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Reviewing Our Theses on Disney, Charter, Comcast, RBI, F1, and Fox

July 31, 2019 in Commentary, Ideas, Letters

This article by Francisco Olivera is excerpted from a letter of Arevilo Capital Management, based in San Juan, Puerto Rico.

The Walt Disney Company (“Disney”)

2019 has been (and will continue to be) a busy year for Disney. So far, Disney has:

  • Released four of the top five global box office hits, including: “Avengers: Endgame,” which has earned $2.78 billion at the global box office; “Lion King” (live action); “Frozen 2;” and “Star Wars: The Rise of Skywalker” will be released in the second half of 2019;
  • Closed the acquisition of Twenty-First Century Fox’s entertainments assets;
  • Detailed its video streaming strategy at an investor day in April, including the financial outlook for its streaming services;
  • Announced a deal with Comcast to assume control of Hulu’s operations. Terms were also set for Disney to purchase the reaming 33% of Hulu it does not own today;
  • Opened “Star Wars: Galaxy’s Edge,” the largest expansion ever to Disneyland. Galaxy’s Edge will also open in Disney World’s Hollywood Studios later this year; and
  • Increased ESPN+’s live and original programming investment, including an expanded partnership with UFC. You must now be an ESPN+ subscriber in order to watch a UFC pay-per-view fight.

Investors have grown more confident in Disney’s long-term outlook because of the Company’s aggressive strategy to succeed in the “streaming wars.”[1] Disney has restructured its operations, with content production on one side of the business and distribution (via Disney+, Hulu, and ESPN+) on the other. With its brands and intellectual property, Disney has a unique opportunity to create a global direct-to-consumer streaming service. Disney+’s $6.99 per month price tag is a strong sign of the Company’s ambitions to add many millions of subscribers. Subscribers to Disney+ will have access to all of Disney’s 2019 box office hits.

Disney’s content production is the heart of the business. Popular box office and television content will lead to more Disney+ subscribers, parks guests, consumer products purchasers, and engagement with Disney’s brands. No other content company can monetize its customers as well as Disney.

In the medium-term, Disney’s financial performance will be cloudy. The Company will be spending significantly on integrating Twenty-First Century Fox, and on growing Disney+, Hulu, and ESPN+. When the dust settles, Disney will be in a stronger competitive position and produce much more free cash flow.

2019 year-to-date total stock return: 27.4%

Charter Communications (“Charter”) / Liberty Broadband

Charter’s operating metrics have continued to improve this year, with increasing broadband penetration and accelerating overall customer growth. Investors have become less fearful of Charter’s prospects in the face of declining pay-tv customers. Charter is a broadband-centric business, providing a service that is essential (and growing in importance) to its customers. The following comment by Charter’s CEO on the company’s last quarterly conference call is noteworthy:

Monthly data usage by our residential internet customers is rising rapidly and monthly median data usage was over 200 gigabytes per customer. When you look at average monthly usage for customers that don’t subscribe to our traditional video product, usage climbs to over 400 gigabytes per month, which compares to an average mobile usage of well under 10 gigabytes per month.[2]

Not only is broadband usage growing, but also double in size for non-pay-tv customers and exponentially higher versus wireless users. Given the importance of the broadband product and Charter’s advantage versus competitors (such as copper-based internet service providers), we believe Charter’s broadband penetration is poised for growth.

Charter’s free cash flow margins and growth is positioned to expand as residential and commercial customer additions grow, integration expenses dwindle, and capital intensity in the business declines. Charter is using all of its free cash flow and debt capacity to return capital to shareholders via share repurchases. Growing free cash flow combined with share repurchases produce even faster growth in free cash flow per share.

Charter’s share repurchase strategy is a significant benefit for long-term investors. Liberty Broadband Chairman, John Malone, recently said the following regarding Charter: “Right now the focus is on building out their broadband infrastructure. Their valuation is strong and their growth is good. They’re very cash flow accretive. It’s a great business.”[3] We could not have said it better.

Charter 2019 year-to-date total stock return: 38.7%

Liberty Broadband A & C shares 2019 year-to-date total stock return: 43.2% & 44.7%

Comcast Corp. (“Comcast”)

Similar to Charter, Comcast’s cable business is performing well to start the year. Comcast is on-track to add over 1 million broadband customers for the 14th year in a row and average revenue per broadband customer increased 5% in the first quarter.

The biggest development from the NBC-Universal business is the announcement of a new advertisement-based streaming service, which will launch in 2020. Comcast’s approach to competing in the “streaming wars” is to augment Xfinity and Sky’s pay-tv services. The new streaming service will be widely distributed to pay-tv customers in the U.S. (led by Xfinity) and in Europe (via Sky). We believe Comcast’s approach to compete against the “streamers” is sensible, because (i) it requires less investment, (ii) has the potential to increase pay-tv customer engagement, (iii) will increase opportunities for Comcast’s ad customers, and (iv) provides flexibility to monetize its content.

