Unicredit (UCG) is one of Italy's largest commercial banks with additional retail operations throughout Central and Eastern Europe. The EBA bank stress tests conducted in Q4 revealed UCG's need to raise €7.5 billion of capital by June 30, 2012 to reach the minimum 9% threshold required under Basel III. In November 2011, UCG announced a €7.5 billion rights offering with pricing to be determined in early 2012. Demand from UCG's shareholder base to underwrite the deal was weak however, given that nearly 25% of its shareholders (mainly Italian foundations and the Libyan Central Bank) lacked additional capital. This prompted the consortium of banks underwriting the deal to price the new shares at a ~60% discount, nearly 2x that of similar transactions and more than doubling the shares outstanding.
The deal was announced on the first trading day of 2012 in thin markets due to arcane regulatory requirements in some eastern European countries where UCG operates. The offering's extreme discount and fears of indiscriminate selling by underwriters shocked thinly‐staffed trading desks across Europe and drove the stock down by ~50%. Panicked selling nearly forced the stock through the rights price, meaning the market temporarily deemed the rights close to worthless.
The technical pressures and forced selling naturally caught our attention. The enormous time we have invested as a team in attempting to understand the broader impacts of the ECB's recently announced three‐year LTRO also proved critical. The ECB's latest attempt to support ailing banks generated little fanfare when initiated in December 2011 but appeared to us as a potential game‐changer for Euro area risk premia. Based on our belief that the LTRO would significantly compress risk premia, particularly in Italian sovereign yields, we began buying UCG rights. These rights, on a converted basis, allowed us to create the stock at 10% discount to prevailing market levels and ~0.25x tangible common equity. This multiple implied nearly a 25% cost of equity for a bank in the upper quartile of capitalization versus its peers, with adequate liquidity for the foreseeable future, and domiciled in a sovereign with collapsing credit spreads. Furthermore, at our entry prices we were largely covered by UCG’s stakes in publicly traded Russian and Turkish banks and effectively getting its Central European assets for free.
As expected, Italian sovereign yields compressed and attracted attention to UCG’s meaningfully depressed valuation. The rights closed their discount to the shares and it became clear underwriters would not be forced to hold unwanted stock. UCG quickly rerated to 0.5x price to tangible common equity, enabling us to double our money in less than one month. At the current valuation, investors need to be confident in management’s operational restructuring plan. This was not a bet we were willing to take, and so we have fully exited our position with a significant gain.
Long Equity Position: Skyworks Solutions Skyworks Solutions (SWKS) is a leading provider of radio frequency (RF) semiconductors for wireless devices. The Company is levered to the growth in connected devices such as cellphones, tablets, and consumer electronics, and in connection options per device (cellular 2G, 3G, 4G, WiFi, Bluetooth). The growth in wireless devices and forms of connectivity is further amplified by the proliferation of new wireless spectrum bands used in carrier networks (e.g. 700MHz, 800MHz, 1900MHz, 2100MHz, and 2500MHz). These trends have resulted in a surge of RF semiconductor content in wireless devices.
During late 2011, Skyworks’ shares sold off aggressively due to market share shifts within the iPhone 4S. By focusing exclusively on the Apple story, the markets missed the company’s growing success outside of Apple products and the secular trends noted above. Tax‐loss selling moved the share price from $22 to $14, and we capitalized on the sell‐off to build a partially hedged position in December. Skyworks was trading at a steep P/E discount to the semiconductor space and more specifically its RF peers RFMD and TQNT. With solid 4Q results and 1Q guidance, continued 4G device traction, a window to regain share within iPhone 5 in 2Q/3Q, and the recovery in semiconductor shares, we believed Skyworks was poised to re‐rate back toward peer P/E multiples, which would imply nearly $30 per share. Our thesis came to fruition quickly, and we exited the position in the mid‐ $20’s for a tidy gain early in March.
At the Investor Day, we discussed our position in EXPT, a quasi‐governmental Norwegian institution created to lend capital for private infrastructure projects primarily in the global oil and gas industry. The government announced that EksportFinans would be wound down and a new wholly‐government owned institution would be created in its place to provide this export financing. Moody's and S&P, which had previously treated this credit as essentially government paper, interpreted this statement to mean that the government would not continue to backstop the outstanding loans and downgraded EXPT by seven notches, from AA to BB+.
Panic ensued among the traditional holders of the paper – primarily pensions and others – and forced selling caused the bonds to trade off 15‐20 points, as shown on the chart below: We saw this downgrade as an immediate opportunity and sent one of our credit analysts to Norway to meet with government officials and traditional holders of these loans. Working in our favor was the Thanksgiving holiday, and an analyst happy to give up his turkey and football to build a $500 million position in a relatively low‐risk, high return credit situation over just a few days.
