Beta is Risk

Yes, you read the headline correctly. The academics got it right. Sort of…

Public market investing rewards those who can identify assets trading at discounts to what they will be worth in the future. But what about the time in between initial purchase and the future? That’s where Beta comes in.

Beta, for those that don’t know, is the measure of a stock’s movement compared to the market. So, if a stock has a Beta of 1.25 a stock holder should expect to see 1.25x the volatility (good or bad) of the market. That volatility can cause some pretty costly errors.

Many, if not most, people have the capability to pick businesses that make sensible investments. Many, if not most, people have the ability to decide a sensible price to pay for an asset. Few people, however, have the ability to consistently see how assets are trading and remain rational. Moreover, the faster the prices move, the less rational people are. Why?

Upside volatility in stocks people don’t own causes FOMO (fear of missing out). This can lead to investors chasing stocks that run at exactly the wrong time. Downside volatility in stocks people own cases the flight response nature ingrained in our psyches. This can lead to people bailing on stocks they own at exactly the wrong time. Joel Greenblatt summarized public investing well when he said he gets paid more to have a strong stomach than for his analytical ability. See http://cfany.gallery.video/fullconference/detail/video/6053271135001/joel-greenblatt—keynote-presentation:-ben-graham-vi at 17:20 and 21:00ish.

So yes, Beta is risk. To the investor’s behavior. Beta, however, is not investment risk. Nor is it business risk. Thus, the academics got it right. Sort of…

Buybacks: An Inside View

Delta bought $1Bn+ of their own shares in February 2019. In doing so, Delta accelerated management’s planned capital return to shareholders. My first thought was “Delta thinks its stock is cheap.” Today, I view the move as smart capital allocation with potential upside.

Delta funded the transaction with a seasonal working capital debt facility. Usually a company has to pay an upfront fee to obtain a new debt facility. Let’s assume the upfront fee was ~37.5bps given Delta’s credit profile and ongoing bank relationships. Like all debt facilities, there’s an associated interest expense with the facility. These facilities are usually priced in relation to LIBOR. For this discussion, I assumed Delta has to pay LIBOR + 150bps. That said, I suspect the cost is closer to LIBOR + 75bps or LIBOR + 100bps. Either way, the example yields the same conclusion.

Assuming Delta obtained the facility in January, the cost of the facility looks something like this:

Note – the repayment assumptions accelerate during the summer because that is peak travel season.
Note also – Delta’s 2020 bonds yield slightly more than 2.60% to maturity. The facility above assumes a 4.15% interest rate. Thus, I suspect these calculations prove overly punitive to Delta’s ultimate interest expense.

As shown above, Delta incurred an incremental interest expense of roughly $13.8mm. What did Delta gain?

Delta’s dividend savings during the period almost exceeded the cost of the facility. On an annualized basis, the dividend savings exceed the assumed facility cost by 138%. Obviously, this math can get taken to an extreme because the company can retire more shares as it borrows more money. That said, this is a great example of how an investment grade balance sheet enables a company to play offense when opportunities present themselves.

Delta’s decision carries some risk. If the summer travel season is poor then Delta may not be able to pay the facility off as quickly as I assume. In that case, the facility costs will exceed my projections. Nevertheless, the company could manage an additional billion dollars of debt, if necessary (it had $1.9Bn of cash as of 3/31/19).

Importantly, despite any temptations, management didn’t get too carried away on the facility size. Accordingly, Delta made a low risk, potentially high reward bet. Those are exactly the kinds of bets I want my management teams making.

NOTE: Delta increased their dividend from $1.24/sh/yr to $1.40/sh/yr following the repurchase. This reduced the annualized savings from retiring the February shares from $24.3mm to $2.2mm. Personally, I would prefer for them to retire the shares and pay special dividends rather than raising the promised dividend. That said, I understand management’s decision and remain pleased with the corporate finance decisions.

European ULCCs – Time Arb Available

Ryanair (“the Company” or “RYAAY”) is Europe’s largest low cost airline (“LCC”).  The Company’s operations are extremely strong and it’s balance sheet is pristine.  Historically, the Company consistently produced the best margins in the industry.  RYAAY’s income statement is under pressure because Europe has way too much flying capacity and competitors are acting irrationally.  Moreover, Brexit fears and a recently adopted union contract (Ryanair wasn’t “union” until last year) have investors very nervous about the future.  So nervous that Ryanair’s ADRs are selling at $70.19/ADR (as of 5/22/2019) vs a high of ~$127.20/ADR (set 11/27/17).

Consequently, Ryan Air’s EV has meaningfully declined:

Note, the current EV is $13.3Bn (excluding leases, which account for 6% of the fleet) on a $12.8Bn market cap.  The company thinks its stock is cheap and just announced a $700mm buyback.  Therefore, roughly 5.5% of shares outstanding will be bought in at arguably attractive prices. 

Importantly, Michael O’Leary, the CEO, is not known to overpay for anything.  Further, he’s demonstrated particularly adept capital allocation. For instance, he made an incredible aircraft purchase following 9/11 and opts to pay a special dividend in order to maintain cash flow optionality.  Given his record, it’s unlikely he is going to meaningfully overpay for stock. Further, he has 112 million reasons to double profits over the next 5 years. See https://skift.com/2019/02/11/ryanair-ceo-michael-oleary-could-get-a-giant-payday-despite-airlines-current-woes/. Thus, I don’t foresee him using cash for anything unproductive at this time. Accordingly, I give this share buyback more weight than others.  

Nevertheless, it’s important to see whether anything fundamentally changed within the company to warrant the downward enterprise value rerating?

Operating Performance

Going back to 2006, Ryanair’s operating performance has been fairly volatile.  That said, the company’s trends are strong driven by increasingly efficient asset utilization.  A chart may help show this:

As shown in the chart above, over time, Ryanair generates more sales per dollar of assets employed.  This indicates the Company consistently improves it’s ROE potential.  However, margins are volatile.  Today, margins are within the “normal” historical range.  That’s a pretty impressive feat considering the state of European air travel.  Most importantly, RYAAY’s margins have a reasonably high probability of increasing as the competitive landscape rationalizes.

