Coho Capital Management letter to shareholders
January 31, 2014
Dear Partners,
Please find attached your year-end statement for 2013. For the quarter ended December 31, 2013, Coho Capital increased 11.1% and finished the year with a gross return of 53.2%. Net returns for the year, after incentive compensation and fees, were 42.4%. This compares to a gain of 32.4% for the S&P 500 for the year. Individual results may vary contingent upon a Partner’s timing of Fund investment and high water mark.
When viewing Coho’s returns on a risk-adjusted basis we are pleased with our results. We do not utilize leverage and have not employed options in pursuit of our gains. In addition, we carried double-digit cash balances through the first half of the year as a result of not finding investments that met our criteria.
In our mid-year letter, we shared with you economic data indicating a recovery in consumer household finances.
We wrote, “enhanced financial prospects and improved confidence have enabled Americans to pay down debt and do a better job of managing their bills. This is one of the biggest news stories of the year, but coverage has been minimal with media predisposed to a crisis narrative. We think the economic recovery underway is stronger than the headlines suggest. As the storm clouds clear, investors will regret not buying at today’s prices.”
While the gloom and doom view is still pervasive within the media there is much to be optimistic about including the following:
The Wilshire 5000, roughly equivalent to the total capitalization of all US equities, has risen from $7 trillion in 2009 to $19 trillion. The “wealth effect” on consumer consumption should not be underestimated.
Debt payments as a share of income are the lowest since record keeping on the measure began in the early 1980s. As of the third quarter of 2013, the percentage of disposable household income dedicated toward debt servicing was 10.4%, down from 14% in 2007. As a result, US consumers are half a trillion richer than if the debt service ratio held constant with 2007 levels. As Wells Fargo CEO, John Stumpf, put it in an interview late last year, “I have never seen credit this good in my 32 years at the company.”
Banks’ capital levels are the best since the 1930’s. A combination of equity raises, asset sales and recovering earnings have pushed bank equity to 11.1% of total assets, the highest level since 1934 and well above the average of 7.6% over the last eighty years. A healthy banking sector attracts capital, increases confidence in the economy, and spurs loan creation to start new businesses.
Corporate balance sheets are flush with cash at nearly 30% of current assets, close to a thirteen year high.
Congress achieved a rare truce in fiscal wars reaching a bi-partisan budget agreement earlier this month without discordant rhetoric.
The Federal budget deficit has been reduced by more than half since 2009 with federal debt as a percentage of GDP falling from 9.2% in 2009 to 4.1% in 2013.
With a 32% advance in 2013, there is no question that the market has begun to discount some of the favorable developments. After steady expansion in its price/earnings multiple, the S&P 500 sits at 15.2 times this year’s estimated earnings. While not cheap, valuations are far from expensive with the S&P 500’s price/earnings multiple still below its 50 year average of 16 times. In periods of low inflation, below 2.5%, the market has averaged a price/earnings multiple of 19 times. At present, annual inflation is 2%.
Of course we are not buying the market but instead deploying capital in individual companies whose fortunes and risk/return profiles are often independent of what the market does. That is an important point to remember with much of the business media focused on market prognostication. If someone claims to know what the market is going to do, take your wallet and run the other way.
Portfolio Activity
We fully exited our position in AIG during the fourth quarter, registering a gain of 28%. As detailed in last year’s annual letter, our thesis on AIG was premised upon the company achieving a double digit return on equity (ROE) through a rationalization of its complex web of assets and more disciplined underwriting. A key component of that thesis was dislodged in November when AIG suspended its guidance for a 10% plus ROE by 2015. AIG’s 10%+ ROE target has been outlined in SEC documents and been a key guidepost in communications with investors since the company’s re-IPO process in 2011. We can only conclude that AIG is no longer confident of achieving its goals. With less projected ROE improvement, the rationale for owning
AIG became less compelling. We don’t believe sub double-digit ROE insurers are worthy of price-to-book ratios above one, removing one of the key constructs for a higher valuation.
AIG did not offer a reason for its lower ROE guidance, but recent performance trends were cause for alarm with AIG posting disappointing combined ratios in a low loss environment while its competitors were posting ROEs of 10-15%. Perhaps the writing was on the wall when Berkshire poached the CEO of AIG’s property-casualty division earlier in the year.
