3 October 2011
Bes t Equity Near-Term Ideas
J.P. Morgan’s Roadmap for Equity Investors
Bloomberg JPUS4Q11 <INDEX> <GO> Bloomberg subscribers can use the ticker JPUS4Q11 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 JPUS4Q11 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 JPUS4Q11, please contact your J.P. Morgan salesperson or the Delta One Desk.
This third edition of J.P. Morgan’s Best Equity Near-Term Ideas highlights 40 of our fundamental analysts’ best ideas for the upcoming three months and includes commentary from our equity strategist. In addition, our Equity Derivatives & Delta One Strategy team has created a new basket (JPUS4Q11 on Bloomberg) leveraging our analysts' best ideas.
Macro
Equity Strategy ... 3
Accounting and Valuation ... 9
Delta One Strategy ... 12
Capital Goods/Industrials Boeing (BA) ... 17
Union Pacific (UNP) ... 18
Canadian National (CNI) ... 18
Quanta Services (PWR) ... 19
Deere (DE) ... 20
Consumer United Continental Holdings (UAL) ... 21
Harman Int’l. (HAR) ... 22
Las Vegas Sands Corp. (LVS) ... 23
Owens Corning (OC) ... 24
Brinker International (EAT) ... 25
Home Depot (HD) ... 26
Reynolds American (RAI) ... 27
Energy ITC Holdings (ITC) ... 29
Cimarex Energy (XEC) ... 30
Noble Corporation (NE) ... 31
Financials Wells Fargo (WFC) ... 33
Comerica (CMA) ... 34
CME Group Inc. (CME) ... 35
Reinsurance Group of America (RGA) ... 36
Aon Corp. (AON) ... 37
Simon Property Group (SPG) ... 38
Ares Capital (ARCC) ... 39
Health Care Celgene (CELG) ... 41 Ariad (ARIA) ... 42 CVS Caremark (CVS) ... 43 St. Jude Medical (STJ) ... 44 Agilent (A) ... 45 Pfizer (PFE)... 46
Watson Pharmaceuticals (WPI) ... 47
Materials LyondellBasell Industries (LYB) ... 49
Kinross (KGC) ... 50
Freeport-McMoRan (FCX) ... 51
Rock-Tenn (RKT) ... 52
Media & Telecom Verisk Analytics (VRSK) ... 53
Yahoo! (YHOO) ... 54
American Tower (AMT) ... 55
Technology NCR (NCR) ... 57
Apple (AAPL) ... 58
Broadcom (BRCM) ... 59
Synopsys (SNPS) ... 61 Note: Unless otherwise noted, all stock prices and ratings in this report are as of the close on 27 September 2011.
Equity Strategy
Valuations Approaching March 2009 Levels but Still Significant Event Risk from Europe
Significant headwinds have pressured equities since late July, as the spreading of European sovereign concerns, coupled with the US political rancor, has undermined investor confidence. And unfortunately, as weeks have passed, liquidity in risky markets continues to deteriorate, putting more downside pressure on US equities. For equities to regain their footing, in our view, requires Europe leaders to visibly move in a direction to contain the crisis.That said, the current high volatility continues to point to equities making a sizable move in the next few months—either a downside or upside break. We believe the move is to the upside (similar to ’98) predicated on the notion that European leaders successfully leverage the EFSF.
Recent Leadership from Discretionary, Technology, and
Utilities
Since the July 2011 highs, the market has seen 8 discrete sell-offs/rallies, which represents significant volatility and we believe is reflective of the conflicting forces of: (i) worsening European outlook (although stabilizing recently); (ii) concerns about Asia/China growth and (iii) sell-offs in commodities offset by still expansionary data in the US.
One of the surprises, recently, has been the outperformance seen at the sector level. Take a look at Figure 1 below. Over the last few weeks of rallies/declines, three groups have been consistent in outperformance: Discretionary, Technology, and Utilities. The outperformances of the first two are reflective, in our view, of an economy still in expansion. In other words, despite fears of a US recession, the data is more consistent with a slowdown—and not contraction.
Thomas J Lee, CFA AC
(1-212) 622-6505 [email protected] Daniel M McElligott (1-212) 622-5598 [email protected] J.P. Morgan Securities LLC
Ma
cro
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Figure 1: Sector Performance Since July 2011
Source: J.P. Morgan and FactSet
Valuation: 53% of Stocks with P/E <12X…67% in 3/09
We believe investors need to be mindful that valuation levels are getting close to levels that we have not seen since the March 2009 lows.
• Currently, 53% of stocks have a P/E less than 12x and 33% less than 10x, which is higher than anytime since the 2009 lows.
• At the 3/09 low, the % of stocks with a P/E NTM less than 12x was 67%—we are basically looking at valuations that are very similar to 3/09 lows.
• In contrast, on the day of Lehman’s failure (the market was already off 20%), the % of stocks with a P/E less than 12x was 27%—we are double that today. Think about this: The market appears cheaper today than it did during the height of the US financial crisis—we believe this is a strong argument that the sell-off we are seeing, while significant, is not consistent with equities having further significant downside.
7/22 - 8/8 8/8 - 8/17 8/17 - 8/22 8/22 - 8/31 8/31 - 9/9 9/9 - 9/16 9/16 - 9/22 9/22 - Now 7/22 - Now
S&P500 -16.8% 6.6% -5.9% 8.5% -5.3% 5.4% -7.1% 2.2% -14.2%
Sectors Relative Performance:
Cyclicals -1.2% -0.1% -0.9% 1.4% -0.4% 0.9% -1.1% -0.7% -2.1% Materials -3.4% 1.8% -1.3% 1.8% -0.7% -0.9% -4.8% -2.4% -9.4% Industrials -3.0% -0.9% -0.8% 2.1% -1.6% 1.0% -2.1% 1.3% -4.3% Discretionary -0.5% 0.1% -0.1% 1.4% -0.5% 1.6% 0.3% -0.7% 1.1% Technology 2.2% -1.4% -1.4% 0.3% 1.3% 1.7% 2.3% -0.7% 4.1% Near Cyclicals -4.4% 1.5% -2.0% 1.7% -1.7% -0.3% -3.6% 1.1% -8.0% Energy -4.4% 2.2% -1.9% 0.1% -0.1% -1.3% -3.8% -0.2% -9.1% Financials -4.4% 0.9% -2.1% 3.3% -3.4% 0.6% -3.4% 2.4% -7.0% Defensives 5.0% 0.3% 3.2% -3.6% 1.7% -1.3% 3.1% -0.1% 8.9% Staples 7.8% -1.7% 3.8% -4.3% 2.3% -2.0% 2.8% -1.0% 8.8% HealthCare 1.4% -0.1% 2.4% -1.0% 1.0% -1.7% 2.4% -0.2% 4.5% Telecom 4.8% 0.8% 2.9% -5.4% 1.7% -0.9% 2.7% 0.8% 7.8% Utilities 5.8% 2.3% 3.7% -3.6% 1.9% -0.7% 4.5% 0.2% 14.4% Crisis Market low
Figure 2: % of Stocks with P/E <12X
Since 2007
Source: J.P. Morgan and FactSet.
Equity Risk Premium at 50-Year Highs
We believe another useful measure of relative value is the equity risk premium. We calculate this by using an equity discount rate (5-yr div discount model to calculate this discount rate) and compare it to real 10-yr yields (10-yr less expected inflation). Currently, this figure is at 6.27%, a 55-year high Figure 3:
• This is higher than seen at major stock market lows of ’74,’80 and ’09. • This is even higher than the levels seen at the height of the Asia crisis and
subprime crisis.
What Is This Telling Us? Reflects Concerns About Contagion, Recession, and Risk Aversion
Of course, when investors are fearful (look at the VIX), relative value does not matter, in our view. This tells us that investors are risk-off and, of course, reflects anxiety about Europe. However, this anxiety is greater than at any time in the past 55 years. The fact that investors are worried is obviously reasonable, but we believe the question is really whether the magnitude of fear is warranted.
