Research

China – Look For The Commodities That Are Less Oversupplied

Written November 21st, 2014 by

China’s interest rate cut has got everyone’s attention today and the markets are rallying as are most commodities.  We have seen interest rate cuts all over the world over the last two years and their impact on economic growth/consumer spending has generally been positive, but not dramatic.  If we assume the same for China, some of these commodity moves may be premature, as even with increased demand in China we have so much global overcapacity that incremental demand from China may not be enough.

Iron ore, for example, is in such significant oversupply that incrementally better demand in China will likely not be enough to make a difference and any price response will be met with a supply response, as we saw with Aluminum through 2012 and 2013 – see chart.   It is unlikely that lower rates in China will lead to significant increases in infrastructure spending, so Iron ore and Steel are going to have to rely on consumer driven demand increases – for example in Autos.

Increases in consumer spending in China and possible also in Europe, as Draghi unlooses every tool in his belt to stimulate growth, would be good for Autos, but also for housing and other consumer goods.

We would focus first on Aluminum as a way to play this change.  We know from the way that prices have moved this year that the global Aluminum market is in better shape that it was a year ago, and growth rates are already strong.  Alcoa would be the big winner here and we still see significant upside in the stock: we continue to believe that it could double.

A second focus might be Titanium Dioxide; DD and HUN in our universe.  This is a commodity very much at the bottom of the cycle, but better autos and housing means better paint demand.  There is an oversupply here and it is focused in China, and it is not obvious how close we might be to a point of inflection.  There is still more capacity coming on line in China and while valuations are interesting for both companies they are not nearly as compelling as they were for Alcoa when we made the initial recommendation to own the stock.  DD is in the process of carving out its TiO2 business, either for sale or for spin, but it will remain part of DD most likely through the middle of 2015.

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Relative Price & Value of pre-Phase III Pipelines for the 23 Largest Drug & Biotech Companies – Updated View

Written November 20th, 2014 by

We use patent data to estimate the amount and quality of innovation in companies’ pre-phase III (aka ‘hidden’ pipelines); we then determine whether companies’ share prices accurately reflect what’s in these hidden pipelines.  Since inception (November 2012), companies that screen as >= 20% undervalued have outperformed their peers by 1.4x (cap wtd) to 1.6x (equally wtd)

Because of large misvaluations in hidden pipelines, shares of VRTX, BMY, SNY, and GSK all appear at least 20 percent undervalued. Conversely shares of ALXN, BIIB, CELG, GILD, NVO, REGN, and SHPG all appear at least 20 percent overvalued

For more information on our pipeline valuation methods, and for related R&D productivity metrics covering the 23 largest publicly-traded companies (by R&D spending) please visit hiddenpipeline.com

For our full research notes, please visit our published research site

Quick Thoughts: Qualcomm Analyst Day – Hang On for a Bumpy Ride

Written November 19th, 2014 by

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-       China is a double-edged sword for QCOM – regulators and scofflaws plague QTL, while QCT is successfully competing for Snapdragon and baseband business.

-       Projected device ASP erosion of 9-10% will hit royalties, but will be offset by chipset unit volume growth driven by emerging market smartphone demand

-       QCOM is driving global wireless technology innovation, combining aggressive R&D spend with historical leadership and positioning itself to attack new opportunities.

-       The regulatory and licensing issues will take several quarters to resolve – meanwhile QCOM’s potentially dominant position may be temporarily immaterial to investors.

QCOM’s annual analyst day saw rookie CEO Steve Mollenkopf and his leadership team take the stage to persuade investors of the company’s dominant position in nearly all wireless markets despite headwinds from regulators in China. The company earlier in the day unveiled a new baseband chip pushing the boundaries of LTE-Advanced technology with 450 Mbps speeds in a more power efficient 20-nm package. It also revealed that it is planning on entering the server chip market, with Facebook a likely launch customer deploying QCOM’s ARM based server chips across its webscale data centers. Despite the company’s leading positions across mobile and plans to enter adjacent markets, growth over the next five years is expected to proceed at an 8-10% clip, fairly conservative guidance given the continued growth of smartphones and the likely size of emerging mobile opportunities. The prospect of Chinese regulators levying stiff penalties continues to haunt management and investors with Mollenkopf’s team giving only vague indications progress is being made for a resolution. Still, the company tried to allay China concerns with videos during the interludes between speakers featuring companies like Xiaomi, China Mobile, and foundry SMIC extolling the virtues of their QCOM partnership.

