Corsair Capital letter for the second quarter ended June 30, 2016; titled, “Quintiles Transnational / IMS Health Thesis.”
H/T Market Folly
Dear Limited Partner:
For the second quarter ended June 30, 2016, Corsair Capital was up an estimated 1.3%* net, after all fees and expenses, bringing our 2016 performance to 0.6%*. Corsair Select was up an estimated 2.9%* net, after all fees and expenses, bringing our 2016 performance to 1.2%*. Since inception in January 1991, Corsair Capital’s compounded net annual return is 12.6%. Since inception in January 2004, Corsair Select’s compounded net annual return is 10.8%.
Despite the seemingly negative geopolitical and macro-economic global headlines during the second quarter, equity markets generally continued their rebound from mid-February’s low. Only at the end of the quarter, with the surprising final results of the United Kingdom’s Brexit resolution in hand, did the U.S. stock market suffer somewhat of a small correction. Furthermore, while the initial reaction in Europe to this vote was quite violent (London’s FTSE 2500 Index declined 7% – its worst one-day performance since the 1987 crash, the British Pound lost 8% – its largest drop since its 1967 devaluation, and the equity markets in Spain and Italy both declined more than 12%), much of the losses suffered were recovered as of early July.
The best explanation for equities’ positive performance may come from interest rates, a subject we have discussed in many of our past quarterly letters. The United Kingdom’s vote to exit the European Union seemed to exacerbate global uncertainty and cause a continued flight to “safety” by investors into sovereign bonds around the world. The result being not only record low interest rates around the globe, but also asset value inflation as the cost to finance any asset purchase continued to decline.
In fact, interest rates are not just at record lows, but they are actually negative in many countries. According to Bank of America Merrill Lynch, $13 trillion of bonds are now priced with negative yields, up from effectively none two years ago. This represents an astounding 30% of all sovereign bonds globally. Theoretically, this should never happen as investors could just hold on to their cash versus lending it out. Furthermore, according to the reference guide “A History of Interest Rates,” this is the first time the world is seeing truly negative interest rates since 3,000 B.C.
How one correctly values equities in this new interest rate world is a question few can definitively answer. Needless to say, because there have been no other analogous time periods since the Bronze Age, statistical analysis of how asset values have previously performed is moot. “A World Turned Upside Down” is how the Wall Street Journal recently described things as investors are now paying for the privilege of lending money to Germany as that country became the first Euro-zone nation to sell 10-year bonds with a negative yield. And how should one value the price of a home in Denmark? According to the Grant’s Interest Rate Observer, interest rates are so low in “the land of Hans Christian Anderson that the mortgagees pay the mortgagors, rather than the other way around.”
The U.S. stock market is currently trading at approximately 16x-17x next year’s earnings. This equates to an earning’s yield of approximately 6% after-tax and 8% on a pre-tax basis – a big gap to 10-year treasury bonds yielding just 1.5%. As long as investors believe that stocks will generally continue to earn what they currently do (even with zero growth), equities will seem to be mathematically quite cheap compared to bonds. Of course, just because bonds are expensive doesn’t mean investors have to invest in stocks. However, if not stocks, where will investors turn? It just seems the answer is TINA – there is no alternative – as all assets are historically expensive and stocks may prove to be the proverbial “best house in a lousy neighborhood.”
With the U.K.’s vote to leave the European Union, there is certainly public groundswell in other European nations to vote for their countries to do the same. Thus, an investor likely needs to consider slower economic growth in not only Europe but for the world as well. We believe U.S. domestically-oriented companies should be less affected by European political upheaval and continue to focus our efforts in the mid-capitalization sector in the U.S. As mentioned in our last letter, companies are generally reporting solid results and optimistic outlooks. As John Stumpf, the CEO of Wells Fargo recently put it, all indicators “point to continued relative strength in the U.S. Economy.” So, while there is risk to the price of all assets should interest rates rise significantly, we believe there remains a substantial cushion between the value and price of many U.S. companies.
The largest contributors and detractors for the quarter were:
Diamond Resorts International (“DRII”) shares rose 23% in Q2 after Apollo Global Investments (“APO”) announced a cash tender at $30.25 on June 29th. Our interest in DRII dates back to 2014 and our thesis was underpinned by the following: DRII had a) an undervalued recurring fee stream associated with managing timeshare properties b) a robust free cash flow profile with low corporate debt obscured by GAAP optics and c) a highly aligned/incentivized management team. Additionally, we took comfort in the fact that a large percentage of sales go to existing customers and that customers are willing to pay a premium price for DRII’s vacation points. We made DRII a core position after management announced it was pursuing strategic alternatives and we continued to add throughout Q2 as DRII continued to execute. Given its low financial leverage and limited capex requirements, we believed DRII would be an ideal takeout candidate for either a strategic or PE buyer. We also believed DRII had upside as a standalone company given it had the financial flexibility to return a significant amount of cash to shareholders via a special dividend or stock buyback. The cash tender from APO validated our thesis. DRII stock ended the second quarter at $29.96.
