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A key focus of our South American trip was to continue to improve our understanding of the most important markets for the Fund investment in Liberty Latin America (“Liberty LatAm”), which operates in the Caribbean, South America, and Central America.  While in Santiago, we met with the CEO and CFO at the headquarters of VTR, Liberty LatAm’s Chilean subsidiary.  VTR enjoys an outstanding culture, a stout competitive position, and opportunities for growth.  The company has another five-plus years of runway to build out its residential fixed network in the country.  These projects have compelling returns on investment, and the realized penetration on new homes passed is currently ahead of management’s initial expectations.  While not a core strategic thrust, VTR is incrementally improving its mobile offering and successfully reducing customer churn, leading to higher lifetime value.  Lastly, VTR has an opportunity to expand its fixed services into the small and medium business market (to date, the company has focused its fixed networks efforts on residential markets).

We took the picture on the left from a Santiago sidewalk with a VTR store in the foreground and the VTR corporate tower in the background. The picture on the right is David playing with the interactive touchscreen in that store, which asks a series of questions about a subscriber to build a suggestion for the best bundle.

We also traveled to Panama to meet with the COO of Liberty LatAm business in the country, Cable & Wireless Panama.  Cable & Wireless Panama is a bit of a turnaround based on the competitive dynamics in that market, namely the presence of four competitors for mobile services.  Liberty LatAm is transforming the business and is implementing best practices from around the broader Liberty system.  We are optimistic about the way the market will develop over the next few years with reinvestment opportunities in broadband internet, expansion in business-to-business services, and the consolidation of the wireless industry.  In addition, management is rationalizing costs through simple initiatives like moving a regional call center from South Florida to Panama.  Overall, we are pleased with how the Liberty LatAm team is allocating capital and its common-sense decisions to manage operating costs.

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In the third quarter of 2019 we met with the CEO and CFO of the Fund holding Coca-Cola Embonor in Santiago.  Embonor bottles and distributes beverages in parts of Chile and most of Bolivia.  Consistent with what we are seeing across the Coke system, Embonor is expanding its product portfolio.  The purpose is to find accretive ways to take advantage of Embonor’s superior distribution reach. Two recent and ongoing examples are instructive.  First, Embonor joined up with fellow bottler Andina and The Coca-Cola Company to buy the local Chilean brand Guallarauco, which manufactures and distributes high-end juices, ice creams, jams & preserves, and other meal and dessert items.  These product extensions complement Embonor existing offerings, and the brand is growing quickly now that it has superior access to the market.  The bottlers expect to innovate other new products under the Guallarauco umbrella to take advantage of the positive positioning in consumers’ minds.

The second example is the Embonor partnerships with Diageo and Capel to distribute alcoholic beverages.  Diageo distills Johnnie Walker, Smirnoff, Captain Morgan, and many other popular spirits.  These global brands now have much broader availability in the country thanks to the agreement with Embonor.  On the other hand, Capel is a distinctly Chilean business.  It is a cooperative of grape growers that manufactures and sells pisco, which is a brandy that is widely celebrated as the national drink of Chile[1] (and Peru).  Capel is the leading producer of pisco in the country and offers labels at a variety of price points.  Even though these brands were already widely available, Embonor has materially increased Capel’s addressable points of sale and has captured incremental profits in the process.

We also spent a day with Embonor CEO Cristian Hohlberg and the local management team in Santa Cruz, Bolivia.  Santa Cruz has grown dramatically in the last five years.  This region of Bolivia holds the most promise for volume and revenue growth for Embonor.  Fittingly, when we toured the plant in Santa Cruz, we noticed how much it had grown and modernized since our last visit five years ago.

We took the picture on the left of the growing Santa Cruz skyline from the side of the city’s new mall, which is similar to what can be found in an American suburb. The food court included KFC, Burger King, and Sbarro, while Nike, Under Armour, and Swarovski had stores. On the right, Richard is touring the Embonor Santa Cruz plant with the production team.

[1] Piscola, pisco mixed with Coke, is a favorite Chilean drink.  Talk about synergies!


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About 70 kilometers south of Lima, we toured Corporación Lindley’s state-of-the-art production facility in Pucusana.  Back in Lima, we met with Lindley’s CEO and CFO, evaluated the viability of several new convenience store formats, and visited “mom and pop” stores, which remain the most important channel for bottlers in emerging markets.  One store we visited had just completed an overnight conversion from Pepsi to Coca-Cola bannering (see the transformation below).  The renovation included installation of specialty Coca-Cola refrigerators, new paint, advice on how to run the store, and relocation of merchandise.  These upgrades will allow this store to better compete with the formal convenience stores that are entering the neighborhood.

Before-and-after pictures of a “mom and pop” store in Lima that transitioned to the Coke brand overnight. “Painting stores red” has a high return on investment for bottlers like Lindley.

Lindley is making progress across the board.  Management is growing revenues, expanding margins significantly, improving its investment discipline, and boosting product innovation to meet changing consumer tastes.  In fact, operating income margins have expanded nearly five percentage points since Arca took control of Lindley.  Additionally, the most significant Lindley capital expenditures, such as the plant in Pucusana, are now complete.  In combination, these dynamics have sharply grown the company’s free cash flows, and we expect increasing dividends to follow.  These improvements are not properly reflected in the company’s stock price, which is trading at a significant discount to the intrinsic value of the business.  In fact, Lindley trades at a 38% discount to the price Arca paid in 2018 for The Coca-Cola Company remaining ownership stake.

