Patrick Brennan's Brennan Asset Management 4th-Quarter Letter

January 25, 2023

After a brief fourth quarter rally, investors again turned glum and ended 2022 in the same dour mood present throughout the year. As has been well discussed, investors continue to debate how high rates must go and how long they stay elevated, how deep or shallow a possible recession would be and whether weaker markets sufficiently discounted further bad news. Some encouraging inflation data early in 2023 suggests progress on the inflation front and perhaps signals that the US Federal Reserve can slow down, pause or even cut rates later in the year. Of course, other recent data suggests that the economy may be slowing and many will argue that stock valuations do not fully reflect a possible 2023 recession. It would be great to know which scenario unfolds, but unfortunately we don’t have this allusive clairvoyance. But as we have discussed multiple times, neither other investors nor the most credentialed “data dependent” multi-variate wielding econometric modeled professionals at the Federal Reserve can consistently predict inflation data and interest rate levels or foresee recessions¹ even one year in advance. We will predict that there will be multiple data points throughout 2023 that will appear to confirm slowing inflation or an impending recession -- only to be offset by data that gives the exact opposite signal. While this out-on-a-limb prediction will likely not secure us many macro speaking engagements, it likely is no less accurate than many of the beginning-of-the year forecasts. Additionally, rather than trying to guess the unknowable and pondering “when is it a good time to get in or get out?”, we continue to believe that investors are better served by trying to keep a longer-term time frame and accepting that volatility is part and parcel of the investing process.

There were a couple of developments at Charter (CHTR, Financial), Megacable (MEX:MEGACPO, Financial) (MHSDF, Financial) and Blackstone (BX, Financial). While we provide a more thorough discussion below, the highest-level summary is as follows:

• MEGA received a takeover offer from cable competitor Televisa (TV, Financial). While the company has publicly declared itself “not for sale,” we believe a deal is more likely than not.
• CHTR’s December investment day had encouraging news, but investors only heard “more capital expenditures” and dumped the stock. The selling is overdone and we think there is substantial upside.
• BX has experienced redemption pressure in one of its real estate funds. While these outflows and a more challenged fundraising environment could persist, we think predictions about private equity’s demise are greatly exaggerated, especially for this premier financial service name.

For those interested, we provide a more detailed update on the three names in the space that follows as well as a link to a recent presentation we gave on CHTR and MEGA. We also want to briefly update two other names. During early December, we spent time speaking with the senior team at Liberty Latin America (LILAK, Financial), a name we have discussed in multiple prior letters. The discussion confirmed our conviction that the large inflection in free cash flow should begin in 2023 and continue over the following two years, yet LILAK’s bombed-out stock price does not reflect this turn. The company is currently pondering whether to invest further funds into its 50/50 Chilean Joint Venture with América Móvil. We made clear that the stock works quite well even with no ascribed value for the joint venture, assuming that cash flow is used to retire mispriced LILAK shares. After promising that any investment decision will be judged against other capital allocation options (including no -brainer buybacks), we believe the management team will act rationally. That said, we and other investors will closely evaluate LILAK’s capital allocation choices at this critical moment for the company.

During the fourth quarter, Permanent TSB (LSE:IL0A, Financial) closed its Ulster purchase described in previous letters. While the Ulster deal was a central part of our thesis, the enormous moves in the Euribor curves were not and the latter is immensely positive for TSB (dropdown income on tracker mortgages, interest as opposed to payments on ECB cash deposits, higher security portfolio income, higher loan rates, less refinancing) and other European banks. We show yield curves² over the past year along with ECB inflation projections during this time frame. If the change in forecasts over a nine-month period doesn’t offer a dose of humility for macroeconomic forecasting….well, we’re not sure what will.

Permanent TSB has hiked its mortgage rates twice since November and we suspect there will be further rate hikes by TSB and the two other remaining banks (AIB and the Bank of Ireland) in Ireland during 2023. While TSB has moved higher, it still trades at roughly 50 percent of tangible book value, despite having a viable path to 10-12 percent ROEs in the years ahead. It is highly unlikely that Europe will return to the negative rate regime that plagued bank shares over the past decade, but investors still broadly view European financial names through this lens. Any change in this viewpoint could lead to a powerful industry-wide valuation rerating. Decreasing the government’s current 62.5 percent stake in TSB is the key to unlocking value. Substantial progress has been made on the other two Irish banks⁴, and we believe it is just a matter of time before attention turns towards a TSB “re-IPO.”

