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Lehman Stagflation Report Final

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Lehman Stagflation Report Final

  1. 1. Performance in Stagflation Lehman Brothers | Title PLEASE SEE ANALYST CERTIFICATION AND IMPORTANT DISCLOSURES, INCLUDING FOREIGN AFFILIATE DISCLOSURES, ON PAGES 157–158 Falling Growth and Rising Inflation in Asia The relentless demand for resources is creating a need for large-scale investment in agriculture, water, and alternative energy Investors confront the reality of rising inflation and slowing growth Regional Research Team May 2008 Lehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Customers of Lehman Brothers in the United States can receive independent, third-party research on the company or companies covered in this presentation, at no cost to them, where such research is available. Customers can access this independent research at www.lehmanlive.com or can call 1-800-2-LEHMAN to request a copy of this research. This research report has been prepared in whole or in part by research analysts who are not registered/qualified as research analysts with FINRA.
  2. 2. Lehman Brothers | Equity Research EXECUTIVE SUMMARY Describing Asian stagflation Our definition of stagflation in an Asian context can be described as significantly slowing growth and rising inflation. We have both of these in every single country in Asia, without exception. These stagflationary forces produce: (1) capital shortages, (2) rising costs, (3) diminishing aggregate demand, (4) margin squeeze and (5) rising taxes. In this environment, the characteristics of the likely winners, in our view, include (1) low debt, (2) pricing power, (3) captive buyers, (4) control of input prices, (5) makers of consumer staples and (6) “sin” stocks. Winners and losers The countries which are implementing significant price control and/or large subsidy program risk economic destabilization. These countries include India, China, the Philippines and Indonesia. Countries which allow market forces to determine prices – and therefore which allow supply and demand to recalibrate effectively and quickly – are the likely winners. These include Hong Kong, Singapore, Thailand and Taiwan. Countries which should also benefit are those which have large agricultural sectors. Malaysia wins on this score. Korea stands as an outlier in that it is highly dependent on hard and soft commodities, is heavily indebted, produces large-scale capital goods and is vulnerable to an economic slowdown in the West. Sector winners and losers Sectors which stand to benefit in a world of stagflation are iron ore, plantations, coal, telecom, properties and selected utilities. Other consumer sectors include tobacco, alcohol, gambling and health care. Sectors which are likely to be affected poorly by stagflation are lower margin, high-debt businesses, such as container shipping, shipbuilding, low margin technology businesses, autos, high-end and discretionary consumer goods, basic materials, price-controlled oil & gas, and selected construction materials. Currencies We also highlight countries with large current account surpluses and large budget surpluses which can withstand the economic pressures from falling growth and rising prices. These include CNY, MYR, SGD and TWD. Countries with troublesome current account deficits and budget deficits are threatened by excessive subsidies. These include Indonesia, India and the Philippines. Stagflation Portfolio The following portfolio shows stocks which we believe will be winners under a stagflationary environment. EV/ 3 Mth Ave P/E P/B Div Yield EBITDA Lehman Current Mkt Cap Liquidity ROE Net Debt/ Altman Company Ticker Rating Price US$mn (US$mn) FY08E Assets Z-Score FY08E FY08E FY08E FY08E Industry Sector Cheung Kong Infra 1038 HK Utilities 1-OW 31.8 9,248 9.0 13 -2% 5.3 55.6 13.9 1.8 3.8 Hong Kong Electric 6 HK Utilities 1-OW 45.2 12,724 27.5 15 2% 3.5 9.4 12.8 1.9 4.4 China Mobile 941 HK Telecom 1-OW 132.5 379,182 477.7 28 -27% 10.1 10.8 20.6 5.4 2.1 Sun Hung Kai 16 HK Property 1-OW 138.0 45,174 178.8 6 10% NA 27.0 26.3 1.7 1.8 CNOOC 883 HK Oil & Gas E&P 2-EW 13.9 94,145 237.9 28 -16% 10.1 9.7 14.3 3.7 2.6 Shenhua 1088 HK Energy 1-OW 35.0 14,379 153.4 20 3% 1.9 2.0 20.4 4.0 1.7 Rio Tinto RIO AU Mining 0-NR 145.3 64,535 197.2 40 44% 1.4 4.8 15.7 4.9 1.2 IOI IOI MK Palm Oil 0-NR 7.1 13,801 31.3 26 7% 7.5 14.7 21.6 5.0 2.4 EGCO EGCO TB Utilities 2-EW 95.5 1,547 1.8 18 8% 3.4 8.8 6.4 1.1 5.7 HK and Shanghai Hotels 45 HK Hotels 1-OW 13.5 2,544 1.8 5 5% 2.9 12.0 20.1 0.9 1.5 Ranbaxy RBXY IS Pharmaceuticals 1-OW 466.3 4,355 4.6 24 44% 3.2 18.0 24.7 5.7 2.0 KT&G 033780 KS Consumer 1-OW 82500.0 11,019 31.2 23 -3% 11.3 10.7 14.8 3.3 NA Melco 200 HK Equit Conglomerates 0-NR 11.6 1,891 7.5 4 11% 5.6 82.7 43.5 1.4 0.1 Average 50,350 104.6 27 6% 8.6 11.9 19.3 4.6 2.1 Source: BES, Worldscope, Lehman Brothers estimates Prices as of May 7, 2008 Paul Schulte and regional team Lehman Brothers Asia Limited May 2008 3
  3. 3. Lehman Brothers | Equity Research COUNTRY SUMMARY Country Lehman Brothers Comments In a stagflation scenario Top Gainers Top Losers Australia Australian institutional processes and flexible, yet aggressive, policy settings Telstra Bluescope Steel (David are likely to soften inflationary impacts, in our view. The demand side of the PrimeAg Fairfax Media Langford) stagflation equation may prove to be the toughest issue for Australian policy makers. As a result, we believe that more attractive investment exposures are likely to be provided by those companies which enjoy: (i) limited exposure to input cost inflation (e.g., materials and labor); and (ii) product sets with a high degree of substitutability for higher priced products in a cost- conscious environment. China China is trying to deal with rising inflation by appreciating the currency and COSL Guangzhou (Cheng Khoo) keeping rates high. We believe growth is likely to slow down somewhat in R&F China Shenhua 2008 and again in 2009. Inflation risks are to the upside. Minsheng Bank Hong Kong We expect Hong Kong’s internal consumption to slow, unemployment to rise, HK Electric Giordano (Ivan Lee) and input cost (in terms of energy, labor, rental, etc.) to rise quickly. This is Hutchison Shangri-la Hotel not positive, especially for the consumer, hotel, manufacturing, gaming, Whampoa financial, and export sectors, mainly due to Hong Kong’s fairly open economy, close linkage with China’s economy, and because its currency is pegged to the US dollar. However, housing prices will likely continue to benefit from a negative interest rate environment, in our view. Also, we expect regulated utilities, whose earnings are tied to capex instead of tariff and fuel cost, and conglomerates with diversified earnings streams to have earnings resilient performance. India We do not believe that India will be hit significantly by stagflation and we Ranbaxy Larsen and (Prabhat think growth will remain