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Liberty Latin America (Liberty LatAm) was the second biggest contributor in the first quarter after its stock price rose 33% during the period.  Like ABI, Liberty LatAm stock traded down in the fourth quarter of 2018, although this stock price decline seemed unrelated to fundamentals.  In fact, actual 2018 Liberty LatAm financial results were better than our expectations going into the year, and we continue to believe that the company’s cash flow will improve materially in 2019 as Puerto Rico largely has recovered from Hurricane Maria and most other markets are growing revenues and profits organically.

We recently spent a half-day with Liberty LatAm’s CEO, Balan Nair, and CFO, Chris Noyes.  They are optimistic about and doggedly working on the opportunity to create the first scale telecommunications player in Latin America.  The meaningful time we have spent visiting the company’s markets and talking with its competitors, peers, and suppliers has led us to cautiously share this optimism. We believe the company has and will have many places to deploy cash at internal rates of return higher than 20% for years to come.  We love situations where a company has a long runway of easy capital allocation decisions.  Furthermore, we believe that the management team now in place is the right group of people to drive this development and realize the company’s potential.

Several members of the executive team continue to buy shares in the open market.  That activity has been alongside our own, as we added to the Fund investment in Liberty LatAm during the first quarter.  This investment is not without risk.  For example, we continue to research 5G technology to evaluate the competitive threat it may represent to Liberty LatAm fixed broadband offerings.  We believe 5G is still a few years away from being commercially deployable in Latin America, and our work suggests that hybrid fiber-coaxial networks — due to a variety of technical challenges and cost considerations — will remain a superior method of transporting data to most homes in the region for the foreseeable future.  In total, Liberty LatAm offers one of the deepest discounts to intrinsic value within the Fund portfolio.

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Lindley, Peru’s Coca-Cola bottler, struggled with some significant headwinds outside of the company’s control during 2018. In May, Peru’s Ministry of Economy unexpectedly increased taxes on alcohol, sugar, cigarettes, gasoline, and other products. The biggest of these tax increases was the sudden and unexpected jump from 17% to 25% on beverages containing sugar. Lindley passed on this full 8% price increase to customers, which decreased volume by 10%, revenue by 4%, and operating profit by 6% for the first nine months of the year. Lindley’s most important competitor, AJE, fared far worse with volume and revenues declining 10% and profitability falling more than 50%. AJE’s financial situation is challenged, so management is divesting and closing operations in a number of markets around the world. Using other markets where sugar taxes were enacted as a guide (including Arca’s previous experience in Mexico), we expect volumes to surpass 2017’s pre-tax totals in a couple of years. Compounding the impact of these higher taxes, political instability due to the unexpected resignation of Peru’s president early in the year retarded infrastructure spending and other investments and weakened consumer confidence. The political climate in the country has stabilized under a new administration, and the economy accelerated in the second half of 2018.

As we hoped and expected, Lindley continued to invest in its business despite these challenges. The company installed over 23,000 point-of-sale coolers and added 700,000 returnable bottles to the market in the first nine months of 2018. These investments will almost certainly yield a nice return. Lindley’s new state-of-the-art plant was operational for all of 2018, and the company recently opened a new distribution center in Lima that serves 22,000 points of sale. Discussions with management and store visits in Peru indicate that the company still has a series of high-return reinvestment opportunities to capitalize on in the coming years.

As you may recall, Lindley is majority-owned by Arca following Arca’s purchase of the Lindley family’s voting stake in 2015. The Coca-Cola Company had been the second largest owner of voting shares until September, when Arca bought Coke’s stake at US$2.26/share. While we hold investment shares that lack voting rights (which is acceptable to us given Arca’s controlling position and our confidence in its management), the Fund’s shares have the same economic interest. Our average cost is US$1.06, and the last trade in the investment shares was at US$1.32/share. This large of a gap between the prices of voting and non-voting shares is irrational, and we expect it to close over time. Just as importantly, we expect that the value of all shares will increase over time as Lindley’s owner earnings begin to grow again in 2019 and beyond.

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In the first nine months of 2018, Embonor grew revenues about 1% and operating earnings around 8%.  Both the Chilean and Bolivian company  operations, each about half the overall business, contributed to this growth.  Chile is a relatively mature Coke market, and we expect long-term earnings to grow in the low- to mid-single digits for the foreseeable future, in line with 2018 results.  In an interesting experiment, the company is beginning to distribute Diageo products in Chile.  This effort will not have a large impact on nearer-term results, but it is a free option that could grow into something more significant over time.   

While Bolivian operations returned to revenue and earnings growth after the weather impacted 2017,  results in 2018 were still below our expectations.  Economic growth in Bolivia leveled off to around 4% in both 2017 and 2018.  Its economy relies on crude oil exports, and oil price declines slowed overall economic growth.  While Bolivia has a high per capita consumption of Coca-Cola products relative to its per capita GDP of around US$3,400, ready-to-drink packages have lots of room for growth as consumers gain wealth.  Our research and past experiences in the industry suggest that people consume progressively more of their beverages in pre-packaged formats data-contrast=”auto”>as their annual incomes rise from US$5,000 to US$15,000.  With weak competition, dominant brands, and superior distribution, Embonor will expand the consumption of a broader array of ready-to-drink products such as bottled water and fruit juices over the coming years.  

