Investing in the face of uncertainty

If we begin with certainties, we shall end in doubts; but if we begin with doubts, and we are patient with them, we shall end in certainties – Sir Francis Bacon

Fat tails

Perhaps the most challenging aspect of risk management is accounting for uncertainty. Unlike risk, uncertainty implies an inability to determine the likelihood and/or impact of a future event. As risk managers, our role is to transform uncertainty into a probabilistic assessment of risk. In truth, this isn’t always possible, and one must be prepared to wear some level of uncertainty.

Conventional statistics offer a false sense of security. Many investors have been conditioned to think about risks and probabilities in terms of normal distributions, or bell curves. These distributions imply that catastrophic events are extremely unlikely to happen. The reality is that these “rare” events – credit crises, sovereign defaults, currency devaluations, terrorist attacks, wars, and political upheaval, to name a few – occur with much higher frequency than statistics would imply. 100-year climatic events, for example, happen far more often than once a century. In financial markets, there is enough empirical support to suggest distributions that measure the likelihood of risk and their impact bulge around the edges, creating “fat tails”. Fat tails tells us that even though we might be capable of assigning probabilities to regular events, we’re especially bad at predicting the irregular.


This does not mean the prediction of unlikely events is impossible. Observable risks such as the extension of credit and wealth inequality can cumulatively result in low probability catastrophes, with risks that have the potential to spread uncontrollably having a higher degree of uncertainty attached to them. Whilst it’s unlikely one could predict where the pieces of a fallen Jenga tower may come to rest, the points of fragility become increasingly evident as the tower grows. There is significant value in observing the things we can, and a holistic framework for monitoring the build-up of risk is paramount to early defence.

The age of populism

The idea of liberalised international trade and investment flows, free flow of human and financial capital and de-regulation is facing fresh scepticism and new challenges. Decades of rising wealth inequality, made acute by lower real wages in the de-leveraging aftermath of the global financial and European sovereign crises, has stoked the most recent wave of populist revolt across the US, Europe, South-East Asia and Latin America.

The essence of populism is the belief that society can be divided into two antagonistic classes – the people and the powerful. The powerful are presumed to be devious and corrupt, determined to feather their own nests and adept at using intermediary institutions such as the courts, media and politics to frustrate the people. Around the world charismatic populist leaders are finding success selling deceptively simple answers to difficult questions, using the failings of free trade and mass migration as a convenient whipping boy for rising inequality. Giving a voice to people’s frustration is one thing, addressing the cumulative long-term effects of privatisation, de-regulation, corruption and technological change that have silently eroded the economic rights of the individual is another.

A global economy flush with cheap capital has not helped, generating asset price inflation to the glee of the wealthy and accelerating a boom in skill-biased technological innovation. Arguably, it is the failure of policy makers to equip their labour forces with the skills of the future that has been the most profound contributor to the growing angst around wealth differentials. The real question for policy makers is how to return opportunity to the people, with the societies that prove more resilient being the ones that can afford to balance the need for equal opportunity with unequal reward.

What matters for investors is that populist policies almost always result in looser fiscal policy, often at the expense of productivity enhancing structural reform with negative short-term social consequences. The euro area is a case in point. Following the European sovereign crisis, the European Central Bank embarked on an asset purchasing program with the design of creating a more favourable environment for unleashing market mechanisms in Europe’s rigid economies and bloated welfare systems – a precondition for steady and balanced growth. The short-term impact of fiscal austerity, for example, created socio-political problems of rising unemployment and falling state revenues – a policy outcome no euro area government had a mandate for. Witness the social turmoil and political changes in Greece, France, Italy, Spain and Portugal as these countries experienced a powerful pushback to labour reform and austerity.

The rise of populism across Europe has also been accompanied by a surge in tensions between autonomists and centralisers, with the potential to further exacerbate fiscal risks. Interestingly, this trend is not a reaction to economic woes, being most pronounced in Europe’s most successful regions. Northern Italy, the wealthiest part of the country, has long flirted with the idea of floating off to form a country called Padania. Catalonia, the most productive part of Spain, has been fighting for independence to cut its payments to poorer Andalusians. The continent’s integration was meant to solve such questions, but they are surfacing once more to the angst of Europe’s leaders.

Not even the United Kingdom, where the House of Commons plays the role of one of the oldest representative institutions on Earth, has been immune to the spread of populism. Britain has succumbed to the populist wave because it decided to apply the most powerful tool in the populist toolbox – the referendum – to the most profound question regarding its relationship with its main political and economic partner. Whilst the visible result has been the re-shaping of British politics by “Brexiteers” claiming that the people have spoken, the less visible result has been a constitutional revolution. Before the referendum, Parliament reflected the best interests of the sovereign. Now, for the first time in Britain’s parliamentary history, MP’s feel obliged to give in to a populist revolution.

Recent events in Italy are a timely reminder that populism, fiscal policies, bank balance sheets and lending to the private sector are inextricably linked. Through rising yields, bond markets sanction any perception of unsound fiscal policies likely to aggravate budget deficits and public debt, or in the case of the euro area, violate commitments to deficit and debt targets. Rising bond yields shrink the value of bank assets which consist of large holdings of government bonds, in turn making banks more risk averse and less inclined to extend credit to the private sector. With Trump’s populist policies seeking to widen US fiscal deficits to levels last seen in times of war or recession, markets may soon begin to discount the US government’s EM like sovereign risk profile (Figure 3) and increasingly limited fiscal firepower.

With the populist locomotive now set in motion, increasing political risks have the potential to stress nations that have rapidly accumulated public/private debt, reliant on external capital and/or have weaker institutional frameworks. Set against a backdrop of tighter global monetary liquidity and the potential for slower growth/higher inflation, the financial and political tail risks are elevated.


A decade of overindulgence has led to another set of tail risks. As generationally low interest rates and QE induced yield curve flattening has throttled excess capital towards increasingly risky financial assets, investors have been willing to pay a premium for the illusion of durability in an uncertain world.

Intensifying competition and “structural” growth

The bubble in “structural” growth is perhaps the most poignant example. Technology products and their suppliers have changed the world, making up a higher proportion of global market capitalisation than ever before (globalisation has been a conduit for even greater industry concentration and risk). Tending to dominate their early niches, businesses such as the FAANNGM’s (an ever expanding acronym), Alibaba and Tencent have generated tremendous value protected by deep moats. In search of the next legs of growth, this value is being reinvested in the seemingly “won” opportunities of their competitors. Whether it’s Amazon and Netflix competing on content streaming or Amazon’s Alexa threatening Google’s core search business with its voice search capabilities, the titans are bumping heads.

For competing software and internet businesses, barriers to entry are being eroded. The ability to deploy, then effortlessly scale their technology on platforms offered by Amazon Web Services, Microsoft Azure and Google Cloud reduces up-front capital expenditure. Combined with large addressable markets and a boom in cheap venture capital funding, particularly in the US and China, the seeds for intensifying competition have been sown. The next frontier of technological disruption won’t be so easily won. With valuations for structural growth implying more of the same, the risk to investors is that this type of growth succumbs to cyclical forces. Seemingly stable businesses may prove to be anything but over the next decade, with active management affording one the luxury to own those least likely to be disrupted.

Debt accumulation

In a similar vein, a world awash with cheap capital has nurtured the accumulation of debt. Studies of financial crises[1] have shown that rapid debt accumulation, whether it be by sovereigns, corporates or individuals, contribute more to systemic risks than the absolute stock of debt. In the case of China, whilst the sheer level of debt (~250% of GDP) is reason enough to pause, it’s worth highlighting the pace at which it was acquired, and thus the potential for misallocation. Figure 2 shows the most extreme “credit gaps” today, i.e. the difference between credit to GDP and long-term trend. Hong Kong and China stand out in a global context, driven largely by their corporate sectors, followed closely by the US government and property driven debt cycles in Canada, Singapore and Scandinavia.


In response to this debt overhang, over the course of the last three years China has implemented strict measures to control excesses in the shadow banking system, including forcing banks to re-classify shadow loans as traditional corporate loans (thereby bringing the loans back under regulatory scrutiny), take on more nonperforming loans as over-capacity industries shut down and reduce their reliance on wholesale funding to alleviate liquidity pressures. Monetary conditions are likely to remain tight as the long-term nature of Chinese policy remains committed to working off these excesses and supporting the transition from capital-intensive industrial to capital-light consumption and services driven growth. Ironically, this may reverse should the trade war escalate and exports continue to slow.

Another defining characteristic of the current cycle is the explosion of US non-investment grade (“high yield”) debt, with the stock of debt outstanding and the average leverage ratio high relative to the recent “goldilocks” combination of low base rates, tight credit spreads and high profit margins. Against a backdrop of relatively subdued inflation, US growth has been resilient, with Trump’s domestic policy analogous to burning all the furniture in the room. Whilst some indicators, such as the corporate profit cycle, industrial production, unemployment and consumer confidence suggest the economic cycle is maturing, residential/corporate investment and wage inflation is still at early or mid-cycle levels. Increasingly, the risk to the cycle is monetary policy, with an increasingly limited fiscal backstop.

