The Great Rotation (cont): follow the money
When the world's largest sovereign wealth fund and biggest owner of equities intimates it's about to sell more bonds in favour of stocks, the rest of the world's pension fund managers should take note. Despite significant exposure to equities already (60%), the fund's CEO, Yngve Slyngstad, said it may be wise to reduce the amount of investments in fixed-income assets. This is symptomatic of a slow, albeit inevitable change in favour of equities and stands in stark contrast to a European pension fund industry which is overwhelmingly exposed to deflationary outcomes. For example, the guardians of our wealth in the UK have doubled our exposure to bonds and halved our exposure to equities since 2000. Germans have only 6% of their wealth in equities and only 41% of analyst recommendations across all stocks in STOXX 600 are rated BUY, less than the level seen during the EM crisis in 1996-97, the tech selloff in 2003, and the financial crisis in 2009. Bull markets die on euphoria, but things are far from euphoric. Now, all that's fine if we get outright deflation. But it could cause a mad rush for the exits should we get anything else. To that end, and what is a frightful chart for asset-allocators heavily exposed to bonds, the EU equities vs. bonds ratio is breaking out following the US example but two years later. This points to further outperformance, a painful reality for many pension fund managers and suggests the great rotation is likely to continue. Now, there are numerous ways to play this theme (buying equities for one) but one country where these trends are acute and come from a starting base of excessively large savings is Italy. If you were to pick one name to benefit from the expected €400bn or so likely to be allocated to mutual funds over the following few years, we would pick Anima. It's hugely operationally geared to these very favourable dynamics. Stay long.
Economic momentum likely to accelerate in H2
Despite much focus being given to the micro with earnings season now fully underway we, as always, have one eye on the macro, and in the past few days, we have begun to notice the Economic Surprise Index has started to pick up after a period of deterioration. If these trends continue, it should - if history rhymes - provide a good signal for cyclical outperformance as we enter the second half of the year. (See the chart of the Cyclicals vs. Defensives ETF versus the Economic Surprise Index, it has shown remarkable correlation over the past few years and is good in timing style shifts in markets). Giving us confidence the economic momentum is likely to accelerate, we note only a mild slowdown due to the Greek hiatus but with this now in the past, and with improving liquidity (see M1), we expect activity levels will reaccelerate in H2 (for where M1 goes activity tends to follow). As such, we remain buyers of our Reflation Recovery Basket, Banks and our favourite market Italy (more below).
My, how things have changed in Italy!
Italy said Thursday it would cancel some of its upcoming government bond auctions due to "the large cash availability as well as the reduced funding needs." It was only four years ago that Italy was considered the biggest risk to European financial stability. How things have changed! Italy is now one of the brightest spots in Europe with stable government, a strengthening Treasury, accelerating economic growth, improving credit availability, improving house prices, lower unemployment and, most importantly, economic reforms. Despite this, its market cap remains 25% below its 2007 peak. The DAX in contrast is 15% above. It also remains one of the cheapest developed markets in the world on a CAPE basis on just 12.6x vs. the US on 25.5x. Endorsement came from price action this week with all-time highs in the mid-cap Italian ETFs led by a number of names we like such as Anima, Cerved, OVS and Recordati (OTCPK:RCDTF). Mediobanca (OTC:MDIBF) (OTCPK:MDIBY) is breaking out as is UBI Banca (OTC:BPPUY) (OTCPK:BPPUF), Mediaset (OTC:MDIEF) (OTCPK:MDIUY) and Telecom Italia (OTC:TI), all Aviate Buys and we suspect others will follow. This action suggests the growth/liquidity context in Italy remains very robust, as it does for a number of other domestic reflation stories (i.e. banks) and reinforces our conviction to stay long these asset classes. We remain buyers of: Mediobanca, Intesa Sanpaolo (OTCPK:IITOF) (OTCPK:ISNPY), UBI, UNI, BP (NYSE:BP), UniCredit (OTCPK:UNCFF) (OTCPK:UNCFY), Credit Agricole (OTCPK:CRARY) (OTCPK:CRARF), Anima, OVS, Mediaset, Telecom Italia.
Where can one get proper, sustainable income growth?
