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

We show that: 1) ROW healthcare demand is less elastic than in the US; 2) that the components of ROW demand (volume, price, mix) appear to maintain their relative proportions in upturns and downturns (in contrast, US healthcare demand elasticity is almost entirely a matter of falling per-capita ‘unit’ demand); and, 3) that changes in ROW prices (during downturns) fall disproportionately on high-tech medical imports

Thus non-Rx consumables companies face less demand cyclicality from ROW than US sales (ROW is generally less than 50% of sales; and, healthcare demand elasticity is considerably lower ROW than in the US); and, non-Rx consumables face less risk from an ROW economic downturn than their higher-tech multinational healthcare peers (who are disproportionately subject to falling export prices)

Despite recent outperformance we see further upside to hospitals, who remain well below their pre-2008 PE-forwards (relative to cap wtd healthcare); this implies hospitals ultimately could see further outperformance even if ACA were overturned

We suspect HMOs will underperform as the market prices in increased utilization, though we’re convinced HMOs in fact gain earnings power as the economy improves, and so view weakness as an opportunity to buy. We recommend holding both hospitals and HMOs across the Supreme Court decision on ACA, as the market seems to believe that what (in the context of ACA decisions) is good for HMOs is bad for hospitals, and vice versa

-          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.

What will they be buying?  First, and foremost, Facebook is a company of enormous potential.  We have written extensively about the opportunities potentially addressed by the leaders of the consumer cloud.  (See LINK)  The addressable market numbers are staggering – $4 trillion in brick-and-mortar retail sales, $1.5 trillion in advertising, $300B in traditional media, $150B in financial transaction fees, $100B in consumer services, and so on, and so on.  Against that, Facebook has established a massive global base of 850 million active and loyal users with substantial switching costs that it has only just begun to try to monetize.  Facebook is generating less than $4.50 per year in revenue from each of its users, mostly from advertising, where it is less than 10% the size of its supposed rival, Google, which generates more than $30/year from its users.  Facebook’s 88% YoY sales growth rate suggests that gap is much more a function of the company’s relative youth than to any lack of opportunity.

Facebook is also an outstanding software company with an extraordinary distributed data processing infrastructure.  The company manages one of the world’s largest data bases, allowing a truly global base of 850 million users to make unstructured queries against a staggeringly deep array of user managed information, all at near lightning speed.  This, of course, requires IT talent, which the company has in spades, and infrastructure, on which it is spending at a breakneck pace. Despite the massive investment requirements in human and physical capital, Facebook is enviably profitable, delivering 27% net margins.

Of course, it is not a given that Facebook will execute against the opportunities in front of it, or even if the company will make the effort at all.  Google and Amazon investors will testify to the frustrations of owning stock in companies run by well insulated billionaires who care more about long term growth than about near term profit.  Arguably, Facebook is likely to be even more frustrating.  Post IPO, Mark Zuckerberg will still control 57% of the voting stock of the company.  He reportedly only decided to go through with the IPO after learning that Facebook would have to file financial statements anyway as the total number of investors tipped above the 500 limit.  His letter to investors is a straightforward warning – “Simply put: we don’t build services to make money; we make money to build better services.”  In a quarter where both Amazon and Google blindsided their investors with disappointing results, Zuckerberg is indicating his own indifference, should Facebook feel the need to do the same someday, so be forewarned.

In the end, I think that Facebook will probably turn out to be worth the frustration, but there are some significant strategic hurdles to be breached, many of which are duly noted in the risk section of the S-1.  It does not have a platform at the device level, and must depend on Apple, Google and Microsoft to deliver its users, giving these rivals the first crack at addressing the commerce, advertising, and media opportunities.  Its historically aggressive stance on user privacy could put it in the crosshairs of regulators in many geographies.  It has been curiously passive in pursuing paths to monetization and it faces stiff competition for most of the most obvious opportunities.  Investors loved Facebook when it was a mystery that they couldn’t buy.  It will be curious to see whether they are nearly as enthusiastic once the door is open.

