FPA Capital Fund commentary for the first quarter ended March 31, 2016.
Dear fellow shareholders,
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After five quarters of disappointing performance, FPA Capital Fund’s results in the first quarter of 2016 were in line with our benchmark, the Russell 2500 (0.15% Fund return vs. 0.39% benchmark return). The quarter was significantly more volatile than the March 31st figures suggest. Halfway through the quarter, as of February 12th, the FPA Capital Fund’s performance was -11.77%. Then we made up for the FPA Capital Fund’s shortfall in the second half of the quarter.
The events of the quarter played to the strengths of our strategy. Our high cash balance and significant energy investments, which had recently been liabilities, turned into assets. Because our flexible mandate allows us to patiently build cash until opportunities appear, we had funds available to invest at a time when leveraged market participants were liquidating their energy positions at fire-sale prices. Our long-term time horizon gives us the luxury of not having to perfectly time the bottom. When we see a dislocation between price and value, we can take a view and let time work for us, not against us.
Obviously, we don’t put too much emphasis on how we performed in the second half of a given quarter. What really matters to us—and to you, as our fellow shareholders—is long-term performance. As frustrated as we are with our underperformance over the past five years, we’d like to point out that the underperformance occurred during a five-quarter period from Q4 2014 to Q4 2015. That’s a short period of time for a strategy with an average holding period of 28 quarters. While past performance does not guarantee future results, some historical context is also helpful. In the FPA Capital Fund’s almost 32-year history, we experienced five years of performance worse than -3%: 1990, 2000, 2002, 2008 and 2015. Robust performance followed the drawdowns in 1990, 2000, 2002 and 2008: the average cumulative 3-year performance following each of those years was 98.01%.
In this quarter’s letter, we will discuss our technology investments and provide an update on our education-related names in the portfolio commentary section. In the market commentary section, we will reiterate our energy thesis and provide a quick update on our energy-related investments.
FPA Capital Fund – Portfolio commentary
Our two largest industry allocations remain technology (24.9%) and energy (23.5%). We discuss below our three largest technology investments: Western Digital Corporation (Nasdaq: WDC), Arris International plc (Nasdaq: ARRS), and InterDigital, Inc. (Nasdaq: IDCC). Collectively, these investments accounted for 15.7% of portfolio weighting at the end of the first quarter.
Western Digital Corporation:
Western Digital designs, develops, manufactures, and sells hard disk drives (HDDs), and increasingly, solid-state drives (SSDs). The company’s hard disk drives are used in desktop and notebook computers, enterprise applications, and consumer electronic applications. Among the most profitable product areas for WDC is in the enterprise drive segment. Overall, WDC’s market share in the HDD industry is roughly 44%. During the last several years, the HDD industry has consolidated substantially, and the top three companies now control nearly 100% of the market. Furthermore, WDC’s vertically integrated business model makes it the lowest-cost producer of disk drives. It is also important to note that WDC management has done a superb job of returning the firm’s strong and consistent free cash flow to shareholders via buybacks and dividends. WDC also recently made a series of bold moves that could become gamechangers for the industry.
The company received approval from the Ministry of Commerce of the People’s Republic of China (MOFCOM) to fully integrate the Chinese assets from its acquisition of Hitachi’s disk drive business. We believe the combination could add more than $2.40 to EPS3 (using current share count), given the possible savings of more than $400 million a year in operating expenses, and $250 million in the cost of goods sold.
WDC also announced a deal to acquire SanDisk (Nasdaq: SNDK) for approximately $19 billion in cash and stock, catapulting the company into a leadership position in SSDs. The move gives the company a very competitive offering and should put to rest fears that WDC could be cut out of the drive business by SSD players.
A quick summary of our evaluation of potential best-case and worst-case scenarios is shown below:
- Downside ($55 per share): $18 billion of revenue and $4.8 billion of EBITDA4. Assumes $650 million of MOFCOM synergies, $500 million of SNDK synergies (up to $1.1 billion over the long term), offset by 6% decline in the core business. Using an 8x multiple on owner earnings5 implies a stock value of $55 per share.
- Upside ($138 per share): $18.9 billion of revenue and $5.2 billion of EBITDA. Assumes $650 million of MOFCOM synergies and $700 million of SNDK synergies (up to $1.1 billion over the long term). Using a 14x multiple on owners’ earnings implies a stock value of $138 per share.
Western Digital has been in our portfolio since early 2007. The investment is a good example of how we scale up and down our position size over time.
Arris International plc:
Arris provides cable operators with communication systems that make it possible for users to consume bandwidth. When customers demand faster internet speeds and more bandwidth to watch movies or upload pictures, the internet providers have to upgrade their infrastructure. This is where ARRS comes in, because it provides the hardware and software needed for expanding network capacity.