Competitive Landscape

European air travel demand is remarkably resilient.  Since 2005, passenger kilometers traveled have increased at 4.9% per annum (vs. 2.1% in the US).  JP Morgan attributes that growth to (1) the stimulus of low fares (the low cost carrier (“LCC”) model is younger in Europe than the US); (2) Western European trips/capita well below the US; and (3) under penetrated growth opportunities in Eastern Europe.  Moreover, LCCs grew their share of air travel from 17% in 2008 to 25% in 2018.  This happened because LCCs (1) stimulated air travel with low fares (remember, trains are very viable competitors in Europe); (2) took market share from legacy airlines; and (3) opened new bases at secondary airports.

Here are a couple interesting charts illustrating potential European travel per capita and LCC market share:

Unfortunately, the European airline sector made a classic mistake.  They expanded capacity way too quickly; growing capacity by 8-9% in calendar 4q18.  Estimates suggest 1q19 capacity growth will also be close to 8-9%.  Compare those rates to the 4.9% growth in passenger kilometers traveled and it’s easy to see why there are short term capacity problems.  Michael O’Leary discussed Europe’s airline industry on Ryanair’s May 2019 conference call:

I’ll bet O’Leary’s comments prove reasonably accurate.  Especially as they pertain to Ryanair’s ability to weather the storm.  Yes, he is outspoken, brash, and sometimes contradicts himself, but his track record at Ryanair is impeccable.  Further, his relentless focus on cost cutting is where I want to bet in a commodity game.  That said, avoiding commodity games could be a smarter way to invest.  Regardless, I have a sickness that pulls me toward my perception of value wherever I find it.

See below for some additional context on potential consolidation and the European airline industry’s recent economics:

Ryan Air Business Strategy

Ryanair is an amalgamation of Walmart, Amazon, and the airline industry.  The company is hyper focused on efficiency.  According to a friend (@Maluna_Cap on Twitter), Ryanair’s IR department said the entire airline has a call every morning.  After the first wave of flights takes off, the head of each airport dials into a conference call.  On the call they all give status updates.  Managers are expected to explain the reasons behind any and all delays.  Imagine the pressure of having to explain to ~80 peers why your airport performance was poor that day. Needless to say, that culture results in an efficient airline.

Note: Overall on time performance is declining in Europe due airport congestion and inadequate air traffic control infrastructure.

Ryanair’s strategy is to price seats extremely low in order to drive yield factors.  Beginning in 2014, Ryanair adopted its own version of “scale benefits, shared.” The airline has consistently dropped price in order to drive yield. Since 2014, prices per passenger declined from €46/passenger to €39/passenger. On average, Ryanair’s fares are 15-20% lower than its nearest competitor (Wizz), 30-40% lower than EasyJet, and 70-80% less expensive than Lufthansa, IAG, and Air France/KLM.  The result speaks for itself:

Note: Ryan Air pursued the strategy of using fares to stimulate growth

Ryanair’s low fares stimulate air travel.  Many of RYAAY’s destination airports are secondary airports (think Midway in Chicago rather than O’Hare).  Therefore, they are less expensive to fly into (Wizz benefits from using secondary airports as well).  Moreover, they are looking to increase passenger traffic. This gives Ryanair negotiating leverage over the airports. Consequently, Ryanair’s network has structural cost benefits embedded in it; especially against anyone not named Wizz.  Importantly, those cost advantages are hard to replicate because Ryanair’s scale results in increased discounts.  See below for Ryanair’s scale advantage:

Next, Ryan Air sells consumers ancillary products.  Similar to a grocery store’s use of milk, Ryanair prices seats at razor thin margins in order to sell additional upgrades (seat choices, preferred boarding, snacks, etc).  Thus, high load factors help (1) improve (a) revenue (additional people to buy ancillary products), (b) margin (ancillary revenues are almost completely accretive to margins), and (2) reduce costs as Ryan Air can negotiate better rates with airports, as discussed above.

Finally, Ryanair operates a very young fleet, which it owns.  The young fleet requires less maintenance and downtime.  Therefore, Ryanair’s maintenance costs are low and fleet utilization is high.  Moreover, Ryanair carries very modest leverage so the entity avoids a lot of the fixed costs embedded in financing a capital heavy business.

Putting it all together, below is a chart that shows Ryanair’s costs (CASK), revenues (RASK), and operating profit (EBIT per ASK) vs. Easy Jet and Wizz (note: all units per kilometer, which is the appropriate metric to use; generally longer trips generate more profit):

Business Conclusion

Fundamentally, its hard to see why Ryanair’s enterprise multiple warrants a long term multiple contraction.  Yes, there are short term issues.  And yes, the decision to recognize unions could hurt the underlying economics of the business in the short term.  However, based on Ryanair’s history, I suspect they will manage their unions as well as anyone.  Moreover, there is room to raise ticket prices to cover additional costs and still offer incredible value to customers.

Brexit is a major short term concern.  In the event of a hard Brexit, Ryanair is going to have to work with the EU to structure their shareholders in a way that 50% or more are EU domiciled (due to EU regulations).  Further, there will likely be some travel disruptions as 23% of Ryanair’s sales come from the UK.

However, it’s hard to see Brexit being a permanent overhang on the LCC travel industry.  Travel existed before Brexit.  One would think rational minds can prevail in order to keep travel occurring after Brexit.  That statement may be debatable.  Regardless, it appears as though extremely poor short term industry dynamics and Brexit concerns resulted in a potential opportunity. 

Valuation

Ryanair’s relative valuation is pretty low compared to it’s history. While the growth potential may have slowed, it still exists. Slower growth, combined with potentially higher labor costs, would warrant some multiple compression. However, the current rerating seems overdone.

