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  • 1. MORGAN STANLEY RESEARCH Morgan Stanley & Co. International plc October 14, 2010  UK strategy – time to think about Europe North inflation … Investors should focus on the America longer-term impact of QE and the UK ## Consumer Discretionary implications for higher inflation, which ## Consumer Staples should be good news for equities vs. ## Energy/UtilitiesGraham Secker (Page 3) bonds, argues INVESTMENT  ## Financials Semiconductors – too early to turn positive: Francois Meunier initiates coverage ## Healthcare PERSPECTIVES ## Industrial/Business Services that it is too with a Cautious view, arguing early to buy into the sector, especially with ## Materials an inventory correction looming in the PC ## Media and consumer space (Page 23). ## Property  Imperial Tobacco – the merits of ## Retail partnering: Toby McCullagh argues that ## Technology partnering can add a capital- international ## Telecommunications risk driver to light and relatively low Imperial’s top-line growth and a further leg ## Transportation to his Overweight thesis (Page 27). Strategy and Economics 15 US Economics UK Roadmap to Sustainable Growth Richard Berner, David Greenlaw 3 UK Strategy Time to Think about Inflation… and Equities 17 US Credit Strategy Outperforming Bonds Tale of Two Markets Graham Secker Rizwan Hussain, Maya Abdurahmanova 7 UK Economics 19 Commodity Strategy Spending Review: Further Lines of Attack for Natural Gas – Fundamentally Oversupplied Critics Hussein Allidina, Stephen Richardson, Tai Liu Melanie Baker, Anthony O’Brien, Cath Sleeman Industry & Company Analysis 9 UK Interest Rate Strategy 21 Airlines UK Rates: Time to Deliver Short Haul: Long Opportunity Anthony O’Brien, Melanie Baker, Cath Sleeman Penelope Butcher, Suzanne Todd, Menno Sanderse Global 23 Initiation Semiconductors 11 European Credit Strategy Cautious on Sector but Upside in ARM, IFX, ING Deleveraging and the Debt/Equity Clock and WLF Andrew Sheets, Phanikiran Naraparaju, Carlos Egea, Francois Meunier, Sunil George, Patrick Standaert, Serena Tang, Jonathan Graber Mark Lipacis, Atif Malikm Sanjay Devgan Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision. Customers of Morgan Stanley in the US can receive independent, third-party research on companies covered in Morgan Stanley Equity Research, at no cost to them, where such research is available. Customers can access this independent research at www.morganstanley.com/equityresearch or can call 1-800-624-2063 to request a copy of this research. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report. + = Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.
  • 2. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Table of Contents (continued) (continued…) 27 Imperial Tobacco Partnering Model Could Offer Upside to Growth Estimates Toby McCullagh, David Adelman, Matthew Grainger 29 SOCO International Back to Core – Stay OW Theepan Jothilingam, Matthew P Lofting 31 Initiation Unite Group Superior NAV Growth Even With Modest Rental Growth Bianca Riemer, Bart Gysens, Christopher Fremantle 33 Vodafone Group Rising Cash Returns Nick Delfas, Terence Tsui, Luis Prota, Frederic Boulan 35 Wolseley plc Increased Confidence in Restructuring: Stay OW Jessica Alsford, David Hancock, Simone Porter-Smith 37 Wood Group Value Materialised; Downgrade to Equal-weight Martijn Rats, Robert Pulleyn Portfolio and Valuations 39 UK Economic Forecasts 40 Indices, Sector and Stock Performance 41 UK Industry Valuations and Forecasts 42 Diary of Key Upcoming Events 47 Company and Directors’ Share Buybacks 54 UK Stock Coverage List 2
  • 3. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Strategy and Economics October 12, 2010 Japan is the exception not the rule, and the authorities are on the case UK Strategy When considering the inflation/deflation debate, it is apparent to us that the market appears to be deferring to the Japanese Time to Think about Inflation… experience. While this is understandable to a degree, given and Equities Outperforming Bonds some of the similarities between Western economies today and Japan over the last 20 years, we are conscious that Morgan Stanley & Co. Graham Secker Japan itself has been something of an anomaly in the sense International Limited+ Graham.Secker@morganstanley.com that it is the only country in recent economic history that has Looking to the longer-term ramifications of QE effectively chosen the deflation rather than inflation route. With pretty much every asset class apart from the US dollar More importantly, in our view, however, is the fact that the rising in recent weeks, it appears that the market is busy authorities are going all out to prevent deflation taking hold. preparing for a renewed bout of quantitative easing (QE) by While these authorities are not omnipotent, we think it would the Fed. While a period of good performance is always nice, be unwise to bet explicitly against them, at least at this stage. we believe investors should take this opportunity to focus on the more medium to longer-term ramifications of QE (and Core CPI is a key indicator to watch … other forms of monetary stimulus). In this article we focus on Consequently, we believe investors should keep a close eye the implications for asset allocation and, specifically, the on current inflation trends going forward as any evidence of a possibility that this new QE programme coincides with a trough could have significant implications for asset allocation. trough in US core inflation. In his recent report QE Coming: Slow Rise in Inflation Not Enough to Satisfy the Fed, 1 October 2010, our US economist We expect moderate inflation rather than deflation Richard Berner argues for a slow rise in inflation through 2011 When considering the link between asset allocation and and notes that rents, which account for 40% of the core CPI inflation, the relative performance and valuation of equities basket, are now rising again, as Exhibit 2 illustrates. The versus bonds suggests to us that investors are predominantly Fed’s preferred measure of inflation is the PCEPI which has a concerned about deflationary risks. While we accept that much lower housing weighting in the index – this series has deflation in Western economies is a possible outcome from held up much better than core CPI this year and may already here, we firmly believe that it is not a probable outcome in the be troughing. medium term. At the same time, we do not predict a big inflation problem. Instead, we expect inflation to be a bit … and a number of macro indicators suggest it may be higher than one would naturally expect for a low rate of troughing economic growth – i.e. a more benign version of stagflation. In terms of other indicators, we note that the recent rise in the prices paid component of the ISM manufacturing survey points Exhibit 1 When faced with a debt problem most countries Exhibit 2 tend to choose inflation – Japan was the exception US rents are 40% of core CPI and are now rising $1,000 94.5% $980 94.0% National Effective Rent (Left Scale) National Occupancy Rate (Right Scale) $960 93.5% $940 93.0% $920 92.5% $900 92.0% $880 91.5% Source: National Statistics, Morgan Stanley Research $860 91.0% Apr-08 Aug-08 Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 Aug-10 Source: Axiometrics 3
  • 4. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Strategy and Economics to upside risks to CPI, as does the rise in capacity utilisation Exhibit 3 that is now underway in the US (and Germany and the UK The Fed’s preferred measure of inflation (PCEPI) is too). Finally, we note that US yield curves remain steep at showing signs of troughing both the 10-2yr level and the 30-10yr level – arguably, the 3.5% former suggests the growth outlook is okay while the latter, which is at a 30-year high, suggests inflation will return. 3.0% 2.5% A trough in inflation would be an important signal for US Inflation asset allocation 2.0% If we do see the start of an uptrend in global inflation pressures over the next six months, this could have a 1.5% PCEPI profound impact on asset allocation. The huge amount of liquidity sloshing around the global financial system right now 1.0% is predominantly sitting in bond funds. However, while this is Core CPI understandable in a world worried about deflation, we think 0.5% Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 such a position is much harder to justify if investors start worrying about rising, not falling, inflation. As Exhibit 7 shows, Source: Haver, Morgan Stanley Research developed equity markets have shrunk significantly in size Exhibit 4 compared to developed bond markets over the last decade or Break-even inflation expectations are rising … so. Consequently, a moderate outflow from bonds to equities 3.3 is more meaningful now than it would have been 10 years ago. 3.1 10-yr Breakeven inflation expectations When we consider asset allocation in this regard it is 2.9 UK important to note that there is, in our opinion, a significant 2.7 divergence in view between equity and fixed income investors 2.5 at this time, with the latter significantly more bearish on 2.3 growth and inflation than the former. Assuming this is indeed 2.1 US true, then it suggests that the investment implications of any uptick in inflation is more profound for bonds than stocks. In 1.9 particular, we would highlight the traditional link between US 1.7 core inflation and US bond yields, as highlighted in Exhibit 5 – 1.5 yields always back up around a trough in core inflation. Oct 09 Nov 09 Dec 09 Jan 10 Feb 10 Mar 10 Apr 10 May 10 Jun 10 Jul 10 Aug 10 Sep 10 Oct 10 Source: Bloomberg, Morgan Stanley Research Bonds are more popular now than equities were in 2000 Exhibit 5 In addition to bond investors’ bearish macro view as a starting … and a trough in core CPI often coincides with a point, we also note that bonds are far more popular as an trough in treasury yields asset class than equities are. The best chart we have come 16 across to illustrate this point is Exhibit 6 – simply put, bonds are more popular today than equities were at the peak of the 14 TMT bubble in 2000. 12 In addition, the market’s hunger for all things fixed income is 10 reflected in recent bond news, such as: US 10-yr treasury yield (%) 8 6  corporates borrowing at record low interest rates (e.g. IBM issuing bonds at 1%, Microsoft borrowing at 4 sub-1%); 2 US core CPI 0 Jan-80 Jan-83 Jan-86 Jan-89 Jan-92 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 Jan-10 Source: Datastream, Morgan Stanley Research 4
  • 5. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Strategy and Economics  corporates issuing 100-year bonds at sub 6% yields (for Exhibit 6 example, Norfolk Southern and Rabobank); Bonds are more popular now than equities were in 2000  Mexico issuing 100-year bonds at 6.1% yields; 500 Rolling 12M Aggregate Flows To US Mutual Funds $bn . 400  Brazilian companies in highly cyclical industries, such as cement and real estate, now issuing perpetual bonds 300 (i.e. where there is no maturity and companies can choose 200 when to pay back the debt at their own discretion). 100 Returns are not risk-free 0 We acknowledge that one explanation for the strong demand -100 for bonds and aversion to stocks is that some investors are Equities predominantly focusing on the risk, as opposed to the reward, -200 Bonds side of the investment equation. True, investors are unlikely -300 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 to lose money in nominal terms. However, we suspect many are buying bonds today on the basis that it is impossible to Source: ICI, Morgan Stanley Research lose money. We do not believe this premise is necessarily Exhibit 7 true, certainly in real terms, and would note the following: DM equity markets are now just 40% of DM bond markets 1. Government bonds have been in a strong bull market for 110 the last 30 years or so. However, pre-1980 gilt yields trended DM Market Cap as % Debt Securities Outstanding 100 up and a nominal series of gilt prices trended down (Exhibit 8). 90 2. The low return on bonds pre the 1980s coincided with a 80 period of heightened inflation so that real returns to investors 70 were negative. Exhibit 9, which comes from the book Triumph 60 of the Optimists by Dimson, Marsh and Staunton, shows that 50 investors in US bonds lost money in real terms over a 40-year period between 1940 and 1980. Note that this chart looks 40 exactly the same for the UK too. 30 20 A pick-up in inflation should be good for equities initially 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 If inflation does ultimately start to rise (given that it is already Source: Company data, Morgan Stanley Research high in the UK we should say if higher inflation becomes more Exhibit 8 entrenched), we believe it will be good news for equities Prior to the last 30 years bond prices fell regularly… initially (especially relative to bonds). For much of the last 30 20 130 years or so a trough in inflation has generally been perceived to be bad for stocks as investors reacted to a prospective 18 UK gilt price index - rhs 120 UK gilt yields change in the interest rate environment. However, we think 16 110 FT All Govt Bond Priice Index this relationship is related to the existence of the debt 14 100 UK 20Yr Gilt Yields supercycle which meant that markets became more sensitive 12 90 to changes in the cost of credit rather than changes in the 10 80 underlying growth outlook. As our global strategist Gerard 8 Minack has regularly highlighted over the last year or so, the 6 70 ending of the debt supercycle means that the stock market is 4 60 now much more sensitive to changes in economic growth 50 2 than it is to the interest rate outlook. 0 40 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 Source: Datastream, Morgan Stanley Research 5
  • 6. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Strategy and Economics More likely to get ‘bad’ rather than ‘good’ inflation Exhibit 9 However, we are under no illusion that inflation is the answer In real terms investors lost money in US bonds to our structural macroeconomic problems – the inflation we steadily between 1940-1980 do get is more likely to be ‘bad’ inflation (i.e. non-discretionary inflation, which is running at 7% year-on-year in the UK) than ‘good’ inflation (i.e. a rise in incomes, wages and profits). Consequently, inflation acts as something of a tax on the domestic economy and a reallocation of funds away from import-oriented economies in favour of the exporters of inflation. Buy the sources of inflation – sell the takers of inflation We would highlight two implications for equity investors. First, investors should avoid exposure to domestic discretionary spending where inflation eats into disposable income. For Source: Triumph of the Optimists, Dimson, Marsh & Staunton example, with wage growth slow and inflation high, Exhibit 11 Exhibit 10 shows that the current level of real consumer disposable The trough in CPI in 1998 coincided with a rapid income growth is already at its lowest level since 1977. acceleration in TMT outperformance Second, investors should look to gain exposure to the sources 4.0 160 of inflation – specifically, this is likely to mean industrial and 150 commodity companies (including domestic focused plays 3.5 140 such as agriculture). In addition, stocks with strong pricing 130 power that can pass on higher input prices should perform US TMT vs US Market 3.0 US TMT Rel Perf - rhs well, as should gold. 120 US CPI 2.5 110 In terms of sectors, we are currently overweight Insurance, 100 2.0 Materials, Energy and Telecoms in our European model US CPI 90 portfolio. Of the four, we believe that the latter is the only 80 1.5 sector that does not give us exposure to the theme of rising 70 inflation or bond yields. Traditionally, banks/financials are 1.0 60 perceived to be big losers in an inflationary environment Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 (when you want to be a borrower rather than a creditor). Source: Datastream, Morgan Stanley Research However, that situation is arguably reversed when the Exhibit 11 borrower is under water and asset price inflation would reduce the risk of negative equity. We are neutral banks. UK household disposable income growth at a 33-year low 12 An uptick in inflation would also point to underperformance Real Aggregate Household Disposable IOncome (YoY %) from bond proxies and other stocks with poor growth profiles 10 irrespective of valuation (i.e. beware of low growth value 8 traps). Instead, higher inflation would point to owning stocks 6 with a good growth profile (which have a better ability to 4 absorb higher costs or pass them on to their customers). Note 2 that we saw a marked upturn in inflation at the end of the 1990s as authorities’ reacted to the 1998 growth scare with 0 additional stimulus (sound familiar?), and we consequently -2 saw outperformance from the area of the market that was -4 perceived to have the best growth prospects – TMT. Today, -6 the area of the market where growth perceptions are highest 60 65 70 75 80 85 90 95 00 05 10 is emerging markets. Source: Haver, Morgan Stanley Research 6
  • 7. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Strategy and Economics October 8, 2010 … but this Spending Review is set to be a bit different. UK Economics  Large budget cuts: The overall ‘spending envelope’ was set out in the June Budget. On the government’s Spending Review: Further Lines of own estimates, government spending is set to be cut Attack for Critics by around £80 billion between 2010/11 and 2014/15) 1 . That is, some 6% of 2009 GDP over five years. The Morgan Stanley & Co. Melanie Baker, CFA overall planned deficit reduction looks very ambitious International plc+ Melanie.Baker@morganstanley.com Anthony S O'Brien, Cath Sleeman when scaled against previous reductions. We assume there will not be major changes to the path for In the view of our Interest Rate Strategy Team, as long as the government spending and investment shown in the market perceives that the government is sticking to its plans, Budget. the October 20 Spending Review should not be a negative risk event for Gilts. However, fiscal spending plans have yet  It will go beyond departmental budgets: This to be spelled out in much detail. The upcoming Spending Spending Review, as well as laying out departmental Review will outline the departmental spending cuts and, we budgets, will also look at the bits of spending that assume, provide additional detail on actual programme cuts cannot be ‘firmly fixed’, including social security, tax within this. credits and public service pensions. It is therefore a very wide-ranging exercise. We assume that we are This is of course a necessary step in maintaining fiscal unlikely to learn exactly what these decisions will do credibility. However, the details of the Spending Review will for the size of the public sector workforce. We provide more ‘lines of attack’ for critics who doubt that the assume, however, that we will get a reasonable plans can be achieved without considerable damage to the amount of detail about specific programme cuts. real economy and to public services. It will be particularly important therefore to see how much protection is given to  Ambition goes beyond just cost-cutting: The spending that is likely to boost the UK’s longer-term growth Spending Review is not just seen by the government potential. However, given the scale of the spending cuts as an exercise in fiscal consolidation, but, according to planned, some compromise on that front seems inevitable, in the Spending Review Framework, as an opportunity to our view. “think innovatively about the role of government in society”. A step that should be about shoring up credibility and that should provide more certainty about the path of government Big cuts for some departments spending, could therefore also become a trigger for weaker The scale of the departmental cuts, and the overall economic confidence among households and businesses and doubt implications of the budget, will be affected by the split among investors about the ability of the economy to generate between cuts in welfare and departmental spending and the growth. That effect could be magnified if 3Q GDP growth – degree to which some sectors are protected. released only a few days after the Spending Review – disappoints (as we think it may well do; we forecast: 0.1%Q).  Split between welfare, pensions and departmental spending: Welfare cuts will mean that less has to be This Spending Review is different cut from departmental expenditure. Since the June The basics …: The path for public expenditure was set out in Budget Chancellor Osborne has announced a further the 22 June Budget (see our budget review note). The £4 billion in welfare cuts 2 ; this should ease Spending Review will lay out in more detail how this path will departmental settlements (very) slightly. Further cuts be achieved and will cover the years from 2011/12 to in welfare could come (and have, with the recently 2014/15. Designed to help multi-period planning, such announced cuts to Child Benefit). However, some of spending reviews have occurred regularly since the late this will likely cover the upfront cost of far-reaching 1990s (the last in 2007). 1 Against baseline where departmental spending rises with inflation. 2 http://www.bbc.co.uk/news/uk-politics-11250639 7
