Update on Third Point Offshore Fund Performance for Investors

In the Third Quarter, the flagship Offshore Fund of Third Point experienced a return of -3.2%. This performance reflects the challenging market conditions we faced during this period.

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The top five performers this quarter included Pacific Gas and Electric Co. (PCG), Ventyx Biosciences, Inc. (VTYX), Cano Health, Inc. (CANO), SentinelOne Inc. (S), and Short A.^[1] In contrast, the five least performing stocks were Colgate-Palmolive Co. (CL), The Walt Disney Co. (DIS), Short B, Private A, and Ferguson plc (FERG).

In-Depth Portfolio Analysis and Future Market Outlook

In the Third Quarter, our primary focus was on capital preservation, resulting in a loss of about 3%, contrasting with the S&P and MSCI global indices that experienced losses of 5-6%. Throughout this period, macroeconomic factors took precedence over company fundamentals, reminiscent of a shifting market landscape. Following a brief uptick in July, driven by positive inflation signals and speculation of a soft landing, market sentiment turned increasingly negative in August and September, reflecting broader economic uncertainties.

The beginning of Q4 has continued this trend, exacerbated by the new UK government’s disarray in managing its monetary and fiscal policies, highlighted by the sudden dismissal of its finance minister. This situation has sparked fresh concerns regarding financial stability, adding to an already precarious outlook. Influential analysts, including the well-known perma-bear Nouriel Roubini, have articulated warnings about a looming severe recession and an extended bear market, which have resonated within the investment community.

During recent hedge fund gatherings, the prevailing sentiment mirrored this negativity, with attendees presenting their bleak forecasts for potential financial downturns. This was coupled with an intense discussion around the lowest price-to-earnings (PE) multiples of revised S&P earnings expectations. Data from prime brokers has illustrated a stark decline in net and gross returns within the hedge fund sector, further underscoring the pervasive sense of unease.

While I acknowledge the validity of many economic and geopolitical concerns being raised, amidst this pervasive pessimism, there exist exceptionally attractive valuations in the market. This is especially true if we assume that the economic landscape is not headed towards total financial chaos. We are currently increasing our investment exposures in selected opportunities. As a wise mentor of mine once observed, while the timing of market bottoms is uncertain, it is often preceded by dismal economic indicators.

A memory comes to mind of a New York Post headline from March 9, 2009, declaring “Warren Buffet: The Economy Has Fallen Off a Cliff!” I have experienced similar cycles of pessimism firsthand, having warned investors in a letter dated March 10, 2009, to “brace for impact,” only to witness a significant market turnaround just days later as I recalibrated my stance based on emerging data, leading to increased positions in banks and automotive stocks.

At this juncture, the pivotal question revolves around whether the Federal Reserve’s policy on interest rates and inflation will dictate market behavior or if the bottoming of the real economy—evidenced by metrics like unemployment, income, industrial spending, and comprehensive GDP indicators—is what truly matters.

Currently, while we remain vigilant of numerous identified risks, we are actively seeking to deploy capital into top-tier companies that are currently available at discounted prices. We are also exploring event-driven situations that offer some protection against market volatility. Should the economy deteriorate further, our strategy includes maintaining short positions and market hedges to mitigate potential losses while remaining poised to seize opportunities in the credit market, as elaborated below.

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Strategic Equity Investment Focus: Colgate-Palmolive

Recently, Third Point has taken a significant position in Colgate-Palmolive, aligning with crucial investment criteria in the current market landscape. This investment is compelling for several reasons:

• Initially, the company operates defensively and possesses substantial pricing power, which is especially advantageous during inflationary periods.
• Additionally, there exists considerable hidden value within the Hill’s Pet Nutrition division, which could command higher multiples if spun off from Colgate’s consumer segments.
• The consumer health sector is also showing a favorable trend, with new entrants emerging through spin-offs and potential for consolidation.
• Finally, the current valuation presents an attractive opportunity, as earnings growth is positioned to accelerate, offering shareholders significant optionality regarding Hill’s or any future consolidation in the consumer health arena.