Since we initiated the position, EXPT has performed as we expected. Before the government's announcement, the bonds were trading at ~115. We purchased most of our position after they plunged to ~85, and spreads have since narrowed so the paper is in the mid‐90’s today. We expect the spreads to further condense towards their pre‐crisis levels in the near‐term and so continue to own our position.
Hidden Growth We also spent time at the Investor Presentation discussing another approach we believe is fruitful in this macroeconomic environment: paying fair multiples for “hidden” growth rather than cheap multiples for stagnation. This approach has led us to revisit certain emerging markets with renewed energy. While we have tended to gravitate towards cyclical equity names in the past, we believe we need to have more balance in our portfolio in a year which will continue to be turbulent from a macroeconomic perspective. A focus on companies benefitting from hidden growth should help add this balance, ultimately dampening volatility while increasing overall profit.
Long Equity: Abercrombie & Fitch We began purchasing shares of Abercrombie & Fitch (ANF) in January after the stock price declined by nearly half over the past few months. Abercrombie & Fitch was attractive because we believe we paid roughly 10x cy12 EPS (ex $7 net cash) for a business that should grow earnings at a double digit rate for at least the next few years. That growth will come from recovering US profitability and from continued growth of the company's high margin online (2009‐11 CAGR +38%) and international businesses (2009‐11 CAGR +70%). In the US, management is aggressively right‐sizing the store base and plans to close another 20% of its stores by 2015. US profitability should rebound as the competitive environment improves after a highly promotional holiday season and as average unit costs decline, in part due to lower cotton prices. Outside the United States, the company is opening highly profitable stores in Europe and Asia where the brand appeals to a wider customer base and the company is able to charge a premium price. While it is difficult to know how overseas profitability will trend over time, we think it is far too early to write off the potentially lucrative international growth story and believe our entry point provides a sufficient margin of safety if we are wrong.
Long Equity: Volkswagen Volkswagen (“VW”) is a long‐term holding that we initiated in the spring of 2010. VW is valued by the market as a low‐quality, cyclical stock at less than 7x forward earnings. We have a differentiated view on VW’s earnings as we believe the market continues to underestimate two of VW’s secular earnings drivers. First, VW’s ongoing shift to a modular production system is driving structural margin expansion. Second, as we have explained previously, VW sells more than half its units in emerging markets with a particularly strong presence in China and Brazil. These two drivers are contributing ~20% to “through‐the cycle” compounded annual earnings growth from 2008 to 2013 earnings.
VW’s pending acquisition of Porsche’s operating business remains a key catalyst for the stock. We suspect that VW may find a way to acquire the remaining 51% stake in the next 12 months, which should be more than 10% accretive to VW.
Long Credit: Ally Financial As our investors know, our Credit team has spent a significant portion of the past three years investing in the auto industry. Ally Financial, formerly known as GMAC, is the world’s largest auto finance company and a rapidly growing online savings bank with ~$30 billion in deposits. Ally received government support during the financial crisis largely due to its efforts to support its failing mortgage subsidiary, ResCap, which remains one of the five largest mortgage servicers in the US. As a result of the capital injection, the US Treasury now owns ~75% of Ally, diluting the stakes of its former owners, Cerberus Capital Management and GM, and giving Ally a robust 11% Tier 1 Common Ratio under Basel III.
Given its strong capital metrics and ample liquidity, Ally’s debt structure traded in line with more highly rated competitors like Ford Motor Credit for most of 2011 and maintained fairly tight spreads in its long‐dated bonds and non‐UST preferred shares. However, Ally was not spared when global credit spreads widened during the August sell‐off. Simultaneously, fears began to mount over Ally’s mortgage‐related liabilities from wrongful foreclosures, representation and warranty breaches, and securities law fraud suits associated with its pre‐crisis sale of mortgage‐backed securities. The majority of these potential liabilities originated from the ResCap subsidiary, and although Ally has repeatedly stated its belief that any liability for these issues can be ring fenced at ResCap, uncertainty remains. This combination of rising global credit risk premiums and mortgage liabilities fears dramatically widened Ally’s spread to Ford Motor Credit and significantly increased the spreads on its long‐dated bonds and preferred equity.
We began initiating our position in Ally’s long‐dated bonds and preferred shares during the fourth quarter because we believed that the mortgage‐related liabilities would be contained at ResCap or if not, that they would not be large enough to significantly impair Ally’s capital or credit position. We also believed that 2012 would provide a meaningful resolution of these liabilities such that Ally debt could be upgraded. Furthermore, all of our securities were purchased at large discounts to par and carry between 8.0 – 8.5% current pay coupons, providing significant downside protection.
