Betting Battles

The sports betting and online gaming sector is going through transformative times. Firms like William Hill (WMH.L), GVC (GVC.L) and Flutter (FLTR.L), the new name for Paddy Power Betfair, are grappling with greater regulatory restrictions, more taxes, and the need to be seen to take the issue of problem gambling seriously (some of which are outlined in this previous post). Many of these issues are having a direct impact on revenues and margins. At the same time, they are trying to build a presence in the newly opened US gambling market. The exhibit below, from a recent GVC presentation, shows the players by revenues, both in the physical and the online market.

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A look at the operating margins of these firms show the impact on profits for the largest firms, with the pure online players Bet365 and The Stars looking the most lucrative (although it will be interesting to see the results for Bet365 to March 2019 when they are released in November).

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The future size of the US market is impossible to forecast, although all the firms are highlighting the potential. As per this post (when I had time to do proper research for my posts!!), its unlikely that the US market when it matures will be as profitable as the European or Australian markets. As Flutter/Paddy Power Betfair is the best public firm in the sector (Bet365 is private) and the one I am most familiar with, and have posted on many times (here, here and here for example), I had a shot at estimating the results to 2020 and came up with an EPS of £3.54 for 2020 compared to just over £3.00 for 2019, as below. These estimates are very rough and ready, based primarily upon a doubling of US revenues and a reduction of EBITDA losses in the US to £20 million in 2020 from £55 million in 2019.

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Based upon today’s price, I estimate a PE ratio for Flutter (hate the name by the way) for 2019 and 2020 of 22 and 18.8 based upon the EPS estimates above. Given the risks in these business models and the uncertainties over the development of the US market (plus my negative macro outlook), that’s still too rich for my liking. For others, given there was takeover rumours a few months ago in this ever-changing sector, it may be worth the gamble.

Creepy Things

It has been a while since I looked at the state of the reinsurance and specialty insurance markets. Recent market commentary and insurers’ narratives at recent results have suggested market rates are finally firming up, amidst talk of reserve releases drying up and loss creep on recent events.

Just yesterday, Bronek Masojada the CEO of Hiscox commented that “the market is in a better position than it has been for some time”. The Lancashire CEO Alex Maloney said he was “encouraged by the emerging evidence that the (re)insurance market is now experiencing the long-anticipated improvements in discipline and pricing”. The Chubb CEO Evan Greenberg said that “pricing continued to tighten in the quarter while spreading to more classes and segments of business, particularly in the U.S. and London wholesale market”.

A look at the historical breakdown of combined ratios in the Aon Benfield Aggregate portfolio from April (here) and Lloyds results below illustrate the downward trend in reserve releases in the market to the end of 2018. The exhibits also indicate the expense disadvantage that Lloyds continues to operate under (and the reason behind the recently announced modernisation drive).

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In the Willis Re mid-year report called “A Discerning Market” their CEO James Kent said “there are signs that the longstanding concern over the level of reserve redundancy in past year reserves is coming to fruition” and that in “some classes, there is a clear trend of worsening loss ratios in recent underwriting years due to a prolonged soft market and an increase in loss severity.

 In their H1 presentation, Hiscox had an exhibit that quantified some of the loss creep from recent losses, as below.

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The US Florida hurricane losses have been impacted by factors such as assignment of benefits (AOB) in litigated water claims and subsequently inflating repair costs. Typhoon Jebi losses have been impacted by overlapping losses and demand surge from Typhoon Trami, the Osaka earthquake and demand from Olympics construction. Arch CEO Marc Grandisson believes that the market missed the business interruption and contingent BI exposures in Jebi estimates.

The fact that catastrophic losses are unpredictable, even after the event, is no surprise to students of insurance history (this post on the history of Lloyds is a testament to unpredictability). Technology and advances in modelling techniques have unquestionably improved risk management in insurance in recent years. Notwithstanding these advances, uncertainty and the unknown should always be considered when model outputs such as probability of loss and expected loss are taken as a given in determining risk premium.

To get more insight into reserve trends, it’s worth taking a closer look at two firms that have historically shown healthy reserve releases – Partner Re and Beazley. From 2011 to 2016, Partner Re’s non-life business had an average reserve release of $675 million per year which fell to $450 million in 2017, and to $250 million in 2018. For H1 2019, that figure was $15 million of reserve strengthening. The exhibit below shows the trend with 2019 results estimated based upon being able to achieve reserve releases of $100 million for the year and assuming no major catastrophic claims in 2019. Despite the reduction in reserve releases, the firm has grown its non-life business by double digits in H1 2019 and claims it is “well-positioned to benefit from this improved margin environment”.

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Beazley is one of the best insurers operating from London with a long history of mixing innovation with a balanced portfolio. It has doubled its net tangible assets (NTA) per share over the past 10 years and trades today at a 2.7 multiple to NTA. Beazley is also predicting double digit growth due to an improving rating environment whilst predicting “the scale of the losses that we, in common with the broader market, have incurred over the past two years means that below average reserve releases will continue this year”.

