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Overview

Equity Research Europe

Periodical

April 16, 2003 Flagship Conferences — Hold the Date 3

Strategy and Economics

EUROPE Teun Draaisma European Strategy: Japanese Roadmap for European Equities 7 Annemarieke Christian Euroland Economics: But What About Debt? 9 Christel Rendu de Lint UK Economics: 2003 Budget — The Growth Dance 10 Elga Bartsch German Economics: The State of the Reform Play 11 GLOBAL Barton M. Biggs Global Strategy: Asset Allocation — Art and Science 13 S. Galbraith/M. Viviano/F. Lim US Strategy: Fat Tails Thinning 15 Richard Berner US Economics: Balance Sheet Repair Still a Work in Progress 17 Andy Xie Asia/Pacific Economics: Crazy? 19 Stephen L. Jen Currencies: The JPY and Low and Falling Yields in Japan 21

Quarterly Volatility Rating Update

Europe: All European Stocks Under Coverage with Volatility Flags 24 Europe: Volatility Flags Added Since January 22, 2003 25 Europe: Volatility Flags Deleted Since January 22, 2003 25 Europe: Changes in Reasons for Volatility Flags 25

Opinion Changes

Luis Prota/Juan Jimenez/Paul Marsch ! Portugal Telecom: Downgrading to Equal-weight 27 Javier Marin/Edward Steel ! Media & Internet: Downgrading Stocks on Valuation Grounds 29

New Coverage

J. Messenger/A. Pereda/B. McGarry Travis Perkins: More Than a ‘Safe Haven’ 31

Industry Analysis

Alejandra Pereda Building & Construction: Waiting for the Dragados Deal Outcome 33 Pablo Morales/Martin Borghetto Transport: Aberti — Use an Alternative Route 35

Continued...

European Investment Perspectives

Morgan Stanley

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European Investment Perspectives – April 16, 2003

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Page 7

European Strategy April 14, 2003

Japanese Roadmap for European Equities Teun Draaisma ([email protected]) (+44 20 7513 6600)

This is an extract from a report (16 pp) dated April 14, 2003.

Could Europe be the next Japan? Is Germany already the next Japan? What are the implications for investors, in terms of asset allocation, sector selection and stock selection? These are the questions we try to answer in this study.

In economic terms, Europe is possibly not the next Japan. We have more confidence in the political and corporate system in Europe, the bubble was smaller than in Japan, monetary policy is more proactive already and the financial system is healthier. Low growth, low inflation is more likely than outright deflation. However, structural reforms are needed and wages need to moderate, and this might take several years.

However, European equity markets are set to face a Japan-style period. We expect equity markets to be range-bound and volatile in the next few years, with the range for MSCI Europe between 700 and 1,100 broadly. Despite the many differences between Japan in the 1990s and Europe now, similarities abound. We expect economies to show low growth and pressure on profit margins.

The main message of this study is the implications for investors. If European equity markets are in this multi-year range trading environment, characterised by low nominal growth and high volatility, the Japanese experience holds nine concrete lessons for investors, we believe.

1. Market timing is everything in the low-return, high-volatility world. In Japan, a buy-and-hold equities strategy was doomed. Between 1990 and 2003, buy and hold would have yielded an average annualised return of minus 7%, for 22% annualised volatility. Buying and holding bonds yielded 7% for 6% volatility, not spectacular but much better. Getting the market timing between equities and bonds right significantly improved this return, since there were four rallies of over 30% in the last 12 years. If you had perfect monthly foresight, your return would have increased to 36% for 12% volatility!

2. To justify market timing, one had to be right at least 70% of the time. If the default strategy is owning bonds throughout the difficulties, how often should an investor be right in order to justify doing market timing between equities and bonds? The answer is at least 70% of the times, in the period between 1990 and 2003 in Japan. This is based on a modelling exercise, assuming that an investor decided every month to invest all in equities or all in bonds (Exhibit 1).

3. Hopes of a change in policy were the main driver of equity market rallies in Japan. According to our Japanese colleagues, rallies were driven time and time again by the hope of improvement. The hope could be related to fiscal policy, such as Prime Minister Miyazawa�s switch to aggressive fiscal easing in August 1992, or monetary easing, such as when the yen weakened significantly starting in 1995, or structural policy reform, which seems to be happening now.

4. Valuations at the market level were useful for sell signals, but not for buy signals. We back-tested a whole range of traditional valuation measures, but our conclusion could only be that valuations did not matter. Rallies happened only from a cheap valuation base, but being cheap was by no means a sufficient buy signal. However, being expensive was a sufficient sell signal.

5. Similarly, the bond bubble is likely to persist as long as we are not out of the woods, growth remains sluggish and markets risky. In other words, in the fixed-income market too, valuations are not enough.

6. Use a normalised cost of equity, because lower bond yields do not mean a lower cost of equity. The correlation between bonds and equities turned negative in Japan after the financial bubble burst. This decoupling meant that, when bond yields fell, equity markets fell too. The cost of equity rises when rates fall, because the risk premium goes up more than rates go down. This is another way of saying that, when deflation threatens, lower rates are bad news not good news.

7. Return reversal (one month) was the best tool for picking stocks and sectors. Of all measures tested by our Japanese quantitative analyst Katsuji Moriguchi for stock or




Page 8

sector picking, the best measure was one-month return reversal (Exhibit 2). In other words, in a range trading market, you should buy what has just gone down, and sell what has just gone up. This factor is even stronger if applied sector by sector, or on a sector-neutral basis. It is also one of the best measures for sector selection.

8. Valuation worked reasonably well for stock and sector picking. Other measures that worked were valuation metrics such as P/BV, P/E and dividend yield. But these factors were much less consistent than the one-month return reversal strategy we found earlier. What did not work were earnings revisions, return on equity, or 12-month momentum or return reversal. For sector selection, one-month return reversal was not the best factor. Better factors for sector selection included normalised P/BV and historical P/E.

9. Look for stable growth, pricing power and export- oriented industries. The strong finding that return reversal was the most successful stock- and sector-picking strategy does not mean there were no long-term winners. In looking at the table of best and worst sectors, we learn that, since

1990, Pharmaceuticals has been by far the best performing sector. The worst have been Banks, Diversified Financials and local sectors such as Hotels, Real Estate and Retailing. It seems that desirable attributes are stable growth such as is found in the Health Care sector to counter the low-growth environment, pricing power through specialised areas such as Household & Personal Products and luxury goods to counter the deflationary threat, and export-oriented sectors such as cyclical leaders to circumvent the problem of sluggish domestic demand.

Finally, Europe stands a better chance to come out of this stronger than Japan did. The differences between Europe now and Japan in the 1990s suggest to us that Europe should have a better chance to get out of this difficult situation in the coming years. Monetary policy is effectively more proactive already and the health of the financial system is better. The missing element is serious structural reform. German Chancellor Schröder�s recent speech was encouraging. Let us hope that European authorities have learnt the lesson from the Japanese experience. If that is the case, we believe Europe will go through a Japanese-style period only for a couple of years or so. The risk is that it will last longer.

Exhibit 1

Market Timing and Asset Allocation in Japan, 1990-2003 Choices between equities and bonds needed to be correct 70% of the time in order to beat holding bonds throughout

Bonds

Equities

Never right10% right

20% right30% right

40% right50% right

60% right

70% right

80% right

90% right

Always right

-40

-30

-20

-10

0

10

20

30

40

0 5 10 15 20 25

Volatility

Ret

urn

Note: Chart shows risk-return profiles based on owning bonds throughout, owning equities throughout, and various levels of accuracy in case of active asset allocation. Source: Morgan Stanley Research

Exhibit 2

Best Five Stock Selection Strategies in Japan (Sector Neutral)

0%

50%

100%

150%

200%

250%

300%

Mar

-92

Sep-

92

Mar

-93

Sep-

93

Mar

-94

Sep-

94

Mar

-95

Sep-

95

Mar

-96

Sep-

96

Mar

-97

Sep-

97

Mar

-98

Sep-

98

Mar

-99

Sep-

99

Mar

-00

Sep-

00

Mar

-01

Sep-

01

Mar

-02

Sep-

02

Mar

-03

1 month return reversalAttractive PB3 month return reversalAttractive Dividend YieldAttractive IBES PE

Note: Our Japanese quantitative analyst Katsuji Moriguchi tested 18 different sector-neutral stock strategies, based on going long the first quintile and short the fifth quintile. These are the best five, with easily the most consistent being the one-month return reversal strategy. Source: MSCI, Morgan Stanley Research QS Japan




Page 9

Euroland Economics April 14, 2003

But What About Debt? Annemarieke Christian ([email protected]) (+44 20 7513 4182) Markets overlook dangerous debt dynamics. With markets focusing primarily on budget deficits at the moment, the danger is that they may lose sight of the other important pillar of the Maastricht framework: government debt levels. While the deficit only provides a snapshot of fiscal policy, the debt level is key when it comes to the long-term sustainability of public finances. Here, we look at the long-term debt dynamics of the three high debt countries in the euro area, Belgium, Italy and Greece. According to our simulations (see Exhibit 1), Belgium is in the best position to reduce its debt markedly in the next decades. While Italian debt is likely to decline only gradually, Greece should be helped by strong growth in the near term, but could see debt rising again as growth is likely to converge towards that of its euro area peers in the long term.

Belgium likely to reduce debt faster than Italy and Greece. Our long-term debt simulations take into account the effects of an ageing population on public finances and are based on the GDP growing at trend. We assume no other structural changes in fiscal policy. These simulations indicate that Belgium could bring its government debt down below the Maastricht limit of 60% of GDP within a decade. Meanwhile, the Italian debt level is likely to ease only gradually and remain firmly above 60% of GDP during the period up to 2030. Greek debt reduction is likely to receive a boost from relatively strong GDP growth in the near term. However, with growth likely to converge towards the euro area average in the long term, the debt level could start to spiral upwards again from around 2020.

Similar debt levels to start with … Belgium is in a stronger position than Italy and Greece in terms of managing the costs of an ageing population. Estimates by the European Commission (EC) suggest that Belgium could face an increase in pension and healthcare expenditure of around 4.4% of GDP up to 2030. While the EC estimates the increase in public expenditure to be smaller for Italy (2.9% of GDP), Greece is likely to have to cope with a much larger increase of around 8% of GDP up to 2030. However, at the moment, both Italy and Greece have a higher share of pension and healthcare expenditure in GDP than Belgium. In

addition, their cyclically-adjusted primary budget surpluses are lower than is the case in Belgium. As a result, our analysis indicates that the pace of debt reduction should be slower there than in Belgium.

