To Our Shareholders,
For the quarter ended June 30, 2015, the net asset value (“NAV”) per Class A Share of The Gabelli Value 25 Fund Inc. decreased 0.2% compared with an increase of 0.3%, and a decrease of 0.3% for the Standard & Poor’s (“S&P”) 500 Index and the Dow Jones Industrial Average, respectively. See page 2 for additional performance information.
Gabelli Value 25 Fund – Second Quarter Commentary
The second quarter of 2015 saw the return of the dreaded ‘C’ word – contagion, the transmission of a crisis from one country to others. The current vectors for contagion are well known: struggling borrowers such as Greece and Puerto Rico, a decelerating China, and unstable areas of the Middle East. What makes contagion so concerning for the markets is its wildfire-like unpredictability. With 11 million people and $230 billion in GDP (smaller than that of half of the states in the U.S.), Greece may be small, but the impact of a write-off of its debt on the European banking system, the repercussions of its exit from the European political and currency unions, and the precedents it might set for Portugal, Spain, and Italy are unknown. China, of course, is a far mightier country whose slowdown has already dampened the economies of its raw material suppliers, and any signs of social unrest could have unsettling second and third order effects for its neighbors. The U.S. has so far acted as a global fire break, with long awaited signs of wage inflation, but the recovery remains slow, fragile, and vulnerable to derailment by global events or a miscalculation by the Federal Reserve.
The kindling in the spread of any contagion is leverage. Public and private leverage has been employed generously since the 2008 financial crisis. Borrowing by countries and companies can be used intelligently to invest in growth and smooth investment cycles. Too often, too much of it has been squandered by elected officials and Boards of Directors on projects that do not generate adequate returns. The level of debt at any entity may be represented in a number of ways, but the coverage ratio – cash flow divided by debt service costs (e.g., interest expense) – is often most telling. Coverage ratios improve when cash flow rises or interest expense falls, the situation for the last several years in a recovery abetted by the Federal Reserve. Due to low rates, although U.S. federal debt held by the public stood at a record $13 trillion (74% of GDP) at June 30, 2015, the $200 billion in annual cost to service that debt is lower in absolute terms and as a percentage of GDP (1.3%) than in 2008. The situation is similar for many other countries, U.S. local governments, and corporations globally. But what happens when the business cycle turns and/or interest rates begin rising again? Or worse, what happens when there is a liquidity shock when lenders refuse to roll-over funds as happened in 2008 and is currently the situation in Greece? We are not predicting any of these dynamics, nor are we terribly troubled by the balance sheet management of most borrowers. In some corners of the world under these circumstances, however, contagion could become conflagration.
Due to its dual creative and destructive powers, we consider leverage at the corporate level in selecting securities and constructing portfolios. Ideally we can identify management teams who understand how to prudently deploy debt, i.e., set it at appropriate levels and terms and reinvest in attractive return opportunities. We also make our own judgments about a corporation’s ability to service debt based on factors including the predictability of its cash flows, its economic sensitivity, and reliance upon volatile inputs. As an example, a subscription business such as a broadband provider can shoulder more debt than a cyclical, transactional business such as an auto manufacturer. Ultimately, we weigh leverage against our own return requirements; in general, the more leverage a company supports relative to what we judge to be optimal for the nature of its business, the “riskier” its cash flows and the greater discount to Private Market Value we will require before investment. Conversely, a company generating attractive returns on capital without leverage may be a more enticing investment and may even present an opportunity to boost equity returns further through a gearing of its balance sheet. This discipline in part has helped us to preserve capital in down markets and we believe should do the same if the Greek fire spreads.
Gabelli Value 25 Fund – Deals, Deals and More Deals
Deal making reached an all-time record – $1.4 trillion – in the second quarter, led by several mega-deals including Charter’s $80 billion acquisition of Time Warner Cable (TWC). Charter, whose agreement follows the government’s blocking of Comcast’s (1.2%) acquisition of TWC, will utilize financing provided in part by Fund holding Liberty Broadband (0.7% of net assets as of June 30, 3015).
Financial engineering, often the precursor to M&A, was especially robust in the second quarter with spin-offs including Edgewell/Energizer (1.7%), Graham Holdings (1.1%)/CableOne and Baxter/Baxalta. John Malone continued his streak of financial engineering with Liberty Global (2.7%), issuing the UK’s first tracker stock, LiLAC, which reflects the performance of the leading Chilean and Puerto Rican broadband providers. Other spin-offs set for the remainder of the year include eBay (0.7%)/PayPal and Madison Square Garden Sports (3.3%)/Entertainment.
