Thursday, September 27, 2007



Conclusion: We are raising our 3Q07 global handset forecast by 7% to 300 million units driven by upside at Nokia and Samsung over the course of the quarter that
also appears to be driving strong order momentum into 4Q07.
What's New: We met with industry contacts at 52 companies in Asia over the past two weeks, spanning semiconductors, handset components, EMS, and component distribution.
Component Implications: We reiterate our Overweight ratings on Skyworks and OmniVision and are raising our above-consensus estimates for both companies as our
checks indicate fundamentals are accelerating faster than we expected. We are also incrementally more positive on RFMD (upgraded to Equal-weight on 8/24/2007) as Nokia demand appears to be driving near-term upside to estimates and the company appears to be preparing for a much larger Nokia transceiver ramp than we were  modeling.
Handset Vendor Implications: Our colleagues are upgrading Nokia to Overweight from Underweight as they see 15% upside to 2H07 consensus EPS driven by higher than expected volumes led by a ramp at the mid-to-high-end, increased market share and new product introductions continuing to stabilize ASPs resulting in margin and revenue outperformance. Our colleagues who cover Motorola are reducing 3Q07 and 4Q07 unit estimates as they see a slower than expected recovery.


Estimates Appear High for Q3 2007:

Our earnings forecast for Independent R&M companies’ declines by 10% with today’s revision. Our estimates were 15% but are now 20% below consensus for Q3 2007. We are maintaining financial projections for 2008-2009 and under normal conditions.
Straw Hats in Winter Seasonal Trade Ahead?
Margins in refining, financial projections in R&M and investor sentiment typically declines during the 2nd half of each year, setting up the seasonal trade. With performance of R&M stocks superior during December to May in 15 of 18 years, we prepare for “Straw Hats in Winter”.
Constructive Outlook Remains For 2008-2010:
Margins are likely to remain near record levels during 2008-2010. Global growth in supply of “light-products” will modestly outpace that of demand, but global utilization rates and margins will remain unusually high, in our view.
Maintain In-Line on R&M Sector:
While earnings estimates appear high for 2007, financial conditions in refining will remain positive thorough the end of the decade. Valuation appears attractive on
normalized conditions, with select equities representing attractive value over the longer-term.
Overweight Stocks: VLO, SUN, TSO, COP, MRO, and XOM: Our price objectives are VLO - $90/sh., TSO - $66, SUN - $95/sh. COP - $105/sh., MRO - $75/sh., and
XOM - $96/sh.,


Positive power price trend to continue: CEZ, EDF, IPR and SSE all explained that investment needs and sustainable high costs for power plant technology, fuel and CO2 emission certificates should continue to support higher power prices. We forecast that prices in Europe will increase by around 10%, to around EUR 60/MWh, over the next few years. This should continue to benefit European generators, especially the nuclear and hydro based generators like EDF, British Energy and Fortum.
Growth strategies: Many companies mentioned organic growth opportunities in the construction of new power plants and regional expansion not only in Europe
but also in the US, South America, Asia and South Africa. IPR’s growth pipeline offers one of the most clear-cut growth opportunities in our view. Regulated
utilities like Severn Trent, Terna and Snam Rete Gas see scope for growth in the expansion of their asset base and cost savings. The reinvestment of cash and
value that this can create will be an increasing focus over the next year in our view.
Renewable energies gaining attention: Utilities like IPR, SSE, EDP and CEZ all stressed their renewable plans. Some are more advanced than others — and
after major acquisitions in the last year we believe that IPR and EDP will move to a more organic development focus from now on. The major challenges to the
execution of a renewables strategy are finding the appropriate project and location, securing the relevant government approvals and sourcing the equipment in a
tight market. Nevertheless, an increased focus on renewable energy is a clear trend.
Our Key Overweight ratings are AEM, EDF, Centrica, International Power and Veolia.
Our Key Underweight ratings are PPC, United Utilities and Union Fenosa.


Volumes matter. After four years of declining volumes for the integrated oils, we see a resumption of growth between 2007 and 2009. It will be very unevenly dispersed between companies, and should act as a catalyst for performance.
It’s the declines that matter most. New projects are important, but the key is in the underlying declines. We separate out growth from decline and analyse our numbers and company targets in the context of realistic decline scenarios.

StatoilHydro, BG and Total stand out. The Norwegians look set for an outstanding year in 2008; BG is slowing down, but only slips to number two in the sector. Total has the highest growth rate of the larger companies, albeit it more risky than StatoilHydro and BG, and should show the greatest contrast with the last three years.
BP set to beat expectations by the most. BP has humble targets of just 1%. Our forecasts suggest 2% CAGR to 2009. We believe that the company has built in
aggressive underlying decline, and see up to 3% CAGR as viable.
Resuming coverage of StatoilHydro at Overweight. StatoilHydro replaces BG as our top pick in the sector, with 9% volume growth in 2008, the benefits of the merger and leverage to crude prices from a reasonable valuation base.
Integrated oils are 20-30% undervalued. We believe that the integrated oil sector is fundamentally undervalued. We expect a combination of continued earnings upgrades to both 2008 and longer term numbers, as well as a resumption of growth, to act as a catalyst for performance.

Citi: Food 4 Thoughts: China Wind Power Industry - Sexy Growth but Not Risk Free

Citigroup Asian Utility Research
China Wind Power Industry - Sexy Growth but Not Risk Free

New news:

* A Food-for-Thought Investor Luncheon Event — We hosted the event on 25 Sep 2007 with more than 70 investors discussing China Wind Energy with speakers: 1) Alex Tancock, general manager of a wind power consultant firm Wind Prospect (HK) with experience in the UK, Australia and China; and 2) Yuchuan Tian, managing director of Hong Kong Energy (Holdings) Ltd, the renewable energy arm of Hong Kong Construction (190 HK, NR).

* High growth potential — China is the fifth-largest global wind market with 1,700MW by end-2006. Wind Prospect forecasts this capacity will rise to 30,000MW by 2020, implying a CAGR of 23% pa. Most of the increment would be in Northeast China with high wind speed and large load.

* Tariffs setting to be a key Based on Wind Prospect, plants larger than 50MW are of limited profitability as they are granted on competitive biddings; but, projects smaller than 50MW each are determined at the local level, offering 5-12% project return, though PPAs are unlikely in place until after commissioning. Big projects are often broken up into 49.5MW each to avoid bidding.

* Risks — Key risks are (i) wind mast and data collection are rarely to global standards, (ii) data in feasibility report could be questionable, (iii) local entity may choose non-IEC compliant local turbines, (iv) delayed completion, (v) problems in grid connection and (vi) uncertain tariffs before completion.

* Rewards — Key rewards are (i) projects could be built quickly, (ii) less uncertainty after getting local government support, (iii) huge market in China, (iv) possible equipment cost cut once domestic manufacturers are familiar with them, and (iv) extra profit from CDM and carbon credits.

* Hong Kong Energy (Holdings) Ltd — It is an early bird in PRC wind power with one operational wind farm in Heilongjiang, with two more (in Hebei and Inner Mongolia) planned. They also invest in waste-to-energy and biofuel projects.

* Stock implications — PRC IPPs should invest more in wind power plants as the government requires those with over 5,000MW to have 8% of capacity from renewable energy. Among the five HK listed PRC IPPs, Huadian and CR Power have operational wind power plants and Datang has a farm under construction.


Global Economics : Priced for Perfection - Joachim Fels

Our latest estimate of fundamental fair value for 10-year US Treasury yields stands at 5.0%, based on our MSFAYRE model, still some 35 basis points above current 10-year yield levels. The model also tells us that the current 10-year yield of 4.65% is consistent with a fed funds rate of 4% and actual core inflation and inflation expectations a touch lower than they are now — in other words, bonds look to be currently priced for perfection.
We believe inflation expectations will respond to global pressures and dollar depreciation, pushing bond yields up. The Fed rate cut and a fall in actual and expected inflation have pulled our fair value estimate down by some 30 bp. Bond yields have risen some but should continue to rise further to their fair value of 5%. Why? Current economic conditions resemble a midcycle slowdown rather than a recession.
Our fair-value estimate suggests that Treasuries still look expensive, and we expect yields to rise towards their fair value in the next several quarters. Already, 10-year yields have priced in a fed funds rate of 4%, which would take the Fed to neutral according to estimates from our natural rate model. Being bullish on bonds at current levels then implies a hard landing for the US economy, with the Fed being forced to slash rates below neutral.

GEMS Equity Strategy : Multiple Expansion — Where Next? - Jonathan Garner
The next leg of the EM bull market will be driven largely by an expansion in multiples, we believe, in line with a rerating in global equities. For the most part in the rally since 2003, earnings growth has been a key driver of performance: On average, EPS growth has contributed 84% of the yearly price returns for the MSCI EM. We expect P/E expansion to assume a greater role in driving performance from here.
MSCI EM has already started to benefit from multiple expansion. China’s substantial re-rating has been a prime driver of the multiple expansion for the overall asset class. In the last 18 months, MSCI China’s trailing P/E increased by 125%. Russia, in contrast, has had the largest multiple contraction of the top eight markets. The multiple expansion of the MSCI EM as a whole in this period has been 16%. Countries that have the greatest potential for multiple expansion and that are overweighted in our country allocation model include Russia, Turkey, Hungary, Israel and Malaysia.
At the sector level, consumer discretionary, industrials and financials have re-rated the most this year. In contrast, EPS growth has been the primary driver of
performance in materials, energy and utilities. Those sectors which should benefit most from multiple expansion and which we continue to favour on a fundamental basis are energy and materials.
Historically, P/E expansion has been an important driver at this stage of the cycle. It should be all the more so in light of the recent reflationary actions by  central banks. These are intended to boost credit availability, but the short-term effect will also be to raise the price of real assets. The liquidity increase should quickly be intermediated into financial assets perceived to offer defensive growth, such as Asian and EM equities and oil, mining and industrial stocks. These measures add fuel to an EM bull market that was structurally intact, in our view.