It’s too early to tell if Comcast’s acquisition of Sky will be a success, but Comcast has moved quickly to consolidate redundant businesses, create partnerships amongst its businesses, and reduce consolidated financial leverage. Sky provides Comcast with significant scale to invest in content and technology that will improve the Company’s products and services for many years to come.

2019 year-to-date total stock return: 24.8%

Restaurant Brands International (“RBI”)

Jose Cil, RBI’s new CEO, led an investor day in May to provide insight into the Company’s strategy and long-term goals. RBI’s priority is to grow its three brands (Burger King, Tim Hortons, and Popeyes) globally by expanding from 26,000 restaurants today to 40,000 over the next 8 to 10 years. The target implies store count growing 4.4% to 5.5% annually, an ambitious (but achievable) target. If store count grows 5% annually and same stores sales can maintain low single-digit growth, RBI’s free cash flow will grow immensely over the next decade. After the investor day, RBI announced plans to open Tim Hortons restaurants in Thailand and Popeyes restaurants in Spain.

We believe RBI’s focus on growing its brands globally combined with its “balanced capital allocation” approach (dividend payments, share repurchases, debt repayment, and M&A) will produce attractive long-term value to shareholders.

2019 year-to-date total stock return: 34.9%

Formula One Group (“F1”)

Formula One’s marketing and commercial initiatives are starting to gain momentum. In March, Netflix released “Formula 1: Drive to Survive,” a documentary series on the 2018 F1 season. The show was well received and we believe it helped expand the league’s audience (particularly in the US, where the sport’s viewership is growing). F1’s management team is also working on improving the race calendar. Two new races have been added to the calendar for next year (Vietnam and Netherlands) and plans for a race in Miami, Rio, and a second race in China are underway. Over time, we believe the race calendar will reflect a balance of legacy race tracks and “destination city” events that will lift F1’s global profile.

Management’s biggest goal for the rest of the year is to sign a new Concorde Agreement with all F1 teams. The Concorde Agreement is the contract that defines the economic and technical regulations for F1’s teams, regulator (FIA), and commercial rights holders (Formula One Group). The current contract expires at the end of 2020, but a new contract needs to be agreed upon by the end of this year.

A more equitable economic structure amongst teams and simplified technical regulations will help create more competition and excitement for fans. More competition and fan engagement will lead to long-term value for shareholders.

2019 year-to-date total stock return: 20.7%

Fox Corp. (“Fox”)

Fox was spun-off from Twenty-First Century Fox right before Disney acquired its entertainment assets. Fox owns the Fox network, 28 television stations, a group of cable channels (led by Fox News), and other assets (real estate, Roku investment). After the Disney transaction, Fox has become a purely domestic television business that is highly dependent on the pay-tv bundle. Knowing the secular headwinds being faced by the pay-tv bundle, management created a business focused on the most valuable part of the bundle: live news and sports. Fox owns the most popular news channel, Fox News, and holds the rights to nearly 40% of NFL games, the most watched sports league in the U.S. Fox also owns the rights to the World Series, the World Cup (both men and women’s), WWE’s “Smackdown”, NASCAR’s Daytona 500, and a variety of college sports.

In a world where the value of the pay-tv bundle is driven by live content, Fox is extremely well positioned. Half of Fox’s revenues are derived from contracted affiliates fees (paid by pay-tv distributors and affiliated TV stations) and half from advertising. 70% of ad revenues are from live programming, which face less risk relative to entertainment programming. Over the next three fiscal years, 73% of affiliate fee revenues will be renewed. Fox has an opportunity to demand higher affiliate fees because their channel portfolio is relatively small and their live content is arguably the most valuable in the pay-tv bundle.

We continue to hold our investment in Fox given the low free cash flow multiple and pricing opportunity going forward. However, we are vigilant of the secular risks facing the pay-tv industry.

A & B shares 2019 year-to-date total stock return: (8.6%) & (9.6%)[4]
_____

1 “Streaming wars” has become a popular way to describe the competition between tech companies (led by Netflix) and traditional media companies (such as Disney, HBO and Comcast) in online video entertainment.
2 Source:https://seekingalpha.com/article/4258162-charter-communications-inc-chtr-ceo-thomas-rutledge-q1-2019-results-earnings-call-transcript?part=single
3 Source:https://variety.com/2019/biz/news/john-malone-faang-sun-valley-charter-1203263342/
4 Total stock return calculated from the spin-off date.

