EMEA Equity Research Multi-sector September 2010 HSBC Nutshell David May* Head of Equity Research. EMEA HSBC Bank Plc +44 20 7991 6781 david.may@hsbcib.com David May is Head of Equity Research, EMEA (Europe and CEEMEA regions) at HSBC, a role he has been in since August 2007. He was previously Global Head of Equity Product Management at HSBC. Prior to HSBC, David worked in an Equity Sales role and an Equity Product Management role at a major American investment bank. HSBC Nutshell A guide to equity sectors Tim Hammett* Head of Research Marketing, EMEA HSBC Bank Plc +44 20 7991 1339 tim.hammett@hsbcib.com Tim Hammett is Head of Research Marketing for EMEA, He joined HSBC in August 2009, bringing seven years experience of research marketing and knowledge management with a major American investment bank and a previous 13 years of equity fund management experience. Nicholas Peal* Research Marketing, EMEA HSBC Bank Plc +44 20 7991 5353 nicholas.peal@hsbcib.com Nicholas joined HSBC in 2006. Prior to his current role within research marketing he gained experience in both foreign exchange and interest rate derivative product areas. Multi-sector – Equity This guide will help you gain a quick, but relatively thorough understanding of 22 equity research sectors and industry groups It will help you to understand the organisation of the sector, the key drivers, indicators and themes, historical context, and suitable valuation approaches It is also an open offer to access HSBC’s expertise in fundamental equity sector research *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations. Co-ordinated by David May, Tim Hammett and Nicholas Peal September 2010 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 September 2010 abc Dear Client This HSBC Nutshell: A guide to equity sectors has been compiled by the EMEA Equity Research team at HSBC to help you gain a quick, but thorough understanding of the 22 sectors and industry groups we cover. The guide assumes some basic working knowledge of the world economy, equity markets, financial terminology and ratios, although it is designed to be used by new joiners or people who are looking at industries with which they are not familiar. As one of its business principles, HSBC Group is committed to providing outstanding customer service. HSBC’s Equity Research team reflects this principle in the way we work with you, our clients, on a daily basis. We view working with our clients as a partnership. Within Equity Research, we aim to provide you with ‘best in class, financially robust, independent, insightful, actionable research on a global, regional and local basis’. We are making our resources, knowledge and expertise available to you. Following the publication of this guide, we would like to remind you, our clients, that we are happy to arrange one-on-one or group meetings with our senior analysts to help you build on your sector, industry or stock knowledge – from the nuts and bolts of the industry dynamics through to individual company valuation and recommendation. Please get in touch with your HSBC representative to organise this, if required, or come to me directly. On the front page of each industry section within this guide, you will find the names and contact details of our sector analysts and, where relevant, their specialist sales person/people. If you do not know these analysts and sales people, we would be delighted to set up an initial meeting or call to discuss the HSBC offering and how we can help you. We hope you find this guide useful, and we look forward to working with you or to continue working with you in future. Regards David May Head of Equity Research, EMEA (Europe/CEEMEA) david.may@hsbcib.com +44 20 7991 6781 1 abc EMEA Equity Research Multi-sector September 2010 Contents Aerospace and Defence 3 Metals and Mining 103 Autos 11 Oil and Gas 111 Banks 19 Real Estate 119 Beverages 25 Retail – General 127 Business Services 33 Sporting Goods 135 Capital Goods 41 Chemicals 49 Telecoms, Media & Technology 141 Clean Energy and Climate Change Transport and Logistics 149 57 Travel and Leisure 157 Utilities 163 Basic Accounting Guide 171 Disclosure appendix 186 Disclaimer 188 Construction and Building Materials 65 Food and HPC 73 Food Retailing 81 Insurance 89 Luxury Goods 97 NB: Company names listed in the sector organisation charts are examples of major players in those industries We acknowledge the efforts of Elizabeth Gill in the production of this report. 2 abc EMEA Equity Research Multi-sector September 2010 Aerospace and Defence Aerospace and Defence team Harry Nourse* Analyst HSBC Bank Plc +44 20 7992 3494 harry.nourse@hsbcib.com Sector sales Rod Turnbull* Sector Sales HSBC Bank Plc +44 20 7991 5363 rod.turnbull@hsbcib.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 3 4 EMEA Equity Research Multi-sector September 2010 The aerospace and defence sector Aerospace & Defence Aerospace Commercial jet manufacturers Defence Business jet manufacturers Engine manufacturers Prime contractors Boeing Gulfstream General Electric BAE Systems Airbus (EADS group company) Bombardier Honey well Boeing Defence Dass ault IAE (RR, MTU, etc) EADS (Defence) Embraer Pratt & Whitney General Dynamics Cess na Rolls-Royce (RR) Lock heed Martin Hawker Beechcraft Safran Northrop Grumman Bombardier Embraer Superjet International Systems and Com ponent suppliers Tier 2/Primes Tier 3/Systems providers Tier4/Sub-contractors Tier 5/Component suppliers Finmeccanica Cobham Chemring AAR L3 Communications Ultra electronics Goodrich Chemring Raytheon Rockwell Collins Meggitt HEICO Thales Meggitt Moog Umeco Safran abc Source: HSBC 140 Aerospace is a long-cycle industry with peak-to-peak timeframes in orders (and deliv eries) being approximately 8-10-years 120 Mushrooming low-cost airlines, strong traffic growth, particularly in emerging economies, and launch of new aircraft (B787) drives orders Restocking recovery 100 80 100 80 Weak economic conditions in 1990, followed by First Gulf War (1991), significant spike in oil prices and Asian crisis in the mid-90s The 1980s oil and economic crisis followed by a period of strong growth in liberalised markets 60 120 R2 (stock price vs orders) = 0.80 over past 10-years 60 40 40 20 20 Traffic, orders collapse post-9/11: lessors & low cost airlines come to the rescue Jan-80 Jul-80 Jan-81 Jul-81 Jan-82 Jul-82 Jan-83 Jul-83 Jan-84 Jul-84 Jan-85 Jul-85 Jan-86 Jul-86 Jan-87 Jul-87 Jan-88 Jul-88 Jan-89 Jul-89 Jan-90 Jul-90 Jan-91 Jul-91 Jan-92 Jul-92 Jan-93 Jul-93 Jan-94 Jul-94 Jan-95 Jul-95 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 0 EMEA Equity Research Multi-sector September 2010 Aerospace: Commercial aircraft orders vs stock price performance for Boeing 12m M. Avg orders 0 Boeing share price (RHS) Source: Boeing, Thomson Reuters Datastream, HSBC Defence: US DoD investment account spending vs PE relative to S&P 500 ( US defence primes) 130% 25% 20% 120% 15% 110% 10% 100% 5% 0% 90% -5% 80% -10% -20% 60% 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 y-o-y growth (invt. account spend) Source: Boeing, Thomson Reuters Datastream, HSBC 1995 1996 1997 1998 1999 2000 2001 PE rela tive vs S&P 500 (RHS) 2002 2003 2004 2005 2006 30-year average PE relative 2007 2008 2009 2010e 5 abc 70% -15% EMEA Equity Research Multi-sector September 2010 Sector description The aerospace and defence (A&D) industry sits at the long end of the cyclical landscape, with peak-topeak durations in the region of 8-10 years for aerospace OE and 15-17 years for US defence spending. Aerospace – the sub-sector serves the aviation industry and manufactures commercial jets (>100 seat aircraft), regional jets and business jets. The sub-sector also includes the commercial and institutional satellite/related services business. Defence – the sub-sector serves the armed services and homeland security markets and its activities relate primarily to the design and manufacture of defence equipment including military aircraft, warships, submarines, land-based vehicles, surveillance and radar equipment, and related armaments. While the drivers for each sub-sector are clearly different (air traffic versus threat and geopolitical considerations), there are significant commonalities in terms of technological development, and components, systems and products utilised. The overlap between the sub-sectors is especially significant at the systems and component supplier level. As a result, most component suppliers in the industry operate in both sub-sectors, thereby deriving benefits of economies of scale from common developments. It is also the case that the major aerospace OEMs have significant defence operations, partly to diversify their businesses and to mitigate cyclical pressures. Players in the industry can be classified as: Original equipment manufacturers (OEMs) in aerospace and prime contractors (tier 1) in defence. These companies are at the forefront of most defence contracts or programmes, with responsibility for designing, manufacturing and assembling the equipment, integration of electronic systems and satisfactory delivery to the end customer; they bear most risk for the programme. There are few competitors in this category due to the requirements of scale, breadth of products, execution capabilities and political influence (in the case of defence). Tier 2 suppliers. These are suppliers of major systems and are increasingly transitioning to risk revenue sharing partners on commercial aerospace programmes. They do not have the product breadth or execution capabilities to compete as prime contractors. They generally bear only some of the risk on the programmes and therefore exhibit less earnings volatility than tier 1 players. Sub-systems suppliers (tier 3). These have high value added technologies and focus on niches. They are able to extract economies of scale, and risks are spread across programmes, which makes them more profitable than tier 1 or 2 players. Component suppliers (tier 4 and 5) produce high-volume but relatively low-tech components. They often display high earnings volatility and do not boast long-term competitive technologies. The industry structure also drives the industry’s earnings volatility – this is an ‘M’ shaped graph – with earnings volatility being higher for tier 1 (due to programme risk) and tier 4/5 (volume driven) players across the cycle. 6 abc Harry Nourse* Analyst HSBC Bank Plc +44 20 7992 3494 harry.nourse@hsbcib.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations EMEA Equity Research Multi-sector September 2010 abc Key themes Aerospace OE versus aftermarket Like any capital intensive industry, there are two phases to the end customer’s spend – the purchase of original equipment (OE, be it aircraft, engines or systems), followed by the stream of maintenance and spares expenditure (aftermarket – AM). What is unique to aerospace is that the airframers (aircraft manufacturers like Boeing and Airbus) share OE revenues with suppliers, but the latter get the full benefit of the AM revenues from a large installed base of equipment. A good example of this is the engine manufacturer, Safran, which generates c35% of its aerospace revenues but more than 80% of its profit from the aftermarket. Additionally, suppliers also benefit from the differential cyclicality of the two revenue streams – AM revenues tend to decline sooner and recover earlier than OE revenues during a typical cycle. Airframers versus suppliers Both major airframers, Airbus and Boeing, engage in fierce product competition and, as a result, spend significant amounts on R&D and face significant programme execution risk. This leads to relatively low margins on a high fixed cost base. In contrast, suppliers of engines, components and systems are arguably in a better position, due to a well-functioning oligopoly and lower programme risk and the ability to diversify those risks somewhat across airframers. Suppliers tend, therefore, to be more profitable through the cycle. Airframers – from oligopoly to competitive duopoly (and back again?) Over the past four decades, the commercial OE industry has reduced to a highly competitive duopoly, with Boeing and Airbus vying to capture a bigger share of the market. Currently the narrow-body market is essentially in equilibrium, and the two firms have largely been competing for share in the wide-body segment. As we move into the next decade, however, we anticipate increasing competition from new entrants. For example, Bombardier (previously a regional jet manufacturer) is entering larger territory with its new 130 seat CSeries, Russia with its Superjet 1000 and China with its C919. Although most of this additional competition will be in the single-aisle aircraft segment (100-150 seats), that segment is a key cash generator for Boeing and Airbus and funds large aircraft development: a risk to demand here could have repercussions for other products. Currency Sales in the aerospace industry are dollar denominated, while costs are in local currency. This is a particular structural problem for European firms, who typically hedge their dollar exposure over a minimum three-year period. The depreciation of the US dollar versus the euro over 2001-08 led to a structural competitive disadvantage for the European manufacturers, in particular EADS (given its cUSD70bn hedgebook). This trend reversed in 2009-10, and resulted in most European aerospace names being traded as proxy for the USD/EUR exchange rate. Defence It’s all about the money – affordability versus military superiority Defence spending, as a proportion of GDP, has declined steadily across most of the Western world since the end of the Cold War, thanks to a perceived ‘peace dividend’ and a shift in government priorities. For 7 EMEA Equity Research Multi-sector September 2010 the US, which accounts for 46% of total global spend, this trend reversed after 9/11, although expenditure now appears to be peaking, as the wars in Iraq and Afghanistan wind down. The current state of government finances, particularly in Europe and the US, remain far from comfortable and there is increasing pressure on governments to reduce defence spending (historically an early target for cuts), without compromising effectiveness or military superiority. As a result, we believe affordability and not just superiority of defence equipment will increasingly affect the industry landscape over the coming years. Emerging market opportunity While Western governments are facing pressures on their finances and defence budgets, some emerging powers are raising budgets. As a result, exports to regions like Middle East, India and Asia ex-China are increasingly becoming focus areas, with the added benefit to contractors of higher margins on export sales. However, contract terms and technology transfer requirements can result in complex negotiations (mostly government-to-government), leading to frequent delays. Sector drivers Aerospace Passenger and freight traffic Demand for aircraft is largely driven by increases in passenger and freight traffic (measured in revenue passenger/freight mile – RPM). Air traffic demand is driven by two trends; economic growth has a particular impact on premium passenger traffic (business class), freight demand, tourism and leisure, while flight demand is also affected by consumer confidence (air fares are a form of consumption spending). Changes in traffic growth drive airline profitability and, consequently, new aircraft orders. Yields and fuel prices Yields (the amount of passenger revenue received for each RPM) and fuel prices affect the industry in three ways: (1) they are a direct input for determining airline profitability and, hence, ability to buy new aircraft; (2) increasing fuel prices drive replacement demand for more fuel efficient aircraft; and (3) it impacts the economic lives of aircraft, which is particularly important for lessors. Yields have been trending lower over time, as low-cost carriers blossom and increases in fuel prices have resulted in pressure on airlines to replace old aircraft and in a reduction in the economic life of existing models. Availability of finance During the freezing of the credit markets, the availability of external financing declined significantly as, for example, a number of lease firms suffered from their parents’ financial distress (for example ILFC/AIG, CIT and RBS Aviation Capital). While the US Export-Import Bank and European export credit agencies have stepped in as part of government efforts to protect industrial jobs, the return of aircraft financing markets to normal levels is likely to be a major driver of future demand for aircraft. We believe that heightened levels of government support are distorting the market at the expense of the health of the secondary aircraft market, where debt financing remains hard to obtain for purchasing aircraft more than 10 years old; this is potentially a serious problem in an industry where assets are assumed to have a useful life of about 25 years. 8 abc EMEA Equity Research Multi-sector September 2010 abc Defence Defence spending is typically driven by threats, war, and politics and ideology. For export sales, rising wealth (particularly in countries with abundant natural resources and high levels of economic growth) is a major driver. Similarly, the actions of competitor nations can be important. There is an ongoing requirement to replace existing, outdated equipment, and new threats can stimulate demand for responsive technology, such as missile defence. Valuation: equity characteristics and accounting dilemmas A&D firms are most commonly valued on forward PE, EV/EBITDA, and P/FCF multiples. As with all cyclical businesses, aerospace valuation multiples tend to peak in the early stages of an up-cycle, in anticipation of increasing earnings. Commercial aerospace OEMs have significant operating leverage due to their high fixed costs, providing the prospect of strong earnings growth as margins expand on higher volumes. Aircraft production typically requires a long lead-time (a minimum of 18 months) and orders are therefore a keenly observed lead indicator of revenue and earnings growth: they often have more of an effect upon share price performance than actual quarter-to-quarter operational performance. A normalised range for aerospace valuations on forward PE is 8-25x; for defence stocks, the range is rather tighter at 8-18x and is heavily influenced by the direction and trajectory of budgets, which are the most important macroeconomic variable. For the defence companies valuations largely track investment account spending and DoD budget growth rates, although smaller firms may operate in niche, fastergrowing areas, and can attract a higher multiple as a result. Accounting: Boeing uses programme accounting to spread the significant costs of new aircraft development over the life of the programme, rather than expensing them all up front. This permits a smoothing of margins over the production period, but does not provide a particularly helpful measure of current operational profitability (for which the cash-based, unit cost accounting methodology provides a better snapshot). The level of R&D capitalisation is important to aerospace investors, as it can lead to overstatement of EBIT. Airbus does not use programme accounting and this is one reason for its lower (and more volatile) EBIT margins, which are also heavily influenced by hedge rates and other anomalies. Pension: On the European side, pension deficit is a major issue for BAE, which has seen the deficit rise nearly three-fold over the past two years and which has had to make substantial cash contributions to fund the plans. Pensions is more a timing issue with the US defence players since pension costs are reimbursed by the DoD as part of the contract billing. Aerospace OEMs like Boeing and Honeywell, however, face the risk of having to fund large pension deficits for the non-defence businesses. Aerospace and defence: M&A M&A has been a particular theme in the sector since the 1990s, particularly among defence names. Multiple factors have driven industry consolidation– the multi-year decline in defence budgets after the Cold War (1995-98 defence M&A boom in US), the need to achieve critical scale and pool development resources (European consolidation 1999-2003), the need to acquire key technology and, more recently, the demand from aerospace OEMs to have fewer, more consolidated suppliers capable of sharing development risks and offering bundled products (for example Safran’s proposed purchase of Zodiac). 9 EMEA Equity Research Multi-sector September 2010 Notes 10 abc abc EMEA Equity Research Multi-sector September 2010 Autos Autos team Horst Schneider* Analyst HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 3285 horst.schneider@hsbc.de Niels Fehre* Analyst HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 3426 niels.fehre@hsbc.de Sector sales Rod Turnbull* Sector sales HSBC Bank Plc +44 20 7991 5363 rod.turnbull@hsbcib.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 11 12 EMEA Equity Research Multi-sector September 2010 The autos sector Autos Car makers Mass market car makers Auto Components Premium car makers Diversified / multi product suppliers Tyre makers Toyota Audi (Volkswagen) Denso Michelin Volkswagen brand Mercedes-Benz (Daimler AG) Bosch* Goodyear/ Sumitomo General Motors* BMW Continental AG Bridgestone Hyundai –Kia Porsche (Volkswagen) Aisin Seiki Continental AG Ford Ferrari, Maserati (Fiat Group) Magna Pirelli Honda Aston Martin* Johnson Control Nokian Renkaat OYJ PSA Peugeot Citroen Jaguar–Landrover (Tata Motors) Faurecia Yokohama Nissan Delphi* Hankook Fiat + Chrysler Valeo Cooper Renault BorgWarner Suzuki Changan Group SAIC First Auto Works (FAW) Specialised suppliers (Telematics, safety, electricals, chassis etc.) Autoliv Leoni Elringklinger Rheinmetall *Private companies Source: HSBC Harman* abc Magneti Marelli (Fiat) 106 17 Car scrappage schemes Bursting of dotcom bubble 16 9-11: consumer confidence nose dives The boom of the 1990s 15 Scrappage schemes expiry Financial crisis & Lehman collapse 104 EMEA Equity Research Multi-sector September 2010 Consumer confidence in Europe versus passenger car registrations 102 Europe recession 100 14 98 13 96 12 94 92 11 1991 1992 1993 1994 1995 1996 1997 1998 1999 Europe PC registrations 12m rolling (m) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Consumer Confidence Index; Europe (RHS) Source: ACEA, Thomson Reuters Datastream abc 13 EMEA Equity Research Multi-sector September 2010 Sector description The European automotive sector is very important to the European economy, supporting around 12m jobs (2m directly) and contributing significantly to the EU’s GDP with a net trade of cEUR40bn a year. Developments in the auto sector influence and indicate the mood of the economy. Consequently, it is not only tracked by financial analysts but also closely watched by the political community. The sector can broadly be classified into mass market car makers and premium car makers. Mass-market manufacturers derive most of their sales from smaller and cheaper cars, with typically lower margins, and are exposed to a larger extent to cyclical demand. They rely on high production to push asset turnover, which in turn is the key profitability driver. Besides being exposed to the fragmented small-car segment, they are challenged by low capacity utilisation and constant pricing pressures. Premium car makers, with exposure to larger-car and SUV segments, typically derive 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 require high investments to develop low-emission technologies. They also now face greater market fragmentation and weakening product mix as they enter smaller car segments to cater to changing consumer preferences. At the onset of the economic crisis, the highly cyclical nature of the sector caused new-car sales, particularly in the Western markets, to collapse as consumer confidence plunged. Scrappage schemes intended to boost short-term demand during the crisis have also created a strong pull-forward effect that is creating additional medium-term challenges, especially for mass-market car makers, as issues of overcapacities in Europe are left unaddressed. Coupled with government austerity measures in Europe and weakening US macro data, we believe that represents further risk for 2011 and beyond. Key themes Emerging-market growth compensating for weaker developed markets Low car penetration and rising disposable incomes should lead to higher organic growth in emerging markets, even as the outlook for developed markets remains uncertain. In China, for example, only 45 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 from first-time buyers. In developed markets, sales are dominated by higher-priced large, premium cars and by replacement demand. Beyond an uncertain 2011, we expect unit sales growth in all regions. But we do not expect light-vehicle sales in Western Europe and the US to return to the pre-crisis levels of 2007 until after 2014. We believe that globally, light-vehicle sales will continue to be led by emerging markets, particularly the BRIC economies. Scrappage incentives led to pre-buying and aggravated pricing risks Scrappage schemes in the US, Europe and China significantly boosted demand, particularly for small cars, from which mass-market car makers stand to benefit. They have had limited effect on premium cars and light commercial vehicles. Even though the incentives helped the industry get through the crisis, they have pulled forward future demand, causing steep declines after they expired. For example, Germany had one of the most successful incentive schemes; it offered a discount of EUR2,500 on new cars if a car nine years or older was scrapped in return. This enabled 20% y-o-y growth in 2009, but now after its expiry, 14 abc Horst Schneider* Analyst HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 3285 horst.schneider@hsbc.de Niels Fehre* 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 EMEA Equity Research Multi-sector September 2010 abc we expect sales to decline c24% y-o-y in 2010 and to reach 2007 levels only by 2012e. Margins face additional risks from consumers accustomed to the incentives now expecting discounts from car dealers. Size matters: Capacity utilisation and restructuring Low capacity utilisation and insufficient scale is a particular concern 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 that only by consolidation can car makers raise production volumes high enough to increase asset turnover and alleviate pricing pressures. Fiat’s CEO defines this level as more than 5.5m cars a year and more than 1m cars per platform. However, political ramifications and government loans make meaningful consolidation difficult to achieve in the near future in Europe. In 2008 and 2009, restructuring was mostly confined to short-time work, only temporary plant shutdowns, transferring some manufacturing capacities to low-cost Eastern European sites and doing some minor structural cost savings. By contrast, US companies underwent intensive restructuring, resulting in the Fiat-Chrysler alliance and many discontinued brands. In China, one of the most fragmented markets, the government is pushing car makers to consolidate and has also brought in mechanisms to keep tabs on capacity expansions. Reducing CO2 emissions Stricter emission standards, CO2-based taxation in developed markets and higher oil prices have driven investments in alternative power-train and low-emission technologies. Premium car makers are particularly burdened by stricter emission regulations, even putting their old business model at risk and forcing them to enter smaller car segments. Significant R&D is currently devoted to improving the efficiency of existing gasoline engines, downsizing engines and emission reduction. The next frontier for the industry is developing alternative power trains. From alternate fuels to hybrids, plug-ins and pure electric vehicles, green technology requires significant R&D investment by both car makers and component suppliers. Challenges involving charging infrastructure, technology limitations and product costs mean such technologies are likely to dilute earnings before they can be expected to pay dividends. We forecast electric-car penetration rates to reach 7.5% of global light-vehicle sales by 2020e. Modular architectures and platform sharing Increasing standardisation by greater use of modular platforms is a key strategy. It reduces the number of architectures even though the average number of units per model series may decline. Standardisation helps to reduce the R&D cost per vehicle and to realise purchasing synergies from shared components. Significant cost savings can be achieved by standardising components such as air-conditioning systems, gearboxes, engines and axles that 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 leverage 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 or Volkswagen and Suzuki, involve equity cross holdings. Others, like PSA and Mitsubishi or Daimler and BMW, are only strategic in nature. 15 EMEA Equity Research Multi-sector September 2010 Sector drivers Volumes and macro data As a capital-intensive business with rising costs for new model and technology development, car makers must spread fixed costs across as many units as possible, underscoring the need for more economies of scale and standardisation. Volumes are thus primary margin drivers for the sector, which in turn depends on macroeconomic factors such as: consumer confidence, unemployment, disposable incomes and GDP. The sector is extremely data-intensive. Some of the closely tracked statistics are: monthly sales numbers from ACEA for Europe, US SAAR data, and for other key markets like Brazil, China and Japan; monthly sales by car makers; incentives data in Europe and the US; residual value of used cars; and inventory at dealer networks. Appreciating the complex nature of factors influencing volumes, and their vital role in determining top-line and margin forecasts, we use data from our partner consultancy IHS GlobalInsight, which offers a competitive edge to our research. With that, we are able to make sales and production forecasts by models, geographies, and vehicle segments as well as platforms. Pricing Pricing is another closely monitored element of car makers’ margins. For the mass-market segment, price elasticity is fairly high, which makes it difficult to pass on price increases to customers. Pricing is influenced by a combination of factors, including segment/product mix shifts, new product launches and competition. Scrappage incentives in Europe improved pricing for small cars because of the huge demand, but with their expiry in 2010, the issue is back on the table. Aggressive volume targets in a contracting market and efforts to increase capacity utilisation will leave car makers fighting on the pricing front in 2010, especially in the mass market segment. Product mix and new model momentum For car makers, it is very relevant whether unit sales are dominated by large or small cars. Premium car makers derive higher revenue per unit by selling larger sedans and SUVs than the mass-market car makers who 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 have a lower price and therefore smaller earnings margins. In general, higher CO2 taxation and fuel prices and increasing emergingmarket exposure have helped small cars gain market share, which is exposing all car makers to additional mix challenges. Car makers can only hope to counter this trend by selling cars with more feature-rich technology packages, which boosts margins per car. New models and their consequent product-mix and volume effects are vital earnings drivers as well. In a highly competitive industry, car makers are obliged to constantly invest in developing new model ranges; only recent and profitable model ranges help counter competitive pressures and boost margins. Exogenous factors: FX, raw material prices and interest rates Currencies: Since companies cannot always produce their cars where they sell them, and being predominantly an export-driven business, European and Japanese car makers are exposed to currency risks. Although Japanese car makers benefited from a weak JPY in the past, and German companies have been burdened with a stronger euro, the recent sovereign debt crisis has reversed this trend briefly. 