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Oct 11, 2023

3Q23 Opportunity Equity Quarterly Review

Christina Siegel Malbon

3q23 OPP Equity Attribution
Market Proxy is S&P 500. Returns greater than 1 year are annualized. Source: Bloomberg and Patient Capital Management

The data provided is from APX and Patient Capital Management, LLC and is believed to be reliable, but is not guaranteed as to its timeliness or accuracy. Percentages and returns may not sum to 100% due to rounding effects. A three-factor attribution consists of the allocation effect, selection effect, and the interaction effect, which sum to the portfolio's performance relative to the benchmark. 
Allocation. The allocation effect represents the portion of the portfolio's excess return attributable to differences in sector weights between the portfolio and the benchmark index.
Selection. The selection effect represents the portion of the portfolio's excess return attributable to differences in the weights of individual securities within each sector between the portfolio and the benchmark index.
Interaction. Most complex and sometimes counterintuitive, the interaction effect represents the portion of the portfolio’s excess return attributable to combining sector allocation decisions with security selection decisions, and is often thought of as measuring the accuracy of manager’s convictions.

Please note that the methodology used by our independent third-party attribution software vendor will at times present sector allocation effects that are counterintuitive. For example, the software may calculate a negative sector effect even when the portfolio, on a weighted average basis for the period, was overweight an outperforming sector. Under the vendor's methodology, allocation effects in recent months may overwhelm the allocation effects from earlier in the period, particularly over longer time frames.

Returns illustrated above are provided net of fees and include cash. Total portfolio return figures provided above reflect the sum of the returns of the holdings in the representative account portfolio due to price movements and dividend payments or other sources of income.

Strategy Highlights

During the third quarter of 2023, the Opportunity Equity strategy generated a total return of -6.0% net of fees. In comparison, the Strategy’s unmanaged benchmark, the S&P 500 Index, returned -3.3%.

Using a three-factor performance attribution model, interaction effects contributed to the portfolio’s underperformance which was partially offset by both allocation and selection effects. Splunk Inc. (SPLK), Ovintiv Inc. (OVV), UBS Group (UBS), Energy Transfer LP (ET), and Mattel Inc. (MAT) were the largest contributors to performance, while Farfetch Ltd (FTCH), S4 Capital plc (SFOR LN), Delta Air Lines Inc. (DAL), United Airlines Holdings Inc. (UAL), and Norwegian Cruise Line Holdings Ltd. (NCLH) were the largest detractors.

Relative to the index, the strategy was overweight the Consumer Discretionary, Communication Services, Financials, Energy, and Industrials sectors on average during the quarter. With zero allocation to Real Estate, Utilities, and Consumer Staples, the strategy was underweight these sectors along with the Information Technology, Healthcare, and Materials sectors.

The portfolio added four positions and eliminated three positions during the quarter, ending the quarter with 41 holdings where the top 10 stocks represented 51.5% of total assets compared to 30.6% for the index, highlighting the strategy’s meaningful active share of around 106.1%.

Portfolio Review

Markets are uncertain, as the third quarter demonstrated. Concerns around a Fed policy mistake re-entered the market psyche as inflation trended lower while unemployment stayed at all-time lows. Questions on what “higher for longer” would mean for equities brought heightened uncertainty. Consumer Discretionary took the brunt of the hit on fear of a weakening consumer. Energy was the standout performer in the quarter as commodity prices rebounded following a series of OPEC cuts along with continuing demand growth.

While no one likes volatility, we attempt to benefit from it by “monetizing the volatility” in markets. We pared back some of our biggest winners early in the quarter and added to weakness. We focus on making long-term investments while looking through near-term uncertainty.

Energy detracted in the first half of the year. We saw an opportunity, added to our exposure, and benefited in the third quarter rebound. We still believe there is an attractive long-term opportunity in the energy space. Investment in supply remains muted. Companies remain disciplined about capital investment and returns on capital. They generate significant free cash flow unlike the past and geopolitics presents upside price risks.

Our travel names exhibited the exact opposite performance as our energy names, with strong first half performance followed by poor third quarter performance. Travel names were hit as the market began to price in a hard landing. While travel could slow from its recent torrid pace, we think the industry remains well positioned to weather any softness. Our travel names (EXPE, DAL, UAL, TNL, NCLH) remain quite undervalued relative to what we believe they are worth.

Airlines returned to trough multiples as higher oil prices pressured costs. Historically, airlines have passed these costs on to customers. We think Delta Air Lines Inc. (DAL) is a premium brand valued like its economics aren’t sustainable. With mid-teens returns on capital, significant free cash flow generation, excellent capital allocation and long-term earnings per share growth in the high-single to low-double-digits, we think the company is significantly mispriced.