We have maintained our stakes in the following positions:
Hartford Insurance warrants (HIG-WT) – HIG continues to transition from an insurance company conglomerate into a property casualty focused entity. The company’s efforts to wind down its variable annuity business have gained traction with scores of policy holders electing to accept a one-time payment from HIG in exchange for surrender of their policy. In addition, HIG sold its U.K. variable annuity business earlier this year to Berkshire for $285M. Progress on the annuity front is important as it could potentially allow a quicker return of capital to shareholders. HIG’s remaining annuity book is fully hedged helping to insulate the company from a market downdraft.
On the property and casualty front, HIG has been successful in pushing through large (8%+) price increases for both its commercial and personal lines of business. It is perhaps not surprising then that HIG, unlike AIG, has guided for ROE of 10% in 2014.
Hartford warrants have rallied 69% from our initial purchase in April, but we believe they remain a compelling value and increased our stake this week.
Yahoo (YHOO) – YHOO was our top performing stock last year returning 103%.
It has been a busy year for CEO Marissa Meyer, who in her first full year on the job executed scores of acquisitions, reoriented the company toward mobile and restored company morale. An infusion of talent and a tilt toward younger demographics, through its Tumblr acquisition, has enabled YHOO to regain relevancy. Domestic operations are showing signs of stabilization but it will take time for YHOO to regain the confidence of advertisers.
While we are pleased with the progress Ms. Meyer has made with Yahoo’s US operations, we have always believed the true value of Yahoo resided in its Asian assets, in particular Alibaba.
“People say China hasn’t created a Steve Jobs but I think they have, I think it’s Jack Ma,” Paul Gillis of Beijing University’s Guanghua School of Management. “
Founded by former English teacher Jack Ma, Alibaba is a phenomenon. The company dominates the world’s largest e-commerce market with a 49% share, compared to Amazon’s 20% share of the US online retail market. Approximately 73% of all online retail transactions in China utilize Alibaba’s online payment platform, Alipay.
Alibaba possesses profit margins of 44% compared to 0.5% for Amazon.
It would not surprise us if in a few years’ time, Alibaba is amongst the world’s most highly valued companies. The numbers are simply astonishing. Alibaba’s merchandise volume handled across its two primary sites, Taobao and Tmall, reached $170B in 2012, more than last year’s totals for eBay and Amazon combined.
Alibaba shoppers spent more than twice as much on Singles Day (a Chinese holiday on November 11th similar to Black Friday) as US shoppers spent across all online retailers during Black Friday and Cyber Monday combined. Yes, you read that correctly.
In the third quarter, Alibaba’s revenue jumped 60% to $2.15B with net income of $946M. Put another way, that’s roughly the same revenue as Facebook but more than twice the profit. Facebook trades at a valuation of $131B, such a valuation is far from a stretch for Alibaba. In fact, the hedge fund, Tiger Global, recently invested $200M in Alibaba in a private transaction valuing the company at $125B. YHOO owns 24% of Alibaba, which has made Ms. Meyer’s job much easier.
Howard Hughes Corporation (HHC) – HHC advanced 64% last year. The company did an excellent job of monetizing its master planned communities in Houston and Las Vegas to fund development of significant retail, commercial and residential anchors in New York City and Honolulu.
Despite a 233% rise from our initial purchase price, HHC remains attractively priced at a price to book of 2.2 times, in-line with the industry average for home builders. We think this is far too low for HHC’s trophy collection of assets. We expect book value to grow materially with development of Ward Village in Honolulu and the redevelopment of the South Street Seaport in New York City.
We are not the only ones that think highly of HHC’s development potential. Chairman William Ackman recently increased his economic interest in HHC to 26% of shares outstanding and George Soros and John Paulson joined us as shareholders in the third quarter.
General Motors (GM-WT) – Our investment in GM warrants returned 100% last year. Despite significant appreciation last year, GM still trades at a significant discount to its peer group. Narrowing the valuation gap
would result in a 40%+ gain in shares and a greater than 70% return in GM warrants. With its best in class exposure to emerging markets, fortress balance sheet ($27B in cash) and increased product cadence (GM will replace 89% of its product portfolio between 2013-2016), we think GM should at least trade in-line with its peer group.
