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Brennan Asset Management's 3rd-Quarter Letter

Discussion of markets and holdings

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Sydnee Gatewood
Oct 25, 2021

Summary

  • Market volatility picked up during the last part of the third quarter as investors again assessed the temporary versus permanent inflation debate.
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October 14, 2021

Transition to Green Increases Inflationary Worries

Market volatility picked up during the last part of the third quarter as investors again assessed the temporary versus permanent inflation debate and considered the impact of rising input costs and interest rates on overall valuation levels. In our past letters, we noted that consumer price jumps of 5%+, housing price increases (+20% in July), widespread reports of container shipping capacity, used car price jumps and multiple management teams across industries describing the difficulty in retaining and hiring employees all suggested reasons to doubt the “don’t worry, inflation is temporary” message proclaimed by the world’s central bankers. During the last part of the third quarter, further jumps in oil and natural gas prices (particularly in Europe) offered further reason for concern.

Specifically, a drawdown in European inventories due to a colder 2020 winter collided with a post-COVID rebound in economic activity from businesses and consumers fueling the recent price jump. Further complicating matters, the green transition to wind and solar ran into a snag when the wind was calmer than normal, storage capacities (especially in the UK) were lower, and the continent frantically sought previously shunned fossil fuels to keep the lights on before a potentially harsh winter. As seen from the above chart, Asian gas prices have also surged, forcing European and Asian economies to bid against each other to secure supply. In the short term, Europe might be more dependent on the kindness of Gazprom (and ultimately on Vladimir Putin) for increased supplies in the event of a cold winter. What could possibly go wrong with this strategy? In addition to skyrocketing natural gas prices, thermal coal prices have also jumped to multi-year highs. Despite widespread efforts to reduce what is often considered the dirtiest of commodities, coal still accounts for a large portion of many developing economies’ energy generation, including an estimated 50-60% of China’s total energy production. China’s preliminary efforts to reduce its carbon footprint, combined with its difficulty in sourcing coal supplies,1 has led to rolling blackouts in multiple parts of China. Previously, jumps in natural gas and oil prices would generate an immediate response from the US energy industry, the new so-called “swing” producer. But, a multi-year period of plummeting commodity prices, poor returns on shale drilling projects and environmental social governance (ESG) mandates have all pressured the fossil fuel complex and made many producers reluctant to even contemplate supply increases. At a certain point, high enough energy prices will choke off demand and threaten economic growth. So, is the world on a return to the rolling energy, inflation/stagflation crisis experienced in the 1970s? Certainly, this outcome appears unlikely. That said, it does seem highly likely that the transition to green energy will not be painless. And therefore, the recent commodity variability may not prove temporary, nor may the inevitable price hikes passed along by various businesses reacting to higher energy prices.

All the above factors into the interest rate levels and the valuation of financial assets. As rates increased in the first part of 2021, these rises were generally viewed as “good” since they signaled revitalized economic activity. Interest rates fell during the second quarter as Delta COVID cases increased. Within the past 4-6 weeks, the rebound in longer-term rates associated with some of the inflationary factors noted above have often been viewed as “bad” because they signal inflation versus economic growth. The distinction between good and bad interest rate increases can be highly subjective with many different interpretations of data, and this intersection of viewpoints can result in the volatility experienced during September.

Portfolio Generally Well Positioned on Pricing Power and Valuation…But Reversions Non-Linear

So how are we positioned for a possible change to a world of higher inflation/interest rates? As we have discussed in past letters, many of the portfolio’s value names could benefit, but the degree of benefit varies by individual name. Rising interest rates would likely be highly positive for financial names, including our positions in Markel (

MKL, Financial) and Permanent TSB (LSE:IL0A, Financial) (TSB) among others. Please see our previous letters for more detail. For non-financial names, success in a more inflationary environment is dependent on a business’s pricing power and in many ways by starting valuation levels. Our portfolio of names generally scores favorably on the first test. Pre-COVID, broadband was an essential service whose utility was not far behind electricity, water and food. In a post-COVID, work and school from home environment, broadband may have moved up a notch. An increasing demand for data should allow further pricing power for years to come. Our other non-cable businesses also score highly on pricing power, whether it is cell phone towers (Telesites (MEX:SITESB-1, Financial)), satellite radio (Sirius (SIRI, Financial)), McDonald’s franchises (Arcos Dorados (ARCO, Financial)) or alternative investments (Blackstone (BX, Financial)).

As we have noted in past letters, we see more value outside the United States. The international names have solid growth prospects and trade at low relative (especially versus the United States) and absolute valuation levels with the international cable holdings (Liberty Global (

LBTYA, Financial) (LGI), Liberty Latin America (LILAK, Financial) and Megacable (MHSDF, Financial) (Mega)) all trading at nearly incomprehensible low levels. That said, rising US interest rates could initially cause capital outflows away from international assets and towards the perceived safety of the US dollar. These emerging market outflows and potentially weakening foreign exchange ratios could cause some volatility in several of our names. But ultimately, the combination of solid growth and attractive valuations should attract investor interest, especially if capital becomes more fearful of nosebleed valuations in certain parts of the US market. Additionally, smart capital allocation can also generate substantial value. We are particularly encouraged by LGI’s aggressive capital return plans, whereby the company will retire 10 percent of outstanding shares per year for the next 3 years regardless of price. LILAK has announced a couple of attractive deals (we will detail shortly) and has restarted its $100 million buyback program. As for Mega, the stock trades at ~4.5x forward EBITDA despite high single-digit to low double-digit growth prospects for the next 3-5 years, unleveraged balance sheet (sigh…) and clear takeover appeal. We continue to implore the company to consider aggressive repurchases.