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Liberty Latin America (“Liberty LatAm”) made progress on a number of operational fronts in 2018, which advanced its goal of becoming the leading cable and mobile telecom provider in Latin America and the Caribbean.  The biggest and most profitable Liberty LatAm market remains Chile, where — operating under the VTR brand — it has the largest high-speed internet and cable television business in the country.  VTR broadband speeds are twice as fast as that of its closest rival, and more and more consumers are upgrading to the leading high-speed offering.  This competitive advantage also helps the business cross-sell by bundling its cable television, fixed-line telephony, and mobile phone offerings.  In 2018, VTR revenues and operating profits expanded 10% with margins around 40%.  Already passing more than 3.5 million homes and with more investment in process, VTR is poised to increase further its penetration in the country and expand its already attractive profit margins.

One of the company’s biggest concerns heading into 2018 was recovery of its Puerto Rico operation following damage done by Hurricane Maria in September 2017.  The team did yeoman’s work to fully restore operations by the end of the third quarter in 2018.  While all customers are now online and billable, Maria did have a more-lasting negative impact on the size of the market.  As of its last disclosure, Liberty LatAm had 699,000 revenue generating units[1] (RGUs) on the island versus 804,000 before the hurricane in mid-2017.  Because the island’s population has declined, Liberty LatAm may not return all the way to the 800,000+ RGUs immediately, but we expect the business to continue to gain share from the incumbent telephone operator’s considerably slower DSL offering.  In fact, estimated 2018 operating earnings of $150M+ would exceed the 2017 total of $133M.  More encouragingly, the greater than $50M in operating earnings we expect from Puerto Rico in the fourth quarter of 2018 implies a run-rate for 2019 operating earnings in excess of $200M.  This steady upward trend is a nice recovery for a business that was decimated heading into 2018.

Liberty LatAm’s Cable & Wireless (C&W) division encompasses much of its business in Central America and the Caribbean.  In its Chile and Puerto Rico markets, Liberty LatAm primarily offers services over its hybrid fiber/coaxial cable network, with an emphasis on high-speed broadband internet service.  In this type of market, an operator whose network is the only one to pass a home can typically make an outsized return on capital.  If a competitor passes the same home, prices and returns on capital typically fall.  As a result, the first mover usually enjoys excellent economics permanently, as a competitor is loath to enter an already-covered market.  Such is not the case in the wireless business where switching costs are low, and antennas are commonly co-located on towers owned by third parties.  In markets with two or even three mobile operators, results can be satisfactory, but in markets with four operators, price competition and customer churn typically erode profits.

In November, we visited C&W operations in Panama, which is primarily a mobile phone market for Liberty LatAm, to better understand the dynamics at play in a market with four operators.  We found what we expected: the four operators were competing away profits as they aggressively pushed to steal customers from one another.  Fortunately, the government recently passed legislation that will allow consolidation.  Regardless of whether it plays a part in the consolidation, Liberty LatAm will likely benefit when the market loses a competitor or two.

We also visited Costa Rica on the same trip to check on the recent Liberty LatAm acquisition of Cabletica, the leading cable company in the country.  As opposed to the case in most of its markets, Liberty LatAm and a competitor pass many of the same homes in Costa Rica due to the relative youth of the cable industry in the country, historical regulator aversion to mergers, and a high concentration of the country’s affluent customers in the urban capital of San Jose.  Over time, we expect Liberty LatAm to bring cable to unserved homes elsewhere in the country and drive consolidation in the industry.  Both of these efforts should improve scale, reduce competitive pressures, and increase returns on capital.

In the Caribbean, Liberty LatAm competes most often with Digicel.  Thanks to an over-leveraged balance sheet, Digicel is in financial distress.  The company is slashing capital expenditures to meet debt payments and is also selling assets to raise cash.  Underscoring the precariousness of the company’s financial condition, Digicel bonds due in 2020 and 2022 yield approximately 35% as the market lacks confidence that the company will be able to borrow new money to repay these bonds’ principal when they come due.  We expect Digicel financial duress to be a tailwind for Liberty LatAm in these markets as Digicel is unable to compete on price and is underinvesting in its network.

Recently, Millicom and Liberty LatAm confirmed that they engaged in discussions about a possible merger.  Millicom provides telecommunications principally in Central America with substantial wireless assets.  Mauricio Ramos, Millicom CEO, previously worked for Liberty Global and serves on the John Malone-influenced Charter Communications Board alongside Liberty LatAm CEO, Balan Nair.  Both companies have an enterprise value of about $10 billion and could almost certainly shed costs following a combination.  The two companies walked away from the discussions without an agreement; we suspect price was the likely stumbling block.

