Category Archives: Investing Ideas

CenturyLink levelled

It’s been over 6 months since I last posted on the upcoming merger of Level 3 (LVLT) and Centurylink (CTL). Since then, LVLT’s CEO Jeff Storey has been named COO of the combined entity and CEO from January 2019, after a gentle push from activist investor Keith Meister of Corvex Management (here is an article on their latest position), effectively meaning the merger is an operational LVLT takeover of CTL. In June, CTL also got hit by a lawsuit from an ex-employer alleging a high-pressure sales culture which ripped customers off (an avalanche of class action suits followed). And, potentially more damaging, the recent results of CTL continue to point to deteriorating trends in the legacy part of their business and lackluster growth on the strategic part of the business. CTL missed their quarterly estimates again in the most recent quarter, the third miss in a row.

Picking up on my recent telecom industry post, the sector will struggle in the short term to find top line growth before the full impact of new “digital lifestyle” opportunities emerge. The figures below for enterprise, including public sector, and wholesale revenues for some of the biggest US players (which have been adjusted judgmentally for items such as the impact of the XO acquisition on Verizon’s revenues and the ever-changing classifications and reclassifications that telecom’s love) illustrate the current struggle in getting newer IP enabled services to fully compensate for declining legacy revenues.

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These figures imply average quarterly declines since 2014 of -0.3% and -1.2% for enterprise and wholesale business respectively. However, the trend has been getting worse. The average quarterly change was 0.2% and -1.1% for enterprise and wholesale business respectively from 2014 to 2015. Since 2016, the average quarterly change is -0.9% and -1.3% for enterprise and wholesale respectively. Not exactly a cheery trend when contemplating the prospects of a merged CTL/LVLT!

As can be seen below, the share price of LVLT and deal implied price have converged, particularly as CTL’s dividends get paid, albeit with a sharply downward bias in recent weeks over worries about dividend sustainability, valuation, sector trends, lawsuits and uncertainty over the closing date of the merger (a delay by California, the last State approval needed, may mean the end of September deadline is missed).

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My estimates for a standalone LVLT compared to analyst figures and those presented by LVLT management in the S4 (figures presented for merger negotiations are generally on the optimistic side) are below. Even factoring in higher interest rates (about 40% of LVLT’s debt is floating) over the coming years, I am comfortable with a standalone share price around the current mid-50’s, in the unlikely event the merger falls apart.

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To recap on my confidence in the ability of LVLT’s current management team to deliver, the results of the last merger between LVLT and TWTC show that management delivered a 40% uplift in the amount of free cashflow (e.g. EBITDA less capex) on flat revenues from 2014 to 2017 (e.g. combined FCF of both entities in the year prior to the merger to actual H1 results and my estimates for H2 2017). Some of my many previous posts on LVLT are here, here and here. Such a repeat in FCF in the CLT/LVLT merger is not a realistic expectation given the larger scale and different business mix, as the analysis below illustrates. Of course, the flat revenues over the past 3 years is a key concern (but worthy of praise given the industry trends highlighted above) and one of the catalysts for the CLT deal. Also, the health of designate CEO Jeff Storey may also be a factor over the next few years given his heart issues a few year ago.

My knowledge of CTL’s business is not as deep as that of LVLT’s and my confidence in their prospects on a standalone basis is nowhere near as lofty. My projections, split over a conservative base scenario and a more conservative low business scenario, can be seen below. My projections are primarily based upon the more recent trends in their business lines across their legacy and strategic enterprise and consumer businesses. The vast variance in my estimates, based upon recent trends, and those presented by management in the S4 (again, acknowledging that these are generally optimistic) illustrates why the market has lost such confidence in the outgoing management team at CTL, in my opinion.

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In terms of trying to model the merged CTL/LVLT, I have assumed the deal closes by the end of 2017 with 2018 being the first year of the merged entity. I have made a number of judgmental adjustments in my model, including assuming some loss of revenue due to the merger and cost reductions above published target synergies (e.g. $1 billion of operating synergies by end 2020 and $150 million of capex synergies by end 2019, higher than the announced target savings of $850 million and $125 million for opex and capex respectively). I have taken analyst estimates as an optimistic case (in CTL’s case I have taken their EBITDA estimates but still can’t get anywhere near their revenue figures) and called it the high scenario. My two projections above are used for the base and low scenarios. The resulting operating metrics for each scenario is shown below.

