October 19, 2016

Planes, Trains and Newspapers – Read All About Why We Own These Names

Income Opportunity Strategy 3Q 2016 Commentary

Income Opportunity Strategy had a strong quarter, returning 7.79% (net of fees)1, outperforming the Merrill Lynch US High Yield Index by 230 basis points. The strategy also generated more than two times the S&P 500’s 3.85% return for the quarter. As the dividend comprised approximately 2% of the strategy’s value at the beginning of the period, the bulk of the return came from rising values of portfolio holdings. We’d like to highlight the rationale for two of our largest holdings at quarter-end, as one contributed significantly to performance while the other was one of our worst detractors.

The best performing name in the portfolio was Fortress Transportation & Infrastructure Investors (FTAI), now our largest holding. The company owns and operates transportation-related assets like aircraft engines, ports, railways and energy terminals. We bought the name on the May 2015 IPO, and we regularly added to the position as the share price fell in half between June of last year and this February. The pattern is one we have seen before – a closed-end company raises capital in an IPO and subsequently falls as it struggles to put the money to work as quickly as the market hoped. This situation often affords patient investors the ability to accumulate shares at an inexpensive price and wait until the market fully appreciates the earnings power of the business. At FTAI’s bottom in February, shares traded hands at about half of book value, much of which was cash. At the end of the third quarter, FTAI still traded at 86% of book value, suggesting the market is becoming increasingly less negative on the firm’s ability to earn its 11% dividend yield. We remain far more optimistic than the market. CEO Joe Adams is well-regarded by other management teams in the business, and he has repeatedly said on earnings calls that he remains very confident in FTAI’s ability to sustainably earn the dividend; we believe it may only be a few quarters until the company proves this to the market. Other publicly traded infrastructure partnerships like Brookfield Infrastructure (BIP) and Macquarie Infrastructure (MIC) trade north of 2x book value at mid-single-digit dividend yields. If FTAI were to trade in-line with these peers, it would need to double from here.

On the flipside, the second-worst performing name during the quarter was New Media Investment Group (NEWM), which was the strategy’s third-largest holding at quarter-end. It owns and operates local newspapers and is also an affiliate of Fortress Investment Group (FIG) — another stock we own and think is materially undervalued. New Media received two analyst downgrades during the quarter. Both downgrades cited slow sales growth and no meaningful M&A activity, and each analyst seemed doubtful of management’s stated goal to stem organic sales declines by the end of 2017. Neither analyst seemed to give the company credit for the ample free cash flow that New Media generates above and beyond the dividend. As of the end of the second quarter, New Media had over $100M in available liquidity between $60.7M in cash and $40M of available borrowings under its revolving debt facility, giving the company lots of room to acquire additional local newspapers and grow free cash flow per share. All of this means that we have a high level of confidence in the 9% dividend yield not only continuing but possibly growing in the future, though we wouldn’t mind seeing additional liquidity going toward share repurchase with shares trading at these levels. Insiders have historically purchased the stock around $16, and at quarter-end it closed at $15.50, while we believe intrinsic value is north of $20 per share.

We hope these two ideas provide fellow shareholders with insight into how we think about some of the opportunities within the portfolio. We remain the largest individual shareholders in the strategy, and we welcome any questions or comments.

Strategy Highlights

During the third quarter of 2016, the Income Opportunity Strategy generated a total return of 7.79% (net of fees)1. In comparison, the Strategy’s unmanaged benchmarks, the BofA Merrill Lynch US High Yield Master II Index and the S&P500 returned 5.49% and 3.85%, respectively.

We initiated four positions and eliminated four during the quarter, ending the quarter with 42 holdings.

Top Contributors

  • Fortress Transportation and Infrastructure Investors rebounded during the third quarter rising 39.3% despite missing expectations in the second quarter. FTAI closed its Repauno acquisition on July 1st and continued to expand their aviation business. The company has continued to meet the dividend obligation, with an implied yield of 10.6%. Joe Adams, CEO, bought stock in the open market in August.
  • Seagate Technology (STX) was up 61.0% during the quarter, supported by strong performance over the last two quarters. The company positively pre-announced the last two quarters, with the most recent quarter, Q1 FY ’17 (Sept), revenue of $2.8B, or $100M ahead of $2.7B guidance and gross margin of 29% or 200bps ahead of management guidance.
  • NorthStar Realty Finance (NRF) ended the quarter up 18.7% despite fears of the proposed merger with NorthStar Asset Management and Colony Capital being blocked by shareholders. Activist firm, Land & Buildings, along with Whydah LLC have announced opposition to the merger believing that the deal undervalues NorthStar Asset Management and NorthStar Realty Finance. The deal is still widely expected to go through.

Top Detractors

  • OCI Partners (OCIP) stock fell -22.0%. The company did not declare a distribution after revenues fell 30% from Q2 ’15. A combination of downtime at its facilities and a weak pricing environment contributed to the poor quarter.
  • New Media Investment Group ended the second quarter down -11.5% as the company reported results below the Street’s consensus estimate despite encouraging sales trends. Operating EPS of $0.24 were five cents short of the consensus estimate, though the company’s $0.65 in adjusted free cash flow per share easily covered the $0.33 dividend (8.5% yield). Top-line organic revenues declined at a slower 4.9% rate, which represents continued progress toward management’s goal of organic revenue growth by year-end 2017.
  • Frontier Communications Corp. 11.125% Preferred declined -8.7% during the quarter. Second quarter results showed lighter-than-expected revenues from legacy businesses, causing total revenue of $2.6B to fall short of the $2.7B estimate. However, the company also increased its cost synergy expectation from the Verizon transaction to $1.25B from a previous level of $700M. Over the period, the company announced a new CFO, R. Perley McBride, who was most recently the CFO at Cable & Wireless Communications Plc.

Read the notes from our 3Q 2016 quarterly investor call.

1Income Opportunity Strategy performance reflects the deduction of an annual model investment management fee of 1% (the highest fee for separate accounts under our fee schedule) and certain other expenses. For important information about Income Opportunity Strategy performance, please click on the Income Opportunity Composite Performance Disclosure. Past performance is no guarantee of future results.

Contact LMM to obtain information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to Strategy performance.

Investment Risks: All investments are subject to risk, including possible loss of principal.

The views expressed in this report reflect those of the LMM LLC (LMM) strategy’s portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.

©2016 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.

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