Preparing for uncertainty

The challenge with the current environment is the number of low probability, but potentially material events that are difficult to build a portfolio around. With central banks and passive liquidity having acted as shock absorbers to risk assets more broadly[2], the normalisation of global monetary policy and spread of populism represent the most likely near-term catalysts for disturbing the current state of fragility. Accordingly, over the long-term, we believe that a holistic framework for managing uncertainty is likely to prevail.

To summarise the Antipodes Partners approach:

  • At the position level, seek to own attractively priced businesses (margin of safety) with investment resilience (characterised by multiple ways of winning). The opposite logic applies to our shorts, i.e. no margin of safety and multiple ways of losing. Rather than relying on momentum or passive beta, our research effort is directed at uncovering sources of idiosyncratic alpha – the essence of our pragmatic value approach
  • Build an awareness of fragility through quantitative and macroeconomic risk assessment. To exemplify, our macroeconomic risk framework (Figure 3) is a comprehensive measurement of a nation’s resilience to cyclical and structural external funding pressures and the velocity of credit accumulation in the household, corporate and public sectors. Whilst this framework doesn’t capture the resilience of a nation’s institutional framework or political risk, these qualitative assessments are made in the context of a broader financial risk assessment, with special attention paid to risks that have the potential to “spread”. Insights from this style of analysis feed into the margin of safety requirement at the position level and the management of overall portfolio concentration risk.
  • Looking beyond the more simplistic model of regional or sector diversification, our investments are grouped into clusters that share overlapping sentiment, idiosyncratic, end-market and quant/macro sensitivities. As stocks within clusters are likely to exhibit a higher correlation to each other, we limit cluster sizes to no more than 15% of the portfolio whilst attempting to minimise the correlation between clusters. In this sense we aim to control, to a higher degree, concentration risk within the portfolio and mitigate the impact of the unknown unknowns.
  • Multiple levers – longs, shorts and active currency/cash management to offset building portfolio risk
  • Around the edges of the portfolio, the implementation of low cost/high payoff tail-risk hedges. Despite being an equity manager, Antipodes Partners has a multi-asset toolkit at its disposal.



[1] “This Time Is Different: Eight Centuries of Financial Folly”, Carmen Reinhart and Kenneth Rogoff, 2009

[2] See our blog post “Volatility: Dead or in Hibernation” at

General Electric

Dismembering a Fallen Giant
Tuesday 26th June, 2018 was an historic day for General Electric (“GE”). Before the market opened on that day GE was removed from the Dow Jones Industrial Average Index after 110 years of continuous membership. It was the last remaining member of the 12 original constituents of the Dow[1] at its launch on May 26, 1896. This symbolic blow crowned the end to an underwhelming 24 months for GE, over which period the shares have lost more than 60 per cent of their value.

There was a second historic event which took place that morning. GE’s then new management team released their plan for restoring credibility and realising the significant value in the portfolio. Having spent a year studying the available options, management settled on break-up plan, slimming the Company down to a portfolio centred on GE Aviation, the jewel in GE’s crown, which is the world’s leading developer of the design and maintenance of commercial and military aircraft engines.

Since that point management has again changed with Larry Culp, the highly respected former CEO of Danaher, succeeding John Flannery as Chairman and CEO. Mr Culp is the first outsider to lead the Company, and we view his appointment positively. We believe that Mr Culp will pursue the strategy laid out by his predecessor, albeit with a greater focus on the operational excellence which was a hallmark of his time at Danaher.

We believe in both the plan and the management team and see the shares as significantly undervalued at current levels.


Before we look forward, we should consider the past and what has gone wrong at GE. This is a combination of historically poor capital allocation, the burden of their legacy insurance business and a downturn in the market for power equipment. The combination of these items has meant that GE currently carries too much debt, has taken meaningful charges against its legacy insurance liabilities and suffered significant earnings downgrades in the Power business. Having gone to great lengths to understand each we believe the point of maximum pain has passed.

Historically GE has been an organisation with a powerful central function which took decisions on the part of the divisions, with a remuneration policy which was too closely tied to group rather than divisional performance. Capital allocation has been both prescriptive and questionable. The new management team have resolved to dismantle large parts of those central functions whilst increasing divisional autonomy and self-determination. This has been allied with a change in the remuneration policy that increases the focus on both divisional results and cashflow, something which has been underwhelming for too long at GE.

Whilst most of GE’s businesses are executing well in buoyant markets, the Power business is facing a severe industry downturn, most notably in the market for large gas turbines for utility-scale generation where the number installed globally in 2017 was the lowest it has been since 1986. Both new installations and utilisation have been under pressure, squeezing earnings for both the original equipment and service businesses. In response, capacity and capital are being withdrawn from the sector, whilst utilisation of the existing fleet is rising, suggesting better times ahead even if there is no immediate volume recovery. The market appears convinced that the downturn in large gas turbine demand is structural rather than cyclical, with which we strongly disagree. As global attempts to decarbonise gain pace, we see it as almost inevitable that gas powered generation displaces existing coal plants. Global LNG prices have been buoyed by strong demand from Asia, whilst the surge in the carbon price in Europe is approaching the point where it should begin to incentivise switching from coal to gas, which was its ostensible purpose since the European carbon market was introduced in 2010 – but which has only started to have an impact post changes to market structure in 2017. Natural gas is the fossil generation fuel source of the future, and GE have a compelling offering.

GE hasn’t written an insurance policy since 2006 but continues to suffer the impact of the pre-existing book of business. In late 2017, the Company took an after-tax charge of over $6 billion and agreed to contribute approximately $15 billion of capital over the next seven years to rebuild the reserve base. Management assert that they are now well reserved, a claim which the available information supports – albeit in an industry which has suffered a very adverse claims history. In response the management of GE Capital and the approach to both the assets and liabilities have been changed, whilst the business remains very sensitive to higher rates which both boost assets and diminish liabilities. Management are also exploring the possibility of moving the liabilities off GE’s balance sheet. The market believes that the cost of such a move would be exorbitant, and doubts it’s even possible, but this is a well reserved block where liabilities have potentially been marked at what may prove to be the low point of the global rate cycle. Resolving this issue may not be as expensive as the market fears.

Competitive Dynamics & Product cycle

What has been lost in the current share price malaise is the strength of some of the businesses inside the conglomerate, notably Aviation and Healthcare which are the assets in which the bulk of the value lies. These are leadership businesses with high barriers to entry in structurally growing industries – the kind of businesses we look for at Antipodes – and it’s rare to find such assets trading at such lowly valuations compared to peers.

The management team are breaking up the Company, an entity which had only really expanded in scope from formation up until the financial crisis. At the heart of what will be left is the Aviation business, the quality of which is currently obscured by the travails of the broader group. GE’s jet engine business powers, either directly or through the CFM joint venture, 70 per cent of the world’s operating fleet of narrow body planes and nearly 50 per cent of the world’s fleet of wide body planes.


Figure 1



Figure 2

Booked orders point to market shares persisting at around the current level. GE’s scale and presence across the thrust range represent an advantage in manufacturing cost and breadth of customer offering.

Over the long time-term, the commercial aviation industry has grown at approximately 1.5 times underlying economic expansion, with that excess growth visible in both mature and developing markets. Increasing affluence, rising propensity to travel and a persistently declining cost of aviation are all significant contributors.

It is that latter driver of air travel that the engine makers including GE have been instrumental in delivering to the airline industry, as the improved efficiency of subsequent generations of engines have arguable done more to lower the cost of air travel than any other single item. As fuel is, and is likely to remain, the largest single cost for airlines globally, the returns on efficiency driving innovation remain high and technology leadership remains sustainable. This innovation helps force a natural upgrade cycle as airlines seek to remain competitive on fuel efficiency, a dynamic which only intensifies in high oil price environments.

Whilst industry practice is that the initial sale of an engine happens at either a low margin or a loss, the engine makers extract their returns as those engines are overhauled and have parts replaced through their operating life, which can be more than 30 years. The majority of engines that GE sells, have an associated service agreement which gives them contractual lock over the sale of future spares. For those sold without such a contract, customers have little incentive or ability to source alternatives, particularly given the return enhancing incremental improvements to parts the original equipment makers implement through the decades an engine is in production for.

Put simply, each engine delivered today has significant earnings and net present value associated with it, neither of which are adequately reflected in the current financial performance.
Most of GE’s major businesses are of similar quality to Aviation, innovative leaders in consolidated industries with a rational competitor set, significant aftermarket content and little prospect of new entrants disrupting those oligopolies. Even the Power business may meet these criteria in a more benign market environment.


The bulk of GE’s value today lies in the Aviation and Healthcare businesses, two highly regulated and safety critical industries. Staying with Aviation, selling an engine today gives GE visibility over a multi-decade stream of spare parts sales as the engines are used, both as parts wear out and as stringent safety legislation mandates their replacement at specified intervals.

Management & Financial

We view the recent management change positively. The former CEO addressed many of the problems inherited from his predecessors, changing remuneration to be more aligned with shareholder interests and refocusing the Company. The new CEO has a long and proven track record of shareholder value creation. Management, like us, believe the intrinsic value of the business is well above the current share price and we share their view that considered and deliberate actions, rather than knee-jerk ones in response to temporary challenges, are the best way to realise that value.

