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Chesapeake Energy: A Turnaround Rally Worth Buying Into

Chesapeake is exhibiting financial discipline by lowering costs and reducing leverage, and investors are once again warming up to the shale giant

The transformation at Chesapeake Energy is well underway as it looks to become a leaner and more disciplined entity – one that is more suited to weather the ongoing turmoil in the energy markets.

Crude oil and natural gas prices have been highly volatile over the past two years. West Texas Intermediate and Brent crude benchmarks were trading north of $100 per barrel when the collapse started in mid-2014, and bottomed out around $26 per barrel. Oil is now trading around $45 per barrel. Given the substantial price decline in its major revenue driver in such a short span of time, Chesapeake was caught off-guard – and ended up with billions of dollars of debt at the time.

Chesapeake’s approach to its predicament is marked by strong financial discipline. The company is looking to balance capital expenditure with cash flow generated from operations. It is also looking to increase financial and operational flexibility while trying to achieve investment-grade metrics.

At an energy conference hosted by Barclays earlier this month, Chesapeake outlined the progress it has made in recent years. And it is fair to say the natural gas producer has made huge strides in an uphill battle.

In an investor presentation at the Barclays conference, Chesapeake said it has strengthened its balance sheet while reducing the complexity of its capital structure. At the end of 2012, the company had total leverage of $21.537 billion, which included operating leases, finance leases, subsidiary preferred equity as well as volumetric production payments (VPPs).

Chesapeake’s total leverage currently stands at $10.894 billion (as of July 30, 2016), half of what it was at the start of 2013. Debt principal constitutes $4.4 billion or 34% of the total leverage reduction – the industry-leading figure during this timeframe.

This leverage reduction is no mean feat given that the company managed it during a severe pricing downturn. Another notable achievement is Chesapeake’s cost structure. The company has brought its cash costs to $4.10 per barrel (expected at the end of 2016), down from $7.80 per barrel at the end of 2012.

Cash costs include production and general & administrative (G&A) expenses. The reduction in cash costs is crucial as realized prices have shifted dramatically lower amid the oil slump. In 2013, Chesapeake’s average realized price for oil was $96.78 per barrel. However, for the first half of 2016, average realized price for oil declined 57% to $40.93 per barrel.

Shares of Chesapeake, a potential bankruptcy candidate earlier this year, were valued at a mere $1.59 in February. However, its ongoing initiatives including asset sales, cost cuts and debt repurchases have transformed it into a leaner, low-cost producer that is equipped to survive the current pricing environment. The stock has gained more than 50% since the company announced last month it would exit the Barnett shale region and announced cash tender offers for early debt redemption.

There is also the roughly $10 billion debt load that Chesapeake still has to tackle, but the company is already in the process of trimming it down. It is currently looking to repurchase its contingent convertible senior notes and nonconvertible senior notes.

On Tuesday, the company confirmed it would repurchase $600 million of 2037 convertible notes and around $108 million of 2038 convertible notes. For notes maturing from 2017 through 2023, Chesapeake is buying back $897.7 million of the principal amount.

When first announced, the offers indicated the company would accept a maximum of $1 billion of notes for repurchase, but now it expects to buy back roughly $600 million more. In addition to these tender offers, Chesapeake aims to retire $2 billion to $3 billion of debt through asset sales and reach a net debt/EBITDA multiple of 2x by 2020.

Chesapeake’s efforts to curb costs and reduce its debt burden have eased concerns that the company may go under in the near term, and this has been the primary driver for its recent stock performance. And there could be more catalysts up ahead. The company has scheduled an analyst day on October 20, where management is likely to shed further light on the ongoing transformation. Investors are likely to keep Chesapeake on their radar ahead of the crucial meet, where more positive developments could send the stock even higher.

#$CHK

FedEx Can Deliver Strong Results, But Prospects Hinge On TNT Integration

FedEx is expected to record a year-over-year increase in net earnings amid uncertainty over expenses related to the integration of TNT

FedEx is scheduled to report first-quarter results for fiscal 2017 after the market closes on September 20. Although the company has had a relatively quiet quarter compared to the previous one, it is still expected to post a year-over-year increase in revenue and net earnings.

However, Citibank analysts believe FedEx shares might come under pressure as we move closer to the earnings. This is due to the complexity surrounding the company’s decision to reveal the impact of TNT’s acquisition on its financials. FedEx stock has gained only 0.4% over the past three months, underperforming the S&P 500 index, which has risen 3% during the same period.

Delivering Growth, But at What Price?

According to data compiled by Bloomberg, FedEx is expected to report revenue of $14.61 billion for the quarter, roughly 19% higher than the figure reported in the same period last year. Wall Street analysts are expecting the company to post adjusted net earnings of $754.33 million or roughly $2.81 per share. In the same quarter last year, the logistics giant recorded adjusted net earnings of $692 million or $2.42 per share. FedEx has managed to beat analysts’ EPS, revenue and net income estimates in six out of the last nine quarters.

Although the current quarter was much quieter compared to the previous one, FedEx continued its solid performance and increased capital spending to further strengthen its value proposition against competitors. It announced the acquisition of TNT for $4.8 billion last year and closed the deal on May 25, this year. During the company’s fourth-quarter earnings call, it announced plans to allocate $5.1 billion to capital expenditures for fiscal 2017, which does not include the TNT acquisition. In the three month period ending August 31, the company continued to integrate TNT into its operations as well.

TNT and Brexit Hangover

Despite having posted strong earnings for the fourth quarter on June 21, FedEx shares dropped 4.5% the following day. The tepid response from investors was largely driven by the ambiguity that continued to weigh on TNT’s integration into FedEx’s sprawling logistics system.

In a report following the earnings, Cowen & Co.’s Helane Becker wrote: “We find it frustrating that management did not give better metrics regarding the merger as it will be a large driver of growth into the future.” TNT had generated 6.9 billion euros in calendar year 2015, up from 6.7 billion euros in 2014 and is expected to fortify FedEx’s position in the European market.

Analysts have been eagerly awaiting more disclosures regarding the earnings impact of the TNT acquisition, given the opportunity that it presents for the company in Europe. But the UK’s decision to leave the European Union has placed a damper on future prospects of the euro bloc. Investors are likely to be fixated on commentary related to TNT’s impact from Brexit—which was announced just two days after the company released its quarterly and full-year report on June 21.

During the earnings call, CEO Fred Smith said: “We don't think it's appropriate for us to be speculating on what may happen in the United Kingdom and should Brexit take place.” However, now that Brexit has become a reality, I believe that investors are eager for an update on management’s take on the issue and its spillover effect on FedEx.

FedEx’s arch nemesis, UPS, reported a 3.9% year-over-year increase in the total average daily package volume for the second quarter of the year, the three months ended June 30. The company attributes the strong growth to higher export activity in the Asian and European markets—an opportunity that FedEx hopes to capitalize on with the TNT Acquisition.

Citigroup, which has a Buy rating on FedEx, expects the company to provide more details on the TNT acquisition in the upcoming earnings result. The bank was of the opinion that the first half results for fiscal 2017 would be clouded with integration costs and that FedEx’s Ground segment margins would show an improvement in the second half of the year.

However, Fedex said during the June earnings call that it expects to complete TNT’s purchase price allocation into its financial statements by the end of fiscal 2017. Management also mentioned that full integration of TNT into its operations would take several years due to the size and complexity of the deal. Hence, there might still be some ambiguity surrounding acquisition expenses.

An Attractive Package Ahead of Earnings?

FedEx shares have risen 10.8% year-to-date, outperforming the S&P 500, which has gained 5.7% during the same period. While the company stock’s performance has outpaced the broader market, UPS has fared even better this year—having gained 12.2% in 2016 as of yesterday’s close.

However, FedEx shares trade at a much more attractive price to earnings (P/E) multiple compared to UPS, at 13.80 times its next four quarter’s consensus earnings. In comparison, UPS trades at 18.37 times its next four quarter’s expected earnings. That is surprising given that FedEx is expected to grow its adjusted earnings by 17% in calendar 2016, compared to just 7% for UPS, according to estimates compiled by Bloomberg.

It’s not hard to understand that investors are looking for more clarity in FedEx’s earnings prospects before giving it more credit. While more details on the integration would be welcome, the FedEx story still hinges on how it executes a complex merger.

#$FDX

Gilead Hit With HCV Patent Suit Yet Again: A Serious Blow?

The lawsuit comes at a crucial time for the biotech as it already faces declining growth of its HCV franchise

Gilead Sciences, Inc. (GILD), the once undisputed leader in the fast expanding market of HCV drugs, is hit with a blow to its highest yielding HCV drugs franchise yet again. The biotech’s key compound of all its three HCV drugs, sofosbuvir, has been targeted with another patent challenge, this time by the University of Minnesota. It is yet to be seen if this patent suit results in a major blow to Gilead’s HCV sales.

The biotech’s stock has been declining since August 29, 2016 when the patent suit was first put forward. GLD stock has lost 3.61% in the last five trading sessions, only further adding to its gloomy performance. Gilead’s shares have fallen 24.73% so far this year, significantly underperforming the market; the iShares NASDAQ Biotechnology Index (IBB) lost 17.67% during the same period.

The recent lawsuit against Gilead’s key HCV compound puts blame on biotech for intentionally infringing upon a patent held by the school. The university states that sofosbuvir was originally discovered by Dr. Carston Wagner, who currently works at the university affiliated with its College of Pharmacy as the endowed chair in medicinal chemistry. The school claims that Mr. Wagner first won the patent, ‘830, on his work on nucleotide prodrugs in 2014 after which the patent rights were transferred to the institution.

