Third
Point
LLC390
Park
Avenue
New
York,
NY
10022
Tel
212
715
3880
May 1, 2014
First
Quarter
2014
Investor
Letter
Review
and
Outlook
Harsh winter weather caused the economy and corporate earnings to falter in the first quarter of this year, a seasonal phenomenon we expect will dissipate this spring. This weakness was exacerbated by new Fed Chair Janet Yellen’s statements shifting the market’s expectations of the timing of the Fed’s first rate hike. Four months into 2014, it now seems evident that investment performance will require a combination of good stock selection, patience, and deft trading. Looking back, perhaps our optimism at the beginning of the year was misplaced. First, certain sectors were clearly exhibiting bubblelicious valuations. Looking at the bigger picture, it is evident in hindsight that at least for the first part of the year, we were toiling against somewhat of a “Lose/Lose” backdrop. On one hand, if growth did not accelerate then the market appeared fairly valued (at best) given 2013's significant re‐rating. On the flip side, if growth did accelerate, the timing of the Fed's change in monetary policy would hang over the market. Taking a look at the current landscape, the decline in overinflated sectors, though painful in the short term, is healthy in our view. We have seen an equally painful reversion to the mean on many popular trades. Consensus positions entering this year – long Japan, long momentum, and short bonds – have all underperformed, while value and emerging markets have accelerated. This reversion has created a violent bout of deleveraging, particularly among hedge fund holders, creating chances to add to our portfolio at attractive levels. Despite its challenging start, it appears as we begin May that the U.S. economy is beginning to accelerate from the low levels of Q1. As a result, perhaps 2014 will be the year where one should not “Sell in May and go away”. Nevertheless, it is important to keep in mind that by this Fall, we will have had negative real interest rates in the U.S. for a longer consecutive period than at any other time – even after the Great Depression. As tapering ends, most likely in October, and the discussion shifts to an impending first rate hike (probably around the time when unemployment is approaching 6% and inflation is ticking higher), we will have to buckle our seatbelts for an inevitably more volatile environment.
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Quarterly
Results
Set forth below are our results through March 31
st
and for the year 2014:
Third Point Offshore Fund Ltd. S&P 500 2014 Year‐to‐Date Performance* 3.3% 1.8%
Annualized Return Since Inception* 17.9% 7.3%
*Through March 31, 2014. **
Return from inception, December 1996 for TP Offshore Fund Ltd. and S&P 500.
Our performance in the first quarter was buoyed by corporate credit and mortgage investments, which provided roughly half of our returns despite being only roughly 25% of our exposure. The funds are hard closed to all investors and not currently accepting new capital.
Select
Portfolio
Positions
Equity
Position
Update:
The
Dow
Chemical
Company
(“Dow”)
Since we disclosed our stake in January, Dow’s management has taken several shareholder‐friendly actions including increasing the company’s dividend, approving a $4.5 billion buyback to address the impending conversion of the Warren Buffett/KIA preferred securities, and committing to more portfolio divestitures. Management’s level of shareholder engagement has also risen notably, demonstrating an admirable and strong commitment to addressing long‐standing concerns. We also applaud Dow’s recently stated initiative to increase transparency. Shareholders have long called for the company to increase disclosure, improve the clarity of their reporting, and clearly identify underlying business drivers. On Dow’s first quarter earnings call, management suggested it could simplify the portfolio reporting structure by re‐classifying (or removing) the Feedstocks & Energy segment. In our view, simply joining the Feedstocks & Energy and Performance Plastics segments would not effectively increase transparency. Instead, the priority should be to implement a consistent, market‐based transfer pricing methodology across
and
within
all segments so shareholders can clearly understand each business unit’s underlying profitability. Further, to be consistent with its peers, all of Dow’s petrochemical capacities need to be disclosed in detail so that shareholders can more easily benchmark performance versus competitors. All shareholders eagerly anticipate progress on these important initiatives. Despite the positive steps taken, we still believe Dow is under‐earning its potential in its petrochemical businesses, a concern that management has yet to adequately address. To quantify the extent of under‐earning, we sought to compare Dow’s capacity and profits
3
relative to peers and industry average margins. The result of this carefully researched analysis led us to conclude that Dow’s integrated strategy does not maximize profits.
Petrochemical
Under
‐
Earning
Dow’s management has yet to address the crux of Third Point’s case for increasing value: curing under‐earning in the Petrochemical businesses. This under‐earning is clear when one compares Dow to its largest North American petchem peer, LyondellBasell (“Lyondell”). Dow has ~30% more North American ethylene capacity, triple the Middle Eastern ethylene capacity, and more North American derivatives capacity than Lyondell, yet the two companies generate the same amount of EBITDA in their respective petrochemical businesses.