  • 8. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Strategy and Economics planned reforms to the benefits system. Generalised Effect on the economy public sector pension savings will help ease the We still think that the planned fiscal consolidation will act as a burden on departmental budgets. significant drag on the economy over the next few years. The Spending Review itself may have additional implications.  Split between departments for departmental spending: Two departments are protected: Certainty versus confidence: The Spending Review may Health and International Development. Further, in the bring more certainty for businesses (particularly those with Budget the Chancellor hinted that education and large public sector contracts) and households (particularly defence would see easier settlements, implying that benefit-dependent households and those with public sector the cuts to other unprotected departments would be workers). But it may also encourage a dawning realization of bigger again (see Exhibit 1 for one way the cuts could just how big these cuts are. It is not clear that the full be shared). magnitude and implications are apparent to households. Exhibit 1 More ‘positive’ if age-related expenditures addressed and Example of how the spending cuts could fall potential ‘growth boosting’ areas protected: In judging the £billion % change overall impact, it will be important to see what has been cut. Baseline real For example, cuts to public sector retirement benefits can 2010-11 2014-15e enhance long-term fiscal sustainability. There may be Spending Review 'envelope' 659 particular negative implications for longer-term growth from Social security/tax credits 193 210 any substantial cuts to the education budget, cuts to Net public service pensions 4 9 science/research and cuts to the transport budget. The Locally-financed expenditure 33 35 Other AME in Spending Review 15 25 government has promised to protect as far as possible Departmental budgets (DEL) 394 380 “spending that generates high economic returns.” 1 Further, Education 58 57 -10 PM Cameron has apparently ordered ministers to draw up a Health 106 119 2 plan for boosting potential growth with a growth White Paper Communities & local to be published after the Spending Review 2 . However, the government 36 30 -24 spending cuts are ambitious enough for us assume Business, innovation & compromises will be made. skills 21 18 -24 Defence 46 45 -10 Near-term implications for monetary policy: We assume Devolved administrations 56 46 -24 that what matters more for monetary policymakers is the Work and Pensions 9 7 -24 overall size of spending cuts rather than the specific detail. Home office 10 8 -24 But clearly the effects on consumer and business confidence Justice 10 8 -24 and the effect on markets will be important to the Bank of Transport 14 11 -24 England’s calculations on what to do next on monetary policy. Other* 29 31 -4 Hits to business and consumer confidence could be enough Source: HM Treasury and Morgan Stanley research estimates (= e) Notes: Baseline uses figures from June 2010 Budget. For 2014-15 figures for all items in the to prompt a QE extension, alongside any disappointment in table up to ‘Departmental budgets (DEL)’ use numbers from Budget table C13. Except ‘Spending Review envelope’ which comes from table 2.3. Social security/tax credits is also GDP growth. However, the Spending Review is likely to be less the £4bn of welfare cuts announced by Chancellor Osborne. ‘Departmental Budgets ‘too young’ for the effects on confidence to be read very (DEL) from table C13 adds £4bln from welfare savings. In order to calculate % change in real terms, nominal figures in the 2014-15 column are translated into 2010-11 prices using the clearly by the MPC by the time of the November meeting. We GDP deflator (OBR forecast from the June Budget). * Includes protected overseas aid budget. The government has committed to real term continue to think that any QE extension is unlikely in the UK at increases in health spending in each year of the parliament (i.e. to 2014/15). The government has also committed to spending of 0.7% of gross national income on overseas this stage, unless 3Q GDP contracts (data released on aid (by 2013). 26 October). 1 Source: Spending Review Framework 2 http://www.ft.com/cms/s/0/e773f5c2-cd8d-11df-9c82- 00144feab49a.html 8
  • 9. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Strategy and Economics October 8, 2010 Exhibit 1 UKT and DBR 10y a/s spread UK Interest Rate Strategy UKT 10y UK Rates: Time to Deliver 12 Richening into June Budget DBR 10y -19 Morgan Stanley & Co. Anthony S O'Brien DBR 10y a/s (bp) UKT 10y a/s (bp) International plc+ Anthony.O'Brien@morganstanley.com 8 -23 Melanie Baker, CFA, Cath Sleeman 4 -27 Investors have given the coalition the benefit of the doubt Investors appear to have given the Coalition the benefit of the doubt, in terms of their ability to carry out the aggressive 0 -31 spending cuts the Chancellor announced in June’s Emergency Budget. UKT 10y yields have outperformed bund -4 -35 yields by 30bp since mid-June, but underperformed US Jun-10 Jul-10 Aug-10 Sep-10 treasuries. However, using perhaps a better gauge of fiscal Source: Morgan Stanley Research credibility - performance versus swaps, 10y gilts have richened by 12bp, whereas treasuries are unchanged and Exhibit 2 bunds actually cheapened a touch – see Exhibit 1. We had UKT 30y a/s spread and deficit/GDP recommended long asset swap positions since before the % Deficit to GDP -110 Budget, sensing Chancellor Osborne would ‘talk tough’ on 30y a/s spread 4 deficit reduction, however, we suggested taking profits in A/s spread (bp) inverted September ahead of the Conference season and October -70 Deficit to GDP (5) Spending Review as political uncertainties loomed. Now it is 0 time for the Chancellor to deliver. -30 -4 Overall, their members generally backed the coalition parties during Conference, no matter how unpalatable some 10 grassroots supporters found the fiscal plans. The Spending -8 Review presents the next hurdle before the austerity axe finally lands next fiscal year. As our economists discussed in -12 50 the previous section, the Chancellor’s plans presented in the Dec-00 Dec-03 Dec-06 Dec-09 Dec-12 Dec-15 Spending Review should be credible and demonstrate that Source: Bloomberg and HMT the Coalition will not shy away from the tough deficit reduction plan it laid out in June. This suggests that a/s spreads should Exhibit 3 continue their richening trend, making new wides, although GfK Consumer Confidence Index speculation at the degree of ‘re-profiling’ should mean 5 spreads underperform as we approach 20 October (see later). Exhibit 2 plots the percentage deficit to GDP ratio and 30y a/s -5 spreads since 2000. We also include the deficit reduction path laid out in the Emergency Budget, which implies the 30y -15 spreads should test zero in 2012. Index The consensus among investors seems to be that adherence -25 GfK Index to the spending plans will have a detrimental effect on June economic growth. We would argue that much of this is already -35 Budget in the price, with short sterling contracts implying the MPC will be on hold for the next 12mths. Indeed, the OBR believes the -45 cost to growth from the faster fiscal consolidation will be only Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 a few tenths of GDP. However, one should remember Source: Bloomberg 9
  • 10. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Strategy and Economics consumer confidence reached its lowest levels this year just Exhibit 5 after the Emergency Budget – see Exhibit 3. Confidence is UKT yield curve and 3-month carry and rolldown heading lower again according to the GfK and if it hits a new 4.0 Max Carry 20 low after the Spending Review, this would give the MPC much & roll to consider so close to Christmas. 3.0 15 Yields to test new lows Carry & Roll (bp) Spot Yield (LHS) Yield (%) Carry + Roll (RHS) So with the Spending Review unlikely to back-track on any of 2.0 10 the plans set out in the Emergency Budget, we think yields are likely to test new lows. We continue to recommend being 1.0 5 long GBP 2y2y outright and via receiver spreads (UKT 2s4s cash for cash extensions), earning as much carry/rolldown as 0.0 0 possible while waiting for a decision on QE. We would like to Dec-11 Dec-17 Dec-23 Dec-29 Dec-35 Dec-41 add receiving GBP 5y5y to our suit of trades. Unlike many of Source: Morgan Stanley Research its foreign currency peers, it still trades over 4% (rec GBP 5y5y at 4.12%, target 3.70%, stop 4.30%). Looking across the Re-profiling yield surface, we believe it offers an attractive combination of Concerns are emerging about the extent of “re-profiling” that level of yield and rolldown (1/2bp a week). Clearly the risk to may take place (a term used in Whitehall for delaying cuts this trade would be if the Chancellor delayed the spending until later in the parliament). The FT reported on 7 October cuts he announced in the Budget. that many spending cuts scheduled for 2011/2 may be difficult For the gilt curve, although carry and rolldown have fallen to implement due to existing contracts etc. Talk of delays will throughout the year both on an absolute and vol-adjusted weigh on asset swap spreads particularly in the long end with basis, it still favours owning the belly of the curve vs. barbells, the upcoming syndication to accommodate. Hence, we would hence we continue to favour 5->10y bullets vs. the 2y and expect asset swap spreads to underperform into the Spending 20/30y wings – see Exhibit 5. Review. However, detail is essential, as we think investors are likely to support some delays to cuts if the reasons are The devil is in the lack of detail credible or unavoidable and not a sign of the coalition We see two potential risks to our bullish assessment – not softening their deficit reduction targets enough detail and the extent of “reprofiling”. Investors are MPC minutes also on 20 October unlikely to demand too much in the way of detail, as most of the decisions about where to focus the incisions will be left to However, the Spending Review could possibly be the various departments and not the Chancellor. However, overshadowed by the release of the MPC minutes for the some detail on where the largest savings will be made are October meeting earlier that day. We expect a 3-way split in essential, in our view. vote on monetary policy (a rare event, but one that has happened before in May and August 98 and May 06 and Exhibit 4 GBP 2y2y and 5y5y to Set Test New Lows arguably in November 09), with Sentance still seeing a need to tighten monetary policy and Posen, following his recent speech, advocating an extension of QE. We believe interest 5.0 will focus on whether any members join Posen, given the dovish tone to the minutes from the September meeting. We think that the current high inflation rate and strong 2Q GDP Yield (%) 4.0 data mean the effective ‘barrier’ to extending QE is relatively high at present. Therefore, we do not foresee many members having voted for QE in October, especially given the proximity 3.0 GBP 5y5y of the November Inflation Report and Q3 GDP release (26 GBP 2y2y October). The absence of other members voting for QE may be a slight disappointment to the gilt market, however, we 2.0 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 believe this will be short lived as the November Inflation Report could be a “game changer” for members and hence prolong Source: Morgan Stanley Research the interest in further QE. 10
  • 11. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Strategy and Economics October 8, 2010 Exhibit 2 European Inv. Grade Debt/Equity Clock European Credit Strategy YoY LTM EBITDA Change -6% -4% -2% 0% 2% 4% 6% 8% 10% 12% Deleveraging and the Debt/Equity -10% Q1 03 Clock -5% Q3 03 Q2 04 04 Q4 Q3 Q4 04 Q1 10 Q1 04 Q4 02 03 Q1 05 Q2 03 Q2 10 Morgan Stanley & Co. Andrew Sheets Q4 09 Q2 06 Q2 05 Q3 06 06 International plc Andrew.Sheets@morganstanley.com Q4 0% Q3 05 Q2 07 06 Q1 YoY Net Debt Change Q3 02 Q1 07 Phanikiran Naraparaju, Carlos Egea, Q3 07 Serena Tang, Jonathan Graber Q2 08 Q4 07 Q4 05 Q2 02 5% Q1 02 Q1 08 Key sentiment indicators suggest a market that recently Q3 09 Q4 01 Q3 08 became more bullish, which in our view argues for more 10% Q2 09 tactical caution near-term (see Not Over, But Over Bought, Oct 8, 2010). Our caution is tactical (the next 2-3 weeks) 15% Q3 01 Q4 08 largely because corporate balance sheet trends still suggest a Q1 09 highly constructive stage of the broader credit cycle. In this Q2 01 20% week’s note, we revisit the balance sheets of European IG and High Yield issuers, focusing on liquidity, leverage, and the Source: Morgan Stanley Research, company reports, Bloomberg trends at the border of BBB & BB-rated names. For the moment, corporate trends remain encouraging, and still quadrant, with leverage still falling as corporates remain suggestive of ‘early cycle’ activity, although not without conservative amidst the volatile macro, but EBITDA exceptions. With our data suggesting that European mutual recovering on the back of better global growth. fund inflows are moderating (see What European Credit The ‘recovery’ quadrant can be a rare stage that is supportive Mutual Funds are Up to, Oct 1, 2010), fundamentals appear of both credit and equity, as operations are generally increasingly important in supporting the strategic credit story. improving but risk appetite (of either aggressive M&A, or Exhibit 1 shareholder friend activity) remains more constrained. Indeed, Our “Debt/Equity Clock” several measures of corporate risk tolerance - the current pace of M&A, Debt Growth, or Capex Spending - are more 1 Leverage 2 REPAIR (1H09) Falling (2003-05, 2H09 - ?) RECOVERY reminiscent of 2003/04 than 2006/07. Similar to 2003, fears of Balance sheet repair, rights issues to pay back debt, focus on cash Restructuring efforts boost cash flow. Margins rising, FCF growing, leverage deflation still linger, European corporate debt levels are falling generation and survival. falling. YoY (despite the record-low level of rates), and capital Credit Better Than Equity Both Equity and Credit UP spending remains muted (again, despite cheap financing Low Growth The Debt- High Growth 4 Equity Clock 3 costs). Although M&A activity is picking up, and should Both Equity and Credit DOWN Equity Better Than Credit continue to, volumes remain at 2004-levels and transactions DOWNTURN (2H07 – 2008 ) (2006, 2007) EXPANSION generally seem ‘early cycle’ in nature (i.e., deals are value Recession. Attempts to delever Leverage rising intentionally. foiled by falling asset prices. Corporate activity speculative, accretive, reasonably financed). Continued bear market for credit. volatility rising. Credit bear market Equities enter bear market. starts, equities still in bull market. Leverage Above, we attempt to put real-world data behind our stylized Source: Morgan Stanley Credit and Equity Strategy Rising debt/equity clock. The x-axis measures year over year Source: Morgan Stanley Equity & Credit Strategy changes in profitability (EBITDA) and the y-axis measures Debt/Equity clock update YoY changes in net debt. Both the IG and HY markets are now in the top-right quadrant, where LTM profits are higher For almost a decade, our Credit Strategy group has been than a year before and net debt levels are lower. using a “debt/equity clock” to frame four stages of the credit cycle: expansion, downturn, repair, and recovery. The model, The above chart focuses only on non-financial corporates. albeit simplistic, helps remind us that the “credit cycle” is With banks at the heart of the recent cycle’s stresses, it is exactly that, a process that moves through stages to the reasonable to see the memories of peering into the abyss benefit or detriment of our asset class. At the moment, we mean that their managers and regulators remain committed to view credit as occupying the “recovery” stage in the top-right risk-reduction for longer in the current cycle. In corporates, we fear the same tug will be weaker, simply because many non- financials were further removed from the market’s worst 11
  • 12. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Strategy and Economics stretches. Although we don’t feel that capex or inventory Exhibit 4 activity will show the exuberance usually associated with short % of Companies Deleveraging (YoY) in IG and HY business cycles, we can see a scenario where companies do 80% turn more aggressive more quickly going forward if we look beyond 6-12 months. For a discussion on the prospects for 70% more equity-friendly behaviour, and how this might manifest itself, please see Credit is Telling Equities to Hike the 60% Dividend, Sept 17, 2010. 50% Different drivers of deleveraging 40% IG corporates showed limited sequential improvement in terms of net leverage (roughly flat at 1.8x net debt/EBITDA), IG 30% HY but largely held on to the year-over-year improvements during a difficult quarter for trading. The HY market actually turned in 20% a more impressive quarter in terms of deleveraging, with 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 median net leverage at 3.3x, about a turn lower than the peak Source: Morgan Stanley Research, Company Reports, Bloomberg in 3Q09. Always welcome, deleveraging comes in different forms. As Liquidity remains strong Exhibit 2 shows, the EBITDA rebound is currently a more One defining aspect of corporate fundamentals through the important driver of year-on-year deleveraging. We are just past recession has been strong cash generation as measured beginning to see these companies pay down gross debt. by free cash flow to debt. Companies tightened working Exhibit 3 capital and slashed capex to preserve cash. IG companies Net Leverage – IG & HY spent 15% less than a year ago on capital expenditures. HY corporates had to cut even further, reducing their capex 4.5 spend by 21.5% over the same period. Not only is FCF/Debt 4.0 strong for both cohorts, but the % share of FCF positive HY IG 3.5 companies remains near historical highs. 91% of IG corporates and 74% of HY corporates are generating net 3.0 cash. 2.5 Exhibit 5 2.0 FCF/Debt across IG and High Yield 20% 1.5 1.0 15% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 10% Source: Morgan Stanley Research, Company Reports, Bloomberg An important characteristic of recent deleveraging is that it’s 5% broad-based. In IG over 70% of the universe have reduced 0% net leverage year-on-year, and close to 65% of HY 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 companies have delevered over the same period. -5% -10% IG HY -15% Source: Morgan Stanley Research, Company Reports, Bloomberg 12
  • 13. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Strategy and Economics Exhibit 6 current levels, by sector and rating, of FCF/Debt, Cash/Debt, % of Companies FCF+ across IG and High Yield Interest Coverage and Net Leverage. The year-on-year 100% absolute change of these metrics is reported in parentheses. Exhibit 7 90% European IG Sector Scorecard 80% FCF/Debt Cash to Debt Int Cov Net Leverage Autos 120% (101%) 186% (107%) - -0.5 (-2.2) 70% Chemicals 21% (3%) 41% (15%) 7.6 (-1.1) 1.1 (-0.7) Cons. Disc. 43% (19%) 21% (5%) 11.0 (1.6) 1.5 (0.2) 60% Cons. Stap. 22% (10%) 18% (3%) 5.7 (0.9) 2.3 (-0.3) IG Energy 0% (-17%) 30% (0%) 33.1 (12.3) 0.8 (-0.1) 50% HY Health Care 34% (-4%) 44% (-18%) 13.1 (1.6) 0.6 (0.2) Industrials 19% (-3%) 32% (5%) 7.3 (1.8) 1.6 (-0.2) 40% Materials 14% (2%) 14% (-9%) 8.8 (1.7) 2.0 (0.3) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Media 22% (0%) 28% (3%) 8.8 (2.7) 1.6 (-0.3) Telecom 15% (3%) 16% (0%) 7.4 (1.1) 2.3 (-0.2) Source: Morgan Stanley Research, Company Reports, Bloomberg Utilities 8% (5%) 9% (-3%) 5.5 (0.3) 3.7 (0.7) Market 19% (4%) 21% (1%) 7.3 (1.2) 1.8 (-0.3) Are the gains to cash generation from these cuts at risk? Source: Morgan Stanley Research, Company Reports, Bloomberg There is the risk that working capital consumes more cash as companies restock. Our European economists note that IG fundamental trends look pretty consistent across the manufacturers have acted more aggressively on the working board. IG Autos have performed exceptionally well at the capital management front this cycle compared to any of the industrial co level, enjoying the benefits of various national previous cycles, cutting inventories deeper and restocking auto stimulus plans. Chemicals also show impressive more slowly. The latter trend reflects business skepticism deleveraging on the back of an EBITDA rebound thanks to about the durability of the recovery, but recovering order global demand. Materials are also faring better than the demand has forced a reassessment: surveys show a record headline; ex-MTNA, the sector has delevered half a turn year share of euro area manufacturers “view their inventories of on year. As we’ve mentioned before, we like Materials names finished products as insufficient right now” (Euroland for their exposure to global growth. Economics: Chewing on Green Shoots, Aug 5, 2010). Despite Exhibit 8 the uptick in order demand, there is yet little pressure to European HY Sector Scorecard expand operations organically. Capacity utilization in the FCF/Debt Cash to Debt Int Cov Net Leverage eurozone sits at just 75.5% at the end of the second quarter, Autos 25% (18%) 49% (28%) - 1.1 (-1.1) well below the 15-year average (~82%) and even the early Chemicals 11% (-2%) 30% (0%) 3.8 (0.4) 2.5 (-0.5) Cons. Disc. 13% (13%) 30% (11%) 4.8 (1. 7) 1.6 (-1.0) 1990s nadir (76.7%). Cons. Stap. 14% (4%) 9% (4%) 3.7 (-0.6) 3.2 (-0.3) Despite these potential stresses on free cash flow generation, Energy 14% (21%) 17% (-1%) 3.0 (-0.5) 4.9 (-1.6) Industrials 1% (4%) 24% (-6%) 2.7 (0.2) 4.7 (0.0) projected figures are upbeat. Aggregating the estimates of our Materials 6% (-4%) 26% (4%) 2.4 (0.0) 3.4 (-1.9) equity analysts for western European companies, 2011e FCF Media 9% (5%) 7% (2%) 2.1 (-0.5) 5.3 (0.6) should be just 4% off 2009 levels, and 2012e FCF a 5% Telecom 9% (6%) 3% (-3%) 4.5 (1.0) 2.6 (0.0) improvement. As the debt/equity clock turns, FCF is likely to Market 8% (3%) 20% (4%) 3.0 (0.1) 3.3 (-0.8) once again turn lower as companies (or their acquirers) find Source: Morgan Stanley Research, Company Reports, Bloomberg other uses for the cash. But for now, high levels of cash and Please note that all important disclosures including personal holdings cash flow remain highly supportive of credit quality, and near- disclosures and Morgan Stanley disclosures appear on the Morgan Stanley public website at www.morganstanley.com/researchdisclosures. term default risk. Trends by sector and rating HY fundamental trends exhibit a little more dispersion. HY Digging a level deeper, we look at trends at the sector and Media is faring the worst in terms of net leverage, and its rating level. Our one high-conviction sector trade has been interest coverage is the lowest among the sectors. Autos, overweight financials, especially sub-debt. Within non-financials, Consumer Discretionary, and Materials have shown the most we’re pleased with the broad-based fundamental improvement progress in deleveraging, reflective of a cyclical rebound. The across sectors, and find more value in contrasting individual deleveraging in the Energy sector is due entirely to Petroplus credits, beyond the sector level. In Exhibits 7-8 we present the returning to profitability. 13
  • 14. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Strategy and Economics Exhibit 9 Exhibit 11 Scorecard by Rating (AA-CCC) European Leverage by Rating FCF/Debt Cash to Debt Int Cov Net Leverage 4.0 AA 21% (-4%) 27% (-6%) 19.7 (-2.7) 1.2 (0.3) A 20% (8%) 27% (6%) 8.8 (0.8) 1.4 (-0.4) 3.5 BBB 16% (3%) 20% (1%) 6.9 (1.7) 2.1 (-0.4) 3.0 BB 11% (4%) 23% (7%) 4.5 (1.1) 2.3 (-1.2) B 8% (5%) 14% (-7%) 2.6 (-0.3) 4.0 (0.9) 2.5 CCC -2% (-3%) 23% (18%) 2.0 (0.7) 6.7 (-0.5) 2.0 Source: Morgan Stanley Research, Company Reports, Bloomberg 1.5 Looking at fundamental improvement trends by rating, AAs and single Bs are meeting the greatest resistance, with 1.0 BB leverage increasing 0.3x and 0.9x year-on-year, respectively. BBB 0.5 A BB fundamentals seem to have made the most impressive strides, closing the gap to BBBs. We examine this comparison 0.0 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 in the next section. Source: Morgan Stanley Research, Company Reports, Bloomberg Exhibit 10 European Non-Financial Spreads by Rating We like switching from long dated BBBs into shorter-dated 1000 BBs, reducing duration and picking up spread. Shortening 900 reduces rate risk at a time when Bunds are near all-time lows, and minimizes the window for credit-negative corporate actions. 800 BB Switching into BBs more than compensates for the loss of 700 BBB spread, and BBs should benefit more from continuing credit 600 healing. We conclude with a table presenting some attractive A 500 switches into BB credits with strong fundamental trends. 400 Exhibit 12 300 Buy Shorter-Dated BBs, Sell Longer-Dated BBBs 200 Net FCF/ 6M Net Lev BB Rating Maturity Ask Px Z-Spread Lev Debt Change 100 FREGR Ba1/BB Jul-15 118 263 3.2 11% 0.0 0 ITVLN (£) Ba3/B+ Oct-15 99 308 1.8 23% -1.7 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 RENAUL Ba1/BB Oct-14 107 310 2.4 34% -2.4 TRW B2/BB Mar-14 103 309 0.8 11% -0.9 Source: Markit iBoxx VERSTL B3/BB- Jun-14 88 634 2.7 9% -0.1 Average May-15 103 365 2.2 18% -1.0 Digging deeper into the BB/BBB divide BBB Rating COFP -/BBB- Feb-17 105 127 3.1 11% -0.2 A favorite point for comparison is the BB/BBB divide. As DT Baa1/BBB+ Mar-20 106 99 2.2 15% 0.3 FGPLN (£) -/BBB- Sep-18 123 202 3.0 9% 0.1 Exhibit 9 shows, the gap between the two cohorts’ SESGLX Baa2/BBB Mar-20 107 120 3.2 8% 0.2 fundamentals is not large. Exhibit 11 shows the outsized WKLNA Baa1/BBB+ Apr-18 119 115 2.9 16% 0.1 progress BBs have made in deleveraging, relative to BBBs Average Nov-18 112 133 2.9 12% 0.1 Source: Morgan Stanley Research and single-As. As Exhibit 10 shows, the pick-up for this additional risk is quite substantial. At the index level, the switching from BBBs into BBs looks like a homerun, but are there actionable single name switches? 14