Ally’s credit spreads have started to normalize in 2012 and the company recently achieved the first milestone in resolving mortgage‐related liabilities via the widely publicized State Attorney Generals’ Settlement. Despite returns of between 10% ‐ 25% so far this year, we continue to hold our securities as we expect full clarity (if not resolution) of mortgage liabilities and a potential eventual upgrade to an investment grade rating could drive additional total returns of 15 – 35%.
Long Equity: Yahoo! – The Case for Alibaba As investors are aware, we established a sizeable position in Yahoo (YHOO) following a difficult operational and strategic stretch during the waning days of CEO Carol Bartz’s tenure that culminated in a significant sell‐off in the shares in August. Initially, we were attracted to the company simply by its significant discount to intrinsic value. In September, we announced publicly that we had accumulated 5.2% of the shares of the company and laid out our case for why the valuation was depressed. While the travails of “core Yahoo” grab all the headlines, core Yahoo forms only a modest portion of the Company’s actual value (a mere $1.50 per share, trading at ~$14.49 as of 03/12/12). The after‐tax value of Yahoo’s Asian assets – Alibaba and Yahoo! Japan – currently constitutes $11 per share of its value (76%), with an additional $2 per share of net cash.
Central to our investment thesis is the hidden jewel in the Asian asset portfolio, and indeed in Yahoo itself: Yahoo’s 40% stake in Alibaba Group, the dominant e‐commerce platform in China. According to iResearch, Alibaba currently has 49% of the B2B e‐commerce market (four times greater than its nearest competitor), 90% of the C2C e‐commerce market (analogous to Ebay), and 53% of the B2C e‐commerce market (analogous to Amazon) in 2011. It has complemented these core commerce positions with the leading online payment platform, Alipay, with 49% market share, and also holds the #2 share of the Chinese online ad market (17%, behind Baidu at 28%). Particularly exciting is Alibaba’s share of China’s rapidly growing B2C market represented by Taobao Mall, or Tmall (recently renamed Tian Mao).
According to iResearch, China had 187 million online shoppers in 2011, compared to 170 million in the U.S. As Boston Consulting Group noted in its November 2011 report, “The World’s Next E‐Commerce Superpower”, e‐commerce transaction value in China is likely to overtake the U.S. by 2015, helped by conditions that mirror the U.S. and in some ways favor e‐commerce in China. A combination of broad product assortments and lower prices mirror the U.S., while e‐commerce in China benefits from the fixed price certainty missing in China’s traditional retail culture (where haggling is common), from relatively lower shipping costs than in the U.S., and from the limited geographic reach of brick‐and‐mortar chains. The Boston Consulting Group report highlights “The Taobao Phenomenon” and notes more products were purchased on Taobao in 2010 than at China’s top‐five brick and mortar retailers combined.
The scale and velocity of China’s e‐commerce opportunity, when combined with Alibaba’s dominant position, make for a very compelling story. As it moves toward an IPO, Alibaba should quickly take its place amongst China’s online leaders – Tencent ($47 billion market cap), and Baidu ($48 billion market cap). A November 2011 report on Softbank by UBS’s Makio Inui, the product of extensive research into Alibaba Group and a detailed valuation, placed a $63 billion value on Alibaba Group, which would imply just over $13 per Yahoo share after tax. It appears that while 2012 will be the year of Facebook, 2013 could very well be the year of Alibaba as it moves toward a listing.
At the reported $35 billion valuation ascribed to the October 2011 purchase of employee shares by Silver Lake, Temasek and Yunfeng (an affiliate of CEO Jack Ma), Yahoo’s stake was worth ~$7.60 per share after tax. That implies Yahoo’s stake has grown at a compounded rate of 55% per annum since its investment in October 2005, and it is significant that the majority of Yahoo’s value is now driven by its Alibaba stake. Clearly, as evidenced above, we see tremendous upside in just the Alibaba piece of the Yahoo puzzle. While the media has covered the drama surrounding the negotiations with Mr. Ma in some detail, Wall Street has continued to neglect the underlying Alibaba valuation story and the press makes too little of it. Certainly there is some compelling reason why Mr. Ma is so interested in repurchasing Yahoo’s stake! We share his excitement and enthusiasm for the Alibaba opportunity, and we respect and appreciate the dominant and dynamic franchise he has built amongst the world’s largest base of Internet users.
Over the last six months we have witnessed the Board of Directors’ “strategic review” that has to date resulted in the hiring of a new CEO, Scott Thompson, the resignation of Jerry Yang, and the pending exit of Board Chairman Roy Bostock and three other Directors. In mid‐February we announced that we intend to run our own slate of Directors for the Yahoo board during this proxy season. We stated our intention to nominate well‐known leaders in the media space Jeff Zucker and Michael Wolf, restructuring guru Harry Wilson, and Dan himself to the Board. We are glad Yahoo has played a critical role in Alibaba’s early development and hope new leadership at Yahoo can chart a new course for the company’s relationship with Mr. Ma and Alibaba.