A new outlook for commodity stocks

US equities

Commodity stocks had a good week, as hopes for an economic recovery lifted the sector. Since an improvement in the economy would also drive demand for commodities, investors started to buy into commodity related stocks. We value the commodities industry as attractive, as we believe that it is at the trough of the cycle and is in a transition phase to new growth.

It is not only crude oil, on which we have turned positive a while ago, and which has seen stable high prices, even after the war premium dissipated. But we are also beginning to see an improvement in metal prices as well. Aluminium prices are recovering since the sharp decline in 2001, where huge overcapacity has plagued the market. A phase of consolidation and restructuring followed, which eliminated some of the excess capacity. The industry has also learned to implement tight capital discipline during the downturn.

For 2003, worldwide aluminium sales should increase by 4-7%, mainly due to a price increase, according to Standard & Poor's. Data points coming from US aluminium maker Alcoa Inc. (AA, $24.61, CSFB: Outperform) underpin this view. Alcoa has reported stronger than expected earnings, but the most encouraging point was an improvement in margins.

This came despite high energy costs and shows that Alcoa's efforts to cut cost are starting to bear fruit. Alcoa will continue slashing cost to further improve profitability and give the company the potential to outperform the industry as demand picks up. We believe that it is a good time to buy into the stock, as an investment in the commodity sector, based on our long-term positive view on commodities. Alcoa's indicated dividend yield of 2.44% makes the stock additionally attractive.

Last week we added International Business Machines Corp., or IBM (IBM, $88.04, CSFB: Neutral), to our list of recommended stocks, as we believe that the company has been neglected of late and has underperformed the information technology sector during the rally over the last two months. In our view, this is not justified if we look at IBM's consistency in revenues over the last two years. They have remained relatively stable and the outlook is equally attractive.

IBM has been growing its IT services business, also through the acquisition of the PriceWaterHouseCooper consulting business, to make its revenues less dependant on technology cycles, as this business is characterized by long term contracts providing IT service companies with a large amount in recurring revenues. During 2002 IT services have made up 48% of IBM's revenue and for 80% of its pre-tax profits. With the increasing complexity of computer infrastructure, the IT service business has a good long-term outlook, as more support will be needed.

However If the IT services business provide the stability in earnings, the company's key growth engines are the company's hardware and increasingly its software division. The software division achieves gross margins of 85%, which will boost the company's profits once IT spending recovers.

Qualcomm Inc. (QCOM, $33.55, CSFB: Neutral) is another stock in the technology sector, which has not been participating to the rally, but has the potential to see a share price appreciation. The risk of competition has put the Qualcomm share price under pressure, as Texas Instruments Inc. (TXN, $20.50,CSFB: Not rated) announced plans to enter the CDMA chipset market. Competition however should not start to play a role until late 2005, which gives Qualcomm the time to capture the first wave of growth in the CDMA market.

Currently the company is betting on India and China, which currently contribute to a major part of the CDMA subscriber growth. And while fears that SARS might slow down growth in the near-term, Qualcomm's CEO is confident that 6 million mobile-phone users in India will subscribe to telecom services using CDMA phones. This would add to the approximately 147 million CDMA phone users worldwide. We believe that the market has overreacted on the fear of competition and in our view the stock should catch up with the market to the upside.

The stocks of the automotive suppliers could be beneficiaries of the new tax law signed by President Bush. Among the suppliers that pay dividends the average dividend yield is 2.1%, above the 1.7% dividend yield for the S&P 500. Among our recommendations, Johnson Controls Inc. (JCI, $83.25, CSFB: Not rated) is one of the companies with the fastest dividend growth (9% growth p.a. for the past five years).

Currently, JCI offers a gross dividend yield of 1.73%. We believe the company would continue to increase its dividend. Furthermore, the company has a strong balance sheet with low indebtedness, where total borrowings represent 18% of total assets, and a positive free cash flow growing at an average rate of about 14% p.a. for the past five years. Therefore, JCI offers a good holding for investors seeking for sustainable dividend payments in the automobile industry.

Last week a Massachusetts Appeals Court through out another class action lawsuit against Philip Morris USA. The Case was a class action lawsuit brought against Philip Morris USA by smokers of Light Cigarettes, Marlboro Lights to be precise. This was more a case of product liability and not health damage whereby the plaintiffs purported that Philip Morris misled smokers about the dangers of Light Cigarettes.

Due to the avenue for health damage cases narrowing rapidly, Plaintiffs have been filing increasingly novel claims. This had been the second class action lawsuit to be decertified in less than a week. There is another Lawsuit pending appeal in Illinois, which is also a Lights case. Last night's decision by the Massachusetts Appeals court sets a very favourable precedent and bodes well for Philip Morris as far as the Illinois case is concerned.

We would like to reiterate that it is Class Action Lawsuits, which pose the biggest threat to the Tobacco industry. In the last two cases, which were thrown out, The appeals court Judges have made it explicit that Class Action Lawsuits against the Tobacco industry are simply no longer plausible.

