Tag Archives: investment ideas

From flowmageddon to paymageddon

Morningstar have coined the witty term flowmageddon, in this article, for the on-going outflows that many in the active asset management sector are experiencing. In the US, passive equity funds have doubled their market share over the past decade and now make up over 40% of invested assets whilst bond fund assets have grown to over a quarter of the market, as the graph below shows.

click to enlargePassive % of US Bond Funds

The competition from passive investments such as ETFs has forced fees down for active managers. As per this FT article, Tim Guinness, chief investment officer of Guinness Global Money Managers Fund commented that “the days of great prosperity for active fund management may be behind us”. In other words, flowmageddon is leading to paymageddon!

According to this recent Economist article, the future for many active asset managers does not look too bright given the costs of increased regulation, such as the new fiduciary rules from the Department of Labour in the US, and the increased ability of technology to replicate complex investment strategies without the need for a load of vastly overpaid investment managers . Given that the majority of active managers consistently fail to beat their benchmarks after fees, the on-going shakeup is no bad thing.

Apple below $100

In a market like this one, it’s impossible to tell what is going to happen next. The smell of fear has been in the air with greed cowered by uncertainty. Greed may push back soon with earnings, and particularly guidance, dictating the short term path whilst oil and China, amongst other macro factors, will continue to dominate the overall direction.

Overall I remain cautious on equities with a downward bias. I am sticking to my conviction stocks whilst keeping cash on the sidelines until I find a blatant bargain or two. Notwithstanding that stance, it’s always good to look at your positions and see if some risk management re-weighting is called for. And that’s the reason for a quick look over Apple before its earnings next Tuesday.

Apple is in a hapless position currently and likely has to blow away the December quarter estimates (on the number of iPhones sold, the average price, and the gross margin received) PLUS give a strong March quarter guidance to move up in a meaningful way. Given that a repeat of the outstanding results of last December’s quarter (see post here) compared to current expectations is improbable, I would suggest Apple could trade around or below $100 for a while yet. Analysts, whilst screaming about its valuation, have become increasing negative on the December quarter and guidance for their Q2 quarter. Apple may struggle to come in much above the top end of its guidance of 77.5 million iPhones (it has come in above guidance for 5 consecutive quarters albeit at a steadily reducing level above the top estimate).

The geographic split of revenue, as per the graph below, will also be closely watched to see if China’s economy is impacting Asian growth.

click to enlargeAAPL Revenue by region Q42015

Despite its best efforts, Apple remains primarily a phone company with last year’s iPhone revenues making up two-thirds of the total, as per the graph below (with my estimates for Q1).

click to enlargeAAPL Revenue by product Q42015

I played with some estimates to stress the view on an AAPL valuation below $100. Taking a jaundice view of adjusting average analyst non-GAAP estimates for 2016 and 2017 plus some pessimistic estimates of my own on 2016 and 2017 (with iPhone slowing to sales of 220 million and 200 million compared to around 230 million for 2015), I estimated the forward PEs, excluding net cash (currently around $150 billion), as per the graph below (based upon diluted GAAP EPS, not the adjusted EPS analysts love) using tonight’s close of $96.30. The multiples are quarterly point estimates using the share price one month after the quarter’s end.

click to enlargeAAPL Forward 12 Month PE Ratios Q4 2015

The graph above clearly shows the swings in sentiment on Apple over recent years as the market grapples with the future demand for the iPhone after each upgrade cycle. Tuesday will indicate whether the current concerns about iPhone sales and margins peaking are justified. Other concerns, such as a possible $8 billion tax bill from the EU, pale in comparison to those iPhone concerns. Notwithstanding these real concerns, forward multiples of below 8 look too low to me given Apple’s operating record (unless you buy into the Apple could be the next Nokia thesis which I don’t).

By way of a comparison, my estimate for a similar graph for Google is below (again using diluted GAAP EPS). Google will be another stock where earnings for Q4 will be very interesting as they split out their figures in line with the new Alphabet structure and (maybe) demonstrate again their new emphasis on cost control. Expectations look high based upon its current valuation.

click to enlargeGoogle Forward 12 Month PE Ratios Q4 2015

The comparison does reflect positively on Apple’s current valuation multiple and I’m happy to hold the AAPL position I have. A key outcome from the AAPL earnings call will be if Cook can provide sufficient catalysts for Apple’s value to trade significantly above $100.

As always, time will tell.


