The second quarter was marked by choppy markets caused by fears about Europe, a soft patch in the U.S., more signs of a Chinese slowdown, and U.S. consumers and business owners alike frustrated by the Obama Administration, which is openly hostile to most businesses and unable to articulate or implement policies to spark growth and reduce unemployment. Since "Euro‐phobia" has roiled the markets for over twelve months, we attributed the second quarter's sell‐off mostly to the renewed worries over US weakness and pervasive concerns about a Chinese hard landing, which punished any assets linked to global growth.
Despite taking a defensive posture, we were down slightly for the second quarter, though significantly less than the market until the final days of June. We pared back our long equity exposure in April, stayed mostly out of Europe, increased short exposure, and structured index trades to act as market hedges. Our credit portfolio continued its standout YTD performance and easily surpassed the relevant indices. Distressed credit was up +4.3% for Q2 and is up +15.3% YTD on average exposure (excluding additional profits in post‐reorg equities and sovereign debt). Performing credit made +4.8% in Q2 and is up 16.4% YTD on average assets invested. These results compare favorably to the high‐yield indices' average returns of +6.7% YTD. Returns in the performing and distressed books have been driven by a benign corporate credit market and some positive catalysts including the initiation of certain creditor distributions, select favorable operating results, and three refinancings or take outs. Our mortgage portfolio appreciated with tailwinds from the recovering US housing industry, and is +7.3% this year on invested assets.
The weakness in overall performance can be explained primarily by our long exposure to cyclical and industrial names, which suffered disproportionately as the risk‐off trade picked up steam through Q2. Some of these positions have recovered losses in July. As we discussed in our last letter, our moderate positioning throughout the year has kept our portfolio mostly insulated from day‐to‐day swings. It is a bit frustrating for us to lag the S&P but given the risks that concerned us earlier in the year, we believed it was prudent to chart a "first, do no harm" course through these markets and focus on capital preservation. Viewed through this prism, we are satisfied with the performance of our diversified approach to these markets and are ready to strike when we see compelling opportunities. In July, we increased our net equity exposure, initiated several new positions, and added to some existing names.
Set forth below are our results through June 30, 2012.
The top five winners for the quarter were Yahoo! Inc, Progress Energy Resources Corp, Vertex Pharmaceuticals Inc, Ally Financial, and Portuguese Government Bonds. The top five losers for the period were Delphi Corp, Sara Lee Corp, Abercrombie & Fitch Co, Short A, and Ivanhoe Mines Ltd.
Assets under management at June 30, 2012 were $8.7 billion. The funds remain closed to new investments with limited exceptions as discussed previously.
Select Portfolio Positions
Europe in 2012
We are often asked what "event‐driven" investing means in today's environment, and whether that landscape is still fertile. We have found it to be especially so in Europe in 2012, where we have managed to make money despite the continental chaos by looking for negative events, capitalizing on the dislocations they generate, and trading well around these individual situations. While Europe overall is a place where we currently have little interest in long‐term investing given the circumstances, surprisingly, many of our top winners so far in 2012 are European situations.
In times of turmoil, we look for "fat pitches" that come from factors like forced or panicked selling, market dislocations, or a move in the cycle away from greed towards fear. With all of the mayhem in Europe in the past 12 months, we have been able to find quite a few of these types of investments while remaining disciplined about avoiding anything in the region that falls outside of our very narrowly defined investment parameters. Investors are familiar already with our profitable trades in Eksportfinanz credit, the Unicredito rights offering, and Portuguese sovereign bonds, as we have discussed these in previous letters and in conversations with many of you. Each represented a sizeable opportunity driven by a negative event resulting in a mispricing that we believed would remedy itself within 12‐ 18 months. We were able to deploy dry powder decisively and take profits quickly when equilibrium was restored, capitalizing on the fear resulting from an unexpected, downsideinducing event in a market already spooked by its own shadow.
With the turmoil in Europe showing no signs of abating, we expect to continue seeing these types of attractive opportunities. We recently added a new position that fits these parameters through the European IG bond index known as iTraxx.