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Quick Thoughts – Implications of SnapCash for ACH and Person-to-Person (P2P) Payments

Written November 18th, 2014 by

With its announcement of Snapcash on Monday, Snapchat (with a $10bn valuation in its last funding in August[1]) enters the market for integration of social media and person-to-person (P2P) payments in competition with PayPal’s Venmo (which handled over $300mm in consumer payments in FQ12014 putting it on a par with the SBUX mobile app – see Chart); the back-end for Snapchat is provided by Square which expands the potential reach of its Square Cash product to the 100mm MAU’s of Snapchat. These direct-messaging services compete with bank P2P applications that use e-mail addresses or telephone numbers (through text-messaging) as tokens including PeopleMoney and PopMoney (white-labeled to banks from FIS and FISV respectively) and clearXchange (owned by BAC, JPM, WFC, and COF).

The Square Cash, and hence Snapchat, solution is distinctive because it uses the Visa and MasterCard networks while the other solutions use either: ON-US clearance (where the sender and receiver share the same bank); proprietary networks such as those run by FIS, FISV, clearXchange, and PayPal[2]; or the ACH network). The advantage for Square Cash is that it can promise next-day funds-availability whereas solutions that may need to use ACH often only promise funds within 3-5 days. The reason for the delay is that, while ACH is a next-day settlement system if a debit transaction is accepted by the receiving bank (“RDFI”), it can take 3 days for the originating bank (“ODFI”) to learn that the RDFI has returned, rather than accepted, a transaction (because, for example, the target account for the debit does not have funds available).  Zen Payroll provides a masterful explanation of the finicky return process that affects ~5% of ACH transactions.

SquareCash, however, can promise funds within 1-2 days because it uses the Visa or MasterCard networks rather than ACH and because the issuing bank in a Visa debit transaction (equivalent to the RDFI in an ACH debit) provides surety of payment at the time the transaction is authorized; as a result, the next-day settlement is not subject to a return. The challenge for SquareCash is that this faster settlement comes at a price: each debit transaction generates a cost of 30-35 cents (of which 25 cents is paid to the issuing bank as “interchange”) and , given neither Square Cash nor Snapchat are currently looking to recover the cost through a customer fee, the P2P offering is therefore a loss-leader. ACH involves a far lower fee of 1-2 cents paid by the ODFI.

The challenge for the banks is that their brands are being wrapped by app-providers whether Snapchat or Square in the case of P2P transactions or Apple Pay in the case of POS transactions. This is at a time when a strategic priority is to extend consumer engagement with bank-branded mobile apps beyond the initial use-cases of balance-checking and remote-deposit capture. As a result, the banks are looking to make the ACH-based solutions on which their P2P services are based (whether through clearXchange or white-labeled solutions from FIS and FISV) more competitive in terms of the timing of settled funds; the plans announced by NACHA this March to move ACH from next-day to same-day settlement would reduce the gap by one day and, combined with Secure Vault Payments which leverages the ACH network to offer real-time guarantee of good funds for participating banks, could make ACH-based solutions as fast as Visa-based solutions.

As discussed in our note of Monday “The Migration to Real-Time Payments in the US and Opportunity for ACIW”), we expect the NACHA plans to be ratified by year-end (in contrast to similar plans that were presented in 2012 and vetoed by large banks that November) catalyzing ACH-based solutions including from vendors such as ACIW, eFunds (acquired by FIS in June 2007) and Alaric (acquired by NCR in December 2003). While these will not provide issuing banks with the interchange revenue of a Visa-based solution, they will allow greater control of the bank brand and drive traffic to bank mobile apps. In addition, there is a potential revenue opportunity from customer fees with USB, for example, charging $3.50 for an instant payment, $0.75 for a next-day payment, and no fee for a standard payment within 3-5 business days[3]. The “instant” and “next-day” solutions require a bank to take settlement risk by irrevocably posting debits and credits to a customer account ahead of final inter-bank settlement although this risk will decline as ACH builds capabilities around same-day settlement and real-time funds verification through Secure Vault.

