Archive for November, 2011

Quick Thoughts: Naughty or Nice?

Written November 28th, 2011 by

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http://www.zdnet.com/blog/btl/black-friday-cyber-monday-euphoria-clicks-cannibalize-bricks/64275

Black Friday passes the baton to Cyber Monday, as the assembled pundits parsed the tea leaves from the estimated 16% YoY rise in spending, including a 26% jump on-line.  Most analysts were unambiguously impressed by this performance, although a smattering of naysayers expressed concern that the strong growth was more reflective of aggressive promotion and early shopping, and that the spending could peter out over the course of the Holiday season.  Interestingly, IBM CoreMetrics reports that 9.8% of on-line sales were made from mobile devices, up from 3.2% in 2010, and that mobile devices generated 14.3% of overall site traffic for e-tailers, up from 5.6%.  This is a powerful indicator of the long term potential for these devices as instruments of commerce, as the brick-and-mortar store increasingly becomes a showroom for on-line merchants.  It also highlights the potential for e-wallet applications as an NFC-based infrastructure rolls out.

The big and obvious beneficiary of this is Amazon, which is teasing strong sales of its recently launched family of new Kindles, including the Kindle Fire tablet.  ComScore reports Amazon as the leading on-line retailer, with a 50% sales advantage on number two Wal-Mart.  We note that the ComScore numbers show on-line sales growth accelerating from 15% prior to Thanksgiving, to 18% on Turkey day and 26% on Black Friday.  Given just 6% average YoY growth in on-line spending for Black Fridays 2008-2010, we are inclined to see this as bullish, even if some of the growth is the result of sales pulled forward by promotion.

Apple is also an obvious beneficiary.  Apple was the fifth largest online retailer for Black Friday, its stores were clearly a top destination for foot traffic, and its products top sellers for a wide range of other retailers.  iPhones and iPads accounted for more than 10% of total e-commerce traffic, and 70% of ecommerce traffic generated by mobile platforms.  Interestingly, shoppers visiting sites via iPad were 60% more likely to buy than the average.  All of this highlights mobile devices, in general, and Apple’s iOS family in particular, as future instruments of commerce.  In a season where shopping is surprisingly strong and where iPads and iPhones are amongst the most highly sought after items, it stands to reason that Apple will enjoy the Holidays.

Google benefits too, as a strong shopping season drives search activity and advertising.  Ditto for Facebook, where the Holidays build community spirit and with it, traffic as users consult each other over gift buying strategies.  Glad tidings too, for the chain of companies tied to the successful iPad/Phone and Android franchises – e.g. Samsung, HTC, LG, Qualcomm, Texas Instrument, OmniVision, Nuance, etc..  The happy Holiday would also seem to be relatively good news for wireless carriers – Verizon, AT&T and Sprint, even if we don’t see them as long term winners.  As data center virtualization chugs along in its middle innings, the usual suspects – VMWare, EMC, IBM, etc. – should follow – and with the move to the cloud becoming ever more apparent as inevitable to IT managers, opportunities for consulting abound, to the boon of IBM, Accenture, and their ilk.

As for those that might find coal in their stockings, we remain pessimistic about the consumer PC market, and with it, the Christmas fortunes of the likes of Dell, HP, and Intel, although the rising tide of overall spending could cushion the blow of the share loss to tablets.  We are also fairly sanguine about the prospects for enterprise IT spending on desktops or major new software projects, so a bit of skittishness on SAP, Oracle and friends may be justified.

More Transatlantic: So Allied World DID Consider Runoff to Get Back in the Game!

Written November 22nd, 2011 by

The Transatlantic saga is turning into one of the stranger events in insurance history.  Multiple bids, hostile bids, and now…consideration of runoff to make the deal more attractive.  This latter item is most interesting to us, as it is the exact topic of our most recent piece.  But first, some context.

As things stand now, Transatlantic (TRH) will now become majority-owned by Alleghany (Y), who will likely let the company run more or less independently.  However, there was a last-minute attempt by the original suitor, Allied World (AWH), to get back in the game.  According to the Insurance Insider (link, although a subscription is required), AWH was planning on teaming up with private equity firm JC Flowers via its insurance runoff firm Enstar (ESGR).  The idea was that ESGR would take on some share of TRH’s older reserves, while AWH would get renewal rights.  This type of transaction is exactly what we described in our November 11 note.

