Smart Money Masters — June 2017 Issue

Nicholas Vardy

Nicholas Vardy has a unique background that has proven his knack for making money in different markets around the world.

The #1 Bet of the World’s Leading Activist Investor

Your Smart Money Masters portfolio had a solid month, with several of your positions soaring by more than 5%. Charlie Munger’s bet on Costco Wholesale Corporation (COST) recovered 7.90%. The company announced that it plans to return $3.1 billion to shareholders through the payment of a special dividend.

Costco will pay investors a huge $7-per-share special dividend on May 26. This sum is in addition to a regular quarterly dividend of $0.50 per share.

Last month’s Smart Money Masters recommendation, Prem Watsa’s bet on BlackBerry Limited (BBRY), also rose a solid 6.03%.

Carl Icahn’s PayPal Holdings (PYPL) had a monster month with the stock soaring 14.95% as the cashless revolution takes hold.

Ironically, U.S. consumers see a lot less of this sea change in payment systems than the rest of the world does. From my perch in “Old Europe,” I am struck by how behind the United States is compared to even less developed European countries.

In Sweden, day-to-day use of cash has all but disappeared. The government has even given beggars electronic payment processors so that passers-by can donate digitally. Cash use has plummeted in London with the advent of “contactless payment.” Even in the former Communist countries, you can pay by mobile phone almost everywhere thanks to a network of contactless payment processors sponsored by MasterCard.

Finally, the falling oil price dragged down Wilbur Ross’ Navigator Holdings Ltd. (NVGS) this past month. Nevertheless, the fundamentals of the business remain intact. On May 8, the company reported a first-quarter profit of $2.7 million, which is equal to a net income of 10 cents per share. That exceeded Wall Street expectations of 8 cents per share.

Big Bet on Baxter

This month’s Smart Money Masters recommendation — Baxter International Inc. (BAX) — is the top investment bet of one of the world’s best-known activist investors, Dan Loeb, founder and CEO of hedge fund Third Point, LLC.

Baxter was the largest stock holding in Third Point’s portfolio at the end of March, accounting for 22.59% of the portfolio’s value. Third Point’s 51,901,767 shares are now worth $2.31 billion.

Not surprisingly, Loeb has called Baxter “one of the most promising positions in our portfolio.” Baxter has been a sound investment for Third Point so far. Third Point bought Baxter at around $40 per share in the summer of 2015.

Today, Baxter is trading around $56. A 40% return over 22 months is just the start of a profitable investment for Third Point.

Loeb remains bullish on Baxter despite Baxter’s recent run-up. As Loeb has written: “Despite this meaningful move in performance, [Baxter’s] current size is consistent with our conviction about the company and its leadership and the potential we see for meaningful upside from these levels.”

Investment Philosophy

Third Point’s investment in Baxter is a textbook example of Dan Loeb’s philosophy of activist investing. Loeb’s investment approach is a research-driven strategy based on fundamental value. His primary focus is to identify situations which could lead to a significant revaluation of a company’s stock.

Loeb prides himself on being opportunistic and investing in stocks that are undiscovered by others. Loeb also takes advantage of companies with financial problems by investing in special situations and spin-offs.

Consistent with his activist investment style, Loeb is willing to take large positions in a stock to influence the business of companies by gaining positions on the Board of Directors. This activist helps ensure that the stock price moves in the right direction. As Loeb has put it:

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“We invest wherever we see some kind of special situation element, an event that will either help create the investment opportunity or help to realize the opportunity.”

Such efforts are often unfriendly. Loeb is famous for his public letters in which he harshly criticizes company CEOs for both their professional performance, as well as often for their personal behavior. Other activist hedge funds send such missives. But most agree that Loeb’s are the most florid, nasty and personal as the excerpt below confirms:

“It is time for you to step down from your role as CEO and director so that you can do what you do best: retreat to your waterfront mansion in the Hamptons, where you can play tennis and hobnob with your fellow socialites.”

