10 Things to Think About in 2004 (MS)

8/2/2019 10 Things to Think About in 2004 (MS)

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Please see analyst certification and other important disclosures starting on page 22

22 December 2003

10 Things to Think About in 2004

Pertinent Factors in the Convertibles Marketfor the Year Ahead

Colum McCoole +44 (0)20 7425 3055 [email protected]

Kelley Myers +44 (0)20 7425 8910 [email protected]

Morgan Stanley does andseeks to do business withcompanies covered in itsresearch reports. Investorshould consider this reportas only a single factor inmaking their investmentdecision.


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Index

Convertible Market Update

Focus areas:

1. Economic / Strategy Outlook2. Convertible Valuations

3. Volatility What might trigger a reversal?

4. Credit Spreads Further scope for tightening?

5. Deleveraging Persisting with Balance Sheet repair

6. New Issuance / Redemption TrendsCall Risk Europe / Asia ex Japan

7. Evolving Prospectus Language / Structures

8. Accountancy-related Issues

9. European Enlargement

10. Cross-Asset Investing

Slide

0306

08

10

12

1315

17

18

20

21


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1. Economic / Strategy Outlook for 2004 / 2005 (i)


After accelerating to 4.2% in03, MS looks for global GDPgrowth to decelerate to 3.7%

in 05. If economic recovery

continues as we expect, 2004could be a year of outrightlosses in the US bond market(our US strategists reducebonds to 20% v. 65% equity).

US strategist 12-month targetfor equities is S&P 500 at 1100

1125; modest upside; USmarket at fair value based onDDM (Div. Disc. Model).

Positive

Aggressive monetary tightening unlikelywith inflation low and likely to rise gradually

Tax cuts boost to spending / saving

Capex returning for maintenance + repair/ tax incentives bring forward from 05 to 04

Will FCF go to paring financial leverage?

Negative

4 key challenges: Jobless recovery; higherenergy prices; weak global recovery;protectionism

Investors have already discounted the cyclicalrecovery (sectors with biggest earnings misses in03 such as materials, industrials, IT and utilities,have already had the biggest moves).

Steve Roach deeply sceptical that Asia can bean important growth engine in of itself, especiallyas China growth is quelled forcefully, with

implications for Japan, Korea and Taiwan.

US

US Strategy:

Underweight Tech, consumer discretionary,financials, telecoms and utilities

Overweight Healthcare, industrials, energyand consumer staples

Equal-weight Materials

GNP / GDP Growth (%) CPI Inflation (%)

2001 2002 2003E 2004E 2005E 2001 2002 2003E 2004E 2005E

Global Economy 2.2 2.8 3.2 4.2 3.7 2.4 2.4 2.4 2.0 2.1

US 0.3 2.4 3.1 4.7 3.8 2.8 1.6 2.3 1.6 2.2

Europe 1.7 1.0 0.8 2.1 2.1 2.3 2.1 2.2 2.0 2.1France 2.1 1.2 0.2 2.1 2.3 1.6 1.9 2.1 1.9 1.6

Germany 0.8 0.2 0.0 2.1 1.8 2.0 1.4 1.1 1.3 1.3

Italy 1.7 0.4 0.5 2.0 1.9 2.8 2.5 2.7 2.1 2.0

UK 2.1 1.7 2.0 2.7 2.6 1.8 1.6 2.9 2.8 2.7

Japan 0.4 0.1 2.6 1.9 1.5 -0.9 -0.8 -0.3 -0.2 -0.6Asia ex-Japan 4.1 5.9 5.8 6.2 5.7 2.2 1.4 1.7 1.8 1.8

Latin America 0.4 -0.1 1.0 3.8 3.3 5.5 12.9 8.3 6.4 5.9

Exhibit 1: Morgan Stanley Economic Forecasts: GDP and Inflation Forecasts out to 2005

Source: Morgan Stanley Research, e = Morgan Stanley Research Estimates

#1


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Exhibit 2:Morgan Stanley Base Rate Fcasts


Although our Economics teamhave raised their Q4 GDPforecast for Europe to 3%, they

see moderating growth in Q104.Doubts about the sustainabilityof the current global boom anda stronger euro have temperedtheir outlook for 2004, wherethey retain their 2% GDPforecast.

