Not only did those companies under the most price pressure meet our operating expectations, but their upside prospects increased due in large part to the actions of our CEO partners. To provide insight into these positions and why we continue to have long-term conviction in their potential to outperform, we discuss them below.
In the U.S.
The worst performing sector in the S&P 500 and MSCI World Indices was energy, down 9.1% and 9.5% respectively. With the unusually cool summer, natural gas prices fell 7%, crude 13%, and coal 13%. Within the sector, exploration and production companies (E&Ps) such as Chesapeake and Murphy (MUR, Financial), as well as coal stocks, including CONSOL, suffered more than the average, which was helped by subgroups such as refining and storage and transportation. While lower energy prices rather than company-specific disappointments in our energy names drove declines, they did not impact our appraisals of these three companies because our models already incorporated lower commodity prices based on the futures curve pricing and the marginal cost of production in our various plays. Higher commodity prices would likely lift their stocks, but these three companies do not require a rise in energy prices for intrinsic values to be recognized. At Chesapeake (CHK, Financial), CEO Doug Lawler is continuing to drive value recognition in ways he can control — selling non-core assets at reasonable prices, reducing debt, and increasing operating efficiencies in both corporate and production activity. He is building additional upside with $2-3 billion of annual discretionary capital spending that management projects should deliver strong returns on capital, even without higher commodity prices. Neither is Murphy’s CEO, Roger Jenkins, relying on higher commodity prices for value recognition. The company is selling its UK downstream assets and announced the sale of 30% of its Malaysian assets at a price above our appraisal. Moreover, Jenkins built value by repurchasing shares as they became more discounted, a move he properly viewed as buying their proven barrels of oil for much less than it would cost to drill new wells or buy other plays. CONSOL (CNX, Financial) is more than its category of “coal and consumable fuels.” In fact, management has been selling coal assets, and more than half of our appraisal is attributable to gas reserves in the Marcellus and Utica shale plays. To monetize production value in the recent quarter, Executive Chairman Brett Harvey and CEO Nick Deluliis successfully IPO’d a midstream Master Limited Partnership (MLP) at metrics above both our appraisal and the projected price. The company’s variety of assets, including the Baltimore port terminal, provide multiple options for gaining value recognition without reliance on commodity price increases.
Outside the U.S.
At least one of three significant performance detractors outside of the U.S. impacted the Small-Cap, International, and Global Funds. In spite of their stock declines, these companies met our underlying business expectations during the quarter. They are diverse businesses but faced various emerging market uncertainties in addition to currency pressures and company-specific issues. In each case, management is taking the initiative to overcome current market perceptions through discounted buybacks, productive capital investments, and/or value accretive transactions.
Melco International (HKSE:00200, Financial), the Macau gaming company held in the International and Global Funds, fell alongside all Macau gaming stocks. A meaningful drop in VIP visitors has led to lower revenues. The causes include China’s crackdown on corruption causing wealthier people to keep a lower profile away from Macau, slower Chinese economic growth hurting property sales that boosted gambler credit, and liquidity challenges faced by junket operators who organize VIP visits and extend credit to them. Other pressures impacting the stocks are difficult to quantify, such as tighter transit visa requirements, wage inflation and labor unrest, UnionPay credit card restrictions, and a smoking ban starting in October. The negative news flow did not impact our conviction in Melco. Our appraisal already incorporated lower growth in both VIP and mass revenues than most sell-side analysts had previously assumed for the year. Over 80% of Melco’s EBITDA (earnings before interest, taxes, depreciation and amortization) comes from the non-VIP segment that is still growing gross gaming revenue at 15%. This important mass market has margins several times higher than the margins on VIPs whose revenues are split with junket operators. 100% hotel occupancy also has limited growth this year, but planned new hotels should increase visitation over the next few years as should the new Hong Kong–Macau bridge that will allow passengers at the Hong Kong airport to arrive in Macau in half an hour. Melco has a near-term supply advantage with its Studio City casino and hotel opening in Q3 2015. Despite analyst downgrades on Macau gaming stocks, Melco is estimated to have high EBITDA growth in 2015 and 2016. The company began repurchasing shares in Melco Crown in September, and our partner, CEO Lawrence Ho, has bought more stock personally in the last two quarters.
OCI (XAMS:OCI, Financial), owned by Longleaf Small-Cap, International, and Global, consists of a legacy construction business and the much larger nitrogen fertilizer business. Natural gas is the primary component in nitrogen fertilizer production, and during the quarter, gas supply interruptions impacted production at OCI’s two Egyptian plants. Although the stock declined, our appraisal held steady, as it already incorporated 50% Egyptian utilization for 2014, and because OCI’s other plants around the world are operating at or near full capacity with low cost gas and higher prices for Ammonia and Urea, two primary outputs. The long-term case for OCI remains compelling as the company is the low cost industry leader in nitrogen fertilizer, essential for world food production. In the next 12–18 months the company will have higher production and lower capex with the opening of a greenfield plant in Iowa and the completion of the Beaumont, Texas extension. The company is also building the largest methanol plant in the country in Texas. CEO Nassef Sawiris has built and monetized substantial value historically; specifically, he has added enormous value for Southeastern’s clients and our partners in the Longleaf Funds through his work at Texas Industries and Lafarge. Most recently, he announced that in early 2015 OCI will separate the fertilizer and construction businesses to remove the conglomerate discount in the stock price.
