-       The Facebook IPO has priced at $38, at the high end of its revised range, representing a market cap of $108.6B, assuming exercise of vested options.

-       The price is about 26 times trailing revenues and 104 times earnings, which discounts 66.2% compound annual growth over the next 10 years.  In comparison, Google grew at a 42.4% CAGR in the 8 years after it hit the $4B revenue milestone.

-       As consumer Internet use shifts decisively toward mobile platforms, Facebook’s ability to monetize their position is constrained by the control that Apple and Google have over 3^rd party Apps.

-       GM’s repudiation of its Facebook ads is also troubling, calling into question the efficacy of ads, even on the browser platform.

At $38, the outstanding shares of Facebook will yield a market cap of just over $81B, but adding in employee options vested but not exercised adds another $26B to the total, bringing the practical value of the company to a whopping $108.6B.  Revenues over the past four quarters were $4.1B, up roughly 90% YoY, making the sales multiple a healthy 26 times trailing.  This valuation implies a 10 year growth rate of 66.2% at constant margins.  To put this in context, Google passed a $4B annual run rate in mid 2004, and has grown at a 42.4% CAGR in the 8 years since.  Without doubt, the expectations for Facebook are robust, if not realistic.

On the desktop, consumers access Facebook through a neutral browser, opening the site and, typically, keeping it open as a tab for most of the day.  This mode allows Facebook opportunity to extend the set of activities of its users within its own boundaries, track their behaviors, serve them advertising and sell them things.  Unfortunately for Facebook, Smartphones and Tablets appear on track to supplant PC browsers as the dominant access platform for consumer Internet usage.  Unlike PCs, mobile platforms feature Apps to access web-based services directly, bypassing the browser.  For a iPhone, iPad or Android user, Facebook is an App to be opened as needed and closed again when not in use.  This gives the platform master – e.g. Apple, Google and Microsoft– enormous advantages over the 3^rd party App publisher.  First, the platform master may decide to integrate some of the functions addressed by the App directly into the OS or to include an alternative App as a default shipped with the device.  Of course platform masters favor their own Apps, or Apps by companies willing to pay a fee for the privilege.  The platform masters will also take a portion of App revenue and may limit the ability of Apps to link to other revenue generating services.  Moreover, the platform masters can address the user FIRST, serving ads and offering services before they click on the App.  Facebook already generates revenues from games and has hopes of extending into streaming media – this will be very difficult to accomplish on mobile platforms controlled by their biggest competitors.

Facebook has acknowledged its difficulty in delivering effective advertising for its Apps, pointing the constraints of a smaller screen size and a more time sensitive user.  General Motors, one of the largest advertisers in the world with sophisticated resources for evaluating its advertising, announced this week that it would discontinue its $10M annual program with Facebook.  Given the tiny size of this program within a multi-billion dollar annual budget, it seems unlikely that GM would go to the trouble to cut it without clear reasons.  It may be that embedding advertising into social interactions is not nearly as effective as tying it to search or to transactions.  If so, Facebook needs to find a mechanism to apply its vaunted social graph to an application that finds users in a mood to shop, not easy when options are constrained by the App model.

This adds to my skepticism over Facebook.  The company has been flirting with investors for a long time and perhaps the thrill of finally consummating a long distance infatuation upon the IPO will be too much for investors to resist.  I’d rather spend my time with the platform masters.

The crucial distinction is between rising utilization for the average American, as compared to rising utilization for the average commercial beneficiary. As more households gain employment, household incomes rise, and households shift from less generous (e.g. un-insured, Medicaid) to more generous (e.g. employer-sponsored) forms of health insurance. It’s this national shift of households from under-employed, under-earning, and under-insured to normally employed / earning / insured that drives growth in utilization for the average American

The average commercial beneficiary is a different thing altogether. The modal commercial beneficiary has been employed before, during, and since the recession, and her levels of income and health insurance have not greatly changed. The marginal (new employee) commercial beneficiary will consume more than he did when under-employed and under-insured (driving national average utilization higher) – but less than the modal commercial beneficiary who’s been in the risk pool throughout the economic cycle. Thus the average commercial beneficiary isn’t really exposed to what’s driving utilization at the level of the average American

For completeness’ sake: rising consumer confidence, including among the constantly employed (i.e. commercial beneficiaries) does increase healthcare utilization, but this effect is smaller than that of shifting households to higher incomes and better health insurance, and in the context of HMOs’ margins more than offset by the benefits of rising enrollment

