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May 23, 2013 – Quick Thoughts: Xbox One Delivers on Steve Jobs Vision of TV Future

Written May 23rd, 2013 by

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-          Xbox One is the FIRST real next generation TV solution, trumping Apple, Google, Sony and others by leveraging a gaming legacy, rich content partnerships, and groundbreaking interface technology.

-          The Xbox360 was already the #1 streaming TV solution, with 46M Xbox Live subs delivering the largest slice of Netflix traffic. Gaming? The exclusive Halo franchise has sold 50M+ units to date.

-          MSFT added a slick voice, gesture and mobile device interface that controls your set-top as well as the Xbox One, with split-screen multitasking, rich content discovery tools, and interactive apps. Special deals, with partners like EA, the NFL, and Steven Spielberg, promise exciting proprietary content and applications.

-          Enthusiastic gamers will drive FAST adoption of the platform – think 20M+ first year units – giving MSFT a huge first mover advantage vs. would-be rivals Apple and Google in the living room.

In his widely read biography of the Steve Jobs, Walter Isaacson quotes the late Apple CEO – “I’d like to create an integrated television set. It would be seamlessly synched with all of your devices and with iCloud. It would have the simplest user interface you could imagine. I’ve finally cracked it!” That quote, published just two months after Jobs untimely passing, has fueled a cottage industry of Apple iTV whisperers passing on reports of clandestine meetings, skunk works engineering teams and grainy spy photos from Asian manufacturing sites as evidence of that “One more thing” from Apple. While the iTV remains legend, like Nessie, Big Foot and the Abominable Snowman, Apple has traipsed forward with its “hobby”. The AppleTV alternative set-top is a me-too box, competing with the likes of Roku and Boxee, with a few cool proprietary bells and whistles. It is hardly the living room miracle promised by the Steve Jobs quote.

In the analyst sycophancy around the iTV, Mister Softy has generally been ignored. The Xbox360 model has been with us since Christmas 2005. It has sold 76 million units with 46 million households subscribing to Microsoft’s on-line Xbox Live service. With those subscriptions, Xbox Live members have access not only to multiplayer games and exclusive gaming content, but to streaming video from Netflix, Hulu Plus, YouTube, HBOtoGo, Amazon Instant Video, Microsoft’s own service and a host of other options. Those 46M households dwarf the installed base of AppleTV, TiVo, or Roku, making the Xbox360 the most important streaming platform in the market, accounting for the largest share of Netflix traffic.

The Xbox One leverages that legacy. The gaming community is famously filled with early adopters who have been champing at the bit for nearly a decade since the last major console upgrades. Given sales of the tired Xbox360 have been running at 10M a year in its dotage, the Xbox’s big time processor and graphics upgrades, souped up game controllers, hypersensitive Kinect motion sensors, 300,000 server-strong cloud processing network and blockbuster new title line-up should be good for first year sales topping 20M units. But the Xbox One will be a lot more than that.

Microsoft has serious chops in voice recognition and gesture controls. Most of the main system level commands can be spoken, including “Xbox On” to activate the whole living room entertainment system from sleep, without need for “training” or fear of inadvertent commands stemming from normal conversation. The new Kinect system is a wonder, able to detect the fine movements of 6 people simultaneously at distance and in wide angle, in low light or bright sunshine, down to finger movements and joint rotations. The 1080p camera system and sophisticated microphone systems are also there for Skype video conferencing, video recording, and other voice/video enhanced applications that developers come up with. If talking or gesturing commands from the couch is too much trouble, Microsoft’s SmartGlass apps will allow the Xbox One to be fully controlled by smartphones and tablets, along with synching the mobile devices for 2nd screen applications tying to content fed to the TV.

