We see many bottom-up investment opportunities in the global credit markets, particularly in industries with high barriers to entry.
We view healthcare, lodging, Asian gaming, master limited partnerships/pipelines, energy, wireless telecom, cell towers, cable, satellite, media and U.S. banks as attractive industries.
Companies’ unique patents, licenses, brands, content and intellectual property, among other advantages, can help support investment returns in both bull and bear markets.
While fundamental healing regionally has been mixed, many companies’ operating results have improved due to industry consolidation, higher utilization levels or modest capacity additions supporting the supply side as well as cyclical and secular growth engines kicking in on the demand side. In the years ahead, we believe companies operating in favorable industry settings will differentiate themselves further – even if global economic growth remains subdued.
Investors who have embraced the “outer perimeter” risk assets (see Figure 1) – including real estate, equities and higher-beta credit – that we highlighted in our previous Global Credit Perspectives over the past five years have been well-rewarded with ample alpha opportunity as a result of these trends. While many of these drivers of the global credit markets remain in place, future investment success will likely depend on the ability to discern regional differences and emphasize “bottom-up” analysis. Investors will also need to play both offense and defense and embrace a more flexible investment strategy to outperform the market given that the supply and demand dynamics for bonds and equities, global central bank policies and fundamental trends are destined to change in the years ahead. This is particularly important today because valuations for outer perimeter assets are no longer collectively as cheap as they were several years ago.
An emphasis on barriers to entry
At PIMCO, we have refocused our bottom-up credit analysis on identifying industries globally with pricing power and/or compelling growth prospects – conditions that can foster the creation of “rising star” credits (see “Growth and Rising Stars,” Global Credit Perspectives, September 2013). We also recognize that pricing power and growth can invite unwanted competition.
That is why high barriers to entry are an important characteristic for the sustainability of attractive economic profits. If an industry’s structure discourages new entrants, it passes an important screen in our investment process and therefore warrants further assessment. While an industry with high barriers to entry does not automatically generate excess profit, it does offer competitive shelter – and the higher the barrier to entry, the greater the prospect for above-average returns, in our view. We believe investing in companies with strong barriers to entry is even more important today given increasing regional differentiation and more compressed risk premiums.
Companies in industries with high barriers to entry may be better equipped to produce alpha for investors and exert inherent strength, durability and flexibility in economic downturns. Our global portfolio management and credit analyst team has extensive experience analyzing industry structures. Once we are drawn to a specific industry, we then focus on the specific barriers to entry to determine where the best investment opportunities exist today.
What company-specific attributes should investors favor? We continue to focus on companies that control patents, licenses, proprietary brands, content, intellectual property, permits, real estate or land, and contracts. We also favor companies that operate in more regulated industries with high switching costs and high capital intensity where a low cost structure and superior product quality and innovation can create a sustainable advantage (see Figure 2).
Industries including healthcare, lodging, Asian gaming, master limited partnerships (MLPs)/pipelines, energy, wireless telecom, cell towers, cable, satellite, media and U.S. banks have many of these barriers to entry. These companies tend to have an ability to generate strong free cash flow with a high degree of stability and predictability, making them potential alpha generators and attractive investment opportunities now from a bottom-up perspective.
Healthcare
We view the healthcare sector as having above-average barriers to entry, given a regulatory-intensive operating environment across the sector as well as patents and intellectual property in the pharmaceutical and medical device sectors.
For hospital companies, the key differentiators include their regulatory licenses (particularly in states that require a certificate of need), their established physician referral relationships and their embedded real estate assets. For pharmaceutical and medical device companies, the key barriers include their product patents (as well as nonpatent intellectual property) and their operational expertise in terms of manufacturing and distribution (versus Food and Drug Administration regulation, which has recently increased in scope).
In addition to supportive barriers to entry, we also continue to expect select issuers in the healthcare sector to benefit from the recent trend toward increased strategic mergers and acquisitions (M&A), which can bring greater scale, resources and cost savings to the merged companies.
