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FPA Capital 1Q17 Commentary – Positioning for Downturn, Oil Thesis, BW, VSTO, WDC

FPA Capital Fund 1Q17 Commentary, April 6, 2017

Deja Vu

  • Side effects of running a highly focused portfolio is volatility; at one point during last year’s first quarter, portfolio returned -13.26% but ended the year up 22.86%
    • This quarter was another one of those with a -3.73% return

Market Commentary

  • As of end of 1Q17, Russell 2500 index is up 14.78% since November 8, 2016 election
  • Each component of Trump’s platform independently could be very beneficial to the US economy and stock prices but in reality, no clear progress has been made in any of those areas
  • Total debt outstanding for Russell 2500 companies is $2.1 trillion (vs. market cap of around $4.8 trillion); every 1% rate increase would translate to over $20 billion of additional interest expense over a period of time
  • Last year, passive funds/ETFs had $563 billion of inflows while active funds had $326 billion of outflows
    • Since 2007, $1.2 trillion dollars disappeared from actively managed US domestic equity funds and $1.4 trillion dollars were added to passive strategies
  • The consequence of unrelenting inflows into passive funds is that stocks receive ongoing support by the indiscriminate purchases made by these funds regardless of company’s fundamentals
    • On the flip side, unfortunate stocks that are not included in a major index receive the reverse treatment
  • Buy and sell decisions entirely disconnected from a company’s fundaments sets the stage, should the table turn, for an exceptionally compelling investment environment
    • Also, with reduced liquidity, we expect increasing volatility in the marketplace
  • The weapons of mass destruction during the Great Financial Crisis were three-letter words: CDS, CDO, etc
    • Current weapon of mass destruction is also a three-letter word: ETF
  • Cumulative market cap of Russell 2500 has grown 16% from end of 2014 and yet the decline in net income was nearly 20% in 2016 over the past two years
    • Essentially, stock appreciation has come entirely from multiple expansion
    • 32% of companies in Russell 2500 had negative income in 2016
  • What are management teams doing as stock indices continue climbing higher? They are selling.
    • Insider sales were 11x larger than purchases which amounts to a 3.5 standard deviation above the mean
    • To put it in perspective, there were 3,200 insider buyers in November 2008 and only 279 in January 2017
  • What are investors doing? Investors are so excited that margin debt hit an all-time record in February 2017: borrowed $528.2B against their brokerage accounts

Energy Investments

  • Energy sector generated higher returns in 2016 but struggled in the first quarter of 2017
    • Russell 2500 energy companies down 9.12% (4.26% underperformance vs the index)
  • Believe the market is rebalancing oil prices will go higher – OPEC inventory draws suggest that market has been undersupplied since Q3 2016
    • OPEC and 13 additional countries have accelerated reductions in excess inventory by largely complying with November agreement
    • Global demand has been consistently revised upward
  • Why have oil prices declined during the quarter?
    • Investor impatience surrounding US petroleum stocks: weekly imports have been trending downward since January just as refining utilization is set to ramp up after a heavy maintenance season; at the same time, OECD Europe & APAC stocks have been falling sharply
    • Anxiety about a resurgence in US shale supply: Domestic rig count experienced notable acceleration while crude production bounced back by over 600k bpd over the last 5 months; interestingly, EIA data show more than 100% of the increase from Sept to Dec 2016 came from Alaska and federal offshore projects; US production alone is simply insufficient to offset the onslaught of OPEC production cuts, limited OPEC spare capacity, historically muted production gains outside OPEC and the US, multiple years of lower global capital investment, natural production decline rates, and steadily growing global demand
    • Many investors worry OPEC will scale back recent cuts in response to surging US shale production: IMF estimates that kingdom needs at least an $80 oil price to balance its budget
  • Some simple math to better illustrate why those concerned with today’s oil market concerns may be missing the larger picture:
    • On the demand side, IEA expects global oil demand to grow by 6 million bpd from 2016 to 2022
    • On the supply side, EIA estimates that OPEC currently has 2 million bpd in spare capacity (3% of global supply); US production is expected to increase by just 800 thousand bpd by YE2018; Non-OPEC ex-US production growth has not budged since 2010 while investment has fallen off a cliff
    • Add in a supply shock emanating from Venezuela, Nigeria, Libya, or elsewhere and situation becomes more precarious and yet constructive for higher oil prices

