Markets live chat transcript for the chat ending at 12:00 on 29 Jul 2008. Participants in this chat were: Neil Hume (NH) Bryce Elder (BE)
If they were to mark to market at ML’s level then they would need to raise an additional $16 bln of capital,
prior to 2005; there is no explicit disclosure of the vintages of the assets
that were sold, however we assume – based on the marks and the relevant ABX
indices – that these were mainly 2006-2007
which could provide insights into the current clearing prices for CDO-related
assets. The characteristics of the sale as we understand them are:
Exposures to US super senior ABS CDOs
Gross notional value of $30.6 bn
Selling price as disclosed yesterday $6.7 bn – implied carrying value of 22c/$
ML is providing financing for c.75% of the transaction with the loan secured
against the CDO portfolio – implicitly leaving ML exposed if valuations drop
below 16c/$
ML states that the remaining exposures ($8.8 bn) are mainly related to vintages
prior to 2005; there is no explicit disclosure of the vintages of the assets
that were sold, however we assume – based on the marks and the relevant ABX
indices – that these were mainly 2006-2007
necessarily conclude that they are all subprime and that therefore subprime is
being carried at 22c/$1. It is possible that subprime is being carried at less
than 22c but the value of the overall book is supported by other assets which
are worth more.
Read-across for European banks with super senior ABS CDO exposure:
average of 33 c/$ as of 1Q08. In our forecast for 2Q, the mark downs we
anticipate imply a valuation adjustment of -46%, or a carrying value of 18 c/$
CS – has already reported 2Q results and booked no major additional net marks
on its CDO exposure as trading profits and positive basis risk off-set the
value adjustments. The net exposure at the end of 2Q08 stand at CHF1.1 bn
(CHF5.2 bn long versus CHF4.1 bn short).
DBK – had a total net subprime ABS CDO exposure of €0.9 bn (after marks) as of
1Q08. The disclosure does not allow us to calculate an average mark on the
respective vintages, however the exposure is relatively modest in the context
of the Group.
SG – marked its subprime ABS CDO for vintages 2006-07 of €124 mn (after marks)
to 8c/$, and CDO squared (i.e. CDOs of CDOs) to zero as of 1Q08. In our
forecasts for 2Q, we assume further markdowns on all exposures of c20% from the
1Q level (particularly on 2005 vintages).
(after marks) as of end 1Q08. The implied marks on these exposures cannot be
obtained from the disclosure, however the average mark for the overall
portfolio of €1.9 bn (after marks) stood at 55c/$ – importantly, this includes
all vintages and non-subprime exposures. For the 2Q, we forecast €400 mn of
additional marks, implying an overall average mark of 44c/$.
RBS – £2 bn of net exposure split between £1.6 bn of high grade and £0.4 bn of
Mezzanine. The average price for the high grade was 52c/$ and for the Mezzanine
it was 20c/$. RBS’s attachment points on the exposures was on average 74% after
writedowns. This splits down between 63% for the High Grade and 89% for the
Mezz. 76% of exposures are 2006-07.
BARC – £4 bn of net exposure split between £3.4 bn of High Grade and £0.6 bn of
Mezzanine. We have no average price for these exposures. BARC has protection up
to 52% through a combination of subordination, hedging and writedowns. 30% of
exposures are 2006-07.
[HBOS LN HBOS.L], 275p, In-line, sector – Neutral
CDOs
HBOS has immaterial exposure to US sub-prime mortgage collateral: £92m RMBS and £329m ABS CDOs (£221m net of monoline insurance) within its Treasury business.
The group’s £6.6bn CDO book largely comprises corporate exposures (CBOs and CLOs represent 95% of total). The valuation of this book is at risk as corporate credit quality deteriorates, but not as a direct consequence of ML’s announcement.
Investor focus continues to be the gross £6.8bn Alt-A RMBS exposure, which has been written down by 20% (cf. RBS at 21% and Barclays at 28%). Again, there is no specific read-across from ML’s announcement.
HBOS has signalled it intends to maintain the majority of treasury positions rather than sell assets into a weak market, but if ML’s action has been influenced by concerns over the recoverability of monoline contracts, then there is a risk that HBOS will recognise write-downs and/or impairment against its exposure.
Gross monoline insurance exposure is £5.0bn, comprising £2.8bn negative basis CDS and £2.2bn of wrapped bonds (it has not been disclosed but we assume the majority of these bonds are Alt-A RMBS).
As at the end of May, HBOS disclosed credit exposure of £1.48bn to monolines. Following the rating downgrades of MBIA and Ambac in June (86% of the wrapped bonds are insured by these two monolines and FSA), we expect the credit exposure has increased.
