Dan Loeb Buys Seven & i Holdings, Baxter – Q3 Letter

Dan Loeb

Dan Loeb’s Q3 letter is out – see an excerpt below

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Dan Loeb on macro

Over the past few months, S&P volatility exacerbated by sector rotation has taken investors on a harrowing round trip. The consensus view of the cause of the correction has been well-mapped by now; a maelstrom of fears overwhelmed the market during Q3, including:
A weakening China, where the new question is not whether but how severe the slowdown of the world’s foremost growth machine will be. In August, we saw for the first time the limits of the Chinese government’s ability to manipulate the economy as animal spirits triumphed over central planning. While the situation has stabilized somewhat since, the downside scenario for China seems more intimidating than ever before;
Janet Yellen may have inadvertently checked herself and the Fed into the Hotel California. It is increasingly difficult to see how the Fed can justify raising rates in 2015, particularly considering recent employment weakness in the U.S. (an unwelcome surprise) and similar softness in manufacturing figures. Unlike the concerns that weighed on the Committee earlier in the year – that a rate hike might damage the fragile environment outside of the U.S. – recent data undermining consensus U.S. growth assumptions requires different analysis. If the U.S. consumer is weaker than had previously been believed, the Fed needs to be careful not to push the world into a recession. Ms. Yellen cannot afford to get this wrong;
With 2016 looming on the horizon, market participants see some inexperienced, unserious candidates leading on the GOP side and economically unfriendly Democrats on the other. Republicans in the House are now also deeply divided and relying on Paul Ryan’s leadership to pull them back from the brink. None of this increases market confidence;
The Middle East is in shambles; a situation spilling over increasingly into Europe with potentially far-reaching consequences for both regions;
Investors feel there is no longer a monetary safety net, as a tidal shift in fund flows from central banks has removed the “Fed put”, creating headwinds instead of tailwinds.

While many of these issues were already on investors’ radars, this particular combination of concerns caused S&P multiples to de-rate sharply in Q3 and, despite the recent rally, most companies are trading lower than where they started the year.

Despite a difficult quarter for our portfolio, we are optimistic about what we own: a mostlyU.S.-centric, concentrated portfolio of event-driven names and structured credit. We understand the macro and market challenges to the overall investment environment. We do not see indicators of a looming U.S. recession and so, while volatility is likely here to stay and multiples may be capped, we are seeing some compelling value opportunities in stocks. The environment for short selling is also attractive and we have more single short names than long positions in our book today. We have reduced our net exposure by nearly a third through sales and new shorts over the past few months while maintaining significant positions in our highest conviction, event-rich names. The conviction to keep and add to our core healthcare names during the selloff enabled us to re-establish ourselves on positive footing this month

Dan Loeb on Baxter

Baxter International Inc. (the “Company”) During Position:the third quarter, we disclosed a 9.9% stake in Baxter International Inc. making us the Company’s largest shareholder. Baxter provides critical, life-savingmaterials to patients and physicians in over 100 countries with an emphasis on renal care and medical products.
To represent the interests of all shareholders, Third Point Partner Munib Islam joined Baxter’s Board of Directors in September and participated in the search process for the newly appointed CEO, Jose “Joe” Almeida. Mr. Almeida successfully led Covidien as CEO from 2011-2015 before selling the company to Medtronic. The agreement between Third Point and Baxter also required the Company to add a second new member to the Board and we were pleased that the Company attracted Michael Mahoney, the CEO of Boston Scientific, as a new Director. Mr. Mahoney helped revive Boston Scientific when it was confronted with similar opportunities and challenges. Baxter seems to be at an inflection point for two reasons: (i) the Company recently spun off Baxalta, its biosciences business. As our longtime investors know, break-ups and spinoffs are classic opportunities and Baxter fits this mold; and (ii) we believe that the new CEO canre-invigorate the more focused, post-spin company and drive it toward industry-leadingoperational performance by following a similar playbook to the one he executed so successfully at Covidien. Mr. Almeida’s international experience, cost conscious mentality, and strategic vision will be instrumental in helping Baxter accelerate its revival through consistent execution and portfolio reshaping. He has a strong track record of creating shareholder value: during his tenure as CEO from July 2011 to January 2015, Covidien shares rose nearly +140% vs the S&P 500’s +54% return. Given the ample room to drive margin expansion at Baxter and the new CEO’s history of delivering consistent top quartile shareholder returns, we see Baxter as one of the most promising positions in our portfolio.

