Corsair Capital Management commentary for the third quarter ended September 30, 2016.
Dear Limited Partner:
For the third quarter ended September 30, 2016, Corsair Capital was up an estimated 2.5%* net, after all fees and expenses, bringing our 2016 performance to 3.1%*. Corsair Select was up an estimated 3.2%* net, after all fees and expenses, bringing our 2016 performance to 4.4%*. Since inception in January 1991, Corsair Capital’s compounded net annual return is 12.6%. Since inception in January 2004, Corsair Select’s compounded net annual return is 10.8%.
Equity markets continued to rise in the third quarter as interest rates generally continued to decline around the globe. The bull market in bonds (i.e., declining interest rates) has now lasted some 35 years, dating back to October 1981 when the yield on the 30-year Treasury bond reached 15.23% – what a difference a generation or two makes. Just a few years ago Sub-Zero only meant an appliance brand and not the investment return on much short-term sovereign debt!
As we have discussed in a number of our past letters, very low returns on bonds have all sorts of investment implications, not the least of which is very high theoretical equity valuations based on dividend discount or discounted cash flow models. Likewise, this great reduction in interest rates caused by purchases of bonds by Central Banks (in the hopes of stimulating inflation and growth) has forced investors to look for yield outside of fixed income securities. As one investment pundit put it, “dividend paying stocks are the new long-term bond.”
Another investment theme of late has been the popularity of investing into index funds (both ETFs and mutual funds). Over the years, the pendulum has swung back and forth between active management and passive investing. Lately, the pendulum is clearly in the passive camp, taking with it money flows out of active managers’ hands and into the index funds. This movement of funds means, on the margin, there is selling pressure on non-index names and incremental demand for the individual stocks in the major indices. For a while, this movement of money exacerbates the situation as investors flock to what currently is working (to us, akin to market flows in 1998 and 1999). However, for the long-run, we believe this means non-index stocks are under-owned and undervalued, while the opposite is true for those in the major indices.
Furthering this investment theme, Central Banks have recently started to buy stocks in addition to their vast bond purchases. In particular, it is thought that the Bank of Japan, the Swiss National Bank, and an affiliate of China’s Administration of Foreign Exchange have been large buyers of global equities, likely on a market weighted indexed basis. We believe this buying has clearly buoyed the largest stocks within the largest global indices.
In a recent interview, Joel Greenblatt, Columbia University professor and professional investor, describes the futility of investors chasing recent investment trends. “Multiple studies will tell you there is very little correlation between the past one, three, five [year periods] and the next one, three, five. So people should really look for managers that follow a process they can believe in and stick with over the long term.” Greenblatt furthers this point by mentioning his discovery that the best performing fund between 2000 and 2010 was up 18% per annum. However, on a dollar-weighted basis, investors in the fund actually lost money (!) as they chased after good performance and left after the poor years.
As we start the last quarter of the year, interest rates have ticked up a bit. Some analysts believe this is due to new regulations that affect prime money market funds, which took hold as of early October. As a long delayed reaction to the financial crisis of 2008, when regulators became concerned about the potential collapse of certain money market funds holding Lehman Brothers debt, these new rules allow prime money-market funds to impose redemption fees and/or halt redemptions in times of market stress. While these rules might make the “system” safer in the long-run, in the short-run, investors have reacted by leaving these funds. Some believe this shift in holdings has, in turn, caused a rise in the cost of hedging currencies for overseas investors looking to pick up yield amid ultra-low or negative rates at home. Thus, higher interest rates here are needed to make their swaps worthwhile. Once this shift in money market holdings is over, however, it is quite possible for hedging costs to normalize to previous levels and for interest rates to tick back down.
Finally, the election season is upon us. What can we say that hasn’t already been said elsewhere? No matter who is elected President in November, there will be a large portion of the population very unhappy with the result. Of course, this is well known. Less well followed here in the U.S. are the elections in Italy, including a referendum on changes to the Italian Constitution. Prime Minister Matteo Renzi has warned that if he does not get the authority to proceed with reforms, he will resign, which might put Italy inadvertently on Britain’s European Union exit path. While the betting is currently with the Prime Minister, this is a reminder that shortterm pot holes are an inevitable part of the investing game.
Generally speaking, our outlook is for slow growth around the world with interest rates remaining at below historical average rates. We expect to continue to own a U.S.-centric portfolio quite different than that of the S&P 500. Most importantly, we believe our 26-year investment practice of investing in companies going through change will continue to stand us in good stead over the long term.