Source: Bloomberg; 5 year Equity Relative Valuation vs. Self
Source: Bloomberg; 2 year Equity Relative Valuation vs. Self

Moreover, the company is guiding to between €700-€950 of profit this fiscal year. That means the offered unlevered earnings yield on the enterprise is 6-8% on depressed earnings. Furthermore, an entering shareholder’s return will benefit from the 5% share buy back authorization.

As of today, I believe Ryanair is approximately 25%-30% undervalued. I’m basing that on a number of scenarios. The downside risk to my terminal value estimate is approximately 33%, my base case expects terminal value to increase by 58%, and my blue sky scenario expects terminal value to increase 86%. The investment’s realized return will depend on the accuracy of those estimates, the time it takes for the market to realize Ryanair’s value, and whatever cash flows Ryanair generates.

In short, I firmly believe the expected value of this bet is positive. My bet is Ryanair’s current valuation reflects short term (12-18 month) concerns rather than a permanent degradation in operating potential. Accordingly, Ryanair warrants consideration at these levels.   Disclosure: Purchased a starter position on 5/21/2019 (yesterday); concerned about portfolio construction considering my Delta and Alaska investments.

———————————————————————————————-

Wizz is also interesting around these levels because almost all of the same analysis applies.  Wizz, however, is smaller, younger (still non union), and leases its planes.  Generally speaking, my view is the offered price on Wizz is much closer to intrinsic value.  That said, Wizz will likely reward its shareholders through growth.  In my view, Ryanair’s current EV and balance sheet provide a reasonable source of margin of safety.  Therefore, I am more comfortable buying the proven asset at a discount to what I think it is currently worth.  Moreover, Ryanair’s growth isn’t done even if it is going to be slower. 

Airlines – Grounded or Taking Off?

It doesn’t make any sense that Warren Buffett, arguably the greatest quality investor ever, retreated to his “value” roots to invest in airlines. This is the same guy that didn’t let Nike get through his investment filter. And now he invested in airlines? Airlines! The…worst…business…ever. Or is it?

Note: This is not investment advice! An airline investment is extremely risky and should only be undertaken after deep due diligence. If you believe what is written here and buy the shares of any company mentioned you should expect to lose your capital to someone more informed than you. Furthermore, the volatility in airline stocks is not for the faint of heart. Do not let yourself get interested in this idea if you consider Beta to be a meaningful metric.

Airlines: A Brief History

First, some facts must be stated:

  • Airlines will never be a capital light business. They require reinvestment to remain relevant. They may not need to purchase all new airplanes (ahem, American), but they do have to consistently reinvest in the cabin and airport experience.
  • No matter what, people will complain about flying. Very rarely do you hear someone say “Let me tell you how much I enjoy flying commercial airlines.” Usually people say they are being treated like cattle and getting gouged. The gouging claim is particularly interesting considering its never been less expensive to fly, but I digress. See
    https://www.travelandleisure.com/airlines-airports/history-of-flight-costs
  • The history of the airline industry is littered with wasted stakeholder capital. Note, I did not say shareholder. Everyone has had to compromise; shareholders, debt holders, employees, and sometimes customers. Here’s a quick look at a truly horrendous industry history:
Source: BAML

Historically, financially weak competitors wreaked havoc on financially responsible airlines. Usually, the weak competitor had poor cost structures and too much leverage. Combine that with high exit barriers and high fixed costs and you have a recipe for disaster.

Why? Airline seats are commodities. Always have been and probably always will be. Thus, airlines can’t do much when competitors react to financial trouble by pricing seats to cover variable (rather than all in) costs. Once an airline prices seats in that manner, all competing airlines are faced with two bad choices:

  • Don’t match price, lose yield, and pray to cover costs.
  • Match price, lose margin, and pray to cover costs.

Neither of those choices are great. The problem gets exacerbated when the financially distressed competitor files for bankruptcy. Bankruptcy usually enables poorly run/capitalized airlines to restructure their liabilities (such as union contracts, debt arrangements, etc.). Following the bankruptcy proceedings, a new, lean airline emerges to compete against the well run and responsible airline. Thus, responsible airlines have had to compete with poorly run airlines while they were in decline followed by cost advantaged competitors post restructuring. That’s a tough equation.

The Enigma

If all that is true why did Buffett choose to invest in this space? Doesn’t he understand history? Doesn’t he understand that buying a one of a kind brand like Disney at a market multiple is a great bet? Isn’t he the one that said a capitalist should have shot the Wright brothers? Isn’t this the man that said:

“Businesses in industries with both substantial overcapacity and a ‘commodity’ product are prime candidates for profit troubles. Over-capacity may eventually self-correct, either as capacity shrinks or demand expands. Unfortunately for the participants, such corrections often are long delayed. When they finally occur, the rebound to prosperity frequently produces a pervasive enthusiasm for expansion that, within a few years, again creates over capacity and a new profitless environment.

The Pari-Mutuel System

Buffett understands compounders, capital light compounders, pricing power, quality, and any other phrase you throw at him. But, what I believe he understands better than most is the odds at which each bet stacks up against each other. As Charlie put it:

“Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so o­n and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet…The prices [are such]…that it’s very hard to beat the system.” – Charles T. Munger

While the odds offered are important, any damn fool can also tell you a three legged horse isn’t going to win the race. A lame horse is a lame horse. Good odds aren’t going to change that. So, what does Warren see that makes this horse worth betting on?

Industry Facts

Today, 4 major airlines control 80+% of all US seats.

Source: BAML

More importantly, at least 3 of the 4 are financially stable. The one that concerns me the most is American. Doug Parker, American’s CEO, would respond by saying the company’s loan to asset value (“LTV”) is reasonable. I don’t necessary disagree with that thought process. However, I worry about the interest expense (an added fixed cost in a downturn) causing irrational behavior. Given the industry’s history, I’d far prefer American to have a better balance sheet this late in a cycle.

