Auto Part Manufacturers: safer play than carmakers

US Equities

• Recommendation update

Consumers are spending an increasing amount of time in their vehicles and demanding new features. The number of Americans travelling twenty minutes or more to work increased 21% between 1990 and 2000 (source: Census data). Auto Parts Manufacturers respond to these needs by emphasizing interiors, particularly in light trucks. Complete interiors and full cockpits are longer-term opportunities and frequent product updates and/or new features help mitigate price pressure. During the auto show in Detroit last month, the interior was one of the major topics. Higher implementation of options such as leather seats, heated seats, third row seats would likely continue as would implementation of newer products such as rear seat entertainment systems. For example, leather seats were factory installed on 28.3% of vehicles in 2002 vs. 21.1% in 1998 (source: Morgan Stanley). Furthermore, with capital spending, and asset growth among large interior companies, we believe potential new entrants have significant barriers. We see the main risk factor in this industry as being a sharp decline in vehicles sales, which would force carmakers to reduce spending on interiors. However, Ford design chief reiterated that Ford Motor Co. (F, $8.32, CSFB: Neutral) would not cut costs on the interiors. Hence we maintain our long-term Buy rating on Johnson Controls Inc. (JCI, $77.96, CSFB: Not rated). Firstly, JCI is a leader in seats manufacturing. Its Automotive System Group makes seats and interior systems sold to the original equipment automotive market, in addition to the automotive replacement market. In 2002, this segment accounted for about 75% of JCI's total sales. Secondly, we believe with a wide range of customers, sales should be protected from high volatility. Major customers include Advanced Auto, AutoZone, Costco, DaimlerChrysler, Fiat, Ford, General Motors, Honda, Interstate Battery Systems of America, John Deere, Mazda, Mitsubishi, Nissan, NUMMI, Pep Boys, Peugeot, Sears, Toyota, Volkswagen, and Wal-Mart (source: SASI). However, in the short-term, stock price would remain under pressure from a likely war on Iraq, like the majority of consumer-related stocks.

Europe

• The DJ EUR Stoxx 50 closed the week 3% lower.

The results of the recent reporting season suggest that the gap between the dividend yield and cash (positive for the first time in 25 years) is relatively safe and probably growing slightly. Although there were many cases especially in the insurance sector where dividends were cut, there were also many cases where dividends were increased substantially. Several UK banks such as RBOS (RBS LN; GBP 14.53) or Barclays (BARC LN; GBP 3.67) raised dividends by 15% and 10% respectively. Companies on our recommendation list such as DaimlerChrysler (DCX GY; EUR 28.40) raised it by 50% and Nestle (NESN VX; CHF 273) by 10%.

Further rate cuts from the ECB will widen this gap even more. We would assign a 75% chance of the ECB cutting rates by 50bps and a 25% chance on 25bps. We would like to reiterate our call to focus on dividend yield when picking stocks - a strategy, which we believe, provides for some downside protection in the current environment.

Roche (ROG VX, CHF 81.45) reported full year result and forecasted double-digit sales and operating profit growth in local currencies and stable operating profit margins for the whole group in 2003.

With the release of the results, Roche addressed several unresolved issues, which resulted in several substantial one-off charges leading to a CHF 4.03bn net loss for 2002.
On a pre-exceptional basis, the results were in line with expectations. Operationally, the results showed progress with operating profit growth of +12%.

Both core business grew faster than the market in local currencies with Pharmaceuticals posting a 9% increase and Diagnostics 11%, which reflects the achievement of its operational goals for 2002 and the on-going strengthening in its two core businesses. The Pharmaceutical division remains committed to raising its operating profit margin to 25% in the next two years (current: 21.1%) and the Diagnostic division targets a margin 'slightly better than 20%' by 2006 (current: 15.6%)The strength of its two core divisions reaffirms our positive stance towards the company.

Nestle (NESN VX, CHF 273) reported figures, which were weaker than expected and impacted by the strong Swiss Franc. Group sales at constant exchange rates grew by 13% whereas the reported number shows only an increase of 5.3%.

The RIG (real internal growth), which is the most important indicator of sales performance, came in slightly lower than expected at 3.4% (2001: 4.4%, expected at 3.5%). Organic growth reached 4.9% (RIG 3.4% + positive pricing impact 1.5%), which is the second best performance in the European sector next to Danone (BN FP, EUR 109.8). A further positive is that all regions contributed to growth.

Net profit increased 13.1%. Please note that these figures were influenced by a number of one-off events. EBITDA margins increased to 12.3%, which reflects Nestle's commitment to improving margins.

Despite the slightly weaker than expected figures, we would like to highlight the solid and defensive nature of Nestle which we believe complements any portfolio in the current environment.

Arcelor's (LOR FP, EUR 9.29) group revenue declined 3.3%. EBITDA increased to 7.4% of net sales (2001 5% of net sales) and the significant improvement is due to cost reduction progress and synergies, which at EUR 190m represent almost double the target, set at the time of the merger and implementation of price increases. A dividend of EUR 0.38 has been proposed, which translates to an expected dividend yield of 4.4%.

Although sales was slightly lower than expected, the operating performance measured by EBITDA shows that the group is on track to achieve its target on the cost reduction and synergies.
Given current low valuations, the attractive expected dividend yield and further progress in synergies and debt reduction we remain positive on the stock. In addition, given the fact that the global steel fundamentals remain strong on the pricing side, further price increases can be expected.

ENI's (ENI IM; EUR 13.727) results were mixed. Whereas net income for the 4Q came in slightly above expectations at EUR 1,581m, operating income was below at EUR 2,450m. The biggest disappointment was the 28% decline in 4Q Gas and Power operating profits, which were driven by warmer weather, reduced distribution margins following contract renegotiations and a sales mix changing in favour of lower wholesale margins on much increased gas sales at the Italian border. However, potential was reflected in Eni's growth rate of 7.5% in its Exploration & Production division. Dividend was confirmed at EUR 0.75 per share, which translates to an expected dividend yield of 5.5%. We believe Eni offers an interesting combination of a hedge against high oil prices and an attractive dividend yield.