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Dan Loeb’s 2Q17 Letter – US Growth in 2H, Baxter, Alibaba, BlackRock

Third Point Second Quarter 2017 Investor Letter, July 26, 2017

  • +4.6% returns during 2Q17, bringing total returns YTD to 10.7%
  • During second quarter, reduced investments in bank financials, exited reflationary macro trades, and reoriented the portfolio towards investments in companies that benefit from low inflation
  • Looking ahead, still believe that central banks have turned hawkish, their tone is changing and they are well past the point where any hiccup in the market will prompt increased accommodation
  • In the US, current weak levels of inflation and poor CPI and retail sales reports present a quandary for the Fed
    • Janet Yellen does not seem likely to advocate drastic action
    • However, do believe that the Fed will begin balance sheet reduction shortly but that the next rate hike will be on hold until growth and inflation accelerate
  • Economic growth in the US has been generally disappointing, particularly relative to expectations
    • Markets on the other hand, have been helped by better performance globally, which also explains why non-US market performance has been strong
  • Believe that US growth will pick up in the second half, driven by seasonality and other factors
    • US will continue to have an overhang until Congress and the President show they can get major legislation passed this year
    • With substantial corporate tax reform promised but not delivered, companies are sitting on their cash hoards and their M&A plans, waiting for clarity
  • Despite the market run-up, we continue to find compelling investment opportunities, particularly with global growth intact
    • We are also finding opportunities to hedge the portfolio with single name shorts that we believe are overpriced

Baxter International

  • 2 years ago, initiated a 9.9% position worth over $1.5bn in Baxter – an under-earner in the medtech industry with margins trailing its peers, Baxter was about to spin out its biopharma business, Baxalta
  • Shortly after the spinoff, Baxter’s long-time CEO announced his intention to retire
  • Believed these two major changes at the company presented an opportunity to create a more focused Baxter, cure its under-earning problem, and even make it an industry leader in operational performance
  • Jose Almeida became Baxter’s new CEO starting on January 1, 2016 – sweeping changes over the past 18 months have created meaningful shareholder value
    • Prior to his arrival, Baxter has guided to 2016 operating margins of 10%, growing to 14% by 2020
    • Under Mr. Almeida’s leadership, Baxter delivered 2016 operating margins of 13.6% and in May 2016, updated 2020 guidance to 17-18% operating margins; Baxter substantially upgraded its 2020 guidance to ~20% margins on the Q2 2017 earnings call
  • Cost cutting initiatives: Mr. Almeida instituted a Zero-Base Budgeting process that had an immediate impact – SG&A spend declined over 10% in 2016 vs. pro forma 2015 levels while R&D spend also declined year over year in absolute dollars
  • Addition by subtraction: Mr. Almeida made decisions to exit certain unprofitable product lines/markets and legacy R&D projects with negative expected value
  • Focus on high gross margin businesses: Supplemented its generic injectable drug pipeline through 3 transactions and strategic partnerships; as the pipeline matures and products are approved, the high gross margin products will naturally improve underlying operating margin
  • FCF generation has benefitted from the improved operational efficiency
    • Prior FCF guidance was for $400M in 2016 growing to $1.1Bn by 2020
    • Under Mr. Almeida, reported $935M in 2016 FCF that is forecasted to grow to $2Bn by 2020
  • In addition to continued margin expansion and improving FCF generation, there is renewed anticipation about how Baxter might deploy its pristine balance sheet
    • Sits at 0 net debt position relative to medtech peers who carry 1-2x net leverage
  • Between January 2016 and June 2017, Baxter delivered total shareholder return of 61%, nearly 3x S&P 500 return
  • Despite the 18 month outperformance, forward EV/EBITDA multiple has remained largely unchanged at 12.5-13.0x
    • Looking forward, confident that Mr. Almeida can combine operational efficiency with an unlevered balance sheet to drive continued earnings growth which – even absent multiple expansion – should drive strong returns for shareholders