16 abc EMEA Equity Research Multi-sector September 2010 abc Raw material prices: Steel is the most important input factor for car production and makes up around 60% of the total car weight on average. Having benefited from lower steel and other commodity prices in 2009, higher raw material prices are expected in H2 2010 from contract re-pricing with steel makers. Other commodities include aluminium, plastics, precious metals and rubber. Interest rates: Financial services operations at auto makers are a capital-intensive business; any change in refinancing costs can have a substantial impact on group P&L. Refinancing conditions determine the net interest income and are one of the key profitability drivers. Those conditions are determined by overall risk-free interest rates, the individual car maker’s credit rating and its credit default swap rates. Leading indicators: Consumer confidence Sales and production forecasts for the auto sector depends on the overall view for consumer spending, which in turn depends on a wide range of factors, among them consumer sentiment, unemployment, GDP growth and development of disposable income. We believe consumer confidence is the best indicator for short-term demand developments, while unemployment rates are more of a lagging indicator. Disposableincome changes have a limited effect on car sales in developed markets; they probably affect demand growth in emerging markets to a larger extent. Valuation: equity characteristics and accounting dilemmas The market has a good degree of visibility on performance, as all companies in the sector provide detailed disclosures by business segments on a quarterly basis except for the French companies, which only provide sales and revenue data quarterly and other details in their half-yearly report. Monthly unit sales figures also provide visibility on top-line development in the sector. Headline operating profits are reported by most companies by business segments. Companies in the sector trade on traditional multiples, which are 12-month-forward price/earnings ratios, EV/sales, EV/EBIT and EV/EBITDA. However, traditional multiples are of limited help in comparing auto sector stocks with their peers in the wider industrial sector. Typically, the activities of auto companies are organised into two distinct segments, core industrial operations and financial services. The activities of the financial services business are akin to those of banks: they accept deposits and undertake leasing and financing of cars and dealerships in addition to issuing securitised debt, which will not be found in the financials of their industrial peers. In addition, these companies hold significant financial stakes in other companies, and have segments engaged in diverse business activities – trucks, financial services, motorcycles and logistics – with varied exposure to cyclicality. 17 EMEA Equity Research Multi-sector September 2010 Notes 18 abc abc EMEA Equity Research Multi-sector September 2010 Banks Banking team Sector sales Carlo Digrandi* Co-Global Sector Head HSBC Bank Plc +44 20 7991 6843 carlo.digrandi@hsbcib.com Nigel Grinyer* Sector Sales HSBC Bank Plc +44 20 7991 5386 nigel.grinyer@hsbcib.com matt.charlton@hsbcib.com james1.rogers@hsbcib.com Robin Down* Co-Global Sector Head HSBC Bank Plc +44 20 7991 696 robin.down@hsbcib.com Matt Charlton* Sector Sales HSBC Bank Plc +44 20 7991 5392 Peter Toeman* Analyst HSBC Bank Plc +44 20 7991 6791 peter.toeman@hsbcib.com James Rogers* Sector Sales HSBC Bank Plc +44 20 7991 5077 Carlo Mareels* Analyst HSBC Bank Plc +44 20 7991 6722 carlo.mareels@hsbcib.com Johannes Thormann* Analyst HSBC Trinkaus & Burkhardt AG, Germany +49 21 1910 3017 johannes.thormann@hsbc.de Joanna Telioudi* Head of Greek Equities Research HSBC Pantelakis Securities SA +30 210 6965 209 joanna.telioudi@hsbc.com Dimitris Haralabopoulos* Analyst HSBC Pantelakis Securities SA +30 210 6965 214 dimitris.haralabopoulos@hsbc.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 19 20 EMEA Equity Research Multi-sector September 2010 The banking sector European Banks Austria France and Belgium Germany Greece Italy Spain UK Erste Group Bank KBC Aareal Bank Alpha Bank Banco Popolare Banco de Sabadell SA Barclays Raiffeisen International KBC Ancora Commerzbank Bank Of Cyprus Lloyds Banking Group Deutsche Postbank EFG Eurobank Ergasias Banca Popolare di Milano Banco Popular BNP Paribas Santander Royal Bank of Scotland Credit Agricole S.A. Natixis Societe Generale comdirect bank Deutsche bank National Bank of Greece Piraeus Bank SA Intesasanpaolo Monte dei Paschi BBVA Bankinter Standard Chartered UBI Unicredit Marfin Popular Bank Hellenic Postbank Source: HSBC abc EMEA Equity Research Multi-sector September 2010 European stock market movements 700 Northern Rock 600 Dotcom bubble Asian Financial crisis 500 Lehman Bankruptcy China market crash 09/11 400 300 AIG Fund infusion 200 "Black Monday" 100 European debt crisis 0 1987 1988 1990 1992 1993 1995 1997 1998 Euro Stoxx Banks index rebased 2000 2002 2003 2005 2007 2008 2010 Stoxx 50 Index rebased Source: Thomson Reuters Datastream abc 21 EMEA Equity Research Multi-sector September 2010 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). The bank sector includes institutions providing a comprehensive product offering to their clients, mostly known as universal banks, as well as more specialised institutions focusing on a more limited business segments such as corporate and investment banking activities (CIBM). With a few exceptions (Credit Suisse, UBS) the majority of European banks are universal banks, although in some cases (Societe Generale, BNP Paribas, Deutsche Bank) CIBM activities account for a large part of their profits. The various lines of business for banks are classified below: Net interest income, defined as the difference between the interest rate earned on assets and the interest rate 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 transacting in securities/derivatives/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. 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 recent 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. Key themes Key themes have changed rapidly in the past two years, but those detailed below are likely to remain for some time. Funding issues. Recent events have proven that the funding issue remains one of the key issues, risks or themes 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 management focus over the next few years. The liquidity ratio, typically calculated as the ratio of loans to deposits, is the 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. Fears on sovereign risk: The stress test of European banks by the Committee of European Banking Supervisors (CEBS) proved to be a non-event as some of the assumptions it used were considered too 22 abc Carlo Digrandi* Co-Global Sector Head HSBC Bank Plc +44 20 7991 6843 carlo.digrandi@hsbcib.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations EMEA Equity Research Multi-sector September 2010 abc mild. Among others, it failed to consider sovereign default, envisaged only conservative credit losses and used headline Tier I instead of core Tier I. Sector profitability: The introduction of tougher regulation has raised some doubts about sector profitability over the next cycle. Most would argue that this should be lower due to lower leverage and declining margin. Increased regulation (Basel III and related issues). The introduction of Basel III (currently still in discussion) is expected to heavily affect capital requirements, obliging banks to raise additional funds to meet new rules. It seems, however, that Basel III proposals will be subject to several changes, which may limit the impact on the sector; nevertheless, this will remain an issue until the final proposal is approved. 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 is linked to unemployment, for example. Hence banks could be considered a proxy for GDP growth. Other than 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 vice versa. 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 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 vice versa. 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 two years, following the subprime crisis, the role of regulators in the banking sector has increased dramatically and it is expected to increase 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, 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. 23 EMEA Equity Research Multi-sector September 2010 Valuation: equity characteristics and accounting dilemmas 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 should be trading at or close to its book value (market volatility and equity risk premium are captured in the cost of equity). Over the past five years 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 ROEs rather than reported figures. Accounting issues abound among banks. Tier 1 calculations, for example, differ from one country to another, Spanish banks have large generic reserves and LLPs are treated differently from a tax perspective in the different European countries. In the majority of cases, we do not adjust earnings for all these and other issues, as the process would be too cumbersome and much data is unavailable. Instead, we use core earnings figures, which are adjusted for extraordinary and one-off items such as disposals, acquisitions, write-offs and large trading losses. 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, PBV 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 among divisions as the corporate centre is also used as a financing fulcrum by most banks. 24 abc abc EMEA Equity Research Multi-sector September 2010 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* Analyst HSBC Bank Plc +44 20 7991 6793 erwan.rambourg@hsbcib.com 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 25 26 The beverages sector EMEA Equity Research Multi-sector September 2010 Beverages Non-Alcoholic Beverages Concentrate companies Alcoholic Beverages Bottlers Brewers Latam Brewers Other Alcoholic companies Coca-Cola Co. Coca-Cola Enterprises A-B InBev Ambev Diageo PepsiCo Coca-Cola FEMSA SABMiller FEMSA Remy Cointreau Coca-Cola Hellenic Boston Beer Grupo Modelo Pernod Ricard Coca-Cola Icecek Tsingtao Brown-Forman Constellation Brands Source: HSBC abc Historical PE valuation of the non-alcoholic and alcoholic beverage industry EMEA Equity Research Multi-sector September 2010 40 August 1998 Valuation of Coca-Cola Co. (KO) peaked and then began to be re-evaluated by investors 35 August 2007 Global consumer slowdown began 30 August 2008 Investors looking for safety in the defensive consumer staples sector (valuations become more normalised) 25 20 15 10 5 Aug-90 Aug-92 Aug-94 Aug-96 World Aug-98 Consumer Non-durable Aug-00 Aug-02 Beverages: Non-Alcoholic Aug-04 Aug-06 Aug-08 Beverages: Alcoholic Source: HSBC, FactSet abc 27 EMEA Equity Research Multi-sector September 2010 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. 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. Recently, PepsiCo acquired its two largest bottlers, Pepsi Bottling Group and PepsiAmericas, and in the fourth quarter of 2010, Coca-Cola Co. is scheduled to acquire 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 deteriorating consumer environment as a result of the economic downturn; increasing costs 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 as 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/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. Revive the carbonated soft drink category – this is a longer-term solution, which is easier said than done, but should be key to jump-start volume and profit growth. Capitalise 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. 28 abc 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 EMEA Equity Research Multi-sector September 2010 abc Capture growth in high-margin immediate consumption channel (mix) – drive revenue-per-case growth with improvements in product and package mix. Step up media and new product launches – to remain competitive, more needs to be invested in product promotion and development. Focus on and grow international operations – go where the growth is, reinvigorate domestic operations but take advantage of opportunities overseas. Beer We believe that the key concerns/themes for the beer industry are: Weakening economic conditions – a pullback in consumer spending, particularly on higher-margin premium brands and on-premise purchases; beverage volume tends to closely track GDP growth or decline. 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. Competitive/consolidating industry – many beverage companies are global, and the beer industry has become more competitive as consolidation continues (SABMiller was surpassed as the largest brewer by volume by Anheuser-Busch InBev). Wine and spirits We believe that the key concerns/themes for the wine and spirits industries are: Trading up vs 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 from weakening macro-economic trends, there has been a growing preference for premium wine and spirits and imported/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; health-conscious: looking for lower calories or carbohydrates, such as light beers, white wine and clear spirits; 29 EMEA Equity Research Multi-sector September 2010 availability: good product placement and marketing, which is the responsibility of the brand owner and distributors. 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 and emerging market presence. Continued cost management/realisation of synergies – beverage companies have tightened their belts, which could deliver significant cost savings, through realising bottling plant or brewery efficiencies, streamlining organisation or leveraging global scale. Continue to selectively invest – 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 A preference for premium wine, spirits and imported or craft beers, particularly in a stable or strengthening economic environment Also a need for variety, availability and healthier beverages (low calorie/low or no carbohydrates) Winning in a competitive environment Necessary to have strong brands, stronger brand equity and the strongest distribution system Right balance of volume and pricing growth, while running an efficient production and distribution system Manage through a tough cost environment (rising energy and raw-material costs) Global players should be better positioned to capture future growth Scale and scope matter in the beverage industry Expect to see more acquisitions and production/sales/distribution agreements among companies Realise growth in core, profitable markets but also look to expand into emerging markets Capitalise on favourable demographics, particularly younger consumers with more disposable income 30 abc EMEA Equity Research Multi-sector September 2010 abc Valuation: equity characteristics and accounting dilemmas Beverage companies tend to trade on forward-looking price/earnings ratios and on EV/EBITDA. For Coca-Cola 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/debtintensive. 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 which 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 14-16x 2011e consensus earnings, below historical averages in the high-teens. On EV/EBITDA, the bottlers are trading at 7-8x 2011e consensus EBITDA estimates, also below historical averages closer to 9-10x. For the brewers, 7-11x 2011e 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 the company’s true growth rates. 31 EMEA Equity Research Multi-sector September 2010 Notes 32 abc abc EMEA Equity Research Multi-sector September 2010 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 33 34 Business Services BPO / Consulting Distributors Staffing Security firms Rental companies FM & Hygiene Atkins Bunzl Adecco G4S Aggreko Davis Services Capital Electrocomponents Hays Securitas Ashtead Mears Experian Premier Farnell Michael Page Northgate Mitie Serco Wolseley Randstad Regus Rentokil Xchanging EMEA Equity Research Multi-sector September 2010 The business services sector SThree USG Source: HSBC abc 40.0% 80.0% December 2007 Great recession in US 30.0% 60.0% 20.0% 40.0% 10.0% 20.0% 0.0% Jan-91 EMEA Equity Research Multi-sector September 2010 US market proxy and UK Business Support Services Index 0.0% Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 -10.0% Jan-08 Jan-09 Jan-10 -20.0% Lehman collapse -20.0% March 1991 End of recession March-November 2001 US economic recession October 2009 US unemployment rate at 10.1%, the highest rate since 1983 -30.0% -40.0% -60.0% US market proxy UK-DS Bus Sup Svs - Price Index Source: HSBC, Thomson Reuters Datastream abc 35 EMEA Equity Research Multi-sector September 2010 Sector description Business services can be generally classified as enablers or intermediaries. It includes businesses such as staffing, distributors, BPO and consulting firms. BPO/consulting firms have a broad variety of business models. At one end of the spectrum we have 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. 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 either offered directly to the client 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 to the premises of their clients, ranging from facilities management, pest control and reception services, to work-wear and linen, among others. Key themes BPO/consulting Outsourcing companies, by and large, have less cyclical cash flow streams than much of the rest of the business services sector. However, the most pertinent question is the extent to which individual companies are less cyclical, or indeed whether they respond differently to different cycles. In order for valuations to be attractive, the companies must demonstrate more defensive growth than is in the price. This will broadly depend upon three questions: (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 effectively 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 move towards using fewer, larger and better-stocked centres – which can reduce staff costs as well as freeing up property. This process has been under way for some time and is now largely complete, although there are doubtless additional options. 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-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 36 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 EMEA Equity Research Multi-sector September 2010 abc discounted rate, enhancing their gross margins. However, if distributors engage in cost-cutting measures in a downturn that cut capacity, this can reduce the medium-term upside during 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 largely centres on the volume and price of services offered and the ability of companies to reduce cost without damaging client relationships. Investors should be cautious of businesses that cut headcount more aggressively than peers as staffing remains a relationship business and the elimination of too many client-facing costs can materially reduce long-term growth during and following recovery. The key distinction between staffers stems from the temp: perm mix, and geographical diversity. Bluecollar temps are 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 correlated more to volumes. Indeed, the 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 since 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 the cyclical nature of its 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 relatively quickly in response to changing end-markets. Rental companies are also notorious for their gearing, leading to exaggerated profit and share price behaviour at turning points in an economic cycle. However, the nature of this gearing is more nuanced than it first appears. Consolidation remains a long and ongoing structural trend in these highly fragmented markets, and rental companies’ ROIC profiles are likely to approximate their cost of capital across a cycle. Security firms The business is widely perceived as being late cyclical, and has historically demonstrated 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. 37 EMEA Equity Research Multi-sector September 2010 FM and hygiene The FM and hygiene businesses provide a host of diverse services and the businesses face different markets and challenges. Given the diversity of business, some of the companies in the sector have complex margin drivers. Spot-contract mix is one of the key determinant of margins. Historically, spot sales have been c8-10% of sales at the peak of the cycle and have disappeared in recessions; however, they held up in the latest downturn. Sector drivers 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 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, and distributors effectively suffer or benefit from the cyclicality of their clients. 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 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: Broadly speaking, 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 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 38 abc EMEA Equity Research Multi-sector September 2010 abc 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. 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, then sales and also 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: equity characteristics and accounting dilemmas Companies in this sector trade on traditional metrics, but a few exceptions do exist. Although the PE ratio is the most widely used multiple, other multiples often considered for valuation are EV/EBITA, EV/EBITDA (mainly for rental companies), EV/sales, FCF yield and FCF to EV. For companies where pension liability is a major concern, analysts prefer using EV/EBITA (adjusted for the pension). Some analysts prefer a blended valuation obtained via relative valuation, historical multiples and a DCF-based valuation. However, use of DCF-based valuations should be viewed with caution – particularly during periods of economic uncertainty and poor earnings visibility. Accounting notes Companies within the sector report their profits in a dissimilar fashion despite sharing nomenclature categorised as trading profit, operating profit, EBIT and EBITA, for example. The key differences stem from the classification of amortisation arising from acquisition intangibles, the share of profit from associates and exceptionals. Hence, one needs to be careful when comparing multiples across companies, to ensure that they convey the same economic content. For example, comparing staffing companies on EV/EBITDA may be meaningful as these are not capex-intensive businesses. It is also important to keep track of changes in regulation and the resulting impact on accounts. For instance, a recent 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. Discrepancies and/or changes arising from accounting adjustments need to be handled carefully when comparing historical trends or different companies. Leading indicators: The broad lead indicators for business services sector include the TCB leading indicator, OECD leading indicators and ISM. Each of the sub sectors has a different lead indicator specific to the dynamics of the business. For distributors, key leading indicators are industry shipments, book-to-bill ratio, inventory-to-sales ratio. Also, lead indicators of the clients are 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. Job vacancies in the US, the UK and Europe are the best lead indicator for UK staffing agencies. For the rest of the blue-collar general services, man hours are among the key indicators, eg security man-hours, alarms man-hours, uniform supply man-hours for security firms and pest control man-hours, grocery man-hours and janitorial man-hours for FM and hygiene. 39 EMEA Equity Research Multi-sector September 2010 Notes 40 abc abc EMEA Equity Research Multi-sector September 2010 Capital Goods Capital Goods team Colin Gibson* Global Sector Head, Industrials HSBC Bank Plc +44 20 7991 6592 colin.gibson@hsbcib.com Matt Williams* Analyst HSBC Bank Plc +44 20 7991 6750 matt.j.williams@hsbcib.com Sector sales Rod Turnbull* Sector Sales HSBC Bank Plc +44 20 7991 5363 rod.turnbull@hsbcib.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 41 42 Capital Goods Core capital goods Diversified / multi-industry conglomerates Construction / construction materials EMEA Equity Research Multi-sector September 2010 The capital goods sector Siemens Philips Honeywell Smiths Group Larsen & Toubro Production technology Power technology Building technology Commercial vehicles ABB BHEL Schneider Electric Volvo Emerson Electric Alstom Schindler Paccar Atlas Copco Dongfang Electric Kone Scania Sandvik Doosan Heavy Legrand MAN SKF Shanghai Electric Assa Abloy Sinotruk Rockwell Automation Harbin Power Geberit Alfa Laval Metso Source: HSBC abc 40% 1980s: poor start, but good recovery as liberalised markets promoted growth 30% Growth of the BRICS – decoupling starts Lehman collapse EMEA Equity Research Multi-sector September 2010 Capital goods historical global capex 20% 10% 0% -10% 9/11: corporate debt markets close -20% 1971 1976 1981 1986 Global 1991 Emerging 1996 2001 2006 Developed Source: HSBC abc 43 EMEA Equity Research Multi-sector September 2010 Sector description The distinguishing characteristic of the capital goods sector is a profound heterogeneity, which extends through technologies, applications and customer groups and shows up in growth rates, profitability levels and, ultimately, valuation multiples. Diverse markets are inevitably niche markets, with relatively little in the way of good third-party data (no Gartner, no JD Power). Much of the job of capital goods research is thus the development of an understanding of the specific markets a supplier is active in, likely growth rates, and their 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. There are normally positive economies of scale to be had, and consequently barriers to entry are high, rewarding the incumbent leaders. These barriers to entry do not just refer to manufacturing efficiency but also include input costs and perhaps most importantly, aftersales provision. What differentiates capital goods from consumer goods is the level of utilisation, as companies typically sweat assets far more than private individuals do. Accordingly, aftersales or ‘MRO’ (maintenance, repair and overhaul) accounts for a far larger proportion of the total market opportunity than it typically would in consumer markets. Buyers typically expect reliable and geographically extended MRO networks, which new entrants struggle to provide. The leading companies within 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 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. EMs grew rapidly over the past decade and, if these growth rates are maintained, could overtake DMs in total dollar value during or around 2013. 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 have led to demand for cleaner, more efficient energy technology. Put simply, EMs need energy right now; DMs need clean energy. Providing a ‘solution’ The ‘solution’ has become a buzzword within the capital goods sector, and represents a desired step away from just supplying a tangible product. The 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. 44 abc Matt Williams* Analyst HSBC Bank Plc +44 20 7991 6750 matt.j.williams@hsbcib.com Colin Gibson* Analyst HSBC Bank Plc +44 20 7991 6592 colin.gibson@hsbcib.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations EMEA Equity Research Multi-sector September 2010 abc 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. As sales have recovered for some companies, margins have expanded significantly; the challenge now is to see what proportion of cost savings are permanent, and which inefficiencies will begin to creep back in, now that survival appears guaranteed. For those companies that did target fixed costs effectively, margin expansion driven by operational leverage has been impressive. Key components: assembly versus manufacture In the first decade of the new millennium, unfocused conglomerates began a wave of divestments, exiting noncore 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). With this refocusing on ‘core activities,’ companies have become much more actively involved in the ‘make or buy’ decision. Outsourcing of components increased – not limited to just ‘simple’ components – and the proportion of ‘assembly’ business increased in turn. This outsourcing has allowed for greater flexibility by 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 the capital expenditure activities of their end customers, both 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, 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. 45 EMEA Equity Research Multi-sector September 2010 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 item. Policies vary, but as a general rule, the sector does not engage in overly long-term hedging, and consequently has an exposure 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. In contrast, certain more complex high-end solutions sold to DM offer higher profit margins. 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 in three separate aspects of building technology, and Siemens is present in power technology and lighting (and various other segments) – 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, which has largely been concentrated, with acquisition of smaller fry by the larger players within 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 at 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 would include Philips’ sales 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 have collected significant cash on the balance sheet, which has led to intense speculation as to likely M&A targets or the means by which cash would 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 46 abc EMEA Equity Research Multi-sector September 2010 abc 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 subsequently 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. Valuation: equity characteristics and accounting dilemmas Industrial companies trade on traditional metrics, namely forward-looking PE ratios, EV/EBITDA, and to a lesser extent, price/book. At the peak of the cycle, the rolling one-year-forward PE reached 19x, while it troughed at 8x, immediately post 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, solves for the market-assessed cost of capital (MACC). This MACC can then be compared with the sector average (is company X rich or cheap to 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 operating activities and earnings prospects. Some stocks are especially popular with local retail investors, and Bloomberg free float estimates can overstate. 