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FPA Capital Comments on Arris Group
Posted by: Holly LaFon (IP Logged)
Date: October 23, 2013 03:53PM

We initiated one new position in the third quarter, Aarons (AAN), and purchased shares in several existing investments, including small amounts in Apollo Group (APOL) and Devry (DV) and a larger increase in Arris Group (ARRS). We have written about the for-profit education companies in previous letters, so please refer to those letters should you want to familiarize yourself with APOL or DV.

Let us share some thoughts about ARRS. Our team has followed ARRS since 2005 and purchased the first share for the portfolios we manage in October 2010. Arris provides communication hardware products to cable operators. Every day, we demand faster speeds and more bandwidth from our intern et providers in order to achieve a higher satisfaction with our internet experience. We also ask for more High-definition (HD) channels from our TV/video providers. We want to stream movies and upload our own movies or videos to the internet. All these desires require large capital investments by cable operators.

In order to meet this demand, cable operators need to continuously update their infrastructure and this is where Arris comes in. ARRS manufactures and sells a wide range of technology products so all of the above wishes can be realized. ARRS has been gaining market share in many of its product niches because of the quality of its offerings and its leading technology innovations, which many of its customers and industry experts view as the "gold standard".

We initially invested in Arris at an attractive valuation at close to 12% free cash flow yield and under four times total enterprise value to EBITDA3. At the time of our investment, the company's net cash position made up approximately 35% of its market capitalization. The management team, which we hold in high regard and which has demonstrated a strong operational track record, has been taking advantage of this low valuation by gradually buying back their outstanding convertible debt and reducing their outstanding shares.

However, in December 2012, a major development occurred when ARRS acquired Motorola Home from Google for $2.5b. An industry analyst described the acquisition quite correctly as "minnow eats whale." We believe ARRS got a good deal by buying from a motivated seller. As mentioned earlier, we have been following ARRS for nearly a decade and think this management team is very disciplined. That said, as with any major acquisition, we worry about the integration/execution issues, but we have confidence ARRS's management team will optimize the operations. After the initial cost savings and synergies are accomplished in approximately a year, we believe the Company can generate substantially higher owner earnings and, therefore, good returns on our invested capital.

We continued to take advantage of strong upward momentum in the market place and trimmed a number of positions. When the market is trading at rich multiples, we trim or sell our positions. Currently, the market is expensive so we have more cash than usual. We are absolute value managers so we will stay on the sidelines as long as it takes and husband our cash until excellent investment opportunities become available. On the other hand, we will quickly deploy capital into investments if they are attractive–like we have done on three separate occasions this year.

We have done just that over the last 29 years for the strategy. Our portfolio is very defensive right now and has a great valuation advantage over our benchmark. Our P/E ratio is roughly 13 multiple points lower than Russell 2500's nearly 27x multiple at the end of the quarter.

During the quarter, we also fully exited a position– Alliant Techsystems (ATK). Our long-term clients know that our average holding period is over 6 years. Alliant Techsystems was in the portfolio for only approximately one year, and appreciated more than 115% from our cost basis. Our long-term clients also know that we start trimming our positions when we believe our required margin of safety diminishes. We also sell the position outright if our investment thesis has worked out and/or the investment thesis has changed. All these criteria were met with Alliant Techsystems.

Alliant Techsystems is an armament and aerospace company. The company has three segments. Aerospace is the first one. In this segment, the company provides mainly two products. The first one is what is called a Solid Rocket Motor. Each time NASA sends a cargo into the space, they need one of ATK's propulsion systems. Another product line for the Aerospace segment is aircraft components such as wing skins, fuselage skins, and other composites. The Company's products can be found on F-35s and Airbus A350s.

The second segment is Defense. The Company is the overwhelming majority provider of small caliber ammunition to the U.S. Army. In this segment, they also offer medium and large caliber ammunition and missiles.

The last segment is called Sporting. They sell sporting and law enforcement ammunition, accessories, and tactical gear. These are sold to police departments, Department of Homeland Security, FBI, and U.S. Secret Service on the law enforcement side. On the commercial side, the largest customers are Wal-Mart, Cabela's, Gander Mountain, and large distributors. Our team started looking at defense companies when many investors were worried about defense budget cuts, sequestration, and the end of wars. Alliant's stock price peaked at around $120 in late 2007 and gradually decreased to $90 in 2010 and then started decreasing more rapidly and hit $43 in Q3'12. That's when we started buying and built a small position with an average price of approximately $43.50.

By September 2013, our investment thesis played out – investors who were worried about lower armament sales and NASA contract losses were proved wrong. In 2012, we believed that the selling was overdone, as the uses of armament were mainly for military training, and the rest of the aerospace business was doing well. The stock price subsequently increased to over $95 per share, which is in the range where we exited the position.

As you know, we endeavor to find and invest your capital in more stocks like ATK. Unfortunately, it is currently not a target-rich environment for dedicated Small/Mid-Cap Value investors. We have experienced these droughts several times over the past few decades. Our patience has ultimately been rewarded as we have subsequently been able to put capital to work when the tide changes. We remain optimistic. If we can discover three new stocks for your portfolio in a year like 2013, we are confident that we will be able to put more capital to work when the market experiences greater volatility.

From FPA Capital's third quarter 2013 commentary.



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