HBOS has not disclosed write-downs against monoline counterparties, but based on management’s statement that no treasury assets have been impaired we would assume any write-down to date is small.
Comment
The risk remains that HBOS will recognise further write-downs (and possibly impairment) as credit market conditions remain challenging, and ML’s statement does nothing to allay concerns in this regard. In our view, these concerns will serve to maintain HBOS’ valuation at a discount to tangible book (currently 0.7x 2008E NTAV).
In 2008, we expect fair value adjustments of £1.2bn pre-tax in the P&L (HBOS disclosed £1,028m to end May) and £2.0bn post-tax taken directly to AFS reserves (£1,825m end May).
HBOS will report H1 results this Thursday, 31 July.
Merrill Lynch has announced the sale of a CDO portfolio at a price of 21% of gross notional amount.
It appears that the majority of the CDOs are based on collateral written in either 2007 or 2006.
RBS has £7.2bn of CDO relating to 2006 and 2007 sub-prime collateral (76% of its total gross exposure). On the broad brush approach of valuing all CDO based on recent vintages at 21% implies RBS’ gross exposure is worth £0.5bn.
To arrive at the £2.0bn valuation, RBS has hedges valued at £5.6bn. Part of the hedges are through monolines; RBS discloses £3.6bn of monoline exposure on RMBS and CDO of RMBS. In total RBS proposes within the prospectus to write-down 44% of its monoline exposure; RBS does not disclose how much of the CDO monoline exposure is written down.
In summary, the Merrill transaction supports the write-downs that RBS proposes to take against its CDOs. In our view there is risk of further write-downs on the monoline exposure, which has a notional value of £25.0bn and mark to market value of £6.2bn. RBS will book a total of £2.7bn against its monoline exposure (of which £0.9bn already booked in 2007) but with the value of the underlying assets remaining under pressure and the credit quality of the counterparty also slipping, further marks are probable in our view.
readacross for Euro names in our view is less optimistic.
MER’s announcement of
further significant write downs of $5.7bn pre tax ($4.4bn on ABS CDOs and
$1.3bn on the hedges associated with these CDOs with bond insurers) is likely
to upset the market on the prospect of further write downs at the Europeans
especially UBS given its relatively large exposures ($68bn estimated post
Blackrock sale and pre Q2 results).
European close but MER announced the $5.7bn of pre-tax write downs and $8.5bn
capital raise post the close.
MER’s write downs are in ABS super senior CDOs ($4.4bn) on selling a $30.6bn
portfolio to Lone Star and on the associated hedges (from XL and others) by
$1.2bn. MER has sold the $30.6bn portfolio at 22c and it was marked at 36c at
end Q2. UBS’s exposures are all as of Q1 so not up to date and we would expect
to have fallen post the write downs.
UBS’s super senior ABS exposure is much
lower than MER at $6.7bn gross end Q1 vs $19.9bn and was marked at 33c as at Q1
although we would expect this to be somewhat lower in Q2 and it could already
be around this level of mark given write downs of $6bn expected in Q2 on 12
Aug.
another $4bn of CDOs wrapped by monolines but these are additional CDOs. UBS’s
more sizeable exposures are in Alt A (estimated $10bn) and other RMBS (unknown
post the sale to Blackrock but could be $10bn gross). MER’s very large capital
raising of $8.5bn or $9.8bn post the over allotment is also driven by a
restructuring of the mandatory convertibles of $2.5bn paid to Temasek and
additional dividends of $2bn. The pro forma book value post all this is $22 at
While the direct read through on the implied write downs at UBS is not that
large it is still likely to hit UBS given its generally large exposures. UBS’s
are diverse in nature with a lot that are not sub prime but it does show the
cost of a clear up of exposures. Other banks with large super senior are
Barclays, RBS, CASA and SG.
has EUR700m net exposure to XL – 31% of its net EUR2.3bn total. Compares to
EUR162m for SG. As per our note yesterday, we expect heavy write-downs for
CASA& SG to monoline exposures. BNPP much less exposed. Of the UK banks,
Barclays have £4.0bn net Super Senior exposures and RBS £3.8bn
After the close on Monday, Merrill Lynch announced an $8.5 billion equity raise as
well as a “substantial sale of U.S. ABS CDOs” that would reduce its CDOs
exposure by $11.1 billion. While MER has significantly diluted existing
shareholders, we applaud this purging of assets as an attempt to cut its losses and
focus on stabilizing its platform and righting the franchise towards growth. While
MER’s stock still sells at a premium to book value and is expensive in our opinion,
we believe the stock is getting closer to fairly valued levels as now the hardest work
is behind the company.