-          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.

Why take this abuse?  Well, it starts with that 35% sales growth, which occurred in a quarter where Europe was melting down and overall retail sales were slightly over flat.  Yes, this is less than the 41% growth that the sell side consensus was expecting, but with companies like Amazon, where guidance is minimal, channel checks are impossible, and there are no real comparables, sell side analysts were basically guessing.  Yes, the sales guidance showed a mid-point that was below the consensus for 1Q12 and equated to just 29% growth, but the sales guidance has been historically conservative, including the guidance for this past quarter, where the “disappointing” sales came in at the high  end of guidance.  Objectively?  34% growth is astounding for a $48 billion retailer in this economy.  The kicker? Amazon has only taken a tiny slice of the addressable $13B global retail market.  That is a LOT of runway.

Amazon has established a WalMart like advantage in e-commerce and is keeping the foot on the gas pedal, building out physical distribution to manage a broad international expansion.  Their Kindle product line is a bold move to vie for leadership in on-line media, not just e-books, but music and video as well, and is establishing a third platform play for the hearts and minds of internet users.  The Amazon Prime program ties into this, tying real e-tail benefits, like free shipping, to media freebies, like free movie streaming, to build the loyalty of their user base and expand the range of products and services it can sell to them.  Amazon Web Services is another way to exploit the company’s massive investment in IT infrastructure and expertise.  All of this offers extraordinary long-term promise, but all of it requires substantial near term spending.

Amazon, like Google and Apple, is a throwback to the days when companies strategized and invested for the long run rather than to beat the next quarter.  IPO-to-be Facebook can be expected to behave in exactly the same way.  The top executives are staggeringly wealthy and insulated by their substantial ownership from investor pressures to deliver short term performance.  Investors have to decide whether or not they are willing to take the roller coaster ride that often accompanies such quarterly indifference.  I think that the long term stakes are more than high enough to deal with the frustration.

Most multichannel TV forecasts assume a stable industry model facing incremental changes that will play out over many years.  We believe that assumptions for robust ARPU gains, higher ad sales, and a stable subscriber base are unrealistic, given high current prices, pressures on consumer budgets, and increasingly strong competition.  A accelerating cycle of a growing on-line audience, increasing internet ad spend, and improving streaming content, fueled by advancing technology is a serious threat to the status quo inherent in these forecasts.  While recent cord cutting has been modest, as the on-line cycle approaches a tipping point where the audience reaches critical mass, we expect the phenomenon will strongly accelerate.  As a result, we remain skeptical of the long term health of multichannel TV and favor companies levered against the eventual move to an on-line distribution model.

Most cable industry forecasts project growing revenues for channelized video from growing ARPU, rising ad dollars, and stable subscribership.  SNL Kagan’s ten year forecast for the cable system operators projects a revenue CAGR of 2.5%.  A big piece of this derives from assuming a 3.7% annual rise in ARPU for operators and 8.2%/yr growth in cable advertising.  Against this, Kagan projects total multichannel TV subscriptions to grow almost 1% a year.  Analyst estimates for public operators suggest that Kagan’s views roughly mirror consensus.

Projections for 40% 10yr rise in video ARPU are aggressive – prices already high, squeeze on HH budgets, on-line alternatives, etc.  Most of the increase in projected ARPU is simply increasing prices, with the monthly cost of basic service rising from just over $50 in 2012 to more than $70 in 2021, with the incremental fee for premium tiers and HDTV assumed as steady.  This assumes that a trajectory that saw multichannel video go from 0.9% of household expenditures to 1.9% over the past decade can continue on to more than 2.5% in the next 10 years.  With rising household costs for health care, education, food and taxes, this seems unrealistic, even without the threat of on-line video.