Nevertheless, here is Scott Kirby, President of United, discussing what is “different this time:”

American remains my “canary in the coal mine.” That said, American is acting rational and the Big 4 have been rational since they consolidated. Whether they remain rational in a downturn remains TBD. But, as my friend Jake Taylor mentioned in his book The Rebel Allocator, industries can usually remain rational when they have under 5 major participants…

In the meantime, airlines benefit from:

  • structural tailwinds (people valuing travel and bragging via Instagram; the trend towards urbanization also helps because consumer spending on travel to see family has proven to be resilient),
  • technological advancements (far better scheduling and pricing ability),
  • more efficient, rolling hubs (3 large legacy carriers can run much more efficient hubs than 6 carriers could ever hope to),
  • decoupling of booking fees and ancillary revenues (ancillary revenues are harder to price shop and therefore more inelastic),
  • airport infrastructure that is difficult to expand (gates are somewhat constrained), and
  • the often overlooked credit card agreements.

A Quick Note on Game Theory

Airlines seem to face a prisoner’s dilemma with pricing decisions. A description of the prisoner’s dilemma can be found at
https://en.wikipedia.org/wiki/Prisoner%27s_dilemma. There’s validity to the argument that in any given pricing situation Airline A is incentivized to “cheat” on price in order to gain market share. Since Airline B is afraid of that incentive, Airline B is incentivized to do the same. Thus, they will both end up cheating and aggregate returns will be suboptimal.

However, the prisoner’s dilemma applies to a game played only once. In the airline industry the game is played thousands of times every day. If Airline A cheats on one route, Airline B can respond on a different route. The 4 major participants signal to each other over and over again. They all also respond to these signals. When the game is repeated with such frequency it’s more likely to lead to prices that generate acceptable (though not great) returns.

Therefore, the repetition of the game reduces the potentially destructive incentives to cheat. Borrowing/bending a term from physics, the industry remains in quasi stable equilibrium. See
https://web.ma.utexas.edu/users/davis/375/popecol/lec9/equilib.html.

Competitive Position Assessment

SCG likes the competitive positions of the ultra low cost carriers (Allegiant, Spirit, Frontier), Delta (generates a revenue premium), and Alaska (benefits from a cost advantaged union contract that is unlikely to go away). As I see it, costs are the only way to win consistently in commodity industries. That said, Delta is an incredibly well run airline and has proven revenue premiums are sustainable in this industry. It’s only right to credit Phil Ordway of Anabatic Investment Partners as the original source for that line of thought. His thought process is compelling and I haven’t been able to debunk the reasoning. Disclaimer: Long Delta and Alaska.

Credit Card Agreements: The Gem No One Cares About

The industry’s credit card agreements are immensely profitable for the airlines. Further, the cash flows are growing at reasonable rates and generate free cash flow “float.” Alaska Air Group discussed their credit card agreement at a JP Morgan event. Here’s what they said:

Note: ALK’s enterprise value is $11.4Bn (inclusive of pension obligations and operating leases). So, cash flow from credit card/loyalty agreements totals 8.7% of a fully baked enterprise value.

It’s certainly interesting that Buffett, who’s core competence is financials, just happens to be interested in airline stocks at the same time the industry’s credit card economics improved. Maybe it’s a coincidence. Maybe not.

Interestingly, Delta recently announced that they renegotiated their deal with American Express. See
https://ir.delta.com/news/news-details/2019/American-Express-and-Delta-Renew-Industry-Leading-Partnership-Lay-Foundation-to-Continue-Innovating-Customer-Benefits/default.aspx. That new deal extends the relationship to 2029. Delta expects to generate $7.0Bn of free cash flow from this agreement by 2023 (vs. $3.5Bn in 2018). Of that $7.0Bn, $3.0-4.0Bn will be a “marketing fee.” Marketing fees are pure margin and don’t require Delta to fulfill any obligations. The remaining $3.0-4.0Bn of cash flow has a murkier margin because the benefits usually reduce revenues per flight. That said, if the benefits are used to fill an otherwise empty seat they are virtually all margin since the variable cost of that seat is negligible.

At a minimum these credit card agreements are a very efficient way to finance the business. A bull would argue this portion of the business is a high margin sales organization growing at ~14% per year. What’s that worth? Joe DiNardi, an analyst for Stifel, Nicohaus & Co is asking that same question:

Most importantly, why have the credit card economics changed so much and are these changes sustainable? That was a difficult question to answer. Scott Kirby believes it’s because of the airlines’ improved financial positions. See below:

Mr. Kirby’s explanation is rational. Distressed loans require banks to hold more capital against the loans. That additional capital requires a return. Therefore, the notion that banks historically hit their “hurdle rate” by keeping all the credit card economics makes sense. With the industry in better shape, banks now hold less capital against the loans and probably generate more cash management (and other ancillary) revenues. Thus, they are more willing to give up some of the credit card economics.

Importantly, Delta’s recent announcement seems to suggest the good times will continue for the airlines and credit card commissions. That’s good for all stakeholders.

Why Delta

Now that we’ve established that airlines might be reasonably healthy horses, it’s time to look at the odds offered on the bet. This post will analyze Delta because SCG believes it’s far and away the best run hub and spoke airline in the world. Further, Atlanta is a sustainable competitive advantage for Delta’s network. Atlanta is so valuable because it’s incredibly efficient. Some estimates say Atlanta is up to 200bps more profitable than other hubs. This advantage stems from Delta dominating the hub and Atlanta’s traffic volume.

Perhaps most importantly, Delta can survive turbulent periods. In the event of a downturn, Delta has $1.9Bn of cash, $3.0Bn of revolver availability, and generated free cash flow in 2009. Therefore, Delta can probably handle the left tail of potential outcomes. Delta has $1.7Bn of debt maturities coming due in 2020 and $1.4Bn due in 2022. It would be nice to see them refinance and meaningfully extend the term of that debt. Now is a good time to refinance because debt markets are seemingly starved for yield.

Delta’s Offered Odds

With that in mind, let’s take a look at Delta’s free cash flows available to equity since 2009. This analysis of free cash flow available to equity adds back a proforma adjustment assuming 40% of capex was financed with debt. As of today, Delta’s debt to Net PP&E totals 37%. Delta’s management is pleased with the balance sheet today. Thus, analyzing average free cash flows using a proforma adjustment assuming 40% of capex will be financed going forward is reasonable assumption.