In our third quarter letter, we took a deeper dive into two cable names - MEGA and CHTR. As previously noted, both names were in the news during the quarter and therefore we wanted to provide a further update. For those who want even further details, we gave a brief update on MEGA and a more in-depth dive in CHTR during Manual of Ideas Best Idea conference earlier this month. We’ve included a link to the presentation below:

https://www.youtube.com/watch?v=JKFJP6AtpPA&t=3s

MEGA: Not for Sale vs. Not Stupid

As we noted in our third quarter letter, investors’ perception of cable (and multiples they are willing to pay) has fluctuated wildly historically, despite the consistent operating results posted over time and throughout economic cycles. During 2022, sentiment turned dire (as bad as we can remember) and cable names sold off around the world, including those in MEGA and CHTR. In December 2022, Grupo Televisa (TV, Financial), the largest cable company in Mexico, went public with its proposed offer to merge its cable operations with those of MEGA. Under the proposed deal, MEGA would receive a roughly 20 percent premium for its EBITDA contribution and MEGA would receive a 14.8 billion peso special dividend. While TV’s bid is certainly opportunistic, MEGA was clearly vulnerable as the company failed to repurchase shares despite an enormous gap between its public share price and any reasonable estimate of fair value. Our firm publicly questioned why the company would not repurchase stock during MEGA’s third quarter conference call this past October and we received a rather nonsensical answer. We have included part of the rambling below:

“Megacable is not a financial business….But we don’t plan to distract ourselves or distract resources or leverage the company to buy stock. I mean even though (it) is one of the best investment(s) you could do…You all know the numbers. The stock half of what it was 5 years ago, and the EBITDA is up 50%+. The fundamental of the company are much better. So the stock should rise, but will not distract ourselves in trying to do a repurchase at this time.”

If you are confused, join the club. Unfortunately, this was not a case of a Spanish/English “lost in translation” issue (although we were contemplating asking the question in Portuguese to see if we received a better response). The response was a total abdication of capital allocation responsibility, a primary duty of a publicly traded company. With MEGA publicly ruling out buybacks despite a bombed-out stock price, it is no surprise that an outside party swooped in nor that minority shareholders nearly universally support a deal, as the combined company would (in addition to offering attractive synergies) likely be more liquid, trade at a higher valuation, and finally fix the inefficient capital structure at MEGA.

While MEGA has publicly noted that it is not for sale, we believe a deal could still be consummated and MEGA has leverage in any negotiations. TV’s need for a deal is great. TV likely must upgrade at least 50 percent of its plant to fiber, and the deal would cleverly allow TV to leverage MEGA’s balance sheet to fund this upgrade. As we have detailed in past letters, MEGA has already upgraded (outside of the planned fiber rollout) 50 percent of its plant and has already started plans to upgrade half of the remaining 50 percent. Given the cheaper labor costs, there is no real DOCSIS 4.0⁵ vs. Fiber debate: Mexico is heading towards fiber in large portions of the country. TV is particularly vulnerable as MEGA can offer a smaller premium to its base average revenue per user (ARPU) in TV territories and still come in at a discount to TV. Additionally, TV’s expansion into MEGA’s footprint is generally in places where MEGA has already upgraded, and therefore TV is offering a “me too” product at the same price as MEGA (and at a discount to TV’s base). As if this isn’t bad enough, American Movil (AMX) is talking about upgrading fiber in ~80-85 percent of its footprint over the next several years.

While MEGA is better positioned than TV absent a deal, MEGA could also struggle. US investors could rightfully conclude that the company is “uninvestable” if MEGA had an opportunity to double its share price and simply thumb sucked. Additionally, the IRRs on MEGA’s newbuild project could be much tougher to achieve if AMX achieves its targeted fiber upgrades.