Set-tops supplied by Comcast, AT&T, Verizon and others will feed directly into the Xbox One, replacing the God-awful blue grids and impenetrable menus with that nifty voice/gesture/smartphone interface. The spoken command “Xbox, Watch Game of Thrones” will show you options for watching the HBO broadcast directly, identify episodes saved in your DVR, and availability on the streaming services to which you subscribe. Using a feature called Snap, you can go split screen and pull up another application while you are watching a show or playing a game. Indeed, Microsoft’s Xbox Studios has cut exclusive deals with ESPN and the NFL to tie special 2nd screen content to their broadcasts – e.g. fantasy statistics or user controlled replays. Xbox Studios has also been hard at work negotiating other exclusive content deals, including a live action series based on the iconic “Halo” franchise to be supplied by legendary director Steve Spielberg.

All of this will be backed up by Microsoft’s serious distributed cloud data processing infrastructure, the same one needed for Azure, Office365, DynamicsERP, Bing, Outlook, Skype and Microsoft’s other cloud-based initiatives. 300,000 server cores have been pledged directly to support the additional traffic on Xbox Live, a commitment that can be scaled upward as needed to deliver a superior user experience as demand grows. Microsoft’s cloud resources and expertise trail only Google and Amazon amongst potential competitors, giving at substantial and sustainable advantage over others.

For many investors and analysts, used to considering Microsoft as an enterprise software company only, except, perhaps, to belittle their progress with the Windows Phone mobile platform, the excellence of the Xbox One may be difficult to believe. Microsoft has had the good sense to give the Xbox team a strong measure of autonomy and some of the best and brightest engineers in the organization. The result is the most fully realized next generation TV solution announced to date, one with strong distribution and a full steam of customer anticipation to boot. Assuming availability ahead of the Holiday season, we expect Xbox One to be the biggest selling alternative TV device in the market by large measure, and expect a cheaper, media specialized version to follow for 2014, widening Microsoft’s already formidable head start toward leadership in the battle for the living room. Longer term, the success of Xbox One in the living room could be a spur toward wider adoption of Microsoft’s smartphone and tablet platforms should its interface and applications prove popular.

Meanwhile, the most likely challengers to Xbox in the living room, Apple and Google, have struggled to gain traction with their solutions. Apple TV has sold about 10 million units in its history and features a nifty Airplay function to mirror content from iPads and iPhones onto the TV, but the interface is pedestrian and the list of content partners is unimpressive, leaving analysts and bloggers to pine for the mythical iTV set. GoogleTV is even further adrift, with afterthought commitments from consumer electronics partners to load the software solution into a few models, but no real value proposition to distinguish it from other connected television solutions. Microsoft has thrown down its gauntlet, and we will see if its platform rivals can respond in kind.

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

May 21, 2013 – Data Center Spending: We Don’t Get Fooled Again!

Written May 21st, 2013 by

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The data center virtualization cycle that drove enterprise spending over the past decade has peaked. IT managers are now looking to a future where many of their applications will be handled by web-scale distributed cloud data centers with dramatic cost and performance advantages over privately run operations. Still, the obstacles remain daunting – e.g. security concerns, conversion costs, management complexity – and enterprises are proceeding cautiously. The result is a fallow period in IT spending – investment in client-server era data center hardware and software is slowing, but cloud-related spending has yet to hit the knee of its growth curve. The circumstances are reminiscent of the late ‘80’s/early ‘90’s when sales of the mainframes and minis that had dominated the previous era began to give way to client-server architecture. Then, as now, overall IT spending was sluggish and analysts projected a long slow adoption curve for the new approach. Now, as then, projections of the shift to new architectural paradigm are overly conservative. As such, we remain long-term bearish on enterprise data center systems and software – e.g. configured servers, RAID storage, networking gear, infrastructure software and traditional applications – even though some of these areas are still delivering growth. We believe patient investors will be well rewarded by a focus on large distributed data center operators, Software as a service applications, IT consulting, and commodity components, such as disk drives.