In mid‐June European sovereign and corporate credit markets came under extreme duress and the IG index was pricing in a default rate of ~12%, compared to its maximum historic 5‐year cumulative default rate of ~4% and average cumulative default rate of ~1%. The elevated implied default rate meant that European IG spreads were near all‐time wide levels, and these were further amplified in the junior tranches of the iTraxx Index. Despite limited tranching of recent vintages, iTraxx Series 9, created in 2008, still has a very actively traded tranche market. CDS on the most junior tranche, known as "0% ‐ 3%", began trading at 40 points up front or a ~70% IRR for a contract that expires in June 2013. The 0% ‐ 3% tranche is a first loss piece of the index that has a narrow detach point at 3%. This means losses to the overall index on an individual default are magnified by ~33x. It also means that any mispricing of default risk manifesting in increased index spread is also magnified by ~33x, hence the ~70% 1 year IRR.
At 40 points up front, and assuming conservative recovery levels, our June 2013 contract would not incur principal losses until at least 4 defaults occurred. Of the 125 underlying credits, there was an extremely large gap in the 1 year CDS of the four "riskiest" credits compared to the remaining 121 names. Our diligent coverage of all European credit opportunities enabled us to quickly and comfortably underwrite 1 year default risk in these 4 "risky" credits at those return levels. Furthermore, the remaining 121 credits appeared to be experiencing temporary mispricing typical of the European risk roller‐coaster. Giving us additional comfort was that our maximum potential loss was fixed at ~55% of our notional risk and we viewed our breakeven scenario of at least 4 defaults as extremely unlikely without a Eurozone breakup. Furthermore, given the magnitude of the upside, we were able to buy protection for the biggest risk we saw – a potential Eurozone collapse – via both market and currency hedges intended to offset potential losses stemming from a worst‐case scenario. Anticipated positive events in the "risky" names and overall index spread compression have helped our position appreciate significantly since our purchase, and our contract now trades at ~20 points up front. We anticipate Europe's dysfunctional capital markets to continue generating a steady stream of similar event‐driven, attractive ideas for us to incorporate into our portfolio.
Long Equity: Yahoo! (YHOO) Update
Third Point's investment in Yahoo! appreciated 4% during the second quarter. Due to Yahoo!'s concentrated size in our funds, this modest appreciation still made it the biggest winner for the period.
We were pleased to have favorably resolved the proxy contest we commenced in Q1. Following a subsequent kerfuffle involving misstated academic records of its then‐CEO and a now former board member, Yahoo!'s directors determined that it was in the best interests of the Company to invite our nominees Daniel Loeb, Michael Wolf, and Harry Wilson onto the board.
Since we joined the Board in mid‐May, Yahoo! has achieved three significant milestones. First, Yahoo! and Alibaba, the privately held Chinese internet company in which Yahoo! owns a 40% stake, reached an agreement for Alibaba to repurchase about half of that position at an attractive valuation. This agreement provides pricing transparency and a path to liquidity for this key Yahoo! asset, and is expected to close sometime in Q3. Yahoo! has indicated that it will return substantially all of the expected $5B of cash it will receive from this transaction to shareholders. Second, the Company was able to amicably settle a patent lawsuit filed in the first quarter against Facebook, one of its largest partners, resulting in a new, expanded partnership between the two companies.
Lastly, Yahoo recently appointed Marissa Mayer as CEO. Mayer, a Stanford graduate with a B.A. in Symbolic Systems and M.S. in Computer Science, was Google's 20th employee when she joined the fledging company in 1999. During her 13 years at Google, she oversaw the design of numerous well‐known products and was responsible for its iconic home page design. Mayer is a leading innovator in Silicon Valley whose creative vision made her a critical part of Google's leadership team. Her appointment was received favorably by employees and the tech community. We were very pleased to have had the opportunity to work with our fellow directors towards this extremely positive outcome and wish Marissa the best.
