Is it over yet?
The market climbs a wall of worry. Greece, the current one, is still not dealt with but once it has been, rest assured attention will turn to the next 'risk' and that could be any of Russia/Ukraine, the UK's in/out referendum and 'Brexit', China's 'bubble' popping (which we ardently oppose!) or the Fed's all-but-inevitable rise in interest rates (see wage inflation points below). We make an observation - it is not symptomatic of a market top to see persistent rumination on the risk of negative event risks accompanied by market resilience. Indeed widely-known fears often present opportunity and we believe the current environment is no exception (ref our comments "get prints/layer-in" from June 16th). As Ken Fisher suggests in the FT "…stocks climb the 'wall' until investors are out of worries and become euphoric, or until a huge nasty surprise knocks them. Size and surprise, or euphoria." We certainly do not observe the latter, and we don't think it likely Grexit produces the former, assuming that occurs which we don't believe it does. Europe is still Europe with or without Greece, and Europe still has a fully functioning lender of last resort in the ECB. The time to worry is not necessarily when negatives hog the headlines but the converse - worry when few do.
Focus on the fundamentals, they are improving.
Greece aside there are reasons for optimism in Europe. We see them most especially in Italy and even 'problem child' France where the Composite PMI made 4 year highs and the Manufacturing PMI ticked to expansionary (>50) for the first time since April '14. GDP was higher than expectations and so was consumer confidence which rose to 94, a post-crisis high. Money supply continues to grow in Europe (although at a slightly lower rate than in May), impressive against the backdrop of what's happening in Greece and turbulence in bond markets. The most liquid element of M3 actually strengthened from 10.5% to 11.2%, which signals further acceleration in economic activity. In Italy business confidence rose close to a four-year high, consumer confidence remains at levels not seen in a decade and Confindustria upgraded its outlook for Italian GDP. While her economy accelerates, so too the Italian Government's reform agenda. Italy has all the ingredients for continued outperformance - economic momentum, reform and it is the CHEAPEST developed market in the Western world on a CAPE basis (excluding Russia, Poland, Turkey and Greece.) We remain buyers of Intesa Sanpaolo (OTCPK:ISNPY), PMI, UBI, Mediobanca (OTCPK:MDIBY), Banco Popolare, UniCredit (OTCPK:UNCFY), Credit Agricole (OTCPK:CRARY), Cerved, Anima, OVS, Mediaset (OTCPK:MDIUY), Telecom Italia (NYSE:TI).
Stay long Italian Banks
According to Cerved only 49% of bankruptcies applied for in Italy in 2007-08 were finalised within six years. Therefore Tuesday's decree to improve and speed up bankruptcy/repossession procedures and work through the backlog of outstanding cases should help the banks to better manage/dispose their NPLs and allow them to focus energy on new lending. This further supports and stimulates the recovery of the Italian economy. The most levered to this reform are BMPS (see below) and UCG and the advent of a clearing process for NPLs should lift further barriers to consolidation (buy PMI, UBI and MB on this). For the sector generally it means higher capital, higher earnings and lower NPLs. It is still possible to buy Italian Banks and the top of the NPL cycle into a recovering economy, with a glide-path to further reform and consolidation on sub 1x TBV. For example, after consolidation in Spain, banks traded on 1.3x TBV which is an obvious parallel before any upgrades (of which there will be many). Banks generally have been the best performers for some time; indeed they have outperformed since the market topped on April 15 - a positive technical set-up that portends to continued outperformance on the rebound. Indeed many (PMI, Credit Agricole, Intesa Sanpaolo, BP and BPE) are already breaking out. As such we stay long Intesa Sanpaolo, PMI, UBI, Mediobanca, Banco Popolare, UniCredit and Credit Agricole. We buy even more Cerved (which benefits from all these trends) and Anima as the roll-up beneficiary of popolari fund inflows.
With respect to BMPS we have this, very guarded note, to add: BMPS stands to gain the most from the reforms. Their current NPL book - at €24bn - stands at over 4x the market cap of €5.5bn. That book includes a 65.5% coverage on gross NPLs, which leaves scope for a combination of lower provisioning in the future and possible write-backs of past provisions. More than half of these net NPLs are in mortgage debt (you fix housing…). We believe that's a market in which there is now plenty of learned experience along with capital to deploy following the work-outs in Spain and Ireland. Remember 2018 guidance is for €2.6bn of Pre Provision Profits - almost half the market cap - which implies that markets don't yet believe the worst is over. If the provisioning is done, as the clouds lift so will BMPS market cap.
More on Italian Banks here.
Market internals favour Banks and Telcos, our two favourite sectors.
Banks and Telcos have been the best performing sectors since market top on April 15th and are the first to have regained their highs amid positive market internals. In telcos, we see the same constructive technical set-up noted for banks, and we reiterate the point that it normally points to continued outperformance during any subsequent rebound. With break-outs in Intesa Sanpaolo, Pop. di Milano, Pop. Emilia Romagna (OTCPK:BPXXY), Banco Popolare, Credit Agricole, ING (NYSE:ING) too should gain momentum as 'liquidity chases the inflating assets' and beta gets bought by those who, on a beta-adjusted basis, are underweight the sector. Telcos are undergoing a decadal transformation and the tide has turned. It was ebbing for the past 15 years and is now clearly coming in again. This is fertile territory for outperformance especially given a confluence of regulatory reform, consolidation, market repair, operational gearing and growth. As a reminder our favourites remain Numericable (Altice) (OTCPK:NUMCF), Telecom Italia, Vodafone (NASDAQ:VOD), Deutsche Telecom (OTCQX:DTEGY) and in cable it's NOS.
