Income Strategy 4Q 2020 Letter

The Miller Income Strategy ended 2020 on a stronger note than we began the year, generating a 19.17% net return in the fourth quarter versus 6.48% for the unmanaged benchmark. Since inception, our goal has been to provide a high level of income through a portfolio that would perform better than more traditional fixed income strategies in a procyclical environment, as the world tends to grow most of the time. Our modus operandi has been to search for and own yield that the market is likely to pay more for in the future than it does today. It is from this perspective that we explore the thought process behind one of our more recent and unique purchases – MicroStrategy’s 0.75% convertible bond.

MicroStrategy’s core business, historically, has been data analytics and collaboration software; it is among the largest such companies ranked by revenue. It caught our attention last year after announcing an accelerated share repurchase in conjunction with a strategic shift in the core product. Further research would reveal minimal analyst coverage and a CEO that owns over a quarter of the company, both things we love to see. In addition, Michael Saylor is among the longest-tenured CEOs of all publicly traded companies, and he is the only sitting CEO we can find that has thrived after presiding over a 99.86% decline in his company’s equity price. He has clearly demonstrated a unique ability to catch an emerging, scalable trend early and build an enduring business around it while also retaining a substantial economic stake despite ups and downs along the way. We became especially interested when he announced that MicroStrategy would put all its cash into a technology we have long supported: Bitcoin, a topic which merits further discussion on its own from an investment perspective (link to “The Value Investor’s Case for…Bitcoin?!”).

First, what is Bitcoin? Bitcoin is a decentralized network of value storage. Its core technological breakthrough lies in users’ ability to transfer value to other network participants without any central administrator or authority. This means that users can shift large quantities of value to each other around the globe almost instantly, 24 hours/day, 365 days/year, using only another participant’s “public key” and little administrative hassle. “Miners” verify transactions in exchange for new coins, though the reward for each mined “block” decreases every 210,000 blocks, or approximately every four years. Unlike the dominant systems of account now in use (currencies), the supply of measuring units is predetermined and will never exceed 21,000,000. While aggregate participation in the network is effectively unlimited, there will never be more than 21 million spots (“bitcoins”) on the ledger, which means that more network participation makes each spot on the ledger more valuable. Each bitcoin is divisible into 100 million units, or “satoshis,” and one satoshi is worth ~$0.0004 as of this writing. At a price of $1,000,000 per bitcoin, a satoshi would equal one cent.

Now that we know what Bitcoin is, why might someone want to own some? The short answer is that there is no other asset that combines Bitcoin’s liquidity with its upside potential. Bitcoin is still an emerging and under-owned technology in an enormous addressable market, and it has a brilliant, logically consistent protocol with distributed governance. Data from the World Bank, IMF and OECD imply that the total amount of broad money in the world at the end of 2020 was north of $130 trillion. At a market capitalization of $700 billion, Bitcoin represents approximately half of one percent of all the accounting systems in the world, despite some clear advantages over them. Between the end of 2019 and October of 2020, the globe’s stock of broad money grew at a 20% annualized rate. In comparison, the supply of Bitcoin grew by 2.5% in 2020. In other words, Bitcoin’s total market capitalization today equates to just half of the global money printed during an average two-week period in 2020. Its supply isknown and will not change due to new constituencies, policymaking errors or unanticipated consequences. No one will threaten to temporarily shut down owners’ access to Bitcoin because of a pandemic. It is harder to steal than other stores of value, and it changes hands much more easily. There is more information and transparency around Bitcoin than there has been around any currency in the history of the world, and buyers know what they are getting.

Perhaps most importantly, Bitcoin has been the best performing asset over eight of the past ten calendar years, and its annualized performance has blown away the next-best performer, the Nasdaq, by a factor of ten over the past decade. Not owning any Bitcoin has been a massive mistake, and we expect that will continue to be true. A long-term candlestick chart shows progressively higher lows despite significant volatility, clearly representing growing demand from long-term holders willing to tolerate the swings. There is a twelve-year track record of demand growing consistently faster than supply, and failing to own any Bitcoin at this point implies a belief that there will be a reversal in a long-prevailing and increasingly powerful trend. Almost every long-term holder of Bitcoin has earned a higher rate of return in Bitcoin than in anything else, and those who understand it see little reason to put their excess marginal liquidity into other assets at this point. The world is ruled by fat-tail events, or seemingly improbable occurrences that have an outsized impact, and all indicators so far point to Bitcoin being one. Preferred mediums of exchange tend to move in long cycles, and we may be in the midst of a major global transition that continues to go largely unnoticed.

