Omicron: Return to Normal Delayed Again?
It is more than mildly depressing to begin another quarterly letter discussing COVID, but the emergence of the Omicron virus in late November dominated headlines and became a key focus of markets. As has been widely reported, the virus has proven to be far more contagious than the previous Delta variant and new infections have set new records in many parts of the world.
Thus far, however, the virus appears to be less severe than Delta, and hospitalization rates, while increasing, have generally not surpassed previous levels. While our family was lucky to return from Brazil just before the Thanksgiving holiday, many were not as fortunate, and reports of widespread flight cancelations continued throughout December and into January as airlines struggled with widespread employee illness. Omicron is a depressing reminder that new mutations are possible, that existing vaccines may not protect against all changes and therefore that the return to “normal life” could take longer than anticipated.
Inflation: Hot at Home and Abroad
Meanwhile, the inflation data discussed in prior letters continues to run above expectations with markets now speculating that four US interest rate increases may be required in 2022. Furthermore, there is widespread discussion about how quickly the Federal Reserve will begin reducing the size of its nearly $9 trillion balance sheet. The prospect of higher interest rates has already caused selloffs in some of the more speculative areas of the market. Sundial Capital Research estimates that nearly 40 percent of stocks within the NASDAQ index are down at least 50 percent from their recent highs, even though the broader NASDAQ index is down ~10 percent from its peak. While certain market participants have suggested that recent declines presented exceptional opportunities in some of these more speculative names, we would be biased towards the other side of the trade: names that now sell at 25x forward revenue -- while 50 percent lower than levels several months ago -- may still be just as challenging to justify with a standard discounted cash flow analysis. We would also note that although the ~25 basis point jump in 10-year treasury yields during the first weeks of 2022 is the briskest pace in nearly 30 years, the absolute level is still nearly 130 basis points below highs over the last seven years, a time period when the underlying consumer price index was rising far below the 7 percent increase in December.
As we have noted in past letters, history suggests that most recession warnings, interest rate predictions or any type of macro forecast have an amazingly poor long-term track record. So, it is fair to acknowledge that inflation data could ease throughout the year, that the long end of the treasury curve may not move materially higher and that Dogecoin, meme stocks and other speculative “investments” may regain their highs by year’s end. That said, it is still worthwhile to ponder a world with higher rates. We would encourage readers to review our third quarter letter for a more detailed discussion, but we would simply reiterate that higher rates would likely broadly benefit our portfolio, albeit the timing of the impact will be uneven across our names. Most of our businesses have pricing power, an important necessity for operating in a higher inflation environment. On the plus side, higher rates would be welcome news for our financial holdings. On the flip side, higher US rates could mean continued US dollar strength, which would serve as headwind for several of our international names. As we will discuss later, this dollar strength likely was a factor behind some of the late year weakness in several LATAM telecom names. Of course, we believe that most of our holdings, including essentially every international name, are inexpensive (completely bombed out would be a fairer description) on a relative and absolute basis. As we have repeatedly argued, only a little good news needs to break our way for these names to rerate given current valuations. Again, we would contrast this setup with several more speculative areas of the market which appear dependent on a “lower for longer” rate environment which could be threatened by recent data.
Permanent TSB: Irish Eyes Are Smiling
The Brazil trip was not our only international foray during the fourth quarter. We visited Ireland this past October and spent time with Permanent TSB’s (LSE:IL0A, Financial) entire management team, visited with members of Davy’s research/economics team and discussed the Irish mortgage market with a major non-bank mortgage competitor. The key takeaways from the TSB/non-bank competitor discussions are as follows:
- The Irish economy is likely the strongest in Europe and has strong growth prospects for years to come.
- The housing shortage in Ireland remains acute and the government is pulling out all stops to increase housing supply.
- Mortgage origination volumes are likely to rise at least 50 percent from the ~€10.5 billion originated in 2021, which should disproportionately benefit the 3 remaining banks.
- Non-bank competitors, which typically offer the lowest mortgage rates, will gain share but remain highly dependent on a functioning securitization market (which could be tested in a higher rate environment).