Loeb’s investment philosophy is similar to that of rival hedge fund manager Joel Greenblatt. In fact, Loeb considers Greenblatt’s book “You Can Be a Stock Market Genius” to be the best investment book ever written. In the book, Greenblatt examines various value-investment concepts and focuses on investing in strategies involving spinoffs, mergers and risk arbitrage.

California Surfer Boy to Wall Street Billionaire

Daniel Loeb founded Third Point LLC on June 1, 1995, with $3.4 million. The then- 33-year-old had money from only five investors — all friends and family — and $340,000 of his own money, which was his life savings from 10 years working on Wall Street.

Today, the billionaire activist investor manages around $17.5 billion in assets. As of December 2016, Third Point has returned an average of 15.8% a year since inception.

A life-long surfer, Loeb grew up in sunny Santa Monica, California, and became fascinated with investing around the age of five. A teacher nicknamed him “Milo Minderbinder” — a character from Joseph Heller’s novel “Catch-22,” a World War II profiteer who controlled the black market.


Daniel Loeb

When he was 12 years old, Loeb hired his classmate Rob Schwartz for 25 cents a day to be his “bodyguard” to protect him from bullies. Schwartz works with Loeb today on his fund’s venture capital arm, Third Point Ventures.

After two years at Berkeley, he transferred to Columbia University in New York City. Loeb studied economics at Columbia and also discovered a love for literature and art. In 1991, the CEO of Jefferies hired Loeb to work in its Los Angeles offices as a sell-side research analyst.

The night before he launched his fund in 1995, Loeb said he “absolutely panicked.” “I thought, ‘Oh my God. What am I doing? I’m a fraud.’ There no way I could do it. What was I thinking? This is crazy. Luckily, I was up 8% the first month and didn’t have that fraud feeling again…”

Aside from surfing, Loeb is a self-described “health nut,” and practices Ashtanga yoga. He also competes in triathlons. Today, the California surfer has an estimated net worth of $ 2.9 billion, according to Forbes.

Anthony Scaramucci, the founder of SkyBridge Capital, said Loeb is “one of the best investors of his generation… He is the guy that would chew through the wallboard to create a return for his investors.”

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Activist Investing in Action

Headquartered in Deerfield, Illinois, Baxter Pharmaceuticals is one of the largest medical instrument companies in the world. With a market cap of close to $30 billion and $10 billion in annual sales, the company sells a broad array of renal and hospital products. These range from kidney dialysis machines to drug infusion pumps to surgical tools and anesthesia drugs.

In August 2015, Third Point went public with its hostile effort to restructure Baxter, and disclosed a stake of almost 10% in BAX. Third Point’s view was that with the right management, Baxter had the opportunity to improve margins and increase shareholder value substantially. After all, Baxter’s products in many cases are #1 or #2 in their markets. With the company’s opportunity to grow in emerging markets, Baxter’s potential global franchise was undervalued.

When Third Point takes an activist position, it often seeks positions on the company’s Board of Directors, as well as to influence CEO selection. And that’s exactly what Third Point did with Baxter. Within months of taking its position in Baxter, Third Point had wrestled control of the company from CEO Bob Parkinson and Baxter’s Board of Directors. Not only did Third Point force Baxter’s CEO out, but it also spurred Baxter’s Board of Directors to add two new members — Third Point Partner Munib Islam and Boston Scientific CEO Michael Mahoney.

Third Point’s Munib also headed the search committee for a new Baxter CEO. By November 2015, Baxter’s board had settled on a seasoned medical device executive and former Covidien CEO Joe Almeida. By January 1, 2016, Third Point had full control of the company.

Loeb Bets on Baxter’s New Jockey

Joe Almeida came to Baxter from The Carlyle Group LP (CG), where he had served as an operating executive. Before working at Carlyle, Almeida had run Covidien, another medical products company that now is part of Medtronic Plc. As CEO at Covidien, Almeida had earned a reputation as a skilled cost cutter and dealmaker. While there, he had improved profitability, pursued a string of acquisitions and spun off the company’s generic drug business.

