Not the anatomy of a market top
Another week passes with Greece dominating the media and influencing investor psyches. While we cannot profess to predict the outcome, we can posit our views on the market and on our themes and stocks. Given ongoing Greek uncertainty, one could be forgiven for acting cautiously (or in fact not acting at all.) We would point to one theme that seems to be overlooked by many - when you look beyond Greece the rest of the world is in reasonable shape. Recent data from the US suggest it is rebounding from an early spring slump. US job openings have surpassed their 2000 peaks; in other words, there is more job demand now than during the internet boom when unemployment was 1.5% lower. We have also noted the Nasdaq and Small Cap indices b both made new highs this week. While you wouldn't know it from reading the media - the front page of the FT doesn't even mention the milestone - the Nasdaq actually broke through its March 10th2000 peak of 5048. Further positives in Europe: PMIs look set to recover further, helped by continued acceleration in the money-supply which is at the highest levels since March 2009 (credit precedes activity); and Italy's growth is accelerating. Elsewhere, China's growth is H2 weighted and so could surprise the legion of naysayers as could the wealth effects of the stock-market doubling. Whilst we have seen volatility in bond markets, break-evens have been relatively immune and point to slow-but continued "reflation". For these reasons, we continue to add to our Reflation Recovery Basket
Give me time, not timing
The decision to increase ECB bond purchases in May was interpreted by many at the time - ourselves included - as being positive for reflation assets. It wasn't. The SXXP is down 5% since and the banks are down more (although that's still much better than bonds). What's quite clear is the ECBs move was to protect Europe from contagion risks of default or of Grexit - events that are looking more likely because the Tsipras government with their game theory master, Yanis Varoufakis, still perceives the threat of financial contagion as their trump card in negotiations. That may be misplaced - the ECB has created fire-breaks. Contagion risks are contained because the ECB can print money without constraint; most of the creditor risks are well-known; the banks have recapitalised (post AQR); Europe is growing again which means it is more rather than less immune to shock. If Greek equities, bonds and GDP disappeared, it would surely be a tragedy, but not one of epic and globally-destructive proportions (except perhaps for Angela Merkel). Europe's equity market amounts to €10tr vs. 'only' c.€20bn for Greece and Hellenic GDP is now less than 1.5% of Europe's. Some would call that a rounding error. A Greek default might indeed occur but only if it doesn't really matter. A default may inevitably create "panic" in stocks but we think that moves opportunity towards those with strong hands (see our US investor feedback on this point). If there is no default the market will rally on relief. Either way, those with a longer-term horizon would be wise to put some of that large cash-balance you've recently accumulated to work and start buying where you have conviction - there is always opportunity in crisis. You may have to weather a little short-term pain in a worst case scenario but we think you will be rewarded on a longer view. Moreover, you also protect yourself from the opposite - and more likely scenario - where a deal is done.
Make prints/layer-in on weakness
We remain sellers of Autos
We have been bearish on Autos (especially vs. banks) for some time and noted the convergence of a number of head-winds this week which makes us think the sell-off may continue - once we bounce off these technical levels. The idea of "Peak-Car" - a term we coined in November last year - gained traction as Uber announced Uber rides in China DOUBLED last month to over 1 million rides. Granted, car demand may initially rise as fleets are upgraded/new drivers join such services. However, they tend to be lower margin cars and once the initial surge subsides, the fall may come at a time of massive capex commitments and growing uncertainty over electric vehicles (and costs associated with re-tooling). This reminds us of the excavator market in China. That didn't end well! In many urban centres, especially in China it seems, the car is becoming a utility you call on, not something you own. It's the Spotify approach to cars: a pay-by-the-hour subscription model. The "new-normal" in China continues to hurt domestic producers (DongFeng (OTCPK:DNFGY), Great Wall (OTCPK:GWLLY) - currently suspended - and Brilliance (OTCPK:BCAUY) have all lost a third of their market value the past month), and we fear the recalibration is far from complete with respect to European exposures. We first discussed the threat from parallel imports in December last year, since then it's become quite an issue and is now cited by a number of analysts as a reason for caution. Worryingly this price pressure is coming at a time volumes are under-pressure, indeed May was the worst month on YoY basis EVER! Discounting is becoming more evident as an off-set (see announcement from Great Wall) which is never a good sign for margins. One should not overlook the impacts of a rising stock market either. As the SHCOMP rallies it is sucking monetary demand from all areas and with car purchases the second largest monetary commitment an individual can make (behind property), consumption in this area has been at best deferred. Add to this the beginnings of a property market recovery (last month saw the second largest monthly contracted sales on record at +56% YoY) and utilising savings to buy a car would currently seem to have a substantial opportunity cost attached to it.
