Markets Now - Monday 24th August 2020

Hotness Delusion Syndrome is defined by KPMG demographer Bernard Salt in his 2011 book The Big Tilt as a tendency among middle-aged men to think they’re much more attractive than they are.

In related news:

The board of BT Group is preparing to defend it against takeover approaches from industry rivals and buyout firms after the suspension of its dividend prompted its shares to slump to their lowest level in more than a decade.

Sky News has learnt that Britain’s biggest telecoms group, which now has a market capitalisation of just £10.1bn, has asked bankers at Goldman Sachs to update its bid defence strategy in recent weeks.

Robey Warshaw, a boutique headed by two of the City’s leading investment bankers and a long-standing adviser to Vodafone, may also be asked by BT to play a role, according to insiders.

Sources said this weekend that BT had not yet received a formal approach from any potential suitor.

That’s Sky’s Kleinman, reporting on the latest outbreak of generalised erotomania in Newgate Street. It follows closely behind reports in May that BT Openreach was attracting interest (which triggered a weirdly handled denial of sorts) and an (as-yet unconfirmed) Telegraph story in June about Saudi Arabia’s Public Investment Fund building an (as-yet undisclosed) stake. The single most important thing to take from all this is a belief that everyone desires BT, the General Zapp Brannigan of incumbent telecoms companies.

Here’s Jefferies:

It is likely that PE firms are looking closely at BT, identifying a stark disconnect between their assessments of the FV of its dominant infrastructure and today’s share price. But there are two immediate obstacles facing any PE bidder.

... (1) future pension funding commitments won't be known until the triennial review concludes (May 2021); and (2) fibre regulation won’t be finalised until Ofcom reports (1Q 2021). Both decisions could be influenced by change of control at BT. DT retains 12% shareholding in BT. We find it hard to see how already-levered DT could sell the idea of buying BT to shareholders.

And JPMorgan:

Given limited details offered by the single source of unconfirmed information, we struggle to believe a deal is looming. We admit that BT has limited avenues available to turn around its share price, and valuations might be enticing for a private infrastructure-focused buyer, but we see a combination of the pension fund, UK infrastructure goals and network security as a difficult series of hoops for a buyout consortium to jump through. We believe this report, combined with Openreach reports in May, offers further evidence that BT is struggling to join the infrastructure trade that so many of its peers are moving towards via tower and fiber sales, JVs and partial IPOs. We can’t write off the prospect of a deal, but believe that investors should be more attuned to this as a tail risk rather than primary concern for now

And Barclays:

Given the relative performance of BT and headline multiples (when excluding the pension), BT looks very inexpensive vs peers. However, when adjusting for items such as pension, spectrum, fibre and IFRS16, BT trades broadly inline with peers on most FCF metrics, and there is no dividend support. Trends in the last quarter remain weak (EBITDA -7%), and FCF is set to remain subdued for the coming years as any rebound in EBITDA is set to be offset by Fibre capex increases (per management commentary on the 1Q earnings call).

The big problem with BT is that it’s BT. Other telecoms companies, even the state-built-then-privatised ones, have been able to rejig themselves with sales of towers and fibre networks, divisional stake sales, IPO spinouts and so on. Telecoms companies tend to have a lot of debt and a lot of expensive infrastructure whose returns can be long-dated and inflation linked. Selling the latter to pay down the former is a very simple trade, but it’s one BT’s not been able to chase (beyond a small towers deal with Cellnex last year). That’s because nearly all of BT’s infrastructure is tied up in Openreach, and Openreach is tied down by Ofcom.

The great WFH experiment of the past few months has heaped pressure on BT to accelerate its rather lazy plans to make the country full fibre (4.5m homes passed by March 2021 and 20m by the mid- to late-2020s, versus 2.6m currently). But cities already have Bran Flakes-quantities of fibre going into the ground, with the Telefonica O2/Virgin Media, CityFibre/TalkTalk and Hyperoptic consortia all digging up the most valuable roads. Overbuild in the profitable bits looks inevitable and it’ll be BT alone that gets the nub end of the deal, as it’s obliged to connect up barren wildernesses like the Highlands, Northumberland and Clapham.