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The high scenario shows revenues flat-lining slightly above $24 billion for 2018 and 2019 with top-line growth returning in 2020 (YoY above 2.5%). EBITDA margins hit 40% by 2019 and remain stable around 40% thereafter. Capex is assumed to hit 15.5% of revenues by 2019 and remain at that percentage thereafter. This scenario assumes that management will be able to generate an approximate 30% uplift in the amount of free cashflow (e.g. EBITDA less capex) from 2017 (e.g. combined FCF of both entities in the year prior to the merger) to FY 2020.

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The base scenario shows revenues flat-lining around $23.5 billion for 2018 through 2020 with top-line growth returning in 2021 (YoY just below 2%). EBITDA margins hit 40% by 2019 and slowly trend down toward 39% thereafter. Capex is again assumed to hit 15.5% of revenues by 2019 and remain at that percentage thereafter. This scenario assumes that management will be able to generate an approximate 22% uplift in the amount of free cashflow (e.g. EBITDA less capex) from 2017 (e.g. combined FCF of both entities in the year prior to the merger) to FY 2020.

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The low scenario shows revenues around $23.5 billion for 2018 and drifting down to $23 billion before slowly hitting $23.5 billion again by 2022. Thereafter revenue growth builds slowly from 1.5% to 2.5% by 2027. EBITDA margins hit 39.5% by 2019 and slowly trend down toward 38.5% thereafter. Capex is again assumed to hit 15.5% of revenues by 2019 and remain at that percentage thereafter. This scenario assumes that management will be able to generate an approximate 18% uplift in the amount of free cashflow (e.g. EBITDA less capex) from 2017 (e.g. combined FCF of both entities in the year prior to the merger) to FY 2020.

I also assume the merged entity will carry $38 billion of debt from the offset (resulting from merger expenses, the cash payout to LVLT shareholders, and existing debts from both firms, after factoring any proceeds from recent CTL divestitures). I estimate that only 30% of this debt load is subject to a floating rate. In all scenarios, I assume the LIBOR rate linked to the floating rate increases incrementally by 275 basis points over the next 3 years (the current 12 month US rate is about 175 basis points). With a net debt to EBITDA ratio of approximately 3.8 at the end of 2018 across all scenarios, I believe that getting that ratio below 3 within 4 years by 2021, at the latest, will be a primary objective of the new management team. That would only be prudent in my view given the likely tightening monetary environment over the next few years which will punish valuations of corporates with high debt levels. Also, management will want to remain flexible if higher capex is needed to compete in new technologies for the IoT and digital lifestyle era (see recent sector post). I haven’t factored in an upside from LVLT’s CFO Sunit Patel proven ability to actively manage debt rates and maturities (his ability is highlighted by the fact that LVLT’s fixed debt costs 5.5% compared to CTL’s admittingly much larger fixed debt costing 6.8%)

That leads to the thorny question of the sustainability of the annual dividend of $2.16 per share (particularly given that share count will double, amounting to $2.3 billion per year). Under the high scenario, maintaining the current dividend and getting the net debt multiple below 3 by 2021 is doable if a little tight (primarily due to the cashflow benefits of LVLT’s NOLs). For both of the base and low scenarios maintaining the current dividend level is not realistic in my view, with a cut in the dividend to $1.30 and $1.00 needed in each scenario respectively (a 40% and a 55% cut). The current dividend yield on CTL is over 10%. Each of the cuts above would reduce that yield to approximately 6% and 5% for the base and low scenarios respectively based upon the current share price. Addressing the uncertainty over the dividend should be one of the priorities of the new management (and may even result in Jeff Storey’s move to the CEO position ahead of the planned January 2019 date).

Finally, before I reveal my per share valuations, I haven’t given any consideration to the financial impact of the current legal cases on alleged aggressive sales tactics as the level of current detail makes any such estimate impossible. Some of the class action cases claim anything from $600 million to $12 billion but these claims are always bloated and the eventual settlement figure, if there even is one, are often for a lot less than that claimed. Nor have I considered the potential impact of a spin-off of the consumer business (that’s for another time!).

