To Our Shareholders,
For the quarter ended September 30, 2014, the net asset value (“NAV”) per Class AAA Share of The Gabelli Asset Fund decreased 4.2% compared with an increase of 1.1% for the Standard & Poor’s (“S&P”) 500 Index. See page 2 for additional performance information.
Market Commentary
The third quarter saw a return of volatility to financial markets, starting with a decline in July, as macroeconomic factors, including conflict in Ukraine and Israel, a slowdown in emerging market growth, and Argentinian debt default on the last day of the month all weighed on the market. Markets rebounded sharply in August, as mostly positive second quarter earnings reports were coupled with dovish comments from Federal Reserve Chair Janet Yellen, who at the annual Federal Reserve meeting in Jackson Hole, reiterated, "that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after our current asset purchase program ends." In other words, rates are likely to remain low for some time. With the backdrop of a slowly improving economy and continued accommodative Fed policy, the S&P 500 hit an all-time high on September 19.
Towards the end of the month, however, markets began factoring in the possibility of a recession in Europe, a worse than expected emerging markets slowdown, the negative impact of foreign currencies on overseas earnings (especially in the Eurozone), concerns about the impact of communicable diseases on travel and leisure industries, and continued conflict around the globe, whether in Ukraine, Iraq, Syria, or elsewhere.
In volatile times, we believe it is important to reiterate that, as value investors, we seek for “Mr. Market” to serve us, rather than inform us about the value of a company. We continue to use stock-specific and market dislocations (as has been with small capitalization stocks this year) in order to buy even more of the companies we own on your behalf. These are high-quality, cash generating franchise businesses, operating in industries in which we have a core competency, which have potential catalysts to surface value: a takeover of the company, financial engineering, new management, regulatory changes, a change in cash flow allocation, or some other dynamic. We note that continued low rates mean that companies will continue to have access to low-cost financing, with which they can pursue mergers and acquisitions (M&A). This underscores our confidence that the “Fifth Wave” of takeover activity is likely to continue.
Deals, Deals, and More Deals
Dealmaking continued in the third quarter, with worldwide M&A up 59% to $2.7 trillion for the first nine months of 2014, although year over year deal value declined in the third quarter. Fund holding Alere (ALR) (0.2% of net assets as of September 30, 2014), leading diagnostics company, received an inquiry from its former CEO, Ron Zwanziger, about taking the company private in September. While the company has so far rebuffed Mr. Zwanziger’s advances, we believe that a transaction is still very possible and note that the company has launched a “strategic review” of its operations. Additionally, Tyson Foods (TSN) (less than 0.1%) completed its acquisition of Fund holding Hillshire Brands, a leading branded meat company, in August.
In addition to M&A activity, financial engineering continued in the third quarter. Fund holding eBay (EBAY) (0.2%) announced plans to spin off its PayPal secure payments business from its core online marketplace operations. We had long anticipated this move and think it could eventually result in the acquisition of one or both units.
Let’s Talk Stocks
The following are stock specifics on selected holdings of the Fund. Favorable earnings prospects do not necessarily translate into higher stock prices, but they do express a positive trend that we believe will develop over time. Individual securities mentioned are not necessarily representative of the entire portfolio. For the following holdings, the percentage of net assets and their share prices are presented as of September 30, 2014.
Alere Inc. (0.2% of net assets as of September 30, 2014) (ALR - $38.78 - NYSE) is the largest manufacturer of rapid, point-of-care diagnostics in the world. The company has underperformed for the past year, weighed down by manufacturing problems and a heavy debt load from questionable past acquisitions. An activist investor has been publicly pushing the company to improve operations and, after being slow to respond initially, Alere’s Board of Directors forced the company’s founder and CEO to resign on July 1. However, he has now partnered with private equity partners and is seeking to take the company private with an initial bid of $46 per share. Whatever the final outcome is, we believe positive change is in the air for Alere.
AMETEK Inc. (1.7%) (AME - $50.21 - NYSE) is a leading global manufacturer of analytical instruments for the process, aerospace, and industrial markets, and a leading producer of electric motors and blowers for the floor care and outdoor power equipment markets. In the near term, the company continues to experience significant growth in its longer cycle businesses in the aerospace, power generation, and process industries. Longer term, the company continues to make acquisitions to augment growth. In the Electronic Instruments Group, AMETEK expects one half to two thirds of its revenue growth to come from acquisitions. The company is focused on acquiring differentiated businesses with revenues of $30-$100 million. Differentiated businesses compete on the basis of product capability, have higher growth rates, and offer superior returns. In the Electromechanical Group, AMETEK’s key strategy is to reduce costs by increasing efficiency and moving noncore operations to low cost countries such as Mexico, the Czech Republic, and China.