… but very different long-term dynamics. On our analysis, the Belgian level of debt should ease steadily to below the limit of 60% of GDP in the next decade and fall further thereafter. The level in Italy is likely to ease much more slowly, remaining firmly above the 60% limit over the period to 2030. Greece faces a much tougher challenge with regard to population ageing. While strong GDP growth in the next few years could bring the debt level down below 60% of GDP in a decade, the growth outperformance of Greece relative to the euro area is not likely to last in the long term. As a result, we see the debt level spiralling back up from 2020 Thus, our simulations show that similar debt levels at present can mask very different developments in the long term. With the demographic pressures associated with an ageing population likely to kick in around 2010, we think that markets ought to turn their attention to debt levels soon, if they have not already done so.

Exhibit 1 Belgium, Italy and Greece: Long-Term Debt Dynamics, 2000-30

0

20

40

60

80

100

120

2000 2005 2010 2015 2020 2025 2030

% of GDP

Italy

Belgium

Greece

60% limit

Note: Our simulations are based on trend growth of 2.2% for Belgium, 1.8% for Italy and growth convergence from 3.2% now to 2.2% in 2030 for Greece. Source: Morgan Stanley Research estimates




Page 10

UK Economics April 9, 2003

2003 Budget — The Growth Dance Christel Rendu de Lint ([email protected]) (+44 20 7513 4182)

Hopeful budget spells trouble for the future In his budget statement on April 9, UK Chancellor Gordon Brown announced additional spending, no significant changes in taxes and lower growth forecasts, yet he managed to increase net borrowing by less than observers had been expecting. This fails to square up well, in our opinion. We think Gordon Brown is counting on increasingly optimistic growth and tax elasticity projections. While he did lower his forecast for GDP growth for this year, it is still well above ours; he also increased his growth forecasts for the following years; and, most importantly, he left his projections for domestic demand growth � the part of GDP that matters for fiscal receipts � unrevised at a substantial 3.0-3.5% on average over the next three years. He also expects fiscal receipts to grow faster over the next five years than was postulated in the pre-budget report. We find these bullish assumptions alarming and think that they signal a lack of real commitment to bringing public finances back into check.

Only very minor revisions The Chancellor made the smallest possible adjustments, in our view. While this may have made his announcement easier, we think it might well make prospective budgets considerably less pleasant. As we expected, the Treasury cut its GDP growth forecast by 0.5 percentage points in 2003, to 2.0-2.5%. However, it left its projection for 2004 unchanged at 3.0-3.5% and raised its forecast for 2005 by 0.25 percentage points to 3.0-3.5%. These mini-revisions leave growth well above our projections of 1.7% this year and 2.4% in 2004.

Breakdown of growth reveals a lack of prudence We believe that, when broken down, these results reveal a lack of prudence. Although this year�s GDP growth forecast was reduced, the government�s expectation for domestic demand growth (on which almost all fiscal receipts draw) was left unrevised in 2003 at 3.0-3.5%, which we view as optimistic compared with our own expectation of only 2.5%. Indeed, while Mr. Brown lowered his fixed investment

expectation, he actually increased his forecast for household spending by 0.5 percentage points to 2.75-3.0%. We view this as particularly risky because we believe that spending is on the verge of a sharp slowdown and should at best rise by 2.2% this year (see �How Much of a Bubble?� in UK Panorama, March 14, 2003). If our more bearish stance is correct, VAT receipts alone could turn out to be some £400 million lower than projected by the Chancellor.

Net borrowing raised less than we expected … The main components of the additional spending Mr. Brown announced are £1.5 billion on the war in Iraq (bringing the total to £3 billion), £330 million on domestic anti-terrorism measures and £240 million on UN humanitarian relief. The additional spending amounts to roughly £2 billion. The 0.5 percentage-point downward revision to GDP growth, on the Treasury�s own rule of thumb, implies a £2 billion shortfall in fiscal receipts. The total rise in net borrowing should therefore be £4 billion. However, the Chancellor announced an increase in net borrowing this year of only £3 billion, taking total borrowing to £27 billion. How did he manage to save £1 billion? He cut this year�s gross investment by the same amount. For next year, net borrowing has been raised by £5 billion to £24 billion, in line with our expectations.

… but we think this is only the beginning Except for Ireland and Luxemburg, the UK has the lowest debt ratio in the European Union and one of the lowest in the OECD. The UK government can afford to use fiscal policy to reflate the economy now. However, the Treasury needs to show that it is committed to reducing deficits again in the future. This means controlling spending, but also making realistic assumptions about expected fiscal receipts. Instead, the Chancellor has raised his already aggressive assumptions. The government expects fiscal receipts to rise by 6.7% per year over the next five years, versus 6.5% previously. A realistic assumption, in our view, would be to count on a growth rate of 5%, in line with potential nominal growth (2.5% real trend growth and 2.5% inflation). The bottom line is that we expect net borrowing to increase again in the next pre-budget report, to £31 billion this year and £28 billion in 2004.




Page 11

German Economics April 14, 2003

The State of the Reform Play Elga Bartsch ([email protected]) (+44 20 7513 5434)

Economy holding up better than expected, so far. Admittedly, the coincident economic indicators reported out of Germany recently have been significantly better than we had expected. Despite showing a small contraction on the month, industrial production, order demand and retail sales all suggest that an outright contraction in first-quarter GDP, which is what we had pencilled in, now seems unlikely. By contrast, we are probably looking at a small, positive growth rate for the first three months of the year. Growth seems to have been underpinned by consumer and investment spending alike. This is remarkable in itself, if you consider that social-security contributions have been increased by around �17.5 billion or 0.8% of GDP. As payroll taxes are split equally between employers and employees, household disposable income is likely to have contracted by around 0.5% on the quarter. This implies that, absorbing the shock, the savings rate is likely to have dropped by more than 1 percentage point from the 10.6% of household disposable income recorded late last year. Likewise, domestic orders placed with German capital goods producers point to a continuation of the recovery in capital expenditure, already seen in the fourth quarter of 2002, in early 2003, thus defying the negative repercussions on corporate profits. However, weakening business and consumer confidence, together with deteriorating labour-market conditions during March and a renewed rise in the savings rate, points to a weak entry into the second quarter. So, even though we might eventually raise our annual 2003 GDP growth average by a few tenths from an abysmal �zero-growth� projection at the moment, there is not much reason to rejoice (yet).

Schroeder’s reform plans reach critical juncture … In addition, the implementation of Chancellor Schroeder�s reform agenda is reaching a critical point (for details of the agenda see German Economics: Schroeder’s Master Plan, March 18, 2003). While the administration is busy drafting new legislation on labour markets, healthcare and social security, resistance against the reforms within the Social Democratic Party (SPD) and the trade-union camp seems to be on the rise. This holds in particular for reforming labour-market institutions, which are at the heart of Germany�s meagre economic performance (see Is Germany Doomed? January 3, 2003) and also form the centre of the reform package. The labour-market reforms will be split into two separate draft laws. While both should become effective by January 2004, the first, covering job protection and unemployment benefits, is scheduled to be debated in cabinet in May. The second, covering the merger of social and unemployment benefits, will only be sent to cabinet in August.

… as party leadership calls for a special party congress … In order to address these concerns, Chancellor Schroeder has called for a special party congress in early June. Not known to shy away from taking political risks, he will probably use this opportunity to align the party behind his reform agenda. And even though he might be willing to compromise on some of the lesser details, he and his party leadership seem determined to press ahead on reforms, hoping that party delegates will not go as far as voting down the reform package altogether, thereby risking an early election. Since his State of the Nation address in mid-March, there can be no doubt that Chancellor Schroeder is willing to put his political future on the line to push through the reforms. But it is by no means clear that the message coming in unison from a vast number of academic and empirical studies, including yet another reprimand on the lack of labour-market reforms from the European Commission last week, has sunk fully into the mindset of the party�s left wing. The question is, however, whether the SPD�s left-wing would go as far as toppling Chancellor Schroeder, who (unlike his party) has bounced back in terms of personal popularity lately.

… and as further holes are gaping in the budget. Unfortunately, Chancellor Schroeder has no tax money left

Exhibit 1

Main Elements of Schroeder’s Reform Agenda • Limit the maximum duration of unemployment benefit to 12

months (18 months for older job-seekers aged 55 and over) from the present 32 months.

• Reduce unemployment benefits towards the level of social benefit. • Remove sickness benefits from statutory health insurance, where

contributions are split equally between employees and employers, and offer private insurance coverage for employees instead.

• Lift job-protection legislation for smaller enterprises. • Enforce opening clauses to industry-wide wage contracts, if

needed.

Source: Chancellor’s Office




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to sweeten the deal for the left-wing hardliners within the SPD. In fact, following the compromise reached between both houses of parliament last Friday, he is still short by about �2.4 billion in terms of consolidation effort prescribed by the Excessive Deficit Procedure for this year�s budget. And, while the effect of the lower-than-planned amount of tax rises on this year�s budget is marginal, the longer-run impact on the budget is not. Instead of a total of �15.6 billion, the government will now only raise �4.4 billion through tax changes, thereby leaving a total budget gap of about 0.5% of GDP. Hence, unless some additional budget savings are implemented, in the form of either tax rises or spending cuts, the German budget deficit runs the danger of overshooting the 3% Maastricht-threshold for the third year running.

Missing the deficit ceiling again in 2004 would have significant repercussions on the workings of the European Stability and Growth Pact and could possibly put rating agencies on alert too. But Finance Minister Eichel is likely to hold fire until the next tax estimate, due in mid May, reveals the full extent of tax revenue shortfalls. Given that the government�s growth estimate for this year, underlying the tax estimate, will probably decline from 1% to less than 0.5%, there will possibly be an additional shortfall in tax

revenues of �3 billion, leaving Hans Eichel with a budget hole of �5 billion for this year alone. Apart from the holes in

the budget, additional funding shortfalls are looming in the social-security system. The state pension scheme, whose liquidity reserves have fallen to a half month of payouts, may have to dip into real-estate sales to maintain liquidity requirements.

Uphill struggle ahead for the Schroeder government. In conclusion, the German government is facing an uphill battle in the next few weeks: pushing through with reform and getting a grip on the budget deficit. Unfortunately, the attempt to lift some labour-market restrictions has already met with some resistance within both the SPD and the trade-union camp. In this context, the recent nomination of Jürgen Peters as successor to Klaus Zwickel, the moderate leader of the powerful IG Metall union whose term expires this autumn, signals the unrest that the proposed reforms have caused already at trade-union headquarters. With Mr. Peters, a traditional trade unionist, as their designated new leader, the trade unions are probably poised to raise the stakes. But, if the trade unions as well as the SPD party�s left-wing were to embark on a strategy of fundamental opposition to any legislative changes that would free the economy from some of its shackles, they would both risk losing their influence on the reform process altogether. Next to that, it would be unwise (and thus, unlikely), we think, for the trade unions to oust Chancellor Schroeder on the back of his reform proposals and risk an early election. For such early elections might give rise to a change in government, because the opposition leads the present Red-Green coalition by a wide margin in the opinion polls. And, with the economy likely to stagnate for yet another year, unemployment edging towards the 5 million mark and a budget deficit far above the 3% ceiling, the writing on the wall should be all too clear even for die-hard leftists.

