Investment perspectives — uk

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Morgan Stanley & Co. International plc

O c t o b e r 1 4 , 2 0 1 0

## Consumer Discretionary

## Consumer Staples

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North America

Europe UK strategy – time to think about

inflation … Investors should focus on the longer-term impact of QE and the implications for higher inflation, which should be good news for equities vs. bonds, argues Graham Secker (Page 3)

Semiconductors – too early to turn positive: Francois Meunier initiates coverage with a Cautious view, arguing that it is too early to buy into the sector, especially with an inventory correction looming in the PC and consumer space (Page 23).

Imperial Tobacco – the merits of partnering: Toby McCullagh argues that international partnering can add a capital-light and relatively low risk driver to Imperial’s top-line growth and a further leg to his Overweight thesis (Page 27).

UK INVESTMENT PERSPECTIVES

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Strategy and Economics UK

3 UK Strategy Time to Think about Inflation… and Equities Outperforming Bonds Graham Secker

7 UK Economics Spending Review: Further Lines of Attack for Critics Melanie Baker, Anthony O’Brien, Cath Sleeman

9 UK Interest Rate Strategy UK Rates: Time to Deliver Anthony O’Brien, Melanie Baker, Cath Sleeman

Global 11 European Credit Strategy

Deleveraging and the Debt/Equity Clock Andrew Sheets, Phanikiran Naraparaju, Carlos Egea, Serena Tang, Jonathan Graber

15 US Economics Roadmap to Sustainable Growth Richard Berner, David Greenlaw

17 US Credit Strategy Tale of Two Markets Rizwan Hussain, Maya Abdurahmanova

19 Commodity Strategy Natural Gas – Fundamentally Oversupplied Hussein Allidina, Stephen Richardson, Tai Liu

Industry & Company Analysis

21 Airlines Short Haul: Long Opportunity Penelope Butcher, Suzanne Todd, Menno Sanderse

23 Initiation Semiconductors Cautious on Sector but Upside in ARM, IFX, ING and WLF Francois Meunier, Sunil George, Patrick Standaert, Mark Lipacis, Atif Malikm Sanjay Devgan

2


October 14, 2010 Investment Perspectives — UK

Table of Contents (continued)

(continued…)

27 Imperial Tobacco Partnering Model Could Offer Upside to Growth Estimates Toby McCullagh, David Adelman, Matthew Grainger

29 SOCO International Back to Core – Stay OW Theepan Jothilingam, Matthew P Lofting

31 Initiation Unite Group Superior NAV Growth Even With Modest Rental Growth Bianca Riemer, Bart Gysens, Christopher Fremantle

33 Vodafone Group Rising Cash Returns Nick Delfas, Terence Tsui, Luis Prota, Frederic Boulan

35 Wolseley plc Increased Confidence in Restructuring: Stay OW Jessica Alsford, David Hancock, Simone Porter-Smith

37 Wood Group Value Materialised; Downgrade to Equal-weight Martijn Rats, Robert Pulleyn

Portfolio and Valuations

39 UK Economic Forecasts

40 Indices, Sector and Stock Performance

41 UK Industry Valuations and Forecasts

42 Diary of Key Upcoming Events

47 Company and Directors’ Share Buybacks

54 UK Stock Coverage List



Strategy and Economics

October 12, 2010

UK Strategy Time to Think about Inflation… and Equities Outperforming Bonds Morgan Stanley & Co.

International Limited+

Graham Secker [email protected]

Looking to the longer-term ramifications of QE With pretty much every asset class apart from the US dollar rising in recent weeks, it appears that the market is busy preparing for a renewed bout of quantitative easing (QE) by the Fed. While a period of good performance is always nice, we believe investors should take this opportunity to focus on the more medium to longer-term ramifications of QE (and other forms of monetary stimulus). In this article we focus on the implications for asset allocation and, specifically, the possibility that this new QE programme coincides with a trough in US core inflation.

We expect moderate inflation rather than deflation When considering the link between asset allocation and inflation, the relative performance and valuation of equities versus bonds suggests to us that investors are predominantly concerned about deflationary risks. While we accept that deflation in Western economies is a possible outcome from here, we firmly believe that it is not a probable outcome in the medium term. At the same time, we do not predict a big inflation problem. Instead, we expect inflation to be a bit higher than one would naturally expect for a low rate of economic growth – i.e. a more benign version of stagflation.

Exhibit 1

When faced with a debt problem most countries tend to choose inflation – Japan was the exception

Source: National Statistics, Morgan Stanley Research

Japan is the exception not the rule, and the authorities are on the case When considering the inflation/deflation debate, it is apparent to us that the market appears to be deferring to the Japanese experience. While this is understandable to a degree, given some of the similarities between Western economies today and Japan over the last 20 years, we are conscious that Japan itself has been something of an anomaly in the sense that it is the only country in recent economic history that has effectively chosen the deflation rather than inflation route. More importantly, in our view, however, is the fact that the authorities are going all out to prevent deflation taking hold. While these authorities are not omnipotent, we think it would be unwise to bet explicitly against them, at least at this stage.

Core CPI is a key indicator to watch … Consequently, we believe investors should keep a close eye on current inflation trends going forward as any evidence of a trough could have significant implications for asset allocation. In his recent report QE Coming: Slow Rise in Inflation Not Enough to Satisfy the Fed, 1 October 2010, our US economist Richard Berner argues for a slow rise in inflation through 2011 and notes that rents, which account for 40% of the core CPI basket, are now rising again, as Exhibit 2 illustrates. The Fed’s preferred measure of inflation is the PCEPI which has a much lower housing weighting in the index – this series has held up much better than core CPI this year and may already be troughing.

… and a number of macro indicators suggest it may be troughing In terms of other indicators, we note that the recent rise in the prices paid component of the ISM manufacturing survey points

Exhibit 2

US rents are 40% of core CPI and are now rising

$860

$880

$900

$920

$940

$960

$980

$1,000

Apr-08 Aug-08 Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 Aug-10

91.0%

91.5%

92.0%

92.5%

93.0%

93.5%

94.0%

94.5%

National Effective Rent (Left Scale)National Occupancy Rate (Right Scale)

Source: Axiometrics

3




to upside risks to CPI, as does the rise in capacity utilisation that is now underway in the US (and Germany and the UK too). Finally, we note that US yield curves remain steep at both the 10-2yr level and the 30-10yr level – arguably, the former suggests the growth outlook is okay while the latter, which is at a 30-year high, suggests inflation will return.

A trough in inflation would be an important signal for asset allocation If we do see the start of an uptrend in global inflation pressures over the next six months, this could have a profound impact on asset allocation. The huge amount of liquidity sloshing around the global financial system right now is predominantly sitting in bond funds. However, while this is understandable in a world worried about deflation, we think such a position is much harder to justify if investors start worrying about rising, not falling, inflation. As Exhibit 7 shows, developed equity markets have shrunk significantly in size compared to developed bond markets over the last decade or so. Consequently, a moderate outflow from bonds to equities is more meaningful now than it would have been 10 years ago.

When we consider asset allocation in this regard it is important to note that there is, in our opinion, a significant divergence in view between equity and fixed income investors at this time, with the latter significantly more bearish on growth and inflation than the former. Assuming this is indeed true, then it suggests that the investment implications of any uptick in inflation is more profound for bonds than stocks. In particular, we would highlight the traditional link between US core inflation and US bond yields, as highlighted in Exhibit 5 – yields always back up around a trough in core inflation.

Bonds are more popular now than equities were in 2000 In addition to bond investors’ bearish macro view as a starting point, we also note that bonds are far more popular as an asset class than equities are. The best chart we have come across to illustrate this point is Exhibit 6 – simply put, bonds are more popular today than equities were at the peak of the TMT bubble in 2000.

In addition, the market’s hunger for all things fixed income is reflected in recent bond news, such as:

corporates borrowing at record low interest rates (e.g. IBM issuing bonds at 1%, Microsoft borrowing at sub-1%);

Exhibit 3

The Fed’s preferred measure of inflation (PCEPI) is showing signs of troughing

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09

US

Infl

atio

n

Core CPI

PCEPI

Source: Haver, Morgan Stanley Research

Exhibit 4

Break-even inflation expectations are rising …

1.5

1.7

1.9

2.1

2.3

2.5

2.7

2.9

3.1

3.3

Oct 09 Nov 09 Dec 09 Jan 10 Feb 10 Mar 10 Apr 10 May 10 Jun 10 Jul 10 Aug 10 Sep 10 Oct 10

10-y

r B

reak

even

infl

atio

n e

xpec

tati

on

s

UK

US

Source: Bloomberg, Morgan Stanley Research

Exhibit 5

… and a trough in core CPI often coincides with a trough in treasury yields

0

2

4

6

8

10

12

14

16

Jan-80 Jan-83 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 Jan-10

(%) US 10-yr treasury yield

US core CPI

Source: Datastream, Morgan Stanley Research

4




corporates issuing 100-year bonds at sub 6% yields (for example, Norfolk Southern and Rabobank);

Mexico issuing 100-year bonds at 6.1% yields;

Brazilian companies in highly cyclical industries, such as cement and real estate, now issuing perpetual bonds (i.e. where there is no maturity and companies can choose when to pay back the debt at their own discretion).

Returns are not risk-free We acknowledge that one explanation for the strong demand for bonds and aversion to stocks is that some investors are predominantly focusing on the risk, as opposed to the reward, side of the investment equation. True, investors are unlikely to lose money in nominal terms. However, we suspect many are buying bonds today on the basis that it is impossible to lose money. We do not believe this premise is necessarily true, certainly in real terms, and would note the following:

1. Government bonds have been in a strong bull market for the last 30 years or so. However, pre-1980 gilt yields trended up and a nominal series of gilt prices trended down (Exhibit 8).

2. The low return on bonds pre the 1980s coincided with a period of heightened inflation so that real returns to investors were negative. Exhibit 9, which comes from the book Triumph of the Optimists by Dimson, Marsh and Staunton, shows that investors in US bonds lost money in real terms over a 40-year period between 1940 and 1980. Note that this chart looks exactly the same for the UK too.

A pick-up in inflation should be good for equities initially If inflation does ultimately start to rise (given that it is already high in the UK we should say if higher inflation becomes more entrenched), we believe it will be good news for equities initially (especially relative to bonds). For much of the last 30 years or so a trough in inflation has generally been perceived to be bad for stocks as investors reacted to a prospective change in the interest rate environment. However, we think this relationship is related to the existence of the debt supercycle which meant that markets became more sensitive to changes in the cost of credit rather than changes in the underlying growth outlook. As our global strategist Gerard Minack has regularly highlighted over the last year or so, the ending of the debt supercycle means that the stock market is now much more sensitive to changes in economic growth than it is to the interest rate outlook.

Exhibit 6

Bonds are more popular now than equities were in 2000

-300

-200

-100

0

100

200

300

400

500

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Ro

llin

g 1

2M A

gg

reg

ate

Flo

ws

To

US

Mu

tual

Fu

nd

s $b

n

.

Equities

Bonds

Source: ICI, Morgan Stanley Research

Exhibit 7

DM equity markets are now just 40% of DM bond markets

20

30

40

50

60

70

80

90

100

110

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

DM

Mar

ket

Cap

as

% D

ebt

Sec

uri

ties

Ou

tsta

nd

ing

Source: Company data, Morgan Stanley Research

Exhibit 8

Prior to the last 30 years bond prices fell regularly…

0

2

4

6

8

10

12

14

16

18

20

1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009

UK

20Y

r G

ilt Y

ield

s

40

50

60

70

80

90

100

110

120

130

FT

All

Gov

t B

ond

Pri

ice

Ind

ex

UK gilt price index - rhs

UK gilt yields


5




More likely to get ‘bad’ rather than ‘good’ inflation However, we are under no illusion that inflation is the answer to our structural macroeconomic problems – the inflation we do get is more likely to be ‘bad’ inflation (i.e. non-discretionary inflation, which is running at 7% year-on-year in the UK) than ‘good’ inflation (i.e. a rise in incomes, wages and profits). Consequently, inflation acts as something of a tax on the domestic economy and a reallocation of funds away from import-oriented economies in favour of the exporters of inflation.

Buy the sources of inflation – sell the takers of inflation We would highlight two implications for equity investors. First, investors should avoid exposure to domestic discretionary spending where inflation eats into disposable income. For example, with wage growth slow and inflation high, Exhibit 11 shows that the current level of real consumer disposable income growth is already at its lowest level since 1977. Second, investors should look to gain exposure to the sources of inflation – specifically, this is likely to mean industrial and commodity companies (including domestic focused plays such as agriculture). In addition, stocks with strong pricing power that can pass on higher input prices should perform well, as should gold.

In terms of sectors, we are currently overweight Insurance, Materials, Energy and Telecoms in our European model portfolio. Of the four, we believe that the latter is the only sector that does not give us exposure to the theme of rising inflation or bond yields. Traditionally, banks/financials are perceived to be big losers in an inflationary environment (when you want to be a borrower rather than a creditor). However, that situation is arguably reversed when the borrower is under water and asset price inflation would reduce the risk of negative equity. We are neutral banks.

An uptick in inflation would also point to underperformance from bond proxies and other stocks with poor growth profiles irrespective of valuation (i.e. beware of low growth value traps). Instead, higher inflation would point to owning stocks with a good growth profile (which have a better ability to absorb higher costs or pass them on to their customers). Note that we saw a marked upturn in inflation at the end of the 1990s as authorities’ reacted to the 1998 growth scare with additional stimulus (sound familiar?), and we consequently saw outperformance from the area of the market that was perceived to have the best growth prospects – TMT. Today, the area of the market where growth perceptions are highest is emerging markets.

Exhibit 9

In real terms investors lost money in US bonds steadily between 1940-1980

Source: Triumph of the Optimists, Dimson, Marsh & Staunton

Exhibit 10

The trough in CPI in 1998 coincided with a rapid acceleration in TMT outperformance

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01

US

CP

I

60

70

80

90

100

110

120

130

140

150

160

US

TM

T v

s U

S M

arke

t

US CPI

US TMT Rel Perf - rhs


Exhibit 11

UK household disposable income growth at a 33-year low

-6

-4

-2

0

2

4

6

8

10

12

60 65 70 75 80 85 90 95 00 05 10

Rea

l Ag

gre

gat

e H

ou

seh

old

Dis

po

sab

le I

On

com

e (Y

oY

%)

Source: Haver, Morgan Stanley Research

6




October 8, 2010

UK Economics Spending Review: Further Lines of Attack for Critics Morgan Stanley & Co.

International plc+

Melanie Baker, CFA [email protected]

Anthony S O'Brien, Cath Sleeman

In the view of our Interest Rate Strategy Team, as long as the market perceives that the government is sticking to its plans, the October 20 Spending Review should not be a negative risk event for Gilts. However, fiscal spending plans have yet to be spelled out in much detail. The upcoming Spending Review will outline the departmental spending cuts and, we assume, provide additional detail on actual programme cuts within this.

This is of course a necessary step in maintaining fiscal credibility. However, the details of the Spending Review will provide more ‘lines of attack’ for critics who doubt that the plans can be achieved without considerable damage to the real economy and to public services. It will be particularly important therefore to see how much protection is given to spending that is likely to boost the UK’s longer-term growth potential. However, given the scale of the spending cuts planned, some compromise on that front seems inevitable, in our view.

A step that should be about shoring up credibility and that should provide more certainty about the path of government spending, could therefore also become a trigger for weaker confidence among households and businesses and doubt among investors about the ability of the economy to generate growth. That effect could be magnified if 3Q GDP growth – released only a few days after the Spending Review – disappoints (as we think it may well do; we forecast: 0.1%Q).

This Spending Review is different

The basics …: The path for public expenditure was set out in the 22 June Budget (see our budget review note). The Spending Review will lay out in more detail how this path will be achieved and will cover the years from 2011/12 to 2014/15. Designed to help multi-period planning, such spending reviews have occurred regularly since the late 1990s (the last in 2007).

… but this Spending Review is set to be a bit different.

Large budget cuts: The overall ‘spending envelope’ was set out in the June Budget. On the government’s own estimates, government spending is set to be cut by around £80 billion between 2010/11 and 2014/15)1. That is, some 6% of 2009 GDP over five years. The overall planned deficit reduction looks very ambitious when scaled against previous reductions. We assume there will not be major changes to the path for government spending and investment shown in the Budget.

It will go beyond departmental budgets: This Spending Review, as well as laying out departmental budgets, will also look at the bits of spending that cannot be ‘firmly fixed’, including social security, tax credits and public service pensions. It is therefore a very wide-ranging exercise. We assume that we are unlikely to learn exactly what these decisions will do for the size of the public sector workforce. We assume, however, that we will get a reasonable amount of detail about specific programme cuts.

Ambition goes beyond just cost-cutting: The Spending Review is not just seen by the government as an exercise in fiscal consolidation, but, according to the Spending Review Framework, as an opportunity to “think innovatively about the role of government in society”.

Big cuts for some departments

The scale of the departmental cuts, and the overall economic implications of the budget, will be affected by the split between cuts in welfare and departmental spending and the degree to which some sectors are protected.

Split between welfare, pensions and departmental spending: Welfare cuts will mean that less has to be cut from departmental expenditure. Since the June Budget Chancellor Osborne has announced a further £4 billion in welfare cuts2; this should ease departmental settlements (very) slightly. Further cuts in welfare could come (and have, with the recently announced cuts to Child Benefit). However, some of this will likely cover the upfront cost of far-reaching

1 Against baseline where departmental spending rises with inflation. 2 http://www.bbc.co.uk/news/uk-politics-11250639

7

http://linkback.morganstanley.com/web/sendlink/webapp/BMServlet?file=haljms24-3nru-g000-8c1b-6fafd4536c9e&user=87xsrckbtkj-708&__gda__=1371879977_76f2b433a713d59bd602931696c0fa19

http://www.hm-treasury.gov.uk/d/spending_review_framework_080610.pdf

http://www.bbc.co.uk/news/uk-politics-11250639




planned reforms to the benefits system. Generalised public sector pension savings will help ease the burden on departmental budgets.

Split between departments for departmental spending: Two departments are protected: Health and International Development. Further, in the Budget the Chancellor hinted that education and defence would see easier settlements, implying that the cuts to other unprotected departments would be bigger again (see Exhibit 1 for one way the cuts could be shared).

Exhibit 1

Example of how the spending cuts could fall

£billion % change

Baseline real

2010-11 2014-15e

Spending Review 'envelope' 659

Social security/tax credits 193 210

Net public service pensions 4 9

Locally-financed expenditure 33 35

Other AME in Spending Review 15 25

Departmental budgets (DEL) 394 380

Education 58 57 -10

Health 106 119 2

Communities & local government 36 30 -24

Business, innovation & skills 21 18 -24

Defence 46 45 -10

Devolved administrations 56 46 -24

Work and Pensions 9 7 -24

Home office 10 8 -24

Justice 10 8 -24

Transport 14 11 -24

Other* 29 31 -4

Source: HM Treasury and Morgan Stanley research estimates (= e) Notes: Baseline uses figures from June 2010 Budget. For 2014-15 figures for all items in the table up to ‘Departmental budgets (DEL)’ use numbers from Budget table C13. Except ‘Spending Review envelope’ which comes from table 2.3. Social security/tax credits is also less the £4bn of welfare cuts announced by Chancellor Osborne. ‘Departmental Budgets (DEL) from table C13 adds £4bln from welfare savings. In order to calculate % change in real terms, nominal figures in the 2014-15 column are translated into 2010-11 prices using the GDP deflator (OBR forecast from the June Budget). * Includes protected overseas aid budget. The government has committed to real term increases in health spending in each year of the parliament (i.e. to 2014/15). The government has also committed to spending of 0.7% of gross national income on overseas aid (by 2013).

Effect on the economy

We still think that the planned fiscal consolidation will act as a significant drag on the economy over the next few years. The Spending Review itself may have additional implications.

Certainty versus confidence: The Spending Review may bring more certainty for businesses (particularly those with large public sector contracts) and households (particularly benefit-dependent households and those with public sector workers). But it may also encourage a dawning realization of just how big these cuts are. It is not clear that the full magnitude and implications are apparent to households.

More ‘positive’ if age-related expenditures addressed and potential ‘growth boosting’ areas protected: In judging the overall impact, it will be important to see what has been cut. For example, cuts to public sector retirement benefits can enhance long-term fiscal sustainability. There may be particular negative implications for longer-term growth from any substantial cuts to the education budget, cuts to science/research and cuts to the transport budget. The government has promised to protect as far as possible “spending that generates high economic returns.”1 Further, PM Cameron has apparently ordered ministers to draw up a plan for boosting potential growth with a growth White Paper to be published after the Spending Review2. However, the spending cuts are ambitious enough for us assume compromises will be made.

Near-term implications for monetary policy: We assume that what matters more for monetary policymakers is the overall size of spending cuts rather than the specific detail. But clearly the effects on consumer and business confidence and the effect on markets will be important to the Bank of England’s calculations on what to do next on monetary policy. Hits to business and consumer confidence could be enough to prompt a QE extension, alongside any disappointment in GDP growth. However, the Spending Review is likely to be ‘too young’ for the effects on confidence to be read very clearly by the MPC by the time of the November meeting. We continue to think that any QE extension is unlikely in the UK at this stage, unless 3Q GDP contracts (data released on 26 October).