Figure 3: Equity Risk Premium at 50-Year Highs…
Calculated as Earnings Yield Less Real 10Y Yield (10Y Less Inflation)
3/6/08 24% 9/11/08 28% 3/5/09 65% 9/22/11 53% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 1/07 4/07 7/07 10/07 1/08 4/08 7/08 10/08 1/09 4/09 7/09 10/09 1/10 4/10 7/10 10/10 1/11 4/11 7/11 10/11 1/12 % stocks with P/E less than 12x Current Key Dates
Bear Stearns collapse Bear market bottom Lehman bankruptcy 9/11 6.27 10yr Avg 1.00 2.00 3.00 4.00 5.00 6.00 7.00
Equity Risk Premia 10yr Avg
Asia
Crisis Subprime Crisis Euro Crisis at 60-year highs...
Crisis
Market low Market low
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Two Different Outcomes: What Worked in Both ’98 and ’08?
Growth and Higher Valuations...Semis, Tech Hardware and
Retail
We noted a few weeks ago that we saw the market at a juncture similar to both ’98 and ’08 (see “Europe Severe but Some Reasons Closer to Asia ’98…” dated 09/15), with both involving a financial crisis. In fact, in some aspects, this crisis more resembles Asia (but with larger consequences) given the need for the weaker Euro periphery to delever (need to devalue, which cannot be done without leaving the Eurozone).
We looked at both periods to see what outperformed in the six months following each crisis—post-98 (test and passed) and post-Lehman’s failure (test and failure). This is important, as the S&P 500 direction could not be more different—up 40% post-98, down 40% post-Lehman.
• Five Industries (Figure 4): There were five industries (GICS level 2) that outperformed in both periods: Semiconductors, Consumer Services, Software, Tech Hardware, and Retail. Doesn’t this look like Early Cycle?
• Five Styles (Figure 5): There were also five styles that outperformed: High P/B, Pure Growth (Citigroup Pure Growth), High P/E, High EV/EBITDA, and More Liked (FC Mean).
The takeaway? It seems that whether this crisis resolves positively or negatively, Early Cycle, Growth/Consensus (FC Mean), and more expensive stocks could outperform.
Figure 4: Industry Groups that Outperformed in Both Periods…
Source: J.P. Morgan and FactSet.
Figure 5: Styles that Outperformed in Both Periods…
Source: J.P. Morgan and FactSet.
% chg vs S&P 500: 6-mos after event
Industry '98 crisis
Post-Lehman
'08 Combined
S&P 500 performance 40% -40%
Relative performance (vs S&P 500)
Semiconductors 41% 11% 26%
Consumer Svcs 15% 10% 13%
Software & Svcs 58% 7% 33%
Tech Hardware & Equip 49% 6% 27%
Retailing 35% 4% 20%
% chg vs S&P 500: 6-mos after event
Style '98 crisis
Post-Lehman
'08 Combined
S&P 500 performance 40% -40%
Relative performance (vs S&P 500)
Expensive P/B 49% 4% 26%
Pure Growth 40% 6% 23%
Expensive P/E 32% 2% 17%
Expensive EV/EBITDA 28% 2% 15%
Figure 6: Relative Six-Month Performance of Industry Groups After Past Crises
Source: J.P. Morgan and FactSet.
Figure 7: Relative Six-Month Performance of Styles After Past Crises
Source: J.P. Morgan and FactSet.
Market Strategy: 40 Best Near-Term Stock Ideas
Energy
Materials
Capital Goods Commercial Svcs & Supplies
Transportation
Autos & Components Consumer Durables &
Apparel
Consumer Svcs
Media Retailing Food & Staples Retailing
Food Beverage & Tobacco
HH & Personal Products Health Care Equip & Svcs
Pharma, Biotech & Life Sciences
BanksInsurance Diversified Financials Software & Svcs Tech Hardware & Equip Semiconductors Telecom Services Utilities -32.0% -22.0% -12.0% -2.0% 8.0% 18.0% -52.0% -32.0% -12.0% 8.0% 28.0% 48.0% 68.0% Re lat ive P er f in 6 m os af ter Leh ma n b an kr up tcy
Relative Perf in 6 mos after 1998 Low
Ou tpe rfo rm ed afte r Le hm an f ail ur e
Outperformed after '98 Low Outperformed in both periods
Low Price High Price
Market Cap Smaller
Market Cap Larger
Cheap P/E Expensive P/E Cheap P/B Expensive P/B Low Beta High Be Low Momentum High Momentum Cheap EV/EBITDA Expensive EV/EBITDA More Liked Less Liked
S&P High Quality
S&P Low Quality
Pure Growth Pure Value Cyclical Defensive -13.0% -8.0% -3.0% 2.0% 7.0% -50.0% -30.0% -10.0% 10.0% 30.0% 50.0% 70.0% Re lat ive P erf in 6 m os af ter Leh man ban kru ptcy
Relative Perf in 6 mos after 1998 Low
Ou tpe rfo rm ed afte r Le hm an f ail ur e
Outperformed after '98 Low Outperformed in both periods
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Figure 8: J.P. Morgan Fundamental Analysts Best Near-Term Stock Ideas — LONG STOCK IDEAS
$ in mm; Priced as of 9/27/11
Source: J.P. Morgan and FactSet
Figure 9: J.P. Morgan Fundamental Analysts Best Near-Term Stock Ideas — SHORT STOCK IDEA
$ in mm; Priced as of 9/27/11
Source: J.P. Morgan and FactSet
JPM Coverage EPS & Valuation
Name Industry Ticker
Current Price Market Cap JPM Rtg JPM Analyst Target Price Implied Upside 2011E EPS P/E ('11E) P/B 1 Cimarex Energy Co. Oil Gas & Consumable Fuels XEC $60.01 $5,135 OW Joseph Allman, CFA $132.00 120% $6.35 9.4x 1.78x 2 Freeport-McMoRan Copper & Gold Inc. Metals & Mining FCX $34.82 $33,005 OW Michael F. Gambardella $74.00 113% $5.89 5.9x 2.28x 3 United Continental Holdings Inc. Airlines UAL $20.43 $6,758 OW Jamie Baker $36.00 76% $3.64 5.6x 3.48x 4 LyondellBasell Industries N.V. Cl A Chemicals LYB $29.59 $16,913 OW Jeffrey J. Zekauskas $50.00 69% $4.93 6.0x 1.24x 5 Owens Corning Building Products OC $23.45 $2,894 OW Michael Rehaut, CFA $39.00 66% $2.23 10.5x 0.76x 6 Noble Corp. Energy Equipment & Services NE $31.89 $8,331 OW J. David Anderson, PE, CFA $53.00 66% $1.72 18.6x 1.11x 7 Wells Fargo & Co. Commercial Banks WFC $24.96 $131,785 OW Vivek Juneja $41.00 64% $2.81 8.9x 1.05x 8 Harman International Industries Inc. Household Durables HAR $32.18 $2,250 OW Himanshu Patel, CFA $50.00 55% 1.58x 9 Rock-Tenn Co. Cl A Containers & Packaging RKT $52.09 $3,709 OW Phil Gresh, CFA $80.00 54% $5.32 9.8x 1.05x 10 Kinross Gold Corp. Metals & Mining KGC $15.02 $17,070 OW John Bridges CFA, ACSM $23.00 53% $0.87 17.3x 1.14x 11 Agilent Technologies Inc. Life Sciences Tools & Services A $33.56 $11,653 OW Tycho W. Peterson $50.00 49% $2.91 11.5x 2.78x 12 Ariad Pharmaceuticals Inc. Biotechnology ARIA $10.14 $1,344 OW Cory Kasimov $15.00 48% -$0.80 168.59x 13 St. Jude Medical Inc. Health Care Equipment & Supplies STJ $38.97 $12,841 OW Michael Weinstein $57.00 46% $3.27 11.9x 2.65x 14 CVS Caremark Corp. Food & Staples Retailing CVS $34.69 $46,653 OW Lisa C. Gill $50.00 44% $2.78 12.5x 1.22x
15 Deere & Co. Machinery DE $69.48 $28,759 OW Ann Duignan $100.00 44% $6.43 10.8x 3.82x
16 Boeing Co. Aerospace & Defense BA $62.78 $46,526 OW Joseph B. Nadol III $89.00 42% $4.24 14.8x 9.82x
17 Pfizer Inc. Pharmaceuticals PFE $17.75 $138,488 OW Chris Schott, CFA $25.00 41% $2.25 7.9x 1.57x
18 Reinsurance Group of America Inc. Insurance RGA $48.05 $3,560 OW Jimmy S. Bhullar, CFA $67.00 39% $7.08 6.8x 0.67x 19 Union Pacific Corp. Road & Rail UNP $85.66 $41,810 OW Thomas R. Wadewitz $119.00 39% $6.51 13.2x 2.28x 20 Brinker International Inc. Hotels Restaurants & Leisure EAT $22.34 $1,847 OW John Ivankoe $31.00 39% 4.22x 21 Comerica Inc. Commercial Banks CMA $23.41 $4,705 OW Steven Alexopoulos, CFA $32.00 37% $2.20 10.6x 0.69x