Telcos and investing with Billionaires
Few understand the capabilities Patrick Drahi and team can bring to bear when it comes to extracting cost-synergies. Introducing a private equity mentality to formerly state-run (in many cases), inefficient, cost-heavy, fragmented companies and markets is a bit like fishing in a barrel for a team like Altice (OTCPK:ATCEY), especially given so many of their employees once worked for Telco-suppliers and know exactly how to extract value…(as an aside, that means we remain seller a of Ericsson). The other driver of note is they could become multi-multi-millionaires should they hit their targets. That was clearly attractive to the current CEO of Alcatel who will join Altice when the Nokia deal closes. The value comes from cost rationalization. With an enviable track-record of success here (e.g. Numericable have seen their margins rise 700bps YoY and are already at their 2018 targets) we see no reason to fade them now. On our numbers, we see 70% upside in Numericable (see flexer model attached). Altice should continue to rally and the evidence mounts that we are well through the in-country/OPEX phase of telco consolidation. A cross-border phase will inevitably follow, one in which we think the end game is 5 major pan-European players, likely to be led by Deutsche Telekom, Malone/Vodafone and then of course Altice/Numericable (more below). WE reiterate - ten years of an ebbing tide in telcos is over. The next decade looks far more interesting not only from a consolidation angle, but also what if we see growth as we expect? The operating leverage is significant. Yet the street has no growth factored in for 2016/17.
Altice/Numericable: stay long.
What a week. It started on Monday morning with the news NUM-SFR had offered to buy BTel from Bouygues at an attractive price of more than €10bn in cash, double what Iliad had offered previously. On Tuesday evening, Bouygues rejected the offer out of hand after their board meeting - this was somewhat surprising. Gains in Numericable, Bouygues and Orange stock prices reversed on Wednesday. On Thursday NUM put out more details of their offer, which served to undercut somewhat the rationale of Bouygues' rejection, making Bouygues look a little amateurish and shareholder unfriendly in the process. At the time of writing, all stocks are still higher than their Friday closes from the previous week meaning there is 'something' in the prices of the relevant stocks, but not much at all.
So where to now? While we think Numericable/Altice are streets ahead of Bouygues (OTCPK:BOUYY) when it comes to M&A transactions, Martin Bouygues has put himself and the board in a difficult position: accept a new offer and the previous rationale for rejection looks a little flaky; turn down a higher bid and they come across as irrational. We think Numericable must come in with a revised offer and break fee in order to allow the Bouygues board to save face. Given the higher value BTel can create for NUM, we do think a revised offer will come. Whether Bouygues accepts it is a much tougher decision to call. We see this as a greater risk than the regulatory concerns. We observe low expectations of a revival of a deal. We prefer to be long NUM here as there is 30% upside without BTel and more than 60% upside with it. There is upside in Bouygues too but the level of discount for lack of shareholder alignment with management ticked upwards this week.
High Quality Growth Basket #6
If looking for those increasingly rare through-cycle compounders that express the scarcities of quality, growth and yield and also REMAIN cheap, we published our sixth edition of the High Quality Growth basket this week. The first thing to note is that only large cap stocks in Europe now qualify!! As we discuss further below, "in the year ahead, the big change is the lack of choice, since we are holding fast to the valuation criterion we have always held, a minimum 5% FCF yield Y2 on consensus estimates. Previously we could choose from a list of at least 40 names. In 2015, the list has dwindled to just 15". That in itself is an interesting development - quality costs. There are still opportunities out there - in the list of 15 stocks, there are seven new entrants (three for the first time ever) and eight returners from HQGB 5. Just one stock has been in every year, AB-InBev (NYSE:BUD). The names are (7 new entrants, 8 returning): Aberdeen Asset Management, Anheuser-Busch InBev, Brenntag, Cap Gemini, Experian, GEA Group, Havas, Heineken, Merck, Next, Roche, Sage Group, Sika, Sodexo, Wartsila.
CREE warned on Wednesday, with LED not looking great. We still have real concerns about healthcare given Mindray price wars and now it looks increasingly unlikely Philips (NYSE:PHG) will rebound in healthcare. We remain a seller. More bad news for Pearson (NYSE:PSO) this week - for-profit colleges lost their legal battle to block the U.S. government's "gainful employment rules". The policy is now due to take effect from 1st July and "gainful employment" rule will block access by schools to Federal funds if they fail to provide adequate tools for their students to find work. This is bad news as for-profit colleges rely on Federal grants for as much as 90% of their revenues. Higher Education is the biggest contributor to Pearson's profit and accounts for over 40% of Pearson's operating income. Piece by piece Pearson's difficulty in adopting digital solution and legacy footprint is being taken apart. Riccardo has initiated a new sell on SGS (OTCPK:SGSOY) this week, interesting given Elementis (OTCPK:ELMTY) warned citing O&G operations earlier in the week. From a fundamental standpoint SGS trades on 22X and FCF Yield sub 5% next three years means it's still EXPENSIVE. The street expects a meaningful rebound for Ericsson (NASDAQ:ERIC). After the Q1 shock, Q2 operating profit is forecast to heroically jump +144% QoQ and +25% Y/Y and still model +40% for 2015 (and 7% 2015 top line growth). Given Ericsson's chequered history of performance and in light of the spectrum pricing above (together with the ramifications of carrier consolidation we have discussed these recovery estimates,), these numbers look too optimistic. SELL Ericsson. Competition is starting to mount for Rocket Internet which wants to be "the world standard of food ordering"!? With ambitions to be the "Facebook of food ordering" and a strategy to "make more complementary investments" we suspect the company's appetite for further dilutive and risky deals is high. Facebook (NASDAQ:FB) has scale. Facebook has best in class technology. The same applies to Tencent (OTCPK:TCEHY) and to Alibaba (NYSE:BABA). With Rocket, not so much. We remain sellers.
