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EMEA
Global Equity Research
Multi-sector
July 2012
Xavier Gunner*
Deputy Head of Equity Research
HSBC Bank plc
+44 20 7991 6749
xavier.gunner@hsbcib.com
HSBC Nutshell - A guide to equity sectors and emerging countries
Chris Georgs
Global Head of Equity Research
HSBC Bank plc
+44 20 7991 6781
chris.georgs@hsbc.com
HSBC Nutshell
A guide to equity sectors and emerging countries in EMEA
This guide will help you gain a quick but thorough understanding of the major sectors, industry
groups and countries in the region
It provides detailed information on structures, key drivers, indicators, themes and valuation
approaches
EMEA
A product of the Global Equity Research Team
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations.
July 2012
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it
EMEA Equity Research
Multi-sector
July 2012
abc
Dear Client,
We are pleased to present HSBC Nutshell: A guide to equity sectors and countries, our inaugural suite of
multi-regional and global primers. The Nutshell guides have been compiled by our global equity research
team to help new and seasoned professionals gain a quick, but thorough, understanding of markets in
Latin America, EMEA, and Asia. For investors looking to invest globally and especially in emerging markets,
the guides provide a broad, top-down perspective on these markets and the sectors related to them.
We have assumed that our readers will have some basic working knowledge of the world economy,
equity markets, financial terminology and ratios, although the Nutshell guides are designed to be used by
anyone wanting to gain a deeper understanding of countries or industries with which they are not familiar.
The Nutshell guides are designed to provide consistency and comparability. For each sector, our analysts
explain how they value companies, and assess the key drivers affecting the sector, as well as the macro
issues and trends impacting the sector on a regional and global basis. We then build on the sector
framework to include regional macro overviews and country sections that provide a broader perspective
on the sectors and geographies that we cover, addressing topics such as market composition, liquidity,
fund flows, and political and regulatory structures.
We look forward to making our analysts available to you on a one-on-one or group basis to help you build
on your country, sector, industry or stock knowledge – from the nuts and bolts of the industry dynamics
through to individual company valuation and recommendations. The front page of each industry or
country section within these guides includes the names and contact details of our sector analysts and,
where relevant, their specialist sales person/people. Please get in touch with your HSBC representative to
organise this, contact us directly, or email HSBC.Nutshell@us.hsbc.com.
We hope you find these guides useful, and we look forward to continuing to work with you in the future.
Regards,
Chris Georgs – Global Head of Equity Research
Patrick Boucher – Head of Product Management, Equity Research
David May – Head of Equity Research, Asia Pacific
1
EMEA Equity Research
Multi-sector
July 2012
2
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EMEA Equity Research
Multi-sector
July 2012
Contents
Europe overview
5
Sectors
17
Autos
19
Beverages
29
Business services
39
Capital goods
51
Chemicals
61
Clean energy & technology
73
Climate change
83
Construction & building materials
93
Financials – Banks
103
Financials – Insurance
113
Food & HPC
123
Food retail
133
General retail
143
Luxury goods
153
Metals & mining
161
Oil & gas
171
Telecoms, media & technology
181
Transport & logistics
191
Travel & leisure
201
Utilities
211
EMEA countries
221
Egypt
223
Russia
231
Saudi Arabia
239
South Africa
247
Turkey
255
Basic valuation and
accounting guide
263
Disclosure appendix
278
Disclaimer
280
3
EMEA Equity Research
Multi-sector
July 2012
4
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EMEA Equity Research
Multi-sector
July 2012
abc
Europe overview
5
6
Country
Austria
Belgium
Denmark
Finland
France
Germany
Greece
Ireland
0.4%
1.6%
1.9%
1.2%
13.9%
12.9%
0.1%
0.5%
Financials (43%)
Energy (22%)
Telecoms (14%)
Cons. staples (64%)
Materials (12%)
Financials (12%)
Health Care (60%)
Industrials (15%)
Financials (9%)
Industrials (27%)
Financials (16%)
IT (15%)
Industrials (16%)
Cons. disc. (14%)
Energy (13%)
Cons. disc. (18%)
Materials (16%)
Financials (16%)
Cons. staples (47%)
Financials (26%)
Cons. disc. (19%)
Materials (48%)
Health care (27%)
Cons. staples (22%)
Omv (22%) Anh-Busch InBev (57%)
Novo Nordisk (54%)
Erste Group Bank (16%)
Solvay (7%)
Danske Bank (8%)
Telekom Austria (14%)
Umicore (6%) APMoller-Maersk (7%)
Nokia (15%)
Sampo (14%)
Kone (13%)
Total (12%)
Sanofi (10%)
Danone (5%)
Siemens (9%) Coca-Cola HlcBt (47%)
BASF (9%) Natl Bnk Greece (26%)
SAP (7%)
Opap (19%)
CRH (48%)
Elan (27%)
Kerry Group (22%)
Weight in MSCI Europe
Key sub-sectors
Three largest stocks
Trading data
Market cap. (free-float EURbn)
ADTV (5-year) (EURm)
Performance in past 10 years
Absolute
Relative to MSCI Europe
Correlations of country MSCI
index returns (5-year) with
MSCI Europe
Exports (country)
Nominal GDP (country)
US ISM
Key country stats
12M-forward EPS growth
Long-term average 12M-forward PE
12M-forward PE
Long-term average PB
Current PB
Long-term average ROE (%)
Current ROE
20
183
78
389
84
396
54
714
662
4,582
582
5,793
3
172
21
140
9%
-12%
-1%
-20%
143%
97%
-12%
-29%
7%
-13%
33%
8%
-81%
-85%
-57%
-65%
0.66
0.27
0.18
0.57
0.74
0.31
0.15
0.52
0.74
0.22
0.01
0.45
0.62
0.21
0.11
0.24
0.87
0.32
0.08
0.47
0.81
0.31
0.05
0.47
0.51
0.12
-0.12
0.38
0.69
0.15
0.22
0.32
24%
13.8
7.3
1.6
0.8
11%
6%
18%
12.3
11.9
1.5
1.5
12%
7%
28%
15.4
15.2
1.9
2.3
13%
10%
-6%
23.3
13.3
2.8
1.4
15%
12%
5%
14.2
8.9
1.7
1.1
12%
10%
13%
15.3
9.1
1.9
1.4
10%
11%
205%
12.3
5.9
2.0
0.6
14%
6%
14%
14.4
17.8
2.2
1.7
13%
6%
EMEA Equity Research
Multi-sector
July 2012
Europe country by country
Source: HSBC, Thomson Reuters Datastream, MSCI, IBES
abc
Country
Italy
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
United Kingdom
Weight in MSCI Europe
3.2%
3.8%
1.5%
0.3%
3.9%
4.8%
13.5%
36.6%
Energy (35%)
Financials (26%)
Utilities (18%)
Cons. staples (38%)
Financials (16%)
Industrials (14%)
Energy (54%)
Financials (13%)
Materials (13%)
Utilities (29%)
Cons. staples (23%)
Energy (17%)
Financials (39%)
Telecoms (21%)
Utilities (12%)
Industrials (30%)
Financials (24%)
Cons. disc. (14%)
Health care (32%)
Cons. staples (25%)
Financials (17%)
Energy (20%)
Financials (17%)
Cons. staples (17%)
ENI (25%)
ENEL (10%)
Intesa Sanpaolo (7%)
ING Groep (10%)
ASML Holding (9%)
Philips Eltn.Kon (8%)
151
3,167
171
1,741
67
801
13
153
188
2,646
226
1,422
634
2,716
1,727
7,626
-28%
-41%
3%
-17%
142%
96%
-13%
-29%
29%
5%
130%
86%
48%
20%
25%
1%
0.71
0.33
0.01
0.41
0.87
0.26
-0.05
0.52
0.71
0.40
0.45
0.52
0.67
0.31
0.37
0.32
0.77
0.31
0.03
0.41
0.78
0.44
0.37
0.47
0.75
0.26
-0.04
0.37
0.85
0.47
0.65
0.50
14%
15.8
7.2
1.6
0.8
11%
7%
11%
12.8
9.3
1.7
1.3
15%
9%
9%
11.2
9.4
1.7
1.5
15%
16%
12%
13.6
10.2
2.0
1.2
14%
9%
-3%
12.7
8.1
1.5
0.9
17%
11%
11%
15.0
11.3
2.0
1.9
14%
13%
11%
14.1
11.7
2.1
2.1
14%
13%
5%
13.0
9.4
1.9
1.7
16%
16%
Key sub-sectors
Three largest stocks
Trading data
Market cap. (free-float EURbn)
ADTV (5-year) (EURm)
Performance in last 10 years
Absolute
Relative to MSCI Europe
Correlations of country MSCI index
returns (5-year) with
MSCI Europe
Exports (country)
Nominal GDP (country)
US ISM
Key country stats
12M-forward EPS growth
Long-term average 12M-forward PE
12M-forward PE
Long-term average PB
Current PB
Long-term average ROE (%)
Current ROE
Statoil (31%)
EDP (24%)
Telefonica (22%) Hennes&Mauritz (11%)
Seadrill (14%) JeronimoMartins (23%) Banc Santander (21%)
Ericsson (9%)
Telenor (13%)
Galp Energia (17%) BBV.Argentaria (12%)
Nordea Bank (7%)
EMEA Equity Research
Multi-sector
July 2012
Europe country by country
Nestlé (24%) Royal Dutch Shell (9%)
Novartis (15%)
HSBC Hdg. (7%)
Roche Holding (14%) Vodafone Group (6%)
Source: HSBC, Thomson Reuters Datastream, MSCI, IBES
abc
7
8
Sector
Weight in MSCI Europe
Key sub-sectors
Three largest stocks
Energy
Materials
Industrials
12%
10%
11%
Consumer Consumer staples
discretionary
9%
15%
Integrated oil & gas Diversified metals Industrial conglom Auto manufacturers Packaged foods &
(84%)
& mining (38%)
(16%)
(23%)
meats (40%)
Oil & gas equip &
Diversified
Industrial Apparel, access&
Tobacco (16%)
services (8%) chemicals (16%) machinery (15%) luxury gds (23%)
Oil & gas drilling
Industrial gases
Aerospace &
Apparel retail
Brewers (13%)
(4%)
(11%)
defense (11%)
(10%)
Royal Dutch Shell
BP
Total
Trading data
Market cap. (free-float EURbn)
ADTV (5-year) (EURm)
Performance in last 10 years
Absolute
Relative to MSCI Europe
Correlations of sector MSCI index
returns (5-year) with
MSCI Europe
Nominal GDP (euro area)
US ISM
Key sector stats
12M-forward sales growth
12M-forward EPS growth
Long-term average 12M-forward PE
12M-forward PE
Long-term average PB
Current PB
Long-term average ROE(%)
Current ROE
BASF
Rio Tinto
Siemens
ABB
Daimler
LVMH
BHP Billiton Schneider Electric Hennes & Mauritz
Nestle
British American
Tobacco
Diageo
Health care
Financials
Information
technology
Telecomms
services
Utilities
12%
18%
3%
6%
5%
Pharmaceuticals Diversified banks
(87%)
(49%)
Health care
Multi-Line
equipment (4%) insurance (14%)
Health care Diversified capital
services (4%)
markets (10%)
Novartis
HSBC Hdg
Glaxosmithkline Standard Chartered
Roche Holding
Banco Santander
Application
Integrated
Electric utilities
Software (38%) telecomms (60%)
(43%)
Communications
Wireless Multi utilities (42%)
equipment (24%) telecomms (38%)
Semiconductors Alternative carriers Gas utilities (5%)
(13%)
(1%)
SAP
Ericsson
Vodafone Group
Telefonica
National Grid
E On
ASML Holding Deutsche Telekom
Centrica
578
2,701
460
4,103
525
3,162
420
4,196
743
2,357
608
1,727
904
8,818
140
1,394
318
1,898
225
1,985
53%
9%
100%
42%
78%
26%
63%
16%
120%
56%
66%
18%
-29%
-49%
-10%
-36%
91%
36%
80%
28%
0.65
-0.08
0.30
0.85
0.10
0.39
0.93
-0.01
0.36
0.91
-0.03
0.25
0.69
-0.04
0.23
0.56
-0.09
0.21
0.91
0.11
0.41
0.79
-0.09
0.17
0.66
0.10
0.10
0.75
0.25
0.30
0%
4%
10.5
7.6
2.5
1.4
19%
18%
5%
6%
11.3
9.1
1.9
1.6
14%
14%
5%
12%
13.0
11.2
2.4
2.1
14%
14%
7%
12%
12.9
10.1
2.3
1.9
13%
16%
5%
9%
14.4
14.3
3.6
3.1
20%
17%
3%
3%
14.3
11.0
5.1
3.1
21%
21%
4%
15%
9.9
7.3
1.8
0.7
11%
6%
0%
-2%
17.3
15.0
4.9
2.2
12%
16%
-1%
-1%
12.1
9.0
2.3
1.3
13%
14%
0%
4%
12.0
9.7
2.1
1.1
14%
10%
EMEA Equity Research
Multi-sector
July 2012
Europe sector by sector
Source: HSBC, Thomson Reuters Datastream, MSCI, IBES
abc
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EMEA Equity Research
Multi-sector
July 2012
Europe overview
Introduction
The past two decades have been among the most volatile periods in the history of the European stock
market. During this time we have seen the development of a huge technology-led bubble (the late 1990s)
that subsequently burst and, in doing so, triggered a three-year bear market (2000-03). A five-year
upswing followed, fuelled by strong emerging market growth (led by China). This drove the European
equity market to within touching distance of its 2000 peak level, but the trend proved unsustainable. This
time the downturn was primarily a consequence of the bursting of bubbles in the credit and housing
markets in many countries. The outcome was the biggest post-war recession, a financial crisis (still
ongoing) and a collapse in value of risk assets, with financials bearing the brunt of the selling. The bear
market ran from 2007 to 2009, causing the European equity market to lose 50% of its value and revisit its
Peter Sullivan*
Strategist
HSBC Bank plc
+44 20 7991 6702
peter.sullivan@hsbcib.com
Robert Parkes*
Strategist
HSBC Bank plc
+44 20 7991 6716
robert.parkes@hsbcib.com
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
2003 lows.
The combination of a major fiscal and monetary policy response and signs of stabilisation in the global
economic indicators eventually led to a recovery in stock prices in early 2009. But as the financial crisis
shifted from the private sector to the public sector, the rally stalled in the first half of 2011 and the market
has since remained range-bound.
1. MSCI Europe price index (EUR)
2. Largest stocks in MSCI Europe
180 0
160 0
140 0
120 0
100 0
80 0
60 0
40 0
20 0
0
Stock rank
Stock name
1
2
3
4
5
Top 5
6
7
8
9
10
Top 10
Royal Dutch Shell (A+B)
Nestlé
HSBC Holding
Vodafone Group
Novartis
90 92
94 96 98
00 02 04 06 08 10 12
MSCI Europe
Index weight
BP
GlaxoSmithKline
Roche Holding
British American Tobacco
Total
3.5%
3.2%
2.5%
2.3%
2.1%
13.5%
2.0%
1.9%
1.9%
1.6%
1.6%
22.7%
Source: MSCI, Thomson Reuters Datastream, HSBC,
Source: MSCI, Thomson Reuters Datastream, HSBC
Chart 1 shows the extent of the volatility we have seen over recent times in the European stock market.
What is clear is that from the late 1990s onwards a buy and hold strategy would not have performed
consistently well.
9
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EMEA Equity Research
Multi-sector
July 2012
Market structure
Europe’s largest companies are shown in table 2. The energy (RDS A+B, BP and Total) and
pharmaceuticals (Novartis, GlaxoSmithKline and Roche) sectors each contribute three companies. There
are two companies from the consumer staples sector (Nestlé and British American Tobacco). A bank
(HSBC) and telecoms company (Vodafone) complete the list. Combined, these 10 companies account for
over one-fifth of the total index market capitalisation.
The collapse in value of the financials sector has resulted in a more balanced spread of sector weightings
in Europe. Its weighting peaked at 31% in Q4 2006 but has now fallen to 18%, although it remains the
largest sector in Europe. The consumer staples sector has the second-highest weight (15%), with energy
(12%) and healthcare (12%) tied in third place.
The most important markets in Europe by size in descending order are: the UK (37% weight), France
(14%), Switzerland (13%) and Germany (13%). Note that the periphery (Spain, Italy, Portugal, Ireland
and Greece) accounts for just 8% of total European market capitalisation.
Of the markets in the European index with a weighting over 3%, Spain, Switzerland and Italy are the
most concentrated and the UK the least concentrated (table 3).
Market structure and liquidity are important factors explaining volatility in European markets. Illiquid
markets and/or those dominated by a small number of companies tend to experience more volatility. In
markets with low volumes (table 4 gives detail on market liquidity), prices often fall quickly when
investors rush for the exit. In highly concentrated markets such as Norway (where Statoil accounts for
around 30% of the MSCI Norway index), the volatility of the market is subject to the underlying volatility
of a limited number of companies.
Measured over the past five years, the most volatile markets have been Greece, Norway, Austria and
Ireland. The least volatile were Switzerland, the UK, Portugal and France (table 5).
3. MSCI Europe: country weights of top 5/top 10 stocks
Austria
Belgium
Denmark
Finland
France
Germany
Greece
Ireland
Italy
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
United Kingdom
MSCI Europe
Source: MSCI, Thomson Reuters Datastream, HSBC,
10
4. MSCI Europe: daily average stock market turnover (EURm)
Top 5
Top 10
79%
80%
83%
62%
35%
38%
100%
100%
56%
40%
77%
88%
70%
38%
63%
33%
14%
100%
98%
98%
90%
51%
60%
100%
100%
77%
61%
100%
100%
85%
60%
80%
49%
23%
Current 5-year average
Austria
Belgium
Denmark
Finland
France
Germany
Greece
Ireland
Italy
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
United Kingdom
MSCI Europe
Source: MSCI, Thomson Reuters Datastream, HSBC,
66
349
260
356
3,551
3,687
46
55
1,897
1,162
415
90
1,612
1,101
1,866
5,794
22,308
183
389
396
714
4,582
5,793
172
140
3,167
1,741
801
153
2,646
1,422
2,716
7,626
32,644
abc
EMEA Equity Research
Multi-sector
July 2012
5. MSCI Europe: earnings and index volatility
MSCI indices
________Trailing earnings volatility* ________
10 years
5 years
Austria
Belgium
Denmark
Finland
France
Germany
Greece
Ireland
Italy
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
United Kingdom
MSCI Europe
99%
299%
33%
35%
41%
62%
40%
208%
40%
91%
45%
27%
26%
149%
49%
23%
21%
________ Market returns volatility* _______
10 years
5 years
53%
423%
40%
39%
30%
51%
47%
292%
28%
127%
52%
26%
28%
34%
65%
28%
23%
27%
24%
22%
28%
21%
24%
35%
25%
23%
23%
30%
20%
23%
26%
15%
18%
19%
34%
28%
27%
29%
23%
25%
43%
29%
28%
25%
36%
22%
27%
29%
16%
22%
21%
Note: *calculated as the annualised standard deviation of monthly changes
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
The volatility of earnings clearly contributes to the overall level of price volatility. Over the past 10 years,
Sweden, the Netherlands and Germany have been among the larger European markets with the highest
level of earnings volatility. Earnings volatility has been lowest in the UK and Spain.
Correlations
So far we have examined market structure, liquidity and volatility in earnings to explain market
behaviour. Another factor that drives market volatility is the sensitivity of markets to global and domestic
economic factors.
To examine this further, we correlated various macro and fund flow factors with equity markets (table 6).
We used the ISM and country exports as a proxy for global macro conditions and country GDP as a proxy
for domestic economic conditions.
6. MSCI Europe: market correlations
Country
Austria
Belgium
Denmark
Finland
France
Germany
Greece
Ireland
Italy
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
United Kingdom
__Economic factors (past 20 years)____
US ISM
Exports GDP nominal
(country)
(country)
0.57
0.52
0.45
0.24
0.47
0.47
0.38
0.32
0.41
0.52
0.52
0.32
0.41
0.47
0.37
0.50
0.27
0.31
0.22
0.21
0.32
0.31
0.12
0.15
0.33
0.26
0.40
0.31
0.31
0.44
0.26
0.47
0.18
0.15
0.01
0.11
0.08
0.05
-0.12
0.22
0.01
-0.05
0.45
0.37
0.03
0.37
-0.04
0.65
_________ Fund flows __________
past
past
6 to 10
10 years
5 years years ago
0.08
0.20
-0.08
0.17
-0.26
0.04
0.06
-0.01
0.16
-0.06
-0.14
0.00
0.21
0.33
0.07
0.21
-0.05
0.24
-0.08
0.23
-0.35
0.05
0.05
0.01
0.15
-0.06
-0.17
0.02
0.22
0.39
0.08
0.25
0.29
-0.10
-0.12
0.01
-0.10
0.12
0.23
n/a
0.20
-0.16
n/a
0.00
0.10
0.22
0.08
0.12
_ Indices (past 20 years)__
MSCI Europe
World
0.66
0.74
0.74
0.62
0.87
0.81
0.51
0.69
0.71
0.87
0.71
0.67
0.77
0.78
0.75
0.85
0.60
0.66
0.68
0.63
0.79
0.74
0.42
0.68
0.63
0.82
0.69
0.57
0.68
0.73
0.72
0.81
Source: MSCI, Thomson Reuters Datastream, Eurostat, HSBC
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7. MSCI Europe: actual versus in sample trend earnings*
8. MSCI Europe: 20-year annual EPS growth CAGR
6.0
10
8
5.5
6
4
5.0
2
4.5
94
96 98
Real EPS
00
02
04
06 08 10 12
In sample trend
*Note: calculated using a weighted least squares method
Source: MSCI, Thomson Reuters Datastream, HSBC
UK
Nethlnd
Europe
Switz
Italy
Germany
92
France
4.0
Spain
Sweden
0
Annualised growth rate % (20 years)
Source: MSCI, Thomson Reuters Datastream, HSBC
The key takeaway here is that global economic factors are more important than the health of the domestic
economies.
Earnings and ratings
European earnings have followed a cyclical pattern over the past 20 years. They have recovered from the
financial crisis low of late 2009 but remain below the 20-year trend (chart 7).
Earnings have grown by 5.2% annually on average over the past 20 years (table 8). The countries that have
recorded the highest annualised growth rates are: Sweden (+8.9%), Spain (+7.7%) and France (+7.2%).
Earnings growth has lagged the European average in the UK (+3.6%) and the Netherlands (+3.7%).
If we look at how accurate analysts have been in forecasting this growth, it becomes apparent that they
have tended to be too optimistic when forecasting European earnings. The average miss to 12M-forward
EPS expectations (since 1995) has been 7%.
Analysts’ earnings revisions (upgrades and downgrades) do correlate well with the market (chart 11).
Turning points in the consensus EPS revisions ratio (number of upgrades to 12M-forward EPS expressed
as a percentage of the number of upgrades plus the number of downgrades) can often help to identify
turning points in stocks.
9. MSCI Europe: earnings momentum – Europe versus returns
10. MSCI Europe: 12M-forward EPS growth versus returns
40%
30%
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
60%
60%
60%
40%
40%
40%
20%
20%
20%
0%
0%
0%
04 04 05 05 06 06 07 07 08 08 09 0 9 10 10 11 11 12
Europe ea rnings mo me ntum
MSCI Europe YoY (RHS)
Source: MSCI, Thomson Reuters Datastream, IBES, HSBC
12
-20%
-20%
-20 %
-40%
-40%
-40 %
-60%
-60%
-60 %
04 04 05 05 06 06 07 07 08 08 0 9 09 10 10 11 11 12
Europ e EPS growth
MSCI Eur ope YoY (RHS)
Source: MSCI, Thomson Reuters Datastream, IBES, HSBC
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11. MSCI Europe: EPS revisions ratio* versus price index
60%
80%
70%
40%
60%
20%
50%
40%
0%
30%
-20%
20%
-40%
10%
0%
-60%
04
05
06
07
Ea rnings Revisions
08
09
10
11
12
MSCI Europe YoY (RHS)
Note: *number of upgrades to 12m fwd EPS as a % of all changes
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
12. Europe recommendation consensus score
2.80
2.70
2.60
2.50
2.40
2.30
2.20
2.10
2.00
94
96
98
00 02
RCS
+2SD
04
06
08 10
Average
-2SD
12
Source: Thomson Reuters Datastream, HSBC
Early 2009 proved to be a good example of why this indicator can be important. The pace of downgrades
started to slow in January 2009, signalling that the outlook for earnings was starting to look less bad. But
there was a delayed response in terms of share prices: the MSCI Europe index did not bottom until March
2009, after which it rebounded sharply.
Admittedly, analysts were slow to cut their numbers during the financial crisis in 2008. However, perhaps
this at least partly explains why they have been particularly aggressive about cutting their numbers over
the past 12 months, in response to the worsening economic slowdown and sovereign debt concerns.
Analysts’ recommendations on companies can also signal turning points in the market: Historically, when
analysts have started to downgrade after being particularly optimistic (lots of buy recommendations), this
has tended to help reinforce a new downtrend in the equity market. The opposite is also true: When
analysts have started to upgrade after being very pessimistic (lots of sell recommendations), this can help
to confirm a new uptrend in the equity market.
The peak of the tech bubble in 2000 and the 2009 low that followed the financial crisis are two examples
of how a combination of the level and change in analyst recommendations can confirm turning points in
the market (chart 12). We therefore conclude that it is wrong to dismiss analyst behaviour as being
irrelevant, even when, as now, the environment is predominantly macro-driven.
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July 2012
Valuations
In the past decade, Europe has traded on an average of 14.6x earnings, with Sweden being the most
expensive. Of the larger markets, Spain, the Netherlands and Italy have historically traded at a discount to
the Pan-European aggregate (table 13).
Intriguingly, it was only a decade earlier that Sweden had experienced a financial crisis which resulted in
the part-nationalisation of the banking system. In a way this highlights the danger of extrapolating
forward the currently low level of valuations in Europe (which have been driven down by the ongoing
sovereign debt crisis).
The European market has been on a de-rating trend over the past 12 years. This initially was a response to
the bursting of the technology bubble, but has since continued, driven by increasing concern about
lacklustre developed world growth and the fall-out from the financial crisis. That dragged the PE multiple
for Europe down to just 9.6x (34% below the 10-year average), implying that 52% upside is needed to get
the equity market back to its decade average valuation. Italy, Germany and Spain are currently trading on
the biggest discounts to their 10-year average PE multiples.
If we invert the PE multiple to get the earnings yield and compare this with the bond yield over time, we can
see that the gap has been steadily widening since the onset of the financial crisis five years ago (chart 14).
Up until 2007 the European market tended to trade in the 15x-20x PE range, but it then dropped to the
10x-15x range and has very recently edged into the 5x-10x range (chart 15).
Long-run average European country ROEs range from 10% in Germany to 17% in Spain. With earnings
currently below trend, current ROEs are lower in most cases, the only exceptions being Germany and
Norway.
13. MSCI Europe: 12M-forward PE (EBG) by market
Austria
Belgium
Denmark
Finland
France
Germany
Greece
Ireland
Italy
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
United Kingdom
MSCI Europe
PE
now
Avg
2001-11
% diff
Avg
1993-2011
% diff
7.3
11.9
15.2
13.3
8.9
9.1
5.9
17.8
7.2
9.3
9.4
10.2
8.1
11.3
11.7
9.4
9.6
12.4
12.5
16.5
16.3
14.5
15.3
12.9
14.9
14.1
13.4
11.8
14.7
13.4
17.4
15.9
15.0
14.6
-41%
-5%
-8%
-19%
-38%
-41%
-55%
19%
-49%
-31%
-20%
-31%
-40%
-35%
-27%
-38%
-34%
15.5
14.0
17.6
19.0
17.6
18.8
13.7
14.6
22.0
15.1
13.3
15.6
14.9
20.8
17.0
15.8
16.4
-53%
-15%
-14%
-30%
-49%
-52%
-57%
22%
-67%
-38%
-29%
-35%
-46%
-46%
-31%
-41%
-42%
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
14
14. Europe: earnings yield (EY) versus bond yield (BY)
16%
14%
12%
10%
8%
6%
4%
2%
0%
01 02 03 04 05 06 07 08 09 10 11
EY
Source: Thomson Reuters Datastream, HSBC
BY
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15. MSCI Europe: PE band chart
16. MSCI Europe: PB versus ROE/COE
3,000
5
4
4
3
3
2
2
1
1
0
2,500
2,000
1,500
1,000
500
0
02
03 04
MSCI PI
15X
05
06
07
5X
2 0X
08
09
10
11
10X
25X
12
0 0 01 02 0 3 04 05 0 6 07 08 0 9 10 11 1 2
PBR
Source: MSCI, Thomson Reuters Datastream, HSBC
ROE/CO E
Source: MSCI, Thomson Reuters Datastream, HSBC
While valuations tend to tell us very little about the short-term direction of equity markets, they can,
when they reach extreme levels (think 2000 and 2009), often help to identify turning points in the market.
Moreover, for longer-term investors the empirical evidence suggests that valuation is a more important
guide to long-term stock market returns than other indicators such as trend economic growth rates.
We also looked at sector valuations across Europe (table 17). The story here is the same as for the country
analysis, with a broad range of sectors trading well below their 10-year average PE ratios. We find that
only the consumer staples sector is trading in line with its average multiple over the past decade. Eight of
the ten sectors are more than one standard deviation below average, financials and energy being the most
extreme cases.
17. MSCI Europe: 12M-forward PE versus 10-year average and standard deviations from average
Energy
Materials
Industrials
Consumer discretionary
Consumer staples
Health care
Financials
Technology
Telecom
Utilities
Europe
Current PE
Rolling 10-yr avg
Rolling 10-yr SD
# ST Dev from avg
7.6
9.1
11.2
10.1
14.3
11.0
7.3
15.0
9.0
9.7
9.6
10.5
11.3
13.0
12.9
14.4
14.3
9.9
17.3
12.1
12.0
11.8
2.0
2.0
1.8
1.9
1.5
3.0
1.7
4.0
2.7
1.9
1.5
-1.5
-1.1
-1.0
-1.4
0.0
-1.1
-1.5
-0.6
-1.2
-1.2
-1.4
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
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18. Cumulative foreign institutional funds into equities in
Europe since 2000
19. Cumulative buying into country equity funds, Europe exUK regional equity funds and Europe regional equity funds
since January 2000
USDm
50
0
-50
-100
-150
-200
00 0 1 02 03 04 05 06 07 08 09 10 1 1 12
Cumulative funds flows since 2 000 USDbn
Source: EPFR, HSBC
Austria
Belgium
Denmark
Finland
France
Germany
Greece
Ireland
Italy
Netherlands
Norway
Portugal
Spain
Sweden
Switzerland
United Kingdom
Europe ex-UK
Europe
Total
-302
-932
-578
-70
-6,678
17,138
25
4
-2,115
-1,544
-116
-42
-1,467
479
-8,682
-11,278
-58,234
-84,521
-158,913
Source: EPFR, HSBC
Fund flows/holdings
Since 2000, investors have withdrawn USD159bn from the European equity market – all of it since the
onset of the financial crisis in 2007. Looking at the country breakdown, we find that only the German
market has experienced meaningful net inflows. Both of these points highlight the ongoing high level of
risk aversion, from the perspective of both asset and equity allocation (Germany being the perceived safe
haven within the eurozone).
We find that fund holdings analysis (specifically how large international funds are positioned) is another
tool that can be used to signal relative country and sector performance over the medium term. Our
analysis shows that these funds tend to move as a herd when either ‘fear’ or ‘greed’ dominate. And this
can trigger a reversal in relative performance over the next one to two years. For example, if this group of
investors were very underweight a particular sector, we would view this as a positive signal for future
relative performance and the reverse is true. See our latest Fund Holdings report (Equity Insights – Fund
holdings: The US is a winner from the eurozone crisis, 28 May 2012) for further details on this.
Emerging Europe
Given the growing importance of emerging markets (in a European context this means Central and
Eastern Europe, Middle East and Africa – CEEMEA), in this Nutshell we have included analysis of the
five most important countries: Russia, Turkey, South Africa, Saudi Arabia and Egypt. They are very
different in terms of growth and risk characteristics, but are becoming increasingly important recipients of
capital flows. We believe that it is important to know something about the key stocks and general
characteristics of these markets; for example, Gazprom, listed in Russia, is one of the most high profile
energy companies in both Europe and the world.
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Sectors
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July 2012
Notes
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Autos
European autos team
Horst Schneider*
Analyst
HSBC Trinkaus & Burkhardt AG, Germany
+49 211 910 3285
horst.schneider@hsbc.de
Niels Fehre*, CFA
Analyst
HSBC Trinkaus & Burkhardt AG, Germany
+49 211 910 3426
niels.fehre@hsbc.de
Sector sales
Rod Turnbull
Specialist Sales
HSBC Bank Plc
+44 20 7991 5363
rod.turnbull@hsbcib.com
Billal Ismail
Specialist Sales
HSBC Bank Plc
+44 20 7991 5362
billal.ismail@hsbcib.com
Oliver Magis
Specialist Sales
HSBC Trinkaus & Burkhardt AG, Germany
+49 211 910 4402
oliver.magis@hsbc.de
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
19
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Sector structure
Autos
Car mak ers
Mass-market car makers
Auto compone nts
Premium car makers
Diversified/multi-product
suppliers
T yre makers
Fiat + Chrysler
Audi (Volkswagen)
Bosch*
Continental
PSA Peugeot Cit roen
BMW
Con tinenta l
Michelin
Ren ault
Mercedes-Be nz (Da imler)
Faurecia
Nokian Renkaat
Volkswage n brand
Porsche (Volkswagen )
Thyssen Krupp
Pirelli
Ford
Ferra ri, Mase rati (Fiat
Group)
Valeo
Goodyear/ Sumitomo
Delphi
Cooper
Magna
Bridgestone
Johnson Cont rol
Yokoha ma
Lear
Hankook
General Motors
Hon da
Nissan
Suzuki
Toyota
Hyund ai–Kia
Beijing Automotive*
Cha ngan Group
First Auto Works (FAW )
Don gfeng
SAIC
Aston Martin*
Ja guar–Landrover (Tata
Motors)
Cadillac (GM)
Lin co ln (Ford)
Acura (Honda)
Den so
Aisin Seiki
Infinit i (Nissan)
Lexus (Toyota)
Volvo (Geely)
Specialised suppliers
(telematics, safety,
electricals, chassis etc.)
Aut oliv
Elringklinger
Leoni
Magneti Marelli (Fia t)
Rheinmetall
ZF group*
TRW Automotive
Source: HSBC
abc
*Private companies
450
Greek crisis, sharp rise in oil
prices
Financial crisis & Lehman collapse
End of incentives
400
Early 2000: Impact of 9/11
and bursting of dotcom
bubble
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EMEA Equity Research
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July 2012
Sector price history: Euro STOXX Auto and Parts
Car scrappage
schemes
Strong recovery in mid
2000s
300
Boom in the 1990s
250
Europe recession
200
150
100
Jan-12
Jul-11
Jul-10
Jan-11
Jan-10
Jul-09
Jul-08
Jan-09
Jan-08
Jul-07
Jan-07
Jul-06
Jan-06
Jul-05
Jan-05
Jul-04
Jul-03
Jan-04
Jan-03
Jul-02
Jul-01
Jan-02
Jan-01
Jul-00
Jan-00
Jul-99
Jan-99
Jul-98
Jan-98
Jul-97
Jan-97
Jul-96
Jan-96
Jul-95
Jul-94
Jan-95
Jan-94
Jul-93
Jul-92
Jan-93
Jan-92
Jul-91
Jul-90
Jan-91
Jan-90
50
Euro STOXX Auto & Parts Index
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Source: Thomson Reuters Datastream, HSBC
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EBIT margin versus asset turnover (2007-11 average)
2.75
Sector Avg = 4.4%
Faurecia
2.50
2.25
Asset Turnover (x)
2.00
1.75
Leoni
1.50
PSA
Daimler
Volkswagen
BMW
Valeo
1.25
Rheinmetall
Continental
1.00
Sector Avg= 1.2x
Michelin
Elringklinger
Nokian
Renault
0.75
Pirelli
0.50
0%
5%
10%
EBIT Margin(%)
15%
20%
25%
Source: Company data, HSBC
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Sector description
The European automotive sector plays a vital role in the European economy, supporting around 12.6m jobs
(2.3m directly) and contributing significantly to the EU’s GDP, with net trade of some EUR60bn a year
(source: ACEA). At 17m vehicles pa, Europe accounts for 25% of global auto production, led by Germany,
France and Spain. Developments in the auto sector influence many other sectors (eg capital goods, steel and
chemicals) and are thus closely monitored by financial analysts as well as the political community. The sector
can be broadly divided into mass-market car makers and premium car makers.
Mass-market manufacturers derive most of their sales from smaller and cheaper cars, which typically
have lower margins and are more exposed to cyclical demand than more expensive models. These
companies rely on high production to push asset turnover, which, in turn, is the key driver of profitability.
Besides being exposed to the fragmented small-car segment, they are challenged by low capacity
utilisation and constant pricing pressures, predominantly in Europe.
abc
Horst Schneider*
Analyst
HSBC Trinkaus & Burkhardt
AG, Germany
+49 211 910 3285
horst.schneider@hsbc.de
Niels Fehre*, CFA
Analyst
HSBC Trinkaus & Burkhardt
AG, Germany
+49 211 910 3426
niels.fehre@hsbc.de
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
Premium car makers, with exposure to the larger-car and SUV segments, typically achieve higher margins.
Added value from advanced technology, rich features and brand equity enable them to command higher
transaction prices. However, they face challenges from stricter CO2 regulations globally, which oblige them to
invest heavily in developing low-emission technologies. Furthermore, greater market fragmentation and a
weakening product mix (as they enter smaller-car segments) are increasing challenges.
At the onset of the economic crisis, the highly cyclical nature of the sector caused new car sales to
collapse, particularly in the Western markets, as consumer confidence plunged. Scrappage schemes
intended to boost short-term demand during the crisis pulled demand forward, creating additional
medium-term challenges, especially for mass-market car makers, as issues of overcapacity in Europe
were left largely unaddressed. Further risks for 2012 and beyond stem from plummeting consumer
confidence due to austerity measures in Europe, uncertainty about the future of the eurozone against the
backdrop of the Greek sovereign crisis and fears of a slowdown in China.
Key themes
Low car ownership in emerging markets offsets weakness in developed markets
In our view, global light vehicle sales growth will continue to be driven by emerging markets, particularly
the BRIC economies. Low car penetration and rising disposable incomes should lead to higher organic
growth in emerging markets, even though the outlook for developed markets remains uncertain. In China,
for example, only 45 out of 1,000 people and in Russia only 243 out of 1,000 people own a car, compared
with 40% to 50% of the population in Western Europe. Sales in emerging markets are skewed towards
small cars, and most purchases are by first-time buyers. In developed markets, sales are largely dominated
by replacement demand. Although we expect unit sales to grow after 2012, we do not forecast lightvehicle sales in Western Europe and the US to return to their pre-crisis levels of 2007 until after 2014.
Thus car makers with a higher exposure to emerging markets should enjoy higher top-line growth than
those whose operations are highly concentrated in stagnating developed markets.
Modular architectures and platform sharing
A key strategy is to increase standardisation through the greater use of modular platforms. This reduces
the number of architectures even though the average number of units per model series may decline.
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July 2012
Standardisation helps to reduce the R&D cost per vehicle and to realise purchasing synergies through the
use of shared components. Significant cost savings can be achieved by standardising components such as
air-conditioning systems, gearboxes, engines and axles, which are not technological or brand
differentiators. Modularisation also gives large car makers, such as Volkswagen, an advantage over
smaller competitors, such as Renault and PSA, since the large companies can combine more units on a
single platform.
To reduce per-unit costs and exploit the benefits of scale, car makers now increasingly rely on alliances
and joint ventures to share platforms with other manufacturers. Other areas for exploring synergies
involve joint procurement, product development and technology sharing. Some alliances, such as Renault
and Nissan, PSA and GM or Volkswagen and Suzuki, involve equity cross-holdings. Others, such as
those between PSA and Mitsubishi or Daimler and BMW, are only strategic in nature.
Size matters: capacity utilisation and restructuring
Low capacity utilisation and insufficient scale are particular concerns for mass-market car makers, where
high production volume is the prime earnings driver. Plagued by overcapacity, the European auto industry
is in dire need of consolidation, in our view: we believe this is the only way for car makers to raise
production volumes high enough to increase asset turnover and alleviate pricing pressures. Fiat’s CEO
defines this level as more than 5.5 million cars a year and more than 1 million cars per platform.
However, the political ramifications of the impact on employment levels make meaningful consolidation
difficult to achieve in Europe in the near future. In 2008 and 2009, restructuring was mostly confined to shorttime work, only temporary plant shutdowns, the transfer of some manufacturing capacity to low-cost Eastern
European sites and the achievement of some minor structural cost savings. In contrast, US companies
underwent intensive restructuring, resulting in the Fiat-Chrysler alliance and the discontinuation of many
brands. In China, one of the most fragmented markets, the government is pushing car makers to consolidate
and has also introduced mechanisms to keep tabs on capacity expansions.
Scrappage incentives distort demand and aggravate pricing risks
Scrappage schemes in the US, Europe and China significantly boosted demand in 2009 and 2010,
particularly for small cars; mass-market car makers were the main beneficiaries. Although these
incentives helped the industry get through the crisis, they pulled forward future demand, causing declines
after they expired. Margins face additional risks as consumers have become accustomed to the incentives
and now expect discounts from car dealers, at a time of declining demand. On our estimates, net prices for
mass-market cars in Europe declined by around 1.5% on average in 2011. This increases the need for car
makers to cut costs in order to compensate for the negative pricing effects.
CO2 regulation and high R&D requirements
Regulation plays a pivotal role in shaping the industry structure and its future growth trajectory as it
encompasses rules on emissions and safety. Concerns about climate change mean that stricter CO2
emission rules are the regulatory issue most affecting the car industry. In Europe, for example, legislation
mandates a reduction in tailpipe CO2 to an average of 130g/km through technology measures. This will
apply to 65% of newly registered cars by 2012, increasing to 100% by 2015. Average CO2 emissions
already declined to 140g/km in Europe in 2011 (source: Transport & Environment, Brussels) and most
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European car makers should meet the regulatory target by 2015. However, CO2 emissions will also need
to be cut thereafter since the European Commission has set a target of 95g CO2/km on average per new
car in 2020. In our view, this target can only be achieved by increasing the penetration rate of hybrid and
electric vehicles, which require ongoing high R&D spending for all car makers in Europe (particularly
premium manufacturers). European car makers have spent an average of around 5% of their revenues pa
on R&D in the past five years, which corresponds to around EUR3.5-4bn per car maker. We expect R&D
expenditure to remain high in the next few years, increasing the need to allocate this burden across a high
number of unit sales in the next few years. Size also matters in this respect.
Sector drivers
Volumes and macro indicators
Volumes are the most important factor influencing EBIT margins in the auto sector and they, in turn,
depend on macroeconomic factors such as consumer confidence, unemployment, disposable income and
GDP. Sales and production forecasts for the auto sector depend on the overall outlook for consumer
spending, which itself depends on a wide range of factors, including consumer sentiment, unemployment,
GDP growth and disposable income trends. We believe consumer confidence is the best indicator of
short-term demand developments, while unemployment rates are more of a lagging indicator.
The auto sector is highly data-intensive. Some of the most closely tracked statistics are: monthly sales
numbers from ACEA for Europe, US SAAR data, and figures from other key markets such as Brazil,
China and Japan; monthly sales by car makers; incentives data in Europe and the US; residual values of
used cars; and inventory levels at dealers.
Pricing
Pricing, another closely monitored element of car makers’ margins, is influenced by a combination of
factors, including segment/product mix shifts, new product launches and general competition. For the
mass-market segment, price elasticity is fairly high, which makes it difficult to pass on price increases to
customers. For the premium car market, pricing has been better in the past few years due to soaring
demand in China, which has led to high capacity utilisation and long delivery times. It is unclear whether
this trend will remain intact, since capacity has been increased by some premium car makers and demand
growth in China has started to cool somewhat.
Product mix and new model launches
Sales mix plays a vital role in driving car maker’s earnings margins, determining, for example, whether
sales are dominated by large or small cars. Premium car makers earn higher revenue per unit by selling
larger sedans and SUVs than the mass-market car makers, which predominantly sell smaller A-, B- and
C-segment cars. Premium car makers tend to be more profitable than mass-market car makers, largely
because small cars are lower priced and typically achieve smaller earnings margins. The number of new
model launches per year is another important metric for all car makers since new models tend to achieve
better sales volumes and better pricing than older, existing models.
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Exogenous factors: FX, raw material prices and interest rates
Currencies: Since companies cannot always produce their cars in the same place as they sell them, all car
makers are exposed to currency risks. The earnings of Japanese car makers have been acutely burdened by a
strong yen, while European OEMs have benefited from a weaker euro due to the sovereign debt crisis.
Raw material prices: Steel is the most important input factor for car production, accounting for around
60% (or around 1 tonne) of the total car weight on average. Car makers have been affected by higher raw
material prices since 2010 due to contract repricing with steel makers. Other commodities used for car
production include aluminium, plastics, precious metals and rubber.
Interest rates: Financial services is an important tool that enables car makers to stimulate their new car
sales and keep residual values under control. At German premium car makers, an average of roughly 4050% of new car sales also include a lease or financing contract (source: company data for 2011). Due to
low refinancing costs and low credit loss ratios the financial services business has been highly profitable
for most car makers in the past two years. In the event of an economic downturn, declining residual
values are the main risk to earnings since cars coming off lease may be sold at a lower-than-expected
price, creating the potential for high one-off charges at car makers – as seen at BMW and Mercedes Cars
in 2008 and 2009.
Key segments
Car makers (OEMs), automotive suppliers, tyre makers
In addition to the car makers, explained in detail above, the sector includes automotive suppliers and tyre
makers further downstream. Some of these suppliers are majority owned by OEMs, which are their main
customers.
Auto suppliers’ sales are primarily driven by production volumes and are therefore cyclical in nature.
Other important drivers are geographic exposure, as well as exposure to OEMs (premium versus mass
market), fast-growing technologies (such as active safety and emission technologies) and the key growth
platforms of OEMs (such as MQB at Volkswagen). Bosch, Continental, Faurecia and Valeo (all
European), Delphi, Johnson Controls and Magna (all US), and Aisin Seiki and Delphi (all Japanese) are
some of the major auto suppliers commanding a global footprint.
Tyre makers are considered more defensive in nature than suppliers and less exposed to the vagaries of
macroeconomic conditions, since around 75% of total tyre sales typically stem from the replacement
channel. Tyre makers are segmented by type into passenger car tyres (summer and winter (highly
profitable)), truck tyres and specialty tyres (eg mining, agricultural, aircraft tyres). Key trends include: (1)
shifting the focus to profitable premium segments; (2) a focus on regions with high growth and profit
potential (LatAm and Russia); and (3) the impact of new regulations (eg EU tyre legislation from
November 2012). Tyre makers are exposed to the highly volatile prices of natural rubber (highly
speculative prices and exposed to weather conditions in South-East Asia) and oil (the source of synthetic
rubber and carbon black, among others). Michelin, Bridgestone, Goodyear and Continental are global tyre
makers operating across all segments, while niche players Nokian and Pirelli operate in highly profitable
segments/regions. Like the car makers, Michelin and Pirelli release market data for their major regions,
and this is a closely tracked statistic in the subsector.
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EMEA Equity Research
Multi-sector
July 2012
Valuation
The visibility of sector performance is good, as most companies provide detailed disclosures by business
segment on a quarterly basis; French firms are the exception, as they provide only sales and revenue data
quarterly, reporting both earnings and cash flow in their half-yearly report. Monthly unit sales figures also
give the market visibility on the sector’s top-line development.
Companies in the sector are typically assessed on traditional multiples, which are EV/sales, EV/EBITDA
and price/earnings ratios. We prefer to value most companies on a sum-of-the-parts basis, which makes it
possible to factor in valuation differences between mass-market, premium car and truck brands. We
currently tend to value the automotive business of premium car makers at EV/sales of 35% and EV/
EBITDA of 3.0x, whereas we value the automotive business of Renault and Peugeot at an EV/sales of
only 4% and an EV/EBITDA of 0.4x – roughly in line with the current valuation implied by (Factset)
consensus for 2012. Furthermore, we tend to value stakes held in other companies at their market or book
value, less a holding discount of at least 30%. We value the companies’ financial services businesses at
around 80% of their 2012e book value.
The main problem for us at present is coping with the current de-rating of the sector. On average, the
sector is trading 30-40% below the 12M-forward (Factset) consensus multiples seen in 2004-07, even
though the profitability of some companies (such as German car makers) is now higher. The market
seems not to believe that the currently high earnings of the premium car makers, in particular, are
sustainable. For European car makers, the average sector 12M-forward PE is currently around 6x (source:
Factset) versus around 10x for the period 2004-07. Although auto suppliers trade at similar multiples, tyre
makers generally enjoy a premium as their business is less volatile.
Autos: growth and profitability
Growth
Sales
EBITDA
EBIT
Net profit
Margins
EBITDA
EBIT
Net profit
Productivity
Capex/sales
Asset turnover (x)
Net debt/Equity
ROE
2008
2009
2010
2011
2012e
-0.8%
-16.2%
-44.0%
-29.2%
-12.1%
-29.3%
-99.4%
-136.8%
21.5%
81.2%
nm
nm
15.3%
12.2%
32.9%
52.5%
7.1%
9.9%
4.9%
-7.9%
11.9%
3.2%
3.1%
9.5%
0.0%
-1.3%
14.2%
6.1%
4.8%
13.9%
7.0%
6.3%
14.2%
6.9%
5.4%
7.6%
1.2x
0.1x
9.5%
6.8%
1.1x
0.0x
-3.7%
6.0%
1.2x
-0.2x
15.1%
6.6%
1.2x
-0.1x
19.3%
6.9%
1.2x
-0.1x
15.6%
Note: based on all HSBC coverage of Auto OEMs, suppliers and tyre makers across Europe.
Source: Company data, HSBC estimates
27
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EMEA Equity Research
Multi-sector
July 2012
Sector snapshot
Core industry driver: car registrations driven by consumer
confidence
96
Top 10 stocks: MSCI Europe Auto and Components Index
Stock rank
Stocks
1
2
3
4
5
6
7
8
9
10
Daimler
BMW
Volkswagen
Michelin
Renault
Porsche
Continental
Fiat
Nokian
Pirelli
W Europe PC registration 12M rolling (m)
EU consumer confidence indicator
Index weight
27.65%
17.61%
19.79%
7.71%
5.32%
5.19%
4.77%
3.01%
2.81%
1.55%
2012
12.0
2011
97
2010
98
12.5
2009
13.0
2008
99
2 007
100
13.5
2006
14.0
2005
101
2004
102
14.5
2001
Source: MSCI, Thomson Reuters Datastream, HSBC
15.0
2003
MSCI Europe Auto and
3.2% of MSCI Europe
Components Index
Trading data
5-yr ADTV (EURm)
1,588
Performance since 1 Jan 2000
Absolute
4.05%
Relative to MSCI Europe
37.81%
3 largest stocks
Daimler, BMW, Volkswagen
Correlation (5-year) with MSCI Europe
0.83
2002
Key sector stats
Source: Thomson Reuters Datastream, HSBC
PE band chart: MSCI Europe Auto and Components Index
300
15x
250
200
10x
150
Source: MSIC, Thomson Reuters Datastream, HSBC
100
5x
50
2012
2011
2010
2009
2008
2007
75.6%
16.2%
5.6%
3.47%
2.6%
2006
Germany
France
Italy
UK
Finland
0
2005
Weights (%)
2004
Country
2003
Country breakdown: MSCI Europe Auto and Components Index
MSCI Europe Auto & Comps
Source: MSCI, Thomson Reuters Datastream, HSBC
PB vs. ROE: MSCI Europe Auto and Components Index
Source: MSCI, Thomson Reuters Datastream, HSBC
2.5x
20%
15%
2.0x
10%
1.5x
5%
0%
1.0x
-5%
ROE (RHS)
PB ratio
Source: MSCI, Thomson Reuters Datastream, HSBC
28
2012
2011
2010
2009
2008
2007
2006
2005
-10%
2004
0.5x
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EMEA Equity Research
Multi-sector
July 2012
Beverages
Beverages team
Lauren Torres
Analyst
HSBC Securities (USA) Inc
+1 212 525 6972
lauren.torres@us.hsbc.com
James Watson
Analyst
HSBC Securities (USA) Inc
+1 212 525 4905
james.c.watson@us.hsbc.com
Erwan Rambourg*
Head of Consumer Brands and Retail, Global Research
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6572
erwanrambourg@hsbc.com.hk
Antoine Belge*
Head of Consumer Brands and Retail Equity Research, Europe
HSBC Bank Plc, Paris Branch
+33 1 56 52 43 47
antoine.belge@hsbc.com
Sophie Dargnies*
Analyst
HSBC Bank Plc, Paris Branch
+33 1 56 52 43 48
sophie.dargnies@hsbc.com
Sector sales
David Harrington
Sector Sales
HSBC Bank Plc
+44 20 7991 5389 david.harrington@hsbcib.com
Lynn Raphael
Sector Sales
HSBC Bank Plc
+44 20 7991 1331 lynn.raphael@hsbcib.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
29
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EMEA Equity Research
Multi-sector
July 2012
Sector structure
Beverages
Non-a lcoholic Beverages
Concentrate
compan ies
Alcoholic beverages
Bottlers
Brewers
LatAm brewers
Other alcoholic
beverag e companies
Coca-Cola Co.
Arc a Continental
A-B InBev
AmBev
Brown-Forman
PepsiCo
Coca-Cola Enterprises
Anadolu Efes
Grupo Modelo
Constellation Brands
Coca-Cola FEMSA /
FEMSA
Boston Beer Co.
Diageo
Heineken
Pernod Ricard
Molson Coors
Remy Cointreau
Coca-Cola Hellenic
Coca-Cola Ic ecek
SABMiller
Source: HSBC
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EMEA Equity Research
Multi-sector
July 2012
Historical PE valuation of the non-alcoholic and alcoholic beverage industry
40
1998: Valuation of Coca-Cola (KO)
peaked and then began to be reevaluated by investors
35
2007: Global consumer
slow dow n began
30
2008: Investors lo oking
fo r safety in the
defensive co nsumer
staples secto r
(valuatio ns beco me
more no rmalised)
25
20
15
10
5
May-12
May-10
May-08
Bev erages: Non-Alcoholic
May-06
May-04
Consumer Non-durable
May-02
May-00
May-98
May-96
May-94
May-92
World
Bev erages: Alcoholic
Source: Factset, HSBC
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EMEA Equity Research
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July 2012
EBIT margin versus asset turnover chart (2011)
2 .0
Boston Beer
1 .5
Tha i Beverage
Andina
Monster
Asse t Turnov er (x)
Tsing tao
Asia Pacific
Baltika
Coke Icecek
1 .0
Asa hi
Coke He l enic
Coca-Cola En terprises
Anado lu E fes
Coke FEMSA
Pe psiCo
Arca Contal
Brown-Forman
0.8
FEMSA
Coke Amatil
Kir in
SAB
Heine ken
San Miguel
CCU
Modelo
Jiangsu Yan ghe
DPS
Ambev
Coca-Cola
Wulian gye Yibin
Diag eo
0 .5
Carlsberg
Remy Cointreau
Constellat ion
B eam
Pernod
A-B Inbev
Molson Coo rs
0 .0
5%
10 %
15 %
20%
25 %
EBIT Margin (%)
Source: HSBC, FactSet
30%
3 5%
40 %
4 5%
5 0%
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0%
EMEA Equity Research
Multi-sector
July 2012
Sector description
The beverage sector includes companies that develop, produce, market, sell and distribute non-alcoholic
and alcoholic products, including soft drinks, beer, wine and spirits.
abc
Lauren Torres
Analyst
HSBC Securities (USA) Inc.
+1 212 525 6972
lauren.torres@us.hsbc.com
 Soft drink concentrate companies such as Coca-Cola Co. and PepsiCo own and market nonalcoholic beverages. Both companies manufacture and sell concentrate/syrup to their bottling
partners. They are best known globally for their Coca-Cola and Pepsi trademark brands, but they also
have a diverse portfolio of water, juice, tea and sports drink brands.
 Soft drink bottlers produce, sell and distribute soft drinks to retailers in designated regions. CocaCola Co. and PepsiCo have a global network of bottling partners, in some of which they hold an
equity interest. In 2010, PepsiCo acquired its two largest bottlers, Pepsi Bottling Group and
PepsiAmericas, and Coca-Cola Co. acquired the North American bottling business from its largest
bottler, Coca-Cola Enterprises.
 Brewers produce, market, distribute and sell beer. Some are regional; others, like A-B InBev,
SABMiller and Heineken, are global. Brewers have undergone a fair amount of consolidation over
the past several years, creating an industry where scale matters.
 Wine and spirits companies manufacture, bottle, import, export and market a wide variety of wine
and liquor brands. They tend to be more regional than the brewers but have been active in
acquisitions and have broadened their geographic and brand exposure. Price points vary widely from
super-premium to mainstream to value brands.
Key themes
Over the past couple of years, the beverage industry has experienced its fair share of challenges: a weak
consumer environment as a result of the economic downturn; the increasing cost of ingredients,
packaging and energy; and a competitive price environment. We believe beverage companies need to
revive struggling categories while focusing on potentially higher-growth categories, be proactive with
new-product introductions, rationalise costs and expand globally. On a positive note, the beverage sector
is a defensive industry, which is typically more resilient during challenging economic and market
conditions because it can offer affordable products to consumers.
Soft drinks
We believe that the key concerns and themes for the soft drink industry are:
 Cost of doing business is going up, particularly sweetener (sugar and/or high fructose corn syrup)
and oil costs, but realising opportunities to offset these increases is necessary to operate more
efficiently.
 Reviving the carbonated soft drink category in the US: this is a longer-term solution, and it is
easier said than done, but should be key to jump-starting volume and profit growth.
 Capitalising on energy drinks, sports drinks and enhanced water: this is a near-term solution,
which should support volume growth and cater to health and wellness trends.
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EMEA Equity Research
Multi-sector
July 2012
 Capturing growth in high-margin immediate consumption channel (mix): drive revenue per case
growth with improvements in product and package mix.
 Stepping up media and new product launches: to remain competitive, more needs to be invested
in product promotion and development.
 Focusing on and growing international operations: go where the growth is, reinvigorate domestic
operations but take advantage of opportunities overseas.
Beer
We believe that the key concerns and themes for the beer industry are:
 Weak economic conditions: there has been a pullback in consumer spending, particularly on highermargin premium brands and on-premise purchases; beverage volume tends to track GDP growth
closely.
 Currency devaluation: depending on the company’s reporting currency, a stronger US dollar may
hurt results because of higher local procurement costs and a translation hit to earnings.
 Continued cost pressure: more expensive ingredients (barley, malt and hops) and packaging
(aluminium and glass) have been an issue that may not be resolved in the near future, since fixed-rate
contracts are in place.
 Aggressive price promotions: the pricing environment has been favourable, but price promotions
could return to protect share and boost volume.
 Intended marketing spend may not be enough: brewers may need to re-invest more in their brands
through greater and more effective marketing spend. Part of the industry’s revival could depend on
improved beer brand equity.
 A competitive/consolidating industry: many beverage companies are global, and the beer industry
has become more competitive owing to consolidation.
Wine and spirits
We believe that the key concerns and themes for the wine and spirits industries are:
 Trading up versus trading down: depending on the market environment, consumers tend to trade up
to higher-priced and higher-margin products that are aspirational and considered to be affordable
luxuries. But they also trade down to lower-priced and lower-margin products when disposable
income is reduced, often brought about by high unemployment.
 Changing ‘share of throat’: independent of weakening macroeconomic trends, there has been a
growing preference for premium wine and spirits, and imported and craft beer, over mainstream brands.
 Reasons for shift in preference: variety – catering to changing consumer tastes and needs (different
brands, package sizes and price points); brand image – desire for affordable luxuries; healthconsciousness – looking for products lower in calories or carbohydrates, such as light beers, white
wine and clear spirits; availability – good product placement and marketing, which is the
responsibility of the brand owner and distributors.
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Multi-sector
July 2012
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Sector drivers
In difficult market conditions, we believe it is important to consider a company’s product and geographic
portfolio, and its ability to manage costs while still investing in growth opportunities.
 Resilience of beverage sales during economic downturns: these categories offer consumers
variety at attractive price points, more so with non-alcoholic than with alcoholic brands. That allows
beverage companies to achieve volume and pricing growth despite a pullback in overall spending.
 Geographic diversification: global companies have an advantage over smaller competitors,
particularly those not overly exposed to any one market; they have a more stable, developed market
presence in addition to good growth potential with an emerging market presence.
 Continued cost management/realisation of synergies: beverage companies have tightened their
belts, which could deliver significant cost savings and margin improvement, through realising
bottling plant or brewery efficiencies, streamlining the organisation or leveraging global scale.
 Continue to invest selectively: despite continued market and industry pressures, companies need to
take advantage of investment opportunities to emerge as stronger competitors when healthier
conditions return.
Conclusions
Shift in consumer preferences
 Beverage consumers want a quality product with a strong brand image.
 There is a preference for premium wine, spirits and imported or craft beers, particularly in a stable or
strengthening economic environment.
 There is also a need for variety, availability and healthier beverages (low calorie/low or no
carbohydrates).
Winning in a competitive environment
 It is necessary to have strong brands, stronger brand equity and the strongest distribution system.
 The right balance of volume and pricing growth, while running an efficient production and distribution
system, is essential.
 Managing through a tough cost environment (rising energy and raw-material costs) is key.
Global players should be better positioned to capture future growth
 Scale and scope matter in the beverage industry.
 We expect to see more acquisitions and production, sales and distribution agreements among companies.
 Global players realise growth in core, profitable markets but also look to expand into emerging markets.
 They capitalise on favourable demographics, particularly younger consumers with more disposable
income.
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EMEA Equity Research
Multi-sector
July 2012
Key segments
Developed markets – US and Europe
The beverage industry has flourished in developed markets where consumers have higher disposable income
and where there is strong brand equity and loyalty. According to Coca-Cola Co., 403 eight-ounce servings
of its products were consumed per person in 2011 in the US versus the worldwide average of 92 servings. In
Europe, this number varies by country (Italy 137, France 149, Great Britain 210, Spain 287 and Belgium
340), but the average is greater than the worldwide average and is increasing. Beverage volume growth in
the industry often trends in line with GDP growth on a country-by-country basis. Therefore, low to mid singledigit total ready-to-drink (RTD) beverage volume growth has typically been delivered on an annual basis.
In addition to improving volume, beverage companies have benefited from increased pricing, which generally
tracks in line with inflation. As a result, revenue growth in the industry can increase at a mid to high singledigit rate. In developed markets, non-alcoholic and alcoholic beverage companies strive to achieve
sustainable, balanced volume and pricing growth. Owing to the aspirational yet affordable nature of the
beverage category, there is pricing power in the industry, which is traditionally absorbed by the consumer.
Emerging markets – Latin America, Asia and Africa
According to Coca-Cola Co., it is focused on doubling its business this decade by “driving profitable
growth through innovation in developed markets; maximising value through segmentation and building
consumer loyalty in developing markets; and driving volume and investing for accelerated growth in
emerging markets”. Delivering growth from less developed markets has been a key strategy for most
global beverages companies, which are looking to capitalise on a growing and more affluent consumer
base. Over the past several years, when developed market performance slowed because of a weaker
economy, developing markets continued to produce above-average volume growth in the beverage sector.
Consumers in markets such as Latin America, Asia and Africa have chosen to spend a greater percentage
of their increasing discretionary income on packaged goods, specifically RTD beverages. In Latin
America, particularly Mexico, per-capita consumption of Coca-Cola’s products has traditionally been
high but continues to increase as consumers consider these products to be affordable. Beverage
companies are interested in attracting new consumers, keeping them within their product portfolio (across
all beverage categories) and then eventually trading them up to higher-priced brands. We believe that the
soft drink, beer, wine and spirits industries have been successful at generating increased interest in their
various products, while looking to gain both volume and value share.
