The onset of a wobbly tooth from a year old crown caused me to have a look at Sirona Dental Systems (SIRO) again. I last blogged on it in August 2014 here. SIRO has had a good run since then moving from around $80 to $109 today. The recent increase is due to the announcement in September of a merger of equals with DENTSPLY which is expected to close in Q1 2016.
SIRO, with 65% of its revenues outside of the US, felt the impact of the dollar strength with flat line revenue growth in 2015 (year ending in September). In local currencies, SIRO achieved 9.8% growth which was broad based across the US and international markets with respective growth at 9.2% and 10%. Despite the FX headwind, and a volatile Q2, operating margins were impressive, as the graph below shows. Operating cash-flow after capital expenditure has also been strong closely running at approximately 65% of operating income.
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DENTSPLY (ticker XRAY) is a larger company in revenue terms with lower operating margins and a focus on dental consumable products. Dental specialty products such as endodontic (root canal) instruments and materials, implants and related products, bone grafting materials, 3D digital scanning and treatment planning software, dental and orthodontic appliances and accessories make up approximately 50% of revenues. Dental consumable products such as dental anesthetics, prophylaxis paste, dental sealants, impression materials, restorative materials, tooth whiteners and topical fluoride make up approx 30% of sales. The rest of sales are split between dental laboratory products and consumable medical device products. Geographically DENTSPLY also sells its products globally with 65% outside the US. DENTSPLY’s historical results (with assumed Q4 to December for 2015) are as below and the net cash-flow profile of DENTSPLY relative to operating income is similar to SIRO in recent years.
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The investor presentation on the merger highlights further details. One interesting angle on the investment thesis is that the combined company is a good play on the aging population trend in the developed world. The $21 billion global dental market (of which the merged firm will have approximately 18%) is represented at increasing one to two times GDP. The plan also allows for a $500 million share buy-back programme post-closing with $125 million of operating costs savings (or approx 3% of operating margin based upon combined revenues) expected.
SIRO has approximately $500 million in cash with little debt. Goodwill and intangibles make up approximately 40% of SIRO’s total assets. DENTSPLY on the other hand has approximately $230 million in cash with $700 million in debt. Goodwill and intangibles make up nearly 60% of DENTSPLY’s total assets.
Based upon 5% top-line growth, my rough estimates for 2016 for the combined entity are a 21% operating margin post savings or approximately $830 million of operating income and $560 million of net income. Assuming 250 million shares (not taking the buy-back into account) I estimate an EPS of approximately $2.40. These are real back of the envelop calculations so I would caution against any rash conclusions. They do indicate a 25 times multiple of XRAY’s current share price around $60 which looks to me stretched given the integration risks. Still it’s a name for the watch list to monitor and wait for a better entry point.
In the meantime, it’s back to the dentist with this wobbly tooth.
Posted in Investing Ideas
Tagged advances in technology, dental CAD/CAM systems, dental instruments, dental sector, financial crisis, information technologies, Investing, investing ideas, investment ideas, shareholder returns, shareholder value, Sirona Dental, Sirona Dental Systems, stockmarket valuation, technology, technology advances, technology earnings
While waiting for earnings season to show how firms are forecasting the impact of macro trends, it’s a good time to look over some investing ideas for the future. Having a few names selected that can be picked up in market weakness is always a good way of building quality positions. It also helps in viewing current positions to see if they stack up to alternatives.
Regular readers will know that I think the insurance sector is best left alone given pricing and competitive pressures. Despite the odd look from afar, I have never been able to get comfortable with hot sectors such as the Chinese internet firms (as per this July post). The hype around new technologies such as 3D printing has taken a battering with firms like 3D Systems and Stratasys bursting the bubble. A previous post in 2014 highlighted that a focussed play on 3D printing such as Sirona Dental makes better sense to me. The Biotech sector is not one I am generally comfortable in as it seems to me to be akin to leveraged one way bets (loss making firms with massive potential trading a large multiples of revenue). Firms such as GW Pharma which are looking at commercializing cannabinoid medicines for multiple sclerosis, cancer and epilepsy have had the shine taken off their gigantic runs in the recent volatility. My views on Trinity Biotech (which is not really a biotech firm) were expressed in a recent post in May and haven’t really changed despite a subsequent 25% drop. I need to see more results from TRIB to get comfortable that the core business justifies the current valuation with the upside being in the FDA approval of the Troponin point-of-care cardiac tests. Other ideas such as online education firm Houghton Mifflin Harcourt (in this post) have failed to sparkle.
