It’s one of those down days and corporate news is quite thin so we’ll start with an overview of the top-down research. If macro and strategy bumf is not your thing please scroll through the next 2,000 or so words, where for convenience the break from macro to micro is marked (as is tradition) with a cat.
RBC Capital Markets’ quarterly “mood of the market” survey finds most US investors think stocks will go down but also up:
The two big things you need to know: First, bearish outlooks on the US equity market are rising, while bullish views are retreating. Second, our survey identified several things behind the increase in bearishness – valuation concerns have risen to a new survey high, most of our participants expect a long, slow economic recovery, and fears of a 2nd wave of the coronavirus are high as are worries about the outcome of the 2020 election in the US. . . .
Those describing themselves as bullish or very bullish declined sharply in our latest survey, from 58% in March to 42% in June. This stands in contrast with our 1Q20 survey, when bulls hit the highest percentage we have seen since we started our poll 10 quarters ago. At the same time, those with a bearish or very bearish stock market outlook moved up for the second survey in a row from 20% in March to 23% in June.
The vast majority expect a stock market correction of 10% or more sometime in 2020: In total 69% expect the stock market to peak (put in a high before embarking on a 10% or more drawdown) either before 2Q20 is up, in 3Q20, or 4Q20. Another 13% think the S&P 500 peaked on June 8th. 3Q20 was the most popular response. The bias towards 3Q is noteworthy, as that will be right before the 2020 election in the US. There’s little agreement on how high the S&P 500 will go before correcting again. When asked about what path the S&P 500 recovery will take, W remained the most popular choice with 45% percent of the vote. Just 30% expect a V shaped recovery in the stock market.
A surge in those who say valuations are a problem, to a new survey high: Those who say valuations are attractive or very attractive plummeted to one of the lowest levels we have seen since we started conducting the survey in 1Q18 (just 13%). By contrast, those who say valuations are expensive or very expensive surged. At 56%, this is the highest percentage of respondents we have seen in the survey who believe valuations are expensive or very expensive. The percentage that see valuations as expensive is higher than what we saw in our 1Q18 and 4Q19 polls, which preceded difficult periods in the stock market.
That kind of stuff perhaps looks overly simplistic, because it is. No one’s going to justify their fee for saying “I reckon the economy’s going to look like a Nike swoosh.” For impenetrable theorising on what’s really (maybe) driving markets they need to channel the quant strategists, such as Nomura’s Masanari Takada:
[I]n the context of a market driven by the pandemic, observers tend to simplistically attribute short-term share price fluctuations in various countries to COVID-19 case numbers or the dynamics of the macroeconomic environment. It looks to us, however, as if these common factors have lost their sway, and that the various stock markets have begun to turn back toward factors specific to those markets. It therefore seems useful for short-term trading strategies to take a look at the various technical issues by region.
European equities: Risk appetites are still gradually recovering in the European equity market. Given the upside scope in macroeconomic indicators, European equity investors look likely to shift toward high beta little by little. At the same time, CTAs have been sporadically expanding their long positions in equity index futures as well. We expect CTAs to continue to chase upside in major European equity futures considering that (1) their long positions remain light at this point and (2) they benefit from tailwinds from higher unrealized gains and lower volatility.
• US equities: The trends of value buying, momentum selling, and low-vol selling that accelerated in European markets yesterday (23 June) ended the day a bit anticlimactically in US markets. Sentiment looks to be at a standstill. Of course, the flow of trend-following speculative investment is still playing its part in the improvement in equity supply and demand dynamics. At the same time, while CTAs’ long positions in UST futures (TY) are declining from their peak, any unwinding is likely to be short lived under current conditions with 10-yr UST yields below 0.84%. Overall, momentum trades for both US equities and US bonds have become a bit sclerotic. Looking at CTAs’ positions in DM bond futures, however, we see that they have begun selling some bond futures, having gone net short on Euro-Bund futures and JGB futures. We think investors should recognize that 10yr UST yields are likely to take on upside pressure heading into summer.
