Mittleman Brothers Investment Management commentary for the third quarter ended September 30, 2016. Does not mention Carson Block of Muddy Waters but is obvious – see below full letter.
Mittleman Brothers Investment Management, LLC ’s composite gained 10.8% net of fees in the third quarter of 2016, versus advances of 3.9% in the S&P 500 Total Return Index and 9.1% in the Russell 2000 Total Return Index. Longer-term results for our composite through 9/30/16 are presented below:
Mittleman Brothers – Portfolio Review
The top three contributors to our Q3 2016 performance were Revlon (REV): $32.18 to $36.78 (+14.3%). Carmike Cinemas (CKEC): $30.12 to $32.69 (+85%). and International Game Technology (IGT): $18.74 to $24.38 (+31.2% with dividend). The larger percentage gain from IGT was less impactful than the smaller percentage gains from Revlon and Carmike because those stocks had much larger portfolio position weightings than IGT.
The three most impactful detractors from our Q3 2016 performance were Rallye SA (RAL FP): $17.24 to $16.39 (-4.9%). First Pacific Company Ltd. (142 HK): $0.72 to $0.71 (-0.35% with dividend). and ABS-CBN Holdings Corp. (ABSP PM): $1.01 to $1.01 (unchanged).
We discussed Revlon in our Q1 2016 Investment Review. when it was the top performer. and again in the Q2 2016 letter when it was down for that quarter in our basket of deplorables. So rather than rehash the story here yet again. suffice it to say that the business seems to be trending well under new CEO. Fabian Garcia, formerly of Colgate-Palmolive, with innovative new product launches noticeable in stores recently. And the stock remains extremely undervalued. We estimate $78.50 per share is a fair appraisal of intrinsic value per share. which is 113% higher than the quarter-end price of $36.78. Revlon. at 9.1x EBITDA at quarter-end. would be 13.5x EBITDA ($50oM estimated for 2017) at our estimate of fair value. and still below the valuations of its larger peers such as L’Oreal (OR FP € 168.10) at 14.5x EBITDA. Estee Lauder (EL $88.56) at 13.7X. and Coty (COTY $23.50) at 14.5x. Revlon’s EBITDA margin. recently about 19.5%. should drop in 2017 to 17.3%, due to their recently closed $923M acquisition of the much less profitable Elizabeth Arden. but that metric should rebound in the ensuing years as the anticipated long-term synergies in that merger are realized. EBITDA margins for their peers are: L’Oreal: 21.2%. Estee Lauder: 19.8%. and Coty at 17.5% most recently. So Revlon’s profitability should not stand in the way of it attaining a valuation multiple much closer to the industry average. especially since the company has been growing faster than their larger peers over the past five years. mainly through acquisitions. but. importantly, with market share gains as well.
Our second biggest contributor to Q3 2016 performance, Carmike Cinemas, rose 8.5% during the quarter on the news released July 25th that AMC Entertainment had raised its offer to buy Carmike by 10.2% from $30 per share in cash to $33.06 per share in cash. or 1.0819 shares of AMC stock. but prorated such that no more than 30% of the total consideration paid will be in AMC stock (issuance fixed at $30.56 per AMC‘ share). As you know, we vocally opposed the first iteration of this deal. announced on March 3, 2016. which would have cashed us out of Carmike’s stock completely at only $30 per share. That we were able to garner enough support from other large shareholders and the major proxy voting advisory firms to effectively vote down that original deal is moderately satisfying. but the terms ofthis improved offer. while substantially better due to the AMC stock component introduced, are still well below the $40 per share minimum value we think represents the lowest price acceptable in a change of control situation such as this one. We continue to reach out to other large shareholders, explaining our ongoing opposition to this transaction, despite the improved terms, in hopes of encouraging other shareholders to vote against this unfairly undervalued takeover. As we pointed out in our Q2 Investment Review. at $33.06 per share AMC would be paying only 5.3x EBITDA post-synergies to acquire CKEC. the 4th largest theater chain in the U.S., and thus making the combined AMC/CKEC the number one chain in the country. This is especially galling since in mid-July AMC announced the acquisition of an almost identically sized theater chain based in the UK. called Odeon-UCI. for a 9.ox EBITDA multiple post-synergies. for a businesses that is substantially less profitable than CKEC (EBITDA margin of only 14.6% versus CKEC’s 16.8%). Usually when #2 buys #4 to become a new #1 there is a substantial premium paid in terms of valuation. and those deals don’t provide such massive accretion to the buyer in year one. We’ve previously noted that B. Riley & C 0. has claimed AMC ’s buyout of CKEC would be accretive to AMC‘ even if they paid into the mid $4os for CKEC‘. More recently FBR Co. issued a report on October 1oth estimating that on the improved bid, AMC would still create over $7 per AMC share in value from closing the CKEC buyout on these terms. That is $682M in value accretion on a deal costing them $1.2B. which is a huge amount of value accretion that should be more equitably shared with CKEC’s shareholders. The vote will occur at a shareholder meeting on November 15th. We are aware that one of the other largest shareholders of CKEC has changed their vote from “against” to “in favor” based on the modestly improved terms. and one of the two largest proxy advisory firms. 188. also changed their recommendation from “against” to “in favor,” mainly citing the improved terms. So with diminished support for our opposition, we must acknowledge the probability is much higher now that C armike will have enough votes to close the deal on November 15th. If that happens. we plan to hold on to the AMC stock we’ll receive for our CKEC‘ shares. as we believe AMC is also worth about $40 at fair value (versus $31.09 on O9.«””30.«””16), in which case the total consideration of cash and AMC stock we’d receive for our CKEC shares would be valued just over $36 per CKEC share. Not nearly enough to be considered fair. but certainly better than $30.
