HSBC Nutshell-A guide to equity sectors and emerging ... · PDF fileEMEA countries 221 Egypt 223 Russia 231 Saudi Arabia 239 South Africa 247 Turkey 255 Basic valuation and accounting

A product of the Global Equity Research Team

This guide will help you gain a quick but thorough understanding of the major sectors, industry

groups and countries in the region

It provides detailed information on structures, key drivers, indicators, themes and valuation

approaches

Disclosures and Disclaimer This report must be read with the disclosures and analyst

certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

Ju

ly 2

012

HSBC NutshellA guide to equity sectors and emerging countries in EMEA

Global Equity Research

Multi-sector

July 2012

Chris Georgs

Global Head of Equity Research

HSBC Bank plc

+44 20 7991 6781

[email protected]

EMEA

EM

EA

HS

BC

Nu

tsh

ell - A

gu

ide to

eq

uity

secto

rs a

nd

em

erg

ing

co

un

tries

Xavier Gunner*

Deputy Head of Equity Research

HSBC Bank plc

+44 20 7991 6749

[email protected]

*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations.

120723_50909_MULTI_REGIONAL_NUTSHELL_F7:Normal Cover 2011 v1 7/24/2012 4:04 AM Page 1

1

EMEA Equity Research Multi-sector July 2012

abc

Dear Client,

We are pleased to present HSBC Nutshell: A guide to equity sectors and countries, our inaugural suite of

multi-regional and global primers. The Nutshell guides have been compiled by our global equity research

team to help new and seasoned professionals gain a quick, but thorough, understanding of markets in

Latin America, EMEA, and Asia. For investors looking to invest globally and especially in emerging markets,

the guides provide a broad, top-down perspective on these markets and the sectors related to them.

We have assumed that our readers will have some basic working knowledge of the world economy,

equity markets, financial terminology and ratios, although the Nutshell guides are designed to be used by

anyone wanting to gain a deeper understanding of countries or industries with which they are not familiar.

The Nutshell guides are designed to provide consistency and comparability. For each sector, our analysts

explain how they value companies, and assess the key drivers affecting the sector, as well as the macro

issues and trends impacting the sector on a regional and global basis. We then build on the sector

framework to include regional macro overviews and country sections that provide a broader perspective

on the sectors and geographies that we cover, addressing topics such as market composition, liquidity,

fund flows, and political and regulatory structures.

We look forward to making our analysts available to you on a one-on-one or group basis to help you build

on your country, sector, industry or stock knowledge – from the nuts and bolts of the industry dynamics

through to individual company valuation and recommendations. The front page of each industry or

country section within these guides includes the names and contact details of our sector analysts and,

where relevant, their specialist sales person/people. Please get in touch with your HSBC representative to

organise this, contact us directly, or email [email protected].

We hope you find these guides useful, and we look forward to continuing to work with you in the future.

Regards,

Chris Georgs – Global Head of Equity Research

Patrick Boucher – Head of Product Management, Equity Research

David May – Head of Equity Research, Asia Pacific

http://www.hsbcnet.com/nutshell

http://www.hsbcnet.com/nutshell/latin-america.html

http://www.hsbcnet.com/nutshell/emea.html

http://www.hsbcnet.com/nutshell/asia-pacific.html

mailto:[email protected]

2


abc

3


abc

Europe overview 5

Sectors 17

Autos 19

Beverages 29

Business services 39

Capital goods 51

Chemicals 61

Clean energy & technology 73

Climate change 83

Construction & building materials 93

Financials – Banks 103

Financials – Insurance 113

Food & HPC 123

Food retail 133

General retail 143

Luxury goods 153

Metals & mining 161

Oil & gas 171

Telecoms, media & technology 181

Transport & logistics 191

Travel & leisure 201

Utilities 211

EMEA countries 221

Egypt 223

Russia 231

Saudi Arabia 239

South Africa 247

Turkey 255

Basic valuation and accounting guide 263

Disclosure appendix 278

Disclaimer 280

Contents

4


abc

5


abc

Europe overview

EM

EA

Eq

uity R

esearch

Multi-sector

July 2012

6

ab

c Europe country by country

Country Austria Belgium Denmark Finland France Germany Greece Ireland

Weight in MSCI Europe 0.4% 1.6% 1.9% 1.2% 13.9% 12.9% 0.1% 0.5% Key sub-sectors Financials (43%) Cons. staples (64%) Health Care (60%) Industrials (27%) Industrials (16%) Cons. disc. (18%) Cons. staples (47%) Materials (48%) Energy (22%) Materials (12%) Industrials (15%) Financials (16%) Cons. disc. (14%) Materials (16%) Financials (26%) Health care (27%) Telecoms (14%) Financials (12%) Financials (9%) IT (15%) Energy (13%) Financials (16%) Cons. disc. (19%) Cons. staples (22%) Three largest stocks Omv (22%) Anh-Busch InBev (57%) Novo Nordisk (54%) Nokia (15%) Total (12%) Siemens (9%) Coca-Cola HlcBt (47%) CRH (48%) Erste Group Bank (16%) Solvay (7%) Danske Bank (8%) Sampo (14%) Sanofi (10%) BASF (9%) Natl Bnk Greece (26%) Elan (27%) Telekom Austria (14%) Umicore (6%) APMoller-Maersk (7%) Kone (13%) Danone (5%) SAP (7%) Opap (19%) Kerry Group (22%) Trading data Market cap. (free-float EURbn) 20 78 84 54 662 582 3 21 ADTV (5-year) (EURm) 183 389 396 714 4,582 5,793 172 140 Performance in past 10 years Absolute 9% -1% 143% -12% 7% 33% -81% -57% Relative to MSCI Europe -12% -20% 97% -29% -13% 8% -85% -65% Correlations of country MSCI index returns (5-year) with

MSCI Europe 0.66 0.74 0.74 0.62 0.87 0.81 0.51 0.69 Exports (country) 0.27 0.31 0.22 0.21 0.32 0.31 0.12 0.15 Nominal GDP (country) 0.18 0.15 0.01 0.11 0.08 0.05 -0.12 0.22 US ISM 0.57 0.52 0.45 0.24 0.47 0.47 0.38 0.32 Key country stats 12M-forward EPS growth 24% 18% 28% -6% 5% 13% 205% 14% Long-term average 12M-forward PE 13.8 12.3 15.4 23.3 14.2 15.3 12.3 14.4 12M-forward PE 7.3 11.9 15.2 13.3 8.9 9.1 5.9 17.8 Long-term average PB 1.6 1.5 1.9 2.8 1.7 1.9 2.0 2.2 Current PB 0.8 1.5 2.3 1.4 1.1 1.4 0.6 1.7 Long-term average ROE (%) 11% 12% 13% 15% 12% 10% 14% 13% Current ROE 6% 7% 10% 12% 10% 11% 6% 6%

Source: HSBC, Thomson Reuters Datastream, MSCI, IBES

EM

EA

Eq

uity R

esearch

Multi-sector

July 2012

7

ab

cEurope country by country

Country Italy Netherlands Norway Portugal Spain Sweden Switzerland United Kingdom

Weight in MSCI Europe 3.2% 3.8% 1.5% 0.3% 3.9% 4.8% 13.5% 36.6% Key sub-sectors Energy (35%) Cons. staples (38%) Energy (54%) Utilities (29%) Financials (39%) Industrials (30%) Health care (32%) Energy (20%) Financials (26%) Financials (16%) Financials (13%) Cons. staples (23%) Telecoms (21%) Financials (24%) Cons. staples (25%) Financials (17%) Utilities (18%) Industrials (14%) Materials (13%) Energy (17%) Utilities (12%) Cons. disc. (14%) Financials (17%) Cons. staples (17%) Three largest stocks ENI (25%) ING Groep (10%) Statoil (31%) EDP (24%) Telefonica (22%) Hennes&Mauritz (11%) Nestlé (24%) Royal Dutch Shell (9%) ENEL (10%) ASML Holding (9%) Seadrill (14%) JeronimoMartins (23%) Banc Santander (21%) Ericsson (9%) Novartis (15%) HSBC Hdg. (7%) Intesa Sanpaolo (7%) Philips Eltn.Kon (8%) Telenor (13%) Galp Energia (17%) BBV.Argentaria (12%) Nordea Bank (7%) Roche Holding (14%) Vodafone Group (6%) Trading data Market cap. (free-float EURbn) 151 171 67 13 188 226 634 1,727 ADTV (5-year) (EURm) 3,167 1,741 801 153 2,646 1,422 2,716 7,626 Performance in last 10 years Absolute -28% 3% 142% -13% 29% 130% 48% 25% Relative to MSCI Europe -41% -17% 96% -29% 5% 86% 20% 1% Correlations of country MSCI index returns (5-year) with

MSCI Europe 0.71 0.87 0.71 0.67 0.77 0.78 0.75 0.85 Exports (country) 0.33 0.26 0.40 0.31 0.31 0.44 0.26 0.47 Nominal GDP (country) 0.01 -0.05 0.45 0.37 0.03 0.37 -0.04 0.65 US ISM 0.41 0.52 0.52 0.32 0.41 0.47 0.37 0.50 Key country stats 12M-forward EPS growth 14% 11% 9% 12% -3% 11% 11% 5% Long-term average 12M-forward PE 15.8 12.8 11.2 13.6 12.7 15.0 14.1 13.0 12M-forward PE 7.2 9.3 9.4 10.2 8.1 11.3 11.7 9.4 Long-term average PB 1.6 1.7 1.7 2.0 1.5 2.0 2.1 1.9 Current PB 0.8 1.3 1.5 1.2 0.9 1.9 2.1 1.7 Long-term average ROE (%) 11% 15% 15% 14% 17% 14% 14% 16% Current ROE 7% 9% 16% 9% 11% 13% 13% 16%


EM

EA

Eq

uity R

esearch

Multi-sector

July 2012

8

ab

cEurope sector by sector

Sector Energy Materials Industrials Consumer discretionary

Consumer staples Health care Financials Information technology

Telecomms services

Utilities

Weight in MSCI Europe 12% 10% 11% 9% 15% 12% 18% 3% 6% 5% Key sub-sectors Integrated oil & gas

(84%) Diversified metals

& mining (38%)Industrial conglom

(16%)Auto manufacturers

(23%)Packaged foods &

meats (40%) Pharmaceuticals

(87%)Diversified banks

(49%)Application

Software (38%)Integrated

telecomms (60%)Electric utilities

(43%) Oil & gas equip &

services (8%) Diversified

chemicals (16%)Industrial

machinery (15%)Apparel, access& luxury gds (23%)

Tobacco (16%) Health care equipment (4%)

Multi-Line insurance (14%)

Communications equipment (24%)

Wireless telecomms (38%)

Multi utilities (42%)

Oil & gas drilling (4%)

Industrial gases (11%)

Aerospace & defense (11%)

Apparel retail (10%)

Brewers (13%) Health care services (4%)

Diversified capital markets (10%)

Semiconductors (13%)

Alternative carriers (1%)

Gas utilities (5%)

Three largest stocks Royal Dutch Shell BASF Siemens Daimler Nestle Novartis HSBC Hdg SAP Vodafone Group National Grid BP Rio Tinto ABB LVMH British American

Tobacco Glaxosmithkline Standard Chartered Ericsson Telefonica E On

Total BHP Billiton Schneider Electric Hennes & Mauritz Diageo Roche Holding Banco Santander ASML Holding Deutsche Telekom Centrica Trading data Market cap. (free-float EURbn) 578 460 525 420 743 608 904 140 318 225ADTV (5-year) (EURm) 2,701 4,103 3,162 4,196 2,357 1,727 8,818 1,394 1,898 1,985Performance in last 10 years Absolute 53% 100% 78% 63% 120% 66% -29% -10% 91% 80%Relative to MSCI Europe 9% 42% 26% 16% 56% 18% -49% -36% 36% 28%Correlations of sector MSCI index returns (5-year) with

MSCI Europe 0.65 0.85 0.93 0.91 0.69 0.56 0.91 0.79 0.66 0.75Nominal GDP (euro area) -0.08 0.10 -0.01 -0.03 -0.04 -0.09 0.11 -0.09 0.10 0.25US ISM 0.30 0.39 0.36 0.25 0.23 0.21 0.41 0.17 0.10 0.30Key sector stats 12M-forward sales growth 0% 5% 5% 7% 5% 3% 4% 0% -1% 0%12M-forward EPS growth 4% 6% 12% 12% 9% 3% 15% -2% -1% 4%Long-term average 12M-forward PE 10.5 11.3 13.0 12.9 14.4 14.3 9.9 17.3 12.1 12.012M-forward PE 7.6 9.1 11.2 10.1 14.3 11.0 7.3 15.0 9.0 9.7Long-term average PB 2.5 1.9 2.4 2.3 3.6 5.1 1.8 4.9 2.3 2.1Current PB 1.4 1.6 2.1 1.9 3.1 3.1 0.7 2.2 1.3 1.1Long-term average ROE(%) 19% 14% 14% 13% 20% 21% 11% 12% 13% 14%Current ROE 18% 14% 14% 16% 17% 21% 6% 16% 14% 10%


9


abc

Introduction The past two decades have been among the most volatile periods in the history of the European stock

market. During this time we have seen the development of a huge technology-led bubble (the late 1990s)

that subsequently burst and, in doing so, triggered a three-year bear market (2000-03). A five-year

upswing followed, fuelled by strong emerging market growth (led by China). This drove the European

equity market to within touching distance of its 2000 peak level, but the trend proved unsustainable. This

time the downturn was primarily a consequence of the bursting of bubbles in the credit and housing

markets in many countries. The outcome was the biggest post-war recession, a financial crisis (still

ongoing) and a collapse in value of risk assets, with financials bearing the brunt of the selling. The bear

market ran from 2007 to 2009, causing the European equity market to lose 50% of its value and revisit its

2003 lows.

The combination of a major fiscal and monetary policy response and signs of stabilisation in the global

economic indicators eventually led to a recovery in stock prices in early 2009. But as the financial crisis

shifted from the private sector to the public sector, the rally stalled in the first half of 2011 and the market

has since remained range-bound.

1. MSCI Europe price index (EUR) 2. Largest stocks in MSCI Europe

0

200

400

600

800

1000

1200

1400

1600

1800

90 92 94 96 98 00 02 04 06 08 10 12MSCI Europe

Stock rank Stock name Index weight

1 Royal Dutch Shell (A+B) 3.5% 2 Nestlé 3.2% 3 HSBC Holding 2.5% 4 Vodafone Group 2.3% 5 Novartis 2.1% Top 5 13.5% 6 BP 2.0% 7 GlaxoSmithKline 1.9% 8 Roche Holding 1.9% 9 British American Tobacco 1.6% 10 Total 1.6% Top 10 22.7%

Source: MSCI, Thomson Reuters Datastream, HSBC, Source: MSCI, Thomson Reuters Datastream, HSBC

Chart 1 shows the extent of the volatility we have seen over recent times in the European stock market.

What is clear is that from the late 1990s onwards a buy and hold strategy would not have performed

consistently well.

Europe overview

Peter Sullivan* Strategist HSBC Bank plc +44 20 7991 6702 [email protected]

Robert Parkes* Strategist HSBC Bank plc +44 20 7991 6716 [email protected]

*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations

https://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=wDK0jr8ED2&n=336918.HTM

10


abc

Market structure Europe’s largest companies are shown in table 2. The energy (RDS A+B, BP and Total) and

pharmaceuticals (Novartis, GlaxoSmithKline and Roche) sectors each contribute three companies. There

are two companies from the consumer staples sector (Nestlé and British American Tobacco). A bank

(HSBC) and telecoms company (Vodafone) complete the list. Combined, these 10 companies account for

over one-fifth of the total index market capitalisation.

The collapse in value of the financials sector has resulted in a more balanced spread of sector weightings

in Europe. Its weighting peaked at 31% in Q4 2006 but has now fallen to 18%, although it remains the

largest sector in Europe. The consumer staples sector has the second-highest weight (15%), with energy

(12%) and healthcare (12%) tied in third place.

The most important markets in Europe by size in descending order are: the UK (37% weight), France

(14%), Switzerland (13%) and Germany (13%). Note that the periphery (Spain, Italy, Portugal, Ireland

and Greece) accounts for just 8% of total European market capitalisation.

Of the markets in the European index with a weighting over 3%, Spain, Switzerland and Italy are the

most concentrated and the UK the least concentrated (table 3).

Market structure and liquidity are important factors explaining volatility in European markets. Illiquid

markets and/or those dominated by a small number of companies tend to experience more volatility. In

markets with low volumes (table 4 gives detail on market liquidity), prices often fall quickly when

investors rush for the exit. In highly concentrated markets such as Norway (where Statoil accounts for

around 30% of the MSCI Norway index), the volatility of the market is subject to the underlying volatility

of a limited number of companies.

Measured over the past five years, the most volatile markets have been Greece, Norway, Austria and

Ireland. The least volatile were Switzerland, the UK, Portugal and France (table 5).

3. MSCI Europe: country weights of top 5/top 10 stocks 4. MSCI Europe: daily average stock market turnover (EURm)

Top 5 Top 10

Austria 79% 100% Belgium 80% 98% Denmark 83% 98% Finland 62% 90% France 35% 51% Germany 38% 60% Greece 100% 100% Ireland 100% 100% Italy 56% 77% Netherlands 40% 61% Norway 77% 100% Portugal 88% 100% Spain 70% 85% Sweden 38% 60% Switzerland 63% 80% United Kingdom 33% 49% MSCI Europe 14% 23%

Source: MSCI, Thomson Reuters Datastream, HSBC,

Current 5-year average

Austria 66 183 Belgium 349 389 Denmark 260 396 Finland 356 714 France 3,551 4,582 Germany 3,687 5,793 Greece 46 172 Ireland 55 140 Italy 1,897 3,167 Netherlands 1,162 1,741 Norway 415 801 Portugal 90 153 Spain 1,612 2,646 Sweden 1,101 1,422 Switzerland 1,866 2,716 United Kingdom 5,794 7,626 MSCI Europe 22,308 32,644

Source: MSCI, Thomson Reuters Datastream, HSBC,

11


abc

5. MSCI Europe: earnings and index volatility

MSCI indices ________Trailing earnings volatility* ________ ________ Market returns volatility* _______ 10 years 5 years 10 years 5 years

Austria 99% 53% 27% 34% Belgium 299% 423% 24% 28% Denmark 33% 40% 22% 27% Finland 35% 39% 28% 29% France 41% 30% 21% 23% Germany 62% 51% 24% 25% Greece 40% 47% 35% 43% Ireland 208% 292% 25% 29% Italy 40% 28% 23% 28% Netherlands 91% 127% 23% 25% Norway 45% 52% 30% 36% Portugal 27% 26% 20% 22% Spain 26% 28% 23% 27% Sweden 149% 34% 26% 29% Switzerland 49% 65% 15% 16% United Kingdom 23% 28% 18% 22% MSCI Europe 21% 23% 19% 21%

Note: *calculated as the annualised standard deviation of monthly changes Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

The volatility of earnings clearly contributes to the overall level of price volatility. Over the past 10 years,

Sweden, the Netherlands and Germany have been among the larger European markets with the highest

level of earnings volatility. Earnings volatility has been lowest in the UK and Spain.

Correlations So far we have examined market structure, liquidity and volatility in earnings to explain market

behaviour. Another factor that drives market volatility is the sensitivity of markets to global and domestic

economic factors.

To examine this further, we correlated various macro and fund flow factors with equity markets (table 6).

We used the ISM and country exports as a proxy for global macro conditions and country GDP as a proxy

for domestic economic conditions.

6. MSCI Europe: market correlations

__Economic factors (past 20 years)____ _________ Fund flows __________ _ Indices (past 20 years)__Country US ISM Exports

(country) GDP nominal

(country) past

10 yearspast

5 years6 to 10

years agoMSCI Europe World

Austria 0.57 0.27 0.18 0.08 -0.05 0.29 0.66 0.60 Belgium 0.52 0.31 0.15 0.20 0.24 -0.10 0.74 0.66 Denmark 0.45 0.22 0.01 -0.08 -0.08 -0.12 0.74 0.68 Finland 0.24 0.21 0.11 0.17 0.23 0.01 0.62 0.63 France 0.47 0.32 0.08 -0.26 -0.35 -0.10 0.87 0.79 Germany 0.47 0.31 0.05 0.04 0.05 0.12 0.81 0.74 Greece 0.38 0.12 -0.12 0.06 0.05 0.23 0.51 0.42 Ireland 0.32 0.15 0.22 -0.01 0.01 n/a 0.69 0.68 Italy 0.41 0.33 0.01 0.16 0.15 0.20 0.71 0.63 Netherlands 0.52 0.26 -0.05 -0.06 -0.06 -0.16 0.87 0.82 Norway 0.52 0.40 0.45 -0.14 -0.17 n/a 0.71 0.69 Portugal 0.32 0.31 0.37 0.00 0.02 0.00 0.67 0.57 Spain 0.41 0.31 0.03 0.21 0.22 0.10 0.77 0.68 Sweden 0.47 0.44 0.37 0.33 0.39 0.22 0.78 0.73 Switzerland 0.37 0.26 -0.04 0.07 0.08 0.08 0.75 0.72 United Kingdom 0.50 0.47 0.65 0.21 0.25 0.12 0.85 0.81

Source: MSCI, Thomson Reuters Datastream, Eurostat, HSBC

12


abc

7. MSCI Europe: actual versus in sample trend earnings* 8. MSCI Europe: 20-year annual EPS growth CAGR

4.0

4.5

5.0

5.5

6.0

92 94 96 98 00 02 04 06 08 10 12

Real EPS In sample trend

0

2

4

6

8

10

Swed

en

Spai

n

Fran

ce

Ger

man

y

Italy

Switz

Euro

pe

Net

hlnd UK

Annualised growth rate % (20 years)

*Note: calculated using a weighted least squares method Source: MSCI, Thomson Reuters Datastream, HSBC

Source: MSCI, Thomson Reuters Datastream, HSBC

The key takeaway here is that global economic factors are more important than the health of the domestic

economies.

Earnings and ratings European earnings have followed a cyclical pattern over the past 20 years. They have recovered from the

financial crisis low of late 2009 but remain below the 20-year trend (chart 7).

Earnings have grown by 5.2% annually on average over the past 20 years (table 8). The countries that have

recorded the highest annualised growth rates are: Sweden (+8.9%), Spain (+7.7%) and France (+7.2%).

Earnings growth has lagged the European average in the UK (+3.6%) and the Netherlands (+3.7%).

If we look at how accurate analysts have been in forecasting this growth, it becomes apparent that they

have tended to be too optimistic when forecasting European earnings. The average miss to 12M-forward

EPS expectations (since 1995) has been 7%.

Analysts’ earnings revisions (upgrades and downgrades) do correlate well with the market (chart 11).

Turning points in the consensus EPS revisions ratio (number of upgrades to 12M-forward EPS expressed

as a percentage of the number of upgrades plus the number of downgrades) can often help to identify

turning points in stocks.

9. MSCI Europe: earnings momentum – Europe versus returns 10. MSCI Europe: 12M-forward EPS growth versus returns

-50%-40%-30%-20%-10%

0%10%20%30%40%

04 04 05 05 06 06 07 07 08 08 09 09 10 10 11 11 12

-60%

-40%

-20%

0%

20%

40%

60%

Europe earnings momentum

MSCI Europe YoY (RHS)

-60%

-40%

-20%

0%

20%

40%

60%

04 04 05 05 06 06 07 07 08 08 09 09 10 10 11 11 12

-60%

-40%

-20%

0%

20%

40%

60%

Europe EPS growth MSCI Europe YoY (RHS)

Source: MSCI, Thomson Reuters Datastream, IBES, HSBC Source: MSCI, Thomson Reuters Datastream, IBES, HSBC

13


abc

11. MSCI Europe: EPS revisions ratio* versus price index 12. Europe recommendation consensus score

0%

10%

20%

30%

40%

50%

60%

70%

80%

04 05 06 07 08 09 10 11 12

-60%

-40%

-20%

0%

20%

40%

60%

Earnings Revisions MSCI Europe YoY (RHS)

2.002.102.202.302.402.502.602.702.80

94 96 98 00 02 04 06 08 10 12RCS Average+2SD -2SD

Note: *number of upgrades to 12m fwd EPS as a % of all changes Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

Source: Thomson Reuters Datastream, HSBC

Early 2009 proved to be a good example of why this indicator can be important. The pace of downgrades

started to slow in January 2009, signalling that the outlook for earnings was starting to look less bad. But

there was a delayed response in terms of share prices: the MSCI Europe index did not bottom until March

2009, after which it rebounded sharply.

Admittedly, analysts were slow to cut their numbers during the financial crisis in 2008. However, perhaps

this at least partly explains why they have been particularly aggressive about cutting their numbers over

the past 12 months, in response to the worsening economic slowdown and sovereign debt concerns.

Analysts’ recommendations on companies can also signal turning points in the market: Historically, when

analysts have started to downgrade after being particularly optimistic (lots of buy recommendations), this

has tended to help reinforce a new downtrend in the equity market. The opposite is also true: When

analysts have started to upgrade after being very pessimistic (lots of sell recommendations), this can help

to confirm a new uptrend in the equity market.

The peak of the tech bubble in 2000 and the 2009 low that followed the financial crisis are two examples

of how a combination of the level and change in analyst recommendations can confirm turning points in

the market (chart 12). We therefore conclude that it is wrong to dismiss analyst behaviour as being

irrelevant, even when, as now, the environment is predominantly macro-driven.

14


abc

Valuations In the past decade, Europe has traded on an average of 14.6x earnings, with Sweden being the most

expensive. Of the larger markets, Spain, the Netherlands and Italy have historically traded at a discount to

the Pan-European aggregate (table 13).

Intriguingly, it was only a decade earlier that Sweden had experienced a financial crisis which resulted in

the part-nationalisation of the banking system. In a way this highlights the danger of extrapolating

forward the currently low level of valuations in Europe (which have been driven down by the ongoing

sovereign debt crisis).

The European market has been on a de-rating trend over the past 12 years. This initially was a response to

the bursting of the technology bubble, but has since continued, driven by increasing concern about

lacklustre developed world growth and the fall-out from the financial crisis. That dragged the PE multiple

for Europe down to just 9.6x (34% below the 10-year average), implying that 52% upside is needed to get

the equity market back to its decade average valuation. Italy, Germany and Spain are currently trading on

the biggest discounts to their 10-year average PE multiples.

If we invert the PE multiple to get the earnings yield and compare this with the bond yield over time, we can

see that the gap has been steadily widening since the onset of the financial crisis five years ago (chart 14).

Up until 2007 the European market tended to trade in the 15x-20x PE range, but it then dropped to the

10x-15x range and has very recently edged into the 5x-10x range (chart 15).

Long-run average European country ROEs range from 10% in Germany to 17% in Spain. With earnings

currently below trend, current ROEs are lower in most cases, the only exceptions being Germany and

Norway.

13. MSCI Europe: 12M-forward PE (EBG) by market 14. Europe: earnings yield (EY) versus bond yield (BY)

0%2%4%6%8%

10%12%

14%16%

01 02 03 04 05 06 07 08 09 10 11

EY BY


PE now

Avg 2001-11

% diff Avg 1993-2011

% diff

Austria 7.3 12.4 -41% 15.5 -53% Belgium 11.9 12.5 -5% 14.0 -15% Denmark 15.2 16.5 -8% 17.6 -14% Finland 13.3 16.3 -19% 19.0 -30% France 8.9 14.5 -38% 17.6 -49% Germany 9.1 15.3 -41% 18.8 -52% Greece 5.9 12.9 -55% 13.7 -57% Ireland 17.8 14.9 19% 14.6 22% Italy 7.2 14.1 -49% 22.0 -67% Netherlands 9.3 13.4 -31% 15.1 -38% Norway 9.4 11.8 -20% 13.3 -29% Portugal 10.2 14.7 -31% 15.6 -35% Spain 8.1 13.4 -40% 14.9 -46% Sweden 11.3 17.4 -35% 20.8 -46% Switzerland 11.7 15.9 -27% 17.0 -31% United Kingdom 9.4 15.0 -38% 15.8 -41% MSCI Europe 9.6 14.6 -34% 16.4 -42%

Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

15


abc

15. MSCI Europe: PE band chart 16. MSCI Europe: PB versus ROE/COE

0

500

1,000

1,500

2,000

2,500

3,000

02 03 04 05 06 07 08 09 10 11 12

MSCI PI 5X 10X15X 20X 25X

011

223

34

4

5

00 01 02 03 04 05 06 07 08 09 10 11 12

PBR ROE/COE

Source: MSCI, Thomson Reuters Datastream, HSBC Source: MSCI, Thomson Reuters Datastream, HSBC

While valuations tend to tell us very little about the short-term direction of equity markets, they can,

when they reach extreme levels (think 2000 and 2009), often help to identify turning points in the market.

Moreover, for longer-term investors the empirical evidence suggests that valuation is a more important

guide to long-term stock market returns than other indicators such as trend economic growth rates.

We also looked at sector valuations across Europe (table 17). The story here is the same as for the country

analysis, with a broad range of sectors trading well below their 10-year average PE ratios. We find that

only the consumer staples sector is trading in line with its average multiple over the past decade. Eight of

the ten sectors are more than one standard deviation below average, financials and energy being the most

extreme cases.

17. MSCI Europe: 12M-forward PE versus 10-year average and standard deviations from average

Current PE Rolling 10-yr avg Rolling 10-yr SD # ST Dev from avg

Energy 7.6 10.5 2.0 -1.5 Materials 9.1 11.3 2.0 -1.1 Industrials 11.2 13.0 1.8 -1.0 Consumer discretionary 10.1 12.9 1.9 -1.4 Consumer staples 14.3 14.4 1.5 0.0 Health care 11.0 14.3 3.0 -1.1 Financials 7.3 9.9 1.7 -1.5 Technology 15.0 17.3 4.0 -0.6 Telecom 9.0 12.1 2.7 -1.2 Utilities 9.7 12.0 1.9 -1.2 Europe 9.6 11.8 1.5 -1.4

Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

16


abc

18. Cumulative foreign institutional funds into equities in Europe since 2000

19. Cumulative buying into country equity funds, Europe ex-UK regional equity funds and Europe regional equity funds since January 2000

-200

-150

-100

-50

0

50

00 01 02 03 04 05 06 07 08 09 10 11 12

Cumulative funds flows since 2000 USDbn

Source: EPFR, HSBC

USDm

Austria -302 Belgium -932 Denmark -578 Finland -70 France -6,678 Germany 17,138 Greece 25 Ireland 4 Italy -2,115 Netherlands -1,544 Norway -116 Portugal -42 Spain -1,467 Sweden 479 Switzerland -8,682 United Kingdom -11,278 Europe ex-UK -58,234 Europe -84,521 Total -158,913

Source: EPFR, HSBC

Fund flows/holdings Since 2000, investors have withdrawn USD159bn from the European equity market – all of it since the

onset of the financial crisis in 2007. Looking at the country breakdown, we find that only the German

market has experienced meaningful net inflows. Both of these points highlight the ongoing high level of

risk aversion, from the perspective of both asset and equity allocation (Germany being the perceived safe

haven within the eurozone).

We find that fund holdings analysis (specifically how large international funds are positioned) is another

tool that can be used to signal relative country and sector performance over the medium term. Our

analysis shows that these funds tend to move as a herd when either ‘fear’ or ‘greed’ dominate. And this

can trigger a reversal in relative performance over the next one to two years. For example, if this group of

investors were very underweight a particular sector, we would view this as a positive signal for future

relative performance and the reverse is true. See our latest Fund Holdings report (Equity Insights – Fund

holdings: The US is a winner from the eurozone crisis, 28 May 2012) for further details on this.

Emerging Europe Given the growing importance of emerging markets (in a European context this means Central and

Eastern Europe, Middle East and Africa – CEEMEA), in this Nutshell we have included analysis of the

five most important countries: Russia, Turkey, South Africa, Saudi Arabia and Egypt. They are very

different in terms of growth and risk characteristics, but are becoming increasingly important recipients of

capital flows. We believe that it is important to know something about the key stocks and general

characteristics of these markets; for example, Gazprom, listed in Russia, is one of the most high profile

energy companies in both Europe and the world.

17


abc

Sectors

18


abc

Notes

19


abc

Autos

European autos team Horst Schneider* Analyst HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 3285 [email protected]

Niels Fehre*, CFA Analyst HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 3426 [email protected]

Sector sales Rod Turnbull Specialist Sales HSBC Bank Plc +44 20 7991 5363 [email protected]

Billal Ismail Specialist Sales HSBC Bank Plc +44 20 7991 5362 [email protected]

Oliver Magis Specialist Sales HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 4402 [email protected]

*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations

EM

EA

Eq

uity Research

M

ulti-sector July 2012

20

ab

cSector structure

*Private companies

Premium car makers

Audi (Volkswagen)

BMW

Mercedes-Benz (Daimler)

Porsche (Volkswagen)

Ferrari, Maserati (Fiat Group)

Aston Martin*

Jaguar–Landrover (Tata Motors)

Cadillac (GM)

Lincoln (Ford)

Acura (Honda)

Infinit i (Nissan)

Lexus (Toyota)

Volvo (Geely)

Mass-market car makers

Fiat + Chrysler

PSA Peugeot Cit roen

Renault

Volkswagen brand

Ford

General Motors

Honda

Nissan

Suzuki

Toyota

Hyundai–Kia

Beijing Automotive*

Changan Group

First Auto Works (FAW )

Dongfeng

SAIC

Car makers

Tyre makers

Continental

Michelin

Nokian Renkaat

Pirelli

Goodyear/ Sumitomo

Cooper

Bridgestone

Yokohama

Hankook

Bosch*

Continental

Faurecia

ThyssenKrupp

Valeo

Delphi

Magna

Johnson Control

Lear

Denso

Aisin Seiki

Diversified/multi-product suppliers

Auto components

Specialised suppliers (telematics, safety,

electricals, chassis etc.)

Autoliv

Elringklinger

Leoni

Magneti Marelli (Fiat)

Rheinmetall

ZF group*

TRW Automotive

Autos

*Private companies

Premium car makers

Audi (Volkswagen)

BMW

Mercedes-Benz (Daimler)

Porsche (Volkswagen)

Ferrari, Maserati (Fiat Group)

Aston Martin*

Jaguar–Landrover (Tata Motors)

Cadillac (GM)

Lincoln (Ford)

Acura (Honda)

Infinit i (Nissan)

Lexus (Toyota)

Volvo (Geely)

Mass-market car makers

Fiat + Chrysler

PSA Peugeot Cit roen

Renault

Volkswagen brand

Ford

General Motors

Honda

Nissan

Suzuki

Toyota

Hyundai–Kia

Beijing Automotive*

Changan Group

First Auto Works (FAW )

Dongfeng

SAIC

Car makers

Tyre makers

Continental

Michelin

Nokian Renkaat

Pirelli

Goodyear/ Sumitomo

Cooper

Bridgestone

Yokohama

Hankook

Bosch*

Continental

Faurecia

ThyssenKrupp

Valeo

Delphi

Magna

Johnson Control

Lear

Denso

Aisin Seiki

Diversified/multi-product suppliers

Auto components

Specialised suppliers (telematics, safety,

electricals, chassis etc.)

Autoliv

Elringklinger

Leoni

Magneti Marelli (Fiat)

Rheinmetall

ZF group*

TRW Automotive

Autos

Source: HSBC

EM

EA

Eq

uity Research

M


21

ab

cSector price history: Euro STOXX Auto and Parts

50

100

150

200

250

300

350

400

450Ja

n-90

Jul-9

0

Jan-

91

Jul-9

1

Jan-

92

Jul-9

2

Jan-

93

Jul-9

3

Jan-

94

Jul-9

4

Jan-

95

Jul-9

5

Jan-

96

Jul-9

6

Jan-

97

Jul-9

7

Jan-

98

Jul-9

8

Jan-

99

Jul-9

9

Jan-

00

Jul-0

0

Jan-

01

Jul-0

1

Jan-

02

Jul-0

2

Jan-

03

Jul-0

3

Jan-

04

Jul-0

4

Jan-

05

Jul-0

5

Jan-

06

Jul-0

6

Jan-

07

Jul-0

7

Jan-

08

Jul-0

8

Jan-

09

Jul-0

9

Jan-

10

Jul-1

0

Jan-

11

Jul-1

1

Jan-

12

Euro STOXX Auto & Parts Index

Strong recovery in mid 2000s

Financial crisis & Lehman collapse

Car scrappage schemes

End of incentives

Greek crisis, sharp rise in oil prices

Europe recession

Boom in the 1990s

Early 2000: Impact of 9/11 and bursting of dotcom bubble


EM

EA

Eq

uity Research

M


22

ab

c

EBIT margin versus asset turnover (2007-11 average)

Continental

Leoni

ElringklingerRheinmetall

BMW

DaimlerVolkswagen

Faurecia

Renault

PSA

Valeo

Michelin

Nokian

Pirelli

0.50

0.75

1.00

1.25

1.50

1.75

2.00

2.25

2.50

2.75

0% 5% 10% 15% 20% 25%EBIT Margin(%)

Ass

et T

urno

ver (

x)

Sector Avg = 4.4%

Sector Avg= 1.2x

Source: Company data, HSBC

23


abc

Sector description The European automotive sector plays a vital role in the European economy, supporting around 12.6m jobs

(2.3m directly) and contributing significantly to the EU’s GDP, with net trade of some EUR60bn a year

(source: ACEA). At 17m vehicles pa, Europe accounts for 25% of global auto production, led by Germany,

France and Spain. Developments in the auto sector influence many other sectors (eg capital goods, steel and

chemicals) and are thus closely monitored by financial analysts as well as the political community. The sector

can be broadly divided into mass-market car makers and premium car makers.

Mass-market manufacturers derive most of their sales from smaller and cheaper cars, which typically

have lower margins and are more exposed to cyclical demand than more expensive models. These

companies rely on high production to push asset turnover, which, in turn, is the key driver of profitability.

Besides being exposed to the fragmented small-car segment, they are challenged by low capacity

utilisation and constant pricing pressures, predominantly in Europe.

Premium car makers, with exposure to the larger-car and SUV segments, typically achieve higher margins.

Added value from advanced technology, rich features and brand equity enable them to command higher

transaction prices. However, they face challenges from stricter CO2 regulations globally, which oblige them to

invest heavily in developing low-emission technologies. Furthermore, greater market fragmentation and a

weakening product mix (as they enter smaller-car segments) are increasing challenges.

At the onset of the economic crisis, the highly cyclical nature of the sector caused new car sales to

collapse, particularly in the Western markets, as consumer confidence plunged. Scrappage schemes

intended to boost short-term demand during the crisis pulled demand forward, creating additional

medium-term challenges, especially for mass-market car makers, as issues of overcapacity in Europe

were left largely unaddressed. Further risks for 2012 and beyond stem from plummeting consumer

confidence due to austerity measures in Europe, uncertainty about the future of the eurozone against the

backdrop of the Greek sovereign crisis and fears of a slowdown in China.

Key themes Low car ownership in emerging markets offsets weakness in developed markets

In our view, global light vehicle sales growth will continue to be driven by emerging markets, particularly

the BRIC economies. Low car penetration and rising disposable incomes should lead to higher organic

growth in emerging markets, even though the outlook for developed markets remains uncertain. In China,

for example, only 45 out of 1,000 people and in Russia only 243 out of 1,000 people own a car, compared

with 40% to 50% of the population in Western Europe. Sales in emerging markets are skewed towards

small cars, and most purchases are by first-time buyers. In developed markets, sales are largely dominated

by replacement demand. Although we expect unit sales to grow after 2012, we do not forecast light-

vehicle sales in Western Europe and the US to return to their pre-crisis levels of 2007 until after 2014.

Thus car makers with a higher exposure to emerging markets should enjoy higher top-line growth than

those whose operations are highly concentrated in stagnating developed markets.

Modular architectures and platform sharing

A key strategy is to increase standardisation through the greater use of modular platforms. This reduces

the number of architectures even though the average number of units per model series may decline.

Horst Schneider* Analyst HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 3285 [email protected]

Niels Fehre*, CFA Analyst HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 3426 [email protected]


24


abc

Standardisation helps to reduce the R&D cost per vehicle and to realise purchasing synergies through the

use of shared components. Significant cost savings can be achieved by standardising components such as

air-conditioning systems, gearboxes, engines and axles, which are not technological or brand

differentiators. Modularisation also gives large car makers, such as Volkswagen, an advantage over

smaller competitors, such as Renault and PSA, since the large companies can combine more units on a

single platform.

To reduce per-unit costs and exploit the benefits of scale, car makers now increasingly rely on alliances

and joint ventures to share platforms with other manufacturers. Other areas for exploring synergies

involve joint procurement, product development and technology sharing. Some alliances, such as Renault

and Nissan, PSA and GM or Volkswagen and Suzuki, involve equity cross-holdings. Others, such as

those between PSA and Mitsubishi or Daimler and BMW, are only strategic in nature.

Size matters: capacity utilisation and restructuring

Low capacity utilisation and insufficient scale are particular concerns for mass-market car makers, where

high production volume is the prime earnings driver. Plagued by overcapacity, the European auto industry

is in dire need of consolidation, in our view: we believe this is the only way for car makers to raise

production volumes high enough to increase asset turnover and alleviate pricing pressures. Fiat’s CEO

defines this level as more than 5.5 million cars a year and more than 1 million cars per platform.

However, the political ramifications of the impact on employment levels make meaningful consolidation

difficult to achieve in Europe in the near future. In 2008 and 2009, restructuring was mostly confined to short-

time work, only temporary plant shutdowns, the transfer of some manufacturing capacity to low-cost Eastern

European sites and the achievement of some minor structural cost savings. In contrast, US companies

underwent intensive restructuring, resulting in the Fiat-Chrysler alliance and the discontinuation of many

brands. In China, one of the most fragmented markets, the government is pushing car makers to consolidate

and has also introduced mechanisms to keep tabs on capacity expansions.

Scrappage incentives distort demand and aggravate pricing risks

Scrappage schemes in the US, Europe and China significantly boosted demand in 2009 and 2010,

particularly for small cars; mass-market car makers were the main beneficiaries. Although these

incentives helped the industry get through the crisis, they pulled forward future demand, causing declines

after they expired. Margins face additional risks as consumers have become accustomed to the incentives

and now expect discounts from car dealers, at a time of declining demand. On our estimates, net prices for

mass-market cars in Europe declined by around 1.5% on average in 2011. This increases the need for car

makers to cut costs in order to compensate for the negative pricing effects.

CO2 regulation and high R&D requirements

Regulation plays a pivotal role in shaping the industry structure and its future growth trajectory as it

encompasses rules on emissions and safety. Concerns about climate change mean that stricter CO2

emission rules are the regulatory issue most affecting the car industry. In Europe, for example, legislation

mandates a reduction in tailpipe CO2 to an average of 130g/km through technology measures. This will

apply to 65% of newly registered cars by 2012, increasing to 100% by 2015. Average CO2 emissions

already declined to 140g/km in Europe in 2011 (source: Transport & Environment, Brussels) and most

25


abc

European car makers should meet the regulatory target by 2015. However, CO2 emissions will also need

to be cut thereafter since the European Commission has set a target of 95g CO2/km on average per new

car in 2020. In our view, this target can only be achieved by increasing the penetration rate of hybrid and

electric vehicles, which require ongoing high R&D spending for all car makers in Europe (particularly

premium manufacturers). European car makers have spent an average of around 5% of their revenues pa

on R&D in the past five years, which corresponds to around EUR3.5-4bn per car maker. We expect R&D

expenditure to remain high in the next few years, increasing the need to allocate this burden across a high

number of unit sales in the next few years. Size also matters in this respect.

Sector drivers Volumes and macro indicators

Volumes are the most important factor influencing EBIT margins in the auto sector and they, in turn,

depend on macroeconomic factors such as consumer confidence, unemployment, disposable income and

GDP. Sales and production forecasts for the auto sector depend on the overall outlook for consumer

spending, which itself depends on a wide range of factors, including consumer sentiment, unemployment,

GDP growth and disposable income trends. We believe consumer confidence is the best indicator of

short-term demand developments, while unemployment rates are more of a lagging indicator.

The auto sector is highly data-intensive. Some of the most closely tracked statistics are: monthly sales

numbers from ACEA for Europe, US SAAR data, and figures from other key markets such as Brazil,

China and Japan; monthly sales by car makers; incentives data in Europe and the US; residual values of

used cars; and inventory levels at dealers.

Pricing

Pricing, another closely monitored element of car makers’ margins, is influenced by a combination of

factors, including segment/product mix shifts, new product launches and general competition. For the

mass-market segment, price elasticity is fairly high, which makes it difficult to pass on price increases to

customers. For the premium car market, pricing has been better in the past few years due to soaring

demand in China, which has led to high capacity utilisation and long delivery times. It is unclear whether

this trend will remain intact, since capacity has been increased by some premium car makers and demand

growth in China has started to cool somewhat.

Product mix and new model launches

Sales mix plays a vital role in driving car maker’s earnings margins, determining, for example, whether

sales are dominated by large or small cars. Premium car makers earn higher revenue per unit by selling

larger sedans and SUVs than the mass-market car makers, which predominantly sell smaller A-, B- and

C-segment cars. Premium car makers tend to be more profitable than mass-market car makers, largely

because small cars are lower priced and typically achieve smaller earnings margins. The number of new

model launches per year is another important metric for all car makers since new models tend to achieve

better sales volumes and better pricing than older, existing models.

26


abc

Exogenous factors: FX, raw material prices and interest rates

Currencies: Since companies cannot always produce their cars in the same place as they sell them, all car

makers are exposed to currency risks. The earnings of Japanese car makers have been acutely burdened by a

strong yen, while European OEMs have benefited from a weaker euro due to the sovereign debt crisis.

Raw material prices: Steel is the most important input factor for car production, accounting for around

60% (or around 1 tonne) of the total car weight on average. Car makers have been affected by higher raw

material prices since 2010 due to contract repricing with steel makers. Other commodities used for car

production include aluminium, plastics, precious metals and rubber.

Interest rates: Financial services is an important tool that enables car makers to stimulate their new car

sales and keep residual values under control. At German premium car makers, an average of roughly 40-

50% of new car sales also include a lease or financing contract (source: company data for 2011). Due to

low refinancing costs and low credit loss ratios the financial services business has been highly profitable

for most car makers in the past two years. In the event of an economic downturn, declining residual

values are the main risk to earnings since cars coming off lease may be sold at a lower-than-expected

price, creating the potential for high one-off charges at car makers – as seen at BMW and Mercedes Cars

in 2008 and 2009.

Key segments Car makers (OEMs), automotive suppliers, tyre makers

In addition to the car makers, explained in detail above, the sector includes automotive suppliers and tyre

makers further downstream. Some of these suppliers are majority owned by OEMs, which are their main

customers.

Auto suppliers’ sales are primarily driven by production volumes and are therefore cyclical in nature.

Other important drivers are geographic exposure, as well as exposure to OEMs (premium versus mass

market), fast-growing technologies (such as active safety and emission technologies) and the key growth

platforms of OEMs (such as MQB at Volkswagen). Bosch, Continental, Faurecia and Valeo (all

European), Delphi, Johnson Controls and Magna (all US), and Aisin Seiki and Delphi (all Japanese) are

some of the major auto suppliers commanding a global footprint.

Tyre makers are considered more defensive in nature than suppliers and less exposed to the vagaries of

macroeconomic conditions, since around 75% of total tyre sales typically stem from the replacement

channel. Tyre makers are segmented by type into passenger car tyres (summer and winter (highly

profitable)), truck tyres and specialty tyres (eg mining, agricultural, aircraft tyres). Key trends include: (1)

shifting the focus to profitable premium segments; (2) a focus on regions with high growth and profit

potential (LatAm and Russia); and (3) the impact of new regulations (eg EU tyre legislation from

November 2012). Tyre makers are exposed to the highly volatile prices of natural rubber (highly

speculative prices and exposed to weather conditions in South-East Asia) and oil (the source of synthetic

rubber and carbon black, among others). Michelin, Bridgestone, Goodyear and Continental are global tyre

makers operating across all segments, while niche players Nokian and Pirelli operate in highly profitable

segments/regions. Like the car makers, Michelin and Pirelli release market data for their major regions,

and this is a closely tracked statistic in the subsector.

27


abc

Valuation The visibility of sector performance is good, as most companies provide detailed disclosures by business

segment on a quarterly basis; French firms are the exception, as they provide only sales and revenue data

quarterly, reporting both earnings and cash flow in their half-yearly report. Monthly unit sales figures also

give the market visibility on the sector’s top-line development.

Companies in the sector are typically assessed on traditional multiples, which are EV/sales, EV/EBITDA

and price/earnings ratios. We prefer to value most companies on a sum-of-the-parts basis, which makes it

possible to factor in valuation differences between mass-market, premium car and truck brands. We

currently tend to value the automotive business of premium car makers at EV/sales of 35% and EV/

EBITDA of 3.0x, whereas we value the automotive business of Renault and Peugeot at an EV/sales of

only 4% and an EV/EBITDA of 0.4x – roughly in line with the current valuation implied by (Factset)

consensus for 2012. Furthermore, we tend to value stakes held in other companies at their market or book

value, less a holding discount of at least 30%. We value the companies’ financial services businesses at

around 80% of their 2012e book value.

The main problem for us at present is coping with the current de-rating of the sector. On average, the

sector is trading 30-40% below the 12M-forward (Factset) consensus multiples seen in 2004-07, even

though the profitability of some companies (such as German car makers) is now higher. The market

seems not to believe that the currently high earnings of the premium car makers, in particular, are

sustainable. For European car makers, the average sector 12M-forward PE is currently around 6x (source:

Factset) versus around 10x for the period 2004-07. Although auto suppliers trade at similar multiples, tyre

makers generally enjoy a premium as their business is less volatile.

Autos: growth and profitability

2008 2009 2010 2011 2012e

Growth Sales -0.8% -12.1% 21.5% 15.3% 7.1% EBITDA -16.2% -29.3% 81.2% 12.2% 9.9% EBIT -44.0% -99.4% nm 32.9% 4.9% Net profit -29.2% -136.8% nm 52.5% -7.9% Margins EBITDA 11.9% 9.5% 14.2% 13.9% 14.2% EBIT 3.2% 0.0% 6.1% 7.0% 6.9% Net profit 3.1% -1.3% 4.8% 6.3% 5.4% Productivity Capex/sales 7.6% 6.8% 6.0% 6.6% 6.9% Asset turnover (x) 1.2x 1.1x 1.2x 1.2x 1.2x Net debt/Equity 0.1x 0.0x -0.2x -0.1x -0.1x ROE 9.5% -3.7% 15.1% 19.3% 15.6%

Note: based on all HSBC coverage of Auto OEMs, suppliers and tyre makers across Europe. Source: Company data, HSBC estimates

28


abc

Sector snapshot Key sector stats

MSCI Europe Auto and Components Index

3.2% of MSCI Europe

Trading data 5-yr ADTV (EURm) 1,588 Performance since 1 Jan 2000 Absolute 4.05% Relative to MSCI Europe 37.81% 3 largest stocks Daimler, BMW, Volkswagen Correlation (5-year) with MSCI Europe 0.83 Source: MSCI, Thomson Reuters Datastream, HSBC Top 10 stocks: MSCI Europe Auto and Components Index

Stock rank Stocks Index weight

1 Daimler 27.65% 2 BMW 17.61% 3 Volkswagen 19.79% 4 Michelin 7.71% 5 Renault 5.32% 6 Porsche 5.19% 7 Continental 4.77% 8 Fiat 3.01% 9 Nokian 2.81% 10 Pirelli 1.55%

Source: MSIC, Thomson Reuters Datastream, HSBC

Country breakdown: MSCI Europe Auto and Components Index

Country Weights (%)

Germany 75.6% France 16.2% Italy 5.6% UK 3.47% Finland 2.6%


Core industry driver: car registrations driven by consumer confidence

12.0

12.5

13.0

13.5

14.0

14.5

15.0

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

96

97

98

99

100

101

102

W Europe PC registration 12M rolling (m)EU consumer confidence indicator


PE band chart: MSCI Europe Auto and Components Index

0

50

100

150

200

250

300

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

MSCI Europe Auto & Comps

5x

10x

15x


PB vs. ROE: MSCI Europe Auto and Components Index

0.5x

1.0x

1.5x

2.0x

2.5x

2004

2005

2006

2007

2008

2009

2010

2011

2012

-10%

-5%

0%

5%

10%

15%

20%

ROE (RHS) PB ratio


29


abc

Beverages

Beverages team Lauren Torres Analyst HSBC Securities (USA) Inc +1 212 525 6972 [email protected]

James Watson Analyst HSBC Securities (USA) Inc +1 212 525 4905 [email protected]

Erwan Rambourg* Head of Consumer Brands and Retail, Global Research The Hongkong and Shanghai Banking Corporation Limited +852 2996 6572 [email protected]

Antoine Belge* Head of Consumer Brands and Retail Equity Research, Europe HSBC Bank Plc, Paris Branch +33 1 56 52 43 47 [email protected]

Sophie Dargnies* Analyst HSBC Bank Plc, Paris Branch +33 1 56 52 43 48 [email protected]

Sector sales David Harrington Sector Sales HSBC Bank Plc +44 20 7991 5389 [email protected]

Lynn Raphael Sector Sales HSBC Bank Plc +44 20 7991 1331 [email protected]




EM

EA

Eq

uity Research

Multi-sector

July 2012

30

ab

c

Sector structure

Beverages

Non-alcoholic Beverages Alcoholic beverages

Concentrate companies

Coca-Cola Co.

PepsiCo

Bottlers

Arca Continental

Coca-Cola Enterprises

Coca-Cola FEMSA / FEMSA

Coca-Cola Hellenic

Coca-Cola Icecek

Brewers

A-B InBev

Anadolu Efes

Boston Beer Co.

Heineken

Molson Coors

SABMiller

LatAm brewers

AmBev

Grupo Modelo

Other alcoholic beverage companies

Brown-Forman

Constellation Brands

Diageo

Pernod Ricard

Remy Cointreau

Beverages

Non-alcoholic Beverages Alcoholic beverages

Concentrate companies

Coca-Cola Co.

PepsiCo

Bottlers

Arca Continental

Coca-Cola Enterprises

Coca-Cola FEMSA / FEMSA

Coca-Cola Hellenic

Coca-Cola Icecek

Brewers

A-B InBev

Anadolu Efes

Boston Beer Co.

Heineken

Molson Coors

SABMiller

LatAm brewers

AmBev

Grupo Modelo

Other alcoholic beverage companies

Brown-Forman

Constellation Brands

Diageo

Pernod Ricard

Remy Cointreau

Source: HSBC

EM

EA

Eq

uity Research

Multi-sector

July 2012

31

ab

c

Historical PE valuation of the non-alcoholic and alcoholic beverage industry

5

10

15

20

25

30

35

40

May-92

May-94

May-96

May-98

May-00

May-02

May-04

May-06

May-08

May-10

May-12

World Consumer Non-durable Bev erages: Non-Alcoholic Bev erages: Alcoholic

1998: Valuation of Coca-Cola (KO) peaked and then began to be re-evaluated by investors

2007: Global consumer slow dow n began

2008: Investors looking fo r safety in the defensive consumer staples sector (valuations become more normalised)

Source: Factset, HSBC

EM

EA

Eq

uity Research

Multi-sector

July 2012

32

ab

c

EBIT margin versus asset turnover chart (2011)

Coca-ColaAmbev

A-B Inbev

PepsiCo

SAB

Diageo

Heineken

FEMSA

Pernod

Jiangsu Yanghe

Coke FEMSA

Modelo

Wuliangye Yibin

Carlsberg

Monster

Brown-Forman

KirinSan Miguel

Asahi

Coke Amatil

Beam

DPS

Coca-Cola En terprises

Tsing tao

Anado lu E fes

Arca Contal

Molson Coors

Asia Pacific

Baltika

Tha i Beverage

Coke He llenic

CCU

Constellat ion

Andina

0 .0

0 .5

1 .0

1 .5

2 .0

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

EBIT Margin (%)

Asse

t Tur

nove

r (x)

Boston Beer

0.8

Coke Icecek

Remy Cointreau

Source: HSBC, FactSet

33


abc

Sector description The beverage sector includes companies that develop, produce, market, sell and distribute non-alcoholic

and alcoholic products, including soft drinks, beer, wine and spirits.

Soft drink concentrate companies such as Coca-Cola Co. and PepsiCo own and market non-

alcoholic beverages. Both companies manufacture and sell concentrate/syrup to their bottling

partners. They are best known globally for their Coca-Cola and Pepsi trademark brands, but they also

have a diverse portfolio of water, juice, tea and sports drink brands.

Soft drink bottlers produce, sell and distribute soft drinks to retailers in designated regions. Coca-

Cola Co. and PepsiCo have a global network of bottling partners, in some of which they hold an

equity interest. In 2010, PepsiCo acquired its two largest bottlers, Pepsi Bottling Group and

PepsiAmericas, and Coca-Cola Co. acquired the North American bottling business from its largest

bottler, Coca-Cola Enterprises.

Brewers produce, market, distribute and sell beer. Some are regional; others, like A-B InBev,

SABMiller and Heineken, are global. Brewers have undergone a fair amount of consolidation over

the past several years, creating an industry where scale matters.

Wine and spirits companies manufacture, bottle, import, export and market a wide variety of wine

and liquor brands. They tend to be more regional than the brewers but have been active in

acquisitions and have broadened their geographic and brand exposure. Price points vary widely from

super-premium to mainstream to value brands.

Key themes Over the past couple of years, the beverage industry has experienced its fair share of challenges: a weak

consumer environment as a result of the economic downturn; the increasing cost of ingredients,

packaging and energy; and a competitive price environment. We believe beverage companies need to

revive struggling categories while focusing on potentially higher-growth categories, be proactive with

new-product introductions, rationalise costs and expand globally. On a positive note, the beverage sector

is a defensive industry, which is typically more resilient during challenging economic and market

conditions because it can offer affordable products to consumers.

Soft drinks

We believe that the key concerns and themes for the soft drink industry are:

Cost of doing business is going up, particularly sweetener (sugar and/or high fructose corn syrup)

and oil costs, but realising opportunities to offset these increases is necessary to operate more

efficiently.

Reviving the carbonated soft drink category in the US: this is a longer-term solution, and it is

easier said than done, but should be key to jump-starting volume and profit growth.

Capitalising on energy drinks, sports drinks and enhanced water: this is a near-term solution,

which should support volume growth and cater to health and wellness trends.

Lauren Torres Analyst HSBC Securities (USA) Inc. +1 212 525 6972 [email protected]

34


abc

Capturing growth in high-margin immediate consumption channel (mix): drive revenue per case

growth with improvements in product and package mix.

Stepping up media and new product launches: to remain competitive, more needs to be invested

in product promotion and development.

Focusing on and growing international operations: go where the growth is, reinvigorate domestic

operations but take advantage of opportunities overseas.

Beer

We believe that the key concerns and themes for the beer industry are:

Weak economic conditions: there has been a pullback in consumer spending, particularly on higher-

margin premium brands and on-premise purchases; beverage volume tends to track GDP growth

closely.

Currency devaluation: depending on the company’s reporting currency, a stronger US dollar may

hurt results because of higher local procurement costs and a translation hit to earnings.

Continued cost pressure: more expensive ingredients (barley, malt and hops) and packaging

(aluminium and glass) have been an issue that may not be resolved in the near future, since fixed-rate

contracts are in place.

Aggressive price promotions: the pricing environment has been favourable, but price promotions

could return to protect share and boost volume.

Intended marketing spend may not be enough: brewers may need to re-invest more in their brands

through greater and more effective marketing spend. Part of the industry’s revival could depend on

improved beer brand equity.

A competitive/consolidating industry: many beverage companies are global, and the beer industry

has become more competitive owing to consolidation.

Wine and spirits

We believe that the key concerns and themes for the wine and spirits industries are:

Trading up versus trading down: depending on the market environment, consumers tend to trade up

to higher-priced and higher-margin products that are aspirational and considered to be affordable

luxuries. But they also trade down to lower-priced and lower-margin products when disposable

income is reduced, often brought about by high unemployment.

Changing ‘share of throat’: independent of weakening macroeconomic trends, there has been a

growing preference for premium wine and spirits, and imported and craft beer, over mainstream brands.

Reasons for shift in preference: variety – catering to changing consumer tastes and needs (different

brands, package sizes and price points); brand image – desire for affordable luxuries; health-

consciousness – looking for products lower in calories or carbohydrates, such as light beers, white

wine and clear spirits; availability – good product placement and marketing, which is the

responsibility of the brand owner and distributors.

35


abc

Sector drivers In difficult market conditions, we believe it is important to consider a company’s product and geographic

portfolio, and its ability to manage costs while still investing in growth opportunities.

Resilience of beverage sales during economic downturns: these categories offer consumers

variety at attractive price points, more so with non-alcoholic than with alcoholic brands. That allows

beverage companies to achieve volume and pricing growth despite a pullback in overall spending.

Geographic diversification: global companies have an advantage over smaller competitors,

particularly those not overly exposed to any one market; they have a more stable, developed market

presence in addition to good growth potential with an emerging market presence.

Continued cost management/realisation of synergies: beverage companies have tightened their

belts, which could deliver significant cost savings and margin improvement, through realising

bottling plant or brewery efficiencies, streamlining the organisation or leveraging global scale.

Continue to invest selectively: despite continued market and industry pressures, companies need to

take advantage of investment opportunities to emerge as stronger competitors when healthier

conditions return.

Conclusions

Shift in consumer preferences

Beverage consumers want a quality product with a strong brand image.

There is a preference for premium wine, spirits and imported or craft beers, particularly in a stable or

strengthening economic environment.

There is also a need for variety, availability and healthier beverages (low calorie/low or no

carbohydrates).

Winning in a competitive environment

It is necessary to have strong brands, stronger brand equity and the strongest distribution system.

The right balance of volume and pricing growth, while running an efficient production and distribution

system, is essential.

Managing through a tough cost environment (rising energy and raw-material costs) is key.

Global players should be better positioned to capture future growth

Scale and scope matter in the beverage industry.

We expect to see more acquisitions and production, sales and distribution agreements among companies.

Global players realise growth in core, profitable markets but also look to expand into emerging markets.

They capitalise on favourable demographics, particularly younger consumers with more disposable

income.

36


abc

Key segments Developed markets – US and Europe

The beverage industry has flourished in developed markets where consumers have higher disposable income

and where there is strong brand equity and loyalty. According to Coca-Cola Co., 403 eight-ounce servings

of its products were consumed per person in 2011 in the US versus the worldwide average of 92 servings. In

Europe, this number varies by country (Italy 137, France 149, Great Britain 210, Spain 287 and Belgium

340), but the average is greater than the worldwide average and is increasing. Beverage volume growth in

the industry often trends in line with GDP growth on a country-by-country basis. Therefore, low to mid single-

digit total ready-to-drink (RTD) beverage volume growth has typically been delivered on an annual basis.

In addition to improving volume, beverage companies have benefited from increased pricing, which generally

tracks in line with inflation. As a result, revenue growth in the industry can increase at a mid to high single-

digit rate. In developed markets, non-alcoholic and alcoholic beverage companies strive to achieve

sustainable, balanced volume and pricing growth. Owing to the aspirational yet affordable nature of the

beverage category, there is pricing power in the industry, which is traditionally absorbed by the consumer.

Emerging markets – Latin America, Asia and Africa

According to Coca-Cola Co., it is focused on doubling its business this decade by “driving profitable

growth through innovation in developed markets; maximising value through segmentation and building

consumer loyalty in developing markets; and driving volume and investing for accelerated growth in

emerging markets”. Delivering growth from less developed markets has been a key strategy for most

global beverages companies, which are looking to capitalise on a growing and more affluent consumer

base. Over the past several years, when developed market performance slowed because of a weaker

economy, developing markets continued to produce above-average volume growth in the beverage sector.

Consumers in markets such as Latin America, Asia and Africa have chosen to spend a greater percentage

of their increasing discretionary income on packaged goods, specifically RTD beverages. In Latin

America, particularly Mexico, per-capita consumption of Coca-Cola’s products has traditionally been

high but continues to increase as consumers consider these products to be affordable. Beverage

companies are interested in attracting new consumers, keeping them within their product portfolio (across

all beverage categories) and then eventually trading them up to higher-priced brands. We believe that the

soft drink, beer, wine and spirits industries have been successful at generating increased interest in their

various products, while looking to gain both volume and value share.