• EM equities: Compared with developed markets (DM), emerging market (EM) stocks continue to lack vigor. In particular, the performance differential between cyclicals and defensives is decoupling as DM equities make a sharp recovery while EM equities continue to lose steam. We think this is attributable to economic surprise index readings that are deteriorating in emerging markets, opposite to the DM situation (especially for the US), and may point to fragility in actual economic conditions weighing on EM stocks. Of course investors do not at this point appear to view the underlying weakness in EM equities as a risk for DM equities. That said, until the EM economic surprise index bottoms out, we think it worth keeping in mind that some cautious investors may temporarily reverse position on EM equities.
Over at Goldman Sachs the quest for pattern finding has all gone a bit John Nash:
Meanwhile, on the increasingly abstract subject of things to buy, Andrew Garthwaite and team at Credit Suisse are pushing global smallcaps. You might think there’s already been a flight to sh██e but no, apparently, not. “In general, small caps are cyclical, benefit from falling spreads, and have not yet reflected the fall in VIX,” CS says. Stocks highlighted on page one are Tradeweb and United Therapeutics in the US, Georg Fischer and Dialog Semiconductor in Europe and Synthomer and Elementis in the UK:
US small caps – raise to overweight: i) The relative performance of small caps is closely following ISM new orders and seems to be currently pricing in no recovery in ISM (a pick up to 50 would imply c17% outperformance). ii) Given their higher leverage, small caps are very sensitive to credit spreads, but US small caps have not yet priced in the recent fall in spreads. iii) Small caps tend to outperform when inflation expectations rise (and we expect inflation to rise to 2.5% over the next 18 months from 1.3% currently) and the 30-5 year yield curve steepens (already at a 3-year high). iv) The P/B relative of small caps relative to large caps is well below its 2009 low and the yield relative is unusually high – P/Es are meaningless in the current environment with loss-making small caps back to peak levels (c33% of the Russell 2000). v) Since 1923, small caps outperformed by 2.3% a year. The biggest five stocks as a percentage of market cap have never been more than 30% of market cap in any major market and are now already 23% in the US. vi) Although small caps are ‘underweight’ tech, they have been able to outperform around 80% of the time when growth outperforms value as long as PMIs are rising.
European small caps – raise to overweight: i) Small caps are cyclical (being overweight industrials) and seem to be pricing in only a 45 on PMI manufacturing new orders (we expect PMIs to rise above 50). ii) Small caps are more domestic and thus tend to outperform when the euro strengthens (we think the euro appreciates towards EURUSD 1.20). iii) Small caps tend to outperform when credit conditions ease – bank lending conditions are expected to loosen sharply and the ECB is buying c70% of outstanding eligible non-financial corporate bonds. iv) Valuations appear reasonable and earnings revisions are much better than those of large caps.
UK small caps – raise to overweight: Small caps tend to outperform when sterling appreciates (we expect GBPUSD 1.29 by year-end). As elsewhere, small caps outperform when spreads fall. The P/E relative is one standard deviation below its norm with earning revisions better than those of large caps. Small caps are once again cyclically outperforming as PMIs rise, with small caps significantly overweight of consumer/industrial cyclicals. Small caps in the UK have outperformed by 3.2% a year since 1950.
So to corporate. First-half results from Crest Nicholson are unexpectedly bad. Headline earnings from the weakest of the UK housebuilders are terrible (revenue down 52 per cent and pre-tax profit down 93 per cent to £5m) but not too surprising in context. Of more importance are the exceptionals, including a £34m portfolio impairment charge that bakes in anticipated price falls of 7.5 per cent for residential and 32 per cent for commercial. Another £9m is written off against a mixed-use scheme in Kent that’s been scrapped because it won’t be profitable.
These are to our knowledge the first Covid-19 writedowns from a UK housebuilder. There’s also a profit warning. Here’s JP Morgan Cazenove:
Summary of H1-2020 Results. The group’s revenues for H1-2020 (ending Apr-2020) came in 52% below last year, due to 35% drop in completions (COVID-19 linked disruption) and mix impact on ASP (positioning towards lower price points). Adj. Operating margin was also significantly impacted and came in at 5% (vs. 14% last year), reflecting lower completions and no land sales this year (£12m last year). In addition, the group has also recorded £51m one-off exceptional charge (largely relating to impairment of inventory).
