Sharp energy price declines resulted in our energy holdings becoming further depressed. Oil prices fell more than 50% over the last year—something that has happened less than 2% of the time in the last 115 years.1 China macro fears impacted companies with Asian exposure. The media industry broadly declined after several large businesses reported declining U.S. ad revenues in August, sparking fears over the long-term health of the television business. Stock price declines were not reflective of changes to underlying business appraisals. We continue to see a high level of value-additive corporate activity across the entire portfolio, at both top contributors and those businesses that declined the most in the quarter.
Integrated satellite company ViaSat (VSAT, Financial) was the largest positive contributor in the quarter, up 7%. While the company had a slight decline in Exede broadband subscribers, average revenue per user (ARPU) was up 7% year-over-year and churn was also down. ViaSat captured good margin performance at its government and satellite services segments. The government segment posted its best growth performance in two years, along with a healthy order book and a 22% increase in backlog. ViaSat still plans the launch of its next generation ViaSat-2 satellite in 2016, which will further improve the company’s ability to deliver superior broadband technology across a larger customer base.
HollyFrontier (HFC, Financial), the independent petroleum refiner that owns and operates five refineries throughout the Mid-Continent, Southwest and Rocky Mountain regions, rose 14% in the quarter prior to our selling the stock as it approached our appraisal. As a refiner, HollyFrontier benefitted from lower feedstock cost and more miles driven from increased demand for gasoline. CEO Mike Jennings bought in undervalued shares and focused on projects with master limited partnership (MLP) potential amidst the market’s thirst for yield. This strategy helped the stock price rise to intrinsic value, as HollyFrontier appreciated 55% over our short holding period.
One of the noted energy holdings, CONSOL Energy (CNX, Financial), the Fund’s largest performance detractor, fell 55% in the quarter after disappointing revenue and earnings on weaker-than-expected thermal coal production and negative natural gas differentials versus the New York Mercantile Exchange. Management is adjusting to lower commodity prices with cost controls and took steps to recognize the value of CONSOL’s coal assets by offering shares in the MLP CNX Coal, which generated $200 million in proceeds. We filed a 13-D during the quarter to discuss with third parties as well as management and the board a potential monetization or separation of the valuable Marcellus and Utica gas assets. We believe these assets alone are worth demonstrably more than CONSOL’s total equity capitalization. They are unique, low cost reserves given the company’s fee ownership of many acres. CONSOL is exploring monetization paths for all of its assets, including thermal coal, metallurgical coal, pipelines, and the Baltimore port terminal.
Film studio DreamWorks Animation (DWA, Financial) was down 34% in the quarter. A change in accounting for DreamPlace sales, currency impacts, and slower-than-expected merchandise licensing agreements cut in half revenue guidance for its developing Consumer Products division. We believe merchandise licensing will gain traction over time and deliver more recurring revenues, offering significant upside to our DreamWorks appraisal. DreamWorks’ other core businesses performed well. The strong results of the feature film Home highlights the company’s creative talent in generating engaging content that will build the film library. In addition, newer growth initiatives in the Television segment continued to ramp strongly, and the New Media segment, which contains AwesomenessTV, doubled revenues with strong gross margins.
Wynn Resorts (WYNN, Financial), the luxury gaming and hotel company with properties in the United States and Macau, was also down in the third quarter, by 46%. Wynn Palace-Cotai is expected to open in March, and the company commenced site remediation for Wynn Everett-Boston, yet the stock price reflects no value for these assets before they generate revenues. While gross gaming revenue continues to decline in Macau, bears are extrapolating poor results forward and ignoring the potential for Wynn to gain market share next year upon the opening of Palace. The company sells for roughly our appraisal of its Las Vegas properties plus its Boston concession, after net debt. The stock price implies almost no value for Macau, even though the depressed market value of its 72% stake in Wynn Macau (down YTD from HKD 21.85 to HKD 8.78) is worth around $50 per Wynn share. Even bear case analysts project higher visitors and revenues in Macau over the next five years, but the uncertainty of the next 12 months translates into minimal value for Wynn’s Macau properties today.