A diverse product and geographic portfolio offers some stability during challenging macroeconomic
conditions. Beverage companies that offer a wider variety of products at different price points to
consumers in various regions are less inclined to be affected by country-specific macro or industry
pressures. Global beverage players tend to benefit from better volume growth in underdeveloped,
emerging markets, while realising higher profit growth from more mature, established markets. In soft
drinks, both Coca-Cola Co. and PepsiCo have looked to stabilise their flagship US businesses and
strengthen their international franchises. Among the brewers, the three largest competitors – A-B InBev,
SABMiller and Heineken – have been active building a global presence, both organically and through
acquisitions. Similarly, larger spirits companies look to capitalise on an increasing number of consumers
across the world with growing income levels, particularly in emerging markets.
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EMEA Equity Research
Multi-sector
July 2012
Valuation
Beverage companies tend to trade on forward-looking price/earnings ratios and on EV/EBITDA. For CocaCola Co. and PepsiCo, PE is the most widely used valuation metric. There are disadvantages to using PE for
brewers, as there have often been a number of below-the-line items with wildly skewed earnings (EPS),
meaning EV/EBITDA could be a better metric for historical and peer group comparison. For the bottling
stocks, EV/EBITDA is a better metric, since the companies tend to be more capital/debt-intensive.
The graph ‘historical PE valuation of the non-alcoholic and alcoholic beverage industry’ shows beverage
companies have traded, on average, in a rather narrow range, and typically reflect the economic, market
and consumer environments. There are some outliers that take into consideration mergers, acquisitions, or
market speculation of a potential change in the industry. In the non-alcoholic beverage industry, CocaCola Co.’s share price began to fall after reaching historical highs in the late 1990s, as growth rates began
to slow and relationships with its bottling partners became disjointed. In the alcoholic beverage industry,
certain stocks have traded more on takeout speculation, rather than fundamentals, as there has been a fair
amount of M&A activity in the sector.
Currently, the concentrate companies are trading at 16-18x 2012 consensus earnings, below historical
averages in the high-teens. On EV/EBITDA, the bottlers are trading at 7-11x 2012 consensus EBITDA
estimates, in line with historical averages. For the brewers, 8-15x 2012 consensus EBITDA is the current
range, with faster-growing companies, such as Brazilian brewer AmBev, at the high-end of the range.
We would also highlight that bottling stocks tend to be more volatile than the concentrate companies.
They are more exposed to higher ingredient, packaging and energy costs. Brewers face the same pressures
but typically are more diversified and can manage this more effectively. Lastly, when looking at a
company’s results, it is important to sift through reported and organic (comparable) results to understand
its true growth rates.
Global beverages: growth and profitability (calendarised data)
2009
2010
2011
2012e
2013e
Growth
Sales
EBITDA
EBIT
Net profits
21.5%
24.9%
26.8%
25.1%
9.2%
10.4%
13.4%
19.8%
14.8%
10.3%
9.7%
12.7%
8.3%
7.7%
8.6%
10.4%
7.1%
8.3%
9.5%
10.0%
Margins
EBITDA
EBIT
Net profit
29.9%
24.6%
15.6%
30.4%
25.7%
17.0%
29.6%
24.9%
16.7%
29.5%
25.1%
17.1%
29.9%
25.6%
17.5%
Productivity
Capex/sales
Asset turnover (x)
Net debt/equity
ROE
5.3%
0.71
14.8%
27.7%
5.9%
0.65
15.5%
25.0%
6.6%
0.65
16.0%
24.6%
6.2%
0.66
13.8%
24.6%
5.9%
0.67
11.2%
24.3%
Note: based on all HSBC coverage of global beverages. All data is market-cap weighted.
Source: Company data, HSBC estimates
37
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EMEA Equity Research
Multi-sector
July 2012
Sector snapshot
Key sector stats
Core industry driver: Eurozone GDP and inflation
MSCI Europe Beverages Dollar 3.4% of MSCI Europe US Dollar
Index
4
Trading data
5yr ADTV (EURm)
Aggregated market cap (EURm)
Performance since 1 Jan 2000
Absolute
Relative to MSCI Europe US
Dollar
3 largest stocks
436
284.4
201%
209%
2
0
-2
-4
-6
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Diageo, Anheuser-Busch InBev,
SABMiller
Correlation (5-year) with MSCI Europe
0.52
US Dollar
GDP
Inflation
Source: MSCI, Thomson Reuters Datastream, HSBC
Source: Thomson Reuters Datastream, HSBC
Top 10 stocks: MSCI Europe Beverages Dollar Index
Stock rank
Stocks
1
2
3
4
5
6
7
8
9
10
Diageo
Anheuser-Busch InBev
SABMiller
Pernod-Ricard
Heineken
Carlsberg
Heineken
Coca-Cola Hellenic
Remy Cointreau
_
PE band chart: MSCI Europe Beverages Dollar Index
Index weight
350
30.3%
27.8%
17.6%
10.3%
5.4%
3.8%
2.0%
1.7%
1.1%
300
17x
250
14x
200
11x
150
8x
100
50
2004
2005
2006
2007
2008
2009
2010
2011
2012
Source: MSCI, Thomson Reuters Datastream, HSBC
Source: MSCI, Thomson Reuters Datastream, HSBC
Country breakdown: MSCI Europe Beverages Dollar Index
Country
UK
Belgium
France
Netherlands
Denmark
Greece
Source: MSCI, Thomson Reuters Datastream, HSBC
Weights (%)
47.9%
27.8%
11.4%
7.4%
3.8%
1.7%
PB vs. ROE: MSCI Europe Beverages Dollar Index
4.0
21.0
3.5
19.0
3.0
17.0
2.5
15.0
2.0
13.0
1.5
11.0
1.0
0.5
9.0
2004 2005 2006 2007 2008 2009 2010 2011 2012
12M Fwd PB
12M Fwd ROE (RHS)
Source: MSCI, Thomson Reuters Datastream, HSBC
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EMEA Equity Research
Multi-sector
July 2012
Business services
Business services team
Matthew Lloyd*
Analyst
HSBC Bank plc
+44 20 7991 6799
matthew.lloyd@hsbcib.com
Alex Magni*
Analyst
HSBC Bank plc
+44 20 7991 3508
alex.magni@hsbcib.com
Rajesh Kumar*
Analyst
HSBC Bank plc
+44 20 7991 1629
rajesh4kumar@hsbcib.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
39
40
Business services
BPO/Cons ulting
Distributors
Staffing
Re ntals
Sec urity
FM & Hygiene
TIC
Capita
Bunzl
Adecco
Aggreko
G4S
Berendsen
Bureau Veritas
Experian
Electrocomponents
Hays
Ashtead
Securitas
Mitie
SGS
Serco
Premier Farnell
Michael Page Intl
Northg ate
Prosegur
Rentokil Initial
Interte k
Xchanging
Wolseley
Randstad
Regus
EMEA Equity Research
Multi-sector
July 2012
Sector structure
SThree
USG
Source: HSBC
abc
80%
40%
60%
30%
December 2007
Great Recessio n in US
40%
20%
20%
10%
0%
0%
M arch 1991
End of recessio n
-20%
EMEA Equity Research
Multi-sector
July 2012
Sector price history
-10%
Lehman co llapse
M arch-No vember 2001
US Eco no mic recessio n
-40%
-20%
Octo ber 2009
US emplo yment rate at 10.1%, the
highest since 1983
-60%
-30%
May - May - May - May - May - May - May - May - May - May - May - May - May - May - May - May - May - May - May - May - May - May 91
92
93
94
95
96
97
98
99
00
UK Business Serv ices support index (LHS)
01
02
03
04
05
06
07
08
09
10
11
12
US Market Prox y (RHS)
Source: BLS, Thomson Reuters Datastream, HSBC
abc
41
42
EMEA Equity Research
Multi-sector
July 2012
12-month rolling PE multiple (3M average) versus mark-up over labour (average of 2009-11)
21.0
SG S
Interte k
19.0
B ure au V erita s
S T hre e
12M ro llin g fwd PE (3M avg)
17.0
15.0
Ha y s
P ro s egu e r
C a p ita
13.0
A dec c o
S e rc o
M itie
11.0
R an d stad
G 4S
US G
S e cu ritas
9.0
10%
20 %
3 0%
40 %
50%
60 %
7 0%
80 %
90%
M a rk -u p o ve r lab ou r co st (2 009 -11 )
Source: Company data, HSBC
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EMEA Equity Research
Multi-sector
July 2012
Sector description
Business services firms can be generally classified as enablers or intermediaries. The sector includes
businesses such as staffing, distributors, testing & inspection, and BPO/consulting firms.
BPO/consulting firms have a broad variety of business models. At one end of the spectrum there are pure
outsourcing firms, which work on a cost arbitrage model, and at the other end, there are consulting firms
providing engineering and design services to their clients.
Distributors purchase items, store them and re-sell to a client base. The distributors sub-sector has a very
diverse client exposure, ranging from builders and grocery stores to janitors and research scientists.
Staffing includes firms which provide permanent and temporary workforce to organisations, and is
primarily categorised as general staffing business, focusing on positions requiring general skills, and
professional staffing business, focusing on positions requiring professional skills.
abc
Matthew Lloyd*
Analyst
HSBC Bank Plc
+44 20 7991 6799
matthew.lloyd@hsbcib.com
Alex Magni*
Analyst
HSBC Bank Plc
+44 20 7991 3508
alex.magni@hsbcib.com
Rajesh Kumar*
Analyst
HSBC Bank Plc
+44 20 7991 1629
rajesh4kumar@hsbcib.com
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
Rental services is a heterogeneous sub-sector, where companies broadly work on renting a variety of
assets. The different rental companies are distinguished from one another by factors such as asset type,
geographical exposure, capital structure and economic sensitivity.
Security services provide a wide array of security services such as manned guarding, prison management,
alarm monitoring and security assessment. The industry is fragmented and services are offered to the client
either directly or through a facilities management contractor. The latter is more common in the UK and the US,
the former in Europe.
FM and hygiene offer a range of diverse services at the premises of their clients, ranging from facilities
management, pest control and reception services to work-wear and linen, among others.
Testing & inspection firms serve a wide range of industries, testing, inspecting, auditing, and certifying
products, commodities and services based on regulatory or voluntarily adopted standards.
Key themes
BPO/consulting
Outsourcing companies tend to have less cyclical cash-flow streams than the rest of the sector. However,
the most pertinent question is how far individual companies are less cyclical, or indeed whether they
respond differently to different cycles. For valuations to be attractive, the companies must show more
defensive growth than is in the price. This will depend upon three issues: (a) whether non-public
expenditure is non-cyclical; (b) whether business revenues are affected by the tax receipt cycle; and (c)
how margins are affected by the cycle.
Distributors
Distributors suffer or benefit from the cyclicality of their clients. They have an arsenal of efficiency
measures to offset pricing and volume pressures. One option is to aim to use fewer, larger and betterstocked centres – which can reduce staff costs and free up property. This process has been under way for
some time and is now largely complete, although additional options remain. Costs may also be reduced
by managing the number of stock-keeping units (SKUs). By focusing on a smaller list of SKUs, a
distributor can focus its purchasing power on fewer suppliers and reduce input costs. Another cost-
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EMEA Equity Research
Multi-sector
July 2012
reduction strategy is the use of private labels or own brands. This enables a distributor to buy large
quantities of a product from a supplier and offer them to clients at a discounted rate, enhancing their gross
margins. However, if distributors engage in cost-cutting measures that cut capacity in a downturn, this
can reduce the medium-term upside during the ensuing recovery.
The distribution business lends itself to acquisitions because of the fragmented nature of the market.
Another increasing trend among distributors is to move towards web-based sales. Typically, web sales are
not only higher margin but also result in better inventory management and higher cash conversion.
Staffing
Staffing companies’ growth is linked to labour market gross volumes and velocity. The market closely
watches industry data about the number of vacancies, as well as the hours and wages of temporary and
permanent placements. In addition, time-to-hire has a major impact on organic growth and operational
gearing. Time-to-hire measures the speed at which vacancies are converted into sales. Ceteris paribus, if
vacancies grow and the time taken to convert each vacancy into sales declines, that should boost staffers’
organic growth rates and operational gearing. Analysis based on pure vacancies is problematic as it does
not capture the time lag between the vacancy being posted and the actual filling of the vacancy. One of
our preferred lead indicators to analyse underlying demand for the staffing sector is “vacancies adjusted
for time-to-hire”, as it directionally leads both vacancies and organic growth rates for staffers, numbers of
temps, multiples and share prices.
The key distinction between staffers stems from the temp:perm mix, and geographical diversity. Bluecollar temps are a largely low-margin business with limited operational gearing, but during economic
recovery they grow before white-collar temps. In the early stages of a recovery, temp tends to recover
earlier and more quickly than perm, since permanent staff are expensive and carry more employment
risks. However, during initial phases there is frequently a spurt of catch-up hiring in the labour market.
When an early spurt in perm subsides, gross profit growth becomes subdued as temp constrains the value
per sale and the gross margins. However, growth in overheads tends to be more correlated to volumes.
Indeed, this effect particularly bedevilled the profit recovery during the early part of this decade, and in
the early 1990s. Evidence that operational gearing is a later-cycle phenomenon is powerful, given that
wage growth happens in the later stages. In previous recoveries, there has been emergent pricing pressure
on certain key sections of the market. The effect was significant in the blue-collar markets and the UK IT
market in 2001-04.
Rental companies
Despite its cyclical end-markets, the rental business model permits an unusual degree of flexibility in
controlling cash flows. The capital base in a rental business is not fixed and can be expanded or shrunk
quickly in response to changing end-markets. Rental companies are also notorious for their gearing,
which exaggerates profit and share price behaviour at turning points in an economic cycle. The nature of
this gearing is more nuanced than it first appears, though. Consolidation is a long and ongoing structural
trend in these fragmented markets, and rental companies’ ROIC profiles tend to approximate their cost of
capital across a cycle.
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Security firms
The business is widely viewed as late cyclical, and has historically shown margin pressure late in the
cycle. This is because the upward pressure to raise wages clashes with clients’ desire to reduce costs. In
developed markets, guarding is a reasonably mature market and outsourced service appears to be a stable
proportion of the market. Advances in technology have extended the scope of security to electronic
surveillance and monitoring. These services are normally a mark-up to labour charges. Security firms
nowadays provide integrated technology services, offering bundled services of access control, alarms and
monitoring services, for example.
Testing and inspection
The stocks are seen as global trade plays with limited cyclical downside, well positioned to benefit from a
recovery in global trade and likely to continue to outperform in a downturn, both in terms of organic
growth and share prices. As most contracts have wage inflation escalators, rising wages are a significant
element of organic growth, and are highly correlated to it. Broadly, wage rate inflation is fastest in the
emerging markets, as is organic growth, and this is where margins, and returns, are highest. We would
argue that geographic mix is an equally important factor to consider in addition to business mix. At least
half of the organic growth of testing companies over the past decade has been the result of passing
through wage inflation, which is higher in emerging markets. Our industry analysis suggests that
emerging market operating margins for the sector are significantly greater than in the developed world.
The difference in growth rates between the two halves of the world should support testing companies’
margins and return profiles over the next five years.
FM and hygiene
FM and hygiene businesses provide a host of diverse services, and the various businesses face different
markets and challenges. Given this diversity, some of the companies in the sector have complex margin
drivers. Spot-contract mix is one of the key determinants of margins. Historically, spot sales have been
around 8-10% of sales at the peak of the cycle and have disappeared in recessions; however, they held up
in the latest downturn.
Sector drivers
Leading indicators: The broad lead indicators for the sector include the TCB leading indicator, OECD
leading indicators and ISM. Each sub-sector has a different lead indicator specific to the dynamics of the
business. For distributors, key leading indicators are industry shipments, book-to-bill ratio and inventoryto-sales ratio. The clients’ lead indicators are also important for analysing distributors. As with building
distributors, the key leading indicators are private housing starts, housing price and inventory, and
plumber man-hours, for example. The US employment market has historically been a leading indicator
for the rest of the world. The best leading indicator for labour markets remains US temp numbers. For the
rest of the blue-collar general services, man-hours are among the key indicators, eg security man-hours,
alarms man-hours and uniform supply man-hours for security firms, and pest control man-hours, grocery
man-hours and janitorial man-hours for FM and hygiene.
Outsourcing
Government spending: Companies in this sub-sector have varying exposure to government contracts
and are directly exposed to local and central government spending, driven by government revenue, fiscal
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EMEA Equity Research
Multi-sector
July 2012
deficit and tax receipt cycles. Government tax receipt cycles play a key role, and growth in the companies
exposed to the public sector has weakened in the wake of a fall in government tax receipts in previous
cycles.
Contract mix: Margins of BPO and consultancy companies are largely determined by the contract and are
applicable for long periods. Although contracted revenues are indexed to inflation, the key driver of
margin is mix: the more complex the contract, the more margin variation is possible. Spot business
generally attracts higher margins while longer-term contracts usually have lower margins.
Distributors
Cyclicality of client: Distributors have a diverse client exposure, ranging from builders and grocery
stores to janitors and research scientists. These clients exhibit a degree of cyclicality, which either hurts or
benefits the distributors. The more cyclical the client base, the more cyclical a distributor’s business.
Inflationary or deflationary environment: Distributors are beneficiaries of a mildly inflationary
environment as there is a lag of a few weeks or months between their purchase and sale of a product.
Generally they are able to pass on most of the inflationary price rise to their clients, giving them holding
period gains. The effect is magnified lower down the P&L because much of the SG&A is volume related.
Ceteris paribus, in a period of ‘accepted inflation’, sales rise faster than volumes, gross margins may
nudge up, and SG&A costs grow with volume. In a deflationary period, the inverse is true.
Staffing
Temp/perm mix: Temporary staffing is a lower-margin business than permanent placement as the wages
of a temporary worker form part of the agents’ sales and cost of goods sold, whereas no such cost exists
for a permanent placement. A decline in the perm mix has a magnified impact on margins.
Wage rate mix: A lower wage rate implies a lower gross margin. The wages of candidates are a product
of the scarcity of their skills at any point in time. This same scarcity tends to drive the gross margin that a
staffing agency can charge for sourcing candidates. A fall in the average wage rate reduces the value of
sales more than a fall in volume, and also affects the gross margins or conversion of gross margin into
operating profit.
Rental companies
Size is a key driver for rental companies given low entry barriers and service differentiation. Large,
diversified fleets help broaden the customer base, give negotiation power and help to achieve economies
of scale. Long-run returns are driven by: (1) rental rates; (2) utilisation; (3) cost of delivery (sales,
purchasing, maintenance, distribution and services); and (4) the cost of funds. Scale helps in all four.
Testing and inspection
TIC stocks have a strong structural story to support their obvious growth: trade globalisation, product
diversity, outsourcing and regulation all drive testing and inspection volumes. A further important factor
is pricing driven by the pass-through of wage inflation. The organic sales growth of the TIC stocks is
driven by: the number of testers, inspectors, certifiers and billable hours. Pricing growth is largely driven
by wage inflation for front-line staff – explicitly in many contracts, implicitly in others. Pricing power
causes increases in wage costs to be passed through on the whole of the contract amount. Other costs
grow slower than wages, providing a mechanism to support and drive margins. As wage rate inflation is
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July 2012
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fastest in the highest-margin geographies, the pass-through of wage inflation supports margins, and
margin expansion is more feasible than many believe.
Other businesses sector
The other businesses sector covers a host of largely blue-collar general services. These tend to be
contract-backed but volume-dependent. If a client wishes to clean its facilities less frequently or engages
less security, both sales and margins are likely to come under some degree of pressure. Most such
services are cyclical and can be tracked through employment numbers. The core economics of the
security business is the mark-up over the cost of labour. Gross margin risk can frequently come from
rising wage rates, which cannot be passed on to customers in a recession.
Valuation
Companies in this sector trade on traditional metrics, with a few exceptions. PE is the most widely used
multiple, but EV/EBITA and EV/EBITDA are also used (mainly for rental firms), EV/sales, FCF yield
and FCF to EV. Where pension liability is a concern, analysts prefer EV/EBITA (adjusted for the
pension). Some prefer a blended valuation based on relative valuation, historical multiples and DCF.
However, use of DCF should be viewed with caution – particularly during periods of economic
uncertainty and poor earnings visibility.
The average 12-month rolling forward mid-cycle PE multiple (2006-07) for the business services sector
was 15x (range of 12x to 20x), versus 12x in the last downturn (range of 7x to 21x). However, PE
multiples in the sector tend to range widely whatever the economic climate, due to the differing growth
and margin profiles. Security firms generally trade at the lower end of the spectrum (average mid-cycle
multiple of 12x); testing and inspection companies command a higher premium (18x) owing to their
better margin and return profile.
Accounting notes
Companies in the sector report their profits differently, despite sharing nomenclature such as trading
profit, operating profit, EBIT and EBITA. The key differences stem from the classification of
amortisation arising from acquisition intangibles, the share of profit from associates and exceptionals. The
comparison of multiples across companies should therefore be approached with caution, to ensure that
they convey the same economic content. It is also important to keep track of changes in regulation and the
resulting impact on accounts. For instance, a change in regulation requiring a reclassification of French
business tax from COGS to tax has boosted gross margins for staffing companies without affecting
EPS/operating cash flow.
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Staffing sector: growth and profitability
Growth
Sales
EBITDA
EPS growth
Margins
EBITDA
Multiples
PE
EV/EBITDA
FCF/EV
ROE
Mark-up over labour
2010
2011
2012e
2013e
13.6%
68.0%
95.0%
11.1%
11.9%
14.0%
2.0%
8.2%
12.8%
6.3%
18.7%
25.4%
5.4%
5.3%
5.5%
6.2%
15.1
8.2
7.9%
14.8%
55.4%
13.0
7.4
9.0%
11.2%
37.9%
11.9
6.6
9.1%
14.5%
38.3%
9.5
5.1
13.6%
16.4%
42.3%
2010
2011
2012e
2013e
6.2%
7.5%
5.0%
10.9%
6.6%
4.5%
12.4%
11.9%
15.0%
11.3%
15.0%
18.7%
20.9%
20.1%
20.0%
20.7%
24.5
11.5
4.4%
36.5%
51.6%
23.5
11.0
3.2%
32.4%
46.9%
20.4
9.8
4.2%
32.1%
49.4%
17.2
8.3
5.6%
32.3%
54.1%
Note: based on all HSBC coverage of Staffing sector (market cap weighted)
Source: Company data, HSBC estimates
Testing and Inspection sector: growth and profitability
Growth
Sales
EBITDA
EPS growth
Margins
EBITDA
Multiples
PE
EV/EBITDA
FCF/EV
ROE
Mark-up over labour
Note: based on all HSBC coverage of testing and inspection sector (market cap weighted)
Source: Company data, HSBC estimates
48
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Sector snapshot
Core industry driver: ISM and US temps (m-o-m annualised)
* Due to the nature of the sector, other indices are used to demonstrate its structure.
*Absolute price performance for the sector for all listed companies since 1 January 2000, and
is weighted by market cap.
**Correlation of Europe Business Services Price index with MSCI Europe
Source: MSCI, Thomson Reuters Datastream, HSBC
May-12
SGS, Experian, Wolseley
0.64
May-09
128%
149%
May-06
473
121,463
40
30
20
10
0
-10
-20
Ma y-03
Trading data
5-yr ADTV (USDm)
Aggregated market cap (USDm)
Performance since 1 Jan 2000
Absolute*
Relative to MSCI Europe US
Dollar
3 largest stocks
Correlation (5-year) with MSCI Europe
US Dollar **
60%
40%
20%
0%
-20%
-40%
-60%
-80%
May-00
% of MSCI Europe US Dollar not
meaningful*
May-97
Business services
May-94
Key sector stats
US Temps (m-o-m annualised) (LHS)
ISM : New Orders less Inv entories Spread (RHS)
Source: Thomson Reuters Datastream, HSBC
PE band chart: Bloomberg EMEA Commercial Services Index
Top 10 stocks: Bloomberg EMEA Commercial Services Index
Europe Business Serv ices Price lev el
20x
2000
15x
1500
1000
10x
500
5x
May-12
Source: Bloomberg
May-09
0
May-06
8.49%
8.30%
n/a
5.57%
5.37%
4.49%
3.88%
3.52%
3.58%
3.09%
May-03
SGS
Experian
Wolseley
Bureau Veritas
Aggreko
Adecco
Intertek
Capita
G4S
Bunzl
2500
May-00
1
2
3
4
5
6
7
8
9
10
Index weight
May-97
Stocks
May-94
Stock rank
Source: Thomson Reuters Datastream, HSBC
Country breakdown: Bloomberg EMEA Commercial Services
4.0
30.0
3.0
20.0
2.0
10.0
1.0
0.0
0.0
May-12
40.0
May-09
5.0
May-06
50.0
May-03
19.5%
13.3%
8.7%
7.6%
6.0%
May-00
France
Switzerland
Ireland
Spain
Italy
Europe Business Services PE and PB multiples
May-97
Source: Bloomberg
32.9%
May-94
1
2
3
4
5
6
Index weight
UK
May-91
Country rank Country
Europe Business Serv ices PE (RHS)
Europe Business Serv ices PB (LHS)
Source: Thomson Reuters Datastream, HSBC
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EMEA Equity Research
Multi-sector
July 2012
Notes
50
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Multi-sector
July 2012
Capital goods
Capital goods team
Colin Gibson*
Global Sector Head, Industrials
HSBC Bank plc
+44 20 7991 6592
colin.gibson@hsbcib.com
Michael Hagmann*
Analyst
HSBC Bank plc
+44 20 7991 2405
michael.hagmann@hsbcib.com
Sector sales
Rod Turnbull
Sector Sales
HSBC Bank plc
+44 20 7991 5363
rod.turnbull@hsbcib.com
Oliver Magis
Sector Sales
HSBC Trinkaus & Burkhardt AG, Germany
+49 21 1910 4402
oliver.magis@hsbc.de
51
52
Capital goods
Diversified / m ulti-industry
c onglomerates
Core ca pital goods
Ae rospace & defence
Construction / building
mate rials
EMEA Equity Research
Multi-sector
July 2012
Sector structure
Eaton
Emerson Electric
General Electric
Hitachi
Honeywell
Hyundai Hea vy
Philips
Sie men s
Toshiba
United Technologies
Production technology
Process technology
Power technology
Buildi ng tec hnology
Transport/comm.
vehicles/cons t. equip
Alfa Laval
ABB
Assa Abloy
Bombardier
Fanuc
Andrit z
Alstom
Cooper Industries
Caterpillar
JTEKT
Flowse rve
BHEL
Daikin
Fiat Industrial
NSK Bearings
GEA
Dong fang Electric
Hubbell Inc.
Hitachi Con st ruction
Ken nametal
Invensys
Doosan Heavy
Johnson Cont rols
Komatsu
Rockwell Automa tion
Metso
Harbin Power
Keyence Corp.
MAN AG
San dvik
Omron Corp.
Mitsub ishi Heavy
Kone
Paccar
SKF
Parke r-Hannif in
Prysmian
Legrand
Scania
Rot ork
Shangha i Electric
Schneider Electric
Terex
Source: HSBC
Sulzer
Volvo
Yokogawa Electric
Wärtsilä
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Atlas Copco
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EMEA Equity Research
Multi-sector
July 2012
Sector price history (12M-forward PE)
Overall sector
Sub-sector: diversified/multi-industry
30
30
26
26
+ 2 Std. Dev
+ 2 Std. Dev
22
22
18
18
14
14
10
10
- 2 Std. Dev
6
- 2 Std. Dev
Source: Thomson Reuters Datastream, HSBC calculations
Source: Thomson Reuters Datastream, HSBC calculations
Sub-sector: production technology
Sub-sector: power technology
30
30
26
+ 2 Std. Dev
2011
2009
2007
2005
2003
2001
1999
1997
1995
1993
1991
2011
2009
2007
2005
2003
2001
1999
1997
1995
1993
1991
6
+ 2 Std. Dev
24
22
18
18
14
12
- 2 Std. Dev
10
- 2 Std. Dev
6
10
10
6
6
Source: Thomson Reuters Datastream, HSBC calculations
2011
14
2011
14
2009
18
+ 2 Std. Dev
2007
2005
2003
2001
1999
1997
1995
1993
- 2 Std. Dev
1991
2011
18
2009
22
2007
22
2005
26
2003
26
2001
30
1999
30
1997
Sub-sector: transport/comm. vehicles/const. equip
1995
Sub-sector: building technology
1993
Source: Thomson Reuters Datastream, HSBC calculations
1991
Source: Thomson Reuters Datastream, HSBC calculations
2009
2007
2005
2003
2001
1999
1997
1995
1993
1991
2011
2009
2007
2005
2003
2001
1999
1997
1995
1993
1991
6
Source: Thomson Reuters Datastream, HSBC calculations
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EBIT margin versus capital turnover (2007-11 average)
6.0
Kone
5.0
Alstom
Invested Capital Turnover (x)
4.0
ABB
3.0
Wartsila
Metso
Atlas Copco
Volvo
2.0
Siemens
Philips
Alfa Laval
SKF
Sandvik
1.0
Schneider Electric
Legrand
0.0
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
20.0%
EBIT margin (%)
Source: Company data, HSBC
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Sector description
The distinguishing characteristic of the capital goods sector is its heterogeneity, which extends through
technologies, applications and customer groups, showing up in growth rates, profitability levels and, ultimately,
valuation multiples. Diverse markets are inevitably niche markets, with relatively little good third-party
data (no Gartner, no JD Power). Much of the job of capital goods research is thus to develop an understanding
of the specific markets in which a supplier is active, likely growth rates and its competitive environment.
Within capital goods, many sub-sectors have historically been, and continue to be, relatively cosy
oligopolies. Often, the rump of the market is highly fragmented and occupied by many smaller unlisted
companies, whose profitability and financial health are hard to ascertain.
abc
Colin Gibson*
Analyst
HSBC Bank plc
+44 20 7991 6592
colin.gibson@hsbcib.com
Michael Hagmann*
Analyst
HSBC Bank plc
+44 20 7991 2405
michael.hagmann@hsbcib.com
*Employed by a non-US affiliate of
HSBC Securities (USA) Inc, and
is not registered/ qualified
pursuant to FINRA regulations
There are normally positive economies of scale to be had, so barriers to entry are high, rewarding
incumbent leaders. These barriers do not just refer to manufacturing efficiency but also input costs and,
perhaps most importantly, aftersales provision. Capital goods is differentiated from consumer goods by
the utilisation level: companies typically sweat assets far more than private individuals do. Aftersales or
‘MRO’ (maintenance, repair and overhaul) therefore accounts for much more of the total market
opportunity than it usually would in consumer markets. Buyers typically expect reliable and
geographically extended MRO networks, which new entrants struggle to provide. The leading companies
in each sector have traditionally exploited this power and have faced relatively few pricing pressures;
there have been instances of price-fixing and collusion on occasion.
Key themes
Volume (growth) and price decoupling
There seems to be an iron law for capital goods suppliers: there is a long-term inverse relationship between an
equipment market’s trend rate of price erosion and its trend rate of volume growth. Through the low-capex
1990s, this was the saving grace of low-growth mature capital goods: these may not have been enjoying techlike volume growth rates but they were not suffering tech-like pricing pressure either. Things seemed to have
changed in the 2000s, with companies enjoying both strong volume growth and a good pricing environment,
which in hindsight was because of the relatively inflexible supply curves that resulted from the years of low
growth.
For much of 2011, Europe’s capital equipment makers, most of which operate in oligopolies, enjoyed
double-digit volume growth but suffered considerable cost inflation (raw materials). Generally, this
scenario would depict an archetypal sellers’ market, with the prospect of robust price increases. But that
was not the case, as price/mix were slightly negative during the year. Moreover, there was a great divide
between machinery makers – most of which managed to generate at least some degree of positive pricing,
and electrical equipment makers – most of which did not.
We believe that 2011 witnessed the start of what might well become a multi-year supply response to the
strong volume growth enjoyed by equipment makers in the past decade.
Emerging versus developed markets
In emerging markets, dominated by the ‘E3’ of China, India and Brazil, demand has focused on the rapid
build-out of infrastructure and manufacturing capacity. In developed markets, demand focuses more on
replacement and MRO. EM capex grew rapidly over the past decade and, as a result, the dollar value of
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capex in those countries is now greater than in DMs. However, this said, we expect the big spread that we
have seen between EM and DM capex growth rates over the past decade to narrow again.
It’s all about the energy
A key capital goods theme has been the provision of energy to a rapidly industrialising EM space, and
power technology companies have benefited. At the same time, demand for more modern energy
technology is seen in DMs, where a combination of political pressure for energy efficiency, increasing oil
prices and environmentalism has led to demand for cleaner, more efficient energy technology. Put simply,
EMs need energy right now; DMs need clean energy.
Providing a ‘solution’
‘Solution’ has become a buzzword within the capital goods sector and represents a desired step away
from just supplying a tangible product. A classic example is the bundling together of a product with a
service component (aftermarket care, or energy efficiency consulting) in order to provide a more
comprehensive, higher-value-added product offering. This often has positive effects on margin expansion,
while the service element adds balance sheet lightness to the equation.
Restructuring effects and operational leverage
Post-Lehman, the sector underwent widespread restructuring, aimed at targeting the cost side and preserving
margins in the face of declining sales. Some companies put staff on shorter working contracts (four-day
weeks not being uncommon), while others closed factories and reduced staffing levels. In some instances,
existing progressions to relocate manufacturing jobs to low-cost countries were accelerated, with plants in
Western Europe being converted to assembly rather than actual manufacture, or being closed altogether.
Key components: assembly versus manufacture
In the first decade of the new millennium, unfocused conglomerates began a wave of divestments, exiting
non-core operations in order to concentrate on more profitable, value-added activities. Businesses that had
become commoditised and consequently faced greater competition, from, say, EM manufacturers (such as
cable manufacturing or semi-conductors) were spun out (either via IPO or trade sale or LBO).
This refocusing on ‘core activities’ has involved companies much more actively in the ‘make or buy’
decision. Outsourcing of components increased (not limited to just ‘simple’ components), in turn
increasing the proportion of ‘assembly’ business. This outsourcing has increased the flexibility of capital
goods companies, but has also led to some occasions of supply chain problems, where specific
components are in short supply.
Sector drivers
Capex cycle
Capital goods companies’ earnings are directly related to their end customers’ capital expenditure activities,
in both the private and public sector (the latter currently exposed to austerity budgets). Customer activity, in
turn, is linked to the broader economic cycle, and the likelihood that these capex investments will generate
positive-NPV projects. As such, the financing environment for such projects must also be borne in mind.
Capex versus opex
Despite this primary focus on capex, there is also a distinction between a customer’s capital expenditure and its
operational expenditure – capital goods firms vary in their exposure to either. Mining equipment companies,
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for example, are often more exposed to customer opex than true capex (they sell more replacement drill heads
than complete new drills, for example) and can maintain revenues even at low points in the capex cycle.
New equipment versus aftermarket
In addition, many capital goods companies make substantial profits on the aftermarket component:
commercial truck makers provide vehicle servicing, while elevator companies maintain the lifts after they
come off warranty. In such circumstances, the continued development of the installed service base (and
competition in the third-party aftermarket sector) is key to maintaining these defensive revenue
characteristics. In some circumstances, the sale of the new equipment is done at paper-thin margins (or
even as a loss-leader), the primary target being the fatter service margins.
Another significant distinction can be made in the product destination. Assa Abloy, for example, stresses
that two-thirds of its products are sold to refit and refurbishment markets, and not new build, reducing the
overall cyclicality of the business. At low points in the capex cycle, firms are universally keen to
emphasise these more defensive aspects of their product portfolio.
Input costs
Capital goods companies are big buyers of raw materials, including (but not limited to) industrial metals such
as iron, steel, nickel and copper, plus plastics and other miscellaneous items. Policies vary, but as a general
rule, the sector does not engage in overly long-term hedging, and is therefore exposed to rising input costs. That
said, rising raw material prices usually correlate with rising end-user demand, especially in EM. In addition, the
leading companies enjoy strong pricing power, and can often pass on price increases to end-customers.
Mix effects
Mix, namely the relative profitability of different products within the offering, also affects profitability.
For example, in some sub-sectors, the products required by EM are less sophisticated than those in DM,
and consequently margins are lower. By contrast, certain more complex high-end solutions sold to DM
offer higher profit margins. In addition, we note a significant mix effect from the sale of spares versus
OE. This is more prevalent among Western OEMs with a large installed base of equipment.
Intra-sector specialisation, de-leveraging, industry consolidation
Although some companies do operate across the many specialised sectors that make up capital goods, the
majority stick to one particular operational axis, such as electrical equipment. The value of broader
economies of scale achieved by operating across the segments is not viewed as significant. Consequently,
industry consolidation exists primarily within a sector, eg, Schneider Electric operates in both low- and
medium-voltage electrical. Some companies do operate in more than one sub-sector – for example,
United Technologies is present across climate control and elevators – but this normally represents a step
into the diversified industrials segment, as opposed to any attempt to cross-sell.
The sector has seen its fair share of M&A activity, mostly concentrated, involving the acquisition of smaller fry
by larger players in each sub-sector as opposed to mega-mergers of equals. M&A has recently focused on the
acquisition of technology from smaller growth firms and geographical expansion, most notably within EM.
At the same time, some of the conglomerate-style companies have sought to turn over their portfolio in
order to maintain a presence in the sweetest spot of the sector, and divestments and spin-offs have not been
uncommon, often via IPO, and often when that business has become overly commoditised (examples
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would include Philips’ sale of its semi-conductors business, or ABB’s exit of the cables business). The
natural consequence of such activity is that those involved on both sides of the coin have purchased
attractive, high-PE businesses while selling commoditised or highly cyclical, low-PE businesses. During
lulls in M&A activity, some firms collected significant cash on the balance sheet, which led to intense
press speculation as to likely M&A targets or the means by which cash could be returned to shareholders.
Since companies have focused activities, reduced cyclicality, reduced debt and increased balance sheet
cash, one could be forgiven for considering the likelihood of private equity activity within the sector. This
is a valid argument, although the size of the targets is a complicating factor, as is a possible perception
that most of the fat has already been trimmed.
Leading indicators
The activities of capital goods companies are summarised at the macro level by the measurement of gross
fixed capital formation, ie, the value quantity of the fixed assets ordered and then manufactured. Some
(larger) products lend themselves better to the publication of order book statistics than others. There is a
huge array of data covering the sector, including such diverse data series as EMEA Regional Gas &
Steam Turbine Orders, Chinese Fixed Asset Investment in the Oil & Gas Sector, and Australian mining
capex, to name but three.
Key segments
Production technology: “Stuff that makes stuff”, ie, mechanical, electromechanical and electronic
equipment used in the production process in both manufacturing and process industries. Key drivers
underpinning demand for the global production technology industry are high growth in EM, rising labour costs
and growing environmental awareness.
Building technology: Low-voltage electrical distribution equipment, building automation & control
equipment, lighting, elevators and cranes, among others. The building technology sector has four key
drivers: urbanisation, energy efficiency, security and safety and energy intensity.
Transport: On-road heavy and medium commercial vehicles (read trucks) but not light commercial
vehicles (LCVs) (read vans), off-road commercial vehicles, primarily construction equipment, agricultural
equipment and rail equipment, ships and diesel engines. Key drivers for global truck markets are economic
growth, infrastructure investments, regulatory action (such as emission norms), oil prices and liquidity.
Process technology: Caters mainly to process industries (or industries engaged in continuous production
process) including oil & gas, petrochemicals, chemicals, metals (ferrous & non-ferrous) and paper &
pulp. Major products include field devices (eg, flow meters, gauges, sensors, transmitters, valves), control
electronics (such as CNCs, production controllers or PLCs) and the software that actually runs and
controls the process (such as the SCADA software). The key driver of demand in these industries is the
significant capex spending driven by resource-heavy EM growth, technological advances that support
upgrades, environmental awareness/regulations and the need to improve cost efficiencies.
Power technology: The hardware and software needed to generate, transmit, distribute and condition the
quality of electrical power. This includes electrical power generation equipment and high- and mediumvoltage electrical transmission equipment. Key drivers for the global power technology industry are
demand for energy in emerging markets and demand for clean energy in developed markets.
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Valuation
Industrial companies trade on traditional metrics, namely forward-looking PE ratios, EV/EBITDA,
EV/EBIT and, to a lesser extent, P/BV or EV/IC. At the peak of the cycle, the rolling one-year-forward PE
reached 19x, while it troughed at 8x immediately after the Lehman collapse. A normalised range for the
sector is around 12-18x. Companies can also be valued using traditional discounted cash flow analysis,
applying a weighted average cost of capital (WACC) to forecasts in order to arrive at a theoretical fair
value. Alternatively, one can employ a ‘reverse DCF’, a method which avoids the use of backward-looking
data (such as beta). Instead one determines an appropriate growth rate for cash flow returns on invested
capital (CROIC) and then, using the current valuation as the PV, calculates the market-assessed cost of
capital (MACC). This MACC can then be compared with the sector average (is company X rich or cheap
compared with the sector?) or versus its own history (is company X at a historical peak or trough?).
Intra-sector free floats vary considerably. In some cases, the reduced liquidity makes it unaffordably risky
for hedge funds to short, and thus stocks enjoy artificial support beyond that of the fundamental quality of
their operating activities and earnings prospects. Some stocks are especially popular with local retail
investors, and Bloomberg free float estimates can be overstated.
Different companies elect to report operating profits in different ways, making comparisons complicated.
Some report their headline number as EBITA, some as EBITDA and others are content to publish a
simple EBIT number. Legrand, for example, chooses to use ‘maintainable adjusted EBITA’. There is,
unfortunately, no solution other than going through the notes to the accounts to determine exactly how
that company’s unique brand of profit has been decided.
There are also wildly varying levels of disclosure within the companies’ own operating segments: some
companies do not split out profitability by either business unit or by geography, and in some cases, the
suspicion remains that cross-divisional subsidies mask the true profitability picture. In addition, some
firms publish their order intake as part of their quarterly reporting, while others decline to do so.
European capital goods: growth and profitability
Growth
Sales
EBITDA
EBIT
Net profits
Margins
EBITDA
EBIT
Net profit
Productivity
Capex/sales
Asset turnover (x)
Net debt/equity
ROE
2008
2009
2010
2011
2012e
6.4%
-12.8%
-18.2%
-18.1%
-10.0%
-11.2%
-16.5%
-51.8%
8.9%
41.9%
57.7%
104.5%
6.4%
7.2%
7.1%
4.5%
6.3%
6.3%
14.5%
20.4%
11.0%
7.3%
6.6%
10.8%
6.8%
3.5%
14.1%
9.8%
6.6%
14.2%
9.9%
6.5%
14.2%
10.7%
7.3%
4.0%
0.82
0.38
17.6%
2.8%
0.87
0.31
8.8%
2.7%
0.76
0.22
16.7%
2.4%
0.76
0.33
16.0%
2.6%
0.76
0.27
17.8%
Note: based on all HSBC coverage of European capital goods. All data is added together in EUR.
Source: Company data, HSBC estimates
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Sector snapshot
Core industry driver: capital goods historical global capex
Key sector stats
0.3
0.1
0
-0.1
Global
Emerging
2012e
2008
2004
2000
1996
1992
-0.2
Source: MSCI, Thomson Reuters Datastream, HSBC
1988
98%
66%
Siemens AG, ABB Ltd.,
Schneider Electric
0.96
0.2
1984
1,524
482,785
1980
Correlation (5-year) with MSCI Europe
0.4
1976
Trading data
5-yr ADTV (EURm)
Aggregated market cap (EURm)
Performance since 1 Jan 2003
Absolute
Relative to MSCI Europe
3 largest stocks
8.2% of MSCI Europe
1972
MSCI Europe Capital Goods Index
Developed
Top 10 stocks: MSCI Europe Capital Goods Index
Source: MSCI, Thomson Reuters Datastream, HSBC
Price level
350
300
250
20x
15x
200
10x
50
0
25.7%
17.7%
15.5%
13.0%
10.5%
4.1%
3.5%
3.1%
2.8%
2011
2010
2009
2008
Weights (%)
5x
2007
Country breakdown: MSCI Europe Capital Goods Index
France
Germany
Sweden
UK
Switzerland
Finland
Netherlands
Spain
Italy
450
400
150
100
Source: MSCI, Thomson Reuters Datastream, HSBC
Country
PE band chart: MSCI Europe Capital Goods Index
2012
13.1%
6.3%
4.9%
4.7%
4.1%
3.9%
3.9%
3.4%
3.0%
2.7%
2006
Siemens AG
ABB Ltd.
Schneider Electric
EADS NV
Atlas Copco AB
Rolls-Royce Holdings Plc.
Vinci SA
St. Gobain
Philips
Sandvik AB
Source: Country accounts, HSBC estimates
2005
1
2
3
4
5
6
7
8
9
10
Index weight
2004
Stocks
2003
Stock rank
Source: MSCI, Thomson Reuters Datastream, HSBC
PB vs. ROE: MSCI Europe Capital Goods Index
25%
4.0
3.6
3.2
2.8
2.4
2.0
1.6
1.2
0.8
0.4
0.0
20%
15%
10%
5%
Fwd ROE
2012
2011
2010
Fwd P/B(x)-RHS
Source: MSCI, Thomson Reuters Datastream, HSBC
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2009
2008
2007
2006
2005
2004
2003
0%
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EMEA Equity Research
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Chemicals
EMEA Chemicals team
Dr Geoff Haire*
Head of Chemicals Equity Research, EMEA and Americas
HSBC Bank plc
+44 20 7991 6892
geoff.haire@hsbcib.com
Sriharsha Pappu*, CFA
Analyst
HSBC Bank Middle East
+971 4423 6924
sriharsha.pappu@hsbc.com
Sebastian Satz*, CFA
Analyst
HSBC Bank plc
+44 20 7991 6894
sebastian.satz@hsbcib.com
Jesko Mayer-Wegelin*, CFA
Analyst
HSBC Trinkaus & Burkhardt AG, Germany
+49 211 910 3719
jesko.mayer-wegelin@hsbc.de
Yonah Weisz*
Analyst
HSBC Bank plc (Tel Aviv)
+972 3 710 1198
yonahweisz@hsbc.com
Omprakash Vaswani*
Analyst
HSBC Bank plc
+91 80 3001 3786
omprakashvaswani@hsbc.co.in
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
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Chemicals
Developed
Petroche micals
Classic
Speciality
Agrochemicals
Industrial Gas es
Ineos (EU)
Akzo Nobel (EU)
Croda (EU)
K+S (EU)
Air Liquide (EU)
LyondellBas ell (EU)
Arkema (EU)
Givaudan (EU)
Syngenta (EU)
Linde (EU)
Georgia Gulf (US)
BASF (EU)
Johnson Matthey (EU)
Yara (EU)
Air Products (US)
Westlake (US)
Clariant (EU)
Symrise (EU)
Israel Chem (EU)
Praxair (US)
DSM (EU)
Umicore (EU)
Alpek (LatAm)
Lanxess (EU)
Wacker Chemie (EU)
Advanced Petrochemical
(ME)
Rhodia (EU)
Mosaic (US)
Solvay (EU)
Potash Corp (US)
Celanese (US)
Arab Potash (ME)
Eastman Chem (US)
Acron (EM)
Huntsman (US)
Bagfas (EM)
PPG (US)
Gubretas (EM)
Sherwin Williams (US)
PhosAgro (EM)
EMEA Equity Research
Multi-sector
July 2012
Sector structure
Monsanto (US)
Braskem (LatAm)
Industries Qatar (ME)
Methanol Chemical (ME)
De veloping
Mexichem (LatAm)
National Petrochemical (ME)
Sahara Petrochemical (ME)
SABIC (ME)
Saudi Industrial Investments
(ME)
Saudi International
Petrochemic al (ME)
Saudi Fertilisers (ME)
Synthos (EM)
Tekfen (EM)
Uralkali (EM)
Saudi Kayan (ME)
Sibur (EM)
Yanbu Petrochemic al (ME)
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Source: HSBC
Restocking-led
recovery
Rising oil
prices
Eurozone
debt crisis
Lehman
18.00%
10
17.00%
EMEA Equity Research
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July 2012
Return on invested capital for chemical stocks versus growth in European industrial production (year-on-year)
16.00%
5
14.00%
0
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11
12
13.00%
12.00%
-5
11.00%
10.00%
-10
Average ROIC (%)
Growth in EU Industrial Production (% y-o-y)
15.00%
9.00%
8.00%
-15
7.00%
6.00%
-20
Overcapacity coupled with
global economic recession
Asian Credit
Crunch
Recession
-25
Asian-led
recovery
5.00%
4.00%
Growth in EU IP (% y-o-y)
ROIC (RHS)
Source: Thomas Reuters Datastream, HSBC
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EBIT margin versus asset turnover chart (2012e)
3.0
Honam Petroc hem ic al
2.5
Formosa C hemical and Fibr
Lanx es s
Asset T urn over (x)
2.0
Ark ema
Formos a Plas tics
LG Chemical
BASF
Yara
C roda
Nany a Plas ticsM ex ichem
Sy ngenta
Israel C hem ic als
Clariant
DSM
Akz o Nobel
Johnson M atthey
Braskem SA
1.5
Solv ay
Hanw ha Chemic al
Giv audan
1.0
Arab Potash
SAF C O
U mic ore
Sy mris e Adv anced Petrochem ic al
K+S SABIC
Air Liquide
Linde
N ational Industrialization
Industries Qatar
Saudi Industrial Inv estments
0.5
Sahara
Yanbu Petroc hem ical
National Petrochem ical Co
Inte rnational Petrochemical
Methanol C hem ic als
Saudi Kayan
Uralkali
0.0
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
EBIT Marg in
Source: HSBC estimates
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Sector description
The chemical sector, particularly in Europe and the US, comprises a wide range of companies serving
various end-markets. There are four sub-sectors – classics & petrochemicals, industrial gases, speciality
and agrochemicals. Several chemical conglomerates encompass all of the sub-sectors.
Summary of sub-sector characteristics
Sub-sector
Classics and
petrochemicals
Specialities
Dr Geoff Haire*
Analyst
HSBC Bank plc
+44 20 7991 6892
geoff.haire@hsbcib.com
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
__________ Companies ___________ Characteristics
Akzo Nobel
DSM
 need to keep cost base low
Arkema
DuPont
 high capital intensity
BASF
Lanxess
 tend to be price-takers
Clariant
SABIC
 cyclical; exposed to economic and supply-demand cycles
Dow Chemical
Solvay
Croda
Symrise
 generally exposed to consumer demand
Givaudan
Umicore
 high consolidation
 low capital intensity
Johnson Matthey
 product offering requires constant innovation in order to maintain margins
 natural pricing power
Industrial gases
Air Liquide
Linde
 high capital intensity
Air Products
Praxair
 long-term contracts of up to 15 years account for about 25-35% of sales
 high consolidation; big four players represent approximately 80% of the
market
 end-markets tend to be cyclical: steel, refining, chemicals
Agrochemicals
Israel Chemicals
Syngenta
 High R&D requirement, particularly in crop protection and seeds
K+S
Uralkali
 highly dependent on crop demand and farmer economics
MA Industries
Monsanto
Yara
 high capital intensity in fertilisers so low cost base is key
Source: HSBC
Transforming in search of higher margins
Twelve years ago there were 17 large-cap chemicals companies. Since then, nine companies have either
exited chemicals (for example, UCB, Bayer and Hoechst) or have been acquired by competitors or private
equity (BOC, Courtaulds, ICI and Rhodia). The remaining companies have also undergone major
transformations as they have generally exited any commodity chemicals in which they did not have a
leading position. We expect M&A to continue to play a major role in the sector.
The classic and petrochemical sub-groups have the challenge of maximising margins through portfolio
change to become either speciality players or the “best-in-class”. Classic chemical companies tend to be
large conglomerates. Speciality players, on the other hand, end to be smaller, niche producers. Over the
past 15 years, companies in the European chemical sector – Akzo Nobel, Bayer, DSM and Solvay, for
example – have been shedding businesses with low margins and returns, or where they were lacking a
market-leading position. Within the classic sub-sector, companies have adopted two strategies to improve
profitability: increasing their presence in products where they hold leading positions or completely exiting
businesses where their market share is low or where they are at a competitive disadvantage (eg no access
to cheap feedstocks). Over the past 10 years, BASF has exited low-margin commodity products such as
polyolefins and fibres (nylon) while investing in areas such as engineering plastics, superabsorbents,
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electronic chemicals, construction chemicals, catalysts and natural products. This has caused trough
returns to increase: the return on invested capital was 7.9% in 2009 compared with 4.6% in 2001.
The industry is mostly made up of a series of global oligopolies, reflecting the fragmented nature of the
end-markets. However, companies are generally price-takers as either customers have more bargaining
power or prices are set with respect to supply-demand balances, which is particularly true for classics and
fertiliser producers. The barriers to entry are capital costs, customer relationships and technology.
Key themes
Emerging versus developed market economic growth
Historically, the industry’s end-markets have been focused in the developed world, where growth is likely
to remain below trend for the foreseeable future. However, growth in manufacturing, the upgrading of
infrastructure and a growing middle class are making emerging markets increasingly important to the
chemicals sector. The sector average exposure to emerging markets is a third of sales. However, a number
of companies in the European sector already have a more sizeable position in emerging markets,
including Givaudan (46% of sales), Syngenta (46%), Linde (43%), DSM (38%) and Yara (38%).
Commoditisation
One of the inevitabilities in the chemical industry is commoditisation. There are two broad categories of
chemicals – commodity and specialities.
Commodity chemicals prices tend to be set by public markets and are heavily correlated with input costs
and supply-demand balances. Raw material costs represent more than 65% of the overall price, customers
can easily switch suppliers, products are defined by chemical entities and the barriers to entry are low if
you have unlimited capital. There are many competitors in this category.
In contrast, speciality chemical prices tend to be driven by the value the chemical adds to the customer’s
products/processes. Raw material costs represent less than 40% of the price, it is not easy for customers to
switch suppliers as this can involve changing manufacturing processes, and there are few competitors in
this category.
However, history has shown that speciality chemicals can easily become commodities in the absence of
innovation, or as a result of end-market changes or new entrants chasing higher margins. We have seen
examples of this in plastic additives, engineering polymers and fine chemicals. In our opinion, the term
speciality has been misused by companies and should only apply to products that can sustain high
margins and growth – such as crop protection, catalysts, fragrances and some engineering polymers.
M&A
Over the past 12 years we have seen significant M&A in the sector. There have been three types of
activity: consolidation within the sector (for example Solvay acquiring Rhodia), private equity activity
(the formation of Ineos, Access Industries’ creation of LyondellBasel from two acquisitions, and Apollo’s
later acquisition of LyondellBasell), and oil and healthcare companies spinning off their chemical
businesses (for example Novartis and Astra Zeneca forming Syngenta, and Total spinning out Arkema, its
chemical businesses). We expect M&A to continue in the sector as balance sheets are healthy; currently
DSM and BASF are active buyers according to their management teams. We also expect private equity to
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bring chemical companies back to the market – although this will depend on the state of the equity
markets and the macroeconomic backdrop. Over the last two years we have seen AZ Electronic Materials,
Brenntag and Christian Hansen returning to the public market.
Substitution
The threat of external substitution to the chemical industry is limited but internal substitution is a constant
threat. Internal substitution is driven by other producers looking for new end-markets as well as
customers looking for lower-priced materials, for example polyethylene being substituted for
polypropylene in packaging. Currently many companies are investigating new technologies, such as
biotechnology and nano-materials, which could result in new lower-cost or better-performing products, or
new low-cost manufacturing processes.
Sector drivers
In our initiation report (It’s Showtime: Initiating on the European chemical sector, 1 December 2010 we
introduced three sets of value drivers to help differentiate between companies in the sector and their
ability to increase and/or sustain their return on invested capital. We believe ROIC is the best metric to
reflect the returns investors can expect from the capital that management teams are putting to work to
generate future profits, particularly in the case of companies with high capital intensity. Historically, we
have found a strong link between share price performance and return on capital.
In all, we have identified 10 drivers that influence valuation, which fall into three broad categories: topline growth, ROIC expansion and leverage. We have ranked all the companies in the European chemical
sector on each driver to gain a better understanding of which are best positioned to generate sustainable,
above-average returns in the future. The categories are:
 Top-line growth: we believe the key components of sales growth are: (1) end-market structure;
(2) exposure to developing economies; (3) barriers to entry; and (4) pricing power.
 ROIC expansion: we believe the key components of returns are: (1) exposure to raw materials;
(2) degree of consolidation; (3) cost base restructuring; (4) cash conversion; and (5) foreign exchange
exposure.
 Leverage: it is particularly important to scrutinise a company’s balance sheet in times of economic
uncertainty. Leverage is also important because it allows companies to take advantage of growth
opportunities – via either organic investment or acquisitions. The components of this sub-category
are: (1) net debt/EBITDA; and (2) debt maturity.
Macroeconomics and pricing power
Top-line growth in the sector is driven by GDP and industrial production (IP). Over the past 20 years
there has been a high correlation between the performance of the European and US chemical sectors and
IP in the developed world. In the shorter term, Chinese and Asian industrial growth has become an
important driver of earnings and share price performance. Volume growth rates across sub-sectors vary
dramatically, with catalysts, industrial gases, engineering polymers and electronics growing at over 2x
GDP, but paper and textile chemicals volumes at less than GDP. We believe average volume growth rates
tend to be around 1.5-2.0x GDP. Over the past 10 years, volumes in the classic sub-sector have grown at
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2.0x global GDP on average and 1.2x IP, specialty chemicals volumes at 1.2x global GDP and 0.7x IP,
and industrial gases at 1.9x GDP and 1.2x IP.
Historically, we have seen many cases where classic chemical companies were not able to recover higher
costs for raw materials, and margins were squeezed as a result. However, tight supply-demand balances
following the financial crisis have momentarily put pricing power firmly into the hands of the classic
players. Conversely, several consumer-related speciality companies that tend to be price setters have
struggled with the strong rise in raw materials, as their contracts often only allow for erratic price
increases. It is worth noting that the industrial gas players tend to have prices linked to inflation and the
cost of energy for the large plants (tonnage) that they operate for customers.
In Juggling in a slowdown – 4 October 2011 we discuss in some detail the relationship between volumes
and price and macroeconomic drivers, particularly GDP and the oil price.
Input costs
We estimate that 55% of the sector’s input costs, if we include energy, are fossil-fuel based. Commodity
companies are more exposed to input costs than speciality producers, as these represent more than half of
the price of a product (as much as 65%). As commodity producers strive to reduce their cost base, they
have shifted a large amount of production to the Middle East, attracted by low gas prices. In 2001 Europe
and North America accounted for 54% of the world’s ethylene production; by the end of 2010 we expect
this to have fallen to approximately 40% and the Middle East to account for 19% by 2010 compared to
9% in 2001. The other sub-sectors are less exposed to input costs and potentially have more pricing
power. Historically, in times of fast-rising input costs, the majority of the industry has struggled to pass
on price increases quickly. However, following the financial crises of 2008-09, contract lengths for
commodity/industrial chemicals were reduced, enabling increases in input costs to be passed on more
quickly. However, for companies with contracts lasting more than a quarter there is a risk of margin
compression if input costs increase quickly.
North American natural gas advantage
Prior to 2008 the view was that the US petrochemical industry was in structural decline due to high
feedstock costs, and the ratio of the crude oil to the natural gas price (WTI/Henry hub) was around 6.0x,
which is considered to be feedstock parity. However, the advent of shale gas has lowered the gas price
substantially.
Therefore the US petrochemical industry has moved to using more gas (ethane) as a feedstock instead of
oil-based naphtha, shifting the cracker slate more towards ethylene and reducing the amount of the other
two key building blocks, propylene and butadiene, which are only obtained when using naphtha as a
feedstock. This trend is expected to continue given the amount of shale gas available in the US. There are
two implications of such a shift: 1) CMAI (Chemical Market Associates) is expecting the US
petrochemical industry to be at the top of the second quartile of the cost curve, making it significantly
more competitive than the European and Asian naphtha-based producers, so the US could once again
become a major exporter; and 2) there could be a structural shortage of propylene (C3) and butadiene
(C4). This has resulted in prices for propylene and butadiene, which are key raw materials for the
European chemicals sector, increasing significantly relative to ethylene.
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In North America a number of cracker feasibility studies are under way; if all were built, this would add
7mtpa of ethylene capacity (c5% of global capacity), which would likely either be exported (particularly
to high-cost naphtha-based petrochemical regions, such as Europe and Asia) or used as feedstock for the
manufacture of chemicals.
Chemical industry to supply ‘3E’-solution
In the Energy in 2050 research report HSBC highlights that the world can only grow and have enough
energy if energy efficiency improves and the energy mix changes. Given the chemical industry’s role as an
‘enabler’, a number of companies within the sector have technology that can help with this:
 Energy mix – Syngenta, K+S, BASF (fertiliser, crop protection, seeds), DSM (biofuels), BASF,
Johnson Matthey, Umicore (fuels cells, batteries), Wacker Chemie and Umicore (exposure to solar)
 Efficiency – this comes through the substitution of metal by engineering plastics (BASF and DSM),
improved insulation with polyurethanes (BASF and Bayer), enhanced oil recovery (Linde and Air
Liquide) and high performance tyres (Lanxess)
 Environment – Johnson Matthey, Umicore and BASF (emission catalysts).
Feed the world
We expect population growth and urbanisation in the developing world to cause a rise in GDP/per capita
as well. This would increase demand for agrochemicals, particularly if we saw higher demand for meatbased protein. We note that it takes 7kg of grain to produce 1kg of beef and 4kg of grain to produce 1kg
of pork.
As the amount of arable land has remained unchanged over the past 50 years, at approximately 38% of
total land, arable land per capita has decreased by 30%, from 0.23ha to 0.16ha.
The UN’s Food and Agriculture Office (FAO) estimates that approximately 90% of the crop production
growth required to meet future demand will need to come from higher yields. The rest should come from
an increase in arable land in the developing economies.
This has prompted some governments in countries with scarce arable land and fast-growing populations
to buy or lease land in other countries. The International Food Policy Research Institute estimates that 1520m ha, valued at USD20-30bn, have been sold or leased since 2006. The biggest purchasers have been
South Korea (2.3mha), China (2.1mha), Saudi Arabia (1.6m ha) and the UAE (1.3m ha).
If the world’s future demand for crops is to be met, there is a massive need to increase production yields
through a combination of more effective agrochemicals and the use of plants modified by seed technology
to be capable of surviving in difficult environments, such as drought conditions.
Valuation
The market is focused on short-term earnings growth. It tends to value companies on a 12- to 18-month
forward earnings basis, mainly using PE and EV/EBITDA multiples, as well as sum-of-the-parts (SOTP) for
conglomerate companies. The drawback to this for chemical companies is that they have changed so much
over the past 10 years that using historical multiples might be misleading; moreover, this methodology does not
capture the future value of those companies that have invested heavily either in R&D or acquisitions.
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In contrast, a return on capital metric (ROIC or CROCI) or a discounted cash flow (DCF) takes into
account the return on all the capital that has been invested in the company historically. This is important
for highly capital-intensive companies. A DCF captures the future value of investments that have already
been made, as the key drivers of a DCF are growth in invested capital (IC), asset turn (sales/IC), profit
margin and weighted cost of capital.
