Patrick Brennan's Brennan Asset Management 3rd-Quarter Letter

October 19, 2022

If the first quarter was difficult, the second more challenging, then the third felt exhausting. A brief summer rally proved fleeting, and stocks retreated again after Federal Reserve Chair Jerome Powell openly spoke at an August Jackson Hole event about the “costs of reducing inflation” and, invoking past Central Bank head and widely respected inflation fighter Paul Volcker, the need to “…keep at it until the job is done.” Subsequent inflation readings and jobs reports offered few signs of cooling and the dollar continued its relentless advance. Meanwhile, war continued to rage in Europe. Ukraine’s considerable advances against Russia have been inspiring, but the evil Russian leader’s repeated nuclear threats are deeply troubling. As investors looked down the barrel of further rate hikes, further dollar strength, higher probabilities of a recession and unresolved geopolitical turmoil, volatility returned, bond yields rose, credit spreads blew out and equities plunged. Quite the happy summer.

Avoid 6-Month Declines Versus Capturing 5-Year Gains

In past letters, we have tried to articulate the detailed reasons we want to own selective names over a time horizon of 3-5+ years. We continue to reevaluate investment assumptions on a regular basis. Certainly, we have misjudged the strength of a particular business or misjudged the trajectory of certain businesses’ cash flow (more specifics in a minute). But, on many days during 2022, the selling likely has little to do with a debate over an actual free cash flow forecast (i.e., the market thinks Liberty Latin America (LILAK, Financial) free cash flow will only be $300 million in 2024 versus our estimates of $400+) and more to do with some technical factor (i.e. “sell anything with leverage or foreign currency exposures - no questions asked”). We understand the frustration with these recent selloffs, especially following a period where value has underperformed growth. And, unfortunately, there is risk that the environment will get worse before it gets better. Nobody can credibly know when interest rates will stop rising and/or when/if/how deep a recession will materialize in 2023. Many bearish prognosticators could conceivably look exceptionally smart 6 months from now if assets prices were to fall another 20-30 percent from current levels. With two-year treasuries now offering ~4.5 percent risk free yields versus yields closer to zero nearly 1 year ago, why not sell everything and avoid a “nearly certain” drawdown? Well, for starters, we think it is far from certain exactly what will transpire over the next 6 months. And, secondly, we think investors could inadvertently be selling securities that compound at 20+ percent rates over the next 3-5 years while chasing assets with flat or negative real yields.

An investor must ask himself/herself: Is it more important to protect principal for the next 6 months or to compound capital over the next 5 years? A bit of historic perspective could be helpful. While we do not believe the current environment mirrors the 2008/2009 period, perhaps it is still helpful to look back at this period, perhaps the darkest over the past 20 years. By mid-September 2008, the week Lehman Brothers failed, markets had already declined roughly 15 percent since the start of the year (the S&P 500 would finish the year down -37 percent). Working at a different firm, we remember deploying capital the week Lehman imploded and watching each purchase quickly decline in value. By March of 2009, the S&P 500 was down a further 45 percent from levels the week Lehman failed. As we described in our Q2 2022 letter, CBS looked to be one of the cheaper names we had come across in late 2008 at ~$10, but by March of 2009, it traded near $3. Running for the hills was clearly the better strategy for the investor with a 5–6-month horizon. Even though economic statistics would get progressively worse throughout 2009, the market finished 2009 nearly 65 percent above the March lows (still roughly 11 percent below prices the week Lehman failed). Those few “who saw it [the financial crisis] coming” and exited before the drawdown faced a dilemma by the end of 2009: do you really feel comfortable reentering when there is widespread concern about the financial system/economy and yet stock prices had just jumped 65 percent? What does this same investor do at the end of 2010 when markets jumped again by another 15 percent and were now higher than levels the week of Lehman’s failure?¹