- Our projections for a substantial ramp in TSB earnings continue to look directionally accurate.
In December, TSB announced binding agreement terms for the Ulster loan purchase discussed in prior letters.1 While we saw little risk that the originally announced MOU would not lead to a binding agreement, this announcement made the transformational acquisition official. As part of the deal, TSB will purchase an expected €6.75 billion2 of Ulster loans at ~98% of par value and Natwest (parent company of Ulster) will take a roughly 17 percent stake in TSB (reducing the government’s position from 75 percent to ~63 percent). Within the definitive agreement, there is now a formal agreement between the Irish Government and NatWest that (among other items) coordinates future stock sales between the two parties. TSB should also book a total gain on purchase of nearly €300 million – this gain includes mark-to-market gains as the underlying loans are revalued at a premium to book value. Taking into account expected loan runoff prior to close, the Ulster purchase should increase TSB’s performing loan balance by nearly 50 percent.
Separately, the Irish government provided additional positive news during December when it announced plans to begin selling its Allied Irish Banks (AIB) shares in the open market over the coming six months. The deal follows the government’s previous announcement to completely exit its Bank of Ireland stake (currently ~8 percent of shares remain held by the government). Importantly, in announcing the AIB share reduction, the Finance Ministry also noted that it remained open to targeted buybacks and accelerated bookbuilds. We had a chance to speak with AIB’s senior team in the early days of 2022, and they firmly believe some directed buyback and/or secondary offering is possible during 2022. Reductions in government ownership are a major part of the TSB thesis and the AIB news is unquestionably positive for all banks.
We would also note that our forward estimates assume no change in the underlying “lower for longer” interest rate environment, even as this assumption seems more questionable than ever. While the European Central Bank (ECB) tried to assure investors in December that it sees inflation abating in the months ahead and has no intention of raising rates in 2022, the ECB simultaneously projected that Eurozone underlying inflation will now run at 3.2% in 2022, nearly double its 1.7% forecast given 3 months earlier. Furthermore, in the early days of 2022, we learned that Eurozone inflation jumped 5 percent in December, a record high for the single currency, which was created more than two decades ago. The jump was driven by increases in energy and food prices. We discussed the green energy inflationary impact in our last letter and we would suggest that, while headline prices will remain volatile throughout the year, there is a strong possibility that higher energy prices are not a short-term phenomenon and that companies will continue passing along any increases. We expect continued volatility in inflation data and rate expectations in the months ahead, but small changes in expectations could meaningfully rerate the entire European financial sector.
In summary, while many European financial names look statistically cheap and while most would benefit from any change in interest rate expectations, we believe the situation in Ireland is unique. Ireland’s economy, demographic trends and consolidated banking sector look far different (read: better) than the rest of continental Europe. While all three Irish banks should benefit from these trends, TSB seems best positioned for outsized gains given its smaller size, lower market share and lower current valuation level.
KW: Another Ireland Winner
During our time in Ireland, we also had an opportunity to meet with Peter Wilson, President of Kennedy Wilson (KW, Financial) Europe, who graciously showed us around the company’s multiple apartment projects and walked through completed and work-in-progress buildings. Peter pointed out the offices of all the technology players and described the large number of tech employee tenants at KW’s Capital Dock apartments. Despite public rhetoric about the “greedy private rental sector,” Peter noted that government officials and planning commissions have been very accommodative towards KW. The economics of developing a new apartment building in Dublin (often anywhere from ~€400,000 - €600,000) require third party capital, as it is not economically feasible for builders to sell apartment units individually. Additionally, apartments are a smaller percentage of the total housing stock in Ireland compared to the rest of Europe and the bottom line is that Ireland needs more housing of every kind. The Irish government’s goal is to supply 30,000-40,000 units per year versus the roughly 10,000-20,000 that have been built annually over the past decade.
