July 20, 2017

Out of Jail and Into Malls

Income Strategy 2Q 2017 Commentary

The second quarter was a good one for our Income Strategy, as we outperformed the primary benchmark, the BofA Merrill Lynch High Yield Master II Index, for the fourth consecutive quarter. The Strategy also declared and paid a $0.15 dividend, implying a 7.2% annualized current yield. Compare this to the high-yield index, which ended the quarter with a 5.7% yield-to-worst, representing the fifth percentile of yield going back to 1994. Put differently, the diversified high-yield market has been less expensive on an absolute basis approximately 95% of the time over the past 23 years. This is partially why the majority of the Strategy remains in equities, which look to be a far better value proposition for the long-term investor. One advantage of running a flexible, concentrated strategy is that we can wait for what Warren Buffett has called “fat pitches.” We ended the second quarter with only 44 individual positions. Five of those positions are in overlapping issuers, so we own securities of just 39 issuers. In the paragraphs below, we will review our thinking around some of the more significant changes in the Strategy in the past quarter.

The most significant change was the liquidation of our largest position, corrections operator GEO Group (GEO). We invested in the company shortly after the previous administration’s Department of Justice announced in August of 2016 that they intended to phase out the use of private prisons, cutting the stock by almost 40% in one day. After reviewing facility contract details in company filings, we determined that the extent of the stock’s move was far too large in relation to what was practical. We thought the cratered stock was an attractive value proposition even if the government did phase out private operators, and while a Trump victory was not our base-case scenario, we thought it could be another way for GEO owners to do even better. After the election and rescission of the phase-out order, the stock rallied to an all-time-high price, which we did not believe would allow us to generate a risk-adjusted return substantially above our benchmark, so we sold the stock. We eliminated several other smaller positions, though this was the most significant sale.

The proceeds of the GEO sale went into a handful of new positions, the most controversial of which are probably our shopping center REITs (real estate investment trusts), Washington Prime Group (WPG) and CBL & Associates (CBL). The ongoing narrative is that Amazon is fundamentally changing the retail business as we know it and killing many traditional retailers in the process, which is true. However, we think the narrative reflected in current prices has outpaced reality. The stocks now trade near a low-teens dividend yield, and the ample free cash flow coverage of the dividends, combined with what we think is the most likely path for the cash flow, means the dividends are likely safe for the foreseeable future. Seasoned management teams run these companies, and this is not the first time consumer preferences have changed. The firms are using the excess cash flow above and beyond the dividends to redevelop their properties, and such investments thus far appear to generate compelling incremental rates of return.

We will continue to stick to our valuation-driven approach to finding undervalued, income-generating securities. As always, we welcome your questions and comments.

Top Contributors

  • Private equity firm Carlyle Group LP (CG) soared in second quarter after reporting Q1 EPS of $1.09, handily surpassing the consensus estimate of $0.38. Performance was strong across segments, helping drive a 34% bump in the firm’s net accrued carry; the market also cheered commentary around accelerating fundraising. Minimal harvesting activity caused the company to declare a dividend of $0.10/unit (2.0% annualized yield).
  • Valeant Pharmaceuticals International Inc. 6.75% 8/21 rose 11.8% over the period. The company reported Q1 adjusted EBITDA of $861M versus analyst estimates of $858.9M. Management also raised FY adjusted EBITDA guidance to $3.60-$3.75B, up from $3.55-$3.70B. The company completed the sale of Dendreon ($819.9M) in June and announced the sale of iNova for $930M. If successfully completed by year end, the company will have paid down ~$5.4B in debt, meeting their goal to pay down $5B by February 2018.
  • Apollo Global Management LLC (APO) continued its climb in the second quarter after reporting 1Q EPS of $0.82, which easily surpassed analyst estimates of $0.64. Management declared a distribution of $0.49/share (7.3% annualized yield), representing the highest distribution in two and a half years.

Top Detractors

  • Frontier Communications Corp. (FTR) common stock and Frontier Communication Corp. 11.125% Preferred were the top two detractors falling 44.0% and 35.9%, respectively. The company declined after reporting Q1 EPS of -$0.11, below analyst estimates of -$0.05. The company also slashed its dividend 62% to $0.04/share (16.0% annualized) and continued to see elevated customer churn. The company launched a seven-year $1.5B term loan to improve liquidity and lower debt costs, but Moody’s still downgraded the firm’s corporate family rating to B2 from B1 based on weak operating results and subscriber losses.
  • Medley Capital (MCC) declined -14.7% during the quarter. The company reported fiscal 2Q adjusted net investment income of $0.17/share versus analyst estimates of $0.20 and cut their dividend -27.3% to $0.16/share (10.1% annualized yield) as credit challenges persisted.

Contact LMM 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.

©2017 Miller Value Partners

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