5 key models to identifying opportunities
At Avenir Capital, we think there are 5 broad categories of private equity-style valuation mispricing’s that can be applied methodically to searching for a diversified portfolio of good value investments across a broad variety of industries and geographies.
These categories can be quickly applied to any stock in the initial search phase, thus enabling efficient application of analytical resources to determine intrinsic value. The important thing is that the portfolio starts to blend growth and traditional value characteristics, but with a focus on minimising downside risk (margin of safety).
1.Undervalued Franchise (e.g. Infineon, Wuliangye Yibin)
An Undervalued Franchise is a very high-quality company with a deep and enduring competitive moat and a long runway of growth that is not being fully appreciated, and thus, not fully valued by the market.
Undervalued Franchises often have monopoly or duopoly type characteristics and operate in industries with long-term secular growth. We should be prepared to pay a higher price for Undervalued Franchise companies but should still demand a large mispricing and margin of safety.
Such businesses have highly defendable revenues and margins, thus giving them excellent defensive characteristics.
Undervalued Franchise investments may not drive excessive short term returns in the portfolio but can be the engine room for compounding over time and provide stability and robustness in turbulent
Place in our portfolio: Downside Protection & More Predictable Growth
Stock Case-study: Infineon (ETR: IFX)
Infineon is a power semiconductor manufacturer with a significant electric vehicle opportunity. They dominate various niche categories that are difficult to substitute.
EVs have promised but apart from Tesla, mostly disappointed to date, hurt by poor product variety, high prices, range anxiety and long charging times (and poor charging infrastructure). That short-term disappointment has presented an opportunity to own what we believe is one of the biggest beneficiaries of this transition, Infineon Technologies.
Power semis are a niche sub segment of the broader chip market that has very different market dynamics to the memory and logic chips most think of when they think of semiconductors. The products are less commoditised, end markets tend to be less competitive and prices more stable. Technological barriers to entry are very high and the very different manufacturing process makes the risk of competition, even from other chipmakers, very low.
We believe the conditions are right for the transition to EVs to surprise on the upside – emission standards are becoming increasingly strict in Europe and China, whilst pricing is rapidly becoming more competitive with traditional cars and driving ranges and charging times have improved significantly. Infineon is arguably the dominant manufacturer of the components that control the flow of electrons from the battery to the electric motor and back again. Each EV is potentially USD400 or more of incremental revenue opportunity for Infineon and it’s in products where the reliability and performance trumps price, unlike the commodity materials such as lithium or nickel used in the batteries.
We are also comfortable that should the EV transition happen slower than we might have hoped, Infineon is supported by a broader semiconductor business that benefits from the increasing semiconductor content in cars generally (exclusive of EVs), investment in renewable energy (both wind and solar) and low exposure to fickle, price-sensitive smartphone makers. With the completion of the Cypress acquisition, Infineon is now the largest automotive semiconductor maker globally and more than 40% of revenues comes from automotive applications. Longer-term, Infineon should also benefit from incremental autonomous driving features, which require a significant complement of sensors, computing power and microcontrollers.
Caption: There is almost $800 of semiconductor content in an EV, twice that of a traditional combustion engine car. As autonomous driving features become more common, there’s potentially a doubling again of content.
To conclude, we see Infineon as a leading manufacturer of power semiconductors, a market that in turn has characteristics that make it attractive to long-term investors, such as few substitutes, significant IP barriers to entry, yet low capital requirements – all the characteristics of a franchise business. It has significant growth opportunities from the shift to EVs but is supported today by diverse and stable income streams from existing automotive, industrial and consumer end markets. Recent short-term market concerns around automotive weakness in China and elsewhere has presented an opportunity to own the company at much cheaper multiples than in recent years.
Stock Case-Study: Wuliangye Yibin (SHE: 000858)
Wuliangye is one of China’s premium baijiu (spirit) brands. Wuliangye is a very strong consumer brand in China due to its premium quality and 600+ year history, enabling the company to have strong pricing power and allowing the company to generate very high gross margins of 74% and EBIT margins of 45%. Margins are expanding with today’s 45% EBIT margin up from 35% in 2016. These margins are still below those of the industry leader, Kweichow Moutai, who is delivering gross margins of 90%+ and EBIT margins of 68%, offering upside potential for Wuliangye.
Wuliangye is likely to benefit from significant growth in the premium baijiu consuming population in China, which should drive growth in premium-quality baijiu consumption. Wuliangye is well placed to grow in the ultra-premium baijiu segment as its flagship product is more affordable than Moutai, its chief competitor.
