Best Pharmaceuticals and Biotech Analyst, Ian Hunter, Goodbody
In a year when drug pricing, the US presidential election and Medicare/Medicaid issues were concerns for the industry over the first eight months, it was company-specific newsflow in the latter half of 2004 that instigated the greatest share price movements. Drug withdrawals, FDA safety reviews and pipeline setbacks saw larger pharmaceutical companies taking a hit, setting the sentiment for the sector moving into 2005.
The biotech sector fared better in 2004. Given the stock-specific nature of newsflow, 2004 was characterised by super-normal gains and losses. The winners were undoubtedly Elan (+288 per cent) and Biogen (+67.3 per cent) on the back of the accelerated approval of Tysabri.
It is tempting to see current pharma prices as cheap and, therefore, the sector undervalued. However, greater visibility on sustainable growth is required to merit any sector upward re-rating. Currently, there is no sign of that visibility in 2005. The sector will continue to be dogged by the threat of patent expiry, generic challenge, safety concerns and pricing pressures, with only the catalyst of pipeline potential as a counterbalance.
Individual companies will, however, continue to perform well, driven by stock-specific issues, making 2005 a year for stock picking rather than general sector exposure. Momentum will continue in the drug wholesale and contract research sectors, although it may be difficult to maintain share price appreciation at 2004 levels.
Few blockbuster drugs come off patent in 2005, but from 2006 onwards the pace will pick up. Unfortunately, there is little sign of the industry producing new blockbuster drugs to fill the gaps. The only drug with such potential approved in 2004 was Elan/Biogen Idec’s Tysabri, which augurs well for those individual companies, but gives little comfort to the large cap pharma companies with blockbuster drugs under threat.
With the generic threat in mind, pipeline potential will remain a key issue in 2005. Even early-stage advances will be rewarded by the market as it looks for longer-term potential. The companies best positioned in the short-term are Pfizer and Eli Lilly. Those with greater long-term potential include GlaxoSmithkline, Sanofi-Synthelabo and Roche.
2005 is going to be a harder challenge for Elan than 2004, with the requirement to deliver on market expectations for Tysabri. Pipeline progress has also to be maintained against Crohn’s, rheumatoid arthritis and Alzheimer’s. United Drug enters 2005 on a relatively expensive rating compared to peers. However, the business has been a trusty performer over the past 20 years and there are no apparent barriers to continued business momentum in 2005.
Icon’s 2005 performance hinges on maintaining a sustainable level of net new business wins (over $100 million) and bringing the laboratory back into profitability. For Trinity Biotech, the company now has to deliver increased revenues (improving margins) and show marked impact of the Unigold HIV test in the US, from its established cost base.
Best Technology Analyst, Gerry Hennigan, Goodbody
Looking ahead for the technology sector we expect much of the pattern of 2004 to be replicated in 2005. Last year the Nasdaq was up eight per cent, though that performance masked a 15 per cent rise in Q4. Issues that warrant attention include: (i) corporate spending patterns; (ii) the strength of consumer spending; (iii) currency fluctuation and; (iv) seasonality.
Industry surveys on corporate spending continue to suggest low to mid-single digit growth, marginally ahead of 2003 (c. two per cent). While stability in terms of corporate spending does appear to be in evidence, a new wave of innovation is required to re-ignite stronger growth. On the consumer side of the equation, demand continues to be steadier, although concerns exist regarding its sustainability, in view of the low savings rate, particularly in the US.
Given such an outlook one could ask why then is the sector trading at a premium to its long-term average of 130 per cent relative to the S&P as a whole (currently closer to 140 per cent). Much of the explanation, in our view, lies in currency trends and seasonality. Dollar weakness coincided with upward movements in the Nasdaq both in 2003 and 2004. While that could well be coincidental there is a rationale for the move.
Technology companies typically sell globally and thus for those that report in dollars, but have a significant source of revenue that is not dollar denominated, dollar weakness results in a positive translation effect.
Assuming a cost base that is also biased towards the dollar, confidence in the ability of technology companies to meet earnings forecasts increases, which, in turn, is positive for share prices.
Seasonality is also a factor and is generally most pronounced in small-cap software and less so in large-cap hardware. The reason largely lies in the fact that large-caps have more mature, diversified revenue streams.
The trend, however, is for the sector to outperform in Q4 and underperform in the first half and we expect that pattern to repeat in 2005.
An innovative, high growth environment tends to favour smaller vendors but as there is limited evidence to suggest that an obvious catalyst for such a turnaround is imminent we expect he current environment to continue to favour the large-caps. That is not to suggest that smaller caps cannot grow in the current market.
