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Christopher P. Mittleman's letter

Christopher P. Mittleman's letter



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Published by: DealBook on Aug 16, 2011
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"The Next Berkshire Hathaway?
- Harbinger Group, Inc. (HRG $4.48)
- August 11, 2011The Brains, Capital, and Deal Flow of a Billionaire Investor at a 38% Discount to NAV"When someone has the audacity to claim, even tentatively, that they may have stumbled uponthe next Berkshire Hathaway, experienced investors should rightly cringe with skepticism.Berkshire Hathaway (BRKA) was a slowly dying textile manufacturer when Warren Buffett firstbegan acquiring its stock at around $8 per share in 1962 (when its net tangible book value was$22.51). After becoming the company's controlling shareholder in 1965 and redeploying itscapital into better returning assets, the stock price has since risen to $107,100 per share, acompounded annual growth rate (CAGR) of 21.4% over 49 years, turning each $1 millioninvested then into $13.4 billion today; a nonpareil compounding machine over such a long timeframe.Whether or not any other publicly traded conglomerate will ever be able to exceed both theamplitude and duration of Berkshire Hathaway's track record remains to be seen, but a fewnoteworthy candidates appear to be well on their way to doing just that. And there nowappears to be another upstart joining in on that quest.When Ian M. Cumming and Joseph S. Steinberg bought control of Leucadia National (LUK) in1979 (then called Talcott National), it had ended the year prior with a split-adjusted stock priceof $0.01 per share (and negative shareholder equity of $7.7 million). Today it's $28.22 per share(with shareholder equity of $7 billion), a CAGR of 27.2% over 33 years, not including substantialdividends paid along the way.Brothers Steven M. Rales and Mitchell P. Rales paid $6.6 million for 30% of a nearly bankruptpublicly traded REIT called DMG and converted it into an acquisition vehicle which theyrenamed Danaher Corp. (DHR) in 1983. Their cost per share (split-adjusted) appears to havebeen about $0.032. Today it's $43.35, a CAGR of 29.7% over 28 years.I began my investing career in 1990 as a stock broker trainee at Shearson Lehman Hutton,before starting what would become an eleven year stint at PaineWebber on September 21,1990. That day, had I been smart enough to take advantage of it (I was not), the publicly tradedCanadian LBO firm Onex Corp. (OCX CN) was available for C$1.00 per share (split-adjusted).Today it's C$33.50, a CAGR of 18.2% over 21 years, not including dividends. Onex Corp. wasfounded and is still controlled by Gerry Schwartz, a great investor and businessman.When exceptional investors and/or business operators take control of otherwise unremarkablepublic corporations, it's often a prelude to a lucrative transformation of which outside investorscan also take advantage, if they happen to notice what's going on before Wall Street wakes upto metamorphosis in progress.
For example, many clients of our investment advisory firm, Mittleman Brothers, LLC, have beenwith me since my days as a stockbroker and will recall investing at my behest in IcahnEnterprises L.P. (IEP) beginning in 1996 (then just a pile of cash and real estate known asAmerican Real Estate Partners L.P. (ACP)) at around $9.00 per share (with a net tangible bookvalue then in the low $20s). For the next six years it frustratingly stayed anchored around that$9.00 price as I continued to buy it for clients, and as Carl Icahn increased his stake from 50% to86%. Finally in 2003, once Carl had bought enough stock on the cheap, he then started focusingon maximizing the share price, and we sold our position on average in the $50+ range during2006 (it then reached over $135 in 2007, but is back to $41.50 today). Even the mostunfortunate of my clients who bought that stock six years too early in 1996, and had to wait afull decade for it to reach and then exceed my estimate of fair value, still achieved an estimatedCAGR of about 19.6% on average ($9 to $54) on that investment over those ten years.When we were investing in what would become Carl Icahn's primary investment vehicle back in1996, one of the reasons it was available so cheaply was because Icahn's reputation was at a lowpoint, with his investment in airline company TWA wiped out after its second bankruptcy (TWA'sfirst bankruptcy was in 1992, the second and final one occurred in 1995), and his investment inbankrupt comic book company Marvel Entertainment also going down the tubes in 1996. Butwith the margin of safety provided by a discount to NAV in excess of 50%, and operating underthe simple assumption that decades of outstanding investment returns are not undone by oneor two bad bets, we correctly decided that Icahn had not suddenly become an inept