Tag Archives: uncertainty

Beautiful Models

It has been a while since I posted on dear old Solvency II (here). As highlighted in the previous post on potential losses, the insurance sector is perceived as having robust capital levels that mitigates against the current pricing and investment return headwinds. It is therefore interesting to look at some of detail emerging from the new Solvency II framework in Europe, including the mandatory disclosures in the new Solvency and Financial Condition Report (SFCR).

The June 2017 Financial Stability report from EIOPA, the European insurance regulatory, contains some interesting aggregate data from across the European insurance sector. The graph below shows solvency capital requirement (SCR) ratios, primarily driven by the standard formula, averaging consistently around 200% for non-life, life and composite insurers. The ratio is the regulatory capital requirement, as calculated by a mandated standard formula or a firm’s own internal model, divided by assets excess liabilities (as per Solvency II valuation rules). As the risk profile of each business model would suggest, the variability around the average SCR ratio is largest for the non-life insurers, followed by life insurers, with the least volatile being the composite insurers.

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For some reason, which I can’t completely comprehend, the EIOPA Financial Stability report highlights differences in the SCR breakdown (as per the standard formula, expressed as a % of net basic SCR) across countries, as per the graph below, assumingly due to the different profiles of each country’s insurance sector.

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A review across several SFCRs from the larger European insurers and reinsurers who use internal models to calculate their SCRs highlights the differences in their risk profiles. A health warning on any such comparison should be stressed given the different risk categories and modelling methodologies used by each firm (the varying treatment of asset credit risk or business/operational risk are good examples of the differing approaches). The graph below shows each main risk category as a percentage of the undiversified total SCR.

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By way of putting the internal model components in context, the graph below shows the SCR breakdown as a percentage of total assets (which obviously reflects insurance liabilities and the associated capital held against same). This comparison is also fraught with difficulty as an (re)insurers’ total assets is not necessarily a reliable measure of extreme insurance exposure in the same way as risk weighted assets is for banks (used as the denominator in bank capital ratios). For example, some life insurers can have low insurance related liabilities and associated assets (e.g. for mortality related business) compared to other insurance products (e.g. most non-life exposures).

Notwithstanding that caveat, the graph below shows a marked difference between firms depending upon whether they are a reinsurer or insurer, or whether they are a life, non-life or composite insurer (other items such as retail versus commercial business, local or cross-border, specialty versus homogeneous are also factors).

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Initial reactions by commentators on the insurance sector to the disclosures by European insurers through SFCRs have been mixed. Some have expressed disappointment at the level and consistency of detail being disclosed. Regulators will have their hands full in ensuring that sufficiently robust standards relating to such disclosures are met.

Regulators will also have to ensure a fair and consistent approach across all European jurisdictions is adopted in calculating SCRs, particularly for those calculated using internal models, whilst avoiding the pitfall of forcing everybody to use the same assumptions and methodology. Recent reports suggest that EIOPA is looking for a greater role in approving all internal models across Europe. Systemic model risk under the proposed Basel II banking regulatory rules published in 2004 is arguably one of the contributors to the financial crisis.

Only time will tell if Solvency II has avoided the mistakes of Basel II in the handling of such beautiful models.

CenturyLink levelled

It’s been over 6 months since I last posted on the upcoming merger of Level 3 (LVLT) and Centurylink (CTL). Since then, LVLT’s CEO Jeff Storey has been named COO of the combined entity and CEO from January 2019, after a gentle push from activist investor Keith Meister of Corvex Management (here is an article on their latest position), effectively meaning the merger is an operational LVLT takeover of CTL. In June, CTL also got hit by a lawsuit from an ex-employer alleging a high-pressure sales culture which ripped customers off (an avalanche of class action suits followed). And, potentially more damaging, the recent results of CTL continue to point to deteriorating trends in the legacy part of their business and lackluster growth on the strategic part of the business. CTL missed their quarterly estimates again in the most recent quarter, the third miss in a row.

