Tuesday, 28 June 2011

Healthcare information assets still hot

Hot on the heals of Thomson announcing its intention to sell its Healthcare operations, which primarily service US healthcare payers with infomation services to manage the ever spiralling costs of healthcare, Experian has today reported a purchase in the same space, albeit of a considerably smaller operation.

Experian is paying $185m for Medical Present Value (MPV) which maintains a data-base of health claims and provides products to establish patients eligibility for insurance and other financial support and supplements a segment that Experian initially entered only back in 2008.

http://production.investis.com/experian/rns_news/rnsitem?id=4321055

Not much financial information on the subscription based MPV has been provided beyond a 3-year compound revenue growth reported at +30%, and prospective revenues and EBIT of $45m and >$10m respectively (therefore >22% margins and slightly ahead of Thomson Healthcare). On a year-1 basis, MPV is therefore priced at an aggressive >4x revenues and >18x EBIT (5.5% yield), on which basis Experian expects MPV to be EPS accretive. Including similar assumptions for cash conversion (of 90%) and tax (at 30%) as I used for Experian and the Y1 FCF yield of under 3.5%. Clearly Experian will be looking for cost synergies with existing activities as well as a network effect on revenues to raise this to its own FCF yield of over 5%. Another couple of years of 20% compound growth should do the trick!

While Experian will face the task of convincing its shareholders of the maths, the deal however should assist Thomson in its own valuation expectations for its healthcare assets and where a 5% current year FCF yield would support a gross price of around $1.4bn and comfortably over $1bn after tax.




Another example of how legacy print media valuations have tanked

David Levin's long term re-structuring of UBM to exit its declining legacy print businesses continues. Yesterday UBM announced that it is selling its UK entertainment and technology portfolio (including Music Week and Pro Sound News) to Intent Media. In itself, there is little of surprise as UBM exits this small segment which represented less than 4% of its print magazine revenues last year and will gain some additional scale benefits in the sector from Intent (albeit only modestly).  Of interest however is the miserable price achieved of only £2.4m. This represents an exit multiple of under 50% of the portfolio's sales last year (of £5.4m) and 4x EBITA (of c. £0.6m). What is not revealed however, is the prospective liabilities being assumed by Intent (including redundancies and possibly pensions etc) to offset what would appear to be a deal generating an initial EBITA return of around 25%.

Impact on UBM's valuation? Another example of the need to look through to see where the profits come from rather than the overall figure. While the multiple of sales of under 50% is similar to the level at which I already value UBM's print magazine interests (from a normalised FCF yield basis) it may provide a wake-up call to those who have valued the business on an overall PE basis, which anyway is already flattered by the treatment of the tax assets and low tax charge recognised through the P&L.

UBM valuation








 

Thomson Reuters - another divestment, but what to do with the cash?

Unless one wants to lend to one of the PIIGS, cash returns are currently too low to tempt corporates to sit on excess cash. But what to do with it? For Thomson Reuters this issue will become increasingly pertinent following its announcement to divest its healthcare operations (c. $500m of sales and $100m of EBITA) which I estimate could generate a further $1.2bn on net proceeds in addition to the c. $1bn already raised from the disposal of peripheral assets across Legal and Markets divisions (of BAR BRI, Scandinavian Legal & Tax businesses, Risk and Portia businesses). By the end of 2011, net debt therefore could fall to below $4bn (from $6.4bn), which with $6.6bn of term debt could see gross cash  of over $2.5bn sitting on the balance sheet and diluting EPS. With $2.5bn of un-utilised bank facilities this could provide the group with a potential funding headroom (under existing funding arrangements of over $5bn.


For a subscription based professional publisher, a 2-3x net debt to EBITA ratio is a comfortable level of financial leverage and indeed, broadly reflects the average levels sustained by the sector over the past 20 years. While the issue of under-leverage will not be unique for Thomson Reuters after this year, a debt to EBITA ratio of below 1.0x and the sizable gross cash position will exert pressure on management to allocate this into more productive areas. In the past, management has not shied away from taking bold steps to refocus the portfolio (Reuters being a case in point) and has also instigated share buy-back programmes to soak up excess capital.  Since the $17bn acquisition of Reuters in 2008 however, the group has been relatively inactive in applying its circa $1.5bn pa of FCF (I estimate $1.8bn for 2011 and $2.4bn for 2012), with only $349m of acquisition spend and $905m of dividends in 2009, rising to $612m and $898m respectively for 2010. For 2011 the group has continued to focus its acquisition strategy on smaller infill purchases such as Manatron (property tax software for Governments), Mastersaf Brazil (Brazil legal publisher) and World-Check (personal & corporate risk information) and has not yet signalled an appetite for something more substantial. The disposal strategy meanwhile seems to aim at discarding peripheral activities, even if currently performing strongly. Healthcare, which has been exploiting the rising demand for 3rd party payer services in the US appears another example, delivering robust growth, but with a US market model that may have more limited applications elsewhere. 


