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Dear Investor, This past December marked our tenth anniversary as a firm. It is with great pride that we begin our letter with the following chart showing the most important aspect of investing to our clients. Over the past decade, every one of our products generated: i) Attractive absolute performance; ii) Meaningful outperformance versus hedge fund peers; and iii) Even more significant outperformance versus relevant market benchmarks. • Importantly, Glenview and Little Arbor delivered this performance with significantly lower volatility than the markets as a whole.
Profits Gained by a “Day 1” Investor in each of Our Products1
GLENVIEW Jan2001 - Dec2010 GO Jul2006 - Dec2010 LITTLE ARBOR May2004 - Dec2010 CREDIT Sep2007 - Jan2010
$330 $300 $270 $240 $210 $180 $150 $120 $90 $60 $30 $0 -$30
$122 $77 $71 $46 $18 $15 $9 $30 $40 $19 $4
($23) Fund Relevant peer benchmark (HFRI/Hennessee) S&P HY Market
It is with great pride that we recognize that each individual who ten years ago chose to invest $1 million into Glenview vs. the average hedge fund or the US equity markets now has up to $3 million2 of additional capital to invest in the education of their children, to improve the standard of living for their families and to invest in their communities. We are equally pleased that a pension fund or philanthropic endowment or foundation that invested $100 million in Glenview on Day 1 has $230 million to $286 million3 of additional capital today to provide retirement income for their members, to enhance funding for groundbreaking medical research and to promote educational quality and social good. On behalf of our entire team at Glenview, we thank you for the opportunity to serve you over the past decade. Armed with the additional knowledge and experience from our first decade, we now turn our attention towards protecting and growing your capital over the next year and years.
* Please refer to page 21 for all reference notes found in this report. Please refer to page 22 for important disclosures regarding the information in this report.
Executive Summary i) We continue to generate attractive risk adjusted returns, as all of our products had strong performance during the fourth quarter with below average volatility, as indicated in the chart below:
Q4 Performance Gross Net GLENVIEW FUNDS Glenview Capital Partners (Cayman), Ltd. Glenview Institutional Partners, L.P. Glenview Capital Partners, L.P. GLENVIEW OPPORTUNITY FUNDS Glenview Offshore Opportunity Fund, Ltd. Glenview Capital Opportunity Fund, L.P. GCM Opportunity Fund, L.P. GCM LITTLE ARBOR FUNDS GCM Little Arbor Partners (Cayman), Ltd. GCM Little Arbor Institutional Partners, Ltd. GCM Little Arbor Partners, L.P. 6.93% 6.92% 6.90% 11.85% 11.89% 12.39% 5.76% 5.14% 5.30% 5.54% 5.75% 6.25% 9.54% 9.76% 10.12% 4.63% 4.17% 4.32% Q4 Volatility 7.17% 7.49% 8.24% 12.51% 12.73% 12.47% 4.09% 4.07% 4.04% 2010 Calendar Year Performance Gross Net 16.72% 16.61% 16.42% 28.28% 28.77% 28.73% 16.47% 15.95% 15.81% 14.22% 15.34% 15.72% 22.51% 23.15% 23.60% 13.17% 13.26% 12.64%
ii) We remain constructive on the investment environment over the medium term supported by attractive valuations, excessive corporate liquidity, a growing economy and ample global liquidity. iii) Forward risks are no longer tilted towards deflation / double digit recession but instead include inflationary pressures and the corresponding impact on sovereign creditworthiness. iv) With the recovery in both economy and markets, our ability to find attractive single name short opportunities is increasing, and our short exposure is shifting away from indices towards individual equities. v) In the Glenview and GO Funds, we continue to withdraw capital from long fixed income strategies and redeploy capital in long equity strategies with superior risk / reward characteristics. vi) With the evolution of risk scenarios that now include inflationary pressures, we have adjusted our alternative hedge positioning towards protection from rising interest rates as well as mortgage putback liabilities, while harvesting a portion of our sovereign CDS hedges. * Fourth Quarter Discussion Our funds performed well and inline with our long-term expectations, driven by the following: i) Broadbased success in our investment portfolio, led by strength in healthcare (Life Technologies, McKesson, Medco and Thermo Fisher Scientific), technology (Flextronics, Xerox and BMC) and specialty financials (Aon and AIG). ii) Continued steady performance from our corporate fixed income portfolio, driven by a diverse set of names including Cengage, Mueller Water Products, MBIA, Terrestar and Ceridian.4 iii) Modest positive returns from our US Treasury hedge as the first signs of inflationary pressures emerged, raising yields and reducing bond prices. iv) Offsetting these gains, our short equity portfolio performed approximately inline with the broader equity markets in the quarter on a cash on cash basis, producing negative returns. * *
While our portfolio holdings are diversified by industry, end market and growth drivers, we felt that the common elements of modest valuations, above consensus earnings growth and accelerating productive capital deployment would all serve to promote value for our largest equity holdings. It is therefore not a coincidence that of our eight largest individual equity winners in the quarter, all of them beat consensus earnings for the September quarter, and six of them were aggressive repurchasers of their own shares. We believe these trends of secular growth, excess capital deployment and a modest expansion of valuation multiples will continue to drive positive absolute returns from our investment portfolio in 2011 and beyond, and we discuss many of our positions in depth in the “A Ten Year View – Looking Back and Looking Forward” section of this letter.
As the quarter progressed and valuations expanded, we were able to broaden our short portfolio to include more single names that should be negatively impacted by the coming economic, fiscal and monetary environment: a) We established short positions in a series of REIT equities whose valuations reflect exceedingly low cap rates proportional to the exceedingly low interest rate environment. We do not believe that our core competency is predicting forward interest rates, but we are exceedingly comfortable betting that over the course of the next year, twelve months will pass. As we examine the term structure of interest rates, a 3.3% 10-year bond yield is comprised of a one year yield of 25bps, and therefore the subsequent nine years average 3.65% (of which the last eight years are 4%). For REITs that reflect a 6% cap rate, a 70bps move over the two years will create 10% multiple compression solely by moving two years forward on the term structure of interest rates. Should inflation accelerate above expectations, this rate rise would be even more pronounced, and the multiple compression more significant. While we don’t expect REITs to implode, we do believe they will underperform over time. b) We established short positions in cruise lines and other travel related equities that will likely see profits eroded by declining revenue on aging assets combined with inflationary cost pressures including oil. Furthermore, asset intensive travel industries such as hotels are also often valued on cap rates and susceptible to the same valuation compression as REITS, as described above. c) We broadened our portfolio of shorts in companies that derive a significant portion (or all) of their revenue from government sources whose ability to grow such spending is impaired by their own balance sheet constraints and fiscal deficits. Such companies are likely to see decelerating revenue trends and more intense pricing and margin pressure as a result of the deteriorating financial health of their government and government related customers. d) In healthcare, we expanded our short positions in companies that we believe will come under more intense pricing and reimbursement pressure as the healthcare reform debate migrates from coverage back towards bending the cost curve.
