We continue to like high yield, low valuation and low-beta stocks --Is the recent rally sustainable?

ameinfo.com Monday, May 12 - 2003 at 16:26

US Equities

1Q results of the Standard & Poor’s 500 index have just passed. It was the best profit growth since the 3Q of 2001, an average of 13.2%. But looks can be deceiving.

Over half the growth came from oil companies when crude prices went as high as $40 during the quarter. Excluding the energy sector, the average increase of earnings of the S&P500 was just 6.3%. This figure is even lower than the average profit growth of 7% for the index since the 1950.

With oil prices down to $25 per barrel, the market hardly looks like a bargain at 17x expected 2003 earnings. We believe the fair value for the market is around 15x. Therefore, we advice caution, and use rallies to take profits.

We continue to like high yield, low valuation and low-beta stocks:

• Altria Group Inc. (MO, $31.70, CSFB: Neutral) • Northrop Grumman Corp. (NOC, $88.80, CSFB: Outperform) • Johnson Controls Inc. (JCI, $83.82, CSFB: Not rated)

Continue with our theme play. The Federal Communications Commission (FCC) will vote on what would be the most significant change in the rules governing media ownership. This would expand the reach of the nation’s largest broadcast and newspaper companies. The following are companies that we think would benefit from the up-coming changes:

• Clear Channel Communications (CCU, $39.60, CSFB: Outperform) • Walt Disney (DIS, $18.66, CSFB: Outperform)) • Viacom (VIA/B, $44.57, CSFB: Outperform)

General Motors Corp.’s (GM, $35.97, CSFB: Restricted) assembly plant in Oklahoma City has been shut down temporarily. The plant had been running on two shifts with daily output of 600 units. According to management, the company is currently assessing damages and has not yet determined when the plant would be re-opened. However, with current inventories above normal for vehicles assembled in Oklahoma City, sales should not be affected dramatically in the short-term. However, if the plant remains closed for a longer period, the company would face shortages, which could have a significant impact on an already weak business. It is unclear whether the company’s coverage includes only repair costs of the plant or any portion of the lost profitability on the units of both. Morgan Stanley estimates GM could be losing roughly $3.6mm per day, assuming a variable profit of $6,000 per unit produced at Oklahoma City. Therefore, we would not recommend investing in GM for the moment.

JP Morgan Chase & Co.’s (JPM, $30.08, CSFB: Outperform) commercial credit portfolio has been for several quarters a source of concern. Lately, the company has seen stabilization, and expects cost to be in line with the results reported in 1Q’03 (commercial charge-offs were $292 million, down 33% q-o-q). First, there have not been a lot of new credits deteriorating, and certain industries, such as telecom, are progressing and generating recoveries for lenders. Furthermore, the company has been actively looking to reduce the overall size of the portfolio. In 1Q’03, commercial credit exposure stood at $406 billion (18% non-investment grade), down from $413 million (20% non-investment grade) q-o-q. This is a good step for JPM in order to regain investors’ confidence, however, despite this reduction; JPM still has a significant amount of risk from troubled industries such as telecom ($2.3 billion in criticized exposures), cable ($2.2 billion), and merchant energy ($1.4 billion, source: Putnam Lowell NBF). For investors having bought JPM stocks at lower prices, we recommend taking profit, because we believe stock price would remain under pressure in the short-term, due to profit taking on U.S. equities. The theoretical price, given by the Dividend Discount Model is $29.40 (source: Bloomberg).

Our recommended oil service Schlumberger Ltd. (SLB, $44.98 CSFB: Neutral) and Noble Corp. (NE, $33.81 CSFB: Neutral) saw a nice rally during last week, as the inventory build up was lower than the market had expected at the beginning of the month. Instead of the expected increase of 3 million barrels, the API reported an increase in inventories of 1.2 million barrels of crude oil.

But the rise in the share prices was also helped by a steady increase in exploration activity. The rig count has been increasing since the beginning of the year, driven by the strong crude oil prices, but during the last couple of weeks the increase seems to have accelerated, mainly thanks to growth in offshore and especially in natural gas exploration activity. The growth in end demand for natural gas in the US is expected to continue its rising trend over the next couple of years. Globally demand for natural gas could be growing by 12% per annum through 2007, driving the exploration activity in this area and thus creating new opportunities for companies such as Noble Corp and Schlumberger.

Exxon Mobil Corp. (XOM, $35.47 CSFB: Neutral) has a strong position in natural gas production in the US, where demand is growing rapidly, and therefore should be benefit from this trend. However, in the very short term we expect to see some profit taking activity, mainly in Schlumberger, whose share price has risen over 18% over the last four weeks and is starting to look toppish on a technical perspective. We therefore advise trading oriented investors to consider locking in some of their short-term gains in the stock.