Non-video ARPU will be sharply pressured by wireless telephony substitution and the poorly appreciated potential of wireless broadband.  Kagan projects cable telephony subscribers to hold steady at ~25M households through 2021 despite rampant wireless substitution – 50%+ of adults under 30 are wireless only (25% of all households) vs. 0% in 2000.  Cable modem subs are expected to grow at a 2% CAGR at flat rates, assuming little to no competition, although next-gen 4G wireless will be able to deliver residential broadband with cost and performance advantages vs. current cable technology.

Trend line forecasting for cable ad revenues greatly understates threat of on-line competition, although 2012 should be strong on campaign spending.   Kagan projects top MSOs to increase ad revenues per sub per month from about $4.75 to $8.50 over 10 years.  Including DBS, telco, regional sports nets and video-on-demand, total industry ad sales is expected to grow at 8.2%/yr.  On-line video advertising, with its precise targeting, is particularly threatening to this aggressive forecast.  While advertising is only ~4% of revenues today, it accounts for 100bp of the forecast growth through 2021.

Multichannel service subscriptions are projected to grow 1%/yr, despite sharply increasing prices and rapidly emerging competitive alternatives.  Cable subscriptions are projected to decline slightly, while DBS and telco TV gain.  This seems inconsistent with rising ARPU, given rising household costs for health care, education and food, and improving on-line alternatives.  Moreover, the explosion of tablets and connected TVs over the past year are likely to disrupt the historical viewing trends behind the projections.  We also believe that the most valuable content will NOT remain exclusive to multichannel distributers – an assertion that we will address in detail in subsequent research.  “TV Everywhere” offerings may sap some early demand for on-line only services, but do not address the increasingly high cost of cable service for consumers or recognize the interest of content owners in nurturing their own on-line offerings.

Shifts in viewership and advertising, and an increasing choice and quality of on-line video offerings will predate cord-cutting, which will accelerate in the back half of the decade.  Cord cutting is a modest trend today, but is likely to grow surprisingly robust with time.  A self-reinforcing cycle has begun by which the growing audience for on-line video is attracting advertisers willing to pay a premium for more certain and targeted impressions.  In turn, programming networks are getting more serious about their on-line offerings, as creative talent negotiates with on-line aggregators and explores developing content specifically for on-line audiences.  This cycle is already accelerating, and, we believe, will spur increasingly serious cord-cutting as multichannel service prices rise and the alternative gets increasingly attractive and easy to access.

On-line aggregators, aggressive network brands, Internet savvy advertising, and talent will win.  The shifting audience and advertising market represents significant opportunity for on-line video streaming aggregators, such as Amazon, Google, and possibly, NetFlix, and for companies positioned to lever existing businesses into on-line video, like Apple, Facebook and Microsoft.  Networks that are aggressive in establishing their channel brands on-line, such as CBS and NewsCorp could also prosper, along with advertising firms that fully embrace the change.  Finally, producers/owners of compelling content will gain greater control over their offerings and thus, capture more of the value.

Multichannel system operators, resistant network brands, and traditional advertising will lose.   The rise of on-line video is unequivocally bad for multichannel system operators, who will also face growing competition in their internet and telephony franchises.  Networks that are slow to establish their brands on-line will also suffer, as will advertising businesses that don’t develop internet expertise

For comparison, we provide our analysis of renewal versus new business for Chubb’s Commercial Lines:

The underlying new business price change in Q4 was about -28%, worse than the -17% for the year.  Recall for Travelers that we calculated  -14% for Q4 and -22% for the year.  But also realize that, with a 56% non-cat loss ratio, Chubb’s average price level in Q4 is about 16% higher than Travelers, with a 65% loss ratio (making no allowances for mix difference).

Chubb is also still releasing reserves, even more strongly than in 2010 (for Commercial, 7 points in 2011 vs. 4 points in 2010).  This is all consistent with our view that Chubb emerged from the 2001-03 pricing cycle with one of the best constructed books of business of any US commercial carrier.  Given an 11% ROE in 2011 with above-average catastrophes and below-average yields, plus a newly-announced $1.2 billion stock buyback, Chubb does not appear to need much pricing, yet here we are.  It is this seeming disconnect from historical behavior that we think bears careful monitoring.