Globally Europe is still in a sweet-spot - its recovery is later and from a very low base - but even the rate of increase decelerated last month which worries us regarding our once-favoured Peugeot (OTCPK:PUGOY) - especially so when it's Chinese JV partner is in freefall (see 489 HK). They own 51% of Faurecia as well which has cratered this week so taking profits remains the sensible option. We have also had more of a look at Fiat and, after some initial enthusiasm, we now see many reasons for caution, not least their potential bid for GM! More on this below.
We remain buyers of Banks.
Despite ECB QE purchases of European ABS securities, ABS issuance has not picked up. The reason? For 'normal' ABS investors (banks, insurance companies) the capital requirements are too expensive compared with covered bonds. As part of its harmonisation programme, the ECB is endeavouring to change this. However the market needs real change. The indications emerging from the various central bank discussion forums are promising although we are not there yet. As covered in the FT on Friday 19 June, David Rule (BoE policy director and chairman of the Iosco task force on securitisation) was quoted at the Barcelona conference this week, pointing to the need for "a more level playing field". This would be very promising for the ABS market. Even with ECB QE, it is clear the market will not develop without more favourable capital treatment for purchasers. If this issue is resolved - at this stage it is still an 'if' - the time might finally come for a proper ABS market in Europe. The ECB is in favour of this market, principally because covered bonds, the mainstay of the asset-backed market in Europe, are for mortgages. Widening the pool of available assets to all loans offers a more powerful transmission of credit supply. If ABS issuance were to grow, there is potential for the second order beneficiary of ABS, i.e. ECB qualifying securitisation (QS) where the ECB would buy a whole range of super-senior loans from banks instead of sovereign bonds. We have written in the past why QS can be more favourable than QE if the conditions are right. Given ECB QE by definition will effectively end in H2 2016, the timing is about right. So no concrete changes yet but the indication from regulators is they have got the message and more favourable conditions for a proper ABS market are on the way. That is good news for credit growth in Europe and therefore banks and insurance companies. Buy banks, especially the Italians Intesa Sanpaolo (OTCPK:ISNPY), Mediobanca (OTCPK:MDIBY), PMI, UBI, Unipol (OTC:UGFNY), UniCredit (OTCPK:UNCFY), Anima, Ceved etc.
High Quality Growth
If, like many of our US clients, you prefer to ignore the cycle and focus instead on the long-term drivers of value, we would direct you to Terry Smith's excellent article in the Telegraph last weekend and to the sixth iteration of the Aviate High Quality Growth basket. Of note is there are now only 19 stocks that still qualify on growth and valuation metrics, four of which have been excluded due to a deterioration in margin profiles (Edenred (OTCPK:EDNMY), Babcock (OTCPK:BCKIY), Kering (OTCPK:PPRUY), SAP). SAP (NYSE:SAP) has been excluded after 6 years of inclusion, interestingly it's replaced by Capgemini (OTCPK:CGEMY) (which fits with our fundamental views). Fresenius was promoted out on valuation. Only one name has remained in for all 6 years, Anheuser-Busch. Experian (OTCQX:EXPGY) and Sodexo (OTCPK:SDXAY) are 5 year veteran's, Roche (OTCQX:RHHBY) and Brenntag (OTCPK:BNTGY) are four year vet's, and Next and Aberdeen AM are in for their third year's. Three names that were promoted out in the past have now re-entered; Heineken (OTCQX:HEINY), Sage Group (OTCPK:SGPYY) and Wartsila (OTCPK:WRTBY). The four new entrants include Cap Gemini, Havas (OTC:HVSYY), Merck (OTCPK:MKGAY) and Sika (OTCPK:SXYAY). Now the screening and selection process is complete we hope to have a full note (with charts) ready by the week's end.
More woes for Swatch (OTCPK:SWGAY). Poor Swiss watch exports data adds more pressure on Swatch. May was the weakest YoY growth for years globally at -8.4%, while both the US and China were weak. Note these growth figures are in CHF which experienced a 5% currency tailwind YoY. Philips (NYSE:PHG) has traded poorly again this week and believe that much like Elekta it faces structural challenges in the healthcare business. Weremain sellers of Pearson: we view their deal this week to sell PowerSchool as a further reason to be short. The deal rationale is perplexing. We don't understand the rationale - removing PowerSchool increases volatility, reduces revenue visibility and subtracts from Pearson's digital footprint. Furthermore, Pearson has given no indication of what it intends to do with the $350m in new cash now burning a hole in the corporate pocket. Interesting to see Berenberg cutting Aryzta (OTCPK:ARZTY) from Buy to Hold in reaction to their numbers which were two weeks ago? This won't be the last. More will follow. Edenred, we haven't mentioned for a while although reminded of it today as it was ejected from the HQGB due to a deterioration in margin trends. The CEO departure (May 18) can't be construed positively - in our minds - and we see little reason for altering our stance with respect the structural issues around vouchers, nor Brazil. EDP (OTCPK:EDPFY) in Portugal provides a good Grexit hedge and also is exposed to structural headwinds. It highly levered and about to suffer from de-regulation.