22 Synopsys Inc. Software SNPS $24.91 $3,588 OW Sterling Auty, CFA $33.00 32% $1.80 13.8x 1.69x
23 Las Vegas Sands Corp. Hotels Restaurants & Leisure LVS $44.69 $32,632 OW Joseph Greff $59.00 32% $1.90 23.5x 4.49x 24 Apple Inc. Computers & Peripherals AAPL $399.26 $370,150 OW Mark Moskowitz $525.00 31% $27.68 14.4x 5.34x
25 AON Corp. Insurance AON $41.21 $13,463 OW Matthew G Heimermann $53.00 29% $3.40 12.1x 1.60x
26 Broadcom Corp. Semiconductors & Semiconductor Equipment BRCM $35.04 $16,854 OW Harlan Sur $45.00 28% $2.96 11.8x 3.19x 27 ITC Holdings Corp. Electric Utilities ITC $75.70 $3,883 OW Stefka Gerova, CFA $95.00 25% $3.33 22.7x 3.26x 28 Ares Capital Corp. Capital Markets ARCC $13.78 $2,827 OW Richard Shane $17.00 23% $1.40 9.8x 0.90x 29 Simon Property Group Inc. Real Estate Investment Trusts (REITs) SPG $113.60 $33,375 OW Michael W. Mueller, CFA $140.00 23% $2.57 44.2x 7.02x 30 NCR Corp. Computers & Peripherals NCR $18.01 $2,833 OW Paul Coster, CFA $22.00 22% $1.82 9.9x 2.95x 31 CME Group Inc. Cl A Diversified Financial Services CME $262.29 $17,537 OW Kenneth B. Worthington, CFA $320.00 22% $17.41 15.1x 0.84x 32 Quanta Services Inc. Construction & Engineering PWR $19.43 $4,030 OW Scott Levine $23.50 21% $0.70 27.8x 1.24x 33 Home Depot Inc. Specialty Retail HD $33.88 $52,998 OW Christopher Horvers, CFA $40.00 18% $2.35 14.4x 2.92x 34 Celgene Corp. Biotechnology CELG $63.97 $29,350 OW Geoffrey Meacham, Ph.D. $75.00 17% $3.60 17.8x 4.91x 35 Yahoo! Inc. Internet Software & Services YHOO $14.54 $18,358 N Doug Anmuth $17.00 17% $0.74 19.7x 1.46x 36 American Tower Corp. Wireless Telecommunication Services AMT $54.58 $21,600 OW Philip Cusick, CFA $60.00 10% $1.03 53.1x 6.07x 37 Verisk Analytics Inc. (Cl A) Professional Services VRSK $34.49 $5,175 OW Michael A. Meltz, CFA $36.00 4% $1.64 21.0x 38 Watson Pharmaceuticals Inc. Pharmaceuticals WPI $72.10 $9,671 OW Chris Schott, CFA $73.00 1% $4.46 16.2x 2.63x
39 Reynolds American Inc. Tobacco RAI $37.24 $21,708 OW Rae Maile $2.65 14.1x 3.26x
Average 41% 12.8x 2.28x
JPM Coverage EPS & Valuation
Name Industry Ticker
Current Price Market Cap JPM Rtg JPM Analy st Target Price Implied Upside 2011E EPS P/E ('11E) P/B 1 Canadian National Railw ay Co. Road & Rail CNI $68.12 $30,451 N Thomas R. Wadew itz $75.00 10% $4.77 14.3x 2.58x
Accounting and Valuation
Elevated Pension Risk
Year-to-date pension trends imply funded status deterioration if these conditions hold through year-end
Pension performance is primarily driven by two factors: 1) discount rates and 2) asset returns. The year-to-date performance of both of these factors imply that we should expect pension plan funded status deterioration if these trends hold or worsen between now and companies’ fiscal yearends. If this “perfect storm” of poor plan asset performance and substantial increases in pension obligations due to large year-over-year decreases in discount rates holds through December, the deterioration in 2011 pension funding levels could be the worst pension performance over the past decade, which has already seen two particularly bad years in 2002 and 2008. The Moody’s Aa rate fell to 3.94 on September 22. If current trends in Aa or higher corporate credit rates hold through yearend, it could result in some December-yearend companies lowering discount rate assumptions by as much as 125 basis points for some companies. The implication of this discount rate trend would be higher pension projected benefit obligations (PBOs).
Figure 10: YOY Moody’s Aa Corporate Bonds Index Month-end Performance, 2010 and YTD 2011
Source: Moody's and J.P. Morgan Estimates.
With the S&P 500 down 10% since December 31, 2010, many pension plans could see material declines in plan asset balances if trends hold through yearend.
3.75 4.00 4.25 4.50 4.75 5.00 5.25 5.50 5.75 R at e Month
YOY Moody's Aa Bond Index Monthend Rates
2010 2011
Lower YOY rate means higher PBO Dane Mott, CFA, CPA AC
(1-415) 315-5905 [email protected] Amy Schmidt (1-415) 315-6705 amy.m.schmidt @jpmorgan.com J.P. Morgan Securities LLC
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Figure 11: S&P 500 Index, 2010 and YTD 2011
Source: Standard and Poor’s and J.P. Morgan Estimates.
Volatile markets elevate the need to consider pension exposure when making investment decisions
Pension plans represent a very real source of risk for companies. In the worst case scenario, an unhealthy pension plan can push an otherwise healthy company with a value-creating portfolio of operating businesses into financial distress or bankruptcy. As we have said in prior research, one of the problems with pension exposure is that it has the potential to create situations where “the tail wags the dog.” That is, pensions have the potential to create very serious problems at a company when the size of the pension plan begins to be comparable or larger than the size of the "operating businesses."
A big pension plan can make even a seemingly straightforward business model very complicated. In some situations, how someone thinks about the risks associated with a company’s pension exposure should change how they think about a stock, because it may alter the risk-reward tradeoff of the investment in a material way.
As we had often stated, we think about pension plans like insurance entities. From our perspective, having exposure to a pension plan is analogous to having exposure to a business segment that is an insurance entity managing a book of annuity contract obligations.
Consistent with this philosophy, we take a two-step approach to pension analysis in the valuation process. Those steps are:
Step 1. Identify companies with elevated levels of pension risk. Identify
companies where the pension plans are large enough that an investor should think of the pension plan as a materially large business unit; and
Step 2. Model the companies with the highest levels of pension risk. Once a company has been isolated as having a materially-large pension risk exposure, we
1,000 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400 M on th -E nd Pr ic e Month
YOY S&P 500 Index Monthend Prices
2010 2011
recommend modeling the pension to forecast the balance-sheet, income-statement, and cash-flow effects associated with the pension plan.
We have various resources that can help clients conduct this two-step analysis. Contact us if you would like copies of our most recent pension risk ratio analysis research or if you would like a copy of our proprietary model that you can use to forecast pension and other post-retirement plan behavior for up to 6 years.
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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Basket Details
Bloomberg Ticker JPUS4Q11 <Index>
Benchmark SPX Index
Number of Components 39
Weighting Scheme Equally Weighted
Source: J.P. Morgan.
Bloomberg subscribers can use the ticker JPUS4Q11 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 JPUS4Q11 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 JPUS4Q11, please contact your J.P. Morgan
salesperson or the Delta One Desk.
