Daniel Loeb's Q1 Letter - Comments on Liberty Global, Japan, International Paper, Mortgages
Review and Outlook
Third Point started the year strongly, delivering solid risk‐adjusted returns for our partners by finding compelling event‐driven investments in each of our main areas of focus. We previously highlighted that we expect 2013 to be a favorable year for Third Point's bread and butter event‐driven investing style. During the first quarter, we generated alpha primarily from select special situations, continued strong performance from Yahoo, good trading in financials, and many "singles and doubles" across sectors and strategies. Thus far in 2013, we see investors hunkered down in two camps. In the first, we find investors who believe in a recovery, see increasing flows into risk assets, are long the market, and inclined to ride out downturns. In the other camp, bears are concerned about disintegration in Europe, dampened corporate profit expectations, slipping global economic indicators, and poor market internals that favor safety over growth. These investors are anxious but buying defensive stocks to avoid missing a rally into equities. Consistent with our approach over the past few quarters, we have approximately half the equity exposure of the market and vary our net and gross dynamically. We are continuing to find interesting event‐driven opportunities in equities, credit and currencies.
Set forth below are our results through March 31, 2013:
The top five winners for the quarter were Yahoo! Inc., Japanese Macro, American International Group Inc., Virgin Media, and Herbalife Ltd. The top five losers for the period were Gold, Short A, Short B, Short C, and Greek Government Bonds.
Assets under management at March 31, 2013 were $11.7 billion. The funds are hard closed to all investors and not accepting new capital.
Select Portfolio Positions: Updates
We visited Japan last April following the Bank of Japan's ("BOJ") announcement of a new policy of targeting a 1% annual inflation rate. We recognized from past experience that meaningful quantitative easing in Japan could provide opportunities like our "don't fight the Fed" investments in 2009‐10 and European sovereign debt trades in 2012. Meetings with academics and government officials last April convinced us that the articulated "changes" were more rhetorical than practical at the time, but also revealed that many Japanese realized wholesale shifts would be necessary to pull the country out of the deep doldrums it had entered after the tsunami and subsequent nuclear catastrophe of 2011. Despite returning disappointed that this time wasn't different (yet), we had developed an understanding of the signals that would indicate the start of a paradigm shift if the time came.
In the fall of 2012, we recognized as a critical catalyst the increasing likelihood of a transition to leadership by the Liberal Democratic Party, led by Shinzō Abe. In statements leading up to his election as Prime Minister, Abe had articulated reflationary policies dramatically different than the BOJ's recent initiatives. Accordingly, we established a position speculating that the Japanese currency would be devalued aggressively and equities would rise once Abe took office. We sized the position decisively after concluding the investment had highly asymmetric outcomes.
The "Abe‐nomics" catalysts have played out essentially as we anticipated, and his approach has been met with unusual public support from the Japanese. Our optimism was reinforced by the appointment of Haruhiko Kuroda as the Governor of the BOJ on February 27. By analyzing Governor Kuroda's speeches and papers over the past two decades, we recognized him as a proponent of radical change, structural reform, and "dovish" monetary policy. Another important catalyst was the (grumbling) acquiescence by Western powers throughout Q1 as Japan began asserting its case for devaluing its currency.
Despite massive market speculation and an already significant move in the Yen, potential QE measures were simply speculative until last week's first Kuroda‐led BOJ meeting. We increased our position ahead of the meeting, rejecting the market consensus that the upside was already baked into any policy moves that might be announced. As we had hoped, the Governors managed to exceed even the highest of expectations with their initial actions, ticking all of the boxes we anticipated and adding others. The steps amounted to a complete reboot of the Japanese monetary experiment. The impact of this bold plan should be far‐reaching, not only for Japanese companies but also for Japan's trading partners. Perhaps most importantly, from a Third Point process and framework perspective, we have learned that in environments where QE and government intervention are critical engines, our catalyst‐driven approach allows us to find compelling "macro" opportunities. We believe there is still value in our initial currency/index trade reflecting this important structural inflection point and also have taken selected positions in single name stocks that we believe will benefit from this policy shift.
Equity Position: International Paper (IP)
International Paper is a core position in our portfolio, which we sized up during the First Quarter. IP has a compelling case for ownership buoyed by excellent sector and secular tailwinds.
With a current market capitalization of ~$20 billion, IP is the largest player in the highlyconsolidated North American Containerboard ("NACB") industry, which benefits from
strong pricing power despite flat volumes due to nearly 100% operating rates. In 2009 and again in 2011, IP took on substantial leverage to acquire assets that dramatically increased IP's revenue mix towards NACB. After a complex integration process, this year NACB will generate at least 60% of IP's total EBITDA and 75% of all North American EBITDA. This "new" IP should produce strong and stable free cash flow, allowing increased capital return to shareholders and valuation uplift.
Aided by these important NACB tailwinds, IP has multiple near‐term catalysts. The most immediate should come by the end of this month when the market learns if the industry's latest price increase has been officially sanctioned. Proceeds from post‐merger asset sales combined with IP's robust pro forma free cash flow should complete IP's multi‐year deleveraging, which has reduced debt by ~$10 billion over the last four years. With a cleaner balance sheet and no opportunities for further acquisitions, we believe IP's consistent cash flows will be returned increasingly to shareholders through buybacks and dividend increases. Even using stressed assumptions, IP should generate +$2.00 FCF per share, and we expect the dividend will eventually rise to this level.