Liberty LatAm stock price has not responded to the progress we saw in 2018, as it traded down over 30% to finish around $16 as of year-end.  As a result, Liberty LatAm trades at a mere seven times our expectation for 2019 owner earnings[2], and we expect this earnings stream to grow 5-10% annually for the foreseeable future.  We doubled the size of our investment in the company during the year given the combination of stock price weakness and operational performance improvements.  It has the biggest discount to intrinsic value of any company in our portfolio, and we expect to enjoy a satisfactory return over the next few years.  We would make Liberty LatAm a larger position for the Fund if the company’s debt levels were lower.

[1] A revenue generating unit (RGU) is industry jargon for each billable service sold to a customer.  For example, a customer who has just high-speed internet service equals one RGU.  A customer who has cable television and fixed-line telephone services, in addition to high-speed internet, equals three RGUs.

[2]Our April 2018 letter profiles Liberty LatAm and includes a discussion of some of the intricacies of reported earnings versus owner earnings for the company.

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If we ever create a business hall of fame, one of our first inductees will be Francisco “Pancho” Garza Egloff.  Pancho has been the Director General (CEO) of Arca Continental since the company was formed in 2001 when three family-owned Northern Mexican bottlers (Argos, Arma, and Procor) merged their operations.  In the subsequent 18 years, Pancho has led acquisitions of bottlers in Mexico, Ecuador, Peru, Argentina, and most recently Texas.  Over this period, Arca grew its revenues more than ten times from US$740 million to over US$8 billion to become the third largest Coca-Cola bottler in the world.

This growth and success are the result of an amazing culture built on a few core principles.  First, Pancho often quips, “The customer is the boss!”  The entire Arca organization is geared towards continually delighting customers with its offerings.  Years of this focus have helped make Northern Mexico the market with the highest per capita consumption of Coca-Cola products anywhere in the world.  Second, Pancho created a culture of excellence among Arca’s associates.  We have witnessed this firsthand on store visits in all of its regions.  The investor relations departments of most companies avoid introducing investors to deeper layers of management because of their fear that these investors might learn how the organization is actually run. Arca is different, as Pancho has always been happy for us to meet management throughout the organization — he has great confidence that his people are doing the right things.

We spent time stranded on the side of the road with the district manager for Tucumán, Argentina, after his car ran out of gas, and we have toured bottling plants, dairy processing plants, and points of sale with local and regional managers in Ecuador, Peru, and Mexico.  When an organization invests in developing its people, communicates a clear set of goals, incents these employees to achieve them, and always insists on integrity, it can achieve remarkable results.  Pancho greets everyone he meets and asks first about his or her health and family.  In a recent interview, he shared, “I never tire of saying how important it is to have humility.  For me, arrogance is a disease.”  The success of Arca, the quality of the team throughout the organization, and the number of people who call him a friend are testaments to Pancho’s dedicated leadership.

At the end of the year, Pancho stepped down as CEO but will remain on the Arca Board.  Arturo Gutierrez is now CEO, and the company remains in great hands.  Arturo has a master’s degree from Harvard Law School and has served in various roles within Arca for more than seventeen years, including the last few years as Deputy CEO.  We have known Arturo for years and have every confidence that Arca is going from strength to strength. We had a chance to spend time with Pancho and Arturo in October in New York and again in December when they visited us in Birmingham.  We are excited about the future of Arca and the opportunities available to the business as a result of the platform they have built.  Cook & Bynum has been invested in Arca for more than ten years, and the company has contributed more profits to the Fund than any other investment.  We are grateful for their efforts.  The next time you drink a Coke, please do so in honor of Pancho Garza.

In the first nine months of 2018, Arca had to deal simultaneously with a number of macroeconomic and political issues but was still able to grow volumes by 9%, revenues by 18%, and cash flows from operation by 8%.  Net income was down, although that was primarily attributable to a one-time gain in 2017 for the sale of rights to the Topo Chico brand (in the U.S.) to The Coca-Cola Company[1].  Topo Chico mineral water is increasingly popular in the U.S., where its volume grew 24% in the first three quarters of 2018.  Underneath this overall strong operational performance, results were choppier within Arca South American markets, especially in Argentina as recessionary conditions and inflation hurt consumers’ pocketbooks and depressed profits in the territory.  Peru was also hurt by soft consumer conditions due to political uncertainty early in the year and a sugar tax increase (since the Fund also owns Arca Peruvian Coke bottler, Corporación Lindley, directly, we include a more comprehensive discussion of Lindley in its own section).  Arca did increase volumes 5% in Ecuador with its launches of Monster and Dasani.  Finally, the company made great progress in its new U.S. markets.  Volume and revenues were up more than 4% organically in the third quarter of 2018, which is healthy growth for a mature market.  Earnings should further improve in the coming years, partially due to a new manufacturing facility the company is building in Houston — the Coke system’s first new bottling plant in the U.S. in ten years.  Arca expects cost savings to reach $30 million annually from the plant, providing double-digit returns on the capital invested in the project.

Arca stock finished 2018 down 18% even as the business increased in value.  We expect to earn strong returns over time from the current price, and we will consider expanding the position if the stock price declines further.

[1] Topo Chico, a great example of The Coca-Cola Company growing its sugar-free offerings, was originally sourced and bottled by Procor from an “enchanted” spring in Monterrey, Mexico in 1895.  Given the success of the product in North America, Coca-Cola purchased rights to sell Topo Chico in the U.S.