Babcock & Wilcox Enterprises (BW)

  • Leader in the construction of power generation systems with an operating history of 150 yrs
  • Designs, engineers, constructs, installs, and services utility and industrial boiler plants, scrubbers, steam generators, environmental control systems, power plant equipment, air pollution control systems, etc
    • Operates 3 segments: Power (62% of sales); Renewables (22%); Industrial (16%)
  • Initiated a position in 3Q15 and company executed in-line with expectations; spun out its nuclear business which we subsequently sold at a gain; generated strong FCF and used it to either buy back stock or make acquisitions that diversify them away from coal; all was going well until it reported its 4Q16 earnings in March 2017 and announced a number of project errors in their Renewables division
  • Believe the errors occurred because company has been emphasizing its goal to increase BW’s valuation multiple by decreasing its reliance on coal – in order to achieve this, may have grown the Renewables business too fast
  • Renewables business itself could be separated into 3 divisions: O&M, technology, and architectural engineering
    • O&M is doing well; Technology is considered superior; Architectural engineering is struggling as it is the lowest margin, highest risk part of the segment and BW should not perform this phase of any project
  • On the day of announcement, stock price decreased by 37% (or $300 million in market value)
    • We calculated a deterioration of $4 million/yr in normalized earning power
    • There is simply not enough liquidity in the market for companies with smaller market cap

Vista Outdoor (VSTO)

  • 56% of revenue from its Shooting Sports segment which sells consumer ammunition and long-gun firearms to a much lesser extent; remaining 44% comes from Outdoor Products segment which consists of a portfolio of leading brands in firearm accessories, hydration products, water sports, grilling, and action sports helmets
  • Initiated a small position prior to the 2016 election; thesis at initial investment was that the stock price did not fully reflect VSTO’s ability to grow earnings over the long term for two reasons
    • Despite event-driven cyclicality issues, believe demand for Shooting Sports products should benefit from an industry that now has many more shooting participants including a higher proportion of women and young people; this larger pool is more interested in target practice than hunting and product has shifted toward more ammunition-intensive firearms
    • Unlike the highly concentrated ammunition industry, outdoor product businesses are not only highly fractured but also have very little overlap with other well-resourced competitors
  • Stock has sold off since our small purchase on news of an impairment charge and by concerns about data indicating another cyclical downturn in firearms and ammunition
    • Impairment charge related to 2 older acquisitions; we are growing more alarmed about the underperforming organic growth in the recently acquired brands and the fact that management has not shared key data with investors
    • Concern around ammunition business – believe it is transitory; inventory levels are elevated partially because everyone bet on Hillary Clinton victory and stocked too much product ahead of the election; believe this is yet another cyclical gyration and that long-term growth will remain supported by higher shooting participation
  • Slightly increased position – holding back because we want more clarity on acquisition performance and believe it will take several quarters to clear out excess firearm and ammunition inventory across the industry
  • Modeling a 20% consolidated sales decline in our downside case along with 30% decremental margins; in our upside case, remain conservative by modeling a 10% sales contraction this year, followed by 3 years of pre-Obama era top-line growth and margins getting back in line with the last 12 months; using a low teens multiple gets us to a 3:1 reward-to-risk ratio at a mid-to-high teens stock price

Western Digital Corporation (WDC)

  • Highest weighting in our portfolio at end of both 4Q16 and 1Q17; owned WDC continuously over the last 10 years
  • Price started declining in 2015 when company announced its intention to acquire SanDisk in a $17B deal; selling pressure was high due to high sticker price, increased debt loan, and the foray into a new business (NAND flash semiconductors)
    • We saw this as an incredible opportunity to almost double our position because we believed the deal would catapult WDC into a leadership position in the NAND memory business
  • WDC immediately started integrating the business and used its strong cash flow to decrease its debt load
  • Big news now involves its flash manufacturing JV partner Toshiba; Toshiba’s financial difficulty due to its unrelated nuclear business forced them to put its memory business on the selling block (which includes its ownership interest in the JV)
    • Difficult to know the impact but we think WDC may be well situated to benefit if they participate in a deal – we continue to track the situation closely
Image Source: FPA Capital, CapIQ
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