Dear Fellow Shareholders,
2015 was a disappointing year for the market and even more so for deep-value investors. The Fund’s performance was not immune to this and, in fact, we considerably underperformed during the year. It is during difficult times similar to 2015, when major economic regions are in recession, profits are declining, and global consumers are frightened by significant geopolitical uncertainty, that we rely on the most important metric to value investing. That is, strong corporate balance sheets which allow companies to persevere during the inevitable industry downturns are the ultimate life saver. One representative measure of the current portfolio holdings’ solid balance sheet position is that at year-end nearly 40% of holdings were in a net-cash position.
Investing in the stock market ultimately boils down to a probabilistic equation. In other words, what are the odds that a stock will rise versus decline during one’s holding period? In the short term, sentiment and psychology can influence prices more than fundamentals. In the long run, fundamentals, including strong balance sheets, weigh more heavily on stock prices than sentiment. As we have stated in previous letters, we assiduously avoid companies that exhibit the combination of weak cash flows, high leverage, and an abundance of rapidly maturing debt.
In the sections detailed below, we strive to explain what drove our underperformance and the key attributes of the current portfolio, and we remark on a few market drivers. We note the energy companies’ relatively strong balance sheets, and we emphasize both Apollo Education’s (APOL, Financial) and DeVry’s (DV, Financial) production of free cash flow and their large net cash positions. Importantly, we continue adding to these solid but depressed stocks. Over the past three decades, we have achieved our stated goals by adding to depressed sectors and not bailing out and investing in the latest hot stocks.
When we review some of the top positive contributors to the recent quarterly results, it is interesting to note that three of the top five stocks were energy-related. This is despite oil prices falling another 18% or so in the fourth quarter 2015. Conversely, two of the bottom five detractors in the quarter were energy companies. For the year, the three areas that accounted for the majority of the portfolio’s weakness were for-profit education, energy, and Western Digital (WDC, Financial).
Let’s start with energy, as we know it is top of mind for many of our shareholders. A crucial factor we want to express is that the energy companies in the portfolio do not have any near-term refinancing risk, unlike many other energy companies that have large sums of debt coming due this year or next. A very recent example of how a strong balance sheet can benefit shareholders is Noble Energy (NBL, Financial). NBL refinanced some of its intermediate debt maturities with shorter-term debt at substantially lower interest rates in early January 2016. Today, most energy companies seeking to refinance their debt would experience much higher interest payments, if they could even access the credit market. NBL was not only able to access the credit market but also lower its annual interest expense by $50 million for the same amount of debt outstanding.
When we assess the energy stock’s impact on the FPA Capital Fund (Trades, Portfolio), it is interesting to observe that the fund realized a net gain of over $200 million from 2008 through the end of 2015. The Fund realized gains every year from 2008-2014, with among the largest gains realized in 2014, when oil prices peaked. With hindsight, we blew it. We should have sold every one of our energy stocks by the end of 2014 and added the proceeds to our cash position.
At the end of 2015, the Fund had less than one percent unrealized losses in energy stocks embedded in the portfolio. Overall, the Fund has realized large gains in its energy investments over the years, and we fully expect to realize more gains over the coming years once oil prices rebound to more normal levels. We have taken some temporary hits, and more short-term volatility should be expected, but these stocks are, in our estimation, severely depressed from intrinsic value, and now is not the time to cut and run!
Let’s now address a few specific stocks that impacted the portfolio’s performance. Two stocks that positively contributed in the quarter were Babcock & Wilcox (BW, Financial) and Patterson-UTI Energy (PTEN, Financial). BW manufactures equipment for the power and industrial markets. When we initially invested in the company in October 2014, it was called The Babcock & Wilcox Company. It was a leader in the construction of power generation systems and nuclear components. Subsequently, it executed a tax-free spin-off of its nuclear equipment business. The remaining BW power generation business is a market leader in its field, with strong after-market sales opportunities and growth potential as new environmental regulations are enhanced globally, and the company has margin improvement opportunities as the company streamlines its costs now that it is a more focused company. With over $6 of net cash per share on the balance sheet, and trading at 45% of sales and 1.4x book value, BW is inexpensive in our opinion and one that we added to during the quarter.