Wuliangye is a Chinese majority state-owned operation (SOE) and is benefitting from SOE reforms that took place in 2017. These included issuing equity to employees, distributors and domestic investors. The increased alignment of interest has already provided a boost to performance as the company has worked to drive through material price increases and flatten distribution by doubling its sales and marketing team and encouraging distributors to sell directly to end-users.
The SOE reforms provided an inflection point for the company which has shown improved financial performance since then. Earnings growth is accelerating with EBIT increasing over the past ten years at roughly 20% per annum, over the past five years at 26% per annum, and over the past three years at 41% per annum. The company earns a return on invested capital (ROIC) of roughly 150% and ROE of 35%.
Wuliangye is an incredibly strong consumer franchise with almost unmatched history and brand power providing a strong economic moat. The company is delivering improved operating performance in a secularly growing market and Wuliangye has the potential to compound its intrinsic value at an attractive rate for many years.
2. Public LBO (Leveraged Buyout)
We define a public LBO (leveraged buyout) as a company with debt or leverage levels higher than normal for a public company.
Typically, the leverage would be greater than 3.0x net debt to EBITDA. Companies in this category need to be competitively advantaged and of very high quality and able to support elevated debt levels in a safe manner. This means, generally, having few competitors, stable end demand, high quality management, limited customer or supplier concentration, high returns on invested capital and the ability to reduce debt through internally generated cash flow.
The company should be able to pay down at least 10% of net debt per year through internally generated cash flow and the Interest Coverage Ratio (EBITDA less capex / Interest) should be greater than 3.0x.
Other risk management features often present include separable business units that can be sold, if necessary, to generate cash to pay down debt, no elevated capex requirements in the near term and low operating leverage.
Most companies are not able to support Public LBO style elevated debt levels in a prudent manner and so companies that qualify to be Public LBOs are a rare breed.
This type of investment is very much like a private equity investment in the public market, it is a return enhancer and demands a long-term and patient holding period.
Place in our Portfolio: Return Enhancer
Stock Case-Study: Charter Communications (‘Spectrum’ brand) (NASDAQ: CHTR)
Charter is the second largest cable company in the U.S. providing 27 million households (out of the 50 million households ‘passed’) with broadband internet, television and telephone services. Charter is a toll-road on the internet highway and is the major broadband provider in most of the regions in which it operates giving the company a monopoly-like structure and ability to raise prices on average 5% per annum.
Charter has a material debt load which, we think, is appropriate for a company with recurring revenue streams and we view Charter as a ‘public LBO’. Charter has an effective duopoly with the largest cable business, Comcast, although the negligible footprint overlaps between the two means that they rarely compete directly.
Charter is often classified as a television company, yet it should really be considered a broadband business. We estimate broadband makes +50% EBITDA margins compared to the 30% margin for the whole business. Television is less profitable due to high programming fees that have grown from 28% of cable TV revenues 20 years ago to almost 65% in 2017 with content providers demanding more of the pie every year.
The company was trading cheaply due to negative views on the recent trend of ‘cord cutting’ whereby customers end their cable TV contract and rely on streaming content over the internet. However, in the US, television and internet travel over the same cord and this ‘television cutting’ can be advantageous to Charter. The company not only makes more money on internet-only packages, due to not having to pay the rising programming fees, customers also use twice as much internet data when they cancel their television package.
Charter provides cable broadband to residential customers which far exceeds the speed and data capacity available from other technologies. Charter has an attractive industry structure in which it is generally able to provide the fastest broadband in the markets in which it operates. While a consumer signing up to the likes of Netflix, Hulu, HBO, Amazon Prime, or the numerous new and soon to be new streaming services available including Disney, Apple and CBS Now, may mean one less cable TV customer, it means a broadband customer that will generally use 2-3x more data than non-streaming customers. The best place to get that high data requirement is via Charter’s broadband cable connection with 80% of the customers in Charter’s footprint subscribing to 100Mbps or more of internet speed.
In addition, if a customer ‘cuts the cord’ and no longer wants Charter’s cable TV offering, Charter no longer needs to pay ever-increasing content costs to serve that customer. There are no content costs involved in the provision of broadband connectivity generally making this product more profitable for Charter than a stand-alone cable TV customer. Nearly 40% of Charter’s customers only subscribe to internet, up from 28% four years ago (June 2015), and we expect this trend to continue which should increase margins over time. The development of 5G mobile wireless technology, however, is a potential future risk.