The answer, we think, will mostly come from high quality compounders - businesses that generate decent returns on capital and can reinvest and compound that capital. These characteristics are especially valuable in an era of lower modulation in growth/interest rate cycles, which seems to be the case for now at least. But what has become increasingly evident is that CASH returns are what count. Genuine cash compounders are great core long-term portfolio holdings (even if at times they don't appear great value on conventional metrics). On the flip side, where there is a significant and/or growing divergence between cash and P&L returns on capital that signals danger. However, P&L returns may be being flattered relative to cash, at some point that tends to become unsustainable, and the stock suffers. With this in mind, we have spent the last 2 months developing a new screening and analytical tool which we hope to launch next week. It should help us (and you) distinguish between the genuine cash compounders and those which may appear attractive but are structurally flawed - some interesting ideas are emerging already. You will not be surprised by the good names; Next (OTCPK:NXGPF), Novo Nordisk (NYSE:NVO), Kone (OTCPK:KNYJF) (OTCPK:KNYJY), Pandora (NYSE:P), Rightmove (OTCPK:RTMVF) (OTCPK:RTMVY), Roche (OTCQX:RHHBY), Reckitt Benckiser (OTCPK:RBGPF) (OTCPK:RBGLY), InterContinental Hotels (NYSE:IHG), etc., but it's those names being perceived as quality compounders, that may offer interesting optionality on the short-side. On this basis, we would flag Aryzta (OTC:ARZTF) (OTCPK:ARZTY) (Aviate Sell), Barry Callebaut (OTCPK:BYCBF), Balfour Beatty (OTCPK:BAFBF) (OTCPK:BAFYY), Diageo (NYSE:DEO) and BASF (OTCQX:BASFY) (OTCQX:BFFAF) as names where the divergence between cash-earnings and reported needs some explaining. More on BASF and Diageo below.
BASF, a closet commodity business, over-investing, declining CROIC
A common occurrence in many commodity businesses is they have a tendency to increase their investment capex just as the main buyer goes ex-growth. We all know what happens next (see share prices of Anglo American (OTCQX:AAUKF) (OTCPK:AAUKY), BHP Billiton (NYSE:BHP) and Shell (NYSE:RDS.A) (NYSE:RDS.B) for clues). Now, what of those closet commodity businesses like Aryzta (baking), Barry Callebaut (chocolate) or BASF (oil + chems). Should we be worried when larger proportions of cash flow are being reinvested in capex despite their cash-returns having started to materially decline. What if they get the cycle wrong - the recovery is protracted or worst, delayed. We know, for example Shell may not be as rational in terms of supply in H2 as they were in H1. It reminds of the kind of 'group think' that existed in the mining sector from 2010-13. Management is desperate to show some growth, so they invest. The problem is, so do competitors. A 5% FCF yield and a 3.5% dividend yield may be appealing in a low interest rate world, but a look at the cash ROIC chart clearly shows on a cash basis, BASF is destroying value. On a 15x P/E 2015 vs. a 10-year average of 12.5x, that makes no sense to us. Sell.
Diageo, are they stuffing the channel?
Another name flagged by our CROIC work is Diageo. All the spirits companies have seen a deterioration of cash returns, so why pick on Diageo? The scope of the declines in cash ROIC and the cash conversion cycle are far sharper at Diageo than Pernod Ricard (OTCPK:PDRDF) (OTCPK:PDRDY) and Brown Forman (NYSE:BF.B) for example. This week we learnt they are being investigated by the SEC, and two law firms representing investors have announced they will be launching an inquiry. The question is if they are channel stuffing? The numbers we are talking about re channel stuffing are probably small in absolute numbers, but the cash outflow from working capital is meaningful relative to FCF. The US business (34% sales, 45% EBIT in FY14) has seen several management changes, the head of North America is retiring and the head of Marketing and National Accounts has left we believe. Diageo may be no worse than the rest of the spirits names, but on 50x trailing FCF, Diageo and peers are very expensive and the valuation implies a significant improvement. We fail to see why this is a good bet, it's not as if Diageo is a restructuring story. It may turn out these investigations are all a ruse to get the share price down and entice an activist investor or change of management. But on fundamental grounds, there are clear gaps between cash and P&L earnings and returns, never a good sign for a stock trading on a RECORD high PE multiple of over 20x NTM P/E. If you want a real cash-compounder, you are better off in AB-InBev (NYSE:BUD).
We remain sellers of German Autos
More downgrades to German Auto stocks this week, after brokers discover the new-normal in China is worse than originally thought. More will follow. The next step will be the street starting to factor the impacts of 'peak-car ownership'. In the first instance, this uncertainty in the future should soon impact residual values insofar PCPs are concerned (think contingent liabilities), for how can a dealer make an estimate of future value when they have little visibility as to the shape of the market in 3-5 years time. Will electric vehicles proliferate by then? Will semi-autonomous systems be de rigueur and if so, will they be required safety features. Will ride-sharing/Uber render car-ownership redundant? Software is eating the world, and we believe it's about to disrupt the auto-market in a way that could dramatically alter the shape of the industry. Worryingly, these changes are occurring at a time most OEMs have been rapidly expanding in capacity, some of which is likely to be redundant should these trends proliferate, as we believe they might. Drilling down to the stocks, the main story this week was Daimler (OTCPK:DDAIF), which after reporting best ever results, the stock fell. Why? Because they are basically at margin targets yet are already at peak EV/Sales and P/B valuations. They say China is fine - it is not (see Volkswagen's (VLKAY) comments this week and previous on the "new-normal") and that the US truck cycle has not peaked (cf Volvo who say the opposite). What Daimler do have right is their product cycle, but this too will end from mid-2016. Add threats from peak-car ownership, ride-sharing and the disruptive aspects of technology (semi/autonomous car) and you have all the hallmarks of serial underperformance from here. We remain sellers of German Autos.