Now, this deal appears to have been rejected because of the Y offer.  We’re not surprised: if we were TRH management, we’d want a straight offer for independence, too.  But it’s important to understand why such a structure would even come up, and why we are suggesting this could come up again.

In essence, the insurance market is trying to deal with a situation where capital-intensive entities are currently trading persistently below book value.  In a “normal” market where this would be viewed as temporary, investor tend to want management to greatly constrain capital actions, mostly to just buying back stock.  But we claim the current environment—which is a market phenomenon, not insurance-specific—is more or less “permanent”, at least as long as the market has a post-crisis mentality.  Yet as the TRH soap opera showed, investors still resisted any deal that was below book (and so the Y deal make yet face some hurdles).

If the current market risk premium is so high that capital-intensive financials now trade “permanently” below book, then restricting capital actions to buyback is equivalent to ordering such companies to shrink; i.e. reduce risk.  Even if the insurer believes its valuation is temporary and its risk are “manageable,” if a company wants to make a capital decision today, its options are constrained.  This is why we hypothesized that runoff of older business would be considered.  It is most likely not desired by said managements, or even deemed necessary, but that’s beside the point.  The market is forcing consideration of this option because no others seem to be allowed!

We do not think this phenomenon will remain sporadic until and unless a industry capital event occurs…but that’s likely at some point.  In particular, while we are not optimistic for a big pricing cycle turn in the near future, we do think something like this will happen by 2014-15.  And literally since our first day at Sector & Sovereign, we have been warning that some companies are going to find themselves without easy access to capital, in stark contrast to past pricing turns.  The TRH saga gives a small preview of what’s at stake.  We suspect people will continue to be skeptical about this.  We admit, our thesis seems extreme.  But in case it wasn’t clear, this market is extreme.  We suspect it will take another crisis, like chronic loss reserve deficiencies (not there yet, of course), to bring this point home.  And when that occurs, companies like ACE Limited (ACE), which have drawn the ire of investors for not more aggressively returning capital, may look prescient.

The Transatlantic Saga: As Close to a Private Deal as a Public Company Can Get

Written November 21st, 2011 by

In the most recent episode of the Transatlantic Re (TRH) takeover soap opera, it appears that they have reached a deal with Alleghany (Y) to buy the company for $3.4 billion, per various news outlets.  Alleghany is an example of what many investors think of as a mini-Berkshire (Markel and White Mountains are anothers): a holding company that may own various insurance-type companies (and other industries), generally running them in a hands-off manner.

As a result, if the deal goes through—and it looks like it is likely to make everyone happy except for hostile suitor Validus—we would argue that this is about as close to a private-like deal that can be done with public companies.  One of the main impediments to prior TRH transactions has been how far below book value they were.  Indeed, this is a problem for the entire reinsurance industry, as we have discussed obsessively.  The TRH/Y deal is still below book: at $60 per share, this is about 86% of last stated book value.  But because TRH will be left largely alone, and because Y is known to be a long-term oriented investor, this is about as close as we can get to TRH finding patient capital that is not private.  Because the rumored deal involves Y stock, current TRH investors are being asked to take a longer-term stance, which seems to be what is required at present.

The problem we see is that there does not seem to be a lot of capacity to keep doing deals like this.  While private money does seem interested in entering reinsurance at some point, they seem more interested in starting with fresh capital, rather than taking on the historical baggage of existing balance sheets.  So reinsurers as a class are still at risk of capital constraint if any major events occur (which could be broader than just “catastrophes”).  We’d be very cautious in attempting to “read across” this result to other companies.  Our most recent piece (http://wp.me/p1W1lB-1ub) about the troubles facing the highly capital-intensive insurance subsectors still seems quite relevant: without more saviors like Y, more drastic balance sheet actions may be required if patience wears thin.

The Open Source Software Threat – Wait, It Gets Worse!

Written November 17th, 2011 by

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The direct threat of open source software (OSS) to the flagship products of the major commercial software vendors is accelerating with the growing maturity of the open source movement, even as the impending move to the cloud opens another broad avenue for OSS incursion.  We believe that this will be a substantial challenge for commercial software vendors, particularly those whose primary business is in infrastructure, tools and/or middleware software where the threat from OSS is most acute.  Applications are less threatened by OSS, except where products are reaching maturity.  Successful cloud hosts will be the biggest beneficiaries, with opportunities to drive their own applications as differentiated SaaS offerings.