Indeed, many of the indigenous companies under our remit have seen significant share price appreciation over the recent past. While some have benefited from stock-specific factors - ‘chip and pin’ adoption in the UK (Trintech), valuation and exposure to Ireland (Horizon) - most enjoy strong market share in niche markets and have been able to consolidate or grow that position.
All have undergone significant re-structuring and re-trenched to their core markets and some are starting to grow again, Trintech and Horizon, being the standouts.
Best Resources Analyst, Job Langbroek, Davy
Last year saw significant gains in the price of oil, base metals and industrial commodities in general. Although a weaker US dollar played a part, a large element of this price response was due to underlying strong demand and supply tightness which, in many cases, resulted in major inventory reductions.
As we look ahead to 2005 many of these factors will still be present. Far East industrial growth, led by China, may ameliorate but is still likely to be a cornerstone of demand for commodities in general. Recent high contract prices for basic raw materials such as coal and iron ore are due to the demand coming from economies that are industrialising rapidly. With regard to crude oil, Chinese demand now lags only behind the US. Chinese (and Indian) state oil companies are to be found globally looking to source oil and gas supplies.
Even if Chinese growth in consumption of oil during 2005 does not match 2004 levels, it is still likely to be a major part of the global growth in demand for crude. In short we see another year of solid demand for industrial commodities.
The supply side is an area of uncertainty. After years of under-investment in primary production, arguably both in oil and industrial commodities, the result has been a lack of spare capacity. This certainly played an important role in pushing prices to the levels seen in 2004. Higher prices will inevitably pull in more supply and there may be specific commodities that will revert to an oversupply situation and see inventories rebuild. In general supply side issues will not support commodity prices in 2005 to the same extent that they did in 2004.
One part of the equation that is difficult to predict is the role short-term investment money, sometimes called hedge funds, will play in pricing. Their role has tended to reinforce price momentum but with prices much more up with events than a year earlier, their impact may be to make the market more volatile rather than push it in any one direction. Overall, our sense is that 2005 is unlikely to result in price increases anywhere close to 2004. Instead, while we believe average commodity prices should still move ahead, any gains are likely to be no more than single digit increases.
Looking specifically at crude oil and a couple of headline metals, a good marker for the baseline oil price in 2005 is the recent comment by the Saudi’s that they believe US$33/$34 is a fair return to producers. However we believe strong Far East demand and political uncertainty will add a premium to this level. Consequently we see oil prices trading in a US$35 to US$40 range for 2005. Gold will inversely track the fortunes of the US dollar while copper prices will require very strong demand to remain at current levels.
Best Hotel and Leisure, Mid-cap, Media and Telecoms Analyst,
Neil Clifford – Goodbody.
Following the de-listing of Gresham Hotel Group from the Irish market during 2004, the Irish Hotel and Leisure sector is now defined by just two companies, Jurys Doyle and Paddy Power, which really have very little in common with each other outside of a very promising UK development strategy.
In relation to Jurys Doyle, while the share prices of most UK hotel companies performed strongly during 2004, up by 24 per cent, the share price of Jurys Doyle really only rallied during the final two months of the year to finish in line with the overall sector. Improving revenues per available room in the UK, specifically in the London market, were the key driver for the sector and while Jurys’ hotels participated fully in the UK recovery, the weak performance of its four-star hotels in Ireland held back the share price for most of the year.
What has driven the strong rally in the share price in more recent months has, in our view, been increasing optimism about the company’s plans to re-engineer/redevelop several of its Irish hotels. The company has already initiated this process with its Jurys Cork hotel and the expectation is that the Dublin hotels will become the next area of focus during 2005. The outcome of this process will, in our view, be a key driver of the performance of the shares in the coming year as it will not only lead to better margins in Ireland in the longer term but may also result in a significant release of capital which is likely to be re-invested in accelerating the roll-out of its higher margin Inns product in the UK. A further update in relation to this process is likely when the company reports full year results at the end of February but given the strong run in the share price the market appears to be expecting something quite significant.
Gaming stocks had a more mixed performance during 2004, with the pure bookmaking stocks, Paddy Power and William Hill, delivering the strongest share price performances, up 51 per cent and 31 per cent respectively. The share price performances of the casino operators, Stanley Leisure and Rank, were unimpressive, largely due to the disappointing amendments that were made to the Gambling Bill towards the end of the year.