Following another forecast Bankof England rate hike in January,

MS is forecasting the ECB tohike 25bp in Q2.

Our currency economistscontinue to believe that a USDcrash remains an outsidescenario and think the EUR/USDwill range between 1.22 and 1.25in the coming months.

Positive

Tax cuts in Germany (even if they are phasedin over 2 years) and France will supportgrowth. These are being used to offsetstructural reforms that threaten to depressconsumer sentiment near-term.

Prospect of improved labour markets andhigher capex (with sounder balance sheets).

If Fed doesnt raise rates; our strategists2H04 downturn in equities may not materialise.

Strategists prepared to stay exposed toMaterials, cap goods and insurance; alsofavour energy, food retail and pharma asdefensives.

Negative

With the Stability and Growth Pact buried,our economics team expects the ECB to startraising rates in the spring, to anchor inflationexpectations below 2%.

A likely rise in headline inflation from Marchonwards make bond markets vulnerable toan inflation scare, our economists believe.They expect Bund yields to test 5% over thenext 6-months.

EUR/USD may overshoot to 1.28 in 1Q04

(may drag growth; but control inflation).

75bp of tightening by ECB during 2004.

Europe

1. Economic / Strategy Outlook for 2004 / 2005 (ii)

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

Jan-97 Jan-99 Jan-01 Jan-03 Jan-05

UK Base RateMS Forecast3Mth Impl. Fwd Curve

(%) UK Repo Rate

Source: Morgan Stanley Research, Bloomberg

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0


Fed Funds

TargetMS Forecast

3Mth Impl.Fwd Curve

(%) US Fed Funds Rate


2.0

2.5

3.0

3.5

4.0

4.5

5.0


ECB Refi.

Rate

MSForecast

3Mth Impl.

Fwd Curve

(%) ECB Refi. Rate


ECB

Refi.

Rate

Fed

Funds

Rate

UK

Repo

Rate

Current 2.00 1.00 3.75

1Q04E 2.00 1.00 4.00

2Q04E 2.25 1.00 4.25

3Q04E 2.50 1.25 4.254Q04E 2.75 1.75 4.50

Exhibit 3: Morgan Stanley Interest Rate Forecasts and Market Implied Forward Curves

#1

Source: Morgan Stanley Research


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2. Convertible Valuations (i)


In spite of a year of decliningvolatilities (by implication,drawing convertible implieds

lower), convertible arbinvestors generally benefitedfrom improved Issuer credits.

From Exhibit 6, Convert Arbreturns in 2003 were, onaverage, in the low double-digit range.

Outright convertibleinvestors, as measured bythe MSGCI Euro 75 index,were up, on average, 6 7%.

Positive:

Convertible implieds have been relativelyresilient (compared to single-stockimplieds) during 2003, although the

market, in general, has been marked downabout 10 vol. points and now trades onrelatively attractive low 30s level (seeExhibit 5)

Versus the end of 1Q 03, the marketfeels less vulnerable to a further sharpcorrection in valuations.

New paper has tended to have attractivevaluations, as many Issuers stocks havemulti-year low volatilities.

20

25

30

35

40

45

50

12/02 02/03 04/03 06/03 08/03 10/03 12/03

Median Implied Vol.(10 day Moving Avg.)

Single-stock Impl.(Avg. 3M ATM)

(%)

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

Dec-99 Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

Monthly

Cumulative

(%) Convertible Arb Strategy Return, Monthly or Cumulative

Exhibit 5: Convertible v. Single Stock Option Valuations:Median Convert Implied Volat. Versus Avg. Single-stock Implied


Exhibit 6: Convertible Arbitrage Returns:Monthly and Aggregate Returns for CSFB Tremont Index

Source: CSFB Tremont

#2

Negative:

Convertible implieds are still

suspended at higher levels relative tosingle-stock vols. However, theirlonger-dated nature tends to keep themat a premium (in terms of higherimplieds).

Numerous new issues brought tomarket in December came on low

valuations, with implications for drawingbroader market valuations lower, if thattrend persists into 1Q04.