For all this and more, read on.
Have a great weekend.
1. Keep buying risk/reflation assets, especially Italian banks and our RRB
The decision to increase ECB bond purchases in May was interpreted by many at the time - ourselves included - as positive for reflation assets. It wasn't, the SXXP is down 5% since with the banks down more (albeit that's still much better than bonds). What is quite clear is the ECB's move was to protect Europe from contagion risks of a Grexit or default, an event that is looking increasingly more likely given the Tsipras government with their game theory master, Varoufakis, still seeing the threat of financial contagion as their trump card in negotiations. It's not - the ECB has created a fire-break, contagion risks are contained insofar the ECB can print money without constraint, most of the creditor risks are well-known, the banks have recapitalised (post AQR), Europe's is growing again and so, is more immune to shock. If Greek equities, bonds and GDP disappeared, it would certainly be a tragedy, but not of epic and globally destructive proportions (except perhaps for Angela Merkel). Europe's equity market amounts to €10tr vs. only ~€20bn for Greece; Greece's GDP is now less than 1.5% of Europe's. That's a rounding error. So, a Greek default might indeed occur, but only if it doesn't really matter. And if it does an inevitable panic will ensue, one that will ultimately get bought by stronger hands (see our US investor feedback on this point). If it doesn't, the market should rally on relief. Either way, for those of you with a longer-term horizon we would use some of that large cash-balance you've recently accumulated and start buying where you have conviction - there is always opportunity in crisis. You may have to weather a little short-term pain should the worst case ensue, but ultimately we suspect you will be rewarded. Moreover, you also protect yourself from the alternative - and more likely scenario - that a deal is done. Buy now, layer in on weakness.
2. The anatomy of a bull-market
The Nasdaq and Small caps made new highs this week with the Nasdaq finally closing above its March 10th, 2000 peak of 5048. The Front page of the FT doesn't even mention the milestone?
Bull markets don't end on scepticism.
3. Greece aside, there is reason for optimism
Greece aside, there is reason for optimism in many global economies. Eurozone PMIs look set to recover further, helped no less by continued acceleration in the money-supply which is at the levels since March 2009 (credit precedes activity). Italy's growth is accelerating. The recent US data suggests it is rebounding from its early Spring slump, indeed the US growth surprise index looks like this:
And Job openings have surpassed their 2000 peaks, in other words there is more job demand now than during the internet craze when unemployment was 1.5% lower. China's growth is H2 weighted and so could surprise the many naysayers, so too could the wealth effects of the stock-market doubling. And while bond markets have been acting wildly, break-evens have been relatively immune and point to slow-but continual "reflation".
For this reason, we continue to add to our Reflation Recovery Basket, emboldened perhaps by our US investor feedback - who believe that even with a Grexit European assets are attractive. That and sentiment is now becoming quite extremely negative. The AAII bullish index is at 20.04, the lowest since April 11, 2013. Cash levels are elevated and fear is quite extreme.
Bull markets end on Euphoria, not Pessimism.
4. The case for Thematic Investing
In meetings in NYC last week we learned Blackrock have hired Andrew Ang, a finance professor at Columbia and advocate for Thematic investing to lead a new strategy group that overseas $125bn in assets, a shift that underlies Blackrock's intention to focus more on systematic styles like "smart-beta", than traditional active management. Of the c$5tr they oversee, ~$3tr is already managed via ETFs which offer systematic exposure to a market or index, but they now intend to create specially designed indices that track a specific investment theme, similar to our own process at Aviate. For example, our own stable of baskets and themes could easily be turned into ETFs like the Aviate Reflation Recovery Basket, the GET-Clean Basket, Pharma Bull Market and the Globesity Basket, High-Quality Growth Basket, War and Defence spending, Italian Reform/recovery or China Consumer/Reform basket etc. Perhaps in time they will!? While we view this approach as complimentary to our clients' process, Ang wants to challenge the traditional approach, with its focus on asset classes and sector labels, as being too crude and ultimately too costly to serve investors adequately. Ang focuses instead on "factor risks", the peculiar sets of drivers that cut across asset classes/sectors, and that must be the focus of attention if investors are to weather market turmoil and receive the rewards that come with doing so. For example, there have only been a few big ideas that we needed to get right over the past 7 or so years probably the biggest being the FED. And Bonds.