Fiber and networking company Level 3 Communications (LVLT, Financial) declined 17% as concerns about near term top-line growth rates outweighed improvement in margins and free cash flow (FCF) generation. During the quarter, the company reported organic revenue growth across North America and EMEA (Europe, Middle East, and Africa) in-line with expectations, while Latin America, which represents approximately 10% of consolidated revenue, had weaker growth mainly due to currency. The integration of tw telecom remains on track with synergy realizations ahead of schedule. Level 3 already has achieved approximately $115 million of annualized run-rate EBITDA synergies and the company should achieve 70% or $140 million of its annualized synergy target by the end of the first quarter of 2016. FCF growth at Level 3 is ramping up and, we believe, marching toward explosive FCF growth on a per share basis in the next few years as a result of the business’ strong incremental margins, the aforementioned tw telecom synergies, and continued debt reduction and refinancing. During the quarter, major bond rating agencies upgraded approximately $11 billion of the company’s rated debt and credit commitments, further proof of Level 3’s improving business and financial profile.
We purchased Tribune Media (TRCO, Financial) and one other holding during the quarter. We previously invested profitably in Tribune via its distressed bonds when the company went through bankruptcy. After completing the spin-off of its publishing business last year, Tribune is now a diverse mix of television and digital properties spanning news, entertainment, and sports. The company owns or operates 42 broadcast stations, representing the country’s largest combined independent station group. Additionally, Tribune’s spectrum ownership is uniquely valuable given its concentration in large, coastal cities. Management’s capital allocation discipline has been demonstrated by repurchasing undervalued shares and selling off non-core assets at compelling prices.
We sold several of the Fund’s investments in the quarter, including our position in Cable ONE (CABO, Financial) after Graham Holdings spun it out at the beginning of the quarter. The stock sold for our estimate of fair value. We applaud Graham Holdings’ CEO Don Graham for his ongoing efforts to build and recognize value for shareholders.
Northern Oil & Gas, HollyFrontier, Diamond Offshore and California Resources are energy companies that we purchased in the Fund in late 2014 and early 2015 amidst the sharp decline in oil and gas prices. During the quarter, we selectively sold these companies. Northern Oil & Gas and HollyFrontier both proved profitable investments for the Fund as they approached our appraisals. With further energy price declines and some changes in our investment cases, our appraisals of Diamond Offshore and California Resources fell, and we sold the stocks as our risk-reward potential became less attractive. We consolidated our energy exposure into CONSOL and an increased stake in Triangle Petroleum.
Despite our frustration over recent returns, we believe that the positive fundamentals of the companies we own will be reflected in their stock prices. The Fund has three categories of companies that we see driving returns. Roughly half of the portfolio is a collection of what we feel are industry leading businesses that have the competitive strength and management leadership to compound value per share at a potentially high rate. Based on our appraisals, as a group this category of holdings sells for 65 cents on the dollar. Prospects for these holdings’ value growth, especially as a diversified basket, are greatly enhanced due to their combinations of pricing power and gross profit royalty status. Their managements’ track records and ownership alignment suggest strongly that these steadily growing free cash flow streams should be reinvested to build even more corporate value.
In our opinion, this group includes the best global digital fiber network in Level 3 Communications, a most valuable independently owned animated film library in DreamWorks, the premier collection of mountain resort properties in Vail Resorts, the world’s best casino developer and operator in Wynn, and the best U.S. cable channel company with HGTV and Food Network (via Scripps Networks). These companies are among those that offer a combination of competitive advantages, balance sheet strength, and glaring undervaluation that gets lost in the focus on the few names that have hurt recent results. As the largest portion of the Fund, however, it is this group of holdings that we look to as the primary long-term driver of potential future outperformance.
