Risks feel more real

This week kicks off the World Economic Forum (WEF). The great and the good will not be flying in from all around the globe, as many did previously on their private jets, to pontificate on the world’s problems as this year the event is virtual. The situation seems apposite given the mess we are in and the prevalence of environmental risks highlighted in the Global Risks report that precedes each meeting, as shown in the list below.

Infectious diseases have made an obvious come-back onto the list after an absence of 10 odd years. To be fair, nobody foresaw the likelihood or impact of the Covid-19 pandemic and identifying global risk are inherently uncertain. One article that caught my attention on the WEF website was on the link between climate change and pandemics. I did see a TV report earlier this year that highlighted how land development in China was encroaching upon the natural habitat of wildlife resulting in more contact between humans and animals that could be an explanation for the initial Chinese outbreak, if indeed that is where Covid-19 first began (just to ensure I do not sound like the orange vainglorious one!). But that report didn’t stick in my mind. Until now.

As the WEF article highlights, the World Health Organization (WHO) has stated there is no evidence of a direct link between climate change and Covid-19. However, they acknowledge that changes in living environments of the animals on Earth caused by climate change may impact infectious diseases.  Dr. Anthony Fauci co-authored a paper in September that stated “the COVID-19 pandemic is yet another reminder, added to the rapidly growing archive of historical reminders, that in a human-dominated world, in which our human activities represent aggressive, damaging, and unbalanced interactions with nature, we will increasingly provoke new disease emergences.

Although not a journal noted for its medical or scientific expertise, this article in December from Rolling Stone on the topic frightened the hell out of me. Just another happy thought to add to expanding list these days! If I had read an article like this a year or older ago, I would likely not have given it as much thought as I do now. And that is a reflection on what the last year has done. Lists of risks such as those in the WEF Global Risks report seem a lot more real today.

To 2021 and beyond…

My father was not a man of many words, but when he spoke, he generally made a lot of sense. Somebody could not be called anything more derogatory by my father than to be called a clown, a term he generally used often when watching politicians on the TV. He would have had absolutely no time for the current US president, a clown of the highest order in my father’s meaning of the word. Notwithstanding the loss of life from the Capitol Hill rioting, the pantomime that played out on the 6th of January was pure theatre and showed the vacuous inevitable end destination of Trump’s narcissism (and hopefully of Trumpism). Rednecks roaming around capitol building with confederate flags and wearing silly costumes feels like a fitting end. I thought it would be months, if not years, before the doubtless shenanigans that Trump has been up to over the past 4 years (and before that, of course) would be made public in all its glory and before a large proportion of the otherwise sensible 74 million Americans who voted for him would finally see him for the “very flawed human being”, in his ex-Chief of Staff John Kelly’s wonderfully diplomatic words, that he is. My father had another word for him. There are too many issues to be dealt with that are more important than the man child who will, after this week, be a (hopefully!) much-diminished and irrelevant force.

Most people are happy to see the back of 2020 and there is little that I can add to that sentiment. Like others, I have avoided any year end round ups as it all seems too raw. My family and I have been blessed to not been adversely impacted health-wise by Covid-19 during the year. The horrible global death toll from the virus reached the grim milestone of 2 million with some pessimistic projections of the final toll at double that figure, even if mass vaccinations result in the utopian herd immunity (optimistic projections for the developed world to reach such a state by this time next year with the rest of the world taking another 12 months). It seems likely that the public health situation will get worse before it gets better.

Reaching the milestone age of 21 symbolizes the entry into adulthood, an age of maturity, and not just in relation to the legal procurement of alcohol in some countries! Maturity and long-term thinking in addressing the challenges of the coming year, including likely bottlenecks in vaccine rollouts and the rebuilding of multilateral cooperation, should replace the narrow nationalist thinking of the Trump and Brexit eras. God willing, the biblical symbolism of 21 representing the “great wickedness of rebellion and sin” will not be backdrop for the post-Covid era!