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Kate Welling on Her Book, Merger Masters

July 30, 2019 in Audio, Meet-the-Author Forum, Meet-the-Author Forum 2019, Meet-the-Author Forum 2019 Featured, Transcripts

Kate Welling discussed her book, Merger Masters: Tales of Arbitrage, at MOI Global’s Meet-the-Author Summer Forum 2019. Kate is the editor and publisher of Welling on Wall St.

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About the book:

Merger Masters presents revealing profiles of monumentally successful merger investors based on exclusive interviews with some of the greatest minds to practice the art of arbitrage. Michael Price, John Paulson, Paul Singer, and others offer practical perspectives on how their backgrounds in the risk-conscious world of merger arbitrage helped them make their biggest deals. They share their insights on the discipline that underlies their fortunes, whether they practice the “plain vanilla” strategy of announced deals, the aggressive strategy of activist investment, or any strategy in between on the risk spectrum.

Merger Masters delves into the human side of risk arbitrage, exploring how top practitioners deal with the behavioral aspects of generating consistent profits from risk arbitrage. The book also includes perspectives from the other side of the mergers and acquisitions divide in the form of interviews with a trio of iconic CEOs: Bill Stiritz, Peter McCausland, and Paul Montrone. All three took advantage of M&A opportunities to help build long-term returns but often found themselves at odds with the short-term focus of Wall Street and merger investors. Told in lively, accessible prose, with bonus facts and figures for transaction junkies, Merger Masters is an incomparable set of stories with plenty of unfiltered lessons from the best managers of our time.

About the author:

Kate Welling, the author with Mario Gabelli, of “Merger Masters, Tales of Arbitrage,” (Columbia Business School Publishing, 2018), is an accomplished journalist who has been covering the Wall Street beat for 45 years.

Kate is the editor and publisher of Welling on Wall St., an independent online journal for professional investors, which she founded in 2012 as a successor to Welling@Weeden, the widely-read investment research publication she had created in 1999 under the aegis of institutional brokerage firm, Weeden & Co. WOWS, as her current newsletter is familiarly known, is eagerly read by savvy pros who subscribe for its uncommon perspective, depth of research and insights into the ever-evolving maelstrom that is the battle for financial survival.

When Kate left the Wall Street Journal’s copyediting corps to latch onto a staff writing job at Barron’s in 1976, she wasn’t two years out of Northwestern’s Medill School of Journalism, not yet 24 years old. It was at Barron’s that Kate honed her journalistic and financial skills — from the basics, like reading disclosure documents from the footnotes up, to the ineffable art of eliciting truths in interviews, whether with corporate titans, investment pros at the pinnacles of their careers or with the scallywags inevitably trying to pass themselves off as genuine articles to unwary investors. Working with Alan Abelson, Kate learned to tell those stories, engagingly, fully and fearlessly. She also institutionalized Barron’s in-depth interviews and Roundtables as both an art form and a crowning achievement in the careers of many participants.

After more than 25 years at Dow Jones, many spent serving as Barron’s managing editor, virtually all of them as a back-up reporter and occasional writer on Abelson’s iconic column, Up and Down Wall Street, Kate left Barron’s after putting its 1999 Roundtable issues to bed. She had been offered the opportunity to start her own investment journal, in conjunction with Weeden & Co. With Alan Abelson’s full-throated encouragement, she accepted the challenge. Today, each issue of WOWS, her independent, subscription-supported successor to that publication (accessible at www.wellingonwallst.com) is eagerly read by thousands of savvy investment pros.

Lauren Templeton on Her Book, Investing the Templeton Way

July 29, 2019 in Audio, Meet-the-Author Forum, Meet-the-Author Forum 2019, Meet-the-Author Forum 2019 Featured, Transcripts

Lauren Templeton discussed her book, Investing the Templeton Way: The Market-Beating Strategies of Value Investing’s Legendary Bargain Hunter, at MOI Global’s Meet-the-Author Summer Forum 2019. Lauren is the founder and principal at Templeton & Phillips Capital Management.

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About the book:

Called the “greatest stock picker of the century” by Money magazine, legendary fund manager Sir John Templeton is revered as one of the world’s premiere value investors, widely known for pioneering global investing and out-performing the stock market over a five-decade span. Investing the Templeton Way provides a never-before-seen glimpse into Sir John’s timeless principles and methods.

Beginning with a review of the methods behind Sir John’s proven investment selection process, Investing the Templeton Way provides historical examples of his most successful trades and explains how today’s investors can apply Sir John’s winning approaches to their own portfolios. Detailing his most well-known principle investing at the point of maximum pessimism- this book outlines the techniques Sir John has used throughout his career to identify such points and capitalize on them.