Currencies : Demographic Trends and the Financial Markets - Stephen L. Jen
Demographic trends have important economic and financial implications. Without remedial action, global ageing in the developed world tends to raise the level of real interest rates, flatten the yield curves, benefit equities at the expense of bonds, and lower the value of the dollar.
Declining fertility and mortality rates. These two trends have been the primary factors behind the demographic trends (slow population growth and ageing structure) in much of the developed world. With the exception of China, much of the developing world is still enjoying a ‘demographic dividend,’ as their youth populations continue to grow rapidly.
Ageing exerts fiscal burdens that could lead to higher borrowing costs. The levels of real interest rates could be distorted by the lower potential growth rates, lower tax intake, and higher fiscal outlays associated with an ageing population.
Population ageing could also twist the shape of the yield curve. Notwithstanding the point above, decelerating potential growth rates imply higher short-term interest rates and lower long-term interest rates. Conversely, young and growing populations tend to bias the slope of the yield curve upward.
Ageing in the developed world may favour equities over bonds. While the popular notion among academics is that retirees prefer safe assets (i.e., bonds over equities), longevity risk could force retirees to take on more investment risk, as it already has in Japan. While pension funds still hold more bonds than equities, the share of the latter has been rising rapidly.
The US demographic trend is not friendly to the dollar.
Unless the US raises its savings rate at a faster pace than that of dis-saving by the rest of the world, a resurgence in its current-account deficit would not be good for the dollar.

US Economics - How Much More Work Does the Fed Have to Do? - Richard Berner

Fed officials left the door wide open to further easing last week but gave little guidance either on the economic outlook or on the path of monetary policy. Yet their intentions are clear: They will respond as needed to forestall downside risks to economic activity.
We expect another 50 bps of easing by early next year, with the Fed having “front-loaded” stimulus so far. Risks seem balanced around that baseline: The uncertain collateral damage from the housing downturn implies downside risks to rates. But the Fed could also do less, partly reflecting healing markets.
Expect weaker growth in earnings. Investors should continue to expect steeper yield curves, elevated volatility, a weak dollar, and weakening earnings growth. That backdrop may challenge equities. In my view, the jump in breakeven inflation so far signals the reflationary impact of policy on commodity prices, rather than a near-term inflation pickup.
Markets face three risks: Rising defaults may upset the benign outlook for both credit and equities. Inflation might fall faster than expected. Conversely, although the chance seems small, investors should consider that the economy could pick up sooner than expected.

Tuesday, September 18, 2007

Global DRAMs - Stay away until rationality returns

* Reduce exposure to DRAM stocks over the next 2-3 quarters

Given that the DRAM market is already rolling over in what should be a seasonally strong quarter, we believe the market environment will deteriorate further sequentially into 4Q07 and a seasonally weak 1H08.
That said, we advise investors to reduce exposure to DRAM stocks over the next 2-3 quarters. We downgraded Powerchip to Hold and ProMOS to Sell. We maintain Hold on SEC and Hynix.

* DRAM market has already peaked; capex discipline needed

As the DRAM market is unraveling again after a brief recovery during early 3Q07, we now expect CY07 DRAM ASPs to be down 46% YoY, exiting the year with new lows in terms of ASPs. We now forecast 4Q07 to be no longer in short supply with an excess of 0.2% vs. a 1.1% shortage previously. The poor DRAM market in CY07 is attributable to substantial capex-induced 91% YoY bit supply growth. In order to prevent another oversupply situation in CY08, the industry must reduce capex significantly. While we expect CY08F global DRAM capex to decline 12% YoY, capital intensity should remain high at 46%, not sufficient enough a cut to stave off the potential oversupply.

* CY08 likely to be another poor year for DRAMs

Therefore, we expect CY08 to be another weak year for DRAMs and forecast a DRAM ASP drop of 38% YoY with market oversupply of 4.4% compared to 6.3% in CY07. Also, we now forecast DRAM contract ASPs of US$1.80 (4Q07F), -13% QoQ, US$1.60 (1Q08F), -11% QoQ, and US$1.45 (2Q08F), and -9%QoQ before a slight recovery into 2H08F.

* A positive scenario is possible in CY08 though after severe pain early on

However, we believe that not everything is doom and gloom for CY08.
There is one potentially positive (or first pain then gain) scenario.
A drastic DRAM ASP collapse to below or near cash costs in early CY08 coule induce significant cutbacks in CY08 capex and accelerate the de-commissioning of "8" capacities, leading to a powerful supply-constraint-driven structural recovery into 2H08. In this scenario, a large capex cut/delay announcements should catalyze potential entry points into DRAM stocks.

* More competitive/diversified players should outperform weaker rivals

While we are cautious on all DRAM-related stocks, we believe some interesting pair trades are possible within the group. For example, we believe those with a competitive edge such as SEC and Hynix can outperform weaker rivals such as ProMOS (Sell; TWD 9.44) and Micron (NR; $11.00). SEC and Hynix's more diversified business mix should also provide a bit more cushioning during downturns. Risks to the upside/downside include memory chip capex, 8"de-commissioning, and global economic strength.



This time is not different - at least not in terms of the initial investor response to an unexpectedly aggressive Fed rate cut. But I'm not convinced that the Fed's move makes a material difference to the risk of recession, which is the decisive issue for medium-term investors. A few thoughts:
First, rate cuts are like tequila shots: You rarely have just one. Morgan Stanley US economist Richard Berner expects the FOMC to ease by a cumulative 100 basis points. The prospect is underlined by the second-round collapse in housing indicators. For example, Reality Trac reported overnight a substantial jump in housing foreclosures in August (Exhibit 1).
Second, equities usually perform well in the initial stages of a Fed easing cycle. Morgan Stanley European strategist Teun Draaisma has provided a nice summary of past equity performance around the first Fed cut (see Striking Statistics, 17 September). Teun notes that historically the first rate cut may only stabilize markets, while better returns follow the second easing. Rightly, however, Teun notes that it's not a stretch to argue that the discount rate cut was the first easing in this cycle.
Third, equities are a sell in extended Fed easing cycles. That's because extended easing cycles usually occur in recessions, and recessions are always bad for equities. But even within recession-driven bear markets, Fed rate cuts can provide a short-term boost for the market, particularly if they are unexpected. Amidst the TMT rout of 2000-03, the NASDAQ jumped 14% on the day of the first (surprise) Fed cut in 2001. Of course, in a bear market, it pays to sell such bounces.
With the daily run of economic data soft, but not providing compelling evidence of recession, my base case assumption is that the Fed easing will provide support for equities in the next quarter or so. For medium-term investors, however, the key issue remains simple: Is the US heading into recession?


Quick Comment: Hyundai M&F (HM&F) announced that it will inject an additional W25bn into its online auto insurance subsidiary, Hi-Car Direct. This is in-line with our expectation, and we expect an additional capital injection in the future if Hi-Car Direct continues to increase its market share.
What's New: Due to the nature of auto insurance business, it is inevitable that online auto insurers would require additional capital in their initial stages to maintain adequate capital levels and to help increase market share. Hi-Car Direct was established with initial capital of W20bn in Dec 2005 and since it began operations in Apr 2006, HM&F have injected additional W35bn in Sep 2006. Following today's announcement of W25bn, Hi-Car Direct's paid in capital will increase to W80bn and its solvency ratio will rise from 140% to 200% level.
Implications: Hi-Car Direct's market share is about 2% in total auto insurance market and 13.6% among online auto insurers closely catching up to no.2 player Daum Direct with about 15% market share. If Hi-Car Direct continues to increase it market share, we expect HM&F to inject an additional W20-30bn into Hi-Car Direct in the future.
Reiterate Overweight Rating: We believe recent share price weakness provides a good buying opportunity as we expect the company to continue to benefit from sector turnaround in auto insurance business and from its maturing high-yield guaranteed policies.


Quick Comment: Kookmin Bank has decided to sell a 5.1% stake in ING Life Korea (20/80 JV with ING Group) to ING Group sometime next week, which will lower Kookmin Bank's ownership to 14.9%. This transaction between KB and the ING Group had long been scheduled to occur this year.
Transaction Details: Out of 1,400,000 shares held, Kookmin Bank will sell 357,000 shares for W193.9bn (or W543,000 per share). These were bought at W11.6bn (or W32,417 per share) back in 1999. Currently, 5.1% of ING Life is booked at W31.8bn, suggesting the potential gain from the stake sale could amount to W162.1bn.
Impacts on Kookmin Bank: Even though this is a one-off event, we believe that the impact on Kookmin Bank will be big enough to attract attention, increasing the bank's 3Q07E earnings by 15.5%. In addition, 07E EPS and 07E BV could be raised by 3.7% and 0.7%, respectively, based on our analysis.
Kookmin's Book Value Understated by 2%: Kookmin will not mark-to-market its remaining 14.9% stake in ING Life Korea, as it has been classified as equity-method applied stocks. If we use W543,000 per share value for remaining shares, Kookmin's 07E BV could increase by 2.2%.