The US government finished disposing its stake in GM during the fourth quarter. This should prove to be a catalytic event as the government’s near half-decade of ownership has created near constant selling pressure on GM shares. We also expect the resumption of dividends (current yield of 3.3%), announced earlier this month, to broaden the shareholder base.
GM should also benefit from recent product rewards. After earning the highest score ever achieved by a sedan in Consumer Reports for its Impala, GM’s Chevrolet Silverado was named best truck by the magazine. Motor
Trend named the Cadillac CTS its Car of the Year. At the North American International Auto Show, held earlier this month, GM’s Corvette Stingray won Car of the Year and the Chevrolet Silverado was named Truck of the Year. The 49 member jury is not affiliated with the auto show but instead consists of auto reporters from a variety of online and print publications.
One individual that deserves much of the credit for GM’s product accolades is Mary Barra, who previously served as GM’s head of Global Product Development. A 33 year GM veteran, Ms. Barra was named CEO of
GM earlier this month. By elevating the individual that previously ran product development to lead the company, GM is sending a message that quality product will be prioritized.
While it has been a catalyst rich few months for GM, we believe there is more potential to be unlocked and believe the Barra era will be rewarding for shareholders.
Bank of America (BAC) – BAC shares rose 35% last year with investors applauding the company’s visible cost cutting, curtailment in legacy assets, and reduction in legal tail risks. Most important, BAC is once again a steward of an excellent balance sheet due to CEO Brian Moynihan’s focus on risk management as compared to the go-go growth culture that characterized the prior leadership regime. A return to safe banking practices has left BAC primed for success for a resurgent US economy. BAC’s loan-to-deposit (LTD) ratio is near decade lows due to strong growth in its deposit base and a downsizing of loans and leases outstanding. This leaves the company well positioned for a pick-up in loan demand and enables the company to be more aggressive with its loan book once interest rates widen.
BAC’s efforts to increase cross-selling of financial products to its existing base have been wildly successful. According to bank efficiency consultant, Mike Moebs, BAC generates more fees per dollar of assets than any other large money-center bank. This should be an important driver of earnings growth going forward as consumers once again tap credit after years of deleveraging.
With its asset sensitive balance sheet and exposure to the US consumer, BAC represents one of the best ways to play a recovery of the US economy. A healthy balance sheet should enable BAC to accelerate capital return to shareholders this year providing the next leg up in share price appreciation.
We added a number of new positions during the second half of the year including the following:
Fiat (F.MI) – Fiat is an Italian auto-maker, which in addition to its namesake brand, has full ownership of luxury nameplates Ferrari and Maserati and recently acquired full control of Chrysler. Under a savvy bit of deal making, CEO Sergio Marchionne acquired the 41.5% of Chrysler it did not own for $4.35B, a fraction of the $36 billion that Daimler paid to acquire the company in 1998.
Chrysler has produced several popular models over the past years including its Dodge Ram line of trucks, the Dodge Dart, and most notably a well-received re-design of the Jeep Cherokee. Sales increased 9.3% last year and have increased for 44 consecutive months.
Our investment in Fiat, reminds us of our investment in Yahoo. When we acquired Yahoo, Wall Street and the media were solely focused on the company’s domestic operations and glossed over the company’s 40% ownership of Alibaba. Few analysts factored Alibaba into their valuation scenarios. Similarly, with Fiat, the analyst community has narrowly focused on the company’s competitively challenged Fiat brand in European markets while ignoring the company’s majority stake in a resurgent Chrysler and the latent value to be surfaced in the Ferrari and Maserati brands.
Another significant miss by the analyst community, in our view, was the collective failure to adjust Fiat’s debt profile for its government sponsored pensions. While Fiat has to contend with rigid labor rules in its home markets, the upside is a government that picks up the tab on worker retirement benefits. Failure to make this adjustment to Fiat’s enterprise value would have made its valuation less alluring and it debt servicing capacity more challenging than reality.
Fiat’s acquisition of Chrysler is a game changer. Fiat’s Italian factories have been a significant drag on margins with production at 41% of capacity. Full Integration with Chrysler will allow Fiat to optimize its global manufacturing footprint by directing production to geographies with spare capacity. We expect an attendant rise in operating leverage to have a salutary effect on profit margins. In addition, greater scale will allow Fiat to spread its R&D, and corporate functions across multiple product lines, lower capital expenditures through shared platforms, and most important, provide access to Chrysler’s balance sheet and cash flow. It also paves the way for a listing of Fiat-Chrysler in New York, providing enhanced access to more efficient credit markets and wider visibility.