Picking up on my recent telecom industry post, the sector will struggle in the short term to find top line growth before the full impact of new “digital lifestyle” opportunities emerge. The figures below for enterprise, including public sector, and wholesale revenues for some of the biggest US players (which have been adjusted judgmentally for items such as the impact of the XO acquisition on Verizon’s revenues and the ever-changing classifications and reclassifications that telecom’s love) illustrate the current struggle in getting newer IP enabled services to fully compensate for declining legacy revenues.

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These figures imply average quarterly declines since 2014 of -0.3% and -1.2% for enterprise and wholesale business respectively. However, the trend has been getting worse. The average quarterly change was 0.2% and -1.1% for enterprise and wholesale business respectively from 2014 to 2015. Since 2016, the average quarterly change is -0.9% and -1.3% for enterprise and wholesale respectively. Not exactly a cheery trend when contemplating the prospects of a merged CTL/LVLT!

As can be seen below, the share price of LVLT and deal implied price have converged, particularly as CTL’s dividends get paid, albeit with a sharply downward bias in recent weeks over worries about dividend sustainability, valuation, sector trends, lawsuits and uncertainty over the closing date of the merger (a delay by California, the last State approval needed, may mean the end of September deadline is missed).

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My estimates for a standalone LVLT compared to analyst figures and those presented by LVLT management in the S4 (figures presented for merger negotiations are generally on the optimistic side) are below. Even factoring in higher interest rates (about 40% of LVLT’s debt is floating) over the coming years, I am comfortable with a standalone share price around the current mid-50’s, in the unlikely event the merger falls apart.

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To recap on my confidence in the ability of LVLT’s current management team to deliver, the results of the last merger between LVLT and TWTC show that management delivered a 40% uplift in the amount of free cashflow (e.g. EBITDA less capex) on flat revenues from 2014 to 2017 (e.g. combined FCF of both entities in the year prior to the merger to actual H1 results and my estimates for H2 2017). Some of my many previous posts on LVLT are here, here and here. Such a repeat in FCF in the CLT/LVLT merger is not a realistic expectation given the larger scale and different business mix, as the analysis below illustrates. Of course, the flat revenues over the past 3 years is a key concern (but worthy of praise given the industry trends highlighted above) and one of the catalysts for the CLT deal. Also, the health of designate CEO Jeff Storey may also be a factor over the next few years given his heart issues a few year ago.

My knowledge of CTL’s business is not as deep as that of LVLT’s and my confidence in their prospects on a standalone basis is nowhere near as lofty. My projections, split over a conservative base scenario and a more conservative low business scenario, can be seen below. My projections are primarily based upon the more recent trends in their business lines across their legacy and strategic enterprise and consumer businesses. The vast variance in my estimates, based upon recent trends, and those presented by management in the S4 (again, acknowledging that these are generally optimistic) illustrates why the market has lost such confidence in the outgoing management team at CTL, in my opinion.

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In terms of trying to model the merged CTL/LVLT, I have assumed the deal closes by the end of 2017 with 2018 being the first year of the merged entity. I have made a number of judgmental adjustments in my model, including assuming some loss of revenue due to the merger and cost reductions above published target synergies (e.g. $1 billion of operating synergies by end 2020 and $150 million of capex synergies by end 2019, higher than the announced target savings of $850 million and $125 million for opex and capex respectively). I have taken analyst estimates as an optimistic case (in CTL’s case I have taken their EBITDA estimates but still can’t get anywhere near their revenue figures) and called it the high scenario. My two projections above are used for the base and low scenarios. The resulting operating metrics for each scenario is shown below.

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The high scenario shows revenues flat-lining slightly above $24 billion for 2018 and 2019 with top-line growth returning in 2020 (YoY above 2.5%). EBITDA margins hit 40% by 2019 and remain stable around 40% thereafter. Capex is assumed to hit 15.5% of revenues by 2019 and remain at that percentage thereafter. This scenario assumes that management will be able to generate an approximate 30% uplift in the amount of free cashflow (e.g. EBITDA less capex) from 2017 (e.g. combined FCF of both entities in the year prior to the merger) to FY 2020.