Another Disappointing Quarter Likely: Our channel checks indicate that, unlike other technology companies, Samsung SDI (SDI) is likely to report another weak result, even in seasonally strong 3Q07, on weaker volume growth and a higher start-up cost burden.
Maintain Underweight Rating: We expect the magnitude of the seasonal earnings recovery to be very disappointing due to competition with other display devices, such as TFT-LCD, the start-up cost burden from new production lines in PDP and AM OLED, and restructuring charges in CRT. We view anticipation of Samsung group's rescue plans for SDI, including possible business portfolio changes, as highly speculative in the near term. We maintain our Underweight rating on the stock.
·PDP (Better volume but no improvement in profitability): We now expect SDI's 3Q shipment volume to grow around 40% QoQ, higher than guidance for 30% sequential growth and our prior estimate of 30%. Our full-year shipment forecast of 3.2 million units is unchanged considering softer 4Q07 volume guidance. The company is guiding for mid-10% ASP erosion in 3Q07, on continuing pricing pressure from TV customers. We expect SDI to record a similar operating loss in 3Q on the initial ramp-up cost burden from the new P4 line and pricing pressure despite stronger volume growth.
·Mobile Display (Worse Mix): We expect overall volume shipment to meet the guidance of mid-10% sequential growth but actual revenue growth to remain flattish on a worse product mix (less TFT-LCD) and continuing pricing pressure. We expect the operating margin to remain at the mid-single-digit level in 3Q07.

4Q07 Eye on Asian Economies

We have just published our 4Q07 Eye on Asian Economies. As may be
guessed from the title: Apocalypse begins, changes in this quarter, are
typically downgrades. We have cut our projections for 2008 growth in all
but four countries. Across the ten Asia ex-Japan countries we forecast our
2008 growth forecasts are down 0.5ppts from the third quarter EoAE (our
Japan forecast has been cut 0.8ppts). For the same ten countries our 2008
GDP growth projections are 2.4ppts below consensus (we are 2% below
consensus for Japan in CY2008).

We have reinstated aggressive US rate cuts in our forecast, a decision
vindicated by the Fed’s 50bp cut on Tuesday. This creates the potential for
Asian rates to come down. However in a number of countries rates are
already so low, thanks to the liquidity inflows in the last two years, that it
is unrealistic to expect Asian central banks to match US cuts one for one.
On the contrary the reversal of these flows means that rate cuts in many
places will be limited (and we expect a small increase in T-Bill rates in the
Philippines). We see the greatest prospects for interest rate cuts in
Singapore and Hong Kong.
Last week’s Triple-A introduced the changes to our forecasts for the US, EU
Japan and China. Though there are few changes to our numbers for 2007 – a
sharp US slowdown has been in our forecast since the start of this year – the
scale of the credit unwind in the last quarter has caused us to move back the
point at which we expect the US economy to recover from 2H08 to 2H09. We
have made a similar change to our EU forecast, greatly moderated the upturn
we expect for 2008. Economic data have been softer than we expected in the
last quarter and the EU financial system is likely to be no less affected by the
credit and risk unwind than that of the US. Following the revision to 2Q GDP
Japan’s economy is already in reverse. Japanese cycles are short and we expect
a recovery to begin in 2H08. But this will be modest while other developed
markets are weak and, from an Asian perspective, Japan is not large enough to
act as an offset to weakness in the EU and US.

The absence so far of any meaningful slowdown in China has caused us to
increase our 2007 growth forecast to 11.5%; this implies no deceleration
compared with the second half of the year. For 2008 we have maintained our
expectation of 9% growth, with most of this front loaded into the first half
thanks to aggressive government infrastructure spending and the inevitable, but
temporary, boost to consumer spending that that will result from the Beijing Olympics. For the second half of the year we remain pessimistic about Chinese
growth. Its massive current account surplus (we estimate that the surplus will
be 12.1% of GDP this year) points to productive capacity having grown far
beyond domestic demand. This makes China vulnerable to a slowdown in its
external markets. And 23.5% of China’s exports go to the US with a further
22% to the EU. The 9% full year 2008 forecast implies a quite rapid
deceleration in the second half.

The Indian exception
The combination of weak US and EU demand throughout 2008, an anaemic
Japan and China slowing in the second half is a difficult one for most Asian
countries. The exception to the rule is India. Its economy is driven by domestic
forces. Growth in the second (calendar) quarter was stronger than we expected
thanks to robust performances from manufacturing, financial services and
community, social and personal services. The last of these is a category unique
to India and includes retailing and wholesaling. It accounts for 15% of GDP.
With finance and manufacturing also motoring ahead despite tighter monetary
conditions it is now difficult to see India recording less than 9% real growth in

We expect next year to be slower but India has a key advantage over China. Its
interest rates are much more appropriate relative to its trend rate of growth than
are those in the PRC. There has not, therefore, been the rapid overexpansion of
capacity that has ballooned out the Chinese current account surplus. While
global growth, liquidity and risk appetite has been abundant this difference has
been seen as an advantage for China allowing faster rates of investment, GDP
and asset price growth. But these have been achieved through an inadequate
discipline on investment. Indian businessmen have been kept on a much tighter
leash – the dependency on external demand to absorb incremental production
has not been developed and bad investments have been heavily discouraged.
India is an outperformer in our forecast; we expect GDP growth of 8.4% in
2008/09. By the end of 2008 this will make it the fastest growing economy in

Don’t rely on OPEC
Outside of India however conditions will be difficult. The slowdown we expect
in the EU and US will directly affect the order books of Asian manufacturers.
The electronics industry is likely to be especially badly hit. China at this point
will still be acting as an offset but a rather smaller one than the share it takes in
each country’s exports implies. Intra-industry trade, whereby materials and
parts are shipped to China, assembled and shipped to their final destination, has
muddied the issue. In some countries, most conspicuously Taiwan and Korea,
parts (as best we can judge) have been the largest source of export growth to
China. Slowing US demand will hit these countries via their Chinese order

Chinese growth in the first half is, however, likely to maintain demand for
commodities. In turn this suggests that demand for Asian goods from
commodity producers will remain firm. We see a more acute risk of falling
commodity prices in the second half of 2008 than the first. However, even
while Chinese demand remains strong, EU and US demand will be weakening
and rising risk aversion and contracting liquidity also suggests softer
commodity prices. In short we think that the peak has now passed for oil and
commodity prices and consequently for the export revenues of commodity
exporting countries. In Asia this has direct implications for Indonesia and,
especially, Malaysia but it also means that it is unwise to rely on current robust
exports to OPEC, Latin America and the CIS. Certainly such reliance flies in
the face of experience.
It is almost embarrassing putting Figure 1 into Triple-A again as it is a chart
that we have used repeatedly this year (most recently two weeks ago). It shows
which regions have driven extra-Asian export growth. We have included it
again because the high correlation of Asian export growth to all four trading
blocs – USA, EU, commodity producing countries and the rest of the world is
the clearest indication we know of why robust Asian exports to commodity
producers now is no indication that they will continue to act as an offset when
world growth slows.

A number of Pacific Rim countries showed robust domestic demand growth in
1H07. But we do not feel confident projecting that to continue in light of the
broad export slowdown implied by Figure 1. In some cases domestic spending
is weakening already. We believe that Korea’s consumer spending indicators
are looking tired and, though capital spending is stronger, we judge that it too
has passed its peak. Others will soften when the second round effects of a US
and EU slowdown develop. In the first half of this year Malaysia combined
decent consumer spending growth with lacklustre exports of goods. But this
says nothing about whether consumer spending can stay robust faced with falling exports of goods if commodity prices are also weakening (reversing
rural outperformance) and, thanks to falling oil prices, shrinking export receipts
are weakening Islamic banking’s primary market.

Soft domestic demand is the rule
But in truth more countries display fragile domestic demand stories than robust
ones meaning that a net export slowdown will bite directly. Taiwan is probably
the archetype here. Its domestic economy is weak and if electronics exports
slow growth will fall rapidly. Thailand is in the same position. Consumption
and investment are both presently soft and we are sceptical that a general
election will deliver the decisive result needed to support a rebound in
confidence and spending. Philippines consumption growth has been good. But
there is little capex and consumption is fragile, supported by a single – cyclical
– revenue source: overseas workers remittances. The downgrades to our extra-
Asian demand assumptions therefore imply cuts in our 2008 Asian growth
projections. Figure 2 shows the forecasts in the fourth quarter EoAE with the
3Q report for comparison.

Excluding India we have increased our 2008 growth projections in only one
country, Korea. This reflects the competitiveness gains that allowed it to live
with an appreciating won between 2003 and 2006. Our numbers for China and
Hong Kong remain unchanged. In all other countries we are less optimistic
about 2008 growth than we were three months ago.
The extent of the downgrade is broadly speaking a function of the openness of
the economy and the anticipated resilience of domestic demand. Hence
Malaysia and Singapore have received the biggest cuts in our forecasts because
these countries are most geared into world trade. Thailand and Indonesia
because weaknesses in their economies leave domestic demand vulnerable.

[GS] Commodities: Super spike framework remains intact. Raising WTC forecasts

GS GLOBAL OIL CALL => Raising WTI forecasts to $80 and $90 in 08/09; no signs of demand destruction
The core drivers of our "super spike" framework remain intact: spare capacity throughout the oil value chain remains limited, supply is struggling to grow, and demand growth continues.   (Note below conf call details with GS global commodities team)

What’s changed:
1) Higher WTI assumptions
- $67, $80, $90 per barrel in 07/08/09 (vs $65, $68, $68 before)
- $80, $75 per barrel in 2010/11 (vs $45 normalized before)
2) Higher normalized oil price assumptions
- Normalized oil price (in 2012 and beyond) pushed up to $50 (was $45) reflecting cost escalation

Reasons for the upgrade
1) Accelerating demand growth in 2007
- After two years of deceleration, demand growth has accelerated in 2007 despite oil prices at $60-70/bbl
- GS expects ~1.5m b/day per annum demand growth for the remainder of this decade
- Demand growth has been the strongest since 2004 in part because the y/y price inflation has been at the lowest level in three years.  Stable oil price ($60-$80 / bbl range) has stimulated demand growth, particularly in the US and China, despite a sluggish US economy in 2007. 

- Demand at the current price is likely more inelastic (The massive rise in energy prices from late 2004 to the summer of 2006 killed off excess discretionary demand and a large price increase is likely required to slow demand growth similar to the experience of 2005 and 2006).

