Still comfortable with oil stocks

US Equities

After disappointing results from its fixed income division, Goldman Sachs Group Inc. (GS, $84.70, CSFB: Not rated) stock price lost 8.6% in four days last week, while competitors announced strong earnings from their fixed income businesses.

The company bought millions of dollars in mortgage portfolios from clients, but interest rates rose before it could resell them, leaving it with substantial losses (source: Wall Street Journal). We have a Buy rating on GS for trading investors, wanting to play a rebound in the stock price.

The U.S. Senate accepted a $368 billion defense-spending bill, sending it to President George W. Bush for his signature. Defense contractors Boeing Co. (BA, $34.01, CSFB: Outperform), Lockheed Martin Corp. (LMT, $45.43, CSFB: Outperform), and Northrop Grumman Corp. (NOC, $86.15, CSFB: Outperform) would benefit from the bill, which boosts the military's buying power for ballistic missiles, armoured vehicles, aircraft, and other equipment by $3.1 billion to $74.7 billion.

After a 7%-decline in stock price last week, due to several downgrades in aerospace & defense sector, we re-iterate our Buy rating on Northrop Grumman, believing current stock price offers an attractive buying opportunity for the long-term.

OPEC decided to cut its daily production by 900,000 barrels to 24.5 million starting November 1. The organisation had already raised concerns earlier, that the current production would exceed global demand. Crude oil prices declined sharply in late August, after US inventory levels saw an unexpected increase. The end of the US summer holiday driving season would have suggested a large draw in inventories, keeping demand levels high.

Another factor weighing on crude oil prices was an increase in Iraqi production. Latest estimates see Iraqi production at 1.28 million barrels a day, about half the level of output the country had before the war.

OPEC also signalled that it would decide to cut quotas further if necessary, during its next meeting in December. This was interpreted as a hint, that crude oil prices could continue to come under pressure and led to profit taking in oil industry stocks.

We expect the sector to remain volatile over the next days, but medium term the inventories for heating oil being still 10% below year ago levels and with the start of the winter season starting in six weeks, demand from this side should keep crude oil prices stable at high levels. Hence we remain comfortable with the outlook for the oil sector.

An investigative hearing in the US House Energy and Commerce Committee took place last week, in order to shed light on drug companies pricing practices in Medicaid. Medicaid is the government health insurance of the poor and represents about 16-18% of total pharmaceutical spending. The hearing was part of an ongoing investigation by Congress on this subject, hence not a new issue. The question the committee was addressing was whether drug companies have been manipulating the Medicaid payment structure, or whether the states are getting the rebates they are entitled to.

Beside this we are also looking for an acceleration of the work on the Medicare reform bill. October 17 could be a tentative deadline for a comprehensive proposal. Although the Congress is not expected to trim down the benefits, there are some issues that could have a negative impact on the pricing power of the pharmaceutical industry, such as drug re-importation and the Waxman/Hatch provisions that would make it easier for generics to come to market.

Looking at the valuations in the pharmaceutical stocks, a widely negative outcome of the Medicaid hearings and Medicare drug bill appear to be priced in. We believe that as the legislative work on the bill is progressing and we gain greater visibility on the content, this should partially lift the pressure on the share price of drug companies.

The passage of a comprehensive reform could even lead to a relief rally for the sector. We reiterate our positive view on Pfizer Inc (PFE, $30.56, CSFB: Outperform) and Merck & Co. (MRK, $50.83, CSFB: Neutral) and see current valuations as attractive.

Service Corp International (SRV US, $4.95), the largest death care provider has risen 22% since our recommendation in July 2003. It was just $0.05 short of our target price, but we have decided to exercise caution and lock in our gains for now. There has been no clear news as to why the stock has suddenly surged over the last week. However, after having spoken to some US analysts, we have been informed that there has been a substantial amount of insider buying.