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. 47 EMEA Equity Research Multi-sector September 2010 Notes 48 abc abc EMEA Equity Research Multi-sector September 2010 Chemicals Chemicals team Geoff Haire* Head of Chemicals Europe, EMEA and Americas HSBC Bank Plc +44 20 7991 6892 geoff.haire@hsbcib.com Jesko Mayer-Wegelin* Analyst HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 3719 jesko.mayer-wegelin@hsbcib.com Sebstian Satz* Analyst HSBC Bank Plc +44 20 7991 6894 sebastian.satz@hsbcib.com Yonah Weisz* Analyst HSBC Bank Plc +972 3710 1198 yonahweisz@hsbc.com Sriharsha Pappu*, CFA Analyst HSBC Bank Middle East Limited +971 4423 6924 sriharsha.pappu@hsbc.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 49 50 Chemicals Commodity Speciality AgroChemicals Industrial Gases Conglomerates Arkema (EU) Akzo Nobel (EU) K+S (EU) Air Liquide (EU) BASF (EU) Clariant (EU) Croda (EU) Syngenta (EU) Linde (EU) Dow Chemical (US) Lanxess (EU) DSM (EU) Yara (EU) Air Products (US) DuPont (US) Rhodia (EU) Givaudan (EU) Solvay (EU) Johnson Matthey (EU) Monsanto (US) Symrise (EU) Mosaic (US) Celanese (US) Umicore (EU) Potash Corp (US) Eastman Chemicals (US) Wacker Chemie (EU) Huntman (US) Braskem (EM) EMEA Equity Research Multi-sector September 2010 The chemicals sector Praxair (US) Israel Chemicals (EM) PPG (US) MA Industries (EM) Sherwin Williams (US) Uralkali (EM) SABIC (EM) Source: HSBC abc EMEA Equity Research Multi-sector September 2010 Return on invested capital for chemicals stocks versus growth in industrial production 10 12.00% Restocking recovery Rising oil prices Asian led recovery 11.00% 5 0 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 9.00% -5 Rising oil prices Asian Credit Crunch 8.00% Average ROIC (%) Growth in EU Industrial Production (% y-o-y) 10.00% -10 7.00% Recession -15 6.00% -20 Overcapacity coupled with global economic recession 5.00% -25 4.00% Growth in EU IP (% y-o-y) ROIC (RHS) 51 abc Source: Thomson Reuters Datastream, HSBC abc EMEA Equity Research Multi-sector September 2010 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 – commodities, industrial gases, speciality, agrochemicals. There are several chemical conglomerates encompassing all of the sub-sectors. Summary of sub-sector characteristics Sub-sector Commodities __________ Companies ___________ Characteristics Arkema Lanxess - need to keep cost base low BASF Rhodia - high capital intensity Braskem SABIC - tend to be price-takers Dow Chemical Solvay - cyclical, exposed to economy and supply demand cycle Akzo Nobel Johnson Matthey Croda Symrise - generally exposed to consumer rather than industrial demand - fragmented end-market and few leading players DSM Umicore - low capital intensity DuPont Specialities - to maintain constant margins need to innovate product offering Givaudan Industrial Gases Air Liquide Linde - high capital intensity Air Products Praxair - long-term contracts, up to 15 years - highly concentrated markets, big 4 players represent approximately 75% of the market - customer service is key 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 Yara - high capital intensity in fertilisers so low cost base is key Monsanto Source: HSBC Sector has undergone a strong transformation Ten years ago there were 17 large-cap chemicals companies. Since then, nine companies have either exited chemicals (for example, UCB and Bayer) or have been acquired by competitors or private equity. 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 industry is made up of a series of global oligopolies reflecting the fragmented nature of the endmarkets. However, companies are generally price-takers as customers have more bargaining power (specialities and industrial gases) or prices are set with respect to the macro environment (commodities and agrochemicals). The barriers to entry are capital cost, customer relationships and technology. Key themes Emerging versus developed market economic growth Historically the industry’s end-markets have focused on the developed world, which has resulted in topline growth trailing that of other industrial sectors. However, with the growth of manufacturing, upgrading of infrastructure and a growing middle class, emerging markets are of increasing importance to the Chemicals sector. The sector average exposure to emerging markets is 27% of sales. However, a 52 Geoff Haire* Head of Chemicals Europe, EMEA and Americas HSBC Bank Plc +44 20 7991 6892 geoff.haire@hsbcib.com Sebstian Satz* Analyst HSBC Bank Plc +44 20 7991 6894 sebastian.satz@hsbcib.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations EMEA Equity Research Multi-sector September 2010 abc number of companies in the European sector already have a sizeable position in emerging markets, including Rhodia (45% of sales), Givaudan (35%), Symrise (35%), Linde (35%), Syngenta (33%) and Lanxess (33%). Commoditisation One of the inevitabilities in the chemical industry is commoditisation. There are two broad categories of chemicals – commodity and specialities. Commodities chemicals prices tend to be set by public markets and are heavily correlated with input costs and supply/demand balances. Raw material costs are 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. There are few competitors in this category. However, history has shown that speciality chemicals can easily become commodities in the absence of innovation, 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 ten years we have seen significant M&A in the sector. There have been three types of activity: consolidation within the sector (for example Akzo Nobel acquiring ICI), private equity activity (the formation of Ineos, and Access Industries creating LyondellBasell from two acquisitions and, later, Apollo acquiring 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 vinyls chemical businesses). We expect M&A to continue in the sector as balance sheets are healthy, currently Solvay and DSM are active buyers and BASF has just acquired Cognis for EUR3.1bn. We also expect private equity to bring chemical companies back to the market as the economy and equity markets recover; in the first half of 2010 two companies, Brenntag and Christian Hansen, had already come back 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 there are many companies 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. 53 EMEA Equity Research Multi-sector September 2010 Sector drivers Macro economics and pricing power Top-line growth in the sector is driven by GDP and industrial production (IP). Over the last 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 1.4-2.5x GDP. Over the last ten years, commodity chemicals volumes have grown at 2.3x global GDP and 1.4x IP, specialty chemicals volumes at 1.4x global GDP and 0.8x IP and industrial gases at 2.0x GDP and 1.3x IP. Commodity players generally only have pricing power when input costs are rising and even then they may not be able to recover all of the higher costs, so at the peak of the pricing cycle margins may already be falling. However, speciality chemical, agrochemical and industrial gas producers will have varying degrees of pricing power as they are providing a service that is essential to their customers’ products and processes. 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. Input costs We estimate that 65% 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 the 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. In times of fast-rising fossil fuel prices, the majority of the industry has struggled to pass on price increases quickly, as customers are reluctant to take higher prices, resulting in margin compression for a few quarters. Restructuring This is constant activity within the industry as companies look for ways to reduce the fixed cost base of below-par businesses or integrate new acquisitions. There are at least two reasons for this. First, as product portfolios become commoditised, management need to reduce costs or invest in new high-growth businesses. Secondly, the movement in real long-term pricing (ie after inflation) is negative, therefore if volume is growth just above global GDP, top-line growth is at best flat, so growth can only come from cost reduction. However, as a rule of thumb, approximately 50% of any cost savings are given back within five years of them being achieved. Environment One of the key long-term secular drivers in the sector is the environment, which is both a positive and a negative. The positive aspects come from governments and regulators around the world being focused on 54 abc EMEA Equity Research Multi-sector September 2010 abc reducing vehicle emissions. The main beneficiaries of tighter emissions have been the catalyst producers – BASF, Johnson Matthey and Umicore. We expect the focus on vehicle emissions to continue as the EU and North America progressively reduce limits and the emerging markets (Brazil, China and India) start to tackle the problem of emissions. Moreover, the engineering polymer producers (DSM, Solvay, BASF and DuPont) also benefit as vehicle producers substitute plastics for metals. The “holy grail” is mass production of zero emission vehicles (ZEVs), which can be achieved with either fuel cells or batteries. Although the technology currently exists for this, it is not commercially attractive and a new fuel/recharging infrastructure would need to be established. The negative aspect of the environmental issue is regulations requiring the chemical industry to reduce emissions in Europe. This includes REACH (Registration, Evaluation, Authorisation and Restriction of Chemicals) and carbon emission limits to which they have to conform or be taxed on any emissions above the limits. Feed the world There is a clear need for more food as the developing world becomes richer and more urbanised, ie eating more meat, populations rise, a move toward biofuels and the amount of arable land is restricted. Therefore, there is a need for agrochemical companies (crop protection and fertiliser) to develop products that can increase yields, through protecting plants, as 40% of the world’s harvestable crops are destroyed by weeds, insects and fungi. Valuation: equity characteristics and accounting dilemmas The market is focused on short-terms 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 using sum-of-the-parts (SOTP) for conglomerate companies. The drawback to this is that the companies have changed so much over the last ten years that comparing current with historical multiples is of little value, and does not capture the future value of those companies that have invested heavily either in R&D or acquisitions. In contrast, a return on capital metric (ROIC or CROCI) or a discounted cash flow (DCF) takes into account the return of 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 that have been made already, as the key drivers of a DCF are growth in invested capital (IC), asset turn (sales/IC), profit margin and weighted cost of capital. 55 EMEA Equity Research Multi-sector September 2010 Notes 56 abc abc EMEA Equity Research Multi-sector September 2010 Clean Energy and Climate Change Clean Energy and Climate Change team Robert Clover* Global Sector Head, Clean Energy HSBC Bank Plc +44 20 7991 6741 robert.clover@hsbcib.com Christian Rath* Analyst HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 3049 christian.rath@hsbc.de Nick Robins* Head, Climate Change Centre of Excellence HSBC Bank Plc +44 20 7991 6778 nick.robins@hsbc.com Murielle André-Pinard* Analyst HSBC Bank Plc, Paris Branch +33 1 56 52 43 16 murielle.andre.pinard@hsbc.com Zoe Knight* Analyst HSBC Bank Plc +44 20 7991 6715 zoe.knight@hsbcib.com Vangelis Karanikas* Analyst HSBC Pantelakis Securities (Greece) +30 210 6965 211 vangelis.karanikas@hsbc.com James Magness* Analyst HSBC Bank Plc +44 20 7991 3464 james.magness@hsbcib.com Charanjit Singh* Analyst HSBC Bank Plc +91 80 3001 3776 charanjit2singh@hsbc.co.in Sector sales Burkhard Weiss* Analyst HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 3722 burkhard.weiss@hsbc.de Mark Van Lonkhuyzen* Sector Sales HSBC Bank Plc +44 20 7991 1329 mark.van.lonkhuyzen@hsbcib.com Billal Ismail* Sector Sales HSBC Bank Plc +44 20 7991 5362 billal.ismail@hsbcib.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 57 58 EMEA Equity Research Multi-sector September 2010 The clean energy and climate change sector Clean Energy and Climate Change Sector Low Carbon Energy Bio-energy - OEM Sao Martinho Geothermal - OEM Daldrup & Soehne Nuclear - OEM Doosan Heavy Industry Solar - OEM Centrosolar Wacker Chemie Wind - OEM Vestas Wind Clipper Windpower Renewable Power Providers Acciona Iberdrola Renovables Source: HSBC Water & Waste Building Efficiency Aixtron Philips Water American Water Works Veolia Environment Industrial Efficiency Krones Rational Waste New Environment Energy Seche Environment Transport Efficiency Delachaux SA Vossloh Multi-theme Efficiency Alstom Schneider Electric Energy Storage Saft Groupe SFC Energy Fuel cells Ballard Power Systems SFC Smart Fuel Cell abc Low carbon Power Providers EDP Fortum OYJ Energy Efficiency 150 100 1988 1990 1992 1994 1996 1998 2000 200 2002 2004 2006 2008 WAVE II Take Off 2010 2012 IPCC 5th Report Annex I – Moving to higher end of targets? Non Annex I - Binding deviation from BAU? EU ETS – Phase III starts Aviation sector under EU ETS CoP 16 – Mexican Protocol? CoP 15 – Copenhagen Accord IPCC 4th Report - Human impact ‘unequivocal’ Stern Report on Climate economics Kyoto Protocol enters in to force & EU ETS starts Russia ratifies Kyoto Protocol CoP 7: Marrakech Accords agreed WAVE I Laying the Foundations 2014 59 abc Source: New Energy Finance, HSBC CoP 3: Kyoto Protocol agreed 250 IPCC 2nd Report - Human link in emissions UNFCCC signed 0 IPCC 1st Assessment 50 IPCC established Annual clean energy investment (USDbn) 300 EMEA Equity Research Multi-sector September 2010 Waves of climate commitment WAVE III Transformation? EMEA Equity Research Multi-sector September 2010 Sector description Clean energy comprises a wide range of technologies intended to address climate change and energy security by shifting from a high-carbon to a low-carbon economy. Those technologies include low-carbon energy, energy efficiency for building, industry and transport, and efficient water and waste technologies. Low-carbon energy includes power generation using no fuel or less fuel than conventional powergeneration technologies and producing no or fewer pollutants than conventional technologies. It uses nuclear energy and renewable-energy sources that, unlike fossil fuels, are not depleted over time, such as biomass and biofuels, solar power, wind power, geothermal and hydropower. Low-carbon power producers like utilities are also included in the sector. Energy efficiency 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 and transport. It also includes energy-storage technologies such as batteries and alternative energy storage technologies such as fuel cells which can store energy through storing reactants like compressed hydrogen. 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 and manage power consumption in buildings. Industrial efficiency and multi-theme efficiency encompasses products or processes to conserve energy in industrial sectors. These include process automation, control systems, instrumentation, smart grids and energy-control and power-management systems. Transport efficiency includes technologies that reduce the carbon emitted by conventional transport. Lowcarbon-intensive 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 – are 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. The water sector includes companies providing 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. Key challenges Clean energy is a growing industry in both developed and developing markets, but challenges remain to the competitiveness of clean energy companies. One is regulatory uncertainty, since growth is driven to a large extent by regulation, which tends to have been formulated in an effort both to reduce greenhousegas emissions and to provide secure sources of energy. Another is the need for innovation in low-carbonenergy technologies, which requires enough investment by governments and the private sector to offset the economic advantage of conventional technologies. A third is the diversity of sub-sectors. Especially in 60 abc Robert Clover* Global Sector Head, Clean Energy HSBC Bank Plc +44 20 7991 6741 robert.clover@hsbcib.com Nick Robins* Head, Climate Change Centre of Excellence HSBC Bank Plc +44 20 7991 6778 nick.robins@hsbc.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations EMEA Equity Research Multi-sector September 2010 abc energy efficiency, they cover a wide range of technologies, resulting in a highly fragmented market occupied by a large number of smaller, unlisted companies, whose profitability and financial health is hard to determine. Key themes Emerging versus developed 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. Investment in the industrialised world is likely to continue to dominate over the next decade, but the share of emerging markets will increase. Looking at the three key players from the industrialised world, the EU, the US and Japan, and the three leading emerging markets, Brazil, China and India, we estimate the share of the former will decline from 60% in 2009 to 53% in 2020, while the share of the latter will grow from 25% to 34%. In emerging markets, the spotlight will be on China. Its goals for low-carbon energy and energy efficiency mean its demand for clean energy technologies is likely to outstrip that of its developingmarket peers. In the developed world, demand is expected to be more for replacement of existing lowcarbon energy production. Along with regulatory uncertainty, especially in the US, that is likely to see a shift in demand to the developed world for new technologies. Energy efficiency: theme for next decade A transition to a low-carbon economy will be driven by climate-change regulation and concern over energy security. They define two complementary policy trends. One is taking carbon out of energy supply by curbing emission from fossil fuels, notably coal, oil and gas, and providing incentives for low-carbon sources, notably renewable and nuclear energy. The second is taking energy out of growth, by promoting energy efficiency in buildings, industry and transport. The transition to a low-carbon economy will create winners and losers by having major, but different, value implications across sectors. So far, the lowcarbon economy has been dominated by changes in energy supply. We believe that will change in the coming decade 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 replacement cycle spending as global economic growth improves. We estimate the energy-efficiency market will outgrow other clean-technology sectors and may grow from around USD320bn in 2009 to between USD722bn and USD1.4trn by 2020. Credit crisis and its impact The renewable-energy industry is young, and few developers generate enough free cash flow to sustain their own investment needs. Wind and solar projects in the developed world are typically funded 20% by equity and 80% by project finance, so the availability of financing is critical. As credit dried up after the collapse of Lehman Brothers in September 2008, new investment in clean energy saw a significant dip. It has since started to look up again. 61 abc EMEA Equity Research Multi-sector September 2010 Credit crisis impact – global new financial investment* in clean energy (USDbn) 45 40 35 30 25 20 15 10 5 0 Q1 10 Q3 09 Q1 09 Q3 08 Q1 08 Q3 07 Q1 07 Q3 06 Q1 06 Q3 05 Q1 05 Q3 04 Q1 04 Note: *Total new financial investment includes venture capital, private equity, public equity, asset finance (equity, debt, lease and other sorts), bonds and corporate debt. The quarterly figures are not adjusted for reinvestment, for instance money raised on public markets later invested in projects. Source: New Energy Finance, HSBC Sector drivers Climate change remains for many a distant and uncertain threat, notwithstanding the record-breaking global temperatures and severe floods and droughts in 2010. The need to address climate change while facilitating economic growth and social progress will be a challenge for governments worldwide. Drivers for clean energy technologies and associated countries Policy Drivers: Climate Change / Mex Aus Env ironmental / Energy Efficiency Itly UK High Carbon Economy High Carbon Economy Other Ger EU India Economic Chin Japn Drivers: Energy Security Competitiv eness Av ailability and US Cost of Tech/Jobs Technological Drivers: Low Carbon Economy Fra Innov ation SKor Brzl High Carbon Economy Cand Idsia Saud Resource Drivers: Renew able and Energy Efficiency Potential Source: HSBC 62 High Carbon Economy EMEA Equity Research Multi-sector September 2010 abc The response so far has come mainly in various cap and trade schemes and through international regulations like the Kyoto Protocol. In the European Union, for example, the Emission Trading System aims to reduce emissions 20% from 1990 levels by 2020. But population growth and increasing industrialisation is likely to drive demand for energy up by more than 50% by 2030, according to the International Energy Agency. Achieving energy security will become increasingly important for many countries as demand rises and fossil fuel reserves are depleted. The high, volatile energy prices of 2008 were a warning for many countries of their growing vulnerability, prompting them to opt for renewable, inexhaustible energy sources. Many factors come into play to encourage a business to invest in low-greenhouse-gas energy, and the investment normally flows to where the highest and quickest returns can be made. Energy efficiency is probably the preferred approach, because of its potential and its low cost. More important for a growing number of decision-makers, however, is the way low-carbon strategies can stimulate industrial innovation. In Japan and France, for example, early innovation has resulted in widespread deployment of low-carbon technologies such as high-efficiency coal power plants and nuclear power making them less carbon-intensive than other countries. Valuation: equity characteristics and accounting dilemmas For wind-energy companies – primarily wind turbine manufacturers and component suppliers – DCF is the main valuation tool. DCF is preferred to relative multiple valuation methodology given the difficulties involved in multiple analysis for a relatively young sector with poor profitability. The other advantage of DCF is that it is an absolute valuation methodology. Wind-farm developers are usually valued using sum-of-the-parts-based (SOTP) valuation methodology in combination with DCF. The valuation generally takes into consideration the different underlying regulatory frameworks in the various countries in which the company is present. For solar stocks DCF is also primarily used as a valuation tool. A combination of DCF and SOTP, based on peer group multiples, or an economic value-added (EVA) approach, based on book value growth and ROE, are also used. 63 EMEA Equity Research Multi-sector September 2010 Notes 64 abc abc EMEA Equity Research Multi-sector September 2010 Construction and Building Materials Construction and Building Materials team John Fraser-Andrews* Head of European Construction and Building Materials 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 *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 65 66 Construction Building Materials Producers EMEA Equity Research Multi-sector September 2010 The construction sector CRH HeidelbergCement Holcim Kingspan Lafarge Saint-Gobain Residential builders Commercial real estate and public works contractors Barratt Developments ACS Bellway Balfour Beatty Berkeley Group Carillion Bovis Homes FCC Kaufman & Broad Hochtief Persimmon Skanska Nexity Vinci Redrow Taylor Wimpey Source: HSBC abc EMEA Equity Research Multi-sector September 2010 Cement consumption per capita versus GDP per capita 1400 Spain Consumption per capita, Kg 1200 Syria Ireland Saudi Arabia* 1000 Greece Korea, Rep. China Italy 800 Portugal Croatia Slovenia Turkey Bulgaria Algeri a Czech Republic Egypt Estonia Morocco Thailand Hungary 400 Russia Poland Romania Brazil Serbia Ecuador* Mexico Lit huania Ukraine South Africa Argentina 200 India Sri Lanka* Colombia Indonesia Pakistan Bangladesh* 0 Kenya 0 5,000 10,000 600 Austria Belgium Iran France Germany 15,000 20,000 USA Netherlands Finland Denmark Sweden UK 25,000 30,000 35,000 40,000 GDP per capita (USD) Source: Cembureau, World Bank, GDP per capita in constant USD2000, * Represents Cembureau estimates Cement consumption and construction output growth versus real GDP growth in the UK (1956-2009) 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 0.20 0.15 0.10 -0.15 -0.20 Real GDP growth 67 Source: ONS, Cembureau Construction is a highly cyclical industry Construction output growth 2008 2006 2004 2002 2000 1998 1996 1994 1992 1990 1988 1986 1984 1982 1980 1978 1976 1974 1972 1970 1968 1966 1964 1962 Cement consumption and construction output growth exceeds real GDP growth (the cement/construction to GDP growth multiplier exceeds unity) Cement consumption and construction output growth undershoots real GDP growth (the cement/construction to GDP growth Cement consumption growth abc -0.10 1960 -0.05 1958 0 1956 0.05 EMEA Equity Research Multi-sector September 2010 Sector description The construction sector is a vertical chain of sub-sectors that begins with the building materials companies, as shown in the sector organisation chart. Building materials Building materials companies produce the materials used to build homes (by residential developers) and commercial real estate and infrastructure (by contractors). The companies can be divided into the heavyside materials majors, Holcim, Lafarge, Cemex and Heidelberg Cement, 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 a structural expansion in infrastructure. Light-side producers are predominantly exposed to weak and fragmented construction end-markets in debt-laden developed economies. Housebuilders and contractors are the main customers for 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/construction output growth in excess of real GDP growth, up to a saturation point, when infrastructure and the housing stock have largely been provided. 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” on the previous page), after which the cement-demand-to-real-GDP multiplier falls below unity. 68 abc John Fraser-Andrews* Head of European Construction and Building Materials 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 *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations abc EMEA Equity Research Multi-sector September 2010 Road provision per 1,000 persons 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 Source: Cembureau, World Bank, HSBC, *US data is for FY 2006 Rail provision per 1,000 persons Urbanisation levels (%) 0.80 100% 0.60 80% 60% 0.40 40% 0.20 20% UK Brazil US France Algeria China Egypt U.S. Russia Source: World Bank France Germany U.K. Mexico Turkey Iran Korea, Rep. Malaysia India Jordan China Rail kms per 1000 people (2007) 0% India 0.00 Urban population as a % of total population Source: World Bank 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). Conversely, in developed countries like 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). 69 abc EMEA Equity Research Multi-sector September 2010 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 because: 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 substantially increase 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 25% 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. Heavy-side producers offer a more defensive investment opportunity Comparison of heavy-side and light-side Cement Substitutability Very weak, limited to mixing cementitious substitutes by cement producer to reduce cost batch. Transportability Low, recognised that uneconomic to travel by road for more than 300km. Market concentration High, determined by high capital investment barrier to entry. Finished goods Consequences Medium, producers compete on innovation. Lower competition in cement markets versus competitive markets for building materials. Transcontinental transport determined by weight and build. Medium, economies of scale here led to consolidation but transportability ensures competition. Cement imports restricted to markets near shipping lanes. Building products more susceptible to overseas 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. Source: HSBC The table above shows 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. 70 EMEA Equity Research Multi-sector September 2010 abc 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. 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: equity characteristics and accounting dilemmas The building materials companies and contractors trade on traditional earnings metrics, namely forward looking EV/EBITDA and price/earnings (PE) multiples. The heavy-side building materials companies currently trade at EV/EBITDA and PE multiples of 4.5-5.0x and 6.4-9.7x respectively on consensus 2012e estimates– discounts to the respective long-term sector averages of 7.0x and 12.5x. This discount exists despite our expectation of a strong earnings rebound to 2013 for the cement majors on robust emerging-market growth (approximately two-thirds of company cement capacities) and an operationally geared US construction recovery from 2011. Light-side producers are now trading at forward EV/EBITDA multiples at or just below their averages in 2004-06, despite a weaker developed-world macro-economic outlook, which is likely to result in sluggish earnings growth, in our view. 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 the fact that: The land write-downs which have been 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. 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 then mark the book value of each land tranche to today’s market value (we 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 landbank. 71 EMEA Equity Research Multi-sector September 2010 Notes 72 abc abc EMEA Equity Research Multi-sector September 2010 Food and HPC Food and HPC team Cedric Besnard* Analyst HSBC Bank Plc, Paris Branch +33 1 56 52 43 26 cedric.besnard@hsbc.com Sector sales David Harrington* Sector Sales HSBC Bank Plc +44 20 7991 5389 david.harrington@hsbc.com Lynn Raphael* Sector Sales HSBC Bank Plc +44 20 7991 1331 lynn.raphael@hsbc.