focus on stabilizing its platform and righting the franchise towards growth
n MER announced that it plans to raise $8.5 billion through a public offering of
common stock (plus $1.3 billion option granted to the underwriter). Temasek
Holdings has agreed to purchase $3.4 billion of common stock and MER’s
executive management team will purchase roughly 750,000 shares of common
stock in the offering.
n In accordance with the reset provisions in the prior Temasek investment
agreement, MER will pay Temasek $2.5 billion which Temasek is obliged to
invest 100% in the offering at the public offering price without any future reset
protection.
n The transactions announced on Monday by Merrill Lynch will result in a net
pre-tax loss of $5.7 billion for 3Q08. This loss is comprised $4.4 billion on the
sale of the CDOs, $0.5 billion due to the termination of XL hedges, and a
maximum loss on potential terminations to other monoline hedges.
n Pro forma book value per common share is $21.95 vs. $21.43 reported in the
2Q08 earnings release. On an “if-converted” basis pro forma BVPS is $22.21
vs. $24.94 reported in the 2Q08 earnings release. We note that MER’s stock
price of $24.33 (as-of 7/28/2008 close) trades above pro forma book value at
1.1x.
n Our 2008 EPS estimate goes to a loss of $10.50 from a loss of $8.37 (vs.
consensus EPS estimate of loss of $6.75). Our 2009 EPS estimate goes to
$1.27 from $1.75 (vs. consensus EPS estimate of $3.66).
We regard the recent rally as a selling opportunity in domestic UK bank stocks. We are particularly negative towards UK corporate lending, which we believe again represents the biggest threat to value, as in the early 1990s. Consequently, we are negative towards HBoS and RBS.
We remain negative towards the sector, while there is no catalyst for a floor for asset prices, notably US real estate. Against a background of rising credit losses, we regard traditional valuation metrics as relatively meaningless. We view
balance sheet quality as the key driver, in particular relative exposure to key asset quality risks. Consequently, we continue to regard
Lloyds TSB as the most defensive of the domestic UK banks.
is potential for upgrades to consensus expectations and that although emerging markets are likely to slow, prospects remain superior
to developed markets, particularly in Anglo Saxon countries.
We expect interim figures to show initial signs of rising corporate credit losses, although from a low base, with the full effects unlikely
to be visible until 2009. Instead, there is likely to be material deterioration in mortgage related exposures, notably in specialised
lending, although this is less significant for value for the larger banks. There are also likely to be additional charges for capital
markets exposures, notably to monolines, Alt A and insurance volatility, with negative margin trends at banks reliant on wholesale
funding.
expect the full scale of these charges to become visible in 2009, as the impact of the slow down on corporates takes effect.
By contrast, we expect the smaller effects of the housing downturn on the consumer to be visible more quickly. Within the corporate
sector, we are most cautious on the prospects for commercial real estate and leveraged loans. In the early 1990s, banks incurred credit
losses that were 11% of their corporate exposures over a four year-period; this included 25% of their commercial real estate and related
exposures and 3-4% of the rest. Our new estimates assume corporate sector credit impairment charges are half the scale of the 1990s
downturn. We are assuming 2009 corporate charges, equivalent to 3% of commercial real estate and 50bp of other corporate lending.
As we expect the corporate sector exposures to present the greatest asset quality risks, we are most cautious towards the UK banks
with the biggest proportionate exposure to domestic corporate lending, which we believe to be RBS and HBoS. In addition, both banks
are particularly exposed to commercial property and we believe have also been the two largest providers of leveraged loan finance.
level and compared to the consensus, upstream is higher, refining & marketing is slightly lower, other business and corporate and consolidation adjustments are less negative and the underlying tax rate of 35.0% is also below consensus.
Valuation – With respect to 2008E, we measure a PER of 7.6x, EV/DACF multiple of 5.0x, dividend yield 5.2% and equity free cash flow yield of 10.5%. We note that BP’s dividend yield now exceeds the yield on the 10 year UK gilt – yet BP’s £ dividend CAGR 1980-2008E is almost 8%. The shares now suffer an extreme
38% discount to our SOTP of 845 pence – this is the largest discount to our BP SOTP that we have ever recorded. Whilst CDOs may be changing hands at less than 30 cents in the dollar, we see absolutely no reason why BP’s assets should trade at 60 cents in the dollar. In our view, all these metrics confess to very good value in the shares.
