Gabelli Value 25 Fund Q2 Letter: Activists All AroundVW Staff
Gabelli Value 25 Fund’s letter to shareholders for the quarter ended June 30, 2014.
To Our Shareholders,
For the quarter ended June 30, 2014, the net asset value (“NAV”) per Class A Share of The Gabelli Value 25 Fund Inc. increased 4.1% compared with increases of 5.2% and 2.8% for the Standard & Poor’s (“S&P”) 500 Index and the Dow Jones Industrial Average, respectively. See page 2 for additional performance information.
Gabelli Value 25 Fund: The economy
The second quarter of 2014 offered its share of surprises: first quarter GDP was revised to 2.9%, ten year U.S. Treasury rates declined to 2.5% after ending 2013 at 3.0%, tensions worsened in Ukraine, and the previously little known group ISIS executed a lightning-fast takeover of much of oil-rich northern Iraq. Perhaps the biggest surprise, however, was that in the face of these dynamics, the S&P 500 marched up over 5% for the quarter. Clearly, the market is looking at other variables. Job growth continues to improve and the housing market is showing pockets of strength, but neither to the extent that would cause the Federal Reserve to accelerate the withdrawal of stimulus; interest rates are likely to remain historically low well into 2015. The market has also been heartened by a surge in mergers and acquisitions (M&A), as quarterly global transaction volumes more than doubled year-over-year, exceeding $1 trillion for the first time since 1998. Several years ago, we noted that we expected a “Fifth Wave” of post-World War II M&A, fueled by low interest rates and a dearth of organic growth opportunities. Two additional ingredients – rising corporate confidence and the pursuit of tax domiciles outside of the U.S. – have recently swelled that wave. We believe that a virtuous cycle of more deals and awakening animal spirits has been set into motion, which should extend the M&A trend into the foreseeable future.
As we have written in the past, the level and trajectory of interest rates and inflation are likely to have the biggest impact on future M&A and the stock market. Spurring the economy to outgrow an eventual normalization of rates is the needle that central banks around the world must thread. There are certainly many obstacles to achieving this goal, including geopolitical instability. The price of oil, often a barometer of global tensions, rose substantially in the quarter and is a factor we monitor carefully, as it could snuff the global recovery.
Gabelli Value 25 Fund: Activists all around
While Russian President Vladimir Putin and Federal Reserve Chair Janet Yellen have been active in their respective spheres, we concern ourselves here with the rising ride of so-called shareholder activists. Tracing their history to the conglomerateurs of the 1970s and raiders of the 1980’s, today’s activists tend to be more institutionalized, even partnering with other corporations, as Valeant Pharmaceuticals Intl Inc (NYSE:VRX) did recently with Pershing Square in a bid for Allergan, Inc. (NYSE:AGN). Often seen among the varied goals of activists are changes in capital structure, corporate transactions (e.g. a sale or spinoff) and improved governance or operations. The toolbox used to pursue these measures includes a combination of public relations and proxy contests.
We take a nuanced view as to the long term impact of these campaigns – it depends on the target, the objectives, and the activist. Although we would not consider ourselves activist investors, your Advisor issued a Magna Carta of Shareholder Rights in 1988 which states: “We are neither for nor against management. We are for shareholders.” The document goes on to list a number of governance policies we favor (e.g. cumulative voting, golden parachutes, one share/one vote) and oppose (e.g. poison pills, super dilutive option plans). Unlike many of today’s headline grabbing activists, we do not typically enter a situation seeking change. However, if we believe a company in which we have invested is harming its shareholders, we will be tireless in protecting (y)our interests.
Gabelli Value 25 Fund: Deals, deals, and more deals
The Fund was a significant beneficiary of deal activity in the second quarter. Suntory’s acquisition of Beam Suntory Inc (NYSE:BEAM) for $83.50 per share, announced in January, closed in April. Beam was the global distilled spirits business that resulted from the October 2011 split-up of Fortune Brands and Fortune Brands Home & Security Inc (NYSE:FBHS) (0.2% of net assets as of June 30, 2014). The product of another split-up, Hillshire Brands (1.1%), from the result of Sara Lee’s separation of its meats and coffee units, became the subject of a bidding war in the quarter, with Tyson Foods, Inc. (NYSE:TSN)’s agreeing to pay $63.00 per share. Covidien plc (NYSE:COV) (0.3%), itself a result of Tyco International Ltd. (NYSE:TYC)’s original 2007 breakup, agreed to be acquired by Medtronic, Inc. (NYSE:MDT), which sought, among other things, Covidien’s domicile in Ireland. Finally, on the heels of Comcast Corporation (NASDAQ:CMCSA)’s (1.1%) acquisition of Time Warner Cable Inc (NYSE:TWC) (1.1%), AT&T Inc. (NYSE:T) agreed to acquire DIRECTV (NASDAQ:DTV) (2.5%) for $95 per share in cash and stock. We had long believed a telecom operator would covet DIRECTV’s premium brand and customer base. We believe the continued strong pace of financial engineering will facilitate more deal activity in the future.