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SSR Index of Current-Quarter Healthcare Demand Growth, Initial 2Q13 Estimate

Written May 19th, 2013 by

We expect 2.9% (nominal) y/y growth in US health services demand during 2Q13, the product of 1.5% growth in unit demand, and 1.4% price growth. Unit demand growth remains very slow; the projected 1.4% rate is below the inherent rate of demand growth (1.5%) attributable to population growth and aging alone, and well below our long-term expectation of 2.8%

We expect nominal pricing to decelerate 50 bps, from 1.9% to 1.4%; this is a direct consequence of the 2% decline in Medicare payment rates brought about by the ‘fiscal cliff’ sequester. Dental services are significantly less affected by the sequester, and appear able to maintain steady price growth of roughly 3.7%

Independent of our quarterly growth rate models, we handicap the odds of a trend break, i.e. a significant acceleration or deceleration in demand. The trend-break model indicates near zero probability – <2% – of accelerating demand in 2Q13

Our models correctly anticipated that the downward trend in unit demand would persist during 1Q13 – however the fall was even more dramatic than our pessimistic view. This is directionally consistent with company reported results from the quarter – where surprises to the downside of sell-side analyst revenue consensus estimates far exceeded positive surprises

We believe demand is weak primarily because of low employment, which translates into a smaller percentage of households having the benefit of the most generous source (employer-sponsored) of health coverage. Employment gains, expansion of Medicaid eligibility, and the initiation of state health insurance exchanges all are likely to expand the availability of health coverage in the relatively near-term

We recommend a pro-US / pro-cyclical tilt to healthcare portfolios; this translates into overweight positions for Hospitals, select Non-Rx Consumables (especially more US-focused names such as CFN and OMI), and select Dental names (emphasize more US-focused names with product lines that include higher-mix items, such as XRAY and PDCO). We recommend underweight positions in Large-cap Pharmaceuticals (on US real pricing power concerns), drug trades (Retail, Wholesale, PBM)(on the loss of AWP pricing, and risks of PBM disintermediation), and Research Tools / Services (implied revenue growth exceeds R&D spending growth)

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

Quick Thoughts: Google I/O – Winning the Cloud

Written May 15th, 2013 by

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-          Unlike last year’s Jelly Bean intro, Nexus 7 launch and Glass skydiving extravaganza, Google I/O 13 had no single OMG moment and introduced no major new product categories.

-          The 3 ½ hour key note reeled off more than 100 enhancements to core franchises – Search/Now, Maps, Google+, Chrome, Play, Wallet, and the Android developer kit all got major upgrades.

-          The All Access music service, the pure Android Galaxy S4, and new photo editing/sharing tools lead the headlines, but integrated functionality across apps and platforms is the big step forward.

-          Google’s mastery of the cloud is a powerful weapon as platform differentiation and monetization shifts from the device to the web-based services that will increasingly define the user experience.

Last year, Google closed the opening keynote of its I/O developers conference, with a team of extreme athletes skydiving onto the roof of the San Francisco Moscone convention center and performing a series of mountain bike half-pipe stunts, before rappelling down to street level and bursting into the auditorium, all broadcasted to the audience via the first Google Glass units ever seen in the wild. This “Dire Wolf and Unicorn Show” (dog and pony seems too pedestrian), launched a year of Google Glass mania in nerd world and nearly over shadowed the Android 4.0 Jelly Bean and Nexus 7 tablet launches that had come earlier in the program. A second keynote on day two of the conference more quietly launched Google’s Compute Engine cloud hosting program aimed squarely at Amazon Web Services. That was a lot of “all new” for a single conference.

