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Dan Loeb’s 2Q18 Letter: Macro Outlook, PayPal, Emerging Markets, Credit Update

  • AUM at June 30, 2018 were $17.7bn
  • Our view of the current economic backdrop is: 1) US growth will remain buoyed at a high level due to the fiscal stimulus impulse from spending increases coming into the system. Barring an escalation of trade conflict, most of the deceleration in the global manufacturing cycle is likely behind us; 2) inflation has remained stable in the first half of the year, with little sign of impending acceleration, despite a record low unemployment rate; 3) the cycle can extend longer than many people think as companies are in good shape, particularly in the US, and the consumer is strong while carrying only modest debt levels; and 4) equites are not expensive at 16x forward earnings
  • Risk of recession in the next year remains low and without this concern weighing heavily on markets and with the tailwinds we have described, we believe equities should go higher but at a moderate pace
  • The single most important factor to follow is Fed action. If the Fed is determined to “kill the patient” through aggressive intervention in the form of rate hikes then the current health of the patient is irrelevant. If the Fed continues at its current pace, it will have tightened by ~3% by the end of 2019. Tightening of that magnitude has almost always resulted in recession. While we believe this well-seasoned Fed understands exactly the tightrope it is walking, the risk of destructive action is not zero
  • Markets could be upset by several factors, including: 1) an escalating trade war. At this point, we are not concerned about the impact on the economy from the current tariff tit-for-tat, but an out-of-control battle could inject fear and caution into markets. More important is that a trade war threatens the margin structure of the S&P 500. Since 2000, 100% of margin expansion has been driven by manufacturers. We estimate that global value chains have driven between one-quarter and one-third of this expansion. Thus, a trade war that results in substantial increases in labor costs or even disruption to the current system could meaningfully reduce a key element of corporate profitability; 2) any growth acceleration will be less strong than in 2017 and is likely to be concentrated in the US, an unfavorable comparison to the previous year that may encourage pessimism; and 3) increasing signs of inflation, given the tight labor market

Growth is where the value is

  • Over time, we have generated returns by adjusting our exposure levels, by shifting our allocation to equity versus credit, and even by adding skills in new areas like sovereign and structured credit to take advantage of dislocations in those markets
  • Over the past 5 years, we have added adjacent styles to our equity investing tool kit, moving from purely an event-driven, value-based universe of stocks to include “compounders” and, increasingly, what are classically considered “growth” stocks
  • Value-based argument for owning “growth” stocks is that their P/E premium to the rest of the market is not especially large compared to what we have seen historically
  • We have not shifted our entire portfolio to fast-growing, high-multiple securities but we see a place for the companies of tomorrow as investments alongside our classic special equity and credit situations
  • In a world of increasing disruption in virtually every industry, we recognize that we must continuously evolve our framework or risk being disrupted too

PayPal

  • $100bn market cap online payments company that processes ~20-30% of all ecommerce transaction volume globally (ex-China), led by the excellent CEO Dan Schulman
  • With 237 million active accounts and 19 million merchants using the iconic PayPal checkout button online, PayPal enjoys a dominant competitive position with a 10x scale advantage relative to peers
  • Consumers love PayPal because it enables hassle-free, one-touch checkout across millions of online merchants; merchants love PayPal because it drives higher sales, with a checkout conversion rate of 89% – almost 2x that of credit/debit cards
  • We see parallels between PayPal and other best-in-class internet platforms like Netflix and Amazon: high and rising market share, untapped pricing power, and significant margin expansion potential
  • PayPal is in the process of evolving from a pure-play “checkout button” to a broader commerce solutions platform, expanding into adjacent verticals organically and through M&A
  • We forecast above-consensus EPS growth driving shares to $125 within 18 months, for ~50% upside
  • In the near term, we see three large incremental revenue opportunities for PayPal: 1) Venmo monetization, 2) dynamic pricing, and 3) offline payments
  • PayPal is just starting to monetize Venmo, a P2P platform that has grown 25x in 4 years, and now accounts for ~10% of PayPal’s transaction volume; PayPal launched a “Pay with Venmo” button in early 2018 for commercial transactions, as well as a new Venmo-branded debit card that consumers can use to fund commercial transactions both online and offline
    • We think Venmo can contribute $1bn in incremental annual revenue for PayPal within 3 years
  • PayPal is just scratching the surface on pricing power: the company recently shifted away from a “one-size-fits-all” approach in merchant contracts to a dynamic pricing model that reflects the value-add of a growing suite of products
  • In May 2018, PayPal announced the $2bn acquisition of iZettle, a fast-growing provider of mobile POS systems for offline merchants in Europe and LatAm. We expect iZettle’s growth to accelerate as PayPal cross-sells iZettle into its existing network of 19 million merchants
    • This deal takes PayPal from the world of online commerce to that of offline commerce
  • PayPal has multiple top-line drivers in the years ahead, with core online volume growing in the mid-20% range, latent untapped pricing power with merchants, Venmo on the cusp of monetization, and the potential to gain scale in the vast offline payments market
  • Despite revenue scale approaching that of peers, PayPal’s 25% operating margin on net revenues is ~20-40 points lower than that of large-cap payments peers
  • Margins are an area where PayPal management has a clear opportunity to deliver, even as the company invests for the future. We think there are opportunities for expense reduction in IT, customer service, and credit servicing and collections
  • Moreover, changing relationship with eBay presents opportunities on both costs and revenues. PayPal can cut substantial costs associated with its legacy eBay contract while capturing incremental revenue by signing new contracts with eBay’s faster-growing competitors
  • PayPal is covered primarily by financial services analysts and currently trades at 37x 2018 and 31x 2019 “street” estimates which makes it appear expensive to certain investors
  • We believe that PayPal is as much a fast-growing internet company as a consumer financial services company and that a premium multiple is warranted – particularly given the company’s sizable net cash position
  • Our analysis suggests PayPal trade at just 18x 2020E EPS, excluding net cash
  • Given PayPal’s multi-year revenue growth path, margin expansion opportunity, and opportunistic acquisition strategy, we expect upward earnings revisions and P/E multiple expansion as management delivers
  • Management’s new strategy – embracing partnerships with banks and networks, expanding the suite of services offered to merchants, and deploying the balance sheet through M&A and buybacks – make PayPal a very “new” company for most investors and one that is not yet well-understood