OSS, which is defined by open licensing with rights to adapt the underlying source code, is not synonymous with “freeware”.  Many open source platforms, such as Android and JAVA, are owned and licensed by commercial entities.  Others – Linux, SQL, OpenFlow, etc. – may be available in the public domain, but require commercial support to make them viable enterprise solutions for any but the most sophisticated organizations.  Typically, OSS-based solutions are brought to market with licensing and maintenance fees, but at significant savings vs. closed proprietary commercial software.

Historically, closed software vendors have sold their products on the basis of proprietary functionality and performance advantages vs. open source.  Over the past decade, OSS has closed those gaps in many categories, as time yields product maturity.  As such, OSS is extending its appeal to less sophisticated IT shops and gaining credibility for mission critical systems.  Some large organizations are implementing hybrid solutions and shunting growth to OSS platforms to avoid exceeding seat limits for their expensive closed systems.  While not a sea change shift, these subtle changes siphon off growth opportunities and create price pressure for many software companies.

The impact is heaviest on infrastructure, tools and middleware software, where switching has lower costs on end users and where focus on virtualization and the cloud puts a premium on flexibility.  A Gartner survey of 547 global IT organizations showed that nearly 80% were using OSS solutions in at least some areas, with a third using them comprehensively or as a strategic tool to gain competitive advantage.  The biggest reason for adoption was to achieve strategic IT goals, such as flexibility, openness, and speed of implementation, followed by cost considerations.  The top five areas of OSS use were Data Base Management Systems, Server Operating Systems, Office Suites, Client/Desktop Operating Systems, and Application Development.

Many leading commercial software vendors have acceded to enterprise demand for OSS by offering open source solutions of their own.  For example, Oracle offers MySQL as an alternative data base solution, IBM offers Xen OSS virtualization, and even noted open source hold out Microsoft has pledged support for the emerging Hadoop open standard for business intelligence data analysis software.  This strategy allows large enterprise software companies to broaden their product lines to retain business that might otherwise be at risk, but also to use OSS to lever into new areas where they lacked differentiated proprietary products.  However, smaller enterprise software vendors may lack the resources to extend into open source and will be all the more vulnerable for it.

The cloud – software-as-a-service (SaaS) and infrastructure-as-a-service (IaaS) is a further catalyst, as the big potential benefits to enterprises drives re-evaluation of software strategies and since cloud hosts, like Amazon, IBM and Google, are inclined to base their own services on self-customized open source platforms.  These big, ambitious cloud players are amongst the most sophisticated IT managers in the world, looking to gain competitive advantage via differentiated, internally developed implementations of open source solutions for major infrastructure software categories – SQL data case, Linux OS, Xen virtualization, Hadoop data mining, OpenFlow IP routing, etc.  As such, the substantial scale and access benefits of the cloud will greatly squeeze opportunities for both closed and open software sales by independent vendors.  As the pendulum swings to the cloud, look for increased concentration of the software market value into the hands of integrated players winning in the cloud hosting and SaaS game.

As cloud-hosted systems become a prevalent model, the cutting edge technical expertise of these organizations will likely pressure software beyond servers.  Modern internet architecture derives performance advantage from distributed data centers that deliver data from the closest possible location.  Managing the substantial networking and storage assets that enable this architecture is a substantial point of differentiation for these providers, raising the profile of open source projects for IP networking (OpenFlow) and storage management (OpenFiler).  Internal solutions built on OSS threaten integrated software solutions from the likes of Cisco, Juniper, EMC, NetApp and others.

The winners – companies that have already established strong bona fides in the cloud business, e.g. Amazon, IBM, Google, Microsoft, Salesforce.com, etc..  The losers – focused infrastructure, middleware, and tools players, e.g. BMC Software, VMware, CA, etc…  At risk, long term – OSS vendors that could be squeezed by the cloud, e.g. Red Hat, Citrix, etc. and integrated software, e.g. Cisco, Juniper, EMC, NetApp, etc..  On the bubble – broad software players that have not yet established a strong cloud presence, e.g. Oracle, HP, etc…  Unaffected – differentiated applications vendors, e.g. SAP, Concur, etc.

Is It a Pricing Cycle, or a Capital Raising Cycle? Some Initial Thoughts

Written November 17th, 2011 by

This post reflects an idea we’ve been mulling over, and now we’ve had some client conversations expressing the same thought.  Let us first bring in our existing research to provide context.