We are doing this calculation of likely new business price changes because we want to remind investors of the quality of this current cycle.  In a “classical” pricing cycle, new business would be going up, too, so what we are seeing is not a typical cycle.  As best we can tell, what we are seeing is a cycle driven by desire for increased profits.  This is very nice, but it’s never happened before.  What is normally needed are much higher loss levels, usually that come by surprise.  Given that we think more upside surprises are likely on the reserve front, we continue to be cautious, but do now think that sustained pricing is more likely in 2012 than we did previously.

Our working theory at present is that enough time has passed from the financial crisis that insurers are more willing to attempt to get price they likely wanted 3 years ago, but were afraid to push for given the financial condition of their customers.  This is tough to prove quantitatively, of course, but trying to find data and metrics to monitor this unusual pricing cycle will be a focus of our research this year.

-          Unlike Amazon and Google, Apple cares about margins and proved it in 1QFY12

-          Set up for a strong 2012 if expectations don’t get too out of hand

-          A successful transition to iCloud is the key to the next phase of Apple growth

After Apple’s odd earnings miss in its September quarter, the company gave bullish commentary for the coming Holidays and investors were left wondering whether the historic pattern of offering comically conservative guidance was over.  Well, it wasn’t.

There’s not a lot to add about the blowout 4Q numbers, which will be parsed ad nauseam by brokerage analysts in their flamboyant victory laps.  iPhone and iPad were huge sellers for Christmas, particularly overseas, where Apple is aggressively expanding its brand footprint.  Apple doesn’t have to deliver groundbreaking innovation to drive sales – the iPhone 4S was considered a mild disappointment by analysts expecting an iPhone 5, but it didn’t matter, even with hot products on the Android platform doing well in their own right.  More carriers, more stores, more revenues – in spades.  Apple, unlike its Internet-era running mates Amazon and Google, cares about its margins – read Adam Lachinsky’s “Inside Apple” for details of its unusual parsimony – and served up gross margins of 44.7%, up almost 600bp YoY.  Guidance for March is probably intended to be very conservative.  A new iPhone and iPad expected later this year will very likely be wildly successful, with fanboys camping out for first day bragging rights.

In the longer term, the big quarter doesn’t tell us much.  Management noted that 85 million users had signed up for iCloud, although critical reaction to the product has been mixed.  The success of iCloud – meaning active, committed users, not just sign ups – is crucial to the next phase of Apple growth.  Ultimately, the prize is establishing Apple as a comprehensive, integrated entryway to EVERYTHING that its users do on the Internet, with huge e-commerce, advertising, service fee, and transaction charge opportunities in the balance.  Over the next few years, the massive growth in tablet and smartphone sales will taper down and competitive products will erode iPad market share, just as Android smartphones have overtaken iPhone.  However, if Apple can establish iCloud, it won’t matter at all.

It was a major point of contention last quarter that Travelers was reported increasing renewal pricing, yet its combined ratio deteriorated even excluding catastrophes and reserve development.  In Business Insurance, where Travelers reports sufficient data to attempt this analysis, the Q3 non-cat accident year loss ratio (AY LR) was 68.9% vs. 62.3% in Q3 2010.  Although Travelers reported renewal premiums increases of 4%, the implied underlying new business price change could have been a decrease of as much as 40%.

This quarter looks much better, and Q3 looks more like a fluke.  We have attempted the same analysis, using Travelers supplements and disclosures, for both 2011 Q4 and the full year.

The headline result for Q4 was 6% average renewal pricing across Business Insurance, with pockets as high as 8% in Commercial Accounts, for example.  But unless one is in a raging hard market, it is usually the case that new business will get a decrease on average.  That was still the case in Q4, but the results look better than Q3, and trend over the year looks good.  We estimate about a 14% new business price decline, averaging to a Q4 total nominal price change (new and renewal) of 1.7%.  The was an improvement over the full year, where assuming an average renewal price change of 3%, we get an implied new business price decrease of -22%, and -1.5% total price change.  So the average price change across all business in Q4 is 3 points better than the full year 2011.  That’s a big improvement.

