Trim positions to focus on opportunities

Paul Roukis, a managing director and portfolio manager at Rothschild Asset Management in New York, reduced his positions in two big companies in 2017. Why? He points to balance sheet issues and competitive challenges, among other factors.

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The two companies were computer hardware giant Intel and P&C and life insurer AIG. Roukis, whose firm manages the Renaissance U.S. Equity Value Fund, explains his rationale.

Balance sheet deterioration

Roukis says there’s a lot to like about Intel. He points to its “dominant positions in microprocessors for PCs, data centres and other applications, as well as the company’s reputation for manufacturing excellence.”

Plus, “over time the company has done a very good job at expanding to networking, communications and wireless applications,” he adds.

Still, Roukis reduced his position in the company after it “reduced growth in margin targets for its data centre group, which in 2016 accounted for about 30% of company-wide revenues.” He notes that “while there’s a secular growth theme underpinning [Intel’s] market—driven by things like mobile applications, e-commerce and cloud service—we just see competition limiting growth opportunities.”

He calls for a data-centres arms race, with competitors like ARM and Qualcomm, among others. These companies, he says, “could very well limit revenue and margin opportunities, which are the drivers to long-term appreciation of Intel stock.”

Roukis is also concerned about the influx of Intel’s M&A and capital spending. “This is not a good combination from a cash flow perspective. The company announced an acquisition of Mobileye [in March] for $15 billion, and Mobileye is focused on autonomous mobile applications, camera-based systems.” (Last week, Intel CEO Brian Krzanich explained the deal at Code Conference in California.)

As such, “We see Intel’s balance sheet is weakening a bit, while margins are unlikely to materially improve in the short-term.”

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Roukis concedes Intel has a strong balance sheet, but at the margin, “we’re seeing some deterioration. The bulls will point to an attractive valuation at about 14x 2017 earnings expectations, and more like 13x 2018. The company also pays a sizeable dividend at 3%, which appears competitive in a world where 10-year Treasurys yield 2.3%.”

However, Roukis notes, “If you look at the valuation on a cash-flow basis, and one that’s more of a free cash-flow basis, adjusting for capital spending, we don’t think the valuation is as attractive with a projected multiple of 18x enterprise value to free cash flow. So we decided to trim our position in Intel, and reallocate the resources to other ideas that we think have better upside in the near term.”

Intel’s stock closed at US$36.13 on June 6, on par with 2017 performance so far, but up from about US$33 in December 2016 and from its one-year low of US$30.72 in late June 2016.

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Despite recovery, challenges ahead

“AIG has come a long way from the depths of the financial crisis when it had to be bailed out by the government for ill-conceived financial product bets,” says Roukis. “Since then, it’s certainly not the same company it was before 2008, since the company has simplified its business model and balance sheet and exited non-core businesses.”

His firm has owned the stock for years and benefited from the company’s post-crisis recovery. “However, in the last few quarters, we’ve simply lost confidence in the company’s ability to further their recovery. […] From our vantage point, the recovery has stalled.”

One reason is the increasingly challenging P&C insurance environment. “The industry has lots of excess capital chasing few opportunities, which hurts pricing and ultimately profitability.”

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But Roukis says the company’s biggest challenge is it “has to regain credibility following major shortfalls to operating goals in 2016. The shortfall resulted in another senior management transition.”

He adds, “Restoring confidence in commercial underwriting profitability, reserve adequacy and another management transition are things that just don’t happen overnight, so this will be a much longer-term recovery story.”

Since late April, when Roukis shared his view, AIG has named new president and CEO Brian Duperreault in place of Peter Hancock, and Duperreault has pledged to grow the company. While some industry players, including investment banker Morgan Stanley, have claimed they’re now optimistic, others also decreased their positions during the first quarter of the year.

At the end of May, insurer credit rating agency A.M. Best moved AIG from ‘under review with negative implications’ to ‘stable,’ based on a review of AIG’s most recent financial information.

As Roukis notes, bullish investors will like AIG for its capital allocation strategy, “and that is right to a degree. AIG has excess capital and it’s being deployed to share buy-backs in a rather aggressive mode, so that is definitely happening, but maybe not to the level investors expect.”

In his view, “At the very best, AIG could continue with its capital management strategy and that is at the consensus expectation. Arguably the stock looks inexpensive; [as of late April], it was trading at a roughly 20% discount to tangible book value, but this is a company that is also expected to generate a return of equity of below 8% for the foreseeable future. So the discount to book is justified in our view.” The stock closed at US$63.31 on June 6, up from late April’s US$59 but lower than where it started this year.

Roukis says AIG’s post-2008 recovery has demanded investors’ patience. “This is a company that won’t get the benefit of the doubt from investors, so a rebound in shares will require evidence of improvement, and not just anticipation of one.” He suggested in April that the new CEO would have a lot of work to do.

Roukis concludes he and his team “saw better opportunities in the financial services sector and decided to exit our position in AIG.”

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