While Charter (

CHTR, Financial) and Blackstone have fantastic franchises and clear pricing power, neither name could be considered statistically cheap after material gains over the past couple of years. We have slowly sold down both names to reinvest in some of the other names mentioned above and we will continue to reevaluate both holdings relative to other opportunities. It is certainly possible that the macro picture may change again, central bankers’ temporary inflation forecast may prove prescient and rates may stay lower for longer. Both CHTR and BX would likely continue to do well in such an environment. We also concede that Qurate (QRTEA, Financial) certainly does not have the same pricing power as the other names mentioned above. And while its ability to avoid inventory risk in most cases and change its selling mix in real time offers better protection versus other retailers in a possibly more inflationary environment, it is possible that the company could struggle with input cost rises and sourcing challenges. That said, the stock is so inexpensive (~4x free cash flow), that we believe the stock can work well from here, assuming intelligent capital allocation. We expect some combination of special dividend or buybacks to be announced when the company reports third quarter earnings.

LILAK Deals: Consolidation in Panama/Scale in Chile – Hard Not to Like

As previously mentioned, LILAK has been busy the last couple of months, announcing two deals with América Móvil (

AMX, Financial). First, the company announced the acquisition of AMX’s mobile business in Panama for $200 million in cash. Then, LILAK announced it was combining its LILAK’s Chilean operations (VTR) with AMX’s Chilean fixed and mobile business via a 50/50 Joint Venture. Both deals are highly strategic and were done at a low absolute multiple in the case of Panama and at an attractive relative valuation (with no M&A premium) in the case of Chile. We believe both deals should create substantial value in the years ahead.

As noted in previous letters, legislation changes allowed the Panama mobile market to consolidate from 4 to 3 players (Millicom (

TIGO, Financial) and Digicel are the other two players) as brutal price competition had negatively impacted all participants and led to concerns about mobile investment in the country. LILAK paid roughly 4x post-synergy EBITDA for AMX’s business. Assuming the division’s normal 4x leverage ratio, this implies that LILAK will ultimately pay for the entire deal with leveraged synergies (i.e., zero equity contribution). Additionally, the deal will double LILAK’s spectrum holdings and likely allow some price rationalization going forward. It is exceedingly difficult to find anything to not like about the deal.

The Chilean JV is the more significant of the two deals and is equally compelling. As we have previously discussed, Chile has been LILAK’s problematic market over the past several quarters because of increased fiber competition as well as from self-inflicted issues with network outages suffered during the country’s lockdowns. By combining with AMX (again at no M&A premium), LILAK will participate in 50 percent of the substantial synergies - the $180 million of targeted synergies which equates to roughly 40 percent of the two companies annualized Q2 EBITDA. Additionally, the deal will transfer debt and capex requirements off-balance sheet, substantially expand wireless spectrum assets (AMX has invested heavily in the 3.5GHz band and VTR has substantial unutilized spectrum) and create enormous optionality if the country changes existing rules on quad-play (broadband, video, telephone and mobile) discounting. The combined JV currently passes ~4-4.5mm homes in Chile, and the JV anticipates expanding its footprint to an additional 1.5-2mm homes and thus essentially blanket the entire country. This fiber push is the “carrot” for regulatory approval of the deal. VTR will be transferring roughly 4x more net debt to the JV ($1.5B vs. $0.4B) and will make a $100 million equalization payment to AMX. The deal structure implies a roughly 2x turn multiple premium for VTR’s assets vs. AMX’s business (e.g. 10x vs. 8x). From a market perception perspective, this deal addresses the only weaker link in LILAK’s story. LILAK has demonstrated substantial operational progress over the past several quarters, and the company continues to make intelligent capital allocation decisions. While the stock price continues to frustrate, we believe the LILAK investment case continues to be compelling, as the stock trades far below any reasonable estimate of intrinsic value.

Garrett Motion Preferred: Admittedly Difficult Industry…But Still Materially Mispriced Security

Finally, we wanted to detail the rationale behind a newer purchase: shares in the preferred stock (

GTXAP.PFD, Financial) of Garrett Motion (GTX, Financial). GTX is a post-bankruptcy special situation name, and we believe GTXAP is mispriced relative to the common stock. GTX is one of two leading global providers of turbochargers. Turbochargers are centrifugal compressors driven by an exhaust gas turbine and employed in engines to boost the charge air pressure. Turbocharger performance influences all important engine parameters, such as fuel economy, power and emissions. In short, turbochargers enable smaller, lighter and more efficient engines. Now, several readers may stop us right here and question what we could possibly know about turbochargers. Certain more knowledgeable family members who happen to be car aficionados would have considerable fun quizzing us on basic car components. Well, in our defense, we have watched several Fast and Furious movies as well as multiple viewings of Gone in Sixty Seconds, so…yes, we would concede that the investment is on the fringes of our circle of competence. That said, we feel confident that GTXAP is mispriced relative to the common stock (GTX, Financial), and therefore the investment offers a compelling risk/reward situation.

