Comments on mortgage industry

United States
• Tenet Healthcare a value buy in the hospital sector

Last week's data came out better-than-expected. In October, existing home sales rose 6.07% m-o-m to 5.77M, while consensus expected 5.35M, as low mortgage rates lured buyers. New home sales decreased less than expected to 1,007K (-4.46% m-o-m), while consensus expected 990K. It is expected that total sales for this year would probably reach a new record due to the lowest mortgage rates in at least three decades (source: Bloomberg). For this year, the Mortgage Bankers Association is predicting total mortgage origination volume to exceed $2.4 trillion, reflecting a 19% increase from 2001. For next year, they expect strong volumes to remain through the first half and gradually decline in the second half of 2003, resulting in total volume of about $1.75 trillion for the year. However we would be cautious on the mortgage industry for the coming year. Mortgage rates are likely to rise in 2003. The figure below shows the yield curve for conventional mortgages.

Among the mortgage companies, Countrywide Financial Corp. (CFC, $49.30, CSFB: Not covered) remains our favourite. The company has solid fundamentals and still attractive valuation (current P/E ratio at 10x, and P/B ratio at 1.27x). The company delivers steady earnings growth (on average +20% p.a. in the last 5 years). Furthermore mortgage origination accounted for only 32% of CFC's FY01 pre-tax earnings, which should mitigate the expected decrease in mortgage origination for 2003.

The healthcare sector's performance has been lagging the broad market over the past weeks, as investors' risk appetite increased. Some of the stocks are still not cheap, however, as they remained relatively stable during the market decline in early October, thanks to their earnings visibility. The sector fundamentals however, remain sound.

For this reason we have added Tenet Healthcare (THC, $18.45, CSFB: Neutral) a hospital company to our US Buy List. Tenet Healthcare stocks dropped sharply, losing 70% of their value, after two physicians in one of the company's hospitals were accused of overbilling their patients and providing unnecessary services. The case is currently being investigated, but so far it looks like Tenet Healthcare as such, acted within the complex Medicare reimbursement rules. But as a consequence, the company is reviewing its pricing policy.

In the past few years the hospital sector has seen strong growth thanks to certain demographic developments and strong pricing power. We do not expect the sector to continue to see 15-20% annual profit growth, but the demographic development with an ageing US population, continues to be fundamentally positive for the industry. The Baby-Boomers are approaching an age where they will require more healthcare and hospital treatment. But the pricing power should not remain as strong, as the US administration attempts to cut back on the cost explosion within the healthcare system and seeks to reform the Medicare system. Cuts in reimbursement are however a politically sensitive topic and so it could be some time before the government takes any action.

Nevertheless, at the current price, we believe Tenet Healthcare shares have discounted the legal risks surrounding the two physicians accused of overbilling and we believe the stock is currently undervalued.

In order to assess the stock's fair value, we have taken a conservative approach. We have deducted 10% of the consensus 2003 full year EPS and assumed an 8% annual growth, which resulted in a fair value $39.50 in our dividend discount model. As we expect the stock to trade at a discount to fair value, given the negative media coverage during the investigation against the two physicians, we see $30 as a 12-months price target. We believe the stock has a good recovery potential from current levels based on valuations. Tenet Healthcare is a good value buy for long-term investors.

We are initiating coverage of Carolina Group (CG US, $18.51, CSFB: Not Rated) with a BUY rating, a target price of US$23 and a stop-loss level of US$15.50. CG is essentially a tracking stock issued by Loews Corp to monitor the performance of Lorillard Inc, which is one of the principal US Tobacco industry players. We believe the stock offers compelling valuations trading at 5.3x FY02 earnings with a hefty dividend yield of 9%. Due to weak US Tobacco industry fundamentals, our Carolina Group recommendation is principally an income play. We do not see much capital appreciation for the coming 4Q02 and FY03, but a healthy yield supported by strong company fundamentals, we believe, should more than make up for this.

Europe Equities
• The Euro STOXX50 closed the week 0.3% higher at 2656.85
• We stick to our trading discipline and took Infineon, Vodafone and BNP from our trading recommendation list as they hit our stop-loss levels amidst Tuesday's session of profit taking and BNP's weakness after they won the auction by paying a 49% premium to buy a 10.9% stake in Credit Lyonnais

With relatively few big names reporting and closed US markets on Thursday due to Thanksgiving the markets were trendless. The economic figures released last week in Europe painted a different picture. The German IFO business confidence posted its sixth consecutive decline to 87.3 in October from 87.7 in September. This marks the lowest level in the last nine months. A survey released by the European Commission showed that consumer confidence in the region fell to its lowest level in more than five years in November. This will keep up the pressure on the ECB to finally cut rates in its meeting this Thursday. We believe there is a high chance that they will reduce the rate by 50bps.