Certainly, the investor who ran for the hills in September 2008 and somehow perfectly reentered the market in 2009 did far better than the investor who stuck around or the chum who was buying as a major bank/financial system appeared to be imploding. Unfortunately, we have met few who are great at this timing game, and we probably have seen more investors who sold somewhere between September 2008 and March of 2009 and reentered 5-7 years later (while seeking impossible assurances that 2008/2009 declines will never reoccur). Many will argue that quantitative easing and massive federal spending temporarily saved the market for ~12+ years and the chickens have (finally!) come home to roost. Possibly. Of course, we also remember multiple negative headlines over the 2009-2012 period (and frankly over nearly every period we have ever invested) and never remember a magic bell signaling “all clear” to reenter volatile markets. A large portion of current commentary essentially debates: are we closer to September 2008 or March 2009 or exactly what point in between these two arbitrary dates? Our likely unsatisfying answer is “We don’t know.” In fact, the two key takeaways are: (We suspect our answer to the question will feel similar to the frustration of a patient who asks a doctor about suggestions for weight loss and then hears cliches about the benefits of diet and exercise – “thank you Captain Obvious”).

1. No matter how authoritative any “expert” may sound, it is nearly impossible to successfully predict short-term market direction.
2. Prices can trade far removed (in either direction) from what a “rational” person would estimate as fair value.

While many will dismiss the above as meaningless platitudes, we still find that we relearn these lessons on a regular basis. The current period appears far less daunting than that of 2008/2009, but we certainly do not want to belittle the investment headwinds. War continues to rage in Europe and inflation remains stubbornly high all over the world. The higher rates necessary to combat inflation could cause a meaningful worldwide recession. As we noted in our Q1 letter, even though we have avoided the frothier areas most impacted by the higher rate environment, the market has shunned most emerging market names or those with leverage, regardless of fundamental outlook. The dollar has risen ~16 percent year-to-date and further increases are entirely possible. This rise has masked the strength of names like Permanent TSB (FRA:IL0A, Financial) (see past letters) that greatly benefits from a higher rate environment. Despite our confidence in the disconnect between the value and price of multiple holdings, we cannot offer assurances on when this gap will close. That said, we firmly believe that the recent selling has left multiple names that we follow very closely with nearly inexplicable valuations, such that we believe risk/rewards are highly skewed for those who are not looking for instant gratification over the shorter-term.

Cable: Deeply Unpopular at Home and Abroad

Moving from macro to micro, our cable holdings had a difficult quarter. Full stop. We will drastically exceed our self-imposed cable word quota in this letter, but we wanted to spend time discussing some recent investor concerns regarding Charter (CHTR, Financial) / Liberty Broadband (LBRDA, Financial) and to discuss investor indifference to one of the more mispriced securities (Megacable (MHSDF, Financial)) we have ever come across. We will provide a summary of the two names and then more details in an appendix for those who want to read more. At the highest level, some of the recent cable selling likely was because of broader market concerns over leverage or international exposure (Liberty Global (LBTYA, Financial), LBRDK, LILAK), but less leveraged names Millicom (TIGO, Financial) (TIGO – please see our Q2 2022 Letter) and painfully unleveraged name MEGA were also caught in the selling. Again, we will discuss MEGA in more detail shortly. Historically, cable names have generally performed well or at least better than most other businesses during past recessions (broadband ranks slightly less important than food in most households). We believe this again will prove directionally accurate should we enter a worldwide recession in 2023. We will not rehash all the comments we made in our Q1 2022 letter about the longer duration/interest rate and foreign exchange (FX) hedged debt of our cable names, but simply note that we believe that capital structures are appropriate, given the resiliency of the business as well as interest rate/FX hedging.

We would also quickly note that LILAK closed its Chilean Joint Venture with América Móvil (AMX, Financial) in early October. While the closure was not unexpected, it is a significant event as consolidation should eventually improve LILAK’s most challenged market. The deal will also allow significant synergies, and the absence of Chile will highlight growth within the remainder of the business. At a recent investor conference, CEO Balan Nair noted that at an assumed 7x valuation for LILAK’s Puerto Rican business, the implied equity value was greater than LILAK’s current valuation, implying that investors were ascribing no value for the Cable & Wireless (including the subsea business), Panama, and Costa Rica businesses as well as LILAK’s 50 percent stake in the Chile Joint Venture. We believe LILAK will continue to repurchase its own shares and that these should be massively accretive over time.