Finally on Autos
The best performing sector this year being the first derivative benefit of QE via the weakening of the euro and a jump in export margins. A lot of that has played out. We wouldn't expect the rate of the euro's decline to continue - it may even reverse. That means other reasons must exist - as must upgrades - for the sector's outperformance to be maintained. Indeed the sector multiple has re-rated from just above 11x to over 13.5x this year alone - impressive stuff. However, the sector now needs upgrades to kick in to justify them. This is where we are struggling as short of another collapse in the euro we find it hard to identify where such upgrades might come from (Europe being the exception). Of key importance is the 'new-normal' in China where not only are price impacts being felt thanks to parallel imports, volumes are declining. We would add that the market has yet to consider the secular threats posed by ride-on-demand/car-sharing platforms espoused in our theory of 'Peak Car' (see aviatelive.com for more). As we said last week, we are expecting the sector to bounce off technical levels and it has. Now seems a good opportunity to sell into strength as we don't expect it to persist. From a technical standpoint we note the sector failed to break its 200dma and unlike Banks (and Telcos) it is a long way from regaining its high for the year. As we have said for some months our preference now is for beneficiaries of second order effects of QE - domestic reflation, which is why we prefer Banks (and Telcos) to Autos.
K+S bid. Reinforces our view on the Animal Biome
Potash (POT) has bid €40/share for K+S - they rejected the bid (they have traded as high as €72/sh in the past). This is hot on the heels of Syngenta's rejection of Monsanto's offer - clearly there is something going on in the Ag-Chem space. Another sub-sector that shares similar drivers is Animal Nutrition where our current enthusiasm for the animal biome (and supply chain thereof) should also benefit. In time, we believe this could become a mega-trend. It's one only a handful of companies are exposed to. The best way of improving microbe diversity in humans is via faecal transplant and/or probiotics. One can get exposure to probiotics via organic food producers, mainly in the US. Biotherapeutics is a small but potentially exciting field of inquiry (see 4D Pharma in UK) but the biggest opportunity could be in probiotics, where consuming "good" bacteria has proven effective in combating many of the issues mentioned above. What's equally interesting such issues don't affect only humans but are present in animals too and maybe even apply to plant production. Enhanced nutrient take-up and natural antibiotic production could significantly improve meat production yields and efficiencies. In a world getting hungrier, healthier and more interested in provenance, this has all the hall-marks of a mega-trend. Stocks exposed include Chr Hansen (OTCPK:CHYHY)(the largest library of probiotic bacteria strains), Novozymes (OTCPK:NVZMY) sees significant bio-agriculture potential from microbes, Bayer and Sanofi market probiotic supplements, DSM includes them in some animal feed and Danone sells probiotic yoghurt.
Inflation and pricing power of labour
An ongoing theme for us this year is to highlight the burgeoning pricing power of labour. This is a key component of the inflation debate and it occurs at a time most commentators (and market positioning) view inflation as benign and unlikely to be a problem for many years to come. That in turn obviates the risk that it might be. Returning to the logic that is "the price of labour, like any commodity, will see its price rise as demand for it rises", we note the following:
Job openings in the US have hit new record highs, even higher than in March 2000 during the Internet craze. Importantly there are now more jobs being offered than applicants for those jobs. Wage inflation will follow….
The UK labour market is "fizzing away nicely" and wages are growing faster than expected according to Martin Weale at the Bank of England.
German unemployment rate is the lowest on record.
And finally in Japan, a country where wage inflation was considered a subject for fairytales, we note there were 1.19 jobs open for every applicant in May, compared with 1.17 a month earlier. This is the highest level in 23 years
Aviate stocks in the news
ITV (OTCPK:ITVPY) announced another content deal this week acquiring TwoFour. It adds to ITV's strong content production capabilities and studios including Mammoth Screen, Talpa Media and The Garden. ITV strategy is to build an international content business but not at any price and not to entertain deals which fall out of their core competency. This latest deal ticks all those boxes. Ultimately we think such a strategy will likely prove a winner, either independently, or under the ownership of a larger media conglomerate (Comcast). More positive news for ARM (NASDAQ:ARMH). ARM's TAM is forecast to expand by $43bn by 2020, yet residential IoT is not included in these estimates. With new end markets emerging and the sheer scale of IoT the opportunity is hugely under-appreciated. The ARM opportunity has never been greater. The Architecture Billings Index for May was released this week. It came in at 51.9 vs. 48.8 in April. The Inquiry Index also improved. This is good news for CRH, Wolseley and HeidelbergCement. Interesting to see activist investor Cevian increase their stake in ABB to over 5% this week - they have experience in extracting value. Ingenico launched a E500m convertible this week which is another example of corporates taking advantage of record low rates. While promoted out of our High Quality Growth Basket due to valuation, it remains a great business. A report by Neilsen this week reminds us to stay long Sky. It shows that new viewing records were set this year for both the NBA finals and the Superbowl. The death of pay TV has been greatly exaggerated and live action sports is the differentiator. Buy more Sky (OTCQX:SKYAY). Some bear capitulation in Next this week. This stock remains very misunderstood by the street. We remain convinced of the merits of owning Next (a returning member of our HQGB), especially into a context of rising wages in the UK and e-commerce trends in China. Washington University have published a striking (and worrying) study this week which showed 75% of men and 67% of women in the US are overweight or obese. The consequences of this are clear when looking at the increasing numbers of people with Diabetes and this is only going one way. Novo Nordisk (OTCPK:NONOF) remains the unintended prime beneficiary of this alarming trend. Novo remains one of our preferred names in global pharma because it is at the confluence of multiple thematics namely Globesity, High Quality Growth, a Top Three Compounder and member of the Dividend Aristocrats Index.