Big money is made from big ideas.
If you have further interest in this topic Andrew Ang has written a book on the subject called:
Asset Management: A Systematic Approach to Factor Investing. It is well worth a read. You can buy from Amazon.
With this in mind, we note a few thematic aspects from our daily below.
5. Banks, we remain a buyer
While we can rationalise Bank weakness in the face of Grexit uncertainty, underlying fundamentals of the banking business are improving and we would expect further support from the results of the TLTRO tender, where interestingly the consensus seems decidedly cautious on the potential uptake based on a view loan demand is poor? That view seems incongruous with respect M3 which is now running at 5.3%, an indicator that often portends to higher activity (PMIs) and also bank stock performance in the future. See Chart 1 below, it's M3 vs. Banks/SXXP. With respect to our call to favour domestic cashflows we point to the fact the Euro has not only stabilised but is up 8% from its low - a fact which strongly correlates with Ban/s/Autos, see chart 2 below.
Chart 1: Banks/Market (white) vs. M3 (yellow).
Chart 2: Banks/Autos (white) vs. EUR (yellow).
6. Banks and qualifying securitisations
Expect more discussion re Qualifying Securitisations after Regulators fuelled hope of an easing in capital rules widely seen as stifling the revival of the securitisation market. As discussed, any revival of this market could have large implications for credit liquidity and help change the rhetoric from crisis era deleveraging, to releveraging - a return to normal. Bank stocks are far from discounting this reality in terms of valuations. Elsewhere note a bigger than expected uptake in the 4th TLTRO, especially by Italian banks, which tells you they have demand for funding, and these loans will be issued at higher rates (good news for returns). Note too Private equity have decided to buy Istituto Centrale Banche Popolari (ICBPI) in Italy, which will help CREVAL and also remind investors of the potential from consolidation (remember the Spanish went from 0.6x TBV to 1.3x TBV pre to post consolidation. The Italians stand c0.8x now).
We buy Intesa Sanpaolo, Mediobanca, PMI, UBI, Unipol, UniCredit, Anima, Ceved etc.
Further our comments (below) and the FT article on Securitisations, we add the following.
7. Qualifying Securitisations
The EU ABS market: making progress towards a real market, perhaps to ECB Qualifying Securitisations one day
Despite ECB QE purchases of European ABS securities, ABS issuance has not picked up. The reason is, for 'normal' ABS investors (banks, insurance companies) the capital requirements are too expensive cf. covered bonds. The ECB, as part of its harmonisation programme, is endeavouring to change this. But the market needs real change. While we are not there yet, the indications emerging from the various central bank discussion forums is promising. As covered in the FT on Friday 19 June, David Rule (BoE policy director and chairman of the Iosco task force on securitisation) was quoted at the Barcelona conference this week, pointing to the need for "a more level playing field". This would be very promising for the ABS market if effected by policy-makers. It is clear, even with ECB QE, the market will not develop without more favourable capital treatment for purchasers.
If, and at this stage it is still an 'if', this issue is resolved, the time might finally come for a proper ABS market in Europe. The ECB is in favour of this market, principally because covered bonds, the mainstay of the asset-backed market in Europe, are for mortgages. Widening the pool of available assets to all loans offers a more powerful transmission of credit supply. And if ABS issuance were to grow, this offers potential for the second order beneficiary of ABS, i.e. ECB qualifying securitisation (QS) where the ECB would buy a whole range of super-senior loans from banks instead of sovereign bonds. We have written in the past why QS can be more favourable than QE if the conditions are right. But given ECB QE by definition will effectively end in H2 2016, the timing is about right. So no concrete changes yet, but the indication from regulators is they have got the message and more favourable conditions for a proper ABS market are on the way. That is good news for credit growth in Europe and therefore banks and insurance companies.
8. Remove the cycle to focus on High quality growth
If, like many of our US clients, you prefer to ignore the cycle and focus instead on the long-term drivers of value, we would direct you to Terry Smith's brilliant article in the Telegraph this weekend, and to the 6th iteration of the Aviate High Quality Growth basket.
Firstly with respect to Terry Smith, his fund follows a very simple yet proven strategy for outperformance (much like that of Nick Train) and only invests in companies that have a long history of success in a few sectors such as consumer staples, medical equipment and franchising. In using the analogy of a horse pundit, he's not into "picking winners" but bets on companies that have "already won"; "he simply waits until the market misprices these shares in order to get his chance to bet on a certain winner". A Grexit could be the sort of thing that misprices these shares, and so, with this in mind we have updated our HQGB basket.
