Hazelton Capital Partners commentary for the third quarter ended September 30, 2020, discussing their top five holdings, which are Renewable Energy Group (REGI), Micron Technology (MU), Caesar Entertainment (CZR), Apple Inc (AAPL), and Berkshire Hathaway Inc. (BRK-B).
Michael Mauboussin’s 10 Attributes of Great Investors [Pt.1]
In 2016, Michael J. Mauboussin completed his 30th year on Wall Street. The analyst, who was working at Credit Suisse at the time, decided to celebrate by reflecting on the ten attributes of great investors he had observed over the previous three decades. He published his ideas in a report in August 2016. I've summarised Read More
Hazelton Capital Partners, LLC (the “Fund”) returned 11.9% from July 1, 2020 through September 30, 2020 and has appreciated 4.6% year-to-date. By comparison, the S&P 500 returned 8.9% during the same quarter and 5.6% year-to-date.
The Quarter in Review - The “K” shaped recovery
Hazelton Capital Partners ended the 3rd quarter with a portfolio of 16 equity positions and a cash level equivalent to 10% of assets under management. The top five portfolio holdings, which are equal to roughly 60% of the Fund’s net assets, are: Renewable Energy Group (REGI), Micron Technology (MU), Caesar Entertainment (CZR), Apple Inc (AAPL), and Berkshire Hathaway Inc. (BRK-B).
Even though the US economy continued to improve in the 3rd quarter, it still is unclear what kind of economic recovery we can expect going forward. So far, the overall recovery has been described as “V” shaped, declining through March of 2020, then quickly snapping back in the subsequent quarters. For those segments of the economy benefitting from the new work-from-home business model, their recovery looked more like a checkmark – achieving economic growth beyond levels experienced in January and February. However, I think the recent recovery would be best described as a “K” recovery, reflecting the divergence between the different segments within the economy. The rising tide of economic recovery is not lifting all boats. It is hard not to see that restaurants, service professionals, and the travel industry (hotel, airlines, and cruise ships) have been devastated by the Covid Pandemic and will continue to struggle for the foreseeable future. In contrast, online and hybrid retailers like Amazon, Walmart, and Home Depot have strengthened their competitive advantage to source, deliver, or provide curbside pickup from online orders helping to both reinforced and expand their market share at the expense of local or less digitally savvy businesses.
The divergence of Covid’s impact on the economy is not being fully reflected in the stock market creating a disparity between Wallstreet and Mainstreet. Through the 3rd quarter, the S&P 500 was up 5.6%, an acceptable return but even more remarkable when considering that starting in March a large portion of the economy was shut down and people were forced to quarantine. Over the past number of years, technology companies have come to dominate the S&P 500 index. As of the end of September, Apple (AAPL), Microsoft (MSFT), Google (GOOG), Amazon (AMZN), and Facebook (FB) represented nearly 25% of the S&P 500 index. These companies, along with other technology names, were able to operate while their business model benefitted from the Covid/work-from-home environment. Without the contribution of these top five holdings of the S&P 500, the index would have had a negative return for the first nine months of the year.
Hazelton Capital Partners’ portfolio was not constructed to replicate an index and, except for having Apple as our fourth-largest holding, does not have a meaningful exposure to the tech industry. As the market pendulum has swung from fear to greed, the Fund’s top holdings have remained mostly the same. Since Hazelton Capital Partners limits its portfolio membership to 15-20 holdings, pruning takes place when a position meets one of three criteria: the stock has reached its expected intrinsic value, the original investing thesis was flawed/meaningful changes to the business model have taken place, or a better opportunity has presented itself. Over the past nine months, approximately five positions were removed or trimmed to either add to existing positions or make room for new holdings. Alaska Airlines was removed from the portfolio because the Fund no longer had a clear outlook of the kind or timing of the airline industry’s recovery.
Renewable Energy Group (REGI) Current Holding
In the 3rd Quarter, Renewable Energy Group (REGI) grew into Hazelton Capital Partners’ largest holding by a significant margin. Already the Fund’s second largest holding, shares of REGI appreciated over 80% in the first 3 quarters of the year. In the second quarter of 2020, during the height of the US economic shutdown, refiners saw demand declines of 70%, 50%, and 30% for jet fuel, gasoline, and petroleum diesel, respectively. During that same period, REGI witnessed steady demand for its biomass-based diesel, as states like California and Oregon and international markets continued to focus on shrinking their carbon footprint. Because of the economic shut down, sourcing feedstocks (greases, used cooking oil, and agriculture oils) became more challenging but also served to highlight one of REGI's competitive advantages, their ability to source and process multiple feedstocks at the same refinery without slowing their output.