Ashtead (sell): upgrade cycle looks over
United Rentals (NYSE:URI) has cut EBITDA FY15 by 5% and cutting capex. This is a rational decision as utilisation falls and pricing rolls over. URI generates a lot of FCF and has upped the buyback, a 10% FCF yield in fact. Conversely, Ashtead (OTCPK:ASHTF) (OTCPK:ASHTY) is betting the house on a never-ending cycle. It looks cheap on P/E, but unlike URI, there is no FCF, the money has gone into fleet capex, and the business has been borrowing to fund it, so the rational thing for AHT management to do now is to cut capex. But this will mean the EPS upgrades that have driven the 1,000% move in the last 5 years looks to be over. We first mentioned Ashtead as a sell in October 2014, we were too early then and you might have some further upgrades from Ashtead management, but there is now clear evidence of the cycle rolling over, since the number one player in the market has warned of lower time utilisation and weakening price momentum. Remain a seller.
Great numbers from Thales (OTCPK:THLEF) (OTCPK:THLEY) this week sent the stock up 7% to new all-time highs. With respect to our long-term theme on rising Defence spending, note Thales made the following comments: "…with the elevated level of geopolitical tension that we know at present, defence budgets in emerging markets, particularly in the Middle East and Asia are very likely to continue to be on the rise. In Western countries also despite ongoing purchase pressures, the outlook probably looks better than a year ago. The level of perceived threats limits the downward pressure on security and defence spending". We totally agree, and given the operating leverage to these improvements across the sector, we would continue to own Safran (OTCPK:SAFRF) (OTCPK:SAFRY), Thales, Meggitt (OTCPK:MEGGF) (OTCPK:MEGGY), Cobham (OTCPK:CBHMF) (OTCPK:CBHMY), Finmeccanica (OTCPK:FINMF) (OTCPK:FINMY), Dassault Systemes (OTCPK:DASTY) (OTCPK:DASTF), BAE Systems (OTCPK:BAESF) (OTCPK:BAESY), etc.
Pearson (sell), selling the good to focus on the bad
Pearson (NYSE:PSO) (OTC:PSORF) closed down on the day after announcing the sale of the FT. The market digests the fact they have sold off their prize asset to focus more on a business that faces structural challenges. This and we struggle to share their enthusiasm for H2 prospects, and so expect further disappointment in time. Too many uncertainties remain. On the media sector's main valuation metric, EV/EBITDA, PSO trades at 12.1x F12M multiple versus 9.6x trend. If nothing else, just a reversion to trend suggests fair value is closer to 975p, 23% lower than here. Group EBITDA is forecast to grow 27% in FY15, 8% in FY16. Given US education is 60% of business and the headwinds are about to intensify the downside risk to H2 and FY numbers is accelerating. We remain a seller and our preference in this space is for Reed Elsevier (NYSE:ENL).