strong in relative terms. In our view, the negative Toubro Hindustan Lever Awasthi) impact will be felt by interest rate-sensitive stocks or by companies not in a Tata Motors position to pass on cost pressures to consumers. Korea In Korea, we expect defensive industries such as telco and tobacco to be the KT Hanjin Shipping (Zayong Koo) least affected while other consumer related and export related industries KT&G LG Display would be adversely affected. However, we believe Samsung Electronics although the industry in which it operates is likely to be hurt by stagflation, the company is nevertheless well positioned globally to actually benefit from the downturn. Taiwan We believe Taiwan’s export-oriented economy is likely to underperform TSMC AUO (Kent Chan) compared with its Asian peers owing to its high dependence on technology, Taiwan Cement Nanya Tech excessive competition, and its dependence on imported oil. The domestic economy (property, telecoms, and insurance) and asset reflation stocks would continue to rise, potentially like they did after the inflation shock in the 1970s, in our view. May 2008 4
  4. 4. Lehman Brothers | Equity Research SECTOR SUMMARY Sector Comments Top Gainers Top Losers Auto The auto sector could be a likely loser since auto demand is tied to Denway Hyundai Motor (Zayong Koo) economic conditions and the level of disposal income that consumers enjoy. In a slower growth environment and with higher inflation, non- essential high-cost items such as cars could face some pressure. Banks Banks are mirrors of the underlying economy. We believe none of the Nil Huaxia Bank (Lucy Feng) Chinese banks could survive well in a severe economic downturn. Furthermore, players with weak fundamentals, poor risk management, and less prudent lending procedures will suffer more. Conglomerates Because of their business diversification, the earnings of Hutchison Shanghai Industrial (Benjamin Lo) conglomerates have a higher degree of defensiveness than many Whampoa other single-industry-focused companies. All conglomerates are also cash-rich and some are industry leaders in their core businesses. We, therefore, maintain an overall positive stance on conglomerates under a stagflation scenario. Consumer China retail softlines and department stores/broadlines are more Parkson People’s Food (Phoebe Wong, resilient in the current high inflationary cycle, while F&B might not fare KT&G Lotte Shopping Hong Taik as well because of their high exposure to soft commodities and thin Chung) margins, in our view. In the Korean retail space, we favor discount stores to department stores. Among Korean consumer staple names, we expect top-tier players that can prove strong market leadership and experience steady consumer demand to generate stable earnings. Info Tech Most IT manufacturers are likely to employ a low pricing policy to spur Samsung Hon Hai (James Kim) demand and sustain fab utilization rates. However, we believe that a Electronics rapid rise in material costs and labor expenses will make it very difficult for IT companies to post meaningful profits. With the exception of a few segments, we believe there will be few winners among IT manufacturers when faced withising inflation and slowing growth. Media/Internet The media/Internet sector in Asia-Pacific will weather the stagflation Focus Media Fairfax Media (Paul Wuh) storm better than many other industrial sectors. We focus on media companies that: (1) have a subscription model that is unlikely to face lost revenues in an economic downturn and can raise prices if needed to counter inflation (such as, cable TV and satellite TV companies); (2) have relatively low operating costs and are able to easily scale their businesses to meet changing business environments (such as Internet gaming and e-commerce); (3) are relatively low cost to advertisers and are success-based (such as Internet portal/search companies). Metal and We believe inflation-driven upstream sectors (i.e., coal) should remain China Shenhua Chalco Mining (Oliver the winners given their strong pricing power, while downstream sectors Du) with relatively weak pricing power, such as aluminum and copper smelters, would be the losers. Oil & Gas We expect the physical oil demand to decline. In the near term, we Sinopec Honam (Cheng Khoo) expect the tight supply situation to continue, which could further boost oil prices. However, by the end of 2008 and especially in 2009, as new capacities come into the market, we believe oil prices are likely to decline. Property (Paul Housing and low-end retail, we believe, should prove the most resilient SHKP HK Land Louie, Min as they cover basic needs; office and high end-retail are likely to fare Chow Sai) the worst. At the country level, performance should be tied to existing supply levels. Hong Kong with the lowest expected housing supply for the next four years should prove the most defensive, in our view. Telecom In our opinion, the telecom services sector will do much better than Chunghwa Bharti (Paul Wuh) other industries in a period of stagflation. However, revenue growth for Telecom telecom operators in developing markets like China, India, and SE Asia will be affected more than those in developed markets. Transportation We believe the shipping sector would be a likely loser since demand is Nil Evergreen (Andrew Lee) driven by global economies and shipping lines bear higher costs because carriers struggle to pass on higher costs to customers. Further, given that shipping is a highly fragmented industry, carriers are mainly price takers. Utilities and In a stagflation environment, defensive and regulated utilities that are HK Electric KEPCO Renewable cash rich, have strong cash flow, and have fixed returns tied to a Energy (Ivan regulated asset base tend to outperform, in our view. Lee) May 2008 5
  5. 5. Lehman Brothers | Equity Research Table of Contents Executive Summary 3 Country Summary 4 Sector Summary 5 Regional Strategy 9 Effects on equities from rising inflation and slower growth.................................................9 Country Analysis 15 Australia’s Brief Stagflation 16 Tight policies limit local stagflation risk ............................................................................16 China Stagflation Scenario 20 Can the government tame rising inflation and rescue slowing growth? .....................................20 HK Stagflation Scenario 31 Effects of rising inflation and slower growth .....................................................................31 India and Stagflation 36 Tight policies limit local stagflation risk ............................................................................36 Korea Stagflation Scenario 39 Effects of rising inflation and slower growth .....................................................................39 Taiwan Stagflation Scenario 45 Can politics offset rising inflation and slower growth? ............................................................45 Sector Analysis 