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2013 Preview
12 December 2012
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Dear Investor, While 2012 comes to a close amid continued uncertainty, the U.S. equity market looks to end the year more than 12% higher than at its start. Some of the gains posted early in the year were pared in the second quarter as economic momentum slowed and macro overhangs loomed. However, the S&P 500 advanced steadily from June through October leading up to the presidential election, after which investor focus shifted to the likelihood of a compromise in Washington. Optimistic expectations at the beginning of the year have given way to the realization that the U.S. recovery is more likely to be a marathon than a sprint, and fiscal challenges present a major hurdle along the way. We anticipate that some, but far from all, of the austerity implied by the fiscal cliff will be realized next year and expect the expansion to soldier on, in spite of the fiscal policy headwinds, with housing carrying the baton. Our economists expect inflation could move even lower and look for supportive monetary policy to offset some of the drag from fiscal actions. Following solid performance this year, we remain constructive on U.S. equities. Tom Lee, J.P. Morgans Chief U.S. Equity Strategist, expects the secular bull market to continue for a fifth year and has established a year-end 2013 target for the S&P 500 of 1580, which would represent a new all-time high. He anticipates stronger performance in the second half after a tricky first half, as policy clarity and acceleration in durable goods spending should lead to multiple expansion. We designed this report as a sector-by-sector guide to equity investing in the United States for the upcoming year. We asked our analyst teams to identify key drivers of sector stock prices and to present their best investment ideas, framed by commentary from our economists, strategists, as well as derivatives and accounting experts. One of the most common themes was the need for investors to be selective, given uncertainties related to fiscal policy and notable risks to both upside and downside. Against this backdrop, we highlight 73 best ideas. As always, we aim to provide analysis that proves helpful in your investment decisionmaking process and hope you find this report useful.
J.P. Morgan Securities LLC Equity Research 383 Madison Avenue, New York, NY 10179
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Table of Contents
Macro Portfolio Strategy ............................................................................. 7 Accounting & Tax Policy................................................................. 42 Economics..................................................................................... 45 Equity Derivatives .......................................................................... 49 Equity Derivatives & Quantitative Strategy ...................................... 58 Equity Quantitative Strategy ........................................................... 63 Capital Goods/Industrials Aerospace & Defense .................................................................... 65 Boeing Company (BA) Airfreight & Surface Transportation................................................. 66 Canadian Pacific Railway (CP) Electrical Equipment & Multi-Industry.............................................. 67 Danaher (DHR) Engineering & Construction............................................................ 68 Quanta Services, Inc. (PWR) Environmental Services.................................................................. 69 Waste Connections (WCN) Machinery...................................................................................... 70 Eaton Corp. (ETN) Marine Transportation.................................................................... 71 Teekay Offshore Partners (TOO) Consumer Airlines .......................................................................................... 73 Delta Air Lines, Inc. (DAL) Autos & Auto Parts......................................................................... 74 Harman International (HAR) Beverages ..................................................................................... 75 PepsiCo (PEP) Food Manufacturing ....................................................................... 76 Hershey (HSY) Food Retail .................................................................................... 77 Whole Foods Market (WFM) Gaming.......................................................................................... 78 Las Vegas Sands Corp. (LVS) Homebuilding & Building Products.................................................. 79 PulteGroup, Inc. (PHM), KB Home (KBH) Household & Personal Care Products............................................. 80 Newell Rubbermaid Inc. (NWL) Leisure .......................................................................................... 81 Harley-Davidson (HOG) Consumer (cond) Lodging.......................................................................................... 82 Wyndham Worldwide (WYN) Restaurants Casual Dining .......................................................... 83 Brinker International (EAT), DineEquity Inc. (DIN), Texas Roadhouse (TXRH) Restaurants QSR ........................................................................ 84 Starbucks (SBUX), McDonalds (MCD) Retailing Broadlines, Apparel & Footwear .................................... 85 Macys (M) Retailing Hardlines/Discounters ................................................... 86 Target (TGT) Retailing Specialty....................................................................... 87 Urban Outfitters (URBN) Tobacco......................................................................................... 88 Reynolds American (RAI) Energy Electric Utilities............................................................................... 89 Duke Energy Corp. (DUK) Energy MLPs ................................................................................. 90 Oneok Inc (OKE), EQT Midstream Partners (EQM) Independing Refiners ..................................................................... 91 Phillips 66 (PSX) Integrated Oils and Major Producers............................................... 92 Suncor Energy (SU.TO) Oil & Gas Exploration & Production................................................. 93 Denbury Resources (DNR) Oilfield Services & Equipment......................................................... 94 Schlumberger (SLB) Financials Asset Managers, Brokers and Exchanges....................................... 95 Invesco Ltd. (IVZ) Banks Large Cap......................................................................... 96 Bank of America (BAC) Banks Mid- and Small Cap .......................................................... 97 First Republic (FRC) Insurance Life ............................................................................. 98 Prudential Financial (PRU) Insurance Non-Life...................................................................... 99 Allstate Corp. (ALL) REITs/Real Estate Services.......................................................... 100 ProLogis (PLD) Specialty & Consumer Finance..................................................... 101 Capital One (COF)
Health Care Biotechnology ...............................................................................103 Gilead (GILD) SMid Biotechnology ......................................................................104 Onyx Pharmaceuticals (ONXX) Healthcare Technology & Distribution ............................................105 McKesson Corporation (MCK) Life Sciences Tools & Diagnostics .................................................106 Agilent Technologies (A) Managed Care ..............................................................................107 Cigna (CI) Medical Supplies & Devices ..........................................................108 Heartware International (HTWR) Medical Technology SMid Cap ..................................................109 Intuitive Surgical (ISRG) Pharmaceuticals Major...............................................................110 Pfizer Inc. (PFE) Pharmaceuticals Specialty..........................................................111 Mylan (MYL) Materials Chemicals Specialty, Commodity & Agricultural...........................113 LyondellBasell Industries (LYB) Coal..............................................................................................114 CONSOL Energy (CNX) Gold .............................................................................................115 Goldcorp Inc (GG) Metals & Mining ............................................................................116 Carpenter Technology (CRS) Paper & Packaging .......................................................................117 MeadWestvaco (MWV) Silver............................................................................................118 Silver Wheaton (SLW)
Media & Telecom Internet ........................................................................................ 119 eBay (EBAY) Media .......................................................................................... 120 CBS Corporation (CBS) Telecom, Cable & Satellite............................................................ 121 Comcast (CMCSA) Technology Alternative Energy LED ............................................................. 123 Cree Inc. (CREE) Alternative Energy Solar PV....................................................... 124 First Solar (FSLR) Avoid Applied & Emerging Technologies ................................................ 125 Verint Systems (VRNT) Business Services........................................................................ 126 Robert Half International (RHI) Communications Equipment & Data Networking............................ 127 Ciena Corp. (CIEN) Computer Services & IT Consulting .............................................. 128 Visa Inc. (V) Education Services....................................................................... 129 American Public Education (APEI) Information Services..................................................................... 130 Nielsen Holdings N.V. (NLSN) IT Hardware................................................................................. 131 Apple Inc. (AAPL) Semiconductor Capital Equipment ................................................ 132 Nanometrics Incorporated (NANO) Semiconductors ........................................................................... 133 Texas Instruments (TXN) SMid Semiconductors................................................................... 134 Broadcom Corporation (BRCM) Software ...................................................................................... 135 Oracle Corp. (ORCL) Software Technology.................................................................... 136 Guidewire Software (GWRE)
Disclosures .................................................................................. 140 US Equity Research Staff List.................................................... 144 Note: Unless otherwise noted, all stock prices and coverage lists in this report are as of the close on December 6, 2012, and target prices for December 2013.
Portfolio Strategy
Year-End 2013 S&P 500 Target Is 1580: Tricky 1H, Clearer 2H
Thomas J Lee, CFA AC
(1-212) 622-6505 thomas.lee@jpmorgan.com
Macro
Katherine C Khor
(1-212) 622-0934 katherine.khor@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA TLEE<GO>
were due to recession (42 bull and 57 bull) and the third saw GDP growth decelerate from 10% (real) to 2% (probably felt like a recession, 62 bull). We favor remaining Cyclical and our top picks are Materials, Technology and Energy. Cyclicals have outperformed in 2012 by 200bp and we still see them as attractive with above-average expected EPS growth (2013E EPS growth of 6%) and P/E multiples that still stand at a substantial discount to those for Defensives (98% vs. 122% on 2014E P/E). History also has shown that Cyclicals typically have led in the fifth year of a bull market. Moreover, we believe investors should focus on capital gainsthat is, stocks with potential to re-rate. We found that companies with high FCF yields and low dividend yields have tended to outperform in the fifth year of a bull market. Bottom line, we remain constructive. Our year-end target represents an all-time high for the S&P 500 (previous peak was 1565 in October 2007) and would validate, in our view, the ability of equities to generate real returns (above inflation). Our target represents upside of about 11% with a total return of 13% (with dividends). We list the 2013 best ideas of J.P. Morgans fundamental equity analysts. There are 72 LONG ideas and 1 AVOID idea. The Long ideas are: A, AAPL, ALL, APEI, BA, BAC, BRCM, CBS, CI, CIEN, CMCSA, CNX, COF, CP, CREE, CRS, DAL, DHR, DIN, DNR, DUK, EAT, EBAY, EQM, ETN, FRC, GG, GILD, GWRE, HAR, HOG, HSY, HTWR, ISRG, IVZ, KBH, LVS, LYB, M, MCD, MCK, MWV, MYL, NANO, NLSN, NWL, OKE, ONXX, ORCL, PEP, PFE, PHM, PLD, PRU, PSX, PWR, RAI, RHI, SBUX, SLB, SLW, SU.TO, TGT, TOO, TXN, TXRH, URBN, V, VRNT, WCN, WFM and WYN. The Avoid idea is FSLR.
TARGET: Year-End 2013 Target of 1580 1H13 Tricky, Then 2H Rally to 1580
We are establishing a year-end 2013 target of 1580 for the S&P 500, based on a target P/E multiple of 13.5x our 2014 EPS estimate of $117 (see Figure 1). This target represents price appreciation of about 11.5% (from current levels), slightly lower than the 2012 return for the S&P 500 (13% plus 2% dividends, or 15% total return). We forecast the forward P/E to rise from 12.9x currently to 13.5x, consistent with trends in maturing bull marketstypically P/E has expanded in the fifth year of bull markets. Moreover, we see 2013 as likely to be back-end loaded, and believe markets will be flattish in 1H13.
Figure 1: Year-End 2013 Target Sensitivity
S&P 500 Target
EPS 2014E EPS Target YE P/E (2014E) 2013E Target $117.00 13.5X 1,580 P/E 1580 12.5X 13.0X 13.5X 14.0X 14.5X
Source: J.P. Morgan.
Contrarian on Timing: Consensus Sees New Highs in 2013 (Therefore Positive to Start), Suggesting 1H Could Be Weak
In contrast to last year, investors and strategists seem optimistic about 2013. We expect equity markets to rise in 2013 but believe this optimism needs to be challenged. Hence, our belief equity markets will perform poorly in 1H13. Seven of 10 strategy forecasts (NI WGT <<GO>>) look for all-time highs for the S&P 500 in 2013. (Recall, as noted above, more than half did not think 2011 highs would be exceeded in 2012.) Moreover, our sense from clients is that they missed the 2012 rally (and underperformed) and intend to compensate for this by moving to risk-on in 2013. This does suggest the potential for a big January effect for small-cap stocks. Thus, the consensus seems constructive to start the year. This creates a tricky dilemma for us. On the one hand, we see reasons to be constructive for the year. However, in past years the 1H has seemed to run counter to consensus. Thus, given the constructiveness noted above, and the past pattern of markets foiling consensus, we see downside risks in 1H.
Consensus OPTIMISTIC
10
Source: 2013 US Fixed Income Outlook by Terry Belton and Srini Ramaswamy. Note: For chart on the left-hand side, * Fed funds assumed to be 0.125% for Fed funds/3m Libor calculation. For the chart on the right-hand side, * spread to Treasuries, while ** spread to swaps.
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Near Cyclicals Energy OW Financials OW Defensives Staples HealthCare Telecom Utilities S&P 500 S&P ex-Fin Cyclicals Near-Cyclicals Defensives UW OW N UW
3% 10% 6% 5% 4% 4%
2% 3% 9% 12% 0% 0% 5% 5% 6% 4% 3% 3%
$105.00 $110.00 $117.09 $88.35 $45.55 $31.40 $28.05 $17.50 $92.35 $48.30 $32.80 $28.90 $19.40 $98.56 $51.94 $35.20 $29.96 $21.98
1,407 1,580 1,198 1,344 625 354 428 197 705 409 466 239
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$200.00
$20.00
3/02 $44.19
6/09 $51.97
+53%
9/69 12/66 $5.89 $5.55 9/67 12/70 $5.30$5.13 12/65 12/70
12/55 $3.62
$147 to $165
12/75
12/80
12/85
12/90
12/95
12/00
12/05
12/10
12/15
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Sales as % of GDP at 61% not near peaks of 65% in 2000 and 64% in 2008 Ultimately, top line is the primary driver of further margin expansion. The S&P 500 top line is approximately $10T (LTM) but around 61% as a percentage of US GDP. As shown below in Figure 8, this is lower than the peaks of 65% in 2000 and 64% in 2008. Thus, we see room for further margin expansion as top line expands further. In terms of incremental sales, an increase to peak levels (61% vs. peaks of 6465%) would represent about $300 billion on top of incremental sales generated by global GDP expansion. Thus, we see a case for top line to expand and arguably at a faster rate as capital spending recovers (see discussion of Capex in the Durable Goods section).
Figure 7: Net Profit Margins (All Stocks)
Since 1980
Recessions S&P EPS Troughs 10 9
66.0% 64.0% 62.0% 60.0% 58.0% 56.0% 54.0% 52.0% 2009 57.2% 2012 LTM 60.8%
8 7 6 5 4 3 2 12/80
12/84
12/88
12/92
12/96
12/00
12/04
12/08
1993
1996
1999
2002
2005
2008
2011
Source: J.P. Morgan, FactSet and BEA. Annual data for S&P 500 Index. Latest data as of 12/2011.
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SECTORS: Cyclicals Should Outperform Again in 2013; Focus on Materials, Technology and Energy
We are sticking with the Cyclical play given better economic visibility (particularly in 2H13) coupled with valuations that are more attractive than those for Defensives. Take a look at Figure 9 below. Cyclicals EPS are projected to grow 300-400bp faster than those for Defensives in 2013/2014 and Cyclicals still have lower P/E multiples (average discount of 10-15%). We understand the appeal of Defensives; however, they underperformed the S&P 500 by 300bp in 2012 and we expect 300bp of 2013 underperformance.
Figure 9: Summary Sector Views on 2013
$ per share
JPM Strategy EPS JPM Strategy Rating Cyclicals Materials Industrials Discretionary Technology Near Cyclicals Energy Financials Defensives HealthCare Telecom Staples Utilities S&P 500 Cyclicals Near-Cyclicals Defensives
Source: J.P. Morgan.
EPS % (JPM) '12E '13E '14E vs. v s. v s. 2014E $5.04 $12.15 $11.12 $23.63 '11 -1% 7% 7% 8% '12E '13E 6% 9% 6% 5% 20% 8% 8% 5%
2014 P/E LongTerm Current Target 9.4x 11.7x 14.3x 11.7x 11.5x 12.8x 15.8x 13.4x Avg 16.5x 16.5x 17.9x 23.6x % Upside 22% 10% 10% 14% Comments Works best in 5th yr. Better '14 EPS gth plus low valuation Play on global recov ery plus US durable goods boom Leader in a bull market and consumer supported by better housing Still defensive grow th. Low multiples and benefit from global recov ery
OW OW OW OW
OW OW
$14.75 $16.65
$15.15 $17.65
$16.67 $18.53
-8% 25%
3% 6%
10% 5%
8.7x 11.3x
10.4x 12.7x
14.8x 13.2x
19% 13%
Should improv e as EPS growth recov ers in '13e/'14e Play on US housing and durable goods boom
OW N UW UW
0% 0% 2% -4% 5% 7% 8% 0%
2% 9% 4% 0% 5% 6% 4% 3%
3% 12% 4% 0% 6% 8% 7% 4%
Still like lower P/E and GARP'y names in this group Improv ing EPS growth positive Fairly ex pensiv e group Trades at a meaningful premium to the S&P 500
As for valuations, note that Cyclicals still trade at a sizable discount to Defensives, although both trade at a premium to the S&P 500. Historically, Defensives have traded at a 15-20% discount to Cyclicals, but the opposite is the case currently, with Cyclicals trading at a discount of approximately 17% to Defensives. Lastly, as noted in Figure 14, Cyclicals typically have outperformed by 700bp in the fifth year of a bull market, with a win ratio of 75%. In fact, the two bestperforming sectors in the fifth year of a bull market have been Basic Materials and Energy (1,600bp and 1,500bp outperformance, respectively).
Figure 10: Sector Performance Since 2009
Since Start of 2009 Bull Market; P/E Multiples as of the Start of the Year for 2009, 2010, 2011 and 2012
Annual Return 2009 S&P500 Cyclicals Near Cyclicals Defensives Materials Industrials Discretionary Technology Energy Financials Staples HealthCare Telecom Utilities
Cyclicals
YoY EPS Growth 2011 0% -2% -8% 9% -12% -3% 4% 1% 3% -18% 11% 10% 1% 15% 2012 (YTD) 12% 12% 11% 9% 7% 9% 21% 13% 1% 20% 10% 15% 14% -3% Forecast 2009 0% -4% -115% -3% -49% -32% 63% 2% -58% -172% 3% 1% -23% 6% 2010 38% 55% 111% 1% 92% 24% 62% 44% 50% 171% 2% 3% -8% 6% 2011 14% 21% 22% 2% 32% 22% 11% 17% 36% 7% 6% 7% -4% -2% 2012 5% 5% 8% 0% -1% 7% 7% 8% -8% 24% 2% 0% 0% -4% 2013E 2014E 10% 17% 7% 8% 28% 10% 15% 13% 2% 12% 9% 6% 17% 0% 11% 11% 13% 12% 9% 10% 16% 11% 16% 10% 9% 7% 25% 7%
Premium/Discount: P/E relative to SPX (NTM) Forecast 2009 13.2x 108% 128% 100% 132% 109% 99% 90% 126% 130% 102% 85% 122% 89% 2010 20.3x 103% 91% 105% 110% 105% 98% 98% 92% 90% 106% 90% 130% 93% 2011 20.3x 110% 100% 111% 113% 112% 118% 98% 85% 115% 114% 89% 145% 97% 2012 16.5x 94% 78% 115% 86% 98% 106% 86% 82% 73% 118% 93% 133% 115% 2013E 2014E 16.5x 102% 86% 119% 97% 101% 116% 93% 89% 83% 121% 103% 137% 113% 14.4x 101% 88% 120% 95% 101% 116% 92% 91% 85% 125% 107% 129% 119%
2010 13% 20% 14% 6% 20% 24% 26% 9% 18% 11% 11% 1% 12% 1%
23% 40% 13% 9% 45% 17% 39% 60% 11% 15% 11% 17% 3% 7%
Defensives
NearCyclicals
the reduced expectations, and P/E of 9.4x 2013E (Energy only sector that is cheaper), we see the potential for outperformance.
Figure 11: Basic Materials Two-Year Trailing Return vs. S&P 500
Since 1975; Two-Year Rolling Relative Return
80% 60% 40% 20% 0% -20% -40% -60% -80% 1/75 7/77
Basic Materials
Secular issues Outperforms
Current
1/00
7/02
Aluminum, Coal, Mining and Steel Have Lagged Most (If One Is Thinking of Low Expectations)
As shown in Figure 12, several groups have suffered historic underperformance. We sorted these industries based on worst overall one- and two-year relative returns (percentiles vs. their history). For instance, Aluminum stocks have seen the worst two-year performance since 1973. We also note Steels underperformance of 4,500bp is nearly as bad. While deceleration in China and Europe has pressured pricing, an improvement in pricing could follow upside surprises to growth. Mining and Gold stocks are not far behind (9th/25th percentile, respectively). Clearly fundamentals are challenged and exports weak. But, again, with 3,0004,000bp of underperformance over two years, expectations are likely to be extremely low, in our view.
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1-year returns
%-tile rank Relativ e (100=highes t)
%-tile
Aluminum General Mining Steels Gold Mining Non-ferrous Metals Commodity Chemicals Forestry Specialty Chemicals Paper & Forest Products
1 5 12 25 5 29 46 48 79
8 10 8 8 39 40 62 65 82
5 8 10 17 22 35 54 57 81
J.P. Morgan Analyst Coverage of Basic Materials: CRS, GG, MWV, SLW and LYB Are Top Ideas
We have compiled J.P.Morgan analyst coverage of the Basic Materials sector in Figure 13. The largest sub-group (GICS level 4) is Specialty Chemicals ($122B). And the names in most of the sub-industries tend to be mid-cap. J.P. Morgan Analyst 2013 top picks are shown as well. The tickers are CRS, GG, MWV, SLW and LYB.
Figure 13: J.P. Morgan Analyst Coverage of Basic Materials
S&P 1500; $ millions
# Stocks Market (S&P Cap (S&P 1500) 1500) 23 $122,038 JPM Analyst Coverage Jeffrey J. Zekauskas Tycho W. Peterson 2 3 4 5 Diversified Chemicals Fertilizers & Agri Chem Industrial Gases Diversified Metals & Mining Steel Paper Products Gold Metal & Glass Containers 7 6 3 8 $114,432 $82,835 $56,670 Jeffrey J. Zekauskas Jeffrey J. Zekauskas Jeffrey J. Zekauskas Top Pick LYB
Other Stocks Covered ALB, ASH, CE, ECL, FOE, FUL, IFF, MTX, ROC, RPM, SHW, VAL SIAL DOW, DD, EMN, HUN, PPG AGU, CF, MON, POT, SMG, MOS APD, PX FCX, GSM, IMN.TO, MCP, RTI, TC Kb.TO, TC, TIE CMP AKS, ATI, CLF, CMC, HAYN, MUSA, NUE, RS, STLD, X, WOR AEM, ABX, BVN, GRZ, JAG, KGC, NEM, NG ATR, BLL, CCK, GEF, OI, SLGN BMS, BZ, GPK, PKG, RKT, SEE, SON EXP, MLM, VMC CSTE AA, CEN X CBT, GGC, WLK
6 7 8 9
13 10 2 6 5 5 3 5
$37,609 Michael F. Gambardella CRS $29,531 $17,826 $17,816 $15,274 Phil Gresh, CFA Phil Gresh, CFA Phil Gresh, CFA Scott Levine Michael Rehaut, CFA Jeffrey J. Zekauskas
MWV UFS, IP
10 Paper Packaging 11 Construction Materials 12 Aluminum 13 Commodity Chemicals 14 Precious Metals &Minerals
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1978 S&P500 (Abs) Cyclicals Near Cyclicals Defensives Materials Energy Technology Industrials Discretionary Staples Financials HealthCare Telecom Utilities 6% -3% 12% -13% 4% 21% -3% -3% -11% -12% 2% -8% -17% -14%
1986 38% 11% -1% -20% 22% 24% 10% 5% 7% -9% -27% -6% -22% -43%
Avg 18% 7% 5% -8% 16% 15% 7% 3% 2% -3% -5% -6% -7% -15%
Win Ratio 100% 75% 75% 25% 100% 75% 75% 75% 50% 50% 50% 0% 50% 25%
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51% 75% 45% 100% 37% 75% 36% 75% 34% 75% 32% 30% 23% 26% 25% 24% 22% 37% 100% 100% 100% 100% 50% 75% 75% 85%
48% 56% 42% 39% 21% 20% 19% 73% 106% -28%
Asset Managers-15% -15% -11% 6% Mortgage Fin -6% -23% 16% -21% Eqt Ivst Ins -8% Inv estment Cos. -8% Pharm 2% -6% -17% -11% Water 5% -41% -7% 11% Inv estment Sv s -8% -26% 9% -5% Food Products -7% -12% Brewers -16% -5% -1% -7% -8% 0%
Oil Eq & Sv s 23% 48% -17% Fd Rtl & W 10% -10% 12% Average
Source: J.P. Morgan and Datastream.
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Notice that the market has tended to be flattish in 1H of the 5th year of bull
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Recession or Big Downshift in GDP for Three Bull Markets Ending in Fifth Year
The natural question is what has caused bull markets to end by the fifth year. Figure 18, below, shows returns in each year of the 11 bull markets since 1932. There have been three that ended during the fifth year: 1942-1946, with a recession starting in February 1945; 1957-1961, with a recession starting in April 1960); and 1962-1966, after GDP growth of 10% annually for several years downshifted to 2% beginning in 1966in addition, the Vietnam War was starting. In the five that lasted through the fifth year, the average gain in year 5 was 19%, even stronger that in year 4. As we do not expect a recession in 2013, we do not expect the current bull market to end.
Figure 18: Bull Markets Annual Equity Market Returns
% Change; Since 1932 (Based on S&P 500 Returns)
SPX Bull Markets Start Date End Date 3/14/1935 3/10/1937 4/28/1942 5/29/1946 6/13/1949 8/2/1956 10/22/1957 12/12/1961 6/26/1962 2/9/1966 10/7/1966 11/29/1968 5/26/1970 1/11/1973 10/3/1974 11/28/1980 8/12/1982 8/25/1987 12/4/1987 3/24/2000 10/9/2002 10/9/2007 Average return ALL years 3/9/2009 12/3/2012 Length (months) 24 49 86 50 44 26 32 74 60 148 60 59 45 Annual % change Yr 1 77 54 42 31 33 33 44 38 58 21 34 42 69 Yr 2 29 3 12 10 17 7 11 21 2 29 8 13 16 (7) 14 (8) 7 5 3 7 28 18 13 15 4 6 38 13 15 19 20 7 19 25 29 21 19 8 (2) 34 25 29 21 19 16 24 13 (5) 2 26 (2) 28 4 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Yr 11 Yr 12
recession 2/45
20 37 16 5
recession 4/60 US GDP downshifts from 10% saar to 2% plus Vietnam war
22
P/E Ratios in Those Three Markets Also Considerably Higher than Current Level
In Figure 19, below, we illustrate the NTM P/E multiples at the beginning of each year in the 11 bull markets since 1932, and highlight the higher P/E multiples for those bull markets that ended by the fifth year. The P/Es ranged from 16x to 22x, well above the current 14x. In contrast, the P/Es for the bull markets that extended into the fifth year have been lower at 9-16x although 1992 was an exception (P/E of around 20x).
Figure 19: Bull Markets P/E Ratio
NTM P/E; Since 1932
Bull Markets Start Date End Date 3/14/1935 3/10/1937 4/28/1942 5/29/1946 6/13/1949 8/2/1956 10/22/1957 12/12/1961 6/26/1962 2/9/1966 10/7/1966 11/29/1968 5/26/1970 1/11/1973 10/3/1974 11/28/1980 8/12/1982 8/25/1987 12/4/1987 3/24/2000 10/9/2002 10/9/2007 Average return ALL years 3/9/2009 12/3/2012 Length (months) 24 49 86 50 44 26 32 74 60 148 60 59 45 P/E ratio Yr 1 19.1x 10.7x 8.4x 17.7x 18.9x 18.0x 19.5x 11.4x 13.3x 11.9x 19.8x 15.3x 18.4x Yr 2 17.8x 12.8x 7.7x 16.6x 19.2x 18.3x 18.5x 10.7x 10.2x 14.4x 17.4x 14.9x 15.4x 8.8x 12.3x 14.5x 16.2x 13.9x 14.0x 8.7x 16.3x 20.7x 15.9x 16.3x 13.6x 7.1x 19.4x 20.4x 17.1x 15.1x 13.2x 13.9x 15.1x 18.4x 21.3x 25.6x 28.6x 18.0x 15.2x 16.4x 18.4x 21.3x 25.6x 28.6x 8.9x 14.9x 9.9x 16.4x 18.2x 20.7x 9.9x 22.3x 16.1x 11.3x 12.7x 12.6x 13.8x Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Yr 11 Yr 12
23
This market is tracking 1982-1987 closely both on price and P/E We have plotted price and P/E for both markets (1982-1987 and 2009-2014) below in Figure 20 and Figure 21. Thus far, this market is tracking 1982-1987 closely. On price, if this market follows the prior markets trend, we see 1H13 as flattish. On P/E, note how the P/E multiple really began to re-rate as the prior market (1985-1986 period) moved forward.
Figure 20: Comparative Price 2009 Bull Market vs. 1982 Bull Market
S&P 500 in 2009-2014 vs. 1982-1987
Figure 21: Comparative P/E 2009 Bull Market vs. 1982 Bull Market
S&P 500 P/E in 2009-2014 vs. 1982-1987
Flattish
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U.S. Private Fixed Investment & Personal Consumption of Durable Goods as % of GDP
24%
22%
20%
The next closest period was the early 90swhich was followed by a period of abovetrend growth
3/56 3/61 3/66 3/71 3/76 3/81 3/86 3/91 3/96 3/01 3/06 3/11
9/12 21%
18% 3/51
Source: J.P. Morgan and BEA. Note: Data from 1951 to the present reflects quarterly data.
25
This is logical to us, since credit generally is required to fund durable goods purchases, and the related cycle leads to above-trend growth.
Figure 23: P/E Ratios Have Expanded During Periods of Rising Durable Goods Spending
Periods of rising durable goods spending Durable goods and fix ed investment spending Start date End date 9/30/1958 9/30/1959 6/30/1961 3/31/1966 3/31/1967 3/31/1969 12/31/1970 3/30/1973 6/30/1975 3/30/1979 9/30/1982 9/30/1986 12/31/1991 3/31/2000 3/31/2003 3/31/2006 Average Start 21.90% 21.80% 22.60% 22.80% 22.90% 23.70% 21.00% 24.10% 22.60% End 24.00% 24.70% 24.40% 26.50% 27.60% 26.40% 26.70% 26.00% 25.79% Change 2.10% 2.90% 1.80% 3.70% 4.70% 2.70% 5.70% 1.90% 3.20% Start 13.7 17.9 16.2 15.9 10.7 8.3 17.4 22.2 15.3
P/E re-rates
GDP CAGR 6.9% 6.2% 4.1% 6.2% 5.1% 5.0% 3.9% 3.5% 5.1% End 16.4 17.8 17.6 18.6 8.8 13.2 27.0 17.6 17.1 Change 2.6 (0.1) 1.4 2.7 (1.8) 4.9 9.6 (4.6) 1.8
Source: J.P. Morgan and BEA. Note: Data from 1929 to 1946 reflects annual data. Data from 1947 to the present reflects quarterly data.
26
Figure 25: S&P 500 EPS Has Peaked When Durable Goods Spending Peaked
% of GDP and $ per share
S&P 500 Peak EPS % GDP Durable Goods Dates 3/51 12/55 12/66 9/69 9/74 3/80 12/84 6/89 EPS $2.83 $3.62 $5.55 $5.89 $9.11 $15.29 $16.64 $25.22 $57.37 $92.15 Capex + Construction + Consumer durables) 26.5% 25.4% 23.4% 24.2% 24.9% 26.7% 26.0% 24.5% 26.4% 24.8% 25.3% $101.64 20.5% -4.8% Construction (Priv ate Fix ed Inv estment in 3.5% 4.2% 4.3% 4.8% 4.4% 4.3% 4.4% 4.6% 4.3% 2.3% -2.0% Auto Sales (Nominal consumption of motor vehicles and parts) 4.3% 4.2% 3.7% 3.8% 3.4% 3.4% 3.8% 3.8% 3.6% 2.9% 3.7% 2.5% -1.1%
U.S. Private Fixed Investment & Personal Consumption of Durable Goods as % of GDP
26%
1 2 3 4 5 6 7 8
9/12 20%
24%
22%
20%
18% 3/51 3/56 3/61 3/66 3/71 3/76 3/81 3/86 3/91 3/96 3/01 3/06 3/11
Current
Source: J.P. Morgan, Bloomberg and BEA. Note: Data from 1947 to the present reflects quarterly data.
Source: J.P. Morgan and BEA. Note: Data from 1929 to 1946 reflects annual data. Data from 1947 to the present reflects quarterly data.