Keep in mind that this analysis is rough, but hopefully reasonable.  The 3% assumed loss trend is a plug.  We have no ability to adjust for large losses or other distortions.  And the numbers we are pulling off of various Travelers graphs themselves are estimates.  Still, the direction of change looks good.  Travelers believes they will begin to see underwriting margin improvement in the first half of 2012, and we think this more likely that we would have 12 month ago.  Until and unless our forecast for re-emergence of favorable prior year development occurs, the trend looks to be for higher pricing near-term.

US healthcare demand has slowed for almost entirely cyclical reasons; 2010 was a 50-year low for the cyclical components of demand (per-capita ‘units’ and ‘mix’). Improvements to volume and mix are more likely than either continuation of the 50-year low or further declines; this augurs well for volume-sensitive healthcare sub-sectors generally, and hospitals specifically

In addition to poor volume / mix, hospital valuations imply weak pricing; in contrast we believe the aggregate price trend across all payors (Medicare, Medicaid, commercial) is at least stable, and in fact may improve

Hospitals have rising commercial pricing power as 2014 approaches; assuming the Affordable Care Act (ACA) remains reasonably intact, health plans hoping to participate in 2014’s enrollment gains need premier hospitals in their networks more than they need to control these hospitals’ prices. 2014’s marginal enrollees are likely to have been un- or under-insured beforehand, and so are unlikely to be familiar with local health plans. These same potential enrollees are likely to be very familiar with higher-profile local hospitals; and the presence or absence of preferred hospitals should have a large effect on which plans new enrollees choos

This dynamic appears to have played out during Massachusetts’ ’07 – ’09 reform-related enrollment expansion; across this period MA teaching hospitals had greater margin gains than both their smaller MA peers specifically, and the nation’s hospitals more generally

We believe hospitals as a group are undervalued, and their near-term fundamentals underestimated; accordingly we believe the group should outperform the broader healthcare index. The primary risk to our call is that the Supreme Court dismantles ACA sufficiently to reduce the likelihood of 2014 enrollment gains, thus reducing hospitals’ commercial pricing power, not to mention the adverse effect this would have on longer-term expectations regarding both patient volumes and uncompensated care

The main outcome of this analysis is that we are changing our Short-Term Qualitative View on Reinsurance to Neutral from Positive; the rest of our View remains unchanged.  We would play any pricing cycle improvements through P&C Specialty in particular, along with P&C Multiline and P&C Commercial (both Short-Term Positive).  P&C Specialty has the potential to benefit from both insurance and reinsurance pricing improvements

Reinsurance looks less likely to turn pricing expectations into subsequent premium growth, even though reinsurance property pricing (5-15%) seems more likely to absolutely exceed estimated commercial insurance pricing (3-8%).  This is consistent with what happened after the large catastrophe losses of 2005, which was also disappointing for reinsurance stocks.  In addition, reinsurers were more capital constrained than expected in 2006, inhibiting growth.  Current low price/book ratios put a constrain on capital raising ability, which is a ratings consideration with respect to growth potential

In contrast, we think the current primary commercial environment has some similarities to 2000, where companies with non-life exposure strongly outperformed (15-95%) while starting to modestly raise price.  Of course, much of the performance is related to the collapse of the “tech bubble”, but we increasingly think that the “tech bubble” spurred on some of the late 90s soft market, leading to the “exhaustion” of the 2000 market and subsequent single-digit price increases, similar to the situation today.  Reinsurance did well during this period also, but the change in risk perception over the last decade means we need to shift to lower-risk opportunities

P&C Specialty represents something of a “sweet spot”, with both exposure to insurance and reinsurance, without the capital intensiveness of pure reinsurance.  The highest quality reinsurers may be more likely to generate premium growth than their peers (e.g. RNR, PRE), but even these companies tended to lag more specialty-oriented companies (e.g. AXS, ACGL) in similar situations