At the core of GE’s plan is the intention to monetise part of the Healthcare business and divest the majority holding in Baker Hughes, a GE Company which provides products and services to the oil and gas sector. These actions will reduce the debt burden to a more sustainable level. At the end of the process, GE will comprise 3 divisions compared to the current 7 – that is, Aviation, Power and Renewables. Management will also cut corporate costs and further reduce the size of GE Capital. At some point in this process, GE shareholders will likely become shareholders of both the Transport and Healthcare businesses, exposures we would be keen to take on.

Style & Macro

In a market that is prepared to pay a very high valuation multiple for structural growth, our investment in GE represents a remarkably cheap way of gaining such an exposure. For Antipodes, this would represent a potential style tailwind that should accelerate a rerating of the Company assuming our fundamental case is sound.


Figure 3


Whilst GE represents a complex asset, the new management team is focused on simplifying the structure and realising value. Our proprietary quant tools clearly show that within GE are businesses which would trade at higher multiples if they were separately listed. The Antipodes proprietary heat map lends support to this view. Developed world Aerospace and Defence companies are the most expensive relative to their history of any industrial sector globally, whilst North American industrial conglomerates are the cheapest. Buying GE today therefore represents an inexpensive route into a very highly valued sector, a discrepancy which we believe will close as management execute on their plan.

At the end of management’s disposal process, GE will be a business which on our estimates will derive more than 70 per cent of operating profit from Aviation, an industry in which the median valuation of industry peers is 14-times EV to EBIT. GE could be trading on as little as 9-times EV to EBIT in 2020.

This methodology is just one way to value GE given the flux in the portfolio. We believe it looks materially undervalued on nearly all of them. Should we assume no further contributions to the insurance business beyond those already announced then we can justify the current share price with the Aviation and Healthcare divisions alone. By implication, at the current price the market is discounting that all of GE’s other assets (Power, BHGE, Renewables, Transport, Lighting, Capital) are either worthless or consumed by the insurance liabilities. We cannot say categorically that will not be the case, but the risk reward is incredibly favourable.

Listed below are the other original 11 members of the Dow Jones Industrial Average. That their names are long forgotten by most is testament to the constant innovation and self-reinvention that has been the hallmark of GE since its formation. Another reinvention is required. The current reinvention is not one of product, where they have ample technical capabilities in attractive industries, but one of normalising the balance sheet for questionable past capital allocation decisions and realising the value in the portfolio. We believe they have the right management team to do that.


Whilst GE has idiosyncratic issues our conviction in the value proposition leverages our work on the European power market, our work justifying our belief that gas is the fossil generation fuel of the future and our work on the wind sector.

It also leverages the detailed work we have done on Siemens, another portfolio holding, on the Power and Healthcare businesses. In the case of both GE and Siemens a globally dominant franchise in an attractive growth industry is undervalued in the current corporate structure. In GE’s case that asset is the Aviation business, in Siemens case the automation business. We expect that in both instances the undervaluation will be exposed and eliminated over time.

[1] The other original members of the Dow were: American Sugar; North American Company; United States Rubber Company; Chicago Gas Company; National Lead Company; Tennessee Coal, Iron and Railroad Company; United States Leather Company; American Cotton Oil; American Tobacco Company; Distilling & Cattle Feeding Company; and Laclede Gas Company.


Correlation Cluster

Mobile connectivity positions such as Qualcomm currently comprise ~5% of the Antipodes Global Fund, with our position in the latter building steadily since mid-2017. These exposures are cheap relative to rapidly expanding addressable markets as the confluence of low latency 5G and accelerated computing technologies facilitates autonomous driving, IoT and immersive device-led VR applications. Figure 1 details how aggressively North American Semiconductor, Software and Internet stocks have been rerated and Figure 2 how starkly Qualcomm has been left behind.

FIGURE 1: Antipodes Partners Technology, media and communications valuation heat-map

Qualcomm 1

The above heat-map provides an illustration of valuation clustering across technology related sectors and regions. Cell colouring indicates the degree to which a sector’s Enterprise Value (EV) to Sales multiple relative to the world is above or below its 33-year trend (expressed as a Z-Score, the number of standard deviations above or below the average). The warmer the colour, the greater the relative multiple versus history; vice versa for the cooler blues, with extremes highlighted by the boldest of colours.

Irrational Extrapolation

More than 2 billion people rely on Qualcomm’s technology to make and receive phone calls, consume digital services and conduct commerce over mobile devices. Qualcomm invented many of the technologies that are at the heart of the communications revolution of the past 25 years and remains dominant in the supply of intellectual property (IP) and chips that allow mobile communication systems to function. However, more broadly, the company is a leading designer of low power, high performance chipsets and is well positioned to broaden its dominance in mobile into server and automotive applications.

Yet these virtues have been clouded in recent years by a series of controversies surrounding its Licensing business and relatively mediocre profitability from the Technologies or mobile chipset business. The result is a stock which has significantly underperformed semiconductor peers and now trades at a single digit multiple of long-term earnings power.

Qualcomm operates as two business, Licensing and Technologies, with Licensing providing approximately 75% of operating profits historically ($6.5 billion of $8.1 billion in 2016). The licensing business generates revenue by charging mobile device manufacturers such as Samsung and Apple for the use of Qualcomm’s intellectual property (IP). This is typically a stable, high-margin business that has grown, and should continue to grow, with the number of devices that are shipped globally each year. In mid-2017 however, Qualcomm and Apple’s relationship soured to the point where Apple withheld licensing/royalty payments whilst they argued that Qualcomm’s terms for payment were unfair. Analysts have lowered their Qualcomm’s 2018 profit estimates to ~$5.0 billion to reflect an estimated $3.2 billion in lost Apple licensing revenue, largely pure profit, and $500 million in additional legal costs incurred in defence of its IP position.

Multiple Ways of Winning

Apple’s decision has led some to believe there will be a fundamental reset to the way in which IP is monetised across the industry – overturning 25 years of industry practice and creating uncertainty to the outlook. However, whilst one may have expected all other handset vendors to take this as an opportunity to also cease paying Qualcomm its dues, this has largely not occurred and critical new deals, certifying the ongoing legal legitimacy of the patents, have since been signed with many key vendors, including government agencies such as China’s NDRC, representing over 100 Chinese device makers, and customers such as Samsung Electronics who refreshed their deal in January 2018. Hence whilst we don’t have specific insights into how a court might ultimately adjudicate, we would be surprised if any court could determine that Apple should somehow be treated differently from others in the industry and that broader patent protection, which is unambiguously something that benefits American companies, no longer applies for innovators. Ultimately a court decision is highly improbable and a commercial agreement is likely to be reached which would restart the Apple royalty stream, including a onetime payment for royalties withheld since mid-2017. Whilst unlikely, the worst case entails Qualcomm accepting a 25%-40% reduction in payments, what we understand Apple is arguing for, which would perhaps then trickle to other licensees and impair license profits by up to 50%. Apple continue to ship millions of devices each quarter which rely heavily on Qualcomm IP and, ahead of important developments in 5G over the next 2 years, we believe Apple will want certainty around their own business model.

Qualcomm’s Technologies business supplies chips that power mobile devices – the modems and application processors that are the brains of the modern-day cell phone. This segment has been historically undermanaged, with margins significantly below what we believe are achievable given Qualcomm’s scale. Essentially, this amounts to taking a much harder line on product range and cost, while noting that semiconductor peers with similar dominance routinely generate operating margins well above 20% versus Qualcomm’s more recent levels in the mid-teens. This can be an important lever to drive value for shareholders over the next few years.

In addition, Qualcomm should take control of the world’s leading supplier of semiconductors to the automotive market (NXP Semiconductor) later this year, where we see tremendous synergies with its existing prowess in communications meeting the demand of the next generation of connected vehicles – an exciting combination which fits with several other Antipodes holdings in our Mobile Connectivity cluster.

In summary, we see multiple ways to win over the next 3 years including a) settlement of outstanding disputes with Apple, b) a much sharper focus on margins within the Technologies business, c) successful integration of NXP, and d) the initial ramp of 5G technologies where Qualcomm should naturally lead.

FIGURE 2: Qualcomm price performance and relative valuations (2001 – 2018)

Qualcomm 2
Source: FactSet

Margin of Safety

Qualcomm has de-rated relative to both the World and its Semiconductor industry benchmarks (Figure 2). As the uncertainties that have weighed on the stock are resolved, the market is likely to recognise Qualcomm’s earnings power and potentially a share price of over $90/share. Further, naturally high profitability allows the company to sustain a generous pay-out ratio and an attractive ~5% dividend yield whilst we wait for our investment case to play out.

At the current share price of $55, Qualcomm has an enterprise value of $65 billion. In looking at potential outcomes we’ll consider 3 scenarios: firstly, the downside/doomsday scenario of the Apple negotiation permanently wiping out 50% of licensing profits with Technologies profit remaining flat; secondly, the base case of the existing royalty framework maintained with Apple and Technologies profit remaining flat and; thirdly, the upside case of also successfully closing the NXP acquisition or applying the $17 billion of surplus cash to buy back 20% of issued shares whilst also growing Technologies margin to 25%, from 17% currently. Applying a peer benchmark PE ratio of 18x[1] leads us to the conclusion that the asymmetrical nature of the risk-reward payoff is highly favourable.