We believe that a possible path forward is a higher premium for MEGA’s share of the combined company’s EBITDA and a larger special dividend for MEGA. If the combined company took net leverage to 2x from 1.5x (TV needs to contribute some debt to make this deal work), the special dividend to MEGA could be closer to 30 billion pesos and the combined ownership would be ~50/50. Combining the above assumptions with modest cost synergies would equate to ~110+ pesos in total value per share for MEGA (as of this letter, the stock trades ~58 pesos), assuming the combined company can ultimately trade for 6x post-synergy EBITDA. While MEGA is likely acutely aware of the above math, we sent our work to the company and outlined our various assumptions. In our admittedly biased opinion, a deal more favorable for MEGA would still be attractive for TV as the implied value for TV’s ~50 percent share in the combined cable company would be greater than TV’s current market capitalization. This would imply a negative value for the portion of TV (media assets) that most of its investors believe to be the most valuable part of the company. Even if MEGA cannot achieve all of what is outlined above, MEGA still should be able to negotiate a more favorable deal, and this would be a far better option than a standalone company.

While MEGA’s publicly reported position is “we are not for sale,” we think the real line is closer to “we are not stupid.” MEGA CEO Enrique Yamuni (who would likely run the combined company) and the other four family owners are not necessarily aligned with the Bours family if the Bours family (who controls 42% of Megacable) tries a “take under.” During follow-up calls with MEGA, we did not receive any serious pushback on either the industrial logic of the deal or on our basic assumptions behind possible deal negotiation. Our sense is that the company is willing to do a deal but is simply angling for a better price. MEGA has room to push TV, but it is certainly possible that the company overplays its hand or that the Bours family just hits the self-destruct button and walks away. While a deal is far from guaranteed, there is reason to be cautiously optimistic that a transaction materializes.

CHTR Capital Expenditures: The Sun Also Rises

As noted in past letters, CHTR’s recent investor concerns centered around the following (please see our Q3 2022 letter for greater detail on the first two bullet points):

• Increased broadband competition from fixed wireless and fiber competitors
• Higher interest costs associated with more leveraged balance sheets
• Increased capital expenditures associated with DOCSIS 4.0 upgrades/additional network expansion
• Doubts about the wireless business viability

CHTR faced further selling pressure in mid-December following an analyst presentation which detailed its overall operational/capital allocation plans over the coming years. Despite projected network investment spending coming in below most estimates on a cost-per-home passed basis ($100 per home passed), CHTR investors simply heard “more capex” and dumped shares. Additionally, CHTR believes the Rural Digital Opportunity Fund (RDOF) buildouts offer mid-teen+ unleveraged IRR returns. Certainly, it would be helpful for CHTR to provide more detail behind its IRR calculations, but this granularity would likely be helpful for competitors who are also bidding for broadband funding. For those interested, we include IRR buildout estimates in our MOI presentation. While CHTR’s decision to accelerate spending on both capex buckets increases capital intensity over the medium-term, the spending also increases the long-term growth of the business. We believe current subscriber forecasts do not give full credit for the likely gains from CHTR’s network expansion and we therefore believe consensus broadband estimates over the coming 3-4 years appear low.

Additionally, we also suspect that investors are underestimating cable’s potential in wireless, where cable companies offer sizeable discounts to incumbent carriers. Cable companies have posted solid mobile additions the last several quarters, but Charter only has ~5 percent market share relative to the number of homes passed. Reported EBITDA losses by cable companies mask the value of their wireless business and investors are likely incorrectly capitalizing these losses into current valuations. Incremental margins on wireless gains are currently ~36 percent and are poised to increase as more lines per household are added and as data is transferred to its Citizens Broadband Radio Service (CBRS) spectrum from Verizon’s network over the coming years. It is quite possible that wireless margins expand to 15-20 percent with increased scale (see the MOI presentation for further detail) and that CHTR’s wireless offering eventually becomes a driver for further broadband growth.

Rumors of cable’s demise have been greatly exaggerated at various points over the past 30+ years, and we think this latest bout of pessimism provides a unique opportunity for the patient investor. As we have described in past letters, we own CHTR shares via Liberty Broadband (LBRDA) and this holding allows a “look-through” purchase 20 percent+ below CHTR’s beaten down stock price. We added to our position in LBRDA just before the new year.

BX: Rumors of Private Equity’s Death Have Been Greatly Exaggerated.