The clear consensus of most P&C underwriting managements is that a pricing cycle seems to be forming.  There is some debate as to its breadth (i.e. most agree it is property-focused right now), and brokers are more likely to show skepticism than underwriters, but there are now forecasts that pricing could be up as much as 8-10% next year.  If true, this would certainly be a big improvement over the past several years.

However, readers of our research know that we are skeptical as to the sustainability of any pricing cycle, as long as balance sheets are a healthy as we think.  Reserve adequacy as of year-end 2010 was still very high, and it is unlikely that enough reserve releasing has occurred in 2011 to bring reserves as deficient a level as has been needed in the past produce a big pricing turn.  We are not the only ones who think reserves are still quite adequate (e.g. Aon Benfield).  Based upon past relationships, it does not seem like we can have enough balance sheet “pain” to turn the cycle until around 2015.

As a result, we have a Short-Term Positive View on most cycle-exposed insurance subsectors (brokers, P&C Commercial, P&C Multiline, P&C Specialty, Reinsurance), but a Long-Term Negative View on these same subsectors (except for Brokers, where our Long-Term View is Neutral).  Put simply, we think the momentum on the change in pricing views will work short-term, but we think the risk is great that in 2012, insurers will realize they were too conservative once again, this time on the 2008-10 underwriting years.  This realization will likely derail any short-term pricing momentum.

The next step in our research process is to consider what we might be getting wrong.  It is a common cliché that “every pricing cycle is different.”  In fact, they aren’t all that different, in our view.  The exact specifics differ every time, but the basic result is the same: once enough balance sheet destruction occurs, we get a pricing turn.  For example, loss reserves became as redundant in the mid-1990s as they did in the mid-2000s.  We still have not seen anything as bad as the late 1990s market conduct.

What is different this time is valuations, or more precisely, investor opinions on balance sheets.  Valuations have been persistently low since the onset of the financial crisis in 2007-08.  We argue that the resulting rerating of all insurance subsectors has been consistent with generally higher risk aversion.  So to claim that valuations “have to rise” from here is a market call, in our view, and it is not something where we think we add much value.

The next question is how might companies increase price/book valuations on their own.  Our most recent work suggests that ROE increases are unrealistic: it would take over 15 points of additional ROE on average to bring valuations back to pre-crisis levels.  Of course, insurance investors know that price/book ratios are likely to rise temporarily to above-normal levels while they are raising price.

This fact raises an intriguing idea.  In a “typical” cycle, insurer balance sheets are damaged to varying degrees, which necessitates raising capital.  However, they also raise pricing simultaneously, which raises price/book ratios (usually), as investors anticipate higher future ROEs.  The causation chain in this case is balance sheet damage à price increases à higher price/book à capital raising à higher ROE (the precise order of the middle 3 items is debatable).  The ultimate goal of this activity is balance sheet repair.  Now we argue that balance sheets don’t need repair yet.  But what if the goal this time is simply to raise more capital?  Average valuations in many subsectors are chronically below book value, which is precluding any capital actions except stock buybacks.  But if valuations could be temporarily brought above book, could companies could raise non-dilutive capital.

This scenario might seem quite cynical, but this is a cynical moment.  Companies have objectively behaved better so far than in past cycles (at least based upon what we can measure), yet they are trading below any historical floors.  The reason for this has nothing to do with insurers specifically and everything to do with investor risk aversion generally.  We generally reject as insufficient reasons like current ROE, low interest rates, etc.  But for insurance companies, the result is the same: their hands are tied with respect to capital actions.  So if there is a way get in a capital raise with the goal of hunkering down until overall market valuations rise, this may be worth pursuing.  And rather than come out and say this, instead they talk about returns and low investment yields.

Because no cycle has evolved  this way before, we are still formulating ways to analyze the problem.  But we wanted to get this issue out in market, if for no other reason than to get investors thinking about it.  Our initial view that that the combination of current low valuation and the reduced price/book increases from pricing cycles generally makes this gambit unlikely to succeed, and so our current subsector Views seem reasonable.  But we bring this up precisely because we could be wrong, and it is worth thinking about.  In particular, we have not examined that pricing cycle in the context of risk-adjustment before, so some of the techniques we used in our most recent note on valuations may prove useful.  We are very interested in investor commentary while we continue to think about how to measure this issue.