Seeing that management is privy to information pertaining to the company before the market is, we view insider interest as a good sign. We will be reassessing the situation, as there may be good reason to go back into the stock if we do see a clear catalyst that would enable SRV rise further. For now, we would advise investors to exit the stock and we will keep you posted on whether or not it would be worthwhile revisiting SRV.

European Equities


• The DJ Stoxx 50 slid 5% and closed the week at 2447.92 on the back of sharp currency movements, some profit taking and OPEC's oil quota cut.

• CSFB increased the capital goods sector from underweight to marketweight with MAN AG and Siemens AG among their favourites

• Update on Adidas-Salomon and Vodafone

The comments by the G7 leaders over last weekend acted as a trigger for the round of expected consolidation. However, the speed and the extent was faster and sharper than many expected.

Sharp gains of the Euro impacted Europeans exporters such as the auto sector, the surprised move by the OPEC to cut production stabilized the recent pull back of the oil price but put renewed pressure on the chemical sector where oil makes up a large portion of their input cost and concerns rose again about the sustainability of the recovery. We believe that we might have some volatile weeks of consolidation ahead however remain positive in the medium/long-term.

The German IFO Business climate index surprised on the upside as a whole. The assessment of the current situation came in slightly lower than expected, but the expectations component remained strong. However, whereas it is not unusual for expectations to lead the rise, we need to see a follow-though to the real data for an improvement in the current economic environment.

Although the reading is for the month of September, around 70% of the participants replied before the 16th September. Given that on an index level the current correction only started last week, there is some downward risk to next month's current situation reading in our view.

CSFB upgraded the capital goods sector from underweight to market weight. This is especially interesting as CSFB was negative on the sector for years.

According to CSFB, two new themes are emerging from a structural point of view: (i) companies are more profitable at the trough of this cycle than CSFB thought they would be (explained among others by greater outsourcing, more efficient working practices and greater supply-side discipline) suggesting higher mid-cycle EBITA margins. (ii) capital spend to depreciation is lower - this implies higher return on invested capital.

CSFB believes the global industrial cycle has troughed and are increasingly confident that industrials will enjoy organic top-line growth in 2004 - this is crucial when operational gearing is 4-5x for most companies. Among their preferred plays are Siemens (SIE GY; EUR 51.95) and MAN (MAN GY; EUR 18.89). CSFB has slightly raised the revenue estimates for Siemens due to improved top line growth in ICM and ICN. 2004 EPS estimates are for EUR 3.33 and for 2005 EUR 4.13.

We remain positive on both companies. However, given the current environment we would advise to add new positions in stages.

Adidas-Salomon (ADS GY; EUR 78.08) was one of the stocks bucking the downward trend this week. Please recall that we recommend Adidas-Salomon as play on a strengthening Euro. A major part of the production is outsourced to Asia and denominated in USD in addition to the Euro sales. Adidas has a net USD exposure of over USD1bn and should therefore benefit from an appreciating Euro.

Furthermore the stock was supported this week by an upgrade by UBS on the basis of their belief that the market underestimates the value of its European operations while the US may be overestimated. The US back-to-school season seems to be better than expected, however, order backlog in the US should still be down by around 12% yoy.

However, we believe this should already priced in. From 1Q04 onwards comparisons should become more favourable and in the long-term Adidas-Salomon's favourable exposure to the strengthening Euro should come into effect. We reiterate our buy.

CSFB upgraded their EPS 04 forecast for Vodafone (VOD LN; GBP 1.225) by 7% to 8.1p and 04 free cashflow by 5% on the back of encouraging industry margin trends, a more upbeat view of mobile data and the sale of Japan Telecom. As a consequence, CSFB is also increasing Vodafone's target price from 135p to 140p per share.

Given the sharp share price gains of higher beta stocks and the fact that European service provider only increased more or less in line with the market increases the possibility for a rerating of more defensive stocks with sound fundamentals.

In addition, Vodafone appears on top of Citigroup's contarian screen meaning Vodafone has a price momentum, which is moving in the opposite direction to its earnings momentum. We remain positive on the stock ahead of its interim results.