1
Additionally, Dow engages in multiple downstream businesses in its Performance Materials segment that Lyondell does not.
Figure
1:
2
This discrepancy is difficult for the market to identify, because Dow does not disclose any of its capacities. Therefore, to identify the magnitude of under‐earning, we did our own bottom‐up analysis examining: i) the capacities for the petrochemicals Dow produces, ii) average 2013 industry margins for those capacities, and iii) the actual 2013 feedslate mixes by plant (where applicable). The result of this bottom‐up analysis shows a meaningful gap between what Dow’s capacities indicate potential EBITDA
should
be
and the amount of EBITDA
actually
generated:
1
Dow’s petrochemical business includes the Feedstocks & Energy, Performance Plastics, and Performance Materials segments. LYB’s petrochemical business includes all segments except Refining and Technology.
2
Dow’s Petchem EBITDA includes all Feedstocks & Energy, Performance Plastics, and Performance Materials. We allocate corporate expense to Dow’s 2013 segment EBITDA based on an estimate of Dow’s Petchem % of total employees. LYB Petchem EBITDA includes all segments except Refining and Technology. LYB allocates corporate expense to segment EBITDA. Both Dow and LYB 2013 EBITDA has been adjusted to include an estimate of JV EBITDA in excess of equity income. Source: Company filings, Third Point estimates. Capacity data: IHS, company filings, Third Point.
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Unconvincing
Integrated
Strategy
Figure 4 is the visual representation of what Dow’s management describes as taking low cost inputs and using value‐add innovation to make differentiated downstream products. This, in our opinion, is the essence of why Dow’s strategy is flawed – none of ethylene, propylene, or chlorine provides any product differentiation or specialization in packaging, coatings, or food & nutrition products:
Figure
4:
7
On the Q4 earnings call, CEO Andrew Liveris claimed that “more than half the profits that are coming out of [the petchem] chain come from innovation, not from low‐cost feedstocks”. We respectfully disagree. The fact that Dow’s petchem businesses under‐earn their capacities (see Figure 2) suggests that this claim is impossible. Dow needs to provide investors analytical or numerical evidence about the value derived from integration and innovation if the market is to believe these claims. Given Dow’s decision to exit chlor‐alkali, it appears that Dow believes that its Ag Chemicals and Ag Biology businesses do not derive value‐add differentiation from chlorine integration. We take this logic one step further and question whether Dow’s specialty segments need ethylene or propylene integration.
8
Within petrochemicals, there are upstream and downstream products in which we see few identifiable niches where incremental value from integration exists (notwithstanding the value derived from raw materials being transferred at cost rather than market price). Rather, as we stated above,
7
Source:
Dow
Strategic
Update
, Slide Presentation 3/19/2014.
8
Specialty segments include Agricultural Sciences, Coatings & Infrastructure, and Electronic & Functional Materials.
7
there appears to be negative value from converting upstream petrochemical molecules into downstream products.
Poor
Returns,
Poor
Capital
Allocation,
Misleading
Benchmarking
Dow recently shared a benchmarking analysis comparing the Return‐On‐Assets (“ROA”) of its Performance Plastics segment with a self‐selected chemicals universe.
9
The comparison is not apples‐to‐apples because the Performance Plastics segment is Dow’s most profitable division and is almost exclusively a polyethylene business, whereas the chemicals universe is comprised of entire companies, many of which are in very different businesses.
Figure
5:
10
The Performance Plastics segment also receives the entirety of its ethylene inputs at cost from the Feedstocks & Energy segment. Again, due to inadequate disclosure, it is not clear whether the numerator or the denominator in Performance Plastics’ ROA is an accurate reflection of true profitability or assets. We believe a more fair assessment would be to examine the ROA of Feedstocks & Energy, Performance Plastics, and Performance Materials together, which encompasses all of Dow’s upstream‐downstream integrated petrochemical returns and assets. To be consistent, we have used Dow’s own ROA calculation and constructed a table with all of the segment ROAs:
9
Chemicals universe consists of Axiall, BASF, Bemis, Celanese, CF Industries, Dupont, Eastman, FMC, Huntsman, LyondellBasell, Mosaic, Potash, PPG, Sealed Air, and Westlake. Source:
Dow
Strategic
Update
, Slide Presentation 3/19/2014.
10
Source:
Dow
Strategic
Update
, Slide Presentation 3/19/2014.