Dismal EU Growth Forecasts Mean Pricing Pressure on (Innovative) Healthcare Exporters

Written November 15th, 2011 by

On Thursday, the European Union cut its 2012 real GDP growth forecast to just 0.5% – down nearly 70 percent from its 1.9% projection just six months ago. Ominously, the EU added that “the probability of a more protracted period of stagnation is high. Given the unusually high uncertainty around key policy decisions, a deep and prolonged recession complemented by continued market turmoil cannot be excluded.” We anticipate this implies more export-market pricing pressure, and view this pressure as a dominant systematic risk to healthcare portfolios in the immediate term

In a call late last year we argued that exporters of healthcare products to European countries – where governments tend to be the dominant purchasers – faced intense pricing pressure as a result of the Euro zone debt crisis; and that makers of more innovative products (pharmaceuticals; artificial joints; pacemakers) faced greater risks than makers of less innovative products (gauze; bandages; sutures)

Our working thesis was that the relationship between the rate of change in consumables imports and the rate of change in GDP should be distinct across the three subcategories of hi-tech (more innovative), mid-tech, and lo-tech (less innovative) medical products. More specifically, we expected higher tech consumables to decline more when GDP was contracting – consistent with the idea that these governments’ single-payors would preferentially seek to reduce pricing on higher-margin innovative products during times of economic stress. Lower-tech products should behave more like commodities, wherein demand growth associated with an economic recovery would be more likely to increase commodity manufacturers’ capacity utilization, thus exerting at least a modest upward effect on pricing

When we examined imports of products in these categories into developed markets over several economic cycles, from 1989 through 2008, we found that in fact the change in demand during times of economic stress (GDP contraction) clearly follows the pattern we suggest – hi-tech consumable imports fall far more with a falling GDP than mid-tech consumables, which in turn decline far more with a falling GDP than lo-tech consumables (Exhibit 1). The dynamic is reversed (though far less responsive) during periods of economic growth

Plainly, these findings are daunting for manufacturers selling into the EU, particularly in the context of the updated growth forecasts – near zero; declining; risks heavily skewed to the downside – and immediate threat of further drastic austerity measures throughout the region. At the level of healthcare subsectors large-cap pharmaceuticals and biotech generally are most exposed

Individual Mandate Now 2-1-1 in Circuit Court; Supreme Court Will Weigh-In…

Written November 14th, 2011 by

On November 14 the Supreme Court agreed to review the constitutionality of the Affordable Care Act’s individual mandate, granting petitions for writs of certiorari on four aspects of the 11th Circuit Court’s decision in Florida et al v. Dept. of H&HS et al

Specifically, the Court agreed / asked to hear arguments from all parties regarding the following questions[1]:

(1)    Anti-Injunction Act Applicability (Supreme Court order)

“Whether the suit brought by respondents to challenge the minimum coverage provision of the Patient Protection and Affordable Care Act is barred by the Anti-Injunction Act, 26 U.S.C. §7421(a)”

(2)    Constitutionality (Dept. of H&HS et al petition for writ cert)

“Whether Congress had the power under Article I of the Constitution to enact the minimum coverage provision”

(3)    Severability (National Federation of Small Business et al[2] petition for writ cert; Florida et al petition for writ cert)

“Whether the ACA must be invalidated in its entirety because it is nonseverable from the individual mandate that exceeds Congress’ limited and enumerated powers under the Constitution”

“[Whether] the Affordable Care Act‘s mandate that virtually every individual obtain health insurance exceed[ed] Congress‘s enumerated powers and, if so, to what extent (if any) can the mandate be severed from the remainder of the Act”

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PBM Pricing Post-AWP – An Estimate of Sustainable Earnings Power

Written November 13th, 2011 by

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Using Medco (MHS) as a proxy for large PBMs, we show that generic buying margins dominate PBM gross profits; PBMs appear to have sacrificed most (or even all) alternative sources of gross margin, levering the industry’s pricing structure almost completely to generic spreads

As the Average Wholesale Price (AWP) pricing benchmark is phased out, the arbitrage in generic margins closes, forcing PBMs to a wholly different pricing model, and raising the question of sustainable post-AWP earnings power. We define sustainable pricing – and thus sustainable gross margin – as a level at which clients’ next best alternative is a less efficient choice than the traditional PBM

As generic dispensing margins fall, PBM clients can recreate retail and mail networks using alternative service providers. Benchmarking to closed loop payment processing margins, we estimate that drug-benefit cards can be issued and a retail payment / claims processing network operated for roughly 2.7% of retail drug costs. For prescriptions filled at mail, we believe post-AWP dispensing margins of $11.04 or less are feasible (v. current retail of $14.10). All-in, this virtual / alternative network can operate on 16% less gross margin than MHS