2) Non OPEC supply growth remains challenged
- Non OPEC supply growth has continued to fall short of consensus expectations
- GS expects not more than 700k b/day non-OPEC supply growth per annum in the coming years
3) OPEC spare capacity at minimal levels
- As demand growth continues and non-OPEC supply falls short, expect rising dependence on OPEC to grow its production
- GS base-case assumes Saudi Arabia meets its 3% per annum production capacity growth targets
- Note all the super majors have been falling short of their own production growth targets 
4) No signs of demand destruction – subsidies suppress demand elasticity
- Key Reason: 2/3 of demand growth comes from emerging economies (China, India, Mideast) where prices are heavily subsidized

- Estimate tipping point for demand destruction is >US$130 (At that level, gasoline spend as % of income will be 7% - the level in early 80s when demand growth turned negative. Today gasoline spend as % of income is 4.5%)

5) Note slower US demand growth is already built into assumptions
- GS has already assumed incremental demand from the US falls from 370k bbl/day in 07, to 270k bbl/day in 08
- Even assuming the entire 270k bbl/day disappears (ie, ZERO demand growth), global oil demand growth is 1.1m bbl/day (instead of 1.4m bbl/day)

- Still significantly outstrips non-OPEC supply growth of only 700k bbl/day

Risks: Lower US demand if US goes into recession plus potential near-term Energy equities sell-off. GS thinks oil prices will remain firm because of tight global supply and strong demand from emerging markets. 

Traders' perspective Energy and gold remain the focal points of the commodity complex leading into todays FOMC - both creeping higher in a subdued trading environment yesterday.

Oil Early yesterday oil dropped on diminishing storm fears (Ingrid was downgraded) and flow on effects of jitters in other financial market but the dip was short lived ... option expiry explained much of the late rally and the 60 cent burst after the close (beyond $81, currently $81.14)) was also seen to be gamma scramble.

We're getting plenty of questions about the best way to play the crude market to the long side in the current environment - its actually a very easy question to answer and its well illustrated in the chart below. The crude forward curve is discounted (light blue line), implied vols are historically low (red line), lagging other asset classes and there is very little Call skew that you need to pay. Six and twelve month 105 and 110 Calls make good sense and price up attractively - ie. 6 month $85 (105% of spot) WTI Call is $2.25 per barrel or (2.75% of spot (spot WTI $81)).



Gold traded up to $718.75 from $711.00 (in Asia) on a spot basis yesterday and has held most of those gains in pre-FOMC trading. The positioning issue is slowly gaining a focus as the CFTC reports from Friday showed a 4m oz build which is 78% of its maximum positioning; up from 40% 2 months ago. The Northern Rock issue which was seen to contribute to a $10 spike in prices on Friday, lingers in the background. ETF demand is likely to continue and one senses that money market fears are not yet easing. The vol market was mostly unchanged yesterday, with some FOMC related upside Call interest. Theres been some good sized selling around in gold this morning that seemed to be triggered by a little-dip in the EUR (USD strength) - Tocom related profit taking also going through but the market is absorbing it well - down $1.50 from the New York close.



Asia Events - Singapore Trade, Taiwan Export Orders & RBA Governor Speech: We forecast Singapore's NODX growth to pick up further to 8.3% YoY, though downside risks to external demand could undermine export growth in late 2007 or early 2008. RBA Governor Stephens' comments are expected to reveal a hard-line attitude toward the market turmoil. See page 2 for details.
Asia Earnings - Agile Property, Fosun, China Coal, Henderson Land, Sino Land & Coles Group Results: Consensus EPS growth expectations for AP ex-Japan in 2007 and 2008 are 15.5%Y (vs. 15.1% last week) and 10.9%Y (the same as last week), respectively. Asia is trading on 16.4x 07 and 14.8x 08 consensus earnings estimates.
International Economic Events: FOMC & BOJ Rate Decisions, US CPI & Housing Data: We expect the Fed to cut rates by 25 bps, while the BOJ is likely to leave rates unchanged. US Housing Starts are expected to fall another 2.2% MoM to 1.35k. See page 3 for details.
International Earnings - US Investment Banks, Best Buy, Oracle, FedEx & General Mills Results: Consensus EPS growth expectations for the S&P 500 are 8.5%Y in 2007 and 11.7%Y in 2008. The S&P 500 is trading on 15.5x 07 and 13.9x 08 consensus estimates. See page 3 for details.
Market Performance - Equities Flat: Global equity markets were mixed last week, with the US up 0.4%, Europe down 0.4% and Japan down 2.9%. Asia-Pac ex-Japan was flat, with Hong Kong (+4.8%) outperforming, while Korea (-2.1%) and the Philippines (-1.9%) lagged. The US 10-year bond yields declined by 5 bps. Most Asian currencies strengthened against the US dollar, with the NZ dollar rising 3.8%. WTI oil price rose a further 5% to a record US$80.1/bbl. Base metal prices gained, with copper up by 2.5% See pages 4-8 for details


What's New: The MSBCI gained eight points in early September to 38%, retracing half of August's stunning 17-point plunge. But deterioration in survey details augurs weakness. Among them: Advance bookings edged down by two points to 48%, while the business conditions expectation index plunged nine points to 40%.
Conclusions: The overseas-domestic results dichotomy extends to the bottom line. Earnings at those S&P 500 companies for which international sales account for more than 25% of total sales (roughly half of the S&P 500) are expected to grow 6.8% in 3Q07 versus 1.3% for the domestically-focused companies, based on consensus estimates.
Market Implications: Ongoing weakness in business indicators continues to spur expectations of aggressive Fed ease, steepening of the yield curve.
Risks: Although pricing conditions didn't change much from last month and commodity prices have risen 3.6% from a month ago according to the GSCI (3.5% ex-energy), prices charged have risen faster than unit costs for 34% of the companies, up from 26% last month. Similarly, 59% of analysts expect margins to expand in 2007, up from 51% last month. Analysts may be overly optimistic given these trends.


Last Week-Top and Bottom Performers Globally: SiRF +16% (GPS chip maker), Solomon Systech +8% (handset display driver IC supplier in Hong Kong), and Motech +7% (Taiwan solar manufacturer) were the best performers in our global semiconductor universe in the last week. Richtek 13% (Taiwan power management IC supplier faced concerns on double ordering), Sandisk -10% (NAND-flash memory maker), and International Rectifier -10% (power discrete and IC supplier with accounting problems) were the worst performers in our global semiconductor universe in the last week.
YTD-Top and Bottom YTD Performers Globally: JA Solar +122% (solar cell manufacturer in China), LDK Solar +102% (solar cell manufacturer in China), and Mediatek +84% (Handset and advanced TV IC maker in Taiwan) are the best YTD performers in our global universe. ViMicro -56% (vendor of handset media processor ICs based in China), Core Logic -53% (handset camera ICs based in Korea), and Mtekvision -44% (Korean camera control processors for camera phones) are the worst YTD performers.
Technology Sector Performance (Exhbiit 5): We expect a strong Q3 earnings season will serve as a catalyst for strength in semiconductor shares, but our confidence in the 2008 industry outlook has diminished somewhat and will also likely cap a short term rally. The semiconductor stocks in our N. American universe advanced 0.2% last week versus a 2.1% increase in the S&P500 and a 1.4% increase in the NASDAQ.
Industry Observation: Channel inventory appears low and the rise in semiconductor company inventory appears to represent a structural shift not a cyclical problem. Investors appear to have discounted much of the positive 2H seasonality but the global credit crunch has increased the uncertainty into the 2008 semiconductor industry outlook.


It's happening slowly, but it does seem that the US consumer is weakening. The monthly data are noisy, but Friday's retail sales data show that real sales increased by just 0.75% at annual pace over the three months to August (I've assumed no retail-level price increase for the August month). The broader personal consumption expenditure series increased by 1.4% over the three months to July, down from 3.7% in the March quarter.
Detecting a change in trend, even when looking at growth over three months, is not straightforward. In particular, swings in real consumer spending are clearly affected by the swing in energy prices. Exhibit 1 shows the rolling three-month growth in real sales and a rolling three-month change in energy costs (inverted, so the line goes down when energy costs go up).
But not all the slowdown in real spending reflects an energy-inspired price squeeze. Nominal spending is also slowing at the margin: the dollar value of sales was up only 2.4% saar in the three months to April, while PCE was up 5.3%% in the three months to July, down from a recent peak of 7.3% in the March quarter. (This can be erratic: this series fell to 2.1% in the three months to last November.)
Moreover, energy prices were not a factor in the softer-than-expected July sales report. Despite the recent increase in oil prices, petrol (gasoline) prices were sharply lower in August compared to July (Exhibit 2).
The most immediate implication of this is that it builds the case for the Fed to ease policy on macro-management grounds. A softer consumer almost always leads to a broader slowdown, for example amongst goods-producers (Exhibit 3). Our US team expects the Fed to ease by 25 points at this week's FOMC.


Singapore-August Trade (Sep 17): August trade data are likely to continue to register strong momentum. We believe the next few months' data are likely to remain healthy as well. However, downside risks to external demand could pose a threat to export strength in late 2007/ early 2008, in our view.
Australia -RBA comments will be the obvious focus. So far other central bankers - notably in Europe and the UK - have taken a hard-line attitude on market turmoil. We expect Glenn Stephens to have the same attitude.


A Fed cut could help regional equity markets but effect on economies less impressive.  Based on option pricing, the market is assigned a 50% chance of a 25bp cut, a 42% chance of a 50bp cut and an 8% chance of a 75bp cut – there is absolutely no probability of the Fed keeping rates on hold. One month ago, the probability of a 50bp cut was only 5%. If the Fed does cut, will that help Asia? The answer depends on why they are cutting.