  • 15. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Strategy and Economics October 8, 2010 annual rate in the past three months. Ongoing improvements in proprietors’ income and the US Economics reinstatement of unemployment insurance benefits are providing enough wherewithal to sustain the 2% pace of Roadmap to Sustainable Growth consumer spending we expect in H2. Morgan Stanley & Co. Richard Berner  Third, lower mortgage rates are promoting a modest Incorporated Richard.Berner@morganstanley.com refinancing wave, despite the inability of many current David Greenlaw borrowers to qualify under current GSE guidelines. We David.Greenlaw@morganstanley.com estimate that the recent decline in mortgage rates will QE coming soon. It’s virtually certain that today’s below- reduce interest payments and provide a $10-15 billion trend growth and too-low inflation will spur aggressive further windfall to borrowers. That will accelerate the decline in asset purchases from the Fed. Growth has slipped to 2-2½% the household debt service ratio — already down from in the second half of this year, and slack in the economy is 14% in Q3 07 to 12.1% in Q2 — to a sustainable 11-12% beginning to rise; the unemployment rate edged up from 9.5% range by late this year, with ongoing benefits to consumer in July to 9.6% in September, and a further increase is likely. discretionary income and creditworthiness. As evidence Core inflation stands at 1.4% measured by the core personal of consumers’ new capacity to borrow, nonrevolving consumption price index, or somewhat below the Fed’s consumer credit rose for the fourth month in a row in unofficial target of 1¾-2%. While we strongly believe that August. inflation is bottoming, the rise we expect to 1.6% next year is  Finally, lingering fiscal stimulus in the form of rising unlikely to satisfy the Fed. With the Fed missing on both infrastructure spending will boost near-term growth. aspects of its dual mandate, and other policies caught in Outlays for highways, bridges and other state and local political gridlock, it’s appropriate for the Fed to ease policy infrastructure jumped at a 20.1% annual rate in the three further. months ended in August, and double-digit gains in such spending are likely at least through the mid-term elections. Yield outlook depends on policy. Our interest rate strategy That will keep overall state and local spending growth flat team and we believe that ten-year Treasury yields will likely in H2. In contrast, the delay in such outlays and cuts in decline slightly further, to 2.25% or so. The Fed wants to state and local spending trimmed an average 0.3 depress real yields to support growth while boosting inflation percentage point from GDP in each of the three quarters expectations, so the composition of yields between real and ended in Q1 10. inflation compensation matters more than the level of nominal rates. With ten-year real (TIPS) yields at 50 bp, down 70 bp Will QE2 work? We think there’s modestly good news from July, real yields are clearly headed in the right direction. ahead: The combination of easier financial conditions and But the trough will depend on how low officials think real strong overseas growth should help trigger a return to yields must go and how long they need to stay there to sustainable, slightly above-trend growth in 2011. QE is no support growth. It seems likely that the Fed will keep the panacea, of course, and its bang per buck will be small, but it funds rate near zero until 2012. will help. QE will work through several channels: It will lower financing costs, boost risky asset prices and household Consensus is too pessimistic on growth, inflation. wealth, and continue to weaken the dollar. Freddie Mac Despite our subdued outlook, we think the consensus view of reported this week that 30-year conventional mortgage rates 1-2% growth and declining inflation is too dour. We see four declined to 4.27%, and many lenders are offering rates factors that will sustain growth at 2-2½% in the second half of between 3.875% and 4.25%. Since Fed Chairman this year: Bernanke’s Jackson Hole speech, popular stock price gauges  First, we think net exports will rebound in H2 as export have risen by 10%. That reversed the second-quarter decline growth persists and imports retrace some of their aberrant and puts household equity wealth up 5.6% ($960 billion) so Q2 gain. Quirky seasonal factors for petroleum imports far this year. And the dollar on a broad, trade-weighted basis will likely defer that improvement until Q4, but a one-point has declined by 5.2%. annualized contribution to growth from net exports in H2 Those developments will help support credit-sensitive should partly offset the near-record 1.9% H1 drag from net spending, foster a stable-to-lower saving rate, and help net exports. exports. At the margin, lower mortgage rates will promote  Second, personal income is growing again. Even with refinancing and make housing more affordable. Corporate modest job gains, increases in the workweek have America is borrowing at historically low rates. Standard sustained real wage and salary income growth at a 2% 15
  • 16. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Strategy and Economics models suggest that the rise in wealth, if sustained, will Import slowdown has begun. A spring surge in US imports prompt an extra $44 billion (0.4%) in consumer spending. thwarted what we expected to be a moderate contribution Likewise, our empirical work suggests that a sustained 5% from global to US growth earlier this year. But we think the depreciation in the real trade-weighted dollar will over three 33.5% annualized Q2 import surge was only a temporary years boost net exports by about 1% of GDP. However, development. Swings in inventories magnified the Q2 import blockages in the monetary policy transmission channel mean surge and dampened recovery in domestic output. Because that the direct impact from QE on domestic demand will be that inventory leverage works both ways, a slowing in limited. Tougher mortgage origination criteria have limited the inventory accumulation will depress import growth going number of eligible borrowers, and originators faced with forward. Consequently, we think that import growth “putbacks” from the GSEs (Fannie and Freddie) on prior loans henceforth will re-sync with the pace of US domestic demand, are understandably skittish to extend credit to less-than- promoting a deceleration in imports and ultimately a much- pristine borrowers. needed rebalancing of the US economy. Strong growth abroad will lift US net exports. The Needed: Job and income growth. Ultimately, the influence of strong global growth on US demand and output is sustainability of the recovery will hinge in significant part on a key factor that differentiates us from pessimists. US net the continued revival of job and income growth. On that exports are poised to add to growth over the next year. While score, the moderation in the pace of private job gains and the growth in developed market economies is tepid, a modest significant declines in state and local government jobs are reacceleration in emerging market growth, especially in both a concern. The good news is that a rising work week capital spending, will help US exports. The surge in non-oil has through most of this year promoted healthy gains in imports has ended, and stable import penetration means paychecks; the bad news is that private hours stalled in imports will grow only slightly faster than domestic demand. September and growth must improve to restart that process. In turn, a sharp moderation in US demand and inventories More ominously, state and local payrolls skidded by a monthly should slow imports dramatically. As mentioned above, if average of 54,000 in the summer. As noted below, a further sustained, the dollar’s decline will augment those gains. revival in revenues will be needed to stabilize and ultimately Global growth slowed in the spring, casting doubt on its revive state and local government hiring. potential support for US growth. But even with a slower pace, Coming resolution to tax uncertainty. Policy gridlock in three global factors are likely to boost US exports: a shift in Washington has created economic uncertainty and a drag on the mix of US exports toward faster-growing EM economies growth. If this gridlock is not resolved soon, expectations of and Canada, a global capex upswing, and the Russian fiscal drag will become reality, perhaps trimming three- drought and export ban that will boost agricultural exports. quarters of a percentage point from growth in 2011. The fate Moreover, the slowing in global growth may be ending. Qing of the expiring tax cuts is a key uncertainty for the outlook. If Wang notes that “while there has been no clear indication of the tax cuts expire, households will be hit with $175 billion in re-acceleration in Chinese growth, forward-looking indicators higher taxes on January 1. We now expect that Congress such as PMIs and the MS China Business Condition Index do and the Administration will resolve that uncertainty by early point to re-acceleration in the coming quarters.” Chetan Ahya next year with a one-year extension of all tax provisions. observes that in India “the volatile IP number showed a month Fiscal drag: Less than feared. Three sources of fiscal drag on month deceleration in June but July data released in mid- could hold back growth: Stimulus enacted in 2009 under the September came right back with a 6% (MoM) rise. Key American Recovery and Reconstruction Act (ARRA) will domestic demand indicators such as auto sales for August continue to fade, unemployment benefits may not be and September have been robust.” extended, and state and local governments could cut Finally, US QE may indirectly promote faster US growth spending further. However, we expect that Congress will through an international channel: The Fed’s actions are extend UI benefits at least for a while. And rising tax receipts strengthening currencies abroad and forcing policymakers to mean that the drag from state and local restraint should be choose whether to accept currency strength, adopt easier modest. Total state and local tax revenue gained 1.7% policies, or implement capital controls. Many central banks in year/year in Q2, a third straight small gain after the worst both EM and DM economies (e.g., Australia, Canada) are decline on record last year. The combination of a modest choosing the second alternative to resolve this ‘trilemma,’ or rebound in revenues and Federal stimulus funds for impossible trinity, meaning they are choosing faster growth as infrastructure seems likely to support renewed spending well as global rebalancing. growth. 16
  • 17. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Strategy and Economics October 8, 2010 and financials will remain prone to be a source of funds should volatility rise from here. US Credit Strategy Are trading volumes really all that different now? Tale of Two Markets Compared with the first 9 months of 2010, most investors will fondly recall the virtually one-way move tighter of spreads Morgan Stanley & Co. Rizwan Hussain over the first 9 months of 2009. But to the extent that market Incorporated Rizwan.Hussain@morganstanley.com Maya Abdurahmanova, CFA liquidity conditions have something to do with the differing Maya.Abdurahmanova@morganstanley.com market sentiments, how do the two periods compare? Despite buoyant primary markets, the tone in secondary Exhibit 1 markets hasn’t been as consistently positive. With Different Times, Similar Trading Patterns earnings season commencing, companies will soon offer 14 greater confirmation or denial of the strength and staying 13 Avg Daily Volume ($bn) power of a sustained US rebound. Meanwhile, high-grade credit markets just finished the seventh biggest month of the 12 past decade in new issues, and yet corporate excess returns 11 were strongly positive, ringing in their third best month of the year. We hope that goes some way in severing the mental 10 association many still have between sizeable primary Subdued ahead Subdued ahead 9 of US banking of EUR banking issuance and subsequent credit underperformance. Primary stress tests stress tests issuance confirming secondary market spreads was certainly 8 at work, and admittedly the technical backdrop remained Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec favorable. 2009 2010 Source: Morgan Stanley, MarketAxess Recent conversations with investors suggest that many remain frustrated with the lack of opportunity away from new As shown in Exhibit 1, high-grade corporate bond traded issues. Many argue that thin, illiquid markets are barely volume (as captured by TRACE) earlier this year ranked providing an opportunity to meaningfully add risk (or for that favorably versus the equivalent period of 2009, when strains matter, shed it), leaving the new issue space virtually the only remained elevated in advance of the US banking system game in town. Only when new issue markets slow down – as stress tests. It wasn’t until some resolution on this front in in earnings season now – does the focus seem to (perhaps April 2009 that trading activity accelerated. Similarly, in 2010, reluctantly) shift back to existing issues in the hunt for value. volumes had been buoyant in advance of the surfacing of worries in European banks, and it wasn’t until some resolution We have explored some of the statistics around secondary in July that trading volumes rebounded. Now we are left with trading this year, as well as how it has and hasn’t changed what looks like an increasingly ‘normal’ trading environment over the past nine months. While this content may be a bit again, at least relative to just 2009, which provided anything more backward-looking than we typically offer, we believe but a ‘normal’ backdrop. Volumes over the last 2 months are there are lessons to be learned from a broader portfolio- actually running slightly ahead of 2009’s pace, likely driven by management perspective. In summary: the historic level of new issuance lately and the secondary  Similar to market experience ahead of the US banking market trading activity that follows in its wake. system stress tests of last year, trading volumes did However, a slightly mixed picture emerges when we look at decline in advance of a similar exercise in Europe this the actual number of trades. Judging by average daily trade summer, but more importantly, are now tracking last year’s count, every month this year saw a decline versus the similar levels. period last year. Simple math then implies that the average  The top 20 most actively traded credits have consistently trade ticket size each month this year has actually been accounted for about 40% of overall trading volume in the greater than it was for each month last year, with the last two years. This remains a source of frustration overall exception of June. So again, here, the frustration with in secondary markets today, but it is not a new dynamic. secondary markets seems somewhat misplaced – perhaps  Meanwhile, the top 20 most actively traded issuers remain there are fewer trades going through, but they’ve actually highly skewed towards financials. Primary markets remain been marginally larger in notional terms. the path of least resistance to add non-financial credit risk, 17
  • 18. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Strategy and Economics The frustration is with what is (and is not) trading. precursor to sustained weakness in credit spreads. Since Compared to the status quo at the start of many of our almost half of daily traded volume is driven by a relatively careers, the ability of the sell-side to warehouse and park small set of names (financials in particular), we would expect credit risk on balance sheets today is constrained. Some these specific names to serve as the ‘high beta’ credits in any factors behind this are consolidation across dealer desks, bouts of volatility in the coming months. This will likely keep scarcity of capital post-crisis at the remaining dealers, and a the pace of spread repair slower and more volatile than we shift away from running large risk positions. expected a few months ago. Consolidation among financials that occurred during the crisis will also continue to serve as a Exhibit 2 negative technical, as investors will increasingly adhere to Just 20 Credits Consistently About 40% of Traded name-specific exposure limits. Quarterly Volume – Both 2009 and 2010 43% Lastly, while overall market liquidity conditions don’t seem materially different from last year gauged by trading volumes, 42% we are concerned that many, on both the buy-side and the 41% sell-side, perceive just the opposite. With climbing expectations of a new round of quantitative easing that 40% removes fixed income product from the market, and cross- 39% asset correlations remaining high, the risk of crowded trades is growing (within and across assets). And crowded trades 38% typically don’t end well. (For details see our Credit Basis Report of October 8. 2010.) 37% Q1 Q2 Q3 Q4 Exhibit 3 2009 2010 Most Active Bonds Dominated by New Issues and Source: Morgan Stanley, MarketAxess Financials But what do we actually see trading in secondary markets? In 3Q2010 3Q2009 % of % of Exhibit 2, we track the percentage of overall trading volume # Ticker Coupon Maturity Mkt Ticker Coupon Maturity Mkt seen in just the top 20 issuers since the markets began their 1 BAC 5.625 7/1/2020 0.91 C 8.500 5/22/2019 0.72 rally early last year. Indeed, while the percentage of trading 2 GS 6.000 6/15/2020 0.72 DOW 8.550 5/15/2019 0.57 volume commanded by the top 20 issuers has climbed 3 MS 5.500 7/24/2020 0.68 C 6.375 8/12/2014 0.51 modestly this year, it has moved in a relatively narrow range 4 JPM 4.400 7/22/2020 0.62 BAC 7.625 6/1/2019 0.48 from just about 39% to 42% over the last two years. Also, 5 KFT 5.375 2/10/2020 0.45 C 8.125 7/15/2039 0.47 financials represent nearly 75% of the total of these top 20 6 C 5.375 8/9/2020 0.44 PETBRA 7.875 3/15/2019 0.45 issuers’ trading volume for the most recent quarter, whereas 7 C 4.750 5/19/2015 0.40 GS 7.500 2/15/2019 0.39 they make up 35% of the overall outstanding credit risk in 8 GS 3.700 8/1/2015 0.40 BAC 6.500 8/1/2016 0.38 benchmark indices. If you’re shunning financial risk, but 9 C 8.500 5/22/2019 0.38 MS 7.300 5/13/2019 0.34 looking to add non-financial credit risk, primary markets have 10 APC 6.375 9/15/2017 0.37 JPM 6.300 4/23/2019 0.33 admittedly continued to be the path of least resistance. 11 BPLN 5.250 11/7/2013 0.35 BAC 7.375 5/15/2014 0.32 12 BAC 3.700 9/1/2015 0.33 GS 6.750 10/1/2037 0.32 Exhibit 3 breaks down the top 20 most actively traded specific 13 MS 4.000 7/24/2015 0.33 BACR 5.200 7/10/2014 0.30 issues over the last two quarters. Two points worth noting. 14 GE 5.500 1/8/2020 0.33 GE 6.875 1/10/2039 0.29 First, while these specific issues represent just 8.5% of the 15 DOW 8.550 5/15/2019 0.33 ORCL 5.000 7/8/2019 0.29 overall volume in the most recent quarter, financials again 16 APC 5.950 9/15/2016 0.31 GE 6.000 8/7/2019 0.28 dominate the list. Additionally, of these 20 issues in the most 17 CS 4.375 8/5/2020 0.30 GE 5.875 1/14/2038 0.28 recent quarter, only 6 were issued before the last 6 months. 18 BHI 5.125 9/15/2040 0.30 GS 6.000 5/1/2014 0.26 19 AA 6.150 8/15/2020 0.29 MO 9.250 8/6/2019 0.26 What are the portfolio implications? As noted above, we 20 GE 3.500 6/29/2015 0.29 T 5.800 2/15/2019 0.25 do think active primary markets can support both credit Source: MarketAxess outperformance and a healthy secondary market, just as they do now, with secondary volumes today tracking right on top of daily volumes from a year ago. Alternatively, we push back at the perception that robust new-issue markets alone are a 18
  • 19. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Strategy and Economics October 11, 2010 and until producers are willing to pare back their drilling efforts, the North American gas market will remain Commodity Strategy fundamentally oversupplied. Natural Gas – Fundamentally Exhibit 2 Recent Surge in Horizontal Rig Activity Will Keep Oversupplied Production Elevated Morgan Stanley & Co. Hussein Allidina, CFA (Left axis: rig count; right axis: dry gas production, bcf/d) Incorporated Hussein.Allidina@morganstanley.com 1,600 62 Stephen Richardson 1,400 60 Stephen.I.Richardson@morganstanley.com 1,200 58 Tai Liu 56 Tai.Liu@morganstanley.com 1,000 54 800 Through 2011, oversupply will likely continue. We see 52 600 2011 natural gas prices averaging $4.00/mmBtu, as the US 50 400 48 balance is fundamentally oversupplied and is likely to remain 200 46 so through 2011. NYMEX futures are trading at - 44 ~$4.00/mmBtu, very different from the ~$14.00/mmBtu we Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 saw in mid-2008. The root of today’s depressed price Horizontal rigs Vertical/Directional rigs Production, bcf/d environment lies with elevated production, driven by robust horizontal drilling activity — the latest EIA data, covering July Source: EIA, Smith Bits, Morgan Stanley Commodity Research 2010, show US dry gas production averaging ~58.5 bcf/d, up 1.5 bcf/d year over year. The three key drivers of our bearish Moreover, the US is sitting on a large inventory of gas. price outlook for 2011 are (1) the momentum of rig activity in Assuming no hurricane-related production losses, we recent months; (2) the lagged response of production to the estimate end-October storage at ~3,750 bcf, only slightly laying down of rigs; and (3) today’s elevated gas inventory. lower than last year’s record 3,807 bcf. Inventories would have been much higher if not for the significantly warmer than Exhibit 1 normal summer we experienced. Assuming 30-year normal We Are Bearish on 2011 Natural Gas weather, we forecast end-March 2011 inventory at roughly ($/mmBtu) 2010 2011 2012 1,900 bcf, the highest level we have ever seen for the end of Forecast $4.36 $4.00 $5.50 March. As a comparison, the 5-year average inventory for Forward $4.41 $4.57 $5.25 Note: Prices as of Oct. 8, 2010. end-March is 1,572 bcf, and this year inventories stood at Source: Bloomberg, Morgan Stanley Commodity Research estimates 1,662 bcf at end-March. And making matters worse, Canadian gas inventories are also plentiful, currently sitting at Horizontal rig activity has rebounded strongly, averaging about 710 bcf, and are likely to enter the heating season at near 580 rigs, after hitting a trough of near 300 rigs in mid- ~750 bcf – just shy of last year’s record 752 bcf. 2009. According to Smith Bits, some 880 rigs are actively drilling for gas today (both horizontal and vertical). As a Despite bearish fundamentals, there is a strong bullish comparison, rig activity bottomed at ~610 in July 2009. We seasonal pattern in the gas market in early winter. In the expect the surge in rig activity and higher-productivity early days of the heating season, spot purchases from utilities horizontal rigs to lift production in the months ahead. can provide support to near-dated prices. Unregulated utilities look at economic reasons to justify their purchasing In our base case, we assume rig activity declines to ~700 decisions, while reliability requirements and operational by end-2010, and thereafter falls to ~630 by mid-2011. issues shape regulated utility gas purchases. Essentially, we Under these assumptions, we see US gas production anticipate two sets of opposing forces to work in the early part averaging ~59.4 bcf/d in 2010 and ~60.2 bcf/d in 2011. If of the heating season: (1) bullish forces – utilities buying for actual rig activity turns out to be materially different from our economic, reliability, and operational reasons; and (2) bearish assumptions (i.e., most likely we are too optimistic on the forces – weak fundamentals owing to elevated rig decline), we will have to adjust our production forecasts. activity/production levels resulting in bloated inventories. Due to a confluence of events, producers have continued While the bearishness of underlying fundamentals will to drill in the current low-gas-price environment. Unless ultimately pressure prices, determining the short-term price 19