Gabelli Value 25 Fund – Let’s Talk Stocks
The following are stock specifics on selected holdings of our Fund. Favorable earnings prospects do not necessarily translate into higher stock prices, but they do express a positive trend that we believe will develop over time. Individual securities mentioned are not necessarily representative of the entire portfolio. For the following holdings, the share prices are listed first in United States dollars (USD) and second in the local currency, where applicable, and are presented as of June 30, 2015.
Diageo plc (3.0% of net assets as of June 30, 2015) (DEO – $116.04 – NYSE) is the leading global producer of alcoholic beverages, with brands including Smirnoff, Johnny Walker, Ketel One, Captain Morgan, Crown Royal, J&B, Baileys, Tanqueray, and Guinness. The company has a balanced geographic presence in both mature and emerging markets, and it benefits from the trend of consumers around the world trading up to premium brand products. Over the past several years, Diageo made acquisitions that enhanced its presence in emerging markets: a majority stake in United Spirits, the leading spirits producer in India, Mey Icki, the leading spirits company in Turkey; Shui Jing Fang, a leading Chinese baiju producer; Ypioca, the leading cachaca producer in Brazil; and an increased stake in Halico, the leading domestic spirits producer in Vietnam. While economic conditions in emerging markets have caused some of these investments to struggle recently, the long-term fundamentals of the spirits industry remain very favorable, and Diageo will be one of the largest beneficiaries of industry growth.
DISH Network Corp. (1.4%) (DISH – $67.71 – NASDAQ) is the third largest pay television provider in the U.S. with approximately 14 million subscribers. As a satellite operator unburdened by local franchising requirements and wired plants, DISH can market and deliver video extremely efficiently across the entire country. As founder of the company, Charlie Ergen owns approximately 53% of DISH’s shares and lends his strategic vision to its benefit. DISH has accumulated a significant spectrum position at attractive prices and unsuccessfully attempted to enter the mobility market via the acquisition of Sprint. DISH could monetize its spectrum through a sale of the spectrum or the whole company, or (more likely) a partnership with an existing wireless operator.
Energizer Holdings Inc. (1.7%) (ENR – $131.55 – NYSE), based in St. Louis, Missouri, is a manufacturer and marketer of battery and lighting products ($1.8 billion of revenue) and personal care products ($2.6 billion), such as Schick-Wilkinson Sword blades and razors, Edge/Skintimate shaving preparation products, Banana Boat sunscreen, and Playtex feminine hygiene products. In April 2014, the company announced its intention to split into two publicly traded firms through a tax-free spin-off of the Household division, which was completed on July 1, 2015. As a result, shareholders received one share of Edgewell Personal Care and one share of the household business, Energizer Holdings Inc. This transaction created two leading and focused consumer companies, each with a strong balance sheet and flexibility to reinvest in its respective businesses, repurchase shares and/or make acquisitions. Both businesses may also be attractive acquisition candidates on a standalone basis to either strategic or financial buyers.
Graham Holdings Co. (1.1%) (GHC – $1075.05 – NYSE) is the former Washington Post Company. With the 2013 divestiture of its newspaper business and this year’s spinoff of its cable television operations, GHC operates in two primary businesses; television broadcasting and for-profit education (Kaplan). Additionally, the company has been making investments in home health care and manufacturing. Notably, the sale of the former flagship Washington Post newspaper to Amazon’s Jeff Bezos signaled to us that Graham management had “crossed the Rubicon,” and would likely be more open to further financial engineering. In 2014, the company completed a cash rich split with Berkshire Hathaway, exchanging a television station in Miami and cash for a significant block of GHC stock held by Berkshire in a tax advantaged transaction. The company plans to distribute the stock of Cable ONE tax free to shareholders later this year. Although BRK’s Warren Buffett is no longer a member of the company’s Board of Directors, he remains an “informal” advisor to Graham, and we may see GHC morphing into a mini-Berkshire over time.
Liberty Global plc (1.0%) (LBTYK – $50.63 – NASDAQ) (1.7%), (LBTYA – $54.07 – NASDAQ) is the leading international cable operator, offering advanced video, telephone, and broadband Internet services. The company operates broadband communications networks in fourteen countries, principally located in Europe under the brands UPC, Unitymedia (Germany), Virgin (UK), Telenet (Belgium), and VTR (Chile). As part of its June 2013 acquisition of Virgin Media, Liberty Global redomiciled in the UK, increasing its strategic flexibility for the future. The company is internationally focused and well positioned to capitalize on the growing demand for digital television, broadband Internet, and digital telephony (VoIP) services in markets across its diverse geographic footprint. In July 2015 Liberty issued the UK’s first tracker stock, known as “LiLAC,” to highlights its properties in Chile and Puerto Rico.