Of note is there are now only 19 stocks that still qualify on growth and valuation metrics, 4 of which have been excluded due to a deterioration in margin profiles (Edenred, Babcock, Kering, SAP). SAP has been excluded after 6 years of inclusion, interestingly it's replaced by CAP (which fits with our fundamental views). Fresenius was promoted out on valuation. Only one name has remained in for all 6 years, Anheuser-Busch. Experian and Sodexo are 5 year veterans, Roche and Brenntag are four year vet's, and Next and Aberdeen AM are in for their third years. Three names that were promoted out in the past have now re-entered; Heineken, Sage Group and Wartsila. The four new entrants include Cap Gemini, Havas, Merck and Sika. Now the screening and selection process is complete we hope to have a full note (with charts) ready by the week's end.
9. Telecom Italia (buy): VIV pushing for positive strategic change
Bollore's new and increasing influence over TIT brings with it the potential for some positive strategic changes. Reports this week claim that Vivendi (OTCPK:VIVHY) wants Telecom Italia to consider an exit from Brazil. Management's official line on this recently has been that they remain committed, but that could well change under a wider new strategic direction. When a Brazil exit was mooted in the past, the expectation was a break up of TIM - revisiting that idea would be well received by investors. Although we see longer-term value in Brazil, that is somewhat dependent on consolidation which has remained elusive for various reasons - a break up of TIM would effectively monetise the value of that consolidation for TIT.
Vivendi also said it wants TIT to consider cost-cutting plans and to "potentially merge with a rival in the medium term". Those two points echo what we think should and will happen in European Telco's over time. We think the end game will be a small number (3-5?) of operators across the whole of Europe - regulators must allow that or risk operators not incentivised to invest in developing next generation Telco infrastructure. Value creation will come largely from consolidation and cost-cutting. On the commercial side, convergence will be the norm and first movers may sustain an advantage there.
It seems Bollore shares that vision and is priming TIT accordingly. Where TV/content distribution features and how that will be monetised for TIT shareholders remains to be seen, but is a source of optionality. In the meantime, we think consolidation in Italian mobile remains a high probability near-term event, and opportunities for cheap re-financing could boost FCFs.
10. Vodafone (buy): change in Germany
The potential value creation from a VOD/LBTY deal far outweighs short term ups and downs in Vodafone's (NASDAQ:VOD) various businesses. That said, Vodafone Germany was the focus of attention and disappointment following FY results. The CEO conceded Germany has not been commercially run as well as it should be, so news of management change there, should be viewed positively.
Bigger picture, we think Liberty (NASDAQ:LBTYA) and Vodafone must act on the current window of opportunity to create a leading European converged telco powerhouse. If the bold changes needed for that are too much for Vodafone to stomach, Liberty could turn buyer and still create value through a deal at north of 300p (30%+ upside).
11. Autos, remain a seller
We remain a seller of Auto stocks, especially BMW. Many of the head-winds we identified from Peak-Car and the growth as car-sharing/ride on demand vs. ownership, the "new-normal" in China (parallel imports, anti-graft/lower volumes), greater pressure from efficiency/clean air, greater discounting/incentives, a stabilising Euro taking the gloss off export earnings and greater dispersion in stock-markets generally, are converging such that we would expect further share price weakness over the short to medium term, especially relative to domestic cash-flows businesses like Banks (see below).
The news flow over the past week has been decidedly bearish, notably that coming from China - the former cash cow for many OEMs, especially luxury ones. We first highlighted parallel importing in January since when it's become quite an issue. Worryingly this price pressure is coming at a time volumes are under-pressure in China, indeed May was the WORST MONTH ON A YOY BASIS EVER! A rising stock market is sucking monetary demand from all areas and with car purchases the second largest monetary commitment an individual can make (behind property), consumption in this area has been at best deferred. Add to this the beginnings of a property market recovery (last month saw the second largest monthly contracted sales on record at +56% YoY) and utilising savings to buy a car would currently seem to have a substantial opportunity cost attached to it. Anti-graft continues and our "Peak-Car" theory is gaining traction. The fact Uber DOUBLED their Uber rides to 1m last month, from 500k the month prior - the strongest signal yet the car is becoming a utility you call on, not something you own; "Car-sharing represents a shift in the way we think about our cars. Instead of being an asset to own, they're a utility to call on. It's the Spotify approach to cars: a pay-by-the-hour subscription model" (aviatelive). Just this week Bloomberg reports the biggest Chinese SUV maker, Great Wall, cut prices c.5% which could signal a price war is about come (as it often does when volumes slow, a double whammy for margins). Granted Europe is still a sweet-spot as it's recovering later and is off a very low base, but even the rate of increase decelerated last month which worries us for our once favoured Peugeot - especially so when it's Chinese JV partner is in freefall (see 489 HK). They own 51% of Faurecia which has been in free-fall as well, so taking profits remains the sensible option. We have also had more of a look at Fiat, and after some initial enthusiasm we now see many reasons for caution, not least their potential bid for GM!
