Wedgewood Partners letter to investors for the second quarter ended June 30, 2016.
Brexit: The Vote Heard ‘Round The World
“I think a lot of the market reaction is less about the financial impact and more about populism and what it means for the liberal economic order. The Brexit vote reflects a deep distrust of the benefits of the global economic system among a wide swath of voters in Europe and the United States, and a broadly held view that government institutions – whether in Washington or Brussels – are calcifying and don’t work well. Both of these forces have a lot of wind at their back.” — Glenn Hubbard, Dean of Columbia Business School
“The people have spoken…the bastards!” — Dick Tuck, Political Consultant 1966
Wedgewood Partners – Review and Outlook
Our Composite (net-of-fees) declined -1.82% during the second quarter of 2016. This decline compares unfavorably to the gain of +.61% in our benchmark, the Russell 1000 Growth Index and the S&P 500 Index’s gain of +2.46%.
Top performance contributors included Kraft Heinz, Express Scripts, Schlumberger, and Qualcomm. Absolute performance detractors during the quarter included Apple, Perrigo, Stericycle, and Cognizant.
During the quarter, we trimmed our positions in Qualcomm and Express Scripts. We sold shares of Perrigo and initiated new positions in TJX Companies and Ross Stores.
Kraft Heinz Company was a top performer during the quarter. First quarter adjusted EBITDA grew 21% year over year and earnings per share grew 38% year over year, as the Company’s consolidated adjusted EBITDA margins reached 30%, up a staggering 600 basis points from the year ago period. We estimate that these margins are best-in-class for the large-cap food products sub-industry, and nearly twice the median. In our view, the vast majority of large capitalization food product competitors, despite possessing great brands, are improperly incentivized, and are content to generate revenues at the expense of profits and long-term shareholder returns. In contrast, we continue to be impressed by Kraft Heinz’s new management culture, as recently brought to bear by 3G Capital and Berkshire Hathaway, which aggressively aligns management and employee incentives with shareholders. For example, rather than simply cutting overhead costs, the Company is intently focused on eliminating financial promotions for retailers (that frequently resulted in profitless revenues) and then reinvesting the savings into alternative product support, such as new products, form factors, and ad campaigns. We are seeing nascent evidence that this profit-focused strategy can be successfully executed without sacrificing revenue growth, as the Company posted low single-digit constant-currency organic revenue growth. As Kraft Heinz continues its aggressive new approach of reinvestment, we expect organic revenue growth to accelerate, along with continued margin expansion.
Express Scripts was a top contributor during the quarter. The stock recovered some of the poor performance from the first quarter after Anthem management noted that, despite filing a lawsuit over Express Scripts’ pricing, they believed any ruling on the lawsuit would take several years and were still open to negotiations. Express Scripts is the sole, independent pharmacy benefits manager (PBM), which we think is key for maintaining their alignment with customers. We continue to expect Express Scripts to drive mid-to-high single-digit EBITDA growth using its scale to negotiate better pricing with drug manufacturers and service providers, while increasing patient adherence. We think earnings per share can continue to grow at a double-digit rate as shares are repurchased at what, in our view, are attractive valuations. That said, as shares rallied from their previous lows, we reduced the stock’s weighting to better reflect the risk/reward of Express Scripts’ growth and valuation.
Schlumberger contributed .42% to composite performance during the quarter. Despite the dramatic decline in exploration and production (E&P) capex budgets during the past 18 months, Schlumberger continues to reinforce its competitive positioning relative to other integrated oil service companies. With one of the largest, most highly-skilled upstream workforces in the private sector, and nearly $7 billion in cumulative research and development spent during the previous up-cycle, we think Schlumberger is poised to take an increased budget share of E&P spending as the Company’s customers outsource more services to improve returns in a “lower-for-longer” oil price environment. We expect Schlumberger’s earnings to significantly rebound in 2017, driven by increased market share as well as the release of over two years of pent-up E&P spending.