[1] http://online.wsj.com/articles/snapchat-fetches-10-billion-valuation-1409088794?tesla=y

[2] Of course, a customer’s PayPal account may ultimately be funded by a Visa or MasterCard account

[3] http://thefinancialbrand.com/43203/paypal-venmo-social-mobile-payments/

 

Hold-Out States Will Expand Medicaid – Just Ask History

Written November 17th, 2014 by

The original Medicaid program was passed in ’65, going into effect in ’66 – and only 26 states joined the program in that first year. By 1970 all but Alaska and Arizona had joined; Alaska held out until ’72, Arizona until ‘82

As with any large social program, Medicaid was born into political controversy. Yet as the program’s date of passage fell into the past, the framing of the debate shifted – from national politics to state politics and economics. Ultimately allstates chose not only to participate in Medicaid, but to expand their programs well beyond the federal minimums – at an average marginal cost of $0.43 per $1.00 of Medicaid spend

As the current Administration winds down, the Medicaid expansion debate again moves from national politics to state political economics. States can expand their programs at a marginal cost of $0.10 per $1.00 of Medicaid spend – good economics for even the most reluctant Keynesian. On average, states can expand to eligibility to 100FPL by raising their total state budgets by only 0.2%, or to 138FPL by raising total state budgets by 0.4%

We expect most ‘non-expansion’ states to expand to at least 100FPL in or around 2016; this raises enrollment by 6%, and total Medicaid spending by 4%. Full expansion to 138FPL would raise enrollment by 11%, and total Medicaid spending by 7%

Medicaid HMOs (e.g. CNC, MOH, WCG) are the primary beneficiaries of further expansion; of these CNC is by far the most exposed to the non-expansion states, and would benefit most from growth in these states’ programs

Hospitals (e.g. CYH, HCA, LPNT, UHS, THC) also are beneficiaries of further Medicaid expansion, mainly because of reduced costs for uncompensated care; of these HCA has the greatest share of its beds (86%) in states that have not yet expanded, and presumably would benefit most

For our full research notes, please visit our published research site

SCOTUS Round II: Does King Really Matter?

Written November 11th, 2014 by

The Supreme Court of the United States (SCOTUS) will hear arguments in King v. Burwell, in February or March of 2015, with a ruling likely in June of 2015. A decision to uphold King would mean persons buying health insurance on federally (rather than state) managed health insurance exchanges (HIEs) are ineligible for subsidies

If King is upheld, governors in affected states (those with federally managed HIEs) can keep federal subsidies flowing on their HIEs by simply taking over management of the HIE. We believe most are likely to do so

In the 27 states with federally managed HIEs, we count roughly 11.8M persons who are likely to favor state control of the HIEs in order to keep $12.2B in subsidies flowing; included in this number are 3.8M persons currently receiving subsidies (which average +/- $3,216 / year), 2M persons who are likely to need federal subsidies in any given year because of job loss, and 6.5M healthcare employees. In these same states we count roughly 6.8M persons who oppose state control of the HIEs in order to shield themselves from penalties for being uninsured, which average about $590 per person per year, and total about $4.0B in aggregate. On net, voters in favor arguably outnumber those opposing, and voters in favor arguably are more motivated (the dollar impact of subsidies gained is far larger than the dollar impact of penalties avoided) (see Appendix 1 for details by state)

 

Where we’re BULLISH: Biopharma companies with undervalued pipelines (e.g. VRTX, BMY, SNY): Biopharma companies with pending major product approvals (e.g. TSRO, ALKS, HLUY, EBS, BMY, BVRX, CBST, ACRX, BMRN, PCYC); ABBV and ENTA on sales prospects in Hep C; CFN, BCR, CNMD and TFX on rising hospital patient volumes; XRAY and PDCO on rising dental patient volumes and rising average dollar values of dental products and services consumed per visit; CNC, MOH and WCG on bullish prospects for Medicaid HMOs; and, DVA and FMS for the likely gross margin effects of generic forms of Epogen

