The Fund’s six energy-related holdings in 2015 combined to account for the Fund’s negative return and relative underperformance of the year and dampened the otherwise strong absolute and relative performance in the fourth quarter. Although our oil and gas price assumptions have been wrong, we believe that CONSOL Energy (CNX, Financial) could rapidly rebound with major asset sales and, along with Triangle Petroleum, will benefit when commodity prices correct as supply and demand eventually rebalance. At both companies, our management partners are taking action, including cutting costs, increasing financial flexibility, and selling assets to ensure the companies can withstand the difficult commodity environment. These two companies trade at a substantial discount to our appraisal and, we believe, offer greater potential upside than the index. However, the short-term performance masked the positive progress across the majority of our businesses in the year.
A top contributor to the Fund, film studio DreamWorks Animation (DWA, Financial) gained 16% for the year after a substantial 48% rise in the fourth quarter—an example of how quickly payoff patterns can move. The company had a box office success with the late March release of the movie Home, which continued to do well in home video and streaming. In December, DreamWorks announced a co-production deal with DHX Media, demonstrating that the company’s efforts to develop television content has progressed into recurring revenues. The New Media segment, which contains AwesomenessTV, had impressive revenue growth and margins. License renewals helped drive strong revenue and earnings growth in the consumer division. CEO Jeffrey Katzenberg’s push in the Chinese film distribution market via the 45% Oriental DreamWorks JV has potential for meaningful upside.
Level 3 Communications gained 10% for the full year after being another top contributor in the fourth quarter, returning 24%. Over the course of the year, operating metrics continued to improve. During the fourth quarter, company segment Core Network Services’ (CNS) organic revenue grew 6% year-over-year. Within CNS, Enterprise revenue grew 8%. This revenue growth, combined with the synergies created by the merger with tw telecom, resulted in margin expansion. The high contribution margins, which are currently over 60%, have been one of the focal points of our Level 3 investment case and are one of the primary drivers of high growth in both EBITDA (earnings before interest, taxes, depreciation and amortization) and FCF (free cash flow growth). In 2016, we believe the company will generate approximately $5.00/ share of FCF before discretionary growth capital expenditures, which translates to approximately 10x FCF on current price. The company’s success-based growth capex is tied to new, high margin, revenue-producing contracts. Given management’s excellent execution, we expect leverage ratios to continue to improve from their current 4x debt/EBITDA levels into the 3x’s.
Also performing well in the fourth quarter, Wynn Resorts, the luxury gaming and hotel company with prime real estate in Las Vegas, Boston, and Macau, was up 15% but down 34% since we first added the position earlier in the year. Our exposure via options represented approximately one-third of the returns. The stock became deeply discounted as China’s anti-corruption campaign pressured revenues in Macau where Wynn is among six current operators and is scheduled to open the Wynn Palace in Cotai in June 2016. During the recent quarter, Macau sentiment began to turn as revenues stabilized. CEO Steve Wynn demonstrated his commitment and confidence in the business, purchasing over one million shares in early December and bringing his stake in the company to nearly 11%. Year-over-year comparable gross gaming revenues should improve in 2016, and Wynn cash flow will be bolstered with the Cotai property coming online. Longer term, we believe the company can generate impressive returns. Macau revenues from mass and premium mass visitors should grow with added non-gaming attractions, needed hotel room supply, and infrastructure improvements that bolster arrivals. Additionally, the Wynn Everett is in early site preparation with a strategic location just outside of Boston, but its value is not reflected in the stock price because it is several years from opening. Opportunities to partner with proven value creators like Steve Wynn at such a large discount to our appraised value exist over time, but rarely do we see one where the near-term market extrapolations are so distinct from the long-term earnings power of the company.
Vail Resorts (MTN, Financial), the largest owner of ski resorts in the world, gained 23% in the fourth quarter and 44% for the year, making it the Fund’s top contributor in 2015. So far in the 2015/2016 U.S. ski season, the company has posted strong pass sales (+13%), with price increases of 6% and higher units. With Vail’s strong financial position and positive operating cash flow (OCF), CEO Rob Katz reaffirmed the company’s plan to continue to return capital to shareholders via an increased dividend and share buybacks. The board recently authorized an additional 1.5 million shares for repurchase (roughly 4% of shares outstanding). Our appraisal of the company grew in the quarter and over the year.
In the first quarter, amidst the market selloff of energy companies, we purchased HollyFrontier (HFC, Financial), the independent petroleum refiner that owns and operates five U.S. refineries. The company owns plants in superior locations that allow for above-average margins. Additionally, management has a history of productive capital allocation. As a refiner, HollyFrontier benefits from the decline in energy prices which lead to more miles driven and increased demand for gasoline. During the year, CEO Mike Jennings bought in undervalued shares and focused on projects with master limited partnership (MLP) potential to cater to investors’ thirst for yield. This strategy, plus takeover speculation, helped the stock rise to our appraisal. HollyFrontier appreciated 55%, was among the year’s largest contributors to performance, and was sold in the third quarter.
A large detractor to the Fund’s performance in the fourth quarter, media and education company Graham Holdings’ (GHC, Financial) 16% decline took its 2015 return to -11%. The stock price was impacted by broader weakness in the media industry and for-profit education where the regulatory and economic environment continued to be challenging. In the quarter, Graham Holdings’ Kaplan business reported worse U.S. student trends, and margins and revenue growth declined.