US cable companies had sustained outperformance during COVID. It was widely believed that the companies “pulled forward” customers during the 2020/2021 period, but it was difficult to quantify the exact number. As noted in our Q3 2021 letter, we sold a meaningful portion of our LBRDA (which had been our largest holding) given its size/heightened valuation but we noted that historically our biggest errors had been selling good businesses too soon (Blackstone was/is in the same boat). We did not sell the entire position as we believed Charter could compound at reasonable rates in the future. While we believe this viewpoint is still directionally correct, the market sentiment on US cable companies has changed 180 degrees over the past year. Cable share prices have fallen so quickly that we believe even slower growth with substantial repurchases should be enough to rerate shares. With the benefit of hindsight, we should have sold even more aggressively when Charter shares sported historically high multiples. But, at current levels, CHTR shares discount a tremendous amount and we believe a patient investor can do very well (and even better in shares of LBRDA² with the discount). As we noted in past letters, investors’ perception of cable (and multiples they are willing to pay) has fluctuated wildly historically, despite the consistent operating results posted over time and throughout economic cycles. With shares now trading at ~8x forward free cash flow per share and with Charter potentially poised to repurchase 30-40 percent of shares over the next several years, a small change in sentiment could lead to a significant rerating.

MEGA: Historical Mispricing

We wanted to revisit our holding in Mexican cable name MEGA in more detail. After following the name from afar for several years, we first purchased MEGA shares in late 2019 and then increased the position size over time, including during the past quarter. MEGA has consistently added new subscribers over the past several years and the company’s corporate business has grown at a double-digit compounded annual growth rate over the past 5 years despite challenges during COVID. Despite the positive operating results, investors have kept selling and the essentially underleveraged company’s valuation has collapsed to roughly 3x enterprise value/forward EBITDA.

Figures in millions of Mexican Pesos

So, if the company is this undervalued, why does it choose to pay out dividends rather than repurchasing its abandoned shares? This has been an ongoing source of frustration and we have had multiple conversations with the company about this topic. The actual buyback question is among the biggest layups we have come across…ever. As noted, MEGA currently trades at ~3x Enterprise Value/2023E EBITDA. We actually have the company earning well above consensus estimates, so the ratio could be lower -- but, frankly, at this level this is just a secondary point. Even taking the lower estimate, MEGA is stupid, stupid cheap. MEGA has net debt to trailing 12 -month EBITDA of 0.6x, making the company a true outlier among cable companies who are leveraged at 2-3x at a minimum. As previously noted, MEGA is plowing all free cash flow back into a potentially high IRR project. If the returns disappoint, MEGA could stop the spending, and capital expenditures as a percentage of revenue reverts to 20 percent or lower.

While the decline in MEGA has been frustrating, we do not believe it is rational. As noted earlier in the letter, on many days the selling has little to do with any fundamental analysis (i.e., we are selling MEGA because we think IRRs on the newbuild projects will be 7-8 percent vs. 15+) but likely more to deal with some sort of sector rotation (i.e. “Sell all international telecom names”). Eventually, something will give and we believe a combination of faster growth and/or shareholder pressure should help rerate shares. We continue to believe that MEGA is one of the more mispriced securities we have come across.

Please see the appendix for a more in-depth discussion of LBRDK and MEGA.

Qurate (QRTEA, Financial): Sold Equity, Moved to Better Risk/Reward Preferred

We sold shares of Qurate and deployed the capital into the company’s preferred stock trading at ~40-50 percent of par value. We have owned QRTEA at various sizes and discussed the holding multiple times in past letters. The online retailer has posted inconsistent operational results but generally consistent free cash flow for multiple years. Management’s take (as was ours) on the operational challenges was overly optimistic and Liberty has far from dressed itself in honor with capital allocation decisions: Zulily has been a disaster thus far and, while HSN Networks generated substantial synergies, the business’ top-line performance has not met expectations. QRTEA has been inconsistent in its allocation to dividends versus share repurchases, and the buybacks have been executed at materially higher prices.