Exhibit 2

Main Elements of the Tax Compromise • Three-year moratorium on tax rebates that companies can claim

when paying out dividends. These deferred tax assets still stem from the time when the corporate tax on retained earnings was above that on distributed earnings.

• Limiting the ability to offset profits of one company against losses of another within a group of companies (Organschaft) and for so-called �sleeping� partnerships.

• The ability of local municipalities to reduce the trade income tax levy from an average rate of around 16% to zero should be curtailed from next year.

• The proposal to increase income taxes on company cars, to raise fuel taxes on intra-European flights and to extend capital gains taxes on the level of the individual investor have been abandoned (see Small Print, October 17 2002 for details). While tax subsidies to first-home buyers remain in place for now, there is still a possibility that they could be limited to a level of subsidies that buyers of existing homes will receive in the future.

Source: Government sources




Page 13

Global Strategy April 14, 2003

Asset Allocation — Art and Science Barton M. Biggs ([email protected]) Last week we had our annual spring Lyford Cay Conference for investment fiduciaries. The sky was clear, the sun sparkled on the blue ocean, but I would characterize the mood as somber and restrained. Conviction levels are low, and most of the chief investment officers of pension funds and endowments present say they are looking to increase allocations to absolute-return strategies of one type or another. Equity ratios have been reduced substantially, some funds are even below their minimum equity benchmarks, and there was a definite sense in the group that the piper has not yet been paid in full.

This emotion was best expressed by Sir John Templeton, now 90 years old, a little frail, but still doing his daily walk up the beach in (but not yet on) the ocean. He articulately argues that progress in medicine, technology, and world trade is accelerating, and he forecast that the Dow would reach 1,000,000 in this century. But, in response to a question, he said he was not particularly optimistic about the next decade. He pointed out that after the bursting of every bubble he had studied, there was invariably a long period of low returns in the affected asset class. The bigger the bubble; the longer the dull period. However, that did not exclude the possibility that other asset classes might prosper.

Sir John is a very religious and philosophical man, so it was fascinating to hear him say that although there has been fantastic progress in so many areas of human endeavor, he was deeply disappointed that there wasn�t progress in religion and spirituality. The leaders and thinkers of all the major religions are focused on rejection rather than growth, and tend to be more interested in debunking other religions and debasing new ideas than in developing innovative approaches to expand human spirituality. This neglect is reflected in the fact that The Templeton Prize, the richest international award, has a real scarcity of nominations.

David Swensen was also present. I have written several times about David, always with awe and respect for the incredible record he has put together at the Yale Endowment. It is in the first percentile of the relevant data base. He has probably done more for Yale than anyone who has ever lived,

with the possible exception of old Elihu himself. With the numbers he has put up (17% a year for 20 years through rain and shine), David could go anywhere, but he loves the investment environment at Yale and teaching. He combines the intuitive art of contrary asset allocation with the science of analysis. He is a philosopher prince in a profession saturated with self-promotional paranoids.

When David spoke, everyone listened. As he explained his basic philosophy, the two fundamentals of a portfolio should be, first, an orientation to being an owner, in other words, equities; and second, diversification. Someone asked about the role of liquidity. It�s both a fallacy and an illusion, Swensen answered. He doesn�t worry much about liquidity. In fact, he says, markets pay you staggering amounts for accepting illiquidity. The Yale portfolio looks illiquid, but actually through repos the endowment could easily raise several billions of dollars in a few days.

After the meeting I asked David whether he really was convinced that in the long run, equities were truly superior. Was it possible that there could be long periods in which equities were actually inferior? Peter Bernstein has recently questioned what the long-term return from equities really is. He notes that the Ibbotson data, which everyone cites and which shows that the annual geometric total return from equities was 11.0%, begins in 1926 when valuations were low and ends in 2000 when they were still high. If your entry point was the year 1900, the return from equities for the century would be a lot lower. Maybe equities have lost their luster.

Swensen rightly replied that almost by definition in a capitalist system, an ownership position has to deliver a higher return over the long run than a creditor position. Afterwards, I looked to see what Ibbotson had to say on very long-term returns. Its 2001 yearbook addressed this issue, noting that from 1825 to 1925 the geometric total return from equities was 7.3%. From 1825 through 2000 the geometric mean was 8.9% per annum, and the arithmetic mean was 10.4%. It is interesting to note that in the geometric mean calculation, the income return was 5.2%, and capital appreciation was only 3.5% per annum. These returns compare favorably with the 5.3% per annum return of




Page 14

long-term government bonds. Equities truly are the wealth creator.

Speaking of high returns, a new case study by the Harvard Business School of the Yale Endowment reports the record of Yale�s large venture-capital portfolio through the fiscal year ending June 30, 2000. At that time Yale had $1.16 billion (or roughly 11% of the endowment) in venture capital. The return was 132% in 1999 and 444.2% in 2000. For the five years ending 2000, the venture portfolio compounded at 105.4% a year, and it has grown 38.4% a year since 1978. The even larger LBO portfolio has compounded at 32.6% since 1978. Incidentally, Yale has reduced venture capital substantially since then and has avoided much of the destruction of the bursting bubble by hedging the venture equities that went public.

The last time venture capital had a run was from 1980 to 1983, during what in retrospect was a mini-bubble. The endowment posted returns of 208%, 33%, 26%, and 123% in those four years. In the subsequent six years, annual returns for the endowment�s portfolio averaged 3.1%. It will be interesting to see what happens to venture capital from here. The CIOs at our conference reported that it was still impossible to get into the really good venture programs. The week before last, I was in Silicon Valley, and several prominent venture capitalists said that too much money remained a problem and that deal pricing was still inflated. In other words, there is still indigestion.

Swensen also maintained that staying power was an essential factor in long-term performance. He gave a striking example. If you had bought the Ibbotson small-stock index in 1929, by 2002 you would have made 6800 times on your money. But by 1932, for every dollar you had invested in 1929, you would have had ten cents, certainly a test of your fortitude. However, if you didn�t get shaken out, by 2002 that dime would have been worth 68,000 times as much. Staying the course is essential.

He went on to say there are three ways to generate returns in a portfolio: asset allocation, security selection, and market timing. For a detailed study of this subject, read his book Pioneering Portfolio Management, published by The Free Press several years ago. It is the best! In essence, he believes that asset allocation is most important and that by concentrating on manager selection you can further enhance returns. The crucial discipline is re-balancing. He is skeptical about market timing � perhaps, he says, because he is no good at it. David is being modest, because his asset allocation changes have been very correct and have been a major part of Yale�s record. He claims he is a �gradualist� rather than a timer.

On manager selection, his view is that picking bond managers is a waste of time, because the difference between first and fourth quartile is 70 or 80 basis points. Making interest rate bets, in his view, is a loser�s game. On the other hand, spending a lot of time on selecting LBO and venture managers is an entirely different proposition, because the difference between first and fourth is 50,000 or more basis points.

Today, Swensen says he is Jeremy Grantham-bearish. In other words, he wouldn�t be surprised if the S&P 500 and the Dow Jones Industrial Average ended up with five handles. His allocation to public equities is minuscule. Bonds are 10% and owned merely as a reserve. His favorite asset class is �real assets,� in other words, real estate, timberland, and oil and gas. All three, in his view, offer sensitivity to inflationary forces, high and visible current cash flow, and the opportunity to exploit inherent inefficiencies in an asset class. All three are excellent diversifiers. Again, the variation in manager performance is huge. He has 20% of the portfolio in real assets, versus 3% for the average endowment. He also likes �absolute return� strategies such as event-driven and value-oriented hedge funds.




Page 15

US Strategy April 14, 2003

Fat Tails Thinning Steve Galbraith ([email protected]) Mary Viviano ([email protected]) Frances Lim ([email protected])

The market has been a disaster for three years now, volatility indices are elevated, the world is at war, and there�s actually a show on TV today entitled Are You Hot? The Search for America’s Sexiest People. If the above do not speak of a world in chaos, what does? Despite an environment where cats are chasing dogs, we are here to tell you that when it comes to individual stock returns, fat tails are thinning. That�s correct. Although we suspect it does not feel this way to most investors, the market has recently experienced a very significant liposuction operation. The fat-tailed return distribution pattern for stocks we chronicled during the aftermath of the bubble has left the building. So have many of the root causes of this extraordinary episode of volatile returns. There are several implications to draw from these thinning tails. First, single-stock risk may be dissipating, suggesting fewer catastrophes ahead. Second, the opportunity set in long-short hedge portfolios has probably been winnowed massively. Third, while it seems wildly counter-intuitive given the extreme outcomes that could play out politically and economically, low returns and low volatility, not low returns and high volatility, could characterize the future.

Long-short nirvana. As is usually the case, the nexus of this piece derived from a client question. On a monthly basis, what have been the return spreads between the best- and worst-performing stocks? At its core, this question gets at the return distribution of stocks that we have written much about (see Fat Tails, Fat Tails Redux, etc.), but at a more practical level. That is, in the past we have looked at how far stocks deviated from a normal bell-curve distribution. To a typical money manager, though, the middle of the bell curve is noise (or worse, mediocrity). What interests investors are the best and worst extremes. Well, below we provide such a look at the best and worst. Exhibit 1 shows the performance spread between the quintile of stocks offering the best and worst returns in the market on a monthly basis. The spread (or opportunity, really, for long-short fund managers) reached surreal levels over the past few years. Initially, the long-short opportunity was in an environment of unusually high positive returns for the market, later in a period of outright losses. In each instance, though, assuming stock

selection was sound (always easier said than done), the alpha opportunity was extraordinary. Today the spread is actually below 20-year averages (or at them excluding bubble data).