Lodging
The recovery in the U.S. lodging sector has been broad-based, with record-high occupancy driving higher rates and stronger revenue per available room (RevPAR) growth across both full- and limited-service hotels. Over the long term, we view the premium end of the market as a high-barrier-to-entry industry and, therefore, an area that provides relatively more attractive investment opportunities.
While new supply is creeping into some markets, most notably New York City, it has been concentrated in the limited-service segment, and demand has been strong enough to absorb this new supply. Elsewhere, new supply in the high-end and luxury segments has been, and should remain, minimal across the country for the foreseeable future given the increasing difficulty of finding attractive land to build on within the major lodging submarkets, the high absolute costs, the lengthy construction timelines to build luxury hotels, and a more disciplined construction financing market characterized by lenders requiring more equity from sponsors and limiting financing to sponsors with solid track records. Building brand awareness and customer loyalty is also a significant hurdle for potential new entrants into the industry.
Looking forward, we view lodging C corporations as an attractive area of investment in the sector. All of these companies have shifted toward an asset-light operating model, whereby an increasing percentage of EBITDA (earnings before interest, taxes, depreciation and amortization) is generated from highly scalable management and franchise fees, which require very limited capital expenditures leading to higher free cash flows. While hotel demand remains highly sensitive to the economic cycle given “daily leases,” these companies tend to generate significant free cash flow and carry very low levels of debt.
Asian gaming
The Asian gaming industry has historically generated high returns on invested capital and represents a unique investment opportunity. The limited number of operating licenses creates a high barrier to entry in the industry.
In Macau, a gaming market that serves Hong Kong and mainland China, only six licenses to own and operate casinos have been granted. Gaming revenues for the last 12 months were US$47.5 billion according to Gaming Inspection and Coordination Bureau Macau SAR, as of 31 August 2014, making Macau the largest market in the world (seven times the size of Las Vegas). Several new resort projects are currently under development, but the increase in supply is measured given the limited number of licensees. Furthermore, we believe that the Chinese market is still underpenetrated, and that Macau will continue to exhibit strong growth for many years to come. Growth could arguably accelerate in future years as infrastructure projects come online, such as the intra-Macau light rail and the bridge connecting Macau to Hong Kong.
While not as large a market as Macau, Singapore has only two casino license holders, each allowed to operate just one property. In Las Vegas, by comparison, there is no limit on the number of gaming licenses that can be granted. Las Vegas is just now recovering from the excess supply brought online in 2009–2010 and continues to be fiercely competitive, thus generating lower returns for the casino operators in Asian markets such as Macau and Singapore.
MLPs/pipelines
We believe the midstream energy sector (which we define as MLPs and regulated pipeline assets) has high barriers to entry and can serve as a defensive asset class. This sector exhibits stable cash flow and has the potential for a solid total return story in the longer run. Regulations also help shape a more stable environment for MLPs. The Federal Energy Regulatory Commission (FERC) closely regulates pipeline assets, while protecting rights of way and providing attractive rates of return.
Long-haul transportation pipelines are long-lived FERC-regulated assets, which are critical infrastructure assets. Many pipeline assets (transporting both natural gas and liquids) are virtually impossible to replicate given population density, new construction costs and right-of-way permitting issues. Additionally, certain demand pull pipelines have dominant market share in key demand centers with critical interconnects with local distribution companies. Thus, switching costs for demand pull customers are high.
Additionally, exploration and production companies are increasingly looking to midstream energy companies to provide a full value chain of services including gathering, processing, transportation, storage and fractionation, which all require very large capital investments. As a result, producers dedicate acreage positions to midstream companies in order to provide gathering and processing services. Many contracts are “life of lease,” allowing the incumbent midstream company the right to provide gathering and processing services only. Thus, critical production areas (including the Permian Basin, Bakken and Eagle Ford formations) tend to be dominated by a few midstream energy companies.
The MLP/pipeline sector’s inherent tax efficiency and robust business models allow MLPs to pay out a significant portion of available cash flow to investors, though they are not legally bound to do so. MLPs are structurally counter-cyclical due to their high barriers to entry, toll-road business models, predominantly fee-based revenues and FERC-regulated rate protection.