QRTEA struggled immediately before COIVD but was seemingly given a second life during the pandemic when stuck-at-home customers tried the service and trailing 12 -month customer counts increased ~7% from 2019 to 2021. Many of these newer customers have abandoned the service and customer counts declined 17 percent year-over-year in Q2 2022 (-11% versus Q2 2019). Most of the decline from the pre-pandemic period stemmed from new and reactivated customers, with the losses tied to low product availability in consumer electronics and home categories. These out-of-stock issues were the result of supply chain challenges that impacted the entire retail industry, but they were particularly difficult for QRTEA given its business model dependence on “Today’s Special Value” sales. While the company was able to increase digital sales, declines in linear TV viewing also took their toll on the business as QRTEA was forced to spend more to acquire new customers. In addition to the previously mentioned supply chain challenges, a fire at the company’s Rocky Mount distribution center that handled 25-30 percent of volume has caused significant further challenges. A new management team has articulated a plan to grow sales, cut costs and increase customer counts. We believe the company’s free cash flow will remain sticky at lower levels, but there are legitimate concerns about whether the company can consistently grow in the years ahead.

We have few illusions that the next couple of quarters will be kind to QRTEA. Turnarounds take time and the macroeconomic environment has deteriorated. Despite these challenges, the company will likely continue to generate substantial free cash flow, driven by its hyperactive shoppers who account for roughly 16 percent of QRTEA’s customer base but account for ~70 percent of sales. Retention rates for these customers are near 99 percent, which likely makes them among the most loyal cohorts in all of retail. Importantly, this base can likely continue to produce substantial free cash flow, even if all QRTEA growth initiatives fail. QRTEA executed multiple sale/leaseback transactions earlier this year, generating nearly $685 million in after -tax proceeds. The transactions provided substantial near-term liquidity, and this allows the new management team time to turn the business. So, if the business will continue to generate substantial free cash flow and if the sale lease backs increase liquidity, shouldn’t the bombed-out stock rise substantially from current levels? In many cases, we believe the answer is “yes,” but there are risks with this strategy and the huge drop in the preferred stock now offers a better risk/reward against a more severe recession or a scenario where QRTEA fails to ever generate growth consistently. The 8% preferred currently yields ~15 percent at our purchase price with a yield-to-maturity north of 20 percent. The company has publicly declared its intention to continue paying the preferred coupons and there are onerous consequences if the preferred is not paid – namely, a step-up in coupon by 1.5 percent per annum to a maximum of 11 percent. Perhaps more importantly, QRTEA cannot return capital (dividends or buybacks) to the common equity unless the preferred is current under all dividends. In short, we simply need QRTEA to survive (versus thrive) in order to do well on the preferred. Depending on the company’s operating performance, we may revisit the common equity later, but we believe that preferred security is the better risk/reward at present.

In closing, we again acknowledge the widespread uncertainties in the current investing environment, and we admit that the difficult environment could continue. Furthermore, it is frustrating to have avoided some of the bubbly craziness over the last several years and be “rewarded” with further markdowns on existing positions. We will continue to reevaluate assumptions on all holdings and, as discussed above, we have and will continue to make mistakes in evaluating certain businesses. That said, we have tried to articulate further why we see such compelling risk/rewards in multiple names and why we believe that we will ultimately be rewarded for taking a five-year perspective versus focusing on the next six months.

Thanks for your continued support.

Patrick

1 After dropping from ~$10 in October 2008 to ~$3 in March 2009, CBS would finish 2009 ~$14 and rise to $19 by the end of 2010.

2 As a reminder, LBRDA owns ~48.5 million shares (outside of those backing exchangeables) in Charter Communications (CHTR, Financial) and CHTR is the second largest US cable firm. As LBRDA trades at a ~23 percent discount to its net asset value and is actively repurchasing its shares, investors get a “double discount” on LBRDA purchases.

