April 30, 2024
Higher-For-Longer, Elevated Starting Valuations…Investors Appear Unconcerned
Investors debated future interest rate paths throughout the first quarter of 2024. After initially expecting up to 6 interest rate cuts at the beginning of 2024, investors reversed course following stronger inflation and employment data. At present, markets price only 1-2 rate cuts for the remainder of 2024 and also price a ~20 percent chance of an actual increase. The latter scenario would have seemed unthinkable at the end of 2023, and we suspect that, if presented with this piece of information at that time, many market strategists would have predicted a sharp correction in early 2024. Instead, broader markets have rallied, buoyed by excitement over artificial intelligence (AI) and its potential to bring productivity gains to the larger economy. We are certainly in no position to opine intelligently on whether the hopes and dreams of AI will ultimately fulfill what appear to be current lofty expectations. These new technologies could be transformative, but even people highly knowledgeable in this space are unsure of how quickly productivity advances will be realized or which companies will be clear winners (or losers) from any AI disruptions. Separately, we suspect that market commentary over the coming months will likely focus on geopolitical tensions in the Middle East and what is sure to be a dysfunctional presidential campaign in which both sides predict Armageddon if the other side triumphs. While these headlines could move markets in the shorter term, we think interest rate levels and starting valuation levels will be more impactful on longer-term returns. And admittedly, a higher-for-longer environment and an elevated cyclically adjusted price earnings ratio (CAPE)1 ratio of ~34x look less promising.
It is frustrating that several sectors/companies that we focus on seem galaxies removed from this ebullient mood prevalent in the largest market names. Many smaller, foreign names or those with leverage (even if appropriate for the business/industry) have been left behind by the broader rally and languish at depressed relative and absolute valuation levels. Certainly, not all investments will work out as anticipated as our assumptions will simply be proven incorrect for certain holdings. As discussed in our fourth quarter letter, we continue to monitor where new information contradicts existing investment theses and we have committed ourselves to more decisively reversing course in these cases. That said, wholesale selling of underperforming names would be a mistake. In fact, we think the smarter decision is to maintain or to increase position sizes where the risk/reward appears firmly in our favor.
We had a chance to speak with management teams at several of our holdings and therefore we wanted to dive right into a couple of portfolio updates.
PTSB: Earnings Revisions Look Overly Conservative…Cost of Senior Debt Irreconcilable with Cost of Equity
As noted in our fourth quarter letter, PTSB (LSE:PTSB, Financial) attended the Keefe, Bruyette & Woods' (KBW) financial services conference in mid-February of this year. We had a chance to meet with PTSB's management team at this conference, at a subsequent Davy conference in New York and finally at the company's headquarters in Dublin at the end of March.
PTSB's year -to-date weakness has stemmed less from actual 2023 results that were reported in early March and more from reduced medium- term guidance (PTSB's 2026 earnings per share target was reduced from €0.40 to €0.30). As noted in previous letters, PTSB's projected expenses are elevated relative to our original investment expectations, and this drove the roughly one-year delay in achieving the ~€0.40+ of earnings that we were assuming could occur by 2026. PTSB's cut in guidance from ~€0.40 to ~€0.30 is primarily driven by more conservative assumptions on deposit growth and funding costs, along with a more conservative outlook for overall mortgage volume and market share. As noted in prior updates, there is far less competition for deposits in Ireland versus other markets. Thus far, there has been minimal “terming out” of deposits (moving money from non-interest accounts to interest- bearing deposits) across the remaining Irish banks. While this may sound unsustainable, remember that there is no TreasuryDirect in Ireland to easily move deposits, that there is a ~33 percent tax on deposit interest income, and that PTSB has lower absolute average deposit balances (~70 percent of total deposits are below the €100,000 threshold). While we can't disprove PTSB's assertion that all deposit growth will only be in the most expensive term deposits (when the two larger banks are not aggressively chasing new deposits), this is a major driver behind one of the company's new assumptions which PTSB concedes is conservative.