European chemical sector EV/IC range of 1.2x-2.0x over the
last 20 years
European chemical sector EV/EBITDA range of 5.0x-10.0x
over the last 20 years
2.2
10.0
2.0
9.0
1.8
8.0
1.6
7.0
1.4
6.0
1.2
5.0
1.0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Average EV/IC
Trend
Source: Thomas Reuters Datastream, HSBC
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+1 StdDev
-1 StdDev
4.0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Average EV/EBITDA
Trend
Source: Thomas Reuters Datastream, HSBC
+1 StdDev
-1 StdDev
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Sector snapshot
Core industry driver: European industrial production
Key sector stats
MSCI Europe Chemicals Dollar
Index
3.4% of MSCI Europe US Dollar
15%
10%
Trading data
5-yr ADTV (EURm)
1,293
Aggregated market cap (EURm)
196,522
Performance since 1 Jan 2000
Absolute
66%
Relative to MSCI Europe US
167%
Dollar
3 largest stocks
BASF, Air Liquide, Syngenta
Correlation (5-year) with MSCI Europe US
0.23
Dollar
5%
0%
-5% Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3
06 06 07 07 08 08 09 09 10 10 11 11 12e 12e
-10%
-15%
-20%
Industrial Production (y-o-y)
Sector volumes (y-o-y)
Source: Thomas Reuters Datastream, HSBC estimates
Source: MSCI, Thomas Reuters Datastream, HSBC
PE band chart: MSCI Europe Chemicals Dollar Index
Top 10 stocks: MSCI Europe Chemicals Dollar Index
450
Stock rank
Stocks
1
2
3
4
5
6
7
8
9
10
BASF
Air Liquide
Syngenta
Linde
Yara
Akzo Nobel
Givaudan
Solvay
DSM
Johnson Matthey
400
350
300
250
200
Index weight
26.1%
13.9%
12.2%
10.4%
4.5%
4.5%
3.6%
3.5%
3.5%
3.1%
17x
14x
11x
8x
150
100
50
2004
2005
2006
2007
2008
2009
2010
2011
2012
Source: MSCI, Thomson Reuters Datastream, HSBC
Source: MSCI, Thomson Reuters Datastream, HSBC
PB vs. ROE: MSCI Europe Chemicals Dollar Index
Country breakdown: MSCI Europe Chemicals Dollar Index
Country
Germany
Switzerland
France
Netherlands
Belgium
UK
Source: MSCI, Thomas Reuters Datastream, HSBC
Weights (%)
44%
17%
16%
8%
4%
3%
3.0
19.0
2.5
17.0
2.0
15.0
1.5
13.0
1.0
11.0
9.0
0.5
2004 2005 2006 2007 2008 2009 2010 2011 2012
12M Fwd PB
12M Fwd ROE (RHS)
Source: MSCI, Thomson Reuters Datastream, HSBC
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Notes
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Clean energy &
technology
Clean energy & technology team
Sector sales
Sean McLoughlin*
Analyst
HSBC Bank plc
+ 44 20 7991 3464
Sonja Kimmeskamp
Sales
HSBC Trinkaus & Burkhardt AG, Germany
+49 211 910 4854
sonja.kimmeskamp@hsbc.de
sean.mcloughlin@hsbcib.com
Christian Rath*, CFA
Analyst
HSBC Trinkaus & Burkhardt AG, Germany
+ 49 211 910 3049
christian.rath@hsbc.de
Tim Juskowiak
Sales
HSBC Trinkaus & Burkhardt AG, Germany
+49 211 910 4452
tim.juskowiak@hsbc.de
Jenny Cosgrove*, CFA
Analyst
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6619
jennycosgrove@hsbc.com.hk
Charanjit Singh*
Analyst
HSBC Bank plc
+91 80 3001 3776
charanjit2singh@hsbc.co.in
Murielle André-Pinard*
Analyst
HSBC Bank plc, Paris branch
+331 56 52 43 16
murielle.andre.pinard@hsbc.com
Gloria Ho*, CFA
Analyst
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6941
gloriapyho@hsbc.com.hk
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
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Clean energy & technology sector
Renewable & low carbon energy production
Supply
Renewable OEMS
Solar
Energy efficiency & management
Resource efficiency & management
Building efficiency
Water & waste
Demand
Renewable utilities
Low carbon OEMS
EDP Renovaveis
China Longyuan Power
Acciona
Nuclear
Aixtron
Imtech
Seoul Semiconductor
Veolia Environnement
Pennon Group
Séché Environnement
China Everbright
Industrial efficiency
GCL Poly
Trina Solar
SMA Solar
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Sector structure
Doosan Heavy Industry
China Guangdong
Nuclear Power Group
Low carbon power providers
EDP
EDF
Krones
Rational
Crompton Greaves
Pollution control
Johnson Matthey
Umicore
Wind
Transport efficiency
Vestas
Xinjiang Goldwind
Suzlon
Energy transmission
Transmission infrastructure
Delachaux
Vossloh
ALL-America Latina Log
Support services
Intertek
SGS
Hydro
Andritz
Sinohydro Corporation
Nexans
Prysmian
Conversion efficiency
Infineon
Dialog Semiconductor
Biofuels
Sâo Martinho
Power storage
Saft
ABB, Alstom, Samsung, Schneider Electric, Siemens
Source: HSBC
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Multi-theme industrials
Stern report on
500
EU Energy & C limate package
400
'Green austerity ':
C openhagen Sum mit
clim ate ec onom ics
US Green
Spain freezes
Stim ulu s Bill
Ky oto enters into force
Fukushima nuclear renew able
disas ter
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HSBC clean energy & technology sector benchmark indices: price history
s ubsidies
200
100
0
2004
2005
Wind
2006
Solar
2007
2008
Energy Efficiency & Energy M anagem ent
2009
2010
2011
Water, Waste & Pollution Contr ol
2012
MSC I World
Note: Sector indices are generated by HSBC Equity Quantitative Research (HSBC Climate Change Benchmark Index).
Source: HSBC Equity Quantitative Research, Thomson Reuters Datastream
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Low carbon pow er
2.50
Energy efficiency
2.00
Asset turnover (x)
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HSBC clean energy & technology sector benchmark indices: EBIT margin versus asset turnover chart (2011)
Resource efficiency
1.50
1.00
0.50
0.00
-40.0%
-30.0%
-20. 0%
-10.0%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
EBIT margin (%)
Source: Company data, HSBC
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Sector description
This sector comprises a wide range of businesses involved in the production and use of technologies that
are intended to enable the shift away from carbon-intensive fossil fuels, such as coal, as part of the
gradual decarbonisation of the global economy, and towards more sustainable and cleaner products.
These technologies include those for the generation of renewable and low carbon power, and more
efficient production, distribution and management of energy and resources.
abc
Sean McLoughlin*
Analyst
HSBC Bank Plc
+44 20 7991 3464
sean.mcloughlin@hsbcib.com
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
From an equity perspective, clean energy cuts across traditional sector boundaries where pure plays and
incumbents both feature. HSBC clean energy and technology research is closely related to the work of our
climate change team globally, which analyses cross-sector macroeconomic trends associated with the
climate change theme.
Low-carbon power includes power generation using no fuel or less fuel than conventional power-
generation technologies, and producing no pollutants or fewer than conventional technologies. It uses
renewable energy sources that, unlike fossil fuels, are not depleted over time, such as biomass and
biofuels, solar power, wind power, geothermal and hydropower. It also uses nuclear energy which, though
it consumes a limited mineral resource, produces low levels of carbon over its lifetime compared with
conventional power generation. This sector includes manufacturers of equipment for renewable energy
production and generation companies, such as utilities.
Energy transmission includes companies involved in the transmission of low-carbon power through
distribution networks. A rising proportion of renewable power, which is intermittent in nature, requires
greater grid flexibility to handle the higher variability of power supply. This sector includes grid operators
and equipment providers for transmission and distribution infrastructure.
Energy efficiency and management involves replacing existing technologies and processes with new
ones that provide equivalent or better service but consume less energy. The sector includes energy-saving
technologies to reduce energy consumption in buildings, industries, transport and in power conversion,
and also includes energy-storage technologies such as batteries.
Building efficiency includes: improved building materials that control the transfer of heat into and out of
buildings; more efficient lighting, which relies on the use of light-emitting diodes, compact fluorescent
lamps and sensors; energy-efficient chillers and directional lighting; and smart systems that control power
consumption in buildings.
Industrial efficiency encompasses products or processes to conserve energy in industrial sectors. These
include process automation, control systems, instrumentation and energy control systems.
Conversion efficiency includes devices involved with power management within electronics products
and with conversion of power for grid compatibility of generation equipment.
Transport efficiency includes technologies that reduce the carbon emitted by conventional transport.
Low-carbon fuels like biodiesel and ethanol are also included. A shift from road to rail transport and use
of electric and hybrid-electric vehicles, which emit less carbon than fossil-fuel vehicles, falls under
transport efficiency. Mass transit – buses, trains and trams – is considered part of transport efficiency as
well, as are companies that supply efficient-engineering systems or parts that are supplied to cleaner
forms of transport.
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Resource efficiency and management includes companies involved in the treatment and recycling of
resources such as water and waste, and in the application of chemical and materials to carbon abatement
processes such as pollution control. In the water sector, companies provide efficient water supply, water
conservation and recycling, and advanced water-treatment technologies. Waste management comprises
mainly the collection, transport and disposal of waste. Some support-services companies provide
environmental consulting, which also falls under this theme. Companies in pollution control are involved
in carbon-abatement technologies such as catalysts in vehicle exhaust systems.
Key themes
Capital intensity
The sector relies on investments in new energy generation infrastructure or replacement of existing
energy management products with more energy-efficient products or improved use of resources.
The sector thus requires supportive policy – the rapid growth in the uptake of renewables has come about
thanks to favourable policies rewarding investors with a long-term return on their investment via a range
of subsidy schemes. Rising regulatory uncertainty from governments reducing subsidies for renewables in
a time of austerity and potentially applying retroactive measures to existing generation infrastructure
where investments have already been made, has raised the perceived risk premium and the corresponding
cost of capital for future investments.
Availability and cost of financing are also important determinants of demand for new clean energy powergeneration projects. Wind and solar projects in the developed world are typically funded 75% by project
finance and 25% by equity. Projects are being rendered uneconomical, unfinanceable or subject to delays
owing to tightening project finance availability and widening finance spreads. This is owing to the collateral
damage to banks’ balance sheets from the euro crisis and increased capital adequacy requirements.
Resource and energy efficiency: theme for next decade
In parallel to reducing the carbon intensity of power production by curbing emissions from fossil fuels,
notably coal, oil and gas, and providing incentives for low-carbon sources, notably renewable and nuclear
energy, a growing trend is for taking energy out of growth, by promoting energy efficiency in buildings,
industry and transport. Energy efficiency is generally less capital intensive than clean energy (many small
projects, rather than single large infrastructure projects), as well as generally having short payback times,
so is a theme better suited to austerity. Additionally, it results in the retention and even creation of many
highly localised jobs owing to its manufacturing and installation dynamics.
So far, the low-carbon economy has been dominated by changes in energy supply. We believe that will
change in the coming years as governments implement policies to deliver ‘negative cost’ improvements in
building and industrial efficiency, and push for a shift in transport to hybrid and electric vehicles. Saving
costs through energy efficiency should make the economics compelling for expansionary plus replacementcycle spending as global economic growth improves. We estimate the energy-efficiency market will
outgrow other clean-technology sectors and may grow to between USD722bn and USD1.4trn by 2020.
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Ongoing shift from developed to emerging markets
The developed world has been the mainstay of the low-carbon economy over the past decade, primarily
because it has a larger base of installed nuclear and renewable generation capacity and more focus on
installation of energy-efficient technologies. Recently, China has risen to become a dominant force in
clean energy (China accounted for ~50% of new wind installations globally in 2011 and hosts nine of the
top 10 solar manufacturers). With China’s goals for low-carbon energy and energy efficiency implying
that Chinese demand for clean energy technologies is likely to outstrip that of its developing-market
peers, we expect China to continue to exert a strong influence globally in clean energy. Increasingly,
other emerging markets in Asia and Latin America are supplanting developed markets as growth drivers
for clean energy demand.
Sector drivers
Policy support
The EU-27 nations, which have binding 2020 targets and a National Renewables Energy Action Plan
(NREAP) as a driver for subsidies, accounted for 90% of solar and 75% of wind installed globally by the
end of 2011. As green stimulus measures come to an end with central cutbacks to public spending,
governments are threatening to reduce subsidies for renewable energy, or have already done so.
Uncertainty in government subsidy regimes remains the biggest hurdle for investment in capex-intensive
projects (this applies to solar and offshore wind projects in particular, which are more expensive per
MWh than onshore wind) and constitutes a risk for suppliers, developers and operators. Hurdle rates for
projects have risen to reflect a growing perception of this risk as well to account for the rising cost of
financing. In the EU, policy visibility beyond 2020 should help support longer-term government
commitments to clean energy.
For energy efficiency, no binding targets exist at an EU level, unlike for renewables and emissions
reductions. Nonetheless, national governments in the EU, including France, Germany and the UK, are
continuing to support efficiency measures in spite of austerity pressures. An EU energy-efficiency
directive, currently in advanced discussions and expected soon to be voted into law, would set hard
targets for energy-efficiency measures in Europe, thus providing a stable policy basis for sustained growth.
Corporate and private equity funding to replace banking credit shortfall
With Basel III rules limiting the ability of banks to provide project finance loans, many banks are pulling
out of long-term lending for large infrastructure projects such as energy developments involving wind or
solar. Despite high upfront capex costs, the stable cash flow and low operating costs of clean energy projects
are proving attractive to corporates, and private and institutional equity players, which are increasingly
investing in the sector. As commodity prices continue to rise and resource scarcity becomes an increasing
reality, companies have begun to step up their environmental efforts and revise their sustainability
strategies. Rising quantities of corporate equity should help support clean energy market growth.
Rationalisation of OEM capacity
The wind, solar and LED industries currently suffer from oversupply, which is putting pricing and
producer margins under pressure. In solar, the emergence of low-priced Asian competitors and low
barriers to entry for manufacturers led to a glut of module production capacity in 2011. Bankruptcies and
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capacity rationalisation in the solar sector will help industry winners emerge more quickly. In wind, fierce
competition and low-priced Chinese manufacturers have helped depress turbine pricing, and an expected
downturn in global demand in 2013 suggests production margins will remain low.
Key segments
Renewable OEMs
It seems increasingly clear to us that subsidies for new renewable capacity will continue to decline until
they are withdrawn entirely. This cut in support will force the industry to become competitive with
traditional power generation, presumably at the expense of many present participants that cannot breach
such a transition. We therefore expect strong medium-term growth prospects for wind and solar,
notwithstanding the current near-term pressures.
Renewable and low-carbon utilities
We believe the green utility names will benefit in a number of ways from the adverse macro conditions in
the wind and solar sectors. First, falling prices in solar and more competitive turbine prices lead to lower
capex requirements and hence better returns. Second, a reduction in capex commitments in an
unfavourable environment for future projects can improve cash flow and potentially lead to higher
dividend payouts.
Energy efficiency
Energy efficiency refers to the ratio between energy outputs (services such as electricity, heat and
mobility) and inputs (primary energy). It is the simplest way of curbing emissions and can target a wide
range of industries and processes along the three major steps of the energy value chain (generation,
transmission, consumption). For example, higher efficiency in power conversion could not only lower
CO2 emissions but also reduce material and electricity costs. In particular, lighting is one of the main
drivers of a building’s energy use, accounting for approximately 40% of energy consumption and 36% of
EU CO2 emissions (source: EU). In LEDs, we believe that declining LED prices will fuel a transition to
this form of lighting. Although we expect this to result in above GDP growth rates over the next five
years, we have a cautious view on the industry’s long-term winners. High price pressure on LEDs,
competition from new entrants, increased cyclicality and a declining replacement market will reduce
margins and capital returns in the long run, in our view.
Resource efficiency
Resource efficiency refers to improving the productivity of resource inputs. With evidence of mounting
stress in global food, water and energy systems, policymakers are turning their attention to improving
resource efficiency. The argument is that moving upstream and reducing resource inputs – whether
energy, materials or water – is not only a more effective way of cutting the output of greenhouse gas
emissions, but it also enhances security of supply. Currently, the global economy ‘harvests’ around c60bn
tonnes of resources in terms of primary raw materials: construction minerals, ores and industrial minerals,
fossil fuels and biomass. This could more than double to 140bn tonnes per annum by 2050 on ‘business
as usual’ trends. In 2007, the world average per-capita resource use was c9 tonnes, with industrialised
countries consuming c16 tonnes per capita compared with c5-6 tonnes for developing countries.
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Valuation
The clean technology sector encompasses different product industries (wind, solar, light-emitting diodes,
semiconductors and so on) as well as different positions in the renewable value chain – manufacturers versus
developers, owners and operators (utilities) – so different valuation methodologies are needed. We prefer,
in many cases, to use a blend of valuation techniques to capture both short-term earnings pressure and
market risk along with long-term growth potential. In our view, this helps us combine a floor for current
negative expectations while factoring in additional value, which could crystallise in the longer term.
We use DCF-based valuation to capture the sector’s long-term growth potential. For utilities, for example,
a DCF-based SOTP in our view captures the visible and long-term cash generation profile of generation
assets. We also use fair RoE-implied PB valuation, which is an absolute valuation metric but, unlike the
DCF methodology, allows us to take a conservative and more short-term view and capture the current
market situation and risks. For example, DCF currently provides little support to the assessments of fair
value for solar companies, in our view, given low or negative earnings and heavy consolidation in the
industry. We also adopt a peer-group-based approach (EV/sales or EV/EBITDA) where appropriate and
for stocks with cyclical sales/earnings growth potential (for example, semiconductor producers).
Clean energy & technology: growth and profitability
Growth
Sales
EBITDA
EBIT
Net profit
Margins
EBITDA
EBIT
Net profit
Productivity
Capex/sales
Asset turnover (x)
Net debt/equity
ROE
2008
2009
2010
2011
2012e
11.1%
0.4%
-1.9%
-7.5%
-5.2%
1.5%
-1.9%
-25.4%
8.5%
11.9%
13.8%
29.1%
4.4%
1.5%
-4.2%
-9.3%
3.2%
1.5%
7.9%
10.4%
19.6%
13.5%
8.7%
18.8%
11.8%
6.6%
21.1%
14.3%
8.8%
18.2%
9.7%
4.9%
17.4%
9.9%
4.9%
0.21
0.92
0.60
0.20
0.19
0.76
0.52
0.21
0.16
0.78
0.73
1.14
0.15
0.75
0.55
0.06
0.10
0.71
3.68
0.13
Note: based on all low-carbon power producers, energy efficiency and waste & water stocks under HSBC coverage
Source: company data, HSBC estimates
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Sector snapshot
Core industry drivers: clean energy & technology
Key sector stats
HSBC Climate Change Benchmark Index
Construction cost
Trading data
5-yr ADTV (EURm)
n/a
Aggregated market cap (EURm)
638 (340 constituents)
Performance since 1 Jan 2000
Absolute
21%
Relative to MSCI ACWI
2%
3 largest stocks
Siemens, Honeywell Int, ABB Ltd
Correlation (5-year) with MSCI ACWI
0.95
Financing cost
Raw material
prices
Policy including
Tariff
Technology
Cost
competitiveness
towards grid parity
Note: All data is as of 31 May 2012
Source: MSCI, HSBC Equity Quantitative Research
Stocks
1
2
3
4
5
6
7
8
9
10
Siemens
Honeywell International
ABB
Emerson Electric
Exelon
Schneider Electric
Nextera Energy
Waste Management
Enel
Southern Co
Weather
Source: HSBC
Top 10 stocks: HSBC Climate Change Benchmark Index
Stock rank
Cleantech
Index weight
19.7%
18.6%
18.5%
9.1%
7.6%
5.6%
4.9%
4.8%
3.6%
3.3%
Note: All data is as of 31 May 2012
Source: HSBC Equity Quantitative Research
PE chart: HSBC Climate Change Benchmark Index
25.0
20.0
15.0
10.0
5.0
0.0
2004 2005 2006 2007 2008 2009 2010 2011 2012
Country breakdown: HSBC Climate Change Benchmark Index
Country
US
Germany
Japan
France
Canada
UK
Switzerland
Italy
Taiwan
Brazil
Weights (%)
41.6%
10.3%
9.6%
8.5%
3.3%
3.3%
3.0%
2.2%
2.0%
2.0%
12M forw ard PE
Source: HSBC Equity Quantitative Research
PB vs. ROE: HSBC Climate Change Benchmark Index
4.0
25
3.0
20
2.0
15
Note: All data is as of 31 May 2012
Source: HSBC Equity Quantitative Research
1.0
10
2004
2006
12M f orw ard PB (LHS)
2008
2010
2012
12M f orward R OE % (RHS)
Note: PB/RoE is calculated based on the top 10 index constituents.
Source: Thomson Reuters Datastream, HSBC Equity Quantitative Research
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Climate change
Climate change team
Nick Robins
Head, Climate Change Centre of Excellence
HSBC Bank plc
+44 20 7991 6778
nick.robins@hsbc.com
Zoe Knight
Director, Climate Change Strategy
HSBC Bank plc
+44 20 7991 6715
zoe.knight@hsbcib.com
Wai-Shin Chan
Director, Climate Change Strategy - Asia-Pacific
The Hongkong and Shanghai Banking Corporation Limited
+852 2822 4870
wai.shin.chan@hsbc.com.hk
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Canada
EU
Alberta Specified Gas Emitters regulation
(2007), Western Climate Initiative cap and
trade for BC, Manitoba, Ontario and Quebec
scheduled for January 2013. Carbon tax
planned in BC and Quebec (2012)
EU ETS energy and industrial sectors (2005).
Extended to the aviation sector January 2012.
Carbon taxes in Finland (1990), Sweden (1991),
Norway (1991), Denmark (1992), and Switzerland
(2008), Ireland oil and gas (2010), UK carbon
floor price scheduled April 2013
EMEA Equity Research
Multi-sector
July 2012
Emission trading schemes and carbon taxes around the world
China
Planned pilot cap and trade in
provinces (Beijing, Shenzhen,
Chongqing, Guangdong, Hubei,
Shanghai and Tianjin) (2014). Carbon
tax by 2015 under discussion
Japan
Voluntary ETS (2005),
Tokyo Metropolitan Trading
Scheme (2010); planned
carbon tax (October 2012)
US
Regional GHG Initiative
(RGGI) (2009), Western
Climate Initiative cap and
trade for California
scheduled for January 2013,
California Cap and Trade
scheduled for January 2013.
Carbon tax in Bay Area
District (California) and
Boulder (Colorado)
South Korea
Mandatory cap from
2012; ETS scheduled for
2015
India
Mexico
Tax on coal
production and
imports (2010). Energy
efficiency trading
scheme (PAT) (2012)
National Climate Change
Law proposes a national
emissions trading scheme
Brazil
Planned Rio de Janeiro
ETS (2013)
Key
Existing carbon reduction scheme
Planned carbon reduction scheme
Source: HSBC Policy Database, Reuters, government sources
Planned carbon tax (2013/14). Levy
on electricity from non-renewables
Australia
Carbon tax takes effect July
2012; Cap and trade scheduled
to replace carbon tax in 2015
New Zealand
ETS (2010). Waste
included from 2013,
agriculture from
2015
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Currently no schemes announced
South Africa
EMEA Equity Research
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July 2012
Climate change – a long-term structural force
Goods and services derived from the natural environment (natural capital) are crucial for local and
national economies, and maintaining healthy natural capital is structurally important to future economic
prosperity. Land for agriculture, water for energy production and industrial processes, clean air for hightech goods are examples of natural capital. Impairing natural capital through over-extraction, pollution
and the introduction of non-native species can cause imbalance in the ecosystem and prevent natural
rejuvenation; the long-term advance of climate change can exacerbate these resource issues.
The climate is best understood as “average weather” expressed in terms of temperatures, seasonal
variations, rainfall, as well as extreme events such as floods, storms and droughts. In essence, climate
change disrupts historical patterns, exacerbating existing natural resource stresses confronting the global
economy. For example, agricultural yields are affected by increasing temperatures, industrial production
is disrupted by water availability (too much or too little) and lifestyles and health can be distressed by
extreme events and changes in the average weather.
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Nick Robins
Head, Climate Change Centre
HSBC Bank plc
+44 20 7991 6778
nick.robins@hsbc.com
Zoe Knight
Climate Change Strategy
HSBC Bank plc
+44 20 7991 6715
zoe.knight@hsbcib.com
Wai-Shin Chan, CFA
Climate Change Strategy
The Hongkong and Shanghai
Banking Corporation Limited
+ 852 2822 4870
wai.shin.chan@hsbc.com.hk
To slow climate change, global policy momentum remains focused on reducing emissions; the map at the
front of this section shows the many schemes and policies which have been put in place globally in order
to reduce greenhouse gas (GHG) emissions. Some 138 countries, accounting for 87% of global emissions,
have a national climate change strategy in place1. However, economic permafrost – sub-par economic
growth and the era of austerity – is not politically conducive to reducing emissions and the recarbonisation of the global economy is a real concern because, over the longer term, it affects the natural
capital which contributes so much to the economy. 2011 was a year of re-carbonisation for the global
economy (see tables at the back of this section), with emissions growing faster, at 3.2%, against global
GDP growth of 2.5%. On this basis we are moving too slowly to prevent a global warming temperature
rise of 2°C from GHG emissions.
While we are aware of the scientific basis underlying climate change (see No debate among climate
scientists: it’s happening, 2 November 2011), we examine climate change from an investment
perspective. The two key issues at the heart of climate change analysis are: (1) the impact on industry and
the economy of the drive to reduce emissions; and (2) the impact of disruption relating to rising
temperatures and the resultant weather extremes, such as the floods in Thailand last year. Since climate
change is a global phenomenon, these two issues are to some extent applicable to all sectors, all regions
and all asset classes.
1
Copenhagen Accord
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Sector impacts
Climate change is multi-sector – part of a wider resource nexus
The effects of climate change can be disruptive, and the exacerbation of existing natural resource stresses
is already being felt across many industries. The chart below shows why the climate is so important to
key areas of the economy and especially to the strategic relationship between energy, water and food.
Resource nexus
Energy
r
ate
w
g
s in s s
Ri stre
Fo
od
F u vs
el
Constraints
on thermal
power
Impacts
on yields
Fo
od
Fu vs
el
r
ate
w
ing ss
Ris stre
Water
Climate
Decarbonising
energy
Impacts on food
production
Food
Source: HSBC
Incorporating the “climate factor” into investment analysis involves examining the impact of changes and
strains within these strategically important relationships. For many sectors, whether the impact is positive
or negative depends on the nature of the exposure. A positive driver could mean increased revenue
opportunity from a beneficial regulatory environment (eg for energy efficiency), or that the disruptive
impacts of climate change create a market opportunity (eg for agricultural chemicals). A negative driver
could relate to increased costs arising from regulation that targets emission reduction (eg for electric
utilities), or from increased input costs caused by potential climate-change-related weather disruption (eg
for food producers). The timing and magnitude of the climate factor in financial terms varies by sector
and can only be fully determined at a company level.
Climate change and energy: Energy is the source of 66% of global GHG emissions. Therefore, efforts
to slow global warming require not only a reduction in energy demand but also for the energy supply
itself to have a lower carbon footprint – ie the decarbonisation of energy (see Energy in 2050, March
2011). Several factors are influencing changes to energy use. High oil prices are causing business to turn
towards energy efficiency, which can help to save on costs (see Oil is the new carbon, 8 March 2012).
The shale gas boom is contributing to energy security in the US and will help its emissions footprint over
the short term, although shale gas could also be taking investment away from other renewable energy
technologies and is under scrutiny for its potential environmental impact, such as groundwater pollution
(see How does shale fit into a low-carbon future, 10 February 2011). In Europe, we estimate that the
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combination of efficiency and renewable energy laws could lead to the gradual decline of gas usage
overall, and this should stimulate more investment in other energy forms, as environmental concerns have
halted or slowed shale exploration before it has become commercial (see European Utilities: Gas
consumption on the slide, 2 April 2012). The Fukushima accident last year has also caused many
countries to rethink their energy strategies, but replacing nuclear with a lower-emission technology is not
easily done in the short term (see Thermal spikes from nuclear loss, 10 May 2012).
Climate change and food: Agricultural processes contribute 14% to global GHGs, while land use
change (mostly deforestation for agriculture) contributes a further 13%. Rising temperatures and
increasing levels of carbon dioxide in the atmosphere have direct impacts on agricultural output.
Although mostly negative for output, this is not always the case: increased carbon can boost crop
fertilisation (up to a certain point) and in temperate, colder regions, increased temperatures can boost
yields. In Agriculture: Double Trouble (12 December 2011), we look in detail at the climate impacts on
the global agriculture sector, highlighting that companies which improve productivity, such as fertiliser or
seed producers and those involved in crop protection, could be long-term winners. We also found that
global cereal growth would be lower with climate change, creating volatile prices and changing trade
flows. The food issue is also a concern as the global population is rising faster than agricultural yields.
Food demand is estimated to increase by 50-70% by 2050 whereas cereal production could only increase
30% (see Resources and the great transformation – food security, 25 January 2012).
Climate change and water: Water availability – too much or too little – is a major expression of climate
change. Rising temperatures can exacerbate droughts in regions already prone to water shortage, and the
frequency and magnitude of extreme events can be influenced by increased water vapour (see Extreme
climate; expect more droughts and floods, 22 November 2011). The floods in Thailand last year had a
significant effect on local GDP (see More flooding: Thailand this time, 13 October 2011). Also, the growing
trend of shifting facilities to more cost-effective regions such as China means that water issues need to be
considered by companies which might be based in water-abundant countries, but whose operations are
exposed to water-scarce regions (see The water hole in the supply chain, 29 November 2011).
The three resources of energy, food and water are also interrelated:
Energy and food: There is tension between producing agricultural crops for food or fuel.
Food and water: Agriculture accounts for around 70% of global water withdrawal, hence more erratic
water availability for agriculture will likely lead to variable output levels and volatile prices.
Energy and water: Water supply is essential for thermal power generation, whereas key renewable
technologies are much more water-efficient; water constraints also highlight the need for energy
efficiency.
Regional impacts
Climate change is multi-regional – reflected in national economic strategies
From a cross-boundary perspective, we compare the climate change vulnerability and opportunities of the
G-20 in Scoring climate change risk (9 August 2011). At a national level, the sector drivers described
above come together to form policies such as energy and food security, GHG emission mitigation and
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energy efficiency. Much of our work therefore focuses on climate strategies at a country level, and we
have published in-depth reports on the emerging markets of China, India, Brazil and South Korea; in
addition we publish shorter updates on policy for the EU and the US.
Global markets
We analyse global climate discussions for sector and regional impacts. The United Nations climate
negotiations provide a longer-term window on prospects for the global climate economy (see Dispatches
from Durban, 13 December 2011). The urgency of climate change is almost generally accepted, although
how to deal with the issues, and which countries should shoulder more responsibility is often debated at
these climate negotiations (see Gear shift needed in climate talks, 20 May 2012). The perspective of
individual countries is often a sticking point as GHG emissions know no boundaries (see Aviation
wildcard – BASICs remain as others waver, 24 February 2012).
Emerging markets
China: The impact of climate change could affect energy, agriculture, industry and water availability in
China. Natural capital is under great stress and this has serious implications for companies that source
from, operate in and sell to China (see China's rising climate risk, 6 October 2011). The impact on each
province is different and we look not only at national policies on emissions control, industrial efficiency,
and water usage but also how they filter down to various provinces and are implemented across such a
vast country (see Is China too big to filter down?, 21 March 2012).
India: The 2008 National Action Plan on Climate Change set out India’s ambitions for low-carbon
growth, driven by achieving climate and energy security as well as reducing emissions and dependence
on energy imports. The climate economy could grow in terms of solar power, energy efficiency and
renewable installations (see Sizing India’s climate economy, 28 January 2011). The subsequent launch of
the “Perform, Achieve and Trade” scheme has implications for energy consumption across many sectors.
We believe the key beneficiaries to be solution-providers such as process control, automation and
manufacturers of more efficient equipment (see India: Trading energy efficiency, 12 April 2012).
Brazil: The resource nexus of water, energy and food supplies more than half of Brazil’s economy –
producing sugar cane, coffee, beef and chicken as well as allowing hydropower to supply 75% of the
country’s electricity (see Brazil: LatAm’s bio super power, 25 April 2012). However, of the G-20
countries Brazil is also the fifth most vulnerable to the disruptive effects of climate change because it is
so dependent on the basic resource most disrupted by climate change – water availability. We look at how
Brazilian companies maintain their low-carbon energy advantage and strengthen resilience against
potential climate change impacts, especially across the agriculture, food processing, utilities and financial
services sectors (see Investing in the bio super power, 25 April 2012).
South Korea: Its economic success has been accompanied by rising energy consumption and a 96%
dependence on energy imports. With oil accounting for one-quarter of total imports, Korea has committed
itself to green growth, breaking away from a high-energy, high-carbon trajectory. The national strategy
focuses on the export potential of its core industrial base – for example, batteries, light-emitting diodes
(LED) technology, nuclear and solar (see Korea at the green growth crossroads, 16 March 2012). We
also examine the new carbon policies which constrain the emissions of large emitters, making carbon
performance another factor for investors to evaluate. At the same time, companies which accelerate the
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design and deployment of smart technologies that can succeed in the world’s growing markets for lowcarbon solutions could be at the cutting edge of climate solutions such as fuel cell technology (see
Investing in Korea’s green growth, 16 March 2012).
Developed markets
The greater disclosure in certain developed markets, such as the EU and the US, provides information on
how climate policy will be enacted and enforced. For example, efficiency targets in Europe have to filter
down to national targets (see EU efficiency deal inches closer, 1 March 2012) and politics can often take
the spotlight away from climate change issues in the US (see US: Emerald lining for efficiency, 15
February 2012). Austerity in developed markets does not mean that climate issues are falling down the
agenda; instead we believe it provides an opportunity to rebuild the economy in a more efficient manner
(see Designing a Green Exit : Five steps to a resource-efficient recovery, 25 May 2012).
Asset impacts
Climate change is multi-asset – affecting asset allocation
The effects of climate change cut across all asset classes. Real estate investors may be aware that rising
sea levels may affect physical properties located in coastal areas; commodity traders may be aware that
rising temperatures affect commodity prices through agricultural yield disruptions; investors in forest
assets may forgo the wood harvest in return for payment in order to reduce emissions. The solutions
available to either reduce emissions or protect against climate impacts must still be financed, and thus
provide investment opportunities within different asset classes.
For companies, insurance options change as assets are perceived to be more in harm’s way (see Insuring
Asia against climate risk and natural disasters, 7 February 2012). For investors, especially longer-term
investors such as pension funds, investing in fixed income or debt through bonds provides a less risky
option for investment in national strategy, such as a changing the energy mix in favour of renewable
energy (see Offshore wind: The wheel of fortune, 28 May 2012). We estimate the value of bonds aligned
to the climate economy at around USD174bn globally and expect more climate-themed bond issuance by
development banks, municipalities and project developers in the near future (see Bonds and climate
change: the state of the market in 2012, 23 May 2012). Currently, low-carbon transport such as rail
dominates the climate bond market, with Europe the largest source of outstanding bonds.
The climate change theme is closely related to the work of our clean technology team globally, which
analyses climate solutions through renewable technologies such as solar and wind power; also, our
quantitative research team produces HSBC’s proprietary climate change index.
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Climate change drivers
Emissions are continuing to rise…
Dev eloped
tCO2bn
35
… on a recarbonising trend
Dev eloping
GDP
% yoy
6.0
30
4.5
25
3.0
20
C O2 em iss ions
1.5
15
Note: Fossil fuel emissions only.
Source: CDIAC, HSBC
Source: HSBC, IEA, Thomson Reuters Datastream, World Bank
Temperatures are rising…
… increasing the likelihood of disruptive extreme events
0.9
ºC
Drought
Droughts
35
Flood (RHS)
Floods
250
30
0.6
2012
2008
2004
1984
1892
1898
1904
1910
1916
1922
1928
1934
1940
1946
1952
1958
1964
1970
1976
1982
1988
1994
2000
2006
2012
2000
-3.0
1996
0
1992
-1.5
1980
5
1988
0.0
10
200
25
0.3
0
20
150
15
100
10
-0.3
50
5
0
Note: Anomaly relative to the 1951-1980 period.
Source: NASA GISS, HSBC
Source: EMDAT disaster database., HSBC
Investors supporting a global policy framework are
increasing…
… and climate bond financing is increasing
USDtrn
USDbn
25
(285)
20
15
(187)
(259)
Transport
119.0
10
5
2012
2007
Finance
22.4
B uildings
and
Industry 1.5
A griculture
and
Fo restry
0.7
Waste 1.2
0
Energy 29.4
2009
Source: CERES, HSBC
90
2002
1997
1992
1987
1982
1977
1972
1967
0
1962
2012
2002
1992
1982
1972
1962
1952
1942
1932
1922
1912
1902
1892
1882
-0.6
2010
2011
Source: Bloomberg, HSBC, Climate Bond Initiative
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Wind: Top 10 markets for installed capacity today
2011
GW
120
Solar: Top 10 markets for installed solar PV today
2014e
2011e
GWp
2014e
40
100
80
30
60
40
20
20
10
Korea
Belgium
Czech
China
France
Spain
USA
Japan
Italy
0
Germany
Other Europe
C anada
UK
F rance
Italy
India
Spain
Germ any
US
China
0
Source: HSBC
Source: HSBC
Scoring climate risk reveals India as the most exposed and
sensitive to change (top right most vulnerable, bottom left
least vulnerable)
India is also less able to adapt on a relative basis (top right
most vulnerable, bottom left least vulnerable)
10.0
Sensitivity
8.0
Russia Germany
India
Indo nesia
Franc e
Italy
UK B razil
Saudi
South A rabia
Argentina M exico
A frica
Korea Turkey
6.0
4.0
2.0
Canada
US
Adaptive capacity
10.0
China
Australia
2.0
Ch ina
Indonesia
Saudi
S Africa
A rabia
Turkey B razil
Italy
M exico
R ussia
Germany
A rgentina
France
6.0
4.0
Australia
UK
J apan
Ko rea Japan
2.0
0.0
0.0
India
8.0
4.0
6.0
Exp osure
8.0
US
2.0
10.0
Cana da
4.0
6.0
Adaptive potential
Source: HSBC, World Bank, Thomson Reuters Datastream
Source: HSBC, World Bank, Thomson Reuters Datastream
China has overtaken Germany as the world’s largest
exporter of climate-smart goods and technologies
Carbon intensity of the G-20
Ex ports US$bn
CAGR 2005-10 (RHS)
35%
60
30%
50
25%
3
40
20%
2
30
15%
20
10%
10
5%
0
0%
US
Jp
Ita
Note: CSGT =-Climate-smart goods and technologies
Source: UN Commodity Trade Statistics Database, HSBC
Fra
Kor
4
1
0
Russia
China
India
S.Africa
Indonesia
S_Arabia
Turkey
Australia
S.Korea
Mexico
Canada
US
Brazil
Argentina
EU27
Germany
Italy
UK
France
Japan
Ger
10.0
tCO2mn/USDbn
70
Ch
8.0
Note: Most recent data from 2008
Source: Thomson Reuters Datastream World Bank, WRI CAIT, HSBC
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Notes
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Construction &
building materials
Construction & building materials
team
John Fraser-Andrews*
Analyst
HSBC Bank plc
+44 20 7991 6732
john.fraser-andrews@hsbcib.com
Jeff Davis*
Analyst
HSBC Bank plc
+44 20 7991 6837
jeffrey1.davis@hsbcib.com
Tobias Loskamp*, CFA
Analyst
HSBC Trinkaus & Burkhardt AG, Germany
+49 211 910 2828
tobias.loskamp@hsbc.de
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
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Sector structure
Construction
Building materials
produce rs
CRH
HeidelbergCement
Holcim
Kingspan
Lafarge
Saint-Gobain
Residential builders
Commercia l rea l estat e
and public works
contractors
Barratt Developments
ACS
Bellway
Balfour Beatty
Berk eley Group
Carillion
Bovis Homes
FCC
Kaufman & Broad
Hochtief
Pers immon
Skans ka
Nexity
Vinci
Redrow
Taylor Wimpey
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Source: HSBC
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Cement consumption per capita versus GDP per capita (2010)
1400
Syria
1200
Consumption per capita, Kg
Saudi Arabia*
1000
Greece
Korea, Rep.
Chin a
800
Slovenia
Turkey
Bulgaria
Algeria
Czech
Republic
Egypt
Estonia
Portugal
Morocco Thailand
Hungary
Russia
400
Poland
Romania
Brazil
Serbia Ecuador*
Mexico
Lithuania
Ukraine South Africa
Argentina
200
India Sri Lanka* Colombia
Indonesia
Pakistan
Bangladesh*
Kenya
0
0
5,000
10,000
15,000
600
Iran
Austria
Belgium
Croatia
Spain
Italy
France
Germany
Netherlands
Ireland
Finland
20,000
25,000
Denmark
Sweden
UK
30,000
35,000
USA
40,000
GDP per capita (USD)
* Represents Cembureau estimates
Note: GDP per capita in constant USD 2000
Source: Cembureau, World Bank, HSBC
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95
96
0.25
Urbanisation reaches high levels; Infrastructure largely provided.
Urbanisation cycle breaks down, undermining construction structural growth prospects
Structural construction growth period, underpinned by
infrastructure deployment and expansion of housing stock
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Cement consumption and construction output growth versus real GDP growth in the UK (1956-2009)
0.15
0.10
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
1962
1960
1958
0
1956
0.05
-0.05
-0.10
-0.15
Cement consumption and construction output growth
exceeds real GDP growth (the cement/construction to GDP
growth multiplier exceeds unity)
Construction is a highly
cyclical industry
Cement consumption and construction output growth
undershoots real GDP growth (the cement/construction
to GDP growth
-0.20
Real GDP growth
Construction output growth
Cement consumption growth
Source: ONS, Cembureau, HSBC
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Sector description
Producers of building materials and users, housebuilders and contractors
The construction sector is a vertical chain of sub-sectors that begins with the building materials
companies, as shown in the sector structure chart.
Building materials
Building materials companies produce the materials used to build homes (by residential developers) and
to build commercial real estate and infrastructure (by contractors). The companies can be divided into the
heavy-side materials majors, Holcim, Lafarge, Cemex and HeidelbergCement, and the light-side materials
manufacturers, for example, Saint Gobain and CRH.
Heavy-side materials (cement, aggregates ready-mix concrete and asphalt) are consumed by infrastructure
projects like road expansion and utilities infrastructure, as well as the foundations stage of residential and
non-residential buildings. Light-side materials (concrete products, wallboard, insulation, bricks, tiles, pipe
and glass) are used predominantly in above-ground-level building construction. The heavy-side majors
have about two-thirds of their cement capacity in fast-growing emerging markets that are benefiting from
structural expansion in infrastructure. Light-side producers are predominantly exposed to weak and
fragmented construction end-markets in debt-laden developed economies.
abc
John Fraser-Andrews*
Analyst
HSBC Bank plc
+44 20 7991 6732
john.fraserandrews@hsbcib.com
Jeff Davis*
Analyst
HSBC Bank plc
+44 20 7991 6837
jeffrey1.davis@hsbcib.com
Tobias Loskamp*, CFA
Analyst
HSBC Trinkaus & Burkhardt
AG, Germany
+49 211 910-2828
tobias.loskamp@hsbc.de
*Employed by a non-US
affiliate of HSBC Securities
(USA) Inc, and is not
registered/ qualified pursuant
to FINRA regulations
Housebuilders and contractors: the main customers of building materials companies
Residential developers combine land (which must have residential planning approval in the UK) and
building materials to construct and sell houses. The UK is comfortably the most consolidated market in
Europe, where approximately 35% of production is undertaken by the seven listed builders. About 80% of
UK new-build homes are sold speculatively to individuals. The other 20% – called social units – are built
for and sold to government bodies at low margins, often as a necessary concession for residential
planning approval from the local planning authority (called Section 106 agreements).
The contractors deliver services essential to the creation and care of infrastructure and non-residential
buildings assets, including project design, engineering and construction and facilities management.
Key themes
Urbanisation cycle underpins decades of robust EM construction growth
Our statistical regression analysis suggests that cement consumption is determined by real GDP per capita
growth, as illustrated in the first graph above.
 Typically, GDP per capita of around USD1,000 to USD3,000 triggers population growth and
urbanisation from a low base, underpinning cement-intensive mass infrastructure investment and real estate
development. Urbanisation further perpetuates population growth, which enhances absolute GDP and
growth thereof.
 This urbanisation cycle (see chart ‘The cement intensive urbanisation cycle’ below) supports cement
consumption and construction output growth in excess of real GDP growth, up to a saturation point,
when infrastructure and the housing stock have largely been provided.
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Road provision per 1,000 people
The cement intensive urbanisation cycle
GDP per capita
growth
25
20
15
10
Infrastructure
investment
5
Population
growth,
urbanisation &
housing demand
0
U.S.*
France
Germany
U.K.
Russia
Turkey
Malaysia
Mexico
India
China
Iran
Korea, Rep.
Jordan
Road kms per 1000 people (2006)
Source: HSBC
*US data is for FY2006 (all other years are calendar years)
Source: Cembureau, World Bank, HSBC
Rail provision per 1,000 people
Urbanisation levels (%, 2008)
0.80
100%
0.60
80%
60%
0.40
40%
0.20
20%
0.00
UK
Brazil
US
France
Algeria
China
Egypt
India
U.S.
Russia
Source: World Bank, HSBC
France
Germany
U.K.
Mexico
Turkey
Iran
Korea, Rep.
Malaysia
India
Jordan
China
Rail kms per 1000 people (2007)
0%
Urban population as a % of total population
Source: World Bank, HSBC
 This saturation point is at around GDP per capita of USD13,000 (the top of the hump in the graph
‘Cement consumption per capita versus GDP per capita’ earlier in the section), after which the
cement-demand-to-real-GDP multiplier falls below unity.
We expect emerging markets to deliver robust cement and construction growth for at least the next 30
years because:
 Our Global Economics team expects emerging markets to generate the highest-trend GDP per capita
growth in the long term as these countries converge toward western levels.
 Our regression analysis concludes that cement/construction-to-GDP-growth multipliers are higher
than unity in almost all EM.
High construction/cement-to-GDP-growth multipliers in emerging markets are explained by expectations
of high population growth coupled with low infrastructure provision (see road and rail provision charts
above) and urbanisation levels (see chart above).
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abc
Conversely, in developed countries such as the UK, demographics are less favourable and urbanisation is
largely complete, so those countries have low long-term cement and construction growth potential (ie the
cement/construction-output-to-GDP-growth multipliers are near zero).
High household indebtedness and constrained finance availability to weigh on developed market
construction growth for several years
In developed economies, we expect the availability of finance to remain constrained for at least the next
two years for the following reasons.
 Many western economies are suffering from record household indebtedness, high unemployment,
weak earnings growth and stretched long-term housing affordability. Unsurprisingly, banks are
unwilling to increase substantially the availability of cheap finance to households and businesses in
this fragile economic climate.
 The banking industry continues to deleverage due to funding constraints and more stringent regulation.
Weak loan growth is likely to weigh on residential and non-residential construction because:
 Most home-buyers need mortgage support, so we expect housing demand to remain weak for some time.
 Private developers rely heavily on finance to fund their working capital requirements and for
financial leverage to amplify their returns on capital.
 We expect UK housebuilders to suffer sluggish volume (and top-line growth) for several years, which
implies weak demand for building materials.
Fiscal austerity set to drive large cuts in European infrastructure construction
European governments are suffering from record indebtedness and unsustainable budget deficits. The
policy response has been austerity programmes to reduce fiscal deficits over the next four to five years.
The US government has increased infrastructure spending, relying on reserve currency status to maintain
a high budget deficit and indebtedness.
We expect European infrastructure budgets to suffer from public spending cuts as governments give
priority to spending on front-line services. We forecast public construction spending will decline by 35%
from the end of 2009 to 2013e in Spain and Ireland, and by 10% to 14% in other European countries.
European contractors face a challenging market in the medium term and we expect demand for building
materials from the European infrastructure end market to remain weak until 2013e.
Robust cement volume growth in emerging markets during 2008-09 global crisis
Lafarge serves as a proxy for the cement sector, and the performance of its operations in 70 countries is
representative of the volume development in different regions since 2005. The period 2005-07 was
characterised by a construction boom in emerging markets, with a more subdued growth rate in western
Europe, and US cement volumes peaking in 2006.
Growth decelerated significantly during the 2008-09 crisis as contagion from the West impacted
sentiment and funding flows, but emerging markets demonstrated significantly greater volume resilience
than developed markets. Since 2010, emerging market volume growth has accelerated, although Lafarge
has underperformed industry growth, particularly in Africa and the Middle East, where the company has
lost market share to new regional competitors.
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Lafarge’s cement volumes in Western Europe continued to slide in 2010-11, following the collapse of the
construction industry in 2008-09, as austerity hit southern Europe, to which Lafarge has a heavy
exposure. North American volumes have recovered slightly from a low base due to the stimulus spending
in the US and a robust market in Canada.
Lafarge cement volumes 2005-11 (compound annual growth rates)
Western Europe
Central and East Europe
North America
Africa Middle East
Latin America
Asia
Group
2005-07
2008-09
2010-11
2.3%
16.1%
-1.7%
6.8%
8.3%
3.2%
3.4%
-16.9%
-11.6%
-18.8%
3.3%
2.3%
5.9%
-4.8%
-5.5%
1.3%
4.0%
-2.2%
5.6%
2.2%
0.0%
Source: Company data, HSBC
Cement markets less competitive than light-side materials in developed markets
Comparison of heavy-side and light-side materials
Cement (heavy-side)
Finished goods (light-side)
Consequences
Substitutability
Very weak, limited to mixing
cementitious substitutes by cement
producer to reduce cost batch.
Medium, producers compete on
innovation.
Lower competition in cement markets
versus competitive markets for building
materials.
Transportability
Low, recognised that uneconomic to
travel by road for more than 300km.
Transcontinental transport determined
by weight and build.
Cement imports restricted to markets
near shipping lanes. Building products
more susceptible to overseas
competition.
Medium, economies of scale here led
to consolidation but transportability
ensures competition.
Cement is generally supplied on a local
market basis by a limited number of
producers, leading to higher pricing
discipline, than in fragmented finished
goods markets.
Market concentration High, determined by high capital
investment barrier to entry.
Source: HSBC
The table above shows that the heavy-side materials market benefits from several characteristics, such as
high concentration, barriers to entry and low import penetration, that underpins more disciplined pricing
than in light-side markets, which are generally fragmented and highly competitive.
Sector drivers
Construction and building materials leading indicators
Affordability and mortgage availability are key long-term leading indicators for residential construction.
They determine the level of buyer enquiries and housing sales (proxies for short-term housing demand),
which can usually be tracked on a monthly basis. High housing demand drives growth in building-permit
applications and housing starts, which may lag if the housing inventory is high.
Vacancy rates show the demand/supply balance in commercial real estate markets. We track office
employment, retail sales and manufacturing output as proxies for commercial real estate space demand. A
combination of high space demand and low vacancy usually leads to rising rents, which should provide an
incentive for development.
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We use governments’ infrastructure budgets to determine future public construction wherever possible.
Debt-to-GDP ratios and fiscal deficits also indicate the availability of future public finances.
Valuation
Trading at significant discount to historical averages
The building materials companies and contractors trade on traditional earnings metrics, namely forwardlooking EV/EBITDA and price/earnings (PE) multiples.
The heavy-side building materials companies currently trade at EV/EBITDA multiples of 5.3-7.5x and PE
of 7.1-13.2x on our 2013e estimates, representing discounts to the long-term sector averages of 7.0x and
12.5x, respectively. These discounts exist despite our expectation of a strong earnings rebound to 2015
for the cement majors on recovery in US construction activity, robust emerging-market growth and cost
saving measures.
The only key accounting issues are the plant depreciation rates of building materials producers and the
profit-recognition policies of contractors.
The housebuilders trade on forward price to tangible book multiples (TNAV). Using accounting TNAV,
rather than adjusted TNAV, however, does not reflect that:
 the land write-downs taken to date (which determine reported NAV) have not been enough to restore
profitability and returns to levels that an investor would deem acceptable on new investment; and
 each company has applied different assumptions to determine land write-downs, rendering crosssector relative valuation difficult.
To calculate adjusted TNAV, the builders’ landbanks are decomposed into tranches by age and region
and the book value of each land tranche is then marked to today’s market value (one may also exclude
goodwill). The mark-to-market adjustments restore the landbanks to full margin and returns on capital. In
theory, therefore, the builders should trade at slight premiums to these adjusted TNAVs to reflect the
potential economic value creation on building out of the land bank.
European building materials: growth and profitability
Growth
Sales
EBITDA
EBIT
Net profit
Margins
EBITDA
EBIT
Net profit
Productivity
Capex/sales
Asset turnover (x)
Net debt/Equity
ROE
2008
2009
2010
2011
2012e
7.9%
1.1%
-4.1%
-19.1%
-17.5%
-23.1%
-32.5%
-55.1%
4.3%
3.2%
0.0%
-11.2%
5.7%
-2.4%
-5.8%
-23.8%
3.9%
5.2%
12.4%
56.9%
19.4%
13.8%
8.6%
18.1%
11.3%
4.7%
17.9%
10.8%
4.0%
16.5%
9.6%
2.9%
16.7%
10.4%
4.4%
10.9%
61.0%
1.15x
16.2%
7.5%
49.7%
0.74x
6.4%
6.3%
49.5%
0.66x
4.9%
6.2%
51.8%
0.64x
3.6%
6.2%
51.4%
0.56x
5.5%
Note: based on sector comprising CRH, HeidelbergCement, Holcim, Lafarge
Source: MSCI, HSBC estimates
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Sector snapshot
US construction spending by end markets (USDbn)
800
600
400
200
Residential
Public buildings
Source: MSCI, Thomson Reuters Datastream, HSBC
Top 6 stocks: MSCI All Country Europe Construction Materials
Dollar Index *
Stock rank
Stocks
1
2
3
4
5
6
Holcim
CRH
Lafarge
HeidelbergCement
Cimpor
Imerys
Index weight
30%
22%
20%
14%
8%
6%
2011
2010
2009
2008
2007
0
2006
-18%
3%
Holcim, CRH, Lafarge
0.95
1000
2005
963
51
1200
2004
Trading data
5-yr ADTV (EUR)
Aggregated market cap (EURm)
Performance since 1 Jan 2000
Absolute
Relative to MSCI Europe US Dollar
3 largest stocks
Correlation (5-year) with MSCI Europe
US Dollar
0.7% of MSCI Europe
US Dollar
2003
MSCI All Country Europe Construction
Materials Dollar Index
2002
Key sector stats
Non-residential
Civ il engineering
Source: The United States Census Bureau, HSBC
PE band chart: MSCI All Country Europe Construction
Materials Dollar Index
600.0
500.0
400.0
300.0
* There are only 6 stocks in this index
Source: MSCI, Thomson Reuters Datastream, HSBC
200.0
100.0
Country breakdown: MSCI All Country Europe Construction
Materials Dollar Index
Switzerland
France
Ireland
Germany
Portugal
Source: MSCI, Thomson Reuters Datastream, HSBC
30%
26%
22%
14%
8%
Actual
5x
10x
15x
May-12
May-10
May-08
May-06
May-04
May-02
May-00
Weights (%)
May-98
May-96
Country
0.0
20x
Source: MSCI, Thomson Reuters Datastream, HSBC
PB vs. ROE: MSCI All Country Europe Construction
Materials Dollar Index
2.6x
22%
2.1x
18%
14%
1.6x
10%
Fw d PB (LHS)
Source: MSCI, Thomson Reuters Datastream, HSBC
102
ROE (RHS)
May-12
May-10
May-08
May-06
May-04
May-02
2%
May-00
0.6x
May-98
6%
May-96
1.1x
abc
EMEA Equity Research
Multi-sector
July 2012
Financials – Banks
Europe
CEEMEA
Carlo Digrandi*
Global Head of Financial Institutions Research
HSBC Bank plc
+44 20 7991 6843 carlo.digrandi@hsbcib.com
Gyorgy Olah*
Head of Ceemea Banks Research
Analyst, HSBC Bank plc
+44 20 7991 6709 gyorgy.olah@hsbcib.com
Robin Down*
Analyst, Global Sector Head, Banks
HSBC Bank plc
+44 20 7991 6926 robin.down@hsbcib.com
Aybek Islamov*, CFA
Analyst, HSBC Bank Middle East
+971 4423 6921
aybek.islamov@hsbcib.com
Monica Patrascu*
Analyst, HSBC Bank plc
+44 20 7991 6828 monica.patrascu@hsbcib.com
Peter Toeman*
Analyst, HSBC Bank plc
+44 20 7991 6791 peter.toeman@hsbcib.com
Rob Murphy*
Analyst, HSBC Bank plc
+44 20 7991 6748 robert.murphy@hsbcib.com
Iason Kepaptsoglou*
Analyst, HSBC Bank plc
+44 20 7991 6722 iason.kepaptsoglou@hsbcib.com
Lorraine Quoirez*
Analyst, HSBC Bank plc
+44 20 7992 4192 lorraine.quoirez@hsbcib.com
Johannes Thormann*
Global Head of Exchanges
Analyst, HSBC Trinkaus & Burkhardt AG, Germany
+49 211 910 3017 johannes.thormann@hsbc.de
Tamer Sengun*
Analyst, HSBC Yatirim Menkul Degerler A.S.
+90 212 376 46 15 tamersengun@hsbc.com.tr
Jan Rost*
Analyst, HSBC Securities (South Africa) (Pty) Ltd
+27 11 676 4209 jan.rost@za.hsbc.com
Sector sales
Nigel Grinyer
HSBC Bank plc
+44 20 7991 5386 nigel.grinyer@hsbcib.com
Martin Williams
HSBC Bank plc
+44 20 7991 5381 martin.williams@hsbcib.com
Jonathan Weetman
HSBC Bank plc
+44 20 7991 5939 jonathan.weetman@hsbcib.com
Dimitris Haralabopoulos*
Analyst, HSBC Securities SA
+30 210 6965 214 dimitris.haralabopoulos@hsbc.com
Juergen Werner
HSBC Trinkaus & Burkhardt AG, Germany
+49 211 910 4461 juergen.werner@hsbc.de
Nitin Arora*
Analyst, HSBC Bank plc
+44 20 7991 6844 nitin2.arora@hsbcib.com
Philip P Dragoumis
HSBC Securities SA
+30 210 696 5128 philip.dragoumis@hsbc.com
Matthew Robertson
HSBC Bank plc
+44 20 7991 5077
matthew.robertson@hsbcib.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
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Sector structure
Banks
Sectoral breakdown
Geographical breakd own
L ocal players
Commercial banks
France
LLOYDS, ISP
BNPP, SOGN
International players
Germany
Wholesale banks
STAN, SAN
DB, CBK
BARC, BNPP
Spain
CIBM
SAN, BBVA
UBS, CS
Poland
Exchanges
LSE, Deutsche Boers e
Asset managers
Pek ao, PKO
Italy
UCG, ISP
Ashmore, Sc hroders
Turkey
Speciality finance
L enders
Isbank, Garanti
UK
STAN, RBS, LLOYDS
Provident Financial
Russia
Switz erlan d
Inter dealer bro kers
Sberbank, VTB
UBS, CS
ICAP, Tullett Prebon
South Africa
Middle East
QNB, NBAD
Source: HSBC
BOC, NBG
CEEMEA
abc
SBK, FSR
Greece
180
September 2001
09/11 attacks
March 2008
Bear Stearns
rescue
160
April 2010
First Greek
rescue package
September 2008
Lehman Brothers
bankcruptcy
EMEA Equity Research
Multi-sector
July 2012
Sector price history
140
September 2007
Northern Rock
bank run
120
100
80
60
40
20
0
Sep00 Jan01 May 01 Sep01 Jan02 May 02 Sep02 Jan03 May 03 Sep03 Jan04 May 04 Sep04 Jan05 May 05 Sep05 Jan06 May 06 Sep06 Jan07 May 07 Sep07 Jan08 May 08 Sep08 Jan09 May 09 Sep09 Jan10 May 10 Sep10 Jan11 May 11
Source: Thomson Reuters Datastream, HSBC
Stox x 600 Index rebased
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Stox x 600 Banks Index rebased
EMEA Equity Research
Multi-sector
July 2012
45
40
GPSr.AT
CNAT.PA
35
BMPS.MI
BARC.L
30
CSGN.VX
SOGN.PA
EFGr.AT
CBKG.DE
UBSN.VX
25
Leverage (x)
106
Return on tangible assets (RoTA) versus leverage (tangible equity/tangible assets) 2013e
BNPP.PA
ERST.VI
ARLG.DE
BKT.MC
BTO.MCSABE.MC
20
LLOY.L
RBS.L CRDI.MI
UBI.MI
ISP.MI
BAPO.MI
SAN.MC
RBIV.v i
STAN.L
BBVA.MC
SBKJ.J
BURG.KW
NBGr.AT
15
BAER.VX
NEDJ.J
AUDI.BY
BLOM.BY
CIEB.CA
BOCr.AT
ACBr.AT
PMII.MI
KFIN.KW
10
ADCB.AD
ASYAB.IS
NBO.OM
MRBR.AT
FSRJ.J
ASAJ.J
NBAD.AD
VTBRq.L
ALBRK.IS
VAKBN.IS
ISCTR.IS
YKBNK.IS GARAN.IS
BMAO.OM
AKBNK.IS PKOB.WA
BAPE.WA
UNB.AD
1010.SE
OTPB.BU
5
COMI.CA
HALKB.IS
NSGB.CA
1120.SE
SBER.RTS
QNBK.QA
FGB.AD
1090.SE NBKK.KW
QISB.QA
COMB.QA
1150.SE
0
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
RoTA
Source: HSBC estimates
abc
EMEA Equity Research
Multi-sector
July 2012
Sector description
The bank sector functions as an intermediary between sources of capital (investors and depositors) and
users of capital (individuals, corporations and governments). In providing this function, banks take on
three major risks: credit risk (the risk that a borrower will not repay a loan), interest rate risk (changes in
the yield curve may change funding costs and asset yields) and liquidity risk (the risk, usually in a crisis,
that assets cannot be liquidated quickly enough to cover any short-term funding deficiency).
abc
Iason Kepaptsoglou*
Analyst
HSBC Bank Plc
+44 20 7991 6722
iason.kepaptsoglou@hsbcib.com
*Employed by a non-US affiliate of
HSBC Securities (USA) Inc, and is
not registered/ qualified pursuant to
FINRA regulations
The European banks and financials sector includes institutions providing a comprehensive product
offering to their clients (mostly known as wholesale banks) and banks that mainly focus on retail
customers and smaller corporate clients (commercial banks), as well as more specialised institutions
focusing on a more limited range of business segments such as corporate and investment banking
activities (CIBM), or exchanges and specialised financial services (inter-dealer brokers, asset managers
etc). With a few exceptions (Credit Suisse and UBS), the majority of European banks are universal banks,
although in the case of some wholesale banks (Société Générale, BNP Paribas and Deutsche Bank) CIBM
activities account for a large part of their profits. Within the CEEMEA region most banks are universal
banks.
The various lines of business for banks are classified below:
 Net interest income, defined as the difference between the interest earned on assets and the interest
paid on liabilities: typically 65%+ of revenues.
 Fee and commission income includes account fees, overdraft fees, payments, arrangement fees,
guarantees as well as asset management and insurance: typically 25% of revenues.
 Trading income: banks derive trading income by carrying out transactions in securities, derivatives
and forex. Also, banks hold securities to manage their liquidity. Banks need to mark to market their
securities, leading to valuation gains/losses. Trading income is typically 10% of total revenue.
The banking sector remains a highly regulated sector globally, with multiple regulatory bodies keeping
close watch on the industry. There have also been efforts to evolve global standards in banking via the
Basel norms, developed by the Bank for International Settlements. In light of the financial crisis there has
been an increased focus on regulating banking activities and minimising the impact of future banking
failures, if any, on the economy.
The wider sector also incorporates exchanges and speciality finance. Exchanges, such as the LSE and
Deutsche Boerse, provide price discovery, exchange matching and trade clearing services to facilitate
trading in securities, commodities, derivatives and other financial instruments. Their activities are mainly
driven by market volumes and capital market activity. Furthermore, some of them offer custody and
settlement services in the post-trade arena. Asset managers manage money on behalf of institutional and
retail investors. They tend to be high-beta stocks as their earnings are driven by market movements along
with flows from pension funds, insurance companies and retail clients. Typically, both flows and market
movements go hand in hand, thereby creating a volatile earnings stream. These stocks outperform in up
markets and underperform in down markets.