Since sofosbuvir is the main element in all of Gilead’s three main HCV drugs, Harvoni, Sovaldi, and recently-approved Epclusa, the latest lawsuit claims that all these drugs prove to infringe upon ‘830 patent. The school has clearly stated that it had first approached Gilead, informing it of the suspected infringement last year in July and also discussed the matter in detail in August 2015; the company failed to accept any blame.

If this lawsuit holds true, it can translate into a serious dent to Gilead’s future growth since its HCV drugs franchise has been the main reason for propelling the biotech amongst the top players of the industry. Since Sovaldi’s entry into the market in 2013—Gilead’s first ever HCV drug—the three drugs have shored up a hefty $40 billion in worldwide sales, contributing to striking growth over a period of less than three years.

The lawsuit stated: "Gilead has infringed, and continues to infringe, the University’s intellectual property rights by, among other things, selling medicines containing the drug sofosbuvir, including brand name drugs Sovaldi, Harvoni, and Epclusa."

However, this is not the first time that Gilead has encountered such a lawsuit against its top selling products. It has faced a number of such lawsuits, but most of them did not prove to be much of a threat.

The most recent one which gained much interest from investors was that from pharmaceutical giant, Merck. It was sued for infringing upon its HCV patents, claiming not only damages but also royalties on future sales of Gilead’s HCV drugs. Merck surprisingly won the lawsuit winning $200 million in damages; however, the decision from federal jury was later overturned when it was revealed that Merck’s attorney had lied in the court. Gilead stood victorious in protecting patent on its top selling cash cows.

Considering the past events, Jefferies recently released a research note on this issue holding the stance that “the lawsuit clearly holds a low probability of success." However, until the suit’s first proceeding is held, it remains uncertain whether the matter will hit the company’s stock and gain any attention in the market.

The lawsuit Adds to Gilead’s Troubles

The lawsuit comes at a crucial time for the biotech, which is already facing troubles at the hands of declining growth in its leading HCV drugs portfolio. The company’s HCV drugs franchise consists of two top blockbusters that have been reaping surprising growth since their launch.

Sovaldi turned out to be a major breakthrough and proved to shorten the treatment duration by a considerable amount compared to standard HCV treatments. The other HCV drug, Harvoni, was advanced version of Sovaldi and won the final nod from Food and Drug Administration (FDA) in October, 2014. These two drugs yielded $12.4 billion for fiscal year 2014 (FY14) in combined sales, which went on to hit $19.1 billion in FY15.

Aforementioned records from the blockbuster drugs were not a piece of cake for Gilead as it faced numerous lawsuits to defend their patents. In addition to that, the company has been severely criticized for hefty price tags on these two HCV drugs; Solvaldi costs $84,000 for a 12-week treatment, while Harvoni carries an even higher price of $94,500 for 12-week treatment.

The biotech firm was pressurized by insurers and various public health officials to offer discounts on its blockbuster drugs, so as to increase their affordability for a large HCV population. These hefty discounts further explain the dent received by the company’s total HCV revenue.

In addition to discounts, these drugs shorten the HCV treatment duration, and it leaves a smaller share of untreated population with more patients successfully treated; Gilead’s strength has thus resulted in its own blow too. The aforementioned reported their first ever sales decline in the first quarter (1Q) of fiscal 2016 this year; Sovaldi sales fell 17.5% on a quarter-over-quarter (QoQ) basis to $1.28 billion while that of Harvoni’s stood at $3.02 billion, with a 9.8% decline QoQ.

Since Gilead’s HCV franchise generates more than 60% of the company’s total revenue, the decline was meant to hit the company hard. For the 1Q, Gilead’s revenue stood at $7.79 billion, an 8.46% decrease QoQ.

However, the sales decline is expected to face a turnaround soon on the back of Gilead’s new HCV molecule, Epclusa; the drug received FDA approval in June this year as the first ever pan-genotype HCV drug meant for treating all genotypes of the debilitating liver disease. Epclusa can be the new generation HCV drug in the market, bringing a much needed turnaround to revenue decline of the leading biotech.

For more information on Gilead financial performance and history, refer to our Gilead Data Analysis section.

#$gild

Are US Banks’ Defenses Shockproof to Low Rates?

Regulators have raised questions over the degree of restructuring efforts of US banks

The rate hike conundrum in the US is on the rise as we head closer to the September policy meeting, one of the last three policy meetings for this year. As the low interest rate environment has persisted since the financial crisis of 2008-09, US banks have overhauled their operations to resist the effect of lower-for-longer rates. Regulators have raised questions asking whether the extent of the re-organization of banks is viable.

Three regulators have identified the risks associated with the interest rate and business restructuring. The Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC) and the Office of Financial Research (OFR) have all raised concerns over the degree of restructuring at banks. Martin Gruenberg, FDIC chairman, has emphasized that banks’ overhaul “raises the interest rate risk issue that we are very focused on,” as per Reuters.

The other two regulators, the OFR and OCC have also remarked on the interest rate risk. The OFR emphasized that the central bank could test the robustness of banks through a sudden disruption, similar to the Brexit vote. “Investors (are) open to heavy losses from large jumps in interest rates, whether from surprises in the Federal Reserve’s monetary policy or other shocks,” the OFR noted.

US banks have been cutting costs by slashing jobs and trimming operations which have underperformed in the times of the heightened market tumult. For instance, Bank of America Corp. announced plans to grind down its expenses through its Simplify and Improve (SIM) strategy, during the second quarter earnings conference call.

Moreover, banks are expanding their business footprints in avenues which have proved to be more resilient in generating a steady income, like wealth management and digital banking. Although challenging market conditions since the start of this year have driven banks’ restructuring efforts, they have become relatively more buoyant to withstand such conditions.

One of the recent events which amplified market volatility was Britain’s vote to exit the European Union (EU). This impacted the financial sector's stock performance in the immediate term, causing a drastic decline in investor confidence over the sector's ability to weather adverse economic effects. However, US banks proved to be more resilient as their better-than-expected second quarter earnings season helped lift up the once abating investor confidence.

In August, Federal Reserve chairwoman Janet Yellen’s hawkish tone while speaking at the Jackson Hole Symposium implied that the Federal Reserve was all set for its next rate lift-off this year. This led the month to end with a positive note, as stocks of US banks rallied, showing that investors were expecting a rate hike this year from the three Federal Reserve policy meetings. According to the Financial Times, Atlantic Trust chief investment officer David Donabedian said, “There is a perceived earnings catalyst with financials. The perception has turned over in the last month that the Fed is in fact going to embark on a series of rate hike.”

Additionally, banks have already delineated a strategy to withstand the worst market conditions that could potentially arise in the second half of this year. This reflects that while uncertainty is continuing to affect the remaining part of this year, banks are now more watchful about weathering any potential macro turbulence.

On this note, it is important to consider the fact that the US banks have become more well-capitalized following the crisis period, as the Federal Reserve’s recent stress tests showed. The Comprehensive Capital Analysis and Review (CCAR) tests are conducted annually to gauge the capital position of banks in times of severe economic downturn. This year, the Federal Reserve cleared the capital plans of 30 out of 33 banks. After the financial crisis of the last decade, regulators imposed stringent capital requirements so that banks had enough capital in times of financial distress.

When rates increase, net interest margins increase, which is the main interest rate sensitive metric for banks. This in turn raises banks’ profit, and banks have long waited for rate hikes to improve their earnings. The table above shows the NIM of four major banks over the past five quarters. Considering Ms. Yellen's hawkish tone at Jackson Hole, it can be concluded that a rate hike might be near, although only three meetings are left this year, scheduled in September, November and December.

Meanwhile, banks have made efforts to improve the growth of loans to offset low-yield financing (consider 2Q data in the table below). All in all, banks might be in for a surprise if the central bank makes a sudden move. However, in the long term, banks are most likely to remain resilient.

Freeport-McMoRan: Digging Up A Turnaround

Freeport can mine its way to better times; it is leaner and meaner with lower debt and higher quality metals

Freeport-McMoRan has been struggling to post profits for the past two years due to sluggish global economic growth, weak commodity prices and wrong bets on oil and gas. In the past 24 months, the company’s stock has lost over 70% in value and the mining giant has also added more debt to its balance sheet.

However, in the more recent past, Freeport has shown signs of improvement and has become one of the most attractive companies in the mining sector. With its vigorous cost-control strategies, asset sales and greater focus on the extraction of higher quality metals, the company has enhanced its value proposition and is in a better state to combat weaker economic conditions.

According estimates compiled by Bloomberg, Freeport is expected to report adjusted full-year 2016 EPS of 47 cents compared to 3 cents reported in 2015. Moving forward, the copper giant’s EPS is expected to rise further to $1.1 per share in 2017. Currently, the stock trades at an attractive price to earnings (P/E) ratio compared to mining peers, at 9.6 times its fiscal year 2017 earnings. In comparison, Rio Tinto trades at 16.19 times next year’s earnings, while BHP Billiton trades at a P/E multiple of 31.41.

Freeport shares have gained 52% year-to-date, outperforming the S&P 500, which grew only 5.2% during the same period. According to Bloomberg, the mining giant has a 12-month price target of $11.99. Wall Street largely appears to be on the sidelines, with 15 out of 19 analysts polled by Bloomberg rating the stock a Hold. Only three analysts recommend buying FCX shares at this time.