  • 20. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Strategy and Economics direction is a challenge, and near-term price direction will when the rig count does decline, gas production will not likely be dependent on the deviation of weather from normal. immediately roll over. The momentum of drilling activity will continue to bolster production. If drilling activity rolls off in Reliability and operational requirements of regulated mid-2Q11, the lagged impact on production from drilling in utilities will likely provide some support to gas prices in 3Q10 will still be felt, and it will not be until mid-3Q11 (at the the early part of the winter. A utility’s foremost responsibility earliest) that we will see production start to decline. is reliability. To ensure reliability, utilities often buy spot gas early in the heating season, ensuring inventories for the latter Exhibit 3 part of the winter. By doing so, pressure is maintained, Producers Will Sell Near $5/mmBtu, allowing for maximum withdrawals, if needed, during January While Utilities Are Likely to Buy Below $4/mmBtu and February, the months with the highest demand. For ($/mmBtu) unregulated utilities (and to a certain extent, regulated 6.5 Above $5/mmBtu, utilities), the decision to buy spot gas or draw from storage is 6.0 producers look to sell based on economics. When temperatures fall, utilities 5.5 essentially have two avenues to satiate demand: they can 5.0 either draw on gas from storage or buy spot gas. This 4.5 decision will depend first on the shape of the forward curve, 4.0 and then on the price paid for gas in storage. If the forward 3.5 curve is in backwardation, utilities will likely draw on inventory. 3.0 However, if the forward curve is in contango, as it is currently, Below $4/mmBtu, 2.5 utilities look to buy utilities may make spot purchases. The decision to buy spot 2.0 will depend on the cost of gas injected into storage. If the Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 spot price of gas is less than the cost of gas injected into storage, utilities will likely buy spot and save gas in storage for Source: Bloomberg, Morgan Stanley Commodity Research later in the season. The two key risks to our bearish outlook on gas prices A soft floor for gas prices in the near term is the utilities’ are weather and rig activity. We are currently using 30-year cost of gas in inventory, estimated at ~$4.00/mmBtu. normal weather in our modeling of the supply and demand While the cost of gas in inventory fluctuates by utility balance. If the winter proves colder than our assumption, all depending on when the gas was purchased and owing to the else equal, inventories will register below our expectations. If varying accounting methods employed, we nonetheless come the winter proves to be 5% colder than the 30-year normal, up with what we believe is a reasonable estimate of demand will be bolstered by some ~310 bcf, which in turn $4.00/mmBtu by looking at gas prices through the current and would leave end-March inventories more balanced at 1.6 Tcf. past injection seasons. Any upside to gas in the near term is And rig activity is another wild card. We have assumed that likely to be capped by producer hedging, which we believe the gas rig count will fall to around 630 by mid-2011; however, would come into the market at prices around $5.00/mmBtu. if producers curtail activity faster or slower than we have modeled, our production and inventory numbers will be off. In the latter months of the 2010-11 heating season and for 2011 as a whole, we remain firmly in the bear camp. Into Trade recommendation: With end-March 2011 inventory 2011, gas prices will reflect weather, inventory, production, likely to be abundant, we see downside to March 2011 gas and end-March storage expectations, we believe. While prices, prompting our opening of a short Mar-11 position, weather always presents a wild card, it is our view that prices currently trading at $4.27/mmBtu. While utility buying early in will remain under pressure once we get through the early the heating season may support near-dated contracts, we months of the 2010-11 heating season. Assuming a 30-year believe that underlying bearish fundamentals will ultimately normal winter, our supply and demand model shows end- pressure prices lower. Our stop loss on this position is set at March inventories at ~1,900 bcf. If our forecast is realized, we $4.60/mmBtu, and we will exit this position at $3.50/mmBtu. believe that gas prices will come under significant pressure, Risk to this position includes a colder-than-normal winter or a which should force producers to scale back their drilling while fall in production exceeding our expectations, which would also encouraging further coal-to-gas substitution in the power leave inventories below the 1.9 Tcf that we are modeling. sector. (For details see our Natural Gas report dated October 11, 2010.) Unless and until the rig count declines, we see the gas market balance as remaining loose. Bear in mind that even 20
  • 21. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Industry Analysis October 8, 2010 Exhibit 1 Ryanair now #1 in capacity in 3/5 key EU markets Airlines 25.0% Short Haul: Long Opportunity 20.0% Morgan Stanley & Co. Penelope Butcher, CFA International plc+ Penelope.Butcher@morganstanley.com 15.0% RYA #1 - Suzanne Todd UK, Spain & Italy Suzanne.Todd@morganstanley.com 10.0% Menno Sanderse Menno.Sanderse@morganstanley.com RYA #3 - 5.0% France & Germany LCCs are leveraged to recovery with strong franchises, market share growth opportunities and compelling 0.0% Nov-09 Jan-09 May-09 Jun-09 Aug-09 Sep-09 Apr-10 May-10 Jun-10 Sep-10 Feb-09 Mar-09 Apr-09 Jul-09 Oct-09 Dec-09 Jan-10 Feb-10 Mar-10 Jul-10 Aug-10 medium-term valuations. We estimate easyJet (EZJ) & UK France Germany Italy Spain Ryanair (RYA) expand returns to 2-2.5x WACC by 2014. Source: OAG, Morgan Stanley Research Through crisis, opportunity has knocked … The European Exhibit 2 short-haul market has undergone a substantial capacity shift Short-haul loads: Record levels this summer in the past two years, in part exacerbated by the financial 95% crisis and subsequent European recession. This has led to a 90% major shift in capacity and market shares from the legacy EZJ 85% airlines toward low-cost carriers (LCCs). In certain markets, European Load Factor 80% RYA the LCCs are now the largest airlines by market share of 75% short-haul services. BA 70% 65% AF- … leading to pricing power for LCCs. The result of this KLM 60% LHA capacity shift has been twofold in nature. First, load factors 55% have expanded as demand began its recovery earlier this 50% year. Second, these rising and sustained high loads have led Oct 07 Dec 07 Oct 08 Oct 09 Aug 07 Feb 08 Apr 08 Dec 08 Jun 08 Aug 08 Feb 09 Apr 09 Dec 09 Jun 09 Aug 09 Feb 10 Apr 10 Jun 10 Aug 10 to improved pricing power within the EU market. Using the UK as a benchmark – where LCCs (EZJ and RYA) represent Source: Company data, Morgan Stanley Research ~40% of total capacity today – there is still a significant opportunity for greater market penetration at the EU level Exhibit 3 overall where share levels currently stand at 18%. This step- Opportunity still high for LCC share gains in up in market share would represent 110-120m extra Scandinavia and Eastern Europe passengers a year – double the levels of LCC traffic this year. 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Norway Greece Structurally, LCCs have significant long-term opportunity. Netherlands We rate RYA OW and EZJ EW in the context of our Attractive Switzerland sector view. While we believe short-term trading updates will Sweden Portugal likely be favourable, we see the opportunity for investors as Ireland more medium term in nature. Building fleet sizes and market Austria EZJ shares further separates these carriers from small-scale Denmark RYA Incumbent competitors, enabling an expansion of economies of scale Belgium Other Finland benefits. The dominant market shares will likely be followed Poland by pricing power and thereby significant expansion of returns following their fleet growth reduction plans in 2012-13. This Source: OAG phenomenon sees a major expansion in free cash flows: in Industry Views RYA’s case we see FCF yields reaching 15% by 2014, and Airlines: Attractive EZJ’s reaching 20% over a similar time period. 21
  • 22. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Industry Analysis Exhibit 4 Investment case for LCCs Ryanair yields move to positive growth in 2010 LCCs are leveraged to recovery, but also operate strong 40.0% franchises, have market share growth opportunities and 30.0% compelling medium-term valuations. Using the UK as a 20.0% benchmark – where LCCs (EZJ and RYA) represent ~40% of total capacity today – there is still a significant opportunity for Growth YoY 10.0% greater market penetration at the EU level overall where 0.0% share levels currently stand at 18%. This step-up in market -10.0% share would represent 9-10 million extra passengers per -20.0% month assuming an 80% load factor on the additional seat capacity. -30.0% 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11e Pax Yield Ancillary Yield Revenue drivers e = Morgan Stanley Research estimates Source: Company data, Morgan Stanley Research Exhibit 5 Expansion of market share – EZJ and RYA share top 3 Intra EU volumes back to positive growth – helped positions in the UK, Spain and Italy, but are relatively by premium volume bounce underpenetrated in France, Germany, Scandinavia and the Passenger Growth in European Market remainder of Europe. Premium Total Europe RYA EZJ 30.0% Improving frequency – building out route frequency with 20.0% RYA fleet growth helps to attract business passengers who are 10.0% EZJ typically higher yielding than leisure passengers. 0.0% -10.0% Expansion of ancillary opportunities – in part driven by -20.0% Total Intra EU longer stage lengths, but also improving penetration of -30.0% Premium EU existing offerings like hotels, car hire and insurance, which -40.0% expand with long duration vacations and repeat trips. Nov-06 Nov-07 Nov-08 Nov-09 May-06 May-07 May-08 May-09 May-10 Jul-06 Sep-06 Jan-07 Mar-07 Jul-07 Sep-07 Jan-08 Mar-08 Jul-08 Sep-08 Jan-09 Mar-09 Jul-09 Sep-09 Jan-10 Mar-10 Jul-10 Cost drivers Source: Association of European Airlines, IATA, Morgan Stanley Research Fleet growth enables opportunity to reduce or at least Exhibit 6 sustain capital cost advantages. EZJ & RYA have lower comparative frequency Airport and supplier volume benefits – guarantees of scale 23.6 Southwest 26.4 volumes to airports and local regions can help reduce airport GOL 16.6 16.7 costs. This can also be a feature of supplier agreements such Virgin Blue 15.8 21.6 15.1 as maintenance, insurance and marketing. AirTran 19.9 JetBlue 14.4 14.4 Returns sustained above cost of capital Air Asia 13.6 13.6 Westjet 11.1 15.4 By our calculations, EZJ and RYA will expand their Tiger Airways 7.4 10.4 returns to reach 2-2.5 times WACC by 2014. This easyJet 8.9 9.8 6.6 compares to an average of 1.5 times that we assume for the Air Arabia 5.7 Ryanair 5.0 main legacy carriers. 6.2 0 5 10 15 20 25 30 Sep-08 Sep-10 Source: Company data, anna.aero, Morgan Stanley Research 22
  • 23. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Industry Analysis October 7, 2010 European Semiconductors Rating Price Target Implied Semiconductors upside ARM Overweight 530p 31% Cautious on sector but upside in Imagination Overweight 505p 33% ARM, IFX, ING and WLF Wolfson Overweight 340p 30% Infineon Overweight €6.3 23% Morgan Stanley & Co Francois Meunier STMicroelectronics Equal-weight €6.1 11% International plc+ Francois.Meunier@morganstanley.com Sunil George, Patrick Standaert, ASML Underweight €21.3 -2% Mark Lipacis, Atif Malikm Sanjay Devgan CSR Underweight 355p 3% For valuation methodology and risks associated with any price targets above, please email Too early to buy into European semiconductors morganstanley.research@morganstanley.com with a request for valuation methodology and risks on a particular stock. We initiate coverage on the European semiconductor sector Source: Morgan Stanley Research with a Cautious view, as we believe it is too early to buy into the sector, with an inventory correction looming in the PC and Exhibit 1 consumer space, in particular. Our European semiconductor We see most upside for ARM, Wolfson, Imagination ‘investing clock’ shows most indicators are still on the ‘underweight’ 40% position. Consensus earnings estimates have started to decline, but we expect more cautious comments from 30% companies on Q4 and 2011 to bring consensus still lower, reflecting weaker consumer demand in the US and in Europe. 20% Key Overweight ideas 10% We believe there are still good returns to be made on ARM, Wolfson and Imagination, which benefit from a structural shift 0% ASML CSR STMicro Wgtd Avg Infineon ARM Wolfson Imagination in end demand from PCs to smartphones and tablets, and on Mkt Cap Infineon, which benefits from secular trends in power -10% semiconductors and from a leading position in that market. Source: Morgan Stanley Research estimates Beneficiaries from the structural shift from PCs to tablets and smartphones. In our view, the potential inventory Exhibit 2 correction in PCs is exacerbated by the structural shift in end- Smartphone penetration is increasing in a growing demand for smaller, less power-hungry devices. We view handset market ARM as a key enabler for tablets and smartphones, and see Wolfson and Imagination as beneficiaries in the sound and 2000 45% 1800 graphics space for smartphones and tablets. We initiate on 40% 1600 ARM, Imagination and Wolfson at OW, as we believe these 35% 1400 30% trends are not fully priced in (~30% implied upside). 1200 25% 1000 Infineon – German exports enabler: Infineon is a key 20% 800 supplier of power semiconductors chips to German exporters 15% 600 in automotive, industrial and clean energy. With no more 400 10% exposure to either memory or wireless, we expect margin 200 5% expansion to drive a 23% rerating of the shares, and initiate 0 0% 2005 2006 2007 2008 2009 2010 2011 2012 2013 with Overweight. Smartphone Units Handset units Smartphones as % of HS We see less share price upside for ASML, CSR and Source: Company data, Morgan Stanley Research estimates (2010-13) STMicroelectronics with less margin leverage to these trends. Although we view ASML as one of the highest quality companies in the sector, the valuation is not sufficiently attractive versus its peers, in our view. 23
  • 24. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Industry Analysis Exhibit 3 Introducing our European semiconductors ‘investing clock’ – too early to turn positive BUY OVERWEIGHT - Late cycle semiconductor companies continue to warn but a few isolated - A majority of semis companies raise guidance for revenues and margins companies in the PC, packaging or foundry supply chain raise their guidance - Capex increase - Capex on hold, cut and potential production capacity reduction - Inventory days stable or increasing slowly - Inventory days on a downward trend - YoY revenue growth for OSAT (SPIL, ASE…) and foundries (TSMC…) on an - Some form of capitulation from either investors, sell-side or corporates upward trend - YoY revenue growth for OSAT (SPIL, ASE…) and foundries (TSMC…) close - ISM manufacturing index close to a trough, potential inflexion point to a trough, potential inflexion point - US and Asian semis stocks start outperforming, ahead of European stocks - ISM manufacturing index close to a trough, potential inflexion point - Consensus estimate upgrades - US and Asian semis stocks start outperforming, ahead of European stocks - Relatively high PER valuation, indicating the market doesn’t believe pessimistic consensus estimates UNDERWEIGHT SELL - Late-cycle semiconductor companies continue to raise guidance but a few - Profit warning from a majority of semiconductor companies, some companies isolated companies in the PC, packaging or foundry supply chain warn or cut stop giving guidance guidance - Capex on hold - Capex keeps rising - Inventory days rising at a slower pace - Inventory days rising - YoY revenue growth for OSAT (SPIL, ASE) and foundries (TSMC) on a - YoY revenue growth for OSAT (SPIL, ASE…) and foundries (TSMC…) close downward trend to a peak, potential inflexion point - ISM manufacturing on a downward trend. - ISM manufacturing index close to a peak, potential inflexion point - US and Asian semis stocks start outperforming, ahead of European stocks - US and Asian semis stocks start underperforming, ahead of European stocks - Consensus estimates downgrades. - Relatively low PER valuation, indicating the market doesn’t believe excessive consensus estimates Source: Morgan Stanley Research Exhibit 4 Valuation summary EPS Ccy Price Mkt. Cap. EV EV/Sales EV/EBIT PER CAGR PEG EBIT Margin Gross Margin 01-Oct (€m) (€m) 2010e 2011e 2012e 2010e 2011e 2012e 2010e 2011e 2012eFY11-12e FY10e 2010e 2011e 2012e 2010e 2011e 2012e European Semiconductors ASML € 21.69 9,327 8,382 1.94x 1.90x 1.61x 7.1x 7.4x 5.3x 9.6x 10.2x 7.6x 13% 0.8 27% 26% 30% 44% 43% 46% STMicroelectronics € 5.51 4,916 3,788 0.52x 0.50x 0.46x 12.5x 6.6x 4.6x 11.3x 8.0x 6.3x 34% 0.3 4% 8% 10% 39% 41% 43% Infineon Technologies € 5.13 6,045 3,656 1.05x 1.02x 0.93x 6.4x 5.7x 5.1x 13.4x 10.9x 9.4x 19% 0.7 16% 18% 18% 35% 38% 40% ARM Holdings GBp 405.00 5,979 5,857 13.13x 11.08x 9.60x 31.8x 23.3x 18.2x 44.8x 33.6x 27.4x 28% 1.6 41% 48% 53% 94% 94% 95% Imagination Technologies GBp 378.90 1,051 1,013 9.02x 7.22x 5.96x 39.5x 23.3x 15.7x 57.7x 35.0x 24.3x 54% 1.1 23% 31% 38% 69% 72% 75% CSR GBp 344.40 697 390 0.66x 0.63x 0.60x 6.4x 7.0x 6.1x 13.9x 16.0x 13.3x 2% 6.2 10% 9% 10% 47% 46% 46% Wolfson Microelectronics GBp 261.50 339 271 2.30x 1.58x 1.29x 85.3x 10.4x 5.5x NA 17.8x 9.5x NM NA 3% 15% 23% 51% 51% 53% MEAN 4,051 3,337 4.09x 3.42x 2.92x 27.0x 11.9x 8.6x 25.1x 18.8x 14.0x 25% 1.8 18% 22% 26% 54% 55% 57% MEDIAN 4,916 3,656 1.94x 1.58x 1.29x 12.5x 7.4x 5.5x 13.7x 16.0x 9.5x 23% 0.9 16% 18% 23% 47% 46% 46% Source: Morgan Stanley Research estimates 24
  • 25. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Industry Analysis Three key debates ARM, we expect ARM to take 11% of the PC microprocessor market in 2011. In contrast, we view this transition as slightly Debate #1. Is now the time to buy Semis? negative to ASML revenues (€300m or 5% negative impact on Too early to turn positive – Introducing our proprietary 2011e revenues) as the mix of tools to produce NAND European Semiconductors ‘investing clock’ includes fewer immersion tools than DRAM. We see a mild inventory correction ahead Should investors focus only on the wireless end market? With the US and European consumer under increased Wireless is a volatile sector, driven by relatively short design pressure, we expect retailers and OEMs to be relatively cycles, and market share shifts can be very rapid and difficult cautious about inventories in Q4, which is likely to result in to forecast. This can make it challenging to generate decent semiconductor companies guiding below seasonal trends for returns across the cycle. We therefore think investors will the quarter. In our view, the risk of an inventory correction is reward Infineon’s decision to sell its wireless business ahead exacerbated in the PC supply chain, which is affected by a of potential market concerns about share loss at Apple. structural shift in end demand toward tablets. In our base Although we prefer ARM and Imagination as long-term case, we assume a mild inventory correction, bottoming at the investments, owing to the sales and earnings visibility end of Q1 2011. afforded by their semiconductor IP business models, we also believe it makes sense to buy stocks such as Wolfson that We would wait for more companies to warn on Q3 and/or have good prospects for market share gain in wireless. For Q4 before turning positive on the sector value investors, we believe it makes more sense to We introduce our European semiconductor ‘investing clock’, concentrate on stocks exposed to the automotive and which aggregates several quantitative momentum indicators industrial end markets, where returns are higher than average based on our experience of the semiconductor cycle. and design cycles much longer than in wireless, and hence Although it is not indicating a buy signal yet, this should not carry lower risk, even if they remain cyclical in nature. deter investors from buying companies with solid structural growth potential and 20-30% upside to valuation, such as Debate #3: Is automotive attractive for semis? ARM or Infineon. We think the market underestimates this space, which offers superior risk-reward to wireless Debate #2: What will be the impact of the smartphone and tablet upgrade cycle? Our analysis of the global automotive market with Morgan ARM, Imagination and Wolfson should benefit most Stanley’s Autos team suggests that China has become the largest growth driver for the semis auto market. This is ARM, Imagination and Wolfson have the highest leverage confirmed by our discussions with the main German auto to the smartphone upgrade cycle manufacturers, who are seeing a positive mix effect towards ARM benefits from an improved product mix, i.e. with a higher mid and high end cars, which contain as many as four times number of cores and higher ASPs per cores used in the number of semiconductor chips as standard cars. smartphones (35c average royalty per smartphone vs 10c for average phones, according to our proprietary calculations) Infineon appears to be the best positioned company to and is independent from market share shifts between benefit from the structural growth in automotive and smartphone vendors. Imagination is skewed towards Apple industrial demand in emerging markets. and Android and should benefit from the proliferation of We believe that companies exposed to the automotive and graphics. Wolfson is a key provider of audio chips, skewed industrial sectors could benefit from: 1) the structurally low towards Android and potentially to Apple. We believe these penetration of cars in emerging markets and particularly in trends are not fully priced in at current levels, and see ~30% China, where demand for high-end cars is especially strong; upside for all three stocks. and from 2) the structural growth in power – in particular, clean power and rail infrastructure in emerging markets. ARM and Imagination benefit most from cannibalization Infineon holds a key competitive position in power of netbooks by tablets semiconductors used in both end markets. STMicroelectronics is Similar to the smartphone upgrade cycle, ARM and also exposed to the automotive segment, but Infineon has Imagination are best positioned to benefit from the greater exposure to the German manufacturers, the key cannibalization of netbooks by tablets, in our view. Based on exporters to China – and we think the stock could be played our proprietary calculations, even if Windows is not ported to as a proxy for German exports to China. 25