27
30%
Qatar (#21; $98,900; United Arab Emirates 28.6%) Australia (# 33) (# 30)
25% Singapore (# 53) Canada (# 59) Hong Kong (# 68) Turkey (# 71) Burundi (# (# 61) Zimbabwe 70) Russia (# 76) Austria (# 77) Spain (# 80) Belgium Saudi Arabia (# 81) Japan (# 87) (# 86) Mexico (# 82) (# 91) Norway (# 92) France (# 94) Switzerland Luxembourg (# 104; Italy (# 97) EU (# 112) Sweden (# 115) $80,600; 19.0%) Brazil (# 100) Netherlands (# 119) Germany (# 116) Egypt (# 136) Kuwait (# 134) (# 139) (# 140) Greece (# 141) UK Iceland US (# 144) 10% 0 10,000 20,000 30,000 40,000 GDP Per Capita ($) (PPP) (2011 est.) Ireland (# 149) 50,000 60,000
20%
15%
Source: J.P. Morgan and CIA World Factbook. Note: The gross fixed investment entry (shown above) "records total business spending on fixed assets, such as factories, machinery, equipment, dwellings, and inventories of raw materials, which provide the basis for future production. It is measured gross of the depreciation of the assets, i.e., it includes investment that merely replaces worn-out or scrapped capital." Data reflects 2011 estimates for 228 countries. Korea* reflects South Korea. The top 10 countries listed are, in order of rank: Equatorial Guinea, Sao Tome and Principe, China, Cape Verde, Republic of the Congo, Belarus, Armenia, Kosovo. Lesotho and Seychelles. GDP per capita (PPP) is defined as GDP on a purchasing power parity (PPP) basis divided by population as of 1 July for the same year. The top 10 countries listed for GDP per capita, in order of rank: Qatar, Liechtenstein, Luxembourg, Bermuda, Singapore, Jersey, Falkland Islands (Islas Malvinas), Norway, Brunei, Hong Kong and United States.
Source: J.P. Morgan, CIA World Factbook and World Bank. Note: 2011E US reflect estimates from the CIA World Factbook. Data from 1965 through 2011 reflects World Bank estimates. Gross fixed capital formation (formerly called gross domestic fixed investment) is defined by the World Bank as "includes land improvements (fences, ditches, drains, and so on); plant, machinery, and equipment purchases; and the construction of roads, railways, and the like, including schools, offices, hospitals, private residential dwellings, and commercial and industrial buildings. According to the 1993 SNA, net acquisitions of valuables are also considered capital formation."
We provide a time series of this metric for the United States and China since 1965 in Figure 27 above. Notice that from 1975 to 2000 spending levels in both the US and China generally were range-bound. It was not until 2005 that the trajectories of spending for each country diverged meaningfully. Chinas spending surged to 46% of GDP from a prior range of 25-35%. Over the next decade, in our view, this is likely to revert to the prior range of 25-35%. Conversely, US spending has collapsed since 2007 from its long-time range during 1975 to 2003. We similarly expect this spending to recover as the US cannot defer spending indefinitely.
28
Line Item (from BEA) Personal consumption expenditures Goods Durable goods Motor v ehicles and parts
LT Avg 65.0% 29.2% 8.8% 3.5% 2.3% 1.9% 1.0% 20.4% 35.8% 15.9% 15.3% 10.7% 3.6% 7.1% 4.6% 4.5% 0.1%
Delta vs. LT Avg 5.6% -5.2% -1.1% -0.9% -0.6% 0.4% 0.2% -4.1% 10.8% -2.7% -2.7% -0.5% -0.7% 0.2% -2.2% -2.1% 0.0%
# of std dev from LT avg 1.8 (1.1) (1.7) (1.9) (1.6) 1.0 1.7 (0.9) 1.5 (1.6) (1.9) (0.4) (1.1) 0.2 (2.3) (2.3) (2.0)
Furnishing and durable household equipment 1.7% Recreational goods and vehicles 2.2% Other durable goods 1.2% Nondurable goods Services Gross private domestic investment Fix ed Investment Nonresidential Structures Equipment and software Residential Structures Equipment 16.3% 46.6% 13.2% 12.6% 10.2% 2.9% 7.3% 2.5% 2.4% 0.1%
% of GDP Line Item (from BEA) (3Q12) Structures 2.9% Commercial and health care 0.6% Office 0.2% Health care 0.2% Hospitals and special care 0.2% Hospitals 0.1% Special care 0.0% Medical buildings 0.0% Multimerchandise shopping 0.1% Food and beverage establishments 0.0% Warehouses 0.0% Other commercial 0.1% Manufacturing 0.3% Power and communication 0.6% Power 0.5% Electric 0.3% Other power 0.2% Communication 0.1% Mining exploration, shafts, and wells 1.0% Petroleum and natural gas 0.9% Mining Other structures 0.0% 0.4%
LT Avg 3.6% 1.2% 0.4% 0.3% 0.2% 0.2% 0.0% 0.1% 0.2% 0.1% 0.1% 0.1% 0.5% 0.7% 0.5% 0.3% 0.1% 0.2% 0.5% 0.5% 0.0% 0.7%
Delta vs. # of std dev LT Avg from LT avg -0.7% (1.1) -0.6% (1.9) -0.3% (1.6) 0.0% (0.8) 0.0% (0.8) 0.0% (0.5) 0.0% (1.3) 0.0% (0.5) -0.1% (1.8) -0.1% (1.9) -0.1% (1.9) -0.1% (2.4) -0.2% (1.1) -0.1% (0.5) 0.0% (0.1) -0.1% (0.6) 0.1% 1.1 -0.1% 0.5% 0.5% 0.0% -0.3% (1.8) 1.6 1.6 0.5 (1.9)
Line Item (from BEA) Structures Permanent site Single-family structures Multifamily structures Other structures Manufactured homes
LT Avg 4.5% 2.8% 2.2% 0.5% 1.6% 0.1% 0.0% 1.1% 0.4% 0.0%
Delta vs. # of std dev LT Avg from LT avg -2.1% -1.8% -1.4% -0.4% -0.2% -0.1% 0.0% -0.1% 0.0% 0.0% (2.3) (2.3) (2.3) (1.3) (0.8) (1.6) (0.1) (0.6) (0.1) 0.7
Dormitories 0.0% Improvements 1.0% Brokers' commissions on sale of structures 0.4% Net purchases of used structures 0.0%
Source: J.P. Morgan and BEA. Note: BEA tables 1.1.5; 2.4.5U; 5.3.5; 5.5.5U and 5.4.5U.
29
Supply (a) (b) (c ) = (a) + (b) Demand (d) (e) (f) = (d) / (e) (g)=(f) - (c ) / Base case: (h) (i)=(g) + (h) - (c ) / Upside case:
2010s...
4,500
Adult population change '12-'17 Ratio pop/ shelter Incremental housing units demand Net required housing units to be built 5 y ears 12-'17 annual housing starts BASE case Plus: pent-up household formation Net required housing units to be built 5 y ears 12-'17 annual housing starts HIGH case
3,500
000s
Fewer adults
Fewer births
Fewer adults
3,000
2,500
2,000 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025
Source: J.P. Morgan and U.S. Census Bureau. Note: Census data as of 2Q12.
30
CAPEX / Sales (%) Current LTM S&P 500 Cyclicals Materials Industrials Discretionary Technology Near-Cyclicals Energy Financials Defensives Staples HealthCare Telecom Utilities 6.2% 5.0% 6.8% 5.1% 4.5% 5.0% 7.7% 12.4% 2.9% 5.5% 2.7% 1.9% 14.0% 24.1% % 5.1% 4.1% 4.4% 4.1% 3.9% 3.7% 4.2% 5.8% 2.2% 5.5% 2.7% 1.7% 13.6% 15.2% Low Date 2009 2009 2004 2010 2009 2009 2000 2000 2004 2006 2010 2010 2009 2006 % 8.1% 7.7% 9.7% 10.4% 8.1% 8.0% 8.1% 14.0% 3.8% 15.2% 4.4% 6.1% 27.6% 41.2% High Date 1998 1996 1996 1996 1997 1995 1997 1997 2009 2001 1997 1995 2001 2002 Low
Decile
High
Source: J.P. Morgan and FactSet. Note: LTM reflects estimates. Near-Cyclicals reflects an average of energy and financials.
31
5.5%
9.50
9.00
32
3/91
Net % of Respondents Tightening Standards
80.0% 60.0% 40.0%
6/95
12/00
9/11
7/92
20.0% 16 mos 0.0% 22 mos
4/97
37 mos
1/04
-20.0% 9/90 9/92 9/94 9/96 9/98 9/00 9/02 9/04 9/06 9/08 9/10 9/12 9/14
Source: J.P. Morgan and Bloomberg. Note: Latest survey released for October 2012.
33
9/12 11%
12/76 6%
3/56
3/60
3/64
3/68
3/72
3/76
3/80
3/84
3/88
3/92
3/96
3/00
3/04
3/08
3/12
US debt service ratios back to best levels in 30 years Leading up to the recession, the household debt service ratio climbed to 20-year highs as households increased mortgage borrowings. Since the 2007 peak, the household debt service ratio has declined significantly, falling below the long-term average, to 1993 levels. About one-third of that decline has been due to lower borrowings and the balance to lower interest costs. As shown in Figure 37 below, the debt service ratio has only been as low as the most recent 10.7% (per the Federal Reserve) in the early 80s and early 90s.
Figure 37: Debt Service Ratio for Households
Since 1980; Ratio of Household Service to Disposable Personal Income; Seasonally Adjusted (SA, %)
Household Debt Service Ratio (SA, %) LT Avg 1 st dev 3Q2007, 14.1% 14.5% 14.0% 13.5% 13.0% 12.5% 12.0% 11.5% 11.0% 10.5% 10.0% 4Q1993
1 st dev 1 st dev
LT Avg, 11.96%
2Q2012, 10.7%
Source: J.P. Morgan and Federal Reserve Flow of Funds. Note: Household debt service ratio defined by the Federal Reserve Board as an estimate of the ratio of debt service payments (consistent of the estimated required payments on outstanding mortgage and consumer debt) to disposable personal income.
34
1Q1980 1Q1981 1Q1982 1Q1983 1Q1984 1Q1985 1Q1986 1Q1987 1Q1988 1Q1989 1Q1990 1Q1991 1Q1992 1Q1993 1Q1994 1Q1995 1Q1996 1Q1997 1Q1998 1Q1999 1Q2000 1Q2001 1Q2002 1Q2003 1Q2004 1Q2005 1Q2006 1Q2007 1Q2008 1Q2009 1Q2010 1Q2011 1Q2012 1Q2013 1Q2014
Source: J.P. Morgan and Datastream. Note: ROE, Interest Charge Coverage and FCF Yield calculations exclude the 1974 Bull Market due to unavailable data.
Source: J.P. Morgan and Datastream. Note: ROE, Interest Charge Coverage and FCF Yield calculations exclude the 1974 Bull Market due to unavailable data.
35
What Groups Have Highest FCF Yields and/or Lowest Dividend Yields?
We have highlighted the 15 groups with the highest FCF yields (>7%, left side of Figure 40) and the lowest dividend yields (right side, less than 0.4%). There are some industries that appear in both categories: Positive combination of High FCF Yield/Low Div Yield: Education Services, Tires & Rubber and Home Entertainment. Negative combination of Low FCF Yield/High Div Yield: Electric Utilities, Gas Utilities, Multi-Utilities and Oil & Gas Storage.
Figure 40: Top 15 and Bottom 15 FCF Yield and Dividend Yield Industries (Current)
FCF Yield List Excludes Financials
FCF Yield - Top 15 Industries (highest FCF Yield) Dividend Yield - Top 15 Industries (Lowest Div Yield) FCF FCF FCF Div Div Div Industry Yield Industry Yield Industry Yield Industry Yield Industry Yield Industry Yield Education Services 19% 6 Airlines 12% 11 Oil & Gas Refining & Marketing 8% 1 Tires & Rubber 0.0% 6 Health Care Technology0.1% 11 Wireless Telecommunication 0.1%Services Office Electronics 16% 7 Tires & Rubber 10% 12 Office Services & Supplies 8% 2 Education Serv ices 0.1% 7 Construction Materials 0.1% 12 Internet Retail 0.2% Computer Hardware 15% 8 Semiconductor Equipment9% 13 Brewers 8% 3 Automotive Retail 0.1% 8 Real Estate Services 0.1% 13 Application Software 0.3% Computer Storage & Peripherals 15% 9 Automobile Manufacturers9% 14 Home Entertainment Software 7% 4 Homefurnishing Retail 0.1% 9 Internet Software & Services 0.1% 14 Health Care Services 0.4% Commercial Printing 14% 10 Systems Software 8% 15 Data Processing & Outsourced 7% Services 5 Health Care Facilities 0.1% 10 Home Entertainment Software 0.1% 15 Biotechnology 0.4% Average 9% Average 0.2% FCF Yield - Bottom 15 Industries (lowest FCF Yield) FCF FCF FCF Industry Yield Industry Yield Industry Yield Trucking -52% 6 Oil & Gas Drilling -6% 11 Agricultural Products -3% 1 Oil & Gas Exploration-16% & Production 7 Diversified Metals & Mining -6% 12 Multi-Utilities -3% 2 Independent Power Producers -15% &8 Energy Gas Utilities Traders -5% 13 Oil & Gas Equipment &-2% Services 3 Gold -7% 9 Integrated Oil & Gas -4% 14 Homebuilding -2% 4 Electric Utilities -6% 10 Oil & Gas Storage & Transportation -3% 15 Health Care Facilities -1% 5 Average -3% Dividend Yield - Bottom 15 Industries (highest Div Yield) Div Div Div Industry Yield Industry Yield Industry Yield Commercial Printing 11.2% 6 Computer & Electronics4.8% Retail 11 Home Furnishings 4.3% Office Services & Supplies 8.5% 7 Thrifts & Mortgage Finance 4.7% 12 Oil & Gas Storage & Transportation 4.2% Integrated Telecommunication 7.6% Services 8 Electric Utilities 4.7% 13 Gas Utilities 3.9% Casinos & Gaming 5.2% 9 Specialized Consumer Services 4.6% 14 Steel 3.9% Tobacco 5.0% 10 Multi-Utilities 4.4% 15 Diversified REITs 3.7% Average 4.3%
1 2 3 4 5
1 2 3 4 5
36
37
NEAR CYCLICALS Energy 1 CNX 2 DNR 3 EQM 4 PSX 5 SLB 6 SU.TO 7 TOO Financials 1 ALL 2 BAC 3 COF 4 FRC 5 IVZ 6 PLD 7 PRU
38
Figure 42: Top LONG Stock Ideas from J.P. Morgan Fundamental Analysts (1 of 3)
Priced as of 12/6/2012; Sorted by Implied Upside to J.P. Morgan Target Prices Within Each Sector
JPM Coverage EPS and Valuation
Name Materials 1 Carpenter Technology Corp. 2 Goldcorp Inc. 3 MeadWestvaco Corp. 4 Silver Wheaton Corp. 5 LyondellBasell Industries N.V. Cl A Industrials 6 Delta Air Lines Inc. 7 Robert Half International Inc. 8 Boeing Co. 9 Nielsen Holdings N.V. 10 Quanta Services Inc. 11 Canadian Pacific Railway Ltd. 12 Waste Connections Inc. 13 Danaher Corp. 14 Eaton Corporation PLC Discretionary 15 Harman International Industries Inc. 16 Texas Roadhouse Inc 17 PulteGroup Inc. 18 KB Home 19 CBS Corp (Cl B) 20 Brinker International Inc. 21 Target Corp. 22 Harley-Davidson Inc. 23 Comcast Corp. Cl A 24 Wyndham Worldwide Corp. 25 Macy's Inc. 26 American Public Education Inc. 27 Las Vegas Sands Corp. 28 DineEquity Inc. 29 McDonald's Corp. 30 Newell Rubbermaid Inc. 31 Urban Outfitters Inc. 32 Starbucks Corp.
Source: J.P. Morgan and FactSet.
Sub-Industry
Ticker
Current Price
2013E EPS
P/E ('13E)
P/B
CYCLICALS: Materials, Industrials, Discretionary, Technology Steel Gold Paper Products Precious Metals & Minerals Specialty Chemicals CRS GG MWV SLW LYB $47.76 $36.82 $30.49 $35.08 $51.90 $2,545 $30,282 $5,365 $12,662 $30,951 OW Michael F. Gambardella $70.00 OW John Bridges, CFA, ACSM $51.00 OW Phil Gresh, CFA OW Jeffrey J. Zekauskas $38.00 $57.00 OW John Bridges, CFA, ACSM $39.00 47% 39% 25% 11% 10% $3.39 $2.95 $1.77 $2.25 $5.70 14.1x 12.5x 17.2x 15.6x 9.1x 2.18x 1.36x 1.62x 4.25x 2.51x
Airlines Aerospace & Defense Research & Consulting Services Construction & Engineering Railroads Environmental & Facilities Services Industrial Conglomerates Electrical Components & Equipment
OW Jamie Baker OW Andrew C. Steinerman OW Joseph B. Nadol III OW Andrew C. Steinerman OW Scott Levine OW Thomas R. Wadewitz OW Scott Levine OW Ann Duignan
4.1x 16.1x 14.5x 14.0x 16.5x 17.5x 18.0x 15.1x 11.7x 4.93x 7.41x 2.13x 1.51x 3.21x 2.21x 1.96x 2.16x
Consumer Electronics Restaurants Homebuilding Homebuilding Broadcasting Restaurants General Merchandise Stores Motorcycle Manufacturers Cable & Satellite Hotels, Resorts & Cruise Lines Department Stores Education Services Casinos & Gaming Restaurants Restaurants Housewares & Specialties Apparel Retail Restaurants
HAR TXRH PHM KBH CBS EAT TGT HOG WYN M APEI LVS DIN MCD NWL URBN SBUX
$39.99 $16.13 $16.28 $14.17 $35.65 $30.25 $62.20 $46.18 $49.59 $38.92 $35.59 $43.84 $62.30 $88.09 $21.78 $36.97 $53.70
$2,764 $1,138 $6,355 $1,118 $21,283 $2,237 $40,531 $10,512 $78,463 $6,963 $15,578 $646 $35,944 $1,154 $88,832 $6,301 $5,451 $39,887
OW Ryan Brinkman OW John Ivankoe OW Michael Rehaut, CFA OW Michael Rehaut, CFA OW Alexia S. Quadrani OW John Ivankoe OW Kevin Milota OW Philip Cusick, CFA OW Joseph Greff OW Jeffrey Y. Volshteyn OW Joseph Greff OW John Ivankoe OW John Ivankoe OW John Faucher OW Brian J. Tunick OW John Ivankoe
$60.00 $21.00 $21.00 $18.00 $45.00 $38.00 $56.00 $45.00 $60.00 $42.00 $51.00 $73.00 $101.00 $24.00 $40.00 $55.00
50% 30% 29% 27% 26% 26% 22% 21% 21% 21% 18% 18% 16% 17% 15% 10% 8% 2%
$3.54 $1.11 $1.14 $2.91 $2.31 $4.89 $3.41 $2.23 $3.62 $3.77 $2.63 $2.62 $4.20 $5.79 $1.82 $1.91 $2.16
11.3x 14.5x 14.3x 12.2x 13.1x 12.7x 13.6x 16.7x 13.7x 10.3x 13.5x 16.8x 14.8x 15.2x 12.0x 19.3x 24.9x
1.76x 2.07x 2.99x 3.00x 2.23x 8.34x 2.49x 3.89x 2.01x 3.45x 2.80x 4.05x 3.96x 4.87x 6.40x 3.05x 4.29x 7.87x
$0.13 106.5x
CMCSA $37.14
39
Figure 43: Top LONG Stock Ideas from J.P. Morgan Fundamental Analysts (2 of 3)
Priced as of 12/6/2012; Sorted by Implied Upside to J.P. Morgan Target Prices Within Each Sector
JPM Coverage EPS and Valuation
Name Technology 33 Broadcom Corp. 34 Apple Inc. 35 Guidewire Software Inc. 36 Verint Systems Inc. 37 Oracle Corp. 38 Visa Inc. 39 Texas Instruments Incorporated 40 Nanometrics Inc. 41 eBay Inc. 42 Cree Inc. 43 Ciena Corp.
Sub-Industry Semiconductors Computer Hardware Application Software Application Software Systems Software Data Processing & Outsourced Services Semiconductors Semiconductor Equipment Internet Software & Services Semiconductors Communications Equipment
Ticker
Current Price
Market JPM Cap Rtg JPM Analyst $17,080 $1,598 $1,101 $79,508 $33,411 $346 $67,276 $3,802 $1,567 OW Harlan Sur OW Mark Moskowitz OW Sterling Auty, CFA OW Paul Coster, CFA OW John DiFucci OW Tien-tsin Huang, CFA OW Christopher Danely OW Christopher Blansett OW Doug Anmuth OW Christopher Blansett OW Rod Hall, CFA
Target Implied Price Upside $47.00 $770.00 $40.00 $35.50 $40.00 $165.00 $33.00 $16.00 $56.00 $34.00 $16.00 41% 41% 39% 29% 25% 11% 11% 8% 8% 4% 2%
2013E EPS $2.92 $49.26 $0.29 $2.85 $2.91 $7.25 $1.82 $0.57 $2.74 $1.20 $0.49
P/E ('13E) 11.4x 11.1x 98.4x 9.7x 11.0x 20.5x 16.4x 25.9x 19.0x 27.2x 31.9x
P/B 2.53x 4.35x 8.25x 5.76x 3.57x 3.60x 2.93x 1.56x 3.38x 1.47x
BRCM $33.36 GWRE $28.84 VRNT ORCL V TXN EBAY CREE CIEN $27.46 $148.47 $29.81 $51.99 $32.70 $15.64
$32.03 $154,354
NANO $14.79
NEAR CYCLICALS: Energy, Financials Energy 44 Consol Energy Inc. 45 Denbury Resources Inc. 46 Suncor Energy Inc. 47 Schlumberger Ltd. 48 Teekay Offshore Partners L. P. 49 Phillips 66 50 EQT Midstream Partners LP Financials 51 Prudential Financial Inc. 52 Capital One Financial Corp. 53 INVESCO Ltd. 54 First Republic Bank 55 Prologis Inc. 56 Allstate Corp. 57 Bank of America Corp.
Source: J.P. Morgan and FactSet.
Coal & Consumable Fuels Oil & Gas Exploration & Production Integrated Oil & Gas Oil & Gas Equipment & Services Oil & Gas Storage & Transportation Oil & Gas Refining & Marketing Oil & Gas Storage & Transportation
OW John Bridges, CFA, ACSM $63.00 OW Joseph Allman, CFA $26.50 OW Katherine Lucas Minyard, CFA $44.00 OW J. David Anderson, PE, CFA $95.00 OW Christopher G Combe OW Jeremy Tonet, CFA $33.50 $34.00 OW Katherine Lucas Minyard, CFA $60.00
SU.TO $32.79
Life & Health Insurance Consumer Finance Asset Management & Custody Banks Regional Banks Industrial REITs Property & Casualty Insurance Other Diversified Financial Services
$70.00 $74.00
OW Kenneth B. Worthington, CFA $32.00 OW Steven Alexopoulos, CFA $40.00 OW Michael W. Mueller, CFA $41.00 OW Matthew G Heimermann $48.00 OW Vivek Juneja $11.50
$0.20 172.0x
$10.46 $112,685
40
Figure 44: Top LONG Stock Ideas from J.P. Morgan Fundamental Analysts (3 of 3)
Priced as of 12/6/2012; Sorted by Implied Upside to J.P. Morgan Target Prices Within Each Sector
JPM Coverage EPS and Valuation
Name Staples 58 Reynolds American Inc. 59 Whole Foods Market Inc. 60 Hershey Co. 61 PepsiCo Inc. HealthCare 62 HeartWare International Inc 63 Agilent Technologies Inc. 64 Onyx Pharmaceuticals Inc. 65 Intuitive Surgical Inc. 66 McKesson Corp. 67 Cigna Corporation 68 Mylan Inc. 69 Pfizer Inc. 70 Gilead Sciences Inc. Utilities 71 ONEOK Inc. 72 Duke Energy Corp. Average
Source: J.P. Morgan and FactSet.
Sub-Industry
Ticker
Current Price
2013E EPS
P/E ('13E)
P/B
DEFENSIVES: Staples, HealthCare, Telecom, Utilities Tobacco Food Retail Packaged Foods & Meats Soft Drinks RAI WFM HSY PEP $42.94 $91.17 $24,001 $16,914 OW Rae Maile OW Ken Goldman OW Ken Goldman OW John Faucher $61.00 $117.00 $86.00 $82.00 42% 28% 19% 17% $3.12 $2.89 $3.58 $4.41 13.8x 31.5x 20.1x 15.9x 4.19x 4.45x 16.39x 5.04x
Health Care Equipment Life Sciences Tools & Services Biotechnology Health Care Equipment Health Care Distributors Managed Health Care Pharmaceuticals Pharmaceuticals Biotechnology
OW Michael Weinstein OW Tycho W. Peterson OW Cory Kasimov OW Tycho W. Peterson OW Lisa C. Gill OW Justin Lake OW Chris Schott, CFA OW Chris Schott, CFA OW Geoff Meacham
-$3.35 $3.04 -$1.64 $17.70 $8.05 $6.32 $2.78 $2.29 $4.39 29.4x 11.8x 8.3x 9.8x 11.2x 16.8x 12.6x
$25.61 $188,556
OKE DUK
$43.67 $64.17
$8,935 $45,191
$54.00 $69.00
24% 8% 25%
$2.04 $4.40
Figure 45: Top AVOID Stock Ideas from J.P. Morgan Fundamental Analysts
Priced as of 12/6/2012; Sorted by Implied Upside to J.P. Morgan Target Prices Within Each Sector
JPM Coverage EPS and Valuation
Sub-Industry
Ticker
Current Price
2013E EPS
P/E ('13E)
P/B
CYCLICALS: Materials, Industrials, Discretionary, Technology Semiconductors FSLR $30.72 $2,674 UW Christopher Blansett $14.00 -54% -54% $4.09 7.5x 7.5x 0.77x 0.77x
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Fiscal Cliff and Tax Reform: Long-Term Tax and Spending Policy Reform Likely in 2013 in the Wake of the Fiscal Cliff Trigger
We believe there is simply too much work to be done in Washington between now and January 1 to reasonably expect serious compromise that would lead to an outright solution to the fiscal cliff issues by year-end 2012. If compromise is reached before year-end or in early 2013, some fiscal cliff provisions may be conceded on both sides of the aisle in exchange for an agreement to reduce some of the most economically or politically damaging parts of the fiscal cliff. For example, we could see a scenario in which some 2012 laws are extended through the end of 2013 in exchange for an agreement to attempt to pass comprehensive tax and spending reform by some date in the future (such as by the end of 2013). If compromise is not achieved regarding fiscal cliff issues, we expect the economy and markets to react to the various new parts of our tax regime and the effects of the $109 billion in 2013 budget cuts brought on by sequestration. Investors need to be prepared for a very real possibility of this scenario coming to fruition. From our perspective, the best case scenario in the short term is that some targeted fiscal cliff measures are relaxed or postponed until the end of 2013 in exchange for an agreement to attempt to negotiate long-term tax and spending reforms during 2013. Such a situation would give representatives more time to negotiate longer-term reform. In our view, if long-term reform is to be achieved, negotiations will require both parties to take actions that are counter to their respective political brands. For Republicans this could mean potentially being open to take hikes (in violation of the Grover Norquist federal taxpayer protection pledge). For Democrats, this could mean a willingness to negotiate for entitlement reforms. If one or both parties are not willing to negotiate with these issues on the table, it is very possible that negotiations could break down and we could be facing the same issues at the end of 2013 as we are currently facing at the end of 2012. The Bowles-Simpson report could potentially play a prominent role in any hypothetical negotiations for long-term tax and spending reform in 2013. For a more detailed discussion of all of these issues, see our November 27th report, Accounting Issues: Countdown to Fiscal Cliff on January 1, 2013. In this piece we also discuss which agencies could be most affected if sequestration occurs as currently enacted and we talk about how corporate taxation might change if longterm tax reform is accomplished.
Pensions: GAAP Funded Status May Deteriorate but It Shouldnt Trigger Large Funding Calls due to MAP-21 Pension Funding Relief
The Moodys Aa Index, a rate we use for a back of the envelope benchmark for US GAAP pension discount rates, has fallen from 3.91% at year-end 2011 to 3.62% as of December 10, a decrease of 29 basis points. This implies slightly higher US GAAP pension obligations in 2012 relative to 2011. If we use the S&P 500 as a benchmark for equity returns, the index was 1418.55 on December 10 versus 1257.6
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at year-end 2011, an increase of 12.8%. If both of these trends hold through year-end, most companies will likely see a y/y improvement in their GAAP funded status during 2012. While most pension plans are significantly underfunded, we do not expect the majority of companies to be required to make material pension contributions during 2013 due to the pension funding relief that was part of the Moving Ahead for Progress in the 21st Century Act (MAP-21) in July 2012. As a result of MAP-21, companies will use discount rates based off of 25-year moving averages of discount rates for the next several years. As a result of moving to a 25-year moving average discount rate from a 24-month moving average discount rate for calculations of obligations for funding purposes, discounts will increase 100-400 basis points at various parts of the yield curve segments which will make obligations temporarily and drastically smaller for funding purposes. These increases in funding discount rates and decreases in funding obligations mean that pension contributions will be smaller for the next several years relative to what they would have been without this discount rate relief. Therefore, while the GAAP funded status will not be impacted by these adjustments, companies will see a potential cash flow benefit if they decide to make smaller contributions in response to this relief. Over the past year, we have seen a number of companies follow the lead of Honeywell (HON), AT&T (T) and Verizon (VZ) and change their pension accounting so it is more consistent with mark-to-market (fair value) accounting. We expect this trend to continue as it provides companies with the opportunity to retroactively assign pension losses to historical periods when they occurred (e.g., 2008 and 2011) and improve their forward earnings outlooks.
Accounting Standard Setting: The Joint Work of the FASB and the IASB Continues
Much of the work of the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) over the past decade has been joint work. Joint projects will continue to dominate the boards time during 2013. The FASB and IASB intend to release joint exposure drafts (ED), joint standards (S) or Conceptual Framework chapters (CF) in the following areas: Accounting for Financial Instruments: The FASB and IASB are working together to overhaul financial instrument accounting. The project has been subdivided into three primary sections: impairment, classification and measurement, and hedging. An exposure draft on impairment could be issued before year-end 2012 and another exposure draft on classification and measurement could be issued sometime during the first half of 2013. Revenue recognition: The FASB and IASB are working together to create a common revenue recognition standard for US GAAP and IFRS. A final standard is expected to be released in the first half of 2013. If issued on time, we expect fiscal years beginning after December 15, 2014 to be the likely effective date for the new model. Generally speaking, we expect the proposed new standard to require managements to apply greater judgment in when and how revenue is recognized. Companies with long-term contracts and/or multi-element contracts would be among the companies that could see the timing of their revenue recognition change the most relative to current practice. See our July 23, 2012 presentation on jpmorganmarkets.com for more details on this project.
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Leases: We expect the FASB and IASB to release a second exposure draft on leases either during December 2012 or the first half of 2013. If this ED is successfully approved and issued as a final standard, we would expect fiscal years beginning after December 15, 2014 to be the likely effective date for the new model. This model would look to bring almost all leases (including operating leases) onto company balance sheets, yet lead to minimal disruption in how they are currently treated in the income statement. See our July 23, 2012 presentation on jpmorganmarkets.com for more details on this project. Insurance: The FASB and IASB are attempting to work together to conceive a new insurance accounting model. The work is ongoing. It is possible that an exposure draft could be issued during the first half of 2013. Given the complexity of this project, we have no visibility regarding if a joint solution can be achieved and when a hypothetical joint approach would possibly be enacted for use. The theme of global convergence in accounting standard setting seems to be decelerating. The U.S. Securities and Exchange Commission (SEC) was expected to announce a decision regarding whether the U.S. would move to IFRS since as early as 2011, but no decision has been made as of yet and the timing of such a decision is unclear. The FASB and IASB will likely pursue a less exclusive relationship on future projects beyond the Big Four projects mentioned above. The relationship between the two boards has taken some hits over the past several years and the boards have not always seen eye-to-eye on the approach or timing for many of the joint projects. At this point, we would be very surprised to see an announcement from the SEC that the U.S. will make a date-certain full conversion to IFRS as issued by the IASB. From our perspective, convergence will likely be a much slower, more deliberate process that will stretch over many years rather than some point in the immediate future.
Dane Mott is a member of the FASBs Investor Technical Advisory Committee and two IASB advisory committees: the Capital Markets Advisory Council and the Employee Benefit Working Group. Dane Mott is also a former member of the IASBs IFRS Advisory Council. JPMorgan Chase & Co. and its affiliates do not provide tax advice or advice on tax accounting matters. Accordingly, this material is not intended or written to be used, and cannot be used or relied upon, by any recipient in connection with promotion, marketing or a recommendation for the purpose of avoiding U.S. tax-related penalties. Each client should consult his/her personal tax and/or legal advisor to learn about any potential tax or other implications that may result from acting on a particular recommendation.
