Clough Capital Partners LP’s letter to investors titled, “Free Cash Flow Perspectives.”
To Our Investors:
Within the free cash flow theme, Clough Capital Partners’ goal is to make attractive bottom-up investments for the Fund within a top-down context. In October our top-down context came into play in a rather dramatic fashion. Equity markets sold off sharply, and the sell-off was most pronounced in securities that saw forced selling as certain hedge funds unwound gross exposure. We are negatively affected in the short term by this kind of dynamic, but the fact that we generally carry a low gross exposure allows us to carry our high conviction investments through such periods. We stress tested our positions for what we think are two serious risks related to a strengthening US dollar: exposure to international demand, and sensitivity to a normalizing cost of capital. On the first point, our free cash flow theme investments currently skew overwhelmingly to the US as a potential source of revenue, and even more so as a potential source of profits and profit growth. On the second point, this is really why we focus on “quality” to begin with, and believe that it shines in a more discriminating capital environment. We invest in companies that we think are able to sustainably generate returns significantly in excess of their cost of capital.
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We think of this spread as the company’s pricing for the value that they’re providing, and the sustainability of that spread as the strength of their competitive positioning. While the “spread” for some companies can shrink dramatically (we are beginning to see this in many areas of the commodity markets), we believe the “spread” for our companies will remain attractive. Next, I will highlight a few of the core positions where we were recently able to add exposure at attractive prices.
Clough Capital Partners – Liberty Broadband spin-off to create value for Liberty Media
The first example is Liberty Media, where we believe that the recent spin-off of Liberty Broadband is likely to create significant value for legacy Liberty Media shareholders. Liberty Media shareholders received one share of Liberty Broadband for every four shares of Liberty Media, as well as a subscription right to acquire one share of Series C Liberty Broadband stock for every five shares of Liberty Broadband they receive in the spin-off. There are two main reasons we are optimistic about this transaction. First, similar to both a) the Liberty spin from TCI that occurred in 1991, and b) the Liberty Ventures spin from Liberty Interactive that occurred in 2012, this transaction involves a smaller entity being spun from a larger entity. These were seemingly unattractive transactions and the spun companies traded very cheaply at their inception. What makes that scenario attractive for us as legacy shareholders is that we are able to exercise our subscription rights to increase our ownership in the newly spun entity at a discount to what we believe is already a cheap price.
Second, while the newly spun entities typically trade on a NAV based on their percentage ownership in another publicly traded company (in the case of Liberty Ventures, it was Expedia and TripAdvisor, and in the case of Liberty Broadband, it is Charter Communications), we hold a bullish view of Charter and think its shares are a good value at their current market price. Charter is unique in the cable industry in that it has the lowest footprint overlap with fiber in the industry, has historically been undermanaged and therefore exhibits lower than average EBITDA per home passed, and now has what might be the best management in the industry under Tom Rutledge, who joined Charter a few years ago from Cablevision, where he drove EBITDA per home passed to the highest in the industry.
Clough Capital Partners – CarMax a compounder’s stock
The second company is CarMax, which is a new position for Clough Capital Partners. It is the kind of stock we call a “compounder”. It is a very high quality business, in our opinion, and there is a certain issue/controversy which is providing us with a significantly different long-term earnings outlook than consensus. CarMax displays individual store economics that generate attractive unlevered, after-tax returns on capital. Given its scale (2x revenue than its next largest competitor), differentiated value proposition (transparent, no-hassle consumer experience), and differentiated business model (its auto finance and wholesale units complementing its retail operation); we believe its returns are high and sustainable. CarMax also has a significant growth opportunity. Based on the number of metropolitan statistical areas (MSAs) that are unserved or underserved, and fit CarMax’s model, we think the company may be able to double its store base over the next ten years.
Compounding at those returns over the length of that growth runway could create potentially significant value for shareholders. As is typical of a great entry point in a compounder, CarMax’s valuation is currently discounting the impact of subprime financing on its business. The facts are that a rebound of subprime acceptance drove extremely strong comps at CarMax throughout that period. Industry data shows that subprime acceptance rates have since leveled out (albeit significantly below pre-crisis levels), and CarMax has even commented that they are seeing some of their lending partners tighten standards. We believe that industry trend has been exacerbated at CarMax as its largest subprime lending partner was going public during the same time period and therefore had incentive to loosen standards to show growth in their loan book.
We think CarMax fits extremely well into our current pattern recognition model for successful specialty retail equities. That model, loosely, is positive comps on top of significant square footage growth, leveraged by consistent share repurchases with excess cash. In the case of CarMax, we certainly feel like we have the first two pieces of the model in place, and with regard to the third, the company has only just started buying back meaningful amounts of its own stock in the last two years. This last piece has significant room to run, in our opinion. While CarMax has been buying back a substantial amount of its own stock, it’s been doing so with its excess cash flow, not yet tapping into what we believe is a significantly under-levered balance sheet.