A diverse product and geographic portfolio offers some stability during challenging macroeconomic

conditions. Beverage companies that offer a wider variety of products at different price points to

consumers in various regions are less inclined to be affected by country-specific macro or industry

pressures. Global beverage players tend to benefit from better volume growth in underdeveloped,

emerging markets, while realising higher profit growth from more mature, established markets. In soft

drinks, both Coca-Cola Co. and PepsiCo have looked to stabilise their flagship US businesses and

strengthen their international franchises. Among the brewers, the three largest competitors – A-B InBev,

SABMiller and Heineken – have been active building a global presence, both organically and through

acquisitions. Similarly, larger spirits companies look to capitalise on an increasing number of consumers

across the world with growing income levels, particularly in emerging markets.

37


abc

Valuation Beverage companies tend to trade on forward-looking price/earnings ratios and on EV/EBITDA. For Coca-

Cola Co. and PepsiCo, PE is the most widely used valuation metric. There are disadvantages to using PE for

brewers, as there have often been a number of below-the-line items with wildly skewed earnings (EPS),

meaning EV/EBITDA could be a better metric for historical and peer group comparison. For the bottling

stocks, EV/EBITDA is a better metric, since the companies tend to be more capital/debt-intensive.

The graph ‘historical PE valuation of the non-alcoholic and alcoholic beverage industry’ shows beverage

companies have traded, on average, in a rather narrow range, and typically reflect the economic, market

and consumer environments. There are some outliers that take into consideration mergers, acquisitions, or

market speculation of a potential change in the industry. In the non-alcoholic beverage industry, Coca-

Cola Co.’s share price began to fall after reaching historical highs in the late 1990s, as growth rates began

to slow and relationships with its bottling partners became disjointed. In the alcoholic beverage industry,

certain stocks have traded more on takeout speculation, rather than fundamentals, as there has been a fair

amount of M&A activity in the sector.

Currently, the concentrate companies are trading at 16-18x 2012 consensus earnings, below historical

averages in the high-teens. On EV/EBITDA, the bottlers are trading at 7-11x 2012 consensus EBITDA

estimates, in line with historical averages. For the brewers, 8-15x 2012 consensus EBITDA is the current

range, with faster-growing companies, such as Brazilian brewer AmBev, at the high-end of the range.

We would also highlight that bottling stocks tend to be more volatile than the concentrate companies.

They are more exposed to higher ingredient, packaging and energy costs. Brewers face the same pressures

but typically are more diversified and can manage this more effectively. Lastly, when looking at a

company’s results, it is important to sift through reported and organic (comparable) results to understand

its true growth rates.

Global beverages: growth and profitability (calendarised data)

2009 2010 2011 2012e 2013e

Growth Sales 21.5% 9.2% 14.8% 8.3% 7.1% EBITDA 24.9% 10.4% 10.3% 7.7% 8.3% EBIT 26.8% 13.4% 9.7% 8.6% 9.5% Net profits 25.1% 19.8% 12.7% 10.4% 10.0%

Margins

EBITDA 29.9% 30.4% 29.6% 29.5% 29.9% EBIT 24.6% 25.7% 24.9% 25.1% 25.6% Net profit 15.6% 17.0% 16.7% 17.1% 17.5%

Productivity

Capex/sales 5.3% 5.9% 6.6% 6.2% 5.9% Asset turnover (x) 0.71 0.65 0.65 0.66 0.67 Net debt/equity 14.8% 15.5% 16.0% 13.8% 11.2% ROE 27.7% 25.0% 24.6% 24.6% 24.3%

Note: based on all HSBC coverage of global beverages. All data is market-cap weighted. Source: Company data, HSBC estimates

38


abc


MSCI Europe Beverages Dollar Index

3.4% of MSCI Europe US Dollar

Trading data 5yr ADTV (EURm) 436 Aggregated market cap (EURm) 284.4 Performance since 1 Jan 2000 Absolute 201% Relative to MSCI Europe US Dollar

209%

3 largest stocks Diageo, Anheuser-Busch InBev, SABMiller

Correlation (5-year) with MSCI Europe US Dollar

0.52


Top 10 stocks: MSCI Europe Beverages Dollar Index


1 Diageo 30.3% 2 Anheuser-Busch InBev 27.8% 3 SABMiller 17.6% 4 Pernod-Ricard 10.3% 5 Heineken 5.4% 6 Carlsberg 3.8% 7 Heineken 2.0% 8 Coca-Cola Hellenic 1.7% 9 Remy Cointreau 1.1% 10 _


Country breakdown: MSCI Europe Beverages Dollar Index

Country Weights (%)

UK 47.9% Belgium 27.8% France 11.4% Netherlands 7.4% Denmark 3.8% Greece 1.7%


Core industry driver: Eurozone GDP and inflation

-6

-4

-2

0

2

4

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

GDP Inflation


PE band chart: MSCI Europe Beverages Dollar Index

8x

11x

14x

17x

50

100

150

200

250

300

350

2004 2005 2006 2007 2008 2009 2010 2011 2012


PB vs. ROE: MSCI Europe Beverages Dollar Index

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2004 2005 2006 2007 2008 2009 2010 2011 20129.0

11.0

13.0

15.0

17.0

19.0

21.0

12M Fwd PB 12M Fwd ROE (RHS)


39


abc

Business services

Business services team Matthew Lloyd* Analyst HSBC Bank plc +44 20 7991 6799 [email protected]

Alex Magni* Analyst HSBC Bank plc +44 20 7991 3508 [email protected]

Rajesh Kumar* Analyst HSBC Bank plc +44 20 7991 1629 [email protected]


EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

40

ab

c

Sector structure

Business services

BPO/Consulting

Capita

Experian

Serco

Xchanging

Distributors

Bunzl

Electrocomponents

Premier Farnell

Wolseley

Staffing

Adecco

Hays

Michael Page Intl

Randstad

SThree

USG

Rentals

Aggreko

Ashtead

Northgate

Regus

Security

G4S

Securitas

Prosegur

FM & Hygiene

Berendsen

Mitie

Rentokil Initial

TIC

Bureau Veritas

SGS

Intertek

Business services

BPO/Consulting

Capita

Experian

Serco

Xchanging

Distributors

Bunzl

Electrocomponents

Premier Farnell

Wolseley

Staffing

Adecco

Hays

Michael Page Intl

Randstad

SThree

USG

Rentals

Aggreko

Ashtead

Northgate

Regus

Security

G4S

Securitas

Prosegur

FM & Hygiene

Berendsen

Mitie

Rentokil Initial

TIC

Bureau Veritas

SGS

Intertek

Source: HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

41

ab

c

Sector price history

-60%

-40%

-20%

0%

20%

40%

60%

80%

May -

91

May -

92

May -

93

May -

94

May -

95

May -

96

May -

97

May -

98

May -

99

May -

00

May -

01

May -

02

May -

03

May -

04

May -

05

May -

06

May -

07

May -

08

May -

09

May -

10

May -

11

May -

12

-30%

-20%

-10%

0%

10%

20%

30%

40%

UK Business Serv ices support index (LHS) US Market Prox y (RHS)

M arch 1991End of recessio n

M arch-November 2001US Economic recession

Lehman co llapse

December 2007Great Recessio n in US

October 2009US employment rate at 10.1%, the highest since 1983

Source: BLS, Thomson Reuters Datastream, HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

42

ab

c

12-month rolling PE multiple (3M average) versus mark-up over labour (average of 2009-11)

SG S

Ha y s

A dec c o

M itie

Ca p ita

Interte k

B ure au V erita s

S e rc o

S e cu ritas

P ro s egu e r

S T hre e

R an d stadG 4SUS G

9 .0

1 1 .0

1 3 .0

1 5 .0

1 7 .0

1 9 .0

2 1 .0

1 0 % 20 % 3 0% 40 % 5 0 % 60 % 7 0% 80 % 90%

M a rk -u p o ve r lab ou r co st (2 009 -11 )

12M

ro

llin

g fw

d P

E (3

M a

vg)


43


abc

Sector description Business services firms can be generally classified as enablers or intermediaries. The sector includes

businesses such as staffing, distributors, testing & inspection, and BPO/consulting firms.

BPO/consulting firms have a broad variety of business models. At one end of the spectrum there are pure

outsourcing firms, which work on a cost arbitrage model, and at the other end, there are consulting firms

providing engineering and design services to their clients.

Distributors purchase items, store them and re-sell to a client base. The distributors sub-sector has a very

diverse client exposure, ranging from builders and grocery stores to janitors and research scientists.

Staffing includes firms which provide permanent and temporary workforce to organisations, and is

primarily categorised as general staffing business, focusing on positions requiring general skills, and

professional staffing business, focusing on positions requiring professional skills.

Rental services is a heterogeneous sub-sector, where companies broadly work on renting a variety of

assets. The different rental companies are distinguished from one another by factors such as asset type,

geographical exposure, capital structure and economic sensitivity.

Security services provide a wide array of security services such as manned guarding, prison management,

alarm monitoring and security assessment. The industry is fragmented and services are offered to the client

either directly or through a facilities management contractor. The latter is more common in the UK and the US,

the former in Europe.

FM and hygiene offer a range of diverse services at the premises of their clients, ranging from facilities

management, pest control and reception services to work-wear and linen, among others.

Testing & inspection firms serve a wide range of industries, testing, inspecting, auditing, and certifying

products, commodities and services based on regulatory or voluntarily adopted standards.

Key themes BPO/consulting

Outsourcing companies tend to have less cyclical cash-flow streams than the rest of the sector. However,

the most pertinent question is how far individual companies are less cyclical, or indeed whether they

respond differently to different cycles. For valuations to be attractive, the companies must show more

defensive growth than is in the price. This will depend upon three issues: (a) whether non-public

expenditure is non-cyclical; (b) whether business revenues are affected by the tax receipt cycle; and (c)

how margins are affected by the cycle.

Distributors

Distributors suffer or benefit from the cyclicality of their clients. They have an arsenal of efficiency

measures to offset pricing and volume pressures. One option is to aim to use fewer, larger and better-

stocked centres – which can reduce staff costs and free up property. This process has been under way for

some time and is now largely complete, although additional options remain. Costs may also be reduced

by managing the number of stock-keeping units (SKUs). By focusing on a smaller list of SKUs, a

distributor can focus its purchasing power on fewer suppliers and reduce input costs. Another cost-

Matthew Lloyd* Analyst HSBC Bank Plc +44 20 7991 6799 [email protected]

Alex Magni* Analyst HSBC Bank Plc +44 20 7991 3508 [email protected]

Rajesh Kumar* Analyst HSBC Bank Plc +44 20 7991 1629 [email protected]


44


abc

reduction strategy is the use of private labels or own brands. This enables a distributor to buy large

quantities of a product from a supplier and offer them to clients at a discounted rate, enhancing their gross

margins. However, if distributors engage in cost-cutting measures that cut capacity in a downturn, this

can reduce the medium-term upside during the ensuing recovery.

The distribution business lends itself to acquisitions because of the fragmented nature of the market.

Another increasing trend among distributors is to move towards web-based sales. Typically, web sales are

not only higher margin but also result in better inventory management and higher cash conversion.

Staffing

Staffing companies’ growth is linked to labour market gross volumes and velocity. The market closely

watches industry data about the number of vacancies, as well as the hours and wages of temporary and

permanent placements. In addition, time-to-hire has a major impact on organic growth and operational

gearing. Time-to-hire measures the speed at which vacancies are converted into sales. Ceteris paribus, if

vacancies grow and the time taken to convert each vacancy into sales declines, that should boost staffers’

organic growth rates and operational gearing. Analysis based on pure vacancies is problematic as it does

not capture the time lag between the vacancy being posted and the actual filling of the vacancy. One of

our preferred lead indicators to analyse underlying demand for the staffing sector is “vacancies adjusted

for time-to-hire”, as it directionally leads both vacancies and organic growth rates for staffers, numbers of

temps, multiples and share prices.

The key distinction between staffers stems from the temp:perm mix, and geographical diversity. Blue-

collar temps are a largely low-margin business with limited operational gearing, but during economic

recovery they grow before white-collar temps. In the early stages of a recovery, temp tends to recover

earlier and more quickly than perm, since permanent staff are expensive and carry more employment

risks. However, during initial phases there is frequently a spurt of catch-up hiring in the labour market.

When an early spurt in perm subsides, gross profit growth becomes subdued as temp constrains the value

per sale and the gross margins. However, growth in overheads tends to be more correlated to volumes.

Indeed, this effect particularly bedevilled the profit recovery during the early part of this decade, and in

the early 1990s. Evidence that operational gearing is a later-cycle phenomenon is powerful, given that

wage growth happens in the later stages. In previous recoveries, there has been emergent pricing pressure

on certain key sections of the market. The effect was significant in the blue-collar markets and the UK IT

market in 2001-04.

Rental companies

Despite its cyclical end-markets, the rental business model permits an unusual degree of flexibility in

controlling cash flows. The capital base in a rental business is not fixed and can be expanded or shrunk

quickly in response to changing end-markets. Rental companies are also notorious for their gearing,

which exaggerates profit and share price behaviour at turning points in an economic cycle. The nature of

this gearing is more nuanced than it first appears, though. Consolidation is a long and ongoing structural

trend in these fragmented markets, and rental companies’ ROIC profiles tend to approximate their cost of

capital across a cycle.

45


abc

Security firms

The business is widely viewed as late cyclical, and has historically shown margin pressure late in the

cycle. This is because the upward pressure to raise wages clashes with clients’ desire to reduce costs. In

developed markets, guarding is a reasonably mature market and outsourced service appears to be a stable

proportion of the market. Advances in technology have extended the scope of security to electronic

surveillance and monitoring. These services are normally a mark-up to labour charges. Security firms

nowadays provide integrated technology services, offering bundled services of access control, alarms and

monitoring services, for example.

Testing and inspection

The stocks are seen as global trade plays with limited cyclical downside, well positioned to benefit from a

recovery in global trade and likely to continue to outperform in a downturn, both in terms of organic

growth and share prices. As most contracts have wage inflation escalators, rising wages are a significant

element of organic growth, and are highly correlated to it. Broadly, wage rate inflation is fastest in the

emerging markets, as is organic growth, and this is where margins, and returns, are highest. We would

argue that geographic mix is an equally important factor to consider in addition to business mix. At least

half of the organic growth of testing companies over the past decade has been the result of passing

through wage inflation, which is higher in emerging markets. Our industry analysis suggests that

emerging market operating margins for the sector are significantly greater than in the developed world.

The difference in growth rates between the two halves of the world should support testing companies’

margins and return profiles over the next five years.

FM and hygiene

FM and hygiene businesses provide a host of diverse services, and the various businesses face different

markets and challenges. Given this diversity, some of the companies in the sector have complex margin

drivers. Spot-contract mix is one of the key determinants of margins. Historically, spot sales have been

around 8-10% of sales at the peak of the cycle and have disappeared in recessions; however, they held up

in the latest downturn.

Sector drivers Leading indicators: The broad lead indicators for the sector include the TCB leading indicator, OECD

leading indicators and ISM. Each sub-sector has a different lead indicator specific to the dynamics of the

business. For distributors, key leading indicators are industry shipments, book-to-bill ratio and inventory-

to-sales ratio. The clients’ lead indicators are also important for analysing distributors. As with building

distributors, the key leading indicators are private housing starts, housing price and inventory, and

plumber man-hours, for example. The US employment market has historically been a leading indicator

for the rest of the world. The best leading indicator for labour markets remains US temp numbers. For the

rest of the blue-collar general services, man-hours are among the key indicators, eg security man-hours,

alarms man-hours and uniform supply man-hours for security firms, and pest control man-hours, grocery

man-hours and janitorial man-hours for FM and hygiene.

Outsourcing

Government spending: Companies in this sub-sector have varying exposure to government contracts

and are directly exposed to local and central government spending, driven by government revenue, fiscal

46


abc

deficit and tax receipt cycles. Government tax receipt cycles play a key role, and growth in the companies

exposed to the public sector has weakened in the wake of a fall in government tax receipts in previous

cycles.

Contract mix: Margins of BPO and consultancy companies are largely determined by the contract and are

applicable for long periods. Although contracted revenues are indexed to inflation, the key driver of

margin is mix: the more complex the contract, the more margin variation is possible. Spot business

generally attracts higher margins while longer-term contracts usually have lower margins.

Distributors

Cyclicality of client: Distributors have a diverse client exposure, ranging from builders and grocery

stores to janitors and research scientists. These clients exhibit a degree of cyclicality, which either hurts or

benefits the distributors. The more cyclical the client base, the more cyclical a distributor’s business.

Inflationary or deflationary environment: Distributors are beneficiaries of a mildly inflationary

environment as there is a lag of a few weeks or months between their purchase and sale of a product.

Generally they are able to pass on most of the inflationary price rise to their clients, giving them holding

period gains. The effect is magnified lower down the P&L because much of the SG&A is volume related.

Ceteris paribus, in a period of ‘accepted inflation’, sales rise faster than volumes, gross margins may

nudge up, and SG&A costs grow with volume. In a deflationary period, the inverse is true.

Staffing

Temp/perm mix: Temporary staffing is a lower-margin business than permanent placement as the wages

of a temporary worker form part of the agents’ sales and cost of goods sold, whereas no such cost exists

for a permanent placement. A decline in the perm mix has a magnified impact on margins.

Wage rate mix: A lower wage rate implies a lower gross margin. The wages of candidates are a product

of the scarcity of their skills at any point in time. This same scarcity tends to drive the gross margin that a

staffing agency can charge for sourcing candidates. A fall in the average wage rate reduces the value of

sales more than a fall in volume, and also affects the gross margins or conversion of gross margin into

operating profit.

Rental companies

Size is a key driver for rental companies given low entry barriers and service differentiation. Large,

diversified fleets help broaden the customer base, give negotiation power and help to achieve economies

of scale. Long-run returns are driven by: (1) rental rates; (2) utilisation; (3) cost of delivery (sales,

purchasing, maintenance, distribution and services); and (4) the cost of funds. Scale helps in all four.

Testing and inspection

TIC stocks have a strong structural story to support their obvious growth: trade globalisation, product

diversity, outsourcing and regulation all drive testing and inspection volumes. A further important factor

is pricing driven by the pass-through of wage inflation. The organic sales growth of the TIC stocks is

driven by: the number of testers, inspectors, certifiers and billable hours. Pricing growth is largely driven

by wage inflation for front-line staff – explicitly in many contracts, implicitly in others. Pricing power

causes increases in wage costs to be passed through on the whole of the contract amount. Other costs

grow slower than wages, providing a mechanism to support and drive margins. As wage rate inflation is

47


abc

fastest in the highest-margin geographies, the pass-through of wage inflation supports margins, and

margin expansion is more feasible than many believe.

Other businesses sector

The other businesses sector covers a host of largely blue-collar general services. These tend to be

contract-backed but volume-dependent. If a client wishes to clean its facilities less frequently or engages

less security, both sales and margins are likely to come under some degree of pressure. Most such

services are cyclical and can be tracked through employment numbers. The core economics of the

security business is the mark-up over the cost of labour. Gross margin risk can frequently come from

rising wage rates, which cannot be passed on to customers in a recession.

Valuation Companies in this sector trade on traditional metrics, with a few exceptions. PE is the most widely used

multiple, but EV/EBITA and EV/EBITDA are also used (mainly for rental firms), EV/sales, FCF yield

and FCF to EV. Where pension liability is a concern, analysts prefer EV/EBITA (adjusted for the

pension). Some prefer a blended valuation based on relative valuation, historical multiples and DCF.

However, use of DCF should be viewed with caution – particularly during periods of economic

uncertainty and poor earnings visibility.

The average 12-month rolling forward mid-cycle PE multiple (2006-07) for the business services sector

was 15x (range of 12x to 20x), versus 12x in the last downturn (range of 7x to 21x). However, PE

multiples in the sector tend to range widely whatever the economic climate, due to the differing growth

and margin profiles. Security firms generally trade at the lower end of the spectrum (average mid-cycle

multiple of 12x); testing and inspection companies command a higher premium (18x) owing to their

better margin and return profile.

Accounting notes

Companies in the sector report their profits differently, despite sharing nomenclature such as trading

profit, operating profit, EBIT and EBITA. The key differences stem from the classification of

amortisation arising from acquisition intangibles, the share of profit from associates and exceptionals. The

comparison of multiples across companies should therefore be approached with caution, to ensure that

they convey the same economic content. It is also important to keep track of changes in regulation and the

resulting impact on accounts. For instance, a change in regulation requiring a reclassification of French

business tax from COGS to tax has boosted gross margins for staffing companies without affecting

EPS/operating cash flow.

48


abc

Staffing sector: growth and profitability

2010 2011 2012e 2013e

Growth Sales 13.6% 11.1% 2.0% 6.3% EBITDA 68.0% 11.9% 8.2% 18.7% EPS growth 95.0% 14.0% 12.8% 25.4% Margins EBITDA 5.4% 5.3% 5.5% 6.2% Multiples PE 15.1 13.0 11.9 9.5 EV/EBITDA 8.2 7.4 6.6 5.1 FCF/EV 7.9% 9.0% 9.1% 13.6% ROE 14.8% 11.2% 14.5% 16.4% Mark-up over labour 55.4% 37.9% 38.3% 42.3%

Note: based on all HSBC coverage of Staffing sector (market cap weighted) Source: Company data, HSBC estimates

Testing and Inspection sector: growth and profitability

2010 2011 2012e 2013e

Growth Sales 6.2% 10.9% 12.4% 11.3% EBITDA 7.5% 6.6% 11.9% 15.0% EPS growth 5.0% 4.5% 15.0% 18.7% Margins EBITDA 20.9% 20.1% 20.0% 20.7% Multiples PE 24.5 23.5 20.4 17.2 EV/EBITDA 11.5 11.0 9.8 8.3 FCF/EV 4.4% 3.2% 4.2% 5.6% ROE 36.5% 32.4% 32.1% 32.3% Mark-up over labour 51.6% 46.9% 49.4% 54.1%

Note: based on all HSBC coverage of testing and inspection sector (market cap weighted) Source: Company data, HSBC estimates

49


abc


Business services % of MSCI Europe US Dollar not meaningful*

Trading data 5-yr ADTV (USDm) 473 Aggregated market cap (USDm) 121,463 Performance since 1 Jan 2000 Absolute* 128% Relative to MSCI Europe US Dollar

149%

3 largest stocks SGS, Experian, Wolseley Correlation (5-year) with MSCI Europe US Dollar **

0.64

* Due to the nature of the sector, other indices are used to demonstrate its structure. *Absolute price performance for the sector for all listed companies since 1 January 2000, and is weighted by market cap. **Correlation of Europe Business Services Price index with MSCI Europe Source: MSCI, Thomson Reuters Datastream, HSBC

Top 10 stocks: Bloomberg EMEA Commercial Services Index


1 SGS 8.49% 2 Experian 8.30% 3 Wolseley n/a 4 Bureau Veritas 5.57% 5 Aggreko 5.37% 6 Adecco 4.49% 7 Intertek 3.88% 8 Capita 3.52% 9 G4S 3.58% 10 Bunzl 3.09%

Source: Bloomberg

Country breakdown: Bloomberg EMEA Commercial Services

Country rank Country Index weight

1 UK 32.9%

2 France 19.5%3 Switzerland 13.3%4 Ireland 8.7%5 Spain 7.6%6 Italy 6.0%

Source: Bloomberg

Core industry driver: ISM and US temps (m-o-m annualised)

-80%-60%-40%-20%

0%20%40%60%

May

-94

May

-97

May

-00

May

-03

May

-06

May

-09

May

-12

-20

-100

10203040

US Temps (m-o-m annualised) (LHS)ISM : New Orders less Inv entories Spread (RHS)


PE band chart: Bloomberg EMEA Commercial Services Index

0

500

1000

1500

2000

2500

May

-94

May

-97

May

-00

May

-03

May

-06

May

-09

May

-12

20x

10x

15x

5x

Europe Business Serv ices Price lev el


Europe Business Services PE and PB multiples

0.0

10.0

20.0

30.0

40.0

50.0

May

-91

May

-94

May

-97

May

-00

May

-03

May

-06

May

-09

May

-12

0.0

1.0

2.0

3.0

4.0

5.0

Europe Business Serv ices PE (RHS)Europe Business Serv ices PB (LHS)


50


abc

Notes

51


abc

Capital goods

Capital goods team Colin Gibson* Global Sector Head, Industrials HSBC Bank plc +44 20 7991 6592 [email protected]

Michael Hagmann* Analyst HSBC Bank plc +44 20 7991 2405 [email protected]

Sector sales Rod Turnbull Sector Sales HSBC Bank plc +44 20 7991 5363 [email protected]

Oliver Magis Sector Sales HSBC Trinkaus & Burkhardt AG, Germany +49 21 1910 4402 [email protected]

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

52

ab

cSector structure

Capital goods

Core capital goods Aerospace & defenceConstruction / building

materialsDiversified / multi-industry

conglomerates

Eaton

Emerson Electric

General Electric

Hitachi

Honeywell

Hyundai Heavy

Philips

Siemens

Toshiba

United Technologies

Process technology

Alfa Laval

Andritz

Flowserve

GEA

Invensys

Metso

Omron Corp.

Parker-Hannif in

Rotork

Sulzer

Yokogawa Electric

Production technology

Atlas Copco

Fanuc

JTEKT

NSK Bearings

Kennametal

Rockwell Automation

Sandvik

SKF

Transport/comm. vehicles/const. equip

Bombardier

Caterpillar

Fiat Industrial

Hitachi Construction

Komatsu

MAN AG

Paccar

Scania

Terex

Volvo

Wärtsilä

Building technology

Assa Abloy

Cooper Industries

Daikin

Hubbell Inc.

Johnson Controls

Keyence Corp.

Kone

Legrand

Schneider Electric

Power technology

ABB

Alstom

BHEL

Dongfang Electric

Doosan Heavy

Harbin Power

Mitsubishi Heavy

Prysmian

Shanghai Electric

Capital goods

Core capital goods Aerospace & defenceConstruction / building

materialsDiversified / multi-industry

conglomerates

Eaton

Emerson Electric

General Electric

Hitachi

Honeywell

Hyundai Heavy

Philips

Siemens

Toshiba

United Technologies

Diversified / multi-industry conglomerates

Eaton

Emerson Electric

General Electric

Hitachi

Honeywell

Hyundai Heavy

Philips

Siemens

Toshiba

United Technologies

Process technology

Alfa Laval

Andritz

Flowserve

GEA

Invensys

Metso

Omron Corp.

Parker-Hannif in

Rotork

Sulzer

Yokogawa Electric

Process technology

Alfa Laval

Andritz

Flowserve

GEA

Invensys

Metso

Omron Corp.

Parker-Hannif in

Rotork

Sulzer

Yokogawa Electric


Atlas Copco

Fanuc

JTEKT

NSK Bearings

Kennametal

Rockwell Automation

Sandvik

SKF


Atlas Copco

Fanuc

JTEKT

NSK Bearings

Kennametal

Rockwell Automation

Sandvik

SKF


Bombardier

Caterpillar

Fiat Industrial


Komatsu

MAN AG

Paccar

Scania

Terex

Volvo

Wärtsilä


Bombardier

Caterpillar

Fiat Industrial


Komatsu

MAN AG

Paccar

Scania

Terex

Volvo

Wärtsilä

Building technology

Assa Abloy

Cooper Industries

Daikin

Hubbell Inc.

Johnson Controls

Keyence Corp.

Kone

Legrand

Schneider Electric

Building technology

Assa Abloy

Cooper Industries

Daikin

Hubbell Inc.

Johnson Controls

Keyence Corp.

Kone

Legrand

Schneider Electric

Power technology

ABB

Alstom

BHEL

Dongfang Electric

Doosan Heavy

Harbin Power

Mitsubishi Heavy

Prysmian

Shanghai Electric

Power technology

ABB

Alstom

BHEL

Dongfang Electric

Doosan Heavy

Harbin Power

Mitsubishi Heavy

Prysmian

Shanghai Electric

Source: HSBC

53


abc

Sector price history (12M-forward PE) Overall sector Sub-sector: diversified/multi-industry

6

10

14

18

22

26

30

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

+ 2 Std. Dev

- 2 Std. Dev

6

10

14

18

22

26

30

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

+ 2 Std. Dev

- 2 Std. Dev

Source: Thomson Reuters Datastream, HSBC calculations Source: Thomson Reuters Datastream, HSBC calculations

Sub-sector: production technology Sub-sector: power technology

6

10

14

18

22

26

30

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

+ 2 Std. Dev

- 2 Std. Dev

6

12

18

24

30

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

+ 2 Std . Dev

- 2 Std. Dev


Sub-sector: building technology Sub-sector: transport/comm. vehicles/const. equip

6

10

14

18

22

26

30

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

6

10

14

18

22

26

30

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

+ 2 Std. Dev

- 2 Std. Dev


EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

54

ab

cEBIT margin versus capital turnover (2007-11 average)

Metso

Wartsila

Volvo

SKFSiemens

Schneider Electric

Sandvik

Philips

Legrand

Kone

Atlas Copco

Alstom

Alfa Laval

ABB

0.0

1.0

2.0

3.0

4.0

5.0

6.0

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0% 20.0%

EBIT margin (%)

Inve

sted

Cap

ital T

urno

ver (

x)


.

55


abc

Sector description The distinguishing characteristic of the capital goods sector is its heterogeneity, which extends through

technologies, applications and customer groups, showing up in growth rates, profitability levels and, ultimately,

valuation multiples. Diverse markets are inevitably niche markets, with relatively little good third-party

data (no Gartner, no JD Power). Much of the job of capital goods research is thus to develop an understanding

of the specific markets in which a supplier is active, likely growth rates and its competitive environment.

Within capital goods, many sub-sectors have historically been, and continue to be, relatively cosy

oligopolies. Often, the rump of the market is highly fragmented and occupied by many smaller unlisted

companies, whose profitability and financial health are hard to ascertain.

There are normally positive economies of scale to be had, so barriers to entry are high, rewarding

incumbent leaders. These barriers do not just refer to manufacturing efficiency but also input costs and,

perhaps most importantly, aftersales provision. Capital goods is differentiated from consumer goods by

the utilisation level: companies typically sweat assets far more than private individuals do. Aftersales or

‘MRO’ (maintenance, repair and overhaul) therefore accounts for much more of the total market

opportunity than it usually would in consumer markets. Buyers typically expect reliable and

geographically extended MRO networks, which new entrants struggle to provide. The leading companies

in each sector have traditionally exploited this power and have faced relatively few pricing pressures;

there have been instances of price-fixing and collusion on occasion.

Key themes Volume (growth) and price decoupling

There seems to be an iron law for capital goods suppliers: there is a long-term inverse relationship between an

equipment market’s trend rate of price erosion and its trend rate of volume growth. Through the low-capex

1990s, this was the saving grace of low-growth mature capital goods: these may not have been enjoying tech-

like volume growth rates but they were not suffering tech-like pricing pressure either. Things seemed to have

changed in the 2000s, with companies enjoying both strong volume growth and a good pricing environment,

which in hindsight was because of the relatively inflexible supply curves that resulted from the years of low

growth.

For much of 2011, Europe’s capital equipment makers, most of which operate in oligopolies, enjoyed

double-digit volume growth but suffered considerable cost inflation (raw materials). Generally, this

scenario would depict an archetypal sellers’ market, with the prospect of robust price increases. But that

was not the case, as price/mix were slightly negative during the year. Moreover, there was a great divide

between machinery makers – most of which managed to generate at least some degree of positive pricing,

and electrical equipment makers – most of which did not.

We believe that 2011 witnessed the start of what might well become a multi-year supply response to the

strong volume growth enjoyed by equipment makers in the past decade.

Emerging versus developed markets

In emerging markets, dominated by the ‘E3’ of China, India and Brazil, demand has focused on the rapid

build-out of infrastructure and manufacturing capacity. In developed markets, demand focuses more on

replacement and MRO. EM capex grew rapidly over the past decade and, as a result, the dollar value of

Colin Gibson* Analyst HSBC Bank plc +44 20 7991 6592 [email protected]

Michael Hagmann* Analyst HSBC Bank plc +44 20 7991 2405 [email protected]


56


abc

capex in those countries is now greater than in DMs. However, this said, we expect the big spread that we

have seen between EM and DM capex growth rates over the past decade to narrow again.

It’s all about the energy

A key capital goods theme has been the provision of energy to a rapidly industrialising EM space, and

power technology companies have benefited. At the same time, demand for more modern energy

technology is seen in DMs, where a combination of political pressure for energy efficiency, increasing oil

prices and environmentalism has led to demand for cleaner, more efficient energy technology. Put simply,

EMs need energy right now; DMs need clean energy.

Providing a ‘solution’

‘Solution’ has become a buzzword within the capital goods sector and represents a desired step away

from just supplying a tangible product. A classic example is the bundling together of a product with a

service component (aftermarket care, or energy efficiency consulting) in order to provide a more

comprehensive, higher-value-added product offering. This often has positive effects on margin expansion,

while the service element adds balance sheet lightness to the equation.

Restructuring effects and operational leverage

Post-Lehman, the sector underwent widespread restructuring, aimed at targeting the cost side and preserving

margins in the face of declining sales. Some companies put staff on shorter working contracts (four-day

weeks not being uncommon), while others closed factories and reduced staffing levels. In some instances,

existing progressions to relocate manufacturing jobs to low-cost countries were accelerated, with plants in

Western Europe being converted to assembly rather than actual manufacture, or being closed altogether.

Key components: assembly versus manufacture

In the first decade of the new millennium, unfocused conglomerates began a wave of divestments, exiting

non-core operations in order to concentrate on more profitable, value-added activities. Businesses that had

become commoditised and consequently faced greater competition, from, say, EM manufacturers (such as

cable manufacturing or semi-conductors) were spun out (either via IPO or trade sale or LBO).

This refocusing on ‘core activities’ has involved companies much more actively in the ‘make or buy’

decision. Outsourcing of components increased (not limited to just ‘simple’ components), in turn

increasing the proportion of ‘assembly’ business. This outsourcing has increased the flexibility of capital

goods companies, but has also led to some occasions of supply chain problems, where specific

components are in short supply.

Sector drivers Capex cycle

Capital goods companies’ earnings are directly related to their end customers’ capital expenditure activities,

in both the private and public sector (the latter currently exposed to austerity budgets). Customer activity, in

turn, is linked to the broader economic cycle, and the likelihood that these capex investments will generate

positive-NPV projects. As such, the financing environment for such projects must also be borne in mind.

Capex versus opex

Despite this primary focus on capex, there is also a distinction between a customer’s capital expenditure and its

operational expenditure – capital goods firms vary in their exposure to either. Mining equipment companies,

57


abc

for example, are often more exposed to customer opex than true capex (they sell more replacement drill heads

than complete new drills, for example) and can maintain revenues even at low points in the capex cycle.

New equipment versus aftermarket

In addition, many capital goods companies make substantial profits on the aftermarket component:

commercial truck makers provide vehicle servicing, while elevator companies maintain the lifts after they

come off warranty. In such circumstances, the continued development of the installed service base (and

competition in the third-party aftermarket sector) is key to maintaining these defensive revenue

characteristics. In some circumstances, the sale of the new equipment is done at paper-thin margins (or

even as a loss-leader), the primary target being the fatter service margins.

Another significant distinction can be made in the product destination. Assa Abloy, for example, stresses

that two-thirds of its products are sold to refit and refurbishment markets, and not new build, reducing the

overall cyclicality of the business. At low points in the capex cycle, firms are universally keen to

emphasise these more defensive aspects of their product portfolio.

Input costs

Capital goods companies are big buyers of raw materials, including (but not limited to) industrial metals such

as iron, steel, nickel and copper, plus plastics and other miscellaneous items. Policies vary, but as a general

rule, the sector does not engage in overly long-term hedging, and is therefore exposed to rising input costs. That

said, rising raw material prices usually correlate with rising end-user demand, especially in EM. In addition, the

leading companies enjoy strong pricing power, and can often pass on price increases to end-customers.

Mix effects

Mix, namely the relative profitability of different products within the offering, also affects profitability.

For example, in some sub-sectors, the products required by EM are less sophisticated than those in DM,

and consequently margins are lower. By contrast, certain more complex high-end solutions sold to DM

offer higher profit margins. In addition, we note a significant mix effect from the sale of spares versus

OE. This is more prevalent among Western OEMs with a large installed base of equipment.

Intra-sector specialisation, de-leveraging, industry consolidation

Although some companies do operate across the many specialised sectors that make up capital goods, the

majority stick to one particular operational axis, such as electrical equipment. The value of broader

economies of scale achieved by operating across the segments is not viewed as significant. Consequently,

industry consolidation exists primarily within a sector, eg, Schneider Electric operates in both low- and

medium-voltage electrical. Some companies do operate in more than one sub-sector – for example,

United Technologies is present across climate control and elevators – but this normally represents a step

into the diversified industrials segment, as opposed to any attempt to cross-sell.

The sector has seen its fair share of M&A activity, mostly concentrated, involving the acquisition of smaller fry

by larger players in each sub-sector as opposed to mega-mergers of equals. M&A has recently focused on the

acquisition of technology from smaller growth firms and geographical expansion, most notably within EM.

At the same time, some of the conglomerate-style companies have sought to turn over their portfolio in

order to maintain a presence in the sweetest spot of the sector, and divestments and spin-offs have not been

uncommon, often via IPO, and often when that business has become overly commoditised (examples

58


abc

would include Philips’ sale of its semi-conductors business, or ABB’s exit of the cables business). The

natural consequence of such activity is that those involved on both sides of the coin have purchased

attractive, high-PE businesses while selling commoditised or highly cyclical, low-PE businesses. During

lulls in M&A activity, some firms collected significant cash on the balance sheet, which led to intense

press speculation as to likely M&A targets or the means by which cash could be returned to shareholders.

Since companies have focused activities, reduced cyclicality, reduced debt and increased balance sheet

cash, one could be forgiven for considering the likelihood of private equity activity within the sector. This

is a valid argument, although the size of the targets is a complicating factor, as is a possible perception

that most of the fat has already been trimmed.

Leading indicators

The activities of capital goods companies are summarised at the macro level by the measurement of gross

fixed capital formation, ie, the value quantity of the fixed assets ordered and then manufactured. Some

(larger) products lend themselves better to the publication of order book statistics than others. There is a

huge array of data covering the sector, including such diverse data series as EMEA Regional Gas &

Steam Turbine Orders, Chinese Fixed Asset Investment in the Oil & Gas Sector, and Australian mining

capex, to name but three.

Key segments Production technology: “Stuff that makes stuff”, ie, mechanical, electromechanical and electronic

equipment used in the production process in both manufacturing and process industries. Key drivers

underpinning demand for the global production technology industry are high growth in EM, rising labour costs

and growing environmental awareness.

Building technology: Low-voltage electrical distribution equipment, building automation & control

equipment, lighting, elevators and cranes, among others. The building technology sector has four key

drivers: urbanisation, energy efficiency, security and safety and energy intensity.

Transport: On-road heavy and medium commercial vehicles (read trucks) but not light commercial

vehicles (LCVs) (read vans), off-road commercial vehicles, primarily construction equipment, agricultural

equipment and rail equipment, ships and diesel engines. Key drivers for global truck markets are economic

growth, infrastructure investments, regulatory action (such as emission norms), oil prices and liquidity.

Process technology: Caters mainly to process industries (or industries engaged in continuous production

process) including oil & gas, petrochemicals, chemicals, metals (ferrous & non-ferrous) and paper &

pulp. Major products include field devices (eg, flow meters, gauges, sensors, transmitters, valves), control

electronics (such as CNCs, production controllers or PLCs) and the software that actually runs and

controls the process (such as the SCADA software). The key driver of demand in these industries is the

significant capex spending driven by resource-heavy EM growth, technological advances that support

upgrades, environmental awareness/regulations and the need to improve cost efficiencies.

Power technology: The hardware and software needed to generate, transmit, distribute and condition the

quality of electrical power. This includes electrical power generation equipment and high- and medium-

voltage electrical transmission equipment. Key drivers for the global power technology industry are

demand for energy in emerging markets and demand for clean energy in developed markets.

59


abc

Valuation Industrial companies trade on traditional metrics, namely forward-looking PE ratios, EV/EBITDA,

EV/EBIT and, to a lesser extent, P/BV or EV/IC. At the peak of the cycle, the rolling one-year-forward PE

reached 19x, while it troughed at 8x immediately after the Lehman collapse. A normalised range for the

sector is around 12-18x. Companies can also be valued using traditional discounted cash flow analysis,

applying a weighted average cost of capital (WACC) to forecasts in order to arrive at a theoretical fair

value. Alternatively, one can employ a ‘reverse DCF’, a method which avoids the use of backward-looking

data (such as beta). Instead one determines an appropriate growth rate for cash flow returns on invested

capital (CROIC) and then, using the current valuation as the PV, calculates the market-assessed cost of

capital (MACC). This MACC can then be compared with the sector average (is company X rich or cheap

compared with the sector?) or versus its own history (is company X at a historical peak or trough?).

Intra-sector free floats vary considerably. In some cases, the reduced liquidity makes it unaffordably risky

for hedge funds to short, and thus stocks enjoy artificial support beyond that of the fundamental quality of

their operating activities and earnings prospects. Some stocks are especially popular with local retail

investors, and Bloomberg free float estimates can be overstated.

Different companies elect to report operating profits in different ways, making comparisons complicated.

Some report their headline number as EBITA, some as EBITDA and others are content to publish a

simple EBIT number. Legrand, for example, chooses to use ‘maintainable adjusted EBITA’. There is,

unfortunately, no solution other than going through the notes to the accounts to determine exactly how

that company’s unique brand of profit has been decided.

There are also wildly varying levels of disclosure within the companies’ own operating segments: some

companies do not split out profitability by either business unit or by geography, and in some cases, the

suspicion remains that cross-divisional subsidies mask the true profitability picture. In addition, some

firms publish their order intake as part of their quarterly reporting, while others decline to do so.

European capital goods: growth and profitability

2008 2009 2010 2011 2012e

Growth Sales 6.4% -10.0% 8.9% 6.4% 6.3% EBITDA -12.8% -11.2% 41.9% 7.2% 6.3% EBIT -18.2% -16.5% 57.7% 7.1% 14.5% Net profits -18.1% -51.8% 104.5% 4.5% 20.4% Margins EBITDA 11.0% 10.8% 14.1% 14.2% 14.2% EBIT 7.3% 6.8% 9.8% 9.9% 10.7% Net profit 6.6% 3.5% 6.6% 6.5% 7.3% Productivity Capex/sales 4.0% 2.8% 2.7% 2.4% 2.6% Asset turnover (x) 0.82 0.87 0.76 0.76 0.76 Net debt/equity 0.38 0.31 0.22 0.33 0.27 ROE 17.6% 8.8% 16.7% 16.0% 17.8%

Note: based on all HSBC coverage of European capital goods. All data is added together in EUR. Source: Company data, HSBC estimates

60


abc


MSCI Europe Capital Goods Index 8.2% of MSCI Europe

Trading data 5-yr ADTV (EURm) 1,524 Aggregated market cap (EURm) 482,785 Performance since 1 Jan 2003 Absolute 98% Relative to MSCI Europe 66% 3 largest stocks Siemens AG, ABB Ltd.,

Schneider Electric Correlation (5-year) with MSCI Europe 0.96

Source: MSCI, Thomson Reuters Datastream, HSBC Top 10 stocks: MSCI Europe Capital Goods Index


1 Siemens AG 13.1% 2 ABB Ltd. 6.3% 3 Schneider Electric 4.9% 4 EADS NV 4.7% 5 Atlas Copco AB 4.1% 6 Rolls-Royce Holdings Plc. 3.9% 7 Vinci SA 3.9% 8 St. Gobain 3.4% 9 Philips 3.0% 10 Sandvik AB 2.7%


Country breakdown: MSCI Europe Capital Goods Index

Country Weights (%)

France 25.7% Germany 17.7% Sweden 15.5% UK 13.0% Switzerland 10.5% Finland 4.1% Netherlands 3.5% Spain 3.1% Italy 2.8%


Core industry driver: capital goods historical global capex

-0.2

-0.1

0

0.1

0.2

0.3

0.4

1972

1976

1980

1984

1988

1992

1996

2000

2004

2008

2012

e

G lobal Emerging Developed

Source: Country accounts, HSBC estimates

PE band chart: MSCI Europe Capital Goods Index

0

50

100

150

200

250

300

350

400

450

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Price level

20x

15x

10x

5x


PB vs. ROE: MSCI Europe Capital Goods Index

0%

5%

10%

15%

20%

25%

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

0.00.40.81.21.62.02.42.83.23.64.0

Fwd ROE Fwd P/B(x)-RHS


61


abc

Chemicals

EMEA Chemicals team Dr Geoff Haire* Head of Chemicals Equity Research, EMEA and Americas HSBC Bank plc +44 20 7991 6892 [email protected]

Sriharsha Pappu*, CFA Analyst HSBC Bank Middle East +971 4423 6924 [email protected]

Sebastian Satz*, CFA Analyst HSBC Bank plc +44 20 7991 6894 [email protected]

Jesko Mayer-Wegelin*, CFA Analyst HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 3719 [email protected]

Yonah Weisz* Analyst HSBC Bank plc (Tel Aviv) +972 3 710 1198 [email protected]

Omprakash Vaswani* Analyst HSBC Bank plc +91 80 3001 3786 [email protected]


EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

62

ab

c

Sector structure

Synthos (EM)

Chemicals

Classic

Akzo Nobel (EU)

Arkema (EU)

BASF (EU)

Clariant (EU)

DSM (EU)

Lanxess (EU)

Rhodia (EU)

Solvay (EU)

Celanese (US)

Eastman Chem (US)

Huntsman (US)

PPG (US)

Sherwin Williams (US)

Speciality

Croda (EU)

Givaudan (EU)

Johnson Matthey (EU)

Symrise (EU)

Umicore (EU)

Wacker Chemie (EU)

Agrochemicals

K+S (EU)

Syngenta (EU)

Yara (EU)

Israel Chem (EU)

Monsanto (US)

Mosaic (US)

Potash Corp (US)

Industrial Gases

Air Liquide (EU)

Linde (EU)

Air Products (US)

Praxair (US)

Petrochemicals

Ineos (EU)

LyondellBasell (EU)

Georgia Gulf (US)

Westlake (US)De

velo

ped

Alpek (LatAm)

Advanced Petrochemical (ME)

Braskem (LatAm)

Industries Qatar (ME)

Methanol Chemical (ME)

Mexichem (LatAm)

National Petrochemical (ME)

Sahara Petrochemical (ME)

SABIC (ME)

Saudi Industrial Investments (ME)

Saudi International Petrochemical (ME)

Saudi Kayan (ME)

Sibur (EM)

Yanbu Petrochemical (ME)

Arab Potash (ME)

Acron (EM)

Bagfas (EM)

Gubretas (EM)

PhosAgro (EM)

Saudi Ferti lisers (ME)

Tekfen (EM)

Uralkali (EM)

De

velo

pin

g

Synthos (EM)

Chemicals

Classic

Akzo Nobel (EU)

Arkema (EU)

BASF (EU)

Clariant (EU)

DSM (EU)

Lanxess (EU)

Rhodia (EU)

Solvay (EU)

Celanese (US)

Eastman Chem (US)

Huntsman (US)

PPG (US)

Sherwin Williams (US)

Speciality

Croda (EU)

Givaudan (EU)

Johnson Matthey (EU)

Symrise (EU)

Umicore (EU)

Wacker Chemie (EU)

Agrochemicals

K+S (EU)

Syngenta (EU)

Yara (EU)

Israel Chem (EU)

Monsanto (US)

Mosaic (US)

Potash Corp (US)

Industrial Gases

Air Liquide (EU)

Linde (EU)

Air Products (US)

Praxair (US)

Petrochemicals

Ineos (EU)

LyondellBasell (EU)

Georgia Gulf (US)

Westlake (US)De

velo

ped

Alpek (LatAm)

Advanced Petrochemical (ME)

Braskem (LatAm)

Industries Qatar (ME)

Methanol Chemical (ME)

Mexichem (LatAm)

National Petrochemical (ME)

Sahara Petrochemical (ME)

SABIC (ME)

Saudi Industrial Investments (ME)

Saudi International Petrochemical (ME)

Saudi Kayan (ME)

Sibur (EM)

Yanbu Petrochemical (ME)

Arab Potash (ME)

Acron (EM)

Bagfas (EM)

Gubretas (EM)

PhosAgro (EM)

Saudi Ferti lisers (ME)

Tekfen (EM)

Uralkali (EM)

De

velo

pin

g

Source: HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

63

ab

c

Return on invested capital for chemical stocks versus growth in European industrial production (year-on-year)

-25

-20

-15

-10

-5

0

5

10

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Gro

wth

in E

U In

dust

rial P

rodu

ctio

n (%

y-o

-y)

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

11.00%

12.00%

13.00%

14.00%

15.00%

16.00%

17.00%

18.00%

Aver

age

ROIC

(%)

Growth in EU IP (% y-o-y) ROIC (RHS)

Overcapacity coupled with global economic recession

Restocking-led recovery

Asian Credit Crunch

Rising oil prices

Recession

Lehman Eurozonedebt crisis

Asian-led recovery

-25

-20

-15

-10

-5

0

5

10

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Gro

wth

in E

U In

dust

rial P

rodu

ctio

n (%

y-o

-y)

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

11.00%

12.00%

13.00%

14.00%

15.00%

16.00%

17.00%

18.00%

Aver

age

ROIC

(%)


-25

-20

-15

-10

-5

0

5

10

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Gro

wth

in E

U In

dust

rial P

rodu

ctio

n (%

y-o

-y)

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

11.00%

12.00%

13.00%

14.00%

15.00%

16.00%

17.00%

18.00%

Aver

age

ROIC

(%)


Overcapacity coupled with global economic recession

Restocking-led recovery

Asian Credit Crunch

Rising oil prices

Recession

Lehman Eurozonedebt crisis

Asian-led recovery

Source: Thomas Reuters Datastream, HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

64

ab

c

EBIT margin versus asset turnover chart (2012e)

LG Chemical

Honam Petrochem ical

Formosa Plas tics

Hanwha Chemical

Formosa Chemical and Fibr

Nanya Plas ticsM ex ichem

Braskem SA

Yanbu Petrochem ical

Saudi KayanInternational Petrochemical

Saudi Industrial Inv estments

SABIC

SAFCO

Sahara National Petrochem ical Co

National Industrialization

Methanol Chem icals

Industries Qatar

Arab Potash

Adv anced Petrochem ical

Yara

Uralkali

SAFCO

K+S

Israel Chem icalsSy ngenta

Linde Air Liquide

Umicore

Sy mrise

Johnson M atthey

Givaudan

C roda

Solvay

Clariant

Lanxess

DSM

BASFArkema

Akzo Nobel

0.0

0.5

1.0

1.5

2.0

2.5

3.0

0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0%

EBIT Margin

Ass

et T

urn

over

(x)

Source: HSBC estimates

65


abc

Sector description The chemical sector, particularly in Europe and the US, comprises a wide range of companies serving

various end-markets. There are four sub-sectors – classics & petrochemicals, industrial gases, speciality

and agrochemicals. Several chemical conglomerates encompass all of the sub-sectors.

Summary of sub-sector characteristics

Sub-sector __________ Companies ___________ Characteristics

Classics and petrochemicals

Akzo Nobel

Arkema

BASF

Clariant

Dow Chemical

DSM

DuPont

Lanxess

SABIC

Solvay

need to keep cost base low

high capital intensity

tend to be price-takers

cyclical; exposed to economic and supply-demand cycles

Specialities Croda

Givaudan

Johnson Matthey

Symrise

Umicore

generally exposed to consumer demand

high consolidation

low capital intensity

product offering requires constant innovation in order to maintain margins

natural pricing power

Industrial gases Air Liquide

Air Products

Linde

Praxair

high capital intensity

long-term contracts of up to 15 years account for about 25-35% of sales

high consolidation; big four players represent approximately 80% of the market

end-markets tend to be cyclical: steel, refining, chemicals

Agrochemicals Israel Chemicals

K+S

MA Industries

Monsanto

Syngenta

Uralkali

Yara

High R&D requirement, particularly in crop protection and seeds

highly dependent on crop demand and farmer economics

high capital intensity in fertilisers so low cost base is key

Source: HSBC

Transforming in search of higher margins

Twelve years ago there were 17 large-cap chemicals companies. Since then, nine companies have either

exited chemicals (for example, UCB, Bayer and Hoechst) or have been acquired by competitors or private

equity (BOC, Courtaulds, ICI and Rhodia). The remaining companies have also undergone major

transformations as they have generally exited any commodity chemicals in which they did not have a

leading position. We expect M&A to continue to play a major role in the sector.

The classic and petrochemical sub-groups have the challenge of maximising margins through portfolio

change to become either speciality players or the “best-in-class”. Classic chemical companies tend to be

large conglomerates. Speciality players, on the other hand, end to be smaller, niche producers. Over the

past 15 years, companies in the European chemical sector – Akzo Nobel, Bayer, DSM and Solvay, for

example – have been shedding businesses with low margins and returns, or where they were lacking a

market-leading position. Within the classic sub-sector, companies have adopted two strategies to improve

profitability: increasing their presence in products where they hold leading positions or completely exiting

businesses where their market share is low or where they are at a competitive disadvantage (eg no access

to cheap feedstocks). Over the past 10 years, BASF has exited low-margin commodity products such as

polyolefins and fibres (nylon) while investing in areas such as engineering plastics, superabsorbents,

Dr Geoff Haire* Analyst HSBC Bank plc +44 20 7991 6892 [email protected]


66


abc

electronic chemicals, construction chemicals, catalysts and natural products. This has caused trough

returns to increase: the return on invested capital was 7.9% in 2009 compared with 4.6% in 2001.

The industry is mostly made up of a series of global oligopolies, reflecting the fragmented nature of the

end-markets. However, companies are generally price-takers as either customers have more bargaining

power or prices are set with respect to supply-demand balances, which is particularly true for classics and

fertiliser producers. The barriers to entry are capital costs, customer relationships and technology.

Key themes Emerging versus developed market economic growth

Historically, the industry’s end-markets have been focused in the developed world, where growth is likely

to remain below trend for the foreseeable future. However, growth in manufacturing, the upgrading of

infrastructure and a growing middle class are making emerging markets increasingly important to the

chemicals sector. The sector average exposure to emerging markets is a third of sales. However, a number

of companies in the European sector already have a more sizeable position in emerging markets,

including Givaudan (46% of sales), Syngenta (46%), Linde (43%), DSM (38%) and Yara (38%).

Commoditisation

One of the inevitabilities in the chemical industry is commoditisation. There are two broad categories of

chemicals – commodity and specialities.

Commodity chemicals prices tend to be set by public markets and are heavily correlated with input costs

and supply-demand balances. Raw material costs represent more than 65% of the overall price, customers

can easily switch suppliers, products are defined by chemical entities and the barriers to entry are low if

you have unlimited capital. There are many competitors in this category.

In contrast, speciality chemical prices tend to be driven by the value the chemical adds to the customer’s

products/processes. Raw material costs represent less than 40% of the price, it is not easy for customers to

switch suppliers as this can involve changing manufacturing processes, and there are few competitors in

this category.

However, history has shown that speciality chemicals can easily become commodities in the absence of

innovation, or as a result of end-market changes or new entrants chasing higher margins. We have seen

examples of this in plastic additives, engineering polymers and fine chemicals. In our opinion, the term

speciality has been misused by companies and should only apply to products that can sustain high

margins and growth – such as crop protection, catalysts, fragrances and some engineering polymers.

M&A

Over the past 12 years we have seen significant M&A in the sector. There have been three types of

activity: consolidation within the sector (for example Solvay acquiring Rhodia), private equity activity

(the formation of Ineos, Access Industries’ creation of LyondellBasel from two acquisitions, and Apollo’s

later acquisition of LyondellBasell), and oil and healthcare companies spinning off their chemical

businesses (for example Novartis and Astra Zeneca forming Syngenta, and Total spinning out Arkema, its

chemical businesses). We expect M&A to continue in the sector as balance sheets are healthy; currently

DSM and BASF are active buyers according to their management teams. We also expect private equity to

67


abc

bring chemical companies back to the market – although this will depend on the state of the equity

markets and the macroeconomic backdrop. Over the last two years we have seen AZ Electronic Materials,

Brenntag and Christian Hansen returning to the public market.

Substitution

The threat of external substitution to the chemical industry is limited but internal substitution is a constant

threat. Internal substitution is driven by other producers looking for new end-markets as well as

customers looking for lower-priced materials, for example polyethylene being substituted for

polypropylene in packaging. Currently many companies are investigating new technologies, such as

biotechnology and nano-materials, which could result in new lower-cost or better-performing products, or

new low-cost manufacturing processes.

Sector drivers In our initiation report (It’s Showtime: Initiating on the European chemical sector, 1 December 2010 we

introduced three sets of value drivers to help differentiate between companies in the sector and their

ability to increase and/or sustain their return on invested capital. We believe ROIC is the best metric to

reflect the returns investors can expect from the capital that management teams are putting to work to

generate future profits, particularly in the case of companies with high capital intensity. Historically, we

have found a strong link between share price performance and return on capital.

In all, we have identified 10 drivers that influence valuation, which fall into three broad categories: top-

line growth, ROIC expansion and leverage. We have ranked all the companies in the European chemical

sector on each driver to gain a better understanding of which are best positioned to generate sustainable,

above-average returns in the future. The categories are:

Top-line growth: we believe the key components of sales growth are: (1) end-market structure;

(2) exposure to developing economies; (3) barriers to entry; and (4) pricing power.

ROIC expansion: we believe the key components of returns are: (1) exposure to raw materials;

(2) degree of consolidation; (3) cost base restructuring; (4) cash conversion; and (5) foreign exchange

exposure.

Leverage: it is particularly important to scrutinise a company’s balance sheet in times of economic

uncertainty. Leverage is also important because it allows companies to take advantage of growth

opportunities – via either organic investment or acquisitions. The components of this sub-category

are: (1) net debt/EBITDA; and (2) debt maturity.

Macroeconomics and pricing power

Top-line growth in the sector is driven by GDP and industrial production (IP). Over the past 20 years

there has been a high correlation between the performance of the European and US chemical sectors and

IP in the developed world. In the shorter term, Chinese and Asian industrial growth has become an

important driver of earnings and share price performance. Volume growth rates across sub-sectors vary

dramatically, with catalysts, industrial gases, engineering polymers and electronics growing at over 2x

GDP, but paper and textile chemicals volumes at less than GDP. We believe average volume growth rates

tend to be around 1.5-2.0x GDP. Over the past 10 years, volumes in the classic sub-sector have grown at

http://www.research.hsbc.com/midas/Res/RDV?ao=20&key=bRnGBlHXWw&n=285322.PDF

68


abc

2.0x global GDP on average and 1.2x IP, specialty chemicals volumes at 1.2x global GDP and 0.7x IP,

and industrial gases at 1.9x GDP and 1.2x IP.

Historically, we have seen many cases where classic chemical companies were not able to recover higher

costs for raw materials, and margins were squeezed as a result. However, tight supply-demand balances

following the financial crisis have momentarily put pricing power firmly into the hands of the classic

players. Conversely, several consumer-related speciality companies that tend to be price setters have

struggled with the strong rise in raw materials, as their contracts often only allow for erratic price

increases. It is worth noting that the industrial gas players tend to have prices linked to inflation and the

cost of energy for the large plants (tonnage) that they operate for customers.

In Juggling in a slowdown – 4 October 2011 we discuss in some detail the relationship between volumes

and price and macroeconomic drivers, particularly GDP and the oil price.

Input costs

We estimate that 55% of the sector’s input costs, if we include energy, are fossil-fuel based. Commodity

companies are more exposed to input costs than speciality producers, as these represent more than half of

the price of a product (as much as 65%). As commodity producers strive to reduce their cost base, they

have shifted a large amount of production to the Middle East, attracted by low gas prices. In 2001 Europe

and North America accounted for 54% of the world’s ethylene production; by the end of 2010 we expect

this to have fallen to approximately 40% and the Middle East to account for 19% by 2010 compared to

9% in 2001. The other sub-sectors are less exposed to input costs and potentially have more pricing

power. Historically, in times of fast-rising input costs, the majority of the industry has struggled to pass

on price increases quickly. However, following the financial crises of 2008-09, contract lengths for

commodity/industrial chemicals were reduced, enabling increases in input costs to be passed on more

quickly. However, for companies with contracts lasting more than a quarter there is a risk of margin

compression if input costs increase quickly.

North American natural gas advantage

Prior to 2008 the view was that the US petrochemical industry was in structural decline due to high

feedstock costs, and the ratio of the crude oil to the natural gas price (WTI/Henry hub) was around 6.0x,

which is considered to be feedstock parity. However, the advent of shale gas has lowered the gas price

substantially.

Therefore the US petrochemical industry has moved to using more gas (ethane) as a feedstock instead of

oil-based naphtha, shifting the cracker slate more towards ethylene and reducing the amount of the other

two key building blocks, propylene and butadiene, which are only obtained when using naphtha as a

feedstock. This trend is expected to continue given the amount of shale gas available in the US. There are

two implications of such a shift: 1) CMAI (Chemical Market Associates) is expecting the US

petrochemical industry to be at the top of the second quartile of the cost curve, making it significantly

more competitive than the European and Asian naphtha-based producers, so the US could once again

become a major exporter; and 2) there could be a structural shortage of propylene (C3) and butadiene

(C4). This has resulted in prices for propylene and butadiene, which are key raw materials for the

European chemicals sector, increasing significantly relative to ethylene.

https://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=QkpRztI2Gu&n=309341.PDF

69


abc

In North America a number of cracker feasibility studies are under way; if all were built, this would add

7mtpa of ethylene capacity (c5% of global capacity), which would likely either be exported (particularly

to high-cost naphtha-based petrochemical regions, such as Europe and Asia) or used as feedstock for the

manufacture of chemicals.

Chemical industry to supply ‘3E’-solution

In the Energy in 2050 research report HSBC highlights that the world can only grow and have enough

energy if energy efficiency improves and the energy mix changes. Given the chemical industry’s role as an

‘enabler’, a number of companies within the sector have technology that can help with this:

Energy mix – Syngenta, K+S, BASF (fertiliser, crop protection, seeds), DSM (biofuels), BASF,

Johnson Matthey, Umicore (fuels cells, batteries), Wacker Chemie and Umicore (exposure to solar)

Efficiency – this comes through the substitution of metal by engineering plastics (BASF and DSM),

improved insulation with polyurethanes (BASF and Bayer), enhanced oil recovery (Linde and Air

Liquide) and high performance tyres (Lanxess)

Environment – Johnson Matthey, Umicore and BASF (emission catalysts).

Feed the world

We expect population growth and urbanisation in the developing world to cause a rise in GDP/per capita

as well. This would increase demand for agrochemicals, particularly if we saw higher demand for meat-

based protein. We note that it takes 7kg of grain to produce 1kg of beef and 4kg of grain to produce 1kg

of pork.

As the amount of arable land has remained unchanged over the past 50 years, at approximately 38% of

total land, arable land per capita has decreased by 30%, from 0.23ha to 0.16ha.

The UN’s Food and Agriculture Office (FAO) estimates that approximately 90% of the crop production

growth required to meet future demand will need to come from higher yields. The rest should come from

an increase in arable land in the developing economies.

This has prompted some governments in countries with scarce arable land and fast-growing populations

to buy or lease land in other countries. The International Food Policy Research Institute estimates that 15-

20m ha, valued at USD20-30bn, have been sold or leased since 2006. The biggest purchasers have been

South Korea (2.3mha), China (2.1mha), Saudi Arabia (1.6m ha) and the UAE (1.3m ha).

If the world’s future demand for crops is to be met, there is a massive need to increase production yields

through a combination of more effective agrochemicals and the use of plants modified by seed technology

to be capable of surviving in difficult environments, such as drought conditions.

Valuation The market is focused on short-term earnings growth. It tends to value companies on a 12- to 18-month

forward earnings basis, mainly using PE and EV/EBITDA multiples, as well as sum-of-the-parts (SOTP) for

conglomerate companies. The drawback to this for chemical companies is that they have changed so much

over the past 10 years that using historical multiples might be misleading; moreover, this methodology does not

capture the future value of those companies that have invested heavily either in R&D or acquisitions.

https://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=TB0uEyzId3&n=293253.PDF

70


abc

In contrast, a return on capital metric (ROIC or CROCI) or a discounted cash flow (DCF) takes into

account the return on all the capital that has been invested in the company historically. This is important

for highly capital-intensive companies. A DCF captures the future value of investments that have already

been made, as the key drivers of a DCF are growth in invested capital (IC), asset turn (sales/IC), profit

margin and weighted cost of capital.