As for the earnings guidance, we continue to believe that there is meaningful upside to the company's projections and that capital relief is highly likely. Yet, even if we are wrong on both accounts, PTSB is meaningfully undervalued, trading at just ~5x PTSB's (overly conservative) earnings forecast and a mere ~0.4x tangible book value. Even after incorporating many of PTSB's new medium-term assumptions at face value (including the company's current elevated cost base), we continue to arrive at earnings forecasts that are above PTSB's 2026 guidance of €0.30 per share. Leaving aside our belief that there could be up to €50 million in excess company operating costs, PTSB's guidance looks particularly conservative, considering the company's recent successful MREL2 offering and the likely 2025 redemption of a junior security (Additional Tier 1 (AT1)) – neither of which are factored into PTSB's medium- term guidance. Specifically, PTSB was able to place €500 million of senior MREL bonds in mid-April at a 4.25 percent coupon, or nearly 240 basis points narrower than their prior MREL offering in June of 2023. We would note that this senior debt cost is completely inconsistent with the stock's ~0.4x price/tangible book valuation, which implies 20+ percent cost of equity. One might conclude that either debt investors have completely lost their collective minds, or that PTSB shares are massively undervalued and equity investors are far too pessimistic. It will come as no surprise that we strongly believe the latter. We estimate that the lower bond coupon results in ~€11 million of annual interest cost savings versus
what was assumed in PTSB's medium term guidance. And, as noted above, we believe that PTSB may redeem one of its AT1 securities in November 2025, which would lead to an additional ~€ 10 million in annual savings. This too has not been factored into PTSB's guidance nor has the possibility of any share repurchases, which would be highly accretive at current levels.
We have described PTSB's higher risk densities in prior letters. Our conversations with PTSB's chief risk officer (Barry D'Arcy) at KBW's conference and again in Dublin further increased our confidence that PTSB remains well on the path toward being eligible for substantial capital relief by the end of 2025. While it is frustrating that we must wait that long, we believe that this relief could ultimately help unlock excess capital equivalent to more than half of PTSB's current market capitalization.
Certainly, PTSB's illiquidity remains one of the chief constraints to a higher valuation. The government, NatWest and other larger shareholders own ~57 percent, ~12 percent and perhaps 15 -20 percent of PTSB shares respectively. This means that freely tradeable shares may only be ~10- 20 percent (€ 85-€130 million) of PTSB's total market capitalization. A larger freely tradeable float would allow a larger number of institutional holders to purchase shares. The KBW conference proved that PTSB's story can resonate with U.S. investors, and we believe there is enormous interest in a possible follow-on offering. Currently, the problem is that NatWest and the government are reluctant sellers at recent depressed levels. Meanwhile, potential buyers of PTSB shares are anticipating a follow-on offering at a 5-10 percent discount, so they remain on the sidelines despite a weaker share price. While we cannot predict the day or the hour of any follow-up offering, we remain confident that this shorter-term technical overhang will be resolved and possibly sometime in 2024. While NatWest rightfully believes PTSB shares are cheap, its ~€100 million position is insignificant relative to the bank's ~£ 700 billion balance sheet. Again, we believe that NatWest will ultimately sell and that the government will follow. For those with a longer-term horizon and a little bit of courage, we believe that this is a fantastic time to step into the void and accumulate shares. We continue to speak with investors about this opportunity. Please feel free to contact us for further details.
CHTR: Universally, Unequivocally Hated
As noted in prior updates, Charter Communications (CHTR, Financial)3 has taken hits on multiple fronts. Fixed wireless offerings and continued fiber buildouts have taken market share. As a result, CHTR's total broadband additions are now running negative despite heavier spending on new rural buildouts. In addition to rural buildouts, CHTR is spending heavily to upgrade its existing network (DOCSIS 4.0) to make the company's network more competitive with newer fiber offerings. If this is not enough, 2024 brought a new concern. Affordable Connectivity Program (ACP) funding, which offers broadband subsidies to lower income households, has thus far not been renewed, and CHTR has the largest exposure (~5 million customers) to the program relative to other providers. While many ACP customers will transition to other CHTR internet offerings, there will likely be cuts in average revenue per customer and some customers will simply disconnect. Furthermore, despite having debt with a weighted average life of nearly 13 years at a cost of 5.3 percent, some have fretted that the EBITDA slowdown makes CHTR's 4-4.5x targeted leverage unsustainable. Respectfully, we strongly disagree but acknowledge that the concern weighs on CHTR's multiple. Seemingly, the only other shoe to drop would be for a large asteroid to plummet towards CHTR's headquarters.
