Longleaf Partners Fund commentary for the third quarter ended September 30, 2016.
Longleaf Partners Fund delivered a hefty 11.07% in the third quarter, taking the year-to-date (YTD) return to 18.32%. In spite of above normal cash levels, our results far surpassed the S&P 500 Index’s 3.85% return for the last three months and 7.84% for 2016. Over the last twelve months, the Fund has more than doubled our annual absolute goal of inflation plus 10% and outperformed the index.
The sustained environment of slow economic growth and low interest rates has reduced capital costs associated with acquisitions and spurred consolidation that can increase not only revenues but margins. Most of our companies were positive contributors this quarter. Actual or anticipated successful integration of mergers and acquisitions, along with transactions that strengthened balance sheets, helped drive our strong performance. Chesapeake Energy sold assets and bought debt below face value. LafargeHolcim also reduced debt through asset sales and captured synergies from last year’s merger. FedEx raised guidance in anticipation of the benefits from its TNT acquisition and raised margins in its Ground and Express divisions. CK Hutchison gained approval for a merger that will create the largest mobile phone operator in Italy.
Capable management partners deserve particular credit for achieving returns of this magnitude when economic growth rates are not powering earnings. Assessing and engaging with managements is an important part of our process with an emphasis on capital allocation options. We are gratified by the strong execution of our CEOs and boards as they focus on building value per share.
Longleaf Partners Fund – Contributors/Detractors
(3Q portfolio return; 3Q Fund contribution)
Chesapeake (+112%; +4.0%), one of the largest U.S. producers of natural gas, oil, and natural gas liquids, was the top contributor to performance during the quarter. Early in the year we swapped our equity position for near-term bonds and preferred stocks which offered equity-like returns and a shorter horizon for value recognition. As management delivered good results, the bonds approached par. Consequently, we sold all of the remaining bonds over the last three months. On the final day of the quarter, we exchanged all of our preferreds into equity at a price well below our appraisal. In the quarter, both operating expenses and capital expenditures continued to improve, additional debt was retired below face value, and management reduced distribution costs through restructuring agreements with Williams and selling the Barnett assets. The company is pursuing more cost improvements and increased its asset sale target for the year to $2 billion after surpassing the original $1 billion goal. Asset sales plus proceeds from the recent upsized term loan and convertible debt offering, which raised more capital at better terms than expected, should cover the company’s obligations for at least three years. We remain confident that CEO Doug Lawler and Chesapeake’s board will continue to successfully navigate the company through this lower-for-longer commodity price environment.
LafargeHolcim (+31%; +1.5%), the world’s largest global cement, aggregates, and ready-mix concrete producer, was also a top contributor. During the quarter, CEO Eric Olsen and his management team made progress with respect to divestitures, merger synergies, and pricing. The company sold assets in India, Sri Lanka, and Vietnam at attractive prices. These sales coupled with previously announced transactions in South Korea, Saudi Arabia, and China got the company to its 2016 CHF3.5 billion divestiture goal ahead of schedule and helped LafargeHolcim reduce its debt from CHF18 billion to CHF13 billion in 2016. An announced CHF1.5 billion of additional divestitures are targeted for 2017, which will move the balance sheet to investment grade quality and allow management to return free cash flow (FCF) to shareholders. Expected synergies from last year’s merger between Lafarge and Holcim have come through on target with an expected CHF450 million this year. Industry cement pricing is moving in the right direction. During the quarter, prices increased 2.2% sequentially versus 1.2% in 1Q 2016 and -1.6% in 4Q 2015. LafargeHolcim now has higher prices in almost 70% of its markets versus 2015 levels. Even though volumes did not grow in all markets, higher prices and large cost savings resulted in strong earnings before interest, taxes, depreciation, and amortization (EBITDA). Despite the stock’s rise, the company remains one of the more undervalued securities in the portfolio.