Since 2013, Delta’s average pro forma free cash flow available to equity totaled $4.1Bn per year. As stated, this number rests on the proforma adjustment assuming that 40% of capex was/will be financed. Again, I am comfortable with that assumption because (a) it’s unreasonable to expect Delta to not finance any equipment purchases, (b) the balance sheet is in a reasonable financial position (debt and debt like obligations account for 41% of asset value; those obligations consist of $9.0Bn of pension obligations, $10.7Bn of debt, and $5.8Bn of operating leases), and (c) it’s more important to figure out how the business is going to look going forward rather than what it looked like in the past.

2013 is a valid starting point for the analysis because it is the year the DOJ approved the last of the Big 4 mergers. A reasonable argument can be made that requires the analysis to look back to 2009 (which is why I showed those years as well in the chart above). That said, I base this analysis on the competitive period that is most similar to today.

Going forward, Delta should return most of the free cash flow available to equity to shareholders. Let’s say they use 20% of cash flow to build cash reserves and 20% to voluntarily reduce pension obligations. That leaves about $2.5Bn for dividends and share repurchases. As of 3/31/2019 there were 655mm shares outstanding with a promised dividend of $1.40/share/year. Therefore, Delta will be paying roughly $920mm in dividends annually. Thus, approximately $1.5Bn, or 4% of the current market cap is available for share repurchases. Note, this assumption doesn’t take into account the impending growth in credit card cash flows.

I’d be remiss not to mention that Delta’s market cap includes $2.0Bn of equity investments in other airlines, a refinery that does about $4.0Bn of sales every year (total assets were $1.5Bn at 3/31/19), and a maintenance repair organization (“MRO”). The MRO has run rate revenues of ~$800mm annually with “mid teens” margins. Further, Delta expects the MRO to achieve $2Bn of revenues over the next 5 years. All together lets say the assets mentioned in this paragraph are worth $4.0Bn.

Accepting the assumptions above, Delta currently trades at an 11+% free cash flow available to equity yield. Moreover, they have the opportunity to “buy in” 4% of their shares every year. IF the competition remains rational shareholders have a reasonable chance to earn 13-15% on their capital in the foreseeable future. Those kinds of returns will generate a lot of wealth when rates are below 3%.

The Bet

Returning to Munger for a moment…the airline “horse” may not be the best. But the odds offered are intriguing. Importantly, the horse is reasonably healthy. One question remains: is the future actually different this time? Who knows? Buffett put his chips in. I did too. But, I may be some schmuck that convinced himself an elegant theory was correct because I wanted to believe it so badly. Time will tell. I’ll still be in the position when the story is told.

The beauty of this game is Buffett’s “fat pitch” doesn’t have to be anyone else’s. Regardless of people’s conclusions, it’s important to look at why the greats do what they do. The thesis above isn’t dispositive, but it does hit many of the key points. See also
https://twitter.com/BillBrewsterSCG/status/1010219620131893250 for a bit more industry information.

As always, please feel free to contact me with any questions and/or corrections.

PS. I asked Charlie about the airline investment. He said this:

Recommended Reading/Viewing/Listening

https://www.sec.gov/Archives/edgar/data/1670076/000119312517106522/d366312ds1.htm

See also the Airline Weekly podcast: found at
https://airlineweekly.com/
And really any of the speeches at The Wings Club found on YouTube

The Rebel Allocator is a fantastic and fun book with many pearls of investment wisdom.

PPS. If you liked any of the above commentary look into subscribing to Airline Weekly. Also, follow Phil Ordway @pcordway on Twitter. Phil is the Portfolio Manager at Anabatic Investment Partners LLC. He gave a fantastic presentation to Manual of Ideas that started my research journey. Finally, try to participate in any Manual of Ideas events you can. John Mihaljevic puts on great events and strikes me as a person doing it for the right reasons.

FIZZled Out

The world can change. Fast. Or at least perception can.

At hand is a confession. Or rather, a reflection.

The game of investing is hard. Very hard. A mere 18 months ago I was fairly convinced LaCroix was a true brand. The kind that could stand the test of time. The kind that a young Buffett and Munger would dream of. At the time I saw (and to some extent still see) a low wallet share, frequently purchased, habit forming product that didn’t suffer from taste attrition. The taste attrition attribute was absolutely key to my thesis because it’s the quality that makes Coke so desirable. And, more importantly, keeps customers returning. See the clip below (starting at ~44:28 for why I thought that was so key).

Below are screenshots of when I made my meaningful purchase and sell decisions on National Beverage Corporation (“National Beverage” or “FIZZ”), the owner of LaCroix. I am sharing because I think it’s important to be transparent. In that same spirit I have to admit I bet too little at the time. I wasn’t fully comfortable running a portfolio back then so my strategy was to bet small and ensure survival.

Below is a chart of what happened during my “investment.” I put investment in quotes because it is never my intention to hold a position for under a year. In my view, holding a security under a year is closer to speculation than investing.

Ultimately, I got nervous about how quickly the position increased. I just couldn’t get myself to hold on to an entity priced at ~2.5% current cash flow yield (~$100mm of trailing 12 month free cash flow and a $4.0Bn enterprise value at time of sale). So I sold. The hardest part of selling is I was certain the business would continue to grow. So, I felt pretty horrible as I watched the stock increase another 20% within 10 weeks.

Fast forward to today…I tweeted at @alderlaneeggs (hereafter “Mr. Cohodes”) asking why he was short the company. I was poking around because the stock has fallen substantially since I exited.

Mr. Cohodes is known for shorting frauds. It was odd to see him short this company because, while I agree there are substantial corporate governance issues, I don’t believe fraud is a major risk. While he didn’t give me a direct answer, he did mention competition and his Twitter feed has pictures showing Costco discounting LaCroix Curate (an extension of the LaCroix brand). Therefore, I believe Mr. Cohodes is short because of capital cycle theory (more assets/competition chasing the market) resulting in LaCroix discounting to drive sales. Discounting is not only a sign of organic demand declining, but also results in lower margins.