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The base scenario shows revenues flat-lining around $23.5 billion for 2018 through 2020 with top-line growth returning in 2021 (YoY just below 2%). EBITDA margins hit 40% by 2019 and slowly trend down toward 39% thereafter. Capex is again assumed to hit 15.5% of revenues by 2019 and remain at that percentage thereafter. This scenario assumes that management will be able to generate an approximate 22% uplift in the amount of free cashflow (e.g. EBITDA less capex) from 2017 (e.g. combined FCF of both entities in the year prior to the merger) to FY 2020.

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The low scenario shows revenues around $23.5 billion for 2018 and drifting down to $23 billion before slowly hitting $23.5 billion again by 2022. Thereafter revenue growth builds slowly from 1.5% to 2.5% by 2027. EBITDA margins hit 39.5% by 2019 and slowly trend down toward 38.5% thereafter. Capex is again assumed to hit 15.5% of revenues by 2019 and remain at that percentage thereafter. This scenario assumes that management will be able to generate an approximate 18% uplift in the amount of free cashflow (e.g. EBITDA less capex) from 2017 (e.g. combined FCF of both entities in the year prior to the merger) to FY 2020.

I also assume the merged entity will carry $38 billion of debt from the offset (resulting from merger expenses, the cash payout to LVLT shareholders, and existing debts from both firms, after factoring any proceeds from recent CTL divestitures). I estimate that only 30% of this debt load is subject to a floating rate. In all scenarios, I assume the LIBOR rate linked to the floating rate increases incrementally by 275 basis points over the next 3 years (the current 12 month US rate is about 175 basis points). With a net debt to EBITDA ratio of approximately 3.8 at the end of 2018 across all scenarios, I believe that getting that ratio below 3 within 4 years by 2021, at the latest, will be a primary objective of the new management team. That would only be prudent in my view given the likely tightening monetary environment over the next few years which will punish valuations of corporates with high debt levels. Also, management will want to remain flexible if higher capex is needed to compete in new technologies for the IoT and digital lifestyle era (see recent sector post). I haven’t factored in an upside from LVLT’s CFO Sunit Patel proven ability to actively manage debt rates and maturities (his ability is highlighted by the fact that LVLT’s fixed debt costs 5.5% compared to CTL’s admittingly much larger fixed debt costing 6.8%)

That leads to the thorny question of the sustainability of the annual dividend of $2.16 per share (particularly given that share count will double, amounting to $2.3 billion per year). Under the high scenario, maintaining the current dividend and getting the net debt multiple below 3 by 2021 is doable if a little tight (primarily due to the cashflow benefits of LVLT’s NOLs). For both of the base and low scenarios maintaining the current dividend level is not realistic in my view, with a cut in the dividend to $1.30 and $1.00 needed in each scenario respectively (a 40% and a 55% cut). The current dividend yield on CTL is over 10%. Each of the cuts above would reduce that yield to approximately 6% and 5% for the base and low scenarios respectively based upon the current share price. Addressing the uncertainty over the dividend should be one of the priorities of the new management (and may even result in Jeff Storey’s move to the CEO position ahead of the planned January 2019 date).

Finally, before I reveal my per share valuations, I haven’t given any consideration to the financial impact of the current legal cases on alleged aggressive sales tactics as the level of current detail makes any such estimate impossible. Some of the class action cases claim anything from $600 million to $12 billion but these claims are always bloated and the eventual settlement figure, if there even is one, are often for a lot less than that claimed. Nor have I considered the potential impact of a spin-off of the consumer business (that’s for another time!).

So, based upon the analysis outlined in this post and using a discount rate of 8.5%, my valuation estimates for each of the three scenarios are below.