An ECB rate cut and a positive tone in this week's US data (manufacturing and non-manufacturing ISMs, factory goods orders, non-farm payrolls), would leave room for at least high beta stocks to continue their rally. The technical nature of the 4Q rally can also be seen in the sector performance ranking since 9 October which is in reverse order to those seen for the rest of the year. However, the macroeconomic picture, geopolitical uncertainties, tame corporate profitability levels and profit forecast growth which we believe are still too high (IBES profit forecast growth of EURO Stoxx 50 is 36% for 03) remind us that we are experiencing a rally in a bear market.

With profit taking setting in on Tuesday high beta stocks suffered the most, which caused our trading recommendations on Infineon (IFX GY; EUR 10.21) and Vodafone (VOD LN; GBP 1.22) to fall below our stop-loss levels. Since we advise trading discipline on both sides we executed the stop losses and booked a loss of about 5% for both stocks. However, we remain confident on Vodafone's fundamental medium-term development. The stock is poised to trade range-bound in the GBP 1.10-1.30 range.

The financial sector was focused on rumours of a German merger between HVB (HVM GR; EUR 16.49) and Commerzbank (CBK GR; 9.35) and the announcement of BNP (BNP FP; EUR 41.0) to have won the auction to buy a 10.9% stake in Credit Lyonnais (CL FP; EUR 50.25) from the French Finance Ministry. This came as a complete surprise to the market since the government announced the auction only 24 hours beforehand. BNP paid EUR 58 per share or a 49% premium, which was an offer that was significantly above the other bids. The high premium paid caused concerns about BNP's strategic discipline towards acquisitions but also fears that the bank might be prepared to overpay for a majority stake. Even though the latter was denied the stock dropped while Credit Lyonnais gained 29% in the last week. BNP has hit our stop-loss level (EUR 42.50) on our trading call issued last Friday and we removed the stock from the trading recommendation list.

BNP has paid EUR 2.2bln for the stake, which reflects over 20x consensus 03E earnings and a 2x book value for a 10% ROE. This price would imply a 43% premium to the sector and 73% to BNP's own rating, which looks rather demanding. In order to justify the earnings multiple of the transaction BNP would need to achieve synergies of EUR 843 million or 26% of Credit Lyonnais' 2002E cost base, which seems very high. In the short term we expect the stock to remain volatile.

Over the weekend it was reported that the bank bought an additional 5.3% of shares during the last week which makes it Credit Lyonnais' no. 1 shareholder with 16.2%.

On the pharmaceutical front, the FDA approved OTC status of Schering-Plough's (SGP US; USD 22.66) Claritin. Although the market seems to believe that the OTC Claritin and the patent challenge will radically impact the future growth of Aventis' (AVE FP; EUR 55.95) Allegra, we think the fears are overdone:

1) only US sales of Allegra (around 10% of core sales in 02) are subject to a challenge

2) OTC Claritin is expected to be priced in line with other already existing OTC products available in the market (around USD 30 per month)

3) Managed care plan accounts for 82% of Allegra sales and within managed care Tier1/Tier2 account for 87% of Allegra sales. Given the rebates Aventis gives to these managed care plans, we see limited incentive for them to move Allegra to Tier 3 as they will lose any rebate previously enjoyed from Aventis

4) 67% of Allegra users are chronic users, which are unlikely to switch given the little economic incentive

5) CSFB estimates the risk of generic competition emerging in 04 as very low (1 in 20) and judge this to be an acceptable investment risk

Aventis still holds about 25% of Rhodia, which they 'inherited' from Rhone-Poulenc when it merged with Hoechst to form Aventis in 1999. Aventis offered USD 1bn in cash for all its bonds exchangeable into Rhodia shares. We see this step as a further sign that Aventis will finally divest its Rhodia stake and focus on its core business.

We would use any weakness around EUR 55 to buy the stock as we believe Aventis has a strong product pipeline adding four new blockbusters to its existing three in the coming years and will be able to deliver above sector average growth next year.