Hazelton Capital Partners has shared its investment thesis for REGI frequently (some may say ad nauseum) over the past 6 years, highlighting many of the short-term uncertain headwinds that impacted the company’s runway for growth. Starting in 2020, many of those headwinds have been resolved or greatly diminished. Today, it appears that REGI is beginning to hit an inflection point beyond our original thesis. Use of bio and renewable diesel is expanding globally as both a reliable source of transportation fuel and a proven way to reduce greenhouse gases. Demand for renewable diesel outweighs biodiesel as it is chemically identical to petroleum diesel with greater reduction of greenhouse emissions even when using the same feedstock. Recently, REGI announced plans to expand their renewable diesel operation at its Geismar refinery from 90mmgy to 340mmgy. The company projected that even with their conservative estimates, they expect to achieve return on their investment greater than 20%.
It only took six years after Hazelton Capital Partners initial investment in REGI for the bio & renewable diesel refiner to become an overnight success. During those long and often frustrating six years, the Fund learned a great deal about the benefits of biodiesel & renewable diesel, logistics and feedstock procurement, bio-fuel refining, greenhouse gas reduction, and the benefits of a clear-headed management team. Mostly, the Fund learned the advantage of being a patient and thoughtful investor. Because of Hazelton Capital Partners’ investing strategy and the way it builds an investment over time, it is often early to the party. I often described Hazelton Capital Partners’ investment timing as that “guy” at the wedding helping himself to the buffet table while everyone else is enjoying hors d'oeuvres and cocktails, and then having to wait patiently until dessert is served. That wait can feel intolerable.
In late September and into early October, Hazelton Capital Partners began paring down its position in REGI. The Fund has always prided itself on building and managing a concentrated portfolio. However, as the end of the 3rd quarter grew near, the size and impact of the REGI position was overshadowing the rest of the portfolio. Even after trimming the position by 40% (through October), REGI still remains Hazelton Capital Partners’ largest holding but more in line with the other positions within the top 5. The capital gain generated by the sale of REGI shares was offset by the capital losses taken when money was redirected from Alaska Air and other positions liquidated in the first and second quarters of this year. As REGI expands its renewable diesel production and downstream opportunities, both the company’s margins and long-term intrinsic value will benefit. Hazelton Capital Partners intends to continue to be a long-term holder of REGI shares and may even find an opportunity to add more shares at the right price.
Caesar Entertainment (CZR) Current Holding
In mid-July Eldorado (ERI) completed its $17.3bn acquisition of Caesar Entertainment (CZR), absorbing both its iconic brand and its national properties including Caesar Palace in Las Vegas. Caesar Entertainment is Hazelton Capital Partners 3rd largest position; it may be new to our top five holdings but the Fund has been invested in the casino operator for over three years. In mid-2018, Hazelton Capital Partners significantly reduced its holdings as the company was approaching its long-term intrinsic valuation. During the Funds holding period, Eldorado transformed itself from a Nevada based casino with a handful of regional properties into the largest US regional casino operator with an expanding footprint reaching over 26 properties. In late 2018, as the price of Eldorado’s shares were falling in concert with the rest of the market, Hazelton Capital Partners re-established and expanded its position as the company continued to improve its operations. In June of 2019, Eldorado announced the $17.3 billion acquisition of Caesar Entertainment, a bold move for a regional operator in an industry dominated by global competitors like Wynn Resorts (WYNN), Las Vegas Sands (LVS), and MGM Resorts International (MGM). What made the acquisition both challenging and prolonged, besides the sizable amount of debt needed, was the number of state gaming commissions that needed to approve the deal.
Hazelton Capital Partners was comforted by the impressive track record Eldorado’s management had achieved in acquiring, integrating, and improving operations and profitability from the previous properties they acquired. The same was expected to hold true for the Caesar merger, as management guided annual savings of $500 million, which many believed a conservative hurdle. Most of the savings would come from reduction or elimination from corporate spending, 3rd party professionals, streamlining staffing needs, and leveraging Eldorado’s legacy properties once they are added to the Caesars Rewards program. Before Eldorado had announced its acquisition, Caesar Entertainment had already been hard at work upgrading its properties; an investment that was expected to start paying off in late 2020 and early 2021 and was not part of the announced $500 million savings.