3This excludes 59,000 customer disconnects related to the discontinuation of the Emergency Broadband Benefit Program and additional requirements of the Affordable Connectivity Program. If one includes this impact, the total was -21,000.

4 T-Mobile has cited Opensignal data showing download speeds of ~170 Mbps. In September of 2022, Openreach data has shown mid-band speeds of closer to 70-80 Mbps for AT&T and Verizon. These speeds compare with CHTR’s minimum broadband download speeds of 300 Mbps and offers for 1 Gbps.

5 The above numbers are taken from cable companies’ disclosure. The World Bank shows broadband penetration per 100 inhabitants and has consistently showed far lower levels of broadband penetration. Mexico’s ~17/100 penetration levels are low even by emerging market standards.

Appendix: Deeper Dive into US Cable Concerns and Megacable

Fiber Overbuilds are Steepest Part of Wall of Worry…But 4.0 can be an Effective Counterpunch

Before diving into LBRDA, a bit of a refresher might be useful. The market’s primary fear is that cable subscriber gains have turned flat to slightly negative during the most recent quarters (CHTR: +38,000³ in Q2 2022 versus +400,000 and +800,000 in Q2 2021 and Q2 2020, respectively). Subscriber additions represent the net of cable additions (new households taking the service) and disconnects (those who leave and represent “churn”). According to cable companies’ management teams, the primary driver of the reduced net additions has been the drop-off in moving activity. This has substantially reduced the number of “jump balls” where customers are actively looking to purchase broadband services (cable companies have historically strong win/loss records with these customers). Cable companies also acknowledged that customers were pulled forward during COVID. More recently, cable companies have also conceded that increased competition from 5G wireless broadband offerings and fiber overbuilds has had some impact on the lack of subscriber additions, but quickly noted this has been a far secondary impact. While US cable companies do not report churn figures, they have noted that these are near record lows, and therefore the problem has been on the gross addition side. This suggests that certain new customers (likely concentrated in slower DSL services) who may have subscribed to cable in the past could be choosing alternatives.

Investors reject cable explanations and instead have convinced themselves that 5G wireless offerings will continue to take share, that cable companies will spend far more than anticipated to upgrade their plant, that fiber overbuilds will make cable companies’ HFC plant permanently disadvantaged and that cable companies likely had a role in all that ails society (well – the last point may not be a completely universal opinion among the bears). If all this weren’t enough, investors have also gotten overly antsy over the 14-year duration/4.2 percent debt that we discussed in our Q2 letter. And to top everything off, Tom Rutledge (CEO since 2012) announced plans to retire and COO Chris Winfrey will take over. While Winfrey’s assent to the top spot was not a surprise, the timing was sooner than many expected. Some speculated (based on no concrete evidence) that this could mean a significant change in capital allocation.

Certainly, this is quite the “wall of worry.” We have discussed 5G offerings in past letters (see Q1 2017 and Q1 2018 letters). While we will not discuss the detailed differences on the newer mid band/low band 5G offerings, we will acknowledge that these newer fixed wireless products offer better signals than the early high frequency offerings from Verizon which, while significantly faster than mid band offerings, struggled mightily with trees, rain and sometimes just air. Compared to a slower DSL offering, a faster⁴ mid band 5G offering could be a satisfactory upgrade, especially in a time of other cost pressures, but will be far slower than speeds offered by cable and fiber companies. Additionally, the sheer amount of data consumed could overwhelm mobile networks which typically transport a fraction of the data consumed on fixed networks. As seen below, over 17x more traffic was consumed via fixed versus mobile networks in 2021, and the amount of data should continue rising over time. While 5G additions dominate recent cable commentary, we would agree with the argument that many of these customers may ultimately switch to fixed broadband offerings over time.