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Key themes
Funding issues: Recent events have proven that the funding issue remains key in bank management.
This relates to both internal (pertinent to a specific bank) and external factors, such as perceived country
risk, for example. In our view, the asset and liabilities structure is likely to remain at the forefront of
managements’ focus over the next few years. The liquidity ratio, typically calculated as the ratio of loans
to deposits, is a key indicator: a ratio of 100% or less indicates that the bank can count on a balanced
structure with an optimum balance between loans and deposits. A higher ratio would imply a need to
procure liquidity in the wholesale market, with a consequent impact on funding costs. Funding pressures
have forced European banks to deleverage (reduce the asset base relative to the capital base), which has
had a negative effect on profitability. Funding issues arising in Western Europe have also spilled over to
emerging Europe. The funding structure of CEEMEA banks is generally less dependent on wholesale
markets, with the exception of the South African banks that raises a substantial amount of funding in its
domestic wholesale markets.
Fears on sovereign risk: Given the ongoing eurozone sovereign crisis and the strong link between
sovereigns and banks, the sector has been largely driven by sovereign concerns. The recent EBA
(European Banking Authority, the overseeing regulator) exercise that forced banks to mark-to-market
their sovereign bond holdings is just one manifestation of the increased interdependency of banks and
sovereigns, with both the market and regulators carefully monitoring this space.
Sector profitability: The introduction of tougher regulation has raised some doubts about sector
profitability over the next cycle. Most would argue that this should come down, due to lower leverage and
declining margins. The outlook for profitability in the CEEMEA sector is more positive as it operates in
growth economies that still have under-penetrated banking services.
Increased regulation: The introduction of Basel III, a supranational agreement on capital adequacy, is
expected to have a major effect on capital requirements, with some aspects still awaiting confirmation.
Regulators across Europe are also focusing on liquidity, funding, reducing risk in trading activities, increasing
the level of non-equity loss-absorbing capital, fees charged to retail customers and ring-fencing the commercial
business among other issues. Recently, the European authorities have begun considering the establishment of a
single centralised oversight entity with the mandate to regulate banks across Europe but the level of detail that
has been given is not yet sufficient to assess the potential impact on the sector. CEEMEA banks also face
pockets of increased regulatory pressure, as is the case with FX mortgages in Hungary.
Sector drivers
Banks’ earnings are very closely correlated to economic growth in the countries where they operate:
volume growth is a function of GDP growth, while growth in loan loss provisions (provisions for loans
that are no longer performing) is linked to country-specific factors such as unemployment. Therefore
banks could be considered a proxy for GDP growth. In addition to GDP, we would summarise the main,
fundamental sector drivers as follows:
 Lending and deposit volumes: These are mainly related to GDP, as lending demand is normally
positively correlated to expanding economic conditions and lending demand can drive economic
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July 2012
conditions. Deposit growth is more a function of market yield, alternative investment opportunities
and gearing ratios, but is, again, correlated to economic conditions.
 Interest rates: Cost of money is based on a spread banks apply to interest rates. Although spreads are
controlled to a large extent by banks, the level of the interest rate is given by the market. For obvious
reasons banks tend to prosper in a high interest rate environment (when the spreads between assets and
liabilities tend to be wider) and suffer when rates are low. The steepness of the yield curve is also a key
factor, as banks normally tend to spread their financing according to the different rate levels along the
curve – for example making the spread the differential between short rates (lending or borrowing) and long
rates (borrowing or lending).
 Asset quality and loan-loss provisions (LLPs): Non-performing loans (NPLs) tend to increase in
periods of economic difficulty, thereby forcing banks to increase LLPs and write-offs. In several
European countries NPLs and unemployment growth are closely correlated. Empirical analysis also
suggests that LLPs and GDP growth are relatively well correlated.
In the past few years, following the subprime crisis, the role of regulators in the banking sector has
increased dramatically and it is expected to expand even more in the future. New compliance rules have
simultaneously increased costs, lowered margins and changed the sector’s revenue base, thereby making
banks less profitable overall. As a result, this is proving to be a key driver for the sector.
A second important element relates to market conditions and the interdependence of the banking system.
The recent liquidity crisis has shown the extreme importance of this factor and the weight that market
conditions (rates, interbank lending and the role of the central banks) can have on banking stocks. In our
view these are extremely important drivers, as they are mostly exogenous and affect the sector overall,
making it very difficult to differentiate between individual stocks.
Valuation
Banking stocks are generally valued on PE multiples, although book value multiples dominate in periods
of low earnings/recession. Most recently, analysts have been using a warranted equity value (WEV)
model. This is not a new valuation methodology, as it is simply the correlation between book value and
profitability (ROE), based on the theory that where a company’s return is similar to its cost of equity, it
European Banks: growth and profitability (calendarised data)
Growth
Revenue
Pre-provision profit
Operating income
Net profit
Margins
Net interest margin
Cost/income
Cost of risk
Productivity
Revenue over ATA
Op. income over ATA
RoTA
RoTE
2008
2009
2010
2011
2012e
-15%
-37%
-83%
-92%
24%
75%
153%
457%
8%
7%
88%
77%
-2%
-8%
-3%
-16%
4%
6%
12%
27%
1.04%
72%
1.05%
1.10%
61%
1.50%
1.24%
61%
1.07%
1.16%
63%
0.91%
1.09%
62%
0.89%
1.65%
0.10%
0.03%
1.5%
2.05%
0.25%
0.18%
7.1%
2.35%
0.49%
0.33%
10.6%
2.23%
0.47%
0.27%
8.2%
2.26%
0.51%
0.33%
9.7%
Note: based on all HSBC coverage of European Banks
Source: company data, HSBC estimates
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should be trading at or close to its book value (market volatility and equity risk premium are captured in
the cost of equity).
In the past, the sector has benefited from a consolidation process, especially in some European countries.
This has also boosted goodwill, leading investors to adopt a more cautious approach. As a result, valuation
methodologies are based on tangible book values and tangible ROEs rather than reported figures.
Accounting issues abound among banks. Capital and risk-weighted assets calculations, for example, differ
from one country to another. For example, Italian banks have higher average risk weightings than their
European peers and LLPs are treated differently from a tax perspective in the individual European
countries.
In the case of large complex banks (such as Credit Suisse, UBS, Unicredit, Intesasanpaolo, Santander,
BBVA and RBS) a sum-of-the-parts method is often used. This is just a combination of the above criteria
and is based on the application of ‘exit PEs’ and, in some cases, PTBV for the divisional businesses of the
bank. This method makes it possible to isolate the corporate centre, thereby assessing the real profitability
of the business. On the other hand, there is no means of assessing the cross-subsidy between divisions as
the corporate centre is also used as a financing fulcrum by most banks.
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Sector snapshot
Core industry driver: eurozone total loan growth
Key sector stats
MSCI Europe Banks Index
Trading data
5-yr ADTV (EURm)
Aggregated market cap (EURbn)
Performance since 1 Jan 2000
Absolute
Relative to MSCI Europe
3 largest stocks
Correlation (5-year) with MSCI Europe
9.12% of MSCI Europe
14%
6,499
432
10%
-64%
-45%
HSBC, SAN, STAN
0.92
6%
2%
Source: MSCI, Thomson Reuters Datastream, HSBC
-2%
Jan04
Top 10 stocks: MSCI Europe Banks Index
Stock rank
Stocks
1
2
3
4
5
6
7
8
9
10
HSBC Holdings Plc
Banco Santander Sa
Standard Chartered Plc
BNP Paribas
Barclays Plc
BBV Argentaria Sa
Nordea Bank Ab
Lloyds Banking Group Plc
Société Générale
Svenska Handelsbanken Ab
Index weight
28.3%
10.6%
9.4%
6.3%
6.3%
5.8%
3.9%
3.5%
2.7%
2.7%
Jan06
Jan08
Jan10
Jan12
Source: ECB, HSBC estimates
PE band chart: MSCI Europe Banks Index
350
300
250
200
150
Source: MSCI, Thomson Reuters Datastream, HSBC
15x
10x
100
50
Country breakdown: MSCI Europe Banks Index
Country
Weights (%)
UK
Spain
Sweden
France
Italy
Norway
Denmark
Germany
Austria
48.9%
18.1%
10.5%
10.2%
5.9%
1.7%
1.6%
1.1%
0.9%
Source: MSCI, Thomson Reuters Datastream, HSBC
5x
0
2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: MSCI, Thomson Reuters Datastream, HSBC
PB vs. ROE: IBES MSCI Europe Banks Industry Group
2.5
20
2.0
15
1.5
10
1.0
0.5
5
0.0
0
2004 2005 2006 2007 2008 2009 2010 2011 2012
Fwd PB (LHS)
ROE % (RHS)
Source: MSCI, Thomson Reuters Datastream, HSBC
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Notes
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Financials – Insurance
Insurance team
Kailesh Mistry*, CFA
Analyst, Head of European Insurance
HSBC Bank plc
+44 20 7991 6756
kailesh.mistry@hsbcib.com
Thomas Fossard*
Analyst
HSBC Bank plc, Paris branch
+33 1 5652 4340
thomas.fossard@hsbc.com
Dhruv Gahlaut*
Analyst
HSBC Bank plc
+44 20 7991 6728
dhruv.gahlaut@hsbcib.com
Sector sales
Martin Williams
Sector Sales
HSBC Bank plc
+44 20 7991 5381
martin.williams@hsbcib.com
Juergen Werner
Sector Sales
HSBC Trinkaus & Burkhardt AG, Germany
+49 211 910 4461
juergen.werner@hsbc.de
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
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Sector structure
Insurance
Primary ins urance
Reinsurance
Hannover Re
Korean Re
Munich Re
Life insurance
Non-life insurance
Com posites
Lloyds
AEGON
Admiral
Allianz
Amlin
AIA
Euler Hermes
Aviva
Catlin
Bangkok Life
Fondiaria-Sai
AXA
Hiscox
China Life
PICC
Balois e
Lancashire
CNP
Korea Life
RSA Insurance
China Pac ific
China Taiping
Legal & General
Dongbu
New China Life
Generali
Prudential plc
Hyundai
Samsung Life
ING
Standard Life
LIG
Swiss Life
Meritz
Tong Yang Life
Ping An
Sc or
Swiss Re
PZU
Samsung F ire & Marine
Vienna Insurance Group
Zurich Financial Services
Source: HSBC
abc
12%
500
M arket crash: Dot-com
bubble
450
Scor acquires Converium;
Allianz buys out minority in
AGF
CGU Plc & Norwich Union Plc
merger t o f orm CGNU Plc,
renamed Aviva Plc later
St andard Life IPO;
Aviva buys
AmerUS
400
Axa buys Sun Life
Pru buys M &G
(GBP1.9bn)
Converium
IPO
300
AXA sells its UK Lif e
and savings
operations
(EUR2.75bn)
Winterthur acquisition
(EUR7.9bn) and Axa rights
issue (EUR4.1bn); Generali
acquires Toro (EUR3.85bn)
Allianz sells
Dresdner bank;
VIG rights issue
Allianz right s issue
(EUR4.4bn); M unich Re
rights issue (EUR3.8bn)
250
ING f ounded by a merger
between Nationale-Nederlanden
and NM B Post bank Group
Aegon buys Scott ish
Equitable;
Axa buys M ONY
L&G rights issue
(GBP0.8bn)
50
AXA sells
Canadian
operat ion
(EUR1.9bn
)
8%
6%
PZU IPO
9/ 11
att acks in
US
150
100
10%
Lehman collapse &
problems at AIG
Friends Provident IPO
350
200
AXA sells Australia and
NZ operations and
acquires AXA APH Asia
Lif e operations
EMEA Equity Research
Multi-sector
July 2012
Sector price history
Norwich Union IPO
M erger of Sun
Alliance & Royal
Insurance
Aegon buys
Transamerica Corp
Rights issue by Aegon
(EUR 2.0bn); ZFS right s
issue (USD2.5bn)
Swiss Life
right s issue
Pru and Scor
right s issue;
Admiral IPO
Resolut ion group creat ed
in 2004 & relaunched in
2008
4%
Allianz acquires minorit y
in RAS;Hurricane
Kat rina, Wilma & Rita
strikes US
Swiss Re raises
capital
Aegon, Axa &
ING right s issue
2%
Sale of Alico
announced by
AIG (USD
15.5bn)
Scor buys
Transamerica Re
(USD0.9bn)
0%
0
01/1990 01/1991 01/1992 01/1993 01/1994 01/1995 01/1996 01/1997 01/1998 01/1999 01/2000 01/2001 01/2002 01/2003 01/2004 01/2005 01/2006 01/2007 01/2008 01/2009 01/2010 01/2011 01/2012
DJ Ins absolute
DJ Sto xx abso lute
B und 10 year yields
Source: Company data, Bloomberg, Factset, HSBC
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0%
Increasing riskiness
50%
100%
CNP
Solvency I
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Movement in Solvency I ratio versus asset leverage for primary insurers, 2008 to last reported
Generali
Allianz
150%
Aviva
AXA
Swiss Life
L&G
200%
Pru
SL
ZFS
RSA
250%
300%
100%
200%
300%
400%
500%
600%
700%
800%
900%
1000%
Asset Lev erage
Source: Company data, HSBC
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Sector description
Insurance companies provide protection to individuals and businesses against uncertain events by
transferring risk to an underwriter, which promises to pay the insured an amount, usually unknown, if
those events occur. The unknowns make estimating profits difficult and give rise to accounting that has
been a topic of debate for investors and insurance companies for some time now. Insurance companies
have also expanded into accumulation products where there may or may not be an insurance element.
Over the last decade and a half, this has reversed somewhat as insurers reassess business models.
The global insurance industry generated USD4,324bn of premiums, or about 7% of global GDP, in 2010. Life
insurance accounted for 58% of premiums, and non-life for 42%. The US is the largest insurance market, with
around 27% of the global premiums, followed by Japan and the UK. The chart below illustrates the widely
referenced S-curve in the industry, which highlights the level of maturity of the insurance market and per capita
GDP, and may be used as an indication of potentially high-growth markets as GDP per capita increases.
Kailesh Mistry*, CFA
Analyst, Head of European
Insurance
HSBC Bank plc
+44 20 7991 6756
kailesh.mistry@hsbcib.com
Thomas Fossard*
Analyst
HSBC Bank plc, Paris branch
+33 1 5652 4340
thomas.fossard@hsbc.com
Dhruv Gahlaut*
Analyst
HSBC Bank plc
+44 20 7991 6728
dhruv.gahlaut@hsbcib.com
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
Proportion of GDP spent on insurance versus per capita GDP in 2010 (USD)
TW
16%
14%
UK
SA
12%
SK
10%
8%
6%
IN
4%
CH
2%
PH
0%
100
1,000
ID
TH MY
BZ
CL
PL
HN
N
HK
Fra
Jap
C
US
I
G
SP
AUS
SW
CZ
RN
10,000
100,000
Country legend: Aus - Australia, C - Canada, Fra - France, G - Germany, HK - Hong Kong, I - Italy, ID- Indonesia, Jap - Japan, MYMalayasia, N - Netherlands, PH-Philippines, SA - South Africa, SK - South Korea, SP - Singapore, SW - Switzerland , TH-Thailand,
CZ - Czech Republic, RN - Romania, PL - Poland, HN - Hungary, IN - India, CH - China, TW - Taiwan, CL - Chile, BZ - Brazil
Source: Sigma, HSBC estimates
The sector has a mix of mutual and listed companies, whose total market capitalisation equates to about 5% of
that of the DJ Stoxx 600. The sector is divided into primary insurance and reinsurance, depending on the nature
of the risk underwritten. Primary insurance, which underwrites risk directly from households and businesses, is
further split between life and property and casualty, or non-life. Reinsurance refers to the way primary insurers
insure themselves against the risk. Some insurers also have banking and asset management operations
alongside the typical life and non-life underwriting segments.
Life insurance comprises two main classes of products: savings products, for which margins are tied to
investment returns or fees linked to asset values as well as insurance protections offered, and personal risk
products, which cover death and disability and whose margins are linked to underwriting and technical
factors such as mortality and morbidity. Health insurance covers medical expenses and often belongs to
the primary life segment.
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Key themes
Regulatory and accounting changes: Introduction of new regulatory solvency and accounting standards
are a key theme in the sector. The current solvency regime, referred to as Solvency I in Europe, is a nonrisk-based measure which is inconsistently implemented across different countries, making comparisons
difficult. The inconsistency primarily relates to allowable capital resources, which varies by country,
although the approach to the calculation of capital requirements appears to be more consistent. The
European Union plans to introduce risk-based Solvency II by 1 January 2014, which has been behind
schedule according to market commentary and could be delayed further, and the US is reviewing its
capital adequacy requirements; China is also moving towards a risk-based system. In theory, this should
increase consistency.
There is a similar debate on accounting standards, which diverge between regions. New standards are
being considered and will be introduced over time. For example, IFRS Phase II is due to be implemented
in 2014. The life insurance industry is also seeing a transition to embedded value accounting to market
consistent embedded value (MCEV) from European embedded value or traditional embedded value.
There is also greater demand for insurance company cash flow disclosure.
Focus on efficiency: Insurance companies have increasingly focused on efficiency and cost reduction
over the past few years. In our view, this theme has been driven by pressure on underwriting and
investment margins, the increasing maturity of the industry and the consequences of shareholder
ownership rather than mutuality, as in the past. The industry has tried to reduce costs through integrating
back offices, centralising group functions, off-shoring jobs to lower-cost territories, cutting headcount,
reducing policy administration costs and moving to lower-cost distribution channels. Since 2010, insurers
within our coverage universe have announced EUR2.5bn of new cost savings and have already achieved
EUR0.8bn of cost saving out of that.
Primary life segment: Life insurers have emerged from the financial crisis with an improved capital
position, while avoiding widespread forced capital raisings. Increasingly life insurers have been focusing
on improving underwriting profitability through action on prices, guarantee rates and charging for
specific features. In addition, the trend for moving away from high upfront commissions paid to
distributors to level-loaded structures is helping to improve the cash flow credentials of the sector. There
has also been a focus on lowering administration costs and reducing dependence on investment markets
by moving to fee-based products.
Primary non-life segment: Premium growth, evolution of pricing, prior-year reserve development, claims
inflation, investment returns and changes in distribution are the key themes for this segment. The balance
of these factors will differ over time and affect the underwriting cycle, which varies by product and
region. For example, in the personal motor insurance market in Europe we are seeing a hardening or
increase of insurance rates as a result of deterioration in underwriting profitability. Prior-year reserve
releases have declined across Europe while investment returns remain under pressure, forcing insurers to
improve underwriting profitability rather than subsidising present-year losses through positive prior-year
development and strong investment results. We are also seeing a shift away from the usual broker/agent
distribution channel towards greater use of internet, phone and affinity tie-ups to sell non-life insurance,
especially in the personal motor and property segment, with the aim of reducing distribution costs.
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Reinsurance segment: The industry is similar to the primary non-life segment in terms of having an
underwriting cycle and a conservative investment portfolio relative to the rest of industry. However, the
catalyst for the reinsurance industry remains large claims events, which forces an increase in insurance
rates. The exceptionally high level of Nat Cat recorded in 2011 has driven up rates across various
business lines especially in the Cat affected region. That said, the reinsurance segment could be a key
beneficiary of the Solvency II regime, which is expected to generate additional demand for reinsurance
from smaller and less-diversified insurers as well as mutuals. We expect a reduction in retention rates by
primary insurers, which have reached their highest point since 2002, to increase the demand for
reinsurance as the primary segment continues to de-risk its business models.
Increase in GDP and per capita income: Growth in the economy and per capita income boosts demand
for insurance. As income rises, demand expands from compulsory products (motor insurance) to more
sophisticated products, such as saving products, asset protection, such as household insurance and
retirement products.
Importance of emerging markets: Emerging markets have lower insurance penetration than developed
economies and offer significant opportunities for expansion. The growth story is well supported by the
recovery in GDP growth, high rates of household savings and lack of social security structures in some of
these countries. Insurance companies based in developed markets have shown their desire and willingness
to expand in these regions and we expect the trend to continue. Regions such as LatAm, Asia ex Japan,
and Taiwan and Central and Eastern Europe remain attractive geographies for insurance companies to
expand into.
Premium growth was significantly higher in emerging markets than the developed market in 2000-2010
World
5.9%
Industrialised countries
5.2%
Emerging markets
10.9%
Japan
1.1%
North America
3.5%
Western Europe
7.1%
Oceania
7.7%
South & East Asia
9.6%
LATAM
12.3%
Middle East & Central Asia
13.3%
Other Europe
17.2%
0%
2%
4%
6%
8%
10%
12%
Premiums growth (10 year CAGR)
14%
16%
18%
20%
Source: Sigma, HSBC estimates
Sector drivers
Capital adequacy: The insurance sector, like banks, needs to maintain a minimum level of solvency to
be able to underwrite new products and honour its future liabilities. Investors screen companies using
regulatory and rating-agency models to measure the group’s solvency position and gauge its financial and
operational flexibility. The adoption of a risk-based approach to the calculation of capital adequacy and
quality of capital are the next steps in the debate on capital adequacy. A minimum rating is required to
underwrite business in reinsurance as well as certain lines of businesses in the non-life segment and life
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segment. As already highlighted, life insurers continue to move away from higher capital-intensive
products and have emerged in a much better state from the crisis as a result of management actions
implemented in the last few years. Management teams have taken action to improve the capital position
by reducing risk, disposing of assets, saving on costs and focusing on underlying profitability.
Underlying profitability: Underwriting profitability and investment returns are key elements of operating
profits. Underwriting profitability depends on the pricing of products, fee structure, claims experience and
expenses, and is relevant to both primary and reinsurance segments. Underlying profitability at life companies
is dependent on the type of product and is, broadly, made up of risk result and investment spread for the
traditional product, which are generally split between policyholder and shareholder in a defined proportion, and
fee income for the unit-linked product. Surrender and lapses of policies also affect profitability at life insurers
and have to be considered in calculations, along with expenses. Primary non-life and reinsurance companies
measure technical profitability based on the combined ratio, the total of claims paid and losses incurred versus
the premiums collected. We have already mentioned the increasing focus on efficiency and changes in
distribution cost structures for both the primary life and non-life segments.
Investment exposure: Investment exposure has changed over time as insurance companies have lowered
their gearing to equity markets from the levels seen at the start of the decade, and instead increased their
exposure to corporate bonds and alternative investments. Currently life insurers have a higher exposure to
riskier assets like equity and corporate bonds, while reinsurers and primary non-life insurers are mainly
invested in shorter-duration bonds and cash. Shareholders are fully exposed to asset-quality risks in the
non-life segment, but the risks are shared with policyholders in the life segment – assets are largely
managed on behalf of policyholders. Bond duration also varies, with life insurers having a longer duration
as a result of the longer maturity of liabilities.
Adequate reserving: Prudent reserving is critical for insurance companies. Premiums are paid in the short
term, but liabilities are paid over a long period. Inadequate reserves will need to be replenished, possibly
funded by shareholders, although surplus reserves, if any, may be released to improve or smooth profits.
Influence of yields and credit risks: Company earnings, to differing extents, are dependent on
investment earnings. The level of interest rates, government bond yields and corporate bond yields are
important because insurers' investment portfolios are dominated by fixed income assets. The current low
level of interest rates are a concern for investors for two reasons: (1) for P&C companies lower
reinvestment rates will result in lower investment income which feeds directly into lower earnings
estimates; (2) for life companies, lower yields result in lower guarantees being offered on new business
which reduces products’ attraction, while lower reinvestment rates make it harder to hedge guarantees
offered in the past which have not already been hedged. In the worst case, this would require additional
capital to be allocated to covering guarantees; more realistically it will result in investment spread
compression. In addition, bond defaults and write-downs are important since they have an adverse impact
on earnings and are deductive to capital. Fixed income asset values are important where liabilities are
liquid and not relevant where liabilities are illiquid, and assets and liabilities are matched.
Premium growth: This vital aspect depends on factors ranging from economic activity and development
of the insurance market to government policies and social security systems. In the past 10 years,
premiums have grown twice as fast in emerging markets as in developed markets, and we expect EM
growth to remain higher.
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Valuation
Investors consider several metrics when valuing insurance firms, including book value (BV), earning
multiples, cash-flow multiples and dividend yield. For non-life insurance companies, the BV calculation
is fairly straightforward as investors use IFRS estimates, but for life companies there has been ongoing
debate about the use of IFRS or embedded value (EV) estimates to calculate BV, given reliability and
acceptance of EV metrics.
In simplistic terms, EV is the present value of the future cash flows that are expected to emerge from the
in-force book of the life insurance company together with the value of shareholders’ net tangible assets.
The methodology for calculating EV has changed over time, although there are still concerns about its
comparability and consistency among insurers and regions. In Europe, some insurers have already
adopted market consistent embedded value (MCEV) principles, the latest in the series, while others are in
the process of doing so. The use of different methodologies for calculation of EV and the lack of
sufficient disclosure make comparisons difficult among insurers and leads to investors examining both
IFRS and EV metrics. Also, the current IFRS metrics do not fully reflect the true profitability of new
business and are inconsistent in their treatment of assets and liabilities. Given the complexity in
comparison and valuation, we are seeing an increasing focus on the operating cash flow of life businesses.
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Sector snapshot
Core industry driver: bond yields (%)
Key sector stats
5% of MSCI Europe
10
8
Trading data
5-yr ADTV (EURm)
Aggregated market cap (EURm)
Performance since 1 Jan 2000
Absolute
Relative to MSCI Europe
3 largest stocks
Correlation (5-year) with MSCI Europe
1,947
247,047
6
4
2
US
Japan
UK
France
Germany
China
Italy
South Korea
Canada
Life (%)
Non-life (%)
Total (%)
20.2%
17.9%
8.0%
7.7%
4.6%
5.7%
4.9%
2.9%
2.0%
36.1%
6.4%
5.5%
5.0%
6.7%
3.9%
2.9%
2.3%
3.5%
26.9%
13.0%
6.9%
6.5%
5.4%
5.0%
4.0%
2.6%
2.6%
Life
Insurance
*Insurance relates to DJ Euro Stoxx Insurance index while life relates to FTSE Europe
Life Insurance index and non-life to FTSE Europe Nonlife Insurance index
Source: Thomson Reuters Datastream, HSBC
2012e P/EV vs. Normalised ROEV
1.8x
Source: HSBC, Swiss Re Sigma
Lancashire
2012e P/EV
1.5x
1.2x
0.9x
0.6x
0.3x
Hiscox
L&G
PZU SL G C
B
EH
HR M R
SR
V IG
Scor
Aegon SW
CNP
RSA
A mlin
AL
ZFS
Pru
Aviva
A XA
0.0x
0.0%
8.0%
16.0 %
24.0%
No rmal ised ROEV
32.0%
Legends:AL-Allianz , B- Baloise,C-Cat li n , EH-Euler, G-General i,HRHannov er Re, MR-Muni ch Re, SR- Swiss Re, SL - St d Lif e, SW- Swiss Lif e.
Source: HSBC estimates
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Jun-12
Jun-11
Jun-10
Non-life
Jan-11
Country
18
16
14
12
10
8
6
4
2
0
Jul-09
Country breakdown (by premium volume)
Forward PE multiple*
Jan-08
Source: HSBC, Thomson Reuters Datastream
Source: Thomson Reuters Datastream, HSBC
Jul-06
12.0%
9.0%
8.2%
8.0%
6.7%
6.6%
6.2%
5.0%
3.8%
3.5%
Jan-05
Allianz
Zurich Insurance Group
AXA
Prudential
ING Group
Munich Re
Swiss Re
Generali
Sampo
Aviva
Jul-03
1
2
3
4
5
6
7
8
9
10
UK Govt. 10 Yr
US Corp. AA 5-7 Yr
UK Corp AA 5-7 Yr
Index weight
Jan-02
Stocks
Jun-09
US Treasury 10 Yr
EMU Corp AA 5-7yr
EMU Govt 10 Yr
Top 10 stocks: DJ Euro Stoxx Insurance index
Stock rank
Jun-08
Source: MSCI, Thomson Reuters Datastream, HSBC
Jun-07
0
Jun-06
-65%
-31%
Allianz, ZFS, AXA
0.97
Jun-05
MSCI Europe Insurance index
abc
EMEA Equity Research
Multi-sector
July 2012
Food & HPC
Food & HPC team
Sector sales
Western Europe
Cédric Besnard*
Analyst
HSBC Bank plc, Paris branch
+33 1 56 52 43 66
cedric.besnard@hsbc.com
David Harrington
Sector Sales
HSBC Bank plc
+44 20 7991 5389
david.harrington@hsbcib.com
Lynn Raphael
Sector Sales
HSBC Bank plc
+44 20 7991 1331
lynn.raphael@hsbcib.com
Florence Dohan*
Analyst
HSBC Bank plc
+44 20 7992 4647
florence.dohan@hsbc.com
CEEMEA
Michele Olivier*
Analyst
HSBC South Africa (Pty) Ltd
+27 011 6764 208
michele.olivier@za.hsbc.com
Raj Sinha*
Analyst
HSBC Middle East
+971 4423 6932
raj.sinha@hsbc.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
123
124
Consumer & Retail - Europe
Food retail
Beve rages
See sector section for
further details
See sector s ection for
further details
F ood Producers
Nestlé
Danone
Food and HPC
Ge neral retail
Lux ury
See sector section for
further details
See sector section for
further details
Home
EMEA Equity Research
Multi-sector
July 2012
Sector structure
Personal Care
Reckitt Benck iser
Lindt
Henkel
L’Oréal
Beiersdorf
Unilever
Source: HSBC
abc
Dec. 07 - Dec. 08
Dec. 08 - Dec. 09
Input costs inflation concern Collapse in mature economies, but
emerging markets save the day.
Input costs deflation help margins + 8.0%
800
700
+ 7.0%
Dec. 04 - Dec. 07
Premiumisation era
Sector organic sales growth
EMEA Equity Research
Multi-sector
July 2012
Sector price history to May 2012
600
+ 6.0%
500
+ 5.0%
400
+ 4.0%
300
+ 3.0%
200
+ 2.0%
Sector share price index
100
+ 0.0%
Dec-90
Dec-91
Source: Thomson Reuters Datastream, HSBC
Dec-92
Dec-93 Dec-94
Dec-95 Dec-96
Dec-97 Dec-98
Dec-99
Dec-00 Dec-01
Dec-02 Dec-03
Dec-04 Dec-05
Dec-06
Dec-07 Dec-08
Dec-09 Dec-10
Dec-11
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0
Jan-90
+ 1.0%
EMEA Equity Research
Multi-sector
July 2012
1.1
Beiers dorf
Lindt
1.0
U nilev er
0.9
Asset Turnover(x)
126
EBIT margin* versus asset turnover chart (2011)
Henkel
0.8
N estl é
L'Oréal
0.7
Reckitt
Dan one
0.6
0.5
5.0%
10.0%
15. 0%
20.0%
25.0%
30.0
Adju sted EB IT M arg in(%)
* EBIT margin adjusted for restructuring and other exceptional costs; asset turnover as a ratio of sales to total assets
Source: Company reports, HSBC calculations
abc
EMEA Equity Research
Multi-sector
July 2012
Sector description
Segments
The sector consists of two segments: food manufacturing and home and personal care (HPC). It is
dominated by several large, international multi-brand groups. Some of them focus on food, such as
Nestlé, others on HPC, such as L’Oréal, and some combine both, such as Unilever.
Brands and categories
Food and HPC companies rely on brand awareness. Managing the distribution channel, from hard
discounters to department stores, through negotiations with retailers on price and in such areas as on-shelf
availability, is key. Sector categories like dairy products and skin care are not fixed entities. They are
shaped by the leading brands and by innovation. Each category goes through a life cycle from growth,
driven by an increase in the penetration rate, to maturation, when concentration is high, volume growth
decelerates – only offset by emerging markets – and price elasticity is greater.
Sector characteristics
Food and HPC is historically a defensive sector. Cyclicality is limited by the relatively small share of
discretionary purchases in its sales in most categories. Pricing power is low, so operating leverage mostly
depends on volume growth to cover cost inflation.
abc
Cédric Besnard*
Analyst
HSBC Bank Plc, Paris Branch
+33 1 56 52 43 26
cedric.besnard@hsbc.com
Florence Dohan*
Analyst
HSBC Bank Plc
+44 20 7992 4647
florence.dohan@hsbc.com
Michele Olivier*
Analyst
HSBC South Africa (Pty) Ltd
+27 011 6764 208
michele.olivier@za.hsbc.com
Raj Sinha*
Analyst
HSBC Bank Middle East
+971 4423 6932
raj.sinha@hsbc.com
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
Key themes
Emerging markets
We estimate the industry has increased its exposure to emerging markets by at least 50% in 20 years. In
2011 the European stocks we cover derived around 44% of sales from emerging economies, where
category growth is driven by rising income per capita, which implies migration to branded products,
demographics and urbanisation. These markets account for more than two-thirds of the sector’s sales
growth (sometimes 100%), and represent the biggest growth driver in coming years, especially as
saturated US and European categories tend to become zero-sum games that are costly to expand.
However, competition is also growing, and not all categories benefit as much from emerging markets.
The European companies already have a good level of penetration in the soap and laundry mass markets
in some emerging economies, for example, since they have been targeting the low end of the income
ladder for years. Skin care and baby food are still taking off.
Raw materials
Raw materials, from milk to petrochemicals or vegetable oils, are a key manufacturing cost. Raw material and
packaging costs represent about 15% to 25% of sales for cosmetics players but around 30% to 35% of sales for
food and home care. That means input-cost price volatility is a key issue, as the cost base can quickly rise and
require risky price increases to offset it. The main commodities are milk (Danone being the most exposed
because of its yoghurt business), oil-related/PET/plastics (which affects all players, but mostly Henkel, Reckitt,
Unilever), tea (Unilever), cocoa (Nestlé), coffee (Nestlé), vegetable oils/palm oil (Unilever), sugar, fruit and
vegetables. These companies usually hedge by three to six months for most of these commodities, implying
that price variations tend to come through to the gross margin with a time lag. Some of these commodities are
either regulated (EU sugar) or quoted (cocoa). A commodity like milk is less visible, since it is not quoted and
needs to be purchased locally. When input costs start to bite, the debate is on whether the company can offset
this with price increases (or emergency cost savings), while commodity deflation usually raises questions as to
whether companies will pass on the full benefit to consumers.
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July 2012
Pricing capacity more relevant than the “myth” of pricing power
The industry pricing has hardly ever beaten inflation in the last decade. Groups’ pricing capacities are
thus mainly a result of their exposure to inflation-driven emerging countries. Advantages of all sorts (for
example, softening commodity costs and favourable FX) are usually reinvested in pricing or advertising
in order to foster volumes growth. This can cause price wars.
The threat of price wars: food specialists less at risk than the HPC oligopoly
We view food as an industry of specialists, and an aggregate of local monopolies/rational duopolies
(including Danone in yoghurts, Unilever in European spreads, Nestlé and Mars in pet food, and Kraft in
cream cheese). HPC is much closer to being a global oligopoly, with the top 6 FMCG almost always
operating in the same categories and/or regions. This implies different pricing behaviours, in our view.
Therefore, while food players have more differentiated pricing policies, HPC players are more likely to
follow peers’ pricing in order to maintain market shares. This puts the HPC sub-sector more at risk of
margin-dilutive price wars, as in 2009-10 with the price war in Indian laundry between Procter and
Unilever, which spread to European home care. In such a competitive oligopoly, it is particularly
important to identify any early signs that a key player is not “playing by the rules” and is trying to gain
market shares by increasing price/promotional investments, as this can start a chain of events impacting
all companies.
Sector drivers
The ‘cubic matrix’
Most of the companies are exposed to the same consumption trends, but organic sales growth, excluding
FX and M&A, can range between high and low single digits. Each company can be seen as a cubic
matrix, with its organic growth potential the sum of three drivers: category mix, geographical mix and
execution – the capacity to gain market share and roll out innovation. A combination of growing
categories – those that aren’t too mature or competitive and provide pricing power, for example – and a
good execution track record seem most important. A category can always be rolled out in new countries,
although being in growing countries but with mature or competitive segments, or with execution issues,
may offer less visibility. The end game for all companies is to find the right balance inside the cubic
matrix to generate sustainable organic sales growth, the clear earnings growth driver over the long term,
in an industry not over-reliant on cost cutting.
The components of organic growth – watch for volume growth
Organic growth in food and HPC is driven by three metrics:
(1) Price increases: These are a less important driver than some may think. We estimate that “pure”
pricing (ex mix) over 20 years averaged c2% a year in the sector, implying low pricing net of inflation.
Furthermore, in some categories, price elasticity can cap the companies’ ability to raise prices for more
than a year (in the case of external shocks like input-cost inflation).
(2) Mix: Improving the mix means introducing a new product that is sold for more than the company’s
average price point for products, or a replacement product at a higher price than the old version, usually
justified by the argument that it offers more benefits. The company invests in R&D to improve the
product and advertising and marketing to promote it. We believe the return on a successful change in mix
is quite high as a significant part of the fixed cost is the same as for the old version, but the new product
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July 2012
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sells at a higher price. That said, mix is a tool with little visibility (consumers trading down is a common
pattern in the industry) and requires strong innovation to be a sustainable driver.
(3) Volume growth: Volume growth is the driver offering the most visibility and thus is the most looked
at by the market. There are various ways to generate volume growth, some cheaper than others. We
identify three main drivers, appropriate to different stages of the product cycle.
(a) Volume can be increased by increasing the number of consumers of the products, primarily by
expanding the penetration of particular categories in a country. This requires little investment once the
cost of creating the category has been passed on. Most of the growth comes from consumers taking up a
newly available product. Companies can increase volumes by entering emerging markets, for example,
since rising income per capita in those countries makes consumers migrate to branded goods.
(b) Increasing the frequency of consumption within a category is usually more important when increasing
the number of consumers becomes harder. Hair care would be a good example: selling a conditioner to
accompany a regular shampoo doubles consumption each time customers wash their hair. Another
category is biscuits, where companies have promoted the idea of eating biscuits at a variety of times –
10am, then noon, then mid-afternoon.
(c) A greater focus on market share is the last step in a category life cycle. It occurs when a category is
fully penetrated, private labels have appeared in mature regions as credible alternatives, and roll-out in
new regions has been completed or has become a necessity. Excluding innovations, market-share gains
are the only driver of volume growth. They need to be generated by advertising and promotions,
execution or price cuts. At this point the cost of growth is very high and needs to be accompanied by costcutting or M&A.
A&P: a critical tool to drive volume growth
Advertising and promotions (A&P) is a key to driving volume growth. It represents about 12% to 15% of
sales in the food industry and as much as 30% for the cosmetics industry. We do not consider A&P to be
a variable cost in a marketing-driven environment; it is more an inflationary fixed cost. But in practice it
is also partly a variable cost. Marketing expenses are not only linked to growth, product activity and
launches, but they also can be adjusted in the short term to smooth margins. However, the boundary
between phasing and short-term cuts sometimes becomes blurred. There are numerous examples of A&P
phasing when margins are under pressure, although this is generally not considered as a positive.
Consumer staples evolve in a multi-brand-driven environment, where growth investment is key to
winning market share and delivering operating leverage in the long term. It’s true that what counts is the
share of voice – the proportion of a company’s advertising as a percentage of the industry’s total
advertising spending. A&P spend in absolute terms can thus go down if the industry overall is cutting
marketing spending, as the share of voice can remain constant and the brand franchise untarnished. But
no company wants to be the first to cut marketing, at the risk of being the only one, especially as tough
times demand more A&P, not less, to justify price levels. We see here a classic dilemma, where all
players have an interest in pushing the A&P level down, but none has an interest in moving first
(especially when savings can give some leeway in margin phasing). Beyond the normal productivity gains
slightly deflating the marketing expenses ratio, and the increasing use of cheaper digital media, we do not
believe there will be a structural decrease in A&P ratios in the coming years.
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July 2012
M&A: buying growth, building scale
When categories start to become too saturated or competitive, buying market share or new categories through
M&A (balance sheets are usually healthy due to good cash conversion) can look more attractive than overinvesting to expand categories with limited potential. Accordingly, Nestlé increased its exposure to the growing
but very competitive infant nutrition segment by buying Pfizer’s baby food unit in April 2012, acquiring an
EM-led, high growth business and reducing exposure to more mature segments such as confectionery. This
also helped Nestlé build scale in baby food, which we think could have maximised its margins. In a sector
where profitable growth is the key valuation driver, deals often rely on growth synergies, rather than on cost
efficiencies. We agree that growth synergies are the more important of the two, but they also take longer to
achieve and are harder for the market to quantify. This results in analysts frequently being proved to have been
mistaken in their view of a deal, followed by stock market corrections. We believe the best example of this is
Danone-Numico: the deal made a lot of strategic sense, relying on growth synergies, but Danone paid a rich
22x EBITDA, explaining the 2007 share price correction.
Valuation
A structural PE premium to the market
The food and HPC sector (the weighted average of the European stocks under our coverage) has traded at a
premium to the broader market fairly consistently since the start of our relative PE historical analysis in January
1998. Its relative premium has averaged 40% to date, a function of strong visibility on top-line growth and FCF
generation. The previous peak industry premium was 100% (November 2008, during the market meltdown):
the premium had decreased to 7% by August 2009. The HPC sector typically trades at a higher premium than
food: in the past investors put more emphasis on HPC’s profit growth potential
DCF is the traditional tool to value the companies given their stability, rather high visibility on sales growth
and resulting operating leverage.
In terms of disclosure, most companies split out organic growth between price/mix and volume (the key metric
investors look at), at least every half year, and usually disclose their A&P investments.
European Food and HPC: growth and profitability *
Growth
Sales
EBITDA
EBIT
Net profit
Margins
EBITDA
EBIT
Net profit
Productivity
Capex/Sales
Asset turnover
Net debt/Equity
ROE
2008
2009
2010**
2011
2012e
4.8%
32.5%
37.0%
34.9%
-1.0%
-16.0%
-18.8%
-30.3%
7.0%
66.3%
83.2%
118.8%
-4.9%
-20.9%
-22.1%
-25.4%
6.3%
7.3%
8.5%
10.7%
20.9%
17.9%
14.3%
17.1%
13.9%
10.2%
26.9%
24.0%
20.4%
17.6%
14.8%
11.0%
17.9%
14.9%
11.2%
8.7x
1.0x
0.6x
23.5%
4.9x
0.9x
0.4x
23.7%
8.5x
0.9x
0.3x
22.7%
9.2x
0.8x
0.4x
20.9%
4.9x
0.8x
0.3x
21.7%
Note: based on all HSBC coverage of European Food and HPC - all data are weighted by sales, in constant currency
* all data are reported figures, thus implying very high volatility due to contribution from one offs ** 2010 figures inflated by Nestlé capital gain on Alcon
Source: Company reports, HSBC estimates
130
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EMEA Equity Research
Multi-sector
July 2012
Sector snapshot
Core industry driver: the components of organic growth
Key sector stats
MSCI Europe Food Products
Dollar Index
5.12% of MSCI Europe US Dollar
Trading data
5-yr ADTV (EURm)
Aggregated market cap (EURbn)
Performance since 1 Jan 2000
Absolute
Relative to MSCI Europe US
Dollar
3 largest stocks
Correlation (5-year) with MSCI Europe
US Dollar
8%
7%
930
300.3
6%
5%
4%
145%
167%
3%
2%
Nestlé, Unilever, Danone
0.55
1%
0%
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
Source: MSCI, Thomson Reuters Datastream, HSBC
Volume grow th
Mix contribution
Price increases
Top 10 stocks: MSCI Europe Food Products Dollar Index
Stock rank
Stocks
1
2
3
4
5
6
7
8
9
10
Nestlé
Unilever
Danone
Associated Brit.Foods
Lindt & Spruengli
Kerry Group 'A'
Suedzucker
Barry Callebaut
Tate & Lyle
Aryzta
Index weight
51.2%
24.3%
11.2%
3.9%
2.1%
2.0%
1.6%
1.3%
1.2%
1.1%
Source: Company data, HSBC
PE band chart: HSBC European Food and HPC coverage
350
21x
19x
18x
16x
14x
300
250
200
150
100
Source: MSCI, Thomson Reuters Datastream, HSBC
50
Switzerland
UK
Netherlands
France
Ireland
Germany
Source: MSCI, Thomson Reuters Datastream, HSBC
55.7%
16.2%
13.2%
11.2%
2.0%
1.6%
Jul-11
Jul-08
J an-10
J ul-05
Jan-07
Jul-02
Jan-04
J ul-99
Jan-01
Weights (%)
Jan-98
Jan-95
Country
Jul-96
0
Country breakdown: MSCI Europe Food Products Dollar Index
Source: Thomson Reuters Datastream, HSBC
PB vs. ROE: HSBC European Food and HPC coverage
4.5
30
4.0
26
3.5
22
3.0
18
2.5
14
10
2.0
2004
2005
2006
2007
2008
Fw d PB (x ) - (LHS)
2009
2010
2011
2012
F wd ROE (%) - (RHS)
Source: Thomson Reuters Datastream, HSBC
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EMEA Equity Research
Multi-sector
July 2012
Notes
132
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EMEA Equity Research
Multi-sector
July 2012
Food retail
Food retail team
Jérôme Samuel*
Analyst
HSBC Bank Plc, Paris Branch
+33 1 56 52 44 23
jerome.samuel@hsbc.com
Emmanuelle Vigneron*
Analyst
HSBC Bank Plc, Paris Branch
+33 1 56 52 43 19
emmanuelle.vigneron@hsbc.com
Raj Sinha*
Head of MENA Research
HSBC Bank Middle East Ltd
+971 4423 6932
raj.sinha@hsbc.com
Sector sales
David Harrington
Sector sales
HSBC Bank Plc
+44 20 7991 5389
david.harringon@hsbcib.com
Lynn Raphael
Sector sales
HSBC Bank Plc
+44 20 7991 1331
lynn.raphael@hsbcib.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
133
134
Consumer & Retail - Europe
Food
and HPC
Beverages
See sector section for
further details
See sector section for
further details
Food retail
General retail
Luxury
See sector section for
further details
See sector section for
further details
Bricks & mortar
EMEA Equity Research
Multi-sector
July 2012
Sector structure
Online
Ocado
UK
CEEMEA
Europe
Morrison
Casino
Tesco
Carrefour
Sainsbury
Colruyt
Magnit
DIA
Jeronimo Martins
Metro
Ahold
Delhaize
Source: HSBC
abc
1000
Delhaize buys
Hannaford (2000)
DIA spin-off
(2011)
Profit warnings from
Carrefour and Metro
(2011)
Merger CarrefourPromodès (1999)
EMEA Equity Research
Multi-sector
July 2012
Performance of European Food retail stocks 1990-2012
800
Morrison buys
Safeway (2004)
Promodès launches unfriendly
takeover for
on Casino (1997)
600
400
Auchan buys Docks
de France (1996)
Sector boosted by
property valuation
(2007)
Wal-Mart buys
Asda (1999)
First ever profit warning
from Tesco (2012)
200
0
90
92
96
98
00
02
04
06
08
10
12
135
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Source: Thomson Reuters Datastream, HSBC
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EMEA Equity Research
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July 2012
3.5
DIA
3.0
2.5
Colruy t
Asset turnover
136
EBIT margin versus asset turnover (2012e)
Jeronimo Martins
Ahold
2.0
Metro
Sainsbury
Delhaize
Morrison
Carrefour
1.5
Casino
Tesco
1.0
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
5.5%
6.0%
6.5%
EBIT margin
Source: HSBC estimates
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EMEA Equity Research
Multi-sector
July 2012
Sector description
Food retailing is the largest consumer sector, at least by sales, with an estimated GBP132bn of revenues
in the UK in 2012, according to Verdict Research. It has always been seen by investors as a defensive
sector, but we believe this is no longer the case. In the 1980s, food retailers with negative working capital
benefited from high inflation and high interest rates. In the 1990s, sector performance was driven by
international expansion and consolidation in mature markets. The top five market shares now exceed 50%
in the main European countries.
There are several reasons why the sector is not as defensive as it was. Food spending has shrunk as a
percentage of total spending, few listed players are pure food retailers, and even discounters are exposed
to economic slowdowns.
 In mature markets, spending on food as a percentage of total household spending has continued to
shrink, and now accounts for an average 14% of consumer spending in mature European markets,
one-third of its level in the 1960s.
abc
Jérôme Samuel*
Analyst
HSBC Bank Plc, Paris Branch
+33 1 56 52 44 23
jerome.samuel@hsbc.com
Emmanuelle Vigneron*
Analyst
HSBC Bank Plc, Paris Branch
+33 1 56 52 43 19
emmanuelle.vigneron@hsbc.com
Raj Sinha*
Head of MENA Research
HSBC Bank Middle East
+971 4423 6932
raj.sinha@hsbc.com
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
 Few listed food retailers are pure food retailers and are therefore largely immune to a slowdown in
discretionary spending. Metro and Carrefour are the most exposed to non-food; Jeronimo Martins,
Morrison, Ahold, Delhaize, Dia and Colruyt still sell mainly food.
 Discount stores enjoyed faster organic growth than other formats in the past decade, taking market
share from hypermarkets and supermarkets in Germany, France and Belgium, and even in the UK.
That trend has since reversed in France and Germany, as hypermarkets have started to compete more
on price and as the economic crisis has curbed spending by lower-income households.
The industry operates in various store formats: hypermarkets, supermarkets, discounters, convenience
stores, cash and carry and department stores, which often reflect market positioning: premium, mass or
value-orientated.
 Hypermarkets are large stores (above 5,000 square metres per store) that focus on volumes; they sell
groceries and general merchandise, offering up to 50,000 stock-keeping units (SKUs).
 Supermarkets (around 2,500 square metres per store) are medium-sized stores focusing on groceries,
with a limited non-food range and about 13,000 SKUs in grocery.
 Discounters have smaller stores, fewer SKUs and aggressively promote non-food items.
 Convenience stores offer a variety of food and are generally located near their target customers,
who are prepared to pay higher prices than in hypermarkets or discount stores as a result.
 Cash and carry stores offer low prices but only sell groceries and general merchandise in bulk to
hotel, restaurant, catering customers and small retailers.
 Department stores have multiple categories functioning as different business units under one roof.
They are sometimes national chains and often carry the largest number of SKUs.
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EMEA Equity Research
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July 2012
 Online grocery retailing: Among other formats, it is worth highlighting the emergence of online
grocery retailing, which has two types of players: conventional retailers that have added online
retailing and pure online retailers such as Ocado.
A typical discount store will have a leaner cost structure than a hypermarket, with a lower gross margin
but also much lower SG&A. A supermarket enjoys a higher gross margin but provides a higher level of
service in store. We estimate that hypermarkets have an operating margin of 4.5%, supermarkets and
discount stores about 5.5%, and convenience stores higher, all things being equal.
Along with location, brand awareness and private labels are key success factors in food retailing,
attracting customers and helping build their loyalty. Private labels ensure higher margins for the retailers
– in terms of percentage rather than cash – since, although private label goods are sold at lower prices
than national brands (c25% on average), their costs are much more heavily discounted. In all mature
markets, private labels are growing much faster than national brands. The UK is the leader, with private
labels representing more than 40% of retailers’ sales, but French, German and the other European retailers
are catching up; private labels now account for more than 25% of their sales.
Key themes
Top line: organic sales
An important metric is like-for-like (same-store, identical) sales growth: the constant currency sales
growth in stores that have been open more than a year (the duration may differ slightly from company to
company). Like-for-like gives an indication of how the retailer has performed in attracting more
customers and increasing sales per customer through techniques such as better branding, pricing,
offerings and loyalty programmes. It gives a fair representation of actual sales growth, excluding forex,
new stores and stores acquired/disposed of.
Historically, the top line has helped drive returns for investors, since margins tend not to change much.
With top-line growth opportunities drying up in existing stores, retailers keep opening new stores and
increasing store sizes. Organic growth represents increases in sales ex-currency effects and ex-M&A.
Besides company-specific factors (eg brand awareness, loyalty programmes, promotional activity),
certain structural differences explain why some retailers enjoy faster sales growth than others.
 Maturity of the domestic market: As a general rule, the higher the retail density, or retail space per
capita, the lower the growth potential.
 Extent of opening programmes: Retailers plan store openings to improve coverage, complementing
the coverage of existing stores and adding new space that will later contribute to like-for-like growth.
 Exposure to growth markets: Although currency fluctuations and shorter economic cycles may
increase earnings volatility, emerging markets offer a good opportunity for top-line growth. Modern
retailing is still at an early stage of development in emerging markets. A weak currency may have a
positive impact on financial interest by lowering net debt. Most food retailers try to ensure that their
international activities are self-financed in local currencies and are not hedged. Large food retailers
are present in multiple countries, thereby bearing significant forex risk. Although most of the
sourcing is done locally, the currency exposure still brings volatility to the top line and the bottom
line, if not the margins.
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 Exposure to different formats: Different formats have different dynamics and may grow at widely
differing levels even in the same region. For example, in France, discounters lost market share in
2009 and 2010 as a consequence of greater price competition from hypermarkets.
Cost savings
Of late, the focus for large retailers has turned more towards cost savings (mainly Carrefour and Metro) and the
resultant margin improvement. Economies of scale provide an opportunity for significant cost savings – for
example the ability to harness synergies in purchasing and distribution for different banners within the same
company. Building efficiency in logistics and optimising store size also helps improve margins.
Since 2009, most of the major food retailers have been executing cost-saving plans. Asda, for example,
describes the virtuous circle of its trading model as buying better, lowering prices, improving quality,
getting the offer right, driving volume and finally improving operational profitability. In other words, low
prices help to drive higher volumes through gains in market share, which in turn leads to better buying
conditions and hence the ability to offer even better prices to customers.
M&A
Big mergers like Carrefour-Promodès in 1999 and Morrison-Safeway in 2004 had problems with
integration and value creation. Most synergies announced at the time of the deals have not been delivered,
especially in the case of cross-border deals where buying synergies have been made on a national basis.
As the top players enjoy major market shares in mature markets, few developed countries offer
opportunities for consolidation. However, emerging markets are a source of growth, and many players
enter them through acquisitions. Sometimes retailers also swap assets, which may make sense if each
lacks critical size. For example, in 2005, Carrefour and Tesco agreed to swap some Tesco stores in
Taiwan for Carrefour stores in the Czech Republic and Slovakia.
Sector drivers
Consumer confidence
In mature economies, consumer confidence is one of the main drivers of the top line. Although the sector
withstands shocks well, consumers do tend to trade up when confidence is high and vice versa. Emerging
markets are structurally different. Their low per-capita incomes and lower retail penetration provide room
for significant long-term structural growth.
Economy/inflation
Moderate inflation is good for the sector; it helps both the top line and the bottom line for those who have
pricing power. The worst scenario for food retailers is deflation. In general, macroeconomic factors such
as rising per-capita income and expenditure levels help sales growth.
Loyalty programmes, private labels
Food retailers have been developing ever more attractive and innovative loyalty schemes. Loyalty
schemes have been found to work well for retailers, leading to improved repeat purchases and consumer
data collection. The data collected from such schemes lead to useful insights in tailoring the offerings and
increasing loyalty further. Tesco’s Clubcard has been one of the most successful. Private labels command
higher margins for food retailers with lower prices for consumers. Obviously, food retailers focus on
increasing the share of private labels in total sales.
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Over the long term, the food retailers that have performed best have been mono-format retailers with a
strong concept and brand awareness and the ones that have managed to secure loyal customers.
Key segments
Capex is a leading indicator
On average, capex for food retailers is expected to equate to 4% of net sales in 2012e, compared with 5%
in 2008, reflecting the economic crisis. One of the sector’s strengths is that total capex comprises a
multitude of small investments, offering more flexibility in a downturn. Capex comparisons between
retailers can be distorted by the nature of the business (mix of food versus non-food), the property strategy
(freehold or leasehold), the proportion of owned stores versus franchises and the regions of expansion.
Distribution costs
Distribution costs are not entirely comparable because retailers do not all account for their costs in the
same way. Formats, assortment, exposure to non-food and the level of service in stores have a direct
impact on distribution costs and margins.
Property
The level of property ownership is different for each company, making EBITDA comparisons difficult.
However, EBIT is generally comparable as it includes both rental costs (for leased property) and
depreciation (for freehold property).
Valuation
Most of the major international food retailers provide good revenue and earnings visibility, so they can be
valued using a discounted cash flow model. The presence of comparable peers means relative valuation
can also be used. We estimate that the food retail sector in Europe now trades at 2012e EV/sales of 36%
and EV/EBITDA of 5.7x, and on a 2012e PE of 10.4x, compared with the 16.3x at which it traded on
average between July 1999 and August 2010. During the same period, the average PE relative to the DJ
Stoxx 600 for European food retailers was around 1.03x.
European food retail: growth and profitability
2008
2009
2010
2011
2012e
Growth
Sales
EBITDA
EBIT
Net profit
7.2%
7.4%
7.6%
-0.9%
1.2%
1.3%
-0.1%
-4.0%
3.3%
5.6%
8.0%
15.8%
4.4%
1.0%
-0.9%
-2.4%
6.8%
4.8%
4.6%
2.6%
Margins
EBITDA
EBIT
Net profit
6.48%
4.26%
2.44%
6.49%
4.21%
2.32%
6.63%
4.40%
2.60%
6.42%
4.18%
2.43%
6.30%
4.09%
2.33%
Productivity
Capex/sales
Asset turnover (x)
Net debt/Equity
ROE
5.1%
1.71
56%
14.4%
3.5%
1.64
46%
12.7%
3.7%
1.65
41%
13.6%
3.8%
1.67
48%
13.0%
3.9%
1.71
46%
12.8%
Note: based on all HSBC coverage of European food retail sector All data in the table are aggregated from the individual company data
Source: company estimates, HSBC estimates
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Sector snapshot
Food CPI and consumer confidence are industry drivers
(% change y-o-y)
Key sector stats
MSCI Food & Staples Retailing
Dollar Index
2.1% of MSCI Europe US Dollar
Trading data
5-yr ADTV (EURm)
Aggregated market cap (EURbn)
Performance since 1 Jan 2000
Absolute
Relative to MSCI Europe US
Dollar
3 largest stocks
Correlation (5-year) with MSCI Europe
US Dollar
12.0%
8.0%
498
99.2
4.0%
-75%
-60%
0.0%
Tesco, Ahold, Carrefour
0.85
Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11
-4.0%
Source: MSCI, Thomson Reuters Datastream, HSBC
Consumer confidence
Top 10 stocks: MSCI Food & Staples Retailing Dollar Index
Stock rank
Stocks
1
2
3
4
5
6
7
8
9
10
Tesco
Ahold
Carrefour
Jeronimo Martins
Morrison
Metro
Casino
Sainsbury
Colruyt
Delhaize
Inflation (food)
Source: Thomson Reuters Datastream, HSBC
Index weight
30.5%
10.0%
9.5%
8.7%
8.5%
7.2%
7.2%
6.7%
5.3%
2.6%
PE band chart: MSCI Food & Staples Retailing Dollar Index
190
19x
17x
160
15x
13x
130
100
Source: MSCI, Thomson Reuters Datastream, HSBC
70
2001
Country breakdown: MSCI Food & Staples Retailing Dollar Index
Country
UK
France
Netherlands
Portugal
Belgium
Germany
Spain
Finland
Source: MSCI, Thomson Reuters Datastream, HSBC
Weights (%)
45.7%
16.7%
10.0%
8.7%
7.9%
7.2%
2.4%
1.3%
2003
2005
2007
2009
2011
Source: MSCI, Thomson Reuters Datastream, HSBC
PB vs. ROE: MSCI Food & Staples Retailing Dollar Index
3
20
3
15
2
10
2
5
1
0
2004 2005 2006 2007
Fwd PB (LHS)
2008 2009 2010 2011 2012
Fwd ROE % (RHS)
Source: MSCI, Thomson Reuters Datastream, HSBC
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Notes
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General retail
General retail
Paul Rossington*
Analyst
HSBC Bank plc
+44 20 7991 6734
paul.rossington@hsbcib.com
Sector sales
Lynn Raphael
Sector sales
HSBC Bank plc
+44 20 7991 1331
lynn.raphael@hsbcib.com
David Harrington
Sector sales
HSBC Bank plc
+44 20 7991 5389
david.harrington@hsbcib.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
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Consumer & Retail - Europe
Food retail
See sector section for
furth er details
Clothing & Home
Beverages
Gene ral retail
xxxxxxxxx x
See sector section for
further details
DIY
Food and HPC
xxxxxxxx xxxxxx
See sector section fo r
fu rther de tails
Ele ctric als
Internet & catalogue
Luxury
EMEA Equity Research
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Sector structure
See sector sectio n for
further details
Spe cialty
Debenhams (FTSE 250)
Home Retail Group (FTSE 250)
Dixons (FT SE 250)
Asos plc (FTSE AIM)
Carphone Warehous e (FTSE 250)
Hennes & Mauritz (MSCI EU)
Kingfisher (FTSE 100)
Inchcape (FTSE 250)
Brown N Group (FTSE 250)
Halfords (FTSE 250)
Inditex (MSCI EU)
Dunelm (FTSE 250)
Kesa Electricals (FTSE 250)
PPR (MSCI EU)
Marks & Spencer (FT SE 100)
Signet (FTSE 250)
Mothercare (FTSE 250)
WH Smith (FTSE 250)
Next (FTSE 100)
Sports Direct (FT SE 250 )
Source: HSBC
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500
25
400
Collapse in UK
GDP as credit
crunch bites
Periods of low interest
rates, consistently
rising house prices and
mortgage equity
withdrawal
UK leaves ERM in
Sept 1992, resulting
in sharp fall in interest
rates and economic
recovery
EMEA Equity Research
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Sector price history
13
300
1
200
-11
‘Bricks and Mortar’ retailers out of fashion, as internet
fever drives market (note subsequent recovery as
internet bubble bursts in March 2000). Period coincides
with start of serious competition for traditional retailers
from supermarkets and fast fashion discounters.
