Senvest Capital 2Q16 Letter To InvestorsVW Staff
Senvest Capital letter to investors for the second quarter ended June 30, 2016.
Senvest Capital – Overall Performance
The second quarter began positively with the markets up for the months of April and May. The release of Federal Reserve Bank minutes in the middle of May indicated a hawkish stance and had signaled a potential rate increase in June or July. Markets seemed to digest the possibility of a rate increase as acceptable. A late May speech by Fed Chair Yellen stated that the Fed would raise rates “gradually and cautiously”. This may have bolstered confidence with the additional observation from Ms Yellen that “the economy is continuing to improve…growth looks to be picking up”. This calm was then shattered. Equity markets roiled in June in response to the UK referendum vote on EU membership and the unexpected outcome of “Brexit.” European equity markets in particular suffered some of their worst two day performances (in USD terms) in the last 30 years (Bespoke Investment Group). Despite the uncertainty created by Brexit, US equity markets managed to bounce back toward the end of the month and earn back some of their losses.
Pundits and the media have been wringing their hands in the face of Brexit. We don’t dispute the notion that the near term economic outlook for the UK will be under pressure given the uncertainty of the rules of engagement that will likely pause investment spending. However, we think that further out in time, the economic impact on the UK and the broader global economy doesn’t have to be gloomy. Since the UK operates with its own currency, the exchange rate mechanism enables trade flexibility. Moreover, it remains to be seen if Brexit actually occurs and if it does take place, what will it look like? It is in the economic interests of both Europe and the UK to minimize disruption. The Brexit vote has to deal more with politics than anything as the UK and Europe posture and position to negotiate what they each need. In the end, the likely outcome may be something that allows each side to declare victory with minimal economic pain. In any case, Brexit hasn’t influenced our investment outlook or positioning.
As previously reported Senvest Capital Inc. (“Senvest” or the “Company”) had a difficult year in 2015. These difficulties persisted into 2016. Most of the major benchmarks have been relatively flat for the year to June 30. We experienced losses in the first quarter of 2016 which were mostly unrealized, mark-to-market losses. We made back some of these losses in the second quarter but were still down for the year.
Some of our largest holdings as at June 30, 2016 were, Deckers Outdoor, Tower Semiconductors, Depomed, NorthStar Realty Finance, and Radware. Of these, Depomed and Tower Semiconductors increased in price in the quarter while Deckers, NorthStar Realty and Radware fell. Specialty pharmaceutical company Depomed was our largest gainer for the second quarter increasing by over 40% and making back the loss it incurred in the first quarter. Activist investor Starboard Value LP (“Starboard”) filed a 13D which indicated it owned a 9.8% stake in DEPO. Starboard presented its view that management and the board were entrenching themselves at the expense of shareholders, particularly in the way in which DEPO handled the hostile bid from Horizon Pharmaceuticals (“HZNP”). Starboard further indicated its intention to call a special meeting and nominate its own slate of directors in order to replace the entire DEPO board.
NorthStar Realty Finance (NRF) is affiliated with asset manager NorthStar Asset Management (“NSAM”) and both are significant holdings of the Company. At the beginning of June, NSAM announced the results of its review of strategic alternatives with the three-way stock merger of NSAM, NRF and another diversified equity, mortgage and institutional asset management REIT Colony Capital (“CLNY”). The market seems to have been underwhelmed with this proposed transaction. The deal does provide a number of benefits including substantial cost savings (north of $80mm in annual cash costs according to the company); the recombination of NRF with NSAM which would alleviate investor concerns about external management of NRF; and the addition of an institutional asset management platform from CLNY, which will round out NSAM’s retail non-traded REIT asset management business. NSAM expects the deal to close in January 2017. Moreover, it appears that the new company will operate with relatively less leverage than NRF’s current level (which would be designed to appeal to potential investors who previously took issue with NRF’s leverage ratio). We also note that real estate equity related stocks, such as NRF and NSAM, will likely benefit from the imminent creation of a new real estate industry classification. Presently, under the Global Industry Classification Standard (GICS) developed by Standard and Poor’s and MSCI, real estate equity related stocks are classified as financials. On September 1, 2016, these companies will be reclassified under their own real estate sector which should create more awareness of the group. JP Morgan research stated that active equity managers have been underweight real estate equities for “years” and estimates that “…it would take $125-$150 billion of buying to move to a benchmark weight.”
