Gabelli Q3: Opportunities In M&A Amid Dearth Of ValueVW Staff
To Our Shareholders,
For the quarter ended September 30, 2013, the net asset value (“NAV”) per Class AAA Share of The Gabelli Asset Fund increased 6.7% compared with an increase of 5.2% for the Standard & Poor’s (“S&P”) 500 Index. See page 2 for additional performance information.
Déjà Vu All Over Again
The third quarter was marked by events that have become all too familiar over the last few years: the Fed continued its program of quantitative easing, the economy improved (albeit slowly), tensions flared in the Middle East, Washington seems to be at an impasse, and of course, markets rose substantially, with the S&P up over 5% for the quarter.
While the backdrop is well known at this point, the details are slightly different. The Fed surprised markets when, instead of starting its tapering process of cutting back on bond purchases, it decided to continue with its current level of $85 billion per month. While this event was celebrated by markets, it in some ways led to even more uncertainty, since the infamous taper will have to begin at some unknown point in time and it also shows that the Fed isn’t convinced the economy is on a strong footing yet. Further complicating matters, Larry Summers, thought of as one of the favorites to succeed Ben Bernanke as Fed Chairman, withdrew from the running – an event that also sent markets upward, since the frontrunner for the job became (presumably dovish) Fed Vice Chairman Janet Yellen, who was formally nominated shortly after quarter end. While liquidity is the lifeblood of markets, one wonders whether continually adding more will simply increase the pain down the road, when current policies must be unwound.
At the end of the quarter, the attention turned to events in Washington. While markets shrugged off the federal government shutdown that started on October 1, the potential of the United States bumping up against the Federal debt ceiling was beginning to look more possible, if not likely, as of the writing of this letter. While we expect a deal to be reached before or just after this happens, the potential of these events to rattle markets that have essentially coasted upward for the first three quarters of the year is a distinct possibility.
Despite all of these macro factors influencing the markets, our process remains the same since the Fund’s inception. Our stock selection is driven by fundamental, bottoms up research conducted globally by our team of analysts and portfolio managers. We seek quality companies trading at a material discount to Private Market Value with catalysts in place to surface value. As long as we have a margin of safety, we are willing to hold stocks for a very long time and will seek to use volatility (either in individual stocks or the market) in order to add to positions at more attractive prices. While the market has done well this year, we continue to believe that equities remain the most attractive asset class relative to other options, and are prepared to use any pullback due to the debt ceiling debate or other unforeseen events in order to increase our holdings in the best opportunities we have available.
Deals, Deals, and More Deals
In August, Verizon Communications Inc. (0.3% of net assets as of September 30, 2013) announced it would buy Fund holding Vodafone’s (0.1%) stake in Verizon Wireless in a $130 billion transaction. We believe this transaction may serve as a catalyst for more global telecom industry M&A and demonstrates that strategic acquirers are increasingly warming to the idea of stepping up to take advantage of the extremely attractive financing environment to pursue deals. Notwithstanding the political and macro uncertainty, we believe the Fifth Wave of takeover activity since World War II is growing in momentum, and many of the Fund’s holdings are potential takeover candidates.
Let’s Talk Stocks
The following are stock specifics on selected holdings of our Fund. Favorable earnings prospects do not necessarily translate into higher stock prices, but they do express a positive trend that we believe will develop over time. Individual securities mentioned are not necessarily representative of the entire portfolio. For the following holdings, the percentage of net assets and their share prices stated in U.S. dollars or U.S. dollar equivalent terms are presented as of September 30, 2013, except as noted.
American Express Co. (1.5% of net assets as of September 30, 2013) (AXP – $75.52 – NYSE)(AXP) is the largest closed loop credit card company in the world. The company operates its eponymous premiere branded payment network and lends to its largely affluent customer base. American Express has 104 million cards in force and over $63 billion in loans, while its customers charged nearly $900 billion of spending on their cards in 2012. The company’s strong consumer brand has allowed American Express to enter the deposit gathering market as an alternate source of funding, while the company’s affluent customers have picked up spending. Longer term, American Express should capitalize on its higher spending customer base and continue to expand into other payment related businesses like corporate purchasing, while also growing in emerging markets. Similarly, the company is looking at the growing success of social media as an opportunity to expand its product base and payment options.