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 73 74 Consumer & Retail - Europe Food and Staples Retailing Beverages See sector section for further details See sector section for further details Food Producers Nestle Danone Food and HPC General Retail Luxury and Sporting Goods See sector section for further details See sector section for further details Home EMEA Equity Research Multi-sector September 2010 The food and HPC sector Personal Care Henkel L’Oreal Beiersdorf Reckitt Benckiser Unilever Source: HSBC abc + 8.0% 800 December 2004-December 2007 Premiumisation era + 7.0% 700 December 2007-December 2008 Input costs inflation concern 600 + 6.0% 500 + 5.0% 400 + 4.0% 300 + 3.0% EMEA Equity Research Multi-sector September 2010 Food and HPC historical share price index and organic sales growth December 2008-December 2009 200 + 2.0% collapse of mature economies, but emerging markets save the day. Input costs deflation help margins 100 + 1.0% 0 + 0.0% Jan-90 Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Index Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 2 per. Mov. Avg. (Organic growth) Source: Thomson Reuters Datastream, HSBC abc 75 EMEA Equity Research Multi-sector September 2010 Sector description Coverage: Our universe of stocks consists of two segments: food manufacturing and home and personal care, or 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 also 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 more limited than it seems, so operating leverage mostly depends on volume growth to cover cost inflation. Although the companies are huge, giving the impression the food industry is highly concentrated, European big-cap companies tend to focus on a few categories, such as nutrition, confectionery and ice cream, or water. Other parts of the industry, such as bakeries, are left to smaller players or private labels. The home-care industry is much more concentrated. Procter, Unilever and Henkel dominate in European laundry. Reckitt tends to focus on niche categories such as dishwashing and air and toilet care. Cosmetics, despite limited private label presence, is also very competitive. Key themes Emerging markets We estimate the industry has increased its exposure to emerging markets by at least 50% in 20 years. Almost 40% of sales is derived from emerging economies, where category growth is driven by rising income per capita, which implies a migration towards 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 soap and laundry mass markets are already decently penetrated in some emerging economies, for example, since companies 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 are a key part of manufacturing cost, from milk to petrochemicals or vegetable oils. Raw material and packaging costs represent about 15% to 25% of sales for cosmetics players – higher product prices imply raw materials and packaging represent a lower share of the product value – but around 30% to 35% of sales for food and home care. That means input-cost price volatility is a key issue. It can quickly inflate the cost base and require risky price increases to offset it. The main commodities are milk (Danone being the most exposed for its yoghurt business), oil-related/PET/plastics (everybody, 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 76 abc Cedric Besnard* Analyst HSBC Bank Plc, Paris Branch +33 1 56 52 43 26 cedric.besnard@hsbc.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations EMEA Equity Research Multi-sector September 2010 abc these commodities, implying that price variations tend to have an impact on 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’s not quoted and needs to be purchased locally. When input costs start to bite, the debate is on whether the company can offset them with price increases (or emergency cost savings). Pricing power (or the lack of) and the rise of the “trading down concept” In a context of growing demand and low price elasticity, input cost inflation would be a structural issue to bear in mind, but the short-term implications would be mitigated by easy price increases passed on to a more willing customer. However, when price increases are implemented in the context of the consumer’s falling available income, the risk of a volume backlash is high. This risk is reinforced by a dreaded consumption pattern: down-trading. In a sector focused on premiumising brands and creating new needs, a return to non-branded, low price, more basic substitution products (usually private labels) is a setback that is sometimes hard to survive. We believe that down-trading is a risk in categories where brands have difficulty claiming specific health benefits (chocolate, frozen/chilled) or where the perceived needs can easily be ignored in favour of the benefits of more “vital” needs (make-up, specialty household). However, down-trading is not as new as in the 1990s, and input cost inflation is far worse news for private labels, as raw materials and packaging account for a higher share in the profit and loss of these low-priced/low-marketed products, thus making their life more difficult in inflationary times. 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 from high-single-digit to low-single-digit. 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, but 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. Pricing (ex mix) over 19912009 was below 2% a year in the food industry, 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 – basically introducing a new product but with a higher price, usually driven by the “more benefits” argument, which companies fuel with R&D (to create the claim) and advertising and promotions (to justify it). We believe the return on mix, when successful, is quite high – a significant part of the fixed 77 EMEA Equity Research Multi-sector September 2010 cost remains the same as the product that’s replaced, but with a higher price. That said, mix is a tool with little visibility (trading down is a common pattern in the industry) and requires strong innovations to be a sustainable driver. As a result, putting aside the profitable but cyclical mix element, (3) volume growth is the driver offering the most visibility and thus the most looked at. There are various ways to generate volume growth, some cheaper than others. We believe there are three main drivers to volume growth. An increase in the number of consumers, primarily driven by categories increasing their penetration in a country, provides a rather cheap volume driver, once the cost of creating the category has been passed on. Most of the growth comes from a natural flow of consumers to the product. Companies entering new emerging markets, for example, can increase volumes, since the rising number of users is driven by rising income per capita, making consumers migrate towards branded goods. Increasing the frequency of usage is usually more important when increasing the number of consumers becomes harder. Shampoo would be a good example: adding conditioner to regular shampoo. So are biscuits: 10am, then noon, then mid-afternoon. A greater focus on market share would be 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. This is clearly when the cost of growth becomes very high and requires costcutting – or M&A. A&P: a critical tool to drive volume growth Advertising and promotions, or 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 33% for the cosmetics industry. We do not consider A&P a variable cost in a marketing-driven environment. It’s more an inflationary fixed cost – but in real life it’s also partly a variable cost. Marketing expenses are not only linked to growth, product activity and launches. They also can be a short-term adjustment tool to smooth margins, but from phasing to shortterm cut the border sometimes becomes blurred. There are numerous examples of A&P phasing when margins are under pressure. This is generally not considered as a positive, though. 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 can go down if the industry overall is cutting marketing spending. The share of voice will remain constant and the brand franchise untarnished. But you do not want 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 everybody has an interest in pushing the A&P level down, but nobody has an interest in moving first (especially when savings can afford you some leeway in your margin phasing). Beyond the normal productivity gains slightly deflating the marketing expenses ratio, we do not believe A&P ratios should go down structurally in coming years. 78 abc EMEA Equity Research Multi-sector September 2010 abc M&A: buying growth When categories start to become too saturated or competitive, it is tempting to buy market share or new categories through M&A (balance sheets are usually healthy due to a good cash conversion) rather than over-invest to expand categories with limited potential. Accordingly, Kraft bought Cadbury to diversify away from the saturated US cookies and cream cheese categories; Reckitt bid for SSL to get access to new categories as its own home care segments are under pressure in Europe. In a sector where profitable growth is the key valuation driver, deals thus often rely on growth synergies, rather than on cost efficiencies. We agree they are the most important, but they also take longer to achieve and are harder for the market to quantify. This results in frequent misunderstandings with analysts and stock market corrections. We believe the best example would be Danone-Numico: this 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: equity characteristics and accounting dilemmas A structural PE premium to the market The food and HPC sector (the weighted average of the stocks under our coverage) has almost always traded at a premium to the broader market since the start of our relative PE historical analysis in January 1998, a function of strong visibility on top-line growth and FCF generation. But the industry premium to the market at the end of last year (100% in November 2008) was unsustainable; it was pricing in total resilience to a consumer slowdown. The sector’s PE relative to the market peaked at the end of November 2008 at a 100% premium, far above its previous peak of c65% in 2002 and compared with a 1998-2009 average of 39%. However, the valuation range is quite wide. The food industry has on average traded at a c20% premium to the market since 1998, while over 2004-07 the HPC sector traded at c70% premium to the market. To value the companies, DCF is the traditional tool, 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 (which is the key metric investors look at), at least every half year, and usually disclose their A&P investments. From an accounting perspective, it is worth bearing in mind that Nestlé’s reported pricing is slightly inflated by the fact that, unlike peers, it does not report "temporary" rebates inside pricing (which peers deduct from pricing) but below the line (added to A&P). As a result, across the whole sector, only the EBIT margins are really comparable since IFRS restatements in 2004. 79 EMEA Equity Research Multi-sector September 2010 Notes 80 abc abc EMEA Equity Research Multi-sector September 2010 Food Retailing Food Retailing team Jérôme Samuel* Analyst HSBC Bank Plc, Paris Branch +33 1 56 52 44 23 jerome.samuel@hsbc.com Sector sales David Harrington* Sector sales HSBC Bank Plc +44 20 7991 5389 david.harringon@hsbc.com Lynn Raphael* Sector sales HSBC Bank Plc +44 20 7991 1331 lynn.raphael@hsbc.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 81 82 Consumer & Retail - Europe Food and HPC Beverages Food and Retail See sector section for further details See sector section for further details General Retail Luxury and Sporting Goods See sector section for further details See sector section for further details Not purely online EMEA Equity Research Multi-sector September 2010 European food retailing sector Online Ocado UK Europe Morrison Casino Tesco Carrefour Sainsbury Jeronimo Martins Metro Ahold Delhaize Source: HSBC abc 600 Merger CarrefourPromodès (1999) EMEA Equity Research Multi-sector September 2010 Performance of European food retail stocks 1990-2010 Delhaize buys Hannaford (2000) 500 Morrison buys Safeway (2004) Promodès launches unfriendly takeover on Casino (1997) 400 Auchan buys Docks de France (1996) 300 200 Sector boosted by property valuation (2007) Wal-Mart buys Asda (1999) 100 0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Stock performance Source: Factset, HSBC abc 83 EMEA Equity Research Multi-sector September 2010 Sector description Food retailing is the largest consumer sector, at least by sales, with EUR146bn of revenues in 2009 in the UK, according to the Institute of Grocery Distribution (IGD). 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, a third of its level in the 1960s. Few listed food retailers are pure food retailers and therefore largely immune to a slowdown in discretionary spending. Metro and Carrefour are the most exposed to non-food; Jeronimo Martins, Morrison, Ahold and Delhaize 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 and France and even in the UK. That trend has since reversed in France and Germany as hypermarkets started to compete more on price and as the economic crisis 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-oriented. 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 merchandises 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. 84 abc Jérôme Samuel* Analyst HSBC Bank Plc, Paris Branch +33 1 56 52 44 23 jerome.samuel@hsbc.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations EMEA Equity Research Multi-sector September 2010 abc 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 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 hypermarkets have an operating margin of 4.5%, supermarkets and discount stores about 5.5% and convenience stores higher. Brand awareness and private labels are key success factors in food retailing, along with location. They attract customers and help build their loyalty. Private labels ensure higher margins for the retailers, not necessarily in terms of cash but in percentage terms, since although private labels are sold at lower prices than national brands (c25% on average) their costs are discounted to an even greater degree. 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 such techniques as better branding, pricing, offerings and loyalty programmes. It gives a fair representation of actual sales growth, excluding forex, new stores and acquired/disposed of stores. 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), there are structural differences explaining 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 interests by lowering net debt. Most food retailers try to have their international activities 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 85 EMEA Equity Research Multi-sector September 2010 done locally, the currency exposure still brings volatility to the top line and the bottom line, if not the margins. Exposure to different formats: Different formats have different dynamics and may grow at widely differing levels even in the same region. For example, discounters lost market share in 2009 as a consequence of greater price competitiveness from hypermarkets in France. Cost savings Of late, the focus for large retailers has turned more towards cost savings (mainly Carrefour and Metro) and subsequent 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 lead 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-borders 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 in confident times 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. 86 abc EMEA Equity Research Multi-sector September 2010 abc 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 in terms of 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. 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. Valuation: equity characteristics and accounting dilemmas Capex is a leading indicator On average, capex for food retailers is expected to equate to 3.6% of net sales in 2010e, compared with 4.8% in 2008, reflecting the economic crisis. One of the sector 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 vs non-food), the property strategy (freehold or leasehold), the proportion of owned stores vs 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 different companies, 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. Hence, a discounted cash flow model may be used to value them. The presence of comparable peers means relative valuation can also be used. We estimate the food retail sector in Europe now trades at EV/sales of 44% and EV/EBITDA of 6.5x in 2011e and on a 2011e PE of 11.9x, 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 c103. 87 EMEA Equity Research Multi-sector September 2010 Notes 88 abc abc EMEA Equity Research Multi-sector September 2010 Insurance Insurance team Kailesh Mistry* 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 89 90 Insurance Primary insurance Reinsurance EMEA Equity Research Multi-sector September 2010 The insurance sector Hannover Re Korean Re Life insurance Non-life insurance Composites Lloyds Aegon China life Admiral Euler Hermes Allianz Aviva Amlin Brit Insurance CNP Fondiaria-Sai Axa Catlin Korea Life PICC Baloise Hiscox Legal & General Mediolanum RSA Insurance China Pacific China Taiping Lancashire Prudential plc Dongbu Standard Life Swiss Life Generali Hyundai T&D Holdings ING Munich Re Scor Swiss Re LIG Meritz MS&AD Insurance Group NKSJ Holdings Ping An Samsung Fire & Marine Sony Financial Tokio Marine Vienna Insurance Group Zurich Financial Services Source: HSBC abc 500 12% 450 Market crash: Dotcom bubble CGU Plc & Norwich Union Plc merger to form CGNU Plc, later renamed Aviva Plc Friends Provident IPO 400 Axa buys Sun Life 350 Standard Life IPO; Aviva buys AmerUS Pru buys M&G (GBP1.9bn) Converium IPO Winterthur acquisition by Axa (EUR7.9bn) and Axa rights issue (EUR4.1bn); Generali acquires Toro (EUR3.85bn) Scor acquires Converium; Allianz buys out minority in AGF Lehman collapse & problems at AIG 8% Allianz sells Dresdner bank; VIG rights is sue 6% 300 9/11 attacks in US 250 200 ING founded by a merger between Nationale-Nederlanden and NMB Postbank Group Allianz rights issue (EUR4.4bn); Munic h Re rights issue (EUR3.8bn) Aegon buys Scottish Equitable; Axa buys MONY PZU IPO L&G rights issue (GBP0.8bn) 150 Norwich Union IPO 100 50 10% EMEA Equity Research Multi-sector September 2010 European Insurance sector since 1990 Merger of Sun Alliance & Royal Insurance Aegon buys Transamerica Corp Rights issue by Aegon (EUR 2.0bn); ZFS rights is sue (USD2.5bn) 0 Swiss Life rights issue Pru rights issue; Scor rights issue; Admiral IPO Resolution group created in 2004 & relaunched in 2008 4% Allianz acquires minority in RAS; Hurric ane Katrina, Wilma & Rita strikes US Swiss Re raises capital Aegon, Axa & ING rights issue 2% Sale of Alico announced by AIG (USD 15.5bn) 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 DJ Ins abso lute DJ Sto xx abso lute B und 10 year yields Source: Company data, Bloomberg, Factset abc 91 abc EMEA Equity Research Multi-sector September 2010 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. The global insurance industry generated USD4,066bn of premiums, or about 7% of global GDP, in 2009. Life insurance accounted for 57% of premiums, and non-life for 43%. The US is the largest insurance market, with around 28% 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. Proportion of GDP spent on insurance versus per capita GDP in 2009 (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 F ra Jap C US I SP G AU S SW CZ RN 10,000 100,000 C ountry legend: A us - Aus tralia, C - C anada, F ra - France, G - Germany, H K - H ong Ko ng, I - Italy, ID - Indonesia, Jap - J apan, M Y- M alays ia, N - Netherlands , P H-P hilippines, SA - South A fric a, SK - So uth Ko rea, SP - Singapo re, SW - Switzerland , T H -T hailand, C Z - C zec h R epublic , RN - Ro mania, P L - Po land, HN - H ungary, IN - India, CH - C hina, TW - T aiwan, C L - C hile, BZ - B razil Source: Sigma, HSBC estimates The sector has a mix of mutual and listed companies, whose total market capitalisation equates to about 6% of that of the DJ Stoxx 600. The sector is divided into primary insurance and reinsurance, depending on the nature of 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. Key themes Regulatory and accounting changes: Introduction of new regulatory solvency and accounting standards are a key theme in the sector. The current solvency calculation, referred to as Solvency I in Europe, is a nonrisk-based measure which is inconsistent across different countries, making comparisons difficult. The 92 Kailesh Mistry* 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 EMEA Equity Research Multi-sector September 2010 abc 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 2013, 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 2013. 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 low-cost-centre territories, cutting headcount, reducing policy administration costs and moving to lower-cost distribution channels. In a report on cost-cutting potential, we analysed 49 insurers across Europe and estimated cost-restructuring potential of EUR24bn in our base case, some of which has already been executed or announced. Primary life segment: Life insurers have emerged from the financial crisis with an improved capital position, while avoiding forced capital raising. 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 to move 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 UK personal motor insurance market we see a hardening or increase of insurance rates as a result of significant 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. 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. Despite a high claims burden in H1 2010, reinsurance capacity still exceeds demand, which is putting prices under pressure. 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 the retention rates by primary 93 abc EMEA Equity Research Multi-sector September 2010 insurers, which have reached their highest points 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 their 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 regions for insurance companies to expand into. Premium growth was significantly higher in emerging markets than the developed market during the period 1999-2009 Wo rld 5.7% Industrialised co untries 5.2% Em erging m arkets 10.1% Japan 0.1% Nor th A merica 3.9% Oceania 5.1% West ern Euro pe 7.4% South & East A sia 8.3% LATA M 11.8% M iddle East & C entral A sia 11.9% 18.8% Ot her Euro pe 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% P re miu ms gr o wt h (10 ye ar C A GR ) 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 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 since the 2003 crisis. 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 94 EMEA Equity Research Multi-sector September 2010 abc companies is dependent on the type of product and can be broadly broken into 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 for 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 exposures have 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 assetquality 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 smoothen profits. 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 as in developed markets, and we expect EM growth to remain higher. Valuation: equity characteristics and accounting dilemmas 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 straight-forward 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. We use a SOTP methodology to calculate the fair value for companies. Our 12-month target prices are based on our SOTP, which uses capital and/or earnings multiples to reflect our views about the sustainability of returns by business line. Our view on the level of sustainable returns is based on the company’s track record and our forecast of future performance. 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 lack of sufficient disclosure makes 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. 95 EMEA Equity Research Multi-sector September 2010 Notes 96 abc abc EMEA Equity Research Multi-sector September 2010 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* Analyst HSBC Bank Plc +44 20 7991 6793 erwan.rambourg@hsbcib.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 97 98 Luxury goods sector EMEA Equity Research Multi-sector September 2010 Luxury Goods Diversified Groups or Holdings LVMH ‘Hard luxury’ companies Christian Dior PPR Richemont ‘Soft luxury’ companies Swatch Group Louis Vuitton 42% LVMH Stake Gucci Cartier Omega Hennessy Dior Couture Brand Puma Montblanc Breguet Retail assets IWC Calvin Klein Panerai Swatch Sephora Tiffany Bulgari Coach Burberry Tod’s Hermès Source: HSBC abc Luxury goods valuation 12-month forward PE (average*) EMEA Equity Research Multi-sector September 2010 40.0 x 35.0 x 2000 bubble 30.0 x SARS epidemic China starts to matter 2007 market peak 25.0 x 20.0 x 15.0 x 10.0 x Post-Lehman collapse 5.0 x Asian financial crisis 09/11 attacks 0.0 x Mar-97 Mar-99 Mar-01 Mar-03 Mar-05 Mar-07 Mar-09 Note: *Non-weighted average of LVMH, Richemont, Swatch, Tiffany (other companies do not have the necessary history, own non-luxury assets or their valuations have been distorted by speculation). Source: HSBC abc 99 EMEA Equity Research Multi-sector September 2010 abc 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 goods, such as LVMH, with its fragrances and wines and spirits, or in businesses that are part of a vertical integration drive, such as the watch-component division of the Swatch Group. 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 emergingmarket 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. 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 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 hard-luxury companies are Richemont, with its star brand Cartier, and the Swatch Group, with the star brand Omega. Monobrand companies include Tiffany, which sells mostly jewellery, and Bulgari, which sells jewellery, watches and fragrances. 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, Tod’s and Coach. Key themes Luxury goods stocks historically have been strong growth stocks 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 but 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 100 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* Analyst HSBC Bank Plc +44 20 7991 6793 erwan.rambourg@hsbcib.com 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 EMEA Equity Research Multi-sector September 2010 abc 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 seemed sluggish in the first half of 2010, but luxury demand soared as wealthy consumers un-tightened 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, higher-margin 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 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. Since the October 2008 slowdown, the industry has suffered from much lower volumes. Market share/polarisation – Trading less implies that some brands have a reference status and will both grow 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 trade them up. Image control – It is hard to trade consumers 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 in which the company has not developed 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 access to higher-growth countries and developing leadership positions there, where margins are already currently 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, generally in France and Italy, 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, in some cases, such as Bulgari and Hermes, to the yen. After a decade of negative FX impacts from a stronger euro, we believe the 101 EMEA Equity Research Multi-sector September 2010 sector should now benefit from currency effects at least until the end of 2011 – hedging policies are in place – if the current spot rates prevail. M&A and cash management – Few acquisitions have occurred since an LVMH buying spree in 19992000. But with cash piling up, talk about deals has resurfaced. We do not believe the interesting assets have suffered in the downturn (and many theoretical targets are privately held), but cash generation could become an issue if buy-back programs or dividend hikes do not occur. 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: equity characteristics and accounting dilemmas 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 (eg following 9/11) and peaks when the sector was trading at a 100% premium (eg during the 2000 bubble). In absolute terms, the sector traded in the low to mid-20x forward PE range in 2002-2007. Since the downturn, it has traded more in the mid- to high-teens range. The sector has shown how cyclical it is in the downturn and now depends on Asian growth. Consequently, it could be difficult to trade back at the historical absolute PE. But strong organic growth rates are likely and the rare currency boost to earnings, after a decade during which FX held back earnings, suggests a re-rating is possible. One thing to bear in mind about investments and cost containment in the sector: 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 can sometimes be disturbing for investors. 102 abc abc EMEA Equity Research Multi-sector September 2010 Metals and Mining Metals and Mining team Andrew Keen* Head of Metals and Mining Research, EMEA HSBC Bank Plc +44 20 7991 6764 andrew.keen@hsbcib.com Thorsten Zimmermann* Analyst HSBC Bank Plc +44 20 7991 6835 thorsten.zimmermann@hsbcib.com Sabrina M Grandchamps Analyst HSBC Securities (USA) Inc. +1 212 525 5150 sabrina.m.grandchamps@us.hsbc.com Sector sales Jacques Vaillancourt* Sector Sales HSBC Bank Plc +44 20 7991 5210 jacques.vaillancourt@hsbcib.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 103 104 EMEA Equity Research Multi-sector September 2010 The metals and mining sector Metals and Mining Mining Base Meta ls Bulks Aluminium Alcoa A lumina Steel Iron ore Rio P lat inum/ Pa lladium Ferre xpo Ru sal Nalco BHP S esa Go a No rsk Hydro Hinda lco Va le Fortescu e Ch alco Rio Ku mb a Copper Lonmin Cliffs Coking / Therma l coal Newmo nt Barrick Go ldco rp Kinross Xstrata Pol yus Buenaventura Teck Yaman a Goldfields Randgo ld Polyme tal Ang loGold IAMGo ld Harmony Cen ter ra Kazakhmys Grupo Mexico Fir st Quan tum Ferrochrome ENRC Terniu m Outokumpu Ar celo rMi ttal Th ysse nKrupp Voestal pine US Steel Tata Posco Ge rdau JFE Baoste el BHP BHP China ste el SS AB AK Ste el Gold / Silver NWR Southern Copper Sa lzgitter Acerino x No rilsk Aurubis KGHM Blast Furnace Nuco r Amplats Antofagasta Xstra ta Fre epor t Electric Arc P re cious Me tals IFM Merafe Zinc / Lead CS N Usiminas Long steel EZZ Flat s teel S tainless Nucor ArcelorMittal ThyssenKr upp Acerinox E rdemir Salzgitter SS AB Outokumpu Tata US S teel Posco Rautarru kki Voesta lpine Nippon S AIL Ch ina steel JFE Ge rdau Te rnium Bao steel Nyrstar Bolid en AK Steel Korea Zinc Terramin Usi mi nas Hi ndustan Zinc Kaga ra Xstra ta CSN Integrated Non integra ted Nickel No rilsk Vale Tin Severstal A rce lorMittal MMK Krup p Usiminas Terni um Nipp on Thyssen Source: HSBC Ma jors: Anglo American BHP Billiton Rio Tinto Others Boliden Ved anta ENRC Xstrata V ale S alzgi tter US Steel NL MK S SAB S ail P osco Nucor Tata G erdau A K S tee l CSN abc Evraz Diversified companie s V oestalp ine EMEA Equity Research Multi-sector September 2010 Steel intensity: metal intensity increases with higher level of wealth Steel intensity - USA from 1900, all others from 1980 1400 1200 Steel consumption kg/capita 1000 800 600 400 200 0 0 5000 10000 15000 20000 25000 30000 35000 40000 45000 real GDP/capita US from 1900 China Korea Japan India Source: HSBC abc 105 EMEA Equity Research Multi-sector September 2010 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, nickel, and precious metals platinum and gold. Mining companies also produce “bulk commodities” such as thermal coal, coking coal and iron ore (the latter two 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 as flat-rolled, 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. 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. Mining industry The mining industry has undergone significant consolidation over the past decade, and is now dominated by five large companies (BHP Billiton, Rio Tinto, Anglo American, Xstrata and Vale – the first four of which are listed in London). 