Senvest recorded a net income attributable to the owners of the parent of $14.7 million or $5.22 per diluted common share for the quarterly period ended June 30, 2016. This compares to net loss attributable to owners of the parent of ($29.8) million or ($10.87) per diluted common share for the second quarter of 2015 year. After a 2015 year where there was significant appreciation in the US dollar versus the Canadian dollar, the first half of 2016 resulted in a reversal of some of that appreciation. For the first two quarters of 2016 the result has been a currency translation loss of about $50 million. This amount is not reported in the Company’s income statement rather it is reflected in the Comprehensive income. The Company remains committed to being profitable over the long-term. However the volatility and choppiness of the markets will result in wide profit swings from year to year and from quarter to quarter.
The Company’s income from equity investments in the second quarter of 2016 was the biggest contributor to the net income recorded and partially offset the loss on equity investments incurred in the first quarter. The net gain on equity investments and other holdings totalled $67.5 million in the current quarter versus a loss of ($53.4) million the second quarter of 2015. Due to the continued depreciation of the US dollar versus other major currencies, our foreign exchange loss for the quarter was approximately $1.6 million.
The Senvest Partners fund is focused primarily on small and mid-cap companies. The fund recorded a loss of 5% net of fees for the first six months of 2016, however it was up more than 4% in the second quarter. Since inception in 1997 the fund is up over 2000%. With most of the long portfolio invested in small and mid-cap stocks, the fund outperformed its most relevant benchmark the Russell 2000 for the second quarter but trails this index on a year to date basis. The fund has also underperformed the S&P 500 index for the year to date but outperformed it in the second quarter. The fund does not consider the S&P 500 index as a benchmark. The Senvest Israel Partners fund was initiated in 2003 to focus on investing in Israel related companies. This fund recorded a loss of 4.6% net of fees for the first six months of 2016, however it was up more than 4% in the second quarter. Since inception the Israel fund is up over 900%. The two funds had a total of about $1 billion of net assets under management at June 30, 2016. Both of these funds are consolidated into the accounts of the Company.
Senvest Cyprus Recovery Investment Partners, LP fund (“SCRIF”) owns an investment in the Bank of Cyprus (“BOC”) which was purchased in 2014. Based on the Fund’s initial closing date, the investment period was scheduled to end on July 31, 2016. We have chosen to extend this for an additional year as provided for in the fund documents so that the Fund will now expire July 31, 2017. In addition we are offering each partner the opportunity to voluntarily elect a further extension of their own investment period for an additional one year period to July 31, 2018. We believe that management’s plan to list BOC shares on the FTSE later in 2016 (we have not heard if the Brexit vote will alter this timetable) should greatly improve liquidity of the shares and attract institutional investors. Together with investor recognition of continued improvements of its fundamentals (continued restructuring and reduction of NPLs, asset disposals, and a stronger Tier 1 capital ratio) as well as the potential new listing on the London exchange, could form a catalyst that may lift any overhang on the bank’s stock price.
The Company has a portfolio of real estate investments, investing as a minority partner in selected properties. Real estate investments totalled $43.4 million as at June 30, 2016. Almost 60% of this amount represents investments in different US REITs. These REITs are not publicly traded and there is no established market for them. The most likely scenario for a disposal of these holdings is an eventual sale of the underlying real estate properties of the REITs and the distribution to its holders. The remaining amounts are minority interests in private entities whose main assets are real estate properties. As described above for the REITs, the most likely scenario for a disposal of these holdings is an eventual sale of the underlying real estate properties.
From time to time the Company enters into derivative financial instruments consisting primarily of options and warrants to purchase or sell equities, equity indices and currencies, as well as over the counter derivatives. All contracts are denominated in US dollars. There is deemed to be no credit risk for the options that are traded on exchanges. The warrant contracts are not exchange traded and allow the company to purchase underlying equities at a fixed price. The maximum exposure to credit risk associated with these warrants or with non-exchange traded options is their recorded amount.
The Company has made significant investments in its US operations, primarily in people, systems, technology and new office space. This investment represents a significant effort in a short amount of time to raise the quality of its infrastructure and personnel. As a result the Company’s operating costs have been increasing in the recent past from historical levels.