So, based upon the analysis outlined in this post and using a discount rate of 8.5%, my valuation estimates for each of the three scenarios are below.

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The market’s current valuation of CTL around $20 indicates scenario 3 as the current expectation. This emphasizes the need to address the uncertainty over future dividend levels and the validity of the legal cases. Uncertainty over the closing date of the deal is overblown, in my view, and a few months of delay will not prove material. I do think the current valuation is harsh, given the potential upsides from the deal and longer-term industry trends. Interestingly, my base scenario valuation of £31 is not too far off the value of $34.75 by BofA Merrill Lynch and Morgan Stanley in the S4 (see this post on the S4). The base scenario is the one I would have the most confidence in, based upon my current knowledge, rather than the high scenario of $43 which does look too optimistic to me given current market trends.

I was never going to reinvest the cash component of the deal for LVLT shareholders given my current reservations about market valuations and move to cash across my portfolio. The analysis presented in this post indicates to me that the CTL shares due from the deal for LVLT shareholders are worth holding from a valuation perspective. For now.

For new investors, I’d wait to see how some of the uncertainties play out, particularly the dividend issue.

Peaky Power

The last time I posted on Paddy Power Betfair (PPB.L), I highlighted it was looking pricey in the mid-to high 90s. It has since traded down to the eighties and recently dipped below £83 after the full year results. Although it has now quickly recovered up around £88, the initial disappointment over the online revenue in Q4 sent the stock down 6%.

The graph below shows quarterly revenues, which met expectations largely due to the favourable A$ rate with Australia revenue up 34% in sterling but only 18% in the underlying currency. Management make a point of stating that “approximately 70% of our profits are sterling denominated, and accordingly, we are not exposed to FX translation fluctuation”. Events such as the summer 2016 Euros contribute to the revenue spike in Q2 2016.

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They exceeded my expectations on the bottom line with an operating profit of £182 million for H2 over my expectation of £160 million, with the merger expense and intangible write-off impacts of £300 million for the full year stripped out. The EPS of £3.30 for 2016 on average 80 million shares was impressive. I messed up on the average share count (again!) in my previous EPS estimate.

PPB stated that they “expect to complete the integration of our European online platforms by the end of 2017” and “until then, new product releases on the Paddy Power brand will be relatively limited, but on completion customers will see immediate benefits”. Despite their market beating margins on their dominant online segment, they caution that “a lot of the sportsbook operators acknowledge that gaming got harder in the second half of last year” and  they always emphasis that they operate in a very very competitive market. It looks to me like PPB management are trying to carefully manage expectations for 2017 and are likely nervous that large competitors like William Hill and Ladbrokes could possibly recover from recent online slumps and (just maybe) finally get their act together online.

There is an ongoing regulatory headwind in this business and 2016 bought items such as the online gaming point of consumption tax, the statutory Horserace Betting Levy, and the UK Competition and Markets Authority (CMA) investigation into UK online gambling (update due in April) to the fore. In addition, South Australia announced a 15% consumption tax effective from July 2017. The UK Government’s Review of Gaming Machines is a much bigger deal for PPB’s larger competitors as it only makes up 6% of their revenue.

PPB have substantially completed the integration of risk and trading functions which means that Paddy Power proprietary pricing and risk management tools are now used for over 85% of the bets on the Betfair sportsbook across 19 sports. They stated that “operating two individual brands on an integrated shared function is also proving to be beneficial for efficiency” and that the “pooling of analytics data has improved our econometric modelling, giving us greater insight into the effectiveness of marketing activity and leading to improved optimisation of spend”. These are critical factors in why PPB is differentiating itself operationally from its peers and are important to the success of the business model envisaged by the merger.

So, although I have likely got the share count wrong again (I am assuming an average of 85 million this time across 2017 and 2018), my new projections are below. I estimate growth of 5% and 11% for revenue in 2017 and 2018 respectively and EPS growth of 14% and 20% respectively. I factored in a degree of topline and bottom line upside in 2018 from the soccer world cup in Russia (assuming politics hasn’t messed up the world order by then!). That represents a PE multiple of 19.4 on an 2018 EPS estimate at a share price of £88 (2017 PE of 23.3). Not bargain basement cheap but not crazy mad either. With a targeted payout rate of 50%, my estimates could mean a dividend yield of 2% and 3.5% for 2017 and 2018 (again at a £88 share price).