International Game Technology, our third biggest contributor to Q3 2016 performance was up 31.2% including a dividend payment, as investors finally seem to be waking up to the magnitude of the valuation aberration that has long plagued this high quality cash flow machine. The largest lottery systems management business globally, and the largest slot machine company in the world; investors seemed to have been overly pessimistic about the weakness in their slot machine business, while ignoring the strength in their lotteries business. We think this high-margin (36% EBITDA margin) highly recession-resistant business should trade at no less than 8x EBITDA ($1.83B estimated for 2017) and 14x FCF ($50oM in normalized Free Cash Flow in 2017), which would put the stock at $34.25, up another 40% from the quarter-end price of $24.38, not including the 3.3% dividend yield. Given the aforementioned characteristics, we can imagine the stock trading at 10x EBITDA and 21X FCF which would be $52 per share, more than 100% upside. And why not? Food companies like Kellogg (K $77.47) trade at 13.6X EBITDA and 19X FCF but with much lower EBITDA margin (19.5%) only partially offset by lower cap-ex needs, and no better growth prospects, or Kraft Heinz (KHC‘ $89.51) at 15.9X EBITDA and 24.5X FCF with a 32% EBITDA margin. Lotteries and gambling are secular growth industries, while selling junk food is not so much anymore.
International Game Technology, our third biggest contributor to Q3 2016 performance was up 31.2% including a dividend payment, as investors finally seem to be waking up to the magnitude of the valuation aberration that has long plagued this high quality cash flow machine. The largest lottery systems management business globally, and the largest slot machine company in the world; investors seemed to have been overly pessimistic about the weakness in their slot machine business, while ignoring the strength in their lotteries business. We think this high-margin (36% EBITDA margin) highly recession-resistant business should trade at no less than 8x EBITDA ($1.83B estimated for 2017) and 14x FC F ($50oM in normalized Free Cash Flow in 2017), which would put the stock at $34.25, up another 40% from the quarter-end price of $24.38, not including the 3.3% dividend yield. Given the aforementioned characteristics, we can imagine the stock trading at 1ox EBITDA and 21X FC F which would be $52 per share, more than 100% upside. And why not? Food companies like Kellogg (K $77.47) trade at 13.6X EBITDA and 19X FC F but with much lower EBITDA margin (19.5%) only partially offset by lower cap-ex needs, and no better growth prospects, or Kraft Heinz (KHC‘ $89.51) at 15.9X EBITDA and 24.5X FC‘F with a 32% EBITDA margin. Lotteries and gambling are secular growth industries, while selling junk food is not so much anymore.
Leading the list of top three laggards in Q3 2016 was Rallye SA, down 5%. We discussed the stock at length in our Q2 2016 Investment Review when it was in the top three gainers, and not much has changed since then. But, since a well-known short-seller mentioned it negatively again during a recent Bloomberg TV interview, I will provide further color on our thesis here. Rallye owns 51% of Casino Guichard (CO FP), the llth largest supermarket company in the world, with operations primarily in France, Brazil, Colombia, and Argentina. Rallye is 55.3% owned by French billionaire Jean-Charles Naouri who has built an excellent track record in acquiring high-quality grocery store and other retail chains and then developing the surrounding real estate and selling the fully developed real estate assets at very good cap rates. At quarter-end price of $16.39 (€14.60). Rallye’s dividend yield is12.5%. We estimate fair value is $31, +89% not including the large dividend. At $31. the dividend yield would be 6.6% (presuming quarter-end EURfUSD at 1.1235 is unchanged). The stock remains cheap because Rallye is a highly leveraged holding company and their dividend is not fully covered by cash flow to the holding company. leading some to expect a dividend cut. But the source of Rallye’s cash flow. their 51% stake in Casino-Guichard, has ample capacity to provide Rallye further liquidity if needed. The dividends paid out by Rallye, € 89M per year. are funded by the dividends Rallye receives from Casino-Guichard, which amount to €179M per year (51% of Casino-Guichard’s total dividend payout of €35oM per year; well covered by €50oM per year in free cash flow). But Rallye also has interest expenses and other costs totaling €123M per year, so adding the dividend of€ 89M to that means €212M is going out against only €179M coming in, an annual shortfall of€ 33M. Rallye has been meeting that shortfall by liquidating other assets including real estate and financial assets on its own balance sheet of which about € 10oM remains as of June 3oth., and occasionally issuing debt, as they just did on October 19th selling €2OOM in 5.25% notes due in 2022. They also have €1.4B in undrawn and available credit lines. So Rallye has ample resources to wait until C‘asino-Guichard feels comfortable raising