  • 26. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Industry Analysis Stock ideas Industrial and Multisegment (78% of sales), where it is exposed to the positive structural trends that are benefiting ARM (Overweight) – best placed in wireless Infineon. However, we believe share performance over the ARM holds an undisputed position in mobile phones and is next 12 months is largely contingent on the scale and timing likely to take a significant share of the laptop/tablet market, of the recovery at ST-Ericsson, STM’s wireless chips JV with even if Intel and AMD maintain their leadership in terms of Ericsson (22% of sales). With restructuring of the venture now microprocessor shipments. With many positive catalysts in largely complete, the business is now dependent on the ramp view, and investors likely to be positively surprised by the with customers (which include Nokia and Samsung, we PIPD business (Artisan), we believe that more investors will believe) to reach break-even. Timing and visibility on this look at a DCF valuation for ARM. More royalties flowing through remains uncertain, and the stock’s trading history suggest the P&L and opex under control mean we expect operating investors are unlikely to price in a turnaround in the business margins to exceed 45% as early as 2012, barring a double dip until ST-E’s customers’ products are successfully in the scenario, and then move up gradually towards 60-65%. market. Even with forecasts above consensus in 2012 and Imagination (Overweight) – proliferation of graphics 2013, our price target implies only 11% upside. For this Imagination is a semiconductor IP company, like ARM, but reason, we see better opportunities elsewhere in the sector. focuses on the graphics market for phones, smartphones, ASML (Underweight) – all eyes on 2011 capex tablets and notebooks, as well as on reconfigurable software There are two ways to invest in ASML: as a market share radios. Imagination has a similar business model to ARM and taker in a cyclical but growing lithography market; or by significant leverage to the smartphone, tablet and netbook playing momentum on book to bill. For the long-term investor, markets, as well as potential proliferation in consumer ASML should be a key holding, in our view, as it is the electronics. Our DCF valuation implies 33% upside to the dominant player in lithography tools, having taken c.80% of shares, as margins exceed 40% from 2015 onwards. the market. In that case, we believe that ASML should be Infineon (Overweight) – power of margin expansion valued as a multiple of cross-cycle earnings, taking the cash With the volatile and value destructive DRAM business and generated through the cycle into account. For investors structurally challenged wireless business out of the picture, interested in momentum, we believe that ASML’s book to bill we believe that Infineon is well positioned to benefit from is a key decision factor. With the book to bill already falling positive structural trends in power and automotive and a potential recovery of this ratio at best in 2Q11, we semiconductors, two sectors in which it is the market leader believe it is probably too early to buy the shares. due to its competitive advantage in producing power CSR (Underweight) – focus on wireless strategy semiconductors. Margin expansion, coupled with the likely CSR is a supplier of Bluetooth, GPS and WiFi chips for introduction of a €0.10 dividend yielding 2% and a potential phones, headsets, automotive and consumer electronics. €500m share buyback in 2Q11, should lead to a re-rating of CSR’s non-mobile business is thriving, driven by the the shares in the next 12 months, from the current 1.0x acquisition of SiRF at the bottom of the market and the FY2011e EV/Sales to 1.3x EV/Sales, in our view. increased penetration of Bluetooth and GPS in non-mobile Wolfson (Overweight) – the sound of smartphones segments, such as cars, satnavs, consumer electronics and Wolfson is supplier of audio chips for phones, smartphones, gaming consoles. However, it is not doing as well in wireless, tablets and consumer electronics such as TVs. We believe where it is mostly exposed to non-smartphone devices, for that consensus estimates do not fully reflect the potential for which pricing pressure is intense. Furthermore, unit growth is revenue growth in smartphones, especially running Android, constrained by consumer appetite to use smartphones rather in the next three years. With 20% upside to consensus than feature phones. We believe that management is aware underlying EPS estimates in 2011, in our view, and 30% of the challenges, and we expect some form of strategic upside in our base case, we believe the shares are good decision in the near term to tackle the market share losses in value on 9.5x 2012e PER excluding cash. However, we would this business. Separately, we think there is downside to recommend buying the shares towards the end of the results consensus Q4 and 2011 forecasts owing to softness in season, once large-cap semis have warned. consumer end markets, and that sell-side estimates will have to be reset after the Q3 results. In the short term, the prospect STM (Equal-weight) – ST-Ericsson turnaround is key of a share buyback limits the downside, but we would advise We expect STMicroelectronics to expand core operating investors to wait for the Q3 results and the Analyst Day to buy margins from 10% in 2010 to 16% by 2013, driven mainly by the shares with an increased level of confidence. 26
  • 27. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Company Analysis October 6, 2010 Stock Rating: Overweight Reuters: IMT.L Bloomberg: IMT LN Imperial Tobacco Price target Shr price, close (Oct 6, 2010) 2,270p 1,910p Partnering Model Could Offer 52-Week Range Mkt cap, curr (mn) 2,159-1,728p £19,437 Upside to Growth Estimates Morgan Stanley & Co. Toby J McCullagh Fiscal Year ending 09/09 09/10e 09/11e 09/12e International plc+ Toby.McCullagh@morganstanley.com ModelWare EPS (p) 161 178 192 220 Morgan Stanley & Co. David J. Adelman Consensus EPS (p)§ 159 179 193 211 Incorporated David.Adelman@morganstanley.com P/E** 11.1 10.6 10.0 8.7 Matthew Grainger Div per shr (p) 73 83 93 110 Div yld (%) 4.1 4.4 4.9 5.8 ** = Based on consensus methodology International partnering can add a capital-light and § = Consensus data is provided by FactSet estimates relatively low risk driver to top-line growth; success e = Morgan Stanley Research estimates would add a further leg to our OW investment case. Our AlphaWise survey on brand switching and the potential Price Performance for Davidoff in the South Korean cigarette market suggests Imperial Tobacco Group PLC (Left, Br itish Pounds) that, although Korea is unlikely to be material for Imperial Relativ e to FTSE UK ALL-SHARE(GBP) (Right) Relativ e to MSCI W orld Index /Food Bev erage & Tobacco (Right) Tobacco (IMT) in isolation, a partnering strategy exported into £ additional markets could add a capital-light and relatively low- % 24 160 risk driver to top-line growth (see Kelly Kim, KT&G: Silver 150 Lining in Domestic Market Share, 6 October, 2010). The 22 140 partnering model could access new top-line growth in a way 20 130 that suggests future cost savings will still fall to the bottom 18 120 line, rather than being redirected towards expensive attempts 16 110 100 to enter new markets, as some investors fear. 14 90 06 07 08 09 10 Source: FactSet Research Systems Inc Stay Overweight: Our Overweight rating is based on sustained strong pricing, our view that IMT’s relative organic growth Company Description prospects are better than the market expects, and rapid Imperial Tobacco is one of the world’s largest cigarette manufacturers de-leveraging and incremental cost savings post realization of and the world's largest cigar manufacturer. The company also has leading positions in hand-rolling and pipe tobacco, cigarette paper and the Altadis synergies. Success in its partnering strategy would cigarette tubes. add a new leg to our investment case. With a secure 4.4% Tobacco/United Kingdom dividend yield, IMT offers a 20%-plus total return to our Industry View: Attractive 2,270p price target. With industry volumes flat to declining and portfolio mix under pressure from the economic backdrop, pricing is the key driver of cigarette companies’ profit growth. IMT’s partnering strategy GICS Sector: Consumer Staples Strategists' Recommended Weight: 12.6% At its recent Investor Day, IMT outlined its ambitions to MSCI Europe Weight: 12.6% achieve “significant growth in emerging markets” in a plan based on three key drivers: Based on our in-depth analysis of the main global cigarette 1. Organic growth profit pools, Pricing Remains the Key Driver of Profit Growth, - Targeted increase in A&P investment from July, we found that IMT already enjoys a structural - Structural investments organic profit growth opportunity of around 6% per year based 2. M&A on its existing regional footprint. The company has already announced an 8% increase in A&P in FY10, with the - Expanding market footprint overwhelming majority of that increase targeted in emerging 3. Strategic alliances markets, which should support faster growth. - Such as recent announcements in Korea and Mexico 27
  • 28. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Company Analysis Exhibit 1 Exhibit 2 Partnering for growth in unrepresented markets S. Korea is one of the world’s largest cigarette markets Local partner Country Agreement 400 PMI distributes Davidoff and manufactures PMI / IMT Mexico and distributes West in Mexico 350 (Market volume (bn sticks) BAT manufactures and distributes 300 BAT / IMT Argentina Parisienne brand in Argentina 250 BAT manufactures and distributes IMT BAT / IMT Australia brands in Australia 200 KT&G manufactures and distributes 150 KT&G / IMT South Korea Davidoff in South Korea 100 Barakat distributes Davidoff in key cities in Barakat / IMT India India 50 IMT (Altadis USA, not Habanos) has a 0 CNTC / IMT China framework agreement for cigars in China y SA ly n am a ea a ne a e di si si pa Source: Company data, Morgan Stanley Research Ita rk or ai U us ne In tn Ja Tu kr K e R do Vi U S. In Although the company is currently in debt reduction mode, we Source: Euromonitor data (2009) expect the rapid pace of deleveraging should ensure that IMT’s balance sheet can support further M&A, especially tuck- capita consumption have remained broadly stable, supported in opportunities associated with emerging markets’ state by flat taxes and a lack of industry price increases. monopoly privatisations, within the relatively short term. We think the company’s growing partnering model offers a capital- Appetite for international brands light and comparatively low risk opportunity to generate profits in The Korean market has offered a significant growth opportunity markets where it has no presence and where the barriers to for international brands since KT&G, the former state and risks of organic market entry are not compelling. monopoly, was privatised in 2002 and the market opened to Attractions of the Korean market foreign players. KT&G has suffered perennial share loss since The Korean cigarette market is the sixth largest global market the market opened up, as Korean smokers, especially those (ex-China). According to Euromonitor, it is one of only three of in younger age cohorts, have defected to foreign brands the top ten markets (the others being Russia and Indonesia) BAT has enjoyed great success with Dunhill in the premium with volume growth over the past four years, albeit off a low segment, while PMI introduced Marlboro, Parliament and Lark in base, following a significant tax hike in 2004. Volumes have the premium segment and Virginia Slims in the above premium remained resilient as prevalence rates, at about 25%, and per segment, and JT introduced Mild Seven as a premium brand. Exhibit 3 Market overly focused on short-term concerns; we think pace of deleveraging and structural growth opportunities are under-appreciated p3,000 Bull Case 2,590p: Exceeds growth potential identified in our profit pool analysis, driven by 100bps pa stronger pricing and 2590p (+36%) stronger post-Altadis cost savings lifting margins by 150bps. 2,500 Assumes FY10-13 revenue and operating profit CAGRs of 4.2% 2,270p (+19%) and 6.5%, respectively. 1,910p 2,000 Base Case 2,270p: IMT deleverages to 2.5x Net debt / EBITDA by the end of FY11 through retention of FY09 NWC gains and strong cash conversion. IMT achieves €400mn Altadis 1,500 1460p (-24%) cost savings target by FY12. Assumes FY10-13 revenue CAGR of 3.5% (vol +0.4%/price +3.1%) and operating profit CAGR of 1,000 4.5% (FY10-13 margin +150bps). Bear Case 1,460p: Core markets slow volume growth and 500 competition pressures pricing and margins. Our bear case assumes FY10-15 revenue and CAGR of 2.2% (vol -0.3%/price +1.8%) and operating profit CAGR of 2.0% on lack of incremental 0 cost savings. Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11 Price Target (Oct-11) Historical Stock Performance Current Stock Price Price Target Methodology: Derived using long-term average WARNINGDONOTEDIT_RRS4RL~IMT.L~ forward P/E multiple of 11.5x on calendarised 2011e EPS. Source: FactSet (historical share price data), Morgan Stanley Research estimates 28
  • 29. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Company Analysis October 13, 2010 Stock Rating: Overweight Reuters: SIA.L Bloomberg: SIA LN SOCO International Price target Shr price, close (Oct 12, 2010) 470p 369p Back to Core – Stay OW 52-Week Range Mkt cap, curr (mn) 510-305p US$1,962 Morgan Stanley & Co. Theepan Jothilingam, CFA International plc+ Theepan.Jothilingam@morganstanley.com Matthew P Lofting, CFA Fiscal Year ending 12/09 12/10e 12/11e 12/12e Matthew.P.Lofting@morganstanley.com ModelWare EPS (US$) 0.15 0.04 0.15 0.38 Consensus EPS (US$)§ 0.15 0.15 0.43 0.68 P/E** 35.6 143.9 38.1 15.2 Shares down sharply as Vietnam exploration disappoints. ROE (%) 7.2 1.9 5.9 14.1 Yesterday’s sharp correction (18%) in SOCO’s share price ** = Based on consensus methodology was brutal but not unjustified, in our view, given § = Consensus data is provided by FactSet estimates e = Morgan Stanley Research estimates management’s optimism on TGD (exploration block in Vietnam) last month. Although recent well results can best be Price Performance described as disappointing, our thesis from early this year remains intact: namely, that either the company’s E&A Soco International PLC (Left, British Pounds) Relativ e to FTSE UK ALL-SHARE(GBP) (Right) campaign delivers transformational change (the DRC Relativ e to MSCI W orld Index /Ener gy (Right) campaign is ongoing and there was some good news on £ % TGD); or management would look to crystallize value through 6 5.5 a corporate or asset sale, which should realise a value higher 5 300 than today’s share price. 4.5 250 4 3.5 200 Cutting PT but undemanding valuation keeps us OW. 3 2.5 150 We lower our NAV per share to 468p, which brings down our 2 100 price target to 470p (from 550p), while highlighting that our 1.5 06 07 08 09 10 core value, excluding upside for the DRC, TGT or the fan Source: FactSet Research Systems Inc channel play in Vietnam, is 370p/share – SOCO now trades at the lowest premium to Core NAV in our coverage universe. Company Description As such, we remain Overweight. Soco International is an oil and gas company focused on exploration in Vietnam and Yemen. The company also has interests in Thailand, the Republic of Congo (Brazzaville), the Democratic Republic of Congo TGD flows are sub-commercial … SOCO announced that (Kinshasa) and Angola. the TGD-2X well (Vietnam, worth c.52p/share in our Base Oil & Gas/United Kingdom case NAV) has encountered significant hydrocarbons in a Industry View: Attractive We maintain an attractive view on Energy, supported by inexpensive clastics reservoir sequence, but the flow rates are valuation (on both an absolute and relative basis) and a positive view on sub-commercial. The well will now be plugged and medium-term oil prices. abandoned. Given the substantial optimism provided by GICS Sector: Energy management in the run-up to the drilling results and the Strategists' Recommended Weight: 12.2% potential to de-risk further prospectivity in the fan channel play MSCI Europe Weight: 10.2% (worth an incremental 32p/share in our Base case), the result is clearly disappointing. Next catalysts: The material KNY-1 well on the Nganzi block (DRC, 25 day well, unrisked c.188p/share) is currently drilling, … while TGT provides a small positive: The result from the with results expected by the end of October. first two development wells at TGT (Vietnam) appear to confirm that the field extends to the east. We currently Specific risks for SOCO: On the downside, disappointing incorporate a 250mb reserve size for the TGT fields, but drilling results from Vietnam and Congo, and delays to the believe the drilling results should help SOCO partially de-risk development of existing assets in Vietnam. On the upside, the 500mb upside case (risked at 33% in our Base case, we see risks from materially better success from the drill bit unrisked worth c.137p/share). Incremental news flow on potential reserve upgrades may come in November/December, with production to start mid-2011. 29
  • 30. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Company Analysis Exhibit 1 Bear to Bull 800 700 22p 135p 600 53p 625p 500 38p 8p 60p 400 468p 300 Price Target: 470p 310p 200 100 0 Bear Higher Oil DRC Congo Vietnam Base Incr. Explor Incr. Bull Case Price Case Success Develop. Case Success Source: Morgan Stanley Research estimates Exhibit 2 Overweight ahead of an active 2010 drilling campaign p 700 BULL CASE: 625p Increased exploration and appraisal success. Consists of our 625p (+68%) 600 base case plus the assumption that the company is 2.5x more successful in exploration/development than in our base case. 500 BASE CASE: 468p 470p (+27% ) Risked exploration success and mid-cycle oil price. Includes 400 371p risked value from exploration and development activity. Our core value, at a US$90/bbl oil price, plus risked upside from 310p (-16%) exploration and development projects in 2010 and 2011. 300 BEAR CASE: 310p 200 No upside from exploration and development activity. It consists of the company’s producing fields and fields under development, at US$70/bbl oil price, less net debt and present 100 value of group overheads. 0 PRICE TARGET METHODOLOGY Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11 Our 12-month price target is set around our base case NAV of Price Target (Oct-11) Historical Stock Performance Current Stock Price 468p assuming Base case oil prices of LT US$90/bbl Brent. Source: FactSet (historical share price data), Morgan Stanley Research estimates 30
  • 31. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Company Analysis October 4, 2010 Stock Rating: Overweight Reuters: UTG.L Bloomberg: UTG LN Unite Group Price target Shr price, close (Oct 1, 2010) 260p 223p 52-Week Range 312-159p Superior NAV Growth Even With Mkt cap, curr (mn) £364 Modest Rental Growth Fiscal Year ending 12/09e 12/10e 12/11e 12/12e NAV per share (p) 265 295 319 346 Morgan Stanley & Co. Bianca Riemer ModelWare EPS (p) 0.3 (0.3) 0.6 2.1 International plc Bianca.Riemer@morganstanley.com Div per shr (p) 0 0 0 0 Bart Gysens, CFA Revenue (£mn)** 81 86 90 98 Christopher Fremantle, CFA ** = Based on consensus methodology e = Morgan Stanley Research estimates We expect superior NAV growth for Unite, even with Price Performance conservative rental growth assumptions. Valuation is unchallenging and upside to 260p attractive: We initiate Unite Group PLC (Left, British Pounds) Relativ e to FTSE UK ALL-SHARE(GBP) (Right) coverage at Overweight. Relativ e to MSCI W orld Index /Real Estate (Right) £ % 180 Twice as much NAV growth as the UK average. We 5 160 estimate that Unite can grow its NAV by 10% per annum over 140 4 the next three years, approximately twice as much as the 120 3 100 other UK stocks we cover. Key drivers are rental growth 80 2 (contributing 6% p.a. of growth) and development completions 60 (contributing approximately 3% p.a.). We base our estimates 1 40 20 on a relatively cautious 3% annual rental growth (versus 7% 06 07 08 09 10 p.a. on average over the last 5 years), and estimate that each Source: FactSet Research Systems Inc 1pp in rental growth increases NAV by 2pp, thanks to Unite’s relatively short leases and high financial gearing. Company Description Unite Group is a developer and co-investing manager of commercial student accommodation. It manages about 40,000 beds located in Catalyst: Government decision on tuition fees. We think university cities across the UK valued at £1.8bn, of which it owns about that the results of the Browne Review and a government 45% by value. announcement on tuition fees will lift the uncertainty weighing Property/United Kingdom Industry View: Cautious on the share price. The impact on Unite will be seen in the pre-let numbers for the 2011/12 academic year in the group’s GICS Sector: Financials interim report in November. Strategists' Recommended Weight: 25.1% MSCI Europe Weight: 23.1% 8 reasons why we think rents will continue to grow, albeit at a slower pace than previously: 2. Universities to offer more places to non-EU students We think that in the light of government funding cuts, 1. Unite’s tenant base will be unaffected, in our view universities will likely increase their intake of non-EU students Unite’s tenants tend to be from above-average income who pay significantly higher tuition fees (up to £20,000 p.a. for households, and we think that a fall in the number of students, undergraduate courses, compared to a capped annual fee of if at all, is most likely to be in students from lower-income £3,290 p.a. for UK/EU students currently). Several universities backgrounds. According to UCAS, the agency that have already indicated they are in the process of doing this, administers undergraduate applications, there is a positive and some are even cutting places for UK/EU students in order correlation between A-level results and parents’ incomes. This to increase their non-EU intake (according to a recent HESA would imply that, if the government were to cut university press release). Non-EU students tend to be less price-sensitive places, for example, fewer students from lower income and value the all-inclusive nature of Unite’s rents (including backgrounds would win places. By the same token, we think utility bills, insurance and broadband), as well as its proximity any increase in tuition fees would tend to have less effect on to university campuses. Moreover, it is significantly more school-leavers from higher-income backgrounds. difficult for non-EU students to rent in the private rented sector. 31