Bitcoin is not without its doubters, and any serious investor must consider the opposite perspective and weigh its merits. We have thought through some of the common objections, which follow:

  1. “It’s a Ponzi Scheme.” This is easiest to address, because it demonstrates a lack of understanding of both Bitcoin and Ponzi schemes. Bitcoin is quite the opposite of a Ponzi scheme, which involves a central criminal extracting value from current investors using new investors’ money to fund redemptions while falsifying stated returns. There is no middleman in Bitcoin – only a network of users governed by an established protocol. Indeed, the value of the network grows with its aggregate usage, but users share in the value growth as new users adopt the technology. The market’s deep liquidity and supporting infrastructure leave no doubt that the price and stated returns of Bitcoin are as real as it gets.
  2. “It Produces Nothing and Therefore Has No Intrinsic Value.” What it “produces” is the ability to store and transmit value according to a logical, predetermined algorithm and decentralized governance. The value of any asset that pays no dividends, like Berkshire Hathaway stock or the US dollar, is what buyers and sellers collectively believe it is worth. At Bitcoin’s current market capitalization of $700 billion, buyers and owners believe it is more valuable than all but six companies in the S&P 500 (all of which are tech companies).
  3. “Some Other Coin or Technology Will Replace It.” Unlikely at this point. A look at the history of new technological standards would show many instances in which the winner is not always the most robust technology but the one that is early and robust enough. Bitcoin’s market cap is over 5x Ethereum’s, and while Ethereum may be a survivor, there are ways to mimic its functional benefits with Bitcoin.
  4. “It’s Too Volatile to Be a Store of Value or Medium of Exchange.” Indeed, as we flagged earlier, it has done much better than simply “store” value. When Bitcoin’s volatility approaches that of Treasuries, its market cap and price per bitcoin will be immensely higher and leave little room for excess return. At that point, one could imagine Bitcoin transitioning to become a more commonly used medium of exchange.
  5. “If It Actually Works, Regulators Will Ban It.” It has worked for twelve years with little regulatory interference under multiple administrations. In fact, the regulatory outlook for Bitcoin in the US has never been brighter, which may explain why so many institutions are now getting involved. In 2014, a senior member of the Federal Reserve Bank of Saint Louis studied Bitcoin and concluded that, “enforcing an outright ban is close to impossible…well-run central banks should welcome the emerging competition.” The Office of the Comptroller of the Currency, which is a branch of the United States Treasury Department, has said that chartered banks can now custody cryptocurrency and use blockchain technology to settle transactions. The US government collects capital gains taxes on Bitcoin and has auctioned over $6.5 billion dollars at current market value to the public. It would be an abuse of power to sell property of that much value to a government’s constituents, collect taxes on it and then ban it. The new head of the SEC, Gary Gensler, is a Bitcoin fan. While we believe the next decade will see adoption grow at a much faster rate than it did during Bitcoin’s first decade, it is unlikely that Bitcoin will work so quickly that it becomes disruptive to long-standing reserve currencies, and to the extent it does, it will be worth a lot more.

After reviewing the investment case for Bitcoin, it is time to review the MicroStrategy convertible security we own. It is the only debt the company has, and the amount of the issue is $650M, which is approximately half of what we think the core business is worth. So, when MicroStrategy issued the bond at par, in our assessment there was very little downside and an almost-free call option on Bitcoin. MicroStrategy now owns more Bitcoin than any operating company, which imbues some scarcity value above and beyond the value of the core business and the coins it holds. We have not fully considered MicroStrategy’s new optionality between its direct data feed into the world’s largest companies and its massive stash of Bitcoin, but it is likely that Michael Saylor has.

There are probably not many other income strategies buying convertible securities tied to Bitcoin, so we figured it would be worth highlighting our thinking on this unique opportunity, as it demonstrates what differentiates our investment process from others’. As always, we remain the largest investors in the Strategy and welcome any questions or comments.

