Archive for February, 2012

Bipolar on the P&C Pricing Cycle

Written February 29th, 2012 by

Our stance on P&C underwriters in 2012 is decidedly “bipolar”, with a Short-Term Positive View on most commercial P&C subsectors, but a Negative View Long-Term.  This contrast all hinges upon assessment of the evolving commercial lines pricing cycle

Short-term, there are reasons to be positive beyond the optimistic management commentary and renewal disclosures: 1) premium levels are depressed versus GDP in a way comparable to past bottoms (1984, 2000); and 2) reported underwriting returns considering low interest rates are consistent with the premium/GDP metric

But digging deeper, these metrics do appear to be short-term biased: for example, if we smooth catastrophes to long-term averages, 1984 and 2000 still look like cycle bottoms, but 2011 no longer does, better resembling shorter-term cat-driven cycles like 1992

The disconnect seems driven by loss reserve adequacy: we estimated 2010 year-end US loss reserves were $19 billion redundant, and using available 2011 data, year-end 2011 will likely still be redundant by $10 billion.  To be consistent with 1984 and 2000, we’d need more like a $50 billion deficiency (~10% of premium) to get a comparable cycle

Reserve adequacy is a key pricing indicator, as reserve deficiencies almost always result in big price increases about 3 years after the first deficient accident year is booked.  So far, we do not even think 2011 has been booked deficiently, resulting in 2014-15 as our best estimate for when reserve can be deficient enough for a classical turn

Company-level reserve adequacy appears very dispersed, meaning the industry may no longer move together: we examined general liability (GL) at the company level, the most redundant single line and very important to the pricing cycle; several large companies (e.g. CB, TRV in P&C Multiline) appear to have GL adequacy much higher than the average

For the near-term, we would favor subsectors with high perceived safety, like P&C Multiline and Brokers, which have low reserve risk and may even show upside to consensus (i.e. Brokers get top-line leverage to pricing sooner, Multiline reserve adequacy potentially boosts earnings).  P&C Specialty would be a good choice for investors wanting more near-term leverage to the cycle and are willing to take on additional potential balance sheet risk

Interestingly, some analysts and investors are becoming concerned about potentially weaker reserve releases hurting earnings.  We hold the opposite view: there may be upside short-term, but ironically this is what could ultimately derail current pricing, thus driving our more negative long-term view—i.e. a “real” cycle bottom by 2014-15 or so

Quick Thoughts: Apple Doomsayers – Way Too Early is the Same as Wrong

Written February 28th, 2012 by

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http://www.nytimes.com/2012/02/25/business/apple-confronts-the-law-of-large-numbers-common-sense.html?_r=1&scp=4&sq=apple&st=cse

http://www.nytimes.com/2012/02/27/technology/apple-riding-high-but-for-how-long.html?pagewanted=2&_r=1&partner=rss&emc=rss

 

As Apple flirts with a $500B market cap, media attention seems to have shifted from speculation on what the company might do in the post-Jobs era to scouring the company’s foundation for cracks.  The New York Times seems to have taken the lead on fanning the flames of worry with the two widely circulated pieces linked above, but the usual suspects – The Wall Street Journal, CNBC, Forbes and Bloomberg amongst them – have weighed in with similar sentiments, as though gaining the top of the market cap list carried a jinx akin to a Sports Illustrated or Madden NFL cover.

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Large Cap Pharma’s Dependence on US List Price Growth is Unsustainable

Written February 26th, 2012 by

List price increases account for 48% of real US pharma sales growth since 1980, and roughly ½ of global returns to R&D spending since 1990. More recently eroding mix has compounded reliance on real pricing, which drove 145% of real US sales growth over the last half decade

Despite the average real price of a US Rx having grown nine-fold since 1980, because 3rd-party payors absorbed all drug inflation the average household’s out-of-pocket (OOP) spending on prescription drugs has remained constant

Because drug consumption is highly concentrated, 20% of total spending is accounted for by only 1% of persons, and 70% of drug spending by 10% of persons, who spend as much OOP on drugs as on housing (top 1%) or groceries (top 10%) respectively

