Tag Archives: technology

Age of Change

As if we all needed proof that the people across the so called developed world are troubled about the future, the election of Donald Trump to the US presidency last Tuesday is still a shock and unfolded in a spookingly familiar manner to the Brexit vote. “Wrong!” as Alec Baldwin has so aptly mimicked could be the call to the pollsters and commentators who are now scratching around despondently for reasons.

Why, we again ask, could an electorate so recklessly vote against conventional wisdom. I think the answer is in the question. Although the factors behind Trump’s vote are multi-faceted and reflect a bizarre coalition that will be impossible to satisfy, the over-riding factor has to lie at the door of an electorate that is troubled by future prospects and rejects the status quo. Why else would they vote for a man that polls suggests a majority acknowledge as been unqualified for the job? Aspects such as the worry of aging baby boomers at the diminishing returns on savings, the insecurity of the middle and working classes over globalisation, and the realisation that the technology from the shared economy is a cover for unsecure low wage employment have all contributed. Like in the Brexit vote, Trump tapped into a nostalgia for times past as an easy answer to the complex questions facing the world we live in.

The age profile of the Brexiteers in the UK and Trump voters in the US is interesting in that it highlights that Trump’s surprise victory is slightly less of a factor of age than Brexit.

click to enlargetrump-brexit-vote-by-age

Aging demographics in the developed world has been highlighted by many as a contributor to the current low growth. I last posted on this topic before here and the graph below is a reminder of one of the current predictions by the UN.

click to enlargeunited-nations-population-projections-2015-to-2100

The impacts of aging on future dependency ratios can be seen below, again from UN predictions.

click to enlargeglobal-dependency-ratios

A fascinating report from the research department of the FED last month, entitled “Understanding the New Normal: The Role of Demographics”, argues that demographic factors alone in the US account for 1.25% decline in the nature rate of interest and real GDP growth since 1980. The report concludes that “looking forward, the model suggests that low interest rates, low output growth, and low investment rates are here to stay, suggesting that the U.S. economy has entered a new normal”.

There was an interesting article recently in the FT called “The effects of aging” which included the graph below from UBS which strikingly highlights the changes in demographic trends and financial crises.

click to enlargefinancial-crisis-demographic-turning-points

Whatever disparate concoction of economic policies that Trump will follow in an attempt to tap the ghost of Reaganomics, it is clear that lower taxes and increased US debt will be feature. Trump may surprise everyone and use debt wisely to increase productivity on items such as rebuilding infrastructure, although it’s more likely to go on wasteful expenditure to satisfy his motley crew of constituents (eh hello, a Mexico wall!).

I constructed an index to show the relative level of debt dependency of countries using the 2020 debt level predicted by the IMF and the average 2020 to 2050 dependency ratios by the UN. Both the US and the UK are above the average based upon current forecasts and really can’t afford any debt laden policy cul-de-sacs. One only has to look at Japan for enlightenment in that direction. We have to hope that policies pursued by politicians in the US and the UK in their attempt to bring back the past over the next few years don’t result in unsustainable debt levels. Maybe inflation, some are calling the outcome of Trump’s likely policies trumpflation, will inflate debts away!

click to enlargedebt-dependency-index

In his recent book, “A banquet of consequences”, Satyajit Das articulated the choice we have in terms of a choice of two bad options by using the metaphor of the ancient  mythical sea monsters, Scylla and Charybdis, who terrorised sailors. Das said “Today, the world is trapped between Scylla, existing policies that promise stagnation and slow decline, and Charybdis, decisive action that leads to an immediate loss in living standards.

The character of Charybdis is said to be the personification of a whirlwind. Remind you of anyone….?

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.

Level-headed

After a week like the one just gone, where the S&P500 hit the 10% down threshold for the year, it’s perversely healthy to see debates rage about the likelihood of a recession, the future for oil prices, the bursting of the unicorn bubble, the impact of negative interest rates and the fallibility of central bank macro policy in the developed world, to name just a few. Considering and factoring in such risks are exactly what should be happening in a well functioning market, rather than one far too long reliant upon the supposed omnipresent wisdom of central bankers to answer any market ills that may come along. Although the market volatility during the opening months of 2016 hasn’t been pleasant and will hopefully find a floor soon, valuations didn’t reflect risks and an adjustment was needed.

I have no idea where the market is headed, although I suspect we are just one more shake-out from capitulation. Valuations have come off their unsustainable highs and a select few are beginning to look attractive. After some of this week’s indiscriminate falls, it’s always a good risk management discipline to assess current and possible new positions in light of developments. I assessed AAPL’s valuation recently in this post and offered my thoughts on the new Paddy Power Betfair in this post.