In general, we still believe that low valuations and strong liquidity make it a challenging market to generate absolute returns in short equities. However, those conditions are less pronounced than at any time over the past five to six quarters, and therefore it is natural that our individual short equity portfolio has begun to expand. Investment Outlook The core of our outlook section was written prior to the tragic events in Japan in recent days. Our thoughts and sympathies go out to those families who have suffered loss of life, loss of property and loss of community. As you might expect, the publishing of our year-end letter took a back seat to our risk management duties as we struggle to understand and define the impact of both the natural disaster and the nuclear emergency on economies and markets, and on specific industries and companies. As the outcome of events at the Fukushima nuclear plants continues to be uncertain, we feel it is most instructive to provide our thoughts on the year independent of this event as well as our initial thoughts on its impact. Obviously these events are dynamic, and we will provide additional communication in our next investment letter. Looking back, as we came into 2010, we identified the four legs of the investment stool that we felt were strong enough to produce reasonable investment returns in the equity markets: i) Reasonable equity valuations, particularly reasonable in light of the interest rate environment, ii) Excess corporate liquidity, with $1.4 trillion of cash at non-financial US public companies, an all-time high which will serve to support and propel valuations through share repurchase, M&A activity and investment that yields greater ROEs than are available through cash interest income (which is near zero), iii) Healthy economy, with developed economies moving forward at approximately a 2% pace with faster emerging market growth, and iv) Healthy overall liquidity, with interbank spreads and corporate spreads all reasonably tight. Of course, the third and fourth legs of the stool, overall economy and liquidity, were the most vulnerable and subject to change quickly, since they were each being supported by unprecedented monetary and fiscal stimulus that can not
be sustained indefinitely. In fact, coming into 2010, the first hurdle to cross was the end of quantitative easing in March of 2010 when the scheduled Treasury and mortgage purchases in the US were set to expire. While the events and the path of the market were largely unpredictable as we moved through them, in hindsight the market followed the stimulus. Markets peaked in late April 2010, a matter of weeks after the expiration of quantitative easing, and whether it was due to a cause-and-effect relationship or a coincident event, the economy and liquidity conditions each began to falter during the second quarter. The twin worries of European sovereign credit and refunding issues, as well as the fraud charge brought against Goldman Sachs that destabilized US bank borrowing spreads, together changed the tone of liquidity, and short cycle industries including retail and technology components began to slow throughout the summer. US employment statistics continued to deteriorate until October, when QE2 was announced, and purchases of Treasury securities resumed. Again whether linked causally or coincidentally, the markets began to recover in early September and climbed 20% in the final four months of 2010. Ultimately, each of the four legs of the stool held up well, but the economic and overall liquidity legs needed reinforcement in order to remain strong. While it is convenient for us to think in one year increments and to adjust our views on a calendar basis, the "four legs" approach to the market is just as valid and relevant in 2011 as 2010. First, while the equity markets rose 13% in the US, forward earnings expectations grew 17% (2011 vs. 2010) and as such valuation multiples compressed slightly, making a cheap market even cheaper. Second, despite some notable cash M&A transactions and significant share repurchase activity, corporate cash levels in aggregate grew approximately 7% to $1.5 trillion, and thus the overcapitalization of Corporate America became even more pronounced throughout the year. Economic growth has reaccelerated, and some deeply cyclical businesses such as automotive, agricultural and capital equipment have begun to show signs of strength, with commercial construction likely to show growth beginning 2H 2011. Finally, credit spreads continued to tighten, and the average high yield bond yield fell from 19% at year-end 2008 to 7.5% by the end of 2010. In fact, debt markets have become so healthy (or potentially irrationally exuberant again) that issuers are now coming to market with holdco PIK toggle bonds yielding below 11%, on average. The first two legs of the stool – valuation, and overcapitalization – seem likely to remain solid, and if these two legs of the investment case do disappear, it would be because markets rallied and cash was deployed, which is a healthy outcome. It is possible that earnings estimates are broadly too high, as raw material pressures and possible economic weakness down the road could pressure earnings, or alternatively corporate tax rates, in the aggregate, could rise further pressuring earnings. Our own portfolio is constructed to minimize these risks, given its low cyclicality and emphasis on recurring services businesses, and we believe our earnings estimates are reasonable and achievable in most scenarios. However, the overall economic and liquidity legs of the stool are again vulnerable to change rapidly, and as such, we are keeping a close watch on these two factors as we assess our overall risk posture. Another key construct we had to understand and monitor global economic and liquidity conditions was our analogy of “bowling with gutter guards”. As you recall, if in a healthy economy the ball rolls down the middle of the lane on its own with little volatility, then in the "new normal" economy, which is being fueled by exceedingly high government intervention, the ball is likely to bounce back and forth between the "right gutter" of inflation and the "left gutter" of double-dip recession/deflation. We explained that the Fed is acting as the left gutter guard through its extended zero interest rate policy as well as its expansion of balance sheet through QE and QE2, and that Congress is also acting as a left gutter guard through fiscal stimulus and short-term tax credits for things like capital equipment purchases. On the right gutter of inflation, we contended that the Fed and markets are the right gutter guard, whereby in an inflationary scenario the Fed could begin to liquidate its excess Treasury holdings while markets would drive up long-term rates, which together would slow global growth and reduce inflationary pressures. Furthermore, we did not see the conditions for inflation beyond commodity inflation, as high levels of unemployment and the globalization of the workforce would likely contain wage pressures. Finally, excess housing inventory and a weak job market did not seem conducive to inflation in the cost of shelter (particularly as it is measured in US government statistics). Using this gutter guard analogy, the economy and markets bounced off the left gutter guard twice in 2010: first in May during the European Sovereign crisis, when Germany led the ECB through a rescue arrangement for the debt of Greece and other ailing Eurozone sovereigns, and second in the Fall of 2010 when the US led a global round of QE2, which preceded what appears to be the beginning of a more firm and broadbased economic and job recovery.
As we crossed from year-end, the economic ball was back in the center of the lane, and heading from deflation to inflation. Finally, we discussed in our last few communications the coiled spring effect of low valuations on the long-term performance of equity markets. As we shared earlier, the major difference between euphoria and misery was not earnings growth but multiple expansion / compression as follows:
Euphoria 12/94 - 12/99 10% +14 points 2% 26% per year Misery 12/00 - 12/10 8% (8) points 1.5% 1.5% per year
Earnings Growth Multiple Expansion / Contraction Dividend Yield TOTAL RETURN
As such, we believe that low earnings valuations create the "bent knees" for the market to spring forward over the coming three to five years, as earnings growth can shine through absent multiple compression, with the possibility for multiple expansion if history is a guide (relative to interest rates and average market multiples). The first lesson we should take from 2010 is to respect the end of quantitative easing, either as an actual or psychological calendar event that could trigger a change in liquidity and economic activity. There are three reasons we should be concerned about the end of QE2 and the unlikelihood of QE3: 1) QE2 is set to expire in June, and it took seven months last time before a new round of quantitative easing was enacted. Thus, it seems reasonable to expect QE2 to lapse, particularly as the economy has rebounded and deflation seems contained as a risk (see #2). 2) US Fed Chairman Bernanke said in his most recent congressional testimony on March 1 that the "risk of deflation has become negligible." If that is the case, it would be odd for the Fed to come forward four months later with further extraordinary monetary stimulus. 3) Two days later, the ECB President Trichet said that an increase in rates at the next meeting (April) is possible. Again, this doesn't seem consistent with an extension of QE2 globally. As such, we will be closely watching liquidity and economic conditions as the first elements of the unprecedented level of global monetary stimulus are withdrawn. Second, we believe that the markets are next going to deal with the economic ball bouncing off the "right gutter" of inflationary pressures in early 2011. We already have seen extreme spikes in food and textile commodities, and since late August, the price of oil has risen 50% as a result of global demand and Middle East turmoil. Interest rates on the US 10-year Treasury bond rose over 100bps from the early October lows and, as described above, the tone and tenor of Central Bank commentary are now more weighted towards the risks of inflation. Finally, it appears that the practical implications of a rising federal deficit ($1.3 trillion) in the US and a renewed emphasis on deficit reduction in Congress (not only the "Tea Party" but across both major parties) will likely slow the growth of both Federal and State/Local spending that has played such a key role in reinforcing the economy to prevent a double-dip recession. This is playing out in state legislatures in Wisconsin and New Jersey, in the President's budget that calls for reductions in discretionary spending, and in the debates this month about extending the debt ceiling to accommodate additional federal deficits. Taken together, these factors pose a complex scenario for our relatively simple and straightforward gutter guard scenario: just as the ball seems to be bouncing off the inflation gutter guard, both Congress and the Fed seem to be removing the left gutter guard. This is of course logical – if we want to fight inflation, we should first stop fueling it. However, it does beg the question – if the contemporaneous removal of extraordinary monetary and fiscal stimulus through the expiration of QE2 and a move to a more balanced budget does in fact slow the economy, will there be sufficient time, will and resources to re-establish a left gutter? Such is the danger of a zero interest rate policy, as it gives you little incremental room to provide incremental stimulus.
As you know, our job and skill set is not to solve complex macroeconomic puzzles or to best forecast the economy, but rather to establish a risk management framework to measure and monitor these potential changes in liquidity and economy in order to guide our overall exposure and risk posture. As we will discuss in our lookback over the past decade, we make our money one industry, one company and one security at a time, and this macroeconomic framework will simply serve to guide us in our efforts to minimize risk and volatility during times of future uncertainty. As such, our eyes are squarely on our core mission, which is to find long equity investments, distressed debt securities, event driven situations and individual equity / debt shorts that provide appropriate risk / rewards and meet our cost of capital requirements. Over the next three to five years, we are confident that our ability to identify good, growing and defensible businesses will yield a portfolio of long investments that compound fundamental value at 15% or greater, and we believe that this "bent knee" effect will allow for modest multiple expansion to drive returns even higher for securities that are purchased at attractive prices. Surrounding that effort, we believe we will be best served establishing our core position around the favorable dynamics of the four legs of the investment stool, but we will be vigilant in reducing exposure should the economic and liquidity legs of the stool show signs of instability in the more immediate term. Obviously, the events at Fukushima are a significant example of an unforeseen event that can have profound impacts on economy and liquidity. Our overall outlook provides a useful framework to put these developments into economic and investing context: 1) Some disruption in first quarter and second quarter earnings for many industries is likely, as supply chains are disrupted in technology, medical devices and automobiles, while spending patterns by both Japanese consumers and corporations are likely to be significantly altered. The magnitude of this disruption is dependent on how quickly and completely authorities can contain the nuclear emergency. 2) In order to stabilize markets, the Bank of Japan is engaging in what effectively is the first QE3, a necessary and appropriate step to promote stability in liquidity and markets. 3) Should the economic disruption caused by these events prove more significant and long-lasting, inflationary pressures would ease and the economic bowling ball would move away from the right, inflationary gutter in the near-term. 4) On a medium-term basis, Japan will need to engage in a significant program to rebuild infrastructure which may add to inflationary pressures. Additionally, should nuclear power broadly be constrained or curtailed, this would increase inflationary pressures on oil, coal and natural gas. In summary, it is likely that this tragedy has the economic effect of pushing the inflationary challenges out in time, but may exacerbate their magnitude. Additionally, economic disruptions are likely to not only reduce global growth but to pressure 1H 2011 earnings growth, which creates a bit more challenging environment for stock picking in the immediate term. As you would expect, we have modestly reduced gross long and net long exposures within our equity book to compensate for this additional uncertainty, though these changes are more modest than one may expect due to our domestic defensive investment orientation. A Ten Year View – Looking Back and Looking Forward It is said that history doesn’t repeat itself, but it rhymes. This is like the Russian Doll of analogies: this analogy says that we will be best able to predict the future by making analogies with the past. As I’ve written about in past letters, my father worked at a horse racetrack and taught me how to handicap horses when I was young. We would examine the past performances of the horses together, looking at their past times and order of finish to try to predict which horse would win the next race. If history repeated itself, handicapping horses would be easy. However, in horse racing, and in investing, a look backwards only tells part of the story. In order to be a skilled handicapper, you need to pay attention to the environment in which the horse was racing (which race track held his past races, and was the track fast and dry or slow and muddy), the quality of the competition (did he beat good or bad horses), the ease of the trip (was there heavy traffic or an unimpeded path) and the quality of the jockey (whose weight is added in certain handicapped races to equalize competition). In betting on horses, the odds are stacked significantly against you: approximately 18% of money wagered is used to support the race track, the horsemen and the government, and the remaining 82% is split among betters based upon their relative skill and luck. I have met several skilled handicappers over time, but none of them has made the Forbes 400 list, and for good reason – in racing, history rhymes much more often than it repeats, and sometimes it doesn’t rhyme all that well.