In a widely optimistic thought along the lines of rebellion and sin but without the wickedness, the post-Covid era could be characterised by a radical shift in societal norms, akin to the 60’s, where youth culture demands that the challenges of our day, specifically climate change and income equality, are addressed urgently. Combining technology with a passion for action and upsetting lifestyle norms could instigate real change. A new countercultural movement, with its own hedonistic soundtrack, would also be nice after all the introspection of lockdowns! 2020 has taught us that rapid social change can take place and we can adapt to uncertainty if we are pushed.

So back to the realities of 2021! I read recently that those of us lucky enough to be able to continue working relatively unperturbed from home during Covid having been working on average an hour a day extra and that is consistent with my experience (and thus my lack of posts on this blog!). Overcoming the challenges of the current Covid operating environment, such as avoiding the development of splintered or siloed cultures, whilst maintaining a collective corporate spirit will likely be a much-discussed topic in 2021. As the social capital of pre-Covid working networks is eroded by time and Covid fatigue, moving to a new hybrid work/office model in our new distributed working environment, whilst minimising people and talent risk, will create both challenges and opportunities for leaders and managers of differing skillsets.

One of my biggest concerns for 2021 is the financial markets. The macabre sight of stock markets hitting highs as the pandemic worsened is surely one of paradoxes of 2020. The S&P500 is currently trading at a forward PE ratio of over 22 as the graphic below shows.

In November, the oft debated (see this post as an example) cyclically adjusted price-to-earnings (CAPE) ratio for the S&P 500 hit 33, just above the level it was at in September 1929, the month before the crash that preceded the Great Depression! CAPE has only been higher twice in history than it is now, in the late 1920’s and the early 2000’s. Apple (AAPL) is currently valued at a forward PE of over 30 (based upon its 2022 earnings estimates), trading well above the sub $100 level I pitched as fair value earlier this year (in this post). Tesla is often cited as the poster child for crazy valuations. I like to look at the newly public Airbnb (ABNB) for my example, a firm that depends upon cross border travel for its core business, which has lost $1 billion on revenue of $3.6 billion over the last 12 months (revenue down from $4.8 billion in 2019) and is now valued at $100 billion or a multiple of over 27 times sales! The market seems to be solely focussed on the upward leg and ignoring the downward leg of the so-called K shaped (bifurcated) recovery, even though small business in the US generate 44% of US economic activity. The forward PE on the Russell 2000 is above 30. In classic bubble style, speculative assets like bitcoin reached all-time highs. The latest sign is that much shorted stocks are being targeted in short squeeze trades.

This NYT article, aptly named “Why Markets Boomed in a Year of Human Misery” offers one of the clearest explanations for the market euphoria, namely that the “Fed played a big part in engineering the stabilization of the markets in March and April, but the rally since then probably reflects these broader dynamics around savings”. The broader dynamics referred to are the NPIA statistics from March to November. The article highlights that fiscal action taken to support US households through Covid support has resulted in salaries and wages only being marginally down on the prior year, despite widespread lockdowns, whilst spending has fallen. This combination pushed the US savings rate through the roof, over $1.5 trillion higher that the March to November period in 2019.

The arguments about a bubble have been rehashed of late and here are some examples:

  • In November, Robert Shiller (of CAPE fame) co-authored an article which stated “many have been puzzled that the world’s stock markets haven’t collapsed in the face of the COVID-19 pandemic and the economic downturn it has wrought. But with interest rates low and likely to stay there, equities will continue to look attractive, particularly when compared to bonds.
  • The great Martin Wolf of the FT asked (in this article) “Will these structural, decades-long trends towards ultra-low real interest rates reverse? The answer has to be that real interest rates are more likely to rise than fall still further. If so, long-term bonds will be a terrible investment. But it also depends on why real interest rates rise. If they were to do so as a product of higher investment and faster growth, strong corporate earnings might offset the impact of the higher real interest rates on stock prices. If, however, savings rates were to fall, perhaps because of ageing, there would be no such offset, and stock prices might become significantly overvalued.
  • The ever-pessimistic John Hussman responded in this market commentary that “when people say that extreme stock market valuations are “justified” by interest rates, what they’re actually saying is that it’s “reasonable” for investors to price the stock market for long-term returns of nearly zero, because bonds are also priced for long-term returns of nearly zero. I know that’s not what you hear, but it’s precisely what’s being said.
  • And the equally sunny veteran market player Jeremy Grantham opened his latest investor letter  (the wonderfully titled “Waiting for the last dance”) thus: “The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.”