Alibaba

  • Reinitiated an investment in Alibaba
  • Alibaba has consistently surpassed our growth estimates for GMV (gross merchandise value), revenue, and earnings and today, company has achieved scale ($550Bn GMV last year, equal to 5% of Chinese GDP)
  • Currently at an inflection point after rolling out significant changes over the past year to its advertising platform, which currently generates the majority of the company’s revenue
  • Combined with an attractive multiple, believe now is the time to own Alibaba again
  • Launch of personalized advertising: Launched its first advanced ad targeting tools, allowing merchants to better personalize ads based on its users’ data profiles and browsing histories; since launching this new ad personalization initiative, seen a steady CTR on ads, creating a growing tailwind to revenue growth as demonstrated in its recently-issued full-year fiscal 2018 revenue growth guidance of 45-49%; still at a very early stage relative to Google and Facebook; because Alibaba has a highly engaged user base with strong purchase intent, along with extensive transaction data from its users’ purchase history, believe Alibaba’s targeting capabilities will eventually surpass its global competitors
  • New ad tech for brand advertisers: Historically has captured little revenue from large brands, relying instead on small merchants; unlike Baidu and Tencent, which we estimate earn 1/3 of their ad revenue from brand advertising, believe only ~5% of Alibaba’s revenue comes from large brands; uni-marketing should allow Alibaba to not only capture a higher share of large brands’ ad budgets but also create new revenue streams from ad inventory sold on third-party platforms
  • Latent revenue potential from higher ad load: Last increased ad load on Taobao in September 2015 which led almost immediately to an acceleration in ad revenue growth; today we estimate that ads represent only 10-15% of content units on a typical mobile Taobao search page, versus 30-50% for commercial searches on Google and Baidu
  • Mobile monetization gap now closed: Alibaba initially generated a much lower revenue yield on mobile than on desktop, resulting in a drag on revenue growth as more GMV shifted to mobile; mobile revenue yield has steadily risen and by late 2016 the monetization gap between mobile and desktop had fully closed; Q1 2017 marked the first quarter in which the mobile revenue yield significantly exceeded the desktop revenue yield
  • Low revenue yield indicates long monetization runway: Alibaba’s current revenue yield is much lower than peers at less than 4% versus 6-15% for all other large platforms; revenue yield has already begun expanding over the past two years and believe this trend will continue
  • Alibaba trades at 18x P/E on our calendar 2019 estimate for non-GAAP EPS
    • Excluding the value of Alibaba’s expected net cash at year-end 2017, its stake in Ant Financial at the latest private valuation ($8/share) and our current estimate for the value of its Aliyun cloud business ($16/share), we estimate Alibaba’s core business is currently valued at $121/share, or 15x our calendar 2019 EPS estimate of $8.20, while growing earnings in excess of 30% y-o-y
  • As the company continues to execute, we believe its valuation multiple can approach other best-in-class high growth businesses, namely Tencent, which trades at 32x consensus 2018 EPS

BlackRock

  • World’s largest asset manager with $5.7 trillion in AUM
  • In a classic scale industry, BlackRock is an asset-gathering machine, with organic net inflows of over 7% annualized
  • Coupled with a tailwind from rising markets, AUM grew 17% y-o-y in the second quarter, which remains a key input for earnings power
  • Yet we see BlackRock as far more than an asset manager dependent on market movements
  • It is increasingly becoming a network or index-like business, with earnings power driven by ETFs and data & analytic services
  • These are oligopoly businesses with faster growth and much higher incremental margins than traditional asset management – and thus deserve much higher P/E multiples over time
  • With shares at less than 15x our 2019 EPS forecast, and an outlook for consistent mid-teens EPS growth, think BlackRock is a misunderstood franchise that is just beginning to inflect
  • iShares business has over 38% global market shares in ETFs and rising – we think this acceleration in ETFs is just getting started as regulatory change globally pushes lower-cost, transparent investment products, and institutional investors use ETFs as investment solutions, particularly in fixed income
  • Aladdin business is a data, analytics, and risk management platform originally built for internal use that now services over 25,000 external users
    • Historically, Aladdin was focused on institutional investors and corporates but we see a huge opportunity to bring it directly to retail financial advisor networks
    • This new product will link the world’s biggest asset manager and ETF provider directly to the desktops of thousands of financial advisors and their customers
    • We see Technology and Risk Management revenue continuing to grow at 12-15% and delivering 20% of incremental operating income growth in 2019
  • BlackRock is valued like a traditional asset manager but it has much greater potential for structural revenue growth and operating margin expansion
  • Previous headwinds like USD strength have now become tailwinds, helping recent performance, but we are much more excited that higher-margin, higher-multiple businesses like iShares and Aladdin will become almost 2/3 of BlackRock’s earnings power within 3 years
  • Evolution in business mix should deliver 20x+ forward P/E multiples for the stock as well as faster, more consistent mid-teens EPS growth – a combination which drives ~40% total return potential for shares over the next 2 years

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: Jewish Business News
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