Corsair Capital Management – Portfolio Update
The largest contributors and detractors for the quarter were:
Quintiles IMS Holdings (“Q”), an investment we featured in the Appendix of our Q2 2016 investor letter, rose 24% for the quarter. The stock’s performance was driven by strong standalone Q2 results at both Q and IMS. Q reported revenue and adjusted EPS above consensus expectations and raised full year EPS guidance. Most importantly, after a disappointing book-to-bill in Q1, Q posted a book-to-bill of 1.6x at its core Product Development segment for Q2, which eased concerns and allowed investors to focus on the pro forma company. IMS posted an EPS “beat and raise” as well for the quarter, providing significant momentum for the shares as the announced merger with Q drew closer to completion in early October. Our view is that the new combined company’s earnings power will grow toward $8.00 per share by 2020 and is a high-quality business deserving an earnings multiple of 20x or more. Q stock closed the third quarter at $81.06.
Voya Financial Inc. (“VOYA”) increased by 16% during the third quarter as investors began to regain confidence in its ability to manage through a protracted low interest rate environment. As we noted in our last letter, VOYA’s stock has struggled over the past 12 months due to concerns around earnings and capital sensitivity to interest rates. During the quarter, VOYA gave investors further disclosure around interest rate sensitivity, which was far less draconian than some bears had assumed. Additionally, the company announced solid Q2 results and continues to execute towards its 2018 goals. Both pieces of news were well received by investors. Our core thesis on VOYA still holds; management should continue improving ROE towards its 2018 goals, exploring further earnings/capital opportunities, and returning excess capital/FCF to shareholders. Without using aggressive assumptions or multiples, VOYA stock could move back into the $40s and eventually even higher. VOYA management seems to believe its stock is materially undervalued as the company repurchased ~$270MM worth of stock or more than 4% of total shares outstanding in Q2 alone and still has enough excess capital (before FCF to be generated in the future) to purchase an additional 13% of its shares outstanding, which we expect them to utilize over the next year. VOYA closed the quarter at $28.82.
Colony Capital/Northstar Asset Management/Northstar Realty Finance (‘CLNY’, ‘NSAM’, ‘NRF’), which are slated to enter into a tri-party merger to create a large-scale diversified REIT, gained 19%, 27%, and 15%, respectively, during the quarter. The third quarter saw a reversal of the second quarter’s sharp decline as the companies collectively released two proxies, updated pro forma figures, and announced a $1B share repurchase/debt pay down program. This program, which can be executed after an affirmative shareholder vote, was particularly important as it helped investors better understand how the merged entity will manage its excess cash. We expect the proposed deal to close as investors realize the substantial synergy opportunities and the likely multiple re-rating from the collapse of the NSAM/NRF externally managed REIT structure. CLNY, NSAM, and NRF shares finished the third quarter at prices of $18.23, $12.93, and $13.17, respectively.
Olin Corporation (“OLN”) fell 17% after pre-announcing weaker than expected Q2 earnings as customer outages and higher input costs weighed on results. Prior to the preannouncement, positive sentiment in OLN stock continued as the industry was able to realize three consecutive months of price increases for caustic soda. However, a number of domestic customer outages, lower near-term benefits from pricing moves, and adverse raw material movements all resulted in a surprise FY guidance takedown. While we were disappointed with how Q2 came together, we firmly believe that the chlor-alkali market is on the upswing with OLN set to benefit disproportionately, given its scale. At current levels, we believe investors are heavily focused on short-term raw material pressures, which once again skews the risk-reward in our favor. OLN shares finished the third quarter at a price of $20.52.
Despite a solid Q2 report and continued momentum at its newest asset Zulily, Liberty Interactive Corp (“QVCA”) shares fell 21% as management warned that its QVC segment had experienced mid/high single digit sales declines in the last few weeks of the quarter and into Q3. Given the company’s history of stable low/midsingle digit growth and the loyalty of its customer base, this was a significant and unexpected development. The company has attributed the deceleration in sales to several factors that hurt the business simultaneously, including an FDA warning regarding a popular hair care product and a challenging promotional retail environment during the spring/summer. As a highly data-driven company, QVCA pointed out that viewership had not changed and it did not see any signs of deterioration in its model. Liberty CEO Greg Maffei reiterated later in the quarter that there has been no secular change in the business and that he has already seen the “green shoots” that point toward a recovery. Over the past three years, QVCA has repurchased more than 20% of its outstanding shares at approximately $26/share and post the second quarter’s announcement, has indicated its intention to continue significant repurchases. QVCA shares finished the third quarter at a price of $20.01.
As of October 1, 2016, the five largest positions in Corsair Select were Aon plc, IAC/InterActiveCorp, KAR Auction Services Inc., Orbital ATK, and Quintiles IMS Holdings Inc.
Thank you for your continued support and confidence. See the attached Appendix for a write-up of a current core investment. Please feel free to call us with any questions you may have at 212-949-3000.
Corsair Capital Management, L.P.