1 Source: Spending Review Framework 2 http://www.ft.com/cms/s/0/e773f5c2-cd8d-11df-9c82-

00144feab49a.html

8

http://www.hm-treasury.gov.uk/d/spending_review_framework_080610.pdf

http://www.ft.com/cms/s/0/e773f5c2-cd8d-11df-9c82-00144feab49a.html

http://www.ft.com/cms/s/0/e773f5c2-cd8d-11df-9c82-00144feab49a.html




October 8, 2010

UK Interest Rate Strategy UK Rates: Time to Deliver Morgan Stanley & Co.

International plc+

Anthony S O'Brien Anthony.O'[email protected]

Melanie Baker, CFA, Cath Sleeman

Investors have given the coalition the benefit of the doubt Investors appear to have given the Coalition the benefit of the doubt, in terms of their ability to carry out the aggressive spending cuts the Chancellor announced in June’s Emergency Budget. UKT 10y yields have outperformed bund yields by 30bp since mid-June, but underperformed US treasuries. However, using perhaps a better gauge of fiscal credibility - performance versus swaps, 10y gilts have richened by 12bp, whereas treasuries are unchanged and bunds actually cheapened a touch – see Exhibit 1. We had recommended long asset swap positions since before the Budget, sensing Chancellor Osborne would ‘talk tough’ on deficit reduction, however, we suggested taking profits in September ahead of the Conference season and October Spending Review as political uncertainties loomed. Now it is time for the Chancellor to deliver.

Overall, their members generally backed the coalition parties during Conference, no matter how unpalatable some grassroots supporters found the fiscal plans. The Spending Review presents the next hurdle before the austerity axe finally lands next fiscal year. As our economists discussed in the previous section, the Chancellor’s plans presented in the Spending Review should be credible and demonstrate that the Coalition will not shy away from the tough deficit reduction plan it laid out in June. This suggests that a/s spreads should continue their richening trend, making new wides, although speculation at the degree of ‘re-profiling’ should mean spreads underperform as we approach 20 October (see later). Exhibit 2 plots the percentage deficit to GDP ratio and 30y a/s spreads since 2000. We also include the deficit reduction path laid out in the Emergency Budget, which implies the 30y spreads should test zero in 2012.

The consensus among investors seems to be that adherence to the spending plans will have a detrimental effect on economic growth. We would argue that much of this is already in the price, with short sterling contracts implying the MPC will be on hold for the next 12mths. Indeed, the OBR believes the cost to growth from the faster fiscal consolidation will be only a few tenths of GDP. However, one should remember

Exhibit 1

UKT and DBR 10y a/s spread

-4

0

4

8

12

Jun-10 Jul-10 Aug-10 Sep-10

UK

T 1

0y

a/s

(b

p)

-35

-31

-27

-23

-19

DB

R 1

0y

a/s

(b

p)

UKT 10y

DBR 10y Richening into June Budget

Source: Morgan Stanley Research

Exhibit 2

UKT 30y a/s spread and deficit/GDP

-12

-8

-4

0

4

Dec-00 Dec-03 Dec-06 Dec-09 Dec-12 Dec-15

Def

icit

to

GD

P (

5)

-110

-70

-30

10

50

A/s

sp

read

(b

p)

inve

rte

d

% Deficit to GDP

30y a/s spread

Source: Bloomberg and HMT

Exhibit 3

GfK Consumer Confidence Index

-45

-35

-25

-15

-5

5

Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10

Ind

ex

GfK Index

June Budget

Source: Bloomberg

9




consumer confidence reached its lowest levels this year just after the Emergency Budget – see Exhibit 3. Confidence is heading lower again according to the GfK and if it hits a new low after the Spending Review, this would give the MPC much to consider so close to Christmas.

Yields to test new lows

So with the Spending Review unlikely to back-track on any of the plans set out in the Emergency Budget, we think yields are likely to test new lows. We continue to recommend being long GBP 2y2y outright and via receiver spreads (UKT 2s4s cash for cash extensions), earning as much carry/rolldown as possible while waiting for a decision on QE. We would like to add receiving GBP 5y5y to our suit of trades. Unlike many of its foreign currency peers, it still trades over 4% (rec GBP 5y5y at 4.12%, target 3.70%, stop 4.30%). Looking across the yield surface, we believe it offers an attractive combination of level of yield and rolldown (1/2bp a week). Clearly the risk to this trade would be if the Chancellor delayed the spending cuts he announced in the Budget.

For the gilt curve, although carry and rolldown have fallen throughout the year both on an absolute and vol-adjusted basis, it still favours owning the belly of the curve vs. barbells, hence we continue to favour 5->10y bullets vs. the 2y and 20/30y wings – see Exhibit 5.

The devil is in the lack of detail

We see two potential risks to our bullish assessment – not enough detail and the extent of “reprofiling”. Investors are unlikely to demand too much in the way of detail, as most of the decisions about where to focus the incisions will be left to the various departments and not the Chancellor. However, some detail on where the largest savings will be made are essential, in our view.

Exhibit 4

GBP 2y2y and 5y5y to Set Test New Lows

2.0

3.0

4.0

5.0

Oct-08 Apr-09 Oct-09 Apr-10 Oct-10

Yie

ld (

%)

GBP 5y5y

GBP 2y2y


Exhibit 5

UKT yield curve and 3-month carry and rolldown

0.0

1.0

2.0

3.0

4.0

Dec-11 Dec-17 Dec-23 Dec-29 Dec-35 Dec-41

Yie

ld (

%)

0

5

10

15

20

Car

ry &

Ro

ll (b

p)

Spot Yield (LHS)

Carry + Roll (RHS)

Max Carry & roll


Re-profiling

Concerns are emerging about the extent of “re-profiling” that may take place (a term used in Whitehall for delaying cuts until later in the parliament). The FT reported on 7 October that many spending cuts scheduled for 2011/2 may be difficult to implement due to existing contracts etc. Talk of delays will weigh on asset swap spreads particularly in the long end with the upcoming syndication to accommodate. Hence, we would expect asset swap spreads to underperform into the Spending Review. However, detail is essential, as we think investors are likely to support some delays to cuts if the reasons are credible or unavoidable and not a sign of the coalition softening their deficit reduction targets

MPC minutes also on 20 October

However, the Spending Review could possibly be overshadowed by the release of the MPC minutes for the October meeting earlier that day. We expect a 3-way split in vote on monetary policy (a rare event, but one that has happened before in May and August 98 and May 06 and arguably in November 09), with Sentance still seeing a need to tighten monetary policy and Posen, following his recent speech, advocating an extension of QE. We believe interest will focus on whether any members join Posen, given the dovish tone to the minutes from the September meeting. We think that the current high inflation rate and strong 2Q GDP data mean the effective ‘barrier’ to extending QE is relatively high at present. Therefore, we do not foresee many members having voted for QE in October, especially given the proximity of the November Inflation Report and Q3 GDP release (26 October). The absence of other members voting for QE may be a slight disappointment to the gilt market, however, we believe this will be short lived as the November Inflation Report could be a “game changer” for members and hence prolong the interest in further QE.

10




October 8, 2010

European Credit Strategy Deleveraging and the Debt/Equity Clock Morgan Stanley & Co.

International plc

Andrew Sheets [email protected]

Phanikiran Naraparaju, Carlos Egea, Serena Tang, Jonathan Graber

Key sentiment indicators suggest a market that recently became more bullish, which in our view argues for more tactical caution near-term (see Not Over, But Over Bought, Oct 8, 2010). Our caution is tactical (the next 2-3 weeks) largely because corporate balance sheet trends still suggest a highly constructive stage of the broader credit cycle. In this week’s note, we revisit the balance sheets of European IG and High Yield issuers, focusing on liquidity, leverage, and the trends at the border of BBB & BB-rated names. For the moment, corporate trends remain encouraging, and still suggestive of ‘early cycle’ activity, although not without exceptions. With our data suggesting that European mutual fund inflows are moderating (see What European Credit Mutual Funds are Up to, Oct 1, 2010), fundamentals appear increasingly important in supporting the strategic credit story.

Exhibit 1

Our “Debt/Equity Clock”

Source: Morgan Stanley Equity & Credit Strategy

Debt/Equity clock update

For almost a decade, our Credit Strategy group has been using a “debt/equity clock” to frame four stages of the credit cycle: expansion, downturn, repair, and recovery. The model, albeit simplistic, helps remind us that the “credit cycle” is exactly that, a process that moves through stages to the benefit or detriment of our asset class. At the moment, we view credit as occupying the “recovery” stage in the top-right

Exhibit 2

European Inv. Grade Debt/Equity Clock

Q2 10

Q1 10

Q4 09

Q3 09

Q2 09

Q1 09Q4 08

Q3 08

Q2 08

Q1 08

Q4 07

Q3 07Q2 07Q1 07

Q4 06Q3 06Q2 06

Q1 06

Q4 05

Q3 05

Q2 05

Q1 05Q4 04Q3 04Q2 04

Q1 04 Q4 03

Q3 03

Q2 03

Q1 03

Q4 02

Q3 02

Q2 02

Q1 02

Q4 01

Q3 01

Q2 01

-10%

-5%

0%

5%

10%

15%

20%

-6% -4% -2% 0% 2% 4% 6% 8% 10% 12%YoY LTM EBITDA Change

Yo

Y N

et

De

bt

Ch

an

ge

Source: Morgan Stanley Research, company reports, Bloomberg

quadrant, with leverage still falling as corporates remain conservative amidst the volatile macro, but EBITDA recovering on the back of better global growth.

The ‘recovery’ quadrant can be a rare stage that is supportive of both credit and equity, as operations are generally improving but risk appetite (of either aggressive M&A, or shareholder friend activity) remains more constrained. Indeed, several measures of corporate risk tolerance - the current pace of M&A, Debt Growth, or Capex Spending - are more reminiscent of 2003/04 than 2006/07. Similar to 2003, fears of deflation still linger, European corporate debt levels are falling YoY (despite the record-low level of rates), and capital spending remains muted (again, despite cheap financing costs). Although M&A activity is picking up, and should continue to, volumes remain at 2004-levels and transactions generally seem ‘early cycle’ in nature (i.e., deals are value accretive, reasonably financed).

Above, we attempt to put real-world data behind our stylized debt/equity clock. The x-axis measures year over year changes in profitability (EBITDA) and the y-axis measures YoY changes in net debt. Both the IG and HY markets are now in the top-right quadrant, where LTM profits are higher than a year before and net debt levels are lower.

The above chart focuses only on non-financial corporates. With banks at the heart of the recent cycle’s stresses, it is reasonable to see the memories of peering into the abyss mean that their managers and regulators remain committed to risk-reduction for longer in the current cycle. In corporates, we fear the same tug will be weaker, simply because many non-financials were further removed from the market’s worst

Low Growth

Leverage Falling

Leverage Rising

The Debt-Equity Clock4

1

High Growth

3

2

(2003-05, 2H09 - ?) RECOVERY

Restructuring efforts boost cash flow. Margins rising, FCF growing, leverage

falling.

Both Equity and Credit UP

Equity Better Than Credit

(2006, 2007) EXPANSION

Leverage rising intentionally. Corporate activity speculative,

volatility rising. Credit bear market starts, equities still in bull market.

Both Equity and Credit DOWN

WNTURNDO (2H07 – 2008 )

ecession. Attempts to delever iled by falling asset prices. ontinued bear market for credit.

ities enter bear market.

Source: Morgan Stanley Credit and Equity Strategy

EPAIR

RfoCEqu

R (1H09)

ance sheet repair, rights issues to ay back debt, focus on cash

neration and survival.

Credit Better Than Equity

Balpge

Low Growth

Leverage Falling

Leverage Rising

The Debt-Equity Clock4

1

High Growth

3

2

(2003-05, 2H09 - ?) RECOVERY


falling.






High Growth

3

2

(2003-05, 2H09 - ?) RECOVERY


falling.






Both Equity and Credit DOWN

WNTURNDO (2H07 – 2008 )

ecession. Attempts to delever iled by falling asset prices. ontinued bear market for credit.

ities enter bear market.

Source: Morgan Stanley Credit and Equity Strategy

EPAIR

RfoCEqu

R (1H09)

ance sheet repair, rights issues to ay back debt, focus on cash

neration and survival.

Credit Better Than Equity

Balpge

11

https://secure.ms.com/fidweb/firLink/webapp/openFile.jsp?action=stream&filename=mtb55790.pdf






stretches. Although we don’t feel that capex or inventory activity will show the exuberance usually associated with short business cycles, we can see a scenario where companies do turn more aggressive more quickly going forward if we look beyond 6-12 months. For a discussion on the prospects for more equity-friendly behaviour, and how this might manifest itself, please see Credit is Telling Equities to Hike the Dividend, Sept 17, 2010.

Different drivers of deleveraging

IG corporates showed limited sequential improvement in terms of net leverage (roughly flat at 1.8x net debt/EBITDA), but largely held on to the year-over-year improvements during a difficult quarter for trading. The HY market actually turned in a more impressive quarter in terms of deleveraging, with median net leverage at 3.3x, about a turn lower than the peak in 3Q09.

Always welcome, deleveraging comes in different forms. As Exhibit 2 shows, the EBITDA rebound is currently a more important driver of year-on-year deleveraging. We are just beginning to see these companies pay down gross debt.

Exhibit 3

Net Leverage – IG & HY

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

HY IG

Source: Morgan Stanley Research, Company Reports, Bloomberg

An important characteristic of recent deleveraging is that it’s broad-based. In IG over 70% of the universe have reduced net leverage year-on-year, and close to 65% of HY companies have delevered over the same period.

Exhibit 4

% of Companies Deleveraging (YoY) in IG and HY

20%

30%

40%

50%

60%

70%

80%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

IGHY


Liquidity remains strong

One defining aspect of corporate fundamentals through the past recession has been strong cash generation as measured by free cash flow to debt. Companies tightened working capital and slashed capex to preserve cash. IG companies spent 15% less than a year ago on capital expenditures. HY corporates had to cut even further, reducing their capex spend by 21.5% over the same period. Not only is FCF/Debt strong for both cohorts, but the % share of FCF positive companies remains near historical highs. 91% of IG corporates and 74% of HY corporates are generating net cash.

Exhibit 5

FCF/Debt across IG and High Yield

-15%

-10%

-5%

0%

5%

10%

15%

20%

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

IG HY


12




Exhibit 6

% of Companies FCF+ across IG and High Yield

40%

50%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

60%

70%

80%

90%

100%

IG

HY


Are the gains to cash generation from these cuts at risk?

g

wly. The latter trend reflects business skepticism overy, but recovering order

demand has forced a reassessment: surveys show a record share of euro area manufacturers “view their inventories of finished products as insufficient right now” (Euroland

There is the risk that working capital consumes more cash as companies restock. Our European economists note that manufacturers have acted more aggressively on the workincapital management front this cycle compared to any of theprevious cycles, cutting inventories deeper and restocking more sloabout the durability of the rec

Economics: Chewing on Green Shoots, Aug 5, 2010). Despite the uptick in order demand, there is yet little pressure to expand operations organically. Capacity utilization in the eurozone sits at just 75.5% at the end of the second quarter, well below the 15-year average (~82%) and even the early 1990s nadir (76.7%).

Despite these potential stresses on free cash flow generation, projected figures are upbeat. Aggregating the estimates of our equity analysts for western European companies, 2011e FCF

FCF a 5%

nd near-

Trends by sector and rating

Digging a level deeper, we look at trends at the sector and rating level. Our one high-conviction sector trade has been overweight financials, especially sub-debt. Within non-financials, we’re pleased with the broad-based fundamental improvement across sectors, and find more value in contrasting individual credits, beyond the sector level. In Exhibits 7-8 we present the

evels, by sector and rating, of FCF/Debt, Cash/Debt,

absolute change of these metrics is reported in parentheses.

Exhibit 7

should be just 4% off 2009 levels, and 2012eimprovement. As the debt/equity clock turns, FCF is likely to once again turn lower as companies (or their acquirers) find other uses for the cash. But for now, high levels of cash andcash flow remain highly supportive of credit quality, aterm default risk.

current lInterest Coverage and Net Leverage. The year-on-year

European IG Sector Scorecard FCF/Debt Cash to Debt Int Cov Net Leverage

Autos 120% (101%) 186% (107%) - -0.5 (-2.2)Chemicals 21% (3%) 41% (15%) 7.6 (-1.1) 1.1 (-0.7)Cons. Disc. 43% (19%) 21% (5%) 11.0 (1.6) 1.5 (0.2)Cons. Stap. 22% (10%) 18% (3%) 5.7 (0.9) 2.3 (-0.3)Energy 0% (-17%) 30% (0%) 33.1 (12.3) 0.8 (-0.1)Health Care 34% (-4%) 44% (-18%) 13.1 (1.6) 0.6 (0.2)Industrials 19% (-3%) 32% (5%) 7.3 (1.8) 1.6 (-0.2)Materials 14% (2%) 14% (-9%) 8.8 (1.7) 2.0 (0.3)Media 22% (0%) 28% (3%) 8.8 (2.7) 1.6 (-0.3)Telecom 15% (3%) 16% (0%) 7.4 (1.1) 2.3 (-0.2)Utilities 8% (5%) 9% (-3%) 5.5 (0.3) 3.7 (0.7)Market 19% (4%) 21% (1%) 7.3 (1.2) 1.8 (-0.3)


IG fundamental trends look pretty consistent across the

year

board. IG Autos have performed exceptionally well at the industrial co level, enjoying the benefits of various national auto stimulus plans. Chemicals also show impressive deleveraging on the back of an EBITDA rebound thanks to global demand. Materials are also faring better than the headline; ex-MTNA, the sector has delevered half a turn on year. As we’ve mentioned before, we like Materials namesfor their exposure to global growth.

Exhibit 8

European HY Sector Scorecard FCF/Debt Cash to Debt Int Cov Net Leverage

Autos 25% (18%) 49% (28%) - 1.1 (-1.1)(0.4) 2.5 (-0.5)

7) 1.6 (-1.0)Cons. Stap. 14% (4%) 9% (4%) 3.7 (-0.6) 3.2 (-0.3)Energy 14% (21%) 17% (-1%) 3.0 (-0.5) 4.9 (-1.6)Industrials 1% (4%) 24% (-6%) 2.7 (0.2) 4.7 (0.0)Materials 6% (-4%) 26% (4%) 2.4 (0.0) 3.4 (-1.9)Media 9% (5%) 7% (2%) 2.1 (-0.5) 5.3 (0.6)Telecom 9% (6%) 3% (-3%) 4.5 (1.0) 2.6 (0.0)Market 8% (3%) 20% (4%) 3.0 (0.1) 3.3 (-0.8)

Chemicals 11% (-2%) 30% (0%) 3.8 Cons. Disc. 13% (13%) 30% (11%) 4.8 (1.


Please note that all important disclosures including personal holdings disclosures and Morgan Stanley disclosures appear on the Morgan Stanley public website at www.morganstanley.com/researchdisclosures.

HY fundamental trends exhibit a little more dispersion. HY Media is faring the worst in terms of net leverage, and its interest coverage is the lowest among the sectors. Autos,

wn the most progress in deleveraging, reflective of a cyclical rebound. The deleveraging in the Energy sector is due entirely to Petroplus returning to profitability.

Consumer Discretionary, and Materials have sho

13




Exhibit 9

Scorecard by Rating (AA-CCC) FCF/Debt Cash to Debt Int Cov Net Leverage

AA 21% (-4%) 27% (-6%) 19.7 (-2.7) 1.2 (0.3)A 20% (8%) 27% (6%) 8.8 (0.8) 1.4 (-0.4)BBB 16% (3%) 20% (1%) 6.9 (1.7) 2.1 (-0.4)BB 11% (4%) 23% (7%) 4.5 (1.1) 2.3 (-1.2)B 8% (5%) 14% (-7%) 2.6 (-0.3) 4.0 (0.9)CCC -2% (-3%) 23% (18%) 2.0 (0.7) 6.7 (-0.5)


Looking at fundamental improvement trends by rating, AAs and single Bs are meeting the greatest resistance, with leverage increasing 0.3x and 0.9x year-on-year, respectively. BB fundamentals seem to have made the most impressive strides, closing the gap to BBBs. We examine this comparison in the next section.

Exhibit 10

European Non-Financial Spreads by Rating

0

100

200

300

400

500

600

700

800

900

1000

Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

BB

BBB

A

Source: Markit iBoxx

Digging deeper into the BB/BBB divide

A favorite point for comparison is the BB/BBB divide. As Exhibit 9 shows, the gap between the two cohorts’ fundamentals is not large. Exhibit 11 shows the outsized progress BBs have made in deleveraging, relative to BBBs and single-As. As Exhibit 10 shows, the pick-up for this additional risk is quite substantial. At the index level, the switching from BBBs into BBs looks like a homerun, but are there actionable si

Exhibit 11

European Leverage by Rating

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

BB

BBB

A

Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Source: Morgan Stanley Research, Company Reports, Bloomberg

We like switching from long dated BBBs into shorter-dated BBs, reducing duration and picking up spread. Shorteningreduces rate risk at a time when Bunds are near all-time lows, and minimizes the window for credit-negative corporate actionsSwitching into BBs more than compensates for the loss of spread, and BBs should benefit more from continuing credit healing. We conclude with a table presenting some attractive switches into BB credits with strong fundamental trends.

Exhibit 12

.