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16%

20%

24%

28%

32%

80 85 90 95 100 105 110 115 120

%Strike

ImpliedVolatility

1m 3m 6m 9m 1y

25%

26%

27%

28%

29%

30%

31%

32%

33%

34%

80 85 90 95 100 105 110 115 120

%Strike

ImpliedVolatility

1m 3m 6m 9m 1y

14%

16%

18%

20%

22%

24%

26%

28%

80 85 90 95 100 105 110 115 120

%Strike

Implied

Volatility

1m 3m 6m 9m 1y

Exhibit 11: European Banks SectorSingle-stock 80/120 Skews; Term Structures

Source: Morgan Stanley Equity Derivatives Source: Morgan Stanley Equity Derivatives Source: Morgan Stanley Equity Derivatives

Exhibit 12: European Telecoms SectorSingle-stock 80/120 Skews; Term Structures

Exhibit 13: European Tech SectorSingle-stock 80/120 Skews; Term Structures

3. Volatility What might trigger a reversal? (ii)#3


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4. Credit Spreads Further scope for tightening? (i)


Credit markets, both highyield and investment grade,have seen unprecedentedtightening over the past 12months. So much so, that

current spread levels arethe tightest in more than 5years (see Exhibit 14).

Our credit strategists pointto the fact credit marketsare pricing for perfection, inspite of an evident slowing

in the process ofdeleveraging (Exhibit 15).

MS credit strategy team are bearish on European credit markets and expect a meaningful correction in creditspreads in 1H04 (they look for the Dow Jones TRAC-X index to widen by 20bp)

In 2003, a combination of renewed GDP growth, balance-sheet repair and an accommodative monetary policywere key drivers behind the rally in credits. Now they think the risk / reward trade-off is unattractive. They dontbelieve that technical factors (such as strong demand for credit coupled with likely limited new supply) will play-

out to the same degree in 2004.

They estimate credit risk premium has fallen to sub 20bp (or even close to 10bp if one strips out Parmalat), from120bp mid 2002. This, they believe, leaves little margin for error in terms of continued deleveraging.

Possible triggers to wider spreads in 2004:(i) global growth slow-down (particularly in the US and China)(ii) monetary tightening (particularly if the underlying growth proves not to be robust)(iii) breakdown in balance-sheet discipline (renewed capex in pursuit of growth)

Favour securitised product over corporate bonds; favour non-cyclicals (telecoms and utilities) over cyclicals(industrials and basic materials);

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03

0.00

0.50

1.00

1.50

2.00

2.50

3.00

Net Debt (LH) Leverage (RH)

Net Debt ( millions) Leverage (times)

Exhibit 15: Decline in Net Debt of European Corps. Has SlowedNet Debt and Leverage Stats for circa 20 Largest Eur. Credits

Source: Morgan Stanley Fixed Income Research

#4

0

20

40

60

80

100

120

140

160

180

12-98

03-99

06-99

09-99

12-99

03-00

06-00

09-00

12-00

03-01

06-01

09-01

12-01

03-02

06-02

09-02

12-02

03-03

06-03

09-03

12-03

0

200

400

600

800

1000

1200

1400

1600

1800

ECCI Spread (Left Hand Axis)

High Yield Spread (Right Hand Axis)

ECCI Spread (bp) MSHYi Eur & Stg (bp)

ECCI European Corporate Credit Index

MSHYi Morgan Stanley High Yield Index

Source: MSCI

Exhibit 14: Tightening High Yield / Invt. Grade Spreads5 year spread history for key European Credit indices


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5. Deleveraging Persisting with Bal. Sheet Repair


Positives:

The European Telecom sector has demonstrated thegreatest progress in terms of reducing net debt. InQ202, net debt was close to 200bn. As of Q303, netdebt is now under 150bn.

Net Debt-to- Operating Cash flow has normalised forthe telecom sector (Exhibit 18). The European utilitysector has also reversed part of the aggressiveleveraging it undertook in 2002.

2002 / 2003 saw the emergence of cross-over

credits as an important asset-class. By now, themajority of cross-over names have addressed leverageand liquidity problems, however the remaininguncertainty lies with the ability of management toachieve operational improvement and, by implication,sustainably generate cash.