Aviate stocks in the news
According to Barclays, only 41% of analyst recommendations across all stocks in the STOXX 600 are rated buy, less than the level seen during the EM crisis in 1996-97, the tech selloff in 2003 and the financial crisis in 2009. Numbers from easyJet (OTCPK:EJTTF) (OTCQX:ESYJY) this week were 2.0% ahead at the sales line, with guidance for the full year slightly ahead of expectations at the mid-point. Fleet expansion and new hubs (such as Venice, planned for April 2016) mean a structurally lower FCF than NI, but this is more than reflected in the valuation - at 12.3x earnings for EPS 11% growth. We remain a buyer. Numericable (OTCPK:NUMCF) is popping back above 50, helped by an upgrade to Bouygues (OTCPK:BOUYF) (OTCPK:BOUYY) this week. We still see a lot of upside on a standalone basis but HUGE upside should they manage to acquire B Tel. Not one gaming analyst follows Microsoft (NASDAQ:MSFT). Pity, if they did we may have received confirmation of views on the cycle. Xbox is outperforming Microsoft's own expectations ("incredible" Q4 as evidenced by 27% Xbox revenue growth). This is very good news for the leading third party game developers, like Ubisoft (OTCPK:UBSFY) (OTCPK:UBSFF). As a reminder, this entertainment gaming cycle (hardware) is tracking >50% above the last. Typically, third party gaming stocks peak on 30-40x P/Es. Ubisoft is today on 12x and that is without factoring in any upside to the "E". We remain a buyer (and call for Neil's note on what Microsoft had to say on the cycle with respect to the huge growth at Xbox). News that AA data shows price quotes increasing in the UK can insurance sector (up 5.2% in the 3 months ending in June). A spokesperson for AA Insurance says "days of cheaper car insurance premiums are over". This confirms the data we flagged on Wednesday last week (15 July) from the confused.com website, which showed premiums rising for the first time YoY after 13 consecutive months of declines. Admiral (OTCPK:AMIGF) remains an attractive stock with a 5.9% yield, after investing in the exciting growth opportunities in Spain, Italy and the USA. Vodafone (NASDAQ:VOD) was another to report this week. Headline group service rev growth +0.8% for Q1 FY16 (est. 0.5% and vs. +0.1% in Q4). Sequential trends in core markets look solid (more below) and management statement reads positively: "European businesses returning to growth", "contract churn in Europe falling", "more stable pricing environments". Another small cap biotech blow up in the US this week reminds us to stick with the quality, namely Roche. Sunesis Pharma (NASDAQ:SNSS) -60% after hours as FDA asks for further data on drug Vosaroxin for AML leukemia and doesn't support filing. Roche trades on 18x FY2 P/E, 12.3x EV/EBITDA; a substantial discount to US peers Bristol-Myers (NYSE:BMY) on 30x and 23x respective multiples, Lilly's (NYSE:LLY) 24x and 16.4x, and Biogen's (NASDAQ:BIIB) 20x and 14.2x. Undeserved, especially as Roche has the largest, most successful biotech pipeline in the world which we suspect is still vastly undervalued within SOTP considerations. Positive news for Deutsche Telekom (OTCQX:DTEGF) (OTCQX:DTEGY) this week as FCC Chairman Wheeler recommended they approve the AT&T (NYSE:T) deal for DTV. The DOJ yesterday also confirmed it won't challenge the deal. The FCC is now expected to vote in favour of the deal. Positive reads from the US this week for 2 of our favoured media plays, Havas (OTCPK:HAVSF) (OTC:HVSYY) and ITV (OTCPK:ITVPF) (OTCPK:ITVPY). Omnicom (NYSE:OMC) in the US reported strong organic growth. Q2 Organic 4% expected. Reported +5.9% in North America, +5.4% in UK, +3.9% in Europe, +7.6% in Asia and +11.9% in Africa/Middle East. Infosys (NYSE:INFY) in India raised guidance this week. This is a positive read for the wider industry. Infosys' Q/Q volume growth of 5.4% the highest in 19 quarters. Q1 revenue growth of 7% Q/Q, the highest… stay long Cap Gemini (OTCPK:CAPMF). Mediaset noted that their Italian ad sales jumped by more than 6% in June which seems a large number and a major acceleration over the previous months. The recovery is such they are resuming talk of dividend payments, which tells you something about their expectation for the future.
For all this and more, read on.
1. The Great Rotation (cont): follow the money
When the world's largest sovereign wealth fund and biggest owner of equities intimates it's about to sell more bonds in favour of stocks, the rest of the world's pension fund managers should take note. As we highlighted yesterday, despite significant exposure to equities already (60%), Yngve Slyngstad who manages Norway's sovereign wealth fund, said it may be wise to reduce the amount of investments in fixed-income assets. This is symptomatic of a slow, albeit inevitable change to favour inflation over deflation assets in stark contrast to a European pension fund industry who are overwhelmingly exposed to deflationary outcomes. For example the guardians of our wealth in the UK have doubled our exposure to bonds and halved our exposure to equities since 2000. Germans have only 6% of their wealth in Equities. All that's fine if we get outright deflation. But it could cause a mad rush for the exits should we get anything else (which we believe we will). In what is a frightful chart for asset-allocators heavily exposed to bonds, the EU Equities vs. Bonds ratio is breaking out following the US example but two years later. This points to further out-performance, a painful reality for many pension fund managers and suggests the great rotation is likely to continue.
Buy more European equities.
2. Economic data-points starting to surprise, again
In the past few days we have begun to notice the Economic surprise index has started to pick up after a period of deterioration (as the street got ahead of itself). If these trends continue it should - if history rhymes - provide a good signal for Cyclical outperformance as we enter the second half of the year. See the chart below showing the Cyclicals vs. Defensives ETF versus the Economic surprise index.
We would buy stocks in our Reflation Recovery Basket on weakness (call for list).
Stay long Banks, especially Italian ones.
