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Dan Loeb’s 3Q17 Letter – Review/Outlook, Dover, DowDuPont, Honeywell, Nestle

Third Point 3Q17 Investor Letter, October 20, 2017

Review and Outlook

  • Earned 3.4% in the Offshore Fund and 4.9% in the Ultra Fund, bringing total returns for the year to 14.5% and 23.0%, respectively, compared to S&P returns of 4.5% for the quarter and 14.2% for the year
  • We were constructive on markets coming into 2017 based in part on expectations of more favorable conditions for businesses via deregulation and tax reform
  • Deregulation is occurring quickly and although tax reform remains in the works, expect that markets will continue to move higher, driven by strong consumer and business confidence
  • Strength in global growth largely owed to worldwide easing of financial conditions that started during 1Q16, catalyzed by weakening of USD and Fed’s failure to execute on its forecasted four interest rate hikes last year
  • Big surprise for the markets in the past twelve months has not been political events like Brexit or Trump’s election but the degree and breadth of global GDP upgrades
  • Believe US has room to lead versus the rest of the world from here and while we have increased exposure to Europe overall this year, majority of portfolio remains in US equities
  • Bottom-up estimates imply ~12% earnings growth next year which would still be 7% after the typical 5% haircut that such estimates experience as the year unfolds
  • While the implied 17.5x forward P/E ratio is high by historical standards, low interest rates coupled with still solid earnings growth suggest valuations can remain high amid a tame business cycle, absent an exogenous shock
  • Biggest risk to our positioning and view is recession (by nature, are unexpected). However, we think the risk today is low for 3 reasons:
    • Economic growth levels are relatively high and momentum is fairly stable. When these conditions are present, recession risk is low, particularly in the near-term
    • In the medium-term, recent inflation has been less responsive to changes in “slack” than it has been historically. This lowers the chances that the Fed will need to hike aggressively, which in the past has been associated with increased recession odds if it failed to properly calibrate policy withdrawal
    • Credit growth has been subdued. While there are pockets of the credit markets that pose risk, we have not seen evidence of broad-based excesses and thus do not see a systematic risk of a popping credit bubble at present
  • Expect the Fed to continue to raise rates but changes to FOMC leadership will determine the pacing
  • Our equity investment framework has drawn us to larger market capitalizations and we have learned to “pay up” for certain higher-quality companies with market-dominating positions
  • In credit, we have added expertise in structured credit and sovereign debt since the financial crisis, allowing us to invest successfully during dislocations in those markets

Dover Corporation

  • Industrial conglomerate with a $15Bn market capitalization; leading share in several highly consolidated end markets, including retail fueling, industrial printing, retail refrigeration equipment, and artificial lift for US onshore energy production
  • Shares have materially underperformed the industrial peer group over the 3-year period preceding our investment. Significant earnings decline in energy business and the substantial fall in global crude oil prices were the primary drivers behind the underperformance
  • By this summer, energy commodity prices had stabilized and short cycle industrial end markets began to accelerate
  • Engaged in constructive dialogue with management regarding several compelling value creation opportunities:
    • Separate the energy segment: Believe the strong cash flow generation, recurring parts and service revenue, and margin profile of Dover’s energy segment will make it an attractive strategic target to many buyers. At the same time, removing energy cyclicality from Dover will reduce earnings volatility, allowing investors to focus on a high quality industrial portfolio with strong growth drivers and supporting a re-rating
    • Address under-earning in core industrial portfolio: Over half of EBIT generated in consolidated markets where it has a #1 or #2 market share – primarily printing and identification and retail fueling. Despite these attractive end market dynamics, Dover industrial segment margins are well below peers in these businesses. Dover took the first step to address this material underearning and issued a plan that calls for 300bps of margin improvement by 2019
    • Optimize capital allocation: Dover’s industrial peers with strong capital deployment frameworks receive credit for forward cash generation. Believe the company needs to communicate a strategic vision, continue to optimize its portfolio around that vision, and set stringent M&A criteria. With a disciplined approach to capital allocation, believe the market will begin to discount the >$4Bn of cash generation at Dover industrial over the next 5 years
  • Since this summer, announced it is exploring strategic alternatives for its energy business; plan to switch to “adjusted EPS” reporting to better highlight its strong FCF generation
  • See significant upside with shares trading at 14x 2019 estimated FCF versus the broader multi-industrial peer group that trades at 18x 2019 consensus FCF

DowDuPont Inc.

  • Been engaged shareholders for nearly 4 years – adding 2 Board nominees as part of 2015 settlement and engaging extensively with management regarding the optimal post-merger structure for DowDuPont
  • After the recent merger with DuPont, DowDuPont will embark on a compelling business separation that is consistent in both substance and rationale with the proposal in our 4Q13 letter
  • While a significant portion of the public debate regarding spin-off structure for DowDuPont was devoted to the “multiples” the various companies would trade for, what most excites us about our investment is the dynamic that Joel Greenblatt described in his book, How to be a Stock Market Genius
    • “When a business and its management are freed from a large corporate parent, pent-up entrepreneurial forces are unleashed. The combination of accountability, responsibility and more direct incentives take their natural course”
  • DowDuPont carries an unlevered balance sheet and retains significant M&A optionality. Yet, DowDuPont trades at just 8.6x consensus EBITDA in 2019, a substantial discount to its sum-of-the-parts when we look at the multiples of the likely comparables for the 3 or more Spin-Cos

Honeywell International

  • We were drawn to Honeywell because of the company’s strong businesses, portfolio optionality, untapped balance sheet, and change in leadership from one excellent CEO to another
  • Management retained advisors and conducted a thorough, data-driven portfolio review and last week announced plans to split off its homes and transportation units, which have a combined $7.5Bn in annual revenue, into two separate companies by the end of 2018
  • Board’s decision to keep Aerospace signals management’s confidence in an improving organic growth outlook following years of Aerospace underperformance

Nestle SA

  • When we disclosed our $3.5Bn investment in the company in June, laid out four paths to value creation at Nestle: 1) set a specific margin target; 2) increase leverage to return more capital to shareholders; 3) reshape the portfolio; and 4) monetize the legacy stake at L’Oreal
  • Dr. Schneider and his team gave a strong presentation which indicated a new approach of greater investor responsiveness
  • Approach to balancing sales and margin development in the new world of consumer preferences and habits represented a strong shift for Nestle
  • Their commitments – including reaccelerating sales growth to mid-single digits, achieving a 17.5-18.5% margin target, and undertaking a CHF 20 billion share buyback – imply a return to double digit EPS growth through 2020 after 5 years of essentially zero growth
  • Also encouraged that Nestle will consider portfolio divestments of up to 10% of sales. This should help improve the composition of the portfolio as well as provide proceeds for incremental buybacks and growth initiatives, including M&A
  • Believe there is much more opportunity to unlock value, particularly by further optimizing capital allocation and carefully evaluating the L’Oreal stake as part of a comprehensive portfolio review

Credit Update

  • Reduced credit exposure by over two-thirds since the beginning of 2016
  • Spreads are near the levels reached in 2007 but interest rates are 200 bps lower today, creating little opportunity for total return
  • Unlike in 2016, when we were able to capitalize quickly on dislocation in the energy sector, we see no deep weakness in any area or geography
  • There is stress in telecom and retail space but we do not believe the secular challenges are fully reflected in security prices yet
  • Cannot forecast the timing of the next credit cycle other than to note we are late in this economic cycle, corporate leverage is high, and interest rates are increasing

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.

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