European chemical sector EV/IC range of 1.2x-2.0x over the last 20 years

European chemical sector EV/EBITDA range of 5.0x-10.0x over the last 20 years

1.0

1.2

1.4

1.6

1.8

2.0

2.2

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Average EV/IC Trend +1 StdDev -1 StdDev

4.0

5.0

6.0

7.0

8.0

9.0

10.0

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Average EV/EBITDA Trend +1 StdDev -1 StdDev

Source: Thomas Reuters Datastream, HSBC Source: Thomas Reuters Datastream, HSBC

71


abc


MSCI Europe Chemicals Dollar Index


Trading data 5-yr ADTV (EURm) 1,293 Aggregated market cap (EURm) 196,522 Performance since 1 Jan 2000 Absolute 66% Relative to MSCI Europe US Dollar

167%

3 largest stocks BASF, Air Liquide, Syngenta Correlation (5-year) with MSCI Europe US Dollar

0.23

Source: MSCI, Thomas Reuters Datastream, HSBC

Top 10 stocks: MSCI Europe Chemicals Dollar Index


1 BASF 26.1% 2 Air Liquide 13.9% 3 Syngenta 12.2% 4 Linde 10.4% 5 Yara 4.5% 6 Akzo Nobel 4.5% 7 Givaudan 3.6% 8 Solvay 3.5% 9 DSM 3.5% 10 Johnson Matthey 3.1%

Source: MSCI, Thomson Reuters Datastream, HSBC Country breakdown: MSCI Europe Chemicals Dollar Index

Country Weights (%)

Germany 44% Switzerland 17% France 16% Netherlands 8% Belgium 4% UK 3%

Source: MSCI, Thomas Reuters Datastream, HSBC

Core industry driver: European industrial production

-20%

-15%

-10%

-5%

0%

5%

10%

15%

Q106

Q306

Q107

Q307

Q108

Q308

Q109

Q309

Q110

Q310

Q111

Q311

Q112e

Q312e

Industrial Production (y-o-y) Sector volumes (y-o-y)

Source: Thomas Reuters Datastream, HSBC estimates

PE band chart: MSCI Europe Chemicals Dollar Index

8x

11x

14x

17x

50

100150

200

250

300

350

400

450

2004 2005 2006 2007 2008 2009 2010 2011 2012


PB vs. ROE: MSCI Europe Chemicals Dollar Index

0.5

1.0

1.5

2.0

2.5

3.0

2004 2005 2006 2007 2008 2009 2010 2011 2012

9.0

11.0

13.0

15.0

17.0

19.0

12M Fwd PB 12M Fwd ROE (RHS)


72


abc

Notes

73


abc

Clean energy & technology

Clean energy & technology team Sean McLoughlin* Analyst HSBC Bank plc + 44 20 7991 3464 [email protected]

Christian Rath*, CFA Analyst HSBC Trinkaus & Burkhardt AG, Germany + 49 211 910 3049 [email protected]

Jenny Cosgrove*, CFA Analyst The Hongkong and Shanghai Banking Corporation Limited +852 2996 6619 [email protected]

Charanjit Singh* Analyst HSBC Bank plc +91 80 3001 3776 [email protected]

Murielle André-Pinard* Analyst HSBC Bank plc, Paris branch +331 56 52 43 16 [email protected]

Gloria Ho*, CFA Analyst The Hongkong and Shanghai Banking Corporation Limited +852 2996 6941 [email protected]

Sector sales Sonja Kimmeskamp Sales HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 4854 [email protected]

Tim Juskowiak Sales HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 4452 [email protected]


EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

74

ab

cSector structure

Supply

Clean energy & technology sector

Multi-theme industrials

EDP RenovaveisChina Longyuan Power

Acciona

EDP

EDF

Doosan Heavy IndustryChina Guangdong Nuclear Power Group

GCL PolyTrina SolarSMA Solar

VestasXinjiang GoldwindSuzlon

AndritzSinohydro Corporation

Sâo Martinho

AixtronImtechSeoul Semiconductor

KronesRational

Crompton Greaves

DelachauxVossloh

ALL-America Latina Log

Infineon

Dialog Semiconductor

Veolia EnvironnementPennon GroupSéché EnvironnementChina Everbright

Johnson MattheyUmicore

ABB, Alstom, Samsung, Schneider Electric, Siemens

Nexans

Prysmian

Saft

IntertekSGS

Demand

Energy efficiency & management

Energy transmission

Renewable OEMS

Solar

Wind

Hydro

Biofuels

Low carbon OEMS

Nuclear

Power storage

Low carbon power providers

Renewable utilities

Transmission infrastructure

Building efficiency

Pollution control

Conversion efficiency

Transport efficiency

Industrial efficiency

Water & waste

Support services

Resource efficiency & managementRenewable & low carbon energy production

Supply

Clean energy & technology sector

Multi-theme industrials

EDP RenovaveisChina Longyuan Power

Acciona

EDP

EDF

Doosan Heavy IndustryChina Guangdong Nuclear Power Group

GCL PolyTrina SolarSMA Solar

VestasXinjiang GoldwindSuzlon

AndritzSinohydro Corporation

Sâo Martinho

AixtronImtechSeoul Semiconductor

KronesRational

Crompton Greaves

DelachauxVossloh

ALL-America Latina Log

Infineon

Dialog Semiconductor

Veolia EnvironnementPennon GroupSéché EnvironnementChina Everbright

Johnson MattheyUmicore

ABB, Alstom, Samsung, Schneider Electric, Siemens

Nexans

Prysmian

Saft

IntertekSGS

Demand

Energy efficiency & management

Energy transmission

Renewable OEMS

Solar

Wind

Hydro

Biofuels

Low carbon OEMS

Nuclear

Power storage

Low carbon power providers

Renewable utilities

Transmission infrastructure

Building efficiency

Pollution control

Conversion efficiency

Transport efficiency

Industrial efficiency

Water & waste

Support services

Resource efficiency & managementRenewable & low carbon energy production

Source: HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

75

ab

c

HSBC clean energy & technology sector benchmark indices: price history

0

100

200

300

400

500

2004 2005 2006 2007 2008 2009 2010 2011 2012

Wind Solar Energy Efficiency & Energy M anagem ent Water, Waste & Pollution Control MSCI World

Ky oto enters into force

Stern report on

clim ate econom ics

EU Energy & C limate package

US Green

Stim ulus Bill

Copenhagen Sum mit

Fukushima nuclear

disas ter

'Green austerity ':

Spain freezes

renew able

subsidies

Note: Sector indices are generated by HSBC Equity Quantitative Research (HSBC Climate Change Benchmark Index). Source: HSBC Equity Quantitative Research, Thomson Reuters Datastream

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

76

ab

c

HSBC clean energy & technology sector benchmark indices: EBIT margin versus asset turnover chart (2011)

0.00

0.50

1.00

1.50

2.00

2.50

-40.0% -30.0% -20. 0% -10.0% 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0%

EBIT margin (%)

Ass

et tu

rnov

er (x

)

Low carbon pow er

Energy efficiency

Resource efficiency


77


abc

Sector description This sector comprises a wide range of businesses involved in the production and use of technologies that

are intended to enable the shift away from carbon-intensive fossil fuels, such as coal, as part of the

gradual decarbonisation of the global economy, and towards more sustainable and cleaner products.

These technologies include those for the generation of renewable and low carbon power, and more

efficient production, distribution and management of energy and resources.

From an equity perspective, clean energy cuts across traditional sector boundaries where pure plays and

incumbents both feature. HSBC clean energy and technology research is closely related to the work of our

climate change team globally, which analyses cross-sector macroeconomic trends associated with the

climate change theme.

Low-carbon power includes power generation using no fuel or less fuel than conventional power-

generation technologies, and producing no pollutants or fewer than conventional technologies. It uses

renewable energy sources that, unlike fossil fuels, are not depleted over time, such as biomass and

biofuels, solar power, wind power, geothermal and hydropower. It also uses nuclear energy which, though

it consumes a limited mineral resource, produces low levels of carbon over its lifetime compared with

conventional power generation. This sector includes manufacturers of equipment for renewable energy

production and generation companies, such as utilities.

Energy transmission includes companies involved in the transmission of low-carbon power through

distribution networks. A rising proportion of renewable power, which is intermittent in nature, requires

greater grid flexibility to handle the higher variability of power supply. This sector includes grid operators

and equipment providers for transmission and distribution infrastructure.

Energy efficiency and management involves replacing existing technologies and processes with new

ones that provide equivalent or better service but consume less energy. The sector includes energy-saving

technologies to reduce energy consumption in buildings, industries, transport and in power conversion,

and also includes energy-storage technologies such as batteries.

Building efficiency includes: improved building materials that control the transfer of heat into and out of

buildings; more efficient lighting, which relies on the use of light-emitting diodes, compact fluorescent

lamps and sensors; energy-efficient chillers and directional lighting; and smart systems that control power

consumption in buildings.

Industrial efficiency encompasses products or processes to conserve energy in industrial sectors. These

include process automation, control systems, instrumentation and energy control systems.

Conversion efficiency includes devices involved with power management within electronics products

and with conversion of power for grid compatibility of generation equipment.

Transport efficiency includes technologies that reduce the carbon emitted by conventional transport.

Low-carbon fuels like biodiesel and ethanol are also included. A shift from road to rail transport and use

of electric and hybrid-electric vehicles, which emit less carbon than fossil-fuel vehicles, falls under

transport efficiency. Mass transit – buses, trains and trams – is considered part of transport efficiency as

well, as are companies that supply efficient-engineering systems or parts that are supplied to cleaner

forms of transport.

Sean McLoughlin* Analyst HSBC Bank Plc +44 20 7991 3464 [email protected]


78


abc

Resource efficiency and management includes companies involved in the treatment and recycling of

resources such as water and waste, and in the application of chemical and materials to carbon abatement

processes such as pollution control. In the water sector, companies provide efficient water supply, water

conservation and recycling, and advanced water-treatment technologies. Waste management comprises

mainly the collection, transport and disposal of waste. Some support-services companies provide

environmental consulting, which also falls under this theme. Companies in pollution control are involved

in carbon-abatement technologies such as catalysts in vehicle exhaust systems.

Key themes Capital intensity

The sector relies on investments in new energy generation infrastructure or replacement of existing

energy management products with more energy-efficient products or improved use of resources.

The sector thus requires supportive policy – the rapid growth in the uptake of renewables has come about

thanks to favourable policies rewarding investors with a long-term return on their investment via a range

of subsidy schemes. Rising regulatory uncertainty from governments reducing subsidies for renewables in

a time of austerity and potentially applying retroactive measures to existing generation infrastructure

where investments have already been made, has raised the perceived risk premium and the corresponding

cost of capital for future investments.

Availability and cost of financing are also important determinants of demand for new clean energy power-

generation projects. Wind and solar projects in the developed world are typically funded 75% by project

finance and 25% by equity. Projects are being rendered uneconomical, unfinanceable or subject to delays

owing to tightening project finance availability and widening finance spreads. This is owing to the collateral

damage to banks’ balance sheets from the euro crisis and increased capital adequacy requirements.

Resource and energy efficiency: theme for next decade

In parallel to reducing the carbon intensity of power production by curbing emissions from fossil fuels,

notably coal, oil and gas, and providing incentives for low-carbon sources, notably renewable and nuclear

energy, a growing trend is for taking energy out of growth, by promoting energy efficiency in buildings,

industry and transport. Energy efficiency is generally less capital intensive than clean energy (many small

projects, rather than single large infrastructure projects), as well as generally having short payback times,

so is a theme better suited to austerity. Additionally, it results in the retention and even creation of many

highly localised jobs owing to its manufacturing and installation dynamics.

So far, the low-carbon economy has been dominated by changes in energy supply. We believe that will

change in the coming years as governments implement policies to deliver ‘negative cost’ improvements in

building and industrial efficiency, and push for a shift in transport to hybrid and electric vehicles. Saving

costs through energy efficiency should make the economics compelling for expansionary plus replacement-

cycle spending as global economic growth improves. We estimate the energy-efficiency market will

outgrow other clean-technology sectors and may grow to between USD722bn and USD1.4trn by 2020.

79


abc

Ongoing shift from developed to emerging markets

The developed world has been the mainstay of the low-carbon economy over the past decade, primarily

because it has a larger base of installed nuclear and renewable generation capacity and more focus on

installation of energy-efficient technologies. Recently, China has risen to become a dominant force in

clean energy (China accounted for ~50% of new wind installations globally in 2011 and hosts nine of the

top 10 solar manufacturers). With China’s goals for low-carbon energy and energy efficiency implying

that Chinese demand for clean energy technologies is likely to outstrip that of its developing-market

peers, we expect China to continue to exert a strong influence globally in clean energy. Increasingly,

other emerging markets in Asia and Latin America are supplanting developed markets as growth drivers

for clean energy demand.

Sector drivers Policy support

The EU-27 nations, which have binding 2020 targets and a National Renewables Energy Action Plan

(NREAP) as a driver for subsidies, accounted for 90% of solar and 75% of wind installed globally by the

end of 2011. As green stimulus measures come to an end with central cutbacks to public spending,

governments are threatening to reduce subsidies for renewable energy, or have already done so.

Uncertainty in government subsidy regimes remains the biggest hurdle for investment in capex-intensive

projects (this applies to solar and offshore wind projects in particular, which are more expensive per

MWh than onshore wind) and constitutes a risk for suppliers, developers and operators. Hurdle rates for

projects have risen to reflect a growing perception of this risk as well to account for the rising cost of

financing. In the EU, policy visibility beyond 2020 should help support longer-term government

commitments to clean energy.

For energy efficiency, no binding targets exist at an EU level, unlike for renewables and emissions

reductions. Nonetheless, national governments in the EU, including France, Germany and the UK, are

continuing to support efficiency measures in spite of austerity pressures. An EU energy-efficiency

directive, currently in advanced discussions and expected soon to be voted into law, would set hard

targets for energy-efficiency measures in Europe, thus providing a stable policy basis for sustained growth.

Corporate and private equity funding to replace banking credit shortfall

With Basel III rules limiting the ability of banks to provide project finance loans, many banks are pulling

out of long-term lending for large infrastructure projects such as energy developments involving wind or

solar. Despite high upfront capex costs, the stable cash flow and low operating costs of clean energy projects

are proving attractive to corporates, and private and institutional equity players, which are increasingly

investing in the sector. As commodity prices continue to rise and resource scarcity becomes an increasing

reality, companies have begun to step up their environmental efforts and revise their sustainability

strategies. Rising quantities of corporate equity should help support clean energy market growth.

Rationalisation of OEM capacity

The wind, solar and LED industries currently suffer from oversupply, which is putting pricing and

producer margins under pressure. In solar, the emergence of low-priced Asian competitors and low

barriers to entry for manufacturers led to a glut of module production capacity in 2011. Bankruptcies and

80


abc

capacity rationalisation in the solar sector will help industry winners emerge more quickly. In wind, fierce

competition and low-priced Chinese manufacturers have helped depress turbine pricing, and an expected

downturn in global demand in 2013 suggests production margins will remain low.

Key segments Renewable OEMs

It seems increasingly clear to us that subsidies for new renewable capacity will continue to decline until

they are withdrawn entirely. This cut in support will force the industry to become competitive with

traditional power generation, presumably at the expense of many present participants that cannot breach

such a transition. We therefore expect strong medium-term growth prospects for wind and solar,

notwithstanding the current near-term pressures.

Renewable and low-carbon utilities

We believe the green utility names will benefit in a number of ways from the adverse macro conditions in

the wind and solar sectors. First, falling prices in solar and more competitive turbine prices lead to lower

capex requirements and hence better returns. Second, a reduction in capex commitments in an

unfavourable environment for future projects can improve cash flow and potentially lead to higher

dividend payouts.

Energy efficiency

Energy efficiency refers to the ratio between energy outputs (services such as electricity, heat and

mobility) and inputs (primary energy). It is the simplest way of curbing emissions and can target a wide

range of industries and processes along the three major steps of the energy value chain (generation,

transmission, consumption). For example, higher efficiency in power conversion could not only lower

CO2 emissions but also reduce material and electricity costs. In particular, lighting is one of the main

drivers of a building’s energy use, accounting for approximately 40% of energy consumption and 36% of

EU CO2 emissions (source: EU). In LEDs, we believe that declining LED prices will fuel a transition to

this form of lighting. Although we expect this to result in above GDP growth rates over the next five

years, we have a cautious view on the industry’s long-term winners. High price pressure on LEDs,

competition from new entrants, increased cyclicality and a declining replacement market will reduce

margins and capital returns in the long run, in our view.

Resource efficiency

Resource efficiency refers to improving the productivity of resource inputs. With evidence of mounting

stress in global food, water and energy systems, policymakers are turning their attention to improving

resource efficiency. The argument is that moving upstream and reducing resource inputs – whether

energy, materials or water – is not only a more effective way of cutting the output of greenhouse gas

emissions, but it also enhances security of supply. Currently, the global economy ‘harvests’ around c60bn

tonnes of resources in terms of primary raw materials: construction minerals, ores and industrial minerals,

fossil fuels and biomass. This could more than double to 140bn tonnes per annum by 2050 on ‘business

as usual’ trends. In 2007, the world average per-capita resource use was c9 tonnes, with industrialised

countries consuming c16 tonnes per capita compared with c5-6 tonnes for developing countries.

81


abc

Valuation The clean technology sector encompasses different product industries (wind, solar, light-emitting diodes,

semiconductors and so on) as well as different positions in the renewable value chain – manufacturers versus

developers, owners and operators (utilities) – so different valuation methodologies are needed. We prefer,

in many cases, to use a blend of valuation techniques to capture both short-term earnings pressure and

market risk along with long-term growth potential. In our view, this helps us combine a floor for current

negative expectations while factoring in additional value, which could crystallise in the longer term.

We use DCF-based valuation to capture the sector’s long-term growth potential. For utilities, for example,

a DCF-based SOTP in our view captures the visible and long-term cash generation profile of generation

assets. We also use fair RoE-implied PB valuation, which is an absolute valuation metric but, unlike the

DCF methodology, allows us to take a conservative and more short-term view and capture the current

market situation and risks. For example, DCF currently provides little support to the assessments of fair

value for solar companies, in our view, given low or negative earnings and heavy consolidation in the

industry. We also adopt a peer-group-based approach (EV/sales or EV/EBITDA) where appropriate and

for stocks with cyclical sales/earnings growth potential (for example, semiconductor producers).

Clean energy & technology: growth and profitability

2008 2009 2010 2011 2012e

Growth Sales 11.1% -5.2% 8.5% 4.4% 3.2% EBITDA 0.4% 1.5% 11.9% 1.5% 1.5% EBIT -1.9% -1.9% 13.8% -4.2% 7.9% Net profit -7.5% -25.4% 29.1% -9.3% 10.4%

Margins


Productivity

Capex/sales 0.21 0.19 0.16 0.15 0.10 Asset turnover (x) 0.92 0.76 0.78 0.75 0.71 Net debt/equity 0.60 0.52 0.73 0.55 3.68 ROE 0.20 0.21 1.14 0.06 0.13

Note: based on all low-carbon power producers, energy efficiency and waste & water stocks under HSBC coverage Source: company data, HSBC estimates

82


abc


HSBC Climate Change Benchmark Index

Trading data 5-yr ADTV (EURm) n/aAggregated market cap (EURm) 638 (340 constituents)Performance since 1 Jan 2000 Absolute 21%Relative to MSCI ACWI 2%3 largest stocks Siemens, Honeywell Int, ABB LtdCorrelation (5-year) with MSCI ACWI 0.95

Note: All data is as of 31 May 2012 Source: MSCI, HSBC Equity Quantitative Research

Top 10 stocks: HSBC Climate Change Benchmark Index


1 Siemens 19.7% 2 Honeywell International 18.6% 3 ABB 18.5% 4 Emerson Electric 9.1% 5 Exelon 7.6% 6 Schneider Electric 5.6% 7 Nextera Energy 4.9% 8 Waste Management 4.8% 9 Enel 3.6% 10 Southern Co 3.3%

Note: All data is as of 31 May 2012 Source: HSBC Equity Quantitative Research

Country breakdown: HSBC Climate Change Benchmark Index

Country Weights (%)

US 41.6% Germany 10.3% Japan 9.6% France 8.5% Canada 3.3% UK 3.3% Switzerland 3.0% Italy 2.2% Taiwan 2.0% Brazil 2.0%

Note: All data is as of 31 May 2012 Source: HSBC Equity Quantitative Research

Core industry drivers: clean energy & technology

Cleantech

Construction cost

Raw material prices

Technology

Weather

Cost competitiveness

towards grid parity

Policy including Tariff

Financing cost

Cleantech

Construction cost

Raw material prices

Technology

Weather

Cost competitiveness

towards grid parity

Policy including Tariff

Financing cost

Source: HSBC

PE chart: HSBC Climate Change Benchmark Index

0.0

5.0

10.0

15.0

20.0

25.0

2004 2005 2006 2007 2008 2009 2010 2011 2012

12M forw ard PE

Source: HSBC Equity Quantitative Research

PB vs. ROE: HSBC Climate Change Benchmark Index

1.0

2.0

3.0

4.0

2004 2006 2008 2010 2012

10

15

20

25

12M forw ard PB (LHS) 12M f orward ROE % (RHS)

Note: PB/RoE is calculated based on the top 10 index constituents. Source: Thomson Reuters Datastream, HSBC Equity Quantitative Research

83


abc

Climate change

Climate change team Nick Robins Head, Climate Change Centre of Excellence HSBC Bank plc +44 20 7991 6778 [email protected]

Zoe Knight Director, Climate Change Strategy HSBC Bank plc +44 20 7991 6715 [email protected]

Wai-Shin Chan Director, Climate Change Strategy - Asia-Pacific The Hongkong and Shanghai Banking Corporation Limited +852 2822 4870 [email protected]

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

84

ab

c

Emission trading schemes and carbon taxes around the world

Key

Existing carbon reduction scheme

Planned carbon reduction scheme

Currently no schemes announced

USRegional GHG Initiative (RGGI) (2009), Western Climate Initiative cap and trade for California scheduled for January 2013, California Cap and Trade scheduled for January 2013. Carbon tax in Bay Area District (California) and Boulder (Colorado)

CanadaAlberta Specified Gas Emitters regulation (2007), Western Climate Initiative cap and trade for BC, Manitoba, Ontario and Quebec scheduled for January 2013. Carbon tax planned in BC and Quebec (2012)

JapanVoluntary ETS (2005), Tokyo Metropolitan Trading Scheme (2010); planned carbon tax (October 2012)

AustraliaCarbon tax takes effect July 2012; Cap and trade scheduled to replace carbon tax in 2015

South KoreaMandatory cap from 2012; ETS scheduled for 2015

BrazilPlanned Rio de Janeiro ETS (2013)

New ZealandETS (2010). Waste included from 2013, agriculture from 2015

South AfricaPlanned carbon tax (2013/14). Levy on electricity from non-renewables

IndiaTax on coal production and imports (2010). Energy efficiency trading scheme (PAT) (2012)

EUEU ETS energy and industrial sectors (2005). Extended to the aviation sector January 2012. Carbon taxes in Finland (1990), Sweden (1991), Norway (1991), Denmark (1992), and Switzerland (2008), Ireland oil and gas (2010), UK carbon floor price scheduled April 2013

ChinaPlanned pilot cap and trade in provinces (Beijing, Shenzhen, Chongqing, Guangdong, Hubei, Shanghai and Tianjin) (2014). Carbon tax by 2015 under discussion

MexicoNational Climate Change Law proposes a national emissions trading scheme

Key

Existing carbon reduction scheme

Planned carbon reduction scheme

Currently no schemes announced

USRegional GHG Initiative (RGGI) (2009), Western Climate Initiative cap and trade for California scheduled for January 2013, California Cap and Trade scheduled for January 2013. Carbon tax in Bay Area District (California) and Boulder (Colorado)

CanadaAlberta Specified Gas Emitters regulation (2007), Western Climate Initiative cap and trade for BC, Manitoba, Ontario and Quebec scheduled for January 2013. Carbon tax planned in BC and Quebec (2012)

JapanVoluntary ETS (2005), Tokyo Metropolitan Trading Scheme (2010); planned carbon tax (October 2012)

AustraliaCarbon tax takes effect July 2012; Cap and trade scheduled to replace carbon tax in 2015

South KoreaMandatory cap from 2012; ETS scheduled for 2015

BrazilPlanned Rio de Janeiro ETS (2013)

New ZealandETS (2010). Waste included from 2013, agriculture from 2015

South AfricaPlanned carbon tax (2013/14). Levy on electricity from non-renewables

IndiaTax on coal production and imports (2010). Energy efficiency trading scheme (PAT) (2012)

EUEU ETS energy and industrial sectors (2005). Extended to the aviation sector January 2012. Carbon taxes in Finland (1990), Sweden (1991), Norway (1991), Denmark (1992), and Switzerland (2008), Ireland oil and gas (2010), UK carbon floor price scheduled April 2013

ChinaPlanned pilot cap and trade in provinces (Beijing, Shenzhen, Chongqing, Guangdong, Hubei, Shanghai and Tianjin) (2014). Carbon tax by 2015 under discussion

MexicoNational Climate Change Law proposes a national emissions trading scheme

Source: HSBC Policy Database, Reuters, government sources

85


abc

Climate change – a long-term structural force Goods and services derived from the natural environment (natural capital) are crucial for local and

national economies, and maintaining healthy natural capital is structurally important to future economic

prosperity. Land for agriculture, water for energy production and industrial processes, clean air for high-

tech goods are examples of natural capital. Impairing natural capital through over-extraction, pollution

and the introduction of non-native species can cause imbalance in the ecosystem and prevent natural

rejuvenation; the long-term advance of climate change can exacerbate these resource issues.

The climate is best understood as “average weather” expressed in terms of temperatures, seasonal

variations, rainfall, as well as extreme events such as floods, storms and droughts. In essence, climate

change disrupts historical patterns, exacerbating existing natural resource stresses confronting the global

economy. For example, agricultural yields are affected by increasing temperatures, industrial production

is disrupted by water availability (too much or too little) and lifestyles and health can be distressed by

extreme events and changes in the average weather.

To slow climate change, global policy momentum remains focused on reducing emissions; the map at the

front of this section shows the many schemes and policies which have been put in place globally in order

to reduce greenhouse gas (GHG) emissions. Some 138 countries, accounting for 87% of global emissions,

have a national climate change strategy in place1. However, economic permafrost – sub-par economic

growth and the era of austerity – is not politically conducive to reducing emissions and the re-

carbonisation of the global economy is a real concern because, over the longer term, it affects the natural

capital which contributes so much to the economy. 2011 was a year of re-carbonisation for the global

economy (see tables at the back of this section), with emissions growing faster, at 3.2%, against global

GDP growth of 2.5%. On this basis we are moving too slowly to prevent a global warming temperature

rise of 2°C from GHG emissions.

While we are aware of the scientific basis underlying climate change (see No debate among climate

scientists: it’s happening, 2 November 2011), we examine climate change from an investment

perspective. The two key issues at the heart of climate change analysis are: (1) the impact on industry and

the economy of the drive to reduce emissions; and (2) the impact of disruption relating to rising

temperatures and the resultant weather extremes, such as the floods in Thailand last year. Since climate

change is a global phenomenon, these two issues are to some extent applicable to all sectors, all regions

and all asset classes.

1 Copenhagen Accord

Nick Robins Head, Climate Change CentreHSBC Bank plc +44 20 7991 6778 [email protected]

Zoe Knight Climate Change Strategy HSBC Bank plc +44 20 7991 6715 [email protected]

Wai-Shin Chan, CFA Climate Change Strategy The Hongkong and Shanghai Banking Corporation Limited + 852 2822 4870 [email protected]

http://www.research.hsbc.com/midas/Res/RDV?ao=20&key=AY45gVbPLJ&n=312474.PDF

http://www.research.hsbc.com/midas/Res/RDV?ao=20&key=AY45gVbPLJ&n=312474.PDF

86


abc

Sector impacts Climate change is multi-sector – part of a wider resource nexus

The effects of climate change can be disruptive, and the exacerbation of existing natural resource stresses

is already being felt across many industries. The chart below shows why the climate is so important to

key areas of the economy and especially to the strategic relationship between energy, water and food.

Resource nexus

Energy

Food

Climate

Water

Decarbonisingenergy

Impacts on food production

Constraints on thermal

power

Impacts on yields

Rising water

stress

Food vs Fuel

Food vs Fuel

Rising water

stress

Energy

Food

Climate

Water

Decarbonisingenergy

Impacts on food production

Constraints on thermal

power

Impacts on yields

Rising water

stress

Food vs Fuel

Food vs Fuel

Rising water

stress

Source: HSBC

Incorporating the “climate factor” into investment analysis involves examining the impact of changes and

strains within these strategically important relationships. For many sectors, whether the impact is positive

or negative depends on the nature of the exposure. A positive driver could mean increased revenue

opportunity from a beneficial regulatory environment (eg for energy efficiency), or that the disruptive

impacts of climate change create a market opportunity (eg for agricultural chemicals). A negative driver

could relate to increased costs arising from regulation that targets emission reduction (eg for electric

utilities), or from increased input costs caused by potential climate-change-related weather disruption (eg

for food producers). The timing and magnitude of the climate factor in financial terms varies by sector

and can only be fully determined at a company level.

Climate change and energy: Energy is the source of 66% of global GHG emissions. Therefore, efforts

to slow global warming require not only a reduction in energy demand but also for the energy supply

itself to have a lower carbon footprint – ie the decarbonisation of energy (see Energy in 2050, March

2011). Several factors are influencing changes to energy use. High oil prices are causing business to turn

towards energy efficiency, which can help to save on costs (see Oil is the new carbon, 8 March 2012).

The shale gas boom is contributing to energy security in the US and will help its emissions footprint over

the short term, although shale gas could also be taking investment away from other renewable energy

technologies and is under scrutiny for its potential environmental impact, such as groundwater pollution

(see How does shale fit into a low-carbon future, 10 February 2011). In Europe, we estimate that the

http://www.research.hsbc.com/midas/Res/RDV?ao=20&key=TB0uEyzId3&n=293253.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=SMJHfCFfMM&n=323536.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=30yli0HTrP&n=290636.PDF

87


abc

combination of efficiency and renewable energy laws could lead to the gradual decline of gas usage

overall, and this should stimulate more investment in other energy forms, as environmental concerns have

halted or slowed shale exploration before it has become commercial (see European Utilities: Gas

consumption on the slide, 2 April 2012). The Fukushima accident last year has also caused many

countries to rethink their energy strategies, but replacing nuclear with a lower-emission technology is not

easily done in the short term (see Thermal spikes from nuclear loss, 10 May 2012).

Climate change and food: Agricultural processes contribute 14% to global GHGs, while land use

change (mostly deforestation for agriculture) contributes a further 13%. Rising temperatures and

increasing levels of carbon dioxide in the atmosphere have direct impacts on agricultural output.

Although mostly negative for output, this is not always the case: increased carbon can boost crop

fertilisation (up to a certain point) and in temperate, colder regions, increased temperatures can boost

yields. In Agriculture: Double Trouble (12 December 2011), we look in detail at the climate impacts on

the global agriculture sector, highlighting that companies which improve productivity, such as fertiliser or

seed producers and those involved in crop protection, could be long-term winners. We also found that

global cereal growth would be lower with climate change, creating volatile prices and changing trade

flows. The food issue is also a concern as the global population is rising faster than agricultural yields.

Food demand is estimated to increase by 50-70% by 2050 whereas cereal production could only increase

30% (see Resources and the great transformation – food security, 25 January 2012).

Climate change and water: Water availability – too much or too little – is a major expression of climate

change. Rising temperatures can exacerbate droughts in regions already prone to water shortage, and the

frequency and magnitude of extreme events can be influenced by increased water vapour (see Extreme

climate; expect more droughts and floods, 22 November 2011). The floods in Thailand last year had a

significant effect on local GDP (see More flooding: Thailand this time, 13 October 2011). Also, the growing

trend of shifting facilities to more cost-effective regions such as China means that water issues need to be

considered by companies which might be based in water-abundant countries, but whose operations are

exposed to water-scarce regions (see The water hole in the supply chain, 29 November 2011).

The three resources of energy, food and water are also interrelated:

Energy and food: There is tension between producing agricultural crops for food or fuel.

Food and water: Agriculture accounts for around 70% of global water withdrawal, hence more erratic

water availability for agriculture will likely lead to variable output levels and volatile prices.

Energy and water: Water supply is essential for thermal power generation, whereas key renewable

technologies are much more water-efficient; water constraints also highlight the need for energy

efficiency.

Regional impacts Climate change is multi-regional – reflected in national economic strategies

From a cross-boundary perspective, we compare the climate change vulnerability and opportunities of the

G-20 in Scoring climate change risk (9 August 2011). At a national level, the sector drivers described

above come together to form policies such as energy and food security, GHG emission mitigation and

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=2z1LAZ0e8a&n=325748.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=2z1LAZ0e8a&n=325748.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=j1yafk0fGq&n=329867.PDF

http://www.research.hsbc.com/midas/Res/RDV?ao=20&key=tC6aViwlgJ&n=308859.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=DmDcGg57tL&n=319181.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=HkZ5QlELPx&n=314319.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=HkZ5QlELPx&n=314319.PDF

http://www.research.hsbc.com/midas/Res/RDV?ao=20&key=7vbFvd6kCn&n=310291.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=wiw8JSmH0N&n=314972.PDF

http://www.research.hsbc.com/midas/Res/RDV?ao=20&key=N9JAiLm0es&n=304322.PDF

88


abc

energy efficiency. Much of our work therefore focuses on climate strategies at a country level, and we

have published in-depth reports on the emerging markets of China, India, Brazil and South Korea; in

addition we publish shorter updates on policy for the EU and the US.

Global markets

We analyse global climate discussions for sector and regional impacts. The United Nations climate

negotiations provide a longer-term window on prospects for the global climate economy (see Dispatches

from Durban, 13 December 2011). The urgency of climate change is almost generally accepted, although

how to deal with the issues, and which countries should shoulder more responsibility is often debated at

these climate negotiations (see Gear shift needed in climate talks, 20 May 2012). The perspective of

individual countries is often a sticking point as GHG emissions know no boundaries (see Aviation

wildcard – BASICs remain as others waver, 24 February 2012).

Emerging markets

China: The impact of climate change could affect energy, agriculture, industry and water availability in

China. Natural capital is under great stress and this has serious implications for companies that source

from, operate in and sell to China (see China's rising climate risk, 6 October 2011). The impact on each

province is different and we look not only at national policies on emissions control, industrial efficiency,

and water usage but also how they filter down to various provinces and are implemented across such a

vast country (see Is China too big to filter down?, 21 March 2012).

India: The 2008 National Action Plan on Climate Change set out India’s ambitions for low-carbon

growth, driven by achieving climate and energy security as well as reducing emissions and dependence

on energy imports. The climate economy could grow in terms of solar power, energy efficiency and

renewable installations (see Sizing India’s climate economy, 28 January 2011). The subsequent launch of

the “Perform, Achieve and Trade” scheme has implications for energy consumption across many sectors.

We believe the key beneficiaries to be solution-providers such as process control, automation and

manufacturers of more efficient equipment (see India: Trading energy efficiency, 12 April 2012).

Brazil: The resource nexus of water, energy and food supplies more than half of Brazil’s economy –

producing sugar cane, coffee, beef and chicken as well as allowing hydropower to supply 75% of the

country’s electricity (see Brazil: LatAm’s bio super power, 25 April 2012). However, of the G-20

countries Brazil is also the fifth most vulnerable to the disruptive effects of climate change because it is

so dependent on the basic resource most disrupted by climate change – water availability. We look at how

Brazilian companies maintain their low-carbon energy advantage and strengthen resilience against

potential climate change impacts, especially across the agriculture, food processing, utilities and financial

services sectors (see Investing in the bio super power, 25 April 2012).

South Korea: Its economic success has been accompanied by rising energy consumption and a 96%

dependence on energy imports. With oil accounting for one-quarter of total imports, Korea has committed

itself to green growth, breaking away from a high-energy, high-carbon trajectory. The national strategy

focuses on the export potential of its core industrial base – for example, batteries, light-emitting diodes

(LED) technology, nuclear and solar (see Korea at the green growth crossroads, 16 March 2012). We

also examine the new carbon policies which constrain the emissions of large emitters, making carbon

performance another factor for investors to evaluate. At the same time, companies which accelerate the

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=jhknavMhiR&n=316255.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=jhknavMhiR&n=316255.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=f5sc4lAwRQ&n=331588.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=cqNE1z6gk0&n=322156.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=cqNE1z6gk0&n=322156.PDF

http://www.research.hsbc.com/midas/Res/RDV?ao=20&key=Fxjcu6AJgD&n=309614.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=refCpfczS5&n=324821.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=qEs6Juv9Em&n=282369.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=xB9GcWvGtV&n=326828.PDF

http://www.research.hsbc.com/midas/Res/RDV?ao=20&key=PrdTAbKpKD&n=327947.PDF

http://www.research.hsbc.com/midas/Res/RDV?ao=20&key=DiAQMSixTK&n=327972.PDF

http://www.research.hsbc.com/midas/Res/RDV?ao=20&key=bpw7L1iZ0w&n=324195.PDF

89


abc

design and deployment of smart technologies that can succeed in the world’s growing markets for low-

carbon solutions could be at the cutting edge of climate solutions such as fuel cell technology (see

Investing in Korea’s green growth, 16 March 2012).

Developed markets

The greater disclosure in certain developed markets, such as the EU and the US, provides information on

how climate policy will be enacted and enforced. For example, efficiency targets in Europe have to filter

down to national targets (see EU efficiency deal inches closer, 1 March 2012) and politics can often take

the spotlight away from climate change issues in the US (see US: Emerald lining for efficiency, 15

February 2012). Austerity in developed markets does not mean that climate issues are falling down the

agenda; instead we believe it provides an opportunity to rebuild the economy in a more efficient manner

(see Designing a Green Exit : Five steps to a resource-efficient recovery, 25 May 2012).

Asset impacts Climate change is multi-asset – affecting asset allocation

The effects of climate change cut across all asset classes. Real estate investors may be aware that rising

sea levels may affect physical properties located in coastal areas; commodity traders may be aware that

rising temperatures affect commodity prices through agricultural yield disruptions; investors in forest

assets may forgo the wood harvest in return for payment in order to reduce emissions. The solutions

available to either reduce emissions or protect against climate impacts must still be financed, and thus

provide investment opportunities within different asset classes.

For companies, insurance options change as assets are perceived to be more in harm’s way (see Insuring

Asia against climate risk and natural disasters, 7 February 2012). For investors, especially longer-term

investors such as pension funds, investing in fixed income or debt through bonds provides a less risky

option for investment in national strategy, such as a changing the energy mix in favour of renewable

energy (see Offshore wind: The wheel of fortune, 28 May 2012). We estimate the value of bonds aligned

to the climate economy at around USD174bn globally and expect more climate-themed bond issuance by

development banks, municipalities and project developers in the near future (see Bonds and climate

change: the state of the market in 2012, 23 May 2012). Currently, low-carbon transport such as rail

dominates the climate bond market, with Europe the largest source of outstanding bonds.

The climate change theme is closely related to the work of our clean technology team globally, which

analyses climate solutions through renewable technologies such as solar and wind power; also, our

quantitative research team produces HSBC’s proprietary climate change index.

http://www.research.hsbc.com/midas/Res/RDV?ao=20&key=XxchVIMaFJ&n=324281.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=rkWdzY1C3k&n=322692.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=zq4PvfeUj9&n=321283.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=BpIcFxkUs9&n=331284.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=IhgNrpg3RG&n=320384.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=IhgNrpg3RG&n=320384.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=h0HC0A99jb&n=331397.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=2za2M1a3ty&n=330639.PDF

https://www.research.hsbc.com/midas/Res/RDV?ao=20&key=2za2M1a3ty&n=330639.PDF

90


abc

Climate change drivers Emissions are continuing to rise… … on a recarbonising trend

0

5

10

15

20

25

30

35

1892

1898

1904

1910

1916

1922

1928

1934

1940

1946

1952

1958

1964

1970

1976

1982

1988

1994

2000

2006

2012

tCO2bn Dev eloped Dev eloping

-3.0

-1.5

0.0

1.5

3.0

4.5

6.0

1980

1984

1988

1992

1996

2000

2004

2008

2012

% yoy GDP CO2 emiss ions

Note: Fossil fuel emissions only. Source: CDIAC, HSBC

Source: HSBC, IEA, Thomson Reuters Datastream, World Bank

Temperatures are rising… … increasing the likelihood of disruptive extreme events

-0.6

-0.3

0

0.3

0.6

0.9

1882

1892

1902

1912

1922

1932

1942

1952

1962

1972

1982

1992

2002

2012

ºC

0

5

10

15

20

25

30

35

1962

1967

1972

1977

1982

1987

1992

1997

2002

2007

2012

Droughts

0

50

100

150

200

250FloodsDrought Flood (RHS)

Note: Anomaly relative to the 1951-1980 period. Source: NASA GISS, HSBC

Source: EMDAT disaster database., HSBC

Investors supporting a global policy framework are increasing…

… and climate bond financing is increasing

Source: CERES, HSBC Source: Bloomberg, HSBC, Climate Bond Initiative

0

5

10

15

20

25

2009 2010 2011

USDtrn

(187) (259)

(285)

Transport119.0

Finance22.4

Agriculture and

Forestry0.7

Energy 29.4

Waste 1.2

Buildings and

Industry 1.5

USDbn

91


abc

Wind: Top 10 markets for installed capacity today Solar: Top 10 markets for installed solar PV today

0

20

40

60

80

100

120

Chin

a

US

Ger

man

y

Spai

n

Indi

a

Italy

Fra

nce

UK

Can

ada

Oth

er E

urop

e

GW 2011 2014e

0

10

20

30

40

Ger

man

y

Italy

Japa

n

USA

Spai

n

Fran

ce

Chi

na

Cze

ch

Belg

ium

Kore

a

GWp 2011e 2014e

Source: HSBC Source: HSBC

Scoring climate risk reveals India as the most exposed and sensitive to change (top right most vulnerable, bottom left least vulnerable)

India is also less able to adapt on a relative basis (top right most vulnerable, bottom left least vulnerable)

Argentina

Australia

Brazil

Canada

China

Franc e

GermanyIndia

Indonesia

Italy

J apan

M exico

Russia

Saudi ArabiaSouth

A fricaKorea Turkey

UK

US

0.0

2.0

4.0

6.0

8.0

10.0

0.0 2.0 4.0 6.0 8.0 10.0Exp osure

Sens

itivi

ty

ArgentinaAustralia

Brazil

Canada

Ch ina

FranceGermany

India

Indonesia

Italy

Japan

M exicoR ussia

Saudi Arabia

S Africa

Korea

Turkey

UK

US2.0

4.0

6.0

8.0

10.0

2.0 4.0 6.0 8.0 10.0Adaptive potential

Ada

ptiv

e ca

paci

ty

Source: HSBC, World Bank, Thomson Reuters Datastream Source: HSBC, World Bank, Thomson Reuters Datastream

China has overtaken Germany as the world’s largest exporter of climate-smart goods and technologies

Carbon intensity of the G-20

0

10

20

30

40

50

60

70

Ch Ger US Jp Ita Fra Kor

0%

5%

10%

15%

20%

25%

30%

35%Ex ports US$bn CAGR 2005-10 (RHS)

0

1

2

3

4

Rus

sia

Chi

naIn

dia

S.Af

rica

Indo

nesi

aS_

Arab

iaTu

rkey

Aust

ralia

S.Ko

rea

Mex

ico

Can

ada

US

Braz

ilAr

gent

ina

EU27

Ger

man

yIta

lyU

KFr

ance

Japa

n

tCO2mn/USDbn

Note: CSGT =-Climate-smart goods and technologies Source: UN Commodity Trade Statistics Database, HSBC

Note: Most recent data from 2008 Source: Thomson Reuters Datastream World Bank, WRI CAIT, HSBC

92


abc

Notes

93


abc

Construction & building materials

Construction & building materials team John Fraser-Andrews* Analyst HSBC Bank plc +44 20 7991 6732 [email protected]

Jeff Davis* Analyst HSBC Bank plc +44 20 7991 6837 [email protected]

Tobias Loskamp*, CFA Analyst HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 2828 [email protected]


EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

94

ab

c

Sector structure

CRH

HeidelbergCement

Holcim

Kingspan

Lafarge

Saint-Gobain

Building materials producers

Barratt Developments

Bellway

Berkeley Group

Bovis Homes

Kaufman & Broad

Persimmon

Nexity

Redrow

Taylor Wimpey

Residential builders

ACS

Balfour Beatty

Carillion

FCC

Hochtief

Skanska

Vinci

Commercial real estate and public works

contractors

Construction

CRH

HeidelbergCement

Holcim

Kingspan

Lafarge

Saint-Gobain

Building materials producers

Barratt Developments

Bellway

Berkeley Group

Bovis Homes

Kaufman & Broad

Persimmon

Nexity

Redrow

Taylor Wimpey

Residential builders

ACS

Balfour Beatty

Carillion

FCC

Hochtief

Skanska

Vinci

Commercial real estate and public works

contractors

Construction

Source: HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

95

ab

c

Cement consumption per capita versus GDP per capita (2010)

France

Finland

Estonia

Denmark

Czech Republic

CroatiaBulgaria

BelgiumAustria

0

200

400

600

800

1000

1200

1400

0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000

GDP per capita (USD)

Cons

umpt

ion

per c

apita

, Kg

Colombia

Morocco

Saud i Arabia*

PakistanBangladesh*

Sri Lanka*South Africa

Argentina

Algeria

UkraineSerbia Ecuador*

Syria

Kenya

IranEgypt

Indonesia

Mexico

Thailand

Brazil

Korea, Rep.

Russia

USAIndia

China

Greece

UK

Turkey

Sweden

SpainSlovenia

Romania

PortugalPoland

NetherlandsLithuania

Italy

IrelandHungary

Germany

France

Finland

Estonia

Denmark

Czech Republic

CroatiaBulgaria

BelgiumAustria

France

Finland

Estonia

Denmark

Czech Republic

CroatiaBulgaria

BelgiumAustria

0

200

400

600

800

1000

1200

1400

0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000

GDP per capita (USD)

Cons

umpt

ion

per c

apita

, Kg

Colombia

Morocco

Saud i Arabia*

PakistanBangladesh*

Sri Lanka*South Africa

Argentina

Algeria

UkraineSerbia Ecuador*

Syria

Kenya

IranEgypt

Indonesia

Mexico

Thailand

Brazil

Korea, Rep.

Russia

USAIndia

China

Greece

UK

Turkey

Sweden

SpainSlovenia

Romania

PortugalPoland

NetherlandsLithuania

Italy

IrelandHungary

Germany

France

Finland

Estonia

Denmark

Czech Republic

CroatiaBulgaria

BelgiumAustria

* Represents Cembureau estimates Note: GDP per capita in constant USD 2000 Source: Cembureau, World Bank, HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

96

ab

cCement consumption and construction output growth versus real GDP growth in the UK (1956-2009)

-0.20

-0.15

-0.10

-0.05

0

0.05

0.10

0.15

0.20

0.25

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

Real GDP growth Construction output growth Cement consumption growth

Structural construction growth period, underpinned by infrastructure deployment and expansion of housing stock

Urbanisation reaches high levels; Infrastructure largely provided.Urbanisation cycle breaks down, undermining construction structural growth prospects

Cement consumption and construction output growth exceeds real GDP growth (the cement/construction to GDP

growth multiplier exceeds unity)

Cement consumption and construction output growth undershoots real GDP growth (the cement/construction

to GDP growth Construction is a highly cyclical industry

-0.20

-0.15

-0.10

-0.05

0

0.05

0.10

0.15

0.20

0.25

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

Real GDP growth Construction output growth Cement consumption growth

Structural construction growth period, underpinned by infrastructure deployment and expansion of housing stock

Urbanisation reaches high levels; Infrastructure largely provided.Urbanisation cycle breaks down, undermining construction structural growth prospects

Cement consumption and construction output growth exceeds real GDP growth (the cement/construction to GDP

growth multiplier exceeds unity)

Cement consumption and construction output growth undershoots real GDP growth (the cement/construction

to GDP growth Construction is a highly cyclical industry

Source: ONS, Cembureau, HSBC

97


abc

Sector description Producers of building materials and users, housebuilders and contractors

The construction sector is a vertical chain of sub-sectors that begins with the building materials

companies, as shown in the sector structure chart.

Building materials

Building materials companies produce the materials used to build homes (by residential developers) and

to build commercial real estate and infrastructure (by contractors). The companies can be divided into the

heavy-side materials majors, Holcim, Lafarge, Cemex and HeidelbergCement, and the light-side materials

manufacturers, for example, Saint Gobain and CRH.

Heavy-side materials (cement, aggregates ready-mix concrete and asphalt) are consumed by infrastructure

projects like road expansion and utilities infrastructure, as well as the foundations stage of residential and

non-residential buildings. Light-side materials (concrete products, wallboard, insulation, bricks, tiles, pipe

and glass) are used predominantly in above-ground-level building construction. The heavy-side majors

have about two-thirds of their cement capacity in fast-growing emerging markets that are benefiting from

structural expansion in infrastructure. Light-side producers are predominantly exposed to weak and

fragmented construction end-markets in debt-laden developed economies.

Housebuilders and contractors: the main customers of building materials companies

Residential developers combine land (which must have residential planning approval in the UK) and

building materials to construct and sell houses. The UK is comfortably the most consolidated market in

Europe, where approximately 35% of production is undertaken by the seven listed builders. About 80% of

UK new-build homes are sold speculatively to individuals. The other 20% – called social units – are built

for and sold to government bodies at low margins, often as a necessary concession for residential

planning approval from the local planning authority (called Section 106 agreements).

The contractors deliver services essential to the creation and care of infrastructure and non-residential

buildings assets, including project design, engineering and construction and facilities management.

Key themes Urbanisation cycle underpins decades of robust EM construction growth

Our statistical regression analysis suggests that cement consumption is determined by real GDP per capita

growth, as illustrated in the first graph above.

Typically, GDP per capita of around USD1,000 to USD3,000 triggers population growth and

urbanisation from a low base, underpinning cement-intensive mass infrastructure investment and real estate

development. Urbanisation further perpetuates population growth, which enhances absolute GDP and

growth thereof.

This urbanisation cycle (see chart ‘The cement intensive urbanisation cycle’ below) supports cement

consumption and construction output growth in excess of real GDP growth, up to a saturation point,

when infrastructure and the housing stock have largely been provided.

John Fraser-Andrews* Analyst HSBC Bank plc +44 20 7991 6732 [email protected]

Jeff Davis* Analyst HSBC Bank plc +44 20 7991 6837 [email protected]

Tobias Loskamp*, CFA Analyst HSBC Trinkaus & Burkhardt AG, Germany +49 211 910-2828 [email protected]


98


abc

This saturation point is at around GDP per capita of USD13,000 (the top of the hump in the graph

‘Cement consumption per capita versus GDP per capita’ earlier in the section), after which the

cement-demand-to-real-GDP multiplier falls below unity.

We expect emerging markets to deliver robust cement and construction growth for at least the next 30

years because:

Our Global Economics team expects emerging markets to generate the highest-trend GDP per capita

growth in the long term as these countries converge toward western levels.

Our regression analysis concludes that cement/construction-to-GDP-growth multipliers are higher

than unity in almost all EM.

High construction/cement-to-GDP-growth multipliers in emerging markets are explained by expectations

of high population growth coupled with low infrastructure provision (see road and rail provision charts

above) and urbanisation levels (see chart above).

The cement intensive urbanisation cycle Road provision per 1,000 people

GDP per capita growth

Population growth, urbanisation & housing demand

Infrastructure investment

0

5

10

15

20

25

Jordan

Korea, Rep.

Iran

China

India

Mexico

Malaysia

Turkey

Russia

U.K.

Germ

any

France

U.S.*

Road kms per 1000 people (2006)

Source: HSBC *US data is for FY2006 (all other years are calendar years) Source: Cembureau, World Bank, HSBC

Rail provision per 1,000 people Urbanisation levels (%, 2008)

0.00

0.20

0.40

0.60

0.80

China

Jordan

India

Malaysia

Korea, Rep.

Iran

Turkey

Mexico

U.K.

Germ

any

France

Russia

U.S.

Rail kms per 1000 people (2007)

0%

20%

40%

60%

80%

100%

Indi

a

Egyp

t

Chi

na

Alge

ria

Fran

ce US

Braz

il

UK

Urban population as a % of total population

Source: World Bank, HSBC Source: World Bank, HSBC

99


abc

Conversely, in developed countries such as the UK, demographics are less favourable and urbanisation is

largely complete, so those countries have low long-term cement and construction growth potential (ie the

cement/construction-output-to-GDP-growth multipliers are near zero).

High household indebtedness and constrained finance availability to weigh on developed market

construction growth for several years

In developed economies, we expect the availability of finance to remain constrained for at least the next

two years for the following reasons.

Many western economies are suffering from record household indebtedness, high unemployment,

weak earnings growth and stretched long-term housing affordability. Unsurprisingly, banks are

unwilling to increase substantially the availability of cheap finance to households and businesses in

this fragile economic climate.

The banking industry continues to deleverage due to funding constraints and more stringent regulation.

Weak loan growth is likely to weigh on residential and non-residential construction because:

Most home-buyers need mortgage support, so we expect housing demand to remain weak for some time.

Private developers rely heavily on finance to fund their working capital requirements and for

financial leverage to amplify their returns on capital.

We expect UK housebuilders to suffer sluggish volume (and top-line growth) for several years, which

implies weak demand for building materials.

Fiscal austerity set to drive large cuts in European infrastructure construction

European governments are suffering from record indebtedness and unsustainable budget deficits. The

policy response has been austerity programmes to reduce fiscal deficits over the next four to five years.

The US government has increased infrastructure spending, relying on reserve currency status to maintain

a high budget deficit and indebtedness.

We expect European infrastructure budgets to suffer from public spending cuts as governments give

priority to spending on front-line services. We forecast public construction spending will decline by 35%

from the end of 2009 to 2013e in Spain and Ireland, and by 10% to 14% in other European countries.

European contractors face a challenging market in the medium term and we expect demand for building

materials from the European infrastructure end market to remain weak until 2013e.

Robust cement volume growth in emerging markets during 2008-09 global crisis

Lafarge serves as a proxy for the cement sector, and the performance of its operations in 70 countries is

representative of the volume development in different regions since 2005. The period 2005-07 was

characterised by a construction boom in emerging markets, with a more subdued growth rate in western

Europe, and US cement volumes peaking in 2006.

Growth decelerated significantly during the 2008-09 crisis as contagion from the West impacted

sentiment and funding flows, but emerging markets demonstrated significantly greater volume resilience

than developed markets. Since 2010, emerging market volume growth has accelerated, although Lafarge

has underperformed industry growth, particularly in Africa and the Middle East, where the company has

lost market share to new regional competitors.

100


abc

Lafarge’s cement volumes in Western Europe continued to slide in 2010-11, following the collapse of the

construction industry in 2008-09, as austerity hit southern Europe, to which Lafarge has a heavy

exposure. North American volumes have recovered slightly from a low base due to the stimulus spending

in the US and a robust market in Canada.

Lafarge cement volumes 2005-11 (compound annual growth rates)

2005-07 2008-09 2010-11

Western Europe 2.3% -16.9% -5.5% Central and East Europe 16.1% -11.6% 1.3% North America -1.7% -18.8% 4.0% Africa Middle East 6.8% 3.3% -2.2% Latin America 8.3% 2.3% 5.6% Asia 3.2% 5.9% 2.2% Group 3.4% -4.8% 0.0%


Cement markets less competitive than light-side materials in developed markets

The table above shows that the heavy-side materials market benefits from several characteristics, such as

high concentration, barriers to entry and low import penetration, that underpins more disciplined pricing

than in light-side markets, which are generally fragmented and highly competitive.

Sector drivers Construction and building materials leading indicators

Affordability and mortgage availability are key long-term leading indicators for residential construction.

They determine the level of buyer enquiries and housing sales (proxies for short-term housing demand),

which can usually be tracked on a monthly basis. High housing demand drives growth in building-permit

applications and housing starts, which may lag if the housing inventory is high.

Vacancy rates show the demand/supply balance in commercial real estate markets. We track office

employment, retail sales and manufacturing output as proxies for commercial real estate space demand. A

combination of high space demand and low vacancy usually leads to rising rents, which should provide an

incentive for development.

Comparison of heavy-side and light-side materials

Cement (heavy-side) Finished goods (light-side) Consequences

Substitutability Very weak, limited to mixing cementitious substitutes by cement producer to reduce cost batch.

Medium, producers compete on innovation.

Lower competition in cement markets versus competitive markets for building materials.

Transportability Low, recognised that uneconomic to travel by road for more than 300km.

Transcontinental transport determined by weight and build.

Cement imports restricted to markets near shipping lanes. Building products more susceptible to overseas competition.

Market concentration High, determined by high capital investment barrier to entry.

Medium, economies of scale here led to consolidation but transportability ensures competition.

Cement is generally supplied on a local market basis by a limited number of producers, leading to higher pricing discipline, than in fragmented finished goods markets.

Source: HSBC

101


abc

We use governments’ infrastructure budgets to determine future public construction wherever possible.

Debt-to-GDP ratios and fiscal deficits also indicate the availability of future public finances.

Valuation Trading at significant discount to historical averages

The building materials companies and contractors trade on traditional earnings metrics, namely forward-

looking EV/EBITDA and price/earnings (PE) multiples.

The heavy-side building materials companies currently trade at EV/EBITDA multiples of 5.3-7.5x and PE

of 7.1-13.2x on our 2013e estimates, representing discounts to the long-term sector averages of 7.0x and

12.5x, respectively. These discounts exist despite our expectation of a strong earnings rebound to 2015

for the cement majors on recovery in US construction activity, robust emerging-market growth and cost

saving measures.

The only key accounting issues are the plant depreciation rates of building materials producers and the

profit-recognition policies of contractors.

The housebuilders trade on forward price to tangible book multiples (TNAV). Using accounting TNAV,

rather than adjusted TNAV, however, does not reflect that:

the land write-downs taken to date (which determine reported NAV) have not been enough to restore

profitability and returns to levels that an investor would deem acceptable on new investment; and

each company has applied different assumptions to determine land write-downs, rendering cross-

sector relative valuation difficult.

To calculate adjusted TNAV, the builders’ landbanks are decomposed into tranches by age and region

and the book value of each land tranche is then marked to today’s market value (one may also exclude

goodwill). The mark-to-market adjustments restore the landbanks to full margin and returns on capital. In

theory, therefore, the builders should trade at slight premiums to these adjusted TNAVs to reflect the

potential economic value creation on building out of the land bank.

European building materials: growth and profitability

2008 2009 2010 2011 2012e

Growth Sales 7.9% -17.5% 4.3% 5.7% 3.9% EBITDA 1.1% -23.1% 3.2% -2.4% 5.2% EBIT -4.1% -32.5% 0.0% -5.8% 12.4% Net profit -19.1% -55.1% -11.2% -23.8% 56.9%

Margins


Productivity

Capex/sales 10.9% 7.5% 6.3% 6.2% 6.2% Asset turnover (x) 61.0% 49.7% 49.5% 51.8% 51.4% Net debt/Equity 1.15x 0.74x 0.66x 0.64x 0.56x ROE 16.2% 6.4% 4.9% 3.6% 5.5%

Note: based on sector comprising CRH, HeidelbergCement, Holcim, Lafarge Source: MSCI, HSBC estimates

102


abc


MSCI All Country Europe Construction Materials Dollar Index


Trading data 5-yr ADTV (EUR) 963 Aggregated market cap (EURm) 51 Performance since 1 Jan 2000 Absolute -18% Relative to MSCI Europe US Dollar 3% 3 largest stocks Holcim, CRH, Lafarge Correlation (5-year) with MSCI Europe US Dollar

0.95


Top 6 stocks: MSCI All Country Europe Construction Materials Dollar Index *


1 Holcim 30% 2 CRH 22% 3 Lafarge 20% 4 HeidelbergCement 14% 5 Cimpor 8% 6 Imerys 6%

* There are only 6 stocks in this index Source: MSCI, Thomson Reuters Datastream, HSBC

Country breakdown: MSCI All Country Europe Construction Materials Dollar Index

Country Weights (%)

Switzerland 30% France 26% Ireland 22% Germany 14% Portugal 8%


US construction spending by end markets (USDbn)

0

200

400

600

800

1000

1200

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Residential Non-residentialPublic buildings Civ il engineering

Source: The United States Census Bureau, HSBC

PE band chart: MSCI All Country Europe Construction Materials Dollar Index

0.0

100.0

200.0

300.0

400.0

500.0

600.0

May

-96

May

-98

May

-00

May

-02

May

-04

May

-06

May

-08

May

-10

May

-12

Actual 5x 10x 15x 20x


PB vs. ROE: MSCI All Country Europe Construction Materials Dollar Index

0.6x

1.1x

1.6x

2.1x

2.6x

May

-96

May

-98

May

-00

May

-02

May

-04

May

-06

May

-08

May

-10

May

-12

2%

6%

10%

14%

18%

22%

Fwd PB (LHS) ROE (RHS)


103


abc

Financials – Banks

Europe Carlo Digrandi* Global Head of Financial Institutions Research HSBC Bank plc +44 20 7991 6843 [email protected]

Robin Down* Analyst, Global Sector Head, Banks HSBC Bank plc +44 20 7991 6926 [email protected]

Monica Patrascu* Analyst, HSBC Bank plc +44 20 7991 6828 [email protected]

Peter Toeman* Analyst, HSBC Bank plc +44 20 7991 6791 [email protected]

Rob Murphy* Analyst, HSBC Bank plc +44 20 7991 6748 [email protected]

Iason Kepaptsoglou* Analyst, HSBC Bank plc +44 20 7991 6722 [email protected]

Lorraine Quoirez* Analyst, HSBC Bank plc +44 20 7992 4192 [email protected]

Johannes Thormann* Global Head of Exchanges Analyst, HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 3017 [email protected]

Dimitris Haralabopoulos* Analyst, HSBC Securities SA +30 210 6965 214 [email protected]

Nitin Arora* Analyst, HSBC Bank plc +44 20 7991 6844 [email protected]

CEEMEA Gyorgy Olah* Head of Ceemea Banks Research Analyst, HSBC Bank plc +44 20 7991 6709 [email protected]

Aybek Islamov*, CFA Analyst, HSBC Bank Middle East +971 4423 6921 [email protected]

Tamer Sengun* Analyst, HSBC Yatirim Menkul Degerler A.S. +90 212 376 46 15 [email protected]

Jan Rost* Analyst, HSBC Securities (South Africa) (Pty) Ltd +27 11 676 4209 [email protected]

Sector sales Nigel Grinyer HSBC Bank plc +44 20 7991 5386 [email protected]

Martin Williams HSBC Bank plc +44 20 7991 5381 [email protected]

Jonathan Weetman HSBC Bank plc +44 20 7991 5939 [email protected]

Juergen Werner HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 4461 [email protected]

Philip P Dragoumis HSBC Securities SA +30 210 696 5128 [email protected]

Matthew Robertson HSBC Bank plc +44 20 7991 5077 [email protected]


EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

104

ab

cSector structure

Banks

Sectoral breakdown Geographical breakdown

Commercial banks

Local players

Wholesale banks

CIBM

Exchanges

Speciality finance

International players

Asset managers

Lenders

Inter dealer brokers

CEEMEA

UBS, CS

LSE, Deutsche Boerse Ashmore, Schroders

Provident Financial

ICAP, Tullett Prebon

STAN, SAN

LLOYDS, ISP

France

BNPP, SOGN

Germany

DB, CBK

Spain

SAN, BBVA

Italy

UCG, ISP

UK

STAN, RBS, LLOYDS

Switzerland

UBS, CS

Greece

BOC, NBG

Poland

Pekao, PKO

Turkey

Isbank, Garanti

Russia

Sberbank, VTB

South Africa

SBK, FSR

Middle East

QNB, NBAD

BARC, BNPP

Banks

Sectoral breakdown Geographical breakdown

Commercial banks

Local players

Wholesale banks

CIBM

Exchanges

Speciality finance

International players

Asset managers

Lenders

Inter dealer brokers

CEEMEA

UBS, CS

LSE, Deutsche Boerse Ashmore, Schroders

Provident Financial

ICAP, Tullett Prebon

STAN, SAN

LLOYDS, ISP

France

BNPP, SOGN

France

BNPP, SOGN

Germany

DB, CBK

Germany

DB, CBK

Spain

SAN, BBVA

Spain

SAN, BBVA

Italy

UCG, ISP

Italy

UCG, ISP

UK

STAN, RBS, LLOYDS

UK

STAN, RBS, LLOYDS

Switzerland

UBS, CS

Switzerland

UBS, CS

Greece

BOC, NBG

Greece

BOC, NBG

Poland

Pekao, PKO

Poland

Pekao, PKO

Turkey

Isbank, Garanti

Turkey

Isbank, Garanti

Russia

Sberbank, VTB

Russia

Sberbank, VTB

South Africa

SBK, FSR

South Africa

SBK, FSR

Middle East

QNB, NBAD

Middle East

QNB, NBAD

BARC, BNPP

Source: HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

105

ab

cSector price history

0

20

40

60

80

100

120

140

160

180

Sep00 Jan01 May 01 Sep01 Jan02 May 02 Sep02 Jan03 May 03 Sep03 Jan04 May 04 Sep04 Jan05 May 05 Sep05 Jan06 May 06 Sep06 Jan07 May 07 Sep07 Jan08 May 08 Sep08 Jan09 May 09 Sep09 Jan10 May 10 Sep10 Jan11 May 11

Stox x 600 Banks Index rebased Stox x 600 Index rebased

September 200109/11 attacks

September 2007Northern Rockbank run

March 2008Bear Stearnsrescue

September 2008Lehman Brothersbankcruptcy

April 2010First Greek rescue package


EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

106

ab

c

Return on tangible assets (RoTA) versus leverage (tangible equity/tangible assets) 2013e

CSGN.VX

BAER.VX

UBSN.VX

BNPP.PA

CNAT.PA

SOGN.PA

ARLG.DE

CBKG.DE

ERST.VI

RBIV.v i

ACBr.ATBOCr.AT

EFGr.AT

NBGr.AT

MRBR.AT

GPSr.AT

BAPO.MI

PMII.MI

ISP.MI

BMPS.MI

UBI.MICRDI.MI

SABE.MCBTO.MC SAN.MC

BBVA.MC

BKT.MC

BARC.L

LLOY.LRBS.L STAN.L

AKBNK.IS

ASYAB.ISGARAN.IS HALKB.ISISCTR.IS

ALBRK.ISVAKBN.ISYKBNK.IS

VTBRq.L

SBER.RTS 1120.SE

1150.SE

1010.SE 1090.SE NBKK.KW

KFIN.KW

BURG.KW

QNBK.QAQISB.QA

COMB.QA

FGB.AD

NBAD.AD

UNB.AD

ADCB.AD

BMAO.OMNBO.OM NSGB.CA

COMI.CA

CIEB.CA

AUDI.BYBLOM.BY

OTPB.BU

PKOB.WABAPE.WA

ASAJ.JFSRJ.J

NEDJ.J

SBKJ.J

0

5

10

15

20

25

30

35

40

45

0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0%

RoTA

Leve

rage

(x)


107


abc

Sector description The bank sector functions as an intermediary between sources of capital (investors and depositors) and

users of capital (individuals, corporations and governments). In providing this function, banks take on

three major risks: credit risk (the risk that a borrower will not repay a loan), interest rate risk (changes in

the yield curve may change funding costs and asset yields) and liquidity risk (the risk, usually in a crisis,

that assets cannot be liquidated quickly enough to cover any short-term funding deficiency).