Revised guidance implies 25% downside to consensus. Management remains cautious on the market outlook but has reinstated 2020 Adj. Pretax profit guidance to be £35-45m (JPMe: £66m, consensus: £53m), implying 25% downside to consensus expectations. The group notes that no further resolutions have been made in respect of dividends in the current financial year.
Liquidity not a major concern, but Balance Sheet relatively stretched. At 30 April 2020 the Group had net debt of £93m (£317m incl. Land Creditors). After fully drawing its £250m RCF, the group’s gross cash position stood at £255m. While the group now has access to £300m CCFF facility providing further liquidity, it currently remains undrawn. On land spend, the group remains disciplined and notes that COVID-19 has prompted it to cancel, renegotiate or defer planned purchases in the period.
Does any of this undermine the central argument for investing in (and/or prosecuting) housebuilders? The one about how they strangle supply, hoard landbank, play the planning approvals process and shovel all the state subsidies they can take through to bonuses and dividends as rapidly as possible? Not really, no. Charts and words via HSBC:
[W]e now estimate 2019 industry output should almost recover by 2022 to -4% versus -10% previously. We expect the buoyant post-lockdown trading to be confirmed next week in trading updates by Barratt and Persimmon.
Although we now forecast a 2% decline in new build house prices in Q4 2020, we observe a raft of supportive factors [low mortgage costs, newbuild out-of-town locations with gardens, etc] and emerging trends to support them and we expect this decline to be fully offset by lower build costs in 2021. We raise our 2022 EBIT forecasts by an average of 13% for the 9 housebuilders in this report, and dividend forecasts for 5 of them to reflect the higher output. Our 2022 EBIT estimates are on average 8% higher than consensus. . . . .
Listed housebuilders’ share of housing transactions is set to soar with the continuing advantage of help-to-buy augmented by the incentives that they can deploy, the advantage of their product in an infection-wary environment and the suitability of their product mostly located on the edges of towns and suburbs of cities to post COVID-19 demand trends. . . .
Housebuilders’ financial positions are much stronger than in the previous recessions as a result of long forward order books built up during lockdown and the much higher returns on invested capital they have earned since 2014. This should enable them to be disciplined on pricing, free of the need to discount to improve financial liquidity as was the case in the two previous recessions.
The key risk to our forecasts and valuations is a harsher recession that could be induced by a second wave of COVID-19 infections. Such a scenario could cause a more significant fall in completions and a steeper drop in house prices that could not be offset by production cost reductions, in our view. This is our bear scenario for a 10% fall in new build house prices (implying a 15% fall in existing) and housing completions in 2022 to be 22% lower than 2019 (versus 3.5% lower in our base case for the industry). Even these scenario valuations are on average almost in line with the current share prices (2% lower).
The main upside risk continues to be an extension of the government Help-to-Buy equity loan programme, beyond the scheduled withdrawal in March 2023. This is the only change in our bull scenario to our base case and would increase most housebuilders’ completions by 15% in the two years to 2024, increasing turn-in-invested capital and ROIC. We project 37-131% upside in our bull valuations.
Everything’s a “buy”:
Elsewhere, Petrofac half-year results are bad. Numis offers a balanced view of it all:
The weak - Petrofac guided to ~$2.0bn of H1 revenues versus our forecast of $2.1bn, so no surprise at that level. However, it also guided to net E&C margins (E&C is ~75% of revenues) of only 2.0-2.25% versus our prior forecast of 4.7% and a ‘normal’ expectation of 5-6%. Approximately 1% of the erosion is due to higher costs of lockdown measures, with the rest of the shortfall due to contract close out negotiations with Aramco over the Jazan project, where clearly negotiations did not go Petrofac’s way in the sub-$30/bbl environment that prevailed at the time. Aramco is reportedly ‘happy’, and we are not surprised! Given that PFC cannot credibly bid in Saudi right now for new E&C work due to SFO-related fallout, the Jazan 1H loss is a bitter pill to swallow.