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Buckle Up! A Summary of Adverse Selection Pressures on Health Insurance Exchanges

Written May 15th, 2013 by

For most households, the marginal costs of acquiring health coverage on an exchange are within shouting distance of the annual cost of a new car (Exhibit 1); and, the odds of health costs (if uninsured) exceeding costs of coverage (if insured) are less than 50 pct (Exhibit 3). Among subsidy-eligible households, in many cases net premium costs are higher for younger (and presumably healthier) than for older (and presumably sicker) beneficiaries with similar incomes (Exhibit 4). It follows that many households – especially younger and healthier – may choose not to purchase coverage

Assuming households that do purchase coverage do so optimally, +/- 80 pct of households would buy the cheapest (Bronze) coverage and the remainder (+/- 20 pct) the most expensive (Platinum) coverage. By purchasing the cheapest plan, healthy households (the 80 pct on Bronze) minimize their payment of excess premiums (premiums above their costs of care), and thus minimize the extent to which they subsidize households (the 20 pct on Platinum) whose medical costs exceed premiums paid

Small employers with younger and healthier employees can almost certainly save by self-funding, i.e. by avoiding the exchanges entirely. Stop-loss policies to self-funding employers can be priced to reflect a specific employer’s health risks, where fully-insured policies on the public exchanges cannot. This is likely to result in small group exchanges consisting of significantly worse-than-average health risks

We believe that the Affordable Care Act’s (ACA’s) provisions for limiting adverse selection are too weak (e.g. penalties for being uninsured are too low), or even counter-productive (higher effective premiums for younger than for older subsidy-eligible beneficiaries at a given level of income). The Act’s provisions for risk sharing are relatively strong; however these only serve to ensure equivalent relative exposure to unsustainably high absolute risks

Conclusion: Enrollment in individual and small group exchanges will be much less than originally (and perhaps even currently) expected; sellers of alternatives to full risk policies (ASO services, medical stop-loss insurance) in the small group markets will see accelerating demand; and, additional legislation and/or regulatory rule-making (i.e. further reforms) may be necessary soon after the exchanges begin operating

Cigna (CI) is a notable beneficiary of rising demand for ASO services and medical stop-loss in the small group market. Health Net (HNT) and Aetna (AET) are relatively exposed to small group risk, and stand to lose from a shift by employers (with healthier workers) to self-funding. AET’s acquisition of Coventry, completed last week, increases their exposure

Risks to other insurers have less to do with adverse selection (you can see it coming and price for it; and, the ACA ensures the risks are more or less equally shared), and more to do with the high likelihood that adverse selection forces new – and potentially adverse – legislation and/or rule-making

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

Getting Left Behind – Hard For Industrials To Keep Pace With This Market

Written May 10th, 2013 by

Early in the year we commented on the relative high value of most of the Industrials and Materials sectors and suggested that it would be hard for the group to outperform a rising market.  The market has been rising quite quickly – the S&P 500 is up 14% year to date – and the Industrials and Materials group has lagged.  We would expect this lag to continue given that we see no signs of a quick recovery in the global economy and given the importance of consumption growth to these sectors.  Moreover, on market down days, these groups go down too because there is an instinct to sell the higher beta names first.

Only two subsectors are staying ahead of the market this year – Transports and Packaging.  Transports was expensive to start with, so what we see is investors continuing to favor the consolidation and market structure story here – pushing many stocks to new highs.  The Packaging story is more of a value play, with stocks that looked cheap reacting to more positive expectations.  The Packaging sector has also seen significant consolidation, but these moves are quite recent and we have yet to see any return on capital improvement at the sector level, of the type that has propelled the Transports sector.   Both of these groups are consumers of energy – fuel and plastics/glass/aluminum – and as we see oil prices moderate this might also be a boost.  See our recent research note for more analysis of what is and is not working.

