Mittleman Brothers Q1 2016 Letter: Long HC2 Holdings, Revlon, Carmike Cinemas, Sberbank
Mittleman Investment Management, LLC’s composite gained 9.4% net of fees in the first quarter of 2016, versus an advance of 1.4% in the S&P 500 Total Return Index and a 1.5% decline in the Russell 2000 Total Return Index.Longer-term results for our composite through 3/31/16 are presented below:
The three biggest contributors to our Q1 2016 performance were Revlon (REV): $27.84 to $36.41 (+30.8%),Carmike Cinemas (CKEC): $22.94 to $30.04 (+31%), and Sberbank of Russia (SBRCY): $5.79 to $6.94 (+19.9%).
The three most impactful detractors from our Q1 2016 performance were Pacific Exploration & Production (PRE CN): $1.24 to $0.55 (average sale price at which we exited position) (-56%), Clear Media (100:HK): $1.03 to $0.86 (-16.5%), and HC2 Holdings (HCHC): $5.29 to $3.82 (-27.8%). The larger percentage decline from HCHC was less impactful than the smaller percentage decline in Clear Media because HCHC held a smaller position weighting in the portfolio.
While it is refreshing, to say the least, to have had our first quarterly out-performance in more than one year, we recognize that we still have a long way to go to reclaim our high water mark. After losing money in both 2014 and 2015, a -22.6% cumulative loss, even after Q1 2016’s +9.4% rebound, we still need a further 18% gain from here to get back to where we were on 12/31/13. Fortunately, our portfolio appears to offer over 64% upside potential if marked at our conservative appraisals of fair value for each of our 19 holdings, so we are very well-positioned to exceed our high water mark and more.
The weighted average valuation of our portfolio remains very low compared to the S&P 500, with an Enterprise Value (EV) to EBITDA multiple of 6.8x, versus 10.7x for the S&P 500, both based on 2016 estimates. And on a price to Free Cash Flow (FCF) multiple comparison, our portfolio appears to be at 10.9x, versus 18x for the S&P 500. Not only do our holdings appear to be vastly undervalued relative to the S&P 500, but we believe the businesses in which we’ve invested have a much less cyclical business profile on average, with over 60% of the portfolio invested in businesses that are highly recession resistant, and in some cases recession-proof, as well as having discernibly better long-term growth prospects.
While a rebound in emerging markets gave us a boost in Q1, the bulk of our out-performance came from our two largest holdings, Revlon and Carmike Cinemas, both of which are domestically domiciled companies, and both of which had better than expected earnings reports, and news relating to merger and acquisition activity, or the potential for such.
Revlon (REV) has no brokerage firm analysts covering the stock, but their Q4 2015 earnings report, released on February 26th, was much stronger than we anticipated, leading us to raise our 2016 estimate for Revlon’s adjusted EBITDA from $340M to $372M, which assumes that 2016’s EBITDA will be flat at the 2015 level. The stock ran up on that February earnings report, which built on the price gain achieved after the January 15th announcement that Revlon’s controlling shareholder, MacAndrews & Forbes (a Ron Perelman-owned holding company), was exploring strategic alternatives for their Revlon stake. But expectations that this change in stance might lead to a sale of Revlon were tempered by the announcement that their 47year-old CEO Lorenzo Delpani was stepping down, followed a month later by news that his replacement was hired. The new CEO at Revlon, Fabian T. Garcia, a 56 year-old Venezuelan hired away from Colgate-Palmolive after 13 years there, seems to have the requisite experience, but he is the 9th CEO that Revlon has hired in the just over 30 years since Ron Perelman bought control of the company in 1985, so it remains to be seen if he will finally be the one who is both worthy and capable of sticking around for the long-term. Perelman has had 5 wives over roughly the same time frame, so either he changes his mind a lot, or he is difficult to get along with, or maybe some combination of both. Regardless, we like the business and the valuation remains overly penalized, we believe, primarily due to the Perelman factor. We estimate Revlon’s fair value at $63 (+73% from $36.41 price on 3/31), which is 13.5x the $372M in EBITDA produced in 2015. Most major cosmetics firms change hands at around 15x EBITDA, so I think we’re being conservative with this appraisal. For many years now the mass market cosmetics business (which is Revlon’s market, selling through drug stores and Wal-Mart) has experienced a slower growth rate than the prestige brands (selling through department stores and Sephora). But with upward pressure on the minimum wage, and income inequality becoming an increasingly prominent issue, maybe we are at the inflection point when the mass market customer starts to make a bit more money, which would make growth in this segment a little easier than it has been over the past 15 years.