Instead, these skill sets are much more useful and productive when applied to public markets investing. First, transaction costs are much lower than 18%, meaning alpha generation can fall to the bottom line rather than be eaten up in the process of investing. Second, businesses are more predictable than horses: in general, a good business for the past ten years is likely to remain a good business for the next several years as well. Third, there is much more data to analyze: an average horse will have run ten races in a season, meaning that many times you have less than ten observation points from which to forecast. In fact, one of the most valuable lessons to learn in racing is not to bet Maiden races (horses who have never won), which is the functional equivalent of investing in companies that only have one quarter of operating history. And finally, while in horse racing you may only bet before the start of the race, in investing you may alter your capital allocation at all points during the life of the investment, meaning that an investor can add alpha not only at the inception of an investment but on a continuous basis. As we complete our tenth lap around the track as a firm, we thought it would be a useful exercise to look back on the ways in which we’ve generated positive investment returns and positive alpha, so that we may be best prepared to further capitalize on these conditions as history rhymes in the coming year and years. In doing so, we identified a number of scenarios in which we have a repeatable process to generate excess returns. Some of them, such as purchasing levered equity stubs into an economic and liquidity recovery, are not relevant to today’s portfolio. However, the majority of these scenarios are persistent in nature and present in our current portfolio, with ten such examples set forth below:
INVESTMENT CATEGORY Growth on Growth Where There's Mystery, There's Margin Law of Accelerating Marginal Returns Wash, Rinse, Relever (Operate, Generate, Allocate) Time Arbitrage - Getting Paid To Wait The Power of Persuasion Tax Arbitrage - The Tax Man Go-eth to Switzerland When Merger is N'Sync, Baby Buy Buy Buy Capex Behind You, Growth In Front of You Breaking Up Is Hard To Do, But Worth It PREVIOUS EXAMPLE Pill in '06 / Pills in '14 PBMs / HMOs Fisher Scientific (TMO) / Express Crown Castle / DIRECTV 3G / Power Plants / Baby boomers Siebel Systems / TakeTwo Canadian Income Trusts / Weyerhaeuser Thermo Fisher Scientific / Xerox 3G wireless / Independent Power Plants WellPoint CURRENT EXAMPLE McKesson HMOs Laboratory Corp Viacom Goodrich Expedia Tyco Aon Clearwire Pfizer
Growth on Growth: McKesson (MCK: $78) I’m 5 feet 10 inches tall. I always wanted to be 6 feet tall, and at 41 years old I realize this isn’t going to happen for me. There’s nothing wrong with 5’ 10” – it is just human nature to wish for a little bit more. Drug distribution is a good business. It generally grows top line about mid-single digits and earnings and value per share at a low to mid-teens rate after margin expansion and the productive use of free cash flow. There’s nothing wrong with that at all – over the long-term such a rate of return will be greater than average. In 2004, we identified two factors that would serve to accelerate growth of the entire drug distribution industry and all pharmaceutical services companies, both beginning in 2006. First, volumes would accelerate with the introduction of Medicare Part D, which provided seniors in the US with government funded pharmaceutical insurance coverage for the first time. We believed this would add 2-3% per year to volumes over the first few years of introduction as seniors could meet future medical needs with affordable, or no cost to them, medications. Second, the generics cycle began in earnest in 2006-2009, whereby the generics conversion rate tripled versus the baseline in the first half of the decade, creating incremental profit streams for distributors and others by leveraging competing suppliers to gain superior economics. This was our “Pills in 06” theme, which provided nearly five years of investment opportunities. In the case of Pharmaceutical Services, history may in fact repeat itself. In the coming three years, the industry will benefit both from a second wave of generics, as shown in the following chart, as well as a volume uplift driven by federal healthcare policy, this time in 2014 driven by the universal healthcare coverage aspects of the recent healthcare reform legislation.
Patent Expirations: Values Apply to Year of Launch
40 35 30 Sales Value ($B) 25 $21 20 $15 15 $10 10 $6 5 0 '01 '05 '06 '07 '08 '09 '10 Timeframe '11 '12 '13 '14 '15 $14 $14 $13 $19 $15 $38
Presently, 52 million Americans are without healthcare coverage, meaning they receive triage care in hospitals but are not compensated for annual wellness visits, and therefore are unlikely to be prescribed medications such as antibiotics and statins for non-emergency situations. As health insurance will be mandated beginning in 2014, those with access to healthcare at no additional cost will use it, and therefore we are likely to see an uplift in prescription volumes once again. Furthermore, there are significant incentives to drive e-prescribing from 20% to 85% over the coming five years, which will improve fill rates and also increase volumes over the period. As such, we are again likely to experience growth on growth. For these reasons, and as we shared with you at our Investor Day, we continue to be very positive on the shares of McKesson, which continues to be our largest investment position despite its appreciation over the past year. In addition to its growth on growth characteristics described above, McKesson literally has everything we like in an investment: i) ii) iii) iv) They operate in an industry where the largest three participants have a 92% market share with significant barriers to entry and rational management teams at each firm. The stock is exceedingly cheap, trading at 12.5x and approximately 10x our calendar 2011/2012 earnings estimates for a sustainable mid-teens grower and a medium term 20%+ earnings grower. The growth drivers are acyclical – as a domestic defensive, they will be less vulnerable to sudden changes in the global economy. They are significantly overcapitalized, with dry powder equivalent to approximately $5 billion, 25% of its current market capitalization. Importantly, management deployed nearly $5 billion in acquisitions and share repurchase in 2010, demonstrating management’s commitment to move capital structure towards its target in a prudent and methodical fashion. Management is excellent, both operationally and as conservative stewards of capital (of course we would prefer that they were less conservative, but we respect the culture).