9
Figure
7:
12
When taking into account gross capital invested (both equity
and
debt
financed
) and Dow’s latest guidance, we estimate that the ROA of the Sadara project (the company’s largest investment since Rohm & Haas) will be 5% ‐ 10%. Only in Dow’s bull case would the returns from Sadara exceed Dow’s own 9% cost of capital.
13
Looking
Forward:
Harnessing the full potential of Dow’s petrochemical assets will take time as it could require a combination of closures, modifications, brownfield investments, and divestitures. Our suggestion to management is to recognize that Dow is involved in numerous commoditizing derivative products and to make a more clear‐cut delineation between low‐cost feedstock and downstream value‐add related profitability. We have urged management to embrace the fact that it is running one of the world’s largest commodity petrochemical businesses, which historically has been a challenge.
14
Conducting an operational review (with market price based raw material transfers) will undoubtedly result in increased scrutiny as to the specialty nature of some of Dow’s petchem business units. This acknowledgement and the subsequent review are crucial to becoming a best‐in‐class, low‐cost petrochemical operator. After a decade of underperformance, shareholders deserve greater transparency and a comprehensive reassessment of Dow’s strategy. We appreciate management’s engagement with all of its shareholders, and look forward to furthering discussions regarding strategy and capital allocation in the pursuit of maximizing Dow’s great potential.
12
Company guidance. Source:
Sadara
Spotlight:
Site
and
Enterprise
Readiness
, Slide Presentation, 3/20/14.
Sadara
Spotlight
, Slide Presentation 9/26/13. Tax rate assumed to be Saudi Arabia’s corporate tax rate.
13
Weighted Average Cost of Capital of 9.2%. Source: Bloomberg, 4/29/14.
14
“It is honestly impossible to think of Dow as a petrochemical company anymore.” – CEO Andrew Liveris, Fourth Quarter 2013 earnings call. “Lots of the K‐Dow scope is now sold. We’ve actually done the divestment of what might have been called a petchem business, the traditional commodity business.” – CEO Andrew Liveris, Fourth Quarter 2013 earnings call.
Sadara JV Return on Assets
($ in millions)
Low Mid High
Dow Revenue Guidance$6,000$7,000$8,000Dow EBITDA Margin Guidance
30.0% 35.0% 40.0%
Implied EBITDA$1,800$2,450$3,200Estimated DD&A (30-Year Life)(643)(643)(643)EBIT$1,157$1,807$2,557 Taxes at 20% (231)(361)(511)
Gross NOPAT $925 $1,445 $2,045
Gross Capital Invested$19,300$19,300$19,300
Implied ROA 4.8% 7.5% 10.6%Dow WACC 9.2% 9.2% 9.2%EVA (4.4%) (1.7%) 1.4%
Capex Multiple of EBITDA
10.7x 7.9x 6.0x
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billion year‐to‐date. These trends play into the four‐pronged equity value expansion story for SoftBank shares:
1)
SoftBank Mobile value expansion of ¥230 per share annually (EBITDA growth, constant multiple)
2)
SoftBank deleveraging of ¥400 per share annually (Capex cliff in 2013)
3)
Alibaba value expansion of ¥500 per share ($20 billion per annum Alibaba appreciation)
4)
Narrowing of the NAV gap (currently 23% versus consensus) From a cash and deleveraging perspective, the recently announced sale of the eAccess business to Yahoo! Japan will further bolster these at SoftBank Mobile, as it offloads nearly $1 billion in annual Capex and transfers $4 billion of net cash from Yahoo! Japan to SoftBank. We believe the Yahoo! Japan transaction will unlock ~¥400 per share value for SoftBank, offset by a ~¥120 de‐rating of SoftBank’s Yahoo! Japan equity stake, for a net ¥280 benefit to NAV. Most significantly, SoftBank’s market cap has grown by only $9 billion since July 2013 while consensus valuations of Alibaba by U.S. sell‐side analysts have nearly doubled from $86 billion to $171 billion today, implying a $31 billion increase in the value of SoftBank’s 37% stake. Likewise, SoftBank’s stake in Sprint has also appreciated by $4 billion. The growth in the underlying asset values, enhanced by the accretive nature of the Yahoo! Japan transaction have only served to increase the relative attractiveness of SoftBank shares since October, despite the market’s hesitation. SoftBank is witnessing substantial growth in underlying asset value, de‐levering via the Yahoo! Japan transaction, and poised to drive further de‐levering and free cash flow growth in SoftBank Mobile. It currently trades at a 23% NAV discount to consensus estimates of value. Alternatively, valuing SoftBank Mobile on a P/FCF methodology suggests SoftBank is trading at a 45% NAV discount. The discrepancy lies in the fact that the EV/EBITDA approach understates SoftBank Mobile’s high free cash flow conversion and low cost of capital. These discounts are clearly unwarranted. We anticipate SoftBank’s NAV will post continued growth and shrink this discount as management’s strategy comes into further focus and transparency around underlying assets (particularly Alibaba) improves.
