July 15, 2024
Never Was So Much Owed by So Many to So Few…Sigh
Many of the broader market themes discussed in our last letter continued to percolate throughout the second quarter. Interest rates remain elevated, but forward curves, Federal Reserve forecasts and more recent inflation data hint at easing ahead. At its June meeting, the Federal Reserve forecast one interest rate cut for the remainder of 2024 (down from 3 previously) while markets now forecast 2 cuts versus ~6 at the beginning of the year. Broadly speaking, the US economy has generally performed well, but recent macroeconomic data and company commentary have signaled possible softening (who knows if this holds). Meanwhile, the broader markets continue to be dominated by a handful of stocks which have accounted for a disproportionate share of overall index advances. As discussed previously, we do not own these names, and this has been a major headwind on returns.
As discussed in prior letters, there is no rule that prevents us from selling out-of- favor value names and piling into the largest technology names that are “working.” Admittedly, many of the largest technology names have robust business models that have grown faster for longer than we would have ever anticipated. Interestingly, there is also a strong momentum tailwind supporting the biggest names that might be as large a factor behind recent moves as the artificial intelligence excitement. Active managers are generally less exposed to the largest technology names versus passive funds, and as passive funds continue to gather assets, the largest technology names receive additional purchase orders. When one also considers the passive inflows from ever popular target date funds, there is a wall of money flooding to the largest names (assuming markets keep advancing). Admittedly, it is difficult to know with any certainty what might break the above loop.
While it is frustrating to see such a narrow group of stocks dominating markets, we still believe it is a mistake to arbitrarily sell beaten-up names where operational execution and smart capital allocation decisions, combined with any small change in sentiment, can drive material moves higher. This is not to say that there will be no change in existing holdings. With the benefit of hindsight, we probably have had too high a concentration in names from one jurisdiction (LATAM) and in cable names with higher leverage levels. We also acknowledge that it is easier for public markets to value names with higher levels of underlying growth and we have tried to apply this insight to newer purchases (as we described with CAB Payments last quarter). That said, we believe 3 of our 4 LATAM names (Millicom (TIGO, Financial), Megacable (MEX:MEGACPO, Financial) and Arcos Dorados (ARCO, Financial) – more on ARCO in a moment) are executing well, trade somewhere between low and nearly incomprehensibly low valuation levels and have appropriate/low leverage levels. As for the more leveraged cable names (Liberty Global (LBTYA, Financial), Charter Communications (CHTR, Financial) and Liberty Latin America (LILAK, Financial), all three have defensible businesses that have historically handled higher debt levels, have longer-dated debt tenors and have religiously hedged away floating rate debt or debt with currency mismatches. We would concede that if rates stay higher for longer, then total leverage levels will likely need to decrease, which could limit the capacity for capital return. That said, sentiment for these names is as bad as it gets – perhaps close to the perceptions of Luka Doncic's defensive capabilities following the 2024 NBA Finals (Cheap shot? Apologies…but Banner 18 was awesome). Certainly, if market dynamics change, if operational execution wanes or if capital allocation mistakes persist, then sales are appropriate. That said, arbitrary rebalancing at peak levels of negativity does not feel wise, but we suspect this is exactly what is now happening as several investors rotate out of multiple value names. Any easing of this selling, combined with smart capital allocation and/or modest new investor interest, could meaningfully rerate several of our names.
Anger at Left and Right…And Little Room to Spend?
As market commentary will soon be in full election mode, we want to provide a couple of quick observations on recent, but less high profile, elections in Mexico, France, and the United Kingdom which admittedly may or may not be relevant for the US later this year. While a victory was widely anticipated, the size of leftish leaning Claudia Sheinbaum's victory caused a negative reaction in Mexico (including to our MEGA position, despite election results having no obvious impact on MEGA's regulation/general operations). Meanwhile, a widely expected Labor Party (leftish on the political spectrum) victory in the UK produced the equivalent reaction of a collective yawn. In France, a market selloff greeted the first round triumph by far-right party National Rally, only to be followed by a collective “unsure” reaction after a far better than anticipated victory by a center/left coalition victory in the second round. This result left the Eurozone's second largest economy facing a hung parliament.
So, what's the discernable trend from the various elections? Unclear, but perhaps one takeaway is that voters appear even grumpier than normal with dissatisfaction directed towards both the left and right. Arguably more important for markets is that whichever side wins, increased debt levels will make it highly difficult to deliver electoral promises. The US, UK and France are running budget deficits of 4-7 percent of GDP -- unprecedented levels given lower unemployment levels.