Causes of fat tails — valuations as nutty as a fruitcake. Anomalies so many standard deviations from the norm rarely occur in a vacuum. We suspect one of the chief drivers of outsized return spreads was the advent and unusually broad acceptance of �new paradigm� valuation methodologies � a euphemism for �folks drank the Kool-Aid.� One of the simplest yet likely most effective ways of measuring how expansive relative valuations became in the late �90s is straight from Graham & Dodd � price to book. Over the 1980 to 1996 period, the quintile of stocks with the highest price/book valuations traded within a relatively narrow range of around 4.0 multiple points above the cheapest quintile of stocks. At the height of the market frenzy (proving truth is stranger than fiction), the quintile of most highly valued stocks traded at a 21.1 point book multiple premium to the bottom quintile (and this is based on median levels, not means). Today, the spread between cheap and dear in the market is about 4.9 multiple points, in line with the average of the past 20-odd years (Exhibit 2).

Democratization run amok — Leveraged positions in overvalued stocks. While it remains unclear whether the Internet did in fact change everything, it sure changed something, at least for a while. With the advent of online

Exhibit 1

5 Sigma Long/Short Nirvana

Spread between Top and Bottom Quintile Performance

10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

5 Sigma Event

Avg Spread

Source: Morgan Stanley Research. Universe is Russell 1000




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trading, an important part of the investment process changed radically: the rite of semi-public humiliation. If nothing else, the traditional broker in the broker-client relationship stood as something of governor in the investment process, someone who could visibly see an individual�s prominent investment flyers go horribly astray. With the advent of faceless Internet trading, individual investors could roll the dice without fear that someone else might question whether margining one�s portfolio up to the gills with Webvan was a prudent use of retirement dough. Well, roll folks did. Just as valuation spreads grew some 5 standard deviations above norms, so did margin debt. At its peak (coinciding with the peak in valuation extremes), margin debt reached almost 20% of total consumer credit. Since then, margin levels have returned within the realm of long-term norms.

Ga-ga growth expectations. So we have witnessed unprecedented return spreads and enormous valuation gaps, all in an environment of levered lunacy. Was there some underlying change in investors� growth or return expectations to drive this? Yup. Although it is difficult to argue that anything would really justify the nonsense that went on in the late �90s, there actually was an enormous increase in the spread of forecasts for long-term growth rates for the top and bottom quintile of stocks (Exhibit 4). As goofy as it seems in hindsight, someone was actually forecasting that 200 large companies would increase earnings at a clip almost 8 times nominal GDP (despite 100 years of history that suggest such an outcome was a virtual impossibility). More importantly, a number of folks actually believed those forecasts. Hence, the advent of the wonderful concept of PEG to justify all things obscenely priced. Where are we today? Well, we have moved from a mega-sigma event with respect to long-term growth expectation spreads to � below average.

While it may indeed be better to burn out than to rust, a decent case is building that wide return spreads on stocks have already burned out and are now poised to rust. From a macro perspective, the implications for the money management industry are hardly trivial. In such a circumstance, trading velocity should collapse as investment horizons need to elongate, portfolios should become more concentrated, not less, and fiduciaries seeking to cure their asset-liability mismatches at the golden hands of long-short funds may be disappointed. Given explosive growth in long-short funds and the outright scariness of the world today, we suspect such an outcome would prove among the largest non-consensus outcomes one could concoct. Although it may be too early to predict such an outcome, if the biggest market boom and bust ends with a whimper while the world stage seems to be exploding with a bang, that could be the ultimate ironic ending to this manic era.

Exhibit 2

5 Sigma — Ben Graham Rolling Over in His Grave

Spread Between Top and Bottom Quintile Price-to-Book

0.0

5.0

10.0

15.0

20.0

25.0

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

5 Sigma Event

Average Spread

Source: Morgan Stanley Research. Universe is Russell 1000

Exhibit 3

5 Sigma — Levered Lunacy

Margin Debt % Consumer Credit

0%2%4%6%8%

10%12%14%16%18%20%

Jan-

50

Jan-

54

Jan-

58

Jan-

62

Jan-

66

Jan-

70

Jan-

74

Jan-

78

Jan-

82

Jan-

86

Jan-

90

Jan-

94

Jan-

98

Jan-

02

5 Sigma Event

Average

+1 St Dev

-1 St Dev

Source: Federal Reserve Board, NYSE, Morgan Stanley Research

Exhibit 4

4 Sigma — GaGa Spread in Growth Expectations

Spread Between Top and Bottom Quintile Long Term Growth Estimate

10

15

20

25

30

35

40

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

Average Spread

4 Sigma Event

Source: Morgan Stanley Research; IBES median LTG, universe Russell 1000




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US Economics April 14, 2003

Balance-Sheet Repair Still a Work in Progress Richard Berner ([email protected]) You�d hardly know it from the way that corporate bond spreads have narrowed over the past five months, but corporate credit quality remains a critical issue for investors. Measured by the Morgan Stanley TRACERS� portfolio of investment-grade corporate bonds, spreads over yields of Treasuries of comparable maturity have narrowed from 260 basis points (bp) in early October to 108 bp last week � the tightest spread since that basket�s inception. Credit-quality fundamentals are improving: Cash flow is rising, Corporate America has begun to repair balance sheets, and the slow-growth environment is imposing discipline on would-be capital spenders or serial acquirers.

Progress on balance-sheet repair measured by debt/cash flow and debt/net worth has been disappointing, however, and I share the concerns of Morgan Stanley credit strategist Greg Peters that companies aren�t shedding debt aggressively enough. The good news is that companies have �funded out� a substantial amount of debt to capture low interest rates. Even if corporate yields back up, therefore, corporate interest expense will likely slide further relative to cash flow both this year and next. It�s difficult to assess the corporate credit quality picture because comprehensive macro data on off-balance-sheet liabilities aren�t available. But even without those items, and after more than a year in rehabilitation, key financial ratios remain discouraging (for a

comparison with a year ago, see �The Coming Restructuring of Corporate Balance Sheets,� Global Economic Forum, February 19, 2002).

Debt in relation to cash flow has declined from its peak but remains close to record highs. For the top-100 debt issuers, our corporate bond strategy group estimates that this ratio will decline to 2.9 times by the end of 2003, down 33 bp from 2001 (Exhibit 1). But that would only equal the peak level in the 1990�91 recession. Likewise, in the broader non-financial corporate universe, and as measured in the National Income and Product Accounts (NIPAs), total debt including mortgages stood at 5.97 times cash flow, 100 bp above its 1991 peak. And despite sharply declining interest rates, net interest paid in relation to cash flow for non-financial corporations has declined less than in the last recovery. That ratio has fallen by more than 400 bp in the past year, to just under 24%, but it fell by 550 bp in the first year of the 1991�92 recovery. Nevertheless, despite the slow pace of the rehabilitation process, I believe there are four important pieces of good news.

Despite the slow pace of the rehabilitation process, I believe there are four important pieces of good news.

Corporate America has aggressively ‘funded out’ its debt to lock in low long-term interest rates and has piled up cash. On the aggregate balance sheet of US non-financial corporations, the ratio of long-term debt to total credit-market liabilities stood at 68.2% at the end of last year, the highest level since 1959. Thus, companies are relatively immune to any rise in interest rates. Of course, investors who fear deflation or renewed recession would prefer that companies aggressively delever. Meanwhile, the cash pileup, which has taken the �quick ratio� (short-term assets to short-term liabilities) for non-financial companies to 32.9%, has boosted corporate liquidity to the highest level since the mid-1960s. But as Greg Peters points out, investors should ask why CFOs think cash is king when they could be deleveraging more aggressively. Are they scared or hoarding cash for acquisitions?

Exhibit 1

Slow Improvement in Credit Quality

2.0

2.2

2.4

2.6

2.8

3.0

3.2

3.4

90 91 92 93 94 95 96 97 98 99 00 01 02E 03E

Debt/Ebitda

Note: Debt/EBITDA of top-100 US debt issuers. E = Morgan Stanley estimates Source: Morgan Stanley Research




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A second positive is that interest expense is shrinking, reflecting lower interest rates plus sharply slower borrowing growth, and that is adding significantly to profit margins Growth in overall debt owed by non-financial corporations in the last two quarters of 2002 slowed to just 0.7% annualized, the slowest pace in a decade (Exhibit 2). And if anything, official macro data may understate the degree to which interest expense has already declined. Our equity strategy team notes that interest expense for the S&P 500 companies declined by 4% from a year ago in the fourth quarter, while that measured in the NIPAs is off by only 1.8%. Perhaps the Commerce Department�s macro estimates of interest expense in the NIPAs overlook the fact that CFOs have swapped much of the recent issuance of long-term, straight corporate debt into floating payments, which reduces its all-in cost. Even using official data as the basis, however, the prognosis is good: I expect the ratio of interest expense to cash flow for non-financial corporations to fall by another 300 bp by the end of this year.

The sharp narrowing in corporate spreads is good news for the economy because it represents easier financial conditions, giving better access to credit for companies that were shut out only five months ago. Whether it represents good news for investors looking forward depends on one�s perspective. Courtesy of a thirst for yield in a world of single-digit returns, investors are giving companies the benefit of the doubt, and the flood of cash into corporate debt has arguably narrowed spreads faster and by more than the slow improvement in fundamentals warrants. Indeed, our credit strategy group believes that investors should avoid cyclical sectors for which the market has already discounted � or more than discounted � recovery. A sector-by-sector

review of spread performance shows why. Since October 10 last year, average spreads for basic industry debt have tightened by 50 bp, to 156 bp, and retail spreads have narrowed by 65 bp, to 131 bp. The former group is barely 20 bp wider than consumer staples, and retail is even narrower.

For equity investors, however, I see this spread narrowing as unqualified good news. It should foster a stronger economic recovery. Perhaps more important, the search for yield that lies behind tighter spreads likely reflects a final rejection of the irrationally exuberant capital-gains culture that fueled the bubble. As such, it may indicate a healthy, low level of expectations for equity prices. In addition, fixed-income investors often jump on trends sooner than their equity counterparts. Unless the former group is terribly wrong, this spread narrowing could be a favorable leading indicator. Consequently, this massive disconnect between corporate bond and equity market performance over the past five months may signal opportunity: When and if equity markets begin to anticipate improved fundamentals, �crossover� investors likely will shift from corporate debt into equities.

The final positive is that the slow recovery so far has reinforced capital discipline, giving companies the wherewithal to deploy cash flow into debt repayment � they just need to use it. For non-financial corporations, nominal capital spending has come back from its trough in a �maintenance and repair� recovery, as companies replace depreciated equipment. In addition, inventory liquidation has turned to accumulation, as inventories now stand at historical lows in relation to sales. Investment for non-financial companies stands 15% below its 2000 peak, and cash-flow growth is now outstripping that in investment. As a result, the difference between them � the �financing gap� � has shrunk to near zero, implying scant need for corporate borrowing. Even if the more rapid recovery in capital spending that I expect late this year or early next year materializes, booming credit demand thus seems unlikely.