At the very minimum, we see the large PBMs having to adjust current pricing – and thus current gross margin – by this amount, in order to maintain the total economic benefit (roughly rebates net of fees) that PBM clients presently receive

As available brand rebates fade and generics’ share of dispensing grows, the alternative network becomes increasingly efficient relative to the legacy PBM model, implying that gross margin pressures continue to build well after the shift to AWP

Present consensus calls for considerable earnings growth, implying margin expansion, share gains, or some combination of these, where we see both margin contraction and loss of market share. PBM share prices, at market parity on out-year (2013) consensus, belie the market’s general acceptance of reliable earnings growth

We accept that the relative timing of generic-wave gross profit gains and the negative margin effects we describe above is uncertain, and that we face the near-term risk of gross margins expanding before these pressures unfold, particularly if the market overestimates the synergies or price-stabilizing effects of an ESRX/MHS merger. Nevertheless with share prices reflecting considerable growth in earnings power when rather dramatic (≥ 30%) contraction is far more likely, PBMs remain the most compelling short story in healthcare

Quick Thoughts: Yes, Comcast, There is a Threat From Wireless Broadband

Written November 9th, 2011 by

Quick Thoughts: Yes, Comcast, There is a Threat From Wireless Broadband

In my recent post about the “over the top” threat to cable, I wrote briefly about the potential for 4G wireless networks to compete directly with cable modem service for fixed residential broadband customers.  For cable industry executives, wireless broadband is something akin to the bogeyman – they’ve been hearing about it since they were new hires twenty years ago and they don’t believe it.  In the cable worldview, no existing network is fast enough to compete for video-capable broadband and it is too expensive to build one that can.  Since Verizon decided to stanch its FiOS investment, this is the status quo for more than 70% of Americans (Exhibit 1).

Without competition, Cable MSOs can manage the “over the top” threat.  Since all of the customers on each 500 household cable node share the same 152Mbps of Internet bandwidth, and since a single stream of HDTV quality video can require 7Mbps, only so many users can watch Netflix at the same time before the system capacity is tapped out and everyone sees performance degradation.  Rather than invest to divert system capacity from Cable TV to expanding Internet service, Cable MSOs discourage Internet video by metering usage and hiking the price for high usage households.  If “over the top” video gains enough traction to stimulate “cord cutting”, that is discontinuing channelized TV service in favor of Internet video only, MSOs will just hike the fees for high speed internet to make up the difference – given the rising cost of content, TV is a much lower margin business for cable operators than Internet anyway.  Either way, the Cable industry will win, right?

Uh, no.  The biggest flaw in the Cable wins argument lies in the assumption that no credible competition for high performance residential broadband will emerge.  Yes, today’s 4G wireless networks do not have sufficient capacity to handle the more persistent demands of residential users and the immense cost of building out blanket national coverage is driving high pricing and usage caps that would seem to preclude their use for residential applications.  However, the status does not usually remain quo for very long in wireless (Exhibit 2).

The LTE-Advanced specification was ratified as meeting the ITU standards for 4G in November 2010.  Essentially, this verifies that the proposed technology is able to deliver speeds of at least 100Mbps for mobile users and 1Gbps for limited mobility users.  The differences between the current LTE deployments and LTE-Advanced are substantial, although the specification allows for LTE devices to operate over LTE-Advanced networks and vice versa.    Specifically, LTE-advanced supports the use of as many as 8×8 antennae for MIMO (Multiple Input Multiple Output), while LTE tops out at 4×4 and is currently deployed at 2×2 (Exhibit 3).

This technology offers a roughly linear improvement, meaning a near four-fold improvement in system capacity and device through put vs. current LTE networks.   LTE Advanced is also expected to make use of more sophisticated error correction and other techniques to eke out modest (20-30%) additional throughput.  Furthermore, LTE Advanced allows for the aggregation of up to 100 MHz of spectrum within a single cell, five times the maximum for LTE.  This relationship is also fairly linear.

Today’s LTE systems, such as Verizon’s widely available service, offer roughly 120 Mbps in aggregate capacity per cell, ballpark comparable to the 152Mbps offered over each cable node.  A full 8×8 MIMO, 100MHz LTE advanced system could increase total capacity by more than 15x per cell, to nearly 2Gbps.  While this would obviously dramatically increase the per cell backhaul requirements, these technologies are also evolving quickly enough to accommodate the progress.  Given the 7Mbps per stream requirement for HDTV, each cell site could handle more than 250 simultaneous streams.  This is definitely fast enough and capacious enough to be a viable alternative to cable broadband.  Of course, there are objections from the cable crowd.

