Tag Archives: earnings growth 2016

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.

So….2016

As the first week of January progressed and markets tumbled, I was thinking about this post and couldn’t get away from the thought that 2016 feels very like 2015. The issues that were prominent in 2015 are those that will be so again in 2016 plus a few new ones. The UK vote on the EU and a US presidential race are just two new issues to go with China economic and political uncertainty, Middle East turmoil, Russian trouble making, a political crisis in Brazil, the insidious spread of terrorism, a move towards political extremes in developed countries and the on-going fault lines in Europe and the Euro. All of these macro factors together with earnings and the impact of rising interest rates are going to dominate 2016.

2015 joins two other years, 2011 and 1994, in being a -1% year for the S&P500 in recent times, as the graph below shows. In fact, the movements of the S&P500 in 2015 show remarkable similarity with 2011. However, there the similarities end. 2011 was the year of the Euro crisis, the Arab spring and the Japan quake. Interest rates were falling, earnings stable, and PE multiples were around 15. 1994 was even more different than 2015. In 1994, the economy was taking off and the Fed was aggressively raising rates, earnings were stable and PE multiples fell to around 15. Interesting the next 5 years after 1994 on the stock market were each 20%+ years! With 2015 around a 20 PE and earnings falling, the comparisons are not favourable and may even suggest we got off lightly with just a -1% fall.

click to enlargeS&P500 Years Down -1%

A recent article in the FT does point to the influence of a limited number of stocks on the 2015 performance with the top 10 stocks in the S&P500 up 14% in 2015 and the remaining 490 stocks down 5.8% collectively. The performance of the so-called nifty nine is shown below. The article highlights that “dominance by a few big companies – or a “narrowing” market – is a symptom of the end of a bull run, as it was in the early 1970s (dominated by the “Nifty Fifty”) or the late 1990s (dominated by the dot-coms).”

click to enlargeS&P500 vrs Nifty Nine

Bears have long questioned valuations. The impact of continuing falls in oil prices on energy earnings and a fall off in operating margins are signalling a renewed focus on valuations, as the events of this past week dramatically illustrate. A graph of the PE10 (aka Shiller CAPE) as at year end from the ever insightful Doug Short shows one measure of overvaluation (after this week’s fall the overvaluation on a PE10 basis is approx 30%).

click to enlargeS&P500 Valuation PE10 Doug Short

One of the longstanding bears, John Hussman, had an article out this week called “The Next Big Short”, in honour of the movie on the last big short. Hussman again cites his favourite metrics of the ratio of nonfinancial market capitalization to corporate gross value added (GVA) and the ratio of nonfinancial corporate debt to corporate GVA (right scale) as proof that “the financial markets are presently at a speculative extreme”.

click to enlargeHussman Market Cap to GVA

Many commentators are predicting a flat year for 2016 with some highlighting the likelihood of a meaningful correction. Whether the first week in January is the beginning of such a correction or just a blip along the path of a continually nervous market has yet to be seen. Analysts and their predictions for 2016 have been predictably un-inspiring as the graph below shows (particularly when compared to their 2015 targets).

click to enlarge2016 S&P500 Analyst Targets

Some, such as Goldman Sachs, have already started to reduce their EPS estimates, particularly for energy stocks given the increasingly negative opinions on oil prices through 2016. The 12 month forward PEs by sector, according to Factset Earning Insight dated the 8th of January as reproduced below, show the different multiples explicit in current estimates with the overall S&P500 at 15.7.

click to enlargeS&P500 Sector Forward PE Factset 08012016

Current earnings estimates for 2016 as per the latest Yardeni report (EPS growth graph is reproduced below), look to me to be too optimistic compared to the trends in 2015 and given the overall global economic outlook. Future downward revisions will further challenge multiples, particularly for sectors where earnings margins are stagnating or even decreasing.

click to enlargeS&P500 Earnings Growth 2016 Yardeni

To further illustrate the experts’ views on EPS estimates, using S&P data this time, I looked at the evolution in actual operating EPS figures and the 2015 and 2016 estimates by sector, as per the graph below.

click to enlargeS&P500 Operating EPS by sector

With US interest rates rising (albeit only marginally off generational lows), the dollar will likely continue its strength and higher borrowing costs will influence the environment for corporate profits. Pent up labour costs as slack in the US economy reduces may also start to impact corporate profits. In this context, the EPS estimates above look aggressive to me (whilst accepting that I do not have detailed knowledge on the reasoning behind the EPS increases in individual sectors such as health care or materials), particularly when global macro issues such as China are added into the mix.

So, as I stated at the start of this post, the outlook for 2016 is looking much like 2015. And perhaps even a tad worse.