Colgate boasts a robust brand portfolio and spans four key categories that tend to perform well across various economic climates: oral care, home care, personal care, and pet nutrition. Although Colgate has seen organic sales growth of approximately 5-6% in recent years, earnings growth has lagged, rendering the stock a consistent underperformer. Challenges such as foreign exchange fluctuations have hindered reported results, while reinvestment in the business, supply chain disruptions, and inflationary pressures have heavily impacted margins; fortunately, these challenges are beginning to subside.

Increased investments in demand generation, innovative products, and digital capabilities are beginning to yield positive results. Global supply chain bottlenecks are easing, and product availability is improving significantly. Most importantly, pressures related to raw materials, transportation, and wages are stabilizing, and in some areas, even reversing, coinciding with additional pricing strategies. Collectively, these factors set the stage for Colgate to witness several years of strong earnings growth, as sales continue to rise, foreign exchange impacts become annualized, and margins recover.

Notably, Hill’s Pet Nutrition has emerged as the standout performer within Colgate’s portfolio in recent years. This premium pet food brand primarily sells through specialty and veterinarian channels, with its most recognized products being Hill’s Science Diet and Hill’s Prescription Diet. Hill’s has managed to grow sales organically at an impressive rate of 11-12% over the past several years, achieving mid to high 20% operating margins, and is projected to account for nearly 20% of Colgate’s sales and profits in 2022.

Remarkably, this performance has occurred despite supply constraints. To bolster future growth, Colgate has recently acquired three pet food manufacturing facilities from a third party. This strategic acquisition enables the company to enhance capacity more swiftly than its competitors, capturing market share and accelerating growth.

The pet sector stands out as one of the most promising segments within consumer markets, and Hill’s is a fantastic brand with immense growth potential. We believe that as an independent entity, Hill’s could achieve even more rapid growth and improved margins, potentially earning a premium valuation of 25-30x EPS, leading to an overall valuation of around $20 billion based on CY23 projections. Hill’s represents a valuable consumer growth company and a hidden gem within Colgate’s otherwise defensive product lineup.

Colgate plays a crucial role in the evolving consumer health landscape, which is currently undergoing significant transformations. Recent strategic actions by companies like GSK and Pfizer highlight the dynamic nature of the industry; they have recently spun off their consumer health division, now known as Haleon, after declining a £50 billion acquisition offer from Unilever.

Interestingly, Haleon boasts a strong presence in oral care, featuring brands like Sensodyne, Parodontax, and Polident. Furthermore, Johnson & Johnson plans to separate its consumer health division, which includes iconic brands such as Listerine, Tylenol, and Neutrogena. Such substantial transactions are expected to facilitate further consolidation in the sector, presenting intriguing opportunities for Colgate’s assets. Although Colgate’s Board has a reputation for being conservative and not particularly aggressive in pursuing transformative actions, we are confident that they will act in the best interest of shareholders should Colgate become part of the ongoing mergers and acquisitions landscape in consumer health.

The valuation of Colgate presents a compelling margin of safety combined with significant upside potential. Based on our analysis, shares are currently trading at a low 20x multiple on CY23 earnings. Moving forward, we anticipate that shares will compound at a mid to high teens rate over the next several years, driven by earnings growth and a nearly 3% dividend yield. Any strategic developments surrounding Hill’s or within the consumer health sector could significantly enhance our expected returns.

Current Investment Strategy: The Walt Disney Company (DIS)

As highlighted in our Q2 letter, we re-entered a substantial position in The Walt Disney Company when the stock revisited its Covid lows earlier this year. At its current valuation, Disney’s shares are trading at slightly above the standalone value of its Parks division and only about 15x the “street” consensus for 2024. The company is still in the early stages of its transition to Direct to Consumer (DTC), possessing a leading market position, yet the current stock price suggests minimal value is being assigned to its streaming operations.