We initially invested in Arris in November 2010, and we more than doubled our investment in 2013 after they acquired Motorola Home from Google. This acquisition transformed ARRS into one of the market leaders in all aspects of the cable infrastructure market, with No. 1 market share in cable modem termination systems, No. 1 in cable modem shipments, and a close No. 2 to Cisco in set-top boxes. We thought ARRS got a good deal by buying from a motivated seller, and we had great confidence in the management team’s ability to integrate this very large acquisition. This thesis largely played out, and the stock price tripled from November 2010 to March 2014.
We started buying again at a time when four of the company’s five largest customers—Time Warner, Comcast, Charter and AT&T—were involved in M&A talks. The uncertainty over consolidation forced those companies to rein in big spending, slowing orders at ARRS. We consider this a short-term issue because the level of competition is stronger than ever, between both the traditional players and newcomers such as Amazon and Netflix. In addition, Arris’s products help these companies differentiate themselves, and there is a major replacement cycle around the corner. We believe the future is bright for Arris.
Arris sells a great number of products to a global customer base of corporate giants, and we believe there is tremendous growth ahead for Arris in the foreseeable future. Arris’s largest customers are running out of network capacity, so their CapEx plans should remain elevated.
In April 2015, Arris announced another big acquisition—Pace plc. In our opinion, the deal is very attractive financially because there are large synergy opportunities. Moreover, this purchase cements the company’s size advantage over competitors and further diversifies its client base. At the time of the announcement, the company said it expected 45 to 55 cents of non-GAAP6 accretion in the first year. It has already increased that forecast to 65 to 75 cents.
Once the synergies start kicking in, the company could generate as much as $700 million to $800 million of owner earnings. Arris is trading at about 6x owner earnings to pro-forma enterprise value.
There has been—and will continue to be—tremendous growth in wireless communication. But it’s hard to predict the future market share of any individual company. Nokia and Ericsson were the major mobile phone players 15 to 20 years ago. Today, their phones are industry footnotes, and Apple and Samsung dominate. InterDigital is a company that will allow us to participate in this growth without betting on which smart phone, tablet, or e-reader companies will hold the largest market share in the future. InterDigital’s role is to sell critical technology across the wireless industry. To make sure its technology maintains a vital place inside networks and devices, the company employs 175 engineers who work on new inventions and patents every day. To date, they have obtained or applied for about 20,000 patents, a testament to InterDigital’s innovative strength. The company also works with Standard Development Organizations to incorporate its technology into the standards that ensure that a Samsung Galaxy on Verizon’s network can communicate with an iPhone with service from China Telecom.
We initiated a small position in 2011 and had a chance to increase our ownership substantially in 2012, when InterDigital had lawsuits pending that claimed large industry players owed the company royalties related to the deployment of 4G/LTE technology. They were similar to the lawsuits that followed the rollout of 2G and 3G wireless technologies. In all these cases, the users of the technology waited for the lawsuits to run their course before agreeing on a licensing rate. Our research suggested that there was no doubt that everyone was using their technology. During this downturn, the company managed its balance sheet extremely well and continued to generate cash. It decreased the share count from 45 million at the end of 2010 to 36 million today. Yet net cash still makes up almost 25% of the company’s market capitalization. InterDigital’s goal is to reach $600 million of revenue. At that time, the company could be able to generate more than $7 cash earnings.
In summary, we believe that the world will use more smart phones and tablets going forward, but we don’t know who the top sellers will be. We’ve decided not to try to predict that. We’d rather invest in a company that supplies its technology to all the players. In short: We see InterDigital as a backdoor way to participate in the growth of mobile communications.
FPA Capital Fund – Update on our education-related investments:
While we continue to see significant upside potential from our for-profit education positions, changes in the regulatory environment have increased our concern about the likelihood and magnitude of potential negative outcomes for these stocks. Essentially, we believe the range of possible outcomes has widened, and as such, we decided it was prudent to trim our positions. To be clear, we still believe that both Apollo Education Group (Nasdaq: APOL) and DeVry Education Group (NYSE: DV) are trading at a substantial discount to their intrinsic value, but we are adjusting our position to reflect the risk/reward we now see. So the question is, what changed?
