Level3 flying high

It has been over 6 months since I have posted on the prospects for the telecommunications firm Level3 (LVLT) following its merger with TW Telecom (TWTC). I had previously posted on the strength of TW Telecom’s business model and its admirable operating history so I am extremely positive on the combination. At the time of the last post, LVLT was trading around $45 a share, a five year high. Since that time, the stock fell to a low of $38 in October 2014 before reaching a new high in recent weeks around $54.

My previous post, using figures disclosed in a S-4 filing on the merger negotiations, made a projection that the combined entity could get to $9 billion of revenue and $3 billion of EBITDA by 2016. Based upon the Q4 figures, the firm’s guidance, and the recently filed 10K, I did some more detailed figures and now estimate that the $9B/$3B revenue/EBITDA threshold will more likely be in 2017 rather than 2016. My estimates for each against the consensus from analysts are below.

click to enlargeLevel3 Revenues and EBITDA estimates 2015 to 2017

LVLT is an acquisitive firm and has learned through multiple deals the optimal way of integrating new firms through a shape focus on the customer experience whilst prudently integrating operations and reducing costs. Taking the Global Crossing integration as a template, the graphic below illustrates how my estimates fit in the past.

click to enlargeLevel3 Operating Metrics 2005 to 2015

So, the question now is whether a share price in the mid to high 50s is justified (the average consensus is around $57 with the highest being Canaccord’s recent target of $63). Using an enterprise value to EBITDA multiple based upon a forward 12 month EBITDA figures (actual where relevant and my estimates from Q1-2015), I think a target between $50 and $60 is justified assuming a forward multiple of 10 to reflect growth prospects, as the graphic below illustrates. My DCF analysis also supports a target in the low 60s.

click to enlargeLevel3 10year EVtoEBITDA versus Share Price

Such a target range assumes operating results show positive momentum and that the overall market remains relatively stable with expectations on interest rate increases in the US within current estimates. Due to LVLT’s net debt load of just under $11 billion and a proforma leverage ratio of 4.4 to EBITDA, the stock is historically exposed to macro-economic volatility. A mitigant against such volatility is the increasing level of free cash that the business will generate (I estimate $600/$900/ $1,000 million over 2015 to 2017). Also, about $6.5 billion of its debt is fixed (current blended rate is 7.2%) and LVLT’s CFO has shown considerable skill in recent years at managing the interest rate down in this yield hungry environment. Its remaining floating debt (blended rate of 4.2%) has a minimum LIBOR rate of 1% and therefore offers headroom against movements in current LIBOR rates

In my view, the key in terms of valuation is that the integration goes smoothly and that revenue growth in the enterprise market is maintained. One of the principal reasons for my optimism on LVLT is the operational leverage the business has as the mix of its business moves more towards the higher margin and stickier enterprise market, as the pro-forma revenue split shows.

click to enlargeLevel3 Proforma Revenue Split

As always with LVLT, I recommend using options to protect downside and waiting for a pull-back from current highs for any new investment. This stock has historically not been one for the faint hearted. I do believe however that they are on the path to a more stable future and it remains a core holding for me.

Lancashire finds the love

After going ex-dividend in November, investors went mega bearish on Lancashire (LRE.L) when it nearly dropped below the 500p level, as the graph below shows. A previous post highlighted the reasons behind the change in sentiment over the first half of 2014 on the once darling of the specialty insurance sector.

click to enlargeLancashire Insurance Group 2014 Share Price

The firm released its Q4 today and announced another special dividend of $0.50 on top of the regular $0.10 dividend. Driven by stable results, as per the graph below, and by the chatter that Lancashire could be an M&A target, the price today reflects a respectable 160% multiple to diluted tangible book. It was odd that although the firm’s executives joked about having prepared an answer to the M&A question, no analyst actually asked the question in the conference call today!

click to enlargeLancashire Historical Combined Loss 2008 to 2014

One of the big positives from the call today was the news that the firm has restructured their reinsurance programme that protects their book to give them more event coverage with reinstatements (away from previous aggregate cover). This provides more protection to Lancashire from multiple events. The PMLs as at January expressed as a percentage of the calendar year earned premiums (estimated figures for 2015) show the reduced net risk profile of this arbitrage strategy.

click to enlargeLancashire PMLs January 2015

It’s nice to see Lancashire recover some of its shine and it will be intriguing to see if it does become an M&A target in the coming months.

