FPA Capital Fund Q2 Commentary: Long ATW, TWI Thesis

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FPA Capital 2Q Commentary – Introduction

In the classic movie Casablanca, starring Ingrid Bergman and Humphrey Bogart, Bergman’s character Ilsa asks Sam the Café Americain piano player to play it again Sam. Of course, Sam eventually indulges Ilsa and plays “As Time Goes By.” Later that same evening, Rick Blaine, Bogart’s character, also asks Sam to play it again.

In our modern era, Janet Yellen is “Sam” the piano player. Just like Sam in Casablanca, Janet may be reluctant to play her own rendition of “As Time Goes By,” but investors are asking Janet to play it again…for old time sake. Ms. Yellen’s version of “As Time Goes By” is to keep interest rates at rock-bottom lows until she and the Federal Reserve believe we are at maximum employment levels and/or GDP growth is distinctly on the rise.

The result of this beautiful melody (ultra-low cost money) is soaring equity values. For instance, the S&P 500 (INDEXSP:.INX) rose roughly 5% in the second quarter and is now trading at 20x trailing twelve month’s GAAP earnings; and the Russell 2500 (INDEXRUSSELL:R25I) appreciated more than 3.5% in the quarter to surge to nearly 29x earnings. Seemingly, the major indices touched record highs every day. Indeed, soothing music to the ears of many investors.

FPA Capital Market Commentary

Similar to the first quarter and as mentioned above, the major indices reached new highs in the second quarter. However, unlike the first quarter, we believe the fundamentals for the economy are improving. In our prior letter, we did not express any confidence that the economy was improving because the fundamentals were so weak. As it turns out, the latest report from the government statisticians is that the first quarter GDP declined nearly 3%, even though the January 2014 consensus expectation was for 2.6% “growth.” Thus, the bar has been set relatively low for subsequent quarterly growth for the remainder of 2014, including the second quarter.

This outlook is consistent with our statement last quarter, that we did not expect a recession this year, which is typically defined as two consecutive quarters of negative economic growth. Despite our dour expectation for first quarter economic results, we saw enough evidence that the poor fundamentals were not getting worse and, in fact, were showing some improvements.

For example, new manufacturing orders steadily improved throughout the second quarter, and industrial production also gained momentum. According to the ISM Purchasing Manager’s report, the production index was above 60 for both the months of May and June. An index number greater than 50 indicates that production is growing.

Moreover, in early July the non-farm payroll employment numbers were relatively strong at a positive 288,000 new jobs for the month of June. Large companies are also raising wages at healthy rates. For example, Gap and IKEA recently announced that they are increasing their minimum wages 10% and 17%, respectively. Disney and Anheuser-Busch also recently announced wage increases, and it’s likely we will see other large companies follow suit. Nonetheless, we would not expect consumers to go on a wild spending binge, due to higher energy and healthcare costs that are currently putting a squeeze on the average American’s wallet. We see the proof of this in the earnings releases of many consumer discretionary companies that focus on middle and lower middle class Americans.

The big question is whether earnings will improve with what appears to be better economic factors. Certainly, we do not expect a repeat of the poor first quarter profit results. According to the Bureau of Economic Analysis, total U.S. corporate profits declined 10% quarter-over-quarter and declined 3% year-over-year in the March quarter. These numbers should not be confused with the S&P 500 earnings per share numbers, which take into consideration share buybacks and only include five hundred large, publicly-traded companies. Nevertheless, the EPS growth for the S&P 500 has been very weak over the past year, as discussed in prior letters.

FPA Capital Fund adds Atwood Oceanics and Titan International

We added to a number of existing positions in the quarter and started one new position, which is too small of a position to talk about at this point. Among the stocks that we added to in the quarter were Atwood Oceanics, Inc. (NYSE:ATW) and Titan International Inc (NYSE:TWI).