Debt Reduction

In December 2012, when crude was trading at roughly $90 per barrel, Freeport made a big bet on the energy space by acquiring McMoRan Exploration and Plains Exploration & Production for $19 billion. The company closed the deal in May 2013, substantially increasing its debt. The move was aimed at reducing dependence on copper for revenue, but it backfired and the mining giant saw crude oil and energy prices tumble. At the end of the first quarter of 2016, the copper miner’s total debt stood at over $20 billion.

It was no surprise when Freeport reported a net loss of $4.4 billion for the first six months of 2016, primarily related to the impairment of oil and gas properties and idle rig costs. However, the company has been aggressively trying to reduce debt to improve its balance sheet position. To date, it has already announced over $4 billion in asset sales, including the Tenke mine in Congo. It has so far received aggregate cash consideration of $1.4 billion. The mining giant aims to reduce its current debt of $19 billion to somewhere between $13.2 billion and $10.5 billion by the end of 2017.

During the second quarter of 2016, the company completed asset sales worth $1.3 billion, including the $1 billion sale of an additional 13% undivided interest in its Morenci copper assets. In addition, Freeport has also restructured its oil and gas business to reduce costs and align capital allocation with its debt reduction initiatives.

In the second quarter, the company terminated certain contracts for Freeport-McMoRan Oil & Gas and has canceled several deals involving deep-water drillships. It also settled aggregate commitments totaling $1.1 billion for $755 million, saving $150 million in operating and administrative costs.

By the end of the second quarter, Freeport has retired $369 million of its senior notes by exchanging roughly 28 million shares of common stock. The transaction is expected to reduce annual interest expense by $17 million. The mining giant also intends to issue $1.5 billion of common stock to further reduce its debt. Likewise, Freeport continues to aggressively manage exploration, production, administrative costs and capital spending.

Copper to the Rescue

However, despite Freeport’s efforts to reduce dependence on copper, the metal continues to be its major revenue generating segment and its silver lining in times of economic weakness. According to its second quarter earnings, Freeport sold roughly 1.1 billion pounds of copper bolstered primarily by increasing demand from China, the largest copper consumer in the world. In addition, the sale of the company’s copper assets in Morenci, Arizona is also helped reduce debt. The miner is expected to sell 5 billion pounds of copper in fiscal year 2016.

According to a recent report by Jefferies, Freeport’s earnings before interest, tax, depreciation and amortization (EBITDA) will continue to grow even if copper, gold and oil prices remain weak. The investment bank sees the company’s Cerro Verde mine expansion and the extraction of higher grades of copper from its Grasberg mine throughout 2016 and 2017, as key drivers for growth. The firm has a Buy rating on Freeport with a 12-month price target of $15. On Wednesday, FCX closed the trading session at $10.29.

Gold Cushion

In addition to its prized copper assets, Freeport’s gold operations have also been providing a cushion amid the downtrend in commodities, supported by rising prices of the rare metal. In the second quarter, the company produced 166 thousand ounces of gold, down from 367 thousand ounces in the same quarter last year. Currently, gold is trading at $1,313 per troy ounce, above its year-to-date average of $1,250.

For full-year 2016, the company expects to produce 1.7 million ounces of gold, up from 1.25 million ounces last year. Gold volumes typically fluctuate due the sequencing of areas as a result of varying ore grades at the company’s Grasberg super-mine in Indonesia. Assuming gold prices sustain the uptrend seen this year amid uncertainty in the market, and improving ore grades coming out of Grasberg, Freeport could end the year with a big win, since the bulk of its gold production or 55% is still to come in the fourth quarter.

Investors still uncertain about taking a position in Freeport would find assurance in Carl Icahn making a bold bet on the miner in August last year. Icahn remains the company’s largest shareholder, and after winning board seats in October, set about bringing meaningful changes to improve operations, and stem losses. With the market having warmed up to Freeport this year, and underlying efforts showing urgency to heed to Icahn’s advice, the miner can certainly dig up better results going forward.

*One troy ounce is defined as exactly 31.1g (1.097oz.)

#$FCX #$BHP

US Banks Should Prepare For Tough Times Heading Into 2017

Lingering macro uncertainties threaten U.S. banks earnings in the second half of 2016

The start of 2016 was not the best of times for the financial sector. Global markets tumbled as a result of mounting concerns regarding emerging economies and other macroeconomic slurves. In the midst of the storm, the U.S. banking sector saw trouble of its own on various fronts.

There is no doubt that markets hate uncertainty. With the troubles at the start of the year, fears of a potential recession jeopardized investor sentiment. The collapse of large financial institutions during the 2008-09 meltdown left a deep scar on investor psyche. Fast forward to 2016, they still remain wary of looming economic and geopolitical instability.

However, beginning the year on a jittery note with weak Chinese data was not the only ingredient. The run-up to the referendum that subsequently decided Britain’s fate regarding the EU, added to the mix of concerns. Complementing these macro issues was the Federal Reserve’s decision to stand pat on the interest rate situation in all its meetings so far this year.

While the general belief depicts the Federal Reserve’s stance as a positive and in the best interests of the economy, banks could continue to remain on the losing end of the spectrum. Low interest rates have weighed heavily on the sector, pulling down net interest income and net interest margins. The narrow spread between short- and long-term rates tends to squeeze margins.

The majority of banks have warned investors of ongoing uncertainty in the markets and the volatility that troubled their financial results. Following weak earnings in the first quarter, U.S. banks saw a modest recovery in the second quarter of 2016, largely because of improvements in trading revenue. Going forward, however, the episodic progress in earnings is unlikely to continue in the second half of this year. According to the U.S. Banking Quarterly Comment from Fitch Ratings, banks remain threatened by the challenges of modest economic growth outlook as well as other uncertainties.

Brexit and the upcoming U.S. election have led to a fair amount of speculation on the timing of an expected interest rate hike. Although the minutes of the Fed’s recent meeting and Janet Yellen’s comments might make a strong case for a perspective rate hike, higher future credit costs and lingering macro uncertainties continue to pose a threat.

Interestingly, while Yellen’s recent speech at the Jackson Hole summit in Wyoming might have painted a hopeful picture “for an increase in the federal funds rate,” the crux of the matter is that nothing new has been brought to light in terms of timing.

In addition to the ambiguity around credit quality in the second half of 2016, Julie Solar, senior director at Fitch Ratings, highlighted that energy books might deteriorate along with troubles in non-energy loan losses.

Amid the bear case scenario, certain points might provide some solace. Many banks have seen lower loan losses, while they remain well capitalized with solid liquidity and high capital ratios. Big banks, including Bank of America and JP Morgan cleared this year’s stress test with strong capital ratios. There is also consolation in knowing that the Federal Reserve stands as a guarantor with its annual stress test, which establishes that banks could survive even under severe economic conditions.

But the few positives are still overwhelmed by the persistent bear case scenario. Even though a vast majority of U.S. banks passed the stress test this year, satisfying the Fed’s minimum regulatory capital requirements, a combination of headwinds could still see banks scrambling for additional cost cuts.

"U.S. Banks will not see material improvement in earnings over the near term due to the lower-for-longer interest rate environment, modest economic growth expectations, global and political uncertainties, and higher future credit costs," said Ms. Solar.

China Gearing up Aviation Sector to Compete with Industry Giants

Introducing Aero Engine of China (AECC) following COMAC signifies China’s full-fledged efforts to swipe away market share from the aviation sector

As the aerospace segment is expected to boom in Asia over next two decades, China looks ahead to meet the local market demand by manufacturing domestic aircraft engines. Till now, the government and Chinese airlines have been depending on foreign companies to supply parts used in both commercial and military jets; however, China with the advancement in technology aims to be the game changer.

The mainland with its state-owned aerospace manufacturer – Commercial Aircraft Corporation of China, Ltd (COMAC) is working to launch single-aisle commercial aircraft targeted to compete with the industry giants having jets with similar specification.

In November 2015, COMAC launched its short-range single-aisle ARJ21 commercial aircraft equipped with General Electric Company’s (GE) CF34-10A engine, while simultaneously working on C919, C929, and C939 commercial jets.

Till now, these future models were slated to have foreign company engines, as China did not have its own local aircraft engine manufacturer. August 28, 2016 was a historical day for the Chinese market as the country achieved a milestone by launching Aero Engine Corp. of China (AECC). This new setup with 96,000 employees and $7.5 billion registered capital is ready to manufacture its own aircraft engines.

Chinese government officials regarded AECC’s establishment as a “strategic move” that is expected to help world’s second-biggest economy become a global aviation player. The company is designed not just only to support the local commercial aviation sector but also the defense sector segment, as it is likely to manufacture engines for military jets.

Increasing Competition with Industry Giants amid Positive Future Outlook

If AECC successfully introduces commercial aircraft engines, it would come directly in competition with General Electric Aviation segment, United Technologies Corporation’s (UTX) Pratt & Whitney, CFM International, and Rolls-Royce Aviation segment, which offers both military and commercial aircraft engines. Entering the market would not be easy for the newcomer to beat these giants’ dominance; however, the company might just get preference from Chinese Aircraft manufacturer and airlines, being state-owned and will be offered at lower prices.

Despite tough competition, AECC has promising future prospects as the Asian aerospace industry is expected to bolster over the next two decades, according to Boeing Co’s (BA) 20-year future outlook. Out of total 38,050 jets demand worldwide, Asia is expected to generate 14,330 commercial jets. Furthermore, Boeing also estimates an increased demand of 6,330 commercial jets from China as air traveling is likely to surge.

