Portugal – What’s Next? September 25th, 2012 .For important disclosures, refer to the Disclosure Section, located at the end of this report.
Executive Summary • Program on track – Portugal has been “the good student” following the Troika’s recommendations. The current account deficit is narrowing rapidly. The 5th quarterly review has just finished;Economics • Weak economic outlook – A fiscal‐policy‐induced belt‐tightening points to cyclical economic weakness. A lower growth rate complicates fiscal consolidation. Domestic demand should continue weak; • The reform agenda is continuing – in the areas of job market, healthcare, housing, judiciary, regulation and competition. More needs to be done. Buy, any effect will only by visible in the long term; • Government indebtedness – The debt/GDP path is challenging. A period of growth would help restore solvency; • Market Access – Portugal is supposed to partially go back to the markets in Q3 2013. Given a weak economic backdrop, we like companies with strong foreign exposure. With interest rates at low levels, we think stocks with an attractive dividend policy should also be preferred:Equities • Sonae – A company with quality assets; • EDP Renováveis – Regulatory risk have been reduced. The next catalyst could be approaching; • Portucel – One of the leading Portuguese exporters. BEKP listed prices kept rising in 2Q 2012; • Galp ‐ Exposed to what has been the best exploration play in the world, in the last six years.
EconomicsA debt problem • Accounting for Government debt, Portugal is • Government debt has been increasing much one of the most indebted economies in the faster than GDP towards unsustainable levels; Eurozone; • The State‐owned companies, the co‐financing • A period of deleveraging is needed; agreements (Private Public Partnerships) and • A period of growth would help restore local governments remain important risks; solvency; • Portugal Government´s debt trajectory looks • Leverage among the private sector (higher than challenging. Spain´s) is one important vulnerability. Portugal: Government Budget Portugal: Government Debt 1990 1993 1996 1999 2002 2005 2008 2011 2014 0% 700 Gov. Debt and GDP evolution since 1990 Tota l Government Debt -2% 600 -1.9% GDP nomina l va lues -4% 500 -4.2% % GDP -6% 400 -8% 300 200 -10% 100 -12% years 1991 1994 1997 2000 2003 2006 2009 2012 2015 Source: Eurostat ; INE; Ernst & YoungSource: Eurostat; Ernst & Young
EconomicsNew measures have recently been announced• Over the years, the Government has been running budget deficits;• In 2011, the Government was able to comply with the terms of the MoU thanks to the transfer to the state of some banks‘ pension reserves, for 3.5% of GDP. Excluding this one off, the deficit would stood at 7.7% of GDP;• New measures have been announced in order to comply with IMF/EU quarterly review. Full details are yet to be known;• The Government budget’s target defined for 2012 is now 5% of GDP. Portugal: Government Budget 1990 1993 1996 1999 2002 2005 2008 2011 2014 0% -2% -1.9% -4% -4.2% % GDP -6% -8% -10% -12% years Source: Eurostat; Ernst & Young
EconomicsAn economy that used to run a trade balance deficit• External imbalance reflects an upward trend in • Imports have been reduced due to weak unit labor cost relative to the other Eurozone domestic demand; countries. The main problem is the non‐tradable • Spain’s economic slowdown and the European sector; recession have weaken Portugal’s exports• Wage moderation has begun and should growth rate; continue; • Nonetheless, exports to Angola and China have• A weaker euro would help… but will it happen? provided significant support. Portugal: Monthly Trade Balance Portugal: Exports vs Imports years 70% 2000 2002 2004 2006 2008 2010 2012 60% Exports 0 50% Imports 40% YoY growth rate -500 30%€ million -1000 20% 10% -1500 0% -2000 -10% -20% -2500 -30% -3000 -40% 2000 2002 2004 2006 2008 2010 2012 Source: INE Source: INE
EconomicsLabor market weakness is a problem• During the early 1990s, Portugal’s low wages allowed the country to be a platform for low cost manufacturing;• The unemployment rise reflects a decade of low growth for the Portuguese economy, poor competitiveness and a highly indebted private sector;• Unlike in the housing market hotspots in Europe, Portugal’s house prices have risen more modestly. Nonetheless, the fiscal‐policy‐induced belt‐tightening led to a decline in construction investment (civil engineering). Portugal: Unemployment Rate 18% 16% 14.9% 14% 14.0% % workforce 12% 10% 8% 6% 4% 2% 0% 2000 2002 2004 2006 2008 2010 2012 2014 2016 Source: INE; Ernst & Young years
