Denali Investors: Second Quarter 2014 Investor Letter
Denali Investors’ Performance
During the second quarter, we were able to generate strong returns in a challenging environment. The returns were driven by a sequence of idea specific catalysts that offered good visibility since their initial announcements six to twelve months ago. The outperformance was generated while maintaining significantly less exposure due to our large cash position as well as our high position level and market hedges. We took advantage of the volatility early in the quarter and were able to increase a number of positions including the National-Oilwell Varco, Inc. (NYSE:NOV) + NOW Inc (NYSE:DNOW) spinoff. We also initiated new positions including the Fidelity National Financial Inc (NYSE:FNF) + Fidelity National Financial Inc (NYSE:FNFV) spinoff and Chicago Bridge & Iron Company N.V. (NYSE:CBI), among others. As certain investments hit their price targets and other opportunities arose, we scaled back and exited investments including Iron Mountain Incorporated (NYSE:IRM), and the Penn National Gaming, Inc (NASDAQ:PENN) + Gaming and Leisure Properties Inc (NASDAQ:GLPI) spinoff. In addition to the investments disclosed in this letter, a number of additional ideas are discussed in our recent in-depth interview in the highly regarded Graham & Doddsville newsletter (Link).
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The special situations pipeline for 2014 remains robust and continues to expand. There are numerous specific and understandable catalysts with attractive risk/return profiles. Our portfolio contains a series of hard catalysts that are expected to occur during the third quarter. From the 2014 vintage of special situations, we are increasingly finding and selectively layering in a base of investments that we believe to be high-quality, high-compounding, multiyear vehicles.
Select Portfolio Positions
National-Oilwell Varco, Inc. (NYSE:NOV) – We first identified NOV as a potentially interestingname in Q3 2013 when the company announced plans to spinoff its DistributionNOW (DNOW) business. We established our position in Q1 2014 ahead of the spinoff expected to occur in Q2 2014. The spinoff was completed in early June 2014.
New NOV provides equipment, components and services used in oil and gas drilling and production industry. New NOV will reorganize its two remaining segments, Rig Technology and Petroleum Services, into four reporting segments: 1) Rig Systems, 2) Rig Aftermarket, 3) Completion & Production Solutions, and 4) Wellbore Technologies. New NOV will be able to highlight the significantly higher margin profile and substantial FCF of its core business. It should be rewarded with the higher valuations of similar margin competitors. We expect more dividend increases (dividend was doubled in Q2 2013 and nearly doubled again in Q2 2014) and continued accretive acquisitions. We believed New NOV would be worth more without DNOW obscuring the value of the core business.
NOW Inc (NYSE:DNOW) provides the supply chain management, distribution and transmission of maintenance, repair and operating supplies and spare parts to drill site and production locations worldwide. DNOW is now the second largest for the energy industry. It is similar to an Autozone for the energy industry but operates in an industry that remains highly fragmented. DNOW’s current industry structure is similar to Autozone’s before its consolidation phase as well as that of New NOV itself before its own consolidation phase. At the risk of history repeating itself, DNOW’s industry is ripe for consolidation and we believe DNOW will be the company to do it.
Unlike most spinoffs, DNOW will begin with a favorable net cash position and a $1b revolver to help fund future acquisitions. Interestingly, the highly regarded NOV Chairman & CEO is moving to DNOW. The management has a long track record of structuring favorable deals and seemed deliberately quiet about the spinoff prospects. At our cost basis, we believed that DNOW was being created for free and that New NOV was priced at a substantial discount. This has turned out to be the case.
Fidelity National Financial Inc (NYSE:FNF) – We first identified FNF as a potentiallyinteresting name in Q4 2013 when the company announced strategic alternatives. In January 2014, the company announced the intention to separate the FNF Ventures assets into a tracking stock FNFV Group (FNFV) and with New FNF also becoming a tracking stock FNF Group (FNF). We established our position in Q2 2014. The company completed the FNFV spinoff at the end of Q2 2014. We believe the market was not assigning any value to the FNFV assets.
New FNF is the largest title insurance company in the US and a leading provider of title insurance, escrow and other title-related services for real estate transactions. FNF has about one-third of the US title insurance market in an oligopolistic market (top 4 companies have 90% market share).
New FNF also completed in January 2014 the acquisition of Lender Processing Services (LPS) for $3.4b. New FNF has a two-thirds stake in LPS which has been reorganized as Black Knight Financial Services (BKFS). BKFS offers the mortgage and finance industries’ leading provider of integrated technology, data, and analytics solutions as well as transaction services. The market seems to be discounting the impact of the BKFS segment. Interestingly, LPS (now BKFS) was once a subsidiary of FNF and both companies continue to share a corporate campus. In November 2006, FNF spun off Fidelity National Information Services (FIS) which included LPS as a subsidiary. In July 2008, FIS then spun off LPS into a separate public company.