With an aim of meeting this market demand, Boeing and Airbus have announced plans to set up aircraft completion facility in China that would help them to get more orders from the region. The AECC project might take around five years to introduce a fully-operational aircraft engine, till then the country still has to use US industry giants’ engines.

Troubled Pratt & Whitney and Rolls-Royce

To date, the two aforementioned aircraft manufactures have been facing competition from COMAC and Bombardier that have introduced low-priced jets in the market. However, with the introduction of AECC, the sector can go into fierce competition in the near future.

Simultaneously, Pratt & Whitney and Rolls-Royce are expected to receive pressure from their investors, as they have been facing issues in their most popular aircraft engines. Rolls Royce Trent 1000 engine that powers Boeing’s 787 Dreamliner wide-body jet reportedly faced corrosion, forcing its operator ANA Holding to ground some of its flights.

Alongside this, Pratt & Whitney PW1100G engine that powers Airbus’ latest A320Neo single-aisle commercial aircraft has also been experiencing major malfunctioning since the aircraft’s launch. Airlines still have option to choose from CFM’s or General Electric engines; however AECC can lead them to change their minds.

Conclusion

AECC might increase competition with the industry giants once it’s fully operational; however, the company is in its infancy and needs time to grab the market. Till then, existing aircraft engine manufacturers might intensify their effort to strengthen foothold making it more difficult for AECC to enter the market. Having said this, AECC is expected to receive positive demand and feedback from local Chinese airlines, still depending on foreign suppliers.

#$GE #$BA #$utx

Tesla On Pole Position As Automakers Rush To Bridge Emissions Gap

Electric car makers should cash in on the opportunity that lies ahead as emission laws become stricter

Have you ever wondered why large automakers are increasingly coming up with new electric car models, despite raking fat profits from the sale of gas-guzzlers? Automotive executive Bob Lutz says car makers produce EVs not for making profits but to meet the standards of a tightening fuel economy.

A recent study published by the World Energy Council (WEC) supports Mr. Lutz’s views. The study highlights the role of electric cars in reducing emissions amid tighter regulations to stem environmental impact and climate change. Automakers are following the right strategy by pushing electric vehicles into the mainstream, sniffing the disruption well in advance.

Closing The EV Gap

The E-Mobility 2016 study noted that auto regulators in the world’s three largest car markets—China, the U.S. and the E.U.—have agreed to enhance the fuel efficiency of cars by 30% from 2014 to 2020. This puts pressure on car makers to improve fuel economy of internal combustion engine (ICE) vehicles. However, the study concludes that electric cars have an important role in bridging the “EV gap” between stringent emission standards and the possible improvement in combustion technology.

In order to fill the gap, the study predicts that one out of every six cars sold by 2020 would need to be an electric vehicle. This will make up 16% of new passenger car sales in the three major markets by the end of decade, the report claims. As the current EV market share is less than 1% across the biggest car markets, auto manufacturers need to play their part in bringing green car technology into the mainstream.

This is precisely what Tesla Motors is planning to do. The electric car maker plans to launch the mass market Model 3 by the end of 2017. It will be priced at $35,000, closer to the average cost of a new car ($31,000), according to Bloomberg New Energy Finance. The vehicle, which is still more than a year away from launch, has already grabbed almost 400,000 pre-orders. This underscores the level of rising interest in clean energy vehicles. With major automakers still lagging in the race, the question is whether they will be able to ensure enough supply of EVs in the future.

The positive here is that traditional OEMs have closely started following Tesla’s footsteps in order to close the emissions gap. In line with this objective, General Motors will launch its much touted Tesla killer, the Chevrolet Bolt later this year.

Already reeling from last year’s emissions scandal, Volkswagen is under a lot of pressure to meet fuel efficiency standards. The German auto giant has decided to launch 30 new electric car models by 2025, with a production volume of 2 to 3 million per year. The move is an attempt to move past the diesel emissions saga and improve its tarnished image.

Tesla in Front Seat, Others will Follow

Car makers are coming up with individual EV concepts, so expect stiff competition in this space down the line. However, car makers have a large playing field, as major auto makers will need millions of green cars to meet emission requirements. In order to fill the “EV Gap,” automakers need to sell 0.9 million EVs by 2020 in the U.S. (11% of the projected 2020 passenger car sales). According to the WEC study, a total of 1.4 million and 5.3 million green cars have to be sold in the EU and China, respectively, by the end of this decade in order to close the emissions gap.

Governments in major car markets have offered incentives to auto manufacturers and entrepreneurs to produce and deliver more electric cars. In California, automakers are required to sell non-polluting vehicles proportionate to their market shares, for which they can earn zero-emission vehicle (ZEV) credits. This may be an extra source of revenue, as green car makers that exceed these standards may sell their extra credits to other car makers.

Meanwhile, China plans to sell 5 million electric cars by 2020; only 300,000 short of the “EV Gap” for the country, as estimated by the WEC. Years of government subsidies have paid off in China, and the sale of green cars in the country quadrupled in 2015.

Meanwhile, German Chancellor Angela Merkel has reached a deal with car makers to spend €1.2 billion ($1.4 billion) to support EV sales. EV customers will be given rebates of €4,000 in order to make the cars more affordable.

However, global EV sales haven’t seen the kind of mass market traction that might have been expected. This is mostly due to lack of affordability, stemming from limited technology and “range anxiety” among consumers based on fears about a depleted car battery without a charging station in sight.

The auto industry has been handling these two issues with the help of government incentives and rapid developments in technology. According to a Bloomberg report, Tesla’s Model 3 can cost as low as $25,000, after accounting for federal and state incentives. The automaker is upgrading the battery packs in order to increase the electric range of its vehicles. This week, it launched a 100kWh battery option for the Model X and Model S. The option offers a range of over 300 miles on a single charge.

As battery technology improves, electric cars will likely take time to match their combustion engine counterparts in terms of selling price, and subsequently, in sales. According to a report from Bloomberg, electric and gasoline-powered cars will cost the same by 2022. Improved government incentives, stricter emission laws and developments in battery technology could very well help the EV industry reach that mark.

Here’s How US Banks Turned Buoyant

American banks have optimized business structures in order to deal with the market turmoil

US banks have weathered the weak macroeconomic environment prevalent across the globe, reflecting the maturity level necessary to withstand any potential uncertain economic conditions. The timely business optimization helped US banks overcome obstacles in the wake of the financial crisis 2008-09.

Significant market volatility and uncertain economic conditions have dominated the year. Prolonged periods of low interest rates and stringent regulations forced the banks to actively re-organize their operations following the financial crisis.

Interest Rates

During the financial crisis, the Federal Reserve trimmed the interest rates to near-zero in order to stimulate economic activity. After several years, banks rejoiced the first rate hike, after the central bank decided to further tighten the monetary policy in December last year. Banks’ net interest margin (NIM), the difference between lending and borrowing rates, is tied to the interest rates. The higher rate means higher spread, which boosts earnings.

The table above shows that the four US banks, Bank of America Corp., JPMorgan Chase & Co., Citigroup Inc. and Wells Fargo & Co., have seen a downtrend trend in their NIM for the better part of the past four quarters. According to the Federal Reserve Bank St. Louis data, NIM for all US banks started declining after reaching a peak in 2010. However, the trend slowly reversed after dipping to 2.95% in the first quarter of last year. The metric has improved to 3.01% in the second quarter of this year.

Loans growth is one of the reasons for the improvement in NIM. The big four US banks have made efforts to boost lending activity, while the yield on loans remains low. The banks increase the number of loans in order to offset the impact of flatter yields.

Non-Performing Loans

In contrast to US banks, European banks are burdened with significant non-performing loans (NPL). High NPLs dent banks’ profitability. According to the World Bank statistics, NPL-to-total loans ratio for Euro Zone stood at 5.7% for 2015. Meanwhile, it stood at 1.5% in the US banking industry for last year.

The US banks with exposure to the energy sector, remained under focus as increasing number of oil and gas companies filed for bankruptcy or faced higher financial difficulties. The trend threatens the banks with increased risk of non-performing loans, which might affect banks’ profitability and hurt shareholder value.

This year, the banks have reduced loans exposure to energy sector. According to Bloomberg, the eight biggest US banks have cut the energy sector loans and loan commitment by 6.3% in the first half of this year. By the end of 2015, the bank lent or committed $2.34 trillion to energy sector, but it reduced to $2.19 trillion by the end of June 30.

In July, the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency reviewed the banks. They highlighted that the banks are burdened with deteriorating energy sector loans, but they have raised the underwriting standards.

Adequate Capital

Following the financial crisis, the regulatory authorities imposed stringent capital requirements, making banks to maintain adequate liquidity in order to circumvent any potential crisis. The compliance with these regulations has increased the costs. Therefore, the banks have overhauled operations through headcount reduction and exit from the business lines that underperformed during high market volatility.

In June, the Federal Reserve carried out the annual stress tests to assess the capital position of the banks, under severe economic downturn. Out of 33 banks, 31 banks got green signal for being well-capitalized and having mechanisms in place to face any economic challenges in future.

Brian Moynihan, Bank of America chief executive, highlighted the stress tests “showed on a relative basis that the US stress test scenario is much more severe.” “We’re in a more mature place in this recovery in some ways in terms of banking structure and things, and they’ll get there,” he added in an interview to Bloomberg earlier this month.

