained another 25%+ in Q2, putting the stock up 51% year-to-date. Sberbank’s earnings are recovering sharply from the recession from which Russia appears to be slowly emerging, and we’ve raised our estimate of fair value from $12.50 to $14.50, which would be a P/E ratio of 12.5x the $1.16 in earnings per ADR that the analyst community expects the company to produce in 2016, and a 1.8x book value multiple of its $7.88 per ADR net tangible book value. Our $14.50 per ADR fair value estimate implies 66% upside from SBRCY’s quarter-end price of $8.73. In a report released July 25th, J.P. Morgan strategist David Aserkoff recommended Russian stocks as a “relative safe haven” calling the stocks “undervalued, under-traded, under-owned and with the best dividend yield of any major emerging market.” He named Sberbank his top pick. One year ago, with Sberbank at about half of its current price, fears about the depth and duration of the recession in Russia kept most investors away; so, it’s encouraging to see reason begin to replace panic. That said, our other remaining investment in Russia, Gazprom (OGZPY), is still lagging, but we expect similar upside potential will be realized there eventually. As with oil, there is a global glut of natural gas, but supply gluts don’t last forever, so with Gazprom trading at 3.4x EBITDA and paying a 5.6% dividend yield at current price, we’re content to wait for better prices.
Our Russian investments could head south again if the price of oil drops again, taking the Russian Ruble with it, but we think a more likely scenario is that oil prices stabilize around current levels and head higher over time. Also, we continue to expect economic sanctions imposed on Russia by the U.S. and the E.U. to be lifted before the next World Cup is held in Moscow in 2018, which should boost confidence, growth, and valuations. That is unless Putin invades another country, or pushes further into Ukraine. Our (likely worthless) macro-economic musings aside; we do believe that Sberbank and Gazprom are truly too big to fail, and too cheap to ignore, and their dividends pay us well enough to wait for that cheapness to be resolved.
CMIC Holdings Co., Ltd (2309 JP), our second best gainer in Q2, is one of the largest Japanese CROs (Contract Research Organization) serving the pharmaceutical industry in Japan. Their core CRO business of providing outsourced clinical trials has been doing consistently well, but newer ancillary business lines like CMO (Contract Manufacturing) have been underperforming over the past few years. The stock surged in late April on a stronger than expected earnings report and guidance; an encouraging sign that they may be getting past the problems with their CMO business (a manufacturing facility purchased a few years ago that was under-utilized due to an unexpected contract loss). This is a highly recession-resistant business with years of growth ahead as Japan’s already aged population grays further and the pharma industry in Japan increasingly looks to outsource clinical trials and other service functions to catch up to their multi-national competitors in this regard. CMIC is also expanding to China, South Korea, and Vietnam. We see 30% upside from current price to our $20 per share estimate of fair value, targeting a 9x EBITDA multiple, versus a 12x EBITDA multiple for the larger multi-national peer group such as Quintiles Transnational (Q $74), Charles River Labs (CRL $87), and PAREXEL (PRXL $65). Those larger competitors have higher EBITDA margins, commensurate with their larger scale, but CMIC should grow faster from its smaller base and with an improving EBITDA margin as it scales up and excess manufacturing capacity at its CMO division is steadily put to use. The company’s Chairman and CEO, Kazuo Nakamura, who founded the company in 1992, retains a 40% stake. Mittleman Brothers controls 5.4% of CMIC’s shares, and we also note that other smart value-oriented investors own large stakes in CMIC, such as Dalton Investments (11.4%) and Taiyo Pacific Partners (4%), backed by Wilbur Ross.
The third biggest contributor to our Q2 performance, Rallye SA (RAL FP), was actually down slightly in stock price during the quarter, from $17.37 to $17.24, but it paid out its entire annual dividend of €1.83 (USD 2.03) per share as it normally does on May 31st . So after a 30% withholding tax on this foreign dividend, the boost to the total return from this stock was about +8% in Q2. Rallye is a publically traded leveraged buy-out vehicle controlled by French billionaire Jean-Charles Naouri. Its primary asset is a 50.5% stake in Casino Guichard (CO FP), the 11th largest supermarket company in the world, with operations primarily in France, Brazil, and Colombia. The stock tanked on December 17, 2015 when short-seller Carson Block issued a report in which he claimed Casino Guichard was worth single digits and that Rallye was worth $0. We disagreed with his thesis and bought more as the stock price plunged on his report. Casino Guichard has since sold its operations in Thailand and Vietnam for combined proceeds of €4.2B, an outstanding valuation of about 11x EBITDA, and more than €1.1B above what Carson Block had estimated those assets were worth in his report. His firm, Muddy Waters, now appears to have closed out their short positions in Rallye and Casino Guichard (France requires that short-sellers disclose their positions), so perhaps his negative outlook on these shares has changed. Regardless, we admire Mr. Naouri’s track record in acquiring high-quality grocery store chains and then developing the real estate around them, and regularly selling the fully developed assets at excellent prices. Mr. Naouri, who owns 55.3% of Rallye’s stock, is focused on free cash flow generation and dividends. Annual dividends paid by Casino Guichard have grown from €2.08 per share (€233M) in 2005 to €3.12 per share (€353M) in 2015, and for Rallye from €1.68 per share (€65M) in 2005 to €1.83 per share (€89M) in 2015. At current price, the dividend yield on Rallye is 11.8%. At our $28 per share estimate of fair value (+62% from current price) the dividend yield would be 7.3%. As Brazil comes out of recession, and as Colombia reaps a peace dividend after the June 23, 2016 signing of a ceasefire agreement ending 52 years of civil war with FARC rebels, and as Rallye continues to opportunistically monetize the $4B in owned real estate they