  • 32. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Company Analysis 3. Supply of student accommodation is growing slower 6. New requirement for affordable housing could be than the number of new 1st year undergraduate students barrier to entry for new competitors in London This matters because UK universities guarantee 1st year Student accommodation development schemes have in the undergraduates a room in halls of residence but can only past not had to comply with London’s requirement to have up satisfy 65% of this guarantee – and only 35% in London. to 50% of the scheme in affordable housing. This meant that About 50% of Unite’s direct-let tenants are referrals from Unite and its competitors have been able to build in locations universities that cannot satisfy their rental guarantees. We that would have been unprofitable for, say, an office think that this percentage may well increase as universities developer or a house builder. Some London boroughs are recruit more non-EU students. considering requiring affordable housing to be included in student schemes, unless the scheme is endorsed by a local 4. Unite is the market leader in a niche segment university. We think that Unite’s existing relationships with Unite manages the largest commercial halls portfolio in the universities would give it a clear competitive advantage over UK and is the first provider to publish prices for the potential new entrants in the London market. forthcoming academic year. Our channel checks with surveyors and competitors confirm that competitors tend to 7. Unite has minimal exposure to universities as tenants wait for Unite’s pricing before compiling their own price lists, We do not think that cuts to university funding have a direct and that they generally price below Unite (7% on average in impact on Unite as only 4% of its rental income is from leases Unite’s top 8 locations according to our proprietary price to universities. check in September 2010). 8. Residential substitutes are becoming more expensive, 5. Unite has a strong London focus too, and may not be accessible for all students We expect rental growth to be stronger in London, as there In the latest quarterly residential lettings survey by the are more international students and the supply ratio is Royal Institute of Chartered Surveyors (RICS), 27% more significantly lower. About 40% of Unite’s share in the portfolio surveyors reported a rise rather than a fall in residential rents. it manages is in London, where universities can only satisfy 33% more surveyors now expect rents to increase rather than 35% of their rental guarantee for 1st year undergraduates, and fall over the next quarter. We think that as residential where currently only 2-3% of full-time students live in substitutes become more expensive, Unite will continue to be commercial halls. able to increase its rents, too Exhibit 1 Near-term positive catalyst helps skew risk to the upside p350 BULL CASE 316p: Government allows tuition fee increase of 10%. The government allows universities to increase fees for 316p (+44%) 300 UK/EU students from September 2012, but only up to 10% p.a. Unite’s rents grow 5% p.a. and yields compress 50 bps. The 260p (+18%) stock trades at a 5% discount to NAV. 250 223p BASE CASE 260p: Universities grant more places to non-EU 200 students. The government announces a gradual lifting of the tuition fee cap for new entrants from September 2012, and 150 applications fall marginally, with no impact on places. Unite rents 128p (-42%) grow 3.5% p.a., and yields are stable. The stock trades at a 17% discount to NAV. 100 BEAR CASE 128p: Tuition fees allowed to increase from 50 September 2011. Commercial halls cut rents 10%, and yields rise 50 bps. Unite NAV falls 30%, it trades at a 50% discount. 0 PRICE TARGET METHODOLOGY: We apply a 17% target Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 discount (given its relatively large financial/operational gearing Base Case (Sep-11) Historical Stock Performance Current Stock Price WARNINGDONOTEDIT_RRS4RL~UTG.L~ and absence of recurring earnings) to our mid-2011 NAV estimate. Source: FactSet (historical share price data), Morgan Stanley Research estimates 32
  • 33. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Company Analysis October 4, 2010 Stock Rating: Equal-weight Reuters: VOD.L Bloomberg: VOD LN Vodafone Group Price target Shr price, close (Sept 30, 2010) 175p 157p 52-Week Range 165-127p Rising Cash Returns Mkt cap, curr (mn) £83,427 Morgan Stanley & Co. Nick Delfas Fiscal Year ending 03/10 03/11e 03/12e 03/13e International plc+ Nick.Delfas@morganstanley.com ModelWare EPS (p) 16.4 16.2 16.7 17.3 Terence Tsui P/E** 9.2 9.7 9.4 9.1 Luis Prota Dividend per Share (p) 8.1 11.0 12.0 13.0 Frederic Boulan, CFA Dividend Yield (%) 5.4 7.0 7.6 8.3 ** = Based on consensus methodology Upgrading to EW; PT from 160p to 175p. We feel lucky that e = Morgan Stanley Research estimates Vodafone’s total return has only been in line with the sector Price Performance over the last 6 months (-1% in £, +3% in €). Our downgrade Vodafone Gr oup PLC (Left, British Pounds) (High ROCE, March 25) was based on longer-term risks to Relativ e to FTSE UK ALL-SHARE(GBP) (Right) Relativ e to MSCI W orld Index /Telecommunication Serv ices (Right) returns, and these still exist. However, shareholder dissent at £ the July AGM and press reports that the chairman intends to 2 % 130 retire (c.f. FT, September 6), plus Vodafone’s sale of its China 1.8 120 Mobile stake and resultant share buyback announcement 110 1.6 (£2.8bn, or 3% of market cap) have contributed to a more 100 1.4 supportive atmosphere for the shares. 90 1.2 80 In this report we reassess: 1 70 60  Value – Better prospects in India and Australia, a 06 07 Source: FactSet Research Systems Inc 08 09 10 strengthened yen driving up the Softbank loan note values, and a lower debt position at VZW are only Company Description partially offset by a weaker Italian outlook, and drive our Vodafone is the largest pure-play wireless stock by market capitalisation. Its operations are mostly based in the European Union, price target upgrade from 160p to 175p. together with a 45% stake in Verizon Wireless of the US; whilst its EMEA exposure is dominated by India, South Africa and Egypt.  Asset sales – We estimate potential proceeds of £11- Telecommunications Services/United Kingdom 14bn. The proceeds could be returned to shareholders Industry View: In-Line or used to buy fixed line assets, or a combination of the We see more limited absolute upside for European telecom stocks in 2010. The sector re-rated in 2009 by 20% on FCF yield, all in the two. But the key in our view is that Vodafone is second half of the year. Higher prices and slightly lower forecasts mean beginning to sell well-performing businesses, not just much of the previous value gap has been extinguished. those that have suffered under its ownership as in the GICS Sector: Telecom Services Strategists' Recommended Weight: 8.9% past (such as Sweden, Japan). This means it stands a MSCI Europe Weight: 6.9% better chance of good portfolio management, rather than simply locking in losses. However, improving momentum in cash returns is likely in our  Verizon Wireless dividend – We now include an extra view to support the shares, particularly over the next six £1bn of dividend already in FY11 beyond the dividend months, when asset sales and Verizon Wireless dividend currently being paid to cover tax, and a full payout of announcements could be made. FCFE from FY12. This drives up our DPS estimates from 8.9p to 11.0p for FY11 and from 9.5p to 12.0p for FY12. Our risk-reward range has shifted upwards from 115p- 190p to 140p-205p, and indicates some modest upside We are conscious that the last two are not strictly towards 170-175p as the mid-part of the range, in line with the speaking ‘value’ events beyond the value that accrues sector upside of 14%. A rise in the dividend would mean that from cash being paid out rather than retained by the the FY12e dividend of 12p would yield 7.6% at today’s share company. Furthermore, share buybacks only create value if price, compared to the sector at 6.9% (though FT and TEF the shares are below fair value, and this appears to be only yield 8.7% and 8.8% respectively). Again, this is supportive modestly the case. It is partly for this reason that we are EW. as the dividend payout on earnings before amortization would be 60% at this level rather than 70-80% for FT and TEF. 33
  • 34. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Company Analysis Options for disposal of Verizon Wireless remain hard to  Our colleague Vinay Jaising recently visited Indian gauge. Even a spin-off appears to require Verizon approval. operators. Price falls appear to have ended, and we In our Flexer, we now target a FCFE yield rather than posit a raise our Vodafone India growth rate for FY11 from 5% to sale price less tax paid, as we wish to be neutral in valuation 11%, and margins are up slightly from down 400bps. terms over whether the asset is retained with a dividend stream or sold / spun off – even if we think it is better for  Turkey also improved. Fiscal Q1 margins were in the management focus for it to be separated. high single digits. What are the risks? The major risk in our view is that  Italy weaker – we include margin pressure to respond to smartphone adoption leads to better revenues as handsets TIM – down 220bps from down 70bps – in accordance are “leased” from operators, but also a subsidy war, driving with our recent trip to visit TIM and Wind. down ROCE further. There also appears to be an ongoing  Dividends from Verizon Wireless. Our FCF forecasts price war in Italy, only partially related to smartphones. rise strongly due to increased dividends from VZW. For Our preferred stocks are KPN, Telefonica and the cable FY11e we assume an additional £1bn beyond the £1bn operators KDG, Telenet, and Virgin Media. or so that is already paid to cover the tax liability at the partner level. From FY12e we assume a full payout of Ex FX our FY11e EPS rises 3% for better India and Australia, £4.5bn. This has the effect of bringing down offset by weaker Italy. consolidated net debt / EBITDA to 2.0x in FY13 from 2.5x previously forecast. We change our FX assumptions from €1.15/£ and $1.50/$ to €1.18 and $1.54 to reflect year to date averages and One final open question is capex: could Vodafone adopt a assuming that current spot rates persist to the end of the more aggressive “swap out” policy to reduce 2G / 3G running financial year. costs, and future investment costs, as Telenor has done in Norway? This could form some additional upside to near- Key points to note: term cash flow expectations, even if in the longer term we  Australia is doing well. Margins were up in H1 2010 would expect such gains to be competed away according to Hutchison Australia, at 21% from 7.5% in H2 2009. Exhibit 1 Balanced risk reward p230 BULL CASE 205p: Vodafone Europe flat revenues into perpetuity, with stable cash 210 flow. 205p (+30%) 190 BASE CASE 175p: Vodafone Europe delivers -2% revenue CAGR in FY10-17, with 175p (+11%) 170 11% capex / sales. 157p BEAR CASE 140p: 150 140p (-11%) Vodafone Europe ROCE falls to just over 10% over 7 years as 130 revenues fall 3.5% compound with operating leverage to EBITDA. 110 PRICE TARGET METHODOLOGY: Derived from DCF, assuming blended WACC of 8.6% and 90 terminal growth of 1%. 70 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 Base Case (Sep-11) Historical Stock Performance Current Stock Price Source: FactSet (share price data), Morgan Stanley Research estimates; Prices: KPN €11.35, Telefonica €18.16, KDG €29.1, Telenet €24.61, Virgin Media $23.10 (covered by David Gober) 34
  • 35. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Company Analysis October 1, 2010 Stock Rating: Overweight Reuters: WOS.L Bloomberg: WOS LN Wolseley plc Price target Shr price, close (Sep 29, 2010) 2,030p 1,591p Increased Confidence in 52-Week Range Mkt cap, curr (mn) 1,742-1,155p £4,503 Restructuring: Stay OW Fiscal Year ending 07/09 07/10e 07/11e 07/12e Morgan Stanley & Co. Jessica Alsford, CFA ModelWare EPS (p) (177) 51 77 132 International plc+ Jessica.Alsford@morganstanley.com Consensus EPS (p)§ 64 79 116 154 David Hancock, CFA P/E** 14.1 19.5 13.8 9.3 Div per shr (p) 0 0 38 57 David.Hancock@morganstanley.com Div yld (%) 0.0 0.0 2.4 3.6 Simone E Porter-Smith § = Consensus data is provided by FactSet estimates Simone.Porter-Smith@morganstanley.com ** = Based on consensus methodology e = Morgan Stanley Research estimates Post FY10 results, we continue to recommend that Price Performance investors buy into Wolseley’s recovery story. Although volume growth will be lacklustre across all end markets, W olseley PLC (Left, British Pounds) Relativ e to FTSE UK ALL-SHARE(GBP) (Right) the restructuring story is showing early signs of success. Relativ e to MSCI W orld Index /Capital Goods (Right) £ % 120 A return to positive revenue growth 60 100 LfL revenue growth turned positive in Q4 (+4% versus -2% in 50 Q3), which was the first period of growth since mid-2007. The 40 80 comparative period is easier (-19% in Q4 vs. -17% in Q3), but 30 60 even adjusting for this, there was around 4% sequential 20 40 growth between the two last quarters. Looking ahead, we 10 20 assume that revenue growth continues at roughly the same 06 07 08 09 10 rate, and forecast 3% organic growth for FY11. Comps do get Source: FactSet Research Systems Inc tougher, and so this assumes a 4 percentage point improvement sequentially over the next couple of quarters. Company Description Wolseley is the world’s largest distributor of plumbing and heating There are four drivers of the organic growth: products and a major distributor of other building products to the professional builder market. Sales in fiscal FY2010 were £13.2 billion.  Small decline in overall market volumes The group has operations in North America (~60% of sales) and Europe (~40% of sales). Business Services/United Kingdom  Market share gains Industry View: In-Line  Positive price trends GICS Sector: Industrials Strategists' Recommended Weight: 10.5% MSCI Europe Weight: 10.5%  Branch openings Attractive valuation – remain Overweight: Wolseley shares have rallied by 26% over the last month, outperforming One of the key ways in which Wolseley is aiming to improve the market by 21%. However, on our new forecasts, Wolseley profitability in the UK is through the gross margin. During still only trades on 11.5x calendar PE and 0.39x EV to Sales FY09 and 1H10, the gross margin was falling significantly yoy for 2011e. We believe this is an attractive valuation with in the UK business, including -200bp of decline in 1Q10. c.45% EPS CAGR over the next three years. We raise our Changes made to the UK business over the last six months price target by 7% to 2,030p. have included (i) having a “no price change” policy on non- core products; (ii) reducing the discounts some customers Gross margins stabilised earlier than anticipated receive to better reflect the size of their purchases; For FY10 we had forecast a 30bp decline in the group gross (iii) introducing more private label products. These actions margin in FY10, driven principally by margin pressure in the have already started to deliver results, with the gross margin UK business. However, Wolseley reported flat yoy gross increasing year-on-year during May to August. margins at 27.7%. 35
  • 36. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Company Analysis Performance Builders – progress being made Exhibit 1 In March, CEO Ian Meakins set out a framework for managing LfL growth has turned positive with some the 41 business units that Wolseley had at that time. 19 units sequential growth were identified as Performance Builders, with the priority Q1 Q2 Q3 Q4 being restructuring to improve growth and profitability. Since Q3 2009 Q4 2009 Q1 2010 Q2 2010 Q3 2010 Q4 2010 2011e 2011e 2011e 2011e 5% then two of the businesses have been sold (Brandon Hire and France Public Works), three are to be exited (including 0% Construction Loans) and four have been integrated into other divisions. This leaves 10 business units, including Build Group LfL Growth -5% Center, Brossette and Italy, where progress is being made. For example Build Center is now profitable, whilst Brossette -10% has turned from loss-making to breakeven. More attention is needed on Italy, which is loss-making, but action is being -15% taken with another seven branches to be shut. The Performance Builders now account for less than 5% of group -20% EBITA. We have cautious assumptions, just 1.8% EBITA e=Morgan Stanley Research estimates Source: Company data, Morgan Stanley Research margin in FY13 compared to 0.8% in FY09. inflow that occurred just before year end, but also due to the Balance sheet robust – capex to accelerate and dividend business growing again. However, over the next three years reinstated. we expect free cash flow conversion to average at ~0%. Net debt at 31 July 2010 was only £346mn compared to £959mn at the previous year-end. Timing of working capital Changes to forecasts changes did flatter this position, but even adjusting for this the We have altered very little our underlying operating debt position fell by around £500mn over the last 12 months. assumptions. However, we are raising our EPS forecasts by c.10% to 115p in FY11 and 171p in FY12 due to a lower tax Wolseley has indicated that it intends to pay a dividend again rate from 1H 11 while capex spend is increasing as the company begins to look at growth again. There will be a big working capital outflow during 2011, mainly due to reversing the large Exhibit 2 Greater confidence on margins underpins a positive risk-reward skew p3,000 BULL CASE 2,700p: Highly successful restructuring with new peak margins: Wolseley grows its revenue base with an organic 2700p (+70%) CAGR of +9% (FY10-13e) as it takes market share. The Growth 2,500 Engines reach 9.0% EBITA margins while the Synergy Drivers attain 6.0% return on sales and the Performance builders 4.0%. 2,000 2030p (+28%) BASE CASE 2,030p: Previous peak profitability attained 1,591p again: Organic revenue CAGR of +6% (FY10-13e) as the “Growth Engines” take market share. FY13e peak revenues are 1,500 13% below the previous peak in FY07 (at constant currency). Profitability improves across all business areas. 1060p (-33%) 1,000 BEAR CASE 1,060p: Double dip and restructuring fails: Wolseley continues to lose market share across all business lines. 500 +1% revenue CAGR from FY10-13e with FY13e peak revenues still 24% below the previous peak level (at constant currency). Profitability improves from 2.9% in FY10e to 4.0% in FY13e 0 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Mar-11 Sep-11 PRICE TARGET METHODOLOGY: We derive our PT from an Base Case (Sep-11) Historical Stock Performance Current Stock Price average of three valuation methodologies: DCF (WACC of 8.8% W ARNINGDONOTEDIT_RRS4RL~WOS.L~ and 3% LT growth), EV/Sales and long-term relative P/E (10.8x 2013e EPS discounted back). Source: FactSet (historical share price data), Morgan Stanley Research estimates 36
  • 37. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Company Analysis October 5, 2010 Stock Rating: Equal-weight Reuters: WG.L Bloomberg: WG/ LN Wood Group Price target Shr price, close (Oct 1, 2010) 470p 438p 52-Week Range 444-280p Value Materialised; Downgrade to Mkt cap, curr (mn) US$3,626 Equal-weight Fiscal Year ending 12/09 12/10e 12/11e 12/12e ModelWare EPS (US$) 0.42 0.38 0.48 0.58 Morgan Stanley & Co. Martijn Rats, CFA Prior EPS (US$)* - 0.38 0.46 0.58 International plc+ Martijn.Rats@morganstanley.com P/E 11.9 18.1 14.5 11.9 Robert Pulleyn Dividend per Share (US$) 0.10 0.11 0.12 0.13 Robert.Pulleyn@morganstanley.com Dividend Yield (%) 2.0 1.5 1.7 1.9 * = Based on consensus methodology Increasing visibility on the recovery in Engineering has e = Morgan Stanley Research estimates supported Wood Group’s re-rating. With valuation Price Performance multiples now back to industry averages, we recommend taking profits. John W ood Group PLC (Left, British Pounds) Relativ e to FTSE UK ALL-SHARE(GBP) (Right) Relativ e to MSCI W orld Index /Ener gy (Right) £ Wood Group’s share price has increased 42% since the start % 5 of the year, making it the third best performing stock in our 260 4.5 240 coverage universe after Wellstream (+46%) and Petrofac 4 220 (+44%). As a result, upside to our price target has been 3.5 200 180 reduced to 7%, which is modest compared with the sector. 3 160 Hence, we are lowering our rating on Wood Group from 2.5 140 120 Overweight to Equal-weight. 2 100 1.5 80 06 07 08 09 10 Our previous investment thesis was based on two main Source: FactSet Research Systems Inc factors: first, we believe that Wood Group’s valuation was attractive, and second, we expected the outlook for the Company Description Wood Group (John) plc is an energy services company, providing a Engineering segment to start to improve, which we range of engineering, production support, maintenance management considered to be the main ‘swing factor’ driving confidence in and industrial gas turbine overhaul and repair services to the oil and Wood Group’s earnings recovery in 2011 (also see our report gas, and power generation industries worldwide. It operates in three operating divisions: Engineering and Production Facilities, Well Support Cheapest Play on Oil Service Recovery, January 21, 2010). and Gas Turbine Services. This thesis has now played out, in our view. Oil Services/United Kingdom Industry View: In-Line Valuation gap with key peers closed … Valuations are largely back to normalised levels. Although the onshore market outlook remains positive, offshore awards continue to be Wood Group started 2010 trading on 11.1x consensus 2011 delayed. EPS and 9.4x consensus 2012 EPS. At the time, Wood Group GICS Sector: Energy was the lowest-rated company in our coverage universe on Strategists' Recommended Weight: 12.3% 2011e PE. Also, the two-year forward PE was at a 30% MSCI Europe Weight: 10.3% discount to its long-run historical average, again making Wood Group the lowest-rated company in our coverage earnings at approximately $0.51±0.03, based on the asset universe on that particular metric as well. base the company is likely to have in 2012. Capitalising this at Wood Group’s ten-year average PE multiple of 15.7 yields a Since then, Wood Group has re-rated substantially: at the normalized valuation of 471p (7% upside). However, given moment, it trades on a 2011e and 2012e PE of 15.0 and 12.7 Wood Group’s low beta, limited balance sheet gearing and respectively, which is broadly in-line with peers. Hence, we high return on capital (which we think is sustainable), we also would argue that the valuation gap with the rest of the sector believe that a somewhat higher multiple of around 17.6x can has now largely closed (also see Exhibit 1). be justified from a more theoretical point of view. Incidentally, Wood Group traded on this multiple from late 2005 to late … and discount to normalized valuation much reduced 2008. Capitalising our mid-cycle EPS at 17.6x yields a value As described later, we estimate Wood Group’s mid-cycle of 525p (19% upside) by end 2010. 37
