You can’t escape the truth – fundamentals matter

Years of a beta-driven market rally have let some get away with forgetting about corporate fundamentals. But central banks are no longer buying corporate bonds en masse, liquidity is being withdrawn, and interest rates are beginning to rise. It seems that the markets will soon remind those who have forgotten the old lesson: fundamentals really do matter.

Our focus remains on businesses that we are happy to hold throughout the cycle. While calling the exact peak or trough of the cycle is near-impossible, a sense of where we are in the pendulum swing is important. We’re certainly much closer to the end than the beginning, and with quantitative easing being slowly but surely unwound, conditions will be unfavourable to businesses with weak fundamentals.

The chart below demonstrates that when complacency in the market fades away, like in the sell-off we saw at the end of last year, fundamentals matter. Companies with the weakest free cash flow, a key metric for us in credit analysis, were punished much more than those with strong fundamentals.

Chart: Consistent FCF weakness priced in a lot more from November
(Average z-spread of representative bonds for ten weakest and ten strongest ranked issuers in terms of five different FCF measures over several time periods, e.g. FCF/gross debt over five years and LTM FCF/EBITDA)

Source: Company Information, Bloomberg, BofA Merrill Lynch Global Research estimates

Last November, we participated in a new European high yield issue from a company called Intertrust. It’s a great example of the kind of business we like to lend to. They provide administrative services globally to other firms; for example, if a company wants to open a new corporate entity, Intertrust will set it up. Then they can provide ongoing services like legal and tax compliance, accounting etc. If the customer decides to close that entity, Intertrust closes it for them.

While 90% of Intertrust’s revenues are from recurring, non-discretionary services, the ability to open and close corporate entities for their customers helps create an incredibly non-cyclical business. In an economic upswing, businesses expand to operate in new jurisdictions or to undertake M&A, so they open new entities. In a downturn, they might close entities and consolidate their footprint. Intertrust can do these things for them. This creates a very stable revenue profile and a business that is able to weather cyclical storms – regardless of how their customers do.

Intertrust also has high margins, a sensible amount of leverage, very strong interest coverage metrics and significant free cash flow. Combine that with the attractive business profile and you can see why we like this business. It’s possible that rating agencies could upgrade them to investment grade in the future. Furthermore, this operating profile has been rewarded in the recently volatile market. In EUR terms, since new issue-to-date, Intertrust has outperformed the Bloomberg Barclays Pan-European High Yield index by 0.65%.

A key cornerstone of our philosophy is that you can’t day-trade carry. Kames focuses on fundamentally sound businesses that will persist through the cycle, and deliver to our clients a steady income stream with minimal capital losses. So we are cautiously optimistic for 2019, a year that will provide ample opportunity for us to demonstrate our ‘stock picking first’ approach and deliver positive outcomes for our investors.

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Tick Tock Goes the Klöck

Climate change and general concern for the environment, they’re an ever-increasingly important issue for society, so why would it be any different for investors? It isn’t. This is something we’ve been watching for a long time; our ethical franchise will have been running for 30 years next year, so it’s something deeply engrained in our processes.

Lately, plastics and the pollution they cause have faced increasing scrutiny and regulation. This backlash has a fundamental impact on companies in the high yield universe. Take the metal can specialist, Crown Holdings. They suggest that the aluminium can is the world’s most recycled beverage container… and actually it is estimated that 75% of all aluminium ever produced is still in use today. Crown believe that a 1% shift from plastic bottles to metal cans for soft drinks alone could increase demand by billions of cans. This could be an impressive tailwind for positions that produce metal cans – companies like Ball Corp, Crown and Ardagh.

But for every winner, there’s a loser. Klöckner Pentaplast is one of the world’s largest producers of plastic films. This company makes the rigid plastics that cover your food, wraps around batteries, surround gift cards and the packs that your painkillers come in. As such, Klöckner is highly exposed to plastic packaging regulation (and backlash). While regulation isn’t the only problem that this company faces, it certainly hasn’t helped. Operating performance has been deteriorating, with limited revenue growth, falling earnings and negative free cash flow. To its credit, Klöckner has been trying to use more sustainable raw materials, focusing on recycled plastic. But so has everyone else, and the cost of recycled PET has been rising in response – compounding the problem.