In October 2014, an inter-agency task force was formed to share information about investigations into for-profit education. It included the Federal Trade Commission, Department of Justice, Veterans Administration, Consumer Financial Protection Bureau, Securities and Exchange Commission and numerous state Attorneys General. We have followed the regulatory developments closely, and over the previous six months, it appears that the fervor for prosecuting for-profit schools has increased meaningfully. Our analysis had previously assumed that the regulatory headwinds would diminish over time, primarily because three years of high-level regulatory scrutiny had not produced a substantial case against the industry’s “good actors.” However, the recent FTC lawsuit brought against DeVry, the pending FTC investigation of University of Phoenix, and the increased scrutiny by various AGs and military institutions have given us pause. We believe both schools continue to serve an important function in society, and that the regulatory scrutiny will indeed ultimately die down. But we now believe the costs of negative publicity, a tarnished brand, and regulatory fines, restrictions, and restitutions could be greater than we initially forecast.
While we continue to believe there is substantial value trapped in the Apollo organization, it may be more difficult to extract that value than we originally forecast, particularly considering the pending sale at $9.50 per share. Finally, we have some “headline risk” concerns with the choice of post-transaction CEO, Tony Miller, the former Deputy Secretary of Department of Education from 2009 to 2013.
FPA Capital Fund – Market Commentary
It has been only three months since we published our year-end letter, where we commented on the market. Our views have not changed. Therefore, in this letter, we will focus once again on only one part of the market: Energy, because it makes up 23.8% of our portfolio, which is significantly higher exposure than that of the Russell 2500 (3.1%).
What is going on with oil?
Let’s first discuss the supply side of the equation. We believe it is now almost a mathematical certainty that U.S. production will decline significantly from its peak. It is already down ~900 thousand barrels per day since its peak in June 2015. Based on our conversations with numerous producers towards the end of the first quarter, we do not believe the recent move in spot oil prices from the mid $20s into the low $40s will have much impact on their activity levels. They are focused on protecting their balance sheets first and foremost. The picture is also dire outside of North America.
Schlumberger estimates that global exploration and production (E&P) spending, excluding North America, was down 19% in 2015 and will be down another 19% in 2016.7 This year will mark the first time since 1986 that global E&P spending has fallen two years in a row.8 According to Schlumberger, 2014 yielded the worst exploration results in approximately 25 years. The following year was even worse, and 2016 results are likely to be even worse than that.9 That lack of exploration success will eventually have consequences for global supply. Moreover, by some estimates, OPEC’s spare production capacity is the lowest it has been since the oil shocks of the 1970s, both in absolute terms and relative to global consumption.
Let’s move on to demand. On the demand side, growth continues to be supportive. The International Energy Agency (IEA) had to increase its 2015 demand estimates more than once during the year as consumers drove more in response to falling prices. The IEA currently estimates that demand grew 1.8 million bl/d in 2015 and will grow 1.2 million bl/d in 2016. Year-to-date oil demand is up 5% in China and 2016 growth for India is expected to be 6%. The United States is not much different, since Americans drove more miles in 2015 than ever before.
Who will supply the extra 1.2 million bl/d? Elevated inventories around the world are a natural place to find extra oil in the short term, but beyond that, producers will have to put rigs back to work and drill new wells. Judging by the trajectory of global rig counts, it doesn’t seem as if the upstream industry is focused on a growth agenda. The Middle East was the only region that grew its active rig count in 2015. Outside the region, the rig count was down by 51% in 2015 and was down another 12% in the first two months of 2016. In the United States, the oil-directed land rig count was down 62% in 2015 and was down another 32% as of March 24th.14 Most people expected Iran to fill the void, but the country’s increase in production so far has not matched expectations.
Putting it all together, we believe that the market should come back into balance during 2016, absent a shock to demand.
How does all of that affect our energy investments?
Our energy-related names did well during this volatile quarter. As we have discussed in prior quarterly letters, we have tilted our service company exposure towards U.S. land. Our top-performing name this quarter was one of these service companies (Patterson-UTI Energy Inc.). The U.S. land drilling industry has approximately 2,000 rigs, of which 950 were built with alternating current (AC) drives. AC rigs are more desirable because they are more precise and more efficient than rigs that are powered with direct current or diesel engines. Of the 950, approximately 700 have the desired power level of 1,500 horsepower. Only 360 of the 700 are operating today, but they account for more than 80% of the 436 U.S. land rigs still in operation across all power types. These rigs will be some of the last to be idled and the first to return to work. A recovery of just 200 rigs off the bottom would lead to 80% utilization for this asset class, and that should drive day production rates higher. Importantly, three quarters of these rigs are controlled by just four companies (Helmerich & Payne alone has 320 of them), 15 which is a level of market concentration the industry has not experienced until just recently.