Buy Shorter-Dated BBs, Sell Longer-Dated BBBs

BB Rating Maturity Ask Px Z-SpreadNet Lev

FCF/Debt

6M Net Lev Change

FREGR Ba1/BB Jul-15 118 263 3.2 11% 0.0ITVLN (£) Ba3/B+ Oct-15 99 308 1.8 23% -1.7RENAUL Ba1/BB Oct-14 107 310 2.4 34% -2.4TRW B2/BB Mar-14 103 309 0.8 11% -0.9VERSTL B3/BB- Jun-14 88 634 2.7 9% -0.1

Average May-15 103 365 2.2 18% -1.0BBB RatingCOFP -/BBB- Feb-17 105 127 3.1 11% -0.2DT Baa1/BBB+ Mar-20 106 99 2.2 15% 0.3FGPLN (£) -/BBB- Sep-18 123 202 3.0 9% 0.1SESGLX Baa2/BBB Mar-20 107 120 3.2 8% 0.2WKLNA Baa1/BBB+ Apr-18 119 115 2.9 16% 0.1

12% 0.1 Average Nov-18 112 133 2.9Source: Morgan Stanley Research

ngle name switches?

14




October 8, 2010

US Economics Roadmap to Sustainable Growth Morgan Stanley & Co.

Incorporated

Richard Berner [email protected]

David Greenlaw [email protected]

r

at 1.4% measured by the core personal price index, or somewhat below the Fed’s

that inflation is bottoming, the rise we expect to 1.6% next year is unlikely to satisfy the Fed. With the Fed missing on both aspects of its dual mandate, and other policies caught in political gridlock, it’s appropriate for the Fed to ease policy further.

Yield outlook depends on policy. Our interest rate strategy team and we believe that ten-year Treasury yields will likely decline slightly further, to 2.25% or so. The Fed wants to depress real yields to support growth while boosting inflation expectations, so the composition of yields between real and inflation compensation matters more than the level of nominal rates. With ten-year real (TIPS) yields at 50 bp, down 70 bp from July, real yields are clearly headed in the right direction.

will depend on how low officials think real ields must go and how long they need to stay there to

keep the

n. of

alf of

ome of their aberrant Q2 gain. Quirky seasonal factors for petroleum imports will likely defer that improvement until Q4, but a one-point annualized contribution to growth from net exports in H2 should partly offset the near-record 1.9% H1 drag from net exports.

Second, personal income is growing again. Even with modest job gains, increases in the workweek have sustained real wage and salary income growth at a 2%

al rate in the past three months. Ongoing e and the

reinstatement of unemployment insurance benefits are providing enough wherewithal to sustain the 2% pace of consumer spending we expect in H2.

Third, lower mortgage rates are promoting a modest refinancing wave, despite the inability of many current borrowers to qualify under current GSE guidelines. We estimate that the recent decline in mortgage rates will reduce interest payments and provide a $10-15 billion windfall to borrowers. That will accelerate the decline in the household debt service ratio — already down from 14% in Q3 07 to 12.1% in Q2 — to a sustainable 11-12% range by late this year, with ongoing benefits to consumer discretionary income and creditworthiness. As evidence of consumers’ new capacity to borrow, nonrevolving

in a row in

e

flat

y in such outlays and cuts in

ended in Q1 10.

Will QE2 work? We think there’s modestly good news ahead: The combination of easier financial conditions and strong overseas growth should help trigger a return to sustainable, slightly above-trend growth in 2011. QE is no panacea, of course, and its bang per buck will be small, but it will help. QE will work through several channels: It will lower financing costs, boost risky asset prices and household wealth, and continue to weaken the dollar. Freddie Mac reported this week that 30-year conventional mortgage rates

any lenders are offering rates between 3.875% and 4.25%. Since Fed Chairman Bernanke’s Jackson Hole speech, popular stock price gauges have risen by 10%. That reversed the second-quarter decline and puts household equity wealth up 5.6% ($960 billion) so far this year. And the dollar on a broad, trade-weighted basis has declined by 5.2%.

Those developments will help support credit-sensitive spending, foster a stable-to-lower saving rate, and help net exports. At the margin, lower mortgage rates will promote refinancing and make housing more affordable. Corporate America is borrowing at historically low rates. Standard

QE coming soon. It’s virtually certain that today’s below-trend growth and too-low inflation will spur aggressive furtheasset purchases from the Fed. Growth has slipped to 2-2½% in the second half of this year, and slack in the economy is beginning to rise; the unemployment rate edged up from 9.5% in July to 9.6% in September, and a further increase is likely. Core inflation stands consumption unofficial target of 1¾-2%. While we strongly believe

But the trough ysupport growth. It seems likely that the Fed will funds rate near zero until 2012.

Consensus is too pessimistic on growth, inflatioDespite our subdued outlook, we think the consensus view1-2% growth and declining inflation is too dour. We see fourfactors that will sustain growth at 2-2½% in the second hthis year:

First, we think net exports will rebound in H2 as export growth persists and imports retrace s

annuimprovements in proprietors’ incom

consumer credit rose for the fourth monthAugust.

Finally, lingering fiscal stimulus in the form of rising infrastructure spending will boost near-term growth. Outlays for highways, bridges and other state and local infrastructure jumped at a 20.1% annual rate in the thremonths ended in August, and double-digit gains in such spending are likely at least through the mid-term elections.That will keep overall state and local spending growthin H2. In contrast, the delastate and local spending trimmed an average 0.3 percentage point from GDP in each of the three quarters

declined to 4.27%, and m

15




models suggest that the rise in wealth, if sustained, will 4%) in consumer spending. uggests that a sustained 5%

mon mission channel mearect impact and will be

ited. Tougher mor riteria have limited the umber of eligible borro with

ans

d.

low imports dramatically. As mentioned above, if

ce,

of rs do

ing quarters.” Chetan Ahya onth

ber have been robust.”

econd alternative to resolve this ‘trilemma,’ or as

S imports tribution

ied the Q2 import se

nd,

the

ek

te If n

rag

rst

prompt an extra $44 billion (0.Likewise, our empirical work sdepreciation in the real trade-weighted dollar will over three years boost net exports by about 1% of GDP. However, blockages in thethat the di

etary policy trans n

surge and dampened recovery in domestic output. Becauthat inventory leverage works both ways, a slowing in inventory accumulation will depress import growth going forward. Consequently, we think that import growth henceforth will re-sync with the pace of US domestic demapromoting a deceleration in imports and ultimately a much-needed rebalancing of the US economy.

Needed: Job and income growth. Ultimately, the sustainability of the recovery will hinge in significant part on the continued revival of job and income growth. On that score, the moderation in the pace of private job gains andsignificant declines in state and local government jobs are

th a concer

from QE on domestic demlim tgage origination cn wers, and originators faced “putbacks” from the GSEs (Fannie and Freddie) on prior loare understandably skittish to extend credit to less-than-pristine borrowers.

Strong growth abroad will lift US net exports. The influence of strong global growth on US demand and output is a key factor that differentiates us from pessimists. US net exports are poised to add to growth over the next year. While growth in developed market economies is tepid, a modest reacceleration in emerging market growth, especially in capital spending, will help US exports. The surge in non-oil imports has ended, and stable import penetration means imports will grow only slightly faster than domestic demanIn turn, a sharp moderation in US demand and inventories should ssustained, the dollar’s decline will augment those gains.

Global growth slowed in the spring, casting doubt on its potential support for US growth. But even with a slower pathree global factors are likely to boost US exports: a shift in the mix of US exports toward faster-growing EM economies and Canada, a global capex upswing, and the Russian drought and export ban that will boost agricultural exports.

Moreover, the slowing in global growth may be ending. Qing Wang notes that “while there has been no clear indicationre-acceleration in Chinese growth, forward-looking indicatosuch as PMIs and the MS China Business Condition Index point to re-acceleration in the comobserves that in India “the volatile IP number showed a mon month deceleration in June but July data released in mid-September came right back with a 6% (MoM) rise. Key domestic demand indicators such as auto sales for August and Septem

Finally, US QE may indirectly promote faster US growth through an international channel: The Fed’s actions are strengthening currencies abroad and forcing policymakers tochoose whether to accept currency strength, adopt easier policies, or implement capital controls. Many central banks inboth EM and DM economies (e.g., Australia, Canada) are choosing the simpossible trinity, meaning they are choosing faster growthwell as global rebalancing.

Import slowdown has begun. A spring surge in Uthwarted what we expected to be a moderate confrom global to US growth earlier this year. But we think the 33.5% annualized Q2 import surge was only a temporary development. Swings in inventories magnif

bo n. The good news is that a rising work wehas through most of this year promoted healthy gains in paychecks; the bad news is that private hours stalled in September and growth must improve to restart that process. More ominously, state and local payrolls skidded by a monthlyaverage of 54,000 in the summer. As noted below, a further revival in revenues will be needed to stabilize and ultimately revive state and local government hiring.

Coming resolution to tax uncertainty. Policy gridlock in Washington has created economic uncertainty and a drag on growth. If this gridlock is not resolved soon, expectations of fiscal drag will become reality, perhaps trimming three-quarters of a percentage point from growth in 2011. The faof the expiring tax cuts is a key uncertainty for the outlook. the tax cuts expire, households will be hit with $175 billion ihigher taxes on January 1. We now expect that Congress and the Administration will resolve that uncertainty by early next year with a one-year extension of all tax provisions.

Fiscal drag: Less than feared. Three sources of fiscal dcould hold back growth: Stimulus enacted in 2009 under the American Recovery and Reconstruction Act (ARRA) will continue to fade, unemployment benefits may not be extended, and state and local governments could cut spending further. However, we expect that Congress will extend UI benefits at least for a while. And rising tax receipts mean that the drag from state and local restraint should be modest. Total state and local tax revenue gained 1.7% year/year in Q2, a third straight small gain after the wodecline on record last year. The combination of a modest rebound in revenues and Federal stimulus funds for infrastructure seems likely to support renewed spending growth.

16




October 8, 2010

US Credit Strategy Tale of Two Markets Morgan Stanley & Co.

Incorporated

Rizwan Hussain [email protected]

Maya Abdurahmanova, CFA [email protected]

Despite buoyant primary markets, the tone in secondary markets hasn’t been as consistently positive. With earnings season commencing, companies will soon offer

e

e tal

ry

ew

– as

’s

ancials. Primary markets remain the path of least resistance to add non-financial credit risk,

greater confirmation or denial of the strength and staying power of a sustained US rebound. Meanwhile, high-grade credit markets just finished the seventh biggest month of thpast decade in new issues, and yet corporate excess returns were strongly positive, ringing in their third best month of thyear. We hope that goes some way in severing the menassociation many still have between sizeable primary issuance and subsequent credit underperformance. Primaissuance confirming secondary market spreads was certainly at work, and admittedly the technical backdrop remained favorable.

Recent conversations with investors suggest that many remain frustrated with the lack of opportunity away from nissues. Many argue that thin, illiquid markets are barely providing an opportunity to meaningfully add risk (or for that matter, shed it), leaving the new issue space virtually the only game in town. Only when new issue markets slow downin earnings season now – does the focus seem to (perhaps reluctantly) shift back to existing issues in the hunt for value.

We have explored some of the statistics around secondary trading this year, as well as how it has and hasn’t changed over the past nine months. While this content may be a bit more backward-looking than we typically offer, we believe there are lessons to be learned from a broader portfolio-management perspective. In summary:

Similar to market experience ahead of the US banking system stress tests of last year, trading volumes did decline in advance of a similar exercise in Europe this summer, but more importantly, are now tracking last yearlevels.

The top 20 most actively traded credits have consistently accounted for about 40% of overall trading volume in the last two years. This remains a source of frustration overall in secondary markets today, but it is not a new dynamic.

Meanwhile, the top 20 most actively traded issuers remain highly skewed towards fin

and financials will remain prone to be a source of funds should volatility rise from here.

Are trading volumes really all that different now? Compared with the first 9 months of 2010, most investors will fondly recall the virtually one-way move tighter of spreads over the first 9 months of 2009. But to the extent that market liquidity conditions have something to do with the differingmarket sentiments, how do the two periods compare?

Exhibit 1

Different Times, Similar Trading Patterns

8

9

10

11

12

13

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Avg

Dai

ly V

olu

me

($bn

)

14

2009 2010

Subdued ahead of US banking stress tests

Subdued ahead of EUR banking stress tests

Source: Morgan Stanley, MarketAxess

As shown in Exhibit 1, high-grade corporate bond traded

in

th

g

y

ok at e

rhaps

rginally larger in notional terms.

volume (as captured by TRACE) earlier this year ranked favorably versus the equivalent period of 2009, when strains remained elevated in advance of the US banking system stress tests. It wasn’t until some resolution on this frontApril 2009 that trading activity accelerated. Similarly, in 2010, volumes had been buoyant in advance of the surfacing of worries in European banks, and it wasn’t until some resolutionin July that trading volumes rebounded. Now we are left wiwhat looks like an increasingly ‘normal’ trading environment again, at least relative to just 2009, which provided anythinbut a ‘normal’ backdrop. Volumes over the last 2 months are actually running slightly ahead of 2009’s pace, likely driven bythe historic level of new issuance lately and the secondarmarket trading activity that follows in its wake.

However, a slightly mixed picture emerges when we lothe actual number of trades. Judging by average daily tradcount, every month this year saw a decline versus the similar period last year. Simple math then implies that the averagetrade ticket size each month this year has actually been greater than it was for each month last year, with the exception of June. So again, here, the frustration with secondary markets seems somewhat misplaced – pethere are fewer trades going through, but they’ve actuallybeen ma

17




The frustration is with what is (and is not) trading. rt of many of our arehouse and park onstrained. Some ross dealer desks,

l pos aining dealers, and a from runnin

Exhibit 2

Compared to the status quo at the stacareers, the ability of the sell-side to wcredit risk on balance sheets today is cfactors behind this are consolidation acscarcity of capitashift away

t-crisis at the remg large risk positions.

Just 20 Credits Consistently About 40% of Traded Quarterly Volume – Both 2009 and 2010

37%

38%

39%

40%

41%

42%

43%

Q1 Q2 Q3 Q4

2009 2010 Source: Morgan Stanley, MarketAxess

But what do we actually see trading in secondary markets? InExhibit 2, we track the percentage of overall trading volumseen in just the top 20 issuers since the markets began their rally early last year. Indeed, while the percentage of trading volume commanded by the top 20 issuers has climbed modestly this year, it has moved in a relatively narrow range from just about 39% to 42% over the last two years. Also,

e

e

ific

r, only 6 were issued before the last 6 months.

driven by a relatively xpect

a to

pecific exposure limits.

’t seem materially different from last year gauged by trading volumes, we are concerned that many, on both the buy-side and the sell-side, perceive just the opposite. With climbing expectations of a new round of quantitative easing that removes fixed income product from the market, and cross-asset correlations remaining high, the risk of crowded trades is growing (within and across assets). And crowded trades typically don’t end well. (For details see our Credit Basis Report of October 8. 2010.)

Exhibit 3

financials represent nearly 75% of the total of these top 20 issuers’ trading volume for the most recent quarter, whereas they make up 35% of the overall outstanding credit risk in benchmark indices. If you’re shunning financial risk, but looking to add non-financial credit risk, primary markets havadmittedly continued to be the path of least resistance.

Exhibit 3 breaks down the top 20 most actively traded specissues over the last two quarters. Two points worth noting.First, while these specific issues represent just 8.5% of theoverall volume in the most recent quarter, financials again dominate the list. Additionally, of these 20 issues in the most recent quarte

What are the portfolio implications? As noted above, we do think active primary markets can support both credit outperformance and a healthy secondary market, just as they do now, with secondary volumes today tracking right on top of daily volumes from a year ago. Alternatively, we push back at the perception that robust new-issue markets alone are a

precursor to sustained weakness in credit spreads. Since almost half of daily traded volume is small set of names (financials in particular), we would ethese specific names to serve as the ‘high beta’ credits in any bouts of volatility in the coming months. This will likely keep the pace of spread repair slower and more volatile than we expected a few months ago. Consolidation among financials that occurred during the crisis will also continue to serve asnegative technical, as investors will increasingly adhere name-s

Lastly, while overall market liquidity conditions don

Most Active Bonds Dominated by New Issues and Financials

3Q2010 3Q2009

# Ticker Coupon Maturity% of Mkt Ticker Coupon Maturity

% of Mkt

1 BAC 5.625 7/1/2020 0.91 C 8.500 5/22/2019 0.72

2 GS 6.000 6/15/2020 0.72 DOW 8.550 5/15/2019 0.57

3 MS 5.500 7/24/2020 0.68 C 6.375 8/12/2014 0.51

4 JPM 4.400 7/22/2020 0.62 BAC 7.625 6/1/2019 0.48

5 KFT 5.375 2/10/2020 0.45 C 8.125 7/15/2039 0.47

6 C 5.375 8/9/2020 0.44 PETBRA 7.875 3/15/2019 0.45

7 C 4.750 5/19/2015 0.40 GS 7.500 2/15/2019 0.39

8 GS 3.700 8/1/2015 0.40 BAC 6.500 8/1/2016 0.38

9 C 8.500 5/22/2019 0.38 MS 7.300 5/13/2019 0.34

10 APC 6.375 9/15/2017 0.37 JPM 6.300 4/23/2019 0.33

11 BPLN 5.250 11/7/2013 0.35 BAC 7.375 5/15/2014 0.32

12 BAC 3.700 9/1/2015 0.33 GS 6.750 10/1/2037 0.32

13 MS 4.000 7/24/2015 0.33 BACR 5.200 7/10/2014 0.30

14 GE 5.500 1/8/2020 0.33 GE 6.875 1/10/2039 0.29

15 DOW 8.550 5/15/2019 0.33 ORCL 5.000 7/8/2019 0.29

16 APC 5.950 9/15/2016 0.31 GE 6.000 8/7/2019 0.28

17 CS 4.375 8/5/2020 0.30 GE 5.875 1/14/2038 0.28

18 BHI 5.125 9/15/2040 0.30 GS 6.000 5/1/2014 0.26

19 AA 6.150 8/15/2020 0.29 MO 9.250 8/6/2019 0.26

20 GE 3.500 6/29/2015 0.29 T 5.800 2/15/2019 0.25

Source: MarketAxess

18




October 11, 2010

Commodity Strategy Natural Gas – Fundamentally Oversupplied

Hussein Allidina, CFA Morgan Stanley & Co.

d [email protected]

[email protected]

Through 2011, oversupply will likely continue. We see 2011 natural gas prices averaging $4.00/mmBtu, as the US balance is fundamentally oversupplied and is likely to remain so through 2011. NYMEX futures are trading at ~$4.00/mmBtu, very different from the ~$14.00/mmBtu we saw in mid-2008. The root of today’s depressed price environment lies with elevated production, driven by robust horizontal drilling activity — the latest EIA data, covering July 2010, show US dry gas production averaging ~58.5 bcf/d, up 1.5 bcf/d year over year. The three key drivers of our bearish price outlook for 2011 are (1) the momentum of rig activity in

ed response of production to the

Incorporate

Stephen Richardson [email protected]

Tai Liu

recent months; (2) the lagglaying down of rigs; and (3) today’s elevated gas inventory.

Exhibit 1

We Are Bearish on 2011 Natural Gas ($/mmBtu) 2010 2011 201Forecast $4.36 $4.00 Forward $4.41 $4.57 $5.2

Note: Prices as of Oct. 8, 2010.

2 $5.50

5

Source: Bloomberg, Morgan Stanley Commodity Research estimates

Horizontal rig activity has rebounded strongly, averaging near 580 rigs, after hitting a trough of near 300 rigs in mid-2009. According to Smith Bits, some 880 rigs are activelydrilling for gas today (both horizontal and vertical). As a comparison, rig activity bottomed at ~610 in July 2009. W

e

0

expect the surge in rig activity and higher-productivity horizontal rigs to lift production in the months ahead.

In our base case, we assume rig activity declines to ~70by end-2010, and thereafter falls to ~630 by mid-2011. Under these assumptions, we see US gas production averaging ~59.4 bcf/d in 2010 and ~60.2 bcf/d in 2011. If actual rig activity turns out to be materially different from our assumptions (i.e., most likely we are too optimistic on the decline), we will have to adjust our production forecasts.

Due to a confluence of events, producers have continued to drill in the current low-gas-price environment. Unless

and until producers are willing to pare back their drilling efforts, the North American gas market will remain fundamentally oversupplied.