TABLE 1: Qualcomm valuations under downside, base and upside scenarios

Qualcomm 3

Further evidence of Qualcomm’s portfolio and industry position were provided last year when rival semiconductor company Broadcom unsuccessfully bid for the company. Only an 11th hour US foreign investment review prevented the transaction from completing, but an industry insider was prepared to pay upwards of $80/share, despite current uncertainties, versus recent prices in the mid $50’s. Meanwhile, for what it’s worth, Qualcomm’s ex-Board Chairman and CEO has actively sought financing for a take-private bid for the company.

Gilead Sciences

The healthcare sector is renowned for its dominant drug franchises, pricing power, consolidated distribution and predictable customer (patient) base but has noticeably lagged the broader global market for the past three years. We anticipate healthcare related businesses will continue to be pressured by governments grappling with affordability given decades of high industry cost inflation. But within the sector we like biotechnology leader Gilead Sciences for its historically high market share in HIV treatments and promising new targets emerging in the pipeline.

Correlation Cluster

The Antipodes Partners Healthcare Valuation Heat-map provides a more granular illustration of valuation clustering across healthcare related industries and regions. Cell colouring indicates the degree to which an industry’s Enterprise Value (EV) to Sales multiple relative to the world is above or below its 22 year trend (expressed as a Z-Score, the number of standard deviations from the mean). The warmer the colour, the greater the relative multiple versus history; vice versa for the cooler blues, with extremes highlighted by the boldest of colours.

Figure 1: Antipodes Partners Healthcare Valuation Heat-Map

figure 1_healthcare valuation heatmap

With its deeper subset of stocks compared to Western Europe, the North American Biotechnology sector indicates good value, whilst the Major Pharmaceutical sector across most regions is broadly cheap to very cheap. Gilead Sciences has been a top 10 portfolio holding since inception and whilst it hasn’t paid off to date, multiple tests of the investment case led us to recently increase our position.

Irrational Extrapolation

Gilead’s stock rose to spectacular heights following its acquisition of Pharmasset in November 2011, which enabled development of the Hepatitis C (HCV) blockbuster drug Sovaldi, only to collapse from mid 2015 as pricing fell sooner than expected and the curative nature of the franchise led to a sharp fall in patient starts. We think the market’s preoccupation with the slope of the HCV run-off has obscured appreciation for the resilient HIV franchise and developing pipeline of new treatments. Further driving pessimism has been the healthcare affordability factors mentioned earlier and vulnerability to politicisation as government electoral cycles frequently roll around.

Figure 2: Gilead Science Relative FV/Sales to World (2005-2018)

figure 2_gilead science relative FV sales

Source: FactSet

Multiple Ways of Winning

Predictability of the HCV franchise earnings has improved with stabilisation in patient starts whilst becoming much less significant to the overall investment case. As featured in figure 4, HCV share of total sales is set to fall from a peak of nearly 60% in 2015 to roughly 20% by 2020. Until then the franchise will likely generate cumulative free cash flows exceeding $6bn.

Since first receiving human immunodeficiency virus (HIV) treatment approval in 2002, Gilead has grown to dominate HIV globally with up to 80% market share in the U.S. and around 50% internationally. In the U.S. HIV remains one of the few therapeutic areas where public funding is preserved under the 1990 Ryan White Comprehensive AIDS Resources Emergency Act. The social consequences of increased prevalence of HIV in society are too great for government to ignore or exercise formulary exclusion given potential drug resistance issues as recently evidenced by President Trump’s proposal to cut the National Institutes of Health’s funding by 19% (HIV/AIDS funding was not impacted). The unfortunate tendency for the disease to develop resistance over time helps Gilead’s leading innovation to sustain protection from competition. In February 2018, Gilead’s bictegravir (now Biktarvy) was approved by the FDA for treatment of the HIV-1 infection and is under EU review. The new drug is expected to be “strongly additive” to the existing HIV franchise and help compensate for older therapies due to come off patent. Physician feedback suggests Biktarvy is likely the “go to” medicine for treatment naïve patients, with many having drug resistance concerns for GSK’s Juluca doublet regimen. Biktarvy Phase III data recently showed a superior safety profile with 8% drug related adverse events (headache, nausea, insomnia) vs 16% for GSK’s Triumeq.

Gilead has a demonstrated ability to buy late-stage assets, gain approval and build drug combinations with superior efficacy that can dominate therapeutic areas. After a six year hiatus since acquiring Pharmasset for $11bn, Gilead struck again in August 2017 paying $11.9bn for Kite Pharma. Kite is an industry leader in the emerging field of cell therapy. Chimeric antigen receptor T-cell therapy commonly referred to as CAR-T can remarkably reprogram the body’s own immune cells to recognise and kill cancer cells (Figure 3). Cell therapy has generated compelling clinical data in cancer patients for whom all other treatments have failed. Kite’s lead CAR-T therapy candidate Axi-Cel was approved by the FDA in mid-October, six weeks early and is under expedited review in the EU. Called Yescarta, it is only the second approval of a CAR-T therapy by the FDA (after Novartis’ Kymriah in August 2017) and the first for the indication of DLBCL, a form of lymphoma cancer. Whilst controversial, the $373,000 proposed list treatment price is in line with expectations and ICER (an independent clinical and economic review group) did a public review of CAR-Ts and recommended both Kite’s Yescarta and Novartis’ Kymriah as being cost effective, suggesting pricing is in line with their clinical benefits over a lifetime horizon. The efficacy data is impressive as per Kite’s ZUMA-1 pivotal trial where 72% of patients treated with Yescarta responded to therapy including 51% of patients who had no detectable cancer remaining, i.e. complete remission. Research continues on further indications, including solid tumour potential, which would be a medical game changer.

Figure 3: Car T-Cell Treatment Process

figure 3_car t-cell treatment

Source: Kite Pharma

With the addition of Car-T, Gilead’s development pipeline is deservedly getting more investor attention. Both NASH (non-alcoholic fatty liver disease) and Filgotinib (rheumatoid arthritis and Crohn’s disease) are currently in Phase III and Phase II stages respectively. For both, key data readouts are due next year and could potentially start generating revenue from 2020 as prospective $2bn+ drug franchises.

Figure 4: Gilead Science – Treatment Percentage of Sales

figure 4_gilead science-treatment percentage of sales

Source: Antipodes Partners

Margin of Safety

Gilead’s valuation remains compelling with a 10% EV Free Cash Flow yield, 4x EV to Sales (2018) and 11x Price to Earnings (2018) multiple. We estimate that the HIV franchise alone is worth just over ~$65 per share, the HCV franchise ~$10 per share (accounting for substantial run-off) and the probability adjusted pipeline including CAR-T, NASH, rheumatoid arthritis and Crohn’s disease therapies at ~$20 per share – all up ~$95 per share, against a current share price of $75.

Unlike biotech peers such as Celgene and Regeneron, Gilead is not subject to relatively large binary risk and will be repatriating around $30bn in cash from overseas with optionality for dividends, buybacks or future acquisitions.

Global Telecommunications, Value or Value Trap?

Antipodes Partners’ quantitative tools have progressively highlighted the growing valuation gap between the Telecommunication Sector and the global market. As evidenced in Figure 1, the global Telecommunication Sector has de-rated relative to historical multiples across all regions, ranking close to 1.5 standard deviations “cheap”. Of course, the stocks may be “cheap” for a reason – only fundamental analysis can answer that question, hence, Antipodes Partners has devoted considerable analytical resource to understanding the opportunities across the globe.


Chart 1_Mobile ARPU relative to GDP per capita versus GDP per capita (USD)1

Source: OECD December 2016 “Broadband Statistics” report, Strategy Analytics 2016 report, IMF Database, Antipodes Partners

We see the major reason for the pervasive derating is the view that the sector will remain a proverbial black hole for capital spending (or “capex”) and that profitability will continue to decline. After significant rounds of spending on 3G, 4G, and fixed line fibre, investors are justifiably weary of the constant drain on cash flow. Further, some of the major global telecommunication markets remain structurally challenged in other ways:

  • Policy risk exists in many countries, for example we have seen Australia and Singapore suffer heightened competition with the emergence of government owned National Broadband Networks (NBN), reducing existing telecommunications companies to nothing more than resellers.
  • S. mobile ARPU’s (Average Revenue Per User) are high in both an absolute and relative to GDP sense. Further, the intensity of industrywide competition is set to increase as the cable broadband operators attack this large mobile profit pool which will force the mobile incumbents to fight back with greater fibre broadband investment to address their relatively weak offerings.
  • European regulators have generally been reluctant to allow cross-market consolidation and, hence, whilst mobile pricing has stabilised, the competitive environment remains fragile. We own Telecom Italia, which is the fastest mover in providing fibre broadband, and is a cheap exposure to a relatively unique growth in broadband adoption due to very low market penetration (Chart 2).


