Equity Research

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Equity Research

• An introduction

Dan Togo Jensen, 45 3341 8246,
dato01_at_handelsbanken.se
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Equity ResearchIntroductionOur offering
MethodologyQA
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What is Equity Research?

• Fundamental equity research.
• Assumes stock value eventually reflects company
  fundamentals
• What are fundamentals?
• Income statement
• Cash flow statement
• Balance sheet
• What Drives Solid Company Fundamentals?
• Revenue, earnings, cash flow growth
• Quality of earnings
• Recurring, core earnings of a business
• Solid balance sheet
• Right mix of working capital, cash, assets, debt

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Overview of sell-side Equity Research
Research is Integral to all Functions of an
Investment Bank
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What is an Analyst?

• Typically assigned one or more industry sectors
  (e.g. transport)
• Responsible for formal coverage of 5-10 companies
  
• Price target
• Earnings estimates
• Stock rating - point of view
• Interact with institutional accounts
• Regular dialogue with company mgmt teams
• Provide daily commentary and ideas to clients and
  sales/trading

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Key Responsibilities of a Research Analyst

• Industry Expert
• Fundamental Analysis
• Financial Modeling
• Stock Picking
• Marketing
• Publishing Reports
• New issuance investor and sales/trading
  education
• Work with Trading Desk
• Meeting Facilitator bringing investors together
  with company management teams
• ? Help clients make money/beat their benchmark

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Equity ResearchIntroductionOur offering
MethodologyQA
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Handelsbanken Capital Markets

• Difficult to be more local
• 560 branch offices in Nordic countries
• Listed companies typically have relations with us
  one way or another
• Investment bank presence in all countries
• Equity Sales in New York and London
• Our people know the Whos who

SHB offices
.
.
.
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Value added through bottom-up approach
Macro input - 17 economists Sector ranking 3
strategists Top/Bottom sectors
3-5 outperformance 2004 and 2005
Model portfolio
Best 2006 stock pickers says Starmine and AQ
Top/Bottom stocks Intra-Sector ranking Company
updates Detailed estimates gt1000 company visits
per annum 45 Equity Credit Analysts
Best 2005 Nordic estimates says Starmine
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Products company research
1000 result comments
300 previews
2400 fast comment
500 updates
100 reports
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Equity ResearchIntroductionOur offering
MethodologyQA
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What Does the Market Want?

• Premium valuations go to companies
• Well positioned in an attractive industry segment
• Good track record of execution against current
  opportunities (Mgmt quality)
• Prospects for accelerating growth in future based
  on credible trends, and on expanding the business
  model.
• Structural situation or management ability to
  minimize downside risk better than peers
• ...these are similar in debt, equity, VC,
  acquisition deals

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Why is Growth so Important?

• Philosophical Issue
• If you arent focused on growth, then why are you
  even in business?
• Economic Issue
• Investors base company valuation on expectations
  of future financial performance
• Greater the potential for upside to current
  estimates means the greater the price

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Methodological Framework
Analyse historical performance
Forecast performance
Estimate cost of capital
Estimate continuing (perpetuity) value
Calculate and interpret results

• Macroeconomics
• Supply
• Demand
• Distribution/Delivery
• Competition
• Management

• Analytical tools (examples)
• Standard PEST at the macro level
• Standard 5-forces analysis at industry level
• Standard SWOT analysis at company level

Objective Assess the position of companies on a
broadly consistent basis and relate it to the
valuation
Book Valuation by Copeland, Koller Murrin
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Macroeconomics

• Market growing faster than GDP
• Only 50 of markets can be above average
• Valuation discount if company stuck perceived
  stagnant end market equity investors want
  growth
• Market with a blend of offensive and
  defensive characteristics
• Minimizes potential for cash burn in slowdowns
• Market where structure is evolving in a way that
  favors you (nobody likes a fair fight)

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Supply

• Incremental versions of existing key products to
  improve business short term
• New product pipeline to increase per capita
  wallet share and enter new markets
• Solid architecture to reduce cost of building new
  products/services
• Process management to release high-quality
  products on short, predictable release cycles

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Demand

• Proven customer demand in a market close to an
  inflection point
• Demand driven by multiple independent factors.
• The more independent, the better
• Demand can be bolstered with good marketing and
  sales execution

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Distribution/Delivery( Sales/Marketing)

• Marketing
• Message defines the competitive agenda in the
  marketplace - others react to your initiatives
• Simple, clear message with urgency
• ...This drives sustainable premium valuations
• Sales
• Track record for consistent execution
• Ability to scale sales organization easily
  (training, methodology, forecasting, etc.)

