Tag Archives: operating margins

Restrict the Renters?

It is no surprise that the populist revolt against globalisation in many developed countries is causing concern amongst the so called elite. The philosophy of the Economist magazine is based upon its founder’s opposition to the protectionist Corn Laws in 1843. It is therefore predictable that they would mount a strong argument for the benefits of free trade in their latest addition, citing multiple research sources. The Economist concludes that “a three pronged agenda of demand management, active labour-market policies and boosting competition would go a long way to tackling the problems that are unfairly laid at the door of globalisation”.

One of the studies referenced in the Economist articles which catch my eye is that by Jason Furman of the Council of Economic Advisors in the US. The graph below from Furman’s report shows the growth in return on invested capital (excluding goodwill)  of US publically quoted firms and the stunning divergence of those in the top 75th and 90th percentiles.

click to enlargereturn-on-invested-capital-us-nonfinancial-public-firms

These top firms, primarily in the technology sector, have increased their return on invested capital (ROIC) from 3 times the median in the 1990s to 8 times today, dramatically demonstrating their ability to generate economic rent in the digitized world we now live in.

Furman’s report includes the following paragraph:

“Traditionally, price fixing and collusion could be detected in the communications between businesses. The task of detecting undesirable price behaviour becomes more difficult with the use of increasingly complex algorithms for setting prices. This type of algorithmic price setting can lead to undesirable price behaviour, sometimes even unintentionally. The use of advanced machine learning algorithms to set prices and adapt product functionality would further increase opacity. Competition policy in the digital age brings with it new challenges for policymakers.”

IT firms have the highest operating margins of any sector in the S&P500, as can be seen below.

click to enlargesp-500-operating-profit-margins-by-sector

And the increasing size of these technology firms have contributed materially to the increase in the overall operating margin of the S&P500, as can also be seen below. These expanding margins are a big factor in the rise of the equity market since 2009.

click to enlargesp-500-historical-operating-profit-margins

It is somewhat ironic that one of the actions which may be needed to show the benefits of free trade and globalisation to citizens in the developed world is coherent policies to restrict the power of economic rent generating technology giants so prevalent in our world today…

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.

More musings on the online gambling sector

A previous post on Paddy Power, William Hill and Ladbrokes showed how online sportsbook and gaming revenue are becoming an important part of the revenues of these firms. Another recent post on Betfair showed a similar import. This post will focus on the online gaming (which is a gentlier word used in the sector for what is more aptly described as online gambling) part of the equation.

As a recap, the graph below shows the online gaming revenues from Paddy Power, William Hill, Ladbrokes and Betfair (with PP converted to sterling at today’s rate) which make up 17%, 16%, 8% and 17% of their 2013 revenues respectively. Ladbrokes has approximately half the amount of its competitors. The considerable growth in William Hill’s online gaming (mainly casino) revenue after the creation of WH Online (WHO) in 2008 can clearly be seen. H2 Gambling Capital are forecasting an approximate 9% annual growth in online gaming gross win figures over the next few years

click to enlargeNet Gaming Revenue

None of the firms above split out their operating margins for the online gaming sectors. As casino is the dominant source of revenue for many of the firms, it is interesting to look at a diminutive online casino firm called 32Red, as per the graph below. Although 32Red is relatively small, the reduction in its margin to an average of 6% suggests that competition has pushed margins down in this business.

click to enlarge32Red Operating Metrics

Another two public firms that have a majority of their business in online gaming are 888 and BWIN. 888 is a well established player, particularly in the online casino market, with 40% of revenues in the UK and 40% in the rest of Europe in 2013, and it has been rebuilding its profit margins in recent years. 888’s operating metrics are summarized in the graph below.

click to enlarge888 Operating Metrics

BWIN, following its merger with PartyGaming in 2011, has a higher revenue base across Europe (excluding UK) making up approx 70% of 2013 revenues (25% from Germany) with only 10% from the UK. After some poor results and pressure from shareholders, BWIN is currently cutting its expense base by €30 million or approx 5.5% and is looked at ways it “can increase shareholder value”. BWIN’s operating metrics are summarized in the graph below.

click to enlargeBWIN Operating Metrics

The share performance of these firms has been distinctly mixed in recent years with little old 32Red blowing the others away, as per the graph below. BWIN has clearly underperformed and may likely be broken up. Analysts have speculated that a number of potential bidders, including William Hill and Paddy Power, are looking at various BWIN assets. Janus Capital Management has being building its stake in BWIN over recent months to 11% as at mid-July.

click to enlargeShare price since 2011 888 BWIN 32Red

Comparing the mainly online gaming firms with their more established betting firms in terms of the PBT margin shows the trend for both is downwards, as per the graph below. Headwinds include increased regulation and taxes such as the proposed UK POC tax. Opportunities include the explosion in mobile gambling, the slow re-opening of the US market (although I am sure established US bricks and mortar gambling firms will fight hard for their turf), new product development such as social gaming and the expected market consolidation. Amaya’s recent purchase of PokerStars has focussed minds on what will be needed to succeed in the US.

click to enlarge2003 to 2013 PBT Margin Betting & Online Gaming Firms

One of the more colourful firms in the sector, Playtech, has some interesting things to say about where the future is leading. On increased regulation, Playtech say that “the regulation of online gambling can be a catalyst for market growth, depending on how regulation is introduced, what product verticals the regulator allows and the tax rate applied” and that ”opportunities exist as markets move from a ‘dot.com’ to a ‘dot.national’ regime, although some uncertainties through the transition period are expected”.