For all this and more, read on.
Have a great weekend.
1. There is reason for optimism (cont). Stay long our RR Basket
Confirmation this week the recent acceleration in liquidity (M3 +5.3%) is feeding through to manufacturing activity with further recovery of European PMI's, coming in at 52.5 vs. expectations of 52.2, a new 12 month high. Importantly Germany is seeing a re-acceleration and France entered EXPANSION territory for the first time since April 2014 (with employment gains for the fourth consecutive month). Given our views on Greece from last Tuesday ("get prints into any outcome, layer-in on weakness") we feel comfortable adding to our Reflation Recovery Basket, especially the Italian Banks (Telco's remain our other big sector bet). What has been pleasing is this basket has outperformed on the way down, much like the Banks (and Telcos) who have been the best performing sectors since market top. Such is a constructive set-up and one that normally portends to continued outperformance during the subsequent rebound.
The Aviate Reflation Recovery Basket is up 25.6% YTD.
Flow follows performance as liquidity chases an inflating asset.
2. The benefits of Restructuring and Reform
Restructuring and Reform have been long-standing themes of Aviate's both from a stock and country level. Restructuring offers a two-way bet on the cycle as it provides earnings resilience should the cycle slow, leverage to it should it recover. Over the years the theme has led to significant out-performance like that seen with Peugeot in 2014/15. In terms of country specific reform there is no better example than China whose stock market has more than doubled since first discussing the generational transformation set in motion by the Third Plenum in October 2013. The only other country with a reform agenda as significant is Italy. The speed and extent of reform is unparalleled in post-crisis Europe, made more impressive given this is Italy we are talking about - a country that has had more than 60 different Governments since WW2! They now have a popular leader, one that's likely to stay in power post political reform that he, himself, initiated. This and yet Italy remains one of the cheapest markets on a CAPE basis and where the greatest potential for earnings recovery and surprise still exists. On 12.9x it is half that of the USA and is 2/3 that of Germany. The reform agenda is impressive, the scale of which is unprecedented in peace time, except for perhaps the Schroder reforms of the last decade (that proved quite successful). It's for this reason it remains one of our favoured markets and we stay long the MIB, especially those exposed to domestic recovery.
Source: Star Capital
3. Market internals favour Banks and Telco outperformance
Banks and Telcos have been the best performing sectors since the market top on April 15th, and are the first to have regained their highs, positive market internals.
This is a constructive technical set-up and one that normally portends to continued outperformance during the subsequent rebound. Break-outs in Intesa Sanpaolo, Pop. di Milano, Pop. Emilia Romagna, Banco Popolare, Credit Agricole, ING should gain momentum as 'liquidity chases the inflating assets' and beta gets bought by those underweight the sector on a beta-adjusted basis. Telco's are undergoing a decadal transformation and the tide - which was going out for the past 15 years - is now clearly coming in again, a fertile ground for outperformance especially given a confluence of regulatory reform, consolidation, market repair, operational gearing and growth….As a reminder our favourites remain Numericable (Altice), Telecom Italia, Vodafone, Deutsche Telecom and in cable it's NOS.
We remain buyers of them all.
4. Stay long Italian Banks
According to Cerved only 49% of Italian bankruptcies applied for in 2007-08 were finalised within six years. As such, yesterday's decree to improve/speed up bankruptcy/repossession procedures and work off the outstanding cases, should help the banks to better manage/dispose their NPLs and allow banks to focus more on new lending, further supporting and stimulating the recovery of the Italian economy. The most levered to this reform are BMPS (see below) and UCG, but this should create a line of sight for consolidation now a clearing process for NPLs has begun (buy PMI, UBI and MB on this). For the sector generally it means higher capital, higher earnings and lower NPLs. This and you can still buy Italian Banks and the top of the NPL cycle into a recovering economy, with a glide-path to further reform and consolidation on sub 1x TBV. For example, post consolidation in Spain their banks traded on 1.3x TBV, so there's your target pre any upgrades (of which there will be many). Banks generally have been the best performers for some time, have outperformed since the market topped on April 15 - a positive technical set-up that portends to continued outperformance on the rebound. Indeed many like PMI, Credit Agricole, Intesa Sanpaolo, BP and BPE are already breaking out. As such we remain buyers Intesa Sanpaolo, Mediobanca, PMI, BP, UBI, Unipol, Credit Agricole and UniCredit. We buy even more Cerved (who benefits from all these trends) and Anima as the roll-up beneficiary of popolari fund inflows. With respect to BMPS we have this, very guarded note, to add;
BMPS stands to gain the most from the reforms, as their current NPL book - at €24bn - stands at over 4x the market cap of €5.5bn. This book includes a 65.5% coverage on gross NPLs, which means scope for a combination of lower provisioning in the future and possible write-backs of past provisions. More than half of these net NPLs are in mortgage debt (you fix housing…), a market for which we believe there is now plenty of experience learned and capital to deploy following the work-outs in Spain and Ireland. Remember, 2018 guidance is for €2.6bn of Pre Provision Profits - almost half the market cap - which implies that markets don't yet believe the worst is over. If the provisioning is done, as the clouds lift, so will the BMPS market cap.