● The underlying 1% margin suppression is essentially due to the cost of maintaining staff on sites that are locked down, and is expected to be spread over the life of the contracts, i.e. until at least end 2021.
● The good - cost control and cash saving measures have been aggressive and are mitigating the impact of the downturn. The pipeline of potential awards is huge, totaling $48bn over the next 18m (but with no visibility on actual award scheduling yet). The balance sheet is strong (Net debt only $139m) and Petrofac is well-placed to emerge stronger than almost any of the global E&C peers, into what will hopefully be several years of E&C contract awards catch up from 2021 onwards. Renewables work is a valuable growth area for the company, and several more large wind farm related projects are in the bid pipeline.
● Earnings forecast changes - taking into account the 1H margins guidance and a more conservative 2021 revenue growth assumption (we now assume no E&C revenue growth in 2021 versus a +15% prior forecast), our EBITDA forecasts fall by 26%, 23% and 12% for 2020e, 2021e and 2022e.
● Valuation and rating: The long-standing SFO overhang is clearly compounded for the time being by elevated uncertainty over 2020 and 2021 earnings and cash flow generation. However, for longer term value investors the implied 2022e (we think 2020 and 2021 will both be abnormal, CV19-impacted years) PE and EV/EBITDA of 4.8x and 2.1x are compelling, we believe. We think once orderbook momentum turns, then the current ‘normalised’ valuation of PFC will appear unsustainably low, and any sign of an end to the SFO overhang will be a major positive catalyst event, in our opinion. Our DCF-based PT falls by 10% to 318p/sh, leaving an unchanged BUY rating.
‘Spoons is leading the pub operators lower after saying its lending banks have approved a further £48.3m loan through the Coronavirus Large Business Interruption scheme, as previously flagged. It’s also paused pub development projects for the next 12 months and does some unsubtle brand PR, saying that of the 82 per cent of staff who answered a survey 99 per cent intend to come back to work.
Of course, having work to return to by July 4 will require someone making sense of the hospitality industry guidance, which is so impenetrable it could’ve been written by a quant strategist. We should also note that there’s a hashtag. Anyway, the new loan looks fine for the moment based on Stifel’s numbers:
We estimate liquidity headroom of >£200m based on net debt of £836m at 22 March, £141m gross proceeds from fresh equity in April and committed bank facilities of £923m. Cash burn is £3m per month while pubs are closed and £11m per month thereafter.
Downside risks underestimated by the market
COVID-19 has had an unprecedented impact on UK Retail, driving a significant acceleration in the shift to online retail spend and created short-term demand in some categories. However, most importantly we expect it to drive one of the worst economic crises in a generation which will negatively impact consumer spending. We believe the recent rebound in share prices is based on shorter-term impacts (including store re-openings, potential VAT cuts and “revenge spending”), but underestimates lower fundamental demand.
UK Household Available Cashflow points to a delayed recovery
Our updated UK HAC indicates growth of -7.5% in 2020E, +1.4% in 2021E and +5.0% in 2022E, implying a consumer recovery will take until at least 2022E. Given current market expectations for a V-shaped recovery in 2021E, this implies downside risk for consensus earnings forecasts. In addition, any indication of a second wave of the virus, a structural increase in unemployment or a longer lasting impact on consumer confidence could drive further material downside to earnings and valuations.
Proprietary Citi Retail Framework
We have evaluated and ranked our UK retail coverage across 3 structural factors: (1) industry and business attractiveness; (2) online presence; and (3) B/S resilience) overlaid with 3 valuation metrics based on more “normalized” 2022E earnings. This gives our most preferred UK Retailers as ASOS, BOO, PETSP and DC, with our least preferred KGF, NXT and DNLM.
Boohoo and Pets at Home upgraded to Buy
We see potential for companies to outperform with either an online-focused business model (boohoo) or with a differentiated business model in a resilient retail segment (Pets at Home).