The European banks and financials sector includes institutions providing a comprehensive product

offering to their clients (mostly known as wholesale banks) and banks that mainly focus on retail

customers and smaller corporate clients (commercial banks), as well as more specialised institutions

focusing on a more limited range of business segments such as corporate and investment banking

activities (CIBM), or exchanges and specialised financial services (inter-dealer brokers, asset managers

etc). With a few exceptions (Credit Suisse and UBS), the majority of European banks are universal banks,

although in the case of some wholesale banks (Société Générale, BNP Paribas and Deutsche Bank) CIBM

activities account for a large part of their profits. Within the CEEMEA region most banks are universal

banks.

The various lines of business for banks are classified below:

Net interest income, defined as the difference between the interest earned on assets and the interest

paid on liabilities: typically 65%+ of revenues.

Fee and commission income includes account fees, overdraft fees, payments, arrangement fees,

guarantees as well as asset management and insurance: typically 25% of revenues.

Trading income: banks derive trading income by carrying out transactions in securities, derivatives

and forex. Also, banks hold securities to manage their liquidity. Banks need to mark to market their

securities, leading to valuation gains/losses. Trading income is typically 10% of total revenue.

The banking sector remains a highly regulated sector globally, with multiple regulatory bodies keeping

close watch on the industry. There have also been efforts to evolve global standards in banking via the

Basel norms, developed by the Bank for International Settlements. In light of the financial crisis there has

been an increased focus on regulating banking activities and minimising the impact of future banking

failures, if any, on the economy.

The wider sector also incorporates exchanges and speciality finance. Exchanges, such as the LSE and

Deutsche Boerse, provide price discovery, exchange matching and trade clearing services to facilitate

trading in securities, commodities, derivatives and other financial instruments. Their activities are mainly

driven by market volumes and capital market activity. Furthermore, some of them offer custody and

settlement services in the post-trade arena. Asset managers manage money on behalf of institutional and

retail investors. They tend to be high-beta stocks as their earnings are driven by market movements along

with flows from pension funds, insurance companies and retail clients. Typically, both flows and market

movements go hand in hand, thereby creating a volatile earnings stream. These stocks outperform in up

markets and underperform in down markets.

Iason Kepaptsoglou* Analyst HSBC Bank Plc +44 20 7991 6722 [email protected]


108


abc

Key themes Funding issues: Recent events have proven that the funding issue remains key in bank management.

This relates to both internal (pertinent to a specific bank) and external factors, such as perceived country

risk, for example. In our view, the asset and liabilities structure is likely to remain at the forefront of

managements’ focus over the next few years. The liquidity ratio, typically calculated as the ratio of loans

to deposits, is a key indicator: a ratio of 100% or less indicates that the bank can count on a balanced

structure with an optimum balance between loans and deposits. A higher ratio would imply a need to

procure liquidity in the wholesale market, with a consequent impact on funding costs. Funding pressures

have forced European banks to deleverage (reduce the asset base relative to the capital base), which has

had a negative effect on profitability. Funding issues arising in Western Europe have also spilled over to

emerging Europe. The funding structure of CEEMEA banks is generally less dependent on wholesale

markets, with the exception of the South African banks that raises a substantial amount of funding in its

domestic wholesale markets.

Fears on sovereign risk: Given the ongoing eurozone sovereign crisis and the strong link between

sovereigns and banks, the sector has been largely driven by sovereign concerns. The recent EBA

(European Banking Authority, the overseeing regulator) exercise that forced banks to mark-to-market

their sovereign bond holdings is just one manifestation of the increased interdependency of banks and

sovereigns, with both the market and regulators carefully monitoring this space.

Sector profitability: The introduction of tougher regulation has raised some doubts about sector

profitability over the next cycle. Most would argue that this should come down, due to lower leverage and

declining margins. The outlook for profitability in the CEEMEA sector is more positive as it operates in

growth economies that still have under-penetrated banking services.

Increased regulation: The introduction of Basel III, a supranational agreement on capital adequacy, is

expected to have a major effect on capital requirements, with some aspects still awaiting confirmation.

Regulators across Europe are also focusing on liquidity, funding, reducing risk in trading activities, increasing

the level of non-equity loss-absorbing capital, fees charged to retail customers and ring-fencing the commercial

business among other issues. Recently, the European authorities have begun considering the establishment of a

single centralised oversight entity with the mandate to regulate banks across Europe but the level of detail that

has been given is not yet sufficient to assess the potential impact on the sector. CEEMEA banks also face

pockets of increased regulatory pressure, as is the case with FX mortgages in Hungary.

Sector drivers Banks’ earnings are very closely correlated to economic growth in the countries where they operate:

volume growth is a function of GDP growth, while growth in loan loss provisions (provisions for loans

that are no longer performing) is linked to country-specific factors such as unemployment. Therefore

banks could be considered a proxy for GDP growth. In addition to GDP, we would summarise the main,

fundamental sector drivers as follows:

Lending and deposit volumes: These are mainly related to GDP, as lending demand is normally

positively correlated to expanding economic conditions and lending demand can drive economic

109


abc

conditions. Deposit growth is more a function of market yield, alternative investment opportunities

and gearing ratios, but is, again, correlated to economic conditions.

Interest rates: Cost of money is based on a spread banks apply to interest rates. Although spreads are

controlled to a large extent by banks, the level of the interest rate is given by the market. For obvious

reasons banks tend to prosper in a high interest rate environment (when the spreads between assets and

liabilities tend to be wider) and suffer when rates are low. The steepness of the yield curve is also a key

factor, as banks normally tend to spread their financing according to the different rate levels along the

curve – for example making the spread the differential between short rates (lending or borrowing) and long

rates (borrowing or lending).

Asset quality and loan-loss provisions (LLPs): Non-performing loans (NPLs) tend to increase in

periods of economic difficulty, thereby forcing banks to increase LLPs and write-offs. In several

European countries NPLs and unemployment growth are closely correlated. Empirical analysis also

suggests that LLPs and GDP growth are relatively well correlated.

In the past few years, following the subprime crisis, the role of regulators in the banking sector has

increased dramatically and it is expected to expand even more in the future. New compliance rules have

simultaneously increased costs, lowered margins and changed the sector’s revenue base, thereby making

banks less profitable overall. As a result, this is proving to be a key driver for the sector.

A second important element relates to market conditions and the interdependence of the banking system.

The recent liquidity crisis has shown the extreme importance of this factor and the weight that market

conditions (rates, interbank lending and the role of the central banks) can have on banking stocks. In our

view these are extremely important drivers, as they are mostly exogenous and affect the sector overall,

making it very difficult to differentiate between individual stocks.

Valuation Banking stocks are generally valued on PE multiples, although book value multiples dominate in periods

of low earnings/recession. Most recently, analysts have been using a warranted equity value (WEV)

model. This is not a new valuation methodology, as it is simply the correlation between book value and

profitability (ROE), based on the theory that where a company’s return is similar to its cost of equity, it

European Banks: growth and profitability (calendarised data)

2008 2009 2010 2011 2012e

Growth Revenue -15% 24% 8% -2% 4% Pre-provision profit -37% 75% 7% -8% 6% Operating income -83% 153% 88% -3% 12% Net profit -92% 457% 77% -16% 27% Margins Net interest margin 1.04% 1.10% 1.24% 1.16% 1.09% Cost/income 72% 61% 61% 63% 62% Cost of risk 1.05% 1.50% 1.07% 0.91% 0.89% Productivity Revenue over ATA 1.65% 2.05% 2.35% 2.23% 2.26% Op. income over ATA 0.10% 0.25% 0.49% 0.47% 0.51% RoTA 0.03% 0.18% 0.33% 0.27% 0.33% RoTE 1.5% 7.1% 10.6% 8.2% 9.7% Note: based on all HSBC coverage of European Banks Source: company data, HSBC estimates

110


abc

should be trading at or close to its book value (market volatility and equity risk premium are captured in

the cost of equity).

In the past, the sector has benefited from a consolidation process, especially in some European countries.

This has also boosted goodwill, leading investors to adopt a more cautious approach. As a result, valuation

methodologies are based on tangible book values and tangible ROEs rather than reported figures.

Accounting issues abound among banks. Capital and risk-weighted assets calculations, for example, differ

from one country to another. For example, Italian banks have higher average risk weightings than their

European peers and LLPs are treated differently from a tax perspective in the individual European

countries.

In the case of large complex banks (such as Credit Suisse, UBS, Unicredit, Intesasanpaolo, Santander,

BBVA and RBS) a sum-of-the-parts method is often used. This is just a combination of the above criteria

and is based on the application of ‘exit PEs’ and, in some cases, PTBV for the divisional businesses of the

bank. This method makes it possible to isolate the corporate centre, thereby assessing the real profitability

of the business. On the other hand, there is no means of assessing the cross-subsidy between divisions as

the corporate centre is also used as a financing fulcrum by most banks.

111


abc


MSCI Europe Banks Index 9.12% of MSCI Europe

Trading data 5-yr ADTV (EURm) 6,499 Aggregated market cap (EURbn) 432 Performance since 1 Jan 2000 Absolute -64% Relative to MSCI Europe -45% 3 largest stocks HSBC, SAN, STAN Correlation (5-year) with MSCI Europe 0.92


Top 10 stocks: MSCI Europe Banks Index


1 HSBC Holdings Plc 28.3% 2 Banco Santander Sa 10.6%3 Standard Chartered Plc 9.4%4 BNP Paribas 6.3%5 Barclays Plc 6.3%6 BBV Argentaria Sa 5.8%7 Nordea Bank Ab 3.9%8 Lloyds Banking Group Plc 3.5%9 Société Générale 2.7%10 Svenska Handelsbanken Ab 2.7%


Country breakdown: MSCI Europe Banks Index

Country Weights (%)

UK 48.9% Spain 18.1% Sweden 10.5% France 10.2% Italy 5.9% Norway 1.7% Denmark 1.6% Germany 1.1% Austria 0.9% Source: MSCI, Thomson Reuters Datastream, HSBC

Core industry driver: eurozone total loan growth

-2%

2%

6%

10%

14%

Jan04 Jan06 Jan08 Jan10 Jan12

Source: ECB, HSBC estimates

PE band chart: MSCI Europe Banks Index

0

50

100

150

200

250

300

350

2004 2005 2006 2007 2008 2009 2010 2011 2012

5x

15x10x


PB vs. ROE: IBES MSCI Europe Banks Industry Group

0.0

0.5

1.0

1.5

2.0

2.5

2004 2005 2006 2007 2008 2009 2010 2011 2012

0

5

10

15

20

Fwd PB (LHS) ROE % (RHS)


112


abc

Notes

113


abc

Financials – Insurance

Insurance team Kailesh Mistry*, CFA Analyst, Head of European Insurance HSBC Bank plc +44 20 7991 6756 [email protected]

Thomas Fossard* Analyst HSBC Bank plc, Paris branch +33 1 5652 4340 [email protected]

Dhruv Gahlaut* Analyst HSBC Bank plc +44 20 7991 6728 [email protected]

Sector sales Martin Williams Sector Sales HSBC Bank plc +44 20 7991 5381 [email protected]

Juergen Werner Sector Sales HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 4461 [email protected]



EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

114

ab

c

Sector structure

Primary insurance

Insurance

Hannover Re

Korean Re

Munich Re

Scor

Swiss Re

Reinsurance

Admiral

Euler Hermes

Fondiaria-Sai

PICC

RSA Insurance

Non-life insurance

AEGON

AIA

Bangkok Life

China Life

CNP

Korea Life

Legal & General

New China Life

Prudential plc

Samsung Life

Standard Life

Swiss Life

Tong Yang Life

Life insurance Lloyds

Amlin

Catlin

Hiscox

Lancashire

Composites

Allianz

Aviva

AXA

Baloise

China Pacific

China Taiping

Dongbu

Generali

Hyundai

ING

LIG

Meritz

Ping An

PZU

Samsung F ire & Marine

Vienna Insurance Group

Zurich Financial Services

Primary insurance

Insurance

Hannover Re

Korean Re

Munich Re

Scor

Swiss Re

Reinsurance

Admiral

Euler Hermes

Fondiaria-Sai

PICC

RSA Insurance

Non-life insurance

AEGON

AIA

Bangkok Life

China Life

CNP

Korea Life

Legal & General

New China Life

Prudential plc

Samsung Life

Standard Life

Swiss Life

Tong Yang Life

Life insurance Lloyds

Amlin

Catlin

Hiscox

Lancashire

Composites

Allianz

Aviva

AXA

Baloise

China Pacific

China Taiping

Dongbu

Generali

Hyundai

ING

LIG

Meritz

Ping An

PZU

Samsung F ire & Marine

Vienna Insurance Group

Zurich Financial Services

Source: HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

115

ab

c


0

50

100

150

200

250

300

350

400

450

500

01/1990 01/1991 01/1992 01/1993 01/1994 01/1995 01/1996 01/1997 01/1998 01/1999 01/2000 01/2001 01/2002 01/2003 01/2004 01/2005 01/2006 01/2007 01/2008 01/2009 01/2010 01/2011 01/2012

0%

2%

4%

6%

8%

10%

12%

DJ Ins absolute DJ Stoxx abso lute Bund 10 year yields

Sale of Alico announced by

AIG (USD 15.5bn)

Lehman collapse & problems at AIG

9/11 attacks in

US

Standard Life IPO; Aviva buys

AmerUS

Winterthur acquisit ion (EUR7.9bn) and Axa rights issue (EUR4.1bn); Generali

acquires Toro (EUR3.85bn)

M erger of Sun Alliance & Royal

Insurance

Resolut ion group created in 2004 & relaunched in

2008

M arket crash: Dot-com bubble

CGU Plc & Norwich Union Plc merger to form CGNU Plc,

renamed Aviva Plc later

Norwich Union IPO Rights issue by Aegon (EUR 2.0bn); ZFS rights

issue (USD2.5bn)

Axa buys Sun Life

Allianz rights issue (EUR4.4bn); M unich Re rights issue (EUR3.8bn)

Allianz acquires minorit y in RAS;Hurricane

Kat rina, Wilma & Rita strikes US

ING founded by a merger between Nationale-Nederlanden

and NM B Postbank Group

Allianz sells Dresdner bank;

VIG rights issue

PZU IPO

Swiss Re raises capital

L&G rights issue

(GBP0.8bn)

Pru and Scor rights issue;Admiral IPO

Pru buys M &G (GBP1.9bn)

Aegon buys Transamerica Corp

Aegon buys Scott ish Equitable;

Axa buys M ONY

Friends Provident IPO

Scor acquires Converium; Allianz buys out minority in

AGF

Aegon, Axa & ING rights issue

Converium IPO

Swiss Life rights issue

Scor buys Transamerica Re

(USD0.9bn)

AXA sells its UK Life and savings operations

(EUR2.75bn)

AXA sells Canadian operat ion

(EUR1.9bn)

AXA sells Australia and NZ operations and

acquires AXA APH Asia Life operations

Source: Company data, Bloomberg, Factset, HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

116

ab

c

Movement in Solvency I ratio versus asset leverage for primary insurers, 2008 to last reported 0%

50%

100%

150%

200%

250%

300%

100% 200% 300% 400% 500% 600% 700% 800% 900% 1000%Asset Leverage

Sol

venc

y I

Increasing riskiness

Pru

AvivaCNP

Swiss Life

ZFS

Allianz

SL

AXA

L&G

RSA

Generali


117


abc

Sector description Insurance companies provide protection to individuals and businesses against uncertain events by

transferring risk to an underwriter, which promises to pay the insured an amount, usually unknown, if

those events occur. The unknowns make estimating profits difficult and give rise to accounting that has

been a topic of debate for investors and insurance companies for some time now. Insurance companies

have also expanded into accumulation products where there may or may not be an insurance element.

Over the last decade and a half, this has reversed somewhat as insurers reassess business models.

The global insurance industry generated USD4,324bn of premiums, or about 7% of global GDP, in 2010. Life

insurance accounted for 58% of premiums, and non-life for 42%. The US is the largest insurance market, with

around 27% of the global premiums, followed by Japan and the UK. The chart below illustrates the widely

referenced S-curve in the industry, which highlights the level of maturity of the insurance market and per capita

GDP, and may be used as an indication of potentially high-growth markets as GDP per capita increases.

Proportion of GDP spent on insurance versus per capita GDP in 2010 (USD)

BZCZ

RN

PL

HN

CLIN

CHID

TH MY

PH

SA

TW

SK HK

SPI G

Fra

CJap

UK N

AUS

US

SW

0%

2%

4%

6%

8%

10%

12%

14%

16%

100 1,000 10,000 100,000 Country legend: Aus - Australia, C - Canada, Fra - France, G - Germany, HK - Hong Kong, I - Italy, ID- Indonesia, Jap - Japan, MY- Malayasia, N - Netherlands, PH-Philippines, SA - South Africa, SK - South Korea, SP - Singapore, SW - Switzerland , TH-Thailand, CZ - Czech Republic, RN - Romania, PL - Poland, HN - Hungary, IN - India, CH - China, TW - Taiwan, CL - Chile, BZ - Brazil

Source: Sigma, HSBC estimates

The sector has a mix of mutual and listed companies, whose total market capitalisation equates to about 5% of

that of the DJ Stoxx 600. The sector is divided into primary insurance and reinsurance, depending on the nature

of the risk underwritten. Primary insurance, which underwrites risk directly from households and businesses, is

further split between life and property and casualty, or non-life. Reinsurance refers to the way primary insurers

insure themselves against the risk. Some insurers also have banking and asset management operations

alongside the typical life and non-life underwriting segments.

Life insurance comprises two main classes of products: savings products, for which margins are tied to

investment returns or fees linked to asset values as well as insurance protections offered, and personal risk

products, which cover death and disability and whose margins are linked to underwriting and technical

factors such as mortality and morbidity. Health insurance covers medical expenses and often belongs to

the primary life segment.

Kailesh Mistry*, CFA Analyst, Head of European Insurance HSBC Bank plc +44 20 7991 6756 [email protected]

Thomas Fossard* Analyst HSBC Bank plc, Paris branch+33 1 5652 4340 [email protected]

Dhruv Gahlaut* Analyst HSBC Bank plc +44 20 7991 6728 [email protected]


118


abc

Key themes Regulatory and accounting changes: Introduction of new regulatory solvency and accounting standards

are a key theme in the sector. The current solvency regime, referred to as Solvency I in Europe, is a non-

risk-based measure which is inconsistently implemented across different countries, making comparisons

difficult. The inconsistency primarily relates to allowable capital resources, which varies by country,

although the approach to the calculation of capital requirements appears to be more consistent. The

European Union plans to introduce risk-based Solvency II by 1 January 2014, which has been behind

schedule according to market commentary and could be delayed further, and the US is reviewing its

capital adequacy requirements; China is also moving towards a risk-based system. In theory, this should

increase consistency.

There is a similar debate on accounting standards, which diverge between regions. New standards are

being considered and will be introduced over time. For example, IFRS Phase II is due to be implemented

in 2014. The life insurance industry is also seeing a transition to embedded value accounting to market

consistent embedded value (MCEV) from European embedded value or traditional embedded value.

There is also greater demand for insurance company cash flow disclosure.

Focus on efficiency: Insurance companies have increasingly focused on efficiency and cost reduction

over the past few years. In our view, this theme has been driven by pressure on underwriting and

investment margins, the increasing maturity of the industry and the consequences of shareholder

ownership rather than mutuality, as in the past. The industry has tried to reduce costs through integrating

back offices, centralising group functions, off-shoring jobs to lower-cost territories, cutting headcount,

reducing policy administration costs and moving to lower-cost distribution channels. Since 2010, insurers

within our coverage universe have announced EUR2.5bn of new cost savings and have already achieved

EUR0.8bn of cost saving out of that.

Primary life segment: Life insurers have emerged from the financial crisis with an improved capital

position, while avoiding widespread forced capital raisings. Increasingly life insurers have been focusing

on improving underwriting profitability through action on prices, guarantee rates and charging for

specific features. In addition, the trend for moving away from high upfront commissions paid to

distributors to level-loaded structures is helping to improve the cash flow credentials of the sector. There

has also been a focus on lowering administration costs and reducing dependence on investment markets

by moving to fee-based products.

Primary non-life segment: Premium growth, evolution of pricing, prior-year reserve development, claims

inflation, investment returns and changes in distribution are the key themes for this segment. The balance

of these factors will differ over time and affect the underwriting cycle, which varies by product and

region. For example, in the personal motor insurance market in Europe we are seeing a hardening or

increase of insurance rates as a result of deterioration in underwriting profitability. Prior-year reserve

releases have declined across Europe while investment returns remain under pressure, forcing insurers to

improve underwriting profitability rather than subsidising present-year losses through positive prior-year

development and strong investment results. We are also seeing a shift away from the usual broker/agent

distribution channel towards greater use of internet, phone and affinity tie-ups to sell non-life insurance,

especially in the personal motor and property segment, with the aim of reducing distribution costs.

119


abc

Reinsurance segment: The industry is similar to the primary non-life segment in terms of having an

underwriting cycle and a conservative investment portfolio relative to the rest of industry. However, the

catalyst for the reinsurance industry remains large claims events, which forces an increase in insurance

rates. The exceptionally high level of Nat Cat recorded in 2011 has driven up rates across various

business lines especially in the Cat affected region. That said, the reinsurance segment could be a key

beneficiary of the Solvency II regime, which is expected to generate additional demand for reinsurance

from smaller and less-diversified insurers as well as mutuals. We expect a reduction in retention rates by

primary insurers, which have reached their highest point since 2002, to increase the demand for

reinsurance as the primary segment continues to de-risk its business models.

Increase in GDP and per capita income: Growth in the economy and per capita income boosts demand

for insurance. As income rises, demand expands from compulsory products (motor insurance) to more

sophisticated products, such as saving products, asset protection, such as household insurance and

retirement products.

Importance of emerging markets: Emerging markets have lower insurance penetration than developed

economies and offer significant opportunities for expansion. The growth story is well supported by the

recovery in GDP growth, high rates of household savings and lack of social security structures in some of

these countries. Insurance companies based in developed markets have shown their desire and willingness

to expand in these regions and we expect the trend to continue. Regions such as LatAm, Asia ex Japan,

and Taiwan and Central and Eastern Europe remain attractive geographies for insurance companies to

expand into.

Premium growth was significantly higher in emerging markets than the developed market in 2000-2010

17.2%

13.3%

12.3%

9.6%

7.7%

7.1%

3.5%

1.1%

10.9%

5.2%

5.9%

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%

Other Europe

Middle East & Central Asia

LATAM

South & East Asia

Oceania

Western Europe

North America

Japan

Emerging markets

Industrialised countries

World

Premiums growth (10 year CAGR)

Source: Sigma, HSBC estimates

Sector drivers Capital adequacy: The insurance sector, like banks, needs to maintain a minimum level of solvency to

be able to underwrite new products and honour its future liabilities. Investors screen companies using

regulatory and rating-agency models to measure the group’s solvency position and gauge its financial and

operational flexibility. The adoption of a risk-based approach to the calculation of capital adequacy and

quality of capital are the next steps in the debate on capital adequacy. A minimum rating is required to

underwrite business in reinsurance as well as certain lines of businesses in the non-life segment and life

120


abc

segment. As already highlighted, life insurers continue to move away from higher capital-intensive

products and have emerged in a much better state from the crisis as a result of management actions

implemented in the last few years. Management teams have taken action to improve the capital position

by reducing risk, disposing of assets, saving on costs and focusing on underlying profitability.

Underlying profitability: Underwriting profitability and investment returns are key elements of operating

profits. Underwriting profitability depends on the pricing of products, fee structure, claims experience and

expenses, and is relevant to both primary and reinsurance segments. Underlying profitability at life companies

is dependent on the type of product and is, broadly, made up of risk result and investment spread for the

traditional product, which are generally split between policyholder and shareholder in a defined proportion, and

fee income for the unit-linked product. Surrender and lapses of policies also affect profitability at life insurers

and have to be considered in calculations, along with expenses. Primary non-life and reinsurance companies

measure technical profitability based on the combined ratio, the total of claims paid and losses incurred versus

the premiums collected. We have already mentioned the increasing focus on efficiency and changes in

distribution cost structures for both the primary life and non-life segments.

Investment exposure: Investment exposure has changed over time as insurance companies have lowered

their gearing to equity markets from the levels seen at the start of the decade, and instead increased their

exposure to corporate bonds and alternative investments. Currently life insurers have a higher exposure to

riskier assets like equity and corporate bonds, while reinsurers and primary non-life insurers are mainly

invested in shorter-duration bonds and cash. Shareholders are fully exposed to asset-quality risks in the

non-life segment, but the risks are shared with policyholders in the life segment – assets are largely

managed on behalf of policyholders. Bond duration also varies, with life insurers having a longer duration

as a result of the longer maturity of liabilities.

Adequate reserving: Prudent reserving is critical for insurance companies. Premiums are paid in the short

term, but liabilities are paid over a long period. Inadequate reserves will need to be replenished, possibly

funded by shareholders, although surplus reserves, if any, may be released to improve or smooth profits.

Influence of yields and credit risks: Company earnings, to differing extents, are dependent on

investment earnings. The level of interest rates, government bond yields and corporate bond yields are

important because insurers' investment portfolios are dominated by fixed income assets. The current low

level of interest rates are a concern for investors for two reasons: (1) for P&C companies lower

reinvestment rates will result in lower investment income which feeds directly into lower earnings

estimates; (2) for life companies, lower yields result in lower guarantees being offered on new business

which reduces products’ attraction, while lower reinvestment rates make it harder to hedge guarantees

offered in the past which have not already been hedged. In the worst case, this would require additional

capital to be allocated to covering guarantees; more realistically it will result in investment spread

compression. In addition, bond defaults and write-downs are important since they have an adverse impact

on earnings and are deductive to capital. Fixed income asset values are important where liabilities are

liquid and not relevant where liabilities are illiquid, and assets and liabilities are matched.

Premium growth: This vital aspect depends on factors ranging from economic activity and development

of the insurance market to government policies and social security systems. In the past 10 years,

premiums have grown twice as fast in emerging markets as in developed markets, and we expect EM

growth to remain higher.

121


abc

Valuation Investors consider several metrics when valuing insurance firms, including book value (BV), earning

multiples, cash-flow multiples and dividend yield. For non-life insurance companies, the BV calculation

is fairly straightforward as investors use IFRS estimates, but for life companies there has been ongoing

debate about the use of IFRS or embedded value (EV) estimates to calculate BV, given reliability and

acceptance of EV metrics.

In simplistic terms, EV is the present value of the future cash flows that are expected to emerge from the

in-force book of the life insurance company together with the value of shareholders’ net tangible assets.

The methodology for calculating EV has changed over time, although there are still concerns about its

comparability and consistency among insurers and regions. In Europe, some insurers have already

adopted market consistent embedded value (MCEV) principles, the latest in the series, while others are in

the process of doing so. The use of different methodologies for calculation of EV and the lack of

sufficient disclosure make comparisons difficult among insurers and leads to investors examining both

IFRS and EV metrics. Also, the current IFRS metrics do not fully reflect the true profitability of new

business and are inconsistent in their treatment of assets and liabilities. Given the complexity in

comparison and valuation, we are seeing an increasing focus on the operating cash flow of life businesses.

122


abc


MSCI Europe Insurance index 5% of MSCI Europe

Trading data 5-yr ADTV (EURm) 1,947 Aggregated market cap (EURm) 247,047 Performance since 1 Jan 2000 Absolute -65% Relative to MSCI Europe -31% 3 largest stocks Allianz, ZFS, AXA Correlation (5-year) with MSCI Europe 0.97


Top 10 stocks: DJ Euro Stoxx Insurance index


1 Allianz 12.0% 2 Zurich Insurance Group 9.0% 3 AXA 8.2% 4 Prudential 8.0% 5 ING Group 6.7% 6 Munich Re 6.6% 7 Swiss Re 6.2% 8 Generali 5.0% 9 Sampo 3.8% 10 Aviva 3.5%

Source: HSBC, Thomson Reuters Datastream

Country breakdown (by premium volume)

Country Life (%) Non-life (%) Total (%)

US 20.2% 36.1% 26.9% Japan 17.9% 6.4% 13.0% UK 8.0% 5.5% 6.9% France 7.7% 5.0% 6.5% Germany 4.6% 6.7% 5.4% China 5.7% 3.9% 5.0% Italy 4.9% 2.9% 4.0% South Korea 2.9% 2.3% 2.6% Canada 2.0% 3.5% 2.6%

Source: HSBC, Swiss Re Sigma

Core industry driver: bond yields (%)

0

2

4

6

8

10

Jun-

05

Jun-

06

Jun-

07

Jun-

08

Jun-

09

Jun-

10

Jun-

11

Jun-

12

US Treasury 10 Yr UK Govt. 10 YrEMU Corp AA 5-7yr US Corp. AA 5-7 YrEMU Govt 10 Yr UK Corp AA 5-7 Yr


Forward PE multiple*

02468

1012141618

Jan-

02

Jul-0

3

Jan-

05

Jul-0

6

Jan-

08

Jul-0

9

Jan-

11

Life Non-life Insurance

*Insurance relates to DJ Euro Stoxx Insurance index while life relates to FTSE Europe Life Insurance index and non-life to FTSE Europe Nonlife Insurance index Source: Thomson Reuters Datastream, HSBC

2012e P/EV vs. Normalised ROEV

PZU C

Lancashire

CNP

SRScor

B

Aegon

MRSL

L&G

SW

HRVIG

G

Hiscox Amlin

AL

AXA

Pru

EH

ZFSAviva

RSA

0.0x

0.3x

0.6x

0.9x

1.2x

1.5x

1.8x

0.0% 8.0% 16.0% 24.0% 32.0%Normal ised ROEV

2012

e P/

EV

Legends:AL-Allianz, B- Baloise,C-Cat lin , EH-Euler, G-General i,HR-

Hannover Re, MR-Munich Re, SR- Swiss Re, SL - Std Lif e, SW- Swiss Lif e.


123


abc

Food & HPC

Food & HPC team Western Europe Cédric Besnard* Analyst HSBC Bank plc, Paris branch +33 1 56 52 43 66 [email protected]

Florence Dohan* Analyst HSBC Bank plc +44 20 7992 4647 [email protected]

CEEMEA Michele Olivier* Analyst HSBC South Africa (Pty) Ltd +27 011 6764 208 [email protected]

Raj Sinha* Analyst HSBC Middle East +971 4423 6932 [email protected]

Sector sales David Harrington Sector Sales HSBC Bank plc +44 20 7991 5389 [email protected]

Lynn Raphael Sector Sales HSBC Bank plc +44 20 7991 1331 [email protected]




EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

124

ab

c

Sector structure

See sector section for further details

General retail Luxury


Food retail


Beverages


Food and HPC

Home

Reckitt Benckiser L’Oréal

Beiersdorf

Henkel

Food Producers Personal Care

Nestlé

Lindt

Danone

Unilever

Consumer & Retail - Europe




Food retail


Beverages


Food and HPC

Home

Reckitt Benckiser L’Oréal

Beiersdorf

Henkel

Food Producers Personal Care

Nestlé

Lindt

Danone

Unilever


Source: HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

125

ab

cSector price history to May 2012

0

100

200

300

400

500

600

700

800

Jan-90 Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11

+ 0.0%

+ 1.0%

+ 2.0%

+ 3.0%

+ 4.0%

+ 5.0%

+ 6.0%

+ 7.0%

+ 8.0%

Sector share price index

Sector organic sales growth

Dec. 08 - Dec. 09Collapse in mature economies, but emerging markets save the day.Input costs deflation help margins

Dec. 07 - Dec. 08Input costs inflation concern

Dec. 04 - Dec. 07Premiumisation era


EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

126

ab

c

EBIT margin* versus asset turnover chart (2011)

Henkel

Beiers dorf

L'Oréal

Reckitt

Lindt

U nilev er

Danone

N estl é

0.5

0.6

0.7

0.8

0.9

1.0

1.1

5.0% 10.0% 15. 0% 20.0% 25.0% 30.0

Adju sted EB IT M arg in(%)

Asse

t Tur

nove

r(x)

* EBIT margin adjusted for restructuring and other exceptional costs; asset turnover as a ratio of sales to total assets Source: Company reports, HSBC calculations

127


abc

Sector description Segments

The sector consists of two segments: food manufacturing and home and personal care (HPC). It is

dominated by several large, international multi-brand groups. Some of them focus on food, such as

Nestlé, others on HPC, such as L’Oréal, and some combine both, such as Unilever.

Brands and categories

Food and HPC companies rely on brand awareness. Managing the distribution channel, from hard

discounters to department stores, through negotiations with retailers on price and in such areas as on-shelf

availability, is key. Sector categories like dairy products and skin care are not fixed entities. They are

shaped by the leading brands and by innovation. Each category goes through a life cycle from growth,

driven by an increase in the penetration rate, to maturation, when concentration is high, volume growth

decelerates – only offset by emerging markets – and price elasticity is greater.

Sector characteristics

Food and HPC is historically a defensive sector. Cyclicality is limited by the relatively small share of

discretionary purchases in its sales in most categories. Pricing power is low, so operating leverage mostly

depends on volume growth to cover cost inflation.

Key themes Emerging markets

We estimate the industry has increased its exposure to emerging markets by at least 50% in 20 years. In

2011 the European stocks we cover derived around 44% of sales from emerging economies, where

category growth is driven by rising income per capita, which implies migration to branded products,

demographics and urbanisation. These markets account for more than two-thirds of the sector’s sales

growth (sometimes 100%), and represent the biggest growth driver in coming years, especially as

saturated US and European categories tend to become zero-sum games that are costly to expand.

However, competition is also growing, and not all categories benefit as much from emerging markets.

The European companies already have a good level of penetration in the soap and laundry mass markets

in some emerging economies, for example, since they have been targeting the low end of the income

ladder for years. Skin care and baby food are still taking off.

Raw materials

Raw materials, from milk to petrochemicals or vegetable oils, are a key manufacturing cost. Raw material and

packaging costs represent about 15% to 25% of sales for cosmetics players but around 30% to 35% of sales for

food and home care. That means input-cost price volatility is a key issue, as the cost base can quickly rise and

require risky price increases to offset it. The main commodities are milk (Danone being the most exposed

because of its yoghurt business), oil-related/PET/plastics (which affects all players, but mostly Henkel, Reckitt,

Unilever), tea (Unilever), cocoa (Nestlé), coffee (Nestlé), vegetable oils/palm oil (Unilever), sugar, fruit and

vegetables. These companies usually hedge by three to six months for most of these commodities, implying

that price variations tend to come through to the gross margin with a time lag. Some of these commodities are

either regulated (EU sugar) or quoted (cocoa). A commodity like milk is less visible, since it is not quoted and

needs to be purchased locally. When input costs start to bite, the debate is on whether the company can offset

this with price increases (or emergency cost savings), while commodity deflation usually raises questions as to

whether companies will pass on the full benefit to consumers.

Cédric Besnard* Analyst HSBC Bank Plc, Paris Branch+33 1 56 52 43 26 [email protected]

Florence Dohan* Analyst HSBC Bank Plc +44 20 7992 4647 [email protected]

Michele Olivier* Analyst HSBC South Africa (Pty) Ltd +27 011 6764 208 [email protected]

Raj Sinha* Analyst HSBC Bank Middle East +971 4423 6932 [email protected]



128


abc

Pricing capacity more relevant than the “myth” of pricing power

The industry pricing has hardly ever beaten inflation in the last decade. Groups’ pricing capacities are

thus mainly a result of their exposure to inflation-driven emerging countries. Advantages of all sorts (for

example, softening commodity costs and favourable FX) are usually reinvested in pricing or advertising

in order to foster volumes growth. This can cause price wars.

The threat of price wars: food specialists less at risk than the HPC oligopoly

We view food as an industry of specialists, and an aggregate of local monopolies/rational duopolies

(including Danone in yoghurts, Unilever in European spreads, Nestlé and Mars in pet food, and Kraft in

cream cheese). HPC is much closer to being a global oligopoly, with the top 6 FMCG almost always

operating in the same categories and/or regions. This implies different pricing behaviours, in our view.

Therefore, while food players have more differentiated pricing policies, HPC players are more likely to

follow peers’ pricing in order to maintain market shares. This puts the HPC sub-sector more at risk of

margin-dilutive price wars, as in 2009-10 with the price war in Indian laundry between Procter and

Unilever, which spread to European home care. In such a competitive oligopoly, it is particularly

important to identify any early signs that a key player is not “playing by the rules” and is trying to gain

market shares by increasing price/promotional investments, as this can start a chain of events impacting

all companies.

Sector drivers The ‘cubic matrix’

Most of the companies are exposed to the same consumption trends, but organic sales growth, excluding

FX and M&A, can range between high and low single digits. Each company can be seen as a cubic

matrix, with its organic growth potential the sum of three drivers: category mix, geographical mix and

execution – the capacity to gain market share and roll out innovation. A combination of growing

categories – those that aren’t too mature or competitive and provide pricing power, for example – and a

good execution track record seem most important. A category can always be rolled out in new countries,

although being in growing countries but with mature or competitive segments, or with execution issues,

may offer less visibility. The end game for all companies is to find the right balance inside the cubic

matrix to generate sustainable organic sales growth, the clear earnings growth driver over the long term,

in an industry not over-reliant on cost cutting.

The components of organic growth – watch for volume growth

Organic growth in food and HPC is driven by three metrics:

(1) Price increases: These are a less important driver than some may think. We estimate that “pure”

pricing (ex mix) over 20 years averaged c2% a year in the sector, implying low pricing net of inflation.

Furthermore, in some categories, price elasticity can cap the companies’ ability to raise prices for more

than a year (in the case of external shocks like input-cost inflation).

(2) Mix: Improving the mix means introducing a new product that is sold for more than the company’s

average price point for products, or a replacement product at a higher price than the old version, usually

justified by the argument that it offers more benefits. The company invests in R&D to improve the

product and advertising and marketing to promote it. We believe the return on a successful change in mix

is quite high as a significant part of the fixed cost is the same as for the old version, but the new product

129


abc

sells at a higher price. That said, mix is a tool with little visibility (consumers trading down is a common

pattern in the industry) and requires strong innovation to be a sustainable driver.

(3) Volume growth: Volume growth is the driver offering the most visibility and thus is the most looked

at by the market. There are various ways to generate volume growth, some cheaper than others. We

identify three main drivers, appropriate to different stages of the product cycle.

(a) Volume can be increased by increasing the number of consumers of the products, primarily by

expanding the penetration of particular categories in a country. This requires little investment once the

cost of creating the category has been passed on. Most of the growth comes from consumers taking up a

newly available product. Companies can increase volumes by entering emerging markets, for example,

since rising income per capita in those countries makes consumers migrate to branded goods.

(b) Increasing the frequency of consumption within a category is usually more important when increasing

the number of consumers becomes harder. Hair care would be a good example: selling a conditioner to

accompany a regular shampoo doubles consumption each time customers wash their hair. Another

category is biscuits, where companies have promoted the idea of eating biscuits at a variety of times –

10am, then noon, then mid-afternoon.

(c) A greater focus on market share is the last step in a category life cycle. It occurs when a category is

fully penetrated, private labels have appeared in mature regions as credible alternatives, and roll-out in

new regions has been completed or has become a necessity. Excluding innovations, market-share gains

are the only driver of volume growth. They need to be generated by advertising and promotions,

execution or price cuts. At this point the cost of growth is very high and needs to be accompanied by cost-

cutting or M&A.

A&P: a critical tool to drive volume growth

Advertising and promotions (A&P) is a key to driving volume growth. It represents about 12% to 15% of

sales in the food industry and as much as 30% for the cosmetics industry. We do not consider A&P to be

a variable cost in a marketing-driven environment; it is more an inflationary fixed cost. But in practice it

is also partly a variable cost. Marketing expenses are not only linked to growth, product activity and

launches, but they also can be adjusted in the short term to smooth margins. However, the boundary

between phasing and short-term cuts sometimes becomes blurred. There are numerous examples of A&P

phasing when margins are under pressure, although this is generally not considered as a positive.

Consumer staples evolve in a multi-brand-driven environment, where growth investment is key to

winning market share and delivering operating leverage in the long term. It’s true that what counts is the

share of voice – the proportion of a company’s advertising as a percentage of the industry’s total

advertising spending. A&P spend in absolute terms can thus go down if the industry overall is cutting

marketing spending, as the share of voice can remain constant and the brand franchise untarnished. But

no company wants to be the first to cut marketing, at the risk of being the only one, especially as tough

times demand more A&P, not less, to justify price levels. We see here a classic dilemma, where all

players have an interest in pushing the A&P level down, but none has an interest in moving first

(especially when savings can give some leeway in margin phasing). Beyond the normal productivity gains

slightly deflating the marketing expenses ratio, and the increasing use of cheaper digital media, we do not

believe there will be a structural decrease in A&P ratios in the coming years.

130


abc

M&A: buying growth, building scale

When categories start to become too saturated or competitive, buying market share or new categories through

M&A (balance sheets are usually healthy due to good cash conversion) can look more attractive than over-

investing to expand categories with limited potential. Accordingly, Nestlé increased its exposure to the growing

but very competitive infant nutrition segment by buying Pfizer’s baby food unit in April 2012, acquiring an

EM-led, high growth business and reducing exposure to more mature segments such as confectionery. This

also helped Nestlé build scale in baby food, which we think could have maximised its margins. In a sector

where profitable growth is the key valuation driver, deals often rely on growth synergies, rather than on cost

efficiencies. We agree that growth synergies are the more important of the two, but they also take longer to

achieve and are harder for the market to quantify. This results in analysts frequently being proved to have been

mistaken in their view of a deal, followed by stock market corrections. We believe the best example of this is

Danone-Numico: the deal made a lot of strategic sense, relying on growth synergies, but Danone paid a rich

22x EBITDA, explaining the 2007 share price correction.

Valuation A structural PE premium to the market

The food and HPC sector (the weighted average of the European stocks under our coverage) has traded at a

premium to the broader market fairly consistently since the start of our relative PE historical analysis in January

1998. Its relative premium has averaged 40% to date, a function of strong visibility on top-line growth and FCF

generation. The previous peak industry premium was 100% (November 2008, during the market meltdown):

the premium had decreased to 7% by August 2009. The HPC sector typically trades at a higher premium than

food: in the past investors put more emphasis on HPC’s profit growth potential

DCF is the traditional tool to value the companies given their stability, rather high visibility on sales growth

and resulting operating leverage.

In terms of disclosure, most companies split out organic growth between price/mix and volume (the key metric

investors look at), at least every half year, and usually disclose their A&P investments.

European Food and HPC: growth and profitability *

2008 2009 2010** 2011 2012e

Growth Sales 4.8% -1.0% 7.0% -4.9% 6.3% EBITDA 32.5% -16.0% 66.3% -20.9% 7.3% EBIT 37.0% -18.8% 83.2% -22.1% 8.5% Net profit 34.9% -30.3% 118.8% -25.4% 10.7% Margins EBITDA 20.9% 17.1% 26.9% 17.6% 17.9% EBIT 17.9% 13.9% 24.0% 14.8% 14.9% Net profit 14.3% 10.2% 20.4% 11.0% 11.2% Productivity Capex/Sales 8.7x 4.9x 8.5x 9.2x 4.9x Asset turnover 1.0x 0.9x 0.9x 0.8x 0.8x Net debt/Equity 0.6x 0.4x 0.3x 0.4x 0.3x ROE 23.5% 23.7% 22.7% 20.9% 21.7%

Note: based on all HSBC coverage of European Food and HPC - all data are weighted by sales, in constant currency * all data are reported figures, thus implying very high volatility due to contribution from one offs ** 2010 figures inflated by Nestlé capital gain on Alcon Source: Company reports, HSBC estimates

131


abc


MSCI Europe Food Products Dollar Index


Trading data 5-yr ADTV (EURm) 930 Aggregated market cap (EURbn) 300.3 Performance since 1 Jan 2000 Absolute 145% Relative to MSCI Europe US Dollar

167%

3 largest stocks Nestlé, Unilever, Danone Correlation (5-year) with MSCI Europe US Dollar

0.55


Top 10 stocks: MSCI Europe Food Products Dollar Index


1 Nestlé 51.2% 2 Unilever 24.3% 3 Danone 11.2% 4 Associated Brit.Foods 3.9% 5 Lindt & Spruengli 2.1% 6 Kerry Group 'A' 2.0% 7 Suedzucker 1.6% 8 Barry Callebaut 1.3% 9 Tate & Lyle 1.2% 10 Aryzta 1.1%

Source: MSCI, Thomson Reuters Datastream, HSBC Country breakdown: MSCI Europe Food Products Dollar Index

Country Weights (%)

Switzerland 55.7% UK 16.2% Netherlands 13.2% France 11.2% Ireland 2.0% Germany 1.6%


Core industry driver: the components of organic growth

0%

1%

2%

3%

4%

5%

6%

7%

8%

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

Volume grow th Mix contribution Price increases


PE band chart: HSBC European Food and HPC coverage

21x19x18x16x14x

0

50

100

150

200

250

300

350

Jan-

95

Jul-9

6

Jan-

98

Jul-9

9

Jan-

01

Jul-0

2

Jan-

04

Jul-0

5

Jan-

07

Jul-0

8

Jan-

10

Jul-1

1


PB vs. ROE: HSBC European Food and HPC coverage

2.0

2.5

3.0

3.5

4.0

4.5

2004 2005 2006 2007 2008 2009 2010 2011 2012

10

14

18

22

26

30

Fw d PB (x ) - (LHS) F wd ROE (%) - (RHS)


132


abc

Notes

133


abc

Food retail

Food retail team Jérôme Samuel* Analyst HSBC Bank Plc, Paris Branch +33 1 56 52 44 23 [email protected]

Emmanuelle Vigneron* Analyst HSBC Bank Plc, Paris Branch +33 1 56 52 43 19 [email protected]

Raj Sinha* Head of MENA Research HSBC Bank Middle East Ltd +971 4423 6932 [email protected]

Sector sales David Harrington Sector sales HSBC Bank Plc +44 20 7991 5389 [email protected]

Lynn Raphael Sector sales HSBC Bank Plc +44 20 7991 1331 [email protected]


EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

134

ab

c

Sector structure

Ocado




Food and HPC


Beverages


Food retail


Bricks & mortar Online

UK

Casino

Carrefour

Colruyt

DIA

Jeronimo Martins

Metro

Ahold

Delhaize

Morrison

Tesco

Sainsbury

Europe CEEMEA

Magnit

Ocado




Food and HPC


Beverages


Food retail


Bricks & mortar Online

UK

Casino

Carrefour

Colruyt

DIA

Jeronimo Martins

Metro

Ahold

Delhaize

Morrison

Tesco

Sainsbury

Europe CEEMEA

Magnit

Source: HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

135

ab

c

Performance of European Food retail stocks 1990-2012

0

200

400

600

800

1000

90 92 94 96 98 00 02 04 06 08 10 12

Auchan buys Docks de France (1996)

Promodès launches unfriendly takeover on Casino (1997)

Merger Carrefour-Promodès (1999)

Delhaize buys Hannaford (2000)

Wal-Mart buys Asda (1999)

Morrison buys Safeway (2004)

Sector boosted by property valuation

(2007)

DIA spin-off (2011) Profit warnings from

Carrefour and Metro (2011)

First ever profit warning from Tesco (2012)

0

200

400

600

800

1000

90 92 94 96 98 00 02 04 06 08 10 12


Promodès launches unfriendly takeover for Casino (1997)






(2007)




0

200

400

600

800

1000

90 92 94 96 98 00 02 04 06 08 10 12


Promodès launches unfriendly takeover on Casino (1997)






(2007)




0

200

400

600

800

1000

90 92 94 96 98 00 02 04 06 08 10 12


Promodès launches unfriendly takeover for Casino (1997)






(2007)





EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

136

ab

c

EBIT margin versus asset turnover (2012e)

Tesco

Ahold

Carrefour

Casino

Delhaize

DIA

Jeronimo Martins

Metro

MorrisonSainsbury

Tesco

Colruy t

1.0

1.5

2.0

2.5

3.0

3.5

2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 5.5% 6.0% 6.5%

EBIT margin

Ass

et tu

rnov

er


137


abc

Sector description Food retailing is the largest consumer sector, at least by sales, with an estimated GBP132bn of revenues

in the UK in 2012, according to Verdict Research. It has always been seen by investors as a defensive

sector, but we believe this is no longer the case. In the 1980s, food retailers with negative working capital

benefited from high inflation and high interest rates. In the 1990s, sector performance was driven by

international expansion and consolidation in mature markets. The top five market shares now exceed 50%

in the main European countries.

There are several reasons why the sector is not as defensive as it was. Food spending has shrunk as a

percentage of total spending, few listed players are pure food retailers, and even discounters are exposed

to economic slowdowns.

In mature markets, spending on food as a percentage of total household spending has continued to

shrink, and now accounts for an average 14% of consumer spending in mature European markets,

one-third of its level in the 1960s.

Few listed food retailers are pure food retailers and are therefore largely immune to a slowdown in

discretionary spending. Metro and Carrefour are the most exposed to non-food; Jeronimo Martins,

Morrison, Ahold, Delhaize, Dia and Colruyt still sell mainly food.

Discount stores enjoyed faster organic growth than other formats in the past decade, taking market

share from hypermarkets and supermarkets in Germany, France and Belgium, and even in the UK.

That trend has since reversed in France and Germany, as hypermarkets have started to compete more

on price and as the economic crisis has curbed spending by lower-income households.

The industry operates in various store formats: hypermarkets, supermarkets, discounters, convenience

stores, cash and carry and department stores, which often reflect market positioning: premium, mass or

value-orientated.

Hypermarkets are large stores (above 5,000 square metres per store) that focus on volumes; they sell

groceries and general merchandise, offering up to 50,000 stock-keeping units (SKUs).

Supermarkets (around 2,500 square metres per store) are medium-sized stores focusing on groceries,

with a limited non-food range and about 13,000 SKUs in grocery.

Discounters have smaller stores, fewer SKUs and aggressively promote non-food items.

Convenience stores offer a variety of food and are generally located near their target customers,

who are prepared to pay higher prices than in hypermarkets or discount stores as a result.

Cash and carry stores offer low prices but only sell groceries and general merchandise in bulk to

hotel, restaurant, catering customers and small retailers.

Department stores have multiple categories functioning as different business units under one roof.

They are sometimes national chains and often carry the largest number of SKUs.

Jérôme Samuel* Analyst HSBC Bank Plc, Paris Branch +33 1 56 52 44 23 [email protected]

Emmanuelle Vigneron* Analyst HSBC Bank Plc, Paris Branch +33 1 56 52 43 19 [email protected]

Raj Sinha* Head of MENA Research HSBC Bank Middle East +971 4423 6932 [email protected]


138


abc

Online grocery retailing: Among other formats, it is worth highlighting the emergence of online

grocery retailing, which has two types of players: conventional retailers that have added online

retailing and pure online retailers such as Ocado.

A typical discount store will have a leaner cost structure than a hypermarket, with a lower gross margin

but also much lower SG&A. A supermarket enjoys a higher gross margin but provides a higher level of

service in store. We estimate that hypermarkets have an operating margin of 4.5%, supermarkets and

discount stores about 5.5%, and convenience stores higher, all things being equal.

Along with location, brand awareness and private labels are key success factors in food retailing,

attracting customers and helping build their loyalty. Private labels ensure higher margins for the retailers

– in terms of percentage rather than cash – since, although private label goods are sold at lower prices

than national brands (c25% on average), their costs are much more heavily discounted. In all mature

markets, private labels are growing much faster than national brands. The UK is the leader, with private

labels representing more than 40% of retailers’ sales, but French, German and the other European retailers

are catching up; private labels now account for more than 25% of their sales.

Key themes Top line: organic sales

An important metric is like-for-like (same-store, identical) sales growth: the constant currency sales

growth in stores that have been open more than a year (the duration may differ slightly from company to

company). Like-for-like gives an indication of how the retailer has performed in attracting more

customers and increasing sales per customer through techniques such as better branding, pricing,

offerings and loyalty programmes. It gives a fair representation of actual sales growth, excluding forex,

new stores and stores acquired/disposed of.

Historically, the top line has helped drive returns for investors, since margins tend not to change much.

With top-line growth opportunities drying up in existing stores, retailers keep opening new stores and

increasing store sizes. Organic growth represents increases in sales ex-currency effects and ex-M&A.

Besides company-specific factors (eg brand awareness, loyalty programmes, promotional activity),

certain structural differences explain why some retailers enjoy faster sales growth than others.

Maturity of the domestic market: As a general rule, the higher the retail density, or retail space per

capita, the lower the growth potential.

Extent of opening programmes: Retailers plan store openings to improve coverage, complementing

the coverage of existing stores and adding new space that will later contribute to like-for-like growth.

Exposure to growth markets: Although currency fluctuations and shorter economic cycles may

increase earnings volatility, emerging markets offer a good opportunity for top-line growth. Modern

retailing is still at an early stage of development in emerging markets. A weak currency may have a

positive impact on financial interest by lowering net debt. Most food retailers try to ensure that their

international activities are self-financed in local currencies and are not hedged. Large food retailers

are present in multiple countries, thereby bearing significant forex risk. Although most of the

sourcing is done locally, the currency exposure still brings volatility to the top line and the bottom

line, if not the margins.

139


abc

Exposure to different formats: Different formats have different dynamics and may grow at widely

differing levels even in the same region. For example, in France, discounters lost market share in

2009 and 2010 as a consequence of greater price competition from hypermarkets.

Cost savings

Of late, the focus for large retailers has turned more towards cost savings (mainly Carrefour and Metro) and the

resultant margin improvement. Economies of scale provide an opportunity for significant cost savings – for

example the ability to harness synergies in purchasing and distribution for different banners within the same

company. Building efficiency in logistics and optimising store size also helps improve margins.

Since 2009, most of the major food retailers have been executing cost-saving plans. Asda, for example,

describes the virtuous circle of its trading model as buying better, lowering prices, improving quality,

getting the offer right, driving volume and finally improving operational profitability. In other words, low

prices help to drive higher volumes through gains in market share, which in turn leads to better buying

conditions and hence the ability to offer even better prices to customers.

M&A

Big mergers like Carrefour-Promodès in 1999 and Morrison-Safeway in 2004 had problems with

integration and value creation. Most synergies announced at the time of the deals have not been delivered,

especially in the case of cross-border deals where buying synergies have been made on a national basis.

As the top players enjoy major market shares in mature markets, few developed countries offer

opportunities for consolidation. However, emerging markets are a source of growth, and many players

enter them through acquisitions. Sometimes retailers also swap assets, which may make sense if each

lacks critical size. For example, in 2005, Carrefour and Tesco agreed to swap some Tesco stores in

Taiwan for Carrefour stores in the Czech Republic and Slovakia.

Sector drivers Consumer confidence

In mature economies, consumer confidence is one of the main drivers of the top line. Although the sector

withstands shocks well, consumers do tend to trade up when confidence is high and vice versa. Emerging

markets are structurally different. Their low per-capita incomes and lower retail penetration provide room

for significant long-term structural growth.

Economy/inflation

Moderate inflation is good for the sector; it helps both the top line and the bottom line for those who have

pricing power. The worst scenario for food retailers is deflation. In general, macroeconomic factors such

as rising per-capita income and expenditure levels help sales growth.

Loyalty programmes, private labels

Food retailers have been developing ever more attractive and innovative loyalty schemes. Loyalty

schemes have been found to work well for retailers, leading to improved repeat purchases and consumer

data collection. The data collected from such schemes lead to useful insights in tailoring the offerings and

increasing loyalty further. Tesco’s Clubcard has been one of the most successful. Private labels command

higher margins for food retailers with lower prices for consumers. Obviously, food retailers focus on

increasing the share of private labels in total sales.

140


abc

Over the long term, the food retailers that have performed best have been mono-format retailers with a

strong concept and brand awareness and the ones that have managed to secure loyal customers.

Key segments Capex is a leading indicator

On average, capex for food retailers is expected to equate to 4% of net sales in 2012e, compared with 5%

in 2008, reflecting the economic crisis. One of the sector’s strengths is that total capex comprises a

multitude of small investments, offering more flexibility in a downturn. Capex comparisons between

retailers can be distorted by the nature of the business (mix of food versus non-food), the property strategy

(freehold or leasehold), the proportion of owned stores versus franchises and the regions of expansion.

Distribution costs

Distribution costs are not entirely comparable because retailers do not all account for their costs in the

same way. Formats, assortment, exposure to non-food and the level of service in stores have a direct

impact on distribution costs and margins.

Property

The level of property ownership is different for each company, making EBITDA comparisons difficult.

However, EBIT is generally comparable as it includes both rental costs (for leased property) and

depreciation (for freehold property).

Valuation Most of the major international food retailers provide good revenue and earnings visibility, so they can be

valued using a discounted cash flow model. The presence of comparable peers means relative valuation

can also be used. We estimate that the food retail sector in Europe now trades at 2012e EV/sales of 36%

and EV/EBITDA of 5.7x, and on a 2012e PE of 10.4x, compared with the 16.3x at which it traded on

average between July 1999 and August 2010. During the same period, the average PE relative to the DJ

Stoxx 600 for European food retailers was around 1.03x.

European food retail: growth and profitability

2008 2009 2010 2011 2012e

Growth Sales 7.2% 1.2% 3.3% 4.4% 6.8% EBITDA 7.4% 1.3% 5.6% 1.0% 4.8% EBIT 7.6% -0.1% 8.0% -0.9% 4.6% Net profit -0.9% -4.0% 15.8% -2.4% 2.6%

Margins EBITDA 6.48% 6.49% 6.63% 6.42% 6.30% EBIT 4.26% 4.21% 4.40% 4.18% 4.09% Net profit 2.44% 2.32% 2.60% 2.43% 2.33%

Productivity Capex/sales 5.1% 3.5% 3.7% 3.8% 3.9% Asset turnover (x) 1.71 1.64 1.65 1.67 1.71 Net debt/Equity 56% 46% 41% 48% 46% ROE 14.4% 12.7% 13.6% 13.0% 12.8%

Note: based on all HSBC coverage of European food retail sector All data in the table are aggregated from the individual company data Source: company estimates, HSBC estimates

141


abc


MSCI Food & Staples Retailing Dollar Index


Trading data 5-yr ADTV (EURm) 498 Aggregated market cap (EURbn) 99.2 Performance since 1 Jan 2000 Absolute -75% Relative to MSCI Europe US Dollar

-60%

3 largest stocks Tesco, Ahold, Carrefour Correlation (5-year) with MSCI Europe US Dollar

0.85


Top 10 stocks: MSCI Food & Staples Retailing Dollar Index


1 Tesco 30.5% 2 Ahold 10.0%3 Carrefour 9.5%4 Jeronimo Martins 8.7%5 Morrison 8.5%6 Metro 7.2%7 Casino 7.2%8 Sainsbury 6.7%9 Colruyt 5.3%10 Delhaize 2.6%

Source: MSCI, Thomson Reuters Datastream, HSBC Country breakdown: MSCI Food & Staples Retailing Dollar Index

Country Weights (%)

UK 45.7% France 16.7% Netherlands 10.0% Portugal 8.7% Belgium 7.9% Germany 7.2% Spain 2.4% Finland 1.3%


Food CPI and consumer confidence are industry drivers (% change y-o-y)

-4.0%

0.0%

4.0%

8.0%

12.0%

Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11

Consumer confidence Inflation (food)


PE band chart: MSCI Food & Staples Retailing Dollar Index

19x

17x

15x

13x

70

100

130

160

190

2001 2003 2005 2007 2009 2011


PB vs. ROE: MSCI Food & Staples Retailing Dollar Index

1

2

2

3

3

2004 2005 2006 2007 2008 2009 2010 2011 2012

0

5

10

15

20

Fwd PB (LHS) Fwd ROE % (RHS)


142


abc

Notes

143


abc

General retail

General retail Paul Rossington* Analyst HSBC Bank plc +44 20 7991 6734 [email protected]

Sector sales Lynn Raphael Sector sales HSBC Bank plc +44 20 7991 1331 [email protected]

David Harrington Sector sales HSBC Bank plc +44 20 7991 5389 [email protected]


EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

144

ab

c

Sector structure

Carphone Warehouse (FTSE 250)

Halfords (FTSE 250)

PPR (MSCI EU)

Signet (FTSE 250)

WH Smith (FTSE 250)

Specialty

Home Retail Group (FTSE 250)

Kingfisher (FTSE 100)

Dunelm (FTSE 250)

DIY

Debenhams (FTSE 250)

Hennes & Mauritz (MSCI EU)

Inditex (MSCI EU)

Marks & Spencer (FTSE 100)

Mothercare (FTSE 250)

Next (FTSE 100)

Sports Direct (FTSE 250)

Clothing & Home

Asos plc (FTSE AIM)

Brown N Group (FTSE 250)

Internet & catalogue

Dixons (FTSE 250)

Inchcape (FTSE 250)

Kesa Electricals (FTSE 250)

Electricals


Food and HPC xxxxxxxxxxxxxx

Luxury


Food retail


Beverages


General retail xxxxxxxxxx


Carphone Warehouse (FTSE 250)

Halfords (FTSE 250)

PPR (MSCI EU)

Signet (FTSE 250)

WH Smith (FTSE 250)

Specialty

Home Retail Group (FTSE 250)

Kingfisher (FTSE 100)

Dunelm (FTSE 250)

DIY

Debenhams (FTSE 250)

Hennes & Mauritz (MSCI EU)

Inditex (MSCI EU)

Marks & Spencer (FTSE 100)

Mothercare (FTSE 250)

Next (FTSE 100)

Sports Direct (FTSE 250)

Clothing & Home

Asos plc (FTSE AIM)

Brown N Group (FTSE 250)

Internet & catalogue

Dixons (FTSE 250)

Inchcape (FTSE 250)

Kesa Electricals (FTSE 250)

Electricals





Luxury


Food retail


Beverages


General retail xxxxxxxxxx


Source: HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

145

ab

c


0

100

200

300

400

50019

90

1990

1991

1991

1992

1992

1993

1993

1994

1994

1995

1995

1996

1996

1997

1997

1998

1998

1999

1999

2000

2000

2001

2001

2002

2002

2003

2003

2004

2004

2005

2005

2006

2006

2007

2007

2008

2008

2009

2009

2010

2010

2011

2011

2012

-35

-23

-11

1

13

25

Sector performance (LHS) UK BANK OF ENGLAND BASE RATE (EP) (RHS)

UK GDP (%YOY) NADJ (RHS) UK CONSUMER CONFIDENCE INDICATOR- SADJ (RHS)

Periods of low interestrates, consistently

rising house prices andmortgage equity

withdrawal

Collapse in UKGDP as creditcrunch bites

‘Bricks and Mortar’ retailers out of fashion, as internetfever drives market (note subsequent recovery as

internet bubble bursts in March 2000). Period coincideswith start of serious competition for traditional retailers

from supermarkets and fast fashion discounters.Biggest stock in sector (M&S) loses 60% of its value

between 1998 and 2000

UK leaves ERM inSept 1992, resulting

in sharp fall in interestrates and economic

recovery

Source: HSBC, Thomson Reuters Datastream

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

146

ab

c

EBIT margin versus asset turnover chart CY2012e

Next

Signet

Dunelm

Sport Direct

Inchcape

WH Smith

Dixons

M&S

Kingfisher

Inditex

Home Retail

H&M

HalfordsDebenhams

N Brown

Asos

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%

EBIT Margin (% )

Asse

t Tur

nove

r

Source: HSBC estimates, Thomson Reuters Datastream for uncovered stocks

147


abc

Sector description Pan-European general retail

The Pan-European general retail sector is split between Europe and the UK. Europe is dominated by a

handful of established names, and the combined market capitalisation of Inditex and H&M (cUSD93bn)

accounts for a substantial share of the MSCI European Retail Indices, which also includes a handful of

UK names. With the exception of Inditex, H&M, PPR (covered by luxury goods) and a few specialist mid

cap stocks, there is little in the way of investible sector players outside the UK. The UK is a highly

cyclical and largely mature industry (70% organised retail penetration) with few genuine defensive

propositions and limited exposure to international revenue. A significant share of the industry is in private

hands owing to substantial investment between 2002 and 2007 by private equity firms, which were

attracted by strong cash generation and the availability of cheap debt, as well as by sale-and-leaseback

freehold property assets. Accordingly, the listed component is typically asset-light and varied in nature

with no two companies the same; the combined market capitalisation amounts to just cUSD38bn. The

three FTSE 100 companies (Kingfisher, Marks & Spencer and Next) account for around 65% or

USD25.6bn of this total. Growth stocks in the UK are typically mid cap in nature and share one or more

of the following characteristics:

Specialist propositions with limited exposure to non-specialist/supermarket competition

Ability to derive a higher percentage of revenues from faster-growing international/emerging markets

Exposure to, or the ability to adapt to, structurally higher growth in online consumer spending patterns

Key themes Macro environment: unemployment, income, consumer confidence, savings ratio

Given the mature market positions/domestic market exposure of the vast majority of stocks within this

space, consumer confidence is a key lead indicator of the sector’s performance. This is driven by the

macro environment, primarily the outlook for employment and thus personal/household disposable

income. In most consumption-driven economies (such as the UK) the unemployment rate has a very

strong correlation with the rate of GDP growth. The single largest determinants of households’ future

disposable income are the savings rate (the percentage of disposable income that is not spent) and, by

default, consumer confidence (ie “will I still have a job in 12 months’ time?”). Base rates have a strong

positive correlation with retail sector performance given their direct impact at the beginning of an

Paul Rossington * Analyst HSBC Bank plc +44 20 7991 6734 [email protected]


Northern Europe consumer confidence Southern Europe consumer confidence

(50)

(30)

(10)

10

30

Q1

2008

Q3

2008

Q1

2009

Q3

2009

Q1

2010

Q3

2010

Q1

2011

Q3

2011

Q1

2012

(50)

(30)

(10)

10

30

Germany UK Sweden France

(100)

(80)

(60)

(40)

(20)

0

Q1

2008

Q3

2008

Q1

2009

Q3

2009

Q1

2010

Q3

2010

Q1

2011

Q3

2011

Q1

2012

(100)

(80)

(60)

(40)

(20)

0

Italy Greece Spain Portugal

Source: Thomson Reuters Datastream, HSBC Source: Thomson Reuters Datastream, HSBC

148


abc

economic cycle via lower household mortgage/lending costs, and later via the higher rates used to keep

economic growth in check. Thus although lower interest rates support/encourage consumer spending and

confidence, rising interest rates and the implied increase in GDP growth are the main drivers of longer-

term sector performance. Price inflation is a positive, as long as it is not more than offset by higher input

costs/cost inflation (leading to margin squeeze). Any significant increase in the costs of food, warmth and

shelter will also determine what income remains for discretionary purchases.