PTEN is the second largest land-based drilling rig operator after Helmerich & Payne; the company also owns a fleet of pressuring pump equipment to help shale oil & gas companies fracture rocks that contain hydrocarbons. During the current market down turn, the top 10 pressure pumping companies, including PTEN, have increased their aggregate market share from 60% to 75%. PTEN has a strong balance sheet at 1x debt/EBITDA, and it has no public debt outstanding. Despite oil prices being down 70% from mid-2014, PTEN’s consensus free cash flow expectation for 2016 is $0.75 per share. PTEN is trading at less than book value and 3.5x normalized EBITDA, which we believe are attractive valuation characteristics. We added to the position in the most recent quarter.
Now, let’s turn our attention to WDC. WDC (WDC, Financial) is a stock the Fund has owned for a decade and one from which we have extracted substantial realized gains over the years. In October, WDC announced they would acquire Sandisk (SNDK, Financial) for $19 billion, and many shareholders were surprised by WDC’s decision.
SNDK (SNDK, Financial) is a major player in the NAND flash market and holds some of the most important NAND patents, for which it receives royalties, but some investors believe SNDK is lagging Samsung’s new NAND flash chip architecture (called 3D). NAND flash semiconductor chips are the chips used in Apple iPhones, Android phones, iPads, digital cameras, and a host of other technology equipment to store information and images.
Our perspective is that WDC will be able save a substantial amount of money by having a captive source of NAND flash chips for its enterprise Solid-state Drive (SSD) products. The company believes it will save $30 million for every $100 million of enterprise SSD revenues it achieves. WDC currently has approximately $1 billion of enterprise SSD sales, and storage analysts believe the market could triple in size over the next five years. Assuming WDC maintains its market share and industry analysts are correct about the growth rate for enterprise SSDs, we believe WDC could save upwards of $1 billion within five years by acquiring SNDK. If one were to capitalize the potential $1 billion savings at a 10x multiple, WDC would be paying an adjusted $9 billion for the existing SNDK business or roughly 6x SNDK’s last twelve-months EBITDA.
Furthermore, WDC is among the largest companies in the enterprise SSD niche, and the company will be able to leverage its customer base, industry knowledge, and software it has in the enterprise Hard-disk Drive (HDD) business to go after adjacent markets with new SSD products and capture more growth and profitability in the future. These potential revenue synergies are real but difficult to quantify in a fast-growing market, and we have not incorporated them into our valuation analysis.
Paradoxically, other investors sold off WDC because HDDs are slowly being replaced by SSDs. While we do not think it as simple as one SSD replacing one HDD, even if that were the case, WDC’s acquisition of SNDK mitigates that risk. Frankly, the demand for storage is growing so fast that both technologies will be required years into the future, and in the some ways demand for HDDs is being enhanced by newer, faster SSDs that are opening up new markets like hyper-scale computing and big-data analytics.
Based on the current revenues of both companies, the recent announcement by the Chinese regulator MOFCOM4 to allow WDC to fully integrate its two separate HDD businesses, and the cost, but not revenue, synergies of combining WDC with SNDK, we believe WDC owner’s earning could reach over $10 per share after the deal closes. Thus, with WDC trading down to $60, and less recently, we believe the shares are attractively priced and we added to the position in the fourth quarter.
Lastly, we will discuss the for-profit education sector. It is evident that the industry is struggling to grow student enrollments, and APOL and DV have not been invulnerable to those trends. However, APOL and DV (DV, Financial) have some different factors that have caused their operating metrics to diverge over the past couple of years. While both of these companies have very strong balance sheets with substantial net cash and each generating good cash flow, DV is more diversified than APOL and has more operating options to improve profitability. APOL (APOL, Financial) is trading at less than book value, less than 10% of sales (net of cash), and less than 1x enterprise value-to-EBITDA. APOL is a very cheap stock, in our opinion, and we added to the position in the quarter.
Let’s discuss APOL in greater detail. APOL declined 28% in the December quarter due to reporting lower than expected new student enrollment and a non-fundamental issue. The most important items, profits and free cash flow, met expectations. Incredible as it is irresponsible, the stock partly sold off because the Chairman of the Board received a margin call on stock he had pledged as collateral for a real estate loan he assumed many years ago. Per our discussion with APOL management, the loan was for a little over $25 million and it had a condition that provided that the loan would come due immediately if APOL declined below $10 a share. This occurred on October 22, when APOL announced its earnings, lower new student enrollments, and a $110 million acquisition in Germany. Shareholders initially sold off the stock a couple of dollars and pushed the stock just below $10. Unfortunately, the Chairman did not have the proceeds immediately available that day to pay off the loan, and the margin clerk proceeded to indiscriminately sell approximately three million of the Chairman’s shares, pushing the stock down to close to $7.
