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Jul 26, 2017

Opportunity Equity 2Q 2017 Review

Christina Siegel Malbon

Market Commentary

The S&P 500 Index finished the quarter with a total return of 3.09%.The Dow Jones Industrial Average rose 3.95% and the Nasdaq Composite increased 4.21% on a total return basis for the quarter. Nine of the eleven sectors in the S&P 500 posted positive returns during the period. Healthcare and Industrials were the biggest outperformers with returns of 7.10% and 4.73%, respectively. Large-cap stocks outperformed mid-cap stocks, which beat small-cap names. Specifically, the Russell 1000 Index’s 3.06% gain surpassed the returns of both the Russell mid-cap Index and the Russell 2000 Index which posted 2.70% and 2.46%, respectively for the quarter. Growth stocks beat their value counterparts, as the Russell 1000 Growth Index rose 4.67% compared to the 1.34% return of the Russell 1000 Value Index over the same period. The US Dollar Index declined 4.71% for the quarter and is down 6.44% for the year. Oil decreased 9.01% over the quarter and is down 14.30% for the year despite OPEC supply reductions. Gold was down 0.97% for the quarter but is up 7.10% for the year.

The market continued to climb over the quarter despite the large amount of negative news coming out of Washington. During the period, the news was dominated by the firing of FBI Director James Comey and the appointment of a special prosecutor. Trump announced the USA’s withdrawal from the Paris Climate Agreement and the reinstatement of Cuban travel and business restrictions. Progress on tax reform stalled and the vote on the healthcare bill was postponed until July. Emmanuel Macron won the French elections bringing stability to the EU, while Theresa May, Britain’s Prime Minister, lost her majority in the snap election she called in June. Terrorist attacks continued around the world and North Korea continued to carry out nuclear tests. The Fed raised rates by a quarter point at its June meeting and reiterated its plan to begin winding down its $4T balance sheet later this year. The ECB decided to keep interest rates unchanged.

Strategy Highlights

During the second quarter of 2017, Opportunity Equity returned 12.04% (net of fees)1 versus the S&P 500 Index’s return of 3.09%.

Using a three-factor performance attribution model, security selection, interaction effects and allocation effects contributed to the portfolio’s outperformance. Wayfair Inc. (W), RH (RH), Valeant Pharmaceuticals International Inc. (VRX), American Airlines Group Inc. (AAL), and Intrexon Corp. (XON) were the largest contributors to performance, while Pandora Media Inc. (P), Genworth Financial Inc. (GNW), Seagate Technology (STX), Platform Specialty Products Corp. (PAH) and OneMain Holdings Inc. (OMF) were the largest detractors.

Relative to the index, Opportunity was overweight the Financials, Consumer Discretionary, Healthcare, 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 Consumer Discretionary sector, which underperformed the index, detracted the most from 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 three positions during the quarter, ending the quarter with 35 holdings, where the top 10 represented 48.2% of total assets compared to 19.0% for the index, highlighting Opportunity’s meaningful active share of 100.5%2.

Top Contributors

    • Wayfair Inc. ended the quarter up 89.9% after announcing strong first quarter results. Wayfair posted adjusted earnings before income, taxes, depreciation and amortization (EBITDA) of -$21M versus consensus of -$32M and earnings per share (EPS) of -$0.48 versus consensus of -$0.57. The beat was driven by a 32% rise in direct retail revenues, continued improvement in international investments, better traction with repeat customers, and improved gross margins of +70 basis points. The stock was further supported by strong Q2 guidance that came ahead of Street expectations on revenues of $1.042B (vs. $991M) but lower EBITDA of -$22.4M (vs. -$19.4M).

    • RH continued to climb in the second quarter ending the period up 39.4%. First quarter results were in-line with their pre-announcement in May, but fiscal year guidance disappointed as they lowered earnings expectations but increased revenue due to an acceleration in SKU rationalization. They announced adjusted EPS of $1.67-$1.94 versus previous guidance of $1.78-$2.19 and Revenue of $2.4B-$2.45B versus previous guidance of $2.3B-$2.4B. The company also released a new CEO compensatory arrangement that grants Gary Friedman, CEO, the option to purchase 1M shares of RH, exercisable over four years, if RH stock reaches prices of $100/$125/$150. The company announced that it had completed its $300M share repurchase program announced in February and authorized a new $700M buyback. The company hired Sandra Stangl, the former President of Williams-Sonoma’s Pottery Barn brands, as its President of New Business Development and Prakash Muppirala as CTO and President of RH Digital Innovation, previously Senior Vice President at Staples and Director of Engineering at eBay.

    • Valeant Pharmaceuticals International Inc. rebounded in the second quarter rising 56.2%. The company reported Q1 adjusted EBITDA of $861M versus analyst estimates of $858.9M and reduced their net debt by $1.3B. The company expects to pay down $5B in debt from divestitures and free cash flow by February 2018. Management raised fiscal year (FY) adjusted EBITDA guidance from $3.55-$3.70B to $3.60-$3.75B. Valeant announced the sale of iNova for $930M in June and completed the sale of Dendreon for $819.9M putting them on a path to pay down ~$5.4B of debt by year end. Near the end of the quarter it was announced that John Paulson had joined the board and had taken his position in the company to 6.3%.

Top Detractors

    • Pandora Media Inc. declined 24.5% over the quarter. The company reported lackluster Q1 results that were relatively in-line but cut FY revenue guidance to $1.50-$1.65B from $1.55-$1.70B. Pandora announced a strategic investment from SiriusXM of $480M in convertible preferred along with the sale of Tickeyfly for $200M to Eventbrite. Near the end of the period, the company announced that Tim Westergren would step down as CEO effectively immediately. The current CFO, Naveen Chopra, was appointed the interim CEO while the company searches for a replacement. In addition, Michael Herring stepped down as President and Nick Bartle stepped down as CMO.

    • Genworth Financial Inc. ended the quarter down 8.5% as the speculation continued on China Oceanwide’s ability to complete its announced acquisition of Genworth for $5.43/share. Shareholder approval has already been obtained, but they are still awaiting regulatory approval. During the period, it was announced that Genworth and China Oceanwide had withdrawn and refiled their joint notice to the Committee on Foreign Investment in the United States (CFIUS).

    • Seagate Technology declined 14.3% over the quarter. The company reported fairly in-line third quarter results, but disappointing on fourth quarter guidance. The company report revenue of $2.67B versus consensus of $2.71B and EPS of $1.10 versus consensus of $1.07. Seagate guided for fourth quarter sale of $2.5-2.6B compared to consensus of $2.68B.

Read our 2Q 2017 Opportunity Commentary: "Be fearful when others are greedy and be greedy when others are fearful." - Warren Buffett.

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 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