The tails of the distribution still matter for avoiding credit blowups, notwithstanding the improvement in aggregate indicators of credit quality. That the aggregate progress in balance-sheet repair has been so far disappointing hints that those tails are still fat, and companies that haven�t gotten credit-quality religion may relever when the economy improves. The good news is that blowups in telecom, energy, utilities, and industrials have already occurred, which has bred investor discrimination between the virtuous and the likely sinners. That caution should continue to reallocate capital from those who wasted it in the bubble to the more disciplined who are committed to boosting returns.

Exhibit 2

Debt Service to Slide Significantly in 2003 ... and 2004

0

5

10

15

20

25

30

35

1971 1976 1981 1986 1991 1996 20010

2

4

6

8

10

12

14

16

18

Net interest as a percentage of net cashflow of nonfinancial corporate business(left scale)

3-month nonfinancialcommercial paper rates(right scale)

Note: 1Q03–4Q04 are Morgan Stanley estimates. Source: Federal Reserve, Morgan Stanley Research




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Asia/Pacific Economics April 15, 2003

Crazy? Andy Xie ([email protected]) I was washing my hands in the pantry. “You are all crazy”, the tea lady grumbled. “If you all keep washing your hands like this, we’ll have a water shortage”, she added.

Hong Kong appears to be fixated by the SARS outbreak. One local newspaper mentioned that 10% of the Hong Kong population was washing their hands more than 30 times a day. People on the streets look like astronauts. Friends hurriedly pass each other with eyes lowered to the ground. Talking in lifts is frowned upon. Even kicking open doors is not considered impolite anymore. The management at my apartment building tapes a new plastic sheet on the floor buttons in the lifts every few hours. Yet, the residents still push the buttons with their keys.

Restaurant business is already down by a half. Airlines are announcing flight cutbacks almost daily. Taxi drivers sometimes turn down unmasked customers like me. Movie theaters are shutting down, while DVD rental businesses are booming. Disinfectant sales are going through the roof, making the city smell like a hospital. People don�t share newspapers anymore.

Woody Allen would feel at home in Hong Kong. People are discovering new ways of how to avoid physical contact. I notice that shoppers and shop clerks completely avoid touching each other�s fingers while completing transactions. In meetings, people sit at a safe distance from each other. There are countless excuses for avoiding handshakes.

One prominent person talked about organizing a squad of �suicide diners�, who would descend on Wan Chai and eat something at every restaurant in the area at his expense. He hoped that it would inspire others to do the same. I thought it noble and tried to get in touch. Besides, it was supposed to be free.

I cannot imagine what life is like elsewhere. I am stuck. All of Hong Kong appears to be grounded. A growing number of countries are taking steps to deter visitors from Hong Kong and China. China has suspended group tours to Southeast Asian countries. Airlines have cancelled so many

flights that even the brave would have a limited number of many places to visit.

How do we explain the popular reaction to SARS? Some 90,000 people die from common flu and 40,000 in traffic accidents in the United States every year. This outbreak has caused 1,693 diagnosed infections and 58 deaths outside of China. Hong Kong has 1,150 diagnosed cases and 40 deaths out of a population of seven million. So far, the numbers do not paint a particularly frightening picture.

Is the public�s response irrational? Not necessarily, in my view. Comparing the existing statistics on SARS with those on other diseases does not convey the whole story. The SARS virus is new and is still evolving. We do not know how many people will be infected eventually and if the virus will become less virulent over time. These uncertainties appear to have contributed greatly to the fear and uncertainty in the affected areas.

I received criticism for drawing economic implications on a medical phenomenon that I didn�t have the competence to understand. I thought that I understood the economic implications of peoples� reaction to the virus and cut our GDP forecast for the region accordingly. What has unfolded in the past two weeks has exceeded my worst fears.

We based our central case on a three months� impact from March to May. Risks are rising that our scenario may be too optimistic. The World Health Organization would lift its advisory against traveling to Hong Kong if three incubation periods of the virus (30 days) pass after new daily infections fall into single digits in Hong Kong. The current infection rate is still over 40 per day in Hong Kong. Our scenario requires the daily infection rate to decline to single digits in two weeks.

If the outbreak does not ease by the end of this month, we may have to review our GDP forecast for the region again. The duration of this crisis is critical to the bankruptcy rate that would have a large impact on employment. The service sector is being hardest hit in this crisis. Most service businesses have high fixed costs − rents and wages. The bankruptcy rate resulting from the crisis may rise in a




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non-linear fashion with its duration. If the crisis does last longer than we expect, we may have to put our GDP forecast for some regional economies into negative territory for 2003.

The other complication for the region is that the impact of the crisis on China is escalating. China is the only growing source of demand for many of the region�s economies. There is mounting anecdotal evidence that capex and FDI projects are being delayed, as foreign equipment suppliers and investors delay travel to China. As long as the WHO�s travel advisory against unnecessary visits to parts of China remains, such incidents are only likely to multiply.

Senior Chinese leaders sent strong signals over the weekend that China needed to do much more to contain this outbreak. This, in my opinion, is the best news in two weeks. The SARS crisis has seriously impaired China�s international image. China�s local governments run the country on a day-to-day basis, and we believe that China would only be able to contain the SARS outbreak if the crisis is taken seriously at local government level. Senior leaders now appear to be providing the political incentives for this to happen.




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Currencies April 14, 2003

The JPY and Low and Falling Yields in Japan Stephen L. Jen ([email protected]) (+44 20 7513 8583)

An extraordinary flattening in the yield curve In the past six months, the long bond yield of Japanese Government Bonds (JGBs) (seven to 10 years) has fallen from 1.4% to 0.58%. This rally has surprised most non-Japanese global investors, but has been fully expected by most of the Japanese investment community. In this note, I present my thoughts on the flattening yield curve in Japan and the implications for USD/JPY.

Thought 1. A reflection of declining expected inflation. The most important point I can make about the rally in JGBs is that it makes total sense for long bonds to rally considerably in a capital-surplus country, such as Japan, that is falling ever deeper into the deflation trap � a point that my colleague Takehiro Sato has also made. The popular view outside Japan is that, with the parlous fiscal state of the country and the high stock of existing public debt, JGBs are hugely overpriced and due for a collapse. I believe this view to be erroneous.

Strong JGBs are a sign of weakness, not strength, in Japan. As long as the investment community/the market expects the economy to remain weak, the JGB yield should remain low. Specifically, Japan has satisfied three key criteria that have enabled the sovereign bonds to rally as they have. First, being a capital surplus country, Japan does not rely on foreign financing, which means that interest rates do not need to be high to attract foreign capital. This is also the main reason why interest rates in Switzerland and Singapore, which are also capital surplus countries, are very low. In addition, there is a more subtle point about Japan�s net savings position and low interest rates. Because the country has run a persistent current account surplus over the years, the cumulative large stock of foreign assets has skewed the risk exposure to Japanese investors (that is, there is too much currency and foreign market risk from the large stock of existing foreign asset holdings). This means that Japanese investors are likely to want to be compensated with a yield premium before they are enticed to add to their foreign investment.

Second, these key savers in Japan expect deflation to persist. Persistent deflation of consumer prices allows private-sector savers to be content with low nominal returns on assets, since, in real terms, the return on JGB holdings is still acceptable to most investors in Japan.

Third, these savers in Japan do not expect the yen to depreciate over the medium term. I am often challenged on this claim. But if it is wrong that Japanese investors expect to see capital gains from yen depreciation on foreign bond holdings that also generate higher yields, why would anybody hold JGBs at the current prices. In other words, if the Japanese investor base, in aggregate, expects the currency to depreciate, the JGB yield could not possibly drift as low as it has. It is on this last point I have leveraged my argument about the yen policy in Japan, that the Japanese policy-makers do not have the flexibility to adopt an outright weak yen policy because, if such a policy were credible, the JGBs would sell off. The same logic applies to the second point above about expected deflation: the irony here is that, if the Bank of Japan (BoJ) were to adopt an explicit inflation target and such a target were to become credible, the JGBs would also collapse.

In sum, as long as Japan remains a capital surplus country, (I believe) the Japanese investor base expects deflation to persist and does not expect the yen to depreciate over the medium term, thinking that the JGBs should remain strong and the yield curve flat and low. Note that all three conditions will need to be satisfied for Japan�s interest rates to remain low, in my view.

Thought 2. A flattening yield curve is a problem for Japanese banks. Just as the US savings and loan institutions regained strength through a steep yield curve in the early 1990s, Japanese banks and financial institutions need the help of a steep yield curve to allow them to generate positive net income. However, with the low and still flattening curve in Japan, the income outlook for banks is not positive. While existing holders of JGBs have picked up capital gains, recent and future buyers are forced to accept minimal nominal yields, running the risk of suffering a capital loss on these holdings if the BoJ becomes successful at generating inflation. However, to a large extent this is a zero-sum game.




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While a declining nominal cost of capital is bad for lenders, it is good for borrowers and, if banks enjoy capital gains, someone else suffers from capital losses. Thus, it is important when discussing whether changes in interest rates are good or bad, to be aware of this zero-sum aspect.

Thought 3. Falling yields in Japan and USD/JPY. The temptation here is to jump to the conclusion that �falling yields in Japan equal a weak yen�. However, this presumption is only partly true, I believe, and the thought process is a bit more complicated. Exhibit 1 shows a risk-return framework that we presented in an earlier note, Pondering the Re-Emergency of Bond Culture (March 20, 2003). It illustrates the trade-off between the expected return and risk of available investments. But, instead of tracing how the lending-borrowing curve shifts over time, as we did in the earlier note, I show two distinct lending/borrowing schedules from the perspective of Japanese investors: one for Japanese assets (Lj) and one for foreign assets (Lf). Compared with Lf, Lj is low and flat in the chart, reflecting Japan�s low risk-adjusted return environment � that is, the lower Sharpe Ratio. But one key point I made above is the fact that Japan�s asset returns are significantly below those of foreign assets, partly because Japanese investors do not

believe such a premium on foreign returns compensates adequately for the extra risk. I generalise all of the quantifiable risk premiums and the non-quantifiable factors that drive a wedge between Japan and foreign returns as the �home bias� (HB). Making the simplifying assumption that this home bias is constant across different levels of risk tolerance (σ), we can show a line (Lj + HB) that is parallel to and above Lj.

I make the following points in relation to the chart. First, if we divide Japanese investors into different groups according to their tolerance for risk, commercial banks have low tolerance (σ1) while retail investors may have a higher tolerance (σ2). As returns in Japan decline, foreign investments look increasingly attractive to those investors with a healthy risk tolerance, but not to those with limited tolerance, because of the home bias. I believe this is why we are seeing large commercial banks trimming their holdings of risky assets while, at the same time, retail investors are increasing their purchase of foreign assets. In short, falling yields in Japan have resulted in some capital outflows.