EconomicsConfidence on the banking system has not been shaken • Since the end of last year, the pace of • Since the crisis began, Portugal escaped the deleveraging in Portugal seems to have decline in the deposit base which has affected accelerated markedly; the other peripheral countries: • Given the deepening recession, the Banks’ • A higher risk aversion led to a stronger credit portfolio should continue to demand for less risky assets; deteriorate; • Banks offered more attractive rates in order • A lower credit origination by the banking to meet their funding needs. sector dampens domestic demand. • The Government used €5bn out of the €12bn earmarked in the program to recapitalize private banks. Portugal: Loans Portugal: Deposits 150 170 12% Total Deposits 140 160 10% 130 150 YoY Growth Rate 8%€ Billion 120 € Billion (right scale) 110 140 6% 100 130 4% Loans Non Financial 90 Corporations 120 2% 80 Loans Households 70 110 0% 60 100 -2% 2002 2004 2006 2008 2010 2012 2002 2004 2006 2008 2010 2012 Source: European Central Bank Source: European Cental Bank
EconomicsThe 5th review mission to Portugal is concluded • Real GDP remains in line with projections. It should decline 3% in 2012 and 1% in 2013; Economy • Exports are performing better than expected; • Reduction in the external deficit allows to decrease the external financial needs of the economy. • Revenues are lagging; • The deficit targets were revised to 5% of GDP (2012), 4.5% of GDP (2013) and Gov. Budget 2.5% of GDP (2014), in order to ease the economic and social cost of the fiscal adjustment; • Additional consolidation efforts are required. • The recapitalization of the banking sector and its strengthening are well advanced; Banking Sector • The deleveraging of the banking sector will continue; • Access to credit at reasonable conditions is difficult for several sectors of the economy.
EconomicsNew measures to meet the 2012/13 budget targets. • Last Friday´s meeting of the Council of State called for some changes in the previous Government’s proposals; • The planned increase of the employees’ social contribution (from 11% to 18%) in combination with a reduction of employers’ contribution rate (from 23.75% to 18%) caused swide‐spread protests and forced the Portuguese Government to a U‐turn. • The new measures will be designed to overcome the unconstitutionality of previously planned cuts in the civil‐service Christmas and Summer payments; • Full details of the alternative measures are yet to be known; • The Government intends to share the overall burden of austerity more evenly between the public and private sectors. Some previous cuts in public sector pay will probably be restored. • What measures should we expect? • The level of income tax levied on all workers should increase; • Higher consumption taxes (alcohol and tobacco) are also possible; • Tax rates on capital and property earnings could also increase; • According to press reports, a financial transactions tax could be announced; • Some parts of the Social Security proposal could however be kept. The Government wants to boost the external competitiveness of Portuguese companies.
EconomicsWhat should we expect from the new measures ? • Disposable income should contract more than expected in 2013, as a result of higher income taxes. Domestic demand and private consumption should remain weak. The slight improvement in household confidence since the end of last year is now probably at risk; • Clearly negative for those companies that are more dependent on domestic consumption. • Increased capital gains taxes and a financial transactions tax could be negative news to Portuguese markets. • All measures are important to increase Portugal’s credibility and reduce the risk premium that investors demand when they invest in Portuguese assets. • At the moment of writing, we don´t know if some parts of the early Social Security proposal (mainly those related to employers) will be kept. This would lead to a reduction in the companies’ domestic staff costs. • The new measures have created some instability inside the centre‐right coalition that governs Portugal. Popular support for the parliamentary majority continues to erode since the elections of June 2011; • After the ill‐fated Social Security plan, more confidence have probably been lost.