Although Atwood Oceanics, Inc. (NYSE:ATW) appreciated roughly 4% in the June quarter, in early April the stock was down 10% from its closing first quarter price. As we mentioned last quarter, when we also added to the position, investors are concerned about the prices the company can charge to rent out its equipment to its customers. Atwood owns off-shore drilling rigs, some of which cost upwards of $600 million apiece to construct today. These $600 million rigs, typically very sophisticated drill ships, allow ATW’s oil & gas exploration customers to drill in the ultra-deep waters (UDW) of the Gulf of Mexico, off the coast of western Africa, or in the deep waters of Brazil. These deep water basins, and other basins, hold the potential to extract over a hundred billion barrels of oil over the next few decades. However, these are very expensive and long-term projects, which not every oil company has access to or the capital to risk. Hence, ATW’s drill ships can potentially be rented out to a narrower group of customers than rigs for shallow water drilling (typically four-hundred feet of water depth), where the company’s jack-up drilling rigs operate.

While there are a number of potentially large oil & gas reserves in the ultra-deep waters, generally 7,500 feet of water or deeper, the timing of when these projects get started can be lumpy. Additionally, Atwood Oceanics, Inc. (NYSE:ATW) is not the only drilling rig operator that sees this very large opportunity, so the company’s competitors have also ordered new UDW drill ships. Thus, the market is concerned about a temporary supply and demand imbalance for UDW drill ships.

In our conservative analysis, we think UDW drill ship rental rates may fall from roughly $600,000 a day, which is where day rates were in late 2013, to roughly $500,000 a day. In this downside scenario, we estimate that Atwood Oceanics, Inc. (NYSE:ATW) could earn close to $5.00 a share this year and over $7.00 a share in 2015 and 2016. This also assumes one of the company’s semi-submersible rigs is idled later this year. With ATW trading below $50, we believe the risk-to-reward ratio warranted additional capital being deployed in the stock. Subsequent to our additional purchases in the second quarter, two of ATW’s competitors announced new UDW drill ship contracts at much higher rates than many investors and Wall Street analysts expected. We think these recent higher day rate contracts, which were also higher than our conservative case expectations, bode well for Atwood’s two remaining un-contracted UDW drill ships.

FPA Capital Fund: Thesis for Titan International

As mentioned above, Titan International Inc (NYSE:TWI) declined nearly 12% in the quarter and we added to the position as the stock weakened. As you may recall, we initiated the position in TWI in the fourth quarter of 2013 in the mid-teens. Despite our additional TWI purchases, we do not yet own a full position in the stock. However, we have plenty of capacity to take the stock to a normal full position, which is 3%, but this assumes the company earns the right to have more of your capital allocated to the position.
The primary reason why Titan International Inc (NYSE:TWI) shares sold off recently is that the wheel and tire markets for large construction and mining equipment remain depressed. Investors had hoped that the off-road, large construction equipment and mining business would see some acceleration after the very cold winter season, but that does not appear to be the case. Tire inventory levels for large, off-road equipment were too high for dealers to be aggressive and purchase tires en masse earlier this year. However, there is some recent evidence that much of the excess tire inventory has been reduced to levels that now support some restocking.

Our investment thesis for Titan International Inc (NYSE:TWI) is not predicated on the wheel and tire market for large, off-road equipment to come roaring back to levels experienced before the financial crisis. Rather we believe the assets TWI has accumulated over the past decade can be managed more efficiently and, therefore, profit margins can improve without a huge increase in revenues. We recently visited one of TWI’s Midwest tire facilities and came away with the impression that simply operating the existing production equipment more efficiently would yield substantial improvements in the plant’s profitability.

Furthermore, we believe most of Titan International Inc (NYSE:TWI)’s operating plants have ample room for productivity enhancements and, thus, profit improvement. It is encouraging that the company has promoted Paul Reitz as the firm’s President, and that Mr. Reitz has replaced senior plant managers with more capable people. However, more work needs to be done in order to maximize the profit potential the company’s assets are capable of generating for shareholders.

H/T dataroma

See full FPA Capital 2Q Commentary in PDF format here via FPA Funds

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