Perrigo detracted –1.04% from the composite’s absolute performance. A surprising decline in Perrigo’s normally staid generic prescription (Rx) business had the company reduce full-year guidance by almost 15% in a late April pre-earnings release. In addition, the Company disclosed further write-downs and organizational changes in their nascent Branded Consumer Health (BCH) segment. Last, the Company announced the abrupt exit of long-time CEO, Joe Papa, who joined embattled Valeant Pharmaceutical. Immediately after this slew of data points, we decided it prudent to liquidate our Perrigo stake.
Stericycle was also a top detractor during the second quarter. Stericycle’s early-year bounce reversed itself and then some after management lowered forward earnings expectations for the second time in three quarters. Management noted further weakness in their small (~3% of revenues, we estimate), industrial hazardous waste business, and pushed the timeline of about $20 million of expected synergies from their newly acquired document destruction business into next year. Taken alone, we think the stock’s -21% reaction following the earnings release was an overreaction.
We think Stericycle’s core business of regulated waste management continues to be very attractive, throwing off strong free cash flow, with historically steady results. The Company has consistently reinvested these cash flows into smaller, regulated waste management acquisitions, as well as entering new verticals. Secure document destruction is a relatively new vertical for the Company, but we think the demand characteristics (driven by regulatory requirements) and hub-and-spoke collection and disposal model should fit well over the long term. While management noted a longer than expected timeline for converting on-site processing into off-site processing (similar to the way that medical waste is handled), we expect the Company will be successful in this conversion. As for the Company’s industrial hazardous waste business, it has proven to be highly cyclical. However, we expect the benefits of the Company’s overall hazardous waste platform (acquired in 2014) to more than outweigh the risks, as we estimate that retail and medical hazardous waste have grown to over 5% of revenues, from close to zero in 2014 – more than offsetting industrial waste declines. So while we understand investors’ concerns over the Company’s near-term earnings disappointments, we continue to be patient because we think Stericycle’s long-term opportunity for double-digit growth is intact as returns on reinvestment take hold.
Apple has been a significant underperformer not only during the recent second quarter (-11.8%), but also for nearly a year now. The stock has fallen about -28% on an absolute basis, from its high set back on July 20, 2015. This is the second time that the stock has been put through the wringer since late 2012 on fears of “peak” iPhone growth and the concomitant lack of innovation out of the skunk works in Cupertino. Given the surge of sales of the iPhone 6 in 2015 (pent up demand for a larger iPhone, plus significant demand from China), we are not surprised by the weaker year-over-year earnings comparisons.
The Apple stock advance-and-decline narrative has been pretty straightforward over the past half-dozen years. Given the consented narrative that Apple is “The iPhone Company” – and nothing but the iPhone – when forward analyst estimates of iPhone sales increase, the stock typically advances. When estimates are being cut, well, the stock typically declines, also. Mr. Market really is that binary on Apple’s stock price movements. We would argue, too, that Mr. Market is quite obtuse when it comes to the totality of Apple. Everything else that a rational investor would consider in accessing Apple as an investment is literally put in a vacuum when it comes to the stock. Valuation seems to matter not a wit. By any traditional valuation measure, both absolute and relative to other technology hardware companies, Apple’s stock, in our view, has long been cheap – but it gets cheaper still on estimate cuts. In fact, we would argue that Apple’s stock is currently valued (6.5X FCF ex-cash)2 as if to assume that the Company’s business prospects are little better than a coal mine in 10-year run-off mode.
Here are a few elements of the superiority – and we would argue, rarity – of the Company’s business model via their platform trifecta of hardware, software and services that should matter to investors: iPhone user base estimated at +450 million. Smartphone industry gross profit take of approximately 95%. An installed ecosystem base of over +1 billion sticky users. 13 million active App Store developers. 130 billion downloaded Apps. Relatedly, software services gross revenue business is at an annuity-like run-rate of $40 billion – with profit margins greater than Company average. Company operating margins of 30%. Connected software platforms that include iOS, MacOS and Watch OS. The Company’s near fanatic commitment to user privacy. Apple Watch unit sales of 11-13 million since launch. Over the past four calendar years the Company has generated nearly $216 billion in free cash flow, including $55 billion over the past four quarters. $250 billion in balance sheet liquidity. Tens of billions of stock buybacks, in our view, below intrinsic value.