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Economics
The Outlook for the US Economy in 2013
Michael Feroli
(1-212) 834-5523 michael.e.feroli@jpmorgan.com JPMorgan Chase Bank NA
The expansion will soldier on in 2013, in spite of headwinds from fiscal policy Expected GDP growth of 2.0% would be similar to this years outcome Housing is increasingly the bright spot, while capex is a swing factor Inflation low and going lower will keep the Feds foot on the monetary gas pedal The year 2012 began much like 2011 and 2010: with high expectations that the economy was finally reaching escape velocity. And like the prior two years that enthusiasm gave way to a resignation that the recovery would be a long slog. Unlike the prior two years, though, as 2012 ends, there is not the same temptation to see an open road ahead. Instead, what appears on the horizon is a cliff: a sharp fall-off in fiscal support at the start of the new year. We anticipate that some, but far from all, of the austerity implied by the fiscal cliff will be realized next year, though the exact contours of an agreement remain the greatest source of uncertainty regarding the 2013 outlook. The fiscal cliff, an amalgam of tax and spending measures all expiring on January 1, is a political artifact, but eventual fiscal consolidation is not: trillion-dollar deficits did not materialize out of thin air, but rather resulted from efforts to soften the blow of the downturn and slow recovery. For this reason, it is difficult to separate the performance of the private sectorwhich has been registering modest but steady growth and exhibited signs of financial healingfrom the fiscal issues: the government support measures that may get trimmed were crucial to the convalescence of the private sector in the early stages of the recovery. We expect this support will be removed at a gradual enough pace to allow the economy to continue gradually recovering in 2013, with the sources of private sector growth undergoing rotation. Housing takes the baton Even with the gradual removal of fiscal policy support, we believe the private sector will continue to expand in the coming year, with housing taking a leading role. With household formation picking up and inventories of unsold houses shrinking, an acceleration in housing supply will be needed to keep pace with demand, and we anticipate that real residential investment will grow 19% next year, the fastest since the early 1980s. If this forecast is realizedand the recent housing data flow is consistent with this viewhousing could add around 0.5 percentage point to overall economic growth next year.
Figure 46: J.P. Morgan US Forecast
Real GDP Consumption Core PCE prices Unemployment rate (level) Nonfarm employment (Ch., 000s)
Source: BEA, BLS and J.P. Morgan.
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Exports
Housing got off to a slow start in this recovery but is now accelerating. Exports, in contrast, jumped out of the gate in 2009, but have since steadily decelerated, and more recently they have essentially stalled. J.P. Morgans global economic outlook anticipates some stabilization and modest firming in growth among the USs major export markets. However, the pace of growth is likely to remain subpar, thus limiting the degree to which the US can hitch its wagon to global growth. US manufacturers have become increasingly cost-competitive, particularly with respect to labor costs, and so talk of a manufacturing renaissance is not mere hype. But even cost-competitive producers need healthy markets to sell to, and foreign growth is unlikely to reaccelerate to the pace seen earlier in the expansion. The slowing in foreign demand may be one reason behind the biggest economic mystery of 2012: the sharp slowing in capital spending growth. Through the beginning of the year business capital spending had been growing briskly, and some moderation was expected as the early-cycle, catch-up spending became exhausted. What happened instead was a much sharper slowing than anticipated, with capex essentially flat since the first quarter. In addition to the slowing in foreign demand, uncertainty regarding the fisal cliff may be another factor restraining business spending decisions. In any event, both of these headwinds should become less severe as 2013 progresses, and so some pickup in corporate outlays seems likely. But real business spending growth at the 6.5% rate in our forecast versus the 2.7% we believe will be realized in 2012 results in about 0.5 percentage point of additional GDP growth in 2013, the difference between a year of respectable growth and another year of disappointment. Hiring steady, but wages have been weak The slowing in capital spending was an unwelcome development, but things could have been much worse had business caution also extended to their labor market behavior. Instead, private sector hiring has averaged 155,000 on average in the first 10 months of the year. Moreover, except for a little wobble in the late spring, the pace of expansion in labor market activity has been quite steady. Employment growth has been helped by relatively weak productivity growth, necessitating that businesses add more workers even to meet fairly slow increases in demand. With levels of investment spending still low, we expect productivity growth to remain muted in 2013 and employment to register gains of around 175,000 jobs per month, on average.
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Job growth has been steady in 2012, but wage gains have been soft. In the 12 months ending in October, average hourly earnings increased only 1.6%. Its not hard to see why: still-elevated unemployment rates have left workers little leverage to bargain for greater pay. This has been great for corporate profits, but has presented challenges for consumer spending. In spite of this, consumers have not wilted, and spending has more than kept pace with the meager real income gains. One source of support in this regard that we expect to persist into next year: rising house prices and declining debt burdens have helped to clean up the consumers balance sheet. Even with better balance sheets, we think the consumer will be challenged in the first half of next year. If fiscal support is removed, namely through the expiration of the payroll tax holiday, we see real consumer spending growth slumping to below 1% in the first half of next year. A second-half revivalas in our forecastis dependent on labor income firming. Low inflation and easy monetary policy Not only is the pace of wage gains central for the consumer outlook, but it is a critical determinant of the inflation picture. Through the early years of this expansion, global developments were putting upward pressure on domestic inflation, as import prices were running quite hot. In spite of this, overall consumer price inflation remained tame, thanks to depressed labor costs. More recently, import price inflation has cooled, while domestic labor costs have remained near all-time lows. The combination should not only keep a lid on inflation, but see it move even lower, to around 1.5%.
Figure 48: Income and Saving
% 6 5 4 3 2 2010 2011 2012 2013
Source: BEA and J.P. Morgan.
% ch, oy a 4 3 2
1 0 -1
Forecast Headline
Core
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Low inflation along with high unemployment and lingering downside risks to growth will keep the Fed firmly in accommodation mode. At the historic September FOMC meeting, the Fed not only introduced open-ended QE, but shifted its communications strategy to indicate that it will keep accommodation in place long after the recovery strengthens. We anticipate that the Fed will supplement the current open-ended MBS purchases with open-ended Treasury purchases, in part to fill in for the fall-off in purchases that would otherwise occur as Operation Twist is completed at year-end. These Treasury purchases are expected to have the same terminal condition as the MBS purchases: substantial improvement in the labor market. We interpret this to mean purchases will continue on into 1H14. The current forward guidance on overnight interest rates indicates that the FOMC does not expect an increase in the funds rate until at least mid-2015. We expect that by 2Q13 the guidance will be altered so that instead of specifying a calendar date, the Fed will communicate economic conditions that will need to be met before raising interest rates. This change in communications should further cement the view that rates wont be rising for a very long time: we think the first hike wont occur until late 2015, or possibly even later. The continued gentle posture of monetary policy should keep financial conditions supportive, helping to offset some of the drag imposed by fiscal policy.
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Equity Derivatives
Outlook for Macro Volatility and Correlations
Marko Kolanovic AC
(1-212) 272-1438 marko.kolanovic@jpmorgan.com
Amyn Bharwani
(1-212) 622-8030 amyn.x.bharwani@jpmorgan.com J.P. Morgan Securities LLC
Figure 50: In 2012, the highest level of the VIX was 1.5 times its average, and standard deviation was 2.7 points (inset table). This was the most benign volatility environment since 2006
60%
2009
2010
VIX
2011
50%
VIX
Greek Elections Euro Debt Concerns Short Sale Ban Spain Debt
40%
US Elections
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TVIX Collapse
Draghi Speech
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S&P 500 1M Realized Volatility Feb, 12 Apr, 12 Jun, 12 Aug, 12 Oct, 12 Dec, 12
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6M realized volatility of S&P 500 daily returns. The full fiscal cliff amounts to $700bn in 2013, or ~4.5% of GDP. The risks of a larger adjustment and adverse market reaction are substantial.
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Scratching below the surface of the low headline level of the VIX and S&P 500 realized volatility, one discovers a troubling picture of record-low volatility of individual stocks and very high levels of correlation between them. In fact, the average volatility of individual S&P 500 stocks is at 30-year lows.3 What appears to be a benign environment with moderate levels of the VIX is a result of an extreme regime of low stock volatility and high market correlations, both of which could prove very damaging for fundamental stock investors4 (Figure 52). This unique microstructure is a result of a downward spiral of low equity volumes, macro uncertainty, declining participation of fundamental stock investors, and fund outflows. Equity share volumes are currently near record lows. Historically, low equity volumes cause low equity volatility (and vice versa), which can help explain the decline in stock volatility (Figure 53). On the other hand, macro uncertainty and macro trading based on central bank policy typically drive Index and Index derivatives volumes higher (Futures, ETFs, Index options) and hence increase stock correlations (see Why We Have a Correlation Bubble, Rise of Cross-Asset Correlations). The record-low equity volumes in 2012 reflect even lower participation of active fundamental investors as ~55% of volume is executed by High Frequency Trading (HFT) programs and ~30% is traded in Exchange Traded Funds (ETFs). While there is a significant overlap between ETF and HFT participation, it is clear that a very small fraction of already low equity volumes are due to fundamental stock investors. HFT trading typically employs index arbitrage, statistical arbitrage and automated market making, and these strategies further increase correlation and sap stock volatility. As the spiral of high correlation and low stock volatility makes fundamental investing difficult, long/short stock investors walk away from the market, and equity investments flow into passive (indexation) strategies. In addition to the shift from active to passive or algorithmic strategies, funds further flow out of equities and into the fixed income space, buoyed by their perceived safety and central bank interventions. For instance, Investment Company Institute (ICI) data show that over the past four years, US equity funds recorded $400bn of outflows, while fixed income funds recorded $1,000bn of inflows.
On November 1, average 3M volatility of stocks in the S&P 500 reached 18%, the lowest level in over 30 years. 4 See Why We Have a Correlation Bubble.
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Figure 52: What appears to be a benign environment of moderate levels of the VIX is a result of record-low stock volatility and high correlations, both of which could prove damaging for fundamental stock investors
80% 70% 60% 50% 40% 30% 20% 10% 70% 60%
Figure 53: Equity share volumes are currently near record lows. Historically, low equity volumes cause low equity volatility (and vice versa)
30000
2000 1500
2400
NYSE Volume
Corr: 70%
Stock Correlation
25000
50% 40% 30% 20% 10% 0%
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2000
S&P 500 Volatility
500 0
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0%
20%
40%
60%
1600
15000
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1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Source: J.P. Morgan Equity Derivatives Strategy.
While political risk was the key driver of market performance and volatility, derivatives positioning often had a notable impact on intraday price action and volatility. On September 6 and 13, ECB and Fed announcements caused the market to gap up and a sharp drop in volatility. For several weeks before and after these announcements, the S&P 500 was range-bound around the 1400-1450 levels (Figure 54). Earlier in the year, when the market was ~1300, many investors sold call options at these levels as a part of overwriting or collaring strategies. This caused dealers to be long options (long gamma), and their hedging activity suppressed market realized volatility in August and September, around the 1400 and 1500 levels, in effect similar to a pinning (for details on the mechanics of option hedging impact see Market Impact of Derivatives Hedging). In November, market performance and volatility were dominated by the US election and concerns around the fiscal cliff. On November 7 the market dropped by 33 points after President Obama was re-elected (note that the size of the election move was almost exactly predicted by the S&P 500 term structure as we noted in Election Day Expected Move). During September and October, investors accumulated long put option positions below 1400, which made dealers short options (gamma) below 1400. As the market dropped below 1400, hedging of short option positions created a predictable end of the day momentum effect and subsequent reversal on November 7, 8, 9, and 13, increasing the daily market volatility (Figure 55). Short positioning in S&P 500 options and VIX products did not cause a large increase in market volatility in November. However, we believe there is still a significant overhang of short positions on S&P 500 options and VIX products that could increase volatility if the market drops and the VIX term structure inverts.
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Figure 54: ECB and FED announcements were key drivers of market performance and volatility in September. Hedging of long S&P 500 option positions suppressed volatility around 1400 and 1450 levels
Figure 55: US Elections were key drivers of market performance and volatility in November. Hedging of short S&P 500 option positions increased volatility below the 1400 level
The cost of owning option- and VIX-based hedges has been declining throughout the year.5 The decline in the cost of derivative protection is a result of investors scaling down hedges due to their poor performance, selling of premium to generate yield, overall low levels of equity exposure, and a larger risk complacency post ECB and Fed actions. Holding equity protection in 2012 was very expensive. This can be illustrated by a 70% annualized drop in the VXX just on account of term structure rolldown, and an average 30% loss on long option positions on account of low realized volatility (e.g., 1Y volatility averaged 20%, and realized was 14%). Given the high cost, demand for hedging waned (especially in the second half of the year). As central banks pushed real rates on bonds into negative territory, many investors started outright selling volatility to generate yield. The perception of lower systemic risk prompted investors to sell the volatility premium (e.g., overwriting, short variance strategies) and volatility term structure (e.g. VIX rolldown strategies). In order to forecast volatility in 2013, we start by estimating the likely macro environment and stability of high equity correlation. The European sovereign debt crisis, and more generally the debt problems of the developed world, should continue to be the main source of macro risk. Compared to a year ago, debt to GDP ratios for most of the developed world countries have increased. While the budget deficits have modestly declined, they are still significant (Figure 56). The uncertainty related to the debt crisis and low expected GDP growth rate6 should provide a floor to market volatility. At this point in time, it is not clear how the US fiscal cliff will be resolved, but we do know that it can have a significant implication on equity markets and the rating of US sovereign debt (e.g., large changes in capital gain, dividend, and small business tax rates can have a meaningful impact on stock market performance and volatility, see Impact of Tax Rates on Stock Market Returns).
The cost of option hedges is measured by the premium of implied volatility over realized volatility (Figure 51), and the cost of being long the VIX is measured by the steepness of the term structure. 6 Expected GDP growth for US: 1.7%, Europe 0.0%, Japan 0.0%, Asia-ex 6.5% (see Global Markets Outlook and Strategy).
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To compare the current VIX levels to macro fundamental risk, we have performed a simple quantitative exercise: we compiled a list of 484 macro indicators published by Bloomberg that have a significant correlation to the VIX index and regressed them against the current reading of the VIX. Results show that the current low VIX level is in stark contrast to virtually every macroeconomic indicator across the globe. These indicators include PMI, GDP, payroll and unemployment, housing, retail sales, consumption, inventory, business and consumer confidence, delinquencies, and other economic activity indicators. The 81 US macro series point to a VIX level on average 7.2 points higher, the 214 European indicators point to a VSTOXX level 9.7 points higher, and the 186 Asia economic indicators point to a VNKY level 8.9 points higher (Figure 57). While these results dont signal an imminent increase in the VIX, they do point to a large discrepancy between the market volatility and macro fundamentals. As we do not think that the macro environment will drastically change over the next year, we believe risk for market volatility is to the upside.
Figure 56: Debt and Deficit (as % of GDP) for 10 developed world countries with largest amount of debt outstanding
Country Japan USA Italy UK France Germany Spain Canada Belgium Netherlands Debt (% of GDP) Latest Year ago Change 214% 207% 7.5% 103% 99% 4.1% 126% 122% 4.4% 86% 83% 3.2% 91% 86% 5.0% 83% 81% 1.7% 76% 67% 9.3% 86% 84% 1.8% 103% 98% 4.9% 68% 64% 4.0% Deficit (% of GDP) 2012 2011 % Chg. -9.9% -9.5% 4% -8.3% -9.7% -15% -1.7% -3.8% -55% -7.7% -8.4% -8% -4.5% -5.2% -14% -0.9% -1.0% -11% -5.4% -8.5% -37% -3.5% -4.5% -24% -2.8% -3.9% -28% -4.3% -4.6% -7%
Figure 57: Based on the past 10 years of historical data, macroeconomic indicators across the globe unambiguously point to a higher level of the VIX
10Y Regression of VIX Against Macro Data # of Macro Indicators # point Volatility Cheap # point Volatility Rich Average Points Cheap Standard deviation
Next we focus on market correlations. Over the past 20 years, correlation between stocks showed not only a strong cyclical behavior but also a secular increase from levels of ~20% to the current average level of ~40% (see Why We Have a Correlation Bubble). In addition, the volatility of correlations has increased substantially (Figure 58). We believe that the prevailing macro uncertainty and structural drivers described earlier in this section will keep the average level of stock correlation high. Given the already record low levels of stock volatility, we believe S&P 500 volatility is likely to increase from current levels. Our 2013 forecast for average realized volatility is 16% (up from the current 14%) with a most likely range of 14-19%. We believe the VIX will trade at an average premium of 4 points over realized volatility, which is lower than 2012 average premium of 5 points. Figure 59 shows S&P 500 realized volatility (vertical axis) against average stock volatility (horizontal axis) over the past 20 years. The current level of stock and S&P 500 volatility is illustrated by a red dot. As stock volatility increases, S&P 500 volatility typically increases as well, and the rate of increase is determined by the level of correlation. During periods of low correlations, such as during the Tech Bubble in 2000, substantial increases in stock volatility led only to modest increases in S&P 500 volatility. However, in 2008 and especially 2011, the high level of correlation translated even small increases of stock volatility into significant increases of S&P 500 volatility. The still-high correlation environment leads to higher risk of a volatility spike going forward, in our view.
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Figure 58: Over the past 20 years, correlation between stocks experienced a secular increase from ~20% to the current average level of ~40%
70% 60% 50% 40% 30% 20% 10% 0% 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg.
Figure 59: S&P 500 realized volatility (vertical axis) vs. average stock volatility (horizontal axis). Current level is illustrated by a red dot. There are many different ways for volatility to increase
Stock Correlation
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2008 2011
Tech Bubble
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The risk to our view is that volatility stays at current low levels or decreases further. For volatility to decrease, we would need to see a meaningful decrease in stock correlations, which we think is unlikely. Even if HFT activity declines (as expected by Tabb Group), and index volumes decline, stock correlations would likely stay elevated. The reason for this is because HFT and index trading are essentially only a transmission mechanism and not the principal source of high correlation. The main source of high correlations is macro uncertainty and political risk that is driving the prices of all risky assets. This becomes obvious if one looks at the evolution of correlation of Equities to Interest Rates, Commodities, and Currencies (Figure 60).7 The correlation of equities to other asset classes has increased dramatically since 2008 as the price of risky assets became largely dependent on the resolution of sovereign debt problems, growth expectations, and monetary policy.
Cross-Asset Portfolios
Equity volatility and correlations are important inputs for the asset allocation process. The described macro and political risks are not only driving cross-asset correlations but also the relative performance of risky assets. Treasury bonds and gold reached record levels, as these assets were directly impacted by central bank actions (outright purchases, inflation hedges). For instance, Treasuries have added almost 10% of pure alpha annually since QE2 (Figure 61). As this outperformance is not based on economic fundamentals, medium term, it is expected to reverse and cause outperformance of equities relative to Treasuries and gold. Not only have equities underperformed these assets, but over the past year, equities have been less risky: volatility of the S&P 500 was 14%, 20Y Bond volatility was 15%, and volatility of gold was 17%. In addition, in the scenario of increased inflation expectations, equities are expected to outperform bonds. We believe that beyond the potential near-term equity weakness and increased volatility, medium term, inflows into equities should cause outperformance over bonds and gold and hence put a ceiling on equity volatility. Similarly, the implied volatility premium may come under pressure from fixed income investors searching for yield. Given the prospect
For a detailed review of cross-asset correlations see our report Rise of Cross-Asset Correlations.
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of negative real yields, they may engage in selling equity options and volatility, buying dividends, and other short equity risk premium trades.
Figure 60: Similar to correlation between stocks, correlation of stocks to other asset classes increased as a result of macro uncertainty and monetary policy responses
80% Commodity / Equity Currency / Equity 60% Rates / Equity
Figure 61: Treasury bonds and gold reached record levels as these assets are supported by central bank actions and investors fear of inflation. For instance, Treasuries have added almost 10% of pure alpha annually since QE2
180 160 140
40%
120 100
QEs
20%
0% 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 -20%
Source: J.P. Morgan Equity Derivatives Strategy.
Investors that are currently overweight bonds and gold can likely lower their risk by increasing allocation to stocks. Stocks should be chosen from the high-quality and low-volatility universe, and sectors resistant to inflation (Figure 62). To generate yield, investors can increase allocation to high dividend yielding stocks and overwrite positions by selling call options. Overwriting would not just increase yield but would also significantly cut the risk (e.g., selling at-the-money call option would reduce equity risk by ~50%). Given the medium-term risk of inflation, and what appear to be inflated prices of traditional relatively safe assets, we believe that these equity strategies may provide a more robust relative safe haven than investing in government bonds or gold. Despite modest levels of market volatility, we believe there is still a meaningful risk of a tail event in 2013. On the downside, triggers could be the failure to resolve the US fiscal cliff, leading to a debt downgrade and recession, rapid deterioration of the crisis in the Eurozone, or geopolitical escalation in the Middle East. On the upside, a tail event could result from a quick resolution of the US fiscal cliff, upside surprise in global growth, and start of bonds to stocks rotation. Given the high levels of correlation, cross-asset investors looking to hedge tail risk should compare the pricing of tail hedges in different asset classes. To assess the relative cost of tail risk hedges, we compared long-term historical probabilities (over ~100 years) of realized tail events vs. current option implied probabilities. In particular, Figure 63 shows the ratio of implied to realized tail event probabilities for the S&P 500, Gold, Japanese Yen and 10Y Treasury (for 1M, 3M, 6M, and 1Y time horizons and returns in a -40% to 40% range). Comparing the ratios of implied to realized tail event probabilities across asset classes, we note that in equities, upside tail protection looks cheap and downside tail protection looks the most expensive, compared to other asset classes. This is a result of the supply/demand imbalance for equity index options in which investors are typically buying put options to hedge and selling call options to generate yield or collar positions. Buying
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far out of the money S&P 500 calls or risk reversals (selling out of the money puts and buying calls) appear to be the cheapest upside tail hedges across-asset classes.
Figure 62: Exposure of sectors to increases in Inflation (CPI). Table shows Z-scores of the response to inflation (from 5 months before to 5 months after an increase in CPI). Positive values indicate sectors that may do well, and negative values indicate sectors that may do poorly in a high inflation environment
Sector Food Beverage & Tobacco Pharma Biotech & Life Sci. Food & Staples Retailing Utilities Health C. Equipment & Serv. Transportation Energy Household & Pers. Prod. Commercial & Prof. Serv. Telecomms Consumer Services Retailing Consumer Durable & App. Capital Goods Real Estate Semi & Semi Eqipment Materials Insurance Banks Div Financial Software & Services Tech Hardware & Eqipment Media Auto & Components -5 0.0 0.1 0.1 1.0 0.4 0.5 2.2 -0.1 -0.2 -0.7 -2.7 -2.0 -1.5 1.3 0.6 0.1 0.2 0.3 -1.1 -0.4 -1.0 -0.6 -1.2 -2.0 -4 0.3 0.2 0.8 1.1 0.6 0.3 2.1 0.1 0.2 -0.3 -2.1 -1.8 -1.6 0.9 0.3 0.0 0.1 0.1 -1.3 -1.1 -1.0 -0.5 -1.4 -1.8 -3 0.9 0.7 1.5 1.5 1.2 0.7 2.0 0.6 0.4 -0.5 -1.7 -1.6 -1.4 0.7 0.2 -0.5 0.2 0.0 -1.5 -1.4 -1.1 -1.1 -1.6 -1.7 -2 1.5 1.4 1.5 2.0 1.6 1.3 2.3 1.0 0.3 -0.7 -1.6 -1.2 -1.1 0.4 0.5 -0.6 0.3 -0.4 -1.4 -1.6 -1.4 -1.6 -1.4 -1.9 -1 1.9 1.6 1.1 1.9 1.5 0.9 1.8 1.0 -0.1 -0.8 -1.9 -1.2 -1.2 -0.1 0.1 -0.2 -0.4 -1.4 -1.1 -1.4 -0.9 -1.2 -1.4 -1.9 0 2.4 1.9 1.7 1.7 1.5 1.6 0.3 1.4 0.3 -0.1 -0.9 -0.7 -0.6 -0.2 -0.3 -0.5 -0.9 -1.3 -0.1 -0.7 -0.9 -1.3 -1.6 -2.0 +1 2.7 2.2 2.3 1.7 1.2 1.9 -0.1 1.9 1.1 0.4 0.1 -0.1 0.3 -0.3 -0.6 -0.5 -1.3 -0.7 0.7 -0.5 -1.3 -1.6 -1.7 -1.8 +2 2.7 2.4 2.5 1.5 0.9 1.6 0.0 1.5 1.8 0.3 0.6 0.3 0.7 -0.5 -0.5 -0.3 -1.1 -0.4 0.9 -0.4 -1.2 -1.5 -1.5 -1.8 +3 2.8 2.5 2.0 1.6 0.8 1.1 0.4 1.3 1.7 0.5 0.9 0.1 -0.2 -1.0 -1.0 -0.3 -0.7 -0.8 -0.3 -0.8 -0.9 -1.3 -1.5 -2.4 +4 2.9 2.5 2.1 1.6 1.2 0.8 0.1 1.2 1.7 0.6 1.1 0.6 -0.1 -1.7 -1.2 -0.2 -0.7 -1.2 -1.0 -0.9 -0.6 -1.1 -1.6 -3.0 +5 2.4 2.1 1.8 1.1 1.2 0.4 -0.2 0.8 1.6 0.4 0.9 1.0 0.1 -1.8 -1.1 -0.2 0.0 -0.9 -0.8 -0.2 -0.4 -1.2 -1.5 -2.8
Figure 63: Ratio of options implied to historical realized tail event probability in the S&P 500, Gold, JPY, and 10Y Treasury. Equity upside tail protection looks cheap and downside tail protection looks expensive
Ratio of Implied to Realized Tail Probability -40% -30% -20% -10% -5% S&P 500 1M 4.1 2.8 1.9 3M 4.6 3.0 2.4 1.9 6M 7.2 4.3 3.2 2.2 1.8 1Y 6.4 4.1 3.3 2.1 1.9 Average 6.8 4.3 3.4 2.3 1.8 GOLD 1M 4.8 1.4 1.2 3M 4.8 1.8 1.4 6M 3.5 1.8 1.4 1Y 4.1 2.7 1.7 1.5 Average 4.1 3.9 1.7 1.1 JPY 1M 1.9 0.5 3M 0.6 0.5 6M 0.7 0.5 0.7 1Y 0.8 1.1 0.6 0.7 Average 0.8 0.9 0.9 1.0 10Y Bond 1M 0.4 3M 0.8 6M 0.4 1.0 1Y 0.7 1.0 Average 0.5 0.8
Source: J.P. Morgan Equity Derivatives Strategy.
5% 0.6 0.6 0.6 0.6 0.5 0.8 0.9 0.8 0.8 0.7 1.1 0.9 1.0 1.2 1.9 0.4 0.5 0.6 0.7 0.6
10% 0.2 0.4 0.5 0.5 0.4 0.4 0.7 0.7 0.7 0.7
20%
30%
40%
0.2 0.2
0.4 0.4
56
Booster. In a sell-off, the maximum realized downside potential of a double-up booster is the net premium paid. In a rally, option losses are potentially unlimited as the investor is net short a call. When overlaid onto a long position in the underlying, upside losses are capped (as for a covered call), but downside losses are not. Collar. Locks in the amount that can be realized at maturity to a range defined by the put and call strike. If the collar is not costless, investors risk losing 100% of the premium paid. Since investors are selling a call option, they give up any price appreciation in the underlying above the strike price of the call option. Call Purchase. Options are a decaying asset, and investors risk losing 100% of the premium paid if the underlyings price is below the strike price of the call option. Put Purchase. Options are a decaying asset, and investors risk losing 100% of the premium paid if the underlyings price is above the strike price of the put option. Straddle or Strangle. The seller of a straddle or strangle is exposed to increases in the underlyings price above the call strike and declines in the underlyings price below the put strike. Since exposure on the upside is theoretically unlimited, investors who also own the underlying would have limited losses should the underlying rally. Covered writers are exposed to declines in the underlying position as well as any additional exposure should the underlying decline below the strike price of the put option. Having sold a covered call option, the investor gives up all appreciation in the underlying above the strike price of the call option. Put Spread. The buyer of a put spread risks losing 100% of the premium paid. The buyer of higher-ratio put spread has unlimited downside below the lower strike (down to zero), dependent on the number of lower-struck puts sold. The maximum gain is limited to the spread between the two put strikes, when the underlying is at the lower strike. Investors who own the underlying will have downside protection between the higher-strike put and the lower-strike put. However, should the underlyings price fall below the strike price of the lower-strike put, investors regain exposure to the underlying, and this exposure is multiplied by the number of puts sold. Call Spread. The buyer risks losing 100% of the premium paid. The gain is limited to the spread between the two strike prices. The seller of a call spread risks losing an amount equal to the spread between the two call strikes less the net premium received. By selling a covered call spread, the investor remains exposed to the downside of the underlying and gives up the spread between the two call strikes should the underlying rally. Butterfly Spread. A butterfly spread consists of two spreads established simultaneouslyone a bull spread and the other a bear spread. The resulting position is neutral, that is, the investor will profit if the underlying is stable. Butterfly spreads are established at a net debit. The maximum profit will occur at the middle strike price; the maximum loss is the net debit. Pricing Is Illustrative Only: Prices quoted in the above trade ideas are our estimate of current market levels, and are not indicative trading levels.
57
Introduction
AC
Dubravko Lakos-Bujas
The J.P. Morgan U.S. Best Ideas for 2013 Basket (JPUS2013 <Index> on Bloomberg) represents the portfolio of U.S. stocks that J.P. Morgan Equity Research Analysts have selected as their top long ideas for 2013.
Amyn Bharwani
(1-212) 622-8030 amyn.x.bharwani@jpmorgan.com J.P. Morgan Securities LLC
Bloomberg subscribers can use the ticker JPUS2013 to access tracking information on a basket created by the J.P. Morgan Delta One desk to leverage the theme discussed in this report. Over time, the performance of JPUS2013 could diverge from returns quoted in this report, because of differences in methodology. J.P. Morgan Research does not provide research coverage of this basket and investors should not expect continuous analysis or additional reports relating to it. For information on JPUS2013, please contact your J.P. Morgan salesperson or the Delta One Desk.