Grantham points out that the necessary monetary and fiscal reaction to the pandemic has created heighten moral hazard – “The longer the moral hazard runs, and you have this implied guarantee, the more the market feels it can take more risk. So it takes more risk and builds yet more debt. We’ve counted too much on the permanence and the stability of low rates and low inflation. At the end of this great cycle of stability, all the market has to do is cough. If bond yields mean-revert even partially, they will be caught high and dry.” 

I particularly liked Graham’s summary of the past 20 odd years of monetary policy –All bubbles end with near universal acceptance that the current one will not end yet…because. Because in 1929 the economy had clicked into “a permanently high plateau”; because Greenspan’s Fed in 2000 was predicting an enduring improvement in productivity and was pledging its loyalty (or moral hazard) to the stock market; because Bernanke believed in 2006 that “U.S. house prices merely reflect a strong U.S. economy” as he perpetuated the moral hazard: if you win you’re on your own, but if you lose you can count on our support. Yellen, and now Powell, maintained this approach. All three of Powell’s predecessors claimed that the asset prices they helped inflate in turn aided the economy through the wealth effect.

There is no doubt in my mind that we are in an asset price bubble currently, notwithstanding the fact that it is likely to continue for some time yet. Although not quite at the level of  Joe Kennedy hearing the shoeshine boy talk about his equity positions, I have been struck by the attitude of late of my more junior workmates when they optimistically talk about their equity and bitcoin investment gains. It’s more akin to a level of the mobsters’ spouses trading internet stock ideas in the Sopranos! The TINA trade on steroids or the TINA USP as in “there is no alternative, Uncle Sam’s paying!”.

There is little doubt that extraordinary action, both monetary and fiscal, was needed to counteract the impact of the pandemic. In the words of Andy Haldane, chief economist of the Bank of England, “now is not the time for the economics of Chicken Licken”. It is the sheer scale and reliance on government intervention into markets that surely is unhealthy in the medium to longer term. Central banks now act as market makers, distorting market dynamics such that continued newly created money chases an ever-shrinking pool of investable assets. William White, formerly of the BIS, recently commented that monetary policy has been asymmetric whereby Central banks have put a floor under markets in crises but failed to put a cap on prices in bubbles.

Fiscal stimulus has exploded the world’s government debt stocks. Fitch estimate that global government debt increased by about $10 trillion in 2020 to $78 trillion, equivalent to 94% of world GDP. The previous $10 trillion tranche took seven years to build, from 2012 to 2019. The most immediate impact has been on emerging market debt with sovereign downgrades prevalent. Kenneth Rogoff, former chief economist at the IMF, warned that “this is going to be a rocky road”. High debt levels can only be contained in the future by austerity or inflation, neither of which are pleasant and both of which would further compound high levels of inequality across the world. Covid has laid bare the destructive impact of inequality and anything that will increase inequality will inevitably impact social stability (eh, more populism anyone?). We have, of course been here before, living through it over the past 13 years, but this time the volume is up to 11.

Two other issues that will keep us occupied in 2021 are climate change and cyber risks. 2020 has recently been declared one of the hottest on record. Despite the estimated 7% fall in CO2 emissions in 2020 due to Covid lockdowns, we are still, as UN Secretary-General António Guterres highlighted this week, “headed for a catastrophic temperature rise of 3 to 5 degrees Celsius this century”. David Attenborough’s new TV programme “A Perfect Planet” illustrates the impact that the current temperature rises just above 1 degree are having right now on the delicate balance of nature. The COP26 summit in November this year must be an event where real leadership is shown if this fragile planet of ours has any hope for the long term. The other issue which will likely get more attention in 2021 is the successful cyber intrusions using Solarwinds that the Russians pulled off in 2020. An anonymous senior US official recently stated that “the current way we are doing cybersecurity is broken and for anyone to say otherwise is mistaken”.

