To reiterate, our goal is to have good absolute returns first and foremost, which should lead to good relative returns versus the broader markets. However, I also think it’s important to highlight the performance of the primary sectors in which we feel we have an advantage and in which we invest. There is no reason to present this other than for transparency reasons. Owning a highly concentrated portfolio will prevent our results from looking like anything we compare them to in most years, but knowing the performance of energy broadly, midstream energy specifically, and North American airlines will add some context for those partners who wish to do some higher-level analysis. Please see the accompanying disclaimer & footnotes at the end of the letter for a broader description of each of these indices.
The partnership returned 25.6% gross, 19.7% net of accrued performance fees through June. Despite being only 70% invested, concentrated in 9 cyclical companies, not hedging our positions, and animal spirits once again inflamed across markets, our performance has been decent on an absolute and relative basis. With Nvidia (NVDA), Microsoft (MSFT), Amazon (AMZN), Meta (META) and Eli Lilly (LLY) contributing 55% of the S&P 500’s return this year, none of which we own of course, we’re happy to even be within earshot of the index, let alone beating it. Excluding the “Magnificent 7” the index only returned 6.3%, versus the 15.3% headline number. Broad performance across the market has certainly been respectable, but spectacular performance has generally come from a narrow sliver of Large Cap Growth stocks.
Being the progeny of a mutual fund company, our competitive spirit also incites us to compare ourselves to that corner of the money management world, even though we have completely disparate strategies and fee structures. Morningstar estimates a measly 18.2% of actively managed mutual funds outperformed the S&P 500 YTD; down meaningfully from the still paltry 27.1% annual average over the past decade. And while our partnership returned 48% gross over the trailing 12-months, the best performing actively managed US stock fund, according to the WSJ at least, returned 42.4% (out of 1,218 in the survey). Net of fees our performance would be 500bps lower, but then again that fund was down 36.8% in 2022 and still charged investors 1.2%, while we were up 12.5% and charged investors 2.2%. Our performance-based fee structure prevents us from making a cent when we’ve had such poor returns (less than +4% in fact).
Nate and I continue to think our unconventional, yet logical approach is the right one for long-term success. Our primary focus is on absolute returns, and we will consider ourselves successful if we’re able to outperform the market’s historical long-term average-call it 12%ish. Inception-to-date our annualized return is 18.3% gross, 14.5% net. So far, so good.
And that concludes the first and last Legacy Ridge Partners’ marketing campaign for the year!
Our level of caution-as measured by the percentage of assets held in cash-is relatively high and we averaged ~30% in cash and equivalents over the first 6-months of the year. With most of that idle cash currently earning 4%+, the opportunity cost of such a position is somewhat minimal while the opportunity set available to deploy said cash is very minimal. Few sectors seem out of favor.
One of the sectors we know well which had been out of favor for several years has quickly come into favor: Independent Power Producers (IPPs). We’ve written consistently about NRG and VST since the 2019 letter, have owned each, or both, since 2018, and invested a meaningful amount of our assets in VST specifically the past few years. Nate and I intend on spending more time in the year-end letter on our updated views on the IPPs and our learnings from the on-going investment, but we were a bit surprised how quickly the narrative around these companies changed. Our Blue Sky 2030 estimates of intrinsic value converged with the share price 6-years before we thought probable. In the 2019 letter, with respect to VST, we wrote:
“Over the next decade management should have close to $15 Billion to deploy to share repurchases. If you assume they have to pay an average price for the stock that’s higher than the current one, and they can only repurchase 60% of shares outstanding instead of the 100% the math implies, FCF per share in 2030 would be $14. That’s a $70 stock at today’s valuation, but a $140 stock at a more reasonable FCF yield of 10%.”
And…
“The IPPs are un-investable for most money managers, so there we are. When they become investable we’ll probably be long gone.”
We’re not exactly long gone, but sentiment has certainly surpassed investable. After 5+ years of VST trading between $17 – $26 a share-and $26 exactly a year ago-it hit a high of $107 in May on the heels of the Artificial Intelligence (‘AI’) narrative and the implications for electricity demand. While we agree with the prevailing consensus view that more Data Centers will be built, Data Centers require base load energy, and that the US will probably be short base load energy, predicting the rate of any technological advancement is not our area of expertise, and we feel the margin of safety has dissipated. Therefore, what had been our largest position entering 2023 and 2024, and has been our greatest contributor to performance, is now one of the smaller positions in the fund.
In addition to Vistra’s (VST) performance compelling us to reorder the top of the portfolio, two other positions had news warranting brief updates: Summit Midstream Partners (SMLP) continues restructuring the business and balance sheet, and Equitrans Midstream (OTCPK:EQTNP) is getting acquired by EQT (EQT).
Summit Midstream is more a bet on the jockey than the horse. This wasn’t the case when I made the initial investment several years ago and I’m guilty of shifting my original investment thesis, as one is prone to do when a stock goes down over 70%. Nine out of ten times this is a big mistake, but our current wager that Heath Deneke and team will straighten this company out is looking like a decent one. Within the past couple months the company divested $700mn worth of assets (the Enterprise Value was only $1.6 billion the day before the announcement), added long-term take-or-pay contracts to the Double E pipeline, and announced a C-corp conversion.
The asset sales occurred in two separate transactions, allowing SMLP to fully exit their position in the Utica and Marcellus basins at a 7.4x multiple. After the asset sale, management embarked on a broader refinancing package, issuing new Senior Secured 2nd Lien Notes due 2029 at 8.625%, while redeeming all other maturities with a little help from the credit facility. With several quarters of FCF capable of paying down the ~$120mn drawn on the revolver, by 2026 the only debt remaining should be $575mn from the new Notes.
The chart below illustrates the progress made since Heath joined the company.
Total net obligations are down 63% in 4-years and leverage has declined from 5.4x at the end of last year to 4x today. As a result, interest expense continues to decrease materially, from $127mn in 2023 to potentially as low as $50mn by late 2025.
Management has a leverage target of 3.5x before distributions on the preferred or common equity are reinstated, but we think there is a far better use of capital than dividends. The base business is worth $60-$70 a share in our opinion and Double E is worth $18+ a share, for a combined value of ~$80, or 125% above the current price. At such a steep discount to intrinsic value investors would be far better served by share repurchases than they would by dividends. We hope Heath and team change tact when that time comes, but regardless there is a lot of value left to capture.
Lastly, we wrote about Equitrans Midstream (ETRN) in the 2023 mid-year letter, primarily discussing that company’s long and expensive journey completing the Mountain Valley Pipeline and the short-term opportunity we took advantage of. After all the hand wringing and stress with respect to that one project the whole business will end up right where it started, as part of EQT Corp. In March, EQT announced they are acquiring each ETRN share for .3504 EQT shares. The transaction should close within the next several weeks.
EQT is the top natural gas producer in the United States with a dominant position in the Appalachian Basin and will become one of the lowest cost gas producers in the US, if not the lowest, after consummating this merger. Our fund is going to exchange the ETRN shares and become EQT owners. The investment checks important boxes for us: 1) a disciplined management team focused on tangible value creation; 2) an ability to generate significant FCF that gets returned to shareholders; 3) exposure to a commodity with strong secular demand trends, which gives us a call-option on higher prices. At only 5% of our assets it will start as a small position for us, but with natural gas prices volatile and back in the low-$2’s we should have ample opportunity to exploit the volatility over time and hopefully make it bigger.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