At Expedia Group Inc. (EXPE), we believe the market is underappreciating the company’s transformation. Over the past few years, the company has prioritized its top three brands (,,, successfully implemented a single technology stack, and officially rolled out OneKey their combined loyalty program, across all brands. With strong free cash flow generation, the company continues to buy back their stock, creating a positive flywheel of shareholder return.

We benefited from Cisco Systems Inc.’s (CSCO) acquisition of our holding, Splunk Inc. (SPLK), in the quarter for $157 per share, a 31% premium to where the stock was trading. We were pleased to see our acquisition thesis play out. Mattel Inc. (MAT) progressed its IP-driven transformation with the smashing success of the Barbie movie. The Barbie movie earned over $1.4B at the global box office, becoming the biggest global earning Warner Bros movie ever. On the negative side, we exited Farfetch Ltd (FTCH) after the company disappointed yet again. With increasing debt balances, we grew concerned about the balance sheet and the company’s ability to execute against the long-term potential we believe exists.
New and Eliminated

This quarter we entered four new positions, while exiting three positions. Our largest new position was CVS Health Corp. (CVS). We owned CVS in 2021 through call options, which provided a handsome return. We sold it when it reached our assessment of intrinsic value. In the first half of the year, the stock traded down nearly 40% from its highs. CVS is valued like a pharmacy business in secular decline, while its strategy and assets are far better. CVS owns a healthcare benefits business (Aetna) and a pharmacy-benefits manager (Caremark). It recently acquired Signify Health and Oak Street Health, entering the In-Home Evaluations and primary care spaces enhancing the company’s ability to offer comprehensive healthcare services as we transition to a system more focused on value-based care. Short-term headwinds, such as an unwind from COVID, some unfavorable health care developments and negative headlines from PBM contract losses, weighed on the price. The company is again significantly undervalued, with a trough-level 8.2x P/E multiple well below peers’ 12.2x, with a 3.5% dividend yield. We saw an opportunity to diversify the portfolio with a stable company with a promising strategy and group of assets at an attractive price.

We added to our energy exposure in the quarter, buying shares in Kosmos Energy (KOS), an exploration and production services company with assets in Africa. The company is differentiated in the exploration & production (E&P) space because of its growth profile (+30% YoY in 2024), long reserve life (>20yrs, nearly double the sector average) and focus on liquified natural gas (LNG). We see this as a classic case of time arbitrage where the market is myopically focused on the near-term risk the company will miss production targets for new assets while ignoring the long-term intrinsic value. After years of investing in project development, it is close to moving into the harvesting phase with production expected to grow 30% YoY in 2024. At the same time, capital expenditures should fall 30% YoY leading to very strong FCF yield of >25%, which will initially go towards debt paydown. At these levels, the company will generate more than its current market cap in FCF over the next 5 years at $90 Brent prices. With the combination of gas-heavy reserves and inflecting cash flow generation, we think Kosmos is significantly undervalued and a potential acquisition target.

We built a small position in 2U Inc (TWOU) 2.25% Convertible Notes due May 2025 during the quarter. 2U is a top player in the online learning and education space. In 2021, the company acquired The Center for Reimagining Learning (edX platform) creating one of the world’s largest online learning platforms. We think this is a case of good company, bad balance sheet. The acquisition dramatically increased debt and the company wasn’t yet profitable. The company recently turned EBITDA profitable and expects to reach positive free cash flow by the end of this year. Despite this improvement, the company sits at an all-time low price as their high leverage (5x) and near-term debt maturities (~$760M in 2025/2026) create risk. We think in an adverse scenario, the converts should be fully covered and would wind up as equity. We believe progress on free cash flow and profits should create refinancing options or exchange opportunities before the first debt comes due (May 2025). The yield-to-maturity on the bonds ended the quarter close to 38%, a highly attractive return that compensates for the risk of adverse scenarios where things may get worse before they get better.  

We re-entered DXC Technology Company (DXC) in the quarter. We previously owned DXC and did well in it. Mike Salvino joined the company as CEO in 2019 after spending a decade at Accenture PLC. Upon joining, Mike focused on stabilizing the business with a goal of returning the company to growth using the same playbook he perfected at Accenture. Over the ensuing years, progress was made with improving margins, stronger free cash flow generation, higher client net promoter scores (NPS)and improved employee retention. While the inflection to topline growth has been more challenging, the company produces copious amounts of free cash flow which is being returned to shareholders. The company expects to generate $800M in free cash flow, an 18% FCF yield and is committed to completing their $1B repurchase authorization in FY24, 22% of shares outstanding.

