Income Strategy 1Q 2019 Letter

In the first quarter of 2019, the Income Strategy returned 10.59% (net of fees), outperforming the 7.40% return of its unmanaged benchmark, the ICE BofA Merrill Lynch High Yield Index. The first quarter marked a broad rebound across equities, credit and commodities markets in conjunction with a change in tune from US monetary policy-makers. In the fourth-quarter letter, we discussed how commentary from Federal Reserve Chair Jerome Powell appeared to spook markets into thinking the Fed might tighten beyond the “neutral” rate of interest (the rate that promotes full employment without stoking inflation). This encouraged investors to bid up perceived safety while selling assets that are unlikely to perform well in a deflationary environment. The first quarter of 2019 was markedly different than its predecessor, as Chairman Powell’s January 4th comments implied much more receptivity to the market’s messaging than prior remarks. We have spilled a lot of ink discussing the Fed in the current environment, and we have also pointed out that the portfolio tends to perform better when rates are moving up than down. The first quarter of 2019 bucked that trend, as the Strategy advanced despite the 10-year Treasury rate continuing its downward trajectory from 2.68% at the turn of the year to 2.41% at the end of the quarter. We do not position the portfolio with an explicit rate view in mind; instead, we position it from the perspective that the economy is likely to grow over the long term and that policy-makers have the capabilities to meet their stated goals; simply avoiding a significant monetary policy error should enable our ideas to work. Rather than spend more time focusing on topics beyond our control, we would like to use the balance of this letter to focus on what is in our control — the securities in the portfolio. The three most significant new holdings are Diebold Nixdorf 8.5% unsecured bonds, CenturyLink’s 7.6% unsecured bonds of 2039 and British American Tobacco (BATS) stock.

The portfolio’s largest new holding is the debt of Diebold Nixdorf, which makes automated teller machines (ATMs), connected commerce software and point-of-sale systems, once known as “cash registers.” Diebold issued the debt in 2016 to help finance its acquisition of Wincor Nixdorf, for which a prior management team overpaid. Since the initial attempt at integrating the acquisition, the Board has cleaned house and brought in a new group that appears to have the situation under control. The new management team recently increased guidance for its cost savings program and is aggressively paying down debt while looking to boost cash returns on capital. In addition to already having aligned equity incentives with shareholders, various management members added approximately $1M to their personal stakes in the first quarter with meaningful open market purchases of the stock. Various members of management would presumably not be committing personal capital to a more junior security than our debt unless they had a high degree of confidence that the debt was money-good. At our purchase price, the yield to worst would be north of 11%, though we think we could do better than this depending on the pace of debt paydown and the market’s reaction to it.

Changes in capital allocation priorities can represent a meaningful inflection point for the future trajectory of a security’s price. One company already in the portfolio announced such a change this quarter. CenturyLink reduced the dividend to use a greater portion of free cash flow to pay down debt. There are few better uses of cash for a leveraged secular shrinker than debt paydown; otherwise, math dictates that the equity value gets squeezed at a greater absolute rate than the cash flow shrinks, while the debt load consumes a greater share of the value generated. With the dividend reduction, the company announced that it would accelerate its timing for debt paydown. If they execute their plan, we think multiple parts of the capital structure could represent interesting values at today’s prices. The equity now trades at the lowest cash flow multiple of any major telecommunications firm, Jeff Storey has a record of creating shareholder value, and he now has the retained cash flow to allocate accordingly. A de-levered CenturyLink may also generate value for long-dated bondholders, which is why we own the 7.6% bonds due 2039 — while not a perfect comparison, look no further than the 2039 Verizon 7.35% unsecured bonds, which are levered similarly to CenturyLink’s targets; these Verizon bonds trade at a nearly 50% price premium to where we started buying our CenturyLink bonds.

Not all secularly challenged businesses are the same, as their economic profiles can be vastly different. While telecomm is a capital-intensive business, cigarette production is not. Between the summer of 2017 and January of 2019, the price of British American Tobacco shares fell by almost 60%, which is remarkable for a company whose fundamentals are quite steady. Any company whose stock price exhibits significantly more volatility than its fundamentals is worth a closer look. A quick perusal of analyst notes shows there is no shortage of scapegoats here — a potential ban on menthol cigarettes in the US, declining cigarette shipments globally, increasingly hostile regulators and BREXIT all play a part — but we think the fundamentals are much better than today’s valuation implies. Investors can now pay less than 10x free cash flow, which represents a compelling price for a company with massive returns on capital and growing cash flows. The dividend yield on the stock is now 6.5%, and the company has guided to high-single-digit earnings per share growth while also paying down debt. If the company hits its goals and the stock does not trade to a new all-time-low valuation, investors are likely to do very well, we think, especially in a market craving visibility.