Structured
Credit
Update
Mortgages led the portfolio during the first quarter, returning 14.2% on average exposure and contributing over half of the quarter’s returns. Realized profits were due to sales in our Alt‐A Re‐Remic book, which we began assembling in 2009 and continued to build
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through the beginning of 2013. Despite the recent bout of market volatility, we are continuing to receive attractive bids for these bonds. Much like in our equity book, we believe that our performance will be generated by individual bond selection versus discovering sizeable, displaced asset segments. We have been evaluating each opportunity we uncover and adding diverse exposure to the portfolio. We benefitted from participating in some larger one‐off situations – a benefit of our size – and by opportunistically adding to our subprime portfolio. We have also added exposure outside of the U.S. in the past six months, particularly in Europe, and expanded our CMBS portfolio. We are actively seeking to purchase assets from European banks. Sincerely,
Third
Point
LLC
_____________________
Third Point LLC (“Third Point” or “Investment Manager”) is an SEC‐registered investment adviser headquartered in New York. Third Point is primarily engaged in providing discretionary investment advisory services to its proprietary private investment funds (each a “Fund” collectively, the “Funds”). Third Point’s Funds currently consist of Third Point Offshore Fund, Ltd. (“TP Offshore”), Third Point Ultra Ltd., (“TP Ultra Ltd.”), Third Point Partners L.P. (“TP Partners LP”) and Third Point Partners Qualified L.P. Third Point also currently manages three separate accounts. The Funds and any separate accounts managed by Third Point are generally managed as a single strategy while TP Ultra Ltd. has the ability to leverage the market exposure of TP Offshore. All P & L and performance results are based on the NAV of fee paying investors only and are presented net of management fees, brokerage commissions, administrative expenses, and accrued performance allocation, if any, and include the reinvestment of all dividends, interest, and capital gains. While performance allocations are accrued monthly, they are deducted from investor balances only annually (quarterly for Third Point Ultra) or upon withdrawal. The performance results represent fund‐level returns, and are not an estimate of any specific investor’s actual performance, which may be materially different from such performance depending on numerous factors. All performance results are estimates and should not be regarded as final until audited financial statements are issued. The performance data presented represents that of Third Point Partners L.P and Third Point Ultra Ltd. Exposure data represents that of Third Point Offshore Master Fund L.P. While the performances of the Funds have been compared here with the performance of a well‐known and widely recognized index, the index has not been selected to represent an appropriate benchmark for the Funds whose holdings, performance and volatility may differ significantly from the securities that comprise the index. Investors cannot invest directly in an index (although one can invest in an index fund designed to closely track such index). Past performance is not necessarily indicative of future results. All information provided herein is for informational purposes only and should not be deemed as a recommendation to buy or sell securities. All investments involve risk including the loss of principal. This transmission is confidential and may not be redistributed without the express written consent of Third Point LLC and does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made by means of delivery of an approved confidential offering memorandum. Specific companies or securities shown in this presentation are meant to demonstrate Third Point’s investment style and the types of industries and instruments in which we invest and are not selected based on past performance. The analyses and conclusions of Third Point contained in this presentation include certain statements, assumptions, estimates and projections that reflect various assumptions by Third Point concerning anticipated results that are inherently subject to significant economic, competitive, and other uncertainties and contingencies and have been included solely for illustrative purposes. No representations, express or implied, are made as to the accuracy or completeness of such statements, assumptions, estimates or projections or with respect to any other materials herein. Third Point may buy, sell, cover or otherwise change the nature, form or amount of its investments, including any investments identified in this letter, without further notice and in Third Point’s sole discretion and for any reason. Third Point hereby disclaims any duty to update any information in this letter. Information provided herein, or otherwise provided with respect to a potential investment in the Funds, may constitute non‐public information regarding Third Point Offshore Investors Limited, a feeder fund listed on the London Stock Exchange, as well as Third Point Reinsurance Ltd., a NYSE listed company, and therefore dealing or trading in the shares of either on the basis of such information may violate securities laws in the United Kingdom, United States or elsewhere. _____________________