3. European activity likely to rebound in H2
It should come as little surprise PMIs fell a little last month with the hiatus over Greece, but with that now behind us and with improving liquidity (see M1) we expect activity levels will reaccelerate in H2, and so we remain buyers of our Reflation Recovery Basket, Banks and our favourite market Italy (more below).
As illustrated in the following chart, where M1 goes activity tends to follow.
Source: Trading Economics
According to Barclays, only 41% of analyst recommendations across all stocks in the STOXX 600 are rated buy, less than the level seen during the EM crisis in 1996-97, the tech sell-off in 2003 and the financial crisis in 2009.
Bull markets die on euphoria…
Things are far from euphoric.
5. Best cash-compounders in the market
Where can we get proper, sustainable income growth? The answer, we think, will mostly come from genuine compounders that are lucky enough to dominate niches. If it turns out there is no genuine growth, compounding will be the way forward. So we have had a much closer look at compounders, starting with the SXXP (but will roll out globally). At the same time, given our best shorts have come from stocks perceived to be compounders that turned out not to be, we have also screened for accounting issues (high cost capitalisation, excessive working capital build/mismatches, accelerating op lease charges). It's incomplete, but we wanted to give a preview of initial findings, namely:
- There is no sign of most of the staples, like Nestle (OTCPK:NSRGY) (OTCPK:NSRGF), Unilever (NYSE:UL) (NYSE:UN), Diageo, etc., only Reckitts is there, with BATS.
- There is a wide variation of FCF yields and EV/IC, wide suggests the market is still primarily judge stocks on EPS multiples and not compounding FCF.
- The stocks that are commodity names in disguise are at the other extreme (LHS or red names on CROIC chart), no great surprise, although there are some 'expensive' names in there.
Valuation still matters to us, although the way the maths works the multiple is much less important than the ROIC over the long term. Of the big cap names, the following are around the 4% trailing FCF yield mark and compounding at a high rate: Next, Roche, Kone, Reckitt Benckiser, Atlas Copco (OTCPK:ATLKY), IHG and Burberry (OTCPK:BURBY) (OTCPK:BBRYF).
Feel free to call for more detail.
6. Imposters and aggressive accounting tactics
Given some of our best shorts over the years have come from stocks perceived to be compounders that turned out not to be (Elekta (OTCPK:EKTAF) (OTCPK:EKTAY), Swatch (OTCPK:SWGAY), etc) we have also screened for accounting issues (high cost capitalisation, excessive working capital build/mismatches, accelerating op lease charges). The names that have been flagged and so require further investigation include BASF, Barry Callebaut, Ashtead (although we know the reason for low cash-flow there), Balfour Beatty and Aryzta. For example, take a look at the cash-returns of Barry Callebaut in the chart below, and note the divergence from what they report.
Source: S&P Capital IQ
7. My, how things have changed in Italy!
Italy said Thursday it would cancel some of its upcoming government bond auctions due to "the large cash availability as well as the reduced funding needs". It was only four years ago that Italy was considered the biggest risk to European financial stability. How things have changed! Italy is now one of the brightest spots in Europe with stable government, a strengthening Treasury, accelerating economic growth, improving credit availability, improving house prices, lower unemployment and most importantly, economic reforms. Despite this, it's market cap remains 25% below its 2007 peak. The DAX in contrast is 15% above. We remain buyers of: Mediobanca, Intesa Sanpaolo, UBI, UNI, BP, UniCredit, Credit Agricole, Anima, OVS, Mediaset, Telecom Italia.
8. Stay long Italy
Quite impressive price action from the FTSEMIB as it goes through the 24,000 level - a level last seen at their recent peak - an achievement unique amongst European Indices with the exception of Denmark (see Novo Nordisk, Novozymes, Chr. Hansen, Pandora and Vestas for clues). Such performance in the face of recent volatility underscores their improving fundamentals, accelerating economic momentum (see Italy's central bank revised upwards its 2015 GDP growth expectations to 0.7% this week) and better lending activity. It is evident in the breakout of mid-cap names like Recordati, OVS, Cerved and our favourite asset manager, Anima. Telecom Italia is breaking out (the second cheapest Telco in Europe) and we see plenty more upside on a fundamental basis, as we do Mediaset, both are likely to be involved in further stake-building activity. Renzi's government is yet to put a step wrong, another unique feature within Europe. The next step in their reform program is privatisations, starting with Poste Italiane which will kick off in August. With this and further corporate activity likely, the investment banks will benefit with Mediobanca set to take the lion's share of fees. It's lagged, but we would be buying more. The consolidation in Popolari banks is still to come, and as yet is not priced into bank valuations. Nor is improvement in NPLs. UniCredit and BMPS have the most to benefit from the latter. We remain buyers of Banca Pop. di Milano, UBI Banca and Unipol Gruppo on consolidation, and Riccardo is a buyer of Banca Popolare. We still like Intesa Sanpaolo as the safe, dividend paying National-Champion and for a second derivative play we cite Credit Agricole in France which owns the fourth largest bank in Italy.
