UK Equities: BARC, RIO & MRW

Barclays Bank PLC (BARC.L) 279.00p
Long term holders of Barclay’s shares, multi-year equity supporters of the international bank, have suffered this past year. The stock fell from a 12 month high of 475p to a portfolio crunching 50p, then back up to the recent high of 320p. The share price volatility perfectly articulates the roller coaster journey from the end of the last bull market through the near-collapse of the credit markets and into the current and ongoing economic and banking sector recovery. Barclays, as mentioned in last week’s review, didn’t need a UK government bail-out and it was able to pass the stress tests without discomfort for a good reason. It raised substantial cash from Middle Eastern investors late last year in a deal announced on the 31st October. Management felt they had little choice. The sector was still in free-fall. Western institutional investors were hoarding cash, avoiding risky assets like the plague, and the only players in town awash with cash and confidence were Gulf billionaires, rich from proceeds of enormous oil and gas reserves. So Barclay’s management put on a brave face, welcomed these new and strategic long term investors and received the inevitable verbal broad-sides from the UK institutions that missed out on the equity issue (launched at a significant discount to the 2008 average stock price). This week, news that one of those long term strategic partners, International Petroleum Investment Company (IPIC), had taken advantage of the recent stock rally to off-load 1,304,835,721 shares, albeit at a large discount to the day’s price, was a further kick in the teeth to the mutual fund and pension companies that failed through indecision, or an alleged lack of invitation, to participate in the autumn equity raising. It’s impossible to blame IPIC. Their agenda is to manage their own portfolio, maximising risk-adjusted returns and to take advantage of opportunities as they arise, not to fix the balance sheet inadequacies of London listed banks. But next time a major UK institution needs a serious injection of cash, I suspect management will try just a little harder to work with local partners many of which would have supported the firm’s stock for decades, before embracing new long-term strategic partners with the gift of discounted stock.

Rio Tinto PLC (RIO.L) 3,004.25p
Rio Tinto management have been busy this week. Unfortunately, they have been busy making the writer look like a fool. I made the mistake of interpreting management’s statement regarding the proposed strategic alliance with Chinalco, quoted verbatim from their 2008 annual report below, as their intention to actually complete a deal with Chinalco, and as closure on a possible BHP Billiton deal. The contents of my last review of Rio Tinto, 5 weeks ago, articulated as much.

“On 12 February 2009 we announced the intention to form a major strategic partnership with Chinalco, a leading Chinese diversified resources company that the board unanimously recommends to shareholders.
Chinalco’s cash investment of US$19.5 billion will strengthen our balance sheet on terms that add value to the Group and increase our flexibility to grow as markets recover. It will strengthen Rio Tinto’s position in the industry during a period in which China’s importance in the global economy is growing rapidly.”

Now, in hindsight, Rio’s thinking behind the statement is clearer. Commodity prices had collapsed, the firm was desperate for an equity injection to ease their debt burden and Chinalco were the only firm at the commodity dating-agency with the cheque-book in hand. How 4 months has changed things! Commodity prices have recovered strongly; western institutions are again looking to part with cash in the pursuit of risky assets and BHP Billiton, like every faithful and patient admirer has forgiven Rio Tinto for flirting elsewhere and has agreed an engagement, if not a marriage.

So after priming myself with business as usual research for much of the week, in anticipation of providing a gentle Rio Tinto update, I found myself choking on my Friday morning latte reading eight, yes 8, stock market announcements from Rio Tinto explaining the firm’s new found love for the hard cash of UK institutional investors and it’s satisfaction at signing an agreement with BHP Billiton, regarding its prize Western Australian iron ore assets.

Friday’s announcements confirmed two key events. Firstly, Rio is to commence with a rights issue consisting of 21 New Rio Tinto plc Shares offered for every 40 existing shares at £14 per share and for the Australian stock market, 21 New Rio Tinto Limited Shares offered for every 40 existing shares at Aus $28.29 per share. The new cash will raise approximately US$15.2 billion (gross). The equity issue will enable Rio Tinto to honour its Alcan facility debt repayment obligations fully in 2009 and most of its 2010 liability. Net debt will be reduced to approximately US$23.2 billion.