The Company consolidates the Senvest Management LLC, entity that serves as the investment manager of the Senvest funds. The portion of the expected residual returns of the entity that does not belong to the Company is reflected as non-controlling interest on the statement of financial position. This non-controlling interest is owned by an executive of the Company and totalled $72.9 million as at June 30, 2016 from $80 million as at December 31, 2015.
At the end of June 30, 2016, Senvest had total consolidated assets of $1,939.6 million versus $2,146.4 million at the end of 2015. The main reason for this was the change in equity investments and other holdings. Equity investments and other holdings decreased to $1,848.9 million from $2,036.3 million last December. The Company purchased $615.6 million of investment holdings in the period and sold $537.2 million of such holdings. The net purchased amount was less than the prior year’s period. The Company’s liabilities decreased to $1,182.6 million versus $1,290.1 million at the end of 2015 primarily because of the decreases to equities sold short and liability for redeemable units. The proceeds of equities sold short were $686.8 million and the amount of shorts covered was $689.8 million in the period. Both these figures were less than the amounts for the prior year’s period.
Items included in the financial statements of each of the Company’s entities are measured using the currency of the primary economic environment in which the entity operates (the functional currency). The functional currency of the parent company is the US dollar.
The Company has adopted the Canadian dollar as its presentation currency, which in the opinion of management is the most appropriate presentation currency. Historically, the Company’s consolidated financial statements have been presented in Canadian dollars, and since the company’s shares are listed on a Canadian stock exchange, management believes it would better serve the use of shareholders to continue issuing consolidated financial statements in Canadian dollars. The US dollar consolidated financial statements are translated into the presentation currency as follows: assets and liabilities – at the closing rate at the date of the consolidated statement of financial position; and income and expenses – at the average rate for the period. All resulting changes are recognized in other comprehensive income (loss) as currency translation differences. Equity items are translated using the historical rate.
Financial risk factors
The Company’s activities expose it to a variety of financial risks: market risk (including fair value interest rate risk, cash flow interest rate risk, currency risk and equity price risk), credit risk and liquidity risk.
The Company’s overall risk management program seeks to maximize the returns derived for the level of risk to which the Company is exposed and seeks to minimize potential adverse effects on the Company’s financial performance. Managing these risks is carried out by management under policies approved by the Board.
The Company uses different methods to measure and manage the various types of risk to which it is exposed; these methods are explained below.
Fair value and cash flow interest rate risks
Interest rate risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate as a result of changes in market interest rates.
The majority of the Company’s debt is based on floating rates which expose the Company to cash flow interest rate risk. The Company does not have a long-term stream of cash flows that it can match against this type of fixed debt, so it prefers to use short-term floating rate debt. The Company does not mitigate its exposure to interest rate fluctuation on floating rate debt. If interest rates spike, then the Company could enter into interest rate swaps or more probably just reduce its debt level. As at June 30, 2016, the Company has listed sufficient equity securities that it can sell to reduce its floating rate debt to zero.
Currency risk refers to the risk that values of financial assets and liabilities denominated in foreign currencies will vary as a result of changes in underlying foreign exchange rates. The Company’s functional currency is the US dollar. The following are the main financial assets and financial liabilities that have items denominated in currencies other than the US dollar: cash and cash equivalents, due from/to brokers, bank advances, equity and other holdings, real estate investments, other assets, equities sold short and derivative liabilities and accounts payable.
Equity price risk
Equity price risk is the risk that the fair value of equity investments and other holdings and equities sold short and derivative liabilities will vary as a result of changes in the market prices of the holdings. The majority of the Company’s equity investments and other holdings and all of the equities sold short are based on quoted market prices as at the consolidated statement of financial position date. Changes in the market price of quoted securities may be related to a change in the financial outlook of the investee entities or due to the market in general. Where non-monetary financial instruments ? for example, equity securities ? are denominated in currencies other than the US dollar, the price, initially expressed in a foreign currency and then converted into US dollars, will also fluctuate because of changes in foreign exchange rates.
Equities sold short represent obligations of the Company to make future delivery of specific securities and create an obligation to purchase the security at market prices prevailing at the later delivery date. This creates the risk that the company’s ultimate obligation to satisfy the delivery requirements will exceed the amount of the proceeds initially received or the liability recorded in the consolidated financial statements.