Looking ahead, now that UK deregulation looks like it will deliver a lot less for casino operators, we believe that Paddy Power offers investors the most potential upside of all the UK gaming stocks given the quality of its earnings growth, the potential to accelerate growth and the relatively good prospects for some form of capital return. While we believe the current share price is up with events at this stage, we see the full year results in late February as being the next most likely date for us to revisit our forecasts. At that stage, we expect better visibility on the UK roll-out for the coming year and more clarity on the opportunities that may arise from deregulation of the gambling industry in the UK.
Best Food Analyst, John O’Reilly, Davy
Since the Irish food sector in its current form re-appeared on the stock market (only Fyffes’ listing pre-dates 1986), there has been a revolution in the strategies of the participating companies. This shift in emphasis means that issues which fundamentally affect strategies and performance have changed. No longer are EU related issues the dominant issue though they still matter to some degree (for example, forthcoming reforms of the EU sugar and banana regimes).
They have been replaced by other issues of strategic import which include: consolidation in the retail and food manufacturing sectors; whether output is own or retail branded; whether retail sector winners (Tesco) or losers (M&S, Sainsbury) are critical customers; whether products are in slow or fast growing or mature categories; whether companies have deep understanding of consumer wants and have recognised strategies and product development capabilities to feature in potentially strong growing emerging categories, the chief of which are in the healthier, wellness, better-for-you space?
We are on the cusp of a big change in eating habits, to one that is consistent with disease or illness avoidance and prevention and which is not exemptionalist; i.e. it does not presume that drugs will provide a solution to health problems that originate in bad food (we should rid ourselves of the idea that there are no bad foods, only bad diets!) The corollary may be that if they have not, they may struggle, however good their current rate of growth is.
After all, aggregate food demand in developed countries rises by only 1-2 per cent per year, not enough of itself to produce the earnings growth of a well perceived, well regarded or highly rated company.
Short-term issues like currency changes and increasing energy and other costs must be watched for their potential impact on earnings.
In this report last year it was noted how operationally sound the food sector is now, sounder than at any time since its re-appearance as a market subset in 1986. Since last year it has expanded with the listing of C&C. There is now a good universe of stocks with different strategies and consequent performance potential to satisfy investor preferences, whether this be for growth or for yield or return based on a combination of these.
Runner-up Best Mid-cap Analyst, John Sheehan, NCB
Irish mid-cap stocks delivered another strong performance for investors in 2004, comfortably outperforming the larger cap constituents of the index. Stocks in the 0.3bn-2bn range notching up eye-catching gains during the year included Heiton (+71 per cent), Kingspan (+68 per cent), DCC (+53 per cent), United Drug (+51 per cent), Paddy Power (+51 per cent), Grafton (+49 per cent), McInerney (+39 per cent) and IAWS (+26 per cent).
Given the diversity of the above grouping it is clearly not a sectoral trend which is at play. Equally, it is not a pure Irish story, given that some of the above companies derive in excess of 50 per cent of earnings from the UK market. Instead, the common theme is that all companies have a well-established record of delivering strong earnings and high returns on capital. In recent years the market has chosen to reward this with a higher rating than achieved in the past, resulting in a win-win outcome for investors as continued earnings progression is complemented by multiple expansion to produce impressive stock price appreciation. Corporate activity has also been a factor in certain instances, with the past year seeing the takeout of companies including Warner Chilcott, Heiton and Barlo, each at a significant premium to the pre bid price.
Looking to 2005 we believe that the mid cap segment of the market will again offer scope for returns at least in line with the larger capitalised stocks. Economies are, in general, growing and business models remain robust. Grafton’s acquisition of Heiton will, we expect, provide significant operating and purchasing benefits to the enlarged Group over the next two to three years, while the UK market offers scope for further consolidation. Moves further afield can also be expected over time. IAWS continues the expansion of its specialist bakery business and the recent Groupe Hubert deal in France will provide significant medium-term development potential. DCC’s recent purchase of Shell Direct in the UK represents a significant potential opportunity for expansion in oil distribution in that market, and United Drug has also shown its ability to capitalise on the inexorable rise of drug spending in Ireland. We expect this to continue.
The earnings outlook for the mid-cap sector therefore remains strong and underpins current valuations. Delivery on earnings targets is essential and disappointments would be severely punished given the higher level of expectation implied by current stock prices. We believe there remains some limited scope for a selective further re-rating of these stocks as their greater size and generally improved liquidity opens up an increasing investor base. The weight of money in buyout equity funds also means that opportunities undervalued by the public market become the target of private equity. The private equity market was also the source of two additions to the mid cap universe during 2004, eircom and C&C, the stock prices of which performed well after indifferent starts. Overall, we believe that the sector will again offer an attractive opportunity for investors, though with returns at more modest levels than those achieved in 2003 and 2004.