Peter also opined on the recent Ireland compromise on the Minimum Global Tax, noting that he thought Ireland did fantastic diplomatic work. Peter confirmed that changing the text from “at least 15 percent” to “15 percent” and maintaining the 12.5 percent rate for businesses with revenue under €750 million were major wins for Ireland. Additionally, increased UK corporate tax rates could conceivably expand the delta between UK and Irish rates. Regardless, Ireland appears poised to draw foreign direct investment for years to come. Furthermore, claims that the new global tax regime will cost the country €2 billion in revenue have never been confirmed, and many have speculated that it was very possible Irish revenue would ultimately rise under the proposed tax changes. In Peter’s opinion, the big risk regarding the Global Tax Regime is that the entire plan stalls in the US Congress (Peter believes the momentum for this tax regime is real.) While a failure to get this through the US Congress might give Ireland a short -term reprieve, Peter thought this concept would eventually return and that a future deal could be worse than the one Ireland recently secured.
Outside of Ireland, KW continued growing its multi-family business, concentrated in suburban areas outside of rapidly expanding cities, including developments in Las Vegas, Boise, Seattle, Portland, Salt Lake City, Denver, and Albuquerque. While KW certainly didn’t anticipate COVID, the aftereffects of COVID (work from home, suburban sprawl, avoidance of high rise office buildings) appear to dovetail with the company’s core strategy. Additionally, KW continues to expand its investment management platform with nearly $5 billion of fee-bearing capital as of 09/30/21 and KW is targeting 15-20 percent over the coming 3 years. We suspect even greater growth is possible for far longer than 3 years. The same secular growth in alternative assets that has benefited Blackstone, KKR, Apollo and others should also propel KW’s AUM growth, especially since the company also brings substantial operating expertise. While some investors probably welcomed the recent dividend increase, we believe the company has substantial organic opportunities and we would prefer that excess capital be saved for share repurchases during the inevitable market pullbacks. That said, we continue to believe that KW has a fantastic franchise and multiple opportunities for growth in the years ahead.
LATAM Late Year Blues
Unfortunately, our LATAM names did not finish 2021 with a bang; it was closer to a thud. Investors started selling LATAM and multiple emerging market names during the second half of 2021, and the selling picked up steam after the Omicron news in late November. A combination of dollar strength, emerging market outflows and tax-loss selling contributed to the late year declines. Additionally, many investors still paint LATAM with a broad “COVID Loser” brush and this taint has dulled investor interest regardless of individual valuation levels. We had an opportunity to revisit our LATAM cable thesis at MOI Global’s 2022 Best Idea Conference (we are happy to provide a link for those interested). We have discussed Liberty Latin America (LILAK, Financial) in multiple past letters, so we will provide only brief comments here, but we did want to provide a bit more detail on Megacable’s (MEX:MEGACPO, Financial) fourth quarter fiber announcement (please see our presentation for a fuller discussion).
Mexican cable name Megacable (Mega) announced an aggressive fiber expansion, aiming to roughly double its footprint over the coming five years. The company held a sell-side event and disclosed that it believes it can add subscribers at a cost of ~ $200, implying cost per passing levels far below other projects. Sell-side and competitor commentary suggest deep skepticism over Mega’s assumptions. But, after spending substantial time with Mega’s CFO, our takeaway is that the assumptions may be far more credible than many appreciate. Mega is completing a fiber rollout in half of its footprint and has executed “edge out” projects for years, so the company has meaningful newbuild experience. Additionally, Mega has already started the expansion and is hitting one -year penetration targets after ~4 months. Fiber IRR analysis suffers from the same “Hubble Telescope” issue impacting company discounted cash flow analysis: you touch a dial, and you are in a different galaxy. That said, our best estimates discussed with the company produce unleveraged IRRs in the high 20’s versus the company’s sandbagged estimate of over 15 percent. When we asked Mega’s CFO why the company didn’t begin a wider rollout 2-3 years ago, he responded that the company only gained the confidence as it rolled out fiber to its footprint. Essentially, projected returns would simply be “fun in Excel” exercises until a more substantial fiber rollout was completed. In our opinion, this is a credible answer. Even assuming some cost increases as Mega scales the rollout, Mega could nearly double its EBITDA over the next five years and fund the entire rollout with internal cash flow. The balance sheet remains essentially unleveraged (That noise you heard, was our head hitting the desk in thinking about this balance sheet inefficiency). We think that few investors have done substantial work on Mega. For those who have, we imagine that skeptics question Mega’s rollout costs and argue that the plan means investors will not see free cash flows for half a decade. A fair response might be: “If you had an opportunity to deploy capital at unleveraged returns of 20%+ over the next half decade and to increase EBITDA growth rates from 8-9% annually to 15-20%, would you have any interest?” At ~5x forward EBITDA, essentially no debt and the potential to double its footprint and EBITDA over the next five years, we think the bulls have the better argument.
