Presenting Morgan Stanley's Hate List (European Edition)
Now that American equity markets are controlled by Atari and Commodore, which in turn means stocks go up or down purely based on nanosecond colo lag variations, investors who wish to invest in stocks based on this crazy thing called fundamentals are forced to look elsewhere. One such place could be Europe, and now that the Baltic states, Greece, Portugal, Spain, Iceland and Ireland are literally living on an IMF's prayer, the first market which will take a big leg down will in all likelihood be Europe. Starting with that bearish assumption, we present several ideas out of Morgan Stanley's "Sellers' Compendium February 2010" by Ronan Carr. As the title of the report indicates, Europe bulls may want to skip this post. For everyone else, let's dig in.
In analyzing his universe of potential short candidates, Carr presents four primary axes:
- Weak Fundamentals
- Bullish Sentiment
- As Good As It Gets
- Financial Health/Balance Sheet Focused|
Starting with the first category, Carr first presents companies that screen well for High EV/EBITDA and low ROCE.
Next, MS presents a reverse Ben Graham screen: weak earnings track record; P/3-year average EPS is 20% premium to market; and expensive valuations P/ExP/BV is 20% premium to market.
Next, Carr focuses on the 3 O's - Overloved, overowned and overvalued. For a US comparison, we recommend a quick perusal of any Jim Cramer book for the appropriate list.
Next up: hype stocks:
Morgan Stanley then highlights the "expensive outperformers" - those stocks which have a stretched valuation or a MS rating of hold (gee, thought you were supposed to hold on a "hold") or sell.
Another screen looks for anti-LBO companies: high EV/EBITDA, lew FCF/EV, low interest coverage, high net debt/equity, low cash/assets.
Last, Carr highlights the stocks that have a low Piotroski score.
In summary Morgan Stanley highlights the most susceptible stocks to shorting as follows:
Stocks appearing on more than one screen. There are 65 Multiple Appearances – stocks that appear on at least two
screens (see page 7). Of these, Morgan Stanley has an Underweight rating on Acerinox, Bayer, Brisa, Commerzbank,
Daimler, Enterprise Inns, Kemira, Lonmin, Michelin, Prudential, Renault, Renewable Energy Corp, SEB, SSAB, Thyssen
Krupp, Volvo and William Demant. 13 stocks appear on 3 screens .
- Our selection of sell ideas. In addition to the quantitative screens we recommend six fundamental sell ideas – stocks that we expect to underperform MSCI Europe. We choose these ideas based on our assessment of the key potential drivers of underperformance in the current environment combined with some of our analysts’ best ideas. We suggest new sell ideas in Adecco, Home Retail Group and Verbund. We continue to recommend BME and Ericsson as potential underperformers. We remove ENEL, Enterprise Inns, Millennium & Copthorne and United Utilities as sell ideas. Several themes unite the picks.
- cash flow or balance sheet concerns (Ericsson, Verbund)
- negative earnings momentum despite the macro recovery underway (Adecco, Ericsson, Verbund)
- structural pressures on growth or margins (BME, Ericsson, Home Retail Group)
And here is the focus sell list based on fundamental criteria. One caveat here is that one never knows whether the tentacles of the HiFTopus have stretched all the way to Europe. In such a case, fundamental analysis is completely irrelevant until it is relevant, by which point however the hurt from the correct exposure will likely have been too high.
- Adecco. David Hancock rates Adecco Underweight and it is the team’s least preferred stock within the business services sector. Although an economic recovery should be a benefit, he expects profit recovery to be weaker than at other staffing companies. This is primarily due to Adecco's far greater exposure to (i) the counter-cyclical outplacement business (26% of 2009e EBITA), where profits fell at a -50% CAGR in 2002-05, and (ii) Japan (23% of 2009e EBITA), where our economists forecast only 0.4% GDP growth for 2010. David’s 2010 EPS forecast is 13% below Bloomberg consensus. The integration of Spring and MPS is likely to bring additional challenges in the year ahead. Together they represent around 40% of Adecco’s US revenue and 60% of the UK revenue. Maintaining market share during integration could be a challenge, especially as Adecco has historically underperformed Randstad on revenue growth. Valuation is expensive at 37.8x 2010 and 24.4x 2011 on David’s forecasts, well ahead of staffing peers Randstad and Hays.
