It’s OK to Earn a Return a Different Way – TPL, ATW, WLL, LNG, LSXMK


Be Outside the System – It’s OK to Earn a Return a Different Way

  • Indexation has unwittingly become the place to go for systemic risk
    • Whether the index constituents are designated as consumer discretionary or information technology, or as dividend aristocrats or REITs, their practical capacity to provide differentiated outcomes has been largely drained away
    • Diversification exists primarily in name only
  • Large-cap and mega-cap companies occupy the same multiplicity of ETFs and experience the same inflow of funds upon which they largely depend for their valuation – as they do upon artificially low interest rates
    • They have either substantially saturated their markets and cannot expand their sales, in which case they trade at P/E ratios traditionally reserved for growth companies (22-25x);
    • Or they manifest legitimately rapid growth, in which case their P/E ratios are so anomalously high that they are actually excluded from the index P/E calculations
  • Does the safety of the crowd, herd immunity, still pertain? If the primary risks are systemic, then perhaps one should be outside the system

Texas Pacific Land Trust

  • Even as oil prices fell 41% in the four years through year-end 2016, experienced a 120% increase in revenues from oil royalties and oil-related land leases
  • Extrapolating from 1Q17, 2017 revenues might triple the 2012 result
  • Trust has repurchased 10% of its shares since 2012 and has no debt
  • One of the 10 largest land owners in the US, all of it concentrated in the Permian Basin
  • No Wall Street earnings estimates to be found on Yahoo Finance or Bloomberg, and the shares are not in any indexes (no news stories about it, and almost never an announcement from the Trust itself, other than regular earnings releases)
  • Last month, the Trust filed an announcement: has created a subsidiary called Texas Pacific Water Resources LLC – intent is to provide water-related services to companies engaged in oil drilling activities in the Permian Basin (sourcing, treatment, and recycling, as well as associated infrastructure construction, disposal and even well testing services)
  • Classic example of a dormant or hidden asset. It should also be recognized that no conventional operating business will generate returns as high as a royalty, which is the essential Texas Pacific Land Trust business

True High Yield Investing: Atwood Oceanics (recently sold), Whiting Petroleum bonds (recently sold), and Cheniere Energy Bonds (recently purchased)

  • In early 2016, bought Atwood Oceanics 6.5% Senior Notes due February 2020 and Whiting Petroleum 5% Senior Note due March 2019
    • Atwood rated CAA3 and Whiting rated CAA2
  • At the time, Atwood common shares had dropped by more than 80%, from their mid-2014 high, while the Whiting Petroleum shares had dropped by nearly 90%
  • Using Atwood as an example, it is one of only several global-scope companies that provide ultra-deep-water and harsh environment offshore drilling services to customers like Chevron and Shell
    • Although it was still profitable, most of its contracts were going to expire in the coming 2 years
    • If not renewed or replaced, company would lose most of its revenues
    • On the other hand, long-term debt of $1.61Bn amounted to less than 40% of its PPE of $4.21Bn; moreover, its most valuable vessels, its drillships, were unencumbered
  • With $1.61Bn of debt, PPE would have to be sold for less than 40% of its $4.21Bn book value before its debt would be worth less than face value
    • Margin of safety was greater still, because the average price we paid for the bonds was roughly 56 cents on the dollar, or 44% below face value
    • If operating assets would be written down by 50% and if bank debt were then paid in full, remaining liquidation value of the assets would still exceed the cost of the bonds by 60% – meaning that even under that scenario the bonds would be still be paid off at face value
  • As it transpired, oil prices did not remain at the $25-$30/bbl lows and we sold Atwood bonds this past month at an average price of about 99 cents on the dollar after Ensco agreed to acquire the company (roughly one-year return of 88%; Atwood common stock is lower today than in early 2016)
  • True high-yield investing requires a sufficient discount to face value that the risk has already been factored into the price. This happens by misfortune, not design, and it only happens episodically
  • Sale proceeds of Atwood and Whiting Petroleum bonds were used to purchase the Cheniere Energy 4.25% Convertible Notes due in 2045, at a price of about 70
    • At 70, current yield of 6.1% which is well above the high yield index
    • Bond was issued 2 years ago at a discounted price of 80 which was its official value at the time; that figure is scheduled to increase in small increments every 6 months until it reaches 100 in the year 2045; in March 2020, bond can be called by the company and at that time its official value will be 83
  • If the business does become robust, there is also the possibility for these bonds to be converted into the common shares
    • Shares would have to rise to $138 before the convertibility would increase the value of the bonds above 100 so this would be considered a deep out-of-the-money call option
    • The long maturity date provides, in essence, a 28-year call option on the LNG market
  • In terms of seeking a satisfactory absolute return that is not tied to the common systemic risks now shared by the stock and bond markets, a non-indexed bond like the Cheniere Convertible offers a variety of ways to succeed and many fewer ways to disappoint