Gabelli Value 25 Fund: Let’s talk stocks
The following are stock specifics on selected holdings of the 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 are presented as of June 30, 2014.
Covidien plc (NYSE:COV) (0.3% of net assets as of June 30, 2014) ($90.18) is one of the largest and best positioned medical device manufacturers in the industry. On June 15, 2014, Medtronic agreed to acquire Covidien for $93.22 per share, over $43 billion total. The combined company will be able to partner with customers and bundle together the broadest product offering in the industry. This deal is also structured as a tax inversion, giving the combined company a lower tax rate and more flexibility in using its global cash. At 15x EBITDA and 23x earnings, we think Covidien shareholders are getting full value for their company.
Crane Co. (NYSE:CR) (1.1%) ($74.36) is a manufacturer of highly engineered industrial products serving niche markets in aerospace, fluid handling, automatic merchandising and building products. The aerospace and fluid handling businesses make up about 70% of Crane’s sales. In the Aerospace segment, Crane produces aircraft brake controls, anti-skid systems, pressure sensors, radio frequency components, and custom miniature electronic circuits. This group is poised for significant growth, driven by the increased production of Boeing and Airbus aircraft, including new programs such as the Boeing 787 Dreamliner, the stretched version of the 747, Airbus A380 jumbo jet and the F-35 Joint Strike Fighter. In the Fluid Handling segment, the company makes pumps and valves for the chemical, hydrocarbon processing, pharmaceutical, oil and gas, and commercial construction industries. This later cycle business is showing higher sales driven by increased capital spending in the chemical and process markets. We believe that these dynamics, along with a strong balance sheet and positive free cash flow, position Crane for higher growth in the future.
DIRECTV (NASDAQ:DTV) (2.5%) ($85.01) is the largest pay TV provider in the world, with over 20 million subscribers in the U.S. and over twelve million throughout Latin America. Originally part of General Motors Company (NYSE:GM), 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 five years. Long of interest to its telecom distribution partners, AT&T agreed to acquire the company in April 2014 for $95 per share in cash and stock. We expect the transaction to be approved and close early in 2015.
Energizer Holdings, Inc. (NYSE:ENR) (0.9%) ($122.03) became an independent company after it was spun off from Ralston Purina in April 2000. Energizer manufactures, markets, and sells dry cell batteries and lighting products worldwide. Subsequently, Energizer expanded its product portfolio through acquisitions, including Schick-Wilkinson Sword (2003), Playtex (2007), Edge/Skintimate (2009), American Safety Razor (2010), and most recently, J&J’s feminine hygiene brands (2013). Today, Energizer reports results for two segments: Household ($2.0 billion of revenue), which includes the domestic and international battery businesses, and Personal Care ($2.4 billion), which includes wet shaving, skin, feminine and infant care. In April 2014, ENR announced its intention to split the company into two publicly traded firms through a tax-free spinoff of one of the divisions to shareholders. The transaction is expected to be completed in the second-half of fiscal 2015. This may be the first step in realizing the full value of the two businesses, as both divisions may be more attractive acquisition candidates on a standalone basis.
Grupo Televisa SAB (ADR) (NYSE:TV) (1.0%) ($34.31) is the dominant company in the Mexican broadcast television industry. Televisa has parlayed its vertical integration and strong broadcasting cash flow into a significant position in Mexican satellite and cable television. In an important recent trend, Televisa has solidified its position as a key program supplier to Los Angeles-based Univision, the dominant Hispanic television provider in the U.S. With the results of the 2010 census now well distributed, the growth of the U.S. Hispanic population virtually assures higher cash flow from this partnership to Televisa and makes it likely that investors may accord this business a higher multiple as advertisers value eyeballs greatly. Televisa has an opportunity to monetize this investment as Univision is likely to be sold or to conduct an initial public offering in the next year.
Hillshire Brands Co (NYSE:HSH) (1.1%) ($62.30), formerly the Sara Lee Corp., completed the spinoff of D.E Master Blenders 1753 and paid a $3 cash dividend to shareholders on June 28, 2012. As a result, shareholders received one share of the North American meat company, renamed Hillshire Brands (HSH), which subsequently underwent a reverse split of 1-for-5. Hillshire Brands is a concentrated meat and bakery business in the U.S., generating an estimated $4 billion of revenue. It is the leading player in categories such as protein breakfast, breakfast sausages and hot dogs under the Jimmy Dean, Hillshire Farm and Ball Park brands. On July 2, 2014, following a bidding war between Tyson Foods and Pilgrim’s Pride and the termination of the Hillshire agreement to acquire Pinnacle Foods, which was previously announced on May 12, 2014, Hillshire announced it agreed to be acquired by Tyson Foods for $63 per share in cash. The transaction is expected to be completed by the end of September 2014.