As careful as Eldorado was in planning for the Caesar merger, they could not have foreseen the Covid pandemic or the brutal impact it would have on the gaming industry. Starting in late February and into March, casinos across the nation began to see occupancy fall dramatically as people began to shelter in place. By late March, all the country’s casinos were closed and investors began to worry if the banks were going to honor their debt financing for the Caesar merger. Eldorado’s stock price collapsed from around $70/share to below $8/share in less than 30 days. Even though Eldorado’s management reassure the market that the financing was “locked,” the Coronavirus was forcing regulators to delay their review of the merger adding to the uncertainty. It was not until March 23, when the Federal Reserve announced that it would back the debt market, that Eldorado’s shares began its path to recovery.
In the midst of the Coronavirus and the months since the merger, Caesar (the combined entity) has demonstrated its ability to reduce expenses and improve margins. The company is taking advantage of the Covid operating restrictions (limited occupancy, no buffets, no nightclubs and entertainment, and limited dining) to re-examine its cost structure and profitability by segment & property. The Casino operator is redesigning its operation to be profitable at a lower occupancy by eliminating promotional costs and subsidies, reducing less profitable table games, expanding its rewards program, and reducing customer acquisition costs. The impact of these moves is expected to be seen more clearly when occupancy levels rise.
In late September, Caesar Entertainment announced its plans to purchase British-based sports betting and gaming operator, William Hill for $3.7 billion. The acquisition, which Caesar will partly fund with $1.7 billion of newly issued shares, will expand the casino operator into the fastgrowing segment of online sports betting and gaming. Already partners with William Hill’s US operation (20% partner from Eldorado partnership), Caesar plans to buy the entire company and divest the international segment to focus solely on the US market. Currently, legal sports betting only accounts for less than 8% of gaming revenues, but as more states legalize it, many expect sport betting to eventually overtake live casino gambling and represent over 35% of total gaming revenues. Sports betting has been a mainstay of the Las Vegas casinos for many years and Caesar runs one of the largest and best-known sportsbooks on the strip. But as states are relaxing restrictions around sports betting, it has recently turned into a land grab with companies like Fan Duel and Draft Kings competing with William Hill for share of the mobile market. With its 60 million active Caesar Rewards Members, Caesar Entertainment recognized that mobile sports betting and gaming was another way to engage their reward members when not visiting their casino, build loyalty, and gain a larger percentage of their gaming wallet. The acquisition is expected to close by the second half of 2021.
Hazelton Capital Partners believes that the newly combined Caesars Entertainment will not only be successful but will yield a much stronger and more profitable brand with a national footprint and mobile presence. Even with all its benefits this acquisition expects to achieve, the casino industry is facing an uphill battle to regain its footing. Before the Covid pandemic, the casino industry was already dealing with an aging market and attempting to make gaming relevant to the Millennial and Gen Z demographics. Sports betting and online gaming will help drive younger traffic to become Caesar Reward Members and into their casinos, but in addition, Caesar has also begun diversifying into hosting eSports tournaments. By 2022, Goldman Sachs expects dedicated eSports viewership to increase to 276 million and generate over $3 billion. Over 79% of eSports viewership is 35 years old or younger, a demographic that is highly coveted by the gaming industry to build loyalty, collect their data, and monetize them for years to come. It will not be hard to envision eSports being a strong segment of sports betting at some point in the future. Essentially, the Millennial and Gen Z generations are just as likely to gamble/bet as their parents’ generation, but unlike their parents, the type of gambling (sports betting and online gaming), where they gamble (mobile platforms), and how they gamble (smartphones) is no longer restricted to a casino’s gaming floor.