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And that’s the rub. Although reserves are dwindling, rate improvements should help specialty (re)insurers to rebuild reserves and improve profitability back above its cost of capital, assuming normal catastrophe loss levels. However, market valuations, as reflected by the Aon Benfield price to book exhibit below, look like they have all that baked in already.

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And that’s a creepy thing.

Crazy Days

I have been somewhat out of the loop on the market over the past 2 months, partly due to work and partly due to a general apathy towards trying to understand the current market reasoning. I am very much in a risk off mode on a personal basis having moved mainly into cash since April to protect YTD gains (and take the hit on YTD losses!). At the end of April, I posted my thoughts about the equity market (with the S&P500 being my proxy for the “equity market”). Since then, the equity market has sea sawed 7% down in May and 7% up June to date, now in sight of new all-time highs. The volatility has primarily centred around the China trade talks and the economic outlook.

With the 10-year US treasury yield now just above 2% compared to around 2.5% at the end of April, clearly market expectations have changed. At its meeting last week, the Fed highlighted an increase in uncertainties to the global economy and stated that “in light of these uncertainties and muted inflation pressures, the Committee will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion”. The market is loving the new Powell put rhetoric (he does seem to be overcompensating for the year end 2018 “error”) and some are taking language such aswe will act as needed, including promptly if that’s appropriate” to mean multiple cuts this year, as many as three this year have even been advocated. Equity markets seem to be missing the point that multiple rate cuts will mean the economy has deteriorated rapidly, with a recession a real possibility. Hardly a reason for all time high equity markets!

There’s also the issue of the Fed’s current benchmark rate of 2.25% to 2.5% which is not exactly at normal economic boom levels given it historically has taken cuts of 3-4% to reverse recessionary slowdowns. Powell may be counting on the shock therapy of an early and relatively large cut (50 bps?) as an antidote to any rapid worsening of the trade war with China (or the outbreak of a real war with Iran!). In such an outcome, it is inevitable that talk of QE will re-emerge, providing yet more distortion to this millennium’s crazy brand of monetary policy.

A whole host of other things are bothering me – I highlighted high valuations on the hot business software stocks (here), Slack’s valuation (now over $18 billion. It had $135 million of revenues last quarter!!), a bitcoin rally, the fantasy-land UK conservative party leadership contest (the UK used to lead the world in the quality of its political debate, how did it get to this?), and, last but not least, the Orange One and Iran and well everything else to do with Trump. Sorry, that turned into a bit of a rant.

And so, we come to the G20 meeting of the world’s greatest leaders this week. Maybe it’s my mood but I found myself agreeing with the analysis (here) of Dr Doom himself, known as Nouriel Roubini to his friends. Roubini highlights three possible scenarios on the US China talks – an agreed truce with a negotiated settlement by the end of the year, a full-scale trade & tech & cold war within 6 to 12 months, or no trade deal agreed but a truce whereby tariffs agreed to be capped at 10% to avoid escalation. The third option is in effect a slow-burn trade war or a managed trade escalation.

I would agree with Roubini that either the first (but without the settlement this year) or third options are the most likely as both sides have reasons to avoid a rapid escalation. China needs time to prepare its economy for a prolonged conflict and to see how Trump fairs politically. Trump can portray himself as the John Wayne figure his man-child self longs to be in standing up to China and can pressure the Fed to stimulate the economy from any short-term impacts. Unfortunately, a managed escalation of a trade war is exactly like a managed Brexit. Impossible. You are either in or out. Have a deal or don’t have a deal. Could a grand deal be struck with this G20 meeting proving the turning point? Its possible but unlikely in my view (I’m referring to a real deal, not a fantasy/pretend deal). I hope I’m wrong.

Against this backdrop, forgive my lack of insight into the current collective wisdom of the market but an all-time high equity market makes little sense to me. And that’s me being polite.

The beginning of the end of Brexit?

Although it’s almost 3 years since the Brexit vote in the UK, in many ways it seems like an age, another era. Notwithstanding the fact that the European election in the UK is a poor match to the Brexit referendum in voter turn-out terms, high 30’s compared to over 70% respectively, both polls were singularly about one issue. Nearly 3 years ago, I attempted to estimate the split of the leave and remain votes by political party allegiance (see this post), as reproduced below.

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A similar split for the European election, with an assumption about the leave:remain split of the main Conservative and Labour parties (both of whom polled very poorly in the election), shows that the majority is likely now in favour of remain but by not much more than the leave majority in the Brexit vote.

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There is no doubt that the Brexit issue has changed British politics, likely for a generation. Whether the Brexit party, led by the little Englander Nigel Farage, will be anything other than a one issue party has yet to be seen. The tragedy is that the country looks as split as ever on the issue, the resolution of which is going to result in an embittered minority which could poison British politics for many years to come.