Not only do we find this behavior financially irresponsible but also inconsistent with the prudent stewardship of a publicly-traded company. Subsequently, we wrote a letter to the management team and board, and had a lengthy phone call with the company’s lead- independent board member expressing our views. In summary, we suggested that the company buy back all of the remaining Chairman’s stock and eliminate the dual-class shareholder arrangement. APOL has historically generated excellent returns on capital and has some good opportunities once it completes its repositioning of the University of Phoenix (UoP). Its global business is growing very fast, its global profit margins are expanding, and the global business is expected to generate material operating cash flow this year and in the future. The stock is incredibly cheap by our metrics, at roughly 1x enterprise value-to-EBITDA, but investors are unsure of the repositioning strategy at the UoP and concerned about the heightened regulatory environment.
However, thus far, APOL has largely avoided any material penalties from the numerous investigations that seemingly never end in the for-profit education industry. For example, on January 15, 2016, the Department of Defense (DoD) removed the UoP from probationary status after a three-month review of UoP’s business practices with respect to Tuition Assistance (TA) grants. Anti-for-profit education activists last year made a number of claims about UoP and its enrollment of military personnel in its school. There were concerns that active and former military personnel would never again receive financial aid to attend UoP and APOL would have to pay a massive fine. The bottom line is that the DoD conducted a thorough investigation and within three months removed the TA probation, and APOL was not fined a penny.
Reviewing UoP’s operations, we agree with Tim Slottow, the current President of UoP and the former CFO at the University of Michigan, and his strategy and vision for UoP. President Slottow’s vision is to attract highly qualified adult students to UoP’s Baccalaureate programs and provide them an excellent education in a very efficient system that will allow these students to continue to move their careers up the corporate ladder or healthcare employment track. Retention and graduation rates are among the most significant factors President Slottow is focused on, as well as job placement for students with the hundreds of businesses that recruit from UoP.
Going forward, UoP will require prospective students to take diagnostic tests to determine their capability to complete their degree, rather than having essentially an open-enrollment policy. In the short term this means fewer students will enroll in UoP, but in the long run it is likely more students will persist all the way through to graduation. The objective is to graduate more students who are less likely to drop out and not be able to pay off their student loans.
Subsequent to year-end 2015, on January 11, APOL’s Board of Directors issued a press release indicating that the board hired two investment banks and a law firm to evaluate strategic alternatives for the company. Later that day, the Dow Jones newswire service reported that the private equity firm Apollo Global Management was rumored to have offered over $1 billion to acquire APOL.
We immediately penned another letter to APOL’s board and detailed our assessment of what APOL’s shares are worth. We are concerned that Apollo Global Management is going to offer a reasonable premium above the January 11th, 2015 closing price, but enormously below the intrinsic value of the business, and the board will capitulate and sell the company at the bottom of the cycle. If the board agrees to sell the entire company at what some of the rumors are suggesting -- $1 billion -- that would value the business at less than 2x trailing twelve-months EBITDA -- after considering the net $6 per share of cash on the balance sheet. To put that into perspective, based on Apollo Global Management’s 2015 presentation, LBO takeover EBITDA multiples averaged 9.3x over the past decade, and the lowest average multiple was 8x in 2009 during the financial crisis period.
The $1 billion valuation for APOL would be unquestionably rejected by us, and we hope every other shareholder would reject it. Furthermore, that valuation would give absolutely no consideration for APOL’s rapidly growing international business, nor the large profit improvement opportunity for UoP. Green shoots are now sprouting at UoP, with retention rates starting to turn positive and student enrollment potentially bottoming this quarter. We will update you later should any materially new information be announced with respect to APOL’s strategic review, but below we provide our estimate of what APOL is worth.