The US banks swung to year-over-year (YoY) and sequential profits growth in the second quarter. According to SNL Financial and S&P Global Market Intelligence data, as cited by CNBC, American banks earned $43.6 billion profits in the last quarter compared to $43.01 billion in 2QFY15 and $39.04 billion in 1QFY16. Sequentially, profits climbed 1.4% and increased 11.7% YoY in the 2Q of this year.

Going forward, earnings for the third quarter (3QFY16) remains an important benchmark in the short term. According to the data on Bloomberg, analysts expect a YoY profit growth of 23.2% at Wells Fargo, 21.4% at JP Morgan Chase, 19.7 % at Citigroup and 17.6% at Bank of America, in the third quarter of this year.

Although the US banks have come a long way in restructuring their business structures, the market conditions have weighed down their stock performance. Considering the stock performance year-to-date (YTD), Wells Fargo stock has lost almost 12%, Citigroup stock is down 11%, Bank of America stock is down 9% while JPMorgan Chase stock has lost around 1%.

Boeing In Flux: How Its Navigating Industry Crosswinds

Investors have been concerned over Boeing recent performance, and seem to be overlooking the fact that the company is evolving to accommodate market conditions

With airlines feeling the heat from a prolonged global economic weakness and rising geopolitical concerns, Boeing has also had a tough time filling its order books lately. The aerospace giant has only managed to get 335 commercial orders so for this year, down from 470 orders it had in the comparable period in 2015.

As of August 15, Boeing is among the most heavily shorted companies in the Dow Jones Industrial Average with just over 5% of its float being shorted, as investors show concerns over the company’s recent performance. In the past 12 months, the stock has lost nearly 9% in value, underperforming the Dow Jones US Aerospace & Defense Index, which grew 7.2% during the same period.

Low oil prices have helped airlines extend the use of ageing aircraft. This has eased the urgency to buy more fuel efficient planes, which is making it difficult for manufacturers to sell newer aircraft.

Additionally, demand for wide-body aircraft has been declining, as narrow-body jets become more attractive with added capacity and range. Smaller planes operating on routes also allow for higher frequency of flights. Boeing predicts that greater adoption of the low-cost carrier model— especially in emerging markets—has driven this shift in demand. Although Boeing posted stronger-than-expected revenue of $24.75 billion in the second quarter, the aerospace giant recorded a net loss of $234 million.

An Evolving Boeing

However, Boeing has been evolving—aligning itself to current market trends and making efforts to better adjust to changing demand dynamics. The airplane maker has announced reduced production levels of its legacy 747 planes to just six a year, starting September. It may also stop production of the aircraft after fulfilling its current backlog of 21 airplanes.

Likewise, the company has also announced plans to not increase production levels of the 787 Dreamliner. It plans to keep the production rate of the 787 at its current 12-per-month, while also considering a reduction in the long-range 777. While speaking at the Jefferies Industrial Conference this month, Boeing CFO Greg Smith said: "If the market's not going to demand it, we're not going to go." However, news of the company’s evolution hasn’t been received well by investors.

At the recent Farnborough International Airshow, Boeing Commercial Airplanes President Raymond Conner said: “I think people are in a wait-and-see type of mode, and with fuel prices being down a little bit, they can fly the older aircraft a little bit longer, and they don’t have to make these longer term decisions just yet. We haven’t seen a slowdown with respect to the single-aisles, but the wide-bodies have slowed down a little in terms of sales. We’ll adjust ourselves accordingly. Our view is to always get ourselves balanced with demand.”

Boeing’s recent net-loss on its second-quarter earnings was primarily due to a one-time write-down from the KC-46 tanker and 747-8 programs. The bottom line was also hit when Boeing reclassified expenses related to a couple of 787 Dreamliners. Based on the industry’s seasonality, the first two quarters of the year are generally slower for the aerospace giant in terms of orders and deliveries in comparison to the last two quarters where both metrics tend to pick up pace.

More importantly, Boeing has a mammoth backlog of nearly 5,700 planes with commercial airplane orders worth $417 billion. Roughly 4,400 of those are for the narrow-body 737 and 737 MAX planes, where future demand is expected to come from. Currently, the company is on track to increase production of its 737 planes from 42 to roughly 47 per month by 2017. It also plans to increase production to 52 per month by 2018 and 57 per month by 2019.

According to Boeing’s 20-year forecast, it sees the need for 39,600 airplanes, out of which 28,100 are expected to be narrow-body planes. With such a backlog, even if Boeing doesn’t receive any new orders, it can still sustain itself. However, that doesn’t mean orders are not important, since they tend to cushion the company’s liquidity in the future.

Although Boeing’s deliveries are still low in comparison to the same period in 2015, it has managed to deliver 432 planes so far this year, signifying continuing cash inflows for the company. During the second quarter, the company reported operating cash flow of $3.2 billion primarily due to its deliveries. The majority of the cash inflow for Boeing comes at the time of delivery.

Hence, while orders are showing a downward trend, the company’s relatively strong deliveries have been supporting growth. Boeing is in the process of aligning its production goals to the needs of the market, as some airline carriers have been deferring deliveries—a fact that investors should keep in mind when looking at Boeing stock.

Furthermore, in an attempt to reduce inventory levels, Boeing has recently started to offer the 787 to customers who had placed an order for the 777 aircraft. The company has offered Pakistan International Airlines the option of taking on the 787 Dreamliner in lieu of its outstanding order for five 777-300ERs.

Defense Segment to the Rescue

Recently, Boeing managed to secure a $2.8 billion contract with the US Air Force for the first two production lots of KC-46 Pegasus aerial-refueling tankers. This is part of a $52 billion program for building 179 tankers by 2017 and marks the beginning of efforts to replace roughly 450 Cold War era tankers. Additionally, the defense segment aims to shift its focus on aftermarket services rather than developing newer fighter jets.

According to the head of Boeing’s Defense segment Leanne Caret, it makes more sense to focus on serving the company’s military planes already in the market rather than manufacturing newer ones. According to a recent Canaccord report, Boeing’s Commercial Aviation Services division has the potential to become a $10 billion business unit by 2020. Additionally, the Defense, Space & Security backlog stands at $55 billion, out of which 37% is from international customers.

It’s not hard to understand why Boeing is going through a difficult period during a tectonic shift in airline industry dynamics. According to estimates compiled by Bloomberg, the company’s adjusted EPS is expected to decline 19% in fiscal 2016. From then on analysts project an ascent mode. In 2017—when Boeing starts delivering its 737 MAX aircraft—earnings are projected to rise 54%.

Boeing shares currently trade at an attractive 13.7 times FY17 earnings. With an expected surge in profit next year and successful efforts toward execution of its production realignment, I see a favorable risk-reward case for any investment in the airplane maker’s stock.

#$BA

Is Watson Smart Enough to Breathe Life Into IBM?

IBM’s prospects for the second half this year appear to be pegged to its performance in the cloud analytics and computing sphere

While the concept may be all the rage right now, artificial intelligence is decades old. The technology was first discussed during a conference at Dartmouth College in 1956. Initial deliberations included expectations that the technology would one day substitute anything a human brain can do.

Funding eventually dried up for the folks at Dartmouth, and it was IBM that was responsible for the revival of the layman’s fascination with the idea of man-made intelligence.

The first high-profile display of a clash of the two forms of intelligence was when IBM’s Deep Blue chess playing computer beat Russian chess Grandmaster Garry Kasparov on February 10, 1996. The Grand Challenge, IBM’s quest to push science in ways that were previously considered impossible, was also an effort to establish its lead in the field.

In 2011, IBM’s Watson supercomputer marked the start of a new wave of cloud connected artificial intelligence by competing successfully on Jeopardy! The use and application of Watson has grown exponentially in recent years in areas such as healthcare and wealth management. The platform is expected to transition into a viable stream of revenue for the company, given that the new Cognitive Solutions segment—which operates the Watson unit—generated $4.7 billion in revenue in the second quarter of fiscal year 2016.

Cloudy Disclosures

IBM’s performance in the cognitive space last quarter was attributed to growth in software revenue, driven by Watson’s Analytics and Security. Again, cloud was touted as the bright spot within Cognitive Solutions, with revenue growing 54% in the quarter.

Dissecting IBM’s financial disclosures regarding its cloud business have been known to be a nightmare for analysts. Most of the company’s newly formed segments carry items related to the cloud, with Wall Street divided on even the most basic cloud metrics provided by Big Blue. The debate stems from disagreements over what exactly IBM classifies as cloud revenue—many argue that the company has been shifting traditional revenue streams into the cloud to boost numbers.

Strategic imperatives, which include cloud, analytics and engagement, nonetheless play a meaningful role in helping IBM address its overall revenue decline. In the Global Business Services segment, revenue from strategic imperatives rose 14% in the second quarter.

Revenue attributed to IBM’s strategic imperatives grew 12% overall in the recent three-month period. Although sales from Technology Services and Cloud Platforms (including infrastructure services, technical support services and integration software) fell 0.5%, revenue from strategic imperatives within the segment grew 35%. The company attributed this to the robust performance of its hybrid cloud infrastructure, an area where IBM is seen as a potential leader.

SoftLayer - Strengthening Watson and IBM

IBM’s foray into the burgeoning realm of cloud intelligence had cast doubts around its ambitions at the time. But assertions of success in that area started to gain steam after the company acquired cloud specialist SoftLayer for $2 billion in June 2013 as a way to strengthen IBM’s Jeopardy! champ Watson.

IBM announced in February 2014 that SoftLayer’s cloud infrastructure would be infused with IBM Power Systems—the first product of which would be three Watson solutions; Watson Discovery Advisor, Watson Engagement Advisor and Watson Developer Cloud.