These positive investment dynamics are shared across the other “Big 3” pharmaceutical distribution players with minor nuances, and as such we have broadened our holdings to include both Cardinal Health (CAH: $40) and AmerisourceBergen (ABC: $37) as well. Where There’s Mystery, There’s Margin: Managed Care The mutual fund industry has underperformed its benchmarks for thirty years, and despite this performance it is approaching $12 trillion in AUM (about half in US equities). In aggregate, the underperformance is not difficult to understand: an industry that big has to return the market on average, minus fees and transaction costs. While there were, of course, exceptional performers within the industry, capital would flood to such winners, who were incented
only on assets under management rather than returns, and as such they would accept endless supplies of capital which, in turn, would eliminate their ability to outperform. However, to their customers, the individual investor, security selection was a mystery, and as such customers paid high prices for structurally deficient performance. While in the case of mutual funds, mystery turned a sub-par service into a highly profitable industry, it is more common that mystery can simply improve the return on capital and pricing within a useful and valuable industry. Such was the case with Pharmaceutical Benefit Managers (PBMs) as we first invested in them in late 2001. PBMs provide a valuable service to their clients: they aggregate buying power to reduce pharmaceutical acquisition costs, they create programs to influence consumption patterns to promote the lowest cost therapies within medically equivalent categories, and they promote the efficient dispensing of larger quantities of chronic medicines through lower cost direct mail, bypassing the high cost retail pharmacy channel. Each of these services creates value for clients, and the ability to deliver such savings is dependent on the scale and sophistication of the PBM. Importantly, PBMs achieved savings by reducing the mystery of key vendors and service providers. For example, by creating classes of medically equivalent branded pharmaceuticals, they were able to demystify the differences between statins and, in most cases, to render them commodities whereby the lowest price would drive the highest share. In this manner, PBMs demystified the marketing schemes of large pharma and the distribution stronghold of retail pharmacy, thereby eliminating this downstream margin and delivering savings to customers. It is logical that the PBM industry has consolidated around three large successful enterprises: CVS Caremark, Express Scripts and Medco, and it stands to reason that each should be able to achieve attractive growth, margins and returns on capital. While most can agree that PBMs provide a valuable service that should command fair compensation, we believe the returns on capital, pricing and margins are higher because the exact mechanisms to generate such profit streams are a bit of a mystery to clients. While many investors predicted the demise of the PBM industry because of its lack of transparency, we felt that this mystery was actually a positive investment attribute that would continue to drive and sustain high levels of margin, growth and return on capital. Importantly, through only a few key computations – profitability of a prescription at retail and mail, as a brand or as a generic – one could generate and refine very accurate forward earnings models that removed the mystery from financial analysis of PBMs. Throughout the decade, PBMs would be one of our larger sources of recurring investment returns and remain so today. In today’s portfolio, we believe that HMOs are in a very similar position to their PBM counterparts a decade ago. First, HMOs provide a valuable and in fact indispensable service: they purchase healthcare services in bulk for heavily discounted prices, and they influence consumer behavior to step therapies that seek to responsibly manage cost and waste in addressing health issues in an economically responsible manner. Because of the tri-party nature of healthcare, where payor and customer separately interact with provider, there is always some distrust and dissatisfaction between parties, but having a well-incented intermediary manage costs for the payor in an ethical but economical manner is a necessary and in fact efficient industry structure. Like a PBM, the HMO’s first task is to demystify a complex treatment and to standardize and commoditize it for the purposes of comparison shopping and volume purchasing. While accessing price transparency for various medical procedures is nearly impossible for the individual, health insurers are well versed in the cost / quality tradeoffs for similar services performed by various vendors within a specified geography. The hospital business used to be more profitable before HMOs. The value of the savings they achieve is multiple times that of the fees they charge. For example, total HMO net income for the industry is approximately $10 billion, while total medical spend is approximately $2.4 trillion. While managed care can reduce costs by up to approximately 20%, its profitability is only 0.5% of the pie. Given the value of this service, it also stands to reason that each should be able to achieve attractive growth, margins and returns on capital, the level of which is influenced by the mystery surrounding the industry. Because of the complexity of healthcare plans, with various levels of deductibles, co-pays and breadth of network choice, it is exceedingly difficult to comparison shop HMOs from a customer’s perspective. In fact, regulatory authorities have had challenges assessing and evaluating fair levels of profitability within the industry, and as such passed an industry tax as well as gross margin caps (known as MLR floors) to try to ensure that HMOs do not receive excess returns on capital. Faced with the complexity of the analysis, investors followed the tone and tenor of regulatory commentary rather than the true costs of the regulatory construct, and sold HMOs down to valuation
levels that imply perpetually declining profit streams (6-8x earnings per share and free cash flow). A more reasoned study of the industry would conclude favorably for the sustainability and growth of industry profits: i) The industry tax, which will be charged to both profit and non-profit HMOs alike, should be largely passed along in the form of higher prices to consumers, much the way higher oil prices would be ultimately conveyed to airline or cruise customers. Because medical insurance is a necessity and not a luxury, customers will have no choice but to pay the higher premiums, which will need to be charged by all competitors. The profitability caps are highly technical in nature, but we believe are quantifiable and are fully reflected as a headwind to 2011 earnings. From this lower base, the industry is poised to resume its normal growth pattern. While there were members of the healthcare reform movement who advocated a single payor system that would obviate the need for private health insurers, there was a clear bi-partisan preference for a system of choice that included and in fact relied upon healthy, well-incented private HMOs. As a rational oligopoly within local markets, over the past few decades the industry has maintained premium pricing consistent with expected growth in cost trend, allowing for margin expansion based upon leverage of administrative costs as well as organic and inorganic growth in members. This behavior continues post reform, which will secure and promote healthy growth in HMO profitability. Scale continues to be a significant asset, which will promote accretive consolidation within the industry in a manner that benefits payors and customers at the expense of providers. So long as valuations remain exceedingly low, HMOs can augment revenue growth and operating leverage with significant earnings growth driven by capital deployment, as share repurchase and horizontal integration opportunities are each highly accretive at today’s low valuations. In addition, there is a growth on growth element to HMOs, whereby the additional customers in 2014 that are mandated to purchase health insurance will create a stream of membership growth above and beyond the normal revenue and earnings waterfall, while at the same time many smaller HMOs may cede share or dissolve as they lack the scale to compete profitably under the new MLR caps. Finally, after years of fighting through both cyclical membership headwinds due to rising unemployment and investment income headwinds, the industry appears poised to accelerate membership growth commensurate with a rebuilding of overall employment levels and to benefit from interest rates returning to levels closer to historical averages.
We presently have meaningful positions in Aetna (AET: $35), WellPoint (WLP: $67) Cigna (CI: $42) and United Healthcare (UNH: $43). Set forth below are the multiples of earnings and earnings growth for each player, and the unique value drivers in each case. While presently Aetna is our favorite of the group because of the combination of low valuation and strong earnings growth, our positions will likely be dynamic with respect to catalysts such as asset sales and excess capital deployment:
P/E Aetna WellPoint Cigna United Healthcare 2011 9.2x 9.9x 8.4x 11.5x 2012 7.8x 8.5x 7.3x 10.1x Earnings Growth 2011 2012 4% 17% 0% 16% 4% 15% -9% 13% Comments Growth accelerated by synergies from PBM JV Growth accelerated by elimination of CA losses Possible accretive divestiture of PBM Possible accretive divestiture of PBM
Using an average earnings growth of 15% over the period and a restoration of 12-13x P/E multiples by 2014, we expect the group to generate compound investment returns of approximately 33% annually over the coming three years. Law of Accelerating Marginal Returns: Laboratory Corporation (LH: $88) As a student in business school twenty years ago, we learned about the Law of Diminishing Marginal Returns, an economic concept whereby an incremental investment in people, plant or process will yield lower gains than past investments that were prioritized first and therefore generated the highest returns. Like the majority of things learned in school, the “Law” is often, but not always, true. From an investment standpoint, it would be wonderful to harness companies that exhibited a Law of Accelerating Marginal Returns, whereby incremental investments were of accelerating value because they could also add incremental returns to past investments. Take for example
Western Union, the largest point to point wire transfer service in the world. When they opened their second store, they offered one product: wiring money to the first store. When they opened their 101st store, they offered 100 products – wiring money to 100 different locations. By opening the 101st store, you not only received the base value of opening that location, but you improved the breadth of service, and therefore revenue opportunity, for every other store, which could now offer money transfer to this new location. Such is the network effect, the quintessential example of the Law of Accelerating Marginal Returns. While the Western Union example shows increasing returns from organic expansion, more often we find situations that offer excess returns on capital through adjacent or tuck-in acquisitions. For example, in 2003, Fisher Scientific began a five year journey to increase the percentage of self manufactured products from 20% to 40% of their revenues. These incremental, tuck-in acquisitions generated higher returns on capital than prior investments, because they could harness the power of the distribution network to immediately accelerate sales of an acquired manufactured products company. Other situations like Express Scripts since 2001 offered such network effects based upon the scale curve. Express made five acquisitions over the past eight years that significantly increased their purchasing scale, and each time they increased their scale and lowered their purchasing costs, they increased their competitive position and value-add to all of their clients, not just the acquired ones, which served to accelerate a PBM’s version of same store sales growth. We proactively seek out opportunities to invest in platforms that are being valued at a discount to today’s economics while offering the prospects of high returns on marginal capital through accretive acquisition. During the quarter we initiated a meaningful position in Laboratory Corporation of America (LH), one of two large national networks for medical laboratory tests in the US, based upon the following factors: i) The base business of lab testing produces a reasonably attractive and defensive economic waterfall: low to mid-single digit revenue growth driven by modest growth in both volume and price leads to mid-high single digit operating growth and low-teens earnings per share growth after capital deployment. Small acquisitions add to local market share and increase sample collection route density that accelerate overall returns on capital and reduce their cost position over time. Larger platform acquisitions can add geographic density, provide additional esoteric testing that can be rolled out across all locations and add meaningful volume to leverage existing testing centers with excess capacity. a) LabCorp’s purchase of the testing business of Genzyme will be meaningfully earnings and value accretive beginning in 2012. b) Additionally, LabCorp recently received anti-trust approval to complete their accretive acquisition of Westcliffe Medical Labs, so they will also benefit from this earnings accretion beginning later this year. While LabCorp and Quest Diagnostics represent two-thirds of the independent testing market, the vast majority of the industry is still held as high-cost captive operations of hospital groups, providing a large opportunity for future growth through both acquisition and a superior competitive position. Our investment is timed to capture the bottom of the economic cycle as it relates to testing, as we believe doctor visitations troughed in the third quarter of 2010. LH also fits the growth on growth bucket as the individual mandate in 2014 will accelerate doctor visits and procedures for those currently uninsured, pumping more testing volume through existing testing infrastructure. At a valuation of 11.5x 2012 cash earnings (earnings excluding goodwill amortization) we believe there is significant room for both earnings growth and multiple expansion over the intermediate term.
