MORGAN STANLEY RESEARCH
December 4, 2013
NORTH AMERICA
Big Debates: 2014
Key Investor Debates Likely to Drive Stocks in the Upcoming Year
Even with the S&P 500 close to all-time highs, our North America
Strategy team still sees 12% upside to the index at year-end
2014. Further, using what it’s called "potentially a contrarian bull
thought process," the team believes that the possibility of a
steeper yield curve, a view that the Fed can distinguish between
tapering and tightening, and the lack of a credible bear case in
earnings could drive additional upside. In that context, we think
2014 will be another good year to find double-digit absolute return
opportunities.
Yet some of the underpinnings of our strategists’ thesis are not
universally accepted — debate swirls over how the Yellen Fed will
manage policy; whether “Abenomics” can rekindle Japan’s economy; China’s prospects for transitioning to reform-driven growth;
and whether Europe is truly past its sovereign and banking crises.
2
Asset Managers ....................................................................................
Will Alternative Asset Manager Multiples Re-Rate?
4
Autos & Autos-Related ........................................................................
Storm Clouds Gathering?
Bank of America
6
Will Expense Saves Fall to the Bottom Line?
8
Cable / Satellite .....................................................................................
Will 2014 Be the Year for Transformative Consolidation?
10
Canadian Pacific Railway ....................................................................
Can We Stay Bullish After This Run? ‘Yes, We Can!’
12
Chemicals ..............................................................................................
Will Ethane Feedstock Costs for Petrochemicals Fall in 2014?
14
Consol Energy ......................................................................................
Will Consol Re-Rate to Reflect Its ‘Sum-of-the-Parts’ Value?
16
Education ..............................................................................................
Is Demand for Higher Education Inelastic?
18
Food .......................................................................................................
With those ideas in mind, we publish our annual edition of Big
Debates. In this report, we highlight key debates that we think will
drive the performance of industries and stocks in 2014.
We asked our analysts to look at the industry- and companyspecific investor debates that are likely to drive stocks in the upcoming year. We looked for debates that are likely to matter, that
are likely to be settled (or significantly advanced) in the coming
year, and for which we have a view that differs sharply from the
current market view.
Our job as securities analysts starts with conversations with leading investors. We look to identify which debates matter today, and
more important, which will matter tomorrow. Through these conversations, along with an increasing array of analytics, we also
get a read for “what’s in the price” — the expectations that may
warrant the current price.
Will US Food Manufacturers See a Deflationary Benefit in 2014?
20
Gaming & Lodging ...............................................................................
Does Online Gaming Represent a Meaningful
Growth Opportunity?
22
Healthcare Services / P&C Insurance / Managed Care ....................
Will Private Exchanges Take Over? Winners & Losers
26
IT Hardware and Services....................................................................
How Does Cloud Computing Affect Hardware
and Services Companies?
28
Machinery ..............................................................................................
Will the US Non-Residential Construction Market
(Finally) Recover in 2014?
30
Multi-Industry ........................................................................................
How Much Operating Leverage Is Left This Cycle?
32
Real Estate Investment Trusts ............................................................
Single-Family Rentals: Is Buy-to-Rent on an Institutional
Scale a Sustainable Business or a Trade?
34
Semiconductors ...................................................................................
Will There Be Consolidation in the Wireless Baseband Market?
36
Software.................................................................................................
As always, we look forward to your feedback.
Convergence to a Digital Marketing Suite in 2014?
38
Telecom Services .................................................................................
Could FCF Pressures Drive Multiple Compression in 2014?
Steve Penwell
Director of North America Research
40
United Continental Holdings ...............................................................
We’re Bullish on the Cycle and the Turnaround
Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that
the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley
Research as only a single factor in making their investment decision.
For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report.
+= Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to
NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Asset Managers
Will Alternative Asset Manager Multiples Re-Rate?
Morgan Stanley & Co.
LLC
Matthew Kelley
Matthew.Kelley@morganstanley.com
Our View
Market View
We believe alternative asset managers could continue to
outperform and multiples could begin to re-rate in 2014.
While the stocks are up an average 51% YTD, we estimate
that relative P/E multiples (vs. S&P 500 and traditional asset
managers) are roughly flat. We think the multiples could rerate in 2014 based on our expectation of a strong backdrop, for
three reasons: (1) robust equity market returns; (2) an open
exit window; and (3) strong secular fundraising tailwinds. We
view Blackstone (BX, $28.58) as best-positioned given the
potential for increased realizations (first in real estate, then in
private equity) driving a higher distribution, and strong fundraising growth across its global, diversified platform.
Alternative asset manager stocks are up 51% on average
YTD, and investors are asking if it’s time to sell the space.
As the best-performing stocks YTD have been somewhat momentum plays on which firm could experience the biggest increase in distributions, some investors think that exits may
have peaked and others are trying to buy the laggards with
potential distribution inflections. However, we note that alternative asset managers are still trading at just ~10x 2014 ENI
(vs. traditional asset managers at ~16x), which we view as the
best indicator of earnings power for the stocks. We see an
attractive 19% total return, including 7% yield, for the group.
Constructive on Alternative Asset Managers into 2014, Potential for Re-Rating
Alternatives Outperforming YTD, but Relative P/E Multiples Are Flattish
100%
MSe @ 1/4/13 Current MSe
80%
60%
40%
Alts only start to
outperform S&P
500 on 12/18/12
20%
Alternative AM Mean
Price / ENI
Price / ENI
2013e
2014e
8.9x
10.2x
Traditional AM
13.9x
15.8x
S&P 500
13.5x
15.3x
Relative to Traditionals
64.3%
64.3%
Relative to S&P 500
66.0%
66.4%
0%
2/
1/
3/
20
3/ 12
3/ 201
3/ 2
2
4/ 01
3/ 2
5/ 201
3/ 2
2
6/ 01
3/ 2
7/ 201
3/ 2
2
8/ 01
3/ 2
2
9/ 01
3/ 2
10 20
/3 12
11 /20
/3 12
12 /20
/3 12
/2
1/ 01
3/ 2
2
2/ 01
3/ 3
3/ 201
3/ 3
2
4/ 01
3/ 3
5/ 201
3/ 3
2
6/ 01
3/ 3
7/ 201
3/ 3
2
8/ 01
3/ 3
2
9/ 01
3 3
10 /20
/3 13
11 /20
/3 13
/2
01
3
-20%
Avg Alternative AMs
S&P 500
Avg Traditional AMs
S&P 500 Financials Sector
Traditional AMs include AB, BEN, BLK, FII, IVZ, JNS, LM, TROW, WDR. Alternative AMs include: APO, BX, CG, KKR, and OAK. OAK estimates reflect ANI. APO not included in RHS exhibit in
1/4/13 Price / ENI 2013e as company was not covered at the time. Source: Thomson Reuters, Morgan Stanley Research estimates. Data through 11/25/13.
Three Potential Catalysts for Multiples Re-Rating
 Strong Equity Markets
Strong equity markets typically lead to high realization
levels, so investors assign higher value to future carry.
 Distributions Remain Elevated
PE exits and distributions are elevated vs. history. The
realization backdrop remains strong, with significant fair
value remaining from pre-2008 available to harvest.
 Strong Secular Fundraising Tailwinds
We forecast $84B of avg. annual fundraising for alts under coverage from 2013-17 (vs. $66B from 2010-‘13)
and see growth in pensions, SWFs, and HNW/retail.
Catalyst 1: Investors Place Higher Value on Future
Carry in Strong Equity Markets
As discussed in our November 7, 2011 initiation report
(Initiating on BX & KKR: Carry Creation and Structural Growth
Not Fully Appreciated), the market-implied value of future
carry rises as equity markets rise. For example, the market
placed an ~$8/share higher value on Blackstone’s future carry
from 2Q12 – 3Q13, while the S&P 500 was up 23% during
that time period (see chart below). With the S&P 500 up
~26% YTD, we believe the backdrop for valuation of future
carry – and therefore potential additional multiple expansion –
remains favorable.
2
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Exhibit 1
Future Carry: Market Places Higher Value on Carry
When Equity Markets Are Strong
BX Valuation vs S&P 500
Market implied value of carry has
increased by ~$8 since 2Q12
$30
$25
$6.28
$20
$15
$5.12
$3.22
$3.27
$3.47
fundraising tailwinds for the industry, although the next legs of
growth are likely to be increasingly focused on high net worth
and retail.
1,800
Exhibit 3
1,700
Allocation Increases: Major Investor Buckets That
Have Increased Allocations to PE
1,600
1,500
$0.95
0%
1,400
$10
1,300
$5
1,200
$0
($1.80) ($1.90) ($0.14)
($1.21) ($1.10)
1,100
Net Fee-Related Earnings
Accrued Carry
S&P 500 (Right Axis)
3Q13
2Q13
1Q13
4Q12
3Q12
2Q12
1Q12
4Q11
3Q11
2Q11
1,000
1Q11
($5)
5%
10%
15%
20%
25%
30%
2.6%
2.6%
Insurance Companies
Private Sector Pension
Funds
4.3%
5.6%
2009
2013
5.0%
6.3%
Public Pension Funds
Investments + Cash
Implied Value of Future Carry
8.8%
Foundations
11.7%
Source: Company Data, Thomson Reuters, Morgan Stanley Research estimates
8.3%
Endowments
12.9%
Catalyst 2: Distributions Poised to Remain Elevated
We expect realizations – and unitholder distributions – to remain at elevated levels in 2014-15, assuming continued
strength in equity markets, especially given the significant
amount of fair market value remaining from pre-2008 funds.
In our November 13, 2013 industry report (Still Constructive
on Alternatives, KKR to Overweight) we illustrated that YTD
aggregate distributions per unit for BX, KKR, and APO are up
a combined 167% vs. 2012, and that there has been a strong
(albeit short) relationship between exit activity and the stock
price performance of BX and KKR (KKR, $23.73).
Exhibit 2
Net Realized Carry: We Expect It to Grow in 2014-15
17.9%
Family Offices
24.5%
Source: 2013 Preqin Investor Network Global Alternatives Report via Carlyle Investor Day
2013 Presentation, Morgan Stanley Research
BX: Best Way to Play Re-Rating
We view BX as the best way to play a potential re-rating of the
group given its global, diversified fundraising platforms and
our expectations for distributions to pick up meaningfully in
2014 as Real Estate and PE exits increase. We also expect
10.5% CAGR in fee-paying AuM from 2013-17, which would
be best in the peer group, to lift the floor value of the stock if
markets pull back (when investors pay less for future carry).
($bn)
$6.0
Exhibit 4
$5.0
We Favor BX: Most Diversified Fundraising Platform
with Strongest Fee-Paying AuM CAGR In 2013-17e
OAK
KKR
CG
BX
APO
$4.0
$3.0
$2.0
Fee-Paying AUM CAGR
Blackstone Group
10.5%
10.0%
KKR & Co.
$1.0
$-
Oaktree Capital
2011
2012
2013e
2014e
7.9%
2015e
Source: Company data, Morgan Stanley Research estimates
Carlyle Group
5.1%
Catalyst 3: Strong Secular Fundraising Tailwinds
As discussed in our 10/8/13 Morgan Stanley Blue Paper,
Global Asset Managers: Great Rotation? Probably Not, we
expect outsized organic growth for alternative asset managers
relative to the broader asset management industry. PE industry fundraising has picked up in 2013, with pro forma levels on
track to reach the highest total since 2008. We continue to
view pension funds and sovereign wealth funds as the largest
Apollo Global
3.4%
0%
2%
4%
6%
8%
10%
12%
Source: Morgan Stanley Research estimates
3
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Autos & Auto Related
Storm Clouds Gathering?
Morgan Stanley & Co.
LLC
Adam Jonas
Adam.Jonas@morganstanley.com
Ravi Shanker
Ravi.Shanker@morganstanley.com
Our View
Market View
The auto industry is clearly in better shape than it was in
2006, but it might not be quite as good as you think it is.
We are observing a growing number of cracks in the surface of industry pricing discipline, highlighted by the 3 Cs:
Credit, Currency, and Capacity. The North America industry
is adding back more than 100% of the capacity it cut in the
downturn. Along with rising credit losses, sub-prime back to
pre-recession levels, auto loan term length higher than ever,
booming lease volumes, normalizing used car prices, and
weaker yen could make 2014 a difficult year. Thus, we prefer
shares of suppliers with secular drivers plus outsized exposure
to improvement in Europe — BorgWarner, Delphi, and TRW.
There is still enough room for US SAAR to grow through
pent-up demand met by the capacity increase, with pricing
staying strong. The market also expects used prices to remain resilient in the face of increasing supply of off-lease vehicles.
Further, the market believes that a high degree of Japanese
car production transplanted to the US substantially mitigates
the impact of the weaker yen to merely a translation of profits
rather than a transaction impact.
The 3 Cs: Credit, Currency, and Capacity
Exhibit 1
Exhibit 2
Average Auto Loan-to-Value
Subprime Sales as % of Total New
Auto Loan-To-Value
18%
96%
8.0%
16%
94%
6.0%
14%
6%
Source: Edmunds, Morgan Stanley Research
Credit
Subprime auto credit has returned to pre-crisis levels.
Consumers with sub-prime credit (defined by CNW as a FICO
score below 620) account for ~13% of auto sales in the US
market. This marks a full return to the pre-crisis highs seen in
2006, and a sharp increase from the lows of 2% in late 2008
and 4% in early 2009.
Loan-to-value is back to normal levels. In our opinion, the
most important measure of auto credit availability is auto loanto-value (LTV). Auto loan-to-value in the US currently stands
at 91%, in line with the long-term average. Auto LTV peaked
at nearly 96% in mid-2006 and troughed at 86% in late 2009.
We’re not saying auto LTV is at peak levels. But we believe
Jun-13
Oct-13
Feb-13
Jun-12
Oct-12
Feb-12
Jun-11
Oct-11
Feb-11
Jun-10
Oct-10
Feb-10
Jun-09
Oct-09
Oct-06
Oct-13
Oct-12
Apr-13
Oct-11
Apr-12
Oct-10
Apr-11
Oct-09
Apr-10
Oct-08
Apr-09
Oct-07
Apr-08
Oct-06
0%
Apr-07
(6.0%)
Oct-05
2%
84%
Apr-06
(4.0%)
Feb-09
4%
86%
Jun-08
(2.0%)
8%
Oct-08
0.0%
88%
10%
Feb-08
90%
12%
Jun-07
2.0%
Oct-07
92%
Feb-07
4.0%
Y/Y % Change
Loan-to-Value (%)
Y/Y % Change
Source: CNW, Morgan Stanley Research
much of the “dry powder” on this metric has already been
exhausted, so to keep things rolling, the industry likely must
move into the “damp powder.” That’s usually what it’s done.
Average auto loan term has set new record highs almost
every month recently. A little over a decade ago, the average term of an auto loan was under 60 months. Today it’s
approaching 67 months. Low interest rates have contributed
to pushing up higher and higher levels of content and pricing
for new cars. To offset the inflation of the monthly payment,
lenders have extended auto loan terms further and further.
Credit quality is declining from record strong levels. Auto
credit quality is still performing very well by any historic and
absolute measure we monitor. Looking ahead, we’re watch-
4
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
ing out for the impact that rising interest rates and falling used
car prices will have on repos and loss experience. We fear
this story has a lot of room to get worse.
uct untouched? Certainly not. Our global team expects them
to invest every bit into improving the value proposition of their
vehicles with a positive market share impact.
Used vehicle prices look too high. Manheim used prices
typically follow a 15-20% peak-to-trough decline in a normal
cycle. Given the extraordinary run in prices for newer vintage
vehicles (including a 40% trough-to-peak rebound in the Manheim mix and mileage adjusted off-rental index) an argument
could be made for an even more severe downward correction
in used prices this time around.
Exhibit 3
84%
Total
Mitsubishi
Total
Honda
Total
Japanese
OEMS
Total
Toyota
Total
Subaru
Total
Nissan
22%
44%
48%
52%
65%
85%
Total
Mazda
While off-lease volume has been improving since the start of
2013, it’s been from extremely low levels. Leasing is currently
running at more than 25% of new car volume, suggesting
future off-lease volume should rebound to around 4 million
units annually, more than 3x the size of the off-rental used
market. While US SAAR may have a further 10% or so to run
before its next peak, off-lease volume can double.
MS Estimate of Content from Japan in Cars Sold in US
(2012)
Source: CNW, Morgan Stanley Research
Currency
25% weakness of the Japanese yen. There’s a view in the
market that a high degree of Japanese car production transplanted to the US substantially mitigates the impact of the
weaker yen to merely a translation of profits rather than a
transaction impact. Our analysis suggests this is simply not
true. How else can one explain the $40 billion of pretax
headwinds from FX experienced by the Japanese 11 OEMs
from 2008 to 2012?
Japan’s Prime Minister, Shinzo Abe, might go down as
the greatest car salesman in Japanese history, via his
namesake “Abenomics” policies, which include a weaker yen.
We don’t think the Japanese OEMs will start a price war, but
rather a product offensive. Despite 80% of sales transplanted
to North America, the yen’s move is worth more than $2000
per unit for the J3 and perhaps $4000/unit or more for players
like Mazda, Mitsubishi, and Fuji Heavy, according to work by
Morgan Stanley’s global Autos research team. We believe
200bps of Japanese share gain in the US with 100bps of price
pressure is a reasonable scenario through 2015, with 15-20%
of Ford’s and GM’s EPS at risk. Our global Autos team looks
for the Japanese OEMs to use the model year change-over to
adjust option packages at favorable prices, leading to more
profound product enhancements from mid-2014 onward.
In effect, the Japanese OEMs have been handed (on average) a $3,000 check per unit through the currency move to
use to enhance their product. That’s far more than 1,000 bps
of operating profit margin swing on average. Do we think the
Japanese players will hoard the margins and leave the prod-
Capacity
The industry is adding back more than 100% of what it
took out. The North American auto industry is undergoing
the fastest expansion of manned capacity since 1950. While
much of this is required to satisfy US demand that we expect
to recover to more than 17 million units, we believe the new
capacity could erode price discipline. For the first time since
the downturn, the industry's ability to produce vehicles is now
growing faster than demand.
Exhibit 4
NA Incremental Capacity Additions by Year: 2011-2015
2011
2012
2013
2014
2015
3.5
0.4
0.9
1.1
0.9
0.2
Source: Company data, Morgan Stanley Research
2014–15 figures are Morgan Stanley estimates
As much as new capacity is required to liberate pent-up demand, it is also an enemy of pricing. A 1% cut in US pricing
translates to a 10-15% cut in NA profits, all else equal.
Stocks mentioned: BorgWarner (BWA, $107.12), Delphi (DLPH,
$58.55), Ford (F, $17.08), General Motors (GM, $38.73), and TRW
(TRW, $77.60).
5
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Bank of America
Will Expense Saves Fall to the Bottom Line?
Morgan Stanley & Co.
LLC
Betsy Graseck, CFA
Betsy.Graseck@morganstanley.com
Our View
Market View
We expect $14 billion in expense saves by 2015 (vs 2013)
with the decline in litigation costs and legacy asset servicing (LAS) costs all falling to the bottom line. We’re not looking for net core expense growth, as BAC can cover with efficiencies from $2 billion remaining in cost saves in their “New
BAC” program. As headline expenses decline meaningfully,
we expect an acceleration in earnings growth to outperform
consensus estimates. Further, BAC has incremental efficiency
opportunities through branch and footprint rationalization. If
needed, BAC could also lower current levels of significant reinvestments into businesses, although we do not bake this in.
The Street appears less optimistic on BAC’s expense
saves falling to the bottom line. Consensus suggests core
expenses will rise $2 billion in 2015 vs.2013. Given $2 billion in
“New BAC” expense saves, this implies a gross increase in
core expenses of $4 billion, or 3.25% annually…which we think
is too much.
We believe core expense growth of $1 billion in 2015 vs 2013
(or 1% annually) will be offset by $2 billion in “New BAC” efficiency gains. Further, management credibility is on the line for
shrinking the expense base and taking the battleship to cruising speed.
Bank of America (Overweight): We Believe the Market Underestimates Earnings Power
$ 30
`
25
$25.00 (+58%)
$20.00 (+27%)
20
$ 15.81
15
$11.00 (-30%)
10
5
0
Nov-11
May-12
Nov-12
Base Case (Nov-14)
Risk-Reward Scenarios
0.51x 2014e BVPS
$11
of $21.58
May-13
Nov-13
May-14
Historical Stock Performance
$20
0.90x 2014e BVPS of
$22.16
Bear Case
Base Case
Double Dip Recession. Consumer demand
fades driving double dip recession.
Reps/warranties loss rate rises to 3% vs 2%
implied by recent settlement.
Modest Economic Recovery. Housing recovers modestly in 2014-15 (home price index
growth of 5-7% in 2014 and 3-5% in 2015); nonmortgage credit improves.