53 Auto and Auto Parts 54 Effects of rising inflation and falling growth .....................................................................54 Banks 57 China Banks .......................................................................................................................57 India Banks.........................................................................................................................59 Taiwan Banks .....................................................................................................................61 Cement 62 India Cement ......................................................................................................................62 Conglomerates 64 Effects of rising inflation and slower growth .....................................................................64 Consumer 67 India Consumer ..................................................................................................................67 China/Hong Kong Consumer .............................................................................................69 Korean Consumer...............................................................................................................71 May 2008 6
  6. 6. Lehman Brothers | Equity Research Electrical Equipment 73 India Electrical Equipment .................................................................................................73 IT Industry 75 Effects of rising inflation and slower growth .....................................................................75 Metal & Mining (China) 78 Effects of rising inflation and slower growth .....................................................................78 Materials (Taiwan) 80 Effects of rising inflation and slower growth .....................................................................80 Media/Internet 81 Effects of rising inflation and slower growth .....................................................................81 Oil and Gas 84 Effects of rising inflation and slower growth .....................................................................84 Oil Refining 87 Effects of rising inflation and slower growth .....................................................................87 Petrochemicals 89 Effects of rising inflation and slower growth .....................................................................89 Pharmaceuticals 91 India Pharmaceuticals.........................................................................................................91 Property 92 Reverting to basic needs for shelter....................................................................................92 India Real Estate.................................................................................................................98 Taiwan Property ...............................................................................................................100 Semiconductors – Foundry & SATS 101 Effects of rising inflation and slower growth ...................................................................101 Semiconductors – Memory 102 Effects of rising inflation and slower growth ...................................................................102 Technology – Hardware 104 Effects of rising inflation and slower growth ...................................................................104 Technology – Display 105 Effects of rising inflation and slower growth ...................................................................105 Technology – IC Design 107 Effects of rising inflation and slower growth ...................................................................107 Telecommunications Services 108 Effects of rising inflation and slower growth ...................................................................108 May 2008 7
  7. 7. Lehman Brothers | Equity Research Transportation – Shipping 112 Effects of rising inflation and slower growth ...................................................................112 Utilities/Power/Renewable Energy 117 Effects of rising inflation and slower growth ...................................................................117 Valuation Methodologies 123 Asia Research Roster 138 Coverage Universe 140 Companies under Coverage in Asia, by Country (as of May 14, 2008) ...........................140 Companies under Coverage in Asia, by Sector (as of May 14, 2008)..............................148 May 2008 8
  8. 8. Lehman Brothers | Equity Research REGIONAL STRATEGY Effects on equities from rising inflation and slower Paul Schulte growth LBAL, Hong Kong Tel: (852) 2252 -1409 paul.schulte@lehman.com INTRODUCTION: LOWER GROWTH AND HIGHER INFLATION Justin Lau The world is slowly moving away from a systemic meltdown and toward some LBAL, Hong Kong normalcy. Much of this has been accomplished through the intermediation of central Tel: +852 2252 1420 banks. The introduction of a facility on March 20 to lend directly to investment banks for justin.lau@lehman.com the first time in the history of the Federal Reserve helped greatly in calming markets. These moves by the Fed – and more recently by the Bank of England – have been made Chris Leung, CFA in conjunction with a sharp reduction in interest rates. There have been three LBAL, Hong Kong consequences of this activity. Tel: +852 2252 6183 1. Rising liquidity chris.w.leung@lehman.com There has been a sharp and sudden increase in risk appetite and a sharp rise in liquidity. As risky or worthless assets are taken out of the market by central bank intervention, Shubhankar Das those assets most at risk often go up the most. So, values of risky assets may go up in LBAL, Hong Kong price. Government bonds would go down in price as investors sell risk-free government Tel: +852 2252 1424 bonds and dive back into risky bonds. shubhankar.das@lehman.com 2. Lower growth The above scenario should be great for growth. It makes growth go down less. But the problem is that much of this liquidity being created is not finding its way back to asset creation. It is being bottled up on the balance sheet of banks which are themselves dealing with bad asset liquidation and capital constraints. They are being forced to shed assets from their balance sheet and write off losses against capital. They are being forced to find alternative sources of liabilities (deposits). This is because banks must bring down excessively high loan/deposit ratios at the same time that they are writing off bad assets. So, the asset base must shrink even while liquidity is replenishing the system. We present below the base case set forth by our economics team together with the worst case scenario provided by the strategy team. Figure 1: Slower growth/rising inflation – base case and worst case scenarios GDP (% y-o-y) CPI (%y-o-y) Base Case Worst Case Scenario Base Case Worst Case Scenario Lehman Economics Team Lehman Stategy Team Lehman Economics Team Lehman Stategy Team 2008 2009 2008 2009 2008 2009 2008 2009 US 1.2 0.6 -0.9 -0.4 na na na na Australia 2.5 2.0 1.1 0.9 3.1 2.2 3.1 3.2 China 9.8 8.0 6.1 5.9 5.5 2.8 6.7 6.9 Hong Kong 4.3 6.2 0.3 0.2 5.0 5.5 5.0 5.5 India 7.5 8.5 5.1 4.6 6.9 4.7 6.9 7.1 Indonesia 5.2 7.0 2.7 2.3 10.0 8.0 9.0 9.5 Malaysia 5.0 6.2 2.4 2.2 3.5 4.5 3.9 4.5 Philippines 5.0 7.0 2.6 2.4 7.8 5.5 8.5 8.9 Singapore 4.2 7.0 2.4 2.1 6.0 4.8 6.0 6.1 South Korea 4.1 5.2 2.1 2.0 4.5 3.5 4.1 4.3 Taiwan 3.9 5.7 2.9 2.6 3.8 3.5 3.8 3.9 Thailand 4.2 6.7 2.6 2.5 6.5 4.5 6.0 6.2 Asia ex-Japan 7.3 7.3 4.1 3.8 5.7 3.8 5.7 5.9 Source Lehman Brothers research May 2008 9