Biggest stock in sector (M&S) loses 60% of its value
between 1998 and 2000
100
-23
Sector performance (LHS)
UK BANK OF ENGLAND BASE RATE (EP) (RHS)
UK GDP (%YOY) NADJ (RHS)
UK CONSUMER CONFIDENCE INDICATOR- SADJ (RHS)
2012
2011
2011
2010
2010
2009
2009
2008
2008
2007
2007
2006
2006
2005
2005
2004
2004
2003
2003
2002
2002
2001
2001
2000
2000
1999
1999
1998
1998
1997
1997
1996
1996
1995
1995
1994
1994
1993
1993
1992
1992
1991
1991
1990
-35
1990
0
Source: HSBC, Thomson Reuters Datastream
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4.0
WH Smith
3.5
3.0
Asos
2.5
Asset Turnover
146
EBIT margin versus asset turnover chart CY2012e
H&M
2.0
Next
Home Retail
1.5
Inchcape
Debenhams
M&S
Halfords
Signet
N Brown
Kingfisher
1.0
Inditex
0.5
Dixons
Dunelm
Sport Direct
0.0
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
EBIT Margin (% )
Source: HSBC estimates, Thomson Reuters Datastream for uncovered stocks
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Sector description
Pan-European general retail
The Pan-European general retail sector is split between Europe and the UK. Europe is dominated by a
handful of established names, and the combined market capitalisation of Inditex and H&M (cUSD93bn)
accounts for a substantial share of the MSCI European Retail Indices, which also includes a handful of
UK names. With the exception of Inditex, H&M, PPR (covered by luxury goods) and a few specialist mid
cap stocks, there is little in the way of investible sector players outside the UK. The UK is a highly
cyclical and largely mature industry (70% organised retail penetration) with few genuine defensive
propositions and limited exposure to international revenue. A significant share of the industry is in private
hands owing to substantial investment between 2002 and 2007 by private equity firms, which were
attracted by strong cash generation and the availability of cheap debt, as well as by sale-and-leaseback
freehold property assets. Accordingly, the listed component is typically asset-light and varied in nature
with no two companies the same; the combined market capitalisation amounts to just cUSD38bn. The
three FTSE 100 companies (Kingfisher, Marks & Spencer and Next) account for around 65% or
USD25.6bn of this total. Growth stocks in the UK are typically mid cap in nature and share one or more
of the following characteristics:
Paul Rossington *
Analyst
HSBC Bank plc
+44 20 7991 6734
paul.rossington@hsbcib.com
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
 Specialist propositions with limited exposure to non-specialist/supermarket competition
 Ability to derive a higher percentage of revenues from faster-growing international/emerging markets
 Exposure to, or the ability to adapt to, structurally higher growth in online consumer spending patterns
Key themes
Macro environment: unemployment, income, consumer confidence, savings ratio
Given the mature market positions/domestic market exposure of the vast majority of stocks within this
space, consumer confidence is a key lead indicator of the sector’s performance. This is driven by the
macro environment, primarily the outlook for employment and thus personal/household disposable
income. In most consumption-driven economies (such as the UK) the unemployment rate has a very
strong correlation with the rate of GDP growth. The single largest determinants of households’ future
disposable income are the savings rate (the percentage of disposable income that is not spent) and, by
default, consumer confidence (ie “will I still have a job in 12 months’ time?”). Base rates have a strong
positive correlation with retail sector performance given their direct impact at the beginning of an
Northern Europe consumer confidence
Southern Europe consumer confidence
(60)
(80)
(80)
(100)
(100)
Germany
UK
Source: Thomson Reuters Datastream, HSBC
Sweden
Q1 2012
Q3 2011
Q1 2011
Q3 2010
Q1 2010
Q3 2009
Q1 2009
(50)
Q3 2008
(50)
Q1 2008
(30)
France
Italy
Greece
Spain
Q1 2012
(40)
(60)
Q3 2011
(40)
Q1 2011
(10)
Q3 2010
(10)
Q1 2010
(20)
Q3 2009
10
Q1 2009
10
(30)
0
Q3 2008
0
(20)
Q1 2008
30
30
Portugal
Source: Thomson Reuters Datastream, HSBC
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economic cycle via lower household mortgage/lending costs, and later via the higher rates used to keep
economic growth in check. Thus although lower interest rates support/encourage consumer spending and
confidence, rising interest rates and the implied increase in GDP growth are the main drivers of longerterm sector performance. Price inflation is a positive, as long as it is not more than offset by higher input
costs/cost inflation (leading to margin squeeze). Any significant increase in the costs of food, warmth and
shelter will also determine what income remains for discretionary purchases.
International diversification
Companies that earn a larger share of their revenues outside the domestic market, including in highergrowth emerging markets – thereby increasing the size of their addressable market – offer the greatest
diversification to macro risk. Exposure to high overseas revenues and GDP growth in the respective
markets are positive.
International revenue exposure and sales-weighted market GDP growth (CY2012e)
100%
75%
50%
25%
UK
Eurozone & Wt Europe
Other Developed markets
KESA 0.3%
ITX 1.2%
HMB 1.1%
INCH 1.7%
KGF 1%
ASC 2.1%
DXNS 0.5%
MTC 1.6%
SGP 0.5%
SPD 0.3%
DEB 0.6%
MKS 0.9%
NXT 0.5%
SMWH 0.6%
BWNG 0.5%
HOME 0.5%
HFD 0.5%
0%
Emerging markets
Note: Numbers written next to company denote sales-weighted market GDP growth by company for CY 2012e
Source: Company data, HSBC estimates
Input cost pressures
In the decade until end-2009, European retail was a major beneficiary of the US dollar carry trade; a weak
dollar and the switch to lower-cost Far East sourcing underpinned the sector’s gross margin expansion. This
trend reversed in 2010-11 on a combination of higher Far East manufacturing wage inflation, increased raw
material input costs and a stronger US dollar. While the reduction in raw materials input costs (specifically
cotton) will bring total input costs down over the next two years (we forecast a reduction of around 5-7% in US
dollar sourcing costs in 2012-13e), we ultimately expect Far East sourcing costs to keep rising.
Input cost analysis
Raw material costs (eg cotton)
Labour
Other production costs, SG&A
Manufacturing margin
Freight
Duty
Total
% y-o-y change
Source: HSBC estimates
148
2010
2011
% y-o-y
2012e
y-o-y
2013e
% y-o-y
26
19
34
6
5
10
100
5%
45
23
34
6
9
13
130
30%
74%
20%
0%
0%
79%
27%
36
28
34
6
6
12
123
-5%
-19%
23%
0%
0%
-32%
-3%
22
34
34
6
7
11
114
-7%
-39%
23%
0%
0%
10%
-8%
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Online sales growth in key countries (% y-o-y)
Retail sales growth in key countries (% y-o-y)
20%
10%
10%
15%
15%
5%
5%
10%
10%
0%
0%
5%
5%
-5%
-5%
0%
0%
-5%
-5%
-10%
-10%
-15%
-15%
-10%
Q1 2008
Q2 2008
Q3 2008
Q4 2008
Q1 2009
Q2 2009
Q3 2009
Q4 2009
Q1 2010
Q2 2010
Q3 2010
Q4 2010
Q1 2011
Q2 2011
Q3 2011
Q4 2011
Q1 2012
-10%
UK
France
Germany
US
Source: Thomson Reuters Datastream, HSBC
Q1 2008
Q2 2008
Q3 2008
Q4 2008
Q1 2009
Q2 2009
Q3 2009
Q4 2009
Q1 2010
Q2 2010
Q3 2010
Q4 2010
Q1 2011
Q2 2011
Q3 2011
Q4 2011
Q1 2012
20%
UK
France
US
Germany
Source: Company data, HSBC
Structural shift to online
Given the rollout of broadband networks, increasingly sophisticated website innovation and the suitability
of certain product categories for digital dissemination (eg entertainment), the internet poses a material
competitive threat to some established bricks-and-mortar business models that are already under pressure
from an intensification in non-food competition from the major supermarket groups. For others, however,
it is a substantial growth opportunity. Although it is not yet clear what the level of online penetration in
specific categories will ultimately be (around 13% of total UK retail sales in 2011), this remains an area
of structural growth and is now the fastest route to international expansion via reduced barriers to entry.
Sector drivers
Online: positive for brands but not for boxes
Given the sector theme of the structural shift to online retailing we think the most successful models will be
those able to differentiate themselves either by first-mover advantage in developing an online interface such as
pure-play/specialist internet retailers (Asos plc) or brand proposition/exclusivity. The table below identifies
where online is an opportunity for the stocks in our universe (primarily brands), and conversely where it is a
risk to established businesses (boxes): those worst affected by pricing pressure, those reliant on third-party
brands, and those in historically specialist markets (eg electrical goods) that have been commoditised by the
introduction of non-specialist competition (eg UK supermarket groups) and new market entrants (eg Amazon).
Online revenue exposure (% of group sales): Opportunity or risk?
____ Models that offer potential opportunities ____ ___________ Neutral __________ _____ Models that face potential threats ___
Company
% Company
% Company
%
Asos
100%
Brown (N) Grp
51%
Next
32%
Marks & Spencer Grp (GM sales only)
15%
Sports Direct Intl. (% of retail sales)
8%
Supergroup
8%
Debenhams
8%
H&M
Less than 5%
Inditex
Less than 5%
Halfords
WH Smith
Kingfisher
Inchcape
9%
n/a
n/a
n/a
Home Retail Grp (Argos Only)
Mothercare (as a % of UK sales)
Kesa
Dixons Retail
Carpetright
39%
23%
10%
8%
n/a
Source: Company data (last reported financial period), HSBC
Structural growth in online spending and the opportunity that it provides is also key to the debate about
how many stores a company needs to service its target market (see capacity withdrawal overleaf).
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Consolidation and capacity withdrawal: positive for large retail market share
In recent recessionary times, general retail sectors in developed markets have been characterised by
capacity withdrawal motivated by two key drivers: (1) increase in online spending (eg Amazon); and (2)
the expansion of major supermarket groups into non-food categories (eg Tesco, Asda Walmart,
Sainsbury’s and WM Morrisons). This has had a dramatic effect on UK general retailers, leading to the
failure of both listed and private-equity-backed businesses – typically in price-led commodity categories.
The vast majority of casualties have been relatively small players, which had, in many cases, overexpanded in previous years; their failure to capitalise online spending trends combined with higher
property rental costs led to margin squeeze.
Shopping centre development pipeline: floor space (m sq ft)
UK supermarket space growth slowing (% y-o-y)
120
10%
100
8%
80
5%
3%
60
0%
40
-3%
20
2006
2007
2008
UK
2009
2010
2011
2007a 2008a 2009a 2010a 2011a 2012e 2013e 2014e
Europe
Source: Cushman & Wakefield, Marketbeat Shopping Centre Development Report
Europe March 2010, HSBC
Tesco
Sainsbury
Morrison
Total
Source: Company data, HSBC estimates
While capacity withdrawal is positive for any remaining retailer, the larger companies in the sector (eg
Debenhams in home & beauty and clothing, and Home Retail group in small-ticket electricals,
entertainment and gifting) with the broadest category exposure stand to gain most from reduced
competition, in our view. The benefits can be either from market share gains or the acquisition of
distressed assets (eg complementary brands, physical assets, or client data in the case of internet-based
operators) at depressed valuations.
Cost-cutting and cash-saving initiatives: scale brings advantage
Aggressive cost-cutting initiatives have characterised all but a handful of operators in the sector. By
reducing or optimising what are largely fixed-cost overheads, these companies are now better positioned
to benefit from increased operational gearing on small market share or revenue gains. With larger/more
sustainable businesses repairing their balance sheets through reduced capital expenditure, those with
sustainable business models have used the cessation of dividend payments and equity capital raisings
(rights issues), where appropriate, to restore their balance sheets. For example M&S announced around
GBP300m in cost savings under Plan 2020, Home Retail greatly reduced its cost base by around
GBP200m over four years (2008-11). Overall the sector has become leaner over the years.
Company sales indicators
Although most companies in the sector are cyclical by nature, no two are the same, so the key lead indicators
for sales and earnings growth performance can differ markedly between companies. For Inditex (around 25%
Spanish revenues) we use Spanish chain stores sales; for H&M (some 25% German revenue exposure) we use
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Textilwirschift data for the local market. For other companies we use a variety of UK and French lead
indicators from trade bodies such as British Retail Consortium and ONS/Banque de France data.
Valuation
Key valuation metrics
In the case of the retail sector, EV/EBITDA, PER and yield – both free cash flow (FCF) and dividend –
remain the key metrics by which the sector is most often screened or filtered. With debt concerns largely
removed from the valuation agenda, the PER is generally considered to be the key long-term metric by
which the sector is valued. The 10-year historical one-year forward PE range is 7.2-17.0x, with an
average of 13.1x. Additionally, and supplementing PER analysis, ROIC is often seen as a key measure of
performance for mature companies. Intrinsic valuation methodologies such as discounted cash flow
(DCF), dividend discount models (DDM) and adjusted present value (APV), can then be used to gain an
accurate assessment of the present value of future cash flows by absolute quantum; this is particularly
relevant for companies that generate cash in excess of their own investment requirements (and thus are
either low or ex-growth), and which are looking at a sustainable total shareholder returns (TSR) – a
combination of underlying EPS growth, dividends and share buybacks – as the key mechanisms for
returning value to shareholders.
Classification
Cyclical versus defensive: Cyclical stocks typically trade at a premium to the sector and can often
deliver high or super-normal earnings growth, supported by a structural growth dynamic (eg the internet)
or cyclical recovery. Defensive stocks typically trade at a discount to the sector but are often characterised
by higher FCF/dividend yields, supported by consistent and sustainable cash generation.
UK-centric versus international: Stocks which offer international diversification (Kingfisher, Inditex,
Hennes & Mauritz) typically trade at a premium to UK-centric business models, with exposure to
emerging markets and BRIC territories highly valued by the investor.
FTSE100 versus FTSE350: Given their largely mature status, UK-centric business models and the
resultant low earnings growth rates, FTSE100 stocks typically trade at a discount to other UK FTSE350
General retailers, which often have emerging competitive advantages via scale in specialist retail categories.
General Retail*: growth and profitability (calendarised data)
Growth
Sales
EBITDA
EBIT
Net profits
Margins
EBITDA
EBIT
Net profit
Productivity
Capex/sales
Asset turnover (x)
Net debt/Eq
ROE
2008
2009
2010
2011
2012e
11.5%
6.1%
2.9%
3.9%
9.3%
9.8%
9.3%
9.8%
8.2%
14.3%
17.6%
19.7%
6.2%
1.5%
0.9%
2.5%
10.1%
11.3%
12.2%
10.8%
20.4%
16.6%
12.4%
20.3%
16.2%
12.1%
21.6%
17.6%
13.2%
20.3%
16.3%
12.5%
20.5%
16.7%
12.6%
7%
1.5
0.1x
31%
5%
1.6
-0.1x
29%
5%
1.5
-0.2x
31%
6%
1.5
-0.2x
27%
5%
1.6
-0.2x
28%
Note: Based on all HSBC coverage of General Retail. All data are market cap weighted
Source: company data, HSBC estimates
151
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EMEA Equity Research
Multi-sector
July 2012
Sector snapshot
Core industry driver: Retail clothing sales growth (%)
France
Spain
Source: MSCI, Thomson Reuters Datastream, HSBC
Top 10 stocks: HSBC General Retail coverage (weights are given
for presence in relevant indices)
Inditex
Hennes & Mauritz
Kingfisher
Marks & Spencer
Next
Asos
Debenhams
Home Retail Group
Halfords
N Brown Gp
*36%
*33%
**24%
**21%
**18%
***6%
**3%
**3%
**3%
**3%
20x
3500
3000
15x
2500
2000
10x
1500
1000
8x
Country breakdown*: FTSE 350 General Retail
Source: Thomson Reuters Datastream, HSBC
PB vs. ROE: FTSE 350 General Retail
50
20.0
40
15.0
30
10.0
20
5.0
10
Fw d PB (LHS)
Jan-08
Jan-09
0
Jan-07
0.0
Jan-06
62%
20%
5%
4%
4%
2%
2%
1%
1%
Jan-05
Source: Company data, HSBC
Weights (%)
Jan-04
*Based on geographic revenue exposure
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
500
UK
Eurozone
EM Europe
Other Western Europe
Asia ex Japan
Asia-Pacific
Middle East, Africa
North America
LatAm
Fw d ROE % (RHS)
Source: Thomson Reuters Datastream, HSBC
152
Apr-12
4000
* MSCI EU Retailing index, ** FTSE 350 Gen Retailers, ,***FTSE AIM
Source: MSCI, Thomson Reuters Datastream, HSBC
Region/country
Feb-12
PE band chart: FTSE 350 General Retail
Jan-12
1
2
3
4
5
6
7
8
9
10
Index weight
Note: Spanish large chain store sales
Source: Thomson Reuters Datastream, ine.es, textilwirtschaft, census.gov, HSBC
Jan-11
Stocks
Germany
Jan-10
Stock rank
UK
USA
Oct-11
-18%
Inditex, H&M, Kingfisher
67%
Dec-11
-12%
-18%
Aug-11
-6%
-12%
Apr-11
0%
-6%
Jun-11
6%
0%
Feb-11
10%
31%
12%
6%
Oct-10
549
124.8
18%
12%
Dec-10
Trading data
5-yr ADTV (EURm)
Aggregated market cap (EURbn)
Performance since 1 Jan 2000
Absolute
Relative to MSCI Europe US
Dollar
3 largest stocks
Correlation (5-year) with MSCI Europe
US Dollar
18%
Aug-10
2.1% of MSCI Europe US Dollar
Apr-10
MSCI EU Retailing Index
Jun-10
Key sector stats
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EMEA Equity Research
Multi-sector
July 2012
Luxury goods
Luxury Goods team
Antoine Belge*
Head of Consumer Brands and Retail Equity Research, Europe
HSBC Bank Plc, Paris Branch
+33 1 56 52 43 47
antoine.belge@hsbc.com
Erwan Rambourg*
Head of Consumer Brands and Retail Equity Research
The Hong Kong and Shanghai Banking Corporation Limited
+852 2996 6572
erwan.rambourg@hsbc.com.hk
Sophie Dargnies*
Analyst
HSBC Bank Plc, Paris Branch
+33 1 56 52 43 48
sophie.dargnies@hsbc.com
Sector sales
David Harrington
Sector Sales
HSBC Bank Plc
+44 20 7991 5389
david.harrington@hsbcib.com
Lynn Raphael
Sector Sales
HSBC Bank Plc
+44 20 7991 1331
lynn.raphael@hsbcib.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
153
154
Luxury goods
Diversified groups or holdings
LVMH
Christian Dior
Louis Vuitton
41% LVMH stake
Moët Hennessy
Dior Couture brand
Sephora
DFS
Bulgari
‘Hard luxury’ companies
Richemont
Swatch Group
Cartier
Omega
Montblanc
Breguet
IWC
Tissot
Panerai
Swatc h
‘Soft luxury’ companies
Coach
Burb erry
Prada
Ferragamo
Tod’s
Hermès
EMEA Equity Research
Multi-sector
July 2012
Sector structure
Perfumes
Tiffan y
PPR
Harry Winston
Luxottica
Gucci
Ray-Ban
Puma
Oakley
Retail ass ets
Eyewear licences
Hugo Boss
Lenscrafters
Sunglass Hut
Source: HSBC
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EMEA Equity Research
Multi-sector
July 2012
Sector valuation history (forward PE)
2000 bubble
40.0 x
35.0 x
2007 market
30.0 x
China starts
SARS
25.0 x
to matter
epidemic
20.0 x
peak
15.0 x
10.0 x
Asian financial
5.0 x
09/11 attacks
crisis
0.0 x
Post-Lehman collapse
Jun-
Mar-
Dec-
Sep-
Jun-
Mar-
Dec-
Sep-
Jun-
Mar-
Dec-
Sep-
Jun-
Mar-
Dec-
Sep-
Jun-
Mar-
Dec-
Sep-
Jun-
97
98
98
99
00
01
01
02
03
04
04
05
06
07
07
08
09
10
10
11
12
Source: Factset, HSBC
abc
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EMEA Equity Research
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July 2012
1.9
Coach
1.7
1.5
Asset Turnover (x)
156
EBIT margin versus asset turnover (FY2012*)
Hugo
Ferragamo
1.3
Burberry
1.1
Tiffany
0.9
Prada
Tod's
Hermes
Richemont
Lux ottica
Sw atch
0.7
LVMH
PPR
Christian Dior
0.5
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
EBIT Margin (%)
abc
* FY2012 figures for Burberry, Tiffany, Richemont and Prada are actuals, all other figures are HSBC estimates.
Source: HSBC estimates
EMEA Equity Research
Multi-sector
July 2012
Sector description
The luxury goods sector includes companies that develop, produce, market, distribute and sell high-end
apparel, jewellery, watches, leather goods and accessories. Some luxury goods companies are also
involved in other premium-priced categories, such as LVMH with its fragrances, and wines and spirits, or
are vertically integrated; the Swatch Group, for example, has a watch-component division. Many listed
companies are family-controlled, although some have a 100% free float, such as Burberry and Tiffany.
The sector is characterised by high operating margins, substantial emerging-market exposure and strong
cash generation. M&A has been a driver in the past, but with a few exceptions – Luxottica, for example –
synergies are scarce, making it hard to return cash to investors in an efficient manner.
 Diversified groups/holdings: Some of the listed companies in the space have grown by acquisitions
that gave them large, diversified brand portfolios. The proxy for the sector and the largest group is the
French company LVMH, which now has more than 50 brands in five different product categories:
fashion and leather, fragrance and cosmetics, wines and spirits, watches and jewellery, and selective
distribution. Christian Dior is a listed holding company of LVMH. PPR is more of a conglomerate
than a diversified luxury group, since it holds retail assets, a stake in sports brand Puma and a luxury
portfolio. Richemont and the Swatch Group also have diversified portfolios, although they focus on
so-called hard luxury.
abc
Antoine Belge*
Head of Consumer Brands and
Retail Equity Research, Europe
HSBC Bank Plc, Paris Branch
+33 1 56 52 43 47
antoine.belge@hsbc.com
Erwan Rambourg*
Head of Consumer Brands and
Retail Equity Research
The Hong Kong and Shanghai
Banking Corporation Limited
+852 2996 6572
erwan.rambourg@hsbc.com.hk
Sophie Dargnies*
Analyst
HSBC Bank Plc, Paris Branch
+33 1 56 52 43 48
sophie.dargnies@hsbc.com
*Employed by a non-US affiliate of
HSBC Securities (USA) Inc, and
is not registered/ qualified
pursuant to FINRA regulations
 Hard-luxury companies: ‘Hard luxury’ describes products such as watches, jewellery and pens,
although pens no longer contribute much to sales. Watches and jewellery are often considered
together, but their distribution structures vary considerably. Watches are primarily wholesale-driven,
because consumers want to compare designs, brands, prices and functionality. Jewellery is often
retail-driven – companies sell their own jewellery in their own stores. The largest listed hard-luxury
companies are Richemont, with its star brand Cartier, and the Swatch Group, with the star brand
Omega. Monobrand companies include Tiffany and Harry Winston, which sells mostly jewellery.
 Soft-luxury companies: ‘Soft luxury’ describes high-end apparel and leather goods. Soft-luxury
goods are mostly sold in directly operated stores. Monobrand listed companies include Burberry,
Hermès, Prada, Ferragamo, Tod’s, Hugo Boss and Coach.
Key themes
Luxury goods stocks historically have shown strong growth, trading at a premium valuation to the market.
The key concern is the sustainability of their growth, and the key question for the bigger brands like Louis
Vuitton and Cartier is how close the brand is to being mature. It seems paradoxical to try to sell more of
what theoretically should be exclusive, but the leaders of the industry have walked a fine line between
selling in volume and holding on to their identity (and the consumer). Most of the key themes in the
sector will revolve around image management, pricing power and the concept of maturity.
We believe that the key concerns and themes are:
 High-end consumer behaviour: Most investors consider luxury goods demand to be directly linked to
GDP growth. To a certain extent, that has been the case in some countries. But consumption of luxury is
driven by social, cultural and psychological factors as well as financial issues. Luxury boomed in Japan
during one of the country’s deepest recessions. Similarly, consumer confidence was sluggish in many
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EMEA Equity Research
Multi-sector
July 2012
developed markets in 2010 and 2011, but luxury demand soared as wealthy consumers loosened their belts
after almost two years of austerity.
 Pricing power: Luxury brands do not really compete on price but rather on design and desirability. During
the downturn, prices generally held up. In recovery phases, brands tend to launch higher-priced, highermargin products, and raise prices again.
 Trading up or down, more or less: Linked to this pricing power and the social status that is associated
with luxury, there is a big debate around the consumer behaviour of trading up or down, and trading more
or less. In spirits, trading down is common; customers buy cheaper vodka in the US during a recession, for
example. We think in luxury goods, high-end consumers tend to trade less when times get tough. A
consumer interested in the latest Patek Philippe watch would probably postpone buying it during an
economic crunch rather than trade down to a Casio or Swatch.
 Market share/polarisation: Trading less implies that some brands have a reference status and will both
increase sales when times are good and expand their market share when times are tougher. Louis Vuitton
is usually the reference in leather and accessories; Cartier in watches and jewellery.
 Market maturity/saturation: If Louis Vuitton, for example, increases sales by a high single-digit to
low double-digit rate every year, how long can this last? When will its market be saturated? This is a
theoretical debate that has gone on for years. Japan and possibly a few other countries may be treated
as cash cows now, but we believe companies still have considerable capacity to recruit customers and
persuade them to trade up.
 Image control: It is hard to get consumers to trade up if the distribution network is not up to speed in
product assortment, merchandising and in-store service. Most brands try to control their image as
much as they can. That often means taking back licences or transferring sales from wholesalers to
directly operated stores, which is harder for wholesale-driven businesses such as watches or
fragrances. And if the product category is a profitable diversification from the main business, but is a
category in which the company does not have know-how or a production base, such as fragrances and
eyewear at Burberry or Gucci, a licence makes sense. Another recurring subtheme here is counterfeit
products in luxury.
Sector drivers
Luxury goods have been driven by emerging-market exposure, both within developing countries and through
customers from those countries buying goods in Europe. We expect entering and developing leadership
positions in higher-growth countries, where margins are already higher than in the developed world outside
Japan, will continue to be a key factor for the sector. Historically, currency and M&A have also had an impact
on stock prices.
 Currency: Most European luxury goods manufacturers produce in euros (in France and Italy) or
Swiss francs, and sell throughout the world. They have important exposure to the US dollar and
dollar-linked currencies, such as the renminbi and the Hong Kong dollar, and to the yen. A
weakening of the euro or/and the Swiss franc has a positive impact on earnings for French, Italian
and Swiss luxury companies (which may have a time lag depending on hedging strategies).
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Multi-sector
July 2012
 M&A and cash management: There have been few deals since the LVMH buying spree in 1999-2000;
LVMH’s acquisition of Bulgari in 2011 being one. But with cash piling up, there is recurring talk about
deals, and cash generation could become an issue if buy-back programmes or dividend hikes do not occur.
Beyond the scarcity of targets (many of which are privately held with no pressure to sell), the issue with
acquisitions in the sector is that they do not produce many synergies – if LVMH were to acquire a leather
goods brand, it would not be distributed in existing Louis Vuitton stores.
 Geographic diversification: The US remains an underdeveloped market, in our view, and countries
like India, Russia and Brazil could represent growth opportunities in the future. But the investment
case for the sector now relies greatly on Asia outside Japan. Although there are theoretical risks when
operating in China, we believe they are outweighed by the many reasons to remain excited by the
country’s potential.
Valuation
Luxury goods companies tend to trade on forward-looking price/earnings ratios because they are usually
not very capital/debt-intensive. Historically, the sector has traded at an average 50% premium to the
market, with troughs during which the sector was trading in line (as it did following 9/11) and peaks when
the sector was trading at a 100% premium (for example, during the 2000 bubble). In absolute terms, the
sector traded in a forward PE range lying in the low to mid twenties in 2002-07. Since the 2008-09
downturn, it has traded more in the mid to high teens.
Luxury goods can be described as a ‘momentum sector’ since multiples tend to expand when earnings
estimates are raised (and the reverse is also true).
One thing to bear in mind about investments and cost containment in the sector is that most of the
companies are managed, and their equity held, by families. Consequently, management of brands, people
and profits is done with the long term in mind, not necessarily the next quarter, which investors can
sometimes find a difficult approach.
Luxury goods: growth and profitability
2008
2009
2010
2011
2012e
3.9%
-5.2%
-5.7%
-14.4%
-2.9%
-2.2%
-8.4%
-16.8%
15.3%
44.3%
55.7%
22.9%
18.9%
27.0%
37.7%
33.9%
11.3%
16.2%
16.4%
21.5%
21.1%
17.7%
11.5%
20.7%
16.6%
10.2%
24.3%
20.2%
13.6%
25.8%
23.0%
15.0%
26.4%
23.5%
16.0%
6.5%
0.56
38.9%
20.7%
4.6%
0.72
14.8%
18.3%
5.6%
0.55
-2.7%
27.8%
6.6%
0.50
-7.9%
29.9%
5.8%
0.51
-13.7%
29.1%
Growth
Sales (organic)
EBITDA
EBIT
Net profit
Margins
EBITDA
EBIT
Net profit
Productivity
Capex/sales
Asset turnover (x)
Net debt/Equity
ROE
Note: based on all HSBC coverage of luxury
Source: company data, HSBC estimates
159
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EMEA Equity Research
Multi-sector
July 2012
Sector snapshot
Core industry driver: international tourist arrivals and the
world population, 1995-2010
6.5
700
6.0
600
5.5
500
5.0
400
4.5
2009
2010
7.0
800
2005
2006
2007
2008
7.5
900
2002
2003
2004
Trading data
5-yr ADTV (EURm)
599
Aggregated market cap (EURbn)
212
Performance since 1 Jan 2000
Absolute
106%
Relative to MSCI Europe US Dollar
127%
3 largest stocks
LVMH, Hermes, Richemont
Correlation (5-year) with MSCI Europe
0.58
US Dollar
1000
2001
2.26% of MSCI Europe US
Dollar
1997
1998
1999
2000
MSCI Europe Textiles, Apparel and
Luxury Goods Dollar Index
1995
1996
Key sector stats
International tourist arriv als (LHS, m)
Source: MSCI, Thomson Reuters Datastream, HSBC
World population (RHS, bn)
Top 10 stocks: HSBC luxury goods coverage (weights are given
for presence in relevant indices)
Source: US Census Bureau, World Tourism Organization, HSBC
Stock rank
Stocks
PE band chart: HSBC luxury coverage*
1
2
3
4
5
6
7
8
9
10
LVMH
Hermes International
Richemont
Christian Dior
PPR
Coach
Prada
Luxottica
The Swatch Group 'B'
Burberry Group
Index weight
*44.9%
#2.6%
*17.0%
*14.4%
**13.8%
##0.1%
*#0.2%
*9.4%
*6.9%
*5.3%
* MSCI Europe Textiles, Apparel and Luxury Goods Dollar Index ** MSCI EU Retailing
# SBF120 ##S&P 500 *# S&P Europe LM:$
Source: MSCI, Thomson Reuters Datastream, HSBC
Country breakdown: HSBC Luxury Goods coverage (by market
capitalisation)
Country
France
Switzerland
United States
Italy
Hong Kong
UK
Germany
Source: Thomson Reuters Datastream, HSBC
22x
290
20x
240
17x
14x
190
12x
140
90
40
2001
2003
2005
2007
2009
2011
* Includes LVMH, Christian Dior, PPR, Luxottica, Burberry, Richemont, Hugo Boss,
Swatch, Hermes, Tiffany, Ferragamo, TOD’s, Prada, Coach
Source: Thomson Reuters Datastream, HSBC
Weights (%)
56.5%
15.1%
9.1%
8.3%
6.3%
3.4%
1.3%
PB vs. ROE: HSBC luxury coverage*
4.0
25
3.5
20
3.0
15
2.5
10
2.0
1.5
5
1.0
0
2004 2005 2006 2007 2008 2009 2010 2011 2012
Fwd PB (LHS)
Fw d ROE % (RHS)
* Includes LVMH, Christian Dior, PPR, Luxottica, Burberry, Richemont, Hugo Boss,
Swatch, Hermes, Tiffany, Ferragamo, TOD’s, Prada, Coach
Source: Thomson Reuters Datastream, HSBC
160
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EMEA Equity Research
Multi-sector
July 2012
Metals & mining
Metals & mining team
EMEA
Andrew Keen*
Global Sector Head, Metals and Mining
HSBC Bank plc
+44 20 7991 6764 andrew.keen@hsbcib.com
Asia
Simon Francis*
Regional Head of Metals and Mining, Asia Pacific
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6620
simonfrancis@hsbc.com.hk
Thorsten Zimmermann*, CFA
Analyst
HSBC Bank plc
+44 20 7991 6835 thorsten.zimmermann@hsbcib.com
Thomas Zhu*
Analyst
The Hongkong and Shanghai Banking Corporation Limited
+852 2822 4325
thomasjzhu@hsbc.com.hk
Vladimir Zhukov*
Analyst
OOO HSBC Bank (RR) Ltd
+7 495 783 8316 vladimir.zhukov@hsbc.com
Chris Chen*
Analyst
The Hongkong and Shanghai Banking Corporation Limited
+852 2822 4277
chrislchen@hsbc.com.hk
CEEMEA
Cor Booysen*
Analyst
HSBC Securities (South Africa) Pty(Ltd)
+27 11 6764224
cor.booysen@za.hsbc.com
Jigar Mistry*, CFA
Analyst
HSBC Securities and Capital Markets (India) Private Limited
+91 22 2268 1079 jigarmistry@hsbc.co.in
Richard Hart*
Analyst
HSBC Securities (South Africa) Pty(Ltd)
+27 11 676 4218 richard.hart@za.hsbc.com
North America & Latin America
Jonathan Brandt
Analyst
HSBC Securities (USA) Inc
+1 212 525 4499 jonathan.l.brandt@us.hsbc.com
James Steel
Analyst
HSBC Securities (USA) Inc
+1 212 525 3117 james.steel@us.hsbc.com
Amit Pansari*, CFA
Analyst
HSBC Bank Plc
+91 80 3001 3760 amitpansari@hsbc.co.in
Sector sales
James Lesser
HSBC Bank plc
+44 207 991 1382 james.lesser@hsbcib.com
Patrick Chidley, CFA
Analyst
HSBC Securities (USA) Inc
+1 212 525 4915 patrick.t.chidley@us.hsbc.com
Howard Wen
Analyst
HSBC Securities (USA) Inc
+1 212 525 3726 howard.x.wen@us.hsbc.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
161
162
EMEA Equity Research
Multi-sector
July 2012
Sector structure
Metals and mining
Mining
Base metals
Bulks
Aluminium
Iron Ore
Alcoa
Rusal
Norsk Hydro
Chalco
Alumina
Nalco
Hindalco
Rio Tinto
Copper
Codelco
Antofagasta
Aurubis
Mexico
Kazakhmys
SouthernCopper
Norilsk
Rio Tinto
BHP
Vale
Kumba
NMDC
Ferrexpo
Sesa Goa
Fortescue
Cliffs
Metalloinvest
NWR
BHP
AngloAmerican
Raspadskaya
Yanzhou
Fushan
Peabody
Xstrata
Teck
Mechel
Shenhua
China Coal
Hidlili
Macarthur
Zinc/Lead
Boliden
Terramin
Kagara
Glencore
Electric arc
Platinum/Palladium
Nucor
Acerinox
Outokumpu
Lonmin
Amplats
Northam
Impala
Royal Bafokeng Aquarius
Senior gold producers
Barrick
Newcrest
Newmont
AngloGold
Goldfields
Goldcorp
Kinross
Polyus
Mid-tier gold producers
Buenaventura
Yamana
Randgold
Polymetal
IAMGold
Eldorado
Harmony
Centerra
Petropavlosk
Hochschild
Royal Gold
Semafo
Explorers and developers
Numerous examples
Vale
Tin
Xstrata
JSPL
China Steel
Ternium
Lo ng steel
Ezz
Nucor
Erdemir
Tata Steel
Rautarrukki
SAIL
Gerdau
ArcelorMittal
Salzgitter
US Steel
Voestalpine
China Steel
Termium
Vale Glencore
Hecla
Fresnillo
Flat steel
Stainless
ThyssenKrupp
SSAB
Posco
Nippon
JFE
Baosteel
AK Steel
Usiminas
CSN
JSW
Acerionox
TMK
Outokumpu
Vallourec
TISCO
Tenaris
Schmolz & Bickenbach
Integrated
Severstal
MMK
Evraz
ThyssenKrupp
Voestalpine
US Steel
Posco
JFE
Baosteel
AK Steel
CSN
Usiminas
Pipes
Non-integ rated
ArcelorMittal
Usiminas
Ternium
US Steel
SA IL
CSN
Voestalpine
Nippon
NLMK
Posco
Gerdau
Salzgitter
ThyssenKrupp
SSAB
Nucor
AK Steel
abc
Diversified companies
Source: HSBC
Salzgitter
SSAB
ArcelorMittal
Tata Steel
Gerdau
Gold/Silver
Silver stocks
Silver Wheaton
Couer d’Alene
Silver Standard
Pan American
Majors: AngloAmerican BHP Billiton Rio Tinto
Others: Boliden
ENRC
Vedanta
Blast furnace
Junior gold producers
Numerous examples
Nickel
Norilsk
Precious metals
Coking/thermal coal
Freeport
Xstrata
Grupo
KGHM
BHP
FirstQuantum
Glencore
Nyrstar
Korea Zinc
Hind. Zinc
Xstrata
Ste el
550
European financial crisis
and weaker than
expected global economic
growth
500
Global financial crisis, severe demand
contraction and plummeting commodity
prices
Record high commodity prices
450
EMEA Equity Research
Multi-sector
July 2012
Sector price history
400
350
300
Strong commodity demand driven by
loose Chinese monetary policy and
increasing US consumer debt
250
Quantitative easing and
expectation of a global demand
recovery
200
150
100
MSCI Global Index
Jun12
Dec11
Jun11
Dec10
Jun10
Dec09
Jun09
Dec08
Jun08
Dec07
Jun07
Dec06
Jun06
Dec05
Jun05
Dec04
Jun04
Dec03
Jun03
Dec02
Jun02
50
MSCI Global M&M Index
Source: MSCI, Thomson Reuters Datastream, HSBC
abc
163
US Steel
Ny rstar
Maanshan
Salzgitter
Thyssenkrupp
1.00
Baosteel
Angang
Boliden
NLMK
Tata Steel
Evraz
TMK
Chalco
Hindalco
Voestalpine
Metalloinv est
Severstal
Norsk
Ternium
Gerdau
Posco
ArcelorMittal JSW
0.75
EMEA Equity Research
Multi-sector
July 2012
1.25
Asset Turnover Ratio
164
EBIT margin versus asset turnover chart (2011 calendarised)
AngloGoldCenterra
Mechel
China Coal
Amplats
Alcoa
MMK
0.50
Usiminas
Harmony
0.25
Southern Copper
Codelco
BHP
Freeport
Norilsk
KGHM
Fortescue
Shenhua
Gold FieldsPoly metal Hochschild
Yanzhou
Rio
Peabody
ENRC
Impala
Randgold
Rusal
Anto
Sterlite Xstrata
JSPL Anglo
Iamgold
Vale
NALCO
Vedanta
Petropav lov sk
Sesa Goa
Hindustan Zinc
Lonmin
New mont Raspadskay a
CSN
Northam
Barrick
Agnico-Eagle*
Teck
Kazakhmy s Macarthur
Eldorado
Fushan
Kinross
Kinross*
Yamana
Goldcorp
Hidili
Roy al Bafokeng
NMDC
Roy al Gold
-10%
0%
10%
20%
Mining
30%
40%
EBIT Margin
50%
60%
70%
80%
Steel
Source: Thomson Reuters Datastream, company reports, HSBC
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EMEA Equity Research
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July 2012
Sector description
The metals and mining sector falls broadly into two areas, mining and steel, although these sub-sectors
are closely interrelated. Miners encompass many independent industries, each focused on the extraction
and refining of metals, including base metals (copper, aluminium, zinc and nickel) and precious metals
(gold, silver and platinum). Mining companies also produce ‘bulk commodities’ such as thermal coal,
coking coal and iron ore, the latter two of which are the raw materials for much of the steel industry. The
steel industry is largely a processor of raw materials into downstream products, grouped broadly into flatrolled, stainless and long steel, although some steelmakers are also backward integrated and own
upstream assets.
Steel and base metals are key materials for construction, infrastructure and consumer goods. Major
consumers include construction and automotive firms, capital goods producers, wire and cable
manufactures and food packaging companies. The gold mining segment of the metals and mining sector
has long been considered rather separately from the industrial metals, as it has attracted investors
interested in gold’s special properties as a financial asset and as a rare metal. There is a greater focus on
reserves and resources in the ground, rather than purely on the current year earnings and cash flow.
abc
Andrew Keen*
Global Sector Head, Metals and
Mining Research
HSBC Bank plc
+ 44 20 7991 6764
andrew.keen@hsbcib.com
Thorsten Zimmermann*, CFA
Analyst
HSBC Bank plc
+44 20 7991 6835
thorsten.zimmermann@hsbcib.com
*Employed by a non-US affiliate of
HSBC Securities (USA) Inc, and is
not registered/ qualified pursuant to
FINRA regulations
Metals and mining is arguably the oldest truly global sector, as all producers are subject to global
commodity prices and the sector has long been characterised by cross-border investment.
Key themes
Emerging market growth
Around one-third of industrial metals are consumed in China, which now consumes about three times as
much metal as the US. The acceleration of China as a metal consumer has led to a rise in global growth in
metals demand, from 2-3% pa for much of the 1980s and 1990s to 5-7% pa over the past decade. This has
changed the investment cycle in the industry: whereas growth was once easily satisfied with brownfield
expansion and the occasional new mine, now fresh capital needs to be constantly invested in new
projects. Consequently, commodities are more dependent on ‘incentive pricing’, or the commodity prices
that are required to justify investment in projects that have traditionally been seen as marginal.
This structural change in global demand has been driven by economic growth in China, which has led to
15-20 million people being ‘urbanised’ each year. Although this trend is difficult to define and measure, a
significant proportion of China’s population has reached the personal income band where demand for
metal-intensive goods accelerates significantly. This is due to the movement from rural housing and
employment to urban manufacturing jobs (which require plant and infrastructure) and urban
accommodation (which drives demand for materials such as steel-reinforced concrete and copper wiring).
On our estimates, 75-90% of the metal consumed in China stays there, with the balance exported in the
form of manufactured goods.
Deteriorating resources
A common theme in the sector (although one that we do not entirely subscribe to) is the deterioration in
the quality of natural resources and the impact on commodity prices. Many commentators and some in the
industry claim that the quality and quantity of ore from the next generation of mines is significantly
degraded from the last generation, which will require higher incentive pricing and lead to further delays
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and disruptions. It is becoming more challenging to extract some metals but there is no evidence that
minerals are reaching absolute depletion levels (the predictions made in the 1970s ‘Club of Rome’ have
proved false: reserves and resources have continued to rise over time as technological advances in
exploration, processing and extraction have led to the continued upgrading of known resources and a
containment of structural cost increases).
M&A versus organic growth
Buying has definitely outstripped building as a pathway to growth over the past decade. During the
commodity price upcycle, companies that were in an early stage of the acquisition process (eg Xstrata and
ArcelorMittal) timed their asset purchases well, and were rewarded with strong cash flows. There are now
significant antitrust barriers to further consolidation in many metals industries, and the relatively small
mining companies often have dominant or blocking shareholders. Therefore there has been a shift in
strategy over the past two years towards rediscovering organic growth.
Dividend yield or growth?
Mining stocks are usually relatively low yield, although the sector has derated significantly recently and
core dividend yields are becoming more attractive. These can be boosted by special dividends and share
buybacks when cash flows are strong. Core dividend yields are low because the cyclical nature of the
companies’ earnings prompts management to keep core dividends low in order to avoid cancellations –
although this has not proved entirely successful: three of the four major miners in the UK cancelled
dividends to preserve cash or pursue rights issues during the 2008-09 downturn.
Resource nationalism and political risk
Political risk is an old theme in mining that has gained fresh momentum in recent years. In major mining
regions, minerals are commonly owned by the state, and mining companies operate mines under systems
of mineral leases and royalties. Although the sector was plagued by nationalisation in South America and
Africa during the 1970s, more recent trends include the empowerment process in South Africa and the
imposition of a resources tax in Australia. In addition, rapid demand growth is again pushing mining
firms to return to areas of higher risk such as West Africa (iron ore), the Congo (copper) and Afghanistan
(iron ore and copper). Given China’s dominance of demand and its relatively poor endowment of
minerals (it is a major importer of iron ore and copper in particular), the Chinese state has sought to take
direct interests in a range of small and large mining companies, often in the face of political resistance. It
is likely that this will remain an issue in the sector for the foreseeable future.
Gold prices versus gold equities
Historically gold stocks have been a leveraged proxy for gold itself, although the market behaviour has
changed somewhat recently with stocks almost all declining much more sharply than the gold price over
the last 12 months. Some major producers' shares have even halved despite higher profitability and record
revenue and profits. It has become fairly entrenched conventional wisdom that gold miners are threatened
with lower gold prices (current levels being unsustainable), continually rising costs and poor management
decision making, and face other challenges such as labour shortages, organised opposition to mining and
“resource nationalism”(where governments seek to increase their share of the income from mining
projects). All this has meant that many market participants feel that not only the stock price falls but also
the de-rating of gold equities is justified. A new phase of industry consolidation, or even privatisation
could cause the sector to re-rate.
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Sector drivers
Commodity prices undoubtedly drive the movements of all types of metals stocks. For miners, this is not
surprising as their costs and output levels are broadly stable, so the fluctuating prices of metals drive
margins and cash flows. There are few ways to invest in the sector without taking a view of the
underlying commodity markets for a stock (such as spotting excess cash generation, buybacks and
M&A). In the case of steel, the differences between input (iron ore, scrap and coking coal) and output
(finished steel) prices, as well as operating rates, are critical for forecasting margins.
Due to its dependence on commodity markets, global economic growth is a major driver of stock
performance, and the metals and mining sector is high beta versus the broader market. Given the sector’s
size and volatility, it has also attracted significant interest from hedge funds, and this faster money has
tended to amplify the sector’s beta. The ‘risk trade’ of buying or selling a high-beta sector on economic
data points (particularly those associated with Chinese economic growth or trade) has grown to dominate
the sector’s performance, and this has made the timing of entering and exiting stock investments
increasingly important.
Although commodity prices have a long history of mean reversion and the asset lives of mines can stretch
to many decades (both implying that equity prices should not follow short-term commodity prices),
mining equities tend to be volatile and closely correlated to near-term metal price movements. In simple
terms, when commodity markets are good, the market expects them to stay good forever, and when they
are bad, the market expects them to stay bad forever. Remembering this simple principle, and trying to
spot key inflection points, is the key to moving beyond simple momentum investing in the sector.
Commodity markets are relatively straightforward in principle, but often complex in detail. Metals
markets typically work between two dynamics. In periods of poor demand, inventories in the industry, or
on exchanges for some commodities, rise and prices tend to fall to marginal cost – typically a price at
which 10-25% of producers experience cash operating losses. This leads to an inevitable supply response
and returns a market to equilibrium. At the other extreme, in tight markets, as a result of demand growth
or supply interruptions, prices will explore an upper limit, which is usually defined by demand destruction
through substitution or the availability of new sources of supply.
Key segments
Industrial metals
The mining industry has undergone significant consolidation over the past decade and is now dominated
by six large companies: BHP Billiton, Rio Tinto, Anglo American, Xstrata, Glencore and Vale. This
consolidation has been driven by the desire to secure production growth more quickly than through the
commissioning of new projects. The industry has produced significant excess cash flows over the past
decade, but still struggles to accelerate production growth through greenfield projects, which can take 10
years or longer to bring on stream. Hence, it has been quicker and more profitable to buy than build.
Consolidation has also produced some scale benefits, although SG&A costs for global mining firms are
relatively low in absolute terms.
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Precious metals
Before 1980, listed gold mining companies used to be mainly South African. However, the sector has
evolved since then into one that is currently dominated by Canadian companies, although a growing
group of London-listed companies, as well as those that remain in South Africa and Australia, and a few
other companies from the US and other countries make up the global gold group. Gold mining is often
viewed as a three- or four-tier industry which, in the listed environment, consists of a large group of
exploration companies (perhaps over a thousand) listed mainly in Canada, a smaller group of “junior”
producers, generally producing less than 100koz/year, a group of mid-tier producers which produce 100k1moz/year and a group of about eight “senior” producers, which produce more than 2moz/year. The
market leaders are Barrick Gold, Newcrest Mining, Newmont Mining, Goldcorp and AngloGold. In
general, senior producers are mature and are thought to have limited growth potential, but generate a large
amount of cash flow. Mid-tier producers tend to be growth-orientated and therefore sometimes more
risky, but growth is often substantial (eg tangible plans to double or triple revenues in five years are not
uncommon). While listings and domiciles are often in Canada, Australia or the UK, assets are typically in
more risky locations, such as Latin America, Africa and Central Asia, although there are also significant
gold districts in Nevada and parts of Canada and Australia.
Steel
The global steel industry has undergone substantial changes over the past decade. In developed markets
consolidation was often forced upon an industry that suffered from overcapacity and insufficient margins,
whereas substantial new capacity has been built in emerging markets where urbanisation is driving an
increase in steel consumption. China was the most notable example of this development, accounting for
45% of global steel production in 2011, up from just 15% in 2000. The industry has also undergone
significant changes in the way raw materials are priced. Historically miners offered fixed annual contracts
for iron ore and coking coal. However, as a spot market developed over the years, this gave mills an
incentive to default on their long-term contracts when spot prices were falling. As a consequence longterm price agreements have been replaced by short-term agreements that reference spot market terms. For
steel mills this causes substantially higher earnings volatility, as raw material price fluctuations are
instantly reflected in steel prices, which in turn causes steel users to adjust their inventory more
aggressively. Further important changes for the industry were much higher raw material costs, which give
backward integrated mills a substantial cost advantage, and the development of steel price indices that
substantially improved price transparency. Historically, steel has been seen as a regional industry but we
think that through the changes mentioned above the industry is now feeling the full force of globalisation.
While shipments are, indeed, mostly intraregional due to high transportation costs, steel prices across
regions are highly correlated and import pressure keeps prices relatively closely aligned.
Valuation
Industrial metals
Mining companies tend to trade strongly on cash flow generation, with EV/EBITDA multiples relatively
static through the cycle. Longer-run cash flow measures such as DCF/NPV are also commonly used
(often based on mine-life expectations), although these valuation approaches are less anchored than one
might at first expect, as consensus expectations for commodity prices are dragged up and down by
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movements in spot prices for commodities. Over the long run, major miners have typically traded at
around 90% of the broader market multiple, with a normalised absolute P/FE of 9-11x, although during
periods of risk aversion by the equity market, the level can fall to as low as 5-6x.
Book valuation metrics are less relevant for the miners, in part due to the slow asset turns in the industry.
Some miners are operating assets that have been in production for decades and are carried at a heavily
depreciated book value, while others, which have made large acquisitions, have a revalued book.
Consequently, comparisons on book value metrics can be difficult. Write-downs to historical book values
have not been a negative catalyst for stocks in recent years.
Precious metals
Valuation in the gold mining industry is typically done using DCF methodology, although some analysts
use P/CF and PE as well. The key difficulty of using shorter-term valuation ratios (such as PE and P/CF)
is that they generally fail to capture the longer-term value creation from the large amounts of capital the
industry spends on new developments and extension projects. Many analysts using DCF methodology
tend to forecast very low long-term gold prices which, together with flat or increasing costs, results in
misleadingly low valuations. HSBC uses a proprietary gold price forecasting model which captures
information from the upward-sloping forward pricing curve availability (offset by long-term inflation)
and explicit three-year forecasts.
Steel
For steel companies, as industrial companies with defined plant and equipment, book values are more
relevant and the sector has historically traded at 1.1x P/book. Although earnings multiples are very
volatile through the cycle, a 10x forward PE seems to work well as a rule of thumb, and consensus sees a
5.5x EV/EBITDA multiple as normal. However, we think that globalisation effectively acts as
deconsolidation by the back door, which could compress multiples in future.
European metals & mining: growth and profitability (calendarised data)
Growth
Sales
EBITDA
EBIT
Net profits
Margins
EBITDA
EBIT
Net profit
Productivity
Capex/sales
Asset turnover (x)
Net debt/Equity
ROE
2008
2009
2010
2011
2012e
17.4%
20.5%
-1.9%
-5.3%
-24.2%
-40.4%
-53.7%
-58.8%
15.7%
37.5%
91.9%
109.1%
15.2%
20.8%
13.4%
4.0%
3.0%
5.2%
21.1%
23.7%
27.1%
17.5%
11.6%
21.3%
10.7%
6.3%
25.4%
17.7%
11.4%
26.6%
17.5%
10.3%
27.2%
20.5%
12.4%
10.0%
1.63
0.64
24.9%
11.6%
1.13
0.40
9.2%
10.5%
1.18
0.26
16.0%
10.7%
1.23
0.29
15.1%
13.2%
1.16
0.34
17.9%
Note: based on all HSBC coverage of European metals and mining sector
Source: Company reports, HSBC estimates
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EMEA Equity Research
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July 2012
Sector snapshot
Core industry driver: commodity price drives equity
performance
Key sector stats
4.5% of MSCI Europe
600
500
Correlation - 94%
400
300
200
100
Stocks
1
2
3
4
5
6
7
8
9
10
Rio Tinto
BHP Billiton
Anglo American
Xstrata
Glencore
Arcelormittal
Fresnillo
Antofagasta
Norsk Hydro
Randgold Resources
Index weight
17.0%
15.8%
12.2%
11.4%
10.0%
5.8%
4.4%
4.4%
2.4%
2.3%
Jun12
Jun11
Jun10
Jun09
Jun08
Jun07
Jun06
Jun02
LME Index
Top 10 stocks: MSCI Europe Metals & Mining Index
Stock rank
Jun05
0
Source: MSCI, Thomson Reuters Datastream, HSBC
Jun04
Trading data
5-yr ADTV (EURm)
1,871
Aggregated market cap (EURm)
293,045
Performance since 1 Jan 2000
Absolute
+73%
Relative to MSCI Europe
+162%
3 largest stocks
Rio Tinto, BHP Billiton, Anglo
Correlation (5-year) with MSCI Europe
0.88
Jun03
MSCI Europe Metals & Mining
Index
MSCI Global M&M Index
Source: MSCI, Thomson Reuters Datastream, HSBC
PE band chart: MSCI Europe Metals & Mining Index
1,000
Price level
800
15x
Actual
600
10x
400
Source: MSCI, Thomson Reuters Datastream, HSBC
200
5x
Country breakdown: MSCI Europe Metals & Mining Index
2012
2011
2010
2009
2008
2007
84.2%
5.8%
2.7%
2.4%
1.5%
1.5%
1.2%
0.7%
2006
UK
France
Germany
Norway
Belgium
Sweden
Austria
Spain
0
2005
Weights (%)
2004
Country
Source: MSCI, Thomson Reuters Datastream, HSBC
PB vs. ROE: MSCI Europe Metals & Mining Index
32%
4x
24%
3x
16%
2x
8%
1x
0%
0x
Fw d ROE
Source: MSCI, Thomson Reuters Datastream, HSBC
170
Fw d P/B-RHS
2012
2011
2010
2009
2008
2007
2006
2005
2004
Source: MSCI, Thomson Reuters Datastream, HSBC
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EMEA Equity Research
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July 2012
Oil & gas
Oil & gas team
Sector sales
David Phillips*
Global Co-Head of Oil and Gas
HSBC Bank plc
+44 20 7991 2344
david1.phillips@hsbcib.com
Annabelle O’Connor
Sector Sales
HSBC Bank plc
+44 20 7991 5040
annabelle.oconnor@hsbcib.com
Paul Spedding*
Global Co-Head of Oil and Gas
HSBC Bank plc
+44 20 7991 6787
paul.spedding@hsbcib.com
Peter Hitchens*
Analyst
HSBC Bank plc
+44 20 7991 6822
peter.hitchens@hsbcib.com
Anisa Redman
Analyst
HSBC Securities (USA) Inc.
+1 212 525 4917
anisa.redman@us.hsbc.com
Phillip Lindsay*
Analyst
HSBC Bank plc
+44 20 7991 2577
phillip.lindsay@hsbcib.com
Ildar Khaziev*
Analyst
OOO HSBC Bank (RR)
+7 495 645 4549
ildar.khaziev@hsbc.com
Bulent Yurdagul *
Analyst
HSBC Yatirim Menkul Degerler A.S.
+90 212 376 4612
bulentyurdagul@hsbc.com.tr
John Tottie*
Analyst
HSBC Saudi Arabia
+966 1299 2101
john.tottie@hsbc.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
171
172
Integrated
players
(upstream,
downstream,
transportation,
petrochemicals)
Upstream (E&P)
Europe
Europe
BG
Afren
RD Shell
Statoil
EnQuest
BP
Tullow
Soco International
Total
Ophir Energy
Salamander Energy
ENI
Premier Oil
Heritage Oil
Repsol
Cairn Energy
JKX
OMV
Gulf Keystone
Exillon
Genel Energy
Melrose
Emerging markets
Gazprom
Emerging markets
Petrobras
Novatek
Kazmunaigas EP
Rosneft
OGX
Dana Gas
Lukoil
Tatneft
Surgutneftegaz
MOL
Asia
Asia
CNOOC
PTT E&P
ONGC
Santos
Cairn India
Woodside Petroleum
Oil India
Petrochina
Sinopec
US
Reliance Industries
ConocoPhillips
Encana
PTT
Anadarko
Talisman Energy
Apache
Cheasapeake Energy
EOG Resources
Nexn
US
Oilfield services (OFS)
Independent players
Devon Energy
ChevronTexaco
Marathon Oil
Newfield Exploration
Europe
Neste
ERG
Saras
Petroplus
Statoil Fuel & Retail
Emerging markets
PKN
Hellenic Petroleum
Motor Oil Hellas
Tupras
Oil Refineries
Ayagaz
Petro Rabigh
Aldrees Petroleum
Turcus
Asia
S Oil
SK Innovation
GS Holdings
Indian Oil
BPCL
HPCL
Formosa Petrochem
Thai Oil
US
Valero
Marathon Petroleum
Phillips66
Seismic
Drilling
Subsea & offshore
equipment
CGGVeritas
Transocean
Technip
FMC
Schlumberger
Noble
Saipem
Cameron
PGS
Diamond
KBR
Aker Solutions
TGS Nopec
Seadrill
Fluor
Dril-Quip
Ion
Ensco
CB&I
Technip
Polarcus
Rowan
Petrofac
National Oilwell Varco
Fugro
North Atlantic Drilling
Kentz
GEVetco
BGP/CNPC
COSL
Lamprell
Nexans
Nabors
Amec
Prysmian
Hercules
Maire Technimont
Oceaneering
Seahawk
Aker Solutions
Ezra Holdings
Saipem
Kvaerner
Subsea 7
Fred Olsen Energy
Subsea 7
McDermott
North Atlantic Drilling
McDermott
Saipem
Ocean Rig
Floating
production
Supply vessels
Fugro
Well services
Diversified
SBM Offshore
Bourbon
Schlumberger
Saipem
BW Offshore
Tidewater
Halliburton
Technip
Modec
Farstad
Weatherford
Aker Solutions
OSX
Solstad
Baker Hughes
Bumi Armada
Edison Chouest
Hunting
National Oilwell
Varco
Sevan Marine
Swire
Core Labs
Ezra
Weir Group
Superior Offshore
Schoeller Bleckmann
Trico Marine
Fugro
Siem Offshore
Cal Dive
Gulfmark Offshore
Source: HSBC
E&C
China Oilfield
Services
Tenaris
Vallourec
Fugro
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ExxonMobil
Downstream
(R&M)
EMEA Equity Research
Multi-sector
July 2012
Sector structure
25
120%
2003 Iraq war The
23
American-led inv asion of Iraq
cut resulted in cut in OPEC
spare capcity
21
2005- Hurricanes Katrina
110%
& Rita SPR released
9.8mmbbl
EMEA Equity Research
Multi-sector
July 2012
Sector price history: Global oil sector PE and PE relative to market (IBES year 2 consensus)
2011 (end) Iran
threat
19
2008 (end) Onset of
100%
recession
2010 (end) Start of Arab
Spring
17
2005-08 Sharp increase in demand
from Asia
15
90%
13
80%
11
1997 Asian financial crisis
The Asian Financial Crisis combined
w ith a 10% quota increase by OPEC
9
resulted in low er oil price through
December 1998
70%
1999 Series of OPEC cuts
7
(4.2Mbbl/d) supported oil price
2006 Lebanon war After Israel launched attacks on
rise
Lebanon, oil prices reached a new high of USD78/bbl
2009 (beginning) OPEC cut of 4.2mbbl/d helped oil
price to stabilise
5
Feb-95
60%
Feb-97
Feb-99
Feb-01
Global Oil Sector: Year 2 PE
Feb-03
Feb-05
Feb-07
Feb-09
Feb-11
Global Oil Sector: Year 2 PE Relativ e
Source: Thomson Reuters Datastream, HSBC
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July 2012
2.0
Kentz
1.8
Wood Group
1.6
AKSO
1.4
Lukoil
RD Shell
AMEC
Petrofac
BP
FMC
1.2
Asset turnover (x)
174
Asset turnover versus net margin: 2005-11 average
MOL
Repsol OMV
1.0
Hunting
Lamprell
Total
Statoil
Tatneft
ENI
Fugro
Saipem
Cameron
Surgutneftegas
Technip
Subsea7
0.8
Rosneft
SBM
0.6
KMGEP
Novatek
PGS
CGGV
BG
0.4
Gazprom
Transneft
Bourbon
Seadrill
0.2
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
Net margin (%)
Source: Company data, HSBC
3.0%
3.5%
4.0%
4.5%
5.0%
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EMEA Equity Research
Multi-sector
July 2012
Sector description
The value chain of the oil and gas sector includes the production of oil and gas, transport, refining,
petrochemicals and the marketing of oil and gas products. It can also include power generation. While
integrated players tend to operate across the entire value chain, the independents often only focus on parts of it.
Upstream is the key value generator
Integrated international oil companies (IOCs) view the upstream industry as a key value generator. It
normally accounts for around 70% of their value, but tends to attract more than its fair share of growth
capex. The industry is fairly mature. Annual growth in demand is 1% to 2% for oil and 2% to 3% for gas.
Growth tends to be higher in non-OECD regions and can be flat or even negative in parts of the OECD
(Organisation for Economic Co-operation and Development). As the existing production base declines on
average by 3-5% a year, the industry needs to add new productive capacity equivalent to 5% to 7% of
existing production in order to achieve growth in net capacity of 1% to 2% annually. Development of this
new capacity often involves long lead times, typically 5-10 years from discovery to first production. For
larger projects, the lead time can be considerably longer. The industry is also capital-intensive, with some
of the majors spending in excess of USD25bn a year. We estimate that the industry spends around
USD1trn a year on maintenance and growth capital expenditure. Oil companies also face tightening fiscal
regimes and the threat of resource nationalism as host governments seek to maximise their return from oil
and gas discoveries. Because of their size, the international oil companies tend to focus on very large
projects such as integrated gas (such as LNG) or tar sands. The capital-intensive nature of these can
reduce project returns. In contrast, the independents are more focused on conventional plays. They are
also more ready to exit projects by selling or farming-down should capital requirements prove
challenging. This can mean that the independents have a better return on capital than the majors.
abc
Paul Spedding*
Global Co-head of Oil & Gas
HSBC Bank plc
+44 20 7991 6787
paul.spedding@hsbcib.com
David Phillips*
Global Co-head of Oil & Gas
HSBC Bank plc
+44 20 7991 2344
david1.phillips@hsbcib.com
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
Downstream – oversupply a problem
Following the decline in demand in 2008, the refining industry has suffered from oversupply, which has been
exacerbated by capacity additions in Asia over the past two years. The industry’s reaction has been to reduce
capacity in the OECD through closures (some temporary) and disposals. Most of the investment in this sector is
in growth regions, such as Asia, or in countries with advantaged feedstock, such as Saudi Arabia.
Oil services – cyclical but a distinction in exposure to long and short cycles
Oilfield services are diverse; some are asset-heavy, some asset-light. The main sub-sectors are seismic, drilling,
engineering and construction, subsea/offshore equipment and construction, supply vessels, floating production,
and well services. One distinction between the different parts of the sector is cyclicality. All areas are cyclical,
but some have longer cycles (related to capex), others shorter cycles (related to operating expenditure and
exploration activity). The equity-listed structure of the global oilfields services sector is, unsurprisingly, more
developed in the Western world, but it is likely to become increasingly important (as a traded sector) in
emerging markets, particularly Latin America and Asia. The oil service industry is a large-cap sector in the US
and a mid-cap sector in Europe. In Europe, the sector has high exposure to capex trends (long cycle) and to
offshore activities, which drive 75% to 80% of earnings. In the US, the sector is weighted more towards well
services (onshore and offshore) and drilling.
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Key themes
Access to resources
With most of the world’s easily accessible hydrocarbon basins already licensed, the competition for new
oil and gas acreage has intensified over the past decade. National oil companies (NOCs) often have
priority access to domestic acreage and are also seeking to expand internationally. This often limits the
acreage that international oil companies (IOCs) can access. This has meant that the IOCs have begun to
take greater risks with their exploration and also increased their focus on unconventional oil and gas
projects, areas in which the NOCs have less experience.