Current Stock Price
$25
Bull Case
Nov-14
WARNINGDONOTEDIT_RRS4RL~BAC.N~
1.12x 2014e BVPS
of $22.34
Sharper Economic Recovery. Economy accelerates in 2014-15 as world rebounds more
sharply driving down cost of equity, and housing
improvement accelerates. Market prices in
higher ROEs as Net Interest Margin increases
on rising interest rates.
Source: Thomson Reuters, Morgan Stanley Research
Valuation Methodology: Based on blend of methodologies (residual income, P/E, P/B rel. to ROE, P/TBV rel. to ROTCE and sum-of-the-parts. Resid. income valuation assumes 5.0% risk-free rate
and 4.5% equity market risk premium. Downside Risks: Higher cum losses, particularly in residential mortgage, lower home prices than expected, hard landing in Europe, US recession, higher
legal and reps/warranties costs. Upside Risks: Eliminating reps/warranties costs, higher home prices, lower consumer losses, realization of any of several different investments.
6
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
(2) $7b in lower litigation costs in 2015 vs 2013: We model
a legal cost decline from $8b in 2013 to $1.8b in 2014 and
$1b p.a. in 2015-18, for payouts on remaining legal cases
which include: FHFA, AIG, LIBOR, and monoline settlements.
(3) No core expense growth: We don’t expect BAC to ramp
up investment in the business as it is already re-investing.
Current run-rate includes $3.6b of annual technology investments geared toward future functionality. Incremental investments could be driven by branch and footprint optimization as
consumers rapidly adopt mobile and online channels.
We Model $14b Expense Decline in 2014-15 vs. ’13
Operating Expenses ($B)
70
72.1
0.9
Litigation
8.0
11.6
9.0
61.0
0.9
1.8
4.8
55
50
Retirement
Eligible
Comp
71.2
0.9
5.5
65
60
56.9
0.9
1.0
2.3
57.6
0.9
1.0
2.0
54.2
53.3
53.6
52.6
53.7
2012
2013E
2014E
2015E
2016E
45
LAS Costs
Core
Expenses
3Q13
2Q13
1Q13
4Q12
3Q12
2Q12
LAS Full-Time-Employees and Contractors (in thous)
57
58
58
15
16
17
50
42
42
39
FTEs
Contractors
43
38
7
36
6
32
5
32
28
3Q13
42
11
2Q13
60
50
40
30
20
10
0
Exhibit 4
What’s the Remaining Litigation Risk?
($bn)
0
2
4
6
Legal
Reserves Est:
3Q13 ($B)
6.6
Reserve Build
Est: 4Q13-2016E
0.00
8
12
14
16
0.0
(4.0)
(2.0)
AIG
0.0
(2.0)
0.00
LIBOR
Other
10
7.9
FHFA
(1.0)
Monolines
Exhibit 1
75
Headcount in Legacy Asset Servicing Division
Declined by 35% YTD to 32K, on Its Way to 5K;
Suggests 85% Decline Still to Come
1Q13
(1) $7b in lower LAS costs in 2015 vs 2013: We expect the
quarterly run-rate to decline from $2.2b in 3Q13 to $1.9b in
4Q13 on its way to $0.9b by 4Q14 and $0.5b by 3Q15. The
decline in delinquent loans serviced should drive down headcount needed to service fewer delinquent loans.
Exhibit 3
4Q12
Three key drivers for BAC’s expense decline:
1,200
1,000
800
600
400
200
0
3Q12
 Mid-July 2014: 2Q14 Earnings Announcement
Demonstrate execution on expense cuts. Expect $600m
decline in run rate expenses in legacy asset servicing
costs vs 4Q13 levels.
60+Day Delinquent Loans Serviced (# of Loans)
2Q12
 Mid-March 2014: Capital Plan & Stress Test Results
Expect stress test to show resiliency of BAC’s balance
sheet and expect BAC to announce share repurchase
program of $6b for 2Q14-1Q15 up from $5b in 2Q131Q14 and a dividend hike to 5c per quarter from 1c.
60+ Day Delinquent Loans Serviced Down 50% YTD
to 398K Loans… Expenses to Exit with 2-Qtr Lag
1Q12
 Mid-January 2014: 4Q13 Earnings Announcement
Expect 4Q earnings to show a $300m decline in run rate
expenses in legacy asset servicing costs vs. 3Q13.
Exhibit 2
1Q12
Potential Catalysts
 Year-End 2013
Expect Judge Barbara Kapnick to approve BAC’s $8.5b
RMBS settlement with private investors. This is already
fully reserved for and judicial approval would remove
sizeable tail risk.
0.00
5.5
Source for exhibits 1-4: Company Data, Morgan Stanley Research
E = Morgan Stanley Research Estimates
Investment thesis: Overweight BAC on improving housing,
execution of cost saves, and rising capital return. We see
accelerating expense cuts more than offsetting remaining
litigation risk. Importantly, we expect cost saves to accelerate
in 4Q and into 1H13. We think BAC has ample capacity to
sizably ratchet up capital return in 2014-15 with a Basel 3 CT1
ratio of 9.9% already above the FSB’s minimum of 8.5%. Our
Large-Cap Banks Industry View is Attractive.
7
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Cable/Satellite
Will 2014 Be the Year for Transformative Consolidation in Cable / Satellite?
Morgan Stanley & Co.
LLC
Benjamin Swinburne
Benjamin.Swinburne@morganstanley.com
Our View
Market View
After years of relative dormancy, we believe some consolidation in cable is possible (if not likely) in 2014, but we do
not expect any consolidation to swing the balance of power away from content owners. Sparked by Liberty Media
taking a 27% stake in CHTR (see next page), there has been
broad media reportage (CNBC, Bloomberg, WSJ, et al.) about
consolidation in US Cable, focusing on the possible sale of
TWC (Comcast and Charter have reportedly shown interest,
though neither has commented). There is ample industrial
logic for consolidation, as we believe structural changes to the
industry may be the only remedy to the imbalance of power in
the TV ecosystem that is driving nearly double-digit programming cost growth (this underpins our Attractive view of Media
vs. In-Line view of Cable/Satellite). However, while some
deals are possible, we believe it is unlikely that Cable/Satellite
operators will gain sufficient scale in 2014 to materially change
the growth trajectory of programming costs.
Cable market cap expansion since June seems to imply a
high probability that multiple cable operators will consolidate over the next year. Since June, the market cap of cable
operators we cover (CMCSA, TWC, CHTR, CVC) has expanded by nearly $35 billion, or 25-30%. Adjusting for growth in the
S&P 500 over that time, we estimate ~$22 billion of market
outperformance, which we estimate accounts for nearly all of
the NPV of near-term cost synergies that could be achieved by
rolling up all four companies. This implies the market is assigning a high probability to Cable consolidation and perhaps a
more material change to potential revenue growth and programming cost growth than we are willing to assume. Aside
from a theoretical DISH-DTV combination, Cable M&A would
not remove a competitor from a market, so synergies are perhaps less significant to pricing and input costs than in other
industries that consolidate.
Exhibit 1
Exhibit 2
Cable’s Outperformance since June Implies Market
Is Assuming Industry Synergies
Programming Costs Have Pressured Video Margins
Cable and Satellite Video Gross Margin
64%
Est. NPV of Base-Case Synergies in a CMCSA/CHTR/CVC/TWC
Merger vs. Market Cap Outperformance vs. the S&P500
Video Gross Margin
62%
$25.0
Billions
$20.0
$15.0
$10.0
60%
58%
56%
54%
52%
$5.0
50%
$0.0
PV Synergies
Change in Market Cap Relative to
S&P 500
Source: Thomson Reuters (share price data), Morgan Stanley Research
We believe cable/satellite industry consolidation
makes sense…
(1) Programming costs: Programming costs, roughly 45-50%
of video revenue, are growing roughly 10% per year – well
ahead of retail pricing. Ultimately, if this continues, it will become increasingly difficult to grow EBITDA. While not a given
that consolidation would shift the leverage back to distribution,
at a minimum moving to a large company’s rate card through
a change of control would have short-term benefits.
(2) Commercial Telecom: While to date cable operators have
taken share in small and medium enterprises (SME), as this
business matures the opportunity will be in larger business
2011
2012
Source: Morgan Stanley Research
2013E
2014E
2015E
customers that need a scaled telecom provider that can service multiple locations with a broad suite of products (including wireless services). Commercial today is growing 20-30%
for the major players, and represents one of the rare major
growth areas for the cable industry.
(3) Financing: Record low interest rates, particularly available
to predictable cash-flow businesses such as the cable / satellite industry, create the ability to debt-finance horizontal acquisitions that are immediately accretive to FCF.
(4) Competition: We may be on the brink of a new competitive reality for pay-TV: The emergence of the “virtual cable
operator” (see our 4/17/13 note, Intel Inside your TV). This
8
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
new non-facilities based competition would come from large
technology companies with substantial capital, and put further
pressure on distribution returns. This competition will focus
on software and user-interface differentiation, an area that
requires scale for product development and marketing from
incumbents to respond.
…but the question is, ‘Which deals are feasible?’
We believe an acquisition of TWC is feasible, but we do
not believe a TWC deal would provide an acquirer enough
scale to materially change programming cost dynamics.
Over the last 6 months, Overweight-rated Time Warner Cable
(TWC, $138.22) has been the focus of most industry consolidation press reports, we think in part because TWC is the only
large, publicly traded cable operator that is not subject to
family / insider control. As mentioned, CHTR and CMCSA
have been discussed in the press as potential acquirers.
We see a variety of reasons why a largely cash/debt financed
potential bid has notable attractive elements for CMCSA.
Credit for synergies – CHTR has just now reached the level of
top-line growth Comcast has been delivering for years. Pro
forma leverage – CMCSA has the capacity to offer a largely
cash deal without pushing leverage above TWC’s 3.25x comfort range, compared to TWC/CHTR where leverage likely
lands at 4-5x. Furthermore, for CMCSA, its current stated
path to de-lever to 1.5-2x gross leverage is a drag on equity
returns, and more leverage in an accretive (10-15% on FCF /
share) deal for TWC would likely lift shares. A large optical
challenge for a Comcast bid is the valuation spread, with
TWC at a 0.5 turn premium to Comcast despite slower growth
(see our 11/25/13 report Comcast Gets Involved).
Likewise, for CHTR we see a variety of reasons a potential
TWC acquisition would make sense. As noted in our joint
report with Chief US Equity Strategist Adam Parker Macro
Meets Micro: A Five-Year View of the Cable and Satellite Industry published September 26, 2013, in this sector, over the
long term, higher financial leverage has been a benefit — a
CHTR-led TWC would likely run NewCo more levered. Second, CHTR has meaningful tax-loss assets, so a dollar of
EBITDA at CHTR/TWC would convert more efficiently to FCF
than for CMCSA/TWC. Overall, TWC represents a unique
opportunity for CHTR, and smaller transactions would have
less of an impact on driving long-term FCF. Partnering with
Comcast would make sense in areas like LA, where TWC and
CHTR have systems and Comcast does not (see our 11/1/13
report, Running Down a Dream, Reprise).
A DTV-DISH merger is the only potential single deal, in
our view, that could be transformative to the content /
distribution ecosystem, but we believe a deal is unlikely
in the near- to medium-term. We believe regulatory issues
that arose in the 2002 merger attempt remain, which combined with a relatively difficult merger environment in DC and
potential cultural issues suggest to us that a combination appears unlikely near-term. Longer-term, however, we believe
the industrial logic and value of a combination increases,
while regulatory obstacles potentially diminish.
The synergy potential in a deal could be as much as ~50% of
combined market cap today, we estimate. Our base case for
potential after-tax cost synergies from a DTV-DISH merger is
$2.0-2.5B annually by Year 3, ~$25B in NPV, or a 450500bps lift to combined EBITDA margins, in part because a
combined DTV-DISH would be the No. 1 US pay-TV provider
(~34M subscribers), potentially with enough scale to nudge
bargaining power back to distribution (see our 9/10/13 report,
Dare to Dream – Sizing Up a DirecTV-DISH Combination).
At current prices, we think Cablevision (CVC, $16.77) is
unlikely to participate in industry consolidation, supporting our Underweight rating. While we believe TWC is
CVC’s “most natural” acquirer given its adjacent footprint, our
analysis suggests a moderate risk to TWC shares even at a
minimal premium paid and high cost synergies. We estimate
an acquisition would be roughly neutral to TWC’s FCF/share
by 2016. We also believe an offer would likely create threefold risk to TWC’s valuation, as: (1) CVC could be modestly
dilutive to TWC’s EBITDA growth; (2) TWC would need to
reduce or suspend its buyback to de-lever to its leverage goal,
leading to moderate FCF/share growth dilution; and (3) an
offer would likely eliminate the M&A premium currently embedded in TWC shares (see our 7/16/13 note, Priced In).
Our work with Adam Parker suggests acquisitions have
not been positive for Cable/Satellite equity returns.
Measured by market-relative returns post-consolidation; M&A
has been less successful than in other industries, and timing
of deals not consistently opportune (see our 9/26 report).
Sparking the debate: Earlier this year, Liberty Media took a
27% stake in Charter Communications, and in June Dr. John
Malone posited that LMCA could use CHTR as a “horizontal
acquisition machine” to roll up US Cable. Since then, there
has been broad discussion among investors and in the press
about industry consolidation. We have no knowledge of any
pending deals; aside from Liberty, none of the companies
mentioned in this article has commented on press reports.
Potential Catalysts in 2014
 New entrants, namely virtual MSOs, could be a catalyst
for consolidation. Intel was a candidate to launch a virtual MSO service; however, it now appears unlikely.
 Regulatory, FCC: Tom Wheeler, the new Chairman of
the FCC, could express a view on cable consolidation.
 Regulatory, Antitrust: M&A outside the Cable/Satellite
industry could lift or lower expectations based on perceptions of the regulatory environment.
9
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Canadian Pacific Railway
Can We Stay Bullish After This Run? Four Reasons We Say ‘Yes, We Can!’
Morgan Stanley & Co.
LLC
William J. Greene
William.Greene@morganstanley.com
Our View
Market View
There is still ample scope for upside surprise at Canadian
Pacific and the shares represent a compelling risk-reward
even after the recent run. CEO Hunter Harrison has a long
history of surprising investors to the upside. Although the pace
of the improvements at CP has been far better than anticipated, we believe there are still four potential surprises in 2014/15
to take shares even higher: (1) CP can still beat expectations;
(2) Timing and size of buyback could surprise;
(3) Upcoming labor negotiations could result in productivity
gains; and (4) strategic actions by CP are not necessarily a
theoretical.
Canadian Pacific is an interesting stock idea, but given the
stock’s appreciation over the past 18 months, all the good
news is priced in. Mr. Harrison has injected new life into a
company that was perceived to be structurally challenged.
After ~1,000 bps improvement in margins over 18 months,
there is no credibility gap and the stock is already pricing in an
operating ratio in the low 60s. Thus, at ~19x 2014 consensus
EPS, the shares are no longer interesting in the context of a
turnaround and current valuation is much too rich to add to a
position in the shares.
Canadian Pacific Railway (CP, Overweight, PT C$180 YE14, Industry View: Attractive)
C$250
C$209.00 (+28%)
200
C$ 162.91
C$180.00 (+10%)
150
C$133.00 (-18%)
100
50
0
Nov-11
May-12
Nov-12
Price Target (Dec-14)
Risk-Reward Scenarios
14x P/E on Bear Case on
C$133
2015 EPS of C$9.48
May-13
Nov-13
Historical Stock Performance
C$180
17.5x P/E on Base Case
2015 EPS of C$10.25
Bear Case
Base Case
A stagnant economy drives slower volume
growth, and pricing is below expectations.
“Key man risk” occurs and Mr. Harrison unexpectedly leaves the company or the market
loses patience with the timing of the turnaround and confidence in the ultimate potential.
Industry volumes grow at low single-digit rates
in 2014/2015 driven by moderate economic
improvement. Pricing gains moderate, but remain above core rail inflation, supporting continued margin expansion. Mr. Harrison's operating improvements continue to serve as an
overall tailwind for margin expansion, ultimately
resulting in a 63% OR in 2015
May-14
Current Stock Price
C$209
Bull Case
Nov-14
WARNINGDONOTEDIT_RRS4RL~CP.N~
19x P/E on Bull Case
2015 EPS of C$11.00
Industry volumes grow at mid-single digit CAGR
in 2014-15 as GDP momentum resumes. In
addition to operating leverage ahead of base
case expectations, Mr. Harrison achieves a
sub-62% OR in 2015. CP accelerates asset
sales, generating significant excess free cash
flow and initiates a large share buyback program.
Source: Thomson Reuters, Morgan Stanley Research Valuation Methodology: We apply a 17.5x multiple to our 2015 EPS estimate to generate our price target valuation of C$180. Our 2014
year-end TMF P/E multiple is a premium to CP's historical range to account for turnaround story Risks: “Key man risk” with CEO Hunter Harrison; potential for operating setbacks, as Canada
winters tend to be more extreme than in the US; volume headwinds with slowing macro; valuation on our base case estimates does not appear especially compelling.
10
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Potential Surprises That We Think Are Not Priced In
 Raising long-term guidance
At the 2014 investor day, CP could surprise investors
with even more aggressive financial targets.
 Timing and magnitude of buyback
Investors expect an announcement on buybacks in
2H14, but timing could be sooner and magnitude larger.
 Labor productivity breakthrough
Canadian operating union contracts expire at YE14, creating a possibility for significant productivity gains.
 Strategic actions
We see scope for surprise from asset sales and purchases that are not currently in consensus.
Our thesis on CP’s shares has long been that the turnaround
has the potential to be the most compelling investment opportunity in railroads for the next few years. We argued that the
arrival of CEO Hunter Harrison in mid-2012 catalyzed change
on a network that was not broken and had strong potential.
We saw significant opportunity for operating ratio (OR) improvement with non-economic drivers to growth and productivity – a hallmark of Mr. Harrison’s precision railroad model.
In 18 months, Mr. Harrison has impressed even the most bullish investors at the scale and pace of improvement in operating and financial metrics. Skeptics argue that at ~19x 2014
consensus, CP is fully-valued with no scope for upside surprise. We flatly disagree. Mr. Harrison has arguably the industry’s strongest track record of creativity and innovation.
We see ample opportunity for CP to surprise investors to the
upside. If we’re wrong and CP delivers financial results as
expected, then shares likely rise only modestly over the next
few years. But if any number of surprises occur, the CP train
has room to run (C$209 in our Bull case). Below, we outline
four potential surprises that could occur, but are not priced
into shares.
(1) CP may need to further raise its long-term guidance.
When Mr. Harrison detailed targets for 2016 at the December
2012 Investor Day, we were impressed by the boldness. But
we noted at the time that the top end of CP’s long-term operating ratio (OR) guidance was slightly below our base case
model. Since then, CP has significantly exceeded expectations and unofficially raised OR targets to mid-60s by 2014
(two years early), impressing even the most bullish investors
and causing a sharp rise in consensus. Why should we assume that’s it? Mr. Harrison has typically outlined goals that
seem aggressive, and then beaten them. CP will host an
investor day in 2014 and we believe CP’s updated projections
can surprise again (driven either by productivity or revenue
gains that exceed plans). Though investors today argue that
further upside to projections is hard to imagine, we believe
that investors aren’t paying for further surprises, though we
see a reasonably probability for them occurring.
(2) Buybacks are coming and they may be large. Given
the pace of margin improvement, CP’s free cash flow should
grow significantly, as Mr. Harrison expects capex to remain
relatively steady at ~$1.2 billion/year. Thus, we project CP’s
FCF should approach $1.0 billion in 2014 and grow significantly thereafter. Mr. Harrison indicated he expects the board
to consider instituting a buyback by 2H14. We believe CP
can buy back 2-3% of shares annually beginning next year
using FCF. Holding leverage constant, we estimate CP could
buy back 4-5% annually. Giving credit for monetizing over
three years the full $2 billion in non-operating assets that Mr.
Harrison estimates CP has, implies the buyback could be as
much as ~6% annually. We model that a buyback begins in
2014 and averages 3% annually through 2017 (similar to consensus, we believe). Bigger buybacks are a source of upside
surprise likely not priced into shares.
(3) Labor productivity could be a game-changer. Mr. Harrison has long argued that shifting from mileage-based work
rules to a framework of pay for productivity is a win-win for CP
and its operating union employees. Mr. Harrison struck such
a deal at Illinois Central, where employees are the highest
paid in the industry with more days off per month, but boast
productivity more than double CP employees when measured
in mileage per employee day. Such an agreement is not in
our base case assumptions, but even if initial productivity
gains were offset by higher wages, over time, the new framework could be a game-changer, driving significant productivity
at an enterprise level. CP’s operating union contracts expire
at YE14. Though a new deal is far from certain, this sort of
win-win outcome is not priced into shares, in our view.
(4) Don’t underestimate strategic creativity. Since the
‘90s, Mr. Harrison has shown significant creativity and risktaking around asset sales and purchases. He is the only CEO
currently running a Class I rail who has both sold his company
(Illinois Central to Canadian National) and acquired other railroads of size (e.g., Wisconsin Central while at CN). Despite
broad agreement among peer CEOs that further industry consolidation is unlikely, Mr. Harrison maintains that more M&A is
not just inevitable, it’s good for the economy, industry and
customers. We don’t know what sort of strategic actions Mr.