And total accumulated debt has skyrocketed, with the International Monetary Fund (IMF) showing total debt/Gross Domestic Product (GDP) rising to 104%, 112% and 126% in the UK, France and the US, respectively1. Is this sustainable? Skeptics quickly dismiss these concerns and point to Japan where publicly held debt is at a whopping ~215 percent of GDP. Skeptics could rightly note that calls for Armageddon never materialized and instead left a trail of tears for those who have shorted Japanese bonds. If a country can print money in the same denomination as its debt, then perennially large and growing deficits are unproblematic…right? Of course, former UK prime minister Liz Truss lasted a total of 49 days in 2022 after her less-than-well received unfunded tax cut proposals (cuts to be funded in the same UK pounds that the Bank of England could print indefinitely). Days after the proposals, markets reacted swiftly with the pound and bond markets tanking and ultimately forcing intervention by the Bank of England. After France's recent election results, the spread between Germany and France's 10-year bonds rose post first round elections and equity markets declined. The left and right in France both want to spend more money which France appears to have little wiggle room to fund. (Sound vaguely familiar to US readers?) It is harder to look at this and not conclude that another bond market freakout is possible. It is also worth noting that while market commentary focuses on shorter-term inflation data, JPMorgan (JPM, Financial) CEO Jamie Dimon noted in JPM's last annual report that the longer-term trends of fiscal deficits, nearshoring, defense buildup, healthcare spending, and energy transition spending -- among others -- all point towards higher long-term inflation. Again, whether any of the above European reverberations repeat stateside is far from clear. However, we would argue that the ramifications of possible echo events are more relevant for markets than any gnashing of teeth over which potential leader of the world's largest economy is slightly less bad than the other.
If Deficits Matter Again or Inflation Persists, Targeted Leverage May Come Down
As noted earlier, if rates stay higher for longer or if the longer end of the curve becomes more nervous about government debt levels, then corporate financing will be more expensive and lower debt levels will likely be required, including for our telecom names. MEGA and TIGO both have very manageable debt levels (MEGA at 1.4x, TIGO at 3.1x). MEGA's ratio is low by cable company standards and will fall over the coming year as it completes its expansion program described in previous letters. MEGA continues to execute and its business should not be impacted by recent presidential results. During the second quarter, TIGO again raised its free cash flow guidance. TIGO now anticipates ~$660 million of free cash flow (after a massive guidance hike to $550 million earlier this year) and announced that debt should end 2024 near its targeted 2.5x leverage ratio, a goal likely to be hit roughly one year ahead of schedule. Furthermore, TIGO now forecasts free cash flow to expand to over $830 million by 2026. In perhaps one of the bigger no-brainers of all time, a special committee of TIGO's Board formally rejected a $24 offer from ~29 percent shareholder Atlas Luxco S.à r.l.1 (Atlas – this is Xavier Niel's catchy investment group name) and told Atlas (nicely) to pound sand at $24. Atlas' offer would imply a price equal to ~6.2x free cash flow (~16 percent yield) on current year projections and this does not consider the value of one of the ten largest Latin American tower portfolios (~9,000 towers) which could be monetized later this year. Atlas knows shares are worth far more than $24 and the committee was right to state the obvious.
Liberty Global (LBTYA, Financial), Charter (CHTR, Financial) and Liberty Latin America (LILAK, Financial) have higher debt levels (Net Debt/EBITDA ratios of 4.9x, 4.4x and 4.6x). We believe leverage levels are manageable for all 3 names given the stability of their businesses, hedging discipline, and longer debt tenors. That said, interest rate concerns have weighed on total valuation levels, especially considering slower top-line growth. We should have more adequately anticipated this concern as the rate environment changed. All three names are targeting lower debt ratios through some combination of organic growth, debt repurchases at discounts to par value, straight debt paydown or synergy realization (LILAK). For CHTR and LBTYA, organic capex should decline in the coming years following heavier investment in existing networks. LBTYA is sitting on over $3 billion of cash, continues to repurchase shares and is planning to split parts of the company into separate entities (including an IPO of its Swiss operations later this year). All three names are undervalued. We will adjust position sizes as appropriate, but we are conscious of doing this at a time when valuation levels are so depressed.
If Irish Green So Radiant…Why the Investor Blues?