Where we’re BEARISH: Biopharma companies with overvalued pipelines (e.g. GILD, ALXN, SHPG, REGN, CELG, NVO, BIIB); PBMs facing loss of generic dispensing margin as the AWP pricing benchmark is replaced (e.g. ESRX, CTRX); Drug Retail as dispensing margins are pressured by narrowing retail networks and replacement of AWP (e.g. WAG, CVS, RAD); and, suppliers of capital equipment to hospitals on the likelihood hospitals over-invested in capital equipment before the roll-out of the Affordable Care Act (e.g. ISRG, EKTAY, HAE, VOLC)

 

For our full research notes, please visit our published research site

November 10, 2014 – SaaS Revisited: Still Growing After All These Months

Written November 10th, 2014 by

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SaaS Revisited: Still Growing After All These Months

The dramatic cost and performance advantages of web-scale cloud platforms over private data centers have lowered the barriers to entry for “Software as a Service” (SaaS) application developers – opening the door to innovation and competition in enterprise applications, pressuring SaaS pioneers with older architectures, and posing an existential threat to traditional application vendors. Sales of applications delivered from the “cloud,” are expected to more than double to nearly $56B by 2018. New SaaS companies continue to emerge with 6 companies having gone public in the US during the last 6 months. More SaaS IPO are likely into 2015. SaaS names have performed relatively poorly since our last note on SaaS in March, with an average decline for US listed SaaS companies with market cap in excess of $500M of 6.6%, This presents buying opportunities for companies, such as WDAY, SPLK, ULTI, and VEEV, that are innovating, executing, and building scale economies. This, rather than locking-in customers or depending on product life-cycles, will win share. Winners will also include old paradigm companies that are successfully transitioning to the cloud, e.g. MSFT, ADBE, and ADSK.

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What Healthcare Stocks’ Share Prices Imply about Future Growth, and How this Squares (or not) with Fundamentals

Written November 6th, 2014 by

Hospitals are benefiting from rising patient flows and reduced costs for uncompensated care; however as insured patients move to cheaper forms of coverage they owe larger percentages of hospital bills, which they often don’t pay. Thus Hospitals’ net pricing is likely to come under further pressure as we lap the benefit of reducing the ranks of uninsured. Suppliers of Consumables to Hospitals enjoy all of the benefits of rising patient flows, but with more predictable pricing … yet many have share prices that imply slower growth than Hospitals (e.g. BCR, TFX, OMI; see pages 6-8)

Hospital employment fell at the beginning of 2014, and Hospital new construction spending is in outright decline. This implies Hospital administrators may have anticipated more demand growth from the Affordable Care Act (ACA) than has materialized. This further implies weak demand for companies that supply capacity-expanding (e.g. hospital beds) and capabilities-expanding (e.g. advanced imaging, robotic surgery) capital equipment to Hospitals. Inventories are rising at several of these firms, particularly EKTAY, HAE, ISRG, and VOLC (see pages 10-12)

Medicaid-predominant HMOs are gaining share in a rapidly growing (as hold-out states expand Medicaid) market, and average contract values stand to increase as higher-spend dual eligibles eventually are enrolled. In sharp contrast, Commercial-predominant HMOs stand to lose share (to local carriers) in a more gradually expanding market, and average contract values are stalling as enrollees choose cheaper forms of insurance. Nevertheless valuations fail to capture the difference in growth potential; we believe implied rates of growth for select Medicaid-predominant HMOs (particularly CNC, MOH, WCG) are far too low (see pages 13-14)

Demand for Dental products and services appears to be more elastic than demand for other healthcare products and services – meaning Dental demand should grow more quickly as employment grows and coverage expands. Despite this, Dental names (especially XRAY, PDCO) imply slower growth than the broader Healthcare universe (see pages 14-16)

