Summary List PlacementThe growing chances of a rollout this year of an effective vaccine against COVID-19 has energized the equity market bulls, fueling a sustained rotation into value shares, but Morgan Stanley says not all these cyclical stocks are built the same and some definitely look like selling opportunities right now, according to a research note on Monday. The US bank continues to prefer cyclicals over defensives over the longer term, underpinned by its forecast that there will be "strong and synchronous multi-year recovery in GDP and EPS", which traditionally supports so-called real economy stocks, the note said. But the steep rally in cyclical stocks in the second half of November has made some look expensive and now maybe the time to book profits, the bank said. "Prices have just run too hard and valuation[s] now looks stretched." Value stocks, as measured by the S&P 500 Value index, rose by around 14% in November, marking one of their biggest ever one-month increases, while growth stocks, measured by the S&P 500 Growth index, rose around 9.7%. "While we favor cyclicals over defensives, post their recent rally, cyclicals look tactically overbought and relative valuations have moved to the high end of their historical range. While we want to maintain a pro-cyclical bias for the next 12M given prospects of material EPS outperformance versus defensives, investors should be patient in identifying entry points for sectors and stocks," the note said. "At the stock level we continue to like our 'cyclicals at a reasonable price' thesis. Our preferred cyclical sectors are mining, construction, consumer services, transport and media," the note added.ABB
Ticker: $56.9 bln Sector: Capital Goods MS Rating: Underweight Price Target: CHF 19.40.
Analyst commentary (Ben Uglow): Interesting equity story, but too much to look through in the earnings reality.
"Equity case at ABB centres on expectations that new management can facilitate an operating turnaround at the company. However, when talking to investors, we are not sure that the challenges facing ABB are fully recognised," he said, highlighting the low level of underlying growth ex- M&A (~1% CAGR since 2010) as a key "surprise".
"Turnaround potential – Expectations have built in enough for now. ABB shares have increased by c.22% since July 2019, on expectations that new CEO Björn Rosengren would be able to facilitate an operating turnaround at the company. Although we believe that EBITA gains can be made, market consensus is already discounting a 370bps margin expansion and >35% underlying operating earnings increase inside three years. Our own growth and margin forecasts are less positive," he added.
"We see the 'growth fix' as complicated," he said, adding that ABB is an "outstanding individual businesses: for example its robotics portfolio; its strength in distributed control systems and electrical motors; and its overall market presence in China." However, the company has "generally lagged peers on growth," he added, concluding that "while ABB shares could be supported near-term by market hot buttons (like the buyback) we see limited upside under 'best case' conditions – and absolute downside potential of ~20% to a scenario that we view as fair and reasonable."
Ticker: $12.8 bln Sector: Surface transportation MS Rating: Underweight Price Target: N/A
Analyst Commentary (Nicolas Mora):
"ADP has recently rebounded by ~+30% on the back of supportive Covid-19 vaccine newsflow. This implies the passenger traffic recovery to 2019 level has been front- loaded by ~2 years (~2024e vs. 2026e previously) and removes the bear-case scenario of languishing traffic recovery into the back-end of the decade. The stock now trades on ~12-10x 2022-23e EV/EBITDA (core Paris Airports), i.e. fair value three years out. Yet, we see mounting earnings / de-rating risks from regulation, capex and retail, which led us to downgrade ADP from Equal-weight to Underweight," he wrote. "We believe the focus on traffic recovery risks overlooking the mounting challenges posed by: (1) regulation (tariffs cuts), (2) capex (from capex holiday to capex wall), and (3) retail (high consensus expectations vs. structural ecommerce/Chinese duty-free re- shoring headwinds)," he added.
Ticker: $2.7 bln Sector: Airlines MS Rating: Underweight Price Target: N/A
Analyst commentary (Carolina Dores): AF-KLM is our least preferred airlines play on valuation grounds, its need for balance sheet repair, and ongoing discussions on restructuring.
"Even in a scenario of the airlines under our coverage raising liquidity via bank debt, it is plausible that some may still have to address capital structure, given high gearing even in a recovery. As we show below, the legacy carriers in particular – Air France-KLM and Lufthansa – appear likely to need to raise funds, for example via disposals, equity and quasi equity instruments, to return to pre-Covid levels of gearing. Both management teams have stated that some form of balance sheet repair will be required in 2021/2022," Dores wrote "We think Air France-KLM shares do not price in the risk of dilution from a potential recapitalization. According to an unconfirmed article in Le Monde, a €6bn funding plan is under negotiation between the group and the French and Dutch governments. Given the shares' recent rally, AF-KLM is now trading at an enterprise value c20% above pre-covid levels, despite a cash burn in FY2020 of more than 100% its market cap at the start of the year. We see this as an uncompelling valuation in light of the risk of dilution from a potential equity increase," Dores concluded.