Please keep in mind that analyses of pricing expectations leading to premium growth are shorter-term in nature.  We expect favorable commercial pricing expectations to persist until our forecast of higher than expected reserve adequacy manifests itself, which could well happen this year.  But until this happens—and timing such a forecast is very difficult—it seems better to bet that the current favorable commercial pricing momentum will continue

-       Google miss may portend general economic weakness, but long term position is still extremely attractive

-       Strong Intel sales curious given PC weakness reported by others, we’re still skeptical long term

-       Microsoft gets strength from Xbox, beats despite weak PC biz, positioned for a play for the consumer market

-       IBM is IBM, playing both sides of the game and winning on execution

Four tech bellwethers reported, three beats and one miss.  Google delivered sales growth of 25%, obviously strong but disappointing relative to 33% YoY growth in the previous quarter and expectations that the company would deliver more of the same.  While reasons abound for the shortfall – exposure to Europe, currency issues, a drop in click-through ad pricing – the concern is that the biggest issue is a softening advertising market that could portend weakness in the broader economy.  Meanwhile, profits grew just 7% in the quarter after a 26% jump in Q3, as expenses outgrew revenues by more than 1000bp.  The naysayers will see these results as prima facie evidence of Google’s inability to monetize its prodigious investments and project a further downward spiral in 2012.  The believers will shrug off the quarter as hanging on short term market conditions and anticipate long-term payoff for the company’s aggressive strategy.

We are inclined to remain with the believers.  Google’s long-term objectives – e.g. greatly expanding its share of the $1.5 Trillion global advertising market and establishing beachheads in e-commerce, mobile payments, streaming media, amongst other huge and lucrative markets – are grand and achievable, and one quarter, particularly one that still delivers 25% growth against a tough compare in a difficult global economy, is not enough to establish a different trajectory.

In contrast, Intel turned in an excellent quarter of its own, with similar sales growth (+21% YoY) and and EPS growth (+7% YoY) to Google with a significantly smaller PE.  We have been critical of Intel’s long term position against a market that we believe will turn sharply toward mobile platforms.  We have also been skeptical of forecasts for continued growth in the PC market dominated by Intel’s x86 platform and a cash cow for the company.  In Q4, chips for client PCs jumped 17% in the face of concerns that disk drive shortages due to flooding in Thailand would disrupt demand.  Apparently not – although concerns remain of inventory corrections in 1H12.  Despite the strong results, we are not enthusiastic about Intel’s positioning for the future.  Overall PC market forecasts continue to be adjusted downward, progress by Intel in the tablet market is spotty, and opportunities exist for ARM based architectures to make incursions into the lucrative server market.

Microsoft’s beat came against fairly tepid expectations.  Sales for the quarter were up 5% and profits were up 1%.  Notably, Windows sales were weak, down 6% YoY, seemingly counter to Intel’s robust client PC chip sales and probably a cleaner take on actual PC demand for the quarter without share shifts or inventory levels to account for.  The big upside came from Xbox, which is intriguing.  We believe Microsoft has the potential to integrate its mobile and consumer businesses to establish itself as a credible alternative to the Apple and Google hegemony.  Xbox is an important but unsung weapon in this, as offers an end-run onto the living room TV for tens of millions of households.  Content deals cut for Xbox could extended and integrated for Windows Phone and Windows 8 devices.  We are cautiously optimistic at the chances.

IBM saw sales up just 2%, slightly missing expectations, but blew past earnings estimates and posted 11% growth in operating income on improved efficiency, continued shifts to higher margin software and services and share buybacks.  We are skeptical that the strong enterprise data center investment cycle will keep its pace in 2012, and believe that a long-term shift to the public cloud will propagate hardware commoditization and open source competition in software.  IBM will feel these changes, but has also positioned itself as a leading cloud host and IT consultant, businesses that will thrive even as its more traditional offerings are under threat.