I didn’t realize I’d find out whether he was right so quickly. Tonight FIZZ released its 10-Q. It contained the following:

Source: http://ir.nationalbeverage.com/static-files/6b551c4f-17d8-40e9-82c9-a7faf2302bec

In layman’s terms the 10-Q said “We’re selling less LaCroix because of a lawsuit ( https://www.usatoday.com/story/money/nation-now/2018/10/05/lacroix-lawsuit-claims-sparkling-water-ingredients-cockroach-insecticide/1532241002/ ). Consequently, our manufacturing margins declined because we processed fewer units and costs stayed fairly constant.” I’m skeptical the lawsuit is the real driver of the volume decline. Therefore, as of today, it looks like Mr. Cohodes is right.

Alternatively, it is possible the lawsuit against LaCroix really has hurt volumes and customers are waiting for the outcome. I suspect the headline of the lawsuit reads worse than the facts ultimately prove. If that is truly the case, I’d bet LaCroix will recover (see Chipotle for an example of a food company rebounding from negative health publicity).

Nevertheless, look at the reaction to the 10-Q:

Which brings me to my takeaways from this post:

  • Beware that facts can change pretty quickly- Just last quarter FIZZ disclosed 16% growth in the Power+ (mostly LaCroix) brands. What a difference a quarter makes.
  • Don’t be afraid to sell when you think you are getting above fair value- I exited when the cash flow yield felt egregious. The short term pain of exiting and watching the stock run up is worth not being in the stock today.
  • Be mindful that things you know may not be so- I was certain LaCroix would grow and grow. This is now two consecutive quarters of free cash flow erosion. Pay attention to facts as they develop and don’t get anchored to an opinion/conclusion.
  • Seek out smart people with divergent opinions- I wasn’t prepared to purchase the stock today. I didn’t have enough data. But, tweeting at Mr. Cohodes (and his response) reframed how I view the situation.
  • The only thing worse than a value trap is a busted growth story.
  • Remain humble.
  • Never anchor to a narrative.

ROIC And Returns

Warren Buffett discussed his Kraft Heinz mistake with Becky Quick. While he still views Kraft Heinz as a wonderful business, he paid too much. Here is a screenshot of the transcript:

Source: https://www.cnbc.com/2019/02/25/full-transcript-billionaire-investor-warren-buffett-speaks-with-cnbcs-becky-quick-on-squawk-box-today.html

Investors often say that overtime your returns will converge with the business’ returns. As Buffett mentions above, that is simply not true. What is true, however, is your returns converge with the underlying business when you purchase a business and it grows substantially following your purchase. The higher the entry price, the more the business has to grow in order to provide the owner with the business’ underlying economics.

The reason is simple. As an owner/partner, you earn your proportionate economics on the earnings a business generates. However, each partner has a different entry price based on a different earnings base (depending on when they purchased shares and/or LP interests). Therefore, each owner/partner is entitled only to his/her purchase yield on the base he/she acquired. Following the purchase, however, an owner’s economics on the incremental earnings base mirrors the underlying economics of the business.

Kraft cannot grow the earnings base Buffett paid for. Thus, he is stuck (for now) earning $6Bn on his $100Bn purchase price. His economics will only improve if KHC (1) repurchases shares when they yield more than 6% on the enterprise (he is effectively averaging down in that transaction), (2) grows again and is able to earn more than $6Bn pretax without needing to raise additional equity, or (3) successfully executes an accretive acquisition.

As the greatest of all time shows, price is extremely important on slow growing businesses. More importantly, he provides some clarity on an often misunderstood investing idea.

Note: This discussion assumes Buffett purchased Kraft with 100% equity. That’s not factually accurate. Financing decisions can change the specifics of the discussion above, but the points made above are accurate for teaching purposes.

FB, AAPL, GOOG – SHAME

The spirit of Henry Singleton cried a little this earnings season. If you don’t know who he is see https://25iq.com/2014/11/08/a-dozen-things-ive-learned-from-henry-singleton-about-value-investing-venture-capital/. In short, he was one of the best capital allocators of all time. He issued shares when Mr. Market loved his company and bought them back when Mr. Market didn’t like his company. Dr. Singleton didn’t care about Mr. Market’s opinion. He used Mr. Market to his advantage.

Today, corporate share buybacks are all over the news. On December 21, 2018 Barron’s ran an article about corporate buybacks setting a record in 2018. https://www.barrons.com/articles/2018-record-stock-buybacks-51545361596. This excerpt was particularly exciting for long term oriented investors:

Why? Because in December there was carnage in the market. Everyone was selling everything indiscriminately. The selling offered up some very interesting opportunities in certain companies. That’s when management teams should pounce.

So what did Facebook, Apple, and Google all do with their cash hoards at that time? Nothing. At least nothing meaningful. And that is a disgraceful outcome given the amount of talent that is at these companies. In retrospect, it’s pretty clear that December was not a fundamentally driven sell off. It was fear based (though Apple actually had a meaningful slowdown in China).

Moreover, these companies had internal data that showed they were healthy. The CFOs knew the businesses were not deteriorating like the stock price. That is the exact time a corporate finance department should increase their buying activity. Especially in a cash generative company! Instead, they sat on their hands.

And that lack of action demonstrates why corporations, in aggregate, are not very good at share repurchases. Corporate buybacks decrease share count and shares historically tend to increase in price. So, for the long term investor buybacks at most prices are better than nothing. But, buybacks have immense potential power and even today’s best companies don’t understand how (or are too scared) to use them properly.

In the interest of disclosure, SCG reduced its cash position from 33% in October to just under 20% by the end of December. This isn’t a promotional statement. In fact, it’s way too early to determine whether that was the right long term decision. But, why in the world were the best companies not meaningfully deploying capital when SCG was? The answer lies in the institutional imperative. And that is a sad realization considering who those companies supposedly employ.