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The market’s current valuation of CTL around $20 indicates scenario 3 as the current expectation. This emphasizes the need to address the uncertainty over future dividend levels and the validity of the legal cases. Uncertainty over the closing date of the deal is overblown, in my view, and a few months of delay will not prove material. I do think the current valuation is harsh, given the potential upsides from the deal and longer-term industry trends. Interestingly, my base scenario valuation of £31 is not too far off the value of $34.75 by BofA Merrill Lynch and Morgan Stanley in the S4 (see this post on the S4). The base scenario is the one I would have the most confidence in, based upon my current knowledge, rather than the high scenario of $43 which does look too optimistic to me given current market trends.

I was never going to reinvest the cash component of the deal for LVLT shareholders given my current reservations about market valuations and move to cash across my portfolio. The analysis presented in this post indicates to me that the CTL shares due from the deal for LVLT shareholders are worth holding from a valuation perspective. For now.

For new investors, I’d wait to see how some of the uncertainties play out, particularly the dividend issue.

Anarchy in the UK

Uncertainty reins and the economic impacts of Brexit on the UK and on Europe have yet to become clear. And a big factor in the uncertainty is the political path to Brexit. The UK political class are now trying to rally around newly agreed leadership of their respective parties (assuming Labour MPs eventually manage to get rid of their current leader) and craft policies on how to engage in the divorce negotiations.

A unique political feature of the UK is their first past the post (FPTP) electoral system. The graph below of the 2015 general election shows how the system favours the larger political parties. It also shows how parliamentary representation under FPTP can be perverse. The Scottish SNP, for example, got 4.8% of the vote but 8.6% of the members of parliament (MPs). The right wing little Englander party UKIP, whose rise in popularity was a direct cause of the decision to have a referendum on Brexit, got 12.6% of the vote but just 0.26% of the MPs. Despite its obvious failings, the British are fond of their antiquated FPTP system and voted to retain it by 68% in a 2011 referendum (albeit with a low voter turnout at 42%).

click to enlarge2015 UK General Election Results

One lasting impact of the Brexit vote is likely to be on the make-up of British politics. Much has been commented on the generational, educational and geographical disparities in the Brexit vote. A breakdown of the leave-remain vote by the political parties, as per the graph below, shows how the issue of the EU has caused schisms within the largest two parties. Such schisms are major contributors to the uncertainty on how the Brexit divorce settlement will go.

click to enlargeUK Brexit Vote Breakdown by Political Party

Currently both sides, the UK and the EU, have taken hard positions with Conservative politicians saying restrictions on the freedom of labour movement is a red line issue and the EU demanding that Article 50 is triggered and the UK agree the divorce terms before the future relationship can be discussed.

Let’s assume that all of the different arrangements touted in the media since the vote boil down to two basic options. The first involves access to EU markets through the European Economic Area (EEA) or the European Free Trade Association in exchange for some form of free movement of labour, commonly referred to as the Norway or the Switzerland options. The second option is a bilateral trade agreement with a skills based immigration policy, commonly referred to as the Canadian option (although it’s interesting to see that there is political uncertainty in Europe over how the Canadian trade deal, which has been agreed in principle, will be ratified). I have called these option 1 and option 2 respectively (commonly referred to as soft and hard Brexit respectively).

Let’s assume the negotiations on Brexit in the near future will be conducted in a sensible, rather than an emotive, manner whereby the economic impacts have been shown to be detrimental albeit not life threatening. And both sides come to realise that extreme positions are not in their interest and a workable compromise is what everybody wants. In such a scenario, I have further assumed that the vast majority (e.g. 98%) of remain voters would favour option 1 and I have judgmentally assigned political preferences for each option by political party (e.g. 90% and 75% of Conservative and Labour leave voters prefer option 2 respectively). Based upon these estimates, I calculate that there would be a 56% majority of the UK electorate in favour of option 1, as per the graph below.

click to enlargeBrexit Options Breakdown by Political Party

Now, the above thought experience makes a lot of assumptions, most of which are likely to be well off the reality. Particularly, I suspect the lack of emotive and divisive negotiations is an assumption too far.