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That looks like a better dynamic that the one at a share price in the mid to high 90’s, as per my post in August. If only I wasn’t so negative about overall valuations across the market, I would have added to my PPB position on the dip after the results last week. [Customary caution: PPB is not for the faint hearted, it is the gambling business after all!]. My instinct tells me markets will be bumpy in the coming months, valuation wise (e.g. rising interest rates, politics!). That may prove an opportune time to get more of PPB at a good price. After all, the game of speculation it is all about getting the best odds!

Bad education

I have been neglecting this blog as the soap opera that is American politics has been playing out. Trump’s decision to go for it full throttle straight from the off looks like resulting in political war in the US which will no doubt result in a messy few weeks, if not months, ahead. The jury is still out on whether this new form of extreme politics can survive indefinitely, or whether one of Trump’s skeletons will come crashing out of the closet, or whether Trump gets catch out dealing with an unexpected event. For the Democrats, there is the depressing thought that if Trump messes up big time, the option of impeachment requiring their consent to a two third majority in congress, would only result in President Pence!

My instinct is telling me to reduce equity exposure currently, on valuation concerns rather than political ones, and my hard fought for risk management discipline means I am acting on that instinct. I also distrust the neatness of the market consensus that markets will rise on stimulus hopes to mid year before falling back to sustainable valuations by year end. Reality is never neat, especially I suspect in Mr Trumpland. Notwithstanding this environment, one of my new year’s resolutions was to try and get some new equity ideas to track and maybe pick up if valuations get more attractive.

The disappointing results from Pearson Plc two weeks ago reminded me of my last post on the technological changes disrupting the education sector. I thought I would have a quick look over some of the firms mentioned in that post three years on. The trends at Pearson are not pretty, as the graph below shows. Particular poor results in the US higher education sector mean the firm is selling off Penguin Random House and “taking more radical action to accelerate our shift to digital models and to keep reshaping our business”. Pearson’s stock is down over 50% since my last post three years ago and another shakeup in management, if not strategy, looks inevitable.

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In fact the hope that the juicy margins of the old world text book business can be transferred to the new on-line world is looking fanciful. The shift to on-line education looks like another example of technology gutting the margins of yesteryear’s reliable business models. Houghton Mifflin Harcourt (HMHC) has a younger school focus and was the main education stock featured in my 2014 post. HMHC too is down considerably over the past three years, approx 42%. The graph below shows the downward trend in its core revenues and margins.

click to enlargehoughton-mifflin-harcourt-2011-to-2016-revenue-ebitda-margin

So it looks like hoping established education firms can transition with seamless profits into the digital world is not a place to look for new investment ideas. Of course, there have been big successes in the online sphere from newer firms and business models. TAL Education (ticker TAL), the Chinese K12 after school online tutor, is one and it’s up approx 250% over the past three years. It’s outside of my risk appetite as I prefer large diverse established firms with a clear market advantage, an understandable reason for upside and a management team I can believe in to entrust my optimism.

The search for new ideas goes on…

PS – Any ideas out there would be greatly welcome!

Trinity Meltdown

In May last year I posted on an undisciplined investment, Trinity Biotech (TRIB), which I bought at $21 per share and, after ignoring some basic investing rules, didn’t sell until it hit $16. I had thought that the underlying metrics of TRIB existing business would improve, with a big upside potential with the FDA approval of its Meritas Troponin Point-of-Care test (as outlined in this post). Since last year, I have kept an eye on the firm as their operating results continued to be uninspiring, as per the graph below.

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I continued to monitor the firm from afar to see how the FDA approval was progressing, for curiosity sake more than anything else (the investment case was similar a coin toss given the operating results and I have, thankfully, grown out of such gambles). The timing of any final approval was dependent upon FDA queries but Q4 was been talked of as a possible time for a final FDA decision.

