US stimulus package implications

ameinfo.com Tuesday, May 27 - 2003 at 09:27

With US economic stimulus plan passed, we reiterate our preference for the pharmaceuticals and energy sectors. Our crude oil price assumptions are towards an average of USD28.50 for this year. And we have added two stocks to our recommendation list that benefit from the weak US dollar.

US equities

Congress on Friday finally passed the hotly debated economic stimulus package worth US$350bn. The centrepiece of the bill is the cut in capital gains and dividend tax to 5% and 15% from the current top rates of 38.6% and 20% for capital gains.

The bill dovetails neatly with our thematic play on stocks offering high and safe dividend yields. Our current dividend plays are Altria (MO, $42.31, CSFB: Outperform) and Carolina Group (CG, $23.66, CSFB: Not Rated). However, it is our belief that the Bill would not necessarily radically change the dividend policy of US corporations as the dividend tax cut only last through to 2009.

Insurance stocks had a pretty rough week, falling 2.96% on average vs. the S&P 500’s 1.17% decline. According to a recent report by the Insurance Services Office (ISO), property/casualty insurers are expected to pay out approximately $1.55 billion in insured losses from the severe thunderstorms and tornadoes that struck 18 states from May 2 through May 11. ISO’s Property Claims Services unit estimates that insurers will receive more than 429,000 claims from these storms.

For example, Travellers Property Casualty Corp. (TAP/A, $16.21, CSFB: Outperform) sees storm loss damages of $78 million in 2Q’03, or about $0.08 per share. All told, estimated insured losses place the storm system as the third worst windstorm event in U.S. history, behind a $2.2 billion catastrophe loss in April 2001, and a $1.7 billion catastrophe loss in April 2002. For the short-term, we remain cautious on property/casualty insurers.

Life insurers could face a negative impact from the new dividend tax policy. It appears as if dividends received in variable annuity sub-accounts will not receive the same treatment. Given the fact that variable annuities require a long holding period (roughly 12 years) for their tax advantages to overcome higher fees compared to taxable mutual funds, the new policy would erode the tax advantages that annuities have over taxable mutual funds and cause the holding period to extend to about 15 years (source: JP Morgan).

However, we do not believe this would have a significant negative impact on life insurers’ stock prices. Therefore we maintain our Buy rating on Aflac Inc. (AFL, $32.67, CSFB: Not rated). The company sells complementary insurance, helping to fill gaps in consumer’s primary insurance coverage.

Pfizer has partially recovered from the sell-off after the US Supreme Court decision that the US state of Maine can implement a program to force drug makers to extend discounts to uninsured residents from current 10% to 25%. In Maine around 325,000 people could benefit from such discounts.

The market feared that worse might happen and that this could be a precedent for other states to join in which would hurt the drug industry’s revenues.

But as further legal hurdles could prevent the implementation of this program, the worst-case scenario that the market feared, appears not to be likely at this stage. The program has still to be validated by the District Court and needs approval from the Health Secretary, which means that at this point the US Department of state determines the extent to which states are allowed to give discounts on prescription drugs.

A certain implication will be a rise in tone in the discussion about the drug price inflation and the pharmaceutical industry will be under increased pressure to contribute their part to contain the rise in prescription drug prices. This is an issue that has been on the table for years and still it seems far from conclusion, as the pharmaceutical industry has plenty of clout.

In the meantime the weakness in the share price has offered a good buying opportunity for Pfizer Inc. (PFE, $31.88, CSFB: Outperform), which with its strong growth perspectives for the next two years at least and a forecasted earnings growth of 15-18% per annum, remains a top pick in the industry.

Given the uncertainties surrounding the implementation of the Maine drug program, we estimate our valuation model for Pfizer still to be accurate and also maintain our Buy recommendation and 12-months price target of USD 37.

Our newly recommended integrated oil stock ConocoPhillips (COP, $53.16, CSFB: Outperform) had a strong week, as crude oil prices stabilized at levels above $29 per barrel West Texas Intermediate. Exxon Mobil Corp. (XOM, $35.98, CSFB: Neutral) also saw a positive share price movement. We could see prices for both stocks moving up even further, if crude oil prices stay at these levels, as analysts might have to adjust their earnings models upwards, in order to take into account higher crude oil prices.

So far our crude oil price assumptions are towards an average price of $28.50 per barrel West Texas Intermediate (WTI) for this year. But it could prove too conservative, in so far as during this year the price for the WTI has mostly traded above $28.50, peaking at $37.83 in March.

We feel comfortable with our oil price assumptions and our forecasts for ConocoPhillips and Exxon Mobil. As we had reported earlier, the supply/demand situation could tighten, if disruptions from Nigeria, Venezuela and Iraq persist into the third and fourth quarter of the year, when demand increases due to the winter season in the Northern Hemisphere.