Liberty SiriusXM Group (LSXMK)

  • Shares have a trailing P/E of 34.2x and according to Wall Street estimates, trade at 30.4x this year’s expected earnings
    • Those P/E ratios are just the kind of misinformation that an active manager appreciates because the valuation is really about half that
  • As to why we expect to continue holding the shares, must first review some interesting growth statistics about a slightly different company that is necessary to understanding LSXMK. This other company’s:
    • Revenues have been rising at a 10.1% rate for the past 5 years
    • Benefits from scale economies as evidenced by an operating margin that expanded from 22.4% to 28.5% in 2016
    • Net income over the five years has increased by 11.8% a year
    • After-tax FCF is much higher than its net income and has increased by 18.6% a year
    • Reduced its share count by 24% over the last 4 years
    • Per share, revenues are up 16.9% a year, net income 18%, and FCF 25%
    • Part of the reason the FCF is so high is that the company pays no federal income taxes, due to its $1.4Bn of NOL carryforwards and tax credits
    • Company is controlled by John Malone
  • This company has a $25Bn market value so it should be a prime candidate for major index inclusion. However, only 1.85% of its shares are held by ETFs
    • This company is called Sirius XM Holdings Inc (Sirius) and it is the provider of the dominant subscription based satellite radio service, the equipment for which is installed in 75% of new cars in the US
    • Economics of satellite radio are vastly superior to those for streaming music providers as content costs are ~90% of revenue at streaming services compared to less than 40% for satellite radio
    • Over 67% of the Sirius shares are held by LSXMK – accordingly, Sirius’s float is fairly limited
      • Though investors typically assign a premium to companies that might be takeover targets and though an independent Sirius certainly would be, Sirius isn’t independent and can’t be acquired, since it is controlled by LSXMK
      • Therefore, of that much less interest to the short-term investor
    • As to valuation, Sirius trades at 22.0x our calculation of trailing FCF which is a far more conservative measure of earnings than net income or the P/E ratio
      • 22x is almost precisely the P/E ratio of the S&P 500 and while that is hardly a low valuation, the Sirius growth rate far exceeds that of S&P 500
      • Moreover, if Sirius can increase its operating margins by 4% over the next 4 years and allowing for only 5% revenue growth (which is one half the historical 10% experience), current price is equivalent to less than 13x FCF of 2020 – this does not include the beneficial impact upon per-share value of continued share repurchases
      • We own Sirius at a discount through LSXMK: LSXMK has a market cap of $14Bn (only asset is the shares it holds of Sirius)
        • LSXMK shares trade at about a 20% discount to that NAV which would be roughly 18x trailing FCF
        • There are reasons for this discount: LSXMK is presently what is known as a trading stock, as many John Malone companies have been from time to time, not an independent corporation
        • In the event of a major liability or dissolution, Sirius shareholder could not lay specific claim to LSXMK assets
        • Over 47% of the voting power of LSXMK is held by John Malone
      • History of many corporate realignments John Malone has engaged in over time is that they are designed specifically to take advantage of either excessive discounts or premiums that the market applies to entities in the constellation of his business interests
        • Tactics include buying in shares of undervalued subsidiaries, full or partial spin-offs of subsidiaries, recombining or reacquiring them, and so forth

Horizon Kinetics 2nd Quarter Commentary, July 2017

Image Source: Behavior Gap