We are seeing some extremes in valuation – companies with below trend returns on capital where valuations are expecting returns to fall further and companies with above trend returns on capital, pricing in a further gain.  The most extreme examples are summarized in the exhibit.

blog exhibit

Cheap, Shy, or Just Misbehaving? PFE Sells Viagra Direct to Consumers

Written May 6th, 2013 by

PFE announced direct to consumer sales of Viagra; orders placed on Viagra.com will require a legitimate US prescription, and will be filled by CVS

Viagra is a perennial favorite of drug counterfeiters. The National Association of Boards of Pharmacy (NABP) counts more than 10,000 online pharmacies dispensing to US customers but operating outside of state and/or federal regulatory compliance; more than 8,000 of these will either issue prescriptions or dispense prescription products without one. Thus patients too embarrassed to ask for a prescription, and/or those with off-label plans, can avoid physicians

Beyond being shy and/or misbehaving, men are cheap. Years ago when Levitra and Cialis ended Viagra’s ED monopoly, we asked men to ‘build’ an optimal ED drug by allocating 100 points among their preferred drug attributes, with more points given to the more important features. Men gave as many points to low price as to speed of onset, and twice as many points to low price as to duration of effect. Price matters – a lot

The typical Viagra Rx is $160 – $190 at retail (6 to 7 pills at about $27 each). Viagra is not covered by Part D, so not many men over 65 have coverage. A little more than two-thirds of commercial plans cover ED treatments, but most require co-payments well above the prevailing tier-2 $30 for ‘preferred’ brands. Counterfeits are available for $1 to $3 / pill – cheaper than the best co-pay

For all of these reasons ‘online pharmacies’ will remain attractive to men who are cheap, shy, or misbehaving. PFE’s online service can only cater to men with legitimate prescriptions that are willing to pay either retail, or their applicable co-pay. Notably, most commercial drug benefits will not pay for drugs received by mail, unless the prescription is filled by the payor’s own mail order operation. Thus outside of CVS (who administers PFE’s program) there may be many men with drug benefits that cover Viagra, but that will not cover prescriptions sourced from Viagra.com

Thus on net, the marginal utility of Viagra.com is that it serves men who are: 1) sufficiently self-confident to talk to their doctors (and thus get legitimate US prescriptions); 2) willing to pay either retail or their share of retail; 3) if covered, belong to a commercial plan that will cover a mail Rx dispensed out of network; AND, either: 4) too shy to have the Rx filled at retail; and/or who prefer the convenience of Viagra.com over any mail alternative their plan may offer. The initiative makes total sense – but offers very little answer to men’s motives for buying counterfeits – so the counterfeits will continue

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

May 1, 2013 – Qualcomm: Whadda We Gotta Do to Get Some Respect Around Here!

Written May 1st, 2013 by

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Consensus expects Qualcomm’s sales and earnings growth to sharply decelerate, with investors even more skeptical, worried that the company’s lucrative IPR licensing business will slow with cheaper phones and royalty rate challenges. We disagree. QCOM’s addressable market will grow with the global migration from 2G GSM, with adoption of cellular in tablets, with the rise of machine-to-machine networking, and with adoption of 4G LTE for residential broadband. We also believe that royalty rates will prove far more stable than many fear. QCOM is the largest IPR holder for LTE, with particularly profound contributions in the technologies most critical for 4G devices, with a peerless R&D program continually adding to the portfolio. We also note that Qualcomm’s innovative licensing approach has established a long-standing legal precedent for the value of its IPR, and that, as a chip maker, it has asymmetrical negotiating leverage over device makers. Finally, we believe Qualcomm’s strength in semiconductors is underappreciated – its modem and ARM-based processor designs are best-in-class, it leads in system-on-a-chip integration, and it recently announced a potentially game changing 40 band RF chip that could be integrated into a single package, turn-key solution. This technical mastery is driving market share gains, while opening more of the device bill-of-materials to Qualcomm.

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Why Smaller Employers Will Shift to Self-Funding; Who Wins and Loses

Written April 28th, 2013 by

Affordable Care Act (ACA) provisions stand to increase smaller (≤ 100 employee) employers’ premium costs by 20 percent or more in 2014, before accounting for medical trend (+/- 6 pct)

The ACA provisions driving the premium increase for smaller employers (e.g. community rating, minimum essential benefits, excise tax on premiums) can be entirely avoided by shifting from fully-insured coverage to self-funding – self-funded plans are exempt from these ACA provisions.