9. Telecom Italia (buy): catalysts, strategic value, new highs. Stay long
Of the several angles underpinning our buy case on Telecom Italia, some have begun to play out and some remain potential catalysts. We have highlighted its potential strategic value for several months - now Vivendi (OTCPK:VIVEF) (OTCPK:VIVHY) has accrued a 14.9% stake and may continue to build on that (and remember that before Bollore, Sol Trujillo expressed interest in acquiring a large stake). As well as widening the scope for value creation through improved content deals, Bollore's influence may revive the possibility of an exit from Brazil, which would effectively monetise the benefits of consolidation in Brazil for Telecom Italia shareholders immediately. Even absent a Brazil exit, we think TIM's strong position there offers value over the medium term through monetisation of huge data growth.
Consolidation in Italian mobile remains another key catalyst on the horizon; we think people underestimate the likelihood because a deal has been on/off the cards a few times before. But this time the key obstacle cited in the past has been resolved, it may take some more time at the time at the table, but both sides appear keen to find a solution.
Cheap refinancing opportunities should boost cash flows from next year; the INWIT IPO marked progress with management's disposal programme; and at some point TIT should be one of the key beneficiaries of Renzi's eagerness to ensure Italy catches up with the rest of developed Europe on fibre infrastructure.
All this, and Telecom Italia remains the second cheapest European Telco on EV/EBITDA even after making 52 week highs last week. Stay long.
10. Ashtead (sell): upgrade cycle looks over
URI is cutting EBITDA FY15 by 5% and cutting capex. This is a rational decision as utilisation falls and pricing rolls over. URI generates a lot of FCF and has upped the buyback, a 10% FCF yield in fact.
Conversely, AHT is betting the house on a never-ending cycle. It looks cheap on PE, but unlike URI, there is no FCF…
Source: S&P Capital IQ
…the money has gone into fleet capex…
Source: S&P Capital IQ
…and the business has been borrowing to fund it…
Source: S&P Capital IQ
…so the rational thing for AHT management to do now is to cut capex. But this will mean the EPS upgrades that have driven the 1,000% move in the last 5y looks to be over. While a little early to this in November last year, you have to question why you would still own the stock now.
We first mentioned Ashtead as a sell in October 2014, we were too early then and you might have some further upgrades from Ashtead management, but there is now clear evidence of the cycle rolling over, since the #1 player in the market has warned of lower time utilisation and weakening price momentum. Sell.
11. China, more perspective and upcoming catalyst
Despite the 14% rebound in the last 2 weeks HK volumes -40% below average this week reflect the current risk averse nature of investors towards China and pressure reporting to trustees causing a "too much career risk in owning China" mentality. While we acknowledge there are risks in China, our contention is these risks are being significantly mispriced and the reality is the situation in China is significantly better than headlines and press suggest, the economy is in a much better position than it was 6-12 months ago, quality of growth is improving, progress on reform is continuing, valuations are back nearing multi-decade lows and we are approaching a major event - the 13th 5-year plan - which we believe encourages further SOE reform, requires further monetary and triggers an increase in domestic demand for China equities. For a sense of the scale here consider: SOEs currently own 65% of the SHCOMP (c. 21tn RMB) yet they have in excess of 100tn RMB of cash on their balance sheets currently earning uneconomic returns (compares to LGFV liabilities in the order of 25tn RMB). The listed SOE banks themselves have around 31tn RMB of cash on their balance sheets (>4X the proportional amount of India and 18X higher proportionately than the Australian banks). We expect further RRR cuts to free up at least half of this excess low yielding cash for reinvestment. With the market wondering who the next marginal buyer of China is, here is your answer. Finally, with respect to the consensual view the recent rout in Chinese shares will lead to widespread wealth destruction we offer this for context:
The SHComp is now up 27% YTD, 100% in 12 months.
12. German Autos and China's new normal (cont)
Notwithstanding our comments above we remain bearish on the Chinese auto-exposed names for both cyclical (namely overcapacity at a time penetration rates normalise) and structural (peak car) reasons. This week we got further evidence the "new-normal" in China is getting worse with respect Hyundai's (OTCPK:HYMTF) (OTCPK:HYMPY) announcement they are boosting their discounting: "In the mid- to long-term, it's inevitable for us to cut production cost as local carmakers are aggressively increasing sales with competitive pricing." The price action with Daimler also underwhelms, despite what looked like decent numbers.
Perhaps the market is looking forward…?
With the most exposure to China (in terms of profits) we remain sellers of the German autos.