  9. 9. Lehman Brothers | Equity Research 3. Higher inflation All this liquidity is not creating more assets. It is supporting the shrinking of assets in an attempt to keep a balance sheet cleansing event from turning into a depression. The cost we are paying for this dynamic is excessive liquidity with low growth. Inflation’s classic definition is too much money chasing too few assets. This is as classic an inflationary phenomenon as it gets. So, liquidity, like lava bursting from a volcano, will roll down the mountain, seeking a path of least resistance to those areas where it is needed most: in the shortages. The greatest shortage of liquidity in the world is in agriculture. The food inflation problem has been brewing since 2004, but was rising right in the midst of the credit crisis. So, this liquidity is creating inflation in an area which had chronic shortages already. This food inflation has spread quickly and has created generally high inflation all over Asia. Oil is part of this as well. Oil shortages are receiving the liquidity as well. We think these price rises are a symptom of inflation, not the other way around. EFFECT ON EBIT: SHRINKING MARGINS? With rising costs in food and energy, the CPIs of many Asian countries are rising quickly. This is because the CPI has a very large proportion of food and energy in the baskets relative to the West. In many cases, it is 30-50%. So, price changes are accelerating quickly. In addition, many governments are responding to sharp increases in food, fertilizers, and oil with price caps and/or subsidies. We believe these policy responses are unhelpful and lead to more inflation. This is because price caps, for instance, lead consumers to consume more, given the perception that prices are unusually low. This also leads to a cutback in production given the perception that producers are not being given a fair price for the goods they sell. So, everyone loses. There are three effects on margins. In the meantime, high fertilizer costs spill into higher food prices. Higher oil spills into high coal prices. The chain reaction goes on. 1. Rising cost of labor As food and energy prices increase, the employees at corporates demand higher wages given that lifestyle costs are rising sharply. So, SG&A expenses rise. We are seeing this all across Asia, as wage growth begins to rise in earnest. Wage rises are a response to rising prices. In many parts of Asia, inflation is rising to multi-decade highs. Figure 2: Asia CPI % y-o-y Headline CPI 8 Core CPI 6 4 2 0 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Source: Lehman Brothers research May 2008 10
  10. 10. Lehman Brothers | Equity Research 2. Rising cost of goods The costs associated with production given rising energy costs are felt throughout the industrial food chain. Cost of energy also goes up dramatically. So, input costs rise. Growth, while falling, is still high in many parts of Asia. As a result, an increasing number of companies have expressed confidence for the first time in many years to pass through price increases to end users. Steel producers are passing prices through to buyers of steel. This is best seen in the rise of the Producer Price Index. Figure 3: Japan’s domestic corporate goods prices % y-o-y 5 4 3 2 1 0 -1 -2 -3 -4 Jan-90 Jan-94 Jan-98 Jan-02 Jan-06 Source: CEIC, Lehman Brothers research 3. Rising cost of money In the midst of a waning credit crisis, the sharp rise in liquidity is not reaching into the cost of money. The cost of money has actually risen. This is because banks are trying to recapitalize and at the same time shed bad assets. Concentrating on lending is the last thing on their minds. So, while the cost of money is now down to 2% in the US, for instance, the cost of a loan has barely budged. This also reaches into the world of working capital. Working capital is also more expensive although rates are now a lot lower. So, financing costs are higher and new money is harder to come by. There will, of course, be exceptions. For example, we think price makers (monopolies, plantations, oil producers) will make a windfall here. The middle man loses. Lower-end retail wins. Banks which are healthy win big. Unhealthy banks lose altitude and are in danger of crashing. Those banks which try to pick up cheap assets too early can get dragged down. EFFECT ON CASH FLOW: EFFECT ON CAPEX GIVEN FALLING CASH FLOWS AND CAPITAL SHORTAGE? In an environment of restrained lending, rising costs, and increasing wages, corporates may face three hurdles. 1. Working capital is working harder and may turn negative Inflation drives up the cost of doing business. Some corporates will be able to pass on these costs. Others will not. Those with less pricing power or those which sell low- margin goods or middlemen are most at risk for a cash squeeze. (Our stagflation portfolio favours companies that are most decidedly out of this area). Rising working capital tends to be associated with an aversion to corporate activity or high cash levels that have yet to be put to work. On the liabilities side, slowing payments (short-term liabilities rising faster than short-term assets) in a world of liquidity but with hesitant banks is not at all surprising to us. May 2008 11
  11. 11. Lehman Brothers | Equity Research 2. Rising cost of funds for capex One of our preferences in our portfolios has been for companies with cash flow sufficient to cover capex. In a world of hesitant banks, the cost of finishing a project will very likely rise. The assumptions for viability in projects included interest costs which were a lot lower a year ago. We estimate that interest costs are up, on average, from Libor +150 to Libor +300 to 500. This is a significant increase in interest expense and eats into cash flow. 3. Cutbacks in capex or cancellation of projects The dangerous part of a global slowdown is that companies which are in the middle of major expansion are in danger of not finishing a very expensive project. The anticipation of completion is the source of earnings. In the event of cessation of funding in a half- finished project, the problems are quite serious. With a great deal of money spent, the value of the asset is essentially still zero. Companies in this sort of condition are either forced to sell an impaired asset or are forced into bankruptcy proceedings. WHAT HAPPENED IN THE 1970S? In the early 1970s, the US was in the middle of an unwinnable and increasingly expensive war. It was funding large budget deficits. It was facing high commodity prices. The US – and other countries – imposed price controls to deal with inflation. If this sounds familiar, it is because it is familiar. Many investors agree that analogies to the 1970s are appropriate. As Mark Twain, however, said, “History does not repeat itself. It rhymes.” History will likely play itself out differently, but with many similarities. There are three similarities we see. 1. Inflation hit suddenly and hard Inflation reared its head in a small way from the early 1970s and then hit all of a sudden. When it did, it hit hard and took a long time to go away. Interest rates in 1980 were still 21%. Government bond yields peaked at 14%. Gold, oil, agricultural commodities, and general prices soared. These conditions are eerily similar. 