Chemtura Corp. (0.1%) (CHMT - $23.33 - NYSE) is a global developer, manufacturer, and marketer of engineered specialty chemicals. Its products are used as additives, ingredients, or intermediates serving major industries such as agriculture (being sold), building and construction, energy, electrical & electronics, transportation, and general industrial. Since its emergence from Chapter 11 in November 2010, under the leadership of Craig Rogerson, the management team has focused on actively managing its portfolio via investments in three vertical markets (transportation, electronics & energy, and agriculture), while monetizing businesses with below target long term potential. The previously announced sale of AgroSolutions to Platform Specialty Products (PAH) for $950 million in cash and two million shares of PAH worth $51 million at today’s price of $25.45 for a total consideration of $1 billion. The transaction is expected to close shortly; it will generate net proceeds estimated at $850 million. Following debt reduction of $200 million, $650 million will be used for share repurchase (including the monetization of PAH within one year of closing). Following 5.6 million shares acquired in the first half with the proceeds of the sale from Consumer Products, we estimate that Chemtura will repurchase another 26 million shares (28% of its float), lowering its outstanding shares to 65 million by year end 2015. The remaining operations, Industrial Performance Products (IPP) (petroleum additives and urethanes) and Industrial Engineered Products (IEP) (bromine/flame retardants and organometallics), are expected to grow revenues via innovations, share gain, and geographic expansion, while the bottom line will benefit from internal actions. We anticipate IPP to reach its EBITDA target of $200 million in 2016. However, IEP results are one year behind schedule due to the industry excess capacity and lack of selling price increases, in spite of Chemtura’s announcements. Increasing demand for mercury removal, the switch to greener flame retardants (higher prices), and improvement in electronic applications will tighten the market and result in price increases and substantially higher EBITDA. As per CEO Craig Rogerson, “In 1-3 years Chemtura will be part of a bigger entity, with a merger the most likely outcome.” We estimate that the “new Chemtura” (exclusive of consumer and agriculture) will generate EPS of $1.25 and $1.85 in 2015 and 2016, respectively. The EPS calculation is based on the already mentioned decline in the shares outstanding. We calculate Private Market Values (PMVs) of $30 and $44 for 2015 and 2016, respectively.
Cablevision Systems Corp. (0.9%) (CVC - $17.51 - NYSE) provides broadband, television, and phone service to over three million subscribers in the New York metropolitan area. An industry pioneer, CVC has developed the most advanced cable plant in the country and converted over 70% of its subscribers into triple play (video, phone, and broadband) customers. In the process, Cablevision achieved industry leading average monthly subscription revenues and margins. This peak performance led the company to become a victim of its own success; combined with competition from Verizon FiOS (0.3%) in approximately half its footprint, Cablevision saw reduced growth and a sagging share price in 2012/2013. The company’s efforts to address these declines appear to be paying off. Management has also been active on the financial front, spinning off Madison Square Garden (0.8%) in February 2010 and AMC Networks (0.6%) in June 2011 and repurchasing over 10% of shares outstanding. Cablevision is now a single-market, pure-play cable operator, which could facilitate an eventual consolidation of the company in our view.
Genuine Parts Co. (1.3%) (GPC - $87.71 - NYSE) is an Atlanta based distributor of automotive and industrial replacement parts, office products, and electrical and electronic components. We expect GPC’s well known NAPA Auto Parts group to benefit as an aged vehicle population, which includes the highest percentage of off warranty vehicles in history, helps drive sales of automotive aftermarket products over the next several years. Additionally, economic indicators remain supportive of the company’s industrial and electrical parts distribution businesses amid steady economic expansion. Finally, GPC’s management has shown consistent dedication to shareholder value via share repurchases and dividend increases.
Rogers Communications Inc. (1.0%, 0.1%) (RCI - $37.42 - NYSE, RCI/B - $37.43 - Tokyo Stock Exchange) is one of the few companies in North America to offer consumers the “Quadruple Play” of video, high speed data, and fixed and wireless telephony through a wholly owned plant. The company, founded by late telecom pioneer Ted Rogers, is Canada’s largest cable and wireless company. As the largest spectrum owner in North America, Rogers is aggressively deploying the next generation of wireless services. Rogers also has a substantial media business that operates radio stations, television networks (including The Shopping Channel), magazines, and trade publications, the Toronto Blue Jays baseball team, and interests in the Toronto Maple Leafs (NHL) and Raptors (NBA). In late 2013, Rogers hired a new CEO named Guy Laurence from Vodafone (less than 0.1%). While Mr. Laurence has yet to formally unveil his vision, we expect it to include a focus on improving the customer experience through continued investment in plant, balanced by regular capital returns to shareholders.