5. Telecom Italia: remains a buy
Vivendi confirmed it has increased its stake in Telecom Italia (TIT) from 8.2% to 14.9% and may continue to build on that. One key driver of Vivendi's interest is of course expanding distribution channels for its own content - but Bollore clearly also recognises the potential value to be created from a country-wide fibre roll-out. And his increasing influence over TIT brings scope for positive strategic change, namely a Brazil exit. We see value in TIM Brasil over the longer term, but that does depend somewhat on consolidation and an exit would effectively crystallise that value for TIT shareholders. There are still some complications with Brazil standing in the way of consolidation, but TIT management, for now officially "committed to Brazil", could face increasing pressure to consider an exit.
The angles underpinning our case for TIT are unfolding. Consolidation in Italian mobile remains on the cards, we think more so than currently priced in. All this going on, and TIT is still the second cheapest telco in Europe at a >10% discount to sector average on EV/EBITDA (excluding cable). Stay long.
6. Deutsche Telecom (buy): Thursday looms large…
Gregarious T-Mobile CEO Legere is on a collision course with the FCC Chairman Wheeler over spectrum allocations and the duel could come to a head on Thursday when the FCC open meeting on the subject is held. T-Mobile has been calling for larger spectrum set-asides in the next government spectrum auction. Set asides are rules which limit how much spectrum giants Verizon and AT&T can bid in. FCC Wheeler has been increasingly vocal in recent weeks of his opposition to T-Mobile proposals and sees no reason to increase set asides (no wonder; more competition leads to higher auctions and $$$ into the government coffers). If the FCC makes plain its intent to refuse set-aside increases this week the result may spur T-Mobile to the negotiating table with Dish given the strong spectrum position Dish owns. Either outcome therefore has positive implications for Deutsche Telecom shares.
And Legere is up to something. The most vocal CEO user on Twitter this week vowed it is, "almost time to shake things up a bit". With a further "KA-POW!! That is the sound of us saving wireless competition!" The best 'KA-POW' in our view remains a combination between TMUS and DISH. The combined company would no longer have the spectrum disadvantage Legere laments. Dish and T-Mobile's combined spectrum would rival AT&T's footprint. With Dish's satellite rival DTV combining with AT&T, and Dish's race against the clock to 'use it or lose it' (Spectrum) the logic of a combination of Dish/T-Mobile increases by the day.
Thursday could prove pivotal.
7. Other Telco consolidation plays: Vodafone, Telecom Italia and NOS
The rationale for a Vodafone/Liberty deal has been abundantly clear for some time (not as much of a no-brainer as Numericable/BTel, but still very compelling). Critically, what has changed this year is that Liberty has now acknowledged the need to own mobile assets rather than lease. That shifts the balance of power in negotiations considerably, particularly given how important the UK is to Liberty (35% of op CF for Liberty vs. 11% of EBITDA for Vodafone) and with BT due to lead the move into converged services once the EE deal closes in Q1 2016.
John Malone seems keen on making a deal work (per BBG interview last month) and Vodafone seems ready to come to the table. The Vodafone CEO's initial comments regarding exploring an asset swap were not well received by the market - rightly so, as that would be a total waste of an incredible opportunity to create a European converged telco powerhouse and thereby value for shareholders. Yes it is a big, complex deal and there are hurdles to clear - but they should not be insurmountable given the opportunity that lies ahead. Do something now and the market should reward. Wait too long and windows of commercial opportunity may disappear and regulators may temporarily reign in further consolidation. If the bold decisions needed by Vodafone (e.g. major disposals) are too much for its board to stomach, then Liberty could even turn buyer - we think they can make a deal work at north of 300p per Vodafone share (30% +upside) and still create value. Deal flexer model available on request. Stay long.
8. NOS: stay long
Liberty's UPC chief has again called out for industry consolidation. While this time referencing Eastern Europe the same dynamics and rationale is true for the cable industry the world over. Liberty themselves have admitted they could do more in Southern Europe and private equity has recently been linked with the sector.
Given the wider context of media and telco consolidation (refer our earlier thoughts on Altice, Numericable, Bouygues Tel, Sky) cable remain scarce assets. The NOS story stands on its own merits, offering a combination of market repair and shareholder return story. And with the Portuguese Economy running ahead of the average in Europe (which incidentally is the only region seeing an acceleration in GDP growth according to OECD updates) the reasons for owning NOS are compelling.
Buy NOS PL.
