Dan Loeb Q2 Letter to investors
Second Quarter 2017 Investor Letter
Review and Outlook
During the second quarter of 2017, Third Point earned +4.6% in the Offshore Fund, bringing total returns for the year to +10.7%. We have generated alpha through good stock picking in an environment that has proven unpredictable, but favorable for our opportunistic style.
In our January letter to investors, we shared our view that 2017 would be a year characterized by reflation globally, an end to central bank easing, and a US economy juiced up by the Trump administration’s increased fiscal spending and tax reform. So far, none of these predictions has come to pass. In April’s investor letter, we noted that actions out of Washington would be delayed or even denied, but explained that we remained fully invested because we believed that the emergence of synchronized global growth was more important than the fading “Trump Trade”.
We were correct on this point and during the second quarter, we reduced investments in bank financials, exited reflationary macro trades, and reoriented the portfolio towards investments in companies that benefit from low inflation. Europe, which we highlighted as a source of opportunity in our Q1 Letter, has been a bright spot. Our exposure there is higher than it has been since 2010, led by our recently announced investment in Nestlé. Our portfolio is well balanced across equity sectors but with declining exposure to credit strategies.
Looking ahead to the second half of the year, we still believe that central banks will be important drivers of action. While it might be too early to say that the key central banks have turned hawkish, their tone is changing and they are well past the point where any hiccup in the market will prompt increased accommodation. In the US, current weak levels of inflation and poor CPI and retail sales reports present a quandary for the Fed. Based on her recent remarks, Janet Yellen does not seem likely to advocate drastic action. However, we do believe that the Fed will begin balance sheet reduction shortly but that the next rate hike will be on hold until growth and inflation accelerate.
Economic growth in the US has been generally disappointing, particularly relative to expectations. Markets, on the other hand, have been helped by better performance globally, which also explains why non-US market performance has been strong. We believe that US growth will pick up in the second half, driven by seasonality and other factors. However, the US economy will continue to have an overhang until Congress and the President show they can get major legislation passed this year. With substantial corporate tax reform promised but not delivered, companies are sitting on their cash hoards and their M&A plans, waiting for clarity.
Despite the market run-up, we continue to find compelling investment opportunities, particularly with global growth intact. However, not all stocks that have appreciated are trading at fair value and accordingly, we are also finding opportunities to hedge the portfolio with single name shorts that we believe are overpriced.
Equity Investment: Baxter International Inc.
Two years ago, we initiated a 9.9% position worth over $1.5 billion in Baxter. An under-earner in the medtech industry with margins trailing its peers, Baxter was about to spin out
its biopharma business, Baxalta. Shortly after the spin-off, Baxter’s long-time CEO announced his intention to retire. We believed these two major changes at the company presented an opportunity to create a more focused Baxter, cure its under-earning problem, and even make it an industry leader in operational performance – if the company took the right steps. Third Point’s Munib Islam joined the Baxter Board of Directors in September 2015. Munib also participated on the search committee that successfully recruited former Covidien CEO José “Joe” Almeida as Baxter’s new CEO starting on January 1, 2016.
Mr. Almeida’s sweeping changes to Baxter’s business over the past 18 months have created meaningful shareholder value. His tenure thus far is a case study on how leadership and cultural change can be transformational. Prior to his arrival, Baxter had guided to 2016 operating margins of 10%, growing to 14% by 2020. Under Mr. Almeida’s leadership, Baxter delivered 2016 operating margins of 13.6% and in May 2016, updated 2020 guidance to 17-18% operating margins. Due to continued strong operational performance, Baxter subsequently upgraded its 2020 guidance to ~20% operating margins on the Q2 2017 earnings call. The increases have been driven by multiple factors including:
• Cost cutting initiatives: Mr. Almeida instituted a Zero-Base Budgeting process that had an immediate impact: SG&A spend declined over 10% in 2016 vs pro forma 2015 levels, while R&D spend also declined year over year in absolute dollars.
• Addition by subtraction: As part of an extensive portfolio review, Mr. Almeida made decisions to exit certain unprofitable product lines/markets and legacy R&D projects with negative expected value.
• Focus on high gross margin businesses: Baxter supplemented its generic injectable drug pipeline through three transactions and strategic partnerships (including the proposed acquisition of Claris Injectables). As the pipeline matures and products are approved, the high gross margin products will naturally improve Baxter’s underlying operating margin. Baxter’s free cash flow generation has benefited from the improved operational efficiency. The prior free cash flow guidance was for $400 million in 2016 growing to $1.1 billion by 2020. Under Mr. Almeida, Baxter reported $935 million in 2016 free cash flow that is forecast to grow to ~$2.0 billion by 2020. Through the Zero-Base Budgeting process, the company has cut capex spending by nearly $200 million to $720 million in 2016 and forecasts continued reduction in capex through 2020.
In addition to continued margin expansion and improving free cash flow generation, there is renewed anticipation about how Baxter might deploy its pristine balance sheet. Since the spinoff, Baxter successfully monetized its Baxalta retained stake and currently sits at a zero net debt position; this contrasts with medtech peers who carry 1-2 turns of net leverage. Mr. Almeida has significant capacity to create value for shareholders through a combination of business development, share repurchases, and potential dividend increases.
Investors have clearly approved of Mr. Almeida and Baxter’s improved performance. Between January 1, 2016 and June 30, 2017, Baxter delivered a Total Shareholder Return (TSR) of 61%, nearly 3x the S&P 500 return of 22.4%. Despite the 18 month outperformance, Baxter’s forward EV / EBITDA multiple has remained largely unchanged at 12.5-13.0x; stock appreciation has been driven almost exclusively by an increase in Baxter’s underlying earnings power. Looking forward, we are confident that Mr. Almeida can combine operational efficiency with an unlevered balance sheet to drive continued earnings growth which – even absent any multiple expansion – should drive strong returns for Baxter shareholders.
Equity Investment: Alibaba Group Holding Ltd.
We have reinitiated an investment in Alibaba, a name which we have owned directly and via our positions