International diversification

Companies that earn a larger share of their revenues outside the domestic market, including in higher-

growth emerging markets – thereby increasing the size of their addressable market – offer the greatest

diversification to macro risk. Exposure to high overseas revenues and GDP growth in the respective

markets are positive.

International revenue exposure and sales-weighted market GDP growth (CY2012e)

0%

25%

50%

75%

100%

HO

ME

0.5%

HFD

0.5

%

BWN

G 0

.5%

SMW

H 0

.6%

NXT

0.5

%

MKS

0.9

%

DEB

0.6

%

SPD

0.3

%

SGP

0.5%

MTC

1.6

%

DXN

S 0.

5%

ASC

2.1

%

KGF

1%

INC

H 1

.7%

HM

B 1.

1%

ITX

1.2%

KESA

0.3

%

UK Eurozone & Wt Europe Other Developed markets Emerging markets

Note: Numbers written next to company denote sales-weighted market GDP growth by company for CY 2012e Source: Company data, HSBC estimates

Input cost pressures

In the decade until end-2009, European retail was a major beneficiary of the US dollar carry trade; a weak

dollar and the switch to lower-cost Far East sourcing underpinned the sector’s gross margin expansion. This

trend reversed in 2010-11 on a combination of higher Far East manufacturing wage inflation, increased raw

material input costs and a stronger US dollar. While the reduction in raw materials input costs (specifically

cotton) will bring total input costs down over the next two years (we forecast a reduction of around 5-7% in US

dollar sourcing costs in 2012-13e), we ultimately expect Far East sourcing costs to keep rising.

Input cost analysis

2010 2011 % y-o-y 2012e y-o-y 2013e % y-o-y

Raw material costs (eg cotton) 26 45 74% 36 -19% 22 -39% Labour 19 23 20% 28 23% 34 23% Other production costs, SG&A 34 34 0% 34 0% 34 0% Manufacturing margin 6 6 0% 6 0% 6 0% Freight 5 9 79% 6 -32% 7 10% Duty 10 13 27% 12 -3% 11 -8% Total 100 130 123 114 % y-o-y change 5% 30% -5% -7%


149


abc

Online sales growth in key countries (% y-o-y) Retail sales growth in key countries (% y-o-y)

-10%

-5%

0%

5%

10%

15%

20%

Q1

2008

Q2

2008

Q3

2008

Q4

2008

Q1

2009

Q2

2009

Q3

2009

Q4

2009

Q1

2010

Q2

2010

Q3

2010

Q4

2010

Q1

2011

Q2

2011

Q3

2011

Q4

2011

Q1

2012

-10%

-5%

0%

5%

10%

15%

20%

UK France Germany US

-15%

-10%

-5%

0%

5%

10%

Q1

2008

Q2

2008

Q3

2008

Q4

2008

Q1

2009

Q2

2009

Q3

2009

Q4

2009

Q1

2010

Q2

2010

Q3

2010

Q4

2010

Q1

2011

Q2

2011

Q3

2011

Q4

2011

Q1

2012

-15%

-10%

-5%

0%

5%

10%

UK France US Germany

Source: Thomson Reuters Datastream, HSBC Source: Company data, HSBC

Structural shift to online

Given the rollout of broadband networks, increasingly sophisticated website innovation and the suitability

of certain product categories for digital dissemination (eg entertainment), the internet poses a material

competitive threat to some established bricks-and-mortar business models that are already under pressure

from an intensification in non-food competition from the major supermarket groups. For others, however,

it is a substantial growth opportunity. Although it is not yet clear what the level of online penetration in

specific categories will ultimately be (around 13% of total UK retail sales in 2011), this remains an area

of structural growth and is now the fastest route to international expansion via reduced barriers to entry.

Sector drivers Online: positive for brands but not for boxes

Given the sector theme of the structural shift to online retailing we think the most successful models will be

those able to differentiate themselves either by first-mover advantage in developing an online interface such as

pure-play/specialist internet retailers (Asos plc) or brand proposition/exclusivity. The table below identifies

where online is an opportunity for the stocks in our universe (primarily brands), and conversely where it is a

risk to established businesses (boxes): those worst affected by pricing pressure, those reliant on third-party

brands, and those in historically specialist markets (eg electrical goods) that have been commoditised by the

introduction of non-specialist competition (eg UK supermarket groups) and new market entrants (eg Amazon).

Online revenue exposure (% of group sales): Opportunity or risk?

____ Models that offer potential opportunities ____ ___________ Neutral __________ _____ Models that face potential threats ___ Company % Company % Company %

Asos 100% Halfords 9% Home Retail Grp (Argos Only) 39% Brown (N) Grp 51% WH Smith n/a Mothercare (as a % of UK sales) 23% Next 32% Kingfisher n/a Kesa 10% Marks & Spencer Grp (GM sales only) 15% Inchcape n/a Dixons Retail 8% Sports Direct Intl. (% of retail sales) 8% Carpetright n/a Supergroup 8% Debenhams 8% H&M Less than 5% Inditex Less than 5%

Source: Company data (last reported financial period), HSBC

Structural growth in online spending and the opportunity that it provides is also key to the debate about

how many stores a company needs to service its target market (see capacity withdrawal overleaf).

150


abc

Consolidation and capacity withdrawal: positive for large retail market share

In recent recessionary times, general retail sectors in developed markets have been characterised by

capacity withdrawal motivated by two key drivers: (1) increase in online spending (eg Amazon); and (2)

the expansion of major supermarket groups into non-food categories (eg Tesco, Asda Walmart,

Sainsbury’s and WM Morrisons). This has had a dramatic effect on UK general retailers, leading to the

failure of both listed and private-equity-backed businesses – typically in price-led commodity categories.

The vast majority of casualties have been relatively small players, which had, in many cases, over-

expanded in previous years; their failure to capitalise online spending trends combined with higher

property rental costs led to margin squeeze.

Shopping centre development pipeline: floor space (m sq ft) UK supermarket space growth slowing (% y-o-y)

20

40

60

80

100

120

2006 2007 2008 2009 2010 2011

UK Europe

-3%

0%

3%

5%

8%

10%

2007a 2008a 2009a 2010a 2011a 2012e 2013e 2014e

Tesco Sainsbury

Morrison Total

Source: Cushman & Wakefield, Marketbeat Shopping Centre Development Report Europe March 2010, HSBC

Source: Company data, HSBC estimates

While capacity withdrawal is positive for any remaining retailer, the larger companies in the sector (eg

Debenhams in home & beauty and clothing, and Home Retail group in small-ticket electricals,

entertainment and gifting) with the broadest category exposure stand to gain most from reduced

competition, in our view. The benefits can be either from market share gains or the acquisition of

distressed assets (eg complementary brands, physical assets, or client data in the case of internet-based

operators) at depressed valuations.

Cost-cutting and cash-saving initiatives: scale brings advantage

Aggressive cost-cutting initiatives have characterised all but a handful of operators in the sector. By

reducing or optimising what are largely fixed-cost overheads, these companies are now better positioned

to benefit from increased operational gearing on small market share or revenue gains. With larger/more

sustainable businesses repairing their balance sheets through reduced capital expenditure, those with

sustainable business models have used the cessation of dividend payments and equity capital raisings

(rights issues), where appropriate, to restore their balance sheets. For example M&S announced around

GBP300m in cost savings under Plan 2020, Home Retail greatly reduced its cost base by around

GBP200m over four years (2008-11). Overall the sector has become leaner over the years.

Company sales indicators

Although most companies in the sector are cyclical by nature, no two are the same, so the key lead indicators

for sales and earnings growth performance can differ markedly between companies. For Inditex (around 25%

Spanish revenues) we use Spanish chain stores sales; for H&M (some 25% German revenue exposure) we use

151


abc

Textilwirschift data for the local market. For other companies we use a variety of UK and French lead

indicators from trade bodies such as British Retail Consortium and ONS/Banque de France data.

Valuation Key valuation metrics

In the case of the retail sector, EV/EBITDA, PER and yield – both free cash flow (FCF) and dividend –

remain the key metrics by which the sector is most often screened or filtered. With debt concerns largely

removed from the valuation agenda, the PER is generally considered to be the key long-term metric by

which the sector is valued. The 10-year historical one-year forward PE range is 7.2-17.0x, with an

average of 13.1x. Additionally, and supplementing PER analysis, ROIC is often seen as a key measure of

performance for mature companies. Intrinsic valuation methodologies such as discounted cash flow

(DCF), dividend discount models (DDM) and adjusted present value (APV), can then be used to gain an

accurate assessment of the present value of future cash flows by absolute quantum; this is particularly

relevant for companies that generate cash in excess of their own investment requirements (and thus are

either low or ex-growth), and which are looking at a sustainable total shareholder returns (TSR) – a

combination of underlying EPS growth, dividends and share buybacks – as the key mechanisms for

returning value to shareholders.

Classification

Cyclical versus defensive: Cyclical stocks typically trade at a premium to the sector and can often

deliver high or super-normal earnings growth, supported by a structural growth dynamic (eg the internet)

or cyclical recovery. Defensive stocks typically trade at a discount to the sector but are often characterised

by higher FCF/dividend yields, supported by consistent and sustainable cash generation.

UK-centric versus international: Stocks which offer international diversification (Kingfisher, Inditex,

Hennes & Mauritz) typically trade at a premium to UK-centric business models, with exposure to

emerging markets and BRIC territories highly valued by the investor.

FTSE100 versus FTSE350: Given their largely mature status, UK-centric business models and the

resultant low earnings growth rates, FTSE100 stocks typically trade at a discount to other UK FTSE350

General retailers, which often have emerging competitive advantages via scale in specialist retail categories.

General Retail*: growth and profitability (calendarised data)

2008 2009 2010 2011 2012e

Growth Sales 11.5% 9.3% 8.2% 6.2% 10.1% EBITDA 6.1% 9.8% 14.3% 1.5% 11.3% EBIT 2.9% 9.3% 17.6% 0.9% 12.2% Net profits 3.9% 9.8% 19.7% 2.5% 10.8% Margins EBITDA 20.4% 20.3% 21.6% 20.3% 20.5% EBIT 16.6% 16.2% 17.6% 16.3% 16.7% Net profit 12.4% 12.1% 13.2% 12.5% 12.6% Productivity Capex/sales 7% 5% 5% 6% 5% Asset turnover (x) 1.5 1.6 1.5 1.5 1.6 Net debt/Eq 0.1x -0.1x -0.2x -0.2x -0.2x ROE 31% 29% 31% 27% 28%

Note: Based on all HSBC coverage of General Retail. All data are market cap weighted Source: company data, HSBC estimates

152


abc


MSCI EU Retailing Index 2.1% of MSCI Europe US Dollar

Trading data 5-yr ADTV (EURm) 549 Aggregated market cap (EURbn) 124.8 Performance since 1 Jan 2000 Absolute 10% Relative to MSCI Europe US Dollar

31%

3 largest stocks Inditex, H&M, Kingfisher Correlation (5-year) with MSCI Europe US Dollar

67%


Top 10 stocks: HSBC General Retail coverage (weights are given for presence in relevant indices)


1 Inditex *36% 2 Hennes & Mauritz *33% 3 Kingfisher **24% 4 Marks & Spencer **21% 5 Next **18% 6 Asos ***6% 7 Debenhams **3% 8 Home Retail Group **3% 9 Halfords **3% 10 N Brown Gp **3%

* MSCI EU Retailing index, ** FTSE 350 Gen Retailers, ,***FTSE AIM Source: MSCI, Thomson Reuters Datastream, HSBC

Country breakdown*: FTSE 350 General Retail

Region/country Weights (%)

UK 62% Eurozone 20% EM Europe 5% Other Western Europe 4% Asia ex Japan 4% Asia-Pacific 2% Middle East, Africa 2% North America 1% LatAm 1%

*Based on geographic revenue exposure


Core industry driver: Retail clothing sales growth (%)

-18%

-12%

-6%

0%

6%

12%

18%

Apr-1

0

Jun-

10

Aug-

10

Oct

-10

Dec

-10

Feb-

11

Apr-1

1

Jun-

11

Aug-

11

Oct

-11

Dec

-11

Feb-

12

Apr-1

2

-18%

-12%

-6%

0%

6%

12%

18%

France UK GermanySpain USA

Note: Spanish large chain store sales Source: Thomson Reuters Datastream, ine.es, textilwirtschaft, census.gov, HSBC

PE band chart: FTSE 350 General Retail

500

1000

1500

2000

2500

3000

3500

4000

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

20x

10x

15x

8x


PB vs. ROE: FTSE 350 General Retail

0.0

5.0

10.0

15.0

20.0

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

0

10

20

30

40

50

Fw d PB (LHS) Fw d ROE % (RHS)


153


abc

Luxury goods

Luxury Goods team Antoine Belge* Head of Consumer Brands and Retail Equity Research, Europe HSBC Bank Plc, Paris Branch +33 1 56 52 43 47 [email protected]

Erwan Rambourg* Head of Consumer Brands and Retail Equity Research The Hong Kong and Shanghai Banking Corporation Limited +852 2996 6572 [email protected]


Sector sales David Harrington Sector Sales HSBC Bank Plc +44 20 7991 5389 [email protected]

Lynn Raphael Sector Sales HSBC Bank Plc +44 20 7991 1331 [email protected]




EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

154

ab

c

Sector structure

Luxury goods

‘Hard luxury’ companies ‘Soft luxury’ companies

LVMH

Louis Vuitton

Moët Hennessy

Sephora

DFS

Bulgari

Perfumes

Christian Dior

41% LVMH stake

Dior Couture brand

PPR

Gucci

Puma

Retail assets

Richemont

Cartier

Montblanc

IWC

Panerai

Swatch Group

Omega

Breguet

Tissot

Swatch

Coach Burberry

Tiffany Harry Winston Tod’s Hermès

Prada Ferragamo

Hugo Boss

Luxottica

Ray-Ban

Oakley

Eyewear licences

Lenscrafters

Sunglass Hut

Diversified groups or holdings

Luxury goods

‘Hard luxury’ companies ‘Soft luxury’ companies

LVMH

Louis Vuitton

Moët Hennessy

Sephora

DFS

Bulgari

Perfumes

Christian Dior

41% LVMH stake

Dior Couture brand

PPR

Gucci

Puma

Retail assets

Richemont

Cartier

Montblanc

IWC

Panerai

Swatch Group

Omega

Breguet

Tissot

Swatch

Coach Burberry

Tiffany Harry Winston Tod’s Hermès

Prada Ferragamo

Hugo Boss

Luxottica

Ray-Ban

Oakley

Eyewear licences

Lenscrafters

Sunglass Hut

Diversified groups or holdings

Source: HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

155

ab

c

Sector valuation history (forward PE)

0.0 x

5.0 x

10.0 x

15.0 x

20.0 x

25.0 x

30.0 x

35.0 x

40.0 x

Jun-

97

Mar-

98

Dec-

98

Sep-

99

Jun-

00

Mar-

01

Dec-

01

Sep-

02

Jun-

03

Mar-

04

Dec-

04

Sep-

05

Jun-

06

Mar-

07

Dec-

07

Sep-

08

Jun-

09

Mar-

10

Dec-

10

Sep-

11

Jun-

12

Asian financial

crisis

2000 bubble

09/11 attacks

SARS

epidemic

China starts

to matter

2007 market

peak

Post-Lehman collapse0.0 x

5.0 x

10.0 x

15.0 x

20.0 x

25.0 x

30.0 x

35.0 x

40.0 x

Jun-

97

Mar-

98

Dec-

98

Sep-

99

Jun-

00

Mar-

01

Dec-

01

Sep-

02

Jun-

03

Mar-

04

Dec-

04

Sep-

05

Jun-

06

Mar-

07

Dec-

07

Sep-

08

Jun-

09

Mar-

10

Dec-

10

Sep-

11

Jun-

12

Asian financial

crisis

2000 bubble

09/11 attacks

SARS

epidemic

China starts

to matter

2007 market

peak

Post-Lehman collapse

Source: Factset, HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

156

ab

c

EBIT margin versus asset turnover (FY2012*)

Hermes

Ferragamo

LVMH

Christian DiorPPR

Lux ottica

Richemont

Sw atch

Tiffany

Coach

Burberry

PradaTod's

Hugo

0.5

0.7

0.9

1.1

1.3

1.5

1.7

1.9

10.0% 15.0% 20.0% 25.0% 30.0% 35.0%

EBIT Margin (%)

Ass

et T

urno

ver

(x)

* FY2012 figures for Burberry, Tiffany, Richemont and Prada are actuals, all other figures are HSBC estimates. Source: HSBC estimates

157


abc

Sector description The luxury goods sector includes companies that develop, produce, market, distribute and sell high-end

apparel, jewellery, watches, leather goods and accessories. Some luxury goods companies are also

involved in other premium-priced categories, such as LVMH with its fragrances, and wines and spirits, or

are vertically integrated; the Swatch Group, for example, has a watch-component division. Many listed

companies are family-controlled, although some have a 100% free float, such as Burberry and Tiffany.

The sector is characterised by high operating margins, substantial emerging-market exposure and strong

cash generation. M&A has been a driver in the past, but with a few exceptions – Luxottica, for example –

synergies are scarce, making it hard to return cash to investors in an efficient manner.

Diversified groups/holdings: Some of the listed companies in the space have grown by acquisitions

that gave them large, diversified brand portfolios. The proxy for the sector and the largest group is the

French company LVMH, which now has more than 50 brands in five different product categories:

fashion and leather, fragrance and cosmetics, wines and spirits, watches and jewellery, and selective

distribution. Christian Dior is a listed holding company of LVMH. PPR is more of a conglomerate

than a diversified luxury group, since it holds retail assets, a stake in sports brand Puma and a luxury

portfolio. Richemont and the Swatch Group also have diversified portfolios, although they focus on

so-called hard luxury.

Hard-luxury companies: ‘Hard luxury’ describes products such as watches, jewellery and pens,

although pens no longer contribute much to sales. Watches and jewellery are often considered

together, but their distribution structures vary considerably. Watches are primarily wholesale-driven,

because consumers want to compare designs, brands, prices and functionality. Jewellery is often

retail-driven – companies sell their own jewellery in their own stores. The largest listed hard-luxury

companies are Richemont, with its star brand Cartier, and the Swatch Group, with the star brand

Omega. Monobrand companies include Tiffany and Harry Winston, which sells mostly jewellery.

Soft-luxury companies: ‘Soft luxury’ describes high-end apparel and leather goods. Soft-luxury

goods are mostly sold in directly operated stores. Monobrand listed companies include Burberry,

Hermès, Prada, Ferragamo, Tod’s, Hugo Boss and Coach.

Key themes Luxury goods stocks historically have shown strong growth, trading at a premium valuation to the market.

The key concern is the sustainability of their growth, and the key question for the bigger brands like Louis

Vuitton and Cartier is how close the brand is to being mature. It seems paradoxical to try to sell more of

what theoretically should be exclusive, but the leaders of the industry have walked a fine line between

selling in volume and holding on to their identity (and the consumer). Most of the key themes in the

sector will revolve around image management, pricing power and the concept of maturity.

We believe that the key concerns and themes are:

High-end consumer behaviour: Most investors consider luxury goods demand to be directly linked to

GDP growth. To a certain extent, that has been the case in some countries. But consumption of luxury is

driven by social, cultural and psychological factors as well as financial issues. Luxury boomed in Japan

during one of the country’s deepest recessions. Similarly, consumer confidence was sluggish in many

Antoine Belge* Head of Consumer Brands and Retail Equity Research, Europe HSBC Bank Plc, Paris Branch +33 1 56 52 43 47 [email protected]

Erwan Rambourg* Head of Consumer Brands and Retail Equity Research The Hong Kong and Shanghai Banking Corporation Limited +852 2996 6572 [email protected]



158


abc

developed markets in 2010 and 2011, but luxury demand soared as wealthy consumers loosened their belts

after almost two years of austerity.

Pricing power: Luxury brands do not really compete on price but rather on design and desirability. During

the downturn, prices generally held up. In recovery phases, brands tend to launch higher-priced, higher-

margin products, and raise prices again.

Trading up or down, more or less: Linked to this pricing power and the social status that is associated

with luxury, there is a big debate around the consumer behaviour of trading up or down, and trading more

or less. In spirits, trading down is common; customers buy cheaper vodka in the US during a recession, for

example. We think in luxury goods, high-end consumers tend to trade less when times get tough. A

consumer interested in the latest Patek Philippe watch would probably postpone buying it during an

economic crunch rather than trade down to a Casio or Swatch.

Market share/polarisation: Trading less implies that some brands have a reference status and will both

increase sales when times are good and expand their market share when times are tougher. Louis Vuitton

is usually the reference in leather and accessories; Cartier in watches and jewellery.

Market maturity/saturation: If Louis Vuitton, for example, increases sales by a high single-digit to

low double-digit rate every year, how long can this last? When will its market be saturated? This is a

theoretical debate that has gone on for years. Japan and possibly a few other countries may be treated

as cash cows now, but we believe companies still have considerable capacity to recruit customers and

persuade them to trade up.

Image control: It is hard to get consumers to trade up if the distribution network is not up to speed in

product assortment, merchandising and in-store service. Most brands try to control their image as

much as they can. That often means taking back licences or transferring sales from wholesalers to

directly operated stores, which is harder for wholesale-driven businesses such as watches or

fragrances. And if the product category is a profitable diversification from the main business, but is a

category in which the company does not have know-how or a production base, such as fragrances and

eyewear at Burberry or Gucci, a licence makes sense. Another recurring subtheme here is counterfeit

products in luxury.

Sector drivers Luxury goods have been driven by emerging-market exposure, both within developing countries and through

customers from those countries buying goods in Europe. We expect entering and developing leadership

positions in higher-growth countries, where margins are already higher than in the developed world outside

Japan, will continue to be a key factor for the sector. Historically, currency and M&A have also had an impact

on stock prices.

Currency: Most European luxury goods manufacturers produce in euros (in France and Italy) or

Swiss francs, and sell throughout the world. They have important exposure to the US dollar and

dollar-linked currencies, such as the renminbi and the Hong Kong dollar, and to the yen. A

weakening of the euro or/and the Swiss franc has a positive impact on earnings for French, Italian

and Swiss luxury companies (which may have a time lag depending on hedging strategies).

159


abc

M&A and cash management: There have been few deals since the LVMH buying spree in 1999-2000;

LVMH’s acquisition of Bulgari in 2011 being one. But with cash piling up, there is recurring talk about

deals, and cash generation could become an issue if buy-back programmes or dividend hikes do not occur.

Beyond the scarcity of targets (many of which are privately held with no pressure to sell), the issue with

acquisitions in the sector is that they do not produce many synergies – if LVMH were to acquire a leather

goods brand, it would not be distributed in existing Louis Vuitton stores.

Geographic diversification: The US remains an underdeveloped market, in our view, and countries

like India, Russia and Brazil could represent growth opportunities in the future. But the investment

case for the sector now relies greatly on Asia outside Japan. Although there are theoretical risks when

operating in China, we believe they are outweighed by the many reasons to remain excited by the

country’s potential.

Valuation Luxury goods companies tend to trade on forward-looking price/earnings ratios because they are usually

not very capital/debt-intensive. Historically, the sector has traded at an average 50% premium to the

market, with troughs during which the sector was trading in line (as it did following 9/11) and peaks when

the sector was trading at a 100% premium (for example, during the 2000 bubble). In absolute terms, the

sector traded in a forward PE range lying in the low to mid twenties in 2002-07. Since the 2008-09

downturn, it has traded more in the mid to high teens.

Luxury goods can be described as a ‘momentum sector’ since multiples tend to expand when earnings

estimates are raised (and the reverse is also true).

One thing to bear in mind about investments and cost containment in the sector is that most of the

companies are managed, and their equity held, by families. Consequently, management of brands, people

and profits is done with the long term in mind, not necessarily the next quarter, which investors can

sometimes find a difficult approach.

Luxury goods: growth and profitability

2008 2009 2010 2011 2012e

Growth

Sales (organic) 3.9% -2.9% 15.3% 18.9% 11.3% EBITDA -5.2% -2.2% 44.3% 27.0% 16.2% EBIT -5.7% -8.4% 55.7% 37.7% 16.4% Net profit -14.4% -16.8% 22.9% 33.9% 21.5% Margins EBITDA 21.1% 20.7% 24.3% 25.8% 26.4% EBIT 17.7% 16.6% 20.2% 23.0% 23.5% Net profit 11.5% 10.2% 13.6% 15.0% 16.0% Productivity Capex/sales 6.5% 4.6% 5.6% 6.6% 5.8% Asset turnover (x) 0.56 0.72 0.55 0.50 0.51 Net debt/Equity 38.9% 14.8% -2.7% -7.9% -13.7% ROE 20.7% 18.3% 27.8% 29.9% 29.1%

Note: based on all HSBC coverage of luxury Source: company data, HSBC estimates

160


abc


MSCI Europe Textiles, Apparel and Luxury Goods Dollar Index


Trading data 5-yr ADTV (EURm) 599 Aggregated market cap (EURbn) 212 Performance since 1 Jan 2000 Absolute 106% Relative to MSCI Europe US Dollar 127% 3 largest stocks LVMH, Hermes, Richemont Correlation (5-year) with MSCI Europe US Dollar

0.58


Top 10 stocks: HSBC luxury goods coverage (weights are given for presence in relevant indices)


1 LVMH *44.9% 2 Hermes International #2.6% 3 Richemont *17.0% 4 Christian Dior *14.4% 5 PPR **13.8% 6 Coach ##0.1% 7 Prada *#0.2% 8 Luxottica *9.4% 9 The Swatch Group 'B' *6.9% 10 Burberry Group *5.3%

* MSCI Europe Textiles, Apparel and Luxury Goods Dollar Index ** MSCI EU Retailing # SBF120 ##S&P 500 *# S&P Europe LM:$ Source: MSCI, Thomson Reuters Datastream, HSBC

Country breakdown: HSBC Luxury Goods coverage (by market capitalisation)

Country Weights (%)

France 56.5% Switzerland 15.1% United States 9.1% Italy 8.3% Hong Kong 6.3% UK 3.4% Germany 1.3%


Core industry driver: international tourist arrivals and the world population, 1995-2010

400

500

600

700

800

900

1000

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

4.5

5.0

5.5

6.0

6.5

7.0

7.5

International tourist arriv als (LHS, m)

World population (RHS, bn)

Source: US Census Bureau, World Tourism Organization, HSBC

PE band chart: HSBC luxury coverage*

20x

17x

14x

12x

22x

40

90

140

190

240

290

2001 2003 2005 2007 2009 2011

* Includes LVMH, Christian Dior, PPR, Luxottica, Burberry, Richemont, Hugo Boss, Swatch, Hermes, Tiffany, Ferragamo, TOD’s, Prada, Coach Source: Thomson Reuters Datastream, HSBC

PB vs. ROE: HSBC luxury coverage*

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2004 2005 2006 2007 2008 2009 2010 2011 2012

0

5

10

15

20

25

Fwd PB (LHS) Fw d ROE % (RHS)

* Includes LVMH, Christian Dior, PPR, Luxottica, Burberry, Richemont, Hugo Boss, Swatch, Hermes, Tiffany, Ferragamo, TOD’s, Prada, Coach Source: Thomson Reuters Datastream, HSBC

161


abc

Metals & mining

Metals & mining team EMEA Andrew Keen* Global Sector Head, Metals and Mining HSBC Bank plc +44 20 7991 6764 [email protected]

Thorsten Zimmermann*, CFA Analyst HSBC Bank plc +44 20 7991 6835 [email protected]

Vladimir Zhukov* Analyst OOO HSBC Bank (RR) Ltd +7 495 783 8316 [email protected]

CEEMEA Cor Booysen* Analyst HSBC Securities (South Africa) Pty(Ltd) +27 11 6764224 [email protected]

Richard Hart* Analyst HSBC Securities (South Africa) Pty(Ltd) +27 11 676 4218 [email protected]

North America & Latin America Jonathan Brandt Analyst HSBC Securities (USA) Inc +1 212 525 4499 [email protected]

James Steel Analyst HSBC Securities (USA) Inc +1 212 525 3117 [email protected]

Patrick Chidley, CFA Analyst HSBC Securities (USA) Inc +1 212 525 4915 [email protected]

Howard Wen Analyst HSBC Securities (USA) Inc +1 212 525 3726 [email protected]

Asia Simon Francis* Regional Head of Metals and Mining, Asia Pacific The Hongkong and Shanghai Banking Corporation Limited +852 2996 6620 [email protected]

Thomas Zhu* Analyst The Hongkong and Shanghai Banking Corporation Limited +852 2822 4325 [email protected]

Chris Chen* Analyst The Hongkong and Shanghai Banking Corporation Limited +852 2822 4277 [email protected]

Jigar Mistry*, CFA Analyst HSBC Securities and Capital Markets (India) Private Limited +91 22 2268 1079 [email protected]

Amit Pansari*, CFA Analyst HSBC Bank Plc +91 80 3001 3760 [email protected]

Sector sales James Lesser HSBC Bank plc +44 207 991 1382 [email protected]


EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

162

ab

cSector structure

Metals and mining

Aluminium Iron Ore Platinum/Palladium

Alcoa AluminaRusal NalcoNorsk Hydro HindalcoChalco Rio Tinto

Rio Tinto FerrexpoBHP Sesa GoaVale FortescueKumba CliffsNMDC Metalloinvest

Lonmin AmplatsNortham ImpalaRoyal Bafokeng Aquarius

Coking/thermal coalCopper Gold/Silver

Codelco FreeportAntofagasta XstrataAurubis GrupoMexico KGHMKazakhmys BHPSouthern- First-Copper Quantum

Norilsk Glencore

Diversified companies

Senior gold producersBarrick NewcrestNewmont AngloGold Goldfields Goldcorp Kinross Polyus

Mid-tier gold producersBuenaventura YamanaRandgold PolymetalIAMGold EldoradoHarmony CenterraPetropavlosk HochschildRoyal Gold Semafo

Junior gold producersNumerous examples

Explorers and developersNumerous examples

Silver stocksSilver Wheaton HeclaCouer d’Alene FresnilloSilver Standard Pan American

NWR XstrataBHP TeckAngloAmerican MechelRaspadskaya ShenhuaYanzhou China CoalFushan HidliliPeabody Macarthur

Zinc/Lead

Nyrstar BolidenKorea Zinc TerraminHind. Zinc KagaraXstrata Glencore

Norilsk Vale

Nickel

Tin

Majors: AngloAmerican BHP Billiton Rio Tinto Xstrata Vale GlencoreOthers: Boliden ENRC Vedanta JSPL

Mining Steel

Electric arc Blast furnace

Nucor Salzgitter China Steel ThyssenKruppAcerinox SSAB Ternium VoestalpineOutokumpu ArcelorMittal US Steel

Tata Steel PoscoGerdau JFE

BaosteelAK SteelCSNUsiminas

Long steel Flat steel Stainless Pipes

Ezz Nucor ArcelorMittal ThyssenKrupp Acerionox TMKErdemir Salzgitter SSAB Outokumpu VallourecTata Steel US Steel Posco TISCO TenarisRautarrukki Voestalpine Nippon Schmolz & BickenbachSAIL China Steel JFE Gerdau Termium Baosteel

AK SteelUsiminasCSNJSW

Base metals Bulks Precious metals

Integrated Non-integrated

Severstal ArcelorMittal Voestalpine SalzgitterMMK Usiminas Nippon ThyssenKruppEvraz Ternium NLMK SSAB

US Steel Posco NucorSA IL Gerdau AK SteelCSN

Metals and mining

Aluminium Iron Ore Platinum/Palladium

Alcoa AluminaRusal NalcoNorsk Hydro HindalcoChalco Rio Tinto

Rio Tinto FerrexpoBHP Sesa GoaVale FortescueKumba CliffsNMDC Metalloinvest

Lonmin AmplatsNortham ImpalaRoyal Bafokeng Aquarius

Coking/thermal coalCopper Gold/Silver

Codelco FreeportAntofagasta XstrataAurubis GrupoMexico KGHMKazakhmys BHPSouthern- First-Copper Quantum

Norilsk Glencore

Diversified companies

Senior gold producersBarrick NewcrestNewmont AngloGold Goldfields Goldcorp Kinross Polyus

Mid-tier gold producersBuenaventura YamanaRandgold PolymetalIAMGold EldoradoHarmony CenterraPetropavlosk HochschildRoyal Gold Semafo

Junior gold producersNumerous examples

Explorers and developersNumerous examples

Silver stocksSilver Wheaton HeclaCouer d’Alene FresnilloSilver Standard Pan American

NWR XstrataBHP TeckAngloAmerican MechelRaspadskaya ShenhuaYanzhou China CoalFushan HidliliPeabody Macarthur

Zinc/Lead

Nyrstar BolidenKorea Zinc TerraminHind. Zinc KagaraXstrata Glencore

Norilsk Vale

Nickel

Tin

Majors: AngloAmerican BHP Billiton Rio Tinto Xstrata Vale GlencoreOthers: Boliden ENRC Vedanta JSPL

Mining Steel

Electric arc Blast furnace

Nucor Salzgitter China Steel ThyssenKruppAcerinox SSAB Ternium VoestalpineOutokumpu ArcelorMittal US Steel

Tata Steel PoscoGerdau JFE

BaosteelAK SteelCSNUsiminas

Long steel Flat steel Stainless Pipes

Ezz Nucor ArcelorMittal ThyssenKrupp Acerionox TMKErdemir Salzgitter SSAB Outokumpu VallourecTata Steel US Steel Posco TISCO TenarisRautarrukki Voestalpine Nippon Schmolz & BickenbachSAIL China Steel JFE Gerdau Termium Baosteel

AK SteelUsiminasCSNJSW

Base metals Bulks Precious metals

Integrated Non-integrated

Severstal ArcelorMittal Voestalpine SalzgitterMMK Usiminas Nippon ThyssenKruppEvraz Ternium NLMK SSAB

US Steel Posco NucorSA IL Gerdau AK SteelCSN

Source: HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

163

ab

cSector price history

50

100

150

200

250

300

350

400

450

500

550Ju

n02

Dec

02

Jun0

3

Dec

03

Jun0

4

Dec

04

Jun0

5

Dec

05

Jun0

6

Dec

06

Jun0

7

Dec

07

Jun0

8

Dec

08

Jun0

9

Dec

09

Jun1

0

Dec

10

Jun1

1

Dec

11

Jun1

2

MSCI Global Index MSCI Global M&M Index

Strong commodity demand driven by loose Chinese monetary policy and

increasing US consumer debt

Record high commodity prices Global financial crisis, severe demand contraction and plummeting commodity

prices

Quantitative easing and expectation of a global demand

recovery

European financial crisis and weaker than

expected global economicgrowth


EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

164

ab

c

EBIT margin versus asset turnover chart (2011 calendarised)

Rusal

Norilsk

Severstal

Evraz

NLMK

MMK

TMK

Mechel

Raspadskay a

KGHM

Metalloinv est

Vale

ShenhuaYanzhou

China Coal

Fushan

Hidili

Agnico-Eagle*

AngloGold

Barrick

Centerra

Eldorado

Gold Fields

Goldcorp

Harmony

Hochschild

Iamgold

Kinross*

New montPetropav lov sk

Poly metalRandgold

Roy al Gold

Yamana

Baosteel

Maanshan

Angang

Posco

CSNUsiminas

Gerdau

Hindalco

Hindustan Zinc

JSPL

JSW

NALCO

NMDC

Sesa Goa

Sterlite

Tata Steel

Amplats

Impala

Northam

Roy al Bafokeng

Anglo

BHP

Rio

Xstrata Anto

Boliden

Norsk

Ny rstar

Vedanta

ENRC

Kazakhmy s

Lonmin

ArcelorMittal

SalzgitterThyssenkrupp

Voestalpine

Kinross

Alcoa Freeport

CodelcoTernium

Teck

Southern Copper

Peabody

Fortescue

Chalco

Macarthur

US Steel

-

0.25

0.50

0.75

1.00

1.25

-10% 0% 10% 20% 30% 40% 50% 60% 70% 80%

EBIT Margin

Ass

et T

urno

ver

Rat

io

Mining Steel

Source: Thomson Reuters Datastream, company reports, HSBC

165


abc

Sector description The metals and mining sector falls broadly into two areas, mining and steel, although these sub-sectors

are closely interrelated. Miners encompass many independent industries, each focused on the extraction

and refining of metals, including base metals (copper, aluminium, zinc and nickel) and precious metals

(gold, silver and platinum). Mining companies also produce ‘bulk commodities’ such as thermal coal,

coking coal and iron ore, the latter two of which are the raw materials for much of the steel industry. The

steel industry is largely a processor of raw materials into downstream products, grouped broadly into flat-

rolled, stainless and long steel, although some steelmakers are also backward integrated and own

upstream assets.

Steel and base metals are key materials for construction, infrastructure and consumer goods. Major

consumers include construction and automotive firms, capital goods producers, wire and cable

manufactures and food packaging companies. The gold mining segment of the metals and mining sector

has long been considered rather separately from the industrial metals, as it has attracted investors

interested in gold’s special properties as a financial asset and as a rare metal. There is a greater focus on

reserves and resources in the ground, rather than purely on the current year earnings and cash flow.

Metals and mining is arguably the oldest truly global sector, as all producers are subject to global

commodity prices and the sector has long been characterised by cross-border investment.

Key themes Emerging market growth

Around one-third of industrial metals are consumed in China, which now consumes about three times as

much metal as the US. The acceleration of China as a metal consumer has led to a rise in global growth in

metals demand, from 2-3% pa for much of the 1980s and 1990s to 5-7% pa over the past decade. This has

changed the investment cycle in the industry: whereas growth was once easily satisfied with brownfield

expansion and the occasional new mine, now fresh capital needs to be constantly invested in new

projects. Consequently, commodities are more dependent on ‘incentive pricing’, or the commodity prices

that are required to justify investment in projects that have traditionally been seen as marginal.

This structural change in global demand has been driven by economic growth in China, which has led to

15-20 million people being ‘urbanised’ each year. Although this trend is difficult to define and measure, a

significant proportion of China’s population has reached the personal income band where demand for

metal-intensive goods accelerates significantly. This is due to the movement from rural housing and

employment to urban manufacturing jobs (which require plant and infrastructure) and urban

accommodation (which drives demand for materials such as steel-reinforced concrete and copper wiring).

On our estimates, 75-90% of the metal consumed in China stays there, with the balance exported in the

form of manufactured goods.

Deteriorating resources

A common theme in the sector (although one that we do not entirely subscribe to) is the deterioration in

the quality of natural resources and the impact on commodity prices. Many commentators and some in the

industry claim that the quality and quantity of ore from the next generation of mines is significantly

degraded from the last generation, which will require higher incentive pricing and lead to further delays

Andrew Keen* Global Sector Head, Metals and Mining Research HSBC Bank plc + 44 20 7991 6764 [email protected]

Thorsten Zimmermann*, CFA Analyst HSBC Bank plc +44 20 7991 6835 [email protected]


166


abc

and disruptions. It is becoming more challenging to extract some metals but there is no evidence that

minerals are reaching absolute depletion levels (the predictions made in the 1970s ‘Club of Rome’ have

proved false: reserves and resources have continued to rise over time as technological advances in

exploration, processing and extraction have led to the continued upgrading of known resources and a

containment of structural cost increases).

M&A versus organic growth

Buying has definitely outstripped building as a pathway to growth over the past decade. During the

commodity price upcycle, companies that were in an early stage of the acquisition process (eg Xstrata and

ArcelorMittal) timed their asset purchases well, and were rewarded with strong cash flows. There are now

significant antitrust barriers to further consolidation in many metals industries, and the relatively small

mining companies often have dominant or blocking shareholders. Therefore there has been a shift in

strategy over the past two years towards rediscovering organic growth.

Dividend yield or growth?

Mining stocks are usually relatively low yield, although the sector has derated significantly recently and

core dividend yields are becoming more attractive. These can be boosted by special dividends and share

buybacks when cash flows are strong. Core dividend yields are low because the cyclical nature of the

companies’ earnings prompts management to keep core dividends low in order to avoid cancellations –

although this has not proved entirely successful: three of the four major miners in the UK cancelled

dividends to preserve cash or pursue rights issues during the 2008-09 downturn.

Resource nationalism and political risk

Political risk is an old theme in mining that has gained fresh momentum in recent years. In major mining

regions, minerals are commonly owned by the state, and mining companies operate mines under systems

of mineral leases and royalties. Although the sector was plagued by nationalisation in South America and

Africa during the 1970s, more recent trends include the empowerment process in South Africa and the

imposition of a resources tax in Australia. In addition, rapid demand growth is again pushing mining

firms to return to areas of higher risk such as West Africa (iron ore), the Congo (copper) and Afghanistan

(iron ore and copper). Given China’s dominance of demand and its relatively poor endowment of

minerals (it is a major importer of iron ore and copper in particular), the Chinese state has sought to take

direct interests in a range of small and large mining companies, often in the face of political resistance. It

is likely that this will remain an issue in the sector for the foreseeable future.

Gold prices versus gold equities

Historically gold stocks have been a leveraged proxy for gold itself, although the market behaviour has

changed somewhat recently with stocks almost all declining much more sharply than the gold price over

the last 12 months. Some major producers' shares have even halved despite higher profitability and record

revenue and profits. It has become fairly entrenched conventional wisdom that gold miners are threatened

with lower gold prices (current levels being unsustainable), continually rising costs and poor management

decision making, and face other challenges such as labour shortages, organised opposition to mining and

“resource nationalism”(where governments seek to increase their share of the income from mining

projects). All this has meant that many market participants feel that not only the stock price falls but also

the de-rating of gold equities is justified. A new phase of industry consolidation, or even privatisation

could cause the sector to re-rate.

167


abc

Sector drivers Commodity prices undoubtedly drive the movements of all types of metals stocks. For miners, this is not

surprising as their costs and output levels are broadly stable, so the fluctuating prices of metals drive

margins and cash flows. There are few ways to invest in the sector without taking a view of the

underlying commodity markets for a stock (such as spotting excess cash generation, buybacks and

M&A). In the case of steel, the differences between input (iron ore, scrap and coking coal) and output

(finished steel) prices, as well as operating rates, are critical for forecasting margins.

Due to its dependence on commodity markets, global economic growth is a major driver of stock

performance, and the metals and mining sector is high beta versus the broader market. Given the sector’s

size and volatility, it has also attracted significant interest from hedge funds, and this faster money has

tended to amplify the sector’s beta. The ‘risk trade’ of buying or selling a high-beta sector on economic

data points (particularly those associated with Chinese economic growth or trade) has grown to dominate

the sector’s performance, and this has made the timing of entering and exiting stock investments

increasingly important.

Although commodity prices have a long history of mean reversion and the asset lives of mines can stretch

to many decades (both implying that equity prices should not follow short-term commodity prices),

mining equities tend to be volatile and closely correlated to near-term metal price movements. In simple

terms, when commodity markets are good, the market expects them to stay good forever, and when they

are bad, the market expects them to stay bad forever. Remembering this simple principle, and trying to

spot key inflection points, is the key to moving beyond simple momentum investing in the sector.

Commodity markets are relatively straightforward in principle, but often complex in detail. Metals

markets typically work between two dynamics. In periods of poor demand, inventories in the industry, or

on exchanges for some commodities, rise and prices tend to fall to marginal cost – typically a price at

which 10-25% of producers experience cash operating losses. This leads to an inevitable supply response

and returns a market to equilibrium. At the other extreme, in tight markets, as a result of demand growth

or supply interruptions, prices will explore an upper limit, which is usually defined by demand destruction

through substitution or the availability of new sources of supply.

Key segments Industrial metals

The mining industry has undergone significant consolidation over the past decade and is now dominated

by six large companies: BHP Billiton, Rio Tinto, Anglo American, Xstrata, Glencore and Vale. This

consolidation has been driven by the desire to secure production growth more quickly than through the

commissioning of new projects. The industry has produced significant excess cash flows over the past

decade, but still struggles to accelerate production growth through greenfield projects, which can take 10

years or longer to bring on stream. Hence, it has been quicker and more profitable to buy than build.

Consolidation has also produced some scale benefits, although SG&A costs for global mining firms are

relatively low in absolute terms.

168


abc

Precious metals

Before 1980, listed gold mining companies used to be mainly South African. However, the sector has

evolved since then into one that is currently dominated by Canadian companies, although a growing

group of London-listed companies, as well as those that remain in South Africa and Australia, and a few

other companies from the US and other countries make up the global gold group. Gold mining is often

viewed as a three- or four-tier industry which, in the listed environment, consists of a large group of

exploration companies (perhaps over a thousand) listed mainly in Canada, a smaller group of “junior”

producers, generally producing less than 100koz/year, a group of mid-tier producers which produce 100k-

1moz/year and a group of about eight “senior” producers, which produce more than 2moz/year. The

market leaders are Barrick Gold, Newcrest Mining, Newmont Mining, Goldcorp and AngloGold. In

general, senior producers are mature and are thought to have limited growth potential, but generate a large

amount of cash flow. Mid-tier producers tend to be growth-orientated and therefore sometimes more

risky, but growth is often substantial (eg tangible plans to double or triple revenues in five years are not

uncommon). While listings and domiciles are often in Canada, Australia or the UK, assets are typically in

more risky locations, such as Latin America, Africa and Central Asia, although there are also significant

gold districts in Nevada and parts of Canada and Australia.

Steel

The global steel industry has undergone substantial changes over the past decade. In developed markets

consolidation was often forced upon an industry that suffered from overcapacity and insufficient margins,

whereas substantial new capacity has been built in emerging markets where urbanisation is driving an

increase in steel consumption. China was the most notable example of this development, accounting for

45% of global steel production in 2011, up from just 15% in 2000. The industry has also undergone

significant changes in the way raw materials are priced. Historically miners offered fixed annual contracts

for iron ore and coking coal. However, as a spot market developed over the years, this gave mills an

incentive to default on their long-term contracts when spot prices were falling. As a consequence long-

term price agreements have been replaced by short-term agreements that reference spot market terms. For

steel mills this causes substantially higher earnings volatility, as raw material price fluctuations are

instantly reflected in steel prices, which in turn causes steel users to adjust their inventory more

aggressively. Further important changes for the industry were much higher raw material costs, which give

backward integrated mills a substantial cost advantage, and the development of steel price indices that

substantially improved price transparency. Historically, steel has been seen as a regional industry but we

think that through the changes mentioned above the industry is now feeling the full force of globalisation.

While shipments are, indeed, mostly intraregional due to high transportation costs, steel prices across

regions are highly correlated and import pressure keeps prices relatively closely aligned.

Valuation Industrial metals

Mining companies tend to trade strongly on cash flow generation, with EV/EBITDA multiples relatively

static through the cycle. Longer-run cash flow measures such as DCF/NPV are also commonly used

(often based on mine-life expectations), although these valuation approaches are less anchored than one

might at first expect, as consensus expectations for commodity prices are dragged up and down by

169


abc

movements in spot prices for commodities. Over the long run, major miners have typically traded at

around 90% of the broader market multiple, with a normalised absolute P/FE of 9-11x, although during

periods of risk aversion by the equity market, the level can fall to as low as 5-6x.

Book valuation metrics are less relevant for the miners, in part due to the slow asset turns in the industry.

Some miners are operating assets that have been in production for decades and are carried at a heavily

depreciated book value, while others, which have made large acquisitions, have a revalued book.

Consequently, comparisons on book value metrics can be difficult. Write-downs to historical book values

have not been a negative catalyst for stocks in recent years.

Precious metals

Valuation in the gold mining industry is typically done using DCF methodology, although some analysts

use P/CF and PE as well. The key difficulty of using shorter-term valuation ratios (such as PE and P/CF)

is that they generally fail to capture the longer-term value creation from the large amounts of capital the

industry spends on new developments and extension projects. Many analysts using DCF methodology

tend to forecast very low long-term gold prices which, together with flat or increasing costs, results in

misleadingly low valuations. HSBC uses a proprietary gold price forecasting model which captures

information from the upward-sloping forward pricing curve availability (offset by long-term inflation)

and explicit three-year forecasts.

Steel

For steel companies, as industrial companies with defined plant and equipment, book values are more

relevant and the sector has historically traded at 1.1x P/book. Although earnings multiples are very

volatile through the cycle, a 10x forward PE seems to work well as a rule of thumb, and consensus sees a

5.5x EV/EBITDA multiple as normal. However, we think that globalisation effectively acts as

deconsolidation by the back door, which could compress multiples in future.

European metals & mining: growth and profitability (calendarised data)

2008 2009 2010 2011 2012e

Growth Sales 17.4% -24.2% 15.7% 15.2% 3.0% EBITDA 20.5% -40.4% 37.5% 20.8% 5.2% EBIT -1.9% -53.7% 91.9% 13.4% 21.1% Net profits -5.3% -58.8% 109.1% 4.0% 23.7% Margins EBITDA 27.1% 21.3% 25.4% 26.6% 27.2% EBIT 17.5% 10.7% 17.7% 17.5% 20.5% Net profit 11.6% 6.3% 11.4% 10.3% 12.4% Productivity Capex/sales 10.0% 11.6% 10.5% 10.7% 13.2% Asset turnover (x) 1.63 1.13 1.18 1.23 1.16 Net debt/Equity 0.64 0.40 0.26 0.29 0.34 ROE 24.9% 9.2% 16.0% 15.1% 17.9%

Note: based on all HSBC coverage of European metals and mining sector Source: Company reports, HSBC estimates

170


abc


MSCI Europe Metals & Mining Index

4.5% of MSCI Europe

Trading data 5-yr ADTV (EURm) 1,871 Aggregated market cap (EURm) 293,045 Performance since 1 Jan 2000 Absolute +73% Relative to MSCI Europe +162% 3 largest stocks Rio Tinto, BHP Billiton, Anglo Correlation (5-year) with MSCI Europe 0.88

Source: MSCI, Thomson Reuters Datastream, HSBC Top 10 stocks: MSCI Europe Metals & Mining Index


1 Rio Tinto 17.0% 2 BHP Billiton 15.8% 3 Anglo American 12.2% 4 Xstrata 11.4% 5 Glencore 10.0% 6 Arcelormittal 5.8% 7 Fresnillo 4.4% 8 Antofagasta 4.4% 9 Norsk Hydro 2.4% 10 Randgold Resources 2.3%


Country breakdown: MSCI Europe Metals & Mining Index

Country Weights (%)

UK 84.2% France 5.8% Germany 2.7% Norway 2.4% Belgium 1.5% Sweden 1.5% Austria 1.2% Spain 0.7%


Core industry driver: commodity price drives equity performance

0

100

200

300

400

500

600

Jun0

2

Jun0

3

Jun0

4

Jun0

5

Jun0

6

Jun0

7

Jun0

8

Jun0

9

Jun1

0

Jun1

1

Jun1

2

LME Index MSCI Global M&M Index

Correlation - 94%


PE band chart: MSCI Europe Metals & Mining Index

0

200

400

600

800

1,000

2004

2005

2006

2007

2008

2009

2010

2011

2012

Price level

15x

10x

5x

Actual


PB vs. ROE: MSCI Europe Metals & Mining Index

0%

8%

16%

24%

32%

2004

2005

2006

2007

2008

2009

2010

2011

2012

0x

1x

2x

3x

4x

Fw d ROE Fw d P/B-RHS


171


abc

Oil & gas

Oil & gas team David Phillips* Global Co-Head of Oil and Gas HSBC Bank plc +44 20 7991 2344 [email protected]

Paul Spedding* Global Co-Head of Oil and Gas HSBC Bank plc +44 20 7991 6787 [email protected]

Peter Hitchens* Analyst HSBC Bank plc +44 20 7991 6822 [email protected]

Anisa Redman Analyst HSBC Securities (USA) Inc. +1 212 525 4917 [email protected]

Phillip Lindsay* Analyst HSBC Bank plc +44 20 7991 2577 [email protected]

Ildar Khaziev* Analyst OOO HSBC Bank (RR) +7 495 645 4549 [email protected]

Bulent Yurdagul * Analyst HSBC Yatirim Menkul Degerler A.S. +90 212 376 4612 [email protected]

John Tottie* Analyst HSBC Saudi Arabia +966 1299 2101 [email protected]

Sector sales Annabelle O’Connor Sector Sales HSBC Bank plc +44 20 7991 5040 [email protected]


EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

172

ab

c

Sector structure

Integrated players

(upstream, downstream,

transportation, petrochemicals)

Europe

RD Shell

BP

Total

ENI

Repsol

OMV

Emerging markets

Gazprom

Petrobras

Rosneft

Lukoil

Tatneft

Surgutneftegaz

MOL

Asia

Petrochina

Sinopec

Reliance Industries

PTT

US

ExxonMobil

ChevronTexaco

Subsea & offshore equipment

FMC

Cameron

Aker Solutions

Dril-Quip

Technip

National Oilwell Varco

GEVetco

Nexans

Prysmian

Oceaneering

Ezra Holdings

Subsea 7

McDermott

Saipem

Fugro

Seismic

CGGVeritas

Schlumberger

PGS

TGS Nopec

Ion

Polarcus

Fugro

BGP/CNPC

Drilling E&C

Supply vessels

Bourbon

Tidewater

Farstad

Solstad

Edison Chouest

Swire

Ezra

Superior Offshore

Trico Marine

Siem Offshore

Cal Dive

Gulfmark Offshore

Well services

Schlumberger

Halliburton

Weatherford

Baker Hughes

Hunting

Core Labs

Weir Group

Schoeller Bleckmann

Fugro

Diversified

Saipem

Technip

Aker Solutions

National OilwellVarco

China Oilfield Services

Tenaris

Vallourec

Fugro

Oilfield services (OFS)

Transocean

Noble

Diamond

Seadrill

Ensco

Rowan

North Atlantic Drilling

COSL

Nabors

Hercules

Seahawk

Saipem

Fred Olsen Energy


Ocean Rig

Technip

Saipem

KBR

Fluor

CB&I

Petrofac

Kentz

Lamprell

Amec

Maire Technimont

Aker Solutions

Kvaerner

Subsea 7

McDermott

Independent players

Upstream (E&P)

Europe

BG

Statoil

Tullow

Ophir Energy

Premier Oil

Cairn Energy

Gulf Keystone

Genel Energy

Emerging markets

Novatek

OGX

Asia

CNOOC

ONGC

Cairn India

Oil India

US

ConocoPhillips

Anadarko

Apache

EOG Resources

Devon Energy

Marathon Oil

Downstream (R&M)

EuropeNeste

ERG

Saras

Petroplus

Statoil Fuel & Retail

Emerging marketsPKN

Hellenic Petroleum

Motor Oil Hellas

Tupras

Oil Refineries

AyagazPetro Rabigh

Aldrees Petroleum

Turcus

AsiaS Oil

SK Innovation

GS Holdings

Indian Oil

BPCL

HPCL

Formosa PetrochemThai Oil

USValero

Marathon Petroleum

Phillips66

Afren

EnQuest

Soco International

Salamander Energy

Heritage Oil

JKX

Exillon

Melrose

Kazmunaigas EP

Dana Gas

PTT E&P

Santos

Woodside Petroleum

Encana

Talisman Energy

Cheasapeake Energy

Nexn

Newfield Exploration

Floatingproduction

SBM Offshore

BW Offshore

Modec

OSX

Bumi Armada

Sevan Marine

Integrated players

(upstream, downstream,

transportation, petrochemicals)

Europe

RD Shell

BP

Total

ENI

Repsol

OMV

Emerging markets

Gazprom

Petrobras

Rosneft

Lukoil

Tatneft

Surgutneftegaz

MOL

Asia

Petrochina

Sinopec

Reliance Industries

PTT

US

ExxonMobil

ChevronTexaco

Subsea & offshore equipment

FMC

Cameron

Aker Solutions

Dril-Quip

Technip

National Oilwell Varco

GEVetco

Nexans

Prysmian

Oceaneering

Ezra Holdings

Subsea 7

McDermott

Saipem

Fugro

Seismic

CGGVeritas

Schlumberger

PGS

TGS Nopec

Ion

Polarcus

Fugro

BGP/CNPC

Drilling E&C

Supply vessels

Bourbon

Tidewater

Farstad

Solstad

Edison Chouest

Swire

Ezra

Superior Offshore

Trico Marine

Siem Offshore

Cal Dive

Gulfmark Offshore

Well services

Schlumberger

Halliburton

Weatherford

Baker Hughes

Hunting

Core Labs

Weir Group

Schoeller Bleckmann

Fugro

Diversified

Saipem

Technip

Aker Solutions

National OilwellVarco

China Oilfield Services

Tenaris

Vallourec

Fugro

Oilfield services (OFS)

Transocean

Noble

Diamond

Seadrill

Ensco

Rowan


COSL

Nabors

Hercules

Seahawk

Saipem

Fred Olsen Energy


Ocean Rig

Technip

Saipem

KBR

Fluor

CB&I

Petrofac

Kentz

Lamprell

Amec

Maire Technimont

Aker Solutions

Kvaerner

Subsea 7

McDermott

Independent players

Upstream (E&P)

Europe

BG

Statoil

Tullow

Ophir Energy

Premier Oil

Cairn Energy

Gulf Keystone

Genel Energy

Emerging markets

Novatek

OGX

Asia

CNOOC

ONGC

Cairn India

Oil India

US

ConocoPhillips

Anadarko

Apache

EOG Resources

Devon Energy

Marathon Oil

Downstream (R&M)

EuropeNeste

ERG

Saras

Petroplus

Statoil Fuel & Retail

Emerging marketsPKN

Hellenic Petroleum

Motor Oil Hellas

Tupras

Oil Refineries

AyagazPetro Rabigh

Aldrees Petroleum

Turcus

AsiaS Oil

SK Innovation

GS Holdings

Indian Oil

BPCL

HPCL

Formosa PetrochemThai Oil

USValero

Marathon Petroleum

Phillips66

Afren

EnQuest

Soco International

Salamander Energy

Heritage Oil

JKX

Exillon

Melrose

Kazmunaigas EP

Dana Gas

PTT E&P

Santos

Woodside Petroleum

Encana

Talisman Energy

Cheasapeake Energy

Nexn

Newfield Exploration

Floatingproduction

SBM Offshore

BW Offshore

Modec

OSX

Bumi Armada

Sevan Marine

Source: HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

173

ab

c

Sector price history: Global oil sector PE and PE relative to market (IBES year 2 consensus)

5

7

9

11

13

15

17

19

21

23

25

Feb-95 Feb-97 Feb-99 Feb-01 Feb-03 Feb-05 Feb-07 Feb-09 Feb-11

60%

70%

80%

90%

100%

110%

120%

Global Oil Sector: Year 2 PE Global Oil Sector: Year 2 PE Relativ e

1997 Asian financial crisis

The Asian Financial Crisis combined

w ith a 10% quota increase by OPEC

resulted in low er oil price through

December 1998

1999 Series of OPEC cuts

(4.2Mbbl/d) supported oil price

rise

2003 Iraq war The

American-led inv asion of Iraq

cut resulted in cut in OPEC

spare capcity

2005- Hurricanes Katrina

& Rita SPR released

9.8mmbbl

2006 Lebanon war After Israel launched attacks on

Lebanon, oil prices reached a new high of USD78/bbl

2005-08 Sharp increase in demand

from Asia

2008 (end) Onset of

recession

2009 (beginning) OPEC cut of 4.2mbbl/d helped oil

price to stabilise

2010 (end) Start of Arab

Spring

2011 (end) Iran

threat


EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

174

ab

c

Asset turnover versus net margin: 2005-11 average

Transneft

Rosneft

HuntingTatneft

Surgutneftegas

MOL

KMGEPNovatek

Lukoil

Gazprom

Wood Group

Technip Subsea7Saipem

PetrofacAMEC

AKSO

Seadrill

SBM

PGS

Lamprell

Kentz

Fugro

FMC

CGGV

Cameron

Bourbon

Total

Statoil

RD Shell

Repsol OMV

ENI

BP

BG

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0%

Net margin (%)

Ass

et tu

rnov

er (x

)


175


abc

Sector description The value chain of the oil and gas sector includes the production of oil and gas, transport, refining,

petrochemicals and the marketing of oil and gas products. It can also include power generation. While

integrated players tend to operate across the entire value chain, the independents often only focus on parts of it.

