Founded in 1985, Blackstone is a premier global investment firm and leader in alternative asset management. The company has become a trusted partner to many of the world’s largest institutional investors and sovereign wealth funds. Blackstone’s investment vehicles are focused on four segments—real estate, private equity, hedge fund solutions and credit.
Alternative investment management is an industry with favorable economics and long holding periods — typically 7-10 years. Clients pay to invest, pay while funds are invested, and later pay a share of any profits. Blackstone has the scale and organizational structure to benefit from growing institutional interest in alternatives. The company‘s fundamentals remain solid given attractive secular trends, its strong long-term investment performance record and remarkable fundraising momentum.
Exceptional Business Model
With its expansive private equity fund business, Blackstone is also one of the largest real estate investment managers with assets of $154 billion; the world’s largest discretionary allocator to hedge funds with $81 billion; and a leader in credit with $139 billion. One of the company‘s competitive advantages is its size, which has been augmented by institutional interest in alternatives, low interest rates and attractive corporate valuations across sectors and industries. Additionally, Blackstone has created an organizational structure and a corporate culture that rewards independent thinking to drive results for its clients.
Opportune Corporate Conversion
Until recently, many publicly-traded alternative asset management firms were structured as publicly-traded partnerships to avoid most corporate taxes, including tax on capital gains from the sale of businesses. Meanwhile, partnerships have been excluded from the vast majority of market indices, not to mention many investors are restricted or refuse to invest in them given the IRS Schedule K-1 reporting requirements. However, the Tax Cut and Jobs Act (TCJA) reduced the top corporate income tax rate from 35% to 21%. Blackstone converted to a C-Corp last July. Management’s goals were not only to simplify its tax structure, but also to attract a wider investor base and to become eligible to be held in market indices to drive a higher public valuation and better share price. Since it announced its conversion, Blackstone shares have surged +38.5% versus the S&P 500 which returned +2.6%.
Intrinsic Value Greater Than Current Share Price
We acknowledge there is little consensus as to how to value alternative asset managers. Some investors are discouraged by the complexity and unpredictable earnings. However, we welcome the industry’s move towards reporting after-tax distributable earnings as a key performance measure. Since mark-to-market gains and losses are excluded, we applaud the change as it reduces volatility. In our view, alternative asset managers continue to receive minimal credit for future performance fees and subsequent distributions. As such, we continue to value Blackstone by applying a “sum of the parts” analysis. Using this metric, we arrive at a private market value of $56.81. At September 30, 2019, the stock closed at $48.84 which represents a 14% discount to our private market value. At current levels, we believe the market is discounting Blackstone’s structural advantage of a lengthy lock-up period, its healthy fundraising momentum, and the sustainability of its incentive income.
BorgWarner makes highly-engineered systems and components, primarily for car engines and light vehicle drivetrains. Its engine group creates 60% of the company’s revenue with products such as gas turbochargers, engine timing systems, diesel turbochargers and emissions systems. Remaining sales come from drivetrain applications such as all-wheel-drive, dual clutch transmission and transmission components. The company was once a part of Borg Warner Security, but was spun off as a stand-alone company in 1993 and now employs approximately 30,000 people in 19 countries.
Headwinds from China and Europe
BorgWarner is a global supplier to auto manufacturers with its revenues split almost equally between the Americas, Europe and Asia. The geographic mix allows the company to better weather volatility in any specific market. However, recently the company has faced headwinds from both Europe and China leading to market concerns. In Europe, newly implemented fuel consumption and emissions standards led to unease in the market. In China, weak auto demand has followed an extended period of growth. Overall, we believe the company is well-positioned to handle these short-term issues.
Increasing Regulatory Pressures On Auto Manufacturers
Around the globe, car companies are facing growing regulation around fuel economy and emissions. BorgWarner’s products help automakers meet regulatory requirements. For example, a BorgWarner turbocharger enables car makers to use a smaller engine. This turbo-charged engine gives the driver plenty of power while using less fuel, resulting in lower emissions. We think the regulatory environment will continue to be a tailwind to create demand for BorgWarner’s products, from turbo-chargers in combustion engines, to components for hybrid engines.