Exhibit 2

Recent Surge in Horizontal Rig Activity Will Keep Production Elevated (Left axis: rig count; right axis: dry gas production, bcf/d)

-

200

400

600

800

1,000

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

44

46

50

52

54

56

1,200

1,400

1,600

60

62

48

58

Horizontal rigs Vertical/Directional rigs Production, bcf/d

Source: EIA, Smith Bits, Morgan Stanley Co

mmodity Research

October storage at ~3,750 bcf, only slightly wer than las record 3,807 bcf. Inventories would

een much higher if r the significantly warmer than u e u -ywe ca M 011 inv y l

9 cf, th er f da As ar aver v o

rch i 7 r inve s6 cf at M ing mat o

ian g e tifu r n 710 b r the h g

y 5 f.

be e re is o sl p n t in e

ys o h pot pu e ivide ces. Unreg

look o e justify n, w ts an er

hap u l urchas sate tw ts es to w n eatin a rces – esic, r l l reas an weak f als o lev rig

on levels resulting in bloated inventories. While the bearishness of underlying fundamentals will ultimately pressure prices, determining the short-term price

Moreover, the US is sitting on a large inventory of gas.Assuming no hurricane-related production losses, we estimate end-lohave b

t year’snot foncenormal s mmer we experi d. Ass ming 30 ear normal

weather, fore st end- arch 2 entor at rough y 1, 00 b e highest level we have ev seen or the en of M rch. a comparison, the 5-ye age in entory f r end-Ma s 1,5 2 bcf, and this yea ntorie stood at 1, 62 b end- arch. And mak ters w rse, Canad as inv ntories are also plen l, cur ently sitti g atabout cf, and are likely to ente eatin season at ~750 bcf – just sh of last year’s record 7 2 bc

Despite arish fundam ntals, the a str ng bulli h seasona atter in the gas marke arly winter. In the early da f the eating season, s rchas s from ut lities can pro support to near-dated pri ulated utilities at ec nomic r asons to their purchasi g decisions hile reliability requiremen d op ational issues s e reg lated uti ity gas p es. E sentially, we anticip o se of opposing forc ork i the early partof the h g se son: (1) bullish fo utiliti buying for econom eliabi ity, and operationa ons; d (2) bearishforces – undament wing to e atedactivity/producti

19

20




llenge, and near-term price direction will eather from normal.

ed es in

ter. A utility’s foremost responsibility liability, utilities often buy spot gas

ing se ries for the latter winter. By tained,

allowing for maximum d, during January and February, the mo or unregulated utilities (a t, regulated tilities), the decision to buy spot gas or draw from storage is

ard curve,

entory. y,

r

00/mmBtu. y utility

on when the g

he current and

d for

tion,

ile wer

market balance as remaining loose. Bear in mind that even

ivity will g activity rolls off in

1, the lagged impact on production from drilling in

when the rig count does decline, gas production will not immediately roll over. The momentum of drilling actcontinue to bolster production. If drillin

direction is a chalikely be dependent on the deviation of w

Reliability and operational requirements of regulatutilities will likely provide some support to gas pricthe early part of the winis reliability. To ensure re

mid-2Q13Q10 will still be felt, and it will not be until mid-3Q11 (at theearliest) that we will see production start to decline.

early in the heatpart of the

ason, ensuring invento doing so, pressure is main withdrawals, if needenths with the highest demand. Fnd to a certain exten

Exhibit 3

Producers Will Sell Near $5/mmBtu, While Utilities Are Likely to Buy Below $4/mmBtu ($/mmBtu)

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5ubased on economics. When temperatures fall, utilities essentially have two avenues to satiate demand: they can either draw on gas from storage or buy spot gas. This decision will depend first on the shape of the forwand then on the price paid for gas in storage. If the forwardcurve is in backwardation, utilities will likely draw on invHowever, if the forward curve is in contango, as it is currentlutilities may make spot purchases. The decision to buy spot will depend on the cost of gas injected into storage. If the spot price of gas is less than the cost of gas injected into storage, utilities will likely buy spot and save gas in storage folater in the season.

A soft floor for gas prices in the near term is the utilities’

Below $4/mmBtu, s look to buy

Above $5/mmBtu, producers look to sell

utilitie

Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10

Source: Bloomberg, Morgan Stanley Commodity Research

The two key risks to our bearish outlook on gas prices are weather and rig activity. We are currently using 30-year normal weather in our modeling of the supply and demand balance. If the winter proves colder than our assumption, alelse equal, inventories will register below our expectations. If the winter proves to be 5% colder than the 30-year normal, demand will be bolstered by some ~310 bcf, which in turn would leave end-March inventories more balanced at And rig activity is another wild card. We have assumed that the gas rig count will fall to around 630 by mid-2011; howeveif producers curtail activity faster or slower than we

cost of gas in inventory, estimated at ~$4.While the cost of gas in inventory fluctuates b l

1.6 Tcf.

r, have

,

e

would

2010.)

depending as was purchased and owing to the varying accounting methods employed, we nonetheless come

a reasonable estimate of up with what we believe is $4.00/mmBtu by looking at gas prices through tpast injection seasons. Any upside to gas in the near term is likely to be capped by producer hedging, which we believe would come into the market at prices around $5.00/mmBtu.

In the latter months of the 2010-11 heating season an2011 as a whole, we remain firmly in the bear camp. Into2011, gas prices will reflect weather, inventory, producand end-March storage expectations, we believe. While

modeled, our production and inventory numbers will be off.

Trade recommendation: With end-March 2011 inventory likely to be abundant, we see downside to March 2011 gas prices, prompting our opening of a short Mar-11 positioncurrently trading at $4.27/mmBtu. While utility buying early in the heating season may support near-dated contracts, wbelieve that underlying bearish fundamentals will ultimately pressure prices lower. Our stop loss on this position is set at $4.60/mmBtu, and we will exit this position at $3.50/mmBtu. Risk to this position includes a colder-than-normal winter or a fall in production exceeding our expectations, whichleave inventories below the 1.9 Tcf that we are modeling. (For details see our Natural Gas report dated October 11,

weather always presents a wild card, it is our view that prices will remain under pressure once we get through the early months of the 2010-11 heating season. Assuming a 30-year normal winter, our supply and demand model shows end-March inventories at ~1,900 bcf. If our forecast is realized, webelieve that gas prices will come under significant pressure, which should force producers to scale back their drilling whalso encouraging further coal-to-gas substitution in the posector.

Unless and until the rig count declines, we see the gas



Industry Analysis

October 8, 2010

Airlines Short Haul: Long Opportunity Morgan Stanley & Co.

International plc+

Penelope Butcher, CFA [email protected]

Suzanne Todd [email protected]

Menno Sanderse [email protected]

LCCs are leveraged to recovery with strong franchises, market share growth opportunities and compelling medium-term valuations. We estimate easyJet (EZJ) & Ryanair (RYA) expand returns to 2-2.5x WACC by 2014.

Through crisis, opportunity has knocked … The European short-haul market has undergone a substantial capacity shift in the past two years, in part exacerbated by the financial crisis and subsequent European recession. This has led to a major shift in capacity and market shares from the legacy airlines toward low-cost carriers (LCCs). In certain markets, the LCCs are now the largest airlines by market share of short-haul services.

… leading to pricing power for LCCs. The result of this capacity shift has been twofold in nature. First, load factors have expanded as demand began its recovery earlier this year. Second, these rising and sustained high loads have led to improved pricing power within the EU market. Using the UK as a benchmark – where LCCs (EZJ and RYA) represent ~40% of total capacity today – there is still a significant opportunity for greater market penetration at the EU level overall where share levels currently stand at 18%. This step-up in market share would represent 110-120m extra passengers a year – double the levels of LCC traffic this year.

Structurally, LCCs have significant long-term opportunity. We rate RYA OW and EZJ EW in the context of our Attractive sector view. While we believe short-term trading updates will likely be favourable, we see the opportunity for investors as more medium term in nature. Building fleet sizes and market shares further separates these carriers from small-scale competitors, enabling an expansion of economies of scale benefits. The dominant market shares will likely be followed by pricing power and thereby significant expansion of returns following their fleet growth reduction plans in 2012-13. This phenomenon sees a major expansion in free cash flows: in RYA’s case we see FCF yields reaching 15% by 2014, and EZJ’s reaching 20% over a similar time period.

Exhibit 1 Ryanair now #1 in capacity in 3/5 key EU markets

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

Jan

-09

Feb

-09

Ma

r-0

9

Ap

r-0

9

May

-09

Jun

-09

Jul-0

9

Aug

-09

Sep

-09

Oct

-09

No

v-0

9

Dec

-09

Jan-

10

Feb

-10

Ma

r-1

0

Ap

r-1

0

May

-10

Jun

-10

Jul-1

0

Aug

-10

Sep

-10

UK France Germany Italy Spain

RYA #1 -UK, Spain & Italy

RYA #3 -France & Germany

Source: OAG, Morgan Stanley Research

Exhibit 2

Short-haul loads: Record levels this summer

50%

55%

60%

65%

70%

75%

80%

85%

90%

95%A

ug 0

7

Oct

07

Dec

07

Feb

08

Apr

08

Jun

08

Aug

08

Oct

08

Dec

08

Feb

09

Apr

09

Jun

09

Aug

09

Oct

09

Dec

09

Feb

10

Apr

10

Jun

10

Aug

10

Eu

rop

ea

n L

oa

d F

acto

r

EZJ

RYA

BA

AF-KLM

LHA


Exhibit 3 Opportunity still high for LCC share gains in Scandinavia and Eastern Europe

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Norway

Greece

Netherlands

Switzerland

Sweden

Portugal

Ireland

Austria

Denmark

Belgium

Finland

Poland

EZJ

RYA

Incumbent

Other

Source: OAG

Industry Views Airlines: Attractive

21

22



Industry Analysis

Investment case for LCCs Exhibit 4

Ryanair yields move to positive growth in 2010

-30.0%

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11e

Gro

wth

Yo

Y

Pax Yield Ancillary Yield

LCCs are leveraged to recovery, but also operate strong

franchises, have market share growth opportunities and

compelling medium-term valuations. Using the UK as a

benchmark – where LCCs (EZJ and RYA) represent ~40% of

total capacity today – there is still a significant opportunity for

greater market penetration at the EU level overall where

share levels currently stand at 18%. This step-up in market

share would represent 9-10 million extra passengers per

month assuming an 80% load factor on the additional seat

capacity.

Revenue drivers e = Morgan Stanley Research estimates Source: Company data, Morgan Stanley Research

Exhibit 5 Expansion of market share – EZJ and RYA share top 3

positions in the UK, Spain and Italy, but are relatively

underpenetrated in France, Germany, Scandinavia and the

remainder of Europe.

Intra EU volumes back to positive growth – helped by premium volume bounce

Passenger Growth in European Market

-40.0%

-30.0%

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

May

-06

Jul-0

6

Sep

-06

Nov

-06

Jan-

07

Mar

-07

May

-07

Jul-0

7

Sep

-07

Nov

-07

Jan-

08

Mar

-08

May

-08

Jul-0

8

Sep

-08

Nov

-08

Jan-

09

Mar

-09

May

-09

Jul-0

9

Sep

-09

Nov

-09

Jan-

10

Mar

-10

May

-10

Jul-1

0

Premium Total Europe RYA EZJ

Premium EU

Total Intra EU

RYA

EZJ

Improving frequency – building out route frequency with

fleet growth helps to attract business passengers who are

typically higher yielding than leisure passengers.

Expansion of ancillary opportunities – in part driven by

longer stage lengths, but also improving penetration of

existing offerings like hotels, car hire and insurance, which

expand with long duration vacations and repeat trips.

Cost drivers Source: Association of European Airlines, IATA, Morgan Stanley Research Fleet growth enables opportunity to reduce or at least

sustain capital cost advantages. Exhibit 6

EZJ & RYA have lower comparative frequency Airport and supplier volume benefits – guarantees of scale

volumes to airports and local regions can help reduce airport

costs. This can also be a feature of supplier agreements such

as maintenance, insurance and marketing.

6.2

5.7

9.8

7.4

15.4

13.6

14.4

19.9

21.6

16.7

26.4

5.0

6.6

8.9

10.4

11.1

13.6

14.4

15.1

15.8

16.6

23.6

0 5 10 15 20 25 30

Ryanair

Air Arabia

easyJet

Tiger Airways

Westjet

Air Asia

JetBlue

AirTran

Virgin Blue

GOL

Southwest

Sep-08 Sep-10

Returns sustained above cost of capital

By our calculations, EZJ and RYA will expand their

returns to reach 2-2.5 times WACC by 2014. This

compares to an average of 1.5 times that we assume for the

main legacy carriers.

Source: Company data, anna.aero, Morgan Stanley Research



Industry Analysis

October 7, 2010

Semiconductors Cautious on sector but upside in ARM, IFX, ING and WLF Morgan Stanley & Co

International plc+

Francois Meunier [email protected]

Sunil George, Patrick Standaert, Mark Lipacis, Atif Malikm Sanjay Devgan

Too early to buy into European semiconductors We initiate coverage on the European semiconductor sector with a Cautious view, as we believe it is too early to buy into the sector, with an inventory correction looming in the PC and consumer space, in particular. Our European semiconductor ‘investing clock’ shows most indicators are still on the ‘underweight’ position. Consensus earnings estimates have started to decline, but we expect more cautious comments from companies on Q4 and 2011 to bring consensus still lower, reflecting weaker consumer demand in the US and in Europe.

Key Overweight ideas We believe there are still good returns to be made on ARM, Wolfson and Imagination, which benefit from a structural shift in end demand from PCs to smartphones and tablets, and on Infineon, which benefits from secular trends in power semiconductors and from a leading position in that market.

Beneficiaries from the structural shift from PCs to tablets and smartphones. In our view, the potential inventory correction in PCs is exacerbated by the structural shift in end-demand for smaller, less power-hungry devices. We view ARM as a key enabler for tablets and smartphones, and see Wolfson and Imagination as beneficiaries in the sound and graphics space for smartphones and tablets. We initiate on ARM, Imagination and Wolfson at OW, as we believe these trends are not fully priced in (~30% implied upside).

Infineon – German exports enabler: Infineon is a key supplier of power semiconductors chips to German exporters in automotive, industrial and clean energy. With no more exposure to either memory or wireless, we expect margin expansion to drive a 23% rerating of the shares, and initiate with Overweight.

We see less share price upside for ASML, CSR and STMicroelectronics with less margin leverage to these trends. Although we view ASML as one of the highest quality companies in the sector, the valuation is not sufficiently attractive versus its peers, in our view.

European Semiconductors

Rating Price Target Implied upside

ARM Overweight 530p 31%

Imagination Overweight 505p 33%

Wolfson Overweight 340p 30%

Infineon Overweight €6.3 23%

STMicroelectronics Equal-weight €6.1 11%

ASML Underweight €21.3 -2%

CSR Underweight 355p 3% For valuation methodology and risks associated with any price targets above, please email [email protected] with a request for valuation methodology and risks on a particular stock. Source: Morgan Stanley Research

Exhibit 1

We see most upside for ARM, Wolfson, Imagination

-10%

0%

10%

20%

30%

40%

AS

ML

CS

R

ST

Micro

Mkt C

apW

gtd Avg

Infineon

AR

M

Wolfson

Imagination

Source: Morgan Stanley Research estimates

Exhibit 2

Smartphone penetration is increasing in a growing handset market

0

200

400

600

800

1000

1200

1400

1600

1800

2000

2005 2006 2007 2008 2009 2010 2011 2012 2013

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Smartphone Units Handset units Smartphones as % of HS Source: Company data, Morgan Stanley Research estimates (2010-13)

23

mailto:[email protected]



Industry Analysis

Exhibit 3

Introducing our European semiconductors ‘investing clock’ – too early to turn positive

BUY

- Late-cycle semiconductor companies continue to raise guidance but a few isolated companies in the PC, packaging or foundry supply chain warn or cut guidance- Capex keeps rising- Inventory days rising- YoY revenue growth for OSAT (SPIL, ASE…) and foundries (TSMC…) close to a peak, potential inflexion point- ISM manufacturing index close to a peak, potential inflexion point- US and Asian semis stocks start underperforming, ahead of European stocks- Relatively low PER valuation, indicating the market doesn’t believe excessive consensus estimates

SELL

OVERWEIGHT

UNDERWEIGHT

- Late cycle semiconductor companies continue to warn but a few isolated companies in the PC, packaging or foundry supply chain raise their guidance- Capex on hold, cut and potential production capacity reduction- Inventory days on a downward trend- Some form of capitulation from either investors, sell-side or corporates- YoY revenue growth for OSAT (SPIL, ASE…) and foundries (TSMC…) close to a trough, potential inflexion point- ISM manufacturing index close to a trough, potential inflexion point- US and Asian semis stocks start outperforming, ahead of European stocks- Relatively high PER valuation, indicating the market doesn’t believe pessimistic consensus estimates

- A majority of semis companies raise guidance for revenues and margins- Capex increase- Inventory days stable or increasing slowly- YoY revenue growth for OSAT (SPIL, ASE…) and foundries (TSMC…) on an upward trend- ISM manufacturing index close to a trough, potential inflexion point- US and Asian semis stocks start outperforming, ahead of European stocks- Consensus estimate upgrades

- Profit warning from a majority of semiconductor companies, some companies stop giving guidance- Capex on hold- Inventory days rising at a slower pace- YoY revenue growth for OSAT (SPIL, ASE) and foundries (TSMC) on a downward trend- ISM manufacturing on a downward trend.- US and Asian semis stocks start outperforming, ahead of European stocks- Consensus estimates downgrades.

BUY

- Late-cycle semiconductor companies continue to raise guidance but a few isolated companies in the PC, packaging or foundry supply chain warn or cut guidance- Capex keeps rising- Inventory days rising- YoY revenue growth for OSAT (SPIL, ASE…) and foundries (TSMC…) close to a peak, potential inflexion point- ISM manufacturing index close to a peak, potential inflexion point- US and Asian semis stocks start underperforming, ahead of European stocks- Relatively low PER valuation, indicating the market doesn’t believe excessive consensus estimates

SELL

OVERWEIGHT

UNDERWEIGHT




SELL

OVERWEIGHT

UNDERWEIGHT





Exhibit 4

Valuation summary

Ccy Price Mkt. Cap. EV EV/Sales EV/EBIT PEREPS

CAGR PEG EBIT Margin Gross Margin01-Oct (€m) (€m) 2010e 2011e 2012e 2010e 2011e 2012e 2010e 2011e 2012eFY11-12e FY10e 2010e 2011e 2012e 2010e 2011e 2012e

European Semiconductors

ASML € 21.69 9,327 8,382 1.94x 1.90x 1.61x 7.1x 7.4x 5.3x 9.6x 10.2x 7.6x 13% 0.8 27% 26% 30% 44% 43% 46%STMicroelectronics € 5.51 4,916 3,788 0.52x 0.50x 0.46x 12.5x 6.6x 4.6x 11.3x 8.0x 6.3x 34% 0.3 4% 8% 10% 39% 41% 43%Infineon Technologies € 5.13 6,045 3,656 1.05x 1.02x 0.93x 6.4x 5.7x 5.1x 13.4x 10.9x 9.4x 19% 0.7 16% 18% 18% 35% 38% 40%ARM Holdings GBp 405.00 5,979 5,857 13.13x 11.08x 9.60x 31.8x 23.3x 18.2x 44.8x 33.6x 27.4x 28% 1.6 41% 48% 53% 94% 94% 95%Imagination Technologies GBp 378.90 1,051 1,013 9.02x 7.22x 5.96x 39.5x 23.3x 15.7x 57.7x 35.0x 24.3x 54% 1.1 23% 31% 38% 69% 72% 75%CSR GBp 344.40 697 390 0.66x 0.63x 0.60x 6.4x 7.0x 6.1x 13.9x 16.0x 13.3x 2% 6.2 10% 9% 10% 47% 46% 46%Wolfson Microelectronics GBp 261.50 339 271 2.30x 1.58x 1.29x 85.3x 10.4x 5.5x NA 17.8x 9.5x NM NA 3% 15% 23% 51% 51% 53%MEAN 4,051 3,337 4.09x 3.42x 2.92x 27.0x 11.9x 8.6x 25.1x 18.8x 14.0x 25% 1.8 18% 22% 26% 54% 55% 57%MEDIAN 4,916 3,656 1.94x 1.58x 1.29x 12.5x 7.4x 5.5x 13.7x 16.0x 9.5x 23% 0.9 16% 18% 23% 47% 46% 46%


24



Industry Analysis

Three key debates

Debate #1. Is now the time to buy Semis? Too early to turn positive – Introducing our proprietary European Semiconductors ‘investing clock’

We see a mild inventory correction ahead With the US and European consumer under increased pressure, we expect retailers and OEMs to be relatively cautious about inventories in Q4, which is likely to result in semiconductor companies guiding below seasonal trends for the quarter. In our view, the risk of an inventory correction is exacerbated in the PC supply chain, which is affected by a structural shift in end demand toward tablets. In our base case, we assume a mild inventory correction, bottoming at the end of Q1 2011.

We would wait for more companies to warn on Q3 and/or Q4 before turning positive on the sector We introduce our European semiconductor ‘investing clock’, which aggregates several quantitative momentum indicators based on our experience of the semiconductor cycle. Although it is not indicating a buy signal yet, this should not deter investors from buying companies with solid structural growth potential and 20-30% upside to valuation, such as ARM or Infineon.

Debate #2: What will be the impact of the smartphone and tablet upgrade cycle? ARM, Imagination and Wolfson should benefit most

ARM, Imagination and Wolfson have the highest leverage to the smartphone upgrade cycle ARM benefits from an improved product mix, i.e. with a higher number of cores and higher ASPs per cores used in smartphones (35c average royalty per smartphone vs 10c for average phones, according to our proprietary calculations) and is independent from market share shifts between smartphone vendors. Imagination is skewed towards Apple and Android and should benefit from the proliferation of graphics. Wolfson is a key provider of audio chips, skewed towards Android and potentially to Apple. We believe these trends are not fully priced in at current levels, and see ~30% upside for all three stocks.