Best Financials Analyst, Seamus Murphy, Merrion
The Irish financial sector recorded a very strong share price performance in 2004, delivering a c. 16 per cent return. This compares to an eight per cent return from the European Financial 300 index. However, 2004 was a bumpy ride, with significant volatility within this return profile.
Apart from an improved mix effect, downward pressure on spreads is likely to again be a feature as we move into 2005. In particular, we are more bearish on the sustainability of mortgage returns than other areas of the market.
So how do we stand as we look into 2005? We believe a number of factors are important:
Earnings momentum still positive: Irish GNP growth revisions remain positive and operating upgrades (rather than downgrades) for the sector are therefore still more likely in 2005.
International Financial Reporting Standards (IFRS): All European listed companies must report under IFRS from January 1st 2005. We estimate that Bank of Ireland may be negatively influenced in EPS terms by c. nine per cent relative to AIB. Furthermore, the net asset value (NAV) of Anglo Irish Bank may rise c. 15 per cent. Irish Life & Permanent may be influenced the greatest, as its earnings may decline by between c. eight per cent and 22 per cent, whilst its EV may fall by between 17 per cent - 20 per cent. Whilst the cash flows don’t change, the ability to compare performance should be more uniform.
Property market: The greatest threat to the Irish banks’ valuations, in our view, remains the prospect of a sharp correction in the domestic property market. Volumes and asset price growth continue to be supported by negative real interest rates, and high availability of liquidity. Tempering this inherent long term bearish assessment is the prospect that Euro interest rates remain low for a longer period than we previously assumed. Therefore, volumes may again prove more resilient in 2005 than we currently assume.
Valuations: The Irish bank sector now trades at close to its five year high in terms of its price-earnings (P/E) rating relative to its Euro and UK peers. This would appear to suggest that a further relative P/E re-rating from here is less likely. However, when compared to bond yields the overall UK, European and Irish bank sectors still appear very attractive. Furthermore, if we review the movement in bond yields since the late 1990s, the P/E ratio of financial stocks has contracted as bond yields have fallen. This is an apparent anomaly.
In our view, this divergence reflects increased concerns on the property market as an increased risk premium is incorporated in Irish and global financial to reflect this ‘excess liquidity’ issue. Therefore, unlike the mid to late 1990s, when Irish banks were afforded P/E ratings of up to 18x, current P/E ratings, in our view, are likely to remain closer to their historic low double digit averages as this risk premium is maintained. We therefore believe that earnings growth and upgrades will be the key drivers of share price performance in 2005. With this in mind, Anglo Irish Bank and Allied Irish Bank may offer the greatest returns again in 2005.
Best Media Analyst, Neil Clifford, Goodbody
While the share price performance of European media stocks performed broadly in line with the overall European market throughout 2004, the two Irish media stocks, Independent News & Media (INM) and UTV, continued to deliver strong performances during the year, with the share prices of both up by 21 per cent and 16 per cent respectively, compared to a six per cent increase in the European media sector. Although the two companies are very different in terms of media focus and geographic exposure, the improving economic outlook in Ireland and market share gains in the UK have been two common themes which have helped to drive the share price performance of both stocks during 2004, in our view. Looking ahead, we expect the same two themes to dominate the share price performance of the two companies and further outperformance of the sector during 2005 looks likely.
In relation to IN&M, the company has entered a unique period in its cycle where all of its operations are performing strongly. While the group’s Southern Hemisphere operations have continued to deliver strong growth over the last two years, the Irish and UK operations are now beginning to drive the overall performance of the group, due to an improving advertising market in Ireland and the ongoing success of the compact in the UK. Current valuation ratings do not look overly expensive to us relative to the sector and over the next 12 months IN&M’s share price should be capable of growing in line with earnings, which are currently forecasted to grow by 15 per cent during 2005. The dividend yield of almost 3.7 per cent, which is one of the most generous in the European media sector, is an added attraction.
We expect UTV to deliver another strong year of growth during 2005, boosted by strong growth in television and radio advertising in the Republic of Ireland and further growth in its share of the ITV advertising market. While a further expansion of current valuation multiples looks less likely in the near-term, the current rating looks well underpinned given the group’s outlook for growth and the medium term prospect that the company (or at least its television business) will be eventually acquired by ITV plc. As a result, share price appreciation in line with earnings growth of 10 per cent per annum over the next two years is a reasonable expectation based on current forecasts.