“Yes, but LTE Advanced is years away and will likely be delayed!”  LTE Advanced was ratified in November 2010 as meeting the ITU standards for true 4G – 100Mbps mobile download speeds and 1Gbps limited mobility downloads, amongst other requirements – and commercial equipment is expected by year end 2012, with network deployment in early 2013.  While the full capability of LTE Advanced, may not be included in the first deployments due to current semiconductor processes, the speeds and capacities should progress steadily akin to Moore’s Law.  Note that 3G networks were launched worldwide in 2001-2002, and have improved user speeds by more than a full magnitude in the decade since.  Current industry roadmaps suggest hitting the full 4G capabilities by 2015 in commercially available equipment is a reasonable expectation.

“Yes, but there isn’t enough radio spectrum available to implement LTE Advanced!”  At this moment, this is partly true, but change is afoot.  The FCC has identified 415MHz of spectrum that it believes can be made available for wireless broadband over the next 5 years, which if the FCC is successful, would more than double the spectrum in use for commercial wireless services.  120 MHz of this spectrum is being wastefully used by television broadcasters, and is awaiting Congressional approval for incentive auctions that would motivate these station owners to vacate expeditiously with a portion of the proceeds (Exhibit 4).  We believe that this will be approved.  Another sizeable piece of spectrum is in use for commercial satellites and could be effectively shared with terrestrial applications.  Both LightSquared and Dish are pursuing LTE projects using these bands.  While there are currently objections that both networks would create interference for adjacent spectrum users, including GPS, these problems are technical in nature and can be resolved through refinement of the technology.  The FCCs proposals do not include Clearwire’s 150MHz of spectrum in the relatively high band of 2.5GHz.  Clearwire’s holdings are greatly disadvantaged for mobile service, as the maximum area covered by a cell at its frequencies is less 20% of the size that Verizon or AT&T LTE sites can cover at 700MHz.  For fixed residential broadband, this distance limitation would be far less of a liability.

“Yes, but wireless networks are so expensive, operators cannot be cost competitive!”  The big investment for wireless network operators is coverage.  AT&T and Verizon have both built out more than 50,000 cell locations across the U.S. for their 3G networks.  Upgrading a base station to support LTE costs $40-70K and adding a new LTE base station runs just over $100K (Exhibit 5).  If a new cell tower is to be built, that can add $250-500K to the cost, assuming an appropriate location can be secured.  Other one-time costs, such as upgrading backhaul and backbone networks can add further capital items.  So if one is to build a nationwide LTE Advanced network, it would cost well into the billions of dollars.  BUT WAIT!  Who said every network has to provide blanket coast-to-coast coverage?  For fixed broadband purposes, I can roll out LTE Advanced on a patchwork basis, cherry picking attractive communities.  My first cell site will cost me $100-200K to build and will give me up to 100 square miles of coverage assuming that I have a chunk of the 700MHz spectrum block and that I am serving a flat topology.  Once I put up that cell site, I can begin selling to every household in my coverage radius – potentially tens of thousands of households, depending on population density.  I don’t really have to put up another cell site until the first one starts to run thin on capacity, but with up to 2Gbps to divvy up, my economics can look pretty good.  A carrier already providing LTE on a national coverage basis may choose to upgrade to LTE advanced only in attractive residential markets – I suspect most users requiring multiple streams of HD video are not traveling at vehicular speeds – and achieve even better economics than a new build carrier.  Once built, we note that all broadband carriers have the same marginal costs for carrying data – zero.

Adding it all up, we are confident that wireless will challenge wireline broadband.  A decade ago, telephone executives pooh-poohed the idea that cable could ever take 10% of their residential market share, much less the nearly 25% that they have today.  The idea that anyone would drop their fixed line telephone in favor of their cell phone would have been considered ridiculous.  Now, nearly 30% of American adults have done so.  Ask Verizon CEO Ivan Seidenberg who said “I’ve seen the movie” referring to his own company’s struggles to combat its own “cord cutting” against new technology enabled rivals.  The lesson: ignore the relentless march of technology at your own peril.

Nothing To Be Done? Is The Current Valuation Discount for Underwriters Permanent?

