Hazelton Capital Partners commentary for the second quarter ended June 2021, discussing their position in DXC Technology Co (NYSE:DXC).
Q2 2021 hedge fund letters, conferences and more
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second half of 2022, outperforming the 3.4% return for Read More
Hazelton Capital Partners, LLC (the “Fund”) returned 4.1% from April 1, 2021 through June 30, 2021 and has returned 16.6% year-to-date. By comparison, the S&P 500 returned 8.6% during the same quarter and 15.3% year-to-date.
The Quarter in Review
Hazelton Capital Partners ended the 2nd quarter with a portfolio of 16 equity positions and a cash level of less than 10% of assets under management. The top five portfolio holdings, which are equal to roughly 55% of the Fund’s net assets, are: Micron Technology (NASDAQ:MU), Renewable Energy Group (NASDAQ:REGI), Caesar Entertainment (NASDAQ:CZR), DXC Technology (NYSE:DXC), and Apple Inc (NASDAQ:AAPL). The only significant change to the top five portfolio holdings was the inclusion of DXC technology which will be discussed later in this letter. Unlike last quarter’s positive contribution, the top five portfolio holdings negatively impact the Fund’s quarterly return by 110 basis points or 1.1%. The two main culprits were Micron Technology and Renewable Energy Group, positions that had strong performances in both Q1 of 2021 and for the year 2020.
Managing Hazelton Capital Partners’ equity portfolio is like managing a basketball team. The Fund has its starting players (top five holdings), key stocks with the greatest influence on the portfolio’s outcome year-over-year, second-string equities, whose role is to support the starting players by continued improvement especially when a key player is not performing well, and then there are the rookie stocks, equity positions that are just entering the portfolio and will need time to develop. Just like a basketball team, equities are “drafted” to meet specific fundamental needs of the portfolio: growth, robust balance sheet, cash flow generation, and management with strong asset allocation skills. It is important to remember that none of Hazelton Capital Partners’ current top five holdings began in the top five; they earned their spot through growth, hard work, and patience. The average age of the top five (including DXC which was added to the portfolio just over a year and a half ago) is six and a half years. Of course, there are times when a portfolio position needs to be either traded or retired because it is not contributing to the team, or it has achieved its fundamental goals and it’s time to let another equity take its spot. Reviewing each portfolio holding at least four times a year assures that there are no “sacred cows” in the portfolio.
Over the last few review periods, Hazelton Capital Partners has been spending some time focusing on the impact of inflation on the Fund’s holdings. Although we do not have any clear insight as to if, when, or the impact inflation may have on the economy, we felt it would be a good exercise, like a fire drill. Many investors believe that investing in equities is a good hedge against inflation, as businesses will be able to pass along the inflated goods and labor costs to their customers. This blanket statement is not reliable as it really depends on the industry, the company, and its brand. A restaurant will find it much more challenging to pass along higher wages and food costs to its customers than a consumer goods company with strong brands, like Nestle or Unilever, which can spread costs over a greater number of customers, while achieving volume discounts from their suppliers. In addition, it is also important to keep in mind that the pace of inflation will impact how and when companies choose to raise their prices. By going through each company’s business model, financials, and comparing that to those of its competitors, Hazelton Capital Partners has gotten a better sense of the challenges facing each of its portfolio positions. Overall, the Fund feels comfortable with our current holdings and recognizes that there will be adjustments to the portfolio over time, especially if the impact from inflation continues for an extended period.
The Cost of Restarting the Global Economic Flywheel
Isaac Newton’s first law of motion states that an object in motion stays in motion unless acted upon by an external force. In March of 2020, Covid-19 became that external force as the World Health Organization declared the Corona Virus a worldwide pandemic. Its impact put the global healthcare systems in crisis and forced countries to shut down their economies and quarantine their citizens. Throughout the world, once-bustling commercial business districts became ghost towns, airports, train, and bus stations eerily empty, and manufacturing plants lay idle. Except for the businesses deemed essential: grocery stores, pharmacies, e-commerce, and liquor stores (primarily for parents with young children), the global economy was essentially shut down.
In 2020, over 200,000 US businesses were forced to close their doors permanently with over two-thirds of those closures from individual companies. Providers of personal services were the hardest hit representing over 50% of all businesses closed. By spring of 2021, states, counties, and municipalities across the country began to slowly emerge from the economic thaw as restaurants and bars welcomed patrons back for indoor dining, doctor offices began seeing patients in person, and manufacturing plants began to expand their shifts. The low revving sound of the US economic engine grew louder and faster each day.