AMETEK Inc. (1.7%) (AME – $46.02 – NYSE)(AME) is a leading global manufacturer of analytical instruments for the process, aerospace, and industrial markets, and a leading producer of electric motors and blowers for the floor care and outdoor power equipment markets. In the near term, the company continues to experience significant growth in its longer cycle businesses in the aerospace, power generation, and process industries. Longer term, the company continues to make acquisitions to augment growth. In the Electronic Instruments Group, AMETEK expects one half to two thirds of its revenue growth to come from acquisitions. The company is focused on acquiring differentiated businesses with revenues of $30-$100 million. Differentiated businesses compete on the basis of product capability, have higher growth rates, and offer superior returns. In the Electromechanical Group, AMETEK’s key strategy is to reduce costs by increasing efficiency and moving noncore operations to low cost countries such as Mexico, the Czech Republic, and China.
Amgen Inc. (0.2%) (AMGN – $111.94 – NASDAQ)(AMGN) is one of the largest biotechnology companies in the world, with medicines for cancer, kidney dialysis, osteoporosis, and other conditions. Given its large size and mature product portfolio, revenue growth has slowed, but the company has been able to cut costs and repurchase shares to sustain double digit earnings per share growth. Earlier this year, Amgen offered to acquire Onyx Pharmaceuticals Inc. (less than 0.1%) to bolster its oncology portfolio, with Nexavar for liver cancer and Kyprolis for blood cancers. On Aug 25, after a brief auction, Amgen agreed to pay $125 per share, or $10.4 billion, for Onyx. While initially dilutive to earnings, this acquisition provides significant visibility into Amgen’s future, with two blockbuster drugs that could eventually generate over $5 billion in annual sales.
Diageo Plc. (1.2%) (DEO – $127.08 – NYSE)(DEO) is the leading global producer of alcoholic beverages, with brands including Smirnoff, Johnny Walker, Ketel One, Captain Morgan, Crown Royal, J&B, Baileys, Tanqueray, and Guinness. The company has a balanced geographic presence in both mature and emerging markets, and it benefits from the trend of consumers around the world trading up to premium branded products. In 2011 and 2012, Diageo made several acquisitions that enhanced its presence in emerging markets: Mey Icki, the leading spirits company in Turkey; Shui Jing Fang, a leading Chinese baiju producer, Ypioca, the leading cachaca producer in Brazil; and an increased stake in Halico, the leading domestic spirits producer in Vietnam. Diageo also made an investment in United Spirits, the leading spirits producer in India, which will provide the company with the leading position in another fast growing emerging market. Over the medium term, Diageo expects organic top line growth of 6% and 200 bps of margin improvement, leading to double digit earnings per share growth. Longtime executive Ivan Menezes took over as CEO on July 1, 2013, and we expect him to continue to drive the company’s growth in both mature and emerging markets.
DIRECTV (1.4%) (DTV – $59.75 – NASDAQ)(DTV) is the largest pay television provider in the world, with nearly twenty million subscribers in the United States and eight million subscribers throughout Latin America. Originally part of General Motors, DTV used its technological advantage, focus on high income customers, recognition of the necessity for superior customer service, and clever (Sunday Ticket) participation in exclusive sports programming to cement its position in the U.S. The company used essentially the same strategy in Latin America, where it is benefiting from the growth of the middle class in countries such as Brazil and Colombia. Atop a superior operating business, DTV has layered a capital structure that maximizes equity returns. The company has used modest leverage to repurchase stock, in the process cutting its shares outstanding by more than half over the last six years.
Genuine Parts Co. (1.3%) (GPC – $80.89 – NYSE)(GPC) is an Atlanta based distributor of automotive and industrial replacement parts, office products, and electrical and electronic components. We expect GPC’s well known NAPA Auto Parts group to benefit as an aged vehicle population, which includes the highest percentage of off warranty vehicles in history, helps drive sales of automotive aftermarket products over the next several years.
Additionally, economic indicators remain supportive of the company’s industrial and electrical parts distribution businesses amid steady economic expansion. Finally, GPC’s management has shown consistent dedication to shareholder value via share repurchases and dividend increases.
News Corp. (0.4%) (NWSA – $16.06 (0.3%) NWS – $16.43 (0.1%) – NASDAQ)(NWSA), based in New York, operates in five segments: 1) News and information services – U.S., United Kingdom, and Australian publishing businesses, including The Wall Street Journal, the Times of London, and the New York Post, along with News America Marketing Corp., a leading provider of free standing inserts (FSIs or cents off coupons); 2) Cable network programming – Fox Sports Australia; 3) Digital real estate services – a 62% interest in publicly traded REA Group Ltd. (Australia); 4) Book publishing – Harper Collins, one of the largest English language publishers in the world; and 5) Other – primarily the company’s K-12 education business – Amplify. On June 28, 2013, ‘old News’ Corp. (now Twenty-First Century Fox Inc. (2.4%)) spun off most of its non entertainment assets (‘new News’) to holders on a one for four basis. We estimate that the company will generate about $800 million of EBITDA on $8.7 billion of revenues for the year ending June 30, 2014.