Our fixed-income research group believe ABB, post its

rights issue, will have net debt/EBITDA of 1.4x, which ismore in-line with a single-A rating. They therefore seescope for as much as a further 150bp in tightening, iflegal approval for the companys asbestos trust can beachieved.

Of the European cross-over credits, our creditanalysts would highlight both Corus and EMI as the only

particularly vulnerable credits remaining. EMI iscurrently offered at 118 on a 2.4% YTM and the Corus

bonds are trading at 87.0 on a 11% YTM.

Exhibit 19: Status and Key Metrics of Cross-over European Credits(data is approximated and does not adjust for different reporting periods)

Company

Leverage (Net

debt / EBITDA)

Debt < 18 Mths

( bn) % Total Debt

Liquidity

(cash) ( bn)

Stable /

UncertainABB 1.9 4500 56 6200 Stable

Ahold 3.2 1975 15 1000 Stable

Alcatel n.a. 1800 28 7000 Stable

Carlton 2 21 1 771 Stable

Corus 13.7 701 29 432 Uncertain

EMI 2.9 112 8 141 Uncertain

France Telecom 2.8 10300 15 25400 Stable

KPN 1.9 900 8 2200 Stable

Repsol 1.4 1725 15 4500 StableRolls-Royce 2.2 800 37 1072 Stable

Vivendi Universal 2.6 4000 24 3151 Stable


#5

-1.00

-

1.00

2.00

3.00

4.00

5.00

6.00

4Q01 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03

NetDebt/OperatingCashFlow

Telecom Autos Utilities Consumer Industrial

Exhibit 18: Net Debt / Operating Cash Flow Gearing



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6. New Issuance / Redemptions (i)


On a dollar basis, Europeanconvertible issuance in 2003has been another record year,with almost $49bn in issuance

YTD compared to

approximately $47bn in 2001.

Exchangeables have returnedconvincingly, as Issuerpreference for convertsprevailed over block trades.

0.0

10.0

20.030.0

40.0

50.0

60.0

Exchangeable 8.7 14.9 26.4 2.9 21.0

Convertible 22.4 14.3 21.4 19.1 27.6

1999 2000 2001 2002 2003

US$bn

28%

55%Exchangeablecomponent was

51% in 2000

13%

43%

0

20

40

60

80

100

120

140

160

180

1996 1997 1998 1999 2000 2001 2002 2003

Asia

Europe

USA

Japan

Asia 7.1 7.8 5.3 2.2 4.8 6.2 8.8 12.0

Europe 11.0 14.4 24.2 31.1 29.2 46.2 21.3 48.6

USA 36.8 33.7 35.2 42.0 56.2 102.5 57.0 85.0

Japan 41.1 8.8 2.4 8.3 4.6 4.8 7.2 11.1

1996 1997 1998 1999 2000 2001 2002 2003

US$ billion - New Issuance

(to mid Dec.)

Exhibit 20: Global Convertible Issuance (1998 2003), by Region (US$bn)

Total Gross Issuance, converted into US dollar at the prevailing FX rate

Exhibit 21: European Convertible v. Exchangeable Issuance

Split between pure Convertible and Exchangeable-type Issuance

Source: Morgan Stanley Research Source: Morgan Stanley Research

#6

Positive:

Following a disappointing 2002, this year hasbeen another important year for the convertibleproduct, with close to $160bn in issuance, in-linewith record issuance in 2001.

In Europe, Exchangeable issuance has been aboon. This is encouraging for continued supply ofnew paper in our market.

The mandatory market made encouragingprogress in 2003.

Negative:

Weve had a relatively heavy calendar over thepast month, so valuations are already becoming a bitpressured, in anticipation of a busy Q1.

A tightening interest-rate cycle and lower volatilitycertainly dont augur well for continued newissuance, but as weve highlighted in the past, theseare secondary drivers much more important arethe general buoyancy of equity markets and thescope for renewed M&A-driven issuance.