There is much to like about Fiat. Like GM, the company should benefit from an increased product cadence with a total of 40 launches scheduled to occur over the next three years. The Fiat brand maintains the number one share in Brazil at 23%. In Europe the Fiat brand has steadily lost share, but its Mini-like Fiat 500 has been warmly received. Fiat plans to attack its competitive ills in Europe by expanding its product line-up at Maserati with plans to bolster production to 50,000 cars per year compared to 6,000 cars in 2012.
“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business” – Warren Buffett
One would be hard pressed to find a global brand more emblematic of pricing power than Ferrari. Even after naming its new car, “LeFerrari,” the company managed to immediately sell out its entire production run at a price of $1.8 million per vehicle. Ferrari’s waiting lists stretch over years and many of its cars actually appreciate in value. We think the value of Ferrari’s lush margins is too valuable for Fiat to consider monetizing the ultra-luxury brand through a spin-off. Nonetheless, we think the value of Fiat’s Ferrari stake provides
important downside support to Fiat’s stock. Analysts have estimated that a spin-off of Ferrari would command a valuation of $7 billion, equivalent to 55% of Fiat’s market cap. We think of Ferrari as a royalty on global wealth creation and expect its market value to compound over time.
Fiat management has guided to consolidated margins of 7+% by 2016. If the company is successful, we expect Fiat to double from current levels. Risks include an uncertain economic backdrop in Brazil, a poor market reception to new models and a potential for over-capacity in global auto manufacturing. In addition, we are not fond of Fiat’s plans to revitalize its Alfa Romeo brand. A consummate poker player, we suspect Mr. Marchionne’s grand plans for Alfa Romeo were a bluff utilized to extract favorable terms from Chrysler during buy-out negotiations. Nonetheless, we will be closely watching the resources dedicated toward this effort.
Amerco (UHAL) - UHAL owns U-Haul, the nation’s dominant Do-it-Yourself moving company. The company invented the intra-city moving model over 60 years ago and owns hubs in urban centers which would cost a multiple of its current market cap to replicate from scratch. UHAL is one of the most ubiquitous companies in America with more locations than Starbucks and its trucks serving as roving billboards in hundreds of cities across the country on a daily basis. The company’s competitive position is unassailable with eight times as many locations as it nearest competitor and a fleet size four times the size of its closest competitor. UHAL’s 17,000 locations provide a network effect virtually guaranteeing UHAL has a location nearby. Additionally, each new store opening increases the asset utilization of all stores by providing more city-to-city drop-off options. This provides scalability of fixed costs leading to increased asset utilization over time.
Rental truck earnings are driven by fleet utilization. With its extensive hub and spoke network of service centers UHAL can better match its fleet to demand, allowing for greater pricing flexibility than competitors.
Further, rental moving trucks are not the core focus at UHAL’s primary competitors, Budget (car rental) or
Penske (commercial truck rental), which makes the economics of building out scale to compete against UHAL a non-starter.
In addition to its truck rental business, UHAL has a hidden asset in its storage business with truck rental sites also serving as storage facilities for DIY movers. The division has been showing impressive revenue growth as of late with sales growth of 20% in the most recent quarter. The self-storage business possesses superior economics to UHAL’s truck rental business with less capital intensity, higher margins and less cyclicality. Similar to the truck rental business, UHAL’s storage facilities benefit from closer proximity to customers than competitor options adding to pricing power and keeping demand steady.
UHAL owns significant real estate in its self-storage facilities. If converted to a REIT it would be the third largest storage business in the US. If you were to spin out UHAL’s storage business and accord it a market multiple inline with other storage REITs, its stock price would be $97.00. UHAL’s remaining business would trade for 9.4x the $13.41 in non-storage earnings. At present, management has not indicated plans for spinning out its storage operations as a REIT but it helps to put a floor on the stock price and is illustrative of the real estate value embedded within UHAL’s assets.
