During the first quarter, our businesses continued to perform well. We saw numerous upward earnings revisions as the economic recovery gained strength and company specific initiatives took hold. While relative performance was particularly good this quarter—a welcome reversal from last year—our big picture view still holds: there are lofty expectations imbedded in many areas of the market, with pockets of outright speculation. Aggressive investment behavior has been rewarded over the last several years, and prudence has been penalized. With this backdrop, we particularly like our risk-aware investment approach and portfolio of businesses that we believe can deliver attractive long-term growth at reasonable valuations.
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In the balance of this letter, we address our recent trim of long-time holding, O’Reilly Automotive, and provide an update on our largest holding, Brookfield Asset Management.
O’Reilly Automotive (ORLY) – During the quarter we sold roughly one-third of our O’Reilly position, reducing it from a large size to a medium size position at about 6% of assets. We continue to believe that the company enjoys a wide economic moat, and believe its competitive position is as secure as ever. However, O’Reilly has been so successful for so long that it is reaching some natural limits: it is 86% of the way to its stated potential of 6,500 U.S. stores, gross margin—up 920 basis points over the last fifteen years to 52.4%—is getting more challenging to improve, its accounts payable/inventory ratio exceeds 100%, and the company should hit its target-adjusted debt to EBITDAR leverage this year after an eleven-year glidepath to get there.
Further, O’Reilly has seen a big boost to demand during the pandemic. Stimulus checks and newfound leisure time have translated into increased spending on vehicle maintenance. Comparable store sales were up 10.9% in 2020, and we estimate year-to-date comps are tracking up mid-teens (we expect comps to be flattish in Q2, negative in Q3, and up modestly in Q4). Earnings per share (EPS) growth in 2020 and 2021 looks set to average 20% compared to a more normal mid-teens percentage. This surge in demand will make comparisons in subsequent years much more difficult as stimulus payments end and life returns to normal (offset somewhat by vehicle miles traveled returning to normal).
We also acknowledge the growing governmental and original equipment manufacturer (OEM) push toward electric vehicles (EVs), which have far fewer moving parts requiring repair. While EVs, even under very aggressive adoption assumptions, should have virtually no impact on O’Reilly’s economics over the next decade (and could be a net positive if the U.S. temporarily transitions to hybrids rather than full EVs), it is a growing potential threat to the business long-term.
We still think O’Reilly can compound EPS at an attractive low- to mid-teens rate over the next five to ten years, and current valuation is reasonable at 21x next twelve-month earnings. While our long-term EPS CAGR expectations are above consensus, our variant perception is not as variant as it once was, so we have reduced the position size accordingly.
Brookfield Asset Management (BAM) – Brookfield Asset Management finished the quarter at 9.8% of assets, making it our largest holding. We first invested in Brookfield in 2014, and since then our initial thesis has turned out to be largely correct. Brookfield has delivered strong investment results to its limited partners allowing for robust fundraising and double-digit annualized organic asset under management (AUM) growth. The business has continued its shift from on-balance sheet asset ownership to third party asset management, reducing its capital intensity and improving its return on capital, and management has navigated well through a variety of challenging environments to position the company for continued success.
Today, Brookfield is stronger and more diversified than ever. Its private equity business has become a powerful third pillar complimenting its historical strength in property and infrastructure, and the acquisition of a majority interest in Oaktree in 2019 added a premier distressed debt/fixed income capability to the roster. Meanwhile, Brookfield has significantly broadened its base of limited partners and channels of distribution adding stability to the franchise.
Fortunately, despite more than tripling fee-bearing capital since our first investment, Brookfield’s growth prospects still appear excellent. Brookfield’s flagship funds in real estate and infrastructure will probably reach their capacity limits in the next few years, but private equity has much more headroom, and numerous adjacent opportunities have emerged that were not previously evident to us.
