Lakewood Capital letter to partners for the first quarter ended March 31, 2016. Send annonymous tips to tips (@) valuewalk.com
In the quarter ended March 31, 2016, the Lakewood Capital fund recorded a net loss of 0.9%. At quarter end, the fund’s equity exposure was 77.0% long and 44.0% short for a net equity exposure of 33.0%. In addition, the fund was 4.0% long and 0.2% short fixed income securities for a net fixed income exposure of 3.8%.1 The top five positions constituted 23.4% of equity capital and the top ten positions constituted 41.0% of equity capital.
Lakewood Capital – Review of the Quarter
The Lakewood Capital fund generated a net loss of 0.9% in the quarter. Although the fund’s long and short positions on average ended the quarter in roughly the same place they began, the start of 2016 was one of the most volatile and tricky periods we have seen in years as underscored by a 16% mid-quarter decline in the Russell 2000 Index. Defensive sectors like consumer staples, telecommunications and utilities performed very well in the quarter as record low interest rates pushed investors to bid up shares in companies they perceive generate stable cash flows while most other sectors languished. Long equity positions generated a -1% return on capital, hedged long equity positions generated a -5% return on capital, short equity positions generated a +1% return on capital and fixed income positions generated a +2% return on capital.
The Lakewood Capital fund’s largest winners in the quarter were long positions in HCA Holdings (64bps), Ingram Micro (60bps) and FedEx (59bps). I discussed HCA in our second quarter 2015 letter, and after a temporary spike in labor costs caused a sell-off in the stock in the third quarter of 2015, the company announced strong fourth quarter results, leading to a sharp rise in its shares. I have mentioned Ingram Micro on several occasions over the years (we initiated our position six years ago), and during the quarter, the company agreed to be acquired at a substantial premium to its trading price. It is gratifying to see a private market buyer recognize the company’s considerable value that we have highlighted numerous times over the years. I shared our thesis on FedEx in our third quarter 2015 letter, and the shares increased during the quarter as the company continued to deliver impressive earnings performance and appears poised for continued growth.
[drizzle]The Lakewood Capital fund’s largest losers in the quarter were long positions in Citigroup (88bps) and Citizens Financial Group (80bps). Both Citigroup (discussed in our fourth quarter 2014 letter) and Citizens Financial Group (third quarter 2014 letter) declined during the quarter as a result of general weakness in the financials sector. While investors have grown concerned about the impact of rising credit costs and low interest rates on financial stocks, we believe both Citigroup and Citizens have significant excess capital positions to weather any losses and each company has sizeable cost reduction opportunities to boost profitability. At valuations well below tangible book value and solid prospects for these businesses to generate attractive returns on equity, we believe the shares in both companies have tremendous upside in the coming years.
Lakewood Capital – Some New Ideas
We continue to find many interesting new ideas, particularly on the short side. Below, I briefly discuss our views on our long position in Clydesdale Bank and our short positions in Hormel Foods, Tyson Foods, Advanced Drainage Systems and Badger Daylighting. Clydesdale Bank (Long) We initiated a long position in Clydesdale Bank (which recently changed its corporate name to CYBG) during the quarter and believe it is a classically undervalued spin-off with the potential to double in value over the next two to three years. Prior to its partial IPO and spin-off in February, Clydesdale had been a small and neglected subsidiary of National Australia Bank (NAB), a large Australian bank headquartered more than 10,000 miles away from Clydesdale’s operations in the United Kingdom. Due to legacy issues at Clydesdale, regulatory pressures to simplify operations at NAB and the nuisance value of managing a U.K. operation that contributed just a few percent of total group earnings, we believe that NAB was a price insensitive seller, resulting in an IPO valuation of just 58% of tangible book value. At the current share price of £2.30 per share, Clydesdale still trades at just 75% of tangible book, an attractive valuation for a bank with strong (and likely excess) capital levels that should reach double-digit returns on equity over the next few years.
Clydesdale is a $3 billion market capitalization U.K. bank that operates primarily in northern England and Scotland under two local bank brands, Clydesdale and Yorkshire, and is mainly focused on residential mortgage, credit card and small business lending. Prior to its IPO, Clydesdale had been a relatively small subsidiary of NAB and was poorly managed for many years. Clydesdale had significant management turnover under NAB and was described by the new management team as a “revolving door of expat talent” that resulted in a “confusion of the strategy and a short-term approach.” As a result, Clydesdale currently has a relatively high cost / income ratio of 75% and a low return on tangible equity of 5%. However, we believe that a new management team has positioned Clydesdale to significantly improve operations in the coming years. Clydesdale’s management team is led by CEO David Duffy who joined the company in June 2015. He had previously been CEO of Allied Irish Bank (AIB) from December 2011 to May 2015 where he led an impressive turnaround effort that was centered on the delivery of significant cost savings through workforce reductions and branch closures. While at AIB, Duffy was able to reduce the company’s cost / income ratio from 96% in 2011 to 52% through a €350 million cost reduction effort. We believe that Duffy plans to replicate the AIB playbook at Clydesdale over the next few years and are optimistic about his ability to deliver on Clydesdale’s current target for a cost / income ratio below 60% and double-digit returns on tangible equity by 2020.
We believe our investment in Clydesdale has several sources of significant upside. First, we believe there is a sizeable cost reduction opportunity beyond management’s stated plan, which was developed by NAB prior to the spin-off. Given the magnitude of the cost improvements Mr. Duffy was able to achieve at AIB and our discussions with him around the long-term cost structure of Clydesdale, we believe the company’s current targets are conservative. For example, management has guided to an expense base for 2016 that includes elevated regulatory and IT investments that should decline over time as the projects conclude. Clydesdale also currently operates with a significantly higher employee headcount than its peers. By comparison, Lloyds Bank has 20x the asset base of Clydesdale but just 10x the employee count, while Virgin Money has 20% fewer assets but 60% fewer employees. Additionally, management has indicated a goal of reducing the branch network from 275 currently to around 200. We believe that the planned roll-off of regulatory and IT spending, headcount reductions and the potential closure of 25% of the branch network provide management with material incremental cost reduction opportunities. Furthermore, if the company were