THE MARKET ENVIRONMENT
During the third quarter, global markets continued to contend with the economic ramifications of Covid-19 as worldwide fatalities surpassed the grim 1 million mark. In August, the U.S. Federal Reserve announced a policy change that indicated it would not necessarily increase interest rates upon an improvement in unemployment figures, even if inflation is above the group’s traditional 2% target. At its September meeting, the Fed maintained near zero interest rates and publicized intentions to keep them at this level through 2023. Meanwhile, both the S&P 500 Index and the NASDAQ Index closed near peak levels in the quarter. Ultimately, the Fed raised its forecast for full-year 2020 gross domestic product (GDP) from a 6.5% contraction to a 3.7% contraction.
Similarly, both the European Central Bank and the Bank of Japan opted to keep interest rates steady in September. In Japan, the Nikkei 500 Index reached a record high, while industrial profits in China increased 20% in July and 19% in August. Conversely, the U.K. moved into a technical recession following a roughly 20% contraction in GDP in the second quarter, the largest on record, which followed an approximately 3% contraction in the first quarter. As of the end of the third quarter, the country had yet to secure a Brexit trade deal with the European Union. Furthermore, continued Covid-19 concerns and Saudi Arabia’s plans to cut oil prices translated to a decline in both West Texas Intermediate crude and Brent crude to less than $40 per barrel.
On the vaccine front, China indicated a Covid-19 vaccine may be ready for public consumption as early as November. Meanwhile, a leading vaccine candidate from the University of Oxford and AstraZeneca was halted again in September when a participant in its trial became ill. On the other hand, Johnson & Johnson’s vaccine candidate moved into Phase 3 of its clinical trials, the first single-dose vaccine in the U.S. to do so.
In our view, there is a lot of value in the market today. Though the near-term macro outlook may be mixed, positive vaccine developments or further signs of economic recovery from the initial shock of Covid-19 could improve market sentiment. In the meantime, we are finding good opportunities from a valuation perspective and think it is a ripe environment to be picking stocks.
Considering the operating environment, we found Daimler’s second-quarter earnings results to be acceptable. Though year-to-date Mercedes-Benz cars and vans volumes are down 22% and 29%, respectively, we appreciate that revenue in the segment is only down 14.8%. We think this reflects significant product mix benefits within both markets as well as resilient pricing dynamics. China also contributed with 17% year-over-year growth, despite the overall Chinese auto market being down 4%. Free cash flow was also significantly stronger than had been expected and we believe this is a result of management’s stringent focus on improving cash flow generation. As a result, Daimler ended the second quarter with a strong net financial position and provided earnings guidance that was better than had been anticipated. We believe these results reflect well on the new management team. Later, Daimler announced that it reached an agreement in principle with various U.S. authorities to settle civil and environmental claims regarding emissions control systems on about 250,000 diesel passenger cars and vans in the U.S. The company also reached an agreement with the plaintiffs’ counsel to settle the ongoing class action lawsuit. Importantly, the costs associated with the settlements are covered by existing provisions, which removes a material area of uncertainty for Daimler.
Early in the quarter, G4S announced it settled its deferred prosecution agreement with the U.K.’s Serious Fraud Office for GBP 44.4 million, which was in line with our estimates. We view this development positively as it resolves a long-standing issue and now allows the company to dispose of its non-core care and justice portfolio. G4S’s first-half earnings report was largely in line with analysts’ expectations. In September, GardaWorld announced it was considering an approximately GBP 3 billion offer for G4S and the latter’s share price subsequently rose. However, we agreed with management’s assessment that the offer undervalued the company and we supported the decision to reject the offer. Later, the company issued a trading update for the first eight months of 2020. The group’s underlying earnings run rate improved over the past two months and is now tracking to finish ahead of 2019 results. In our view, the improved earnings trajectory is a clear positive, and our conviction in this investment remains intact.