Among the lessons to be learned:

  • Discover how to keep a cool head when other investors overreact to bad news
  • Become a bargain stock hunter like Sir John-buy the stocks emotional sellers wish to unload and sell them what they are desperate to buy
  • Search worldwide to expand your bargain inventory
  • Protect your portfolio from yourself through diversification
  • Rely on quantitative versus qualitative reasoning when it comes to selecting stocks
  • Adopt a virtuous investment strategy that will endure in all market conditions

About the author:

Lauren C. Templeton is the founder and president of Templeton & Phillips Capital Management, LLC; a value investing boutique located in Chattanooga, Tennessee. Ms. Templeton received a B.A. in Economics from the University of the South. She is the founder and former president of the Southeastern Hedge Fund Association, Inc. based in Atlanta, Georgia. Ms. Templeton currently serves on the Board of Trustees at the Baylor School, the Board of Trustees at the Bright School, the Atlas Economic Research Foundation Board of Overseers, the Board of Directors at Fairfax Financial Holdings Limited and the Board of Directors at Fairfax India Holdings Corporation.

Lauren is the great niece of Sir John M. Templeton and is a current member of the John M. Templeton Foundation, the Templeton World Charities Foundation and a Trustee of Templeton Religion Trust. Lauren Templeton began investing as a child under the heavy influence of her father as well as her late great-uncle, Sir John Templeton. Professionally speaking, Lauren began her career working with managed portfolios and investments in 1998, beginning as a junior associate at the financial advisor Homrich and Berg and later the hedge fund management company New Providence Advisors both of Atlanta. In 2001, Lauren launched her own company which dedicates its efforts to the practice of value investing across the global markets using the same methods learned from her great-uncle, Sir John Templeton. Ms. Templeton is also the co-author of Investing the Templeton Way: The Market Beating Strategies of Value Investing’s Legendary Bargain Hunter, 2007, McGraw Hill, which has been translated into nine languages.

Lauren lives in Tennessee, with her husband, Scott Phillips, who is a portfolio manager and Director of Research at Templeton & Phillips Capital Management, LLC.

Why Boring Stocks Are Beautiful (And May Be Risky Today)

July 28, 2019 in Commentary, Letters

This article is authored by MOI Global instructor Todd Wenning, a senior investment analyst at Ensemble Capital Management, based in Burlingame, California. Visit Ensemble’s Intrinsic Investing website for additional insights.

Investors who’ve studied the works of Warren Buffett and Peter Lynch know that so-called “boring” stocks can present wonderful investment opportunities.

There’s something to it. In Lynch’s One Up on Wall Street, for example, he writes, “Blurting out that you own Pep Boys won’t get you much of an audience at a cocktail party, but whisper ‘GeneSplice International’ and everybody listens.”

Boring companies typically don’t make for media darlings. Often there’s not much variance in quarter-to-quarter or year-to-year growth – due to high recurring revenue, pricing power, etc. – so there isn’t a lot to debate.

In a 2013 paper, the British asset management firm, Fundsmith, set out to explain how and why boring companies are consistently undervalued.

As the below chart shows, people tend to be overconfident in low-certainty events (e.g. lottery tickets) and underconfident in higher-probability events (60-80% certainty). As certainty approaches 100% (e.g. a Treasury bond), people become more correctly confident.

Source: Fundsmith.

Many high-quality, low-volatility stocks find themselves in the 60-80% certainty category. As Fundsmith wrote, these stocks “have regular bond like returns and low share price volatility but they are still stocks with uncertainty about share price and dividend payments whereas bonds have the relative certainty of redemption values and coupons.”

Put another way, this set of businesses is about as fundamentally certain as you can get in the market, but investors have systematically underinvested in them relative to their level of certainty.

To be sure, patient investors in boring stocks have been handsomely rewarded. From June 1990 through mid-July 2019, the S&P 500 low volatility index outperformed the overall S&P 500 Index by about 100 basis points per year (11% vs. 10% CAGR).

Source: Bloomberg, as of July 16, 2019. Normalized, total returns.

Now, during most bull markets, you would expect economically-sensitive, high-volatility stocks to outperform low-volatility stocks, as they did from December 2002 to October 2007, as measured by the S&P 500 high beta index (purple line) vs the Low Volatility index (white line).

Bloomberg, as of July 17, 2019. Normalized, total returns.

Yet here we are today, riding a 10-year bull market and hitting all-time highs, and low-volatility companies continue to crush high beta names.

Bloomberg, as of July 19, 2019. Normalized, total returns.

Don’t get us wrong – at Ensemble, we also love boring, defensive companies flying under Wall Street’s radar. They often have economic moats and get stronger during recessions.

Yet some of these companies’ valuations have been challenging to justify. In August 2016, for instance, we wrote about former holding WD-40 being a case study of the “bubble” in safe stocks.

