Income Strategy 2Q 2018 Letter

In the second quarter of 2018, the Income Strategy returned 11.89% (net of fees)1, marking our fifth best quarter since launching in April 2009. Remarkably, 40 of our 46 positions made money during the quarter. It is tempting to take credit for the performance when everything is working. However, the recent performance is a mirror image of what happened two years ago. Between the end of the second quarter of 2015 and the market bottom on February 11, 2016, 63 out of 71 positions lost money. At the time, we opined that the market was not acting rationally. While we consistently evaluate our process through changing market conditions to help improve risk-adjusted returns, it is also important to appreciate the randomness in capital markets and to not get too excited or despondent about what happens in any one quarter, as our goal is to generate compelling risk-adjusted returns over the long term. With that said, this letter will review some of our holdings to help investors better understand our process.

One of the most dog-eared chapters in our playbook is titled, “When the Market Capitalizes Temporary Dislocations as Permanent.” Our top performer last quarter, National Cinemedia, epitomizes this idea. National Cinemedia operates the largest movie advertising network in the US with a dominant 69% market share in the top 10 cities. Companies pay National Cinemedia for the right to put advertisements on the big screen prior to the movie; it is a cash-generative, capital-light business. The stock first caught our eye in May 2017 after plummeting on the heels of reduced guidance, which management attributed to an unusually weak movie slate and resulting soft demand from advertisers. The stock then took another leg down when the company slashed the dividend to free up funds for reinvestment into new digital functionality. At our average cost in the mid-$6 range, we were buying the market leader in a usually steady business at a 13% free cash flow yield on depressed numbers. While movie popularity and attendance is unpredictable from quarter to quarter, longer-term attendance numbers are much more stable. We believe it is a matter of when, not if, the numbers rebound. The stock traded in a range from the low-teens to the high-teens for years, despite a similar asset base and little change in the trajectory for movie demand over the long term, and we think fair value is much closer to its historical range than where it trades today, despite the strong performance last quarter.

Another new addition whose valuation we find too pessimistic on temporary dislocations is Tupperware. The direct-selling company, known for its durable kitchen containers and utensils, trades near a six-year low, down almost 60% from its peak. “Outlook and trend” investors, who largely focus on current news and the stock’s recent performance when assessing its potential, have a plethora of concerns – the dollar’s strength, a trade war (90% of sales are outside the US), production dislocations and a management transition, just to name a few. We think much of these concerns are too heavily reflected in Tupperware’s enterprise value at just 6.5x this year’s consensus EBITDA estimate. If estimates are reasonable, embedded expectations for Tupperware’s prospects were lower only in the 2009 financial crisis, when few valuations made sense. This is a great business priced like a lousy business, even though the company consistently generated returns on capital north of 20% prior to the recent setbacks. Management agrees that shares are undervalued, as they are incurring additional debt to opportunistically repurchase $200M worth of stock, or almost 10% of the company. In addition, insiders have bought over a half-million dollars worth of stock near current levels. There’s no assurance Tupperware is putting in a bottom near $40/share, but we think the risk-reward skew is favorable at this price.

While we could produce many more pages about why we bought or sold various securities during the quarter, our goal is to maximize readers’ ROIT – return on invested time, which is the scarcest resource anyone has. We hope this letter continues to provide shareholders with a better understanding of our process. We remain the largest individual shareholders in the Strategy, and we welcome any questions or comments.

Bill Miller IV, CFA

Strategy Highlights by Tyler Grason

Top Contributors

  • National CineMedia (NCMI) was the top contributor during the quarter, rising 65.65% after posting strong Q1 EPS of $(0.03) and revenues of $80.2M, both surpassing analyst estimates of $(0.05) and $74.7M, respectively, while maintaining their $0.17/share dividend (8.1% annualized yield). Strong scatter market demand, growth in their National segment, and solid box office numbers fueled better-than-expected performance. Management reaffirmed 2018 guidance, projecting revenues of $425M-$445M (flat to +4.5%) and adjusted OIBDA of $200M-$215M (-2.5% to +4.8%). Further, the stock benefited from news that Cineworld Group (CINE LN) and Cinemark Holdings (CNK) have agreed to acquire the remaining 21.5M shares of NCMI currently owned by AMC Entertainment (AMC) at a price of $7.30. The deal removes a significant sale overhang which had the potential to remain in place until June 2019 and shows support for the long-term confidence in the cinema advertising business model.
  • Greenhill & Co (GHL) rose 53.80% over the quarter as the company soared after posting Q1 revenues of $87.5M and EPS of $0.21, handily surpassing consensus estimates of $62.9M and $(0.03), respectively. A better-than-expected deal-making environment drove the outperformance.
  • Seaspan Corp. (SSW) was up 55.10% over the period. The company reported Q1 EPS of $0.13, missing estimates of $0.17, but covering the dividend of $0.125/share (5.0% annualized yield). Higher one-off interest expenses relating to the GCI acquisition detracted from performance. Moving forward, management will focus on more effective capital allocation decisions, mainly in the form of reducing debt to less than 4x EBITDA, and taking a look at potentially reallocating the dividend to buybacks. Further, the company announced an additional investment of $500M from Fairfax Financial Holdings (FRFHF), who will exercise 77M warrants and provide Seaspan with capital to pay down debt and some high cost preferreds, as well as give management the option to grow their fleet. In lieu of the early exercise, Seaspan will issue warrants that will exercise for 25M shares at $8.05 and a term of seven years.

Top Detractors

  • BGC Partners (BGCP) declined 10.96% during the quarter. While the company reported Q1 EPS of $0.32 and revenues of $956.6, both beating consensus estimates of $0.31 and $933.7M, respectively, an overhang remains regarding the uncertainty and timing of their tax-free spin-off of Newmark Group.
  • Tupperware Brands Corp (TUP) decreased 4.97% for Q2. The company reported Q1 EPS of $0.91, ahead of consensus of $0.89, but the company lowered FY18 guidance, including sales growth of -2% to flat (previously flat to +2%), adjusted pre-tax margin of 15.3%-15.5% (previously 15.5%-15.7%), and adjusted EPS of $4.52-$4.67 (previously $5.09-$5.24). Management did, however, announce a repurchase program of $200M of shares (approximately 10% of outstanding shares) and raised FCF guidance to $180M-$190M (8.6% FCF yield)
  • SunCoke Energy Partners LP (SXCP) fell -13.55% over the quarter after reporting Q1 EPS of $0.26, missing estimates of $0.31, but beat on revenues of $214.8M versus consensus of $205.7M. The company cut their dividend -32.3% to $0.40/share (10.3% annualized yield), which will enable SunCoke to replenish cash and reduce debt so they can achieve their 3.5x target leverage ratio.

Read our 2Q 2018 Market Highlights for a recap on what drove market performance.