As discussed in prior updates, we sold a good portion of our holding in 2021/2022 but then repurchased additional shares at the end of 2022 as the stock sold off after announced network investments. Certainly, with the benefit of hindsight, a complete exit in 2021/2022 would have been the smarter move. Of course, as we have noted in prior letters, our biggest investment mistakes typically have been selling winners too early, and this certainly influenced our thinking with CHTR. While we understand the frustration with the “round trip” on the remaining CHTR holdings, we strongly believe it would be a mistake to indiscriminately sell at current multi-year lows. It is unequivocally true that fixed wireless offerings have taken more share than many (ourselves included) would have expected. However, if one believes that customers' historic data usage continues anywhere near current levels (show of hands for those who believe they will use more data 1, 3, or 5 years from now), then wireless companies will likely not have the capacity to continue adding data customers (many use 30x more data than mobile customers) while still allowing sufficient spectrum for their valuable wireless customers. There are signs that 5G penetration rates may be plateauing, but investors will not give CHTR the benefit of the doubt until these trends are indisputable.
While there are a host of technology companies that receive generous valuations for growing subscribers at the cost of near-term profits, investors refuse to ascribe any value (or perhaps ascribe negative value) to CHTR's wireless business, despite the company consistently adding ~500-600 thousand quarterly additions over the past several quarters. Only ~14 percent of CHTR's total homes passed have CHTR wireless services and the company's total internet/wireless offering prices compare favorably versus competitors. CHTR's subsidized Rural Digital Opportunity Fund (RDOF) cable expansions have outperformed expectations (penetration rate are near 50 percent after one year) and CHTR still sees mid-to-high teens unleveraged returns on this investment. Unfortunately, these returns are less apparent to investors as CHTR absorbs higher capex and operating expenses immediately but only receives subsidies over an extended period of time. Investors appear to be making little distinction between maintenance and growth capital expenditures. This matters as CHTR's valuation on a price to free cash flow basis looks quite different when the growth capex is included (20x/19x), versus when the growth spend is excluded (~7x).
CHTR's senior management team has had a justifiably strong reputation for being strong operators and rational capital allocators. That said, the team deserves criticism for more aggressive share repurchases during 2021/2022 at levels considerably above current stock prices. Additionally, the team also underestimated the degree of COVID “pull forward” in their core business and underestimated the success of fixed wireless offerings. And while network investments and rural buildouts appear to be intelligent uses of capital, these allocations also mean that share repurchases will likely be muted until network upgrades are completed. That said, free cash flow should powerfully inflect in 2026/2027 and investors will likely price this change well before this free cash flow materializes. As we have noted in prior letters, investors have a love/hate relationship with cable stocks going back multiple decades. Current sentiment is as negative as we can remember, and we believe small changes could drive a material rerating.
LILAK/MEGA/TIGO: Progress on 2 out of 3 in LATAM…Insider Buying at the 3rd, but Operational Progress Still Needed Here
As there was positive operational performance from 2 of our 3 Latin American cable names – progress on the third needs to come in the next year – we wanted to provide another quick update. Earlier this quarter, LATAM telecom name Millicom (TIGO, Financial) meaningfully hiked its 2024 estimated free cash flow guidance to $550 million. The improvement was driven by substantial improvement in its larger Guatemalan segment and a significant bump in cost savings. Impressively, TIGO's run rate saving level (~$250 million) is more than double its original targets. Additionally, TIGO has transferred its tower portfolio (~9,000 sites and among the 10 largest tower portfolios in Latin America) to a separate entity and will be looking for an outside party to invest in or possibly purchase a majority stake sometime this year. While TIGO's stock has rallied in the first part of 2024, it is somehow trading at only 6x current year estimated free cash flow. This low relative and absolute valuation persists despite the company's high visibility into net leverage dropping to 2.5x by the end of next year as well as a possible tower asset monetization sometime this year. We see significantly more upside in TIGO shares.
Meanwhile, Mexican cable name Megacable (MEX:MEGACPO, Financial) continues its fiber rollout, finishing the first quarter of 2024 with ~15.9 million homes passed -- a large way towards its original goal of doubling its 2021 passings to ~18 million. Penetration rates in new territories are currently ~13-14 percent and MEGA has reported that some of the early cohorts have reached 20 percent. After several quarters of slower EBITDA growth (impacted by higher fiber rollout costs), EBITDA growth accelerated to 12-13 percent over the past two quarters and MEGA predicted margins would expand in 2024 from the ~46 percent levels in 2023. Balance sheet concerns have been a headwind for two of MEGA's competitors (Televisa and TotalPlay) and therefore MEGA has been able to sustain its rollout with less pressure from competitors in existing territories. MEGA should complete the vast bulk of its rollout by the middle of this year and total capital expenditures will meaningfully decline over the coming years, which should drive a large step-up in free cash flow. While MEGA has rallied since the end of 2023, its shares trade at only ~4x forward EBITDA, even with net leverage at only ~1.4x EBITDA. Again, we see considerable upside from current levels.