Delta One Strategy
J.P. Morgan US Best Near-Term Ideas Basket – JPUS4Q11 <Index>
Basket Methodology and Composition
The J.P. Morgan U.S. Best Near-Term Ideas Basket for Q4 2011 (<JPUS4Q11> Index on Bloomberg) represents a portfolio of US stocks that J.P. Morgan Equity Research Analysts have selected as their best ideas for investors over the next three months. The rationale for each stock’s selection is provided by the analysts in their individual sector notes. The basket is equally weighted, and is well diversified across sectors and capitalization segments. The tables below show the current sector composition and individual members of the J.P. Morgan U.S. Best Near-Term Ideas for 4Q 2011Basket.
Figure 12: Sector Composition of the J.P. Morgan US Best Near-Term Ideas Basket – JPUS4Q11 <Index>, as of Sep 27, 2011 (close)
Source: J.P. Morgan Derivatives & Delta One Strategy, Bloomberg.
Figure 13: Market Capitalization Breakdown of the J.P. Morgan US Best Near-Term Ideas Basket – JPUS4Q11 <Index>, as of Sep 27, 2011 (close)
Source: J.P. Morgan Derivatives & Delta One Strategy, Bloomberg.
Health Care 15% Telecom 3% Financials 18% Technology 10% Industrials 18% C. Discretion 10% Energy 8% C. Staples 5% Materials 10% Utilities 3% Large cap (> $20 bn) 38% Mid cap ($10 - $20 bn) 18% Small cap (< $10 bn) 44%
Derivatives & Delta One Strategy Marko Kolanovic (1-212) 272-1438 [email protected] Kapil Dhingra (1-212) 272-7823 [email protected] Adam Rudd (1-212) 272-1215 [email protected] Amyn Bharwani (1-212) 622-8030 [email protected] J.P. Morgan Securities LLC
Figure 14: Composition of the J.P. Morgan US Best Near-Term Ideas Basket – JPUS4Q11 <Index>, as of Sep 27, 2011 (close)
Source: J.P. Morgan Derivatives & Delta One Strategy, Bloomberg.
Ticker Name Sector Industry Analyst Wgt (%) Mkt. Cap ($B) RatingJPM Price ($)Last 3M ADV ($M)
AAPL Apple Inc Technology Computers & Peripherals Mark Moskowitz 2.56% $ 370.15 OW $ 399.26 $ 8,535
PFE Pfizer Inc Health Care Pharmaceuticals Chris Schott, CFA 2.56% $ 138.49 OW $ 17.75 $ 930
WFC Wells Fargo & Co Financials Commercial Banks Vivek Juneja 2.56% $ 131.78 OW $ 24.96 $ 1,067 HD Home Depot Inc C. Discretion Specialty Retail Christopher Horvers, CFA 2.56% $ 53.00 OW $ 33.88 $ 493
BA Boeing Co/The Industrials Aerospace & Defense Joseph B. Nadol III 2.56% $ 46.53 OW $ 62.78 $ 414
CVS Cvs Caremark Cor C. Staples Food & Staples Retailing Lisa C. Gill 2.56% $ 46.65 OW $ 34.69 $ 358
UNP Union Pac Corp Industrials Road & Rail Thomas R. Wadewitz 2.56% $ 41.81 OW $ 85.66 $ 310
SPG Simon Property Financials Real Estate Investment Trusts Michael W. Mueller, CFA/A2.56% $ 33.32 OW $ 113.60 $ 262
LVS Las Vegas Sands C. Discretion Hotels Restaurants & Leisure Joseph Greff 2.56% $ 32.63 OW $ 44.69 $ 853
FCX Freeport-Mcmoran Materials Metals & Mining Michael F. Gambardella 2.56% $ 33.01 OW $ 34.82 $ 682
CELG Celgene Corp Health Care Biotechnology Geoffrey Meacham, Ph.D. 2.56% $ 29.35 OW $ 63.97 $ 247
DE Deere & Co Industrials Machinery Ann Duignan 2.56% $ 28.76 OW $ 69.48 $ 408
RAI Reynolds America C. Staples Tobacco Rae Maile 2.56% $ 21.71 OW $ 37.24 $ 123
AMT American Tower-A Telecom Wireless Telecommunication SerPhilip Cusick, CFA 2.56% $ 21.60 OW $ 54.58 $ 181
BRCM Broadcom Corp-A Technology Semiconductors & Semiconduct Harlan Sur 2.56% $ 18.75 OW $ 35.04 $ 317
CME Cme Group Inc Financials Diversified Financial Services Kenneth B. Worthington, C 2.56% $ 17.59 OW $ 262.29 $ 142
YHOO Yahoo! Inc Technology Internet Software & Services Doug Anmuth 2.56% $ 18.36 N $ 14.54 $ 484
KGC Kinross Gold Materials Metals & Mining John Bridges CFA, ACSM 2.56% $ 17.07 OW $ 15.02 $ 141
LYB Lyondellbasell-A Materials Chemicals Jeffrey J. Zekauskas 2.56% $ 16.81 OW $ 29.59 $ 140
AON Aon Corp Financials Insurance Matthew G Heimermann 2.56% $ 13.46 OW $ 41.21 $ 105
STJ St Jude Medical Health Care Health Care Equipment & SuppliMichael Weinstein 2.56% $ 12.84 OW $ 38.97 $ 138
A Agilent Tech Inc Health Care Life Sciences Tools & Services Tycho W. Peterson 2.56% $ 11.65 OW $ 33.56 $ 187
WPI Watson Pharm Health Care Pharmaceuticals Chris Schott, CFA 2.56% $ 9.67 OW $ 72.10 $ 101
NE Noble Corp Energy Energy Equipment & Services J. David Anderson, PE, CFA2.56% $ 8.05 OW $ 31.89 $ 144
UAL United Continent Industrials Airlines Jamie Baker 2.56% $ 6.76 OW $ 20.43 $ 148
VRSK Verisk Analyti-A Industrials Professional Services Michael A. Meltz, CFA 2.56% $ 5.68 OW $ 34.49 $ 28
XEC Cimarex Energy C Energy Oil, Gas & Consumable Fuels Joseph Allman, CFA 2.56% $ 5.13 OW $ 60.01 $ 77
CMA Comerica Inc Financials Commercial Banks Steven Alexopoulos, CFA 2.56% $ 4.70 OW $ 23.41 $ 99
PWR Quanta Services Industrials Construction & Engineering Scott Levine 2.56% $ 4.12 OW $ 19.43 $ 46
ITC Itc Holdings Cor Utilities Electric Utilities Stefka Gerova 2.56% $ 3.88 OW $ 75.70 $ 24
RKT Rock-Tenn Co-A Materials Containers & Packaging Phil Gresh 2.56% $ 3.71 OW $ 52.09 $ 55
SNPS Synopsys Inc Technology Software Sterling Auty, CFA 2.56% $ 3.59 OW $ 24.91 $ 29
RGA Reinsurance Grou Financials Insurance Jimmy S. Bhullar, CFA 2.56% $ 3.56 OW $ 48.05 $ 30
ARCC Ares Capital Cor Financials Capital Markets Richard Shane 2.56% $ 2.83 OW $ 13.78 $ 28
OC Owens Corning Industrials Building Products Michael Rehaut, CFA 2.56% $ 2.89 OW $ 23.45 $ 45
NCR Ncr Corp Technology Computers & Peripherals Paul Coster, CFA 2.56% $ 2.83 OW $ 18.01 $ 37
HAR Harman Intl C. Discretion Household Durables Himanshu Patel, CFA 2.56% $ 2.25 OW $ 32.18 $ 33
EAT Brinker Intl C. Discretion Hotels Restaurants & Leisure John Ivankoe 2.56% $ 1.85 OW $ 22.34 $ 48
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Basket Performance
In this section, we examine the hypothetical performance of the J.P. Morgan US Best Near-Term Ideas Basket for Q4 2011 over the last three years. The J.P. Morgan US Best Near-Term Ideas Basket – JPUS4Q11 <Index> – would have significantly outperformed the S&P 500 Index over the past three years. The annualized return of the J.P. Morgan US Best Near-Term Ideas Basket would have been ~5.6% (while the annualized S&P 500 Index return during the same time period was 2%). The
correlation of the basket returns to the S&P 500 Index returns has been 97%, and the recent six-month realized volatility of the basket has been 28.7% (the realized volatility of the S&P 500 Index over the same time frame has been 25%). The figures below show the performance and volatility of the J.P. Morgan US Best Near-Term Ideas 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 in the charts below.