Wash, Rinse, Relever (Operate, Generate, Allocate): Viacom (VIA/B: $45) Shampoo bottles come with directions: wash, rinse, repeat. I do not know who purchases shampoo but doesn’t know how to use it, and I do not know anyone who washes their hair twice, although I can understand why the shampoo company would like you to. At least the disclosure was concise, and it got us thinking of a concise summary of the job of management: operate, generate and allocate.
Like most investors, we prefer to invest in well run companies that are highly cash generative that use their financial resources wisely to allocate such cash towards its highest and best use. As simple as it sounds, in practice it is exceedingly difficult to find all three, but the combination in general yields highly successful investment results. In the past, we’ve been fortunate to own shares in companies whose capital allocation policy was exceedingly clear: Crown Castle International (CCI) and DirecTV (DTV). In each case, management set out a target leverage ratio, and viewed both annual free cash flow and incremental borrowing capacity based upon incremental EBITDA growth as sources of liquidity for offensive purposes. When combined with the positive operating and cash generative characteristics of both businesses, it is logical that each stock meaningfully outperformed over the medium term. In 2005, CCI management provided what we believe is the best description of responsible capital allocation over the decade in the following passages: John Kelly, CEO, 4/29/05 “While you hear some describe share buy back as a return of capital to shareholders, we consider the purchase of our shares as an investment in our own towers for the benefit of those shareholders that remain. Roughly speaking, over the last nine months, we've removed approximately 10% of our shares outstanding, thus spreading the longterm value of our business across the 90% of those shares that remain. We provided you the input that's necessary to evaluate this investment in our own assets, including our belief of prospective U.S. leasing demand, which we have discussed on numerous occasions including at our Analyst Day last April. We used this very same information to confidently invest in our own assets through share repurchases.” Ben Moreland, CFO 8/3/05 “To that point, based on this year's outlook, we expect to grow adjusted EBITDA or cash flow, approximately $40 million and we have the ability to borrow under the new credit facility roughly six times that growth or $240 million, as we've discussed in prior calls, as was our expectation. Which we – which we would expect to invest alongside the recurring cash flow of approximately $200 million today, a run rate of about $50 million a quarter. We expect that as long as the business continues to grow by approximately $40 million per year, we'll be investing more than $400 million in our business annually. This means we anticipate investing on a discretionary basis, roughly $100 million per quarter, to buy stock, acquire towers, or build towers, all at the expectation of maximizing recurring cash flow per share. It is through this combination of growth on our existing assets, plus the investment in new towers and/or the shrinking of our common shares outstanding, that we believe we will be able to achieve our stated objective of growing free cash flow per share by 20% to 25% for the foreseeable future…Until we have a cost of equity that we believe reflects the predictable nature of the cash flow and the expected growth rate, or we alter our belief in that growth rate, we believe our shares will continue to be an attractive investment vehicle for the Company.” Share repurchases executed on the date of CEO John Kelly’s speech generated a 19% annualized return on investment through the end of the decade, far exceeding the 1% return of the S&P 500 over the period. We initiated a position in Viacom in 2010 based upon the same triumvirate of investment positives, with incremental clarity and confidence in both operations and capital allocation. The business is primarily a cable/satellite network franchise, which generates two-thirds of revenue but over 90% of the profitability of the company. We like the stability and growth of cable networks based upon the growing and recurring nature of affiliate fees, and we are in the recovery phase of ad spending coming off of the 08/09 recessionary pullback. Specific to Viacom’s assets, they are in the midst of a ratings upswing, principally at MTV Networks, which has allowed them to begin to spiral up as increased viewership of Jersey Shore provides viewing momentum to adjacent programming. As always, the business remains highly cash generative with free cash flow equal to approximately 110% of net income. As importantly, at the time of our investment, Viacom was approaching its target leverage ratio of 2x adjusted debt to trailing EBITDA and had just 13% of its outstanding debt maturing before 2014. Though management had a history of active stock repurchase – almost $4.5 billion in the two years following its separation from what is now CBS – Viacom, like most companies during the credit crisis, had stopped buying its stock in the fourth quarter of 2008. Five quarters later, we saw Viacom with a high class problem: a balance sheet almost repaired to target ratios – a milestone it shortly thereafter attained – no material maturities to speak of, and prodigious, predictable annual cash flow representing on the order of 10% of its market value. Viacom began to allocate appropriately through
both share repurchase and dividends, with a 20% share repurchase authorization over a two year period. As importantly, as EBITDA accelerates from the fundamental recovery in the business, every dollar of EBITDA growth adds two dollars of debt capacity, which we believe adds an additional 2-3% to annual repurchase capacity and sustainable growth. While the stock is 50% higher than our entry-point of one year ago, we believe Viacom remains compelling at 11x earnings and 10x recurring free cash flow. Time Arbitrage – Getting Paid to Wait: Goodrich (GR: $84) Investing is different than gymnastics, figure skating or competitive diving. In those sports, your scores are not only based upon the mastery of your routine, but you are incrementally rewarded for adding risk to your performance, as you receive degree of difficulty points that add to your total. In the investment world, the returns are what matters, and you don’t get any bonus points for having taken on more risk along the way. As such, we are all in search of the lowest risk situations at any point on the return spectrum. Perhaps the lowest risk prediction an investor can make is that one year from now, one year shall pass. This seems obvious and useless, but we are astounded by the number of opportunities presented by time arbitrage, the gap between what people are willing to pay for events that are certain or nearly certain, but some time out in the future. Time arbitrage has helped us on the short side in various situations: shorting stocks whose profits are driven by only three more years of patent exclusivity, only two more years of below market oil hedges or only one more year of an unusually low tax rate due to prior NOLs. On the long side, many of our healthcare investments harnessed demographic trends and regulatory outcomes that were a certainty with the passage of time. Additionally, purchasing hard assets like power plants and cell phone towers in the 2002 distressed cycle simply required some patience so that time could pass, allowing demand to grow into fixed supply. While we are reluctant to invest in deeply cyclical industries due to their inherent volatility and our inability to predict forward economies with confidence, we do try to find niche industries within the industrial landscape that serve a basic need and whose economics are driven by service, repair and maintenance streams of existing property plant and equipment. While forecasting future demand is challenging, it is safe to say that one year from now, the existing fleet of cars, trucks or planes will, in fact, be one year older, all else constant. During the year, we established a position in the shares of Goodrich, a provider of engine components and aftermarket support for the aerospace industry. They have a leading position selling highly customized engine encasements to Boeing and Airbus, which is followed by a growing annuity of high margin replacement parts sales over the course of the 20 year life. Regularly scheduled maintenance is mandated by governments globally and GR’s products cannot be swapped out for a competitor’s. Further, this annuity accelerates as a plane gets older and requires an increasing intensity of replacement parts and service. As you can imagine, the market for new aircraft is cyclical and lumpy, with boom / bust periods of approximately seven years. The last major capital deployment in global aircraft began in the mid 2000s. This build cycle brought down the average age of GR’s installed base, and in the economic downturn two years ago, GR had headwinds from both new equipment sales and also a fleet getting younger, which put downward pressure on aftermarket mix. Specific to engine encasements, mandatory maintenance occurs after approximately seven to ten years, meaning that we now are entering the echo effect of the mid 2000s capex acceleration. As we are 100% confident that these planes will get older, this provides a secular tailwind for GR revenue and profits. When combined with the longterm 5% growth in global plane capacity and the likelihood of an acceleration in capacity in the intermediate term, Goodrich is likely to go from dual headwinds to dual tailwinds from 2009 through 2014, with the aftermarket tailwind of high certainty. Our long-cycle earnings waterfall is 17% annual growth for Goodrich, driven by 5% global capacity growth, 3% additional Goodrich content per plane, margin expansion from positive aftermarket mix and productive deployment of free cash flow. Over the coming years, we expect several of these factors to be above average, with a resumption in fleet growth, the aftermarket echo effect described above, and a relevering of the balance sheet from presently 0.7x towards their long-term target of 2.5x debt / EBITDA. At 12x 2012 earnings, we believe that Goodrich’s earnings acceleration is worth waiting for.