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This leads me to the online gambling sector that I have posted on many times (here and here for example) and specifically to the Paddy Power/Betfair merge. My interest in this sector has not been one from an investment point of view (despite highlighting that PP and Betfair would make a good combination in May!) but I can’t get the recent performance of these two firms out of my head. The graph below shows the profit before tax margins of each (with my estimate for 2015).
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One of the things that stand out is how Betfair’s margin has improved, despite the recent headwinds such as the UK point of consumption (POC) tax. Indeed the market view that Betfair CEO Breon Corcoran is the new messiah can best be illustrated in the graph below on the firm’s performance since he took charge (revenue in sterling). It shows solid revenue growth (particularly from sustainable markets) and the incredible recent growth in EBITDA margin despite the drag of 9% of EBITDA margin from the POC tax.
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At the most recent results, Corcoran did highlight some headwinds that would bring the margins down (e.g. phasing of marketing spend and increased product investment) but emphasised the “high level of operational gearing” in the business and the “top-line momentum”. The merger of these two high class firms under a proven management team does make one giddy with the possibilities. The brokers Davy have a price target of €129 on the Paddy Power shares (currently trading just below €100). More information should emerge as documents for the shareholder votes are published (closing date expected in Q1 2016). An investor presentation does offer some insight (for example, as per the graphic below).
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I have calculated some initial estimates of what the combined entity will look like. Using an assumed constant sterling to euro FX rate of 1.30 and trying to adjust for Betfair’s funny reporting calendar, I estimate calendar year revenue growth 2016 to 2015 at 17% assuming a sterling reporting currency, as per the split below.
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I also calculated a profit before tax margin for the combined entity of 18% which increases to 21% post cost savings. Given approx 91 million shares in the new entity, my estimated operating EPS for 2016 is therefore approx £3.85 or approx €5.00 which gives a 20 multiple to operating earnings at the Paddy Power share price around €100 today.
So is buying into the merger of two quality firms with top management in a sector that is undergoing rapid change at a multiple of 20 sensible in today’s market? That depends whether you think it’s time for a gamble or whether patience will provide a more opportune time.
Posted in Gambling Sector, Investing Ideas
Tagged 3D printing, 3D Systems, BetFair, Betfair CEO, betfair valuation, betting and gambling sector, Biotech sector, Breon Corcoran, cannabinoid, Chinese internet firms, Davy price target, digital technologies, earnings season, EBITDA margin, fintech, GW Pharma, information technologies, Investing, investing ideas, investment ideas, investor behaviour, investor presentation, macro trends, market weakness, mobile gambling, Online gambling, online gambling sector, operational gearing, Paddy Power, Paddy Power Betfair, Paddy Power Betfair valuation, paddy power price target, Paddy Power shares, paddy power valuation, POC tax, Point of Consumption tax, profit before tax margins, return on invested capital, share price target, share volatility, shareholder returns, shareholder value, Sirona Dental, Stratasys, technological innovations, technology, technology earnings, Time for a Gamble, Trinity Biotech, Troponin point-of-care cardiac tests
With Friday’s selloff, it will be interesting to see if this week brings a pause to the equity run-up. The rise has been dramatic with most US indices up 12% to 14% this year and over 20% since the November lows. I was struck by the last market pause in May and the comments on the US business TV shows. One said that there was a wall of money on the sidelines waiting to buy on the dip. Institutional money desperate for yield and company’s filling buy back programmes do seem to provide this market with a floor.