Something else that’s interesting about Klöckner Pentaplast is how it has structured its debt. The company has issued a type of bond known as a Toggle PIK. These allow the company to pay interest in cash (like normal) or to elect to ‘pay in kind’ (this means adding more debt to its existing debt!). This toggle option means the company isn’t forced to pay cash away when it can’t afford to. But this extra debt means that the company is becoming increasingly indebted – even as it struggles to pay its existing obligations! This risk means that PIK bonds often come with large coupons, and can be an excellent investment when the business is doing well. This is where stock selection is so important.

We decided not to participate in the Klöckner bond when it was first issued at par (i.e. 100) this time last year. I reviewed the company when the bond was trading in the 50s last month, having lost almost half of its value. We chose to pass again, as the firm’s fundamentals had continued to deteriorate. This week, Klöckner announced it would elect to pay its interest in PIK. Today, the bonds are priced at 35. I can hear the Klöck ticking…

Meanwhile, our can makers in the portfolio continue to hold in very well amidst the recent market volatility. These are fundamentally strong businesses that may also benefit from a helpful regulatory tailwind.

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ReWard your investment not your doctor

A key part of our investment philosophy revolves around whether the cash flows generated by the businesses that we invest in are sustainable. While many factors play into our analysis, ESG considerations are a key component in determining the sustainability of cash flows and indeed, a business.

We recently looked into a new issue to fund the KKR-led buyout of Envision Healthcare, a provider of staffing and other services to the US healthcare industry. For the most part, Envision provides doctors when hospitals choose to outsource their emergency departments. We typically place a great deal of emphasis on the ‘G’ in ESG analysis, Governance. But in this case, the social aspects gave us cause for concern.

Healthcare is a social good. The US healthcare system can, at times, seem to challenge this basic assumption. The system has well-publicised issues with costs and a mind-bogglingly complexity that seems egregious to anyone who hails from a country with a healthcare system like the NHS. Be it rocketing drug prices, or paying for your ambulance journey to the hospital, or even $5,000 ‘discharge’ fees, at least you’re okay if you have health insurance, right?

Possibly not. Health insurers in the US often specify hospitals and services as ‘in-network’ and ‘out-of-network’. If they’re in-network, the insurers will pay a bigger portion of the bill. If not, patients might have to foot the whole bill themselves. So if you have to be rushed to the emergency department, you want to make sure you’re going to an in-network hospital. That way, you get to be “in-network”, treated by a doctor, released and all is well. But then the bill comes. Turns out, you’ve gone to an in-network hospital that outsources its emergency department to Envision Healthcare, and its doctor treats you, and all of a sudden…sorry, you’re out-of-network.

Indeed, the health insurer UnitedHealth is in a very public spat with Envision. UnitedHealth has even dedicated a portion of its website to calling-out Envision Healthcare’s billing practices. They estimate that the average charge for Envision’s doctors is three times higher than what Medicare would be for the same service. There’s also a working paper recently produced by Yale University. This paper suggests that Envision actively ups the number of out-of-network procedures when it takes over an emergency department and that its out-of-network charges are significantly higher than competitors’ out-of-network billing. The New York Times has also published a scathing piece on Envision’s practices that has sparked a US Senate investigation, as well as shareholder lawsuits.

Analysis of the company’s financials demonstrates the outsized profitability of charging individuals directly rather than via insurers. So-called ‘Self-pay’ constitutes just 13% of procedure volume, but contributes towards 46% of revenue. Moreover, the sheer size of these bills means they often aren’t paid in full (or at all), so Envision takes massive provisions for uncollectible charges.

Envision is moving more of its revenues to “in-network”. It argues that insurers are trying to avoid paying providers a reasonable rate and that they are trying to shift costs to the patient. But for us, this business model seems to take advantage of those who either don’t know to, or aren’t able to specify an in-network doctor, at an in-network hospital.

In our view, cash flows that seem to depend on opacity rather than transparency will be inherently less sustainable, and are not what we want in any portfolio.

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