Excess liquidity with prospective cash of >$2bn and a further $2.5bn of undrawn facilities
A $2bn buy-back would be a low-risk option
Thomson Reuters may not be the highest yielding media opportunity around, but a share buyback to utilise say $2bn of prospective excess cash would provide a low risk option to offset the EPS dilutive impact of this year's divestments, while representing a 7% reduction in in the equity base. At current levels I estimate that the group trades on an operating FCF yield of 6% for FY11, rising to almost 7% for next year. Grossing up for assumed tax at 30%, this represents an EBITA yield of over 8.5% for FY11 and 9.7% for FY12.

Would Thomson use its $5bn of funding headroom to launch a more sizable bid for either an existing competitor (eg Reed Elsevier or Wolters Kluwer) or to leverage a platform into an adjacent area such as risk information?  This certainly remains a possibility and rival valuations are not particularly demanding. Choice assets such as Wolters Kluwer's CCH tax and accounting business or its compliance or European legal content however could also trigger regulatory investigation which might restrict Thomson's scope for manoeuvre. For the present, I would expect Thomson to continue its policy of infill acquisition of niche content and software, particularly across legal and tax and in emerging markets which can be folded into its existing distribution and technology platform. As such, the recent divestments ought not to be interpreted as prelude to a major acquisition with its accompanying risk of value dilution. While selling businesses on EBITA yields of perhaps 7% (and FCF yields of around 5%) for a cash interest return of possibly less than 2% will have an initially dilutive impact to EPS forecasts, this could be more than offset by a share buyback.


 

Thomson Reuters valuation range +5.5-6.5% CAGR = U$37-45 ps
Underlying Legal and Financial markets are still struggling to find direction while the initial dilution from the divestments are also capping the momentum in EPS forecasts for Thomson. As a consequence, Thomson's growth rating has stalled within a narrow growth rating range of approx +5% to +5.5%. While subscription lag is seeing current organic revenues are lagging this rate of growth, a rising trend of net new sales based on a well invested pipeline of new services, market leadership and supported by pricing power could see organic revenues exceed this growth rating by next year. As revenue momentum recovers there should be scope to see the growth rating return to a +5.5% to +6.5% growth rating range again which would equate to an NPV of around U$37-45 ps.  




Summary valuation








Friday, 24 June 2011

Groupon - marketing services, group buying middleman or loan shark?

The bottom line is that investors will have to take a massive leap of faith to get anywhere near the $20-25bn MV estimates that seem to floating around. And this doesn't even include their aim to disenfranchise new equity by offering non-voting shares or the potential bad debt problem that could emerge from the explosive geographical expansion and inherent business model.

As a piece of financial engineering, Groupon's model is interesting, although not without risk. When I initially looked at Groupon I thought it might be a cross between a marketing services business (providing promotional services to local merchants) and a group buying middle man. From the perspective of some local merchants however, Groupon may also be seen as a lender of last resort to ailing traders. Notwithstanding Groupon's negative working capital characteristics (paying merchants in stages up to 60 days after selling a Groupon), merchants may also end up receiving cash ahead of actually having to deliver on the Groupon obligation. For a Merchant in a cashflow crisis therefore, a Groupon could offer a merchant a quick cash injection, albeit at exorbitant rates. If one looks at Groupon from this perspective, it could be a lender of last resort, but at loan shark rates of 100% plus (with Groupon keeping 50% of the face value of the Groupon).

This might also lead to an adverse selection problem of a deteriorating customer profile as the weaker the merchant, the more likely they need new customers and financing on these terms. It is not clear whether unscrupulous merchants have learnt to game the system yet, but accrued merchant payables are already at over $291m (as at March) and the pace of expansion could well open up a significant bad debt problem that the negative working capital position would help to disguise so long as they keep growing. Should growth stall however, it could all look very messy indeed!

Perhaps the Greeks could use a few of these Groupons

Tuesday, 21 June 2011

Groupon in need of a Groupon

Good to see that markets have a handle on valuing the current batch of internet IPO's. Having initially more than doubled from its listing price, Linkedin's subsequent -35% share price retrenchment means that it is now only 47% ahead on its original offer price last month. Pandora meanwhile also seemed be getting off to a good start with an initial rise of +25%, although the subsequent -50% fall meant that it ended its big day down -35%. But then Pandora is not 'Social Media' and we've all heard that social media is hot, or at least as long as one isn't trying to sell off MySpace! So what about Groupon, that almost social media group buying network, but with explosive growth that is limbering up for its own IPO?