Carmike Cinemas (CKEC) also had a very strong Q4 2015, which they reported on February 29th. But, before the stock could fully adjust to the good news, just three days later, Carmike announced a definitive agreement to sell the company to AMC for $30 per share in cash, a modest 19.5% premium to the $25.11 pre-announcement price, and well below our bare-minimumestimate of fair value at $35. Mittleman Brothers has held a position in Carmike since late 2007, and we were stunned by the low valuation at which Carmike’s CEO and board of directors agreed to sell. We have thus shifted our stance from passive investors and filed a 13D indicating our intent to vote against this deal and encourage other shareholders to do the same. As clients you have received all three of our 13D letters to Carmike, which detail precisely why we feel that this is a terrible deal for CKEC shareholders. Rather than rehash all of those points here again, we’re happy to send those letters to you upon request. We have received encouraging support from other large Carmike shareholders who share our opinion that even at $40 per CKEC share that AMC would be getting an outstanding and undeniably accretive deal on Carmike, but at $30 it is just outrageous. If AMC does not raise its offer substantially (we will not accept a price less than $35 in AMC’s stock, or $40 in cash) then we expect the deal will be voted down. We would not expect Carmike’s stock price to drop much if at all under such a scenario as the results in Q4 2015 were outstanding and the report for Q1 2016, due out on May 2nd, should be similarly strong. So we think $30 is where Carmike should be trading in the open market without any control premium. We expect this situation to be resolved within the next six months.
Sberbank of Russia (SBRCY) has been recovering strongly, both in earnings and share price, for over a year now since it bottomed in December 2014. Still, the stock remains cheap, at a P/E ratio of just under 7x the $1.00 per ADR in earnings the company should produce in 2016, and less than 1x book value of $7.50 per ADR. Not much is run well in Russia, but Sberbank is an exception. We expect fair value is at least $12.50 (P/E 12.5, P/BV 1.7x), +80% from $6.94 on 3/31/16.
Looking now at the three biggest losers of Q1, I finally accepted defeat and sold Pacific Exploration & Production (PRE CN) at around $0.55 per share in March, thus ending a just over two year saga of epic misjudgment on my part, as it became abundantly clear, even to me, that the stock was destined for $0. The company filed for bankruptcy not long after we sold it and the stock is now delisted, so I suppose having saved that last sliver of value is some quantum of solace. We went over everything that went wrong with this investment in our year-end 2015 letter about three months ago, so rather than revisiting it here, suffice it to say that I was wrong about Pacific E & P in every way that an investor could be wrong, and we all paid a heavy price for my poor judgment here. I sincerely apologize for this episode, and will redouble my efforts to avoid exposing us to such vulnerability in the future.
While Clear Media (100:HK) was our second worst performer in Q1, we are not at all troubled by the decline in price, as the business fundamentals appear to remain intact. The company sits on a net cash balance sheet, pays us excellent dividends, and as one of the largest outdoor advertising firms in China, it has years of growth ahead of it. Obviously, a slow down or maybe an outright recession in China would hurt this cyclical business, but this is a business that generates cash in good times and bad, so we can tolerate a bad year every now and then. The stock closed on 3/31 at HKD 6.70 (USD 0.86) which is much too cheap at only 3.8x the $100M in EBITDA we expect the company to produce in 2016 (down from $104M in 2015), and 9.3x the $50M in resulting FCF. Larger competitors around the world like J.C. Decaux (DEC FP) and Lamar (LAMR) trade at 11x to 12.5x EBITDA and 15x to 21x FCF. Clear Media’s 50% owner, Clear Channel Outdoor (CCO $5.00) trades at 10.3x EBITDA and 14.3x FCF, and that company is highly leveraged and addressing a much slower growing U.S. market. We think Clear Media is worth a minimum of HKD 15.50 (USD 2.00) which is up 133% from 3/31 price of $0.86 and that would be 10x EBITDA and 20x FCF.
HC2 Holdings (HCHC), a new entrant to the portfolio in October 2015, has done what many new entrants to our portfolio seem to do right after they join, which is to go down around 50% or more. A vexing phenomenon, but usually transitory. HCHC is run by Phil Falcone, an investor with whom we’ve previously made significant gains in HRG Group (HRG) which we also still own. HCHC is like HRG in that both are investment vehicles, but HCHC is smaller and more highly leveraged and invested in more cyclical businesses, so the risk is higher with HCHC. But the reward in success should be higher, too. On a sum of the parts basis, we estimate NAV at $8.34 at 3/31/16 (down from $9.89 on 12/31/15) but likely to grow significantly. The company operates three FCF-generating businesses (Schuff- steel structure construction, Global Marine- undersea cable installation and maintenance, and Continental Insurance- LTC insurance in run-off) which pay dividends to the holding company. The holding company is operating with negative cash flow (dividends don’t yet cover interest expense and corporate head office expenses), but we think they can get to the necessary scale to achieve or exceed breakeven holding company cash flow, on a run-rate basis, by year-end 2016. HCHC has also invested in some non-cash flow generating investments in venture capital stage companies, which seem exciting, however risky, but they are a small portion of the current NAV. From its depressed price of $3.82 on 03/31, which we think is primarily due to technical factors, the upside to our estimated NAV of $8.34 is +118%.
The extreme whipsaw action of the market indices in Q1, with a scary drop into mid- February, followed immediately by a historic rebound, provides another lesson in the need for patience and maintaining a temperament that does not crumble every time the crowd is panicking. While we had a handful of individual clients who succumbed to that panic in Q1, we could not be happier with the response of the vast majority of our clients (98.3% client retention ratio in Q1), who have learned through a multitude of such experiences to ignore the noise and focus, as we do, on the fundamentals of the businesses in which we’ve invested. We look forward to continue climbing this never-ending wall of worry with you for years to come.
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