The 2nd event, of larger strategic significance, is the 50/50 joint venture agreed with BHP Billiton encompassing both firm’s iron ore interests in W. Australia. Rio predicts the synergies gained from the venture will be worth around $10bn between the two parties. There are significant logistical, as well as financial, advantages of the JV too. More efficient management of port capacity, the alignment of separate mines under a single management structure and a co-ordinated expansion strategy will all ease the burden on stretched Western Australian infrastructure. Rio Tinto will also receive from BHP Billiton US$5.8bn for “equity type interests to equalise the contribution value of the two companies”. It’s great news for shareholders and I am presuming, hopefully, that the statement will be executed, thus preventing me from having to do another u-turn on my analysis some weeks hence. Lastly, if I held Rio Tinto stock, (I don’t), I would take up the rights issue.

WM Morrison Supermarkets PLC (MRW.L) 249.00p
I have been advised by a higher authority that the weekly shopping bill, the cost of an over-flowing trolley of provisions, is £20 a week cheaper in Morrisons relative to another leading supermarket chain. I have also been advised by the same higher authority that the quality of merchandise is at least equal to other leading supermarkets and that there is now an army of housewives who have, for the foreseeable future, changed their supermarket of choice. WM Morrison’s ongoing expansion into the South, discussed in this weekly review some months ago, is clearly working. However, tempting as it is to close my review of the company citing indisputable evidence that Morrisons is doing very well, and will continue to gain market share at the expense of the big three, I will persevere and humbly attempt to add a few relevant facts to the analysis. Fortunately, the information is easily at hand as the management of Wm Morrison Supermarkets PLC, kindly released a Q1 statement, on June 4. Within the bullish report is confirmation that like for like sales grew 8.2% (ex fuel) in the first 13 weeks of the current financial year and that 500,000 more shoppers visited Morrisons each week relative to the same period a year earlier. Total sales improved 9.2%. The firm also moved to stabilise its staff pension scheme, the Achilles heel of many FTSE 100 balance sheets, confirming that a more conservative strategy had been implemented following a cash injection, revised mortality assumptions and a reduction in the fund’s exposure to volatile equities. The good news continued. Management reflected on the 2nd credit rating upgrade in as many years with Moody’s strengthening WM Morrison’s rating to A3, investment grade, in recognition of improved balance sheet “prudence” and strong financial performance.

Since the stock was reviewed last, the price is largely unchanged, which considering the corporate progress made suggests there is growing value at the current price. Reflecting on the sector as a whole, speculators tend to reduce exposure to defensive supermarket shares into a recovery seeking the more leveraged returns available in other traditional growth industries. However, within the sector, it’s difficult to pick another stock at WM Morrison’s expense. And I would be in big trouble with the ‘higher authority’ if I did.

The Global Economy 26th April 2009

The Global Economy Despite further poor economic news over the week, investors have continued to steadily allocate funds away from cash to risky assets. Gold bears, in particular, were forced to sit-up and re-examine their strategy. China, long thought to be committed to hoarding US Treasuries to build its reserves, advised the International Monetary Fund (IMF) that it had aggressively increased its holdings of gold since 2003, the last date the Peoples Republic disclosed its interest. China now has the 5th largest holding at 1,054 tonnes up from 600 tonnes previously. The move makes sense and is an effective hedge against USD depreciation as the commodity is denominated in dollars. The China Gold Association, even taking their own invested interests into consideration, put the magnitude of the increase into perspective suggesting the PRC should accumulate up to 5,000 tonnes, a figure, it suggested, which would be in proportion with Chinas status as the worlds 3rd largest economy, behind Japan and the US. A number of commentators predict that Chinese GDP will overtake Japan’s output shortly and the US within 20 years.