58
Transportation 3% Techn Hardware & Equip 3% Software & Services 7% Semi 5% Retailing 4% Real Estate 1% Pharma, Biotech 7% Media 3% Materials 7% Insurance 3%
Utilities 3%
Banks 1%
Capital Goods 6% Commercial & Prof Serv 4% C. Durables & Apparel 6% C. Services 11%
Diversified Financials 4% Energy 9% Food & Staples Retailing 1% Food Beverage & Tobacco 4%
59
Figure 65: Composition of the J.P. Morgan US Best Ideas for 2013 Basket JPUS2013 <Index>, as of December 6, 2012 (Close)
Ticker AAPL PFE ORCL BAC PEP V CMCSA SLB MCD EBAY GILD BA SU DUK TGT SBUX DHR LVS TXN COF PSX GG LYB PRU RAI ETN CBS MCK ISRG ALL BRCM CP WFM HSY PLD M CI A SLW MYL IVZ NLSN HOG OKE DAL CNX WYN PHM NWL DNR PWR URBN MWV ONXX FRC WCN RHI CREE HAR CRS EAT TOO GWRE CIEN DIN HTWR TXRH VRNT KBH EQM APEI NANO Name Apple Inc Pfizer Inc Oracle Corp Bank Of America Pepsico Inc Visa Inc-Class A Comcast Corp-A Schlumberger Ltd Mcdonalds Corp Ebay Inc Gilead Sciences Boeing Co/The Suncor Energy Duke Energy Corp Target Corp Starbucks Corp Danaher Corp Las Vegas Sands Texas Instrument Capital One Fina Phillips 66 Goldcorp Inc Lyondellbasell-A Prudentl Finl Reynolds America Eaton Corp Plc Cbs Corp-B Mckesson Corp Intuitive Surgic Allstate Corp Broadcom Corp-A Canadian Pacific Whole Foods Mkt Hershey Co/The Prologis Inc Macy's Inc Cigna Corp Agilent Tech Inc Silver Wheaton Mylan Inc Invesco Ltd Nielsen Holdings Harley-Davidson Oneok Inc Delta Air Li Consol Energy Pultegroup Inc New ell Rubbermai Denbury Resource Quanta Services Urban Outfitter Onyx Pharm First Republic B Waste Connection Robert Half Intl Cree Inc Harman Intl Carpenter Tech Brinker Intl Teekay Offshore Guidew ire Softw a Ciena Corp Dineequity Inc Heartw are Intern Texas Roadhous Verint Systems KB Home Eqt Midstream Pa American Public Nanometrics Inc Industry Group Analyst Wgt (%) 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.43% 1.24% 1.43% 1.43% 1.18% 1.43% 0.63% 0.82% 0.37% Technology Hardw are & Equipmen Mark A Moskow itz Pharmaceuticals, Biotechnology Softw are & Services Diversified Financials Food Beverage & Tobacco Softw are & Services Media Energy Consumer Services Softw are & Services Pharmaceuticals, Biotechnology Capital Goods Energy Utilities Retailing Consumer Services Capital Goods Consumer Services Semiconductors & Semiconductor Diversified Financials Energy Materials Materials Insurance Food Beverage & Tobacco Capital Goods Media Health Care Equipment & Servic Health Care Equipment & Servic Insurance Semiconductors & Semiconductor Transportation Food & Staples Retailing Food Beverage & Tobacco Real Estate Retailing Health Care Equipment & Servic Pharmaceuticals, Biotechnology Materials Pharmaceuticals, Biotechnology Diversified Financials Commercial & Professional Serv Automobiles & Components Utilities Transportation Energy Consumer Durables & Apparel Consumer Durables & Apparel Energy Capital Goods Retailing Pharmaceuticals, Biotechnology Banks Commercial & Professional Serv Commercial & Professional Serv Semiconductors & Semiconductor Consumer Durables & Apparel Materials Consumer Services Energy Softw are & Services Consumer Services Health Care Equipment & Servic Consumer Services Softw are & Services Consumer Durables & Apparel Energy Consumer Services Semiconductors & Semiconductor Christopher T Schott John Difucci Vivek Juneja John A Faucher Tien-Tsin Huang Philip Cusick J David Anderson John W Ivankoe Douglas Anmuth Geoffrey Meacham Joseph B Nadol Iii Katherine Lucas Minyard Christopher Turnure Christopher Horvers John W Ivankoe Charles Stephen Tusa Joseph R Greff Christopher Danely Richard Shane Jr Katherine Lucas Minyard John Bridges Jeffrey J Zekauskas Jimmy S Bhullar Rae Maile Ann Duignan Alexia S Quadrani Lisa C Gill Tycho W Peterson Matthew G Heimermann Harlan Sur Thomas R Wadew itz Kenneth Goldman Kenneth Goldman Michael W Mueller Matthew Boss Justin Lake Tycho W Peterson John Bridges Christopher T Schott Kenneth B Worthington Andrew C Steinerman Kevin Milota Jeremy Tonet Jamie N Baker John Bridges Joseph R Greff Michael Rehaut John A Faucher Joseph D Allman Scott Levine Brian J Tunick Phil M Gresh Cory William Kasimov Steven Alexopoulos Scott Levine Andrew C Steinerman Christopher Blansett Ryan Brinkman Michael F Gambardella John W Ivankoe Christopher G Combe Sterling Auty John W Ivankoe Michael N Weinstein John W Ivankoe Paul T Coster Michael Rehaut Jeremy Tonet Jeffrey Y Volshteyn Christopher Blansett Mkt. Cap ($M) $ 514,789 $ 188,556 $ 154,354 $ 112,685 $ 108,311 $ 100,625 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 98,079 94,921 88,440 67,276 55,922 55,787 50,212 45,191 40,479 40,237 36,761 36,100 33,411 33,313 31,897 30,059 29,852 24,526 24,001 23,917 22,817 22,362 20,668 19,844 18,815 17,348 16,914 16,306 16,090 15,384 15,009 13,259 12,429 11,130 10,999 10,467 10,449 8,935 8,522 7,553 6,956 6,289 6,281 5,987 5,686 5,393 5,330 5,151 4,341 4,105 4,028 3,802 2,713 2,514 2,212 2,080 1,598 1,567 1,148 1,148 1,139 1,101 1,093 1,044 643 346 3M ADV ($M) $ 11,606 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 756 732 1,655 366 436 448 418 547 533 589 358 132 237 260 475 207 310 274 233 222 188 239 198 96 213 250 136 184 157 245 68 139 61 93 209 124 141 156 126 77 35 97 45 97 105 65 219 65 97 50 84 29 89 21 24 45 51 27 21 40 10 19 53 6 16 12 6 92 3 4 2
60
Basket Performance
In this section, we examine the hypothetical performance of the J.P. Morgan U.S. Best Ideas for 2013 Basket over the last three years8. The J.P. Morgan U.S. Best Ideas for 2013 BasketJPUS2013 <Index>would have outperformed the S&P 500 Index over the past three years. The annualized return of the J.P. Morgan U.S. Best Ideas for 2013 Basket would have been ~11.6% (while the annualized S&P 500 Index return during the same time period was 8.0%). The correlation of the basket returns to the S&P 500 Index returns is 97%, and the recent 6M realized volatility of the basket is 14% (the realized volatility of the S&P 500 Index over the same time frame has been 13%). The figures below show the performance and volatility of the J.P. Morgan U.S. Best Ideas for 2013 Basket vs. that of the S&P 500 Index. The historical beta and correlation of the basket to the S&P 500 is also shown.
Figure 66: Performance of the J.P. Morgan U.S. Best Ideas for 2013 Basket and S&P 500 Index (Past Three Years)
150 Basket Daily Return (%) 140 130 120 110 100 90 Dec-09
JPUS2013 SPX
Figure 67: Daily Returns of the J.P. Morgan U.S. Best Ideas for 2013 Basket vs. S&P 500 Index Return
10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% R = 95%
Jun-10
Dec-10
Jun-11
Dec-11
Jun-12
Source: J.P. Morgan Derivatives & Quantitative Strategy, Bloomberg. Note: Past performance is not indicative of future returns.
Figure 68: 6M Realized Volatility of the J.P. Morgan U.S. Best Ideas for Figure 69: 6M Beta and 6M Correlation of the J.P. Morgan U.S. Best 2013 Basket vs. S&P 500 Index Ideas for 2013 Basket vs. S&P 500 Index
40% JPUS2013 6M Realized Vol. 35% 30% 25% 20% 15% 10% Jun-10 SPX 6M Realized Vol. 98% 1.3 97% 96% 95% 1.1 94% 93% Jun-10 6M Correl. With SPX(Left) 6M Beta vs. SPX(Right) Nov-10 Apr-11 Sep-11 Feb-12 Jul-12 1.0 Dec-12 1.2 99% 1.4
Nov-10
Apr-11
Sep-11
Feb-12
Jul-12
Dec-12
Source: J.P. Morgan Derivatives & Quantitative Strategy, Bloomberg. Note: Past performance is not indicative of future returns.
Source: J.P. Morgan Derivatives & Quantitative Strategy, Bloomberg. Note: Past performance is not indicative of future returns.
Not all stocks in the basket have three years of price history. In such cases, we have replaced the stock with an equivalent quantity of cash prior to its listing for the purpose of the back-test.
61
62
Quantitative Strategy
The Current Landscape and the Year Ahead
Dubravko Lakos-Bujas AC
(1-212) 622-3601 dubravko.lakos-bujas@jpmorgan.com J.P. Morgan Securities LLC
2012 has been yet again another year during which risk aversion has been the recurring theme. The Beta trade has been a value detractor, as low-Beta stocks have outperformed high-Beta stocks by 6.8% year to date. After a strong Beta rally early this year, the trade reversed and experienced significant loss especially in the second quarter, and since has more or less remained flat while exhibiting a lot of volatility. Beta has been a key driver of equity, and more broadly factor/style, returns. It has exhibited strong positive correlation with Value and negative correlation with Momentum, suggesting that any sort of Beta rally would be indicative of Value gaining and Momentum losing ground. In fact, the figure below illustrates a clear inverse relationship between Value and Momentum.
Figure 70: 2012 Cumulative L/S Factor Performance (Top Quintile Bottom Quintile) MSCI US
115 110 105 100 95 90 85 80 DIVIDEND YIELD VALUE GROWTH QUALITY PRICE MOMENTUM
30-Dec-11
30-Jan-12
31-May-12
30-Jun-12
31-Aug-12
The defensive trade has propelled Momentum into positive territory for the year, as investors have continued to prefer stocks with strong price resiliencea trend that was also observed last year. Given such market conditions, one would also have expected Quality and Dividend Yield to follow suit. However, that has not been the case this yearpossibly due to those trades running out of steam after a strong three-year run or possibly due to their valuations being overstretched. Also, in the case of Dividend Yield it is fair to argue that the market has already started pricing in a future hike in dividend tax rate, and consequently investors have started rotating away from stocks paying high dividends. While Value is still slightly negative for the year and has yet to see a positive year since the financial crisis, it is interesting to observe that for the last five months it has been treading steadily upwards. In the near term, there certainly is further room for Value to rally as the approaching year-end/rebalancing effects have often coincided with investors bottom fishing and starting from a clean slate. Further out, keeping in mind J.P. Morgans 2013 outlook, we see opportunity for Value to continue its recent rally and anticipate that Momentum might be up for a turbulent ride. Lastly, given the significant exposure of factors/styles to Beta, we urge investors to keep a close eye on managing their portfolios risk.
30-Sep-12
29-Feb-12
31-Mar-12
31-Oct-12
30-Apr-12
31-Jul-12
63
64
Capital Goods/Industrials
Christopher Sands
(1-212) 622-9224 christopher.sands@jpmorgan.com J.P. Morgan Securities LLC
Shailendra K Jain
(91-22) 6157-3325 shailendra.k.jain@jpmorgan.com J.P. Morgan India Private Limited Bloomberg JPMA NADOL <GO> Alliant Techsystems Inc. Boeing Company Bombardier CACI International Inc Comtech Telecommunications Embraer SA Exelis Inc. General Dynamics Corp. Harris Corporation Huntington Ingalls Industries L-3 Communications Lockheed Martin Northrop Grumman Precision Castparts Raytheon Rockwell Collins SAIC Spirit AeroSystems Textron TransDigm Group Inc United Technologies Wesco Aircraft Holdings, Inc. ATK BA BBDb.TO CACI CMTL ERJ XLS GD HRS HII LLL LMT NOC PCP RTN COL SAI SPR TXT TDG UTX WAIR OW OW N N OW* N N OW N N N N N OW OW OW OW N OW N OW OW
The commercial aerospace cycle remains upward pointing as Boeing and Airbus continue to implement a 35-40% production increase over 2011-2014, although we do see risks to it. We remain cautiously optimistic that it will remain intact in 2013, as air traffic is still growing, albeit unevenly, and each OEM has seven years of backlog. In addition, replacement demand now accommodates new aircraft that were intended for growth and may have been deferred in a different macro environment, but the high cost of fuel and low interest rates offer strong support. Nevertheless, risks include decelerating air traffic growth, changes in export credit-financing rules and weak cargo demand, which could pressure widebody production. We expect aftermarket demand to recover in 2H13 on easier comps, with potential for a further boost from higher capacity growth. While the same factors boosting replacement demand are hurting the aftermarket, we expect a recovery and an upcycle. Business jet demand should remain weak near term, as indicators do not yet point to a recovery; however, an eventual rebound could commence later in 2013. On the defense side, sequestration is set to take effect in just a few weeks, yet there is no more visibility into the long-term budget outlook than a year ago. We view sequestration as a symptom of the larger U.S. fiscal imbalance; as a result, we dont expect the ultimate outcome to prompt defense multiple re-rating unless it is accompanied by broader fiscal reform. Until the latter occurs, defense multiples likely will remain in the 8-10x range of the last few years as defense will continue to be vulnerable to future budget cuts. We expect the primes to post an average organic sales decline of 4% y/y in 2013, and believe top-line pressure will be exacerbated by 70bps of avg. y/y margin contraction (ex pension) as declining underlying margins and fewer positive EAC adjustments weigh on profitability. Cash flow should be more resilient due to favorable pension dynamics; this could be a source of support for stocks in an otherwise challenging environment. With likely continued budget uncertainty and deteriorating fundamentals, the stocks are likely to act defensively in 2013, outperforming in a weak market and underperforming in a strong market.
$73.98
$77.83
$66.82
Dec
$5.33
$5.05
$4.80
14.6
15.4
$55,787
* Rating as of December 10, 2012. Risks: Incremental problems with production ramp for 787, higher-than-expected commercial aero R&D, and recession or other macro shock that depresses demand for air travel and impairs planned increases in production rates. 65
Alexander K. Johnson
(1-212) 622-6513 alexander.k.johnson@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA WADEWITZ <GO> Thomas R. Wadewitz Arkansas Best C.H. Robinson Worldwide Canadian National Railway Canadian Pacific Railway Con-way CSX Expeditors FedEx Corp Genesee & Wyoming Heartland Express J.B. Hunt Transport Services, Inc. Kansas City Southern Knight Transportation, Inc. Landstar Norfolk Southern Old Dominion Quality Distribution Swift Transportation Union Pacific United Parcel Service UTi Worldwide Werner Enterprises YRC Worldwide Michael R. Weinz Hub Group Pacer International
In an environment of slow growth we expect the railroad group to be the bestperforming area among our transport coverage. Favorable industry structure and continued company focus on inflation plus pricing should help the railroads realize solid pricing gains even in a slow growth environment. We believe there will be room to differentiate among the railroads based on leverage to favorable growth in shipments of crude oil by rail and also leverage to the risk from a likely decline in export coal tonnage. In our view, UPS and FDX have greater sensitivity to the pace of economic growth compared to the railroads but we believe these two companies can deliver solid EPS growth in 2013 and growth in the B2C small package market provides support for overall volume performance. UPS and FDX also have potential company-specific drivers including the TNT acquisition for UPS and the operating improvement/ restructuring plan for FDX. We are broadly cautious on the most cyclical transport groups (truckload and less-than-truckload) in 2013 because we believe a deceleration in pricing performance is likely against a backdrop of slow growth in freight.
ABFS CHRW CNI CP CNW CSX EXPD FDX GWR HTLD JBHT KSU KNX LSTR NSC ODFL QLTY SWFT UNP UPS UTIW WERN YRCW
UW N UW OW UW N N OW OW N OW OW N OW N N N OW OW OW N N N
HUBG PACR
OW N
$100.19
$100.85
$61.23
Dec
$3.20
$4.31
$5.80
23.2
17.3
$17,348
66
We enter 2013 with a less defensive stance than our positioning earlier this year. With year four of the recovery getting booked, our overall view on the sector is that (1) the best stock performance typically comes in the first 2-3 years of an upturn when companies beat estimates by the most and (2) few companies deliver enough through-the-cycle, secular growth to make multiyear returns attractive if held through a recession. This said, we see a few reasons to be more constructive entering 2013. First, 2H12 has seen across-the-board weakness in end markets which has driven estimate cuts (2013 Street estimates down an average of ~5% since May) at the same time leading indicators like the PMI imply a bottoming of the recent inventory correction. We believe this makes Consensus numbers somewhat more achievable for next year, something we did not see as recently as three months ago. Second, we note widespread commentary around delays to capital projects which, if political uncertainty begins to clear in 2013, could come back on the board and drive upside to numbers in 2H13. To be sure, we do not expect robust growth on an absolute basis, but recently lowered expectations suggest potential for a short upward revision cycle, driving another 9-12 months of outperformance for the EE/MI group. On stock selection, we are deemphasizing some of the traditional stock-picking methods: early cycle/late cycle distinctions are generally becoming less meaningful, while a geographical bias toward the US (our preferred positioning entering the year) is now less clear-cut as overweighting North American construction markets looks like a Consensus view. Each name in our preferred group of stocks has a slightly different catalyst and investment thesis: DHR (relatively defensive, M&A), GE (late-cycle organic growth plus GE Capital wind-down), SPW (portfolio play) and ROK (clean leverage to improvement in capital spending).
$53.07
$57.15
$45.06
Dec
$2.86
$3.17
$3.50
16.7
15.2
$36,761
Downside risks relate to (1) longer-term organic growth concerns, (2) execution risk on past and future acquisitions, as well as (3) higher expectations on this stock versus the group.
67
Ankit Varmani
(1-212) 622-5654 ankit.x.varmani@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA LEVINE <GO> Babcock & Wilcox Co. Chicago Bridge & Iron Co. NV Eagle Materials Fluor Corp Foster Wheeler Jacobs Engineering KBR Martin Marietta Materials McDermott International Mistras Group Pike Electric Quanta Services, Inc. The Shaw Group, Inc TMS International URS Corporation Vulcan Materials BWC CBI EXP FLR FWLT JEC KBR MLM MDR MG PIKE PWR SHAW TMS URS VMC N OW N OW OW N OW NR OW OW N OW N OW N NR
Overall, the E&Cs have slightly underperformed the market in 2012 (+12% vs. +13% for the S&P 500), reflecting an uneven pace of award flow across the group, as a weak macro environment and lingering policy uncertainties (particularly in the US) have weighed on award flow across many end markets. Although these factors remain possible overhangs, we expect these headwinds to dissipate over the next year, as the policy lens clarifies with the 2012 election now behind us, while an improving global economy should spur an increase in customer confidence (and capex), assuming the commodity backdrop remains stable and constructive. We think growth prospects remain attractive across most energy verticals (both upstream and downstream), and while award flow could remain biased toward overseas markets (particularly emerging markets), the domestic energy story could gain momentum, fueled by demand for shale-related infrastructure. We also think Power markets should begin to strengthen (with T&D remaining our favored exposure within that market) and Government markets could improve once the Fiscal Cliff is resolved, with public infrastructure a particular bright spot (though Federal markets such as Defense and Environmental could remain more challenged). While trends appear to be improving on the margin, we expect award momentum to build gradually, with an improving demand/supply balance fueling only modest improvement in margins in 2013, as we expect competition to remain fairly intense across most verticals and geographies.
$25.70
$26.69
$19.74
Dec
$0.67
$1.37
$1.60
18.8
16.1
$5,686
68
Environmental Services
Expecting 2013 to Be a Better Year
Scott Levine AC
(1-212) 622-5609 scott.j.levine@jpmorgan.com
Ankit Varmani
(1-212) 622-5654 ankit.x.varmani@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA LEVINE <GO> Scott Levine Casella Waste Systems Inc. EnergySolutions Progressive Waste Solutions Ltd. Republic Services Inc Stericycle Inc. Waste Connections Waste Management Rodney C. Clayton Clean Harbors
N N N N OW OW UW
CLH
OW
We expect a generally stable backdrop for the waste companies in 2013, with fundamental trends remaining steady in solid and specialty waste, and the potential for a long-awaited volume uptick to materialize as the year progresses. In solid waste, executives have recently cited generally stable organic growth trends, and while a sustainable uptick has yet to materialize, several companies have cited early pockets of improvement in construction & deomolition (C&D), and recent improvement in private-market activity (particularly housing) suggests there could be a meaningful lift at some point next year. Despite the potential for improved volumes however, we remain somewhat cautious in the near term, as the reversal of bonus depreciation benefits could limit any prospects for improvement in cash flow (and capital returns) at the major solid waste companies next year. In specialty waste, we expect continued emphasis on a number of company-specific growth opportunities, many of which are driven by an evolving regulatory environment within several markets (including frack water handling, coal ash, pharmaceutical waste and nuclear remediation). We expect M&A to remain a viable growth driver for the group in 2013, as balance sheets remain healthy for several hazardous waste companies, and opportunities are plentiful. Energy waste streams (and related services) have been volatile this year, reflecting recent volatility in pricing, among other factors. That said, we expect any curtailments in energy-related development activity to be modest in North America, which should support a continuation of these revenue streams as growth and margin drivers for several companies, while discrete events (including storm response and remediation activity) could present an opportunity for companies that are well positioned to respond to such events.
$33.43
$33.94
$28.70
Dec
$1.48
$1.48
$1.86
22.6
18.0
$4,105
69
Machinery
Eaton Corp.
Ann Duignan AC
(1-212) 622-0381 ann.duignan@jpmorgan.com
Damien Fortune
(1-212) 622-2250 damien.r.fortune@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA DUIGNAN <GO> Actuant Corp AGCO Corp. Allison Transmission Holdings Caterpillar Inc. CNH Global Commercial Vehicle Group Cummins Inc Deere & Co. Eaton Corp. Illinois Tool Works Joy Global Kennametal Inc. Manitowoc Co. Modine Manufacturing Company Navistar Int'l Oshkosh Corp. PACCAR Inc. Parker Hannifin Terex Corp Westport Innovations Inc. ATU AGCO ALSN CAT CNH CVGI CMI DE ETN ITW JOY KMT MTW MOD NAV OSK PCAR PH TEX WPRT N N N N NR N N UW OW N N N N N N OW N N N N
Our coverage universe is up 11% YTD vs. the S&P 500 up 15%, as continued macro uncertainty both in the U.S. and ROW weighs heavily on investor sentiment. Despite the uncertainty, there are some positive catalysts emerging that could support the group into 2013, once the current uncertainty dissipates. Construction activity, driven primarily by the residential subsector, continues to be a bright spot. Total U.S. construction spend increased 1.4% to $872.1 billion in October, up 9.6% y/y and 16.9% from the February 11 trough of $746.1 billion; however, total spending remains well below recent-peak levels of $1.2 trillion in March 06. Non-residential spending was $297.9 billion in October, up 10.0% y/y and 31.3% from the January 11 trough of $226.8 billion, but remains sluggish. In addition, while the cost of Sandy is unknown, there are a few comparisons that can be made between this storm and Katrina, including statistics such as the 940-mile diameter for Sandy vs. 400 miles for Katrina and equivalent storm surges of 12.5 feet for Sandy vs. 14 feet for Katrina. What this data does not emphasize is the density of population in the Atlantic Northeast vs. the U.S Gulf: 60M people were impacted by Sandy vs. 15M for Katrina. As a result, we prefer companies that have U.S. construction exposure and in particular stocks that have company-specific catalysts. In our view, ETN fits both of these criteria and is our best idea for 2013: following the CBE acquisition it has ~25% exposure to U.S. construction and is likely to be re-rated as the combined entity should have lower earnings volatility going forward.
$51.40
$53.06
$36.38
Dec
$3.97
$4.04
$4.15
12.7
12.4
$23,917
70
Nishant Mani
(1-212) 622-5707 nishant.mani@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA COMBE <GO> GasLog Navios Maritime Acquisition Navios Maritime Holdings Navios Maritime Partners Teekay Offshore Partners Teekay Tankers GLOG NNA NM NMM TOO TNK OW N NR OW OW N
Shipping markets continue to work though fundamental oversupply issues challenges that are only amplified by an uncertain global demand outlook. These pressures continue to be reflected in relatively weak spot and period time charter rates in both the crude tanker and drybulk markets, for which supply/demand parity is not likely to emerge in 2013. While drybulk rates have risen materially in recent months aided by some degree of iron ore restocking, we anticipate a seasonal correction in Q1 with the reduced industrial activity that accompanies Lunar New Year holidays in Asia. Overall, we expect 2013 drybulk shipping demand growth of 4%, down from 5% in 2012, chiefly due to slower thermal coal imports (5% vs. 8% in 12) while Chinese iron ore import growth should be unchanged (6%, same as in 12). This demand growth outlook compares to expected fleet growth of 7% in 2013 with an orderbook representing c.24% of the current global fleet. That said, ongoing limited access to financing could spur cancellations and a speedier return to supply/demand parity. On paper, the net imbalance for crude tankers appears comparable with demand growth of 3% (down from 4%) and fleet growth of 4% (orderbook c.15% of fleet). However, the probability of upside surprise in demand is more limited than in drybulk markets, apart from the opaque and unpredictable efforts to build out the Chinese Strategic Petroleum Reserve. Furthermore, crude tankers face longer-term challenges to weaker physical and tonne-mile demand that may emerge as the U.S. weans itself off imports, with the IEA predicting domestic oil production greater than that of Saudi Arabia by 2020. However, this is likely to be offset partially by continued demand from U.S. refineries for the lighter, sweeter crude from West Africa as opposed to the heavier crude from domestic shale production. The smaller LNG and product tanker segments are relatively more attractive, particularly the former long term with Asian demand/reduced reliance on nuclear expected to drive a 7% CAGR through 2018 (but with risk to near/medium-term spot rates due to oversupply; accordingly, we prefer long-term chartered plays). With nominal supply/demand closer to parity, product tankers may see near/medium-term demand support from growing U.S. exports of naphtha to Asia, while longer-term tonne-mile demand growth may emerge from incremental Asian refining capacity.
$26.22
$30.14
$24.55
Dec
$1.56
$1.38*
$1.53*
19.0
17.1
$2,080
72
Airlines
Consumer
Joseph Abboud
(1-212) 622-7059 joseph.g.abboud@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA BAKER<GO> AerCap Holdings N.V. Air Lease Corp. Aircastle Limited Alaska Air Group, Inc. AMR Corp. Copa Holdings, S.A. Delta Air Lines, Inc. FLY Leasing Ltd. JetBlue Airways Corp. Southwest Airlines Co. United Continental Holdings, Inc. US Airways Group, Inc. AER AL AYR ALK AAMRQ CPA DAL FLY JBLU LUV UAL LCC OW OW N N NR N OW N OW N OW OW
2013 poised to be an opportune time for airlines Cost convergence, fare unbundling, widespread consolidation, diminished new entrant activity and return-oriented management teams have combined to form an industry that actually is managing itself for the first time we can recall. This stands in sharp contrast to the historical tendency to wage wars of attrition. As a result, we believe the industry will continue to take the steps necessary to ensure profitability and continued balance sheet repair. As such, we recommend investors focus on airlines stocks such as DAL. Q4 catalysts include Delta Investor Day, and possibly an AMR-LCC merger Demand trends arent expected to deviate meaningfully as the quarter wears on. Two catalysts have emerged on our close-in radar. Deltas mid-December investor day may prove an industry catalyst if the company indicates meaningful capacity revisions. And we continue to ascribe a likelihood of 75% (with bias to the upside) to an AMR-LCC merger, either in or outside of bankruptcy, and expect to receive clarity on that topic as year-end approaches. Couple these with still-depressed 2013E valuations and it is fairly apparent why our bullishness has failed to wane.
$10.02
$12.25
$7.83
Dec
$1.33
$1.80
$3.00
5.6
3.3
$8,522
73
Amy L. Carroll
(1-212) 622-1206 amy.l.carroll@jpmorgan.com
Samik Chatterjee
(1-212) 622-0798 samik.x.chatterjee@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA BRINKMAN <GO> American Axle Autoliv Inc. BorgWarner Inc. Dana Holding Corporation Delphi Automotive Ford Motor General Motors Gentex Corporation Harman International Johnson Controls Inc. Lear Corporation Magna International Inc. Meritor Inc. Tenneco Inc. Tower International TRW Automotive Visteon Corporation AXL ALV BWA DAN DLPH F GM GNTX HAR JCI LEA MGA MTOR TEN TOWR TRW VC UW OW OW N OW OW OW OW OW N N UW N OW UW OW N
We expect modest growth for the global automotive industry in 2013, characterized by strong demand in the United States and many emerging markets, but continued softness in Western Europe. We forecast a +2% y/y increase in global light vehicle production in 2013, after a +6% y/y increase in 2012, with a portion of the deceleration relating to absence of 2012 inventory replenishment following the 2011 tsunami in Japan. Performance is expected to vary widely by region, with growth in China (+9% vs. +6% in 2012), North America (+5% vs. +17% in 2012, on continued release of pent-up demand), South Asia (+5% vs. +21% in 2012) and South America (+5% vs. flat in 2012) helping offset contraction in Europe (-5% vs. -6% in 2012, on continued macro pressures) and Japan/Korea (-5% vs. +11% in 2012). While production growth is expected to moderate and Europe woes remain front and center in the minds of many investors, we believe the confluence of soft Western Europe demand with low valuation, healthy U.S. industry metrics (e.g., stronger sales, lower incentives and inventories that remain in check), strong BRIC nation demand and receding commodity prices (-6% y/y in 2013, presuming current prices hold) make for attractive entry points in multiple parts suppliers and OEMs. We recommend buying shares of both GM and Ford, and our top supplier picks are HAR, DLPH, TRW and TEN.
$39.99
$52.75
$34.08
Jun
$2.93
$3.60
$4.90
11.1
8.2
$2,713
Valuation: Our target price reflects 5.5x 2014E EBITDAP, a modest premium to the auto parts sector, although substantially lower than the 7.5x at which the shares have traded over time. Risks include: (1) HAR derives a disproportionate amount of revenues from Europe and (2) the costs of commodities, including rare earth metals, could rise faster than expected.
74
Beverages
Better, But Not That Much Better
John Faucher AC
(1-212) 622-6443 john.faucher@jpmorgan.com
Peter K. Grom
(1-212) 622-4876 peter.k.grom@jpmorgan.com
We remain cautious on the Beverages space heading into 2013, but expect we could be more optimistic as the year progresses. At this point, we would be more negative on beverages than on our HPC space, mostly due to a less favorable raw materials outlook, as ag costs are a headwind for 2013 while most of the packaging/ chemical materials are favorable (and HPC has less ag exposure). Many of the factors that contributed to our negative view on beverages are expected to persist as we head into 2013, including weak economies in Europe, input cost inflation, an FX headwind and earnings estimates that are likely too high. That said, in 2012 the vast majority of our beverage names have meaningfully underperformed the market, particularly Coke, Pepsi, Monster and BEAM, which we believe creates significantly less risk for 2013. We do point out, however, that several companies have seen valuations rise over the year, as stock price performance has outpaced EPS growth. PEP, KO, DPS, CCE, BF/B and COT all fall into this category. We expect guidance to remain relatively cautious as many of our companies report the fourth quarter and provide outlooks for 2013. We think the lack of visibility on European volumes is the greatest unknown, for both investors and the companies in the space, and we would expect that to be reflected in cautious guidance. We are currently below consensus on every single beverage name except for COT, for which we are in line with consensus for 2013E. As expectations are likely tempered in late January and February, we would expect the valuations to compress, as most names still trade at hefty premiums to the market. The annual CAGNY conference in February potentially could mark the beginning of a turn for the better, as companies can then focus on the ways that 2013 should be better than 2012, given the strength of headwinds should dissipate. FX will be less of a negative, as will raw materials, leading to acceleration in operating profit growth (and earnings growth). As investors begin to focus on acceleration in underlying earnings growth, instead of the negative revisions, we would expect the group could begin to perform better relative to the market. As we look forward in 2013, we think the focus will switch to sequential improvement in European trends, which could bode well for more international names like Coke, Pepsi, CCE, Monster, BEAM and Brown-Forman.
Sofya Tsinis
(1-212) 622-6391 sofya.s.tsinis@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA FAUCHER <GO> Beam Brown-Forman Corp Coca-Cola Co. Coca-Cola Enterprises Constellation Brands Cott Corp Dr Pepper Snapple Group Molson Coors Brewing Company Monster Beverage Corp. PepsiCo BEAM BFb KO CCE STZ COT DPS TAP MNST PEP N N N N N OW N N N OW
$70.02
$73.66
$62.15
Dec
$4.40
$4.05
$4.31
17.3
16.2
$108,311
75
Food Manufacturing
A Strong Equities Market Portends Underperformance in Packaged Food
Ken Goldman AC
(1-212) 622-0359 ken.goldman@jpmorgan.com
Priscilla Tsai
(1-212) 622-5331 priscilla.tsai@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA GOLDMAN <GO> Annie's, Inc. Campbell Soup Company ConAgra Foods Dean Foods General Mills H.J. Heinz Co. Hain Celestial Group Hershey Hillshire Brands J.M. Smucker Co. Kellogg Kraft Foods Group McCormick & Co., Inc. Mead Johnson Nutrition Mondelz International, Inc. Sanderson Farms, Inc. Smithfield Foods, Inc. TreeHouse Foods Inc. Tyson Foods WhiteWave Foods BNNY CPB CAG DF GIS HNZ HAIN HSY HSH SJM K KRFT MKC MJN MDLZ SAFM SFD THS TSN WWAV OW UW OW NR N N OW OW OW OW N N N OW OW N N N N OW
Packaged food stocks tend to underperform when the market is strong. Almost by definition, consumer staples stocks generally rise by a lower degree than the market when the market is rising at a quicker-than-usual pace. Given J.P. Morgan strategist Thomas Lees optimism about the S&P 500, we might expect investors to find better options elsewhere. We also think the space could be under pressure in general until the dividend tax issue is resolved in Washington, D.C. Packaged food volumes should be better in 2013 than 2012, but what about margins? We expect most traditional packaged food companies to experience lowto mid-single-digit cost inflation in 2013, around half the rate of increase in 2012 on average. This should lead to better volumes as less inflation is passed on to consumers and sticker shock is relatively muted. That said, we find it interesting to ponder which companies may actually pass inflation on via pricing and which may choose to preserve volumes and take a hit on margins. Protein stocks could have a good year, in our view. Stocks such as TSN and SFD have rebounded off their lows recently as earnings have come in better than anticipated. We think this trend may continue thanks to efficiency gains made by many protein companies as well as what could be a more normal year in terms of corn yields. Though it is too early to forecast confidently the size of the corn crop, we expect a very large acreage number as farmers try to take advantage of high prices. Our belief is that there is more downside than upside risk to corn.