    • If the Fed cuts rates to ease money market problems that were not spilling over to the US economy, Asian economies and currencies could pick up strength. Lower US rates would boost US demand for Asian exports and also improve rate differentials (typically helping boost currencies). In some cases, possibly with a lag, lower US policy rates would also translate into lower domestic rates, and help boost activity.
    • However, in our view, the Fed is not responding solely (or even mainly) to the money market problems. Rather, they are likely to cut rates in response to clear signs of a deteriorating economy. In this case, the net impact on Asian activity is unlikely to be positive – the boost from lower US rates is unlikely to outweigh the impact from activity.

Last month, when we estimated the hit to Asian growth from a US slowdown, we already incorporated the average US rate response in the calculations. As a result, even if the Fed cuts rates on Tuesday, we still estimate that a 1ppt further slowdown in US consumption (beyond our baseline) would nudge down Pan-Asian growth by 0.3ppts to 6.9% in 2008, from 7.2% in our baseline, and 7.6% in 2007. For more details, please see the original piece:

Asia Views – Fed Cuts Coming While Asia Hikes

Last week saw a slight easing in global money markets; the largest borrowing from the Fed’s discount window since September 2001; and the emergency bail-out of the largest mortgage lender in the UK. The extreme dislocations in USD, EUR and GBP money markets eased slightly last week, with most short-dated rates rallying and overnight LIBOR actually falling below the effective Fed Funds rate. Further out, 3-month LIBOR rates fell around 8bps over the week. Even the Asset-Backed Commercial Paper spreads edged down a touch. During the week, banks borrowed $7.2bn from the Fed’s discount window, the most since the immediate aftermath of September 11, 2001. On Friday, the Bank of England (until now the “toughest” of the major central banks in its response to money market dislocations) announced it had provided Lender of Last Resort facilities to Northern Rock, secured on its own mortgage book. Despite the draw-downs on the US discount window and some dramatic stories of UK depositors queuing outside branches to withdraw money, the overall mood in global money markets seems to be slightly better now than a week ago.

In Asia, some key rates have continued higher despite the global normalization. In China, 1-month SHIBOR rates climbed another 117bps (and are now up 165bps since end July), 7-day repo rates continued their dramatic spike higher, rising to 21.5% from 11% last Friday and a low of 1.4% on August 20. Unquoted onshore inter-bank rates also increased (albeit far less dramatically), jumping higher a few hours before China announced yet another modest 27bp rate hike (which brought the deposit rate to 3.87% and the lending rate to 7.29%). As we noted last week, Chinese rates are highly immune from global fluctuations – actually falling during the worst of the turbulence in the US and now rising even as things seem to be improving a touch globally. Chinese money markets are protected by capital controls, and have been partly driven by the authorities’ efforts to reign in domestic liquidity (via special T-bill issuance; the September 6 increase in required reserves by another 50bp to 12.5%, and last Friday’s rate hike). A number of important pending IPOs have added to the tightness by taking money out of the banking system, and this impact should fade. In Hong Kong, overnight HIBOR is now 80bps higher than on Tuesday, and 55bps higher than last week, while 3-month yields have edged down in line with global markets. Singapore rates were better behaved, with 3-month SIBOR edging down around 6bps more in line with global conditions.

Despite the PBOC rate hike, Chinese and HK equities outperformed the region, yet implied vols remain high. Chinese and Hong Kong equities rose by 3% and 6% respectively last week, clearly outperforming the 1.8% rise in the regional index MXAPJ, confirming that while the exact timing of hikes is a bit of a lottery, the move was much as expected. Since the recent trough, regional equities have bounced more impressively than their global peers (the regional index is now only 4.5% below its peak after being down 19% at one point). However, implied volatility remains higher in Asia than in the majors (implied vols in AEJ are mostly in the high 20s-low 30s, while the implied vols on the majors in generally in the low 20s). This higher implied vol seems more a direct result of the actual volatility rather than a measure of real fear, as Asian equity markets show less skew than the majors (investors don’t seem to be as one-sided in their desire to get protection from price falls).

DRAM/NAND update (Sep 15): Risks still appear high - more cautious on Tier 2 pure plays

Risks still appear high
We are impressed that chipmakers' guidance has not changed much over the past 2-3 weeks (eg, healthy chip orders, low inventories, no plan to cut back capex, etc) even as investors are getting more worried about a potential US recession. However, DRAM and NAND prices have declined by 15-20% over the past two weeks. We believe chipmakers' current guidance cannot warrant upside if actual sell-through of end products were to be hit by a US-led global slowdown. Our concerns are still (1) chipmakers' record high spending, (2) channel inventories and (3) sell-through of end products. The recent chip price erosions may suggest higher bit growth (sales volume increase) or spot market stabilization (or technical rebound led by speculators) as usual (price elasticity), but we are still worried about record high capex and low margin profiles on top of the US economy.

Key takeaways from our Japan conference
Three major memory companies - Toshiba, Hynix and Elpida - attended our Japan conference this week, which hosted about 1,700 investors and over 200 corporates. All the three companies denied reports that they were cutting back capex and facing order cancellations from their respective customers. Furthermore, they presented a positive outlook for the business by highlighting that: (1) DRAM price should recover or stabilize soon thanks to seasonality and lower supply growth, (2) NAND orders from OEMs remained healthy and that rumors about order cancellations were groundless, (3) price elasticity will continuously function well, particularly with the recent spot price weakness. They also expect a better pricing environment if supply growth turns weak, thanks to acceleration of 200mm fab retirement and companies facing more difficulties in using new nano technologies.

More cautious on Tier 2 pure plays
Spot prices have recently been weaker than expected (DRAM spot: US$1.5 currently vs our estimate of around US$1.8; NAND spot: US$6.8 currently vs US$7.5) with higher volatilities, whereas most memory chipmakers seem to be willing to maintain their target spending - as indicated by the three memory companies at our conference. This will drag industry upturn unless demand can absorb all capacity. We saw short-lived chip price strength this summer, indicating that short-term driven demand recovery (including speculative trading) can easily be counterbalanced by excess capacity. Our global supply-demand model still shows oversupply, particularly in DRAM, not only in 2H07 but also in 2008, if the chipmakers meet their target spending and capacity expansion. This may result in more severe price competition and acceleration of industry consolidation, coupled with Tier 2 players' poor cash flow and the difficulties they are facing in raising new capital. We believe this supports our Sell recommendation on Tier 2 plays, such as Taiwan DRAM stocks - Nanya (NNYAF; NT$22.55; C-3-8), ProMOS (PTGSF; NT$9.82; C-3-9) and Inotera (INMFF; NT$32.35; C-3-8).

Cautious investor positioning + Fed ease = better chance for Q4 strength

Following a large number of meetings in Asia and the US, we find a great deal of
uncertainty among equity investors regarding the prospects for Asian equity markets
and therefore what actions to take in the wake of sharp August declines and
subsequent swift rebounds. We continue to think markets remain vulnerable to
retracing some of their recent gains if 2008 EPS growth estimates are revised down
due to US consumer weakness. However, the chances for a 4Q rally, potentially off a
lower base, are stronger now given evidence of conservative investor positioning and
the likelihood that the Fed will move into easing mode.

We organize our thinking about Asian regional equity market prospects around five main
(1) The strategic case for Asia remains in place;
(2) There will likely be downward revisions to 2008 EPS growth for parts of Asia given
downside risks to US consumption;
(3) Markets have rebounded swiftly from mid-August lows, raising the risk of a reset if
earnings estimates start to be cut; however
(4) Investor positioning appears quite conservative now, following the August market
turbulence, so the ‘pain trade’ is again to the upside; and
(5) The Fed is likely to commence an easing cycle that may cushion the downside risks to
US growth and result in Asia being the unintended beneficiary of more accommodative
monetary policy.

Combining these various leit motifs, the prospects for a 4Q rally, potentially off a lower
base, appear better now than they did several weeks ago. We continue to think that the
key investment criteria will be the level and visibility of earnings growth: stocks that offer
good growth potential with low probability of disappointment are likely to be in demand,
particularly if EPS growth globally is in scarcer supply in 2008. This leads us to emphasize
secular and domestic demand themes and to be cautious on US-sensitive areas, such as
technology and autos. Our market preferences are China, India, Indonesia, Singapore and
Hong Kong, and we remain more cautious on Taiwan and Korea.

UK Strategy Outlook - Still cautious

The UK market has out-performed the rest of Europe during the past month. UK equities continue to gain support from the commodity-related sectors, and the latter have also supported the large cap segment relative to the FTSE 250 and the FTSE Smallcap. Looking ahead, we believe that the the market upside is likely to be capped in the short term.

Yet, we stress that the UK market looks cheap and we stick with our year-end target of 6900 for the FTSE 100. The market has de-rated in the recent sell-off and valuation multiples are now back to levels not seen since a year ago. Indeed, the UK market's low valuation is the chief factor making it attractive relative to other markets (a suggested Overweight) according to our models. Earnings momentum, for instance, is inferior to that of the rest of the pan-European market.
We maintain our Overweight on UK equities in a pan-European context, although we have trimmed our active weight this month as we believe the UK economy is among the most vulnerable given the higher cost of credit.

In terms of positioning, we continue to prefer large caps to small caps. This is in line with our preference for exposure towards economic growth in emerging markets, notably Asia. The FTSE 100 is likely to benefit from this given its large exposure to the Oil & Gas and Basic Resources sectors. In addition, as long as uncertainty prevails in the market, investors are likely to prefer large caps which are often perceived as being safer assets than small and mid caps. Hence, we think that the valuation premuim of the small and mid caps is unjustified.

Sectorwise, this month we are reducing exposure to Banks (to Underweight). In our view, Banks are likely to face the risk of earnings downgrades going forward. Our analysts are also negative towards UK banks, many of which could be vulnerable to the tight money market. We are halving our Underweight in Utilities and are also adding some weight to Personal & Household Goods, focusing on names with relatively less exposure to the UK. Utilities and Consumer Goods have improved on our models during the past month.