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During the second quarter of 2018, we increased our investment in Anheuser-Busch InBev.  ABI is the largest global brewer by volume with roughly triple the scale and double the operating margin of the #2 player Heineken.  In addition to strong brand equity, ABI owns the distribution networks in most of its markets, which is a strong secondary moat for the business.  We have witnessed the power of superior execution at the point of sale in other successful emerging market businesses (e.g. Arca Continental) that have a highly fragmented route to market because of the large informal market populated by mom and pop stores.  As the dominant player in many of its markets, ABI enjoys substantial pricing power, which helps the company pass on, with some lag, input cost pressures.  We also remain pleased with the progress ABI continues to make with the integration of the SAB Miller merger.  These cost savings and cross-selling opportunities, particularly upselling of premium products, will flow to the bottom line over the next few years.

Craft brewing growth in the United States is waning, and we do not expect craft to be a huge threat in other ABI markets for several reasons.  First, brewing is a scale business with large capital requirements.  Second, without the Unites States three-tier distribution system that is a legacy of Prohibition, the route to market outside the U.S., where the producer can also be the distributor, tends to exclude new entrants.  Third, ABI, aware of the risk, is intentionally innovating its own “craft” beers to satisfy customer demand in its emerging markets before third parties can gain a foothold.  In the United States, headlines have focused on the falling demand for Bud Light, but declines in Bud Light volumes are somewhat mitigated by the continued strong growth of Michelob Ultra.  In total, the U.S. business continues to be a cash cow generating over $6 billion of annual operating profit that can be redeployed into fast-growing emerging markets.  ABI is forward thinking about managing demographic trends, creating attractive offerings for women, nurturing premium brands, and targeting wine and spirits drinkers.  In a vote of confidence, controlling shareholders and the CEO continue to buy shares in the open market.  In fact, they have purchased about $200 million worth in the last four months alone.

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We initiated a new position in an outstanding South American consumer products company, Backus y Johnston.  We have long admired this business, which enjoys outstanding customer loyalty and greater than 95% share in its category thanks to some of the best brands of any product category in the country: Cusquena, Pilsen, and Cristal. In fact, one of the best Peru soccer franchises and winner of the 2018 Peruvian league is named Sporting Cristal after the beer and is owned by Backus.

Large scale billboards for Backus products in Peru

We have studied the company’s execution at the point of sale on a series of research trips over the past seven years. Backus is an excellent operator that benefits from terrific economies of scale thanks to a world-class distribution network that reaches all of the formal and informal corners of the country’s fragmented marketplace.  It was also recently named the best place to work in Peru and is a source of national pride.  In total, the company’s moat produces 40%+ returns on tangible assets, 70% returns on equity, and operating margins greater than 45%.  We expect the business to grow revenues and earnings for years to come as (1) the size and wealth of Peru’s middle class expands in both size and wealth, and (2) management executes its strategy of introducing Budweiser, Stella Artois, and Corona to the appropriate points of sale.  Backus roughly doubled the sales of these higher-margin premium products in 2017, and we expect strong results again this year.

Given the company’s limited free float, shares are thinly-traded.  Thanks to our network of contacts in the region, we were able to identify and acquire a block of shares at an attractive price as the broader market sold off.  We plan to incrementally add to our investment as additional shares become available at acceptable prices.  Backus is an incredible business that we would be happy to own for a long time.

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In October 2017, the Fund began building what has currently become an approximately 10% investment in Liberty Latin America Ltd. (“Liberty LatAm”).  Liberty LatAm is a leading cable and mobile telecom provider to twenty consumer markets and over thirty commercial markets across Latin America and the Caribbean.  Liberty LatAm’s services include broadband internet, cable TV, fixed-line telephony, mobile, and a suite of other value-added business-to-business offerings.  The business is competitively entrenched in low penetration markets, has a series of attractive projects offering high incremental returns on invested capital, and has the opportunity to acquire complementary companies within its geographic footprint to achieve superior operating scale.  Liberty LatAm is led by an experienced team including John Malone, Mike Fries, and Balan Nair, a group of disciplined capital allocators who have created enormous shareholder value in the telecom and media industries over the past forty-plus years.  Recently spun off from Liberty Global, Liberty LatAm stock has languished even as the company’s future earnings power has become more apparent, creating a meaningful discount between the company’s stock price and our conservative estimate of its intrinsic value.

Cable is a Good Business…In the Right Markets

The demand for faster internet access continues to grow, driven by the addition of new users and ever-increasing data needs as users consume more content online.  Demand for streaming video is the biggest driver of this increase in data usage.  Most people are well aware of the surge of subscriptions for over-the-top services like Netflix, Hulu, and Amazon Prime, but a large number of other applications and services such as Facebook, Instagram, and Snapchat deliver video at increasing volumes.  Consumers are requiring this streaming video be delivered at higher qualities, and this trend will continue apace with the adoption of 4K streaming, greater interest in virtual reality, and whatever technology comes next.