Harrison might envision, but we’re willing to continue to recommend the shares considering that we do not believe an
option on a bold strategic action is priced into shares.
11
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Chemicals
Will Ethane Feedstock Costs for Petrochemicals Fall in 2014?
Morgan Stanley & Co.
LLC
Vincent Andrews
Vincent.Andrews@morganstanley.com
Our View
Market View
Ethane prices face further downward pressure in 1H14.
Ethane, the key raw materials input for US petrochemical producers, is currently trading at ~$0.25/gallon, in line with natural
gas fuel value at $3.80/MMBTU. The price reached parity with
natural gas in October 2012 and has remained there since (see
Exhibit 2, next page). We believe there is a meaningful chance
that the price will decline further as numerous catalysts are
converging during 1H14. This could provide an additional tailwind to the already advantaged ethane feedstock producers in
the US (LyondellBasell, Dow). We have seen a similar dynamic play out in the Conway, Kansas market in 2011-12.
Consensus estimates assume ethane prices will remain
supported by the theoretical ‘floor’ price of natural gas
fuel value. We suspect that the market believes (as our base
case assumptions reflect) that pipeline rejection economics will
help to maintain the price floor established by natural gas (i.e.
midstream producers can sell ethane for fuel value as a last
resort). Current ethane rejection levels are near record highs,
but the market does not appear worried about reaching potential maximum rejection. The conventional view is that the distressed pricing seen in Conway was an anomaly that will not
be repeated in Mt. Belvieu, Texas (where it would have a much
larger impact).
What’s in the Price
Consensus Estimates Likely Do Not Factor Movement in Ethane Below Floor
Our petrochemical stock models factor in sensitivities to feedstock inputs. We estimate a $0.10/gal reduction in the price of
ethane will generate $241M and $164M in EBITDA for LyondellBasell and Dow respectively (see Exhibit 4). Our base cases do
not factor in pricing deviating from the current position, but instead forecast an increase in ethane pricing from $0.25/gal today to
$0.32/gal in 2015. In addition, both Dow (25% in 2014 and 16% in 2015) and LyondellBasell (7% in 2014 and 14% in 2015) will
increase their consumption of ethane going forward providing even further upside to current estimates. Exhibit 1 outlines the
potential incremental EBITDA for both Dow and LyondellBasell if the price of ethane were to hit zero in either 2014 or 2015. If
ethane prices were to approach zero, we estimate upside for Dow of $514M and $763M, and LyondellBasell $647M and $944M
in 2014 and 2015, respectively.
Exhibit 1
Incremental Petrochemical EBITDA impact from Ethane price Dropping from $0.25/gal to Zero
EBITDA in mm's
10,000
8,000
6,000
Incremental
MS Est.
4,000
2,000
DOW '14
DOW '15
LYB '14
LYB '15
Source: Thomson Reuters, Morgan Stanley Research
12
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Exhibit 3
 March/April 2014
Planned turnarounds for ethane cracker units on the gulf
coast. 10% capacity is expected to be offline during
March/April 2014, resulting in a temporary 100 MBPD
decrease in demand for ethane.
 Throughout 2014
Export opportunities for propane driven by high European prices, combined with low US inventories, incentivizes greater natural gas liquids (NGL) production levels.
Exhibit 2
Could Ethane Pricing Break Below ‘Floor’ in 2014?
30
200
180
25
160
140
120
15
100
c/gal
$/mmbtu
20
80
10
60
40
5
US Ethane Mt. Belvieu
Implied Ethane Ceiling - Naphtha
Implied Ethane Floor
Implied Ethane Ceiling - Propane
20
Jul-13
Oct-13
Apr-13
Jan-13
Jul-12
Oct-12
Apr-12
Jan-12
Jul-11
Oct-11
Apr-11
Jan-11
Jul-10
Oct-10
Apr-10
Jan-10
Jul-09
Oct-09
Apr-09
Jan-09
Jul-08
Oct-08
Apr-08
0
Jan-08
0
Source: Company Data, Bloomberg, Morgan Stanley Research
Record ethane rejection levels. The abundance of ethane
from NGL shale plays resulted in ethane rejection starting in
January 2012. The most recent reported amounts are from
August, when 215 MBPD were rejected. Market participants
estimate that the maximum amount of rejection is in the 250300 MBPD range, although there is considerable uncertainty
around this number. It looks possible that we hit “maximum
rejection” as we move into 2014, which could cause ethane
pricing to trade below the natural-gas-implied floor.
1.20
1.00
0.80
0.60
0.40
0.20
Extraction
Demand
Jul-13
Apr-13
Jan-13
Jul-12
Oct-12
Apr-12
Jan-12
Jul-11
Oct-11
Apr-11
Oct-10
Jan-11
Jul-10
0.00
Apr-10
 December 2013/January 2014
Enterprise Products’ ATEX pipeline will commence shipping of ethane from the Marcellus to the petrochemical
complex on the US Gulf Coast, bringing an additional
190 MPBD of supply to an already oversupplied ethane
market.
1400
1200
1000
800
600
400
200
0
Jan-10
 Current / Ongoing
215 MBPD of ethane was rejected in August (near record highs). There is a maximum amount of ethane rejection that can take place; estimates range from 250–300
MBPD.
Ethane Supply M BPD
215 MBPD
M BPD ethane
rejection
in August
215
Ethane
Rejection
in August 2012
Potential Catalysts
Rejection
Source: EIA, Morgan Stanley Research
ATEX Pipeline. The ATEX pipeline will connect NGL production from Marcellus/Utica to Mt. Belvieu. Almost all of the
ethane being produced at Marcellus/Utica is currently in rejection mode. Market participants indicate that NGLs from Marcellus contain 60%-plus ethane. This pipeline, which comes
online in early 2014, will supply an additional 190MBPD to the
US Gulf Coast.
Steam cracker turnarounds. CMAI estimates that ~10% of
US steam cracker capacity will be offline in March and April
2014 due to scheduled maintenance turnarounds. These
turnarounds will reduce ethane consumption at the same time
as the ATEX pipeline will be ramping up.
Propane market dynamics. US propane levels are at a seasonal 5 year low, despite increased production. Export opportunities, driven by surging prices in Europe, are driving US
spot propane prices higher (currently $1.20/gal). A sustained
export opportunity could incentivize increased production of
NGLs, which would result in an even greater amount of nearterm oversupply of ethane.
Potential impact to North America Ethane consumers.
We do not expect meaningful demand relief for NA ethane
until the large scale cracker capacities come on line in 20162018. Until then, NA ethane crackers would benefit from any
reduction in the feedstock price. As we do not anticipate additional expansion announcements from NA producers, we’d
expect any potential windfall will likely result in incremental
returns of capital to shareholders via repurchases or special
dividends.
Exhibit 4
EBITDA Sensitivities
Current Ethane Consumption (MBPD)
LYB
157
CurrentEthane Consumption (M gal per year)
2,413
EBITDA Sensitvity to $0.10/gal move ($MM's)
$ 241
DOW
107
1,639
$
164
Source: Company Data, Pace Consultants, Morgan Stanley Research
Stocks mentioned: Dow Chemical (DOW, $39.06) and
LyondellBasell (LYB, $77.18).
13
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Consol Energy
Will Consol Re-Rate to Reflect Its ‘Sum-of-the-Parts’ Value?
Evan Kurtz
Evan.Kurtz@morganstanley.com
Morgan Stanley & Co.
LLC
Our View
Market View
Consol’s equity could re-rate to reflect its ‘sum-of-theparts’ value in 2014. We believe Consol Energy could realize
its “sum-of-the-parts” value in 2014 as investors begin to focus
on the value of the gas business. The company recently sold a
major portion of its coal portfolio, but plans to retain some of its
higher-quality coal assets as it increases focus on its gas activities. As asset monetization continues and gas business disclosure improves, we believe Consol will increasingly get credit
from investors for the high-quality acreage the company has in
the Marcellus and Utica shale plays.
Consol will continue to trade at a discount to its ‘sum-ofthe-parts’ value. The market continues to view Consol as a
coal business with gas operations, instead of the other way
around. However, in light of the sale of its Consolidated Coal
subsidiary, more than half of the company’s value comes from
gas, and we estimate that gas will account for more than 50%
of total EBITDA in 2015. We believe the company could move
to further separate the coal and gas businesses if shares continue to trade at a discount to management’s view of “sum-ofthe-parts” value. The stock is currently trading well below our
assessment of “sum-of-the-parts” value of $48/share.
Consol Energy (CNX, $48 PT): Potential to Re-Rate on Gas Driven SOTP Story
$90
80
$77.00 (+116%)
70
60
50
$48.00 (+35%)
$ 35.58
40
30
20
$20.00 (-44%)
10
0
Nov-11
May-12
Nov-12
Price Target (Nov-14)
May-13
Nov-13
Historical Stock Performance
May-14
Current Stock Price
Nov-14
WARNINGDONOTEDIT_RRS4RL~CNX.N~
Risk-Reward Scenarios
Bear Case SOTP
$20
$48
Bear Case
Base Case
Bull Case
We assume the following long term coal prices: $174/t hard coking coal and $58/t NAPP
thermal coal. We value the gas business at a
net asset value of ~$4.2b.
We assume the following long term coal prices:
$180/t hard coking coal and $65/t NAPP thermal coal. We value the gas business at a net
asset value of ~$7.5b.
We assume the following long term coal prices:
$189/t hard coking coal and $73/t NAPP thermal coal. We value the gas business at a net
asset value of ~$11.8b.
Base Case SOTP
$77
Bull Case SOTP
Source: Thomson (price data), Morgan Stanley Research Valuation Methodology: Sum-of-the-parts model; we value the coal business using a DCF and value the gas business using net asset
value. Risks: Noble capex carry agreement depends on natural gas prices; Metallurgical coal demand remains weak; Realization of SOTP value takes longer than expected.
14
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Potential Catalysts
 December 2013-January 2014
Consol currently has two asset sale deals in progress.
We expect the company to announce sale details between now and 4Q13 earnings.
 Throughout 2014
We anticipate enhanced gas business operating disclosure as 2014 progresses.
 Throughout 2014
We expect continued non-core asset sales throughout
2014. See below for a list of eligible assets.
ated cash for reinvestment in the higher-return gas business.
Gas production growth will require extensive capex investment, but internal funding from cash-flow-generative coal assets will help the company keep leverage in check.
Exhibit 1
Consol: Non-Core Assets
Type
Coal Export Terminal
Gathering Pipelines, Processing
Gas Processing Facilities
Fairmont Supply Company
Water Services
Illinois Basin Reserves
Utah Reserves
Canada Reserves
Harrison Resources (49% JV)
Western Allegheny Energy (49% JV)
Description
Shipped 12.7 mt of coal in 2012
4,500 miles of gas gathering pipelines
300 bcf/yr of pipeline quality gas
Mining/drilling supply distributor
Water provision & waste water mgmt
~757 mt of recoverable thermal coal reserves
~30 mt of recoverable thermal coal reserves
Additional Canada met coal reserves
Ohio thermal coal; ~0.4 mt/year
Low-vol met coal; ~0.5 mt+/year; costs of $60-$65/t
Source: Company Data, Morgan Stanley Research
We view the divestiture of the Consolidated Coal subsidiary as a net positive. Consol recently sold a large portion of
its coal portfolio, but is retaining its highest-quality (and most
cash-generative) coal assets. We view the divestiture as a
net positive for Consol. Although the sale was at what we
regard as a fair valuation (~7.2x adjusted EBITDA), the cash
received can be reinvested in gas growth at higher returns.
Reduced legacy liabilities should lower uncertainty and risk as
well as future cash funding needs. Finally, by reducing the
percentage of value attributable to the coal business, Consol
should increasingly be viewed as a gas play (with attractive
basin exposure), garnering a higher valuation.
Increased attention from E&P investment community will
highlight gas business value, in our view. Post-deal, we
estimate that more than half of the company’s value comes
from gas, which should account for more than 50% of total
EBITDA in 2015. We believe that increased attention from
E&P analysts and investors will be an important catalyst. As
the company increases disclosure of gas business operational
and reserve details, we believe investors will ascribe more
value. The company is currently assessing ways to bring gas
business transparency more in line with the E&P peers.
Exhibit 2
Consol Energy Sum-of-the-Parts Valuation
Retained Coal Assets
Gas Operations
Core Operations
Corporate & Other
Non-Core Assets
Noble Carry
Enterprise
2014 Adj.
EBITDA
790
415
1,205
Multiple
7.8x
18.0x
11.3x
Value
6,175
7,486
13,661
(215)
7.8x
990
13.7x
(1,681)
300
1,250
13,530
3Q13 Net Debt
2012 Pre-Tax Pension Liability
2012 Pre-Tax OPEB Liability
2012 Deferred Tax Asset
85 BPS Increase in Discount Rate
Total Liabilities
3,164
225
3,018
(1,135)
(338)
4,934
Cash
PV of Future Royalties
PV of Water Treatment & Port Fees
After-Tax OPEB Divestiture, Adj. for 85 BPS Increase in Discount Rate
Cash Tax Benefit
Coal Asset Sale Value
850
150
34
1,253
150
2,437
Mid-Cycle Value
Per Share
3Q13 Share Count
11,032
$48
229
Source: Company Data, Morgan Stanley Research estimates. In millions, except per-share
value.
About Consol Energy
Further asset monetization may be ahead. We believe
Consol could continue to opportunistically monetize its extensive portfolio of non-core assets. Such sales would not only
generate cash to reinvest in the gas business, but also continue to streamline the organization and increase gas focus. In
addition, the company is examining opportunities for using
MLP structures to maximize the value of midstream assets.
Potential for further coal asset sales, but near term they
provide an internal funding source. We believe over the
next several years, Consol could eventually divest the remaining portion of its coal business. However, in the meantime, we
believe retention provides the company with internally gener-
Low-cost coal producer with premium nat gas assets.
Post-divestiture, Consol Energy is a low-cost, diversified
coal producer with nat gas assets in the Marcellus and Utica shale plays. The company operates efficient longwalls in
Northern and Central Appalachia, producing thermal coal,
low-vol met coal, and cross-over met coal, with both domestic and export sales potential. Consol also has a fastgrowing (23-32% production growth in 2014 and 25-30% in
2015-2016) nat gas business. The company has attractive
Marcellus and Utica shale acreage in addition to coal bed
methane and other Appalachian gas operations.
15
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Education
Is Demand for Higher Education Inelastic?
Morgan Stanley & Co.
LLC
Suzanne E. Stein
Suzanne.Stein@morganstanley.com
Our View
Market View
We believe that in aggregate, demand for higher education
is mostly inelastic. While tuition cuts may fuel short-term
gains in student starts, we expect to see a shift of market share
rather than major increases in starts. Industry price cuts may
have more of an impact on profitability than enrollment growth,
though “90/10” constraints, which limit the ability of for-profit
schools to significantly reduce tuition, should provide a floor.
We believe companies should focus more on retention and
fine-tuning their value proposition (the relationship between
income potential and tuition) than simply chasing enrollments.
Tuition cuts will allow starts to stabilize and grow again,
though concerns linger over the impact on profitability.
Companies that have experimented with deep price cuts have
seen a short-term improvement in starts, leading some to believe that deeper price cuts will drive higher starts. However,
there are concerns about the impact on profitability and therefore these initiatives have been met with mixed response.
What’s in the Price
Industry P/E Multiples Seem to Imply Mid to High Single Digit Enrollment Growth at Lower Prices
Industry enrollment-weighted forward P/Es suggest the market expects a rebound to 4% long term EPS growth. However, we
think lower tuition per student and margin contraction will offset enrollment increases. Since 2010, a 20-25% drop in revenue at
Strayer and Apollo led to 50-75% declines in operating income. At DeVry, a 10% reduction in revenue caused a similar decline.
To estimate market implied enrollment growth, we assume an industry-wide decline in tuition per student over the next two years
followed by a return to pricing increases of ~3% annually in Year 3. Depending on the assumed two-year decline in revenue per
student, a 4% ten-year CAGR implies 5–9% enrollment growth for eight consecutive years. We find such enrollment growth unlikely in the foreseeable future and thus we expect industry revenue growth lower than that implied by current multiples.
Industry Multiples Suggest a Return to Growth
Implied Enrollment Growth at Various Revenue Per
Student Declines Given 4% Perpetual Growth
Perpetual Growth Rate Implied by Industry Forward P/E
Implied Enrollment Growth
6%
4%
2%
0%
-2%
-4%
-6%
2010
2011
2012
2013
10%
8%
6%
4%
2%
0%
10% Decline
15% Decline
20% Decline
Revenue Per Student Decline
Source: Thomson Reuters, Morgan Stanley Research
Source:: Company Data, Morgan Stanley Research
Note: Perpetual growth rate implied by the forward p/e of APEI, APOL, DV ESI, and STRA weighted by total enrollments. 2013 growth rate derived from current price and FY14 consensus EPS.
First the boom, then the bust; many companies are now
taking extreme measures to drive demand. After regulatory
pressure increased in 2010-11, industry-wide starts stagnated
as for-profits pursued higher-quality students. Several firms
increased discount programs or offered scholarships to attract
and retain better students. Scholarships were often designed
to improve graduation rates to help institutions meet regulatory hurdles. Start growth at some of these schools following
price cuts likely encouraged others, including Strayer, DeVry,
and Apollo, to offer price breaks. These three for-profits,
which collectively enroll 356,000 students, have each introduced more aggressive scholarships, and in some cases outright price cuts, since July. Some of these new programs
appear to focus more on improving starts than improving retention. We believe price competition is here to stay and will
likely continue to pressure enrollment figures at higher-priced
institutions without lifting industry starts enough to compensate for lost revenue.
16
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
 Changes to the 90/10 Rule
The reauthorization of the Higher Education Act could
include changes to the 90/10 rule that alter institutions’
pricing strategies.
 New Gainful Employment Rules
New gainful employment rules could cause schools to alter their pricing and retention strategies.
 Announcements on New Tuition Discount Programs
Depending on the success of the new pricing initiatives
other institutions could announce new or expanded discounting programs.
 Industry Starts and Market Share Shifts
Investors will closely watch starts to detect shifts in market share for lower-priced programs.
Total Enrollments at For-Profits Have Declined
Since 2010 (Except Low-Cost Providers Like APEI)
Enrollment Change 2010 - 2013E
APOL
ESI
50%
40%
30%
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
STRA
We maintain Underweight ratings on ITT Educational (ESI,
$38.99) and Strayer (STRA, $37.15). Both companies operate institutions with relatively high tuition prices and are likely
to see relatively large tuition reductions and margin contractions. The other companies in our coverage should generally
move with the market. Diversified educators such as DeVry
benefit from foreign sales or specialized divisions (medical,
graduate degrees) that are less affected by competition for
students seeking Associate/Bachelors degrees. Lower-cost
Potential Catalysts
 Strayer’s 1Q New Enrollments (April 2014)
Investors will focus on the impact on demand of a major
tuition reduction of up to 40% off sticker price.
DV
We expect the industry profitability to decline until the
threat of 90/10 violations cap the reductions on tuition.
Historically 90/10, the rule that limits access to Title IV funds
when schools obtain more than 90% of revenue from the federal student loans/grants, provided a floor on prices. Schools
avoided 90/10 pressures by increasing military enrollments,
adding corporate partnerships, and keeping tuition ahead of
student loan limits. Looking ahead, we believe pricing pressure will not abate until firms have exhausted these tactics
and begin to violate 90/10. As competition for military enrollments (who are counted in the 10%) and corporate sponsorships (who pay in cash) increase, institutions are left with little
alternative but to raise tuitions past loan/grant limits so students will pay with private loans or cash (thereby counting
toward the 10%). Price competition might stop when institutions violate 90/10, are placed on probation, and raise tuitions
to avoid violating the rule a second time, thereby losing access to federal funds.
institutions such as those run by American Public Education
are somewhat insulated from price-cutting but could still face
increasing enrollment pressures, if not margin contraction.
Finally, Apollo already completed much of the required restructuring (reducing enrollments by almost half from the 2010
peak). While Apollo may still face a similar downside in a
falling tuition environment, it is also positioned for significant
upside if it can successfully begin to grow enrollments. Consequently, we remain Equal-weight Apollo (APOL, $26.29).
Overall, our Business & Education Services industry view is
In-Line.
APEI
We believe the industry developed excess capacity during the boom of the late 2000s (through the financial crisis)
that still contributes to pricing pressure. During the boom,
state-funded schools were limiting enrollments, there was an
influx of newly unemployed, federal loan limits were increased, and customer acquisition costs were unusually low
as financial services institutions and auto manufacturers
pulled back on ad spend. These factors encouraged for-profits
to expand capacity to unsustainable levels, and as these factors reversed — state funding stabilized, unemployment lingered but students became more debt averse, ad rates recovered, and some regulations were tightened — there was
more incentive for schools to pursue “high quality” students.