Also on the global stage, the IMF released a comprehensive report on the global economy and commented on the measures taken by governments in recent months to accelerate the pace and strength of the recovery.The IMF report is summarised as:

• The intervention taken by governments, to date, has made a positive impact reducing the severity of the recession, prevented a meltdown in the banking sector, improved corporate confidence and stimulated growth.
• However, further measures are needed to stimulate the global economy, achieve positive growth and to strengthen the banking sector.
• The current process of bank de-leveraging needs to be pursued more aggressively to both reduce systematic risk and strengthen the balance sheets of banks.
• A number of key banks may need to further increase their capital adequacy by either issuing equity or via government support.
• A combination of failing businesses and falling asset prices may result in write-downs in the US of $2.7 trillion (revised up from the previous January 2009 IMF prediction of $2.2 trillion).
• Globally, $4 trillion of asset write downs may be required, of which approx 2/3rds relates to vulnerable assets on bank balance sheets.

The IMF also speculated that if a global recovery occurs earlier and with more momentum than currently predicted these forecasts might be bettered (smaller asset value write-downs). However, as the recession is both highly synchronised across developed and emerging nations and largely caused by systematic failures in the banking and financial sectors, the recession is likely to be both longer and deeper than most recessions of the past 100 years.

With the themes of ‘recession’ and ‘Obama’ dominating the news for some months now, investors have been distracted from other key-geopolitical issues and none is more significant than the growing tension between Israel and Iran and the implications for all asset classes especially gold, oil and equities in the event of an Israeli attack on Iranian nuclear facilities. The recent destruction of a Sudanese convoy carrying weapons destined for Gaza is widely accepted to have been authorised by the Tel Aviv government and executed by the Israeli Air Force. The Israeli authorities are also planning a nationwide drill next month to prepare residents in the event Iran retaliates, which it surely would if attacked. Most tellingly, key Israeli spokesmen are increasingly stressing they can’t and won’t wait much longer before taking action as “when Iran secures a nuclear weapon, it will be too late”. Iran is expected to finalise its weapon program possibly within 2 years. The only external influence capable of preventing an Israeli attack is President Obama who is determined to pursue peace across the region and handle the Iranian state more sympathetically than the previous Bush administration. But if Obama fails to make significant diplomatic progress in the very near term traders would be well advised to keep fingers poised to sell equities, buy oil and buy gold.

Closer to home, Spain has reinforced its status as the weakest major Euro-zone economy. The property market has near-collapsed. Unemployment, traditionally one of the highest in the Euro-zone even in stronger economic periods, has reached an all-time high since organised records began. Economic activity has fallen of a cliff, with a 3% GDP contraction in 2009 probably the best that can be hoped for. Economists therefore awaited the recent update on employment data with apprehension, but even the most pessimistic forecaster must have been shocked on confirmation more than 800,000 lost their jobs in the 1st quarter bringing the total to a staggering 4 million (17.4%). Deflation, a curse on investment, is also an ongoing risk with falling consumer and input prices. The governments previously announced stimulus package amounting to Euro 50 billion is wholly insufficient given the scale of the problem. February’s industrial output, down 22% on the same month a year earlier, further reinforces Spain’s dilemma with the demand for capital goods and exports likely to remain weak for at least another 6-9 months, possibly deep into 2010. Like the UK, Spain will now suffer a multi-year budget gap, the difference between tax receipts and government expenditure, which a traditional cyclical upturn in GDP growth will be inadequate to fix. That ‘place’ in the sun, the 2nd home that Europeans aspire to buy, is going to get a lot cheaper.

UK I hate to sound like a husband, patronising the wife over the household finances, but Darling, you have got your sums wrong. I am, of course, referring to the would-be intellectual colossus, the ex-Transport Secretary, Alistair Darling, who on promotion to the Exchequer was left holding the ‘parcel’ when the music of markets, liquidity, stopped. Just a first few months after moving into Downing Street, Darling has found himself Chancellor of a UK balance sheet ruined by bank bail-outs and 12 years of the government spending beyond its means.