  • 38. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Company Analysis Exhibit 1 Recently, management has commented positively on the Wood Group’s Discount to the Sector Largely outlook for Engineering, confirming that the anticipated Closed after Recent Outperformance recovery is gaining momentum. In its first-half results Wood Group: 2-yr forward PE relative to Oil Service Sector* statement (published Aug 26, 2010), management indicated 1.3 that Engineering is “seeing high bidding volumes and increasing backlog”. Since this statement, Wood Group has 1.2 won key engineering contracts from Chevron for the 1.1 Jack & St Malo fields in the Gulf of Mexico and from BP for the Andrew Area Development in the North Sea. These 1.0 contract wins support management’s view on the recovery. 0.9 The Engineering segment is a key contributor to Wood 0.8 Group’s earnings (estimated 25-30% of Group EBITA in 0.7 recent years). Of all divisions, the market appeared most Oct-03 Oct-04 Oct-05 Oct-06 Oct-07 Oct-08 Oct-09 concerned about the recovery in this segment earlier this year. Hence we believe that the increasing clarity about the * Peer group based on Saipem, Technip, Petrofac, Amec, Acergy, Subsea 7, SBM Offshore, Tecnicas Reunidas; Source: Company data, Morgan Stanley Research prospects for this division has been the key driver of Wood Group’s recent outperformance. At the same time, however, This means that upside to a ‘normalised’ valuation is currently we believe that this factor is increasingly recognized and that in the order of 7% – 19%. This compares to ~45% we this catalyst has now played out. estimated in our January report. Whilst this analysis shows that Wood Group has the potential to trend higher from Raising 2011e EPS by 5% but moving to Equal-weight current levels, we believe that the shares’ relative We are making small changes to our 2011 EPS forecast:: outperformance is now largely behind us and that an increasing our 2011 Engineering EBIT margin from 9.3% to Overweight rating is no longer justified. 10.3% after management’s recent comments. We are also raising our 2011 Well Support margin from 11.0% to 11.9%. Outlook for Engineering recovery increasingly visible At the same time, we have lowered our revenue growth for The second part of our original thesis was our expectation Well Support from 13% in 2011 to 7% as the US rig count that Wood Group’s two-year spell of falling earnings would may stabilize and there may even be some downside risk. In come to an end in 2010 and that earnings would start rising aggregate, this leads to a 5% increase in our 2011 EPS again in 2011, driven by the Engineering division. forecast. Our 2012 forecast is broadly unchanged Exhibit 2 Recent strong performance leaves little room for upside p800 BULL CASE 730p: Global economic growth gains momentum, which quickly tightens oil markets. With greater confidence in the 730p (+67%) 700 oil demand outlook, oil companies kick off a new E&P capex wave. 600 BASE CASE 470p: 2010 marks the bottom of the cycle for Wood Group. As macroeconomic conditions improve, the market 500 438p 470p (+7%) starts to look at 2011 EPS and capitalises those at a PE of 15- 15.5, broadly in line with the ten-year average. 400 BEAR CASE 320p: Weak global economic growth results in 320p (-27%) 300 depressed oil demand. Excess oil production capacity remains an overhang for both oil prices and E&P capex. 200 PRICE TARGET METHODOLOGY: We set our price target for Wood Group at £4.70, which is based on a target 2011e PE of 100 15.3. This is broadly in line with the Company’s 10-year average PE as we expect similar earnings growth over the period 2010-12 0 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 (EPS CAGR 23%) as over the last 10 years (EPS CAGR 20% Price Target (Oct-11) Historical Stock Performance Current Stock Price 1999-2009). Source: FactSet (historical share price data), Morgan Stanley Research estimates 38
  • 39. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK UK Economic Forecasts UK Economic Forecasts, 2009-12e % Change from Prior Quarter (Unless Otherwise Stated) 2009 2010e 2011e 2012e Year over Year 1Q 2Q 3Q 4Q 1Q 2Qe 3Qe 4Qe 1Qe 2Qe 3Qe 4Qe 1Qe 2Qe 3Qe 4Qe 2009 2010e 2011e 2012e Real GDP GDP -2.3 -0.8 -0.3 0.4 0.4 1.2 0.1 0.5 0.2 0.3 0.1 0.5 0.7 0.6 0.5 0.2 -5.0 1.4 1.3 2.0 GDP (%Y) -5.5 -6.0 -5.4 -3.0 -0.3 1.7 2.1 2.2 2.0 1.1 1.1 1.1 1.6 1.9 2.3 2.0 Services -1.4 -0.7 -0.3 0.7 0.3 0.6 0.0 0.3 0.2 0.2 0.0 0.4 0.6 0.5 0.4 0.1 -3.3 1.0 0.8 1.6 Manufacturing -5.6 -0.3 -0.6 1.0 1.5 1.6 0.6 1.1 0.3 0.6 0.3 0.5 0.8 0.9 0.6 0.6 -10.7 3.7 2.6 2.6 Household Consumption -1.2 -0.7 -0.1 0.8 0.0 0.7 0.6 0.2 -0.2 0.1 0.4 0.6 0.4 0.4 1.1 0.1 -3.3 1.2 0.9 2.0 Government Consumption -0.6 0.1 -0.5 0.7 0.7 1.0 -0.6 -0.4 -0.4 -0.6 -0.7 -0.6 -0.6 -0.6 -0.6 -0.6 1.0 1.3 -1.7 -2.4 Fixed Investment -8.4 -5.5 1.5 -2.0 2.9 1.4 -1.5 -0.3 0.0 -0.4 -0.1 0.6 1.5 0.7 0.4 0.5 -15.1 0.8 -0.8 2.7 Imports -7.5 -2.5 1.2 4.5 2.0 2.4 1.1 0.4 -0.1 0.3 0.8 1.2 0.8 0.8 2.0 0.3 -12.3 7.9 2.3 4.1 Exports -8.3 -1.5 0.9 3.7 -0.7 2.3 1.5 2.2 1.5 1.0 0.9 0.8 1.9 1.8 1.8 2.0 -11.1 5.2 6.0 6.1 Contributions to GDP growth Inventories building 0.1 0.2 -0.2 0.3 0.6 0.4 0.0 0.0 0.0 0.2 0.0 0.3 0.1 0.1 -0.1 -0.3 -1.2 1.1 0.4 0.3 Net exports -0.1 0.3 -0.1 -0.3 -0.7 -0.1 0.1 0.5 0.5 0.2 0.0 -0.1 0.3 0.3 -0.1 0.5 0.7 -0.9 0.9 0.5 Final domestic demand -2.4 -1.3 0.0 0.4 0.6 0.9 0.0 0.0 -0.2 -0.1 0.1 0.4 0.3 0.2 0.6 0.0 -4.5 1.2 0.0 1.2 Other Economic Indicators Employment -1.6 -0.1 -0.4 0.2 Unemployment (ILO measure, %) 7.1 7.8 7.9 7.8 8.0 7.8 7.9 8.0 8.3 8.5 8.8 8.8 8.9 8.9 8.7 8.8 7.6 7.9 8.6 8.8 Average Earnings 0.1 2.0 2.7 3.2 Real household disposable income 1.0 -0.9 -0.3 0.8 Savings Rate (%) 6.2 4.8 3.9 3.0 CPI (%Y) 3.0 2.1 1.5 2.1 3.3 3.5 3.1 3.0 3.0 2.8 2.9 2.7 2.2 2.1 2.1 2.0 2.2 3.2 2.8 2.1 RPI (%Y) -0.1 -1.3 -1.4 0.6 4.0 5.1 4.7 4.4 4.1 3.5 3.6 3.6 3.2 3.4 3.4 3.5 -0.5 4.5 3.7 3.4 RPIX (%Y) 2.4 1.4 1.3 2.8 4.5 5.2 4.7 4.3 4.1 3.5 3.5 3.4 2.8 2.8 2.8 2.9 2.0 4.7 3.6 2.8 Public sector (Fiscal Year) Public Sector Net Borrowing (£bn)* 154.7 137.4 121.5 102.7 Net Debt (%GDP)* 53.9 60.7 67.0 71.8 Deficit (%GDP)* 11.0 9.3 7.9 6.3 Exchange Rates EUR/GBP (period end) 0.93 0.85 0.91 0.89 0.89 0.82 0.85 0.87 0.84 0.82 0.79 0.77 n/a n/a n/a n/a 0.89 0.86 0.82 n/a GBP/USD (period end) 1.43 1.65 1.60 1.61 1.52 1.50 1.56 1.56 1.57 1.56 1.59 1.61 n/a n/a n/a n/a 1.56 1.54 1.58 n/a * Public sector net borrowing is PSNB-ex definition. Net debt is ex-financial interventions series. 'Deficit' refers to public sector net borrowing Interest Rate Outlook (period end, %) BoE Policy Rate 3M Interbank 2-Year Gilt 5-Year Gilt 10-Year Gilt 30 Year Gilt Current 0.5 0.7 0.6 1.5 2.9 4.0 4Q10 0.50 0.8 1.0 2.1 3.4 4.4 1Q11 0.50 1.0 1.2 2.4 3.6 4.5 2Q11 0.75 1.4 1.7 2.9 3.9 4.6 3Q11 1.25 1.7 2.1 3.2 4.1 4.8 4Q11 1.50 2.0 2.4 3.4 4.2 4.8 1Q12 2.00 2.5 2.6 n/a 4.3 n/a 2Q12 2.25 2.7 2.7 n/a 4.3 n/a 3Q12 2.50 2.8 2.8 n/a 4.3 n/a 4Q12 2.50 2.8 2.8 n/a 4.3 n/a e = Morgan Stanley Research estimates Source: Office of National Statistics, WM/Reuters, HM Treasury, Morgan Stanley Research 39
  • 40. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Indices, Sector and Stock Performance UK Equity Indices Performance Global Equity Indices Performance Absolute Performance (%) Absolute Performance (%) 2 weeks 3 months 12 months 2 weeks 3 months 12 months FTSE100 3.2 9.0 11.5 MSCI USA 2.9 7.8 9.9 FTSE250 3.2 9.7 16.1 MSCI Europe 3.0 5.8 5.5 FTSE350 3.2 9.1 12.1 MSCI Europe ex UK 2.8 4.2 3.0 FTSE Small Cap 2.7 11.5 -1.6 MSCI Japan -2.4 -3.0 -7.9 FTSE All Share 3.2 9.2 11.9 MSCI Pacific ex Japan 0.8 9.0 3.1 FTSE350 High Yield 3.8 8.0 4.8 MSCI World 2.2 6.1 5.9 FTSE350 Low Yield 2.6 10.2 18.1 NASDAQ 2.7 8.9 14.1 Best-Performing Sectors in the Last Two Weeks Worst-Performing Sectors in the Last Two Weeks Absolute Performance (%) Absolute Performance (%) 2 weeks 3 months 12 months 2 weeks 3 months 12 months Ind. Met & Mines 14.5 25.6 88.8 Leisure Gds -11.0 89.3 133.5 Inds Eng 9.0 22.4 64.2 Alt. Energy -5.8 -27.7 -62.5 Auto & Parts 7.5 35.9 44.8 H/C Eq & Svs -2.9 -7.0 2.4 Mining 7.1 22.9 31.2 S/W & Comp Svs -2.5 5.2 13.5 Financial Svs(4) 6.9 17.4 6.7 Tch H/W & Eq -1.0 18.8 69.0 General Inds 6.5 19.2 38.5 H/H Gds,Home Con -0.9 4.7 1.8 Eltro/Elec Eq 6.4 28.6 67.5 Personal Goods -0.9 23.3 76.7 RE 6.2 14.0 4.8 Fd Producers -0.9 -2.5 2.8 Forestry & Pap 6.1 32.4 57.9 Fd & Drug Rtl -0.5 7.3 15.1 Gen Retailers 5.5 9.0 4.8 Fxd Line T/Cm -0.1 -2.2 6.4 Oil/Eq Svs/Dst 5.1 20.9 42.7 Con & Mat 0.1 8.9 -5.2 Aero/Defence 4.5 5.6 20.8 Life Insurance 0.2 15.6 0.6 Pharm & Bio 4.3 7.3 12.8 Banks 0.3 4.3 0.3 Investment Trust 4.2 9.0 14.2 Nonlife Insur 0.9 4.4 13.8 Oil & Gas Prod 3.8 8.8 -1.2 Inds Transpt 1.2 3.9 14.7 Real Est Inv,Svs 3.8 5.2 -20.0 Electricity 1.7 3.1 10.4 Gs/Wt/Mul Util 3.5 8.8 24.1 Media 1.7 7.4 20.7 Best-Performing FTSE350 Stocks in the Last Two Weeks Worst-Performing FTSE350 Stocks in the Last Two Weeks Absolute Performance (%) Absolute Performance (%) Price (p) 2 weeks 3 months 12 months Price (p) 2 weeks 3 months 12 months MAN GROUP 269 26 22 -23 AUTONOMY CORP. 1,424 -21 -26 -11 EASYJET 455 24 6 15 SOCO INTERNATIONAL 347 -20 -18 -3 DUNELM GROUP 460 21 21 48 PETROPAVLOVSK 1,034 -12 -16 -8 BODYCOTE 301 21 35 68 XCHANGING 135 -12 -37 -38 HERITAGE OIL 351 17 2 -17 HANSEN TNSMS.INTL.(DI) 46 -10 -36 -64 BROWN (N) GROUP 272 17 8 7 BARRATT DEVELOPMENTS 90 -10 -14 -46 FERREXPO 349 15 26 122 PUNCH TAVERNS 77 -9 8 -34 SENIOR 147 14 6 140 SPORTINGBET 72 -9 28 -2 ANGLO AMERICAN 2,884 14 19 33 TAYLOR WIMPEY 27 -8 -3 -38 ENQUEST 132 13 26 #NA CABLE & WIRELESS COMMS. 55 -6 -8 -1 AQUARIUS PLATINUM 390 13 25 30 HALFORDS GROUP 419 -6 -19 8 COMPUTACENTER 332 13 9 1 BOVIS HOMES GROUP 363 -5 1 -21 CHARTER INTL. 779 13 12 13 TALKTALK TELECOM GROUP 140 -5 16 #NA DAEJAN HOLDINGS 2,749 12 18 -4 OCADO GROUP 127 -5 #NA #NA BRITISH AIRWAYS 275 12 33 25 PERSIMMON 382 -5 -4 -13 IMAGINATION TECHNOLOGIES 429 12 34 122 ST.JAMES'S PLACE 276 -5 16 0 STHREE 316 12 6 21 ARM HOLDINGS 382 -5 24 152 KESA ELECTRICALS 165 11 30 7 INMARSAT 636 -5 -15 19 HALMA 343 11 18 48 SUPERGROUP 1,129 -5 41 #NA BIG YELLOW GROUP 353 11 17 -14 JKX OIL & GAS 312 -5 8 5 NA = Not applicable, Source: Datastream 40
  • 41. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK UK Industry Valuations and Forecasts UK Industry Consensus Valuations Price/Earnings Price/Sales EV/EBITDA Dividend Yield (%) Updated as of 14-Oct-10 2010 2011 2010 2011 2010 2011 2010 2011 Automobiles & Components 13.0 10.2 0.6 0.5 5.7 4.9 2.5 3.2 Banks 15.1 10.3 - - - - 2.1 2.4 Capital Goods 12.0 11.0 0.7 0.7 6.7 6.2 2.9 3.2 Commercial & Professional Services 16.1 14.2 1.1 1.0 8.7 8.0 2.4 2.6 Consumer Durables & Apparel 20.3 15.0 1.1 1.0 10.6 8.6 1.2 1.6 Consumer Services 13.3 12.2 0.6 0.6 6.9 6.6 2.6 3.1 Diversified Financials 12.8 10.3 - - - - 3.8 4.2 Energy 9.8 8.7 0.7 0.6 4.7 4.2 3.2 4.4 Food & Staples Retailing 13.6 12.2 0.5 0.5 8.0 7.3 3.4 3.7 Food Beverage & Tobacco 14.0 12.8 1.5 1.4 8.3 7.8 3.8 4.1 Health Care Equipment & Services 15.4 14.1 2.1 2.0 8.6 8.0 1.7 1.8 Household & Personal Products 16.3 16.2 2.9 2.8 11.2 10.9 3.1 3.1 Insurance 8.6 8.1 - - - - 4.5 4.9 Materials 11.4 9.1 1.8 1.7 5.9 4.9 1.3 1.7 Media 12.3 11.3 1.1 1.1 2.6 2.3 2.8 3.1 Pharmaceuticals Biotech & Life Sc 10.0 9.9 2.4 2.4 7.0 6.5 4.5 4.7 Real Estate 23.7 21.3 - - - - 3.5 3.6 Retailing 11.6 10.6 0.4 0.4 5.9 5.5 3.2 3.7 Software & Services 15.7 14.3 1.4 1.3 9.9 9.2 1.8 1.9 Technology Hardware & Equipment 16.8 14.7 1.3 1.2 9.8 8.9 2.8 3.0 Telecommunication Services 10.3 9.9 1.5 1.4 6.8 6.8 5.3 5.7 Transportation 14.8 10.4 0.4 0.4 5.3 4.7 2.1 2.3 Utilities 12.5 11.8 1.0 1.0 8.3 7.8 5.3 5.6 UK (MSCI Coverage) 11.9 10.3 1.0 0.9 6.1 5.6 3.1 3.6 Source: FactSet, IBES, Morgan Stanley Research UK Industry Consensus Growth Forecasts EPS Growth (%) Sales Growth (%) EBITDA Growth (%) Dividend Growth (%) Updated as of 14-Oct-10 2010 2011 2010 2011 2010 2011 2010 2011 Automobiles & Components 226.2 27.7 17.9 5.9 63.8 15.6 - 27.8 Banks - 45.5 - - - - 14.0 11.4 Capital Goods 11.2 8.9 3.8 2.8 9.7 7.5 11.1 9.4 Commercial & Professional Services 5.3 13.7 9.0 7.3 8.0 9.3 16.7 11.6 Consumer Durables & Apparel 154.9 35.5 7.6 9.6 33.7 23.7 46.2 36.1 Consumer Services 3.4 8.6 2.6 2.4 6.3 5.6 16.8 15.5 Diversified Financials 23.9 24.4 - - - - -14.9 11.6 Energy 48.6 13.0 24.9 3.4 32.1 10.8 -34.5 37.1 Food & Staples Retailing 10.6 11.8 7.8 7.3 8.2 9.1 9.6 10.6 Food Beverage & Tobacco 10.3 9.8 6.2 5.2 7.3 6.7 10.9 8.2 Health Care Equipment & Services 8.8 8.9 5.7 3.8 8.5 8.1 14.9 7.2 Household & Personal Products 10.8 1.0 7.4 4.6 9.9 2.4 11.0 0.4 Insurance -17.2 6.9 - - - - 12.5 6.8 Materials 93.1 24.9 30.8 10.4 71.7 19.4 149.8 27.0 Media 9.0 9.6 1.9 2.0 186.5 8.9 6.9 8.2 Pharmaceuticals Biotech & Life Sc 1.9 1.4 1.9 -0.6 -5.9 6.6 6.2 5.3 Real Estate 9.1 11.4 - - - - -0.2 3.7 Retailing 8.0 9.9 2.6 3.1 7.1 6.2 12.6 15.6 Software & Services 8.6 9.4 2.8 3.6 4.5 7.6 1.4 6.8 Technology Hardware & Equipment 43.4 14.4 11.5 6.6 26.0 10.4 8.1 5.3 Telecommunication Services -2.5 3.9 -0.5 0.1 -17.5 0.7 5.4 6.8 Transportation 218.6 41.5 2.8 3.5 34.1 12.9 17.8 9.4 Utilities -3.8 6.0 -3.2 3.8 1.2 6.4 5.6 5.6 UK (MSCI Coverage) 53.1 16.1 12.1 4.2 22.5 9.8 0.1 14.3 Source: FactSet, IBES, Morgan Stanley Research 41
  • 42. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Diary of Key Upcoming Events Monday, 18 Oct to Wednesday, 22 Dec 2010 Date Earnings Release & Trading Statements Economic Data 18 Oct 2010 SABMiller 2Q Trading Statement - 2010/11 Senior Interims - 2010 19 Oct 2010 Whitbread Interims - 2010/11 20 Oct 2010 BHP Billiton plc 1Q Production Report - 2010/11 MPC Minutes - Oct Home Retail Group Interims - 2010/11 Stobart Group Interims - 2010/11 21 Oct 2010 Anglo American 3Q Interims - 2010 Retail Sales, volumes, sa - Sep Autonomy Corporation 3Q Results - 2010 Britvic Trading Statement - 2010 Debenhams Prelims - 2009/10 GlaxoSmithKline 3Q Results - 2010 Henderson Group Interims - 2010 Inchcape Interims - 2010 Manganese Bronze Holdings Interims - 2010 National Express Group Interims - 2010 Petropavlovsk Interims - 2010 Premier Foods Interims - 2010 Smiths News Prelims - 2009/10 22 Oct 2010 British Sky Broadcasting Group 1Q Results - 2010/11 26 Oct 2010 ARM Holdings 3Q Results - 2010 BP 3Q Results - 2010 27 Oct 2010 British American Tobacco 3Q Interims - 2010 Carpetright 1H Trading Statement - 2010/11 CSR 3Q Results - 2010 28 Oct 2010 AstraZeneca 3Q Results - 2010 Axis-Shield 3Q Interims - 2010 Kazakhmys 3Q Production Report - 2010 Pace Interims - 2010 Royal Dutch Shell 3Q Results - 2010 Rugby Estates Interims - 2010/11 William Hill 3Q Interims - 2010 29 Oct 2010 British Airways 2Q Results - 2010/11 GfK Consumer Confidence Survey - Oct F&C Asset Management Interims - 2010 Consumer Credit, sa - Sep Forth Ports Interims - 2010 Mortgage Approvals (for house purchase) - Sep Meggitt Interims - 2010 Shire Group 3Q Results - 2010 01 Nov 2010 G4S Interims - 2010 PMI Manufacturing - Oct Mondi Interims - 2010 Savills Interims - 2010 02 Nov 2010 BG Group 3Q Results - 2010 Cairn Energy Interims - 2010 Imperial Tobacco Group Prelims - 2009/10 Lloyds Banking Group Interims - 2010 St. James's Place 3Q Interims - 2010 03 Nov 2010 Admiral Group 3Q Interims - 2010 BRC Shop Price Index - Oct Antofagasta 3Q Production Report - 2010 PMI Services - Oct Cobham Interims - 2010 Logica plc 3Q Interims - 2010 Next 3Q Interims - 2010/11 Standard Life 3Q Results - 2010 04 Nov 2010 Aviva 3Q Interims - 2010 MPC Decision - Nov Charter International Interims - 2010 Invensys Interims - 2010/11 42
  • 43. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Date Earnings Release & Trading Statements Economic Data Millennium & Copthorne Hotels 3Q Results - 2010 Morrison (Wm) Supermarkets Interims - 2010/11 Old Mutual 3Q Interims - 2010 Rathbone Brothers 3Q Interims - 2010 RSA Insurance Group 3Q Interims - 2010 Synergy Health Interims - 2010/11 Tate & Lyle Interims - 2010/11 Unilever 3Q Results - 2010 05 Nov 2010 British Airways Oct Traffic figures - 2010 Producer Prices - Oct Carphone Warehouse Group Interims - 2010/11 Charles Stanley Group Interims - 2010/11 Grainger Prelims - 2009/10 HSBC Hldgs Interims - 2010 Rentokil Initial 3Q Trading Statement - 2010 Royal Bank Of Scotland Group 3Q Interims - 2010 Smith & Nephew 3Q Results - 2010 06 Nov 2010 Caledonia Investments 3Q Trading Statement - 2010 08 Nov 2010 Dignity Interims - 2010 Hiscox 3Q Interims - 2010 Inmarsat 3Q Results - 2010 Schroders 3Q Interims - 2010 Tomkins Interims - 2010 09 Nov 2010 Associated British Foods Prelims - 2009/10 BRC Retail Sales Monitor - Oct Babcock International Group Interims - 2010 Industrial Production - Sep Barclays 3Q Interims - 2010 Manufacturing Production, sa - Sep Drax Group Interims - 2010 InterContinental Hotels Group 3Q Results - 2010 Legal & General Group 3Q Interims - 2010 Management Consulting Group Interims - 2010 Marks & Spencer Group Interims - 2010/11 Northern Foods Interims - 2010/11 Randgold Resources 3Q Results - 2010 UMECO Interims - 2010/11 Vodafone Group Interims - 2010/11 Yell Group Interims - 2010/11 10 Nov 2010 Ark Therapeutics Group Interims - 2010 Inflation Report - Nov Great Portland Estates Interims - 2010/11 Micro Focus Trading Statement - 2010/11 Novae Group 3Q Interims - 2010 Prudential 3Q Interims - 2010 Sainsbury (J) Interims - 2010/11 Scottish & Southern Energy Interims - 2010/11 11 Nov 2010 Dairy Crest Group Interims - 2010/11 Eurasian Natural Resources Interims - 2010 Euromoney Institutional Investors Prelims - 2009/10 Galiform Interims - 2010 Hikma Pharmaceuticals Interims - 2010 IMI Interims - 2010 International Power Interims - 2010 Resolution Limited Interims - 2010 Trinity Mirror Interims - 2010 Yule Catto & Co Interims - 2010 12 Nov 2010 BT Group 2Q Results - 2010/11 Electrocomponents Interims - 2010 Rolls-Royce 3Q Interims - 2010 Spectris Interims - 2010 Tullett Prebon 3Q Interims - 2010 15 Nov 2010 Amlin Interims - 2010 Beazley Group 3Q Interims - 2010 BTG Interims - 2010/11 Crew Gold 3Q Results - 2010 43
  • 44. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Date Earnings Release & Trading Statements Economic Data Diploma Prelims - 2009/10 e2v technologies Interims - 2009/10 Interserve Interims - 2010 Lonmin Prelims - 2009/10 Workspace Group Interims - 2010/11 16 Nov 2010 Burberry Group Interims - 2010/11 Inflation - Oct Corin Group Interims - 2010 easyJet Prelims - 2009/10 Enterprise Inns Prelims - 2009/10 Menzies (John) Interims - 2010 Oxford Instruments Interims - 2010/11 Persimmon Interims - 2010 Premier Oil Interims - 2010 Rexam Interims - 2010 Robert Wiseman Dairies Interims - 2010/11 Wellstream Holdings 3Q Interims - 2010 17 Nov 2010 Big Yellow Group Interims - 2010/11 Labour Market Statistics - Oct Centrica Interims - 2010 MPC Minutes - Nov Dimension Data Holdings Prelims - 2009/10 Experian Interims - 2010 ICAP Interims - 2010 Mothercare Interims - 2010/11 Serco Group Interims - 2010 Speedy Hire Interims - 2010/11 18 Nov 2010 Avis Europe Interims - 2010 Retail Sales, volumes, sa - Oct Derwent London 3Q Interims - 2010 Halfords Group Interims - 2010/11 Investec Interims - 2010/11 Keller Group Interims - 2010 London Stock Exchange Group Interims - 2010/11 National Grid Interims - 2010/11 QinetiQ Interims - 2010/11 Reed Elsevier Interims - 2010 Ricardo Interims - 2010/11 SABMiller 1H Results - 2010/11 UK Mail Group Interims - 2010/11 19 Nov 2010 Chaucer Holdings Interims - 2010 Chime Communications Interims - 2010 Clarke(T.) Interims - 2010 FirstGroup Interims - 2010 Fuller, Smith & Turner Interims - 2010/11 Gleeson (M J) Group Interims - 2010/11 Johnston Press Interims - 2010 Land Securities Interims - 2010 PayPoint Interims - 2010 Scapa Group Interims - 2010/11 TalkTalk Telecom Group Interims - 2010 Torotrak Interims - 2010 WSP Group 3Q Interims - 2010 22 Nov 2010 MITIE Group Interims - 2010/11 23 Nov 2010 Caledonia Investments Interims - 2010/11 DJ Euro Stoxx50 - Quarterly Index Review Carclo Interims - 2010 Clinton Cards Interims - 2010/11 De La Rue Interims - 2010/11 Hamworthy Interims - 2010/11 Homeserve Interims - 2010/11 Intermediate Capital Group Interims - 2010/11 KCOM Group Interims - 2010/11 RM Prelims - 2009/10 Severn Trent Interims - 2010/11 Signet Jewelers 3Q Results - 2010/11 Telecom Plus Interims - 2010/11 44
  • 45. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Date Earnings Release & Trading Statements Economic Data 24 Nov 2010 Assura Interims - 2010/11 GDP (details) - 3Q BSS Group Interims - 2010/11 Compass Group Prelims - 2009/10 French Connection Interims - 2010/11 Future Prelims - 2009/10 Hampson Industries Interims - 2010/11 Johnson Matthey Interims - 2010/11 United Utilities Group Interims - 2010/11 25 Nov 2010 Antofagasta 3Q Results - 2010 Avon Rubber Prelims - 2009/10 Daily Mail & General Trust (A Shs) Prelims - 2009/10 DSG International Interims - 2010/11 Helical Bar Interims - 2010/11 Sepura Interims - 2010/11 Young and Co's Brewery Interims - 2010/11 26 Nov 2010 Paragon Group of Companies Prelims - 2009/10 GfK Consumer Confidence Survey - Nov Quintain Estates and Development Interims - 2010/11 Vectura Group Interims - 2010 29 Nov 2010 Optos Prelims - 2009/10 Consumer Credit, sa - Oct Mortgage Approvals (for house purchase) - Oct 30 Nov 2010 Aberdeen Asset Management Prelims - 2009/10 Creston Interims - 2010/11 Halma Interims - 2010/11 Mitchells & Butlers Prelims - 2009/10 Northumbrian Water Group Interims - 2010/11 Topps Tiles Prelims - 2009/10 01 Dec 2010 Sage Group Prelims - 2009/10 02 Dec 2010 Britvic Prelims - 2009/10 Kingfisher 3Q Trading Statement - 2010/11 Marston's Prelims - 2009/10 03 Dec 2010 Berkeley Group Interims - 2010/11 British Airways Nov Traffic figures - 2010 Findel Interims - 2010/11 SThree Trading Statement - 2009/10 07 Dec 2010 Caledonia Investments Interims - 2010/11 BRC Retail Sales Monitor - Nov Southern Cross Healthcare Prelims - 2009/10 Industrial Production - Oct Wolseley Interims - 2010/11 Manufacturing Production, sa - Oct 08 Dec 2010 Micro Focus Interims - 2010/11 BRC Shop Price Index - Nov 09 Dec 2010 Ashtead Group 2Q Results - 2010/11 MPC Decision - Dec Premier Farnell 3Q Results - 2010/11 PZ Cussons Trading Statement - 2010/11 Smith (DS) Interims - 2010/11 10 Dec 2010 Consort Medical Interims - 2010/11 Producer Prices - Nov 13 Dec 2010 Spice Interims - 2010/11 14 Dec 2010 Carpetright Interims - 2010/11 Inflation - Nov Domino Printing Sciences Prelims - 2009/10 Drax Group Trading Statement - 2010 Scott Wilson Group Interims - 2010/11 15 Dec 2010 Kesa Electricals Interims - 2010/11 Labour Market Statistics - Nov Senior Trading Statement - 2010 16 Dec 2010 Chrysalis Prelims - 2009/10 Retail Sales, volumes, sa - Nov Sports Direct Interims - 2010/11 Wood Group (John) Trading Statement - 2010 45
  • 46. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Date Earnings Release & Trading Statements Economic Data 17 Dec 2010 DTZ Interims - 2010 TUI Travel Prelims - 2009/10 22 Dec 2010 MPC Minutes - Dec **(T) Provisional dates TBC Note: Morgan Stanley cannot guarantee the accuracy of these dates, which may be subject to change. Source: Columba Systems, Morgan Stanley Research Abbreviations NM Not meaningful NSA Not seasonally adjusted NA Not applicable YTD Year to date N/AV Not available YOY Year on year FCF Free cash flow A Actual FFO Funds from operations E Morgan Stanley Research Estimates SA Seasonally adjusted unless otherwise indicated 46