13. Swatch (sell): Apple watch effect in a chart
The Apple (NASDAQ:AAPL) Watch effect.
Nidec +8% on record numbers. Nidec introduced Haptic devices in April… they are 100% supplier of Haptics for the Apple Watch. We have to connect the dots as Apple won't disclose individual watch sales (yet). This is a typical tactic of Apple on product introductions and is NOT evidence of poor sales which some disingenuous reports attempt to convey. After all, CEO Cook has revealed Watch sales EXCEEDED expectations. Nidec's earnings affirm the same. Nidec upside came from Small Precision Motors which are the actuators for touch sensitive smartphones and Haptic sensors in Apple Watch.
Nidic revealed they are seeing stronger demand in the current quarter for Haptics and for the December quarter onwards; which suggests a major Apple watch ramp for the holidays and it coincides with Watch 2.0 software which is a massive step change for Apple Watch if you delve into the coding which has been released to developers.
Watch out Swatch.
14. Oil: Belief vs. reality
The Street remain miles ahead of the forward curve.
The entire sector is still cum-downgrades.
15. SAP (sell): headlines flatter underlying momentum. Prefer Capgemini
SAP (NYSE:SAP) Q2 headlines read positively at first glance. After all, cloud subscription and support sales grew 129% Y/Y. The company statement speaks of a "surge" in HANA customers, "exceptionally strong" growth and "thriving business" due to a "complete vision". BUT what still really matters is software licenses and support. Why? Because it is 7x larger business than cloud.
So note software licenses constant currency growth is just 3% which is a slowdown from 5% reported in Q1 and 5% for 2014. Software still accounts for 70% of group revenues and 86% of the cloud and software division. A "surge"? Really?
SAP Q2 headline revenues of €4.97bn compare to estimates of €4.91bn, Op Margin 28% below 28.5% expected. Cloud Sub/supp rev €555m versus estimates of €538.7m, helping Cloud & Software sales total €4.07bn (in line), new cloud bookings +162% to €203m. Reiterates 2015 forecast for Cloud SSR €1.95-2.05bn, Cloud & Software rev +8-10%, Op prof €5.6-5.9bn.
But, there are no upgrades on these numbers. We continue to prefer IT Services and specifically Cap Gemini, which trades on an undeserved 25% EV/EBITDA discount to SAP. Furthermore, whereas Cap Gemini now has improving ROIC (admittedly from a lower base) SAP's is declining at an alarming rate; thanks in part to an aggressive, expensive and questionable acquisition strategy.
16. Kone (buy)
A large shareholder is selling their 5% stake, worth close to $1bn. The shareholder is Toshiba, we therefore think the sale has more to do with Toshiba and their need for cash (post accounting scandal) than it has to do with Kone. Kone is a stock that divides opinion, 44% sell ratings vs. 30% buy ratings. The bears say it's expensive on PE and has too much China exposure. We say yes, at 20x PE multiple looks expensive but c.5% FCF yield for a 20% cash ROIC business that returns most FCF to shareholders is attractive (3.7% dividend yield for FY15).
On China, we all know the risks, it's but Kone is clearly taking share (Otis admitted this on their recent call) and the construction market is slowing but showing signs of bottoming. The elevator market in China declined in Q2 (flat in Q1) and China was 40% of Q2 sales for Kone. We could end up being wrong in terms of assessing the sales growth of Kone China, but the operational gearing is low, i.e. low capital intensity, high service revenues. In any case, a 5% FCF yield for a genuine compounder is already good value. We remain positive on Kone and would be buying dips.
17. ARM (buy): sales light, underlying LT metrics strong. Add
ARM (NASDAQ:ARMH) has been weak into numbers on concerns over slowing end markets and subsequent royalty revenue risk. Headline sales numbers of royalty revenues are strong, +30% Y/Y ($ terms, +41% £ terms). However, the licensing revenues +3% ($ terms, +7% £ terms) is weaker than expected leading to a group miss of ~3% on the top line versus estimates. Sequential licensing growth "backlog to be lumpy". Not heard that before; but perhaps there is some window dressing to leave scope for license upside in H2 to offset royalty softness?
Something doesn't quite add up. Record 54 licenses signed in Q2, and 15 on high end Cortex-A processors, yet just 3% Y/Y license growth. So what is happening? The most logical explanation is that many of the current licenses being signed now are for lower license fees upfront in new markets as ARM grow the TAM. Namely the 20 licenses signed for Cortex-M for embedded intelligence in Q2. ARM has ~25% market share in Embedded and typically this is the % when growth starts to accelerate in a market to quickly reach 50% and beyond. The chip unit TAM in embedded alone is >34bn chips by 2020 (and $25bn TAM) from their 4.5bn chips in 2014.