It’s not all good news; turning to the longer-term, we now believe integrated health networks (IHNs) will take a large chunk of enrollees from the commercial HMOs if the Affordable Care Act (and in particular the individual mandate) is upheld. This is plainly an incremental negative to our fundamental view, but there’s room for this news at current valuations

Ahead of the Court’s ruling, we believe fair value for commercial HMOs is roughly 0.9x the S&P 500 – a 50:50 weighting of fair values if the individual mandate falls (1.0x the S&P 500) or survives (0.8x the S&P 500). At current prices, the commercial HMOs trade at 0.76x the S&P 500 on FY + 1 consensus earnings, and 0.63x the S&P 500 on FY + 3

Perhaps worse for Progressive, its main rival for growth, GEICO (part of Berkshire Hathaway), has exceptionally strong Auto reserve adequacy at about 17% of 2011 earned premium.  So it seems more likely that Progressive will need to unilaterally strengthen reserves in the near-term, putting its earnings at somewhat of a risk versus peers

All together, this analysis supports our Short-Term Neutral View on P&C Personal: there is not enough stress to lead to a pricing cycle near-term, but neither do we see enormous competition in the offing

As a side benefit, we completed full company and line reserve analyses for the 5 public companies in this review: Berkshire, Progressive, Allstate, Travelers, and Hartford.  Berkshire’s overall reserves are as exceptional as its Auto book, about 18 points redundant, with no individual lines significantly deficient.  The other 4 companies have seen reserve deterioration over the past 4 years, and now are all within the statistical range of no redundancy or deficiency

Current-quarter pricing can be even more closely estimated (average error < 10 bps) by simply aggregating and weighting monthly healthcare price indices. Combining separate unit and price growth regressions, we model current-quarter demand growth to an average error of 39 bps, again before healthcare earnings are reported

Independent of these demand rate regressions, but also using intra-quarter economic data, we can handicap the likelihood of the demand trend accelerating or decelerating. Ignoring odds and considering only whether the model points to acceleration or deceleration, we correctly predict trend changes with 80% accuracy.

Incorporating the model’s estimate of trend break odds, trend breaks handicapped with odds ≥ 0.75 were 94% accurate

We plan to offer two estimates of demand growth rate (and trend break odds) during each quarter; the first (preliminary) estimate at roughly mid-quarter, and the second (revised) roughly two weeks following the end of the calendar quarter, but before the release of (most) healthcare earnings

Our preliminary estimate of 2Q12 growth in US healthcare demand is 3.1%, the product of 1.4% growth in unit demand and 1.7% medical inflation. The odds of 2Q12 annual demand growth decelerating relative to the 1Q12 y/y rate are 11%

We continue to recommend a pro-cyclical and pro-US tilt to healthcare portfolios; favored subsectors include Hospitals, non-Rx consumables, and HMOs

Recognizing that both Hospitals and HMOs face binary risks from the pending Supreme Court decision on the Affordable Care Act (which can be largely hedged by holding both subsectors); and having greater confidence that we can more accurately time the (we believe ongoing) cyclical demand recovery, we’re more willing to consider holding other volume-sensitive subsectors on our pro-cyclical thesis. Until now we have avoided Laboratories, Drug Retail and Drug Distribution on longer-term concerns (Medicare pricing for the Labs, generic dispensing margins for the drug trades), but now see these as credible pro-cyclical bets, at least until the dust settles from the Supreme Court’s late June / early July decision

We believe that the Internet economy is in the midst of a revolutionary paradigm shift from the neutral browser of the PC era to the tightly managed App model.  While the growth of social and mobile applications have spawned significant new businesses, the evolutionary pace of change has allowed nimble incumbents to adapt.  The shift to Apps is more radical, allowing platform masters – Apple, Google, and maybe, Microsoft and Amazon – to manage their users’ web experiences by integrating functions into their platforms, setting default Apps and controlling the store through which Apps are distributed.  We believe that the App model will allow the platform masters to co-opt much of the value as the web absorbs opportunity from the rest of the economy.  3^rd parties will need critical mass and sustainable competitive barriers to thrive and, we fear many will not.  Even well positioned Apps, like Facebook and Twitter, may find it difficult to monetize their business in adjacent opportunities due to the power of the platform owners.

We believe that the defining factor in the changing web paradigm is platform control.   Many pundits divide Internet history into eras, asserting a “Web 2.0” era driven by the rise of collaborative social applications.  While Web2.0 innovations spawned new businesses, they played out over years and nimble players easily navigated the changes.  Mobility is also evolutionary, enabling new business models but not prohibitive to established franchises.  However, the shift from a neutral “browser” model, to a platform owner controlled “app” model is revolutionary.  Unlike PC browsers, mobile platforms push Apps for direct access, allowing the platform to manage the user experience via pre-loaded defaults, integration of certain apps to the use of the device itself and tight control of the App store.  By this mechanism, platform owners can favor their own services and those from which they receive fees.