Second, this capital outflow is partial, not broad-based. Most institutional investors are still risk-averse. Further, if Japanese investors did not go overseas in the period of the equity bubble, why would they do so now when the world is in a bear market? Third, a key reason why the expected return is so low in Japan could be due to an �identification� problem that investors may have in distinguishing the good companies from the �zombies�, which have their own respective efficient frontiers. If financial-sector and corporate reforms make enough progress, in theory, Japanese investors could move to Lj (good). This is another way of saying that, with successful financial sector reform, the yen should strengthen.

Bottom line �Low� JGB yields make sense, and this is likely, I think, to remain the case as long as Japan remains a capital surplus country, and the Japanese investor base expects deflation to persist and the yen not to depreciate over the medium term. Low yields are negative for lenders and positive for borrowers, and a flat yield curve is bad for banks. Further, low yields in Japan could trigger some capital outflows. But this outflow should be partial, not broad-based.

Exhibit 1

Risk-Return Trade-Off for Japanese Investors

σ1

R

σ2

A2

Good com panies

Foreign

R

Risk-free interest

rates

The Zombies

A1

A3Lf

Lj

Lj(good)

Lj(zom bies)

Lj+HB

Hom e Bias

A2''

A2'

Source: Morgan Stanley Research



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Quarterly Volatility Rating Update April 16, 2003

A Stock Can Receive a “V” Rating in Three Ways (1) Automatic classification based on an analysis of historical price data. We have devised a screen that provides an indicator of risk based on the last three years of data, in local currency. Stocks that appear to have a greater than 25% probability of experiencing a move (up or down) of 25% or more in a single month will be deemed “volatile.” This “25/25” rule is meant to flag a level of risk that we consider noteworthy. The historical volatility data are recalculated quarterly. A “V” flag assigned to any stock based on historical data will be removed only when the quarterly recalculation indicates that the stock’s probability score has dropped below this level.

(2) Automatic classification of stocks with limited trading history. Stocks with less than one year of data will receive a “V” rating automatically. Our Stock Selection Committee must approve any exceptions.

(3) Discretionary classification by the analyst based on outlook for future volatility. An analyst can add a discretionary “V” to any investment rating if he or she believes the stock will become materially more volatile over the next 1-12 months compared with the past three years. These discretionary “V” ratings may be added at any time, and they may be removed any time the analyst believes the risks of increased volatility have dissipated.



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Exhibit 1

All European Stocks Under Coverage with Volatility Flags (Volatility screen was run on April 9, 2003) Company Company (Ticker, Recent Price, Rating, Industry View) Analyst Basis (a) (Ticker, Recent Price, Rating, Industry View) Analyst Basis (a) Aberdeen (ADN.L, 35p, U-V, I) Van Steenis/Hamilton Model Akbank (AKBNK.IS, USc 0.31, O-V, NA) Khan/Yucemen Discr Aktiv Kapital (AIK.OL, NKr 44.70, E-V, I) De Figueiredo/Allchurch/Jimenez Discr Alcatel Optronics (CGO.PA, €6.96, E-V, C) Dean/Gardiner/Lindsay Model Alstom (ALSO.PA, €1.64, E-V, A) Uglow/Sanjuan Discr Amvescap (AVZ.L, 325p, U-V, I) Van Steenis/Hamilton Discr ARM Holdings Plc (ARM.L, 51p, E-V, C) Adrian/Parker Model ASM International (ASMI.AS, €10.55, E-V, C) Adrian Model ASML Holding NV (ASML.AS, €6.76, E-V, C) Adrian/Parker Discr AstraZeneca (AZN.L, US$35.90, O-V, A) Baum/Mann/Moore Discr ATOS Origin (ATOS.PA, €28.10, O-V, C) Rollo/MacMillan Discr AWD (AWDG.DE, €11.05, E-V, C) Procter/Hocking Discr Banca Fideuram (FIBK.MI, €4.32, U-V, A) Serra/Zadra Discr Bayer AG (BAYG.DE, €14.73, E-V, I) Edwards/Eastwood Discr Bergesen (BEA.OL, US$24.46, E-V, I) Mares Discr Bezeq (BEZQ.TA, NIS 4.91, U-V, NA) Wedlake Discr Burberry (BRBY.L, 223p, O-V, I) Kent/Deex <52 Wk Business Objects (BOBJ.O, US$18.47, E-V, C) MacMillan Model Cable & Wireless (CW.L, 83p, E-V, I) Lyall/Marsch Discr Cambridge Antibody Tech (CAT.L, 349p, E-V, A) Mahony/Pinniger/Seyfried Model Canary Wharf Group (CWG.L, 155p, U-V, C) Allen/Jimenez Discr Cap Gemini Ernst & Young (CAPP.PA, €25.25, U-V, C) Rollo Discr COLT Telecom Group PLC (CTM.L, 34p, U-V, I) Marsch/Worthington Model Corus (CS.L, 8.70p, E-V, I) McTaggart/Lun Model Dassault Systemes SA (DAST.PA, €22.10, E-V, C) MacMillan Discr deCODE genetics (DCGN.O, US$2.23, E-V, A) Mahony/Pinniger/Seyfried Model Epcos AG (EPCGn.DE, €12.79, U-V, C) Adrian/Parker Discr Equant NV (EQUT.PA, €5.08, U-V, I) Lyall/Worthington Model Frontline Ltd (FRO.OL, US$11.50, U-V, I) Mares Discr Hanson Plc (HNS.L, 331p, E-V, A) Pereda/McGarry/Messenger Discr Infineon Technologies AG (IFXGn.DE, €7.18, U-V, C) Adrian/Parker Discr Intertek Testing Services (ITRK.L, 372p, E-V, I) Bennett/Allchurch <52 Wk Intrum Justitia (IJ.ST, SKr 37.90, O-V, I) De Figueiredo/Allchurch/Jimenez <52 Wk IS Bank (ISCTR.IS, USc 0.28, E-V, NA) Khan/Yucemen Discr Karo Bio (KARO.ST, SKr 36.00, E-V, A) Mahony/Pinniger/Seyfried Discr Lastminute.com (LMC.L, 90p, E-V, C) Marin/Steel Model LION Bioscience (LIOG.DE, €3.75, U-V, A) Mahony/Pinniger/Seyfried Model Lottomatica (LTT.MI, €17.83, E-V, I) De Figueiredo/Jimenez <52 Wk Lundbeck (LUN.CO, DKr 138.00, E-V, A) Mann/Baum/Moore Discr Man Group (EMG.L, 995p, E-V, I) Van Steenis/Hamilton Discr Medidep (MEDE.LN, €11.49, E-V, A) De Figueiredo Discr

MediGene (MDGGn.DE, €3.05, E-V, A) Mahony/Pinniger/Seyfried Model Misys (MSY.L, 173p, E-V, C) MacMillan/White Discr Mobile TeleSystems (MBT.N, US$45.05, O-V, NA) Wedlake/Hayes Discr M-Real (MRLBV.HE, €6.55, E-V, C) Spencer Discr Munich Re (MUVGn.DE, €71.20, O-V, C) Procter/Hartwell Discr NDS Group (NNDS.O, US$12.00, O-V, I) Mutreja/De Figueiredo/Whitbread Model Nokian Tyres (NOR1V.HE, €35.01, U-V, I) Hirth/Cramer/Jonas Discr Norske Skog (NSG.OL, NKr 95.50, U-V, C) Spencer/Lopez del Rio Discr OPAP (OPAr.AT, €7.76, O-V, I) De Figueiredo/Jimenez Discr ORPEA (ORP.PA, €11.70, U-V, A) De Figueiredo <52 Wk Pirelli & C. Real Estate (PCRE.MI, €18.98, NR-V, C) Allen <52 Wk Porsche (PSHG_p.DE, €308.15, O-V, I) Jonas/Hirth Discr Pro Sieben (PSMG_p.DE, €5.38, U-V, C) Simon/Owen/Poulter Model PT Multimedia (PTMN.IN, €12.01, U-V, C) Marin/Simon Discr Punch Taverns (PUB.L, 176p, E-V, I) Rollo/Beal <52 Wk Reuters Holdings (RTR.L, 111p, U-V, C) Owen/Simon/Singlehurst Discr Rhon Klinikum (RHKG_p.DE, €26.00, O-V, A) De Figueiredo Discr Royal & Sun Alliance (RSA.L, 92p, U-V, C) Hocking/Murray Discr Sage (SGE.L, 119p, U-V, C) MacMillan/White Discr Saint-Gobain (SGOB.PA, €28.21, E-V, A) Pereda/McGarry/Messenger Discr SAP (SAP.N, US$20.90, E-V, I) MacMillan Discr Schroders (SDR.L, 580p, E-V, I) Van Steenis/Hamilton Discr SCOR (SCOR.PA, €4.30, E-V, C) Procter/Hartwell Discr Seat Pagine Gialle (SPG.MI, €0.58, U-V, C) Marin/Steel Discr SEZ Holding (SEZNn.S, SFr 10.00, O-V, C) Adrian/Parker Model Skandia Forsakring (SDIA.ST, SKr 19.60, E-V, C) Broom/Hartwell Discr SOITEC (SOIT.LN, €3.16, U-V, C) Adrian/Parker Model Standard Chartered (2888.HK, HK$10.90, E-V, I) de Winton <52 Wk Technip Coflexip (TECF.PA, €69.15, O-V, I) Mares Discr TeleWest Communications (TWT.L, 2.15p, E-V, C) Simon Model TietoEnator (TIE1V.HE, €13.50, E-V, C) Rollo Discr T-Online International AG (TOIGn.DE, €7.09, O-V, C) Marin/Steel Discr TPI (TPI.MC, €3.69, O-V, C) Marin/Steel Discr TPSA (TPSA.WA, Zl 12.25, E-V, NA) Wedlake/Hayes Discr Turkcell (TKC.N, US$14.11, E-V, NA) Wedlake/Hayes Model Vedior (VDOR.AS, €4.64, O-V, I) Bennett/Allchurch Discr Vestas Wind Systems (VEST.CO, €7.34, E-V, A) Cunliffe Discr Wanadoo (NAD.PA, €5.89, O-V, C) Marin/Steel Discr William Hill (WMH.L, 233p, E-V, I) Rollo/Beal/Pirenc <52 Wk Wood Group (WG.L, 161p, E-V, I) Mares <52 Wk Yapi Kredi (YKBNK.IS, USc 0.09, U-V, NA) Khan/Yucemen Model