Follow-0n Evening 26th after earnings: Over the next few days and weeks, I’m sure the chatter about Apple and the iPhone will likely get over-bearing. The delicately posed share price of $99.99 before earnings will come under pressure. Q1 revenues were at the lower range of expectations and Q2 guidance at $50-$53 billion is weaker than expected. China revenues showed slowing growth. On the positive side, the average revenue per iPhone in Q1 was higher than expected and operating margins were strong. I revised down my estimates for AAPL’s 2016 and 2017 diluted EPS (to $9.15 and $8.60) and iPhone sales to 210 million and 190 million. The revised revenue splits and forward PE multiples (at share price of $99.99) are shown below. Thesis, as per post above, on AAPL’s valuation remains basically unchanged although the share price see some selling pressure in the short term.

click to enlargeAAPL Revenue by region Q12016

click to enlargeAAPL Revenue by product Q12016

click to enlargeAAPL Forward 12 Month PE Ratios Q1 2016.png

Wobbly Tooth

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.

Click to enlargeSIRO Revenue Split & Op Margins YE2015

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.

Click to enlargeXRAY Revenue Split & Op Margins YE2015

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.

Time for a gamble?

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.

click to enlargeInvesting Ideas October 2015

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).

click to enlargePaddy Power Betfair Historical PBT Margins

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.

click to enlargeBetfair Revenue Split & EBITDA Margin to July 2015

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).

click to enlargeOnline Gambling Sector

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.

click to enlargePaddy Power Betfair pro-forma revenue split

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.

Gambling Problems

It has been about 6 months since I posted on the gambling and gaming sector (also earlier here) and there has been a lot going on. BWIN, after being on the block for some time, is closing in on a sale of its business with 888 and GCV (in conjunction with PokerStars and FullTilt owner Amaya) the speculated favourites. 888 itself rejected an offer from William Hill earlier in February this year. Meanwhile, Betfair and PaddyPower opted to return their cash piles of £200 million and €440 million respectively to shareholders rather than get involved in any M&A.

Ladbrokes, after a series of poor results, promoted the digital head Jim Mullen to CEO who is currently involved in a route and branch review of the firm with the outcome due to announced in June. His first move was to put the Irish business into examinership. Ladbrokes woes have continued with poor gambling Q1 results, continuing a run of bad luck after a disastrous boxing day football gross loss, as the exhibit below shows.

click to enlarge2014 Boxing Day 11 standard deviations

As can be seen by the graph below, Breon Corcoran’s rehabilitation of Betfair’s exchange model has resulted in an outstanding performance with a near doubling of the stock. The ex-Paddy Power executive has delivered on his plans for the betting exchange (as detailed in this post). [Update: Numis just released a note on Betfair’s rich valuation as per this article.] The tiny casino player 32Red has also had a good run due to solid 2014 results and M&A speculation.

click to enlargeShare Price 6months to May 2015 William Hill Ladbrokes Paddy Power Betfair 888 BWIN 32red

Internal candidates in William Hill and Paddy Power, James Henderson and Andy McCue respectively, also took over the CEO role.

The challenges for the sector are considerable. In the UK, the point of consumption (POC) tax of 15% has been in force in the UK since December and a new 25% rate of Machine Games Duty (MGD) applied from the 1st of March. Uncertain regulation across Europe and the lack of traction in opening of US markets are other headwinds.

Operator’s ability to reduce pay-outs to punters to counter tax increases is restricted by the competitive nature of the market, particularly online as the graph below on gross win percentages illustrates.

click to enlargeOnline Sportsbook Gross Win Percentage

Taking the commentary from the operators on the impact of increased taxes, I estimated the likely impact on net margins for a number of firms (as the graph below shows).

click to enlargeNet Margin estimates to 2015 gambling firms

The market is giving Betfair and Paddy Power credit for their recent revenue growth, strong operating results, product development and strong mobile adoption. Based upon my estimates, both trade on a 2015 PE in the low 30’s.

click to enlargeMarket valuations gambling firms

A brief review of the business profile of a selection of firms illustrates the differing models, as per the exhibits below.

click to enlargeGambling Sector Revenue Split & EBITDA estimates

click to enlargeGambling Sector Revenue Geographical Split 2015

It will be fascinating to see how the remainder of 2015 plays out for this sector. Scale is undoubting going to be a strength for firms in the future. What the large UK operators, Ladbrokes and William Hill, will do to counter headwinds will be intriguing. Although there is nothing to suggest it is remotely likely, it occurs to me that a tie-up between Paddy Power and Betfair would make a powerful combination.