Bill Miller IV, CFA, CMT

Strategy Highlights by Tyler Grason, CFA

Top Contributors

  • OneMain Holdings (OMF) was the top contributor over the quarter, advancing 56.0% after reporting Q3 Earnings Per Share (EPS) of $2.19, well above consensus of $1.26 and the quarterly dividend, which was increased 36% to $0.45/share (3.5% annualized yield and 11.5% Trailing Twelve Month (TTM) yield). Net interest income of $836M beat estimates of $778M, implying a 24.3% asset yield and 18.7% net interest margin. Origination volumes increased 41% sequentially to $2.9Bn on continued strength in digital while end-of-period net receivables were flat at $17.8Bn. Credit quality remains excellent with net charge-offs of 5.2%, the lowest level since 3Q 2015. Management guided to year-end receivables of $18.1Bn, net charge-offs of 5.6% (from 5.8%-6.0%), and net leverage of 4.3x-4.5x.
  • Bed Bath & Beyond 5.165% unsecured bond due 2044 rose 17.8% during the period following strong earnings, additional non-core asset sale announcements, and their investor day highlighting management’s three-year strategic plan. The company reported fiscal Q2 results with free cash flow (FCF) of $506M (+364% Year-over-Year (Y/Y)), revenue of $2.688Bn (-1% Y/Y), and Earnings Before Income, Taxes, Depreciation and Amortization (EBITDA) of $199M (+35% Y/Y). Comp sales of +6% was the first quarter of positive comp growth since 4Q 2016, driven by 90% growth in digital channels and partially offset by a 12% decline in-store. Gross debt fell by 30% to $1.195Bn following the $236M paydown on the revolving credit facility and repurchase of $300M senior notes via tender offer. Bed Bath exited the quarter with liquidity of $2.2Bn (2x gross debt), comprised of $1.5Bn of cash and $700M available on their asset-based revolving credit facility, implying a net cash position of $300M. Subsequent to earnings, Bed Bath announced agreements to sell four non-core assets during the quarter, including Christmas Tree Shops, Linen Holdings, Cost Plus, and a distribution center for aggregate proceeds of $250M+. Including the Q3 sale of PMall for $245M, the announcement brings total recent divestitures to north of $500M, above the high-end of management’s prior guidance of $350M-$450M. Investor day financial targets include 2021 EBITDA of $500M, gross margins of 35%, and total leverage sub-3.5x and moving to EBITDA of $850M-$1Bn, gross margins of 38%+, and total leverage sub-3x by 2023. Management expects to generate cumulative FCF of $500M-$1.0Bn over the next three years.
  • Diebold Nixdorf 8.5% unsecured bond due 2024 rose 13.2% during the quarter after reporting Q3 revenue of $995M, above consensus of $946M by 5%. Gross margins expanded 310bps Y/Y to 28.6% on continued execution in DN Now initiatives and higher quality revenue. EBITDA of $113M topped the street by 15% and grew 15% Y/Y. FCF use of ($19M) was in-line with management’s expectations but down Y/Y on net working capital. The company exited the quarter with total liquidity of $434M and net leverage of 4.7x. Management tightened 2020 guidance to the high-end of the prior range and sees total revenue of $3.85Bn (+1% at the midpoint), EBITDA of $440M (+5% at the midpoint), and FCF of $30M (+20% at the midpoint and implies Q4 FCF of $180M+).

Top Detractors

  • GEO Group (GEO) was the top detractor over the quarter, falling 19.4%. The company reported Q3 revenue of $579.1M (-1% Quarter-over-Quarter (Q/Q)), net operating income of $151.4M (+2% Q/Q), and Earnings Before Income, Taxes, Depreciation, Amortization, and Restructuring (EBITDAR) of $112.1M (-1% Q/Q). Adjusted funds from operations (AFFO) of $0.67 drove 2.0x coverage on the quarterly dividend of $0.34/share (15.4% annualized yield). GEO exited the quarter with cash of $54M and net debt of $2.6Bn, which on TTM EBITDAR of $448.8M implies net leverage of 5.8x. Management lifted Fiscal Year (FY) 20 guidance across the board, including revenue +0.3% to $4.347Bn, Net Operating Income (NOI) +3% to $609M, EBITDAR +4.4% to $429M, and AFFO +5.6% to $2.44/share (28% FCF yield). Additionally, GEO maintained guidance for $100M of debt paydown in 2020 and a minimum of $50M each year moving forward, which coupled with savings from the previously announced reduced dividend will be applied towards debt reduction.
  • GTT Communications 7.875% unsecured bond due 2024 declined 33.5% during the period. The company announced a definitive agreement with I Squared Capital to sell its infrastructure division for $2.15Bn, including an upfront cash payment of $2.02Bn and deferred payments of up to $130M. While a positive for the capital structure, the on-going accounting review related to the Cost of Telecommunications Services from 2017-2019 has resulted in three forbearance extensions and the inability to file Q2 and Q3 financials. In an effort to bridge the liquidity gap until the company completes the sale of its infrastructure business, GTT entered into a definitive agreement from existing lenders and noteholders to provide the company with a $275M delayed-draw term loan facility. The agreement includes an initial draw of $100M and will mature on the earlier of the consummation of the sale or year-end 2021.
  • NGL Energy Partners (NGL) dropped 37.0% over the period, though its small weight in the fund meant only 12 basis points (bps) of value detraction. NGL reported EBITDA of $138M, missing consensus of $142 by 3% driven by lower than expected crude and water volumes. Distributable cash flow of $73M beat analyst estimates of $69M and provided 5.5x coverage on the reduced quarterly dividend of $0.10/share (13.6% annualized yield). Since July 1st, NGL has retired $75M of unsecured notes, bringing Year-to-Date (YTD) repurchases to $125M. Management remains fully committed to deleveraging and noted a Joint Venture (JV) for the Water business is likely by year-end. NGL exited the quarter with $3.3Bn in total debt, $122M of liquidity, leverage of 5.3x, and remains in full compliance with all debt covenants.