GS Asia banks Sept 18: Taiwan financials/CDOs (-ve); China banks/rate hikes (=); India financials/loan pricing (=); US debt/MEW metrics (-ve)

Taiwan financials: CDP exposures may be understated; remain defensive/selective
Domestic "bond fund" issue in 2004-06 may have lead to some high-risk CDO purchases

  • Since mid-2004, some of Taiwan's local ITCs have been going through a "bond fund" crisis...
  • inverse-floating notes suffered losses in the rate-hike environment which then triggered redemption risk
  • The FSC asked ITCs/key shareholders at that time to step up and bear the loss for bond fund investors.
  • In order to mitigate the loss, some FHCs chose to arrange CBOs...
  • ...mixing those money-losing inverse floating notes with high-yield CDOs, and selling them to other financial institutions (FIs).
  • To ensure they could price these CBOs at attractive terms, CBO arrangers would include some equity/junior tranche CDOs
  • In some cases, arrangers also provided principal guarantees to the FI buyers
  • For instance, Mega Bank disclosed it had arranged two CDOs (NT$18bn in total) under such circumstances in 2005-06.

Banks/FHCs might be understating their CDO exposures as a result of the bundled currency swap

  • The CBO arrangers would sometimes bundle a currency swap with the CBOs to hedge the currency risk and increase their appeal to potential buyers
  • These buyers may then put these currency-risk-free securities within their less-investor-scrutinized NT$ investment portfolio...
  • ...despite the underlying (and now sharply rising) credit risk that resided with such overseas CDO exposures
  • When evaluating/disclosing the extent of their US sub-prime exposure, some FHCs would only look at their FX investment portfolios
  • This could potentially lead to an under-stated CDO exposure figure.

Implications: go defensive; avoid those with huge bond fund balance in the past

  • We are currently checking with each FHC/bank under our coverage to see if they have such exposure in their NT$ investment portfolio.
  • Meanwhile, we suggest investors avoid those FHCs that had huge bond fund balance on their ITC subsidiaries back then (e.g., Fubon FHC).
  • We identify SinoPac FHC (2890.TW, Neutral) as a more defensive play, given its modest CDO exposure, and below ex-growth valuation.
  • Key risks are unexpected proprietary trading loss and asset quality deterioration

China banks: Latest rate hike modestly positive for 2008E NIMs; still key to watch CPI trend
PBOC raised loan and time deposits rates by 27 bps, effective September 15th, while leaving demand deposit rates unchanged.

We see two positives

  • It shows a more decisive PBO move to curb accelerating CPI inflation
  • We estimate it could be modestly (+2bp to +9bp) positive for banks’ 2008 NIM (especially for smaller banks with high L/D ratio and demand deposits)
  • …in turn an earnings buffer for any subsequent tightening measures, e.g. more data-dependent rate hikes, loan growth curbs
  • We believe by allowing for better NIMs, PBOC is hoping for banks to be more cooperative in curbing excessive loan growth (17% YoY in August)
  • However, it remains to be seen if inflation/overheating risks are now under control, before we could turn outright positive on China banks

Key questions in our mind:

  • 1. Whether inflation may continue to accelerate, as we believe:
  • Note this rate hike was largely expected and therefore may not be effective in reducing CPI/asset inflation expectations
  • 1-year real deposit rates after interest tax of 3.7% still far lower than 6.5% CPI in August
  • Overall monetary condition (e.g. loan growth at 17% yoy in August) still far from neutral
  • 2. Whether A-shares/property markets continue to surge before/during the 17th National Congress of the Chinese Communist Party in mid-October
  • This rate hike left demand deposits rates unchanged and did not raise long-term deposit rates more than short-term deposits rates
  • This may therefore not attract much liquidity from A-shares markets back to the banking system
  • We do not rule out the possibility of more heavy-handed tightening after the party meeting in October if potential A-share/asset “bubble” continues to build up

Source of opportunity

  • We retain a neutral stance on China banks at present, and would be more positive if CPI/PPI inflation materially slows.
  • Given the valuation gap and potential QDII expansion, we are more positive on H-share banks than A-shares.
  • We prefer CMB (3968.HK, Buy; one of the highest beneficiary of this rate hike) and ICBC (1398.HK, Buy).
  • CCB (939.HK, Neutral) is our next-best pick, given its high profitability and A-share floating as a near-term catalyst, and as this rate hike slightly benefits CCB’s 08E NIM 1bp to 2bp more than ICBC’s.
  • We keep Neutral rating for CCB on valuation reasons, as its market cap (including 9bn new Ashares) is just 4% below ICBC’s (vs. 1H07 assets 36% below ICBC’s)

India financials: Loan pricing - will it remain stable?
What’s new?

  • Several company/ press releases since start of September noting that banks and finance companies have cut or are considering a cut in mortgage lending rates as well as other retail loan products.

What do we think of the reduction in lending rates?

  • The decision (or talks) by lenders to cut lending rates comes as a bit of an against-the-grind surprise
  • ... as liquidity elsewhere in the world dries up, market rates rise, bank pricing power improves
  • We believe that the motive to cut lending rates on a selective basis is
  • 1) to deploy excess liquidity in the better-yielding assets; or
  • 2) to gain market share in a chosen segment (especially mortgage).
  • This potential action may however, in our view, result in
  • 1) asset liability mismatches if excess short-term liquidity is deployed into L/T assets, e.g., mortgages
  • 2) lower sector profitability, with deposit rates now showing any corresponding signs of decline.
  • The trade-off of growth over profitability would be unfavorable for banks, particularly public sector banks given their low profitability.

Does it change our positive stance on the Indian financial sector?

  • Stable loan pricing environment is one of the key driver to our positive stance on the sector.
  • Despite the announced rate cuts, we continue to maintain our positive stance as.....
  • .....we expect continued benign macro environment, strong demand for loans, and restoration of a stable pricing environment.
  • We attribute low probability to the prospect of further cuts in lending spreads to:
  • 1) our expectation of system pick-up in credit growth in 2HFY2008;
  • 2) its adverse implications on the profitability of the banks.

Our top picks

  • Our top pick are Axis Bank (AXBK.BO, Buy) and HDFC (HDFC.BO, Buy)
  • We also maintain our Buy ratings on ICICIB (ICBK.BO) and IOB (IOB.BO)

Key risk to our positive sector stance

  • A slowdown in economic activity
  • Further tightening of monetary policy (in our view, current macro conditions do not warrant further action in 2007)
  • Significant deterioration in asset quality (we assume a benign environment for credit quality base-case)
  • Deterioration in loan pricing environment.

US macro (-ve) and MEW: Was Q2 the last hurrah for debt?
Backdrop: excerpts from our US economics research team reading on the latest US debt metrics
Asia banks read-across: still focused on impact of falling US mortgage equity withdrawal, combined with subprime/credit markets unwinds, on the US economy and its pass-through impacts to various parts of Asia and its banking sectors.

  • The Fed’s flow of funds report for the second quarter provides evidence of a substantial shift underway in borrowing patterns even before the latest blow-up in credit markets
  • Corporate sector borrowing continues to pick up, with borrowing requirements now at 1.7% of GDP
  • The profligate household sector maintained a steady pace of debt accumulation
  • ...while the federal government actually paid down debt in the second quarter
  • Third-quarter data are likely to show sharp deceleration in borrowing as tighter credit standards took hold
  • Mortgage borrowing looks poised for an especially heavy hit, and as a result we have revised down our forecasts for mortgage equity withdrawal (MEW)
  • We now expect total MEW to fall to just over $200 billion in 2008, from our previous forecast of roughly $300 billion and a 2006 level of $830 billion

Wednesday, September 12, 2007

Citi Regional Strategy: The Asia Investigator - Fed Cuts: What You Pay Determines What You Get

Fed Cuts: What You Pay Determines What You Get (by Markus Rosgen)

  • Since 1980 we’ve had 7 Fed cuts, 2 at current valuations; both times markets fell — During the five periods of Fed easing when markets rose, the P/BV averaged 1.2 times. The two periods when markets fell, P/BV averaged 2.3x. P/BV is currently 2.6x. We are at a 116% premium valuations to periods when markets rose and a 13% premium to levels when markets historically fell by 1/3. 
  • Interest sensitives and consumers outperform — Even though these sectors do well, they are amongst the least well owned by Asian investors. The biggest underweights are still banks, the utilities and the telecoms sectors. Ditto Korea, Taiwan and Thailand, which are relative outperformers. Only Thailand is an overweight. Korea and Taiwan remain investor underweights.
  • A falling OECD indicator is bullish, not a rising one — Whenever the OECD leading indicator has been falling and the Fed has cut, Asian markets have risen. The indicator is currently rising on a year-on-year basis. Historically this has been negative for returns. Composite valuations and earnings yield gap models are still elevated and witnessed Fed rate cuts only once at these levels.
  • Peak valuations since 1975 are 19% away — US markets and European markets peaked in 2000 when valuations reached 3 stdev above mean on either P/BV or P/E. Asia ex is 19% away from reaching 3 stdev above mean.


China: Delay in individual QDII – short-term consolidation expected (by Lan Xue)

According to one of China's most influential financial magazines, Cai Jing, the Chinese government is undertaking a more detailed study of the individual QDII scheme before letting domestic retail investors rush into the HK stock market.

India: Fed cuts generally good for Indian markets as well (by Ratnesh Kumar)

Bar the period when the tech bubble burst and earnings collapsed, the Indian market has done very well for 12-24 months after Fed rate cuts. As we do not see an earnings collapse in India even in our worst-case scenario, due to its broad-based economic growth (current forecast 17% ex-oil earnings growth for FY08 and FY09), Fed cuts will likely be supportive of our positive view on India equities.