Fixed dollar co-pays have grown much more slowly than drug list prices, but co-insurance forces OOP expense to grow at the faster rate of drug list price. 34% of employers offered co-insurance based drug benefits in 2011, up from 13% in 2008

Also, where beneficiaries with fixed dollar co-pays are agnostic to list price differences across more or less interchangeable brands, beneficiaries with percentage co-insurance are sensitive to these differences. We show that brand prices within therapeutic categories are fairly diverse, and that this spread of prices should narrow toward the low end of each therapeutic category’s range as co-insurance becomes more prevalent

Large cap pharma share prices imply a return to (albeit modest) growth following the near-term period of intense loss-of-exclusivity (LOE). This implies real pricing power is as available going forward as in the past; and/or, that volume / mix gains can offset weakening real pricing power. We believe real pricing is simply too large a growth driver to be replaced by any foreseeable combination of volume / mix, and accordingly believe mid-term (+/- 2014) estimates and share prices are too high. AZN, BMY, and LLY are more at risk than their average peer; Roche, SNY, GSK, and ABT are less at risk

We continue to prefer volume-sensitive healthcare sub-sectors, particularly hospitals and non-Rx consumables; and, we continue to be bearish on the drug trades generally and PBMs specifically

Quick Thoughts: Comcast Gaining Speed but Runway is Short

Written February 16th, 2012 by

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-          Comcast’s 4Q11 results were strong, driven by rising pricing and increasing penetration of high speed internet service, and economic recovery, election year ad spending and the summer Olympics could fuel further momentum in 2012.

-          However, deceleration in video subscriber losses is NOT evidence of long term resilience to over-the-top and eventually, cord cutting.

-          Relentless cable price hikes and shifting ad dollars could hasten a transition to on-line video.  TV Everywhere is a short term defensive play that will not stop churn once competitive solutions gain traction.

Comcast’s 5% jump on its 4Q11 numbers capped a three month run that has added more than a third to company’s market value.  Analysts viewing the results cheered the slowing of subscriber losses, which seems akin to wordsmithing a deceleration of the growth in the government budget deficit as a deficit cut.  Some of the slowing in disconnects is seasonal, some of it is a sign of better economic conditions, and some of it may be fewer customers “cutting the cord”.  I agree with Comcast management in so far as I believe that most of the video customer losses since 2008 were driven by economic choice, but question whether or not we can expect to see most of these erstwhile customers back for more $73 per month and rising video service once the household larder is a bit more full.

Moreover, as I have written (most recently HERE), I think that the wave of cord cutting has yet to really begin.  Tablets and connected TVs may seem like old news, but the iPad was only introduced 22 months ago and the penetration of connected TVs is only now starting to get interesting.  The growth of the audience on-line, combined with increased internet video advertising spending and the availability of new on-line content are the more relevant indicators of future viewership, and all are moving rapidly to the detriment of the traditional cable model.  Ultimately, the cable orthodoxy of paying up for content and jamming the costs down on consumers – Comcast monthly video bills were up nearly $3 YoY to $73 – will only exacerbate the problem and hasten the day when cord-cutting really becomes a problem.

Comcast is also taking price in its high speed internet business, hiking its average rate 3% to $41/month.  Given that 70% of Americans have no viable alternative for broadband, the increase was absorbed by consumers, with Comcast’s total cable modem customer base rising 7% YoY in the face of the economic headwinds that are the fallback excuse for the subscriber losses on the multichannel video side.  I note that the ratio of broadband customers to video customers has risen from 74.5% to 81.2%, a reflection of the amount of runway left for penetration growth in the high speed internet business.  I am on record with a prediction that meaningful competition from wireless broadband will emerge within the next 5 years, and that a continued strategy of banging through price raises ahead of inflation without corresponding investment for performance improvement will bring regulatory scrutiny that the industry has been, thus far, able to lobby away.

