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FPA Capital 2Q18 Letter: Energy Investments, Tenneco, Cision

  • Was up 3.41% for the second quarter of 2018

Energy-Related Investments

  • Despite an improving oil price environment, many investors are still shunning the energy sector, which represented just 6% of the S&P 500 index at the end of 2nd quarter
  • Energy equities as a whole are still widely disconnected from what the underlying spot and 24-month futures prices would imply; NBL is the only E&P holding that reflects an oil price of $55
  • Even though inventory levels have fallen back below long-run averages, there is widespread concern that OPEC and Russia will turn on the taps again and send spot and forward oil prices much lower
    • Higher oil prices have dramatically boosted the national incomes of both countries. Why would they flood the market and shoot themselves in the foot?
  • The world needs more oil to avoid a disruptive price spike. Back in April 2017, OECD crude inventories were around 3.05bn barrels, and since then, that figure has been draining at an average rate of around 600,000bbls/d. That has put worldwide inventories below normal, which would imply a $70-80/bbl Brent price based on historical data. OPEC, Russia, and other partner countries originally committed to take 1.8 million bbls/d off the market in November 2016, but output has fallen further than that (128% of the original pledge)
  • This above-and-beyond performance was not a result of the cartel’s generosity but rather from involuntary declines
  • The elephant in the room is Venezuela, which has involuntarily cut nearly as many barrels as Saudi Arabia, and yet its oil production continues to decrease at a very concerning rate
  • Trump administration’s decision to pull out of Iran nuclear deal could conservatively take 200,000 bbls a day off the market
  • Meanwhile, global crude consumption continues to surge, with the typically conservative IEA expecting demand growth of another 1.4 million b/d in 2018
  • OPEC must increase production to offset these sources of supply disruption, moderate climbing oil prices, and avoid a damaging price spike. We believe the amended agreement from the June 23 OPEC meeting was designed to help the cartel control an increasingly precarious deficit so they don’t dramatically overshoot what we believe is an inventory target that’s still roughly 100-150 million bbls below where we stand today
  • Another topic of debate revolves around the recent amplification of logistical constraints in the Permian basin; namely the ability to get gas and crude to market in the face of short term pipeline limitations and limited alternative takeaway capacity
    • This is a temporary issue due to the timing of new pipelines coming online through 2019, and that regional price differentials from supply/demand imbalances naturally incentivize midstream construction to alleviate chokepoints

Tenneco

  • One of the cheapest auto parts supplier stocks in the market today, trading at about 4x next 12-month EBITDA
  • Peers trade at much higher multiples – nearly 7x next 12-month EBITDA, reflecting investor fear that Tenneco’s exposure to the internal combustible engine (ICE) will ultimately send its business into a long-term secular decline
  • Investors are missing a few critical points:
    • Many market participants worry about pure battery-based powertrains taking market share. But even if those vehicles garner 10% market share, Tenneco could still have content on 90% of vehicles sold
    • More stringent regulation will continue to increase Tenneco’s content per vehicle each year over the next decade
    • Ride Performance & Aftermarket businesses (nearly 40% of EBIT) are largely agnostic to powertrain choice
  • Over the last three years, management expressed confidence in the business by buying back stock (nearly 20% of outstanding shares) and routinely reiterated the points we made above
  • But the market continued to focus on secular decline worries, ignored content/vehicle growth, and would not assign a higher multiple to the secularly growing and less cyclical Ride Performance & Aftermarket businesses
  • We were left with a situation where earnings were expanding, but the multiple was contracting
  • In order for each business to be appropriately valued, Tenneco needed to be split up so the secularly growing and stickier Ride Performance & Aftermarket businesses would be valued separately from the Clean Air business
  • Unfortunately, each business was too small to independently support its own public company cost structure, so alternatives needed to be explored
  • The recently announced Federal Mogul transaction allowed the separate businesses to get enough scale to profitably operate independently
  • Tenneco paid 5.4x EBITDA, which we view as a fair price. While the deal adds leverage above levels we like to see from an auto parts supplier, management is focused on reducing leverage rapidly and has established reasonable targets for each business
  • The Federal Mogul transaction provides an opportunity for substantial multiple rerating of both businesses, as capital allocation decision to maximize FCF and shareholder returns can be prioritized in one business, while reinvestment in growth can be prioritized in the other

Cision Ltd.

  • Just six months removed from its IPO, poorly covered by the street, and was trading at significant discount to other vertical software peers
  • Company is the clear leader in an otherwise fragmented market and provides the only comprehensive SaaS platform for public relations and marketing communication professionals at 91 of the top 100 worldwide brands and 96 of the top 100 PR companies in the US
  • Research suggests that CISN can generate attractive long-term organic cash flow growth by converting customers away from a typical infrastructure of disparate point solutions, to its closed-loop SaaS platform, allowing it to grow well beyond its 20% share of the PR Software and Services market
  • Company recently launched the first monitoring tools that truly quantify ROI on earned media campaigns
  • Survey work covering current and potential customers clearly indicates that this could make CISN’s software offering more of a necessity
  • It could also significantly increase the company’s total addressable market by enabling it to enter the much larger Marketing Software market
  • It’s important to understand that there’s a clear consensus view that earned media generates significantly higher ROIs than the dominant paid media category, yet earned media marketing budgets remain very small because reliable attribution tools were previously unavailable
  • We believe that CISN has a great cash-flow profile. Company has predominantly recurring revenues, EBITDA margins gravitating to the high 30s, and the majority of that EBITDA is converted to free cash flow because of low capital investment requirements

FPA Capital 2Q18 Commentary

Image Source: Bloomberg, Cornerstone Analytics

 

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