ARM and Imagination benefit most from cannibalization of netbooks by tablets Similar to the smartphone upgrade cycle, ARM and Imagination are best positioned to benefit from the cannibalization of netbooks by tablets, in our view. Based on our proprietary calculations, even if Windows is not ported to

ARM, we expect ARM to take 11% of the PC microprocessor market in 2011. In contrast, we view this transition as slightly negative to ASML revenues (€300m or 5% negative impact on 2011e revenues) as the mix of tools to produce NAND includes fewer immersion tools than DRAM.

Should investors focus only on the wireless end market? Wireless is a volatile sector, driven by relatively short design cycles, and market share shifts can be very rapid and difficult to forecast. This can make it challenging to generate decent returns across the cycle. We therefore think investors will reward Infineon’s decision to sell its wireless business ahead of potential market concerns about share loss at Apple. Although we prefer ARM and Imagination as long-term investments, owing to the sales and earnings visibility afforded by their semiconductor IP business models, we also believe it makes sense to buy stocks such as Wolfson that have good prospects for market share gain in wireless. For value investors, we believe it makes more sense to concentrate on stocks exposed to the automotive and industrial end markets, where returns are higher than average and design cycles much longer than in wireless, and hence carry lower risk, even if they remain cyclical in nature.

Debate #3: Is automotive attractive for semis? We think the market underestimates this space, which offers superior risk-reward to wireless

Our analysis of the global automotive market with Morgan Stanley’s Autos team suggests that China has become the largest growth driver for the semis auto market. This is confirmed by our discussions with the main German auto manufacturers, who are seeing a positive mix effect towards mid and high end cars, which contain as many as four times the number of semiconductor chips as standard cars.

Infineon appears to be the best positioned company to benefit from the structural growth in automotive and industrial demand in emerging markets. We believe that companies exposed to the automotive and industrial sectors could benefit from: 1) the structurally low penetration of cars in emerging markets and particularly in China, where demand for high-end cars is especially strong; and from 2) the structural growth in power – in particular, clean power and rail infrastructure in emerging markets. Infineon holds a key competitive position in power semiconductors used in both end markets. STMicroelectronics is also exposed to the automotive segment, but Infineon has greater exposure to the German manufacturers, the key exporters to China – and we think the stock could be played as a proxy for German exports to China.

25



Industry Analysis

Stock ideas

ARM (Overweight) – best placed in wireless ARM holds an undisputed position in mobile phones and is likely to take a significant share of the laptop/tablet market, even if Intel and AMD maintain their leadership in terms of microprocessor shipments. With many positive catalysts in view, and investors likely to be positively surprised by the PIPD business (Artisan), we believe that more investors will look at a DCF valuation for ARM. More royalties flowing through the P&L and opex under control mean we expect operating margins to exceed 45% as early as 2012, barring a double dip scenario, and then move up gradually towards 60-65%.

Imagination (Overweight) – proliferation of graphics Imagination is a semiconductor IP company, like ARM, but focuses on the graphics market for phones, smartphones, tablets and notebooks, as well as on reconfigurable software radios. Imagination has a similar business model to ARM and significant leverage to the smartphone, tablet and netbook markets, as well as potential proliferation in consumer electronics. Our DCF valuation implies 33% upside to the shares, as margins exceed 40% from 2015 onwards.

Infineon (Overweight) – power of margin expansion With the volatile and value destructive DRAM business and structurally challenged wireless business out of the picture, we believe that Infineon is well positioned to benefit from positive structural trends in power and automotive semiconductors, two sectors in which it is the market leader due to its competitive advantage in producing power semiconductors. Margin expansion, coupled with the likely introduction of a €0.10 dividend yielding 2% and a potential €500m share buyback in 2Q11, should lead to a re-rating of the shares in the next 12 months, from the current 1.0x FY2011e EV/Sales to 1.3x EV/Sales, in our view.

Wolfson (Overweight) – the sound of smartphones Wolfson is supplier of audio chips for phones, smartphones, tablets and consumer electronics such as TVs. We believe that consensus estimates do not fully reflect the potential for revenue growth in smartphones, especially running Android, in the next three years. With 20% upside to consensus underlying EPS estimates in 2011, in our view, and 30% upside in our base case, we believe the shares are good value on 9.5x 2012e PER excluding cash. However, we would recommend buying the shares towards the end of the results season, once large-cap semis have warned.

STM (Equal-weight) – ST-Ericsson turnaround is key We expect STMicroelectronics to expand core operating margins from 10% in 2010 to 16% by 2013, driven mainly by

Industrial and Multisegment (78% of sales), where it is exposed to the positive structural trends that are benefiting Infineon. However, we believe share performance over the next 12 months is largely contingent on the scale and timing of the recovery at ST-Ericsson, STM’s wireless chips JV with Ericsson (22% of sales). With restructuring of the venture now largely complete, the business is now dependent on the ramp with customers (which include Nokia and Samsung, we believe) to reach break-even. Timing and visibility on this remains uncertain, and the stock’s trading history suggest investors are unlikely to price in a turnaround in the business until ST-E’s customers’ products are successfully in the market. Even with forecasts above consensus in 2012 and 2013, our price target implies only 11% upside. For this reason, we see better opportunities elsewhere in the sector.

ASML (Underweight) – all eyes on 2011 capex There are two ways to invest in ASML: as a market share taker in a cyclical but growing lithography market; or by playing momentum on book to bill. For the long-term investor, ASML should be a key holding, in our view, as it is the dominant player in lithography tools, having taken c.80% of the market. In that case, we believe that ASML should be valued as a multiple of cross-cycle earnings, taking the cash generated through the cycle into account. For investors interested in momentum, we believe that ASML’s book to bill is a key decision factor. With the book to bill already falling and a potential recovery of this ratio at best in 2Q11, we believe it is probably too early to buy the shares.

CSR (Underweight) – focus on wireless strategy CSR is a supplier of Bluetooth, GPS and WiFi chips for phones, headsets, automotive and consumer electronics. CSR’s non-mobile business is thriving, driven by the acquisition of SiRF at the bottom of the market and the increased penetration of Bluetooth and GPS in non-mobile segments, such as cars, satnavs, consumer electronics and gaming consoles. However, it is not doing as well in wireless, where it is mostly exposed to non-smartphone devices, for which pricing pressure is intense. Furthermore, unit growth is constrained by consumer appetite to use smartphones rather than feature phones. We believe that management is aware of the challenges, and we expect some form of strategic decision in the near term to tackle the market share losses in this business. Separately, we think there is downside to consensus Q4 and 2011 forecasts owing to softness in consumer end markets, and that sell-side estimates will have to be reset after the Q3 results. In the short term, the prospect of a share buyback limits the downside, but we would advise investors to wait for the Q3 results and the Analyst Day to buy the shares with an increased level of confidence.

26



Company Analysis

Stock Rating: Overweight Reuters: IMT.L Bloomberg: IMT LN

Price target 2,270pShr price, close (Oct 6, 2010) 1,910p52-Week Range 2,159-1,728pMkt cap, curr (mn) £19,437

Fiscal Year ending 09/09 09/10e 09/11e 09/12e

ModelWare EPS (p) 161 178 192 220Consensus EPS (p)§ 159 179 193 211P/E** 11.1 10.6 10.0 8.7Div per shr (p) 73 83 93 110Div yld (%) 4.1

October 6, 2010

Imperial Tobacco Partnering Model Could Offer Upside to Growth Estimates Morgan Stanley & Co.

International plc+

Toby J McCullagh [email protected]

Morgan Stanley & Co.

Incorporated David J. Adelman [email protected]

Matthew Grainger 4.4 4.9 5.8

** = Based on consensus methodology § = Consensus data is provided by FactSet estimates e = Morgan Stanley Research estimates

Price Performance

06 07 08 09 10

14

16

18

20

22

24

%

90

100

110

120

130

140

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£

Imperial Tobacco Group PLC (Left, Br itish Pounds)Relativ e to FTSE UK ALL-SHARE(GBP) (Right)Relativ e to MSCI World Index /Food Bev erage & Tobacco (Right)

Source: FactSet Research Systems Inc

Company Description Imperial Tobacco is one of the world’s largest cigarette manufacturers and the world's largest cigar manufacturer. The company also has leading positions in hand-rolling and pipe tobacco, cigarette paper and cigarette tubes.

Tobacco/United Kingdom Industry View: Attractive With industry volumes flat to declining and portfolio mix under pressure from the economic backdrop, pricing is the key driver of cigarette companies’ profit growth.

GICS Sector: Consumer Staples Strategists' Recommended Weight: 12.6%

MSCI Europe Weight: 12.6%

International partnering can add a capital-light and relatively low risk driver to top-line growth; success would add a further leg to our OW investment case. Our AlphaWise survey on brand switching and the potential for Davidoff in the South Korean cigarette market suggests that, although Korea is unlikely to be material for Imperial Tobacco (IMT) in isolation, a partnering strategy exported into additional markets could add a capital-light and relatively low-risk driver to top-line growth (see Kelly Kim, KT&G: Silver Lining in Domestic Market Share, 6 October, 2010). The partnering model could access new top-line growth in a way that suggests future cost savings will still fall to the bottom line, rather than being redirected towards expensive attempts to enter new markets, as some investors fear.

Stay Overweight: Our Overweight rating is based on sustained strong pricing, our view that IMT’s relative organic growth prospects are better than the market expects, and rapid de-leveraging and incremental cost savings post realization of the Altadis synergies. Success in its partnering strategy would add a new leg to our investment case. With a secure 4.4% dividend yield, IMT offers a 20%-plus total return to our 2,270p price target.

IMT’s partnering strategy

At its recent Investor Day, IMT outlined its ambitions to achieve “significant growth in emerging markets” in a plan based on three key drivers:

1. Organic growth

- Targeted increase in A&P investment - Structural investments

2. M&A

- Expanding market footprint

3. Strategic alliances

- Such as recent announcements in Korea and Mexico

Based on our in-depth analysis of the main global cigarette profit pools, Pricing Remains the Key Driver of Profit Grofrom July, we found that IMT already enjoys a structural organic profit growth opportunity of around 6% per year bason its existing regional footprint. The company has alrannounced an 8% increase in A&P in FY10, with the overwhelming majority of that increase targete

wth,

ed eady

d in emerging markets, which should support faster growth.

27

28



Company Analysis

Exhibit 1 Exhibit 2

S. Korea is one of the world’s largest cigarette markets Partnering for growth in unrepresented markets

0

50

100

150

200

250

300

350

400

Russia

USA

Japan

Indones

ia

Turkey

S. Kore

aIn

diaIta

ly

Vietn

am

Ukrai

ne

(Mar

ket

volu

me

(bn

sti

cks

)

Local partner Country Agreement

PMI / IMT Mexico PMI distributes Davidoff and manufactures and distributes West in Mexico

BAT / IMT Argentina BAT manufactures and distributes Parisienne brand in Argentina

BAT / IMT Australia BAT manufactures and distributes IMT brands in Australia

KT&G / IMT South Korea KT&G manufactures and distributes Davidoff in South Korea

Barakat / IMT India Barakat distributes Davidoff in key cities in India

CNTC / IMT China IMT (Altadis USA, not Habanos) has a framework agreement for cigars in China


Although the company is currently in debt reduction mode, we expect the rapid pace of deleveraging should ensure that IMT’s balance sheet can support further M&A, especially tuck-in opportunities associated with emerging markets’ state monopoly privatisations, within the relatively short term. We think the company’s growing partnering model offers a capital-light and comparatively low risk opportunity to generate profits in markets where it has no presence and where the barriers to and risks of organic market entry are not compelling.

Source: Euromonitor data (2009)

capita consumption have remained broadly stable, supported by flat taxes and a lack of industry price increases.

Appetite for international brands The Korean market has offered a significant growth opportunity for international brands since KT&G, the former state monopoly, was privatised in 2002 and the market opened to foreign players. KT&G has suffered perennial share loss since the market opened up, as Korean smokers, especially those in younger age cohorts, have defected to foreign brands

Attractions of the Korean market The Korean cigarette market is the sixth largest global market (ex-China). According to Euromonitor, it is one of only three of the top ten markets (the others being Russia and Indonesia) with volume growth over the past four years, albeit off a low base, following a significant tax hike in 2004. Volumes have remained resilient as prevalence rates, at about 25%, and per

BAT has enjoyed great success with Dunhill in the premium segment, while PMI introduced Marlboro, Parliament and Lark in the premium segment and Virginia Slims in the above premium segment, and JT introduced Mild Seven as a premium brand.

Exhibit 3

Market overly focused on short-term concerns; we think pace of deleveraging and structural growth opportunities are under-appreciated

WARNINGDONOTEDIT_RRS4RL~IMT.L~

2,270p (+19%)

1,910p

1460p (-24%)

2590p (+36%)

0

500

1,000

1,500

2,000

2,500

3,000

Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11

p

Price Target (Oct-11) Historical Stock Performance Current Stock Price

Bull Case 2,590p: Exceeds growth potential identified in our profit pool analysis, driven by 100bps pa stronger pricing and stronger post-Altadis cost savings lifting margins by 150bps. Assumes FY10-13 revenue and operating profit CAGRs of 4.2% and 6.5%, respectively.

Base Case 2,270p: IMT deleverages to 2.5x Net debt / EBITDA by the end of FY11 through retention of FY09 NWC gains and strong cash conversion. IMT achieves €400mn Altadis cost savings target by FY12. Assumes FY10-13 revenue CAGR of 3.5% (vol +0.4%/price +3.1%) and operating profit CAGR of 4.5% (FY10-13 margin +150bps).

Bear Case 1,460p: Core markets slow volume growth and competition pressures pricing and margins. Our bear case assumes FY10-15 revenue and CAGR of 2.2% (vol -0.3%/price +1.8%) and operating profit CAGR of 2.0% on lack of incremental cost savings.

Price Target Methodology: Derived using long-term average forward P/E multiple of 11.5x on calendarised 2011e EPS.

Source: FactSet (historical share price data), Morgan Stanley Research estimates



Company Analysis

Stock Rating: Overweight Reuters: SIA.L Bloomberg: SIA LN

Price target 470pShr price, close (Oct 12, 2010) 369p52-Week Range 510-305pMkt cap, curr (mn) US$1,962


ModelWare EPS (US$) 0.15 0.04 0.15 0.38Consensus EPS (US$)§ 0.15 0.15 0.43 0.68P/E** 35.6 143.9 38.1 15.2ROE (%) 7.2 1.9 5.9 14.1

** = Based on consensus methodology § = Consensus data is provided by FactSet estimates e = Morgan Stanley Research estimates

Price Performance

06 07 08 09 101.5

2

2.5

3

3.5

4

4.5

5

5.5

6%

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£

Soco International PLC (Left, British Pounds)Relativ e to FTSE UK ALL-SHARE(GBP) (Right)Relativ e to MSCI World Index /Energy (Right)


Company Description Soco International is an oil and gas company focused on exploration in Vietnam and Yemen. The company also has interests in Thailand, the Republic of Congo (Brazzaville), the Democratic Republic of Congo

October 13, 2010

SOCO International Back to Core – Stay OW Morgan Stanley & Co.

International plc+

Theepan Jothilingam, CFA [email protected]

Matthew P Lofting, CFA [email protected]

Shares down sharply as Vietnam exploration disappoints. Yesterday’s sharp correction (18%) in SOCO’s share price was brutal but not unjustified, in our view, given management’s optimism on TGD (exploration block in Vietnam) last month. Although recent well results can best be described as disappointing, our thesis from early this year remains intact: namely, that either the company’s E&A campaign delivers transformational change (the DRC campaign is ongoing and there was some good news on TGD); or management would look to crystallize value through a corporate or asset sale, which should realise a value higher than today’s share price.

Cutting PT but undemanding valuation keeps us OW. We lower our NAV per share to 468p, which brings down our price target to 470p (from 550p), while highlighting that our core value, excluding upside for the DRC, TGT or the fan channel play in Vietnam, is 370p/share – SOCO now trades at the lowest premium to Core NAV in our coverage universe. As such, we remain Overweight.

TGD flows are sub-commercial … SOCO announced that the TGD-2X well (Vietnam, worth c.52p/share in our Base case NAV) has encountered significant hydrocarbons in a clastics reservoir sequence, but the flow rates are sub-commercial. The well will now be plugged and abandoned. Given the substantial optimism provided by management in the run-up to the drilling results and the potential to de-risk further prospectivity in the fan channel play (worth an incremental 32p/share in our Base case), the result is clearly disappointing.

(Kinshasa) and Angola.

Oil & Gas/United Kingdom Industry View: Attractive We maintain an attractive view on Energy, supported by inexpensive valuation (on both an absolute and relative basis) and a positive view on medium-term oil prices.

GICS Sector: Energy Strategists' Recommended Weight: 12.2%


… while TGT provides a small positive: The result from the first two development wells at TGT (Vietnam) appear to confirm that the field extends to the east. We currently incorporate a 250mb reserve size for the TGT fields, but believe the drilling results should help SOCO partially de-risk the 500mb upside case (risked at 33% in our Base case, unrisked worth c.137p/share). Incremental news flow on

Next catalysts: The material KNY-1 well on the Nganzi bl

potential reserve upgrades may come in November/December, with production to start mid-2011.

ock (DRC, 25 day well, unrisked c.188p/share) is currently drilling,

isappointing drilling results from Vietnam and Congo, and delays to the

with results expected by the end of October.

Specific risks for SOCO: On the downside, d

development of existing assets in Vietnam. On the upside, we see risks from materially better success from the drill bit

29



Company Analysis

Exhibit 1

Bear to Bull

310p

468p

625p

60p38p 8p

53p

135p 22p

Price Target: 470p

0

100

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400

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600

700

800

BearCase

Higher OilPrice

DRC Congo Vietnam BaseCase

Incr. ExplorSuccess

Incr.Develop.Success

BullCase


Exhibit 2

Overweight ahead of an active 2010 drilling campaign


470p (+27%)

371p

310p (-16%)

625p (+68%)

0

100

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500

600

700

Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11

p


BULL CASE: 625p Increased exploration and appraisal success. Consists of our base case plus the assumption that the company is 2.5x more successful in exploration/development than in our base case.

BASE CASE: 468p Risked exploration success and mid-cycle oil price. Includes risked value from exploration and development activity. Our core value, at a US$90/bbl oil price, plus risked upside from exploration and development projects in 2010 and 2011.

BEAR CASE: 310p No upside from exploration and development activity. It consists of the company’s producing fields and fields under development, at US$70/bbl oil price, less net debt and present value of group overheads.

PRICE TARGET METHODOLOGY Our 12-month price target is set around our base case NAV of 468p assuming Base case oil prices of LT US$90/bbl Brent.

30



Company Analysis

October 4, 2010

Unite Group Superior NAV Growth Even With Modest Rental Growth Morgan Stanley & Co.

International plc

Bianca Riemer [email protected]

Bart Gysens, CFA Christopher Fremantle, CFA

We expect superior NAV growth for Unite, even with conservative rental growth assumptions. Valuation is unchallenging and upside to 260p attractive: We initiate coverage at Overweight.

Twice as much NAV growth as the UK average. We estimate that Unite can grow its NAV by 10% per annum over the next three years, approximately twice as much as the other UK stocks we cover. Key drivers are rental growth (contributing 6% p.a. of growth) and development completions (contributing approximately 3% p.a.). We base our estimates on a relatively cautious 3% annual rental growth (versus 7% p.a. on average over the last 5 years), and estimate that each 1pp in rental growth increases NAV by 2pp, thanks to Unite’s relatively short leases and high financial gearing.

Catalyst: Government decision on tuition fees. We think that the results of the Browne Review and a government announcement on tuition fees will lift the uncertainty weighing on the share price. The impact on Unite will be seen in the pre-let numbers for the 2011/12 academic year in the group’s interim report in November.

8 reasons why we think rents will continue to grow, albeit at a slower pace than previously:

1. Unite’s tenant base will be unaffected, in our view Unite’s tenants tend to be from above-average income households, and we think that a fall in the number of students, if at all, is most likely to be in students from lower-income backgrounds. According to UCAS, the agency that administers undergraduate applications, there is a positive correlation between A-level results and parents’ incomes. This would imply that, if the government were to cut university places, for example, fewer students from lower income backgrounds would win places. By the same token, we think any increase in tuition fees would tend to have less effect on school-leavers from higher-income backgrounds.

Stock Rating: Overweight Reuters: UTG.L Bloomberg: UTG LN

Price target 260pShr price, close (Oct 1, 2010) 223p52-Week Range 312-159pMkt cap, curr (mn) £364

Fiscal Year ending 12/09e 12/10e 12/11e 12/12e

NAV per share (p) 265 295 319 346ModelWare EPS (p) 0.3 (0.3) 0.6 2.1Div per shr (p) 0 0 0 0Revenue (£mn)** 81 86 90 98

** = Based on consensus methodology e = Morgan Stanley Research estimates

Price Performance

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Unite Group PLC (Left, British Pounds)Relativ e to FTSE UK ALL-SHARE(GBP) (Right)Relativ e to MSCI World Index /Real Estate (Right)


Company Description Unite Group is a developer and co-investing manager of commercial student accommodation. It manages about 40,000 beds located in university cities across the UK valued at £1.8bn, of which it owns about 45% by value.