While the Fund’s investments have taken some temporary hits, there is still tremendous value in the portfolio companies the Fund holds. The upside potential we see for the vast majority of the investment companies is not predicated on a robust bounce in either the U.S. or global economy. For our energy investments, oil prices need to rise to an equilibrium level that merely reflects the sustainable supply and demand characteristics of a normal market. WDC can rise substantially once investors better understand the strength and merits of their proposed SNDK acquisition. We believe the for-profit education investments should rise if nothing happens but that their share prices simply reflect modest valuations – not the overly depressed valuations they currently exhibit. We are optimistic the headwinds these stocks have faced over the past year will reverse as we progress through 2016 and beyond. Our cash level is at the lowest level since December 2003. We have mentioned a number of times over the years that we are going to deploy capital when fear and uncertainty are rising, and that this contrarian decision has been the key factor in our long-term track record. Most people, including certain professional investors, simply do not have the emotional fortitude to buy into weakness –especially into their existing portfolio that has already been hurt. Not us. We are more than pleased to buy our existing portfolio companies, and other stocks, as their valuations get compressed. This is the essence of contrarian value investing.
Market Commentary
In China, 2015 was the Year of the Goat, but in America’s stock market it was the year of the FANG. FANG stands for Facebook, Amazon, Netflix, and Google (note: Google is now called Alphabet). If an investor at the beginning of 2015 had equally distributed her capital to these four stocks, her total return would have exceeded 80%. The year-end average market capitalization for these four stocks was approximately $300 billion. Given that the S&P 500 is a market-cap weighted index and these four mega-cap stocks produced an average return of over 80% for the year, it is striking that the index barely eked out a positive return of 1.38%. In fact, the index’s return would have been negative if it were not for the dividends paid out by the index’s constituent companies. Yet 60% of the stocks in the S&P 500 had negative returns. Notable detractors were Time Warner (down approximately 22%), Wal-Mart (down approximately 24%) and American Express (down approximately 27%). In our universe, two-thirds of the stocks in the Russell 2500 failed to produce a positive return in 2015. Thus, there was a lot of shared pain in the equity markets.
However, not all stocks in the Russell 2500 had negative returns. As a matter of record, there were twenty seven stocks in the Russell 2500 that generated returns of over 100%. One might naively expect that these highflyers produced incredible profit growth for their shareholders, but that was not the case. Counter-intuitively, in aggregate, these twenty-seven stocks had a combined net income loss of $622 million, which was only a slight improvement from the prior year’s loss of $625 million. Thus, on one hand you had companies losing money year after year, and they appreciated over 100%. On the other hand, you had companies that were profitable, but those profits deteriorated and their stocks plummeted. This is the essence of a manic-depressive market, or extreme speculation and extreme pessimism co-existing in one year.
While not all fourth quarter corporate results were available at the time this letter was written, we estimate aggregate net after-tax profits for the Russell 2500 declined over 26% in 2015. In terms of profit declines, that was one of the worst years in recent memory. If one strips out the energy companies, year-over-year net income is still estimated to have declined over 14% for the remainder of the companies in the Russell 2500. Clearly, a large swath of companies in America is experiencing difficult conditions, and profits continue to decline.
Let’s now address the oil industry and two key questions. Why are oil prices plummeting? And will the price ever rise back to a level where U.S. energy companies can make money? First, oil prices have plunged because the Organization of the Petroleum Exporting Countries (OPEC) is flooding the market with oil. OPEC has increased oil production over the last year by over 1 million barrels per day (bpd) at a time when the market was already slightly oversupplied. Historically, when the world oil market was out of balance, OPEC, particularly Saudi Arabia, had either cut production or added production to bring the market back into equilibrium. This occurred in 2008-09 when oil prices declined from $145 to $35 per barrel and OPEC cut 3 million barrels to stabilize the market. In 2004, OPEC raised production to keep prices from spiking when demand suddenly increased. In 1999, OPEC cut production to stabilize the oil market from the fallout of the Asian economic crisis.
As we mentioned earlier this year, Saudi Arabia, in the face of a modestly oversupplied oil market, not only did not cut its oil production but accelerated it. It now appears that Saudi Arabia increased its production in 2015 by nearly 800,000 (bpd), or slightly over 8%, despite global demand growing only 2%.
