Fundamental Value Q2 2018 Client Letter

FV slightly trailed the market in Q2, returning 3.3% before fees vs 3.6% for the SPDR S&P 500 ETF (SPY). This brings the portfolio’s annualized outperformance, after typical fees, to 6.1% since inception.¹

For the second quarter in a row, the largest negative contributor was Cogeco, as our investments in Cogeco Communications (CCA) and Cogeco Inc (CCA/CGO) declined 10-15%. We continue to think Cogeco is extremely cheap at <10x FCF for a locally dominant cable provider, as we laid out in our Q2 2017 letter. We bought more CCA this quarter, and it remains one of our largest positions. Despite the fall in the stock price, Wall Street EPS estimates for Cogeco Communications have been rising year to date, moving from 6.02 to 6.36 CAD for 2018.² On June 29th, the shares fetched 64.68 CAD.

Another material contributor to performance in the quarter was 21st Century Fox, which re ceived new, higher bids from both Comcast and Disney after the Time Warner merger was greenlighted on June 12th. These bids sent Fox shares soaring from $36.69 to $48.60 at quarter’s end. Clearly, both Comcast and Disney saw the value in Fox that we described in our Q3 2017 letter. Disney’s bid values the target assets at over $38 per Fox share, and does not include Fox News, Fox Sports, or the Fox broadcast network. Although we did sell some of our position (which had grown quite large) in the high 30s, these bids were enough to make Fox our biggest winner for the quarter.

The bidding war for Fox appears to have had a negative effect on the stock prices of both bidders. Disney and Comcast shares have underperformed since the original Disney deal was announced, with Comcast trailing the S&P 500 by nearly 20% since January 1. This is despite Comcast’s business performing well — revenues and EBITDA were up 5.2% and 6.1% respectively in 2017 and are expected to grow in 2018 as well. Yet at its May bottom, Comcast traded at 7.4x EBITDA, a level not seen since September 2013. During that time, S&P 500 valuations have increased from an average of 9.9x EBITDA to over 13x.³

From the beginning, we were less skeptical of the logic of a Comcast bid for Fox than the market seemed to be. First, we saw Fox as undervalued prior to the bidding. Second, there would have been substantial synergies in a Comcast/Fox tie-up. Surely there would be cost savings in combining the two studios, and Comcast would gain access to iconic Fox assets such as the Simpsons, Avatar, X-Men, Deadpool, and Aliens to utilize in their theme parks.

In the end, Comcast bowed out of the bidding for Fox’s core business to focus on its parallel bid for Sky Plc. While it may take on $30B of debt to fund the deal, this amounts to just one year of Comcast EBITDA and Comcast has said that the deal will be accretive to free cash flow per share in year one.

We think Comcast is undervalued whether it completes the Sky deal or not, and we purchased shares for clients at an average price of about $32. This amounts to a little more than 10x our estimate of 2018 owner's earnings.

This is a notably low valuation for what we feel is a high-quality business. Comcast, run by Brian Roberts (son of founder Ralph Roberts), has not had a year of declining EBITDA since 1994. It enjoys dominant broadband positioning in roughly half the United States, and they add territory every year. In some places, AT&T U-Verse and Verizon Fios are legitimate competitors, creating a duopoly. In this respect the business is like Cogeco, in that they face either zero or one legitimate competitor across most of their footprint. It should be no surprise that operating income in Comcast’s cable segment has doubled over the last 9 years, to $13 billion.

Comcast also owns one of the best-performing media assets in the US in NBCUniversal (NBCU). NBCU is a diversified media conglomerate, generating profits from Universal Studios and Dreamworks movies, NBC and Telemundo broadcast networks, cable networks like USA, MSNBC, and CNBC, and theme parks across the world. Since coming under Comcast ownership in 2011, NBCU’s EBITDA has grown from $3.8B to $8.2B. We think Comcast will provide a double-digit rate of return on our investment.

We executed two major sales in the quarter. The first was shares of AT&T that we received in exchange for our Time Warner position. We were pleased to see the deal close as we had expected, although in retrospect we regret not hedging the position with an AT&T short. Regardless, our thesis was not predicated on the value of the AT&T shares and thus we disposed of them.

The other investment we exited was our long-term holding in Berkshire Hathaway. Having appreciated nearly 40% over the last two years (slightly better than the S&P 500), our holding in Berkshire was simply not as cheap as it was in mid-2016. One way to measure this is “look-through earnings,” which treat Berkshire’s minority stock investments as if they were wholly-owned businesses. For example, Berkshire owns 240m shares of Apple. If Apple earns $10 per share, then Berkshire earns $2.4 billion in pre-tax look-through earnings attributable to its Apple stake.

Berkshire traded at about 11x look-through earnings when we first invested. At about 15x now, it is substantially less cheap, and this multiple includes the benefit Berkshire will receive from the new corporate tax rate. We do expect Berkshire to outperform the market, but not by much. And they will likely have to do it without Buffett’s help soon, given the five-year life expectancy of 87-year-old individuals in the United States. We may very well own Berkshire again, as it is a solid collection of businesses, but it will depend, as always, on the price.

We are grateful for your business and your trust, and a special thank you to those who have referred friends and family. There is no greater compliment.

- Bireme Capital

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¹ Net calculations assume a 1.75% management fee. Fee structures and returns vary between clients. FV inception was 6/6/2016.
² Bloomberg data as of 6/29/18.
³ Bloomberg.

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Bireme Capital LLC is a Registered Investment Advisor. Registration does not constitute an endorsement of the firm nor does it indicate that the advisor has attained a particular level of skill or ability. This piece is for informational purposes only. If not specified, quarter end values are used to calculate returns. While Bireme believes the sources of its information to be reliable, it makes no assurances to that effect. Bireme is also under no obligation to update this post should circumstances change. Nothing in this post should be construed as investment advice, and it is not an offer to sell or buy any security. Bireme clients may (and usually do) have positions in the securities mentioned.

Advisory fees and other important disclosures are described in Part 2 of Bireme’s Form ADV. The performance described above is the performance on a dollar weighted average of the securities in all Bireme accounts invested in the FV portfolio. Changes in investment strategies, contributions or withdrawals may cause the performance of your portfolio to differ materially from the performance displayed. Different types of investments involve varying degrees of risk and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. SPY ETF performance includes expenses as well as reinvested dividends. For current performance information, please contact us at (813) 603-2615.