At present, UHAL trades for 12.1x earnings, a 20% discount to the S&P 500 at 15.2x earnings. We think that is far too cheap given UHAL’s competitively entrenched position and increasing pricing power. We think that
UHAL will eventually trade inline with a market multiple as more investors come to appreciate its emerging moat and cyclical tailwinds.
UCP (UCP) – Speaking of cyclical tailwinds, our next investment is poised to be a prime beneficiary of the improving housing market. UCP is a west coast homebuilder that was spun out from Pico Holdings in an IPO last July. Pico capitalized the company in 2008 to take advantage of the fire sale occurring in residential lots during the worst of the housing crisis in 2008-2009. Over-extended homebuilders in need of de-leveraging were desperate to monetize their land-holdings in order to live another day. UCP was happy to oblige and opportunistically deployed over $190M in capital acquiring lots in high-growth West Coast markets.
Altogether, UCP has 6,659 lots with the majority concentrated in Fresno, the Monterey Bay area, the region south of San Francisco and the Puget Sound area of Seattle. UCP has wisely let its lots appreciate in value until the market offered more attractive opportunities for development. With the housing recovery gaining momentum, UCP has commenced home-building operations and ultimately plans to build out 62 communities capable of supporting thousands of homes.
UCP currently trades for a price/book multiple of 1.2x, which compares favorably to the industry average of 2.2x. Similarly sized homebuilders in complementary markets show P/B values of 1.7x to 1.9x. Recent acquisitions also highlight UCP’s value with recent deals suggesting lot values of $100k. In fact, in 2011 UCP’s average lot sale netted out to $100k, highlighting some of the choice coastal markets within its portfolio.
Compare this to the average lot price of $31,000 inferred by UCP’s current enterprise value.
While UCP appears cheap based upon price/book multiples for its peer group and recent transactions within its geographies, the extent of its undervaluation is made much clearer by examining its accounting. GAAP accounting standards require land be carried at historical cost or fair value. Given that UCP spent $191 million dollars acquiring land during the worst housing crisis since the Great Depression, it is fair to say the company’s inventory of lots have experienced some appreciation three years into a housing recovery. Recent facts and figures confirm this with the Case-Schiller index indicating Seattle home prices have risen 53% from trough levels while San Francisco prices have advanced 25%.
We think UCP’s homebuilding operations will catalyze UCP’s market value by reflecting the economic value of its assets rather than the accounting value. As projects come to fruition, economic value will surface and should lead to a gain of over 100%.
UCP reminds us of another one of our portfolio holdings, Howard Hughes Corporation (HHC). Similar to Howard Hughes, when it was spun off from GGP, UCP is a collection of prime undervalued assets that is mispriced due to its orphaned status. Like HHC, we think UCP will rerate materially higher once it proves the development potential of its holdings.
We felt strongly enough about UCP’s investment merits that we presented it earlier this month at the Manual of Ideas’ “Best Ideas” investment conference.
GenCorp (GY) – GY is the leader in propulsion technology. Propulsion technology is utilized by the aerospace and defense industries for space rockets, as well as tactical and ballistic missiles. GY recently completed a transformational acquisition, purchasing the second largest player in the propulsion space, Rocketdyne. The combined company has a 70% market share of missile defense and a 90% share of medium and large rockets for launch vehicles. GY is, in effect, a legal monopoly. The FTC moved to block the acquisition, but the Department of Defense intervened claiming the acquisition was necessary for national defense purposes. A business without competitors is a business we are interested in owning.
Without GY’s propulsion products, most space and missile defense programs would be inoperable. Demand for GY products is highly visible. As a sole-source supplier in most of its product lines, GY is able to establish multi-decade contracted revenue streams. The highly specialized nature of its niche technology, as well as a lengthy certification and qualification process, keeps competitors at bay. This is reflected in GY’s deep customer relationships having served NASA for more than 50 years and Lockheed Martin and Raytheon for 35 and 25 years respectively. Despite customer concentration, pricing power remains high due to the diversity of contracts. For example, GY’s Aerojet division supplied propulsion technology across 270 contracts last year.
Adoption of next-generation propulsion technology in future missile and space programs could add materially to earnings. For example, GY has developed solar electric propulsion technology that is being used for large government satellites. The company notes that not having to haul fuel into space is a game changer potentially worth billions in revenue. In addition, GY has been chosen to develop and demo a new rocket engine for the
U.S. Air Force to replace all existing “third-stage” motors. Both of these opportunities are potentially worth billions in revenue, but at a current enterprise value of $1.6B we are getting the upside for free.