We tend to focus on midstream energy companies that have dominant market share in critical production regions, stable and predictable cash flows and increasing barriers to entry.
Energy
Our bottom-up approach to investing in the exploration and production (E&P) sector begins with identifying companies with assets in “premier zip codes” such as the higher-growth shale regions or emerging plays with potential for strong well economics.
When establishing an acreage position, an E&P company first acquires leases (either from a private land owner or the government/state) that protect against a competing operator drilling on the same acreage for a set period of time, subject to the lease terms (which can range from three to 10 years). This effectively creates a barrier to entry against competition encroaching on an E&P’s assets, allowing the company to potentially gain first-mover advantage as it establishes a sizable acreage position in a given play.
Our credit selection process entails identifying companies with strong underlying asset quality (favorable geology, location relative to infrastructure and refineries, cost structure, etc.) that are protected by the lease contract/drilling rights, and then evaluating their operating expertise, management quality and financial strategy.
Wireless telecom
The U.S. wireless telecom industry has consolidated over the last decade and is now dominated by four national players. It has become increasingly difficult for new players to enter this market because any potential entrant would need a significant portfolio of wireless spectrum to economically compete.
Wireless spectrum licenses grant a holder the right to transmit radio signals over a specific frequency in a given geographical area. The FCC grants these licenses to limit the use of each frequency, thereby preventing signal interference that can disrupt wireless communication.
The scarcity of available wireless spectrum licenses makes these licenses very valuable, and the concentration in spectrum license ownership by the incumbent players creates a high barrier to entry that would deter almost any rational potential competitor.
Cell towers
Similar to wireless telecom, the U.S. wireless tower industry has attractive dynamics characterized by a small number of competitors and scarce resources, which limit competitive intensity.
Wireless towers proliferated throughout the country as wireless services developed over the last two decades, but zoning laws and real estate availability have limited new tower construction in recent years. Tower owners now operate a colocation business whereby they are able to add new “tenants” to existing towers while incurring minimal marginal cost. At the same time, the dominant tower companies have enjoyed a low cost of capital in both the equity and debt markets.
The operational and financial cost advantage, along with the scarcity of desirable tower locations, provides a very high hurdle for any potential new entrants to overcome.
Cable
The U.S. cable sector has consolidated and is dominated by five players with significant scale. Significant barriers to entry include the physical network itself as well as the nonexclusive cable franchises obtained from the local and state authorities.
Potential new entrants to the industry are discouraged by the costs involved: Building a physical cable network from scratch can cost hundreds of millions of dollars, at a minimum, to billions of dollars, depending on the coverage area. Capital intensity is 15%, with 5% of revenues going to maintenance. Cable companies operate regionally under franchises granted to them by local or state authorities, and most areas are served by only one cable company.
Satellites
Satellite providers operate under long-term contracts that give them four years of revenue backlog from customers. Barriers to entry include cost and regulatory issues.
It can take two to three years and cost roughly $300 million to build one satellite. Capital intensity is also very high, with expenditures representing 25%–30% of revenues.
The number of geostationary orbital slots in which satellites can be located is small, and many orbital locations already hold operating satellites pursuant to a complex regulatory process involving many international and national governmental bodies. These satellites typically operate under coordination agreements designed to avoid interference with other operators’ satellites.
Land-based communication providers such as fiber and cable are competitors, but cable build-outs can be expensive as well.
Media
The media industry is dominated by large conglomerates including CBS, Comcast (NBCU), Disney, 21st Century Fox, Time Warner and Viacom. Barriers to entry reduce competition and draw outsize audiences to television, theater, websites or theme parks to yield superior advertising, subscriber, box office and ticket revenues.
Media companies have spent years investing in quality IP/content, brands and distribution capacity. Additionally, “must-see” content such as live sports programming comes in long-term agreements (around 10 years) and at high prices so that only the sizeable conglomerates can afford it.