12. Fiat, further work suggests caution. What if they bid for GM?
Reuters is reporting GM are said to work investment banks Goldman's and Morgan Stanley on a defence from a Fiat bid. FCA (NYSE:FCAU) to go hostile on GM seems the logical approach to us. A merger isn't going to fly since it would require Marchionne to run the combined entity which GM will never agree to. It would be one of the most remarkable deal attempts ever - all paper, GM $58bn mkt cap, FCA $20bn before any premium (a 30% premium would be close to FCA's market cap alone!). We have run some numbers on this already - throw in some bullish synergy numbers and you can make this deal look EPS accretive, in theory at least. Realising these synergies close to impossible in the coming environment though we think. Watch this space.
13. "I couldn't give A-TOS". Switch to CAP
Atos investor day this morning. It would appear from the headlines that the street has got ahead of itself or, rather, the company. Headlines of above €11bn revenues for 2016 suggest no upside to street estimates of €11.22bn. Furthermore, operating margins of 8.5-9.5% for 2016 are a repeat of previous 3-year plan targets set in 2014. Free cash flow guidance is likely the disappointment. The previous €450-500m 2016 target has been upgraded to €500-550m but expectations were for as high as €600m, and a minimum of €550m. Net Income targets of ~€530m are below street estimates of €556m.
All in all, there are NO UPGRADES in Atos estimates here and disappointment in free cash flow and with 68% buy ratings on the street it is tough to see incremental new positives in the short term. In contrast CAP has increased margin targets, has low balled iGate synergies and estimates will be raised when the deal closes. SELL ATO FP, switch to CAP FP
14. Poor Swiss watch exports, sell Swatch (cont)
In our conversation with Swatch after the AGM, the company maintained the thesis that Apple was helping grow the market. Swatch noted despite the launch of Apple Watch, in the US the Swatch brand and the high-end were selling well and therefore the presence of Apple was not hurting Swatch brand sales. They did however note the mid-range - the most important source of profits for Swatch - was underperforming the high and low-end in the US, an interesting observation we think.
The Swiss watch export data, while not necessarily a perfect read for Swatch, make interesting reading for May, especially the US and China (since HK been terrible for a long time). May was the weakest YoY growth for years globally at -8.4%, while both the US and China were weak. Note these growth figures are in CHF, which experience a 5% currency tailwind YoY (+5% vs. the USD) meaning the underlying growth in May was WORSE than the -8%.
Source: Swiss watch export data
Is the Apple Watch having an effect? It's still too early to draw conclusions, but our negative stance remains. For Swatch, perhaps more worryingly, the core profit pool (CHF300-1200) is starting to deteriorate (in CHF, its highest cost region). We remain sellers.
Source: Swiss watch export data
15. Pearson (sell): Selling a cash-cow? Wrong move
Pearson has sold PowerSchool for $350m to private equity (Vista). PowerSchool is back-office software administration for schools and (now) deemed non-core relative to Pearson's strategy of focusing on "learning outcomes". Yet "learning outcomes" is increasingly under scrutiny, especially in the U.S., given issues which are increasingly likely to hurt Pearson.
For more on this see here.
It may have been difficult to leverage a back office data management system with other Pearson education products but it would still provide greater penetration of Pearson $ into schools' footprint and budgets. Software gives solid recurring revenues streams, especially in times of volatility. So removing this increases volatility, reduces revenue visibility and subtracts from Pearson's digital footprint. And this to the fact Pearson has given no indication of what it intends to do with the $350m new cash burning a hole in the corporate pocket and the deal rationale is perplexing.
Pearson, for us, remains a structural sell/underweight
16. UK reflation and consumption growth and Sky
UK wage growth hits four-year high of 2.7% in April. The jump in real wages is the highest for seven years. This morning UK Retail Sales for May ex autos +0.20% vs. -0.1% est. This remains a very good context for UK consumption trends, and so we remain buyers of our favoured names like Next, Ryanair, easyJet and consider also what we discussed with respect to Sky yesterday, added below.
SKY: Third time lucky? Ducks align for FOX bid
The news Rupert Murdoch is stepping down as CEO began circling last week. But the timing, July 1st, is many months ahead of expectations. The announcement comes almost five years to the day Fox (NASDAQ:FOX) tried (unsuccessfully for the second time) to acquire Sky. Since this time Fox has outperformed Sky by ~50%. Given debt remains cheap and FOX are not scared of using balance sheet (remember the $80bn failed bid for Time Warner), the financial terms for them have improved significantly. And Fox's $6bn buyback is due to be completed within the next 10 weeks giving rise to future speculation as to how they next best spend their cashflow. Especially as the company themselves admit "Clearly, we have significant excess cash" (March 2015). Given the news, joining the dots leads to a 3rd bid coming from FOX in our view.