Similar to many of our most lucrative investments, one has to make accounting adjustments to uncover the true value of GY. Uncovering the actual liability of GY’s $475M unfunded pension requires some analytical lifting. With the passage of the MAP-21 Act, no contributions are due to GY’s pension until 2015, at which point the government has agreed to reimburse the company for approximately 84% of its pension obligations. Due to the opacity of GY’s pension dynamics, GAAP earnings are lower than cash earnings. Adjusting for the non-cash nature of pension expenses, and giving credit for anticipated cost synergies with Rocketdyne, results in pro-forma cash earnings of $173M, or an enterprise value of 8.8x cash earnings.
At first blush, GY does not screen well on its asset value either. GenCorp owns over 11,900 acres of prime real estate in Sacramento and 36,000 feet of office space, conservatively worth $500M. Research by Gabelli &
Company estimates that GY’s land holdings are worth $1B. This is not insignificant for a company with an enterprise value of $1.6B. Similar to UCP, GY’s land value is recorded at historical cost, understating GY’s market book value. GY has begun the development process to turn 6,000 of its acres into master planned communities called Easton Place and Glenborough. The land is already entitled allowing for a transaction to occur or for GY to develop the land itself. We expect development of GY’s real estate assets to surface dormant market value and lead to improved price discovery on the stock.
Without adjusting for the value of its land holdings, GY trades for 9x cash earnings. We think this is far too low for a monopoly business with secure long-term contracts and secular tailwinds. After foregoing conference calls and ignoring Wall Street for years (our kind of company!), the new GY plans to reach out to investors beginning with a conference call in March. As the Street begins to appreciate GY’s business drivers and competitive strengths we think shares will respond in kind.
Magnetek (MAG) – MAG is the North American market leader for supplying electric motors and motion control systems to original equipment manufacturers (OEMs) for usage in elevators, cranes and hoists. The company has a large installed customer base with over 70,000 elevators worldwide utilizing MAG components.
MAG’s drive systems have been installed on over 10,000 cranes and boom lifts, providing lucrative service and maintenance revenue streams.
Magnetek is similar to GenCorp in that noise around its financials clouds the company’s true value. In particular, a pension liability of $102M compared to a market cap of $59M. The pension was frozen in 2003 so benefit accruals are not a risk to future pension value. In 2007, MAG’s pension liability was $16M but with interest rates at historical lows, MAG has been forced to revalue its pension liability with a much lower rate. As a result, MAG’s pension assets, which are primarily comprised of high-quality fixed income instruments, are valued with a discount rate of 3.5%, compared to 6.3% in 2007. Lower rates caused MAG’s pension funding gap to balloon. With interest rates near historical lows, the same phenomenon is poised to play out in reverse. Management has stated that for every 100 basis points increase in interest rates its pension liability is reduced by $20M. If one is of the belief that interest rates will head higher from current levels, the future liability posed by MAG’s pension looks far less onerous. Last year’s rise in rates is not reflected in current financials as MAG only changes its discount rate assumptions upon year-end. Financials for 2013 will be released shortly and will reflect higher rates. Current rates would translate into a pension liability of $68M.
As interest rates revert to historic norms, value should accrue to equity holders. Adjusting for non-cash pension expense, MAG would have generated $20M in free cash flow in 2012, equating to a 25% free cash flow yield.
Even if we assume interest rates remain depressed, MAG’s high quality, recurring cash flow business is more than capable of throwing off enough funds to replenish its pension coffers. Between 2007-2012, during one of the most challenging economic environments in modern history, MAG grew its cash balances from $7M to $29M while contributing $50M to its pension fund. In two to three years’ time, MAG’s pension overhang should recede and its true earnings power will emerge.
As an emerging fund, we are always looking for new investors. If you are happy with your experience at Coho Capital please consider sharing your opinion of Coho with others. We encourage you to pass along our letters to those whom you believe would be interested in Coho’s approach toward capital management. We believe our process of investing with conviction in companies that have broad downside support offers a pathway to superior risk-adjusted returns. We thank you for joining us on the journey.
Respectfully yours,
Jake Rosser
Managing Partner
Coho Capital Management
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