Whilst we could not agree more with the history of capex excesses, selectively the future should be very different for incumbent telecommunication companies that have a combination of dense 4G cell site coverage, high broadband penetration (and high proportion of fibre based broadband, Chart 2), and no obvious new broadband competitors. Moreover, these telecommunication companies will tend to have low historic returns on capital employed (“RoCE”) due to having front loaded their mobile and broadband fibre investment and, hence, on a backward looking assessment of profitability, may not initially appear that appealing.

As a result we have settled on Korea (and China) as markets of interest. Our core holding (also top ten) is the Korean ex-government operator, currently the leading fixed line player and second ranked mobile player, KT Corporation (“KT”). In total across different stocks and regions, we have approximately 7% of our Global portfolios and 9% of our Asia portfolio invested in this cluster of opportunity.


Chart 2_Household broadband penetration and fibre as a percentage of total broadband1

Source: OECD December 2016 “Broadband Statistics”, Note: OECD excludes Fibre to the Node under the definition of “Fibre Broadband”, Antipodes Partners


KT’s fixed line broadband internet can serve every apartment building in South Korea, a country of 50m people, with one gigabyte per second internet speeds. That speed is ten times faster than the fastest service available on the Australian NBN and forty times faster than what most NBN customers receive. Whilst the capital expenditure to provide this service hasn’t yet yielded fantastic economic returns, the hard work is done and the infrastructure can be gradually harvested over the next decade or more. In an Australian context, the market’s extrapolation is similar to assuming NBN Co capital expenditure would not fall after the NBN rollout is complete!

With KT’s 5G trials beginning in 2018, the market remains concerned regarding the investment merit of a large scale rollout. A key technical difference to 4G is that 5G will be rolled out on higher frequency spectrum. Whilst higher frequency spectrum offers significant advantages on speed and capacity, its chief drawback is the shorter distance over which a signal may be carried (propagated). Therefore, with each successive generation, physical network density has had to increase, driving higher capital expenditures. However, as confirmed by several large operators, increases in computing power are allowing “Massive MIMO” technology to dramatically lower incremental densification requirements. This technology enables transmission of almost an unlimited number of signals over one radio channel by increasing the number of antennae used, resulting in large increases in capacity and coverage for a given amount of bandwidth. This means densification requirements for 5G are somewhat offset and Korea, as one of the most densified 4G mobile networks globally, should not see any material change in 5G capital expenditure from 4G spend, as some currently fear.

In summary, in Korea (and China), and for KT in particular, heavy densification of the mobile cell site network and near completion of the fiber based fixed line network suggests that we should be entering a period where capital expenditures trend structurally lower than annual depreciation, and that growth in free cash flow accelerates.


Product Cycle
Whilst lower fixed line and mobile capital expenditure is the core of our investment case, we see other opportunities to win.

Competitive Dynamics
The near equivalent tariff plans across providers and customer churn that is near record lows suggest to us that the three Korean telecommunication companies are focused on returns rather than engaging in aggressive competition.

Whilst the Korean regulators have historically been quick to protect the rights of consumers, we’re not sure this could get much worse. We certainly take comfort from the fact that despite the noise generated during the 2017 presidential campaign regarding the need for greater regulation, not much has actually changed.

Despite a similar margin profile to peers, KT remains a relatively inefficient former government controlled operator with optionality to reduce costs – particularly labor costs – which the current CEO has a history of doing. KT also owns a vast real estate portfolio which on conservative estimates is worth USD8bn, a value in excess of KT’s market capitalization of ~USD7.5bn. By 2020, revenue from its property segment should be around $750m, of which half will be rental income. Furthermore, KT’s 27.6% 2016 dividend payout ratio is well below regional telecommunications company’s best practice, and below the capacity of KT to distribute income. We believe KT’s valuation discount to its peer group could be closed via a more progressive dividend policy with little cost to the net financial risk of the group.

In a “style” environment where the market remains enamored with growth, low volatility and yield, we find the Telecommunication Sector exhibits at least two of these characteristics, while growth opportunities may be underappreciated. At a time when infrastructure stocks have been celebrated the world over, telecommunications infrastructure, the beating heart of the digital economy, may be vastly underappreciated.


Chart 3_Asian telecoms EV.EBITDA versus dividend payout ratio

Source: Factset


For its sins of historically over-investing in fixed line prior to earning an economic return whilst also aggressively densifying its 4G mobile network, KT has become one of the cheapest telecommunications stocks globally with an enterprise value (EV) to sales multiple of 0.6x and EV to EBITDA of 2.6x (half the multiple of the Asian peer group) but, more importantly, is also trading on a highly attractive EV to free cash flow yield of approximately 15%.

Further, in a world of low yields, a higher dividend can result in outsized share price appreciation. As detailed in Chart 3, there is strong empirical evidence across listed Asian telecommunication companies that the dividend payout ratio is a critical valuation factor. Based on our analysis of a cross section of regional peers, there is a 53% correlation between “payout ratio” and “EV/EBITDA” ratio.

If KT were to raise its payout ratio to 50% (from the current level of 28%), the shares should command a valuation of around 5-6x EBITDA (the approximate valuation multiple afforded peers with a similar payout ratio), equivalent to W86k or approximately 3x the current share price. Given ample balance sheet capacity and projected strong free cash flow, in our view KT could ultimately sustain a payout ratio closer to 80%, in-line with mature market peers in Taiwan, Malaysia and Australia. Such a payout ratio might correspond to EV/EBITDA valuation multiples of 7-10x, suggesting still further share price upside potential.

In world that is chasing growth in yield and companies that manufacture this by taking on more leverage, the elegance of investing in KT is that this potential growth can be supported by a strong balance sheet and cash-flow generation.

Cooking with gas – global energy opportunities

Europe’s power generation market is undergoing a major transition that shares many similarities to our local Australian experience. At the same time, China’s gas demand growth is accelerating. In a world of perceived energy oversupply, investors have become too complacent – look for asymmetrical risk-reward exposures to higher electricity and Natural Gas prices.

Many investors think that the “new world” (i.e. renewables, batteries and smart grids) is going to wipe out the “old world” (i.e. centralised baseload generated from nuclear and fossil fuels). Whilst we do accept that there will be a transition we are cognisant that there are serious financial, political and practical factors that will keep low cost “old world” assets in demand for the foreseeable future. For the lights to stay on, supply and demand must be actively balanced 24/7, and renewables simply can’t do that yet. Therefore, until affordable storage of TWhs of energy is feasible, electricity will remain a mission critical service, not a commodity.

The workings of electricity markets in Europe are complex and somewhat poorly understood, largely due to an interplay of national and E.U. level policies. However, what is abundantly clear is that the German policy of subsidising renewables has had the unintended consequence of knocking cleaner burning natural gas out of the supply stack in favour of cheaper hard coal (power is dispatched according to short run marginal cost of fuel). As high cost gas plants were removed from their price setting position and increasingly sat idle, vital “peak pricing” gradually disappeared. Depressed gas prices over the past 12 months has further cut into peak price volatility. Thanks to E.U. led market coupling, this power price malaise spread to France and other parts of the continent.

Without the earnings that flow from “peak pricing” both hard coal and gas generators in Germany have failed to recover their all-in costs for a number of years. As a consequence, 15% of hard coal and 23% of gas/oil plants have already declared decommissioning plans. When combined with the forced shutdown of nuclear and lignite plants we estimate that 30% of the total required capacity is set to leave the market by 2023. Whilst renewables will fill some of this gap, gas fired generation will play a much greater role leading to a large pick-up in gas demand as well as a significant increase in power prices. As the U.K. market has recently shown, a properly functioning carbon market would significantly accelerate that shift.

Although not immediately obvious, there are a number of linkages between global gas prices and European electricity prices, with much of the analysis we have done on the North American and global liquefied natural gas (LNG) market helping to inform our views on the European generation market.

The current consensus view is that the wave of new LNG projects from the U.S. and Australia will result in a global oversupply of LNG. Given Europe’s deep spot market liquidity, well connected infrastructure and price sensitive power generation demand, it will become the dumping ground for this “excess” LNG, putting downward pressure on European gas prices and by extension, European electricity prices for a number of years.

We tend to disagree for two major reasons. Firstly, the market is too focused on the supply side of the LNG equation, missing the significant growth in demand from new gas markets such as China. Secondly, we question whether there will actually be sufficient gas production in Australia and the U.S. to meet the future volume commitments of these LNG plants. Whilst talk of gas shortages is now mainstream media in Australia, such an outcome is seen as impossible in North America even though production growth has stagnated in the last 3 years.


Chart 1 - Chines Gas Demand and LNG Imports
Source: Source: BP, Antipodes Partners

Over the next three years, annual global LNG capacity is set to increase by around 100 billion cubic metres (bcm). Set against current LNG demand of 350 bcm, this growth in output is considerable. However in the context of global gas consumption of 3,600 bcm it does appear somewhat insignificant, especially when one considers Chinese demand potential.

Over the last 10 years, Chinese gas demand has grown at 13% p.a., with consumption this year set to come in at 235 bcm, up +15% year on year. Despite this growth, gas still accounts for less than 7% of the energy mix, well short of the Government’s 10% target set for 2020 as part of its clean energy policy.

