Longleaf Q1 letter to investors
During the quarter we exited DIRECTV (NASDAQ:DTV), a highly successful core holding in our U.S. and Global accounts for over a decade. We discuss our DTV experience not to showcase one winner, but because the investment illustrates the process and approach we follow for holdings across all mandates and highlights some of Southeastern’s unique research strengths.
History of DIRECTV (NASDAQ:DTV) Investment (based on Longleaf Partners Fund)Sometimes we can own a company in indirect ways that create part of the discount to intrinsic worth. In the case of DTV, we owned the underlying business via three different stocks over our thirteen-year holding period as shown on the chart that follows. Initially, in 2001 we bought GMH, the tracking stock that General Motors created for the Hughes division that included all of its satellite businesses. By early 2004, the company had been spun fully out of GM and renamed DIRECTV Group. Over the following four years, we opportunistically added to and trimmed our position. In early 2008, John Malone exchanged Liberty Media’s (LMDIA) News Corp shares (NWS) for the 40+% of DTV that NWS owned. We previously had purchased Liberty Media Corp, the precursor to LMDIA, and the 2008 transaction increased our underlying ownership in DTV.
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Throughout 2008, we swapped DIRECTV (NASDAQ:DTV) for LMDIA which traded at a steeper discount to underlying value. In the financial crisis, although DTV’s business remained remarkably stable, LMDIA shares became severely discounted when debt at other Liberty affiliates cast a shadow on LMDIA. We made sure we understood the obligations of each Liberty entity and John Malone’s intentions, and then took LMDIA to a “double weight” (10%) position while maintaining our direct DTV stake. In 2009, LMDIA and DTV merged. Over the next four years, the intrinsic value of the company grew as did the stock price. We trimmed our position as the price-to-value (P/V) gap closed and completely exited in the first quarter of 2014 when the stock reached our appraisal. Because of the strength of DTV’s franchise and management partners, value could continue to build unabated. We followed our discipline to exit when the price reached our appraisal, leaving no margin of safety in the stock.
In every new investment, we analyze why a stock is cheap and how our view of the business differs from the market’s view. Initially, DIRECTV (NASDAQ:DTV)’s core strongholds were rural subscribers with no cable alternatives and premium subscribers willing to pay for the technologically superior digital picture and recording as well as exclusive sports programming. The most valuable DTV subscribers were immune from the market’s concern – the “triple play threat” of a single provider for video, voice and broadband. Subsequent subscriber growth and pricing power as shown through rising ARPU (average revenue per user) were proof of DTV’s advantages.
When we own a name we evaluate how the business evolves and adjust our assumptions about competitive advantages and value growth. Over time, DTV’s U.S. subscriber base grew to more than 20 million, and growth inevitably slowed. Cable providers developed better picture quality and digital recording, and “cord cutting” (leaving pay-TV for video delivery alternatives) also received increasing attention. Verizon invested heavily to become a competitor. Satellite provider DISH’s Hopper grew more competitive due to combining cord cutting with high definition recording. NFL programming became less exclusive. As the competitive landscape changed, at three different points over our holding period, we appointed an analyst to serve as “Devil’s Advocate” (DA) to challenge the entire investment case and appraisal. Although DIRECTV (NASDAQ:DTV)’s U.S. ARPU continued to increase, we reduced our appraisal multiples to account for the increasingly competitive U.S. environment. Management also recognized the U.S. evolution and developed Latin American markets where the lack of infrastructure minimized cable competition. Over the last five years, we adjusted our appraisal as DTV transitioned from a primarily U.S. provider to a company with almost half of its value attributable to its Latin American operations. However, we recently lowered our appraisal of the Latin American business based on currency fluctuations and other geopolitical developments. While shorter-term conditions made a lower appraisal unavoidable, we remained very bullish on the company’s long-term prospects in Latin America.
See full letter: Longleaf Letter to Shareholders
Longleaf Partners Fund Management Discussion
Level 3 Communications, Inc. (NYSE:LVLT) 18% in the quarter, making it the Fund’s largest contributor. This fiber and networking company’s strong results exceeded expectations largely due to growth in the Enterprise business, and management issued higher 2014 guidance. Over the last year since Jeff Storey became CEO, the stock has risen 93% reflecting the expansion of operating margins and improved balance sheet. Level 3 is now cash flow positive with value increasing. The stock remains one of the most discounted in the portfolio even after the significant run up since Storey’s appointment. DIRECTV (DTV) added 9% with strong U.S. subscriber and ARPU (average revenue per user) growth. U.S. churn was the lowest in five years. We sold the stock as price responded strongly to the company’s results and reached our appraisal value. As discussed in our letter to shareholders, we are especially grateful to CEO Mike White and his predecessor Chase Carey for driving the strong value growth that helped
us earn over 385% in this investment since it began as GMH in 2001.
Cheung Kong and CONSOL Energy also contributed nicely in the quarter, each gaining 5%. Cheung Kong, the Asian based global conglomerate, appreciated as the company made value-enhancing asset sales and 50% owned affiliate Hutchison Whampoa Limited (HKG:0013) (OTCMKTS:HUWHY) reported a 20% earnings increase. After almost a decade of investments outpacing disposals, Chairman and primary owner Li Ka-shing quickened the pace of asset sales during the quarter. China contracted land sales rose 27% year-over-year. EBIT (earnings before interest and taxes) margins on property sales in both China and Hong Kong were near 40%. Power Assets, majority owned by Cheung Kong Infrastructure, spun off and listed Hong Kong Electric to maximize cash distributions to shareholders and cater to yieldhungry investors. HWL announced the sale of 25% of A.S. Watson Group, the world’s largest health and beauty retailer, to Singapore fund Temasek Holdings at a price in line with our appraisal. Shareholders will receive a special dividend from the sale proceeds.
CONSOL Energy Inc. (NYSE:CNX)’s long-term strategy to focus on natural gas exploration and production is well underway after the sale of five large thermal coal mines in West Virginia to Murray Energy. The company expects to grow gas production by 30% in 2015 as well as 2016. Management continues work on monetizing the company’s infrastructure assets. Insider purchases during the quarter signaled confidence in the company’s future. As expected, CONSOL announced that long-time executive Nick Deluliis joined the board and will be promoted to CEO and President replacing Brett Harvey, who will become Executive Chairman.
Loews, the diversified holding company owned and managed by the Tisch family, detracted from the Fund’s return in the quarter, declining 9%. Loews’ largest holdings are three publicly traded subsidiaries: property and casualty insurer Cna Financial Corp (NYSE:CNA) (90% owned), offshore contract driller Diamond Offshore (DO) (50.4% owned), and natural gas pipeline Boardwalk Pipeline Partners, LP (NYSE:BWP) (53% owned). During the quarter, CNA reported solid earnings and combined ratios, but DO and BWP disappointed. As large exploration and production companies reined in spending, demand for offshore drilling fell, reducing day rates and rig utilization at DO. Higher gas production in the Northeastern U.S. has reduced demand for pipelines serving that region while the cold winter lowered gas storage. BWP cut its dividend to invest in expanding pipeline reach for higher long-term EBITDA (earnings before interest, taxes, and amortization).