Finally, we are always keenly attuned to a company's management team and its incentives. In 2014, IP mandates the retirement of its CEO John Faraci. During his decade‐long tenure as CEO, Faraci has almost single‐handedly consolidated the NACB industry and by the end of this year will have grown IP's revenue by ~20% and EBITDA by more than 50%, while cutting net debt by $5 billion. We expect Faraci to cement his impressive legacy by using new IP's balance sheet to repurchase shares, increase its dividend, and raise its stock price, reflecting the company's newfound strength.
Equity Position: Liberty Global
During the First Quarter, we increased our exposure to Liberty Global (LBTYA), Europe's largest cable operator, following the announcement of its acquisition of Virgin Media (VMED). The acquisition triggered a wave of investments by arbitrageurs, who created an attractive entry point for us by putting pressure on Liberty Global's shares. Initiating a position in Virgin Media allowed us to purchase additional Liberty Global at a material discount to its pre‐announcement and pro forma trading levels.
Our initial interest in Liberty Global was spurred by multiple catalysts and favorable geographic tailwinds. Relative to the United States cable market, Europe offers materially higher volume growth, lower churn, and meaningful penetration opportunity. Before yearend, we expect catalysts in the stock to include the closing of the VMED deal, the initiation of a substantial buyback plan, and the unveiling of accretive wireless and B2B initiatives. The wireless market in Liberty's key Western European markets generates over $73 billion of annual revenue, presenting Liberty with the opportunity to redefine the MVNO market, leveraging a unique WiFi footprint, full back office and system control, and attractive quad play bundles. Liberty also appears poised to ramp up its B2B efforts, particularly in Germany.
We believe Liberty's strategic value as the primary alternative to the incumbent telecom operator's fixed infrastructure in its markets is overlooked. The growth of mobile broadband will put pressure on carrier spectrum allocations, enhancing the importance of WiFi offload and wireline backhaul infrastructure. In a mobile broadband world, having a strong ground game is more important than ever for wireless operators and European cable players are well‐positioned with dense, upgraded fiber infrastructure offering considerable headroom.
In our analysis, pro forma Liberty Global could generate more than $6 per share of free cash flow in fiscal 2014 when factoring in the considerable buyback plan announced along with the acquisition. Through VMED, we had the opportunity to create Liberty Global at slightly more than 10x FY2014 free cash flow per share, giving us the cheapest free cash flow multiple in European cable in a deal that will be free cash flow accretive and meaningfully de‐leveraging to Liberty. Despite the move in the shares following the VMED announcement, Liberty Global's relative value remains attractive, especially given the recent appreciation of its European cable peers and the interim appreciation of slower growth, mature cable operators in the United States. We believe the shares could trade toward 15x pro forma 2014 free cash flow per share and compound at ~20% per year following the closing.
Third Point's structured credit portfolio has generated outstanding profits so far in 2013, following an excellent 2012. Seasoned mezzanine subprime securities and Re‐Remics have presented the best opportunities for superior risk‐adjusted returns during the past 18 months.
Seasoned mezzanine subprime initially attracted our interest when we noticed that the market was failing to differentiate among various vintages, as anything labeled "subprime" was too toxic (or triggered too much PTSD) for many investors to touch. Since subprime standards declined continually until the credit collapse in 2008, we believed that longerdated vintages – where borrowers were initially subject to more stringent ratings analysis and have had an extended period of making their required payments – should be priced more favorably than their shorter‐dated counterparts.
In 2012, we began to see breakdowns in pricing in seasoned mezzanine subprime securities as the market began to apply differentiated analysis to varying years and tranches. These bonds have benefited from a perfect storm of positive factors so far in 2013, including:
1) Assumption Changes: The market has become more constructive about expected default and severity levels thanks to tailwinds from the housing market and the broader US economic recovery. We believe we own the "fulcrum" security within each trust in our portfolio. Previous consensus expectations suggested we would receive back between $0.30 and $0.70 of principal but improving assumptions now target a recovery of $1.00 (par), driving these bonds higher.
2) Yield Tightening: The yield on these securities has tightened by many hundreds of basis points due to a few factors:
a. Increasing capital available from lenders to hedge funds who use repos and other leverage to generate incremental returns (Third Point does not); b. As assumptions shifted and these securities became "par" bonds, they became "safer" due to the certainty of principal returns and investors therefore required less yield to own them.
3) New Investor Base: Insurance companies and traditional long‐only money managers who have not purchased subprime mezzanine bonds since the financial crisis have flooded the space in 2013 looking for increased yield. The catalyst for their entry was a change in the insurance commissioner's NAIC pricing that allowed these bonds to receive more favorable capital treatment. Following this change, these buyers quickly bid up these bonds, often to inside of a 6% yield to a par return.
We have reduced these holdings significantly but still hold select securities that we believe remain undervalued even at current market prices. As we have sold mezzanine subprime exposure, we have added Alt A, Senior Subprime, CMBS and a small pool of European ABS bonds. We continue to find RMBS opportunities where moderating default levels and improving recoveries are not yet fully priced in. We are monitoring Fannie Mae and Freddie Mac's initiatives to increase private capital in the market, potentially by selling their non‐agency portfolio or mezzanine tranches of future mortgage risk and believe such actions could create new openings to invest in RMBS.
New Addition to the Analyst Team
We are pleased to welcome Megan Bloomer to Third Point, where she will focus on Structured Credit opportunities. Before joining Third Point, she was an Assistant Vice President at Barclays where she traded non‐agency residential mortgages. Megan graduated from Georgetown University with a B.A. in Economics.
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