As our name implies, at Fat Pitch Capital we like to wait until we get a very favorable risk/reward set up on shares of high quality companies. Our checklist items are:
- Durable competitive advantage
- Strong balance sheet
- High returns on invested capital with low capital intensity
- Shareholder-oriented management team
- A price that affords a margin of safety
An example of where we found this in the past is Vodafone. Below are excerpts from our letters to investors in which we discussed this opportunity:
From Q2 2013 letter to investors
Our thesis for owning Vodafone is that the current price does not fully recognize the value to Vodafone’s interest in Verizon Wireless, in part because Vodafone does not consolidate their pro rata share of Verizon Wireless’ earnings. Based on recent comments from both Vodafone and Verizon and our belief that the timing is right, we believe that this joint venture may be unwound fairly soon. We believe that a transaction could lead to a value of around $40 for Vodafone stock. We are estimating $24-27 in pre-tax value per share for the Verizon Wireless stake and $15-20 per share for the remaining Vodafone assets. We then allow for tax slippage and an arbitrage discount. While there is no guarantee that a deal will happen, we are happy with the margin of safety on this investment. We will be monitoring this situation very carefully. While we wait, we will be collecting a 5% dividend yield and benefitting from the company’s ongoing share buyback. During the quarter, we purchased call options on Vodafone with a strike price of $30 and an expiration date in January 2014. These call options will enhance our returns if a deal takes place prior to expiration and we are correct in our analysis. While we could lose the premium we paid for the options, our exposure is limited to a small percentage of our portfolio.
From Q1 2014 letter to investors
We sold our common stock and options in Vodafone. We had anticipated that Vodafone and Verizon would work out a deal to unwind their joint venture in Verizon Wireless. The catalyst occurred and Vodafone stock appreciated, getting close to our target. We were able to realize a nice gain by exiting these positions once as the stock approached our estimate of fair value.
Today, I will highlight two companies that we believe are Fat Pitches. The first is Tribune Media.
From Q4 2015 letter to investors
Tribune Media Company (TRCO) is an asset rich company in the media and entertainment business. The company has 96 million shares outstanding, $3.5 billion of debt and $350 million in cash, giving it an enterprise value of $6.4 billion based on the year-end stock price of $33.81. They own 43 TV stations and the cable network WGN America. During 2016, we expect the local TV stations to benefit from political ad spending, especially since roughly 1/3 are located in swing states. We also believe that WGN America will begin to see the fruits of investment in converting from a superstation to a cable network. We believe that the value of these assets approximates the value implied by the current stock price.
TRCO also owns other valuable assets, including joint venture interests in TV Food Network and CareerBuilder, a job search website. The company also owns 80 real estate assets, including Times Mirror Square in Los Angeles and Tribune Tower in Chicago. They are exploring the possibility of selling some of these and putting others into a REIT. TRCO owns broadcast spectrum, which could be worth as much as $20 per share. They are actively considering how to realize value from this asset.
In an October 17, 2015 article entitled Tribune Media Shares at a 50% Discount, Barron’s made the case that the sum-of-the-parts valuation could be as high as $85. In a December 12, 2015 article, TRCO was listed as one of Barron’s 10 Favorite Small- and Mid-Cap Stocks for 2016. Monetization of non-core assets could be a catalyst for a narrowing of the discount between the stock price and the sum-of-the-parts valuation.
The second Fat Pitch that I would like to highlight is Blackstone Group.
From Q4 2015 letter to investors:
One of the contributing factors to our drawdown during the second half of the year was the significant correction in the price of Blackstone Group (BX). BX is the world’s premier alternative asset management company, with a strong presence in private equity, real estate, credit and hedge fund solutions. The long-term investment performance of their funds after fees is 10 percentage points better than the stock market. In a May 4 article, Barron’s said “… the stock still looks underpriced at $41 and could easily return at least 20% in the coming year.” Instead, the stock has fallen to $29.24.
BX has two distinct sources of revenue. The first is fee-based, where they collect a fee based on their assets under management (AUM). Since their AUM are typically locked up for fairly long periods of time, their fee-based revenues are pretty steady. In the past 15 months, BX has raised nearly $100 billion, which is more than their top four rivals combined. This robust fundraising will result in an expanding base of fee-based AUM, leaving them with significant embedded growth in this first stream of revenue.
Their second source of revenue is performance-based incentives, also known as carried interest. This is where they get a percentage of the profits generated by their funds. This source of revenue is far more variable and is influenced by the ability of BX to sell assets and realize gains. The amount of performance-based fees generated can fluctuate significantly from year to year. In good years, performance-based fees can be quite large and significantly impact the amount of distributable cash flow that BX generates. The ability to generate performance-based incentives is certainly influenced by the health of the financial markets.
Over the trailing twelve months, BX has paid out $2.90 in distributions. Approximately 70% of this came from performance-based incentives. The price action of the stock suggests that the market believes that realizations will decline materially in the near future, resulting in BX paying out lower distributions. We believe that the market is taking an overly pessimistic view. Part of the reason is that we believe BX can achieve realizations in their real estate portfolio, as interest rates remain low by historical standards and the supply demand balance for their assets remains in balance. They also should be able to achieve some realizations in their private equity portfolio by selling portfolio companies to strategic acquirers. We suspect that distributions over the coming 12 months will provide a generous yield based on the year-end stock price.
One positive bi-product of BX‘s successful recent fund raising is that they have $85 billion of newly committed capital to invest in their funds, including $17 billion in GSO, which is their credit arm. If markets continue to decline, they can invest this money opportunistically and lay the groundwork for the generation of future performance-based incentives.
BX’s internal model has a 10-year price objective of around $85 with another $25-30 of cash distributions paid out along the way. They have a strong balance sheet (their credit rating was recently affirmed as A+) and Morningstar gives the company a wide moat rating and estimates that fair value is $53 per share. Management, led by chairman Steve Schwartzman, owns around 40% of the stock.
From Q1 2016 letter to investors
In our last letter, we had a lengthy discussion of Blackstone Group (BX), lamenting the stock’s price decline from $41 to 29.24. When the decline continued into the start of the year, we saw an opportunity to increase our position in the common stock to 15.32% from 11.19% at year-end.
We continue to focus on the long-term earnings potential of the company. As a reminder, BX‘s internal model has a 10-year price objective of around $85 with another $25-30 of cash distributions paid out along the way. Management is significantly aligned with investors, as they own around 40% of the stock.
While near-term economic net income (ENI) may continue below peak level for a while longer, we believe that the company’s significant fund-raising success leaves them with greatly enhanced long-term earnings power. Last year, the company raised over $90 billion and they should be able to raise close $50 billion this year. Our bet is that they will generate lots of fees on this new capital.
BX is the best in class alternative asset management company. They have proven their ability to make money over the course of the investment cycle for 30 years. Along the way, they have also become a fund raising juggernaut. Over time, we should be richly rewarded for this investment.
While we are not yet revealing which company we will highlight at Wide-Moat Investing Summit 2016, both Tribune Media and Blackstone are among the candidates.