Page 25

Exhibit 2

Volatility Flags Added Since January 22, 2003 Company (Ticker, Recent Price, Rating, Industry View) Analyst Basis (a) Aktiv Kapital (AIK.OL, NKr 44.70, E-V, I) De Figueiredo/Allchurch/Jimenez Discr Alstom (ALSO.PA, €1.64, E-V, A) Uglow/Sanjuan Discr ATOS Origin (ATOS.PA, €28.10, O-V, C) Rollo/MacMillan Discr Bayer AG (BAYG.DE, €14.73, E-V, I) Edwards/Eastwood Discr Canary Wharf Group (CWG.L, 155p, U-V, C) Allen/Jimenez Discr Hanson Plc (HNS.L, 331p, E-V, A) Pereda/McGarry/Messenger Discr Intrum Justitia (IJ.ST, SKr 37.90, O-V, I) De Figueiredo/Allchurch/Jimenez <52 Wk Lottomatica (LTT.MI, €17.83, E-V, I) De Figueiredo/Jimenez <52 Wk NDS Group (NNDS.O, US$12.00, O-V, I) Mutreja/De Figueiredo/Whitbread Model Norske Skog (NSG.OL, NKr 95.50, U-V, C) Spencer/Lopez del Rio Discr OPAP (OPAr.AT, €7.76, O-V, I) De Figueiredo/Jimenez Discr Saint-Gobain (SGOB.PA, €28.21, E-V, A) Pereda/McGarry/Messenger Discr SEZ Holding (SEZNn.S, SFr 10.00, O-V, C) Adrian/Parker Model TietoEnator (TIE1V.HE, €13.50, E-V, C) Rollo Discr Vedior (VDOR.AS, €4.64, O-V, I) Bennett/Allchurch Discr Vestas Wind Systems (VEST.CO, €7.34, E-V, A) Cunliffe Discr

Exhibit 3

Volatility Flags Deleted Since January 22, 2003 Company (Ticker, Recent Price, Rating, Industry View) Analyst Basis (a) Arcelor (CELR.PA, €8.79, O, I) McTaggart/Lun Model ASF (ASF.PA, €24.00, O, I) Morales De Labra/Borghetto Model Garanti Bank (GARAN.IS, USc 0.11, E, NA) Khan/Yucemen Model Tiscali (TIS.MI, €4.15, U, C) Marin/Steel Model Zurich Financial Services (ZURZn.VX, SFr 129.25, E, C) Broom Model

Exhibit 4

Changes in Reasons for Volatility Flags Company Basis (a) as Basis (a) as (Ticker, Recent Price, Rating, Industry View) Analyst of Apr 9 of Jan 22 Arcelor (CELR.PA, €8.79, O, I) McTaggart/Lun Model <52 Wk ASF (ASF.PA, €24.00, O, I) Morales De Labra/Borghetto Model <52 Wk Bayer AG (BAYG.DE, €14.73, E-V, I) Edwards/Eastwood Discr Model Canary Wharf Group (CWG.L, 155p, U-V, C) Allen/Jimenez Discr Model Corus (CS.L, 8.70p, E-V, I) McTaggart/Lun Model Discr Hanson Plc (HNS.L, 331p, E-V, A) Pereda/McGarry/Messenger Discr Model Norske Skog (NSG.OL, NKr 95.50, U-V, C) Spencer/Lopez del Rio Discr Model Saint-Gobain (SGOB.PA, €28.21, E-V, A) Pereda/McGarry/Messenger Discr Model Vedior (VDOR.AS, €4.64, O-V, I) Bennett/Allchurch Discr Model Vestas Wind Systems (VEST.CO, €7.34, E-V, A) Cunliffe Discr Model Zurich Financial Services (ZURZn.VX, SFr 129.25, E, C) Broom Model Discr

Notes: O = Overweight; E = Equal–weight; U = Underweight; V = More volatile; A = Attractive; I = In–Line; C = Cautious (a) Definitions of basis for volatility flag: Model = model calculation; Discr = discretionary; <52 Wk = less than 52 weeks of trading history. * Morgan Stanley European model portfolio selection Source: Morgan Stanley Research

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Portugal Telecom April 9, 2003

Downgrading to Equal-weight Luis Prota ([email protected]) (+34 91 412 1217) Juan Jimenez ([email protected]) (+34 91 412 1474) Paul Marsch ([email protected]) (+44 20 7425 6611) STOCK RATING EQUAL-WEIGHT

Price (April 9, 2003) €7.00Price Target €7.5052-Week Range €8.60-4.39ADR Price, Target US$7.35, US$7.90Stock ratings are relative to the analyst’s industry (or industry team’s) coverage universe.

GICS SECTOR TELECOM SERVICES Strategists' Recommended Weight 8.5%MSCI Europe Benchmark Weight 9.5% Currency = Euro (€) Fiscal Year Ends Dec 31 2002 2003e 2004eEPS 0.31 0.23 0.24P/E 22.6 30.4 29.2Dividend 0.10 0.16 0.20Yield (%) 1.4 2.3 2.9

Market Cap (US$mn, €mn) 9,144, 8,778EPS Growth (02-06e) (%) 3.9Shares Outstanding (mn) 1,254.3

Reuters, Bloomberg, ADR PTCO.IN, PTC PL, PT.N

ADR Data — US Dollars (US$) 2002 2003e 2004eEPADR 0.30 0.24 0.24P/E 24.5 30.6 30.6Dividend 0.10 0.17 0.20Yield (%) 1.4 2.3 2.7Exchange Rate (US$/€1) 0.97 1.04 1.00

Ordinary Shares per ADR 1.0e = Morgan Stanley Research estimates Source: Company data, Morgan Stanley Research

Downgrading on fundamentals and valuation There are two main reasons for our downgrade of Portugal Telecom* (PT) from Overweight to Equal-weight: we perceive a significant deterioration in its core business fundamentals and its valuation is less attractive after strong outperformance. This is in the context of our In-Line view of the European Wireline industry. This view is based on market concerns over the near-term supply of paper and continued weak wireline fundamentals, which suggest to us that wireline stocks will perform in line with the market.

Comparing the company with the overall industry, some of the underlying trends in 2002 were much weaker at PT. This worries us, as weakness in the core business is one of our major concerns about the industry as a whole. Our unease stems from a weak economic environment, mobile cannibalisation and competition from fixed operators. Total number of lines, voice retail traffic, fixed-to-mobile traffic, core business EBITDA and average revenue per user (ARPU) were all weaker.

Valuation and risks to our price target We calculate our €7.50 per share price target using a DCF-based sum of the parts. We use a WAAC of 7.0% for fixed and 8.3% for mobile and long-term growth rates of 0% and 2.5% respectively. The main risks to our valuation are a tougher competitive or regulatory environment in Portugal than we expect, especially in fixed telephony, and a weaker economic environment in Brazil than we are forecasting.

The implied upside potential to our price target of €7.50 is 7%, which is slightly below the industry average. Relative to the industry, the stock does not look particularly inexpensive, after its 24% outperformance in the past six months. We see the company’s defensive nature, strong balance sheet, respected management and compelling valuation (until now) as the main reasons behind this good performance.

Stock Price Performance

98 99 00 01 02

6

8

10

12

14

16

5060708090100110120130140

Relative to MSCI The World Index / Telecommunications ServiceRelative to Portugal PSI General (Right)Portugal Telecom (Left, Euro)

Data Source: FactSet Research Systems Inc. Company Description Portugal Telecom is the dominant provider of local, regional, and international telephony, leased lines, broadcasting, cable television, data transmission, and mobile services.

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PT’s shares are trading above the industry average on our estimates for clean P/E from 2003 to 2005. It is one of the most expensive stocks in terms of our estimated EV/EBITDA over the same period. On our forecasts for free cash flow to equity, the shares look inexpensive in the short term (2003 and 2004), and become among the most expensive from 2005 onward. This is because we expect most of the company’s total tax credit of around €900 million to be used in 2003 and 2004, and for tax payments to begin again from 2005.

Core business: some worrying trends We believe that improvements in the results for the fourth quarter of 2002 provided the market with some comfort, particularly in the area of fixed-line traffic. Nevertheless, looking at the industry as a whole, we view some of the trends at PT during 2002 as weak on a relative basis.

Total number of lines declining In addition to mobile cannibalisation, competition from cable companies was responsible for the 2% decrease in PT’s number of fixed lines last year. This is significantly worse than the European industry average, which grew at more than 1% over the same period. PT’s relatively poor performance in fixed lines can be attributed to the fact that it is not offsetting fully that decline with digital subscriber lines (DSL) and cable modem, as is being done elsewhere.

We estimate that PT’s main lines in service plus cable modem connections will decrease by 3% year on year in 2003. Growth in asymmetric DSL could offset this, leading to a total decline of around 2%.

Voice traffic well below the industry For the full year, voice retail traffic declined by almost 12%. Again, we believe the main reasons behind this were the weak economic environment in Portugal, fixed-to-mobile

cannibalisation and the decrease in the number of lines. We estimate that total voice retail traffic will decline by 8% year on year in 2003.

The only operator with reduced fixed-to-mobile traffic PT was the only European operator to report reduced fixed-to-mobile traffic last year. We estimate that its fixed-to-mobile traffic will decline again in 2003, by around 8% year on year.

Core business EBITDA performance not encouraging Performance in the core business at the EBITDA level has also shown some weakness, with a decline of 8.5% in 2002, which is 2% worse than the average for our coverage universe. PT’s starting margin base was much higher at 41% and was 6 percentage points better than the industry’s, but compared with similar high-margin core businesses in Europe, such as those of Telecom Italia or Telefónica, PT’s performance was weaker.

ARPU erosion in mobile PT’s mobile revenue growth slowed from 18% in 2001 to 8% in 2002, while ARPU declined by 10% in 2002. Customer bills were down 4% and interconnection revenues down 21%. The decline in customer bills was the result of a mix of lower tariffs and lower volume per customer and per month. Since the mobile division continues to be the growth driver in the group, we believe that a substantial slowdown could affect the outlook for PT. We expect that ARPU will remain under pressure in 2003 as we forecast reductions in interconnect prices by 15-20% this year. While we believe that margins could increase this year by around 1 percentage point to 43% due to fewer net additions, we believe that it will be challenging to push mobile margins higher in future years.