2. Growth slowed While nominal growth was quite high given that inflation was in the high single digits, real growth slowed dramatically. Wages can grow with inflation, but pretty soon, they can no longer keep up. As a result, real wages fall and spending drops. Interest rates would soar and the cost of borrowing becomes prohibitive. Tax revenues from slowing economic activity would have to rise and deficits rise. Taxes would rise more. Real take- home income then falls. A vicious cycle is born. 3. Inflation expectations rose The hard part of price increases is that they are born of expectations. As people expect prices to rise, prices rise. We have been living in a world for many years where we have expected prices to go down. So, we delay expenditure and wait for prices to fall further. As inflation grabs hold, we come to expect prices to rise and we rush our purchases. We grab onto those types of investments which are seen as an inflation hedge. We eschew fiat money. We seek out commodities, land, precious metals, and rare jewels. A plethora of books have been written on this subject. Suffice to say that it takes much data (and much time) for people to change their expectations on higher prices once higher prices begin their gallop. May 2008 12
  12. 12. Lehman Brothers | Equity Research HOW CAN THE GOVERNMENT HELP EASE THE PAIN? Whether we like it or not, governments in the world are now deciding the price of assets as much as investors are. The decision of the Federal Reserve in March to lend to investment banks essentially put a ceiling on the price of debt for these banks. We think governments can do three things to help. 1. Price controls and subsidies We are facing a shortage of oil, a shortage of coal, and a shortage of food. Governments can help by accelerating the development of alternative energy. They can introduce conservation programs in terms of emissions regulation. They can place price caps on retail prices or they can introduce subsidy programs which compensate producers and make the consumer feel less pain at the cash register. While many insist that subsidies and price controls are destructive in the longer term, they quell social unrest and prevent riots. The problem is that they almost guarantee inflation as they incentivize consumers to consume more and cause producers to produce less. 2. Crash investment programs One of the results of high prices is the need for governments to pay for investment programs for products which are price inelastic. Goods with inelastic prices must be bought independent of price (basic necessities and staples). So, governments have a responsibility to rush the production of these goods to people and so need to step in and jump start programs such as oil exploration, cattle production, and farming. 3. Tax and regulatory relief Governments are famous for changing rules mid-stream. In an environment of rising costs, governments can act to reduce costs by turning a blind eye to restrictive immigration policy. In an environment of bad debt and economic stagnation, they may turn a blind eye to strict marking to market of that bad debt. They may allow banks to alter classification. In a coal shortage, some countries may reduce strict safety standards. In an oil shortage, countries may bend rules on oil drilling in wildlife preserves. Governments can reduce taxes on corporates which are large employers in a period of high unemployment. In other words, governments change valuations of companies and, indeed, cash-flows in the blink of an eye with market-friendly policies which can improve profitability. Conversely, governments which want to quell civil unrest may stick it to some corporates which make staples such as food and gasoline. Price controls can destroy shareholder value in the blink of an eye. We believe we are living in a world of unprecedented intervention by governments. This is an added risk for markets. Figure 4: Stagflation portfolio EV/ 3 Mth Ave P/E P/B Div Yield EBITDA Lehman Current Mkt Cap Liquidity ROE Net Debt/ Altman Company Ticker Rating Price US$mn (US$mn) FY08E Assets Z-Score FY08E FY08E FY08E FY08E Industry Sector Cheung Kong Infra 1038 HK Utilities 1-OW 31.8 9,248 9.0 13 -2% 5.3 55.6 13.9 1.8 3.8 Hong Kong Electric 6 HK Utilities 1-OW 45.2 12,724 27.5 15 2% 3.5 9.4 12.8 1.9 4.4 China Mobile 941 HK Telecom 1-OW 132.5 379,182 477.7 28 -27% 10.1 10.8 20.6 5.4 2.1 Sun Hung Kai 16 HK Property 1-OW 138.0 45,174 178.8 6 10% NA 27.0 26.3 1.7 1.8 CNOOC 883 HK Oil & Gas E&P 2-EW 13.9 94,145 237.9 28 -16% 10.1 9.7 14.3 3.7 2.6 Shenhua 1088 HK Energy 1-OW 35.0 14,379 153.4 20 3% 1.9 2.0 20.4 4.0 1.7 Rio Tinto RIO AU Mining 0-NR 145.3 64,535 197.2 40 44% 1.4 4.8 15.7 4.9 1.2 IOI IOI MK Palm Oil 0-NR 7.1 13,801 31.3 26 7% 7.5 14.7 21.6 5.0 2.4 EGCO EGCO TB Utilities 2-EW 95.5 1,547 1.8 18 8% 3.4 8.8 6.4 1.1 5.7 HK and Shanghai Hotels 45 HK Hotels 1-OW 13.5 2,544 1.8 5 5% 2.9 12.0 20.1 0.9 1.5 Ranbaxy RBXY IS Pharmaceuticals 1-OW 466.3 4,355 4.6 24 44% 3.2 18.0 24.7 5.7 2.0 KT&G 033780 KS Consumer 1-OW 82500.0 11,019 31.2 23 -3% 11.3 10.7 14.8 3.3 NA Melco 200 HK Equit Conglomerates 0-NR 11.6 1,891 7.5 4 11% 5.6 82.7 43.5 1.4 0.1 Average 50,350 104.6 27 6% 8.6 11.9 19.3 4.6 2.1 Note: Prices as of May 7, 2008 Source: IBES, Worldscope, Lehman Brothers estimates May 2008 13
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  14. 14. Lehman Brothers | Equity Research COUNTRY ANALYSIS May 2008 15