In an ideal world, BT would pass some of its capex risk off to infrastructure investors. The pension fund trustees won’t wear it, however -- unless they can be spooked into it with dark muttering about predators and whatnot. Back to JPMorgan:

The BT Pension Scheme has long been a thorn in the side of the company and its management. Ongoing planned pension contributions have been a drain on cash, and the firm has, in the last few years, raised additional debt (some sold to investors, some to the pension fund itself) in order to fund these contributions in an effort to manage its obligations lower. Unfortunately for BT, the interest rate environment has not been particularly friendly, and as such the firm’s triennial valuations in 2014 and 2017 resulted in increases to planned contributions. The latest triennial valuation has now started and the results of it are expected to be announced in mid-2021, at which point we believe the deficit will again prove onerous. We see scope for a possible transfer of a partial stake in Openreach to the pension, which would help to alleviate cash contributions, but agreeing with the Trustee on a valuation could prove difficult.

Structurally, the pension (via the Trustee) has a few senior elements over other stakeholders. First, in the event that the firm generates over £1bn from an asset disposal, it has to contribute one-third of those proceeds to the pension and has to consult with the Trustee before making those disposals. Second, it has to inform the Trustee if it becomes subject to a takeover offer. Third, there is a separate negative pledge covenant in-place such that future creditors cannot be granted superior security to the Pension Scheme over a £1.5bn threshold (until the deficit is below £2.0bn). We believe that the Pension Trustee will express a fair amount of skepticism about any highly levered buyout deal that could threaten the firm’s IG status, and will have to be placated (possibly via an Openreach stake contribution into the pension fund) in order to go along with any large transaction.

11am BST - And then there’s whatever this is:

The Trump administration is considering bypassing normal US regulatory standards to fast-track an experimental coronavirus vaccine from the UK for use in America ahead of the presidential election, according to three people briefed on the plan.

One option being explored to speed up the availability of a vaccine would involve the US Food and Drug Administration awarding “emergency use authorisation” (EUA) in October to a vaccine being developed in a partnership between AstraZeneca and Oxford university, based on the results from a relatively small UK study if it is successful, the people said.

Logic says it absolutely won’t, and absolutely can’t, happen. But logic’s not been a friend of investors in recent years so of course AstraZeneca’s up more than 3 per cent at pixel.

To be clear, an EUA is plausible. Doran Fink, who’s clinical deputy director at Centers for Disease Control & Prevention’s Division of Vaccines and Related Products, mentioned recently the possibility of an EUA in the “white space” between Phase III results being delivered and the submission of a full Biologics License Application. (She also said the EUA wouldn’t necessarily be exclusive to a single manufacturer. Shortages or different cohorts, for example, would justify multiple emergency use approvals.) There was no suggestion of lowering standards, however. Developers still need to do everything that’d be required for a full Biologics License Application, which means delivering the Phase III data, and FDA staffers have historically reacted quite badly to politically motivated shortcuts.

It’s worth bearing in mind also that, from the shareholder perspective, EUA supply wouldn’t make a profit. AstraZeneca has said it’ll sell the potential Oxford vaccine at cost until we’re out of pandemic.

There was an interesting note earlier in the month from SVB Leerink arguing that valuations across the space make sense only if you assume re-vaccination into perpetuity, with rather punchy pricing assumptions and a very big uptake (which really wouldn’t be helped by any perception that the stuff was rushed through as election hype by a serial bullshitter). Here’s Leerink:

The lofty ~$115Bn total valuation today for COVID vaccine products is optimistic, in our view, and requires investors to believe in a durable “COVID pandemic” market with recurring revaccination every two years in perpetuity, sustained pricing above $37 per person in the US ($28 ex-US, developed), initial vaccination rates during the pandemic that surpass seasonal influenza vaccination rates in all countries, contracting by governments, at risk, for excess supply, and profitability that matches branded pharmaceutical products. Any shortfall compared to these assumptions materially lowers the expected value of this portfolio of products, in our view, and suggests downside from these levels. Upside requires either more aggressive assumptions than these . . . or picking a winner, among technologies, companies, or products.

• To further contextualize, by our estimates $115Bn means the vaccine will need to generate ~$104 in present value (not sales, but positive after-tax cash flow) from every human in developed countries, or alternatively, ~$16 in present value from every human on earth.

