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Quick Thoughts: Resisting Facebook

Written May 17th, 2012 by sagawa

- 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.

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Why HMOs are Cheap, Despite Rising Utilization

Written May 16th, 2012 by evans

Utilization rises as the economy strengthens; with economic strength comes rising employment. For commercial HMOs, the question is whether the benefits of employment growth (which brings enrollment growth, sales growth, operating leverage, and improving underwriting risks at the margin) can more than offset the gross margin pressure of rising utilization. We say yes

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

Progressive Strengthening Reserves, But Auto May Not Be Ready for Pricing Turn

Written May 16th, 2012 by bault

Given Progressive’s adverse loss development in Q1, we investigated whether there is enough profitability and reserve stress to lead to a pricing turn in Personal Auto. Unfortunately, this does not seem to be likely: while Progressive’s reserves are only barely adequate (1.3% of 2011 premium), most other companies seem reasonably adequate (around 5% of 2011 premium)

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

SSR Index of Current-Quarter Healthcare Services Demand Estimates Growth within 50bps, Before Earnings are Reported

Written May 15th, 2012 by evans

‘Unit demand’ for US healthcare ties closely to underlying economic measures, including but not limited to rates of employment. A critical mass of these measures is available during or immediately after a given quarter; using these we model current-quarter unit demand growth to an average error of 43 bps, before earnings are reported

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

The Internet Revolution: It’s Not Social OR Mobile, It’s Apps

Written May 15th, 2012 by sagawa

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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.

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Chemicals Skepticism – A Wide Divergence – Commodities vs Coatings

Written May 14th, 2012 by gcopley

Extending our Skepticism Analysis (SSR Skepticism Index – SSRI) to look at the sub-industries within Chemicals we confirm lack of investor conviction in commodity chemicals – valuations underestimate current and expected returns. History shows that this corrects through relative outperformance of more than 11% over 6 months.

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.

US Non-Life Reserve Analysis: Now This Pricing Cycle Makes Some Sense!

Written May 13th, 2012 by bault

In our 2010 US industry loss reserve analysis, we saw many indications that reserve adequacy was holding up better than expected. That completely changed in 2011: reserve adequacy deteriorated across the board in Commercial lines, and only improved for Personal Auto. While still not at the 1999-2000 levels of deficiency, the pricing action seen in 2011 now makes more sense

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

The Insurance Industry’s Growth Issue

Written May 6th, 2012 by bault

Despite our current Short-Term Positive View on subsectors exposed to commercial lines pricing improvement, we are Long-Term Negative on most insurance underwriters, including Life. Our overall thesis is that insurers have written too much risk that the market does not want (e.g. annuities, long-tail), cannot easily find ways to write risk the market does want (e.g. tradable), and will need another set of “crises” before it is driven to make any major changes

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)

April “Employment Situation” Report Mixed on Healthcare Hours. A Flu Effect?

Written May 4th, 2012 by evans

The Bureau of Labor Statistics on Friday published the April 2012 Employment Situation report, which includes payrolls and hours worked at the industry level through March 2012. While aggregate healthcare hours, and medical / surgical hospital hours were slightly up in March as compared to February, and had sequential improvement in y/y growth, physician office hours demonstrated some weakness. Aggregate physician office hours were down slightly from February, but of more concern (since the data series isn’t seasonally adjusted) is that y/y growth fell 60 bps to 4.4% in March (from 5.0% in February). It is worth noting that the 2011-2012 flu season has been particularly mild – hospital companies reporting 1Q12 results have pointed to a 1.5-2.0% drag on y/y admissions growth. We would suspect – though can’t definitively prove – that the weak 1Q12 flu season weighs on the aggregate hours worked comparison

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

Introducing: The SSR Industrials and Basic Materials Skepticism Index

Written May 2nd, 2012 by gcopley

We have extended our “normal valuation” analysis to look at skepticism/optimism, defined as whether the valuation of a sector adequately reflects the underlying current profitability or expected profitability of the sector.

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)

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