Q2 sales +22%, continuing strength seen in Q1 and double the growth posted by the company in 2014. So this is hardly a company which has gone ex-growth. Admittedly, Q2 numbers are a disappointment but company has reiterated FY numbers which suggests 23% sales growth for 2015 and >60% EBIT growth.
With new end markets emerging (e.g. IoV, Embedded Intelligence) 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.
ARM remains a "marmite" stock either loved or hated in equal measure. While it may be a bitter taste today, we still think ARM is one of the most disruptive companies on the planet and use weakness as a compelling opportunity to add to positions in this technology leader.
18. Rocket Internet (sell): you have got to be joking
Rocket (NYSEARCA:ROKT) report FQ1 numbers with the lead headline of 5% increase in "proven winners" (their definition not ours) EBITDA margin. What the headline fails to convey is that this improvement is from -39% to -34%.
Worse, these selective financials exclude some of the biggest businesses. For example, while Rocket lead with 369% Y/Y growth in Hello Fresh (actually that is growth in servings… there is no revenue number given) they then conveniently leave Hello Fresh out of the EBITDA calculation (perhaps because of the launch of TV advertising which won't come cheap). In fact, the biggest sector of Rocket's self defined Proven Winners, Food & Grocery, at 38% of LPV (Last Portfolio Value) is left out of the profit calculations. Perhaps because the likes of Delivery Hero has a -79% EBITDA margin?
Food Panda orders of 4.1m in FQ1 2015 equate to just 1.2 orders per restaurant per day. No restaurant could survive on that business alone. Delivery Hero is better, but still low at 4.8 orders/restaurant/day; low for a business valued at €2.8bn on last financing. Rocket is not alone of course. A similarly low average 4 orders per restaurant per day at Just Eat. We can't compare the metrics to Grub Hub's "daily average Grubs" (seriously? Just call them what they are, orders) of 235k because helpfully the company don't disclose the number of restaurants as they focus on "quality" rather than quantity of establishments (oh, please).
Concerns have already been growing on Rocket's LPV (Last Portfolio) calculations. There is a forensic accounting specialist research firm which has raised concerns on profitability, growth, valuations and disproportionate exposure to valuation losses. The analysis suggests there have been numerous related party transactions mainly involving enrichment of the founders at the expense of other holders and also that some of their co-investors value stakes in portfolio companies at levels DRASTICALLY below where the company has marked their holdings in the annual report. We have already made most of these points but the different accounting treatment is a very alarming point given that the LPV of the Portfolio Companies is substantially all of the 'value' of the company.
The selective quarterly financials and associated spin, self defined LPV and proven winner definitions combined with questionable scale economics and high price deals in the space leave us cautious on Rocket and the entire takeaway food delivery space.
Remain a seller/stay short.
19. STM (sell): Linear Tech warns. Is China mobilising?
Linear Tech (NASDAQ:LLTC) is a boring $10bn semi company. Some of their products have 30 year life cycles. It is less cyclical than many of its cyclical peers. So the fact they have guided FQ1 significantly below estimates is noteworthy. FQ4 sales of $379.5m are below street forecasts of $385m. BUT FQ1 guidance is for sales -7% to -12% Q/Q from the lower base. Which equates to sales of $334-353m versus street estimates of $393.7m, the midpoint of which is a huge 13% below estimates.
"We are optimistic that this will be a short cycle and that this is temporary weakness experienced while our customers react to global uncertainties and adjust their inventories to match their cautiousness and end customer demand".
IMHO there is potentially a greater force at play here that we in the West (by 'we' I also mean the semiconductor companies themselves) are not privy to. China is internalizing R&D and the technology process.
China imports 5x more semiconductor chips than domestically produced. They want to change this dynamic. There is now US$170bn funding support from the Chinese NIIF (National Industry Investment Fund) to scale the innovation curve quickly. The funds focus is to accelerate technology investment, especially in the arena of semiconductors and digital technology to wrestle some of the control from across the Taiwanese strait.
So perhaps the positive data points from the likes of ZTE and Huawei versus negative numbers out of Samsung (OTC:SSNLF), Mediatek, Linear, TSMC (NYSE:TSM) - is a function of the Chinese internalizing? So, for example, Huawei have their own RF and baseband. HiSilicon, Shanghai Huali and Spreadtrum are likely taking share away from the non-Chinese players?
Whether the semiconductor cycle downturn is purely cyclical or short term or structural shifts are afoot STMicro (NYSE:STM), which has years of miss-execution and lack of differentiation remains in the headlights. Trading at 30x P/E with the "E" at risk, assumptions of the best GM's since 2010, with 45% sales exposure to China, and having outperformed US peers and the SOX Index YTD are reasons to sell.
After all, if the semiconductor complex catches a cold, STMicro typically catches pneumonia.
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