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). Steel industry The steel industry has also undergone significant consolidation over the past decade, led by the largest firm in the industry, ArcelorMittal. As a result, the industry is no longer predominantly made up of national-based steelmakers (particularly in Europe) as intra-regional and global steelmakers are becoming more common. There is emerging evidence that this higher level of consolidation in developed countries has changed the industry from being one that traditionally competed aggressively for market share (and frequently looked to governments for support), to one that is producing returns above its cost of capital through the cycle. In the 2008/09 downturn (which represented the worst capacity utilisation cycle for a generation) major steelmakers did not seek bankruptcy protection or assistance from governments, a significant break from past cycles. Key themes Emerging market growth Around one-third of metals are consumed in China, and China is now about three times the size of the US as a metal consumer. The acceleration of China as a metal consumer has led to a rise in global metals demand growth 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, and once growth was easily satisfied with brownfield expansion and the occasional new mine, now fresh capital needs to be constantly invested in new 106 abc Andrew Keen* Head of Metals and Mining Research, EMEA HSBC Bank Plc +44 20 7991 6764 andrew.keen@hsbcib.com Thorsten Zimmermann* 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 EMEA Equity Research Multi-sector September 2010 abc projects. Consequently, commodities are more dependent on “incentive pricing”, or 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 in China, 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 for the next generation of mines is significantly degraded from the last generation, which will require higher incentive pricing and lead to further delays and disruptions. Most mining companies will also claim to have growth pipelines that are in the lower half of the cost curve and relatively easy to deliver, which is incompatible with the claims made on an industry-wide basis. It is becoming more challenging to extract some metals but there is no evidence of reaching absolute depletion levels of minerals (the predictions made in the 1970s “Club of Rome” have proved false – reserves and resources have continued to rise over time as technological advancements in exploration, processing and extraction have led to continued upgrading of known resources and a containment of structural cost increases). M&A versus organic growth Buying definitely outstripped building as a pathway to growth over the past decade. During the commodity price upcycle, companies that were early in the acquisition process (notably Xstrata and ArcelorMittal) timed their purchases of assets well, and were rewarded with strong cash flows. Although there is further scope for consolidation in steel (especially in emerging markets that added capacity very quickly), the mining industry is now dominated by very large companies that face antitrust resistance to further consolation and relatively small mining companies, often with dominant or blocking shareholders. Therefore the industry is in the process of rediscovering organic growth, and mining companies are pointing towards uses for their cash flow over the next five years. Dividend yield or growth? Mining stocks tend to appear to have a low dividend yield, but returns to shareholders can be boosted by special dividends and share buybacks when cash flows are strong. The low yield of core dividends is due to the cyclical nature of the companies’ earnings, with management aiming to avoid having to cancel core dividends (this has not proved entirely successful, with three of the four major miners in the UK cancelling dividends to preserve cash or pursue rights issues during the 2008/09 downturn). 107 EMEA Equity Research Multi-sector September 2010 Resource nationalism and political risk Political risk is an old theme in mining that is gaining fresh momentum. 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, which has transferred ownership of 26% of minerals to previously disadvantaged South Africans, and a recent populist push for a Resource Super Profits Tax in Australia. In addition, rapid demand growth is again pushing mining firms to return to areas of higher risk like West Africa (iron ore), the Congo (copper) and Afghanistan (iron ore and copper). Given China’s dominance of demand and 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 with some political resistance. It is likely that this will remain an issue in the sector for the foreseeable future. Sector drivers Commodity prices undoubtedly drive movements for all types of metals stocks. For miners, this is not surprising given that 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 difference 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) is growing as a trend, 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 asset lives of mines can stretch to many decades (both implying that equity prices should not follow short-term commodity prices), mining equities do 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. 108 abc EMEA Equity Research Multi-sector September 2010 abc Valuation: equity characteristics and accounting dilemmas Mining companies 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 might first be expected, as consensus expectations for near-term (and sometimes long-term) commodity prices are dragged up and down by movement 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. Consensus earnings comparison for the miners tends to focus heavily on EBITDA, and mining companies tend to have extremely detailed earnings releases, giving detailed data on production (such as grades and tonnages), as well as EBITDA down to individual operations in some instances. Companies often have a wide range of asset ownership types, including joint ventures and interests in separately listed subsidiaries, and as a result can see significant movements in associates income and minority dividends in the income statement. Although generally very volatile as a sector, earnings releases are rarely a catalyst for stock performance (as production and prices are known, only costs remain a variable). Book valuation metrics for the miners are less relevant, 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 some, 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. Steel companies For steel companies, as industrial companies with defined plant and equipment, book values are more relevant and the sector 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. It is still up for debate if the higher consolidation that occurred in 2002 and 2006 will transform into structurally higher margins for the industry and allow higher valuation multiples going forward. Steel companies tend to report much less information than miners, with EBITDA broken down into broad regional or product groupings. Stated earnings are not readily comparable, as one-off items can be significant (inventory write-downs, restructuring costs, hedging gains/losses) but the assessment across companies differs significantly about what should be regarded as non-recurring items. Steel mills tend to generate a fair amount of cash flow during upcycles; however, as this is frequently spent on acquisitions and very costly greenfield plants (capex cUSD1,000/t of steel), steel mills tend to be more highly leveraged than the miners. Steel company earnings tend to be more difficult to model than for miners – as a processing business on top of volatility for product prices, they are also more vulnerable to fluctuations in the prices of key raw materials and variances in capacity utilisation. As a result, and unlike miners, steel companies do tend to react to earnings releases, particularly guidance for the quarter ahead. Picking entry points around earnings releases is therefore a key consideration for investing in steel stocks. 109 EMEA Equity Research Multi-sector September 2010 Notes 110 abc abc EMEA Equity Research Multi-sector September 2010 Oil and Gas Oil and Gas team Paul Spedding* Global Co-Head of Oil and Gas HSBC Bank Plc +44 20 7991 6787 paul.spedding@hsbcib.com David Phillips* Global Co-Head of Oil and Gas HSBC Bank Plc +44 20 7991 2344 david1.phillips@hsbcib.com Anisa Redman* Anaylst HSBC Bank Plc +44 20 7991 6822 anisa.redman@hsbcib.com Sector sales Annabelle O'Connor* Sector Sales HSBC Bank Plc +44 20 7991 5040 annabelle.oconnor@hsbcib.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 111 112 Independent Players Independent Players (Upstream, Downstream, Transportation, Petrochemicals) Upstream (E&P) Oilfield Services (OFS) Downstream (R&M) Seismic Drilling Subsea & Offshore Equipment E&C Europe Europe Europe CGGVeritas Transocean Technip FMC BP BG Neste WesternGeco Noble Saipem Cameron RD Shell Total Statoil Tullow ERG Saras - (Schlumberger) PGS Diamond Pride KBR Fluor Aker Solutions DrilQuip ENI Cairn Energy Repsol OMV Dana Petroleum JKX Emerging markets Emerging markets Petrobras Lukoil TGS Nopec Seadrill CB&I Wellstream Emerging markets MOL Ion Polarcus Ensco Rowan Petrofac Kentz Technip Nkt Flexibles PKN EMGS COSL Lamprell Hellenic Petroleum Fugro Nabors Amec National Oilwell Varco OGX Motor Oil Hellas Tupras BGP/CNPC Hercules Seahawk Marie Technimont Aker Solutions Rosneft Asia Oil refineries Saipem Acergy/Subsea 7 Nexans Prysmian Gazprom Novatek CNOOC ONGC Petrol Ofisi Ayagaz Fred Olsen Energy McDermott Oceaneering Cairn India Turcus Asia PTT E&P Petrochina Sinopec Santos Woodside Petroleum Asia S Oil SK Energy Reliance Industries US Sinopec Sanghai US Anadarko Apache Formosa Petrochem BPCL Cheasapeake Energy HPCL ConocoPhillips ChevronTexaco Marathon Oil Devon Energy Encana US EOG resources Valero Newfield Exploration Sunoco Nexen Talisman Energy Tesoro ExxonMobil Source: HSBC Thai oil Supply Vessels GEVetco Well Services SBM Offshore Bourbon Schlumberger BW Offshore Tidewater Halliburton Prosafe Production Modec Farstad Solstad Weatherford Baker Hughes Bluewater Edison Chouest Sevan Marine OSX Swire Ezra Superior Offshore Trico Marine abc PTT Floating Production EMEA Equity Research Multi-sector September 2010 The oil and gas sector 6 1991-94 Following the Gulf War to liberate Kuwait, crude price steadily declined and reached their lowest level in 21 years 1994-98 Sustained low oil prices dampened new investments 1997 – Asian Financial Crisis T he Asia n Financial Cris is combined with a 10% quota increase by OPEC resulted in lower oil price through December 1998 2001 – 9/11 Increase in Russian production, decline in US economy resulted in lower oil price 2003 – Iraq war T he America-le d invasion of Iraq resulted in cut in OPEC spare capacity 2005 – Hu rricanes Katrina and Rita SPR rele ased 9.8MMbbl 5 4 2005/8 Sharp increase in demand from Asia 2009 (beginning) OPEC cut of 4.2Mbbl/d helped oil price to stabilise 2008 (end) Onset of recessio n 120 100 3 EMEA Equity Research Multi-sector September 2010 Oil demand supply balance, oil price, oil sector PE and PE relative 80 2 60 1 0 40 -1 -2 2006 – Lebanon war After Israel launched attacks on Lebanon, oil pric es reached a new high of USD78/bbl 1999 Serie s of OPEC cuts (4.2Mbbl/d) supported oil price rise -3 1991 1992 1993 1994 1995 OECD 1996 1997 1998 Non-OECD 1999 2000 2001 Non OPEC supply growth 2002 2003 2004 OPEC spare capacity 2005 2006 2007 20 0 2008 2009 Brent (RHS) 120% 25 23 110% 21 19 100% 17 90% 15 13 80% 11 9 70% 7 Jan-93 Jan-95 Jan-97 Jan-99 Europe Oils PE2 Source: EIA, Thomson Reuters Datastream, HSBC Jan-01 Jan-03 PE2 relative (RHS) Jan-05 Jan-07 Jan-09 60% 113 abc 5 Jan-91 EMEA Equity Research Multi-sector September 2010 Sector description The value chain of the Oil and Gas sector includes the extraction of oil and gas, transportation of feedstocks, the refining of oil to produce gasoline, diesel and other petroleum products, and the marketing of oil and gas products to consumers. It can also include a gas and power division. This can involve power generation and distribution, gas transportation (both by pipe and as LNG). Integrated players operate across the entire value chain. Independents normally focus on a part of the chain. Upstream is the key value generator – main challenge is to manage access Integrated international oil companies (IOCs) view upstream as a key value generator. It normally accounts for around 70% of their value and on average attracts more than 70% of new investments. Low growth, long lead times, capital intensive: The industry is relatively 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. The industry still needs to add new productive capacity equivalent to 5% to 7% of existing production to achieve growth in net capacity of 1% to 2% annually, since existing fields have decline rates of around 3% to 5% annually. Development of this new capacity involves long lead times, typically five to ten years from discovery to monetisation, and possibly more for large projects. The industry is also capital intensive with most material projects involving multi-billion dollar spending. Oil companies also face tightening fiscal regimes and resource nationalism as host governments seek to maximise their return from oil and gas discoveries. Downstream – oversupply a problem Following the decline in demand in 2008, the refining industry suffers from oversupply, which has been exacerbated by capacity additions in Asia over the past 18 months. The industry’s reaction has been to reduce capacity through closures (many temporary) and disposals. Oil services 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 among different parts of the sector is cyclicality. All areas are cyclical, but some are longer-cycle (related to capex), others shorter-cycle (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 midcap sector in Europe. The European sector has a high exposure to capex trends (long cycle) and to offshore activities, which drive 75% to 80% of earnings. The US sector is weighted more towards well services, both onshore and offshore, and drilling. Key themes Access to resources With growing resource nationalism, companies that have secured acreage in prospective, accessible areas of the world (Brazil, West Africa, the US Gulf and East Siberia, for example) are likely to have the 114 abc Paul Spedding* Global Co-Head of Oil and Gas HSBC Bank Plc +44 20 7991 6787 paul.spedding@hsbcib.com David Phillips* Global Co-Head of Oil and 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 EMEA Equity Research Multi-sector September 2010 abc potential for above-sector average growth. This tends to favour ‘national’ energy champions, many of them partly or wholly government-owned, which often get preferential access to exploration acreage. Some governments also give their national companies automatic participation in discoveries made by other companies. Long-term cyclicality The long lead times in the oil industry mean most of its businesses are at risk of cyclical behaviour. Those are more pronounced in the downstream than in the upstream. OPEC’s policy of managing production at a level sufficient to support oil prices damps some of the cyclicality in the upstream. Prefer refiners in emerging markets than those in developed markets OECD refiners face flat to declining demand for oil products and the potential impact of carbon pricing. Middle East refiners have the advantage of cheaper feedstock. Similarly, the refining industry in Asia enjoys easy access to growth markets. Asian and Middle East refineries also often have a cost advantage over OECD players due to scale and lower local costs. Sector drivers Realisation and margin are key drivers For most companies, realisation and margins are more important drivers of earnings than growth. The three key levers are oil price, natural gas price and refining margins. The dollar is also a key driver. For most companies, short-term movements in their share prices are correlated with the oil price. The degree of sensitivity to the oil price varies depending on the type of company. For example, the shorter-cycle service companies and independent exploration companies are more sensitive than the majors. Upstream: oil price drivers At present, OPEC appears able to exercise control over oil price by limiting production. Its supply cut in 2009 helped stabilise the crude price around the USD70 to USD80/bb. With OPEC spare capacity of currently around 6MMbbl/d, OPEC can also prevent prices rising materially above the top end of its target range if it wants to. We believe the accelerating decline rates for non-OPEC production, particularly deep-water offshore, mean we may be close to a plateau for production outside OPEC. Any incremental demand, therefore, is likely to be met from OPEC. In our view, that may mean OPEC’s spare capacity could be eroded away by the middle or end of this decade. One country that could ease this potential tightness is Iraq. The IEA forecasts Iraq will increase production from 2.5MMbbl/d to 3MM to 4MMbbl/d by 2015. If Iraq can meet its official plan to ramp up its production to 6MMbbl/d by 2015 and 10MM to 12MMbbl/d by 2017, greater discipline might be needed from the rest of OPEC to avoid downward pressure on prices. (We doubt Iraq will achieve its targets because of the security situation and bottlenecks in local oil services.) In our view, the OPEC target price band of USD70 to USD80/bbl is close to the economic price needed for development of marginal sources of crude oil (Canadian tar sands and deep-water US Gulf discoveries). We also estimate the price band is below the level needed to support heavy investment in unsubsidised alternative-energy projects. It is also low enough to allow global economic growth to continue and so is at an acceptable level for both consumers and producers, in our view. 115 EMEA Equity Research Multi-sector September 2010 Gas price – oil price linkage to remain outside the US Globally, around 40% of natural gas is exposed to gas-to-gas competition (primarily the US market), 40% is regulated and only 20% has a direct or indirect link to oil prices (Europe and Asia). The 2008 recession caused a sharp reduction in gas demand in the OECD. That coincided with rising unconventional supplies in the US and the commissioning of several new liquefied natural gas (LNG) schemes during 2009/10, which put downward pressure on spot prices for gas price. Although the proportion of spot sales has increased in Europe, we believe Europe’s link to oil prices is likely to remain in the medium term, but with an increased blend of spot prices. We also believe gas prices in Asia are likely to retain their link to oil prices because of their dependence on imported LNG. (We believe this is necessary to ensure security of supply.) The US could remain a low-price market through rising shale-gas production, but we believe the lack of export facilities makes it unlikely any price pressure will be exported to other markets. Refining – oversupply We do not expect the current overcapacity to disappear in the next five to 10 years unless large-scale closures take place. For the balance of the decade, we believe, increases in demand will be met from new capacity being added, mainly in Asia and the Middle East. We expect OECD refining profitability to remain weak with Asian and Middle East refiners benefiting most from 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 (hence concerns following the BP well blowout). Onshore is driven more by the Middle East and Australasia for capex-related work, and North/South America, the Middle East/North Africa and parts of Asia/FSU for opex-related work (ie existing oil-producing areas). Valuation: equity characteristics and accounting dilemmas Short-term sentiment Due to the sector’s dependence on the external environment of realisation and margins, sentiment towards the sector is influenced by oil prices and refining margin in the short term. Currently, with Saudi Arabia targeting an oil price range of USD70 to USD80/bbl, we believe the price could remain stable in this band. In the medium to long term, the trend in sector earnings relative to those for the market tends to drive relative performance. For the service sector and the independents, corporate activity is also a potential driver. 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). A key variable is the oil price assumed. Some analysts use prices related to those on the futures market, others use their own forecasts. (HSBC uses a 2010 Brent price of USD75/bbl 116 abc EMEA Equity Research Multi-sector September 2010 abc currently.) 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. The price-to-book (P/B) ratio also serves as a useful check to valuation, particularly for companies with significant capital under construction. For some of the smaller companies or for those where a restructuring is possible, analysts can use a sumof-the-parts approach. 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 transaction with adjustments for complexity, size and location. Other assets can be valued on a multiple bases – 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 by deriving a net asset value. 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 base 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. Unlike with the majors, the multiple approach can involve pre-tax measures (EV/EBIT or EV/EBITA) as tax rates vary less amongst downstream relative to upstream companies. 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), a SOTP is often used with individual assets being valued at replacement cost or by using comparable companies as reference. As with downstream companies, multiple-based approaches can be pre- and post-tax. For companies with highly cyclical businesses, midcycle valuation approaches can be used. 117 EMEA Equity Research Multi-sector September 2010 Notes 118 abc abc EMEA Equity Research Multi-sector September 2010 Real Estate Real Estate team Nicolas Lyle* Analyst HSBC Bank Plc +44 20 7992 1823 nicolas.lyle@hsbcib.com Stephanie Dossmann* Analyst HSBC Bank Plc, Paris Branch +33 1 56 52 4301 stephanie.dossmann@hsbc.com Thomas Martin* Analyst HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 3276 thomas.martin@hsbc.de Sector sales Martin Williams* Sector Sales HSBC Bank plc +44 20 7991 5381 martin.williams@hsbcib.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 119 120 EMEA Equity Research Multi-sector September 2010 The real estate sector Real Estate Equity Investment Indirect Direct REITs (Real Estate Investment Trusts and European equivalents) Listed property companies Listed real estate funds UK France Germany Netherlands Property assets Belgium Land Securities Unibail-Rodamco Deutsche Euroshop Corio Wereldhave British Land Klepierre Alstria Eurocommercial Confiimmo Hammerson Gecina Gagfah SEGRO Mercialys DIC Asset Capital Shopping Centres Silic Deutsche Wohnen ICADE IVG Immobilien Capital & Counties ANF VIB Vermoegen Derwent London Fonciere des Regions Great Portland Estates Holding company Property asset Property asset Shaftesbury Workspace Others - See EPRA Index Source: HSBC abc 7000 14.00 First sign of credit defaults emerge in US. LIBOR spikes, liquidity dries up 12.00 Strong global economic growth creates excess liquidity which drives a real estate boom Sector prospects deteriorate as economic growth moderates 10.00 6000 Lehman collapse 5000 8.00 4000 6.00 3000 Sector rebound as UK exits ERM and base rates, LIBOR, halve 4.00 2000 RFR-10 yr gilt (LHS) UK Investment property databank: Equivalent yields (LHS) Jun-10 Jun-09 Jun-08 Jun-07 Jun-06 Jun-05 Jun-04 Jun-03 Jun-02 Jun-01 Jun-00 Jun-99 Jun-98 Jun-97 Jun-96 Jun-95 Jun-94 Jun-93 Jun-92 Jun-91 0 Jun-90 0.00 Jun-89 1000 Jun-88 2.00 FFTSE 350 Real estate sector performance (RHS) 121 abc Source: Investment Property Databank, Thomson Reuters Datastream EMEA Equity Research Multi-sector September 2010 All Property equivalent yield, 10-year gilts yield and quoted sector performance 1988-2010 y-t-d abc EMEA Equity Research Multi-sector September 2010 Sector description Property’s place in the economy The primary purpose of property companies is to provide accommodation to businesses and households. The key driver of pricing the assets in the industry is rental growth expectations, which are derived from imbalances between tenant demand and property supply, reflecting the cyclicality of the economy. Property yields represent the ratio of a property’s annual rental value to its real estate value. The industry can be viewed in the context of ownership, ie the kind of entity that owns the real estate. The amount of money invested in commercial property globally was USD10.9 trillion at the end of 2009 with a total EUR2,998bn in Europe. Of that, EUR629bn was in the UK, EUR410bn in France and EUR451bn in Germany, according to DTZ in its Money into Property report (May 2010). The breakdown of investment by source of capital (see chart) shows that the proportion of public equity (which includes REITs – real estate investment trusts – in the UK) was only 4% of the total or GBP24bn, which is representative of the market capitalisation of the FTSE 350 real estate index. The European public equity market (excluding Nordics and Switzerland) is approximately EUR58bn according to EPRA (European Public Real estate Association) with the key difference being less liquidity due to lower levels of free float. Insurance companies and banks are the largest owners of private debt and private equity invested in the sector as commercial property has traditionally met their need for asset diversification. REITs (and their European equivalents) were invented to enable investment in property via a vehicle offering much greater liquidity than direct property (real estate itself), but the same effective tax treatment with the added possibility, therefore, of attracting new sources of capital into the sector. REITs in the UK have adopted a total return strategy, which aims to deliver income returns (through asset management strategies) and capital growth (via development projects). At various points in the cycle, the emphasis on the different parts of the strategy will vary, and the attraction for investors also depends on the tax treatment of capital gains and income. In the UK, current personal taxation favours capital gains over income. In Europe, lower liquidity and a less transparent valuation network are reflected in lower volatility of capitalisation rates, and therefore market pricing is more focused on income returns. Europe (ex-UK) invested stock by source of capital 2009 UK invested stock by source of capital 2009 Priv ate Private equity 27% equity 32% Priv ate debt 48% Public equity 4% Public equity 4% Public debt Public debt 17% 16% Source: DTZ 122 Source: DTZ Private debt 52% Nicolas Lyle* Analyst HSBC Bank Plc +44 20 7992 1823 nicolas.lyle@hsbcib.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations EMEA Equity Research Multi-sector September 2010 abc Key themes Late in the cycle returns The availability and cost of debt capital determine the size of the investment pool. This was the key driver of the listed sector’s tripling in value between 2003 and 2007. The all property equivalent yield (as measured by the UK investment property databank) fell by 250bps to a trough value of just under 5.40% at the height of the boom, as can be seen in the chart above. Conversely, the near freezing of debt capital in the months around the Lehman Brothers bank collapse in September 2008 caused the greatest fall in property prices in the post-war period with the all property equivalent yield rising just under 400bps to a peak value of 9.30%, causing a 45% fall in capital values over the two years to June 2009. The investment boom left over-leveraged bank balance sheets over-exposed to the sector. As a result, REITs had also over-leveraged themselves in this period and the majority had to resort to rescue rights issues in 2009 as property prices fell beyond expectations and threatened breaches of loan covenants. Bank de-leveraging The property boom of 2003-2007 has led to a record level of bank debt secured against UK commercial property. The Bank of England reports just under GBP250bn of outstanding debt, representing just over 11% of participating banks’ total lending at the end of 2009 compared with 10% at the height of the last credit crisis in the UK in the early 1990s. As in the 1990s credit crisis, significant numbers of loans are in breach of covenants, with industry estimates of GBP50bn in negative equity. In the UK, RBS and Lloyds Banking Group together represent approximately 38% of the GBP250bn market and both have publicly committed to reducing their exposure to non-core property loans. This gradual reduction in exposure to loans secured by commercial property assets is likely to restrict the availability of (debt) capital to the sector for many years to come. Structural decline of income security Historically, a key differentiator of the UK commercial property market from the market in continental Europe was the security of income brought about by the relatively long (and unbroken) lease lengths of 25 years in London offices and 15 years in the retail sector. In the last decade, technological improvements and flexible ways of working, combined with the internet have eroded the value of physical premises as a central workplace or to store goods. As a result, lease lengths are getting shorter with an increasing proportion of leases carrying clauses that give tenants the option to break the lease every five years. This trend has been accelerated by the credit crisis and ongoing downturn. The BPF/IPD annual lease length survey reported that average lease lengths in UK shopping centres and central London offices (for post-1990 leases) are 10.8 and 10.2 years, respectively. Retail consolidation The internet has been a key driver of retailers’ reduced need for physical space in the UK, with an increasing trend among national retailers to open flagship stores in fewer but higher-footfall locations. This has been accompanied by a gradual shift from high streets to edge of town retail parks, where occupancy costs are lower and access is more convenient for car users. As a result, vacancy rates across town centres and in secondary quality shopping centres rose to historic highs in the last three years, sending rental values into freefall. The corollary is that inadequately financed retailers with declining brands have been forced into liquidation, leading to market share gains for the national retailers but reducing overall demand for retail space. 