Remarkably, since we wrote that post three years ago, WD-40 has further expanded its already-lofty P/E multiple and outperformed the S&P 500. In 2016, we would have considered this a low probability outcome, but here we are.

Bloomberg, as of July 16, 2019.

WD-40 isn’t alone. As of this writing, the broader S&P 500 Low Volatility Index P/E (blue line) is four full turns above the S&P 500 Index P/E (brown line).

Bloomberg, as of July 16, 2019.

So what might be going on here? Why are boring stocks trading with such high multiples?

We offer three suggestions:  First, as we argued in our 2016 WD-40 article, investors might be placing a premium on “safer” equities due to bad memories from the financial crisis. Having experienced 30%-50%-plus drawdowns in 2008 and 2009, many investment managers don’t want to mis-time cyclical stocks and look foolish when their peers are hunkering down in safe stocks. Some amount of herding behavior is at play.

Second, index funds, ETFs, and quantitative screens have changed the game. While active fund managers in Lynch’s day (the 1980s) were worried about bad window dressing by holding boring companies, machines are narrative agnostic. Machines could care less if Stock A is boring or exciting – they see businesses as a set of data points. Because boring businesses often have attractive fundamentals, they might get more demand from passive investors seeking quality, low-volatility, and/or dividend yield factors than they otherwise would with active managers.

(As we researched this article, we found it notable that the S&P 500 Low Volatility and High Beta Indexes were launched in April 2011, just two years after the market bottom.)

Third, the continuation of the low interest rate environment. We think the debate between a return of the old normal or getting stuck in the New Normal is a critical one for investors to consider. If we are moving back to an Old Normal (a “normalization” of inflation, higher rates, etc.) then boring stocks are massively overvalued; however, if we’re stuck in a New Normal (persistent low rates, low inflation, etc.), boring stocks, along with the rest of the market, may be fairly- to undervalued, albeit – and this is a key point/trade-off – with expected equity returns below long-term historical averages.

Indeed, if you’re buying low beta/boring stocks at currently-lofty valuations, you’re making an implicit bet that rates will remain low and that future equity returns will be lower than historical averages. We’ve found we’d have to drop our cost of equity assumptions well below 9% to make current valuations work on some low-beta/boring companies.

All three factors are at play, with interest rates playing the largest role in boring stock valuations. In a low rate environment, the opportunity cost for that extra 20-30% certainty (illustrated in the chart earlier in this post) drops. If you’re getting 2% on 10-year government bonds with 100% certainty, you’re more willing to increase your bet on 70-80% certainty in the hope of getting 5-7% annualized returns. The systematic undervaluation of 70-80% certainty names gets “corrected” in a low-rate environment.

Our opinion is that we’re more likely to return to Old Normal than New Normal, though we’ve heard compelling arguments for both cases.

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Jeremy Miller on His Book, Warren Buffett’s Ground Rules

July 27, 2019 in Audio, Meet-the-Author Forum, Meet-the-Author Forum 2019, Meet-the-Author Forum 2019 Featured

Jeremy C. Miller discussed his book, Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor, at MOI Global’s Meet-the-Author Summer Forum 2019. Jeremy is an executive director and research analyst at J.P. Morgan Asset Management.

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About the book:

Using the letters Warren Buffett wrote to his partners between 1956 and 1970, a veteran financial advisor presents the renowned guru’s “ground rules” for investing—guidelines that remain startlingly relevant today.

In the fourteen years between his time in New York with value-investing guru Benjamin Graham and his start as chairman of Berkshire Hathaway, Warren Buffett managed Buffett Partnership Limited, his first professional investing partnership. Over the course of that time—a period in which he experienced an unprecedented record of success—Buffett wrote semiannual letters to his small but growing group of partners, sharing his thoughts, approaches, and reflections.

Compiled for the first time and with Buffett’s permission, the letters spotlight his contrarian diversification strategy, his almost religious celebration of compounding interest, his preference for conservative rather than conventional decision making, and his goal and tactics for bettering market results by at least 10% annually. Demonstrating Buffett’s intellectual rigor, they provide a framework to the craft of investing that had not existed before: Buffett built upon the quantitative contributions made by his famous teacher, Benjamin Graham, demonstrating how they could be applied and improved.

Jeremy Miller reveals how these letters offer us a rare look into Buffett’s mind and offer accessible lessons in control and discipline—effective in bull and bear markets alike, and in all types of investing climates—that are the bedrock of his success. Warren Buffett’s Ground Rules paints a portrait of the sage as a young investor during a time when he developed the long-term value-oriented strategy that helped him build the foundation of his wealth—rules for success every investor needs today.