We exited Taylor Morrison Home Corporation (TMHC) in the quarter as the company reached our assessment of intrinsic value and we found more attractive alternatives. We used Stitch Fix Inc. (SFIX) as a funding source while taking advantage of tax loss harvesting. Farfetch Ltd (FTCH) was exited in the quarter following continued disappointment in cash flow generation combined with their ever-expanding debt balance. From this point, we see serious balance sheet risk for the first time, causing us to question if the company will be able to achieve their long-term plan. We took the opportunity to realize tax losses and will continue to re-evaluate the name. More details on FTCH below.

Top Contributors and Top Detractors

Top Contributors Ticker Net Contribution (bps)
Splunk Inc. SPLK 110
Ovintiv Inc. OVV 67
UBS Group UBS 62
Energy Transfer LP ET 55
Mattel Inc MAT 53
Top Detractors Ticker Net Contribution (bps)
Farfetch Ltd FTCH -153
S4 Capital PLC SFOR LN -127
Delta Air Lines Inc. DAL -113
United Airlines Holdings Inc. UAL -86
Norwegian Cruise Line Holdings NCLH -77
*Contribution illustrated above are provided net of fees and includes cash.

Top Contributors

Splunk Inc. (SPLK) was the top contributor in the quarter, gaining 37.9% following its announced acquisition by Cisco Systems Inc. (CSCO) in September. Cisco agreed to purchase the company for $157 per share, a 31% premium from where the stock was trading. The acquisition is expected to close in September of 2024. Gary Steele joined the company as CEO in April of 2022 with a focus on returning Splunk to a Rule of 40 company generating strong free cash flow. He made strong progress over his 1.5 years at the firm, closing out his time with a solid take-out valuation for a $28B company.

Ovintiv Inc. (OVV) reversed its trend from the first half of the year climbing 25.6% in the quarter as commodity prices caught a bid. The company is benefiting from increases in production due to improved well productivity across its portfolio combined with a lower level of maintenance capex. 40% of oil and 50% of gas exposure is hedge for the next twelve months providing insulation from fluctuations in commodity prices. Ovintiv continues to allocate 50% of post-dividend free cash flow (FCF) to debt paydown, and 50% to shareholder returns via either dividends or buybacks.

UBS Group (UBS) had a strong quarter continuing to rebound from the bank sell-off earlier in the year. During the height of the banking crisis, UBS Group purchased its largest local competitor, Credit Suisse, for an 80% discount. We bought after the deal, believing the market’s myopic focus on short-term integration risks failed to properly value the attractive set of assets. UBS Group successfully restructured its business in preceding years allowing the company to reach best in class return metrics, hitting a Return on Common Equity Tier 1 (RoCET1) of 17.5% in 2021, within their long-term range of 15-18%. While the integration of Credit Suisse’s assets will make the financials messy for the next few years, the company should come out stronger on the other side with a substantially larger wealth management business. Wealth Management will make up 68% of invested assets pushing them to be the number one global player ahead of Morgan Stanley. We estimate $4-6 in earnings power in 3-5 years, meaning you’re only paying 4-6x earnings for a premium asset with a 2.2% dividend yield. Despite the strong move, we continue to see attractive upside from here.

Top Detractors

S4 Capital PLC (SFOR LN) continued its decline from its February peak, dropping 45% in the period as management took down guidance again. S4 is a digitally focused advertising business founded by Sir Martin Sorrell, previously CEO of WPP. We know Sir Martin well, and he’s a proven money-maker. S4 continues to see pressure in their advertising business with the top line now expected to be down for the year. Topline pressure is coming from macroeconomic conditions. Clients’ caution reflects fears of recession leading to extended sales cycles. Despite these dynamics, the company is still committed to reaching their long-term 20% EBITDA targets implementing a 5% headcount reduction in 1H23. The company also announced a new decision to deploy surplus cash flow to shareholders via dividends and buybacks, a dynamic we believe will go a long way to help realizing the value of the business. On a longer-term basis, there continues to be a large opportunity for market share expansion as the company currently represents only 0.8% of the $110B total addressable market (TAM )for agency services. We think the risk/reward is extremely attractive for a business that is generating cash flow and looking to return cash flow to shareholders until the opportunity for more aggressive growth returns.