In spite of our preference for onshore drilling, we have maintained an investment in offshore driller Rowan Companies plc, in part because of its highly differentiated liquidity and free cash flow position, and in part because of its opportunity to drive costs out of the business. At YE2015, the company had over $300 million of cash on the balance sheet in excess what it needs to run the business, and we expect them to generate a combined $300 million over the course of 2016-17, just from its existing backlog. For perspective, the $600 million of deployable cash is equal to nearly 1/3 of their market capitalization. In theory, the deployable cash would allow Rowan to retire almost 30% of its debt through open market purchases at the current average trading price of 78 cents on the dollar—effectively implementing a self-LBO. 16 The company began repurchasing debt in the open market during the fourth quarter and has shown a very enlightened approach to capital allocation, which stands out in an environment of such extreme fear.
Rowan increased its EBITDA margins from 37.2% in 2013 to 48.1% in 2015, in part because of its cost reduction efforts. It also limited the growth of its working capital ex-cash to $20 million over that time period even though their revenues grew by $558 million.
Our exploration and production companies are strong and continue to execute. Cimarex has $780 million of cash on its balance sheet against total debt of $1.5 billion, for a net debt/EBITDA ratio on 2016 consensus estimates of just 1.4x.17 The company cut its capital expenditure budget by 36% for 2016 after cutting it by 52% in 2015.18 These declines are very prudent because Cimarex has great assets and a very strong balance sheet. There is no reason for the company to grow its production at these depressed prices. In spite of the dramatic CapEx reductions, Cimarex production grew 13% in 2015 and is expected to fall by just 8% in 2016 due to increasing productivity. Noble Energy had $1 billion of cash and $5 billion of total liquidity at the end of 2015.19 The company kept its investment-grade credit ratings from S&P and Moody’s after the most recent round of industry rating actions in February, while several of its peers saw their ratings downgraded. Noble Energy has cut its capital expenditure budget by 50% for 2016, adjusted for its acquisition of Rosetta Resources, but production volumes are expected to increase by ~10% on a same-store sales basis, thanks to increasing productivity and a backlog of long lead time projects that are still coming online.
During the quarter, we doubled our high yield bond investments from one to two. Recall that in the fourth quarter of 2015 we initially bought Atwood Oceanics’s 6.50% 2020 senior unsecured bonds at 55 cents on the dollar with a 24% yield-to-worst (YTW). Our worst-case scenario contemplates what would happen if Atwood were to go bankrupt. Assuming the company reorganized, wiping out the equity and equitizing our bonds, we believe the purchase price represented a valuation multiple of 7.3x depressed “new normal” EBITDA of $200 million, which compares with peak EBITDA of $780 million in FY2015 and average EBITDA of $393 million over the last 10 fiscal years. The bonds fell further during the first quarter of 2016, allowing us to add to the position at an average price of 43 cents on the dollar. Atwood’s bonds ended the quarter at $47.50.
We continue to be shareholders of SM Energy. The company is performing well. Its reserve base had positive performance revisions again in 2015. Production volumes this year are expected to be just 4% below 2014 levels, even though the company’s 2016 CapEx budget is 65% below 2014 levels. We believe the company has an underappreciated asset in its backlog of 166 drilled-but-uncompleted wells. As commodity prices took yet another leg down, short sellers began to work their way up the quality spectrum in search of producers whose viability was not previously in doubt. They zeroed in on SM Energy. The company’s bonds had generally traded in a range of 90-100 cents on the dollar since the downturn began, but they began to fall precipitously in December of last year. We took note when they fell below 50 cents on the dollar in February, and established a position in their nearest term maturity—a 6.625% senior unsecured bond due 2021, at 48.4 cents on the dollar. At that price, we invested in the company at an implied valuation in terms of enterprise value per daily flowing barrel of oil equivalent (BOE) production of just $8,300. The constituents of the S&P 500 Oil & Gas E&P Index have traded at $40-50,000 per daily BOE21 or more over the course of the last cycle.
At the end of last year, the FPA Capital Fund hit its lowest cash level in 12 years, at approximately 19%. As of March 31, the FPA Capital Fund had approximately 27.7% cash. You may wonder why the cash level went up for the quarter, given that the Russell 2500 index started and ended Q1 at about the same level. As we discussed earlier in the letter, this was a very volatile quarter. To take advantage of the market swings, we deployed cash during the downturn early in the quarter, and gained more cash back by selling into the rebound in the back half of the quarter.
Our dual goals of protecting and growing capital remain the same. It is true that our one-year performance is -12.74%, but we believe we can make up for the shortfall. We are true contrarian investors, so we own a portfolio of battered-down names. We believe many of them are like a coiled spring waiting to be sprung. We remain very excited about our portfolio prospectively.