A few comments on TV Everywhere.  Comcast’s Xfinity service offers internet access to a broad library of previously aired television content from many of the most popular channels on its flagship cable service.  With a recent agreement with Disney, Comcast now has full access to ABC and cable networks like ESPN and the Disney channel, with rights to stream the content live to its Xfinity subscribers through 2022.  This service is meant to beat the cord cutters to the punch by integrating on-line access with the traditional cable experience, undercutting alternatives by giving it away free (provided you maintain that $73 a month subscription).  While this may rob on-line video streamers of potential customers just looking for a way to get cable content on their portable devices, it does little to slow the migration of users dissatisfied with the relative utility of the cable bundle, particularly as rising content costs force adherence to a pricing trajectory well ahead of inflation.  The average cable video bill is already almost 2% of average household income in the US and the public reputation of cable companies for customer service is comically low.

I also note that not all network operators have been as enthusiastic as Disney/ABC in passing the keys to the kingdom, nor are the on-line content deals exclusive to Comcast.  Moreover, the networks themselves are content buyers, and will pay higher fees themselves to producers and talent for the control of programming, even as these creators test the waters of going directly to on-line aggregators for distribution.  Advertisers will also have their say, accounting, as they do, for two thirds of the money flowing to content networks and facing their own enticements to shift priorities to on-line with its superior targeting and interactivity.

Of course, most of the issues that concern us about cable MSOs in general and Comcast in particular are relatively long lead time items.  As such, the good results of 4Q11 could persist for a few more quarters.  In the near term, the on-line audience and advertising flow is still very small relative to TV, the economy is showing some signs of life, and the combined impact of a presidential campaign year and the summer Olympics should juice advertising.  Assuming subscriber losses remain manageable, a rising tide of revenue could carry the day for 2012.  However, longer term, I believe cable becomes an undifferentiated dumb pipe in a price competitive, asset intensive business.  The question is: how long will it take to get there?

Life Insurance in 2012: Jumping a Big ROE Hurdle

Written February 16th, 2012 by

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Given the strong start for life insurance stocks in 2012, it is important to re-examine our Short-Term Neutral View on the life insurance subsectors.  In this note, we conclude that the Neutral View remains appropriate, owing to a decline in core return on equity, as well as measurable increases in the cost of equity subsequent to the financial crisis

Using US industry statutory data, we examine the components of return on surplus (RoS) both prior to (2003-07) and subsequent to (2010-11) the financial crisis.  Average RoS has declined 300 bps, driven by sustained lower interest rates (130 bps) and structurally lower operating leverage (160 bps) as companies sought to raise capital and reduce risk.  At least in the short-term, these factors seem difficult to control at the company level

The 300 bps decline in industry RoS is mirrored by a comparable decline in GAAP ROE for mid- to large-cap life insurers.  We use a DCF-type model to estimate the change in discount rate pre- and post-crisis that reconciles ROE with average price/book.  We conclude that life insurers face 390 bps on average in higher cost of capital post-crisis, owing to the higher asset and liability risk revealed in 2008-09

The combined 690 bp net increase in ROE hurdle needed to support valuation represents a high hurdle for investors looking for investment opportunities in life insurance, in our view.  If one holds the view that the apparent increase in life insurer cost of capital is transitory, there may be many more opportunities than we think are available.  We think it would be more prudent to focus on those areas where there is a higher probability to improve ROE

At the company level, Life-Investment “value” plays (e.g. LNC, GNW, HIG) seem more challenged to improve ROE near-term, owing to the stress taken during the crisis.  In contrast, the lower-risk Life-Other names (AFL, AMP) already have post-crisis ROEs above the pre-crisis level.  Neither group seems likely to see near-term decline in risk premium, absent a market event

Some Life Investment names—MET in particular and PFG to a lesser extent—may have a higher probability to increase ROE near-term.  Even a recovery of one-half the post-crisis ROE decline (350 bps for MET, 200 bps for PFG) could result in meaningful price/book improvements (on average 100 bps of ROE or cost of capital equates to 0.1 points of price/book)