Best Building Materials, Robert Eason, Goodbody
The global building materials sector recorded another year of strong double-digit growth in 2004 with the European and US indices up 29 per cent and 27 per cent respectively. As in 2003, the building materials sector performance once again outpaced that of the wider market, which was up c. nine per cent. A key driver of this performance was the robustness of forecasts during the year with targets remaining largely unchanged, whereas downgrades were the norm in 2003. Furthermore, in upcoming results for 2004 we expect the sector to deliver on market forecasts for a return to strong growth (10-15 per cent), reflecting relatively healthy market conditions and weak year-on-year comparatives (particularly in the first half of the year), which helped to offset higher input costs, especially energy.
Another year of outperformance by the global building material sector could prove difficult given that the relative rating of the sector vis-?-vis the underlying market is above historical averages and a rising interest rate environment has in the past led to the sector underperforming the general market. At a macro level some of the other key issues for the sector in 2005 are the following: (i) the sustainability of residential activity levels in certain markets, especially in the US; (ii) after a return to growth in 2004 (2.0 per cent versus 0.4 per cent in 2003), can European construction markets maintain this momentum into the current year? (iii) the adverse translation impact of a strong euro (particularly against the US dollar) on profits; and (iv) the need to continue to increase product prices to cover higher input costs (for example, energy, steel, and cement).
Against the above backdrop we believe the investment strategy during 2005 will move from being a general sector decision to stock-specific choices, with a particular focus on quality. In this regard we believe the Irish building materials sector is well placed to outperform its peers, given the following factors: (i) their exposure to Ireland which is set to be one of the strongest European economies; (ii) strong balance sheet positions, which leaves plenty of scope for the companies to continue taking advantage of growth opportunities; and (iii) the track record of the Irish companies in terms of superior return generation and earnings growth. As a result we believe CRH / Grafton / Kingspan are all well placed to perform strongly in 2005. While Readymix is in for another difficult year with earnings under pressure due to price competition in the Irish concrete market, the share price is likely to be supported by ongoing speculation over corporate activity.
Best Airlines Analyst, Joe Gill, Goodbody
Investing in airlines. It’s not like traveling first class on an inter-continental jet. Imagine instead you are strapped into a biplane with an open air cockpit and a dodgy propeller engine that is entering a storm front. It’s that mix of fear and excitement that attracts wannabe risk takers and deters those with more sober souls to stockmarket-quoted airlines.
Today, I could provide a raft of analyst’s notes pointing out a variety of things that will happen during 2005 in the airline industry which in turn will drive their earnings forecasts on top of which you apply ever-more esoteric valuation multiples to derive share price targets. Pick the ones with the largest upside and commit. Simple, right? Not really. Airlines offer one of the most operationally leveraged business models in the marketplace while competing in a notoriously volatile industry. Couple that to a large number of executive management teams who tend to sacrifice shareholder value on the altar of scale up and new aircraft orders. As a global sector, it offers few real opportunities for the fundamental investors. Worldwide, there are just four airlines we would put Granny’s pension into.
Those carriers are Southwest in the US, GoL in Brazil, Air Asia in Malaysia and Ryanair in Europe. Why ? Because each of them stick rigidly to the killer principle in the commercial aviation industry - only lowest unit costs wins. All of them are committed to minimising distribution costs (via the web), utilising flexible and highly productive work practices for cabin and cockpit crew while deploying the most advanced and efficient aircraft platforms available. By lashing that package to strong balance sheets, they can defend and attack successfully in their respective marketplaces. All of them are thriving. The oldest, Southwest, seems on the brink of further major advances in the US mid-west and mid-atlantic regions as it assaults the home markets of large but crippled carriers such as United Airlines and US Airways. The youngest, GoL, has moved to deploy the same size aircraft as Ryanair while correctly targeting bus and car traffic as a key opportunity. Its domestic competitors have weak finances, aging fleets and state-driven work practices. Railroad infrastructure is thin in Brazil.
That all provides a valuable opportunity for a well-funded and tightly managed carrier. Our other pick is Air Asia. It is currently transiting from an all Boeing to all Airbus fleet while maintaining a zealous focus on costs. It is targeting growth in the most densely populated regions of the world and equipped with this new aircraft order it holds first-mover advantage. It is also cutting a variety of deals designed to facilitate growth around tricky bi-lateral restrictions in the region. In Europe, Ryanair stays on track to sustain its industry-highest margins while growing scale. More importantly, the unit cost gap between it and all its competitors has been maintained and in a number of cases widened during 2004. That provides a platform for more profitable expansion without compromising on margin. If you stick to these carriers through thick and thin they can generate returns that exceed not just the airline sector, but the overall market. |