$72.04
$73.42
$57.80
Dec
$2.83
$3.25
$3.65
22.2
19.7
$16,306
76
Food Retail
Stick with Whole Foods as Traffic Concerns Remain for Traditional Grocers
Ken Goldman AC
(1-212) 622-0359 ken.goldman@jpmorgan.com
Priscilla Tsai
(1-212) 622-5331 priscilla.tsai@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA GOLDMAN <GO> Kroger Roundy's Safeway SUPERVALU The Fresh Market Whole Foods Market KR RNDY SWY SVU TFM WFM N N N N N OW
Top-line concerns continue into 2013. We continue to view the food retail environment as challenged heading into 2013. As in 2012, traditional grocers are likely to continue their aggressive pricing strategies in an effort to fend off competition. In addition, while we see higher inflation next year helping ticket growth, we believe the grocers have limited ability to take pricing without experiencing an offsetting negative traffic/volume impact. However, we do see increased store closures as a continuing theme, which should help reduce some pressure in the industry for the stronger players. Commodity inflation could help the top line but impair margins. In 2012, for most traditional grocers the margin benefit from lower commodity costs was more than offset by increased promotional activities and aggressive pricing. In 2013, the competitive environment should continue as retailers struggle to stop volume losses, and commodities should once again be a headwind to margins. Our forecasts for food PPI suggest that inflation could be up nearly 3.7% next year vs. only +2.6% in 2012. Thus, our general outlook on margins is incrementally worse for the food retail space in 2013 vs. 2012 (though of course the top line could benefit, too, as costs are passed on to consumers, but only if traffic/volume do not erode by too much as a result). Specialty retailers should continue to outperform. We think traditional grocers will continue to lose market share to lower-priced alternative grocers as well as higher-end niche retailers. Specifically, in our coverage universe, specialty food retailers such as WFM and TFM continue to be well positioned fundamentally, in our view, and Trader Joes (private) should continue to gain share as well. These retailers have more pricing power than traditional grocers (and much less pricing competition), in our opinion, and should have more ability to take price without sacrificing volumes. Also, we believe the negative impact on margins from increased commodity costs will be more than offset by increased operating leverage as the top line continues to impress and new store growth accelerates.
$91.17
$99.67
$64.35
Sep
$2.52
$2.92
$3.43
31.2
26.6
$16,914
77
Gaming
LVS Remains Our Best Idea at Current Levels
Joseph Greff AC
(1-212) 622-0548 joseph.greff@jpmorgan.com
Jonathan Mohraz
(1-212) 622-1111 jonathan.mohraz@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA GREFF <GO> Joseph Greff Ameristar Casinos, Inc. Bally Technologies, Inc. Boyd Gaming Group International Game Technology Las Vegas Sands Corp. MGM Resorts International Penn National Pinnacle Entertainment Shuffle Master WMS Industries Wynn Resorts James Omstrom Melco Crown Entertainment Scientific Games Corporation
Overall, we remain encouraged by recent growth in Macaus mass table segment and see upside potential to expectations of 15% segment growth in 2013. Relative to growth prospects in other gaming markets (Las Vegas Strip, Singapore, other U.S. gaming markets), this growth rate is attractive. We believe this segment is an important driver for LVS overall, as approximately 40% of total property-level EBITDA company-wide is derived from this segment. While recent (3Q12) results from its property in Singapore and our forward outlook for limited growth there in the near term are disappointing (on lower gaming volumes related to sluggish VIP trends and lower domestic mass and slot volumes due to a government clampdown on local play), we believe current share price levels overlook the companys mass traction in Macau as well as a continued gradual ramp at Sands Cotai Central and the potential for upside to estimates related to the same.
N OW UW N OW OW OW OW N UW OW
ASCA BYI BYD IGT LVS MGM PENN PNK SHFL WMS WYNN
MPEL SGMS
OW* N
$43.84
$58.32
$32.61
Dec
$2.02
$2.15
$2.45
20.4
17.9
$36,100
78
William W. Wong
(1-212) 622-1442 william.w.wong@jpmorgan.com
We believe employment, household formation and consumer confidence should continue to trend positively over at least the next 12 months, which should drive housing demand growth at a moderate pace, supported by dramatically improved supply dynamics relative to the prior 2-3 years. Thus, given our outlook for housing industry fundamentals to continue to improve and still-reasonable valuations, in our view, we believe upside potential remains in the builders. We remain more selective across the Building Products sector largely due to valuation.
$16.28
$18.30
$5.54
Dec
($0.55)
$0.77
$0.98
21.1
16.6
$6,289
Risks include: (1) slower-than-expected order growth, which, given its above-average land supply, could result in impairment charges above our outlook and peer levels; (2) increased competition in its active-adult segment; and (3) incremental liability stemming from its mortgage putback exposure.
KBH Trading at 1.18x P/B (ex-adjusted FAS 109 charges), a 37% discount to its peers, KBH in our view has begun to execute solidly and is on its way to at least breakeven results in FY13; as a result, we continue to believe the company remains undervalued on a relative basis. Moreover, in FY13 we expect gross margin expansion, which has been a challenge for the company over the last 4-6 quarters, and hence represents a positive fundamental turn not currently reflected in the stock, in our view. Our Dec 13 price target of $18 is based on a target P/B multiple of 1.3x our 2013-end book value per share estimate (ex-adjusted FAS 109) of $13.19. We believe this is appropriate as investors begin to anticipate a return to more material book value growth in FY14 amid an inflationary environment for the housing market. Moreover, on an implied P/E basis against our 2016 earnings power analysis, it also represents a still-attractive valuation of 5.1x for KBH vs. an average of 7.9x for our universe.
KB Home (KBH) Overweight Dec 13 Price Target: $18
Price 12/6/2012 52-Wk Range High Low FY End Last (A) FY EPS Cur (E) P/E Next (E) Cur Next Mkt Cap (mil.)
$14.17
$17.30
$6.17
Nov
($2.32)
($0.80)
$0.06
N/M
236.2
$1,093
Risks include: (1) lower-than-expected gross margins, driven by continued underperforming communities and negative fixed-cost leverage; (2) weaker-than-expected order growth in key markets of CA and TX; and (3) further difficulties arising from the company's transition to new mortgage partner, resulting in above-average cancellations.
79
Sofya Tsinis
(1-212) 622-6391 sofya.s.tsinis@jpmorgan.com
Peter K. Grom
(1-212) 622-4876 peter.k.grom@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA FAUCHER <GO> John Faucher Church & Dwight Clorox Colgate-Palmolive Energizer Holdings Estee Lauder Kimberly-Clark Newell Rubbermaid Inc. Nu Skin Enterprises Procter & Gamble SodaStream International Weight Watchers International Sofya Tsinis Tupperware Brands
We remain cautious on the HPC space heading into 2013, but expect we could be more optimistic as the year progresses. At this point, we would be less negative on HPC than beverages, mostly due to a more favorable raw materials outlook, as ag costs are a headwind for beverages in 2013 while most of the packaging/chemical materials are favorable (and HPC has more packaging/chemical exposure). From a geographical perspective, we expect trends to remain subdued in the developed world, particularly in Europe, with the developing markets driving the growth for the group. HPC names generally have greater exposure to the developing markets. Similar to beverage companies, HPC companies are likely to provide fairly cautious outlooks for 2013, given a weak macro backdrop. However, we think 2013 will not be as bad as 2012 for the HPC group and expect reported EPS growth to accelerate, as raw materials and FX should be less of a headwind. While pricing is likely to decelerate, we think volumes will pick up, with top-line trends being fairly similar to those in 2012. Although the HPC group has underperformed the market year to date, the stocks are not particularly inexpensive, with many of the valuations ahead of recent historical averages both on an absolute basis and relative to the market. As relative valuations likely come in during Q4/early Q1, the group in our view could be more attractive heading into CAGNY, as the focus likely will shift to the expected improvement in bottom-line performance.
N N N OW N N OW OW OW OW N
Our best idea for 2013 is Newell, given we think the companys valuation should move up as its top- and bottom-line trends accelerate. Over the past several years, NWL has been turning into a better consumer-oriented company. It is in the process of implementing a multiyear restructuring effort that should help accelerate its organic top-line growth by ~1% and EPS growth by ~2% to 8% in 2013E. Although management has been able to rein in expectations by indicating it will reinvest the majority of the savings from Project Renewal (the restructuring program, which was tripled in Q3) into the win bigger businesses and geographies, we believe this program also gives the company more flexibility to deliver upside on the bottom line in 2013 and beyond. The company is also well positioned to benefit from an improvement in the macro backdrop, as some of its businesses (i.e., office products and professional) are more cyclical in nature. The stock is trading ~12x consensus NTM estimates, which represents a 13% discount to its SMid-cap HPC peers. Given a rising payout ratio (the company just raised the dividend by 50%), lower debt and greater EPS visibility for NWL, its multiple should continue to move up, in our opinion.
Newell Rubbermaid Inc. (NWL) Overweight Dec 13 Price Target: $24
Price 12/6/2012 52-Wk Range High Low FY End Last (A) FY EPS Cur (E) P/E Next (E) Cur Next Mkt Cap (mil.)
$21.78
$22.00
$14.64
Dec
$1.59
$1.69
$1.82
12.9
12.0
$6,281
80
Leisure
Rolling into FY13 with a Full Tank
Kevin Milota AC
(1-212) 622-0987 kevin.milota@jpmorgan.com J.P. Morgan Securities LLC Avis Budget Group, Inc. Carnival Corporation Harley-Davidson Hertz Global Holdings, Inc. Royal Caribbean Cruises Ryman Hospitality Properties CAR CCL HOG HTZ RCL RHP NR N OW NR N N
We remain positive on the Leisure sector heading into 2013, as we believe the consumer continues to strengthen (in line with Tom Lees view), bolstered by easing lending standards, wealth effect driven by higher home prices and equity markets, and steady progress in the labor markets. All of these factors make us constructive on the consumer, which ultimately should translate into a more robust operating environment for motorcycle sales, and consumer demand for cruising.
$46.18
$54.32
$36.06
Dec
$2.33
$2.70
$3.40
17.1
13.6
$10,449
81
Lodging
WYN Remains Our Best Idea at Current Levels
Joseph Greff AC
(1-212) 622-0548 joseph.greff@jpmorgan.com
Kevin Milota
(1-212) 622-0987 kevin.milota@jpmorgan.com
Jonathan Mohraz
(1-212) 622-1111 jonathan.mohraz@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA GREFF <GO> Joseph Greff Chesapeake Lodging Trust Choice Hotels International FelCor Lodging Trust Host Hotels & Resorts Inc. Hyatt Hotels Corporation LaSalle Hotel Properties Marriott International Orient-Express Hotels Starwood Hotels & Resorts Worldwide Sunstone Hotel Investors Inc. Wyndham Worldwide Kevin Milota Avis Budget Group, Inc. Carnival Corporation Harley-Davidson Hertz Global Holdings, Inc. Royal Caribbean Cruises Ryman Hospitality Properties Jonathan Mohraz Strategic Hotels & Resorts
CHSP CHH FCH HST H LHO MAR OEH HOT SHO WYN
N UW N N OW N N N OW N OW
Recent RevPAR growth has decelerated, globally, much more than we had anticipated before the start of 3Q12 earnings. This has been driven by (1) calendar comparison issues (U.S. election, Halloween, holiday timing), (2) adverse FX, (3) generally tough comparisons and (4) slowing near-term global economic activity and worldwide uncertainties (the U.S. fiscal cliff being the most pressing one at the moment). Following the 3Q12 earnings season which ended in early November, we had lowered 4Q12 and 2013 RevPAR and operating earnings estimates to account for slowing growth. 4Q12 should be messy on weather/storms (Hurricane Sandy, noreaster)events that generally took place after earnings season. Indeed, certain lodging companies have provided weather-related impacts (modest for the most part), which we believe most investors will look through, given the one-time nature of the impact. For next year, we are forecasting RevPAR growth of 4%-5%, approximately 100-150bps lower than just three months ago. We are generally positive on the longer-term demand/supply equation, given low supply growth in the U.S. for the next few years, room rate upside relative to rates at the prior cycles peak, and point to secular unit growth opportunities internationally.
NR N OW NR N N
BEE
OW
$49.59
$55.41
$34.07
Dec
$2.49
$3.22
$3.60
15.4
13.8
$6,956
82
Best Ideas Brinker International (EAT), DineEquity Inc. (DIN), Texas Roadhouse (TXRH)
We like EAT for announced sales/margin drivers with valuation below peers. Based on low/mid-teens EPS growth, with the model transitioning from comp and margin driving capex in F12/13 to being more FCF-driven in F14/15, we think Brinker deserves to trade at 14x. Current valuation is attractive at 11.3x C14E EPS vs. 12-14x for peers (ex-DRI at 10.5x). All in all, we believe the stocks reaction following 2Q outlook from management is overdone and the current level of ~$30 provides an attractive entry point for a company we believe will be a sales/margin outperformer in a difficult 2013 consumer environment. Our Dec 13 price target of $38 assumes 14x C14E EPS.
OW OW N N OW OW N
Shaurja Ray
(1-212) 622-2039 shaurja.ray@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA IVANKOE <GO> Bloomin' Brands Brinker International Chipotle Mexican Grill, Inc. Darden Restaurants DineEquity Inc. Texas Roadhouse Inc. The Cheesecake Factory, Inc. BLMN EAT CMG DRI DIN TXRH CAKE
Prefer DIN for financial engineering opportunity allowed by fully franchised model. With all Applebees refranchising transactions now completed, the company will operate under a model that is capex light without much need for operating leverage to support both a high amount of sustained debt and produce well-aboveaverage FCF yield to equity holders by the end of F13. We now assume the expensive $760M of 9.5% bondscallable in October 2014 at 104.75%get refinanced in 4Q14 at a 6% interest rate allowing for $20-25M of interest expense savings (a 5% interest rate would represent close to $30M in savings) and a F15E FCF yield of 14%. Our Dec 13 price target of $73 reflects a 15% discount on 13.5x F15E normalized EPS of $6.21. We like TXRH for high-quality top-line growth matched with potential margin opportunities. The company has industry-leading square footage development of 9%, inherent comp drivers from strong operations and menu positioning but also many potential levers for management to pull as well as margin savingsopex in near term and labor a long-term opportunityand a debt-free balance sheet. On F12E the stock trades at 16.1xa NTM multiple normally granted to 15%-plus restaurant earnings growthbasically implying no earnings growth in F13. Focusing on F14, we believe TXRH remains a very good stock to own in casual dining; our Dec 13 target of $21 assumes a multiple of 17x C14E EPS of $1.25. Risks Key downside risks relate to sustained negative industry traffic due to macro trends which would negatively affect comps across casual dining.
Brinker International (EAT) Overweight Dec 13 Price Target: $38
Price 12/6/2012 52-Wk Range High Low FY End Last (A) FY EPS Cur (E) P/E Next (E) Cur Next Mkt Cap (mil.)
$30.25
$36.24
$23.40
Jun
$1.96
$2.25
$2.55
13.4
11.9
$2,212
$62.30
$64.94
$40.28
Dec
$4.10
$4.00
$4.04
15.6
15.4
$1,148
$16.13
$19.35
$13.88
Dec
$0.88
$1.00
$1.10
16.1
14.7
$1,139
83
Restaurants QSR
Top QSR Picks for 2013 Are Starbucks and McDonalds on Attractive Valuation
John Ivankoe AC
(1-212) 622-6487 john.ivankoe@jpmorgan.com
Shaurja Ray
(1-212) 622-2039 shaurja.ray@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA IVANKOE <GO> Arcos Dorados Holdings, Inc. Domino's Pizza Inc Dunkin' Brands McDonald's Starbucks Sysco Corporation The Wendy's Company Tim Hortons Inc. Yum Brands ARCO DPZ DNKN MCD SBUX SYY WEN THI.TO YUM N N N OW OW N N N OW
$53.70
$62.00
$42.67
Sep
$1.79
$2.11
$2.55
25.5
21.1
$40,237
$88.09
$102.22
$83.31
Dec
$5.27
$5.33
$5.78
16.5
15.2
$88,440
84
In the current volatile macroeconomic backdrop, we recommend a selective approach focusing on core fundamental drivers, competitive forces and valuation ranges. Three notable themes out of 3Q EPS: (1) Online strength across the board (except JCP) with multi-channel initiatives the next leg of opportunity; (2) Balanced Holiday commentary (largely December weighted given hurricane headwind in November) with continuing macro caution (fiscal cliff concerns); (3) Inventory in line with average inventory/sq ft growth of 5.7% (except JCP), which we believe bodes well for margins (despite a fierce promotional backdrop) heading into Holiday. Company-specific drivers: M Online lift of 2.2% in 3Q (vs. 1.7% in 2Q) with 292 stores fully integrated (4Q driver); GPM an upside surprise (+11bps) with underlying core strength. KSS GPM a moving target (4Q: down 80-120bps) with company speaking to opportunity ahead; testing ship from store for online (potential Holiday 13 driver). JCP 3Q SSS worse (-26.1%) with shop performance encouraging (eight shops running at $239/sq ft 3Q annualized); long-term model change worth noting. JWN Online sales (+38%) impressive cycling free shipping/returns (+33% last year) with Retail SG&A remaining the primary pushback (29bps leverage vs. guidance of 55-75bps). DDS Top-line strength (+5%) in 3Q with inventory (flat y/y) boding well for continued GPM expansion. SKS Sequential comp improvement in 3Q (October higher than 3Qs 3.3%) notable with 4Q guidance assuming a sequential SSS deceleration (ex hurricane); GPM a watch factor. Bosss Broadlines Barometer: Winners and losers present opportunity. Across the Broadlines/Apparel & Footwear sectors, we recommend market share leaders with 2013 drivers in place: Macys (Omnichannel top line/GPM, capital allocation), VFC (top brand portfolio, capital allocation) and DLTR (3.0% long-term structural core SSS build, improving new store productivity). Conversely, we remain Underweight BIG given substantial risk to 2013 top- and bottom-line (margin) assumptions with the recent CMO and CEO departures raising leadership risk.
Anne McCormick
(1-212) 622-4163 anne.e.mccormick@jpmorgan.com
Michael J. Joyce
(1-212) 622-2725 michael.j.joyce@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA BOSS <GO> Big Lots, Inc. Dillard's, Inc. Dollar General Corp. Dollar Tree, Inc. Family Dollar Stores, Inc. J.C. Penney Co., Inc. Kohl's Corp. Macy's, Inc. Nordstrom, Inc. PVH Corp. Ralph Lauren Corporation Saks, Inc. The Warnaco Group, Inc. V.F. Corporation BIG DDS DG DLTR FDO JCP KSS M JWN PVH RL SKS WRC VFC UW N N OW OW N N OW N NR N OW NR OW
$38.92
$42.17
$30.42
Jan
$2.88
$3.42
$3.90
11.4
10.0
$15,384
85
Retailing Hardlines/Discounters
Target: Near-Term Catalysts Bridge Longer-Term Earnings Story
Christopher Horvers AC
(1-212) 622-1316 christopher.horvers@jpmorgan.com
Rachel Stubins
(1-212) 622-4245 rachel.stubins@jpmorgan.com
Mark A. Becks
(1-212) 622-5265 mark.a.becks@jpmorgan.com
Leslie Elder
(1-212) 622-3730 leslie.m.elder@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA HORVERS<GO> Advance Auto Parts, Inc. AutoZone, Inc. Bed Bath & Beyond Best Buy Costco Wholesale Corporation Dick's Sporting Goods Genuine Parts Company GNC Holdings hhgregg Lowe's Companies, Inc. O'Reilly Automotive Office Depot OfficeMax Inc. PetSmart, Inc. RadioShack Staples Target Corporation The Home Depot Tractor Supply Vitamin Shoppe, Inc Wal-Mart Stores, Inc. Williams-Sonoma, Inc. AAP AZO BBBY BBY COST DKS GPC GNC HGG LOW ORLY ODP OMX PETM RSH SPLS TGT HD TSCO VSI WMT WSM N OW N NR OW OW N OW N N N OW N N N OW OW OW OW OW OW N
As 2012 draws to a close, we approach 2013 with caution. After many fits and starts since the recession, retailers appear to have found a new normal, returning to largely stable trends, albeit lower than pre-crisis levels. We expect the upturn in housing to continue to be a bright spot in 2013, which has positive implications for HD and LOW and then the rest of retail on a lagged basis. Outside of the housing tailwind, we expect the consumer to retrench after Christmas and remain challenged in 1H13 given lackluster wage gains and the falloff in fiscal support. We favor names that are both offensive and defensive for their ability to weather tough times while having exposure to gains in discretionary spending; these include AZO, COST, TGT, TSCO and the nutrition space. The consumer tends to spend in line with wage growth, with credit and taxes levering spending up and down. While credit is improving, the tax situation is tough with most believing rates will rise and the payroll tax holiday expire (with the latter representing two points of increased taxes to all consumers, suggesting a greater hit to the low-end consumer).
$62.20
$65.80
$47.25
Jan
$4.26
$4.40
$4.80
14.1
13.0
$40,479
86
Retailing Specialty
Beyond Cotton . . . Looking for EPS Acceleration Stories in 2013
Brian Tunick AC
(1-212) 622-6449 brian.tunick@jpmorgan.com
Simeon Siegel
(1-212) 622-0149 simeon.siegel@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA TUNICK <GO> Brian Tunick Abercrombie & Fitch Aeropostale American Eagle Outfitters ANN Inc Ascena Retail Group Inc Chico's FAS, Inc. Coach, Inc Francesca's Holdings Corp JoS. A. Bank Clothiers Inc Limited Brands, Inc. Men's Wearhouse Michael Kors Ross Stores rue21, inc. The Buckle Inc. The Children's Place The Gap, Inc. Tiffany & Co TJX Companies Tumi Holdings Inc Ulta Salon, Cosmetics & Fragrance, Inc. Urban Outfitters Simeon Siegel Express Inc. Zumiez Inc.
ANF ARO AEO ANN ASNA CHS COH FRAN JOSB LTD MW KORS ROST RUE BKE PLCE GPS TIF TJX TUMI ULTA URBN
N N N N N OW OW N N OW OW OW N OW N N N N N N OW OW
Looking across the sector, we expect 40% of the companies in our coverage universe to enter 2013 with record-high EBIT margins; 70% should have EBIT margins above the five-year average. When we consider a normal consumer environment into 2013 (and the lapping of a very strong Spring selling season), less of a tailwind from normalization of sourcing costs, and inventory improvement, it is harder for us to envision EPS growth acceleration for many of our names in 2013 compared to 2012. In addition, short interest for many of the names has declined 40-50% over the past year, taking away another potential catalyst for the group. Overall, the group is trading at 14x P/E and 6.5x EV/EBITDA on 2013 estimates, slightly above the fiveand ten-year averages.
EXPR ZUMZ
N N
$36.97
$40.65
$23.42
Jan
$1.19
$1.58
$1.88
23.4
19.7
$5,393
87
Tobacco
Consistent Delivery
Rae Maile AC
(44-20) 7134-9738 rae.maile@jpmorgan.com J.P. Morgan Securities plc Bloomberg JPMA MAILE <GO> Altria Group Lorillard Inc Philip Morris International Reynolds American MO LO PM RAI OW N N OW
The tobacco sector continues to offer scope for material, consistent profit growth over the medium term but is modestly valued by the stock market, we believe, given both the quantum and quality of that growth. In our view each of the companies in the sector, domestically and globally, has a clear desire to deliver sustainable shareholder value. Sustainable profit growth and prodigious cash generation are used to power earnings and dividend growth, with all of the cash generated being returned to shareholders through a combination of dividend and share repurchases. Pricing remains the key driver of industry profitability, with the industry benefiting from higher rates of tax and duty which mask underlying manufacturers pricing decisions. With duty approximating 65% of retail prices, a manufacturers price increase of 5% implies a retail price increase of only around 2%. With the major manufacturers focusing on product innovation, in packaging, filters, slims and superslims, blends, etc., price has become a much reduced source of competition. It is fair to say that pricing in the U.S. domestic market has been somewhat pedestrian in 2012, but in our view this was a result of the philosophy of the former CEO of Altria, and under new leadership we expect to see firmer pricing in 2013. For Philip Morris International the prospects remain good, with the CEO recently having suggested that the company remains confident in delivering once again on its medium-term guidance of 10-12% EPS growth on a constant-currency basis in 2013. Although Southern Europe is likely to remain weak in volume terms in 2013, profits for the broader region are expected to grow modestly, while the companys exposure to emerging markets is expected to deliver substantially faster growth. EPS growth remains well underpinned by the companys share repurchase programme, which has already retired one-quarter of the equity that was outstanding at the time of the companys listing in March 2008.
$42.94
$46.93
$38.95
Dec
$2.81
$2.97
$3.22
14.5
13.3
$24,001
88
Electric Utilities
Energy
Nazia Sheikh
(91-22) 6157-3272 nazia.x.sheikh@jpmorgan.com J.P. Morgan India Private Limited American Electric Power Black Hills Corp. Dominion Resources Duke Energy Corp. Entergy Corp. Exelon Corp. Great Plains Energy ITC Holdings NextEra Energy Inc. Pepco Holdings PG&E Corp. Portland General Electric Co. Sempra Energy UIL Holdings Corporation Westar Energy Inc Xcel Energy AEP BKH D DUK ETR EXC GXP ITC NEE POM PCG POR SRE UIL WR XEL N OW N OW NR N OW NR OW N N OW N N N N
After a rough year for U.S. Electric Utilities we still do not find valuation attractive and see several headwinds continuing to weigh on the group through at least 1H13. Against the backdrop of J.P. Morgan Equity Strategy teams constructive market view and expectation for multiple expansion in 2013, we believe utilities are too expensive given their lackluster earnings growth rate. Fundamental headwinds are likely to persist as well, including the overhang of dividend tax uncertainty, weak load growth driven by energy-efficiency initiatives, reduced cost-cutting headroom and the potential for slowing load-induced capex curtailments, in our opinion. There are select value opportunities on a company-by-company basis, and wholesaleexposed names appear modestly more attractive going into next year, but we remain on the sidelines for the regulated utility group as a whole. Valuation still not compelling despite underperformance. The UTY index total return has lagged the S&P 500 by 15% YTD after a strong calendar year 2011. However, at 14.5x 2013E EPS the group is still rich by both historical standards and versus the broader market. Expected earnings growth in 2014 averages 4.9% and has been shrinking over the course of the year as load growth estimates weaken. Fundamental headwinds growing. Changes to the dividend tax structure are already weighing on investors minds and we see the issue as an overhang into next year. On the operations side, efficiency- and economic conservationrelated load growth weakness has a strong chance of persisting into 2013, in our opinion. Meanwhile, aggressive cost-cutting measures this year have exhausted low-hanging fruit, reducing the effectiveness of this lever in the near term. We also see the weakening load trend as potentially weighing on transmission and distribution capex, eventually translating into another bottom-line headwind for the group. Defensive market posturing could drive near-term outperformance, but we would not expect it to be long-lived. Utilities had pockets of strength in 2012 and negative investor sentiment could provide a measure of near-term outperformance amid 1H13 GDP concerns. As it did this year, however, we would not expect such performance to persist due in part to the previously mentioned factors. In addition, although the historically wide yield spread to treasuries is making utilities relatively attractive, we only look for this to provide downside support.
$64.17
$71.13
$59.63
Dec
$5.21
$4.26
$4.47
15.1
14.4
$45,191
Note: Price target based on 5% premium to regulated utility avg. P/E multiple.
89
Alistair J. Meadows
(1-212) 622-6442 alistair.j.meadows@jpmorgan.com
Tim Fisher
(1-212) 622-5403 tim.fisher@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA TONET <GO> AmeriGas Partners, L.P. Boardwalk Pipeline Partners, LP Buckeye Partners L.P. CenterPoint Energy Compressco Partners, L.P. Copano Energy DCP Midstream Partners El Paso Pipeline Partners L.P. Enbridge Energy Partners, L.P. Energy Transfer Partners, L.P. Enterprise Products Partners, L.P. EQT Midstream Partners Exterran Partners Ferrellgas Partners, L.P. Gibson Energy Inc. Global Partners LP Inergy Midstream LP Inergy, L.P. Kinder Morgan Energy Partners L.P. Kinder Morgan Inc Magellan Midstream Partners L.P. MarkWest Energy MPLX LP Nustar Energy L.P. Oiltanking Partners, L.P. Oneok Inc ONEOK Partners, L.P. Pacific Coast Oil Trust Plains All American Pipeline, L.P. PVR Partners QR Energy, LP Regency Energy Partners LP Southcross Energy Spectra Energy Partners, LP Suburban Propane Partners Targa Resources Corp Targa Resources Partners LP TC Pipelines Tesoro Logistics LP Williams Companies Williams Partners, L.P. APU BWP BPL CNP GSJK CPNO DPM EPB EEP ETP EPD EQM EXLP FGP GEI.TO GLP NRGM NRGY KMP KMI MMP MWE MPLX NS OILT OKE OKS ROYT PAA PVR QRE RGP SXE SEP SPH TRGP NGLS TCP TLLP WMB WPZ N N OW OW N N N N N N OW OW N UW N N OW N N OW N OW OW* UW N OW N N OW OW OW OW OW N N OW OW UW OW OW OW
NGL concerns to keep MLP valuation cheap. Although MLPs appear relatively inexpensive versus competing yield-oriented investments (495bps spread to 10-yr vs. historical average of 318bps), we believe investors will continue to focus on depressed NGL price levels (not helped by a mild start to winter), preventing a full reversion to the mean on a yield basis. While the potential for a rebound in the light end of the NGL barrel appears limited (although the heavy end appears to be holding in), we expect MLPs with NGL exposure to continue to deliver steady distribution growth as many have already baked in a low commodity price environment. As investors grow comfortable with MLPs ability to achieve solid results despite NGL softness, we see the potential for stronger performance over the course of the year. Distribution growth of ~6% and current yield of 6-7% could drive low-doubledigit total return. Despite the aforementioned concerns, we believe the MLP space possesses an attractive risk/reward profile as investors quest for yield in this low rate environment should provide support and limit downside risk. However, we do see the potential for sporadic turbulence, and should weakness emerge related to tax headline risk, we would view it as a buying opportunity, absent any real change. Favorable structural trends still driving demand for new energy infrastructure. We believe the secular trend towards growing domestic production will continue to drive significant demand for new energy infrastructure. As producers focus on new emerging plays, such as the Eagle Ford, Bakken and Marcellus, we believe new production will overwhelm existing infrastructure capacity and require new midstream buildout. We view MLPs as well positioned to capitalize on these expansion opportunities, underpinning attractive distribution growth.
$43.67
$49.79
$39.32
Dec
$1.68
$1.61
$2.10
27.1
20.8
$8,935
$29.50
$31.39
$21.00
Dec
N/A
$0.81
$1.86
36.4
15.9
$1,044
90
Independent Refiners
Expect PSX to Benefit from Chemicals and Midstream as Drivers of Cash Flow Growth
Katherine Lucas Minyard, CFA AC
(1-212) 622-6402 katherine.l.minyard@jpmorgan.com
Igor Grinman
(1-212) 622-6596 igor.grinman@jpmorgan.com
Timothy Li
(1-212) 622-6490 timothy.li@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA MINYARD <GO> HollyFrontier Marathon Petroleum Phillips 66 Tesoro Valero Energy HFC MPC PSX TSO VLO N N* OW OW N
In contrast to the other major subsectors in energy, the independent refiners have enjoyed lofty market outperformance, with the five major refiners under our coverage up 60% over the last six months compared with an increase of 8% for the S&P 500. We believe the refining call has investors relatively polarizedon the one hand, strong 2012 performance from a notoriously volatile sector has some investors concerned about a pullback; on the other, sustained bottlenecks in the U.S. crude oil transportation system suggest weak crude pricing and strong regional refining margins likely will endure, boosting refiner cash flow generation and potential cash returns to shareholders. In our view, stock selection among the refiners will be more important than the overall sector call in 2013. We believe relatively wide differentials will persist in inland North American crude oil pricing in 2013, as the market awaits pipeline capacity additions and the more-expensive rail option continues to set the cost of transporting the marginal barrel. However, a preference for cash returns to shareholders over expansion-related investment leads us to conclude that not all refiners have the ability to grow their exposure to these lofty margins, suggesting a limit to the extent to which refiners can continue to grow their cash flow.