Thailand: Fundamental analysis meets Quants (by Nithi Wanikpun)

Stars (cheap with strong momentum) are RATCH, ATC and TTA. Note that ATC has been a Star since April 2007. Sell-rated EGCO is in our Stars list due to continued earnings upgrade momentum.

Fun With Flows: Global funds underweight Asia for first time in six years (by Elaine Chu)

Global funds have been well positioned to cope with the current market turmoil. Besides, fund managers trimmed regional weights in Europe and the U.S. by a total 220bps in end-July. Cash weights were raised from 2% to an above-avg 3.8%.



Conclusion: HSBC has agreed with Lone Star to buy a 51% stake of KEB at W18,045 per share, which is at the low end of our calculated M&A value for KEB (see Oversold, In Our View - Stick with Fundamentals, June 29, 2007). The proposed deal is still subject to receiving the necessary regulatory approvals. However, we believe that the announcement itself is very positive for KEB's minority shareholders and KEB's share price.
Minorities to benefit from buyout or deployment of KEB's excess capital: HSBC has said that KEB would remain a listed entity even after the completion of the proposed transaction. However, we think that HSBC may be very tempted to acquire 100% of KEB given: 1) KEB's strong fundamentals, 2) its excess capital, and 3) additional accretion to HSBC's earnings. Even if HSBC kept KEB listed on the KOSPI, minorities could benefit from the potential deployment of excess capital.
What if HSBC fails to get regulatory approvals?If HSBC fails to receive FSS approval, any potential bidders in any subsequent auction may have to pay more than W18,045. Investors should also bear in mind that Korean banks are expected to decide on their 07 dividend payments in February 08, which makes it possible that Lone Star could pay a large dividend for 2007 if the situation remained unclear.
1.4-2.5% accretive to HSBC's 2008E earnings: Anil Agarwal, MS's HK banks analyst, has run a pro-forma analysis for the transaction. Based on our estimates for KEB and assuming funding at 5.5%, we estimate that the transaction as constituted would be accretive to 2008 earnings for HSBC by about 1.4% without any positive synergies (HSBC Holdings: Acquisition of KEB - Impact Analysis, September 3, 2007). According to Anil's analysis, however, the accretion to HSBC's earnings could increase to about 2.5% if KEB increased non-interest income to assets to 1.9% (avg. for HSBC in Asia) from the current 1.3%.

Conclusion: HSBC has agreed to buy KEB at W18,045 (based on KRW939.9 = US$1.0), which is the low end of our calculated M&A value for KEB (See "Oversold, In Our View - Stick with Fundamentals", June 29, 2007). We believe HSBC may face difficulties in winning FSS approval for the acquisition due to complications with Lone Star and KEB. Nevertheless, in our view, the announcement of the deal should be very positive for KEB, positive for Hana FG and IBK, and neutral for KB.
Very Positive for KEB: First, if the FSS approves the transaction, we think HSBC will be very tempted to acquire 100% of KEB (even though HSBC says it intends to keep KEB listed on the KOSPI). Second, even if HSBC dose not buy out minority shares, it may have to release excess capital of KEB, and minority shareholders will benefit. Third, if HSBC failed to receive FSS approval, any subsequent bidders were there to be any) might have to offer more than W18,045 considering fierce competition for KEB. Fourth, Lone Star may pay a large dividend for 2007 (decision to be made in Feb 08) if the situation remains unclear.
Positive for Hana FG and Industrial Bank of Korea: Given limited excess capital, Hana's intention to buy KEB has been a dilution risk to existing shareholders. Hence, HSBC's announcement will likely be positive for Hana's share price as its overhang issue has been removed. In addition, as we think that IBK could be the next target for any further industry consolidation (based on the government's intention to privatize the bank), any deal is also positive for IBK, in our view.
Disappointing, but Neutral to Kookmin Bank: Initially, it should be a disappointing for Kookmin's shareholders. However, we think downside risks on KB should be limited because 1) any positives from KEB have never been reflected in KB's current valuations, 2) there is still a possibility that KB could eventually acquire KEB, and 3) the anticipation of high dividends will provide its share price with downside protection.


While Asia-Pac ex-Japan equities fell just 1.9% (in US$-terms) in August, they tumbled 15% until August 17, followed by a V-shaped 15.1% rebound. The China A- (+17.3%) and H-shares (+7.6%) significantly outperformed, while Malaysia and Thailand lagged. At a sector level, the defensive Telecoms (+5.1%) led, while the cyclical Consumer Discretionary and Tech lagged.
Asia-Pac market fundamentals: Consensus bottom-up MSCI AP ex-Japan 2007 earnings forecasts increased by 2.5 ppts to 15.1% YoY. Asia's forward P/E moderated to 14.9x from 15.7x in mid-July, but remained at a premium (4.5%) to the US. Liquidity conditions remained positive, with strong money growth. Sentiment soured, with foreigners record equity sellers.
Global equities were largely unchanged (-0.2%) in August, with the US rising 1.3%. Emerging markets fell 2.3%, with most market declining, expect China. Sector performance was mixed, with the defensive Consumer Staples and Utilities sectors relatively resilient.
Asia-Pac and Global macro update: Our global lead indicators point to a moderating outlook. However, our Asian lead indicators, led by China, remain strong.
Global bonds rallied: 10-year bond yields declined in the US (-21 bps) and Euro zone (-11 bps). In Asia, bond yields declined in Hong Kong, Taiwan and Australia, but rose in Indonesia, the Philippines, and Korea. The Central Banks in India, Australia, Korea, and China raised reserve requirements or their policy rates.
Currencies and commodities: The Thai Baht (-8.1%) and the high-yielding Kiwi (-7.4%) and Aussie (-3.7%) dollars fell sharply against the US dollar. Among commodities, WTI oil prices declined a sharp 5.3%, as did Zinc (-14.6%) and Copper (-7.1%).

China: Infrastructure investment hits mid-cycle slowdown

The PMI index, up mildly to 54 in August, still points in the direction of a moderation in economic activity in the coming months. This is consistent with our call that GDP growth will soften towards 10.5% in H207, synchronizing to a global slowdown led by the US. Executives complained more about rising food prices and wage rates than commodity prices lately.
The most important message from the survey is the continued weakness in machinery orders. New orders for general machinery, electric machinery and transportation equipment remained subdued. We think a mid-cyclical slowdown in infrastructure investment is happening now, possibly affecting domestic and international machinery producers.
We think the moderation in new loan issuance is probably responsible for the slide. The pace of infrastructure investments in railway, airport and power stations has slowed anecdotally, but this is unlikely to be the end of China's infrastructure boom.
We argue that the real economy is not as overheated as others suggested, and Beijing probably would only launch selective and measured tightening to the real economy. However, inflation remains out of control and interest rates need to rise substantially, in our view. Rate hikes will likely keep up with inflation and maintain a neutral monetary policy stance.


Conclusion: Recent checks with IDHs, local brands, chipmakers, and other food chain suppliers indicate that: 1) China handset demand remains very robust in 2H07 with new emerging local brands gaining the most share; 2) local handset makers are starting to make inroads internationally (e.g. South Asia, Russia and India), but 3) the roll-out of TD-SCDMA seems to be delayed slightly; and 4) the pricing environment remains tough given the lack of new killer applications and rising competition.

Raising our China handset shipment forecasts: We are revising up our 07 shipment estimate to 206 mn units (up 25% YoY) from 176 mn units –with the combination of grey market and emerging local brands outgrowing with 55% YoY growth, far ahead of global brands’ 18% rise and Tier 1 local brand names’ 25% YoY decline. We expect 08 YoY unit growth to decelerate to 16%. Our cross-checks with chipset vendors suggest “export” shipments could reach 52 mn and 78 mn units in 07 and 08, up a sharp 60% and 50% YoY.
Implications for IC design: We see robust handset unit demand as a positive for Mediatek and Spreadtrum, both IC suppliers to the domestic handset makers. We note that while TD appears to be pushed out slightly, it is not unexpected, and actual units are still likely to exceed our current forecasts; we are more comfortable with Spreadtrum’s competitive position after recent checks. On the other hand, the continuation of share loss by Moto is likely to be a negative for Solomon Systech, although our view is that most of this is well understood by the Street and thus in the stock price.
Implications for handset food chain: We read this as overall neutral for China IDHs (SIM Tech, Longcheer) as robust volume growth was offset by pricing and margin erosion, although fundamentals seemed to trough in 1H07. The next catalysts are when overseas expansion starts to bear fruit and TD takes off. Among IDHs, we think SIM Tech is still ahead of peers in NRE collection from brand names despite a delay in TD rollout.


Risk of FPD TV price fall: Risk of slower consumption in N. America is showing up as a rising share of cheaper models in LCD and other FPD TVs. Momentum in Taiwanese/Chinese brands (eg, VIZIO) also needs to be watched for risk of price falls for Japanese brands too.
High risk for Funai, Pioneer: All of our forecasts factor for annual falls of 25-30% for average prices in all sizes, and weighted average falls of 5-10%. However one question we ask concerns the effect on operating profit in a risk scenario of firms pushing through added price cuts of 10%. Funai and Pioneer could be hardest hit, and Sony and Sharp would be affected relatively mildly.
Still bullish on Sony, Sharp: Distances to fair value in our bear case are greatest for Sanyo, followed in order by Sharp, MEI and Pioneer. Sharp’s high valuation multiples relative to industry averages make downside look substantial assuming the valuation gap adjusts. Yet we think the premium is warranted by the high certainty of growth in the LCD business especially, and its cost competitiveness in LCD TVs. Sony currently trades close to our bear case fair value and even with gains on the former HQ land sale is unlikely to turn in strong 2Q numbers. Further PS3 price cuts may also loom from late September. But we are hopeful that momentum will pick up from 3Q and we remain Overweight.
Our industry view is In-Line: We believe the lines of success have already been drawn. Competition is heating up noticeably in the FPD field but we expect the
competitiveness of Japanese brands to shine through again from F/309, as screens become ever larger.