The subject of this post is Level 3 (ticker LVLT), a facilities-based provider of a range of integrated telecommunications services. Prior to their earnings on 4th of February, I had been re-examining my investment rationale on LVLT, one of my highest conviction positions that I last posted on a year ago. As I have highlighted before, LVLT is not an investment for the faint hearted and the past week has again proven that (a beta level of 1.5 according to Yahoo just doesn’t capture it!) with daily moves following the Q4 report of +6.9%,-5.7%,-9.4%,+3.7%,+3%, 0.5%, and Friday’s +1.7%. The graphic below shows the movement in the share price in LVLT, the S&P500 and the S&P High Beta index (SPHB) since the start of 2015. Also shown are the daily changes in LVLT against those of the S&P500.

click to enlargeLevel3 SP500 Share Price & Volatility

To recap on the bull case, the strength of LVLT is its deep and global IP optic network which following the recent mergers with Global Crossing and TW Telecom now has the business scale for the experienced management team to finally achieve operating margins to support its debt (current net debt to 2016 guided EBITDA is approx 3.5) and throw off meaningful cash-flow in the coming years (average FCF growth of 8% according to my estimates over the next few years). The Q4 2015 results and 2016 guidance showed the bull case is intact and the demand for new products such as the security and intelligent network services show how LVLT’s network is a competitive advantage in today’s technology driven world. The CEO Jeff Storey summarized their case at the Q4 conference call as follows:

“Most importantly, is our movement towards our vision of one, one set of products that we take to an expanding market, one network to deliver those products globally, one set of operational support systems to enable a differentiated customer experience, and one team with the singular goal of making Level 3 the premier provider of enterprise and networking services. As we look to 2016, our strategy remains the same. We are focused on operational excellence throughout our business, providing a superior experience to our customers and developing the products and capabilities to meet their complex and evolving networking needs.”

As the talk of a possible recession fuelled worries on business telecom spend, I thought it would be useful to look at the historical “as if” results of the now enlarged LVLT through the financial crisis. This involved looking through old Global Crossing and TW Telecom results and making numerous assumptions on the historical growth of acquired businesses and the business classifications (and numerous reclassifications) of each firm over time. The historical “as if” results combined with the reported figures for 2014 to 2015 and analyst estimates for 2016 to 2018 are shown below.

click to enlargeLVLT Proforma Revenue Split 2007 to 2018

Within the context of the caveat above, the drop in enterprise revenue from 2008 to 2011 was 12.5%, primarily driven the financial crisis with other factors being Global Crossing refocusing its portfolio and the operational missteps by legacy Level3 in integrating its multiple acquisition from 2006-08. TW Telecom’s consistent top-line growth since 2007, despite the financial crisis, can be seen in this post. It’s interesting that the wholesale revenues have been relatively stable historically ranging between $2.10-2.35 billion, supporting the view that price decreases are offset by unit increases in IP traffic.

Since 2012, the benefits of scale combined with the integration prowess of the current LVLT management team (Jeff Storey became CEO in 2013) are vividly shown in the impressive increase in EBITDA margin from 22% in 2009 to 32% in 2015. After cutting capex in 2008-09, the combined business has required 14%-16% since then, now targeted at 15% to support the 8% annual growth in enterprise revenues (on a constant currency basis) that management have set as their target.

In Q4, LVLT’s revenue was derived 80% from the US and management claim that their enterprise business has only a single digit market share in the US leaving plenty of room for growth, particularly against the incumbents Verizon and AT&T. The graph below shows enterprise and wholesale revenues from each firm with AT&T showing revenue stability against a declined trend for Verizon.

click to enlargeVZ AT&T Business Telecom Revenue

Numerous analysts confirmed their estimates on LVLT following the Q4 results and the average target is above $60, approximately 30% above the current level. Regular readers will know that normally I don’t have much time for analysts’ estimates but in this case my own DCF analysis suggests a medium term target of per share in the low 60’s is reasonable. According to my estimates that translates into an EV/EBITDA multiple of approx 8.5 in 2018 which looks reasonable given LVLT’s free cash growth. I used the historical “as if” figures above to calculate a downside valuation for LVLT on the basis of a recession occurring over the next 2 years. I assumed that a 2016-2018 recession would have approx half the impact of the 2008-2011 crisis upon LVLT’s enterprise revenue (e.g. approx 7% decline) before stabilising and recovering. My valuation of LVLT in such a scenario was in the mid 30’s or an approx 25% downside potential from Friday’s close. So at a 25% downside and a 30% upside, LVLT’s risk profile is finely balanced.

LVLT itself may become a target for a firm like Comcast or CenturyLink or another large communication firm looking to bulk up its regional reach or network business. Two interesting items came out of LVLT’s Q4 call; the first being the tightening of its target leverage range to 3 to 4 times EBITDA (from 3 to 5 times) and the second being a renewed appetite by management to use free cash-flow for disciplined M&A rather than shareholder returns such as buy-backs or even initiating a dividend. With LVLT proving their ability to get in excess of $200 million in EBITDA savings from adding TW Telecom’s revenue base of $1.6 billion at the time of the merger (or an impressive 12.5% EBITDA pick-up), the case for disciplined M&A by LVLT’s management is strong. Possible targets in the US include Zayo (their share price is having a hard time of late) or Carl Icahn’s privately held XO Communications (now that the maestro has milked the firms of its tax losses), amongst others. In Europe, possible targets include the now private Fidelity owned COLT (see this post on background) or Interroute, another privately owned pan-European network.

Whatever happens, I am content to hold my position in LVLT at this level. I like the firm’s current risk profile, the developing product range in the ever important network age, and particularly the recent execution record of management. As ever, I would highlight the stock’s volatility and recommend the use of options to protect downside risks (which are not inconsiderable if the probability of recession grows). I again repeat that LVLT is not one for the faint hearted, particularly in this market where near term volatility looks all but certain, but one I trust will be an attractive investment.

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.