$50.97
$52.76
$28.75
Dec
$5.74
$8.00
$6.51
6.4
7.8
$31,897
91
Igor Grinman
(1-212) 622-6596 igor.grinman@jpmorgan.com
Timothy Li
(1-212) 622-6490 timothy.li@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA MINYARD <GO> Baytex Energy Canadian Natural Resources Cenovus Energy Chevron Corp ConocoPhillips Exxon Mobil Corp Hess Husky Energy Lone Pine Resources Marathon Oil MEG Energy Murphy Oil Nexen Occidental Petroleum Penn West Exploration Suncor Energy Talisman Energy BTE.TO CNQ.TO CVE.TO CVX COP XOM HES HSE.TO LPR MRO MEG.TO MUR NXY.TO OXY PWT.TO SU.TO TLM.TO N N N N OW N N N N OW OW N OW OW OW OW NR
Following a year of relatively poor sector performance for the Integrated Oils and Major Producers in 2012, it is tempting to look to value as a potential driver of share price performance in 2013. If current share prices hold until year-end, the sector will enter the new year coming off an average share price drop of 4%, substantially lagging the broader market gains of 12%. However, as we consider both our commodity price view and our overall market outlook, we would favor a more cautious view on the space, as we believe relative underperformance among the group in 2012 stemmed largely from investor concerns around (1) capital allocation as companies pursue increasingly pricey growth strategies, especially in North American unconventional, and (2) deteriorating pricing for North American liquids production, two factors that may not disappear fully in 2013. We would favor the integrateds over the major producers for their exposure along the entire value chain. Our crude price outlook suggests Brent will average $113/bbl in 2013E, relatively little changed from the year-to-date average price of $112.2/bbl, suggesting little in the way of oil pricerelated uplift. Moreover, with our macro view suggesting investors are likely to favor stocks with low volatility, we would seek business models better positioned to weather volatility in both global and North American oil prices. Finally, we believe investors will favor stocks that offer the prospect of sustained growth in cash returns to shareholders, especially in the form of an increasing dividend rather than less-predictable share repurchases.
C$32.48
C$37.28
C$26.97
Dec
C$3.59
C$3.05
C$3.94
10.6
8.2
C$49,737
92
RJ McCain, CFA
(1-212) 622-6215 rj.mccain@jpmorgan.com
Jeanine Wai
(1-212) 622-6489 jeanine.wai@jpmorgan.com
Consistent with our economics team, we are cautious on the U.S. and global economy and, therefore, would recommend investors position themselves conservatively. During both the 2008-2009 financial crisis and the economic stresses of 2H11, the large-cap E&Ps outperformed the mid-caps, which outperformed the small caps. Similarly, in 2012, the large-cap and mid-cap E&Ps significantly outperformed the small caps. We think investors generally should orient their E&P investing towards the more defensive names: larger cap with good balance sheets and efficient cost structures. Our favorite large cap is EOG Resources. Besides our best idea, Denbury Resources (detailed below), we also like Pioneer Natural Resources among the mid-caps. Our favorite small-cap E&P is Approach Resources.
Jessica Lee
(1-212) 622-9812 jessica.s.lee@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA ALLMAN <GO> Anadarko Petroleum Apache Corporation Approach Resources Berry Petroleum Cabot Oil & Gas Carrizo Oil & Gas Inc. Chesapeake Energy Cimarex Energy Co. Cobalt International Energy Concho Resources, Inc. Continental Resources, Inc. Denbury Resources Inc. Devon Energy EOG Resources, Inc. EQT Corporation EXCO Resources, Inc. Goodrich Petroleum Halcn Resources Corporation Laredo Petroleum McMoRan Exploration Company Newfield Exploration Company Noble Energy PDC Energy Penn Virginia Corporation PetroQuest Energy, Inc. Pioneer Natural Resources Plains Exploration & Production QEP Resources Quicksilver Resources Inc Range Resources Corp SandRidge Energy Inc. SM Energy Southwestern Energy Company Swift Energy Company Ultra Petroleum Corp Whiting Petroleum Corporation WPX Energy APC APA AREX BRY COG CRZO CHK XEC CIE CXO CLR DNR DVN EOG EQT XCO GDP HK LPI MMR NFX NBL PDCE PVA PQ PXD PXP QEP KWK RRC SD SM SWN SFY UPL WLL WPX N OW OW OW OW N UW OW OW N N OW OW OW OW N OW N OW NR OW OW OW OW OW OW NR N N OW OW N OW N N N N
$15.47
$21.37
$13.13
Dec
$1.42
$1.48
$1.40
10.5
11.1
$5,987
Note: Target based on our estimate of NAV, which we calculate using a DCF model. Risks: Commodity price volatility, oilfield service cost inflation, leverage to crude, performance of CO2 fields and EOR fields.
93
William S. Thompson
(1-212) 622-9978 william.s.thompson@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA ANDERSON <GO> Baker Hughes C&J Energy Services Cameron Int'l Diamond Offshore Dresser-Rand Dril-Quip Ensco plc Exterran Holdings FMC Technologies Forum Energy Technologies Halliburton Hornbeck Offshore Lufkin Industries National Oilwell Varco Noble Corp. Rowan Companies Schlumberger Transocean Weatherford International BHI CJES CAM DO DRC DRQ ESV EXH FTI FET HAL HOS LUFK NOV NE RDC SLB RIG WFT N N OW N OW N OW N OW OW OW N N OW OW UW OW N OW
All the elements are in place for U.S. Oilfield Service stocks to outperform in 2013, not the least of which are incredibly attractive valuation levels following one of the more disappointing years in recent memory. The story of 2012 was all about North America, as we watched the natural gas rig count melt away throughout the year, putting continual pressure on pressure pumping utilization and pricing. Subsequently, earnings estimates for the service companies were cut several times, and we wouldnt be surprised to see further downside to guidance ahead of year-end earnings. But does the market care that much at this point? We think oilfield services are among the most under-owned in energy (and the rest of the market for that matter) and see few sellers at this point . . . but we see several signs of the tide potentially turning. Natural gas got us into this mess; it may help get us out. J.P. Morgans Oil & Gas Exploration & Development analyst Joe Allmans call for $4.00 gas by the end of the year is looking pretty prescient and E&Ps are likely to see higher y/y cash flow. For the first time in memory, E&Ps exerted capital discipline in 2H12, but are now poised to increase spending on a lower cost basis. International market growth could exceed expectations in 2013. Having just returned from the Middle East, we saw many signs of activity levels accelerating including the Saudi rig count, aftermarket services and expanding gas development into unconventionals and deepwater. Meanwhile, in Latin America strong growth appears sustainable for the next several years with additional opportunities evolving in select countries such as Colombia. Offshore development remains a strong theme. The pace of offshore development has been slower than expected with fewer subsea equipment and newbuild rigs being ordered, but we expect these delays to ease. In other words, the three primary drivers of global upstream spending should all see strong growth in 2013, potentially driving expectations for service earnings higher, and leading investors into the oilfield service group.
$71.50
$80.78
$59.12
Dec
$3.66
$4.22
$4.75
16.9
15.1
$94,921
Risks: The competition has closed the gap; less earnings upside over the near term; Smith acquisition materially dilutive to return on capital; weaker global oil recovery may curtail international spending.
94
Financials
Rahul Nevatia
(1-212) 622-6454 rahul.nevatia@jpmorgan.com
Paul Lanks
(1-212) 622-6495 paul.lanks@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA WORTHINGTON <GO> Apollo Global Management Artio Global Investors BM&F Bovespa CBOE Holdings Charles Schwab CME Group Inc. Eaton Vance Corp Evercore Partners Inc. Federated Investors, Inc. Franklin Resources FXCM Invesco Ltd. Investment Technology Group Janus Capital Group Knight Capital Group LPL Financial Holdings Inc. Manning & Napier NYSE Euronext Oaktree Capital Group, LLC Och-Ziff Capital Management Pzena Investment Management T. Rowe Price Group, Inc The Carlyle Group The Intercontinental Exchange APO ART BVMF3.SA CBOE SCHW CME EV EVR FII BEN FXCM IVZ ITG JNS KCG LPLA MN NYX OAK OZM PZN TROW CG ICE OW N OW N N UW N N UW N OW OW OW UW N N N NR N OW N OW OW OW
Asset Managers Equity markets have performed well since the beginning of this year and raised hopes for retail investors to reengage with active domestic equity funds. However, with the year likely to end on a weak note due to near-term headwinds, we expect no meaningful change in investor behavior early next year. The outlook is for fixedincome strategies to dominate retail interest, and ETFs and passive investing to dominate the domestic equity landscape. We recommend investors in the equities of asset managers look to be positioned in a market-neutral manner. Hence, we like the relative valuation pairings of Invesco (IVZ, OW) vs. Federated (FII, UW) as well as T. Rowe Price (TROW, OW) vs. Janus (JNS, UW) as our favorite ideas in the sector. Exchanges Volumes at exchanges have slowed with every passing quarter in 2012 and the outlook is for ongoing weakness in trading activity in 2013. While macro events could act as short-term catalysts, valuations are still somewhat expensive and leave little incentive for the average equity investor to pay for these exchange stocks. We do not see any meaningful trends emerging at the exchanges to expect anything more than modest earnings growth in 2013. Here, mandated OTC Clearing of Interest Rate Swaps is potentially the key regulatory catalyst and could be a game changer for the sector, particularly CME. We maintain our Overweight rating on ICE which remains one of the few growth stocks in the sector and we rate CME Underweight as its several initiatives are struggling to gather strength and we are concerned incremental revenue from OTC clearing might not meet Street expectations.
$24.77
$26.94
$18.55
Dec
$1.68
$1.72
$1.94
14.4
12.8
$10,999
95
John P. Grassano
(1-212) 622-5605 john.p.grassano@jpmorgan.com
Chris K. Baydar
(1-212) 622-8115 christopher.k.baydar@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA JUNEJA <GO> Bank of America Bank of New York Mellon Corp. BB&T Corporation Citigroup Inc. Fifth Third Bancorp Northern Trust PNC Financial Regions Financial State Street SunTrust Banks, Inc. U.S. Bancorp Wells Fargo BAC BK BBT C FITB NTRS PNC RF STT STI USB WFC OW N N N N N OW N UW OW OW OW
We expect political/regulatory concerns likely will keep bank stocks choppy near term until the fiscal cliff is resolved. However, we expect bank stocks to rise gradually in 2013, benefiting from continued (albeit slow) improvement in the U.S. economy and further recovery in the housing market, assuming fiscal cliff resolution does not cause a recession. In addition, large banks continue to grow capital and are in a strong position to increase dividends and buybacks in 2013, which also should provide some lift to bank stocks. Revenues are expected to remain under pressure in 2013 led by declining net interest margins and tepid loan growth; as a result, EPS growth for most banks is likely to be driven by further reduction in credit costs, some expense cutting and share buybacks. Consolidation activity remains sluggishsome small banks may be squeezed by revenue pressure to consider selling. We expect Money Center bank stocks to outperform Regional bank stocks in 2013, reflecting more offsets to revenue pressures, greater cost-cutting initiatives and lower valuations. Regional banks should be more affected by ongoing low absolute level of interest rates, which is driving sharp declines in net interest margins (NIMs). In addition, loan growth remains tepid and mortgage banking revenues are expected to slow as banks work through backlog of HARP and other refis. Money Center bank NIMs should hold up better given more room to offset with lower funding costs, and more diversified revenue sources should help offset pressures in some fee businesses. Trust and processors: favorable valuations, but some headwinds. We expect trust bank stocks are likely to remain under pressure near term due to increasing pressure on NIMs, weak trends in markets-related activities including F/X trading and securities lending, and shift of assets out of equities as well as higher levels of index/ index-like equity assets. This should be offset only partly by expected increases in share buybacks given strong capital positions and some cost savings.
$10.46
$10.58
$4.92
Dec
$0.82
$0.73
$1.08
14.3
9.7
$112,685
96
Preeti S. Dixit
(1-212) 622-9864 preeti.s.dixit@jpmorgan.com
David Norton
(1-212) 622-5787 david.j.norton@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA ALEXOPOULOS <GO> Astoria Financial BancorpSouth CapitalSource City National Corp Comerica Incorporated Cullen/Frost Bankers Inc. First Horizon National First Republic FirstMerit Corporation Huntington Bancshares KeyCorp M&T Bank MB Financial New York Community Bank People's United Financial PrivateBancorp, Inc. Signature Bank Susquehanna Bancshares SVB Financial Synovus Financial Corp. TCF Financial Corporation Trustmark Corporation Umpqua Holdings Corporation Valley National Bancorp Washington Federal, Inc. Webster Financial Corporation Zions Bancorporation AF BXS CSE CYN CMA CFR FHN FRC FMER HBAN KEY MTB MBFI NYCB PBCT PVTB SBNY SUSQ SIVB SNV TCB TRMK UMPQ VLY WAFD WBS ZION UW UW N OW OW N OW OW NR N OW NR N N N N OW N OW N N UW N UW N N OW
The macro environment is more likely a foe than friend in 2013. In the backdrop of an economy expected to continue growing in the ~2% range in 2013, we expect industry fundamentals to be characterized by (1) sustained pressure on net interest margins, (2) mid-single-digit (at best) loan growth, (3) bottom-line effect from credit improvement migrating from tailwind to headwind, (4) excess capital deployment via share buybacks and dividend increases leaving little to get excited over, (5) industry ROTEs in the 9.5% range (below cost of equity), (6) the pace of M&A remaining subdued (at about 150-200 deals per year; mostly small and off the radar of most investors), and (7) the ink drying on new Fed capital rules (expected to take a bite out of excess capital). We expect the culmination of these points to translate into relatively disappointing EPS growth of 1% on average for regional banks in 2013. With bank stocks trading at 1.33x TBV and 13.7x 2013E EPS, and the vast majority of banks still under-earning their cost of capital, we see limited upside potential for the typical bank in our coverage, with the better performers in the group likely to be found within the handful of niche players. Niche players best positioned to outrun headwinds. With banks in our coverage group entering 2013 with a cost of deposits at 50 basis points on average, pressure on net interest margins is likely to be the primary theme in 2013. Although the Feds QE3 program was intended to further stimulate the economy, in our view the very flat yield curve as well as declining MBS yields tied to QE3 is a net negative for banks given little room left on the deposit rate side to offset pressure on securities yields. Specifically, with our average bank yielding 4.75% on loans and 3.04% on securities portfolios and new cash being invested in the 3.5%-4% range for new loans and 1.2%-1.5% range for new securities, loan growth is likely to be the only lever for banks to offset asset yield pressure. To this end we favor the niche players in the group, such as First Republic, Signature Bank and SVB Financial; we view each as positioned to deliver very strong loan growth (20%-plus) in 2013, enabling NII growth in the 7-12% range.
$33.15
$35.14
$28.65
Dec
$1.68
$2.08
$2.24
15.9
14.8
$4,341
97
Insurance Life
Fundamentals Relatively Healthy but Headwinds Mounting; Outlook Neutral
Jimmy S. Bhullar, CFA AC
(1-212) 622-6397 jimmy.s.bhullar@jpmorgan.com
Our outlook for the life insurance sector is neutral. Although select stocks offer considerable upside, we believe the risk/reward for the overall sector is more balanced following mounting fundamental headwinds and strong year-to-date performance. Business fundamentals are relatively healthy, marked by strong balance sheets and improving pricing in most products. However, we are concerned about ROE compression, weak top-line growth and potential balance sheet charges. ROE compression and weak top-line growth present looming headwinds. We project the life sectors ROE to shrink from 10.8% in 2012 to 10.5% in 2013 and 10.3% in 2014. Near-term results should benefit from ongoing share buybacks, the strong equity market and accretion from recent M&A transactions. However, if the current interest rate environment persists, we project returns to compress about 20bps annually in the next few years. Also, we expect top-line growth in most products to be pressured by the sluggish economy, recent price hikes and weak demand. Low interest rates are our primary concern. The 10-year Treasury yield is currently 1.6%, slightly below the 1.9% at 12/31/11. Meanwhile, credit spreads in most asset classes in which insurers invest have compressed by 100-150 bps year to date, indicating a sharper drop in new money yields than implied by the move in Treasury rates. Margins in most rate-sensitive products have been relatively stable in recent quarters as insurers have proactively cut crediting rates. However, the flexibility for further reductions is limited as a sizeable portion of most insurers liabilities is close to contractual minimum rates. Another key risk not captured in our and consensus return and book value forecasts is the possibility of balance sheet DAC and/or reserve charges stemming from low rates, likely beginning in late 2013 or 2014. Potential charges would reduce capital flexibility for buybacks (the primary driver of ROE expansion in recent years), hurt book values and likely heighten rating agency concerns (Moodys changed its outlook on the life sector from Stable to Negative in September 2012 partly due to the threat of sustained low interest rates). In our opinion, LNC, MET, PL and SYA are most susceptible to sustained low rates. Valuations are no longer overly compelling. The sector is trading at 0.9x BV and 7.6x our 2013 EPS estimates. We forecast the group to generate a 10-11% ROE in the next few years, which we feel merits a P/BV of 0.9-1.0x, close to the current level. Also, the sector is near the high end of its recent trading range (0.6x in November 2011 to 1.1x in March 2012). As such, we feel there is greater likelihood of multiple compression than significant expansion over the next year.
$52.63
$65.17
$44.47
Dec
$6.42
$6.23
$7.98
8.4
6.6
$24,526
98
Insurance Non-Life
Fundamentals More of a Tailwind than Headwind as EPS Moves Closer to Normal Levels
Matthew G. Heimermann AC
(1-212) 622-6545 matthew.g.heimermann@jpmorgan.com
Donald H. Chen
(1-212) 622-2875 donald.h.chen@jpmorgan.com
Pricing power has returned to the industry over the past 12-18 months and we expect further gains over the next 12-24 months, which should translate into improved earnings on an underlying basis. Reported earnings should also remain attractive as accident-year margin gains, combined with continued capital management, offset a lower contribution from reserve releases and low reinvestment rates. The drivers of pricing powerlow reinvestment rates and normalizing loss costsare unlikely to abate near term given current run-rate returns on capital. However, the level of ultimate returns (low-double-digits or low- to mid-single-digit range) likely will be a function of interest rates. If reinvestment rates stay at current levels, most companies in our view will approach normalized earnings and ROE levels in 2014, which could ultimately cap price performance although current risk/reward appears reasonable. However, industry fundamentals are uneven with respect to both margin and growth prospects (and, therefore, leverage) as are stock opportunities. We believe primary insurance companies are in the best position to see ROEs normalize due to better margin and growth leverage, while the reinsurance sector is likely to see fewer companies reach normalized return levels near term. Insurance brokers should benefit from pricing power, but further improvements in growth (and outsized margin gains) likely require a more robust economy. We believe EPS will ultimately be a better barometer of value potential for stocks than balance sheet valuations, especially as investors grapple with normalized earnings potential relative to interest rates. Valuation levels are in line with the historical average on an EPS basis and below historical levels on a book value basis; however, the sector is trading at a premium to book, which reflects improving ROE prospects.
$41.19
$42.81
$25.86
Dec
$1. 20
$3.73
$4.80
11.0
8.6
$19,844
Risks: Our expectations of stabilizing/improving EPS and capital levels proving optimistic, more difficult pricing environment and market share loss, increased high-frequency/low-severity events, headwinds from investment yields, higher leverage than peers.
99
We remain constructive on U.S. REIT stocks heading into 2013. We think the group offers high earnings visibility, high dividend yields and reasonable valuations that are supported by private market values. Underlying are commercial real estate fundamentals that still have a ways to go before reaching cyclical highs. Historically, REITs have demonstrated less volatility than the broader market, and we think the stocks will revert back to this over time; J.P. Morgan strategists view is that 2013 should be a relatively good year for lower-volatility stocks. REITs are poised to generate 7-8% FFO/share growth in 2013, and we see a similar level of growth again in 2014 as internal growth picks up after debt refinancing tailwinds leave off. Dividends should grow at a similar clip, which combined with the current yield of 3.7% and some room for a small amount of valuation contraction over time gets us to a total return expectation of roughly 10%. Fundamentally, 2013 should be the second straight year since the downturn in which all property types produce positive SS NOI growth, and we expect the companies to continue to supplement this growth by using strong balance sheets to deploy capital into new investments. The regional mall and apartment segments are likely to win the day again in terms of absolute core growth rates, and office is likely to be touch-andgo until more consistent job growth and corporate hiring transpire. The industrial sector should continue to improve now that occupancy has been regained, and strip center retail, health care and net lease should wind up somewhere in the middle in terms of core trends. Capital rotation continues to be the biggest risk we see in the space. In the near term, we worry about REITs being lumped in with other dividend-oriented equities that have benefitted from investors seeking income with favorable tax treatment. Recall that REIT dividends were never subject to the Bush tax cuts and the favorable qualified dividend tax rate. As such, any change to the tax rule would in theory be a relative positive for REITs. But were not sure the market fully understands this. And, if equity income funds that own REITs see big outflows, the group could nonetheless feel some pressure as those funds may sell stocks across the board (including REITs). Looking later into 2013, if we move past the fiscal cliff issues and investors decide to take on more risk, we would worry about rotation out of REITs into more cyclically sensitive (risk on) areas.
Molly McCartin
(1-212) 622-6615 molly.mccartin@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA MUELLER<GO> Bloomberg JPMA PAOLONE<GO> Michael W. Mueller, CFA
Acadia Realty Trust CBL & Associates Properties DCT Industrial Trust DDR Corp Equity One Inc. Federal Realty Investment Trust First Industrial Realty Trust General Growth Properties HCP, Inc. Health Care REIT Healthcare Realty Trust Jones Lang LaSalle Inc Kimco Realty Corporation Macerich Medical Properties Trust Pennsylvania REIT ProLogis PS Business Parks Public Storage Ramco-Gershenson Properties Trust Regency Centers Retail Properties of America Simon Property Group STAG Industrial, Inc. Tanger Factory Outlet Centers Taubman Centers Weingarten Realty Investors AIMCO Alexandria Real Estate Equities American Campus Communities AvalonBay Communities Boston Properties Brandywine Realty Trust Brookfield Office Properties Camden Property Trust CBRE Group, Inc Corporate Office Properties Cousins Properties Douglas Emmett, Inc. Duke Realty Education Realty Trust EPR Properties Equity Residential Essex Property Trust Getty Realty Kilroy Realty Lexington Realty Trust Liberty Property Trust Mack-Cali Realty Mission West Properties Piedmont Office Realty Trust Post Properties Realogy Holdings Corp. Realty Income SL Green Realty Corp. UDR, Inc. Vornado Realty Trust 100 Washington Real Estate Investment Trust
AKR CBL DCT DDR EQY FRT FR GGP HCP HCN HR JLL KIM MAC MPW PEI PLD PSB PSA RPT REG RPAI SPG STAG SKT TCO WRI AIV ARE ACC AVB BXP BDN BPO CPT CBG OFC CUZ DEI DRE EDR EPR EQR ESS GTY KRC LXP LRY CLI MSW PDM PPS RLGY O SLG UDR VNO WRE
N OW N N N OW N N N OW N N OW N UW UW OW OW OW UW N N OW N N OW N UW N N NR OW N N N OW N N N N N N NR OW UW OW N N N N N N OW N OW OW N UW
$34.91
$37.58
$26.65
Dec
$1.58
$1.73
$1.65
20.2
21.2
$16,090
Jonathan Philpot
(1-415) 315-6725 jonathan.philpot@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA SHANE<GO> American Capital American Express Annaly Capital Apollo Commercial Real Estate Finance Apollo Investment Apollo Residential Mortgage Ares Capital Ares Commercial Real Estate Corp. BlackRock Kelso Capital Capital One Crexus Investment Corp. Discover Financial MFA Financial PennantPark Investment SeaCube Container Leasing Solar Capital TAL International Western Asset Mortgage ACAS AXP NLY ARI AINV AMTG ARCC ACRE BKCC COF CXS DFS MFA PNNT BOX SLRC TAL WMC OW N N N OW N OW OW N OW N OW N N N N N N
Heading into 2013 we expect Fed policy will focus disproportionately on the economic growth mandate (rather than controlling inflation). Although a housing recovery appears to be under way, we expect aggressive government programs aimed at supporting home ownership will be a top priority under the administration. The credit backdrop across the space should remain relatively benign, with a shift toward normalization in the card space (after three years of improvement) while other creditsensitive asset classes (private-label RMBS, middle-market debt, CRE debt) should benefit from cyclical credit tailwinds. In 2013, we expect investors incrementally will allocate capital into names with call-protected yields and seek companies with the ability to repurchase shares at a discount to intrinsic value. We would urge investors to position capital accordingly.
$57.27
$61.83
$41.27
Dec
$6.83
$6.29
$6.96
9.1
8.2
$33,313
101
102
Biotechnology
Health Care
Michael E. Ulz
(1-212) 622-0900 michael.e.ulz@jpmorgan.com
Anupam Rama
(1-212) 622-0105 anupam.rama@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA MEACHAM <GO> Geoff Meacham Acorda Therapeutics Inc. Alexion Pharmaceuticals Alnylam Pharmaceuticals AMAG Pharmaceuticals Amgen Inc AVEO Oncology Biogen Idec Celgene ChemoCentryx, Inc. Gilead Sciences Idenix Pharmaceuticals InterMune Ironwood Pharmaceuticals Medivation Merrimack Pharmaceuticals PDL BioPharma Regeneron Pharmaceuticals Synageva BioPharma United Therapeutics Vertex Pharmaceuticals ViroPharma Incorporated Anupam Rama Amicus Therapeutics
ACOR ALXN ALNY AMAG AMGN AVEO BIIB CELG CCXI GILD IDIX ITMN IRWD MDVN MACK PDLI REGN GEVA UTHR VRTX VPHM
N OW OW UW N OW N OW OW OW OW OW OW OW OW N N OW UW OW N
Overall, 2012 was solid year for biotech (NBI +33% vs. S&P 500 +12% year to date). While the sector came under some pressure during 3Q12 earnings, with a sell the winners mentality and de-risking noticeably prevalent, a rebound occurred coming out of Thanksgiving. We look for a sort of reset button to be hit heading into 2013 and expect sector newsflow to ramp into the 2013 J.P. Morgan Healthcare Conference. Importantly, the fundamentals for biotech are still very much intact, which we believe was highlighted by a very solid 3Q12 earnings season. Indeed, biotech was a bright spot in healthcare during 3Q12 earnings. Recall, healthcare overall had a very mixed 3Q12 from a top-line perspective. Looking forward, in conjunction with solid fundamentals, we see fewer macro risks (i.e., biosimilars legislation and elections) in 2013 relative to 2012, and many are well vetted at this point (i.e., EU economic situation). As such, we continue to believe biotech will retain its inherent defensive nature in 2013 and continue to favor companies with commercial fundamentals/de-risked pipelines (Alexion, Gilead, Celgene).
FOLD
OW
$73.81
$76.28
$36.98
Dec
$3.86
$3.85
$5.05
19.2
14.6
$55,922
103
SMid Biotechnology
Recent Healthy Dip Keeps Us Constructive on Biotech for 2013 . . . ONXX Still a Top Pick
Cory W. Kasimov AC
(1-212) 622-5266 cory.w.kasimov@jpmorgan.com
Matthew J. Lowe
(1-212) 622-0848 matthew.j.lowe@jpmorgan.com
The small/mid-cap biotech group has performed very well in 2012, and we remain constructive on the sector heading into 2013.Year to date, the key biotech indices have significantly outperformed the broader market (NBI +35% and BTK +43% vs. S&P 500 +14%). However, following an unprecedented run, biotech has pulled back since mid-October, which we believe presents a more attractive entry point heading into 2013. With that backdrop, we still expect investor risk appetite for the SMid biotechs to continue to be driven by high-profile clinical and regulatory catalysts, commercial performance and the continuing potential for M&A activity. In contrast to companies in most industries, SMid biotechs are not as reliant on the performance of the overall economy so long as they have access to capital. Regarding M&A activity, the uptick in 2012 is likely to extend into 2013, in our view, as pharma companies continue to seek out bolt-on deals (facilitated by plush pharma balance sheets and more mature biotech pipelines).
Karen E. Jay
(1-212) 622-4668 karen.e.jay@jpmorgan.com J.P. Morgan Securities LLC Bloomberg: JPMA KASIMOV <GO> Aegerion Pharmaceuticals Alkermes, Inc. Arena Pharmaceuticals, Inc. Ariad Pharmaceuticals Array BioPharma BioMarin Pharmaceuticals Clovis Oncology Dendreon Emergent BioSolutions Exelixis, Inc Geron Corp ImmunoGen Incyte Corporation Lexicon Pharmaceuticals MannKind Corporation Nektar Therapeutics Onyx Pharmaceuticals Orexigen Therapeutics Rigel Pharmaceuticals Savient Pharmaceuticals Seattle Genetics The Medicines Company VIVUS, Inc ZIOPHARM Oncology AEGR ALKS ARNA ARIA ARRY BMRN CLVS DNDN EBS EXEL GERN IMGN INCY LXRX MNKD NKTR ONXX OREX RIGL SVNT SGEN MDCO VVUS ZIOP OW OW N OW OW OW OW N OW N N N OW OW N OW OW OW OW N N N OW OW
$76.70
$93.18
$35.73
Dec
$0.66
($1.26)
($0.70)
N/M
N/M
$5,151
104
Michael Minchak
(1-212) 622-6506 michael.minchak@jpmorgan.com
Gavin S. Weiss
(1-212) 622-5451 gavin.s.weiss@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA GILL<GO> AmerisourceBergen Cardinal Health Catamaran Corp CVS Caremark Corp. Express Scripts, Inc. Henry Schein Inc LabCorp McKesson Corporation Omnicare Inc. Owens & Minor, Inc. Patterson Companies PSS World Medical, Inc. Quest Diagnostics Rite Aid Vocera Walgreen Company ABC CAH CTRX CVS ESRX HSIC LH MCK OCR OMI PDCO PSSI DGX RAD VCRA WAG N OW OW OW OW N N OW OW N N N N N OW N
Underlying earnings visibility remains strong, while a cyclical lift could drive incremental prescription usage and earnings upside. We remain positive on the pharmaceutical supply channel in general, based on favorable demographic trends, growth in specialty pharmaceuticals and the continued generics opportunity. The aging population should continue to help drive prescription utilization as the elderly utilize a significantly higher number of scripts per year than the overall average. Although it is well known that generic launches will decelerate in 2013, we believe residual benefits from a very strong launch year in 2012 will continue to affect profitability for the majority of the companies in the pharmaceutical supply channel. While economic weakness has contributed to slower prescription growth over the past few years, any incremental growth could provide a potential source of upside to the companies across the pharmaceutical channel. Finally, we expect the PBMs, distributors and retail pharmacies to continue to use strong free cash flow to repurchase shares, which could provide a cushion to earnings should a weak economy persist. PPACA could drive increase in pharmaceutical utilization/volume trends. With the presidential elections behind us it appears that the Affordable Care Act (ACA) will move forward towards implementation. In our view, the increase in additional insured patients is a positive across the pharmaceutical channel, especially for the drug distributors as they dont have any specific reimbursement risk. In addition, the drug distributor model has a highly fixed cost base and any incremental scripts are very accretive to the model.
$94.74
$97.23
$74.89
Mar
$6.38
$7.29
$7.93
13.0
11.9
$22,362
105
Evan Lodes
(1-212) 622-5650 evan.lodes@jpmorgan.com
Ramesh C. Donthamsetty
(1-212) 622-6580 ramesh.c.donthamsetty@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA PETERSON <GO> Tycho Peterson Affymetrix Agilent Technologies Bruker Corporation Charles River Laboratories Covance FEI Company GenMark Diagnostics Genomic Health ICON Plc Illumina, Inc. Life Technologies Corporation Luminex Mettler-Toledo Myriad Genetics Inc. Pacific Biosciences Inc. PerkinElmer Qiagen N.V. Quidel ShangPharma Corp. Sigma Aldrich Thermo Fisher Scientific Waters WuXi PharmaTech Evan Lodes Cepheid
AFFX A BRKR CRL CVD FEIC GNMK GHDX ICLR ILMN LIFE LMNX MTD MYGN PACB PKI QGEN QDEL SHP SIAL TMO WAT WX
UW OW N N OW OW OW N N OW N N N N UW OW OW N NR N N OW OW
Government funding pressures have been the defining theme and a major overhang for the life science tools space over the last 18 months, with U.S. issues now coming to a head under the fiscal cliff negotiations in the coming weeks. Throughout the year, we have maintained a cautious outlook on the group, as government funding pressures and cost-cutting at pharma have led to lower growth and more cyclicality for the sector, although these pressures are now better understood by companies and investors, which makes us increasingly more constructive on the outlook for the group after the fiscal cliff issues are resolved. Once this happens, we think group correlation can continue to decline, with company-specific issues once again emerging as the primary drivers of individual stock performance. One theme that has not changed, however, is that as the industry matures and capital deployment becomes a larger driver of returns, investors will continue to be increasingly focused on cash flow return metrics, driving our preference for ROIC-focused companies.