The aforementioned ideas represent only a portion of the opportunities we are finding in today’s market. We continue to source attractively priced securities and ways to improve the portfolio. We remain the largest investors in the strategy and, as always, welcome any questions or comments.

Bill Miller IV, CFA

Strategy Highlights by Tyler Grason

Top Contributors

  • NGL Energy Partners (NGL) was the top contributor over the period, advancing 51.37%. The company reported strong quarterly results where Earnings before Income, Tax, Depreciation and Amortization (EBITDA) of $132.6M came in 5.4% above consensus of $125.8M, driven by better-than-expected results in the Crude, Liquid, and Water segments. Distributable Cash Flow of $84.9M provided dividend coverage of 1.75x and drove a $0.39/share dividend (11.1% annualized yield). Management reaffirmed Fiscal Year (FY) 2019 EBITDA guidance of $450M and announced plans to repurchase up to $150M of its shares.
  • Alternative Asset Managers Carlyle Group (CG) and Apollo Global Management (APO) were both top contributors, rising 18.77% and 17.31%, respectively, over the quarter and in conjunction with the broad equity market.Carlyle reported distributable earnings of $0.57, well ahead of consensus of $0.36, driving a $0.43/share dividend (9.1% annualized yield). Fee-paying assets under management (AUM) rose 8% sequentially to $160B while deployment activity and fundraising both remained strong at $11.5B and $7.1B, respectively. Management guided to $400M in 2019 fee-related earnings with margins of ~25%.

    Apollo reported strong distributable earnings of $0.61, driving a dividend of $0.56/share (7.8% annualized yield). Fee-related earnings of $0.62 was up 30% sequentially, while capital deployment of $6B helped drive strong transaction fees. Capital raising and realization activity remained robust with $21.6B of gross inflows, with permanent capital reaching $136B, representing 48.5% of AUM and 42% of fee-related revenues on a trailing-twelve-month basis.

Top Detractors

  • Tupperware Brands Corp. (TUP) fell 18.14%, but due to the Fund’s exit of the position in the quarter, the name detracted 14.75%. The company reported Q4 earnings per share that was in-line at $1.33, while net sales fell -7% on a local currency basis (versus guidance of -2% to flat) and -14% on a reported basis. The company cut its quarterly dividend 60% to $0.27/share (4.1% annualized yield) and the $80M in annual savings will be used to fund accelerated investment of $100M in the company’s Global Growth Strategy Initiative. Upon completion, the program is expected to enable annual sales growth in the mid-single digits with $50M in annualized savings. Lastly, management provided initial FY19 earnings per share guidance of $4.06-$4.21, or -7% below consensus at the midpoint, as well as -2% to flat local currency sales growth and -4% to -2% net sales decline.
  • CenturyLink Inc. (CTL) fell 19.25% during the period. The company reported in-line Q4 results with revenues and EBITDA of $5.8B and $2.3B, respectively, while Free Cash Flow (FCF) came in 23% above consensus at $1.2B. The company, however, cut their dividend 54% to $0.25/share (7.9% annualized yield). Management noted the cut was not due to a change in the underlying business outlook, but rather due to the belief that a more moderate capital return combined with accelerated deleveraging (target of 2.75x-3.25x) is the best way to create long-term shareholder value. Management guided to FY19 EBITDA of $9.0-$9.2B, FCF of $3.1-$3.4B, and capital expenditure (capex) of $3.5-$3.8B.
  • Greenhill & Co (GHL) fell 11.65% over the quarter after reporting Q4 earnings per share of $0.45, falling short of estimates of $0.51, driven by weaker-than-expected advisory fees of $88M versus expectations of $91M. Management announced the completion of 89% of its share buyback plan and remains optimistic on the strength of the Mergers & Acquisitions cycle and strong restructuring trends.