Long Equity: Delphi (DFG) Update
We have owned Delphi since purchasing its DIP loan facility in June of 2009. Delphi has been a core position of 2‐5% throughout the past three years as distressed debt, post‐reorg equity, post‐IPO locked up equity and since March, as unrestricted common stock trading on the NYSE. Accordingly, Delphi is a good example of a long term investment across the arc of the distressed cycle. Despite negative Q2 stock performance, Delphi is +33% in 2012, and has been the best performing Auto Supplier (or OEM) in a group where ~50% of companies are down for the year. Yet we are often asked why we "still" own Delphi. In our view, Delphi is a best‐in‐class supplier which still trades at the valuation of more commoditized and disadvantaged comparable companies. Delphi has premium business lines, an excellent geographic customer base, no need for further deleveraging, virtually no North American unionized labor, and significantly smaller pension liabilities than almost all of its peers. Using multiples closer to the upper quartile of suppliers – where we feel Delphi belongs and is headed – Delphi's stock should be worth between $35‐$40 per share, or a 30‐40% upside from current levels. We expect Delphi to expedite its multiple expansion by returning a significant portion of its free cash flow – about 25% of the current market cap by year end 2013 – to shareholders through continued share repurchases and the initiation of a quarterly dividend. We believe a $1 per share dividend puts them squarely in line with peer average payouts, is a level which can easily be grown, and should be initiated by the end of 2012 barring macroeconomic calamity or significant changes to tax policy.
Delphi also has limited downside, assuming no significant slowdown in global growth, which we hedge against and monitor across our portfolio. Given Delphi's low cost structure, strong amounts of booked revenue, and a recent acquisition which is margin accretive, we believe the company would still be close to free cash flow break even at trough production levels seen in 2009. This margin of safety makes us comfortable holding Delphi in its current size.
Probably the biggest concern for Delphi holders is the ownership base, which remains heavily skewed toward hedge funds. The exit of some of these investors during the first half of 2012 was positive, even if it temporarily depressed overall P & L on a mark to market basis as these players took long‐term profits and de‐risked their overall portfolios in May and June. We expect Delphi will diversify its concentrated shareholder base over the next few quarters, particularly once a dividend is initiated, and this development will reduce some of the volatility in the stock as it moves higher.
Long Equity and Debt: Progress Energy Resources Corp.
We initiated a position in Progress Energy Resources (PRQ), a Canadian mid‐cap E&P company based in Calgary, Alberta, early in 2012 after the significant sell‐off in natural gas prices and natural gas‐related equities. Progress's primary asset is an 825,000 net acre position in the unconventional Montney gas play in British Columbia. Our thesis was that despite temporarily low gas prices, Western Canadian natural gas producers had strategic advantages due to their ability to monetize their gas in higher‐priced Asian LNG markets. The difference between the price of gas in Asia ($15 or more per mcfe) and the low F&D costs of unconventional gas in Western Canada (~$1 mcfe) caught our attention and Progress was an appealing way to access this arbitrage.
Western Canadian gas assets are more attractive than US shale assets for two main reasons. First, these assets lie in closer proximity to Asia, offering lower costs of shipping LNG products than proposed LNG projects in the US Gulf of Mexico and East Coast. Further, because Canada is an incumbent energy exporter, the country has a favorable regulatory environment, meaning LNG exports to Asia encounter minimal political opposition. We viewed Progress as an ideal target for a larger company with LNG ambitions, given Progress's large, concentrated asset base in the Montney and small size. Our thesis about Progress's attractive assets proved correct, and the Company recently agreed to be acquired by PETRONAS, the Malaysia National Oil Company for C$20.45, a 77% premium. Third Point held both equity and convertible bonds in Progress, which we sold into the acquisition for +67% and +17%, respectively, returns on average exposure.
New Addition to the Analyst Team
We are pleased to welcome Tanmay Chheda to Third Point, where he will focus on Industrials and Commodities. Tanmay joined us last month after finishing two years as a private equity associate at the Texas Pacific Group in San Francisco. Tanmay returned to New York, where he was raised and graduated from NYU. He worked previously in the Mergers and Acquisitions Group at Greenhill & Co.
Third Point LLC