However, the continuing education business (Pace) had solid growth, and Kaplan International met expectations even with tough currency headwinds. Importantly, U.S. for-profit education is now less than 10% of our Graham appraisal value. The television division had a good quarter. The company also announced in November that current President Tim O’Shaughnessy would take over as CEO from Don Graham, who will remain as Chairman. Graham and O’Shaughnessy have grown value per share through wise capital allocation, such as the spin-off of Cable One mid-year and the more recent sale of the most challenged parts of Kaplan. Our sum-of-the-parts appraisal (TV, Kaplan’s International and U.S. education segments, Social Code, other businesses, pension, and net cash) is well above the stock price, which trades at a single-digit multiple of free cash flow.
As noted, CONSOL Energy, the Appalachian coal and natural gas company, was down 76% in 2015 after falling to -19% in the fourth quarter as the company missed OCF estimates amidst declining coal and gas prices. Management is adjusting to lower commodity prices and adopting significant cost controls under zero-based budgeting while still growing natural gas production. We filed a 13-D during the third 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. This has been a constructive process since filing, and we appraise these assets alone at worth demonstrably more than CONSOL’s total equity capitalization. CONSOL’s exploration and production (E&P) business is unique, with low cost reserves given the company’s fee ownership of many acres. CONSOL announced in the fourth quarter that its thermal coal business, which enjoys a low cost position, had contracted for 93% of production for 2016 at a confirmed price of $50-55 per ton, providing near-term downside mitigation. Multiple directors purchased shares in the fourth quarter.
Also previously mentioned, Triangle Petroleum (TPLM, Financial), a Bakken-focused E&P company with an internally developed oil services business (RockPile) and a joint-ventured pipeline business (Caliber), declined 62% for the year after falling 22% in the fourth quarter. Triangle’s integrated strategy provides a cost advantage in North Dakota where there is little infrastructure. Management has shown discipline in a challenged environment by announcing a 71% cut in capex without an offsetting production cut. Additionally, management bought shares personally and repurchased discounted debt at the company level. Late in the year, we swapped the common stock into bonds that were priced at a substantial discount to par, yielding 33% to maturity as of year end. This transaction provided a better risk-reward profile and offset some of the Fund’s realized gains.
Another detractor for the year, media company Scripps Networks (SNI, Financial), which owns cable channels including HGTV, The Food Network, DIY, Cooking, and the Travel Channel, declined to -25% in 2015 despite rising nearly 13% in the fourth quarter. Scripps fell sharply in the third quarter along with the rest of the media industry after Disney acknowledged ongoing challenges in the pay TV landscape, and many peers followed with disappointing ratings. Scripps, unlike most of its media peers, creates and owns valuable content that attracts a specific loyal, upscale audience. For this, Scripps channels receive an advertising premium versus other, less differentiated channels. Scripps also is underpaid by distributors for the ratings points it provides. The final difference versus peers is that Scripps is much earlier in its international expansion and therefore has money-losing yet valuable international properties not credited in a simple earnings multiple. During the year the company acquired TVN, a Polish media asset that has created confusion regarding Scripps’ international expansion plans. The company’s much larger free cash flow than reported earnings makes industry price-to-earnings (P/E) ratio comparisons somewhat meaningless.
We took advantage of discounted segments in the market and bought eight new businesses during the year, four of which were energy related and bought in the first half. As our outlook for energy and these individual companies evolved in the second half, we sold three of them, along with California Resources, which we bought in late 2014. Of these investments three were profitable and approached our appraisals in spite of the sector’s weakness, and one grew less compelling as commodity prices declined further. In the last quarter we exited Empire State Realty Trust, which owns the Empire State Building as well as other properties in the New York metropolitan area. After making 44% in our two-plus year holding period, the price approached our appraised value. We are grateful to our partner, CEO Tony Malkin, and wish him continued success.
Although 2015 performance was disappointing, we believe the Small-Cap Fund is well positioned for a prospective strong rebound. The Fund’s price-to-value (P/V) ratio trades in the high-60s%. The three largest detractors are highly discounted, selling for less than 40% of our appraisals, and the four largest positions, which were among top contributors for the year, remain discounted with solid value growth prospects. Beyond these discounts, the high quality of our businesses and the caliber of our management partners, who are pursuing all available avenues to drive value recognition, make us confident in future results. The Federal Reserve raised interest rates for the first time in more than nine years in December. We believe the portfolio can benefit from a rising rate environment, since the large majority of our businesses have strong balance sheets, many with net cash, and most companies have pricing power or gross profit royalties on revenues. Higher interest rates will not lower our net present value (NPV) valuations because we have maintained an 8-9% discount rate. Cash in the portfolio provides liquidity for attractive new opportunities that might arise as a result of market uncertainty. Additionally, the Fund does not own the segments of the market that have been driven by yield chasing and could shift rapidly with higher rates. As the largest investors in the Fund, we appreciate your continued partnership, and we are confident that your patience and ours should be rewarded with strong future performance.
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.
Capital Expenditure (capex) is the amount spent to acquire or upgrade productive assets in order to increase the capacity or efficiency of a company for more than one accounting period.
Operating Cash Flow (OCF) measures cash generated by a company’s normal business operations.
Price / Earnings (P/E) is the ratio of a company’s share price compared to its earnings per share.
Net present value is the difference between the present value of cash inflows and the present value of cash outflows.
A 13D filing is generally required for any beneficial owner of more than 5% of any class of registered equity securities, and who are not able to claim an exemption for more limited filings due to an intent to change or influence control of the issuer.
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 December 31, 2015, the holdings discussed represented the following percentages of the Longleaf Partners Small-Cap Fund: CONSOL, 2.6%; Dreamworks, 9.4%; Level 3, 11.0%; Wynn Resorts, 0.6%(6.0% adjusted for close of options and purchase of underlying stock); Vail Resorts, 5.8%; Graham Holdings, 5.4%; Triangle, 1.2%; Scripps Networks, 5.0%. 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.