Move to unconventional oil and gas
Unconventional gas plays such as coal bed methane (CBM) and shale gas offer low exploration risk but
can face challenging economics. In the US, the depressed gas price has meant most shale gas projects are
marginal at present. With CBM, the challenge is to get the gas to market, often necessitating major
pipeline projects or an LNG plant. Production from unconventional oil plays, such as shale oil or tar
sands, is rather more straightforward but can prove very capital-intensive should an upgrading unit be
needed to raise the quality of the heavy oil.
Higher risk exploration
The oil majors and independents have increased the level of risk in their exploration programmes over the
past two to three years by increasing the scale of their acreage applications. They have also moved into
more challenging areas where costs are commensurately higher, such as ultra-deep water and the Arctic.
This strategy has had mixed results, with successes in Brazil, East and West Africa and Northern Norway
but failures in Greenland, Namibia and Cuba.
Portfolio rationalisation to improve returns and growth prospects
Most international oil majors find it difficult to deliver material growth due to their size. Independents
find it much easier to deliver growth as a single discovery can be material for the smaller players. Some
of the larger majors have chosen to rationalise their portfolios with some of the proceeds being returned to
shareholders in the form of dividends or share buybacks. As well as increasing shareholder returns, it also
reduces the size of the company, leveraging any growth that is delivered. This strategy is known as
shrink-to-grow and, in some cases, has led to a re-rating of the companies that pursue it.
Long-term cyclicality
Although demand for oil products and gas can change quite quickly, the long lead times (5-10 years) for new
production or refining capacity in the oil industry can mean incremental supply often lags increases in demand.
The cyclical behaviour this can produce is more pronounced in the refining industry. There is also cyclical
behaviour in the upstream part of the industry, as seen in 2008 and 2009, but the presence of OPEC (the
Organisation of Petroleum Exporting Countries) helps keep the oil price stable for much of the time.
Refining: OECD versus non-OECD
OECD refiners face flat to declining demand for oil products and the potential impact of carbon pricing.
They also tend to be higher cost. In contrast, Middle East refiners have the advantage of access to own
crude oil and those in non-OECD Asia have easy access to growth markets. Asian and Middle East
refineries tend to be lower-cost operations due to greater scale and lower personnel costs in those regions.
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Sector drivers
Realisation and margin are key drivers
For most companies, realisations for oil and gas together with refining and marketing margins are more
important drivers of earnings than volume growth. For most companies, short-term movements in their
share prices are influenced by the oil price. The degree of sensitivity to the oil price varies among
different types of companies. For example, the shorter-cycle service companies and independent
exploration companies tend to be more sensitive to moves in crude and gas prices than the majors.
Oil prices – OPEC remains in a position to control prices
Although growth in demand in 2011 and so far in 2012 has remained well below normal levels, we believe it
will recover in 2013 and grow at around 1.6-1.7 million barrels a day each year. Crude supplies from nonOPEC are likely to increase at around two-thirds of this rate, meaning that OPEC will be called upon to make
up the shortfall. It will add new capacity over the next several years, much of it in Iraq. This should enable
OPEC to maintain a reasonable level of spare capacity. Saudi Arabia has already demonstrated its willingness
to act as swing producer to try and stabilise oil prices. It has indicated that it sees prices around USD100/barrel
as acceptable, but we calculate that instability in the Persian Gulf and North Africa has, at times, resulted in a
political premium of up to USD25/barrel. A price of USD100/barrel is high enough to meet the financial needs
of most OPEC countries but low enough to avoid further destabilising world economies. It is also below the
economic threshold for unsubsidised alternative-energy projects (a threat to OPEC).
Gas price – oil price linkage to remain outside the US
Globally, around 40% of natural gas is exposed to gas-to-gas competition (primarily in the US market),
40% is regulated and only 20% has a direct or indirect link to oil prices (Europe and Asia). Although the
proportion of spot sales has increased in Europe due to soft demand, we believe Europe’s gas prices will
retain some degree of oil linkage although the element of spot pricing is likely to gradually rise. We also
believe gas prices in Asia are likely to retain their link to oil prices because of the need for long-term
projects to ensure security of supply. We believe the US is likely to remain a low-price market due to
rising shale-gas production. Shale gas exists elsewhere in the world but the lack of a US-sized oil service
industry (land rigs and fracturing) means it is unlikely to see the same rate of growth as the US. Also, in
some countries with high population densities, protests have led to bans on fracturing activity.
Refining – oversupply
We do not expect the current overcapacity in the market to be eroded in the next five years unless largescale closures take place. For the balance of the decade, we believe increases in demand will be met from
new capacity additions, mainly in Asia and the Middle East. We expect OECD refining profitability to
remain at the low end of its normal range, while Asian and Middle Eastern refiners should benefit most
from rising non-OECD demand growth.
Service sector – capex trends the key
For the service sector, the key is the trend in oil industry capital expenditure. Much of the increase in
spending during 2006-08 was driven by inflation rather than activity. There is, therefore, the potential for
further ‘capex catch-up’. Offshore activity is driven mainly by areas like Brazil, West Africa, the North
Sea, Australasia and the US Gulf. Onshore is driven more by the Middle East and Australasia for capexrelated work, and the existing oil-producing areas North/South America, the Middle East/North Africa
and parts of Asia/FSU for opex-related work.
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Valuation
Short-term sentiment
As oil and gas prices are a major influence on earnings and cash flow, it should be no surprise that movements
in realisations have a material influence on the sector’s performance. In the longer term, the level of the sector’s
cash flow and earnings relative to those of the rest of the market has more influence on its relative performance.
(For example, it is possible for industry earnings to fall despite rising oil prices should costs or taxes increase
sharply.) The sector is seen by some investors as defensive due to its above-average yield and predictability of
future production volumes, which can mean it outperforms during weak markets.
Valuation approaches
There are significant differences in the approaches followed to value integrated large players and small
independent players.
Integrateds – earnings and cash-flow multiples
The large integrated players tend to be valued using traditional multiples (PE, EV/NOPAT, P/CF,
EV/DACF multiples). After-tax valuations are used because the rates of tax can vary markedly from
country to country. One of the key variables in valuations is the oil price. Some investors prefer to use the
price indicated by the futures market, but others prefer to use their own forecasts. The most common
valuation approach used is PE-based, in our view. The long-run PE for the sector is around 80% relative
to the market. Given the tangible nature of oil industry assets, the price-to-book (PB) ratio is also a useful
check to valuation, especially during periods of market weakness.
Sum-of-the-parts (SOTP) valuations are also used, especially for companies with a material proportion of
undeveloped reserves. Upstream assets tend to be valued using discounted cash flow (DCF) analysis or by
using comparable transaction values. Downstream assets are valued using per barrel approaches based on
market transactions adjusted for complexity, size and location. Other assets, such as marketing, can be valued
on a multiple basis – either earnings or cash-flow based – using comparable companies as a reference point.
Upstream companies – per barrel valuations or DCF
Upstream companies tend to be valued using net asset values. This can involve a DCF valuation of the
existing assets or could use a simple per barrel valuation of reserves based on comparable companies or
recent transactions. Exploration assets can be valued on a similar basis but with a risk factor to reflect the
likelihood of success and the difficulty of commercialisation.
Downstream companies – SOTP and multiples
Downstream companies are normally valued on a multiple or SOTP basis. Unlike for the majors, pre-tax
multiples such as EV/EBIT or EV/EBITA can be used as there is less variation amongst tax rates in
different countries than there is in the upstream.
Oil service – SOTP and multiples
Given the diversity of the service sector, the range of valuation approaches is also diverse. For the assetbased companies (such as rig owners), the SOTP methodology is often used, with individual assets being
valued at the replacement cost or by using comparable companies as reference. For asset-light companies,
multiple-based approaches can be employed, both pre-tax and post-tax. For companies with highly
cyclical businesses, mid-cycle valuation approaches can be used.
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Oil & gas sector: growth and profitability
Growth
Sales
EBITDA
EBIT
Net profit
Margins
EBITDA
EBIT
Net profit
Productivity
Capex/sales
Asset turnover (x)
Net debt/Equity
ROE
2008
2009
2010
2011
2012e
27%
17%
18%
12%
-31%
-27%
-38%
-38%
23%
23%
32%
32%
27%
26%
37%
32%
-9%
-5%
-6%
-4%
19%
15%
9%
21%
13%
8%
20%
14%
9%
20%
15%
9%
21%
16%
10%
10%
1.2
22%
23%
14%
0.8
27%
13%
11%
0.8
24%
16%
10%
0.9
22%
18%
11%
0.8
16%
15%
Note: Based on all HSBC coverage of Oil & Gas Sector in Europe and Emerging Europe (excludes upstream mid-cap independents)
Source: company data, HSBC estimates
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Sector snapshot
Core industry drivers: OPEC spare capacity (LHS, million
barrels/day) and Brent price (RHS, USD/bbl)
Key sector stats
MSCI Europe Energy Dollar Index
Trading data
5-yr ADTV (EURm)
Aggregated market cap (EURm)
Performance since 1 Jan 2000
Absolute
Relative to MSCI Europe US Dollar
3 largest stocks
Correlation (5-year) with MSCI Europe
US Dollar
12.55% of MSCI Europe
US Dollar
2,778
782
36%
44%
RD Shell, BP, Total
0.95
Source: MSCI, Thomson Reuters Datastream, HSBC
Stocks
1
2
3
4
5
6
7
8
9
10
ExxonMobil
RD Shell
Chevron
BP
Total
Schlumberger
BG
Occidental
ConocoPhillips
Gazprom
135
5
115
4
95
3
75
2
55
1
35
0
15
2001
2003
2005
2007
2009
OPEC effctiv e spare capacity
Top 10 stocks: MSCI All Country World Index Energy Dollar
Index
Stock rank
6
2011
Brent (RHS)
Source: US Energy Information Administration, HSBC
Index weight
13.6%
7.0%
6.9%
4.2%
3.3%
3.1%
2.4%
2.3%
2.3%
1.7%
PE band chart: MSCI All Country World Index Energy Dollar
Index, Year 2 forward
600
500
15x
400
300
10x
200
Source: MSCI, Thomson Reuters Datastream, HSBC
5x
100
Country breakdown: MSCI All Country World Index Energy
Dollar Index
0
Country
Weights (%)
US
UK
Canada
Russia
France
China
Brazil
Italy
Australia
47.4
14.8
10.6
4.0
3.8
3.7
2.9
2.4
1.9
Source: MSCI, Thomson Reuters Datastream, HSBC
2001
2003
2005
2007
2009
2011
Source: MSCI, Thomson Reuters Datastream, HSBC
PB (LHS) and ROE (RHS): MSCI All Country World Index
Energy Dollar Index, Year 1 forward
3.0
24
22
2.5
20
18
2.0
16
14
1.5
12
1.0
10
2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: MSCI, Thomson Reuters Datastream, HSBC
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Telecoms, media &
technology
Telecoms, media & technology
team
Global TMT
Stephen Howard*
Head, Global TMT Research
HSBC Bank plc
+44 20 7991 6820
stephen.howard@hsbcib.com
Europe
Nicolas Cote-Colisson*
Head, European Telecoms & Media
HSBC Bank plc
+44 20 7991 6826
nicolas.cote-colisson@hsbcib.com
Luigi Minerva*
Analyst
HSBC Bank plc
+44 20 7991 6928
luigi.minerva@hsbcib.com
Dominik Klarmann*, CFA
Analyst
HSBC Trinkaus & Burkhardt AG, Germany
+49 211 910 2769
dominik.klarmann@hsbc.de
Adam Rumley*
Analyst
HSBC Bank plc
+44 20 7991 6819
adam.rumley@hsbcib.com
Christopher Johnen*
Analyst
HSBC Trinkaus & Burkhardt AG, Germany
+49 211 910 2852
christopher.johnen@hsbc.de
Antonin Baudry*
Analyst
HSBC Bank Plc, Paris branch
+33 156 524 325
antonin.baudry@hsbc.com
Sector sales
Tim Maunder-Taylor
Head, European Specialist Sales
HSBC Bank plc
+44 20 7991 5006 tim.maunder-taylor@hsbcib.com
Gareth Hollis
HSBC Bank plc
+44 20 7991 5124 gareth.hollis@hsbcib.com
Kubilay Yalcin
HSBC Trinkaus & Burkhardt AG, Germany
+49 211 910 4880 kubilay.yalcin@hsbc.de
Olivier Moral*
Analyst
HSBC Bank plc, Paris branch
+33 1 56 52 43 22
olivier.moral@hsbc.com
Dan Graham*
Analyst
HSBC Bank plc
+44 20 7991 6326
dan.graham@hsbcib.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
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Telecom, media, technology
Telecom
Media
Technology
Incumbent operators
Global advertising & marketing
Telecom equipment
vendors
Deutsche Telecom
Agencies WPP, Publicis, Aegis
Ericsson, Alcatel-lucent, Nokia
France Telecom
Market research GfK, Ipsos
Telefonica
Outdoor JCDecaux
EMEA Equity Research
Multi-sector
July 2012
Sector structure
Software and services
SAP, Capgemini
BT
KPN
National advertising
Original equipment
manufacturers
Rostelecom
Free-to-air broadcasters (TV & radio)
ITV, ProSiebenSat. 1, TF1,
NRJGroup, TVN
Nokia, Samsung
Alternative network operators
Directories PagesJaunes, Yell,
TeliaSonera
Copper/fibre/mobile
Foundries
TSMC, UMC
Content & services
Publishers Daily Mail, Reed, UBM
Vodafone
Tele2
Iliad
Pay-TV BSkyB, SkyDeutschland
Others Vivendi, Lagardere,
AxelSpringer
MTS
Vimplecom
Networks
Cable
Satellite
Inmarsat, SES
Source: HSBC
abc
Virgin Media, KDG,
Telenet
EMEA Equity Research
Multi-sector
July 2012
Telecoms, media and technology 1995-2012: growth, bubble, burst and recession phases
1600
1400
Dot-com bubble
1200
1000
800
600
Macro & emerging markets led grow th
400
Recessionary environment
Pick up of mobile services
200
EUROPE-DS Telecom - TOT RETURN IND (~E )
Jan-12
Jan-11
Jan-10
Jan-09
Jan-08
Jan-07
Jan-06
Jan-05
Jan-04
EUROPE-DS Media - TOT RETURN IND (~E )
EUROPE-DS Technology - TOT RETURN IND (~E )
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Note: Total return includes share price performance and dividends
Source: Thomson Reuters Datastream indices, HSBC
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
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60.0%
Maroc Telecom
55.0%
Sonatel
50.0%
Telecom Egy pt
Oman Telecommunication Co
Millicom
Orascom Telecom
Zain Group
MTN Group
45.0%
Turk Telekom
Mobile Telesy stems
Wataniy a Telecom
Telecom Italia
TPSA Sw isscom
Rostelecom
Telefonica CZ
EBITDA margin
184
Capex/sales versus EBITDA margin (2011)
Bezeq
40.0%
KPN
TDC
Safaricom
Etihad Etisalat(Mobily )
Portugal Telecom
Cable & Wireless Comm
35.0%
France Telecom Deutsche Telekom
Vodacom Group
Elisa Corporation
Mobistar
OTE
Telefonica
Vodafone Group
Telenor
Belgacom
30.0%
Tele2
TeliaSonera
M agy ar Telekom
Mobinil
Turkcell
Telekom Austria
British Telecom
Telkom SA
25.0%
Colt Group S.A.
20.0%
Cable & Wireless Worldw ide
Jazztel
15.0%
5%
Source: Company data, HSBC
7%
9%
11%
13%
Capex/Sales
15%
17%
19%
21%
abc
QSC
EMEA Equity Research
Multi-sector
July 2012
Sector description
TMT combines three inter-related sectors
Telecoms
Operators provide fixed and mobile telecommunication services, selling connectivity (eg line rental,
broadband) and services (eg voice, messaging, IPTV) to consumers and corporates. Operators can be split
between incumbents (former monopolies) and alternative operators which have been granted access to the
incumbents’ fixed networks and/or have been buying mobile spectrum and built their own mobile networks.
Media
We identify four sub-sectors within media. (1) Global advertising & marketing includes businesses that are
duplicating their franchise on a global scale and can therefore capture growth opportunities in emerging
economies. These include agencies (creative services, media planning and media buying for global
advertisers), market research (including panel research and surveys) and outdoor (street furniture, billboard
and transport). (2) National advertising includes free-to-air (FTA) broadcasters (TV and radios) and
directories (Yellow Pages). (3) Content and services related companies are the professional publishers
(academic and specialist-trade publications, trade shows, conferences, etc), consumer publishers and also payTV operators. (4) Networks-related companies include satellite and cable operators.
abc
Stephen Howard*
Head, Global TMT Research
HSBC Bank plc
+44 20 7991 6820
stephen.howard@hsbcib.com
Olivier Moral*
Analyst
HSBC Bank plc, Paris branch
+33 1 56 52 43 22
olivier.moral@hsbc.com
Antonin Baudry*
Analyst
HSBC Bank Plc, Paris branch
+33 1 56 524 325
antonin.baudry@hsbc.com
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
Technology
The technology sector is also fragmented and diverse. However, for ease of understanding, we have
divided the sector into four sub-sectors: telecom network equipment vendors, software and services,
original equipment manufacturers (eg handsets) and semiconductors.
TMT
The three constituent sectors are closely linked. Telecom operators rely on technology companies to
maintain and upgrade their networks and also to develop the interfaces between these networks and the
end-users (such as handsets, computers, TVs and tablets). Information technology (IT) plays a critical role
in enhancing efficiency and productivity of businesses by automating processes and processing large
amounts of information for better decision-making. Based on their requirements, companies can either
develop their own software from scratch or may licence the software from an IT software vendor. Media
companies aggregate and monetise content which can then be distributed on these networks. But cooperation can also turn into competition. Telecoms operators have entered the media sector with TV
offerings (IPTV). On the media side, cable/satellite TV operators are vying for telecom customers
through converged service offerings of voice and broadband along with TV. In the technology sector,
device/hardware manufacturers such as Apple have had success in software.
A key characteristic of the telecoms sector is the intrinsically very high barrier to entry. Building a network
is expensive, and scale is the key determinant of success. However, regulators have attempted to
undermine these natural barriers to entry by intervening with measures such as unbundling of the local loop
(in fixed line) or encouraging mobile virtual network operators (MVNOs) so as to enable market entry and
promote competition. In the media space, barriers to entry are less obvious although scale is not easy to
build. In some sub-sectors a broader range of competitors has been brought in by the development of
telecom networks. This applies particularly to free-to-air broadcasters and pay-TV operators, which, we
think, will be smaller businesses in the future. In the tech space, we are observing an extensive reshuffle of
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the dominant players in both networks and devices. The dominant players today are different from those at
the start of the last decade thanks to innovation, which has proved particularly striking with mobile
handsets (eg by introducing touchscreens). Another game-changing factor has been the emergence of wellfunded Chinese vendors, which now compete effectively against the most established names in the
industry. In IT services and software, we observe an increase in demand for Cloud, Mobility, Analytics and
Big Memory.
Key themes
Data demand, capex and pricing power
We identify pricing power as a key theme across the three TMT sectors. This is particularly positive for
the largest telecom operators and negative for the established tech players, with the situation varying for
the different sub-sectors in media. Pricing power encompasses many other themes, such as capex
intensity, barriers to entry and market structure.
Telecoms
We think that the malaise in the telecoms sector has, so far, stemmed from operators’ inability to
transform the growing level of demand (mainly fixed broadband and mobile data) into higher revenue,
while, at the same time, competition and regulation are weighing on profitability. One important, but
generally overlooked issue, we think, is that incremental costs in telecoms services have been too low for
a long time. In the current voice-centric world, the cost of a unit of capacity is negligible, and the
temptation to give it away in pursuit of market share is high. However, this may now change with the
fast-growing demand for new services (eg video-on-demand on fixed line networks and value-added
services on mobile networks): marginal costs are significant for the first time since the TMT bubble.
These higher costs come from the need to invest in the terminal part of the access networks: fibre for
fixed networks, more antennas and spectrum for mobile networks. These higher costs mean that services
cannot be given away. This will fall disproportionately on the most price disruptive players in the market.
And this is precisely what is required for a better pricing environment in the telecoms sector. In fixed line,
as the incumbents deploy fibre, we would expect alternative operators to be forced to abandon their
strategy of unbundling the incumbent’s access network and rely on more expensive wholesale offers. In
mobile, operators with the more dense networks are likely to win over smaller competitors.
Media
In media, pricing power is also a key theme. Scarcity factors vary across the media sector and will determine
companies’ ability to monetise the growing demand. Demand for content is growing and the media sector
has historically commanded a good deal of market power due to the limited number of conduits to the
consumer. However, the ability of existing media owners to monetise this demand for content is declining.
Users can access an increasing level of content as the internet lowers barriers to entry, and are demonstrating
reluctance to pay, and lower tolerance for advertising. This trend is already particularly well established for
consumer publishers, but as the availability of content grows faster than demand this could also depress
yields for other media. As the internet causes barriers to entry across the sector to collapse, we think that the
infrastructure providers and media owners with scarce assets such as cable, satellites and professional
publishers can leverage their position and enjoy pricing power. We also identify agencies as relative winners
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in media despite the absence of significant barriers to entry (other than their existing global scale). We
expect European broadcasters, pay-TV and consumer publishers, which lack scarce assets, to underperform.
Technology
In technology, we see limited pricing power, driven by growing competition from Asia. Network
equipment is highly standardised, which limits the ability of a vendor to leverage its innovation for very
long. Asian vendors, especially Chinese vendors, have been taking share in recent years and are exerting a
strong and continuous pressure on prices in the tender offers. For original equipment manufacturers,
innovation seems to grant strong pricing power to leaders but competition remains fierce. In IT, a
structural shift is taking place in the relationship between clients and vendors, with the vendor not being
just the service provider but also a service aggregator that provides end-to-end services.
Sector drivers
Telecoms
Telecoms operators are subject to many drivers, including the rate of technological innovation, the affordability
and availability of services, and the extent of regulatory intervention. And note that, although the sector is not
highly geared to the economy, it is clearly influenced by both economic and business cycles. The level of
penetration (for fixed broadband and mobile services) is a basic driver for telecoms revenues and is, in turn,
driven by the availability and affordability of services. Although penetration levels are now generally very high
in developed markets, demand in emerging markets (EM) remains untapped and this has traditionally pushed
developed market operators to buy exposure to emerging markets. This trend is gradually reversing as EM
telcos’ financial power has increased drastically. Innovation is often the driving force behind new streams of
revenue, as observed with smartphones and mobile broadband applications. The penetration of smartphones is
still lower in Europe (about 30% at the end of 2011) than in the US (42%), so we see strong potential. With
cheaper smartphones now priced under USD100, we expect smartphones to become mass market in EM in
future years. At this stage we would note that, in order not to see mobile data revenue completely cannibalising
legacy revenue (voice and messaging), operators have to put integrated tariffs in place to remove the incentive
for the client to substitute one for the other; the majority of operators have done this. Regulation also plays a
very important role. It is one of the main drivers in determining competitive intensity, as the regulators decide
the number of licences to be issued and set the level of many tariffs (in particular, those relating to the access
cost of the fixed access network). On the mobile side, the regulators set mobile termination rates (MTRs) and
roaming tariffs, which have a material impact on both revenues and EBITDA. The economic environment also
has an impact on the telecoms sector. Consumer spending is usually less cyclical, while enterprise revenues (eg
roaming and IT contracts) exhibit greater cyclicality. However, we stress that the relatively high margins seen
in the telecom sector mean that, while revenues are tightly linked to the economy, profits and cash flows are
relatively defensive in nature.
Media
Media is a heterogeneous sector which lends itself more to stock-picking than to top-down sector-based
analysis. Still, we see global macro as a strong revenue driver for our global advertising & marketing subsector, especially for agencies and outdoor, and to a lesser extent for market research. The companies included
in our national advertising sub-sector (free-to-air TV and radios, directories) have revenue directly submitted to
GDP growth. For content and services, revenues are more subscription-based than advertising-based so are less
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July 2012
sensitive to GDP volatility, although consumer publishers tend to be more exposed. However, we think that an
important driver will be the pace of development of over-the-top (OTT) content for pay-TV operators and the
move to digital (and its new modes of revenue-sharing involved) for consumer publishers.
Technology
For the telecoms equipment vendors, we focus on the factors driving the operators’ capital expenditures,
while for the semis, we focus on the capacity utilisation rate, ASPs (average selling price determined by
technological advance and the level of competition) and shipments to assess the likely trajectory of the
top line. Given the cyclical nature of the semiconductor business, we are cautious about
inventory/capacity build-ups and/or slowdowns in the order book. For original equipment vendors, the
driver is the ability of the telecom operators to build the right platforms which encourage new usages.
Last, for software and services, GDP growth is the key driver.
Valuation
DCF is our principal method to assess the value of the TMT companies
We believe discounted cash flow (DCF) methodology is the most appropriate method to value companies
in the telecom, media and tech sectors. Traditional relative valuation metrics, such as the forward-looking
price-to-earnings and EV/EBITDA ratios, are also considered useful. In addition, in the developed
countries, investors focus on free cash flow (FCF) yield and dividend yield, since top-line growth is
usually muted. Most of the incumbent telcos have dividend yields greater than those of sovereign bonds.
The telecoms sector’s trading multiples have deteriorated over the last few years owing to general market
weakness, and lower sector growth. Emerging market players and developed market companies with
significant emerging market exposure enjoy higher multiples, due to higher growth potential. Over 200608, the average trading PE multiple for the developed market telecom players was 13x, against c16x for
the emerging market players. Over 2009-11, both developed and emerging market PEs have fallen (to 11x
and 14x, respectively), although emerging market players continue to command a premium.
Spectrum costs are lumpy in nature and can take a substantial bite out of operators’ FCF. Unfortunately,
the magnitude and timing of spectrum costs are inherently difficult to predict. Note that they are often
excluded from clean FCF forecasts. The incumbent telecoms operators have large numbers of employees
and, in a few cases, large pension funds. The deficits of some of these funds, BT’s above all, can be very
large – and so become an important valuation driver. In many of the emerging markets regulatory/
political risk is significant, especially for foreign players.
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European and CEEMEA telecoms: growth and profitability
2008
2009
2010
2011a
2012e
Growth
Sales
EBITDA
EBIT
Net profits
5.7%
3.7%
4.0%
9.7%
-0.6%
-1.8%
-8.4%
-0.5%
0.0%
1.9%
7.5%
-0.2%
1.4%
-0.2%
-6.5%
-5.5%
0.1%
-1.9%
2.7%
1.6%
Margins
EBITDA
EBIT
Net profit
33.0%
17.6%
11.1%
32.6%
16.2%
11.1%
33.2%
17.4%
11.1%
32.7%
16.1%
10.3%
32.0%
16.5%
10.5%
Productivity
Capex/sales
Asset turnover (x)
Net debt/equity
ROE
15.0%
1.74
0.85
16.5%
14.1%
1.69
0.87
16.0%
12.6%
1.70
0.79
15.4%
13.2%
1.74
0.84
14.5%
13.9%
1.75
0.80
15.0%
2008
2009
2010
2011a
2012e
Growth
Sales
EBITDA
EBIT
Net profit
7.1%
8.5%
-1.8%
-6.2%
4.6%
2.3%
-3.6%
-13.0%
3.7%
8.7%
28.3%
41.0%
4.4%
4.8%
7.1%
20.1%
5.0%
6.8%
17.2%
11.8%
Margins
EBITDA
EBIT
Net profit
26.7%
13.2%
7.2%
26.1%
12.2%
6.0%
27.4%
15.1%
8.1%
27.5%
15.5%
9.4%
28.0%
17.3%
10.0%
Productivity
Capex/sales
Asset turnover (x)
Net debt/equity
ROE
11.9%
1.99
1.70
14.2%
11.5%
2.04
1.67
12.9%
10.6%
2.11
1.28
16.7%
13.4%
2.01
1.28
18.1%
11.1%
2.06
1.23
19.5%
Note: Based on all HSBC coverage of European and CEEMEA telecoms
Source: Company data, HSBC estimates
European media: growth and profitability
Note: Based on all HSBC coverage of European media
Source: Company data, HSBC estimates
European technology (including IT software services): growth and profitability
Growth
Sales
EBITDA
EBIT
Net profit
Margins
EBITDA
EBIT
Net profit
Productivity
Capex/sales
Asset turnover (x)
Net debt/equity
ROE
2008
2009
2010
2011a
2012e
2.0%
-1.9%
-44.5%
-13.6%
-11.6%
-26.7%
8.0%
-40.7%
3.8%
10.1%
38.9%
30.5%
2.8%
3.0%
-9.7%
-8.6%
1.9%
-6.6%
5.8%
-9.1%
14.4%
4.7%
8.4%
11.9%
5.7%
5.6%
12.6%
7.6%
7.0%
12.7%
6.7%
6.3%
11.6%
6.9%
5.6%
2.6%
14.7
-0.14
19.5%
2.2%
16.2
-0.24
12.3%
2.3%
16.1
-0.24
15.6%
2.3%
15.6
-0.25
13.7%
2.5%
17.5
-0.28
12.1%
Note: Based on all HSBC coverage of European technology
Source: Company data, HSBC estimates
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July 2012
Sector snapshot
Core industry driver: Vodafone smartphone penetration and
mobile data growth
Key sector stats
MSCI Europe Diversified Telecoms
Services and MSCI Europe Wireless
Telecoms Services
Trading data
5-yr ADTV (EURm)
Aggregated market cap (EURbn)
Performance since 1 Jan 2000
Absolute
Relative to MSCI Europe
3 largest stocks
Correlation (5-year) with MSCI Europe
6.43% of MSCI Europe
1,500
60%
50%
40%
30%
20%
10%
0%
1,000
1,948
321
500
-49%
-40%
VOD, TEF, DT
0.92
–
Q1
Q3
Q1
Q3
Q1
Q3
Q1
2009 2009 2010 201 0 2011 2011 2012
Source: MSCI, Thomson Reuters Datastream, HSBC
Mobile data rev enu e, GBPm (LHS)
Mobile data rev enu e grow th, y -o-y (RHS)
Smartphone penetr ation (RHS)
Top 10 stocks: MSCI Europe Diversified Telecoms Services and
MSCI Europe Wireless Telecoms Services
Stock rank
Stocks
1
2
3
4
5
6
7
8
9
10
Vodafone Group plc
Telefonica SA
Deutsche Telekom AG
France Telecom SA
TeliaSonera AB
BT Group plc
Telenor ASA
Vivendi SA
Swisscom AG
KPN
Index weight
28.9%
11.2%
9.4%
7.4%
5.8%
5.5%
5.3%
4.6%
4.1%
3.0%
Source: Vodafone, HSBC
PE band chart: MSCI Europe Diversified Telecoms Services
120
100
15
80
10
60
x
40
5
Source: MSCI, Thomson Reuters Datastream, HSBC
20
0
2001
Country breakdown: MSCI Europe Diversified Telecoms Services
and MSCI Europe Wireless Telecoms Services
Country
UK
France
Spain
Germany
Sweden
Norway
Switzerland
Italy
Netherlands
Source: MSCI, Thomson Reuters Datastream, HSBC
Weights (%)
35.0%
13.6%
11.2%
9.4%
9.0%
5.3%
4.1%
3.3%
3.0%
2003
2005
2007
2009
2011
Source: MSCI, Thomson Reuters Datastream, HSBC
PB vs. ROE: MSCI Europe Diversified Telecoms Services
3.0
25
2.5
20
2.0
15
1.5
1.0
10
2004 2 005 200 6 2007 2008 2 009 20 10 2011 2012
F w d P B (L H S )
Source: MSCI, Thomson Reuters Datastream, HSBC
190
R O E % (R H S )
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EMEA Equity Research
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July 2012
Transport & logistics
Transport & logistics team
Andrew Lobbenberg*
Analyst
HSBC Bank Plc
+44 20 7991 6816
andrew.lobbenberg@hsbcib.com
Julia Winarso*
Analyst
HSBC Bank Plc
+44 20 7991 2168
julia.winarso@hsbcib.com
Joe Thomas*
Analyst
HSBC Bank Plc
+44 20 7992 3618
joe.thomas@hsbcib.com
Achal Kumar*
Analyst
HSBC Bank Plc
+91 80 3001 3722
achalkumar@hsbc.co.in
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
191
192
Transport
Airline s
Network
carriers
Infras tructure
Low-co st
carriers
Air France-KLM
easyJet
British Aiways
Ryanair
Lufthansa
Air Berlin
SAS
Norweigen
Finnair
Vueling
Aeroflot
Aer Lingus
THY
F lybe
Royal
Jordanian
Air Arabia
Airports
Aeroports
de Paris
Fraport
Zurich
Toll
roads
Abertis
Atlantia
Brisa
Groupe
Eurotunnel
Vinci
Logistics/Shipping
Ports
Integrators
Freight
forwarders
Hanburg
Hafen
Deutsche PostDHL
DP World
FedEx
Kuehne &
Nagel
TNT
Panalpina
UPS
DSV
UK bus and rail
Shipping
AP MollerMaersk
TUI AG
Frontline 2012
Rail
operators
EMEA Equity Research
Multi-sector
July 2012
Sector structure
Bus
operators
FirstGroup
Go-Ahead
National Express
Stagecoach
Frontline
Golden Ocean
Source: HSBC
abc
200
Rebound and sustained bull market
with higher liquidity and business
momentum
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Relative stock performance: 10-year performance of MSCI European transport index, MSCI European equity, MSCI World
transport index and MSCI World equity index
Financial crisis due to
over securitisation of risk
160
140
9/11 WTC, NY attack
120
100
80
60
Running Euro
concerns
January 2003
End of Bear market (2000-02)
40
May -00
May -01
May -02
May -03
MSCI World index
May -04
May -05
MSCI Europe transport index
May -06
May -07
May -08
MSCI Europe index
May -09
May -10
May -11
May -12
MSCI World transport index
Source: MSCI, Thomson Reuters Datastream, HSBC
abc
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EMEA Equity Research
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July 2012
60%
FHZN
50%
VIEV
ADP
40%
EBITDAR margin
194
Asset turnover versus EBITDAR margin (2011) – European transport
FRA
30%
RYA
20%
NEX
EZJ
PNL
SGC
FGP
10%
AF
AP
IAG
LH
GOG
DPW
TNTE
0%
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
4.00
4.50
Asset turnover
Source: Company reports, HSBC
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EMEA Equity Research
Multi-sector
July 2012
Sector description
The global transport sector comprises a number of sub-sectors, which often have different economic
characteristics, earnings drivers and valuation references. These sub-sectors are airlines, logistics and
shipping, airports, ports, toll roads, and the bus and rail sector.
Airlines
The air transport industry is a highly cyclical growth industry. Air travel growth generally correlates with
GDP growth, with multipliers in excess of 2x in developing economies and close to one in mature air
transport markets. Within the value chain of air transport, airlines stand out for their sustained track
record of systematic value destruction, in contrast to aircraft manufacturers, airports, distribution systems,
fuel producers and handlers, which typically achieve better profitability.
The industry can be divided into business models:
Full-service network carriers operate short-haul, medium-haul and long-haul networks, offering
connecting opportunities at their hubs. They are often long-established businesses, which can trace their
heritage back to government-owned companies from the dawn of aviation. They are thus often highly
unionised, and burdened by legacy costs and restrictive working practices. They are complex businesses
offering multiple classes of services on board their aircraft and a range of services on the ground.
Network carriers generally operate cargo businesses as well. Some also operate other aviation-related
businesses such as MRO and catering.
abc
Andrew Lobbenberg*
Analyst
HSBC Bank Plc
+44 20 7991 6816
Andrew.lobbenberg@hsbcib.com
Julia Winarso*
Analyst
HSBC Bank Plc
+44 20 7991 2618
Julia.winarso@hsbcib.com
Joe Thomas*
Analyst
HSBC Bank Plc
+44 20 7992 3618
joe.thomas@hsbcib.com
Achal Kumar*
Analyst
HSBC Bank Plc
+91 80 3001 3722
achalkumar@hsbc.co.in
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
Low-cost carriers are typically younger companies that have emerged over the past 20 years from
industry liberalisation. These companies usually operate point-to-point services within regions. They are
simpler businesses, with structurally lower cost bases, utilising a single-type aircraft, often using lowercost airports and offering a single class of service. Low-cost carriers have been at the forefront of
developments to generate ancillary revenues by selling unbundled services.
Airports and toll roads
Airport businesses derive revenues from aviation, retail and real estate activities. Airport fees (eg,
passenger fees and landing fees) are generally set through a regulatory price formula, but the quoted
operators do have a free hand to decide their strategy in non-aviation segments. Overall, factors such as
catchment area, hub attractiveness and the health of the home airline can determine growth potential.
Operators have also chased growth in foreign countries, especially emerging markets, where they have
take on concession agreements. On occasion, this has exposed them to local political risk.
Toll road companies provide infrastructure to enable transportation. These infrastructures require huge
investments with a long gestation period. European governments have disinvested their interests in such
huge projects by partnering with private companies or granting them rights to charge the customers (on
toll road concessions). Traffic is driven by economic activity, while tariffs are generally set through
negotiations with the government.
Logistics and shipping
Most of these supply-chain stocks are cyclical, and earnings correlate with industrial production and
global trade. Logistics refers generally to the carriage of freight, parcels and mail. Typically activities are
segmented into: small parcel express (up to 68kg), mail (50g letters and small packages), freight
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July 2012
forwarding (heavy freight carried in air freight and sea freight containers), road network freight
operations (eg, co-ordination and carriage of less-than-truckload freight shipments, such as palettes) and
supply chain outsourcing services (operating clients’ inventory and warehouse networks). Supply chain
outsourcing is a long-term contracting business but in some circumstances is tied to volumes – so while it
is less cyclical than freight transportation, it is still cyclical.
UK bus and rail sector (land passenger transport)
The sector comprises four London-listed companies. Together these companies run most of the 20 UK rail
franchises and control around 75% of the provincial bus market. National Express only operates in the largely
deregulated markets outside London. Go-Ahead, FirstGroup and Stagecoach (to a lesser extent) also operate in
London, where operators are funded by the public sector for providing contracted services to Transport for
London. The UK rail operation is a largely franchised process, with operators winning the right to operate a
franchise for a period of around seven years. The sector has a high correlation with UK GDP, unemployment
rates and consumer spending. Operators are not responsible for rail infrastructure but instead pay access fees to
Network Rail. The rail industry is highly regulated, and heavily funded by government subsidy and a revenue
support system. All of the operators also have interests in the US (mainly school buses and long-distance
coaches). National Express runs bus services in Spain.
Key themes
Airlines
Capacity moderation: In the face of an uncertain economic environment, airlines across the world are
showing moderation in capacity growth. This moderation is strongest in the US market, but is also a clear
trend globally.
Yield trends uncertain: Passenger yields are benefiting from capacity restraint across the industry.
However, there is considerable uncertainty about the future trajectory of unit revenues. Economic
confidence is weak and growth is slowing in Europe. Evidence is currently mixed, with some carriers
reporting sustained demand for business travel; others are reporting softening yield trends.
Fuel prices: The oil price has moderated from peaks in Q1 2012. However, most airlines hedge their fuel
on a gradual basis; they have high levels of cover for the first quarter but little coverage two years out. In
effect this means that airlines experience market moves with around a 12-month lag, so fuel costs are
currently rising for most airlines.
Restructuring: In the face of the uncertain yield environment and rising fuel costs, airlines are endeavouring to
improve their non-fuel unit costs. Negotiating changes in labour terms and condition is challenging.
Consolidation: There has been a succession of major mergers in Europe, Latin America and the US.
Governments around the world are seeking to sell their airlines. Consolidation also comes from airlines failing.
Logistics and shipping
Growth in global freight flows: Economic uncertainty and austerity measures in Europe in particular are
weighing on global demand. The trade multiplier in 1995-2007 averaged 2.6x global GDP, with an
expanding supply chain. We forecast that this could contract for the next few years owing to the fragility of
the global recovery, the impact of the withdrawal of stimulus and more local sourcing.
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Modal shift: Seafreight is cheaper than airfreight, but it is also much slower. As supply chain management
becomes more sophisticated and the reliability and punctuality of containership services improves, we
expect to see a continued modal shift from airfreight to seafreight.
Inventory/sales ratios: The global downturn prompted significant destocking. Inventory/sales ratios
remain low. Though we see modal shift from air to sea, emergency shipments are helping to support express
volumes, in our view.
Emerging market growth: It’s good to be global. Although the Asia-Europe and Transpacific trade lanes
remain dominant, other trade lanes are starting to rise in importance. We expect to see the highest growth
in intra-Asia lanes, Asia-Latin America, Asia-Africa and Europe-Africa. Backhaul Europe Asia volumes
should also be a key driver of volume growth.
Supply overhang in container and dry bulk shipping: There is oversupply of container and dry bulk
ships. Companies have reduced the supply by laying up some ships and slow streaming (reducing the
speed of the ship). But with some recovery in rates, laid-up ships are coming back into service.
Airports and toll roads
Weakness in passengers and cargo: This reflects capacity restraint from airlines such as Air FranceKLM as they attempt to support unit revenues in a difficult economic environment.
Expansion in developing markets (Asia and Latin America): These high-growth markets are exploring
the PPP model to develop their infrastructure. These airports are often under-exploited in retail terms.
Free cash generation with large capital expenditure programmes: Fraport in particular has high levels of
capex ahead of it. In time, the revenues realised from the resulting tariff structure and capacity/traffic increase
should exceed the expenditure incurred; however, in the short term, this serves to keep ROIV<WACC.
UK bus and rail sector (land passenger transport)
UK bus profits under threat: The bus industry is heavily subsidised (around 40-45% of revenue from
taxpayers). The sector rode the expansion of public spending but now spending cuts are hitting, eroding
margins. We expect these cuts to deepen further in time. The pressures are intensified by higher fuel
costs. Operators initially indicated that these lower subsidies/higher costs could be passed on through
higher fares, but this has proven problematic in a difficult consumer environment.
Rail franchise awards could bring more risk. Fourteen new rail franchises are to be awarded by
December 2015. This will bring the opportunity of large earnings upgrades for the victors. However, we
think that risks will also grow: the new risk-sharing mechanism is tilted more in favour of the
government, in our view. In addition, capex commitments look set to increase. We are not convinced that
margins will adjust to compensate for this higher risk; competition from foreign operators such as
Deutsche Bahn and SNCF is likely to keep bidding tight.
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Sector drivers
Airlines
Global trade volumes and global business confidence are the key drivers of demand for business travel.
Consumer confidence is the key driver for leisure travel. Most airlines disclose traffic data on a monthly
basis. It is important to monitor capacity growth and load factor. Some airlines disclose qualitative data,
such as yields or premium traffic growth, which are particularly relevant. At quarterly results the key
metrics are passenger and cargo yields and unit costs, which are often assessed in total and excluding fuel.
At certain times, there is emphasis on gearing and liquidity.
Logistics and shipping
(1) Global freight flows, GDP and industrial production; (2) airfreight tonnes; (3) sea freight TEUs
(twenty-foot equivalent units); (4) gross profit/unit; (5) parcel shipments per day; and (6) average yields.
Airports and toll roads
(1) Traffic volume growth; (2) runway and terminal capacity; (3) capital expenditure programme; and (4)
dividend yield. There are also other variables, such as length of concession rights and visibility in
tariff/fee increases through negotiations of regulatory and government bodies.
UK bus and rail sector (land passenger transport)
(1) Passenger volume growth; (2) yield growth; (3) government funding; and (4) fuel price.
Valuation
Airlines
There is no definitive method for valuing an airline. The most commonly used metrics include
EV/EBITDAR, EV/IC and PE multiples, with carriers being compared cross-sectionally and relative to
their own historical averages, peaks or troughs. PE multiples are not consistently relevant for network
carriers because of the lack of earnings in large parts of the cycle. Price-to-book multiples or asset-based
valuations are also used, as are assessments based on the replacement value of fleet. For airlines with
diversified assets, sum-of-the-parts analyses may be relevant. DCF analyses are more common for lowcost carriers than network carriers, which are more volatile.
Logistics and shipping
PE, EV/EBITDA and DCF are commonly used for valuing the companies.
Airports and toll roads
EV/EBITDA and DCF are commonly used for most of the segments including toll roads and airports. In
addition, IRR is used to value the new concession projects. RAB (regulated assets base) is also used for
airports.
UK bus and rail sector (land passenger transport)
SOTP is generally used to value the companies. However, different segments are valued using
EV/EBITDA and DCF. Comparisons between companies are often done on a PE basis, both including
and excluding rail (where franchise lives are limited).
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Multi-sector
July 2012
Sector snapshot
Core industry driver: MSCI Europe Transport Index versus
European GDP growth, quarterly
Key sector stats
1.11 % of MSCI Europe
Source: MSCI, Thomson Reuters Datastream, HSBC
Stocks
1
2
3
4
5
6
7
8
9
10
Deutsche Post-DHL
AP Moller Maersk
Kuehne & Nagel
Abertis Infra
Vopak
Eurotunnel
Atlantia
TNT Express
DSV
Lufthansa
Total
Q112
-20%
-4%
-40%
-6%
-60%
Top 10 stocks: MSCI All Country Europe Transport Index
Stock rank
Q111
-2%
Q110
0%
Q109
0%
Q108
20%
Q107
2%
-9%
-4%
DPW, Maersk, K&N
99%
Q106
40%
Q105
4%
Q104
409
131.0
Q103
60%
Q102
6%
Q101
MSCI All Country Europe Transport
Index
Trading data
5-yr ADTV (USDm)
Aggregated market cap (USDbn)
Performance since 1 Jan 2005
Absolute
Relative to MSCI
3 largest stocks
Correlation (5-years) with MSCI Europe
Eur GDP grow th
Eur trans. Index grow th (RHS)
Index weight
Source: Thomson Reuters Datastream, HSBC
21.2%
17.0%
8.8%
6.9%
6.6%
6.6%
5.8%
5.5%
5.3%
3.5%
87.1%
PE band chart: MSCI All Country World Airline Index
2 00
15
1 50
10
x
1 00
50
5
Source: MSCI, Thomson Reuters Datastream, HSBC
0
Country breakdown: MSCI All Country Europe Transport Index
Country
Germany
Denmark
Netherland
France
Switzerland
Spain
Italy
UK
Turkey
Source: MSCI, Thomson Reuters Datastream, HSBC
-50
01
Weights (%)
27.4%
22.3%
12.1%
9.8%
8.8%
6.9%
5.8%
3.1%
2.3%
02
03
04
05
06
07
08
09
10
11
12
Source: MSCI, Thomson Reuters Datastream, HSBC
PB vs. ROE: MSCI All Country World Airline Index
2.0
14
1.5
12
10
8
1.0
6
0.5
4
2
0.0
0
04
05
06
07
08
09
Fw d PB (LHS)
10
11
12
R OE % (R HS)
Source: MSCI, Thomson Reuters Datastream, HSBC
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EMEA Equity Research
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July 2012
Notes
200
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July 2012
Travel & leisure
Travel & leisure
Lena Thakkar*
Analyst
HSBC Bank plc
+44 20 7991 3448
lena.thakkar@hsbcib.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
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July 2012
Sector structure
Travel & leisure
Travel*
Hotels
Le isure
Tour Operators
Bookmakers/
Online Gaming
Cruise Companies
Pubs & Restaurants
Caterers/
Vouchers
Accor Hotels
Holidaybreak
Carnival
888
Enterprise Inns
Compass
IHG
Kuoni
Royal Caribbean
Bwin.Party
Greene King
Edenred
M&C
Thomas Cook
Ladbrokes
JD Wetherspoon
Sodexo
Whitbread
Tui Travel
Paddy Power
Marston's
Playtec h
Mitchells and Butlers
Rank
Punc h Taverns
Sportingbet
Spirit Pub Company
William Hill
The Res taurant Group
*For airlines, bus and rail companies see T ransport section
Source: HSBC
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%y -o-y change in FTSE 350 Trav el and Leisure Index
80%
10 y ear sw ap rate - 2 y ear sw ap rate (RHS)
2.6
60%
1.8
40%
1.0
20%
0.2
0%
-0.6
-20%
-1.4
-40%
-2.2
-60%
-3.0
June-88
June-90
June-92
June-94
June-96
June-98
June-00
June-02
June-04
UK leaves ERM in September 1992
Interest rates fall
Economy recovers
80%
June-06
June-08
June-10
EMEA Equity Research
Multi-sector
July 2012
Travel and leisure sector performance
June-12
Collapse in UK GDP as credit
crunch bites
50
40
60%
30
40%
20
20%
10
0%
0
-10
-20%
-20
-40%
-30
-40
-60%
June-88
June-90
June-92
June-94
June-96
June-98
June-00
Source: Thomson Reuters DataStream, HSBC
June-04
June-06
June-08
UK consumer confidence indicator (RHS)
June-10
June-12
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%y -o-y change in FTSE 350 Trav el and Leisure Index
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2 .0
1 .8
C PG
1 .6
TT
TC G
1 .4
SD X
1 .2
Asset T urn over (x)
204
EBIT margin versus asset turnover chart (2011)*
JD W
1 .0
0 .8
ACCP
WTB
0 .6
0 .4
IH G
M AB
GNK
CCL
RC L
M ARS
E DEN
0 .2
0 .0
0 .0 %
5 .0 %
1 0. 0%
1 5 .0 %
2 0 .0 %
*Whitbread calculations use FY 2012 numbers; year-end is in February
Source: Company data, HSBC estimates
30 .0 %
35 . 0%
abc
E B IT m a r g i n (% )
2 5 .0 %
EMEA Equity Research
Multi-sector
July 2012
Sector description
The travel and leisure sector comprises numerous diverse sub-sectors including pubs and restaurants,
hotels, cruise and tour operators, bookmakers and gaming companies, and catering companies. In
addition, there are a several smaller esoteric businesses that do not fit neatly into a specific sub-sector,
such as the fast-food delivery company Domino’s Pizza and cinema operator Cineworld. Airlines and bus
and rail operators in this report are categorised under transport.
abc
Lena Thakkar *
Analyst
HSBC Bank Plc
+44 20 7991 3448
lena.thakkar@hsbcib.com
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
Key themes
Discretionary spend
In the travel and leisure sector similarities between companies are more subtle than for companies in
other sectors. Broadly speaking, companies in this sector depend on some form of ‘discretionary
expenditure’. When confidence and incomes are high, spending on discretionary items (like eating out or
holidays) is also likely to be strong. Alternatively, during a downturn, confidence falls and consumers cut
discretionary spending. This makes the travel and leisure sector more cyclical than many others.
Long-term growth
Despite this cyclicality, all sub-sectors have in the past exhibited real structural growth, and look likely to
continue to do so over the long term. Travel-related companies such as hotels and tour operators benefit
from GDP growth, globalisation, and political change, which can allow freer movement of people.
Meanwhile, as disposable incomes increase in both developed and emerging markets, there is greater
demand for leisure activities such as eating out, holidays, sporting events and gambling.
Sector drivers
Consumer and business confidence
Quite simply, increasing confidence means greater discretionary spend. We have outlined the nature of
that relationship with regard to consumers above, but it is also worth considering business confidence.
Corporate spending on hotels and catering usually fluctuates with the economy, with rooms and services
being upgraded to premium categories in the good times, but travel restrictions quickly being enforced in
tougher economic conditions.
Capacity and capex
Capacity varies considerably depending on the sub-sector. Within the hotel industry, the current lack of
available finance to build new hotels means supply is increasing slowly, particularly in developed
markets. In comparison, the long-term declines in the UK’s drinking-out market mean the capacity of
wet-led pubs is in decline, although this is being offset by capacity increases in the number of food-led
pubs and other restaurants. In the more mature industries, such as pubs and land-based bookmakers,
capex tends to trend in line with depreciation, unless operators are actively looking to roll out more units.
Input costs
Input costs differ between sub-sectors, although labour is usually one of the highest costs. Other key costs
are food and beverages for hoteliers, pubs and restaurants, and fuel for cruise and tour operators. These
costs ultimately depend on commodity markets, although businesses tend to have long-term contracts
with suppliers in order to reduce volatility.
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Changes in regulation and taxation
Since expenditure in the sector is discretionary, it is often an easy target for governments to tax; duties on
alcohol, gambling and air travel are obvious examples. Changes in regulation often create big operational
risks. When online gaming was outlawed in the US, operators lost more than half of their global market
overnight, and when smoking was banned in all public places in the UK in 2007 wet-led pub operators
had to substitute declining alcohol sales with increased focus on food sales.
Sub-sector drivers
Each sub-sector has its own unique structure and is subject to different macro and micro drivers. For
example, the barriers to entry in the cruising industry are high since large sums of capital are required to
acquire a new cruise ship compared to opening a new restaurant. Key themes in each sub-sector include:
Pubs and restaurants
Themes: growth of the eating-out market versus the decline of the drinking-out market; changes in taste
and preferences; freehold versus leasehold sites and property values; managed, leased, tenanted or
franchise-based operating models; a fragmented industry with consolidation potential; input cost inflation;
competition from supermarkets and the off-trade; changes in duty and taxes; and changes in regulation.
Share price drivers: We believe the three key drivers of share price performance are:
 Top-line resilience: Eating out remains a priority for UK consumers. With value a key driver, pub
restaurants should continue to grow and take share. This trend should intensify as diners’ trade down
to cheaper alternatives if disposable income falls.
 Consolidation and polarisation: The industry has polarised at the fastest rate in history over the past
few years driven by the managed listed companies. Stronger operators have grown and acquired
smaller operators which have struggled or even gone out of business. The successful players have
larger food-led pubs with scale, geographical reach and experienced management.
 Cost outlook: Managed operators have successfully grown their top lines through the recession, but
profits have been slower to rise as margins have not expanded in line with operational gearing levels.
There are two reasons for this: discounting to drive volumes and cost inflation.
Hotels
Themes: penetration of branded hotels versus non-branded hotels; lower growth in developed markets
than in emerging markets; asset-light versus owner-operated business models; recovering demand and
limited new hotel capacity; changes in corporate travel budgets; loyalty schemes; and asset values.
Share price drivers: We believe the three key drivers of share price performance are:
 Macro lead indicators: Hotel revenues are driven by corporate and consumer spend. The common
indicator used by commentators to assess the current health of hotel stocks tends to be RevPAR
(revenue per available room). There is a high correlation between RevPAR and GDP, but GDP
moves tend to lag share prices.
 Brand strength: Strong brands are vital for RevPAR outperformance, resilient growth pipelines and a
shift to an asset-light model. In a strong market, when occupancy rates are high, consumers are travelling
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and businesses are expanding, all hotels can have the confidence to raise prices. However, in a downturn,
when budgets are tight, the strongest and most reliable brands are the first to get booked.
 Emerging markets success: With Western hotels growth reliant on RevPAR recovery and slim net
additions, companies are increasingly focused on emerging markets as the true growth driver where GDP
expansion, as well as tourism and business travel is outstripping the West. Areas of expansion for the
companies are China, India, the Middle East, Africa, Brazil and Thailand/Indonesia.
Cruises
Themes: ship capacity, oil price, currency, ageing population, increasing cruise penetration, new source
areas, and the launch of new and innovative ships.
Share price drivers: We believe the three key drivers of share price performance are:
 Net yields: Cruise companies provide forward capacity numbers and always fill their ships over
100%, so the only unknown is net revenue yield. In general, passengers tend to book cruises well in
advance. Therefore, changes in consumer sentiment can have a lagged effect. Yields are affected by
shocks like maritime accidents, natural disasters, terrorist attacks and financial market panic.
 Industry supply: With 8-9% pa supply growth over the past decade, cruise companies have struggled
to gain any pricing power. In the next three years, industry supply growth is planned at c3% pa, much
lower than the last decade, and so pricing may show some improvement.
 Oil price and currency: Fuel and currency fluctuations are key drivers of earnings volatility for the
cruise companies. Fuel makes up 15-20% of the cost base for the cruise companies.
Tour operators
Themes: changes in aircraft capacity; growth of independent travel, disintermediation caused by the
internet; changes in booking patterns; growth of low-cost carriers; exchange rates; geo-political risk and
climate change; fuel costs; and changes to excise and duty rates.
Share price drivers: We believe the three key drivers of share price performance are:
 UK consumer: UK packaged holidays make up a third of tour operators’ profit. The UK has been the
most challenging and volatile source market. Future performance will ultimately rely on the
consumer environment.
 Structural challenges: Independent and internet travel agencies continue to take share. Packaged
holidays are a commodity product leading to price wars and margin loss in the “lates” market.
 Bid speculation: Tour operators have been subject to bid speculation in the press owing to distressed
valuation and poor operational performance. Share price rallies following such takeover speculation
have been short-lived, with the gains nullified soon after the euphoria settles.
Bookmakers and gambling
Themes: high growth in online versus subdued growth in land-based gambling; changes in tastes and
preference, such as growth in football betting and the decline in horse racing betting; changes to global
regulation, taxes and duties; social acceptance and awareness of gambling.
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Share price drivers: We believe the three key drivers share price performance are:
 Regulation: Changes in regulation affect the profitability of the gambling industry. Regulation is
mostly in the form of taxes applied to the gaming companies or rules around whether certain forms of
gambling are permitted.
 Move to digital: Digital revenue growth is driven by a change in consumer behaviour, launch of new
products and increasing marketing efforts. Many European countries are discussing the approval of
online gaming which will provide a boost to online gaming businesses.
 Mergers & acquisitions: Companies derive cost synergies from disposals of overlapping facilities
and software. Established gaming companies can make acquisitions to gain the benefit of successful
proprietary gaming platforms/technologies developed by small companies.
Caterers
Themes: size of overall market and potential growth of outsourcing; penetration levels vary across
industry sectors and regions; cyclical or defensive; types of contract; input costs (food and labour); and
opportunities in facilities management. Revenues are driven by price, volume and net new business.
Share price drivers: We believe the three key drivers of share price performance are:
 Employment levels: B&I accounts for a major chunk of the catering outsourcing business. When
businesses cut their workforce, this affects the volume of food sold at company cafeterias. Facilities
management’s volume of work is less transient, as it is dependent on clients expanding their offices.
 Inflation: Food and wages make up the bulk of the cost structure of food services companies. Food
and wage inflation therefore have a major impact on contract profitability. Inflation also affects the
pricing of new contracts, as well as renewal of existing contracts.
 Outsourcing/penetration rate: Outsourcing rates for facilities management are relatively low in all
sectors aside from B&I (Business and Industry) and remote sites. The opportunity is in sectors such
as healthcare and education where penetration remains low. In food services globally only 45-50% of
the business is outsourced and 50% of new business comes from first-time outsourcers.
Valuation
Understandably there is no one valuation methodology that is appropriate to the whole sector. In fact there
is not one methodology that is relevant to all companies within most sub-sectors. For example the pub
industry is mature, and has relatively predictable cash flows; a DCF valuation is often favoured. However,
a DCF fails to consider the asset backing inherent in the freehold pub companies.
Likewise in the hotel industry there are two models – the asset-light model tends to attract a higher
multiple as returns on capital are higher, but the capital-intensive model clearly has support from the asset
values, which can often support more debt. We think the most commonly used methodologies are relative
multiple analysis and DCF, with returns-based measures and asset values providing support.
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Accounting issues
Most operators have fairly predictable cash flows since customers pay for their goods and services when
they receive them. Therefore the conversion ratio of operating profit into free cash flows tend to be high,
and this, in most cases, means accounting standards are fairly straightforward.
One issue to be aware of is operating leases, which can be used for property assets such as real estate and
aircrafts. Since these assets are simply leased, the potential full liabilities are not capitalised on the
balance sheet. To compensate for this, a calculation to capitalise the annual lease cost at 8x is often used
or we can use the fixed cover charge, which takes into consideration both interest costs and rent.
Another area to focus on is working capital, particularly for the tour operators as, owing to the seasonal
nature of their businesses, they can see a large swing in working capital from the time cash comes in over
the summer months as customers pay the balance of their holidays, to the low point, usually at the start of
the calendar year, when they pay hoteliers for their allocation of rooms for the previous year.
Hotels sector: growth and profitability
Growth
Sales
EBITDA
EBIT
Net profit
Margins
EBITDA
EBIT
Net profit
Productivity
Capex/sales
Asset turnover (x)
Net debt/equity (x)
ROE
2010
2011
2012e
2013e
8.6%
22.5%
11.8%
5.9%
7.1%
10.6%
18.2%
23.4%
3.0%
3.7%
2.4%
11.6%
5.8%
7.6%
8.9%
11.3%
23.6%
16.8%
10.2%
24.5%
18.4%
11.7%
24.8%
18.4%
11.9%
25.3%
18.9%
12.3%
9.9%
0.59
0.48
42.7%
12.5%
0.67
0.42
33.0%
13.2%
0.68
0.24
24.7%
12.7%
0.70
0.12
21.8%
2010
2011
2012e
2013e
5.7%
7.4%
8.1%
13.9%
5.6%
8.3%
9.3%
12.2%
4.4%
7.5%
7.4%
5.9%
5.2%
9.4%
9.9%
12.2%
12.7%
10.8%
6.3%
12.7%
10.9%
6.8%
12.7%
10.9%
6.7%
13.0%
11.2%
7.0%
2.7%
1.41
0.18
14.8%
2.7%
1.40
0.17
13.5%
2.6%
1.43
0.24
13.5%
2.4%
1.47
0.20
13.2%
Note: based on all HSBC hotels sector coverage
Source: Company data, HSBC estimates
Food services sector: growth and profitability
Growth
Sales
EBITDA
EBIT
Net profit
Margins
EBITDA
EBIT
Net profit
Productivity
Capex/sales
Asset turnover (x)
Net debt/equity (x)
ROE
Note: based on all HSBC food services coverage
Source: Company data, HSBC estimates
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July 2012
Sector snapshot
Core industry driver: US and Europe consumer confidence
25
95
May-10
Compass, IGH, Sodexo
0.9
May-12
97
May-11
50
May-09
99
May-08
75
May-07
101
May-06
16.8%
40.0%
100
May-05
630
58,888
103
M ay-04
Trading data
5-yr ADTV (GBPm)
Aggregated market cap (GBPm)
Performance since 1 Jan 2000
Absolute*
Relative to MSCI Europe US
Dollar*
3 largest stocks
Correlation (5-year) with MSCI Europe
US Dollar
125
May-03
0.9% of MSCI Europe US Dollar
May-02
MSCI Europe Hotels,
Restaurants and Leisure Index
May-01
Key sector stats
US c onsumer confidence index
Europe consumer confidenc e index (RHS)
* Absolute and relative performance of HSBC Travel and Leisure coverage
Source: MSCI, Thomson Reuters DataStream, HSBC
Source: Thomson Reuters DataStream, HSBC
Stock rank
Stocks
1
2
3
4
5
6
7
Compass
IHG
Sodexo
Carnival
Whitbread
Accor
Tui travel
Index weight*
36.6%
13.1%
12.9%
11.3%
10.9%
8.5%
2.2%
PE band chart: MSCI Europe Hotels, Restaurants and
Leisure Index
250
200
Pri ce level
Top 7 stocks: MSCI Europe Hotels, Restaurants and Leisure
Index
*These are top ten stocks as per index weight
150
20x
100
15x
10x
5x
50
Source: MSCI, Thomson Reuters DataStream
Country
UK
France
Greece
Italy
Jun-12
J un-11
J un-10
Jun-09
J un-08
Jun-07
J un-06
J un-05
0
Country breakdown: MSCI Europe Hotels, Restaurants and
Leisure Index
Weights (%)
74.2%
21.4%
2.5%
1.9%
Source: MSCI, Thomson Reuters DataStream
PE vs. PB: MSCI Europe Hotels, Restaurants and Leisure
Index
Source: MSCI, Thomson Reuters DataStream
5
1. 0
J un-12
1. 8
J un-11
10
J un-10
2. 6
J un-09
3. 4
15
J un-08
4. 2
20
J un-07
25
J un-06
5. 0
Jun-05
30
MSCI Europe Leisure index P/ E (x )
MSCI Europe Leisure index P/ B (x )- RHS
Source: MSCI, Thomson Reuters Datastream
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Utilities
Utilities team
Adam Dickens*
Analyst
HSBC Bank Plc
+44 20 7991 6798
adam.dickens@hsbcib.com
José A López*
Analyst
HSBC Bank Plc
+44 20 7991 6710
jose1.lopez@hsbcib.com
Verity Mitchell*
Analyst
HSBC Bank Plc
+44 20 7991 6840
verity.mitchell@hsbcib.com
Dmytro Konovalov*
Analyst
OOO HSBC Bank (RR)
+7 495 258 3152
dmytro.konovalov@hsbc.com
Sector sales
Mark van Lonkhuyzen
Sector Sales
HSBC Bank Plc
+44 20 7991 1329
mark.van.lonkhuyzen@hsbcib.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
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212
Utilities
Power/Gas
Water/Waste
Regulated
Non-regulated
Regulated
Non-regulated
National Grid
SSE
Pennon Group
Veolia Environnement
Snam Rete Gas
Centrica
Severn T rent
Suez Environnement
Terna
Drax Group PLC
United Utilities
Seche Environnement
Red Electrica
E.ON
Enagas
RWE
Federal Grid Company
EDF
Inter RAO
GDF Suez
EMEA Equity Research
Multi-sector
July 2012
Sector structure
Enel
Iberdrola
Gas Natural
Energias de Portugal
Fortum OYJ
Verbund
CEZ a.s.