As with all these embryonic dotcoms, one is being asked to buy into a longer term story that has yet to be fully formulated and where even current data on key metrics, such as merchant retention and customer churn, are not available.  Groupon's current performance provides evidence that, so far at least, the model works as an effective promotional tool for local merchants as well as Groupon's  ability to negotiate a sizable share (50%) of the discount (>50%) offered to customers that it is able to reach. The merchant however retains less than 25% of the full ticket price of the service under the offer, which means that unless it carried an original gross margin of over 75%, the viability of a Groupon as a sustainable marketing tool will hinge on whether it builds repeat customers at full price.  A deeply discounted Groupon clearly builds sampling, but the evidence on customer loyalty and merchant retention is more patchy.  For the present, this does not appear to have adversely impacted Groupon's ability to sign up merchants or to squeeze gross margins or average customer spend as the competitive challenge has emanated mainly from hundreds of daily-deal Groupon clones such as LivingSocial.  The entry of tech and data rich internet networks such as Google, Facebook and Microsoft into this space however, could start to change these dynamics as they leverage their social media and user data to offer relevancy and loyalty tools to merchants. As the competition broadens the value proposition into these areas, will this commoditise those daily-deals sites stranded with a relatively narrow value proposition of offering a discount to an email distribution list? If you think so, then the trajectory for prospective gross margins and customer value may struggle to justify the pre-listing spin of an IPO valuation perhaps topping $20bn.

Quick & Dirty valuation
In its S-1 pre-listing teaser Groupon omitted to include some important metrics on areas such as customer churn and merchant retention which would have provided a better steer on customer life time value (CLTV), customer acquisition costs and therefore the basis for a per customer valuation. A metric which Groupon is choosing to highlight however is something referred to as 'CSOI' (consolidated segment operating income), which excludes marketing and stock compensation charges. While stock compensation should be regarded as a real expensable cost, a pre marketing EBITA can be used to provide some sort valuation perspective; albeit one still needs to make a stab at a normalised marketing spend per subscriber and a churn assumption to estimate the period over which this ought to be amortised. For Q1 FY11, reported CSOI excluding stock comp was $63m or an annualised $16 per customer. Adjusting for the step up infrastructure spend in SG&A in Q1 and some prospective scale benefits, this might suggest adjusted CSOI of perhaps $20-25 per customer pa. At $208m, Q1 marketing costs represented an annualised charge of over $50 per customer, although assuming a 20-30% reduction for future scale efficiencies and an abnormally heavy weighting in Q1 from Groupon's race for leadership, might see this ease back to nearer $35-40 per customer. To breakeven on a per customer basis therefore would need to this figure to be amortised over 1.5-2.0 years and require an underlying customer churn rate of under 35%, if not under 30%. Even spreading customer acquisition expenditure over 5 years (and an approx 12% churn rate) would suggest an underlying EBITA per customer of $12-18. Apply a 5% FCF yield to the upper end of this range (and 14x EBITA assuming a 30% normalised tax rate and 100% cash conversion) and this could suggest a value per customer topping out at around $250. On this basis, markets may need to be looking for 80m customers by year 3 and a quarterly net addition rate over over 5m per quarter to underpin a current EV of over $15bn.

To reach a current market valuation of even $15bn for Groupon may require some aggressive, if not heroic assumptions will need to be made, including an act of faith on future underlying churn. Apply a 3 year valuation horizon and the group will need to be worth at least $20bn at the period end for it to justify $15bn today. Even if Groupon were to add another 20m customers over this period (from 16m currently to 36m) this would require an EV per customer at the period end of over $550. On an operational FCF yield range of 5%-7% (vs >12% for Google and 7% for the market for 2014e) I estimate that the underlying EBITA per customer would need to rise to $36-51 pa on this customer base (and after assuming a 30% normalised 30% tax rate and 100% cash conversion).

EBITA per customer needed to support Yr 3 EV of $20bn 

While no pretense at sophistication is being made in the above 'quick & dirty' calculations, they should help to provide a rough framework of some of the issues and assumptions that will need to be considered in formulating a valuation.  With Groupon still in 'land grab' mode, attention is understandably focused on the stellar growth being achieved in customers and revenues rather than the low barriers to entry and what may also prove to be modest scale advantages. With underlying growth already maturing in some of the earlier penetrated regions, growth is being increasingly based on the geographical extension of the brand, all of which require their own layer of  investment in areas such as sales to support them which might imply a higher level of variable costs and therefore lower rate of operational leverage in the business model than may be assumed in the IPO brouhaha. Using my earlier $15 per customer underlying EBITA estimate ($12-18 range) and 14x EBITA multiple (and 5% FCF yield) on a 36m customer base by 2014, this would suggest an EV of approx $7.5bn or an NPV of nearer $6bn. Not a million miles from Google's offer back in December which was rejected!