9. Ericsson (sell): headwinds remain
News this week of Altice's bid for Bouygues Tel is another step in the eventual process of just three or four major European carriers left standing at the end of the decade. One fallout from this wave of consolidation will be less absolute capex $ spending, especially at a time cash flow is being directed towards spectrum (see below).
Note also Finisar in the US fell 10% on the Friday due to continued weakness in mobile equipment spending.
The scramble for spectrum airwaves continues. The surge in 4G 700Mhz spectrum in the U.S. in January created aftershocks in the equipment market. The U.S. carriers diverted cashflow from equipment spending to pay for the airwaves. Ultimately the auction raised 4.5x the reserve price and 2x the previous auction. The resulting shockwaves led to a collapse in networks margins for exposed equipment providers Ericsson and Nokia. While most expect a strong bounce back in both Q2 and H2 2015 the risk is any perceived improvement will be both short lived and negated by similar events in Europe.
In Europe, a similar path is unfolding. German spectrum auctions finished on Friday. The auction raised €5.08bn in total, 27% above estimates and 3.4x the reserve costs. France will follow suit, selling six blocks of the most valuable 700 MHz frequencies with a minimum reserve totalling E2.5bn.
This is not just a 2015 event. The FCC plan the largest, most complex, most coveted low-frequency airwave auction in early 2016 which will again pressure the carriers into focused investment.
The street expects a meaningful rebound for Ericsson, for example. After the Q1 shock, Q2 operating profit is forecast to heroically jump +144% QoQ and +25% Y/Y and still model +40% for 2015 (and 7% 2015 top line growth). Given Ericsson's chequered history of performance these recovery estimates, in the light of the spectrum pricing above (together with the ramifications of carrier consolidation we have discussed), look too optimistic.
10. High Quality Growth Basket #6
HQGB 5 saw a return to the outperformance of 'high quality growth' vs. the SXXR. The level of outperformance was just under 400bps, slightly below the average of the five years including HQGB 5. In the year ahead, the big change is the lack of choice, since we are holding fast to the valuation criterion we have always held, a minimum 5% FCF yield Y2 on consensus estimates. After being able to choose from a list of at least 40 names, the list has dwindled to just 15.
That in itself is an interesting development - quality costs. But there are still opportunities out there. In the list of 15 stocks, there are seven new entrants (three for the first time ever) and eight returners from HQGB 5. Just one stock has been in every year, AB-InBev.
The names (7 new entrants, 8 returning):
Aberdeen Asset Management, Anheuser-Busch InBev, Brenntag, Cap Gemini, Experian, GEA Group, Havas, Heineken, Merck, Next, Roche, Sage Group, Sika, Sodexo, Wartsila.
11. Next (HQGB): bear capitulation, stay long
A returning member of our HQGB and one of our longest standing buy calls. We remain convinced of the merits of holding this, especially into a context of rising wages in the UK and e-commerce trends in China. What is interesting is how understood the stock remains, with a large number of analysts a Seller.
This may start to change, indeed we note some bear capitulation this week.
Just 21 more analysts to go.
12. National Chocolate Éclair Day. Buy Novo Nordisk
This week saw National Chocolate Éclair Day and National Onion Ring Day. Which is unfortunately apt given yet another alarmist study described as a "wake up call" on obesity. The Washington University study showed 75% of men and 67% of women in the U.S. are overweight or obese. This is a significant increase from a similar study twenty years ago which showed 63% men and 55% women overweight or obese at that time. Novo Nordisk remains the prime beneficiary of this alarming trend and is one of our preferred names in global pharma, being at the confluence of multiple thematics namely Globesity, High Quality Growth, a Top Three Compounder and member of the Dividend Aristocrats Index. Note also there is potential significant trial data due in next 2-3 weeks, namely data from Phase 3 SUSTAIN 1 trial of semaglutide (once weekly injectable GLP-1) - a drug with the potential best in class combination of blood glucose lowering and weight loss. Successful data could also lead to a decision for take oral GLP-1 semaglutide into Phase 3 which could be a significant product in its own right and accelerate growth for the company.
Stay long Novo Nordisk.
13. Roche (buy): what if they listed biotech on Nasdaq?
Consider what Roche's (OTCQX:RHHBY) pipeline could be worth if you applied current AXON market cap/drug considerations. With a total of 65 NMEs and 44 AIs in the Roche pipeline amounts to a potential "value" of over $150bn. Simplistic thinking perhaps but just imagine the appetite/valuation if they chose the path to carve out RBP, Roche Biotech Pipeline, and list it on Nasdaq?
U.S. Biotech Index makes new all-time highs. Following the stunning success of the Axovant IPO it is perhaps little surprise to see another raft of biotech IPOs on deck with four due this week; Seres Therapeutics, Glaukos, Catabasis and Pieris. Axovant (NASDAQ:AXON) achieved what many perceive to be the biggest biotech IPO in the past 20 years, with the market cap surging to ~$3 billion on the day of listing and AXON pocketing $293m in proceeds from its IPO. The reason for the surprise is the valuation afforded for a company eight months old with just one drug, RVT-101, which cost just $5m to acquire from GlaxoSmithKline six months ago. It is the ONLY drug in Axovant's portfolio and it seems unlikely GlaxoSmithKline wouldn't have completed internal due diligence and risk assessment in ascertaining the likely terminal value and success probability before deciding to offload the drug candidate. After all Glaxo had tested the drug in 13 different trials. In clinical trials funded by GSK, RVT-101 showed no benefit over a placebo when given to patients as a monotherapy and mixed results in combo therapy with leading Alzheimer drug Aricept. Perhaps Axovant will succeed where many have failed but the risk is high, especially when there is no plan (drug) B.