By contrast, competing fiber offerings are a legitimate threat to cable. That said, we also believe that the coming cable network upgrades (DOCSIS 4.0) can effectively neutralize the upstream speed differences currently touted by fiber companies. While most of the internet traffic is downloaded, the use of upstream data during COVID (think Zoom calls) has created a marketing opening for fiber networks with better symmetrical speed. Fiber overbuilding has been a notoriously difficult business over time. While costs have come down (more on this in a minute), cable companies have effectively competed with fiber offerings for years. Furthermore, a higher interest rate environment will also be difficult for “micro builders,” as many of these smaller builds employ higher leverage when building new networks. We also suspect that investors are underestimating cable’s potential in wireless. Cable companies have posted solid mobile additions the last several quarters, but Charter only has ~8 percent market share relative to the number of homes passed. We believe penetration rates should be multiples higher in the coming years. A “double play” offering of cable and mobile (with video thrown in for us and the other dinosaurs who still subscribe) is a compelling and cheaper counter to a fiber only offer or an overpriced unlimited mobile and 5G fixed internet combination.

Of all the above cited concerns, perhaps the toughest is one first mentioned by cable executives: the lack of “jump balls.” With mortgage rates approaching 7 percent, it is more difficult to see a pickup in housing activity anytime soon (we were slow to appreciate the degree of this headwind). Unfortunately, this means that it could take time to fully see “the truth”: i.e., will a pickup in move activity and an upgraded cable plant be enough for cable companies to add subscribers in future years? We believe the answer is “yes,” but we also believe they will generate large amounts of free cash flow even at lower growth levels.

MEGA Concerns?

So what’s the pushback on MEGA? The concern centers around the company’s reinvestment plans. Over the past two years, MEGA has overbuilt roughly 50 percent of its footprint with fiber. Cable companies’ footprints have historically utilized fiber to a node within a mile of the home or business, while fiber to the home (FTTH) extends fiber all the way to the home or business—typically terminating the fiber at a customer premises device. While we will not detail the technical difference between hybrid coaxial cable (HFC) and fiber, we would simply note that fiber is considered the better technology as it is generally less expensive to maintain due to a lack of electronic components and offers better symmetrical speeds for customers. The problem with fiber has always been the cost to deploy. As costs per passing have decreased, however, the internal rates of return (IRR) dynamics have become more favorable in certain instances, helped in no small part by multiple years of low interest rates – and obviously this part of the equation is quickly changing.

Cable companies have cost effectively increased HFC capacity in the past. US cable companies believe that the soon-to-be deployed DOSCIS 4.0 upgrades will allow a competitive offering versus fiber. As we previously noted, we believe the US cable companies (Charter and Comcast) have credible reasoning for believing that DOCSIS 4.0 upgrades can effectively compete with fiber and the cost of these upgrades might be ~20% of that of full fiber upgrades and still offer meaningful future capital and operating cost savings (we will save a fuller discussion for another letter).

Back to MEGA: Just as its 50 percent overbuild project was completing, the company announced another enormous capex project. As we detailed in our Q4 2021 letter, MEGA has vowed to double the number of homes passed over the next 3 -4 years. The company believes that penetration rates of 25 percent can produce unleveraged IRRs of 15+ percent. Why are we not terrified of MEGA’s rollout plan and worried that MEGA will join the graveyard of low return overbuild projects? Relative to US overbuilder projects, the cost per passing is considerably lower (Mexico labor costs are substantially below US levels) and the project can be funded with internal free cash flow versus the substantial leverage required for many US overbuilder projects.

Because of confidentiality agreements, MEGA cannot disclose the exact cost per home passed, but the company has indicated it is below Mexican overbuilder TotalPlay who has publicly disclosed $60 per home passed. We estimate that MEGA’s costs are ~$40-$50 per home passed. To put this number in perspective, many US overbuild projects in non-rural cities (not the largest metropolitan areas) utilizing aerial cable might cost $700-$1,200 per home passed. While Mexican average revenue per user (ARPU) levels are considerably lower, MEGA is the low-cost provider in Mexico with prices well below competitors. For newbuilds in larger cities, MEGA will be pricing at a roughly 5 percent premium to its current footprint and still offer a discount relative to existing players. This is a highly unusual situation for an overbuilding project.

