Fundamental Value Q2 2017 Client Letter
We’re proud to report that, as of the middle of the second quarter, Bireme has been actively investing for over a year. There have been trying and frustrating times, but by and large, starting a business has been exciting and rewarding. We sincerely thank you for your trust. We couldn’t have done it without you.
We know you have many options when it comes to investment management, and we’re honored and humbled that you have chosen us. That trust comes with an obligation, and it is one that we feel acutely. We will continue to work extremely hard to protect and grow your assets.
Fundamental Value (“FV”), Bireme’s US equity strategy, had a solid quarter, besting a strong performance of 3.1% by the market with a 4.7% gross return of its own. This brings gross year-to-date returns up to 11.1% versus a 9.2% return for the S&P 500. Since inception in June of 2016, gross returns are 29.9% for FV and 17.3% for the benchmark. Net returns from inception to date vary between approximately 26-28% depending on fee structure, but in all cases FV has significantly outperformed the S&P 500.
New Investment: Cogeco
This quarter, there was one major addition to the portfolio: Cogeco, a Canada-based provider of cable internet and TV. We bought shares of both Cogeco Communications, the operating company, and Cogeco Inc., an upstream holding company.
Selling internet and TV access through cable lines is a good business. It is often a local monopoly, and where it is not a monopoly it is usually a duopoly, with competition from one other firm with inferior technology such as DSL. This business tends to be more stable and profitable than selling mobile wireless internet access, where there tend to be 3 or 4 scale players ruthlessly competing with heavy marketing and discounting. Many fortunes have been made in the cable business.
Over the last 5-10 years, investors have discovered the quality of this industry segment, and significantly bid up the prices of US cable firms, to the point where these capital-intensive businesses trade at 9-12x EBITDA and often 20+ PE ratios.
Quality for a discount
In Cogeco, we believe we’ve found a business of similar if not higher quality, trading at a much lower valuation of 6-7x EBITDA and a mere 10-12x free cash flow.
Cogeco’s cable and internet businesses are very strong in the markets where they compete. With cable assets in Quebec Province, Ontario, Connecticut, Pennsylvania, West Virginia, South Carolina, and Florida, they are geographically diversified but focused on North America. Their Canadian cable business generates the majority of EBITDA, and they compete mainly with Bell Canada (BCE) in these markets.
They provide internet speeds of 150 Mbps or higher in nearly 100% of the markets they serve. Often, they are the sole provider of speeds higher than 10 Mbps, a level below which many consumers will not even consider subscribing . It is no surprise then that they have been gaining internet subscriber market share in their footprint, from 40% to 44% in Canada and from 35% to 45% in the US, since 2013 .
Testing the bear thesis
Fundamentally, buying a stock is an arrogant action—you imply that you are more knowledgeable than the seller. But are you? What might they know that you don’t? We frequently try to get into the mind of the seller when we buy a stock, in order to make sure we are not the proverbial patsy at the poker table.
In the case of Cogeco, one bearish Wall Street analyst is worried about BCE’s coming fiber build out in Canada. We believe this is a concern likely shared by other sellers of the stock. The thought is that a legitimate competitor to Cogeco’s cable internet will hurt pricing, margins, and customer retention. But to us, the concern seems overblown.
For one, Bell’s fiber rollout has consistently been slower and less impactful than expected. Originally, analysts had expected 70% of Cogeco’s Canadian footprint to be serviced by high speed BCE fiber internet by 2017. According to Cogeco management, that number is more like 45% today, almost exclusively in Quebec, and BCE has said they are focusing on major cities like Toronto (not in Cogeco's footprint) for the next year or two. At current rates, BCE’s rollout will take another 6-8 years before it is complete .
In fact, BCE’s rollout may fail to reach Cogeco’s full Ontario footprint. This is due to the low population density of towns that Cogeco serves (many of less than 30,000 residents). A further difficulty is presented by Ontario’s requirement that most fiber be installed underground, a much more expensive proposition than hanging it on poles as allowed in Quebec . We believe this combination of expensive underground installation and low population density might making running fiber to these small towns cost prohibitive.
Finally, BCE has not been undercutting Cogeco’s pricing even where they have installed fiber. In most cities in Quebec that we studied, they are offering $80 for 50 Mbps vs Cogeco’s $60 for 40 Mbps . This pricing strategy indicates BCE is focused on up-selling their current DSL subscribers as opposed to taking Cogeco’s customers. We think this strategy allows for both firms to generate substantial profits in these duopoly markets.
Cogeco Inc and Cogeco Communications combined are roughly a 7% weighting in the Fundamental Value portfolio as of this writing.
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.
1 Bell / Cogeco internet speeds and pricing collected from multiple cities in June of 2017.
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.
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