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6. New Issuance / Redemptions (ii)#6

0

5

10

15

20

25

30

35

40

45

>100%

50 - 100%25 - 50%

100% 2.2 20.1 26.5 7.9 6.2 0.9

50 - 100% 0.0 7.4 3.5 9.4 7.1 1.8

25 - 50% 1.0 3.0 4.8 6.8 3.6 11.7


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7. Prospectus Language / Structures


As M&A picks up, bring withit more corporate actions inits wake, we wouldreemphasise the importance

of focusing on prospectusrisk.

As competition on theinvestment banking /origination side of thebusiness intensifies furtherin the convertible space,expect greater complexityof structures.

#7

Positive:

Most new deals seem to be considerablymore bond-holder friendly, in terms ofchange-of-control language and in somecases, dividend pass-throughs.

2003 saw the emergence of fully-mandatory structures. In a year whentraditional convert arb was under pressure,these carry trades proved effective.

The average maturity of issues inEuropean has lengthened back to 6 years,

which is positive, in our opinion. Whilethere have been a number of sub 3-yearstructures, the market seems to havelearned its lesson.

Negative:

Soft Mandatory structures are becoming moremainstay; while they give the Issuer greaterflexibility, they can often complicate matters forthe investor for instance, most soft-mandatoriesremain undeliverable against CDS contract.

There will be greater investor wariness towardsSPVs (special purpose vehicles) and holdingcompany financing vehicles as Issuers.

Were anticipating more restructuring-type /repair-type deals such as extending puts; or

tendering into longer-dated bonds.


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8. Accounting Convergence Macro Repercussions


#8

Near-term potential forconfusion and volatilityRegulators could ask more

questions on financial reportingpractices fostering greatervolatility and wider risk premiathrough 2004. Could the processalso uncover further Parmalat-likesurprises? Into 2005, additionaldisclosure and accountancy of off-balance sheet items will take time

to be digested. Could we seetechnical defaults of debtcovenants as leverage andprofitability ratios are re-calibrated?

Transparency in longer-term todampen volatilityBetter disclosure should enablemore creditable assessment ofrisks and improved credit profiles,ultimately dampening credit andequity volatility.

International Financial

Reporting Standards

20062005 2007

European Union-- listed companies by 2005 (or 2007 if US

GAAP applied to primary accounts)

Australia -- listed companies

Switzerland -- companies listed on the main board of Swiss

Exchange must use IFRS or US GAAP

United States -- Short-term convergence for limited projects due 2004

Continued review and harmonisation to IFRS is expected but no legislation or formal statement

on the timing of convergence exist. Significant differences to IFRS remain.

SECs target year for convergence is 2007 but talk of the requirement for IFRS-using foreign

entities who are US registrants to reconcile to US GAAP may change before 2007, either

dropped altogether or supplemented with an abbreviated bridging statement.

????

Convergence timeline

uncertain

Formal commitment to

move to IFSR

Key

Timeline for Converging to an International Account Standard

Exhibit 31: Timeline for Converging to IAS


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9. European Enlargement


Unlikely to have anymeaningful implications forthe convertible market, assuch, but this could be a

theme to drive the underlyingstocks of several existingconvert Issuers.

A Possible Theme for Markets to Focus On?

May 2004: 10 new countries join the EU-15; 20% population increase; 5% GDP increase;Poland, Hungary and Czech Republic are key (make up 75% of GDP of acceding 10 countries).

European Commission estimates GDP to get 0.7% boost over the next decade as a result ofenlargement (benefits of low-cost production base). AC-10 are already a relatively importanttrading partner with EU-15 (10.9% of imports; 12.6% of exports).

Important new market not only in terms of cheaper production (labour costs on average 20%of those of Germany), but also in terms of new and expanding consumer markets.

Revenue exposure in terms of W. European corporates is minimal at 2.4% (although for theMaterials sector, it is 5%). The auto industry now has circa 15% of its capacity in E. Europe,which is expected to rise.