Upstream is the key value generator

Integrated international oil companies (IOCs) view the upstream industry as a key value generator. It

normally accounts for around 70% of their value, but tends to attract more than its fair share of growth

capex. The industry is fairly mature. Annual growth in demand is 1% to 2% for oil and 2% to 3% for gas.

Growth tends to be higher in non-OECD regions and can be flat or even negative in parts of the OECD

(Organisation for Economic Co-operation and Development). As the existing production base declines on

average by 3-5% a year, the industry needs to add new productive capacity equivalent to 5% to 7% of

existing production in order to achieve growth in net capacity of 1% to 2% annually. Development of this

new capacity often involves long lead times, typically 5-10 years from discovery to first production. For

larger projects, the lead time can be considerably longer. The industry is also capital-intensive, with some

of the majors spending in excess of USD25bn a year. We estimate that the industry spends around

USD1trn a year on maintenance and growth capital expenditure. Oil companies also face tightening fiscal

regimes and the threat of resource nationalism as host governments seek to maximise their return from oil

and gas discoveries. Because of their size, the international oil companies tend to focus on very large

projects such as integrated gas (such as LNG) or tar sands. The capital-intensive nature of these can

reduce project returns. In contrast, the independents are more focused on conventional plays. They are

also more ready to exit projects by selling or farming-down should capital requirements prove

challenging. This can mean that the independents have a better return on capital than the majors.

Downstream – oversupply a problem

Following the decline in demand in 2008, the refining industry has suffered from oversupply, which has been

exacerbated by capacity additions in Asia over the past two years. The industry’s reaction has been to reduce

capacity in the OECD through closures (some temporary) and disposals. Most of the investment in this sector is

in growth regions, such as Asia, or in countries with advantaged feedstock, such as Saudi Arabia.

Oil services – cyclical but a distinction in exposure to long and short cycles

Oilfield services are diverse; some are asset-heavy, some asset-light. The main sub-sectors are seismic, drilling,

engineering and construction, subsea/offshore equipment and construction, supply vessels, floating production,

and well services. One distinction between the different parts of the sector is cyclicality. All areas are cyclical,

but some have longer cycles (related to capex), others shorter cycles (related to operating expenditure and

exploration activity). The equity-listed structure of the global oilfields services sector is, unsurprisingly, more

developed in the Western world, but it is likely to become increasingly important (as a traded sector) in

emerging markets, particularly Latin America and Asia. The oil service industry is a large-cap sector in the US

and a mid-cap sector in Europe. In Europe, the sector has high exposure to capex trends (long cycle) and to

offshore activities, which drive 75% to 80% of earnings. In the US, the sector is weighted more towards well

services (onshore and offshore) and drilling.

Paul Spedding* Global Co-head of Oil & Gas HSBC Bank plc +44 20 7991 6787 [email protected]

David Phillips* Global Co-head of Oil & Gas HSBC Bank plc +44 20 7991 2344 [email protected]


176


abc

Key themes Access to resources

With most of the world’s easily accessible hydrocarbon basins already licensed, the competition for new

oil and gas acreage has intensified over the past decade. National oil companies (NOCs) often have

priority access to domestic acreage and are also seeking to expand internationally. This often limits the

acreage that international oil companies (IOCs) can access. This has meant that the IOCs have begun to

take greater risks with their exploration and also increased their focus on unconventional oil and gas

projects, areas in which the NOCs have less experience.

Move to unconventional oil and gas

Unconventional gas plays such as coal bed methane (CBM) and shale gas offer low exploration risk but

can face challenging economics. In the US, the depressed gas price has meant most shale gas projects are

marginal at present. With CBM, the challenge is to get the gas to market, often necessitating major

pipeline projects or an LNG plant. Production from unconventional oil plays, such as shale oil or tar

sands, is rather more straightforward but can prove very capital-intensive should an upgrading unit be

needed to raise the quality of the heavy oil.

Higher risk exploration

The oil majors and independents have increased the level of risk in their exploration programmes over the

past two to three years by increasing the scale of their acreage applications. They have also moved into

more challenging areas where costs are commensurately higher, such as ultra-deep water and the Arctic.

This strategy has had mixed results, with successes in Brazil, East and West Africa and Northern Norway

but failures in Greenland, Namibia and Cuba.

Portfolio rationalisation to improve returns and growth prospects

Most international oil majors find it difficult to deliver material growth due to their size. Independents

find it much easier to deliver growth as a single discovery can be material for the smaller players. Some

of the larger majors have chosen to rationalise their portfolios with some of the proceeds being returned to

shareholders in the form of dividends or share buybacks. As well as increasing shareholder returns, it also

reduces the size of the company, leveraging any growth that is delivered. This strategy is known as

shrink-to-grow and, in some cases, has led to a re-rating of the companies that pursue it.

Long-term cyclicality

Although demand for oil products and gas can change quite quickly, the long lead times (5-10 years) for new

production or refining capacity in the oil industry can mean incremental supply often lags increases in demand.

The cyclical behaviour this can produce is more pronounced in the refining industry. There is also cyclical

behaviour in the upstream part of the industry, as seen in 2008 and 2009, but the presence of OPEC (the

Organisation of Petroleum Exporting Countries) helps keep the oil price stable for much of the time.

Refining: OECD versus non-OECD

OECD refiners face flat to declining demand for oil products and the potential impact of carbon pricing.

They also tend to be higher cost. In contrast, Middle East refiners have the advantage of access to own

crude oil and those in non-OECD Asia have easy access to growth markets. Asian and Middle East

refineries tend to be lower-cost operations due to greater scale and lower personnel costs in those regions.

177


abc

Sector drivers Realisation and margin are key drivers

For most companies, realisations for oil and gas together with refining and marketing margins are more

important drivers of earnings than volume growth. For most companies, short-term movements in their

share prices are influenced by the oil price. The degree of sensitivity to the oil price varies among

different types of companies. For example, the shorter-cycle service companies and independent

exploration companies tend to be more sensitive to moves in crude and gas prices than the majors.

Oil prices – OPEC remains in a position to control prices

Although growth in demand in 2011 and so far in 2012 has remained well below normal levels, we believe it

will recover in 2013 and grow at around 1.6-1.7 million barrels a day each year. Crude supplies from non-

OPEC are likely to increase at around two-thirds of this rate, meaning that OPEC will be called upon to make

up the shortfall. It will add new capacity over the next several years, much of it in Iraq. This should enable

OPEC to maintain a reasonable level of spare capacity. Saudi Arabia has already demonstrated its willingness

to act as swing producer to try and stabilise oil prices. It has indicated that it sees prices around USD100/barrel

as acceptable, but we calculate that instability in the Persian Gulf and North Africa has, at times, resulted in a

political premium of up to USD25/barrel. A price of USD100/barrel is high enough to meet the financial needs

of most OPEC countries but low enough to avoid further destabilising world economies. It is also below the

economic threshold for unsubsidised alternative-energy projects (a threat to OPEC).

Gas price – oil price linkage to remain outside the US

Globally, around 40% of natural gas is exposed to gas-to-gas competition (primarily in the US market),

40% is regulated and only 20% has a direct or indirect link to oil prices (Europe and Asia). Although the

proportion of spot sales has increased in Europe due to soft demand, we believe Europe’s gas prices will

retain some degree of oil linkage although the element of spot pricing is likely to gradually rise. We also

believe gas prices in Asia are likely to retain their link to oil prices because of the need for long-term

projects to ensure security of supply. We believe the US is likely to remain a low-price market due to

rising shale-gas production. Shale gas exists elsewhere in the world but the lack of a US-sized oil service

industry (land rigs and fracturing) means it is unlikely to see the same rate of growth as the US. Also, in

some countries with high population densities, protests have led to bans on fracturing activity.

Refining – oversupply

We do not expect the current overcapacity in the market to be eroded in the next five years unless large-

scale closures take place. For the balance of the decade, we believe increases in demand will be met from

new capacity additions, mainly in Asia and the Middle East. We expect OECD refining profitability to

remain at the low end of its normal range, while Asian and Middle Eastern refiners should benefit most

from rising non-OECD demand growth.

Service sector – capex trends the key

For the service sector, the key is the trend in oil industry capital expenditure. Much of the increase in

spending during 2006-08 was driven by inflation rather than activity. There is, therefore, the potential for

further ‘capex catch-up’. Offshore activity is driven mainly by areas like Brazil, West Africa, the North

Sea, Australasia and the US Gulf. Onshore is driven more by the Middle East and Australasia for capex-

related work, and the existing oil-producing areas North/South America, the Middle East/North Africa

and parts of Asia/FSU for opex-related work.

178


abc

Valuation Short-term sentiment

As oil and gas prices are a major influence on earnings and cash flow, it should be no surprise that movements

in realisations have a material influence on the sector’s performance. In the longer term, the level of the sector’s

cash flow and earnings relative to those of the rest of the market has more influence on its relative performance.

(For example, it is possible for industry earnings to fall despite rising oil prices should costs or taxes increase

sharply.) The sector is seen by some investors as defensive due to its above-average yield and predictability of

future production volumes, which can mean it outperforms during weak markets.

Valuation approaches

There are significant differences in the approaches followed to value integrated large players and small

independent players.

Integrateds – earnings and cash-flow multiples

The large integrated players tend to be valued using traditional multiples (PE, EV/NOPAT, P/CF,

EV/DACF multiples). After-tax valuations are used because the rates of tax can vary markedly from

country to country. One of the key variables in valuations is the oil price. Some investors prefer to use the

price indicated by the futures market, but others prefer to use their own forecasts. The most common

valuation approach used is PE-based, in our view. The long-run PE for the sector is around 80% relative

to the market. Given the tangible nature of oil industry assets, the price-to-book (PB) ratio is also a useful

check to valuation, especially during periods of market weakness.

Sum-of-the-parts (SOTP) valuations are also used, especially for companies with a material proportion of

undeveloped reserves. Upstream assets tend to be valued using discounted cash flow (DCF) analysis or by

using comparable transaction values. Downstream assets are valued using per barrel approaches based on

market transactions adjusted for complexity, size and location. Other assets, such as marketing, can be valued

on a multiple basis – either earnings or cash-flow based – using comparable companies as a reference point.

Upstream companies – per barrel valuations or DCF

Upstream companies tend to be valued using net asset values. This can involve a DCF valuation of the

existing assets or could use a simple per barrel valuation of reserves based on comparable companies or

recent transactions. Exploration assets can be valued on a similar basis but with a risk factor to reflect the

likelihood of success and the difficulty of commercialisation.

Downstream companies – SOTP and multiples

Downstream companies are normally valued on a multiple or SOTP basis. Unlike for the majors, pre-tax

multiples such as EV/EBIT or EV/EBITA can be used as there is less variation amongst tax rates in

different countries than there is in the upstream.

Oil service – SOTP and multiples

Given the diversity of the service sector, the range of valuation approaches is also diverse. For the asset-

based companies (such as rig owners), the SOTP methodology is often used, with individual assets being

valued at the replacement cost or by using comparable companies as reference. For asset-light companies,

multiple-based approaches can be employed, both pre-tax and post-tax. For companies with highly

cyclical businesses, mid-cycle valuation approaches can be used.

179


abc

Oil & gas sector: growth and profitability

2008 2009 2010 2011 2012e

Growth Sales 27% -31% 23% 27% -9% EBITDA 17% -27% 23% 26% -5% EBIT 18% -38% 32% 37% -6% Net profit 12% -38% 32% 32% -4% Margins EBITDA 19% 21% 20% 20% 21% EBIT 15% 13% 14% 15% 16% Net profit 9% 8% 9% 9% 10% Productivity Capex/sales 10% 14% 11% 10% 11% Asset turnover (x) 1.2 0.8 0.8 0.9 0.8 Net debt/Equity 22% 27% 24% 22% 16% ROE 23% 13% 16% 18% 15%

Note: Based on all HSBC coverage of Oil & Gas Sector in Europe and Emerging Europe (excludes upstream mid-cap independents) Source: company data, HSBC estimates

180


abc


MSCI Europe Energy Dollar Index 12.55% of MSCI Europe US Dollar

Trading data 5-yr ADTV (EURm) 2,778 Aggregated market cap (EURm) 782 Performance since 1 Jan 2000 Absolute 36% Relative to MSCI Europe US Dollar 44% 3 largest stocks RD Shell, BP, Total Correlation (5-year) with MSCI Europe US Dollar

0.95


Top 10 stocks: MSCI All Country World Index Energy Dollar Index


1 ExxonMobil 13.6% 2 RD Shell 7.0% 3 Chevron 6.9% 4 BP 4.2% 5 Total 3.3% 6 Schlumberger 3.1% 7 BG 2.4% 8 Occidental 2.3% 9 ConocoPhillips 2.3% 10 Gazprom 1.7%

Source: MSCI, Thomson Reuters Datastream, HSBC Country breakdown: MSCI All Country World Index Energy Dollar Index

Country Weights (%)

US 47.4 UK 14.8 Canada 10.6 Russia 4.0 France 3.8 China 3.7 Brazil 2.9 Italy 2.4 Australia 1.9


Core industry drivers: OPEC spare capacity (LHS, million barrels/day) and Brent price (RHS, USD/bbl)

0

1

2

3

4

5

6

2001 2003 2005 2007 2009 2011

15

35

55

75

95

115

135

OPEC effctiv e spare capacity Brent (RHS)

Source: US Energy Information Administration, HSBC

PE band chart: MSCI All Country World Index Energy Dollar Index, Year 2 forward

0

100

200

300

400

500

600

2001 2003 2005 2007 2009 2011

5x

10x

15x


PB (LHS) and ROE (RHS): MSCI All Country World Index Energy Dollar Index, Year 1 forward

1.0

1.5

2.0

2.5

3.0

2004 2005 2006 2007 2008 2009 2010 2011 2012

10

12

14

16

18

20

22

24


181


abc

Telecoms, media & technology

Telecoms, media & technology team Global TMT Stephen Howard* Head, Global TMT Research HSBC Bank plc +44 20 7991 6820 [email protected]

Europe Nicolas Cote-Colisson* Head, European Telecoms & Media HSBC Bank plc +44 20 7991 6826 [email protected]

Luigi Minerva* Analyst HSBC Bank plc +44 20 7991 6928 [email protected]

Dominik Klarmann*, CFA Analyst HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 2769 [email protected]

Adam Rumley* Analyst HSBC Bank plc +44 20 7991 6819 [email protected]

Olivier Moral* Analyst HSBC Bank plc, Paris branch +33 1 56 52 43 22 [email protected]

Dan Graham* Analyst HSBC Bank plc +44 20 7991 6326 [email protected]

Christopher Johnen* Analyst HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 2852 [email protected]

Antonin Baudry* Analyst HSBC Bank Plc, Paris branch +33 156 524 325 [email protected]

Sector sales Tim Maunder-Taylor Head, European Specialist Sales HSBC Bank plc +44 20 7991 5006 [email protected]

Gareth Hollis HSBC Bank plc +44 20 7991 5124 [email protected]

Kubilay Yalcin HSBC Trinkaus & Burkhardt AG, Germany +49 211 910 4880 [email protected]









EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

182

ab

cSector structure

Telecom, media, technology

Telecom Media Technology

Incumbent operators

Alternative network operators

Global advertising & marketing

National advertising

Telecom equipmentvendors

Software and services

Original equipment manufacturers

Content & services

Foundries

Deutsche Telecom

France Telecom

Telefonica

BT

KPN

TeliaSonera

Rostelecom

Agencies WPP, Publicis, Aegis

Market research GfK, Ipsos

Outdoor JCDecaux

Free-to-air broadcasters (TV & radio)ITV, ProSiebenSat. 1, TF1, NRJGroup, TVN

Directories PagesJaunes, Yell,

Publishers Daily Mail, Reed, UBM

Pay-TV BSkyB, SkyDeutschland

Others Vivendi, Lagardere, AxelSpringer

Ericsson, Alcatel-lucent, Nokia

SAP, Capgemini

Nokia, Samsung

TSMC, UMC

Networks

Virgin Media, KDG, Telenet

Satellite

Inmarsat, SES

Cable

Copper/fibre/mobile

Vodafone

Tele2

Iliad

MTS

Vimplecom

Telecom, media, technology

Telecom Media Technology

Incumbent operators

Alternative network operators

Global advertising & marketing

National advertising

Telecom equipmentvendors

Software and services

Original equipment manufacturers

Content & services

Foundries

Deutsche Telecom

France Telecom

Telefonica

BT

KPN

TeliaSonera

Rostelecom

Agencies WPP, Publicis, Aegis

Market research GfK, Ipsos

Outdoor JCDecaux

Free-to-air broadcasters (TV & radio)ITV, ProSiebenSat. 1, TF1, NRJGroup, TVN

Directories PagesJaunes, Yell,

Publishers Daily Mail, Reed, UBM

Pay-TV BSkyB, SkyDeutschland

Others Vivendi, Lagardere, AxelSpringer

Ericsson, Alcatel-lucent, Nokia

SAP, Capgemini

Nokia, Samsung

TSMC, UMC

Networks

Virgin Media, KDG, Telenet

Satellite

Inmarsat, SES

Cable

Copper/fibre/mobile

Vodafone

Tele2

Iliad

MTS

Vimplecom

Source: HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

183

ab

c

Telecoms, media and technology 1995-2012: growth, bubble, burst and recession phases

0

200

400

600

800

1000

1200

1400

1600

Jan-

95

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

EUROPE-DS Telecom - TOT RETURN IND (~E ) EUROPE-DS Media - TOT RETURN IND (~E ) EUROPE-DS Technology - TOT RETURN IND (~E )

Dot-com bubble

Recessionary environment

Macro & emerging markets led grow th

Pick up of mobile services

Note: Total return includes share price performance and dividends Source: Thomson Reuters Datastream indices, HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

184

ab

cCapex/sales versus EBITDA margin (2011)

Wataniy a Telecom

Zain Group

Vodacom Group

Turkcell

Turk Telekom

TPSA

Telkom SA

Telecom Egy pt

Telefonica CZ

Sonatel

Safaricom

Rostelecom

Orascom Telecom

Oman Telecommunication Co

Mobinil

MTN Group

Mobile Telesy stems

Millicom

Maroc Telecom

M agy ar Telekom

Etihad Etisalat(Mobily )

Bezeq

Belgacom

British Telecom

Deutsche TelekomFrance Telecom

KPN

OTE

Portugal Telecom

Sw isscom

TDC

Telecom Italia

Telefonica

Telekom Austria

Telenor

TeliaSonera

Elisa CorporationMobistar

Tele2

Vodafone Group

Cable & Wireless Comm

Colt Group S.A.

Jazztel Cable & Wireless Worldw ide

QSC

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

50.0%

55.0%

60.0%

5% 7% 9% 11% 13% 15% 17% 19% 21%Capex/Sales

EBIT

DA

mar

gin


185


abc

Sector description TMT combines three inter-related sectors

Telecoms

Operators provide fixed and mobile telecommunication services, selling connectivity (eg line rental,

broadband) and services (eg voice, messaging, IPTV) to consumers and corporates. Operators can be split

between incumbents (former monopolies) and alternative operators which have been granted access to the

incumbents’ fixed networks and/or have been buying mobile spectrum and built their own mobile networks.

Media

We identify four sub-sectors within media. (1) Global advertising & marketing includes businesses that are

duplicating their franchise on a global scale and can therefore capture growth opportunities in emerging

economies. These include agencies (creative services, media planning and media buying for global

advertisers), market research (including panel research and surveys) and outdoor (street furniture, billboard

and transport). (2) National advertising includes free-to-air (FTA) broadcasters (TV and radios) and

directories (Yellow Pages). (3) Content and services related companies are the professional publishers

(academic and specialist-trade publications, trade shows, conferences, etc), consumer publishers and also pay-

TV operators. (4) Networks-related companies include satellite and cable operators.

Technology

The technology sector is also fragmented and diverse. However, for ease of understanding, we have

divided the sector into four sub-sectors: telecom network equipment vendors, software and services,

original equipment manufacturers (eg handsets) and semiconductors.

TMT

The three constituent sectors are closely linked. Telecom operators rely on technology companies to

maintain and upgrade their networks and also to develop the interfaces between these networks and the

end-users (such as handsets, computers, TVs and tablets). Information technology (IT) plays a critical role

in enhancing efficiency and productivity of businesses by automating processes and processing large

amounts of information for better decision-making. Based on their requirements, companies can either

develop their own software from scratch or may licence the software from an IT software vendor. Media

companies aggregate and monetise content which can then be distributed on these networks. But co-

operation can also turn into competition. Telecoms operators have entered the media sector with TV

offerings (IPTV). On the media side, cable/satellite TV operators are vying for telecom customers

through converged service offerings of voice and broadband along with TV. In the technology sector,

device/hardware manufacturers such as Apple have had success in software.

A key characteristic of the telecoms sector is the intrinsically very high barrier to entry. Building a network

is expensive, and scale is the key determinant of success. However, regulators have attempted to

undermine these natural barriers to entry by intervening with measures such as unbundling of the local loop

(in fixed line) or encouraging mobile virtual network operators (MVNOs) so as to enable market entry and

promote competition. In the media space, barriers to entry are less obvious although scale is not easy to

build. In some sub-sectors a broader range of competitors has been brought in by the development of

telecom networks. This applies particularly to free-to-air broadcasters and pay-TV operators, which, we

think, will be smaller businesses in the future. In the tech space, we are observing an extensive reshuffle of

Stephen Howard* Head, Global TMT Research HSBC Bank plc +44 20 7991 6820 [email protected]

Olivier Moral* Analyst HSBC Bank plc, Paris branch+33 1 56 52 43 22 [email protected]

Antonin Baudry* Analyst HSBC Bank Plc, Paris branch+33 1 56 524 325 [email protected]


186


abc

the dominant players in both networks and devices. The dominant players today are different from those at

the start of the last decade thanks to innovation, which has proved particularly striking with mobile

handsets (eg by introducing touchscreens). Another game-changing factor has been the emergence of well-

funded Chinese vendors, which now compete effectively against the most established names in the

industry. In IT services and software, we observe an increase in demand for Cloud, Mobility, Analytics and

Big Memory.

Key themes Data demand, capex and pricing power

We identify pricing power as a key theme across the three TMT sectors. This is particularly positive for

the largest telecom operators and negative for the established tech players, with the situation varying for

the different sub-sectors in media. Pricing power encompasses many other themes, such as capex

intensity, barriers to entry and market structure.

Telecoms

We think that the malaise in the telecoms sector has, so far, stemmed from operators’ inability to

transform the growing level of demand (mainly fixed broadband and mobile data) into higher revenue,

while, at the same time, competition and regulation are weighing on profitability. One important, but

generally overlooked issue, we think, is that incremental costs in telecoms services have been too low for

a long time. In the current voice-centric world, the cost of a unit of capacity is negligible, and the

temptation to give it away in pursuit of market share is high. However, this may now change with the

fast-growing demand for new services (eg video-on-demand on fixed line networks and value-added

services on mobile networks): marginal costs are significant for the first time since the TMT bubble.

These higher costs come from the need to invest in the terminal part of the access networks: fibre for

fixed networks, more antennas and spectrum for mobile networks. These higher costs mean that services

cannot be given away. This will fall disproportionately on the most price disruptive players in the market.

And this is precisely what is required for a better pricing environment in the telecoms sector. In fixed line,

as the incumbents deploy fibre, we would expect alternative operators to be forced to abandon their

strategy of unbundling the incumbent’s access network and rely on more expensive wholesale offers. In

mobile, operators with the more dense networks are likely to win over smaller competitors.

Media

In media, pricing power is also a key theme. Scarcity factors vary across the media sector and will determine

companies’ ability to monetise the growing demand. Demand for content is growing and the media sector

has historically commanded a good deal of market power due to the limited number of conduits to the

consumer. However, the ability of existing media owners to monetise this demand for content is declining.

Users can access an increasing level of content as the internet lowers barriers to entry, and are demonstrating

reluctance to pay, and lower tolerance for advertising. This trend is already particularly well established for

consumer publishers, but as the availability of content grows faster than demand this could also depress

yields for other media. As the internet causes barriers to entry across the sector to collapse, we think that the

infrastructure providers and media owners with scarce assets such as cable, satellites and professional

publishers can leverage their position and enjoy pricing power. We also identify agencies as relative winners

187


abc

in media despite the absence of significant barriers to entry (other than their existing global scale). We

expect European broadcasters, pay-TV and consumer publishers, which lack scarce assets, to underperform.

Technology

In technology, we see limited pricing power, driven by growing competition from Asia. Network

equipment is highly standardised, which limits the ability of a vendor to leverage its innovation for very

long. Asian vendors, especially Chinese vendors, have been taking share in recent years and are exerting a

strong and continuous pressure on prices in the tender offers. For original equipment manufacturers,

innovation seems to grant strong pricing power to leaders but competition remains fierce. In IT, a

structural shift is taking place in the relationship between clients and vendors, with the vendor not being

just the service provider but also a service aggregator that provides end-to-end services.

Sector drivers Telecoms

Telecoms operators are subject to many drivers, including the rate of technological innovation, the affordability

and availability of services, and the extent of regulatory intervention. And note that, although the sector is not

highly geared to the economy, it is clearly influenced by both economic and business cycles. The level of

penetration (for fixed broadband and mobile services) is a basic driver for telecoms revenues and is, in turn,

driven by the availability and affordability of services. Although penetration levels are now generally very high

in developed markets, demand in emerging markets (EM) remains untapped and this has traditionally pushed

developed market operators to buy exposure to emerging markets. This trend is gradually reversing as EM

telcos’ financial power has increased drastically. Innovation is often the driving force behind new streams of

revenue, as observed with smartphones and mobile broadband applications. The penetration of smartphones is

still lower in Europe (about 30% at the end of 2011) than in the US (42%), so we see strong potential. With

cheaper smartphones now priced under USD100, we expect smartphones to become mass market in EM in

future years. At this stage we would note that, in order not to see mobile data revenue completely cannibalising

legacy revenue (voice and messaging), operators have to put integrated tariffs in place to remove the incentive

for the client to substitute one for the other; the majority of operators have done this. Regulation also plays a

very important role. It is one of the main drivers in determining competitive intensity, as the regulators decide

the number of licences to be issued and set the level of many tariffs (in particular, those relating to the access

cost of the fixed access network). On the mobile side, the regulators set mobile termination rates (MTRs) and

roaming tariffs, which have a material impact on both revenues and EBITDA. The economic environment also

has an impact on the telecoms sector. Consumer spending is usually less cyclical, while enterprise revenues (eg

roaming and IT contracts) exhibit greater cyclicality. However, we stress that the relatively high margins seen

in the telecom sector mean that, while revenues are tightly linked to the economy, profits and cash flows are

relatively defensive in nature.

Media

Media is a heterogeneous sector which lends itself more to stock-picking than to top-down sector-based

analysis. Still, we see global macro as a strong revenue driver for our global advertising & marketing sub-

sector, especially for agencies and outdoor, and to a lesser extent for market research. The companies included

in our national advertising sub-sector (free-to-air TV and radios, directories) have revenue directly submitted to

GDP growth. For content and services, revenues are more subscription-based than advertising-based so are less

188


abc

sensitive to GDP volatility, although consumer publishers tend to be more exposed. However, we think that an

important driver will be the pace of development of over-the-top (OTT) content for pay-TV operators and the

move to digital (and its new modes of revenue-sharing involved) for consumer publishers.

Technology

For the telecoms equipment vendors, we focus on the factors driving the operators’ capital expenditures,

while for the semis, we focus on the capacity utilisation rate, ASPs (average selling price determined by

technological advance and the level of competition) and shipments to assess the likely trajectory of the

top line. Given the cyclical nature of the semiconductor business, we are cautious about

inventory/capacity build-ups and/or slowdowns in the order book. For original equipment vendors, the

driver is the ability of the telecom operators to build the right platforms which encourage new usages.

Last, for software and services, GDP growth is the key driver.

Valuation DCF is our principal method to assess the value of the TMT companies

We believe discounted cash flow (DCF) methodology is the most appropriate method to value companies

in the telecom, media and tech sectors. Traditional relative valuation metrics, such as the forward-looking

price-to-earnings and EV/EBITDA ratios, are also considered useful. In addition, in the developed

countries, investors focus on free cash flow (FCF) yield and dividend yield, since top-line growth is

usually muted. Most of the incumbent telcos have dividend yields greater than those of sovereign bonds.

The telecoms sector’s trading multiples have deteriorated over the last few years owing to general market

weakness, and lower sector growth. Emerging market players and developed market companies with

significant emerging market exposure enjoy higher multiples, due to higher growth potential. Over 2006-

08, the average trading PE multiple for the developed market telecom players was 13x, against c16x for

the emerging market players. Over 2009-11, both developed and emerging market PEs have fallen (to 11x

and 14x, respectively), although emerging market players continue to command a premium.

Spectrum costs are lumpy in nature and can take a substantial bite out of operators’ FCF. Unfortunately,

the magnitude and timing of spectrum costs are inherently difficult to predict. Note that they are often

excluded from clean FCF forecasts. The incumbent telecoms operators have large numbers of employees

and, in a few cases, large pension funds. The deficits of some of these funds, BT’s above all, can be very

large – and so become an important valuation driver. In many of the emerging markets regulatory/

political risk is significant, especially for foreign players.

189


abc

European and CEEMEA telecoms: growth and profitability

2008 2009 2010 2011a 2012e

Growth Sales 5.7% -0.6% 0.0% 1.4% 0.1% EBITDA 3.7% -1.8% 1.9% -0.2% -1.9% EBIT 4.0% -8.4% 7.5% -6.5% 2.7% Net profits 9.7% -0.5% -0.2% -5.5% 1.6%

Margins


Productivity

Capex/sales 15.0% 14.1% 12.6% 13.2% 13.9% Asset turnover (x) 1.74 1.69 1.70 1.74 1.75 Net debt/equity 0.85 0.87 0.79 0.84 0.80 ROE 16.5% 16.0% 15.4% 14.5% 15.0%

Note: Based on all HSBC coverage of European and CEEMEA telecoms Source: Company data, HSBC estimates

European media: growth and profitability

2008 2009 2010 2011a 2012e

Growth Sales 7.1% 4.6% 3.7% 4.4% 5.0% EBITDA 8.5% 2.3% 8.7% 4.8% 6.8% EBIT -1.8% -3.6% 28.3% 7.1% 17.2% Net profit -6.2% -13.0% 41.0% 20.1% 11.8%

Margins


Productivity

Capex/sales 11.9% 11.5% 10.6% 13.4% 11.1% Asset turnover (x) 1.99 2.04 2.11 2.01 2.06 Net debt/equity 1.70 1.67 1.28 1.28 1.23 ROE 14.2% 12.9% 16.7% 18.1% 19.5%

Note: Based on all HSBC coverage of European media Source: Company data, HSBC estimates

European technology (including IT software services): growth and profitability

2008 2009 2010 2011a 2012e

Growth Sales 2.0% -11.6% 3.8% 2.8% 1.9% EBITDA -1.9% -26.7% 10.1% 3.0% -6.6% EBIT -44.5% 8.0% 38.9% -9.7% 5.8% Net profit -13.6% -40.7% 30.5% -8.6% -9.1%

Margins


Productivity

Capex/sales 2.6% 2.2% 2.3% 2.3% 2.5% Asset turnover (x) 14.7 16.2 16.1 15.6 17.5 Net debt/equity -0.14 -0.24 -0.24 -0.25 -0.28 ROE 19.5% 12.3% 15.6% 13.7% 12.1%

Note: Based on all HSBC coverage of European technology Source: Company data, HSBC estimates

190


abc


MSCI Europe Diversified Telecoms Services and MSCI Europe Wireless Telecoms Services

6.43% of MSCI Europe

Trading data 5-yr ADTV (EURm) 1,948 Aggregated market cap (EURbn) 321 Performance since 1 Jan 2000 Absolute -49% Relative to MSCI Europe -40% 3 largest stocks VOD, TEF, DT Correlation (5-year) with MSCI Europe 0.92


Top 10 stocks: MSCI Europe Diversified Telecoms Services and MSCI Europe Wireless Telecoms Services


1 Vodafone Group plc 28.9% 2 Telefonica SA 11.2% 3 Deutsche Telekom AG 9.4% 4 France Telecom SA 7.4% 5 TeliaSonera AB 5.8% 6 BT Group plc 5.5% 7 Telenor ASA 5.3% 8 Vivendi SA 4.6% 9 Swisscom AG 4.1% 10 KPN 3.0%

Source: MSCI, Thomson Reuters Datastream, HSBC Country breakdown: MSCI Europe Diversified Telecoms Servicesand MSCI Europe Wireless Telecoms Services

Country Weights (%)

UK 35.0% France 13.6% Spain 11.2% Germany 9.4% Sweden 9.0% Norway 5.3% Switzerland 4.1% Italy 3.3% Netherlands 3.0%


Core industry driver: Vodafone smartphone penetration and mobile data growth

–

500

1,000

1,500

Q1

2009

Q3

2009

Q1

2010

Q3

2010

Q1

2011

Q3

2011

Q1

2012

0%10%20%30%40%50%60%

Mobile data rev enue, GBPm (LHS)Mobile data rev enue grow th, y -o-y (RHS)Smartphone penetration (RHS)

Source: Vodafone, HSBC

PE band chart: MSCI Europe Diversified Telecoms Services

0

20

40

60

80

100

120

2001 2003 2005 2007 2009 2011

5

10

x

15


PB vs. ROE: MSCI Europe Diversified Telecoms Services

1 . 0

1 . 5

2 . 0

2 . 5

3 . 0

2 0 0 4 2 0 0 5 2 0 0 6 2 0 0 7 2 0 0 8 2 0 0 9 2 0 1 0 2 0 1 1 2 0 1 2

1 0

1 5

2 0

2 5

F w d P B (L H S ) R O E % (R HS )


191


abc

Transport & logistics

Transport & logistics team Andrew Lobbenberg* Analyst HSBC Bank Plc +44 20 7991 6816 [email protected]

Julia Winarso* Analyst HSBC Bank Plc +44 20 7991 2168 [email protected]

Joe Thomas* Analyst HSBC Bank Plc +44 20 7992 3618 [email protected]

Achal Kumar* Analyst HSBC Bank Plc +91 80 3001 3722 [email protected]




EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

192

ab

cSector structure

Transport

InfrastructureAirlines Logistics/Shipping UK bus and rail

AirportsToll

roadsNetwork carriers

Low-cost carriers

IntegratorsFreight

forwardersShipping

Rail operators

Bus operators

Aeroports de Paris

Fraport

Zurich

Abertis

Atlantia

Brisa

Groupe Eurotunnel

Vinci

Air France-KLM

British Aiways

Lufthansa

SAS

Finnair

Aeroflot

THY

Royal Jordanian

easyJet

Ryanair

Air Berlin

Norweigen

Vueling

Aer Lingus

Flybe

Air Arabia

Deutsche Post-DHL

FedEx

TNT

UPS

DSV

Kuehne & Nagel

Panalpina

AP Moller-Maersk

TUI AG

Frontline 2012

Frontline

Golden Ocean

FirstGroup

Go-Ahead

National Express

Stagecoach

Ports

HanburgHafen

DP World

Transport

InfrastructureAirlines Logistics/Shipping UK bus and rail

AirportsToll

roadsNetwork carriers

Low-cost carriers

IntegratorsFreight

forwardersShippingIntegrators

Freight forwarders

ShippingRail

operatorsBus

operatorsRail

operatorsBus

operators

Aeroports de Paris

Fraport

Zurich

Abertis

Atlantia

Brisa

Groupe Eurotunnel

Vinci

Air France-KLM

British Aiways

Lufthansa

SAS

Finnair

Aeroflot

THY

Royal Jordanian

easyJet

Ryanair

Air Berlin

Norweigen

Vueling

Aer Lingus

Flybe

Air Arabia

Deutsche Post-DHL

FedEx

TNT

UPS

DSV

Kuehne & Nagel

Panalpina

AP Moller-Maersk

TUI AG

Frontline 2012

Frontline

Golden Ocean

FirstGroup

Go-Ahead

National Express

Stagecoach

Ports

HanburgHafen

DP World

Source: HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

193

ab

cRelative stock performance: 10-year performance of MSCI European transport index, MSCI European equity, MSCI World transport index and MSCI World equity index

40

60

80

100

120

140

160

180

200

May -00 May -01 May -02 May -03 May -04 May -05 May -06 May -07 May -08 May -09 May -10 May -11 May -12

MSCI World index MSCI Europe transport index MSCI Europe index MSCI World transport index

9/11 WTC, NY attack

January 2003End of Bear market (2000-02)

Rebound and sustained bull market with higher liquidity and business

momentum

Financial crisis due to over securitisation of risk

Running Euro concerns


EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

194

ab

cAsset turnover versus EBITDAR margin (2011) – European transport

AP

DPW

PNL

TNTE

ADP

FRA

FHZN

VIEV

FGP

GOG

NEX

SGC

AF

EZJ

RYA

LH

IAG

0%

10%

20%

30%

40%

50%

60%

0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50Asset turnover

EB

ITD

AR

mar

gin

Source: Company reports, HSBC

195


abc

Sector description The global transport sector comprises a number of sub-sectors, which often have different economic

characteristics, earnings drivers and valuation references. These sub-sectors are airlines, logistics and

shipping, airports, ports, toll roads, and the bus and rail sector.

Airlines

The air transport industry is a highly cyclical growth industry. Air travel growth generally correlates with

GDP growth, with multipliers in excess of 2x in developing economies and close to one in mature air

transport markets. Within the value chain of air transport, airlines stand out for their sustained track

record of systematic value destruction, in contrast to aircraft manufacturers, airports, distribution systems,

fuel producers and handlers, which typically achieve better profitability.

The industry can be divided into business models:

Full-service network carriers operate short-haul, medium-haul and long-haul networks, offering

connecting opportunities at their hubs. They are often long-established businesses, which can trace their

heritage back to government-owned companies from the dawn of aviation. They are thus often highly

unionised, and burdened by legacy costs and restrictive working practices. They are complex businesses

offering multiple classes of services on board their aircraft and a range of services on the ground.

Network carriers generally operate cargo businesses as well. Some also operate other aviation-related

businesses such as MRO and catering.

Low-cost carriers are typically younger companies that have emerged over the past 20 years from

industry liberalisation. These companies usually operate point-to-point services within regions. They are

simpler businesses, with structurally lower cost bases, utilising a single-type aircraft, often using lower-

cost airports and offering a single class of service. Low-cost carriers have been at the forefront of

developments to generate ancillary revenues by selling unbundled services.

Airports and toll roads

Airport businesses derive revenues from aviation, retail and real estate activities. Airport fees (eg,

passenger fees and landing fees) are generally set through a regulatory price formula, but the quoted

operators do have a free hand to decide their strategy in non-aviation segments. Overall, factors such as

catchment area, hub attractiveness and the health of the home airline can determine growth potential.

Operators have also chased growth in foreign countries, especially emerging markets, where they have

take on concession agreements. On occasion, this has exposed them to local political risk.

Toll road companies provide infrastructure to enable transportation. These infrastructures require huge

investments with a long gestation period. European governments have disinvested their interests in such

huge projects by partnering with private companies or granting them rights to charge the customers (on

toll road concessions). Traffic is driven by economic activity, while tariffs are generally set through

negotiations with the government.

Logistics and shipping

Most of these supply-chain stocks are cyclical, and earnings correlate with industrial production and

global trade. Logistics refers generally to the carriage of freight, parcels and mail. Typically activities are

segmented into: small parcel express (up to 68kg), mail (50g letters and small packages), freight

Andrew Lobbenberg* Analyst HSBC Bank Plc +44 20 7991 6816 [email protected]

Julia Winarso* Analyst HSBC Bank Plc +44 20 7991 2618 [email protected]

Joe Thomas* Analyst HSBC Bank Plc +44 20 7992 3618 [email protected]

Achal Kumar* Analyst HSBC Bank Plc +91 80 3001 3722 [email protected]



196


abc

forwarding (heavy freight carried in air freight and sea freight containers), road network freight

operations (eg, co-ordination and carriage of less-than-truckload freight shipments, such as palettes) and

supply chain outsourcing services (operating clients’ inventory and warehouse networks). Supply chain

outsourcing is a long-term contracting business but in some circumstances is tied to volumes – so while it

is less cyclical than freight transportation, it is still cyclical.

UK bus and rail sector (land passenger transport)

The sector comprises four London-listed companies. Together these companies run most of the 20 UK rail

franchises and control around 75% of the provincial bus market. National Express only operates in the largely

deregulated markets outside London. Go-Ahead, FirstGroup and Stagecoach (to a lesser extent) also operate in

London, where operators are funded by the public sector for providing contracted services to Transport for

London. The UK rail operation is a largely franchised process, with operators winning the right to operate a

franchise for a period of around seven years. The sector has a high correlation with UK GDP, unemployment

rates and consumer spending. Operators are not responsible for rail infrastructure but instead pay access fees to

Network Rail. The rail industry is highly regulated, and heavily funded by government subsidy and a revenue

support system. All of the operators also have interests in the US (mainly school buses and long-distance

coaches). National Express runs bus services in Spain.

Key themes Airlines

Capacity moderation: In the face of an uncertain economic environment, airlines across the world are

showing moderation in capacity growth. This moderation is strongest in the US market, but is also a clear

trend globally.

Yield trends uncertain: Passenger yields are benefiting from capacity restraint across the industry.

However, there is considerable uncertainty about the future trajectory of unit revenues. Economic

confidence is weak and growth is slowing in Europe. Evidence is currently mixed, with some carriers

reporting sustained demand for business travel; others are reporting softening yield trends.

Fuel prices: The oil price has moderated from peaks in Q1 2012. However, most airlines hedge their fuel

on a gradual basis; they have high levels of cover for the first quarter but little coverage two years out. In

effect this means that airlines experience market moves with around a 12-month lag, so fuel costs are

currently rising for most airlines.

Restructuring: In the face of the uncertain yield environment and rising fuel costs, airlines are endeavouring to

improve their non-fuel unit costs. Negotiating changes in labour terms and condition is challenging.

Consolidation: There has been a succession of major mergers in Europe, Latin America and the US.

Governments around the world are seeking to sell their airlines. Consolidation also comes from airlines failing.


Growth in global freight flows: Economic uncertainty and austerity measures in Europe in particular are

weighing on global demand. The trade multiplier in 1995-2007 averaged 2.6x global GDP, with an

expanding supply chain. We forecast that this could contract for the next few years owing to the fragility of

the global recovery, the impact of the withdrawal of stimulus and more local sourcing.

197


abc

Modal shift: Seafreight is cheaper than airfreight, but it is also much slower. As supply chain management

becomes more sophisticated and the reliability and punctuality of containership services improves, we

expect to see a continued modal shift from airfreight to seafreight.

Inventory/sales ratios: The global downturn prompted significant destocking. Inventory/sales ratios

remain low. Though we see modal shift from air to sea, emergency shipments are helping to support express

volumes, in our view.

Emerging market growth: It’s good to be global. Although the Asia-Europe and Transpacific trade lanes

remain dominant, other trade lanes are starting to rise in importance. We expect to see the highest growth

in intra-Asia lanes, Asia-Latin America, Asia-Africa and Europe-Africa. Backhaul Europe Asia volumes

should also be a key driver of volume growth.

Supply overhang in container and dry bulk shipping: There is oversupply of container and dry bulk

ships. Companies have reduced the supply by laying up some ships and slow streaming (reducing the

speed of the ship). But with some recovery in rates, laid-up ships are coming back into service.


Weakness in passengers and cargo: This reflects capacity restraint from airlines such as Air France-

KLM as they attempt to support unit revenues in a difficult economic environment.

Expansion in developing markets (Asia and Latin America): These high-growth markets are exploring

the PPP model to develop their infrastructure. These airports are often under-exploited in retail terms.

Free cash generation with large capital expenditure programmes: Fraport in particular has high levels of

capex ahead of it. In time, the revenues realised from the resulting tariff structure and capacity/traffic increase

should exceed the expenditure incurred; however, in the short term, this serves to keep ROIV<WACC.

UK bus and rail sector (land passenger transport)

UK bus profits under threat: The bus industry is heavily subsidised (around 40-45% of revenue from

taxpayers). The sector rode the expansion of public spending but now spending cuts are hitting, eroding

margins. We expect these cuts to deepen further in time. The pressures are intensified by higher fuel

costs. Operators initially indicated that these lower subsidies/higher costs could be passed on through

higher fares, but this has proven problematic in a difficult consumer environment.

Rail franchise awards could bring more risk. Fourteen new rail franchises are to be awarded by

December 2015. This will bring the opportunity of large earnings upgrades for the victors. However, we

think that risks will also grow: the new risk-sharing mechanism is tilted more in favour of the

government, in our view. In addition, capex commitments look set to increase. We are not convinced that

margins will adjust to compensate for this higher risk; competition from foreign operators such as

Deutsche Bahn and SNCF is likely to keep bidding tight.

198


abc

Sector drivers Airlines Global trade volumes and global business confidence are the key drivers of demand for business travel.

Consumer confidence is the key driver for leisure travel. Most airlines disclose traffic data on a monthly

basis. It is important to monitor capacity growth and load factor. Some airlines disclose qualitative data,

such as yields or premium traffic growth, which are particularly relevant. At quarterly results the key

metrics are passenger and cargo yields and unit costs, which are often assessed in total and excluding fuel.

At certain times, there is emphasis on gearing and liquidity.


(1) Global freight flows, GDP and industrial production; (2) airfreight tonnes; (3) sea freight TEUs

(twenty-foot equivalent units); (4) gross profit/unit; (5) parcel shipments per day; and (6) average yields.


(1) Traffic volume growth; (2) runway and terminal capacity; (3) capital expenditure programme; and (4)

dividend yield. There are also other variables, such as length of concession rights and visibility in

tariff/fee increases through negotiations of regulatory and government bodies.

UK bus and rail sector (land passenger transport) (1) Passenger volume growth; (2) yield growth; (3) government funding; and (4) fuel price.

Valuation Airlines There is no definitive method for valuing an airline. The most commonly used metrics include

EV/EBITDAR, EV/IC and PE multiples, with carriers being compared cross-sectionally and relative to

their own historical averages, peaks or troughs. PE multiples are not consistently relevant for network

carriers because of the lack of earnings in large parts of the cycle. Price-to-book multiples or asset-based

valuations are also used, as are assessments based on the replacement value of fleet. For airlines with

diversified assets, sum-of-the-parts analyses may be relevant. DCF analyses are more common for low-

cost carriers than network carriers, which are more volatile.

Logistics and shipping PE, EV/EBITDA and DCF are commonly used for valuing the companies.

Airports and toll roads EV/EBITDA and DCF are commonly used for most of the segments including toll roads and airports. In

addition, IRR is used to value the new concession projects. RAB (regulated assets base) is also used for

airports.

UK bus and rail sector (land passenger transport) SOTP is generally used to value the companies. However, different segments are valued using

EV/EBITDA and DCF. Comparisons between companies are often done on a PE basis, both including

and excluding rail (where franchise lives are limited).

199


abc


MSCI All Country Europe Transport Index

1.11 % of MSCI Europe

Trading data 5-yr ADTV (USDm) 409 Aggregated market cap (USDbn) 131.0 Performance since 1 Jan 2005 Absolute -9% Relative to MSCI -4% 3 largest stocks DPW, Maersk, K&N Correlation (5-years) with MSCI Europe 99%

Source: MSCI, Thomson Reuters Datastream, HSBC Top 10 stocks: MSCI All Country Europe Transport Index


1 Deutsche Post-DHL 21.2% 2 AP Moller Maersk 17.0% 3 Kuehne & Nagel 8.8% 4 Abertis Infra 6.9% 5 Vopak 6.6% 6 Eurotunnel 6.6% 7 Atlantia 5.8% 8 TNT Express 5.5% 9 DSV 5.3% 10 Lufthansa 3.5% Total 87.1%

Source: MSCI, Thomson Reuters Datastream, HSBC Country breakdown: MSCI All Country Europe Transport Index

Country Weights (%)

Germany 27.4% Denmark 22.3% Netherland 12.1% France 9.8% Switzerland 8.8% Spain 6.9% Italy 5.8% UK 3.1% Turkey 2.3%


Core industry driver: MSCI Europe Transport Index versus European GDP growth, quarterly

-6%

-4%

-2%

0%

2%

4%

6%

Q101

Q102

Q103

Q104

Q10

5

Q10

6

Q10

7

Q10

8

Q10

9

Q11

0

Q11

1

Q11

2

-60%

-40%

-20%

0%

20%

40%

60%

Eur GDP grow th Eur trans. Index grow th (RHS)


PE band chart: MSCI All Country World Airline Index

-50

0

50

100

150

200

01 02 03 04 05 06 07 08 09 10 11 12

5

10

x

15


PB vs. ROE: MSCI All Country World Airline Index

0.0

0.5

1.0

1.5

2.0

04 05 06 07 08 09 10 11 12

0

2

4

6

8

10

12

14

Fw d PB (LHS) R OE % (RHS)


200


abc

Notes

201


abc

Travel & leisure

Travel & leisure Lena Thakkar* Analyst HSBC Bank plc +44 20 7991 3448 [email protected]


EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

202

ab

c

Sector structure

*For airlines, bus and rail companies see Transport section

Travel* Leisure

Travel & leisure

Hotels

Accor Hotels

IHG

M&C

Whitbread

Tour Operators

Holidaybreak

Kuoni

Thomas Cook

Tui Travel

Cruise Companies

Carnival

Royal Caribbean

Bookmakers/Online Gaming

888

Bwin.Party

Ladbrokes

Paddy Power

Playtech

Rank

Sportingbet

Will iam Hill

Pubs & Restaurants

Enterprise Inns

Greene King

JD Wetherspoon

Marston's

Mitchells and Butlers

Punch Taverns

Spirit Pub Company

The Restaurant Group

Caterers/Vouchers

Compass

Edenred

Sodexo

*For airlines, bus and rail companies see Transport section

Travel* LeisureTravel* Leisure

Travel & leisure

Hotels

Accor Hotels

IHG

M&C

Whitbread

Tour Operators

Holidaybreak

Kuoni

Thomas Cook

Tui Travel

Cruise Companies

Carnival

Royal Caribbean

Bookmakers/Online Gaming

888

Bwin.Party

Ladbrokes

Paddy Power

Playtech

Rank

Sportingbet

Will iam Hill

Pubs & Restaurants

Enterprise Inns

Greene King

JD Wetherspoon

Marston's

Mitchells and Butlers

Punch Taverns

Spirit Pub Company

The Restaurant Group

Caterers/Vouchers

Compass

Edenred

Sodexo

Source: HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

203

ab

c

Travel and leisure sector performance

-60%

-40%

-20%

0%

20%

40%

60%

80%

June-88 June-90 June-92 June-94 June-96 June-98 June-00 June-02 June-04 June-06 June-08 June-10 June-12

-3.0

-2.2

-1.4

-0.6

0.2

1.0

1.8

2.6%y -o-y change in FTSE 350 Trav el and Leisure Index 10 y ear sw ap rate - 2 y ear sw ap rate (RHS)

-60%

-40%

-20%

0%

20%

40%

60%

80%


-40

-30

-20

-10

0

10

20

30

40

50

%y -o-y change in FTSE 350 Trav el and Leisure Index UK consumer confidence indicator (RHS)

UK leaves ERM in September 1992Interest rates fall

Economy recovers

Collapse in UK GDP as credit crunch bites

-60%

-40%

-20%

0%

20%

40%

60%

80%


-3.0

-2.2

-1.4

-0.6

0.2

1.0

1.8


-60%

-40%

-20%

0%

20%

40%

60%

80%


-40

-30

-20

-10

0

10

20

30

40

50


-60%

-40%

-20%

0%

20%

40%

60%

80%


-3.0

-2.2

-1.4

-0.6

0.2

1.0

1.8


-60%

-40%

-20%

0%

20%

40%

60%

80%


-40

-30

-20

-10

0

10

20

30

40

50


UK leaves ERM in September 1992Interest rates fall

Economy recovers

Collapse in UK GDP as credit crunch bites

Source: Thomson Reuters DataStream, HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

204

ab

c

EBIT margin versus asset turnover chart (2011)*

C C LR C L

C P G

E D E N

S D X

A C C P

IH GW T B

G N K

J D W

M A B

M A R S

T C G

T T

0 .0

0 .2

0 .4

0 .6

0 .8

1 .0

1 .2

1 .4

1 .6

1 .8

2 .0

0 .0 % 5 .0 % 1 0. 0% 1 5 .0 % 2 0 .0 % 2 5 .0 % 30 . 0 % 35 . 0%

E B IT m a r g i n (% )

Ass

et T

urn

over

(x)

*Whitbread calculations use FY 2012 numbers; year-end is in February Source: Company data, HSBC estimates

205


abc

Sector description The travel and leisure sector comprises numerous diverse sub-sectors including pubs and restaurants,

hotels, cruise and tour operators, bookmakers and gaming companies, and catering companies. In

addition, there are a several smaller esoteric businesses that do not fit neatly into a specific sub-sector,

such as the fast-food delivery company Domino’s Pizza and cinema operator Cineworld. Airlines and bus

and rail operators in this report are categorised under transport.

Key themes Discretionary spend

In the travel and leisure sector similarities between companies are more subtle than for companies in

other sectors. Broadly speaking, companies in this sector depend on some form of ‘discretionary

expenditure’. When confidence and incomes are high, spending on discretionary items (like eating out or

holidays) is also likely to be strong. Alternatively, during a downturn, confidence falls and consumers cut

discretionary spending. This makes the travel and leisure sector more cyclical than many others.

Long-term growth

Despite this cyclicality, all sub-sectors have in the past exhibited real structural growth, and look likely to

continue to do so over the long term. Travel-related companies such as hotels and tour operators benefit

from GDP growth, globalisation, and political change, which can allow freer movement of people.

Meanwhile, as disposable incomes increase in both developed and emerging markets, there is greater

demand for leisure activities such as eating out, holidays, sporting events and gambling.

Sector drivers Consumer and business confidence

Quite simply, increasing confidence means greater discretionary spend. We have outlined the nature of

that relationship with regard to consumers above, but it is also worth considering business confidence.

Corporate spending on hotels and catering usually fluctuates with the economy, with rooms and services

being upgraded to premium categories in the good times, but travel restrictions quickly being enforced in

tougher economic conditions.

Capacity and capex

Capacity varies considerably depending on the sub-sector. Within the hotel industry, the current lack of

available finance to build new hotels means supply is increasing slowly, particularly in developed

markets. In comparison, the long-term declines in the UK’s drinking-out market mean the capacity of

wet-led pubs is in decline, although this is being offset by capacity increases in the number of food-led

pubs and other restaurants. In the more mature industries, such as pubs and land-based bookmakers,

capex tends to trend in line with depreciation, unless operators are actively looking to roll out more units.

Input costs

Input costs differ between sub-sectors, although labour is usually one of the highest costs. Other key costs

are food and beverages for hoteliers, pubs and restaurants, and fuel for cruise and tour operators. These

costs ultimately depend on commodity markets, although businesses tend to have long-term contracts

with suppliers in order to reduce volatility.

Lena Thakkar * Analyst HSBC Bank Plc +44 20 7991 3448 [email protected]


206


abc

Changes in regulation and taxation

Since expenditure in the sector is discretionary, it is often an easy target for governments to tax; duties on

alcohol, gambling and air travel are obvious examples. Changes in regulation often create big operational

risks. When online gaming was outlawed in the US, operators lost more than half of their global market

overnight, and when smoking was banned in all public places in the UK in 2007 wet-led pub operators

had to substitute declining alcohol sales with increased focus on food sales.

Sub-sector drivers

Each sub-sector has its own unique structure and is subject to different macro and micro drivers. For

example, the barriers to entry in the cruising industry are high since large sums of capital are required to

acquire a new cruise ship compared to opening a new restaurant. Key themes in each sub-sector include:

Pubs and restaurants

Themes: growth of the eating-out market versus the decline of the drinking-out market; changes in taste

and preferences; freehold versus leasehold sites and property values; managed, leased, tenanted or

franchise-based operating models; a fragmented industry with consolidation potential; input cost inflation;

competition from supermarkets and the off-trade; changes in duty and taxes; and changes in regulation.

Share price drivers: We believe the three key drivers of share price performance are:

Top-line resilience: Eating out remains a priority for UK consumers. With value a key driver, pub

restaurants should continue to grow and take share. This trend should intensify as diners’ trade down

to cheaper alternatives if disposable income falls.

Consolidation and polarisation: The industry has polarised at the fastest rate in history over the past

few years driven by the managed listed companies. Stronger operators have grown and acquired

smaller operators which have struggled or even gone out of business. The successful players have

larger food-led pubs with scale, geographical reach and experienced management.

Cost outlook: Managed operators have successfully grown their top lines through the recession, but

profits have been slower to rise as margins have not expanded in line with operational gearing levels.

There are two reasons for this: discounting to drive volumes and cost inflation.

Hotels

Themes: penetration of branded hotels versus non-branded hotels; lower growth in developed markets

than in emerging markets; asset-light versus owner-operated business models; recovering demand and

limited new hotel capacity; changes in corporate travel budgets; loyalty schemes; and asset values.


Macro lead indicators: Hotel revenues are driven by corporate and consumer spend. The common

indicator used by commentators to assess the current health of hotel stocks tends to be RevPAR

(revenue per available room). There is a high correlation between RevPAR and GDP, but GDP

moves tend to lag share prices.

Brand strength: Strong brands are vital for RevPAR outperformance, resilient growth pipelines and a

shift to an asset-light model. In a strong market, when occupancy rates are high, consumers are travelling

207


abc

and businesses are expanding, all hotels can have the confidence to raise prices. However, in a downturn,

when budgets are tight, the strongest and most reliable brands are the first to get booked.

Emerging markets success: With Western hotels growth reliant on RevPAR recovery and slim net

additions, companies are increasingly focused on emerging markets as the true growth driver where GDP

expansion, as well as tourism and business travel is outstripping the West. Areas of expansion for the

companies are China, India, the Middle East, Africa, Brazil and Thailand/Indonesia.

Cruises

Themes: ship capacity, oil price, currency, ageing population, increasing cruise penetration, new source

areas, and the launch of new and innovative ships.


Net yields: Cruise companies provide forward capacity numbers and always fill their ships over

100%, so the only unknown is net revenue yield. In general, passengers tend to book cruises well in

advance. Therefore, changes in consumer sentiment can have a lagged effect. Yields are affected by

shocks like maritime accidents, natural disasters, terrorist attacks and financial market panic.

Industry supply: With 8-9% pa supply growth over the past decade, cruise companies have struggled

to gain any pricing power. In the next three years, industry supply growth is planned at c3% pa, much

lower than the last decade, and so pricing may show some improvement.

Oil price and currency: Fuel and currency fluctuations are key drivers of earnings volatility for the

cruise companies. Fuel makes up 15-20% of the cost base for the cruise companies.

Tour operators

Themes: changes in aircraft capacity; growth of independent travel, disintermediation caused by the

internet; changes in booking patterns; growth of low-cost carriers; exchange rates; geo-political risk and

climate change; fuel costs; and changes to excise and duty rates.


UK consumer: UK packaged holidays make up a third of tour operators’ profit. The UK has been the

most challenging and volatile source market. Future performance will ultimately rely on the

consumer environment.

Structural challenges: Independent and internet travel agencies continue to take share. Packaged

holidays are a commodity product leading to price wars and margin loss in the “lates” market.

Bid speculation: Tour operators have been subject to bid speculation in the press owing to distressed

valuation and poor operational performance. Share price rallies following such takeover speculation

have been short-lived, with the gains nullified soon after the euphoria settles.

Bookmakers and gambling

Themes: high growth in online versus subdued growth in land-based gambling; changes in tastes and

preference, such as growth in football betting and the decline in horse racing betting; changes to global

regulation, taxes and duties; social acceptance and awareness of gambling.

208


abc

Share price drivers: We believe the three key drivers share price performance are:

Regulation: Changes in regulation affect the profitability of the gambling industry. Regulation is

mostly in the form of taxes applied to the gaming companies or rules around whether certain forms of

gambling are permitted.

Move to digital: Digital revenue growth is driven by a change in consumer behaviour, launch of new

products and increasing marketing efforts. Many European countries are discussing the approval of

online gaming which will provide a boost to online gaming businesses.

Mergers & acquisitions: Companies derive cost synergies from disposals of overlapping facilities

and software. Established gaming companies can make acquisitions to gain the benefit of successful

proprietary gaming platforms/technologies developed by small companies.

Caterers

Themes: size of overall market and potential growth of outsourcing; penetration levels vary across

industry sectors and regions; cyclical or defensive; types of contract; input costs (food and labour); and

opportunities in facilities management. Revenues are driven by price, volume and net new business.


Employment levels: B&I accounts for a major chunk of the catering outsourcing business. When

businesses cut their workforce, this affects the volume of food sold at company cafeterias. Facilities

management’s volume of work is less transient, as it is dependent on clients expanding their offices.

Inflation: Food and wages make up the bulk of the cost structure of food services companies. Food

and wage inflation therefore have a major impact on contract profitability. Inflation also affects the

pricing of new contracts, as well as renewal of existing contracts.

Outsourcing/penetration rate: Outsourcing rates for facilities management are relatively low in all

sectors aside from B&I (Business and Industry) and remote sites. The opportunity is in sectors such

as healthcare and education where penetration remains low. In food services globally only 45-50% of

the business is outsourced and 50% of new business comes from first-time outsourcers.

Valuation Understandably there is no one valuation methodology that is appropriate to the whole sector. In fact there

is not one methodology that is relevant to all companies within most sub-sectors. For example the pub

industry is mature, and has relatively predictable cash flows; a DCF valuation is often favoured. However,

a DCF fails to consider the asset backing inherent in the freehold pub companies.

Likewise in the hotel industry there are two models – the asset-light model tends to attract a higher

multiple as returns on capital are higher, but the capital-intensive model clearly has support from the asset

values, which can often support more debt. We think the most commonly used methodologies are relative

multiple analysis and DCF, with returns-based measures and asset values providing support.

209


abc

Accounting issues

Most operators have fairly predictable cash flows since customers pay for their goods and services when

they receive them. Therefore the conversion ratio of operating profit into free cash flows tend to be high,

and this, in most cases, means accounting standards are fairly straightforward.

One issue to be aware of is operating leases, which can be used for property assets such as real estate and

aircrafts. Since these assets are simply leased, the potential full liabilities are not capitalised on the

balance sheet. To compensate for this, a calculation to capitalise the annual lease cost at 8x is often used

or we can use the fixed cover charge, which takes into consideration both interest costs and rent.

Another area to focus on is working capital, particularly for the tour operators as, owing to the seasonal

nature of their businesses, they can see a large swing in working capital from the time cash comes in over

the summer months as customers pay the balance of their holidays, to the low point, usually at the start of

the calendar year, when they pay hoteliers for their allocation of rooms for the previous year.