Liberty Latin America (LILAK, Financial) has assured its weary investors that a cash flow inflection point will occur in the back half of this year following the ending of its transition support agreement (TSA) with AT&T. LILAK has projected total free cash flow of $1 billion over the coming three years. Admittedly, one of the chief investment concerns is whether higher than anticipated debt refinancing costs eat up most of/all of the synergy benefits from LILAK's various deals. LILAK's forecast includes some assumed debt refinancing costs, but the company has not provided specific details. And while one can have different opinions on the ultimate debt refinancing costs, it is difficult to reconcile LILAK's $1.5 billion market capitalization against the company's 3-year $1 billion free cash flow target. Theoretically, the company could repurchase 2/3 of outstanding shares and an even larger percentage of the freely traded float. One can guess that some of this “back of the envelope” math was considered by John Malone before he purchased an additional ~$10 million worth of stock near current levels in late March of this year.
While the valuation and insider purchases are certainly positive, investors need to see further signs of execution. Specifically, LILAK needs to hit/exceed Puerto Rican synergy targets and deliver the run-rate free cash flow that it discussed on its last earnings call. We also believe that LILAK's management team needs to decisively allocate capital. As noted in prior letters, we believe the company should either aggressively repurchase stock or sell existing assets and pursue the same strategy. Thus far, we've heard more “the stock is crazy cheap” talk from management and seen less voting with their repurchase wallet. Investors self- selected into LILAK's leveraged equity return model. If public markets continue to ascribe little value to LILAK's equity, management must aggressively repurchase and conceivably retire 40- 50+ percent of outstanding shares. To paraphrase LILAK's “godfather”, the only reason to be public is to sell shares when they are dear and to buy them back when they are cheap. We communicated these thoughts to LILAK's CEO/CFO earlier this year and we will evaluate the company's progress over the remainder of 2024.
LSXMA/SIRI Gap Closes…But Not the Way We Hoped; Still Solid business and S&P 500 Inclusion to Come
We described the merger between Liberty SiriusXM Group (LSXMA, Financial) and car radio company SiriusXM (SIRI, Financial) in our Q4 letter. The discount between LSXMA and SIRI has narrowed, but unfortunately the tightening has occurred due to large declines in SIRI (down ~40 percent year-to-date). The discount is narrower because LSXMA declined less than SIRI (~14 percent year-to -date). While we will not rehash the SIRI secular concern debate that has existed in some form for the past 10+ years (see our Q4 letter for more details), we would note that SIRI, while more mature, has a sticky customer base and should continue to generate substantial free cash flow in the years ahead. It is highly likely that the combined company will join the S&P 500 sometime after the merger is completed, forcing large numbers of passive investors to purchase shares in the new company. Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) continues to aggressively purchase LSXMA shares and now owns just over 30 percent of the company. Berkshire's purchases certainly do not guarantee a favorable outcome (Berkshire has bought at higher prices and has continued buying as the stock declined), but the size of the holding suggests that Berkshire believes in the underlying business versus simply designing a “trade” to benefit from S&P 500 inclusion.
Cab Payments: Secular Growth Not Dead, Albeit Non-Linear…Multiple Expansion Very Possible
Cab Payments (LSE:CABP, Financial) shares have rebounded during the early part of 2024. We described the company in detail in our third quarter letter and, as noted in our fourth quarter letter, presented the company at the 2024 Manual of Ideas Best Idea Conference and at a 2024 GuruFocus Conference. (Again, please let us know if you are interested in receiving links to the presentations).
CAB's full year results came in slightly better than its update from January of this year. Importantly, CAB noted that, despite anticipated weakness in the Nigerian naira currency corridor, it thought 2024 consensus expectations calling for ~7 percent top-line/4 percent EBITDA growth were appropriate. While this growth is pedestrian relative to the 35-40 percent medium-term guidance originally given at the time of the IPO, this forecast assumes that Nigerian growth is down roughly 70 percent in 2024 and that net interest income falls 10-15 percent on lower assumed interest levels. For this reason, hitting this top-line growth likely requires 30+ percent growth in the company's non-Nigerian core foreign exchange and payment business (non-Nigeria foreign exchange and payment revenue grew 28 percent in 2023). This suggests that core growth might not be that dissimilar to levels contemplated at the IPO.