Olin Corporation (“OLN”), a company we featured in the Appendix of our Q3 2015 investor letter, rose 43% in Q2 as chlor-alkali markets tightened and supplier pricing initiatives took hold. After experiencing chlor-alkali price declines in Q1, North American producers saw the benefits of: a) actual and anticipated capacity reductions in the US and Europe and b) stronger export demand thanks to lower Chinese PVC production. Investor confidence grew when OLN affirmed FY 2016 guidance based on April index pricing. Subsequent chlor-alkali pricing gains in May and June were incremental to OLN’s guidance baseline assumptions and gave some credence that supply rationalization was taking hold. Separately, Westlake Chemical (“WLK”) reached an agreement to purchase Axiall (“AXLL”), a beleaguered competitor of OLN; WLK’s aggressive pursuit of AXLL suggested that it saw meaningful value in the upstream part of the chlor-vinyl value-chain, where OLN is the largest and lowest cost producer. Our thesis remains that a) improving supply/demand dynamics in the chlor-alkali market will be a tailwind for OLN and b) OLN will over-deliver on synergies from its acquisition of Dow’s chlor-alkali assets. OLN shares finished the second quarter at a price of $24.84.
Clearwater Paper (“CLW”) reported strong first quarter results and guided second quarter EBITDA above sellside expectations, driving the stock up by 35% for the period. The company continued to execute on its cost savings goals, as the Consumer Products segment posted its highest EBITDA margin in any quarter since the second quarter of 2014. In the Paperboard segment, supply/demand fundamentals remain healthy and the business has performed well, despite pricing pressure from the strong U.S. dollar. CLW also continued its share repurchases, buying back 4% of the company’s outstanding shares in the period. Since 2013, the company has retired more than 25% of its outstanding shares. We believe it is also important to note that the company added new directors John O’Donnell and Alex Toeldte to its board – both activist CEOs. O’Donnell spent 20 years at CLW competitor Georgia-Pacific before taking the CEO position at Neenah Paper (“NP”) in 2011. NP stock has more than tripled since John arrived, fueled by stock buybacks, dividends and acquisitions. Toeldte, a private equity executive, previously held the CEO position at Boise (“BZ”) before selling the company in 2013. We welcome the new appointments as they add more value creators to the CLW team. CLW stock ended the second quarter at $65.35.
IAC/InterActiveCorp (“IAC”) shares rose 20% in what was a transformational second quarter for the company. IAC and its majority-owned Match Group (“MTCH”) reported very positive first quarter results for HomeAdvisor, Vimeo and the MTCH dating assets. MTCH beat consensus EBITDA estimates for the period and also guided full year 2016 EBITDA materially above sell-side expectations. The confidence at MTCH is being driven by improving mobile conversion at match.com and because, as CEO Greg Blatt quipped, “Tinder is really killing it.” At HomeAdvisor, management revealed a path to growing revenue from $355MM in 2015 to over $1 billion in 2020. In addition to the bullish financial results and optimistic commentary on the future, IAC announced it had repurchased 6% of its outstanding shares in the open market in just the first quarter alone. Our view is that this large buyback, alongside an extraordinary shareholder letter by CEO Joey Levin and newly hired CFO Glenn Schiffman, was a significant inflection point for the company. Since Schiffman joined the team in April, there has been a concerted effort on the part of management to be more transparent and shareholder friendly. We applaud management on writing a letter that plainly states the case for IAC shares being materially undervalued and agree with CEO Joey Levin that we “don’t think it’s healthy for our perception of value to be so far off from the market (CEO Joey Levin on the Q1 2016 earnings call).” IAC shares finished the second quarter at a price of $56.30.
Voya Financial Inc. (“VOYA”) declined 17% during the second quarter on fears that lower interest rates for longer will deplete excess capital at the company and cause a headwind to future earnings. The sell-off in the stock came primarily after “Brexit” voters sided with the “leave” campaign and investors sought out safe havens. 10-year treasury yields, a bellwether for US rates, declined to 1.47% at the quarter end, representing a decline of almost 100bps from a year ago. While the company has been successfully moving earnings from capital intensive and macroeconomic sensitive business lines (i.e. life insurance and annuities) into capital light(er) businesses (i.e. retirement and asset management), they still have material exposure to interest rate sensitivity. However, the company has provided some information regarding its sensitivity to interest rates and we believe the current rate environment represents a manageable headwind that will not require an infusion of capital, just less excess capital available to return to shareholders. When interest rates normalize, VOYA will be well positioned to benefit from regaining some of this lost excess capital. As we noted in our Q1 letter, VOYA management has executed on its previous financial goals, used excess cash to aggressively repurchase shares and removed a large shareholder overhang. Assuming the company will need to use some of its excess capital to replace lost income for lower interest rates, the company is still trading at under 6x 2018 estimated earnings. Management is committed to exploring all opportunities to create shareholder value and to returning excess capital to shareholders. We believe VOYA will actively repurchase shares of the company at these levels, creating even further value in the long-term. VOYA closed the quarter at $24.76.
Countrywide plc (“CWD”) declined by 34% during the second quarter on the heels of the U.K. decision to leave the European Union. CWD, the leading real estate broker in the U.K., will certainly be impacted by the “Brexit” decision. However, among the reasons we like CWD is the diversity of its business where almost 45% of the profits relate to recurring revenue fee-stream businesses that are unrelated to home sales. Additionally, the company earns only ~20% of its real estate profits in London, the area likely to be the most impacted by the “Brexit” decision. While this was clearly disappointing news for shareholders, we are encouraged by the diversity and strong cash flows generated by CWD and believe the stock price movement was an overreaction. We believe management will use the near-term turmoil to accelerate restructuring plans and focus on cash management and shareholder returns. CWD closed the quarter at £2.45.
As of July 1, 2016, the five largest positions in Corsair Select were Diamond Resorts International, Aon plc, IAC/InterActiveCorp, KAR Auction Services and Orbital ATK.
Thank you for your continued support and confidence. See the attached Appendix for a write-up of a current core investment. Please feel free to call us with any questions you may have at 212-949-3000.
Corsair Capital Management, L.P.
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