So, 2021 promises to be another significant year, one of more change but, at least it will be without the clown (hopefully). I, for one, will eagerly wait for any signs of that new countercultural movement to take hold, whilst listening out for that hedonistic soundtrack!

A happy and healthy new year to all.

AAPL at $500 ($125 post-split)

Back in early May, I postulated about AAPL’s future. In a heavily caveated post, I predicted iphone sales down from an assumed 188 million in FY2020 to 162 million and 180 million in FY2021 and FY2022 respectively. Well, AAPL stock is up 63% since that post, breaking past $400 ($100 post-split) at the start of August and now breaking through $500 ($125 post-split). I yet again totally called sentiment wrong on AAPL. The latest analyst estimates are below.

By my calculations, the average analyst estimates are assuming somewhere between 220 to 250 million iphone unit sales for FY2021 and FY2022, in addition to rejuvenated iPad and Mac sales plus strong services and other sales. Notwithstanding the growth in non-iphone items, revenues from iphone will still make up approximately 50% of the total in 2021 and 2022. In short, analysts are calling a monster super-cycle for AAPL on demand for their products as a result of our newly digitalised lives and 5G upgrades. I have been wrong enough times on my AAPL calls to accept these newly optimistic projections for the purposes of this post without comment. That said, the valuation of AAPL is clearly elevated as the following graph from a piece this week on Bloomberg from the ever-excellent John Authers shows.

My faithful AAPL chart on forward PE ratios excluding cash using current analysts estimates also illustrates the elevated valuation compared to recent history, as below.

This valuation is despite the risks that exist for AAPL. Navigating the full impacts of the COVID recession on employment and incomes is the obvious headwind. Other current risk includes potential pressure on margins from 5G phones, potential China disruptions from geopolitical tensions between the US and China (e.g. wechat ban), and potential pressure on apple store margins from developers (e.g. fornite/epic quarrel).

For what it is worth, accepting the sunny analyst projections and a heightened multiple around 20, I would put a sensible price around $340 ($85 post-split). Some mega-bulls on AAPL are raising their targets to $700 ($175 post-split). Given that I never thought we would again see the internet bubble behaviour of stocks rallying due to an upcoming stock split (as per AAPL and TSLA), AAPL is more likely to hit $700 ($175 post-split) than $340 ($85 post-split)!

Crazy silly stuff.

Multiple Temptation

I thought it was time for a quick catch up on all things reinsurance and specialty insurance since my last post a year ago. At that time, it looked like the underlying rating environment was gaining momentum and a hoped-for return to underwriting profitability looked on the cards. Of course, since then, the big game changer has been COVID-19.

A quick catch-up on the 2019 results, as below, from the Aon Reinsurance Aggregate (ARA) results of selected firms illustrates the position as we entered this year. It is interesting to note that reserve releases have virtually dried up and the 2019 accident year excluding cats is around 96%.

The Willis Re subset of aggregate results is broadly similar to the ARA (although it contains a few more of the lesser players and some life reinsurers and excludes firms like Beazley and Hiscox) and it shows that on an underling basis (i.e. accident year with normalised cat load), the trend is still upwards and more rate improvement is needed to improve attritional loss ratios.

The breakdown of the pre-tax results of the ARA portfolio, as below, shows that investment returns and gains saved the day in 2019.

The ROE’s of the Willis portfolio when these gains were stripped out illustrates again how underwriting performance needs to improve.

Of course, COVID-19 has impacted the sector both in terms of actual realised losses (e.g. event cancellations) and with the cloud of uncertainty over reserves for multiple exposures yet to be fully realised. There remains much uncertainty in the sector about the exact size of the potential losses with industry estimates ranging widely. Swiss Re recently put the figure at between $50-80 billion. To date, firms have established reserves of just over $20 billion. One of the key uncertainties is the potential outcome of litigation around business interruption cover. The case brought in the UK by the FCA on behalf of policyholders hopes to expedite lengthy legal cases over the main policy wordings with an outcome expected in mid-September. Lloyds industry insurance loss estimate is within the Swiss Re range and their latest June estimate is shown below against other historical events.