its dividend enough to fully fund Rallye’s own payout. And given Casino-Guichard’s aggressive deleveraging over the past year. selling assets at excellent valuations, we think that may happen sooner rather than later. Casino-Guichard already generates enough free cash flow to raise their payout from €35oM currently to €45oM. which would solve Rallye’s payout funding issue. leaving still another $5oM in FCF for Casino-Guichard to use for further deleveraging. Casino-Guichard also sits on €4B (€35.71 per share) in owned real estate in France. from which they opportunistically harvest cash regularly. That real estate is highly underappreciated by analysts and investors. Casino-Guichard. and thus. Rallye. are really in two businesses, grocery stores and retail real estate development. but the latter business is mostly ignored in valuations of Casino-Guichard done by brokerage firm analysts who cover the stock. as they are mostly retail analysts and thus are not focused on real estate assets. If Casino-Guichard’s stock price is €46.00 per share or below then Rallye has a marked-to-market NAV of $0 or less, as is now the case with Casino-Guichard’s stock ending Q3 at €43.30. But at our estimate of fair value for Casino-Guichard of €70.00 per share (15.7X FCF of €50oM). Rallye’s marked-to-market NAV becomes $31.00, +89% from quarter-end price. That NAV also includes €10oM in investments. $233M for their 100% ownership of GO Sport. and net of€2.933B in debt. As the value and earnings of their substantial South American assets are rapidly improving, now. we expect to realize our fair value estimate here in the not too distant future. and to continue receiving very large cash dividends while we wait. Huge insider ownership with a proven owner.«”‘operator, focused on free cash flow and dividends, with a complex structure that obscures critical elements of value and scares away Wall Street analysts… Rallye is the kind of orphaned situation that appeals to us and usually makes us a lot of money.
Our second worst performer in Q3 dropped just 0.35% when including a dividend received. First Pacific Company Ltd. This Hong Kong listed investment vehicle for controlling shareholder Anthoni Salim. an Indonesian billionaire with a good track record. closed Q3 at HKD 5.52 (USD 0.71). but with an NAV of HKD 12.48 (USD 1.61). So. this stock would have to rise 127% from current price just to trade at parity with its end of quarter NAV. a substantial $6.89B worth of dividend producing businesses, nearly 90% of which are publically traded. Such gaping valuation discounts usually don’t last.
Our third worst performer in Q3, ABS-CBN Holdings Corp. was merely unchanged at $1.01 (PHP 49.00). It appeared in this same position in our last Investment Review (Q2 2016). and not much has changed since then. ABS-CBN is the dominant TV broadcaster in the Philippines, with a 44% audience share. and also owns 57.4% of privately held Sky C able. which has 47% market share in cable TV in that country. The stock price languishes in anticipation of the cyclical slowdown in ad spending seen after each election year boost, as the country elected a new President earlier this year. And this new President Duterte has been unusually volatile and bellicose. particularly in his animosity towards the U.S.. which is weighing on share prices there as the country waits to see if his words progress into policy changes. The Philippines is a young. fast-growing country. and we doubt the new President will do too much to thwart that progress. So when AT&T is proposing to pay 13.5X EBITDA to buy Time Warner to marry its entertainment content with AT&T’s distribution, to address the mature U.S market. it’s interesting that our ABS-CBN, where the largest film and TV content producer already owns the largest TV and pay TV businesses in that much faster growing country. is only trading at 5.6x EBITDA. At such a low multiple. a lot can go wrong with the macro economic back drop in the interim. and we can still make a very satisfying return in that stock. We think a minimum fair value for such a dominate entertainment/’media franchise in a fast growing economy is at least 9X EBITDA. which would put AB S-CBN’s stock at $1.75 (PHP 85). up 73% from its quarter-end price of$1.01.
As usual, in this review we’ve touched on six of our eighteen current holdings. but we’re equally excited about the risk/reward ratios we perceive in the other two-thirds of the portfolio that we have not mentioned here. In fact, we believe that the weighted average upside potential to our fair value price targets across the entire portfolio is still over 70%, which is towards the high end of the historical range for that metric. And while it’s unlikely that we will capture all of the upside we perceive in all of our holdings in any one year. the magnitude of the implied upside is usually an encouraging sign for our future performance.
We look forward to updating you again in January 2017 on our Q4 and full year 2016 results.
Christopher P. Mittleman
Chief Investment Officer – Managing Partner
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