The Company’s equity investments and other holdings have a downside risk limited to their carrying value, while the risk of equities sold short and derivative liabilities is open-ended. The Company is subject to commercial margin requirements which act as a barrier to the open-ended risks of the equities sold short and derivative liabilities. The Company closely monitors both its equity investments and other holdings and its equities sold short and derivative liabilities.
The impact of a 30% change in the market prices of the Company’s equity holdings with quoted value and equities sold short as at June 30, 2016 would be as follows (in thousands):
Liquidity risk is the risk the Company will encounter difficulties in meeting its financial obligations. The Company’s largest assets are equity investments and other holdings. Most of these assets are made up of equities in public holdings which can be liquidated in a relatively short time. Due to its large holding of liquid assets, the Company believes that it has sufficient resources to meet its obligations.
All financial liabilities other than equities sold short and derivative liabilities as at the consolidated statement of financial position date mature or are expected to be repaid within one year. The liquidity risk related to these liabilities is managed by maintaining a portfolio of liquid investment assets.
Credit risk is the risk that a counterparty will fail to fulfill its obligations under a contract and will cause the Company to suffer a loss.
All transactions in listed securities are settled or paid for upon delivery using approved brokers. The risk of default is considered minimal, as delivery of securities sold is executed only once the broker has received payment. Payment is made on a purchase once the securities have been received by the broker. The trade will fail if either party fails to meet its obligations.
The Company is also exposed to counterparty credit risk on its cash and cash equivalents, restricted short-term investment and due from brokers
From time to time, the Company enters into derivative financial instruments consisting primarily of warrants and options to purchase or sell equity indices and currencies and over the counter derivatives. These derivative instruments are marked to market. There is deemed to be no credit risk for the options because they are traded on exchanges. The warrant contracts are not traded on an exchange and allow the company to purchase underlying equities at a fixed price. The over the counter derivatives carry credit risk even though they have been executed with major financial institutions
Capital risk management
The Company’s objective when managing its capital is to maintain a solid capital structure appropriate for the nature of its business. The Company considers its capital to be its shareholders equity. The Company manages its capital structure in light of changes in economic conditions. To maintain or adjust its capital structure, the Company initiates normal course issuer bids or adjusts the amount of dividends paid. The Company monitors capital on the basis of its debt-to-capital ratio, which is as follows (in millions):
The Company’s goal is to maintain a debt to Capital ratio below 2.0 in order to limit the amount of risk. The Company believes that limiting its debt to Capital ratio in this manner is the best way to control risk. The Company’s debt to capital ratio was 1.56 at the end of June 2016 from 1.51 at the end of 2015.
Critical accounting estimates and judgments
The Company makes estimates and assumptions concerning the future that will, by definition, seldom equal actual results. The following are the estimates applied by management that most significantly affect the Company’s consolidated financial statements. These estimates have a significant risk of causing a material adjustment to the carrying amounts of assets and liabilities within the next financial year.
Critical accounting judgments
Consolidation of entities in which the company holds less than 50% of the voting rights
Management considers that the company has de facto control of Senvest Management LLC (SML) and RIMA Senvest Master Fund GP LLC, two legal entities wholly owned by an executive of the Company, because of the Company’s board representation and the contractual terms of the investment advisory agreement. SML is the investment adviser to the Funds, whereas RIMA Senvest Master Fund GP LLC is the General Partner.
Management considers that the Company has control of Senvest Master Fund LP, Senvest Israel Partners LP and Senvest Cyprus Recovery Investment Partners LP even though the Company has less than 50% of the voting rights in each of the Funds. The Company assessed that the removal rights of non-affiliated unitholders are exercisable but not strong enough given the Company’s decision-making authority over relevant activities, the remuneration to which it is entitled and its exposure to returns. The Company, through its structured entity, is the majority unitholder of each of the Funds and acts as a principal while there are no other unitholders forming a group to exercise their votes collectively.