Figure 15: Performance of the J.P. Morgan US Best Near-Term Ideas Basket (JPUS4Q11 Index) and S&P 500 Index (since past 3 years)
Source: J.P. Morgan Derivatives & Delta One Strategy, Bloomberg.
Note: All price performance excludes commissions and fees. Past Performance is not indicative of future returns.
Figure 16: Daily Returns of the J.P. Morgan US Best Near-Term Ideas Basket (JPUS4Q11 Index) vs. S&P 500 Index Return
Source: J.P. Morgan Derivatives & Delta One Strategy, Bloomberg.
Note: All price performance excludes commissions and fees. Past Performance is not indicative of future returns.
Figure 17: 6M Realized Volatility of the J.P. Morgan US Best Near-Term Ideas Basket (JPUS4Q11 Index) vs. S&P 500 Index
Source: J.P. Morgan Derivatives & Delta One Strategy, Bloomberg.
Note: All price performance excludes commissions and fees. Past Performance is not indicative of future returns.
Figure 18: 6M Beta and 6M Correlation of the J.P. Morgan US Best Near-Term Ideas Basket (JPUS4Q11 Index) vs. S&P 500 Index
Source: J.P. Morgan Derivatives & Delta One Strategy, Bloomberg.
Note: All price performance excludes commissions and fees. Past Performance is not indicative of future returns. 0 20 40 60 80 100 120 140 160
Sep-08 Feb-09 Jul-09 Dec-09 May-10 Oct-10 Mar-11 Aug-11
JPUS4Q11 S&P 500 R² = 95% -15% -10% -5% 0% 5% 10% 15% -15% -10% -5% 0% 5% 10% 15% B as ke t D ai ly R et ur n (% )
S&P 500 Daily Return (%)
0% 10% 20% 30% 40% 50% 60% 70%
Mar,09 Sep,09 Mar,10 Sep,10 Mar,11 Sep,11
Basket 6M Realized Vol. S&P 500 6M Realized Vol.
0.8 0.9 1.0 1.1 1.2 1.3 92% 93% 94% 95% 96% 97% 98% 99%
Mar,09 Aug,09 Jan,10 Jun,10 Nov,10 Apr,11 Sep,11 6M Correl. (Left) 6M Beta (Right)
Additional Basket Methodology
In order to keep the basket relevant to the investment theme, J.P. Morgan reserves the right to review the following at any time:
• Basket methodology. This is to ensure the rules of the basket remain relevant following any structural changes to the theme. This may include ensuring that the sector exposure of the basket remains broadly consistent with the investment theme.
• Basket change implementation. J.P. Morgan will consider extending the implementation of changes to the basket composition from one trading session to any period up to five trading sessions in the event that a material increase in the liquidity or capacity of the basket is required to minimize market impact. Corporate actions may affect the J.P. Morgan US Best Near-Term Ideas Basket. The composition of a custom basket is typically adjusted in the following manner: Cash Merger. The divisor is adjusted, and we remove the merging company from the basket on the day of merger and redistribute gains into remaining companies according to recalculated market cap weights of surviving constituents in the basket. Stock Merger. If the acquirer is a member of the basket, then the weight allocated to the acquired will transfer to the surviving entity on the close of the last day it trades. If the acquirer is not a part of the basket, then proceeds (losses) from the acquired company will be redistributed to the surviving basket constituents based on the recalculated weighting on the close of its last trading day.
Spinoffs. The spinoff company and parent will be included in the basket, and both the spinoff and parent company weights will be readjusted according to new market capitalizations after the spinoff date.
Tender Offers and Share Buybacks. The company remains in the basket and its weight is adjusted according to the impact the tender/buyback has on the stock’s market value.
Delisting/Insolvency/Bankruptcy. The company is removed from the basket as of the close of the last trading day, and the proceeds (losses) will be redistributed into remaining companies according to re-calculated weights of remaining companies in the basket. If a stock trades on “pink sheets” it will not be included in the basket.
Aerospace & Defense
Boeing: An Attractive Investment Backdrop with Several Potential Near-Term Catalysts
Boeing (BA – $62.78 – Overweight)We see potential for Boeing to outperform over the next three months. The stock trades at only 12x 2012E EPS vs 15x next year’s earnings on average over the past 10 years, yet the company is preparing for a significant ramp in commercial aircraft production. Macro risk is a concern, but we believe Boeing’s dependence on emerging market demand leaves it well-positioned to weather the current global headwinds, which are concentrated in the US and Europe for the most part, and that rate increases will move ahead in all but the most dire economic scenarios, thanks in part to a solid commercial backlog of 3,505 aircraft.
The 787 is a key driver of the coming increase in rates, and just this week the company finally began delivering the aircraft. We see the achievement of this long-awaited milestone as a development that could help attract investors back into the stock. In addition, we see potential for more commercial aircraft orders, including for the recently launched 737 MAX, and these could support the stock as well.
Widebody demand should drive continued orders for the 777 and the 787, particularly if Boeing launches the new 787-10 variant in the coming months. Other potential drivers for Boeing include improving 787 cash flow and falling R&D in the coming years, neither of which is dependent on macro developments. 787 inventory growth of ~$8/share this year should slow as rates ramp up, and cash flow on the program should eventually turn positive, driving FCF of $10/share in 2014E if all goes well.
On R&D, activity on the 787 and 747-8 should ramp down, driving R&D lower in both 2012 and 2013, even with the development of the 737 MAX. We are modeling an $850 mn decline between 2010 and 2013, adding 75-80 cents to EPS.
Joseph B. Nadol AC
(1-212) 622-6548
[email protected] Seth M. Seifman, CFA (1-212) 622-5597 [email protected] Christopher Sands (1-212) 622-9224 [email protected] J.P. Morgan Securities LLC
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Airfreight and Surface Transportation
Legacy Repricing Supports UNP Upside; Pair with CNI Helps Offset Macro Risk
Long Union Pacific (UNP – $85.66 – Overweight) Short Canadian National (CNI – $68.12 – Neutral)Over the next three months, we recommend a pair trade of taking a long position in OW-rated UNP to capture the company’s strong legacy contract repricing story and robust near-term PRB coal volumes, while offsetting the macro risk by taking a short position in N-rated CNI.
UNP should realize a significant tailwind in 2012 from repricing ~$1.05 bn in revenue of old contracts (legacy intermodal and coal), where pricing is likely to rise sharply. We estimate that the combined revenue increase resulting from repricing the legacy contracts is ~$490 mm in 2012 or ~$0.63/share, which contributes 9.7%-points to earnings growth. In contrast, we expect the pricing outlook to be somewhat more muted for CNI, which does not have any meaningful legacy contracts
remaining in its book of business. CNI is also exposed to Canadian regulated grain, which has limited pricing opportunity. In our view, the revenue mix for UNP is more defensive with ~38% of 2010 revenues from the less economically sensitive coal and agricultural segments compared to only ~24% of CNI’s revenues. Although we are recommending a short position in CNI against a long UNP in this pair trade, we continue to rate CNI Neutral, as we believe the stock already reflects a reasonably optimistic outlook. We believe CNI is likely to realize modest margin expansion in the medium term, but our sense is that volume and revenue growth are the more important drivers of the CNI story.
On our 2012 EPS estimates, UNP trades at 11.9x and CNI trades at 13.6x. The long-term average historical P/E range for UNP and CNI is 11x-15x, but we note that during the positive rail pricing story of 2004 – 2008 the rail group realized stronger valuation in the 13x – 17x range. In our view, the more defensive book of business and strong legacy contract repricing story should likely drive a stronger valuation for UNP relative to CNI. We note that the YTD stock performance for UNP is down 7.6%, while CNI is up 2.5% and the S&P 500 is down 8.5%.