European Equities

• The DJ EUR Stoxx 50 closed the week slightly lower at 2314.10 • The ECB decided to leave rates unchanged • Societe Generale – took profit, 15.8% (20% including dividends) since mid February 2003

After a 25% gain since mid March a justified question to ask is if this rebound is sustainable. Given the weak economic environment with growth estimates revised downwards, unemployment rising and consumer confidence although rebounding, but still below the pre-war level, we believe what is needed now is an improvement in economic data before we can call this rally sustainable. In addition, a risk to European earnings remains the strong Euro which approached 1.15 USD last week and today trades even higher on the back of the European Central Bank’s (ECB) decision to keep rates unchanged. Although it was widely expected that the ECB would not be proactive enough, the overall package was not disappointing. The Council evaluated its strategy and confirmed the definition of price stability (defined as a yoy increase in the Harmonised Index of Consumer Prices (HICP) for the Euro area), but did say that instead of targeting inflation between 0 and 2% they ‘aim to maintain inflation rates close to 2% (but below 2%) over the medium term’. The previously defined price stability left room for misinterpretation and with this clarification the ECB signalled that a rate just below the 2% would be acceptable. Another interesting point was the comment that the current level of the Euro reflects fair value and is in line with fundamentals.

During the recent reporting season, most of the companies met expectations, but this was often the result of intense cost cutting. Although the recent cost-cutting exercise was necessary, painful as it was, it would not lead to a sustainable upswing. What it can do is to limit the downside. Therefore, given the current economic environment we believe we need to see a correction and would advise investors to be nimble and to take profit whenever possible.

Hence we decided to take profit on Societe Generale (GLE FP; EUR 55.35). On the back of BNP Paribas’ good earnings results the stock reached our target price of EUR 58 and although we continue to like the company from a fundamental point of view, we would prefer to protect our profits of 15.8% (20% including dividends) since mid February 2003, and have decided to take the stock off our recommendation list. We will wait for lower levels to re-enter.

BNP Paribas (BNP FP; EUR 41.55) reported net income of EUR 962m, which was well ahead of analysts’ expectations. The main difference came from stronger than expected performance from trading income in the wholesale and investment banking business. As we have seen from many US banks the fixed income divisions did very well, but in addition BNP referred to equity derivatives to explain the surge in income.

Despite the difficult environment, a sharp decline in the Dollar and a challenging comparison to strong 1Q02, BNP managed to post a net banking income of EUR 4513mn, which represents an increase of 2.1% compared to 1Q02 and is the group’s highest quarterly net banking income since its inception.

On the provisioning front, group provisions came in at EUR 339m, which includes a provision of EUR 85m to the general reserve in the US. Credit quality did not deteriorate. Cost income ratio stands at 63.3% and annualised return on equity was 14.4%.

We believe this was a sound set of result, which confirms our buy rating.

Further earnings report came from our two preferred energy stocks TotalFina (FP FP; EUR 125.5) and ENI (ENI IM; EUR 13.284). Total, which changed its name from TotalFina, reported a 49% increase in net income to EUR 2.12bn for the 1Q, coming in at the top end of analysts’ forecasts. EPS excluding non-recurring items rose by 55% to EUR 3.28. The favourable oil market environment, higher oil prices and a rebound in European refining margins more than offset the impact of an 18% decline in the US Dollar against the Euro and the continued weakness in Chemicals.

The upstream division achieved its target return of a 5% growth in hydrocarbon production and at the same time the group was able to report a 17% return on average capital employed over the last 12 months. Investors were concerned that the company may not be able to achieve its 2005 target ROACE of 15.5%. However, an output growth of 5% provides 35% of the profit improvement required and is backed by a diverse project portfolio, good reserve replacement rate and a strong track record both on volume and costs.

These figures confirm our belief in the company, which among the supermajors shows one of the highest production growths.

Please recall that CSFB recently upgraded the stock to an outperform as they believe that the current share price assumes no further improvement in underlying returns by 2005 which is much too pessimistic.

Eni’s figure came also in at the top end of the range and overall 41% higher compared to 1Q last year. Net income was EUR 1.9bn and EPS EUR 0.50. Whereas production growth was on the lighter side with 4% yoy due to outage during the strike in Venezuela, strong Gas & Power division mainly drove the outperformance. The rolling return on average capital employed at 22% is higher than the average of the Big Five Majors.

We believe Eni is an interesting play on the energy sector and in addition comes with an attractive dividend yield of 5.65% which, given the high cash generation and strong balance sheet, looks sustainable.

With Credit Suisse, Private Banking Monday, May 12 - 2003 at 16:26 UAE local time (GMT+4)

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This Article was updated on Monday, May 19 - 2003