It has therefore come as a considerable shock to all stakeholders, and a 50% collapse in the share price, when TRIB announced early on Tuesday that it has withdrawn its FDA application for the Troponin test on the advice of the FDA itself. Analysts representing investors vented their anger at the company’s management on the conference call on the news (worth a listen if you are so inclined).

I genuinely felt sorry for management as they tried to explain the “devastating news” about how they could have got the FDA approval so wrong. Although the FDA would not go into the gritty details on a 30 minute call communicating the news to management behind their “minded to refuse” position, TRIB’s management were restrained in expressing their (obviously very disappointed) view that the FDA had moved the goal posts in their assessment criteria. The FDA will give TRIB more detail on their decision over the coming months (strangely only on the condition that TRIB withdrew their application).

Management expressed their view, based upon the information from the FDA call, that any new application was unlikely given the large R&D expenses needed to address the issues raised and announced they would shutter the programme, reducing their annual capitalised expenses from $9 million to $1.5 million including the closure of their Swedish facility. Given they capitalise most of these expenses, the impact will primarily be on cash-flow rather than on the P&L (they may manage to be cash-flow neutral on a pro-forma basis).  Insight into future operating results and what the balance sheet will look like after the write-offs needed on this withdrawal may come with the Q3 results.

At a share price of approx $6.50, TRIB indicated that their Board would likely instigate a large buy-back programme after the early release of their Q3 results (likely due by mid October). With $85 million of cash left from their $100 million convertible debt, TRIB has the firepower if it can get to positive cash-flow on an operating basis in the near term. Analysts were very blunt in their reaction, stating that management now had a major credibility issue and that a sale of the firm should now be the priority.

All in all, a sad day for TRIB, its employees and its future prospects. And, of course, for its shareholders.

Paddy Power Betfair Revisited

It has been about 10 months since I posted on the potential for the Paddy Power and Betfair merger and a lot has happened since. Brexit and the resulting sterling volatility are obvious events of significance. In the betting sector, consolidation has continued with the Ladbrokes and Gala Coral merger having been announced and approved. The audacious proposed tie up by Rank and 888 on William Hill floundered with recent press reports suggesting Rank and 888 could get together. The consolidation in this rapidly changing sector is far from over.

The initial optimism on the future prospects for the two high achieving entities, Paddy Power and Betfair, resulted in the share price trading above the £100 level earlier in the year. Following Brexit, it traded as low as £80. The merged firm reported their H1 figures earlier this week which showed the full extent of the merger costs and provided an increased cost synergies figure for 2017 of £65 million. With 75% of EBITDA being sterling based, the currency impact was not as material as their multi-jurisdictional operations would suggest.

Top-line results for H1 do however indicate that 2016 revenue growth will likely not be as high as the 17% I had expected in November. The reality of issues in this regulated and highly competitive sector also served as a reminder that the path may not be as smooth as initially hoped for. Regulatory headwinds in Australia were an example. As a result, I revised my revenue estimates in November from £1.64 billion to £1.51 billion. The graph below shows the breakdown of my revenue estimates for the next few years with a comparison to overall average analyst estimates.

click to enlargePaddy Power Betfair pro-forma revenue split August 2016

Also, I have revised my previous earnings estimates with an operating profit margin of 20% for 2016, growing to 22% in 2017 and 23% in 2018. Based upon a share count of 86 million as at end June 2016 (which includes 2 million treasury shares), I estimate the H2 EPS at £1.55 which when added to the H1 EPS of £1.45 gives a full year 2016 EPS of £3.02.[ This 2016 estimate does represent an operating EPS of £3.79 which compares to my November estimate of £3.85 albeit that the November estimate was based upon suspect figures like the share count!!]. At today’s share price of £95.65, the PE multiple for 2016 is a hefty 31.6. The graph below shows the multiple based on my EPS estimates for 2016, 2017 and 2018 compared to those using the average analyst estimates.

click to enlargePaddy Power Betfair PE Multiples 2016 to 2018

In conclusion, I remain optimistic about the business model of Paddy Power Betfair particularly given the proven quality of the management team and their history of execution. However, quality doesn’t come cheap and the current valuation is priced for perfection. For new investors, it may be prudent to wait for a better entry point.