We maintain a buy on both our tobacco stocks Altria Group (MO, $41.30, CSFB: Outperform) and Carolina Group (CG, $25.16, CSFB: Not Rated).

However, as both stocks have had quite a run up in the past few days, we believe there could be pull back. We would recommend that an entry level of $39 for MO and $22 for CG.

European equities


• The DJ EUR Stoxx 50 closed the week 3.7% higher at 2330.06

• Take partial profit on Vodafone, which reached our target price of GBP 1.30. Given Vodafone's above sector average free cash flow yield, its strategic advantage over its competitors with the launch of Vodafone Live and its attractive valuation, we decided to move the target price to GBP 1.40. Stop loss remains at GBP 1.15.

After a quiet and directionless start at the beginning of the week due to public holidays in London and the US, markets started to post small daily increases led by technology, insurance and cyclical goods.

Given the Euro's appreciation and the fact that the German economy shrank in the 1Q, the release of the IFO Business Climate Index came as a surprise (actual 87.6 vs. 86.6). It was not only better than expected, but also better than the 16-months low in April.

Especially the sub index of expectations showed an impressive increase (actual 97.2 vs. 94.9). However, we remain cautious as the increase seems to come from retailing and manufacturing, which were at a 15-year low and a bounce from these levels is not an indication of a recovery, but more an indication that the retail recession is easing. In addition, the current conditions component has been a better reflection of German economic reality than the expectations component over recent years.

To summarize our current view: we see opportunities for a long term investor in the energy sector, the commodity sector in general and in newly added stocks, which are a play on the strengthening Euro.

In the energy sector, Total (FP FP; EUR 124.50) offers attractive levels for investors with a 12-month view. Total offers strong growth in production, comes with an attractive dividend yield of 3.62%, trades at a discount to the other supermajors and the restructuring in Chemicals should provide further positive newsflow.

In the commodity sector, specifically in the pulp & paper sector, we like Stora Enso (STERV FH; EUR 8.85). Industry fundamentals remain positive, dividend yield attractive at 5%, price increases coming through and with less revenue generated in the US than its competitors, Stora has a smaller transactional risk.

We would also like to reiterate our two new plays on the depreciation of the US Dollar, Koninklijke KPN (KPN NA; EUR 5.93) and Adidas-Salomon (ADS GY; EUR 74.80).

Vodafone (VOD LN; GBP 132.50) reported a solid set of results for the financial year ending end of March. Vodafone reported a 26% increase in EBITDA to GBP 12.65bn (consensus estimates looked for an increase of 23% to GPB 12.4bn), a 33% increase in sales to GBP30.38bn (consensus estimates looked for GPB 33.8bn) and better than expected free cash flow of GBP5.17bn owing to lower than expected capex and cash taxes, and greater dividends received from associates. EPS before goodwill increased by 32% to GPB 6.81 (consensus expected EPS to rise by 24% to GBP 6.4 before goodwill amortization and exceptional items). Another good news was the 15% increase in dividends to GBP 1.62.

Due to the general write down of goodwill (not related to 3G) of GBP14.5bn, the company reported a net loss of GBP 9.81bn (vs GBP 16.15bn).On the operational side, stronger than expected subscribers (at 119.7m) were offset by weaker than expected ARPU.

Given that Vodafone's CEO Sir Christopher Gent will be stepping down at the end of June after building up Vodafone for 18 years, it is not surprising that the results came in at the top end of expectations. However it will be interesting to see what decisions his successor Arun Sarin will make when he takes office on 1 July. The two most important issues are the minority stake in US cellular company Verizon Wireless and the handling of the 3G licenses.

Last Friday, mmO2 took an asset impairment charge of GBP 5.9bn against its GBP 10bn 3G licenses in Germany and the UK. After several of its competitors managing down expectations on 3G, Vodafone will not write down its 3Q licenses, but amortize them over 20 years for the time being. A potential justification for doing so might be its superior market share. It remains to be seen if the new CEO decides to take different measures.

The strong core earnings and positive broker comments led the stock to new highs of GBP 1.325 on Friday surpassing our target price of GBP 1.30. We would advise investors to take partial profit. Given Vodafone's expected free cash flow yield of 6.3% against 5.5% of the sector, its strategic advantage over its competitors with the launch of Vodafone Live and attractive valuation (with a PER of 15x for 04 the stock is trading at the sector average though the shares deserve a premium due to its market position) we decided to raise the target price to GBP 1.40. Stop loss remains at GBP 1.15.

Nestle's (NESN VX; CHF 273.00) investor seminar was held over two days during last week. CSFB believes that Nestle is on the right track to grow its margins. On the one hand, nutrition is taking up a bigger part of the R&D and should facilitate higher margins on the other hand, a bigger part of the synergies from the Ralston acquisition will now already be realised by the end of this year instead of only next year.

This confirms our stance that in the current environment Nestle remains an attractive defensive play at these levels for a long-term investor. Nestle is currently trading at a 10% discount to the average of its two competitors Unilever (UNA NA; EUR 49.70) and Danone (BN FP; 116.90).