  • 47. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Company and Directors’ Share Buybacks Companies that have bought back stock in the last two Companies whose directors have bought back stock in weeks the last two weeks Name Number of Shares Amount (£mn) Name Number of Shares Amount (£) Experian 995,000 6.77 British American Tobacco 21,200 510,617 CSR 50,000 0.18 Catlin Group 15,000 49,350 AstraZeneca 1,376,883 44.93 Close Brothers Group 13,300 98,420 Vodafone 82,500,000 132.90 CLS Holdings 12,763 64,791 Rightmove 50,000 0.37 Inchcape 500,000 1,647,500 Regus 1,000,000 0.81 ITE Group 7,355 12,859 Greggs 550,000 2.54 ROK 410,000 77,375 Smiths Group 3,000 36,570 Total (£mn) 188.5 Sportech 47,140 19,799 Note: We only include share buyback programmes for the FTSE350 index; we do not include Unilever Plc 1,000 18,465 employee share trust purchases. Total (£mn) 2.5 Note: We only include director purchases where the consideration exceeds £10,000 and the company is a constituent of the FTSE All-Share. We do not include the purchase of shares via options, employee share schemes or dividend reinvestments. These data have been sourced from the LSE and Director Deal. While every effort has been made to validate them, Morgan Stanley cannot guarantee their accuracy or comprehensiveness. Morgan Stanley & Co. Limited, an affiliate of Morgan Stanley, is acting as financial adviser to Rio Tinto plc and Rio Tinto Limited in relation to the production joint venture with BHP Billiton as announced on 5th June 2009. In accordance with its general policy, Morgan Stanley currently expresses no rating or price target on Rio Tinto or BHP Billiton. This report and the information herein are not intended to serve as an endorsement or otherwise of the proposed transaction. This report was prepared solely upon information generally available to the public. No representation is made that it is accurate and complete. This report is not a recommendation or an offer to buy or sell the securities mentioned. Please refer to the notes at the end of this report. 47
  • 48. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK THIS PAGE HAS BEEN LEFT BLANK INTENTIONALLY 48
  • 49. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK THIS PAGE HAS BEEN LEFT BLANK INTENTIONALLY 49
  • 50. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Morgan Stanley ModelWare is a proprietary analytic framework that helps clients uncover value, adjusting for distortions and ambiguities created by local accounting regulations. For example, ModelWare EPS adjusts for one-time events, capitalizes operating leases (where their use is significant), and converts inventory from LIFO costing to a FIFO basis. ModelWare also emphasizes the separation of operating performance of a company from its financing for a more complete view of how a company generates earnings. Disclosure Section Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research that it has prepared, and approves solely for the purposes of section 21 of the Financial Services and Markets Act 2000, research which has been prepared by any of its affiliates. As used in this disclosure section, Morgan Stanley includes RMB Morgan Stanley (Proprietary) Limited, Morgan Stanley & Co International plc and its affiliates. For important disclosures, stock price charts and equity rating histories regarding companies that are the subject of this report, please see the Morgan Stanley Research Disclosure Website at www.morganstanley.com/researchdisclosures, or contact your investment representative or Morgan Stanley Research at 1585 Broadway, (Attention: Research Management), New York, NY, 10036 USA. Analyst Certification As to each company mentioned in this report, the respective primary research analyst or analysts covering that company hereby certify that their views about the companies and their securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this report. Unless otherwise stated, the individuals listed on the cover page of this report are research analysts. Global Research Conflict Management Policy Morgan Stanley Research has been published in accordance with our conflict management policy, which is available at www.morganstanley.com/institutional/research/conflictpolicies. Important US Regulatory Disclosures on Subject Companies The following analyst or strategist (or a household member) owns securities (or related derivatives) in a company that he or she covers or recommends in Morgan Stanley Research: Carlos Egea - Telefonica (common or preferred stock), Vodafone Group (common or preferred stock). Morgan Stanley policy prohibits research analysts, strategists and research associates from investing in securities in their sub industry as defined by the Global Industry Classification Standard ("GICS," which was developed by and is the exclusive property of MSCI and S&P). Analysts may nevertheless own such securities to the extent acquired under a prior policy or in a merger, fund distribution or other involuntary acquisition. As of September 30, 2010, Morgan Stanley beneficially owned 1% or more of a class of common equity securities of the following companies covered in Morgan Stanley Research: ARM Holdings Plc, ASML Holding NV, CSR PLC, Imperial Tobacco, Infineon Technologies AG, Kabel Deutschland Holding AG, KPN, STMicroelectronics NV, Telefonica, Unite Group, Wolseley plc. Within the last 12 months, Morgan Stanley managed or co-managed a public offering (or 144A offering) of securities of Kabel Deutschland Holding AG, Vodafone Group. Within the last 12 months, Morgan Stanley has received compensation for investment banking services from Imperial Tobacco, KPN, Ryanair, STMicroelectronics NV, Telefonica, Unite Group, Vodafone Group. In the next 3 months, Morgan Stanley expects to receive or intends to seek compensation for investment banking services from ARM Holdings Plc, ASML Holding NV, CSR PLC, easyJet, Imperial Tobacco, Infineon Technologies AG, Kabel Deutschland Holding AG, KPN, Ryanair, SOCO International, STMicroelectronics NV, Telefonica, Unite Group, Virgin Media Inc, Vodafone Group, Wolseley plc, Wood Group. Within the last 12 months, Morgan Stanley has received compensation for products and services other than investment banking services from easyJet, Imperial Tobacco, Ryanair, Telefonica, Vodafone Group. Within the last 12 months, Morgan Stanley has provided or is providing investment banking services to, or has an investment banking client relationship with, the following company: ARM Holdings Plc, ASML Holding NV, CSR PLC, easyJet, Imperial Tobacco, Infineon Technologies AG, Kabel Deutschland Holding AG, KPN, Ryanair, SOCO International, STMicroelectronics NV, Telefonica, Unite Group, Virgin Media Inc, Vodafone Group, Wolseley plc, Wood Group. Within the last 12 months, Morgan Stanley has either provided or is providing non-investment banking, securities-related services to and/or in the past has entered into an agreement to provide services or has a client relationship with the following company: ARM Holdings Plc, easyJet, Imperial Tobacco, Infineon Technologies AG, Ryanair, STMicroelectronics NV, Telefonica, Unite Group, Virgin Media Inc, Vodafone Group. Morgan Stanley & Co. Incorporated makes a market in the securities of ARM Holdings Plc, ASML Holding NV, STMicroelectronics NV, Virgin Media Inc. Morgan Stanley & Co. International plc is a corporate broker to Imperial Tobacco, Ryanair. The equity research analysts or strategists principally responsible for the preparation of Morgan Stanley Research have received compensation based upon various factors, including quality of research, investor client feedback, stock picking, competitive factors, firm revenues and overall investment banking revenues. Morgan Stanley and its affiliates do business that relates to companies/instruments covered in Morgan Stanley Research, including market making, providing liquidity and specialized trading, risk arbitrage and other proprietary trading, fund management, commercial banking, extension of credit, investment services and investment banking. Morgan Stanley sells to and buys from customers the securities/instruments of companies covered in Morgan Stanley Research on a principal basis. Morgan Stanley may have a position in the debt of the Company or instruments discussed in this report. Certain disclosures listed above are also for compliance with applicable regulations in non-US jurisdictions. 50
  • 51. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK STOCK RATINGS Morgan Stanley uses a relative rating system using terms such as Overweight, Equal-weight, Not-Rated or Underweight (see definitions below). Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold and sell. Investors should carefully read the definitions of all ratings used in Morgan Stanley Research. In addition, since Morgan Stanley Research contains more complete information concerning the analyst's views, investors should carefully read Morgan Stanley Research, in its entirety, and not infer the contents from the rating alone. In any case, ratings (or research) should not be used or relied upon as investment advice. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Global Stock Ratings Distribution (as of September 30, 2010) For disclosure purposes only (in accordance with NASD and NYSE requirements), we include the category headings of Buy, Hold, and Sell alongside our ratings of Overweight, Equal-weight, Not-Rated and Underweight. Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold, and sell but represent recommended relative weightings (see definitions below). To satisfy regulatory requirements, we correspond Overweight, our most positive stock rating, with a buy recommendation; we correspond Equal-weight and Not-Rated to hold and Underweight to sell recommendations, respectively. Coverage Universe Investment Banking Clients (IBC) % of % of % of Rating Stock Rating Category Count Total Count Total IBC Category Overweight/Buy 1115 42% 394 43% 35% Equal- weight/Hold 1146 43% 413 45% 36% Not-Rated/Hold 14 1% 4 0% 29% Underweight/Sell 381 14% 99 11% 26% Total 2,656 910 Data include common stock and ADRs currently assigned ratings. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan Stanley or an affiliate received investment banking compensation in the last 12 months. Analyst Stock Ratings Overweight (O). The stock's total return is expected to exceed the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Equal-weight (E). The stock's total return is expected to be in line with the average total return of the analyst's industry (or industry team's) coverage universe, on a risk- adjusted basis, over the next 12-18 months. Not-Rated (NR). Currently the analyst does not have adequate conviction about the stock's total return relative to the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months. Underweight (U). The stock's total return is expected to be below the average total return of the analyst's industry (or industry team's) coverage universe, on a risk- adjusted basis, over the next 12-18 months. Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months. Analyst Industry Views Attractive (A): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant broad market benchmark, as indicated below. In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark, as indicated below. Cautious (C): The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant broad market benchmark, as indicated below. Benchmarks for each region are as follows: North America - S&P 500; Latin America - relevant MSCI country index or MSCI Latin America Index; Europe - MSCI Europe; Japan - TOPIX; Asia - relevant MSCI country index. Important Disclosures for Morgan Stanley Smith Barney LLC Customers Citi Investment Research & Analysis (CIRA) research reports may be available about the companies or topics that are the subject of Morgan Stanley Research. Ask your Financial Advisor or use Research Center to view any available CIRA research reports in addition to Morgan Stanley research reports. Important disclosures regarding the relationship between the companies that are the subject of Morgan Stanley Research and Morgan Stanley Smith Barney LLC, Morgan Stanley and Citigroup Global Markets Inc. or any of their affiliates, are available on the Morgan Stanley Smith Barney disclosure website at www.morganstanleysmithbarney.com/researchdisclosures. For Morgan Stanley and Citigroup Global Markets, Inc. specific disclosures, you may refer to www.morganstanley.com/researchdisclosures and https://www.citigroupgeo.com/geopublic/Disclosures/index_a.html. Each Morgan Stanley Equity Research report is reviewed and approved on behalf of Morgan Stanley Smith Barney LLC. This review and approval is conducted by the same person who reviews the Equity Research report on behalf of Morgan Stanley. This could create a conflict of interest. 51
  • 52. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Other Important Disclosures Morgan Stanley & Co. International PLC and its affiliates have a significant financial interest in the debt securities of Imperial Tobacco, KPN, STMicroelectronics NV, Telefonica, Virgin Media Inc, Vodafone Group, Wolseley plc. Morgan Stanley produces an equity research product called a "Tactical Idea." Views contained in a "Tactical Idea" on a particular stock may be contrary to the recommendations or views expressed in research on the same stock. This may be the result of differing time horizons, methodologies, market events, or other factors. For all research available on a particular stock, please contact your sales representative or go to Client Link at www.morganstanley.com. For a discussion, if applicable, of the valuation methods and the risks related to any price targets, please refer to the latest relevant published research on these stocks. Morgan Stanley Research does not provide individually tailored investment advice. Morgan Stanley Research has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial adviser. The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. The securities, instruments, or strategies discussed in Morgan Stanley Research may not be suitable for all investors, and certain investors may not be eligible to purchase or participate in some or all of them. Morgan Stanley Research is not an offer to buy or sell or the solicitation of an offer to buy or sell any security/instrument or to participate in any particular trading strategy. The "Important US Regulatory Disclosures on Subject Companies" section in Morgan Stanley Research lists all companies mentioned where Morgan Stanley owns 1% or more of a class of common equity securities of the companies. For all other companies mentioned in Morgan Stanley Research, Morgan Stanley may have an investment of less than 1% in securities/instruments or derivatives of securities/instruments of companies and may trade them in ways different from those discussed in Morgan Stanley Research. Employees of Morgan Stanley not involved in the preparation of Morgan Stanley Research may have investments in securities/instruments or derivatives of securities/instruments of companies mentioned and may trade them in ways different from those discussed in Morgan Stanley Research. Derivatives may be issued by Morgan Stanley or associated persons With the exception of information regarding Morgan Stanley, Morgan Stanley Research is based on public information. 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  • 53. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at Professional Clients only, as defined by the DFSA. The financial products or financial services to which this research relates will only be made available to a customer who we are satisfied meets the regulatory criteria to be a Professional Client. The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA. As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations. The trademarks and service marks contained in Morgan Stanley Research are the property of their respective owners. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. The Global Industry Classification Standard ("GICS") was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley Research, or any portion thereof may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley Research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request. L19308 53
  • 54. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Stock Coverage List FTSE100 Companies Company Analyst Company Analyst 3i Bruce Hamilton (+7597) Kazakhmys Ephrem Ravi (+2127) Admiral Group Plc Adrienne Lim (+6679) Kingfisher Fred Bjelland (+3612) African Barrick Gold Plc Hannah Kirby (+6014) Land Securities Bart Gysens (+5862) Aggreko Plc Jessica Alsford (+8985) Legal and General Jon Hocking (+2307) AMEC Martijn Rats (+6618) Lloyds Banking Group Steven Hayne (+8332) Anglo American Plc Ephrem Ravi (+2127) Lonmin Plc Ephrem Ravi (+2127) Antofagasta Ephrem Ravi (+2127) Man Group Bruce Hamilton (+7597) ARM Holdings Plc Francois Meunier (+6603) Marks & Spencer Geoff Ruddell (+8954) Associated British Foods Erik Sjogren (+3935) National Grid plc Bobby Chada (+5238) AstraZeneca Andrew Baum (+6647) Next Charlie Muir-Sands (+5207) Autonomy Ashish Sinha (+2363) Old Mutual Jon Hocking (+2307) Aviva Jon Hocking (+2307) Pearson Patrick Wellington (+8605) BAE SYSTEMS Rupinder Vig (+2687) Petrofac Martijn Rats (+6618) Barclays Bank Chris Manners (+3917) Prudential plc Jon Hocking (+2307) BG Group Theepan Jothilingam (+9761) Reckitt Benckiser Mark A.Christensen (+5392) BHP Billiton Plc Ephrem Ravi (+2127) Reed Elsevier PLC Patrick Wellington (+8605) BP plc Theepan Jothilingam (+9761) Resolution Ltd Jon Hocking (+2307) British American Tobacco Plc Toby McCullagh (+6636) Rio Tinto Plc Ephrem Ravi (+2127) British Land Bart Gysens (+5862) Rolls-Royce Rupinder Vig (+2687) BSkyB Patrick Wellington (+8605) Royal Bank of Scotland Chris Manners (+3917) BT Group plc Nick Delfas (+6611) Royal Dutch Shell Theepan Jothilingam (+9761) Bunzl plc Jessica Alsford (+8985) RSA Adrienne Lim (+6679) Burberry Louise Singlehurst (+7239) SABMiller Plc Michael Steib (+5263) Cairn Energy Theepan Jothilingam (+9761) Sage Ashish Sinha (+2363) Capita Group Jessica Alsford (+8985) Sainsbury Geoff Ruddell (+8954) Capital Shopping Centres Bart Gysens (+5862) Schroders Bruce Hamilton (+7597) Carnival Plc Jamie Rollo (+3281) Scottish & Southern Bobby Chada (+5238) Centrica Bobby Chada (+5238) Serco Group plc David Hancock (+3752) Cobham Rupinder Vig (+2687) Severn Trent Bobby Chada (+5238) Compass Group Jamie Rollo (+3281) Shire PLC Karl Bradshaw (+6573) Diageo Michael Steib (+5263) Smith & Nephew Michael Jungling (+5975) Eurasian Natural Resources Cor Ephrem Ravi (+2127) Smiths Group Vidya Adala (+2044) Experian Jessica Alsford (+8985) Standard Chartered Bank Steven Hayne (+8332) G4S David Hancock (+3752) Standard Life Jon Hocking (+2307) GlaxoSmithKline Andrew Baum (+6647) Tesco Geoff Ruddell (+8954) Hammerson Christopher Fremantle (+5761) TUI Travel Jamie Rollo (+3281) HSBC Steven Hayne (+8332) Tullow Oil Theepan Jothilingam (+9761) ICAP Bruce Hamilton (+7597) Unilever PLC Michael Steib (+5263) Imperial Tobacco Toby McCullagh (+6636) United Utilities Nicholas Ashworth (+7770) Inmarsat Terence Tsui (+3095) Vedanta Ephrem Ravi (+2127) InterContinental Hotels Group Jamie Rollo (+3281) Vodafone Group Nick Delfas (+6611) International Power Bobby Chada (+5238) Whitbread Jamie Rollo (+3281) Intertek Group plc Jessica Alsford (+8985) Wm Morrison Geoff Ruddell (+8954) Invensys Ben Uglow (+8750) Wolseley plc Jessica Alsford (+8985) Investec Plc Magdalena Stoklosa (+3933) WPP Group Plc Edward Hill-Wood (+9224) Johnson Matthey Paul R.Walsh (+4182) Xstrata PLC Ephrem Ravi (+2127) To contact the analysts, dial (020) 7425 followed by the four digits that follow their names, or email using the convention firstname.lastname@morganstanley.com Note: Morgan Stanley is a corporate broker to the companies highlighted in bold. 54
  • 55. MORGAN STANLEY RESEARCH October 14, 2010 Investment Perspectives — UK Stock Coverage List Mid-250/Other Companies Company Analyst Company Analyst Aberdeen Asset Management Bruce Hamilton (+7597) ITV Patrick Wellington (+8605) Aegis Plc Edward Hill-Wood (+9224) JD Wetherspoon Vaughan Lewis (+3489) Afren Theepan Jothilingam (+9761) Kesa Electricals Fred Bjelland (+3612) Amlin PLC Adrienne Lim (+6679) Ladbrokes Vaughan Lewis (+3489) Aquarius Platinum Limited Ephrem Ravi (+2127) Lancashire Holdings Limited Adrienne Lim (+6679) Aveva Group Plc Adam Wood (+4450) Logica Patrick Standaert (+9290) Barratt Developments PLC Michael D.Watts (+7515) London Stock Exchange Bruce Hamilton (+7597) Berkeley Group Holdings PLC Michael D.Watts (+7515) Michael Page David Hancock (+3752) Big Yellow Group PLC Bianca Riemer (+2646) Millennium & Copthorne Vaughan Lewis (+3489) Brit Insurance Holdings NV Adrienne Lim (+6679) Misys Adam Wood (+4450) Britvic PLC Eveline Varin (+5717) Mitchells & Butlers Jamie Rollo (+3281) Cable & Wireless Communication Terence Tsui (+3095) National Express Jaime Rowbotham (+5409) Cable & Wireless Worldwide PLC Nick Delfas (+6611) Northumbrian Water Group Bobby Chada (+5238) Capital & Counties Bart Gysens (+5862) Ocado Group plc Geoff Ruddell (+8954) Carillion David Hancock (+3752) PartyGaming Plc Vaughan Lewis (+3489) Catlin Group Ltd Adrienne Lim (+6679) Pennon Group Nicholas Ashworth (+7770) Colt Group S.A. Nick Delfas (+6611) Persimmon plc Michael D.Watts (+7515) Croda Paul R.Walsh (+4182) Phoenix Group Jon Hocking (+2307) CSR PLC Francois Meunier (+6603) Premier Foods Erik Sjogren (+3935) Debenhams Charlie Muir-Sands (+5207) Premier Oil Theepan Jothilingam (+9761) Derwent London Christopher Fremantle (+5761) Punch Taverns Jamie Rollo (+3281) Dixons Retail Geoff Ruddell (+8954) Rentokil Initial Plc David Hancock (+3752) DMGT Edward Hill-Wood (+9224) Salamander Energy PLC Theepan Jothilingam (+9761) Drax Nicholas Ashworth (+7770) SEGRO Bart Gysens (+5862) easyJet Penelope Butcher (+6698) SOCO International Theepan Jothilingam (+9761) Enterprise Inns Jamie Rollo (+3281) Stagecoach Jaime Rowbotham (+5409) Ferrexpo plc Ephrem Ravi (+2127) Synergy Health PLC Andrew Olanow (+4107) FirstGroup Jaime Rowbotham (+5409) TalkTalk Telecom Group PLC Terence Tsui (+3095) Gartmore Group Limited Hubert Lam (+3734) Taylor Wimpey Michael D.Watts (+7515) Genus PLC Peter Verdult (+2244) Thomas Cook Group Jamie Rollo (+3281) Go-Ahead Jaime Rowbotham (+5409) Travis Perkins Jessica Alsford (+8985) Great Portland Estates Christopher Fremantle (+5761) Tullett Prebon Chris Manners (+3917) Halfords Charlie Muir-Sands (+5207) Unite Group Bianca Riemer (+2646) Hargreaves Lansdown Jon Hocking (+2307) United Business Media Patrick Wellington (+8605) Hays David Hancock (+3752) Victrex Paul R.Walsh (+4182) Henderson Group Hubert Lam (+3734) W H Smith Charlie Muir-Sands (+5207) Hikma Pharmaceuticals Plc Peter Verdult (+2244) Wellstream Holdings PLC Robert Pulleyn (+4388) Hiscox Ltd Adrienne Lim (+6679) Vaughan Lewis (+3489) Home Retail Group Geoff Ruddell (+8954) Wood Group Martijn Rats (+6618) Imagination Technologies Group Francois Meunier (+6603) Yell Edward Hill-Wood (+9224) Informa Patrick Wellington (+8605) Yule Catto Paul R.Walsh (+4182) To contact the analysts, dial (020) 7425 followed by the four digits that follow their names, or email using the convention firstname.lastname@morganstanley.com. Note: Morgan Stanley is a corporate broker to the companies highlighted in bold. 55
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