Since then, IBM has poured billions into shoring up its cloud infrastructure and acquiring businesses that can add to its arsenal of cloud companies to deliver a range of solutions. The company spent over $4 billion in 2015 to expand strategic imperatives including the cloud space.

Workday Partnership Adds Strength

In a research note to investors on August 15, Drexel Hamilton analyst Brian White wrote that he was positive following the multi-year strategic partnership with Workday, which offers cloud computing software, but lacks the ability to offer hardware, which is IBM’s forte.

White believes that given IBM’s relative absence in the Enterprise SaaS solutions market, the deal is not likely to run into anti-trust roadblocks. He feels Workday’s growth in the SaaS space will complement IBM’s aim to provide a flexible cloud structure and help establish a noteworthy footprint in the space. Drexel Hamilton has a Buy rating and a 12-month target price of $186 on IBM. The stock closed at just above $159 in trading yesterday.

Over the past three quarters, IBM has seen swift growth in cloud run rate as efforts to establish partnerships and developing existent infrastructure solidify. In November last year, IBM purchased one of Workday’s leading service partners Meteorix for an undisclosed amount. The rush to invest in the cloud has picked up, and IBM won’t be left behind. For the second quarter of 2016, IBM said its cloud revenue over the trailing 12 months came in at $11.6 billion.

IBM Cloud: How it Stacks up Against Rivals?

As part of its turnaround strategy, the company has shifted focus from its legacy hardware business to cloud computing and cognitive solutions. It has worked to aggressively cut costs through layoffs and has increased investment in the quest for higher cloud market share, only to face a prolonged period of dominance by Amazon’s AWS and Microsoft’s Azure.

Cloud revenue showed 30% YoY growth in the second quarter of the year, coming in at $3.4 billion. While cloud revenue at IBM has outshone overall top-line performance—which slumped 3% YoY— Big Blue’s cloud business growth still lags competitors that continue to report cloud contributions as software alone. Amazon’s AWS reported 58% revenue growth in the second quarter of the calendar year, while Azure’s revenue more than doubled in the same period.

Yet, there are signs that IBM’s cloud business could be in for some welcome gains. The annual run rate for revenue from cloud delivered as a service grew 50% to $6.7 billion in the second quarter. That’s up from a growth rate of 42% in the first quarter.

But what’s still unclear is how that revenue is broken down, since IBM groups numerous revenue streams under cloud. I would like to see certain items listed separately such as revenue from the Watson Group, and more clarity on what percentage of each business segment contributes to the cloud.

The company did reaffirm its guidance for full-year EPS, and said that free cash flow for fiscal 2016 is expected to be at the higher end of its projected range. As noted by Barron’s in a story earlier this month, the stock’s main attraction is still the dividend.

Following the announcement of new reporting segments in February this year, Bernstein analyst Toni Sacconaghi called some of the details “more confounding than supportive to IBM's transformation.” Mr. Sacconaghi said in the same note that Cloud and Cognitive operations are “more vision than financial reality today,” begging the question whether investors should bank on IBM’s cloud transformation story as it is told or wait for clearer disclosures.

#$IBM

Pfizer Can Stall the Decision to Split — Thanks to Medivation

The option of a split allows Pfizer to boost its high-growth assets

Pfizer Inc. (PFE) recently acquired the much-sought-after cancer biotech, Medivation, thwarting hopes of many drugmakers who were interested in acquiring the company. Pfizer paid a hefty $81.5 apiece for the acquisition, ahead of the $70 apiece expected by most analysts.

The deal amount comes at a premium of 21% compared to Medivation stock's closing price on August 19. The offer also marks a significant increase of 55.2% against Sanofi’s first offer of $52.5 apiece — dealing a severe blow to the French drugmaker’s five-month long pursuit of Medivation.

Bank of America Merrill Lynch (BofAML) highlights the striking premium Pfizer offered for the biotech – and how unexpected it was – considering its history of being cautious with acquisitions.

BofAML said in a research report on Monday: “While the proposed deal is not a great surprise given recent speculation from news sources telegraphing the discussions, the price paid was, given PFE’s typically high level of financial conservatism/discipline in deal scenarios.”

Most analysts now expect Pfizer to spit up this year to reap full benefits from its high-growth assets. The addition of Medivation’s cancer portfolio can provide a much-needed boost to Pfizer's Innovative Health division and could eliminate the need for a split altogether.

A split would require separation of Pfizer Essential Health, also known as the Global Established Products (GEP) unit, from the rest of the company. The unit mainly comprises aging drugs that are nearing patent expiration. Pfizer now considers GEP among its low-performing businesses and wants to get rid of the segment as early as possible to transition into high-growth markets.

GEP, the largest segment of the company, saw a revenue decline of 9% year-over-year (YoY) in fiscal year 2014, and an even higher 14% in FY15. Revenue clocked in at $25.1 billion and $21.6 billion for the years, respectively.

A declining revenue from GEP overshadows the rising growth in Pfizer's Innovative Health business. The segment has two main units: Global Innovation Products (GIP) and Vaccines Oncology and Consumer (VOC) unit.

The GIP unit comprises new drugs like Enbrel, Lyrica, Eliquis, and Xeljanz. Most of these hold potential to become blockbuster drugs. GIP shored up revenue of $13.95 billion last year.

The VOC segment generates nearly 30% of the company’s total revenue and holds two star products: a vaccine by the name of Prevnar and cancer drug, Ibrance. VOC recorded revenue of $10.14 billion and $12.8 billion in FY14 and FY15 respectively, marking an increase of 9% YoY and 26% YoY.

The decline in GEP is denting the overall revenue of the company. Revenue has been on a decline since 2011 when its once-a-star product Lipitor lost patent. This was followed by patent expiration of blockbusters like Celebrex in May and Zyvox in November 2014.

Pfizer's revenue for FY14 and FY15 stood at $49.6 billion and $48.9 billion respectively, declining 4% and 2% YoY.

Analysts in favor of the split believe that GEP and GIP/VOC units can derive higher value if they operate as standalone entities, while those opposing the split believe getting rid of its top revenue-generating segment would only duplicate costs in the long run.

BofAML said in its latest research report: “The loss of financial flexibility post-split was something CEO Read raised as a concern in our recent meeting (see note) – currently the Essential Health business generates a large proportion of the cash flows, which are used to fund the Innovative Health’s business R&D expense.”

With the addition of Medivation’s cancer portfolio, Pfizer's Innovative Health business might be able to support future R&D spending on its own — and make the idea of a split even less attractive.

BofAML analysts, Colin Bristow and Jeehyea Choi, clearly highlight higher flexibility as the greatest perk in the Medivation buyout. They said: “Assuming the deal goes ahead, we believe it will give PFE greater flexibility – we note a split decision is still expected prior to year-end. We continue to expect PFE to not split for the time being but like the optionality of the strategic move going forward."

Medivation: A Catalyst for Pfizer’s High-Growth Assets

Pfizer has bagged a cash cow for its cancer drug business. Medivation’s most valuable asset is blockbuster prostate cancer drug, Xtandi. The drug has been in the market for four years. It generated sales of almost $2 billion in FY15, of which $1.15 billion came from US.

The cancer drug market touched the $100 billion sales mark last year and is all set to become a $147 billion market by 2018. Pfizer, now with Ibrance and Xtandi, seems geared up to gain a leading position in the burgeoning market.

Medivation also brings a robust pipeline of other cancer drugs: talazoparib, a late-stage drug candidate being tested for its efficacy against germaline BRCA-mutated breast cancer, is set to become another blockbuster drug. The drug could also lead Pfizer into an emerging class of cancer drugs called poly (ADP ribose) polymerase (PARP) inhibitors. Similarly, pidilizumab, which is an immunotherapy being tested as a treatment for refractory diffuse large B-cell lymphoma, will grant entry into the fast-expanding market of immunotherapies, expected to become a $31 billion market by 2021.

Accretive to EPS But Less Compelling to Direct Cash Flows

The addition of Medivation will be accretive to earnings in the very same quarter the deal closes in.

BofAML said in the research note: “PFE expects the deal to be immediately accretive to EPS (deal close anticipated in 3Q/4Q16), with ~$0.05 accretion in the first full year and growth thereafter (no impact to FY16 guidance) – this is not surprising given the deal is financed 100% with cash. The accretion guidance feels conservative based on our initial deal analysis (we see $0.10 achievable in 2017). We see 6-7% EPS accretion as possible by 2020 (assumes 33% operating expense synergies) but note that the DCF impact would be neutral to mildly negative.”

BofAML maintains a price target of $40 on Pfizer stock, which represents an upside potential of almost 14% against the stock’s closing price of $35.09 on Wednesday.

For more information on Pfizer financial performance and history, refer to our Pfizer Data Analysis section.

#$pfe

BofA, Other Banks Navigate Choppy Waters; Await Gains From Rate Hike

Low interest rates have dampened bank earnings; here's what needs to fall in place in order to keep growth coming

Not many had anticipated the Federal Reserve would keep interest rates this low after the liftoff in December. However, as it turned out, looming macroeconomic concerns have dented the prospects of a rise in the short-term interest rate this year.

U.S. banks remain under pressure when it comes to boosting bottom-line results as low interest rates continue to hurt margins. A flatter yield curve and delays in the rate hike have negatively impacted net interest margins. In this case, uncertain market conditions also tend to weigh down capital markets and instill fears of a global slowdown—further restricting upside in bank earnings.