Additionally, investors should note that CAB has every reason to provide conservative forward guidance after the guidance change in October of 2023. We suspect that CAB's Nigerian projections are particularly conservative. Following a devaluation earlier this year (again, CAB acts as middleman in these exchanges and therefore is not subject to sudden losses), the Nigerian naira has stabilized and previously backlogged foreign exchange volumes have cleared during the first quarter. Both data points suggest that CAB's naira revenue could rebound more than expected in 2024. CAB also noted some easing of previous regulatory pressures in the Central African Franc (XAF) and West African Franc (XOF) corridors and noted that both corridors are expected to be among its largest markets in 2024. (Please see our 2023 third quarter letter for more details)
CAB also announced a management change in February and new CEO Neeraj Kapur took over as CEO from the end of March. This change was likely a factor behind CAB not making any capital return announcements when it announced its full year results in March. While CAB clearly wants to lean into its numerous growth opportunities, with a Common Equity Tier One/Risk Weighted Assets (CET1/RWA) ratio of 25 percent (well above required levels) and continued earnings growth, we still believe that it is just a matter of time before the company pays dividends or (hopefully) repurchases shares.
In early April of this year, CAB announced that it finally received a Dutch regulatory license, which allows the company to make outbound calls to European customers. Previously it was forced to only take inbound inquiries from various European institutions. As we noted in past updates, this application became necessary because of Brexit restrictions. It is staggering that CAB has been able to achieve such strong customer growth with this major sales restriction in Europe. Approval was originally expected in the fourth quarter of 2024 but was delayed until April of this year and CAB believes that that this license will provide a major boost to its sales efforts. CAB also expects to receive a US Representative License in the second half of 2024, which would allow CAB to target US national and regional banks more efficiently. As we noted in our 2023 third quarter letter, the “big enchilada” would come if the company ever attains access to the Clearing House Interbank Payments System (CHIPS), which would allow far greater flexibility to process dollar-based payments from current clients. While this would be a game changer for the company, attaining membership will be a multi-year process. CAB needs to reduce Helios's ownership from 45 percent to 25 percent before it can truly begin the application process.
While CAB has proven that its growth will not be linear, the company still appears to have a powerful secular growth outlook. CAB has a small share of an enormous market that continues to grow. Meanwhile, specialist firms are forecast to roughly double their market share versus correspondent banking providers over the next 4-5 years. These two factors alone could drive 15-20 percent top-line growth. As a regulated bank with a nearly 200 -year history in various African markets and growth opportunities in multiple other markets, CAB has unique advantages over many other specialist firms. While CAB's topline growth may not reach the 35-40 percent growth forecast at the time of its 2023 IPO, we believe that growth at roughly half these levels can still provide large upside relative to current levels. Our forward projections assume roughly 20 percent compounded annual top-line growth over the next 4-5 years even if Nigerian revenue finishes 2027 below 2023 levels (unlikely). CAB has no debt and should generate substantial excess capital over the coming years. Admittedly, it will take time for investors to regain trust/confidence in CAB following last year's earnings guidance fiasco. But at roughly 6-7x forward earnings, shares look materially undervalued even if the company only grows at the same underlying rate as other specialist payment providers. Frankly, we have seen far worse growth stories than this command valuations of at least twice CAB's current multiple.
In closing, we would again reiterate that it is more challenging to reconcile a possibly higher-for-longer interest rate environment with elevated valuation levels and bullish investor sentiment. Of course, we nor anyone can accurately forecast whether any meaningful correction occurs during 2024 (or 2025 or 2026 or ...) As we tried to articulate, we see considerable value in the multiple names described above and we believe that several can drive significant returns in the years ahead. Admittedly, there is a fine line between maintaining conviction versus remaining intellectually honest when reality fails to match one's seemingly well-crafted investment theses. As we have noted in past letters, we are committed to changing course if new data points contradict our existing thesis. That said, we will continue to maintain and add to positions where we believe the risk/reward remains firmly in our favor.
Thanks for your support.
Patrick
Contact information
Patrick Brennan, CFA
Brennan Asset Management, LLC
(707) 666-0296 | [email protected]
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1 Price earnings ratio is based on average inflation-adjusted earnings from the previous 10 years, known as the Cyclically Adjusted PE Ratio (CAPE Ratio)
2 MREL (Minimum Requirement for Own Funds and Eligible Liabilities) is a regulatory requirement imposed on banks and financial institutions under the European Union's Bank Recovery and Resolution Directive (BRRD). The main purpose of MREL is to ensure that banks have sufficient loss-absorbing capacity to support their critical functions and avoid taxpayer-funded bailouts in the event of financial distress.
3 We own CHTR shares through Liberty Broadband (LBRDA), which trades at over a 20 percent discount to the underlying CHTR shares that LBRDA owns.
