First quarter commentary:
Longleaf Partners Small-Cap Fund advanced a robust 4.60% in the first quarter, far exceeding the Russell 2000 Index’s -1.52% decline. For the one-year and longer periods, the Fund’s performance also surpassed the index. A number of our stocks had double-digit gains, including several of our most undervalued businesses coming out of 2015. Most of our companies generated solid operating results, and management activity helped drive higher appraisals. Not only were our absolute returns well beyond our goal of inflation plus 10%, but our relative results also benefitted from our lack of exposure to health care, which was among the top performing index sectors in 2015 but was the Russell 2000’s worst performing sector in the quarter.
Stock prices in the first quarter embodied Ben Graham’s description of “Mr. Market,” whose manic short-term swings are driven by investor emotions. The market fell -15.9% at its February 11 low point but then rallied over 17% by the end of March, a 3300 basis point swing. While economic and political uncertainties fostered the volatility, our appraisals proved much more stable, highlighting the importance of anchoring investment decisions to the long-term cash flows and underlying asset values of each company.
The volatility provided opportunistic points to add to four of our more undervalued investments and trim several positions as they became overweight or traded closer to our appraisal values. Our on-deck list of adequately discounted new investments is limited.
Contributors/Detractors
Wynn Resorts (WYNN, Financial) (+36%; +2.0%), the luxury gaming and hotel operator with prime real estate in Las Vegas, Macau, and Boston, was the largest contributor in the quarter. Wynn preannounced positive results to enable management to buy more stock. CEO Steve Wynn demonstrated his confidence in the business by purchasing nearly one million shares, bringing his total stake in the company to 12%. Wynn Las Vegas reported better-than-expected 4Q results. Although pressure continued in Macau’s lower margin VIP segment, mass gaming revenues in Macau stabilized, and year-over-year gross gaming revenue comps in February were the strongest in almost two years. Wynn remains well below our appraisal and offers a compelling long-term opportunity for significant growth with a proven owner-operator at the helm. The value of properties in the development pipeline is not yet reflected in the stock price. The opening of Wynn Palace in Macau later in 2016 could spark additional stock appreciation as capital expenditures (capex) ends and revenues begin.
ViaSat (VSAT, Financial) (+20%; +1.1%), an integrated satellite company, reported a substantial 7% increase in average revenue per user (ARPU) year-over-year. Customer churn declined with the company’s focus on higher value, stable subscribers. Additionally, news reports that American Airlines would reexamine its in-flight Wi-Fi contract with ViaSat’s competitor, Gogo, implied that ViaSat could win the new contract given its superior service quality. CEO Mark Dankberg is a large owner who has invested wisely in expanding ViaSat’s capacity and product lines. The company plans to launch a revolutionary new satellite broadband constellation (ViaSat-3) in 2019 that has the potential to further ViaSat’s lead in the industry. Although ViaSat-3 is not fully reflected in our appraisal, it offers significant longer-term upside to our value and the share price.
CONSOL Energy (CNX, Financial) (+43%; +1.1%), the Appalachian natural gas and coal company that was our top detractor in 2015, added meaningfully to first quarter results. Management adjusted to lower commodity prices by adopting significant cost controls and expects positive free cash flow (FCF) in 2016. Early in the quarter, CONSOL announced it was lowering capex by more than 50% from previous guidance. The company also reduced operating expenses, effectively decreasing its Debt/OCF ratio from 3.8 to 3.6. As we continued our constructive dialogue with management regarding asset monetization, CONSOL announced the addition of three new board members, two of whom we suggested. Additionally, Will Thorndike, whom we previously recommended as a board member, replaced Brett Harvey as Chairman. Shortly thereafter, CONSOL sold its Buchanan mine and other met coal assets for $420 million to a private equity-backed firm. The sale was accretive to the value of CONSOL, and management is pursuing additional asset sales.
Scripps Networks (SNI, Financial) (+19%; +1.0%), the media company that owns cable channels, including HGTV, The Food Network, DIY Network, Cooking Channel, Travel Channel, and Great American Country, reported a strong quarter with all six networks adding new viewers as millennial growth continued. Advertising revenue grew at a mid-single digit rate. The company’s advertising is better than most competitors, with more exposure to stable categories than others have. Affiliate fee revenue growth is expected to grow at a midto-high-single digit rate, and programming cost growth should continue to decelerate. Part of the stock’s discount is related to its international expansion opportunity which has not produced profits yet but has created startup costs and noncash amortization. The company simplified its asset mix, purchasing the remaining 35% of The Travel Channel that it did not own and selling its 7.25% stake in Fox Sports South & Southeast.
OCI (-21%; -0.9%), a global fertilizer and chemical producer, was the primary detractor from the Fund’s strong return. The stock fell early in the quarter, in line with a decline in the underlying urea commodity price which recovered somewhat by quarter-end. Global excess supply should diminish as nitrogen fertilizer demand grows approximately 2% per year while no additional plant capacity is scheduled for at least five years out. Uncertainty around OCI’s planned sale of its U.S. and European assets to CF Industries also weighed on the stock. A major hurdle to the deal was removed in mid-March, when OCI announced that Consolidated Energy Limited would jointly invest in the methanol plant, Natgasoline, which would fall outside of the scope of the assets going to CF. OCI is trading at a steep discount to our appraisal and even more cheaply assuming the CF deal closes in the second quarter of 2016 as planned.
Portfolio Changes
While we had no new investments to report, we added to four of our more undervalued businesses that were smaller positions. In addition to trimming a number of overweight and positive performers, including Wynn and Scripps, we completed the sale of Orascom Construction, which OCI spun out in 2015.
Outlook
We believe We believe the strong absolute and relative returns we posted in the first quarter should be indicative of our expectations going forward. Our top performers rallied from unsustainably low levels to a more normal discount range and have substantial additional upside potential. The portfolio price-tovalue (P/V) in the low-70s% offers an attractive buffer between our conservative appraisals and our companies’ underlying stock prices, especially in a market where we are finding very few new opportunities. Our 21% cash position reflects the limited qualifiers but will enable us to take advantage of additional market volatility or the next great business that becomes deeply discounted. Many of our holdings have management teams pursuing operational improvements as well as longer term strategic alternatives that can build material value.
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