Moving from unpopular telecom to an unpopular Irish bank, we note that a good portion of our first half underperformance stemmed from weakness in PTSB (LSE:PTSB, Financial) shares. Of the multiple investors we speak with about PTSB, many recognize the bank's considerable potential upside. There seems to be a general acceptance about the attractiveness of Ireland's economic backdrop and demographic profile. While there are concerns about possible further competition from existing non-bank players, many recognize that the competitive backdrop is still highly attractive with three banks dominating the loan/deposit market. And with a housing crisis that has only become more critical, Ireland has a clear incentive for a stronger challenger to the two largest players: Bank of Ireland (BOI) and Allied Irish Banks (AIB). Furthermore, investors recognize that considerable capital relief should soon accrue to PTSB after the Central Bank of Ireland's review of mortgage densities. Finally, PTSB has obvious acquisition appeal, and in a May report Autonomous Research named PTSB as the number one acquisition target among European banks. All of this, combined with a bombed-out valuation (<0.40x of tangible book value), make for a compelling equity story. So why have shares languished? We believe there are 3 primary reasons:
- Perceived lack of catalysts until the Central Bank of Ireland (CBI) completes its review of PTSB densities by the end of 2025
- Concern about PTSB's expense trajectory and questions about the lack of management/Board ownership
- Incredibly illiquid float given ~69% government/NatWest overhang, which makes the name difficult for most institutional investors to own
While we won't rehash all the minutia behind the density change (please see prior letters for more details), we would again note that capital accumulation from earnings plus density changes could free up capital totaling 70+ percent of PTSB's existing market capitalization. This capital can be used for buybacks and dividends and for further mortgage and corporate loan growth. This capital release alone should rerate the stock, especially as a chunk of this capital will likely be deployed towards accretive share repurchases. As discussed in our first quarter letter, we agree with the expense criticism and we believe there could be €50 million of cost savings opportunity relative to PTSB's targeted €500 million medium-term run rate. The cost-saving opportunity is far higher in the context of a third-party acquisition given the synergies that could be realized. PTSB is vulnerable to a third-party bid. If PTSB's current management team cannot produce shareholder value, a third party will. As we have noted in past letters, the government/NatWest stock overhang is a bit of a circular problem. PTSB's low valuation reflects the illiquidity of its float, but the government/NatWest do not want to sell because of this low valuation. Ultimately, this will be fixed, but predicting the exact timing is difficult.
We are encouraged that a senior Department of Finance official -- Scott Rankin -- will be joining PTSB in October of this year as head of Investor Relations. We have discussed PTSB with Scott multiple times, articulated our PTSB thesis and provided unfiltered feedback on areas where we believe PTSB needs improvement. Scott was head of financial service research at Irish brokerage firm Davy before joining the Department of Finance in 2009. Scott was involved with Ireland's IMF/EU restructuring discussions in 2010 and represented Ireland when the Irish banks were recapitalized. Scott's background will be invaluable to PTSB as the bank finalizes mortgage density discussions with the CBI and continues its investor outreach program as PTSB attempts to decrease the government's stake and increase the bank's freely tradeable float. This move can also be interpreted as a sign that the Irish government shares private investor frustration with PTSB's stock price and believes that further progress is necessary. In summary, there are multiple catalysts in place for PTSB's bombed-out stock price and we are not alone in pushing for value to be realized. Please call us to discuss any of the above in more detail.
ARCO: COVID Winner, Strong Operator/Grower…F/X and MFA Concerns Give Indigestion
We recently spent time speaking with ARCO's management team and thought it would be worthwhile to provide an update on the company. As a reminder, ARCO is both the largest Quick Service Operator (QSO) in Latin America and the largest independent franchisee in the McDonald's (MCD) system, with the exclusive right to operate MCD franchises in nearly all Latin America countries. ARCO, along with nearly all restaurants worldwide, struggled during COVID, but the pandemic meaningfully enhanced the company's competitive positioning and investors appear to grossly underappreciate this change. During the stay-at-home period, somewhere between 20-30 percent of Brazilian/Mexican restaurants closed and the larger QSR restaurants gained share and greatly accelerated their delivery and drive-thru business. This trend was particularly pronounced with ARCO, given that it has far more free-standing stores (delivery and drive-thru do not work out of mall stores) than its largest competitor Zamp, which operates Burger King stores in Brazil. Digital (delivery, self-order kiosk, and drive-thru) sales accounted for ~55 percent of total sales volumes (~43 percent of these were from delivery/drive-thru) in Q1 2024, up from 36 percent in 2021 and substantially higher than ~11 percent in 2018. Incremental sales from delivery/drive-thru have increased the return on investment of individual stores. ARCO cites mid 20% cash-on-cash returns on new stores -- we derive unleveraged returns closer to 16-20% after considering taxes and maintenance capital expenditures. ARCO's balance sheet has also greatly strengthened over the past several years and net debt/EBITDA levels of 1.2x are low on both a relative and absolute basis. Despite the higher QSR share achieved since the pandemic, LATAM QSR share greatly trails other jurisdictions, suggesting substantial growth potential in the years ahead. ARCO believes there is capacity for at least 1,000 new stores (~2,400 currently). ARCO's phone application is among the most downloaded apps among all Latin American restaurants and ARCO now can identify 22 percent of all digital sales, allowing ARCO to better tailor offers to customer preferences. The investment required for this technology infrastructure is nearly impossible for most other LATAM restaurants to replicate.