Precision Castparts Corp. (1.6%) (PCP – $227.24 – NYSE)(PCP) is a manufacturer of investment castings and forgings, primarily for the aerospace and industrial gas turbine markets. The company also makes fasteners and industrial products for the automotive, aerospace, and general industrial markets. PCP is a strong cash flow generator, and we continue to believe the company will use its cash for acquisitions, such as the recently completed Titanium Metals Corporation. PCP’s acquisition strategy centers on buying businesses within the company’s core competencies, which include manufacturing component products for complex end users. The strategy also includes finding companies that have procurement or technologies similar to PCP’s and similar customer profiles. These characteristics should provide opportunities for PCP to improve the acquired company’s profitability, thereby enhancing PCP’s earnings.
Twenty-First Century Fox Inc. (2.4%) (FOXA – $33.50 (2.2%) FOX – $33.40 (0.2%) – NASDAQ)(FOXA) is a diversified media company with operations in cable network television, television broadcasting, filmed entertainment, and direct broadcast satellite (DBS) television. Cable networks account for 66% of the company’s EBITDA and benefit from contractually recurring affiliate fees and exposure to the fast growing global pay TV market. We also expect the company to benefit from rising demand for premium content, driven by emerging distribution platforms such as Netflix, retransmission revenue, and aggressive share repurchases.
Vodafone Group Plc. (0.1%) (VOD – $35.18 – NASDAQ)(VOD) is the second largest mobile operator in the world based on number of subscribers. Vodafone’s operating units span Europe, Africa, and Australasia. Vodafone’s single most valuable asset has been its 45% equity stake in Verizon Wireless in the U.S. In the third largest M&A transaction ever, Vodafone agreed on September 2 to sell its interest to Verizon for a total consideration of $130 billion. The price represents a multiple of 9.4x the trailing twelve month EBITDA for the unit and approximately 173 pence per Vodafone share. On completion of the transaction, which is expected in the first quarter of 2014, Vodafone intends to return $84 billion to shareholders or 71% of the net proceeds. Vodafone also announced, along with the deal, a new investment program (Project Spring) with £6 billion of organic investment over the next three years to further enhance its network and service leadership in key markets. Some £13.4 billion of the remaining proceeds will be used to reduce net debt, leaving the company with significant flexibility and net debt/EBITDA below 1.0x. The sale of the Verizon Wireless stake is a transformational event for Vodafone. The combination of Project Spring and potential further acquisitions, such as the pending purchase of Kabel Deutschland, will propel Vodafone into a market leading position across its managed businesses. On a pro forma basis, Vodafone shares remain attractive, trading at an undemanding 4.8x March 2014 EBITDA.
Top contributors to performance included Twenty-First Century Fox (2.4% of net assets as of September 30, 2013) (+27%) (formerly News Corp.), which is now focused on its cable networks, broadcast and movie businesses following the spin-off of its publishing assets; IDEX (1.4%) (+22%), which experienced good order growth, particularly in its oil & gas business; Viacom (1.3%) (+23%), which experienced ratings and advertising market improvements and expanded its buyback authorization; Flowserve (1.1%) (+14%), which made significant gains in improving operating margin in its industrial segment; and Telephone & Data Systems (1.0%) (+20%), which rose largely due to continuing M&A activity in the U.S. wireless industry as well as a $250 million stock repurchase authorization announced in early August 2013..
Detractors to performance included Energizer Holdings (0.7%) (–9%), which continues to suffer from secular decline in the battery business, while the growth rate of personal care has moderated; DIRECTV (1.4%) (–3%), which has exposure to the weakening economies in Latin America; Newmont Mining (0.5%) (–6%), which wrote down long term assets in Boddington and Tanami due to lower gold and copper prices; Coca-Cola (0.7%) (–6%), which reported soft second quarter volumes; and J.C. Penney (0.1%) (–31%), which reported continued negative comparable store sales and had investor Pershing Square sell its stake toward the end of the quarter.
The more things change, the more they stay the same. While uncertainty looms, and we would not be surprised by a pullback in the market from current levels, we believe the Fund is well positioned to take advantage of rising M&A activity in order to preserve and grow capital over time