Emerging markets equity and credit update

  • We were caught off-sides in Latin America during 2Q when we failed to anticipate what a strong USD would do to currencies in the region and especially in Argentina, which has devalued the ARS by approximately 30%
    • We moved to sell the entire portfolio quickly while security prices in the local currency were flat but still suffered significant losses
  • In response to the devaluation, the Argentine administration dramatically raised short-term rates, brought in the IMF, and is reprofiling its capital stack to reduce its historic reliance on short-term funding
    • This adjustment process will filter through to the economy over the next few quarters and will be painful
    • We do not have material exposure to Argentina but remain optimistic that Argentina’s excellent leadership will successfully navigate the current fiscal/monetary transition
  • Elections are driving similar uncertainty in many other EM countries. Brazilian elections in October may create new opportunities. Mexico is also undergoing a meaningful leadership shift

Corporate credit update

  • A dearth of attractive opportunities and rising interest rate risk led us to reduce our net performing credit book to zero
  • During 1H18, the investment grade market posted its second worst total return (-3.2%) since 1994 and the high yield market posted its lowest return (+0.6%) since 2008
  • Funds flow have been weak, but the high yield market has been supported by low net new issuance despite high LBO volume. Reflecting strong investor demand for floating rate assets, the majority of new issuance has shifted the loan market
  • Signs of an impending credit cycle include: 1) we are probably at or near peak global growth. Central banks, led by the Fed, are transitioning to tighter monetary policy; 2) the high yield and corporate markets have ballooned through relentless post-crisis issuance, with the corporate market massively bottom heavy with $2.5 trillion of BBB debt; 3) we are seeing an increase of sloppy behavior – for example, “pro forma adjustments” have accounted for over 30% of disclosed EBITDA in recent new issues according to the calculations of one dealer; 4) Eurodollar futures now predict the end of the tightening cycle in less than 18 months
  • Despite this, absent a macro shock, we do not see a significant credit cycle emerging for some time, likely in a couple of years. The nominal level of growth is still good and credit conditions remain very loose

Structured credit update

  • Although structured credit spreads are tight, we have found several interesting if modestly sized opportunities this year
  • In the broader market, the most active areas of new issuance in 2018 are in CLOs and CMBS, with $89 billion in new CLO issuance and $64 billion in CMBS
    • CLOs are facing headwinds of widening liabilities, especially for AAAs, which represent 70% of the financing, and tightening asset spreads against the backdrop of tiering in high yield credits
    • CLOs currently buy more than 50% of leveraged loan issuance
  • In contrast, non-agency mortgage securitization remains muted despite strong fundamentals in housing
  • Total housing value of the US is at $26.4 trillion with household equity at $15.7 trillion
  • With little to do in traditional non-agency RMBS securities, we have expanded into more verticals in the homeowner’s financial lifestyle, combining our interest in marketplace lending and mortgage investing
  • In a rising interest rate environment with low levels of housing inventory, we believe the housing market is ripe for innovation, particularly by helping borrowers both enhance the value of their homes via home improvement loans and access equity with new home equity products
  • While these new products have become a larger portion of our structure credit portfolio, we continue to remain constructive on “reperforming” mortgages and have had success in this sub-sector during 1H18
  • With new origination channels emerging and the increasing intersection of technology and banks and servicers, we believe many of the current impediments to mortgage growth, including high origination costs and cumbersome, paperwork-intensive refinancing processes will become more streamlined and create opportunity

Third Point Second Quarter 2018 Investor Letter, July 23, 2018

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: Bloomberg

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