For example, ESPN – Disney’s sports-themed cable network – commands a subscription fee of $6.04 per month (versus TNT at $1.48, TBS at $0.72 and upstart FS1 at around $0.60) according to SNL Kagan, as of 17 July 2014. Disney has given ESPN funds to lock up high-profile content agreements such as its 12-year, $7.3 billion deal for exclusive rights to the NCAA College Football Playoffs (TV, radio, streaming, international) and access to its vast distribution expertise. This has allowed it to become a powerful global brand reaching consumers across several types of media. ESPN’s popularity has in turn given Disney major negotiating power against cable, satellite and telecom video distributors.
Railroads
The U.S. railroad industry benefits from relatively high barriers to entry due in large part to the dominant market share position of the Class I rails (Burlington Northern, Union Pacific, Norfolk Southern and CSX), the capital-intensive nature of the industry (capital requirements often exceed 20% of sales) and limited transportation alternatives for many shippers.
Following the wave of M&A activity from 1980 to the early 2000s, the top four Class I rails increased their market share of domestic rail traffic to nearly 90%, with the degree of regional and local concentration ending up significantly higher than that. As an example, Burlington Northern alone accounts for nearly 50% of all Western rail traffic, and the vast majority of shippers have access to only one railroad line. Such barriers to entry allow for strong pricing power. Over the past decade, the rails have pushed through price increases above inflation while improving their operating margins by over 1,200 basis points according to company filings, as of 31 December 2013.
Going forward, absent a sea change in the regulatory landscape, we would expect low-single-digit carload growth to continue to be supported by pricing gains above inflation and a modest expansion in operating margins.
U.S. banks
Finally, we also see significant barriers to entry within the U.S. banking sector, particularly as it relates to low-cost deposit funding.
Although ending “too big to fail” was and remains a core aim of the post-crisis Dodd-Frank regulatory reforms, the largest banks have only gotten bigger since the financial crisis. Case in point, the four largest bank holding companies now control approximately 48% of total U.S. deposits (up from 42% in 2007) and the 10 largest banks hold 63% of total deposits (up from 55% in 2007) according to SNL and Federal Reserve data as of 30 June 2014. This concentration of deposits with the largest institutions has continued despite the fact that big banks pay significantly less for deposits than the rest of the industry (the median cost for the top 10 banks is 19 basis points, versus 42 basis points for all others) according to SNL and Federal Reserve data as of 30 June 2014. This reflects a mix of brand power, scale/convenience (more branches and technology offerings) and perhaps some safety perception advantage.
Essentially, established scale coupled with cheap funding equates to a large competitive advantage for big banks versus smaller competitors. Further – and perhaps more importantly for senior bondholders – the suite of regulatory reforms enacted after the financial crisis significantly increased capital and liquidity requirements for large banks, while also restricting their ability to distribute capital to shareholders and/or pursue large scale M&A. These concerns remain on the front burner for nonfinancial corporates.
Alpha opportunities
Barriers to entry will likely play an increasing role in helping to create potential outperformance, or alpha, for investors. While today’s valuations suggest lower absolute returns, the global markets offer numerous “bottom up” investment opportunities, particularly for investors who embrace the benefits of high barriers to entry. Importantly, investors should consider favoring some of the industries and regions mentioned above with unique assets where high barriers to entry can help support investment returns in both a bear and bull market.
The numerous “bottom up” qualities we are emphasizing in our investments, including unique patents, licenses, brands, content, intellectual property, permits, real estate or land and contracts, regulations, switching costs, capital intensity, cost structure, product quality and innovation, can help to provide support for both equity and credit investors in a defensive market while also allowing for multiple expansion in companies with strong growth and pricing power in an offensive market. For these reasons, barriers to entry should play a central role today in “bottom up” investment strategy.
Mark Kiesel
Deputy Chief Investment Officer
8 September 2014
“Rising stars” refers to securities that are currently rated high yield by the ratings agencies that are likely to be upgraded to investment grade.
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.
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