Ticker: $58.8 bln Sector: Autos & Shared Mobility MS Rating: Equal-Weight Price Target: N/A
Analyst commentary (Harald Hendrikse): "Fundamental revenue and margin recovery in 2021 against easy COVID comps, but BMW is now priced at pre-COVID multiples on pre-COVID earnings assumptions. With the sector most overbought for 5 years, cyclical sentiment as well as structural change risks are on the downside," Hendrikse said.
BMW doesn't have a "clear route to BEV leadership," he wrote, adding that "we remain concerned around BMW's future strategy with no clearly articulated path to full electrification".
"We continue to prefer Daimler, and now also VW, to BMW. Whilst Daimler and BMW are similar in many ways, we feel that Daimler has more momentum on BEV and future technologies; Daimler has a more ambitious set of EBIT margin, cost and capex reduction targets, and Daimler's EBIT margins and FCF have improved more quickly than BMW's – allowing a faster dividend recovery. Although VW has not benefitted from the sales momentum of the premium OEMs in China to the same degree, resulting in sharp VW underperformance during FY20, its much more ambitious BEV strategy should remain a strong support as sales of ID3 and ID4 ramp up during FY21E, which BMW cannot match," he added.
"We believe there are only three positive valuation drivers in autos: 1 – cyclical recovery; 2 – company-specific catalyst /EPS momentum; and 3 – potential valuation re-rating for greater sustainability," he said, adding that "BMW does not fit any at this stage."
Ticker: $21.7 bln Sector: Building and Construction MS Rating: Underweight Price Target: CHF 477,25
Analyst commentary (Cedar Ekblom): Solid operation, but fully priced "Geberit reported better-than-expected Q3 results with 9m local currency sales broadly flat (-0.4%) and an EBITDA margin of 32.1%, +130bps from 9m 2019. Better revenue trends were driven by pent up demand (Geberit does not expect this to repeat), lower raw material costs and temporary cost savings from lower marketing and admin due to Covid restrictions. Shares are currently trading at a record high of 31x PE, or 24x EV/EBITDA, yet we see more risks to the downside from here," Ekblom said.
"We see risk that revenue growth falls below mid-term target of 4-6%. Growth has been below target since 2017, and may continue to underperform due to 1) limits to market share gains in core markets and 2) possible pricing risk in in-front-of-wall products over time," they said
"We see little to play for in terms of margin upside. Raw material cost tailwinds, which have benefitted gross margin meaningfully over the last 18 months, can turn to headwinds considering spot prices are no longer declining. Management flags a sequential raw material cost increase in Q4. To put gross margins into context: 9m 2020 gross margin was 73.5% vs. the 10 year average of 70.6%. Management is also clear that they do not intend to undertake any permanent cost reduction, hence we see the current cost benefits below the raw material line as temporary," they added.
Ticker: $30.0 bln Sector: Technology - Software & Services MS Rating: Underweight Price Target: N/A
Analyst Commentary (Adam Wood):
"Rebound in 2021 already seems well priced in - shares trading at historical highs relative to trading range and also vs. software peers" he wrote. "Better 2020 than feared helped by easy comps and cost cutting; 2021 may be tougher than expected now," he said. "Hexagon is currently enjoying a double benefit from lower variable costs (lower commissions, little travel & entertainment, fewer events) and part of the structural cost savings benefits. While the structural savings will still increase from the 3Q run rate, we see much less room for Hexagon to surprise on the upside on margins as variable costs start to increase in 2021," he added. "Shares at a clear premium to historical trading range and a premium to software peers," he said.
Ticker: $11.4 bln Sector: Leisure and Hotels MS Rating: Equal-Weight Price Target: N/A
Analyst Commentary (James Rollo):
"We like IHG's franchise-led and capex-light model, but the stock's recent run has taken it above our price target, and there is substantial downside of >50% in our bear case value of £23. While we are more cautious on some of the travel stocks in our coverage owing to their balance sheets (Underweight TUI and CCL), these are less expensive on recovery 2019 profits, and IHG is expensive on recovery profits so we include it here." he wrote. Rollo identified these risks which threaten the stock's performance:
Strong share price performance: "IHG shares are now flat in USD terms on 12 months ago... There is now 15% downside to our £40 price target, and over twice the downside to our bear case (£23, -51%) as upside to our bull case (£56, +19%)," he said.
Slow recovery with weak corporate demand
Slowing net unit growth could affect valuation multiples Structural risk to the asset light model US exposure risk
Valuation: "On peak 2019 recovery earnings, IHG trades on 21x P/E, 14x EV/EBITDA and a 4% FCF yield. These are close to its long-run averages, yet we do not see these financials returning until 2023. On our base 2022 valuation year, IHG trades on 25x P/E, 16x EV/EBITDA and a 4% FCF yield," he said.