As for LILAK, we certainly concede that we have been dead wrong on the name thus far. We certainly didn’t anticipate COVID, but we do acknowledge that leveraged names are more exposed to unexpected events. While LILAK is likely better prepared today for a major storm that it was when Hurricane Maria ravaged Puerto Rico, it is fair to assume that hurricane concerns will persist indefinitely. Rounding out our mea culpa, we acknowledge that we missed the deterioration in Chile (on a macro and micro level) and we also must acknowledge that the company’s 2020 rights offering was more defensive than the message projected by LILAK at the time. So why stick with the name? First, we believe that the company has made multiple intelligent capital allocation decisions, including essentially every acquisition since Cable & Wireless (CWC) – and we find it hard to question the strategic rational or valuation paid for any of these deals. We also believe there are underappreciated growth opportunities given far lower starting broadband/home penetration levels, albeit this is likely masked by COVID induced economic headwinds. The AMX Chilean joint venture (detailed in our third quarter letter) should address LILAK’s weakest market and highlight faster growth at LILAK’s remaining businesses. Perhaps most importantly, free cash flow is inflecting. We believe the company will generate $400mm+ of owned free cash within 2 years, driven by the realization of Puerto Rico deal synergies, the proforma impact of Costa Rica and Panama mobile deals, and cyclical and structural margin improvement at CWC. With a bombed-out market capitalization of ~$2.5B and extreme negative sentiment across the LATAM cable sector, it would take little to drive a significant rerating.
QRTEA and LSXMA Liberty Analyst Day Highlights: Lots of Value but…Patience Required
We will provide a couple of brief updates on other portfolio positions. Liberty held its investor update in November this past year. Liberty Sirius (LSXMA, Financial) increased its Sirius (SIRI, Financial) ownership to over 80 percent just before the investor meeting, and this ownership bump should make it easier for LSXMA to ultimately execute some form of merger with SIRI. Of course, with a still sizeable 30%+ discount, we believe LSXMA will increase share buybacks to narrow the discount before considering a merger. Within the Liberty nerd investor complex (card carrying member for 20+ years), there has been considerable criticism about the size and duration of the discount and the perception that capital allocation should have been more aggressive to narrow the discount. While there is some merit to the criticism, we continue to believe that the simplest point is the most overlooked: namely, that SIRI is a fantastic business that customers love and that should continue generating recurring revenue and growing free cash flow for years to come. LSXMA simply allows shareholders to own this great business at a sizeable discount. Supply chain disruptions in the back half of 2021 limited new car sales and this will negatively impact self-pay additions during the first part of 2022, but improvement should be visible by the end of 2022. Again, the opportunity to own SIRI at an attractive “look-through” basis is the real opportunity, and we remain confident that Liberty will eventually collapse the discount.
Qurate Retail (QRTEA, Financial) had a volatile end to the year to say the least. Third quarter sales and customer losses disappointed and the size of capital return ($1.25 special dividend) was below expectations. QRTEA’s management team has faced justifiable criticism for its inconsistent commentary on share repurchases. Current QRTEA prices imply no terminal multiple, and it is not crazy to suggest this is linked to the paucity of share repurchases with the stock trading at ~4x sustainable free cash flow. That said, QRTEA Chairman Greg Maffei’s pledge to repurchase 10 percent of its share base implied that large repurchases would be required in the final months of 2021. While the November investor update was light on details, newly appointed CEO David Rawlinson II noted that a fuller assessment of his strategy for the company would be presented in 2022.