The Power of Persuasion: Expedia (EXPE: $22) Operate, generate and allocate is a useful framework to evaluate an investment opportunity, but it is not a mandatory condition for an investment to make sense. In general, the ability of a business to generate cash reflects the quality of the business and the attractiveness of the industry – if we can not see a path forward to adequate cash generation, then the business does in fact become uninvestable to us. However, with issues such as operating efficiency and optimal capital allocation, these factors are controlled by managements, accountable to boards, who in turn are ultimately accountable to shareholders. As such, it is possible in certain circumstances for owners to influence and improve upon operating and capital allocation decisions, through investor activism or through more moderate powers of persuasion. We refer to our brand of constructive ownership as “suggestivism”, in which we will assume a confidential and respectful role in positively influencing board decisions, or at times board composition. We have been active suggestivists over the years, and the intensity of our efforts is of course determined by the magnitude of the opportunity and the willingness of management teams and boards to engage in reasonable debate. The best return on capital and return on time situations are ones in which companies truly are open minded to the discussion and move quickly and decisively towards decisions that create shareholder value. Other successes are harder to achieve, such as the sale of Seibel Systems in 2005 or the change in management in Take-Two Interactive in 2007, but are nonetheless very rewarding as well. Of course, we have run into situations where management and the board are as well entrenched as they are inept, which renders shareholders virtually powerless to protect their investment from harm – such was the case with Reliant Resources in early 2006 when we decided to divest our 9.9% interest in the company. We have been repeatedly asked if we will take on a fully activist position in a company, and after ten years, we still have not had to. Ultimately, we will protect our investors’ capital, and will take on whatever challenges this entails should the value gap be sufficiently extreme. In today’s portfolio, there are many examples of trapped value and less than optimal capital structure, although most conversations are mutually respectful and productive at this point. During the year, we highlighted the overcapitalization at BMC, and we believe management and the board have a medium term strategy to deploy such resources in a rational fashion. We have written in the past that we believe Punch Taverns has opportunities to improve its corporate structure, and we have been working closely and cooperatively with Punch to position the company for future value creation. Finally, we are always on the lookout for newly created trapped value situations where the odds are high that the management and boards are logical capitalists and would most likely take reasonable steps to improve shareholder value. Such is the case presently with Expedia, the largest online travel agent in the world, with 40% of its revenue coming outside the US. We like the base business of Expedia for all the customary reasons: i) ii) iii) iv) Healthy organic revenue and profit growth; Recurring revenue streams with repeat customers and strong brand recognition; Highly cash generative, with free cash flow exceeding net income; and Modest cyclicality with an ability to maintain profitability in a downturn.
However, we like the stock more than the business due to the compelling confluence of several factors that have rendered Expedia shares significantly undervalued at the same time as corporate flexibility is increasing: Expedia shares are down 14% year to date based upon disappointing 2011 guidance that implied significant investment spending in the coming one to two years. While revenue will grow mid-teens, operating profit will only grow at a mid-single digit rate, disappointing investors and sending shares plummeting. We purchased the majority of our position following this decline in share price. b) Expedia is extremely cash generative, began 2010 from an overcapitalized position, and also completed a $750 million long-term bond deal during the third quarter. In combination, Expedia is now significantly overcapitalized with dry powder of $1.6 billion to $2.2 billion, or approximately 30% of the company. a)
Their TripAdvisor business is growing rapidly but may benefit from faster growth post 2011 as an independent company, generating additional ad growth from other non-Expedia online travel sites. We believe the sum of the parts of Expedia is well in excess of a 50% premium to current trading prices. d) Management and the board have acted before, making significant share repurchases at meaningfully higher valuations. We believe they will likely improve upon past history by adding to repurchase activity, but at meaningfully more attractive prices. The stock is exceedingly cheap, trading at 8x forward recurring free cash flow and 6x backing out the TripAdvisor stake. We believe that shareholders, management and the board are likely highly aligned to capitalize on opportunities to create value at Expedia. Tax Arbitrage – The Tax Man Go-eth to Switzerland (TYC: $44) The tax code in the US, and globally, is exceedingly complex and at times defies logic. In a letter of this length, we believe it goes beyond our mandate to preach tax policy to government authorities – instead, our job is to allocate capital to its highest risk adjusted return opportunities, and those companies who pay lower taxes convert pretax income to shareholder returns at a higher rate. In 1997, Tyco announced a business combination with ADT, then a Bermuda based corporation, and the acquisition was structured as ADT purchasing Tyco to preserve the Bermuda tax structure. For the next five years, Tyco management used this advantageous tax structure, in which cash taxes were reduced from the normal 35% corporate rate down to approximately 10% on a cash basis, to acquire a multitude of properties in their various lines of business. It seemed like every acquisition was accretive, and it was: a business earning $100 million of pretax income and $65 million of after tax income would immediately generate $90 million of after tax cash flow under Tyco’s umbrella, a near 40% increase. With these tax synergies in their pocket, Tyco had a better mousetrap. Of course, the right weapon in the wrong hands is exceedingly dangerous, and ultimately Tyco became embroiled in controversy with its executives jailed for improperly using corporate restructuring dollars for personal use, among other allegations. Markets lost confidence in Tyco, wholesale funding for its CIT subsidiary disappeared, they were forced to exit the business on a fire sale basis, their communications business hit a cyclical peak, and the stock unraveled. The 2002 decline in Tyco was our largest loss of the decade. Very quietly over the past seven years, Ed Breen and a new management team at Tyco have been dealing with the aftermath and creating quite an attractive company, and return for shareholders. Tyco rationalized its business portfolio, spun off Covidien in 2007, revitalized its balance sheet, improved its operating focus and re-domiciled the company in Switzerland to solidify the sustainability of its low corporate tax rate. Fourteen years after the initial ADT conversion, Tyco is recording a GAAP tax rate of 18% with opportunities to drive it still lower. With the right weapon in the right hands, at the right point in the business cycle and at the right price, Tyco shares are exceedingly attractive: i) ii) iii) Tyco has sustainable leadership positions in each of its remaining franchises: security, fire protection and valves for process industries. After years of investments, Tyco has truly integrated the operating platforms of each business and is no longer a holding company for disparate, separately managed acquired businesses. Revenue growth should accelerate in 2H 2011, driven by a resumption of growth in commercial construction, with a further kicker in the next two to three years if residential construction returns towards normal levels. We estimate margin expansion of 320bps cumulatively over the next three years (from approximately 10% to 13%) will add approximately 10% to annual EBIT growth above and beyond both revenue growth and acquisition synergies. This significant margin improvement is driven by volume leverage, scale, the reduction of corporate spending and specific productivity initiatives. Earnings growth should be further enhanced by the realization of synergies from several recently announced tuck-in acquisitions, most notably that of Broadview (formerly Brinks Home Security).
vi) Tyco is presently overcapitalized at 0.8x net debt to EBITDA versus a more reasonable target of at least 1.5 turns. Free cash flow plus debt capacity over the next six quarters generates $4 billion of dry powder, representing 18% of the current market cap. vii) They still have a better mousetrap, making every future acquisition potentially more accretive simply through the arbitrage of a lower tax rate. With three well run operating platforms and excess cash generation and debt capacity, they have the right car, and plenty of fuel and skilled drivers, which should allow them to race faster than the pack. At 11x our 2012 earnings estimate, we believe Tyco shares will appreciate meaningfully over the medium term, driven by continued earnings growth and modest multiple expansion. When Merger is N’Sync, Baby Buy Buy Buy: Aon Corporation (AON: $52) There are certain rules of thumb in investing that are so accurate it is scary. For example, any company going through an SAP conversion should be shorted as they will miss earnings at least one quarter due to the lack of financial reporting during the transition (this is less true today but was hyper-accurate five years ago). Another rule of thumb suggests that unexpected acquisitions are exceedingly negative for the acquirer. While this is possible, and perhaps even probable, the exceptions to the rule have proven both researchable and highly profitable. A few examples include Thermo’s acquisition of Fisher Scientific and Xerox’s purchase of ACS. In our second quarter letter, we highlighted our significant position in Aon Corporation whose stock came under significant pressure upon announcing that they would acquire Hewitt Associates in a half stock, half cash transaction. The selling pressure on Aon was both technical (arb pressure) and fundamental (disappointed investors who were confused by the acquisition). While our initial reaction was to wonder why Aon didn’t simply sell their consulting business to Hewitt, upon further diligence we came to understand and appreciate the benefits of the transaction. In our write-up, we suggested that there were several reasons to believe that Aon/Hewitt would prove to be the exception to the rule, and the early evidence suggests this to be the case: i) ii) iii) Core Aon is healthy, well managed, and has potential for continued margin expansion. This was confirmed with the above consensus results delivered in the fourth quarter. Hewitt’s business was also healthy and was not sold at an operating peak. In fact, our primary research checks indicate that demand for Hewitt services is quite firm, particularly in the healthcare vertical. The combined business is overcapitalized and offers potential for accretive deployment of excess cash. Management is wasting no time, as they repurchased $150 million of stock shortly after the deal closed in October, and we expect them to repurchase and additional $550 million in 2011. Organic growth is poised to accelerate based upon a hardening of the insurance market, modest economic growth and improved float income as interest rates rise. Organic revenues were stronger than expected in the December quarter, and the insurance market is likely to harden near-term due to the Japanese earthquakes and tsunami. Finally, time will pass and investors will increasingly focus on 2012 earnings power. We expect the company may adopt a cash earnings metric to highlight earnings excluding acquisition amortization, and on that metric, we expect Aon to earn approximately $5 in 2012 which should command a 13-15x multiple, or 25-45% upside from here.