Delta Air Lines Inc. (DAL) reversed course in the third quarter, falling 24% from its highs in July. The airlines in general were hurt from rising commodity prices that are leading to increased cost per available seat mile (CASM). Historically, airlines have passed on higher fuel prices to customers with a lag. We see Delta as a premium global consumer brand that is materially misunderstood by the market. The market still sees airlines as a cyclical, bankruptcy prone industry. An improved supply-demand picture, management discipline and a better business mix make Delta a more resilient business. Their loyalty program with American Express is a source of stable and growing revenues with $6.5B in remunerations this year with a goal of reaching $10B by the end of the contract in 2028. Premium and ancillary service revenue should generate 65-70% of the total in the next year or two. The company should continue to generate consistent mid-teens returns on capital. As the market begins to understand, we believe the company will continue to be rewarded. On top of this, free cash flow is expected to expand generating a cumulative ~$11B from ’23-’25, or one-half of its current market cap. As the company pays down debt while growing the dividend and eventually resuming share repurchases, we think the stock will continue to trend higher.

Farfetch Ltd (FTCH) was our largest detractor in the quarter as the company massively disappointed expectations, while increasing their debt load. The lack of results and dramatic change in the risk profile over the last year forced us to reconsider the viability of our long-term thesis. With the additional $600M in term loan debt drawn down over the last year and the constant delays in true free cash flow generation (operating cash flow (operating cash flow (OCF)-capital expenditure (CAPEX)) the risk profile of the company has drastically changed from when we first owned it. From a strategic standpoint, the company has made great progress signing new deals, bringing on new partners and proving the value of their offering but their operational performance and financial discipline has sorely disappointed. While the entry of Tim Stone as CFO in September will certainly help the company, we don’t have conviction it will be enough. Debt and interest expense ($100M/annually) have exploded. Limited cash on hand ($753M by year-end), continued cash burn, a risk of a recession and $1B in debt maturities due in 2027, make us concerned about the company’s ability to invest behind and deliver against their long-term targets. We used the opportunity to take tax losses while continuing to re-evaluate the situation.

The S&P 500 Index is a market capitalization-weighted index of 500 widely held common stocks. Investors cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges.

Liquefied natural gas (LNG) is natural gas that has been cooled to a liquid state, at about -260° Fahrenheit, for shipping and storage.

The Net Promoter Score (NPS) measures the loyalty of a company's customer base with a score from -100 to +100

The Rule of 40 is a principle that states a software company’s combined revenue growth rate and profit margin should equal or exceed 40%.

Total addressable market (TAM) is the maximum amount of revenue your company can make by selling in a particular market.

Return on Common Equity Tier 1 (RoCET1): Known as going concern or core capital, Tier 1 is used to fund a financial institution's business activities. It includes Common Equity Tier 1 (CET1) capital and Additional Tier 1 (AT1) capital.  

Cost per available seat mile (CASM) is a common unit of measurement used to compare the efficiency of various airlines. It is obtained by dividing the operating costs of an airline by available seat miles (ASM).

Operating cash flow (OCF) is a measure of the amount of cash generated by a company's normal business operations.

Capital expenditures (CapEx) are funds used by a company to acquire, upgrade, and maintain physical assets such as property, plants, buildings, technology, or equipment.

This information does not constitute, and should not be construed as, investment advice or recommendations with respect to the securities and sectors listed. All investments are subject to risk, including the possible loss of principal. There is no guarantee investment objectives will be met. Neither Patient Capital Management, LLC, nor its information providers are responsible for any damages or losses arising from any use of this information.

The Opportunity Equity composite performance figures reflected above include the deduction of a model investment management fee of 1% (the highest fee for separate accounts under our fee schedule), paid quarterly and certain other expenses. For important information about Opportunity Equity Strategy performance, please click on the Opportunity Equity Strategy Composite Performance Disclosure. Past performance is no guarantee of future results.

All holdings and portfolio data are reflective of a representative Opportunity Equity account.

Performance in attribution table is not official strategy returns. The return is sourced from APX and is net of fees based on the strategy’s representative account.

Contributors detailed above represent the top five securities that contributed positively to performance during the quarter. Detractors detailed above represent the top five securities that detracted from performance during the quarter. Information detailed above is provided net of fees, includes cash, and is based on a representative Opportunity Equity account. Contribution listed above represents the period when the security was held during the quarter. For additional information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to the representative Opportunity Equity account performance contact us.

The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. References to specific securities are for illustrative purposes only. Portfolio composition is shown as of a point in time and is subject to change without notice.

The views expressed in this commentary reflect those of Patient Capital Management analyst(s) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Patient Capital Management disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.

Click for the Opportunity Equity Strategy Composite Performance Disclosure.

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