Unfortunately, in late December, investors learned that a major fire destroyed QRTEA’s Rocky Mountain, North Carolina distribution center, forcing the company to reroute shipments in an already difficult supply chain environment. While the fire is a tragedy and yet another headwind, the company will receive insurance proceeds for the damage and the fire should not impact the longer-term free cash flow prospects of the business. Even assuming no growth at its larger US business, QRTEA still trades at ~4x sustainable free cash flow, with current QRTEA level net leverage at just under 2x. As for the company’s growth prospects, the stay-at-home COVID environment introduced QVC to a large cohort of customers who never previously engaged with the company. Retention metrics from these COVID classes are similar to previous years, including a similar number of new customers (~2%) who graduated to the “best customer” category. This “best customer” cohort currently drives 70 percent of shipped sales and this group sports retention rates of ~99 percent. We do believe that there are scenarios where QRTEA could expand its ecommerce penetration, grow its customer base and provide investors upside far beyond what we envision. But at current valuation levels, a steady, low/no growth business, combined with intelligent capital allocation, are likely sufficient to drive more than satisfactory investment returns. In fact, at current levels, the last standing QRTEA share would be gone in four years if all free cash flow is applied to buybacks. While shares will likely continue to be volatile throughout 2022, the risk/reward in QRTEA shares remains compelling for those with a longer time horizon.
GTXAP: Coming to a Theater Near You…More Repurchases
Finally, we would like to note a couple of quick updates on turbocharger maker Garret Motion (GTX, Financial) whose preferred stock (GTXAP.PFD, Financial) was discussed in detail during our third quarter letter. During the fourth quarter, GTX made two capital return announcements: a $100 million buyback (split 4/1 between GTXAP and GTX) for its preferred and common shares and $411 million of accelerated/expanded purchases of the Series B preferred issued to Honeywell during the bankruptcy process (see our Q3 letter for additional details). Following the Series B payment, the present value of the Series B outstanding is expected to drop to $207 million by the first quarter of 2022 . The retirement of Series B shares reduces fixed obligations, benefitting GTXAP and common shareholders. We believe that GTX is repurchasing GTXAP and common shares at attractive levels, particularly if GTX shows growth in the coming years. While some of the previously mentioned supply chain headaches impacting car sales could cause some headwinds for GTX in the early part of 2022, we suspect the sales environment could look far more favorable in the back half of the year. Meanwhile, we are happy to accrue attractive dividends (11 percent on par value) and we still believe the spread between the preferred and common shares (~$0.70) is far too narrow at current levels. Finally, we know that all turbocharger fans worldwide would be remiss if we didn’t mention that Fast and Furious 10 will be arriving in theatres in May of 2023, hopefully roughly coinciding with GTXAP converting into common stock at a far higher price. As of now, it seems less likely that this conversion will be a central feature of the film, but we promise to update readers in future letters should this change.
In closing, we remain hopeful that Omicron headlines will soon pass but we acknowledge that other variation surprises are certainly possible. The combination of virus headlines, “hot inflation” data, higher interest rates and fuller valuations across the broader market should all provide plenty of volatility in the year ahead. That said, we believe that several of our concentrated positions discussed above have highly favorable risk/reward skews that can drive returns in the years ahead. Here’s to hoping for a safe and prosperous 2022.
Thanks for your continued support.
Patrick
- TSB had previously announced a Memorandum of Understanding (MOU) on July 23, 2021.
- As of June 30, 2021, the portfolio includes €7 billion of performing non-tracker residential loans, €230 million performing micro-SME loans and €400 million of Lombard Asset Finance. The difference between the €7.6 billion and €6.75 billion represents the expected runoff of the portfolio between June 30, 2021 and the expected close in Q4 2022/first half 2023.
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