RusHydro
E.ON Russ ia
Enel OGK 5
OGK 2
abc
Source: HSBC
EMEA Equity Research
Multi-sector
July 2012
Dividend yield (%) of MSCI European Utilities versus MSCI Europe
8
1. The European Utilities sector has historically traded at c40%
dividend yield premium to the market (MSCI Europe)
2. But the yield premium narrowed during 2004-2008 when
the sector traded at a higher PE - valuations underpinned by
a strong upturn in commodity prices (oil, gas, power prices).
7
6
5
4
3
3. However, in wake of the recent
global financial crisis and the
consequent decline in commodity
prices, the sector has regained its
dividend yield premium to the market.
2
1
0
Oct96
Apr97
Oct97
Apr98
Oct98
Apr99
Oct99
Apr00
Oct00
Apr01
Oct01
Apr02
Oct02
Apr03
Oct03
MSCI EUROPE - DIVIDEND YIELD
Apr04
Oct04
Apr05
Oct05
Apr06
Oct06
Apr07
Oct07
Apr08
Oct08
Apr09
Oct09
Apr10
Oct10
Apr11
Oct11
MSCI EUROPE UTILITIES - DIVIDEND YIELD
Source: MSCI, Thomson Reuters Datastream, HSBC
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18%
Drax
16%
E.ON Russia
14%
CNA
SSE
12%
CEZ
10%
RoCE 2012e
214
Net debt + provisions/EBITDA 2012e versus RoCE 2012e of utilities under our coverage
RWE
Inter Rao
UU
Fortum
8%
Verbund
GNF
6%
SVT
REE
Enel OGK5
Enel
RusHy dro
NG
Snam
Enagas
IBE
Suez Env .
EDF
EDP
E.ON
PNN
Terna
GDF Suez
FGC
4%
OGK2
VIE
PPC
2%
0%
0x
1x
2x
3x
4x
5x
6x
Net debt + provisions/EBITDA 2012e
Source: HSBC estimates
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Sector description
Not as defensive as might be presumed
The European utilities sector encompasses companies operating across the value chain in electricity, gas,
water and environmental services. For electricity and gas, upstream activities include: power generation,
and oil and gas exploration and production, while downstream activities are related to retail sales and
services. Returns in generation are typically subject to fluctuations in commodity (gas, coal) and carbon
prices and spreads (influenced by the balance of the market). Infrastructure activities (transmission and
distribution networks and pipes) are subject to regulated returns. Downstream activities such as retail
sales and services are deregulated in most European countries. Environmental and waste services are
competitive activities. Water supply activities in England and Wales are subject to regulated returns, but
are unregulated in France. Operating profit margins are generally higher in more asset-intensive and
regulated activities, but lower in retail supply (single digits) owing to competitive pressures. In Russia,
where we have initiated coverage since the previous Nutshell, electricity is sold on the open market but
annual growth of the end user price is limited by a cap defined by the state. The sector is undergoing a
period of heavy investment. Shares of the western-based utilities typically pay above-market yields, while
Russian utilities mostly do not pay any dividends.
abc
Verity Mitchell*
Analyst
HSBC Bank Plc
+44 20 7991 6840
verity.mitchell@hsbcib.com
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
As regulated networks are relatively immune to economic cycles, the sector is traditionally seen as a
defensive sector or yield play. However, in the context of national austerity measures, even regulated
business has been subjected to additional taxes in Italy. Unregulated activities, which account for around
three-quarters of sector earnings, are not defensive as political pressure (nuclear policy, for example),
environmental legislation, competition and commodity price volatility have contributed to lower margins.
Key themes
Europe – power
EU energy policy and regulation – compromised by differences in national objectives
Energy policy and regulation in Europe is centred on: energy security, environmental protection and
affordability. Regulation in individual member countries is being shaped by the broader EU objectives of
an ‘internal energy market’ and the ‘20-20-20’ initiative for 2020 aimed at energy efficiency. Members
are targeting the establishment of an EU-wide internal energy market as a means of promoting
competition and giving consumers a choice of supplier. However, differing political objectives from
country to country, lack of interconnection among networks and barriers to cross-border M&A activity
have put a brake on this aspiration, exacerbated by the difficult current economic environment.
Climate change energy policy – adds costs, jeopardises load factor of conventional plants
The impact of climate-change policy will continue to affect the utilities sector. The ‘20-20-20’ initiative
aims at a 20% reduction in carbon emissions versus 1990, and for 20% of energy needs in the EU to be
met by renewables by 2020. Regulated companies will potentially benefit from the need to build new grid
to connect renewable energy installations. Non-regulated companies will suffer as a result of the reduced
load factor from flexible conventional plants (CCGT, for the most part) caused by the construction of
renewable plant (wind, solar). There have been calls from within the industry for capacity payments to be
paid to generators for maintaining conventional flexible plant idle but available, as a means of
guaranteeing security of supply when renewable generation output fails (wind and hydro). The EU cap-
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July 2012
and-trade system (EU-ETS) encourages companies to reduce emissions by requiring them to purchase carbon
certificates (essentially, permits to emit CO2 into the atmosphere). Under the current EU-ETS, generators
receive a varying amount of carbon certificates free of charge until the end of 2012. From 2013 most Western
European countries will have to purchase 100% of their requirements. Central and Eastern European (CEE)
countries will have to do likewise by 2020. The recessionary environment has caused demand for carbon
certificates to fall more sharply than assumed, as a result of which carbon prices have virtually collapsed.
Political risk: to remain a large cloud over the sector
Political risk has been a central theme for the sector in 2010 and 2011, depressing the share prices of the
large energy conglomerates in particular. It remains to the fore in 2012, and not only for non-regulated
companies. The sector is vulnerable to being targeted in the context of austerity measures (tax on
regulated distribution and transmission as well as attacks on carbon-free generation), to nuclear policy
after Fukushima (German closures, new French president wants to reduce his country’s nuclear
dependency), to rising costs of renewables, and to the need to resolve long-term structural problems
(Spanish tariff deficit). Only where there is an impending need for new plant (ie the UK), is political risk
absent. Political risk remains a major factor in Russia, too. Privatisation of the state-owned stakes in
Russian utilities is less likely today as the market valuations of the assets have decreased significantly.
The state has also announced plans to consolidate Federal Grid Company and MRSK Holding in order to
deal with multiple issues related to the implementation of RAB and financing of sizeable distribution
capex. Recent events show that the state will continue to control power tariffs and their growth is likely to
be moderate.
Too much new capacity, power market unlikely to tighten suddenly after 2013
The continental European sector suffers from over-capacity, with new plant, committed before the recessionary
environment became established, starting output in a market where demand is 10% smaller than was
anticipated when the investment decision was made. Even with the end of free carbon certificates in January
2013, we are pessimistic about the likelihood that a sudden rush of closures will create tighter markets and thus
higher spreads and prices. The EU and national governments are pushing hard for investment on the
transmission grid – closing bottlenecks and adding capacity – to cope with more volatile and erratic generation
as wind and solar capacity continue to grow, albeit less rapidly than before.
Gas market recovery
According to our estimates, almost one-quarter of sector EBITDA is made in gas. European gas demand has
suffered from uncompetitive pricing (gas import contracts are indexed mostly to oil) and lower carbon prices
(which penalise gas relative to coal in power generation), and the market is in over-supply. The extent of
growth outside Europe (China, Japan in particular) will influence the timing and extent of a tightening in the
market. Meanwhile, we expect a continuation of the process whereby gas import contracts are becoming less
indexed to (dearer) oil and more to (cheaper) spot gas, thereby eradicating a source of losses for the gas
suppliers. A return to wholesale gas profitability by late 2013 and expansion in LNG trading should offset low
earnings growth in upstream and end-user supply. Near term, the market will be watching to see if the utilities
can extract more flexibility from their suppliers in order to avoid wholesale losses in 2012.
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Growth segments… few easy pickings
A common theme amongst European utilities is to seek growth by re-deploying capital in non-EU
countries (typically Latin America followed by Russia, Turkey and Asia) and expanding in renewablebased power generation on a global basis. Though growth opportunities undoubtedly exist, their
attractions can be limited by overcapacity (Turkey), government intervention (Russia), the willingness of
local government-owned operators to accept seemingly uneconomic returns (Brazil), and the sheer length
of the negotiating processes (MENA). In addition, the heavily-indebted balance sheets of the main sector
players imply that disposals will be required to fund expansion in growth markets.
Europe – water & waste
RAB-based valuation
For UK water companies, the RAB (regulated asset base) or RCV (regulatory capital value) is the asset
value (calculated by the regulator in every five-year period) on which companies earn a return based on
an approved WACC that is revised in every regulatory period. For equity investors, the RCV provides a
spot reference point as to whether the stock is trading at a premium or a discount, while stable regulated
returns provide visibility on dividends. Moreover, because of the regulated nature and high visibility of
returns, the proportion of debt to RCV tends to be high, in the range of 55% to 65%. The UK water
companies are allowed to increase their prices each year using the ‘RPI – x + K’ formula, where x
denotes the efficiency savings factor and K is the factor used to raise prices to cover the financing of new
capital expenditure and other expense items related to the improvement of its assets.
Global scarcity
For the French water companies, the scarcity of project finance and the austerity measures by many
governments led to fewer water treatment and desalination project awards over 2009-11. We believe
contracts will be awarded and growth will resume, especially in areas of acute water shortage – the
Middle East, Australia, China and some parts of the US.
Sector drivers
Regulated stocks
Regulated network activities are remunerated through an approved return (WACC) on a RAB. Companies
may extract a return higher than the allowed/approved return through operational and/or financial
efficiencies. Thus, profits for regulated activities are a function of: (1) investment/RAB growth; (2) the
level of allowed returns/WACC; and (3) operational, financial efficiencies.
Unregulated stocks
 Demand growth: Overall, energy demand is directly linked to the pace of economic growth,
industrial demand being more cyclical and residential demand being stable. Reduced demand caused
by the recession has been a drag on the waste management activities of the water companies.
 Commodity prices and spreads: Economic recession results in lower power prices. These are
determined by: (i) the marginal generation fuel which is either gas or coal; plus (ii) the cost of carbon; plus
(iii) the spread (or profit margin), which is influenced by differences between the cost of coal and gas and
the tightness (or otherwise) of the market. In addition to engaging in downstream retail activities that act as
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a natural hedge to upstream generation, utilities typically sell power forward up to three years in advance
to mitigate the impact of commodity price volatility.
 Net-back parity: The Russian government plans to achieve net-back parity (ie the fixed domestic gas
price matches the oil-linked gas export price) by the end of this decade, and for this the domestic cost
of gas will have to grow. This will squeeze the profitability margins of generation companies that use
Gazprom gas as a prime generation fuel.
 Government intervention: Politically motivated measures, for instance to tax nuclear.
Valuation
Valuation parameters
Regulated or midstream activities: For regulated stocks whose infrastructure/network assets produce
relatively stable returns, the preferred valuation techniques are: (1) DDM – higher dividend visibility
given stable regulated earnings and a defined dividend payout range; (2) DCF – the source of value is the
company’s ability to generate free cash flows and long-term growth; and (3) asset valuation – application
of a premium or discount to the RAB depending on the quality of assets.
Upstream activities: Power generation assets are typically valued by the DCF/MW of a particular
technology, with base-load technologies (renewables, hydro, nuclear and lignite) deserving a higher
valuation than the mid-merit to peaking technologies (coal, gas, oil-fired plant and pumped storage units).
Downstream activities: Retail activities are typically valued by ascribing a DCF/customer value to the
number of customers, with more value being assigned to customers with combined power and gas supply.
Key accounting metrics
Earnings metrics: As the favourite market multiplies are EV/EBITDA and PE, the focus is on arriving at
a recurring or EBITDA or EPS. Most utilities report a recurring operating metric that excludes one-off
items. Dividend, which is among the sector’s principal attractions, is often linked to recurring EPS. Given
investors’ preference for consistent dividends, most utilities try to maintain a stable growth rate in
dividends and offer visibility on payout (the typical range for large utilities is 50% to 60%).
European and Russian utilities: growth and profitability
Growth
Sales
EBITDA
EBIT
Net profits
Margins
EBITDA
EBIT
Net profit
Productivity
Capex/sales
Asset turnover (x)
Net debt/Equity
ROE
2008
2009
2010
2011e
2012e
22%
12%
12%
6%
4%
4%
4%
-1%
8%
8%
5%
-1%
8%
2%
0%
-5%
3%
2%
0%
0%
23%
17%
9%
24%
17%
11%
23%
16%
10%
23%
16%
10%
22%
16%
9%
16%
0.47x
112%
17%
17%
0.47x
144%
17%
15%
0.49x
132%
17%
14%
0.49x
100%
14%
16%
0.49x
100%
12%
Note: based on all HSBC European and Russia coverage
Source: company reports, HSBC estimates
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Sector snapshot
GDP (EURbn) and per capita electricity consumption (kWh/EUR)
3000
2500
2000
1500
1000
500
0
1
2
3
4
5
6
7
8
9
10
EON AG
National Grid Plc
GDF Suez
Centrica Plc.
Enel Spa
SSE PLC.
RWE AG
Iberdrola SA
Fortum OYJ
United Utilities
0.2
0.1
Belgium
Portugal
0.0
GDP (EURbn) - LHS
Top 10 stocks: MSCI Europe Utilities Index
Stocks
0.3
Spain
Source: MSCI, Thomson Reuters Datastream, Bloomberg, HSBC
Stock rank
0.4
Italy
Trading data
5yr ADTV (EURm)
2,062
Aggregated market cap (EURm)
343,430
Performance since 1 Jan 2000
Absolute
-9%
Relative to MSCI Europe
28%
3 largest stocks
E.ON, National Grid, GDF Suez
Correlation (5-year) with MSCI Europe
0.86
UK
4.63% of MSCI Europe
France
MSCI Europe Utilities Index
Germany
Key sector stats
Energy Intensity - RHS
Index weight
Source: HSBC, Eurostat
13.8%
13.4%
10.4%
9.1%
7.5%
7.3%
7.1%
6.5%
3.0%
2.6%
PE band chart: MSCI Europe Utilities Index
300
250
200
150
100
Source: MSCI, Thomson Reuters Datastream, HSBC
50
Actual
5x
10x
Jan-11
Jan-09
Jan-07
Jan-05
Jan-03
34.5
21.3
14.9
12.7
11.4
3.0
1.3
0.6
Jan-01
UK
Germany
France
Italy
Spain
Finland
Portugal
Austria
Jan-99
Weights (%)
Jan-97
Country
Jan-95
0
Country breakdown: MSCI Europe Utilities Index
15x
20x
Source: MSCI, Thomson Reuters Datastream, HSBC
PB vs. ROE: MSCI Europe Utilities Index
3.5
20%
3.0
15%
Source: MSCI, Thomson Reuters Datastream, HSBC
2.5
10%
2.0
PB (LHS)
Jan-11
Jan-09
Jan-07
Jan-05
Jan-03
Jan-01
0%
Jan-99
1.0
Jan-97
5%
Jan-95
1.5
ROE (RHS)
Source: MSCI, Thomson Reuters Datastream, HSBC
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Notes
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EMEA countries
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Egypt
Raj Sinha*
Analyst, Head of MENA Research
HSBC Bank Middle East Ltd.
+971 4423 6923
raj.sinha@hsbc.com
Aybek Islamov*
Analyst, banks
HSBC Bank Middle East Ltd.
+971 4423 6921
aybek.islamov@hsbc.com
Patrick Gaffney*
Analyst, real estate
HSBC Bank Middle East Ltd.
+971 4423 6930
patrickgaffney@hsbc.com
Herve Drouet*
Analyst, telecoms
HSBC Bank plc
+44 20 7991 6827
herve.drouet@hsbcib.com
Sriharsha Pappu*
Analyst, chemicals
HSBC Bank Middle East Ltd.
+971 4423 6924
sriharsha.pappu@hsbc.com
Shirin Panicker*
Analyst, banks
HSBC Securities (Egypt) S.A.E.
+202 2 5298439
shirinpanicker@hsbc.com
John Lomax *
Strategist
HSBC Bank plc
+44 20 7992 3712
john.lomax@hsbcib.com
Wietse Nijenhuis*
Strategist
HSBC Bank plc
+44 20 7992 3680
wietse.nijenhuis@hsbcib.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
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Introduction
Before the revolution last year, Egypt was a long-standing favourite among international investors,
offering a combination of strong domestic macro conditions – although the strength of the components
varied – and well-managed companies. Over the past ten years, Egypt has, overall, strongly outperformed
the aggregate emerging markets index. Through 2011, the Egyptian equity market fell sharply as a result
of political developments associated with the Arab Spring. However, this year the market has recovered
well, which was partly because of some specific, bottom-up improvements and partly the result of the
successful early-stage political transition.
Along with Morocco, Egypt is one of only two MENA markets in the MSCI Emerging Markets index,
representing 0.3% of the index (and 1.6% in the MSCI EM EMEA index). The market is therefore a good
way to play certain MENA themes. Morocco has been placed on the review list for a potential downgrade
by MSCI to Frontier Market status, meaning Egypt could become the sole MENA market in the MSCI
EM index.
Market structure
The MSCI Egyptian equity index is heavily concentrated on a small number of materials, telecom and
financial names – the largest five stocks by market cap account for 75% of index representation. For
many investors therefore, stock selection has been as important as the assessment of top-down conditions.
Equity index performance in Egypt
Major stocks in MSCI Egypt index*
2500
1200
2000
1000
800
1500
600
1000
400
500
200
0
0
96
98
00
02
04
06
08
10
12
M SCI Egy pt price index (in Loc al currency )
Hermes financ ial price index (in Loc al currency , RHS)
Rank
Stock Name
1
2
3
4
5
1-5
6
7
8
9
10
6-10
Orascom Construction Industries
Commercial International Bank (Egypt)
Orascom Telecom Holding
Egyptian Company for Mobile Services (Mobinil)
Egyptian Kuwaiti Holding
Telecom Egypt
EFG Hermes Holding.
Talaat Moustafa Group Holding
Orascom Telecom and Media Companies
National Societe Generale Bank (NSGB)
*Data as at 22 May 2012
Source: MSCI, Thomson Reuters Datastream, HSBC
Source: MSCI, Hermes, Thomson Reuters Datastream, HSBC
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Weight (%)
33.0
18.8
10.5
7.7
5.7
75.7
5.6
5.2
5.0
4.6
3.9
24.3
John Lomax *
Strategist
HSBC Bank plc
+44 20 7992 3712
john.lomax@hsbcib.com
Wietse Nijenhuis*
Strategist
HSBC Bank plc
+44 20 7992 3680
wietse.nijenhuis@hsbcib.com
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
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Liquidity (6M ADTV) of equity indices in Egypt
Sector composition of MSCI Egypt index*
250
Sector
Financials
Industrials
Telecommunication Services
Total
200
150
100
Weight (%)
38.6
33.0
28.4
100.0
Note: * data as at 22 May 2012.
Source: MSCI, Thomson Reuters Datastream, HSBC
50
0
07
08
09
10
11
12
Egy pt financial Hermes Index 6M ADTV (U SD m)
Source: Hermes Index, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC
The Egyptian market is one of the more liquid in the MENA region, usually trading above USD100m a
day, although this has dropped off since 2011, as local and regional political developments have resulted
in foreign investors taking a step back from the market. However, we expect liquidity to pick up again
once the political landscape becomes clearer.
Earnings and valuation
Earnings growth was very strong between 2002 and 2007, before dropping sharply during the financial
crisis in 2009. In 2011, earnings growth recovered strongly, having come from a very low base. Egyptian
earnings are now growing well below trend.
The earnings outlook is given some protection by the fact that the MSCI Egyptian index is to some extent
skewed towards multinational companies with a significant non-Egyptian exposure – this also means that
a proportion of earnings are disconnected from ongoing Egyptian economic disruption.
In terms of valuations, the Egyptian market has been among the cheaper markets in the EM universe since
the financial crisis. While on a macro level growth held up well through 2008-09, earnings of Egyptian
corporates are rather more cyclical, so between May 2008 and February 2009 the MSCI Egypt fell c71%
in US dollar terms compared with a drop of c54% in the broader EM index. The discount relative to EM
has held ever since. The reason is fairly straightforward and it boils down to political risk – investors fear
that this will prevent a cyclical upswing from occurring for some considerable time. As part and parcel of
this, perceived currency risk is an additional market obstacle. Equally, there are some legal uncertainties,
which also have political roots. If the current political timelines are adhered to and political stability can
be restored, there is scope for the economic cycle to stabilise gradually, which, in turn, would allow
earnings to recover.
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Actual, trend and forecast earnings of MSCI Egypt index
Annual growth in earnings: MSCI Egypt index
3.0
150%
Log (EPS in Egy ptian Pound)
2.5
100%
2.0
50%
1.5
0%
1.0
-50%
00
02
04
06
12M trail
08
12 e
10
Trend
14 e
2001
2003
I/B/E/S fcast
2005
2007
2009
M SCI Egy pt EPS grow th
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC estimates
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
Earnings momentum* versus returns: MSCI Egypt index
Earnings growth* versus returns: MSCI Egypt index
200%
300%
150%
200%
100%
100%
50%
2011
300%
60%
40%
200%
20%
100%
0%
0%
0%
-50%
-100%
-100%
96
98
00
02
04
06
08
10
0%
-20%
-100%
-40%
12
96
98
00
MSCI Egy pt earnings m omentum
MSCI Egy pt y -o-y returns (R HS)
02
04
06
08
10
12
MSCI Egy pt earnings grow th
MSCI Egy pt y -o-y returns (R HS)
Note: *Earnings momentum is defined as the 6-month % change in 12M-forward EPS
forecast.
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
Note: *Forecast growth in 12M-forward earnings.
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
Earnings revisions* versus returns: MSCI Egypt index
IBES Consensus recommendation score*: MSCI Egypt index
70%
60%
300%
3.0
50%
200%
2.5
40%
30%
100%
2.0
20%
0%
10%
0%
1.5
-100%
Bullis h
96
98
00 02 04 06 08 10
MSCI Egy pt earnings rev ision
MSCI Egy pt y -o-y returns (R HS)
12
*Number of 12M-forward EPS estimates up over the last month as a % of total number
of revisions in estimates over the corresponding period.
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
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Bearis h
1.0
01 02 03 04 05 06 07 08 09 10 11 12
Score
Mean
± 2Stdev
*Represents the market cap weighted aggregated score of the IBES consensus
recommendation of all the constituents. Score should be interpreted as follows – 1.00
to 1.49: Strong Buy; 1.50 to 2.49: Buy; 2.50 to 3.49: Hold; 3.50 to 4.49: Underperform;
4.50 to 5.00: Sell
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
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MSCI Egypt index: 12M-forward PE scenarios*
Earnings yield versus bond yield* in Egypt
5000
20%
4000
25x
3000
20x
2000
15x
10x
1000
15%
10%
5%
5x
0%
0
05
01 02 03 04 05 06 07 08 09 10 11 12
06
07
08
09
10
11
12
Redemption y ield on BoFA ML Egy pt Sov ereign (USD)
12M -forward earnings y ield of MSCI Egy pt
M SCI Egy pt Price Index
*Based on five scenarios of 12M-forward PE multiple(5x, 10x, 15x, 20x and 25x)
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
Note: *Earnings yield is calculated as the reciprocal of the 12M-forward PE ratio of the
MSCI index and the bond yield is the yield-to-redemption of the BofA ML Egypt
Sovereign (USD) index.
Source: MSCI, IBES, BofA ML, Thomson Reuters Datastream, HSBC
12M-forward PB versus RoE: MSCI Egypt index
6.0
5.0
4.0
3.0
2.0
1.0
0.0
05
06 07
08 09
10 11
12
MSCI Egy pt 12M -forward price to book ratio
MSCI Egy pt 12M -forward RoE (RHS)
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
12M-forward PE ratio of MSCI Egypt relative to MSCI EM
40%
20.0x
2.0x
30%
15.0x
1.5x
20%
10.0x
1.0x
10%
5.0x
0.5x
0%
0.0x
0.0x
01
03
05
07
09
11
M SC I Egy pt 12M -fo rw ard PE ratio
rel. to MSCI EM (RHS)
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
Fund flows
International funds flows into Egypt have been persistently weak since the revolution, given the political
uncertainties referred to above. The typical global emerging markets fund is now significantly
underweight Egyptian equities. This represents a sharp difference from historical experience, since, in the
pre-revolution period, Egypt was often highly regarded by international investors and it was frequently
heavily overweighted in international portfolios.
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Flows (% of AuM) into Egypt dedicated funds
Weight of Egypt in GEM funds versus benchmark
20%
3%
10%
2%
0%
-10%
1%
-20%
-30%
0%
-40%
00 01 02 03 04 05 06 07 08 09 10 11 12
Egy pt Fund flow s as % of ass ets under management
Source: EPFR Global, HSBC
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Weight (%) in GEM Equity Funds
Weight (%) in M SCI EM index
Source: MSCI, EPFR Global, HSBC
Economic basics
Egypt is the largest MENA market in terms of population (80 million), and the third-largest economy in the
region (after Saudi Arabia and the UAE). However, with a GDP per capita of around USD2,700 in 2011, it is
also among the poorest.
Economic drivers for Egypt are diverse: on the external side, tourism, Suez revenues and FDI are all key.
Egypt also exports around USD25bn worth of goods a year, around half of which are energy
commodities. Domestically, Egypt is a classic emerging market story, with strong demographics, low
debt levels and a growing middle class. Before the revolution, Egypt also had a strongly pro-market
policy stance. However, the policy environment is more uncertain now. A successful political transition –
if and when it materialises – should reinforce most characteristics of the long-term growth prospects,
while removing the succession risk which had been a major investor concern before the revolution.
Economic policy primer
The establishment of the Ahmed Nazif government in 2004 brought in an era of pro-market reforms,
including privatisation, tax cuts and other incentives for foreign investment. However, progress in the
reformist period was disrupted by the global financial crisis. Moreover, there has been little emphasis on
the need to reduce Egypt’s public sector and generous subsidy spending, due to the political risk
associated with these kinds of reforms.
From a monetary perspective, the Central Bank is thought to target a core inflation rate of 6-8%, although
inflation has rarely remained in this bracket for long.
Since the revolution, there has been extreme uncertainty, not only on the policies of the new parties in
power, but even on the identity of future policymakers. With no constitution in place, and parliament
having been dissolved, there was, at the time of writing, no way of discerning an economic policy
framework.
Political structure
Egypt is currently undergoing a period of deep political transition. Inspired by events in Tunisia, Egyptian
youth and opposition groups organised mass protests over the course of many weeks, eventually
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compelling President Hosni Mubarak to resign in February 2011 after 30 years as president. The military
took control via the Supreme Council of the Armed Forces (SCAF). Under the new regulations of the
March 2011 referendum, the president is limited to two four-year terms. After several delays, presidential
elections were held in June 2012 which led to a victory for Muslim Brotherhood candidate, Mohammed
Morsy, over Ahmed Shafiq, a long-serving member of the former regime. This marks a significant step
forward in Egypt’s political transition. However, at the time of writing there is no clarity on what
authority the new president will enjoy or what goals he will pursue, and no sense that the power struggle
between the Islamist movement and the military is over. These will be key issues for equity investors to
watch in the medium term.
Key regulatory bodies
Central bank: responsible for monetary policy and supervising the banking system.
Financial Supervisory Authority: responsible for supervising non-bank financial markers including
capital markets.
The Egyptian Exchange (EGX): comprises two exchanges, Cairo and Alexandria, which are governed by
the same board of directors and share the same trading, clearing and settlement systems. EGX was
formerly known as the CASE (Cairo and Alexandria Stock Exchange).
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Russia
Vladimir Zhukov*
Head of Equity Research (Russia)
OOO HSBC Bank (RR) Ltd
+7 495 7838316
vladimr.zhukov@hsbc.com
Dmytro Konovalov*
Analyst, utilities
OOO HSBC Bank (RR) Ltd
+7 495 2583152
dmytro.konovalov@hsbc.com
Ildar Khaziev*
Analyst, oil & gas
OOO HSBC Bank (RR) Ltd
+7 495 645 4549 ildar.khaziev@hsbc.com
Anisa Redman
Analyst, oil & gas
HSBC Securities (USA) Inc.
+1 212 525 4917 anisa.redman@us.hsbc.com
Gyorgy Olah*
Analyst, banks
HSBC Bank plc
+44 20 7991 6709 gyorgy.olah@hsbcib.com
John Lomax *
Strategist
HSBC Bank plc
+44 20 7992 3712
john.lomax@hsbcib.com
Wietse Nijenhuis*
Strategist
HSBC Bank plc
+44 20 7992 3680
wietse.nijenhuis@hsbcib.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
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Introduction
Russia has a relatively young stock market. It was created in the early 1990s as a result of the country’s
major transformation into a market economy, which entailed a mass privatisation of industrial companies.
The Russian stock market is dominated by natural resource extraction industries, which account for
almost 70% of the MSCI Russia index. Russia has been one of the top-performing emerging stock
markets in the past 10 years owing to the rising prices of oil and other commodities. In the medium term,
the government is planning to privatise its remaining interests in the oil & gas, utilities and commercial
banking sectors, which should give a boost to the domestic stock market. The downside risk for the oil &
gas sector, apart from global macro conditions, relates to the government’s long-term goal of making the
economy less dependent on natural resources, which entails the re-distribution of oil & gas revenues to
fund growth in other industrial sectors and investments in the public economy.
Market structure
Historically, Russia had two main stock exchanges: the MICEX (Moscow International Currency
Exchange), which was set up in 1992 for currency and government bond trading, and the RTS (Russian
Trading System), which was set up in 1995 to trade stocks. In 2011, the two exchanges merged into the
OJSC MICEX-RTS, which has become the prime Russian exchange for almost all traded instruments,
including stocks, bonds, futures and forwards, commodities, currencies and money market instruments.
Most of the Russian stocks are traded on the main market section of the MICEX-RTS, which accounts for
over the 80% of stock turnover and almost 100% of bond turnover. MICEX-RTS is one of the Top 20
global exchanges by aggregate capitalisation value of all traded stocks. In 2011, the combined traded
volume exceeded USD10trn, with six-month average daily trading volumes of around USD2bn.
The energy sector accounts for 58.2% of the MSCI Russia with Gazprom representing approximately
25% and Lukoil another 14%. Second largest is the financial sector with a 15.4% weight, and Sberbank
accounting for 11.6%. In other industries the companies with significant weights in the index are Uralkali
(4.9%), MTS (4.3%), Norilsk Nickel (3.9%) and Magnit (3.5%).
Equity index performance in Russia
Major stocks in MSCI Russia index*
1800
1600
1400
1200
1000
800
600
400
200
0
3000
2500
2000
1500
1000
500
0
96
98
00
02
04
06
08
10
12
MSCI Russia price index (in Local currency)
Russia RTS price index (in Local currency, RHS)
Rank
Stock name
1
2
3
4
5
1- 5
6
7
8
9
10
6-10
Gazprom Oao
Oil Company Lukoil Jsc.
Sberbank Of Russia Spn.
Rosneft Oil Ojsc
Uralkali Ojsc
Novatek Oao
Mobile Telesystems Ojsc
Ojsc Mmc Norilsk Nickel
Oao Tatneft
Magnit Open Jsc.
Note: * data as at 22 May 2012
Source: MSCI, Thomson Reuters Datastream, HSBC
Source: MSCI, Thomson Reuters Datastream, HSBC
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Weight (%)
24.8
13.7
11.6
5.1
4.9
60.1
4.9
4.3
3.9
3.7
3.5
20.2
Dmytro Konovalov*
Analyst
OOO HSBC Bank (RR) Ltd
+7 495 2583152
Dmytro.konovalov@hsbc.com
Vladimir Zhukov*
Analyst
OOO HSBC Bank (RR) Ltd
+7 495 783 8316
vladimir.zhukov@hsbc.com
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
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EMEA Equity Research
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July 2012
Liquidity (6M ADTV) of equity indices in Russia
Sector composition of MSCI Russia index*
3000
Sector
2500
Energy
Financials
Materials
Telecommunication Services
Utilities
Consumer Staples
2000
1500
1000
Total
500
Weight (%)
58.2
15.4
11.1
8.0
3.9
3.5
100.0
Note: * data as at 22 May 2012
Source: MSCI, Thomson Reuters Datastream, HSBC
0
07
08
09
10
11
12
Russia MIC EX Index 6M ADT V (U SD m)
Source: MICEX, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC
Earnings and valuation
Russia stands out among emerging markets in terms of its valuation characteristics, as well as its
liquidity. Valuation by itself is not enough in Russia – it provides little protection on the downside, but
can create a lot of leverage on the upside. As the Russian stock market is heavily dominated by resource
stocks, it functions primarily as a straight play on the global commodities cycle. Therefore, countryspecific factors may not play as much of a role as fluctuations in investors’ risk appetite. Russian stocks
are normally high beta relative to their developed market peers. Russian stocks are sold off more heavily
when the global macro situation deteriorates, as investors reduce their exposure to what they consider to
be riskier assets, but they become a preferred investment choice in a strong macro environment, which
triggers the return of risk appetite to emerging markets.
Since 2000, earnings in Russia have followed a growth trend, with some fluctuations during major global
economic downturns. Consensus recommendations for Russian stocks have been bullish most of the time
since 2008. However, Russia has been increasingly de-rated relative to global EM, with the discount of
the MSCI Russia forward consensus PE to the MSCI EM increasing from zero in 2006-07 to almost 50%
by 2012. As the Russia MSCI index is heavily dominated by oil & gas stocks, we attribute the market
discount to the weak earnings growth outlook for this sector. Growth will weaken due to a number of
factors, including stagnation of oil output, increasing capex requirements and an increasing tax burden.
As most of these factors will persist for some time, we therefore believe that, as a market, Russia may
continue to look relatively cheap. However, we also believe that Russia offers the best exposure to any
global economic turnaround, as it has the highest operating leverage to oil and other commodity prices.
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Actual, trend and forecast earnings of MSCI Russia index
Log (EPS in USD)
3.0
Annual growth in earnings: MSCI Russia index
80%
2.5
60%
2.0
40%
1.5
20%
1.0
0%
0.5
-20%
0.0
98
00
02
12M trail
04
06
08
10
Trend
12 e 14 e
-40%
2005 2006 2007 2008 2009 2010 2011 2012e2013e
I/B/E/S fcast
MSCI Russia EPS growth
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
Earnings momentum* versus returns: MSCI Russia index
IBES consensus recommendation score*: MSCI Russia index
400%
100%
3.0
Bearish
300%
50%
200%
2.5
0%
100%
-50%
0%
-100%
2.0
Bullish
-100%
96
98 00 02 04 06 08 10
MSCI Russia earnings momentum
1.5
12
01 02 03 04 05 06 07 08 09 10 11 12
Score
MSCI Russia y-o-y returns (RHS)
Mean
± 2Stdev
Note: *Earnings momentum is defined as the 6-month % change in 12 month forward
EPS forecasts.
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
Note: *represents the market cap weighted aggregate score of the IBES consensus
recommendations for all the constituents. Scores should be interpreted as follows –
1.00 to 1.49: Strong Buy; 1.50 to 2.49: Buy; 2.50 to 3.49: Hold; 3.50 to 4.49:
Underperform; 4.50 to 5.00: Sell
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
Earnings growth* versus returns: MSCI Russia index
Earnings revisions* versus returns: MSCI Russia index
400%
100%
400%
300%
80%
300%
40%
200%
60%
200%
20%
100%
40%
100%
0%
20%
0%
100%
80%
60%
0%
-20%
-40%
-100%
96
98
00 02 04 06 08 10
MSCI Russia earnings growth
MSCI Russia y-o-y returns (RHS)
Note: *Forecast growth in 12m-forward earnings
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
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12
0%
-100%
96
98
00 02 04 06 08 10
MSCI Russia earnings revision
12
MSCI Russia y-o-y returns (RHS)
Note:- *Number of upward 12m-forward EPS estimate revisions over the last month as
a % of the total number of revisions
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
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EMEA Equity Research
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MSCI Russia index: 12M-forward PE scenarios*
Earnings yield versus bond yield* in Russia
5000
40%
35%
4000
25x
3000
20x
15x
2000
10x
1000
5x
30%
25%
20%
15%
10%
5%
05
0
06
01 02 03 04 05 06 07 08 09 10 11 12
MSCI Russia Price Index
07
08
09
10
11
12
R uss ia 10Y nom inal par yield on Gov t. s ecurities
12M -forw ard earnings y ield of M SC I Rus sia
Note: *based on five scenarios of 12M-forward PE multiples (5x, 10x, 15x, 20x and 25x)
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
Note: * earnings yield is calculated as the reciprocal of the 12M-forward PE ratio of the
MSCI index and the bond yield is the 10Y nominal par yield on Govt. Bonds.
Source: MSCI, IBES, Oxford Economics, Thomson Reuters Datastream, HSBC
12M-forward PB versus RoE: MSCI Russia index
12M-forward PE ratio of MSCI Russia relative to MSCI EM
22%
1.9
1.7
1.5
1.3
1.1
0.9
0.7
0.5
1.2x
15.0x
20%
18%
1.0x
10.0x
0.8x
16%
14%
0.6x
5.0x
0.4x
12%
10%
05
06 07
08 09
10 11
12
MSCI Russia 12M -forward price to book ratio
MSCI Russia 12M -forward RoE (RHS)
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
0.0x
0.2x
01
03
05
07
09
11
MSCI Rus sia 12M-forward Price/Earnin gs ratio
rel. to MSCI EM (RHS)
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
Fund flows
In the last decade, Russia has seen a substantial amount of foreign investment. However, since the end of
2008, Russia’s relative weighting in GEM funds has fallen from 12% to approximately 7% (June 2012).
The fund outflow which took place in 2011 was to a great extent driven by the rising global macro
uncertainty, related to the crisis in the eurozone and concerns over the potential slowdown in Chinese
economic growth. Although we believe that political uncertainty related to the 2011 parliamentary and
2012 presidential elections, and public protests which broke out towards the end of 2011, contributed to
the fund outflow, we believe the country-specific factors to be of less importance than the global macro
conditions. Indeed, with both presidential and parliamentary elections behind us, we believe that any
inflow of funds into EM and Russian equities is conditional on improvement in the global macro
environment, especially a resolution of the situation in Europe, continuation of high economic growth
rates in China and resumption of economic growth in the US.
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Economic basics
Russia is the ninth-largest economy in the world, with GDP of USD1,850bn in 2011, and the sixth-largest
if measured by purchasing power parity, according to the IMF. On its income per capita basis Russia falls
into the UN’s middle-income category, but it has the highest GDP per capita growth rates among the
BRIC countries.
Russia is an open economy, with exports and imports exceeding 50% of GDP. Consumption (government
plus households) made up two-thirds of Russia’s GDP in 2011, with investment accounting for one
quarter of GDP. The service and goods production sectors contribute almost equal proportions of GDP.
The Russian economy is highly dependant on the global economic cycle, and on commodity markets,
through the export revenues it derives from natural resources (primarily oil & gas) and the associated
taxation. According to HSBC’s economics team, an annual growth rate of above 3% is unsustainable in
the medium term without support from external demand (ie a high oil price), even though economic
growth currently has significant support from domestic consumption.
GDP (PPP, 2011)
Note: GDP based on purchasing power parity (PPP)
Source: IMF, HSBC
GDP (LHS)
1Q 2012
1Q 2011
1Q 2010
1Q 2009
1Q 2008
Italy
France
UK
Brazil
Russia
Japan
Germany
India
China
0
1Q 2007
5
1Q 2006
10
90
60
30
0
-30
-60
-90
1Q 2005
%, y-o-y
15
12
8
4
0
-4
-8
-12
%, y-o-y
High sensitivity to oil (Urals) price
20
US
Current international dollar (trln)
Russia is the 6th largest economy in the world (PPP basis)
Urals (RHS)
Source: Rosstat, HSBC
Economic policy primer
The Central Bank of Russia (CBR) supervises exchange rate stability. The RUB exchange rate is floating
within the corridor set by the CBR against the USD-EUR basket. The CBR uses FX intervention to keep
the RUB within the corridor.
Russia’s medium-term monetary policy is jointly developed by the CBR and the government for a threeyear period and published by the CBR. According to the latest policy, for the 2012-14 period, the CBR is
planning to develop inflation targets based on a target growth range for the consumer price index. The
current target is to keep headline inflation (Dec/Dec) between 6% and 7% in 2012 and to reduce it to 45% in 2014. The CBR also aims to maintain a flexible exchange rate, limiting its FX intervention to
smoothing out RUB volatility, but also aiming to gradually reduce such intervention.
The Russian budget and GDP growth rates are highly sensitive to the oil price. Assuming an oil price of
around USD100/bbl, the government is expecting the country to maintain an annual GDP growth rate of
around 3-4% during 2012-14 with the budget deficit not exceeding 1.5-1.6%. Russia has over USD500bn
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in currency and gold reserves, which it uses to mitigate fluctuations in the local currency as well as to
fund any shortfalls in the government spending budget when government revenues fall on the back of
lower commodity prices. A long-term economic strategy, “Strategy 2020”, has been discussed by the
government; if implemented, it would shift the focus of the economy from natural resources to more
innovative industries and thus change the GDP structure and drivers.
Political structure
The Russian Federation is a federal presidential republic with the executive power split between the
president and the prime minister. The Russian parliament has two houses: the State Duma (450 deputies),
being the lower house, and the Federation Council (178 senators), being the upper house. The Duma
deputies are elected at general public elections for a five-year term. The Duma elections are only open to
political parties registered with the Ministry of Justice. The parties have to pass a threshold of 7% of total
votes to get Duma seats. The Federation Council is comprised of representatives of all regions that are
legal subjects of the Russian Federation. There are two representatives for each region, one appointed by
its executive branch and the other by the legislative branch.
Vladimir Putin was elected the President of Russia on 4 March 2012 for a six-year term. The previous
president, Dmitry Medvedev was appointed prime minister. Elections to the State Duma were held on 4
December 2011, with the pro-government United Russia party taking the majority (53%) of seats in the
new Duma; (the Chairman of United Russia is currently the Russian Prime Minister, Mr Medvedev, who
replaced Mr Putin in that capacity after the latter was elected as the Russian President). The other Duma
parties are the Communists (20% of seats), Fair Russia (14%) and the Liberal Democrats (12%).
Following the liberalisation of the political legislation in 2012, the requirements for registering political
parties in Russia have been dramatically loosened, which should open up the way for more opposition
parties to take part in elections.
Key regulatory bodies
Central Bank of Russia: responsible for monetary policy and supervising the banking system.
Federal Service of Financial Markets: responsible for supervising non-banks and non-auditors, as well
as capital markets, including brokers and stock exchanges.
Federal Tariff Service: the federal agency responsible for setting the tariffs for natural monopolies,
including utilities, gas and railroad transportation.
MICEX-RTS Stock Exchange: the largest stock exchange in Russia responsible for the introduction of
listing requirements for domestic issuers.
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Notes
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Saudi Arabia
Raj Sinha*
Analyst, Head of MENA Research
HSBC Bank Middle East Ltd
+971 4423 6923
raj.sinha@hsbc.com
John Tottie*
Analyst, industrials, natural resources, and energy
HSBC Saudi Arabia Ltd
+966 1 299 2101
john.tottie@hsbc.com
Aybek Islamov*
Analyst, banks
HSBC Bank Middle East Ltd
+971 4423 6921
aybek.islamov@hsbc.com
Patrick Gaffney*
Analyst, real estate
HSBC Bank Middle East Ltd
+971 4423 6930
patrickgaffney@hsbc.com
Sriharsha Pappu, CFA*
Head of Chemicals Equity Research, Asia and CEEMA
HSBC Bank Middle East
+971 4423 6924
sirharsha.pappu@hsbc.com
John Lomax *
Strategist
HSBC Bank plc
+44 20 7992 3712
john.lomax@hsbcib.com
Wietse Nijenhuis*
Strategist
HSBC Bank plc
+44 20 7992 3680
wietse.nijenhuis@hsbcib.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
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Introduction
The Saudi equity market has performed strongly over the last 10 years. The main index, the Tadawul AllShare Index (TASI), has returned a healthy 196%, buoyed by rising oil prices and GDP growth that has
averaged 3.7% per annum. However, the volatility has been significant in a market with over 90% of
trading volumes accounted for by Saudi retail investors. The TASI returned a 720% from early 2002 to
February 2006, but investors who bought at the peak in February 2006 have lost 64%, even though the
market has returned 65% since early 2009. The market has been open for investment since 2007 for
citizens of the nations within the Gulf Co-operation Council (which also includes the UAE, Kuwait,
Qatar, Bahrain and Oman). Since 2008, non-GCC investors have been able to access the market via swap
agreements.
The Saudi equity market tends to trade at a premium to the MSCI emerging markets index, reflecting its
vast hydrocarbon wealth and one of the most attractive demographic profiles globally, including a very
young population and a labour force growing at nearly 3% per annum. The Saudi bourse, the largest in
the Middle East, is open for trading between 11.00am and 3.30pm Saturday to Wednesday.
Market structure
152 stocks are listed on the Tadawul exchange. SABIC and Al Rajhi both account for more than 10% of
the Tadawul All Share Index, with the top 5 names representing one-third of the market. The top 10
names account for 46% of the index, and have an average free float of about 30%. This means that the
Saudi market is more diversified than most other regional exchanges but it is still is fairly concentrated by
developed-market standards. Financials accounts for 37% of the market, followed by a 34% weight for
materials, which includes petrochemical companies. Sector selection is therefore very important.
Equity index performance in Saudi Arabia
Major stocks in Tadawul All Share Index
25000
6000
20000
5000
4000
15000
3000
10000
2000
5000
1000
0
0
99 00 01 02 03 04 05 06 07 08 09 10 11 12
TADAWUL All Share Index (Local currency)
TADAWUL All Share Index (USD, RHS)
Rank
Stock name
1
2
3
4
5
1- 5
6
7
8
9
10
6-10
SABIC
Al Rajhi Bank
Etihad Etisalat Co.
Samba Financial Group
Riyad Bank
National Industrialization Co.
Saudi Arabia Fertilizer Co.
Banque Saudi Fransi
Alinma Bank
Saudi Telecom Co.
Weight (%)
10.9
10.3
4.8
3.8
3.0
32.8
2.9
2.8
2.5
2.4
2.3
12.9
Source: MSCI, Thomson Reuters Datastream, HSBC
Source: Tadawul, Thomson Reuters Datastream, HSBC
The Saudi equity market is one of the most heavily traded in the emerging markets space, with average
daily turnover at USD1.2bn in 2011 and USD2.7bn in the year to June 2012. At times, the market
turnover has been higher than the combined turnover in all other CEEMEA equity markets, even though
volumes are still far below the market peak in 2005/06. The ratio of market capitalisation to GDP, at
about 80%, is high by emerging-market standards.
240
John Tottie*
Analyst
HSBC Saudi Arabia Limited
+966 1 299 2101
john.tottie@hsbc.com
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
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Liquidity (6M ADTV) of Tadawul All Share Index
Sector composition of Tadawul All Share Index
5000
Sector
Financials
Materials
Industrials
Telecommunication Services
Consumer Staples
Utilities
Consumer Discretionary
Energy
Health Care
4000
3000
2000
1000
0
07
08
09
10
11
12
Tadaw ul Index 6M ADT V (USDm)
Total
Weight (%)
37.2
34.4
9.1
8.3
5.2
2.0
1.7
1.5
0.5
100.0
Source: Tadawul, MSCI, Thomson Reuters Datastream, HSBC
Source: Tadawul, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC
The Saudi market has exhibited a low correlation to global equity benchmarks, partly because the market
is currently closed for direct foreign investment. Non-GCC parties can only invest in Saudi equities
through swap contracts and via a limited selection of exchange traded funds. Several local Saudi
brokerage firms offer swap contracts to international investors. These contracts enable the investor to
obtain economic exposure while the legal ownership remains with a Saudi-registered entity.
In April 2012, the chairman of the Saudi Capital Market Authority, Abdulrahman al-Tuwaijri, was quoted
in the news media (Reuters, 3 April 2012), indicating that Saudi Arabia would open its stock market in a
"gradual" manner to protect the bourse's stability. We believe this may happen in 2013. Also in April, the
Saudi stock exchange announced that it had signed an agreement with Morgan Stanley Capital
International (MSCI) to create and issue indices based on the Saudi equity market.
If Saudi opens its market to direct foreign investment, it may potentially be included in the MSCI
Emerging Markets index. The high turnover of the Saudi market suggests that it could be a key
constituent of this key benchmark. Inclusion in the MSCI EM (or even Frontiers EM) index, were it to
happen, could be important for at least two reasons: first, it should allow Saudi to tap the broad
international pool of EM liquidity; second, it has the potential to stimulate more efficient behaviour from
Saudi equities, allowing them to better reflect market fundamentals.
Earnings and valuation
TASI earnings growth failed to break the 10% threshold in both 2010 and 2011. In contrast, oil prices
registered gains of over 20% in both years. Bloomberg indicates that analysts forecast earnings to
increase 18% in 2012 and 14% in 2013, even though most analysts expect oil prices to be range-bound
between USD100 and USD120 per barrel.
The disconnect between corporate earnings and oil prices may appear paradoxical as Saudi Arabia is the
world's largest oil exporter. However, with Saudi Aramco, the national oil company, having full control
and ownership of all oil upstream activities (with the minor exception of those in the Neutral Zone), this
means that oil prices only have an indirect impact on earnings.
The Saudi chemical sector has exposure to oil prices, as chemical prices tend to be set by higher-cost
chemical producers that use oil-based feedstock. This link can, however, be tenuous because many other
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variables impact the sector. Many large private sector projects have experienced delays partly because the
government has become more selective in allocating new gas feedstock.
Oil revenues should also trickle down to corporate revenues through government spending. Indeed, the
new era of high oil prices has translated to unprecedented initiatives by policymakers to make large
investments in construction and infrastructure projects. However, capacity constraints have presented a key
bottleneck: cement is still in short supply, for example, even though capacity has been doubled over the
last five years. Moreover, the government's ability to fund projects directly has resulted in the commercial
banking sector being bypassed, although we are now seeing clear signs that loan growth is recovering.
Saudi Arabia's heavy reliance on expatriate labour has translated into the Kingdom becoming the world’s
second-largest source of remittances, after the United States, with income equivalent to about 25% of
private consumption in the Kingdom being sent abroad.
Perhaps the most obvious effect that rising hydrocarbon income has had on the listed Saudi equity
universe has been through government social spending programmes and other initiatives to boost
consumer disposable income. These include the award of the equivalent of two additional months’ salary
to government workers in 2011, an initiative that many private-sector employers felt compelled to match.
Moreover, very high oil prices combined with near-record Saudi oil production has translated to a very
strong government balance sheet, with a positive knock-on effect on valuations.
Since mid-2009, the Saudi market has tended to trade at a forward earnings premium of approximately
5% to 20% to the MSCI emerging markets index, to reflect, not just its vast hydrocarbon wealth, but also
a very attractive demographic profile, with a young and growing population. At the time of writing, the
Bloomberg consensus has the Saudi market at 11.8x forecast 2012 earnings. In absolute terms, this is
close to the average level over the last four years. However, it represents a relatively high 25% premium
to the consensus MSCI EM forward earnings forecast, following a very strong relative performance by
the Saudi market over the last year. The Saudi market has outperformed the MSCI EM index by about
30% since the European debt crisis intensified in July 2011. At the market peak in early 2006, with a
market capitalisation of the TASI near USD800bn, the Saudi market traded at a valuation exceeding 40x
forward earnings. At the trough in early 2009, the TASI traded at a price multiple of forward earnings as
low as 7x. Over the last three years, the Saudi market has tended to trade between 11x and 14x earnings.
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Actual and forecast earnings of Tadawul All Share Index
Annual growth in earnings*: Tadawul All Share Index
700
50%
600
40%
500
30%
400
20%
300
10%
200
0%
08
09
10
12M -trailing EPS
11
2006
12
2007
12M -forw ard EPS
2008
2009
2010
2011
Earnings grow th
Source: Tadawul, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC
* Calculated as growth in the 12M-trailing earnings at the end of each year
Source: Tadawul, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC
Earnings growth* versus returns: Tadawul All Share Index
Price/sales ratio of Tadawul All Share Index
60%
80%
6.0x
40%
5.0x
50%
40%
30%
0%
4.0x
3.0x
20%
-40%
10%
2.0x
0%
-80%
07
08
09
10
11
1.0x
12
08
12M-forw ard earnings grow th (LHS)
y -o-y returns (RHS)
09
10
12M trailing
*Forecast growth in 12M-forward earnings
Source: Tadawul, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC
11
12
12M forw ard
Source Tadawul,: Bloomberg Finance LP, Thomson Reuters Datastream, HSBC
Dividend yield of Tadawul All Share Index
Price/book of Tadawul All Share Index
6.0%
4.0x
5.0%
3.5x
3.0x
4.0%
2.5x
3.0%
2.0x
2.0%
1.5x
1.0%
1.0x
08
09
12M trailing
10
11
12
12M forw ard
Source: Tadawul, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC
08
09
12M trailing
10
11
12
12M forw ard
Source: Tadawul, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC
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Tadawul All Share Index: 12M-forward PE scenarios*
12M-forward PE ratio of Tadawul All Share Index relative to
MSCI EM
20000
26.0x
1.6x
21.0x
1.4x
16.0x
1.2x
11.0x
1.0x
6.0x
0.8x
15000
25x
20x
10000
15x
10x
5000
5x
0
08
09
10
11
12
07
T ADAWU L All Share Index
08
Saudi Arabia
*Based on five scenarios of 12 month forward P/E multiple(5x, 10x, 15x, 20x and 25x)
Source: Tadawul, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC
Bloomberg Finance LP, Thomson Reuters Datastream, HSBC
09
10
11
12
rel. to MSC I EM (R HS)
Source: MSCI, Tadawul, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC
Bloomberg Finance LP, Thomson Reuters Datastream, HSBC
Fund flows
As noted above, the Saudi market is currently only open for foreign investment via swap contracts and a
limited selection of other products. There is, therefore, a very limited inflow of funds from non-GCC
investors. Since April 2009, swap agreements to buy Saudi securities have totalled SAR40.7bn. Against
SAR35.9bn in swap sell agreements over the same period, this translates to a net inflow of just
SAR4.8bn, or USD1.3bn, over the last three years. On a monthly basis, swap agreements to buy securities
reached their highest level, SAR2.6bn, in February 2012. Against sell contracts of just SAR1.1bn, this
translated to a net inflow of a record SAR1.5bn in February 2012. Net flows reversed sharply in March
and April 2012, when swap agreements accounted for net sell contracts for a combined total of SAR1bn.
Swap agreements, SARbn per month
3
2
1
0
Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12
-1
-2
Buy
Sell
Net buy
-3
Source: HSBC
Economic basics
We forecast the gross domestic product of Saudi Arabia's oil-based economy to reach USD611bn in 2012
on real growth of 4.1%. The Kingdom controls a fifth of the world’s proven oil reserves, and is the
world’s largest producer and exporter of oil. With a population of 29 million, of whom about 20 million
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are Saudi citizens, it is also the most populous GCC nation by some way. With 40% of nationals under
the age of 15, and population growth running over 2% a year, Saudi Arabia also has one of the youngest
and fastest growing populations in the world outside sub-Saharan Africa.
Saudi’s economy centres on oil; the petroleum sector accounts for roughly 80% of budget revenues, 45%
of GDP and 90% of export earnings. The government is encouraging private sector growth to diversify
the economy and boost employment; youth unemployment is above 25%, and despite the oil sector
accounting for a large proportion of the economy, the national oil company employs less than 1% of the
Saudi labour force. The Kingdom is also seeking to reduce unemployment among Saudis by requiring the
private sector to employ more nationals. Currently only about one in every ten private-sector workers is a
Saudi national.
With reserves likely to exceed USD600bn by the end of 2012, Saudi Arabia looks well placed to weather
regional instability or a dip in oil prices. The growth rates we project over the coming two years are, at
best, however, only likely to prevent the current high levels of youth unemployment from rising, given the
rapid growth in the adult population. Despite the push to diversify, the pivotal role played by public
spending means that the Kingdom’s reliance on its oil sector is very high.
Economic policy primer
According to preliminary estimates from the Ministry of Finance, Saudi Arabia recorded a fiscal surplus
of USD82bn in 2011, equivalent to 14% of GDP. The Kingdom has now realised budget surpluses in
excess of 10% of GDP in six of the last eight years. The fiscal position has strengthened, despite
sustained growth in public spending, which more than doubled between 2006 and 2011. This
expansionary stance is set to continue, boosted by a series of supplementary spending commitments made
against the backdrop of the 2011 Arab Spring, focused on infrastructure, housing, education and
healthcare. Although a drop in oil prices might prompt some moderation in spending growth, high
reserves provide a critical buffer to smooth spending.
Monetary policy is carried out by the Saudi Arabian Monetary Agency (SAMA), the central bank. Policy
is anchored by the Saudi Riyal’s peg against the US dollar, which has been in place for a generation and
unchanged in value since the 1980s. Despite the constraints it imposes on policymaking, the forward
Central bank reserves, USDbn
Budget surplus
200
40
150
30
500
100
20
400
50
10
0
0
700
600
300
200
-50
100
-10
2012f
2011
2010
2009
LHS: USDbn
2008
2007
2006
2012f
2011
2010
2009
2008
2007
2006
2005
2004
Source: SAMA, HSBC estimates
2005
2004
0
RHS: Share of GDP (%)
Source: SAMA, HSBC estimates
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markets show no expectation that that there will be a change in the foreign currency regime. As a
consequence, the SAMA’s policy stance is likely to continue to track that of the US, with the repo and
reverse repo policy rates likely to remain at their current historic lows.
Political structure
Saudi Arabia is an Islamic monarchy. The king of Saudi Arabia is both head of state and head of the
government. The Qur’an forms the constitution with Saudi governed on the basis of Shari’a law. The
government is led by the Al Saud royal family. King Abdullah bin Abdulaziz Al Saud assumed the throne
in 2005. Prince Salman bin Abdulaziz became crown prince in June 2012. Key government decisions are
largely made on the basis of consultation among the senior princes of the royal family and the religious
establishment. The government also includes a Consultative Assembly (Shura Council), which has 150
members, all appointed by the king. The council has very limited powers, but can propose laws to the
king. In some cases, the king will submit laws to obtain the council’s advice.
Key regulatory bodies
Capital Market Authority: The CMA's functions are to regulate and develop the Saudi capital markets by
issuing rules and regulations for implementing the provisions of Capital Market Law. Objectives include
creating an appropriate investment environment, boosting confidence, and reinforcing transparency and
disclosure standards in all listed companies.
Saudi Arabian Monetary Agency: Established in 1952, SAMA is the central bank responsible for
monetary policy and banking regulation.
Saudi Arabian General Investment Authority: SAGIA is the authorising body for issuing investment
licences to foreign investors and coordinating with other involved government agencies.
Electricity & Co-Generation Regulatory Authority: ECRA was established to regulate the electricity
and water desalination industry.
Saudi Food & Drug Authority: SFDA regulates, oversees, and controls food, drug, and medical devices.
Ministry of Petroleum & Mineral Resources: The ministry supervises its affiliate companies in the fields
of petroleum and minerals by observing and monitoring exploration, development, production, refining,
transportation, and distribution activities.
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South Africa
Franca Di Silvestro*
Analyst, Head of South African Equity Research
HSBC Securities (South Africa) (Pty) Ltd
+27 11 676 4223
franca.disilvestro@za.hsbc.com
Jan Rost*
Analyst, banks
HSBC Securities (South Africa) (Pty) Ltd
+27 11 676 4209
jan.rost@za.hsbc.com
Michele Olivier*
Analyst, consumer and industrials
HSBC Securities (South Africa) (Pty) Ltd
+27 11 676 4208
michele.olivier@za.hsbc.com
Cor Booysen*
Analyst, metals & mining
HSBC Securities (South Africa) (Pty) Ltd
+27 11 676 4224
cor.booysen@za.hsbc.com
Richard Hart*
Analyst, metals & mining
HSBC Securities (South Africa) (Pty) Ltd
+27 11 676 4218
richard.hart@za.hsbc.com
John Lomax *
Strategist
HSBC Bank plc
+44 20 7992 3712
john.lomax@hsbcib.com
Wietse Nijenhuis*
Strategist
HSBC Bank plc
+44 20 7992 3680 wietse.nijenhuis@hsbcib.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
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Introduction
The South African market is viewed as the most mature equity market in the African territory, having
undergone a number of reforms initiated by both the Johannesburg Securities Exchange (JSE) and the
South African government. The JSE was founded in November 1887. Trading is allowed on the JSE on
weekdays between 0900 and 1700 South African standard time, and works on a rolling T+5 settlement
cycle, meaning that settlement occurs five days after the transaction date, although the exchange is
moving towards T+3 settlement.
The FTSE/JSE All Share (JALSH), a market capitalisation weighted index, serves as the primary gauge
of the South African equity market. Over the past 10 years, the JALSH had returned around 195% in
South African rand terms and some 237% in US dollar terms; this translates into compound annual
growth rates of 11% and 13%, respectively.
According to World Bank data from 2010, South Africa ranks first among the 21 emerging markets on
the metric of market capitalisation as a percentage of GDP. On a global basis, it ranks second only to
Hong Kong on this metric. One theme that attracts investors to the South African equity market is what is
termed “Access Africa” – its exposure to other African markets. Since many other African exchanges are
not liquid and open, investors prefer to look at South African companies with an African reach.
The dominant trends driving the upward trend in the South African equity market over the past decade
have been the global resources boom, together with rising spending by the emerging middle class (buoyed
by an influx of foreign immigrants). This trend has benefited all consumer sectors (including mobile).
Market structure
The MSCI South Africa index is relatively well diversified by comparison with other emerging EMEA
country indices such as Turkey and Russia. Excluding the London listed (dual-listed) stocks, the top 5
companies constitute about 39% and the top 10 companies 55% of the index’s market capitalisation.
MTN and Sasol together constitute around 20% of the index weight. Other major constituents of the
index are Naspers, Standard Bank and AngloGold Ashanti. The major London listed stocks include Anglo
American, BHP Billiton, British American Tobacco, Investec, Lonmin, Old Mutual and SAB Miller.
Equity index performance in South Africa
Major stocks in MSCI South Africa index* (excluding London
dual-listed stocks)
1000
40000
35000
30000
25000
20000
15000
10000
5000
0
800
600
400
200
0
96
98
00
02
04
06
08
10
12
MSCI South Africa price index (in Local currency)
JSE All share price index (in Local currency, RHS)
Rank
Stock Name
1
2
3
4
5
Top 5
6
7
8
9
10
Top 6-10
MTN Group Limited
Sasol Limited
Naspers Ltd.
Standard Bank Group Ltd.
Anglogold Ashanti Ltd.
Gold Fields Ltd.
Impala Platinum Hdg.Ltd.
Firstrand Ltd.
Sanlam Ltd.
Shoprite Holdings Ltd.
Note: * data as at 22 May 2012.
