Finding Value in Debt of Secular Decliners

Income Strategy 4Q 2019 Letter

The Income Strategy ended 2019 on a strong note, returning 9.45% (net of fees) during the fourth quarter versus 2.61% for the unmanaged benchmark, the ICE BofA High Yield Index. It is impossible to pinpoint causation in markets with certainty, but we believe that improving macroeconomic growth prospects, largely due to more accommodative monetary policy in conjunction with improving trade relations, contributed to the results.

In the previous letter titled “Reading Between the Minutes,” we noted that markets had not yet absorbed the significance of a more accommodative Federal Open Market Committee. With the benefit of hindsight, it looks like this view was directionally correct, as the bond market’s expectation for inflation over the next five years bottomed on the day that the the new plan was communicated the new plan, which is probably not a coincidence. At the beginning of October, the bond market expected annualized inflation over the next five years would be 1.25% per year, meaningfully short of the Fed’s own “symmetric” target of 2%; as of this writing in mid-January of 2020, the market now expects inflation over the next five years to be 1.70%, which is closer to the Fed’s goal, but the market remains skeptical that the FOMC will actually allow “symmetry” in realized inflation. We are moderately more optimistic, as we believe that the Fed realizes that achieving their stated goals is likely to provide a better economic outcome for all stakeholders than is a persistent undershoot of a “symmetric” target.

This optimistic outlook may seem at odds with marginal shifts in the portfolio, 38% of which is now in bonds. A cautious stance could not be further from the case. The portfolio shift to a larger bond weight mainly reflects an evolution, and hopefully ongoing improvement, in the portfolio construction process. We believe we may be able to produce comparable returns while reducing some of the downside volatility by owning more bonds that we believe have a “right-tail skew,” meaning that their central tendency of value is hopefully greater than the current price. The weighted yield on our debt holdings is north of 12%, which would probably be a compelling rate of return for equities from this starting point (though there is no guarantee we will realize this rate of return on our bonds). Our bond yield is also over two times the 5.4% yield on our benchmark, which is in the third percentile of yield since 1994. It is from this perspective that we scratch the surface on our thinking about some of our newer fixed income holdings.

Most of our latest bond additions are in challenged businesses. Alliance Resource Partners is one such example; it is the second-largest coal producer in the eastern US. Coal is a dying energy source domestically, steadily losing electricity generation share to renewables and natural gas for more than a decade (however, global installed capacity continues to grow). It is also a cyclical business with heavy capital intensity. However, in this case, there are several mitigating factors that we believe make this bond a compelling portfolio holding. Management and related insiders own over a third of Alliance’s equity, and their stake is worth a half-billion dollars, value they presumably want to preserve. They remain committed to a very conservative balance sheet and have historically not gone too far above 1.0x net debt-to-EBITDA. They are currently running slightly above this level, but they cut the dividend in 2016 to maintain balance sheet flexibility and liquidity, which we think is increasingly likely. Equity value, which represents a perpetual claim on the company’s free cash flow, generally only exists if the bonds are money-good, a probability that we think is underrepresented by the bonds’ current price and high level of implied return.

The recently added GameStop bonds are a similar bet. We have owned the stock in the past and were disappointed by the lack of rigor around the capital allocation framework. Thankfully, these bonds represent an entirely different bet than the stock. At our average cost on these bonds in the mid-high 90s, we could realize a yield north of 8% with very little ostensible risk over the next 14 months, we believe, thanks to a significant pile of cash on the balance sheet and an upcoming next-gen console cycle later this year. Sure, management is guiding to same-store sales declines of 20% or more, but they are also guiding to total cash and liquidity of $900 million at the end of this fiscal year. The bond we own, which is the only debt maturity coming due, is a $421 million issue due in March of 2021.

Not every secularly challenged bond we own is a short-duration bet, but they all have very low leverage relative to the cash flows supporting them. This low level of leverage is why we like the long-dated Bed Bath and Beyond bonds in the low-70s. We think this is a compelling holding because it is priced to yield an equity-like rate of return despite being at the top of the capital structure in a business with a lot of optionality. The new CEO, previously Target’s chief merchandising officer, has a strong reputation and $11 billion of sales to work with. Despite a poor third-quarter report and the removal of guidance, the bond barely budged.