Our Long-Term Views on the Life Insurance subsectors remain unchanged.  We remain Long-Term Negative on Life-Investment, owing to insufficient change in the core asset and liability challenges of variable annuities and their associated guaranties, which are not likely to be full addressed absent another crisis.  Conversely, we have a Long-Term Positive View on Life-Other, given its lower risk profile and higher innovative potential, both of which increase of the probability of eventual decline in market risk premium

The Future of Video Advertising: Three-Screens, #hashtags, and Streams

Written February 13th, 2012 by

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The 2012 Super Bowl may have been a turning point for leading edge advertisers in embracing hybrid campaigns across multiple screens and media.  However, the balance of the market still tilts toward traditional TV ads, partly because the analytical metrics used to evaluate advertising alternatives do not yet adequately address the realities of modern media consumption.  The Nielsen Company and others are pursuing audience measurement solutions that more accurately assess the value of viewer impressions across devices and media.  We believe that these solutions will serve to highlight the value of the on-line impressions, likely at the expense of traditional TV.  Over time, this could mean a meaningful shift in advertising, weakening the value of channel brands and amplifying the opportunity for streaming video and social media.

Quick Thoughts: Why Not Spin Off Hartford’s P&C Business? Because Life Might Be Nearly “Zero”

Written February 8th, 2012 by

Insurance is not generally known for heated exchanges publicly aired.  Yet this is exactly what we got this morning on Hartford’s (HIG) Q4 earnings conference call.  About 55 minutes into the call (and we do recommend listening to the playback if you missed it), a well-known major (largest, actually) shareholder angrily challenged management to take more seriously the idea of spinning off the P&C unit of Hartford in order to realize more value.  Specifically, he cited the research of a competitor firm that suggested up to 70% appreciation in the value of the P&C unit in the case of a spin-off.  Hartford themselves brought up the idea in a presentation slide, but their determination was that many “challenges” existed that currently rendered the proposal unfeasible.  The irate shareholder faulted management for not figuring out ways to overcome the “challenges” to accelerate value creation.

After the drama had passed, we realized that this debate connects to some major research conclusion of ours.  Put simply, the reason why Hartford is likely reticent to consider a spin-off is that it implies the Life company may be worth nearly “zero”.  In fact, the idea that a breakup will actually unlock value is debatable.  Let us first note that we have not done any kind of detailed breakup analysis on HIG.  But it is not difficult using public data to perform a quick sensitivity analysis that suggests a simple “sum of the parts” is rather consistent with current depressed insurance valuations.  It is not clear why HIG would attract a premium multiple on P&C given current market conditions.

We started with HIG’s year-end financial supplement.  HIG has long provided detailed splits of income and balance sheet into Life, P&C, and Corporate segments (which makes breakup analysis more feasible than it might be for some other companies).  We took year-end book value per share and allocated the Corporate segment proportionally by book value to Life and P&C.  Note that HIG specifically noted that such an allocate was not feasible: Corporate is mostly debt, and HIG noted that Life could likely not support more than 1/3 of the debt to maintain ratings.  But we are attempting to estimate implied market value by segment, so it makes sense for us to do the allocation proportionally and show the debt strain on Life.  Using yesterday’s closing price of $19.12, this equates to a 40% price/book for the whole company.  We first assume this valuation applies to both Life and P&C, but then apply the suggestion that P&C could be worth 70% more standalone.  This would assign a suggested price/book ratio of about 70% to P&C, which seems rather conservative but is entirely consistent with the low end of current P&C valuations.  Assuming the market has the total value of the company “right”, this would assign a price/book of 23% to Life.  This is comparable to a peer like Genworth (GNW), another very troubled life insurer.  Finally, if we assume that the Life companies is worth “zero”, it would imply a P&C price/book ratio of 105%, which is not unreasonable and consistent with the current depressed valuations of “quality” P&C companies like TRV or ACE.  We lay out all these calculations in the following table.