We show that because of ACA, the average small employers’ cost of self-funding is on par with, or cheaper than, continuing with fully-insured coverage. For employers with healthier than average employees, self-funding may be far cheaper than fully-insured coverage; stop-loss premiums paid by self-funding employers can still vary according to the health of employees, where fully-insured premiums cannot

As an added motive, employers no longer face the risk of sharp increases in stop-loss premiums in a year following large self-funded claims – because they now have the option of reverting to the exchange for fully-insured, community-rated coverage if and when their employees’ claims rise

Roughly 40 pct of fully-insured commercial lives are sponsored by employers with ≤ 100 employees (Exhibit 4, pg. 4); we expect many of these lives will shift to self-funded plans. CVH is most negatively affected with more than 10 pct of members in small group risk plans; CI is least negatively affected with less than 0.1 pct of members in small group risk (Exhibit 5, pg. 5)
CI and UNH are best positioned to benefit from expansion of self-funding among smaller employers; both have relatively large shares of the ASO (administrative services only) service market for smaller employers (Exhibit 6, pg. 6), as well as the market for medical stop-loss insurance (Exhibit 7, pg. 7)

Taking all moving parts into account (decline in fully-insured, rise in ASO and stop-loss) CI is by far the best positioned and is a clear beneficiary (no meaningful small group risk exposure; strong presence in ASO and stop-loss); CVH is by far the least well positioned and stands to be negatively affected (relatively large exposure in small group risk; little or no exposure in ASO or medical stop-loss)

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

April 22, 2013: Quick Thoughts: Apple – Downward Revisions Ahead, Wait for Capitulation

Written April 22nd, 2013 by

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-          Current sentiment for Apple’s FY 2Q13 is horrible – consensus EPS is down 15% over the last 90 days and Cirrus’s warning drove shares back below $400, off nearly 25% over the same time frame.

-          Consensus says Apple is cheap – 5.8x estimated FY13 EPS and 5.2x FY14, adjusting for $137B in cash and investments – but consensus assumes double digit sales growth and rising gross margins.

-          2Q13 estimates for 8.4% YoY sales growth and 38.5% GMs are tenuous, yet analysts are backend loading 4Q at 20% sales growth and 39% GM, with 12% FY14 growth on stable 39% GMs.

-          Consensus forecasts of reaccelerating growth and rising margins are not credible. Apple may be cheap, but it is unlikely to perform until the megabulls have capitulated and estimates are reasonable.

“Apple under $400 has GOT to be cheap enough, right? It has $137B in cash and investments on the balance sheet and is projected to generate another $51.5B in cash from operations this fiscal year. It trades for just 9 times consensus EPS for FY2013, only 5.8x if you adjust for all of that cash. Sure the company has hit a competitive bump, but a low cost iPhone is on the way, just in time to dominate in China once China Mobile signs that inevitable megadeal to carry it. Furthermore, a new, larger screen iPhone and a major iOS upgrade are also coming to put Samsung and Google in their place. By the way, don’t forget about the Apple Television – Asian manufacturers are working on prototypes as we speak – and the iWatch wrist-based peripheral. That’s two more legs for the Apple stool. Once the big increase in the dividend is announced, watch out! Reiterating strong Buy, with a price target of a ba-jillion dollars.”

It must have been tough being an Apple Bull this past quarter – publishing that same call for the umpteenth time and subjecting yourself to yet another perp walk performance on CNBC. Still, at some point, the national nightmare will have to end, Apple will hit bottom and the bulls will be right again. However, no amount of cheerleading is going to hasten the coming of that day, and in fact, the cheerleaders may, in fact, be their own worst enemies. Buy-side sentiment is indeed bad, but sell side estimates are nowhere near bad enough.

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