About the author:

Jeremy C. Miller, executive director, is an Industrials and Materials analyst for the Mid Cap Value Team in the U.S. Equity Group of J.P. Morgan. He joined the firm after spending two years at Vertical Research Partners as an Industrial and Materials specialist. Previously, Jeremy served as an institutional equity salesperson at Nomura Securities, Banc of America Securities and Credit Suisse First Boston. Jeremy holds a B.A. in East Asian Studies from Oberlin College. He is also the author of Warren Buffett’s Ground Rules – Words of Wisdom from the Partnership Letters of the World’s Greatest Investor. Harper, 2016.

Gautam Baid on His Book, The Joys of Compounding

July 26, 2019 in Audio, Interviews, Meet-the-Author Forum, Meet-the-Author Forum 2019, Meet-the-Author Forum 2019 Featured, Transcripts

Gautam Baid discussed his book, The Joys of Compounding: The Passionate Pursuit of Lifelong Learning, at MOI Global’s Meet-the-Author Summer Forum 2019. Gautam is a Portfolio Manager at Summit Global Investments.

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About the book:

In The Joys Of Compounding, Gautam Baid integrates the wisdom, strategies, and thought processes of over 200 preeminent figures in history whose teachings have stood the test of time. Distilling generations of investment and life lessons and compiling it with his personal experiences into a comprehensive guide on value investing, Baid demonstrates their practical applications in the areas of business, investing, and decision making.

The Joys Of Compounding is a celebration of the value investing discipline. It takes investors beyond stocks and business fundamentals to give them a valuable and compelling life philosophy. All lifelong learners will find this book immensely useful as a timeless source of insight and inspiration.

About the author:

Gautam Baid is Portfolio Manager at Summit Global Investments, an SEC-registered investment advisor based out of Salt Lake City, Utah. Previously, he served at the Mumbai, London, and Hong Kong offices of Citigroup and Deutsche Bank as Senior Analyst in their healthcare investment banking teams. Gautam is a CFA charterholder and member of CFA Institute, USA; an MBA in Finance from Nirma University, India; and an MS in Finance from ICFAI University, India. He is a strong believer in the virtues of compounding, good karma, and lifelong learning. Gautam’s views and opinions have been published on various forums in print, digital, and social media. In 2018, he was profiled in Morningstar’s Learn From The Masters series. Gautam is the author of The Joys Of Compounding: The Passionate Pursuit Of Lifelong Learning. The book has received wide critical acclaim from readers globally and was the #1 new release in 2019 on Amazon USA in Investment Portfolio Management and Investing Analysis & Strategy categories.

Update on Our Investments in U.S. Airlines

July 26, 2019 in Commentary, Ideas, Letters

This article is excerpted from a letter by MOI Global instructor Phil Ordway, Managing Principal at Anabatic Investment Partners, based in Chicago, Illinois.

Alaska (ALK) remains our largest airline investment. We have also added to our investment in Delta (DAL) while selling some of our shares in Spirit (SAVE).[1]

There is never a dull moment in the airline business, and the first half of 2019 was no exception. Gyrating oil prices, fierce competition, swirling macro conditions, and the Boeing 737 MAX tragedy and grounding made for plenty of headlines. In reality, most U.S. airlines did well and continued to make slow, steady progress.

Across the domestic industry the big picture hasn’t changed much since last year. Passenger demand remains strong. Costs have increased, but the rate of change has slowed and come (mostly) back in line with pricing. Most balance sheets are healthy. The competition is fierce but rational. Margins should improve in 2019 for the first time in a few years. Levels of free cash flow and returns on capital remain appealing, especially as weighed against the prevailing market prices.

If the airlines simply mailed us a check with our share of the company’s cash earnings, my guess is that all of us would feel much more confident and secure. Instead, the quoted market prices next to the word “airline” continue to create one of the widest gaps between perception and reality that I’ve ever seen. So long as the business-level analysis is correct that is a gap we can exploit. As always, the best gift we can get as investors is low expectations.

Alaska

ALK has made progress integrating Virgin America. The network and workforce are being fine-tuned, and the cost structure is in good shape. More than half of the acquisition financing has been repaid and the balance sheet is healthy. Margins should improve this year, and management’s goal of 13-15% pre-tax, through-the-cycle margins is achievable. Free cash flow has remained significant and should grow in 2019 and beyond as margins improve and capital spending declines. There is also a meaningful chance of striking a new loyalty-program credit card agreement with Bank of America just as Delta recently did with American Express (see below).

The cultural aspect of Alaska might be the most encouraging element. In my experience there are many organizations with a pocket of talented people or a few prominent executives that exude excellence, but it is rare to find a company with exceptional people at all levels. The people I meet at Alaska – from gate agents and flight attendants and pilots to HQ staffers and senior executives and board members – are impressive. They are enthusiastic about working for their company and serving the customer, and it is impossible miss the difference when compared to most of their peers. There is no way to quantify this cultural edge, but it is a massive advantage over time.