Thomas R. Wadewitz AC
(1-212) 622-6461
[email protected] Michael R. Weinz, CFA (1-212) 622-6383 [email protected] Alexander K. Johnson (1-212) 622-6513 [email protected] J.P. Morgan Securities LLC
Engineering & Construction
PWR Poised for a Move Up into Year-End
Quanta Services (PWR – $19.43 – Overweight)
Growth poised to accelerate into 2012, fueled by transmission. Although earnings have remained relatively flattish y/y in 1H, revenue growth has begun to accelerate, reflecting recent increases in backlog (+18% y/y in Q2) that have been driven primarily by Electric Power (+23% y/y) and, more recently, Telecom (+125% y/y). Given recent growth in backlog, we think revenue growth is set to accelerate into year-end, fueled by increased activity on transmission projects, with PWR having booked several in recent quarters, many of which are expected to ramp into year-end (PWR is expecting to be active on ten projects by YE11). We expect the transmission bid funnel to remain active going forward, and PWR has expressed comfort with its ability to take on additional work despite tightening industry capacity, which could play to its favor as the transmission cycle matures.
Visibility in Natural Gas & Pipeline could also improve by year-end. The Natural Gas & Pipeline business has been disappointing in 2011 (revenues -20% y/y in Q2), and while we don’t expect much improvement in Q3, the business could be poised for a turn in 2012, with visibility perhaps to improve by Q4. Pipeline bidding season typically commences in October, and management has cited a healthy pipeline, suggesting we could see a better performace in 2012 (we assume flat revenues in 2012). In addition, the proposed Keystone XL pipeline could be approved by year-end (the EIS was approved by the State Dept. in late August, providing a positive and necessary step), which could benefit PWR (a leader in pipeline construction that has a strong relationship with sponsor TransCanada) and would likely drive tighter industry capacity trends, which could benefit the industry as a whole in 2012-13. Broadening base of growth drivers could drive a strong close to 2011. PWR shares have been fairly range-bound over the past year despite steady increases in backlog, as weather and regulatory delays have impacted a number of businesses (notably Pipeline & Transmission), causing earnings to trail initial expectations. At 9.2x 2011 and 6.8x 2012 EV-EBITDA estimates, PWR is trading at a premium to the peer group, which we think is warranted given the growth potential in a number of businesses (notably transmission). We think valuation (and sentiment) should improve as growth accelerates, with businesses such as Telecom and Pipeline better compelementing the Electric Power business, thereby driving accelerating earnings growth. Scott Levine AC (1-212) 622-5609 [email protected] Rodney C. Clayton (1-212) 622-2873 [email protected] Ankit Varmani (1-212) 622-5654 [email protected] J.P. Morgan Securities LLC
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Machinery
Global Agriculture Fundamentals Strong; Overweight DE
Deere (DE – $69.48 – Overweight)Our Overweight rating on DE is predicated on the company’s exposure to global agriculture, where fundamentals remain strong. The stock has underperformed peers’ YTD, as investors feared that equipment sales in NA are at, or close to, peak as the replacement cycle is over. We disagree, as Census data shows that we have only replaced about 16% of crop farm equipment this cycle, and there is no “replacement cycle.” Farmers spend money when they have money, and cash receipts should hit a record level in the 2011/12 season. The recent World Agriculture Supply and Demand Estimate (WASDE) report from the USDA forecasted slight increases in year-end stocks-to-use projections, but overall major crop receipts expectations remain strong. We currently expect $151.6 billion in major crop receipts for 2011/12, up 25% YoY. In Brazil, key crop prices remain elevated in 2011 to date; we note that daily sugar prices are up an average of 35% YTD. Soybean prices are up 23% YTD, and government support continues with the Brazilian government passing $54 billion of farm financing packages, which lifts some uncertainty for farmers in the region. In Europe, dairy and livestock are important sectors (combined ~58% of the market); milk and meat prices have increased substantially YTD in 2011. Milk prices increased 15% in 2010 in Europe, according to the USDA, and production is expected to increase a further 1% in 2011. Through August 2011, the FAO's Dairy Price index is up 14% YTD and up 16% YoY, while the Meat Price index is up 6% YTD and 9% YoY. In China, pork prices have risen 43% YTD, and China accounts for 50% of global pork production; farmers are making RMB600-1000 per head, more than double the normal profit. Longer term, modernization and consolidation in pig farming as well as gradual shift to corn or soybean-based feed are ongoing trends; currently, leftover human food makes up a substantial portion of feed on smaller farms.
As a result, we remain bullish on DE’s ability to deliver strong earnings growth into 2012 and beyond. In an environment of economic uncertainty, we like DE’s
exposure to 1) global end markets and 2) agriculture, which we view as less cyclical. Additionally, earnings estimates for 2012 look conservative – with EPS growth of 12% expected vs. its peer group average at growth of 33%. We believe this should result in less downside risk in the near term.
Ann Duignan AC
(1-212) 622-0381
[email protected] Ingrid Aja, CFA (1-212) 622-3730 [email protected] Michael Shlisky (1-212) 622-6656 [email protected] J.P. Morgan Securities LLC
Airlines
UAL: Priced for Turbulence, but We See Friendlier Skies Ahead
United Continental Holdings, Inc. (UAL – $20.43 – Overweight) Let’s not lose sight of the bigger picture. The airline industry has realized over $8 billion of annualized fuel cost savings versus April highs. This represents ~6% of industry revenue. Could revenue decline by this amount and completely offset the savings? Anything is possible, but only 9/11 and the financial crisis in 2009 have ever resulted in demand so weak.
As such, we recommend UAL as one of our best near-term ideas for the following: • Compelling valuation: Current airline enterprise values have returned to their
2009 lows, a time when revenue declines were without precedent and liquidity was rapidly deteriorating. Market valuation today implies things are going to be just as dire this time as when the global financial situation teetered on the brink of collapse, despite the fact that the industry is more consolidated and currently profitable with liquidity stronger across the board. For investors believing in a macro outcome any less severe than in 2009, airline equities, in particular, deserve a close look. To put things in perspective, UAL’s enterprise value – adjusted for CAL – is within ~3% of its 2Q09 level and currently trades lowest among its peers at 3.6x 2011E EV/EBITDAR vs. 4.1x at DAL, 5.2x at LCC, and 12.1x at AMR. With UAL trading at 3.6x EV/EBITDAR, at the low end of historical ranges, we see potential near-term upside opportunity from here. • Strong balance sheet: Relative to peers, we believe UAL has one of the
strongest balance sheets. At 2.6x Net Debt/LTM EBITDAR, UAL has the lowest leverage ratio among legacies, excluding Alaska. Additionally, in terms of liquidity, UAL is current at 24% of LTM revenues as of 2Q11, better than any legacy airline excluding Alaska.
• Down 30 in 30 in effect: Granted, Continental is no longer with us, but we see no reason UAL can’t continue the trend. Since 1993, there were 27 instances in which CAL triggered this rule. In all 27, upside potential then followed, ranging from 5% to 468% with a mean of approximately 105%. Alternatively, 74% of observations resulted in 50% upside or greater.
UAL continues to offer a compelling valuation, in our view, and with oil prices declining followed by capacity cuts expected to take effect in Q4, we believe there is upside opportunity in the stock. However, UAL’s share price is down more than 10% year to date. We believe this is overdone and a near-term correction will follow. As such, UAL is one of our best near-term ideas.
Jamie Baker AC
(1-212) 622-6713 [email protected] Scott Tan, CFA (1-212) 622-5541 [email protected] Joseph Abboud (1-212) 622-7059 [email protected] J.P. Morgan Securities LLC
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Autos and Auto Parts
Harman Int’l: Defensive German Luxury Play; Top Near-Term Pick
Harman Int’l. (HAR – $32.18 – Overweight)While we remain cautious on the Autos space given macro uncertainty, we view HAR as particularly attractive relative to other auto suppliers in our coverage due to HAR’s product mix, its exposure to a relatively resilient global luxury vehicle market, and limited downside potential after the recent sell-off.
We highlight three key points to our bullish call:
• Resilient customer/product exposure: We view HAR as being more defensive in nature than other suppliers in our space: ~45% of the company’s total sales are from German luxury OEMs: Mercedes, BMW, and Audi, whose sales have held up vs. the broader industry. Even if we were to fall into a moderate global recession, we believe luxury sales should continue to be resilient (e.g., luxury sales in China have grown 23% YTD, while overall auto sales are up 5%). Secondly 20% of HAR’s revenues are professional audio (audio for concerts, sporting events, etc.), which, too, did not see a precipitous decline during a recession – in 2008, professional audio only fell 20% peak to trough vs. ~30% for the automotive business.