 

 

 

 

 

 

 

 

 

 

 

 

Sources: Company Reports, Sector & Sovereign Research Analysis

 

Once again, we stress that we have not done any kind of detailed breakup analysis.  It is certainly likely that many different assumptions could be brought to bear.  But it does not seem unreasonable to test the idea that, if something like the notion of 70% upside to the P&C unit is already “in the market”, what this must imply for the Life company.  There is no reason, in our view, to assign any kind of premium valuation to HIG’s P&C unit, unless you want to argue that all P&C companies are undervalued, which is not the intent of this analysis.

This is important in the context of our overall research.  It is our view that the current investor pool is highly skeptical at best, and outright unwilling at worst, to support the legacy assets and liabilities of life insurers, in particular variable annuities (VAs).  In such an environment, it simply may not be possible to break up a company like Hartford without lining up runoff capacity to assume the legacy VA book.  Hartford brought up this possibility themselves, but likely in the context of no breakup as they would need the P&C balance sheet to support that decision.  For a breakup to work, it might be necessary to find investors to take the legacy VA book, and it is not inconceivable that such a buyer would demand nearly all of the capital of the existing Life company.  But ironically, once freed of the VA book, the successor Life company might be better able to raise fresh capital!  All this is very complicated, and a big step that current management might be unwilling to take.  We discussed the topic of “selective runoff” in Nothing To Be Done? Is The Current Valuation Discount for Underwriters Permanent?  We thought such actions would take a long time to play out.  But this morning’s Hartford soap opera suggests that such considerations may need to be accelerated by managements—or the market will do it for them.

Our current Long-Term Qualitative View on Multiline insurers (i.e. those with roughly equal amounts of life and non-life business) is Negative, precisely because we think the strategy is no longer appropriate given investor preferences for greater company focus.  An eventual breakup of a company like Hartford is exactly what we would expect at some future date.  But as the above analysis demonstrates, this might not be possible without considerable pain.

The Pro-Cyclical US Healthcare Thesis – Impact of ROW Economic Risks

Written February 5th, 2012 by

US healthcare demand growth is slow for cyclical reasons; this implies an acceleration of US healthcare demand as the broader economy improves; we recommend hospitals (e.g. HCA, UHS, THC), HMOs (e.g. UNH, WLP), and non-Rx consumables (e.g. BAX, BDX, COV) as pro-cyclical bets

Hospitals and HMOs obviously are US-focused; however non-Rx consumables generally are multinationals with exposure to export market risks, forcing the question of whether ex-US (especially EU) economic risks outweigh pro-cyclical upside in the US

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Quick Thoughts: And You Thought Amazon and Google Didn’t Care About Investors

Written February 2nd, 2012 by

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-          Facebook S1 reveals sales a bit lighter than many thought, but very strong margins

-          The addressable market could be huge IF Facebook decides to go after it

-          Zuckerberg’s letter reveals his indifference to short term profitability

 

So Facebook finally filed its S1, filled with titillating financial tidbits and blog fodder.  All signs post to full subscription at a robust final deal price, with anticipation building over many, many months of Zuckerberg footdragging and displaced enthusiasm driving interest in imperfect Facebook surrogates like LinkedIn and Groupon.  On some day, in April or May, investors will finally get their chance.

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Quick Thoughts: Amazon Still Don’t Care About Your Quarterly Results

Written February 1st, 2012 by

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-          34% organic growth for a $48B retailer in this economy is objectively strong, even if it is short of analyst guesses

-          Amazon (and Google and Facebook and Apple) are playing for multi-trillion dollar markets

-          The long term potential more than makes up for the short term frustration

 

The frustrations of an Amazon investor are abundant.  Management does not really care about you.  Guidance is terse and often inaccurate.  Margins bounce around the waterline as unspecified investments in physical, intellectual, and human capital clog the income statement and pile up on the balance sheet.  Sales growth is objectively outstanding, but zigs and zags, rendering the terse and inaccurate guidance all the more maddening (Exhibit 1).  New products are designed with an intention to sell at a loss to be made up for by the future media sales they inspire. The exact sales of these products and their impact on margins is unspecified, although intentionally vague statistics are offered that make it seem like an important factor.   4Q11 is more of the same.

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