We applaud management’s commitment to communication with both clients and shareholders through this period and believe that the company’s credibility will continue to expand should the integration proceed as planned. Capex Behind You, Growth In Front of You: Clearwire (CLWR: $5) During times of liquidity and market stress, investors tend to significantly shorten their investment duration, and most times to simply look straight down. As such, stocks and bonds in industries that have wonderful long-term prospects but little near-term support are often abandoned. However, while current free cash flow and earnings are normally highly instructive and correlated with future cash flow and earnings streams, there are often times when
the investment phase is behind you, the harvest is in front of you, and if you look straight down you see very little return on investment at that point in time. Such was the case in 2002, when investors abandoned securities in power plants at 10 cents on the dollar of replacement costs, as well as securities in cell phone towers and rural cellular networks where the 3G investments had been made but the 3G revenue streams were yet to materialize. However, while such scenarios do not look attractive as measured on a short investment duration, a two to five year investment horizon yields a much different outlook. In these circumstances, it is precisely the best time to invest – when the capital spending is behind you, and the return on investment is in the intermediate future. We currently own common equity and debt in Clearwire Corporation (“Clearwire”), which owns 45 billion MHz of wireless spectrum and operates the nation’s first true 4G wireless network. To date, Clearwire has invested approximately $20 billion5 in buying spectrum and funding the buildout of its wireless network to its current coverage of 120 MHz pops. Its present enterprise value is $12 billion, meaning you are creating the firm for 60% of invested capital. Importantly, we believe replacement cost is significantly greater than $20 billion given the scarcity of the spectrum assets and the time value of money. Similar to 3G networks in 2007/08, we are at another inflection point in the wireless industry today. From 2007 to 2010, mobile data growth increased 13 times, primarily as increased iPhone and smartphone usage drove pronounced increases in data consumption. Over the next four years, mobile traffic growth is expected to increase 40 times, driven by increased video usage and data plans on PCs/tablets/smartphones. While a portion of that increase can be absorbed on existing spectrum from a combination of increased transmission efficiency and tower investment, ultimately wireless carriers require additional spectrum. The appeal of Clearwire is therefore simple; Clearwire has aggregated an unmatched amount and a sufficient quality of spectrum to be a viable 4G offering for a wireless carrier. An investor in Clearwire today receives the benefit of tens of billions in invested or contributed capital with clear demand drivers in the next three to five years to utilize the assets created by that investment. That scarce asset, combined with predictable demand drivers, makes Clearwire attractive in and of itself, but you are also creating the spectrum asset through the equity at $0.21cents per MHz pop. Compared to where spectrum assets have traded historically, we think that asset valuation provides a floor for the ultimate value of the stock. Interestingly, our own thesis of monetizing capital investment in the past with future growth sets up well given Clearwire’s unique corporate situation. It is 84% owned by strategic investors, primarily by Sprint, with the remainder held by the public. In the next month, we expect successful resolution of a wholesale pricing dispute between Clearwire and Sprint, which we expect to be the first in a series of dominos to fall. Once complete, we anticipate Sprint and/or other strategic investors will eventually invest additional capital to accelerate Clearwire’s network build from its current 120 million MHz pops to target coverage of 220 million MHz pops. Given Clearwire’s importance to Sprint as its 4G solution, we also believe it is possible that at some point in the next 18-24 months that Sprint may buyout the minority public float of Clearwire so as to own and control the entire enterprise. Given the turning point whereby Clearwire becomes EBITDA positive in the next 18 months, assuming current growth plans, consolidation is no longer optically onerous for Sprint. Finally, the recently announced acquisition of T-Mobile by AT&T, which will need to undergo a long and potentially challenging anti-trust review, has significant implications for Clearwire. If the deal goes through, we believe it is more likely that Sprint will move to buy-in the minority. If the deal is rejected on antitrust grounds, Clearwire will become the only alternative for T-Mobile to get to 4G in 2012. So simply put, we like Clearwire because: a) there is significant downside support from asset value, b) the investment to build those assets is substantially behind them, and c) the wireless industry is at an inflection point in terms of demand for these assets. Directionally, we believe we are playing for 25-30% annualized returns in Clearwire. This could happen with a buy-in at asset value over the medium term by Sprint, or through full deployment of the network and achievement of meaningful EBITDA and earnings growth. Looking five years out to 2016, we expect Clearwire could generate as much as $3.4 billion of EBITDA, which should command a 7x multiple, yielding a target enterprise value of $24
billion, and an out-year target equity value of $17 per share resulting in a 28% CAGR over the next five years. While the operational and execution risk inherent in Clearwire is elevated versus our traditional GARP investments, we believe the return profile adequately compensates for that risk and that a modestly sized position in Clearwire equity represents an attractive risk reward.
Breaking Up Is Hard To Do, But Worth It: Pfizer (PFE: $20) Our mission statement upon which we founded Glenview was as follows: to make highly attractive absolute annual returns, regardless of the market environment. We fell short of our mission in two of our ten years, but having our mission spelled out clearly has helped us focus on our objectives with clarity and purpose. Public companies serve many constituents, and there are many complexities in balancing the various operational, financial and social objectives that companies pursue. As a private enterprise, the mission should be centered on generating a highly attractive return on capital for its owners. Often, with the best of intentions, the mission becomes more centered on business purpose, size, scale and impact. In the branded pharmaceuticals space, most management teams and boards believe that their mission is to leverage the resources of the company to fund innovation to improve health outcomes and to grow the company. Neither of these is an unworthy goal, but, at times, each detracts from the company's financial obligations to its owners as public companies to deploy capital in its highest and best use. When you ask a pharma CFO to compute their return on capital from R&D, they will generally answer that in the pharma business you either invest or shrink, and shrinking is not an option. New management is often a catalyst to refocus the mission and redefine the business portfolio to orient the company around disciplined financial objectives of per share value growth and return on capital invested. Such was the case in WellPoint, where they sacrificed their position as a healthcare conglomerate and instead created better shareholder value and delivered superior benefits to their clients by selling their PBM business to Express Scripts in 2009. In December 2010, Pfizer announced a management shakeup that promoted Ian Read to CEO, and with that move, new management and the board seem to have a renewed and refreshing focus on shareholder value. Pfizer is the largest manufacturer of prescription biopharmaceuticals globally. In addition to its biopharma division, the company operates animal health, consumer, nutritionals, and drug delivery system businesses. Consistent with big pharma’s focus on size and scale, Pfizer has pursued a strategy of horizontal integration over the years, purchasing Warner Lambert in 2000, Pharmacia in 2003, and more recently Wyeth in 2009. While the idea of horizontal consolidation in pharmaceuticals is reasonable, other ancillary businesses were also aggregated while core products came closer to their patent cliffs in 2012-2014. After years of aggregation and pouring $40 billion into research pipelines over the past five years with little new product generation to show for it, Pfizer and its new CEO seem determined to plot a different course: i) Management in presentations in the last three months has started every conversation with an acknowledgement that Pfizer must improve shareholder returns. This is a noted change in focus, timing and message. ii) Furthermore, management has undertaken a strategic review of all non-core businesses with a view towards divesting, monetizing or spinning off those franchises that can generate superior value as independent companies or as divisions of other healthcare firms. Management is on record saying they hope to have their review, and definitive actions, completed before year-end. iii) CEO Read is overhauling the R&D culture and splitting the division between its research and development components, creating separate financial incentives and accountability. As such, Pfizer has been able to reduce its forward R&D spend by $1 billion and counting. iv) The company acknowledges that their overall growth profile includes flat EBIT through 2015 due to patent expirations, and that high single digit earnings growth needs to come from balanced capital deployment. Importantly, any acquisitions will be weighted against share repurchase in determining optimal use of capital. At today’s valuations, we believe repurchase will dominate future cash outlays for the intermediate term.