During the quarter, another longer term holding (BX, Financial) faced some negative headlines associated with one of its real estate products, Blackstone Real Estate Income Trust (BREIT). Before diving into the details of BREIT, we thought it might be helpful to review our history with BX. We started following (while working at another firm) BX after its much-hyped 2007 IPO at $31, a price that some prescient market observers signaled a market top. Then came the Global Financial Crisis and BX and all alternative asset management firms crashed. We first looked at BX in 2009. We thought the firm had strong structural drivers behind future fundraising but also believed that the company was giving an overly generous amount of equity to its employees and that difficult capital markets would present challenges to near- term fundraising. While correct on all accounts, we were wrong on the most important conclusion: namely, passing on shares trading near $5. While this sin of omission committed at another firm was not visible to outside parties, it was likely more damaging than all other sins of commission in the years that followed.

We revisited BX again in late 2017/2018 when AUM had grown from ~$90 billion at the time of the IPO to $434 billion and the stock had returned to its IPO price levels. When reviewing the company and the industry, we came across various studies suggesting that private equity returns primarily benefited from leverage and that investors could achieve similar returns (with lower fees) by allocating funds to leveraged index strategies⁶. We also wondered why leveraged alternative fund strategies didn’t compare themselves against leveraged benchmarks.

Fortunately, we put down our blinders and started being more receptive to more bullish takes on the names. It is exceptionally difficult for new asset management firms to scale to $1 billion, let alone $100 billion+. There are few institutions of scale that can show 20+ year return histories at more scaled capital levels and perhaps fewer that have access to the deal flow, contact bases and data from all the various deals closed (and passed on) over time. And while many skeptics argue (justifiably in many cases) that higher asset prices and debt costs will lead to lower future returns, the same arguments were made and played out in 2006 -2008. And while these pre-crisis fund returns were certainly substandard relative to other private equity funds, many of the “worst” 2006 vintage private equity funds still returned ~6%+ despite predictions of complete wipeouts. Furthermore, while the asset base of alternative asset firms was formally dominated by private equity, the firms have now evolved to a more balanced mix of buyout, credit, real estate insurance liability management and infrastructure funds (among others) with some of these categories (credit as an example) offering more opportunities with scale versus limitations in size associated with traditional private equity.

While other alternative managers screened cheaper, BX had (in our opinion) the most diversified mix of product and the best fund raising franchise of the group. Because of this franchise strength, BX did not have to invest the same amount of its own capital into funds and therefore was freer to distribute earnings to shareholders. In addition to an evolving mix of products, BX’s earning base evolved from highly dependent on asset realizations (so called “carry”) to a model more dependent on steadier fee-related earnings. In September of 2018, BX set a multiyear target of $2.00 in fee related earnings per share. It achieved the target earlier than anticipated and the firm could very well earn over $5 of fee-related earnings by 2024.

While the size of BX will likely prevent the firm from replicating its growth over the past 10+ years, BX should still benefit from secular tailwinds. The entire alternative space is expected to grow at a double-digit space over the next five years, and all major client groups are expected to increase their allocations to private equity investors.

Undoubtedly, the current fundraising environment is brutal, but this was the case back in 2007-2009 and 2000-2002 and these sharp pullbacks were followed by more rapid periods of growth. And Blackstone is currently sitting on $182 billion for new investments (so called “dry powder”) with a more favorable backdrop to deploy given the declines in 2022.

BREIT Blues

While the secular story still looks promising, BX is contending with concerns over the previously mentioned real estate product BREIT. BREIT has posted strong returns throughout its history with total annualized returns of +12.5 percent and 2022 returns of +8.4 percent. Total AUM has grown rapidly since its 2017 inception to nearly $69 billion of net asset value and BREIT accounts for ~10 percent of BX’s fee-paying AUM and nearly 14 percent of 2022 estimated EPS. Despite BREIT’s significant outperformance, the fund started experiencing meaningful redemptions in October-December of 2022. Unlike other BX products where capital can be locked up for 7+ years or even indefinitely, BREIT allowed withdrawals limited to 2 percent monthly and 5 percent quarterly. In early December, BREIT announced that withdrawal requests exceeded the 2 percent monthly and 5 percent quarterly limits, and therefore redemptions were limited. According to BX, the redemptions were concentrated within its Asian base of clients. Offshore investors represent 20 percent of BREIT’s capital base but have accounted for ~70 percent of year-to -date redemptions. Many market participants expressed concern that that redemption pressure could accelerate (if others are rushing to get their money out, shouldn’t we consider withdrawing before others do?) and this led to a broader discussion about the marks that BREIT was using for its assets.