investor inthe mid-1990s, and so by the time he was considered an investing genius again about a decadelater, the discount to NAV that had plagued those shares for so many years very suddenlybecame a substantial premium.Today we see the possibility of a similarly successful investment vehicle taking shape withHarbinger Group, Inc. (HRG) which closed yesterday (08/11/11) at $4.48 per share (MittlemanBrothers, LLC controls 1,674,846 shares of HRG (1.2% of shares outstanding) at average cost of $5.68 per share). In this case the out of favor billionaire investor is Phillip Falcone, who alongwith his hedge fund owns 93.3% of HRG's shares outstanding.With a discernable investment track record dating only back to 2001, it's not yet clear if Falcone's phenomenal results managing hedge fund Harbinger Capital Partners, L.P. from 2001to 2007 should be weighed more heavily in judging his investing talent than his disappointingresults from 2008 to 2011. Sometimes sudden wealth can cloud judgment, and lead todisastrous distractions. So it remains to be seen if he will rebound in a second act like a CarlIcahn, or flame-out like a Saul Steinberg (a high-living corporate raider of the '70s and '80s wholost everything when his insurance conglomerate Reliance Group failed in 2001). We’reobviously betting on the Icahn scenario playing out, mainly because Falcone’s investments havetended to be in companies we like: strong franchises with high barriers to entry yieldingsignificant and sustained free cash flow production.
Harbinger Group, Inc. (HRG $4.48) used to be known as Zapata Corp. (ZAP), an oil companyfounded by former President George H. W. Bush in the 1950s, which then became aninvestment vehicle controlled by Malcolm Glazer in 1994 until he sold his controlling stake toFalcone (Harbinger) in June 2009 for $7.50 per share, the approximate net cash value per shareof the company at the time, which had been liquidated years earlier.In January 2011 Falcone and his hedge fund further increased their stake in HRG by exchanging a54.4% stake in Spectrum Brands (27.757 million shares) for 120 million newly issued HRG shares,thus increasing Falcone's stake in HRG from 51.6% to 93.3%. That was when we becameinterested in HRG, as we had already been amassing a stake in Spectrum Brands since itemerged from bankruptcy in September 2009 (Mittleman Brothers, LLC led an official equitycommittee that contested, unsuccessfully, what we viewed as an opportunistic and unfairbankruptcy reorganization plan that awarded Falcone's hedge fund with the bulk of SpectrumBrand's new equity. So to find ourselves investing in an entity he controls does feel a bit odd).Spectrum Brands is a highly recession-resistant group of value-priced consumer brands such asRayovac batteries, Remington personal grooming products, home and garden products like HotShot, Cutter, Spectracide, and a sizable global pet products division, among other businesses.EBITDA and free cash flow have grown substantially since 2007, uninterrupted by the GreatRecession.HRG has 139.202 million shares outstanding. Its stake in Spectrum Brands, valued at SPB's lasttrade of $22.96, is worth $637 million or $4.58 per HRG share. HRG also owns a recentlyacquired 3.7 million share stake in Canadian firm North American Energy Partners Inc. (NOA CNC$5.12), worth $19 million today or $0.14 per HRG share. There is also about $70 million of cashworth $0.50 per HRG share. That totals $5.22 per share in NAV, only 16.5% higher than thecurrent stock price. So where's the big discount?Most of the obvious upside potential lies in Spectrum Brands (SPB $22.96), which looks absurdlyundervalued, trading at a Total Enterprise Value (TEV) of $2.95 billion which is only 5.9x the$500 million in EBITDA we think they can produce in 2012, and a market cap. of only $1.2 billion,or 6.0x the $200 million in Free Cash Flow (FCF) the company has forecast for 2012. Comparablecompanies trade at much higher multiples. For example, Clorox (CLX $67.75) currently trades ata TEV/EBITDA multiple of 10.0x, and a market cap. to FCF multiple of 11.7x. Fortune Brands (FO$55.31) currently trades at a TEV/EBITDA multiple of 10.8x, and a market cap. to FCF multiple of 12.0x. We estimate Spectrum Brands would be fairly valued at $48 per share, which would be aTEV/EBITDA multiple of 8.5x and a market cap. to FCF multiple of 12.5x. If Spectrum Brandswere to hit our estimate of fair value, HRG's stake in SPB would be worth $9.57 per HRG share.Another source of upside potential comes from HRG's recent $350 million acquisition of a lifeinsurance company from Old Mutual PLC called Old Mutual U.S. Life Holdings, Inc., which hasnow been renamed Fidelity & Guaranty Life (FGL). HRG issued $350 million of 10.625% seniorsecured notes due 11/15/15 in order fund the deal which closed in April 2011. In HRG's

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