Delta

DAL is now our second-largest airline investment and our fourth-largest overall. Our initial purchases in the first quarter of 2018 were small, but we added at several points throughout the year. In January and March of this year we bought more shares just before two important developments came to light.

In early April Delta announced an extension of its partnership with American Express through 2029. The extension came earlier and the duration is longer than expected. The deal also comes with better economics for Delta.[2] A lot has changed since the years after 9/11 when AmEx tried to keep Delta out of bankruptcy court by pre-buying SkyMiles at cut-rate prices. Today, the balance of power has clearly swung in favor of Delta.

The new agreement – which was effective retroactively on January 1st of this year – comes with relatively few details, as both the airlines and credit card issuers keep the specifics under lock and key for competitive reasons. But Delta did disclose that its estimate for the cash flow contribution from AmEx each year will grow from $3.4 billion in 2018 to $7.0 billion by 2023.[3] That is a huge improvement from Delta’s perspective, and with some well-founded assumptions it is reasonable to expect that Delta will now generate $2-4 billion of free cash flow per year just from the American Express relationship.[4]

A fountain of free cash flow has many obvious attributes, but the AmEx cash flow also comes with an element of “float” – Delta gets paid each month, but the redemptions don’t occur until months or years later. There is also a substantial amount of “breakage” due to miles that go unused.[5] Delta gets the benefit of both time (the cash upfront can replace debt or equity financing) and margin (attractive deal terms and a mid-teens breakage rate). The only major risk of disappointment on this front would be a cataclysmic failure by either Delta or American Express, or a complete overhaul of the global payments industry. Neither is impossible, but our odds are favorable.

The second major development was announced soon after the American Express extension: Delta repurchased more than $1.3 billion of its stock during the March quarter, retiring almost 4% of the shares outstanding at attractive prices[6]. It was particularly encouraging to see the company accelerate its repurchases to acquire a meaningful amount of stock based on the opportunity in the market.

Delta has many virtues and shares a positive culture that is similar to Alaska’s. The difference in reliability and customer service that Delta provides relative to its network peers help reinforce a virtuous cycle. Delta can charge more for tickets, and it takes much of that premium and reinvests it in even better reliability and service. It then widens its lead and wins more business at a premium.

Delta also has an industry-leading billion-dollar MRO business and a $2 billion collection of equity investments in its international JV partners.[7] Its competitive position in its key hubs would be almost impossible to replicate, and management is making investments that should pay off for years to come.

Spirit

SAVE is doing well both financially and operationally. It continues to grow at a high rate and may produce higher margins this year than last. The roll out of “Basic Economy” by many of its network peers didn’t crush pricing or demand, as feared by some, and it may have helped legitimize the “ultra-low cost” concept in the minds of many flyers.

Two concerns stand out. One is Spirit’s lack of a big loyalty program. Spirit’s non-ULCC peers like Delta and Alaska get a working capital benefit and a boost to margins and ROIC that are huge advantages over time. Spirit’s business is attractive in many ways, but the lack of a powerhouse loyalty program still hurts.

The other concern is the prospect of a dual fleet. Spirit needs to place a large aircraft order within the next year or so, and it is considering the Airbus A220. The A220 has many virtues, but it would add quite a bit of cost and complexity. It might also signal a shift in strategy and it would likely reduce the attractiveness of a potential tie-up with Frontier. The company’s fleet decision – which has already been delayed – should be announced later in 2019.

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[1] This section contains references to prior letters and presentations. Please email us for a copy.
[2] “The new agreements increase the value we receive,” according to page 31 of Delta’s March 31, 2019 10-Q filing.
[3] Delta’s results prior to this extension had been consistently ahead of expectations, and its previous estimate for 2021 was >$4 billion, a level it is likely to achieve in 2019. According President Glen Hauenstein on the 1Q19 conference call, “In 2019, our total contribution from American Express relationship will be over $4 billion, up from the $3.7 billion we previously expected. Over the next three years, we expect continued solid growth with a more significant step-up, starting in 2023 that will drive our total contribution to nearly $7 billion, double what we achieved last year. We expect the [incremental] revenue benefit to Delta in 2019 will be approximately $500 million.” [emphasis added] https://news.delta.com/american-express-and-delta-renew-industry-leading-partnership-lay-foundation-continue-innovating
[4] All estimates are based on our analysis and assumptions. Starting with $1.2 billion of cash flow in 2009, Delta generated $1.7 billion in 2012, $2.0 billion in 2014, $2.7 billion in 2016, and $3.4 billion in 2018, which management estimates will grow to $7 billion by 2023. Using Delta’s disclosure of “Other Revenue – Loyalty Program” that captures “brand usage by third parties and other performance obligations embedded in mileage credits sold, including redemption of mileage credits for non-travel awards” we can begin to estimate the margins and economic results for Delta. Please email or call to discuss further.
[5] Alaska estimates its breakage at 17.2% but Delta does not disclose a specific number. Our research suggests that 10-20% is a reasonable estimate for most U.S. airlines. We also estimate the “duration of float” – that is, the average time between cash payment to the airline and the ultimate redemption of awards – at 1 ½ to 3 ½ years, depending on the airline.
[6] Share repurchases of $1.3 billion in the first quarter of 2019 were made at an average price per share of $50.55, a price we believe to be beneficial to continuing owners. $268 million of repurchases in the second quarter were made at prices between $50 and $60 per share.
[7] As of June 30, 2019, Delta had significant equity investments in global airlines such as Virgin Atlantic, China Eastern, Air France-KLM, Aeroméxico, Korean Air, and others, carried at $2.3 billion.