Dan Loeb Equity Position: Seven & i Holdings (the “Company”)

[drizzle]During the third quarter, we continued to add to our investment in Japan's Seven & i Holdings (the parent company for the “Seven Eleven” franchise) at attractive valuations. The Company has a $40 billion market cap and derives more than 100% of its cash flow from the operation of a 90%-franchised convenience store network in Japan, the U.S. and South East Asia. In Japan, the Company has 18,000 stores and a market-leading 41% share in a rapidly consolidating convenience store industry with latent pricing power. An aging population, a tight labor market, and increased labor force participation by women are playing to Seven Eleven's strengths of offering high quality prepared meals, coffee, and personal care products at affordable prices on the best corners in Japan. Seven Eleven generates one- third higher sales per store than its competitors thanks to its commitment to innovation,state-of-the-art inventory management, and logistics networking that allows store replenishment up to three times a day and superior private label products manufactured at dedicated facilities.

In the U.S., where the Company operates close to 9,000 stores, a recovering economy and cheap gas prices have left more discretionary dollars in consumers' pockets to spend on snacks and Slurpees, contributing to strong sales momentum. In emerging economies, where the Company master franchises local markets, store count is growing rapidly due to urbanization and the powerful Seven Eleven brand. A key contributor to the success of the Company is its CEO, Mr. Suzuki, who introduced the convenience store concept to Japan in the 1970’s and was instrumental in acquiring Seven Eleven’s U.S. parent company after it ran into financial difficulties. Mr. Suzuki instills a culture of singular focus on the customer, a passion for selling only the highest quality products, and urgency to continually improve the company’s best-in-class delivery systems and information technology. All this has propelled the Company to achieve unparalleled productivity and organic growth. Despite being the most valuable Japanese retailer by market capitalization, the Company remains grossly underlevered and undervalued, trading at only 7.2x forward EBITDA versus global peers such as Couche-Tard and Walgreens, which trade at 10x – 12x EBITDA. This valuation gap stems from Seven & i’s long standing divergence between its best-in-class convenience store businesses and its other retail operations, in particular its Ito Yokado superstores, which have an equally notable record of underperformance. Shareholders have suffered from the subsidization of Ito Yokado for so long that Seven & i is emerging as one of the most crucial tests for the success of corporate governance reform in Japan. And while Professor Ito, the author of the corporate governance reform review, was appointed to Seven & i's board last year, shareholders are still faced with a highly inefficient capital structure, a sub-10% ROE, a low dividend, and no buybacks. However, there are signs that management’s focus is shifting in the right direction and that Japan’s renewed emphasis on corporate governance is bringing shareholders’ interests to the forefront. We are encouraged by CEO Suzuki’s announcement earlier this month that 20% of underperforming Ito Yokado stores will be closed and 30% of its corporate office staff will be streamlined. We believe the CEO should go even further: Ito Yokado should leave the group and restructure as a standalone company. If Seven & i evolves into a global convenience store pure-play, shareholders would benefit from a meaningful rerating. As Seven & i’s growth capex spend in Japan comes to an end due to industry consolidation, free cash flow generation will accelerate meaningfully and a significant capital return story will emerge allowing for substantial dividend increases and buybacks in the years ahead. The review of shareholder returns should start immediately, however, as the Company’s balance sheet is vastly overcapitalized and its dividend is only half of what most shareholders desire.
An additional lever of value creation would be a partial listing of Seven Eleven U.S. which management has told us it has considered. By tapping an underlevered balance sheet, Seven Eleven U.S. could accelerate the consolidation of the fragmented North American convenience store industry and trade at a premium multiple.

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