Property/United Kingdom Industry View: Cautious

GICS Sector: Financials Strategists' Recommended Weight: 25.1%

M

SCI Europe Weight: 23.1%

2. Universities to offer more places to non-EU students We think that in the light of government funding cuts, universities will likely increase their intake of non-EU students who pay significantly higher tuition fees (up to £20,000 p.a. for undergraduate courses, compared to a capped annual fee of £3,290 p.a. for UK/EU students currently). Several universities have already indicated they are in the process of doing this, and some are even cutting places for UK/EU students in order to increase their non-EU intake (according to a recent HESA press release). Non-EU students tend to be less price-sensitive and value the all-inclusive nature of Unite’s rents (including utility bills, insurance and broadband), as well as its proximity to university campuses. Moreover, it is significantly more difficult for non-EU students to rent in the private rented sector.

31

32



Company Analysis

3. Supply of student accommodation is growing slower than the number of new 1st year undergraduate students

6. New requirement for affordable housing could be barrier to entry for new competitors in London

This matters because UK universities guarantee 1st year undergraduates a room in halls of residence but can only satisfy 65% of this guarantee – and only 35% in London. About 50% of Unite’s direct-let tenants are referrals from universities that cannot satisfy their rental guarantees. We think that this percentage may well increase as universities recruit more non-EU students.

Student accommodation development schemes have in the past not had to comply with London’s requirement to have up to 50% of the scheme in affordable housing. This meant that Unite and its competitors have been able to build in locations that would have been unprofitable for, say, an office developer or a house builder. Some London boroughs are considering requiring affordable housing to be included in student schemes, unless the scheme is endorsed by a local university. We think that Unite’s existing relationships with universities would give it a clear competitive advantage over potential new entrants in the London market.

4. Unite is the market leader in a niche segment Unite manages the largest commercial halls portfolio in the UK and is the first provider to publish prices for the forthcoming academic year. Our channel checks with surveyors and competitors confirm that competitors tend to wait for Unite’s pricing before compiling their own price lists, and that they generally price below Unite (7% on average in Unite’s top 8 locations according to our proprietary price check in September 2010).

7. Unite has minimal exposure to universities as tenants We do not think that cuts to university funding have a direct impact on Unite as only 4% of its rental income is from leases to universities.

8. Residential substitutes are becoming more expensive, too, and may not be accessible for all students 5. Unite has a strong London focus In the latest quarterly residential lettings survey by the Royal Institute of Chartered Surveyors (RICS), 27% more surveyors reported a rise rather than a fall in residential rents. 33% more surveyors now expect rents to increase rather than fall over the next quarter. We think that as residential substitutes become more expensive, Unite will continue to be able to increase its rents, too

We expect rental growth to be stronger in London, as there are more international students and the supply ratio is significantly lower. About 40% of Unite’s share in the portfolio it manages is in London, where universities can only satisfy 35% of their rental guarantee for 1st year undergraduates, and where currently only 2-3% of full-time students live in commercial halls.

Exhibit 1

Near-term positive catalyst helps skew risk to the upside

WARNINGDONOTEDIT_RRS4RL~UTG.L~

260p (+18%)

223p

128p (-42%)

316p (+44%)

0

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350

Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11

p

Base Case (Sep-11) Historical Stock Performance Current Stock Price

BULL CASE 316p: Government allows tuition fee increase of 10%. The government allows universities to increase fees for UK/EU students from September 2012, but only up to 10% p.a. Unite’s rents grow 5% p.a. and yields compress 50 bps. The stock trades at a 5% discount to NAV.

BASE CASE 260p: Universities grant more places to non-EU students. The government announces a gradual lifting of the tuition fee cap for new entrants from September 2012, and applications fall marginally, with no impact on places. Unite rents grow 3.5% p.a., and yields are stable. The stock trades at a 17% discount to NAV.

BEAR CASE 128p: Tuition fees allowed to increase from September 2011. Commercial halls cut rents 10%, and yields rise 50 bps. Unite NAV falls 30%, it trades at a 50% discount.

PRICE TARGET METHODOLOGY: We apply a 17% target discount (given its relatively large financial/operational gearing and absence of recurring earnings) to our mid-2011 NAV estimate.




Company Analysis

October 4, 2010

Vodafone Group Rising Cash Returns Morgan Stanley & Co.

International plc+

Nick Delfas [email protected]

Terence Tsui Luis Prota Frederic Boulan, CFA

Upgrading to EW; PT from 160p to 175p. We feel lucky that Vodafone’s total return has only been in line with the sector over the last 6 months (-1% in £, +3% in €). Our downgrade (High ROCE, March 25) was based on longer-term risks to returns, and these still exist. However, shareholder dissent at the July AGM and press reports that the chairman intends to retire (c.f. FT, September 6), plus Vodafone’s sale of its China Mobile stake and resultant share buyback announcement (£2.8bn, or 3% of market cap) have contributed to a more supportive atmosphere for the shares.

In this report we reassess:

Value – Better prospects in India and Australia, a strengthened yen driving up the Softbank loan note values, and a lower debt position at VZW are only partially offset by a weaker Italian outlook, and drive our price target upgrade from 160p to 175p.

Asset sales – We estimate potential proceeds of £11-14bn. The proceeds could be returned to shareholders or used to buy fixed line assets, or a combination of the two. But the key in our view is that Vodafone is beginning to sell well-performing businesses, not just those that have suffered under its ownership as in the past (such as Sweden, Japan). This means it stands a better chance of good portfolio management, rather than simply locking in losses.

Verizon Wireless dividend – We now include an extra £1bn of dividend already in FY11 beyond the dividend currently being paid to cover tax, and a full payout of FCFE from FY12. This drives up our DPS estimates from 8.9p to 11.0p for FY11 and from 9.5p to 12.0p for FY12.

We are conscious that the last two are not strictly speaking ‘value’ events beyond the value that accrues from cash being paid out rather than retained by the company. Furthermore, share buybacks only create value if the shares are below fair value, and this appears to be only modestly the case. It is partly for this reason that we are EW.

Stock Rating: Equal-weight Reuters: VOD.L Bloomberg: VOD LN

Price target 175pShr price, close (Sept 30, 2010) 157p52-Week Range 165-127pMkt cap, curr (mn) £83,427


ModelWare EPS (p) 16.4 16.2 16.7 17.3P/E** 9.2 9.7 9.4 9.1Dividend per Share (p) 8.1 11.0 12.0 13.0Dividend Yield (%) 5.4 7.0 7.6 8.3

** = Based on consensus methodology e = Morgan Stanley Research estimates

Price Performance

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1

1.2

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Vodafone Group PLC (Left, British Pounds)Relativ e to FTSE UK ALL-SHARE(GBP) (Right)Relativ e to MSCI World Index /Telecommunication Serv ices (Right)


Company Description Vodafone is the largest pure-play wireless stock by market capitalisation. Its operations are mostly based in the European Union, together with a 45% stake in Verizon Wireless of the US; whilst its EMEA exposure is dominated by India, South Africa and Egypt.

Telecommunications Services/United Kingdom Industry View: In-Line We see more limited absolute upside for European telecom stocks in 2010. The sector re-rated in 2009 by 20% on FCF yield, all in the second half of the year. Higher prices and slightly lower forecasts mean much of the previous value gap has been extinguished. GICS Sector: Telecom Services Strategists' Recommended Weight: 8.9%

M


However, improving momentum in cash returns is likely in our view to support the shares, particularly over the next six months, when asset sales and Verizon Wireless dividend announcements could be made.

Our risk-reward range has shifted upwards from 115p-190p to 140p-205p, and indicates some modest upside towards 170-175p as the mid-part of the range, in line with the sector upside of 14%. A rise in the dividend would mean that the FY12e dividend of 12p would yield 7.6% at today’s share price, compared to the sector at 6.9% (though FT and TEF yield 8.7% and 8.8% respectively). Again, this is supportive as the dividend payout on earnings before amortization would be 60% at this level rather than 70-80% for FT and TEF.

33

34



Company Analysis

Our colleague Vinay Jaising recently visited Indian operators. Price falls appear to have ended, and we raise our Vodafone India growth rate for FY11 from 5% to 11%, and margins are up slightly from down 400bps.

Options for disposal of Verizon Wireless remain hard to gauge. Even a spin-off appears to require Verizon approval. In our Flexer, we now target a FCFE yield rather than posit a sale price less tax paid, as we wish to be neutral in valuation terms over whether the asset is retained with a dividend stream or sold / spun off – even if we think it is better for management focus for it to be separated.

Turkey also improved. Fiscal Q1 margins were in the high single digits.

Italy weaker – we include margin pressure to respond to TIM – down 220bps from down 70bps – in accordance with our recent trip to visit TIM and Wind.

What are the risks? The major risk in our view is that smartphone adoption leads to better revenues as handsets are “leased” from operators, but also a subsidy war, driving down ROCE further. There also appears to be an ongoing price war in Italy, only partially related to smartphones.

Dividends from Verizon Wireless. Our FCF forecasts rise strongly due to increased dividends from VZW. For FY11e we assume an additional £1bn beyond the £1bn or so that is already paid to cover the tax liability at the partner level. From FY12e we assume a full payout of £4.5bn. This has the effect of bringing down consolidated net debt / EBITDA to 2.0x in FY13 from 2.5x previously forecast.

Our preferred stocks are KPN, Telefonica and the cable operators KDG, Telenet, and Virgin Media.

Ex FX our FY11e EPS rises 3% for better India and Australia, offset by weaker Italy.

We change our FX assumptions from €1.15/£ and $1.50/$ to €1.18 and $1.54 to reflect year to date averages and assuming that current spot rates persist to the end of the financial year.

One final open question is capex: could Vodafone adopt a more aggressive “swap out” policy to reduce 2G / 3G running costs, and future investment costs, as Telenor has done in Norway? This could form some additional upside to near-term cash flow expectations, even if in the longer term we would expect such gains to be competed away

Key points to note:

Australia is doing well. Margins were up in H1 2010 according to Hutchison Australia, at 21% from 7.5% in H2 2009.

Exhibit 1

Balanced risk reward

Source: FactSet (share price data), Morgan Stanley Research estimates; Prices: KPN €11.35, Telefonica €18.16, KDG €29.1, Telenet €24.61, Virgin Media $23.10 (covered by David Gober)

BULL CASE 205p: Vodafone Europe flat revenues into perpetuity, with stable cash flow.

BASE CASE 175p: Vodafone Europe delivers -2% revenue CAGR in FY10-17, with 11% capex / sales.

BEAR CASE 140p: Vodafone Europe ROCE falls to just over 10% over 7 years as revenues fall 3.5% compound with operating leverage to EBITDA.

PRICE TARGET METHODOLOGY: Derived from DCF, assuming blended WACC of 8.6% and terminal growth of 1%.

175p (+11%)

157p

140p (-11%)

205p (+30%)

70

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150

170

190

210

230


p




Company Analysis

Stock Rating: Overweight Reuters: WOS.L Bloomberg: WOS LN

Price target

October 1, 2010

Wolseley plc 2,030pShr price, close (Sep 29, 2010) 1,591p52-Week Range 1,742-1,155pMkt cap, curr (mn) £4,503


ModelWare EPS (p) (177) 51 77 132Consensus EPS (p)§ 64 79 116 154P/E** 14.1 19.5 13.8 9.3Div per shr (p) 0 0 38 57Div yld (%) 0.0 0.0 2.4 3.6

§ = Consensus data is provided by FactSet estimates ** = Based on consensus methodology e = Morgan Stanley Research estimates

Price Performance

Increased Confidence in Restructuring: Stay OW Morgan Stanley & Co.

International plc+

Jessica Alsford, CFA [email protected]

David Hancock, CFA [email protected]

Simone E Porter-Smith [email protected]

Post FY10 results, we continue to recommend that investors buy into Wolseley’s recovery story. Although volume growth will be lacklustre across all end markets, the restructuring story is showing early signs of success.

06 07 08 09 10

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Wolseley PLC (Left, British Pounds)Relativ e to FTSE UK ALL-SHARE(GBP) (Right)Relativ e to MSCI World Index /Capital Goods (Right)

A return to positive revenue growth LfL revenue growth turned positive in Q4 (+4% versus -2% in Q3), which was the first period of growth since mid-2007. The comparative period is easier (-19% in Q4 vs. -17% in Q3), but even adjusting for this, there was around 4% sequential growth between the two last quarters. Looking ahead, we assume that revenue growth continues at roughly the same rate, and forecast 3% organic growth for FY11. Comps do get tougher, and so this assumes a 4 percentage point improvement sequentially over the next couple of quarters. There are four drivers of the organic growth:


Company Description Wolseley is the world’s largest distributor of plumbing and heating products and a major distributor of other building products to the professional builder market. Sales in fiscal FY2010 were £13.2 billion. The group has operations in North America (~60% of sales) and Europe (~40% of sales).

Business Services/United Kingdom

Small decline in overall market volumes

Market share gains Industry View: In-Line GICS Sector: Industrials Strategists' Recommended Weight: 10.5%


Positive price trends

Branch openings

Attractive valuation – remain Overweight: Wolseley shares have rallied by 26% over the last month, outperforming the market by 21%. However, on our new forecasts, Wolseley still only trades on 11.5x calendar PE and 0.39x EV to Sales for 2011e. We believe this is an attractive valuation with c.45% EPS CAGR over the next three years. We raise our price target by 7% to 2,030p.

Gross margins stabilised earlier than anticipated For FY10 we had forecast a 30bp decline in the group gross margin in FY10, driven principally by margin pressure in the UK business. However, Wolseley reported flat yoy gross margins at 27.7%.

One of the key ways in which Wolseley is aiming to improvprofitability in the UK is through the gross margin. During FY09 and 1H10, the gross margin was falling significantlyin the UK business, including -200bp of decline in 1Q10. Changes made to the UK business over the last six monthshave included (i) having a “no price change” policy on non-core products; (ii) reducing the discounts some custoreceive to better reflect the size of their purchases; (iii) introducing more private label products. These actions have already started to deliver results, with the g

e

yoy

mers

ross margin increasing year-on-year during May to August.

35

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Company Analysis

Performance Builders – progress being made Exhibit 1

LfL growth has turned positive with some sequential growth

In March, CEO Ian Meakins set out a framework for managing the 41 business units that Wolseley had at that time. 19 units were identified as Performance Builders, with the priority being restructuring to improve growth and profitability. Since then two of the businesses have been sold (Brandon Hire and France Public Works), three are to be exited (including Construction Loans) and four have been integrated into other divisions. This leaves 10 business units, including Build Center, Brossette and Italy, where progress is being made. For example Build Center is now profitable, whilst Brossette has turned from loss-making to breakeven. More attention is needed on Italy, which is loss-making, but action is being taken with another seven branches to be shut. The Performance Builders now account for less than 5% of group EBITA. We have cautious assumptions, just 1.8% EBITA margin in FY13 compared to 0.8% in FY09.

-20%

-15%

-10%

-5%

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Q3 2009 Q4 2009 Q1 2010 Q2 2010 Q3 2010 Q4 2010Q1

2011eQ2

2011eQ3

2011eQ4

2011e

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up

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e=Morgan Stanley Research estimates Source: Company data, Morgan Stanley Research

inflow that occurred just before year end, but also due to the business growing again. However, over the next three years we expect free cash flow conversion to average at ~0%.

Balance sheet robust – capex to accelerate and dividend reinstated. Net debt at 31 July 2010 was only £346mn compared to £959mn at the previous year-end. Timing of working capital changes did flatter this position, but even adjusting for this the debt position fell by around £500mn over the last 12 months.

Changes to forecasts We have altered very little our underlying operating assumptions. However, we are raising our EPS forecasts by c.10% to 115p in FY11 and 171p in FY12 due to a lower tax rateWolseley has indicated that it intends to pay a dividend again

from 1H 11 while capex spend is increasing as the company begins to look at growth again. There will be a big working capital outflow during 2011, mainly due to reversing the large

Exhibit 2

Greater confidence on margins underpins a positive risk-reward skew


BULL CASE 2,700p: Highly successful restructuring with new peak margins: Wolseley grows its revenue base with an organic CAGR of +9% (FY10-13e) as it takes market share. The Growth Engines reach 9.0% EBITA margins while the Synergy Drivers attain 6.0% return on sales and the Performance builders 4.0%.

BASE CASE 2,030p: Previous peak profitability attained again: Organic revenue CAGR of +6% (FY10-13e) as the “Growth Engines” take market share. FY13e peak revenues are 13% below the previous peak in FY07 (at constant currency). Profitability improves across all business areas.

BEAR CASE 1,060p: Double dip and restructuring fails: Wolseley continues to lose market share across all business lines. +1% revenue CAGR from FY10-13e with FY13e peak revenues still 24% below the previous peak level (at constant currency). Profitability improves from 2.9% in FY10e to 4.0% in FY13e

PRICE TARGET METHODOLOGY: We derive our PT from an average of three valuation methodologies: DCF (WACC of 8.8% and 3% LT growth), EV/Sales and long-term relative P/E (10.8x 2013e EPS discounted back).

WARNINGDONOTEDIT_RRS4RL~WOS.L~

2030p (+28%)

1,591p

1060p (-33%)

2700p (+70%)

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3,000


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Company Analysis

October 5, 2010

Wood Group Value Materialised; Downgrade to Equal-weight Morgan Stanley & Co.

International plc+

Martijn Rats, CFA [email protected]

Robert Pulleyn [email protected]

Increasing visibility on the recovery in Engineering has supported Wood Group’s re-rating. With valuation multiples now back to industry averages, we recommend taking profits.

Wood Group’s share price has increased 42% since the start of the year, making it the third best performing stock in our coverage universe after Wellstream (+46%) and Petrofac (+44%). As a result, upside to our price target has been reduced to 7%, which is modest compared with the sector. Hence, we are lowering our rating on Wood Group from Overweight to Equal-weight.

Our previous investment thesis was based on two main factors: first, we believe that Wood Group’s valuation was attractive, and second, we expected the outlook for the Engineering segment to start to improve, which we considered to be the main ‘swing factor’ driving confidence in Wood Group’s earnings recovery in 2011 (also see our report Cheapest Play on Oil Service Recovery, January 21, 2010). This thesis has now played out, in our view.

Valuation gap with key peers closed … Wood Group started 2010 trading on 11.1x consensus 2011 EPS and 9.4x consensus 2012 EPS. At the time, Wood Group was the lowest-rated company in our coverage universe on 2011e PE. Also, the two-year forward PE was at a 30% discount to its long-run historical average, again making Wood Group the lowest-rated company in our coverage universe on that particular metric as well.

Since then, Wood Group has re-rated substantially: at the moment, it trades on a 2011e and 2012e PE of 15.0 and 12.7 respectively, which is broadly in-line with peers. Hence, we would argue that the valuation gap with the rest of the sector has now largely closed (also see Exhibit 1).

… and discount to normalized valuation much reduced As described later, we estimate Wood Group’s mid-cycle

Stock Rating: Equal-weight Reuters: WG.L Bloomberg: WG/ LN

Price target 470pShr price, close (Oct 1, 2010) 438p52-Week Range 444-280pMkt cap, curr (mn) US$3,626


ModelWare EPS (US$) 0.42 0.38 0.48 0.58Prior EPS (US$)* - 0.38 0.46 0.58P/E 11.9 18.1 14.5 11.9Dividend per Share (US$) 0.10 0.11 0.12 0.13Dividend Yield (%) 2.0 1.5 1.7 1.9

* = Based on consensus methodology e = Morgan Stanley Research estimates

Price Performance

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John Wood Group PLC (Left, British Pounds)Relativ e to FTSE UK ALL-SHARE(GBP) (Right)Relativ e to MSCI World Index /Energy (Right)


Company Description Wood Group (John) plc is an energy services company, providing a range of engineering, production support, maintenance management and industrial gas turbine overhaul and repair services to the oil and gas, and power generation industries worldwide. It operates in three operating divisions: Engineering and Production Facilities, Well Support and Gas Turbine Services.

Oil Services/United Kingdom Industry View: In-Line Valuations are largely back to normalised levels. Although the onshore market outlook remains positive, offshore awards continue to be delayed.

GICS Sector: Energy Strategists' Recommended Weight: 12.3%

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earnings at approximately $0.51±0.03, based on the asset base the company is likely to have in 2012. Capitalising this at Wood Group’s ten-year average PE multiple of 15.7 yields a normalized valuation of 471p (7% upside). However, given Wood Group’s low beta, limited balance sheet gearing and high return on capital (which we think is sustainable), we also believe that a somewhat higher multiple of around 17.6x can be justified from a more theoretical point of view. Incidentally, Wood Group traded on this multiple from late 2005 to late 2008. Capitalising our mid-cycle EPS at 17.6x yields a value of 525p (19% upside) by end 2010.

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Company Analysis

Recently, management has commented positively on the outlook for Engineering, confirming that the anticipated recovery is gaining momentum. In its first-half results statement (published Aug 26, 2010), management indicated that Engineering is “seeing high bidding volumes and increasing backlog”. Since this statement, Wood Group has won key engineering contracts from Chevron for the Jack & St Malo fields in the Gulf of Mexico and from BP for the Andrew Area Development in the North Sea. These contract wins support management’s view on the recovery.

Exhibit 1

Wood Group’s Discount to the Sector Largely Closed after Recent Outperformance

Wood Group: 2-yr forward PE relative to Oil Service Sector*

0.7

0.8

0.9

1.0

1.1

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1.3

Oct-03 Oct-04 Oct-05 Oct-06 Oct-07 Oct-08 Oct-09

The Engineering segment is a key contributor to Wood Group’s earnings (estimated 25-30% of Group EBITA in recent years). Of all divisions, the market appeared most concerned about the recovery in this segment earlier this year. Hence we believe that the increasing clarity about the prospects for this division has been the key driver of Wood Group’s recent outperformance. At the same time, however, we believe that this factor is increasingly recognized and that this catalyst has now played out.