  15. 15. Lehman Brothers | Equity Research AUSTRALIA’S BRIEF STAGFLATION Tight policies limit local stagflation risk David Langford LBAUL, Sydney Tel:+612 8062 8440 HOW WOULD STAGFLATION IMPACT AUSTRALIA? david.langford@lehman.com Lehman Brothers Asia is exploring the risks to Asia Pacific markets in the scenario of falling global growth, resulting in slower Asian growth, but in the face of rising input Stephen Roberts costs. In our view, Australia could witness a brief period of stagflation, where inflation is LBAUL, Sydney high and relatively sticky and economic growth is weakening. However, we believe a Tel:+612 8062 8431 lengthy period of stagflation is unlikely because of the Reserve Bank of Australia’s stephen.roberts@lehman.com (RBA) commitment to deliver sufficiently tight monetary conditions to ensure that domestic spending growth and inflation fall. Australia Research Team Unlike many of its Asian neighbors and major trading partners, Australia benefits from a Tel:+612 8062 8000 de-regulated financial system. The characteristics of this system include a freely floating exchange rate and an independent central or reserve bank. The RBA is free to use its cash interest rate to tighten or loosen monetary conditions as it deems necessary. The RBA has a formal 2-3% inflation target that it has agreed (with the Federal Treasurer) to achieve over the course of the economic cycle. Thus, despite the relatively greater acceleration of inflation in most Asian economies when compared with Australia over the past 12 months, the RBA stands almost alone in lifting its cash rate aggressively and allowing its currency to appreciate freely to dampen rising inflation. We consider that Australia is different from Asia in the manner in which policy has responded to rising inflation. In our view, while a consequence of comparatively tighter Australian monetary conditions will be to deliver the “stag” part of stagflation, we expect the “flation” part to recede. The rise of stagflation among Australia’s major Asian trading partners represents a material risk for many Australian companies, in our view. Asia receives around 70% of Australian exports and almost all of Australia’s exports of coal and metal ores. Weakening Asian growth, as a consequence of trying to contain high inflation, could dampen raw material prices significantly, in our view. We believe that attempts to calibrate Australian policy settings at a time when Asian growth may turn in an unpredictable fashion, runs the risk of double trouble for Australian economic growth prospects. Domestic spending is weakening owing to tight monetary policies. We consider that this impact may be further reinforced by an erratic pull-back in Asian demand and commodity prices. May 2008 16
  16. 16. Lehman Brothers | Equity Research WINNERS AND LOSERS Figure 5: Winners and losers (Australia) Winners Ticker Price TP Rating Comments • Telstra’s large infrastructure/sunk cost base limits exposure Telstra TLS.AX A$4.52 A$5.40 1-OW to margin squeeze from a rising cost base, in our view. Telecommunications • Upgraded IT/customer care systems are likely to reduce its exposure to increasing labor costs. • Telstra’s products are believed to be attractive substitutes for businesses and consumers when cutting costs (e.g. phone services/video conf replaces travel) • Inflation-sensitive labor represents ~14% of Austar’s FY08E Austar AUN.AX A$1.35 A$1.65 1-OW total cost base. Programming costs (~48% of Austar’s Subscription Television FY08E total costs) are subject to long-term contracts, we Services believe. We expect the outcome of these factors to be margin strength. • We consider subscription TV services to be price inelastic and a cheap entertainment alternative for cost-conscious consumers. • Austar’s set-top box costs (capex) are subject to declining prices, driven by ongoing technology improvements. • Waste management is an essential/non-discretionary Transpacific TPI.AX A$8.35 A$12.50 1-OW service, we believe. Waste Management Services • We understand that long-term customer contracts (~35% of FY08E revenues) include CPI adjustment clauses. We expect this structure to provide Transpacific a level of immunity from margin squeeze. • PrimAg owns Australian agricultural land and produces soft PrimeAg Australia PAG.AX A$1.99 A$2.25 1-OW commodities. Agricultural Commodities • We expect the company to be a significant beneficiary of food price inflation. Losers Ticker Price TP Rating Comments • Project cost inflation already represents a difficulty for future WorleyParsons WOR.AX A$39.50 $40.00 2-EW growth. Cost pressures may intensify particularly in labor- and Hydrocarbon Engineering commodity-based materials categories. Services • Around 85%+ of Bluescope’s EBIT is derived from sales of Bluescope Steel BSL.AX A$10.61 A$9.35* 3-UW commodity-grade flat steel products at international Flat Steel Products benchmark prices. • Lower Asian growth may result in reduced steel demand (Asia has been a key driver of global steel demand) and therefore, lower international steel prices. • Bluescope Steel’s earnings are highly leveraged to falling international steel prices. • Print advertising and circulation represents ~85% of Fairfax’s Fairfax Media FXJ.AX A$3.34 A$3.80** 2-EW FY08E revenue base. We expect a stagflationary environment to Newspaper and Online weaken ad growth and accelerate the secular trend to cheaper Publisher online alternatives. • Labor costs comprise ~41% of Fairfax’s FY08E total cost base. Accordingly, labor-intensive content requirements and the shift of advertising online are likely to result in margin squeeze, we believe. May 2008 17
  17. 17. Lehman Brothers | Equity Research • Babcock & Brown BNB.AX A$15.38 A$16.20 2-EW Infrastructure investments employ significant gearing, which creates earnings and cash flow risk in a high inflation/interest Brokers and Asset Managers rate environment, we believe. • We expect principal trading gains to be nominally supported by inflation. But the after-tax real gain will be much lower, we believe, because the tax system does not distinguish between real and nominal gains. • Macquarie Group MQG.AX A$60.75 A$62.80*** 2-EW Infrastructure investments employ significant gearing, which creates earnings and cash flow risk in a high inflation/interest Brokers and Asset Managers rate environment, we believe. • We expect principal trading gains to be nominally supported by inflation. But the after tax real gain will, we believe, be much lower because the tax system does not distinguish between real and nominal gains. Source: Lehman Brothers research. Prices as of May 7, 2008. * The 12-month target price for Fairfax Media was cut to A$3.80 (from A$4.30) on 14 May 2008. ** The 12-month target price for Bluescope Steel was revised to A$9.35 (from A$9.25) on 13 May 2008. *** The 12-month target price for Macquarie Group was revised to A$62.80 (from A$59.20) on 15 May 2008 DOWNSIZING THE ENGINE ROOM? Investment spending, in all forms, has been one of the strongest growing segments of the Australian economy. We believe that strong growth has taken place across the spectrum, from public sector infrastructure spending to business investment spending. In 2007, the Australian economy grew 3.9% in real terms, but investment spending was up 8.7%. We believe that the combination of (1) Asian stagflation resulting in weakening commodity demand; and (2) tight domestic monetary policy aimed at softening domestic spending is likely to result in jaundiced growth in investment spending. Apart, from the negative short-term impact on economic growth, Australia’s longer-term potential growth rate is also likely to suffer, in our view. Current