ARCO's concerns center around two issues: currency and the renewal of the Master Franchise Agreement (MFA) with MCD. ARCO has generally been successful at matching most expenses with local market revenue (happy meal toys are notable exceptions), but the company does have certain US dollar denominated capital expenditures. Additionally, since the stock is listed on the New York Stock Exchange, any dividends or repurchases need to be executed in US dollars. ARCO has 20 different markets, but F/X concerns are generally concentrated in the Brazilian real, Mexican peso and Argentine peso. ARCO's recent price declines have followed Brazilian Real and Mexican Peso weakness, the latter following the Mexican presidential election. ARCO also was impacted by a more significant Argentine devaluation earlier this year. It should be noted that a good chunk of ARCO's corporate expenses is Argentine peso denominated and the weaker peso will therefore be partially offset by lower dollar translated corporate expenses. Additionally, it is worth noting that despite currency headwinds, the company has posted record dollar translated EBITDA results over the past couple of years.
While there is no escaping the fact that Brazil is ARCO's largest market and that the real's value will impact ARCO's overall valuation, we see little reason for the company to maintain its current US listing. ARCO originally listed in the US during 2011, partially to capture US investors' infatuation with Brazilian assets – now incredible to believe that such a time existed. Following a couple of severe recessions, some of the worst presidents that the western hemisphere has ever seen (current US company included), a bribery scandal for the ages and a string of underachieving soccer teams (ok, perhaps this is less relevant…but the recent Copa América tournament performance was a disgrace), this infatuation has turned into repulsion. Furthermore, any dividends or buybacks create unhedged dollar obligations which can discourage capital return, as would appear to be the case currently. While certain US investors might have trouble holding Brazilian listed shares, we think a local listing would allow more consistent dividends and possible buybacks. Additionally, local investors would likely be more attracted to a world class consumer brand and ascribe a higher value to ARCO's franchise. Our sense is that ARCO's management team does not fundamentally disagree with this sentiment and ARCO will revisit this issue later this year.
The terms and conditions of the MFA are expected to be finalized at the beginning of August of this year. Under the current MFA, ARCO pays MCD royalties of 7 percent of sales but receives fixed support payments that took royalty payments down to ~6 percent of sales with current payments slightly higher, given fixed support payments and higher than anticipated ARCO sales. ARCO believes that new MFA terms will keep payments near current levels, but certain investors remain concerned about this issue. We believe these concerns are overblown. MCD wants to raise its total restaurant count by approximately 10,000 units to 50,000 units by the end of 2027. Given ARCO's lower restaurant penetration and more aggressive growth plans, ARCO is likely one of MCD's key pillars of unit growth, particularly considering recent concerns about MCD's growth sustainability in China. Historically, ARCO has maintained a healthy relationship with MCD and ARCO's operational performance has been exceptionally strong, especially considering some of the headwinds across ARCO's markets. MCD must strike a balance between unit growth and royalty levels and ARCO appears confident that a favorable agreement will be struck.
Despite systemwide comparable sales growth at over 2x blended inflation rates, 12 consecutive quarters of consolidated guest traffic growth, low absolute and relative debt levels, enormous real estate value in land owned under 475 stores and brand attributes at or near all-time highs, ARCO trades at 10+ year valuation lows at ~5x forward EBITDA. While business models differ by region, several public franchisee companies currently trade at valuation levels 50-100+ percent higher than ARCO. While ARCO may not sell GPUs for generative artificial intelligence, we do think that the company works with one of the best brands on the planet, has a near decade-long growth opportunity and has shown a consistent history of operational execution. In short, while ARCO is based in LATAM, we think it is a compelling growth opportunity trading at bombed out valuation levels.
In conclusion, it has been frustrating to see several of our names languish while the broader market advances on the heels of large advances in a small group of names. Knowing that mistakes and misjudgments are inevitable, we continue to assess individual investment theses, and we remain committed to pivoting when appropriate. That said, as we have tried to articulate, we see considerable value in several of our largest holdings and believe it would be a mistake to arbitrarily sell at levels far below any reasonable assessment of true value.
Thanks for your support.
Patrick
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.
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