Cable companies are well-positioned as the data pipeline (internet service provider) of choice to meet this demand.  In a typical market in which Liberty LatAm operates, the primary competitor to a cable provider’s offering is a DSL (copper) network delivered by incumbent telephone companies.  Through a hybrid fiber-coaxial (HFC) network, cable operators offer a superior product because the maximum delivery speeds possible on thin copper telephone wires, per physics, are slower than what can be delivered on HFC. This advantage for an HFC network translates into broadband speeds of up to 300Mpbs versus only 5Mpbs for DSL. This difference becomes critical for the user as high definition video requires broadband speeds of at least 5Mbps and 4K video needs 25Mbps – speeds that DSL barely can and fundamentally cannot meet, respectively.  Of course, higher speeds also offer a superior internet surfing experience across multiple devices in a home.  In an increasingly digital world, we expect consumers to be relatively price insensitive for the superior internet speeds provided by cable companies.

Incumbent cable companies enjoy a favorable competitive structure that tends to reduce direct competition.  With high up-front capital investments to build out networks and a low marginal cost for offered services, second movers/competitors have little financial incentive to overbuild or replicate a network, as that effort would destroy profitability and impair invested capital for both players.  If a cable operator has already passed a house, it is much cheaper for that operator to sell services to that home than it is for another cable operator to build a new network to reach that house.  And it follows that because the marginal costs of bundling additional services to existing customers are low, the incremental profit margins are high.

Liberty LatAm enjoys these complementary advantages of having a superior offering versus the next best technology (DSL) and a disincentive for fellow cable operators to compete and applies them to geographic markets with lots of room for growth.  As people and countries become wealthier (i.e. as per capita GDP grows), they consume more broadband internet service:

As this chart reflects, most of Liberty LatAm markets have considerably lower penetration rates of broadband internet and other advanced fixed network technologies than are found in the developed world.  In its markets, Liberty LatAm has clear opportunities to deploy capital efficiently by laying fiber and cable in high density housing areas.  Each home that the company’s HFC network passes adds a potential customer for multiple services.  In most of its operating footprint Liberty LatAm offers a “triple-play” bundle of services that includes broadband internet, cable TV, and fixed-line telephony.  Where available, the company also bundles a mobile offering with these triple-play services to offer a “quad-play.”  This breadth of services allows Liberty LatAm to cross-sell its offerings at attractive margins.  Liberty LatAm is earning incremental returns on capital in excess of 20% on these investments to pass new homes.

As explored above, we expect the demand for broadband internet service to continue to grow for the foreseeable future, particularly in Liberty LatAm markets.  The future of its other fixed residential service — namely cable TV and fixed-line telephony — are less certain.  About 19% of the company’s 2017 revenues came from cable TV.  While cable TV will be under both pricing and volume pressure as over-the-top alternatives (e.g., Netflix) continue gathering subscribers, cord-cutting is much more prevalent in the U.S. than other markets due to the historically high prices of cable TV in our country.  Outside of the U.S., cable TV is much cheaper, and it provides some of the best value per entertainment dollar spent (expressed in cost per hours of content consumed).  In fact, in many of Liberty LatAm markets cable TV remains underpenetrated and aspirational.  With these cheaper prices, the incentive to cut the cord is greatly decreased, which makes cable TV revenues defensible and stable for some time.  Management could even further decrease cable TV pricing and still have a profitable offering.  We are less confident about the company’s fixed-line telephony offering given the trend toward mobile-only households.  Notably, a recent CDC survey indicated that nearly one in two households in the U.S. still have a landline, which suggests that fixed-line telephones may hang around for longer than is typically expected by the market.  In any case, this service is less than 10% of Liberty LatAm total revenues, and its decline is incorporated in our expectations for the company’s future earnings.  To the extent the offering remains stickier than we anticipate, owner earnings generated by these subscribers are largely a bonus.

Strong Competitive Positioning in These Attractive Markets

Liberty LatAm is currently organized in three geographic segments:

  • Under the VTR name, Chile is the single largest Liberty LatAm market at just under 30% of the total company’s revenues and profitability. Chile is the richest country in Latin America with a liberalized economy and an expanding middle class that has a growing appetite for broadband internet service.  Regarded as the best cable operator in Latin America, VTR is the market leader and enjoys 55-60% share across all parts of its residential triple-play bundle – broadband, cable TV, and fixed-line telephony.  VTR is also growing mobile subscribers via a quad-play bundle.  With significant investment already in place (3.4 million passed homes) and more ongoing, we are optimistic that VTR can further grow its market share.  This effort is aided by VTR broadband speeds, which are twice as fast as that of its closest HFC rival and serve as a competitively-advantaged entry point to cross-sell its bundle.  VTR is already highly profitable and the business can further expand margins as it captures additional market share and grows revenues.

  • The largest overall segment of Liberty LatAm’s business, accounting for roughly two-thirds of total sales and profitability, is Cable & Wireless (“C&W”). C&W is an integrated telecommunications provider in a variety of Caribbean markets, including Panama, Jamaica, Trinidad & Tobago, and the Bahamas.  Representing about 40% of the segment’s overall revenues, mobile telecom services (both consumer and commercial) are the largest portion of C&W business, with fixed residential services and a regional undersea network making up the bulk of the remaining business.  In general, mobile has less favorable return characteristics than Liberty LatAm’s other service lines as its less-sticky customers tend to invite more motivated competition.  However, C&W generally operates in a duopoly with Digicel, a formidable but highly-levered (currently at about 6.5x EBITDA) regional mobile player.  Earlier this month, Digicel’s bond yields spiked as bondholders became more and more nervous about the company’s sluggish operating performance and ability to refinance its obligations in 2020.