With domestic production growth estimates largely dependent on unproven shale reservoirs, LNG is likely to supply the bulk of this additional demand. So far this is proving to be the case with Chinese LNG imports surging 50% this year. When combined with robust demand from new market such as Pakistan, Jordan and Thailand as well as increased gas fired power generation demand in Europe, we question whether there will be any LNG surplus at all. With LNG spot prices currently trading at premium to long term oil linked contracts, we feel somewhat vindicated in our view.


The Antipodes Partners Industrials, Commodities and Utilities Valuation Heat-map provides a more granular illustration of valuation clustering across sectors and regions. Cell colouring indicates the degree to which a sectors’ enterprise value to sales multiple relative to the world is above or below its 21 year trend (expressed as a Z-Score, the number of standard deviations from the mean). The warmer the colour, the greater the relative multiple versus history; vice versa for the cooler blues, with extremes highlighted by the boldest of colours.


Figure 1 heat-map



Source: Source: Antipodes Partners

Our holdings in EDF and Inpex are well positioned to benefit from this forecast rise in gas and electricity prices and across portfolios we have up to approximately 10% exposure to stocks offering a similar opportunity. Whilst these stocks are correlated, they are also broadly differentiated by activity and regional end-market including resource owners, energy services, European electricity generators and Chinese town gas distributors. Also, as is evident in Figure 1, whilst the global Energy and Electric/Gas Utility sectors appear cheap in most regions of the world, in the current environment of high valuation dispersion, there are also cheap ways to hedge some of the commodity price exposure via shorts. In particular, the North American “shale patch”, where the market is still extrapolating growth with very little focus on returns, still appears significantly over-valued, as do the North American utilities that have been broadly re-rated as bond proxies.

Electricite De France (EDF)

EDF is the owner of the largest nuclear fleet in Europe, supplying 80% of French electricity demand. We think it has been unduly punished by the European regulators and investors alike, who have failed to recognise the systematic importance of this asset.


The power price malaise that spread from Germany to France has depressed French prices to levels EDF’s regulators had never envisioned. Investors are extrapolating these conditions into perpetuity, not recognising the inevitable transition to a more sustainable state of affairs.


Chart 2 - EDF Relative EV EBITDA to World.JPG

Source: Factset


As the largest producer of carbon-free energy in Europe, EDF is system critical not only to France, but to the entire continent. All-in cash cost on EDF’s fleet, even in the middle of a very heavy maintenance cycle, is still cheaper than a comparable cost measure for gas or hard coal (at currently depressed carbon and gas prices).

Energy demand is bound to increase with the economic recovery, at the same time capacity is being withdrawn at a record pace. Electric vehicles (EVs) have potential to further increase energy demand by around 0.7% for every 5% of EV adoption rate.

As marginal fuel shifts from coal to gas, Europe may find itself in a “power price” super-cycle similar to Australia (Chart 3). Poor economics and tighter environmental policies will eventually drive hard coal out of the market and gas burn will increase substantially, pushing gas and electricity prices even higher.


Chart 3 - Australian Electricity Price Case Study

Source: Source: Bloomberg


Despite the 40% rally off the lows, the shares trade at a fraction of the replacement cost of the assets, reflecting a long streak of operational, governance and regulatory mishaps. The 63GW strong nuclear fleet – once an earnings powerhouse of the Group – will likely return a cash break-even result this year. We appraise that the market is valuing this at a negative €20bn equity value.

The French government owns 80% of the company and it has already implemented a number of important regulatory initiatives to bolster the earnings of the French fleet. After funding this year’s €3bn equity injection and multiple foregone dividends, the government is highly incentivised to make the company work again. An extra 10 €/MWh in power prices makes a significant difference to EDF’s earnings (+€1.8bn), but only represents +6% on the total French retail power bill and the country enjoys a power bill roughly 50% lower than the broader region.


Inpex is effectively Japan’s national oil company and is best known in this country as the operator and 62% owner of the $38bn Ichthys LNG project. Ichthys is effectively three mega-projects rolled into one, involving some of the largest offshore facilities in the industry, a state-of-the-art onshore LNG processing facility and an 890km pipeline all with an operational life of at least 40 years.

Ichthys is set to begin producing by the end of the year and by the time it reaches plateau production in 2019 it will be generating 8.9 million tonnes of LNG, 1.6 million tonnes of LPG and 36 million barrels of condensate per annum.

For Inpex, this will translate into an additional output of 200,000 barrels of oil equivalent per day (boe/d), increasing its production base by almost 50%. Given the relatively low operating costs and favourable tax structure, the impact on the cashflow statement will be much greater. Yet despite this upcoming inflection, on most metrics Inpex still trades as the cheapest oil and gas producer globally; so what is the market missing?


Firstly, we believe the market is too focused on what has happened, extrapolating the operational and cost issues that also plagued other Australian LNG developments. Despite having scant tangible evidence to support their claims, the bearish sell-side analysts still forecast significant cost overruns. Whilst we acknowledge that there are residual risks, we take comfort in the fact that the offshore facilities have now been installed and the project is over 90% complete.

Admittedly Ichthys hasn’t been without issue, with the project forecast to come in around 10% over budget and 15 months behind schedule. However in the grand scheme of Australian LNG projects, that actually ranks as somewhat of a success. Yes, the full cycle economics of the project won’t be spectacular but that is largely irrelevant, we are buying the company today when the vast majority of the capital has already been spent and we are now in the position to harvest the cashflow that will be generated.

Secondly, Inpex is also a victim of where it is listed, with most Japanese investors unaccustomed to valuing resource based companies given the lack of local comparisons. Consequently, most tend to value Inpex on shorthand multiples of earnings which fails to capture the asset duration of the portfolio. In addition, by looking at earnings after depreciation we are over-emphasising the cash that has gone in, whilst largely ignoring the significant cash that is set to come out.


Whilst few would argue that the successful ramp-up of Ichthys is crucial to Inpex, we do believe the market is underestimating just how great the cash inflection will be. As stated earlier, the upfront investment of Ichthys has been massive, however the ongoing capex requirements will be no more than $2/boe. Combined with operating cost of $12/boe and minimal tax obligations the project will deliver almost $35/boe of cash flow assuming oil prices of $50. After considering interest and principal repayment, that should result a $2bn uplift in free cash flow for Inpex. When compared to an Enterprise Value of $16.5bn, the significance is stark.

Whilst Ichthys will always dominate the investment debate with Inpex, there is much more to this company than this one project. Indeed the market seems to underestimate just how significant a period of investment the company is now emerging from, with next year also seeing the benefit of the start of the Prelude floating LNG development. This comes on the heel of the successful ramp up of Kashagan with these two projects contributing a further $700m of FCF to Inpex.


One way to consider the valuation is simply to look at Enterprise Value to Proven Reserves. On this metric, Inpex trades on an Enterprise Value of $5/boe compared to the average global sector multiple of $11/boe. However, we are mindful that no barrel is created equal, with variations in realisations, operating costs and taxation rendering the metric somewhat flawed.

For a more objective assessment of valuation we can consider the net present value of its proven reserves, which at the current oil price we estimate to be worth $20bn compared with the Enterprise Value of $16.5bn. Bear in mind this is only proven reserves; no credit is given for possible reserves or future exploration success. Effectively we are buying the business today at a significant discount to the run-off value.

As a sense check, by the time Ichthys has fully ramped up in 2019, Inpex will be on an EV FCF yield of 15% assuming oil prices of $50/boe.

Making Italy Great Again

The European Union (EU) has often been described as an economic impossibility, however a conclusive and over-looked fact remains, that since the birth of the Euro, the EU has produced a better growth outcome than the US and Japan (Chart 1).


Chart 1 Real GDP per capita - EU, US and Japan

Source: OECD, Morgan Stanley

Observing only the experience of the past five years might lead to the conclusion that Europe is structurally flawed. However, this overlooks the 18 year history of superior growth in real GDP per capita. Within the larger picture of course there are smaller episodes of over and underperformance and although recency bias can dictate, we all remember post 2008. During that time Europe faced an unusually rare back to back recession with many of the reasons for the second recession being directly linked to policy errors specific to Europe. We have previously commented on some of the ways that Europe can overcome these short comings – ‘The million euro question facing the EU‘.

Firstly, the European Central Bank (ECB) initially failed in its role as the lender of last resort, providing insufficient liquidity to a banking system that faced solvency issues. Liquidity crises can take down solvent banks, but during the crisis the ECB reacted slowly and turned a controllable liquidity crisis into a potentially catastrophic solvency crisis. Secondly, and thereafter, the EU was slow to resolve solvency issues across its banking system and this led to a moribund recovery over the last seven years, which finally in 2016 turned upwards outpacing the United States in terms of real growth.

The US Federal Reserve (or Fed) and Treasury were much quicker to react in 2008 and better understood the risks within the shadow banking systems. The Fed’s quantitative easing (QE) program became essentially an asset transfer mechanism whereby the Fed created liquidity and transferred this to the banking system via large scale purchases of US government bonds. Bank solvency was managed through the US Treasury’s injection of public funds into the balance sheets of large US banks.