• Oct. 26th analyst day could be a catalyst: We think HAR’s analyst day on Oct. 26th will be used by the company as an opportunity to provide investors with positive mid-decade operating margin targets. We highlight HAR’s fairly bullish tone at the recent J.P. Morgan All Stars conference and expect the company to give encouraging three-year backlog figures in Oct. Further, HAR’s recent trouble in rare earth elements (used in speaker magnets), which has caused the company to guide down earnings for FY2012, is beginning to see some reversal – rare earth prices are down ~20% from recent highs.
• Valuation: We remain Overweight on HAR and believe the stock has solid earnings growth potential with minimal downside from the current price.
Himanshu Patel, CFAAC
(1-212) 622-3906 [email protected] Vivek Aalok (1-212) 622-0798 [email protected] Michael Kimlat (1-212) 622-0458 [email protected] Amy L Carroll (1-212) 622-1206 [email protected] J.P. Morgan Securities LLC
Gaming
LVS: Several Catalysts Should Drive Near-Term Share Performance
Las Vegas Sands Corp. (LVS – $44.69 – Overweight)
Within the Gaming & Lodging sectors, we believe the most attractive fundamentals continue to be in Asia (Macau and Singapore), where gaming growth continues to surpass expectations, as opposed to the low growth domestic markets and uncertain European economic environment. Given these dynamics, we believe LVS’s growth prospects are superior to anything else in our coverage universe, given its strong positioning in the growth markets of Macau and Singapore, which account for ~90% of 2012E EBITDA. We believe LVS is an attractive growth story with a ~40%+ EPS CAGR and ~30% EBITDA CAGR (2011-2013E). While we recently raised our 3Q11, 2011 and out-year estimates on stronger-than-expected Macau and Singapore market strength, we believe there is still room for potential future positive revisions. Please see our note (LVS: Upping Estimates & PT; Positive Catalyst Ahead) from September 9 for additional information.
• Potential near-term catalysts. We think near-term catalysts include (1) a number of gaming investors going to the gaming industry confab, G2E, in Las Vegas this week, coming back bullish on LVS; (2) September Macau market revenue results (early October; we think anything above MOP 21.5B will be well received); (3) a potentially strong Golden Week period in October; (4) 3Q11 reported results in late October; (5) Macau junket progress in late 4Q11/early 1Q12; (6) investors’ under appreciation of relatively easy Singapore VIP volume comparisons in 4Q11, (7) potential announcement of Singapore expansion (VIP rooms/suites) in early 2012; and (8) a staggered 2012 Cotai Central opening, for which we believe there are relatively low investor expectations.
• Investment thesis. Our positive view on LVS is based on our belief that (1) Marina Bay Sands (MBS) can continue to achieve a solid EBITDA ramp throughout 2011 and 2012; (2) LVS’s Macau properties will continue to generate attractive EBITDA growth, with upside potential, due to mass market positioning and potentially improving junket volumes and unit growth in Sites 5&6; (3) LVS will generate relatively stronger LV Strip results compared to its peers given its convention focus and solid position in the Asian baccarat segment (assuming normal table hold, of course); and (4) LVS has the ability to compete for new casino/convention resorts in Asia (South Korea, Japan) and other potential jurisdictions (Europe) given its successes in Macau and Singapore, its proven ability to develop successful integrated casino resorts, and its growing and meaningful free cash flow and low balance sheet leverage.
Joseph Greff AC
(1-212) 622-0548
[email protected] James Omstrom, CFA (1-212) 622-1306 [email protected] Jonathan Mohraz (1-212) 622-1111 [email protected] J.P. Morgan Securities LLC
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Building Products
We Highlight Overweight-Rated OC as Our Best Near-Term Idea Amid Market Turmoil
Owens Corning (OC – $23.45 – Overweight)We continue to highlight OC as our Top Near-Term Pick among our Building Products universe and find this name to be particularly compelling even within today’s more challenging market fundamentals and lower degree of demand visibility. Our Overweight rating continues to be based on our positive outlook regarding the company’s three core segments. First, Roofing should continue to generate above average margins, in our view, as pricing power is supported by the structure of the industry, characterized by no import competition and customer fragmentation, as well as the more recently consolidated competitive landscape, with three major players currently representing roughly 80% of the industry.
Additionally, while OC’s improved cost structure should at a minimum generate 13% margins, we expect margins to remain in the mid-teens over the next several years to the extent that demand is stable to slightly improving over the next two years, which we note is also generally supportive of pricing. Regarding Insulation, we expect profit improvement in 2012 given the non-recurrence of conversion costs in 2011 from the company’s new EcoTouch insulation product, as well as other cost saving actions, which gives us comfort that the loss should narrow even if housing starts do not improve in 2012. Finally, regarding Composites, while OC is currently dealing with an inventory glut in China, we expect the business to continue to demonstrate solid longer-term secular growth, as we believe it can continue to grow at 1.5-2.0x global GDP, and generate low-double-digit margins over time.
Relative to other stocks in our universe, we believe OC is less risky, as we estimate only 10% exposure to new residential construction, as well as the roofing industry’s more stable demand backdrop and a diversified global Composites business that historically has grown at 1.5-2.0x global GDP.
Michael Rehaut AC (1-212) 622-6696 [email protected] Jason A Marcus (1-212) 622-4906 [email protected] William W Wong (1-212) 622-1442 [email protected] J.P. Morgan Securities LLC
Restaurants
Right Time, Right Price to Buy Brinker International
Brinker International (EAT – $22.34 – Overweight)
EAT is our best near-term idea, as we believe three key drivers – comps, structural margin initiatives offsetting commodities, and FCF-driven share repurchases – are intact, and at 10.9x C12E EPS the stock is simply too cheap for the ~20-25% earnings growth we expect in F12 and F13 and low-mid teens growth longer-term.
Chili’s traffic up 1.2% in the past two quarters vs. down 0.2% for casual dining based on KnappTrack, but overall comps were 0.9% vs. Knapp’s 1.6%. We believe, over the past few months, Chili’s has not only maintained its traffic gap to Knapp but is now ahead on overall comps as well.
Remodels allow Chili’s to maintain/grow competitive positioning. After years of iterations, the company has settled on a $225k-$250k per unit package. Out of the ~865 company units, approximately 250 should be done by F12 and the entire system by 2014. While sales-lift targets are a modest 3%, the program should deliver 15%+ returns and add a point to annual comps. Remodels were already part of the capital budget, but the encouraging takeaway is that the cost/benefit is finally in balance. Margins likely to expand despite commodities and in a slow overall sales environment. Current commodity levels reflected in forecasts for a 10-60bp COGS impact, but several recently implemented and upcoming store-level operational changes should grow margins in both F12 and F13. While the company is currently lapping the 100-bp savings from Team Service, the Kitchen Prep process that became fully efficient in 4Q11 is providing 75bps+ of savings, or better than original 50-bp guidance. A new POS/Menu Link system should provide a 50-bp benefit on a run rate as the system is rolled out over the next year. Finally, the company is rolling out its “kitchen of the future” to 3-4 stores per market to serve as training vehicles for stores nearby, which should be fully rolled out by early F13 at a 100-bp+ benefit. Ending F11 share count, FCF + cash + additional borrowing should reduce F12 shares by 11%, F13 by 3%. We expect the company to buy back $165m of stock in F12, after payment of a 3% dividend yield and $25m of amortization on current $525m of debt driven by use of $125-135m of FCF after $155m of capex, $75m of new debt, and $30m of excess cash on balance sheet. We expect approximately $195m of FCF to be directed towards shareholders in F13, which includes capex of $125m, which at this point assumes new unit development remains at zero. To the extent F13 capex does include new units, this will be a function of continued strong sales and profit success at the brands.