CPHD
OW
$38.32
$46.28
$32.51
Oct
$3.12
$3.00
$3.43
12.8
11.2
$13,259
106
Managed Care
Reform Uncertainties May Trump Solid Fundamentals
Justin Lake AC
(1-212) 622-6600 justin.lake@jpmorgan.com
Andrew Valen
(1-212) 622-5764 andrew.valen@jpmorgan.com
Michael Newshel
(1-212) 622-5075 michael.a.newshel@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA LAKE <GO> Aetna Amerigroup Centene Cigna Coventry Health Net Humana Molina UnitedHealth WellPoint AET AGP CNC CI CVH HNT HUM MOH UNH WLP OW* N OW OW N N N N NR N
Healthcare costs unlikely to accelerate. Healthcare utilization growth has tracked below historical levels for the past three years in the wake of high unemployment, and we expect medical costs to remain range-bound into 2013 as the job market likely remains sluggish. Managed care organizations (MCOs) are generally presuming an uptick in medical cost growth in their initial 2013 guidance (similar to initial 2011 and 2012 outlooks that proved conservative), making room for potential continued earnings upside if costs come in lower. Although the magnitude of the assumed uptick is generally smaller than in initial guidance for the prior years, the gap (and thus the potential upside if utilization remains depressed) could widen somewhat depending on how 2012 finishes. We also expect a stable pricing environment for 2013. Recent MCO comments indicate premium pricing is generally rational, with limited aggressiveness in certain local markets which may reflect a margin reset to the new minimum medical loss ratios (MLRs). Our recent analysis of state-level insurance statutory filings revealed margin compression at not-for-profit health plans in recent quarters, giving them less upside to price through next year, and we also expect not-for-profits to maintain capital levels near recent record-high levels during reform implementation. Focus on reform in 2014 may leave multiples range-bound. Most investors likely will be looking past 2013 to 2014, when the new subsidized healthcare exchanges open, Medicaid eligibility expands, an $8B industry premium tax takes effect and Medicare Advantage plans become subject to minimum MLRs. Given the high uncertainty, valuation multiples in the sector could remain range-bound until there is more clarity about how quickly insurance coverage will ramp up and the level at which margins inside and outside the exchanges are likely to settle.
$52.50
$53.75
$39.01
Dec
$5.21
$5.88
$6.30
8.9
8.3
$15,009
Risks: Medical cost trends could accelerate faster than expected or pricing environment could get more competitive; Medicare Advantage enrollment growth could be pressured by rate cuts and 2014 minimum MLR floors; run-off books may require future capital infusions depending on market performance and interest rates. * Rating as of December 7, 2012.
107
Kimberly Gailun
(1-617) 310-0740 kimberly.w.gailun@jpmorgan.com
MedTech stocks struggled in 2012. A combination of structural and cyclical pressures has resulted in weakening end markets and a slowing of industry growth rates. In 2013, we expect these pressures to continue, resulting in low- to mid-singledigit industry revenue growth and mid- to high-single-digit EPS growth. Absent a pickup in US demand, 2013 is likely to bring incremental pricing pressure and make Europe the incremental risk to the industrys 2013 outlook. Southern Europe weakened over the second half of 2012. Downside demand risk from new austerity measures is worth watching, with the potential to pressure 2013 earnings across the space. MedTech stocks are, of course, inexpensive, trading at 12.1x 2013E EPS and a FCF yield of 8.7%. Moreover, the companies are generating ample cash and, in many cases, returning that cash to shareholders. Yet, with 42% of S&P healthcare stocks trading at a discount to the S&P 500, valuation and capital allocation alone arent likely to be enough to improve sector performance. In our view, either fundamentals will need to improve or there needs to be an increased level of interest from strategic or financial sponsors.
Chris Pasquale
(1-212) 622-6590 christopher.t.pasquale@jpmorgan.com
Ross Comeaux
(1-212) 622-1895 ross.w.comeaux@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA WEINSTEIN <GO> Michael Weinstein Abbott Laboratories Baxter Intl Becton, Dickinson & Co BioMimetic Therapeutics Boston Scientific Corporation C.R. Bard Inc. CareFusion Covidien Edwards Lifesciences Heartware International Johnson & Johnson Medtronic St Jude Medical Stryker Corp Tornier Zimmer Holdings Kimberly Gailun Insulet Corp Mako Surgical NxStage Medical, Inc. The Cooper Companies, Inc. Wright Medical Group Chris Pasquale Hansen Medical Integra LifeSciences NuVasive, Inc. Thoratec Corp. Volcano Corporation
ABT BAX BDX BMTI BSX BCR CFN COV EW HTWR JNJ MDT STJ SYK TRNX ZMH
N NR UW NR N N OW OW N OW OW N OW OW N N
OW N OW OW NR
N N N N OW
$79.60
$97.31
$61.00
Dec
($3.94)
($6.26)
($3.07)
N/M
N/M
$1,148
108
Evan Lodes
(1-212) 622-5650 evan.lodes@jpmorgan.com
Ramesh C. Donthamsetty
(1-212) 622-6580 ramesh.c.donthamsetty@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA PETERSON <GO> Accuray Hologic Intuitive Surgical, Inc. Sirona Dental Systems Inc Varian Medical Zeltiq Aesthetics ARAY HOLX ISRG SIRO VAR ZLTQ N OW OW OW OW N
Our SMid-cap Medical Technology coverage skews towards capital equipment providers, which have had a mixed year, as hospitals have increasingly prioritized capital spending, especially in light of HCIT requirements. Overall, we believe the hospital capital equipment environment will remain constrained, but stable over the coming year, with upside risks from economic acceleration, preparation for the 2014 implementation of PPACA and roll-off of HCIT investments, and downside risks from economic deterioration and/or the fiscal cliff effect on hospital reimbursement (which we would expect to be short-lived). Another issue for this group is implementation of the PPACA Medtech Tax, which is scheduled to take effect in January. This 2.3% excise tax on U.S. sales of FDAcleared medical devices will disproportionately hurt smaller, US-centric, less profitable companies, although should be a profit drag for nearly all, and we expect mitigation strategies (layoffs, price increases if possible) to be a focus for investors. Finally, healthcare utilization (visits to physicians and hospitals) has been stable over the last year, and continues to show signs of a small uptick. At a minimum, we think utilization will no longer be a drag on growth, although the big question for the industrywhat happens in 2014 when PPACA is implementedis unlikely to be answered over the next year.
$519.78
$594.89
$420.84
Dec
$12.31
$15.59
$17.56
33.3
29.6
$20,668
109
Pharmaceuticals Major
Strengthening Fundamentals Warrant Upside
Christopher Schott, CFA AC
(1-212) 622-5676 christopher.t.schott@jpmorgan.com
Jessica Fye
(1-212) 622-4165 jessica.m.fye@jpmorgan.com
We see strengthening fundamentals driving continued upside for the major pharma group in 2013. Annual patent expiration rates, product concentration and exposure to the US market are all declining for the group, and there are now broad signs of a recovery in new product flow as refocused pipelines are maturing and FDA hurdles are easing. This dynamic supports greater confidence in the longer-term sustainability of the industrys earnings and cash flow, in our view. We continue to see upside for the US Pharma names to the extent pipeline traction supports a more sustained growth outlook for the sector, a trend we believe is increasingly likely, and would recommend using broader market volatility as a buying opportunity for these names.
$25.61
$26.09
$20.10
Dec
$2.32
$2.20
$2.32
11.6
11.0
$188,556
110
Pharmaceuticals Specialty
Generics Remain Attractive in 2013
Chris Schott, CFA AC
(1-212) 622-5676 christopher.t.schott@jpmorgan.com
Jessica Fye
(1-212) 622-4165 jessica.m.fye@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA SCHOTT <GO> Christopher Schott, CFA Allergan Amarin Corporation Endo Health Solutions Forest Laboratories, Inc Hospira, Inc. Impax Laboratories Kythera Biopharmaceuticals Medicis Pharmaceutical Corp. Mylan Inc. Perrigo Company Sagent Pharmaceuticals Teva Pharmaceuticals Valeant Pharmaceuticals Warner Chilcott Watson Pharmaceuticals Jessica Fye MAP Pharmaceuticals
Generics We see the generics group positioned for multiple expansion in 2013 as the industrys model continues to shift away from patent-challenge exclusivity periods (a low-multiple business in our view) to a more sustainable business focused on highbarrier-to-entry products with limited competition, international expansion, vertical integration/optimization and continued consolidation in developed markets. We believe the best-positioned generics companies under coverage include Watson (WPI) and Mylan (MYL). We would note that while 2012 was a year of significant patent expirations, many of these launches were commodity products and not major earnings drivers. As such, we believe expectations for a profitability decline in 2013 are very much overblown.
N OW OW N N N OW NR OW N N OW NR OW OW
AGN AMRN ENDP FRX HSP IPXL KYTH MRX MYL PRGO SGNT TEVA VRX WCRX WPI
Specialty Pharmaceuticals We anticipate continued consolidation in the specialty group in 2013 as low financing costs, tax arbitrage, depressed valuations and potential cost synergies create an attractive environment for business development, and we see deals as a likely positive for both buyers and sellers in this market. In addition, we expect individual names to trade on potential catalyst events throughout the year including the resolution of tamper-resistant opioid generics by FDA (ENDP), US Phase 3 results for ATX-101 (KYTH), as well as FDA action on efinaconazole (VRX), Vascepas ANCHOR indication (AMRN), Ryatry (IPXL), cariprazine (FRX) and levomilnacipran (FRX).
MAPP
OW
$27.31
$27.54
$19.31
Dec
$2.04
$2.59
$2.80
10.5
9.8
$11,130
111
112
Materials
Wide Spreads
Jeffrey Zekauskas AC
(1-212) 622-6644 jeffrey.zekauskas@jpmorgan.com
Silke Kueck
(1-212) 622-6503 silke.x.kueck@jpmorgan.com
Olga Guteneva
(1-212) 622-6488 olga.v.guteneva@jpmorgan.com
Ben Richardson
(1-212) 622-6455 ben.richardson@jpmorgan.com
Youyou Yan
(1-212) 622-4951 youyou.yan@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA ZEKAUSKAS <GO> Jeffrey Zekauskas Agrium Air Products and Chemicals Albemarle Corporation Amyris, Inc. Ashland Inc. Avery Dennison Cabot Corporation Celanese CF Industries Holdings, Inc. Compass Minerals International, Inc. Dow Chemical DuPont Eastman Chemical Company Ecolab Inc. Ferro Corp Georgia Gulf H.B. Fuller Huntsman Corporation International Flavors & Fragrances LyondellBasell Industries Metabolix Minerals Technologies Monsanto Novozymes Pall Corporation Polypore International Potash Corp. PPG Industries Praxair RPM International Inc. Scotts Miracle-Gro Co. Sherwin-Williams The Mosaic Company Valspar Corp WD-40 Company Westlake Chemical Corp. Silke Kueck Rockwood Holdings, Inc.
In a global economy on a slow growth track, the very sharp downward volatility in oil prices stemming from large demand shortfalls and leading to low plastics values tends to be absent. LyondellBasell is a primary beneficiary of the wide spread between high-cost global oil (Brent) and low-priced natural gas liquid derivatives (ethane) because of its large advantaged domestic presence in ethylene and ethylene derivatives. The United States is innovating through the production of natural gas from shale formations, which is leading to a surplus of natural gas liquids such as ethane, propane and natural gasoline. The surplus appears to be a durable one. Ethane, in particular, is difficult to export because of its low liquefaction temperature and difficulties in moving the material from ports to inland petrochemical complexes. The domestic natural gas industry is interested in building an infrastructure to supply large chemical complexes to be built in the 2017-2020 time frame. Low ethane prices mean wide margins for LyondellBasell. This constellation of factors should lead to a high level of annual free cash flow generation for LyondellBasell over a multiyear period. LyondellBasell is the sole petrochemical company making a regular practice of issuing special dividends. The hurdle rates, in effect, that LYB is using for its capital projects are higher than the rates used by its competitors. LyondellBasell has, as yet, no greenfield projects on the drawing board but a number of certainly higherreturn brownfields under way. LYB is choosing to return cash to shareholders rather than pursue the greenfield route with fervor. This is not to say that LYB will build no greenfield capacity in the future. But, it is to say that should such projects be announced, they are likely to be heavily partnered with a modest level of LYB capital commitment. CEO Jim Gallogly indicated that greenfield ethylene capital costs were $0.75 per pound or $1,650 per metric ton versus brownfield capital costs of $0.50 per pound or $1,100 per ton. Mr. Gallogly insisted that the large greenfield crackers to start up in the 2015-2020 period would arrive later than their planned start dates. We note that, lately, petrochemical companies have been announcing meaningful curtailments of capital expenditures because of slowing global demand. Some of the customers and partners involved in the new capacity are now indicating later dates.
AGU APD ALB AMRS ASH AVY CBT CE CF CMP DOW DD EMN ECL FOE GGC FUL HUN IFF LYB MBLX MTX MON NZYMb.CO PLL PPO POT PPG PX RPM SMG SHW MOS VAL WDFC WLK
N N OW N N NR N N OW UW N N OW N OW OW N N N OW N OW OW N N N N OW N N N N OW N N N
$51.90
ROC N
$52.84
$28.66
Dec
$4.69
$5.30
$5.80
9.8
8.9
$29,852
113
Coal
Tough Year Ahead for Coal
John Bridges, CFA, ACSM AC
(1-212) 622-6430 john.bridges@jpmorgan.com J.P. Morgan Securities LLC
Shwetabh Shrivastava
(91-22) 6157-3317 shwetabh.shrivastava@jpmorgan.com J.P. Morgan India Private Limited
Anant Inani
(1-212) 622-2684 anant.inani@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA BRIDGES <GO> Alliance Resource Partners Alpha Natural Resources Arch Coal, Inc. Cloud Peak Energy CONSOL Energy Peabody Energy ARLP ANR ACI CLD CNX BTU OW N OW N OW OW
US coal prices are off the lows that resulted from the mild 2011/12 winter but the 2% GDP growth rate J.P. Morgan forecasts for 2013 coupled with the continued pressure from the abundance of natural gas is (in our view) insufficient for a robust coal sector recovery. We also note the coal miners initiatives in the last few months to put additional cash and liquidity on their balance sheets, just in case 2013 is another weak year and their businesses consume cash. The export market for US coal is weak reflecting the lackluster global economy and well-supplied coal markets. US thermal coal exports for 2013 seem to be driven more by the need to protect markets rather than profitability. Coking coal prices have picked up a little but prices and volumes look set to be lower in 2013. We are hopeful that, as the fiscal cliff nears, emissions rules will not deliver negative surprises for coal and sour negotiations, but tough implementation of rules is a risk for coal. Conversely, a cold winter or flooding in Australias Queensland coal fields could help tighten the coal market.
$33.16
$40.54
$26.41
Dec
$2.71
$1.22
$0.63
27.2
52.6
$7,553
114
Gold
Thinking About Its Next Move
John Bridges, CFA, ACSM AC
(1-212) 622-6430 john.bridges@jpmorgan.com J.P. Morgan Securities LLC
Shwetabh Shrivastava
(91-22) 6157-3317 shwetabh.shrivastava@jpmorgan.com J.P. Morgan India Private Limited
Anant Inani
(1-212) 622-2684 anant.inani@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA BRIDGES <GO> Agnico-Eagle Mines Barrick Gold Compania de Minas Buenaventura Gold Reserve Goldcorp Inc Jaguar Mining Kinross Gold Newmont Mining NovaGold Resources Stillwater Mining AEM ABX BVN GRZ GG JAG KGC NEM NG SWC N OW N N OW N OW OW NR N
Gold Has Consolidated Three Times Then Moved Higher; Will It Again? Since the bull market for gold began in 2001, gold has consolidated three times and then broken higher. Gold is trading sideways again. The immediate impact of the austerity we expect in 2013 is probably deflationary and may underpin the caution on the metal. However, with no easy solution to the deficit we continue to feel the gold sector remains very interesting as a wealth preserver. Until gold equities can better control their costs, they require a rising gold price to perform, in our view. Gold itself, although down from its 2011 peak relative to the S&P 500, is continuing to grind higher relative to other assets.
$36.82
$52.37
$31.54
Dec
$2.17
$1.97
$2.61
18.7
14.1
$30,046
115
Tyler J. Langton
(1-212) 622-5234 tyler.j.langton@jpmorgan.com
Brian P. Ossenbeck
(1-212) 622-1023 brian.p.ossenbeck@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA GAMBARDELLA <GO> Michael F. Gambardella AK Steel Alcoa Allegheny Technologies Carpenter Technology Century Aluminum Company Cliffs Natural Resources Commercial Metals Dynamic Materials Freeport-McMoRan Copper & Gold Globe Specialty Metals GrafTech International Haynes International Metals USA Molycorp Nucor Corp. Reliance Steel & Aluminum RTI International Metals Steel Dynamics, Inc. Teck Resources Thompson Creek Metals TIMET U.S. Steel Corp Worthington Industries Tyler J. Langton Cameco Inmet Mining Uranium One
Since the beginning of 2012, the metals and mining stocks in our coverage universe have fallen roughly 11% while the S&P 500 has gained 12%. The underperformance in the group has largely, in our view, been driven by fears of the potential impact that a sharper-than-expected deceleration in China and recession in the U.S. could have on metals demand and prices. While risks remain, our commodity strategist believes a hard landing in China and the U.S. will be averted, and continues to think metals are in a broad bottom-forming process. If these growth expectations are at least met, we would expect our stocks to rebound as any lessening in uncertainty likely would cause purchasers to move away from their currently cautious stance. We remain most constructive on the copper market. J.P. Morgans Commodities Research team foresees a tighter global copper balance in both 2013 and 2014 as recent capex deferrals and cancellations will further compound production shortfalls when the global economy recovers. In addition, the team views these changes to capex plans as midcycle softness, not the end of the commodity supercycle, as longterm metal demand still requires significant investment not yet committed and increasingly dependent upon remote and riskier geographies. We remain more cautious on the steel producers. While global steel prices have recently moved higher on firming raw material costs and improving supply/demand conditions in China, we dont believe fundamentals, particularly raw material costs, are supportive of an additional increase in steel prices.
AKS AA ATI CRS CENX CLF CMC BOOM FCX GSM GTI HAYN MUSA MCP NUE RS RTI STLD TCKb.TO TC TIE X WOR
N OW N OW N N N OW NR N OW OW N UW OW N N OW OW OW OW N N
N OW N
$47.76
$58.00
$42.18
Jun
$2.86
$3.44
$4.04
13.9
11.8
$2,514
Key risks include a weakening in the aerospace and energy end markets, delays or cost overruns at the Athens plant, and lower-thanexpected synergies from the Latrobe acquisition.
116
Lovneet Singh
(91-22) 6157-3297 lovneet.singh@jpmorgan.com J.P. Morgan India Private Limited Bloomberg JPMA GRESH <GO> Aptargroup Ball Bemis Boise Crown Holdings Domtar Graphic Packaging Greif International Paper Co. MeadWestvaco O-I Packaging Corp of America Rock-Tenn Sealed Air Silgan Holdings Sonoco ATR BLL BMS BZ CCK UFS GPK GEF IP MWV OI PKG RKT SEE SLGN SON OW N N N OW OW N N N OW N N N OW N N
Macro Likely to Remain Sideways, Causing Us to Look for Idiosyncratic Value Against a backdrop of likely ~2% GDP growth, we see only modest volume growth in the Paper & Packaging sector once again in 2013, making stock picking mostly a function of idiosyncratic stories, as opposed to riding macro tailwinds. In 2012, that opportunity was mostly in the containerboard sub-sector on the Paper side, on the back of consolidation and a subsequent autumn price increase. However, we are neutral on this sub-sector, as we believe the benefits of the price increase are factored in, while we are a bit cautious about the prospects of higher input cost inflation for virgin wood fiber, OCC, energy and chemicals, which could weigh on potential for near-term earnings upside. Should this inflation occur, we would then look for opportunities to buy on dips on the idea that the structurally improved industry could seek further price increases to at least cover this inflation. For Packaging, we also see limited volume growth, particularly in developed markets, a function of continued inflation for consumers on food and beverage products. However, to the extent that inflation subsides here a bit, this could create some easier comparisons, around which we would look to be opportunistic. Developing markets are a wildcard, as Brazil looks poised to see modest reacceleration in growth, while China has slowed from its torrid pace. We assume only moderate growth in both key regions for now.
$30.49
$31.34
$24.76
Dec
$1.37
$1.35
$1.70
22.6
17.9
$5,330
117
Silver
The High-Beta Gold
John Bridges, CFA, ACSM AC
(1-212) 622-6430 john.bridges@jpmorgan.com J.P. Morgan Securities LLC
Shwetabh Shrivastava
(91-22) 6157-3317 shwetabh.shrivastava@jpmorgan.com J.P. Morgan India Private Limited
Silver is one of the most volatile precious metals. The metal is also more exposed to the general economy than gold due to its larger industrial usage. We continue to feel that the biggest driver of silvers performance is investment demand. A recent review by GFMS Thompson Reuters for the Silver Institute shows silver investment demand growth has slowed. We suspect silver demand also has been affected by investors waiting for guidance from the fiscal cliff negotiations. Given silvers greater sensitivity to industrial demand, we still prefer the gold space while recognizing that silvers volatility is attractive to some investors.
Anant Inani
(1-212) 622-2684 anant.inani@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA BRIDGES <GO> Coeur d'Alene Hecla Mining Pan American Silver Silver Wheaton CDE HL PAAS SLW N N UW OW
$35.08
$41.30
$22.94
Dec
$1.58
$1.67
$2.19
21.0
16.0
$12,429
118
Internet
We remain positive on the U.S. Internet sector into 2013 based on strong secular growth, increased online accessibility via mobile devices and strengthening of key trends including social, local and video. Strengthening of the consumer should also be a benefit in the areas of online commerce, advertising and travel in particular. Strong secular growth to continue. With online advertising at ~20% of total ad spending and eCommerce at ~10% of total retail (in the U.S.), these segments should continue to have many years of double-digit growth ahead on a global basis, in our view. The Internet economy also likely will be bolstered by monetization of online video content, applications and cloud-based services. Mobile devices leading confluence of key trends. We believe smartphone and tablet adoption have played a critical role in accelerating key industry trends including social, local and mobile search. As smartphone penetration of the mobile market moves beyond the 51% penetration in the U.S. and 44% globally and as tablets approach mainstream adoption, we expect mobile devices to have an even bigger impact on Internet business models and eCommerce trends. Notably, tablets are mobile devices with PC characteristics, and theyre still underpenetrated. Platform/ecosystem competition to intensify. We believe Amazon, Apple and Google are emerging as primary platforms on which increasing amounts of online/ mobile communications, advertising and commerce are likely to be conducted. Notable characteristics of these major platforms include global reach, large and developing ecosystems, strong network effects and revenue-generating toll-booth capabilities. Looking ahead, we expect these platforms to continue to grow stronger as the rest of the Internet increasingly relies on them.
Bo Nam
(1-212) 622-5032 bo.nam@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA ANMUTH <GO> Amazon.com Bankrate Inc CafePress, Inc. eBay, Inc Expedia, Inc. Facebook Google Groupon HomeAway Inc LinkedIn Corp Netflix Inc Pandora Media Inc Priceline.com QuinStreet, Inc. ReachLocal TripAdvisor, Inc. Trulia Inc. Yahoo Inc Zynga Inc AMZN RATE PRSS EBAY EXPE FB GOOG GRPN AWAY LNKD NFLX P PCLN QNST RLOC TRIP TRLA YHOO ZNGA OW N N OW N OW OW N OW OW N OW OW N OW N N N N
$51.99
$53.15
$29.08
Dec
$2.03
$2.36
$2.83
22.0
18.4
$67,276
Risks: An increase in competitive share in the eCommerce and hardline retail market (e.g., Amazon, Wal-Mart), PayPal competition from large technology and credit card players as well as financial institutions, and take rate erosion. 119
Media
Positive Outlook with CBS as Top Pick
Alexia Quadrani AC
(1-212) 622-1896 alexia.quadrani@jpmorgan.com
Nadia Lovell
(1-212) 622-4885 nadia.s.lovell@jpmorgan.com
Caroline Anastasi
(1-212) 622-0138 caroline.e.anastasi@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA QUADRANI <GO> Alexia Quadrani AMC Networks CBS Corporation Discovery Communications Disney Gannett Company Interpublic Group of Companies Lamar Advertising Co. Lionsgate Entertainment New York Times Company Omnicom Group Scripps Networks Interactive Sinclair Broadcast Group The E.W. Scripps Company Time Warner Valassis Communications Viacom Townsend Buckles, CFA, CPA Cinemark IMAX National CineMedia, Inc. RealD Inc. Regal Entertainment
The advertising outlook for 2013 remains murky given macroeconomic uncertainties, particularly in the first-half of the year. Nonetheless, recent commentary from media buyers as well as from senior executives in the industry suggests spending continues at a healthy clip, and we are currently predicting 3.5% growth in the U.S. in 2013. We believe advertisers continue to default to advertising as a means of driving revenue growth rather than less discretionary investments in this still-uncertain environment and ad spend is likely to remain relatively healthy in 2013, even if the macro environment remains uneven. Furthermore, many of the media companies in our universe derive a significant portion of their revenues from the sale of content, which is a less cyclical and very high margin revenue stream. As consumption of media continues to fragment, we see more bidders for this content continuing to emerge, escalating the value of this asset. In addition, international demand is building following the proliferation of cable in many markets, providing another avenue of growth. Given these very favorable characteristics, we remain positive on the group despite its outperformance in 2012 and look for another great year in 2013.
AMCX CBS DISCA DIS GCI IPG LAMR LGF NYT OMC SNI SBGI SSP TWX VCI VIAB
N OW N OW N OW N OW N OW N N OW OW OW OW
N OW N N N
$35.65
$38.32
$24.49
Dec
$1.94
$2.59
$2.95
13.8
12.1
$22,817
120
Richard Choe
(1-212) 622-6708 richard.choe@jpmorgan.com
Wireless Telecom For 2013, we expect subscriber growth to come mostly from data-only devices. Revenue growth should continue to be robust from increased penetration of smartphones, sales of tablets and higher ARPU driven by higher levels of data usage. Smartphone penetration could exceed 75%, up from ~65% today, with an increasing shift towards LTE devices while more tablets, LTE data cards and MiFi devices also get connected to the networks, driving revenue growth. Moreover, we expect continued activity on the wireless M&A front in 2013, following an active 2H12 Wireline Telecom On the wireline side, we expect consumer trends to remain steady, with modest growth in residential, but ongoing pressure on the enterprise side. For residential, increased penetration of broadband and video should continue to help revenue trends. We believe the biggest upside could come from increased enterprise telecom spending, though we do not assume a macroeconomic recovery in our estimates. We also expect cell tower backhaul revenues to continue to increase as wireless usage continues to grow with increased carrier adoption of 4G technology. In our view, government-related revenue will continue to present downside risk for the sector. Wireless Towers We expect tower companies to continue to benefit from the 4G network buildout by wireless carriers in 2013. Business trends were strong in 2012 and could be even better in 2013, as LTE buildouts gain more scale in the industry. While further consolidation within the industry presents some risk, we believe the current outlooks of the four big wireless carriers provide for a healthy wireless ecosystem, which we view as a positive for the towers overall. New networks including Dish or Public Safety could add to upside potential. Cable and Satellite We maintain a positive view on cable and satellite, as we find the over-the-top threat limited and believe increased broadband growth will offset challenges in video. Given the aggressive telco buildout phase is essentially over, video sub losses should abate somewhat in 2013. Cash generation in the space is attractive, with free cash flow yields of 3.2%-11.8% for 2013E. In our view, continued growth in commercial business offers incremental opportunity vs. slowing residential prospects.
$37.14
$37.96
$22.37
Dec
$1.50
$1.92
$2.16
19.3
17.2
$98,079
Note: Target based on DCF assuming 7.5% WACC and 1.0% perpetual growth, adjusted for GEs 49% stake in NBCU. Risks: Heavy telecom video competition, OTT video challenge, increased investment and ad exposure related to NBCU, Roberts family control. 121
122
Technology
The LED industry looks to start off 2013 slowly, but accelerate throughout the year as consumer electronics demand recovers and Lighting and Automotive demand continue to experience strong secular growth. We think C13 will start amid seasonal and cyclical weakness in the LED space, with C1Q13 likely being the weakest quarter of the year. We believe a modest recovery in consumer electronics demand coupled with continued strong secular growth in Lighting and Automotive applications will cause industry fundamentals to improve throughout the remainder of the year. Most LED makers are currently more focused on improving margins than expanding capacitya trend we believe will keep industry capex low and lead to improved LED utilization rates in C13 vs. C12 levels. Pricing for LED chips and components has returned to relatively normal conditions in C12 and rising utilization rates should allow for modest margin expansion for leading LED chip/component makers. Given the excess capacity that exists in virtually all parts of the LED foodchain, we recommend investors look downstream for outperformance.
William Peterson
(1-415) 315-6711 william.c.peterson@jpmorgan.com
Eugenia Liu
(1-415) 315-6710 eugenia.ic.liu@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA BLANSETT <GO> Cree Rubicon Technology Veeco Instruments CREE RBCN VECO OW OW OW
$32.70
$33.60
$20.25
Jun
$0.93
$1.40
NA
23.4
N/M
$3,802
123
We see the issues currently plaguing the Solar PV industrysignificant overcapacity and declining demand in Europe, which historically has been the largest marketcontinuing in 2013. We expect US-based companies under coverage, First Solar (FSLR), SunPower (SPWR) and MEMC (WFR), to continue to focus on their US-centric project development businesses in order to weather the tough Solar PV market conditions. We believe industry consolidation will continue in 2013 given the expected continued erosion of balance sheets and cash on hand, and weak pricing conditions and general lack of profitability for much of the industry. For US solar PV companies under coverage, investors in our view will focus on the margin profile of their project development activities as newer projects generally have a lower margin profile than older projects. The rate of margin decline in 2013 will be instrumental in determining investor interest in our view as expectations are low. In addition, the ability for these companies to replenish their project pipelines will be closely watched, especially with projects in emerging solar markets such as Souteast Asia, South America or the Middle East, given the high expectations many companies have set for growth in these regions. The majority of the project backlog these companies have in place was generated a number of years ago when utilities were willing to sign high-priced, utility-scale Power Purchase Agreements (PPAs). Since that time, the price points US utilities have been willing to sign up to have declined significantly, over 50% in most instances. In addition, many states have already made significant progress toward meeting their long-term Renewable Energy goals, thus lessening the local utilities interest in signing additional contracts for solar PV, especially given the relatively higher electricity production costs of a solar PV plant vs. a combined-cycle natural gas plant. Unless there is a significant increase in North American natural gas pricing, which seems unlikely given continued productivity improvements of shale-based wells, solar PV stocks are likely to remain out of favor with investors in 2013.
William Peterson
(1-415) 315-6711 william.c.peterson@jpmorgan.com
Eugenia Liu
(1-415) 315-6710 eugenia.ic.liu@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA BLANSETT <GO> Broadwind Energy First Solar, Inc. MEMC Electronic Materials Inc. SunPower BWEN FSLR WFR SPWR N UW UW UW
$30.72
$51.89
$11.43
Dec
$6.13
$4.60
$2.66
6.7
11.5
$2,673
124
Paul J. Chung
(1-212) 622-5552 paul.j.chung@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA COSTER <GO> 3D Systems Corporation Acacia Research Corp. Avid Technology Coinstar Inc. Cubic Corp Diebold, Incorporated DigitalGlobe, Inc. Dolby Laboratories, Inc. DTS, Inc. Echelon Corporation Elster Group SE EnerNOC Inc. ESCO Technologies Inc. Fabrinet FLIR Systems Inc Garmin Ltd. GeoEye, Inc. iRobot Corporation Itron, Inc Logitech International NCR Corporation Nice Systems OmniVision Technologies Plantronics Inc Rambus Inc. RPX Corporation Synaptics Inc. TASER International Inc. TeleCommunication Systems, Inc. TeleNav, Inc. TiVo Inc. Trimble Navigation TTM Technologies Verint Systems, Inc. ZAGG Inc Zebra Technologies Zipcar DDD ACTG AVID CSTR CUB DBD DGI DLB DTSI ELON ELTTY ENOC ESE FN FLIR GRMN GEOY IRBT ITRI LOGI NCR NICE OVTI PLT RMBS RPXC SYNA TASR TSYS TNAV TIVO TRMB TTMI VRNT ZAGG ZBRA ZIP UW OW OW N N UW N UW N N NR N N N UW UW N UW OW UW NR OW OW OW OW OW N N OW N OW OW N OW OW N N
VRNT is a leading supplier of business and security intelligence software solutions, used widely in contact centers, by government agencies and by communications service providers. We expect VRNT to benefit from an increase in enterprise IT spending in 2013. In addition, the reverse merger with the shell company of Comverse is expected to close on approximately February 1, 2013. We believe the elimination of CMVTs majority ownership and the simplification of the capital structure should buoy VRNTs multiple, which currently stands ~3.0 turns below that of peer NICE on a CY12E P/E basis. Following the closing of the reverse merger, we would also expect VRNT to increase its investor relations effort.