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Competition

• Does the company have a lead, even if definition
  gets somewhat narrow
• Demonstrate sustainable advantage over current
  competition (best if it doesnt depend on
  execution)
• Erect structural barriers to entry
• Cant presume competition will execute poorly
  forever

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Management

• Management team with track record for handling
  growth without disruption
• Credible roadmap for products, sales/marketing
  (plans, not dreams)
• Fast decision cycle (agility)
• Ability to implement appropriate process
  management when needed, before problems occur

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Valuation Fundamentals
Analytical Framework

• Intrinsic worth of a business is the PV of its
  cash flow
• All valuation techniques are rearrangements of
  this fundamental law
• Useful to express DCF in terms of return and cost
  of capital
• Enables you to see where and how value is being
  created and, crucially, to tie the valuation to
  the analysis
• If company A is in a stronger competitive
  position than company B it should be able to
  sustain abnormal returns for longer and it should
  be clear what factors lie behind this competitive
  advantage

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Valuation - Key Methods and Considerations

• Discounted cash flow model
• Indicates the Fair Value of the Total Assets of a
  business based on the value of the cash flows
  that the business can be expected to generate in
  the future. The estimated future cash flows are
  discounted to a present value at a discount rate
  that reflects the riskiness of the cash flows of
  the investment, the Weighted Average Cost of
  Capital (WACC). To arrive at the shareholder
  value of the business in question, long-term
  liabilities have to be deducted from the present
  value of cash flows.
• Multiples-based valuation with comparable
  companies
• Indicates the Fair Value of the Total Assets or
  Total Equity of a business based on a comparison
  of the target company to comparable publicly
  traded companies and transactions in its
  industry.
• Take-over premium
• Past transactions indicate that premium are paid
  for corporate control.
• Magnitude is determined among other things by
  strategic fit.
• Average historical UK public takeover premium
  have been between 30 and 50.

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Discounted Cash Flow Method

• Shareholder value is the sum of the positive
  future cash flows generated to the owners by the
  company.

Enterprise value - Net Debt SHAREHOLDER VALUE
Cash Flows In

• Influenced by
• Sales Growth
• Margins Profitability

• Taxes Payable
• Fixed Asset Requirement
• Working Capital Employed

Cash Flows Out
Future Free Cash Flows
Enterprise value

Discounted by WACC(Weighted Average Cost of
Capital)
WACC

• Cost of Equity
• Cost of Debt
• Financing Structure
• Risk Profile

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Typical DCF valuation scenario
Returns, Cost of Capital NPV of Free Cash Flow
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Multiples

• EV/Sales
• explains how valuable the investors find the
  business sales. However it does not separate
  companies with different profitability levels,
  and therefore it should not be used alone.
• EV/EBITDA
• is a good measure for the business operations
  profitability level. This is because the multiple
  is not affected by any difference in the
  depreciation usage.
• EV/EBIT
• multiple is fully comparable for companies that
  have the same planned period of depreciation
  according to plan and no change in depreciation
  difference has risen. The multiple also takes
  into account the CAPEX-level but it does not
  observe the capital structure.
• Price/Earnings (P/E)
• is probably the most used measure describing the
  share price of a stock. However the multiple is
  very sensitive to extraordinary incomes/expenses
  and to depreciation difference and change in
  voluntary reserves.

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Cautious outlook 2007/08

• Ingredient margin guided flat in 2007/08
• Higher raw material and energy prices are to
  blame
• Increased RD in enzymes and higher overheads

Ingredient margin guided flat
Recovery during 2007/08

• We expect Danisco to be able to push forward cost
  increases as they have been able to before
  but it takes time (6-9 mths)
• Palm oil prices is down from peak levels

• The weak share price development makes
  acquisitions less likely
• We believe that the current share buy back
  program of DKK 500m could be increased to DKK
  1000m

Acquisition risk reduced
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BUY with at target price at DKK 520

• Organic growth among food companies is 5-7
  currently
• Margins are expanding among peers and clients due
  to higher prices and nice volumes

Healthy business environment

• We include Sugar at DKK 8bn based on a DCF
  valuation
• We expect sugar production to be reduced in
  Europe from 2008 following quota sale this fall
  (deadline Jan 2008)
• This will reduce the risk on sugar cash flow

Sugar risk will be reduced

• We include Sugar at DKK 8bn based on a DCF
  valuation
• Further more, If you include Danisco enzymes at
  NVZ multiples SOTP is around DKK 640 upside 40

SOTP DKK 520-570
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Ingredients key drivers
Flavour sales reduces growth
Bioingredients will drive margin expansion
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Our SOTP

• 19 upside to discounted SOTP
• 44 upside to non discounted SOTP

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Peer group valuation

• Trading with discount to peers of 2-3
• At a weighted multiple the discount is 10-15

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Equity ResearchIntroductionOur offering
MethodologyQA
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