Cloud-based services are now the primary purpose of consumer computing, with trillions of dollars of opportunity addressable.  Most major consumer applications– e.g. E-mail, search, e-commerce, media streaming, navigation, content sharing and social networking – are inherently cloud centered.  Even traditional applications – e.g. office productivity, games, content creation/editing, and file archives – have cloud-based alternatives with functional and cost advantages.  As platform owners push functionality to the web, they will disproportionately benefit as the Internet absorbs value from the rest of the economy.  For example, Internet penetration into the huge global retail and advertising industries is small, but growing rapidly with enormous room for future growth.

Apple, Google, Microsoft and Amazon are in position to take the lion’s share of Internet opportunities.   The iPhone’s intuitive and integrated user interface was ground zero for the “app” model, which has been emulated by Google, Microsoft and Amazon for their platforms.  Statistics show that users of mobile platforms are far more likely to access internet-based services via apps than through their browsers, giving enormous advantage to integrated functions, default apps and apps favored in the platform owner controlled store.  As smartphones and tablets overtake PCs as the primary mode of consumer web access, these platform owners have the first crack at serving advertising, selling services, and facilitating transactions to users, and can absorb opportunities targeted by 3^rd party apps by integrating similar functionality into the platform or favoring an alternative app.

App driven companies must sustain differentiation, and circumvent the influence of platforms, or risk irrelevance.  Stand alone applications have always been vulnerable to the power of platform integration – the DOJ famously forced Microsoft to disintegrate Explorer after it laid waste to Netscape and others.  Apple’s tight integration of iTunes stymies other media distribution solutions on its devices.  Google’s integration of its own apps – Search, Maps, Places, Google+, Play (books, music, movies, apps), Talk, YouTube, Drive, Voice, etc. – into Android attacks a wide swath of web-based businesses.  Amazon, fearing eventual disintermediation, built its Kindle interface over Android and moved its own e-store to unavoidable prominence.  Against this tide, independent app companies must differentiate themselves with their target customers, build critical mass and establish sustainable barriers to competition from platform integrated alternatives.  Examples of well positioned App companies with scale and barriers include Amazon, Facebook, OpenTable, Twitter, and Hulu.

Even successful, differentiated, sustainable apps, like Facebook, may be stymied in addressing adjacent opportunities without a platform.  Facebook’s revenue projections assume that it can lever its 900 million users to capture advertising and sell web-based services – e.g. media streaming, games, e-tail, etc.  However, in the emerging platform dominant model, the platform owner will have first crack at serving advertising and selling services before the user hits the app, and can be expected to relentlessly move to break competitive barriers and siphon value into their platforms.  As Amazon felt it necessary to establish its own platform, Facebook may need to gain greater integration into a mobile platform to achieve its manifest destiny.  We remain intrigued with the potential for co-operation with Microsoft, and its Metro-based Windows Phone and Windows8 platforms.

The overall Chemical SSRSI is balanced; by what appears to be significant confidence in coatings and to a lesser degree, specialty chemicals.  The diversified chemicals group has a high SSRSI and agricultural chemicals and industrial gases are fairly valued in this analysis.

The coatings SSRSI is close to  20 year lows, suggesting that confidence is close to an all time high  – results have been good and returns on capital  are above trend or even recent averages (despite slow residential construction), but many valuation multiples are at extreme highs.  Investors clearly believe in a continued earnings momentum story in this sector.

We have also looked at expected earnings growth by sector and find that growth expectations for the commodity group exceed those for most sub-sectors including coatings.  As the second chart below shows; the commodity chemicals group is a significant outlier, and the difference in valuation between commodities and coatings is clearly not driven by current earnings expectations.

(click to enlarge) 

Source: Capital IQ, Company Reports and SSR Analysis

Agricultural chemicals appear very fairly valued with a slight premium in current returns on capital reflected in a slight premium to mid-cycle value.  (Ag Equipments stocks are very similarly valued). Estimates are for strong growth, but growth that lags the broader chemical space.  History shows that what is currently discounted in value is almost guaranteed to be wrong.  This group does not discount any expectation of shortages and price escalation in the broader agriculture space.