FedEx (+15%; +1.2%), the global transportation and logistics company, was a leading contributor. The company reported strong results across the board, with an increase in margins in its Express and Ground divisions. Ground had 10% growth in average daily volumes year-over-year and announced a price increase of 4.9% in 2017, once again demonstrating the company’s strong pricing power even in a time of low inflation.
Management indicated that the integration of TNT, which the company acquired in May of this year, would generate at least $750 million of annual synergies across its network over the next few years. The company’s tax rate should also benefit from more profits based in Europe. The company raised guidance for fiscal year 2017 and continued to buy back shares. Our appraisal increased, and in spite of the price appreciation, the stock remains significantly discounted.
CK Hutchison (+18%; +1.1%), the Hong Kong-based global conglomerate, was a top performer in the quarter. Following the initial shock of Brexit in late June, the company’s limited impact from a weaker pound became more apparent. Regulators rejected the company’s proposed acquisition of O2 by its UK mobile phone business Three UK, but CK Hutchison received approval in September for the merger of Three Italia with Wind in a 50/50 joint venture between CK Hutchison and VimpelCom. This combination will create the largest mobile operator in Italy with approximately 37% market share versus the two remaining primary competitors. CK Hutchison expects at least 5 billion euros of synergies from this merger, with most to be delivered within three years of the transaction closing in the fourth quarter of 2016. These projected synergies exclude any upside from selling assets and spectrum, utilizing tax losses, or refinancing expensive debt. CK Hutchison’s European businesses grew nicely, and the company expects to see solid global growth, particularly in its telecom and retail segments. Li Ka-shing and his son, Victor, continue to build value for shareholders.
CONSOL Energy (+19%; +1.1%), the natural gas and Appalachian coal company, added to the Fund’s return. CEO Nick Deluliis and the board, led by Chairman Will Thorndike, continued to pursue monetization of assets with the goal of ultimately separating the coal and gas businesses. Following the disposition of its metallurgical coal assets in the first half of the year, CONSOL sold its high-cost Miller Creek and Fola mines to a privately owned buyer who valued them higher than we did. The company also lowered costs across all segments and delivered positive free cash flow once again. Higher coal and gas prices drove strong returns at CONSOL’s holdings in coal master limited partnership (MLP) CNXC and midstream pipeline MLP CNNX. Sales of other companies’ exploration and production assets in Appalachia highlighted the value of CONSOL’s assets.
Level 3 Communications (-10%; -0.6%), the global fiber and integrated communications network company, was the Fund’s primary detractor in the third quarter. In spite of disappointing flat revenue growth, our appraisal increased with the company’s reported higher free cash flow coupon. In local currencies, the company’s Enterprise business grew across regions, with a particularly strong 10% rate in Latin America. Currency translations, however, created a significant drag in the quarter, turning Latin American and Europe, Middle East, Africa (EMEA) reported top line results negative. More importantly, total EBITDA in the quarter, as well as projections for the remainder of 2016, were exactly in line with expectations. The company’s growing cash position after over $260 million of free cash flow (FCF) in the quarter took net leverage to 3.5X EBITDA. We remain confident that CEO Jeff Storey and his team will continue to execute and will ultimately close the gap between the stock price and corporate value.
We sold health and wellness company Philips in the quarter. Although we applaud actions management took over time to address the conglomerate discount, including the recent partial initial public offering of its lighting business, the execution took longer than expected and reduced our confidence in the case. Philips returned 159% over the course of our investment.
After a multiyear bull market fueled by low interest rates, we continue to have difficulty finding new qualifiers. Our successful returns have meant portfolio sales as some holdings moved closer to our appraisals and became overweight. We managed to deliver double-digit returns in the quarter even though cash rose to 25%. Because our appraisals grew at many of our companies, the Fund remains attractively priced at a low-70s% price-to-value (P/V). We believe that the qualitative and financial strength of our companies will be important if faced with a more challenging environment, and our aligned partners in our competitively advantaged holdings will continue to deliver outsized returns over time.
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