The Saudis’ relentless pursuit to drive oil prices lower is not without precedent. Interestingly, in the mid-1980s, Saudi Arabia had roughly 7.5 million bpd of spare oil capacity and rapidly released approximately 5.5 million bpd into the market, which drove oil prices temporarily below $10/barrel. The resulting questions are: what was the Saudi’s motivation in the 1980s to behave that way, and are there any similarities today that would partly explain their current behavior?
According to Dr. Hossein Askari, who was recently interviewed in Oil & Gas 360, there are similarities. Dr. Askari was born in Iran, educated at M.I.T., and is now the Iran Professor of International Business and International Affairs at The George Washington University. He has served in the U.N., worked at the World Bank and IMF, and importantly served as a Special Advisor to the Ministry of Finance for Saudi Arabia.
Dr. Askari believes the Saudi royal family is increasingly becoming more concerned about Iran’s threat to the Kingdom’s national interests in the Middle East. Askari says the current standoff between these regional powers is rooted in Iran’s 1979 revolution. When the Shah was removed from power, the new revolutionary Iranian government was viewed as a threat to the Saudis in the 1980s. Rather than fight a military battle against the Iranians, the Saudis unleashed their spare oil capacity onto the market to drive oil prices so low that it would substantially reduce the Iranians’ cash flows and, therefore, ability to fund either covert or overt actions against the Kingdom. This was a financial war rather than a conventional military war.
Today, Saudi Arabia again feels threatened by Iran’s potential hegemony in the region. Beyond Shia Iran just across the Persian Gulf, Saudi Arabia feels surrounded by Shia nations. Iraq is now controlled by a Shia-led government, Syria is waging a civil war against Sunnis in their country, and Yemen’s Sunni government was overthrown by the Houthis – a Shia proxy supported by Iran. Furthermore, Iran recently signed a nuclear accord with the U.S. and other leading nations that will unfreeze an estimated $100 billion in assets that Iran will be able to access. Saudi Arabia and others in region are concerned that Iran will spend some of the money to further de-stabilize the Mid-East.
Dr. Askari’s thesis is that the Saudis believe Iran would use the proceeds from higher oil prices to fund activities that are not in the best long-term interest of the Kingdom – including bulking up militarily and potentially building nuclear weapons. Thus, Saudi Arabia is using a page from the 1980s playbook and funneling its spare oil capacity (see chart below) into the market to depress prices and hurt the Iranians’ wallet – as well as all other producers’ cash flows.
From our perspective, there is a major flaw in Saudi Arabia’s thinking – should Dr. Askari’s assessment be correct. The flaw is that today’s global spare oil capacity is substantially lower than in the mid-1980s, and incremental demand is likely to consume today’s near-record low spare capacity in short order, in contrast with taking longer than a decade as it did in the 1980s, assuming the world does not fall into a global recession similar to the 2008-2009 recession.
In numbers, global oil demand in the mid-1980s, when Saudi Arabia started dumping oil into the market, was approximately 57 million bpd and spare capacity was over 10 million bpd, or more than 20% of global oil consumption (see graph below). Saudi Arabia had about 7.5 million barrels of spare capacity three decades ago. Today, the world consumes roughly 95 million bpd, and spare capacity is estimated to be about 2.5 million bpd, or only 2.5%. Currently, Saudi Arabia’s production is ~10.5 million bpd and is thought to have about 2 million bpd of the combined 2.5 million bpd global spare capacity, although the Saudis have never actually proven they can produce their oft-stated 12.5 million bpd of crude capacity. In the past, spare capacity was oil that could be produced from existing wells and delivered to the market in thirty days. Today, spare capacity is defined as oil that can be produced from existing wells and brought to the market in ninety days. The difference is because today’s existing wells are older and have less pressure than a couple of decades ago.
Nonetheless, nearly 100% of OPEC’s, and the world’s, remaining spare capacity could be consumed in 2016, if incremental oil demand in 2016 simply mirrors the growth of 2015. This assumes Iran is allowed to bring their 500,000 bpd of capacity onto the market, which the Iranian oil minister says they could sell once economic sanctions are lifted. However, the incremental 500,000 Iranian barrels likely will be offset by a reduction of U.S. oil production of a similar amount. Moreover, non-OPEC and non-North American oil production could soon start to decline. This decline might occur because the currently low oil prices have led to upwards of $400 billion in oil project cancellations that are required to maintain and grow capacity.
