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Third Point 1Q 2017 Letter: Macro Review, Honeywell, E.On, UniCredit, Short Frac Sand Miners

Third Point First Quarter 2017 Investor Letter, April 27, 2017

“While we recognize that we are in the late stages of an economic cycle, experience has taught us not to miss the end of an expansive period”

Review and Outlook

  • 1Q17 Performance: 5.9% vs. S&P 500 6.1%; Annualized return since inception: 15.8% vs. S&P 500 7.8%
  • During the first quarter, volatility declined and most markets rose in anticipation of global reflation
  • New investments during the quarter were initiated primarily in the financials, industrials, and energy sectors
  • Expect the favorable environment for our investing style to continue for three reasons:
    • Corporate activity should pick up as President Trump’s tax plans are detailed and enacted
    • Opportunities for activist and constructivist investing are robust
    • Combining security selection with a reasonable interpretation of the macro continues to be critical
  • Animal spirits matter in markets and despite the obstacles that the new administration will face in passing legislation, the overall pro-business environment is in sharp contrast to the last “you didn’t build it” administration’s attitude towards business, enterprise, and free markets
  • Have been focused on improving global growth than on the “Trump trade”
    • Goldman Sachs global GDP forecast for 2017 is 4.2% vs. 2% a year ago
    • Seeing more opportunities in Europe because of strong and improving economic data, a trend that will likely continue now that the French elections have passed without incident
    • Although S&P earnings were flat over the past 3 years, expecting earnings growth to drive gains and cyclical names to get a tailwind from US policy shifts this year
  • What are the risks?
    • Legislative failure on tax reform could be negative in the back half of this year but encouraged that BAT seems to be off the table
    • Risk of inflation catching the Fed flat-footed but see this surfacing later in 2018 or 2019 (if at all)
    • Recent dampening of data in the US has raised a red flag and we will know more when we see Q1 GDP
    • Chinese nominal GDP growth has potentially peaked but the main event there will be the change of government this fall (expect a muted status quo until then)

Honeywell International

  • Industrial conglomerate with a $100B market cap organized into four primary segments: Aerospace, Home and Building Technologies, Safety and Productivity Solutions, and Performance Materials and Technologies
  • Key player in the Internet of Things world that is becoming more automated, connected, and energy efficient
  • Recently named Darius Adamczyk to succeed long-time CEO David Cote
  • During David Cote’s tenure, shareholders enjoyed an 11.5% annualized return versus the comparable 7% return of S&P 500
    • Successful operational turnaround and achieved peer-leading earnings growth and ROIC
    • Disciplined capital allocation and portfolio gradually upgraded in quality
  • Despite the attractive positioning and financial characteristics, stock trades at a substantial discount to its industrial peer group
  • Darius Adamczyk committed to enhancing company’s organic growth profile and is actively evaluating the portfolio with the assistance of the Board
  • Third Point believes that separation of the Aerospace unit via spin off transaction would result in a sustained increase in shareholder value in excess of $20B
    • Spin off would transform Honeywell into an industrial growth company with a focus on automation and productivity
    • Large-cap industrial peer group in terms of profitability, ROC, growth characteristics, and end market exposures consists of Emerson Electric, 3M, Fortive, Rockwell Automation, and Illinois Tool Works – this group trades at an average forward P/E of 23x, nearly 30% premium to Honeywell’s forward P/E of 18x
    • More focused Honeywell should match or exceed the multiples of its peer group especially if management delivers on its commitment to return to FCF conversion in excess of 100% by 2018
  • Aerospace’s presence in the portfolio is the chief cause of discounted valuation and its organic growth has lagged its US large-cap aerospace equipment peers and was the main driver behind recent earnings disappointments
    • Independent aerospace public entity would be in a better position to invigorate growth and would benefit from increased management accountability
  • Industrial landscape is rich with examples of corporate separations that have created more focused companies and delivered tremendous shareholder value – examples include: Tyco, Ingersoll-Rand, ITT, Danaher