Conclusion: We reiterate our positive view on the global container shipping industry despite the market’s lingering concerns over the sub-prime issues in the US.
That said, as select stocks in the sector, most noticeably CSCL and OOIL, are now trading either near or above our fair value estimates, we would recommend investors to focus on the Taiwanese long-haul carriers, YMM in particular, for exposure to the anticipated sharp earnings recovery of the sector beginning 2H07.
What's New: Given current low/no profitability of the transpacific trade, slower US import volume should have a minimal impact on liner profitability, in our view. Moreover, as capacity is being continually removed from the trade, the loss-making inter-modal services in particular, we believe this will provide solid support to
freight rates even assuming continued anemic demand growth. On the other hand, we continue to expect carriers’ earnings will improve markedly from 2H07 onwards, underscored mainly by the extremely robust freight rates and volume growth of the Asia-Europe trade since the beginning of this year.
Stock Recommendations: We are downgrading our long-held Overweight rating on CSCL to Equal-weight. We retain our HK$5.35 price target on the stock, but consider the expected strong earnings momentum, proposed A-share issue and possible corporate restructuring activities to have been fully discounted by the 330% share price appreciation YTD. In contrast, we believe the market has continued to underestimate the value of the Taiwanese long-haul carriers, YMM in
particular. The stock is currently trading at 1.0x P/BV, 0.7x P/NAV and 8.5x 2008 P/E, suggesting a 25-55% discount to its HK/China peers.
Risks: Major global economic slowdown.


Monthly, Vol. 138 (August 2007)
Watch for discount factors to ease:
Steel stocks may be discounted due to (1) US-originated financial market instability and recession concerns since late July and (2) alarm over volatile steel prices in China. From Oct-Dec, however, we may be able to confirm a turnaround in North American steel prices and stabilization of Chinese steel prices. As reasons to apply a discount recede, hare price levels should be pushed up.
Domestic steel sheet supply/demand in a phase of inventory buildup: Japan’s steel sheet cycle remains in the inventories rising/shipments rising quadrant. This marks the bumper period for earnings, reflecting aggressive production in response to brisk orders currently being booked by the large steel makers. We
expect earnings in 1H F3/08 to track ahead of full-year company forecasts. There is room for robust fundamentals to be valued more fully in stock prices.
Steel view Attractive, In-Line for nonferrous metals, wire & cable: For steel, high-grade product prices are firming, and we expect mid-term growth in Asian high-grade steel demand. For wire/cable, telecom demand growth is easing but we are watching electronic materials growth strategies. In nonferrous, despite concern about high LME prices, we watch individual strategies in electronic materials, etc.
Picks: JFE, Kobe, Hitachi Metals, DOWA and SEI. Hitachi Metals is lifting core business profits and entering growth areas. JFE faces better fundamentals and has an investor-centric FCF strategy. Kobe Steel has high exposure to special steel and rising medium-term input from machinery, construction machinery and electronic materials. Electronic materials are driving better asset returns at DOWA. SEI has new growth areas (electronic materials, etc.) and automotive business margins should recover in F3/08.



New record for ship price: The Clarkson ship price index gained another point in August and reached 175. We are seeing even higher ship prices in September, as early September prices suggest a ship price index level of 176. Bulk carrier new building pricing led the rise in overall ship prices, up by 27.8% YoY and 3.3% MoM. It is not just tight berth space pushing up prices as building costs are also rising. Korean shipyards and JFE steel agreed to raise heavy plate prices to US$645/ton from US$625/ton (+3.2%), starting this October to March 08.
Robust bulk carrier and containership order: Global new orders were 6.8 mn CGT in August, up 72% YoY.On the back of strong freight rates, bulk carrier and containership new orders soared, up 562% and 93%, respectively. Tanker new orders slowed down by 72% YoY.
Freight rates surge based on shipping demand from China:BDI went up to US$8,270 on September 6, vs. US$6,993 on August 1. Despite recent turmoil in the credit market, demand from China has not shown any sign of weakening yet. While the container freight rate also recovered, tanker rates stayed low. The VLCC Worldscale index for Mid-East to Japan was down 43.2% YoY on August.
Korean yardsplan to add more docks: Major yards came up with new dock plans to leverage the containership new building up-cycle. DSME revealed its plan to purchase a 438m x 84m floating dock and HHI confirmed that it will build a 475m x 175 m new dry dock.
Super Cycle Continues: We expect strong shipping market fundamentals and new orders to continue to drive up ship prices, which should positively contribute to shipbuilders' profitability in 2009E through 2011E. The macro outlook remains as a key risk. We have Overweight rating on three shipbuilders, Hyundai Heavy Industries (TP W480,000), Samsung Heavy Industries (TP W67,000), and Daewoo Shipbuilding Marine Engineering (TP W79,000). Our top pick is Hyundai Heavy Industries.


Impact on Our Views: Although a Rmb200 bn special treasury bond (TB) issuance to the open market is only roughly equal to China's trade surplus in one month, the MoF's decision to directly float a portion of its Rmb1.55 trillion special TBs is exactly what we expected as part of China's "unconventional tightening" efforts (see our note dated May 2, 2007, "What are the Policy Options to Control Market Mania?"). The domestic A-share market should suffer upon this, and we reiterate our Cautious view, given its demanding valuation, inflated growth by securities investment income and overly speculative nature (see our note dated Sep 3, "1H07 Result:Super Growth or Super Bubble?").
What's New: The Ministry of Finance (MoF) just announced that it will issue Rmb200 bn special TBs to the inter-bank market directly. Rmb100 bn of that amount will be sold within this month starting from Sep 17, and the other half will be issued before the end of this year. The bond sale is part of the MoF's planned special bond issuance of Rmb1.55 trn. The ministry will use the proceeds to buy foreign exchange reserves from the People's Bank of China (PBoC) and fund China's sovereign investment agency. Last month, the ministry issued Rmb600 bn special bonds to the PBoC via the Agricultural Bank of China. PBoC has floated Rmb10 bn of that portion in the market already.
Investment Thesis: The market's myth that China will see no aggressive tightening before the 17th CPC Conference in October is now broke. We believe regulators are now turning more hawkish in fear of inflation and onshore asset speculation.
Impact on Offshore Equities: We also believe this new tightening effort will be a moderate negative to offshore-listed China equities in Hong Kong. However, the major risk for Hong Kong market is a US-centric de-risking, not China's tightening. But we do expect asset price-driven sectors such as financials and prope rties to underperform.

Conclusion: We reiterate our Attractive view of the Taiwan TFT LCD industry and our Overweight-V ratings on AUO (NT$50.50) and CMO (NT$33.70). Taiwan panel companies are best positioned for the 2008E super-cycle, in our view, on largest share in Gen 3.5 to 7.5 fab capacities for sweet spot demand growth (42”/32” LCD TV, wide format monitor/notebook, emerging small/medium size applications). Chinese TFT makers’ global share will stay marginal at ~5% in 2008, on our estimates, as most growth will come from existing fab expansion, supporting global capital discipline trend. Like in the US two years ago, Chinese retailers are best positioned in China LCD TV foodchain on good margin, high turnover, and long payment terms for the rapid growth.
What's New: We visited China TFT LCD foodchain across components, panels, TV assembly, TV brand, and retailer last week. Given China accounts for over 70% of global TV, monitor, and notebook assembly production, like in semiconductors, China will build TFT fabs on government supports (only 5% global share
today). Chinese TFT fabs are debt heavy with the highest debt/equity ratio globally (for banks, companies are allowed to have debt to equity mix of 2 to 1 on average debt cost of ~7% per annum). For the long term, we view the announced merger between BOE OT, SVA-NEC, IVO as the best outcome for China TFT on scale and global TFT sector on consolidated supply.

The merger will likely be delayed again from the extended September deadline as: 1) participants need to agree on the swap ratio (not easy in upcycle); 2) the new merged entity needs new state capital injection for expansion that is likely only after 17th Party Commission in October. Given 12 months equipment lead time to production, on weak balance sheet, any new fab production will be in 2009 even if the newly merged SMIC equivalent TFT maker starts to operate by end-2007, which would help supply discipline in 2008.

Impact on Our Views: We have increased confidence that Q2 marked the bottom for handset operating margin and that sequentially improving profitability results should push MOT shares towards our sum-of-the-parts valuation of around $21.
What's New: Motorola hosted an analyst day in NY on Friday where management provided sufficient detail on (1) how it will improve profitability and instill operational discipline in the handset division; (2) increase overall capital efficiency and returns; and (3) the healthy growth and profitability in the Home & Networks and Enterprise Mobility divisions. Among the areas lacking in detail were how Motorola would gain profitable traction in the 3G/WCDMA and GSM markets where it has lost share over the past few quarters. Motorola did not introduce new handsets but indicated launches would occur within the next 30 days.
Investment Thesis: In a crowded market for telecom equipment restructuring stories, MOT may have the best chance to quickly improve results and drive estimates higher. Longer term, we remain concerned about the lack of 3G presence and the drag on growth and earnings coming from iDEN and wireless infrastructure.
Valuation: Shares trade on 0.9x EV/Sales, an attractive multiple assuming that the company is able to grow the top line at least 6+% that we estimate in 2008. Our updated sum-of-the-parts model implies a $21 per share value (higher on sales multiples; lower on EBIT multiples), and each 100 bps of margin improvement in handset over our 5.4% estimate for 2008 adds around 60¢ in value. We estimate normalized earnings power of $1.25 assuming MOT can consistently deliver 30+¢ quarters on average, which implies a price around $21 using a three-year average P/E of 17x.