As alternative assets have grown in size and importance, many allocators have sought to consolidate vendor relationships with fewer, larger asset managers that provide a wide menu of investment solutions. As one of the largest alternatives managers in the world this is a big advantage for Brookfield. Perpetual core funds, green energy/energy transition funds, technology infrastructure funds, regional funds, secondary limited partnership (LP) funds, and life insurance asset management appear to be large growth opportunities that can sustain Brookfield for the next decade.
While very promising, it is not all clear skies ahead. Brookfield is one of the largest owners of both U.S. shopping malls and global office properties, two categories of real estate most impacted by the pandemic.
1. Malls were a controversial real estate asset even before the pandemic hit. The inexorable rise of e-commerce has reduced the need for retail space with many high-profile retail bankruptcies in recent years. Despite this headwind, Class A malls had fared well, with many thriving, while class B and C malls were under obvious strain. Class A malls tend to be large, well located, high traffic assets with premier national retailers and attractive on-site restaurant and entertainment options. Class A malls are more than a utilitarian place to get shopping done, they are an experience and social outlet. Most of Brookfield’s malls—and almost all of their mall net asset value—fall in this category.
For Class A malls, the pandemic was a blow, but recovery trends are promising. Foot traffic across malls was down more than 90% early in the pandemic, but it has improved and is now down just about 25% from normal levels. But purchase intention of those visiting malls today is now much higher, so store sales within malls are down perhaps 10-20% from normal. This increase in per visitor spending has surely benefitted from the massive government stimulus programs, but we are also far from fully reopened as a society. Our expectation is that most Class A malls will return to around pre-covid levels of foot traffic and store sales in the next year or so, and they will reclaim their role as a vibrant and valuable part of the retail landscape.
2. Office properties, in our view, have probably been more permanently impacted by the pandemic. Zoom, Slack, and other technology tools have made the home office a viable substitute to the office building. There are many good reasons for returning to the office—team building, cultural indoctrination, accountability, social, etc.—but many employees prefer working from home, at least part-time, and companies will accommodate them to varying degrees. The office will continue to be an essential hub for almost all companies with white-collar workers, but at the margin, fewer people in the office at any given time will probably mean diminished square footage needs.
Office buildings tend to have very long lease terms; Brookfield’s typical lease is more than ten years long and it has an 8.2-year average remaining lease life across the portfolio. So, any change that does occur is likely to unfold over a very long period of time as leases roll off. We do not expect a step function change in demand or office building economics, but rather a persistent headwind. Instead of our pre-covid assumption of slow and steady cash flow growth from Brookfield’s office portfolio, we now expect it to be more stagnant.
Understandably, over the last year, there has been much concern about Brookfield’s mall and office exposure. This weighed heavily on the stock in 2020, and, while past the level of peak concern, we believe it is still contributing to negative sentiment. By our calculation, Brookfield’s mall and office assets compose only a mid- to high-teens percentage of our firm-wide sum-of-the-parts value. So, malls and offices are very important, but not nearly as important to intrinsic value as the narrative around the stock suggests.
For the reasons summarized earlier, we do not believe Brookfield’s malls and office properties will be a calamity; we think that they will ultimately achieve an acceptable investment return. Yet management would argue that our view is too conservative. Seeing opportunity, they have recently agreed to purchase the remaining interest in Brookfield Property Partners (the publicly listed entity holding most of its mall and office assets) that Brookfield does not already own. Upon completion, we estimate mall and office properties will compose a low 20s% of firm value.
At the end of the quarter Brookfield was trading at a 17% discount to our estimate of sum-of-the-parts value, and at a mid-teens multiple of our next twelve months look-through cash earnings estimate —an appealing absolute valuation level and a modest discount to the average multiple where the stock has traded over the last several years. We believe Brookfield, even if malls and office assets languish, can grow from $280 billion of fee-bearing capital today to nearly $500 billion over the next five years. With this double-digit CAGR, and the free cash flow the business produces, we believe that Brookfield should continue delivering mid-teens compounding of cash earnings per share.
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We thank you for entrusting your capital to us. We will continue to do our best to protect and grow your investment over time.
Broad Run Investment Management, LLC