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Tom Jacobs on Maurece Schiller’s Books on Special Situations

July 24, 2019 in Audio, Interviews, Meet-the-Author Forum, Meet-the-Author Forum 2019, Meet-the-Author Forum 2019 Featured, Transcripts

Tom Jacobs discussed Maurece Schiller’s books on special situations, including How to Profit from Special Situations in the Stock Market, at MOI Global’s Meet-the-Author Summer Forum 2019. Tom has edited and republished the books with authorization by Maurece Schiller’s descendents.

Tom serves as Partner, Investment Advisor, and Portfolio Manager at Huckleberry Capital Management, based in Marfa, Texas.

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About the book:

Special situations make the impossible possible: to obtain almost riskless profits. They were created by Maurece Schiller (1901-1994), an all-but unknown investment advisor toiling alone. This book contains his explanation and examples of this exciting field for value investors, including Schiller’s jewel of a paper, “The Influence of the SEC and Present Market Conditions,” published here for the first time. Warren Buffett wrote the editor: “Never met Schiller, but read some his stuff.” Contains not only Schiller’s 100+ examples, but also 8 detailed modern case studies to illustrate special situations today.

About the author:

Maurece Schiller left Dartmouth and landed on Wall Street in 1922 on the bottom run as a “runner,” delivering orders from the brokerage firm’s customer in the office to the exchange floor, and returning with a confirmation. His experience of seeing shady practices and heedless risk end in the crash and Great Depression led him to choose his life’s work: practice and study of special situations, designed to avoid risk for clients. Beginning in the 1930s, he invented new and refined existing special situations so the investor could experience almost riskless gains and avoid the devastation of the Great Depression again. He rose to the position of Director of Research at Newburger & Loeb in the 1940s. After publishing his first books on special situations in 1955 (the first ever on the subject), 1959 and 1961, he moved from New York to Santa Barbara, where he worked with individual clients of his own registered investment advisory. He published two more books on special situations investing in 1964 and 1966 and contributed articles on the subject through the early 1970s. His works were the only comprehensive treatments of the field until 1997.

About the editor:

Tom Jacobs is a partner at Huckleberry Capital Management, a boutique investment advisory serving clients in 25 states and three non-US countries from offices in Silicon Valley, Asheville, NC, and Marfa, TX.

Tom began learning about money through his weekly allowance. In quarters. And through his savings account passbook, interest hand stamped.

He bought his first shares of stock as a 12-year old learning from his Dad. Apparently not too well or quickly, because his second investment was in his best friend’s father’s new tech company, which turned out to be a fraud. That and his parents’ experience of the Great Depression turned him to a life of teaching, writing, and learning to understand money and risk. Tom’s 20 years of weekly columns offer a unique slant on most money concepts, demystifying them with humor and examples from everyday life. Complacency—what’s popular—is not what he’s about. (He wasn’t popular in high school either.)

After careers as a teacher and lawyer, he became a Senior Analyst at the Motley Fool. Next he formed and managed his own investment research company with Jeff Fischer from 2003 to 2010, and then returned to The Motley Fool as an advisor and portfolio manager from 2010 through 2014. His books include What’s Behind the Numbers? How to Expose Financial Chicanery and Avoid Huge Losses in Your Portfolio, Rule of 72: How to Compound Your Money and Uncover Hidden Stock Profits, and this month, How to Retire on Dividends: Earn a Safe 8%, Leave Your Principal Intact. He edited and republished Maurece Schiller’s five books on special situations investing.

Tom received his law degree from the University of Chicago and his M.A.T. and B.A. from Cornell University. He lives in Marfa, a groovy art destination of 2,000 in Texas’s Big Bend.

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