Fidelity National Financial Inc (NYSE:FNFV) will hold interests in Remy International (REMY), American Blue Ribbon Holdings
(ABRH), J. Alexander’s Holdings (JAX), Ceridian HCM, Comdata, and Digital Insurance.
The stated NAV of FNFV’s holdings is approximately $5 per FNF share (pre reverse split). However, the stated NAV figure is based on at-cost metrics. Based on our analysis, the true NAV is significantly higher than the stated valuation. FNFV contains valuable assets and trades at a substantial discount. We believe management has numerous options to unlock value in the near term, including additional spinoffs, splitoffs, sales, buybacks, etc.
Tracking stocks are widely misunderstood and underappreciated. In fact, both Glass Lewis and ISS proxy advisors recommended against the Fidelity National Financial Inc (NYSE:FNF) and Fidelity National Financial Inc (NYSE:FNFV) tracking stock
conversions. Of the securities universe of 695,528, there is active trading status for 171,471 securities. Of those, only two were tracking stocks – LINTA and LVNTA. These are among the Malone entities, which we have discussed at length. LINTA will soon reorganize into QVCA tracking, LDCA tracking, and New LVNTA tracking (post separation of LTRPA). The only other tracking stocks are now FNF and FNFV. These are among the Foley entities. Currently, the quietly established universe of American tracking stocks consists of only four stocks that are all highly productive, highly creative, and managed by two exceptional owner-operators.
Chicago Bridge & Iron Company N.V. (NYSE:CBI) – We first identified CBI as a potentially interesting name inlate Q2 2014 when a short selling focused research firm released a detailed white paper that triggered a 20% price drop over a short period. CBI is familiar to our partners due to our investment in Shaw Group (SHAW), which was purchased by CBI in 2012. We initiated our position in SHAW in 2011 when it traded at a 0x EV/EBITDA multiple and first analyzed CBI during that period. Upon the merger announcement, we conducted a thorough analysis and believed that the deal terms substantially undervalued SHAW and would be disproportionately beneficial to CBI.
Our extensive analysis regarding SHAW and the CBI merger can be found here: Letter to Board December 2011, Letter to Board August 2012, Press Release September 2012, Press Release October 2012, and Main Presentation – Demanding Fair Value October 2012.
The current short thesis centers on the Purchase Price Allocation (PPA) and Goodwill (GW) adjustments as well as recent reduction in cash flow (CFO) metrics. Our conclusions differ regarding the severity of the PPA/GW/CFO implications and consequences, as well as the ultimate valuation. The next material catalyst will occur in the near term during the upcoming earnings call this month, which will provide management with an opportunity to address the issues.
Denali Investors’ Exited Positions
– We first identified PENN as a potentially interesting name in Q4 2012 when the companyannounced plans to spinoff GLPI, the first casino focused REIT. We believed this step would unlock significant value for the PENN shareholders and established our position in Q3 2013 ahead of the spinoff that was completed in Q4 2013. The valuation for the new
publicly traded casino focused REIT and the planned acquisition strategy of privately owned properties at lower multiples would result in a long runway of accretive transactions for GLPI. A number of transactions were announced and a healthy pipeline of deals is expected. The founder of PENN moved to the GLPI spinoff. Including the special dividend of ~$12 received Q1 2014, GLPI may continue to produce positive returns. However, the investment was exited for other opportunities.
Iron Mountain Incorporated (NYSE:IRM) – We first identified IRM as a potentially interesting name inQ2 2013 after the Internal Revenue Service (IRS) announced a tentatively adverse position on a number of REIT conversions, including that of IRM. We believed the value of IRM as a REIT to be materially higher. We established our position in Q2 2013 after the stock fell by one third on the IRS uncertainty. There were uncertainties about the IRS working group in terms of their personal incentives, political motivations, process, and timing. We believed there existed precedents that would result in an affirmative decision. The IRS Private Letter Ruling (PLR) is independent for each company and so while one cannot rely solely on precedents, the alternatives would be much less probable (grandfathering, new rules and legislation, etc.). The decision process was initially expected to be complete by Q4 2013, however, there were a series of delays that were primarily due to the potential government shutdown that developed in Q4 2013. Although a decision point would resolve the uncertainty, the investment was exited early in the quarter for other opportunities. A positive decision was announced late June 2014, after our exit.
We believe our investment framework and process will continue to produce outperformance over time. As always, above all else our focus remains on investing for survival.
Denali Investors LLC
Net Cash = Fortress: Cash is a valuable strategic asset. Our cash has typically averaged 20% to 35%. Cash remains the default in the absence of greater opportunities.