123 EMEA Equity Research Multi-sector September 2010 Over-renting In the UK, many property companies and some REITs are likely to see underlying net rental income falter between 2010 and 2012, as leases expire on over-rented property (where the passing rent exceeds the value of the market rent). A strong global and domestic economy fuelled five years of continuous rental growth to 2008 which was a key driver behind the surge in property company NAVs. However, prime rents have fallen 20-50% on a net effective basis since the onset of the crisis. As a result, current lease income on many property portfolios is above market values, and so they face a significant reduction of rental income when the current leases expire and new leases are negotiated, exacerbated by historically high levels of available space in secondary locations. This reduction in income will take time to unwind, and will reduce free cash flow growth and constrain commercial property landlords’ ability to grow earnings. Sector drivers The listed vs the direct market REITs share prices (and those of listed property companies) are sensitive to global capital flow imbalances and macroeconomic conditions. Rental growth is the principal driver of property returns over the long term, and as a result the sector is late cycle (owing to the time it takes to ‘renew’ the rent roll as leases expire). The listed sector is also more affected by wider market sentiment, implying greater volatility of returns, although this is compensated in part by the greater liquidity and transparency of share trading. Rental growth Rental value growth is a fundamental driver of property prices as investors determine an acceptable capitalisation rate for rental income projections. Occupier demand is the key driver of portfolio vacancy rates and therefore rental growth potential. In times of economic expansion, tenants’ space requirements increase and drive up occupancy rates to high levels, limiting the choice and availability of accommodation. Consequently, when a tenant needs to move or to expand and property supply does not increase to match these needs, rents rise and capitalisation rates (yields) fall, and if supply exceeds demand the reverse is true. Further, the REIT regime (which requires the payout of 90% of eligible rental income) limits the retention and re-investment of capital. An absence of economies of scale and low barriers to entry compounds the weakness of a capital-intensive industry, placing the sector squarely in the ‘value’ category (rather than in ‘growth’). Sustainable income returns and the potential for rental growth are therefore very important to overall returns, especially in a capital-constrained economy. Availability of debt financing Debt capital is the lifeblood of liquid property investment markets, and comes either from the banks or the capital markets (bonds to CMBS). The relatively large lot size of individual assets and the limited opportunities for raising returns on a standard investment with a long lease imply that debt capital is an appropriate source of finance for commercial property investment. Reflecting this, in the UK at the end of 2009, just under 70% of capital invested into the sector (private and public) was debt capital. 124 abc EMEA Equity Research Multi-sector September 2010 abc Leading indicators Investment market Redemption yield on benchmark 10-year gilts Five-year swap rate Bank margins Banks’ capital ratios, CMBS issuance Occupier market Employment indicators Vacancy rates Development pipelines and space absorption rates Tenant incentive levels Valuation: equity characteristics and accounting dilemmas NAV and NNNAV The traditional valuation measure for European REITs is price/book ratio, referred to as discount/premium to adjusted net asset value (NAV). The valuation premium or discount to book value represents how investors expect property capital values to change either through rental or capitalisation yield changes. (In most European countries, the valuation discount/premium is to the ‘triple net NAV’ or ‘NNNAV’ [see below] due to differences in holding structures such that transfer tax becomes relevant.) Adjusted NAV represents the difference between the value of the company’s assets (as estimated by independent appraisers) and the total sum of its debts or liabilities, adjusted for fair value. The difference between adjusted NAV and ‘triple net NAV’ or ‘NNNAV’ principally reflects the reversal of mark-tomarket movements on the debt and derivatives (included in the adjusted NAV) and the deduction of deferred tax provisions (in respect of latent capital gains). As a result, NNNAV should represent the fair value of the equity and includes fair value adjustments of all material balance sheet items which are not reported at their fair value as part of the NAV per IFRS balance sheet statements. Where capital growth cycles are less pronounced, either due to an excess supply of investable assets, a lack of transparent and liquid markets or lack of investor interest, a pure DCF valuation methodology may be more appropriate because each investor can determine the required rate of return. Income spreading The main accounting adjustment that REITs have to make under IAS 17 (SIC 15) is to account for lease incentives (mostly rent-free periods and capital contributions) as an integral part of the consideration for a leased asset. As a result, these are capitalised and accounted for as a deduction of cash rents, amortising on a straight-line basis, over the life of the lease in line with accounting for net rental income. As a result, timing differences exist between the income and cash rents receivable in any given year, with the income account notably higher than the cash account in the early years of a lease (especially in recession when rent-free periods comprise a greater portion of net rental income). As rent-free periods come to an end, the cash rent roll begins to overtake the income account, reflecting the headline rental value achieved on leasing. In a benign economic environment, rent-free periods are minimal and therefore the gap between the income and cash accounts is minimal. 125 EMEA Equity Research Multi-sector September 2010 Notes 126 abc abc EMEA Equity Research Multi-sector September 2010 Retail – General General Retail team 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 127 128 Consumer & Retail - Europe Food and staples retailing Beverages See sector section for further details General Retail See sector section for further details Hardlines Specialty DSGI (FTSE250) Kesa Electricals (FTSE250) Kingfisher (FTSE 100) Food and HPC Luxury and sporting goods See sector section for further details See sector section for further details EMEA Equity Research Multi-sector September 2010 The consumer and retail sector Softlines Multiline Home Retail Group (FTSE100) Internet & Catalogue Multiline Specialty Asos plc (FTSEAIM) Debenhams (FTSE250) Carpetright (FTSE250) Brown N Group (FTSE250) Game Group (FTSE250) Halfords Group (FTSE250) Marks & Spencer (FTSE100) Hennes & Mauritz(MSCI EU) Mothercare (FTSE250) Inditex (MSCI EU) Next (FTSE100) Sports Direct (FTSE250) Source: HSBC abc 525 UK leaves ERM in Sept 1992, resulting in sharp fall in interest rates and economic recovery 450 21 Periods of low interest rates, consistently rising house prices and mortgage equity withdrawal Collapse in UK GDP as credit crunch bites 13 375 5 300 -3 225 -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 retialers from supermarkets and fast fashion discounters. Biggest stock in sector (M&S) loses 60% of its value between 1998 and 2000 150 75 EMEA Equity Research Multi-sector September 2010 UK Retail sector performance since 1990 -19 -27 -35 0 1990 1990 1991 1992 1993 1993 Sector performance (LHS) 1994 1995 1996 1996 1997 1998 1999 UK Bank of England Base Rate (EP) (RHS) 1999 2000 2001 2002 2002 2003 UK GDP (%YOY) NADJ (RHS) 2004 2005 2005 2006 2007 2008 2008 2009 2010 UK consumer confidence indicator SADJ (RHS) Source: Thomson Reuters Datastream, HSBC abc 129 EMEA Equity Research Multi-sector September 2010 Sector description General retail The UK general retail sector is highly cyclical and a largely mature industry (70% organised retail penetration) with few genuine defensive propositions and limited international revenue exposure. Furthermore, owing to substantial private equity investment between 2002 and 2007, attracted by strong cash generation, and premised on the availability of cheap debt finance and sale-and-leaseback freehold property assets, a significant proportion of the industry is now in private hands. Accordingly, the listed component is typically asset-light, is varied in nature with no two companies the same, and has a combined market capitalisation of just cGBP24bn. The four FTSE 100 companies account for c65% of this total, limiting investment opportunities. This compares with the cGBP62bn combined market capitalisation of Inditex and H&M, the two major European stocks. Where growth propositions do exist in this sector they are typically small/midcap companies, with one or more of the following characteristics: Specialist proposition with limited exposure to supermarket competition. Percentage of revenues from international and emerging markets Exposure to, or the ability to adapt to, the internet and online consumer spending pattern which, except perhaps for the ‘value-based’ propositions (eg fashion), is arguably the only area of structural growth Key themes Sector drivers and sales indicators Macro drivers: unemployment, savings ratio, interest rates and inflation In most consumption-driven economies (like the UK) the unemployment rate has a very strong correlation with the GDP growth rate. Thereafter the savings rate (the percentage of disposable income that is not spent) is the single largest determinant of future household disposable income, an increase in savings rate means less consumer spending with a knock-on effect on GDP and household income. Base rates have a strong positive correlation with retail sector performance. Although lower interest rates help support or encourage consumer spending and confidence, it is rising interest rates and by implication the improving outlook for GDP growth that drives longer-term sector performance. Inflation is good for the sector as it helps the top line and the bottom line for those who have pricing power. Consumer confidence In the short term, consumer confidence is a key lead indicator of the retail sector’s performance. Although consumer confidence has staged a marked recovery since the beginning of 2009 (from historically low levels), the recent problems in Greece and Eurozone debt worries and, specifically for the UK, the general election and emergency budget, have reduced consumer confidence. We note UK consumer confidence is also closely correlated with that of the US. Company sales indicators Although the vast majority of companies in the sector are cyclical by nature, no two companies are the same, and so the key lead indicators for sales and earnings growth performance can differ markedly between companies. We give some examples on the next page. 130 abc 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 abc EMEA Equity Research Multi-sector September 2010 Sales indicators share a strong correlation with top-line drivers Inditex LFL sales vs Spanish retail sales H&M LFL sales growth vs German retail sales -20% Jul-09 Jan-08 Apr-07 Jun-10 Germany : Retail sales - clothing v oln-y oy grow th (%) (LHS) General for retail trade (deflated non cal adjst) (LHS) Inditex LFL sales grow th (RHS) H&M group monthly LFL sales grow th (%) (RHS) Source: Company data, Thomson Reuters Datastream Source: Company data, Thomson Reuters Datastream Next vs BRC Non-food and John Lewis Fashion sales KGF B&Q LFL sales growth lead indicators -5% -50% -6% -9% -120% Aug-10 -3% Dec-09 20% Aug-09 -1% Apr-09 0% Dec-08 90% Aug-08 3% Apr-08 3% Aug-10 Jun-10 Apr-10 Feb-10 Dec-09 Oct-09 Aug-09 Jun-09 Apr-09 0% 160% Dec-07 10% 7% Aug-07 20% 6% Apr-07 30% Apr-10 Mar-10 Dec-09 Jun-09 Sep-09 Mar-09 Dec-08 Jun-08 Sep-08 Mar-08 Dec-07 Jun-07 -4% Sep-07 -2% -15% Mar-07 -10% Jul-10 -12% 0% Apr-10 -8% -15% -5% Jan-10 -4% 2% Oct-09 4% 0% 0% Apr-09 8% Jan-09 12% 4% Jul-08 5% Oct-08 20% 15% Apr-08 23% 6% Jul-07 8% Oct-07 10% B&Q LFL sales (LHS) Av g of UK Retail DIY sales & housing prices (RHS) BBA no of loans approv ed for House purchase % change y oy (RHS) John Lewis- Fashion (4 wk rolling avg) sales growth (LHS) BRC Non-FoodLFL 3 months avg (%) (RHS) Next lfl sales (RHS) Source: Company data, John Lewis Partnership, BRC Source: Company data, Thomson Reuters Datastream, bba.org Argos and Homebase LFL sales growth vs John Lewis Elec & Home category sales growth MKS GM LFL sales growth and John Lewis Fashion sales growth, MKS Food LFL sales growth and Waitrose sales growth 8% -2% -15% 0% -5% Aug-10 Jun-10 Apr-10 Feb-10 Dec-09 Oct-09 Aug-09 Jun-09 Apr-09 John Lew is- Elec & Home Tech (4 w eek rolling av g) (LHS) John Lew is- Home (4 w eek rolling av g) (LHS) Argos lfl sales (RHS) Homebase lfl sales (RHS) Source: Company data, John Lewis partnership Aug-10 -10% -20% Jun-10 -10% Apr-10 1% Feb-10 16% 0% Dec-09 -5% 10% Oct-09 4% 0% Aug-09 24% 20% Jun-09 7% 5% Apr-09 32% 30% John Lewis- Fashion (4 wk roll avg) sales growth (LHS) Waitrose weekly sales growth (LHS) MKS General merchandise lfl sales (RHS) MKS Food lfl sales growth (RHS) Source: Company data, John Lewis partnership 131 abc EMEA Equity Research Multi-sector September 2010 Structural shift – the internet and supermarket operators With the rollout of broadband networks, increasingly sophisticated website innovation and certain product categories being suitable 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, but is a substantial growth opportunity for others. Although it is not yet clear what the level of online penetration (currently 8% of total UK retail sales) in specific categories will ultimately be, this remains an area of structural growth. We consider that most successful models will be either pure-play internet or genuine multi-channel retailers. Input cost pressures European retail has for the last 10 years been a major beneficiary of the USD carry trade; a weak USD and the switch to lower-cost Far East sourcing underpinning gross margin expansion. This trend has now reversed. Those retailers sourcing predominantly in dollars out of the Far East (but deriving the vast bulk of their revenues in euros) will see cash gross profits come under pressure as a result of rising raw material, Chinese labour and freight costs, as well as strength in the dollar and gradual appreciation of the Chinese renminbi. Our analysis suggests that in the absence of volume growth, the retail selling prices of products sourced in the Far East need to rise by c6% for cash profits to stand still, thus offsetting the cumulative impact of a 13% increase in input costs, and imposition where applicable of higher VAT. Accordingly, the companies with the highest exposure to Far East/USD-sourced products, followed by those with greatest exposure to GBP/EURdenominated revenue streams, are under most pressure on cash gross profits and gross margins, and ultimately EBIT margins. Major retailers: proportion of direct Far East/USD-sourced CoGS and respective GBP/EUR revenue exposure Company Home Retail Group* Hennes & Mauritz Inditex Far East/USD sourced CoGS EUR/GBP revenues 35% 65% 35% 100% 85% 60% Company Far East/USD sourced CoGS EUR/GBP revenues 20% 50% 80% 80% 100% 100% Kingfisher Marks & Spencer** Next Note: *Home Retail Group derives >50% of revenues from electrical goods, a large proportion of which are sourced via the local agents of major branded manufacturers based in the Far East thus underlying exposure to rising input cost pressures is greater higher than the directly sourced Far East CoGS would suggest. **Refers to Marks and Spencer General Merchandise sales only. Source: HSBC, company data, all numbers are approximate Cost-cutting and cash-saving initiatives 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. Where balance sheets have been stretched beyond covenant limits, the relaxation of covenants in the short term, reduced capital expenditure, the cessation of dividend payments, and equity capital raisings (rights issues) have been used to restore the balance sheets of those companies with sustainable business models. VAT The increase in UK VAT to 20% from 17.5% not coming into effect until 4 January 2011, six months after the rise was announced, was as good a result as UK general retailers could have hoped for. It minimises implementation costs, as companies can re-price on the introduction of their Spring ranges after Christmas, while providing a six-month window in which to identify the best way to pass on the increase through higher prices and also to switch or renegotiate supply contracts. 132 EMEA Equity Research Multi-sector September 2010 abc Consolidation, capacity withdrawal and M&A In recent recessionary times the retail sector has been characterised by capacity withdrawal with highly leveraged private equity (eg MFI Group) and listed (eg Woolworths) businesses failing alike, often operating in price-led commodity categories. The vast majority of sector casualties have been smaller in nature and characterised by overexpansion in previous years, excessive leverage, structurally challenged business models leading to a short-term collapse in profitability. Although capacity withdrawal has been mitigated by the pre-pack administration/CVA process, it is the larger companies within the sector that stand to gain most from reduced competition either via market share gains or the acquisition of distressed assets (these could be complementary brands, physical assets, client data in the case of internet-based operators) at depressed valuations. Valuation: equity classification and accounting dilemmas 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 historic one-year forward PE range is 7.2x to 17.0x with an average of 13.1x. At the end of August 2010 it was c10x. Additionally, and supplementing PER analysis, ROIC is often seen as a key measure of performance for mature companies. Intrinsic valuations methodologies such as discounted cash flow (DCF), dividend discount model (DDM) adjusted present value (APV), although accurate in assessing the present value of future cash flows by absolute quantum (subject to realistic underlying earnings assumptions), fail to reflect the quality, reliability and surety of underlying cash flows, and management’s wide use of them. Classification Cyclical vs defensive: Stocks can be classified as cyclical and defensive names as well as those offering international diversification or genuine growth potential. 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 vs international: Those stocks which offer international diversification (Kingfisher, Inditex, Hennes & Mauritz, Mothercare) typically trade at a premium to UK-centric business models, with exposure to emerging markets and BRIC territories highly valued by the investor. FTSE100 vs FTSE350: FTSE100 stocks, because of their largely mature status, UK-centric business models and thus low earnings growth rates, typically trade at a discount to other UK FTSE350 General retailers, often characterised by companies with emerging competitive advantages via scale in specialist retail categories. Accounting dilemmas The proposed inclusion of off-balance sheet operating leases (essentially future rent liabilities attached to retail stores) under IFRS accounting rules could negatively impact the perceived valuations of those companies that do not screen well under this metric. 133 EMEA Equity Research Multi-sector September 2010 Notes 134 abc abc EMEA Equity Research Multi-sector September 2010 Sporting Goods Sporting Goods team Erwan Rambourg* Analyst HSBC Bank Plc +44 20 7991 6793 erwan.rambourg@hsbcib.com 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 135 136 EMEA Equity Research Multi-sector September 2010 The sporting goods sector Sporting Goods Global Players Nike adidas Local Players US Lifestyle Companies China Europe Casual Puma UnderArmour LiNing Umbro Lac oste ASICS Lululemon Anta Décathlon private label Diesel Converse Xtep Reebok Kappa Vertical Retailers Uniqlo Luxury Louis Vuitton Christian Dior Tod’s New Balance Niche or specialised Players Action Sports Golf Racquet Sports Billabong Titleist Babolat Quiksilver Callaway Head Hurley Mizuno Prince Ping Source: HSBC abc 35 30 30 25 25 20 20 15 15 10 10 5 5 95 96 97 98 99 adidas AG (DE Listing) - N ext 12 m onths P/E 00 01 02 03 N ike Inc. (Cl B) - N ex t 12 months P/E 04 05 06 07 08 09 EMEA Equity Research Multi-sector September 2010 Historical PE valuation of the Sporting Goods industry: adidas, Nike and Puma forward PE since 1996 35 10 Pum a AG R udolf Dassler Sport (DE Listing) - Nex t 12 m onths P/E Source: FactSet abc 137 abc EMEA Equity Research Multi-sector September 2010 Sector description The Sporting Goods sector includes companies that develop, produce, market, distribute and sell athletic apparel, footwear and/or accessories (hardware such as golf clubs, skis and training machines but also watches, footballs and fragrances). Although most apparel and footwear developed by these companies was initially designed to actually practise a given sport, the consumer trend of wearing sporting goods products on evenings or weekends just for the look has gradually blurred the boundaries between athletic and lifestyle products. Global players: a few companies (those we cover and a few others like Asics and New Balance) have a global footprint and a highly diversified portfolio of products. Nike, the world leader in the sector, sells from California to Tokyo and caters to athletes in most sports, from the very broad football (soccer), running, basketball and tennis product categories to the more regional or specialised categories like baseball, cricket, American football and action sports. Local players: some sporting goods companies have a more local reach. Although UnderArmour (originally grassroots American Football) and lululemon, for instance, have diversified their reach, their main focus is still their domestic market in the US for the time being. Private-label brands, such as those developed by French distributor Décathlon, for instance, are limited in reach by the distributor’s regional exposure. In China, where much of the production for sporting goods is done locally and some consumers may not be able to afford or be willing to purchase the higher-priced Western goods, many local companies, such as LiNing and Anta, have become big successes. Niche/specialised players: some companies have developed an edge/specialty in a given subsector of the industry. In racquet sports, for instance, companies like Babolat and Head have dedicated much of their development to hardware (the actual racquets). Some companies are invested almost exclusively in golf – for example Titleist, Callaway, Mizuno. Lifestyle companies: one of the problems when defining the sector is that consumers are much more volatile than before and open to buying sporting goods as a lifestyle statement. Consequently, the sector is broadly challenged by any company that manufactures sneakers or casual apparel, be it in luxury (eg Christian Dior and Louis Vuitton), casual wear (Lacoste and Diesel) or vertically integrated retailers (eg Uniqlo). US athletic footwear market shares (total: cUSD12bn) 2009 Global athletic footwear market shares (total: cUSD33bn) 2009 Other Other 22% ASICS Reebok Reebok 4% New Balance 4% 4% Skechers VF Corp 5% adidas 6% 138 30% 34% 4% Source: SGI Nike 24% Nike Skechers New Balance Conv erse 7% 9% adidas 4% 9% Source: SGI Puma ASICS 6% 6% Conv erse 7% 15% Erwan Rambourg* Analyst HSBC Bank Plc +44 20 7991 6793 erwan.rambourg@hsbcib.com 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 *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations EMEA Equity Research Multi-sector September 2010 abc Key themes The difficulty of defining the boundaries of the sector itself means that the issue of barriers to entry is of key importance for the companies that operate in Sporting Goods. On the performance side alone, barriers to entry are high, as the major players (Nike, adidas) have considerable marketing and advertising clout, ensuring that they can lock in the key sponsorship deals with high-profile teams (football clubs and national Olympics teams) and athletes (NBA, ATP Tennis, golf stars and football stars). In the lifestyle part of the business, barriers to entry appear more limited although there, too, a brand’s capacity to outspend its competitors is a key sales driver. To make sure that inflation in ad spend and sponsorship costs does not hamper the long-term margin profile of these companies, it is key for them to find ways of expanding/maintaining their gross margin and containing operating expenses other than advertising and sponsorship costs. We believe that the key concerns/themes for the Sporting Goods industry are: Production cost pressures – an important part of production for Sporting Goods takes places in South-East Asia – most notably mainland China. Although the macro environments may influence the cost of goods sold (via the prices of oil and oil derivatives, leather and fabric), we nonetheless believe Chinese wages are likely to increase structurally over the long term, obliging companies in the sector to find ways of offsetting the resulting pressures. Commoditisation risk – with new entrants every year and the increasing credibility of private label, even on technology-driven products, pricing power in the sector may turn out to be a long-term issue. Currency fluctuations – since much is produced in countries with USD-related currencies (and often negotiated in USD), any weakness in the USD against a basket of currencies (notably the EUR) is a positive for the sector, and any strength of the USD is a negative for both European players and Nike. Increasing retail exposure – as a way of controlling their brand image (avoiding tough discounting from distributors) and enhancing their gross margins, many brands have entered into comprehensive own retail strategies. Although we believe the space for performance products should still be dominated by wholesale (eg consumers will want to compare technology, looks, price and brands), we believe own retail makes sense for the more lifestyle-driven products. Advertising and sponsorship deals – one approach to the sector is to look at the inflation in advertising and sponsorship deals, whose costs appear to be consistently rising as a percentage of sales, possibly creating a perception that the value is going to athletes, not investors. This pressure on costs could lead to the belief that “big is beautiful” within Sporting Goods – or at least oblige small brands to be nimble if they are to establish a worthwhile business model. Sector drivers The Sporting Goods sector has been driven by sector-specific events: big events like FIFA World Cups or Olympic Games that can drive sales while increasing marketing spend and also M&A events that have gradually reshaped the competitive landscape. In future, we expect that one of the key drivers beyond these two will be gaining access to higher-growth countries and developing leadership positions there, where margins are already currently higher than in the US – still the leading market for the sector. 139 EMEA Equity Research Multi-sector September 2010 abc Sports events – Sporting Goods is characterised by ‘on years’ and ‘off years’. The on years are all the even years when the sector is moved either by the FIFA World Cup (eg 2006, 2010 and 2014) or by both the UEFA Football Euro and the Olympic Games (eg 2008, 2012). Although some events both bring a strong boost on sales and imply large advertising investments (World Cup); others (typically the Olympics) are more akin to a PR event, entailing high costs but fairly limited event-related sales. M&A and cash management – as advertising/sponsorship costs inflate, the sector has been very active in terms of consolidation. Nike Inc (Nike, Converse, Umbro and Hurley) and the adidas group (adidas, Reebok and TaylorMade) have been among the bigger players in this respect. Geographic diversification – although the US remains the largest market by far, it is also structurally less profitable than others (at least in terms of gross margin) as the products have, to a certain extent, been commoditised there. Market share battles should now focus on higher-growth, higher-margin regions including China. Valuation: equity characteristics and accounting dilemmas As companies in the Sporting Goods sector tend to not be very capital/debt-intensive, they generally trade on forward-looking price/earnings ratios. The adidas stock has been the exception for a few years following the difficult integration of the Reebok brand (acquired in December 2005), although we now believe the main issue for the sector as a whole is cash re-investment rather than debt management. Cash management has been an issue for several years now at Nike, although during the downturn the stock was seen as a debt-free safe haven. There are several reasons that might explain why Nike has historically traded at a premium to its European counterparts: it is listed in the US, has a leadership position and very strong cash levels, its market shares have increased consistently and its history of acquisitions is more reassuring than those of peers (look at how Converse soared and how Umbro issues were rapidly addressed). As illustrated earlier in this section (see graph, Historical PE valuation of the Sporting Goods industry), the companies have traded, on average, in a rather narrow range, and typically reflect the state of the economic, market and consumer environment. Currently, the companies are trading at low- to mid-teen 2011 PEs; relatively in line with or very slightly below the mid-teen historical forward multiple averages. We expect that restructuring measures taken throughout the sector in 2009 and the strong beginning to 2010 (excluding Puma) galvanised EPS. On the other hand, we also think that mounting uncertainties regarding 2011 (especially on the cost side) have made the market less enthusiastic about paying above-average multiples now that the big event for 2010 (World Cup) is behind us. 140 abc EMEA Equity Research Multi-sector September 2010 Telecoms, Media & Technology Telecoms, Media & Technology team Stephen Howard* Head, Global TMT Research HSBC Bank plc +44 20 7991 6820 stephen.howard@hsbcib.com Antonin Baudry* Analyst HSBC Bank Plc, Paris branch antonin.baudry@hsbc.com + 33 156 524 325 Nicolas Cote-Colisson* Analyst HSBC Bank Plc +44 20 7991 6826 nicolas.cote-colisson@hsbcib.com Amit Sachdeva* Analyst HSBC Bank Plc +91 803001 3795 Dominic Klarmann* Analyst HSBC Bank Plc +44 20 7991 6819 dominik.klarmann@hsbcib.com Sector sales Luigi Minerva* Analyst HSBC Bank plc +44 20 7991 6928 luigi.minerva@hsbcib.com Tim Maunder-Taylor* Sector Sales HSBC Bank Plc +44 20 7991 5006 Richard Dineen Analyst HSBC Securities (USA) Inc +1 212 525 6707 richard.dineen@us.hsbc.com amit1sachdeva@hsbc.co.in tim.maunder-taylor@hsbcib.com Olivier Moral* Anaylst HSBC Bank Plc, Paris Branch +33 1 5652 4322 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 141 142 Telecom, Media, Technology Telecom Media Technology Diversified telcos Pay TV operators Telecom equipment vendors Deutsche Telecom BSkyB Ericsson, Alcatel-lucent, Nokia Free TV operators Software and services ITV, Telecinco, Mediaset SAP, Capgemini Advertising agencies Original equipment manufacturers Publicis, GfK, WPP Nokia, Samsung Professional publishers Foundries Reed Elsevier TSMC, UMC Portugal Telecom Telefonica France Telecom Telenor TeliaSonera Mobile network operators EMEA Equity Research Multi-sector September 2010 The telecoms, media and technology sector Mobistar Miscellaneous Tele2 JCDecaux (Outdoor), Pages Jaunes (Internet) Vodafone Satellite operators Inmarsat Cable operators Source: HSBC abc Virgin Media, Telenet Telecoms, media and technology 1990-2003: growth, bubble and burst phases 9.0x Macro improvement Signs of slowdown in economy 8.0x 7.0x 6.0x 5.0x EMEA Equity Research Multi-sector September 2010 Macro & emerging markets led growth 10.0x 4.0x 3.0x 2.0x Recessio nary environment 1.0x 0.0x Jan 04 Jan 05 Jan 06 Jan 07 Europe -DS T elecom - R I Jan 08 Jan 09 Europe -DS T echnology - RI Jan 10 Europe -DS Media - RI Source: Thomson Reuters Datastream, HSBC Telecoms, media and technology 2004-2010 emerging market-led growth, economic slowdown, stabilisation and re-growth 30.0x Peak of dotcom bubble 20.0x Bursting of dotcom bubble 3G licences Pick up mobile services 10.0x 0.0x Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Source: Thomson Reuters Datastream, HSBC Jan-96 Jan-97 Jan-98 Europe -DS Technology - R I Jan-99 Jan-00 Jan-01 Jan-02 Europe -DS M edia - R I Jan-03 143 abc Europe -DS Telecom - R I Jan-95 EMEA Equity Research Multi-sector September 2010 Sector description The Telecoms, Media and Technology (TMT) sector encompasses a wide range of sub-sectors. Telecom sector: The telecoms operators work on two different platforms, fixed line and mobile, and sell raw connectivity (eg line rental and broadband) and services (eg voice and IPTV). Media sector: The media sector brings together a large range of business models; some are advertising-related, others not; some mostly local, others global; some suffer and some benefit from the audience fragmentation due to digital media, some are more capital-intensive than others. Traditional sub-segments are pay-TV and free-TV, communication agencies (together with market research), publishers and internet-related players. Satellite operators (fixed and mobile satellite service) and cable operators are linked to both media and telecom. Technology sector: 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 and foundries. The entry barrier in the telecoms space is intrinsically very high, given that each market is dominated by three to four key players and scale is the key determinant of success. However, regulators have attempted to undermine these natural barriers to entry by intervening with remedies like unbundling the local loop so as to promote market entry. In the media space, the need to have the use of a distribution platform (like satellite) has been a powerful barrier to entry, but in future we believe that viewers will increasingly turn to broadband internet links to receive their video content (eg via the BBC’s iPlayer or Google’s YouTube). This will open up the media market to a broader range of names, in particular to internet and telephony brands. Telecom and media are coming together – converging in some instances and colliding in others. Telecom service providers have entered not only the media sector with TV offerings, but also the technology sector, with a host of applications. On the media side, cable/satellite TV operators are vying for telecom customers through converged service offerings of voice and broadband along with TV. Standalone satellite operators, which have traditionally relied on capacity leasing for revenues, are now becoming more ambitious, and are entering the telecom space, aiming to offer broadband services using the terrestrial and satellite networks. In the technology sector, device/hardware manufacturers, such as Apple have had some success in software. Mobile device/chip manufacturers, such as Qualcomm, have also displayed interest in the mobile services business. Overall, we believe the collision between the sectors will favour multi-play providers over single-play competitors, not only from a customer perspective (bundling, cross-selling and churn prevention), but also from a network cost perspective, as backbone and backhaul capacities can be shared. We therefore expect mobileonly players to increasingly seek to add fixed-line capabilities – as Vodafone attempted to do in 2007 by acquiring Tele2’s operations in Italy and Spain. We also expect integrated telcos to look to expand their content provision capabilities by, say, acquiring football tournament rights or even small content/application companies. Consequently, we expect the purpose of M&A in TMT to shift towards building a cross-sector presence in an individual market from creating a cross-country presence (although the appeal of adding exposure to emerging market growth will continue to drive acquisitions). 