Though schools ultimately reduced capacity, they also recognized the power of price reductions to moderate start declines. Yet price-cutting strategies that test well at individual
schools are unlikely to save the industry when everyone pursues the same tactics. We believe excess capacity will continue to drive price-cutting in the industry.
Source: Company Data, Morgan Stanley Research
17
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Food
Will US Food Manufacturers See a Deflationary Benefit in 2014?
Morgan Stanley & Co.
LLC
Matthew Grainger
Matthew.C.Grainger@morganstanley.com
Our View
Market View
Net deflation appears unlikely and, to the extent it occurs,
may provide little benefit to 2014e EPS. US Food volumes
have declined fairly consistently during the past 10 quarters in
measured channels, a dynamic which has contributed to both
an increasingly intense promotional backdrop and limited gross
margin expansion across the sector. We expect moderate
inflation among US Food manufacturers in 2014, and believe
that — even if modest deflation does occur — any related margin flexibility will likely be offset by increased promotion and
brand-building investments. We continue to view US Food’s
25-30% premium to the S&P 500 as unsustainable on fundamentals, and believe this will moderate as margin expansion
moderate as inflation expectations become more cautious.
Deflationary inputs (particularly grains) could drive upside
to current consensus earnings forecasts. Spot rates foreshadow another year of manageable input costs in 2014. In
certain commodities, particularly grains, expectations are for
deflation, leading certain market participants to conclude that
packaged food companies are poised for earnings upside driven by gross margin expansion. Considering that fundamentals
remain weak, we believe that heightened valuation of US Food
is likely discounting deflation that will lead to earnings flexibility
next year.
What’s in the Price
We View US Food Valuation as Unsustainable on Fundamentals, and Likely Discounting Deflation
US Food Valuation Remain at ~30% Premium to S&P,
Suggesting Optimism on N-T Earnings Growth
Food Underperformed During Prior Periods of
Peak Deflation (e.g., 2H09)
US Food NTM P/E vs. S&P 500
Relative Performance vs. Input Inflation
150%
25%
50%
20%
40%
15%
30%
10%
20%
5%
10%
0%
0%
140%
130%
120%
110%
100%
90%
-5%
80%
70%
Jan06
-10%
-10%
Aug06
Mar07
Oct07
Jun08
Jan09
Aug09
Mar10
Nov10
Jun11
Jan12
Aug12
Mar13
Nov13
Source: Thomson Reuters, Bloomberg, Morgan Stanley Research
Fundamental weakness in US Food seems increasingly
likely to overwhelm the benefit of limited inflation. Valuation of US Food — trading at a 30% premium to the S&P 500,
or more than one standard deviation above the historical average valuation — has, in our view, likely benefited from perceived EPS visibility related to the moderate inflation environment (and potentially to expectations of input cost deflation). However, we increasingly believe that the combination
of weaker industry volumes, moderate inflation, and a height-
-20%
4Q04
4Q05
4Q06
4Q07
4Q08
4Q09
Relative Performance - Food vs. S&P 500
4Q10
4Q11
4Q12
4Q13
Input Spot Inflation (6m lag)
Source: Thomson Reuters, Bloomberg, Morgan Stanley Research
.
ened promotional environment collectively suggest some risk
of disappointing earnings growth in 2014.
2014 looks fundamentally different than 2009-10 — we
expect limited, if any, deflation. 2009-10 was characterized
by a broad-based collapse of commodity prices, translating
into ~290 bps of cumulative gross margin favorability across
our large-cap coverage during 2Q09-3Q10. We view 2013-14
as much different, both in terms of the breadth and magnitude
of input cost deflation. Unlike the earlier period, where broad-
18
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Packaged Food Gross Margin vs. Input Cost Inflation (6-mth lag)
400 bps
40.0%
300 bps
30.0%
200 bps
20.0%
100 bps
10.0%
0 bps
0.0%
YoY Pt Chg in Average GM (bps)
3Q14e
3Q13
1Q14e
1Q13
3Q12
1Q12
3Q11
1Q11
3Q10
1Q10
3Q09
(30.0%)
1Q09
(300) bps
3Q08
(20.0%)
1Q08
(10.0%)
(200) bps
3Q07
(100) bps
1Q07
based commodity weakness led to 15% deflation across the
input cost basket, current spot deflation is predominately isolated to grains. Our expectation for inflation or moderate deflation is predicated on company guidance that underscores
likely inflation. Morgan Stanley’s US Food input cost forecasts suggest very slight deflation (~1%, on a lagged spot
basis) during C2014, which we believe is likely to translate
into modest inflation once hedging is taken into account.
GM Expansion Is Highly Correlated (~75%) with
Input Cost Inflation/Deflation
3Q06
 1H14: As the 2014 inflation outlook takes shape and
manufacturers roll off less flattering prior-year hedges, it
could provide evidence of whether deflation is materializing.
Exhibit 2
1Q06
 C4Q13 Results / 2014 Guidance: We would expect this
to reaffirm the industry’s broader expectation on modest
realized inflation in 2014.
3Q05
 Upcoming WASDE Releases (12/10 and early 2014):
Given Morgan Stanley’s somewhat constructive view on
grain prices into early 2014, these releases could drive
some modest upside to the currently depressed grain
price outlook.
behind innovation / brand-building has resulted in a relatively
consistent downtrend in operating margins. Even during a
period of peak margin expansion during 2009-10 (as commodity prices broadly collapsed), US food underperformed the
S&P 500, partly driven by manufacturers’ decision to reinvest
heavily in promotional spending, which ultimately resulted in
only very limited improvement in industry volume trends.
1Q05
Potential Catalysts
Input Cost Inflation (6-mth lag)
Source: Company Data, Thomson Reuters, Bloomberg, Morgan Stanley Research
Exhibit 3
EBIT Margins Have Been Pressured Since 2006
Exhibit 1
US Food Volumes Have Declined for the Past
~10 Quarters in Tracked Channels
OPM (bps chg, YoY)
OPM
OPM (LTM)
300
18.0%
250
17.0%
Total US Food Tracked Channel YoY % Change
200
10%
150
8%
100
15.0%
6%
50
14.0%
4%
0
13.0%
2%
(50)
16.0%
12.0%
(100)
Volume
Price/Mix
3Q13
1Q13
3Q12
1Q12
3Q11
1Q11
3Q10
1Q10
3Q09
1Q09
3Q08
Sales
Source: Nielsen xAOC, Morgan Stanley Research
Our historical GM/inflation correlation suggests, under
normal volume conditions, limited GM expansion in 2014.
US Packaged Food gross margin expansion in aggregate is
highly correlated with input costs inflation/deflation (~75%).
However, assuming that volume declines moderate, our model forecasts limited, if any, input cost deflation in 2014, implying that GMs will expand at most ~50 bps.
The industry has historically not retained “cyclical” GM upside,
and the market has been reluctant to reward companies for
this dynamic. With the exception of 2009-10, cyclical gross
margins combined with increased promotion and investment
3Q13E
1Q13
3Q12
1Q12
3Q11
1Q11
3Q10
1Q10
3Q09
1Q09
3Q08
1Q08
(6%)
3Q07
10.0%
1Q06
(4%)
11.0%
(200)
1Q07
(2%)
(150)
3Q06
0%
Source: Company Data, Morgan Stanley Research. E = Morgan Stanley Research est.
We see greater upside among companies with both compelling top-line growth prospects and internally-driven
margin expansion potential in 2014. Given our expectation
of sustained weakness in US Food sales trends, within our InLine industry view overall, we see more attractive risk-reward
for companies that have structural rather than cyclical margin
expansion opportunities. We prefer names with (1) Compelling top-line growth prospects like WhiteWave (WWAV,
$21.27) and Mondelez (MDLZ, $33.53), (2) significant margin
expansion and cash generation opportunities like Dean Foods
(DF, $17.98), and (3) the more traditional center-of-store
manufacturers such as Kraft (KRFT, $53.12), which is still in
the early stages of optimizing its manufacturing footprint and
should see more significant structural margin flexibility.
19
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Gaming & Lodging
Does Online Gaming Represent a Meaningful Growth Opportunity?
Morgan Stanley & Co.
LLC
Thomas Allen
Thomas.Allen@morganstanley.com
Our View
Market View
Online gaming in the US represents a very attractive longterm opportunity with clear near-term catalysts. Online
gaming is now live in 3 states —Nevada, Delaware, and NJ
(most important due to its population) — and we expect the
market to be ~$670 million in 2014. We believe NJ’s launch will
be a catalyst for other states to pass legislation and will highlight the larger US opportunity. While initial profitability should
be limited, investors should focus on revenue to understand
the long-term earnings potential, as markets typically consolidate. We expect the NJ market to be competitive out of the
gate (13 sites are currently live), but we expect clear winners to
emerge, with margins improving over time. We view Boyd (or
888, covered by our Europe-based colleague Vaughan Lewis)
as the best way to play US online gaming; we like BYD given
its NJ footprint and its Bwin partnership. We also view Penn
National as an attractive alternative option over the long term.
Stocks reflect little value from online gaming as investors
remain skeptical on the near- and long-term opportunity.
Regional gaming stocks continue to trade in line with historical
multiples, as the online EBITDA opportunity is still a few years
out. With such a wide range of estimates for the NJ market
($250 million to $1.2 billion) and a fairly slow start in markets
so far, investors are taking a wait-and-see approach to better
gauge the market potential. Focus has shifted to the near-term
technical challenges in NJ (e.g., geo-location and payment
processing issues), but we do not believe these issues will
impact the long-term opportunity. Additionally, the competitive
environment in NJ calls into question the market share and
profitability potential, though we remain confident that clear
winners will emerge.
Expect US Online Gaming to Be a $7 Billion Market by 2017
Based on ~$50 Annual Spend per Adult in the 17 States We Expect to Legalize by 2017
$10,000
$9,000
$8,000
US Online Gambling Revs
Other
Ohio
$7,000
Nevada
Massachusetts
$6,000
Michigan
$5,000
Pennsylvania
New Jersey
$4,000
17 states
US 2012e
130.7
$8,745
$56,330
0.64%
$431
Bear
140.8
$9,655
$56,330
0.58%
$400
2017e
Base
140.8
$9,655
$62,193
0.64%
$442
Bull
140.8
$9,655
$66,902
0.69%
$475
$5,901
10.5%
0.06%
$42
$7,383
11.9%
0.08%
$52
$10,354
15.5%
0.11%
$74
Illinois
Florida
$3,000
California
New York
$2,000
$1,000
$0
2013e
($mm)
Adult population
GDP ($B)
Total gambling market
Gambling as % GDP
Spend per head
2014e
2015e
2016e
2017e
2018e
2019e
Online gambling
Online gambling as % Gambling
Online gambling as % GDP
Online gambling spend per head
2020e
Source: H2 Gambling Capital, Morgan Stanley Research
We believe our market estimates are achievable and
could be conservative. Our base case analysis assumes
that 17 states legalize online gaming by 2017 and implies
~$50 annual spend per adult, a discount to most other mature
markets (UK ~$75; Sweden ~$100) given lack of sports betting. However, note that that US adults currently spend ~$385
each year on gambling (higher than UK $350 / Sweden $375).
Research by H2 Gambling Capital suggests Americans spent
$2.6 billion on illegal offshore gambling websites in 2012.
Degree of success in NJ will be a key catalyst in 2014. NJ
officially launched online gaming on 11/26, and it is the first
state with a meaningful population base to go live. The NJ
DGE plans to release December results on January 14, which
Source: H2 Gambling Capital, Morgan Stanley Research
will give a first glimpse into the success of the launch and the
overall size of the market. Several states view NJ as a model
for online gaming, and we believe a successful NJ rollout will
be a key catalyst in other states moving forward.
We expect California and Illinois to be the next states to
legalize online gaming, but Massachusetts, Pennsylvania,
and NY also appear to be in contention. The California
gaming market is dominated by tribes, and if online gaming is
legalized, it would likely be poker-only, still a sizeable opportunity given the state’s population of 38 million (vs. NJ’s 8
million). There are currently two draft bills in process, with a
third potentially proposed in early 2014.
20
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Exhibit 2
Potential Catalysts
 NJ Market Data - January 14, 2014
NJ will release the online gaming results from Nov/Dec,
giving investors a first glimpse into the market’s size.
European Online Gambling Operator Margins in the
20-30% Range; Expect the US to Be No Different
Online gambling EBITDA margins
60%
40%
30%
20%
10%
Exhibit 1
Winners Typically Consolidate Share Over Time
Market share of top 4 companies in key markets
UK
30%
Australia
79%
Spain
80%
Italy sports
70%
Italy Poker
54%
0%
20%
40%
60%
xx
80%
100%
Source: Company Data, H2 Gambling Capital, eGaming Review (14 November),
Morgan Stanley Research
… but the revenue opportunity is what investors should
pay for, as it would shift US regional gaming from maturity to growth. We expect NJ to be a $650 million revenue
market by 2015, a 20% increase to the existing on-ground
market. Similar to other markets, we expect earnings to significantly ramp over time as the markets mature and consolidate. Spain, for example, launched in July 2012 and 888 recently commented that it has just moved into profit in the market (in ~1 year). The average margin of European online gaming companies is 20-30%, and while many operate in markets
without taxes, even in Australia (a market with high duties of
~25% and a limited product set of only sports), the leading
operators generate EBITDA margins of ~25%.
2015e
2014e
2013e
2011
2010
2009
2008
2007
Average online gambling
Bwin
Paddy Power
Ladbrokes online
betfair
2012e
NJ market will be competitive out of the gate, and we expect earnings losses initially… With 7 NJ casinos licensed
for online gaming and nearly 15 competing sites, we expect
initial profitability to be limited. Bwin.party said it expects NJ to
lose €5-10 million in 2013, and to lose around €5 million in
2014. Paddy Power said it would not enter the NJ market as it
is “a very competitive B2C landscape”. Another technology
provider recently commented that its NJ operations likely
won’t generate a meaningful profit until 2015, which is consistent with our market assumptions. Markets typically lose
money at first as entrants jockey to take market share, but the
four key winners usually end up with 30-80% of the market.
2006
0%
-10%
2005
 Other States Move Towards Legalization
As online gaming continues to ramp, we expect other
states to begin the legislative process throughout 2014.
50%
2004
 Potential Calif. and Illinois Legalization — 2014
We expect both California (poker only) and Illinois to legalize online gaming in 2014, with play starting in 2015.
888
PartyGaming / bwinparty
William Hill Online
Unibet
Source: Company Data, Morgan Stanley Research
We view Boyd Gaming (BYD, $11.45) as the best way to
play US online gaming. We believe Boyd is best positioned
given its 50% ownership of the Borgata in NJ (has 50% share
of the AC poker market) and its partnership with Bwin (PartyPoker was the No.1 brand in the US prior to the online ban in
2006). Early numbers suggest Boyd’s sites are already generating ~50% share in NJ online poker. Based on our US estimate, we expect Boyd to generate $75 million of EBITDA
from its online gaming operations by 2017. We value this at a
10x multiple, which, discounted back 2.5 years implies $5 per
share of value in our $14 price target. That $5 is ~2x our
2015 online revenue estimate for Boyd, which we think is fair
in the context of other Internet multiples. We estimate the
market attributes ~$1/share to BYD for online gaming (assuming its on-ground operations are valued at 7.5x 2014
EBITDA), suggesting meaningful upside remains.
Longer-term, we see significant opportunity for Penn National
(PENN, $14.44) to capitalize on online gaming given its
unique footprint across 16 jurisdictions. However, we do not
include any benefit in our price target as Penn does not have
a license in NJ and has yet to announce a technology partner.
888 looks best positioned among European operators.
888 (888.L, 167p, covered by Vaughan Lewis) owns 47% of
All American Poker Network (AAPN), which services several
operators including Wynn and Caesars. We expect AAPN
(and 888 directly through its WSOP supply agreement) to
generate significant high-margin software fees. 888 services
the Nevada and Delaware markets, and recently launched in
NJ through its partnership with Ballys.
Regulatory delays are the key risk. Our call is predicated on
continued legalization of online gambling in new states, including California and Illinois.
21
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Healthcare Services / P&C Insurance / Managed Care
Will Private Exchanges Take Over? Winners & Losers
Morgan Stanley & Co.
LLC
Healthcare Services & Distribution
Ricky Goldwasser
Ricky.Goldwaser@morganstanley.com
P&C Insurance
Gregory Locraft
Gregory.Locraft@morganstanley.com
Managed Care
Andrew Schenker
Andrew.Schenker@morganstanley.com
Our View
We estimate the private exchange addressable market is
~75 million lives, and that ~30 million (40%) lives will be
moved to private exchanges by 2017, according to our bottom-up model (see Exhibit 1 below).
Positive for key insurance brokers… Large P&C Insurance
brokers Marsh & McLennan and AON (owners and operators
of the exchanges) should be beneficiaries.
…an opportunity for MCOs to increase profitability… Further, we believe private exchanges represent an opportunity to
increase profitability for managed care companies if lives that
were previously self-insured convert to fully insured products.
…whereas pricing/profit margins for PBMs are likely to
come under some pressure, all else equal, for those clients that decide to switch. That being said, with somewhat
limited exposure across their books of business to populations
likely to move to an exchange in the near-term, we think headline risk is more prominent than earnings risk for PBMs in the
next 12-18 months. In regaining lives from private exchanges,
we view Express Scripts as best aligned with health plans.
Market View
The market is struggling to size the addressable market
for private exchanges, as well as the number of lives likely
to be migrated. With limited information, markets have tended
to default to estimates provided by insurance brokers, with an
opportunity range as wide as 35-70 million actives in private
exchanges in the next ~5 years.
Stock price movements suggest the market expects insurance brokers to benefit but believes PBM earnings will be
pressured. Announcements by retailers (Walgreen) and large
retiree populations (IBM, AT&T) that were moving covered
lives to private exchanges in 2014/2015 has weighed on
shares of PBMs (CVS, Express Scripts, Catamaran) and
boosted shares of large P&C insurance brokers (Marsh &
McLennan, AON) who own and operate the exchanges.
Investors believe that private exchanges will be a growth
driver for MCOs over time. While managed care companies
have highlighted the potential opportunity from private exchanges over the next few years, given enrollment will likely be
modest in 2014 it is our sense that the stocks have not fully
priced in the potential benefit from private exchanges. There is
still uncertainty on enrollment uptake among populations shifting to the exchange and lack of details on the profitability dynamics.
Exhibit 1
The Private Exchange Addressable Market is ~75 Million Lives
Retirees, Lower-Skill Workers, Temporary Workers are the Low-Hanging Fruit
Source: U.S. Census Bureau, EBRI, Morgan Stanley Research Estimates
22
MORGAN STANLEY RES EARCH
2014: The Big Debates
December 4, 2013
Our bottom-up analysis sizes the private exchange addressable market at ~75 million lives. We believe lowerskill workers represent the majority of the opportunity (~65%,
or ~ 50 million lives) followed by retirees with employer sponsored benefits accounting for ~24% of the opportunity (~18
million lives). Temporary workers represent the remaining
~13% (~10 million), although arguably this population may be
more likely to end up in public exchanges over time. Moreover, some of the total pool could be eligible for public exchanges beginning in 2017 and as such, some employers will
likely defer a decision for now.
We estimate ~30 million lives (40% of the addressable
market) will be moved to private exchanges by 2017. We
expect the transition to take ~3 years (term of an average
PBM contract), translating to an average annual growth rate
of ~11% (9 million lives) through 2017. The initial opportunity
is likely to consist primarily of retirees and temporary workforces, whom we expect will all transition to private exchanges
as employers are likely to see savings from a shift to defined
contribution. We estimate over the same period 5-10% (2.5-5
million lives) of lower-skill workforces will transition, based on
our survey work of benefits manager interest in exchanges
conducted earlier this year.
High-skill workforces are less likely to be transferred to
private exchanges, in our view. Based on our conversations
with benefits managers, health benefits remain a key source
of differentiation among firms competing for talent, and employers might seek to guard against under-insurance for businesses that require a high degree of intellectual capital. Additionally, large companies that already take risk may see little
pricing benefit in switching to an exchange (especially those
with younger employee populations) and may not wish to lose
control of their benefit selection. For instance, in our conversations with large companies transitioning to private exchanges, the price difference between self-insured and fully insured
estimated at a range of ~6% to ~10%, is creating a hurdle to
transition. Although large corporations who are first movers
may be offered compelling economics to entice the change
and become “anchor tenants” in a private exchange, we view
the likelihood that these early-years deals continue is low. As
such, we think larger employers with skilled workforces may
be more likely to control costs by increasing the employee
share of co-insurance and adopting defined contribution plans
outside of the exchange world. Accordingly, in our analysis we
only estimate ~5% to 10% of large employer lives switching.
Pharmacy Benefit Managers
PBMs’ exposure is dependent on customer mix and
health plan relationships. We estimate ~22% of CVS PBM
customers are exposed to a potential private exchange transition, ~20% for Express, and ~11% for Catamaran, with a
roughly equal 1-2% EPS exposure across the group. To estimate who will “win” on exchanges, we looked at PBM relationships with health plans competing on the exchanges.