Fair value estimates of financial instruments
The fair value of financial instruments where no active market exists or where quoted prices are not otherwise available are determined by using valuation techniques. In these cases, the fair values are estimated from observable data in respect of similar financial instruments or by using models. Where market observable inputs are not available, they are estimated based on appropriate assumptions. To the extent practical, models use only observable data; however, areas such as credit risk (both the company’s own credit risk and counterparty credit risk), volatilities and correlations require management to make estimates. Changes in assumptions about these factors could affect the reported fair value of financial instruments.
Financial instruments in Level 1
The fair value of financial assets and financial liabilities traded in active markets are based on quoted market prices at the close of trading on the year-end date. The quoted market price used for financial assets and financial liabilities held by the Company is the close price. Investments classified in Level 1 include active listed equities and derivatives traded on an exchange. The financial assets classified as Level 1 were just over 90% of the total financial assets.
Financial instruments in Level 2
Financial instruments classified with Level 2 trade in markets that are not considered to be active but are valued based on quoted market prices, dealer quotations or valuation techniques that use market data. These valuation techniques maximize the use of observable market data where available and rely as little as possible on entity-specific estimates. If all significant inputs required to fair value an instrument are observable, the instrument is included in Level 2. These include corporate bonds, thinly traded listed equities, over-the-counter derivatives and private equities.
The Company uses a variety of methods and makes assumptions that are based on market conditions existing at each year-end date. Valuation techniques used for non-standardized financial instruments such as options and other over-the-counter derivatives include the use of comparable recent arm’s length transactions, reference to other instruments that are substantially the same, discounted cash flow analyses, option pricing models and other valuation techniques commonly used by market participants, making maximum use of market inputs and relying as little as possible on entity-specific inputs. The financial assets classified as Level 2 were about 5% of the total financial assets.
Financial instruments in Level 3
Investments classified in Level 3 have significant unobservable inputs, as they trade infrequently. Level 3 instruments consist mainly of unlisted equity investments and real estate investments. As observable prices are not available for these securities, the Company has used valuation techniques to derive the fair value. The financial assets classified as Level 3 were about 4% of the total fair value of financial assets.
Level 3 valuations are reviewed by the Company’s Chief Financial Officer (CFO), who reports directly to the Board on a quarterly basis in line with the Company’s reporting dates. On an annual basis, close to the year-end date, the Company obtains independent, third party appraisals to determine the fair value of the Company’s most significant Level 3 holdings. The Company’s CFO reviews the results of the independent valuations. Emphasis is placed on the valuation model used to determine its appropriateness, the assumptions made to determine whether it is consistent with the nature of the investment, and market conditions and inputs such as cash flow and discount rates to determine reasonableness.
As at June 30 2016, Level 3 instruments are in various entities and industries. The real estate investments are made up of investments in private real estate companies and in real estate income trusts. The real estate companies are involved with various types of buildings in different geographical locations. For the main Level 3 instruments, the Company relied on appraisals carried out by independent third party valuators or on recent transactions. There was no established market for any of these investments, so the most likely scenario is a disposal of the underlying assets. For the investments in real estate income trusts, the company relied mainly on audited financial statements, valuing the assets at fair value. The most likely scenario is an eventual sale of the underlying properties and their subsequent distribution to the holders.
Liability for redeemable units
Liability for redeemable units represents the units in the consolidated funds that are not owned by the Company. One class of units may be redeemed as of the end of the first calendar quarter that occurs not less than one year after the date that such units were purchased and at the end of each calendar quarter thereafter. A second class may be redeemed as of the end of the first month that occurs not less than 25 months after the date such units were purchased and at the end of each calendar quarter thereafter. A third class may be redeemed as of the end of any calendar month; provided, however, that redemptions made within the first 24 months will be subject to a redemption fee which is payable to the funds. In addition there are notice periods of 30 to 60 days that must be given prior to any redemption. A fourth class may only be redeemed after two years. These units are recognized initially at fair value, net of any transaction costs incurred, and subsequently measured at redemption amount. At the individual fund level this item is not shown as a liability but as part of shareholders equity. It is deemed to be a liability only for the consolidated financial statements as they are prepared from the point of view of the parent company.
The Company is subject to income taxes in numerous jurisdictions. Significant judgment is required in determining the worldwide provisions for income taxes. There are many transactions and calculations for which the ultimate tax determination is uncertain. The Company recognizes liabilities for anticipated tax audit issues based on estimates of whether additional taxes will be due. Where the final tax outcome of these matters is different from the amounts that were initially recorded, such differences will impact the current and deferred income tax assets and liabilities in the year in which such determination is made.