In an environment where there is clearly concern about global demand, it is unlikely that we will see much outperformance from the commodity chemical group without a change in sentiment around earnings.  As indicated in our earlier piece, we would expect the story to play out through the year.

We estimate that 2011 US industry loss reserves declined to $10.6 billion from $19.1 billion at year-end 2010 (Exhibit 1).  This is only about 2% of 2011 earned premium.  The standard deviation of this estimate is about $10 billion.  Significantly, we estimate that this is the first year since 2002 that the current accident year has been booked deficiently in total (by about $600 million)

The overall estimate masks much deterioration in the core Commercial lines: Small Commercial and Professional Indemnity are deficient (12% and 11% of 2011 earned premium, respectively), and General Liability and Work Comp adequacy fell by large amounts ($4bn and $3.4bn, respectively)

There are still cross-currents, but they are mixed: our estimate last year that Work Comp trends were staying moderate did NOT hold up in 2011, but did for General Liability, though current paid and reported emergence is getting worse here, for the first time in a long while

This analysis supports our Short-Term Positive View on a commercial pricing cycle in the “usual” way, though likely more muted given that the industry is reacting faster than historically.  This applies to Brokers, P&C Multiline, P&C Commercial, and P&C Specialty

Today’s note focuses first on the lack of growth relative to the overall economy (Exhibit 1).  For the last 25 years, auto and liability insurance have been shrinking as a percentage of GDP, as have mortality and annuity products for the last 10 years.  Only Life A&H appears to be a major insurance line that is growing with a healthy pricing cycle.  While property insurance appears stable versus GDP, the details reveal that it has mostly been raising price and cutting exposure

While insurance investors and insiders understand that not all growth is good in insurance (i.e. profits and risk matter), this is a much smaller issue for equities outside of financials.  Without some growth, it is difficult for insurance to be seen as a vehicle for outperformance, except for occasional periods of insurance price correction in P&C, or market events in Life

When we strip out price from exposure, we see no growth versus GDP at all, except for A&H and cyclicality.  Worse, in Life insurance, we do see continued growth in reserves, so Life insurers are accumulating older “obsolete” exposure while newer “better” exposure declines

The subsectors where we are Long-Term Positive are areas where we see the potential for innovation to ignite future growth (P&C Personal, Life Other), or where the imperative to aggressively manage older exposures is already present (Multiline)

We continue to believe that the bulk of aggregate healthcare hours data demonstrates: 1) that demand for healthcare is cyclical; and, 2) that demand is improving from a recent cyclical trough. However, we also must acknowledge that physician office hours have lost some momentum in the last several months. More volume-sensitive healthcare sub-sectors (e.g. hospitals, non-Rx consumables) continue to carry valuations that reflect an expectation of forward demand that is as weak or nearly as weak as trailing demand. Since the sequential weakness in the physician office hours has not carried over into hospitals and hospital hours have remained  strong in spite of the flu season’s drag on admission growth, we believe signs continue to point to a cyclical healthcare demand recovery, and still recommend overweight positions in these subsectors

For more detail, please see our recent full-length research notes: “US Healthcare Demand Slow for Cyclical (i.e. Temporary) Reasons …” January 12, 2012; “The Pro-Cyclical Healthcare Thesis …” February 6, 2012; and “Accelerating Growth in Hospitals’, Physicians’ Offices and Other Care Settings’ Labor Hours Signals Improving Healthcare Demand”, March 12, 2012

Because I have been covering basic industries for so long, I have become programmed to expect disappointment and am now naturally negative. Consequently, we are going to label it the Skepticism Index rather than the Optimism Index.

We have constructed this index by summing our discount from mid-cycle value index (introduced in our initial report) with a similar analysis of how significantly different return on capital (ROC) is from trend within each sector.  The index is high when both the discount and ROCs are high and vice versa. We are summing two standard deviations, so any number above 2 or below -2 is very significant.

For most sectors a high Skepticism Index is followed by aggregate stock performance that exceed the market over a 6 month period, but in most cases the variability of this outcome is quite high, so that while the average is high, one standard deviation of outcome is generally higher than the average. In reverse, we find that a low Skepticism Index (low profitability/high valuation) yields equally interesting relative downside, but with similar variability.

Today, the compelling high is the Metals and Mining space, as discussed in our recent research, and there is not a compelling low. While the Paper sector screens as expensive in our normal value framework, it does not appear much out of line with its current above trend return on capital in this analysis. While Chemicals looks fairly valued in this analysis, commodity chemicals has a high Skepticism Index and we will follow up with additional research in this sector.

 (Click to enlarge)