Source: MSCI, Thomson Reuters Datastream, HSBC
Source: MSCI, Thomson Reuters Datastream, HSBC
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Weight (%)
10.7
9.1
8.0
6.4
5.2
39.4
3.6
3.4
3.3
2.7
2.7
15.7
Franca Di Silvestro*
Analyst
HSBC Securities (Pty) Ltd|
+27 11 676 4223
franca.disilvestro@za.hsbc.com
*Employed by a non-US affiliate of
HSBC Securities (USA) Inc, and
is not registered/ qualified
pursuant to FINRA regulations
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By sector, financials and materials constitute around 48% of the total index market capitalisation of MSCI
South Africa index, followed by consumer discretionary (15%) and telecoms (13%). Despite the higher
weightings of cyclical sectors such as financials and materials and a volatile currency (South African rand
– ZAR), the South African equity market has historically been perceived as defensive (low beta, low
volatility). This is because of its insulation from major markets and its healthy financial system (which is
underpinned by a large domestic institutional asset management industry) and its core gold mining sector
which gained from heavy safe-haven buying of gold. Strong corporate governance relative to other
emerging markets is also a factor driving relative performance.
Liquidity (6M ADTV) of equity indices in South Africa
Sector composition of MSCI South Africa index*
2000
Sector
Weight (%)
Financials
Materials
Consumer Discretionary
Telecommunication Services
Energy
Consumer Staples
Industrials
Health Care
1500
1000
500
26.8
21.2
15.4
12.8
9.1
6.9
4.7
3.2
0
07
08
09
10
11
12
SA FTSE/JSE All Share Index 6M ADTV (USD m)
Total
100.0
Note: * data as at 22 May 2012.
Source: MSCI, Thomson Reuters Datastream, HSBC
Source: Bloomberg Finance LP, Thomson Reuters Datastream, HSBC
Earnings and valuation
As a result of the country’s very well-developed market and financial system, corporate earnings in South
Africa are generally less volatile than those of many emerging markets. Looking at an extended history,
SA corporate earnings have been increasing at a steady pace.
Actual, trend and forecast earnings of MSCI South Africa index
Annual growth in earnings: MSCI South Africa index
2.5
40%
30%
2.0
20%
10%
1.5
0%
1.0
-10%
-20%
0.5
94
96
98
12M trail
00
02
04
06
08
Trend
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
10
12
14
I/B/E/S fcast
-30%
2001
2003
2005
2007
2009
2011
MSCI South Africa EPS growth
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
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Earnings momentum* vs. returns: MSCI South Africa index
20%
100%
10%
50%
0%
Earnings growth* vs. returns: MSCI South Africa index
40%
100%
30%
50%
20%
-10%
0%
0%
10%
-20%
-50%
-30%
96
98
00
02
04
06
08
10
-50%
0%
12
96
M SC I South Africa earnings momentum
M SC I South Africa y -o-y returns (R HS)
98
00
02
04
06
08
10
12
M SCI South Africa earnings grow th
M SCI South Africa y -o-y returns (RHS)
Note: *Earnings momentum is defined as the 6M % change in 12 month forward EPS
forecast.
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
Note: *Forecast growth in 12M-forward earnings.
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
Earnings momentum in 12M-forward earnings estimates measures the changes in analyst perceptions
about future earnings. Earnings estimates for MSCI South Africa were cut around 30% during the 200809 financial crisis. However, actual earnings growth around this period was consistently above 10%.
Over the long term, earnings revisions have been a good indicator of market performance. IBES
consensus recommendation scores, which measure the extent to which the analyst community is bullish
or bearish about South African equities (bottom-right chart below), show that, in aggregate, analysts have
been bearish on the market for the most part since the financial crisis. However, since the beginning of
2009, the MSCI South Africa has outperformed the broader MSCI EM index by around 9% in US dollars.
Earnings revisions* vs. returns: MSCI South Africa index
IBES Consensus recommendation score* versus MSCI South
Africa index
80%
3.0
100%
Bearish
2.8
60%
50%
2.6
40%
0%
20%
2.4
Bullish
2.2
0%
-50%
96
98 00 02 04 06 08 10 12
M SCI South Africa earnings rev ision
M SCI South Africa y -o-y returns (R HS)
Note: *Number of 12M-forward EPS estimates up over the last month as a % of total
number of revisions in estimates over the corresponding period
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
250
2.0
01 02 03 04 05 06 07 08 09 10 11 12
Score
Mean
± 2Stdev
Note: *represents the market cap weighted aggregated score of the IBES consensus
recommendation of all the constituents. Score should be interpreted as follows – 1.00
to 1.49: Strong Buy; 1.50 to 2.49: Buy; 2.50 to 3.49: Hold; 3.50 to 4.49: Underperform;
4.50 to 5.00: Sell
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
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MSCI South Africa index; 12M-forward PE scenarios*
Earnings yield versus bond yield* in South Africa
2500
15%
2000
1500
1000
500
25x
13%
20x
11%
15x
9%
10x
7%
5x
5%
05
0
01 02 03 04 05 06 07 08 09 10 11 12
MSCI South Africa Price Index
06
07
08
09
10
11
12
South Africa 10Y nominal par y ield on Gov t. securitie s
12M -forw ard earnings y ie ld of MSC I South Africa
* Note: Based on five scenarios of 12M- forward PE multiple (5x, 10x, 15x, 20x and 25x)
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
*Note: Earnings yield is calculated as the reciprocal of the 12M- forward PE ratio of the
MSCI index and the bond yield is the 10Y nominal par yield on Govt. Bonds.
Source: MSCI, IBES, Oxford Economics, Thomson Reuters Datastream, HSBC
In terms of valuation, since 2001 the market has traded at around 10x its 12M-forward earnings estimates.
Thanks to the relative resilience of the market, the PE ratio has remained sticky and tightly range-bound,
even during the financial crisis, and earnings yields on equities have largely been above those offered by
government bonds.
For about 10 years after the liberalisation of the market in 1996, the South African equity market
constantly re-rated relative to the MSCI EM as a whole. However, during most of this time, South
African equities traded at a discount to broader EM. In absolute terms, PE bottomed around October
2008. Since then, the market has re-rated constantly but the PE multiple has remained well below the precrisis level of around 12x. The South African market has generally enjoyed a rich PB valuation – between
1.5-2.0x since 2005 – underpinned by a strong return on equity.
12M-forward PB versus RoE: MSCI South Africa index
3.0
12M-forward PE ratio of MSCI South Africa relative to MSCI
EM
26%
24%
22%
20%
18%
16%
14%
12%
10%
2.5
2.0
1.5
1.0
05
06
07 08
09
10
11
12
MSCI South Africa 12M -forward price to book ratio
MSCI South Africa 12M -forward RoE (RHS)
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
1.2x
15.0x
13.0x
1.0x
11.0x
0.8x
9.0x
0.6x
7.0x
0.4x
5.0x
98
00 02 04 06 08 10
12
MSCI South Africa 12M -forw ard PE ratio
rel. to MSCI EM (RHS)
Source: MSCI, IBES, Thomson Reuters Datastream, HSBC
Fund flows
In absolute terms, South African equity funds have seen redemptions amounting to USD361m since 2000.
In the same period, other CEEMEA markets, Russia, Poland and Turkey, have seen net subscriptions of
USD10.8bn, USD0.2bn and USD1.2bn, respectively.
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In GEM fund managers’ portfolios, South Africa had been a structural underweight relative to the MSCI
EM benchmark index. The underweight position was more pronounced between 1996 and 2004, but has
decreased since 2005. The South African market is perceived as a defensive play in an emerging market
context. Generally, investor sentiment about the market tends to become more negative during secular
market upswings. This is not to say that during “risk-on” environments South African equities fall while
other EM equities rise; it merely indicates that South African equities tend to rise less than those in more
cyclical markets. Conversely, South African equities tend to fall less in a “risk-off” environment.
Flows (% of AuM) into South Africa dedicated funds
Weight of South Africa in GEM funds versus benchmark
20%
20%
10%
15%
0%
10%
-10%
5%
-20%
0%
-30%
00 01 02 03 04 05 06 07 08 09 10 11 12
South Africa F und flow s as % of as sets under
m anagem ent
Source: EPFR Global, HSBC
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Weight (%) in GEM Equity F unds
Weight (%) in M SCI EM index
Source: MSCI, EPFR Global, HSBC
Economic basics
South Africa is the African continent’s largest and most advanced economy. The country’s GDP per
capita, around USD8,000 in 2011, is significantly higher than the sub-Saharan African average, while the
economic infrastructure boasts a sophisticated financial system and a large web of companies in almost
every sub-sector of the manufacturing, mining and services businesses. South Africa is also the business
portal to the sub-Saharan Africa region thanks to its numerous internationalised institutions. The country
generally leads the continent on development indices, too, such as the United Nation’s Human
Development Index, the World Economic Forum’s Global Competitiveness Index and the World Bank’s
Ease of Doing Business Index.
South Africa is one of the most mineral-rich countries in the world. Endowed with the world’s largest
resource base in PGMs, gold, manganese and chrome, it is also the global leader for thermal coal, mineral
sands, iron ore and uranium resources. South Africa has a well-developed and well-regulated banking
industry, which compares favourably with the banking industries in most developed countries. Banking
sector assets total around ZAR3,397bn, with loans and advances contributing about 76% of total sector
assets. The four major banks (Absa, FirstRand, Nedbank and Standard Bank) account for 84% of total
banking assets and 86% of the total credit extended in the South African banking sector.
South African banks have been largely protected from the global financial crisis, as banking activities are
mainly focused on the domestic and Sub-Saharan Africa markets. Nevertheless, the tougher capital and
liquidity requirements introduced worldwide under Basel III as a result of the crisis are set to be adopted
by South Africa in January 2013. The challenges of meeting these requirements have been resolved
through the introduction of a Committed Liquidity Facility by the South African Reserve Bank.
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South African industry, together with the mining and quarrying sector, makes up nearly one-third of
GDP; the agricultural sector is relatively small, at around 2.5%, and the remainder of GDP comes from
services, including the construction business. On the demand side, household consumption remains the
largest driver of GDP, at c65%, followed by government consumption at 21%. National infrastructure
projects are the main driver of fixed capital investment, in both public and private sectors, which accounts
for c20% of GDP.
South Africa is a relatively closed economy as exports account for less than 30% of GDP. However, the
country is a large exporter of commodities, in particular precious metals (gold, diamond, and platinum),
coal and other industrial metals. Asia has overtaken Europe as the main destination of exports in the past
two years. Currently, some 35% of South Africa’s exports end up in Asia, around 25% in Europe, 20% in
Africa and 15% in Americas.
The growth rate of South Africa’s fairly large, 49 million strong population has nearly stalled lately,
although it is still dominated by young people, with a median age of around 25 years. However, these
population figures do not take into consideration illegal foreign immigrants, whose inclusion would bring
total numbers closer to 60 million. Nevertheless, SA’s population structure presents significant challenges
as the country’s unemployment rate runs chronically high, at around 25%. The South African economy
suffered only a shallow recession during the global financial crisis, but its recovery has also been very
muted. There are substantial structural constraints to growth, such as a very rigid and unionised labour
market, skill mismatches, a high drop-out rate in the education system, an infrastructure deficit, problems
surrounding social delivery, lack of competition in public utility (parastatal) sectors and uncertainties
surrounding future policy making – for example the ongoing nationalisation debates. On the other hand,
South African officials have been successfully tackling other social problems, such as health, crime,
security and housing for the poor population.
Economic policy primer
South Africa generally adheres to free market principles based on open trade and a flexible exchange rate
regime. The National Treasury (NT) has been liberalising the capital account by gradually removing the
remaining restrictions preventing residents from investing abroad, while inward investments and capital
inflows generally take place in a very liberal framework.
The National Treasury and the South African Reserve Bank (SARB) are orthodox in their execution of
fiscal and monetary policies, respectively. The SARB operates an official inflation-targeting regime,
defining price stability as urban headline consumer inflation within its 3.0-6.0% target band. South
Africa’s recent fiscal challenges stem more from the need to support the investment plans of the parastatal
companies, which are large public utility concerns such as Eskom, the power utility, and Transnet, the
logistics and transport utility. Both have to invest heavily to prevent infrastructure bottlenecks in the
country’s manufacturing and mining sectors.
Political structure
South Africa has a stable and democratic political system with a very progressive constitution. Since the
fall of the apartheid regime in 1994, the country has been run by the liberalising force, the African
National Congress (ANC). The ANC is in a formal tri-party alliance with the Congress of the South
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African Trade Unions (COSATU) and the South African Communist Party (SACP). The incumbent ANC
President Jacob Zuma took office in 2009. The next presidential election will take place in 2014, while
ANC’s primary is scheduled for December 2012.
Key regulatory bodies
National Treasury: agency managing national economic policy and government finances.
South African Reserve Bank: supervisory authority of the banking system.
Financial Services Board: agency responsible for the non-banking financial services industry.
National Credit Regulator: regulator of the consumer credit industry.
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Turkey
Cenk Orcan*
Analyst, Co-Head of Turkish Equity Research
HSBC Yatirim Menkul Degerler A.S.
+90 212 376 46 14
cenkorcan@hsbc.com.tr
Bulent Yurdagul*
Analyst, Co-Head of Turkish Equity Research
HSBC Yatirim Menkul Degerler A.S.
+90 212 376 46 12
bulentyurdagul@hsbc.com.tr
Tamer Sengun*
Analyst, banks
HSBC Yatirim Menkul Degerler A.S.
+90 212 376 46 15
tamersengun@hsbc.com.tr
Levent Bayar*
Analyst, industrials and real estate
HSBC Yatirim Menkul Degerler A.S.
+90 212 376 46 17
leventbayar@hsbc.com.tr
John Lomax *
Strategist
HSBC Bank plc
+44 20 7992 3712
john.lomax@hsbcib.com
Wietse Nijenhuis*
Strategist
HSBC Bank plc
+44 20 7992 3680
wietse.nijenhuis@hsbcib.com
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations
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Introduction
The Turkish Stock Exchange market (ISE) with total market cap of USD223bn (as of June 2012) and
daily trading volume in excess of USD1.0bn, is one of the most liquid equity markets in the emerging
market universe. The Turkish market has provided strong returns since its establishment in 1988, but its
eye-catching 8x return between 2003 and 2007 was fuelled by the strong economic recovery after the
deep 2001 recession and start of the membership negotiation process with the European Union in 2005, as
well as rising liquidity in global markets. Foreign ownership in Turkish stocks increased sharply and
exceeded 70% of the free float in 2007 (62% as of June 2012) while the share of foreigners in daily
trading volume remained below 20-25%, proving that locals are also active in the market, especially in
daily trading activities.
Market structure
The market is mainly led by the banks, which have a heavy index weighting. This increases the volatility
in the market because bank earnings are highly sensitive to macro parameters such as growth, inflation
and interest rates. Movements in FX rates (USD/TRY and EUR/TRY) as well as interest rates also create
volatility as they affect the earnings of industrial companies, which are in general indebted (in both FX
and local currency terms). The benchmark ISE-100 index is diversified in terms of sectors represented
and underlying companies, but the MSCI Turkey index is mainly driven by the top 10 stocks, which have
an overall weight of 71%. The banking sector stocks Garanti (15.5%), Akbank (8.9%), Isbank (7.3%) and
Halk Bank (4.4%) make up more than one-third of the index, while the incumbents of Turkey’s telecoms
sector Turkcell (7.6%) and Turk Telekom (4.6%), and consumer staples companies BIM (7.2%) and
Anadolu Efes (5.9%) also have high representations in the index. The remaining part of the index is
formed by the industrials (9.7%), energy (5.4%), consumer discretionary (4.6%) and materials (4.0%)
sectors. Even though all major names in the index have operations outside of Turkey, their operational
profits are mainly driven by Turkish operations. Therefore, Turkey’s GDP growth, level of local interest
rates and TRY against foreign currencies play an important role on the Turkish market’s EPS growth and
share price performances. Trading volume increased steadily from below USD500m in 2003 to over
USD2.0bn in 2011 but declined to USD1.0bn-1.2bn in 2012.
Equity index performance in Turkey
1200000
1000000
800000
600000
Major stocks in MSCI Turkey index*
80000
Rank
Stock Name
60000
1
2
3
4
5
1- 5
6
7
8
9
10
6-10
Garanti Bankasi
Akbank
Turkcell
Isbank
BIM
40000
400000
20000
200000
0
0
96 98 00 02 04 06 08 10 12
MSCI Turkey price index (in Local currency )
Istanbul SE price index (in Local currency , RHS)
Anadolu Efes
Tupras
Turk Telekom
Koc Holding
Halk Bank
Note: * data as at 22 May 2012.
Source: MSCI, Thomson Reuters DataStream, HSBC
Source: MSCI, Thomson Reuters DataStream, HSBC
256
Weight (%)
15.5
8.9
7.6
7.3
7.2
46.5
5.9
5.4
4.6
4.4
4.4
24.7
Cenk Orcan*
Analyst
HSBC Yatirim Menkul
Degerler A.S.
+90 212 376 46 14
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations
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Liquidity (6M ADTV) of equity indices in Turkey
Sector composition of MSCI Turkey index*
2500
Sector
Weight (%)
Financials
Consumer Staples
Telecommunication Services
Industrials
Energy
Consumer Discretionary
Materials
2000
1500
1000
500
49.2
15.0
12.2
9.7
5.4
4.6
4.0
0
07
08
09
10
11
12
Istanbul SE N atio nal All Share Index 6M ADTV (U SD m)
Total
100.0
Note: * data as at 22 May 2012
Source: MSCI, Thomson Reuters DataStream, HSBC
Source: Bloomberg Finance LP, Thomson Reuters DataStream, HSBC
Earnings and valuation
EPS growth has been volatile in recent years with increases in 2006, 2007, 2009, and 2010 and
contraction in 2008 and 2011. Aggregate market net profit declined by c10% in 2011 in both the banking
and non-banking sectors. Banks’ margins were squeezed last year as a result of the Turkish Central
Bank’s steps to slow economic growth (through higher reserve ratios and general provisions) and nonbank profits were hit by TRY weakness. Turkish company earnings are in general dependent on three
main factors, GDP growth, currency and interest rates. GDP growth helps non-financials companies in
terms of revenues and improved operational leverage, and financials companies in terms of volume
growth, revenue expansion and better asset quality. Currency appreciation is mostly positive in terms of
earnings for non-financials due to the short FX positions of these companies generally. Interest rates are
more important for the financials (especially the banks). Due to the maturity mismatch on their balance
sheets, the margins of the banks are affected positively by periods of declining interest rates.
Actual, trend and forecast earnings of MSCI Turkey index
Annual growth in earnings: MSCI Turkey index
6.0
300%
5.0
250%
200%
150%
4.0
100%
50%
3.0
0%
2.0
94
96
98
12M trail
00
02
04
06
08
Trend
Source: MSCI, IBES, Thomson Reuters DataStream, HSBC
10
12
14
I/B/E/S fcast
-50%
-100%
1997 1999 2001 2003 2005 2007 2009 2011
MSCI Turkey EPS growth
Source: MSCI, IBES, Thomson Reuters DataStream, HSBC
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Earnings momentum* versus returns: MSCI Turkey index
300%
250%
200%
150%
100%
50%
0%
-50%
-100%
400%
350%
300%
250%
200%
150%
100%
50%
0%
-50%
-100%
96
98 00 02 04 06 08 10
MSCI Turkey earnings momentum
Earnings growth* versus returns: MSCI Turkey index
400%
350%
300%
250%
200%
150%
100%
50%
0%
-50%
-100%
400%
350%
300%
250%
200%
150%
100%
50%
0%
-50%
12
96
98
00 02 04 06 08 10
MSCI Turkey earnings growth
MSCI Turkey y-o-y returns (RHS)
12
MSCI Turkey y-o-y returns (RHS)
Note: *Earnings momentum is defined as the 6-month % change in 12M-forward EPS forecast.
Source: MSCI, IBES, Thomson Reuters DataStream, HSBC
Note: *Forecast growth in 12M-forward earnings.
Source: MSCI, IBES, Thomson Reuters DataStream, HSBC
The Turkish equity market’s price performance is highly correlated with both the earnings momentum
and the earnings revisions since 2005. The higher returns in the MSCI Turkey were achieved when
earnings momentum and earnings revisions turned positive, as in 2005, 2007 and 2010. Before 2005,
market returns had no significant correlation with earnings momentum. Earnings growth, on the other
hand, is not much of a determinant of index returns, as the chart on the top right of this page reveals.
According to the IBES consensus recommendation score, the sell side (brokers) was most bullish on the
Turkish equity market back in 2004-05 and 2008 when the prospective earnings momentum expectation
was quite strong. However, while 2004 and 2005 were periods of high returns on the MSCI index, returns
in 2008 and early-2009 were not that satisfactory, although Turkish equities had one of the strongest price
performances in 2010, a year after the sell side turned bullish. Since 2010, the sell side has had a more
neutral to bearish stance on MSCI Turkey stocks.
Earnings revisions* versus returns: MSCI Turkey index
IBES consensus recommendation score*: MSCI Turkey
400%
350%
300%
250%
200%
150%
100%
50%
0%
-50%
-100%
100%
80%
60%
40%
20%
0%
96
98
00 02 04 06 08 10
MSCI Turkey earnings revision
12
MSCI Turkey y-o-y returns (RHS)
Note:- *Number of 12M-forward EPS estimates up over the last month as a % of total
number of revisions in estimates over the corresponding period.
Source: MSCI, IBES, Thomson Reuters DataStream, HSBC
258
2.9
2.8
2.7
2.6
2.5
2.4
2.3
2.2
2.1
2.0
Bearish
Bullish
01 02 03 04 05 06 07 08 09 10 11 12
Score
Mean
± 2Stdev
Note: *represents the market cap weighted aggregated score of the IBES consensus
recommendation of all the constituents. Score should be interpreted as follows – 1.00
to 1.49: Strong Buy; 1.50 to 2.49: Buy; 2.50 to 3.49: Hold; 3.50 to 4.49: Underperform;
4.50 to 5.00: Sell
Source: MSCI, IBES, Thomson Reuters DataStream, HSBC
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MSCI Turkey index: 12M-forward PE scenarios*
Earnings yield versus bond yield* in Turkey
2500000
25x
2000000
25%
20x
20%
15x
15%
1000000
10x
10%
500000
5x
5%
1500000
05
0
01 02 03 04 05 06 07 08 09 10 11 12
MSCI Turkey Price Index
Note: *based on five scenarios of 12M-forward PE multiple (5x, 10x, 15x, 20x and 25x
Source: MSCI, IBES, Thomson Reuters DataStream, HSBC
06
07
08
09
10
11
12
Turkey 10Y nominal par yield on Gov t. securities
12M -forw ard earnings y ield of MSCI Turkey
Note: * earnings yield is calculated as the reciprocal of the 12M-forward PE ratio of the
MSCI index and the bond yield is the 10Y nominal par yield on Govt. Bonds.
Source: MSCI, IBES, Oxford Economics, Thomson Reuters Datastream, HSBC
The MSCI Turkey index has been trading in a wide range of 5-12x 12M-forward looking earnings since
2001. During crisis periods, such as 2009, the PE multiple declined to 5x, and during upbeat earnings
momentum periods, such as 2004, 2005, 2007 and 2010, the PE multiple reached 12x. Having said this,
the normal range for the MSCI Turkey PE is around 9-10x based on historical data. Currently, the
Turkish equity market trades at around 8.5x 12M-forward looking PE – with upward earning momentum
the market PE could easily reach 10x. The PB range of the MSCI Turkey index has been 0.7x to 2.0x
between 2005 and 2012. Although there have been some periods when the correlation between ROE and
PB eased, we observe that the general trend of the PB level is correlated with the level of ROE.
Thanks to declining interest rates since 2009, earnings yields have been outpacing yields on government
securities. Despite earnings yields being lower than in 2009, this is a positive trend in terms of valuation.
MSCI Turkey’s PE level relative to MSCI EM has been quite volatile. However, over the last 10 years,
MSCI Turkey’s PE has generally been at a slight discount to the MSCI EM PE multiple. There have been
periods when the MSCI Turkey index traded at around 40% discount on PE, such as in 2008. Currently,
the discount is around 10%, close to historical averages.
12M-forward PB versus RoE: MSCI Turkey index
12M-forward PE ratio of MSCI Turkey relative to MSCI EM
19%
18%
17%
16%
15%
14%
13%
12%
11%
1.9
1.7
1.5
1.3
1.1
0.9
0.7
0.5
05
06
07 08
09
10
11
12
MSCI Turkey 12M -forward price to book ratio
MSCI Turkey 12M -forward RoE (RHS)
Source: MSCI, IBES, Thomson Reuters DataStream, HSBC
1.6x
1.4x
1.2x
1.0x
0.8x
0.6x
0.4x
0.2x
0.0x
20.0x
15.0x
10.0x
5.0x
0.0x
98
00
02 04 06 08 10
12
MSCI Turkey 12M -forward PE ratio
rel. to MSCI EM (RHS)
Source: MSCI, IBES, Thomson Reuters DataStream, HSBC
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Fund flows
According to EPFR Global, Turkish equity funds have managed to attract inflows of around USD1.2bn
since 2000. Flows into the Exchange Traded Funds (ETFs) outpaced flows into other traditional funds.
The majority of inflows (around USD1.1bn) were received after 2004, the year in which the ETFs market
was established with the aim of providing an organised and transparent market for trading ETFs’
participation certificates. Furthermore, it is worth noting that Turkey has historically enjoyed an
overweight position in the GEMs equity portfolios in general.
Flows (% of AuM) into Turkey dedicated funds
Weight of Turkey in GEM funds versus benchmark
20%
7%
6%
10%
5%
4%
0%
3%
-10%
2%
-20%
1%
0%
-30%
00 01 02 03 04 05 06 07 08 09 10 11 12
Turkey Fund flows as % of assets under management
Source: EPFR Global, HSBC
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Weight (%) in GEM Equity Funds
Weight (%) in MSCI EM index
Source: EPFR Global, HSBC
Economic basics
According to IMF’s estimates, Turkey is currently the world’s 18th largest economy, with a population of
74.7 million. HSBC global economics research estimates that Turkey will be the 12th largest economy in
the world in 2050, after Canada and ahead of Italy. As of 2011, Turkey’s per capita income is
USD10,521; up more than 150% since 2000.
Turkey is a relatively closed economy, with household consumption corresponding to 71% of GDP, while
merchandise and services exports make up only 24% of GDP. The country has a diverse economic base,
with services, manufacturing, agriculture and construction activity. Over 70% of Turkey’s production
growth comes from the services sector, with 16% from manufacturing. Turkey’s exports are dominated
by a broad range of manufactured products with base metals (15% of total), motor vehicles (12.3%) and
textiles (8.6%) being the largest categories. Turkey is a heavy importer of crude oil and gas (18.3% of
total) and chemicals (14.1%).
Turkey is a vibrant emerging market that enjoys a number of long-term, fundamental advantages. First,
Turkey has a young and growing population with a median age of 30; 60% of the population is below the
age of 35, and the UN estimates that the population grows 1.3% per annum.
Another important structural advantage is its low stock of debt. Household debt to GDP in Turkey stands
at only 18%, while mortgage debt is even lower, at 6% of GDP. Corporate and public sector debt are
similarly low, at 45% of GDP and 40% of GDP, respectively. Low leverage allows Turkey to rebound
from recessions rapidly because the economy does not have to go through a protracted period of balance
sheet recession.
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Turkey’s well-capitalised and highly-regulated banking sector is also an important factor to consider.
In addition the country enjoys low FX exposure in the household sector. Since 2007, consumers have
only been able to borrow in Turkish lira, an important prudential measure that has resulted in a long FX
position in the household sector of around 8% of GDP. This advantage is somewhat diminished by the
fact that non-financial corporates have a short FX position of 17% of GDP.
Turkey’s structural weak spot is the fact that when the economy grows, it grows asymmetrically, creating
external imbalances. Years of high growth are accompanied by large current account deficits. Because
domestic savings are low, rapid domestic demand growth renders the country dependent on external
financing.
An additional risk factor is the fact that the quality of the financing has deteriorated over the years. In
2011, Turkey’s current account gap stood at USD77.1bn, or 10% of GDP, with 57% of the deficit being
financed by short-term borrowing, portfolio flows and net errors and omissions. Conversely, FDI flows
financed only 17% of the large deficit.
In 2011, the government and the Central Bank of Turkey (CBRT) put together a framework to address
this structural weakness. On the monetary policy front, the CBRT aims to rebalance the economy so that
domestic demand grows less rapidly and foreign demand grows more strongly. This would also slow the
rapid widening in the current account deficit. The new policy framework is also intended to improve the
quality of the current account gap. On the structural reform front, the government is working on a number
of initiatives to increase the value-added of exports, reduce dependence on imported energy and other
intermediate goods, improve competitiveness and increase savings.
Economic policy primer
The statutory objective of the CBRT since 2006 is to attain and maintain price stability, within an official
inflation-targeting framework. However, the central bank also considers financial stability objectives in
its decision-making process. The central bank’s current flexible monetary policy framework includes the
active use of the following instruments to manage the amount of lira liquidity in the system and to push
short-term interest rates up or down:
 The policy rate is the one-week repo rate, currently 5.75%. This is the rate at which commercial
banks gain funding access from the central bank via quantity auctions.
 The overnight interest rate corridor is currently 5.0-11.5%. The ceiling of the rate corridor is the
overnight lending rate (ie the rate at which banks borrow from the central bank). Primary dealers
borrow from the central bank at a slightly more favourable rate (presently 11%). The floor of the
interest band is the overnight borrowing rate.
 Required reserve ratios for both FX and lira denominated liabilities are also set by the central bank.
They are the central bank’s primary policy tool for controlling credit growth as higher reserve ratios
reduce the supply of loanable funds in the banking sector.
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 FX sale or purchases: When capital flows into Turkey are strong, the central bank purchases US dollars
from the market, building up its FX reserves. When risk appetite is flagging, and the lira underperforms (or
becomes excessively volatile), the central bank sells US dollars, or intervenes directly in the FX market.
Political structure
Turkey is a parliamentary representative democracy with a strong tradition of secularism. The Prime
Minister is the head of the Council of Ministers and holds executive power, while the role of the President
of the Republic is ceremonial. Currently, the Justice and Development Party (AK Party or AKP) is
serving its third term in government, and holds a majority of 326 seats in the 550-seat parliament. Recep
Tayyip Erdogan is the Prime Minister and Abdullah Gul is President. The next presidential election is
scheduled for 2014, and the next parliamentary election for 2015.
Turkey is a member of the United Nations and NATO. It joined the EU Customs Union in 1995 and
started accession talks with the EU in 2005, but progress in EU accession has stalled.
Key regulatory bodies
The Central Bank of Turkey: regulates monetary policy in the country which has a direct impact on the
macro dynamics.
Banking Regulation and Supervision Agency: regulates and supervises the banking sector, which
forms 45% of the major equity index.
The Undersecretariat of Treasury: treasury strategies have a major impact on macro dynamics.
Istanbul Stock Exchange: regulates the stock market.
Turkey Statistical Office: provides detailed information on sectors, macro economy and consumer
behaviour.
Investment Support and Promotion Agency: supports investments of foreigners to Turkey.
Ministry of Finance: manages tax and budget, which are keys for major sectors.
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Basic valuation and
accounting guide
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Five Forces and SWOT
INDUSTRY
Scoring range 1–5 (high score is good)
Power of suppliers
New entrants
A concentration of suppliers will mean less chance to
negotiate better pricing. Substitute producers provide
a price ceiling. A single strategic supplier can put
pressure on industry margins. If switching costs are
high, suppliers can put pressure on the industry.
Downstream integration: the industry can be
disintermediated.
Barriers to entry will be high if economies of scale are
important, access to distribution channels is restricted,
there is a steep ‘experience’ curve, existing players
are likely to squeeze out new entrants, legislation or
government action prevents entry, branding or
differentiation is high.
Rivalry
High rivalry will result from the extent to which players
are in balance, growth is slowing, customers are
global, fixed costs are high, capacity increases require
major incremental steps, switching costs are low,
there is a liquid market for corporate control and exit
barriers are high.
Substitute products
Power of customers
Alternative means of fulfilling customer needs through
alternative industries will put pressure on demand and
margins. Product for product (email for fax),
substitution of need (precision casting makes cutting
tools redundant), generic substitution (furniture
manufacturers vs holiday companies), avoidance
(tobacco).
Buyer power will be high if buyers are concentrated
with a small number of operators where there are
alternative types of supply, where material costs are a
high component of price (ie low value added), where
switching is easy and low cost and the threat of
upstream integration is high.
COMPANY
Strengths






Patents
Strong brand and/or reputation
Location of the business
The products, are they new and innovative?
Quality process and procedures
Specialist marketing expertise
Opportunities






Developing market eg Internet, Brazil
Mergers, strategic alliances
Loosening of regulations
Removal of international trade barriers
Moving into a new market, through new products or new market place
Market lead by an ineffective competitor
Scoring range 1–5 (high score is good)
Weaknesses






Undifferentiated products and services, in relation to the market
Poor quality goods or services
Damaged reputation
Competitors have superior access to distribution channels
Location of the business
Lack of marketing expertise
Threats






New competitor
Price war
Competitor has a new, innovative substitute product or service
Rivals have superior access to channels of supply and distribution
Increased trade barrier
Taxation and/or new regulations on a product or service
Source: HSBC Note: The upper score represents an assessment of the balance of strengths and weaknesses. Similarly the bottom number scores the balance of opportunities and risks.
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The figure above combines a diagram of a Five Forces model used to analyse an industry, with an outline
of a SWOT analysis for evaluating a company.
Porter’s Five Forces is an analytical approach that assesses industries or a company by five strategic
forces; it helps to indicate the relationship between the different competitive forces within the industry.
Five Forces can be used by a business manager trying to develop an edge over a rival firm or by analysts
trying to evaluate a business idea.
Porter’s Five Forces has a scoring system in which positive, negative or neutral results are combined to give a
final score for each force. The higher the score, the more sound the industry, or business is.
SWOT analysis is routinely used to help the strategic planning of a firm in the business world. Strengths
and weakness (SW) apply to any internal factors within the firm, while the opportunities and threats (OT)
are the many external factors that a firm must account for.
Valuation
The following sections give a brief introduction to the main accounting issues and valuations techniques,
their definitions and ratio analysis. It is structured by addressing what is valued, how it is valued, and the
inputs of the valuation. This accounting guide can be used to gain a better understanding of a company’s
financial statements. We include a brief introduction to balance sheet items. The valuation measures and
methods described below apply only to listed companies.
Valuing what?
Enterprise value (EV)
An enterprise is a company and therefore the enterprise value is a measure of the whole company’s value.
It is believed by many to have more uses than market capitalisation, because it takes into account the
value of debt for a company (and also adjusts for minorities and associates) to make it suitable for ratios
above the P&L interest line such as EV/sales, EV/EBITDA and EV/EBIT.
Calculate by: market capitalisation (all share classes) + net debt (and other liabilities, such as pension
deficits) + minority interests – associates (both fair value).
There are three types of enterprise value: total, core and operating.
Enterprise value
Total Enterp rise Value
The value of all business activitie s
Operating Enterprise Value
Core Ente rprise Value
Total EV less non-operating assets at market value
Total EV less non-core asse ts, th is makes Core EV
more subje ctive but can be used for ratios such as Core
EV/core business sale s.
Source: HSBC
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Market capitalisation (market cap)
The value of all the shares of a corporation; it is useful as part of EV and for ratios such as PE
(price/earnings = market cap/net income) or DY (dividend yield = dividends/market cap).
Calculate by: multiplying a company’s shares outstanding (ie, excluding treasury shares owned by itself)
by the current market price of one share.
Net debt
This is the total amount of debt and liabilities a company has after subtracting the value of its cash and
cash equivalents. A company with more cash than debt would be said to have Net Cash.
Minority interest – three main definitions:
 Where an investor or company owns less than 50% of another company’s voting shares, eg ‘owning a
minority interest’
 A non-current liability on a balance sheet representing the portions of its subsidiaries owned by
minority shareholders. Consolidated accounts show 100% of sales, EBITDA, EBIT (in the P&L);
100% of the assets and liabilities (in the balance sheet) and 100% of the cash flows of a subsidiary,
but also deduct the minorities’ shares of profits in a separate minorities P&L line, their share of net
assets in a minorities balance sheet line and any dividends paid to them in the cash flow. For
example, if Company A owns 80% of Company B, where Company B is a GBP100m company.
Company A will have a GBP20m liability, on its balance sheets, to represent the 20% of Company B
that it does not own, this being the minority interest.

As an adjustment in an EV, DCF valuation, etc, at fair value (rather than the book value used in the
balance sheet). For example, if fair value was GBP30m, this would be added to EV and deducted as
part of the DCF.
Pension obligations
This is a projected sum of total benefits that an employer has agreed to pay to retirees and current
employees entitled to benefits. There are two main types of pension scheme:
 Defined Benefit, where payment is linked to employees’ salary level and years of service. The
benefits are fixed but, as the actuarial assessment of the liability depends on changing factors (such as
life expectancy and discount rates), the company’s liabilities (and contributions) are variable. The
company has an obligation to pay out the determined benefit and, if there is a shortfall in the fund,
must draw on the company’s profits to subsidise the discrepancy.
 Defined Contribution, where the employers’ contributions are fixed but the benefits are variable.
The pension in retirement depends on the cumulative contributions to the fund, returns from its
investments and annuity rates at retirement.
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Common terms used to discuss pensions
Accumulated Benefit Obligation (ABO)
An estimate of liability if the pension plan assumes immediate discontinuation; it does not take into
account any future salary increases.
Discount Rate
The rate used to establish the present value of future cash flows.
Prior Service Costs
Retrospective benefit costs for services prior to pension plan commencement or after plan
amendments.
Projected Benefit Obligations (PBO)
This assumes the pension plan is ongoing, as the employee continues to work, and therefore it
projects future salary increases.
Service Cost
The present value of benefits earned during the current period.
Vested Benefit Obligations (VBO)
Most plans require a certain number of years service before benefits can be collected, and this is
‘Vested’. The VBO represents the actuarial present value of vested benefits.
Source: HSBC
Valuing how?
Cash flow
This indicates the amount of cash generated and used by a company over a given period. There are
several different measures, used for different purposes, plus a cash flow statement in the reports and
accounts.
Free cash flow (FCF)
The cash flow after everything except dividends, so attributable to shareholders, used in performance
measures (eg FCF Yield = FCF/market cap). Generally, the higher the FCF the better, at least in the short
term, though too much cost cutting or underinvestment can be risks.
Calculate by: EBITDA – capex – working capital change – net interest – tax
Free cash flows to the firm (FCFF)
The cash flow after everything except interest (net of tax) and dividends, used in DCF calculations (see
below).
Calculate by: EBITDA – capex – working capital change – tax
Discounted cash flow (DCF)
The present value of an investment, ie adjusted for the time value of money. It is the sum of the value of
each period’s FCFF, discounted back to the present day.
For a project lasting n years calculate by:
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For a business lasting beyond the n years for which you have estimated cash flow, add a ‘terminal value’,
being the value at year n discounted to the present day. The value at year n+1, if thought to be a
perpetuity growing at rate g per annum, would have a value in year n of CFn (1+g)/(r-g) and a present
value of CFn(1+g)/(r-g)/(1+r)n.
Market assessed cost of capital (MACC)
MACC turns conventional valuation methodology around; instead of comparing returns on capital and
cost of capital to arrive at an estimate of fair value, it compares market return on capital with market
value to derive an estimate for market assessed cost of capital (MACC). This MACC value can be used
for comparisons against historical observations for the same stock, or for use against peers.
Multiples
Multiple
Calculation
PE ratio
Price of a stock
Earnings per share
Definition/Interpretation
Helps to give investors an overview of how much they are paying for a stock; the ratio states
how many years it would take for the investors to recoup their investment, with the company
keeping profits steady (if fully distributed as dividends).
Generally companies with high PE (over 20) are faster growing, while a low PE may be
an indication that the companies are low-growth or mature industries.
PEG ratios
Price to Book ratio
(P/B ratio)
EV/Sales
EV/EBITDA
Price/Earnings Ratio
Annual EPS Growth
Market capitalisation
Total assets - Intangible assets
- Liabilities
(equal to price / book value per share)
EV (see above to calculate)
Annual Sales
EV (see above to calculate)
Annual EBITDA
This ratio is used to determine a stock’s value taking into account earnings growth,
especially if growth is very high. A low PEG company may reflect high risk.
This ratio compares stock market value with book value; it can be compared throughout
the same industry sector. It can be based on net assets or after deducting intangibles.
As sales are above the interest, associates and minorities lines in the P&L, it is more
consistent and popular to compare EV (including net debt and adjusted for minorities and
associates) with sales than, say, price/sales.
EBITDA (earnings before interest, tax, depreciation and amortisation) is also above the
interest, associates and minorities lines, so comparing with EV is consistent and popular.
Source: HSBC
Economic value added (EVA), Residual Income
This is a measure of a company’s profits, after deducting capital costs (being the capital employed x cost
of capital). It is usually calculated on an enterprise basis: with EBIT, taxes based on EBIT, capital
employed including financed by debt and weighted average cost of capital (WACC – see below).
Calculate by:
Net Sales – Operating Expenses = Operating Profit (EBIT)
EBIT – taxes
= Net Operating Profit after Tax (NOPLAT)
NOPLAT – Capital Costs
= Economic Value Added (EVA)
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Components and inputs of valuation
DCF inputs
Weighted average cost of capital (WACC)
This calculates the firm’s cost of capital, with each category of capital proportionally weighted. It is used
with pre-interest cash flows (eg DCF) or profits (eg Economic Profit).
Calculate by:
WACC = E *Re
(E+D)
+ D *Rd * (1-Tc)
(E+D)
Re= cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
Tc = Corporate tax rate
Cost of debt
This is the effective rate that a corporation pays on its current debt; it can be measured either pre- or posttax. It is usually higher than the risk-free rate (eg 10-year government bond yields) because of the spread
over such bonds that corporate bond holders tend to demand.
Cost of equity
This is in theory the return a stockholder requires for holding shares in a company; representing the
compensation that the market demands in exchange for owning the asset and bearing the risk of ownership.
Calculate by: Risk-free rate + equity beta x equity risk premium
Equity beta
The correlation between a share and the general stock market. It is useful to estimate the cost of equity for
a stock as an investor can, in principle, diversify away uncorrelated risks, but not correlated sensitivity to
the market.
Equity risk premium
This is the premium investors would expect for investing in equities because of the higher risk. It is a
measure for the general stock market rather than individual stocks.
MACC inputs
Invested capital (IC)
This is capital that the company can invest within itself or has already invested internally.
Calculate by: Long-term debt +stock + retained earnings
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Cash return on capital invested (CROIC)
This evaluates a company’s cash return to its equity: it measures the cash profits of a company and
compares this with the proportion of the funding required to generate it.
Calculate by:
Gross Cash Flow
Average Gross Cash invested (GCI)
Where,
 Gross cash flow is operating cash flow plus post-tax gross interest expense
 GCI: Gross fixed assets plus gross intangible assets plus net working capital plus cash
Multiple inputs
Earnings per share
Net profit per share, which may be headline or adjusted (for example, to exclude the impact of nonrecurring items). Shares are normally those in issue (excluding treasury shares owned by the company).
Calculate by:
Net profit for the year
Number of shares
Book value
The value at which an asset is carried on the balance sheet, taking into account depreciation that may have
occurred each year after the asset was brought. Each asset, from the smallest piece of equipment to the
whole business, has a book value. The fair value of an asset may be higher than its book value, and often
is. However, if the fair value is lower than the book value, it should be written down to fair value.
Sales
Total amount of goods sold over a given period, usually reported net of any sales taxes (eg value added tax).
Dividend
This is the distribution of earnings to shareholders. It can be paid in money, stock or, very rarely,
company property. The occurrence of the dividend payment depends on the company; it can either be
paid quarterly, half yearly or once a year, and may be ordinary (usually expected to recur) or
special/extraordinary (often non-recurring).
EVA inputs
Net Sales
This is the sales figure with deductions for any discounts, returns, and damaged or missing goods or sales
taxes (eg value added tax).
Operating expenses (OPEX)
Any expenses brought about by the operations of the company, eg cost of goods sold, SG&A (selling,
general and administrative expenses). It does not include non-operating costs (such as interest or tax).
Net operating profit less adjusted taxes (NOPLAT)
This is operating profit (net sales less opex) minus the tax that would be paid if there were no other
factors (such as tax-deductible interest).
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Key accounting ratios
Ratio
Current ratio
Quick ratio
Debt/equity ratio
Calculation
Definition/Interpretation
Current assets
Current liabilities
This indicates the ability of a company to pay its debts in the
short term. A higher ratio is preferable.
Current assets – Inventories
Current Liabilities
Also measures the ability of a company to pay its short-term
debt but with its most liquid assets. A higher ratio is preferred.
Financial liabilities
Shareholder funds
This measures the company’s financial leverage, by indicating
the ratio of debt to equity.
Net profit margin ratio
Profit after tax
Sales
Interest coverage ratio
EBIT
Interest
Return on equity (ROE)
Net Income
Shareholders Equity
* 100
Used when comparing companies in similar industries; it is a
rate of profitability. Its weakness is that it depends not only on
operations but interest, etc.
This indicates the debt servicing capacity of the company;
the greater the buffer, the safer the debt holders.
* 100
Measures a corporation’s profitability from a shareholder’s
point of view. It depends on operating success and leverage.
Return on invested
capital (ROIC)
NOPLAT
Total Capital
Asset turnover ratio
Sales
Assets
The amount of sales generated by each dollar (or whatever
unit sales are measured in) worth of assets.
Inventory turnover ratio
Sales
Inventory
This ratio shows how many times a company’s inventory is
sold and then replaced over a year.
Debtors turnover ratio
Sales
Average Debtors
This implies the number of times a debtor is turned over every
year. A high ratio is good for low working capital requirement.
Creditors turnover ratio
Credit purchase
Average creditors
This indicates the credit period that firms benefit from before
they pay off their creditors. A high ratio indicates that the
creditors are being paid promptly, while a low ratio is good for
working capital.
Dividend payout ratio
Dividend yield
Yearly dividend per share
Earnings per share
Annual dividends per share
Price per share
Measures profitability from an operating point of view, for both
shareholders and bond holders. It does not depend on
leverage so is more comparable across a sector.
This is the percentage of earnings paid to shareholders in
dividends. Investors often prefer a high ratio, but a low ratio
retains more earnings for use in the business.
Indicates how much a company pays out in dividends relative
to its share price. It may be useful when estimating a floor
value of a stock (if the dividend is sustainable). Some funds
target high-yielding stocks (called ‘Yield Funds’).
Source: HSBC
Income statement line items
Sales or revenues
The total amount of money in a given period that a company obtains after deductions for discounts and
returned merchandise and usually after deducting any sales taxes (eg value added tax).
Cost of goods sold (COGS)
The cost of buying or making the goods sold in the period.
Gross margin
Gross Profit (sales less COGS) as a percentage of sales.
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Selling, general & administrative expenses (SG&A)
This is operating costs other than COGS, between gross profit and EBITDA in the P&L.
Earnings before interest, tax, depreciation and amortisation (EBITDA)
It can be used for comparing profitability and efficiency ratios for a firm. It is one of the most common
ways of comparing the performances of differing companies.
Depreciation
The reduction in value of an asset through time, use, etc. EBITDA less depreciation and amortisation is
EBIT. It is non-cash (the cash already having been paid to acquire the asset) but a part of the P&L and an
annual reduction in balance sheet asset value. If an asset is depreciated over its useful life, it may well
need replacing when fully depreciated at end-of-life.
Amortisation
This is a reduction in the cost of an intangible asset through changes in income. If Company A buys a
piece of equipment with a patent for GBP25m and the patent lasts for 10 years, GBP2.5m each year
would be recorded as amortisation. (Depreciation, by contrast, is for tangible assets such as land,
building, plant and equipment.)
Operating profit or EBIT
Earnings Before Interest and Taxes; it is after D&A but before interest and other financial charges and taxes.
Calculate by: Revenue – Operating Expenses
Interest
Financial income (on cash, etc) less expense (on bonds, bank debt, etc). Some companies include their
share of profits from associates, dividends from investments and various other factors (eg FX gains and
losses) in a Financial Items line along with interest.
Pre-tax profit (PTP or PBT)
Profit after interest but before tax has been taken away from it.
Tax
Taxes on company profit, as opposed to sales taxes (usually deducted directly from sales) or operating
taxes (usually added to staff costs, property costs, etc, in opex).
Net profit, net income or earnings
Profit after everything (except dividends which are a distribution of earnings, after dividends would be
called retained profits), ie after interest, tax and minority charges (the share of any profits attributable to
minority shareholders of subsidiaries of the company).
Note: The above items should appear in most P&L accounts (financial companies often being a notable
exception), while the items below are rarer.
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Provision
Costs are provided for if they are expected but have not yet been paid. For example, banks unlikely to
collect all the money lent provide for the proportion they expect not to collect, damages for a law suit
expected to be lost, etc. Provisions are often included within COGS or SG&A.
Clean profit
Restructuring and other non-recurring costs (or income) are often separately identified by companies to help
understand and predict future profits and often adjusted for in ‘clean’ profit measures, eg clean EBIT.
Continuing operations
These are the segments within a business expected to continue functioning for the foreseeable future.
For investors it indicates what the business could rationally be expected to replicate in future.
Discontinued operations
These are any segments of a business that have been sold, disposed of or abandoned. This is reported
separately in the accounts to continuing operations.
Balance sheet line items
Assets
Anything owned by a business that has commercial value.
Non-current assets
Assets not easily convertible to cash, or not expected to become cash within the next year. Also known as
long-life assets.
Fixed assets
Assets that a company uses over a long period of time; they are not expected to be sold on.
Intangible assets
An asset that is not physical in nature, such as corporate intellectual property rights, goodwill, brand
recognition.
Investment assets
An asset not used within the company’s operations.
Deferred tax assets
The present value of tax credits (eg from past losses) are expected to reduce future tax payments that
would otherwise be incurred.
Receivables
All accounts receivable and debt owed to a company, whether they are due in the short or long term.
Current assets
Assets expected to be turned into cash within the coming year, or assets that are expected to be sold.
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Inventories
The value of the firm’s raw materials, work in process, supplies used in operations and finished goods.
Cash & cash equivalents (CCE)
Assets already in cash or that can be converted into cash rapidly; generally high liquidity and relatively
safe; for example, a treasury bill.
Liabilities
Money, services and goods that are owed by a company.
Non-current liabilities
Liabilities not expected to be paid with a year.
Financial liabilities: debt and financial derivatives
Bonds and borrowings from banks and other lenders that must be repaid (with interest).
Provisions for liabilities and charges
Liability value is not known accurately and therefore an amount is set aside to cover it; for example, the
estimated cost of restructuring or losing a legal case.
Retirement benefit obligations
The present value (usually net of tax) of the expected liabilities for payments to former and current staff
for pensions, healthcare, etc. accumulated during their service.
Current liabilities
Liabilities expected to be paid throughout the coming year. They include short-term debt, payable
accounts, unpaid wages, tax due, etc.
Trade and other payables
Liabilities to suppliers.
Shareholders’ equity, net assets
Total assets less total liabilities (excluding shareholders’ equity itself). By definition, this must either have
been provided to the company through issuing shares or have built up through retained earnings. Therefore,
net assets = total assets – total liabilities = share capital + retained earnings = shareholders’ equity.
Calculate by: Total assets less total liabilities, or by share capital + retained earnings
Share capital
The original value of the shares issued by a company; therefore, even if there is a rise in the share price,
this is not taken into account. Shares may be issued at the creation of the company or later and may be at
nominal value or with a share premium on top.
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Retained earnings
Cumulative total earnings minus that which has been distributed to the shareholders as dividends.
Calculate by: Closing retained earnings = opening retained earnings plus earnings in the period less
dividends declared in the period
Cash flow statement line items
Net cash flow from operating activities
Operating activities include the production, sales and delivery of the company’s product, as well as
collecting payment from its customers. This could include purchasing raw materials, building inventory,
advertising, and shipping the product.
Revenue and expenses
These include cash receipts from sale of goods and services and cash payments to suppliers for goods and
services.
Other income
These include interest received on loans, dividends received on equity securities, payment to employees, etc.
Non-cash items
These include depreciation, amortisation, deferred taxes, etc, which are added back to/subtracted from the
net income figure.
Net cash flow from investing activities
This reports the change in a company’s cash position resulting from losses or gains from investments that
have been made in financial markets or operating subsidiaries. Changes can also result from the amounts
spent on investment in capital assets.
Capital expenditure
Any buying or selling of fixed assets that allow the running of the company to take place.
Expenditure on intangible assets
Buying or selling of intangible assets that contribute to the company.
Disposals of property, plant & equipment
Any profits or losses occurred from discarding concrete material of the companies, such as land and machinery.
Investment in financial assets
This is profit gained from investing in an asset that does not have a physical worth, such as stocks, bonds,
and bank deposits.
Proceeds from sale of financial assets
The money gained by selling the financial asset.
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Net cash flow from financing activities
This reports the change in a company’s cash position resulting from raising or repayment of financial liabilities.
Issue of equity shares
Companies raise capital by issuing new shares either in the initial market (first-time equity issue) or in the
secondary market (subsequent issues of equity).
Proceeds from exercise of share options
The exercise of share options is the purchasing of an issuer’s common stock at the price set by the option,
regardless of the price of the stock at the time the option is exercised. Proceeds can thus be obtained if the
price set by the option initially is less than the current stock price.
Purchase of own shares
This occurs when a company purchases its own shares. A number of restrictions and conditions must be
met for this to occur. The company must pay for the shares out of distributable profits or out of the
proceeds of a fresh share issue to finance the purchase. Following the company share repurchase, the
shares are treated as cancelled.
Dividends paid to equity shareholders
The distribution of the portion of a company’s earnings to their equity shareholders.
Increase in new borrowings
An increase in the new borrowings issued by a company.
Reduction of borrowings
When a company reduces its debt by decreasing borrowings.
Cash interest payable
The cash interests, which are the amounts that accrue periodically on an account that can be paid out
eventually to the account holder, payable to the company.
Further multiples
Multiple
Calculation
EV/EBIT
EV
EBIT
EV/NOPLAT
EV/IC
ROIC/WACC
EV
NOPLAT
EV
IC
ROIC
WACC
Definition/Interpretation
Can be used to value a company, regardless of its capital
structure. Takes into account D&A.
This is another profit multiple, and can be used as a substitute
for EV/EBIT. Takes into account tax.
This is an unlevered price-to-book ratio.
Dividing ROIC by WACC helps to compare returns between
markets (or companies) with different WACC, and may help in
judging what EV/IC is reasonable.
Source: HSBC
This basic valuation and accounting guide was written for the 2010 edition of the HSBC Nutshell. It
has been reviewed by Xavier Gunner, Managing Director, Global Research, HSBC Bank Plc
(employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified
pursuant to FINRA regulations).
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Disclosure appendix
Analyst Certification
Each analyst whose name appears as author of an individual chapter or individual chapters of this report certifies that the views
about the subject security(ies) or issuer(s) or any other views or forecasts expressed in the chapter(s) of which (s)he is author
accurately reflect his/her personal views and that no part of his/her compensation was, is or will be directly or indirectly related
to the specific recommendation(s) or view(s) contained therein: Chris Georgs, Xavier Gunner, Antonin Baudry, Antoine Belge,
Cedric Besnard, Wai-shin Chan, Sophie Dargnies, Jeffrey Davis, Franca Di Silvestro, Florence Dohan, Niels Fehre, Thomas
Fossard, John Fraser-Andrews, Dhruv Gahlaut, Colin Gibson, Michael Hagmann, Geoff Haire, Stephen Howard, Andrew
Keen, Jason Kepaptsoglou, Zoe Knight, Dmytro Konovalov, Achal Kumar, Rajesh Kumar, Matthew Lloyd, Andrew
Lobbenberg, John Lomax, Tobias Loskamp, Alex Magni, Sean McLoughlin, Kailesh Mistry, Verity Mitchell, Olivier Moral,
Wietse Nijenhuis, Michele Olivier, Cenk Orcan, Robert Parkes, David Phillips, Erwan Rambourg, Nick Robins, Paul
Rossington, Jerome Samuel, Horst Schneider, Raj Sinha, Paul Spedding, Peter Sullivan, Lena Thakkar, Joseph Thomas,
Lauren Torres, John Tottie, Emmanuelle Vigneron, Julia Winarso, Vladimir Zhukov and Thorsten Zimmermann
Important disclosures
Stock ratings and basis for financial analysis
HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions, which
depend largely on individual circumstances such as the investor's existing holdings, risk tolerance and other considerations.
Given these differences, HSBC has two principal aims in its equity research: 1) to identify long-term investment opportunities
based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon;
and 2) from time to time to identify short-term investment opportunities that are derived from fundamental, quantitative,
technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating.
HSBC has assigned ratings for its long-term investment opportunities as described below.
This report addresses only the long-term investment opportunities of the companies referred to in the report. As and when
HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at
www.hsbcnet.com/research. Details of these short-term investment opportunities can be found under the Reports section of this
website.
HSBC believes an investor's decision to buy or sell a stock should depend on individual circumstances such as the investor's
existing holdings and other considerations. Different securities firms use a variety of ratings terms as well as different rating
systems to describe their recommendations. Investors should carefully read the definitions of the ratings used in each research
report. In addition, because research reports contain more complete information concerning the analysts' views, investors
should carefully read the entire research report and should not infer its contents from the rating. In any case, ratings should not
be used or relied on in isolation as investment advice.
Rating definitions for long-term investment opportunities
Stock ratings
HSBC assigns ratings to its stocks in this sector on the following basis:
For each stock we set a required rate of return calculated from the cost of equity for that stock’s domestic or, as appropriate,
regional market established by our strategy team. The price target for a stock represents the value the analyst expects the stock
to reach over our performance horizon. The performance horizon is 12 months. For a stock to be classified as Overweight, the
potential return, which equals the percentage difference between the current share price and the target price, including the
forecast dividend yield when indicated, must exceed the required return by at least 5 percentage points over the next 12 months
(or 10 percentage points for a stock classified as Volatile*). For a stock to be classified as Underweight, the stock must be
expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points
for a stock classified as Volatile*). Stocks between these bands are classified as Neutral.
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Our ratings are re-calibrated against these bands at the time of any 'material change' (initiation of coverage, change of volatility
status or change in price target). Notwithstanding this, and although ratings are subject to ongoing management review,
expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily
triggering a rating change.
*A stock will be classified as volatile if its historical volatility has exceeded 40%, if the stock has been listed for less than 12
months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility. However,
stocks which we do not consider volatile may in fact also behave in such a way. Historical volatility is defined as the past
month's average of the daily 365-day moving average volatilities. In order to avoid misleadingly frequent changes in rating,
however, volatility has to move 2.5 percentage points past the 40% benchmark in either direction for a stock's status to change.
Rating distribution for long-term investment opportunities
As of 24 July 2012, the distribution of all ratings published is as follows:
Overweight (Buy)
50%
(27% of these provided with Investment Banking Services)
Neutral (Hold)
37%
(26% of these provided with Investment Banking Services)
Underweight (Sell)
13%
(18% of these provided with Investment Banking Services)
Analysts, economists, and strategists are paid in part by reference to the profitability of HSBC which includes investment
banking revenues.
For disclosures in respect of any company mentioned in this report, please see the most recently published report on that
company available at www.hsbcnet.com/research.
* HSBC Legal Entities are listed in the Disclaimer below.
Additional disclosures
1
2
3
This report is dated as at 29 July 2012.
All market data included in this report are dated as at close 30 May 2012, unless otherwise indicated in the report.
HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its
Research business. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research
operate and have a management reporting line independent of HSBC's Investment Banking business. Information Barrier
procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or
price sensitive information is handled in an appropriate manner.
MSCI Disclaimer
The MSCI sourced information is the exclusive property of MSCI Inc. (MSCI). Without prior written permission of MSCI, this
information and any other MSCI intellectual property may not be reproduced, redisseminated or used to create any financial
products, including any indices. This information is provided on an “as is” basis. The user assumes the entire risk of any use
made of this information. MSCI, its affiliates and any third party involved in, or related to, computing or compiling the
information hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a
particular purpose with respect to any of this information. Without limiting any of the foregoing, in no event shall MSCI, any
of its affiliates or any third party involved in, or related to, computing or compiling the information have any liability for any
damages of any kind. MSCI and MSCI indexes are service marks of MSCI and its affiliates.
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Disclaimer
* Legal entities as at 12 June 2012
Issuer of report
‘UAE’ HSBC Bank Middle East Limited, Dubai; ‘HK’ The Hongkong and Shanghai Banking Corporation
HSBC Bank plc
Limited, Hong Kong; ‘TW’ HSBC Securities (Taiwan) Corporation Limited; 'CA' HSBC Bank Canada, Toronto;
8 Canada Square
HSBC Bank, Paris Branch; HSBC France; ‘DE’ HSBC Trinkaus & Burkhardt AG, Düsseldorf; 000 HSBC Bank
London, E14 5HQ, United Kingdom
(RR), Moscow; ‘IN’ HSBC Securities and Capital Markets (India) Private Limited, Mumbai; ‘JP’ HSBC
Securities (Japan) Limited, Tokyo; ‘EG’ HSBC Securities Egypt SAE, Cairo; ‘CN’ HSBC Investment Bank Asia
Telephone: +44 20 7991 8888
Limited, Beijing Representative Office; The Hongkong and Shanghai Banking Corporation Limited, Singapore
Fax: +44 20 7992 4880
Branch; The Hongkong and Shanghai Banking Corporation Limited, Seoul Securities Branch; The Hongkong
Website: www.research.hsbc.com
and Shanghai Banking Corporation Limited, Seoul Branch; HSBC Securities (South Africa) (Pty) Ltd,
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Banking Corporation Limited, New Zealand Branch incorporated in Hong Kong SAR
In the UK this document has been issued and approved by HSBC Bank plc (“HSBC”) for the information of its Clients (as defined in the Rules of FSA) and
those of its affiliates only. It is not intended for Retail Clients in the UK. If this research is received by a customer of an affiliate of HSBC, its provision to the
recipient is subject to the terms of business in place between the recipient and such affiliate.
HSBC Securities (USA) Inc. accepts responsibility for the content of this research report prepared by its non-US foreign affiliate. All U.S. persons receiving
and/or accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc. in the United
States and not with its non-US foreign affiliate, the issuer of this report.
In Singapore, this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited, Singapore Branch for the general information of
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The Hongkong and Shanghai Banking Corporation Limited makes no representations that the products or services mentioned in this document are available to
persons in Hong Kong or are necessarily suitable for any particular person or appropriate in accordance with local law. All inquiries by such recipients must be
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Nothing herein excludes or restricts any duty or liability to a customer which HSBC has under the Financial Services and Markets Act 2000 or under the Rules
of FSA. A recipient who chooses to deal with any person who is not a representative of HSBC in the UK will not enjoy the protections afforded by the UK
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© Copyright 2012, HSBC Bank plc, ALL RIGHTS RESERVED. No part of this publication may be reproduced, stored in a retrieval system, or transmitted,
on any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of HSBC Bank plc. MICA
(P) 038/04/2012, MICA (P) 063/04/2012 and MICA (P) 206/01/2012
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Xavier Gunner*
Deputy Head of Equity Research
HSBC Bank plc
+44 20 7991 6749
xavier.gunner@hsbcib.com
HSBC Nutshell - A guide to equity sectors and emerging countries
Chris Georgs
Global Head of Equity Research
HSBC Bank plc
+44 20 7991 6781
chris.georgs@hsbc.com
HSBC Nutshell
A guide to equity sectors and emerging countries in EMEA
This guide will help you gain a quick but thorough understanding of the major sectors, industry
groups and countries in the region
It provides detailed information on structures, key drivers, indicators, themes and valuation
approaches
EMEA
A product of the Global Equity Research Team
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations.
July 2012
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it