Comparing share of health plan commercial lives with its PBM
market share, we view Express as likely to recapture 94% of
lives based on its health plan relationships, followed by CVS
(~78%) and Catamaran (~74%).
Pricing/profit margin for PBMs should come under some
pressure, all else equal. We expect identical programs on an
exchange to be ~100 bps less profitable than the same product not offered on an exchange. To prevent margin dilution or
improve margins in some instances, PBMs are likely to offer
more restrictive programs on their exchange products, including mandatory mail and limited retail networks.
Headline risk is more prominent than earnings risk for
PBMs in the near term, in our view. While announced
moves to private exchanges have pushed PBM shares down
by as much as 1-2% for the incumbent for a single account
lost, we see earnings risk as minimal in the near-term, with
total annual earnings exposure of ~1% for CVS / Catamaran
and ~2% for Express. Longer term, if exchanges do capture
more momentum, exposure could increase.
Exhibit 2
EPS Exposure of PBM Earnings in Next 3 Years
Estimated exposure of Employer Book
Employer Book % of EPS
EPS Exposure over next 5 years
CVS
22%
6%
1.1%
ESRX
20%
12%
2.2%
CTRX
11%
7%
1.2%
Source: Company data, Morgan Stanley Research estimates
Exhibit 3
Relative Risk of PBMs Based on Script Share and
Share of Health Plan Commercial Lives
35%
94%
30%
78%
98%
25%
128%
20%
225%
74%
15%
10%
5%
0%
ESRX
CVS
Est. Share of Adj. Rx
CTRX
OptumRx
Prime
Other
Est. Share of Health Plan Commercial Lives
Source: Company data, Morgan Stanley Research
23
MORGAN STANLEY RES EARCH
2014: The Big Debates
December 4, 2013
Large P&C Insurance brokers Marsh & McLennan and
AON should be beneficiaries of the move to private exchanges. It seems logical that the rise of private healthcare
exchanges benefits the owners and operators of the exchanges. Today’s leaders include benefits consultants Hewitt
(owned by AON), Mercer (owned by MMC), and Towers Watson/Liazon (owned by TW). The early exchanges are focused
on serving core market segments of the large brokers, including retirees, large employers, and small/medium employers.
Current offerings are similar to traditional health insurance
offerings and include fully insured and self-insured plans. We
hesitate to even call these “exchanges”. However, the power
of an exchange resides in its “network-effect” business model:
As covered lives and product offerings grow, standardization
among products and a blurring of today’s segments should
emerge. Exchanges that attract the most buyers and sellers
should drive the highest efficiencies for all parties and in turn
provide a growing competitive advantage for exchange operator “winners”. We believe AON and MMC all are well positioned in the early days.
Private exchanges offer upside optionality for Marsh’s
and AON’s long term earnings potential. Determining the
earnings impact of exchanges is particularly challenging, as
the economic model is shrouded in secrecy and hinges on
several assumptions. Key drivers include employee lives
covered, revenue per employee, margins, and cannibalization. We note each employee represents 2.5 covered lives
once dependents are factored, so our assumption of 30 million lives in 2017 equates to 12 million employees in our analysis. Our analysis assumes two-thirds of exchange clients
are existing customers that are converted at a higher margin
(25% vs. 15%), while one-third are new clients. The revenue
per employee is $250/year, based on our industry research.
These assumptions point to potential EPS accretion due to
private healthcare exchanges of as much as 7% by 2017 for
Marsh and AON, based on the speed of the ramp and market
share achieved. Considerable variation exists, but what is
clear to us is that private healthcare exchanges offer material
“upside” to our long-term EPS forecast for both Marsh and
AON.
Exhibit 4
Potential 2017 EPS Accretion from
Private Exchanges for AON and MMC
9.0%
Potential 2017e EPS Accretion From Private Exchanges
8.0%
Base Margin: 15%
New Margin Estimates: 25%
Cannibalization: 67%
Revenue Per Employee: $250
7.0%
EPS Accretion
P&C Insurance
6.0%
5.0%
AON
MMC
4.0%
3.0%
2.0%
1.0%
0.0%
Current
AON=330k
MMC=75k
500k
1m
2.5m
5m
Covered Employees (excluding Dependents)
Source: Company Data, Morgan Stanley Research
Managed Care
Private exchanges represent an opportunity to increase
profitability for managed care organizations (MCOs), in
our view. Private exchanges, depending on plan design, can
offer consumers more choices, encourage individuals to take
greater control of their healthcare needs, and enhance employers’ ability to forecast the medical costs of covered populations. Private exchanges offer an opportunity for MCOs
increase the profitability of legacy commercial members. Specifically, managed care companies will benefit from private
exchanges if lives that were previously self-insured convert to
fully insured products.
As background, self-insured or Administrative Services Only
(ASO) offerings are low-revenue, high-margin products, while
fully insured products are high-revenue, low-margin products.
As such, private exchanges are likely to represent a margin
headwind but earnings tailwind. Notably, Aetna recently suggested that fully insured membership typically generates four
to five times the profit contribution when compared to selfinsured membership. Interestingly, Aetna management also
highlighted that the membership number on private exchanges was likely less relevant than the revenue contribution.
Exhibit 5
Current ASO Exposure
ASO Lives
% of Total ASO Mkt
AET
CI
HUM
UNH
WLP
12,769
11,023
1,161
19,010
20,124
16%
14%
1%
24%
25%
Source: Company data, Morgan Stanley Research estimates
24
MORGAN STANLEY RES EARCH
2014: The Big Debates
December 4, 2013
Among our covered companies, UnitedHealth and WellPoint
have the most ASO lives, representing 24% and 25%, respectively, of the total market, on Morgan Stanley’s estimates.
However, Aetna and Cigna see the largest the largest EBIT
(20–25%) from self-funded lives.
In our conversion analysis, we assume self-funded lives have
a monthly fee of $25 and margin of 15% while private exchange lives are roughly four times more profitable with a
$350 monthly premium (PMPM) and 5% margin. According to
our forecasts, a 10% shift from a self-funded product to a fully-insured product on a private exchange represents a 5%
average increase in EPS for 2014e. WellPoint, Aetna, and
Cigna will likely be the largest beneficiaries of this potential
conversion.
Exhibit 6
For MCOs, 10% Move to Private Exchange from
ASO Represents ~5% Avg. EPS Tailwind in 2014e
10% of ASO Lives Move Exchange
AET
CI
HUM
UNH
WLP
1,277
1,102
116
1,901
2,012
Previous EBIT Contribution (ASO)
$57
$50
$5
$86
$91
New EBIT Contribution (Exchange)
$268
$231
$24
$399
$423
EPS Tailwind
$0.38
$0.42
$0.08
$0.20
$0.71
% 2014E EPS
6%
6%
1%
4%
8%
Source: Company data, Morgan Stanley Research estimates
Stocks mentioned: Covered by Ricky Goldwasser: Catamaran
(CTRX, $45.63), CVS/Caremark (CVS, $66.96), Express Scripts
(ESRX, $67.35). Covered by Gregory Locraft: AON (AON, $81.64),
Marsh & McLennan (MMC, $47.45). Covered by Andrew Schenker:
Aetna (AET, $69.93), CIGNA (CI, $87.45), Humana (HUM, $103.99),
UnitedHealth (UNH, $74.48), WellPoint (WLP, $92.88).
25
MORGAN STANLEY RES EARCH
2014: The Big Debates
December 4, 2013
IT Hardware and Services
How Does Cloud Computing Affect Hardware and Services Companies?
Morgan Stanley & Co.
LLC
Katy L. Huberty, CFA
Kathryn.Huberty@morganstanley.com
Our View
Market View
Secular headwinds from accelerating cloud computing
adoption are offsetting cyclical recovery. Over two-thirds of
companies plan to be running workloads in the public cloud by
year-end 2014, up form half today, with CIOs expecting public
cloud adoption to hit the historically important 20% inflection
point by the end of 2014.
As a result of the accelerating adoption, IT Hardware and Services revenue is deteriorating faster than expected. Despite
improving US and EMEA GDP growth, revenue estimate misses within our coverage universe are widening. Our 2014 revenue growth estimates are below consensus for 12 out of 17
companies within our coverage universe and we model 3%
revenue growth on average, below the Street’s 4%.
Consensus estimates suggest cyclical tailwinds support
better growth in 2014 despite cloud adoption. The Street is
modeling accelerating revenue growth for the majority of IT
Hardware and Services companies we cover, including structurally exposed legacy vendors like Accenture, EMC, IBM, Teradata, and QLogic. Our growth estimates for 2014 are below
consensus for each of these names.
We are more positive on Apple, HP, and Western Digital,
where we see more limited risk from cloud adoption and lower
valuation multiple risk. While our 2014 revenue growth estimates are in line with the Street’s, our EPS estimates are
ahead of consensus for each of the three companies.
We Are EW or UW All Names with 80%+ Revenue at Risk Due to Cloud Computing
We are most concerned about IT Hardware and Services stocks with both:
(1) high revenue at risk of disruption from cloud computing, and (2) valuation multiple risk.
Exposure to Cloud Risk vs. 2014 EV/FCF
30.0
25.0
NCR (EW)
CTSH (EW)
20.0
Higher Risk
IBM (EW)
15.0
TDC (UW)
EV/FCF
CDW (EW)
ACN (EW)
QLGC (UW)
HPQ (OW)
NTAP (EW)
EMC (EW)
10.0
STX (EW)
AAPL (OW)
LXK (UW)
Lower Risk
BRCD (EW)
WDC (OW)
100%
90%
80%
70%
60%
5.0
0.0
10%
% of Revenue at Risk to Cloud Adoption
Source: Thomson Reuters (price data), Morgan Stanley Research
Share prices as of Nov 29: ACN $77.47, AAPL $556.07, BRCD $8.79, CDW $22.30, CTSH $93.89, EMC $23.85, HPQ $27.35, IBM $179.68, LXK $35.37, NCR $34.95, NTAP $41.25, QLGC
$12.41, STX $49.04, TDC $45.64, WDC $75.04
26
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
We see accelerating public cloud adoption posing a
threat to legacy hardware vendors. Cloud computing eliminates the need for on-premise hardware infrastructure, while
many cloud providers like Amazon Web Services (AWS)
mostly procure their compute hardware directly from component vendors or ODMs. We also see risk to traditional IT services providers as compute moves off-premise, pressuring
implementation spend, and IT asset management revenue is
redistributed from system integrators to cloud providers.
Our proprietary survey work indicates 72% of companies expect to run some workloads in the public cloud by the end of
2014, up from half today. Workload migration is also accelerating, with adopters running 18% of workloads in the cloud,
which is expected to exceed 20% by the end of 2014, a historical inflection point in other technology markets.
Exhibit 2
Improving GDP Growth in the US Not Reflected in
Reported Revenue due to Secular Pressures…
US GDP Growth vs. US Revenue Growth
within Our Coverage Universe
6%
US GDP Growth
Coverage Universe US Revenue Growth
5%
4%
3%
2%
1%
0%
4Q12
1Q13
2Q13
3Q13
Exhibit 1
Cloud Adoption Expected to Hit 20% by End of 2014
% of Workloads in Public Cloud
(Among Companies Using Public Cloud)
25%
Source: Bureau of Economic Analysis, Company Data, Morgan Stanley Research
Exhibit 3
22%
23%
… with Revenue Shortfalls Skewed to Companies
with the Most Cloud Exposure
20%
20%
17%
18%
18%
2013 Revenue Cloud Revenue Average Cloud
Miss
Risk
Revenue Risk
19%
16%
15%
10%
5%
0%
End of 2013
Jan 13 Survey
Apr 13 Survey
End of 2014
Jun 13 Survey
Oct 13 Survey
Source: Morgan Stanley CIO Survey
Structural hit from cloud may be greater than the current
cyclical recovery. In July 2013, we saw growing signs of a
cyclical recovery that started in the US and extended more
recently to Europe. Despite improving GDP, US revenue
growth deteriorated modestly from C2Q13 to C3Q13 and
came in below our expectations. Because many early
adopters of cloud computing are US-based, we view the step
back as a sign of cloud adoption offsetting the cyclical recovery.
The companies with the biggest revenue shortfalls compared
to our original January 2013 estimates are: Teradata (missed
by 10%), Brocade (missed by 8%), and IBM (missed by 6%).
Accenture, NetApp, and QLogic also missed revenue by 3%
or more. These make up six of the nine names we estimate
have the greatest (80%-plus) revenue threat from cloud computing. Overall, our industry view is Cautious.
TDC
BRCD
IBM
ACN
QLGC
NTAP
STX
EMC
NCR
HPQ
CTSH
LXK
WDC
-10%
-8%
-6%
-4%
-3%
-3%
-1%
-1%
0%
1%
4%
5%
5%
96%
89%
95%
87%
100%
90%
65%
96%
87%
73%
90%
69%
65%
92%
76%
Source: Company Data, Morgan Stanley Research
Potential Catalysts
 Throughout 2014
New service launches from Infrastructure as a Service
(IaaS) providers. The IaaS market is rapidly evolving,
with exponential growth in new service and feature
launches by AWS and aggressive expansion in competitive offerings from Microsoft, Google, Verizon, etc.
 End of 2014
We expect public cloud workload penetration to reach
20%, a historical inflection point in other technology
markets.
27
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Machinery
Will the US Non-Residential Construction Market (Finally) Recover in 2014?
Morgan Stanley & Co.
LLC
Nicole DeBlase
Nicole.DeBlase@morganstanley.com
Our View
We believe that the US Non-Residential Construction market should finally show signs of recovery in 2014. We believe a dearth of new housing subdivision build-out has been
largely responsible for the absence of a Non-Resi pickup: the
Non-Resi infrastructure to support existing communities has
already been constructed. Our analysis shows that active
community growth, as reported by the US Homebuilders, has
remained essentially flat over the past several years. The good
news is that this metric is ticking up as of 3Q and the homebuilders are forecasting in active communities (and plan to
invest in new land) during 2014.
Market View
Investors are generally positive on the outlook for NonResi, but we think sentiment has moderated amid disappointing Resi data. For the past two years, investors have
hitched their wagons to hopes of a US Non-Resi recovery. This
has seemed rational — it remains one of the few Capital
Goods end markets that has yet to benefit from the ongoing
economic recovery. While history tells us that Non-Resi Construction investment growth should follow Resi, a basic analysis of the typical Resi / Non-Resi lag (~18 months) indicates
that Non-Resi should have picked up already — which has
frustrated many investors.
How Do We Prefer to Play It?
Terex Remains Our Top Pick and a Morgan Stanley North America Best Idea,
but We Believe All Three Machinery Non-Resi Names Are Well Positioned
Although we continue to prefer TEX for its ”self-help” angle as we wait for more concrete signs of a recovery, we
note that all three of our Non-Resi exposed stocks under coverage (Terex, Manitowoc, and United Rentals; see Exhibit 4) are well-positioned to benefit if a Non-Resi recovery materializes in 2014-15e. Although these stocks have
outperformed the broader Machinery group in 2013, only URI has outperformed the S&P 500 YTD and we believe
that Non-Resi sentiment has tempered given a lack of improvement YTD. Based on our conversations with investors, we believe the market is only pricing in a modest recovery in 2014e, which is consistent with more conservative
Machinery company commentary to date. Our Base case calls for mid-single digit growth in US Non-Resi spend during 2014e, which translates to ~10% growth for Machinery OEMs using a ~2x multiplier (consistent with historical
norms, due to inventory adjustments).
For the past two years, investors have anticipated a US
Non-Resi recovery. This makes sense to us, as US NonResi investment remains 15% below prior peak levels and is
only 12% above the most recent trough, making it one of the
most depressed end markets in US Capital Goods.
Moreover, history tells us that Non-Resi Construction
investment growth should follow Resi. A greater number of
new housing subdivisions require infrastructure to support the
new communities. Our analysis shows that Non-Resi spending typically lags Resi expenditure by 18-24 months. In Exhibit 2, we have plotted Y/Y growth in US Resi spend against
US private Non-Resi spend, excluding the power and manufacturing categories (given that these tend to be volatile and
show far less correlation with Resi trends).
This basic analysis implies that a Non-Resi recovery
should now be underway, so we understand investor frustration with the Non-Resi recovery thesis – to date it simply
has not played out. Resi indicators positively inflected in late
2011 (growth in Resi construction spending and housing
Exhibit 1
US Non-Resi Construction Investment Remains
Depressed Relative to Other Industrial End Markets
-60% -40% -20%
0%
20%
40%
60%
US Resi Construction
US Non-Resi Construction
Tools & Appliances
US Ag Equipment
Power Generation
HVAC & Refrigeration
Fire & Security
Electrical Equipment
Aerospace & Defense
Flow Control
Median (ex Resi/Non Resi)
Total Ex-Construction
Utility T&D
Auto
Truck
Healthcare
Oil & Gas
Mining
Source: Company Data, Census Bureau, Morgan Stanley Research
28
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Exhibit 2
monitor monthly construction data and company orders for
more concrete evidence that the recovery is underway.
Historically, Non-Resi Investment Growth Has
Lagged Resi by 18-24 Months…
Total Resi
Exhibit 3
Total Non-Resi
…but Subdivision Growth Has Been Muted
40%
30%
TOL Number of Selling Communities
20%
350
10%
300
0%
250
-10%
200
50
However, it is possible that a dearth of new subdivision
build-out has been responsible for the lack of Non-Resi
pickup to date. We have asked all Machinery companies
with Construction exposure for their best explanation as to
why the Non-Resi recovery has yet to materialize. One of the
more interesting theories (set forth by Deere management)
suggested that to date, US homebuilders have focused on
completing previously started subdivisions rather than opening new communities. From a Non-Resi perspective, the issue
is that the Non-Resi infrastructure to support existing communities has already been built. Our analysis supports this explanation. Y/Y growth in community count and Non-Resi ex2
penditure have shown a strong correlation (R = 0.78).
2012
2013E
2011
2010
2009
2008
2007
2006
2005
2004
2000
starts have been positive since September 2011). If we apply
an 18-month lag, this implies that Non-Resi Construction investment should have picked up already. Clearly, this is not
the case, with public Non-Resi construction spending still declining as of the most recent release, crane sales more than
40% below peak levels, and company commentary still a bit
cautious (though improving in 3Q13).
2003
0
Source: Census Bureau, Morgan Stanley Research
2002
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
100
1996
-40%
1995
150
1994
-30%
2001
-20%
Source: Census Bureau, Toll Brothers, Morgan Stanley Research E = Company Estimate
All three of our Non-Resi exposed stocks should work in
the case of a robust Non-Resi recovery in 2014e. We continue to prefer Terex (TEX, $36.32) while we wait, given the
”self-help” angle in addition to Non-Resi exposure. However,
we are becoming more positive on our other Non-Resi names,
United Rentals (URI, $68.73) and Manitowoc (MTW, $20.59).
We believe that sentiment has moderated, as Resi data points
have disappointed (new home sales have come in below expectations since the summer). However, we see potential for
the ”Non-Resi hope trade” to soon reignite as investors think
about stock positioning for 2014.
Exhibit 4
URI, TEX and, MTW Have the Highest Non-Resi
Construction Exposure in Our Universe
60%
56%
50%
40%
30%
Since the trough, the number of active communities has
essentially remained flat. According to Toll Brothers data
(available since 2000), the total number of selling communities has remained flat since the trough, hovering around 200304 levels. While we don’t have the metric going as far back
for some of the other homebuilders, we note that Lennar and
KB Home have both shown relatively flattish active community
count since 1Q11 as well.
The good news is that homebuilders are growing their
active communities, and were very bullish during 3Q
earnings season. After reading through the transcripts of six
of the largest US Homebuilders, we see clear potential for
community count growth to turn positive Y/Y in 2014e. To this
point, the homebuilders that report total active communities
on a quarterly basis have already begun to note a positive
inflection. While we find this encouraging, we continue to
19%
20%
8%
10%
0%
0%
AGCO
JOY
10%
22%
10%
0%
PH
DE
Total
CAT
MTW
TEX
URI
US
Source: Company Data, Morgan Stanley Research
Other Potential Catalysts
 Third Wednesday of each month
AIA’s Architectural Billings Index results, an important
lead indicator for US Non-Resi Construction markets.
 First business day of each month
US Census Bureau’s Private/ Public Construction data is
released, which provides put-in-place results for both
Resi and Non-Resi markets.
29
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Multi-Industry
How Much Operating Leverage Is Left This Cycle?
Morgan Stanley & Co.
LLC
Nigel Coe
Nigel.Coe@morganstanley.com
Our View
Market View
Margin performance for Industrials has been remarkably
strong over the last several years, and 2013 marked a continuation of this theme. Indeed, 2013 saw an even starker
bifurcation between the cadence of margin expansion and declining organic growth rates. This phenomenon can be attributed predominantly to strong pricing against material input deflation, in addition to internal productivity initiatives and restructuring payback (among other incremental factors). However, the
major debate heading into 2014 is “How much operating leverage is left this cycle?” — given that the majority of Electrical
Equipment/Multi-Industry companies under Morgan Stanley’s
coverage are already operating above prior peak core margins.