Today, Almeida is following the same playbook at Baxter. His goal is to nearly double the company’s 9% adjusted operating margins by 2020, while generating 4% annualized sales growth and 15% to 17% annual profit growth.

The bloodletting at Baxter has already begun. At the end of October 2016, Baxter announced the elimination of 1,400 jobs. To cut costs further, Baxter plans to consolidate manufacturing plants, exit markets with poor returns, restructure operations, retire debt and reduce pension liabilities.

Almeida has conducted an extensive evaluation of Baxter’s businesses and research programs, reviewing which parts of the company’s extensive portfolio should stay and which should go. Almeida is also planning a broad range of product launches, including new infusion pumps, premixed injectable medications and biosurgery products. Overall, Baxter plans to launch more than 100 new products, which could generate additional revenue of $1.2 billion by 2020.

Despite his reputation as the dealmaker, Almeida has ruled out “transformative” deals in favor of smaller bolt-on acquisitions. In December 2016, Baxter did agree to acquire Claris Injectables for $625 million. With Claris, Baxter will compete more efficiently in the global sterile generic injectables market over the next five years.

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In the meantime, Almeida has said he would funnel cash to shareholders through share buybacks and dividend payments. Since he took over, Baxter has boosted its quarterly payment to investors on several occasions. Almeida’s overall goal? To turn “a good company into a great company.”

“It isn’t there yet, but it will be,” Almeida added.

The Numbers, Please

On April 26, Baxter reported an outstanding Q1, confirming that Almeida is continuing to make progress on reducing costs and increasing profitability. In the first quarter, Baxter’s worldwide sales totaled $2.5 billion. That was an increase of 5% on a constant currency basis, compared to the prior-year period. Baxter’s hospital products drove revenue growth, as the company sold more IV therapies and the tubes and components used to deliver IV fluids.

Baxter’s first-quarter income from continuing operations totaled $318 million, or $0.58 per diluted share. That trounced the company’s previously issued guidance of $0.50 to $0.52 per diluted share.

Baxter increased its earnings substantially by reducing costs. Improved gross margins and lower spending on sales, general and administrative expenses helped boost adjusted operating margin to 16.4%. That was an improvement of 590 basis points compared with the year-ago quarter.

Based on its strong Q1, Baxter also raised its financial outlook for 2017. It now expects sales growth of approximately 2% or 3% on a constant currency basis and earnings from continuing operations of $2.20 to $2.28 per diluted share for the full year.

Overall, Almeida’s restructuring efforts at Baxter are going better than expected. Almeida also keeps raising the bar of what he expects to achieve. Baxter provided updated 2020 guidance that surpassed previous numbers, including 1) 17- 18% operating margins versus 14%, 2) 24-25% EBITDA margins, up from 20%, 3) roughly $2.5 billion in operating cash flow versus more than $2.0 billion, and 4) free cash flow of approximately $1.75 billion, up from $1.1 billion.

This improvement in free cash flow is more than triple the 2016 guidance of $500 million and implies a compound annual growth rate of over 35%. Baxter officials told analysts the company can earn $2.75-$3.00 per share by 2020.

Not everyone buys the Baxter turnaround. Short sellers hold roughly 22% of Baxter’s stock float. Ironically, this short selling almost ensures that Baxter’s stock likely will pop at some point, as short sellers are forced to cover their positions.

Third Point and Dan Loeb disagree with the short sellers’ negative view. Loeb has written that he is encouraged by Almeida’s execution of his strategic plan for Baxter. In fact, Third Point forecasts $0.75 per share upside to Baxter’s current 2020 earnings per share (EPS) guidance. That would imply a 2015-2020 EPS compound annual growth rate of over 20%, and plenty of upside to the stock from current levels.

So buy Baxter International Inc. (BAX) today, and place your stop at $48. I’ve given this stock a medium risk rating of 3.


Nicholas Vardy

Nicholas A. Vardy

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