Food services sector: growth and profitability

2010 2011 2012e 2013e

Growth Sales 5.7% 5.6% 4.4% 5.2% EBITDA 7.4% 8.3% 7.5% 9.4% EBIT 8.1% 9.3% 7.4% 9.9% Net profit 13.9% 12.2% 5.9% 12.2% Margins EBITDA 12.7% 12.7% 12.7% 13.0% EBIT 10.8% 10.9% 10.9% 11.2% Net profit 6.3% 6.8% 6.7% 7.0% Productivity Capex/sales 2.7% 2.7% 2.6% 2.4% Asset turnover (x) 1.41 1.40 1.43 1.47 Net debt/equity (x) 0.18 0.17 0.24 0.20 ROE 14.8% 13.5% 13.5% 13.2%

Note: based on all HSBC food services coverage Source: Company data, HSBC estimates

Hotels sector: growth and profitability

2010 2011 2012e 2013e

Growth Sales 8.6% 7.1% 3.0% 5.8% EBITDA 22.5% 10.6% 3.7% 7.6% EBIT 11.8% 18.2% 2.4% 8.9% Net profit 5.9% 23.4% 11.6% 11.3% Margins EBITDA 23.6% 24.5% 24.8% 25.3% EBIT 16.8% 18.4% 18.4% 18.9% Net profit 10.2% 11.7% 11.9% 12.3% Productivity Capex/sales 9.9% 12.5% 13.2% 12.7% Asset turnover (x) 0.59 0.67 0.68 0.70 Net debt/equity (x) 0.48 0.42 0.24 0.12 ROE 42.7% 33.0% 24.7% 21.8%

Note: based on all HSBC hotels sector coverage Source: Company data, HSBC estimates

210


abc


MSCI Europe Hotels, Restaurants and Leisure Index


Trading data 5-yr ADTV (GBPm) 630 Aggregated market cap (GBPm) 58,888 Performance since 1 Jan 2000 Absolute* 16.8% Relative to MSCI Europe US Dollar*

40.0%

3 largest stocks Compass, IGH, Sodexo Correlation (5-year) with MSCI Europe US Dollar

0.9

* Absolute and relative performance of HSBC Travel and Leisure coverage Source: MSCI, Thomson Reuters DataStream, HSBC Top 7 stocks: MSCI Europe Hotels, Restaurants and Leisure Index

Stock rank Stocks Index weight*

1 Compass 36.6% 2 IHG 13.1% 3 Sodexo 12.9% 4 Carnival 11.3% 5 Whitbread 10.9% 6 Accor 8.5% 7 Tui travel 2.2% *These are top ten stocks as per index weight

Source: MSCI, Thomson Reuters DataStream

Country breakdown: MSCI Europe Hotels, Restaurants and Leisure Index

Country Weights (%)

UK 74.2% France 21.4% Greece 2.5% Italy 1.9%


Core industry driver: US and Europe consumer confidence

25

50

75

100

125

May

-01

May

-02

May

-03

May

-04

May

-05

May

-06

May

-07

May

-08

May

-09

May

-10

May

-11

May

-12

95

97

99

101

103

US consumer confidence indexEurope consumer confidence index (RHS)

Source: Thomson Reuters DataStream, HSBC

PE band chart: MSCI Europe Hotels, Restaurants and Leisure Index

0

50

100

150

200

250

Jun-

05

Jun-

06

Jun-

07

Jun-

08

Jun-

09

Jun-

10

Jun-

11

Jun-

12

Pric

e le

vel

20x

15x10x

5x


PE vs. PB: MSCI Europe Hotels, Restaurants and Leisure Index

5

10

15

20

25

30

Jun-

05

Jun-

06

Jun-

07

Jun-

08

Jun-

09

Jun-

10

Jun-

11

Jun-

12

1. 0

1.8

2.6

3.4

4.2

5.0

MSCI Europe Leisure index P/E (x )

MSCI Europe Leisure index P/B (x )- RHS

Source: MSCI, Thomson Reuters Datastream

211


abc

Utilities

Utilities team Adam Dickens* Analyst HSBC Bank Plc +44 20 7991 6798 [email protected]

José A López* Analyst HSBC Bank Plc +44 20 7991 6710 [email protected]

Verity Mitchell* Analyst HSBC Bank Plc +44 20 7991 6840 [email protected]

Dmytro Konovalov* Analyst OOO HSBC Bank (RR) +7 495 258 3152 [email protected]

Sector sales Mark van Lonkhuyzen Sector Sales HSBC Bank Plc +44 20 7991 1329 [email protected]



EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

212

ab

cSector structure

Utilities

Power/Gas

Regulated

National Grid

Snam Rete Gas

Terna

Red Electrica

Enagas

Federal Grid Company

Inter RAO

Non-regulated

SSE

Centrica

Drax Group PLC

E.ON

RWE

EDF

GDF Suez

Enel

Iberdrola

Gas Natural

Energias de Portugal

Fortum OYJ

Verbund

CEZ a.s.

RusHydro

E.ON Russia

Enel OGK 5

OGK 2

Water/Waste

Regulated

Pennon Group

Severn Trent

United Utili ties

Non-regulated

Veolia Environnement

Suez Environnement

Seche Environnement

Utilities

Power/Gas

Regulated

National Grid

Snam Rete Gas

Terna

Red Electrica

Enagas

Federal Grid Company

Inter RAO

Non-regulated

SSE

Centrica

Drax Group PLC

E.ON

RWE

EDF

GDF Suez

Enel

Iberdrola

Gas Natural

Energias de Portugal

Fortum OYJ

Verbund

CEZ a.s.

RusHydro

E.ON Russia

Enel OGK 5

OGK 2

Water/Waste

Regulated

Pennon Group

Severn Trent

United Utili ties

Non-regulated

Veolia Environnement

Suez Environnement

Seche Environnement

Source: HSBC

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

213

ab

cDividend yield (%) of MSCI European Utilities versus MSCI Europe

0

1

2

3

4

5

6

7

8

Oct-96

Apr-97

Oct-97

Apr-98

Oct-98

Apr-99

Oct-99

Apr-00

Oct-00

Apr-01

Oct-01

Apr-02

Oct-02

Apr-03

Oct-03

Apr-04

Oct-04

Apr-05

Oct-05

Apr-06

Oct-06

Apr-07

Oct-07

Apr-08

Oct-08

Apr-09

Oct-09

Apr-10

Oct-10

Apr-11

Oct-11

MSCI EUROPE - DIVIDEND YIELD MSCI EUROPE UTILITIES - DIVIDEND YIELD

1. The European Utilities sector has historically traded at c40% dividend yield premium to the market (MSCI Europe) 2. But the yield premium narrowed during 2004-2008 when

the sector traded at a higher PE - valuations underpinned by a strong upturn in commodity prices (oil, gas, power prices).

3. However, in wake of the recent global financial crisis and the consequent decline in commodity prices, the sector has regained its dividend yield premium to the market.


\

EM

EA

Eq

uity R

esearch

Mu

lti-sector

July 2012

214

ab

cNet debt + provisions/EBITDA 2012e versus RoCE 2012e of utilities under our coverage

PPC

OGK2

Enel OGK5

E.ON Russia

Inter Rao

RusHy dro

FGC

CEZ

Verbund

Fortum

EDP

Enagas

REE

GNF

IBE

Terna

Snam

Enel

GDF Suez

EDF

RWE

E.ON

Drax

SSE

NG

CNA

Suez Env .

VIE

UU

SVT

PNN

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

0x 1x 2x 3x 4x 5x 6x

Net debt + provisions/EBITDA 2012e

RoC

E 20

12e


215


abc

Sector description Not as defensive as might be presumed

The European utilities sector encompasses companies operating across the value chain in electricity, gas,

water and environmental services. For electricity and gas, upstream activities include: power generation,

and oil and gas exploration and production, while downstream activities are related to retail sales and

services. Returns in generation are typically subject to fluctuations in commodity (gas, coal) and carbon

prices and spreads (influenced by the balance of the market). Infrastructure activities (transmission and

distribution networks and pipes) are subject to regulated returns. Downstream activities such as retail

sales and services are deregulated in most European countries. Environmental and waste services are

competitive activities. Water supply activities in England and Wales are subject to regulated returns, but

are unregulated in France. Operating profit margins are generally higher in more asset-intensive and

regulated activities, but lower in retail supply (single digits) owing to competitive pressures. In Russia,

where we have initiated coverage since the previous Nutshell, electricity is sold on the open market but

annual growth of the end user price is limited by a cap defined by the state. The sector is undergoing a

period of heavy investment. Shares of the western-based utilities typically pay above-market yields, while

Russian utilities mostly do not pay any dividends.

As regulated networks are relatively immune to economic cycles, the sector is traditionally seen as a

defensive sector or yield play. However, in the context of national austerity measures, even regulated

business has been subjected to additional taxes in Italy. Unregulated activities, which account for around

three-quarters of sector earnings, are not defensive as political pressure (nuclear policy, for example),

environmental legislation, competition and commodity price volatility have contributed to lower margins.

Key themes Europe – power

EU energy policy and regulation – compromised by differences in national objectives

Energy policy and regulation in Europe is centred on: energy security, environmental protection and

affordability. Regulation in individual member countries is being shaped by the broader EU objectives of

an ‘internal energy market’ and the ‘20-20-20’ initiative for 2020 aimed at energy efficiency. Members

are targeting the establishment of an EU-wide internal energy market as a means of promoting

competition and giving consumers a choice of supplier. However, differing political objectives from

country to country, lack of interconnection among networks and barriers to cross-border M&A activity

have put a brake on this aspiration, exacerbated by the difficult current economic environment.

Climate change energy policy – adds costs, jeopardises load factor of conventional plants

The impact of climate-change policy will continue to affect the utilities sector. The ‘20-20-20’ initiative

aims at a 20% reduction in carbon emissions versus 1990, and for 20% of energy needs in the EU to be

met by renewables by 2020. Regulated companies will potentially benefit from the need to build new grid

to connect renewable energy installations. Non-regulated companies will suffer as a result of the reduced

load factor from flexible conventional plants (CCGT, for the most part) caused by the construction of

renewable plant (wind, solar). There have been calls from within the industry for capacity payments to be

paid to generators for maintaining conventional flexible plant idle but available, as a means of

guaranteeing security of supply when renewable generation output fails (wind and hydro). The EU cap-

Verity Mitchell* Analyst HSBC Bank Plc +44 20 7991 6840 [email protected]


216


abc

and-trade system (EU-ETS) encourages companies to reduce emissions by requiring them to purchase carbon

certificates (essentially, permits to emit CO2 into the atmosphere). Under the current EU-ETS, generators

receive a varying amount of carbon certificates free of charge until the end of 2012. From 2013 most Western

European countries will have to purchase 100% of their requirements. Central and Eastern European (CEE)

countries will have to do likewise by 2020. The recessionary environment has caused demand for carbon

certificates to fall more sharply than assumed, as a result of which carbon prices have virtually collapsed.

Political risk: to remain a large cloud over the sector

Political risk has been a central theme for the sector in 2010 and 2011, depressing the share prices of the

large energy conglomerates in particular. It remains to the fore in 2012, and not only for non-regulated

companies. The sector is vulnerable to being targeted in the context of austerity measures (tax on

regulated distribution and transmission as well as attacks on carbon-free generation), to nuclear policy

after Fukushima (German closures, new French president wants to reduce his country’s nuclear

dependency), to rising costs of renewables, and to the need to resolve long-term structural problems

(Spanish tariff deficit). Only where there is an impending need for new plant (ie the UK), is political risk

absent. Political risk remains a major factor in Russia, too. Privatisation of the state-owned stakes in

Russian utilities is less likely today as the market valuations of the assets have decreased significantly.

The state has also announced plans to consolidate Federal Grid Company and MRSK Holding in order to

deal with multiple issues related to the implementation of RAB and financing of sizeable distribution

capex. Recent events show that the state will continue to control power tariffs and their growth is likely to

be moderate.

Too much new capacity, power market unlikely to tighten suddenly after 2013

The continental European sector suffers from over-capacity, with new plant, committed before the recessionary

environment became established, starting output in a market where demand is 10% smaller than was

anticipated when the investment decision was made. Even with the end of free carbon certificates in January

2013, we are pessimistic about the likelihood that a sudden rush of closures will create tighter markets and thus

higher spreads and prices. The EU and national governments are pushing hard for investment on the

transmission grid – closing bottlenecks and adding capacity – to cope with more volatile and erratic generation

as wind and solar capacity continue to grow, albeit less rapidly than before.

Gas market recovery

According to our estimates, almost one-quarter of sector EBITDA is made in gas. European gas demand has

suffered from uncompetitive pricing (gas import contracts are indexed mostly to oil) and lower carbon prices

(which penalise gas relative to coal in power generation), and the market is in over-supply. The extent of

growth outside Europe (China, Japan in particular) will influence the timing and extent of a tightening in the

market. Meanwhile, we expect a continuation of the process whereby gas import contracts are becoming less

indexed to (dearer) oil and more to (cheaper) spot gas, thereby eradicating a source of losses for the gas

suppliers. A return to wholesale gas profitability by late 2013 and expansion in LNG trading should offset low

earnings growth in upstream and end-user supply. Near term, the market will be watching to see if the utilities

can extract more flexibility from their suppliers in order to avoid wholesale losses in 2012.

217


abc

Growth segments… few easy pickings

A common theme amongst European utilities is to seek growth by re-deploying capital in non-EU

countries (typically Latin America followed by Russia, Turkey and Asia) and expanding in renewable-

based power generation on a global basis. Though growth opportunities undoubtedly exist, their

attractions can be limited by overcapacity (Turkey), government intervention (Russia), the willingness of

local government-owned operators to accept seemingly uneconomic returns (Brazil), and the sheer length

of the negotiating processes (MENA). In addition, the heavily-indebted balance sheets of the main sector

players imply that disposals will be required to fund expansion in growth markets.

Europe – water & waste

RAB-based valuation

For UK water companies, the RAB (regulated asset base) or RCV (regulatory capital value) is the asset

value (calculated by the regulator in every five-year period) on which companies earn a return based on

an approved WACC that is revised in every regulatory period. For equity investors, the RCV provides a

spot reference point as to whether the stock is trading at a premium or a discount, while stable regulated

returns provide visibility on dividends. Moreover, because of the regulated nature and high visibility of

returns, the proportion of debt to RCV tends to be high, in the range of 55% to 65%. The UK water

companies are allowed to increase their prices each year using the ‘RPI – x + K’ formula, where x

denotes the efficiency savings factor and K is the factor used to raise prices to cover the financing of new

capital expenditure and other expense items related to the improvement of its assets.

Global scarcity

For the French water companies, the scarcity of project finance and the austerity measures by many

governments led to fewer water treatment and desalination project awards over 2009-11. We believe

contracts will be awarded and growth will resume, especially in areas of acute water shortage – the

Middle East, Australia, China and some parts of the US.

Sector drivers Regulated stocks

Regulated network activities are remunerated through an approved return (WACC) on a RAB. Companies

may extract a return higher than the allowed/approved return through operational and/or financial

efficiencies. Thus, profits for regulated activities are a function of: (1) investment/RAB growth; (2) the

level of allowed returns/WACC; and (3) operational, financial efficiencies.

Unregulated stocks

Demand growth: Overall, energy demand is directly linked to the pace of economic growth,

industrial demand being more cyclical and residential demand being stable. Reduced demand caused

by the recession has been a drag on the waste management activities of the water companies.

Commodity prices and spreads: Economic recession results in lower power prices. These are

determined by: (i) the marginal generation fuel which is either gas or coal; plus (ii) the cost of carbon; plus

(iii) the spread (or profit margin), which is influenced by differences between the cost of coal and gas and

the tightness (or otherwise) of the market. In addition to engaging in downstream retail activities that act as

218


abc

a natural hedge to upstream generation, utilities typically sell power forward up to three years in advance

to mitigate the impact of commodity price volatility.

Net-back parity: The Russian government plans to achieve net-back parity (ie the fixed domestic gas

price matches the oil-linked gas export price) by the end of this decade, and for this the domestic cost

of gas will have to grow. This will squeeze the profitability margins of generation companies that use

Gazprom gas as a prime generation fuel.

Government intervention: Politically motivated measures, for instance to tax nuclear.

Valuation Valuation parameters

Regulated or midstream activities: For regulated stocks whose infrastructure/network assets produce

relatively stable returns, the preferred valuation techniques are: (1) DDM – higher dividend visibility

given stable regulated earnings and a defined dividend payout range; (2) DCF – the source of value is the

company’s ability to generate free cash flows and long-term growth; and (3) asset valuation – application

of a premium or discount to the RAB depending on the quality of assets.

Upstream activities: Power generation assets are typically valued by the DCF/MW of a particular

technology, with base-load technologies (renewables, hydro, nuclear and lignite) deserving a higher

valuation than the mid-merit to peaking technologies (coal, gas, oil-fired plant and pumped storage units).

Downstream activities: Retail activities are typically valued by ascribing a DCF/customer value to the

number of customers, with more value being assigned to customers with combined power and gas supply.

Key accounting metrics

Earnings metrics: As the favourite market multiplies are EV/EBITDA and PE, the focus is on arriving at

a recurring or EBITDA or EPS. Most utilities report a recurring operating metric that excludes one-off

items. Dividend, which is among the sector’s principal attractions, is often linked to recurring EPS. Given

investors’ preference for consistent dividends, most utilities try to maintain a stable growth rate in

dividends and offer visibility on payout (the typical range for large utilities is 50% to 60%).

European and Russian utilities: growth and profitability

2008 2009 2010 2011e 2012e

Growth Sales 22% 4% 8% 8% 3% EBITDA 12% 4% 8% 2% 2% EBIT 12% 4% 5% 0% 0% Net profits 6% -1% -1% -5% 0% Margins EBITDA 23% 24% 23% 23% 22% EBIT 17% 17% 16% 16% 16% Net profit 9% 11% 10% 10% 9% Productivity Capex/sales 16% 17% 15% 14% 16% Asset turnover (x) 0.47x 0.47x 0.49x 0.49x 0.49x Net debt/Equity 112% 144% 132% 100% 100% ROE 17% 17% 17% 14% 12%

Note: based on all HSBC European and Russia coverage Source: company reports, HSBC estimates

219


abc

Key sector stats

MSCI Europe Utilities Index 4.63% of MSCI Europe

Trading data 5yr ADTV (EURm) 2,062 Aggregated market cap (EURm) 343,430 Performance since 1 Jan 2000 Absolute -9% Relative to MSCI Europe 28% 3 largest stocks E.ON, National Grid, GDF Suez Correlation (5-year) with MSCI Europe 0.86 Source: MSCI, Thomson Reuters Datastream, Bloomberg, HSBC Top 10 stocks: MSCI Europe Utilities Index


1 EON AG 13.8%2 National Grid Plc 13.4%3 GDF Suez 10.4%4 Centrica Plc. 9.1%5 Enel Spa 7.5%6 SSE PLC. 7.3%7 RWE AG 7.1%8 Iberdrola SA 6.5%9 Fortum OYJ 3.0%10 United Utilities 2.6%

Source: MSCI, Thomson Reuters Datastream, HSBC Country breakdown: MSCI Europe Utilities Index

Country Weights (%)

UK 34.5 Germany 21.3 France 14.9 Italy 12.7 Spain 11.4 Finland 3.0 Portugal 1.3 Austria 0.6


GDP (EURbn) and per capita electricity consumption (kWh/EUR)

0500

10001500200025003000

Ger

man

y

Fran

ce UK

Italy

Spai

n

Belg

ium

Portu

gal

0.0

0.1

0.2

0.3

0.4

GDP (EURbn) - LHS Energy Intensity - RHS

Source: HSBC, Eurostat

PE band chart: MSCI Europe Utilities Index

0

50

100

150

200

250

300

Jan-

95

Jan-

97

Jan-

99

Jan-

01

Jan-

03

Jan-

05

Jan-

07

Jan-

09

Jan-

11

Actual 5x 10x 15x 20x


PB vs. ROE: MSCI Europe Utilities Index

1.0

1.5

2.0

2.5

3.0

3.5

Jan-

95

Jan-

97

Jan-

99

Jan-

01

Jan-

03

Jan-

05

Jan-

07

Jan-

09

Jan-

11

0%

5%

10%

15%

20%

PB (LHS) ROE (RHS)


Sector snapshot

220


abc

Notes

221


abc

EMEA countries

222


abc

Notes

223


abc

Egypt

Raj Sinha* Analyst, Head of MENA Research HSBC Bank Middle East Ltd. +971 4423 6923 [email protected]

Aybek Islamov* Analyst, banks HSBC Bank Middle East Ltd. +971 4423 6921 [email protected]

Patrick Gaffney* Analyst, real estate HSBC Bank Middle East Ltd. +971 4423 6930 [email protected]

Herve Drouet* Analyst, telecoms HSBC Bank plc +44 20 7991 6827 [email protected]

Sriharsha Pappu* Analyst, chemicals HSBC Bank Middle East Ltd. +971 4423 6924 [email protected]

Shirin Panicker* Analyst, banks HSBC Securities (Egypt) S.A.E. +202 2 5298439 [email protected]

John Lomax * Strategist HSBC Bank plc +44 20 7992 3712 [email protected]

Wietse Nijenhuis* Strategist HSBC Bank plc +44 20 7992 3680 [email protected]


224


abc

Introduction Before the revolution last year, Egypt was a long-standing favourite among international investors,

offering a combination of strong domestic macro conditions – although the strength of the components

varied – and well-managed companies. Over the past ten years, Egypt has, overall, strongly outperformed

the aggregate emerging markets index. Through 2011, the Egyptian equity market fell sharply as a result

of political developments associated with the Arab Spring. However, this year the market has recovered

well, which was partly because of some specific, bottom-up improvements and partly the result of the

successful early-stage political transition.

Along with Morocco, Egypt is one of only two MENA markets in the MSCI Emerging Markets index,

representing 0.3% of the index (and 1.6% in the MSCI EM EMEA index). The market is therefore a good

way to play certain MENA themes. Morocco has been placed on the review list for a potential downgrade

by MSCI to Frontier Market status, meaning Egypt could become the sole MENA market in the MSCI

EM index.

Market structure The MSCI Egyptian equity index is heavily concentrated on a small number of materials, telecom and

financial names – the largest five stocks by market cap account for 75% of index representation. For

many investors therefore, stock selection has been as important as the assessment of top-down conditions.

Equity index performance in Egypt Major stocks in MSCI Egypt index*

0

500

1000

1500

2000

2500

96 98 00 02 04 06 08 10 12

0

200

400

600

800

1000

1200

MSCI Egy pt price index (in Loc al currency )Hermes financ ial price index (in Loc al currency , RHS)

Rank Stock Name Weight (%)

1 Orascom Construction Industries 33.02 Commercial International Bank (Egypt) 18.83 Orascom Telecom Holding 10.54 Egyptian Company for Mobile Services (Mobinil) 7.75 Egyptian Kuwaiti Holding 5.71-5 75.76 Telecom Egypt 5.67 EFG Hermes Holding. 5.28 Talaat Moustafa Group Holding 5.09 Orascom Telecom and Media Companies 4.610 National Societe Generale Bank (NSGB) 3.96-10 24.3

*Data as at 22 May 2012 Source: MSCI, Thomson Reuters Datastream, HSBC

Source: MSCI, Hermes, Thomson Reuters Datastream, HSBC




225


abc

Liquidity (6M ADTV) of equity indices in Egypt Sector composition of MSCI Egypt index*

0

50

100

150

200

250

07 08 09 10 11 12

Egy pt financial Hermes Index 6M ADTV (USD m)

Sector Weight (%)

Financials 38.6 Industrials 33.0 Telecommunication Services 28.4 Total 100.0

Note: * data as at 22 May 2012. Source: MSCI, Thomson Reuters Datastream, HSBC

Source: Hermes Index, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC

The Egyptian market is one of the more liquid in the MENA region, usually trading above USD100m a

day, although this has dropped off since 2011, as local and regional political developments have resulted

in foreign investors taking a step back from the market. However, we expect liquidity to pick up again

once the political landscape becomes clearer.

Earnings and valuation Earnings growth was very strong between 2002 and 2007, before dropping sharply during the financial

crisis in 2009. In 2011, earnings growth recovered strongly, having come from a very low base. Egyptian

earnings are now growing well below trend.

The earnings outlook is given some protection by the fact that the MSCI Egyptian index is to some extent

skewed towards multinational companies with a significant non-Egyptian exposure – this also means that

a proportion of earnings are disconnected from ongoing Egyptian economic disruption.

In terms of valuations, the Egyptian market has been among the cheaper markets in the EM universe since

the financial crisis. While on a macro level growth held up well through 2008-09, earnings of Egyptian

corporates are rather more cyclical, so between May 2008 and February 2009 the MSCI Egypt fell c71%

in US dollar terms compared with a drop of c54% in the broader EM index. The discount relative to EM

has held ever since. The reason is fairly straightforward and it boils down to political risk – investors fear

that this will prevent a cyclical upswing from occurring for some considerable time. As part and parcel of

this, perceived currency risk is an additional market obstacle. Equally, there are some legal uncertainties,

which also have political roots. If the current political timelines are adhered to and political stability can

be restored, there is scope for the economic cycle to stabilise gradually, which, in turn, would allow

earnings to recover.

226


abc

Actual, trend and forecast earnings of MSCI Egypt index Annual growth in earnings: MSCI Egypt index

1.0

1.5

2.0

2.5

3.0

00 02 04 06 08 10 12 14

12M trail Trend I/B/E/S fcast

Log (EPS in Egy ptian Pound)

e e

-50%

0%

50%

100%

150%

2001 2003 2005 2007 2009 2011

MSCI Egy pt EPS grow th

Source: MSCI, IBES, Thomson Reuters Datastream, HSBC estimates Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

Earnings momentum* versus returns: MSCI Egypt index Earnings growth* versus returns: MSCI Egypt index

-100%

-50%

0%

50%

100%

150%

200%

96 98 00 02 04 06 08 10 12

-100%

0%

100%

200%

300%

MSCI Egypt earnings momentumMSCI Egypt y -o-y returns (R HS)

-40%

-20%

0%

20%

40%

60%

96 98 00 02 04 06 08 10 12

-100%

0%

100%

200%

300%

MSCI Egypt earnings grow thMSCI Egypt y -o-y re turns (R HS)

Note: *Earnings momentum is defined as the 6-month % change in 12M-forward EPS forecast. Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

Note: *Forecast growth in 12M-forward earnings. Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

Earnings revisions* versus returns: MSCI Egypt index IBES Consensus recommendation score*: MSCI Egypt index

0%

10%

20%

30%

40%

50%

60%

70%

96 98 00 02 04 06 08 10 12

-100%

0%

100%

200%

300%

MSCI Egypt earnings rev isionMSCI Egypt y -o-y returns (R HS)

1.0

1.5

2.0

2.5

3.0

01 02 03 04 05 06 07 08 09 10 11 12

Score Mean ± 2Stdev

Bearis h

Bullis h

*Number of 12M-forward EPS estimates up over the last month as a % of total number of revisions in estimates over the corresponding period. Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

*Represents the market cap weighted aggregated score of the IBES consensus recommendation of all the constituents. Score should be interpreted as follows – 1.00 to 1.49: Strong Buy; 1.50 to 2.49: Buy; 2.50 to 3.49: Hold; 3.50 to 4.49: Underperform; 4.50 to 5.00: Sell Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

227


abc

Fund flows International funds flows into Egypt have been persistently weak since the revolution, given the political

uncertainties referred to above. The typical global emerging markets fund is now significantly

underweight Egyptian equities. This represents a sharp difference from historical experience, since, in the

pre-revolution period, Egypt was often highly regarded by international investors and it was frequently

heavily overweighted in international portfolios.

MSCI Egypt index: 12M-forward PE scenarios* Earnings yield versus bond yield* in Egypt

5x

10x

15x

20x

25x

0

1000

2000

3000

4000

5000

01 02 03 04 05 06 07 08 09 10 11 12

MSCI Egy pt Price Index

0%

5%

10%

15%

20%

05 06 07 08 09 10 11 12

Redemption y ield on BoFA ML Egy pt Sov ereign (USD)12M -forward earnings y ield of MSCI Egy pt

*Based on five scenarios of 12M-forward PE multiple(5x, 10x, 15x, 20x and 25x) Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

Note: *Earnings yield is calculated as the reciprocal of the 12M-forward PE ratio of the MSCI index and the bond yield is the yield-to-redemption of the BofA ML Egypt Sovereign (USD) index.

Source: MSCI, IBES, BofA ML, Thomson Reuters Datastream, HSBC

12M-forward PB versus RoE: MSCI Egypt index 12M-forward PE ratio of MSCI Egypt relative to MSCI EM

0.0

1.0

2.0

3.0

4.0

5.0

6.0

05 06 07 08 09 10 11 12

0%

10%

20%

30%

40%

MSCI Egy pt 12M -forward price to book ratioMSCI Egy pt 12M -forward RoE (RHS)

0.0x

5.0x

10.0x

15.0x

20.0x

01 03 05 07 09 11

0.0x

0.5x

1.0x

1.5x

2.0x

MSCI Egy pt 12M-forward PE ratiorel. to MSCI EM (RHS)

Source: MSCI, IBES, Thomson Reuters Datastream, HSBC Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

228


abc

Flows (% of AuM) into Egypt dedicated funds Weight of Egypt in GEM funds versus benchmark

-40%

-30%

-20%

-10%

0%

10%

20%

00 01 02 03 04 05 06 07 08 09 10 11 12

Egy pt Fund flows as % of assets under management

0%

1%

2%

3%

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Weight (%) in GEM Equity FundsWeight (%) in MSCI EM index

Source: EPFR Global, HSBC Source: MSCI, EPFR Global, HSBC

Economic basics Egypt is the largest MENA market in terms of population (80 million), and the third-largest economy in the

region (after Saudi Arabia and the UAE). However, with a GDP per capita of around USD2,700 in 2011, it is

also among the poorest.

Economic drivers for Egypt are diverse: on the external side, tourism, Suez revenues and FDI are all key.

Egypt also exports around USD25bn worth of goods a year, around half of which are energy

commodities. Domestically, Egypt is a classic emerging market story, with strong demographics, low

debt levels and a growing middle class. Before the revolution, Egypt also had a strongly pro-market

policy stance. However, the policy environment is more uncertain now. A successful political transition –

if and when it materialises – should reinforce most characteristics of the long-term growth prospects,

while removing the succession risk which had been a major investor concern before the revolution.

Economic policy primer The establishment of the Ahmed Nazif government in 2004 brought in an era of pro-market reforms,

including privatisation, tax cuts and other incentives for foreign investment. However, progress in the

reformist period was disrupted by the global financial crisis. Moreover, there has been little emphasis on

the need to reduce Egypt’s public sector and generous subsidy spending, due to the political risk

associated with these kinds of reforms.

From a monetary perspective, the Central Bank is thought to target a core inflation rate of 6-8%, although

inflation has rarely remained in this bracket for long.

Since the revolution, there has been extreme uncertainty, not only on the policies of the new parties in

power, but even on the identity of future policymakers. With no constitution in place, and parliament

having been dissolved, there was, at the time of writing, no way of discerning an economic policy

framework.

Political structure Egypt is currently undergoing a period of deep political transition. Inspired by events in Tunisia, Egyptian

youth and opposition groups organised mass protests over the course of many weeks, eventually

229


abc

compelling President Hosni Mubarak to resign in February 2011 after 30 years as president. The military

took control via the Supreme Council of the Armed Forces (SCAF). Under the new regulations of the

March 2011 referendum, the president is limited to two four-year terms. After several delays, presidential

elections were held in June 2012 which led to a victory for Muslim Brotherhood candidate, Mohammed

Morsy, over Ahmed Shafiq, a long-serving member of the former regime. This marks a significant step

forward in Egypt’s political transition. However, at the time of writing there is no clarity on what

authority the new president will enjoy or what goals he will pursue, and no sense that the power struggle

between the Islamist movement and the military is over. These will be key issues for equity investors to

watch in the medium term.

Key regulatory bodies Central bank: responsible for monetary policy and supervising the banking system.

Financial Supervisory Authority: responsible for supervising non-bank financial markers including

capital markets.

The Egyptian Exchange (EGX): comprises two exchanges, Cairo and Alexandria, which are governed by

the same board of directors and share the same trading, clearing and settlement systems. EGX was

formerly known as the CASE (Cairo and Alexandria Stock Exchange).

230


abc

Notes

231


abc

Russia

Vladimir Zhukov* Head of Equity Research (Russia) OOO HSBC Bank (RR) Ltd +7 495 7838316 [email protected]

Dmytro Konovalov* Analyst, utilities OOO HSBC Bank (RR) Ltd +7 495 2583152 [email protected]

Ildar Khaziev* Analyst, oil & gas OOO HSBC Bank (RR) Ltd +7 495 645 4549 [email protected]

Anisa Redman Analyst, oil & gas HSBC Securities (USA) Inc. +1 212 525 4917 [email protected]

Gyorgy Olah* Analyst, banks HSBC Bank plc +44 20 7991 6709 [email protected]




232


abc

Introduction Russia has a relatively young stock market. It was created in the early 1990s as a result of the country’s

major transformation into a market economy, which entailed a mass privatisation of industrial companies.

The Russian stock market is dominated by natural resource extraction industries, which account for

almost 70% of the MSCI Russia index. Russia has been one of the top-performing emerging stock

markets in the past 10 years owing to the rising prices of oil and other commodities. In the medium term,

the government is planning to privatise its remaining interests in the oil & gas, utilities and commercial

banking sectors, which should give a boost to the domestic stock market. The downside risk for the oil &

gas sector, apart from global macro conditions, relates to the government’s long-term goal of making the

economy less dependent on natural resources, which entails the re-distribution of oil & gas revenues to

fund growth in other industrial sectors and investments in the public economy.

Market structure Historically, Russia had two main stock exchanges: the MICEX (Moscow International Currency

Exchange), which was set up in 1992 for currency and government bond trading, and the RTS (Russian

Trading System), which was set up in 1995 to trade stocks. In 2011, the two exchanges merged into the

OJSC MICEX-RTS, which has become the prime Russian exchange for almost all traded instruments,

including stocks, bonds, futures and forwards, commodities, currencies and money market instruments.

Most of the Russian stocks are traded on the main market section of the MICEX-RTS, which accounts for

over the 80% of stock turnover and almost 100% of bond turnover. MICEX-RTS is one of the Top 20

global exchanges by aggregate capitalisation value of all traded stocks. In 2011, the combined traded

volume exceeded USD10trn, with six-month average daily trading volumes of around USD2bn.

The energy sector accounts for 58.2% of the MSCI Russia with Gazprom representing approximately

25% and Lukoil another 14%. Second largest is the financial sector with a 15.4% weight, and Sberbank

accounting for 11.6%. In other industries the companies with significant weights in the index are Uralkali

(4.9%), MTS (4.3%), Norilsk Nickel (3.9%) and Magnit (3.5%).

Equity index performance in Russia Major stocks in MSCI Russia index*

0200400600800

10001200140016001800

96 98 00 02 04 06 08 10 12

0

500

1000

1500

2000

2500

3000

MSCI Russia price index (in Local currency)

Russia RTS price index (in Local currency, RHS)

Rank Stock name Weight (%)

1 Gazprom Oao 24.82 Oil Company Lukoil Jsc. 13.73 Sberbank Of Russia Spn. 11.64 Rosneft Oil Ojsc 5.15 Uralkali Ojsc 4.91- 5 60.16 Novatek Oao 4.97 Mobile Telesystems Ojsc 4.38 Ojsc Mmc Norilsk Nickel 3.99 Oao Tatneft 3.710 Magnit Open Jsc. 3.56-10 20.2Note: * data as at 22 May 2012 Source: MSCI, Thomson Reuters Datastream, HSBC


Dmytro Konovalov* Analyst OOO HSBC Bank (RR) Ltd +7 495 2583152 [email protected]

Vladimir Zhukov* Analyst OOO HSBC Bank (RR) Ltd +7 495 783 8316 [email protected]


233


abc

Liquidity (6M ADTV) of equity indices in Russia Sector composition of MSCI Russia index*

0

500

1000

1500

2000

2500

3000

07 08 09 10 11 12

Russia MIC EX Index 6M ADTV (USD m)

Sector Weight (%)

Energy 58.2 Financials 15.4 Materials 11.1 Telecommunication Services 8.0 Utilities 3.9 Consumer Staples 3.5

Total 100.0

Note: * data as at 22 May 2012 Source: MSCI, Thomson Reuters Datastream, HSBC

Source: MICEX, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC

Earnings and valuation Russia stands out among emerging markets in terms of its valuation characteristics, as well as its

liquidity. Valuation by itself is not enough in Russia – it provides little protection on the downside, but

can create a lot of leverage on the upside. As the Russian stock market is heavily dominated by resource

stocks, it functions primarily as a straight play on the global commodities cycle. Therefore, country-

specific factors may not play as much of a role as fluctuations in investors’ risk appetite. Russian stocks

are normally high beta relative to their developed market peers. Russian stocks are sold off more heavily

when the global macro situation deteriorates, as investors reduce their exposure to what they consider to

be riskier assets, but they become a preferred investment choice in a strong macro environment, which

triggers the return of risk appetite to emerging markets.

Since 2000, earnings in Russia have followed a growth trend, with some fluctuations during major global

economic downturns. Consensus recommendations for Russian stocks have been bullish most of the time

since 2008. However, Russia has been increasingly de-rated relative to global EM, with the discount of

the MSCI Russia forward consensus PE to the MSCI EM increasing from zero in 2006-07 to almost 50%

by 2012. As the Russia MSCI index is heavily dominated by oil & gas stocks, we attribute the market

discount to the weak earnings growth outlook for this sector. Growth will weaken due to a number of

factors, including stagnation of oil output, increasing capex requirements and an increasing tax burden.

As most of these factors will persist for some time, we therefore believe that, as a market, Russia may

continue to look relatively cheap. However, we also believe that Russia offers the best exposure to any

global economic turnaround, as it has the highest operating leverage to oil and other commodity prices.

234


abc

Actual, trend and forecast earnings of MSCI Russia index Annual growth in earnings: MSCI Russia index

0.0

0.5

1.0

1.5

2.0

2.5

3.0

98 00 02 04 06 08 10 12 14


ee

Log (EPS in USD)

-40%

-20%

0%

20%

40%

60%

80%

2005 2006 2007 2008 2009 2010 2011 2012e2013e

MSCI Russia EPS growth


Earnings momentum* versus returns: MSCI Russia index IBES consensus recommendation score*: MSCI Russia index

-100%

-50%

0%

50%

100%

96 98 00 02 04 06 08 10 12

-100%

0%

100%

200%

300%

400%

MSCI Russia earnings momentum

MSCI Russia y-o-y returns (RHS)

1.5

2.0

2.5

3.0

01 02 03 04 05 06 07 08 09 10 11 12


Bearish

Bullish

Note: *Earnings momentum is defined as the 6-month % change in 12 month forward EPS forecasts. Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

Note: *represents the market cap weighted aggregate score of the IBES consensus recommendations for all the constituents. Scores should be interpreted as follows – 1.00 to 1.49: Strong Buy; 1.50 to 2.49: Buy; 2.50 to 3.49: Hold; 3.50 to 4.49: Underperform; 4.50 to 5.00: Sell Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

Earnings growth* versus returns: MSCI Russia index Earnings revisions* versus returns: MSCI Russia index

-40%

-20%

0%

20%

40%

60%

80%

100%

96 98 00 02 04 06 08 10 12

-100%

0%

100%

200%

300%

400%

MSCI Russia earnings growth


0%

20%

40%

60%

80%

100%

96 98 00 02 04 06 08 10 12

-100%

0%

100%

200%

300%

400%

MSCI Russia earnings revision


Note: *Forecast growth in 12m-forward earnings Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

Note:- *Number of upward 12m-forward EPS estimate revisions over the last month as a % of the total number of revisions Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

235


abc

Fund flows In the last decade, Russia has seen a substantial amount of foreign investment. However, since the end of

2008, Russia’s relative weighting in GEM funds has fallen from 12% to approximately 7% (June 2012).

The fund outflow which took place in 2011 was to a great extent driven by the rising global macro

uncertainty, related to the crisis in the eurozone and concerns over the potential slowdown in Chinese

economic growth. Although we believe that political uncertainty related to the 2011 parliamentary and

2012 presidential elections, and public protests which broke out towards the end of 2011, contributed to

the fund outflow, we believe the country-specific factors to be of less importance than the global macro

conditions. Indeed, with both presidential and parliamentary elections behind us, we believe that any

inflow of funds into EM and Russian equities is conditional on improvement in the global macro

environment, especially a resolution of the situation in Europe, continuation of high economic growth

rates in China and resumption of economic growth in the US.

MSCI Russia index: 12M-forward PE scenarios* Earnings yield versus bond yield* in Russia

5x

10x

15x

20x

25x

0

1000

2000

3000

4000

5000

01 02 03 04 05 06 07 08 09 10 11 12

MSCI Russia Price Index

5%10%

15%20%

25%

30%

35%40%

05 06 07 08 09 10 11 12

Russ ia 10Y nominal par yield on Gov t. securities12M -forw ard earnings y ield of M SCI Russia

Note: *based on five scenarios of 12M-forward PE multiples (5x, 10x, 15x, 20x and 25x) Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

Note: * earnings yield is calculated as the reciprocal of the 12M-forward PE ratio of the MSCI index and the bond yield is the 10Y nominal par yield on Govt. Bonds. Source: MSCI, IBES, Oxford Economics, Thomson Reuters Datastream, HSBC

12M-forward PB versus RoE: MSCI Russia index 12M-forward PE ratio of MSCI Russia relative to MSCI EM

0.50.70.91.11.31.51.71.9

05 06 07 08 09 10 11 12

10%

12%

14%

16%

18%

20%

22%

MSCI Russia 12M -forward price to book ratioMSCI Russia 12M -forward RoE (RHS)

0.0x

5.0x

10.0x

15.0x

01 03 05 07 09 11

0.2x

0.4x

0.6x

0.8x

1.0x

1.2x

MSCI Russia 12M-forward Price/Earnings ratiorel. to MSCI EM (RHS)

0.0x

5.0x

10.0x

15.0x

01 03 05 07 09 11

0.2x

0.4x

0.6x

0.8x

1.0x

1.2x

MSCI Russia 12M-forward Price/Earnings ratiorel. to MSCI EM (RHS)


236


abc

Economic basics Russia is the ninth-largest economy in the world, with GDP of USD1,850bn in 2011, and the sixth-largest

if measured by purchasing power parity, according to the IMF. On its income per capita basis Russia falls

into the UN’s middle-income category, but it has the highest GDP per capita growth rates among the

BRIC countries.

Russia is an open economy, with exports and imports exceeding 50% of GDP. Consumption (government

plus households) made up two-thirds of Russia’s GDP in 2011, with investment accounting for one

quarter of GDP. The service and goods production sectors contribute almost equal proportions of GDP.

The Russian economy is highly dependant on the global economic cycle, and on commodity markets,

through the export revenues it derives from natural resources (primarily oil & gas) and the associated

taxation. According to HSBC’s economics team, an annual growth rate of above 3% is unsustainable in

the medium term without support from external demand (ie a high oil price), even though economic

growth currently has significant support from domestic consumption.

Russia is the 6th largest economy in the world (PPP basis) High sensitivity to oil (Urals) price

0

5

10

15

20

US

Chi

na

Indi

a

Japa

n

Ger

man

y

Rus

sia

Braz

il

UK

Fran

ce

Italy

Cur

rent

inte

rnat

iona

l dol

lar

(trln

)

GDP (PPP, 2011)

-12-8-4048

12

1Q 2

005

1Q 2

006

1Q 2

007

1Q 2

008

1Q 2

009

1Q 2

010

1Q 2

011

1Q 2

012

%, y

-o-y

-90-60-300306090

%, y

-o-y

GDP (LHS) Urals (RHS)

Note: GDP based on purchasing power parity (PPP) Source: IMF, HSBC

Source: Rosstat, HSBC

Economic policy primer The Central Bank of Russia (CBR) supervises exchange rate stability. The RUB exchange rate is floating

within the corridor set by the CBR against the USD-EUR basket. The CBR uses FX intervention to keep

the RUB within the corridor.

Russia’s medium-term monetary policy is jointly developed by the CBR and the government for a three-

year period and published by the CBR. According to the latest policy, for the 2012-14 period, the CBR is

planning to develop inflation targets based on a target growth range for the consumer price index. The

current target is to keep headline inflation (Dec/Dec) between 6% and 7% in 2012 and to reduce it to 4-

5% in 2014. The CBR also aims to maintain a flexible exchange rate, limiting its FX intervention to

smoothing out RUB volatility, but also aiming to gradually reduce such intervention.

The Russian budget and GDP growth rates are highly sensitive to the oil price. Assuming an oil price of

around USD100/bbl, the government is expecting the country to maintain an annual GDP growth rate of

around 3-4% during 2012-14 with the budget deficit not exceeding 1.5-1.6%. Russia has over USD500bn

237


abc

in currency and gold reserves, which it uses to mitigate fluctuations in the local currency as well as to

fund any shortfalls in the government spending budget when government revenues fall on the back of

lower commodity prices. A long-term economic strategy, “Strategy 2020”, has been discussed by the

government; if implemented, it would shift the focus of the economy from natural resources to more

innovative industries and thus change the GDP structure and drivers.

Political structure The Russian Federation is a federal presidential republic with the executive power split between the

president and the prime minister. The Russian parliament has two houses: the State Duma (450 deputies),

being the lower house, and the Federation Council (178 senators), being the upper house. The Duma

deputies are elected at general public elections for a five-year term. The Duma elections are only open to

political parties registered with the Ministry of Justice. The parties have to pass a threshold of 7% of total

votes to get Duma seats. The Federation Council is comprised of representatives of all regions that are

legal subjects of the Russian Federation. There are two representatives for each region, one appointed by

its executive branch and the other by the legislative branch.

Vladimir Putin was elected the President of Russia on 4 March 2012 for a six-year term. The previous

president, Dmitry Medvedev was appointed prime minister. Elections to the State Duma were held on 4

December 2011, with the pro-government United Russia party taking the majority (53%) of seats in the

new Duma; (the Chairman of United Russia is currently the Russian Prime Minister, Mr Medvedev, who

replaced Mr Putin in that capacity after the latter was elected as the Russian President). The other Duma

parties are the Communists (20% of seats), Fair Russia (14%) and the Liberal Democrats (12%).

Following the liberalisation of the political legislation in 2012, the requirements for registering political

parties in Russia have been dramatically loosened, which should open up the way for more opposition

parties to take part in elections.

Key regulatory bodies Central Bank of Russia: responsible for monetary policy and supervising the banking system.

Federal Service of Financial Markets: responsible for supervising non-banks and non-auditors, as well

as capital markets, including brokers and stock exchanges.

Federal Tariff Service: the federal agency responsible for setting the tariffs for natural monopolies,

including utilities, gas and railroad transportation.

MICEX-RTS Stock Exchange: the largest stock exchange in Russia responsible for the introduction of

listing requirements for domestic issuers.

238


abc

Notes

239


abc

Saudi Arabia

Raj Sinha* Analyst, Head of MENA Research HSBC Bank Middle East Ltd +971 4423 6923 [email protected]

John Tottie* Analyst, industrials, natural resources, and energy HSBC Saudi Arabia Ltd +966 1 299 2101 [email protected]

Aybek Islamov* Analyst, banks HSBC Bank Middle East Ltd +971 4423 6921 [email protected]

Patrick Gaffney* Analyst, real estate HSBC Bank Middle East Ltd +971 4423 6930 [email protected]

Sriharsha Pappu, CFA* Head of Chemicals Equity Research, Asia and CEEMA HSBC Bank Middle East +971 4423 6924 [email protected]





240


abc

Introduction The Saudi equity market has performed strongly over the last 10 years. The main index, the Tadawul All-

Share Index (TASI), has returned a healthy 196%, buoyed by rising oil prices and GDP growth that has

averaged 3.7% per annum. However, the volatility has been significant in a market with over 90% of

trading volumes accounted for by Saudi retail investors. The TASI returned a 720% from early 2002 to

February 2006, but investors who bought at the peak in February 2006 have lost 64%, even though the

market has returned 65% since early 2009. The market has been open for investment since 2007 for

citizens of the nations within the Gulf Co-operation Council (which also includes the UAE, Kuwait,

Qatar, Bahrain and Oman). Since 2008, non-GCC investors have been able to access the market via swap

agreements.

The Saudi equity market tends to trade at a premium to the MSCI emerging markets index, reflecting its

vast hydrocarbon wealth and one of the most attractive demographic profiles globally, including a very

young population and a labour force growing at nearly 3% per annum. The Saudi bourse, the largest in

the Middle East, is open for trading between 11.00am and 3.30pm Saturday to Wednesday.

Market structure 152 stocks are listed on the Tadawul exchange. SABIC and Al Rajhi both account for more than 10% of

the Tadawul All Share Index, with the top 5 names representing one-third of the market. The top 10

names account for 46% of the index, and have an average free float of about 30%. This means that the

Saudi market is more diversified than most other regional exchanges but it is still is fairly concentrated by

developed-market standards. Financials accounts for 37% of the market, followed by a 34% weight for

materials, which includes petrochemical companies. Sector selection is therefore very important.

Equity index performance in Saudi Arabia Major stocks in Tadawul All Share Index

0

5000

10000

15000

20000

25000

99 00 01 02 03 04 05 06 07 08 09 10 11 12

0

1000

2000

3000

4000

5000

6000

TADAWUL All Share Index (Local currency)

TADAWUL All Share Index (USD, RHS)

Rank Stock name Weight (%)

1 SABIC 10.9 2 Al Rajhi Bank 10.3 3 Etihad Etisalat Co. 4.8 4 Samba Financial Group 3.8 5 Riyad Bank 3.0 1- 5 32.8 6 National Industrialization Co. 2.9 7 Saudi Arabia Fertilizer Co. 2.8 8 Banque Saudi Fransi 2.5 9 Alinma Bank 2.4 10 Saudi Telecom Co. 2.3 6-10 12.9

Source: MSCI, Thomson Reuters Datastream, HSBC Source: Tadawul, Thomson Reuters Datastream, HSBC

The Saudi equity market is one of the most heavily traded in the emerging markets space, with average

daily turnover at USD1.2bn in 2011 and USD2.7bn in the year to June 2012. At times, the market

turnover has been higher than the combined turnover in all other CEEMEA equity markets, even though

volumes are still far below the market peak in 2005/06. The ratio of market capitalisation to GDP, at

about 80%, is high by emerging-market standards.

John Tottie* Analyst HSBC Saudi Arabia Limited +966 1 299 2101 [email protected]


241


abc

Liquidity (6M ADTV) of Tadawul All Share Index Sector composition of Tadawul All Share Index

0

1000

2000

3000

4000

5000

07 08 09 10 11 12

Tadaw ul Index 6M ADTV (USDm)

Sector Weight (%)

Financials 37.2 Materials 34.4 Industrials 9.1 Telecommunication Services 8.3 Consumer Staples 5.2 Utilities 2.0 Consumer Discretionary 1.7 Energy 1.5 Health Care 0.5 Total 100.0

Source: Tadawul, MSCI, Thomson Reuters Datastream, HSBC

Source: Tadawul, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC

The Saudi market has exhibited a low correlation to global equity benchmarks, partly because the market

is currently closed for direct foreign investment. Non-GCC parties can only invest in Saudi equities

through swap contracts and via a limited selection of exchange traded funds. Several local Saudi

brokerage firms offer swap contracts to international investors. These contracts enable the investor to

obtain economic exposure while the legal ownership remains with a Saudi-registered entity.

In April 2012, the chairman of the Saudi Capital Market Authority, Abdulrahman al-Tuwaijri, was quoted

in the news media (Reuters, 3 April 2012), indicating that Saudi Arabia would open its stock market in a

"gradual" manner to protect the bourse's stability. We believe this may happen in 2013. Also in April, the

Saudi stock exchange announced that it had signed an agreement with Morgan Stanley Capital

International (MSCI) to create and issue indices based on the Saudi equity market.

If Saudi opens its market to direct foreign investment, it may potentially be included in the MSCI

Emerging Markets index. The high turnover of the Saudi market suggests that it could be a key

constituent of this key benchmark. Inclusion in the MSCI EM (or even Frontiers EM) index, were it to

happen, could be important for at least two reasons: first, it should allow Saudi to tap the broad

international pool of EM liquidity; second, it has the potential to stimulate more efficient behaviour from

Saudi equities, allowing them to better reflect market fundamentals.

Earnings and valuation TASI earnings growth failed to break the 10% threshold in both 2010 and 2011. In contrast, oil prices

registered gains of over 20% in both years. Bloomberg indicates that analysts forecast earnings to

increase 18% in 2012 and 14% in 2013, even though most analysts expect oil prices to be range-bound

between USD100 and USD120 per barrel.

The disconnect between corporate earnings and oil prices may appear paradoxical as Saudi Arabia is the

world's largest oil exporter. However, with Saudi Aramco, the national oil company, having full control

and ownership of all oil upstream activities (with the minor exception of those in the Neutral Zone), this

means that oil prices only have an indirect impact on earnings.

The Saudi chemical sector has exposure to oil prices, as chemical prices tend to be set by higher-cost

chemical producers that use oil-based feedstock. This link can, however, be tenuous because many other

242


abc

variables impact the sector. Many large private sector projects have experienced delays partly because the

government has become more selective in allocating new gas feedstock.

Oil revenues should also trickle down to corporate revenues through government spending. Indeed, the

new era of high oil prices has translated to unprecedented initiatives by policymakers to make large

investments in construction and infrastructure projects. However, capacity constraints have presented a key

bottleneck: cement is still in short supply, for example, even though capacity has been doubled over the

last five years. Moreover, the government's ability to fund projects directly has resulted in the commercial

banking sector being bypassed, although we are now seeing clear signs that loan growth is recovering.

Saudi Arabia's heavy reliance on expatriate labour has translated into the Kingdom becoming the world’s

second-largest source of remittances, after the United States, with income equivalent to about 25% of

private consumption in the Kingdom being sent abroad.

Perhaps the most obvious effect that rising hydrocarbon income has had on the listed Saudi equity

universe has been through government social spending programmes and other initiatives to boost

consumer disposable income. These include the award of the equivalent of two additional months’ salary

to government workers in 2011, an initiative that many private-sector employers felt compelled to match.

Moreover, very high oil prices combined with near-record Saudi oil production has translated to a very

strong government balance sheet, with a positive knock-on effect on valuations.

Since mid-2009, the Saudi market has tended to trade at a forward earnings premium of approximately

5% to 20% to the MSCI emerging markets index, to reflect, not just its vast hydrocarbon wealth, but also

a very attractive demographic profile, with a young and growing population. At the time of writing, the

Bloomberg consensus has the Saudi market at 11.8x forecast 2012 earnings. In absolute terms, this is

close to the average level over the last four years. However, it represents a relatively high 25% premium

to the consensus MSCI EM forward earnings forecast, following a very strong relative performance by

the Saudi market over the last year. The Saudi market has outperformed the MSCI EM index by about

30% since the European debt crisis intensified in July 2011. At the market peak in early 2006, with a

market capitalisation of the TASI near USD800bn, the Saudi market traded at a valuation exceeding 40x

forward earnings. At the trough in early 2009, the TASI traded at a price multiple of forward earnings as

low as 7x. Over the last three years, the Saudi market has tended to trade between 11x and 14x earnings.

243


abc

Actual and forecast earnings of Tadawul All Share Index Annual growth in earnings*: Tadawul All Share Index

200

300

400

500

600

700

08 09 10 11 12

12M-trailing EPS 12M-forw ard EPS

0%

10%

20%

30%

40%

50%

2006 2007 2008 2009 2010 2011

Earnings grow th

Source: Tadawul, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC * Calculated as growth in the 12M-trailing earnings at the end of each year Source: Tadawul, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC

Earnings growth* versus returns: Tadawul All Share Index Price/sales ratio of Tadawul All Share Index

0%

10%

20%

30%

40%

50%

60%

07 08 09 10 11 12

-80%

-40%

0%

40%

80%

12M-forw ard earnings grow th (LHS)y -o-y returns (RHS)

1.0x

2.0x

3.0x

4.0x

5.0x

6.0x

08 09 10 11 12

12M trailing 12M forward

*Forecast growth in 12M-forward earnings Source: Tadawul, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC

Source Tadawul,: Bloomberg Finance LP, Thomson Reuters Datastream, HSBC

Dividend yield of Tadawul All Share Index Price/book of Tadawul All Share Index

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

08 09 10 11 12


1.0x

1.5x

2.0x

2.5x

3.0x

3.5x

4.0x

08 09 10 11 12


Source: Tadawul, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC Source: Tadawul, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC

244


abc

Tadawul All Share Index: 12M-forward PE scenarios* 12M-forward PE ratio of Tadawul All Share Index relative to MSCI EM

5x

10x

15x

20x

25x

0

5000

10000

15000

20000

08 09 10 11 12

TADAWUL Al l Share Index

6.0x

11.0x

16.0x

21.0x

26.0x

07 08 09 10 11 12

0.8x

1.0x

1.2x

1.4x

1.6x

Saudi Arabia rel. to MSC I EM (RHS)

*Based on five scenarios of 12 month forward P/E multiple(5x, 10x, 15x, 20x and 25x) Source: Tadawul, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC Bloomberg Finance LP, Thomson Reuters Datastream, HSBC

Source: MSCI, Tadawul, Bloomberg Finance LP, Thomson Reuters Datastream, HSBC Bloomberg Finance LP, Thomson Reuters Datastream, HSBC

Fund flows As noted above, the Saudi market is currently only open for foreign investment via swap contracts and a

limited selection of other products. There is, therefore, a very limited inflow of funds from non-GCC

investors. Since April 2009, swap agreements to buy Saudi securities have totalled SAR40.7bn. Against

SAR35.9bn in swap sell agreements over the same period, this translates to a net inflow of just

SAR4.8bn, or USD1.3bn, over the last three years. On a monthly basis, swap agreements to buy securities

reached their highest level, SAR2.6bn, in February 2012. Against sell contracts of just SAR1.1bn, this

translated to a net inflow of a record SAR1.5bn in February 2012. Net flows reversed sharply in March

and April 2012, when swap agreements accounted for net sell contracts for a combined total of SAR1bn.

Swap agreements, SARbn per month

-3

-2

-1

0

1

2

3

Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Mar-12

Buy Sell Net buy

Source: HSBC

Economic basics We forecast the gross domestic product of Saudi Arabia's oil-based economy to reach USD611bn in 2012

on real growth of 4.1%. The Kingdom controls a fifth of the world’s proven oil reserves, and is the

world’s largest producer and exporter of oil. With a population of 29 million, of whom about 20 million

245


abc

are Saudi citizens, it is also the most populous GCC nation by some way. With 40% of nationals under

the age of 15, and population growth running over 2% a year, Saudi Arabia also has one of the youngest

and fastest growing populations in the world outside sub-Saharan Africa.

Saudi’s economy centres on oil; the petroleum sector accounts for roughly 80% of budget revenues, 45%

of GDP and 90% of export earnings. The government is encouraging private sector growth to diversify

the economy and boost employment; youth unemployment is above 25%, and despite the oil sector

accounting for a large proportion of the economy, the national oil company employs less than 1% of the

Saudi labour force. The Kingdom is also seeking to reduce unemployment among Saudis by requiring the

private sector to employ more nationals. Currently only about one in every ten private-sector workers is a

Saudi national.

With reserves likely to exceed USD600bn by the end of 2012, Saudi Arabia looks well placed to weather

regional instability or a dip in oil prices. The growth rates we project over the coming two years are, at

best, however, only likely to prevent the current high levels of youth unemployment from rising, given the

rapid growth in the adult population. Despite the push to diversify, the pivotal role played by public

spending means that the Kingdom’s reliance on its oil sector is very high.

Economic policy primer According to preliminary estimates from the Ministry of Finance, Saudi Arabia recorded a fiscal surplus

of USD82bn in 2011, equivalent to 14% of GDP. The Kingdom has now realised budget surpluses in

excess of 10% of GDP in six of the last eight years. The fiscal position has strengthened, despite

sustained growth in public spending, which more than doubled between 2006 and 2011. This

expansionary stance is set to continue, boosted by a series of supplementary spending commitments made

against the backdrop of the 2011 Arab Spring, focused on infrastructure, housing, education and

healthcare. Although a drop in oil prices might prompt some moderation in spending growth, high

reserves provide a critical buffer to smooth spending. Monetary policy is carried out by the Saudi Arabian Monetary Agency (SAMA), the central bank. Policy

is anchored by the Saudi Riyal’s peg against the US dollar, which has been in place for a generation and

unchanged in value since the 1980s. Despite the constraints it imposes on policymaking, the forward

Central bank reserves, USDbn Budget surplus

0

100

200

300

400

500

600

700

2004

2005

2006

2007

2008

2009

2010

2011

2012f

-50

0

50

100

150

200

2004

2005

2006

2007

2008

2009

2010

2011

2012f

-10

0

10

20

30

40

LHS: USDbn RHS: Share of GDP (%)

Source: SAMA, HSBC estimates Source: SAMA, HSBC estimates

246


abc

markets show no expectation that that there will be a change in the foreign currency regime. As a

consequence, the SAMA’s policy stance is likely to continue to track that of the US, with the repo and

reverse repo policy rates likely to remain at their current historic lows.

Political structure Saudi Arabia is an Islamic monarchy. The king of Saudi Arabia is both head of state and head of the

government. The Qur’an forms the constitution with Saudi governed on the basis of Shari’a law. The

government is led by the Al Saud royal family. King Abdullah bin Abdulaziz Al Saud assumed the throne

in 2005. Prince Salman bin Abdulaziz became crown prince in June 2012. Key government decisions are

largely made on the basis of consultation among the senior princes of the royal family and the religious

establishment. The government also includes a Consultative Assembly (Shura Council), which has 150

members, all appointed by the king. The council has very limited powers, but can propose laws to the

king. In some cases, the king will submit laws to obtain the council’s advice.

Key regulatory bodies Capital Market Authority: The CMA's functions are to regulate and develop the Saudi capital markets by

issuing rules and regulations for implementing the provisions of Capital Market Law. Objectives include

creating an appropriate investment environment, boosting confidence, and reinforcing transparency and

disclosure standards in all listed companies.

Saudi Arabian Monetary Agency: Established in 1952, SAMA is the central bank responsible for

monetary policy and banking regulation.

Saudi Arabian General Investment Authority: SAGIA is the authorising body for issuing investment

licences to foreign investors and coordinating with other involved government agencies.

Electricity & Co-Generation Regulatory Authority: ECRA was established to regulate the electricity

and water desalination industry.

Saudi Food & Drug Authority: SFDA regulates, oversees, and controls food, drug, and medical devices.

Ministry of Petroleum & Mineral Resources: The ministry supervises its affiliate companies in the fields

of petroleum and minerals by observing and monitoring exploration, development, production, refining,

transportation, and distribution activities.

247


abc

South Africa

Franca Di Silvestro* Analyst, Head of South African Equity Research HSBC Securities (South Africa) (Pty) Ltd +27 11 676 4223 [email protected]

Jan Rost* Analyst, banks HSBC Securities (South Africa) (Pty) Ltd +27 11 676 4209 [email protected]

Michele Olivier* Analyst, consumer and industrials HSBC Securities (South Africa) (Pty) Ltd +27 11 676 4208 [email protected]

Cor Booysen* Analyst, metals & mining HSBC Securities (South Africa) (Pty) Ltd +27 11 676 4224 [email protected]

Richard Hart* Analyst, metals & mining HSBC Securities (South Africa) (Pty) Ltd +27 11 676 4218 [email protected]




248


abc

Introduction The South African market is viewed as the most mature equity market in the African territory, having

undergone a number of reforms initiated by both the Johannesburg Securities Exchange (JSE) and the

South African government. The JSE was founded in November 1887. Trading is allowed on the JSE on

weekdays between 0900 and 1700 South African standard time, and works on a rolling T+5 settlement

cycle, meaning that settlement occurs five days after the transaction date, although the exchange is

moving towards T+3 settlement.

The FTSE/JSE All Share (JALSH), a market capitalisation weighted index, serves as the primary gauge

of the South African equity market. Over the past 10 years, the JALSH had returned around 195% in

South African rand terms and some 237% in US dollar terms; this translates into compound annual

growth rates of 11% and 13%, respectively.

According to World Bank data from 2010, South Africa ranks first among the 21 emerging markets on

the metric of market capitalisation as a percentage of GDP. On a global basis, it ranks second only to

Hong Kong on this metric. One theme that attracts investors to the South African equity market is what is

termed “Access Africa” – its exposure to other African markets. Since many other African exchanges are

not liquid and open, investors prefer to look at South African companies with an African reach.

The dominant trends driving the upward trend in the South African equity market over the past decade

have been the global resources boom, together with rising spending by the emerging middle class (buoyed

by an influx of foreign immigrants). This trend has benefited all consumer sectors (including mobile).

Market structure The MSCI South Africa index is relatively well diversified by comparison with other emerging EMEA

country indices such as Turkey and Russia. Excluding the London listed (dual-listed) stocks, the top 5

companies constitute about 39% and the top 10 companies 55% of the index’s market capitalisation.

MTN and Sasol together constitute around 20% of the index weight. Other major constituents of the

index are Naspers, Standard Bank and AngloGold Ashanti. The major London listed stocks include Anglo

American, BHP Billiton, British American Tobacco, Investec, Lonmin, Old Mutual and SAB Miller.

Equity index performance in South Africa Major stocks in MSCI South Africa index* (excluding London dual-listed stocks)

0

200

400

600

800

1000

96 98 00 02 04 06 08 10 12

0500010000150002000025000300003500040000

MSCI South Africa price index (in Local currency)

JSE All share price index (in Local currency, RHS)


1 MTN Group Limited 10.7 2 Sasol Limited 9.1 3 Naspers Ltd. 8.0 4 Standard Bank Group Ltd. 6.4 5 Anglogold Ashanti Ltd. 5.2 Top 5 39.4 6 Gold Fields Ltd. 3.6 7 Impala Platinum Hdg.Ltd. 3.4 8 Firstrand Ltd. 3.3 9 Sanlam Ltd. 2.7 10 Shoprite Holdings Ltd. 2.7 Top 6-10 15.7



Franca Di Silvestro* Analyst HSBC Securities (Pty) Ltd| +27 11 676 4223 [email protected]


249


abc

By sector, financials and materials constitute around 48% of the total index market capitalisation of MSCI

South Africa index, followed by consumer discretionary (15%) and telecoms (13%). Despite the higher

weightings of cyclical sectors such as financials and materials and a volatile currency (South African rand

– ZAR), the South African equity market has historically been perceived as defensive (low beta, low

volatility). This is because of its insulation from major markets and its healthy financial system (which is

underpinned by a large domestic institutional asset management industry) and its core gold mining sector

which gained from heavy safe-haven buying of gold. Strong corporate governance relative to other

emerging markets is also a factor driving relative performance.