• To support the current market capitalization of the total COVID vaccine enterprise requires confidence that one or more of the key variables of vaccine adoption, vaccine pricing, vaccine-franchise redosing, vaccine stockpiling, or vaccine profitability exceed those achieved in any other comparable disease prophylaxis setting. In short, the initial coronavirus vaccination campaign during the pandemic needs to be 86% larger than total global influenza vaccination, and much more profitable just to support the current valuation, by our estimates. Specific assumptions required for this valuation include re-dosing every two years, in perpetuity, initial vaccination rates 25 percentage points higher than flu in developed countries and double that for flu in developing countries, initial pricing at $39/individual in the US and 25% or less discount in other developed countries, single digit price declines in the face of competition, extensive government purchasing at-risk to more than cover the population of developed countries (at these prices) in 2021, and profitability for a commodity product that matches that of traditional sole-source branded pharmaceutical products. Anything less than these assumptions suggests that the real value of this class of products must be lower than is discounted in the market today.

• If the COVID vaccine market opportunity turns out to be just a single course, with vaccination rates approximating influenza, and pricing eroding from current levels similarly to other vaccine markets, then our estimate of the present value of the market is less than one-fifth of the current capitalization of the total COVID vaccine stocks. . . . 

• Uncertainty around initial vaccination rate and recurring “COVID pandemic” markets are unlikely to be resolved anytime soon, but vaccine pricing could start to crumble as soon as early 2021 as more and more manufacturers agree to “pre-delivery” contract pricing at relatively low (compared to expectations) per dose pricing.

(Big.)

12pm BST - Moving seamlessly from Covid vaccines to cat medicine, Liberum has a big sprawling note out on animal health. Here’s the upshot:

The animal health market is broad but has consistent growth (4-5% per annum) and enjoys some of the benefits of the pharma market as well as the most attractive aspects of the consumer health market. These factors mean the key players in each vertical are highly valued and their resilience through COVID-19 has meant that all five of our coverage stocks are either close to or at all-time highs- making stock-picking key. We identify three winners in Genus, Pets at Home and Zooplus, which we rate BUYs, while we believe CVS is now fully valued (HOLD) and see Dechra as overvalued (SELL). We also identify three further small-cap companies that have exciting equity stories but which we do not formally cover.

 Companion Animal most attractive: Our work shows that growth in the three core markets for companion animals is faster than in food animals (c.5% vs. c.3%), while the barriers to entry are also high. We view the vet services market as the most attractive followed by the pharma segment and lastly the retail segment.

 Veterinary Services – BUY Pets, HOLD CVS: We focus on the UK market for vet services given it is the most investable in Europe for public investors. While pet ownership has been more or less stagnant over the past decade, this disguises a mix shift towards high-spend cats and dogs which has been supplemented by owners spending more per pet than ever before, driving market growth of 4-5% annually. Although meeting this demand has been a challenge in recent years due to vet shortages, we believe that Pets at Home (BUY) is well placed to address this and whilst CVS Group (HOLD) should also fare well, its valuation fully reflects this is our view.

 Therapies and Vaccines – SELL Dechra: The market for therapies and vaccines for companion animals is worth $12bn globally and has grown by a consistent 4-5% for the past decade with similar growth expected over the medium term. We believe the market has some of the most attractive aspects of traditional pharma (patents, blockbusters, complex sales channel) and some of the most attractive aspects of the consumer market (brand loyalty, self-pay model). In terms of stocks, we think Dechra is a quality business but is facing increased challenges and needs greater innovation from the pipeline. Its high multiple leaves no room for error on the R&D front, hence we initiate with a SELL.

 Retail – BUY Zooplus: The retail market in Europe for pet products is worth £25bn and growing by 3% annually. There is still significant scope to professionalise and commercialise the market to match increasingly sophisticated customer demands, meaning we expect this growth rate to continue. The traditional bricks-and-mortar model is under pressure, but there can still be winners among those that are geographically focussed and use their retail space for other revenue generating activities, such as Pets at Home. By contrast, the online segment is being helped by the same tailwinds that drove clothing retail online (including COVID-19), but here we believe geographic diversification is key to generating value and that Zooplus is a long-term winner. . . . 

 Our overall thesis is very simple: pretty much every vertical in animal health is growing nicely and the competitive situation is relatively benign – companies should therefore not overcomplicate things. AnimalCare, Benchmark and Eco Animal Health have all been guilty of this in the past, in our view. However, they are all now focussed on new strategies and in some cases are restructuring their businesses. While we do not formally cover these names, we believe that they are in interesting verticals and that each is at an important point in its equity story

• Updates might follow, influenced or otherwise by requests and complaints in the comment box.