Early indications from companies providing frameworks for
2014 guidance suggest the risk of softer operating leverage in
2014 and perhaps beyond, driven by waning price/cost benefits
and the need for internal growth investments, against expected
offsets from restructuring payback and pension tailwind.
Therefore, we believe a key driver of relative performance
in 2014 will be the divergence in operating leverage at the
company level. As such, investor focus will likely remain
focused on genuine ‘Self-Help’ stories that have the potential to drive superior EPS growth. Our top picks here are
Tyco, Danaher, Eaton, and Honeywell.
Exhibit 2
8
8%
6
7%
4
6%
2
5%
0
4%
-2
Source: Company Data, Morgan Stanley Research
We are keenly aware of the concerning bifurcation between
EE/MI core margin expansion (up 240bps, 2009-13e) and
decelerating organic growth (+8.7% in 2010 vs. 1.8% 2013e).
Impressive operating leverage to date is largely attributable to
sustained price/cost benefits — as highlighted above in our
Jun-14
Mar-14
EEMI Organic Sales Y/Y (RHS)
-8
-10
Dec-13
2013e
Jun-13
EEMI Core OM Expansion (LHS)
2012
Sep-13
2011
Mar-13
2010
-6
Dec-12
0%
Jun-12
1%
0%
-4
Sep-12
2%
Mar-12
3%
1%
Dec-11
1%
9%
Jun-11
2%
Price/Cost Has Been a Major Margin Tailwind, but
Gap Is Narrowing Amid Incipient Material Inflation
Sep-11
10%
Sep-10
2%
Mar-11
EEMI Core OM Expansion vs. Organic Sales Growth
Dec-10
Exhibit 1
We do not believe the market is really focused on this issue. We clearly sense a feeling that margins are at very high
levels, but the prevailing view is that with volumes increasing,
capacity utilization levels benign, and pension costs tailing off
(as discount rates rise and plan deficits narrow) then the likelihood is that margins should continue to expand. The market
has been favoring shares of companies with self-help themes,
either through operational improvement and/or capital allocation optionality. But this is largely due to macro uncertainty
putting a premium on “EPS growth from anywhere”, so there is
a risk that this trade could fall out of favor if industrial production does accelerate as lead indicators — including our proprietary Capital Goods Momentum Index (CAPMI) — suggest it
should. However, with 50-100bps of tailwind from price/cost
benefits over the past two years likely to narrow sharply, we
believe companies that can continue to drive above-average
operational leverage, via process improvements, footprint simplifications etc, should continue to outperform.
Source: BLS, Morgan Stanley Research
proprietary Cap Goods Gross Margin Barometer (Exhibit 2),
which represents the gap between price and input cost inflation.
30
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
We further highlight the notion of productivity and internal
initiatives to bolster bottom-line performance, displaying the
consistent improvement in average revenue per employee
across our coverage universe.
premium, and we believe a key debate for Industrial Conglomerates in 2014 will be the ability to continuously expand
margins amidst what is shaping up to be another year of relatively soft market growth (communicated estimates to date
imply 3-5% global end market growth in 2014e).
Exhibit 3
Average Revenue per Employee Up 12% (2009-12)
Exhibit 5
Guidance Framework to Date Implies Earnings /
Revenue Multiplier Trending Notably Lower in 2014
275
6.0x
250
5.0x
4.0x
225
3.0x
2.0x
200
2009
2010
2011
2012
1.0x
EE/MI Average Revenue Per/Employee ($'000s)
0.0x
2010
Source: Company Data, Morgan Stanley Research
2011
2012
2013e
2014e*
EPS Grow th vs. Revenue Grow th Multiplier
However, in line with management commentary calling for a
more challenging pricing environment in 2014, we estimate
that price/cost will trend closer to neutral through C2014.
Moreover, core margins could face additional headwinds from
the need for internal growth investments to support future
growth. As such, with the majority of companies under coverage already operating ahead of prior peak core margins, we
ask the question: How much operating leverage is left
through the balance of this cycle?
Exhibit 4
2013e Core Margins Are 80bps Ahead of Prior Peak
6%
Core OM (2013e) vs. Prior Peak
4%
2%
0%
Therefore, we believe that investors must focus on the
potential for above average operating leverage through
the balance of the cycle via ‘Self-Help’ stories that have
the potential to drive superior EPS growth.
Our top picks in 2014 under this scenario include:
 Tyco International (TYC, $38.14)
Aggressive three-year margin targets for savings from
productivity, IT consolidation, sourcing initiatives, and
real estate square-footage reduction; leverage to a potential Non-Resi construction recovery.
 Danaher (DHR, $74.80)
Potential upside to 2014 consensus numbers via EPS
tailwinds from capital deployment ($8-10 billion could
add $1 incremental EPS, we estimate), restructuring
benefits and margin recovery/expansion at Test &
Measurement, Life Sciences & Diagnostics, and Dental.
-2%
-4%
-6%
-8%
AME
HON
HUBB
LII
DOV
ITW
DHR
ETN
EMR
Median
ROK
IR
UTX
RBC
MMM
SWK
GE
SPW
-10%
-12%
Source: Company Data, Morgan Stanley Research * 2014e includes guidance framework;
comprises MS estimates for SWK, EMR, ROK, TYC and the mid point of guidance for GWW.
Source: Company Data, Morgan Stanley Research
Early indications from companies providing a framework for
2014 guidance suggests that recent improvements in the
earnings / revenue growth multiplier for industrial names could
shrink into 2014, with upward pressure from tax rate an additional factor unless Congress extends important credits such
as R&D and accelerated depreciation. This indicates that operating leverage going forward is more likely to come at a
 Eaton (ETN, $72.66)
We look for Cooper synergies; leverage to Non-Resi
construction and short-cycle industrial recovery; modest
pension tailwind; relative multiple expansion.
 Honeywell (HON, $88.51)
Continued roll-out of Honeywell Operating System,
Functional Transformation, Organizational Effectiveness,
and Velocity Product Development could drive margins
3ppts higher over the next five years. We also see clear
upside potential to consensus numbers.
31
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
REITs — Single-Family Rentals
Is Buy-to-Rent on an Institutional Scale a Sustainable Business or a Trade?
Morgan Stanley & Co.
LLC
Haendel St. Juste
Haendel.StJuste@morganstanley.com
Our View
Market View
Institutional buy-to-rent is a sustainable business that
could grow from $20 billion to over $100 billion and generate 10%-plus ROIC. While initial net yields (~5-6% after
capex) may fall short of WACC, we believe buy-to-rent (BTR)
should be evaluated on a total return basis. In the near-term,
we expect home price appreciation (HPA) to augment cash
flow and drive ROIC above 10%. In the long run, while HPA
should be less of a tailwind, we see upside to rents and expect
margin expansion to drive sustainable double-digit ROIC.
We think the market underappreciates future growth, HPA,
and platform value. The single-family sector currently trades
below the marked-to-market value of its homes, and American
Residential Properties and Silver Bay even trade below book
value (measured at cost). This implies that the market expects
the operation of single family rental portfolios to be a valuedestroying business in the long-run.
What’s in the Price
Single Family REITs Are Trading Below the Marked-to-Market Book Value of Their Portfolios
Marked-to-market book value should serve as a valuation floor. Upside comes from creating value via attractive investment yields and cash flow growth over time. The market is pricing in value destruction, not value creation.
30.00
SFR Subsector Trading Below
Marked-to-Market Portfolio Value
$25.00
26.54
$20.00
$10.00
26.00
-13%
-18%
$15.00
28.98
ARPI Is Our Top Pick
28.00
+3%
$19.50
$15.90
$20.06
$17.38
24.00
24.24
$15.93
$16.49
22.39
22.00
21.80
20.06
21.22
20.00
18.25
$5.00
18.00
Current share price: $17.50
Share Price
Marked-to-Market Book Value/sh
Equity Book Value/sh (through 3Q13)
Mark-to-Market w/ 6% HPA Forecast
4Q17
2Q17
4Q16
2Q16
4Q15
2Q15
4Q14
2Q14
4Q13
AMH
2Q13
ARPI
4Q12
SBY
2Q12
16.00
$0.00
Mark-to-Market w/ 4% HPA Forecast
Mark-to-Market w/ 8% HPA Forecast
Source: Company Data, Thomson Reuters, Morgan Stanley Research NOTE: SBY is not covered by Morgan Stanley Research; data are company data
Total returns are attractive. While bears point to initial net
yields below WACC, we believe BTR investments must be
evaluated on a total return basis, as HPA and NOI growth are
key to the story. In the near term, we believe HPA could
comprise over half of the total return (home prices nationally
are up 13% YTD in 2013, and Morgan Stanley’s Housing
Strategy team forecasts 4-6% HPA in 2014), driving 10%-plus
ROIC. In the long run, HPA will normalize and cash flow
yields should become an increasingly important piece of the
total return puzzle, but we expect ROIC to remain 10%-plus
given material rent upside and cost efficiency opportunities.
Rent upside looks material given: (1) Lack of data and
institutional presence in the BTR market to date has resulted
in sub-optimal rents; (2) We expect operators will shift from a
“get the homes occupied” mentality to an “optimize the revenue” mentality once portfolios stabilize; and (3) Tenant “stickiness” will likely allow BTR operators to push rents on renewal.
We think the opportunity to improve efficiency is underappreciated. As the industry moves out of its acquisition
phase, it will likely devote more resources (and years of experience) to cost management. Similar to Multifamily’s evolution
over the last decade, we think there is a material opportunity
for operational improvements in Single Family, particularly
with technology.
32
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
 Early 2014
We think the second securitization deal will materialize in
early 2014 (or perhaps even late 2013). We believe the
evolution of a securitization market is critical, as it boosts
portfolio growth potential, decreases cost of capital, and
widens the gap between the “haves” and “have-nots.”
 Last Tuesday of each month
Case-Shiller HPA data is the primary driver of single
family rental portfolio values today. Each month that
Case-Shiller indices move higher, the marked-to-market
value of portfolios (which we believe is the value of SFR
REITS to shareholders in a bear case) moves higher.
Exhibit 1
Long-Run Unlevered Total ROIC in Double Digits
Exhibit 2
Homeownership — In Secular Decline?
US Rental Inventory
US Homeownership Rate
70%
45M
69.2%
69%
+12%
68%
40M
67%
66%
LT Avg. 65.5%
35M
65%
65.0%
64%
30M
63%
63.7%
63%
62%
25M
61%
60%
59%
20M
4Q15E
 Early 2014 and forward
All of the SFR REIT portfolios will have had at least one
year of operating history, and we will begin to be able to
measure Y/Y same-store-growth, tenant retention, renewal rent growth, etc. This should start providing
“proof” rather than just “hope” that the SFR story will play
out. Accordingly, we think valuation will start to reflect
more favorable long-term BTR return expectations.
ness that is new, and therefore, we think there is a substantial
opportunity for SFR REITs to be consolidators as well. Given
these drivers, we would not be surprised to see institutional
buy-to-rent operators accumulate in excess of $100 billion of
single family homes (vs. ~$20 million today).
4Q90
4Q91
4Q92
4Q93
4Q94
4Q95
4Q96
4Q97
4Q98
4Q99
4Q00
4Q01
4Q02
4Q03
4Q04
4Q05
4Q06
4Q07
4Q08
4Q09
4Q10
4Q11
4Q12
Potential Catalysts
Source: US Census, Morgan Stanley Research
Securitization is a game-changer. Blackstone’s Invitation
Homes recently issued the first bonds secured by single family rental income, and we expect securitization to become an
option for other large and high quality operators as well. We
believe this will provide an avenue for faster growth at a lower
cost of capital. The Blackstone deal priced favorably
(LIBOR +165), making securitization debt capital look even
more attractive those who are able to do deals.
Total Return on Investment
14.0%
12.3%
12.0%
10.5%
9.8%
10.0%
9.0%
9.2%
9.4%
Y4
Y5
Y6
9.9%
10.2%
10.5%
9.7%
Y7
Y8
Y9
Y10
8.0%
6.0%
4.0%
2.0%
0.0%
Y1
Y2
Y3
NOI Yield (Economic)
Home Price Appreciation
Source: Company Data, Morgan Stanley Research
Long runway for growth. Home ownership has been declining steadily, and we expect it to continue to decline as the rise
of rentership remains a secular phenomenon. Gross yields
also remain attractive today despite broad-based HPA, as
competition from single family rental bidders who were initially
showing up just for a short-term trade has cooled off. As
such, SFRs’ acquisition appetite remains robust (especially
now in the Midwest and Carolinas), and supply remains plentiful with 4.1 million ($650 billion) distressed mortgages in the
US today. Finally, we note that buy-to-rent is not a new phenomenon, as “Mom & Pops” have been renting single family
homes for decades. It is the institutionalization of the busi-
We prefer American Residential Properties (ARPI, $17.56)
to play the buy-to-rent-thesis. We think ARPI offers the
best risk-reward in the space. We argue that three key factors differentiate SFR operators: (1) management structure;
(2) operating experience; and (3) Scale. ARPI is internally
managed, has industry-leading operating experience, and is
growing rapidly in scale. We think this makes ARPI a topquality operator poised to be a long-term value creator in the
space; despite this, ARPI currently trades 13% below markedto-market portfolio value and 5% below book value.
Exhibit 3
We Recommend ARPI to Play Buy-to-Rent Thesis
Homes Owned
Top Markets
American Homes 4 Rent
American Residential
21,267
5,440
Silver Bay
5,575
1. Dallas-Fort Worth (8%)
2. Indianapolis, IN (8%)
3. Atlanta (6%)
1. Phoenix (28%)
2. Houston (17%)
3. Dallas (10%)
1. Phoenix (26%)
2. Tampa (16%)
3. Atlanta (16%)
81%
Current Occupancy
68%
75%
Stabilized Occupancy*
97%
92% (not comparable)
95%
Avg. Investment/Home
$165,985
$144,569
$134,956
Avg. Square Feet
1,969
1,662
1,676
Avg. Age of Home
11
19
26
Management Structure
Internal
Internal
External
SFR Experience Since:
2011
2008
2009
Source: Company Data; Note: Stabilized occupancy is occupancy on homes available for
rent 90+ days for AMH and SBY, vs. homes owned 6+ months for ARPI.
33
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Semiconductors
Will There Be Consolidation in the Wireless Baseband Market in 2014?
Morgan Stanley & Co.
LLC
Morgan Stanley Asia
Limited+
Joseph Moore
Joseph.Moore@morganstanley.com
Bill Lu
Bill.Lu@morganstanley.com
Morgan Stanley & Co.
International plc+
Francois Meunier
Francois.Meunier@morganstanley.com
Our View
Market View
We think Qualcomm and MediaTek continue to gain share
of their respective markets, and that other companies in
our coverage are overspending relative to the opportunity,
in aggregate. As a result, we believe R&D in the space will
likely come down in 2014 whereas consensus expects increased investment from most participants. Collectively, we
think that participants excluding the top two are spending close
to 100% of potential 2014 revenues on R&D, for a market
where the leader only has 16% operating margins. From our
perspective, Broadcom appears to have the strongest case to
reduce investment, though management has been adamant
that they will not. MediaTek and Qualcomm are the clearest
beneficiaries; Broadcom could be a beneficiary as well, but
likely not before mid-2014.
Consensus is mostly bearish on the baseband opportunity
away from the two leaders, but sees little chance that anyone pulls back on investment. It is possible that consensus
is correct, as every company in our coverage is adamant that
they will not back down. But, typically, this is true until it isn’t,
as managements need to be fully committed to customers and
employees until they decide to pull back. Companies that have
exited baseband in the last five years have in some cases outperformed some of those that have continued to invest (with
the exception of Qualcomm and MediaTek). We don’t expect
the smaller market share vendors in baseband to spend 100%
of revenue on R&D in perpetuity, and see potential restructuring value across the group.
The Industry ex-Qualcomm and MediaTek Is Collectively Over-Investing in Baseband
Qualcomm currently stands as the dominant player in high-end, and MediaTek is strong in the China
smartphone market — we expect both to continue gaining share within their respective core markets.
This implies that the alternative vendors are spending nearly 100% of 2014 revenues on R&D for an uncertain profit pool.
Significant Over-Investment In Baseband (Excluding Qualcomm and MediaTek)
Qualcomm Revenue
MediaTek Revenue
All Other Baseband Revenue
All Other Baseband R&D
$14,000.0
$12,000.0
$10,000.0
$8,000.0
$6,000.0
$4,000.0
$2,000.0
$2011
2012
2013
2014
Source: Company Data, Morgan Stanley Research Estimates
34
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Every major participant other than Qualcomm and
MediaTek likely lost share in 2013, which was also the
case the prior three years. Trends in the smartphone market that lead to this situation show no sign of abating — we
see continued concentration of market share at the high end
toward Apple and Samsung, continued proliferation of white
box manufacturers in emerging markets, migration to LTE
(while LTE becomes more competitive in 2014, Qualcomm is
likely to maintain higher LTE share than overall share), and an
increasingly risk-averse supply chain in the larger flagship
phones. All these dynamics are likely to shrink the portion of
the pie accessible to everyone else.
More chip suppliers than profitable high-end customers.
Apple and Samsung dominate the high end and are in turn
almost entirely served by Qualcomm (other than the low end
of the Samsung business which is intentionally diversified).
Samsung may have interest in vertically integrating its own
baseband down the road. MediaTek has been extremely successful in the proliferation of the sub-$100 smartphone market
in China through a model of servicing the needs of those customers and intense focus on low prices, a model we don’t
think US companies can replicate.
Intel, Broadcom, Marvell, NVIDIA, and ST Micro could individually be successful, but we argue that collectively
they are overinvesting to capture the relatively small remaining piece of the pie.
as they continue to monetize the Renesas investment.
We believe Broadcom shares have potential upside should
they act on these concerns, as our work indicates the nonwireless businesses are currently worth more than the
overall valuation of the company. As potential becomes
clearer over the course of 2014, we could see either market success or reduction in spending levels.
 Intel is highly unlikely to back down, in our view, though it
ultimately could make more money providing foundry services to Qualcomm.
 For NVIDIA, we see a clear financial case to reduce investment materially, but we think that is unlikely given the
strong stock price performance this year and substantial
management optimism about Icera prospects.
Baseband Market Share Likely to Consolidate
Baseband Market Share
Qualcomm
Mediatek
Intel
ST Microelectronics
Broadcom
Spreadtrum
Others
Total
2012
60%
10%
9%
5%
4%
4%
9%
100%
Source: Gartner, Morgan Stanley Research Estimates
Collectively, the five largest baseband participants excluding Qualcomm and MediaTek are investing over $3
bn in baseband R&D for a likely $3 bn revenue opportunity in 2014. Qualcomm’s QCT business, despite leading
share, only has 16% operating margins. The potential profit
pool here does not seem to justify this level of investment.
We see multiple reasons for companies to stay around
that don’t change the bigger-picture questions. In our
view: Intel needs baseband success to drive x86 into the
smartphone market; Broadcom needs baseband success to
protect combo share; NVIDIA needs baseband to promote
Tegra. Further, carriers and handset vendors are incented to
exaggerate the opportunity open to Qualcomm alternatives.
Who blinks in 2014? Quite possibly no one, and the industry
would likely simply absorb heavy losses. However, in our US
coverage universe, there are several companies that offer
substantial accretion from expense reduction:
 Broadcom may have the greatest sense of urgency given
both financial and stock price performance and could benefit from substantial R&D cuts, though we don't see an exit
Potential Catalysts:
 Mobile World Congress, February 24-27
Will see several new smartphone designs and get data
points on who is getting traction with which customers.
 Flagship phone launches
Expect Galaxy S5 announcement in late 1Q, and the
iPhone 6 in September; we see a high probability that
Qualcomm continues to be in all models.
 Entry into the LTE markets
Qualcomm dominates today; most other participants
should be shipping LTE over the course of 1H14. In our
coverage, this includes Intel (thin modem only) in 1Q,
Broadcom (the Renesas part, either late 1Q or early 2Q),
and NVIDIA in 1H. MediaTek will have thin modems in
early 2014 and integrated parts in 2H14.
Stocks mentioned:
Covered by Joseph Moore: Broadcom (BRCM, $26.69), Intel (INTC,
$23.84), NVIDIA (NVDA, $15.60), Qualcomm (QCOM, $73.58).
Covered by Bill Lu: MediaTek (2454.TW, NT$436)
35
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Software
Convergence to a Digital Marketing Suite in 2014?
Morgan Stanley & Co.