The US economy operates like a flywheel – the faster it moves the more momentum is stored and the more stable it becomes. When the US economic flywheel is at full speed, manufacturing plants are receiving their raw goods (just-in-time) hours before it is needed, production is optimized, retailers have a steady flow of merchandise to sell, and consumers can visit their favorite brick and mortar or online sites and have a healthy selection of items to choose from. It is a highly intricate, choreographed, economic dance that many of us have come to expect will always work flawlessly, until it doesn’t.
Restarting a flywheel from a standstill is difficult, requiring both time and energy to build up momentum. The US economic flywheel is no different. As businesses across the country continued to recover and expand their operations, they needed to build up their inventories, which required their distributors to meet their growing needs. Pre-Covid, supply chains were optimized and the lead times needed for an inventory build would have been quickly addressed. Since the Covid shutdown, global supply chains have been disrupted and it is taking time for them to get recalibrated.
Part of the problem is logistics. Ninety percent of the world’s trade is transported via ships and it’s the shipping containers that are primarily responsible for bottlenecking the global flow of goods. The issue is not the lack of shipping containers but rather not having them in the right place. During Covid, China was exporting far more goods to the US and Europe than it was importing, causing a growing number of empty containers to pile up at American and European ports. Now that economies are reopening, there is a shortage of shipping containers in China. The buildup of empty containers is also congesting US ports, causing a slowdown in operations, and a queuing of ships to be unloaded. These delays are increasing shipping times, reducing capacity, and elevating shipping rates. Many in the shipping industry believe it will take until early to mid-2022 to resolve the gridlock. Trucking those goods from the ports and distributing them throughout the US has been another logistic headwind as the trucking industry is still operating with 33,000 fewer drivers than it had in February of 2020.
Another issue facing global supply chains is the growing imbalance between supply and demand in key industries. Currently, it is estimated that there are tens of thousands of new cars parked at auto manufacturing lots around the country waiting to be delivered to car dealers, and those numbers are growing. The reason for the delay is because these cars all are missing the semiconductor chips needed to operate the systems within the car. Auto manufacturers operate in a highly cyclical industry, having experienced recessions in the past they were quick to cancel their order for semiconductor chips when the economy shut down in March of 2020. Initially, they were right. However, with 0% financing, strong demand for cars, and dealers pivoting to selling cars online, car sales quickly turned around. By the time auto manufactures were restarting their production lines, there was already a backlog of orders to be filled. Unfortunately, the auto manufacturers lost their place in line with the semiconductor companies and given the heightened demand from computing, mobile, data centers, servers, and other consumer electronic devices, lead times have been extended with no short-term fix.
Prior to Covid, companies like Toyota, Nike, Apple, and McDonald’s operated using just-intime inventory, a management strategy that coordinates the delivery of goods to the times when they are needed. Seen as a competitive advantage, just-in-time inventory management reduces working capital, cuts down on waste, optimizes production schedules, and improves operating margins. Of course, that is all true when the economy’s flywheel has been optimized. During times when supply chains are disrupted or stretched, the advantages of just-in-time inventory can be quickly eliminated and paralyze a company’s operation by not having enough inventory to maintain production.
Over the past two decades, US businesses have been able to deflate their cost curve by offshore manufacturing, just-in-time inventory management, and global supply chains which kept prices low and customers happy. But what helped generate sustainable profits also made companies vulnerable to global disruptions. Covid exposed just how severe that impact could be. Higher shipping rates and supply/demand imbalances have led to a higher cost of goods. It is uncertain whether the recent inflated costs will stick around and be part of the long-term economic outlook for the foreseeable future.
The recent near-death experience for many companies has motivated them to reinforce their supply chains so that they are not completely dependent on China for their survival, a liability corporate boards have been urging their management teams to address. By integrating both domestic and international supply chains, companies are becoming more resilient, but that resiliency comes with higher input costs. Even if shipping costs and the supply/demand imbalance returns to pre-Covid levels, companies will still be forced to deal with higher wages and input costs from domestic supply chains, the direct costs of restarting and keeping the US economic flywheel in motion.
DXC Technology Company
In the most recent quarter, Hazelton Capital Partners’ position in DXC Technology Co (NYSE:DXC) appreciated into a topfive holding. DXC is a global provider of information technology (IT) services and solutions. IT services refer to the maintenance, networking, and software development used to store and process data. Early on this was performed in data centers that a company owned and operated. With the advent of cloud computing, most companies found it much easier and cheaper to transfer their data and IT needs to the cloud. However, there is still a material segment of large companies with either legacy operating systems or industry regulations that prevent them from migrating to the cloud. These companies are still dependent on companies like DXC to keep their systems up and running. Overall, the once lucrative and growing IT service business has plateaued and is now highly concentrated among companies with global reach and expertise (IBM, Cognizant, Infosys, and Accenture).
