Kerrisdale Returns 10%: Gains on Omnicom, Herbalife, AMERCO

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Kerrisdale Partners LP achieved a quarterly return, net to investors, of 9.7% for the quarter ended March 31, 2013. The S&P 500 index returned 10.6% during that time.

Since inception, the hedge fund has achieved a return, net to investors, of 873.5%. The S&P 500 index has returned 84.8% during that time. The top five positive contributors were AMERCO (NASDAQ:UHAL), Omnicom Group Inc. (NYSE:OMC), Herbalife Ltd. (NYSE:HLF), IntercontinentalExchange Inc (NYSE:ICE) and CME Group Inc (NASDAQ:CME). The top five negative contributors were Short A, Apple Inc. (NASDAQ:AAPL), MTN Group Ltd (ADR) (PINK:MTNOY), SNC-Lavalin Group Inc. (TSE:SNC) and Short B, Omnicom Group Inc. (NYSE:OMC).

Omnicom Group logo

We are long the four largest advertising companies in the world, Omnicom Group Inc. (NYSE:OMC), WPP PLC (ADR) (NASDAQ:WPPGY), Publicis Groupe S.A. (ADR) (PINK:PUBGY) (EPA:PUB) and the Interpublic Group of Companies Inc (NYSE:IPG). Our largest position is OMC, which today represents our largest long holding within the fund. We think these companies benefit from the transition from traditional to digital media as well as emerging market growth, and are trading at low valuations given their attractive growth profiles, intelligent capital allocation policies and predictability of the businesses.

Each of these public advertising companies own hundreds of smaller agencies, including large umbrella agencies such as Banco Bradesco S.A. (NYSE:BBDO) or DADA SPA EO 0,17 (FRA:DDB), which each themselves own numerous smaller agencies. Omnicom Group Inc. (NYSE:OMC), for instance, owns a network of 175 agencies and marketing services companies, with three dominant verticals (BBDO, DDB and TBWA) each owning dozens of these agencies.

Multinational companies tend to employ large global advertising agencies for their marketing needs, and will typically hire an agency owned by one of the four large advertising parents. When they switch agencies, they will almost always switch from an agency owned by one of these four parent companies to another agency owned by the four parents. In that sense, advertising agencies are similar to accounting firms: a client dissatisfied with Ernst & Young will likely switch to PWC, Deloitte or KPMG, as opposed to smaller firms.

Also like auditing, marketing is an essential service that will continue to exist 5, 10 and 20 years from now. Marketing agencies are hired by almost every large organization to help craft and deliver a message about products or services, organizations, events or people. It’s a critical function that companies will continue to outsource to experts.

Relationships with advertising agencies tend to be sticky, and the global experience of these firms, combined with their quasi-cartel pricing discipline, leads to attractive pricing power relative to new startups. Research analysts often value companies relative to other companies within the same sector, ignoring absolute value.

We think that the marketing agencies sector is cheap relative to others in the current market environment. Marketing agencies are asset light, have entrenched positions, demonstrate considerable pricing power, have little capex or working capital needs, and are benefiting from emerging market growth. Yet most are trading at 8x-9x EBITDA and 15x-17x P/E. We think they represent an attractive risk/reward relative to most other investments and asset classes. We think marketing firms will be earning significantly more in 10 years than they do today, largely driven by growing marketing spend in emerging economies, and the agencies will achieve this result while expending little incremental capital in their businesses.

One of the attractive aspects about marketing spend is that it’s like an arms race that never ends, since companies perpetually need to advertise to keep their brands competitive, and the marketing agencies are a toll on this propensity to bolster / defend one’s brand. For the past several decades, growth in marketing spend, and thus revenue growth at the marketing agencies, has consistently exceeded GDP growth.

While we own shares in all four advertising parents, Omnicom is our largest holding because of its While we own shares in all four advertising parents, Omnicom is our largest holding because of its superior culture and excellent capital allocation track record. It’s helpful to think of Omnicom as a private equity firm that specializes in advertising agencies. Since its formation in 1986 after the 3-way merger of three of the world’s leading advertising agencies (BBDO, DDB and Needham Harper), Omnicom Group Inc. (NYSE:OMC) has acquired hundreds of agencies including PR firms, specialty communication firms (such as healthcare ad advisory) and other businesses that advise companies and people on how to communicate about their products, services and people.

The firm has maintained a highly decentralized structure whereby the parent handles valuable support such as information technology or human resources, brings access to marquee clients, and oversees capital allocation, and in exchange the entrepreneurs retain relative independence which invariably leads to greater competitiveness. On most financial metrics, including revenue per employee, Retail Opportunity Investments Corp (NASDAQ:ROIC), and organic growth, Omnicom has for years been the benchmark agency in the industry. Decentralization is a difficult structure to SNC-Lavalin Group Inc. (TSE:SNC)

SNC-Lavalin Group Inc. (TSE:SNC) (PINK:SNCAF) is a C$6.5B market cap company which can be viewed as owning three distinct assets:

(a)    the largest engineering & construction (“E&C”) company in Canada, and one of the largest E&C firms in the world, (b) a multi-billion dollar Infrastructure Concessions Investment (“ICI”) portfolio that is estimated to be worth between $25.00 and $35.00 per share, and (c) approximately $3.50 of excess cash on its balance sheet.

(b)   SNC-Lavalin Group Inc. (TSE:SNC) (PINK:SNCAF) has a track record of strong operational performance over the long-term. During the 2000’s, the company more than tripled its E&C profits by expanding into emerging markets. Through the course of its Canadian business, it acquired large stakes in two valuable and irreplaceable infrastructure assets, the 407 toll highway in Toronto and the Altalink transmission grid in Alberta. Meanwhile, the company achieved industry-high margins, growth, return on equity, and has paid a steadily growing dividend since 1989.

The full letter is embedded below in scribd:

Kerrisdale Capital hedge fund letter Quarterly Letter – 3-31-13 by

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