The reasons for the failure of the 2010 attempt to buy Sky have all been resolved. What were the issues? (1) Media Pluarity. Department for Culture (DCMS) now recognises the BBC in plurality discussions (spending £430m on news/year, more than all other UK broadcasters put together), reaching 86% of the population and >70% of TV news watching in the UK. In addition, with the split of FOX from NEWS, media plurality would no longer be an issue. (2) The phone hacking scandal has been put to bed and the related party at the time News Corp, has now been carved out and is an entirely separate entity. (3) The most vociferous opponent to the deal, Vince Cable (former Secretary of State for Business Innovation and Skills) is not even an MP now (thankfully). (4) Rupert Murdoch.
Fast forward five years and the rationale for a deal is even more compelling. Why? (1) Sky itself is now the vehicle for all the European TV assets having taken full ownership of Sky Italia and Sky Deutschland. Not only is Pay TV adoption accelerating across the continent but Sky now has, in house, the hugely valuable SkyD NOL's. (2) Scale is vital across the media footprint. Recent deals in Cable across both Europe and the U.S. are testament to that. New technologies (OTP) and new viewing habits (multi-screen) expand the potential for distribution of quality content, across the globe. (3) A Fox/Sky combination, ultimately, down the line leads to a nice cosy Murdoch/Malone duopoly in Europe. Think of it. Malone has huge distribution through Liberty Global (Virgin Media, Ziggo, Telenet, KBW, Unitymedia) for Fox's content (especially the unrivalled live sports offering) and Liberty's most strategic asset, Virgin Media, is run by Tom Mockridge, who also happens to be Sky's Deputy Chairman.
Other supportive policy for a deal comes in the shape of the NEW Secretary of State for Business Innovation and Skills, Sajid Javid, who just happens to have previously been the Culture Secretary (aka in control of TV). What is Javid's view? "Politicians and Government have no business controlling television" (from Javid's speech on the 15th October 2014). Oh, and he used to be a banker. What of the "meddlers" in Brussels? Unlike the UK opposition in 2010 the EC actually gave unconditional merger clearance so that shouldn't be a hurdle today.
And the new CEO of FOX, who of course happens to have been the former CEO of Sky, has a clear vision for Fox to be; "a dynamic global organization..continuing to be a creative business at scale", James Murdoch (May 2015). And, of course, a combined FOX/SKY would realize his ambition; "both the distribution business and the content business clearly thrive on scale".
The 2010 bid was an all-cash transaction and Sky shareholders would likely favour a higher mix of cash relative to (non-voting) Fox shares today. Fox, we estimate, could afford to pay a 30% premium, use 55% debt/45% equity mix, assume 3% cost of new debt and the post deal combination of an undemanding 3.5x leverage without diluting Fox shareholders.
As discussed, the best M&A candidates are those with solid fundamentals where M&A offers optionality. Sky fits the M.O. With new technologies doubling TV consumption (Nielsen studies) and a payment culture accepted by consumers then remember Sky is a sublime marketer of TV content and a differentiator on technology. And Fox has a substantial global arsenal of such content.
Sky now offers 20% EBITDA growth, 3x the rate of the European sector, yet trades on a discount multiple (10.6x EV/EBITDA versus sector's 11.9x) and with the lowest number of buy ratings in European Media (18%), we remain out of consensus buyers of Sky.
BUY SKY, BEFORE FOX DOES.
17. China property, more signs of a bottom
The 70 city ASPs for a 4th consecutive month show improving trends with momentum continuing on a sequential basis and further second derivative improvements on a YoY comparison. While the investor community won't yell "bottom" until these trends reverse, we nevertheless see this as imminent and remain happy to stay in front of it. The Average new home prices in 100 cities tracked by SouFun (NYSE:SFUN), reversed a yearlong downtrend rose 0.45 percent in May. The China Statistics Bureau said Prices rose in 1st tier cities, remained stable in 2nd tier, and mainly fell in 3rd tier. Note too headlines that China is going to ease restrictions on foreign property purchases…..If you fix housing you fix an awful lot of things not least collateral, confidence and consumption.
18. IoT: at last, a Europe play on IT security
With the rise of the Internet of Things (IoT), cloud technology and the digital age comes the accompanied surge in digital security threats, stolen data and IT security breaches. No surprise, perhaps, to see the Cyber Security ETF (NYSEARCA:HACK) break out to new highs.