LLC
Keith Weiss
Keith.Weiss@morganstanley.com
Our View
Market View
After aggressive consolidation over the last two years, we
expect 2014 to be the year when a comprehensive Digital
Marketing suite emerges. The spoils will go to the vendor(s)
able to effectively integrate acquired pieces into a holistic solution. We view Salesforce.com (CRM, $52.09) and Adobe Systems (ADBE, $56.78, covered by Jennifer Lowe) as the best
ways to play this theme — we believe they are best positioned
based on their focus on the space, brand equity, and experience managing acquisitions. Although many of the leading
standalone entities have already been acquired, continued
consolidation is a possibility (we note that we are unaware of
any potential transactions).
Many executives still perceive Digital Marketing as email
with some social, mobile and search functionality provided by disparate, small vendors. The category for Digital
Marketing tools started out as simple email and today is still
dominated by email, albeit with more advanced audience targeting, and features for social/mobile outreach and search optimization. It remains too early in the market development to
see convergence to a suite. Thus, best-of-breed, point solution
providers continue to be successful, exemplified by consensus
estimates for 32% growth for Marketo, 19% for Responsys,
and 22% for Marin Software for CY2014.
Chasing a $50 Billion Global Opportunity
Marketing Automation Tools Represent a Large Addressable Market with Secular Growth Drivers
2012 Total US Marketing Spend (in $B)
Digital Marketing as % of Total Marketing Spend
Implied US Digital Marketing Spend (in $B)
2012
2017
CAGR
Gartner Marketing
Automation Forecast
$3.6
$9.5
21%
$200
25%
$50
Employee labor costs
Implied US Spend on External Tools (in $B)
40-60%
$25
IDC Marketing
Automation Forecast
$4.7
$7.2
9%
Estimated Global Spend on Digital Marketing
Tools (in $B)
$50
MS Digital Marketing
Tools Forecast
$50
$65
5%
Source: IDC, Gartner, Morgan Stanley Research
Digital Marketing tools are a broad and complex market.
The primary difference between our estimate for addressable
market size of Digital Marketing software and those of IDC
and Gartner is a much broader view of the market’s definition.
As shown in Exhibit 1, there are many areas within Digital
Marketing, and each one requires a separate set of tools. For
example, we estimate Salesforce.com’s Marketing Cloud only
addresses 58% of all possible functionality today.
The Digital Marketing software industry has been highly
fragmented, but we’ve seen rapid consolidation over the
last 3 years. In Exhibit 2 (next page), we outlined some of
the biggest deals within the Digital Marketing category, which
total over $10 billion, with ~$9 billion happening just in the last
three years. Given the current fragmented functionality, attractive potential size of the market, and high spending interest from enterprises, we would expect further consolidation,
led by large, established players aiming to establish a leadership position for the convergence to a Digital Marketing Suite.
Exhibit 1
Digital Marketing Tools Address a Broad Set of
Functionality
% of Digital Marketing Spend per Category
Digital/Online Advertising
12.5%
Content Creation/Management
11.6%
Search Marketing (incl. Paid Search)
10.7%
Design, Development of Corporate Websites
10.7%
Email Marketing
9.6%
Analytics
9.5%
Social Marketing
9.4%
Mobile Marketing
7.4%
Commerce Experiences (Marketing-led)
7.2%
Video production
5.9%
Company Blog
5.3%
Others
0.2%
Source: Company Data, Morgan Stanley Research
36
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Consolidation could be driven by size and importance of
the opportunity, as well as end-user demand. With the
ongoing secular shift of marketing budgets toward digital initiatives, combined with the growing importance of an effective
digital marketing strategy, many software vendors have entered the space through acquisitions (a faster and often
cheaper route than organic product development) Over the
past several years, digital marketers have been forced to become technologists, having to integrate functionality from multiple solutions sourced from numerous point product vendors
into a set of workflows/business processes their companies
could use. We believe many marketers would be willing to
sacrifice some leading-edge functionality in return for integrated workflows and a unified data set across the various
elements of the digital marketing landscape. Larger software
vendors have seized the opportunity to provide integrated
marketing suites to this user base, allowing digital marketers
to return to their core competency — marketing.
Exhibit 2
~$9 Billion of Digital Marketing M&A Since 2011
Acquirer
Adobe
ExactTarget
IBM
Oracle
Salesforce.com
Teradata
Target
Demdex
Efficient Frontier
Neolane
Omniture
Pardot
Coremetrics
Tealeaf
Unica
Collective Intellect
Eloqua
Endeca
Involver
Vitrue
ExactTarget
Buddy Media
Radian6
Aprimo
Date
Jan-11
Nov-11
Jun-13
Sep-09
Oct-12
Aug-10
Jun-12
Aug-10
Jun-12
Dec-12
Oct-11
Jun-12
Jun-12
Jun-13
Jun-12
Mar-12
Jan-11
Size (in $M)
N/A
$375
$600
$1,800
$96
$600
N/A
$480
N/A
$810
$1,000
N/A
$300
$2,500
$689
$326
$525
Source: Company Data, Morgan Stanley Research
Exhibit 3
Sales and Marketing Expected to See Biggest
Budget Increases
IT Budget: Increase by line of business in CY13 vs. CY12
("1" being biggest spending increase and "10" smallest increase)
7.0
6.0
5.0
5.9
6.1
Finance
HR
5.3
4.3
4.5
Sales
Marketing
4.7
4.0
3.0
2.0
Consolidation has to be followed by integration, which is
why we see 2014 as the pivotal year for emergence of a
leading marketing automation suite. After aggressive M&A
over the last two years, we believe acquirers such as Adobe,
IBM, Oracle, and Salesforce.com now have the necessary
critical mass of product functionality to put forward an integrated suite of Digital Marketing tools. The key differentiator
will be how well all the acquisitions are integrated technologically, as well as the effectiveness of communicating a cohesive Digital Marketing suite message to the target market audience. We view offerings from Salesforce.com and Adobe
as best positioned, due to their deep product functionality,
widely recognized brand equity with marketers, deep focus on
the digital marketing industry, and prior experience of acquisition integration.
Standalone vendors can continue to be successful due to
large addressable market, but will need to maintain a rapid pace of differentiated innovation, in our view. The $50
billion estimated addressable market provides ample opportunity for many vendors to be successful, which helps the
standalone Digital Marketing vendors. Going forward, however, we believe the independent software providers will have
to aggressively invest in R&D to keep up their pace of innovation and ensure significant differentiation from the integrated
suite providers.
Potential Catalysts
 Further M&A
Among the traditional consolidators there are still many
functionality gaps within their Digital Marketing product
suites, which could conceivably be filled in through M&A
of private and public companies.
 Adobe Digital Marketing Summit, March 2014
Adobe’s annual Digital Marketing Summit in Utah is an
annual gathering of 5000 digital marketers. Last year
Adobe started to showcase an ERP for Digital Marketing, and we expect to see further progress in March.
 Salesforce.com Dreamforce, October 2014
With the acquisition of ExactTarget, Salesforce.com
added much of the functionality that was missing from its
Marketing Cloud. At this year’s Dreamforce we saw
many examples of how the products could be integrated,
and next year we expect to see how it was all actually
orchestrated.
1.0
Customer
Support
IT Operations
Source: Morgan Stanley CIO Survey. Note: n=75 (US and EU data).
37
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Telecom Services
Could Free Cash Flow Pressures Drive Multiple Compression in 2014?
Simon Flannery
Simon.Flannery@morganstanley.com
Morgan Stanley & Co.
LLC
Our View
Market View
Free cash flow pressures could drive multiple compression for the sector. We are concerned that several factors
will combine to pressure free cash flows in 2014, potentially
leading to multiple compression: (1) rising capex / spectrum
purchases, (2) rising cash taxes, (3) rising interest rates,
(4) rising leverage, and (5) rising competition.
Multiples are supported by high dividend yields and hopes
for improved profitability. The Telecom sector has lagged
the market in 2013, and the Bells’ P/E multiples trade broadly
in line with the historical average. Bells’ dividend yields provide
downside support, while investors are excited by the opportunities at Sprint and T-Mobile.
What’s in the Price
Historical Levels Suggest That Higher Payout Ratios Could Be a Risk
AT&T + VZ / S&P500 RELATIVE NTM P/E (FY 2)
30%
5.0
RBOC Dividend Yield minus 10 year Treasury Yield
4.5
Mean Spread
Sell Bonds
Buy
Telecom
Current
Spread:
193 bps
4.0
20%
Max Spread:
443 bps
3.5
3.0
10%
2.5
0%
5-Yr
Mean Spread:
295 bps
2.0
-10%
Current, -11%
1.5
Assume 10 yr yields 3.5%
1.0
Assume 10 yr yields 4.0%
-20%
Average, -15%
-30%
-40%
Assume 10 yr yields 5.0%
Buy Bonds
Sell Telecom
Current valuations discount secular pressures in wireline, but not wireless competition. CenturyLink and Frontier
have cut their dividends, and we believe that Windstream may
consider cutting the dividend in February, but with dividend
yields near the top of the S&P 500, secular challenges in the
wireline industry appear to be largely discounted by the market. While the Bells’ P/E multiples currently trade broadly in
line with the historical average, we note that P/E multiples
traded at a ~30% discount to the market in the late 1990s /
early 2000s, and may not be pricing in the current dynamics
of the wireless industry.
Morgan Stanley’s Rates Strategy team estimates the 10year Treasury yield will finish 2014 at 3.45%. At the current
spreads, AT&T would yield 5.8% (+237 bps) and Verizon
would yield 5.0% (+153 bps), suggesting ~12% downside
from current levels. However, current spreads are trading at a
discount to the 5-year average of ~300 bps, and given that
3
-1
N
ov
2
-1
3
-1
N
ov
M
ay
1
-1
2
-1
M
ay
N
ov
0
-1
1
-1
M
ay
N
ov
9
-1
0
-0
N
ov
M
ay
8
-0
9
-0
N
ov
M
ay
7
-0
8
-0
N
ov
M
ay
6
-0
7
-0
Source: Company Data, Morgan Stanley Research, Thomson Reuters, Bloomberg. Priced as of November 29, 2013.
M
ay
N
ov
5
-0
6
-0
M
ay
3
(2.0)
N
ov
2
ct
-1
O
1
ct
-1
O
0
ct
-1
O
9
ct
-1
O
8
ct
-0
O
7
ct
-0
O
6
ct
-0
O
5
ct
-0
O
4
ct
-0
O
3
ct
-0
O
2
ct
-0
O
1
ct
-0
O
0
ct
-0
O
9
ct
-0
O
8
ct
-9
O
7
ct
-9
O
6
ct
-9
O
ct
-9
5
Assume 10 yr yields 4.5%
(1.5)
O
ct
-9
0.0
(0.5)
(1.0)
-50%
O
0.5
.
payout ratios are higher, an argument can be made that the
spreads should be wider.
In particular, we are focused on (1) rising capex / spectrum purchases, (2) rising cash taxes, (3) rising interest
rates, (4) rising leverage, and (5) rising competition. We
expect these factors to pressure FCF yields in 2014.
What’s next: (1) Spectrum Purchases – The broadcast incentive spectrum auction could generate ~$30 billion from the
carriers in late 2014 / early 2015, and more with the AWS
spectrum (see next page). This compares to our estimated
~$20 billion of free cash flow for the Big 4 in 2014. (2) Expiration of Bonus Depreciation – This could represent a ~$2.5
billion headwind for Verizon and ~$3 billion for AT&T.
(3) AT&T Dividend – We estimate AT&T will raise the quarth
terly dividend for the 30 consecutive year in December. (4)
2014 Guidance – Earnings outlooks could show evidence of
a more mature and competitive wireless industry.
38
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
AT&T
Verizon
Sprint
T-Mobile
19,448
7,334
(1,262)
na
13,313
10,748
(3,993)
(1,654)
12,939
10,821
(3,675)
(378)
10.3%
3.6%
-4.0%
na
Wireless
25,520
18,413
19,707
6.0%
4.2%
4.4%
CenturyLink
Frontier
Windstream
3,146
750
676
2,621
758
681
2,483
661
872
17.2%
16.3%
14.1%
14.4%
16.4%
14.2%
13.6%
14.3%
18.2%
RLECs
4,572
4,060
4,016
16.5%
14.7%
14.5%
6.9%
5.3%
-11.5%
-2.2%
Exhibit 2
Higher Payout Ratios May Drive Multiple
Compression, as Investors Demand Higher Yields
Bubble size represents dividend yield*
5.0x
WIN
12.4%
FTR
8.6%
4.0x
CTL, 7.0%
VZ
4.2%
3.0x
BCE-T
5.0%
2.0x
1.0x
RCI'B-T
3.8%
0.0x
40%
50%
T
5.1%
Telus
3.9%
60%
70%
FCF Payout (2014E)
80%
90%
Source: Company Data, Morgan Stanley Research, Thomson Reuters.
Priced as of November 26, 2013.
Exhibit 3
Big 4 Capex Reaches a Multi-Year High in 3Q13,
with Network Investment a Key Focus
LTM Big 4 Total Capex
($B)
LTM Capex
Y/Y Growth
$55
20%
18%
$53
25%
20%
$50.4
$50
 AT&T Dividend Decision
We expect that AT&T will raise the quarterly dividend to
$0.46 per share from $0.45 this month.
$48
 2014 Guidance
Earnings outlooks could show evidence of a more mature and competitive wireless industry.
$40
15%
$48.7
10%
$47.4
4%
10%
$43
5%
$45.1
1%
$45
0%
$41.9
-7%
$41.1
$40.6
-5%
-10%
-14%
3Q13
4Q11
3Q11
2Q11
1Q11
4Q10
3Q10
2Q10
1Q10
4Q09
3Q09
2Q09
1Q09
4Q08
-20%
3Q08
-15%
$35
1Q08
$38
2Q08
 Bonus Depreciation
We estimate that the expiration of bonus depreciation
would represent ~$2.5 billion headwind for Verizon and
~$3 billion for AT&T.
7.1%
5.2%
-12.5%
-9.5%
Source: Company Data, Morgan Stanley Research, Thomson Reuters. Priced as of November 26, 2013. Verizon excludes 45% of Verizon Wireless in 2012A and 2013E.
Potential Catalysts
 Spectrum Auctions / Acquisitions
January 22, 2014: AWS H Block spectrum auction.
Late 2014 / Early 2015: Broadcast incentive auction and
~60 MHz AWS spectrum. Assuming 60 MHz of broadcast spectrum at 300 million POPs x $1.50 per MHz /
POP, the auction could generate ~$30 billion from the
carriers, and more with the AWS spectrum.
Free Cash Flow Yield
2013E
2014E
2Q13
We recently downgraded Windstream (WIN, $8.07) to Underweight due to similar concerns. While management has
demonstrated a strong commitment to the dividend, we believe that soft quarterly results, rising cash taxes, and debt
obligations could lead the Board to consider cutting the dividend in February 2014.
2012A
1Q13
Rising Competition: We expect wireless competition to continue to intensify in 2014 as T-Mobile and Sprint’s network
upgrades help their market position, and cable companies
target DSL customers more aggressively.
Free Cash Flow (OCF - Capex)
2012A
2013E
2014E
4Q12
Rising Leverage: A combination of deal-making, potential
spectrum purchases, and increased investment is boosting
leverage across the sector, which could impact valuations and
dividend policy.
Free Cash Flow Yields in 2014
3Q12
Rising Interest Rates: The 10-Year Treasury at 3.45% could
limit refinancing opportunities and make dividend yields relatively less attractive.
Exhibit 1
2Q12
Rising Cash Taxes: The Bells and RLECs could see a significant increase in cash taxes in 2014 and beyond if, as we
expect, bonus depreciation expires at the end of this year.
1Q12
Rising Capex: Big 4 (AT&T, Sprint, T-Mobile, Verizon) capital
spending rose 20% Y/Y in 3Q13, as carriers spent heavily on
network upgrades. We expect spending to remain elevated,
with upside risk, as video drives significant broadband traffic
growth, and carriers compete on network quality.
We recommend the Canadians and Towers. With the wireless penetration at ~80% (v. 100%-plus in the US) and only
three national carriers, the outlook is more attractive in Canada. Meanwhile, the towers continue to benefit from increased
carrier spending, which should continue for some time. We
are also Overweight CenturyLink (CTL, $30.70), CyrusOne
(CONE, $20.43), and Endurance (EIGI, $14.29). Our overall
industry view is In-Line.
Leverage (2014E)
Headwinds to 2014 Free Cash Flow
Source: Company Data, Morgan Stanley Research
39
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
United Continental Holdings
We’re Bullish on the Cycle & the Turnaround
Morgan Stanley & Co.
LLC
John D. Godyn, CFA
John.Godyn@morganstanley.com
Our View
Market View
The ‘New Continental’ bull case is still possible in coming
years, in our view. We believe it’s about time for margin
mean-reversion given the superior scope and scale of UAL’s
assets, which are characterized by (1) the only NY-area hub
and premier transatlantic gateway in its Newark hub; (2) a domestic network benefiting from dominant positions across the
most major metro areas vs. legacy peers; (3) unique, traditionally highly profitable China route authorities supporting its Asia
network; (4) an anchor position in the Star Alliance, which by
many measures is the largest global alliance with the widest
geographic reach; and (5) historically peer-leading corporate/
premium travel exposure. Along these lines, management has
vigorously highlighted its commitment to maximizing value from
its network. Specifically, UAL believes it can grow its corporate
market share in the NYC region, continue to build its China
network, and improve operations in San Francisco — all of
which should help reinforce UAL’s revenue premium vs. peers.
The market seems to have ‘forgotten’ its once-enthusiastic
bull case on United Continental. As a standalone entity,
Continental Airlines had established a history of superior execution, PRASM outperformance, and relative margin stability —
all among the reasons the stock traded at a meaningful premium to other legacy airlines despite lacking many of the advantages of carriers that had emerged from post-9/11 Chapter
11 filings. As such, at the time of its merger with United, M&A
bulls argued the combination of CAL’s (old Continental) and
UAUA’s (old United) assets would be further leveraged by applying CAL’s top-tier execution to UAUA’s franchise, which had
emerged from Chapter 11 as a solid performer in its own right.
Ultimately, the enterprise would not only have margins in excess of peers but the equity would also benefit from a CAL-like
valuation premium. Years after the merger was announced,
this bull case has long been forgotten by most investors — a
change of heart underscoring how quickly sentiment can turn
on an Airline stock. From a relatively low base, we believe
investor sentiment is poised to shift again — in favor of UAL.
What’s in the Price
MS EBITDAR Margin Ests.
We Believe Consensus Underestimates the Mean-Reversion Potential for UAL’s Margins
UAL
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
2012
Source: Company data, Morgan Stanley Research
2013
DAL
LCC
2014
2015
EBITDAR = EBITDA plus Rent expense
UAL announced major self help initiatives at its recent
Investor Day. Management announced self-help measures
totaling $2.7 billion, well ahead of expectations. We were
bullish heading into the event (see UAL Investor Day Preview:
We’re Bullish 11/12/13) but left with even more confidence in
UAL’s self-help story and its potential to begin returning cash
to shareholders. We reiterate our Overweight rating and our
$5/$7 pre-tax EPS estimates in F2014/15. With significant
40
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Specifically, we emphasize the following opportunities:
Cost targets beating, but still might be conservative: UAL
outlined cost savings of ~$2B by 2017, above our $800M estimate, with cost savings from the following buckets: ~$1B
from fuel consumption, ~$100M from maintenance, ~$500M
in productivity, ~$150M from sourcing, and ~$100M from distribution. Further, management provided 2014 CASM ex-Fuel
growth guidance of 1-2%, which was below our 3% growth
estimate. We suspect both the cost savings plan as well as
guidance incorporates a layer of conservatism for three reasons: (1) UAL, like many other airlines, has a long history
(before the last 6 quarters) of providing slightly conservative
guidance and we believe management would like to return to
this traditional pattern; (2) management indicated guidance
incorporates some degree of labor uncertainty, and (3) management made it clear that these cost savings represent a
target that they are confident in achieving, leading us to believe that the self-help initiatives could be conservative.
Potential Catalysts
 Revenue upside from ancillary and premium
We believe UAL is one of the best positioned legacy airlines to expand on its corporate market share presence.
 Announced cost saving initiatives look conservative
UAL has historically offered conservative cost guidance;
we believe that the cost saving initiatives it outlined during its Investor Day could also prove to be conservative.
 Shareholder return strategy potential in 2015
A shareholder return strategy is currently not in Street
estimates, though the margin improvement thesis and
steady capex raise the likelihood of a plan in 2015.
Exhibit 1
Free Cash Flow Inflection Looks Imminent
$3.0
$2.5
$2.0
$1.5
$1.0
$0.5
$0.0
($0.5)
FCF (LHS)
FCF Yield (RHS)
12%
10%
8%
6%
4%
2%
Free Cash Flow Yield
Inflecting FCF and margin expansion potential position
UAL to return cash to shareholders in 2015: If UAL realizes the opportunities outlined at its Investor Day and further
improves its capital structure, we estimate it will be in a position to generate sufficient FCF to implement a shareholder
return strategy in 2015. With margin expansion potential and
relatively steady capex levels through 2015, we estimate
~$1.5 billion of FCF in 2015. Capital returns would broaden
the potential investor base; we also view capital returns as an
additional force of discipline across the cycle.
sheets have materially altered tail risk across airlines, and we
think this has yet to be priced in. Simply put, as airline fundamentals converge toward those of higher-valued peers, so
should their multiples (see Six Sources of Multiple Expansion
Across the Cycle, 5/1/13).