SHORT FRAC Sand Miners

  • Is sand the new gold?
  • In early Q1, combined market cap of frac sand miners reached $11B, pricing in an average EV per ton of over $300 or over 15x replacement value
  • Army of consultants, sell-side analysts, and speculators were confidently pointing to the exponential rise in demand for frac sand as rig counts and company budgets turned a corner, drilling activity was on the upswing, and proppant intensity was rising
  • The frac sand industry’s cheerleaders were certain they could continue to outwit the laws of supply and demand
  • Our field work identified an important shift from the use of northern white to abundant in-basin brown sand
  • In addition to a large and growing number of greenfield projects that are creating new capacity, we uncovered significant overhang that has been sitting on the sidelines and is now being reactivated
  • As sand pricing starts to decline in summer or fall at the latest as a consequence of the outsized supply we have seen, we expect many of the publicly-listed frac sand miners to end up with little if any equity value

UniCredit SpA

  • As reflation trade picked up steam, European banks have maintained lower valuations than US banks (0.7x vs. 1.2x book), driven by a lack of confidence in capital and an inadequate clearing mechanism for legacy non-performing loans
  • ECB recently noted there were still 921B euros of NPLs at significant EU financial institutions with NPL ratios >3x the level of US and Japanese banks
    • Its guidance on NPLs, released in March, offered a firm but pragmatic approach to accelerate NPL resolutions and Q1 2017 was the second biggest quarter for announced capital issuance in over 5 years
  • In the US, opportunity in financials is linked closely to rising rates; in Europe, tangible progress on balance sheet clarity is the opportunity
  • UniCredit is the second largest listed bank in Italy and has significant presence in Germany and Austria – recently raised 13B of euros in fresh capital in March
  • View current recapitalization as a definitive clean-up
  • UniCredit also cleaned up almost half the NPLs in its non-core bank and took significant upfront charges related to its restructuring plan which will see headcount reduced by 14% and branches reduced by 25%
  • Believe in the medium-term story because of its new CEO, Jean Pierre Mustier
    • 20+ year career at SocGen
    • Ran UniCredit’s Corporate and Investment bank
  • UniCredit shares have appreciated but still see significant upside with shares trading at just 0.65x tangible book, <9.0x our 2018E EPS and <7.5x our 2019E estimate
    • These forecasts exclude additional potential upside from rising interest rates or better asset quality, despite the significant progress on NPL resolutions and property transactions we have seen in recent quarters

E.On

  • Invested in German utility operator E.On during the first quarter
  • Following a spin-off of its generation assets into Uniper last year, company has emerged as a regulated grids and renewables business that is currently misunderstood by the market and attractively priced
  • German government’s policy of “energy transition” caused the precipitous buildout of renewables, forced nuclear plant shutdowns, and a number of poor capital allocation decisions that led to an 80% decline in E.On’s market cap over the last decade
    • The worst is in the rear view mirror
  • German government has agreed to set up a state-administered fund to finance the storage of radioactive waste from decommissioned nuclear plants
    • E.On’s portion of the payment into this “nuclear bad bank” is approximately 10B euros
    • This has temporarily pressured balance sheet but believe it will result in imminent, significant, and permanent reduction of the company’s risk profile
  • Investors remain singularly focused on E.On’s weak balance sheet but we believe there are multiple and significant sources of capital from sales of non-core activities that will deleverage balance sheet over the next 12 months
  • When financial leverage is reduced, management has signaled its intent to increase dividend payout ratio to an industry norm of 70%+, implying annual dividend growth in the low-teens range over the next few years
  • Renewables portfolio is comprised of regulated vertically integrated on- and off- shore wind parks with planned expansion opportunities at relatively high regulated rates of return on equity
  • Management focused on cost cutting by addressing lagging labor productivity
  • Core electricity and gas distribution grids are exceptionally valuable as they cannot be replicated
    • Set for decades of profitable growth
    • We like utilities that operate in benign regulatory environments where the regulator has a clear objective to stimulate investment and guarantee attractive returns
    • To achieve its ambitious plans of full decarbonization by 2015, Germany will have to encourage significant investments in its power distribution network
  • Recent purchases of comparable assets have highlighted E.On’s mispricing
    • 2015: Finish utility Fortum sold its Swedish distribution business for 16.6x EBITDA
    • Last month, Portuguese utility EDP agreed to sell its Spanish gas distribution for 15.9x EBITDA
    • E.On trades at less than 8x EV/EBITDA

Third Point is a New York-based long/short, event-driven, and activist hedge fund founded in 1995 by Dan Loeb. As of 2014, Third Point had an estimated AUM of $17.5 billion.

Image Source: Reuters
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