Dan Loeb’s Third Point letter to investors for the first quarter ended March 31, 2015.
I founded Third Point on June 1, 1995 with $3.4 million in capital from five intrepid investors – all close friends and family – and my own nest egg. My goals were to compound at 20% and grow to $20 million in assets. Nearly twenty years later, we have been able to meet our initial return goals (despite over-shooting our asset base target) as a result of remarkable individuals who have come together to form our team. The keys to our success have been remaining entrepreneurial, creative, committed to organizational and individual improvement, rigorous about our process, and singularly focused on achieving superior risk-adjusted returns for our investors.
Today, we are finding opportunities primarily in equities in the US and Japan, in sovereign debt, and in structured credit. We added several positions of significant size over the past few months that reflect geographic and sector diversity. We have invested in more single name shorts this year than in all of 2014 combined. Our portfolio performed well in Q1, beating the index by over 2% with a little over half of the value at risk.
So far in 2015, the real excitement has been overseas, while the S&P is close to flat. Accommodative monetary policy in Europe, Japan, and China has encouraged investors to adopt QE pattern recognition and plow capital into markets where central banks have opened pocketbooks. In the US, markets have been mixed as investors await the Fed’s looming rate hike and worry about dollar strength impacting earnings and the economy.
We remain constructive on the US for three reasons: 1) economic data should improve in the next few quarters; 2) the Fed does not seem to be in any rush to move early and a June rate hike seems unlikely; and 3) while investors are focused solely on the first rate raise, we think the overall path higher will be gradual, in contrast to previous rate shifts. These factors should create an environment where growth improves and monetary policy stays flexible, which is generally good for equities (higher multiples notwithstanding). We may follow last year’s playbook and ignore the old adage to “sell in May and go away.”
Third Point – Select Portfolio Positions
Equity Position: Yum Brands
Third Point holds a significant stake in Yum! Brands (“Yum!”), the second largest global quick service restaurant company (“QSR”), whose brands include Kentucky Fried Chicken, Pizza Hut, and Taco Bell. We initiated our position in the first quarter based on our view that the company was in the early stages of turning the page on recent troubles in its Chinese business. We believe this development should neutralize the largest overhang on the stock, set the stage for a dramatic profit recovery over the next 12-24 months, and change the public market narrative around long-term shareholder value-creation for the company.
Over the past two decades, Yum! has built an enviable consumer franchise in China and the company now operates about 7,000 KFC and Pizza Hut restaurants in more than 1,000 cities and has three times as many restaurants as its closest competitor, McDonald’s. Approximately 80% of those units are owned and operated by the company and the China division is now the largest earnings contributor to the group, accounting for about 1/3 of overall profits.
Yum! has struggled recently in China due to two supplier-related food safety incidents. The first, in November 2012, involved the level of antibiotics and antivirals used by some of the company’s poultry suppliers. The second, in July 2014, concerned the use of expired meat by a different supplier. Food safety is a highly sensitive issue in China and the two incidents, combined with a more dynamic competitive environment, have significantly reduced the company’s profitability in China. Today, the average unit in China generates sales of $1.3 million at a 15% restaurant-level operating margin – compared to $1.7 million in sales at a nearly 20% margin before the first food safety incident – and operating profits per unit are down about 40%.
We have spent substantial time assessing Yum!’s recovery potential and examining whether its status as a “repeat offender” has irreparably damaged the brand in China. Our research suggests that the KFC brand (75% of units in China) continues to resonate strongly with local consumers across a variety of important dimensions, including food quality, value, convenience, and customer experience. By an overwhelming majority, local consumers believe the food at KFC is safe or at least as safe as other restaurant options. Perhaps most importantly, local customers continue to visit KFC, albeit less frequently, suggesting the company can increase traffic with better execution. As a rule of thumb in the restaurant industry, it is easier to generate more business from existing customers than it is to capture new ones or win back those who have left the brand.
We have also been encouraged by recent actions that Yum! corporate and local management have taken to stabilize the business and return it to growth. The senior leadership team in the US, led by new CEO Greg Creed, is taking a more active role in Chinese operations, an important departure from previous management’s practices. Mr. Creed has visited China with a consumer insights team to review local operating and marketing plans. Senior members of the Chinese leadership team have visited their peers at Taco Bell in California to learn best practices from one of the QSR industry’s great success stories. In addition, management has beefed up the local talent bench with key hires, while new menus and marketing plans are rolling out and restaurant labor productivity initiatives are bearing fruit. These efforts seem to be working. Last week’s Q1 earnings revealed some early signs of stabilization: comps showed sequential improvement for the first time since the second food safety incident and restaurant margins held up surprisingly well given the decline in sales.
With China stabilizing and on the road to recovery, we see scope for significant earnings growth ahead as profits recover in the near to medium term and exceed prior peak in the long-term as the company opens more restaurants to meet the needs of the expanding Chinese middle class. Management currently sees the potential for more than 20,000 KFC and Pizza Hut restaurants in China, nearly three times as many as today. This “open-ended China growth” story once captivated Yum! investors and we believe it could again, especially since returns on invested capital remain high and there are few more effective ways for investors to bet on Chinese middle class consumers.
While Yum! investors have been focused on the China story, the stock market has fallen in love with the strong cash flows associated with high franchise restaurant systems that have the ability to grow both units and same store sales. That is what Yum! looks like outside China. Management is already taking steps to increase the mix of franchise units from 91% to 95% by 2017. KFC (nearly 50% profits outside China) and Taco Bell (nearly 33% profits) are currently delivering growth while Pizza Hut (only 20%) treads water. We see room for further improvement though, and we are encouraged by signs that the