Batten Down The Hatches

Banks remain challenged, especially by net interest margin and net interest income. Bank of America, in particular, recorded an 11.9% year-over-year (YoY) decline in net interest income for the second quarter. While net interest income and non-interest income remain suppressed, the declines are partially offset by lower noninterest expense.

Noninterest expense has dropped at banks including Bank of America, Citigroup and JP Morgan and interestingly, much of the decline in operating expenditure can be attributed to cost-saving measures. U.S. banks have resorted to alternative measures in order to combat the tougher profit-generating environment. Cost-saving initiatives mean continued expense management as banks aim to boost bottom-line results with the aid of efficiently managed headcount and other personnel spending.

Sure Cure

The key to maximizing income is the spread between short-term and long-term interest rates—the wider the better. The idea is to borrow funds from depositors at low rates and lend at higher rates. Once the Fed brings itself to nudge rates higher, interest rate sensitive banks can ideally improve their financial statements.

As per Bank of America’s second-quarter regulatory filing, an instant parallel shift of 100 bps in the yield curve would benefit the bank’s net interest income by $7.46 billion over a period of 12 months.

There is no doubt that US banks will need the Fed’s help to boost income. As long as the central bank is not willing to raise rates, banks will continue to see downward pressure on earnings.

Is The Coast Clear?

Although some believe that the Federal Reserve is delaying the inevitable with its decision to stand pat, the real question is: Does the economic uncertainty warrant a hike? The minutes of the Federal Open Market Committee’s July meeting show some members cautioning that the “Brexit vote had created uncertainty about the medium- to longer-run outlook for foreign economies that could affect economic and financial conditions in the United States.”

With the uncertainty around the U.S. elections and Brexit, I believe it is highly unlikely the central bank will make a move this year. However, it is not all doom and gloom for banking giants. Low long-term rates are usually a positive for fixed income fund flow and mortgage banking. Even months after the Brexit vote, long-term rates remain low, but have aided credit trading at investment banks.

#$BAC #$C

Target May be Losing its Direction

Bidness Etc highlights some of the issues engulfing the big-box retailer recently

Target Corporation (TGT) stock has hit a rough patch so far this year. Even as it sought a bounce-back last week before reporting quarterly earnings, investors still couldn’t support a rebound. The big-box retailer slashed its same store sales (comps) and profit guidance for the current fiscal year.

Even as the company reported better-than-expected earnings for the second quarter (2Q) of fiscal 2016, revenue was in line with expectations. However, the cut-back outlook instigated a major sell-off as the stock went downhill 6.43% on August 17—the day of the release.

On the surface, Target posted a dull quarter. Revenue was aligned with the Street’s expectations at $16.2 billion, but declined from comparable quarter by 7.2%. Comps posted a 1.1% decline, marking it the first reversal of positive comps stream in eight quarters.

Net income for the period also shed in value by 10%. It was still better than what many analysts expected. Adjusted earnings per share (EPS) clocked in at $1.23 apiece, beating analysts’ estimates by 11 cents.

The latest report involved both good and bad news for the company. Its e-commerce business grew 16% with mean order amount going up 1.1%. Average selling price (ASP) per unit was also an improvement of 2.6% from comparable quarter. In addition, Target beefed up its gross profit margins by 50 basis points from 30.8% to 31.3%.

Considering how sales went down more than 7% during the three-month period, improvement in gross profits denote intensive cost-cutting measures that helped boost margins in top line. From a perspective of operating margins, Target was able to cut down on Selling, General & Administrative (SG&A) expenses by 7%, helping boost operating margins by 10 basis points.

Disappointing Outlook

And yet, the performance was somehow not adequate enough to ward off the stock sell-off. The downfall came on the back of not just decline in comps, but number of transactions, and units per transaction also dropped during the quarter by 2.2% and 1.5%, respectively. The final blow was obviously the trimmed guidance that the management decided in order to have everyone abreast with the downside to follow in the current quarter and the next.

Target cited intensified competition amongst big-box retailers and decline in grocery sales as the biggest reasons for its outlook. The company’s problems are a reflection of the overall retail industry that needs to deal with a sudden surge in the trend of online shopping as customers ditch brick-and-mortar stores for more convenient e-commerce platforms.

In addition, “difficult” and challenging consumption environment amid economic and political uncertainty has also shaken up sales momentum for the retailer that is likely to take a toll on its yearly performance for the current fiscal year. As per Target’s earnings release: “Based on the current retail environment, the company believes it is prudent to lower its expectations for comparable sales in the second half of the year.”

The outlook now comprises of the company expecting adjusted EPS come in at $5.2, down from prior projection of $4.8 per share. The company had previously said in May that its original forecast of $5.2-5.4 EPS was still achievable in spite of flagging sales momentum during the spring months and the overall first half of the year. Comps are also forecasted to come out in the range of flat to a decline of 2% for the year.

As far as the current quarter is concerned, Target expects to generate some 75-95 EPS, as opposed to analysts’ expected 96 cents apiece. Target CEO, Brian Cornell, is optimistic about the company’s financial performance, as he set the stage for a strategy to reclaim shoppers traffic at its outlets as it continues to concentrate on the online platform. He said during the earnings release: “Although we are planning for a challenging environment in the back half of the year, we believe we have the right strategy to restore traffic and sales growth over time.”

Under Mr. Cornell’s leadership, Target has been trying to revive its performance who took the helm two years ago. In his efforts, the CEO is trying to reclaim the retailer’s affordable but fashionable merchandise status after it suffered from cyber data breach and inventory mishaps; aforementioned even hurt its profits and sales for several quarters since 2014.

However, there are still a few concerns about its operations that raise alarming bells for the company’s productivity. Supplier woes for instance, are going to thump performance this quarter.

Target Severs Ties With Welspun

The company has severed ties with its major textile supplier over Egyptian cotton dispute. It has ended all business with Welspun India Ltd, one of the largest textile manufacturers in the world, after it claimed that the supplier was sending the retailer counterfeit Egyptian cotton sheets.

Last week, Target announced that discovery of 750,000 pillowcases and sheets labeled as Egyptian cotton, but were in fact manufactured with some other cotton type. The company announced that it has halted the sale of these products and pulled them out of its brick-and-mortar setup and online portal. It also started informing customers if they needed to be refunded for these products bought between August 2014 and July 2016.

While this may be purely a supplier’s wrongdoing of deceiving Target of phony cotton sheets, it brings the quality control department into question. It reflects on the company’s failure to detect these fake cotton sheets from actual Egyptian ones. This may involve a backlash from consumer groups in the coming term that could further disrupt sales momentum in the current quarter.

Weak Demand for Apple Products doesn’t Bode Well

The quarter saw Target badly getting hit in the consumer electronics department. While the retailer is yet to completely renovate its grocery unit, the bulk of its sales were impacted by declining sale of electronic gadgets — Apple products particularly. The company announced that the double-digit percentage drop in electronic sales ascribed to almost 2/3rd of Target’s overall revenue during the 2Q.

Of this decline in electronic sales, 1/3rd of the decline was accounted to the fall in demand for Apple’s iPhones, iPads, and other gadgets. This trend was also visible in the tech giant’s own sales that also posted first-ever drop in sales from iPhones, overall contributing to revenue decline at Apple. The retailer on the other hand stated that Apple products saw their demand fall by nearly 20% at its stores.

Looking ahead, Target is continuing with its efforts to collaborate with Apple on revamping its marketing and sales plans for the rest of the year. These plans would now be aimed at the existing and forthcoming Apple products. Apple and Target have hinged their hopes on iPhone 7, as they look to capitalize the maximum off the phone’s long-awaited launch.

For more information on Target financial performance and history, refer to our Target Data Analysis section.

#$tgt

Delta Maintains Lead Over United amid Reduced Operational Outlook

Tough market conditions and internal challenges force Delta to cut its full-year capacity guidance; it maintains US no 2 airline position in terms of traffic

Changing macroeconomic conditions have forced the US airlines to reduce flight operations on certain international routes, along with impacting unit revenues negatively. However, Delta Air Lines, Inc. (DAL) manages to keep its lead over United Airlines as the US number 2 airline in terms of traffic. The challenging market conditions seem to be affecting the operations of the United Airlines as well, impacting its passenger capacity and traffic negatively.

The latest operational performance report for July shows that Delta Air Lines reported year-to-date (YTD) consolidated Revenue Passenger Miles (RPM) of 125.28 billion with 2.8% year-over-year (YoY) growth as compared to United Continental Holdings Inc. (UAL) YTD RPM of 121.30 billion with 0.1% YoY growth. In addition to this, Delta Air Lines also reported YTD consolidated Available Seat Miles (ASM) of 148.39 billion with 2.8% YoY growth as compared to United Airline’s YTD ASM of 146.66 billion with 0.8% YoY growth.

Delta Air Lines manages to report higher traffic and capacity volumes than United Airlines amid cut in its full year 2016 capacity guidance arising from global events. In its second quarter 2016 earnings release, the airline estimated decline of 6 basis points on the US to UK capacity during the upcoming winter season that would reduce system-wide capacity by one basis point during the fourth quarter 2016.

Apart from this, Delta Air Lines also reported September third-quarter 2016 guidance in the second quarter earnings release, according to which it estimates passenger revenues per available seat miles (PRASM) to be down 4-6% YoY. Alongside this, the airline estimates Cost per available seat miles (CASM) to be flat during the quarter and system Capacity to be up 1-2% YoY. Comparatively, United Airlines, in its latest investors update, estimates third quarter 2016 PRASM to be down 5.5-7.5% YoY with its consolidated capacity to increase 1.5-2.5% YoY.