Hybrids and the Electric Automobiles
As the transition from internal combustion engines to hybrid engines and electric motors is occurring, BorgWarner leads the gas and diesel markets. Its turbocharger business for gas and diesel engines has approximately 25% market share. Some investors are concerned the company has an inferior position in the hybrid and electric motor businesses even with recent acquisitions improving its product offering in these end markets. We see significant upside for BorgWarner in hybrid engines given the increased complexity of having both gas engine and electric motor components. Some estimate BorgWarner’s content per vehicle could be 2-3x higher in hybrids and plug-ins than it is today in gas and diesel engines.
The market is focused on the near-term challenges of automakers and suppliers, but underestimating the evolution of the car business. Looking ahead, we believe BorgWarner is poised to benefit from the increasing regulations around fuel economy and emissions. Additionally, the transition of combustion engines to hybrid and electric vehicles bodes well for its business. As of September 30, 2019, shares traded at $36.68, a 41% discount to our current private market value of $61.71.
Zimmer Biomet Holdings, Inc. dates back to 1927 and was spun off from Bristol Myers in 2001. The company is a designer and manufacturer of orthopaedic products including hips, knees, shoulders, and dental implants and devices. The company boasts the #1 global market share in knees and hips followed by #4 in dental. Its primary customers are surgeons, dentists, and hospitals. Zimmer Biomet has a geographically diverse portfolio with products sold in more than 100 countries.
The Past and the Present
We initiated a position in Zimmer Biomet (Zimmer Holdings) in May 2009, when the company and its share price were beginning to recover from a series of product recalls, surgeon frustrations, and regulatory issues. However, in 2016, the company hit another stumbling block. Following the Biomet acquisition, the company faced headwinds from supply constraints and Food and Drug Administration (FDA) facility manufacturing concerns. Bryan Hanson was named Chief Executive Officer in December 2017 after some earnings shortfalls. Hanson took a hands-on approach, with division heads reporting directly to him. With his focus on culture, accountability and metrics, the company has made significant strides.
With research and development reaching nearly $400 million per year, Zimmer Biomet is heavily investing in its pipeline to fuel future growth. For example, robotic devices are a growing complement for orthopaedic surgeons. During 2019, the company launched a robotic suite focused on minimally invasive surgeries: ROSA® ONE Spine offers a solution for complex spinal procedures; ROSA® ONE Brain offers an enhanced performance solution for neurosurgery procedures; and ROSA® Knee offers orthopaedic surgeons increased flexibility for implant positioning. Furthermore, the company has filled in pipeline gaps within its knee franchise, new products that focus on upper and lower extremities, and products specific to sports injuries. We believe the strength in these offerings will help drive revenue growth in the back-half of 2019 and beyond.
Beginning in 2016, the company experienced business disruptions. Moreover, the integration of Zimmer Holdings and Biomet experienced significant challenges. First, the company failed to properly combine the supply channels, which negatively impacted supply. Following a forecasting misstep, one of its facilities was not able to meet the rigorous standards required by the FDA. The company is investing significant resources in its manufacturing processes across the organization to address all remediation needs and has implemented more advanced forecasting software. As 2019 concludes, the company should continue to see revenue and profitability improvements.
The musculoskeletal industry will continue to grow as the world continues to age, the obesity epidemic endures, and “baby boomers” stay active. Furthermore, clinical data illustrates these products improve lives and reduce costs to the healthcare system longer term. Therefore, we believe the utilization rates will continue to increase, albeit at a slower rate versus the early 2000s. As the supply issues are resolved, new products launch, debt is paid down, and the FDA manufacturing concerns subside, Zimmer Biomet will once again regain its momentum in the musculoskeletal marketplace and benefit as global healthcare utilization expands. At 16x forward-12 month cash P/E, we believe upside remains in the stock of Zimmer Biomet Holdings.
Investing in small cap and mid cap stocks is more risky and more volatile than investing in large cap stocks. The intrinsic value of the stocks in which the Funds invest may never be recognized by the broader market.
On this page, we candidly discuss three individual companies to illustrate our investment process. These companies are current holdings of certain Funds, one of which was a top performer for the quarter, one was a new addition to a Fund, and the other was, in our view, undervalued by the market. The information and our opinions were current as of December 31, 2018, but are subject to change. The information shown does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security. These securities do not represent all securities purchased, sold, or recommended to investors during the period. Investors that were not invested in a Fund that held each stock for the entire holding period shown will not have experienced the performance shown. Past performance does not guarantee future results. The performance of any single portfolio holding is no indication of the performance of other portfolio holdings of any Fund or of any particular Fund itself. Portfolio holdings are subject to change. Click here for the top holdings of the Funds.