Australian Federal Treasury estimates put the country’s long-term potential growth rate at around 3.5% per annum. However, we estimate that the long-term growth rate could fall to less than 3% per annum on a material reduction in the pace of growth in investment spending. WHAT HAPPENED IN THE 1970S? In our view, Australia’s experience of stagflation in the past was caused by inappropriate and ineffective monetary and fiscal responses to the oil price shock of the early 1970s. There are many reasons for why we believe the current run-up in key commodity prices will not trigger a re-run of the 1970s. First, we believe that it is more difficult for a commodity price shock to trigger second-round inflation effects in wage claims that help to develop an upward inflationary spiral. In the 1970s, Australia had near-automatic wage indexation, which meant that the latest quarterly rise in inflation fed almost directly into higher wages – i.e., four wage increases a year after each CPI reading. Second, monetary policy was largely ineffective in the 1970s because of bank lending, deposit and interest controls, and a fixed exchange rate regime. Third, the exchange rate could only help to contain inflation periodically – i.e., on occasions when the dollar was formally re-valued. Finally, fiscal policy was very loose, notwithstanding strong supply- side pressures on inflation from higher commodity prices. HOW CAN THE GOVERNMENT HELP EASE THE PAIN? The government can only ease the pain by ensuring that the period of stagflation is as brief as possible. Leaving the central bank to deal with inflation and providing it with the independence and policy armory to do the job is a good start, in our view. We also May 2008 18
  18. 18. Lehman Brothers | Equity Research believe that prudent fiscal policy (Federal Budget surpluses at or above 1% of GDP) should contain domestic inflationary pressures. CONCLUSION We consider that Asian stagflation represents a material risk to the Australian economy and corporate earnings growth. However, we believe that Australian institutional processes and flexible yet aggressive policy settings are likely to soften inflationary impacts. In our view, the demand side of the stagflation equation may prove to be the toughest issue for Australian policy makers. As a result, we believe that more attractive investment exposures are likely to be provided by those companies which enjoy: (1) limited exposure to input cost inflation (e.g., materials and labor); and (2) product sets with a high degree of substitutability for higher priced products in a cost-conscious environment. May 2008 19
  19. 19. Lehman Brothers | Equity Research CHINA STAGFLATION SCENARIO Can the government tame rising inflation and rescue Cheng Khoo slowing growth? LBAL, Hong Kong Tel: +852 2252 6180 cheng.khoo@lehman.com HOW WOULD STAGFLATION IMPACT CHINA? Paul Schulte During a high inflationary period that coupled with slowing global and domestic LBAL, Hong Kong economic growth, we think Chinese companies and the stock market would not be Tel: +852 2252 1409 shielded from a downturn. The Chinese government is in a difficult position. It seems the paul.schulte@lehman.com most logical course of action is to allow the currency to appreciate. In doing so, it: (1) imports deflationary pressures; (2) reduces trade surplus; and (3) reduces the enormous reserves. In essence, importing deflationary pressures and reducing inflationary domestic China Research Team liquidity is just about the only thing China can do, in our view. Interest rates could be raised further, but we believe that would be using the wrong tool. In our view, China’s problems are due to insufficient upstream raw material supply and an excess capacity in selected downstream manufacturing industries, in our view. Ironically, we have to ask whether there has been sufficient investment in China. With fixed capital investment running at 25% per year, we also expect nominal growth at about 19%–20%. Is one way out of the supply-driven inflationary burst an even higher level of capital investment, especially in water and agriculture? The government recently increased its investment in agriculture by 30%, to around US$43 billion. It is also running up large subsidy bills as it keeps consumers from feeling the full brunt of international price increases of most commodities. Our favourite theme for the next few years is agricultural investment. China needs to revolutionize its agricultural sector, including its water supply. When it targets to achieve something, its policies tends to succeed. This, we believe, represents the most promising sector for investors over the coming years. Biofuels, genetically modified (GM) seeds, irrigation, and new labor in rural areas are vital for China to get to the next level. Earnings and margins outlook. We are already seeing the effects on margins in many forms. (1) Many exporters’ margins are eroded by the appreciating renminbi. Other companies are under severe pressure due to price caps on products. The renminbi has appreciated by more than 9% against the dollar in the past few months, eliminating any profits for low-margin businesses. (2) These price caps – actually, for most products in the HSCEI – decimate margins as international prices rise. Consider the case of the biggest oil refining company Sinopec – were it not for a subsidized check, many of them would have already been in the red in 1Q08. Ironically, these price caps themselves are inflationary as they discourage future expansion in plant and equipment, and, therefore, are likely to produce lower installed capacity over time. This is a concern for us. (3) The normal margin pressure comes from input prices going up while wages are also rising. So, we can see many companies with rising land costs, rising energy costs, rising labor costs, and rising capital costs. Market performance. In January, we downgraded China from an overweight because we saw inflationary pressures spilling out all over. We also saw China’s inflation-free growth beginning to show wear and tear. The costs of land, labor, and capital are all moving up dramatically. This is a phenomenon that we strongly believe is a reflection of shortages and, hence, we are sceptical about the issue of overcapacity. So, China is seeing its liquidity seep out of the economy as the government becomes reinvigorated by the need to control inflation. We also think there is a need for a vast “Green Revolution” or “New Deal” to deal with chronic food shortages and water shortages, among others. This necessary, but very expensive, bonanza of spending is, in itself, also inflationary. Hence, we expect a pause in growth as large capital investments are implemented, which do not yield strong results. May 2008 20