We attribute this skepticism to concerns surrounding the long-term profitability of streaming, as evidenced by substantial losses reported at Disney (over $1 billion last quarter) and stagnating margins among competitors like Netflix. During the last earnings call, management outlined three critical factors that could lead to a turnaround in DTC profitability over the coming year: a 38% price increase for Disney+ in the U.S.; a moderation in growth related to cash content expenses; and the launch of an advertising-supported tier for Disney+ within the next two months, which is expected to significantly increase average revenue per user (ARPU) given the brand’s appeal to advertisers.

Although the company has indicated that Disney+ is expected to reach breakeven by the end of the fiscal year ending September 2024, market valuations imply a level of skepticism regarding this guidance. Disney is currently trading at approximately 14x the $7 in earnings it generated before acquiring Fox, suggesting that investors do not anticipate earnings will meaningfully exceed this figure in the near future. Consequently, one of the primary value drivers we identified in our last letter is the potential for management to optimize Disney’s cost structure to drive earnings growth.

We believe Disney has significant opportunities to streamline costs across its operating framework and to deliver targeted content for home viewing that avoids the high expenses associated with exclusive theatrical releases.

We concur with Disney’s management that ESPN remains a vital asset for the company at this juncture. The cash flow generated by ESPN has been crucial in funding streaming losses and supporting the balance sheet in anticipation of the Hulu acquisition. In turn, Disney’s scale and diversification provide a buffer for ESPN as it navigates the early stages of its inevitable transition from traditional linear distribution to DTC. Looking ahead just a few years, by 2025, we envision a markedly different landscape, with Disney’s streaming segment becoming profitable, Hulu fully integrated, and the pay-TV ecosystem reflecting a reduction of approximately 20% in subscribers.

Sadly, the current valuation of DIS shares reflects little value attributed to ESPN. As the preeminent brand in sports, ESPN is positioned to evolve into the leading DTC distributor of sports content in the U.S. However, this transition is complicated by the asset’s existing success; today, ESPN generates around $11 per subscriber in monthly linear affiliate fees across a subscriber base exceeding 70 million households. To replicate these economics in a DTC model, ESPN will need to successfully incorporate a range of value-added services such as sports betting, targeted advertising, fantasy sports offerings, and merchandise sales.

Lastly, as indicated in our recent joint press release with Disney, we are pleased to announce that we have signed a support agreement and that the company has appointed a new Board member, Carolyn Everson, whose expertise in advertising sales, media, and digital technology will enhance the Board’s capabilities. We anticipate continuing our fruitful discussions with Disney’s management team.

Position Enhancement: PG&E Corp. (PCG)

Since our previous commentary on PG&E in May, the company has made significant strides in closing the valuation gap with its regulated peers. Over the third quarter, PCG’s stock surged by 25%, contrasting with a 6% decline in the XLU, a proxy for the S&P 500 Utilities Sector.

This outperformance has been driven by the announcement of PG&E’s inclusion in the S&P 500 index and the committed execution of strategies by Patti Poppe, the newly appointed CEO, and her team. Management has prioritized mitigating physical and financial risks by implementing protective measures against catastrophic wildfires, financial instability, and ratepayer volatility. For a utility company, Ms. Poppe has formulated a plan to undertake essential investments aimed at enhancing safety, reliability, and service quality through capital expenditures while simultaneously curtailing operating costs.

Despite recent gains, we maintain optimism regarding the company’s future prospects, supported by industry-leading projected EPS growth of 10% and the anticipated reinstatement of dividends in 2023. PG&E currently trades at a 6x discount compared to its peers based on 2023 earnings, suggesting that it should continue to re-rate as investors familiarize themselves with the enhanced regulatory framework established under AB1054 and develop increased confidence in management’s ability to execute its strategies effectively.