DXC is the product of a 2017 merger between Computer Science Corporation (CSC) and Hewlett Packard Enterprise’s (HPE) Service unit. The underline goal of the merger, once integrated, was to create a global technology service company with both scale and scope, growing organically through cross-selling and leveraging each company’s area of expertise, while harnessing best practices, and reducing expenses to improve margins. It all sounded promising but by September of 2019, following yearly declines in revenue, disappointing margins, and a slew of lowered earnings guidance, DXC’s board recognized that major restructuring was badly needed. Mike Salvino, a thirty-year veteran of the IT industry, was brought in as DXC’s new CEO to stabilize the decaying customer relationships, refocus the company’s assets into highermargin businesses, and motivate a demoralized workforce. Salvino made a name for himself when he took over as Accenture’s Chief Executive of BPO services (finance & accounting, HR, procurement, and supply chain management). He was later promoted to Chief Executive of Accenture Operations where he was instrumental in integrating BPO services with Accenture’s growing cloud business. Salvino distilled his 10 years of management experience at Accenture into what he called his “Operational Playbook” that focused on turning around unproductive operations.
Hazelton Capital Partners had been following DXC soon after the merger with Hewlett Packard in 2017 but found that the stock price was not reflecting the potential downside risk if the integration or execution did not go as planned. Throughout 2017 and 2018, the Fund watched from the sidelines as the DXC share price continued to escalate, even as revenues, margins and profits had peaked and were in decline. The CEO at the time, Mike Lawrie, accomplished the majority of the proposed synergies and cost reductions, but could not cut expenses fast enough to stay ahead of the accelerating decline in revenues, something he did not anticipate. After Mike Salvino was brought in as the new CEO, the Fund took a fresh look at the company and felt that by the first quarter of 2020, Salvino’s actions were having a positive impact on operations that had yet to be reflected in both its margins and share price. In a short period of time, Salvino had shored up key customer relationships, began realigning and streamlining management teams including relationship managers, while cutting expenses.
In the first quarter of 2020, Hazelton Capital Partners began establishing a position in DXC. A few weeks after the Fund’s initial purchase, the global economy began shutting down because of the Covid pandemic. Given the uncertainty that blanketed the financial markets, Hazelton Capital Partners took the time to re-evaluate all current holdings and whether they should remain part of the portfolio. Since DXC was one of the Fund’s smaller positions, it was one of the last to be evaluated. That delay gave Hazelton Capital Partners additional time to evaluate Salvino’s progress including his decision to sell off the company’s healthcare unit and allow low margins contracts to expire without renewal. By May of 2020, Hazelton Capital Partners had tripled its position in DXC.
Salvino’s “Operational Playbook” for DXC contains three phases. Phase one, stabilizing the operation and balance sheet, has essentially been completed. The company’s margins have been improving quarter-over-quarter, its recent book-to-bill ratio has increased back over 1, and the debt on the balance sheet has been reduced by over $5 billion. The next two phases are about building a foundation for operational growth and then leveraging that foundation for continued and sustainable improvement. In the past, DXC’s revenue growth came primarily from acquisitions. Going forward, the company’s profits will be dependent on higher operational margins, including expense reduction and investing in higher-margin lines of business.
Over the past 5 years, corporate IT spending has been repurposed from building and maintaining data centers to relocating to the cloud, triggering industry consolidation. Companies like DXC can no longer look to revenue expansion as the key metric for earnings growth. Future growth will have to be generated from the company’s operations – reduced expenses, better utilization, and higher margin-businesses. Hazelton Capital Partners does not expect DXC to be as large or generate the kind of revenue that was envisioned when it was created nearly five years ago but given the opportunity for continued growth in operating margins, there remains a pathway for continued upside.
Administrative: Investing in Hazelton Capital Partners
Hazelton Capital Partners was created as an investment vehicle, allowing those interested in long-term exposure to the equity market to invest alongside me. With a substantial portion of my own capital in the fund, I manage Hazelton Capital Partners’ assets in the same way I manage my own capital. The best source of introduction to potential investors in the Fund has come from those that have invested or followed Hazelton Capital Partners progress over the years. Introductions are both welcome and appreciated.
If you are interested in making or increasing your contribution to Hazelton Capital Partners or just learning more about The Fund, please feel free to contact me.
Please do not hesitate to call me at (312) 970-9202 or email me [email protected] with any questions or concerns.