Within the pipeline Roche also has largest exposure to the 'revolutionary' technology based immunotherapy which will transform medicine in the next decade and beyond. Roche accounts for ~40% of immunotherapy clinical pipeline total across the industry. No one comes close.
Stay long Roche.
14. Sell more Autos
Autos are the best performing sector this year, being the first derivative benefit of QE via the weakening of the € and a jump in export margins. A lot of that has played out, we wouldn't expect the rate of the €'s decline to continue - it may even reverse, and so other reasons must exist - as must upgrades - for the sector's outperformance to be maintained. Indeed the sector multiple has re-rated from just above 11x to over 13.5x this year alone - impressive stuff, and the type that now needs upgrades to kick in to justify them. Now, this is where we are struggling as short of another collapse in the € we find it hard to point to where these upgrades are coming from (Europe being the exception). Of key importance is the 'new-normal' in China where not only are price impacts being felt by parallel imports, volumes are declining. This and the market has yet to consider the secular threats posed by ride-on-demand/car-sharing platforms espoused in our theory of 'Peak Car' (see aviatelive.com for more). As we said last week, we are expecting the sector to bounce off technical levels and it has. No seems a good opportunity to sell into strength we don't expect to persist. From a technical standpoint we note the sector failed to break its 200dma and unlike Banks (and Telcos) is a long way from regaining its high for the year. As we have said for some months our preference now is for beneficiaries of second order effects of QE - domestic reflation, which is why we prefer Banks (and Telcos) to Autos.
15. ITV LN: Good deal & more CONTENT. Remains a BUY
ITV has just announced another content deal. This time acquiring TwoFour. The initial price of £55m for 75% of the group equates to 14x T12M EBITDA multiple, a very reasonable multiple given the company grew revenues 56% last year. TwoFour is the largest true independent media group in the UK and is the largest producer of documentary content.
The TwoFour Group comprises seven individual production companies: Boom, Boomerang, Delightful, Indus Films, Mainstreet, Oxford Scientific Films and Twofour. It produces factual, features and entertainment programming for a range of broadcasters including BBC, Channel 4 and Sky and has distribution division Twofour Rights, post production arm Gorilla and has begun to make inroads into the US via Twofour America.
It adds to ITV's strong content production capabilities and studios including Mammoth Screen, Talpa Media and The Garden. ITV strategy is to build an international content business, but not at any price, nor to entertain deals which fall out of their core competency. This deal ticks all those boxes. Ultimately, such a strategy will likely prove a winner in our view, either independently, or under the ownership of a larger media conglomerate (Comcast).
16. Pearson (Sell): Further structural negatives
This week for profit colleges lost their attempt to block the U.S. government's "gainful employment rules". The policy is due to take effect from 1st July and "gainful employment" rule will take away schools' access to Federal funds if they fail to provide adequate tools for their students to find work. For-profit colleges rely on Federal grants for as much as 90% of their revenues. For profit colleges will be at risk of losing their Federal aid should a typical graduate's annual loan repayments exceed 20% of their discretionary income or 8% of total earnings. At the last count some 840,000 students would not pass the accountability rule. The policy could heap further pressure on enrollment figures and, in turn, pressure budget spending on education services.
Higher Education is the biggest contributor to Pearson's profit and accounts for over 40% of Pearson's operating income.
Technology startup EduKart has raised funding for its education distribution platform in India. EduKart will work with online learning companies - including MOOCs - because the sheer size of its network of students could help them find more users. MOOCs (Massive Open Online Courses) are disruptive to the detriment of commercial publishers such as Pearson.
Piece by piece Pearson's difficulty in adopting digital solution and legacy footprint is being taken apart.
We remain sellers of PSON LN.
17. Pearson: reputational issues thwart recovery. SELL
Pearson's CEO yesterday admitted reputation issues (LA contract), testing loss (Texas) and emerging market mixed outlook (Brazil and Africa weaker) weigh on the company. In addition the PARCC testing shift to one assessment a year, from two, and less visibility on common core in the current stage of the Presidential cycle could pressure further. We have highlighted a range of reputational issues for Pearson in the U.S. With respect testing Pearson has contracts with 21 states, D.C. and NYC and a number of these contracts are (or have been) under investigations.
The issues of rising tuition costs and $1.2 trillion of student debt is receiving increasing coverage in mainstream media in the U.S. and is being described as "a huge crisis for future generations" (Andrew Ross, NYU). This media focus is likely accelerating into the July 1st gainful employment rules.
Pearson's recovery is very much focused on top line acceleration yet the U.S. business, at ~60% of revenues, has multiple headwinds. We remain sellers.
18. ARM: Marmite stock. Positive read from Asia. BUY
FIH in Hong Kong this week forecast 141-171% Y/Y rise in six month profit to end of June, c.20% above street estimates. Increase is driven by sales surge of ~64% and is being attributed to strong sales orders at Xiaomi. Their flagship Mi Note uses a Quad core ARM Cortex A53 architecture which is the most power-efficient ARMv8 processor and higher performance than the highly successful Cortex-A7 and is a high royalty product (we estimate 5% royalty rate for A53).