  • Digicel’s financial constraints will likely keep the company’s competitive aspirations in check and facilitate a harmonious cohabitation of the two players.  Connecting 40 countries, C&W’s undersea network is a unique strategic asset which we expect to grow more valuable as regional broadband consumption increases, and we also expect it to unlock synergies in regional acquisitions.  Liberty LatAm is continuing to improve the profitability of C&W, which itself was the result of the merger of C&W Communications and Columbus International in 2015.  Since it acquired C&W in 2016, Liberty LatAm management has been focused on taming the company’s bloated cost structure, and the team expects to realize $150 million in annual savings by 2020 via headcount reduction, improved equipment procurement, and scale content acquisition.
  • Lastly, Liberty LatAm operates in Puerto Rico under the brand Liberty Cablevision. This business currently represents about 10% of total revenues and profitability.  Liberty Cablevision has proven to be a wonderful business with among the highest cable EBITDA margins in the world:

While Liberty Cablevision faces macro and demographic headwinds, the company does have an opportunity to gain market share at the expense of its sole fixed-line competitor, American Movil.  Liberty Cablevision has entry-level speeds of 100 Mbps while Movil’s DSL offering is significantly slower.  Hurricanes Maria and Irma had devastating effects on the island’s electrical grid and a material impact on the segment’s 2017 operational results.  We are closely monitoring recovery of Puerto Rico, particularly changes in the island’s population, which was already contracting before the storms due to the island’s financial difficulties and has accelerated in the last six months as the island has struggled to get back on its feet.  In the face of these challenges, Liberty LatAm progress on its own network restoration has been laudable.  As of early February 2018, over 60% of Liberty Cablevision customers were back online (from ~0% after the storms), and the restoration should be largely complete during the second quarter.  At this pace of recovery and with some stabilization of overall populations levels, we expect a strong financial recovery by 2019, which would again make Liberty Cablevision a cash cow for Liberty LatAm.

Thinking beyond the company’s existing Latin American and Caribbean markets, Liberty LatAm is positioned to become a scale player in a region that currently lacks one.  Liberty Global CEO and Liberty LatAm Executive Chairman Mike Fries is on record stating, “There is a massive consolidation opportunity in a market that remains highly fragmented.”  A prime example of management’s ambitions as a consolidator is the recently announced acquisition of Cabletica, a cable operator that passes 40% of homes in Costa Rica. This all-cash acquisition will leverage Liberty LatAm equipment and content economies of scale, vast subsea fiber network, and operational expertise to improve profitability within the Costa Rican market.  Management plans to continue pursuing these types of strategic add-ons, especially if they can be accomplished at similarly-attractive valuations as this Cabletica transaction (just over 6x EBITDA post-synergies).  In the most recent earnings call, Fries shared, “The deal we just announced in Costa Rica, which we’ve been working on for over a year, is a great example of that. And I’ll tell you, the pipeline is full of both large and small opportunities.”

Great Partners (Who Are Increasing Their Ownership)

If you’re going to ask about quarterly earnings, you’re at the wrong meeting, and you probably own the wrong stock…What we care about is value.  We want to create value for our shareholders.  And I think the best way to create value is to have a very long view, so that’s what we do.  So when we have the opportunity to expand into an area we think is going to have long-term value, we do it.  We don’t have to worry about the impact on earnings.  So it makes a different kind of organization. 

John Malone, Cable Cowboy:  John Malone and the Rise of the Modern Cable Business

Liberty LatAm was formed and is led by a group of Liberty Global veterans who have created an exceptional amount of value for shareholders over more than four decades through operational excellence and prudent capital allocation.  We share their views about the importance of long-term value creation and are thrilled to be partners with this group, which is led by telecom and media billionaire John Malone.  Malone sits on Liberty LatAm’s Board of Directors and is a member of its Executive Committee alongside Liberty LatAm CEO Balan Nair and Mike Fries.  Beyond Mr. Nair, Liberty LatAm management team is full of executives recruited from across other Liberty Global businesses, giving them deep experience in global cable operations and an ability to bring best practices to bear on Liberty LatAm’s markets.

Importantly, insiders have been increasing their ownership in the company.  Malone has led the way, significantly increasing his stake in the business in 2017 with stock purchases totaling $37 million at share prices above current levels.  He now owns 6% of Liberty LatAm economic interest and controls 25% of its voting interest.  Several directors and officers within Malone’s sphere have also acquired shares in the last year.  Additionally, as is typical in Liberty-related businesses, management is well incented to grow the per share value of the business.