Despite the challenged track record of US overbuild projects historically, US investors have recently taken a more favorable view of overbuilders, owing in part to the aforementioned reduced cost of deploying fiber as well as increased government subsidies available for certain rollouts. This viewpoint has not carried over to MEGA despite the lower cost per passing, higher ARPU in newbuild territories versus its existing footprint and internally funded nature of the overbuild. Part of skepticism stems from an informational asymmetry: investors are dependent on MEGA for details regarding the rollout (penetration levels, churn, costs per passing) and they are also dependent on the company to responsibly change course (i.e., stop the buildout) if expectations are not met. We have spent hours on the phone with MEGA’s management team and have been persuaded that 15 percent IRRs are very doable and are possibly conservative. Of course, the trajectory of cable subscriber additions will be back-end weighted – there is a lag between laying fiber/marketing the product and when customers subscribe. Until growth becomes more visible, MEGA will show little true free cash flow as all available capital is reinvested into fiber builds.

More Competition? Harder against Lowest ARPU

Investors are also concerned that other cable companies (Televisa (TV), AMX, TotalPlay) will enter MEGA territories with fiber projects and cannibalize MEGA’s current footprint. While there could be some elevated level of churn, we believe MEGA’s lower ARPU and significant fiber footprint make such incursions challenging. Competitors are essentially forced to offer a “me too” fiber product at the same price as MEGA’s offering and at a discount to competitors’ offerings in other cities. Certainly, there is a risk that competitors may do better than anticipated in MEGA territories and that investors may simply ignore a sector that they view as more challenging. That said, such concerns do not appear to justify the extreme discount in MEGA’s price.

Show Me the Money…Or Perhaps a Sale Becomes Inevitable

Again, MEGA can stop the rollout if returns do not meet expectations. At a more normalized capex margin of 20 percent of revenue in 2023, MEGA would trade at ~6x free cash flow. If one directionally follows MEGA’s rollout schedule and assumes the company passes ~9 million additional homes, MEGA would nearly double EBITDA to roughly 22 billion pesos by 2025 and trade at ~2x 2025 EBITDA and ~4.4 normalized free cash flow. This valuation is simply ridiculous. Yes, the economic environment is challenging and yes there are political risks associated with a mercurial Mexican president. But, this is a very steady business with a proven track record of growth throughout economic cycles. Additionally, Mexican broadband penetration levels (60-80 percent, depending on estimates) are meaningfully below US levels (~92 percent)⁵. One can quibble with the degree of success MEGA will achieve with its ambitious rollout program, but again MEGA can halt newbuilds if IRRs do not match return expectations. Conversely, the fiber rollout program could turbocharge growth and allow 15+ percent EBITDA growth in future periods. The fiber rollout “future proofs” MEGA’s business and likely makes the company an even more attractive buyout candidate (the dollar value of the fiber spend alone approaches 20-25 percent of MEGA’s market capitalization).

So how would a buyback work? If MEGA were to place one turn of debt (taking debt to ~1.5x trailing EBITDA – the ideal ratio is probably 2-3x net leverage), the company could offer a roughly 30 percent premium above current prices and repurchase ~25 percent of outstanding shares. We would happily “roll” our equity rather than sell out in such a scenario. The per share value economics would be so powerful that MEGA could easily justify funding the buyback with 10 percent+ debt and still produce fantastic value for shareholders. MEGA is controlled by the Bours family who have consistently shown a strong aversion to any meaningful leverage with MEGA and with other investments. For many years, MEGA traded at a premium valuation – many times at a premium to US cable peers – and therefore the buyback question was less top of mind. At current levels, we believe the management team is strongly supportive of buybacks, believing MEGA’s current stock price does not remotely reflect the true value of its business. We believe another buyback proposal has been presented to MEGA’s Board of Directors who are examining its options. While it is far from clear that MEGA’s Board will approve such a proposal, we suspect that an outside event could force a decision. It has been widely reported that competitor TV is interested in a merger and that the synergies between the business would be substantial. While current credit markets are currently more challenging, bids from other cable companies or private equity firms cannot be ruled out (if any of the latter are reading this letter, please feel free to call us to discuss further). The family’s majority voting interest may defer many activist investors, but it does not assure complete protection.

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.