The Dialysis providers (DVA, FME) are riding a more powerful demographic wave (obesity = type 2 diabetes = renal insufficiency) than the broader Healthcare universe, and stand to benefit from a sustainable expansion of gross margin once generic forms of erythropoiesis stimulating agents (ESA’s) are available (+/- 2016), yet share prices imply slower growth than for broader Healthcare (see pages 16-17)

For our full research notes, please visit our published research site

Quick Thoughts: QCOM – Little Trouble in Big China

Written November 5th, 2014 by

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-       QCOM delivered 4QFY14 results EPS of $1.26 on sales of $6.69B, falling short of the consensus expectations of $1.32 and $7.03B in revenue

-       QCOM is struggling to collect royalties from unprofitable secondary Chinese brands in the midst of its antitrust dispute with the Chinese government

-       Long term, we expect the problem to become moot as Chinese share consolidates toward large licensees prepared to pay QCOM because of their export ambitions

-       This may take more than a quarter or two to play out, putting near term expectations at risk, but we are bullish on QCOM’s long term position for both patents and chips

At least when Qualcomm misses a quarter, they actually give you some detail about why it happened. (Hint, hint, Jeff Bezos) Sales came in $340M lighter than expected at $6.69B and EPS missed by 4.5%, coming in at $1.26. Along with the admirably granular report and sober guidance by business unit, Qualcomm spoke frankly about its current difficulty in collecting 4G royalties from vendors in China and of new antitrust investigations by regulators in the US and the EU. Those issues have the stock down more than 5% afterhours. While that’s probably appropriate given the short term headwinds and uncertainty created by these challenges, I remain very bullish on Qualcomm’s position for the future of TMT.

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The Power Of Positive Thinking – APD and the DD read-through

Written October 31st, 2014 by

If the previous management of Air Products had delivered a quarter that included the following, the stock would have been down meaningfully on the day:

  • A year on year decline in operating income from its core gases business
  • A write down of around a third of the value of a business acquired only two years ago
  • A suggestion that two of the (much questioned) China based on-site projects have been delayed by 2 quarters

However, the current management was able to announce exactly this and the stock closed up almost 4%, while already commanding a significant multiple premium to Praxair, which over the last 12 months has delivered growth in its gases portfolio – Exhibit.

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What is going on here is “belief”.  Belief that the newly focused APD can drive down costs, allocate capital better and drive better EPS growth than it has in the past.   There were signs of this in the quarter as APD beat estimates, despite the weaker gas numbers.  Very strong results from its Materials and Equipment businesses were largely the cause, but there was also significant focus on cost allowing the company to increase margins.  We are assured that the cost focus will continue.

While we are skeptical as to whether APD can cut costs fast enough to deliver positive earnings surprises given a weaker gas business (which we think will take a couple of years to turn around) that is not the point of this short note.

The point is to highlight the power of a change in sentiment.  APD has almost a 3x multiple premium over PX on 2015 earnings, unheard of at any point in recent history.  The market believes that the change in focus at APD will deliver outsized returns and the stock has been one of the best performers in the space over the last two years.

This change of sentiment will likely take place at DuPont also.  The activist fund in DuPont has the right story in our view – just as the activist fund at APD had 18 months ago.

The issues are what will be the catalyst and when will it happen?  And the answer is simple – we do not know!  What we do know is that there will need to be a catalyst.  DuPont is resisting Trian’s suggestions and, in our view putting up weak numbers and a weak defense.  The war of words has begun.

Catalysts could be: (we are just making stuff up here)

  • A public proxy fight where Trian nominates a couple of very strong board candidates (unlikely that it will come to this)
  • DuPont continues to disappoint on the growth story – increasing shareholder pressure to act
  • A change of management at DD
  • A second activist fund taking a large stake
  • A private equity bid for the company (it is smaller than KO!)

Once the catalyst arrives the stock will stop discounting Trian’s likely failure and start discounting Trian’s likely success.  The stock could appreciate quickly.  We generated a value of $100 per share in a piece that we did on the cost opportunity at the beginning of this month.

The risk to holding the stock is that the company makes a large and poor tactical acquisition to change the game.

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