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Apr 21, 2017

Opportunity Equity 1Q 2017 Review

Christina Siegel Malbon

Market Commentary

The S&P 500 Index finished the quarter with a total return of 6.07%.The Dow Jones Industrial Average rose 5.19% and the Nasdaq Composite increased 10.13% on a total return basis for the quarter. Nine of the eleven sectors in the S&P 500 posted positive returns during the period. Information Technology and Consumer Discretionary were the biggest outperformers with returns of 12.57% and 8.45%, respectively. Large-cap stocks outperformed mid-cap stocks, which beat small-cap names. Specifically, the Russell 1000 Index’s 6.03% gain surpassed the returns of both the Russell mid-cap Index and the Russell 2000 Index which posted 5.14% and 2.46%, respectively for the quarter. Growth stocks beat their value counterparts, as the Russell 1000 Growth Index rose 8.91% compared to the 3.27% return of the Russell 1000 Value Index over the same period. The US Dollar Index declined 1.82% for the quarter. Oil decreased 5.81% over the quarter despite OPEC supply reductions. Gold rose 8.13% during the period.

The quarter started off with optimism on the new administration’s ability to make progress on tax reform, regulation and healthcare, but the reality of the first quarter proved to be much more volatile. Despite all the negative news surrounding the new administration, the travel ban executive order, Congress’ failure to repeal and replace Obamacare, suspected Russian intervention in the election, the resignation of Michael Flynn and the wiretapping allegations, the market continued to climb with the S&P 500 having its best start to the year since 2013. Terrorist attacks continued around the world and North Korea carried out three nuclear tests. The President of South Korea, Park Geun-hye, was removed from office in March and later arrested on charges related to abuse of power and bribes. The head of Samsung, Lee Jae-yong was indicted on bribery and embezzlement charges in connection to the corruption scandal that lead to the impeachment of President Park Geun-hye. The Fed raised rates by a quarter point at its March meeting which was widely anticipated but the release of the March minutes rattled markets as it stated the Fed would begin to wind down its $4T balance sheet later this year. The ECB decided to keep interest rates unchanged.

Strategy Highlights

During the first quarter of 2017, Opportunity Equity returned 7.14% (net of fees)1. In comparison, the strategy’s unmanaged benchmark, the S&P 500 Index, returned 6.07%.

Using a three-factor performance attribution model, interaction effects and allocation effects contributed to the strategy’s outperformance, which was partially offset by security selection. Apple Inc. C100 1/18s, RH (RH), Platform Specialty Products Corp. (PAH), Pulte Group Inc. (PHM) and Inc. (AMZN) were the largest contributors to performance, while Endo Pharmaceuticals Holdings Inc. (ENDP), Valeant Pharmaceuticals International Inc. (VRX), Intrexon Corp. (XON), Endurance International Group Holdings (EIGI), and American Airlines Group Inc. (AAL) were the largest detractors.

Relative to the index, Opportunity was overweight the Financials, Consumer Discretionary, Health Care, Industrials, and Materials sectors on average during the quarter. With zero allocation to Utilities, Consumer Staples, Telecommunications, Energy and Real Estate, the strategy was dramatically underweight these groups and more moderately underweight the Information Technology sector. In terms of sector allocation, the overweight position in the Financials sector, which underperformed the index, detracted the most from the strategy’s relative performance. On the other hand, the underweight in Energy, which underperformed the index, contributed the most to relative performance.

We added three positions and eliminated four positions during the quarter, ending the quarter with 35 holdings where the top 10 represented 49.6% of total assets compared to 18.6% for the index, highlighting Opportunity’s meaningful active share of around 105%2.

Top Contributors

    • AAPL C100 1/18 ended the quarter up 112.8% after announcing strong first quarter results. AAPL beat both revenues and earnings per share (EPS) reporting sales of $78.35B versus consensus of $77.4B and EPS of $3.36 versus consensus of $3.23 while iPhone unit sales grew 4.7% Year-over-Year (YoY). Over the period, AAPL unveiled the iPhone 7 Red Special Edition, the new iPad and announced the acquisition of productivity app maker Workflow for an undisclosed amount. Apple hired Timothy Twerdahl, previously the director of Amazon’s Fire TV division, as a vice president in charge of Apple TV product marketing.