During 2022, the MSCI US Real Estate Investment Trust (REIT) index was down ~24.5 percent versus BREIT’s reported +8.4 percent net asset value (NAV) advance. BX has emphasized the quality of its investment portfolio since 80 percent of its portfolio is comprised of rental and industrial properties (think of Amazon-esque warehouses for the latter) and same store net operating income rose 13 percent during 2022, nearly 50 percent ahead of apartment and industrial comparables. BX also noted that BREIT’s leased market leases are 20 percent below market rental rates, suggesting considerable upside as leases expire. To help calm jittery investors, BX also pointed to a recent Las Vegas property sale⁷ at prices above current marks as well as a $4 billion investment from The University of California (UC), whereby UC agreed to a 6-year lock (versus monthly liquidity) in exchange for Blackstone investing $1 billion of its current holdings in BREIT and UC receiving returns to ensure UC earns an 11.25 percent overall return on its $4 billion investment.⁸ Both transactions became a bit of Rorschach test for bulls and bears. Rather than a sign of confidence regarding marks/investor perception, bears would argue that BX sold what it could (after only holding properties for three years) rather than what it wanted and that it had to offer special terms to attract a meaningful inflow into BREIT. Others (including some close friends in the investment industry) have ranted that the BREIT difficulties were an audible “bell ringing,” signaling the end of the “Golden Age” of private equity. So…could the bears be right?

While anything is possible, we suspect that death bells for the private equity industry might be meaningfully premature. It is worth noting that private equity may be one of the few groups that makes cable companies seem popular. The industry has been lambasted by a broad cross-section of political affiliations regarding the questionable tax treatment of carried interest, the (perceived) excessive leverage and claims of mass layoffs and asset stripping. And the jealousy and animosity extend to others within the investment industry – including from Omaha’s dynamic duo on the latter. Private equity has raised copious amounts of money and has been able to use IRR calculations⁹, leverage and internal marks that make many public managers jealous. We are particularly envious of the latter. We assure readers that Megacable, Charter, Liberty Latin American and Permanent TSB would sport radically different values if we could use third-party estimates versus being subjected to mercurial public markets where non-fundamental factors (money flows, investor redemptions, momentum/factor trades, among a larger list) have meaningful impacts on prices.

While acknowledging that some of the above criticisms are valid, we still believe the largest alternative manager franchises have histories of exceptional returns that are nearly impossible to replicate. Furthermore, it is less clear to us that BX is doing anything nefarious regarding its BREIT marks. Other publicly traded REITs have experienced much more meaningful price declines, but these REITs do not have the same asset mix as BREIT and therefore are far from perfect comparables. BREIT’s asset base likely warrants lower capitalization rates than its peers. Now, it is certainly possible that higher rates/comparable sales will force lower BREIT marks in the future. As a result, one could also argue that an investor might achieve better returns by selling his/her “fairly marked” BREIT shares and then investing the proceeds in a basket of “undervalued” public REITs. Doing so, however, would likely involve swapping to an (often) lower quality mix of assets and to a possibly less competent management team. For the record, if given the opportunity to stay in BREIT or swap to other REITs, we would insist on a “third door” and loosely follow the advice of famed investor Peter Lynch and simply own the underlying fund company (BX, Financial).

It is certainly possible that BREIT redemption pressures continue throughout 2023 and this could serve as an overhang on shares. But, given the size of BX, the extent of the financial impact is less clear. BX’s real estate franchise will likely continue experiencing overall inflows even in the event of continued redemptions at BREIT. BX is targeting $150 billion of flagship fundraising in 2023. If 5 percent quarterly BREIT redemptions continue throughout 2023, the total management fee impact could be closer to $100 million -- less than 2 percent of BX’s 2022 estimated management and advisory fees.

One can certainly argue that BX made a mistake in its basic BREIT design and should have allowed even less frequent withdrawals, considering the less liquid nature of the real estate holdings. Perhaps future iterations of products will adjust. It is worth noting that other alternative firms, including KKR and Starwood Capital, have also limited withdrawals with similar (but far less successful) offerings. High net worth and ultra-high net worth individuals (chart above) alone are thought to represent a 70 trillion¹⁰ (not a typo) addressable market for alternative products. While BX has a ~300-person private wealth management distribution team delivering its message, it is possible that BREIT gives BX a black eye in retail fundraising shorter-term. That said, the size of retail (and other) markets is so large and BX’s depth of product so extensive, it appears less likely that growth will be permanently interrupted. And while a world of higher interest rates will undoubtedly cause some negative marks over time, BX sits on a mountain of capital that will be deployed at more attractive levels and will likely allow the firm to sow the seeds for the next round of fundraising.

