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Equity Research – China Rate Cut

People’s Bank of China (PBOC) begins its rate-cut cycle

The surprise 0.4% cut by the PBOC on 23rd  November 2014 could be the start of a series  of  downward  interest  rate  adjustments  aimed  at  providing  monetary stimulus for the world’s second largest economy.

For the last six years, the world’s central banks have responded to the 2008 crisis by moving benchmark interest rates to levels that are near zero in many cases. Various measures have been employed, quantitative easing and forward guidance to hold them there. China’s People’s Bank of China has left interest rates high at levels commensurate with annual GDP growth of between 7%-8%.

The PBOC cut the one year benchmark lending rate by 0.4% to 5.6% and cut its one year deposit rate by 0.25% to 2.75%. The move included a 0.25% cut to personal mortgages  but  allowed  banks  to  price  deposits  at  up  to  20%  above  their benchmarks (up from 10% previously).

It is odd that a country whose National Bureau of Statistics says grew at 7.4% for the first nine months of 2014 should require monetary stimulus. Central banks have more data on the economy than external commentators so this move suggests a wide information gap. Perhaps the PBOC is concerned about a broader slowdown and the deflationary impact of lower oil prices. The real rate of China’s GDP growth is quite possibly lower than the 7% target.

The 0.4% interest rate cut is the start of an easing cycle designed to mitigate a sharp GDP slowdown (that is possibly being disguised) and an attempt to signal the PBOC is sensitive and alert to downside risks and expects inflationary pressures to ease.

A timely rotation into China sensitive equities

Since 2009 investors have been cautious on China, this partly reflects a slowdown in its GDP growth rate. The Communist Party plans to shift the economy away from export/ infrastructure focus and onto consumers. The correlation between the Shanghai Composite Index and the MSCI All Country World Index is 0.1 – the lowest amongst major equity markets. This means that Shanghai stocks offer good diversification benefits.

China is opening its capital markets, the Shanghai-Hong Kong exchange link opened on 17th November 2014 allows a net Y23.5bn of daily cross border purchases. This is a significant step to allow HK based investors easier access to Shanghai stocks. The Connect programme also allows international investors access to the domestic Chinese market without the need to obtain a Qualified Foreign Institutional Investment (QFII) quota from the Chinese government.

Currency controls, weak corporate governance, and under reported problems in government sectors mean investing directly is a bit problematic. Hence we are opting for UK companies exposed to the Chinese stimulus package.

 

BHP Billiton (BLT) BUY

BHP Billiton is the world’s largest listed diversified miner with significant interests in copper, coal, iron ore, oil & gas, alumina, manganese, nickel and potash.

 

During 2015 BHP Billiton plans to demerge its non-core operations into a new London listed entity which will encompass its manganese, silver, alumina, aluminium nickel and Illawara coal. BHP will distribute shares in the new company (expected to be worth c £8.4bn) to existing holders and retain its five pillars of iron ore, coal, petroleum, copper and potash. The demerger should make achieving productivity and efficiency gains easier.

 

At its Interim Management Statement (IMS) on 24th  November, the board revised upwards its targeted annual productivity gains by $500m to US$4bn by end 2017. Alongside these savings, BHP is cutting capital spending by $600m in 2015 and $1.2bn in 2016. We view this move positively as it demonstrates BHP increased optimisation of development related activity which should free up increased cash for holders. The IMS also repeated that core BHP will not rebase its dividend post the non-core demerger, effectively producing a dividend gain for holders.

The recent decision by OPEC to leave oil production unchanged has led to broader commodity weakness, directly related to the slump in global crude oil prices. Lower crude oil will impact BHP petroleum operations which had $14.8bn revenues (22% of total BHP revenues), Earnings Before Interest & Tax (EBIT) $5.28bn (23% Financial Year (FY)14 BHP earnings) in the year to end June 2014.

 

We assume a worst case scenario is a 40% drop in FY2015 petroleum revenues or around

$2.1bn in terms of EBIT. Assuming the relationship between EBIT $22.9bn to  net earnings

$13.45bn holds in FY15 that would suggest an earnings hit of c.$1.23bn or 23.2 cents per share. BHP earned $2.52 per share in FY14 up from $2.35 in FY13.