    • RH took off in the first quarter ending the period up 51.1%. RH pre-announced preliminary fourth quarter results which showed fourth quarter adjusted EPS of $0.68 versus consensus of $0.65 and revenues of $590M, on the high end of company guidance of $562M-$592M. The company also announced the authorization of a $300M stock repurchase program (23% of the market cap at the time). The company guided for FY17 revenue growth of 8-12% ($2.3B-$2.4B) compared to consensus of $2.33B and adjusted EPS of $1.78-$2.19 compared to consensus of $1.92. The company reiterated that they expect to be Free Cash Flow (FCF) positive in 2017.

    • Platform Specialty Products Corp. continued its climb in the first quarter rising 32.7%. PAH reported fourth quarter adjusted EBITDA of $218M, above consensus of $208M and adjusted EPS of $0.20 versus consensus of $0.18. The company guided for 2017 adjusted Earnings Before Interest, Taxes, Depreciation, and Amoritization (EBITDA) of $800M-830M, 8% YoY increase at the midpoint. The company also announced that John Connolly would be replacing Sanjeev Khattri as CFO.

Top Detractors
Health care companies comprised all three of the top detractors.

    • Endo Pharmaceuticals Holding declined 32.3% over the quarter. The company started off the year announcing that 2017 base generics’ decline would be similar to 2016’s ~30% decline, which was worse than most had modeled. The company released fourth quarter results which were ahead of expectations with fourth quarter revenue of $1.24B compared to consensus of $1.16B and adjusted EPS of $1.77 versus consensus of $1.63. Guidance for 2017 disappointed the markets creating concerns about cash flow and leverage. Management guided for 2017 revenue to be $3.45-$3.6B compared to consensus of $3.7B and adjusted EPS of $3.45-3.75 was far below consensus of $4.29.

    • Valeant Pharmaceuticals International Inc. ended the quarter down 23.8% despite solid fourth quarter results. The company reported fourth quarter results which beat consensus with revenues of $2.4B versus consensus of $2.34B and EPS of $1.26 versus consensus of $1.20. Analysts were disappointed with the 2017 guidance that showed revenues of $8.9-9.1B (consensus of $8.98B) and adjusted EBITDA of $3.55-3.70B (consensus of $3.88B). Over the quarter, Valeant completed the $1.1B pay down of senior secured term loan and raised $3.25B in its new debt offering which it used to commence a tender offer for up to $1.1B of the 6.75% Senior notes due 2018. This was part of a refinancing packaged to which lenders agreed.

    • Intrexon Corp. declined 17.5% over the quarter. The company released fourth quarter results which were below consensus with revenues of $46M vs. consensus of $53M and non-GAAP EPS of -$0.37 versus consensus of -$0.24. The company announced meaningful advances in the development of its Oxitec, Okanagan and AquaBounty businesses. During the quarter, the company spun-off AquaBounty Technologies Inc. shares to investors and announced the acquisition of GenVec in order to expand its gene-delivery platform. The company also announced the formation of a wholly owned subsidiary called “Precigen” as a structural alternative to their healthcare verticals. In addition, XON announced the departure of President Geno Germano from the company.

Read our 1Q 2017 Opportunity Commentary: Finding Value in Patience.

1For important additional information on Opportunity Equity strategy performance, please click on the Opportunity Equity GIPS Composite Disclosure. This additional information applies to such performance for all time periods. Past performance is no guarantee of future results.

2Active share represents the share of strategy holdings that differs from the benchmark index holdings. The greater the difference between the asset composition of the strategy and its benchmark, the greater the active share.

Contact Miller Value Partners/a> to obtain information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to Strategy performance.

Investment Risks: All investments are subject to risk, including possible loss of principal.

The views expressed in this report reflect those of the Miller Value Partners as of the date of the report. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners 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.

©2017 Miller Value Partners