CPG and Capital Theory

The book Capital Returns is too good to summarize. The book itself is a summary of Marathon Asset Management’s investor letters from 2002-2015. The intellectual flexibility that firm demonstrates is inspiring.

One key takeaway is analyzing industries through a capital cycle theory lens. The capital cycle can be described as follows:

  • High returns on capital lead to competition entering an industry.
  • The new competition increases the amount of assets chasing the same dollars of profit.
  • More assets fighting over the same profit dollars reduces margins.
  • Reduced margins decentivize entrants, drive out competition, and enable the surviving companies to begin increasing margins.
  • Repeat

Accordingly, firms and sectors with the lowest asset growth tend to outperform. The phenomenon is called the asset-growth anomaly. See https://www.aqr.com/Insights/Research/Journal-Article/Investing-in-the-Asset-Growth-Anomaly-Across-the-Globe for a solid paper on the topic. That theory is a major reason I like the beer industry so much despite the rise of craft entrants. Globally, I still perceive the industry to be very rational and I view brewpubs more as restaurant competition rather than brewer competition. That said, it’s impossible to view more assets chasing beer sales dollars as bullish for Big Beer. But I digress…

A lot of traditional consumer brands discuss disruption. Why? Historically, traditional large brands leaned on retail distribution channels, dominated shelf space everywhere, scaled production and distribution to enhance margins, and pushed their messages out via advertising. See https://www.forbes.com/sites/antoinegara/2018/04/30/jorge-paulo-lemann-says-era-of-disruption-in-consumer-brands-caught-3g-capital-by-surprise/#2607284d1f9b. Today, the internet eliminated traditional advertising and distribution barriers. Therefore, it is easier to have launch a new brand.

Moreover, consumers are willing to trust brands quickly. Therefore, the brand equity that used to serve as a consumer short cut has eroded. That said, social media influencers and internet marketing are not very discerning. Time will tell whether brand equity makes a comeback. Watch the documentaries on the Fyre Festival on Netflix or Hulu to determine whether you think its plausible that consumers begin to crave the certainty of Big Brands again.

Regardless, barriers to entry are clearly lower than they used to be.
The perception of viability attracts assets to the industry. When new assets chase returns faster than industry profit pools grow, total profit declines. Importantly, Mr. Market knows that. So it’s worth looking to see how entities are priced given the facts. Kraft Heinz is a traditional CPG company impacted by these trends; though mostly because of consumer’s willingness to trust private label brands. Its valuation relative to history looks like:

Source: Bloomberg

I’m not extremely excited about those multiples because a 16x EV/EBIT equates to less than a 5% unlevered (EV/NOPAT assuming no interest expense) cash flow yield on a firm that isn’t growing. Moreover, competition remains strong and private label attacking market share is likely to continue. Personally, I’d like to see Kraft Heinz offer a return on equity north of 12% (PE of ~8.3x) before I got excited given the facts as I understand them.

But, I will continue to watch “melting ice cubes” because when facts and/or results change they can offer very attractive risk/rewards. More importantly, no one else likes to own them. Historically speaking, out of favor companies outperform the most loved companies. Though this last “bull run” makes me wonder whether that rule changed. Time will tell.

BUD Investment Summary

SCG recently acquired a minority interest in AB InBev and presented the idea to MOI Global, a group of investment managers. In the future, I will share the presentation in order to show the investment thought process. In the meantime, below is a summary of my thoughts. NOTE – This is not investment advice, all information should be confirmed, much of this is opinion, and AB InBev carries substantial risk.

Volume and Price Trends

Large beer companies’ biggest brands in developed markets are losing volume. Therefore, they’ve driven growth (if any) by increasing prices. In the U.S., growth in the beer category is attributable to craft and imports. While AB InBev has an impressive import portfolio, it needs a brand that resonates with Hispanic consumers (the company owns the rights to Corona and Modelo globally but had to sell the U.S. brand rights because of antitrust concerns).

People often say 3G doesn’t know how to drive organic growth. Is that true?

Yes, that data is stale. But, that chart doesn’t suggest 3G can’t grow organically. Instead, it says the biggest brands within AB InBev’s U.S. portfolio are losing share. But so are the categories those brands compete in. Stella, Michelob, and Rolling Rock are all growing nicely. Moreover, Corona and Modelo, which benefit from 3G’s international marketing are also growing nicely. I’d argue the trends against AB InBev’s larger brands are so strong that volume losses aren’t really management’s fault.

The beer industry responded to the volume trends above by increasing prices:

How far can they push price? That’s to be determined. In the meantime it’s important to look at how coordinated the price increases are. The beer industry benefits from a consolidated market with rational competitors. Craft is taking share and may put a ceiling on future price increases, but the image above shows an extremely desirable competitive industry dynamic. See http://ec.europa.eu/competition/mergers/cases/decisions/m7881_3286_3.pdf and https://www.justice.gov/atr/case/us-v-anheuser-busch-inbev-sanv-and-sabmiller-plc for interesting discussions about the industry.

Global Consolidation

AB InBev primarily competes in consolidated end markets. Moreover, the company has dominant market share in many end markets:

“Market share is often conflated with a competitive advantage, which it’s not…Generally speaking you will have much better economics when you have a relative scale advantage.” Pat Dorsey to Patrick OShaughnessy on the Invest Like the Best podcast, 2/20/2018 @ 30:25-31:34. The chart above is strong evidence of AB InBev’s relative scale advantage. That scale advantage, combined with consolidated end markets is highly desirable and results in eye popping gross and EBIT margins.