Despite broad industry concern around slowing sales matched with higher commodities, we believe it is highly unlikely that Brinker’s guidance goes down. Our and consensus F12 estimates of $1.82 is relative to company guidance of $1.80-$1.95. Both our estimate and company guidance includes $2.8m ($0.02) in deferred financing expenses in F1Q12, associated with the upsize of the company’s term loan in August. At the current 10.9x C12E multiple, we believe the stock is discounting
John Ivankoe AC (1-212) 622-6487 [email protected] Amod Gautam (1-212) 622-6417 [email protected] Shaurja Ray (1-212) 622-2039 [email protected] J.P. Morgan Securities LLC
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Hardlines Retailing
Home Depot – The Orange Box Under the Christmas Tree
Home Depot (HD – $33.88 – Overweight)
HD is our favorite name for the next three months based on our expectations for: (1) market share growth; (2) margin expansion driving earnings upside; (3) favorable stock seasonality; and (4) easy compares during the spring
“Christmas” season.
HD engine running on all cylinders. The internal momentum at HD continues to gain strength as comps accelerate and the margin profile improves (see chart below). These internal initiatives are likely to yield higher incremental margins, FCF, and EBITDA, thus resulting in greater buybacks and dividends. We expect HD to repurchase 7-8% of shares per year, and the stock has a 3% dividend yield. Combined with the duopoly nature of the industry, this should buffer potential downside on top of the compelling reasons to own the stock.
Margin dynamics building. We see a solid runway to both gross margin and SG&A leverage as HD benefits from its internal initiatives. On the gross margin side, we expect benefits of ~20 bps/quarter from HD’s supply chain transformation. On SG&A, HD’s current installation of systematic labor scheduling tools replaces excel-based processes, which should provide substantial cost opportunities given payroll is the single biggest expense line item.
Home improvement has historically outperformed into year-end. Going back to 1990, overall retail has historically rallied 2x the market in the last two months of the year, up 3.5% in November and 1.4% in December over the last 15 years, on average. Home improvement retail has historically outperformed the S&P by a factor of 3x, up 4.5% in November and 5.7% in December.
HD should rally ahead of 1Q12 against easy compares. HD should also benefit from easier compares in 1Q, as comps declined 0.6% in 1Q11. As a reminder, March and April were the wettest months nationally going back the last 20 years. Furthermore, the Northeast was particularly hard hit, as it experienced rainfall in roughly 25 of the 30 calendar days in April (where HD has 20% of its store base).
While most retailers experience Christmas in December, HD and LOW get theirs in the spring as consumers get back into the backyard.
Figure 19: HD Comp Sales Performance vs. LOW
Source: Company reports and J.P. Morgan estimates. -5.0% -4.0% -3.0% -2.0% -1.0% 0.0% 1.0% 2.0% 3.0% 4.0% Christopher Horvers AC (1-212) 622-1316 [email protected] Mark Becks (1-212) 622-5265 [email protected] Aaron Goldstein (1-212) 622-1336 [email protected] Rachel Stubins (1-212) 622-4245 [email protected] J.P. Morgan Securities LLC
Tobacco
RAI: A Solidity of Earnings Expectations that Is Difficult to Beat
Reynolds American (RAI – $37.24 – Overweight)
Although the stock market has become more concerned regarding the outlook for the consumer and for economies more generally over the course of the last few months, in our view, trading in the tobacco sector globally and in the US remains robust. The habit forming nature of the product continues to offer firm support to pricing, while the scale of industry consolidation over the last decade has resulted in the industry now being controlled by a small number of rational players.
The interim results season in July/August saw company guidance for the full year at least maintained by the US domestic players, and increased in the case of Philip Morris International (which has also recently increased its quarterly dividend by 20%). More recent statements during investor conferences have re-iterated earnings guidance for the current year and medium-term objectives. Generally, we believe this level of confidence in estimates differentiates the tobacco sector from other sectors of the stock market.
We do note that in the US market, CPI data for tobacco inflation has fallen from ~5% a year ago to around 2% now. While this may increase some concerns with respect to pricing trends, we highlight that in the absence of tax increases, and given the increased incidence of tax on retail prices, a 2% retail price increase actually reflects a 4-5% increase in manufacturers’ prices. This is fully in keeping with both our expectations and company earnings guidance, we believe.
Our top pick in the US sector remains Reynolds American. The company modestly increased its mid-point for earnings guidance for the full year in its recent Q2 results to $2.66 (from $2.65), implying 7% EPS growth for the year. We continue to expect a resolution to the ongoing negotiations for release of overpayments to the Master Settlement Agreement, although, in our view, the balance sheet is already strong enough to support the recommencement of share repurchases. Although the 2012E PER has risen to 12.9x, on our estimates, which is in line with international peers’, this is not out of line with the longer run history of the sector. The 2012E dividend yield of 6.1% is generous and well supported by earnings and the prodigious cash generation of the company, in our view.
Rae Maile AC
(44) 20 7155 6102 [email protected] J.P. Morgan Securities Ltd.
Electric Utilities
ITC Offers Defensive Growth
ITC Holdings (ITC – $75.70 – Overweight)
Limited exposure to deteriorating economic trends should provide support, with ample upside potential
ITC is the only pure-play transmission company in the US, and we believe it will continue to benefit from supportive FERC policy on transmission. Furthermore, ITC’s revenue and profitability are not linked to the volume of electricity it
transports, or “sells.” Accordingly, we believe there is limited downside risk to ITC’s earnings (mostly related to potential longer-term project delays), so the biggest risk we see to our thesis in the near term is a deterioration in market multiples. However, in the event of continued pressure on the overall market, we would expect utility multiples to hold up better than the overall market multiple as investors flee to defensive names, thus providing support for the stock.
Best risk/reward proposition in our coverage with limited risk
ITC offers one of the best risk/reward propositions in our coverage universe, in our view. As the only pure-play transmission company in the US, ITC remains best positioned to benefit from a supportive FERC framework for transmission infrastructure investments and incentive mechanisms, including higher authorized returns, prospective rate making and hypothetical capital structure. Furthermore, we anticipate ITC to benefit from recent and upcoming environmental regulations that are likely to reshape the existing configuration of the US grid, thus potentially creating additional outlets for capital deployment for ITC. Despite premium
valuation (~25% on 2012E EPS) relative to the regulated peer group, we continue to believe that ITC’s long-term growth prospects (15-17% EPS CAGR) are superior to the peer group average of 4-6% and are not fully priced in. Finally, we note that ITC is trading below its historical premium to the group of over 40%.
Stefka Gerova AC (1-212) 622-0549 [email protected] Andrew Smith (1-713) 216-7681 [email protected] J.P. Morgan Securities LLC
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Oil & Gas Exploration and Production
Cimarex Energy: Strong Balance Sheet, Visible Growth from Core Assets
Cimarex Energy (XEC – $60.01 – Overweight)Among the E&Ps, we believe XEC is one of the cheapest stocks, has one of the strongest balance sheets and has visible operational catalysts. Cimarex stands out from many other E&Ps with its explicit focus on rates of return for every well it drills.
In a bad economy, XEC shares, of course, could still decline. However, its balance sheet, relatively low-cost operations and superior rates of return would help it to outperform its peers, in our view. In a recovery, the stock has enough leverage to oil and gas and to operational catalysts that it should outperform.
Further delineation of its Cana-Woodford play, continued strong results from its Wolfcamp Shale horizontal drilling program and shallower production declines from the Gulf Coast region could be positive catalysts for the stock. We think the market has focused too much on the Gulf Coast region, an area that yields the company’s best returns but has witnessed recent production declines (because of above-average success in that region in 2009 and 2010). The Gulf Coast makes up only 20% of total company production and 7% of 2011 capex, but attracts ~75% of the questions the company receives from investors. With new production from current drilling, the Gulf Coast production declines have a good chance of easing from here. We expect sequential production growth starting in 3Q11, and we forecast 16% YoY production growth in 2012 and 21% in 2013.
At NYMEX futures prices and using the JPM US E&P price deck, the stock has over 50% upside to reach our NAV estimates. Even using long-term prices of $5 Henry Hub gas and $80 WTI oil, we estimate the stock is worth $81 now, offering ~40% potential upside. Joseph Allman AC (1-212) 622-4864 [email protected] Jessica Lee (1-212) 622-9812 [email protected] Jeanine Wai (1-212) 622-6489 [email protected] J.P. Morgan Securities LLC