144 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 5652 4322 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 EMEA Equity Research Multi-sector September 2010 abc Key themes Scale and capex important; multi-play and NGA likely drivers As the TMT sectors converge, the service providers are expanding their capabilities (organically or via acquisition) to market themselves as a one-stop destination for all telecom, media and software services for residential and business customers. We believe this shift provides new growth opportunities for service providers while cutting the overall cost of services for consumers. We expect the multi-play phenomenon to continue, and forecast that operators pursuing the strategy of investing and expanding their portfolios stand to benefit. Cable companies (eg Virgin Media) have so far been the main beneficiaries of the multi-play trend, as their network upgrades were easier to achieve. For fixed-line telecoms operators (usually the incumbents), we believe the pace of next-generation access (NGA) fibre network deployment (with FTTN/VDSL or FTTP) is the key to success, as this upgrade greatly enhances the bandwidth and range of services it is possible to offer. One key result of the upgrade is that it is likely to change the competitive landscape. At present many incumbents find themselves out-competed by unbundlers that have bought the use of the incumbent’s existing copper infrastructure to offer their broadband ADSL services. Although we would expect regulators to insist on unbundling being extended to NGA platforms as well, the fact is that it is intrinsically very expensive (as the unbundler has to install its equipment in many more locations for it to work, and this necessitates a very much higher capex bill). As a consequence, we think that most competitors will have to purchase a wholesale service from the incumbent (which they will then resell to their customers); and the returns on providing a wholesale fibre service will be much more attractive to the incumbent than the returns it generates on unbundled copper. Data explosion, capacity crunch and capex The proliferation of smartphones and laptop cards has led to rapid growth in mobile data revenues, but has also started to put pressure on mobile networks. A key question for telecom service providers is whether they will need to buy more equipment from vendors (eg Ericsson). Some argue that operators will not have to do so, because improved technology (like LTE) will come to their rescue. However, our research shows that LTE upgrades will boost capacity from the levels provided by today’s 3G systems by only around 30% on a likefor-like basis. We therefore believe that mobile capex will have to rise over the next few years to meet the increase in network demand arising from data growth – and we would expect telecoms equipment vendors to be the key beneficiary. The mobile telecoms operators have done a very poor job, in our view, of monetising the application layer, an area that has been seized by Apple and its app store. However, we believe that the operators can still monetise the raw connectivity provided by their mobile networks, because the very limitations that are becoming apparent in the amount of capacity that technologies like LTE can support will mean that capacity will be intrinsically scarce – and this scarcity should result in pricing power. This is evidenced by the wide range of operators (eg AT&T, KPN) that have now introduced tiered data plans. New media As the reach of the internet widens with increasing fixed-line and mobile broadband penetration, digital is being hailed as the new growth frontier for advertising agencies. The emergence of online advertising, which creates new advertising space without incremental demand, is causing fears of deflation in media prices. Media owners (such as television channel owners and newspaper publishers) are already beginning to feel the 145 EMEA Equity Research Multi-sector September 2010 pressure. The increasing number of TV channels and websites has caused audiences to fragment, making them harder for advertisers to reach and introducing more competition for media owners. Sector drivers Telecoms The telecoms industry is subject to many drivers, including the affordability and availability of services, the rate of technological innovation (Moore’s Law exerts a particularly powerful influence) and the extent of regulatory intervention. And note that, although the sector is not highly geared to the economy, it is clearly influenced by economic and business cycles. The level of penetration (fixed, mobile and broadband) is a basic driver for telecom services and is, in turn, driven by the availability and affordability of services. Although penetration levels have generally reached very high levels in the developed markets, much demand in emerging markets remains untapped. Developed market operators often therefore look to buy exposure to emerging markets, as they must otherwise rely on growth in new services (eg IPTV or mobile broadband) to drive revenues. Data services have recently been the key growth driver for mobile revenues, and we expect this trend to continue. The three main enablers that we think are underpinning the demand for data services are: (1) better network speed and coverage; (2) increased penetration of data-optimised devices, like smartphones; and (3) improved packaging and marketing of data offerings. The penetration of smartphones is still quite low (c15% in Europe at the end of Q1 2010), so we see considerable potential. 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 unbundling). On the mobile side, the regulators set mobile termination rates (MTR) and roaming tariffs, which have a material impact on mobile revenues and EBITDA. Technology cycles (and upgrades) influence the capex intensity of the industry, and operators that upgrade to the new technology early can enjoy competitive advantages over the laggards (but are also often exposed to the practical problems that inevitably accompany new technologies). The economic environment also has an impact on the telecom sector. Consumer spending is usually less cyclical, while enterprise revenues (eg roaming, 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; on the one hand, there are pay-TV operators, satellite operators and professional publishers whose growth is mainly driven by consumer and service take-up and who generate the majority of their revenues from subscriptions whereas free-to-air TV operators, consumer publishers, communication agencies, market research and outdoor rely predominantly upon marketing expenditure (mostly advertising). The professional publishers are typically conglomerates with multiple areas of business eg trade shows, conferences, newswires, academic publications, specialist trade publications, only a few of which overlap which hinders sector generalisations. 146 abc EMEA Equity Research Multi-sector September 2010 abc All pay-TV operators are more defensive in terms of their revenue-generating abilities during a downturn than are free to air TV operators or advertising agencies.Among the purely advertising-driven groups, the communications agencies and market research are global businesses with high exposure to emerging markets (typically 25% of revenues) whereas the media owners (eg TV, radio, directories and newspapers) are typically local businesses usually wholly exposed to their domestic economies. Only outdoor players are developing a media that is fully advertising-related with a business model that can be duplicated everywhere in the world (and catching growth opportunities in emerging areas). Revenue growth is driven by market share gains from competitors, as well as from other types of media (eg if advertisers shift money from radio to TV), and GDP growth. Top-line momentum, EBITDA margins and FCF generation ability each play a critical role in driving the stocks. Media groups are mostly asset-light, and capital intensity varies according to the platform (eg cable TV is much more capital-intensive than satellite TV). Technology The technology sector is highly heterogeneous. For the telecoms equipment vendors, we focus on the factors driving the operators’ capex lines, while for the foundries, we focus on the capacity utilisation rate, ASPs (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 foundries business, we are cautious about inventory/capacity build-ups and/or slowdowns in the order book. Valuation: equity characteristics and accounting dilemmas Discounted cash flow (DCF) methodology is the most traditional method to value companies in the telecom and media sectors. Traditional relative valuation metrics, such as the forward-looking price-toearnings and EV/EBITDA ratios, are also considered useful. In addition, in the developed countries, investors focus on the 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’s growth. Emerging market players and developed market companies with significant emerging market exposure enjoy higher multiples, due to higher growth potential. Over 2005-07, the average trading PE multiple for the developed market telecom players was 14x, against c17x for the emerging market players. Over 2008-10, 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 thus large pension funds for some. The deficits of some of these funds, like those of BT Group and Portugal Telecom, can be very large – and so become an important valuation driver. In many of the emerging markets, especially for foreign players, regulatory/political risk is significant. Since telecoms is considered to be of strategic importance, some governments over-regulate or impose restrictions on operators. 147 EMEA Equity Research Multi-sector September 2010 Notes 148 abc abc EMEA Equity Research Multi-sector September 2010 Transport and Logistics Transport and Logistics team Robin Byde* Global Sector Head HSBC Bank Plc +44 20 7991 6816 robin.byde@hsbcib.com Joe Thomas* Analyst HSBC Bank Plc +44 20 7992 3618 joe.thomas@hsbcib.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 149 150 Transport sector Airlines Network carriers Airports/Toll roads Low-cost carriers Air France-KLM easyJet British Airways Ryanair Lufthansa Airports Aeroports de Paris Fraport Toll roads Abertis Atlantia Brisa Groupe Eurotunnel Logistics/shipping Integrators Deutsche postDHL Freight forwarders DSV FedEx Kuehne & Nagel TNT Panalpina UPS UK bus and rail Shipping AP MollerMaersk Rail operators EMEA Equity Research Multi-sector September 2010 Transport Bus operators FirstGroup Go-Ahead National Express Stagecoach Vinci Source: HSBC abc Relative stock performance: 10-year performance of MSCI European transport index, MSCI European equity, MSCI World transport index and MSCI World equity index EMEA Equity Research Multi-sector September 2010 200 180 Financial crisis due to over securitisation of risk Rebound and sustained bull market with higher liquidity and business momentum 160 140 9/11 WTC, NY attack 120 100 80 60 January 2003 End of Bear Market (2000-02) 40 Aug-00 Aug-01 Aug-02 Aug-03 MSCI Europe transport index Aug-04 Aug-05 MSCI Europe index Aug-06 Aug-07 MSCI World transport index Aug-08 Aug-09 Aug-10 MSCI World index Source: Thomson Reuters Datastream, HSBC abc 151 EMEA Equity Research Multi-sector September 2010 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 and toll roads, and land passenger transport (in Europe HSBC covers the UK bus and rail sector). Airlines Airlines is a highly cyclical global sector, whose volumes correlate with GDP with a multiplier acrossthe-cycle of c1.5x. Airlines generally operate two business models – full-service network carriers, which combine regional feeder and intercontinental networks, and low-cost carriers, which generally operate intra-regional networks, point-to-point. The network carriers also often have large cargo operations, with revenue correlated with industrial production. In addition, network airlines such as Lufthansa and Air France-KLM have other operations, which include MRO (Maintenance, Repair and Overhauling), IT services and catering services. Low-cost airlines operate on a ‘low cost-low fare’ model. Primarily, they operate a young and smaller fleet, use a single-type aircraft and secondary airports, and provide one class of service and sell unbundled services. Airports and toll roads 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 roads concessions). These private companies have infrastructure to design, build, finance, operate and maintain the projects. The infrastructure operators derive revenues from user tolls fees and hence depend on traffic and tariff fee levels. Traffic is driven by economic activity while tariff increases are set through negotiations with the government. Revenues in this sector are less cyclical while margins tend to improve with the maturity of assets. New projects acquisition is a key strategy in this sector. Airport businesses derive revenues from aviation, retail and real estate activities. If the regulator permits, airports have a free hand to decide their strategy and fees in these segments. Overall, factors such as catchment area, hub attractiveness and international travellers’ portfolio can determine growth potential. Logistics and shipping Most of these supply-chain stocks are cyclical, and earnings correlate with industrial production and consumer demand. 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 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 and tends to be neutral to the cycle. UK bus and rail sector (land passenger transport) The sector comprises four London-listed companies and Arriva (recently acquired). Together these companies run most of the 20 UK rail franchises and control c75% of the provincial bus market. Stagecoach and National Express operate in largely deregulated markets outside London. Go-Ahead, 152 abc Robin Byde* Global Sector Head HSBC Bank Plc +44 20 7991 6816 robin.byde@hsbcib.com Joe Thomas* Analyst HSBC Bank Plc +44 20 7992 3618 joe.thomas@hsbcib.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations EMEA Equity Research Multi-sector September 2010 abc FirstGroup and Arriva 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 they pay access fees to Network Rail. The rail industry is highly regulated and heavily funded by government subsidy and a revenue support system. Key themes Airlines Global and regional recovery in demand and yields: Airlines have reported a recovery in traffic, yields and earnings after a big dip in 2008-09. Cargo traffic recovered sharply but passenger traffic recovery is slow, particularly in Europe. Premium traffic recovery has pulled the yields up. Passenger and cargo yields recovered sharply in Q210, but airlines are expecting yield growth to slow down during the winter (September 2010 to March 2011). Structural cost cuts have also supported the earnings lift. Capacity overhang: 2008-09 recession led to overcapacity. In response to this situation most of the deliveries of new aircraft were postponed and older aircraft from running fleets were parked in deserts to reduce the capacity. Now, with the slow recovery, European airlines are bringing the capacity back slowly. However, the expansion of Middle East-based carriers (capacity to grow at 14-15% CAGR 201015) is a worry as this capacity will be deployed on all the routes globally. Fuel prices, emissions controls and departure taxes: Higher and volatile fuel prices remain a concern for airlines; fuel expenses for global airlines increased by USD55bn in 2008 versus 2007 (IATA). Departure tax (APD) came as extra burden for European airlines as airports in Europe are charging (or planning to charge) a departure tax per passenger. If this tax is fully passed onto the passengers, traffic growth may be hampered but if it is (or a part of it) absorbed by airlines, it will burden their earnings. Also, the European Union plans to start charging for carbon emissions from 2012 when each airline in Europe (other regional airlines flying into Europe) will be charged for carbon emissions above a set limit. Others: includes restructuring of the network/flag carriers and the ongoing threat of other modes of transport such as high-speed rail, M&A, Alliance growth and cross-border JVs. Logistics and shipping Trend growth in global freight flows: We forecast slower freight flow growth in the near future due to factors such as near sourcing and a high basis of comparison. The trade multiplier in 1995-2007 averaged 2.6x global GDP, with an expanding supply chain. We forecast this could contract to 1.5x GDP for the next few years due to the fragility of the global recovery, impact of withdrawal of stimulus and near sourcing. Mid-cycle earnings growth: Clearly 2010 is the bounce-back year for earnings, showing significant growth on soft comparables, with a focus now on trend growth through the mid-cycle. Currently we forecast a fairly healthy 2011-2012 CAGR of 10-11% in operating profits versus c16% 2004-06. Slowing of off-shoring: We believe that global freight is at a pivotal point. The rapid growth of the past 20 years with the expanding economy and off-shoring has slowed and even reversed, with a gathering 153 EMEA Equity Research Multi-sector September 2010 trend for production and assembly to be located nearer to end markets. Peak oil and supply chain security are persuading many production managers to choose Mexico and Eastern Europe over China. Supply overhang in container and dry bulk shipping: There is over-supply 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 the recovery in demand, laid-up ships are coming back into service. Fuel prices: Earnings of logistic companies are inversely correlated with increase in fuel prices. Sector consolidation with healthy balance sheets: Gearing is generally low in the sector and companies either have strong net cash or neutral positions. Many large projects have been completed and we expect capex to remain comparatively subdued in the next two years. M&A will rise, particularly if trend organic growth, as we believe, is slower, and also assuming assets prices remain comparatively subdued. Airports and toll roads Recovery in passenger, cargo and road traffic: This is catching up after a big dip in air and road traffic in 2008-09. Companies with dense networks (like Italian toll roads) or good hub characteristics (Frankfurt or CDG airport) are in the best position to show good growth. Eurotunnel has more catalysts here (HS1, new direct destinations from London, 2012 London Olympics) and better service than its ferry competitors. Expansion in developing markets (Asia and Latin America): These high growth markets, are just exploring the PPP model to develop their infrastructure and will provide the value accretion to its shareholders as returns are higher than in developed markets. Regulation and user demand could be a risk if not analysed properly. Free cash generation with large capital expenditure programmes: Regulatory requirements (Atlantia) and capacity constraints (Frankfurt airport) require large capital expenditure programmes. The revenues realised from the resulting tariff structure and capacity increase (and traffic) should exceed the expenditure incurred. UK Bus and Rail Sector (Land Passenger Transport) UK public spending cuts likely to affect the UK bus industry: The bus industry is heavily subsidised (c40-45% of revenue from taxpayers). The sector has ridden the expansion of public spending but now spending cuts are looming. Since 1997, subsidy increases due to the expansion of the London bus network, maintenance of commercially unviable routes and people over 60 being given right to free offpeak travel. HSBC economists expect cumulative real declines in spending of c25% over four years. We expect subsidies to come under pressure, eroding margins. Political will against operators seems to be growing and investigation by the Competition Commission into non-London bus operations is ongoing. Rail franchise opportunities ahead: Rail passenger revenue trends are strengthening after a stuttering performance in 2009. Volumes are recovering and fares outlook is strong with an expected regulated fare increase of 5.8% in 2010 based on July RPI of 4.8%. However, upside to earnings will be limited by the revenue support mechanism, which de-risks rail franchises four years after they have begun. Up to three new franchises were due to be awarded by the next year – a clear positive for the sector – but government consultation on changes to the franchising system delayed the process. Changing competitive landscape: Facing liberalisation in their home markets, European operators are looking for growth abroad. Deutsche Bahn (German railway operator) recently acquired Arriva. The deal 154 abc EMEA Equity Research Multi-sector September 2010 abc reinforces the threat posed by major European operators. The UK is attractive because of its large, privately-owned market and high margins, especially in bus. This could lead to major M&A activities, but expansion could also come organically through rail franchise wins or smaller acquisition in bus. So competition could intensify and margins may take a hit. Sector drivers Airlines (1) Passenger and cargo capacity (measured in available seat kilometres and available cargo tonne kilometres); (2) passenger and cargo traffic (measured in revenue passenger kilometres and freight tonne kilometres); (3) passenger and cargo load factor; (4) passenger and cargo yields (measured in revenue per RPK/per passenger and revenue per FTKs; and (5) fuel costs (6) gearing. Logistics and shipping (1) Global freight flows, GDP and industrial production; (2) airfreight tonnes; (3) sea freight TEUs; (4) gross profit/unit; (5) parcel shipments per day; and (6) average yields. Airports and toll roads (1) Traffic volumes growth; (2) road and terminal capacity; (3) capital expenditure programme; (4) financial muscles; and (5) dividend yield. There are also other variables, such as length of concession rights and visibility in tariff/fee increases through negotiations of regulatory/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: equity characteristics and accounting dilemmas Airlines There is no single method for valuing an airline, so analysts take different approaches. The most commonly used metrics are: P/BV (versus long run average); EV/EBITDAR; REP; PE for low-cost carriers (PE does not work for network carriers due to negative earnings in the down cycle, which makes it difficult to calculate the long-run average); DCF (as DCF cannot be used as the stand-alone valuation method because the industry is highly cyclical and cash flow visibility is very poor, generally the results of this method are blended with others); and SOTP (if the necessary information is available). Many analysts use a blend of two or more methods mentioned above, to value an airline. 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. EV/EBIT is used to value the construction business. UK Bus and Rail Sector (Land Passenger Transport) SOTP is generally used to value the companies. However, different segments are valued using PE, EV/EBITDA and DCF. 155 EMEA Equity Research Multi-sector September 2010 Notes 156 abc abc EMEA Equity Research Multi-sector September 2010 Travel and Leisure Travel and Leisure team Ben O’Toole* Analyst HSBC Bank Plc +44 20 7991 3448 ben.otoole@hsbcib.com Emmanuelle Vigneron* Analyst HSBC Bank Plc, Paris branch +33 1 56 52 4319 emmanuelle.vigneron@hsbc.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 157 158 EMEA Equity Research Multi-sector September 2010 The travel and leisure sector Travel and Leisure Travel* Hotels Tour Operators Leisure Bookmakers/ Online Gaming Cruise Companies Pubs & Restaurants Caterers/ Vouchers IHG Thomas Cook Carnival PartyGaming Greene King Compass Accor Hotels Tui Travel Royal Caribbean bwin Enterprise Inns Sodexo Whitbread Kuoni 888 Punc h Taverns Edenred M&C Holidaybreak Sportingbet Marston's Playtec h JD Wetherspoon William Hill The Res taurant Group Paddy Power Mitchells and Butlers Ladbrokes Rank *For Airlines, Bus and Rail Companies see Trans port Source: HSBC abc Travel and leisure sector performance Recent performance suggests sector rallies when yield curve (represented by 10-year swap rate – 2-year swap rate) steepens and falls when yield curve flattens 3 2 50% 1 EMEA Equity Research Multi-sector September 2010 100% 0 0% 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 -1 -50% -2 -100% -3 y-o-y % change in FTSE350 Travel and Leisure Index 100% 10 year swap rate - 2 year swap rate (RHS) 50 The sector also tends to track consumer confidence 50% 25 0% 0.0 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 -50% -25 -100% -50 UK consumer confidence indicator- UK SADJ 159 abc y-o-y % change in FTSE350 Travel and Leis ure Index Source: Thomson Reuters Datastream, HSBC EMEA Equity Research Multi-sector September 2010 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. One should note that airlines and bus and rail operators also fall under the travel and leisure umbrella, but in this report are categorised under Transport. Key themes Discretionary spend Unlike other sectors, such as banks or oil and gas, where there is a common denominator for all sector constituents, in the travel and leisure sector similarities between companies are more subtle. For example what connects a pub company to a tour operator, or indeed a hotel to an online gaming company? Broadly the connection is that each company depends on some form of ‘discretionary expenditure’. As an example, consumers are unlikely to view expenditure on eating out, going on holiday or gambling as essential, even if it is enjoyable. Moreover, when confidence and incomes are high, spending on discretionary items is also likely to be strong. Alternatively, if economies weaken, confidence falls and individuals and firms cut discretionary spending to ensure sufficient income is available to cover more important expenses such as staples, rents and utilities. It is the dependence on discretionary spending that makes the sector more cyclical than many others. Long-term growth Despite this cyclicality, all sub-sectors have in the past, and most likely will over the long term, exhibit real structural growth. Travel-related companies such as hotels, tour operators and airlines benefit from GDP growth, while increased globalisation means more people travelling and political change 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, sport events and gambling. Part of the art of investing in the Travel and Leisure sector is to determine which factors influencing demand and supply are cyclical and which are structural. Sub-sector drivers Considering the diversity of the sector, we think it is best to analyse each sub-sector independently, knowing that each one 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. In contrast, opening a new restaurant is much easier as there are relatively few barriers in the restaurant industry. At the same time, average spending is high in the cruise industry but volumes are low, while average spending per head in restaurants is low but volumes are high. Although clearly not exhaustive, we have highlighted below some of the key themes to be aware of within each sub-sector: Pubs and restaurants: growth of the eating-out market versus the decline of the drinking-out market; changes in taste and preferences, such as for locally sourced produced and healthier menus; freehold versus leasehold sites and property values; managed, leased, tenanted or franchise-based 160 abc Ben O’Toole* Analyst HSBC Bank Plc +44 20 7991 3448 ben.otoole@hsbcib.