If OPEC and Saudi spare capacity are eliminated later this year or sometime next year, where will global oil refineries source their oil? Should global oil demand continue to grow by 1.5-2.0 million bpd annually, the current excess inventories may decline rapidly. Our belief is that the logical material supplier of incremental oil can be U.S. shale oil companies. Many investors forget that the U.S. shale oil companies supplied approximately 4.5 million bpd, or 50%, of the roughly 9 million bpd increase of incremental global oil demand from early 2010 to early 2015. The other 50% was largely supplied by OPEC because non-OPEC and non-North American producers could not grow their production, despite oil prices being above $100/barrel.
In our opinion, this growth potential for U.S. shale oil is not a one-year phenomenon. Our long-term expectation is that annual global oil demand will continue to grow by roughly 1.5 million bpd for the foreseeable future. In 2015, global oil demand appears to have grown by nearly 2 million bpd, despite economic recessions in Europe, Japan, and South America, weak North American economic results, and China experiencing substantial deceleration in its economy. However, if global GDP weakens further and the U.S. falls into a recession, oil demand could be much weaker than the consensus growth for 2016 of approximately 1.2 million bpd.
While it is very frustrating to see Saudi Arabia accelerating its oil production in an over-supplied market, several oil experts are now suggesting Saudi production is nearing its theoretical, though never attained, capacity. Should this outlook be proven correct and global demand continues to rise modestly, the world could once again call on U.S. shale oil companies to meet the increasing oil demand, just like during the 2010-2014 period.
Conclusion
In closing, we remain confident about our Fund’s future. Our pipeline of potential investments remains robust, as evidenced by the two new stocks, Houghton Mifflin and Sanderson Farms, which went into the portfolio during the fourth quarter. We added to Aarons, AGCO, Dana, Veeco and others as their stock prices declined. We also reduced Arrow, Avnet, Foot Locker, and others as their prices neared record highs. We eliminated Federated Investors, as we believe asset managers could experience outflows should the markets remain turbulent. We also believe some financial institutions could come under stress should the yield curve continue to flatten, and loan defaults might rise if the economy further weakens. Finally, more stocks are starting to show up on our valuation screens, given the recent sell-off in the equity markets. We continue to hold ample liquidity, though reduced, to seize the increasing bargains, and are prepared to deploy capital more vigorously as others bail out.
We truly appreciate the confidence and trust that you have placed in the Fund and on us and know that, as fellow investors, we have felt the underperformance. We work tirelessly to ensure that our analytical and emotional focus is stronger than ever.
Respectfully submitted,
Arik Ahitov
Portfolio Manager
Dennis Bryan
Portfolio Manager
January 19, 2016
Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. This data represents past performance and investors should understand that investment returns and principal values fluctuate, so that when you redeem your investment it may be worth more or less than its original cost. Current month-end performance data may be obtained by calling toll-free, 1-800-982-4372.
To view portfolio holdings from the most recent quarter end, please refer to the end of this document or at www.fpafunds.com.
Portfolio composition will change due to ongoing management of the fund. References to individual securities are for informational purposes only and should not be construed as recommendations by the Funds, Advisor or Distributor.
The views expressed and any forward-looking statements are as of the date of the publication and are those of the portfolio managers and/or the Advisor. Future events or results may vary significantly from those expressed and are subject to change at any time in response to changing circumstances and industry developments. This information and data has been prepared from sources believed reliable. The accuracy and completeness of the information cannot be guaranteed and is not a complete summary or statement of all available data.
The Russell 2500 Index consist of the 2,500 smallest companies in the Russell 3000 total capitalization universe offers investors access to the small to mid-cap segment of the U.S. equity universe, commonly referred to as "smid" cap. The Russell 2500 Value Index measures the performance of those Russell 2500 companies with lower price-to-book-ratios and lower forecasted growth values.
Indices are unmanaged and investors cannot invest directly in an index. These indices do not reflect any commissions or fees which would be incurred by an investor purchasing the stocks they represent. The performance of the Fund and of the Averages is computed on a total return basis which includes reinvestment of all distributions. S&P 500 Index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. The index focuses on the large-cap segment of the market, with over 80% coverage of U.S. equities, but is also considered a proxy for the total market.