EconomicsPortugal’s financing costs are falling• The Outright Monetary Transactions program, announced by the ECB, allowed Portuguese government bond yields to fall;• Lower CDS spreads for Portugal’s government debt. Investors should require a lower country risk premium to invest in Portuguese assets;• The current account deficit is shrinking. This reduces the risk of a further financing crisis. Portugal: Government Bond Yields Portugal: 5Y Credit Default Swaps 25% 1600 1400 20% Yield 10Y 1200Yield to Maturity Yield 2Y basis points 15% 1000 800 10% 600 5% 400 200 0% 2006 2008 2010 2012 0 2003 2006 2009 2012 Source: Bloomberg Source: Bloomberg
EconomicsWill Portugal be able to return to the markets?• Portugal is supposed to partially go back to the markets in Q3 2013 and regain full access to funding by mid‐2014;• Progress has been made in structural reforms. Privatizations so far have been successful;• Portugal seems to need more time. Nonetheless, the Government announced new austerity measures on top of what is already a severe fiscal consolidation. It is important that the pace of structural reform doesnt slow down. For that to happen, political and popular support could be decisive. Portugal: Redemptions Calendar of Tradable Debt (€ million) 171,615 78,527 19,124 16,143 4,626 11,408 10,189 7,035 7,004 8,276 9,283 2012 2013 2014 2015 2016 2017 2018 2019 2020 >2021 Total Source: Bloomberg
Top PicksSonae (last price: €0.536)Investment Case: Key Risks:• H1 2012 revenues decreased 3% yoy to • Tougher macro conditions (Portugal/Spain), €2,531m. Net profit was down 44% yoy to higher peripheral risk, higher competitive €20m. Net Debt decreased €50m to €2,182m; intensity;• Despite its exposure to the Portuguese • Overhang Risk: France Telecom intends to sell consumer, Sonae has had a resilient operating its 20% stake in Sonaecom. performance. An improvement in its cost Valuation: efficiency has been decisive; • We used Bloomberg consensus (average since• Sonae MC: effective promotional activity July) to arrive to a €0.66 price target; through Continente loyalty card. Increased • Main drivers: macro (unemployment, interest penetration of private labels; rates, saving rates, inflation), consumer• Sonae SR: Portugal ‐ Worten is the market confidence, company sales indicators (lfL leader in the electronic segment. Some sales) and availability of debt financing. restructuing is happening in the fashion Company Data business. Spain ‐ Sonae decided to halt its P/E 2013 DY 2013 EPS CAGR Net Debt/EBITDA expansion for 2012 in Spain. Some of its non‐ Est. Est. 2011/13 Est. 2012 Est. performing stores could be closed in 2013; 8.81 6.85 5.61% 3.68 Source: Bloomberg• Sonae has refinanced all debt maturities up to Major Shareholders (% of capital) the beginning of 2014; Azevedo´s Family (53.1%), BPI Bank (8.9%),• A Sonaecom‐Zon merger could be a positive Bestinver (7.5%), Foundation Berardo (2.5%), trigger for the stock. Recently, there’s been Norges Bank (2.0%) increased news flow regarding a possible deal. Source: Sonae’s Web Site
Top PicksPortucel (last price: €2.066)Investment Case: Key Risks:• Q2 2012 Sales growth was 10.4% qoq, taking • Increased tensions in the sovereign debt the H1 outturn to 0.4% yoy. H1 2012 EBIT market, a decrease in BEKP and UWF paper increased 12.7% yoy to €141.2m. H1 2012 Net prices and a worse economic outlook for earnings edged up 8.3% yoy to € 105.7m; Europe (69% of total sales in 2011);• After the turnaround in Dec. 2011, BEKP listed • The UWF paper industry´s demand/supply prices kept rising in Q2 2012. This should environment in Europe. pressure non‐integrated players. UWF paper Valuation prices have been holding quite well; • We used Bloomberg consensus (average since• Portucel is the largest UWF paper producer in July) to arrive to a € 2.368 price target; Europe, vertically integrated and with