Appendix – Element Fleet Management Corp (EFN CN – CAD$ 12.95) – Market cap – USD$3.9B, EV – USD$14.6B
With its recent spinoff of ECN Capital (ticker ECN CN) Element Fleet Management (‘Element Fleet’) emerges as a pure-play provider of outsourced fleet management services with market leading positions in the US, Canada, and Australia. Now separated from ECN Capital, Element Fleet is a new stock that is well positioned for steady earnings growth and robust free cash flow generation. Given the fact that Element Fleet grew up inside of a commercial finance/leasing company, we think the separation will shine a brighter light on the fleet management business, which is characterized by steady growth given extremely high customer retention rates and very low credit losses. We believe Element Fleet has a reasonable path to 8-10% earnings growth over the next few years. With our 2017/18 EPS estimates at $1.15/$1.27, we think a market multiple of 15x generates 30-45% upside from today’s price.
Element Financial, Element Fleet’s predecessor company, was founded in 2007 as an asset/equipment lessor and subsequently made several major acquisitions in the fleet management space to become a scale player (TLS from Scotiabank in 2012, GE Fleet Canada in 2013, PHH Fleet in 2014, and GE US/Mexico/Australia/NZ Fleet in 2015). We believe GE’s desire to trim down its financing business and PHH’s desire to focus on its mortgage services created a unique opportunity for Element to consolidate the industry. It isn’t lost on us that GE Capital had previously tried to acquire PHH’s Fleet business just before the financial crisis to realize the same benefits of scale. We view Element’s decision to separate out its fleet management business in February 2016 as favorable given Fleet’s higher proportion of fee-for-service income, lower credit risk, and ability to generate substantial free cash.
While the fleet management industry is mature, industry consolidation along with advancements in technology and data management create an increasingly compelling value proposition for customers. Fleet managers claim that customers can realize cost savings between 10-20% from outsourcing, which, when combined with an underpenetrated commercial fleet industry, creates a favorable backdrop. In North America, fleet managers help clients finance vehicles predominantly via open-end leases (where residual risk lies with the customer, not the fleet manager) and offer a variety of complementary services such as vehicle remarketing, telematics, and fuel/maintenance services. In this industry, scale matters: the largest players are able to leverage size to optimally buy and sell vehicles and to absorb the fixed cost investment of the IT infrastructure needed to serve clients. Historically, client retention rates have been in the high 90s and credit losses have averaged somewhere between 0-15bps as customers operate their fleets in good and bad times and loss recoveries have been strong. The result is that Element Fleet can sustain a greater degree of financial leverage, which helps convert an attractive ROA into a meaningfully higher ROE with dampened exposure to economic or credit cycles.
With its leading market share, robust product offering, and broad access to the funding markets, Element Fleet is particularly well-positioned in this attractive industry. While Element Fleet has dominant market share in the outsourced fleet industry, 75-80% of the commercial fleets are still in-sourced, which remains a significant organic growth opportunity. While many assume Element Fleet is little more than a financing business, Element Fleet derives 55%+ of its revenues from various fee-based services that tend to be sold as a package with the actual lease, which results in a significant recurring non-spread based revenue stream. Element Fleet also benefits from having a robust ABS program whereby it can securitize the open-ended leases it originates and effectively match its assets and liabilities from an interest-rate perspective while maintaining low funding costs. We believe that the limited credit, residual, and interest rate risk, combined with low capital expenditure requirements, make Element Fleet more of an outsourced business services company rather than a pure financing or residual-bearing, asset-intensive fleet/rental car service company. Finally, management, led by CEO Brad Nullmeyer and COO/President Dan Jauernig, brings decades of experience in asset-based financing, technology, and fleet management services. Both have proven their mettle at Element by successfully integrating the various acquired fleet managers onto a single platform without disruption.
Looking ahead, we expect to see mid to high single digit top-line growth driven by growth in the ‘earning asset base,’ which benefits from continued commercial fleet growth and Element Fleet’s ability to acquire currently self-managed or in-sourced fleets. Element Fleet’s top-line growth will be further accelerated by increasing service fee growth driven by increased penetration of services within its current customer base and introduction of new services. Growth in the EPS line should be helped by Element Fleet’s operating leverage and is expected to be in the 8-10% range. Thus, our estimated 2016 EPS of $1.05 should grow to nearly $1.27 in 2018. We believe this business warrants a mid-teens P/E multiple, which is where smaller, less diversified peers trade in Australia (ECX, SGF) and meaningfully below where pure-play fleet management service companies trade (FLT, WEX).
So what is the catalyst for a re-rating of the stock? We believe that while Element Fleet made up the bulk of the predecessor company’s earnings, it had been overshadowed by shifts in strategic planning for the predecessor’s other businesses. As a standalone entity, Element Fleet requires little equity capital to grow, which means that it can redeploy its free cash for accretive M&A and more substantial shareholder returns. Given that they are no longer restricted by secured debt covenants, we expect Element Fleet to take a hard look at share repurchases and also consider paying a more meaningful dividend. We also believe that disciplined M&A in the fleet management service space can then be leveraged across Element Fleet’s broad base of customers, benefitting both the customers and its own bottom line. Longer term, we see an opportunity for Element Fleet to begin reporting in US Dollars (considering 75%+ of its earning assets are in the US) and potentially list in the US, which would broaden its visibility among US investors.