E. European Exposure (with outstanding converts): SABMiller (21% of revenues come fromthe region); Unicredito (15% of revenues ); France Telecom (10% of revenues through Polishwireline); Continental (11% of revenues; 16% of production); Holcim (8% of revenues); Arcelor(8% of revenues); Deutsche Telekom (7.6% of revenues); Tesco (7% of revenues, mostly

through Polish Hit business) and Danone (6.2% of revenues). Were not expecting any meaningful impact of enlargement in terms of new issuance.

#9


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10. Cross-Asset Investing


Market transparency isimproving all the time,making it easier to lookacross an entities various

asset classes.

Capital Structure Arb wasntall that it was hyped-up to beduring the recovery phase of2003 (fallen angels in 2002tended to present betterasynchronous opportunitiesbetween asset classes).

Still, the market now thinksmore broadly about how tovalue a given asset-class andincreasingly looks to cross-reference other important

pools of liquidity in a givencompanys issued securities.

0

25

50

75

100

125

150

Jan-02 Apr-02 Jul-02 Sep-02 Dec-02 Mar-03 Jun-03 Sep-03 Dec-03

0%

10%

20%

30%

40%

50%

60%

TRACX Eur.100

Estoxx Implied Vol. (3M ATM)

Single-stock Vol. Index

Euro TRAC-X 100 (bp) Implied Volatility (%)

53bp

Exhibit 33: European Vol. v. Credit Market MetricsCorrelation Between Equity Volatility and Credit Spreads Declining


#10

Positive:

The re-emergence of Merton-type modelshas forced the market to probe more deeplyinto optimal company capital structures andquestion the merits of being invested in one

asset class, versus another. While cutting edge buy-siders werefocussed on this many years back, mostinstitutions now make a better effort to lookacross asset classes. Convertible investors,by their nature, still have a competitive edgein this space.

Convertible models, encompassing firmvalue and more of a Merton-type approachare re-emerging.

Negative:

As the volatility of credit spreads and equityvolatility have declined, so too has the correlationthat was evident between the two for the 18 monthssince January 2002.

Per Exhibit 33, volatilities continue to decline asspreads move side-ways. The most recent spread-widening spurred-on by Parmalat, has yet to haveany meaningful impact on broader European stockvolatility.


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Regulatory Disclosures


Analyst Certification

The following analysts hereby certify that their views about the companies and their securities discussed in thisreport are accurately expressed and that they have not received and will not receive direct or indirectcompensation in exchange for expressing specific recommendations or views in this report: Colum McCoole,Kelley Myers.

Important US Regulatory Disclosures on Subject Companies

Important US Regulatory Disclosures on Subject Companies

The information and opinions in this report were prepared by Morgan Stanley & Co. International Limited and itsaffiliates (collectively, "Morgan Stanley").

As of November 28, 2003, Morgan Stanley beneficially owned 1% or more of a class of common equity securitiesof the following companies covered in this report: Corus, EMI, Rolls-Royce, Vivendi Universal, Unicredito Italiano,Continental, Holcim, Carlton Communications, France Telecom, KPN, Repsol-YPF, Danone.

Within the last 12 months, Morgan Stanley managed or co-managed a public offering of securities of Rolls-Royce,SABMiller, Deutsche Telekom, France Telecom, Repsol-YPF.

Within the last 12 months, Morgan Stanley has received compensation for investment banking services from AholdNV, Corus, SABMiller, Continental, Deutsche Telekom, Alcatel, France Telecom, KPN, Repsol-YPF, Tesco.

In the next 3 months, Morgan Stanley expects to receive or intends to seek compensation for investment bankingservices from Ahold NV, ABB, Corus, EMI, Rolls-Royce, Vivendi Universal, SABMiller, Unicredito Italiano,Continental, Holcim, Arcelor, Deutsche Telekom, Alcatel, Carlton Communications, France Telecom, KPN,Repsol-YPF, Danone, Tesco.

The research analysts, strategists, or research associates principally responsible for the preparation of thisresearch report have received compensation based upon various factors, including quality of research, investorclient feedback, stock picking, competitive factors, firm revenues and overall investment banking revenues.

Morgan Stanley & Co. Incorporated makes a market in the securities of Ahold NV, ABB, Corus, Unicredito Italiano,Alcatel, Carlton Communications, Tesco.


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10 Things to Think About in 2004 (MS)

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