a • Main drivers: economic growth, BEKP and UWF diversified revenues stream (Portugal paper prices and USD to Euro exchange rate accounted for only 5% in 2011). It has one of Company Data the highest EBIT margin in the sector; P/E 2013 DY 2013 EPS CAGR Net Debt/EBITDA• Increased exposure to developing economies. Est. Est. 2011/13 Est. 2012 Est. In the developed world, demand is trapped in a 8.52 7.73 ‐1.97% 0.96 structural decline due to increasing usage of Source: Bloomberg devices such as smartphones and tablets;• Portucel has been cutting debt. Together with Major Shareholders (% of non‐suspended voting rights) Semapa´s cash requirements, this has triggered Semapa SGPS (80.84%) a generous dividend policy. Source: Portucel’s Web Site
Top Picks GALP (last price: €12.85)Investment Case: Key Risks:• H1 2012 turnover rose 14.7% yoy to €9,351m. • Lower oil prices or refining margins; EBITDA and EBIT increased 30.9% yoy and 52.6% • Disappointing exploration results; yoy respectively. Net profit reached €178m, a • Development problems in Brazil; 56.7% increase yoy; • Redenomination risk in Portugal;• In H1 2012, Brazil accounted for 52% of total • Overhang risk (ENI). production of crude oil and natural gas; Valuation• Brazil keeps growing. Petrobras and Galp (a 9.8% • We used Bloomberg consensus (average since share) have announced an update on their July) to arrive to a € 15.87 price target; Carcara well in the Santos Basin. The Portuguese • Main drivers: oil price, natural gas price, company expects to have a reserve estimate in refining margins, capital expenditures and USD the next couple of months; to Euro exchange rate.• Galp is exposed to what has been the best Company Data exploration play in the world, in the last six years;• Mozambique continues to have a positive P/E 2013 DY 2013 EPS CAGR Net Debt/EBITDA evolution. Galp is drilling a few more wells; Est. Est. 2011/13 Est. 2012 Est.• The conclusion of Galp´s refining project should 24.56 2.04 32.66% 1.01 start to have progressively an impact in Source: Bloomberg production; Major Shareholders (% of capital)• Overhang risk is still a concern. ENI should Amorim Energia (38.34%), ENI 28.34%), Parpública continue reducing its stake in the Portuguese (7%), Caixa Geral de Depósitos (1%) company. Source: Galp’s Web Site
Top PicksEDP Renováveis (last price: €3.68)Investment Case: • EDPR targets the addition of 2.3GW, putting• H1 2012 EBITDA +23% yoy to €504m. Output was YE15 capacity at 9.8GW. Capex is targeted at up 13% yoy. Average prices increased 10% yoy €3.2bn in 2012‐15. 5% CAGR in selling prices. (higher prices in Europe, Brazil and US). Net EBITDA of €1.35‐1.5bn. income was up 12% yoy to €100m; Key Risks:• Positive news flow on the regulatory front. In • Redenomination risk; Portugal, the wind industry reached an • higher peripheral risk. agreement involving an option they can choose Valuation to take or leave. In Spain, the government • We used Bloomberg consensus (average since announced a package of energy taxes that (i) July) to arrive to a €4.39 price target; involves a lower than expected hit to wind and • Main drivers: operational and financial (ii) could be passed‐through by wind farms. efficiencies, capital expenditures and selling These two events removed uncertainty from prices. EDPR’s equity story; Company Data• The first minority disposal to China Three Gorges P/E 2013 DY 2013 EPS CAGR Net Debt/EBITDA could be an important trigger. Management has Est. Est. 2011/13 Est. 2012 Est. said that none stakes will be sold below book 19.27 1.08 29.21% 4.79 value. This will be the first tranche out of the Source: Bloomberg total €2bn of investment in EDPR assets by 2015 Major Shareholders (% of capital) that was agreed. This should provide EDPR with EDP (77.5%) valuable funding; Source: Galp’s Web Site
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