Rolls-Royce Holding plc (0.9%) (LSE:RR.) (RR - $15.64 - London Stock Exchange) provides jet engines, power and propulsion systems, and services to commercial aviation, defense, marine, oil and gas, and other industries. RR has leading engine positions as the sole supplier on the Airbus A350 and one of two suppliers on the Boeing (0.3%) 787 Dreamliner, two new wide body programs with healthy backlogs, to be delivered over the next decade. A recently announced re-engining of the A330 will extend one of Rolls’ most profitable engine programs, with Rolls as the exclusive engine supplier. Engine deliveries lead to recurring, higher margin parts and service revenues, which benefit the company more than twenty years after new engines are delivered. Rolls’ stock continues to struggle against 2014 guidance that called for a marked falloff in defense revenues and slower than expected improvement in civil aerospace margins. Notwithstanding near term headwinds, we believe that over the next decade, RR will see substantial growth in its civil aerospace operations, accompanied by improved margins approaching the levels of its peers. Recent portfolio changes have been positive, including the two billion GBP acquisition of Daimler’s 50% interest in Rolls-Royce Power Systems and the $1 billion GBP sale of the energy aero-derivative gas turbine business to Siemens. The company’s modest debt levels provide balance sheet optionality for additional investments.
Twenty-First Century Fox Inc. (2.1%, 0.2%) (FOX - $33.31 - NASDAQ, FOXA - $34.29 - NASDAQ) is a diversified media company with operations in cable network television, television broadcasting, filmed entertainment, and direct broadcast satellite television. Cable networks account for 66% of the company’s EBITDA and benefit from contractually recurring affiliate fees and exposure to the fast growing global pay television market. We also expect the company to benefit from rising demand for premium content, driven by emerging distribution platforms such as Netflix, retransmission revenue, and aggressive share repurchases.
Vivendi SA (0.5%) (XPAR:VIV) (VIV - $24.15 - EPA) is a French media and telecommunications holding company in the late stages of a decade long transition. In April 2014, the company announced it had reached an agreement to sell its French wireless operation, SFR, to French cable operator Numericable. More recently, the company reached an agreement to sell its Brazilian telecom operator, GVT, to Telefonica (0.1%). Over the last year, the company also sold most of its 62% stake in Activision Blizzard and sold its entire 53% stake in Maroc Telecom SA. After closing the SFR and GVT sales, Vivendi will be a more focused media firm, consisting of Canal+ (a Francophone focused pay-television network owner and distributor), Universal Music Group (UMG), the number one recording music company and number two music publishing entity in the world. While operating conditions have been challenging in most of Vivendi’s businesses, it appears their trajectory is finally turning more positive and should be supported by a healthier balance sheet.
Walgreen Co. (0.1%) (WAG - $59.27 - NYSE) is becoming a global pharmacy and drug wholesaler through the pending acquisition of Alliance Boots. The combined companies should garner significant purchasing and operational synergies from their worldwide scale, with a strong presence in emerging markets. Management is also becoming more shareholder friendly, granting two Board seats to an activist investor and committing to return significant amounts of cash to shareholders via dividends and share repurchases. While there are likely to be some bumps in the road during the integration process, we believe the combined company will be an attractive global leader in the industry.
Xylem (0.7%) (XYL - $35.49 - NYSE) is a global leader in the design, manufacturing, and application of highly engineered technologies for the transportation, treatment, and testing of water. The company is expected to benefit from favorable long term fundamentals in the water industry, driven by scarcity, population growth, aging of the infrastructure, and the need to improve water quality. Further, with a large installed base of pumps and systems, the company is well positioned to increase aftermarket revenue, which currently represents roughly 40% of total revenues. Xylem’s attractive business mix also generates strong cash flow, which is expected to support acquisitions, debt service, and dividend growth. The company recently appointed a new CEO, Patrick Decker, who has experience in the water industry and is looking to expand geographically as well as sustainably improve operating performance.
Investment Scorecard
Top contributors to performance included Berkshire Hathaway (BRK.A, BRK.B) (1.2% of net assets as of September 30, 2014) (+9%), which reported strong earnings driven by performance by its operating businesses amid an improving U.S. economy; Archer-Daniels Midland (ADM) (0.6%) (+16%), which expanded its food ingredient business by announcing the acquisition of WILD Flavors for €2.3 billion (the deal closed just after quarter end); Procter & Gamble (PG) (0.9%) (+7%), which delivered strong organic growth and margin improvement in its fiscal fourth quarter; and Tenet Healthcare (THC) (0.3%) (+27%), which is seeing a modest acceleration in admissions and a double digit decline in the bad debt/charity care that it provides.
Detractors to performance included Viacom (VIA) (1.1%) (-11%), which declined amid concerns about the television advertising market, ratings and pay-television subscriber growth; Deere (DE) (1.5%) (-9%), which declined due to continued softness in global demand for large agricultural equipment; IDEX (OSL:IDEX) (1.4%) (-10%), which declined due to lower energy prices and a potential slowdown in the global economy; and Rolls-Royce (LSE:RR.) (-15%), which experienced weaker marine aftermarket performance in the first half.
Conclusion
As always, in volatile times, our process remains unchanged. We conduct bottom-up research on companies and industries in order to uncover undervalued businesses we would be happy to own for many years. Our Private Market Value (PMV) with a Catalyst™ stock selection process identifies potential acquisition targets and likely candidates for financial engineering. Should volatility return and “Mr. Market” provide us with an opportunity, we remain prepared to increase our ownership of businesses that fit these characteristics, as well as invest in new opportunities as they become available.
October 9, 2014