The aforementioned bonds are just a few of our latest additions, but we hope the narrative around them helps you better understand a part of our process. We remain the largest shareholders of the Income Strategy, and we appreciate your support and comments
.
Bill Miller IV, CFA, CMT

Strategy Highlights by Tyler Grason, CFA

Top Contributors

Alternative asset managers Carlyle Group (CG) and Apollo Global Management (APO) were both top contributors, rising 26.93% and 27.62%, respectively, over the quarter and in conjunction with the broad equity market.
- Carlyle reported distributable earnings of $0.41, in-line with consensus on a slight beat in fee-related earnings of $109M, driven by lower compensation expense. Net realized performance revenues of $58M topped street estimates of $54M while fundraising of $5.7B was in-line with estimates, bringing total AUM to $221B. The company declared a $0.31/share quarterly dividend (3.9% annualized yield).
- Apollo Global reported distributable earnings of $0.54, below estimates of $0.61 on fee-related earnings of $213M. Gross realized performance fees of $67M beat by $8M, while net carry receivable improved 25% sequentially to $1.93/share. Fundraising remained robust with $16B of gross inflows, bringing total assets under management to $322.7B, half of which is permanent capital. The company maintained their $0.50/share quarterly dividend (4.0% annualized yield).
Seaspan Corp. rose 35.19% over the quarter in conjunction with solid results. Revenue of $282.7M and EBITDA of $180.0M both beat consensus of $281.6M and $172.2M, respectively. Adjusted earnings per share (EPS) of $0.21 also topped estimates of $0.17 and covered the quarterly dividend of $0.125/share (3.6% annualized yield). Further, management announced the acquisition of APR Energy for $750M, which will be financed with 38.3M new shares and $325M in debt. The deal is expected to close in 1Q20 and be accretive by 2021. In conjunction with the acquisition, Seaspan announced a reorganization into a new holding company, ‘Atlas Corp’, which will own Seaspan and APR; it will also deploy capital in existing and additional verticals with a focus on infrastructure assets.

Top Detractors

Quad Graphics was the top detractor over the quarter, falling 53.97%. The company reported revenue of $944M and earnings before income, taxes, depreciation and amortization (EBITDA) of $80M, both missing consensus of $1.0B and $92M, respectively. Management announced plans to divest their book business as part of the ongoing portfolio optimization and expanded their cost reduction program to $50M in annual savings. The Board elected to cut the dividend by 50% to $0.15/share (11.9% annualized yield), generating $30M in annual savings. Management cut FY19 EBITDA guidance to $300M-$330M (from $360M-$400M) and sees free cash flow of $80M-$100M (from $145M-$185M).
NGL Energy Partners fell 15.54% during the period while reporting EBITDA of $119M, 13% below consensus of $135.9M. Distributable cash flow of $59M also fell short of estimates and drove a distribution of $0.39/share (13.4% annualized yield). Management reaffirmed FY20 EBITDA guidance of $540M-$615M. Multiple insiders, including CEO Michael Krimbill, purchased 150,000 shares at an average cost of $9.98
National CineMedia returned -9.01% over the quarter. The company reported revenue and operating income before depreciation and amortization (OIBDA) of $110M and $52M, both missing consensus of $119M and $58M, respectively driven by weaker national advertising as a result of cancelled campaigns and weaker regional demand. EPS of $0.12 fell short by a penny and missed the quarterly dividend of $0.17/share (8.6% annualized yield). Management lowered FY19 revenue guidance to $435M-$445M (from $450M-$465M) and operating income before depreciation and amortization (OIBDA) to $195M-$205M (from $207M-$217M).

Past performance is no guarantee of future results. For important additional information on Income Strategy performance, please click on the Income Strategy GIPS Composite Disclosure. This additional information applies to such performance for all time periods.

Contact Miller Value Partners to obtain information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to Strategy performance.

Investment Risks: All investments are subject to risk, including possible loss of principal.

The views expressed in this report reflect those of Miller Value Partners portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.