  20. 20. Lehman Brothers | Equity Research We would consider upgrading China if we saw signs of inflation peaking. However, we do not see that any time soon. Our sector and company selections follow. WINNERS AND LOSERS Figure 6: Winners and losers (China) Winners Ticker Price Target price Rating Comments • COSL 2883.HK HK$15.56 HK$21.0 1-OW Low earnings risk • China Shenhua 1088.HK HK$34.95 HK$57.0 1-OW Extremely tight supply and asset injections • Price controls a risk • Hutchison Whampoa 0013.HK HK$78.00 HK$93.8 1-OW Cash rich; industry leader; diversified Losers – Company Ticker Price Target price Rating Comments • Guangzhou R&F 2777.HK HK$21.00 HK$31.04 2-EW High gearing of 265%. • A-share listing not assured in current unfriendly environment. • Minsheng Bank 600016.SS RMB8.22 RMB9.85 2-EW Relatively weaker management; insufficient risk management during a downturn. • CSCL 2866.HK HK$3.49 HK$2.9 3-UW Leveraged to changes in inflation and costs Prices as of May 7, 2008 Source: Lehman Brothers estimates LOWER GDP GROWTH WITH HIGHER INFLATION Lehman Brothers’ China economist Mingchun Sun currently forecasts single-digit GDP growth of 9.8% in 2008 for China, which indicates a decline from a growth rate of 11.6% in 2006 and 11.9% in 2007. Expecting deteriorating conditions exacerbated by overinvestment, which is resulting in overcapacity situation in many sectors, he recently downgraded the 2009 GDP forecast from 8.5% to 8%. In terms of inflation, Sun forecasts a full-year 2008 CPI to reach 5.5%, up from 4.8% in 2007, but much lower than the 1Q08’s level of 8%, indicating that 2H08 inflation will likely ease from a high base effect in 2H07. The easing trend then continues into 2009 with a FY09E CPI of 2.8%. Figure 7: China real GDP growth vs CPI China Real GDP Growth vs CPI (YoY % Change) 16 30 14 25 Real GDP growth 12 CPI (RHS) 20 10 15 8 10 6 5 4 0 2 0 -5 1985 1988 1991 1994 1997 2000 2003 2006 2009E Source: CEIC, Lehman Brothers estimates May 2008 21
  21. 21. Lehman Brothers | Equity Research However, in this report, the equity strategy team explores the impact of equities in light of a more negative scenario of a GDP growth rate of only 6.1% in 2008 and 5.9% in 2009 and escalating inflationary environment with a CPI of 6.7% in 2008 and rising further to 6.9% in 2009. By applying higher inflation assumptions, we are exploring the negative impact of real GDP growth. We analyze the risks to revenue growth and profit margins in combination with higher input cost in the various sectors. IMPACT ON REVENUE The market is currently debating whether a slowdown in the US/developed economies would impact the Asian and Chinese economies. Irrespective of the global economic slowdown, Chinese exporters have already started to feel the pinch of rising costs and competitive pressures. These include an appreciating currency, reduced VAT export rebates (and in some cases an increase in export tariffs), removal of favourable policies for processing trade; increasing cost pressure from rising prices of land, labour, energy and raw materials; and tighter standard on product quality, labour conditions, and environmental protection. In terms of trend, export growth has already slowed, especially in volume terms. As global demand weakens, export growth is very likely to be hit further. We think domestic consumption is unlikely to be strong enough to offset weakness in exports. Furthermore, as export growth slows, we expect income growth to decline while high inflation stands to erode the purchasing power of households and be a drag on real spending. During a period of slowing GDP growth, demand normally enters a downward trend, and excess capacity becomes a problem as operating rates decline. This is especially true in sectors that are experiencing an overcapacity situation. Producers have to lower prices in light of the heightened competition. With the global economy expected to slowdown considerably more in 2H08, we expect exports to decline in 2H08, intensifying through 2009. About one quarter of China’s total industrial production is exported, even though some sectors are more dependent on exports than others, such as mobile phones and color TVs. EFFECT ON EBIT: MARGIN SHRINKAGE? As external demand weakens, we think inventories are likely to pile up as soon as in 3Q08, after the Olympics. A strong inventory is being built up in some areas such as fuel and consumer products in anticipation of high demand during the Olympics. We believe firms will probably compete on price despite rising cost, which will likely depress margins. Profit margins are still trending around their highest levels since 1999, but seem to have reached a plateau. The number of loss-making enterprises is currently rising at 8.5%, up from 0.3% in 2007. Figure 8: China net profit margin China Net Profit Margin (%) 12 10 8 6 4 2 0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: Worldscope, Lehman Brothers research May 2008 22
  22. 22. Lehman Brothers | Equity Research With significantly lower economic growth and a rising cost base, we expect corporate earnings to come under pressure. According to consensus (IBES) estimates for Chinese corporations, analysts are projecting slowing EPS growth of 17.6% for 2008 and 16.6% for 2009, down from 32% in 2006. However, only four sectors (capital goods, retailing, diversified financials, and insurance) have negative earnings growth projections for 2008, while only one sector (diversified financials) has negative earning growth estimate in 2009(–10%). In our worst-case scenario, we expect potential downside to this set of earnings estimates. Instead of a majority of the sectors showing earnings growth, we expect the reverse to happen especially for those that are export focused and are facing overcapacity. Figure 9: China EPS growth estimates EPS growth (%) 2007 2008E 2009E China 32.3 17.6 16.6 Energy 7.6 18.7 9.6 Materials 4.8 24.9 14.2 Capital goods 38.6 -3.7 22.7 Transportation 155.2 12.7 9.7 Auto & components 38.4 19.2 16.1 Consumer durables 23.2 11.5 20.5 Consumer services 34.9 34.6 25.8 Retailing 52.0 -22.5 23.7 Food bev & tobacco 26.2 24.5 24.2 Household products 42.9 19.0 25.7 Banks 47.0 39.8 19.2 Diversified financials 360.6 -41.7 -10.0 Insurance 103.3 -17.2 17.3 Real estate 53.0 26.0 37.3 Software & services 24.1 17.1 30.7 Technology hardware & equip 61.0 15.5 15.3 Telecom 19.0 25.1 15.7 Utilities 10.0 1.3 18.2 Source: IBES We believe weaker corporate earnings and rising bankruptcies will increase unemployment and undermine the ability of the firms to repay loans. While bank non- performing loans (NPLs) have declined in recent years, they rose slightly in 4Q07. In addition, we are concerned that a credit cycle may kick in, and Chinese banks could face increased new NPL formation, particularly in risky sectors such as property, manufacturing, and exporters. We think that the weakening earnings will likely be reflected in the stock market as P/E ratios climb. Despite falling by about 30% this year, the Shanghai Stock Exchange A- share Index at a P/E of 27.3 is still expensive compared to the other market index P/Es. May 2008 23

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