The second category of holdings includes companies being led through transitions by strong partners who are focused on growing and unlocking values by highlighting their competitive business segments and/or reinvesting substantial cash in high-return opportunities. As representative examples, Graham has sold or spun numerous assets, with valuable television stations, Kaplan, and a cash-rich balance sheet remaining; OCI is merging most of its assets into CF Industries; and Tribune sold its newspapers and has numerous remaining assets, including television stations, spectrum, and real estate, that management can monetize. This group comprises about 30% of the portfolio, and we feel should drive performance when the gap between price and value closes as our management partners lead these transitions.
The third category contains our energy holdings which, as a bucket, are down 57% YTD, constituting a bona fide crash rather than a mere bear market. The momentum-driven heavy selling and shorting of this “crash bucket” has gotten so out of hand that we feel the companies’ recovery is a large part of our significant potential future return. Even though qualitatively Wynn is in the first category above, its severe undervaluation positions it similarly to our energy investments for a big recovery. To be clear, we do not think these stocks will do well simply because they are down. We believe their long-term fundamentals under the stewardship of their capable leaders should drive prices as contrasted to the short-term perceptions. In the case of our energy holdings, we are not reliant on an energy rebound to move the stocks higher, as our appraisals are over twice the current stock levels based on current depressed commodity futures pricing. Should oil and gas prices move back to their much higher marginal cost of production, the values of these stocks would be materially more. These energy holdings represent around 5% of the Fund, and while we put them in their own group, they share many of the same compelling attributes described in the second category above.
Although we cannot predict short-term prices, we believe the Small-Cap Fund has meaningful attractive upside. The Fund’s price-to-value (P/V) ratio is in the low-60s%, and the sharp uptick in global market volatility, which has now reached its highest level since 2011, has been a precursor to strong Fund returns in the past. While a useful data point, this historic performance is not the basis for our confidence in returns going forward. The competitiveness of our businesses, our extremely capable management partners, and the attractive margin of safety in our companies’ stock prices make us highly confident that the companies we own can perform well and reward your patience and ours.
See following page for important disclosures.
Before investing in any Longleaf Partners Fund, you should carefully consider the Fund’s investment objectives, risks, charges, and expenses. For a current Prospectus and Summary Prospectus, which contain this and other important information, visit longleafpartners.com. Please read the Prospectus and Summary Prospectus carefully before investing.
RISKS
The Longleaf Partners Fund is subject to stock market risk, meaning stocks in the Fund may fluctuate in response to developments at individual companies or due to general market and economic conditions. Also, because the Fund generally invests in 15 to 25 companies, share value could fluctuate more than if a greater number of securities were held. Mid-cap stocks held by the Fund may be more volatile than those of larger companies.
The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3,000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index. An index cannot be invested in directly.
P/V (“price to value”) is a calculation that compares the prices of the stocks in a portfolio to Southeastern’s appraisal of their intrinsic values. The ratio represents a single data point about a Fund and should not be construed as something more. P/V does not guarantee future results, and we caution investors not to give this calculation undue weight.
A master limited partnership (MLP) is, generally, a limited partnership that is publicly traded on a securities exchange.
EBITDA is a company’s earnings before interest, taxes, depreciation and amortization.
Free Cash Flow (FCF) is a measure of a company’s ability to generate the cash flow necessary to maintain operations. Generally, it is calculated as operating cash flow minus capital expenditures.
Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management, and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.
As of September 30, 2015, the holdings discussed represented the following percentages of the Longleaf Partners Small-Cap Fund: Level 3, 9.8%; Graham Holdings, 6.6%; Dreamworks, 6.5%; ViaStat, 5.9%; Vail Resorts, 5.0%; Wynn Resorts, 4.7%; Scripps Networks, 4.5%, OCI, 4.5%; Tribune Media, 3.8%; CONSOL, 3.3%. Fund holdings are subject to change and holding discussions are not recommendations to buy or sell any security. Current and future holdings are subject to risk.
Funds distributed by ALPS Distributors, Inc.