It could be argued that Apple’s only significant competitor is itself. Sure, Android vendors such as Samsung, Huawei, Oppo, and Xiaomi, are competitors in that each does sell high-end smartphones, particularly to first-time smartphone buyers. However, it’s also the case that once one experiences the differentiated nature of a true high-end smartphone, many of those Android customers do find their way to Apple for a significantly better user ecosystem. At this juncture, the consensus on Apple is that the iPhone 7 will be a boring upgrade and thus a flop. Again, the current valuation of the stock implies that Apple is once again a permanently impaired growth company. Given that Apple is our second largest position, we certainly don’t share such dire views.
Wedgewood Partners – Brexit
June 23rd, 2016 will go down as one on the most politically historic days for England and Europe since the end of World War II – politically, thus far. The winning Brexit vote for the Leave campaign to exit the European Union has sent shock waves across global financial markets. The profundity and consequences of the Brexit vote – economic, financial, and political – are just now in their infancy. The unintended consequences will likely be as severe in the months and years ahead. The Brexit vote was – for just the first 48 hours – an earthquake in magnitude of 8.0 on the Richter scale. The immediate visible damage was financial. At the epicenter of the Brexit quake, the British pound made a 6-month high and a six-month low over an eight-hour time frame, finally crashing to 1985 lows. Both U.K. and other European bank shares declined sharply – all from near bear market, multi-year lows before the vote. Over $3 trillion in global paper wealth evaporated in the first two trading days. A global flight to safety, plus the immediate fears of a U.K. and Pan-European recession have sent sovereign bond yields crashing. The 10-year U.K. Gilt yield has fallen to just .96%. The 10-year German Bund yield has gone negative to -.13%. (Of note, the 30-year German Bund yields just .36%. Maybe “free” money does exist.) The 10-year U.S. Treasury has fallen to a record low, 1.37%. In a world starved for yield – and now safety and certainty – a crush of U.S. bond buyers could easily push the U.S. 10-year to 1.00%. The entire yield curve in Switzerland now sports negative interest rates. Post-Brexit, nearly $1 trillion of sovereign debt has been added to the roster of negative interest rates. The word “bubble,” in our view, is thrown around much too often in a cavalier manner by financial pundits. That said, 40-year Japanese bonds (JGB) have gained +50% year-to-date (+77% in U.S. dollars).
The U.S. stock market of course did not go unscathed. The immediate reaction in the first two trading days post-Brexit was to sell those companies with significant business line exposure to the U.K. and Europe, notably exposure to older, more Western E.U. countries – including those companies whose repatriated earnings were unduly exposed to a renewed increase in the U.S. dollar. “Sell now; ask questions later” seemed to be the operative strategy. During those first two kneejerk trading days, a few of our portfolio holdings were torched in the selling deluge. Within our portfolio of 19 stocks, only three of our holdings have zero exposure to the U.K. or E.U. – Charles Schwab, Express Scripts (NASDAQ:ESRX) and Ross Stores (NASDAQ:ROST). Our singular holding with significant exposure to the U.K. is LKQ. Other holdings with meaningful exposure to the U.K. include Verisk Analytics, PayPal (NASDAQ:PYPL), Stericycle (NASDAQ:SRCL) and Schlumberger (NYSE:SLB). Those holdings with meaningful exposure to the E.U. include The Priceline Group (NASDAQ:PCLN), Core Labs (NYSE:CLB), LKQ (NASDAQ:LKQ), PayPal, Qualcomm (NASDAQ:QCOM), Stericycle and Schlumberger. If the first two trading days were panic induced, the trading since has been nothing short of euphoric. Stock and bond prices have ripped to the upside. All it took was the promise of more “helicopter money” from the European Central Bank.