v) Furthermore, Pfizer is considering reducing the size of the company down to its innovative core and investigating the divestiture of its post generic portfolio. The very consideration of reducing the size of Pfizer by one third was unthinkable in past Pfizer management discussions and in the industry over the past decade. The size of the prize is meaningful: We believe the sum of Pfizer’s component parts is worth $27 per share today, a 50% premium to our $18 entry point a few months ago:
% of 2011 Revenue 50% 16% 19% 15% Low 8.0x 12.0x 9.0x 16.0x Target Multiple High 10.0x 15.0x 11.0x 20.0x Mid 9.0x 13.5x 10.0x 18.0x 11.3x % of 2015 Revenue 35% 23% 21% 21% Low 8.0x 12.0x 9.0x 16.0x Target Multiple High 10.0x 15.0x 11.0x 20.0x Mid 9.0x 13.5x 10.0x 18.0x 12.1x
Small Molecule Large Molecule Other (inc. Generics) Animal Health, Consumer, Nutritionals WEIGHTED AVERAGE
Furthermore, Pfizer has spent nearly $40 billion on R&D over the past five years with negligible new product revenue to show for it. While we believe that ultimately this expenditure will yield an unacceptably low return on capital, we do believe that Pfizer’s current pipeline is capable of producing $10 billion of incremental revenues as it commercializes over the coming four years. This growth would be additive to the sum of the parts math quoted above. We expect Pfizer to spin-off several significant businesses in 2011 (animal health, consumer, nutritionals), to repurchase at least $5 billion of stock (3%) and perhaps to repurchase up to $10 billion on an annual rate going forward. This capital allocation, along with an increased dividend payout ratio to 40%, will likely generate high single digit earnings growth and a 4-5% dividend yield over the intermediate term. By 2015, we expect Pfizer to demonstrate mid-single digit revenue growth with earnings growth in the low to mid-teens, commanding a 13-15x multiple in the out years. At 8.5x 2012 trough earnings, we believe Pfizer is poised to deliver a significant total return to shareholders over the coming three to five years. Organization As a result of our positive 2010 investment performance and new capital inflows, total assets under management at Glenview are currently $5 billion. Glenview’s senior Partners remain the largest investors in the funds, and I continue to commit 100% of my investable net worth to Glenview. Our funds are open to additional capital contributions, and we would welcome the opportunity to manage additional funds for you and your organization in a manner that is consistent with our long-term history. On the personnel side, we are pleased to announce the following promotions, which occurred at year end. Each of the following individuals has demonstrated a combination of proficiency and dedication in their years at Glenview, and their increased responsibilities and enhanced opportunities are well earned and well deserved. Peter Hafner has been promoted to Analyst and has moved from our Proprietary research team to our Industrials team, which is led by John McMonagle. On our accounting and operations team, Eric Evanter and Wilson Tran have both been promoted to the position of Senior Staff Accountant. In late December, we parted ways with Brad Neuman, who was a Managing Director on the Consumer Team. In early 2011, Sean Dempsey, a senior analyst on our research team, left us to rejoin his former private equity employer in a leadership position, and Greg Fishbein, an Infrastructure Manager on our IT support team left to become Director of IT at a startup hedge fund. We wish all of them well in their future endeavors, and all are considered respected colleagues and friends. As we continue to grow our business and team organically, we are pleased to announce the following additions to our staff in 2011: We have added two Analysts to our Healthcare Team, under the leadership of Randy Simpson. Stephen Smith joined Glenview in January. Prior to joining Glenview, Stephen worked at the Quadrangle Group, where he was a Private Equity Associate. Prior to Quadrangle, Stephen was an Investment Banking Analyst at Credit Suisse on
their Global Healthcare Team. Stephen graduated from Wharton, Magna Cum Laude. John Kim joined Glenview’s Healthcare team in February. Prior to joining Glenview, John worked for Morgan Stanley, where he was an Investment Banking Analyst, working both in Hong Kong and New York. John graduated from Columbia University, Cum Laude, with a major in Engineering and Management Systems. In March, Joshua Greenberg joined Glenview as an Analyst on our Services Team, under the leadership of Jacob Grossman. Prior to joining Glenview, Josh worked at New Mountain where he was a Private Equity Associate. Prior to New Mountain, Josh was an Investment Banking Analyst at Merrill Lynch on their Multi-Industries Team. Josh graduated from Yale, Magna Cum Laude. Finally, I am pleased to announce the promotion of our two most senior leaders – John Rodin and Mark Horowitz – to Co-Presidents of Glenview. As you know, John joined us in early 2002, opened our European office in 2006, became a Partner in 2007 and became our Director of Research that same year. John’s most difficult job is sitting 15 feet to my left and putting up with me around the clock. Mark joined us in 2004 as General Counsel and Chief Operating Officer, became a Partner in 2008 and, for the past several years, has been responsible for managing all non-investment related personnel and functions. Mark has been responsible for establishing a conservative tone at the top, and his wisdom and insight make him a most trusted advisor. Elevating John and Mark to Co-Presidents is as much putting a title on that which they already did: as a team, they run the firm so that I can run the portfolio, and our fourth Partner, Jeff Patterson, can run our trading operations. Like the market, our firm is more stable relying on all four of these legs, and their ability to continue to shoulder the load of running a global investment business has and will be a key element of our long-term success. On a personal note, I thank each of my Partners for their unwavering loyalty and commitment to our investors, to our team and to me during a turbulent few years in the markets – our ability to fight through difficulty as a team will be one of our finest moments. Liquidity and Risk The overall liquidity of the portfolio remains excellent. At the end of the year, the weighted average median market capitalization of our equity portfolio was $11.5 billion.6 Portfolio volatility during the fourth quarter was 7.2%,7 which remains well below the volatility of the market and our long term averages. * * *
We will end where we started: on behalf of our team at Glenview, thank you for your continued investment, support and confidence. Should you have any questions that remain unaddressed, please feel free to contact our investor relations professionals, Elizabeth Perkins (212) 812-4723 or Chris Venezia (212) 812-4722, at any time. Best regards, Larry Robbins Chief Executive Officer
The “Profits Gained” chart on page 1 is based on an initial investment of $100, at the time of inception, for each product. The index comparisons for each of our products assume that a comparable $100 investment in the respective index was made at the date of inception of our specific fund. For each of our products, the offshore fund’s returns are used as representative of the entire fund family. These figures represent the additional profits earned by investing in our specific product vs. the HFRI index or the S&P index. The figures quoted in the text on page 1 specifically reflect an investment in our flagship product, the Glenview Funds. For an individual investing in Glenview Opportunity (“GO”), the gain would have been an additional $1.04mm to $1.13mm vs. the HFRI and S&P indices, respectively, and for Little Arbor, the gain would have been an additional $0.31mm and $0.47mm vs. the HFRI and S&P indices, respectively. The additional profit figures for an institution investing $100mm into our funds specifically reflect an investment in our flagship product, the Glenview Funds. For an institution investing in GO, the gain would have been an additional $104mm to $113mm vs. the HFRI and S&P indices, respectively, and for Little Arbor, the gain would have been an additional $31mm to $47mm vs. the HFRI and S&P indices, respectively. Comments on fixed income performance apply to our Glenview and Little Arbor products. In addition, for Little Arbor, given its larger allocation to corporate credit, other strong fixed income contributors during the quarter included Fox Acquisition Sub LLC and Local TV. The Clearwire $20 billion figure of capital invested is comprised of the following, (i) $4.6 billion in capital expenditures, (ii) $2.2 billion outlay in cash from operations and (iii) $12.8b billion spectrum valuation based on November 2008 equity investment into Clearwire. The weighted average median market capitalization quoted in the text refers to our flagship product, the Glenview Funds. The weighted average median market capitalized for GO in Q4 was $12.5 billion, and for Little Arbor was $10.4 billion. The 7.2% volatility figure refers to our flagship product, the Glenview Funds, and specifically the offshore fund, Glenview Capital Partners (Cayman), Ltd. For our GO Funds, Q4 volatility was 12.5% for the offshore fund, and for our Little Arbor Funds, Q4 volatility was 4.1% for the offshore fund.
IMPORTANT DISCLOSURES: This report does not constitute an offer to sell nor the solicitation of an offer to buy any interest in any investment fund managed by Glenview Capital Management, LLC ("Glenview"). Such offer or solicitation may only be made by delivery of offering documents containing a description of the material terms of any investment, including risk factors. Any such offering will be made on a private placement basis to a limited number of eligible investors. Net returns reflect the reinvestment of all dividends, income, interest and prior performance returns. In addition, net returns include the deduction of all performance and management fees and expenses. When returns are quoted, returns reflect overall fund-level returns for the specific fund mentioned. Returns related to a particular individual's investment will vary depending on whether such investor participates in designated investments and/or "new issues" and the date of their investment. Past performance is not indicative nor a guarantee of future returns. There can be no assurance that any fund managed by Glenview will achieve comparable results in the future. Investment losses may occur, and investors could lose some or all of their investment. Please refer to the applicable offering documents for a fund for a description of the relevant risk factors pertaining to an investment in such fund. The funds discussed in this report are actively managed and any securities discussed herein may or may not be held by the funds at any given time. Nothing herein shall be deemed to be a solicitation, recommendation or endorsement to buy or sell any security or other financial instrument referenced in this report. Specific securities are highlighted as examples of Glenview's investment approach and to aid in the discussion of Glenview's investment outlook and do not represent an entire portfolio and are not intended to represent the performance of any fund managed by Glenview. Any projections, targets or estimates in this report are forward looking statements and are based on Glenview's research, analysis and various assumptions made by Glenview. There can be no assurance that such projections, targets or estimates will occur and the actual results may be materially different. Other events which were not taken in to account in formulating such projections, targets or estimates may occur and may significantly affect the returns or performance of any fund managed by Glenview. This report is for the use of its intended recipient and may not be copied, reproduced, republished or distributed in any way.
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