Ryanair Holdings’ fiscal first-quarter earnings report showed that revenue (EUR 125.2 million vs. EUR 74.3 million) and net income (EUR -185.1 million vs. EUR -223.2 million) figures bested consensus estimates. The company grounded 99% of its fleet from mid-March–June, but management is anticipating a smaller loss in the second quarter. Ryanair’s costs fell by 85% as it negotiated pay cuts with its pilots and cabin crew and is also working with airports to renegotiate landing fees and gate slots. The company hopes to take delivery of its first Boeing MAX-200 before the end of 2020. The planes offer 4% more seats, 16% lower fuel burn and emissions, and 40% lower noise emissions. Management noted it expects the MAX to enable the company to achieve 200 million passengers per annum over the next five or six years. We spoke with CEO Michael O’Leary and CFO Neil Sorahan who expressed optimism at mid- and long-term opportunities, particularly surrounding profitability as the company has continued to widen the cost gap versus its peers. In our view, the company’s strong balance sheet and ownership of more than 300 unencumbered Boeing 737s with a book value of about EUR 7 billion remains a key competitive advantage versus its peers.
Rolls-Royce Holdings issued a trading update in July, which proved disappointing to investors. The company indicated it will experience a GBP 3 billion cash outflow in the first half and expects a GBP 4 billion outflow for the entire year, which was worse than we had expected. Rolls-Royce also anticipates a 55% decline in wide-body flight hours this year, which was also a larger decrease than we had expected. We spoke with management early in September and learned it wanted to execute an equity raise as a buffer given the huge amount of uncertainty related to the timing of a recovery. Ultimately, Rolls-Royce opted not to sell a stake in the company to a sovereign wealth fund, but did announce a ten-for-three issuance at GBP 0.32 per share to raise approximately GBP 2 billion. This is part of a GBP 5 billion recapitalization package meant to strengthen its balance sheet and ensure adequate liquidity even if flight hours show only modest improvement versus current trends in 2021. Although we continue to believe that Covid-19 will cause a material and long-lasting disruption to the company’s civil business, we also think its power systems and defense business faced less disruption. While we still hold a position in Rolls-Royce, we are monitoring the situation closely.
Lloyds Banking Group’s fiscal-year results fell short of expectations as revenue fell 4%, underlying profit fell 7% and pre-provision profit declined 3% from a year earlier. We attributed these results to a very difficult 2019 operating environment with uncertainty surrounding Brexit and the formation of a U.K. government. First-half results were also disappointing as key metrics fell far short of our estimates, largely owing to impacts from Covid-19. Total revenue from core operations declined 16% from a year ago and operating profit realized a loss of GBP 281 million, driven by a significant impairment provision charge. Management stated the larger than anticipated provision amount was due to a significant deterioration in the forward-looking economic outlook. However, Lloyds’ loan book continues to perform well, in our view, and actual defaults to date remain stable. Despite the difficult operating environment, we find that the company is well capitalized with a common equity Tier 1 ratio of 14.6% and GBP 11.8 billion in excess capital relative to minimum regulatory requirements. In our view, the company possesses a wide range of strengths that it can draw on to reinforce its business during current near-term challenges.
thyssenkrupp’s third-quarter earnings report showed that volumes were severely impacted in Steel Europe and spreads contracted due to overcapacity during the pandemic and raw material pressures. We appreciated better cash flow development due to working capital, but earnings margins were dramatically negative. For its fourth quarter, management expects shipments to improve over 10% quarter-over-quarter but also anticipates that raw material development will be negative. In industrial components, although revenue was down 31.5% due to reduced overall industrial demand, margins were still clearly positive at 5.8% in the third quarter. In regards to its current strategic path, thyssenkrupp completed the sale of its elevators business at the end of July and made progress toward its goal of a 6,000 employee reduction. In our view, the aforementioned sale secured the company’s balance sheet and management now needs to deliver on the portfolio optimization and restructuring. We spoke with thyssenkrupp’s Chairman Dr. Sigfried Russwurm in September, which provided incremental confidence in the state of the company and its path forward. Overall, we continue to believe thyssenkrupp is trading at a steep discount to our perception of its intrinsic value.
During the quarter, we initiated positions in Anheuser-Busch InBev, Fresenius Medical Care and Novartis. We eliminated Kuehne + Nagel, Nestlé, Reckitt Benckiser Group and Taiwan Semiconductor from the portfolio.
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