We expect capital expenditure to taper from 20% of revenue to closer to 15% as digital and cloud technology require less maintenance in the future. The increased free cash flow will be used to buy back shares at an aggressive rate. Over the past few years, Charter has bought back $13 billion worth of shares, reducing share count by 12%. Ongoing buybacks can help drive a +20% per annum growth in free cash flow per share over the next several years. Assuming the company continues to trade on the current 5% free cash flow yield, we estimate, Charter could be worth $575 per share, almost 100% above the current price, in three years’ time.
Charter is also controlled by a major shareholder, board and management team that in our view understand effective capital allocation and the need to drive shareholder returns. The company takes advantage of its highly recurring revenue base to utilise a leveraged capital structure that ensures little to no tax is paid and maximises cash flow that can be used to buy back shares, generally driving free cash flow per share higher. We estimate, Charter’s free cash flow could exceed $50 per share in several years which, at a 5% free cash flow yield, implies a share price of over $1,000 per share.
3. Cashflow Cannibal
A Cashflow Cannibal is a company that is buying back its own shares in an aggressive manner. Typically, to qualify as a Cash Flow Cannibal, a company has to be buying back at least 5% of its shares outstanding per year consistently or engaging in a material share buyback in a one-off manner (for example, after selling a business unit or to utilise excess cash on the balance sheet).
Furthermore, we believe that companies need to be buying back shares at a price we believe to be at a material discount to underlying long term value and not buying back shares primarily to offset dilution from management equity-based compensation or to support the share price in the short term. Share buy backs should be done in order to drive per share value when a company’s share price is materially below its intrinsic value.
Ideally, Cash Flow Cannibals use internally generated cash to buy back shares or debt in a prudent manner. Share buy backs should always be weighed against high return internal investment opportunities and are best done by management teams that have a demonstrated skill and expertise in capital allocation decisions. Cash Flow Cannibals can often, but not necessarily, also qualify as Public LBOs.
Place in our Portfolio: Return Enhancer
Stock Case-Study: HCA (NYSE: HCA)
HCA is a hospital business in the United States, operating 172 hospitals, 44,000 beds and 119 freestanding surgery centres. The company traded at a historically cheap multiple of 7.5x EV/EBITDA at the time of first Avenir’s acquisition in late 2017 This is largely due to market noise in the United States around the repeal of the Affordable Care Act, better known as ‘Obamacare’. We believed the worst-case scenario of a full repeal is more than priced into HCA.
We bought into the company at a 10% free cash flow yield and continue to believe cash earnings per share can grow at double digit rates driven by an aggressive capital allocation policy primarily focused on share buybacks. Since an IPO in 2011, HCA has generated $11.2bn free cash flow. Over the same period HCA has repurchased $9.9bn of shares (reducing share count by 21%), paid $3.2bn in special dividends and made $4.4bn worth of acquisitions. At the same time the company has reduced debt/EBITDA from 4.7x to 3.8x today.
While the noise (and tweets) around healthcare regulation is ongoing, HCA has continued the strategic M&A that the company was founded on. The hospital industry currently provides HCA ample opportunity for such M&A with the two largest peers heavily indebted, at an average debt/EBITDA of 7.8, and undertaking forced asset sales. HCA has a long track record of significantly increasing the operating profitability of hospitals it acquires.
The industry structure also provides protection against regulatory or reimbursement risk. 80% of hospitals in the US are non-profit & government owned. Most of these hospitals operate at very low to negative margins – only keeping the lights on through subsidies from the government. Additionally, hospitals are the largest employer in the congressional districts of 75% of the members of the U.S. House of Representatives. Self-interested politicians are reluctant to engage in bad politics by voting for legislation that could cause local hospital closures thereby negatively affecting a large population of their voters. These industry dynamics provide protection from regulatory and reimbursement risk for the most efficient hospital operators, such as HCA.
4. Classic Value
A Classic Value company is one that is exceedingly cheap on usual statistical valuation metrics such as enterprise value to EBIT, price to sales, price to free cash flow, price to earnings and price to book value (among others). While Classic Value companies should still be of high quality and have competitively entrenched positions, they do not typically have catalysts to close the value gap (other than value being its own catalyst) nor a management team that is taking self-help actions such as share buybacks that might help to close the gap between price and value.
Classic Value investments require patience as they generally require a change in sentiment to drive value which can be very unpredictable in terms of timing and the trigger to bring about the rerating.