Liquidity (6M ADTV) of equity indices in South Africa Sector composition of MSCI South Africa index*

0

500

1000

1500

2000

07 08 09 10 11 12

SA FTSE/JSE All Share Index 6M ADTV (USD m)

Sector Weight (%)

Financials 26.8 Materials 21.2 Consumer Discretionary 15.4 Telecommunication Services 12.8 Energy 9.1 Consumer Staples 6.9 Industrials 4.7 Health Care 3.2 Total 100.0


Source: Bloomberg Finance LP, Thomson Reuters Datastream, HSBC

Earnings and valuation As a result of the country’s very well-developed market and financial system, corporate earnings in South

Africa are generally less volatile than those of many emerging markets. Looking at an extended history,

SA corporate earnings have been increasing at a steady pace.

Actual, trend and forecast earnings of MSCI South Africa index Annual growth in earnings: MSCI South Africa index

0.5

1.0

1.5

2.0

2.5

94 96 98 00 02 04 06 08 10 12 14


-30%

-20%

-10%

0%

10%

20%

30%

40%

2001 2003 2005 2007 2009 2011

MSCI South Africa EPS growth


250


abc

Earnings momentum* vs. returns: MSCI South Africa index Earnings growth* vs. returns: MSCI South Africa index

-30%

-20%

-10%

0%

10%

20%

96 98 00 02 04 06 08 10 12

-50%

0%

50%

100%

MSCI South Africa earnings momentumMSCI South Africa y -o-y re turns (R HS)

0%

10%

20%

30%

40%

96 98 00 02 04 06 08 10 12

-50%

0%

50%

100%

MSCI South Africa earnings grow thMSCI South Africa y -o-y returns (RHS)

Note: *Earnings momentum is defined as the 6M % change in 12 month forward EPS forecast. Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

Note: *Forecast growth in 12M-forward earnings. Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

Earnings momentum in 12M-forward earnings estimates measures the changes in analyst perceptions

about future earnings. Earnings estimates for MSCI South Africa were cut around 30% during the 2008-

09 financial crisis. However, actual earnings growth around this period was consistently above 10%.

Over the long term, earnings revisions have been a good indicator of market performance. IBES

consensus recommendation scores, which measure the extent to which the analyst community is bullish

or bearish about South African equities (bottom-right chart below), show that, in aggregate, analysts have

been bearish on the market for the most part since the financial crisis. However, since the beginning of

2009, the MSCI South Africa has outperformed the broader MSCI EM index by around 9% in US dollars.

Earnings revisions* vs. returns: MSCI South Africa index IBES Consensus recommendation score* versus MSCI South Africa index

0%

20%

40%

60%

80%

96 98 00 02 04 06 08 10 12

-50%

0%

50%

100%

MSCI South Africa earnings rev isionMSCI South Africa y -o-y re turns (R HS)

2.0

2.2

2.4

2.6

2.8

3.0

01 02 03 04 05 06 07 08 09 10 11 12


Bearish

Bullish

Note: *Number of 12M-forward EPS estimates up over the last month as a % of total number of revisions in estimates over the corresponding period Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

Note: *represents the market cap weighted aggregated score of the IBES consensus recommendation of all the constituents. Score should be interpreted as follows – 1.00 to 1.49: Strong Buy; 1.50 to 2.49: Buy; 2.50 to 3.49: Hold; 3.50 to 4.49: Underperform; 4.50 to 5.00: Sell Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

251


abc

MSCI South Africa index; 12M-forward PE scenarios* Earnings yield versus bond yield* in South Africa

5x

10x

15x

20x

25x

0

500

1000

1500

2000

2500

01 02 03 04 05 06 07 08 09 10 11 12

MSCI South Africa Price Index

5%

7%

9%

11%

13%

15%

05 06 07 08 09 10 11 12

South Africa 10Y nominal par y ield on Gov t. securities12M -forward earnings y ield of MSCI South Africa

* Note: Based on five scenarios of 12M- forward PE multiple (5x, 10x, 15x, 20x and 25x) Source: MSCI, IBES, Thomson Reuters Datastream, HSBC

*Note: Earnings yield is calculated as the reciprocal of the 12M- forward PE ratio of the MSCI index and the bond yield is the 10Y nominal par yield on Govt. Bonds. Source: MSCI, IBES, Oxford Economics, Thomson Reuters Datastream, HSBC

In terms of valuation, since 2001 the market has traded at around 10x its 12M-forward earnings estimates.

Thanks to the relative resilience of the market, the PE ratio has remained sticky and tightly range-bound,

even during the financial crisis, and earnings yields on equities have largely been above those offered by

government bonds.

For about 10 years after the liberalisation of the market in 1996, the South African equity market

constantly re-rated relative to the MSCI EM as a whole. However, during most of this time, South

African equities traded at a discount to broader EM. In absolute terms, PE bottomed around October

2008. Since then, the market has re-rated constantly but the PE multiple has remained well below the pre-

crisis level of around 12x. The South African market has generally enjoyed a rich PB valuation – between

1.5-2.0x since 2005 – underpinned by a strong return on equity.

12M-forward PB versus RoE: MSCI South Africa index 12M-forward PE ratio of MSCI South Africa relative to MSCI EM

1.0

1.5

2.0

2.5

3.0

05 06 07 08 09 10 11 12

10%12%14%16%18%20%22%24%26%

MSCI South Africa 12M -forward price to book ratioMSCI South Africa 12M -forward RoE (RHS)

5.0x

7.0x

9.0x

11.0x

13.0x

15.0x

98 00 02 04 06 08 10 12

0.4x

0.6x

0.8x

1.0x

1.2x

MSCI South Africa 12M -forw ard PE ratiorel. to MSCI EM (RHS)


Fund flows In absolute terms, South African equity funds have seen redemptions amounting to USD361m since 2000.

In the same period, other CEEMEA markets, Russia, Poland and Turkey, have seen net subscriptions of

USD10.8bn, USD0.2bn and USD1.2bn, respectively.

252


abc

In GEM fund managers’ portfolios, South Africa had been a structural underweight relative to the MSCI

EM benchmark index. The underweight position was more pronounced between 1996 and 2004, but has

decreased since 2005. The South African market is perceived as a defensive play in an emerging market

context. Generally, investor sentiment about the market tends to become more negative during secular

market upswings. This is not to say that during “risk-on” environments South African equities fall while

other EM equities rise; it merely indicates that South African equities tend to rise less than those in more

cyclical markets. Conversely, South African equities tend to fall less in a “risk-off” environment.

Flows (% of AuM) into South Africa dedicated funds Weight of South Africa in GEM funds versus benchmark

-30%

-20%

-10%

0%

10%

20%

00 01 02 03 04 05 06 07 08 09 10 11 12

South Africa F und flow s as % of as sets undermanagement

0%

5%

10%

15%

20%

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Weight (%) in GEM Equi ty F undsWeight (%) in MSCI EM index

Source: EPFR Global, HSBC Source: MSCI, EPFR Global, HSBC

Economic basics South Africa is the African continent’s largest and most advanced economy. The country’s GDP per

capita, around USD8,000 in 2011, is significantly higher than the sub-Saharan African average, while the

economic infrastructure boasts a sophisticated financial system and a large web of companies in almost

every sub-sector of the manufacturing, mining and services businesses. South Africa is also the business

portal to the sub-Saharan Africa region thanks to its numerous internationalised institutions. The country

generally leads the continent on development indices, too, such as the United Nation’s Human

Development Index, the World Economic Forum’s Global Competitiveness Index and the World Bank’s

Ease of Doing Business Index.

South Africa is one of the most mineral-rich countries in the world. Endowed with the world’s largest

resource base in PGMs, gold, manganese and chrome, it is also the global leader for thermal coal, mineral

sands, iron ore and uranium resources. South Africa has a well-developed and well-regulated banking

industry, which compares favourably with the banking industries in most developed countries. Banking

sector assets total around ZAR3,397bn, with loans and advances contributing about 76% of total sector

assets. The four major banks (Absa, FirstRand, Nedbank and Standard Bank) account for 84% of total

banking assets and 86% of the total credit extended in the South African banking sector.

South African banks have been largely protected from the global financial crisis, as banking activities are

mainly focused on the domestic and Sub-Saharan Africa markets. Nevertheless, the tougher capital and

liquidity requirements introduced worldwide under Basel III as a result of the crisis are set to be adopted

by South Africa in January 2013. The challenges of meeting these requirements have been resolved

through the introduction of a Committed Liquidity Facility by the South African Reserve Bank.

253


abc

South African industry, together with the mining and quarrying sector, makes up nearly one-third of

GDP; the agricultural sector is relatively small, at around 2.5%, and the remainder of GDP comes from

services, including the construction business. On the demand side, household consumption remains the

largest driver of GDP, at c65%, followed by government consumption at 21%. National infrastructure

projects are the main driver of fixed capital investment, in both public and private sectors, which accounts

for c20% of GDP.

South Africa is a relatively closed economy as exports account for less than 30% of GDP. However, the

country is a large exporter of commodities, in particular precious metals (gold, diamond, and platinum),

coal and other industrial metals. Asia has overtaken Europe as the main destination of exports in the past

two years. Currently, some 35% of South Africa’s exports end up in Asia, around 25% in Europe, 20% in

Africa and 15% in Americas.

The growth rate of South Africa’s fairly large, 49 million strong population has nearly stalled lately,

although it is still dominated by young people, with a median age of around 25 years. However, these

population figures do not take into consideration illegal foreign immigrants, whose inclusion would bring

total numbers closer to 60 million. Nevertheless, SA’s population structure presents significant challenges

as the country’s unemployment rate runs chronically high, at around 25%. The South African economy

suffered only a shallow recession during the global financial crisis, but its recovery has also been very

muted. There are substantial structural constraints to growth, such as a very rigid and unionised labour

market, skill mismatches, a high drop-out rate in the education system, an infrastructure deficit, problems

surrounding social delivery, lack of competition in public utility (parastatal) sectors and uncertainties

surrounding future policy making – for example the ongoing nationalisation debates. On the other hand,

South African officials have been successfully tackling other social problems, such as health, crime,

security and housing for the poor population.

Economic policy primer South Africa generally adheres to free market principles based on open trade and a flexible exchange rate

regime. The National Treasury (NT) has been liberalising the capital account by gradually removing the

remaining restrictions preventing residents from investing abroad, while inward investments and capital

inflows generally take place in a very liberal framework.

The National Treasury and the South African Reserve Bank (SARB) are orthodox in their execution of

fiscal and monetary policies, respectively. The SARB operates an official inflation-targeting regime,

defining price stability as urban headline consumer inflation within its 3.0-6.0% target band. South

Africa’s recent fiscal challenges stem more from the need to support the investment plans of the parastatal

companies, which are large public utility concerns such as Eskom, the power utility, and Transnet, the

logistics and transport utility. Both have to invest heavily to prevent infrastructure bottlenecks in the

country’s manufacturing and mining sectors.

Political structure South Africa has a stable and democratic political system with a very progressive constitution. Since the

fall of the apartheid regime in 1994, the country has been run by the liberalising force, the African

National Congress (ANC). The ANC is in a formal tri-party alliance with the Congress of the South

254


abc

African Trade Unions (COSATU) and the South African Communist Party (SACP). The incumbent ANC

President Jacob Zuma took office in 2009. The next presidential election will take place in 2014, while

ANC’s primary is scheduled for December 2012.

Key regulatory bodies National Treasury: agency managing national economic policy and government finances.

South African Reserve Bank: supervisory authority of the banking system.

Financial Services Board: agency responsible for the non-banking financial services industry.

National Credit Regulator: regulator of the consumer credit industry.

255


abc

Turkey

Cenk Orcan* Analyst, Co-Head of Turkish Equity Research HSBC Yatirim Menkul Degerler A.S. +90 212 376 46 14 [email protected]

Bulent Yurdagul* Analyst, Co-Head of Turkish Equity Research HSBC Yatirim Menkul Degerler A.S. +90 212 376 46 12 [email protected]

Tamer Sengun* Analyst, banks HSBC Yatirim Menkul Degerler A.S. +90 212 376 46 15 [email protected]

Levent Bayar* Analyst, industrials and real estate HSBC Yatirim Menkul Degerler A.S. +90 212 376 46 17 [email protected]




256


abc

Introduction The Turkish Stock Exchange market (ISE) with total market cap of USD223bn (as of June 2012) and

daily trading volume in excess of USD1.0bn, is one of the most liquid equity markets in the emerging

market universe. The Turkish market has provided strong returns since its establishment in 1988, but its

eye-catching 8x return between 2003 and 2007 was fuelled by the strong economic recovery after the

deep 2001 recession and start of the membership negotiation process with the European Union in 2005, as

well as rising liquidity in global markets. Foreign ownership in Turkish stocks increased sharply and

exceeded 70% of the free float in 2007 (62% as of June 2012) while the share of foreigners in daily

trading volume remained below 20-25%, proving that locals are also active in the market, especially in

daily trading activities.

Market structure The market is mainly led by the banks, which have a heavy index weighting. This increases the volatility

in the market because bank earnings are highly sensitive to macro parameters such as growth, inflation

and interest rates. Movements in FX rates (USD/TRY and EUR/TRY) as well as interest rates also create

volatility as they affect the earnings of industrial companies, which are in general indebted (in both FX

and local currency terms). The benchmark ISE-100 index is diversified in terms of sectors represented

and underlying companies, but the MSCI Turkey index is mainly driven by the top 10 stocks, which have

an overall weight of 71%. The banking sector stocks Garanti (15.5%), Akbank (8.9%), Isbank (7.3%) and

Halk Bank (4.4%) make up more than one-third of the index, while the incumbents of Turkey’s telecoms

sector Turkcell (7.6%) and Turk Telekom (4.6%), and consumer staples companies BIM (7.2%) and

Anadolu Efes (5.9%) also have high representations in the index. The remaining part of the index is

formed by the industrials (9.7%), energy (5.4%), consumer discretionary (4.6%) and materials (4.0%)

sectors. Even though all major names in the index have operations outside of Turkey, their operational

profits are mainly driven by Turkish operations. Therefore, Turkey’s GDP growth, level of local interest

rates and TRY against foreign currencies play an important role on the Turkish market’s EPS growth and

share price performances. Trading volume increased steadily from below USD500m in 2003 to over

USD2.0bn in 2011 but declined to USD1.0bn-1.2bn in 2012.

Equity index performance in Turkey Major stocks in MSCI Turkey index*

0

200000

400000

600000

800000

1000000

1200000

96 98 00 02 04 06 08 10 12

0

20000

40000

60000

80000

MSCI Turkey price index (in Local currency)

Istanbul SE price index (in Local currency , RHS)


1 Garanti Bankasi 15.52 Akbank 8.93 Turkcell 7.64 Isbank 7.35 BIM 7.21- 5 46.56 Anadolu Efes 5.97 Tupras 5.48 Turk Telekom 4.69 Koc Holding 4.410 Halk Bank 4.46-10 24.7

Note: * data as at 22 May 2012. Source: MSCI, Thomson Reuters DataStream, HSBC

Source: MSCI, Thomson Reuters DataStream, HSBC

Cenk Orcan* Analyst HSBC Yatirim Menkul Degerler A.S. +90 212 376 46 14


257


abc

Liquidity (6M ADTV) of equity indices in Turkey Sector composition of MSCI Turkey index*

0

500

1000

1500

2000

2500

07 08 09 10 11 12

Istanbul SE National All Share Index 6M ADTV (USD m)

Sector Weight (%)

Financials 49.2 Consumer Staples 15.0 Telecommunication Services 12.2 Industrials 9.7 Energy 5.4 Consumer Discretionary 4.6 Materials 4.0 Total 100.0

Note: * data as at 22 May 2012 Source: MSCI, Thomson Reuters DataStream, HSBC

Source: Bloomberg Finance LP, Thomson Reuters DataStream, HSBC

Earnings and valuation EPS growth has been volatile in recent years with increases in 2006, 2007, 2009, and 2010 and

contraction in 2008 and 2011. Aggregate market net profit declined by c10% in 2011 in both the banking

and non-banking sectors. Banks’ margins were squeezed last year as a result of the Turkish Central

Bank’s steps to slow economic growth (through higher reserve ratios and general provisions) and non-

bank profits were hit by TRY weakness. Turkish company earnings are in general dependent on three

main factors, GDP growth, currency and interest rates. GDP growth helps non-financials companies in

terms of revenues and improved operational leverage, and financials companies in terms of volume

growth, revenue expansion and better asset quality. Currency appreciation is mostly positive in terms of

earnings for non-financials due to the short FX positions of these companies generally. Interest rates are

more important for the financials (especially the banks). Due to the maturity mismatch on their balance

sheets, the margins of the banks are affected positively by periods of declining interest rates.

Actual, trend and forecast earnings of MSCI Turkey index Annual growth in earnings: MSCI Turkey index

2.0

3.0

4.0

5.0

6.0

94 96 98 00 02 04 06 08 10 12 14


-100%

-50%

0%

50%

100%

150%

200%

250%

300%

1997 1999 2001 2003 2005 2007 2009 2011

MSCI Turkey EPS growth

Source: MSCI, IBES, Thomson Reuters DataStream, HSBC Source: MSCI, IBES, Thomson Reuters DataStream, HSBC

258


abc

Earnings momentum* versus returns: MSCI Turkey index Earnings growth* versus returns: MSCI Turkey index

-100%-50%

0%50%

100%150%200%250%300%

96 98 00 02 04 06 08 10 12

-100%-50%0%50%100%150%200%250%300%350%400%

MSCI Turkey earnings momentum

MSCI Turkey y-o-y returns (RHS)

-50%0%

50%100%150%200%250%300%350%400%

96 98 00 02 04 06 08 10 12

-100%-50%0%50%100%150%200%250%300%350%400%

MSCI Turkey earnings growth


Note: *Earnings momentum is defined as the 6-month % change in 12M-forward EPS forecast. Source: MSCI, IBES, Thomson Reuters DataStream, HSBC

Note: *Forecast growth in 12M-forward earnings. Source: MSCI, IBES, Thomson Reuters DataStream, HSBC

The Turkish equity market’s price performance is highly correlated with both the earnings momentum

and the earnings revisions since 2005. The higher returns in the MSCI Turkey were achieved when

earnings momentum and earnings revisions turned positive, as in 2005, 2007 and 2010. Before 2005,

market returns had no significant correlation with earnings momentum. Earnings growth, on the other

hand, is not much of a determinant of index returns, as the chart on the top right of this page reveals.

According to the IBES consensus recommendation score, the sell side (brokers) was most bullish on the

Turkish equity market back in 2004-05 and 2008 when the prospective earnings momentum expectation

was quite strong. However, while 2004 and 2005 were periods of high returns on the MSCI index, returns

in 2008 and early-2009 were not that satisfactory, although Turkish equities had one of the strongest price

performances in 2010, a year after the sell side turned bullish. Since 2010, the sell side has had a more

neutral to bearish stance on MSCI Turkey stocks.

Earnings revisions* versus returns: MSCI Turkey index IBES consensus recommendation score*: MSCI Turkey

0%

20%

40%

60%

80%

100%

96 98 00 02 04 06 08 10 12

-100%-50%0%50%100%150%200%250%300%350%400%

MSCI Turkey earnings revision


2.02.12.22.32.42.52.62.72.82.9

01 02 03 04 05 06 07 08 09 10 11 12


Bearish

Bullish

Note:- *Number of 12M-forward EPS estimates up over the last month as a % of total number of revisions in estimates over the corresponding period. Source: MSCI, IBES, Thomson Reuters DataStream, HSBC

Note: *represents the market cap weighted aggregated score of the IBES consensus recommendation of all the constituents. Score should be interpreted as follows – 1.00 to 1.49: Strong Buy; 1.50 to 2.49: Buy; 2.50 to 3.49: Hold; 3.50 to 4.49: Underperform; 4.50 to 5.00: Sell Source: MSCI, IBES, Thomson Reuters DataStream, HSBC

259


abc

MSCI Turkey index: 12M-forward PE scenarios* Earnings yield versus bond yield* in Turkey

5x

10x

15x

20x

25x

0

500000

1000000

1500000

2000000

2500000

01 02 03 04 05 06 07 08 09 10 11 12

MSCI Turkey Price Index

5%

10%

15%

20%

25%

05 06 07 08 09 10 11 12

Turkey 10Y nominal par yield on Gov t. securities12M -forw ard earnings y ield of MSCI Turkey

Note: *based on five scenarios of 12M-forward PE multiple (5x, 10x, 15x, 20x and 25x Source: MSCI, IBES, Thomson Reuters DataStream, HSBC

Note: * earnings yield is calculated as the reciprocal of the 12M-forward PE ratio of the MSCI index and the bond yield is the 10Y nominal par yield on Govt. Bonds. Source: MSCI, IBES, Oxford Economics, Thomson Reuters Datastream, HSBC

The MSCI Turkey index has been trading in a wide range of 5-12x 12M-forward looking earnings since

2001. During crisis periods, such as 2009, the PE multiple declined to 5x, and during upbeat earnings

momentum periods, such as 2004, 2005, 2007 and 2010, the PE multiple reached 12x. Having said this,

the normal range for the MSCI Turkey PE is around 9-10x based on historical data. Currently, the

Turkish equity market trades at around 8.5x 12M-forward looking PE – with upward earning momentum

the market PE could easily reach 10x. The PB range of the MSCI Turkey index has been 0.7x to 2.0x

between 2005 and 2012. Although there have been some periods when the correlation between ROE and

PB eased, we observe that the general trend of the PB level is correlated with the level of ROE.

Thanks to declining interest rates since 2009, earnings yields have been outpacing yields on government

securities. Despite earnings yields being lower than in 2009, this is a positive trend in terms of valuation.

MSCI Turkey’s PE level relative to MSCI EM has been quite volatile. However, over the last 10 years,

MSCI Turkey’s PE has generally been at a slight discount to the MSCI EM PE multiple. There have been

periods when the MSCI Turkey index traded at around 40% discount on PE, such as in 2008. Currently,

the discount is around 10%, close to historical averages.

12M-forward PB versus RoE: MSCI Turkey index 12M-forward PE ratio of MSCI Turkey relative to MSCI EM

0.50.70.91.11.31.51.71.9

05 06 07 08 09 10 11 12

11%12%13%14%15%16%17%18%19%

MSCI Turkey 12M -forward price to book ratioMSCI Turkey 12M -forward RoE (RHS)

0.0x

5.0x

10.0x

15.0x

20.0x

98 00 02 04 06 08 10 12

0.0x0.2x0.4x0.6x0.8x1.0x1.2x1.4x1.6x

MSCI Turkey 12M -forward PE ratiorel. to MSCI EM (RHS)

Source: MSCI, IBES, Thomson Reuters DataStream, HSBC Source: MSCI, IBES, Thomson Reuters DataStream, HSBC

260


abc

Fund flows According to EPFR Global, Turkish equity funds have managed to attract inflows of around USD1.2bn

since 2000. Flows into the Exchange Traded Funds (ETFs) outpaced flows into other traditional funds.

The majority of inflows (around USD1.1bn) were received after 2004, the year in which the ETFs market

was established with the aim of providing an organised and transparent market for trading ETFs’

participation certificates. Furthermore, it is worth noting that Turkey has historically enjoyed an

overweight position in the GEMs equity portfolios in general.

Flows (% of AuM) into Turkey dedicated funds Weight of Turkey in GEM funds versus benchmark

-30%

-20%

-10%

0%

10%

20%

00 01 02 03 04 05 06 07 08 09 10 11 12

Turkey Fund flows as % of assets under management

0%

1%

2%

3%

4%

5%

6%

7%

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Weight (%) in GEM Equity Funds

Weight (%) in MSCI EM index

Source: EPFR Global, HSBC Source: EPFR Global, HSBC

Economic basics According to IMF’s estimates, Turkey is currently the world’s 18th largest economy, with a population of

74.7 million. HSBC global economics research estimates that Turkey will be the 12th largest economy in

the world in 2050, after Canada and ahead of Italy. As of 2011, Turkey’s per capita income is

USD10,521; up more than 150% since 2000.

Turkey is a relatively closed economy, with household consumption corresponding to 71% of GDP, while

merchandise and services exports make up only 24% of GDP. The country has a diverse economic base,

with services, manufacturing, agriculture and construction activity. Over 70% of Turkey’s production

growth comes from the services sector, with 16% from manufacturing. Turkey’s exports are dominated

by a broad range of manufactured products with base metals (15% of total), motor vehicles (12.3%) and

textiles (8.6%) being the largest categories. Turkey is a heavy importer of crude oil and gas (18.3% of

total) and chemicals (14.1%).

Turkey is a vibrant emerging market that enjoys a number of long-term, fundamental advantages. First,

Turkey has a young and growing population with a median age of 30; 60% of the population is below the

age of 35, and the UN estimates that the population grows 1.3% per annum.

Another important structural advantage is its low stock of debt. Household debt to GDP in Turkey stands

at only 18%, while mortgage debt is even lower, at 6% of GDP. Corporate and public sector debt are

similarly low, at 45% of GDP and 40% of GDP, respectively. Low leverage allows Turkey to rebound

from recessions rapidly because the economy does not have to go through a protracted period of balance

sheet recession.

261


abc

Turkey’s well-capitalised and highly-regulated banking sector is also an important factor to consider.

In addition the country enjoys low FX exposure in the household sector. Since 2007, consumers have

only been able to borrow in Turkish lira, an important prudential measure that has resulted in a long FX

position in the household sector of around 8% of GDP. This advantage is somewhat diminished by the

fact that non-financial corporates have a short FX position of 17% of GDP.

Turkey’s structural weak spot is the fact that when the economy grows, it grows asymmetrically, creating

external imbalances. Years of high growth are accompanied by large current account deficits. Because

domestic savings are low, rapid domestic demand growth renders the country dependent on external

financing.

An additional risk factor is the fact that the quality of the financing has deteriorated over the years. In

2011, Turkey’s current account gap stood at USD77.1bn, or 10% of GDP, with 57% of the deficit being

financed by short-term borrowing, portfolio flows and net errors and omissions. Conversely, FDI flows

financed only 17% of the large deficit.

In 2011, the government and the Central Bank of Turkey (CBRT) put together a framework to address

this structural weakness. On the monetary policy front, the CBRT aims to rebalance the economy so that

domestic demand grows less rapidly and foreign demand grows more strongly. This would also slow the

rapid widening in the current account deficit. The new policy framework is also intended to improve the

quality of the current account gap. On the structural reform front, the government is working on a number

of initiatives to increase the value-added of exports, reduce dependence on imported energy and other

intermediate goods, improve competitiveness and increase savings.

Economic policy primer The statutory objective of the CBRT since 2006 is to attain and maintain price stability, within an official

inflation-targeting framework. However, the central bank also considers financial stability objectives in

its decision-making process. The central bank’s current flexible monetary policy framework includes the

active use of the following instruments to manage the amount of lira liquidity in the system and to push

short-term interest rates up or down:

The policy rate is the one-week repo rate, currently 5.75%. This is the rate at which commercial

banks gain funding access from the central bank via quantity auctions.

The overnight interest rate corridor is currently 5.0-11.5%. The ceiling of the rate corridor is the

overnight lending rate (ie the rate at which banks borrow from the central bank). Primary dealers

borrow from the central bank at a slightly more favourable rate (presently 11%). The floor of the

interest band is the overnight borrowing rate.

Required reserve ratios for both FX and lira denominated liabilities are also set by the central bank.

They are the central bank’s primary policy tool for controlling credit growth as higher reserve ratios

reduce the supply of loanable funds in the banking sector.

262


abc

FX sale or purchases: When capital flows into Turkey are strong, the central bank purchases US dollars

from the market, building up its FX reserves. When risk appetite is flagging, and the lira underperforms (or

becomes excessively volatile), the central bank sells US dollars, or intervenes directly in the FX market.

Political structure Turkey is a parliamentary representative democracy with a strong tradition of secularism. The Prime

Minister is the head of the Council of Ministers and holds executive power, while the role of the President

of the Republic is ceremonial. Currently, the Justice and Development Party (AK Party or AKP) is

serving its third term in government, and holds a majority of 326 seats in the 550-seat parliament. Recep

Tayyip Erdogan is the Prime Minister and Abdullah Gul is President. The next presidential election is

scheduled for 2014, and the next parliamentary election for 2015.

Turkey is a member of the United Nations and NATO. It joined the EU Customs Union in 1995 and

started accession talks with the EU in 2005, but progress in EU accession has stalled.

Key regulatory bodies The Central Bank of Turkey: regulates monetary policy in the country which has a direct impact on the

macro dynamics.

Banking Regulation and Supervision Agency: regulates and supervises the banking sector, which

forms 45% of the major equity index.

The Undersecretariat of Treasury: treasury strategies have a major impact on macro dynamics.

Istanbul Stock Exchange: regulates the stock market.

Turkey Statistical Office: provides detailed information on sectors, macro economy and consumer

behaviour.

Investment Support and Promotion Agency: supports investments of foreigners to Turkey.

Ministry of Finance: manages tax and budget, which are keys for major sectors.

263


abc

Basic valuation and accounting guide

264


abc

Five Forces and SWOT

A concentration of suppliers will mean less chance to negotiate better pricing. Substitute producers provide a price ceiling. A single strategic supplier can put pressure on industry margins. If switching costs are high, suppliers can put pressure on the industry. Downstream integration: the industry can be disintermediated.

Power of suppliers

Barriers to entry will be high if economies of scale are important, access to distribution channels is restricted, there is a steep ‘experience’ curve, existing players are likely to squeeze out new entrants, legislation or government action prevents entry, branding or differentiation is high.

New entrants

High rivalry will result from the extent to which players are in balance, growth is slowing, customers are global, fixed costs are high, capacity increases require major incremental steps, switching costs are low, there is a liquid market for corporate control and exit barriers are high.

Rivalry

Alternative means of fulfilling customer needs through alternative industries will put pressure on demand and margins. Product for product (email for fax), substitution of need (precision casting makes cutting tools redundant), generic substitution (furniture manufacturers vs holiday companies), avoidance (tobacco).

Substitute products

Buyer power will be high if buyers are concentrated with a small number of operators where there are alternative types of supply, where material costs are a high component of price (ie low value added), where switching is easy and low cost and the threat of upstream integration is high.

Power of customers

INDUSTRY Scoring range 1–5 (high score is good)

COMPANY Scoring range 1–5 (high score is good)COMPANY Scoring range 1–5 (high score is good)

Patents Strong brand and/or reputation Location of the business The products, are they new and innovative? Quality process and procedures Specialist marketing expertise

Strengths

Undifferentiated products and services, in relation to the market Poor quality goods or services Damaged reputation Competitors have superior access to distribution channels Location of the business Lack of marketing expertise

Weaknesses

Developing market eg Internet, Brazil Mergers, strategic alliances Loosening of regulations Removal of international trade barriers Moving into a new market, through new products or new market place Market lead by an ineffective competitor

Opportunities

New competitor Price war Competitor has a new, innovative substitute product or service Rivals have superior access to channels of supply and distribution Increased trade barrier Taxation and/or new regulations on a product or service

Threats

Source: HSBC Note: The upper score represents an assessment of the balance of strengths and weaknesses. Similarly the bottom number scores the balance of opportunities and risks.

265


abc

The figure above combines a diagram of a Five Forces model used to analyse an industry, with an outline

of a SWOT analysis for evaluating a company.

Porter’s Five Forces is an analytical approach that assesses industries or a company by five strategic

forces; it helps to indicate the relationship between the different competitive forces within the industry.

Five Forces can be used by a business manager trying to develop an edge over a rival firm or by analysts

trying to evaluate a business idea.

Porter’s Five Forces has a scoring system in which positive, negative or neutral results are combined to give a

final score for each force. The higher the score, the more sound the industry, or business is.

SWOT analysis is routinely used to help the strategic planning of a firm in the business world. Strengths

and weakness (SW) apply to any internal factors within the firm, while the opportunities and threats (OT)

are the many external factors that a firm must account for.

Valuation The following sections give a brief introduction to the main accounting issues and valuations techniques,

their definitions and ratio analysis. It is structured by addressing what is valued, how it is valued, and the

inputs of the valuation. This accounting guide can be used to gain a better understanding of a company’s

financial statements. We include a brief introduction to balance sheet items. The valuation measures and

methods described below apply only to listed companies.

Valuing what? Enterprise value (EV)

An enterprise is a company and therefore the enterprise value is a measure of the whole company’s value.

It is believed by many to have more uses than market capitalisation, because it takes into account the

value of debt for a company (and also adjusts for minorities and associates) to make it suitable for ratios

above the P&L interest line such as EV/sales, EV/EBITDA and EV/EBIT.

Calculate by: market capitalisation (all share classes) + net debt (and other liabilities, such as pension

deficits) + minority interests – associates (both fair value).

There are three types of enterprise value: total, core and operating.

Enterprise value

Total Enterp rise Value

The value of all business activit ies

Operating Enterprise Value

Total EV less non-operating assets at market value

Core Ente rprise Value

Total EV less non-core asse ts, th is makes Core EV more subjective but can be used for ratios such as Core EV/core business sales.

Source: HSBC

266


abc

Market capitalisation (market cap)

The value of all the shares of a corporation; it is useful as part of EV and for ratios such as PE

(price/earnings = market cap/net income) or DY (dividend yield = dividends/market cap).

Calculate by: multiplying a company’s shares outstanding (ie, excluding treasury shares owned by itself)

by the current market price of one share.

Net debt

This is the total amount of debt and liabilities a company has after subtracting the value of its cash and

cash equivalents. A company with more cash than debt would be said to have Net Cash.

Minority interest – three main definitions:

Where an investor or company owns less than 50% of another company’s voting shares, eg ‘owning a

minority interest’

A non-current liability on a balance sheet representing the portions of its subsidiaries owned by

minority shareholders. Consolidated accounts show 100% of sales, EBITDA, EBIT (in the P&L);

100% of the assets and liabilities (in the balance sheet) and 100% of the cash flows of a subsidiary,

but also deduct the minorities’ shares of profits in a separate minorities P&L line, their share of net

assets in a minorities balance sheet line and any dividends paid to them in the cash flow. For

example, if Company A owns 80% of Company B, where Company B is a GBP100m company.

Company A will have a GBP20m liability, on its balance sheets, to represent the 20% of Company B

that it does not own, this being the minority interest.

As an adjustment in an EV, DCF valuation, etc, at fair value (rather than the book value used in the

balance sheet). For example, if fair value was GBP30m, this would be added to EV and deducted as

part of the DCF.

Pension obligations

This is a projected sum of total benefits that an employer has agreed to pay to retirees and current

employees entitled to benefits. There are two main types of pension scheme:

Defined Benefit, where payment is linked to employees’ salary level and years of service. The

benefits are fixed but, as the actuarial assessment of the liability depends on changing factors (such as

life expectancy and discount rates), the company’s liabilities (and contributions) are variable. The

company has an obligation to pay out the determined benefit and, if there is a shortfall in the fund,

must draw on the company’s profits to subsidise the discrepancy.

Defined Contribution, where the employers’ contributions are fixed but the benefits are variable.

The pension in retirement depends on the cumulative contributions to the fund, returns from its

investments and annuity rates at retirement.

267


abc

Common terms used to discuss pensions

Accumulated Benefit Obligation (ABO) An estimate of liability if the pension plan assumes immediate discontinuation; it does not take into account any future salary increases.

Discount Rate The rate used to establish the present value of future cash flows.

Prior Service Costs Retrospective benefit costs for services prior to pension plan commencement or after plan amendments.

Projected Benefit Obligations (PBO) This assumes the pension plan is ongoing, as the employee continues to work, and therefore it projects future salary increases.

Service Cost The present value of benefits earned during the current period.

Vested Benefit Obligations (VBO) Most plans require a certain number of years service before benefits can be collected, and this is ‘Vested’. The VBO represents the actuarial present value of vested benefits.

Source: HSBC

Valuing how? Cash flow

This indicates the amount of cash generated and used by a company over a given period. There are

several different measures, used for different purposes, plus a cash flow statement in the reports and

accounts.

Free cash flow (FCF)

The cash flow after everything except dividends, so attributable to shareholders, used in performance

measures (eg FCF Yield = FCF/market cap). Generally, the higher the FCF the better, at least in the short

term, though too much cost cutting or underinvestment can be risks.

Calculate by: EBITDA – capex – working capital change – net interest – tax

Free cash flows to the firm (FCFF)

The cash flow after everything except interest (net of tax) and dividends, used in DCF calculations (see

below).

Calculate by: EBITDA – capex – working capital change – tax

Discounted cash flow (DCF)

The present value of an investment, ie adjusted for the time value of money. It is the sum of the value of

each period’s FCFF, discounted back to the present day.

For a project lasting n years calculate by:

268


abc

For a business lasting beyond the n years for which you have estimated cash flow, add a ‘terminal value’,

being the value at year n discounted to the present day. The value at year n+1, if thought to be a

perpetuity growing at rate g per annum, would have a value in year n of CFn (1+g)/(r-g) and a present

value of CFn(1+g)/(r-g)/(1+r)n.

Market assessed cost of capital (MACC)

MACC turns conventional valuation methodology around; instead of comparing returns on capital and

cost of capital to arrive at an estimate of fair value, it compares market return on capital with market

value to derive an estimate for market assessed cost of capital (MACC). This MACC value can be used

for comparisons against historical observations for the same stock, or for use against peers.

Multiples Multiple Calculation Definition/Interpretation

PE ratio Price of a stock

Earnings per share

Helps to give investors an overview of how much they are paying for a stock; the ratio states how many years it would take for the investors to recoup their investment, with the company keeping profits steady (if fully distributed as dividends).

Generally companies with high PE (over 20) are faster growing, while a low PE may be an indication that the companies are low-growth or mature industries.

PEG ratios Price/Earnings Ratio

Annual EPS Growth This ratio is used to determine a stock’s value taking into account earnings growth, especially if growth is very high. A low PEG company may reflect high risk.

Price to Book ratio (P/B ratio)

Market capitalisation Total assets - Intangible assets

- Liabilities (equal to price / book value per share)

This ratio compares stock market value with book value; it can be compared throughout the same industry sector. It can be based on net assets or after deducting intangibles.

EV/Sales

EV (see above to calculate) Annual Sales

As sales are above the interest, associates and minorities lines in the P&L, it is more consistent and popular to compare EV (including net debt and adjusted for minorities and associates) with sales than, say, price/sales.

EV/EBITDA EV (see above to calculate) Annual EBITDA

EBITDA (earnings before interest, tax, depreciation and amortisation) is also above the interest, associates and minorities lines, so comparing with EV is consistent and popular.

Source: HSBC

Economic value added (EVA), Residual Income

This is a measure of a company’s profits, after deducting capital costs (being the capital employed x cost

of capital). It is usually calculated on an enterprise basis: with EBIT, taxes based on EBIT, capital

employed including financed by debt and weighted average cost of capital (WACC – see below).

Calculate by:

Net Sales – Operating Expenses = Operating Profit (EBIT)

EBIT – taxes = Net Operating Profit after Tax (NOPLAT)

NOPLAT – Capital Costs = Economic Value Added (EVA)

269


abc

Components and inputs of valuation DCF inputs

Weighted average cost of capital (WACC)

This calculates the firm’s cost of capital, with each category of capital proportionally weighted. It is used

with pre-interest cash flows (eg DCF) or profits (eg Economic Profit).

Calculate by:

WACC = E *Re + D *Rd * (1-Tc)

(E+D) (E+D)

Cost of debt

This is the effective rate that a corporation pays on its current debt; it can be measured either pre- or post-

tax. It is usually higher than the risk-free rate (eg 10-year government bond yields) because of the spread

over such bonds that corporate bond holders tend to demand.

Cost of equity

This is in theory the return a stockholder requires for holding shares in a company; representing the

compensation that the market demands in exchange for owning the asset and bearing the risk of ownership.

Calculate by: Risk-free rate + equity beta x equity risk premium

Equity beta

The correlation between a share and the general stock market. It is useful to estimate the cost of equity for

a stock as an investor can, in principle, diversify away uncorrelated risks, but not correlated sensitivity to

the market.

Equity risk premium

This is the premium investors would expect for investing in equities because of the higher risk. It is a

measure for the general stock market rather than individual stocks.

MACC inputs

Invested capital (IC)

This is capital that the company can invest within itself or has already invested internally.

Calculate by: Long-term debt +stock + retained earnings

Re= cost of equity

Rd = cost of debt

E = market value of the firm’s equity

D = market value of the firm’s debt

Tc = Corporate tax rate

270


abc

Cash return on capital invested (CROIC)

This evaluates a company’s cash return to its equity: it measures the cash profits of a company and

compares this with the proportion of the funding required to generate it.

Calculate by: Gross Cash Flow

Average Gross Cash invested (GCI)

Where,

Gross cash flow is operating cash flow plus post-tax gross interest expense

GCI: Gross fixed assets plus gross intangible assets plus net working capital plus cash

Multiple inputs

Earnings per share

Net profit per share, which may be headline or adjusted (for example, to exclude the impact of non-

recurring items). Shares are normally those in issue (excluding treasury shares owned by the company).

Calculate by: Net profit for the year

Number of shares Book value

The value at which an asset is carried on the balance sheet, taking into account depreciation that may have

occurred each year after the asset was brought. Each asset, from the smallest piece of equipment to the

whole business, has a book value. The fair value of an asset may be higher than its book value, and often

is. However, if the fair value is lower than the book value, it should be written down to fair value.

Sales

Total amount of goods sold over a given period, usually reported net of any sales taxes (eg value added tax).

Dividend

This is the distribution of earnings to shareholders. It can be paid in money, stock or, very rarely,

company property. The occurrence of the dividend payment depends on the company; it can either be

paid quarterly, half yearly or once a year, and may be ordinary (usually expected to recur) or

special/extraordinary (often non-recurring).

EVA inputs

Net Sales

This is the sales figure with deductions for any discounts, returns, and damaged or missing goods or sales

taxes (eg value added tax).

Operating expenses (OPEX)

Any expenses brought about by the operations of the company, eg cost of goods sold, SG&A (selling,

general and administrative expenses). It does not include non-operating costs (such as interest or tax).

Net operating profit less adjusted taxes (NOPLAT)

This is operating profit (net sales less opex) minus the tax that would be paid if there were no other

factors (such as tax-deductible interest).

271


abc

Key accounting ratios Ratio Calculation Definition/Interpretation

Current ratio Current assets Current liabilities

This indicates the ability of a company to pay its debts in the short term. A higher ratio is preferable.

Quick ratio Current assets – Inventories

Current Liabilities Also measures the ability of a company to pay its short-term debt but with its most liquid assets. A higher ratio is preferred.

Debt/equity ratio Financial liabilities Shareholder funds

This measures the company’s financial leverage, by indicating the ratio of debt to equity.

Net profit margin ratio Profit after tax Sales

Used when comparing companies in similar industries; it is a rate of profitability. Its weakness is that it depends not only on operations but interest, etc.

Interest coverage ratio EBIT Interest

This indicates the debt servicing capacity of the company; the greater the buffer, the safer the debt holders.

Return on equity (ROE) Net Income Shareholders Equity

Measures a corporation’s profitability from a shareholder’s point of view. It depends on operating success and leverage.

Return on invested capital (ROIC)

NOPLAT Total Capital

Measures profitability from an operating point of view, for both shareholders and bond holders. It does not depend on leverage so is more comparable across a sector.

Asset turnover ratio Sales Assets

The amount of sales generated by each dollar (or whatever unit sales are measured in) worth of assets.

Inventory turnover ratio Sales Inventory

This ratio shows how many times a company’s inventory is sold and then replaced over a year.

Debtors turnover ratio Sales Average Debtors

This implies the number of times a debtor is turned over every year. A high ratio is good for low working capital requirement.

Creditors turnover ratio Credit purchase Average creditors

This indicates the credit period that firms benefit from before they pay off their creditors. A high ratio indicates that the creditors are being paid promptly, while a low ratio is good for working capital.

Dividend payout ratio Yearly dividend per share Earnings per share

This is the percentage of earnings paid to shareholders in dividends. Investors often prefer a high ratio, but a low ratio retains more earnings for use in the business.

Dividend yield Annual dividends per share Price per share

Indicates how much a company pays out in dividends relative to its share price. It may be useful when estimating a floor value of a stock (if the dividend is sustainable). Some funds target high-yielding stocks (called ‘Yield Funds’).

Source: HSBC

Income statement line items Sales or revenues

The total amount of money in a given period that a company obtains after deductions for discounts and

returned merchandise and usually after deducting any sales taxes (eg value added tax).

Cost of goods sold (COGS)

The cost of buying or making the goods sold in the period.

Gross margin

Gross Profit (sales less COGS) as a percentage of sales.

* 100

* 100

272


abc

Selling, general & administrative expenses (SG&A)

This is operating costs other than COGS, between gross profit and EBITDA in the P&L.

Earnings before interest, tax, depreciation and amortisation (EBITDA)

It can be used for comparing profitability and efficiency ratios for a firm. It is one of the most common

ways of comparing the performances of differing companies.

Depreciation

The reduction in value of an asset through time, use, etc. EBITDA less depreciation and amortisation is

EBIT. It is non-cash (the cash already having been paid to acquire the asset) but a part of the P&L and an

annual reduction in balance sheet asset value. If an asset is depreciated over its useful life, it may well

need replacing when fully depreciated at end-of-life.

Amortisation

This is a reduction in the cost of an intangible asset through changes in income. If Company A buys a

piece of equipment with a patent for GBP25m and the patent lasts for 10 years, GBP2.5m each year

would be recorded as amortisation. (Depreciation, by contrast, is for tangible assets such as land,

building, plant and equipment.)

Operating profit or EBIT

Earnings Before Interest and Taxes; it is after D&A but before interest and other financial charges and taxes.

Calculate by: Revenue – Operating Expenses

Interest

Financial income (on cash, etc) less expense (on bonds, bank debt, etc). Some companies include their

share of profits from associates, dividends from investments and various other factors (eg FX gains and

losses) in a Financial Items line along with interest.

Pre-tax profit (PTP or PBT)

Profit after interest but before tax has been taken away from it.

Tax

Taxes on company profit, as opposed to sales taxes (usually deducted directly from sales) or operating

taxes (usually added to staff costs, property costs, etc, in opex).

Net profit, net income or earnings

Profit after everything (except dividends which are a distribution of earnings, after dividends would be

called retained profits), ie after interest, tax and minority charges (the share of any profits attributable to

minority shareholders of subsidiaries of the company).

Note: The above items should appear in most P&L accounts (financial companies often being a notable

exception), while the items below are rarer.

273


abc

Provision

Costs are provided for if they are expected but have not yet been paid. For example, banks unlikely to

collect all the money lent provide for the proportion they expect not to collect, damages for a law suit

expected to be lost, etc. Provisions are often included within COGS or SG&A.

Clean profit

Restructuring and other non-recurring costs (or income) are often separately identified by companies to help

understand and predict future profits and often adjusted for in ‘clean’ profit measures, eg clean EBIT.

Continuing operations

These are the segments within a business expected to continue functioning for the foreseeable future.

For investors it indicates what the business could rationally be expected to replicate in future.

Discontinued operations

These are any segments of a business that have been sold, disposed of or abandoned. This is reported

separately in the accounts to continuing operations.

Balance sheet line items Assets

Anything owned by a business that has commercial value.

Non-current assets

Assets not easily convertible to cash, or not expected to become cash within the next year. Also known as

long-life assets.

Fixed assets

Assets that a company uses over a long period of time; they are not expected to be sold on.

Intangible assets

An asset that is not physical in nature, such as corporate intellectual property rights, goodwill, brand

recognition.

Investment assets

An asset not used within the company’s operations.

Deferred tax assets

The present value of tax credits (eg from past losses) are expected to reduce future tax payments that

would otherwise be incurred.

Receivables

All accounts receivable and debt owed to a company, whether they are due in the short or long term.

Current assets

Assets expected to be turned into cash within the coming year, or assets that are expected to be sold.

274


abc

Inventories

The value of the firm’s raw materials, work in process, supplies used in operations and finished goods.

Cash & cash equivalents (CCE)

Assets already in cash or that can be converted into cash rapidly; generally high liquidity and relatively

safe; for example, a treasury bill.

Liabilities

Money, services and goods that are owed by a company.

Non-current liabilities

Liabilities not expected to be paid with a year.

Financial liabilities: debt and financial derivatives

Bonds and borrowings from banks and other lenders that must be repaid (with interest).

Provisions for liabilities and charges

Liability value is not known accurately and therefore an amount is set aside to cover it; for example, the

estimated cost of restructuring or losing a legal case.

Retirement benefit obligations

The present value (usually net of tax) of the expected liabilities for payments to former and current staff

for pensions, healthcare, etc. accumulated during their service.

Current liabilities

Liabilities expected to be paid throughout the coming year. They include short-term debt, payable

accounts, unpaid wages, tax due, etc.

Trade and other payables

Liabilities to suppliers.

Shareholders’ equity, net assets

Total assets less total liabilities (excluding shareholders’ equity itself). By definition, this must either have

been provided to the company through issuing shares or have built up through retained earnings. Therefore,

net assets = total assets – total liabilities = share capital + retained earnings = shareholders’ equity.

Calculate by: Total assets less total liabilities, or by share capital + retained earnings

Share capital

The original value of the shares issued by a company; therefore, even if there is a rise in the share price,

this is not taken into account. Shares may be issued at the creation of the company or later and may be at

nominal value or with a share premium on top.

275


abc

Retained earnings

Cumulative total earnings minus that which has been distributed to the shareholders as dividends.

Calculate by: Closing retained earnings = opening retained earnings plus earnings in the period less

dividends declared in the period

Cash flow statement line items Net cash flow from operating activities

Operating activities include the production, sales and delivery of the company’s product, as well as

collecting payment from its customers. This could include purchasing raw materials, building inventory,

advertising, and shipping the product.

Revenue and expenses

These include cash receipts from sale of goods and services and cash payments to suppliers for goods and

services.

Other income

These include interest received on loans, dividends received on equity securities, payment to employees, etc.

Non-cash items

These include depreciation, amortisation, deferred taxes, etc, which are added back to/subtracted from the

net income figure.

Net cash flow from investing activities

This reports the change in a company’s cash position resulting from losses or gains from investments that

have been made in financial markets or operating subsidiaries. Changes can also result from the amounts

spent on investment in capital assets.

Capital expenditure

Any buying or selling of fixed assets that allow the running of the company to take place.

Expenditure on intangible assets

Buying or selling of intangible assets that contribute to the company.

Disposals of property, plant & equipment

Any profits or losses occurred from discarding concrete material of the companies, such as land and machinery.

Investment in financial assets

This is profit gained from investing in an asset that does not have a physical worth, such as stocks, bonds,

and bank deposits.

Proceeds from sale of financial assets

The money gained by selling the financial asset.

276


abc

Net cash flow from financing activities

This reports the change in a company’s cash position resulting from raising or repayment of financial liabilities.

Issue of equity shares

Companies raise capital by issuing new shares either in the initial market (first-time equity issue) or in the

secondary market (subsequent issues of equity).

Proceeds from exercise of share options

The exercise of share options is the purchasing of an issuer’s common stock at the price set by the option,

regardless of the price of the stock at the time the option is exercised. Proceeds can thus be obtained if the

price set by the option initially is less than the current stock price.

Purchase of own shares

This occurs when a company purchases its own shares. A number of restrictions and conditions must be

met for this to occur. The company must pay for the shares out of distributable profits or out of the

proceeds of a fresh share issue to finance the purchase. Following the company share repurchase, the

shares are treated as cancelled.

Dividends paid to equity shareholders

The distribution of the portion of a company’s earnings to their equity shareholders.

Increase in new borrowings

An increase in the new borrowings issued by a company.

Reduction of borrowings

When a company reduces its debt by decreasing borrowings.

Cash interest payable

The cash interests, which are the amounts that accrue periodically on an account that can be paid out

eventually to the account holder, payable to the company.

Further multiples Multiple Calculation Definition/Interpretation

EV/EBIT EV EBIT

Can be used to value a company, regardless of its capital structure. Takes into account D&A.

EV/NOPLAT EV NOPLAT

This is another profit multiple, and can be used as a substitute for EV/EBIT. Takes into account tax.

EV/IC EV IC

This is an unlevered price-to-book ratio.

ROIC/WACC ROIC WACC

Dividing ROIC by WACC helps to compare returns between markets (or companies) with different WACC, and may help in judging what EV/IC is reasonable.

Source: HSBC

This basic valuation and accounting guide was written for the 2010 edition of the HSBC Nutshell. It

has been reviewed by Xavier Gunner, Managing Director, Global Research, HSBC Bank Plc

(employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified

pursuant to FINRA regulations).

277


abc

Notes

278


abc

Disclosure appendix Analyst Certification Each analyst whose name appears as author of an individual chapter or individual chapters of this report certifies that the views about the subject security(ies) or issuer(s) or any other views or forecasts expressed in the chapter(s) of which (s)he is author accurately reflect his/her personal views and that no part of his/her compensation was, is or will be directly or indirectly related to the specific recommendation(s) or view(s) contained therein: Chris Georgs, Xavier Gunner, Antonin Baudry, Antoine Belge, Cedric Besnard, Wai-shin Chan, Sophie Dargnies, Jeffrey Davis, Franca Di Silvestro, Florence Dohan, Niels Fehre, Thomas Fossard, John Fraser-Andrews, Dhruv Gahlaut, Colin Gibson, Michael Hagmann, Geoff Haire, Stephen Howard, Andrew Keen, Jason Kepaptsoglou, Zoe Knight, Dmytro Konovalov, Achal Kumar, Rajesh Kumar, Matthew Lloyd, Andrew Lobbenberg, John Lomax, Tobias Loskamp, Alex Magni, Sean McLoughlin, Kailesh Mistry, Verity Mitchell, Olivier Moral, Wietse Nijenhuis, Michele Olivier, Cenk Orcan, Robert Parkes, David Phillips, Erwan Rambourg, Nick Robins, Paul Rossington, Jerome Samuel, Horst Schneider, Raj Sinha, Paul Spedding, Peter Sullivan, Lena Thakkar, Joseph Thomas, Lauren Torres, John Tottie, Emmanuelle Vigneron, Julia Winarso, Vladimir Zhukov and Thorsten Zimmermann

Important disclosures

Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions, which depend largely on individual circumstances such as the investor's existing holdings, risk tolerance and other considerations. Given these differences, HSBC has two principal aims in its equity research: 1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12 month time horizon; and 2) from time to time to identify short-term investment opportunities that are derived from fundamental, quantitative, technical or event-driven techniques on a 0-3 month time horizon and which may differ from our long-term investment rating. HSBC has assigned ratings for its long-term investment opportunities as described below.

This report addresses only the long-term investment opportunities of the companies referred to in the report. As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at www.hsbcnet.com/research. Details of these short-term investment opportunities can be found under the Reports section of this website.

HSBC believes an investor's decision to buy or sell a stock should depend on individual circumstances such as the investor's existing holdings and other considerations. Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations. Investors should carefully read the definitions of the ratings used in each research report. In addition, because research reports contain more complete information concerning the analysts' views, investors should carefully read the entire research report and should not infer its contents from the rating. In any case, ratings should not be used or relied on in isolation as investment advice.

Rating definitions for long-term investment opportunities

Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis:

For each stock we set a required rate of return calculated from the cost of equity for that stock’s domestic or, as appropriate, regional market established by our strategy team. The price target for a stock represents the value the analyst expects the stock to reach over our performance horizon. The performance horizon is 12 months. For a stock to be classified as Overweight, the potential return, which equals the percentage difference between the current share price and the target price, including the forecast dividend yield when indicated, must exceed the required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile*). For a stock to be classified as Underweight, the stock must be expected to underperform its required return by at least 5 percentage points over the next 12 months (or 10 percentage points for a stock classified as Volatile*). Stocks between these bands are classified as Neutral.

279


abc

Our ratings are re-calibrated against these bands at the time of any 'material change' (initiation of coverage, change of volatility status or change in price target). Notwithstanding this, and although ratings are subject to ongoing management review, expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change.

*A stock will be classified as volatile if its historical volatility has exceeded 40%, if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility. However, stocks which we do not consider volatile may in fact also behave in such a way. Historical volatility is defined as the past month's average of the daily 365-day moving average volatilities. In order to avoid misleadingly frequent changes in rating, however, volatility has to move 2.5 percentage points past the 40% benchmark in either direction for a stock's status to change.

Rating distribution for long-term investment opportunities

As of 24 July 2012, the distribution of all ratings published is as follows: Overweight (Buy) 50% (27% of these provided with Investment Banking Services)

Neutral (Hold) 37% (26% of these provided with Investment Banking Services)

Underweight (Sell) 13% (18% of these provided with Investment Banking Services)

Analysts, economists, and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues.

For disclosures in respect of any company mentioned in this report, please see the most recently published report on that company available at www.hsbcnet.com/research.

* HSBC Legal Entities are listed in the Disclaimer below.

Additional disclosures 1 This report is dated as at 29 July 2012. 2 All market data included in this report are dated as at close 30 May 2012, unless otherwise indicated in the report. 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its

Research business. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBC's Investment Banking business. Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or price sensitive information is handled in an appropriate manner.

MSCI Disclaimer The MSCI sourced information is the exclusive property of MSCI Inc. (MSCI). Without prior written permission of MSCI, this information and any other MSCI intellectual property may not be reproduced, redisseminated or used to create any financial products, including any indices. This information is provided on an “as is” basis. The user assumes the entire risk of any use made of this information. MSCI, its affiliates and any third party involved in, or related to, computing or compiling the information hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of this information. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in, or related to, computing or compiling the information have any liability for any damages of any kind. MSCI and MSCI indexes are service marks of MSCI and its affiliates.

280


abc

Disclaimer * Legal entities as at 12 June 2012 ‘UAE’ HSBC Bank Middle East Limited, Dubai; ‘HK’ The Hongkong and Shanghai Banking Corporation Limited, Hong Kong; ‘TW’ HSBC Securities (Taiwan) Corporation Limited; 'CA' HSBC Bank Canada, Toronto; HSBC Bank, Paris Branch; HSBC France; ‘DE’ HSBC Trinkaus & Burkhardt AG, Düsseldorf; 000 HSBC Bank (RR), Moscow; ‘IN’ HSBC Securities and Capital Markets (India) Private Limited, Mumbai; ‘JP’ HSBC Securities (Japan) Limited, Tokyo; ‘EG’ HSBC Securities Egypt SAE, Cairo; ‘CN’ HSBC Investment Bank Asia Limited, Beijing Representative Office; The Hongkong and Shanghai Banking Corporation Limited, Singapore Branch; The Hongkong and Shanghai Banking Corporation Limited, Seoul Securities Branch; The Hongkong and Shanghai Banking Corporation Limited, Seoul Branch; HSBC Securities (South Africa) (Pty) Ltd, Johannesburg; ‘GR’ HSBC Securities SA, Athens; HSBC Bank plc, London, Madrid, Milan, Stockholm, Tel Aviv; ‘US’ HSBC Securities (USA) Inc, New York; HSBC Yatirim Menkul Degerler AS, Istanbul; HSBC México, SA, Institución de Banca Múltiple, Grupo Financiero HSBC; HSBC Bank Brasil SA – Banco Múltiplo; HSBC Bank Australia Limited; HSBC Bank Argentina SA; HSBC Saudi Arabia Limited; The Hongkong and Shanghai Banking Corporation Limited, New Zealand Branch incorporated in Hong Kong SAR

Issuer of report HSBC Bank plc 8 Canada Square London, E14 5HQ, United Kingdom

Telephone: +44 20 7991 8888

Fax: +44 20 7992 4880 Website: www.research.hsbc.com

In the UK this document has been issued and approved by HSBC Bank plc (“HSBC”) for the information of its Clients (as defined in the Rules of FSA) and those of its affiliates only. It is not intended for Retail Clients in the UK. If this research is received by a customer of an affiliate of HSBC, its provision to the recipient is subject to the terms of business in place between the recipient and such affiliate. HSBC Securities (USA) Inc. accepts responsibility for the content of this research report prepared by its non-US foreign affiliate. All U.S. persons receiving and/or accessing this report and wishing to effect transactions in any security discussed herein should do so with HSBC Securities (USA) Inc. in the United States and not with its non-US foreign affiliate, the issuer of this report. In Singapore, this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited, Singapore Branch for the general information of institutional investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (“SFA”) and accredited investors and other persons in accordance with the conditions specified in Sections 275 and 305 of the SFA. This publication is not a prospectus as defined in the SFA. It may not be further distributed in whole or in part for any purpose. The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore. Recipients in Singapore should contact a "Hongkong and Shanghai Banking Corporation Limited, Singapore Branch" representative in respect of any matters arising from, or in connection with this report. In Australia, this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN 65 117 925 970, AFSL 301737) for the general information of its “wholesale” customers (as defined in the Corporations Act 2001). Where distributed to retail customers, this research is distributed by HSBC Bank Australia Limited (AFSL No. 232595). These respective entities make no representations that the products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in accordance with local law. No consideration has been given to the particular investment objectives, financial situation or particular needs of any recipient. This publication has been distributed in Japan by HSBC Securities (Japan) Limited. It may not be further distributed, in whole or in part, for any purpose. In Hong Kong, this document has been distributed by The Hongkong and Shanghai Banking Corporation Limited in the conduct of its Hong Kong regulated business for the information of its institutional and professional customers; it is not intended for and should not be distributed to retail customers in Hong Kong. The Hongkong and Shanghai Banking Corporation Limited makes no representations that the products or services mentioned in this document are available to persons in Hong Kong or are necessarily suitable for any particular person or appropriate in accordance with local law. All inquiries by such recipients must be directed to The Hongkong and Shanghai Banking Corporation Limited. In Korea, this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited, Seoul Securities Branch ("HBAP SLS") for the general information of professional investors specified in Article 9 of the Financial Investment Services and Capital Markets Act (“FSCMA”). This publication is not a prospectus as defined in the FSCMA. It may not be further distributed in whole or in part for any purpose. HBAP SLS is regulated by the Financial Services Commission and the Financial Supervisory Service of Korea. This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited, New Zealand Branch incorporated in Hong Kong SAR. This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. HSBC has based this document on information obtained from sources it believes to be reliable but which it has not independently verified; HSBC makes no guarantee, representation or warranty and accepts no responsibility or liability as to its accuracy or completeness. The opinions contained within the report are based upon publicly available information at the time of publication and are subject to change without notice. Nothing herein excludes or restricts any duty or liability to a customer which HSBC has under the Financial Services and Markets Act 2000 or under the Rules of FSA. A recipient who chooses to deal with any person who is not a representative of HSBC in the UK will not enjoy the protections afforded by the UK regulatory regime. Past performance is not necessarily a guide to future performance. The value of any investment or income may go down as well as up and you may not get back the full amount invested. Where an investment is denominated in a currency other than the local currency of the recipient of the research report, changes in the exchange rates may have an adverse effect on the value, price or income of that investment. In case of investments for which there is no recognised market it may be difficult for investors to sell their investments or to obtain reliable information about its value or the extent of the risk to which it is exposed. HSBC Bank plc is registered in England No 14259, is authorised and regulated by the Financial Services Authority and is a member of the London Stock Exchange. © Copyright 2012, HSBC Bank plc, ALL RIGHTS RESERVED. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, on any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of HSBC Bank plc. MICA (P) 038/04/2012, MICA (P) 063/04/2012 and MICA (P) 206/01/2012

A product of the Global Equity Research Team

This guide will help you gain a quick but thorough understanding of the major sectors, industry

groups and countries in the region

It provides detailed information on structures, key drivers, indicators, themes and valuation

approaches

Disclosures and Disclaimer This report must be read with the disclosures and analyst

certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

Ju

ly 2

012

HSBC NutshellA guide to equity sectors and emerging countries in EMEA

Global Equity Research

Multi-sector

July 2012

Chris Georgs

Global Head of Equity Research

HSBC Bank plc

+44 20 7991 6781

[email protected]

EMEA

EM

EA

HS

BC

Nu

tsh

ell - A

gu

ide to

eq

uity

secto

rs a

nd

em

erg

ing

co

un

tries

Xavier Gunner*

Deputy Head of Equity Research

HSBC Bank plc

+44 20 7991 6749

[email protected]

*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations.

120723_50909_MULTI_REGIONAL_NUTSHELL_F7:Normal Cover 2011 v1 7/24/2012 4:04 AM Page 1

Documents

HSBC Nutshell-A guide to equity sectors and emerging ... · PDF fileEMEA countries 221 Egypt 223 Russia 231 Saudi Arabia 239 South Africa 247 Turkey 255 Basic valuation and accounting