The Company maintains accounts with several major financial institutions in the U.S. who function as the Company’s main prime brokers. The Company has assets with the prime brokers pledged as collateral for leverage. Although the prime brokers are large financial institutions there is no guarantee that any financial institution will not become insolvent. In addition there may be practical or time problems associated with enforcing the Company’s rights to its assets in the case of such insolvency.
While both the U.S. Bankruptcy Code and the Securities Investor Protection Act seek to protect customer property in the event of a failure, insolvency or liquidation of a broker dealer, there is no certainty that, in the event of a failure of a broker dealer that has custody of the Company’s assets, the company would not incur losses due to its assets being unavailable for a period of time, ultimately less than full recovery of its assets, or both. As a significant majority of the Company’s assets are in custody with four prime brokers, such losses could be significant.
On June 27, 2016 Senvest commenced a new normal course issuer bid to purchase a maximum of 56,000 of its own common shares before June 26, 2017. There were 25,700 shares repurchased under the old bid that expired. The number of common shares outstanding as at June 30, 2016 was 2,807,224 and as at July 31, 2016 was 2,806,724. There were no stock options outstanding as at June 30 2016.
The Company’ has a credit facility with a bank, composed of a credit facility and a guarantee facility. The Company also has margin facilities with brokers. The Company has available a 12 million euro guarantee facility that would allow standby letters of credit to be issued on behalf of the Company. In addition, a first ranking movable hypothec in the amount of $30 million on all of its assets has been granted as collateral for both of the facilities. According to the terms of the facilities, the Company is required to comply with certain financial covenants. During the period, the Company met the requirements of all the covenants.
Impact of Certain Income Tax Rules
There were important tax changes to parts of Canada’s foreign affiliate regime effective January 1, 2015. These changes have an effect on the mechanism by which certain foreign income of the Company is taxed in Canada. They will negatively impact the Company’s income tax expense and income tax liability, as well as the Company’s cash flow, for current and future taxation years.
Related party transactions
The Company consolidates the Senvest Management LLC (formerly called Rima Senvest Management LLC), entity that serves as the investment manager of Senvest Partners and Senvest Israel Partners. The portion of the expected residual returns of the entity that does not belong to the Company is reflected as non-controlling interest on the statement of financial position. This non-controlling interest is owned by an executive of the Company and totalled $72.9 million as at June 30, 2016 from $80 million as at December 31, 2015.
Significant Equity Investments
For information on a summary of financial information from certain significant investees please refer to the 2015 annual report. The accounts of Senvest Partners, Senvest Israel Partners and Senvest Cyprus recovery Investment Fund are consolidated with the Company’s accounts.
Forward Looking Statements
This MD&A contains “forward looking statements” which reflect the current expectations of management regarding our future growth, results of operations, performance and business prospects and opportunities. Wherever possible, words such as “may”, “would”, “could”, “will”, “anticipate”,“believe”, “plan”, “expect”, “intend”, “estimate”, “aim”, “endeavour”, “likely” and similar expressions have been used to identify these forward looking statements. These statements reflect our current beliefs with respect to future events and are based on information currently available to us. Forward looking statements involve significant known and unknown risks, uncertainties and assumptions. Many factors could cause our actual results, performance or achievements to be materially different from any future results, performance or achievements that may be expressed or implied by such forward looking statements including, without limitation, those Risk Factors listed in the Company’s annual information form. Should one or more of these risks or uncertainties materialize, or should assumptions underlying the forward looking statements prove incorrect, actual results, performance or achievements could vary materially from those expressed or implied by the forward looking statements contained in this MD&A. These forward looking statements are made as of August 10, 2016 and will not be updated or revised except as required by applicable securities law.
Other Financial Information
There is additional financial information about the Company on Sedar at www.sedar.com, as well the Company’s or Senvest Management’s U.S. SEC section 13 and other filings on www.sec.gov and on the Company’s website at www.senvest.com.
There have been no changes in the Company’s internal control over financial reporting during the quarter ended June 30, 2016, that have materially affected, or are reasonably likely to materially affect, the internal control over financial reporting.
Chairman of the Board and President
Senvest Capital Inc.
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