I think Alex Maloney of Lancashire summarised the situation well when he said that “COVID-19 is an ongoing event and a loss which will take years to mature”, adding that for “the wider industry the first-party claims picture will not be clear until 2021”. Evan Greenberg of Chubb described the pandemic as a slow rolling global catastrophe impacting virtually all countries, unlike other natural catastrophes it has no geographic or time limits and the event continues as we speak” and predicted that “together the health and consequent economic crisis will likely produce the largest loss in insurance history, particularly considering its worldwide scope and how both sides of the balance sheet are ultimately impacted”.

The immediate impact of COVID-19 has been on rates with a significant acceleration of rate hardening across most lines of business, with some specialty lines such as certain D&O covers have seen massive increases of 50%+. Many firms are reporting H1 aggregate rate increases of between 10% to 15% across their diversified portfolios. Insurance rate increases over the coming months and reinsurance rates at the January renewals, assuming no material natural cats in H2 2020, will be the key test as to whether a true hard market has arrived. Some insurers are already talking about increasing their risk retentions and their PMLs for next year in response to reinsurance rate hardening.

Valuations in the sector have taken a hit as the graph below from Aon on stock performance shows.

Leaving the uncertainty around COVID-19 to one side, tangible book multiples amongst several of my favourite firms since this March 2018 post, most of whom have recently raised additional capital in anticipation of a broad hard market in specialty insurance and reinsurance market, look tempting, as below.

The question is, can you leave aside the impact of COVID-19? That question is worthy of some further research, particularly on the day that Hiscox increased their COVID-19 reserves from $150 million to $230 million and indicated a range of a £10 million to £250 million hit if the UK business interruption case went against them (the top of the range estimate would reduce NTAs by 9%).

Food for thought.

Fancy Flutter

Even before the COVID19 outbreak, it was a time of rapid change and transformation in the sports betting and online gaming sector. Since my last post nearly a year ago, the big news was the merger of Flutter (FLTR.L) and the Stars Group Inc. (TSG) in an all stock deal (at a 55%:45% split). The deal was announced in October and closed in May. The headwinds in the sector include an increased regulatory focus, particularly on problem gambling, and an array of new taxes and restrictions which have pushed the sector further along the consolidation route. The great hope for the sector was the opening of online gambling and gaming in the US.

With that as the background, the COVID19 pandemic initially looked like it could create serious issues for the sector with cancelled sports events and retail shop closures. As the virus developed however, the upside in the demand for online gaming and gambling from people stuck at home combined with the spending power of government checks has resulted in a surge of online activity, particularly in gaming. The graph below of the relative share price movements over the past year for a sample of the market players illustrates the renewed optimism with the recent announcements on heightened online activity.

The performance of William Hill, with its over-reliance on retail, shows how far that business model must adapt to regain some of its former glory. 888, always the bridesmaid in the M&A dance of recent years, announced in June a 34% increase in average daily revenue in the year to date and boasted that it expected to beat EBITDA estimates for 2020 by a significant amount. In July, GVC announced a 30% H1 increase in online gaming and a 5% increase in online sports. For Q1, Flutter, which has been the focus of my posts in the past, initially announced approx. 30% growth in quarterly revenues up until the 15th of March with a dramatic fall off thereafter. In May, Flutter announced results to the 17th of May which showed extraordinarily strong gaming results and strong US and Australian performance. In late August, we will get a chance to see the H1 results of the newly merged entity in all its hoped for glory.