The sector continues to have solid medium- to long-term outlook, which also explains why the two stocks have been resilient to crude oil price volatility. We therefore reiterate our buy recommendation on ConocoPhillips and Exxon Mobil.

Altria Group (MO, $41.05 CSFB: Outperform) is up nearly 18% over the past two days. Two days ago Florida's 3rd District Court of Appeals threw out a $145bn dollar punitive awards damage against the US Tobacco industry.

There are FOUR KEY IMPLICATIONS to this verdict for Altria

• The Company's and the only potential bankrupting legal threat is dead in the water • We believe the verdict should accelerate credit rating agency action with a bias to upgrade. • Altria should regain access to $1.2bn dollars it had placed in an escrow account as a bonding requirement for the duration of the appeal • The ruling should be favourable in terms of other litigation with respect to class certification

We are maintaining our target price of $46 AND raising our stop loss to $35 from 31.

European equities

• The DJ EUR Stoxx 50 closed the week 4% lower at 2246.58 • Koninklijke KPN and Adidas-Salomon added to the recommendation list. The common theme being their relative low exposure to the weakening USD.

Given the continued weak economic environment and the strengthening Euro which hit a high of 1.1832USD on Friday for the first time since the launch of the single European currency in January 1999, we are looking for companies with further cost cutting potential and with less exposure to a depreciating US Dollar.

We added two new stocks to our recommendation list: the telecom operator Koninklijke KPN (KPN NA; EUR 5.76) and Adidas-Salomon (ADS GY; EUR 74.20). The common theme for both of them is their relative low exposure to the weakening USD.

The focus of the telecom sector as a whole is more on Europe itself and therefore makes it less sensitive to EUR strengthening. In addition, KPN underperformed in the current rally as all eyes in the telecom sector were on Deutsche Telecom (DTE GR; EUR 12.12) and France Telecom (FTE FP; EUR 19.98).

We believe going forward this gap should narrow as KPN’s management is very committed to further cost cutting and their efficient operating structure should enable them to improve their competitive position. Their strategy is to focus on free cash flow and in fact KPN has one of the highest free cash flow yield in the sector. As the end demand remains weak, an investment in KPN has to be seen as a cost-cutting and restructuring story. We assigned a target price of EUR 6.50 and a stop-loss level of EUR 5.30.

Adidas has a net USD exposure of over USD 1bn (substantial part of production is outsourced to Asia denominated in USD and major part of sales is in Europe), which makes it actually a beneficiary of a depreciating USD. A

According to a study by Deutsche Bank, a 10% depreciation of the US Dollar would have a positive 20% effect on Adidas’ EBIT. Adidas has a strong brand, diversified product portfolio, low beta to the DAX and is attractively valued compared to its peers (in the last 5 years Adidas traded on a PER of 17.2x, PER for 03 stands at 13.11x; current discount to Nike 23%, which is in line with its 5-year average); current premium to Reebook 4.5% (less than its 5-year average of a 26% premium). In addition, Adidas manages to keep its margins rising on the back of an improving product mix and selective price increases. We assigned a target price of EUR 85 and a stop loss level of EUR 70.

As there are few companies, which actually benefit by a depreciating US Dollar it is also worth mentioning Arcelor (LOR FP; EUR 9.03). The positive impact of a 10% weaker US Dollar on Arcelor’s EBIT is estimated to be 10.8%. Arcelor remains a cost cutting and restructuring story as well. Created by a merger only a little over a year ago, the cost cutting achieved so far is impressive.

Besides this ‘currency theme’ we would continue to focus on defensives such as pharmaceuticals. Our favourites remain Sanofi-Synthelabo (SAN FP; EUR 51.40), Aventis (AVE FP; EUR 44.5) and Roche (ROG VX; CHF 97.7). Roche showed a particularly strong performance during the last week increasing by over 12%.

Several developments such as the successful US launch of the hepatitis C drug Pegasys, the FDA approval of the HIV drug Fuzeon, a positive FDA advisory committee vote for the anti- allergy antibody Xolair, and the announcement earlier in the week of the Phase III success of Avastin in colorectal cancer. This should lead to better visibility as the stock enjoys EPS and rating upgrades by several brokers.

Furthermore, we would continue to focus on the energy sector. According to a study by Deutsche Bank the sector with the most positive earnings revision ratio is clearly energy with upgrades for 66% of the companies.

In fact, the 2003E index earnings were upgraded by 3.2% over the last month. Other sectors with upgrades in their 2003E earnings include food & beverages, financial services and telecoms. Our favourite plays in the energy sector remain Total (FP FP; EUR 121.70) and ENI (ENI IM; EUR 13.524).