The Madison Square Garden Co. (3.3%) (MSG – $83.49 – NASDAQ) is an integrated sports and media company that owns the MSG networks (MSG/MSG+), the New York Knicks, the New York Rangers, the Radio City Christmas Spectacular, and the iconic New York venue, Madison Square Garden. These evergreen content assets benefit from sustainable barriers to entry and long term secular growth. We believe the now complete Transformation project and the rising value of sports programming, as demonstrated by the NBA’s recent contract renewal with Time Warner Inc. (1.6%) and Walt Disney Co., should dramatically increase MSG’s earnings power through 2018. We also expect the announced separation of Media and Sports to act as a catalyst for shares.
National Fuel Gas Co. (2.1%) (NFG – $58.89 – NYSE) is a diversified natural gas company. NFG owns a regulated gas utility serving the region around Buffalo, New York, gas pipelines that move gas between the Midwest and Canada and from the Marcellus to the Northeast, gathering and processing systems, and an oil and gas exploration and production business. NFG’s regulated utility and pipeline businesses, as well as its California oil production business, provide stable earnings and cash flows to support the dividend, while the natural gas production business offers significant upside potential. NFG’s ownership of 800,000 net acres in Pennsylvania, including 780,000 acres in in the Marcellus shale, holds enormous natural gas reserve potential. We continue to expect above average long term earnings and cash flow growth from rapidly growing gas production and expansion of the strategically located pipeline network. The company has increased its dividend for over forty consecutive years. In addition, NFG is considering corporate restructuring alternatives, including an MLP of its midstream assets.
Sony Corp. (2.3%) (SNE – $28.39 – NYSE; SNE – ¥3474.77 – Tokyo Stock Exchange) is a diversified electronics and entertainment company based in Tokyo, Japan. The company manufactures televisions, PlayStation game consoles, mobile phone handsets, and cameras, and it operates the Columbia film studio and Sony Music entertainment group. We expect the new PlayStation launch and operational improvements in consumer electronics and entertainment to generate EBITDA growth through 2015. We also think the spinoff of the entertainment assets will be a potential catalyst.
Twenty-First Century Fox Inc. (1.4%) (FOXA – $32.55 – NASDAQ), (0.9%) (FOX – $32.22 – NASDAQ) is a diversified media company with operations in cable network television, television broadcasting, filmed entertainment, and direct broadcast satellite television. Cable networks account for 66% of the company’s EBITDA and benefit from contractually recurring affiliate fees and exposure to the fast growing global pay television market. We also expect the company to benefit from rising demand for premium content, driven by emerging distribution platforms such as Netflix, retransmission revenue, and aggressive share repurchases.
Xylem Inc. (1.3%) (XYL – $37.07 – NYSE) is a global leader in the design, manufacturing, and application of highly engineered technologies for the transportation, treatment, and testing of water. The company is expected to benefit from favorable long term fundamentals in the water industry, driven by scarcity, population growth, aging of the infrastructure, and the need to improve water quality. Further, with a large installed base of pumps and systems, the company is well positioned to increase aftermarket revenue, which currently represents roughly 40% of total revenues. Xylem’s attractive business mix also generates strong cash flow, which is expected to support acquisitions across geographies and end markets and increase returns to shareholders.
Gabelli Value 25 Fund – Investment Scorecard
Top contributors to performance included Cablevision Systems (2.7% of net assets as of June 30, 2015) (+32%), which has emerged as a prime target in the consolidating cable industry. Cablevision spin-off AMC Networks’ (2.1%) (+7%) ratings have been buoyed by hit series such as The Walking Dead, Mad Men, and Better Call Saul. Other contributors to the quarter included Rollins Inc. (0.8%) (+16%), which continued to execute well in the steady pest control industry. Despite gold’s decline in the quarter, Newmont Mining (1.8%) (+8%) was able to reduce costs and improve its balance sheet.
Detractors to performance included media companies Viacom (6.6%) (-5%) and CBS Corp. (4.7%) (-7%), which unlike AMC Networks above, fared poorly in a soft advertising market because of ratings declines. Lastly, Genuine Parts (1.9%) (-3%) declined on exposure to the Australian dollar and concerns about the health of its industrial distribution sales.
Gabelli Value 25 Fund – Conclusion
No matter what the external macro environment, our process remains unchanged. We conduct bottom-up research on companies and industries in order to uncover undervalued businesses we would be happy to own for many years. Our Private Market Value (PMV) with a Catalyst™ stock selection process identifies stocks ripe for change, including potential acquisition targets and likely candidates for financial engineering. Overall we remain hopeful that the situations in Greece and China stabilize, that the U.S. economy reaccelerates, and a potential interest rate move is well discounted, but we are prepared for more volatility.
July 11, 2015