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Dan Loeb’s 1Q18 Letter: Review and Outlook, UTC, DWDP, LEN, DOV

Review and Outlook

  • S&P’s 12% peak-to-trough drawdown during the quarter was the sharpest since Q1 2016 and the index’s overall quarterly loss of 0.8% marked its weakest annual start since 2009
  • Third Point’s performance was similar and losses during the quarter were driven primarily by long equity investments in cyclical sectors while gains came from the short book and credit strategies
  • After a two-year period where growth surprised positively and inflation was benign, we began to see volatility in each of these areas. While earnings growth remains strong, investors now have to contend with increased uncertainty around appropriate multiples
  • One cause of this uncertainty is that, there is finally an alternative to equities in the form of relatively riskless two-year money
    • $400 billion has flooded in so far this year into this option versus a total $80 billion of inflows in 2017
    • Also as PMI’s cool from elevated levels, there is a real question about just which inning of the late cycle we are in
  • While we don’t believe a recession is close, there is definitely a concern that it is getting closer
  • This means the S&P is effectively range-bound and so, to generate profits, investors will need to adjust exposures more aggressively and successfully choose winners and losers across sectors
  • We have reduced net exposure by over 20% this year; we have taken about 15% exposure out of our long book and boosted shorts to about 25% of fund AUM; we intend to further increase exposure to fundamental single names and quant-derived baskets in 2018 and rely less on market hedges to dampen volatility and reduce net exposure
  • We are spending more time evaluating opportunities in risk arbitrage; while credit strategies performed well in Q1, we find most corporate credit markets are too richly valued relative to equities and so we have modest exposure to the asset class
  • AUM of $17.7 billion as of March 31, 2018

United Technologies Corporation (UTC)

  • $100bn industrial conglomerate organized into four businesses: Otis Elevator (Otis), UTC Climate, Controls & Security (CCS), UTC Aerospace Systems (UTAS), and Pratt & Whitney
  • Strong franchise assets with leading market share within each segment but the company’s shares have lagged its industrial peers (XLI Index) by approximately 45% over the last 5 years
  • UTC fits a pattern of many underperforming conglomerates where value is diminished by the ill effects of a “one size fits all” approach to corporate strategy, incentive compensation, and capital allocation
  • We initiated a dialogue with UTC’s board of directors to express our concerns about the Company’s weak operating performance and the inherent disadvantages of its conglomerate structure
  • We believe UTC should split into three focused, standalone businesses: Otis, CCS, and an aerospace company (Aerospace RemainCo) encompassing UTAS and Pratt & Whitney
  • We are encouraged that the Company’s CEO, Greg Hayes, has indicated that the Board is undertaking a portfolio review
  • As standalones, each of these businesses will benefit in the long run from a bespoke corporate strategy, more flexibility in allocating capital, better alignment of management incentives, a dedicated board with relevant industry experience, and greater strategic optionality
  • We believe the split would also highlight to the market the overlooked value of the GTF program currently hidden within UTC
  • Profitability of the GTF program will inflect positively as the GTF moves down the manufacturing learning curve and the highly profitable service revenue stream ramps with the installed base
  • Management has assessed the NPV of the GTF program at approximately $15bn or $19/share
    • Giving credit to GTF’s NPV rather than capitalizing today’s ramp-up losses of $1.2bn would lower UTC’s headline valuation multiple of 11x forward EV/EBITDA to just 9x forward EV/EBITDA
    • Average forward EV/EBITDA multiple for the US large-cap multi-industry peer group is 13x or ~40% higher
  • Aerospace investors, on the other hand, tend to look through new program start-up losses once they are comfortable that peak losses and subsequent profit improvement are in sight
    • One clear example of this is Rolls-Royce; if Rolls-Royce were a subsidiary of UTC, it certainly would not be valued currently at $23Bn or 36x forward P/E
  • Even before giving credit to GTF’s NPV, a three-way split would unlock in excess of $20bn of value (>20% of market cap), net of separation costs
    • All three standalone entities will likely trade at higher multiples than the lowest common denominator assigned to the current UTC conglomerate
    • Otis peers Kone and Schindler trade on average at 15x forward EV/EBITDA
    • CCS peers, Allegion, Ingersoll-Rand, and Lennox, trade on average 13x forward EV/EBITDA
  • Remaining aerospace company would be the only liquid, US large-cap aerospace supplier other than TransDigm, which trades at 15x forward EV/EBITDA
    • Other US large-cap aerospace investment opportunities are limited to Boeing and Honeywell, which trade at 14x and 15x forward EV/EBITDA
    • Aerospace RemainCo will warrant a premium due to synergy potential from Rockwell Collins and Pratt & Whitney’s depressed earnings
    • If Pratt & Whitney achieves an 18% EBIT margin by 2025, it will generate approximately $6bn in EBITDA; assigning a 13x EV/EBITDA multiple to Aerospace RemainCo after stripping out the GTF losses yields a UTC SOTP valuation over $190/share by year-end 2019

DowDuPont (DWDP)

  • Continues to be one of the fund’s largest positions
  • Despite a series of positive developments following the merger’s close last August, the discount to intrinsic value has widened
  • Several prominent sell-side analysts have noted the similarities between DWDP’s three future spins (MaterialsCo, SpecialtyCo, AgCo) and three publicly traded peers: LyondellBasell, 3M, and Monsanto
  • Consensus 2020 EBITDA for DWDP is $23Bn – coincidentally the sum of 2020 estimates for LYB, MMM and MON is nearly identical at $22.5Bn
    • Combined enterprise value for these three companies is $234Bn, about 40% higher than DWDP’s current EV of $167Bn
    • Simply applying a similar EV to DWDP implies a stock price of $92, nearly 50% higher than current levels

Lennar

  • Management is already ahead of their plans to eliminate duplicative expenses, renegotiate contracts to lower construction costs, and improve production efficiency and sales velocity (CalAtlantic acquisition)
  • Ahead of its peers in investing in technology and capabilities to greatly reduce customer acquisition costs, expand financial services, and lower commission rates
  • Early in the cycle, Lennar made smart investments in ancillary businesses, many of which do not contribute to earnings and are not valued by investors
    • As these businesses are monetized and result in several billion dollars of proceeds, Lennar’s low valuation will become apparent
  • Taking into consideration Lennar’s strong integration execution and housing industry fundamentals that support several more years of a positive cycle, we believe buying Lennar’s core homebuilding operation at close to 6x pro forma earnings is a bargain

Dover

  • Since our last update, Dover has made several significant announcements
    • Decided to spin its energy business, Apergy, thus greatly reducing earnings volatility
    • Switched to “cash” EPS reporting to focus investors on strong FCF generation of the portfolio
    • Transitioned to a new CEO, Richard Tobin, who has a strong background operating industrial assets
  • Based on Apergy’s current when-issued share price, the Dover RemainCo is currently valued at an 8% FCF yield on our 2019 estimates, which represents a 30% discount to the US large-cap multi-industry peer group
  • With a high quality set of remaining assets, increased strategic optionality, and a catalyst rich path over the next several months – completion of the Apergy spin, repurchase of 7% of outstanding shares, and communication from the new CEO – we believe Dover’s RemainCo will close the valuation gap to its multi-industry peers

Third Point First Quarter Investor Letter, May 4, 2018

Image Source: Bloomberg

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