The Opportunity

As investors, our overarching goal is to identify businesses that are materially mispriced by the market and sell below their intrinsic value.  The search for this margin of safety leads us to devote the bulk of our research efforts on companies that are either undiscovered or unloved by other investors.  Overlooked companies tend to be smaller in size and/or located in emerging markets, where dedicated investors can create meaningful informational advantages.  On the other hand, out-of-favor businesses are often found in plain sight but evoke undue pessimism for one reason or another.  Both undiscovered and unloved businesses can reward investors who have long time horizons and patience.  Liberty LatAm, whose stock price has declined roughly 50% since its high-water mark as a tracking stock, falls into both categories for a number of reasons:

  • Before being spun-off as an independent business at the end of 2017, Liberty LatAm was a Liberty Global tracking stock. Tracking stocks are typically more complex to analyze, which was true of Liberty LatAm financial results during this time.  Disclosure was scattered, and information was buried deep within Liberty Global broader financial reports.  Further complicating matters, reported results were distorted by one-off charges and integration costs from acquisitions.
  • With Liberty Global owners receiving shares of Liberty LatAm from the spin-off, a much smaller Latin American operation ended up in the hands of investors who were holders of a mature European cable operator. Europe-focused funds were forced to divest their new Liberty LatAm stake, and a number of other investors were simply uninterested in holding a business with such a different profile from their original Liberty Global holding.
  • The option to cut the cord — consumers choosing to forego pay TV and replace it with cheaper over-the-top subscriptions like Netflix — has disrupted cable TV value proposition for consumers and decreased market valuations for the industry. This trend is continuing in the U.S., but for the pricing and value reasons discussed earlier we have found that this trend is not nearly as pronounced in Liberty LatAm markets.
  • The potential disruption from a shift in wireless technology from 4G to 5G has been a focus of our research. 5G promises to reduce latency and increase wireless speeds by at least a factor of 10. Many believe this new technology will replace broadband internet and, in the process, reduce the need for the fixed network infrastructure provided by cable operators.  We believe 5G is still a few years from being commercially deployable in Latin America, and our research suggests that HFC networks will remain a superior method of transporting data to most homes.  Telecom equipment giant Huawei Chairman Eric Xu recently said, “while 5G was faster and more reliable, consumers would find no material difference between the two technologies.”  Wirelessly transporting the gigabytes of data that most broadband customers use would be prohibitively expensive.  Additionally, we expect the mobile telecom providers will need the cable operators’ HFC networks to deploy all of the new antennas necessary to roll out 5G.
  • Poor reported earnings in 2016 and 2017 pushed Liberty LatAm even further out-of-favor. A couple of factors weakened the numbers.  The first is structural and reflects the preference of John Malone-controlled businesses to use debt and rapid depreciation schedules to minimize taxes and maximize shareholder returns.  This “levered equity” model results in financials that are unattractive at first glance when analyzed with traditional metrics.  During this period, Liberty LatAm showed elevated leverage ratios, negative net income, and interest coverage of only one times operating income.  The second factor was a confluence of events that created temporary declines in earnings that we expect to normalize in the next year or two.  Sizeable integration costs following the C&W acquisition and the effects of hurricanes Maria and Irma were the main culprits.  The hurricanes will have an ongoing impact on Liberty Cablevision results in Puerto Rico for at least another year.

Our ultimate input in determining intrinsic value is not reported net income in current periods, but rather long-term owner earnings.  On this basis, Liberty LatAm profitability is much more attractive, and leverage is less pronounced, especially when normalizing operating results for hurricane recovery in Puerto Rico and the full realization of synergies following the C&W acquisition.  Furthermore,  Liberty LatAm’s depressed free cash flows can only be appropriately understood when differentiating between growth and maintenance capital expenditures.  A large portion of the company’s historical and expected future capital expenditures are high-return growth investments to upgrade its network and to pass more homes — both of which are critical to future earnings growth.  Importantly, much of this upfront investment is being made ahead of anticipated consumer behavior.  As long-term investors, we whole-heartedly support this decision to depress current earnings and cash flows to realize even more earnings in the future.                                                                                                                    

Despite all the noise in its recent results, Liberty is a cash-generating machine led by intelligent capital allocators whose interests are aligned with ours.  We expect the company to produce a double-digit owner earnings yield within a couple of years.  We are pleased to be long-term partners with this first-rate team as it applies superior operational practices to competitively-entrenched businesses that have attractive reinvestment opportunities and room for growth.

Archives: Case Studies

After Trump’s election, stock market participants sold most Mexican stocks indiscriminately.  While fears of a cancellation of NAFTA remain legitimate, we took the opportunity to underwrite all of the relevant names on our watch list and separate the ones that would likely be affected significantly by a cancellation of NAFTA from the ones that would see a much smaller impact.  Arca produces a non-cyclical good and sells little that crosses the U.S.-Mexico border.  Yet the stock price sold off 23% in dollar terms from the November 2016 election through January 2017.  We took advantage of this macro-based flow to buy more Arca at an attractive price.  The Fund made 45% on those purchases during 2017.

Pancho Garza, Arturo Gutierrez, and their team continue to improve a wonderful business.  Last April, Arca completed its purchase of bottling assets in Texas, Oklahoma, Arkansas, and New Mexico, and management also continues to strategically expand its snack food business in the United States.  We expect their expertise and discipline to enhance this territory through sensible plant improvements and unexplored revenue opportunities.  Macro headwinds in Ecuador and Argentina continue to be somewhat of a challenge, and the prospect of a sugar tax in Argentina exists.  All in all, we are pleased with the way the company is compounding its intrinsic value.  We only wish the stock price would fall again, so we could buy more.