While the U.S. market has a plethora of related stocks, including FireEye, Fortinet, and PaloAlto and Asia has Trend Micro and Ahnlab, the European market is lacking in public market stock listings, until now.
Sophos, SOPH LN, announced a price range for its IPO with an implied market cap of £945m to £1.25bn with books due to close on June 29th. Sophos has been around for 30 years starting out by providing antivirus and encryption products. The company has progressed to provide a range of cyber security services capable of protecting computer networks and individual devices with a core focus on UTM (Unified Threat Management). In its most recent filing the company posted billings of $476m in the 12 months to March up 22% from the previous year, 3x the market growth of 7% (IDC estimates).
An implied market cap of ~$1.7bn (at mid-point of range) and 3.6x F12M billings is an undemanding valuation for Sophos. FireEye, the leader in UTM, posted L12M billings of $651m, trades on 12.7x L12M billings, 13.2x FY15 P/S and isn't expected to break even until 2018. Sophos makes money, posting EBITDA of $101m in 12M to March 15.
Sophos has been aggressive in building out its UTM portfolio having acquired Astaro in 2011 and Cyberoam in 2014. UTM is the fastest growth market within IT Security and, according to IDC UTM grows at 3x the rate of growth of IPS (Intrusion Prevention Systems).
Sophos, at first glance, looks like a great UK IPO (for once) to take a look at. Especially given the scarcity of plays to one of the biggest growth markets in technology.
Back with more…
19. Globesity/Novo Nordisk: the sad reality that continues to grow
The number of diabetics in Britain has soared 62% in less than a decade, driven by the spiralling obesity problem, with 3.3m adults registered as diabetic in 2014. As many as 590,000 are thought to be undiagnosed. New record high number of people with diabetes in Wales, "rising at an alarming rate" (Dai Williams, director of Diabetes UK Cymru).
Diabetes is now costing the NHS £10bn/year, 80% of which is spent on managing avoiding complications. One in five adults in urban cities in India are now diabetic. Indian Council of Medical Research believe a further 77 million Indians are pre-diabetic. Change in diets (American foods reaching rural areas) could see 60% of the Indian population becoming diabetic by 2020. The cost of diabetes in India is now 3x its health budget. Harvard study has shown a link between an increased intake of trans fatty acids results in atherosclerosis which is a risk factor in Type 2 diabetes. A global study has also revealed deliveries by C-sections increases the risk of childhood type-1 diabetes by 20% (we believe this may have something to do with the micro biome as well - see our discussion on immunology).
Novo Nordisk (NYSE:NVO) is the unintended prime beneficiary of this alarming trend. Novo remains one of our preferred names in global pharma, being at the confluence of multiple thematics namely Globesity, High Quality Growth, a Top Three Compounder (along with Kone and Next) and member of the Dividend Aristocrats Index.
Stay long Novo Nordisk.
20. You fix Housing… Stay long UK Banks/Homebuilders
House prices are rising in every part of the UK for the first time since last summer as a lack of property coming on the market drives prices upwards. London house prices have risen 5.7% to more than £600,000 with Kensington and Chelsea up 25% (Rightmove). Nationally, asking prices increased 3% to £294,351, also a record. Addressing the shortage of new homes is fast becoming a key focus for the Tories and the only way this imbalance rectifies is by more building activity - stay long UK Homebuilders. And while house prices rise, so too the collateral value of UK banks.
We buy more Lloyds.
21. Paris Air Show: could Meggitt be in play post UTX warning?
Bi-annual Paris Air Show took place this week. $104bn UTX (NYSE:UTX) has started the week with a warning, cutting guidance. 2015 EPS of $6.55-6.85, vs. prior guidance $6.85-7.05 and street estimates $7.00. Reduction in guidance due to $0.10 to $0.20 of one-time separation costs (UTX is spinning out helicopter business Sikorsky) along with a $0.10 decline in Sikorsky's operational expectations for the year due to weakness in the oil and gas markets.
UTX is on the prowl for large M&A. "Our focus is on adding to the core, and usually we tend to err on the side of bigger deals rather than smaller ones," Reuters cited UTAS President David Gitlin as saying in an interview. Co. seeking "something that can move the needle".
UTX was praised for its $18bn acquisition of Goodrich in 2011. Companies linked with UTX in the past include Tyco International, Textron and in Europe Meggitt has been tipped as a takeover target many times.
Meggitt currently generates 48% of its revenue from civil aerospace, and its aircraft braking systems and control systems a good fit for United Technologies. North America represents 50% of revenues and Meggitt's 38% aero equipment margins compare favourably with UTC Aerospace's 16%.
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