Place in our Portfolio: Downside Protection & Diversifier
Stock Case-Study: General Motors (NYSE: GM)
General Motors (GM) designs, manufactures, and distributes cars, pick-up trucks, SUVs, vehicle parts and financial services through a network of over 12,000 independent dealers. When GM emerged from bankruptcy in 2009 a more suitable name would have been “Genius Motors,” along with a move from Detroit to Silicon Valley to reflect the direction of the new company. General Motors has rerouted its focus after emerging from bankruptcy towards profitability & ROIC versus scale and embracing the future of cars rather than deterring it.
GM is priced by the market as a cyclical Original Equipment Manufacturer (OEM) of cars and does not receive credit for their highly profitable and sticky truck business with a higher percentage of customers that use their trucks for work, along with a greater focus on rural markets, making it less susceptible to rideshare use cases. GM also runs two significant high-margin less-cyclical businesses, GM Financial and the aftersales business, as well as a growing Chinese business via a joint venture. GM is also taking initiative to be the leader in electric vehicles and autonomous driving via their subsidiary, Cruise.
We value GM on a sum-of-the-parts basis, factoring in the drastic cultural shift since the bankruptcy. Despite the stock being rangebound between $30-$45, we believe the stock is worth upwards of $60 or 70% upside with catalysts in the form of the market appreciating the robustness of the truck segment, continued growth in the less cyclical businesses, the expanding China business and optionality within their technological pursuits.
5. Special Situations
A Special Situation company is one in which there are unique or specific catalysts at play which can drive a material rerating in a company in the short term. The reasons for a Special Situation opportunity are varied but can include spin offs, broken IPOs, the sale/closure of a loss-making business, a change in company strategy, the simplification of a complex organisation or corporate structure, etc. Special Situations rarely include operational turnarounds. Special Situation investments are sometimes not as high a quality business as most Avenir investments (still maintain an important minimum quality threshold) but have shortened time frames due to the special situation which helps to reduce operational and business risk.
Special Situations can often drive short term portfolio returns as the catalyst that can close the value gap is in the next year or two and can provide a nice balance to Undervalued Franchises or Classic Value and other longer-term investments.
Place in our Portfolio: Return Enhancer & Diversifier
Stock Case-Study: ECN Capital (TSE: ECN)
ECN is one of our special situation investments and was a spin-off from a larger parent in 2016. The senior management team of the parent went with the much smaller ECN capital in the spin-off which is always an interesting sign. ECN Capital also went through a well-telegraphed corporate restructuring (not an operational turnaround) that resulted in a smaller, fast growth and high return on equity company emerging from the other end. During this restructuring process, management bought back over 40% of ECN Capital shares outstanding at what we regard as very attractive prices.
The company is a recent spin-off from Element Financial (another Canadian listed entity) and has undergone a fundamental transformation that we believe is not yet fully understood by the market. The company has historically been an asset heavy aviation and rail leasing company but has now substantially transitioned to an asset light business services company through the divestiture of over $6 billion worth of leasing assets and the acquisition of three high return and fast-growing business services companies. The investment downside is protected by the value of the remaining leasing assets, which will gradually be sold, and the upside is provided by the high growth business services businesses which have been acquired at attractive prices.
We have been able to ‘create’ ownership of these fast growth business services businesses at an attractive price of roughly 5x forward P/E once the value of the remaining aviation and rail leasing assets is netted-off our purchase price.
An undemanding 11x P/E multiple for the ECN services businesses, and book value for the remaining aviation and retail leasing assets, yields a price of C$7.00 per share in our estimation compared to our entry price of C$3.90 per share.
This material has been prepared by Avenir Capital Pty Limited (ABN 40 150 790 355, AFSL 405469) (Avenir) the investment manager of Avenir Global Fund (Fund). Fidante Partners Limited ABN 94 002 835 592 AFSL 234668 (Fidante), is the responsible entity of the Fund. Other than information which is identified as sourced from Fidante in relation to the Fund(s), Fidante is not responsible for the information in this material, including any statements of opinion. It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable for your circumstances. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The PDS for the Fund, issued by Fidante, should be considered before deciding whether to acquire or hold units in the Fund. The PDS can be obtained by calling 13 51 53 or visiting www.fidante.com. Neither Fidante nor any of its respective related bodies corporate guarantees the performance of the Fund, any particular rate of return or return of capital. Past performance is not a reliable indicator of future performance. Any projections are based on assumptions which we believe are reasonable, but are subject to change and should not be relied upon. Avenir and Fidante have entered into arrangements in connection with the distribution and administration of financial products to which this material relates. In connection with those arrangements, Avenir and Fidante may receive remuneration or other benefits in respect of financial services provided by the parties.