What the heck, let’s go one step further in these fanciful thoughts. Let’s assume the new leadership in the Conservative party adopt option 2 as their official policy. Let’s also assume that the Labour party splits into old labour, a left wing anti-globalisation party, and a new centre left party whose official policy is option 1. In a theoretical general election (which may be required to approve any negotiated deal), I guesstimate the result below under the unpredictable FPTP system.

click to enlargeTheoretical post Brexit General Election Result

This analysis suggests a majority government of 52% of MPs with option 1 as their policy could be possible with a grand coalition of the new centre party (Labour break away party), the Liberal Democrats and the SNP. The Conservatives and UKIP could, in this scenario, only manage 35% between them (the old labour party at 9% of MPs wouldn’t tolerate to join such a combination no matter what their views on the EU). The net result would be a dramatic shift in UK politics with Europe as a defining issue for the future.

Yea, right!

Back to today’s mucky and uncertain reality….

 

Follow-up: I thought I was been clever with the title of this post and I only realised after posting it that the Economist used it in their title this week! Is there nothing original any more….

A thoroughly modern intellect

In only the way he could, one of Oscar Wilde’s quips highlights the futility in trying to look at future risks when he said “to expect the unexpected shows a thoroughly modern intellect“.

In a recent article from Lucy Marcus called “Preparing for the unknown unknowns”, the author stated the following:

“Moreover, for all the risks that we can and do plan for, it is those for which we cannot prepare that can do the most damage. That is why, alongside all of the identifying, quantifying, and mitigating, we must also embrace the idea that not all change can be clearly foreseen and planned for.”

Notwithstanding the wisdom of these words, it is always interesting to see the results of the Global Risks report published each year by the World Economic Forum prior to the annual Davos meeting. The 2015 report is based upon the results of a survey from nearly 900 experts and the graphs below show the resulting likelihood and potential impact of 28 global risks and the interconnections between these risks.

click to enlargeGlobal Risks 2015

click to enlargeGlobal Risks 2015 Interconnections

Perhaps the most interesting part of the report is the schematic, reproduced below, showing how the top 5 risks in terms of impact and in terms of likelihood have changed from 2007 through to this year’s report.

click to enlargeGlobal Risks 2007 to 2015

The changing colours across the years illustrate now fickle and influenced by recent experiences our concerns for the future can be and just how thoroughly modern our intellect is.

Given the name of this blog, I of course include myself in the previous sentence also.

IOSCO Report on Corporate Bonds

Staff from IOSCO issued a report in April on the global corporate bond market. Although there was nothing earth shattering in the report, there was some interesting insights. The report highlighted 4 themes as below:

  1. Corporate bond markets have become bigger, more important for the real economy, and increasingly global in nature.
  2. Corporate bond markets have begun to fill an emerging gap in bank lending and long-term financing and are showing potential for servicing SME financing needs.
  3. A search for yield is driving investment in corporate bond markets. A changing interest rate environment will create winners and losers.
  4. Secondary markets are also transforming to adapt to a new economic and regulatory environment. Understanding the nature and reasons for this transformation is key in identifying future potential systemic risk issues and opportunities for market development.

The report also highlights the uncertainty that remains on secondary markets in the event of a interest rate shock and the $11 trillion worth of corporate debt (out of $50 trillion) due to mature in the next seven years.

Some interesting graphs in the report include the one below on the different characteristics of issuances pre- and post- 2007.

click to enlargeIOSCO Pre2007 and Post2007 Corporate Bond Issuance April 2014

Other interesting graphs highlight how corporate bonds are taking up the stagnation in bank credit in the US and the EU, and also highlight the boom in bank credit in China, as below.

click to enlargeIOSCO Bank Credit and Corporate Bond Markets April 2014

And finally the graphs below show the increase in non-financial corporate bond issuance and the modest growth in high yield issuance.

click to enlargeIOSCO Corporate Bond Markets April 2014