Specifically on the UK, Playtech commented that “many smaller operators are understood to generate operating margins lower than the expected tax rate of 15% and in the view of industry experts, will struggle to compete. Larger operators can rely on economies of scale and their leading brands to remain competitive. Analysts expect that in 2015 the UK market will undergo significant change led by consolidation, as those operators with the strongest brands, best technology and means to invest in marketing will prevail”.

Playtech is a software gaming firm which offers a fully integrated platform across games and sports-betting called IMS that many of the main players use (licensees include Betfair, bet365, William Hill, Paddy Power and Sky, amongst others). They also run a white label turn-key operation called PTTS and a joint venture business. Their most well known joint venture was one where they very successfully partnered with William Hill in 2008 in the creation of William Hill Online (WHO). William Hill recently bought out Playtech of their 29% stake for £424 million. In March 2013, Playtech entered into a deal with Ladbrokes (in an attempt by Ladbrokes to diversify their business and catch up with their competitors – see first paragraph of this post) where, according to Morgan Stanley, Playtech “has effectively been given a quasi-equity stake, where it will “own” 27.5% of any increase in profits”. A Morgan Stanley report, although over a year old, has more interesting background on Playtech (they are still hot on the stock). The graph below highlights some of the metrics behind Playtech.

click to enlargePlaytech Revenues and PBT Margin 2009 to 2013

Much of the colour behind the firm has been provided by its 40 year old Israeli playboy founder, Teddy Sagi, who has a bribery and insider trading conviction from his youth in the 1990s. Playtech bought many of the assets used in the WHO 2008 deal from Sagi and also the PTTS assets (70% of this business is from Imperial e-Club licensed in Antigua and Barbuda!) in 2011 which caused concerns about conflicts of interest. Concern over such conflicts on what Playtech may do with its new cash pile from the WHO sale (they returned £100 million in a special dividend earlier this year but still have £376 million in cash as at end Q1) and on potential problems that Sagi’s ownership position may do in gaining access to the US resulted in an offering in March this year which reduced his 49% stake to 34%.

Playtech has stated that their “the Board is seeking transformational M&A opportunities to take the business to the next level.” Although it’s a bit too colourful for me, a number of analysts estimate a 20%+ upside on its current share price and it’s interesting to note that David Einhorn’s Greenlight Capital is a believer with an ownership of 3.8%. That, I think, is a good place to end a post on gambling!

High Beta Delight: Level 3 at $30

Following up on a previous post, Level 3 Communications (LVLT) has had a good run since June, breaking out of its trading range and holding around $30. Over the past 2 years, a successful trading strategy on LVLT would have been buying around $20 and selling in the high twenties, so I would expect traders of LVLT to take some profits (also there may be more shares on the market towards the end of the month after LVLT recently called some convertible debt). Given the historical volatility in LVLT and the market high valuations, a pull-back seems inevitable in the short term although over the medium term I have an increasing conviction that the future for LVLT’s long suffering equity holders is bright.

click to enlargeLevel3 Share Price

The recent increase has been driven by improving operating metrics, as per the graph on revenues and EBITDA margin below, and improved valuation multiples in the sector, as can be seen from a graphic on telecomrambings, plus the general increase in market valuations.

click to enlargeLevel3 Operating Metrics November 2013

LVLT has also been working hard on getting its oversized debt load (as at Q3 net debt was approx $8 billion) down to a more manageable size. To date in Q4, the firm managed to refinance approx $1 billion of debt and convert another $200 million. As LVLT achieves sustainable FCF in 2014, a virtuous circle of increased operating margins and reduced debt servicing may follow, vastly improving the credit profile of this once basket case (credit risk wise). The debt tinkering should reduce the average interest rate by 30 bps to 6.9% for year end and, assuming 2014 EBITDA of $1.8 billion, will reduce the net debt to EBITDA multiple from the current 5.2 to a more manageable 4.4.

The analysts have all increased their targets on the back of the recent results under the new leadership of Jeff Storey. UBS AG, Canaccord and DA Davidson are at $30, Goldman Sachs has $34, Cowen has $39, Deutsche Bank is at $40 (although this includes $8 of NOLs).

It’s important to again stress that LVLT has a very volatile history and is not for the weak hearted. YahooFinance calculates the current beta for LVLT at 1.8. The graph below illustrates historical weekly volatility versus the S&P500. There is also an analysis of the relationship between the S&P500 and LVLT since 2009 – LVLT moved with the market 66% of the time (3.2 times on average the market move on the way up and 2.7 times on the way down!), 22% of the time when the S&P was up LVLT was down (by a factor of 3!), and 12% of the time when the S&P was down LVLT was up (by a factor of 6.5!).

click to enlargeMonthly Volatility Level 3 S&P500 2003 to 2013

In an update of the highly influential paper by Andrea Frazzini and Lasse Pedersen called “Betting against Beta”, the authors test a number of investing strategies around beta and state that ”we find empirically that portfolios of high-beta assets have lower alphas and Sharpe ratios than portfolios of low-beta assets”. Although I would caution about short term volatility and an overexcited US equity market currently, I am hopeful that the days of LVLT being a pin-up for the high beta side are numbered.