Kingfisher, Next and Dunelm downgraded to Sell
We believe Kingfisher and Next are less well structurally placed in the mid-term, with Dunelm’s valuation exceeding its fundamental growth prospects in our view.
We open positive Catalyst Watches for Asos and Kingfisher, given the possibility of strong current trading, and a negative Catalyst Watch for Next.
Infineon’s gone to “overweight” at JP Morgan:
There is mounting evidence of a global auto rebound as the US joins China’s already established V-shaped recovery. While it is possible there will be inventory related glitches ahead we have long held the view that the secular shift to hybrid/EV cars is well established and will likely be further promoted by the European stimulus plans. Hence we upgrade Infineon which we believe is the primary beneficiary of this trend to OW. Based on our outlook of strong ’21 recovery we have a €28, June-‘21 target, assuming EPS of €1.2 valued on an EV/EBIT of 20x in line with previous trends. . . .
Our US autos team believes that after rebounding 47% MoM in May, June could be up by as much as 23% MoM eq. to -10% YoY from the May decline of 27.6% YoY. China had already begun showing a Vshaped recovery from Mar. May sales of passenger vehicles (PV) there were up 9% MoM & for the first time showed YoY growth in 22 months of 7%. Thus in the 2 biggest auto markets, there are signs of V-shaped recovery. Data outside US & China is still not as strong but the two major markets are good enough to make us bullish on auto semis. . . .
Though autos and industrial semis companies have proffered strong guidance in calendar Q2, IHS has indicated that auto production was likely down 50% in the same period. Revenue guide in the period is for a sales decline in autos of 20-25%. This means there will be a continuing perceived overhang in the auto semi market which is why we have been reluctant to add to these shares after the initial rebound. However, even if 2Q/3Q results show a substantial increase in inventory if there is ongoing confirmation of strong end demand as evidence in China and now the US then investors are unlikely to care. The inventory position will be a backward looking and less relevant for a forward looking sector.
If the broader economy recovers, then Infineon is well positioned. Infineon has/will have weaker than normal sales in FY19 & FY20, particularly in auto semis but also in their IPC & PSS businesses. If there is a broad-based semi recovery, we could see auto semis up as much as 20% given the snap back but also due to the shift to hybrid/EV which would be helped by the stimulus programs in place in Europe. Secondly all German automakers will have hybrid/EV versions of their flagship models in high volume production. Based on our recovery scenario on pg 7, Infineon stand-alone sales could be up 16% and Cypress sales up 15%. On the back of this trend, we calculate Infineon can report EPS of as much as €1.2 which, if valued at EV/EBIT of 20x based on previous trends, the stock could trade at as much as €28.
And Lufthansa goes down to “sell” at Goodbody ahead of the June 25 EGM vote on its government bailout, and connected brinkmanship. Whether Germany has the bandwidth to deal with another corporate basket case right now is a fair question, but Goodbody doesn’t think the risk-reward is good enough:
Registration for the EGM currently stands at 38%, which is a concern for management given a two thirds majority is required if registration is below 50%. Given this, recent shareholder resistance has raised the possibility that the vote proposal will not receive the necessary approval.
While insolvency proceedings would not provide any benefits for equity holders, it would force a quicker restructuring of the business, provided there is willing backers to step in. An opportunity to realign Lufthansa’s cost base provides an exciting prospect for the European aviation market, however, something this historic seems unlikely given the German governments involvement to date.
We update our forecasts incorporating changes due to Covid-19 and the proposed support package. Our FY20 revenue and adj. Ebit forecasts are €18.87bn, -51.5% yoy, and -€4.22bn respectively. For FY21, we drop our revenue forecast by 36.8% to €24.98bn with our adj. EBIT now at a -€229m loss. Including the estimated liquidity from the German and Swiss governments, net debt climbs to €8.57bn for FY20. Given the strained returns and earnings profile of the Group, discounting back FY22 earnings results in a NPV of €4.20, a 56% downside to the current share price. As such, we move our recommendation from Hold to a Sell.
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