Caldwell North American Equity Strategy – Monthly Update November, 2013
Zimmer Holdings (ZMH-T )
About the Company: Zimmer produces reconstructive and surgical products, primarily replacement knees and hips. It is a global company, and 45% of its revenue generated outside of the Americas.
Investment Thesis: Zimmer has strong operating metrics yet is one of the cheapest names in the health care equipment space. It recently launched a new knee which is customizable, producing a better fit and comfort level versus existing products. Initial results are promising and should drive growth as it takes several years for doctors to adopt new technologies. We also see Zimmer benefiting from demographic trends and health reform in the U.S., as the population ages and health coverage becomes increasingly widespread.
Valuation: ZMH is trading at 9.1x EV/EBITDA. We see 11.3x as a reasonable target given that this is where the stock has historically traded and is also where ZMH’s peer group currently trades. This suggests 24% share price appreciation on multiple expansion alone and we see additional upside on earnings growth from recent product launches.
Expectations: We expect Zimmer to continue to benefit from new product launches, where strong revenue growth should offset industry-wide pricing pressure and drive the share price higher.
About the Company: VeriSign is the exclusive registry operator for all .com, .net, .cc, .tv domain names, and operates the back end systems for all .gov, and .edu domain names. They ensure that, when someone types in a domain name (i.e. a website like caldwellinvestment.com), the person gets forwarded to the appropriate website. There are 126 million domain names and VeriSign collects an annual fee for each name. They also offer website protection/security services, which is a smaller but growing part of their business.
Investment Thesis: VeriSign generates a very strong, stable and growing cash flow stream. We believe domain name growth will continue as emerging markets develop and adopt greater use of the Internet. Management has also indicated that they plan to announce a strategy around leveraging their patent portfolio, which should be a positive catalyst for the shares going forward.
Valuation: VeriSign’s cash yield of 7.8% is very attractive.
Expectations: We expect VeriSign to provide stability to the portfolio. We also expect earnings to grow through continued growth in the number of websites, the leveraging of the patent portfolio and a lower share count as the company uses its strong cash generation to buy back shares.
Brookfield Office Properties (BPO-T)
Reason we Sold the Stock: Last month, BPO’s parent company announced an offer to purchase the public’s ownership in BPO for $19.34/share. Instead of waiting for the offer to play out, we sold the shares and used the cash to purchase the abovementioned equities.
Portfolio Deletions, cont.
Reason we Sold the Stock: We sold the stock on the back of a very weak quarter. While the last several quarters have been weak from a revenue standpoint, some of the weakness was believed to be due to customers drawing down inventories, so that sales were actually running below end market demand. We were also encouraged that margins had held up very well on low utilization levels. Historically, low utilization caused sharp drops in margin (and sometimes earnings losses) and the improvement versus past cycles led us to expect that, when demand picked up, the company would see strong operating leverage, which would translate into strong earnings. This quarter, however, saw a substantial drop in margins and we began to believe that revenue may not recover as previously thought. The valuation without an uptick in demand no longer makes sense and we’d rather hold cash until we find a better use for it.
Company Updates: A Few Highlights
Kohlberg Kravis Roberts (KKR-US)
Strength in the business continues. Strong markets have allowed KKR to monetize investments made in prior years, which is driving strong performance fees. The value of KKR’s balance sheet is also increasing as the company co-invests alongside its clients. Looking to the future, KKR raised $6B in new capital in the quarter. Higher assets under management result in higher management fees, and, more importantly, new capital invested sets the stage for future performance fees, which are the real driver of value. KKR also acquired a company called Avoca Capital, which is a leading credit investment manager with $8 billion in assets under management. Credit remains tight in Europe as European banks have yet to recapitalize their balance sheets. This creates opportunities for Private Equity Firms like KKR to extend credit, and the European acquisition puts KKR in a good position to benefit.
Trilogy Energy (TET-T)
Trilogy issued $200 million of equity last month to fund its capital spending program. Trilogy has one of the best growth profiles of Canadian energy names and owns very attractive land positions in the Duvernay (Alberta), where major companies such as Chevron and PetroChina have been purchasing land. The play is still in early stages of development and players have been slow to release results (for competitive reasons), but results to date have been very strong. Additional data is expected to be released over the next several months, which should act as a positive catalyst for the stock.