Returning to the “well, the returns are only because of leverage and private market marks and, if you took this away, their returns are more average,” line of thought, we believe that a (admittedly less-than-perfect) sports analogy, using what we understand to be one of BX Co-Founder Steve Schwarzman’s favorite athletes, might be helpful. Stephen Curry is the greatest shooter of all time (at least in this asset manager’s mind…and for the record, we hope the Celtics bury the Warriors if they meet again in June) who also benefits from playing in a period where physical contact by defensive players is severely prohibited. If Curry had played in the era of the 1980’s/1990’s, he still would have been a great shooter, but perhaps not the dominant force he is today had he been forced to endure the grabbing/hand-checking/hard fouls of the great Celtics/Lakers/Pistons/Bulls teams of that era. It is harder to shoot well when worried about having one’s arm broken driving the lane. Should Curry be judged on the way the game is played today or through the lens of a non-existent time portal where he competes against defenders with a different set of rules? We wonder if some of the biggest “I don’t get to mark my assets that way” critics come closer to the latter camp. Investing substantial sums of capital in leveraged index strategies with daily pricing is an untouchable marketing strategy, no matter the most fervent dreams of the idealist.

It is certainly possible that there will be increased scrutiny of private equity marks in future periods, that higher interest rates will (temporarily?) limit the degree of leverage in portfolio companies and that that a more difficult market environment will limit fundraising for a more extended period of time. But railing against “the game” doesn’t change the fact that alternative investors have invested at scale in private equity for decades and generally done better than public markets. We still think that it is more likely that the secular drivers of private equity growth will continue and that only a handful of firms possess the historical record, scale and product depth to invest at scale. We think BX is still the preeminent firm in the space.

In closing, we certainly understand that the recent portfolio declines are frustrating and that the drum beat of depressing economic news can be exhausting. That said, we believe that the country/world has a way of “muddling through“ and that markets generally move far before it is obvious that “the coast is clear.” Waiting for evidence of the turn often involves missing some of the best gains. As we have described above, we see mispricings in several key holdings and believe these names can drive substantial gains in the years ahead.

Thanks again for your support.

Patrick

1. Hites Ahir and Prakash Loungani Can economists forecast recessions? Some evidence from the Great Recession
2. Source: Bloomberg, Autonomous Research January 2023
3. Harmonised Indices of Consumer Prices
4. The Irish government has completely sold its stake in Bank of Ireland and reduced its AIB stake to 57 percent from over 70 percent at the beginning of 2022 with further sales widely expected in 2023.
5. DOCSIS is an acronym that stands for Data Over Cable Service Interface Specifications. Put simply, DOCSIS is an industry standard that is an instruction manual for operators looking to enable high-bandwidth data communications and is mainly used by cable operators who have hybrid-fiber coaxial (HFC) infrastructure. DOCSIS 4.0, the latest standard, is being used by, among others, Charter and Comcast to upgrade their HFC network versus utilizing a full fiber upgrade.
6. Financial Analyst Journal Volume 72, July/August 2016: A Bottom-Up Approach to the Risk-Adjusted Performance of the Buyout Fund Market, Jean-François L’Her, CFA, Rossitsa Stoyanova, Kathryn Shaw, William Scott, CFA, and Charissa Lai, CFA.
7. BX sold its 49.9 percent interest in a joint venture that owns the MGM Grand Vegas and Mandalay Bay Resort.
8. BX will receive incremental profits on the $1 billion deployed if BREIT returns 8.7 percent annualized over the next 6 years. BX will also earn a 5 percent on UC returns if BREIT exceeds 11.25 percent annualized returns.
9. Internal Rate of Return (IRR) calculations generally begin when capital is deployed versus when it is first committed – this difference in timing can have a material impact on IRR calculations.
10. Source: Cobalt, Oliver Wyman estimates, Morgan Stanley Research

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