So last weeks confirmation that UK GDP contracted 1.9% in Q1 after falling 1.6% the previous quarter was the final nail in the coffin of Darlings forecasting credibility. In fact, the government’s official predictions for growth differ so much from the forecasts of the IMF and other respected institutions; you could fit one of Darling’s late trains between them, from his ineffectual time at the Department of Transport.

The contraction in the first quarter was the worst 3-month decline in economic output for 30 years with manufacturing, down a deeply worrying 6.2% despite the weakness of Sterling over the quarter, relative to the year before, which should have aided exports.

As soon as the data was being described as “dreadful” by seasoned commentators, you could just sense the government’s public relations machine repackaging the latest batch of Labour clichés; “global recession” and “unprecedented times”. I know there’s a recession Darling, but did you or your neighbour, Gordon Brown, think to save any pennies over the past 12 years, when the country was enjoying growth, so you had a bit saved away for when the household finances worsened?

The GDP data followed the budget announcement earlier in the week, the headlines being:
• Income tax on earners above £150k per annum to increase from 40% to 50%.
• Pension tax relief for highest earners to fall from 40% to 20%.
• UK GDP forecasted at negative 3.5% in 2009, positive 1.25% in 2010.
• Debt to GDP to rise to 79%. Ratio unlikely to improve until 2015.
• Current tax year government borrowing to be approx £175bn.
• ISA allowance to increase to £10,200 p.a.
• Child tax credit increased.
• Duty on cigarettes and alcohol to rise 2p.
• Further rises on fuel duty of 2p, then 1p above inflation.
• Banks to increase mortgage lending by a further £20bn.
• More financial support to assist the unemployed under 25 to secure training or work.
• £2,000 subsidy for new car buyers, when trading in vehicles more than 10 years old.
• Financial support to boost house-building and green industries.

Unimpressed with the budget, gilts prices retreated as investors sold out of UK government debt on concerns over the credibility and accuracy of the budget economic growth forecasts. Further gilt price declines, and therefore higher yields, are predicted as commentators suggest the UK government will have to offer a higher income stream in future to persuade investors to buy its debt as supply is likely to outpace demand at current yields. Some economists are speculating up to £220bn in gilts may have to be issued in the current year up from a pre-budget consensus of £175bn. The Bank of England is likely to come under renewed pressure to increase the purchase of gilts via the recently confirmed quantitative easing policy to help reduce yields and therefore the cost of borrowing.

Company Focus
Barclays Bank PLC (BARC) 236.00p
When we reviewed Barclays just a few weeks ago, on 16th March, the shares were loitering at a miserable 74p and investors had yet to enjoy the sharp market-wide rally that has helped take Barclays stock to 236p. A lot has changed in these few weeks to help drive the price. Barclays passed the FSA stress test, market sentiment has improved towards banks, though concerns over bad debt exposure persist and a number of global players in the sector have released better than expected Q1 earnings data (Credit Suisse, Goldman Sachs and Citigroup in particular). Despite the recent rally, the annual general meeting held on Thursday was bound to be an interesting event with shareholders looking for guidance on the dividend policy and clarification over strategy; whether the bank would lean towards the pursuit of earnings growth or strengthening the balance sheet. Marcus Agias, the Barclays chairman, tackled the issues head-on, first with an acknowledgement of “sincere regret” over the share price volatility and then reassuring shareholders seeking growth that the bank would increase lending by a further £11bn, split equally between home buyers and business loans. Agias also confirmed Q1 2009 was “well ahead of the prior-year period” and that the bank was keen to pay a dividend next year though the pay-out would be more conservative than the historical average payout which adopted a dividend cover of 2 (around 50% of attributable earnings paid to shareholders). The Barclays CEO, John Varley, also took the opportunity to articulate his optimism for both Barclays and the UK economy predicting borrowing and consumption by both companies and consumers would stimulate growth during the latter part of 2009 and in to 2010. The AGM followed a significant sale of BARC shares by the banks largest shareholder, Qatar Holdings, who took advantage of the recent rally to reduce their holding from 6.4% to 5.8% of BARC equity.