 

BHP lost 128p per share in November 2014 (£6.7bn in terms of valuation) taking the stock back to under 5 year lows. The downswing in our view goes a significant way to pricing in lower petroleum related profit issues and the soft commodity environment which is likely to prevail in the second half of BHP current financial year.

Key Catalysts

BHP  has  set  demanding  output  targets  for

2015, petroleum & copper 5% growth, iron ore 11% growth and met coal 4%. However soft commodity prices oil (-27%) iron ore (16.5%) if they persist are headwinds suggesting revenue drops in the 10%-15% range in some areas.

 

We   are   positive   on   the   merits   of   the demerger. The interims, due 18th February should   provide   improved   clarity   on   the

 

Company                              BHP Billiton
Share Price (p)                          1470
Target Price (p)                        2000
52 Wk Hi/Low (p)          2096/1582
Shares O/S                               5.3bn
Market

Capitalisation                      £78.2bn

Avg Daily Volume                  8.84m
Dividend Yield                        4.81%

 

Source; Fidessa plc

demerger   timetable   and   the   financials   /

dividend payout of the demerged entity.

Key Risks to Price Target

i) BHP Billiton profitability is sensitive to base metal prices, oil prices and other commodity related risks such as global metal and oil inventories.

ii) BHP Billiton is in the midst of demerging its non-core businesses, this involves execution related risks. iii) Future profitability will be impacted by Chinese demand for base metals and BHP realising its targeted $4bn of annualised productivity gains.

JIMMY CHOO (CHOO) BUY

Jimmy Choo is a modern high end fashion brand focusing on glamorous shoes and a range of accessory items including sunglasses, eyewear, fragrance and leather accessories. The brand has a wide global recognition and is sold via a growing global distribution network (120 directly operated stores – DOS) alongside a high quality network of wholesale distributors. Jimmy Choo is in the midst of a China/ SE Asia expansion, following an IPO offer of 100.9m shares at 140p on 17th October

2014.

Key Catalysts

We are awaiting updates on the expansion of DOS in greater China, and Russia and potential franchise buybacks in the Middle East, South Korea, Singapore and Malaysia.

Post IPO (140p at the lowest point of the range) we are expecting an update shortly after Christmas. The company has advised it is now organising its corporate calendar.

 

Company J Choo
Share Price(p) 171
Target Price(p) 225
52 Wk Hi/Low (p) 173/140
Shares O/S Market 389.74m
Capitalisation £666.45m
Avg Daily Volume 229k
Dividend Yield 0%
Source; Fidessa plc  

Key Risks to Price Target

i) Jimmy Choo success depends on its ability to anticipate and respond promptly to consumer demands, there are significant inventory related risks

ii) Jimmy Choo faces competitive pressures in the luxury shoe m Its main competition comprises very large luxury brand companies.

iii) Jimmy Choo is exposed to changes in foreign exchange rates, its reporting currency is sterling but it has a high proportion of sales in overseas territories.

FIDELITY CHINA SPECIAL SITUATIONS PLC (FCSS) BUY

Fidelity  China  Special  Situations  (a  UK  listed  investment  trust)  invests  in  a  manager  selected portfolio  of Chinese equities. Its recent outperformance (total return 14.3% to end September) against an index return of 10.1% was attributed to large gains in AliBaba and BitAuto. Fidelity China does use modest gearing of 20.6% to augment exposure to mainly e-commerce and securities companies. The manager has increased exposure to insurance companies due  to low  insurance penetration in China and selective property companies which he thinks are undervalued.

Key Catalysts

The IPO of Alibaba at over $220bn was more than 4x the FCSS pre-IPO investment at $48bn 24 months ago. We await developments on further reductions in the FCSS Alibaba stake.

The board remain confident that property risks have been exaggerated and that current valuations for property companies are too low. The expectation is for an earnings increase of 20% in the coming year which should drive portfolio gains over FY15.

 

Company

Fidelity China

Special Sit

Share Price(p) 129
Target Price(p) 160
52 Wk Hi/Low (p) 129/ 97
Shares O/S 571.2m
Market

Capitalisation

 

£736m

Avg Daily Volume 1.52m
Dividend Yield 0.89%
Source; Fidessa plc  

Key Risks to Price Target

i) Current 12.3% discount to net assets can vary significantly.

ii) Sensitive to key staff and confidence in the manager’s strategy for the investment fund.

iii) Movements in foreign exchange rates specifically between sterling and the Yuan will impact the net assets and performance of the fund.

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