Performance & recommendation – YTD 2008 BP shares have generated a TSR (£) of -13% vs -8% from the European sector, -11% from RD Shell and -13% from Exxon Mobil (all stats in £). YTD 2008 the market consensus for BP’s 2008E EPS (source Bloomberg) has increased 29% from 59p to 76p – so BP’s current year PER multiple has implicitly fallen 33%. We retain our OUTPERFORM recommendation
[BP/ LN 520p], Sector OVERWEIGHT – our fair value remains 750 pence (defined 5 June), potential upside of 44%. We see three triggers for BP’s share price to approach our fair value (i) resolution to the ownership issues at TNK-BP (ii)
continued operational improvement (iii) more market confidence that the oil price is not returning sub-$100 per barrel ie earnings from BP and other oil majors are not about to collapse.
UK credit, mortgages, and money (Jun) – monetary conditions extremely tight
36k mortgages were approved in June, marginally lower than consensus expectations of 37k.
This is 68% lower than the level a year ago and well below the low of 64k seen in the early
90s. Further significant house price declines look likely over the coming months.
The Bank of England’s latest credit conditions suggested that banks were also becoming more
hesitant in advancing unsecured credit and there was some reduction in credit card lending
to £0.9bn from £1.3bn last month.
M4 growth picked up to 11.4% from 10% in June, and M4 lending picked up to 13.6% from 11.3%.
But the detail shows that ‘other financial corporations (OFCs)’ account for this pick up.
The movement of money in OFCs has puzzled the BoE for some time. This may reflect portfolio
shifts and the implication for overall spending and inflation is not clear. Growth in
lending to households moderated to 7.7%. Lending to corporates remained relatively stable at
13.2% and anecdotal evidence, at least, suggests that corporates are drawing on undrawn
credit lines.
Overall, it seems pretty clear that monetary conditions in the UK are already extremely
restrictive. This should be sufficient to ensure the rise in inflation over the coming
months is a near-term energy spike, and by early next year, inflation is falling back
sharply.
easy to overlook the fact that companies are running into increasing
cash-flow difficulties. The liquidity ratio of non-financial corporations (the
ratio of cash and bank deposits to bank lending) has fallen to recession
levels (see chart). Normally this would be a prelude to a downturn in
corporate spending, particularly a severe inventory correction.
In normal times companies at an aggregate level build up cash deposits at
roughly the same rate as they are borrowing from banks; the liquidity ratio
moves sideways. But as one enters a recession companies faced with
increasing cash-flow difficulties draw down money held on deposit, but continue
borrowing (as long as the banks let them). As we have been warning this is
happening again. In the year to June, non-financial corporations holdings of
bank deposits fell, but M4 lending grew by a still significant 13.2%. Multinational
companies may be in a better financial position, but more domestically oriented
corporations are clearly facing increasing cash-flow difficulties. If banks really do
tighten credit conditions to corporations as well as for house purchase, then a
significant downturn in corporate spending could be the next phase of the
downturn.
British Airways PLC
29 July 2008
IBERIA MERGER TALKS
British Airways and Iberia are holding talks with a view to an all-share merger between the two companies. The negotiations are supported unanimously by the boards of both companies.
The British Airways and Iberia brands would be retained as part of a combined group.
Iberia’s chairman and chief executive, Fernando Conte, said: ‘A merger would be good news for our customers and enhance our existing relationship. We’ve worked together for nearly 10 years and a tie-up would build on that success. It would also strengthen the oneworld alliance and further develop Madrid’s position as the European gateway to Latin America’.
British Airways’ chief executive, Willie Walsh, said: ‘The aviation landscape is changing and airline consolidation is long overdue. The combined balance sheet, anticipated synergies and network fit between the airlines make a merger an attractive proposition, particularly in the current economic environment. We’ve had a successful relationship with Iberia for a decade and are confident that both companies’ shareholders would benefit from the proposed tie-up’.
British Airways acquired a nine per cent shareholding in Iberia in 1999 and has recently increased its shareholding to 13.15 per cent. Iberia has announced today that it has recently acquired a 2.99 per cent direct shareholding in British Airways and financial exposure to a further 6.99 per cent through contracts for difference linked to British Airways’ share price. The airlines’ shareholdings reinforce the mutual interest of both companies in each other.
It is expected that it will take several months to reach agreement on the terms of the merger and to finalise a joint business and integration plan for the combined group.
Both parties are confident of securing regulatory approval. The European Union has already granted British Airways and Iberia approval to co-operate widely.
ends
July 29, 2008 094/LG/08
Notes to Editors
1. The principal shareholders in Iberia (other than British Airways) include Caja Madrid at 22.99 per cent of Iberia shares and El Corte Ingles at 3.37 per cent.