Free Cash Flow ($B)
room for upward revisions to consensus, we expect UAL's
initiatives to re-frame the debate on the stock through 2014.
0%
2013
2014
2015
Source: Company Data, Morgan Stanley Research estimates
Exhibit 2
Legacy Airline Valuation: EV / EBITDAR vs. FWD
EBITDAR Margin, Current Valuation vs. Historical
UAUA
CAL
UAL
Other Legacy Airlines
14
12
10
8
6
4
2
0
Adj. EV / TMF EBITDAR
Multiple
Finally, our bullish view on the airline cycle raises our
conviction in our UAL Overweight. We’ve regularly highlighted UAL as one of our top picks among airlines given its
leverage to our “Stronger For Longer” cycle call. In a nutshell,
we remain bullish on the airline cycle due to (1) continued
capacity restraint; (2) a sluggish GDP and elevated fuel backdrop tempering competitive pressure; (3) healthier balance
sheets, cash flow, and capital returns; (4) relatively attractive
valuations; and (5) the possibility of additional industry M&A.
Further supporting the cycle, in our view, is an airline macro
Goldilocks scenario based on the thesis that fuel prices are
likely to trend flat to down while US GDP is upwardly biased,
favoring domestically-levered companies. With 2014 likely to
be a year of industry capacity growth below GDP growth, we
see a strong case for real pricing power and therefore margin
expansion — a trend we expect UAL to participate in. Potentially amplifying this upside is what we believe is a strong case
for multiple expansion. Margin stability and healthier balance
0%
10%
20%
30%
TMF EBITDAR Margin %
Source: Morgan Stanley Research, Includes data gathered from AMR, DAL, LCC, NWA,
ALK, UAUA, CAL, UAL when available from 2000-Present. We impute TMF EBITDAR using
prevailing TMF EPS estimates and annualized quarterly Interest, D&A, and Rent line-items
Prices of stocks mentioned: Delta Air Lines (DAL, $28.98), United
Continental Holdings (UAL, $39.25), US Airways (LCC, $23.48).
41
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Morgan Stanley ModelWare is a proprietary analytic framework that helps clients uncover value, adjusting for distortions and ambiguities created by local accounting regulations. For example, ModelWare EPS adjusts for one-time events, capitalizes operating
leases (where their use is significant), and converts inventory from LIFO costing to a FIFO
basis. ModelWare also emphasizes the separation of operating performance of a company
from its financing for a more complete view of how a company generates earnings.
Morgan Stanley is currently acting as financial advisor and providing financing to Devon Energy Corporation ("Devon") in connection with its definitive agreement to acquire GeoSouthern Energy's assets in the Eagle Ford oil play, as announced on November
20, 2013. The proposed acquisition is subject to customary purchase price adjustments, terms and conditions. Devon has agreed to
pay fees to Morgan Stanley for its services. Please refer to the notes at the end of the report.
Morgan Stanley & Co. International plc ("Morgan Stanley") is acting as financial advisor to The Blackstone Group International
Partners LLP (“Blackstone”) and GIC Special Investments Pte Ltd (“GIC”) in relation to the proposed acquisition of a majority interest in Rothesay Life Limited as announced on 22 October 2013. Blackstone and GIC have agreed to pay fees to Morgan Stanley
for its financial services. Please refer to the notes at the end of the report.
Morgan Stanley is acting as financial advisor and providing financing services to Verizon Communications Inc. ("Verizon") in relation to their definitive agreement with Vodafone Group Plc. ("Vodafone") to acquire Vodafone's U.S. group with the principal asset
of 45 percent of Verizon Wireless, as announced on September 2, 2013.
The proposed transaction is subject to the consent of Verizon and Vodafone shareholders, required federal regulatory approvals
and other customary closing conditions. This report and the information provided herein is not intended to (i) provide voting advice,
(ii) serve as an endorsement of the proposed transaction, or (iii) result in the procurement, withholding or revocation of a proxy or
any other action by a security holder.
Verizon has agreed to pay fees to Morgan Stanley for its services, including transaction fees and financing fees that are subject to
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42
MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
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Gaming Corporation, Broadcom Corporation, Brocade Communications Systems, Cablevision Systems, Canadian Pacific Railway Ltd., Catamaran
Corp, CDW Corporation, CenturyLink, Inc., Cigna Corp, Cognizant Technology Solutions Corp, Consol Energy Inc, CVS/Caremark Corp., CyrusOne
Inc, Danaher, Dean Foods Co, Delphi Automotive PLC, Eaton Corp PLC, EMC Corp., Endurance International Group Holdings,, Express Scripts,
Inc., Ford Motor Company, General Motors Company, Hewlett-Packard, Honeywell International, Humana Inc, IBM, Intel Corporation, ITT Educational Services, KKR & CO. L.P., Kraft Foods Group, Inc., LyondellBasell Industries N.V., Manitowoc Co Inc, Marsh & McLennan Cos, MediaTek,
Mondelez International Inc, NCR Corp., NetApp Inc, NVIDIA Corp., Penn National Gaming, Inc., QLogic Corporation, Qualcomm Inc.,
Salesforce.com, Seagate Technology, Strayer Education, Teradata, Terex Corp., The Blackstone Group L.P., The Dow Chemical Co., Time Warner
Cable Inc, TRW Automotive Holdings Corp., Tyco International, United Continental Holdings, Inc., United Rentals Inc., UnitedHealth Group Inc,
WhiteWave Foods Co, Windstream Corp.
Within the last 12 months, Morgan Stanley has received compensation for products and services other than investment banking services from Accenture Plc, Adobe Systems, Aetna Inc., American Residential Properties Inc, Aon PLC, Apollo Group, Apple, Inc., Bank of America, BorgWarner
Inc., Boyd Gaming Corporation, Broadcom Corporation, Brocade Communications Systems, Cablevision Systems, Canadian Pacific Railway Ltd.,
Catamaran Corp, CDW Corporation, CenturyLink, Inc., Cigna Corp, Consol Energy Inc, CVS/Caremark Corp., CyrusOne Inc, Danaher, Dean Foods
Co, Delphi Automotive PLC, Eaton Corp PLC, EMC Corp., Endurance International Group Holdings,, Express Scripts, Inc., Ford Motor Company,
General Motors Company, Hewlett-Packard, Honeywell International, Humana Inc, IBM, Intel Corporation, KKR & CO. L.P., Kraft Foods Group, Inc.,
Lexmark International, LyondellBasell Industries N.V., Manitowoc Co Inc, Marsh & McLennan Cos, MediaTek, Mondelez International Inc, NCR
Corp., NetApp Inc, Penn National Gaming, Inc., Qualcomm Inc., Salesforce.com, Seagate Technology, Terex Corp., The Blackstone Group L.P.,
The Dow Chemical Co., Time Warner Cable Inc, TRW Automotive Holdings Corp., Tyco International, United Continental Holdings, Inc., United
Rentals Inc., UnitedHealth Group Inc, Windstream Corp.
Within the last 12 months, Morgan Stanley has provided or is providing investment banking services to, or has an investment banking client relationship with, the following company: Accenture Plc, Adobe Systems, Aetna Inc., American Residential Properties Inc, Aon PLC, Apollo Group, Apple, Inc., Bank of America, BorgWarner Inc., Boyd Gaming Corporation, Broadcom Corporation, Brocade Communications Systems, Cablevision
Systems, Canadian Pacific Railway Ltd., Catamaran Corp, CDW Corporation, CenturyLink, Inc., Cigna Corp, Cognizant Technology Solutions Corp,
Consol Energy Inc, CVS/Caremark Corp., CyrusOne Inc, Danaher, Dean Foods Co, Delphi Automotive PLC, Eaton Corp PLC, EMC Corp., Endurance International Group Holdings,, Express Scripts, Inc., Ford Motor Company, General Motors Company, Hewlett-Packard, Honeywell International, Humana Inc, IBM, Intel Corporation, ITT Educational Services, KKR & CO. L.P., Kraft Foods Group, Inc., LyondellBasell Industries N.V.,
Manitowoc Co Inc, Marsh & McLennan Cos, MediaTek, Mondelez International Inc, NCR Corp., NetApp Inc, NVIDIA Corp., Penn National Gaming,
Inc., QLogic Corporation, Qualcomm Inc., Salesforce.com, Seagate Technology, Strayer Education, Teradata, Terex Corp., The Blackstone Group
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MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
L.P., The Dow Chemical Co., Time Warner Cable Inc, TRW Automotive Holdings Corp., Tyco International, United Continental Holdings, Inc., United Rentals Inc., UnitedHealth Group Inc, WhiteWave Foods Co, Windstream Corp.
Within the last 12 months, Morgan Stanley has either provided or is providing non-investment banking, securities-related services to and/or in the
past has entered into an agreement to provide services or has a client relationship with the following company: Accenture Plc, Adobe Systems,
Aetna Inc., American Residential Properties Inc, Aon PLC, Apollo Group, Apple, Inc., Bank of America, BorgWarner Inc., Boyd Gaming Corporation,
Broadcom Corporation, Brocade Communications Systems, Cablevision Systems, Canadian Pacific Railway Ltd., Catamaran Corp, CDW Corporation, CenturyLink, Inc., Cigna Corp, Consol Energy Inc, CVS/Caremark Corp., CyrusOne Inc, Danaher, Dean Foods Co, Delphi Automotive PLC,
Eaton Corp PLC, EMC Corp., Endurance International Group Holdings,, Express Scripts, Inc., Ford Motor Company, General Motors Company,
Hewlett-Packard, Honeywell International, Humana Inc, IBM, Intel Corporation, KKR & CO. L.P., Kraft Foods Group, Inc., Lexmark International,
LyondellBasell Industries N.V., Manitowoc Co Inc, Marsh & McLennan Cos, MediaTek, Mondelez International Inc, NCR Corp., NetApp Inc, NVIDIA
Corp., Penn National Gaming, Inc., QLogic Corporation, Qualcomm Inc., Salesforce.com, Seagate Technology, Terex Corp., The Blackstone Group
L.P., The Dow Chemical Co., Time Warner Cable Inc, TRW Automotive Holdings Corp., Tyco International, United Continental Holdings, Inc., United Rentals Inc., UnitedHealth Group Inc, Windstream Corp.
Within the last 12 months, Morgan Stanley has either provided or is providing non-securities related services to and/or in the past has entered into
an agreement to provide services or has a client relationship with the following company: Mondelez International Inc.
An employee, director or consultant of Morgan Stanley is a director of IBM. This person is not a research analyst or a member of a research analyst's household.
Morgan Stanley & Co. LLC makes a market in the securities of Accenture Plc, Adobe Systems, Aetna Inc., American Residential Properties Inc, Aon
PLC, Apollo Group, Apple, Inc., Bank of America, BorgWarner Inc., Boyd Gaming Corporation, Broadcom Corporation, Brocade Communications
Systems, Cablevision Systems, Canadian Pacific Railway Ltd., Catamaran Corp, CDW Corporation, CenturyLink, Inc., Cigna Corp, Cognizant
Technology Solutions Corp, Consol Energy Inc, CVS/Caremark Corp., CyrusOne Inc, Danaher, Dean Foods Co, Delphi Automotive PLC, Eaton
Corp PLC, EMC Corp., Endurance International Group Holdings,, Express Scripts, Inc., Ford Motor Company, General Motors Company, HewlettPackard, Honeywell International, Humana Inc, IBM, Intel Corporation, ITT Educational Services, KKR & CO. L.P., Kraft Foods Group, Inc.,
Lexmark International, LyondellBasell Industries N.V., Manitowoc Co Inc, Marsh & McLennan Cos, Mondelez International Inc, NCR Corp., NetApp
Inc, NVIDIA Corp., Penn National Gaming, Inc., QLogic Corporation, Qualcomm Inc., Salesforce.com, Seagate Technology, Strayer Education,
Teradata, Terex Corp., The Blackstone Group L.P., The Dow Chemical Co., Time Warner Cable Inc, TRW Automotive Holdings Corp., Tyco International, United Continental Holdings, Inc., United Rentals Inc., UnitedHealth Group Inc, Western Digital, WhiteWave Foods Co, Windstream Corp.
The equity research analysts or strategists principally responsible for the preparation of Morgan Stanley Research have received compensation
based upon various factors, including quality of research, investor client feedback, stock picking, competitive factors, firm revenues and overall investment banking revenues.
Morgan Stanley and its affiliates do business that relates to companies/instruments covered in Morgan Stanley Research, including market making,
providing liquidity and specialized trading, risk arbitrage and other proprietary trading, fund management, commercial banking, extension of credit,
investment services and investment banking. Morgan Stanley sells to and buys from customers the securities/instruments of companies covered in
Morgan Stanley Research on a principal basis. Morgan Stanley may have a position in the debt of the Company or instruments discussed in this
report.
Certain disclosures listed above are also for compliance with applicable regulations in non-US jurisdictions.
STOCK RATINGS
Morgan Stanley uses a relative rating system using terms such as Overweight, Equal-weight, Not-Rated or Underweight (see definitions below).
Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not
the equivalent of buy, hold and sell. Investors should carefully read the definitions of all ratings used in Morgan Stanley Research. In addition, since
Morgan Stanley Research contains more complete information concerning the analyst's views, investors should carefully read Morgan Stanley Research, in its entirety, and not infer the contents from the rating alone. In any case, ratings (or research) should not be used or relied upon as investment advice. 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.
Global Stock Ratings Distribution
(as of November 30, 2013)
For disclosure purposes only (in accordance with NASD and NYSE requirements), we include the category headings of Buy, Hold, and Sell alongside our ratings of Overweight, Equal-weight, Not-Rated and Underweight. Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks
we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold, and sell but represent recommended relative
weightings (see definitions below). To satisfy regulatory requirements, we correspond Overweight, our most positive stock rating, with a buy recommendation; we correspond Equal-weight and Not-Rated to hold and Underweight to sell recommendations, respectively.
Coverage Universe
Stock Rating Category
Overweight/Buy
Equal-weight/Hold
Investment Banking Clients (IBC)
Count
% of
Total
Count
% of % of Rating
Total IBC
Category
995
34%
313
38%
31%
1283
44%
388
47%
30%
Not-Rated/Hold
109
4%
26
3%
24%
Underweight/Sell
537
18%
99
12%
18%
Total
2,924
826
Data include common stock and ADRs currently assigned ratings. 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. Investment Banking Clients are companies from whom Morgan Stanley
received investment banking compensation in the last 12 months.
Analyst Stock Ratings
Overweight (O). The stock's total return is expected to exceed the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months.
Equal-weight (E). The stock's total return is expected to be in line with the average total return of the analyst's industry (or industry team's) coverage
universe, on a risk-adjusted basis, over the next 12-18 months.
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MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
Not-Rated (NR). Currently the analyst does not have adequate conviction about the stock's total return relative to the average total return of the
analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months.
Underweight (U). The stock's total return is expected to be below the average total return of the analyst's industry (or industry team's) coverage
universe, on a risk-adjusted basis, over the next 12-18 months.
Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months.
Analyst Industry Views
Attractive (A): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the
relevant broad market benchmark, as indicated below.
In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant
broad market benchmark, as indicated below.
Cautious (C): The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant
broad market benchmark, as indicated below.
Benchmarks for each region are as follows: North America - S&P 500; Latin America - relevant MSCI country index or MSCI Latin America Index;
Europe - MSCI Europe; Japan - TOPIX; Asia - relevant MSCI country index.
.
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Important disclosures regarding the relationship between the companies that are the subject of Morgan Stanley Research and Morgan Stanley Smith Barney LLC or
Morgan Stanley or any of their affiliates, are available on the Morgan Stanley Wealth Management disclosure website at
www.morganstanley.com/online/researchdisclosures.
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Each Morgan Stanley Equity Research report is reviewed and approved on behalf of Morgan Stanley Smith Barney LLC. This review and approval is conducted by the
same person who reviews the Equity Research report on behalf of Morgan Stanley. This could create a conflict of interest.
Other Important Disclosures
Morgan Stanley & Co. International PLC and its affiliates have a significant financial interest in the debt securities of Adobe Systems, Aetna Inc., Apollo Group, Apple,
Inc., Bank of America, BorgWarner Inc., Boyd Gaming Corporation, Broadcom Corporation, Cablevision Systems, Canadian Pacific Railway Ltd., Catamaran Corp, CenturyLink, Inc., Cigna Corp, Consol Energy Inc, CVS/Caremark Corp., Danaher, Dean Foods Co, Eaton Corp PLC, EMC Corp., Express Scripts, Inc., Ford Motor Company, General Motors Company, Hewlett-Packard, Honeywell International, Humana Inc, IBM, Intel Corporation, Kraft Foods Group, Inc., Lexmark International, LyondellBasell Industries N.V., Manitowoc Co Inc, Marsh & McLennan Cos, Mondelez International Inc, NCR Corp., NetApp Inc, Penn National Gaming, Inc., Salesforce.com,
Terex Corp., The Dow Chemical Co., Time Warner Cable Inc, Tyco International, United Continental Holdings, Inc., United Rentals Inc., UnitedHealth Group Inc, Windstream Corp.
Morgan Stanley is not acting as a municipal advisor and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning
of Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Morgan Stanley produces an equity research product called a "Tactical Idea." Views contained in a "Tactical Idea" on a particular stock may be contrary to the recommendations or views expressed in research on the same stock. This may be the result of differing time horizons, methodologies, market events, or other factors. For all
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MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
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MORGAN STANLEY RESEARCH
2014: The Big Debates
December 4, 2013
North America
Director of Research
Stephen Penwell
1+212-761-1466
CONSUMER STAPLES
Associate Director of Research
Tobacco/Packaged Food
David Adelman
Michelle Teitsch
David J. Adelman
Matthew Grainger
John Colantuoni
Pamela Kaufman
1+212-761-6382
1+212-761-4192
Management
Gail Alvarez
Aaron Finnerty
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Vincent Andrews
MACRO
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Todd Castagno
Snehaja Mogre
Economics
Vincent Reinhart
Ellen Zentner
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Dane Vrabac
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U.S. Strategy
Adam Parker
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Antonio Ortega
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Yaye Aida Ba
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Adam Longson
Tai Liu
Alan Lee
Neel Mehta
Bennett Meier
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1+212-761-3585
1+212-761-3266
1+212-761-8582
1+212-761-4967
Sectors
CONSUMER DISCRETIONARY/RETAIL
RETAIL
Autos & Auto-Related
Adam Jonas
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Yejay Ying
Paresh Jain
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1+212-761-6350
1+212-761-7096
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1+212-761-3356
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1+617-856-8750
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Specialty Softlines, Department Stores
and Branded Apparel
Kimberly Greenberger
Jay Sole
Lauren Cassel
Joseph Wyatt
Amber Turley
Duo Li
ENERGY & UTILITIES
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Evan Calio
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Manav Gupta
Jacob Dweck
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MLPs
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Matthew Giacobbe
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Greg Van Winkle
Albert Lin
Vikram Malhotra
Entertainment & Broadcasting
Clean Tech
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Banks/Large/Mid Cap Banks
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Brokers, Asset Managers & Exchanges
Matthew Kelley
Tom Whitehead
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Toni Kaplan
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Cheryl Pate
Vincent Caintic
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1+212-761-6983
Insurance/Life & Annuity
Nigel Dally
1+212-761-4132
Insurance/Property & Casualty
Gregory W. Locraft Jr.
Kai Pan
Quentin McMillan
1+212-761-0040
1+212-761-8711
1+212-761-3731
Payment Processors and Financial IT
Smittipon Srethapramote
Danyal Hussain
Vasu Govil
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Biotechnology
David Friedman
Brienne Kugler
Yigal Nochomovitz
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1+212 761-6209
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Healthcare Services
Ricky Goldwasser
Zachary Sopcak
Saurabh Singh
Julie Murphy
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1+212-761-4002
1+212-761-6519
1+212-761-3867
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Andrew Schenker
Cornelia Miller
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1+212-761-3809
Benjamin Swinburne
Ryan Fiftal
Hersh Khadilkar
Thomas Yeh
Jennifer Swanson Lowe
Keith Weiss
Melissa Gorham
Jon Parker
May Zhan
Stan Zlotsky
IT Hardware
Kathryn Huberty
Scott Schmitz
Jerry Liu
Natalia Kogay
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Pharmaceuticals
David Risinger
Thomas Chiu
Christopher Caponetti
Mark Nasca
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1+212-761-3688
1+212-761-6235
1+212-761-4130
Business & IT Services
Nigel Coe
Jiayan Zhou
Michael Sang
Drew Ronkowitz
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1+212-296-5469
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47
MORGAN STANLEY RESEARCH
The Americas
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New York, NY 10036-8293
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© 2013 Morgan Stanley
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