Legal & General PLC (LGEN) 50.30p
Legal & General, like Prudential and Aviva, straddles the sectors of life assurance, insurance and asset management. Dozens of years of steady asset accumulation has provided each with a large slice of the consumer savings and pension fund cake. Relative to the investment banks, all three err on the side of caution with a relatively conservative approach to managing money and a healthy diversified mix of assets including equities, fixed interest securities and commercial property. L&G also near-dominates the retail tracker product space offering investors a cheap and cheerful way to track equity markets down, or of course up when risk appetite is so inclined. Having such breadth and depth of exposure to the stock market, and therefore exposure to the health of corporations and the wider economy it is no surprise that L&G felt pain over the past year. So how did it cope relative to the leading competition? Firstly, it cut the dividend in a pretty unpopular move with the City and shareholders. If the grandfather of UK finance, with its cautious approach to fund management had to cut its pay-out to shareholders, it didn’t bode well for the rest of the sector. But then analysts took a glance over at the Pru, with their more ambitious and presumably capital intensive expansion into Asia to cope with. Not only have the Pru maintained their dividend, they actually increased it 5%. Cue sharp fall in L&G stock. Investors who felt obliged to have exposure to the sector reallocated cash from L&G to Prudential. And who can blame them. As well as announcing a dividend cut, L&G also confirmed a fall into the red for the year with a IFRS operating loss of £189m (2007: profit £658m) whilst IFRS shareholders equity per share fell to 61.2p for 2008, relative to 86.5p for the prior year. In an effort to defend the balance sheet from further deterioration L&G sold £1bn of equities and transferred the capital to liquid instruments, which improved balance sheet strength but will hold back returns in the event of a sustained stock market recovery. More logically, L&G also lifted its provision for non profit annuity credit defaults to £1.2bn and described the measure as necessary, despite the relative high quality of its bond portfolio, in case the default rate worsened further to a 70 year high (since the Great Depression). Looking forward the firm is committed to further building balance sheet strength, conserving cash and de-risking the business model, primarily by moving away from capital intensive products. But the damage is already done and is reflected in a weak stock price of 47p compared to a 12-month high of 130p.

US Company Focus
Yahoo & Morgan Stanley
Reflecting the global significance of key US corporate updates, and as we are deep into the Wall Street Q1 reporting season here’s a brief look at two of the headline reports from New York over the past week.

Yahoo, the online email, news and search engine provider announced late on Tuesday its Q1 net income fell to $117.6 million, or 8 cents a share, from $536.8 million, or 37 cents a share in the same period a year earlier. Net revenue fell to $1.2 billion for the period ended in March. The Q1 report is in line with the consensus forecasts provided by leading analysts. The Yahoo CEO, Carol Bartz, also indicated the group may narrow its product range in an effort to streamline the business and improve financial performance in response to the global recession, increasing online competition and lower advertising revenues. Looking forward, sales for Q2, Yahoo predicts, will come in between $1.43bn to $1.63bn, slightly more pessimistic than anticipated. 700 job cuts were announced though Bartz stressed the lay-offs may be off-set by ongoing recruitment in key areas of the business. The company reduced 1,600 workers in Q4, prior to Bartz joining the internet corporation. The update also demonstrates the implications for revenue of the growing consumer trend away from traditional internet players such as Yahoo, (but also Google), towards to new platforms such as Twitter and Stumbleupon which offer real time messaging and more creative search functionality, respectively. In the US financial sector Morgan Stanley, the investment bank and brokerage, cut its dividend to 5 cents a share (from 27 cents) to hoard cash as earnings per share fell significantly short of analyst predictions with a loss of 57 cents, relative a consensus forecast of a 8 cents loss. The worse than expected data is a result of continued asset write downs and bad debt exposure on residential and commercial real estate. The Q1 loss, of $177m, was driven primarily by $1 billion in real estate losses. Noticeably, Morgan Stanley reported much weaker figures relative to other key global players in the same sector; Goldman Sachs, Citigroup and Credit Suisse.

Mike@tradinghelpdesk.com
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