Written November 8th, 2011 by

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There has been no appreciable change in the valuation discount that insurance underwriters have suffered in the wake of the 2008 financial crisis. Average price/book ratios for “capital intensive” insurance subsectors, like reinsurers and annuity-exposed life insurers, are 35% below the long-term average prior to 2008, putting such subsectors at risk for trading chronically below book value

While many investors are therefore attracted to insurance as a once in a lifetime value opportunity, it may be more prudent to consider the possibility that this revaluation is “permanent”. Or more specifically, that the revaluation is mostly a market-driven change in risk preference, and thus there may be nothing insurance underwriters can do short of raising ROEs to unrealistic levels

Using several risk-adjusted ways of examining the valuation discount, it is hard to avoid the conclusion that the market has been internally consistent in the sense of assigning a uniformly higher risk premium in the years post-2007

Insurance subsectors that are arguably not capital intensive (e.g. brokers, personal lines), have also been revalued down 35%, literally the same amount as for capital intensive subsectors. But the difference is that these subsectors are still trading above book value on average

The market has revised price/book ratios downward in a way that is statistically consistent with the volatility of price/book, or the beta of stock prices. That is, price/book ratios both pre- and post-crisis lie along the same continuum of price/book volatility and stock beta, both of which are inversely related to price/book

Most interestingly, price/book ratios as related to the ROE Sharpe ratio show only a change in the average level of price/book, whereas the relativity of price/book across ROE Sharpe ratio is nearly unchanged pre- and post-crisis. In other words, the valuation discount is almost totally independent of individual company risk: all companies have been tarred with the same brush

The ROE Sharpe ratio analysis reveals startling details. For example, the average price/book ratio for a 0 ROE Sharpe ratio (i.e. no expected future return above risk-free) has fallen from 1.25 pre-crisis to 0.80 post-crisis. Investors familiar with the life insurance concept of embedded value—e.g. the economic value of all business booked to date, with no future business—may realize that this result is consistent with the market saying that insurance underwriters have moved from a perceived 25% credit to accounting book to a perceived 20% hole

Herein lies a possible way forward for insurance underwriters, although it is such a potentially drastic way forward that it seems unlikely to occur on a wide scale. It seems all but impossible that the average underwriter can raise its sustainable ROE by the 15+ points implied by ROE Sharpe ratios to get back to pre-crisis valuations. But what certain companies might be able to do is ring-fence past liabilities. We are reaching a point where the possibility of running off past business may be the best future course for many companies, even if this is very costly

A qualitative way to think about this is the recent increase in insurance interest by private entities, be these hedge funds or true PE groups. The idea that private investors would need to be the predominant source of intensive capital is fully consistent with our thesis of risk quantunization, and now we are seeing the beginning signs that investors understand this as well

If this is correct, incumbent underwriters need to consider the possibility that investors wanting exposure to future insurance writings, be these a pricing cycle turn in non-life insurance or a new product cycle in life insurance, will bypass companies with possible legacy liabilities in favor of “clean” capital that will not lose 20% of its value immediately once it is injected into a public company. This may be true even for historically strong companies who think they can demonstrate that their liabilities are “manageable”

If you think we are being too pessimistic, such extreme views on past liabilities are not at all unprecedented. Lloyd’s of London was forced to mutualize all of its pre-1993 business in 1996 in order to end litigation and relieve investors of the capital strain from “open years”. While Lloyd’s stated off badly in the subsequent soft market of 1998-2000, in hindsight Reconstruction & Renewal as it was called is largely deemed a success, with the Lloyd’s franchise now greatly strengthened and more disciplined, and restructuring vehicle Equitas now owned by Berkshire Hathaway

It does not seem at all outlandish that many investors may consider old assets and liabilities to be “toxic” post-2007, or at a minimum something they do not want to bother with if there are alternatives. A private investment in a startup vehicle is one such alternative. Although current insurance managements may not see it this way, many investors might put legacy annuity products or long-tailed non-life contracts, along with various well-known asset classes, into the “do not want” bucket. Getting rid of old business perceived to be a capital drag is rewarded in the market, as was recently observed when Genworth sold off an Australian subsidiary

Of all the insurance subsectors, reinsurers may be best able to execute an organized runoff of some past business. The businesses of runoff and commutation are well-established in the reinsurance industry, and for the right price financial runoff might be a desirable investment for PE, as the founder of JC Flowers recently articulated. It is difficult to forecast exactly who might attempt runoff, but general possibility of such an occurrence needs to be on investor’s radar

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