Investors have been worried regarding this cut in airline’s capacity as it will also impact the operating revenues in the long run. Along with these market challenges, the airline also experienced internal power outage glitch earlier this month that resulted in hundreds of cancelled flights, further raising investors’ concern regarding the capacity and traffic growth for the quarter.

Delta Air Lines experienced technical computer power outage on August 8 that resulted in over 2,100 flight cancellations. The airline managed to recover from the issue, but it took more than three days to fully recover to normal flight operations. The loss of business from flight cancellation and added expenses to resolve the issue, are expected to dent the airline's third quarter earnings.

Based on these internal and external events, it would be a challenge for Delta Air Lines to maintain its lead in capacity and traffic as compared to United Airlines that continued its flight operations normally during the period. Comparison of the estimated third-quarter capacity of both airlines reveals that they estimate almost similar growth in capacity during the quarter. However, power outage might drag down Delta’s traffic and capacity, giving United an edge over its rival.

With the aim to offset the potential decline in its capacity and traffic, Delta Air Lines has been introducing new flight operations to various international and domestic routes since its second quarter earnings release. US Department of Transportation seems to be supporting airlines to sustain growth in capacity by approving flight operations from US to Japan and Cuba. However, it is still unclear whether these new flight operations will offset the potential reduction in capacity.

Conclusion

Delta Air Lines seems to be facing tough challenges, both in the market and within the company. However, it is expected to pass through this phase by adding and restructuring its flight operations. Furthermore, the airline is also changing its aircraft fleet acquisition plan to meet the market demand and save on cash flow during difficult times. The airline might report reduced traffic during this quarter, but it will recover from this slump by current year-end.

#$DAL #$UAL

Department Store Rally: Bucking The Retail Trend In A Short Lived Respite?

Upbeat earnings from some U.S. department stores last week coupled with contradicting retail sales data raises important questions about future prospects of the industry

Last week, three major U.S. retailers, Nordstrom, Macy’s and Kohl’s, each reported upbeat second-quarter earnings, sparking optimism on Wall Street of a sooner-than-expected interest rate hike by the Fed.

The SPDR S&P Retail ETF spiked to a three-month high of $45.59 on August 11, the day the three retailers released quarterly earnings. Two months of solid jobs growth (labor market adding 547,000 workers in June and July) and supplementary gains in U.S. retail sales over that period perhaps made the positive earnings a bit predictable.

What was less predictable though was the latest data for July sales, released last Friday, that shows retail spending in the country landing flat over June versus an expectation of a 0.4% gain.

Notably, core retail sales which exclude spending on building materials, food, gasoline and autos, also remained flat for July against a 0.5% uptick registered in June. Beyond the triumph of second-quarter results, analysts — and perhaps department store retailers themselves — are wondering if they can indeed bank on a stable and growing retail spending environment in the country.

Taking Cues from Corporate Guidance

On paper at least, department store retailers seem to be bracing for a potentially rough ride. Macy’s — which reported a sixth consecutive quarter of declining same-store sales — re-iterated somber full-year earnings guidance ranging from $3.15 to $3.40 per share.

Same-store sales are still seen slipping 3% to 4% for the year.

While the company said it expects a better fourth quarter, the optimism stems mostly from an easier year-over-year comparison as well as aggressive store closures. Macy’s expects to reduce store count by closing around 100 poorly performing stores from its current total of 728.

Kohl’s, which also beat Wall Street’s earnings expectations for the second quarter, scaled back its full-year adjusted earnings guidance to a range of $3.8-$4 from a prior range of $4.05-$4.25.

Seattle-based Nordstrom was the standout performer after upgrading its full-year earnings outlook. Walking into the third quarter with "one of the best inventory positions" the company has had in recent years and other fruitful cost-cutting initiatives, the retailer is hoping to see its full-year earnings fall in the range of $2.6-$2.75 per share. Prior guidance had called for a range of $2.5-$2.7 per share.

Still, department store formats in general seem to be eyeing some trouble in the market ahead this year, a problem perhaps not shared by the broader retail industry at large evident by bolstered auto sales.

Amidst cheaper gasoline prices and increasing jobs, analysts believe the July slowdown in retail sales could be temporary. The upcoming ‘back-to-school’ season for example could kick off retail sales again — more so at discount brick-and-mortar retailers than at larger department store retailers.

Department Stores Have a Bigger Problem

At the heart of tumbling year-over-year revenues for companies such as Macy’s, Nordstrom and Kohl’s is a problem that is much bigger than the swinging holistic retail industry momentum. While a surge in general consumer spending in the second quarter would have played a significant role in buoying earnings results for these companies, tagging their long-term prospects with the retail industry momentum could be an error.

Market share for companies such as Macy’s and JC Penney is being sandwiched between fast growing online retailers such as Amazon on one end and on the other by heavy discount retailers that still benefit from seasonal shopping trends like the upcoming ‘back-to-school’ shopping frenzy. Amazon, which reported results last month, managed to beat revenue and earnings estimates; it posted a fifth consecutive quarter of profitability.

Dissecting the flat U.S. retail sales data for July shows matching trends; while non-store sales — largely comprising online sales — spiked 1.3% during the month, sales at department stores slipped 0.5%.

As department store sales remain pressed, U.S. retail spending will likely continue to be propelled by sales at other format retailers, food services and auto sales. That signals an impending need for department stores to do more to regain their market share than just bank on healthy broader industry sales data.

#$M

GE Power Faces Disproportionate Burden

The company’s decision to return to its industrial roots has put focus on the power segment to deliver gains

In only a few years, General Electric Company (GE) has transformed from a highly diversified conglomerate to a leaner entity focused on its industrial roots. The company has shed GE Capital assets worth $192 billion and divested the appliance business. But the stock has gained only 0.6% in 2016, underperforming the S&P 500 index, which has risen 5.75% during the same period.

Second-quarter earnings saw revenue for the industrial segment grow 7% year-over-year to $28.6 billion. The company’s power business was the prime pick, posting a 31% increase while the oil & gas segment declined 22%.

Power Leading the Way

GE Oil & Gas and Transportation faced major cyclical headwinds while Aviation posted lower growth than the power segment in the second quarter with flattening margins. GE’s power business expects annual demand for turbines more powerful than 30 megawatts (MW) to fall in the 50-55 Gigawatts (GW) range, and its 33% market share in H-class turbines is expected to rise to 50% within the next five years.

Demand for Heavy Duty Gas Turbines (HDGT) is expected to gain in the second half of the year, supported by strong U.S. demand amid the shift from coal-powered plants to natural gas. The US Energy Protection Agency (EPA) has been promoting the use of natural-gas instead of coal to help reduce pollution levels in the country.

According to the latest Long-Term Reliability Assessment (LTRA) report, natural gas generation is projected to rise 10% or add 42 GW by 2019. The retirement of coal plants is expected to move at the same pace as gas plants. J.P. Morgan has suggested coal plants generating a combined 55 GW of electricity will be shut down by 2020.

Demand for gas turbines is expected to decline or remain flat in Europe and China because of economic conditions. The firm expects sales of GE's gas turbines in the Middle East to disappoint as the region continues to rely on oil for energy needs.

Recent Contracts Provide Wiggle Room

General Electric acquired Alstom Power for $10 billion in November last year, and the latter’s backlog has grown by $2 billion since. Second quarter earnings suggest the unit will help create synergies worth $100 million in 2016.

The recent acquisition of Doosan’s heat recovery steam generator (HRSG) business is expected to help the power business meet growing demand for combined-cycle plant solutions.

The company signed a deal with the Iraqi government in January this year, which involves the provision of equipment and servicing to add 1,000 Megawatts to the national grid against the nation’s payment of $328 million.

Coal Power is Hanging On

A recent Wall Street Journal article suggests that GE is again partial to coal plants despite having painted a bleak future of the fossil fuel for years. The article added that top company officials have said it may be able to scrape out decades worth of profits from existing plants following nominal upgrades.

The company nearly doubled the number of overall coal plants after the Alstom deal, and seeks to establish more of these in developing Southeast Asian economies. GE Steam Power Systems chief Andreas Lusch said: “We expect a quite-stable if not increasing amount of installations in coal.” He added: “They are as hungry for energy as we were probably 40 or 50 years ago, and do not have this mind-set to say we want everything to be renewable.”

According to Energy Information Administration statistics released in May this year, electricity produced by coal in 2040 is expected to be 23% higher than in 2012.

Gas Turbines are “Razor-Razorblade” Business

With gas turbine sales on the rise, GE has built a significant backlog in revenue attached to services, which have to be performed frequently for optimum function. The arrangement is usually in the form of a long-term service agreement (LTSA) at the time of sale. JPMorgan analyst Stephen Tusa suggests full-fledged service and replacement of parts can cost as much as $15 million per turbine.

GE Power Digital Solutions is another area poised to empower the company’s renewed focus on energy. The business is aimed at giving more control to customers and help increase efficient and sustainable power generation through improved data analytics. The effort is part of GE’s approach to lead the Industrial Internet of Things (IIOT), and the company has stated that the business is the largest contributor to its overall $5 billion digital portfolio.

As GE tries to set itself apart from peers using superior technology, it will increasingly have to lean on growth in the power segment to boost company-wide sales and profit. That means GE Power may feel a considerable amount of pressure to keep the growth machine churning.

#$GE

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