* Peer group based on Saipem, Technip, Petrofac, Amec, Acergy, Subsea 7, SBM Offshore, Tecnicas Reunidas; Source: Company data, Morgan Stanley Research

This means that upside to a ‘normalised’ valuation is currently in the order of 7% – 19%. This compares to ~45% we estimated in our January report. Whilst this analysis shows that Wood Group has the potential to trend higher from current levels, we believe that the shares’ relative outperformance is now largely behind us and that an Overweight rating is no longer justified.

Raising 2011e EPS by 5% but moving to Equal-weight We are making small changes to our 2011 EPS forecast:: increasing our 2011 Engineering EBIT margin from 9.3% to 10.3% after management’s recent comments. We are also raising our 2011 Well Support margin from 11.0% to 11.9%. At the same time, we have lowered our revenue growth for Well Support from 13% in 2011 to 7% as the US rig count may stabilize and there may even be some downside risk. In aggregate, this leads to a 5% increase in our 2011 EPS forecast. Our 2012 forecast is broadly unchanged

Outlook for Engineering recovery increasingly visible The second part of our original thesis was our expectation that Wood Group’s two-year spell of falling earnings would come to an end in 2010 and that earnings would start rising again in 2011, driven by the Engineering division.

Exhibit 2

Recent strong performance leaves little room for upside

BULL CASE 730p: Global economic growth gains momentum, which quickly tightens oil markets. With greater confidence in the oil demand outlook, oil companies kick off a new E&P capex wave.

BASE CASE 470p: 2010 marks the bottom of the cycle for Wood Group. As macroeconomic conditions improve, the market starts to look at 2011 EPS and capitalises those at a PE of 15-15.5, broadly in line with the ten-year average.

BEAR CASE 320p: Weak global economic growth results in depressed oil demand. Excess oil production capacity remains an overhang for both oil prices and E&P capex.

470p (+7%)438p

320p (-27%)

730p (+67%)

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Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11

p


PRICE TARGET METHODOLOGY: We set our price target for Wood Group at £4.70, which is based on a target 2011e PE of 15.3. This is broadly in line with the Company’s 10-year average PE as we expect similar earnings growth over the period 2010-12 (EPS CAGR 23%) as over the last 10 years (EPS CAGR 20% 1999-2009).




UK Economic Forecasts

UK Economic Forecasts, 2009-12e

% Change from Prior Quarter (Unless Otherwise Stated) 2009 2010e 2011e 2012e Year over Year

1Q 2Q 3Q 4Q 1Q 2Qe 3Qe 4Qe 1Qe 2Qe 3Qe 4Qe 1Qe 2Qe 3Qe 4Qe 2009 2010e 2011e 2012e

Real GDP

GDP -2.3 -0.8 -0.3 0.4 0.4 1.2 0.1 0.5 0.2 0.3 0.1 0.5 0.7 0.6 0.5 0.2 -5.0 1.4 1.3 2.0

GDP (%Y) -5.5 -6.0 -5.4 -3.0 -0.3 1.7 2.1 2.2 2.0 1.1 1.1 1.1 1.6 1.9 2.3 2.0

Services -1.4 -0.7 -0.3 0.7 0.3 0.6 0.0 0.3 0.2 0.2 0.0 0.4 0.6 0.5 0.4 0.1 -3.3 1.0 0.8 1.6

Manufacturing -5.6 -0.3 -0.6 1.0 1.5 1.6 0.6 1.1 0.3 0.6 0.3 0.5 0.8 0.9 0.6 0.6 -10.7 3.7 2.6 2.6

Household Consumption -1.2 -0.7 -0.1 0.8 0.0 0.7 0.6 0.2 -0.2 0.1 0.4 0.6 0.4 0.4 1.1 0.1 -3.3 1.2 0.9 2.0

Government Consumption -0.6 0.1 -0.5 0.7 0.7 1.0 -0.6 -0.4 -0.4 -0.6 -0.7 -0.6 -0.6 -0.6 -0.6 -0.6 1.0 1.3 -1.7 -2.4

Fixed Investment -8.4 -5.5 1.5 -2.0 2.9 1.4 -1.5 -0.3 0.0 -0.4 -0.1 0.6 1.5 0.7 0.4 0.5 -15.1 0.8 -0.8 2.7

Imports -7.5 -2.5 1.2 4.5 2.0 2.4 1.1 0.4 -0.1 0.3 0.8 1.2 0.8 0.8 2.0 0.3 -12.3 7.9 2.3 4.1

Exports -8.3 -1.5 0.9 3.7 -0.7 2.3 1.5 2.2 1.5 1.0 0.9 0.8 1.9 1.8 1.8 2.0 -11.1 5.2 6.0 6.1

Contributions to GDP growth

Inventories building 0.1 0.2 -0.2 0.3 0.6 0.4 0.0 0.0 0.0 0.2 0.0 0.3 0.1 0.1 -0.1 -0.3 -1.2 1.1 0.4 0.3

Net exports -0.1 0.3 -0.1 -0.3 -0.7 -0.1 0.1 0.5 0.5 0.2 0.0 -0.1 0.3 0.3 -0.1 0.5 0.7 -0.9 0.9 0.5

Final domestic demand -2.4 -1.3 0.0 0.4 0.6 0.9 0.0 0.0 -0.2 -0.1 0.1 0.4 0.3 0.2 0.6 0.0 -4.5 1.2 0.0 1.2

Other Economic Indicators

Employment -1.6 -0.1 -0.4 0.2

Unemployment (ILO measure, %) 7.1 7.8 7.9 7.8 8.0 7.8 7.9 8.0 8.3 8.5 8.8 8.8 8.9 8.9 8.7 8.8 7.6 7.9 8.6 8.8

Average Earnings 0.1 2.0 2.7 3.2

Real household disposable income 1.0 -0.9 -0.3 0.8

Savings Rate (%) 6.2 4.8 3.9 3.0

CPI (%Y) 3.0 2.1 1.5 2.1 3.3 3.5 3.1 3.0 3.0 2.8 2.9 2.7 2.2 2.1 2.1 2.0 2.2 3.2 2.8 2.1

RPI (%Y) -0.1 -1.3 -1.4 0.6 4.0 5.1 4.7 4.4 4.1 3.5 3.6 3.6 3.2 3.4 3.4 3.5 -0.5 4.5 3.7 3.4

RPIX (%Y) 2.4 1.4 1.3 2.8 4.5 5.2 4.7 4.3 4.1 3.5 3.5 3.4 2.8 2.8 2.8 2.9 2.0 4.7 3.6 2.8

Public sector (Fiscal Year)

Public Sector Net Borrowing (£bn)* 154.7 137.4 121.5 102.7

Net Debt (%GDP)* 53.9 60.7 67.0 71.8

Deficit (%GDP)* 11.0 9.3 7.9 6.3

Exchange Rates

EUR/GBP (period end) 0.93 0.85 0.91 0.89 0.89 0.82 0.85 0.87 0.84 0.82 0.79 0.77 n/a n/a n/a n/a 0.89 0.86 0.82 n/a

GBP/USD (period end) 1.43 1.65 1.60 1.61 1.52 1.50 1.56 1.56 1.57 1.56 1.59 1.61 n/a n/a n/a n/a 1.56 1.54 1.58 n/a

* Public sector net borrowing is PSNB-ex definition. Net debt is ex-financial interventions series. 'Deficit' refers to public sector net borrowing

Interest Rate Outlook (period end, %) BoE Policy Rate 3M Interbank 2-Year Gilt 5-Year Gilt 10-Year Gilt 30 Year Gilt

Current 0.5 0.7 0.6 1.5 2.9 4.0 4Q10 0.50 0.8 1.0 2.1 3.4 4.4 1Q11 0.50 1.0 1.2 2.4 3.6 4.5 2Q11 0.75 1.4 1.7 2.9 3.9 4.6 3Q11 1.25 1.7 2.1 3.2 4.1 4.8 4Q11 1.50 2.0 2.4 3.4 4.2 4.8 1Q12 2.00 2.5 2.6 n/a 4.3 n/a 2Q12 2.25 2.7 2.7 n/a 4.3 n/a 3Q12 2.50 2.8 2.8 n/a 4.3 n/a 4Q12 2.50 2.8 2.8 n/a 4.3 n/a

e = Morgan Stanley Research estimates

Source: Office of National Statistics, WM/Reuters, HM Treasury, Morgan Stanley Research

39



Indices, Sector and Stock Performance

UK Equity Indices Performance Absolute Performance (%)

2 weeks 3 months 12 months

FTSE100 3.2 9.0 11.5 FTSE250 3.2 9.7 16.1 FTSE350 3.2 9.1 12.1 FTSE Small Cap 2.7 11.5 -1.6 FTSE All Share 3.2 9.2 11.9 FTSE350 High Yield 3.8 8.0 4.8 FTSE350 Low Yield 2.6 10.2 18.1

Best-Performing Sectors in the Last Two Weeks Absolute Performance (%)


Ind. Met & Mines 14.5 25.6 88.8 Inds Eng 9.0 22.4 64.2 Auto & Parts 7.5 35.9 44.8 Mining 7.1 22.9 31.2 Financial Svs(4) 6.9 17.4 6.7 General Inds 6.5 19.2 38.5 Eltro/Elec Eq 6.4 28.6 67.5 RE 6.2 14.0 4.8 Forestry & Pap 6.1 32.4 57.9 Gen Retailers 5.5 9.0 4.8 Oil/Eq Svs/Dst 5.1 20.9 42.7 Aero/Defence 4.5 5.6 20.8 Pharm & Bio 4.3 7.3 12.8 Investment Trust 4.2 9.0 14.2 Oil & Gas Prod 3.8 8.8 -1.2 Real Est Inv,Svs 3.8 5.2 -20.0 Gs/Wt/Mul Util 3.5 8.8 24.1

Best-Performing FTSE350 Stocks in the Last Two Weeks Absolute Performance (%)

Price (p) 2 weeks 3 months 12 months

MAN GROUP 269 26 22 -23 EASYJET 455 24 6 15 DUNELM GROUP 460 21 21 48 BODYCOTE 301 21 35 68 HERITAGE OIL 351 17 2 -17 BROWN (N) GROUP 272 17 8 7 FERREXPO 349 15 26 122 SENIOR 147 14 6 140 ANGLO AMERICAN 2,884 14 19 33 ENQUEST 132 13 26 #NA AQUARIUS PLATINUM 390 13 25 30 COMPUTACENTER 332 13 9 1 CHARTER INTL. 779 13 12 13 DAEJAN HOLDINGS 2,749 12 18 -4 BRITISH AIRWAYS 275 12 33 25 IMAGINATION TECHNOLOGIES 429 12 34 122 STHREE 316 12 6 21 KESA ELECTRICALS 165 11 30 7 HALMA 343 11 18 48 BIG YELLOW GROUP 353 11 17 -14

NA = Not applicable, Source: Datastream

Global Equity Indices Performance Absolute Performance (%)


MSCI USA 2.9 7.8 9.9 MSCI Europe 3.0 5.8 5.5 MSCI Europe ex UK 2.8 4.2 3.0 MSCI Japan -2.4 -3.0 -7.9 MSCI Pacific ex Japan 0.8 9.0 3.1 MSCI World 2.2 6.1 5.9 NASDAQ 2.7 8.9 14.1

Worst-Performing Sectors in the Last Two Weeks Absolute Performance (%)


Leisure Gds -11.0 89.3 133.5 Alt. Energy -5.8 -27.7 -62.5 H/C Eq & Svs -2.9 -7.0 2.4 S/W & Comp Svs -2.5 5.2 13.5 Tch H/W & Eq -1.0 18.8 69.0 H/H Gds,Home Con -0.9 4.7 1.8 Personal Goods -0.9 23.3 76.7 Fd Producers -0.9 -2.5 2.8 Fd & Drug Rtl -0.5 7.3 15.1 Fxd Line T/Cm -0.1 -2.2 6.4 Con & Mat 0.1 8.9 -5.2 Life Insurance 0.2 15.6 0.6 Banks 0.3 4.3 0.3 Nonlife Insur 0.9 4.4 13.8 Inds Transpt 1.2 3.9 14.7 Electricity 1.7 3.1 10.4 Media 1.7 7.4 20.7

Worst-Performing FTSE350 Stocks in the Last Two Weeks Absolute Performance (%)

Price (p) 2 weeks 3 months 12 months

AUTONOMY CORP. 1,424 -21 -26 -11 SOCO INTERNATIONAL 347 -20 -18 -3 PETROPAVLOVSK 1,034 -12 -16 -8 XCHANGING 135 -12 -37 -38 HANSEN TNSMS.INTL.(DI) 46 -10 -36 -64 BARRATT DEVELOPMENTS 90 -10 -14 -46 PUNCH TAVERNS 77 -9 8 -34 SPORTINGBET 72 -9 28 -2 TAYLOR WIMPEY 27 -8 -3 -38 CABLE & WIRELESS COMMS. 55 -6 -8 -1 HALFORDS GROUP 419 -6 -19 8 BOVIS HOMES GROUP 363 -5 1 -21 TALKTALK TELECOM GROUP 140 -5 16 #NA OCADO GROUP 127 -5 #NA #NA PERSIMMON 382 -5 -4 -13 ST.JAMES'S PLACE 276 -5 16 0 ARM HOLDINGS 382 -5 24 152 INMARSAT 636 -5 -15 19 SUPERGROUP 1,129 -5 41 #NA JKX OIL & GAS 312 -5 8 5

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UK Industry Valuations and Forecasts

UK Industry Consensus Valuations

Price/Earnings Price/Sales EV/EBITDA Dividend Yield (%)

Updated as of 14-Oct-10 2010 2011 2010 2011 2010 2011 2010 2011 Automobiles & Components 13.0 10.2 0.6 0.5 5.7 4.9 2.5 3.2 Banks 15.1 10.3 - - - - 2.1 2.4 Capital Goods 12.0 11.0 0.7 0.7 6.7 6.2 2.9 3.2 Commercial & Professional Services 16.1 14.2 1.1 1.0 8.7 8.0 2.4 2.6 Consumer Durables & Apparel 20.3 15.0 1.1 1.0 10.6 8.6 1.2 1.6 Consumer Services 13.3 12.2 0.6 0.6 6.9 6.6 2.6 3.1 Diversified Financials 12.8 10.3 - - - - 3.8 4.2 Energy 9.8 8.7 0.7 0.6 4.7 4.2 3.2 4.4 Food & Staples Retailing 13.6 12.2 0.5 0.5 8.0 7.3 3.4 3.7 Food Beverage & Tobacco 14.0 12.8 1.5 1.4 8.3 7.8 3.8 4.1 Health Care Equipment & Services 15.4 14.1 2.1 2.0 8.6 8.0 1.7 1.8 Household & Personal Products 16.3 16.2 2.9 2.8 11.2 10.9 3.1 3.1 Insurance 8.6 8.1 - - - - 4.5 4.9 Materials 11.4 9.1 1.8 1.7 5.9 4.9 1.3 1.7 Media 12.3 11.3 1.1 1.1 2.6 2.3 2.8 3.1 Pharmaceuticals Biotech & Life Sc 10.0 9.9 2.4 2.4 7.0 6.5 4.5 4.7 Real Estate 23.7 21.3 - - - - 3.5 3.6 Retailing 11.6 10.6 0.4 0.4 5.9 5.5 3.2 3.7 Software & Services 15.7 14.3 1.4 1.3 9.9 9.2 1.8 1.9 Technology Hardware & Equipment 16.8 14.7 1.3 1.2 9.8 8.9 2.8 3.0 Telecommunication Services 10.3 9.9 1.5 1.4 6.8 6.8 5.3 5.7 Transportation 14.8 10.4 0.4 0.4 5.3 4.7 2.1 2.3 Utilities 12.5 11.8 1.0 1.0 8.3 7.8 5.3 5.6 UK (MSCI Coverage) 11.9 10.3 1.0 0.9 6.1 5.6 3.1 3.6

Source: FactSet, IBES, Morgan Stanley Research

UK Industry Consensus Growth Forecasts

EPS Growth (%) Sales Growth (%) EBITDA Growth (%) Dividend Growth (%)

Updated as of 14-Oct-10 2010 2011 2010 2011 2010 2011 2010 2011 Automobiles & Components 226.2 27.7 17.9 5.9 63.8 15.6 - 27.8 Banks - 45.5 - - - - 14.0 11.4 Capital Goods 11.2 8.9 3.8 2.8 9.7 7.5 11.1 9.4 Commercial & Professional Services 5.3 13.7 9.0 7.3 8.0 9.3 16.7 11.6 Consumer Durables & Apparel 154.9 35.5 7.6 9.6 33.7 23.7 46.2 36.1 Consumer Services 3.4 8.6 2.6 2.4 6.3 5.6 16.8 15.5 Diversified Financials 23.9 24.4 - - - - -14.9 11.6 Energy 48.6 13.0 24.9 3.4 32.1 10.8 -34.5 37.1 Food & Staples Retailing 10.6 11.8 7.8 7.3 8.2 9.1 9.6 10.6 Food Beverage & Tobacco 10.3 9.8 6.2 5.2 7.3 6.7 10.9 8.2 Health Care Equipment & Services 8.8 8.9 5.7 3.8 8.5 8.1 14.9 7.2 Household & Personal Products 10.8 1.0 7.4 4.6 9.9 2.4 11.0 0.4 Insurance -17.2 6.9 - - - - 12.5 6.8 Materials 93.1 24.9 30.8 10.4 71.7 19.4 149.8 27.0 Media 9.0 9.6 1.9 2.0 186.5 8.9 6.9 8.2 Pharmaceuticals Biotech & Life Sc 1.9 1.4 1.9 -0.6 -5.9 6.6 6.2 5.3 Real Estate 9.1 11.4 - - - - -0.2 3.7 Retailing 8.0 9.9 2.6 3.1 7.1 6.2 12.6 15.6 Software & Services 8.6 9.4 2.8 3.6 4.5 7.6 1.4 6.8 Technology Hardware & Equipment 43.4 14.4 11.5 6.6 26.0 10.4 8.1 5.3 Telecommunication Services -2.5 3.9 -0.5 0.1 -17.5 0.7 5.4 6.8 Transportation 218.6 41.5 2.8 3.5 34.1 12.9 17.8 9.4 Utilities -3.8 6.0 -3.2 3.8 1.2 6.4 5.6 5.6 UK (MSCI Coverage) 53.1 16.1 12.1 4.2 22.5 9.8 0.1 14.3

Source: FactSet, IBES, Morgan Stanley Research

41



Diary of Key Upcoming Events

Monday, 18 Oct to Wednesday, 22 Dec 2010 Date Earnings Release & Trading Statements Economic Data

18 Oct 2010 SABMiller 2Q Trading Statement - 2010/11 Senior Interims - 2010 19 Oct 2010 Whitbread Interims - 2010/11 20 Oct 2010 BHP Billiton plc 1Q Production Report - 2010/11 MPC Minutes - Oct Home Retail Group Interims - 2010/11 Stobart Group Interims - 2010/11 21 Oct 2010 Anglo American 3Q Interims - 2010 Retail Sales, volumes, sa - Sep Autonomy Corporation 3Q Results - 2010 Britvic Trading Statement - 2010 Debenhams Prelims - 2009/10 GlaxoSmithKline 3Q Results - 2010 Henderson Group Interims - 2010 Inchcape Interims - 2010 Manganese Bronze Holdings Interims - 2010 National Express Group Interims - 2010 Petropavlovsk Interims - 2010 Premier Foods Interims - 2010 Smiths News Prelims - 2009/10 22 Oct 2010 British Sky Broadcasting Group 1Q Results - 2010/11 26 Oct 2010 ARM Holdings 3Q Results - 2010 BP 3Q Results - 2010 27 Oct 2010 British American Tobacco 3Q Interims - 2010 Carpetright 1H Trading Statement - 2010/11 CSR 3Q Results - 2010 28 Oct 2010 AstraZeneca 3Q Results - 2010 Axis-Shield 3Q Interims - 2010 Kazakhmys 3Q Production Report - 2010 Pace Interims - 2010 Royal Dutch Shell 3Q Results - 2010 Rugby Estates Interims - 2010/11 William Hill 3Q Interims - 2010 29 Oct 2010 British Airways 2Q Results - 2010/11 GfK Consumer Confidence Survey - Oct F&C Asset Management Interims - 2010 Consumer Credit, sa - Sep Forth Ports Interims - 2010 Mortgage Approvals (for house purchase) - Sep Meggitt Interims - 2010 Shire Group 3Q Results - 2010 01 Nov 2010 G4S Interims - 2010 PMI Manufacturing - Oct Mondi Interims - 2010 Savills Interims - 2010 02 Nov 2010 BG Group 3Q Results - 2010 Cairn Energy Interims - 2010 Imperial Tobacco Group Prelims - 2009/10 Lloyds Banking Group Interims - 2010 St. James's Place 3Q Interims - 2010 03 Nov 2010 Admiral Group 3Q Interims - 2010 BRC Shop Price Index - Oct Antofagasta 3Q Production Report - 2010 PMI Services - Oct Cobham Interims - 2010 Logica plc 3Q Interims - 2010 Next 3Q Interims - 2010/11 Standard Life 3Q Results - 2010 04 Nov 2010 Aviva 3Q Interims - 2010 MPC Decision - Nov Charter International Interims - 2010 Invensys Interims - 2010/11