Apple (AAPL) Current Holding
Apple is another long-term holding that, like REGI, was pared down in the 3rd Quarter. When Hazelton Capital Partners began investing in Apple over 6 years ago, the iPhone 6 was the latest model, Apple Pay was the most recent feature, and revenue was topping $183 billion. Smartphone sales represented over 60% of Apple’s revenue, with Macs, iPads, Services, and Accessories (renamed Wearables, Home and Accessories) accounting for the remainder. Together, Services and Accessories accounted for 13% of total revenue. Today, thirteen years after the launch of the original iPhone, unit growth has slowed considerably. No longer a novelty and lacking a constant flow of new and “must have” features, Apple’s iPhone upgrade cycle has expanded from 18 months to nearly 4 years. It is estimated that 420 million of the 1 billion iPhone users have an iPhone that is three years or older. In last few years, Apple increased the prices of its iPhones with a starting price of $700 for an entry level and rising to $1100 for the top of the line model. The new pricing served to increase the average selling price per unit, which, in turn, has helped offset the slowing growth of iPhone sales. In addition, Apple focused on expanding its Service and Wearable segments to offset plateauing iPhone sales by launching: Apple Music, Apple Watch, AirPod, AirPod Pro, Apple Credit Card, Apple TV+ streaming service, Apple News+, Apple Arcade, and an upcoming fitness app, Apple Fitness+ (due out late 2020). The focus on Wearables and Services has helped to pivot away from product silos, establishing the iPhone as the focal point for all new Wearables and Services, while seamlessly integrating the smartphone with the Mac and iPad product lines. The increase in Wearables and Services also reinforces Apple’s brand, expands its ecosystem, and complements the user’s experience and reverence for Apple and its products.
In its most recent quarter, Apple’s Service segment had grown to represent 22% of total revenues. Services’ contribution is even more meaningful when factoring in that their margins are nearly double that of Apple’s Product segment, as the inclusion of Wearables and slowing iPhone sales have been weighing on hardware margins. Apple’s Services segment is made up of sales from the App Store, licensing, Apple Care, Apple in-house subscriptions (iCloud, Apple Music, etc.), 3rd Party subscriptions, and Apple’s credit card. Over 70% of Apple’s Service revenue comes from the App Store, Licensing, and Apple Care with subscriptions accounting for most of the remaining revenue. In July, Apple announced that it expected to grow its paid subscriber base to over 600 million subscribers across their various services by years end. It is important to understand that most of the projected 600 million subscribers come from third party subscriptions that are used on Apple’s platform of which Apple takes a small portion of the monthly subscription. Apple does not release metrics on its in-house paid subscribers, but it is estimated that iCloud has over 200 million subscribers with Apple Music coming in around 80 million. During its September product release updating the Apple Watch and iPad, Apple announced a new subscription model called Apple One. Until now, subscription services like Apple Music, Apple Arcade, iCloud, Apple TV+, and Apple News+ were ala cart. Starting in late 2020, Apple is bundling those and other services into a monthly subscription model with three different option plans: Individual, Family, and Premier. Plans begin at $14.95/month/person (Individual) and top out at $29.95/month for up to six family members (Premier).
None of Apple One’s subscription services are unique. Netflix, Peloton, Spotify, Dropbox, and many others offer similar services and apps that can be used on Apple’s platform. What Apple One provides is convenience and a lower bundled price (up to 45% savings vs. ala carte). Apple’s ambition is not to dethrone the likes of Netflix or Spotify but to provide relevant services to its one billion users that will engage and retain their interest, expand Apple’s ecosystem, while gaining a greater share of their wallet. A back of the envelope calculation gets a combined monthly subscription for iCloud and Apple Music in the range of $5.75 - $6.50/month. As new and current monthly paid subscribers transition to the Apple One platform, Apples Service segment and overall profits will continue to benefit. At the time of Hazelton Capital Partners’ initial investment, Apple revenues were growing annually at a rate of 25% with a net cash position of $120 million (20% of Apple’s market capitalization). Because iPhone and hardware sales were responsible for most of the company’s revenue and earnings (Services accounting for less than 10%), Apple has historically been valued as a products company at 10-15x its earnings. With the rollout of the 5G network, many expect the iPhone upgrade cycle to be meaningful over the next few years, as over 40% of iPhone users have a phone that is 3 years or older. Hazelton Capital Partners agrees with that outlook but believes Apple’s future growth will be driven by it’s Services segment. As the iPhone maker continues to expand its Services segment while continuing its transition into a lifestyle brand, a growing portion of their revenue will be recurring with more meaningful margins. In turn, shares of its stock will be rewarded with higher earnings multiple, and a runway for growth.
Administrative: Investing in Hazelton Capital Partners
Hazelton Capital Partners was created as an investment vehicle, allowing those interested in long-term exposure to the equity market to invest along-side me. With a substantial portion of my own capital in the fund, I manage Hazelton Capital Partners assets in the same manner in which I manage my own capital. The best source of introduction to potential investors has come from those that have invested or followed Hazelton Capital Partners progress over the years. Introductions are both welcome and appreciated.
If you are interested in making or increasing your contribution to Hazelton Capital Partners or just learning more about The Fund, please feel free to contact me at (312) 970-9202 or email me [email protected] Questions, comments and concerns are always welcome.