Land grab metrics
From a standing start to $2.5bn pa of revenues, 16m customers and a footprint across 500 markets in just 30 months is certainly impressive. In this dash for growth and first mover advantage however, it is easy to miss that the group has been increasingly reliant on the geographical extension of its model to drive this growth. In the process, the average conversion of 'subscribers' [those on the email distribution list agreeing to receive offers, rather than actual paying subscribers] to customers is in decline (42% in Q1 FY11 vs 45% in Q1 FY10). As Groupon only releases cumulative customer numbers rather than the more relevant active customers, this conversion ratio is therefore already flattered.  Revenue and more importantly gross margin per customer meanwhile are all broadly flat as are average Groupon and merchant margins.

Groupon - quarterly data (annualised)



Unit yield from legacy markets eroding
The original and early roll out regions however are beginning to mature. Absolute growth rates in subscribers, customers and Groupons are still being achieved, but the underlying yields on these are deteriorating. As the customer and merchant base ages, Groupon's yield is eroding. What is less clear is whether this is a natural maturing of the market as new entrants (both customers and merchants) dilute higher spending early adopters or a deterioration in the perceived value proposition by existing customers and merchants after using the service. 

Boston
QoQ revenue growth is still averaging approx +27%, but the quality of the underlying metrics are deteriorating. Revenues per subscriber are averaging -5% QoQ and -20% YoY,  revenues per customer averaging -7% QoQ and -26% YoY,  revenues per merchant averaging -1% QoQ and -23% YoY,  revenue  per Groupon  averaging -6% QoQ and -21% YoY and Groupons per customer averaging -2% QoQ and -7% YoY. 

For more on the Boston -
http://blog.yipit.com/2011/06/03/groupon-s-1-reveals-business-model-deteriorating-in-oldest-markets/

 

Chicago
As the longest standing Groupon region Chicago has exhibited similar trends as Boston with QoQ revenue growth is averaging approx +32%, but the quality of the underlying metrics also deteriorating. Revenues per subscriber are averaging -12% QoQ and -39% YoY, revenues per customer averaging -6% QoQ and -23% YoY, revenues per merchant averaging -7% QoQ and -35% YoY, revenue per Groupon averaging -1% QoQ and -5% YoY and Groupons per customer averaging -5% QoQ and -18% YoY.


Costs
Groupon is currently in a land-grab mode, while a valuation will try and anticipate what the  underlying costs will be in a more steady state environment. The rate of top-line growth has been phenomenal, but this has been more than matched by costs and without a clear perspective on churn, prospective investors may struggle to determine whether this has been acquired profitably from the GAAP numbers. Fully expensing SAC costs presents a fairly alarming increase in marketing costs per customer (from $12 in 2009 to $53 for Q1 FY11, annualised) and the rise in SG&A costs per customer also suggest a sizable step-up in fixed infrastructure spend to support the aggressive geographical expansion.   In total, GAAP operating costs per customer have trebled from $32 pa to $98 pa.



The challenge on modelling Groupon costs is twofold. What is the variable component to costs and over what period should these be recognised? In the below analysis I've guesstimated that variable costs have edged back from 67% to 63% of costs as some (25%) of the recent increase in marketing costs will have reflected a step-up in infrastructure costs from the extending the regional footprint. On the basis of the last reported results (Q1 FY11), amortising these variable costs over say 2 years (approx 30% customer churn) would therefore suggest an annualised variable costs at approx $31 per customer. Include fixed cost at around $36 and the total annual underlying costs would come in at approx $67 per customer vs the GAAP rate of $98.



Modelling gross margin and costs per customer by churn 


NPV per customer


NPV per customer
Applying a $70 per customer average cost (with a 63% variable component) and a 25% customer churn (2.5 Yrs av. life) should deliver an average FCF of approx $13 per customer pa (post tax at 30%). Assuming that the market reaches out beyond the current growth build out to a more steady state environment (in 2014), I estimate that the business could trade within a 5% to 7% operating FCF range (discounting CAGR of +7.5% and +5.5% respectively) and a per customer valuation of $191-$267.

Value per customer by churn and FCF yield



Groupon NPV estimate by customer growth and FCF yield








 



Appendix : Revenue metric charts

Revenue per subscriber: New regions clearly generate considerably less than the the legacy US ones of Chicago & Boston, although the gap is closing as these latter two erode.


Subscriber to customer conversion: New regions have brought down the average, although this metric is distorted by Groupon only reporting on cumulative, rather than active customer numbers which inevitably flatter the customer numbers for the longer established regions.

Revenue per customer: declines across all reported segments although again this will be in part diluted by reporting only cumulative customers rather than active ones

Groupons per customer: As above for revenues per customer


Revenue per Groupon : Apart from London and briefly Berlin, there is little variance by region; at least those disclosed. Trend however still downward, particularly for Boston & Chicago

Revenue per merchant: Relatively stable overall, but with considerable volatility by region and steep declines recently in Boston & Chicago