As mentioned above the Chart 1 above illustrates that the EU has produced a better growth outcome than both the US and Japan. We like to use real growth per head because it actually determines wellbeing and living standards and the best resolution mechanism of indebtedness for a society as a whole. High nominal growth via inflation may sound appealing to a highly indebted society, but it misses the point that one person’s debt is another’s asset. Inflation reduces the burden on debtors by robbing creditors – not a great longer-term wealth creation outcome.


Chart 2 Real GDP Per Capita

Source: OECD, Morgan Stanley

Chart 2 illustrates real GDP per capita for several European countries and tells us a very interesting story, where some countries over time have lagged. Very interestingly in the early periods of the Euro, Germany lagged due to a combination of high unemployment from the post reunification phase which led Germany to enact sweeping structural labour reforms in 2002 to improve competitiveness (in 2015 Italy modelled it’s version of labour reform on this German framework). But post the GFC, the recovery in both Italy and Spain lagged as seen in the real GDP per capita chart.

However, in 2013 Spain achieved a remarkable recovery in real GDP per capita whilst Italy unfortunately did not. Spain through the assistance of the European Union rebuilt the capital positions of its banking system.

Examining net non-performing loans (NPL) to the total equity capital in the banking system demonstrates that Spain managed to restore solvency, something that has alluded Italy until now. Based on our calculations, Italy required approximately EUR55 billion of additional capital to restore confidence and health. Through a combination of private and public market solutions, Italy has finally restored solvency albeit at a snail’s pace. It would be a bold statement to say the Italian banking system is now healthy but it’s far closer to being so than it was in the past.


Chart 3 Net NPL Total Equity Capital

Source: Bloomberg

Italian net NPL to total equity capital is now at the same point it was for Spain in 2013 (see Chart 3). Whilst this doesn’t guarantee that Italy will exhibit the same growth trajectory, it is important to recognise that the obstacles to growth are being lowered at a time when market sentiment towards Italy is still very negative.

For example, through the process of raising capital and forced mergers, the Italian banking system is now more consolidated compared to Spain (see Chart 4).


Chart 4 Deposit Market Share of Top 4 Banks

Source: BAML

For over 18 months Antipodes Partners has been highlighting the opportunities within European domestic industries and, in particular, the banking sector. ING Groep has been a core outperforming holding within portfolios and European banks now on average are priced at ~1.1x Book (see ‘ING Groep – a leader in digital distribution‘). Italian banks, however, remain at a significant discount, trading at ~0.7x Book, reflecting thus far lacklustre growth and ongoing “tail risk” concerns. Growth recovery will be critical for Italy now and would further help Italian banks build further capital and continue the recovery.

Antipodes Partners’ Italian bank portfolio exposures include Unicredit and Mediobanca with each business highly differentiated in its own right.


Volatility: dead or in hibernation?

Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits – Hyman Minsky

Volatility is one of the first concepts that finance students learn to calculate, typically taught with reference to the variability of a stock or stock market’s returns, synonymous with risk.  At Antipodes Partners, we define risk as the likelihood of a permanent loss of capital and/or an extended period of negative returns. In this sense, whilst we seek to minimise unintended downside volatility, we actively embrace the opportunities that volatility can offer investors. Today, realised and implied volatility has fallen to record lows and buying volatility has been a losing bet for years across all asset classes, not just equities[1] (Chart 1).


Chart 3
Source: Goldman Sachs Global Investment Research

Goldman Sachs have provided some useful recent work around the evolution of the current low volatility environment in the context of the long-term experience.

Some of the key observations include:

  • S&P500 index volatility is very close to an all-time low (Chart 1) and much lower than other global market indices (Table 1), though Antipodes Partners observes that low single security, as opposed to index volatility, is globally more pervasive, particularly in Developed Markets.
  • U.S. Treasury and credit index volatility is low relative to average levels post the 1970’s (Table 1), but not as low as the S&P 500. Antipodes Partners connects this outcome directly to central bank QE policies.
  • Cross asset index volatility is close to record lows (Chart 1)
  • Volatility typically spikes when equity markets fall as markets fall faster than they rise, however this doesn’t preclude the coincidence of rising volatility and markets, though this is rare (Chart 2)
  • Low volatility regimes are typically a late cycle phenomenon, the ending of which is difficult to predict but typically associated with rising unemployment/recession. However, the longer a low volatility environment persists, the greater the average equity market drawdown when it ends.


Table 4 without source
Source: Goldman Sachs Global Investment Research

Chart 4
Source: Robert Shiller, Goldman Sachs Global Investment Research, Antipodes Partners

In summary, there is nothing that unusual about the duration of the current low volatility environment. What is unusual is the low absolute level (and spread across sectors) of equity volatility AND cross asset index volatility globally.

As Minsky alluded to, prolonged periods of stability or low volatility do not necessarily equate with low potential risk. In fact, today many investment strategies are increasingly betting on stability and low volatility to generate returns.

Examining the mid-2000s, a virtuous cycle of cheap funding via surplus EM savings combined with a search for yield, resulted in low volatility which fuelled leverage in the developed world private sector. Today, we have a different issue with the central bankers now the key actors dampening volatility and creating the illusion of stability.

Antipodes Partners argues that volatility targeting investment strategies, such as risk parity[2] and minimum variance[3] are an OUTCOME of large scale bond buying programs, rather than the CAUSE of persistently low volatility. Hence, asset volatility, especially equity volatility, is not dead but rather in hibernation.

Furthermore, Antipodes Partners makes the following observations regarding the underlying nature of the current low volatility environment:

  • One of the primary objectives of QE is to cap the range and volatility of long-term government interest rates. Whether the merits for current QE makes sense or not, it’s hard not to argue that QE has successfully anchored long-term interest rate expectations and forced government bond holders to take an increasing amount of duration risk, lowering interest rates further and/or increasing allocations to other government bond markets, thereby supressing yields globally. Chart 3 highlights how aggressively certain central banks have targeted the longer end of the yield curve, with the weighted average maturity of central bank government bond holdings at 8-9 years for the Fed, ECB and BOJ
  • Whilst equity investors see themselves as central, it’s higher up in the corporate capital structure in credit where the impact of QE can be much more meaningful. As central banks have crowded private investors into high yield debt, spreads have compressed across the risk spectrum (Chart 4)
  • Now the cycle is in a virtuous period where low yields and low volatility reinforce the greater use of leverage to manufacture returns

Chart 5
Source: Bank of Japan, European Central Bank, Federal Reserve, UBS, Antipodes Partners

Chart 6
Source: Deutsche Bank

Awakening from the slumber

Simplistically, we see two likely scenarios:

  • Growth surprises to the upside driving urgency from central banks to normalise policy. To minimise disruption to short-term funding markets, tapering would need to focus on the long-end of the yield curve leading to a potentially self-reinforcing pro-growth steepening, resulting in a significant increase in bond volatility and the death of the highly crowded/expensive equity low volatility, bond proxy and growth/quality trade. Conversely, it would be positive for the currently cheaper shorter duration equity exposures such as Banks and other so called cyclical sectors.
  • Growth disappoints via the withdrawal of global liquidity. For example, policy tightening in China combined with weak commodity demand has the potential to send a negative growth impulse to EM. In this scenario, credit volatility would spike triggering a major sell-off in credit sensitive equities regardless of their duration, i.e., a repeat of the 2015/16 commodity high yield melt-down which ended up spilling over into non-commodity exposures. Conversely, the inevitable central bank response would extend the illusion of stability and amplify the imbalances with a continued melt-up in the equity low volatility, bond proxy and growth/quality trade.

Whilst the recent sell-off in oil has many thinking the latter scenario is upon us, the market is somewhat already positioned for the end of the reflation trade. Crowding into bond proxies and growth/quality exposures remains intense, whilst speculative positioning in U.S. Treasury futures is at a record long (Chart 5), with the swing since early 2017 being nothing short of violent.

Chart 7
Source: CFTC, Bloomberg

However, if U.S. growth expectations, which have thus far been very sticky continue to hold-up (Chart 6), we could see an equally violent rotation back to reflation exposures.

Chart 8
Source: Bloomberg

As we highlight in Chart 7, since the 1970’s there has been a tight relationship between average nominal 10 year U.S. bond yields and average nominal GDP growth, though we caveat this inference – in the 40 years following the Great Depression, U.S. yields failed to keep pace with nominal growth. In a cyclical sense, global growth has been accelerating for most of the year. Whilst we would hesitate to extrapolate a higher structural rate of long-term global growth, the recent move in rates highlights that global long-term bond yields may have been mispriced, i.e. too low, relative to growth and that this mispricing may be most extreme in the Eurozone.

Chart 9

Source: Factset, Robert Shiller, Eurostat


Minsky’s assertion that the longer things are stable, the more unstable they become echoes against the current backdrop of extended low cross-asset volatility, one which we believe has created a false sense of security as investors confuse today’s low volatility environment with low risk.

Central bankers have somewhat cornered themselves. Increasingly, political and economic pressure to normalise interest rates or withdraw stimulus is likely to trigger volatility and widen credit spreads (our analysis suggests that U.S. high yield, or junk bond issuers are most vulnerable to this risk – see our research paper titled “The Global Corporate Debt Unwind”[4]). Whilst the low-volatility regime may endure, investors have grown too comfortable with the central bank reaction function, extending the illusion of stability.