National Fuel Gas Co. (NYSE:NFG) (2.3%) ($78.30) is a diversified natural gas company. NFG owns a regulated gas utility serving the region around Buffalo, New York, gas pipelines that move gas between the Midwest and Canada and from the Marcellus to the Northeast, and an oil and gas exploration and production business. NFG’s regulated utility and pipeline businesses, as well as its California oil production business, provide stable earnings and cash flows to support the dividend, while the natural gas production business offers significant upside potential. NFG’s ownership of 800,000 acres in the Marcellus shale, including 745,000 acres in the shale fairway of Pennsylvania, holds enormous natural gas reserve potential, and we believe the position could be worth $3.4 billion based on recent comparable transactions. We continue to expect above average long-term earnings and cash flow growth from rapidly growing gas production and expansion of the strategically located pipeline network. The company has increased its dividend for more than 40 consecutive years.
Republic Services, Inc. (NYSE:RSG) (1.9%) ($37.97), based in Phoenix, Arizona, became the second-largest solid waste company in North America after its acquisition of Allied Waste Industries in December 2008. Republic provides nonhazardous solid waste collection services for commercial, industrial, municipal and residential customers in 39 states and Puerto Rico. Republic serves more than 2,800 municipalities and operates 190 landfills, 199 transfer stations, 336 collection operations, and 64 recycling facilities. Republic is the largest pure play nonhazardous solid waste service provider in North America, with $6.3 billion, or 77%, of its revenue from collection operations. Since the Allied merger, Republic has benefited from synergies driven by route density, beneficial use of acquired assets and reduction in redundant corporate overhead. Republic is committed to its core solid waste business. While other providers have strayed into alternative waste resource technologies and strategies, we view RSG’s plan to remain steadfast in the traditional solid waste business positively. We expect continued solid waste growth acquisitions, earnings improvement, and incremental route density and internalization growth in already established markets to generate real value in the near to medium term, highlighting the company’s potential.
Time Warner Inc (NYSE:TWX) (1.1%) ($70.25), located in New York, New York, is a diversified media company with operations in cable networks through HBO, TNT, TBS & CNN, and film and television production. We like the company’s cable networks, high margins and low capital intensity. We expect the company to use its free cash flow to return capital to shareholders through its $1.27 per share dividend and aggressive share repurchases. Following FOX’s $85 per share bid, we expect Time Warner could be an acquisition target.
Viacom, Inc. (NASDAQ:VIA) (7.6%) ($86.75) is a pure-play content company that owns a global stable of cable networks, including MTV, Nickelodeon, VH1, BET, and the Paramount movie studio. Viacom’s cable networks generate revenue from advertising sales, fixed monthly subscriber fees, and ancillary revenue from toy licensing, etc. The company benefited from a cyclical rebound in advertising and a shift in audience from broadcast networks to cable. Paramount has posted a series of box office successes, with franchises such as Star Trek, Iron Man, and Transformers. Supported by its strong results and outlook, the company expects to repurchase $6.5 billion of stock over the next two years.
Gabelli Value 25 Fund: Investment scorecard
The top contributors to performance for the second quarter were Hillshire Brands (+67%) and DIRECTV (+11%), which were each the targets of deals, as discussed above. Energizer Holdings (+22%) rose sharply after it announced it would separate its battery and personal care businesses, leaving each, in our view, potentially attractive acquisition targets.
Detractors from performance included AMC Networks (1.6%) (–16%) and Discovery Communications (1.0%) (–10%), both of which suffered from concerns about network ratings, advertising, and recent international acquisitions. We continue to view Discovery, effectively controlled by John Malone, as a top shelf operator and AMC Networks, controlled by the Dolan family, as a possible acquisition candidate. Other detractors included Vivendi (1.1%) (–7%), which disappointed investors with a relatively weak capital return plan.
Gabelli Value 25 Fund: Conclusion
Global economic conditions appear to be improving, but we were reminded in the second quarter how volatile the world can be. The push and pull between interest rates and economic growth is likely to dominate stock market returns for the foreseeable future. In this environment, we continue to utilize our Private Market Value (PMV) with a CatalystTM approach to select stocks that offer attractive risk adjusted returns. The increase in shareholder activity is a more prominent catalyst, as it has in several cases accelerated corporate actions that we had previously identified. No matter the impetus, we believe we are well positioned for a robust M&A environment.
July 14, 2014
Note: The views expressed in this Shareholder Commentary reflect those of the Portfolio Managers only through the end of the period stated in this Shareholder Commentary. The Portfolio Managers’ views are subject to change at any time based on market and other conditions. The information in this Portfolio Managers’ Shareholder Commentary represents the opinions of the individual Portfolio Managers and is not intended to be a forecast of future events, a guarantee of future results, or investment advice. Views expressed are those of the Portfolio Managers and may differ from those of other portfolio managers or of the Firm as a whole. This Shareholder Commentary does not constitute an offer of any transaction in any securities. Any recommendation contained herein may not be suitable for all investors. Information contained in this Shareholder Commentary has been obtained from sources we believe to be reliable, but cannot be guaranteed.