Ticker: $7.3 bln Sector: Airlines MS Rating: Underweight Price Target: N/A
Analyst Commentary (Carolina Dores):
"We think the shares do not reflect the impact of Covid-19. Lufthansa is up 44% since the start of February (10pp below EU airlines average) given positive newsflow on vaccine developments. While investors may be inclined to look at normalised earnings, we think this misses two things: (i) Lufthansa's revenue exposure to business travellers (c50%) and long haul routes (c50%) likely means a slower recovery than for mainly intra-EU peers; and (ii) yields may come down initially, slowing cash flow recovery. We estimate Lufthansa will lose €3.5bn of FCF in 2020, c40% of its market cap at the beginning of the year, while its market cap is down only 20% year to date, implying a re- rating of the shares versus where they traded at the start of the year," Dores wrote. "Restructuring likely to be challenging. Lufthansa has announced a profound restructuring, involving asset sales, debt and equity raises and cost cutting. We think asset sales could help raise €2-5bn and reduce net debt/EBITDA by 0.4-0.6x (from 3.4x in 2022e), but this relies on the sector recovering, which we see as unlikely before 2022. Moreover, the group plans to cut costs while reducing its size, which is another challenge. Even incorporating a 15% reduction in headcount (currently being negotiated with the unions), we estimate Lufthansa would need to reduce unit costs (CASK ex-fuel) by 6-18% to deliver a 10% EBIT margin (its previous target), assuming a 10-30% reduction in ASKs," he added.
MTU Aero Engines
Ticker: $13.4 bln Sector: Aerospace & Defence MS Rating: Underweight Price Target: N/A
Analyst Commentary (Andrew Humphrey):
"The market is pricing in a recovery several years before that recovery will emerge," he wrote, adding that "MTU belongs to a subset of stocks that have become more expensive, even as fundamental prospects have deteriorated over the latter part of the year. We think short-term outperformance on earnings may not continue as we head into 2021, and think the recent CMD may have set up a near-term disappointment on cash."
"Trading multiples suggest the market is looking at earnings much further out," he added.
Humphrey noted two specific headwinds for MTU that could impact 2021e earnings:
"Partial reversal of freight trends. MTU has benefited from tailwinds in its spare parts business relating to dedicated freighter demand this year. The return of belly freight capacity to the fleet as traffic recovers could mean a tailwind turns into a headwind, and even see an uptick in retirement of older freighters," he wrote.
"Return of the 737 MAX. MTU performs around 10% of shop visits on the older 737, which we expect to underperform the market as the newer aircraft returns. It is also possible that Airbus customers (where MTU is more exposed) could lose some share as Boeing customers look to regain lost ground," he added.
"Contract accounting could increase complexity, and lead to disappointment on cash," he added.
Ticker: $11.1 bln Sector: Retailling - General MS Rating: Underweight Price Target: N/A
Analyst Commentary (Geoff Randell):
Next's share price has almost doubled from its March low and is now back at pre-COVID levels despite the fact that it has been hit hard by the pandemic, Randell said, adding that like other apparel retailers, Next is still likely to face a very challenging Spring/Summer season in 2021 as its reliance on credit sales leaves it vulnerable as the credit cycle weakens. "We were concerned - even before the pandemic - that the group's EPS growth algorithm was under sever strain," he wrote.
Ticker: $6.3 bln Sector: Capital Goods MS Rating: Underweight Price Target: N/A
Analyst Commentary (Lucie Carrier):
"Signify's shares have rallied 60% since June, outperforming our capital goods coverage c. 20% YTD. The market seems to be anticipating a game-changing growth trajectory on what is perceived as a cheap valuation with an ESG angle. We disagree," Carrier wrote. Carrier disagreed for these three reasons:
"Market expectations for change in growth trajectory are too high," she said.
Citing the recent announcements around the EU Green Deal and UV-C lighting, Carrier argues that both of these factors will have less impact that anticipating, not contributing much more than 1% additional organic growth from '21-24, she wrote. "Considering large revenue dependence on Non-Residential construction (c.80% of sales) and perennial price decline in the industry, we struggle to see the c.4.5% consensus organic growth in 2021 as reachable – MSe stands at 1.2%," she added.
"Valuation looks optically inexpensive, for good reasons," she said.
Since the IPO, Signify has traded at a discount to MS' coverage "given the structural growth challenges the portfolio faces," she wrote, adding that this was not a "turning point in the story."
"While Signify looks cheap on valuation, this is deserved given the weaker topline, earnings growth and even FCF generation offered by the stock... Based on our assessment of what the company's portfolio could deliver, we see the discount as fully justified and thus do not think the valuation argument as a buy case necessarily holds here," she said.
"Interesting internal ESG profile but no sustainable earnings growth in LED," she said, adding that the company's internal ESG performance is "impressive." However, the view that LED can support a sustainable earnings stream "is a stretch," she wrote.
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