- Bolsas y Mercados Espanoles. We continue to recommend BME as a sell idea (rated Underweight by Chris Manners). He expects competition from low-cost platforms in equity trading from Jan-2011e triggered by rule changes at IBERCLEAR. His 2011e EPS is 8% below consensus, which he believes does not capture likely market share losses in Spanish equity trading. The rule changes at IBERCLEAR will likely allow banks to trade Spanish equities without going through SIBE (the BME trading platform) and paying fees, using low-cost Multilateral Trading Facilities (MTFs) instead. BME charges ~1.4bps on value traded vs. MTFs at 0.1bps. Chris calculates that equity trading revenues will fall 40% from 2008-12e through lost share and price cuts. We note that MTFs have captured up to ~40% share in FTSE 100 trading from LSE. BME trading at 12.4x 2011e PE remains unattractively valued given Chris anticipates falling earnings into 2012 and it is at a premium versus peers (Deutsche Borse and LSE trade at 9.0x and 10.6 respectively). Chris has 14% downside to his price target (which assumes 25% market share loss and cumulative 32% price cuts from 2008-2012). He sees 49% downside to his bear case (assuming 65% share loss and 42% price cuts). Recent proposals to ban proprietary trading at banks represents another risk (our analysts estimate prop could account for ~10% of volumes in the market). Valuation methodology and risks: Chris derives his price target of €17.8 for BME using a base case valuation of 12x calendar 2012e EPS of €1.59 discounted back at a 10% cost of equity. The valuation is based on comparable multiples analysis versus the peer group and BME’s own history. This implies a 12-month fair value of €17.8, or 14% downside from the current price. Risks include regulations, exchange rate, markets and competitor action.
- Ericsson. We continue to recommend Ericsson as a sell idea (rated Underweight by Patrick Standaert). Patrick thinks that trading at 14x 2010e EPS (excl JV and restructuring), the stock price does not take into consideration that: i) 1H10 demand should continue to fall requiring further “one-offs”; ii) price and margin pressure should remain intense with all players looking to outgrow the market; and iii) inventory levels leave limited room for further working capital improvements. Earnings excluding JVs and restructurings are likely to be flat in 2010 as telco capex could decline another 6% in 2010 and the services margins could come under pressure with an increased proportion of revenue coming from lower margin managed service deals. Restructurings appear likely to stay: Patrick’s analysis shows Ericsson has booked SEK5bn of “one-off” cash restructurings per annum on average since 2000 (c.2.5% of total sales). In his view, these are too recurrent to be excluded. SEMC’s weak positioning in the handset market looks unlikely to change soon, Patrick believes.
- Home Retail Group. We are cautious on the UK retail sector from a top-down perspective. Reasons include: 1) the group is overowned, 2) it tends to underperform in the policy tightening phase and 3) when lead indicators peak (soon), 4) a likely sharp rise in non-discretionary inflation over the next few months and 5) significantly slower EPS growth than the market in 2010. Geoff Ruddell is also cautious on the outlook for the sector given an increasingly challenging sourcing backdrop and ongoing industry overcapacity problems. A rally in the US dollar is a particular risk this year. He rates Home Underweight seeing it as a key sell idea on these themes. In addition to the cyclical headwinds, he believes there are significant structural challenges. Argos is facing increasing competition from supermarkets and has limited scope to grow. He argues Homebase is under-invested and comparatively weak against a resurgent B&Q in an over-spaced UK DIY market. Geoff thinks valuation multiples (although not excessive) are likely to derate further given the challenges. Geoff’s 2011e PE is 10.1x.
- Verbund. Morgan Stanley’s utilities team sees continued downward pressure on European power and gas prices due to overcapacity, leading to around 10% downside risk to 2011/12 consensus earnings estimates. Sean Lee rates Verbund Underweight and sees it as a key sell idea on the back of this theme. Forward German market prices, which drive Austrian prices, are in steep contango. Sean argues that recent data suggest demand will disappoint, and continued capacity expansion and a gas market in oversupply will put pressure on power prices, unwinding the contango (which has already started to happen recently). Verbund is particularly exposed, with hydro power plants accounting for c.83% of EBITDA and it is also the generator with the lowest level of forward hedging, at only 44% in 2010 and none in 2011. High gearing exacerbates the effect of falling power prices and the company’s low hedging position. Net economic debt to EBITDA is approaching uncomfortable territory at 4.1x in 2010 (3.6x for financial net debt to EBITDA) on Sean’s estimates (where they could have to take action if they want to be sure to keep their A rating). Valuation is expensive (using Sean’s estimates for 2010) at 17.1x PE, 3.5% DY and 10.2x EV/EBITDA, at a big premium to the market and sector.
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