At Antipodes Partners, we do not attempt to predict or time regime change. Whilst a poorly constructed building may eventually collapse, the cause, timing and degree is challenging to predict. As investors, we seek to identify where fragility exists and build a resilient portfolio with asymmetric payoffs at the stock, cluster and portfolio level, i.e. a safer building. At the core of our investment philosophy we seek in our long investments both attractively priced businesses (margin of safety) and investment resilience (characterised by multiple ways of winning), with the opposite logic applying to our shorts, i.e. no margin of safety and multiple ways of losing. Whilst the investment case will always be predicated on idiosyncratic stock factors such as competitive dynamics, product cycles, management and regulatory outcomes, we seek to amplify the investment case by taking advantage of style biases and macroeconomic risks/opportunities.

In our last quarterly, we noted that the blind assumption of unendingly low rates made the market vulnerable to a cyclical back-up in yields. Whilst this thesis initially played out and has partially reversed, we believe the risk is still asymmetrically priced. Accordingly, we are avoiding expensive versions of the bond proxies as long investments, accumulating selective opportunities that have suffered the most from yield curve compression whilst increasing our shorts on the beneficiaries of the low rate world, i.e. expensive bond proxies and growth.

In summary, we’re encouraged by the growing valuation dispersion within and across markets (region/sector/factor) as we think this is indicative of broadening pragmatic value opportunities, both long and short. Further, investment strategies which are seeking idiosyncratic alpha (rather than passive beta), are flexible and risk-aware should outperform in an environment where volatility awakens from temporary hibernation.

[2] Risk parity, or risk premia parity, is an approach to portfolio management which focusses on the allocation of risk, usually defined as volatility, rather than the allocation of capital
[3] Minimum variance strategies seek to exploit an observation that stocks with low volatility, in the right combinations, produce long-term returns equal to or better that the market at lower levels of risk

Office Depot

Though the U.S. office supplies market has consolidated down to Staples and Office Depot (ODP), many investors consider these two extremely dominant businesses dinosaurs facing extinction by Amazon. We beg to differ with ODP a top ten holding.

ODP has two business lines – Commercial and Retail. Commercial covers large corporate office delivery and accounts for ~50% of revenues. The other half comes from Retail, serviced by a national network of 1,400 stores. Following the merger of ODP and Office Max in 2013 (ranked 2nd and 3rd by market share respectively) this network expanded significantly, with the trend towards industry consolidation reaching its zenith in February 2015 as Staples attempted to buy ODP. The deal appeared fate accompli given structural sales declines, particularly within the retail channel. However, in December 2015, the Federal Trade Commission (FTC) blocked the deal due to excessive market power. A subsequent court challenge failed in May 2016 and all bets were off. On the day, ODP and Staples share prices collapsed 40% and 19% respectively. We sensed a buying opportunity with the market underestimating some inherent resilience against online competition.

Irrational Extrapolation

There are two aspects to this. Firstly, the market extrapolated the structural decline in paper use as a structural decline in ODP’s addressable market, paying little heed to its success in broadening the offering into the Maintenance, Repair and Operations (MRO) category. Secondly, the market has failed to give ODP credit for having moved 50% of its business online/direct, with the FTC somewhat validating ODP and Staples dominance in the commercial channel as grounds for preventing the merger.

We’re not denying that the online/Amazon threat is significant but “the everything store” isn’t perfect, having to relaunch its somewhat failed “Amazon Supply” commercial offering as “Amazon Business”, targeting office products as well as MRO. Amazon is struggling to optimise its low-cost service model for commercial customers, often with slower delivery times versus same day at ODP and deploying multiple delivery batches for bulk orders – a point of friction for client receptionists (the gatekeepers).

Multiple Ways of Winning

In the Commercial business, customer service matters as ODP delivery staff physically check client cupboards/storage and automatically refresh, useful for large corporates that order centrally to multiple locations. The multi-year decline in Commercial sales can flat-line from a recovering customer pipeline and cross-selling opportunities into new growth categories such as Kitchen and Cleaning. Commercial clients also receive bulk discounts when shopping via the offline retail store network.

For retail customers, ODP has been price-matching Amazon for close to three years without any signs of weakness. We expect industry retail sales to fall by low single digits, but in the case of ODP, offset by a further USD250m of annual cost savings from supply chain streamlining and closure of a further 5% of retail stores. New CEO Gerry Smith is well qualified for a bruising fight having formerly headed Lenovo America, where he built a PC business battling giants Dell and HP.

Bring back the merger! Under the new Trump administration, Maureen Ohlhausen, the acting chair of the FTC, is on the record suggesting the FTC has been too heavy handed in recent years. A more open posture from the FTC and USD$1-2bn of annual synergies based on +1000 combined stores closures, may tempt Staples and its new private equity owners ($6.9bn privatisation by Sycamore Partners just announced) to revisit the merits of a merger.

Margin of Safety

Despite an 80% rally in its stock price from the lows, ODP’s valuation still looks compelling. The balance sheet carries USD400mn of net cash against a market capitalisation of USD2.9bn providing an enterprise value of USD2.5bn. In 2017, the business should earn USD500m of EBIT (5x EV/EBIT) and USD300m of free cashflow (12% free cashflow yield). Much of that cash should be returned to shareholders via buybacks and dividends. Benchmarking ODP against the takeover offer from Sycamore Partner’s for Staples suggests a further 40% upside, though we think the business is worth 7x EBIT indicating upside of 35%, with material optionality around any merger with the Staples retail assets. There’s still more to come from this so-called dinosaur.

Correlation Cluster

ODP belongs to our “Retail Disruption” correlation cluster which includes traditional offline retailers successfully confronting and adapting to the online reality that the market is overlooking in its fervor to believe that Amazon truly is the “the everything store”. This is a growing cluster with Antipodes Partners’ portfolios and includes a recent successful investment in Belle International.

The Million Euro question facing the EU

With the election of Emmanuel Macron to France’s highest office, the European Union (EU) now stands at a crossroads. As a monetary union with structurally different economies, the Eurozone has often been described as an economic impossibility. The dilemma of having a monetary union without a fiscal, banking or political union has been horribly exposed in recent years. Indeed Macron has said “the EU and the Eurozone will not survive long, without further integration. The question is – what is the way forward?”

Investors have become accustomed to believe that either the EU will permanently remain an inflexible union or disintegrate. However, there is a middle ground between what is good for an individual nation and also the region as a whole, where the necessary flexibility is provided by European institutions and common public goods. In certain areas Europe needs tighter integration, including greater security and military cooperation. Economically, it’s difficult to retain a common currency and a one size fits all monetary policy without allowing regional economies to rebalance via fiscal policy and a banking union to contain deposit outflows in a crisis. Greece is a great example of this dysfunction, its banks having lost plenty of deposits and despite the ECB’s emergency liquidity assistance (ELSA), no plan for growth. Meanwhile, Greece continues to focus on exceeding budget surplus targets even though the economy is burdened by high unemployment.

The million-dollar question is, with the election of a moderate French President, will the EU unite to provide fiscal relief to those member states where growth has lagged?

Meanwhile, European economic fundamentals are much stronger than the headlines imply. Based on a workforce participation measure of employment, the Eurozone recovery in employment has been stronger than that of the US. The data suggests that, in the face of uncertainty, Europeans have deferred consumption resulting in first a catch-up phase, followed by a more durable recovery. Further, with the Euro trading close to its lows on a real effective exchange rate (REER) basis (Chart 1), trade competitiveness is adding fuel to the growth rebound.

Benefits of a competitive exchange rate

Given the strength of the recovery, the ECB is considering normalising rates even as it keeps up its rate of QE, i.e. reversing the order of tightening that the Federal Reserve adopted. Why would it do this? Primarily to improve the profitability of the European banking sector, by encouraging lending whilst also keeping a lid on sovereign yield spreads. Ironically, according to our heat-map, one of the cheapest sectors globally is European Financials, the direct beneficiaries of such a policy. Antipodes Partners’ portfolio exposures here include ING Groep, Mediobanca, Unicredit and Erste Bank, with each business highly differentiated in its own right.

Heat Map

Given Europe’s status as a very large exporter of savings to the rest of the world, the knock-on effects of such a potential policy normalisation should not be underestimated (beyond the potential for the Euro to rebound, just a general tightening in global liquidity conditions).

In summary, the Eurozone bond market (and European Domestic facing equities, especially Financials) are discounting a deep deceleration in growth at the same time that North American domestic-facing equities are discounting a reacceleration in growth. We believe it’s highly likely that both markets are mispriced.

At the core of our investment philosophy, we seek in our long investments both attractively priced businesses (margin of safety) and investment resilience (characterised by multiple ways of winning), with the opposite logic applying to our shorts. Whilst the investment case will always be predicated on idiosyncratic stock factors such as competitive dynamics, product cycles, management and regulatory outcomes, we seek to amplify the investment case by taking advantage of style biases and macroeconomic risks/opportunities.