We have written a more detailed write-up for those interested (or for those who didn’t catch all editions of Fast and Furious), but we will simply highlight a couple of the investment’s salient points. GTXAP pays adeferred2 11% dividend in either cash or stock and is ultimately convertible into common stock. The preferred structure provides downside protection, while the convertible feature could offer compelling upside, given the company’s low current valuation (~6 -6.5x 2022E FCF). Interestingly, this unique security could also allow the receipt of common dividends while our preferred obligation continues to accrue – a rare opportunity to “double dip” across the capital structure. We believe trading volumes and interest in GTX should increase as sellside coverage is reinitiated. GTXAP is less liquid than GTX, but the preferred security recently started trading on NASDAQ (it previously traded over the counter (OTC)) following GTX’s emergence from bankruptcy at the end of April of this year. We are investing in the same security owned by two well regarded institutional investors (Centerbridge and Oaktree) who took control of the company during the bankruptcy process.

The two concerns with GTX centered around its balance sheet and asbestos liabilities that were dumped on the business at the time of the 2018 spinoff from Honeywell (HON) as well as the industrywide move towards electrical vehicles. The first concern was addressed via the bankruptcy: HON accepted a Series B security at a discount to the asbestos liability and because of the bankruptcy process, GTX debt was reduced/restructured. As of 06/30/21, GTX had net leverage of 1.37x (or 2.7x adjusted for the Series B preferred) and total cash of over $600 million. The electrical vehicle concern remains an issue and is one of the reasons for the low valuation. While electric volumes are small relative to total global car sales, their share could rise from less than 5 percent of global annual passenger-car and light-duty vehicle sales to 30 percent or greater by 2030. Even in such a scenario, it is possible that turbocharger-enabled cars continue to grow their share of total vehicle volume. And if electric vehicles do cannibalize share and if GTX experiences declining top-line growth, we believe that intelligent capital allocation can still provide reasonably attractive returns or at least still deliver positive absolute returns and protect against permanent impairment of capital.

As the GTX common story becomes better appreciated and discussions about a possible common stock dividend emerge, we believe the spread between the preferred and common stock can widen while preferred holders enjoy interesting optionality on common share upside. GTXAP appears to offer 15-20% IRR potential, even assuming no valuation improvement. If the industry changes even faster than anticipated, current valuation levels and assumed intelligent capital allocation offer downside protection. Finally, it is possible that the industry evolution may occur more slowly than anticipated and that investors may reassess the duopoly nature of the business (even modest revaluation could drive IRRs closer to 25-30%+). Please call us to discuss the finer details of GTXAP…or to chat about our favorite Fast and Furious film.

To conclude, we certainly take any macro forecast with a considerable grain of salt. That said, we continue to see data points that appear to contradict the temporary inflation narrative espoused by multiple Central Banks, and it appears that the transition to greener energy may only exacerbate these inflationary challenges. While many names in our portfolio should ultimately benefit from higher interest rates, the path will not be linear and some of our holdings could be temporarily caught up in a broader market selloff. That said, we continue to believe that solid growth prospect, amazingly undemanding valuations and intelligent capital allocation can ultimately drive returns in the years ahead.

Thanks for your continued support.

Patrick

PLEASE SEE IMPORTANT DISCLOSURES BELOW

BAM’s investment decision making process involves a number of different factors, not just those discussed in this document.

The views expressed in this material are subject to ongoing evaluation and could change at any time.

Past performance is not indicative of future results, which may vary. The value of investments and the income derived from investments can go down as well as up. It shall not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities mentioned here. While BAM seeks to design a portfolio which reflects appropriate risk and return features, portfolio characteristics may deviate from those of the benchmark.

Although BAM follows the same investment strategy for each advisory client with similar investment objectives and financial condition, differences in client holdings are dictated by variations in clients’ investment guidelines and risk tolerances. BAM may continue to hold a certain security in one client account while selling it for another client account when client guidelines or risk tolerances mandate a sale for a particular client. In some cases, consistent with client objectives and risk, BAM may purchase a security for one client while selling it for another. Consistent with specific client objectives and risk tolerance, clients’ trades may be executed at different times and at different prices. Each of these factors influences the overall performance of the investment strategies followed by the Firm.

Nothing herein should be construed as a solicitation or offer, or recommendation to buy or sell any security, or as an offer to provide advisory services in any jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction. The material provided herein is for informational purposes only. Before engaging BAM, prospective clients are strongly urged to perform additional due diligence, to ask additional questions of BAM as they deem appropriate, and to discuss any prospective investment with their legal and tax advisers.

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I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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