Projecting the short term in this pandemic environment is fraught with danger. Uncertainties relating to how the health situation develops, whether there will be more shut-downs or more openings, a second spike, whether government wage supports will be tempered, how defaults will progress are all subjects of daily discussion across the media. Notwithstanding these uncertainties, I have attempted to do a very rough and ready projection for the newly merged Flutter entity with the overarching assumption that gaming will remain strong, but not as extraordinary as the partial May figures, for the rest of 2020 (as will the US and Australia) but will pull back in 2021 as economies open back up and the full force of the recession and the COVID19 bills become reality. Offsetting the pull-back in 2021 of gaming is the opening of retail (albeit at a lower level than pre-COIVD) and the return of sports betting to a more normal level. The US is projected to continue its march forward in 2021. For my projections, the international and UK business of TSG is allocated to the online gaming and online sports lines as per the historical TSG breakdowns. The Australian business of Flutter and TSG is shown together.

I would again emphasize that my figures are rough guesstimates, particularly the operating results. Although the presentation released at the time of the merger announcement used 2018 figures, I looked through the updated prospectus from March which used 2019 figures and made my COVID adjustments for 2020 based upon trends to date and assumed impacts upon margins. For example, the merger presentation touted EBITDA margins of 30% and above for the future whereas I have assumed the 30% EBITDA margin in 2018 for the combined entity falls to 27%, 25% and 28% for 2019 to 2021 respectively.

The big difference in the business model of the newly merged entity is the amount of debt it is carrying now. I have assumed net debt of £3.85 billion at the end of H1 2020 and a pro-forma net debt to EBITDA multiple of 3.86 and 3.12 for 2020 and 2021 respectively (assuming no debt repayments over that time, the amount of which will depend upon whether they restart dividends). Their stated target to get below 2 quickly (e.g. by end 2022 or 2023 at the latest) looks very achievable given the highly cash generative nature of this business.

My proforma EPS estimates, based upon 144 million shares, is £2.70 and £4.19 for 2020 and 2021 respectively. The 2020 figure is marginally below their stated 150% uplift of the pre-merger 2019 EPS but not materially so given the COVID impact. On a forward PE basis, the stock currently trades at a 27.5 multiple of the 2021 EPS which is not out of line with the current market sentiment. Better growth than I have assumed for the remainder of 2020 and into 2021, the potential for the US business, and future synergies from the merger could justify such a premium rating. For me, cautious as ever and soooo remarkable bad at market timing, I would need to see more on the 2020 trends and a pull-back to be tempted out of my bear pit. I’ll leave it up to you, dear reader, to make your own mind up.

UPDATED H1 NUMBERS

On the 27 August, Flutter released their H1 figures and gave further insight into how 2020 may develop. I did highlight that my figures above were rough guesstimates and the actual H1 numbers showed that I got a few items wrong. First off, I missed the impact of the May 2020 equity raise which means net debt as at the end of H1 was £2.9 billion rather than the £3.85 billion I estimated. Also, share count at the end of H1 was 157 million rather than the 144 million as a result of the equity raise. Secondly, the H1 proforma revenue came in at £2.4 billion, making my FY2020 revenue estimate of £4 billion look light (ditto for 2020 earnings).

The H1 report also contained specifics on the one-off nature of items like poker revenue and net revenue margins, as below.

The report also shows the extraordinary trends from the height of lock-downs in certain sports and gaming categories, as below.

Guidance also highlighted the need to invest in the poker business and, as a result of heightened spending on items like marketing, the reduction in historical EBITDA margins of over 50% going forward. Based upon the pro-forma 2019 and H1 2020 results, my new projections on a half yearly basis are below.

I estimate that, even with tailwinds in 2020 such as the rescheduled UEFA 2021 Euro soccer tournament, 2021 revenue at £4.8 billion will only be marginally above my new 2020 revenue estimate of £4.6 billion. This assumes sporting events in 2021 return to a semblance of normality! I also estimate that EBITDA (excluding the US) in 2021 will be roughly equal to the 2020 mid guidance of £1.25 billion.

My new estimate of adjusted EPS for 2021 (excluding any SDI impact) is £5.00 which puts the current market valuation at 25 times the 2021 adjusted EPS. There is however a lot of uncertainty around that figure (not least that my estimates are way off base again!). It looks like it will take at least another few quarters before the combined business will stabilize into a more predictable pattern.