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations EMEA Equity Research Multi-sector September 2010 abc operating models; a fragmented industry with consolidation potential; input cost inflation; competition from supermarkets and the off-trade; changes in duty and taxes; changes in regulation. Hotels: penetration of branded hotels versus non-branded hotels; low growth in developed markets versus growth in emerging markets; asset-light versus owner-operated business models; recovering demand and limited new hotel capacity; changes in corporate travel budgets; loyalty schemes; asset values. Cruise and tour operators: changes in aircraft and ship 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. Bookmakers and gambling: 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. Caterers: 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); opportunities in facilities management. Sector drivers Consumer and business confidence Quite simply, increasing confidence means greater discretionary spend. We have outlined that relationship for consumers above, but it is also worth considering business confidence. Corporate spending on airlines and hotels usually fluctuates with the economy, with flights and rooms being upgraded to premium categories in the good times, but travel restrictions quickly being enforced in tougher economies. 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 barely increasing, particularly in developed markets. Meanwhile, demand has recovered strongly, which has helped hoteliers increase prices over the last 12 months. 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 Yet again input costs differ between sub-sectors. However, labour is more often than not one of the highest costs. Other key costs are food and beverage costs for hoteliers, pubs and restaurants and fuel costs for cruise and tour operators and airlines. These costs ultimately depend on commodity markets, although businesses tend to have long-term contracts with suppliers in order to reduce volatility. Changes in regulation and taxation Changes in regulation often create big operation 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 work 161 EMEA Equity Research Multi-sector September 2010 places in the UK in 2007 (which includes public places such as bars and restaurants), wet-led pub operators quickly had to substitute declining alcohol sales, due to the change in customer mix, with food sales. 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. Valuation: equity characteristics and accounting dilemmas Valuation Understandably there is not one valuation methodology that is appropriate to the whole sector. In fact there is not one relevant methodology within most sub-sectors. Take for example the pub sub-sector. Since the industry is mature and variables such as revenues, costs and capex and therefore cash flows are relatively predictable, a DCF valuation is often favoured. However, a DCF fails to consider the asset backing inherent in the freehold pub companies, which a price/NAV would account for. Likewise in the hotel industry there are two models – capital-intensive, where the operators own the assets, and asset-light, where the operators do not own the asset, but control the brand and marketing using management contracts and franchise agreements. 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. In our view, the best way to approach valuation is to use a range of methods. However, we think the most commonly used are relative multiple analysis and discounted cash flows with returns-based measures and asset values providing support. 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. Investors need to be aware that as these liabilities are often spread over a long period of time; the actual level of gearing can be understated. To compensate for this, a calculation is made to determine adjusted net debt/EBITDAR, and capitalising the annual lease cost at 8x is often used. Alternatively investors can focus on the fixed cover charge, which takes into consideration both interest costs and rent. Another area to focus on is working capital. Assuming the top line is growing, then working capital tends to be positive, since cash is paid when goods and services are acquired, but suppliers are often paid 90 days later. However, if sales fall, then less cash comes in but suppliers still need to be paid, and there is a working cash outflow. This is particularly important for tour operators as, due 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 from customers paying 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 prior year. 162 abc abc EMEA Equity Research Multi-sector September 2010 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 Sector sales Mark van Lonkhuysen* Sector Sales HSBC Bank Plc +44 20 7991 1329 mark.van.lonkhuysen@hsbcib.com Billal Ismail* Sector Sales HSBC Bank Plc +44 20 7991 5362 billal.ismail@hsbcib.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 163 164 The utilities sector Power / Gas Water / Waste Regulated Non-Regulated Regulated Non-Regulated National Grid Scottish & Southern Northumbrian Water Group Veolia Environnement Snam Rete Gas Centrica Pennon Group Suez Environnement Enagas International Power Severn Trent Seche Environnement Red Electrica Drax Group PLC United Utilities EMEA Equity Research Multi-sector September 2010 Utilities E.ON RWE EDF GDF Suez Enel Iberdrola Gas Natural Energias de Portugal Fortum OYJ Verbund CEZ a.s. Source: HSBC abc Dividend yield (%) of MSCI European Utilities versus MSCI Europe EMEA Equity Research Multi-sector September 2010 7 2. But the yie ld premium narrowed during 2004-2008 when the sector 6 traded at a higher PE - valu ations underpin ned by a strong upturn in 1. The European Utilitie s sector has historically traded at c40% dividend yield premium to the market (MSCI Europe). commodity prices (oil, gas, power prices). 5 4 3 3. However, in wake of the recent global financia l crisis and the consequent declin e in commodity prices, the sector has regained its 2 dividend yield premium to the market. 1 0 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 MSCI Europe - dividend yield Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 MSCI Europe Utilities - dividend yield Source: Thomson Reuters Datastream, HSBC abc 165 EMEA Equity Research Multi-sector September 2010 Sector description Traditionally seen as a defensive sector but earnings volatility increasing The European utilities sector encompasses companies operating across the value chain in electricity, gas, water and environment services. For electricity and gas, upstream activities include: power generation, oil and gas exploration and production, while downstream activities are related to retail sales and services. These activities are lightly regulated in Europe. However, infrastructure activities (transmission and distribution networks and pipes) are subject to regulated returns. Environmental and waste services are competitive activities, water supply activities in England and Wales are subject to regulated returns in contrast but are unregulated in France. Operating profit margins are higher in more asset-intensive and regulated activities, but lower in retail supply (single digits) owing to competitive pressures. As regulated networks are relatively immune to economic cycles, the sector is traditionally seen as a defensive sector or yield play. However, unregulated activities have become less defensive as political pressure (the threat of re-regulation), environmental legislation (Kyoto targets), competition and volatility in commodity prices have contributed to eroding margins. Key themes Power EU energy policy and regulation – competitive pressure Given the challenges of rising energy demand, finite fossil fuel resources and the need to protect the environment, energy policy and regulation in Europe are being centred on three overarching objectives: 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 suppliers. However, lack of interconnection among networks and barriers to cross-border M&A activity have put a brake on this aspiration. Although network activities have been legally unbundled from generation and supply activities in most countries, competition is still weak and there are high barriers to entry owing to high capital costs. In several of the EU’s major markets (France and Germany) the former monopolies still control the transmission and distribution networks. Climate change energy policy – subsidy pressure The ‘20-20-20’ EU goal aims for a 20% reduction in primary energy consumption and carbon emissions, and for 20% of energy needs in the EU to be met by renewables by 2020. The impact of climate-changerelated policy will continue to affect the utilities sector. The regulated companies will potentially benefit from the need to build new grid to connect renewable energy installations, and to reinforce the existing grid to withstand huge fluctuations in renewable output. The non-regulated companies will suffer as a result of the reduced load factor from existing plants and the limited load factor from new flexible plants (CCGT, for the most part) caused by the construction of renewable plant – particularly wind. These companies hope to take advantage of renewable subsidies to offset the lower profitability of their conventional plant by involving themselves in renewable activities, usually via listed subsidiaries. Owing to the fall in load factors of conventional thermal plant, there have been calls from within the industry 166 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 EMEA Equity Research Multi-sector September 2010 abc (E.ON for example) for capacity payments to be paid to generators for running conventional flexible plant as a means of guaranteeing security of supply when renewable generation output fails (wind, hydro). The EU cap-and-trade system – the European Union Emissions Trading Scheme (EU-ETS) – is a mechanism for encouraging companies to reduce carbon emissions by requiring them to purchase carbon certificates to cover amounts that exceed their free allocations. Under the current EU-ETS, generators receive a varying amount of carbon emission certificates free of charge and will do so until 2012. By 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. Energy security and an ageing European fleet – medium-term profit outlook improving The economic crisis led to an increase in the capacity reserve margin (unallocated power available to the grid) and has reduced the need for new investments. It has also reduced spreads (the profit margins achieved by generators). However, new build will be increasingly required in the second half of the next decade irrespective of the degree of demand recovery. Europe has a plant ageing problem, as close to 60% of its conventional plants are in the second half of their lifecycle. Also, under the EU Large Combustion Plant directive (LCPD), a significant number of non-compatible plants are expected to close in 2015. These supply-side constraints call for significant investments, and in clean technologies. There will also be a need to invest in network reinforcements. We believe these pressures could lead to a recovery in spreads and profitability for the sector. Political risk increasing Political and regulatory risk increased with the economic downturn, as EU governments again recognised the possibility of using utilities’ profits and/or driving down regulated utility returns to reduce customers’ bills. Germany intends to raise EUR2.3bn annually from the nuclear power generators as part of its 201114 austerity plan. In the wake of the German nuclear tax, the prospect of regulatory risk has now moved on to Spain, Italy, Belgium and Finland. Whereas Belgium and Sweden already tax nuclear power, Finland now intends to do so as well. Belgium imposed a levy of EUR250m on its nuclear industry in 2008 and 2009, and Sweden already levies EUR6.7/MWh of nuclear output (revised in 2008). In late March 2009 Finland said it intended to levy EUR30m-330m starting from 2011. The UK power companies contribute to a poverty package for consumers but, given the need for investment – especially in new nuclear – we view heavy taxes on generation as less likely in the UK. Growth areas: Emerging markets and renewables Faced with low growth in mature western European markets, utilities have expanded their investment in renewables and their presence in emerging markets (CEE, Russia, Latin America and the Middle East) in search of growth. Major companies with a sizeable presence in renewables and exposure to high-growth markets include Iberdrola, EDP and Enel. Markets include: (i) Latin America: GDF Suez, Gas Natural, Iberdrola, EDP and Enel (through Endesa); (ii) Russia: Fortum (TGK-1, TGK-10), E.ON (OGK-4), and Enel (OGK-5); and (iii) Middle East and Asia: GDF Suez, International Power. Water Investment in growing asset bases Water companies continue to invest in the water network, rehabilitating ageing pipes and enhancing waste water treatment, to comply with EU directives – most notably those covered by the EU Water Framework 167 EMEA Equity Research Multi-sector September 2010 Directive (2013). 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 55-65%. 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 and municipalities led to fewer water treatment and desalination project awards over 200910. We believe contracts will be awarded and growth will resume, especially in areas of acute water shortage – Middle East, Australia, China and some parts of the US. Sector drivers For utilities, earnings drivers differ depending on whether the operations are regulated or unregulated. 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: (i) investment/RAB growth; (ii) the level of allowed returns/WACC; and (iii) operational, financial efficiencies. Unregulated stocks The profitability drivers of unregulated activities are explained below: Demand growth: Overall, energy demand is directly linked to the pace of economic growth, industrial demand being more cyclical and residential demand being stable. Other factors affecting energy demand are demographic changes and advances in energy efficiency methods. Demand growth also affects environmental services. Reduced demand caused by the economic recession has been a negative influence on the waste management activities of the water companies. Commodity prices and power activities: Higher economic growth and consequently higher fuel prices (oil, gas, coal) result in higher power prices – a trend that benefits upstream power generation companies but hurts downstream suppliers. The profitability of power generators also depends on the nature of their assets. For power generators with baseload assets (hydro, nuclear and lignite), earnings tend to be highly geared to commodity prices, and their key profit metric is the achieved power price, as variable costs for such technologies are very low. For mid-merit (coal and gas) plant operators, the key profit driver is the spread between power prices and associated fuel and carbon costs. Finally, for peaking (gas, oil and pumped storage) plant operators, short-term volatility is a key profit driver. In addition to engaging in downstream retail activities that act as 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. 168 abc EMEA Equity Research Multi-sector September 2010 abc Commodity prices and gas activities: The profitability of upstream E&P operations is a direct function of the trend in oil and gas prices, which, in turn, is linked to the level of economic activity and the structural demand-supply balance in a market. Downstream gas suppliers in Europe mostly secure gas on long-term contracts (indexed to oil prices), so movements in spot gas prices versus long-term contracted gas price determine the profitability of gas suppliers. Demand-supply mismatch and level of integration: Power prices and pressure on spreads tend to be lower where reserve margins are comfortable (ie supply exceeds peak demand). Also, the level of interconnection between countries can influence the level of prices through the import/export of energy. Albeit for the time being the level of interconnection in Europe remains relatively low. Weather: The weather affects the sector on both the demand and supply sides. On the demand side, for example, a cold winter can increase energy demand, whilst on the supply side, wind conditions and water/hydro reservoir levels affect the level of electricity production from renewable energy sources. Valuation: equity characteristics and accounting dilemmas Valuation parameters Regulated or midstream activities: For regulated stocks whose infrastructure/networks assets produce relatively stable returns, the preferred valuation techniques are: (i) DDM: higher dividend visibility given stable regulated earnings and a defined dividend payout range; (ii) DCF: the source of value is the company’s ability to generate free cash flows and long-term growth; (iii) residual income method: the technique focuses on value creation through a company’s ability to earn returns above the level allowed by the regulator, and captures long-term growth; (iv) asset valuation: application of a premium or discount to the RAB depending on the quality of assets. Upstream activities: Unlike regulated stocks, utilities whose business model is dominated by upstream power generation, or upstream oil and gas, have volatile earnings that are geared to trends in commodity prices (oil, gas, coal and carbon). Consequently, such stocks tend to trade at higher market multiples during an upturn in commodities, and vice versa. Power generation assets are typically valued by the DCF/MW of a particular technology, with baseload 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 plants). Downstream activities: Although profit margins are high in upstream activities, they are low in the downstream or retail supply of power or gas owing to intense competition. 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 50-60%). 169 EMEA Equity Research Multi-sector September 2010 Notes 170 abc EMEA Equity Research Multi-sector September 2010 abc Basic Accounting Guide *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 171 abc EMEA Equity Research Multi-sector September 2010 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 pricin g. Substitute producers provide a price ceiling. A sin gle strategic supplier can put pressure on industry margins. If switching costs are hig h, suppliers can put pressure on the in dustry. 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, existin g players are likely to squeeze out new entrants, legislation or government action prevents entry, branding or differentia tion is high. Rivalry High rivalry will result from the extent to which players are in balance, growth is slowing, customers are glo bal, 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 hig h. Substitute products Power of customers Alternative means of fulfilling customer needs through alt ernative industries will put pressure on demand and margin s. Product for product (email for fax), substitution of need (precision casting makes cutting tools redundant), generic substitution (furnit ure 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 switchin g is easy and low cost and the threat of upstream integratio n is high. COMPANY Strengths Patents Strong band and/or reputation Locatio n of the business T he products, are they new and innovativ e Quality process and procedures Specialist marketing expertise Opportunities Developin g market eg Internet, Brazil Mergers, strategic alliances Loosening of regulations Removal of international trade barriers Moving into a new market, be through new products or new market place Market lead by a in effective competitor Scoring range 1–5 (high score is good) Weaknesses Undifferentiated products and services, in relation to the market Poor qualit y goods or services Damaged reputation Competitors have superio r access to distribution channels Locatio n of the business Lack of marketing expertise Threats New Competitor Price war Competitors has a new, innovative substitute product or service Rivals have a superior access to channels of supply and dis trib ution Increased trade barrier Taxation and/or new regula tions 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. 172 abc EMEA Equity Research Multi-sector September 2010 The figure above combines a diagram of Five Forces model for analysing an industry with an outline of a SWOT analysis for evaluating a company. Porter’s Five Forces is an analytical approach which 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 into 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, then how it is valued, then the inputs of the valuation. This accounting guide can be used to help gain a better understanding of company’s financial statements. Also included is a brief introduction to balance line 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 felt 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 suited for ratios above the interest P&L 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 Enterprise Value The value of all business actives Operating Enterprise Value Total EV less non-operating assets at market value Core Enterprise Value Total EV less non-core assets, this makes Core EV more subjective but can be used for ratios such as Core EV/core business sales. Source: HSBC 173 EMEA Equity Research Multi-sector September 2010 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 companies’ 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’ Or 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 GBP100million company. Company A will have a GBP20 million 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 EV, DCF valuation, etc. at fair value (rather than the book value used in the balance sheet). For example if the fair value was GBP30m then this would be added to EV and deducted as part of the DCF. Pension Obligations This is a projected sum of total benefits which 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 subsidize the discrepancy. Defined Contribution, here 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. 174 abc abc EMEA Equity Research Multi-sector September 2010 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: 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 175 abc EMEA Equity Research Multi-sector September 2010 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 arrive at an estimate for market assessed cost of capital (MACC). This MACC value can be used to compare 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 the smaller the PE is 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 page 1 to calculate) Annual Sales EV (see page 1 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 to 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) to sales than, say, price/sales. EBITDA (earnings before interest, tax, depreciation and amortisation) is also above the interest, associates and minorities lines, so comparing to EV is consistent and popular. Economic Value Added (EVA), Residual Income This is a measure of the 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) 176 abc EMEA Equity Research Multi-sector September 2010 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) due to 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 part of 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 due to 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 177 abc EMEA Equity Research Multi-sector September 2010 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 to 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; and 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 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 happened every 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 then the book value ought to 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 the 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 (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 which are brought about by the operations of the company, e.g. the 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). 178 abc EMEA Equity Research Multi-sector September 2010 Key accounting ratios Ratio Current ratio Quick ratio Debt/equity ratio Net Profit Margin ratio Interest coverage ratio Return on equity (ROE) Calculation Definition/Interpretation Current liabilities Current assets 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’s Fund This measures the company’s financial leverage, by indicating the ratio of debt to equity. Profit after tax Sales * 100 EBIT Interest 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. 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’). 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. 179 EMEA Equity Research Multi-sector September 2010 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 used 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 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 also include their share of profits from associates, dividends from investments and various other factors (eg f/x gains and losses) in a Financial Items line along with interest. Pre-tax Profit (PTP) 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 cost, property cost, 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 below items are rarer. 180 abc EMEA Equity Research Multi-sector September 2010 abc 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 that they expect 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. 181 EMEA Equity Research Multi-sector September 2010 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 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. 182 abc EMEA Equity Research Multi-sector September 2010 abc 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 into capital assets. Capital expenditure Any buying or selling of fixed assets which allow the running of the company to take place. Expenditure on intangible assets Buying or selling of intangible assets which 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 which 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. 183 abc EMEA Equity Research Multi-sector September 2010 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 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 EV/EBIT EV/NOPLAT EV/IC ROIC/WACC Calculation EV EBIT 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. This section was prepared by Uktarsh Majmudar and Ruzbeh Bodhanwala, Global Research – Best Practise, HSBC EDP (India) Private Ltd 184 EMEA Equity Research Multi-sector September 2010 abc Notes 185 EMEA Equity Research Multi-sector September 2010 abc 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. 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 risk free rate for that stock's domestic, or as appropriate, regional market and the relevant equity risk premium 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 implied return 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. 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, 186 abc EMEA Equity Research Multi-sector September 2010 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 13 September 2010, the distribution of all ratings published is as follows: Overweight (Buy) 51% (21% of these provided with Investment Banking Services) Neutral (Hold) 36% (18% 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 14 September 2010. All market data included in this report are dated as at close 26 August 2010, 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. 187 EMEA Equity Research Multi-sector September 2010 abc Disclaimer * Legal entities as at 31 January 2010 Issuer of report 'UAE' HSBC Bank Middle East Limited, Dubai; 'HK' The Hongkong and Shanghai Banking HSBC Bank plc Corporation Limited, Hong Kong; 'TW' HSBC Securities (Taiwan) Corporation Limited; 'CA' HSBC 8 Canada Square Securities (Canada) Inc, Toronto; HSBC Bank, Paris branch; HSBC France; 'DE' HSBC Trinkaus & London, E14 5HQ, United Kingdom Burkhardt AG, Dusseldorf; 000 HSBC Bank (RR), Moscow; 'IN' HSBC Securities and Capital Markets (India) Private Limited, Mumbai; 'JP' HSBC Securities (Japan) Limited, Tokyo; 'EG' HSBC Securities Telephone: +44 20 7991 8888 Egypt S.A.E., Cairo; 'CN' HSBC Investment Bank Asia Limited, Beijing Representative Office; The Fax: +44 20 7992 4880 Hongkong and Shanghai Banking Corporation Limited, Singapore branch; The Hongkong and Website: www.research.hsbc.com Shanghai Banking Corporation Limited, Seoul Securities Branch; The Hongkong and Shanghai Banking Corporation Limited, Seoul Branch; HSBC Securities (South Africa) (Pty) Ltd, Johannesburg; 'GR' HSBC Pantelakis Securities S.A., Athens; HSBC Bank plc, London, Madrid, Milan, Stockholm, Tel Aviv, 'US' HSBC Securities (USA) Inc, New York; HSBC Yatirim Menkul Degerler A.S., Istanbul; HSBC México, S.A., Institución de Banca Múltiple, Grupo Financiero HSBC, HSBC Bank Brasil S.A. - Banco Múltiplo, HSBC Bank Australia Limited, HSBC Bank Argentina S.A., HSBC Saudi Arabia Limited. 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HSBC Bank plc 2010, 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) 142/06/2010 and MICA (P) 193/04/2010 188 EMEA Equity Research Multi-sector September 2010 HSBC Nutshell David May* Head of Equity Research. EMEA HSBC Bank Plc +44 20 7991 6781 david.may@hsbcib.com David May is Head of Equity Research, EMEA (Europe and CEEMEA regions) at HSBC, a role he has been in since August 2007. He was previously Global Head of Equity Product Management at HSBC. Prior to HSBC, David worked in an Equity Sales role and an Equity Product Management role at a major American investment bank. HSBC Nutshell A guide to equity sectors Tim Hammett* Head of Research Marketing, EMEA HSBC Bank Plc +44 20 7991 1339 tim.hammett@hsbcib.com Tim Hammett is Head of Research Marketing for EMEA, He joined HSBC in August 2009, bringing seven years experience of research marketing and knowledge management with a major American investment bank and a previous 13 years of equity fund management experience. Nicholas Peal* Research Marketing, EMEA HSBC Bank Plc +44 20 7991 5353 nicholas.peal@hsbcib.com Nicholas joined HSBC in 2006. Prior to his current role within research marketing he gained experience in both foreign exchange and interest rate derivative product areas. Multi-sector – Equity This guide will help you gain a quick, but relatively thorough understanding of 22 equity research sectors and industry groups It will help you to understand the organisation of the sector, the key drivers, indicators and themes, historical context, and suitable valuation approaches It is also an open offer to access HSBC’s expertise in fundamental equity sector research *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations. Co-ordinated by David May, Tim Hammett and Nicholas Peal September 2010 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