Historical multiples such as the TTM PE and the PE 10 at 18.85 and 23.89 at the end of May for the Dow are high relative to the historical averages of 15.5 and 16.47 respectively. However given the flood of money printing at Central Banks around the world such levels are not surprising nor excessive. I don’t think we are in bubble territory yet but, given the lack of alternatives for money, we will likely end up there. Whether that takes another 6 or 12 or 24 months is not really important. In cases where risk premia is irrational, a quote from Jim Leitner in “The Invisible Hands” comes to mind where he advises that an investor should focus on “the possibility of buying cheap insurance when the market is willing to sell it, before the horse has left the barn“. It seems to me as this is such a time and I will be looking for such opportunities in the absence of a major pull back. In my mind, its better to spend some profit to give peace of mind whilst also participating in further run-ups.
Longer term, I am disturbed by the macro policies currently been pursued and the impact that an exit from QE may have. It makes little sense to respond to every crisis with loose monetary policy designed to reinflate asset values so that Western consumers can get back to the Mall. I thought our response was going to be more fundamental this time! On that subject, I noticed a review of a book in the Sundays – its called “When the money runs out, the end of western influence” by the HSBC economist Stephen King. The review was just okay although the Economist seems to have given it a better one. Cheery reading for the holidays!
Quarterly reports from Willis Re and Aon Benfield highlight the impact on US catastrophe pricing from the new capital flowing into the insurance sector through insurance linked securities (ILS) and collaterised covers. Aon Benfield stated that “clients renewing significant capacity in the ILS market saw their risk adjusted pricing decrease by 25 to 70 percent for peak U.S. hurricane and earthquake exposed transactions” and that “if the financial management of severe catastrophe outcomes can be attained at multiple year terms well inside the cost of equity capital, then at the extreme, primary property growth in active zones could resume for companies previously restricting supply”.
This represents a worrying shift in the sector. Previously, ILS capacity was provided at rates at least equal to and often higher than that offered by the traditional market. The rationale for a higher price made sense as the cover provided was fully collaterized and offered insurers large slices of non-concentrated capacity on higher layers in their reinsurance programmes. The source of the shift is significant new capacity being provided by yield seeking investors lured in by uncorrelated returns. The Economist’s Buttonwood had an article recently entitled “Desperately seeking yield” highlighting that spreads on US investment grade corporate bonds have halved in the past 5 years to about 300bps currently. Buttonwood’s article included Bill Gross’s comment that “corporate credit and high-yield bonds are somewhat exuberantly and irrationally priced”. As a result, money managers are searching for asset classes with higher yields and, by magic, ILS offers a non-correlating asset class with superior yield. Returns as per those from Eurekahedge on the artemis.bm website in the exhibit below highlight the attraction.
Such returns have been achieved on a limited capacity base with rationale CAT risk pricing. The influx of new capital means a larger base, now estimated at $35 billion of capacity up from approximately $5 billion in 2005, which is contributing to the downward risk pricing pressures under way. The impact is particularly been felt in US CAT risks as these are the exposures offering the highest rate on lines (ROL) globally and essential risks for any new ILS fund to own if returns in excess of 500 bps are to be achieved. The short term beneficiaries of the new capacity are firms like Citizens and Allstate who are getting collaterised cover at a reduced risk premium.
The irony in this situation is that these same money managers have in recent years shunned traditional wholesale insurers, including professional CAT focussed firms such as Montpelier Re, which traded at or below tangible book value. The increase in ILS capacity and the resulting reduction of risk premia will have a destabilising impact upon the risk diversification and therefore the risk profile of traditional insurers. Money managers, particularly pension funds, may have to pay for this new higher yielding uncorrelated asset class by taking a hit on their insurance equities down the road!
Financial innovation, yet again, may not result in an increase in the size of the pie, as originally envisaged, but rather mean more people chasing a smaller “mispriced” pie. Sound familiar? When thinking of the vast under-pricing of risk that the theoretical maths driven securitisation innovations led to in the mortgage market, the wise words of the Buffet come to mind – “If you have bad mortgages….they do not become better by repackaging them”. Hopefully the insurance sector will avoid those mistakes!
Posted in Insurance Market
Tagged Allstate, Aon Benfield, Bill Gross, Buttonwood, CAT, economist, financial innovation, Financial services, ILS, Insurance, insurance linked securities, Investing, natural catastrophe, rate on line, risk premia, Risk premium, securitisation, United States, Willis Re