2. It is expected that there will be a single holding company with a unified management structure built upon representation from both companies.
3. The existing two companies would be responsible for the day to day running of their operations.
4. The new holding company is expected to be a member of the FTSE100 and quoted on the Madrid stock exchange.
5. A contract for difference (CFD) is an agreement to exchange the difference in a share’s value between the time a contract is opened and the time it is closed. Holders of CFDs are financially exposed to the share price but do not own the shares and therefore have no voting rights. The contract has no fixed expiry date.
6 It is envisaged that a new company would acquire both British Airways and Iberia at the same time. Based on the current market capitalisations of British Airways and Iberia, the UK Panel on Takeovers and Mergers has agreed that the current intended transaction is not subject to the UK Takeover Code.
We believe cost pressures are building across the mining industry We estimate cash operating costs can be broken down as follows: 23%
Energy, 26% Labour, 37% Raw Materials & Consumables and 14% Other. We are concerned that these costs may rise at 20% Y/Y in ‘08E vs our base
case of a 15% rise. We remain broadly comfortable with our ‘09 estimate of a further 15% increase and 10% in ‘10 although risks are to the upside on
costs – this is due to compounding effects and ‘sticky’ costs.
most impacted would be Vedanta and the least Antofagasta. In a worse case scenario if costs were another 5% higher, sector earnings would be 5%
lower again. We also note that a 10% weakening US dollar would increase US$ costs and lower earnings by a further c. 5%.
higher/sustained commodity prices – therefore the relative winners should be (i) low cost producers (large cap diversified), (ii) those with volume
growth (Vedanta), (iii) exposed to a weakening Rand (Anglo and the PGM producers), (iv) those with more assets in the lower inflationary developed
regions (large cap diversified) or (v) those with a hedge to higher energy prices (thermal coal producers).
will focus investor attention, in order to get a sense of how acute this issue is and indeed how long it may last.
Important questions after 5 years of outperformance US housing, financial and energy cost concerns threaten demand projections with a long ‘U’
shaped recession while Europe is showing increasing weakness under the weight of a heavy Euro and energy import costs; and Asian growth is
slowing, constrained by costs and inflation. UBS has lowered 2009 global growth forecasts.
Rising costs squeezing margins Rising costs from exchange rates, higher energy, materials and labour are impacting basic materials operating
margins, highlighted by reporting shocks in Q208. Falling commodity prices, lead by oil, is compounding the angst about how quickly margins could fall
if prices decline while costs are rising.
materials-intensive developing world is still growing at 5.2% in 2009E. Supply continues to be constrained by scarcity; resource access is increasingly
politicised while power, capital, labour, climate constraints remain real. The Chinese government’s new tone, prioritising growth vs. inflation is a further
key support.
More short-term weakness likely High levels of equities and commodity prices offer room for further retracement in coming months. We see value in
diversified mining (Xstrata, Anglo American), in reindustrialising US (Barrick Gold, US Steel, Consol Energy), in ag-chemicals (Israel Chemicals,
Potash Corp) and in steel (even after factoring slowdown). We are more cautious on cost, political and country risks.
With bulk commodity prices settled until April 2009 and unlikely to fall thereafter, and nickel, zinc and aluminium trading at marginal cost (with supply responses happening), all eyes are on the copper price to provide the dramatic earnings downgrades which valuations of the diversifieds are implying.
gross margin and higher than expected cost pressures means that
Woolworths will struggle to break even at the group level this year. 2
entertain is to be kept (no real surprise) and the search for a new chief
executive is still on. Market conditions suggest further downside risk. Sell.
down 3.2% with LFL sales down 6.7% in the last six wks (vs. -2.2% in the first
19wks). The gross margin is down 125bp with the continued underperformance
of higher margin outdoor/clothing products and outperformance of lower margin
entertainment products. EUK sales are down 1% (tough comps vs. end of Tesco
contract and Harry Potter) and 2 entertain is up 12.8%, both slightly weaker than
expected.
real surprise to us, given that a reasonable price for a growth business was likely
to be hard to achieve in the current market. A review of the store portfolio and
stock management has been undertaken ahead of finding a new chief executive.
Original target of £8m of cost savings unlikely to be met, given additional utility
cost pressures of c. £4m.
forecast FY numbers. But given the rapid deterioration over the past few weeks,
there is little to suggest a material recovery in H2. We look for -1% LFL sales in
Retail on an optimistic flat gross margin. Average net debt is expected to be
above last year’s £246m. We now assume that a dividend will not be paid. PER
metrics are meaningless. Our 3p TP puts the shares on an 09E EV/EBITDA of
1.5x vs. the sector on 4.8x.