More on Non-existent Deleveraging

McKinsey released their third report on global debt levels recently, entitled “Debt and (not much) Deleveraging”. Covering much of the same ground as the Geneva report in September (see previous post), the highlights of the report include detail behind the rise in public sector and household debt, the growth rates needed to start real deleveraging, the higher capital levels in the banking sector, the detail behind China’s rising debt, and some suggestions to live with high debt levels in the future. I would recommend the report to anybody interested in the macroeconomics.

The report is the subject of the Buttonwood piece this week where he also talks about the challenges that higher global debt brings. A recent post on changes to global demographic profiles is also relevant when thinking about servicing future public and private debt.

Below are a few of the graphics of interest from the report on the size and split of global debt, the mix between private and public debt in developed countries and the growth rate needed to start deleveraging, and the debt in China.

click to enlargeMGI Global Debt

click to enlargeMGI Advanced Economies Public vrs Private Debt

click to enlargeMGI GDP required to start deleveraging

click to enlargeMGI China Debt to GDP

Tails of VaR

In an opinion piece in the FT in 2008, Alan Greenspan stated that any risk model is “an abstraction from the full detail of the real world”. He talked about never being able to anticipate discontinuities in financial markets, unknown unknowns if you like. It is therefore depressing to see articles talk about the “VaR shock” that resulted in the Swissie from the decision of the Swiss National Bank (SNB) to lift the cap on its FX rate on the 15th of January (examples here from the Economist and here in the FTAlphaVille). If traders and banks are parameterising their models from periods of unrepresentative low volatility or from periods when artificial central bank caps are in place, then I worry that they are not even adequately considering known unknowns, let alone unknown unknowns. Have we learned nothing?

Of course, anybody with a brain knows (that excludes traders and bankers then!) of the weaknesses in the value-at-risk measure so beloved in modern risk management (see Nassim Taleb and Barry Schachter quotes from the mid 1990s on Quotes page). I tend to agree with David Einhorn when, in 2008, he compared the metric as being like “an airbag that works all the time, except when you have a car accident“.  A piece in the New York Times by Joe Nocera from 2009 is worth a read to remind oneself of the sad topic.

This brings me to the insurance sector. European insurance regulation is moving rapidly towards risk based capital with VaR and T-VaR at its heart. Solvency II calibrates capital at 99.5% VaR whilst the Swiss Solvency Test is at 99% T-VaR (which is approximately equal to 99.5%VaR). The specialty insurance and reinsurance sector is currently going through a frenzy of deals due to pricing and over-capitalisation pressures. The recently announced Partner/AXIS deal follows hot on the heels of XL/Catlin and RenRe/Platinum merger announcements. Indeed, it’s beginning to look like the closing hours of a swinger’s party with a grab for the bowl of keys! Despite the trend being unattractive to investors, it highlights the need to take out capacity and overhead expenses for the sector.

I have posted previously on the impact of reduced pricing on risk profiles, shifting and fattening distributions. The graphic below is the result of an exercise in trying to reflect where I think the market is going for some businesses in the market today. Taking previously published distributions (as per this post), I estimated a “base” profile (I prefer them with profits and losses left to right) of a phantom specialty re/insurer. To illustrate the impact of the current market conditions, I then fattened the tail to account for the dilution of terms and conditions (effectively reducing risk adjusted premia further without having a visible impact on profits in a low loss environment). I also added risks outside of the 99.5%VaR/99%T-VaR regulatory levels whilst increasing the profit profile to reflect an increase in risk appetite to reflect pressures to maintain target profits. This resulted in a decrease in expected profit of approx. 20% and an increase in the 99.5%VaR and 99.5%T-VaR of 45% and 50% respectively. The impact on ROEs (being expected profit divided by capital at 99.5%VaR or T-VaR) shows that a headline 15% can quickly deteriorate to a 7-8% due to loosening of T&Cs and the addition of some tail risk.

click to enlargeTails of VaR

For what it is worth, T-VaR (despite its shortfalls) is my preferred metric over VaR given its relative superior measurement of tail risk and the 99.5%T-VaR is where I would prefer to analyse firms to take account of accumulating downside risks.

The above exercise reflects where I suspect the market is headed through 2015 and into 2016 (more risky profiles, lower operating ROEs). As Solvency II will come in from 2016, introducing the deeply flawed VaR metric at this stage in the market may prove to be inappropriate timing, especially if too much reliance is placed upon VaR models by investors and regulators. The “full detail of the real world” today and in the future is where the focus of such stakeholders should be, with much less emphasis on what the models, calibrated on what came before, say.