$27.46
$32.76
$24.60
Jan
$2.47
$2.48
$2.66
11.1
10.3
$1,101
125
Business Services
US Flexible Staffing Healthy Despite Fiscal Cliff Uncertainty; Europe Still Challenged
Andrew C. Steinerman AC
(1-212) 622-2527 andrew.steinerman@jpmorgan.com
Jeffrey Y. Volshteyn
(1-212) 622-2940 jvolshteyn@jpmorgan.com
Molly R. McGarrett
(1-212) 622-5841 molly.r.mcgarrett@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA STEINERMAN <GO> Andrew C. Steinerman American Reprographics Company CDI Corp. Cintas G&K Services Iron Mountain ManpowerGroup Resources Global Professionals Robert Half International UniFirst Jeffrey Y. Volshteyn Towers Watson
US flex staffing continues rather healthy growth trajectory despite post-election uncertainty. US flexible staffing growth remains healthy, despite a rather sluggish full-time labor growth environment. During 2012, flex staffing has represented ~9% of nonfarm payroll adds, despite representing less than 2% of the overall workforce. US flex staffing continues to grow in the high-single-digit range seen over the past year (on a monthly basis), but has decelerated modestly in late 2012. Staffers broadly see businesses moving forward despite ongoing uncertainty related to the fiscal cliff. Professional staffing remains strong, while commercial staffing growth shows modest slowing. Healthy overall US staffing market growth continues to be led by strength in the professional staffing segments, particularly in IT and finance and accounting skill-sets. However, commercial staffing has seen some slowing due to easing in some markets and sectors (e.g., initial manufacturing). The supply of skilled professionals remains tight, and professional staffers must be disciplined in pushing for higher bill rates to offset rising wage pressure in these areas. Commercial staffing pricing is more challenged, but seems to be firming somewhat as astute providers (e.g., ManpowerGroup) are being selective and disciplined. PPCA Act might be a net positive to the US flex staffing industry. The new US healthcare regulations slated to go into effect in 2014 represent a source of both potential positive and negative impacts for flex staffing industry. Although it is still too early to frame the extent of the potential impact to staffing firms in the US, we note the negative exposure for staffers seems to be declining as the regulations are clarified. At our recent Ultimate Services Investor Conference, some public staffing firms indicated they now see the healthcare regulations as a potential net positive. European flex staffing markets still challenged. European real GDP expansion remains difficult, and European flex staffing markets are negative. We sense that European staffing will remain pressured until real GDP growth edges positive. In response, global staffer ManpowerGroup is creating new efficiencies to leverage more profitably a prospective rebound in demand in these regions. Growth-cyclical staffing stocks offer attractive risk/reward profile in an uneven economic recovery. US-centric RHI is trading at a ~4% discount to its normal recessionary EV/S multiple, while more European-exposed MAN stock trades at an attractive ~21% discount. With a permissive economy, staffing stocks in our view should offer a favorable combination of secular/cyclical growth, outsized margin recovery and prospective multiple expansion.
N N OW N NR OW N OW N
TW
OW
$28.62
126
$32.32
$25.10
Dec
$1.04
$1.55
$1.82
18.5
15.7
$4,028
Joseph Park
(1-415) 315-6760 joseph.x.park@jpmorgan.com J.P. Morgan Securities LLC
Our most recent J.P. Morgan CIO Survey (Sept.) indicates deteriorating IT spending trends, consistent with our proactive reduction in our communications equipment market forecasts on September 10. As a result of intensifying macro headwinds, weve also noticed a more negative tone throughout Q312 earnings, characterized by delays and/or pullbacks in spending. Despite this, we do see pockets of secular growth such as 100G optical spending within our battered sector. As enterprise spending expectations deteriorate, we find it tough to see winners exposed to IT. Given these troubling indicators along with macro pressures, especially in the public sector, which are likely to persist for some time, we are incrementally more cautious on enterprise-focused companies. We, therefore, prefer carrier-exposed names heading into 2013.
Ashwin Kesireddy
(1-415) 315-6756 ashwin.x.kesireddy@jpmorgan.com J.P. Morgan Securities LLC
Rajat Gupta
(91-22) 6157-3347 rajat.gupta@jpmorgan.com J.P. Morgan India Private Limited Bloomberg JPMA HALL <GO> Acme Packet Ciena Corp. Cisco Systems Corning F5 Networks Infinera Juniper Networks Mitel Networks QUALCOMM Research in Motion Riverbed Tellabs APKT CIEN CSCO GLW FFIV INFN JNPR MITL QCOM RIMM RVBD TLAB N OW N N N N N N OW NR N N
$15.64
$18.39
$10.30
Oct
($0.31)
($0.26)
$0.29
N/M
53.9
$1,567
127
We expect the broader Data Processing group to outperform the IT Services group in 2013, as Data Processors are most leveraged to improving investor sentiment (from a more muted financial regulatory/legislative environment in Washington) and a rebound in durable goods and consumer spending, which could drive multiple expansion and upside to our earnings estimates and price targets. We note our estimates generally assume stable to modestly weaker consumer spending trends.
Puneet Jain
(1-212) 622-1436 puneet.x.jain@jpmorgan.com
Stephanie Davis
(1-212) 622-6591 stephanie.j.davis@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA HUANG <GO> Tien-tsin Huang, CFA Accenture plc Automatic Data Processing Broadridge Cognizant Computer Sciences ExlService Holdings Inc. FIS Fiserv, Inc. FleetCor Genpact Global Payments Green Dot Heartland Payment Systems MasterCard MoneyGram Paychex Inc Vantiv VeriFone Visa Inc. Western Union WEX Inc. WNS Holdings Ltd. Reginald L. Smith Alliance Data Cardtronics, Inc Puneet Jain Syntel, Inc. Virtusa Corp.
ACN ADP BR CTSH CSC EXLS FIS FISV FLT G GPN GDOT HPY MA MGI PAYX VNTV PAY V WU WXS WNS
OW N N OW UW N N OW OW NR N N OW OW N UW OW OW OW N N N
ADS CATM
N N
$148.47
$150.72
$95.05
Sep
$6.20
$7.20
$8.50
20.6
17.5
$100,625
SYNT VRTU
N OW
128
Education Services
Extended Legislative Uncertainty in Higher Ed in 2013; We Prefer Low-Tuition Ed Stocks
Jeffrey Y. Volshteyn AC
(1-212) 622-2940 jvolshteyn@jpmorgan.com
Andrew C. Steinerman
(1-212) 622-2527 andrew.steinerman@jpmorgan.com
Molly R. McGarrett
(1-212) 622-5841 molly.r.mcgarrett@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA VOLSHTEYN <GO> Jeffrey Y. Volshteyn American Public Education Apollo Group Bridgepoint Education Capella Education DeVry Education Management Grand Canyon Education ITT Educational Services Inc Strayer Education
As the composition of the Education Department (ED) will stay largely the same in 2013 and Congress remains divided, the future direction of U.S. higher education policy remains uncertain in our view. We expect that schools will have to operate within this uncertain legislative infrastructure for at least two years. We favor stocks of lower-tuition education companies, such as APEI and LOPE, as low-tuition models should remain attractive in any legislative and regulatory scenario due to their lower student debt burden and better student value proposition, in our view. Extended regulatory/legislative uncertainty is likely in 2013. The ED has been adversarial towards for-profit schools, and Congress has been divided on the majority of higher education issues. We think the higher-education legislative and regulatory frameworks are long overdue for a comprehensive review. While the (scheduled) 2013 reauthorization of the Higher Education Actthe main law for the industry could provide the opportunity for such a review, industry insiders suggest that it is not likely to occur in the next two years due to the wide philosophical differences between the parties and a long list of overdue legislation in the pipeline. Both parties agree on some issues, such as (1) the importance of stable funding for Pell Grants (as Pell is currently safe from cuts even under the sequestration), (2) the need to fund the current shortfall in Pell by removing the interest rate subsidy for undergraduate subsidized loans, (3) the need to change at least portions of the current accreditation system to improve financial performance, and (4) the need to protect military students from aggressive marketing and misrepresentation. That said, the parties remain divided on the key issues such as (1) the usability of the current metrics (cohort default rate, 90/10) and (2) the effectiveness of the gainful employment regulations, among many others. While Democrats support most of the existing metrics and look to enhance them, Republicans see them as ineffective and burdensome. We also think that gainful employment rules are not dead, but dormant for now, waiting for the EDs response to the court decision vacating the thresholds. Ed companies refocus on specific operational strategies to regain growth (through differentiated programs, focused scholarships), improve student persistence and find cost efficiencies.
OW OW N N UW N OW UW N
$35.59
$46.96
$24.88
Dec
$2.23
$2.29
$2.82
15.5
12.6
$643
129
Information Services
Information Services Stocks Provide Defensive Growth Amid Uneven Economic Recovery
Andrew C. Steinerman AC
(1-212) 622-2527 andrew.steinerman@jpmorgan.com
Jeffrey Y. Volshteyn
(1-212) 622-2940 jvolshteyn@jpmorgan.com
Molly R. McGarrett
(1-212) 622-5841 molly.r.mcgarrett@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA STEINERMAN <GO> Andrew C. Steinerman Arbitron D&B Equifax IHS Inc. Nielsen Holdings N.V. Solera Holdings Thomson Reuters Verisk Analytics
Information Services stocks are attractive growth-defensive vehicles amid an uneven economic recovery. Information Services companies provide need to have information for professionals through subscription-based models, driving highly recurring, resilient revenue streams. Dominant positioning in niche markets provides info services firms with high barriers to entry, while strategies to embed products in the workflows of customers create close customer relationships, significant switching costs and high renewal rates. As a result of these factors, Information Services companies benefit from a particularly sticky business model even in an uncertain macro environment. While we are currently seeing non-subscription revenues (from data analytics products, consulting work, etc.) as a percentage of total revenue declining somewhat for the sector due to a pullback in corporate discretionary spending, the resilient nature of the subscription business (which makes up the vast majority of sector revenues) bolsters growth despite cyclical drags. Other growth areas for the Information Services providers include greater penetration of existing customers, global expansion, and the convergence of overlapping and adjacent markets. Build it once, sell it many times database business model drives operating leverage. Information Services firms often derive significant pricing power by providing extensive proprietary databases that are not easily replicable, and offering unique analytics around their own data. Databases drive operating leverage, as they are built once and sold again and again through renewals, cross-selling to existing customers and new customer sales. Info Services companies are also able to translate solid recurring revenues and reliable profit growth into consistent free cash flow streams due to the sectors light capex requirements. Information Services stocks are trading at attractive levels. Over the past 12 years, Info Services stocks have greatly outperformed the S&P 500. Information Services stocks are currently trading in a range of 11-42x CY2013E EPS (at a market cap weighted average of 17x), somewhat below the long-term average for the sector. We see the Information Services stocks as offering solid recurring top-line growth, consistent profitability and prospective multiple expansion in a choppy but still conducive economic recovery.
N UW OW N OW OW N OW
$28.90
$32.07
$25.02
Dec
$1.66
$1.83
$2.08
15.8
13.9
$10,467
130
IT Hardware
Limited Appreciation Opportunities as Techs Growth Profile Slides into a Dust Bowl
Mark Moskowitz AC
(1-415) 315-6704 mark.a.moskowitz@jpmorgan.com
Anthony Luscri
(1-415) 315-6702 anthony.s.luscri@jpmorgan.com
Mike Kim
(1-415) 315-6755 mike.j.kim@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA MOSKOWITZ <GO> Mark Moskowitz Aeroflex Apple Inc. Brocade Dell Inc. EMC Emulex Corp. Fusion-io Hewlett-Packard IBM Lexmark International NetApp Orbotech QLogic Corporation Seagate Technology Western Digital Xerox Corporation Anthony Luscri National Instruments
Still Cautious We do not expect the technology sector to exhibit much of a growth rebound in 2013. Our view remains unchanged that sector growth is likely to trend to levels lower than global GDP expansion, which explains the ongoing compression in tech-related P/E multiples. Most coverage companies are likely to find it difficult to achieve revenue growth exceeding 3%. In our view, financial visibility at most technology companies is not likely to improve in 1H 2013, sustaining recent volatility in the stocks. We think (1) China, EMEA and U.S. government fiscal policies and (2) end market demand conditions need to stabilize before investor sponsorship of tech improves. Set against this cautious backdrop, we still highlight the Big Four. Yes, it has become rather boring recommending Apple, NetApp, EMC and IBM to play defense for more than two years, but we are sticking with that stance. We think these four companies possess the most secular and company-specific attributes to provide partial buffers to macro blues, which are not likely to ease soon, in our view. Meanwhile, we recommend investors steer clear of PC, printing and data center connectivity solutionsrelated companies. Examples include Dell, Hewlett-Packard, Lexmark, Xerox, Brocade, Emulex and QLogic. In our view, the revenue growth profiles of these companies could trend ex-growth beyond the near term, and investment in diversification strategies could present execution risks.
ARX AAPL BRCD DELL EMC ELX FIO HPQ IBM LXK NTAP ORBK QLGC STX WDC XRX
N OW UW OW OW UW N UW OW UW OW N UW N N UW
NATI
OW
$547.25
$705.07
$377.68
Sep
$44.14
$48.92
$52.47
11.2
10.4
$514,789
131
William Peterson
(1-415) 315-6711 william.c.peterson@jpmorgan.com
We believe SemiCap Equipment industry fundamentals likely will trough in C1H13 and improve in C2H13 on increased memory spending and initial 20nm Foundry spending. We continue to believe overall semi capex will decline by 15% y/y and look for a more attractive entry point before we would consider recommending investors be long the sector. Following a meaningful investment in leading-edge foundry capacity in C12 and considering an uncertain macroeconomy, we believe semi capex will decline in C13 by approximately 15%. Specifically, we think muted PC demand will negatively impact logic spending and keep DRAM spending at very low levels in the first half of next year. We also think NAND suppliers will continue to harvest margin rather than make sizeable capacity additions in C1H12. For Foundry, our expectations for additional 28nm capacity investments remain below Street expectations and we believe Foundries will be more likely to focus on 20nm, which would result in significant spending on Wafer Fab Equipment (WFE) in the second half of C13. For SemiCap Equipment stocks, a weak macro outlook is likely to continue to weigh on stocks in the near term, though the downside risk is likely modest at this stage compared to six months ago. We look for a more attractive entry point before becoming more constructive on the sector and think market, not sector risk is a larger concern at this time.
Eugenia Liu
(1-415) 315-6710 eugenia.ic.liu@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA BLANSETT <GO> Applied Materials, Inc. KLA-Tencor Lam Research Nanometrics Photronics AMAT KLAC LRCX NANO PLAB N UW UW OW N
$14.79
$20.99
$12.39
Dec
$1.40
$0.20
$0.68
74.0
21.8
$346
132
Semiconductors
Still Waiting for the Upturn Once Demand Stabilizes
Chris Danely AC
(1-415) 315-6774 chris.b.danely@jpmorgan.com
Shaon Baqui
(1-415) 315-6766 shaon.i.baqui@jpmorgan.com
We believe the macroeconomic environment will be the biggest driver of semi stock performance during 2013, just as it has been in 2012 so far and in 2011, 2010 and 2009. We expect a strong increase in Consensus estimates when semiconductor demand stabilizes, because inventory in the channel is lean and margins are near the trough. We favor Overweight-rated TXN, XLNX, ADI, ONNN and FCS as they offer the most upside potential to margins and EPS. PC end market likely to remain weakest. We expect demand from the PC end market to remain weak in 2013 due to soft global demand and share loss to tablets. In addition, we do not expect Windows 8 to drive incremental PC demand as new operating systems have not driven a major PC refresh cycle since 1995. As a result, we expect soft PC demand to continue to weigh on AMD (90% of sales from the PC end market), INTC (85%) and ISIL (20%) in 4Q12. Handset end market likely mixed. We expect mixed demand from the handset end market with the Apple and Samsung food chains being strong and taking market share from every other handset food chain. We expect companies with high exposure to Samsung and Apple such as Maxim (MXIM) and Avago (AVGO) to benefit. Communications end market improving. We believe low inventory in the communications supply chain and positive guidance from Cisco and AT&T bodes well for Xilinx and Altera in C13 as roughly half of XLNX and ALTR sales are from the telecom end market. Low channel inventory and margins mitigate downside. Inventory in the channel is low and almost back to the trough of the 2008/2009 downturn. In addition, most semiconductor companies gross margins are closer to trough than peak, mitigating the risk of a prolonged downturn. Still waiting for the upturn once demand stabilizes. We expect a strong increase in Consensus estimates when semiconductor demand stabilizes, because inventory in the channel is lean and margins are near the trough. We favor semiconductor stocks with the most upside to margins and EPS. We expect C13 EPS to rise 33% y/y on average for our stocks, with ONNN, FCS, XLNX and TXN having the most growth.
Sameer Kalucha
(1-415) 315-6762 sameer.kalucha@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA DANELY <GO> Advanced Micro Devices Altera Analog Devices Avago Technologies Cypress Semiconductor Fairchild Semiconductor Intel Intersil Corporation Linear Technology Maxim Integrated Products Microchip Technology ON Semiconductor Corporation RF Micro Devices Texas Instruments Vishay Intertechnology Xilinx AMD ALTR ADI AVGO CY FCS INTC ISIL LLTC MXIM MCHP ONNN RFMD TXN VSH XLNX N N OW N UW OW N UW UW N N OW UW OW N OW
$29.81
$34.24
$26.06
Dec
$1.87
$1.37
$1.54
21.8
19.4
$33,411
133
SMid Semiconductors
Demand Outlook Remains Soft; Focus on Mobile Connectivity and Networking Infrastructure
Harlan Sur AC
(1-415) 315-6700 harlan.sur@jpmorgan.com
John S. Ahn
(1-415) 315-6758 john.s.ahn@jpmorgan.com
Saqib Jalil
(1-415) 315-6761 saqib.jalil@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA SUR <GO> Audience Broadcom Corporation Cavium Inc Entropic Communications Freescale Semiconductor Intermolecular LSI Corporation M/A-COM Marvell Technology Group Mellanox Technologies Micron Technology NVIDIA Corporation NXP Semiconductors Peregrine Semiconductor PMC-Sierra SanDisk Corp ADNC BRCM CAVM ENTR FSL IMI LSI MTSI MRVL MLNX MU NVDA NXPI PSMI PMCS SNDK N OW OW N OW OW N OW N N N N N OW N N
The sluggish macro environment that ensnared most of the major market segments for SMid semis in 2012 continues to paint an uncertain backdrop as we head into 2013. However, we do see some areas for optimism, particularly for product cycle driven companies exposed to verticals that we believe are poised to recover meaningfully in 2013. We believe carriers will need to respond to higher wireless data capacity needs in 2013 and resume network build-outs, augmented by widescale deployments of small-cell networks. We also believe IT spending should start to recover in 2013 as corporations take stock of the increasing demand on their data processing/storage infrastructure. Continued ramps of Romley-based servers, ongoing transition to 10G Ethernet and 6G SAS, and greater emphasis on security should fuel growth for our enterprise-exposed companies. The muted PC demand environment likely will continue to weigh on HDD builds but we anticipate a modest recovery through the 1H, as HDD OEMs resume chip consumption after two quarters of inventory adjustments. We believe ramps of higher-capacity mobile HDDs (500GB/platter in 2.5 form factors), hybrid drives and SSDs should help drive better growth for our storage-exposed companies. The one market vertical that bucked the trend and remained strong through the macro sluggishness in 2012 was smartphones/ tablets, and we believe a focus on mobile connectivity will continue to drive robust growth in 2013.
$33.36
$39.30
$27.27
Dec
$2.88
$2.93
$3.30
11.4
10.1
$18,815
134
Software
The Struggle Between Deteriorating Fundamentals and Historically Low Interest Rates
John DiFucci AC
(1-212) 622-2341 john.s.difucci@jpmorgan.com
Sandeep Madhur
(1-212) 622-6516 sandeep.madhur@jpmorgan.com
Darren Jue
(1-212) 622-4071 darren.r.jue@jpmorgan.com
Fundamentals likely to remain challenging in 2013. As has been the case over the past two years, we believe that IT spending will continue to be challenged in 2013. We think this will primarily be due to sluggish demand from three key demand sourcesEurope, US Government, and Financial Serviceswhich collectively account for about 40-50% of global IT and Software spending. Although we have not seen material signs of weakness from the Financial Services vertical to date (at least relative to the other two verticals), we continue to believe the challenges facing the Financial Services industry could dampen spending in 2013. Low interest rates favor equities and Software better positioned than most others. While we have a bearish view on IT and Software spending due to these factors, we also recognize equities are more attractive relative to other asset classes, given the current, unprecedented low interest rates and the Feds commitment to keep them there. So even though fundamentals appear precarious for all of enterprise IT, we believe Software is at least better positioned than most other subsectors given the highly recurring and profitable nature of maintenance (or subscription renewals).
Ken Talanian
(1-212) 622-1303 kenneth.r.talanian@jpmorgan.com
Albert Chi
(1-212) 622-5316 albert.chi@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA DIFUCCI <GO> AVG Technologies BMC Software, Inc. CA Technologies Carbonite Inc. Citrix Systems, Inc. Eloqua ExactTarget LogMeIn Microsoft Oracle Corp. PROS Holdings Qlik Technologies Inc. Red Hat Inc salesforce.com SolarWinds Splunk Symantec TIBCO Software Inc VMware Workday AVG BMC CA CARB CTXS ELOQ ET LOGM MSFT ORCL PRO QLIK RHT CRM SWI SPLK SYMC TIBX VMW WDAY OW N OW OW UW OW OW OW N OW N OW UW N OW OW OW OW N N
$32.03
$33.29
$24.91
May
$2.46
$2.71
$2.93
11.8
10.9
$154,354
135
Software Technology
Looking at Three Scenarios
Sterling Auty, CFA AC
(1-212) 622-6389 sterling.auty@jpmorgan.com
Lauren Choi
(1-212) 622-6102 lauren.choi@jpmorgan.com
Looking to 2013 we see three potential paths that would impact the stocks in our Software Technology coverage universe. In each of the three we believe a different set of stocks likely would perform better than the rest, so we outline each of the scenarios for investors to gauge for themselves the right approach. Our best idea is the name that has the best chance of outperforming regardless of the three scenarios outlined and this is Guidewire Software. Here are the three scenarios: Scenario #1: Base Case Low and Slow This is the scenario outlined by our economists, a 2% overall real GDP increase with growth bottoming in the 1H13 and accelerating into the second half. Here the stocks that should perform best, just like in 2012, have something new going for them: better execution, accretive acquisitions, share repurchases, margin expansion that help them stand out from the crowd. In 2012 in our coverage it was names like Equinix (EQIX), Aspen Technology (AZPN) and Web.com (WWWW) that were outperformers. In 2013 under this scenario we think Web.com could continue its run and be joined by DealerTrack (TRAK) as standouts. Scenario #2: Over the Cliff We Go If we go over the fiscal cliff and the expected result occurs, meaning we slip back into recession, then after the initial shock we would recommend getting defensive. Once the economy rolls over the defensive nature of our security stocks tends to stand out. Here the emphasis would be on names including Check Point Software (CHKP), Imperva (IMPV), Fortinet (FTNT) and especially Qualys (QLYS) with its SaaS subscription model. Scenario #3: Global Economic Expansion The last scenario in our minds is if the fiscal cliff is avoided, and Europe has that defining moment like the US did in March 2009 and begins to see economic expansion. The emergence of coordinated global economic expansion would benefit the most cyclical names in our coverage, especially Autodesk (ADSK), Ansys (ANSS) and Parametric Technology (PMTC).
Saket Kalia
(1-212) 622-6477 saket.kalia@jpmorgan.com J.P. Morgan Securities LLC Bloomberg JPMA AUTY <GO> Sterling Auty, CFA Advent Software Akamai Technologies, Inc. Amdocs ANSYS, Inc. Aspen Technology Autodesk Blackbaud Inc Cadence Design Systems Check Point Software Comverse Technology CSG Systems DealerTrack Holdings Inc Equinix Fortinet, Inc Guidewire Software Imperva Intuit Neustar Parametric Technology Corp. Qualys Rackspace Hosting Rovi SS&C Technologies Synopsys Inc VeriSign Web.com Websense Lauren Choi Synchronoss Technologies Saket Kalia Mentor Graphics Monotype Imaging
ADVS AKAM DOX ANSS AZPN ADSK BLKB CDNS CHKP CMVT CSGS TRAK EQIX FTNT GWRE IMPV INTU NSR PMTC QLYS RAX ROVI SSNC SNPS VRSN WWWW WBSN
UW N N N OW N N OW OW N N OW NR N OW OW OW N N OW OW N OW OW N OW UW
SNCR
OW
MENT TYPE
N OW
$28.84
$38.13
$13.00
Jul
$0.50
$0.28
$0.47
103.0
61.4
$1,598
136
137
138
Company Name Starwood Hotels & Resorts Worldwide Strategic Hotels & Resorts SunPower SVB Financial Symetra Financial T. Rowe Price Group, Inc Tenneco Inc. The Fresh Market The Home Depot The Intercontinental Exchange TNT Express Tractor Supply
Ticker HOT BEE SPWR SIVB SYA TROW TEN TFM HD ICE TNTE.AS TSCO
Rating OW OW UW OW N OW OW N OW OW N OW
Price $54.13 $6.20 $4.60 $55.02 $12.53 $64.85 $32.49 $50.43 $64.34 $131.14 7.90 $84.60
Company Name TRW Automotive Tyson Foods United Parcel Service US Airways Group, Inc. V.F. Corporation Valeant Pharmaceuticals Vitamin Shoppe, Inc Watson Pharmaceuticals Web.com Xerox Corporation Xilinx Yum Brands
Ticker TRW TSN UPS LCC VFC VRX VSI WPI WWWW XRX XLNX YUM
Rating OW N OW OW OW NR OW OW OW UW OW OW
Price $51.41 $19.68 $72.93 $12.61 $153.00 $57.71 $57.50 $87.97 $14.44 $7.02 $34.47 $66.92
139
Disclosures
This report is a product of the research department's Global Equity Derivatives and Delta One Strategy group. Views expressed may differ from the views of the research analysts covering stocks or sectors mentioned in this report. Structured securities, options, futures and other derivatives are complex instruments, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Because of the importance of tax considerations to many option transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated option transactions. Analyst Certification: The research analyst(s) denoted by an AC on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an AC on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst's compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report.
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Market Maker/ Liquidity Provider: J.P. Morgan Securities plc and/or an affiliate is a market maker and/or liquidity provider in Altria Group, Philip Morris International, Reynolds American. Lead or Co-manager: J.P. Morgan acted as lead or co-manager in a public offering of equity and/or debt securities for Altria Group, Philip Morris International, Reynolds American within the past 12 months. Director: A senior employee, executive officer or director of JPMorgan Chase & Co. and/or J.P. Morgan is a director and/or officer of Philip Morris International. Beneficial Ownership (1% or more): J.P. Morgan beneficially owns 1% or more of a class of common equity securities of Teekay Offshore Partners. Client: J.P. Morgan currently has, or had within the past 12 months, the following company(ies) as clients: Altria Group, Philip Morris International, Reynolds American. Client/Investment Banking: J.P. Morgan currently has, or had within the past 12 months, the following company(ies) as investment banking clients: Altria Group, Philip Morris International, Reynolds American. Client/Non-Investment Banking, Securities-Related: J.P. Morgan currently has, or had within the past 12 months, the following company(ies) as clients, and the services provided were non-investment-banking, securities-related: Altria Group, Philip Morris International, Reynolds American. Client/Non-Securities-Related: J.P. Morgan currently has, or had within the past 12 months, the following company(ies) as clients, and the services provided were non-securities-related: Altria Group, Philip Morris International, Reynolds American. Investment Banking (past 12 months): J.P. Morgan received in the past 12 months compensation for investment banking Altria Group, Philip Morris International, Reynolds American. Investment Banking (next 3 months): J.P. Morgan expects to receive, or intends to seek, compensation for investment banking services in the next three months from Altria Group, Philip Morris International, Reynolds American. Non-Investment Banking Compensation: J.P. Morgan has received compensation in the past 12 months for products or services other than investment banking from Altria Group, Philip Morris International, Reynolds American. Company-Specific Disclosures: Important disclosures, including price charts, are available for compendium reports and all J.P. Morgan covered companies by visiting https://mm.jpmorgan.com/disclosures/company, calling 1-800-477-0406, or emailing research.disclosure.inquiries@jpmorgan.com with your request.
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Explanation of Equity Research Ratings and Analyst(s) Coverage Universe: J.P. Morgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analysts (or the analysts teams) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analysts (or the analysts teams) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analysts (or the analysts teams) coverage universe.] Not Rated (NR): J.P. Morgan has removed the rating and, if applicable, the price target, for this stock because of either a lack of a sufficient fundamental basis or for legal, regulatory or policy reasons. The previous rating and, if applicable, the price target, no longer should be relied upon. An NR designation is not a recommendation or a rating. In our Asia (ex-Australia) and U.K. small- and mid-cap equity research, each stocks expected total return is compared to the expected total return of a benchmark country market index, not to those analysts coverage universe. If it does not appear in the Important Disclosures section of this report, the certifying analysts coverage universe can be found on J.P. Morgans research website, www.jpmorganmarkets.com. J.P. Morgan Equity Research Ratings Distribution, as of September 28, 2012
J.P. Morgan Global Equity Research Coverage IB clients* JPMS Equity Research Coverage IB clients* Overweight Neutral (buy) (hold) 44% 44% 52% 46% 42% 48% 69% 61% Underweight (sell) 12% 34% 10% 53%
*Percentage of investment banking clients in each rating category. For purposes only of FINRA/NYSE ratings distribution rules, our Overweight rating falls into a buy rating category; our Neutral rating falls into a hold rating category; and our Underweight rating falls into a sell rating category. Please note that stocks with an NR designation are not included in the table above.
Equity Valuation and Risks: For valuation methodology and risks associated with covered companies or price targets for covered companies, please see the most recent company-specific research report at http://www.jpmorganmarkets.com , contact the primary analyst or your J.P. Morgan representative, or email research.disclosure.inquiries@jpmorgan.com. Equity Analysts' Compensation: The equity research analysts responsible for the preparation of this report receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factors, and overall firm revenues. Registration of non-US Analysts: Unless otherwise noted, the non-US analysts listed on the front of this report are employees of non-US affiliates of JPMS, are not registered/qualified as research analysts under NASD/NYSE rules, may not be associated persons of JPMS, and may not be subject to FINRA Rule 2711 and NYSE Rule 472 restrictions on communications with covered companies, public appearances, and trading securities held by a research analyst account.
Other Disclosures
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To the extent that the information contained herein references securities of an issuer incorporated, formed or created under the laws of Canada or a province or territory of Canada, any trades in such securities must be conducted through a dealer registered in Canada. No securities commission or similar regulatory authority in Canada has reviewed or in any way passed judgment upon these materials, the information contained herein or the merits of the securities described herein, and any representation to the contrary is an offence. Dubai: This report has been issued to persons regarded as professional clients as defined under the DFSA rules. General: Additional information is available upon request. Information has been obtained from sources believed to be reliable but JPMorgan Chase & Co. or its affiliates and/or subsidiaries (collectively J.P. Morgan) do not warrant its completeness or accuracy except with respect to any disclosures relative to JPMS and/or its affiliates and the analyst's involvement with the issuer that is the subject of the research. All pricing is as of the close of market for the securities discussed, unless otherwise stated. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMS distributes in the U.S. research published by non-U.S. affiliates and accepts responsibility for its contents. Periodic updates may be provided on companies/industries based on company specific developments or announcements, market conditions or any other publicly available information. Clients should contact analysts and execute transactions through a J.P. Morgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise. "Disclosures" last revised December 01, 2012.
Copyright 2012 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of J.P. Morgan. #$J&098$#*P
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