Leverage

The biggest risk in this investment is the leverage. While the headline leverage number is very high, it’s important to note that the leverage was incurred to make transformative acquisitions. It’s reasonable to criticize 3G for paying too much for SAB Miller. That said, the acquisition combined the number 1 and 2 players in the market, solidified AB InBev’s relative scale advantage, and gave AB Inbev exposure to growing end markets. Carlos Brito, AB InBev’s CEO, discussed the strategic importance of SAB Miller’s India assets saying:

The Groupo Modelo transaction was also strategically important. Groupo Modelo’s strategy involved gaining market share by keeping price constant. That strategy hurt Big Beer’s ability to raise prices without losing volume. When AB InBev acquired Groupo Modelo the U.S. beer market became more rational and the company acquired fantastic global beer brands. See https://www.justice.gov/atr/case/us-v-anheuser-busch-inbev-sanv-and-grupo-modelo-sab-de-cv for details.

Finally, 3G structured AB InBev’s debt incredibly efficiently. The debt has a weighted average cost below 4.5%, no covenants, and an incredible maturity profile. Recently, they improved the maturity profile even more but did have to issue slightly higher cost debt. See https://www.sec.gov/Archives/edgar/data/310569/000119312519007051/d691727d424b5.htm for prospectus.

Conclusion

There’s a lot of risk in this investment. People have said there’s no Alpha and AB InBev just offers Beta risk. That is a reasonable argument. But, it’s reasonable Beta risk to take because the company has such a strong competitive position and frequently sells a drug to a diversified consumer base.

The market doesn’t like management right now. But, the market is fickle. At these equity prices the investment can work without heroic assumptions. Below is a back of the envelope model.

In my view, the projected return is reasonable and the model is conservative. While I’d prefer returns far higher than 9%, this entity is an extremely strong competitor with a great management team competing in a consolidated, rational industry. Morever, the entity isn’t likely subject to technological disruption. 9% is reasonable given those facts.

Bears will disagree. That’s what makes markets.

The Merits of Writing

First and foremost, SCG is not an investment advisor and does not recommend buying shares in AB InBev.  The investment discussed below has substantial risk and should only be considered after lengthy due diligence.  That said, I recently purchased shares of AB InBev @ $68.37/sh.  Therefore, readers should presume I am promoting my own position when I am talking about AB InBev going forward. 

I recently presented an investment in AB InBev to a group I belong to, The Manual of Ideas, as my “Best Idea of 2019.”  That was my first presentation to the group.  Thus, I took career/reputation risk discussing this investment.  Moreover, it’s an investment with a credible bear thesis so I have a reasonably high chance of looking “obviously foolish.” As if that weren’t emotionally taxing enough, yesterday I saw some numbers released that created some “fast thinking” panic.  Bud and Bud Light both apparently saw U.S. volume declines in excess of 6%.  See https://adage.com/article/special-report-super-bowl/ab-inbev-reveals-super-bowl-ad-plans/316173/?mod=djemCMOToday.

My first reaction to the story was “Great, it took exactly one day for my ‘Best Idea of 2019’ to blow up.” Then I started to do some math and write. 

To begin, I have a high degree of confidence the cited numbers relate to AB InBev’s U.S. business.  The U.S. market accounts for ~31% of sales attributable to AB InBev (AB InBev only owns ~62% of AmBev but consolidates 100% of the entity’s sales).  In 2016 Bud and Bud Light accounted for ~60% of AB InBev’s U.S. volumes.  Presumably this percentage declined as brands like Stella and Michelob grew their percentage share in AB InBev’s portfolio.  But, let’s assume 60% is the correct number and volume production equates to sales.

If 60% of 31% of sales are fading at 6.6% the result is a 1.2% decline in total sales.  That sales decline doesn’t account for the offset in growing brands such as Stella Artois and Michelob Ultra.  That’s actually not that bad. My projected returns rely on U.S. sales declining at 2% per year.  See below.

Do I wish Bud and Bud Light were growing in the U.S.?  Yes.  But I knew they weren’t.  The 6.6% number scared me emotionally.  But once I got rational and “thought slow” I realized I had accounted for that possibility via a conservative underwriting.  That said, rapid volume declines could put my margin assumptions under pressure but as of now I think those margin assumptions are reasonable.  Time will tell.

Without writing I probably couldn’t be so rational about the results because of how badly I want this idea to work.  The presentation induced emotion that otherwise might not have been there.  Thankfully, writing has me thinking slow.  This investment may not work.  But at least the investment’s success or failure won’t be caused by my emotional reaction.

What Should AB InBev Do About Bud and Bud Light?

The investment thesis in AB InBev is not a U.S. focused thesis. That said, the U.S. business is important for AB InBev’s debt repayment. Therefore, data points such as Bud and Bud Light falling 6+% y-o-y are concerning.

I’d like to see more resources diverted towards the craft beer portfolio, Stella Artois, and Michelob Ultra. Those brands are growing nicely. See https://www.bizjournals.com/birmingham/news/2018/10/01/here-are-the-top-20-best-selling-beer-brands-in.html. The recent repackaging in the “Taste of Belgium” 12 pack (Stella, Leffe, and Hoegarden in one 12 pack) is a good packaging innovation. While Bud Light remains important, I don’t believe marketing will solve the consumption trends in that brand; it’s more about milking the cow rather than driving growth.

Longer term, I’d like to see the company figure out how to activate the craft beer portfolio they’ve acquired. Perhaps they should borrow a page from Starbucks and create the beer equivalent of Starbucks Roasteries. A group of really awesome beer shrines in urban environments could be a decent way to remain corporate but also authentic to beer lovers.

Most importantly, AB InBev should focus on emerging markets. The relative scale advantages AB InBev enjoys matter immensely in those economies. Expanding the beer category and offering consumers a reasonably cheap alcoholic beverage solution offers true growth potential in EM. Furthermore, any and all potential distribution advantages should be solidified over the next 3-5 years. Those investments would generate solid ROIC for years to come.

After paying down debt and widening the emerging market moat AB InBev should probably diversify further away from beer. This would be natural as the company already bottles and distributes Pepsi and Gatorade in LatAm. Whether the diversification efforts lead to non drug related beverages or marijuana related beverages remains to be seen. For the near future, let’s work with the portfolio we have and pay down debt. Acquisitions can wait.

Disclosure: Long AB InBev