Weak emerging market results, due in part to currency moves, pressured the price of cement maker Lafarge, held in the International and Global Funds. Additionally, the stock pulled back following its initial surge after the announcement of the Holcim merger. The company’s geographic diversity and our already conservative growth assumptions helped our appraisal remain steady. Slower volume growth in a few markets, such as Latin America, Western Europe, and Eastern Europe, was offset by solid demand in North America, Asia, and the U.K. as well as strong pricing in most markets. The planned merger with Holcim should be completed in 2015, providing upside opportunity through over €1 billion in cost savings and synergies. CEO Bruno Lafont has enhanced the company’s value by divesting a number of plants at attractive prices as he moves to meet anticipated antitrust requirements.
Opportunity Set
A number of our stocks appreciated in the quarter, but none reached our full appraisal, as values also grew. Several of our largest positive contributors in the quarter, such as FedEx in the Partners Fund and formerly in the Global Fund, and Vopak in the International and Global Funds, only recently were in a similar boat to our current detractors facing stock price pressures that did not impact our appraisals. We often find opportunity when short-term uncertainty, either specific to a single area of a company or about macro trends, prices a stock at a discount to its intrinsic worth based on longer term free cash flow.
This time horizon arbitrage created by many of the pressures previously mentioned helped us find new qualifiers in all four Funds in the quarter. We made headway in reducing the cash levels, using our liquidity for several new purchases. In the International and Global Funds where cash was more limited, we replaced existing holdings with more attractive, new opportunities. Overall, prices remain more compelling outside of the U.S., due to more disruptions and broader uncertainty. This geographic discrepancy is evident in our on-deck lists, our lower-than-normal U.S. weight in the Global Fund portfolio, and the cash levels and P/V differences in the Partners and Small-Cap Funds relative to the International and Global Funds.
Outlook
While our third quarter results were disappointing, we used the market’s volatility to enhance our prospective returns by deploying cash and selectively trading out more fully valued existing positions for attractive new opportunities. The stock declines that hurt our performance were not indicative of underlying threats to the investment cases. As we review each company we own, operating results are on track versus our expectations. Our appraisal values are stable or growing. We expect those values to increase and believe that, over time, prices will rise to meet those values like we are beginning to see at some of our stronger performers.
Our management teams continue to hasten value recognition using the levers at their disposal, such as discounted share buybacks, splitting out business segments, and selling assets at attractive prices. We are engaged in productive conversations with our management partners about ways to close the price-to-value gaps while this window of opportunity lasts. Buyers have access to particularly cheap capital and will pay high multiples for yield, tax benefits, and long-term control of natural resources. We have been pleased with how many of our companies have been focusing on their core businesses and monetizing assets at attractive prices. Given our capable partners, we expect to see additional value creative capital allocation decision making that will further enhance our appraisals and ultimate returns. See following page for important disclosures.
Sincerely,
O. Mason Hawkins (Trades, Portfolio), CFA
Chairman & Chief Executive Officer
Southeastern Asset Management, Inc.
G. Staley Cates, CFA
President & Chief Investment Officer
Southeastern Asset Management, Inc.
October 8, 2014
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 Funds are 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 Funds generally invest 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 Funds may be more volatile than those of larger companies. With respect to the Small-Cap Fund, smaller company stocks may be more volatile with less financial resources than those of larger companies. With respect to the International and Global Funds, investing in non-U.S. securities may entail risk due to non-US economic and political developments, exposure to non-US currencies, and different accounting and financial standards. These risks may be higher when investing in emerging markets.
The S&P 500 Index is an index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe. 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. MSCI EAFE Index (Europe, Australasia, Far East) is a broad based, unmanaged equity market index designed to measure the equity market performance of 22 developed markets, excluding the US & Canada. MSCI World Index is a broad-based, unmanaged equity market index designed to measure the equity market performance of 24 developed markets, including the United States. 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.
As of September 30, 2014, the holdings discussed represented the following percentages of the Funds: Chesapeake Energy, 6.0% Longleaf Partners Fund, 4.4% Longleaf Partners Global Fund; Murphy Oil, 3.7% Longleaf Partners Fund, 2.0% Longleaf Partners Global Fund; CONSOL, 5.5%, Longleaf Partners Fund; Melco, 6.6% Longleaf Partners International Fund, 6.4% Longleaf Partners Global Fund; OCI, 4.8% Longleaf Partners Small-Cap Fund, 4.5% Longleaf Partners International Fund, 4.3% Longleaf Partners Global Fund; Lafarge, 7.2% Longleaf Partners International Fund, 4.3% Longleaf Partners Global Fund; FedEx, 6.2% Longleaf Partners Fund; Vopak, 4.1% Longleaf Partners International Fund, 3.3% Longleaf Partners Global Fund. 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.