FIH Parent Hon Hai Chairman Terry Gou was equally upbeat on the opportunity for Hon Hai to grow sales 10% this year and "highly optimistic" on medium term outlook given customer demand. Clearly a positive undertone remains for Apple given 'customer E' is >50% of revenues. In turn this is bullish for ARM.
Biggest driver of ARM stock price is royalties. With the accelerating TAM (see below) and shift to newer, higher royalty rate architectures, upside in ARM estimates remain. ARM growth rate is ACCELERATING. Yet, at the start of last year ARM traded on 43x F12M P/E and in fact the last time growth accelerated the stock traded at 55x F12M P/E. Today it trades on 35x P/E, with earnings momentum moving higher. FY15 sales and earnings estimates +2.5% over the last month is likely not enough in our view.
ARM is a classic "marmite" stock. We love marmite. Buy ARM
19. ARM (cont): the TAM continues to EXPLODE. Stay long
Another potential new market for IoT is emerging in smart home devices. With evidence of a tipping point moving from early adopters to mainstream adoption Navigant statistics suggest residential IoT device market will grow from $7.3bn in 2015 to >$67bn year in the next decade. The biggest barrier is interoperability and multiple standards. There is an easy way to overcome this bottleneck as evidenced in embedded devices, smartphones, consumer entertainment, SDDs, automotive apps processors. Standardize. On what?
ARM IP. ARM's TAM is forecast to expand by $43bn between 2014 and 2020. Yet residential IoT is NOT included in these estimates. With new end markets emerging and the sheer scale of IoT the opportunity is hugely under-appreciated. ARM is developing more advanced technology, multiple processors per chip (from 8 to 256 cores/chip) and generating higher royalty percentage per chip than ever before. In some instances, ARM technology affords licensor's half the initial capital expenditure, 1/7th the running cost, 10x technology density/performance than alternative solutions.
The ARM opportunity has never been greater. Stay long ARM LN.
20. Rocket Internet (Sell): watch out for Alibaba
Rocket Internet (OTC:RCKZF) shareholders have voted to authorize management to possibly issue convertible bond of up to EU2b at some point up to 2020. Such action is "a normal way to be prepared," according to company spokesman Andreas Winiarski. Such are the competitive industry dynamics we suspect this would be utilised sooner rather than later. The most aggressive, pressing, competitive, scale focused operation for Rocket has been in building out the Global Online Takeaway Group (GOTG). GOTG comprises Foodpanda, Delivery Hero, Yemeksepeti, Pizzabo, Talabat and LaNeveraRoja and is now present in 71 countries and #1 in 58, apparently.
Until now, most competition has come from similar early stage vendors Grub Hub and Just Eat. But signs are that one of the most disruptive technology companies, one which doesn't tend to settle for second in anything it touches, is about to throw down the gauntlet. Alibaba.
Alibaba view the O2O market (online-to-offline) as the biggest battleground in offering localised services and drawing users to their platforms. Alibaba, with its affiliate Ant Financial plan to invest ~$1bn in a JV to accelerate the O2O market with the first focus on food delivery. The JV, Koubei, will integrate mobile commerce and big data to transform the food ordering and delivery market. So now users can access food delivery orders through Alibaba's Mobile taobao app, and pay through Alibaba's Alipay wallet.
Koubei is competing with Chinese food-delivery startup Ele.me and group-discount website Meituan to capture a bigger slice of the country's online-to-offline food-delivery businesses. Consultancy Analysis International ranks Ele.me (backed by the other Chinese giant Tencent) as having 40% of the food delivery and meal ordering market and Meituan at 34% in China. Which, in turn, suggests that Rocket Internet's Delivery Hero, or WaimaiChaoRen as it is in China, is lacking in scale. And that is before Alibaba flexes muscle.
But Rocket wants to be "the world standard of food ordering"!? With ambitions to be the "Facebook of food ordering" and a strategy to "make more complimentary investments" we suspect the company's appetite for further dilutive and risky deals is high.
Facebook has scale. Facebook has best in class technology. The same applies to Tencent. And to Alibaba. Neither are proven with Rocket.
We remain sellers of RKET GY.
21. SKY: Where the U.S. leads, Europe follows
Neilsen ratings show Disney (aviate BUY) ESPN is the most watched cable network in prime time TV (8pm to 11pm) year to date. You just can't beat live sports. Records for Sunday Night Football, SuperBowl, and the NBA's have all been achieved this year. A further Nielsen measurement study shows TV consumption is increasing.
The death of pay TV has been greatly exaggerated. Live action sports is the differentiator.
Buy SKY before Fox does.
22. Inwit (IPOd yesterday): key attractions
Telco towers business are qualitatively very appealing. Key attractions include high barriers to entry, good earnings & cash flow visibility and so, handsome payouts. For us they are also exposed to some of the biggest mega-trends in markets namely the growth in DATA, the IoT and car-connectivity. Tower operators are essentially the landlords of mobile telco real-estate. Satellite providers, the landlords of bandwidth in space, have been great for long-term holders - ISAT up nearly sixfold and Eutelsat up fourfold since their IPOs in 2005. We believe Tower's could do something similar over time.
23. 'Ubi - soft' but not for long. Buy weakness
At the peak of the last gaming cycle Ubisoft (OTCPK:UBSFY) afforded 40x Y2 P/E. Today it trades on 10x. Yet this gaming cycle is not only 2x the size of the previous size, the addressable market is 3x given the opportunity on multi-screen and mobile devices.
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