42



Date Earnings Release & Trading Statements Economic Data Millennium & Copthorne Hotels 3Q Results - 2010 Morrison (Wm) Supermarkets Interims - 2010/11 Old Mutual 3Q Interims - 2010 Rathbone Brothers 3Q Interims - 2010 RSA Insurance Group 3Q Interims - 2010 Synergy Health Interims - 2010/11 Tate & Lyle Interims - 2010/11 Unilever 3Q Results - 2010 05 Nov 2010 British Airways Oct Traffic figures - 2010 Producer Prices - Oct Carphone Warehouse Group Interims - 2010/11 Charles Stanley Group Interims - 2010/11 Grainger Prelims - 2009/10 HSBC Hldgs Interims - 2010 Rentokil Initial 3Q Trading Statement - 2010 Royal Bank Of Scotland Group 3Q Interims - 2010 Smith & Nephew 3Q Results - 2010 06 Nov 2010 Caledonia Investments 3Q Trading Statement - 2010 08 Nov 2010 Dignity Interims - 2010 Hiscox 3Q Interims - 2010 Inmarsat 3Q Results - 2010 Schroders 3Q Interims - 2010 Tomkins Interims - 2010 09 Nov 2010 Associated British Foods Prelims - 2009/10 BRC Retail Sales Monitor - Oct Babcock International Group Interims - 2010 Industrial Production - Sep Barclays 3Q Interims - 2010 Manufacturing Production, sa - Sep Drax Group Interims - 2010 InterContinental Hotels Group 3Q Results - 2010 Legal & General Group 3Q Interims - 2010 Management Consulting Group Interims - 2010 Marks & Spencer Group Interims - 2010/11 Northern Foods Interims - 2010/11 Randgold Resources 3Q Results - 2010 UMECO Interims - 2010/11 Vodafone Group Interims - 2010/11 Yell Group Interims - 2010/11 10 Nov 2010 Ark Therapeutics Group Interims - 2010 Inflation Report - Nov Great Portland Estates Interims - 2010/11 Micro Focus Trading Statement - 2010/11 Novae Group 3Q Interims - 2010 Prudential 3Q Interims - 2010 Sainsbury (J) Interims - 2010/11 Scottish & Southern Energy Interims - 2010/11 11 Nov 2010 Dairy Crest Group Interims - 2010/11 Eurasian Natural Resources Interims - 2010 Euromoney Institutional Investors Prelims - 2009/10 Galiform Interims - 2010 Hikma Pharmaceuticals Interims - 2010 IMI Interims - 2010 International Power Interims - 2010 Resolution Limited Interims - 2010 Trinity Mirror Interims - 2010 Yule Catto & Co Interims - 2010 12 Nov 2010 BT Group 2Q Results - 2010/11 Electrocomponents Interims - 2010 Rolls-Royce 3Q Interims - 2010 Spectris Interims - 2010 Tullett Prebon 3Q Interims - 2010 15 Nov 2010 Amlin Interims - 2010 Beazley Group 3Q Interims - 2010 BTG Interims - 2010/11 Crew Gold 3Q Results - 2010

43



Date Earnings Release & Trading Statements Economic Data Diploma Prelims - 2009/10 e2v technologies Interims - 2009/10 Interserve Interims - 2010 Lonmin Prelims - 2009/10 Workspace Group Interims - 2010/11 16 Nov 2010 Burberry Group Interims - 2010/11 Inflation - Oct Corin Group Interims - 2010 easyJet Prelims - 2009/10 Enterprise Inns Prelims - 2009/10 Menzies (John) Interims - 2010 Oxford Instruments Interims - 2010/11 Persimmon Interims - 2010 Premier Oil Interims - 2010 Rexam Interims - 2010 Robert Wiseman Dairies Interims - 2010/11 Wellstream Holdings 3Q Interims - 2010 17 Nov 2010 Big Yellow Group Interims - 2010/11 Labour Market Statistics - Oct Centrica Interims - 2010 MPC Minutes - Nov Dimension Data Holdings Prelims - 2009/10 Experian Interims - 2010 ICAP Interims - 2010 Mothercare Interims - 2010/11 Serco Group Interims - 2010 Speedy Hire Interims - 2010/11 18 Nov 2010 Avis Europe Interims - 2010 Retail Sales, volumes, sa - Oct Derwent London 3Q Interims - 2010 Halfords Group Interims - 2010/11 Investec Interims - 2010/11 Keller Group Interims - 2010 London Stock Exchange Group Interims - 2010/11 National Grid Interims - 2010/11 QinetiQ Interims - 2010/11 Reed Elsevier Interims - 2010 Ricardo Interims - 2010/11 SABMiller 1H Results - 2010/11 UK Mail Group Interims - 2010/11 19 Nov 2010 Chaucer Holdings Interims - 2010 Chime Communications Interims - 2010 Clarke(T.) Interims - 2010 FirstGroup Interims - 2010 Fuller, Smith & Turner Interims - 2010/11 Gleeson (M J) Group Interims - 2010/11 Johnston Press Interims - 2010 Land Securities Interims - 2010 PayPoint Interims - 2010 Scapa Group Interims - 2010/11 TalkTalk Telecom Group Interims - 2010 Torotrak Interims - 2010 WSP Group 3Q Interims - 2010 22 Nov 2010 MITIE Group Interims - 2010/11 23 Nov 2010 Caledonia Investments Interims - 2010/11 DJ Euro Stoxx50 - Quarterly Index Review Carclo Interims - 2010 Clinton Cards Interims - 2010/11 De La Rue Interims - 2010/11 Hamworthy Interims - 2010/11 Homeserve Interims - 2010/11 Intermediate Capital Group Interims - 2010/11 KCOM Group Interims - 2010/11 RM Prelims - 2009/10 Severn Trent Interims - 2010/11 Signet Jewelers 3Q Results - 2010/11 Telecom Plus Interims - 2010/11

44



Date Earnings Release & Trading Statements Economic Data 24 Nov 2010 Assura Interims - 2010/11 GDP (details) - 3Q BSS Group Interims - 2010/11 Compass Group Prelims - 2009/10 French Connection Interims - 2010/11 Future Prelims - 2009/10 Hampson Industries Interims - 2010/11 Johnson Matthey Interims - 2010/11 United Utilities Group Interims - 2010/11 25 Nov 2010 Antofagasta 3Q Results - 2010 Avon Rubber Prelims - 2009/10 Daily Mail & General Trust (A Shs) Prelims - 2009/10 DSG International Interims - 2010/11 Helical Bar Interims - 2010/11 Sepura Interims - 2010/11 Young and Co's Brewery Interims - 2010/11 26 Nov 2010 Paragon Group of Companies Prelims - 2009/10 GfK Consumer Confidence Survey - Nov Quintain Estates and Development Interims - 2010/11 Vectura Group Interims - 2010 29 Nov 2010 Optos Prelims - 2009/10 Consumer Credit, sa - Oct Mortgage Approvals (for house purchase) - Oct 30 Nov 2010 Aberdeen Asset Management Prelims - 2009/10 Creston Interims - 2010/11 Halma Interims - 2010/11 Mitchells & Butlers Prelims - 2009/10 Northumbrian Water Group Interims - 2010/11 Topps Tiles Prelims - 2009/10 01 Dec 2010 Sage Group Prelims - 2009/10 02 Dec 2010 Britvic Prelims - 2009/10 Kingfisher 3Q Trading Statement - 2010/11 Marston's Prelims - 2009/10 03 Dec 2010 Berkeley Group Interims - 2010/11 British Airways Nov Traffic figures - 2010 Findel Interims - 2010/11 SThree Trading Statement - 2009/10 07 Dec 2010 Caledonia Investments Interims - 2010/11 BRC Retail Sales Monitor - Nov Southern Cross Healthcare Prelims - 2009/10 Industrial Production - Oct Wolseley Interims - 2010/11 Manufacturing Production, sa - Oct 08 Dec 2010 Micro Focus Interims - 2010/11 BRC Shop Price Index - Nov 09 Dec 2010 Ashtead Group 2Q Results - 2010/11 MPC Decision - Dec Premier Farnell 3Q Results - 2010/11 PZ Cussons Trading Statement - 2010/11 Smith (DS) Interims - 2010/11 10 Dec 2010 Consort Medical Interims - 2010/11 Producer Prices - Nov 13 Dec 2010 Spice Interims - 2010/11 14 Dec 2010 Carpetright Interims - 2010/11 Inflation - Nov Domino Printing Sciences Prelims - 2009/10 Drax Group Trading Statement - 2010 Scott Wilson Group Interims - 2010/11 15 Dec 2010 Kesa Electricals Interims - 2010/11 Labour Market Statistics - Nov Senior Trading Statement - 2010 16 Dec 2010 Chrysalis Prelims - 2009/10 Retail Sales, volumes, sa - Nov Sports Direct Interims - 2010/11 Wood Group (John) Trading Statement - 2010

45

46



Date Earnings Release & Trading Statements Economic Data 17 Dec 2010 DTZ Interims - 2010 TUI Travel Prelims - 2009/10 22 Dec 2010 MPC Minutes - Dec **(T) Provisional dates TBC Note: Morgan Stanley cannot guarantee the accuracy of these dates, which may be subject to change. Source: Columba Systems, Morgan Stanley Research

Abbreviations

NM Not meaningful NSA Not seasonally adjusted NA Not applicable YTD Year to date N/AV Not available YOY Year on year FCF Free cash flow A Actual FFO Funds from operations E Morgan Stanley Research Estimates SA Seasonally adjusted unless otherwise indicated



Company and Directors’ Share Buybacks

Companies that have bought back stock in the last two

weeks

Name Number of Shares Amount (£mn)

Experian 995,000 6.77 CSR 50,000 0.18 AstraZeneca 1,376,883 44.93 Vodafone 82,500,000 132.90 Rightmove 50,000 0.37 Regus 1,000,000 0.81 Greggs 550,000 2.54 Total (£mn) 188.5 Note: We only include share buyback programmes for the FTSE350 index; we do not include employee share trust purchases.

Companies whose directors have bought back stock in

the last two weeks

Name Number of Shares Amount (£)

British American Tobacco 21,200 510,617 Catlin Group 15,000 49,350 Close Brothers Group 13,300 98,420 CLS Holdings 12,763 64,791 Inchcape 500,000 1,647,500 ITE Group 7,355 12,859 ROK 410,000 77,375 Smiths Group 3,000 36,570 Sportech 47,140 19,799 Unilever Plc 1,000 18,465 Total (£mn) 2.5 Note: We only include director purchases where the consideration exceeds £10,000 and the company is a constituent of the FTSE All-Share. We do not include the purchase of shares via options, employee share schemes or dividend reinvestments.

These data have been sourced from the LSE and Director Deal. While every effort has been made to validate them, Morgan Stanley cannot guarantee their accuracy or comprehensiveness.

Morgan Stanley & Co. Limited, an affiliate of Morgan Stanley, is acting as financial adviser to Rio Tinto plc and Rio Tinto Limited in relation to the production joint venture with BHP Billiton as announced on 5th June 2009.

In accordance with its general policy, Morgan Stanley currently expresses no rating or price target on Rio Tinto or BHP Billiton. This report and the information herein are not intended to serve as an endorsement or otherwise of the proposed transaction.

This report was prepared solely upon information generally available to the public. No representation is made that it is accurate and complete. This report is not a recommendation or an offer to buy or sell the securities mentioned. Please refer to the notes at the end of this report.

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Coverage Universe Investment Banking Clients (IBC)

Stock Rating Category Count % of Total Count

% of Total IBC

% of Rating Category

Overweight/Buy 1115 42% 394 43% 35%Equal-weight/Hold 1146 43% 413 45% 36%Not-Rated/Hold 14 1% 4 0% 29%Underweight/Sell 381 14% 99 11% 26%Total 2,656 910 Data include common stock and ADRs currently assigned ratings. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan Stanley or an affiliate received investment banking compensation in the last 12 months.

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Stock Coverage List

FTSE100 Companies

Company Analyst Company Analyst

3i Bruce Hamilton (+7597) Kazakhmys Ephrem Ravi (+2127)

Admiral Group Plc Adrienne Lim (+6679) Kingfisher Fred Bjelland (+3612)

African Barrick Gold Plc Hannah Kirby (+6014) Land Securities Bart Gysens (+5862)

Aggreko Plc Jessica Alsford (+8985) Legal and General Jon Hocking (+2307)

AMEC Martijn Rats (+6618) Lloyds Banking Group Steven Hayne (+8332)

Anglo American Plc Ephrem Ravi (+2127) Lonmin Plc Ephrem Ravi (+2127)

Antofagasta Ephrem Ravi (+2127) Man Group Bruce Hamilton (+7597)

ARM Holdings Plc Francois Meunier (+6603) Marks & Spencer Geoff Ruddell (+8954)

Associated British Foods Erik Sjogren (+3935) National Grid plc Bobby Chada (+5238)

AstraZeneca Andrew Baum (+6647) Next Charlie Muir-Sands (+5207)

Autonomy Ashish Sinha (+2363) Old Mutual Jon Hocking (+2307)

Aviva Jon Hocking (+2307) Pearson Patrick Wellington (+8605)

BAE SYSTEMS Rupinder Vig (+2687) Petrofac Martijn Rats (+6618)

Barclays Bank Chris Manners (+3917) Prudential plc Jon Hocking (+2307)

BG Group Theepan Jothilingam (+9761) Reckitt Benckiser Mark A.Christensen (+5392)

BHP Billiton Plc Ephrem Ravi (+2127) Reed Elsevier PLC Patrick Wellington (+8605)

BP plc Theepan Jothilingam (+9761) Resolution Ltd Jon Hocking (+2307)

British American Tobacco Plc Toby McCullagh (+6636) Rio Tinto Plc Ephrem Ravi (+2127)

British Land Bart Gysens (+5862) Rolls-Royce Rupinder Vig (+2687)

BSkyB Patrick Wellington (+8605) Royal Bank of Scotland Chris Manners (+3917)

BT Group plc Nick Delfas (+6611) Royal Dutch Shell Theepan Jothilingam (+9761)

Bunzl plc Jessica Alsford (+8985) RSA Adrienne Lim (+6679)

Burberry Louise Singlehurst (+7239) SABMiller Plc Michael Steib (+5263)

Cairn Energy Theepan Jothilingam (+9761) Sage Ashish Sinha (+2363)

Capita Group Jessica Alsford (+8985) Sainsbury Geoff Ruddell (+8954)

Capital Shopping Centres Bart Gysens (+5862) Schroders Bruce Hamilton (+7597)

Carnival Plc Jamie Rollo (+3281) Scottish & Southern Bobby Chada (+5238)

Centrica Bobby Chada (+5238) Serco Group plc David Hancock (+3752)

Cobham Rupinder Vig (+2687) Severn Trent Bobby Chada (+5238)

Compass Group Jamie Rollo (+3281) Shire PLC Karl Bradshaw (+6573)

Diageo Michael Steib (+5263) Smith & Nephew Michael Jungling (+5975)

Eurasian Natural Resources Cor Ephrem Ravi (+2127) Smiths Group Vidya Adala (+2044)

Experian Jessica Alsford (+8985) Standard Chartered Bank Steven Hayne (+8332)

G4S David Hancock (+3752) Standard Life Jon Hocking (+2307)

GlaxoSmithKline Andrew Baum (+6647) Tesco Geoff Ruddell (+8954)

Hammerson Christopher Fremantle (+5761) TUI Travel Jamie Rollo (+3281)

HSBC Steven Hayne (+8332) Tullow Oil Theepan Jothilingam (+9761)

ICAP Bruce Hamilton (+7597) Unilever PLC Michael Steib (+5263)

Imperial Tobacco Toby McCullagh (+6636) United Utilities Nicholas Ashworth (+7770)

Inmarsat Terence Tsui (+3095) Vedanta Ephrem Ravi (+2127)

InterContinental Hotels Group Jamie Rollo (+3281) Vodafone Group Nick Delfas (+6611)

International Power Bobby Chada (+5238) Whitbread Jamie Rollo (+3281)

Intertek Group plc Jessica Alsford (+8985) Wm Morrison Geoff Ruddell (+8954)

Invensys Ben Uglow (+8750) Wolseley plc Jessica Alsford (+8985)

Investec Plc Magdalena Stoklosa (+3933) WPP Group Plc Edward Hill-Wood (+9224)

Johnson Matthey Paul R.Walsh (+4182) Xstrata PLC Ephrem Ravi (+2127)

To contact the analysts, dial (020) 7425 followed by the four digits that follow their names, or email using the convention [email protected] Note: Morgan Stanley is a corporate broker to the companies highlighted in bold.

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Stock Coverage List

Mid-250/Other Companies Company Analyst Company Analyst Aberdeen Asset Management Bruce Hamilton (+7597) ITV Patrick Wellington (+8605)

Aegis Plc Edward Hill-Wood (+9224) JD Wetherspoon Vaughan Lewis (+3489)

Afren Theepan Jothilingam (+9761) Kesa Electricals Fred Bjelland (+3612)

Amlin PLC Adrienne Lim (+6679) Ladbrokes Vaughan Lewis (+3489)

Aquarius Platinum Limited Ephrem Ravi (+2127) Lancashire Holdings Limited Adrienne Lim (+6679)

Aveva Group Plc Adam Wood (+4450) Logica Patrick Standaert (+9290)

Barratt Developments PLC Michael D.Watts (+7515) London Stock Exchange Bruce Hamilton (+7597)

Berkeley Group Holdings PLC Michael D.Watts (+7515) Michael Page David Hancock (+3752)

Big Yellow Group PLC Bianca Riemer (+2646) Millennium & Copthorne Vaughan Lewis (+3489)

Brit Insurance Holdings NV Adrienne Lim (+6679) Misys Adam Wood (+4450)

Britvic PLC Eveline Varin (+5717) Mitchells & Butlers Jamie Rollo (+3281)

Cable & Wireless Communication Terence Tsui (+3095) National Express Jaime Rowbotham (+5409)

Cable & Wireless Worldwide PLC Nick Delfas (+6611) Northumbrian Water Group Bobby Chada (+5238)

Capital & Counties Bart Gysens (+5862) Ocado Group plc Geoff Ruddell (+8954)

Carillion David Hancock (+3752) PartyGaming Plc Vaughan Lewis (+3489)

Catlin Group Ltd Adrienne Lim (+6679) Pennon Group Nicholas Ashworth (+7770)

Colt Group S.A. Nick Delfas (+6611) Persimmon plc Michael D.Watts (+7515)

Croda Paul R.Walsh (+4182) Phoenix Group Jon Hocking (+2307)

CSR PLC Francois Meunier (+6603) Premier Foods Erik Sjogren (+3935)

Debenhams Charlie Muir-Sands (+5207) Premier Oil Theepan Jothilingam (+9761)

Derwent London Christopher Fremantle (+5761) Punch Taverns Jamie Rollo (+3281)

Dixons Retail Geoff Ruddell (+8954) Rentokil Initial Plc David Hancock (+3752)

DMGT Edward Hill-Wood (+9224) Salamander Energy PLC Theepan Jothilingam (+9761)

Drax Nicholas Ashworth (+7770) SEGRO Bart Gysens (+5862)

easyJet Penelope Butcher (+6698) SOCO International Theepan Jothilingam (+9761)

Enterprise Inns Jamie Rollo (+3281) Stagecoach Jaime Rowbotham (+5409)

Ferrexpo plc Ephrem Ravi (+2127) Synergy Health PLC Andrew Olanow (+4107)

FirstGroup Jaime Rowbotham (+5409) TalkTalk Telecom Group PLC Terence Tsui (+3095)

Gartmore Group Limited Hubert Lam (+3734) Taylor Wimpey Michael D.Watts (+7515)

Genus PLC Peter Verdult (+2244) Thomas Cook Group Jamie Rollo (+3281)

Go-Ahead Jaime Rowbotham (+5409) Travis Perkins Jessica Alsford (+8985)

Great Portland Estates Christopher Fremantle (+5761) Tullett Prebon Chris Manners (+3917)

Halfords Charlie Muir-Sands (+5207) Unite Group Bianca Riemer (+2646)

Hargreaves Lansdown Jon Hocking (+2307) United Business Media Patrick Wellington (+8605)

Hays David Hancock (+3752) Victrex Paul R.Walsh (+4182)

Henderson Group Hubert Lam (+3734) W H Smith Charlie Muir-Sands (+5207)

Hikma Pharmaceuticals Plc Peter Verdult (+2244) Wellstream Holdings PLC Robert Pulleyn (+4388)

Hiscox Ltd Adrienne Lim (+6679) Vaughan Lewis (+3489)

Home Retail Group Geoff Ruddell (+8954) Wood Group Martijn Rats (+6618)

Imagination Technologies Group Francois Meunier (+6603) Yell Edward Hill-Wood (+9224)

Informa Patrick Wellington (+8605) Yule Catto Paul R.Walsh (+4182)

To contact the analysts, dial (020) 7425 followed by the four digits that follow their names, or email using the convention [email protected]. Note: Morgan Stanley is a corporate broker to the companies highlighted in bold.

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