* Morgan Stanley European model portfolio selection

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Media and Internet April 11, 2003

Downgrading Stocks on Valuation Grounds Javier Marin, CFA ([email protected]) (+44 20 7513 3503) Edward Steel ([email protected]) (+44 20 7513 4486) GICS SECTOR CONSUMER DISCRETIONARY

Strategists’ Recommended Weight 12.5%MSCI Europe Benchmark Weight 9.3% COMPANIES FEATURED

Company (Ticker, Price, Price Target) RatingT-Online (TOIGn.DE, €6.88, €8.0) Equal-weightTerra Lycos (TRR.MC, €4.75, €5.25) UnderweightWanadoo (NAD.PA, €5.70, €6.0) Underweight Downgrading Wanadoo, T-Online and Terra Lycos. After the strong outperformance of Wanadoo (48%), T-Online (47%), and Terra Lycos (31%) since the beginning of the year, we are cutting our ratings on the three stocks. We are downgrading Wanadoo from Overweight to Underweight but keeping our price target at €6.0 per share; downgrading T-Online from Overweight to Equal-weight and increasing our price target from €7.4 to €8.0 per share; and downgrading Terra Lycos from Equal-weight to Underweight and raising our price target from €5.05 to €5.25 per share.

These rating changes are based on valuation grounds within the context of our Cautious view of the wider European Media and Internet industry, where we see limited opportunities for earnings upgrades. At current prices, the stocks that we cover offer 16% average upside potential to our price targets, weighted by market capitalisation. Our price targets for Wanadoo, Terra Lycos and T-Online imply 5%, 11% and 16% upside potential, respectively.

We see sound reasons for the positive performance of the stocks in the first quarter of the year, and note in particular improving fundamentals and business models, greater earnings visibility and increasing momentum. We still think that the European Internet stocks should be on investors’ radar screens, regardless of whether or not the stock market rebounds, given the resilient nature of their business model, as proven by their financial performance in 2002. Both Wanadoo and T-Online have already achieved EBITDA profitability (Wanadoo even recorded its first positive net income figure in 2002), and, we believe, are poised for a significant improvement in 2003. We expect Wanadoo’s

revenues to grow at 21% in 2003 and EBITDA to treble to €312 million. We forecast a 28% revenue increase for T-Online, with EBITDA more than doubling to €235 million. None of the stocks can be considered low-growth, mature companies, in our opinion; we would say just the opposite.

In addition, we expect last year’s positive and significantly improving performance of the companies’ earnings and value drivers to continue. Both Wanadoo and T-Online are successfully migrating their subscriber bases to broadband (between 60% and 70% of net subscriber additions were broadband subscribers in 2002). The migration to broadband benefits average revenues per user (growing at around 20% in 2002) and churn rates (dropping from 5% per month for free users to less than 1% for ADSL subscribers). In addition, companies are improving the efficiency of their networks by switching usage to off-peak periods and redefining the product portfolio towards megabyte-downloaded pricing schemes (rather than minutes-of-usage schemes). This has allowed them to improve their gross margins and, with tighter control of operating expenses, to achieve positive EBITDA that should enable them to generate positive free cash flow this year, on our estimates.

Such a positive mid-term outlook does not mean valuations do not count. Quite the reverse. Now that the companies are showing that they have sound business models that can return solid earnings, we think valuations will become more central. This is why we are advising investors to look for more comfortable valuation entry points. The potential upside to our price targets is just a reality check (based on valuations); the different ratings on T-Online, Wanadoo and Terra Lycos are based on a number of other factors too, as follows.

First, we are concerned that Wanadoo’s and T-Online’s multiples still look expensive compared with the European media industry, even on our 2004 or 2005 numbers (once they have enjoyed three more years of the high growth that we forecast) — Wanadoo’s in particular.

Second, we base our fundamental view on DCF models. Given the volatility that still exists in the companies’ financial statements (although we think that such volatility might work both ways), we are concerned that we have to

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extend our models to 2007/08 to justify Wanadoo’s current share price. The fact that we can get to T-Online’s share price by extending the DCF model to just 2005/06 makes us more comfortable with its valuation.

Third, the large cash balances of the three companies add another element of risk. If the value of the cash were to be discounted versus face value, the fair value of the three companies would be affected significantly. For instance, if we assume that the cash will never be returned to shareholders or invested, the result is a 40-70% downside risk to the fair value of Terra Lycos (whose cash represents more than 60% of market capitalisation), a 30-40% downside risk for T-Online, and 10-15% for Wanadoo.

Fourth, applying market multiples to the businesses of Wanadoo results in a value per share of €4.99, implying 12% potential downside from current levels. If we were to apply to Wanadoo our current EV/EBITDA multiple estimate of 11.5 for Seat Pagine Gialle’s directories business, the value of Wanadoo would be €5.3. That business is officially for sale, which might have two effects on Wanadoo. First, it is likely to set a level for multiples to be applied to Wanadoo’s directories business. Second, such multiples may be closer to TPI’s* and Eniro’s trading multiples than to Wanadoo’s implicit multiples. The combination of the two might put pressure on Wanadoo’s shares price, which is unlikely to happen in the case of T-Online, a pure Internet service provider (ISP).

As a final comparison, we note that the negative effect of the international Internet-related activities of Wanadoo accounted for a negative EBITDA contribution of €165 million in 2002, while for T-Online they accounted for only €87 million. Although we are confident that Freeserve’s performance will improve in 2003, we think that investors may be willing to apply a greater discount to Wanadoo’s geographical expansion than to that of T-Online.

Given the improved sentiment towards Wanadoo, T-Online and Terra Lycos, we would recommend investors monitor them carefully when looking for an entry point.

• We think such an entry point would be close to €5.0 for Wanadoo, where we believe the downside risk of a de-rating of the directories division would be reflected in the price. At that level, T-Online’s shares would imply a 25% discount to cash, and the stock would be as sensitive to a valuation of cash as is Wanadoo.

• For T-Online, we would be looking for the stock to reach €6.4, 7% below current levels, before we would significantly increase a position. At this level, we think the discount to the cash would be priced in.

• For Terra Lycos, we would wait until the stock drifts down to €4.25, as, at that level, most of the market capitalisation would be explained by the cash balance, the put option on Uno-E and the book value of the tax credits in the balance sheet.

We value T-Online and Wanadoo’s Internet businesses using a DCF, using a perpetual growth rate of 4% and an average discount rate of 10%. For Terra Lycos, we use a sum of the parts, with a multiple of EV/gross profit as our main parameter and DCF as a cross-check, assuming the same perpetual growth and discount rates as for T-Online and Wanadoo.

The main risks to Wanadoo’s price target include the pace of Internet adoption through Europe; the strong inter-dependence between ISPs and public telephone operators, the renewal of advertising contracts by small and medium-sized enterprises, and the pace of the migration from paper to online usage. For T-Online, the key risk remains the company’s dependence on its parent, Deutsche Telekom (DT), which controls 70% of the company and provides all network services, billing services and customer- care centres. Any significant change in DT’s role or stake could cause us to change our price target. For Terra Lycos, risks include the US advertising market not recovering, continued uncertainty from the Bertelsmann contract, and the competitive landscape in Spain becoming tougher.

Price for Seat Pagine Gialle: €0.58.


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Travis Perkins April 14, 2003

More than a ‘Safe Haven’ John Messenger ([email protected]) (+44 20 7513 7833) Alejandra Pereda ([email protected]) (+44 20 7513 5374) Ben McGarry ([email protected]) (+44 20 7513 2127) STOCK RATING OVERWEIGHT

Price (April 9, 2003) 1,063pPrice Target 1,276p52-Week Range 1,200-910pStock ratings are relative to the analyst’s industry (or industry team’s) coverage universe.

GICS SECTOR CONSUMER DISCRETIONARYStrategists’ Recommended Weight 12.5%MSCI Europe Benchmark Weight 9.3% Currency = Sterling (p) Fiscal Year Ends Mar 31 2002 2003e 2004eEPS 91.55 100.48 107.80P/E 11.6 10.6 9.9Dividend 19.50 21.50 23.70Yield (%) 1.8 2.0 2.2

Market Cap (US$mn, £mn) 1,862, 1,197EPS Growth (02-06e) (%) 10.6Shares Outstanding (mn) 112.6

Reuters, Bloomberg TPK.L, TPK LNe = Morgan Stanley Research estimates Source: Company data, Morgan Stanley Research


We view the Building & Construction industry as Attractive. This is based on our more positive view on the heavy building materials constituents of our coverage universe.

A clear value creator in the Building & Construction industry. We think Travis Perkins is the most value-creating stock in our building materials industry coverage, generating superior returns on invested capital and invested equity, a 90% free cash flow/earnings per share conversion, and cumulative earnings growth of 25.7% from 2002 through to 2005, on our forecasts.

Acquisitions absorbing net free cash flow could be highly accretive, in our view. Successful re-investment of the group’s cash flows into acquisitions could, on our sensitivity modelling, boost this cumulative earnings growth to over 40% through to 2005.

Growth opportunities remain, in our view. The group’s 15% UK market share (as at December 2002) provides opportunities for both acquisitive and organic growth, in our view. Further market share would generate increased buying power, thereby supporting continued strong returns as well as offering clear benefits from acquisitions.

UK construction has not, in reality, seen a boom since the late 1980s. The UK construction market, with the exception of commercial building activity, is not booming, in our view. Merchant industry volumes are only just approaching the level of the last peak nearly 14 years ago.

Key demand drivers are still below the last cyclical peak. The key drivers for Travis Perkins are housing repair, maintenance and improvement (which contributed 63% of sales in 2002) and new build activity (20%). Volumes in the former are down 14% and the latter 28% from their last cyclical peaks.

A consolidating market continuing to shift in Travis Perkins’ favour. We think the builders’ merchant market is the most attractive market segment in the building industry supply chain. Merchants are consolidating more rapidly than manufacturers, buying power continues to shift in favour of the merchant, the key customer base — the jobbing builder


98 99 00 01 02

456789

101112

0

50

100

150

200

250

300

Relative to MSCI The World Index / Retailing -IG (Right)Relative to FTSE - UK All-Share (GBP) (Right)Travis Perkins PLC (Left, British Pounds)

Data Source: FactSet Research Systems Inc. Company Description Travis Perkins is a leading UK general builders’ merchant operating from 610 branches (at December 31, 2002) across the UK. The group is 100% UK dependent and is an active player in the continuing consolidation of the UK merchant market. The group is targeting market share of 20% (currently 15%) via bolt-on acquisitions and organic growth in the medium term.

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— remains and will remain fragmented, and the ability to enter the market is becoming more constrained by a difficult planning environment and the inability to compete, given the buying-scale advantages of the majors.

Attractions beyond its peers. Travis Perkins is benchmarked within the building industry, but we think its investment dynamics (margins, returns, performance record and opportunities for organic and acquisitive growth) look fundamentally more attractive than its peers.

Our price target implies potential upside of 20%. We initiate coverage with an Overweight rating and a price target of 1,276p, which would put the stock on 12.7 times our 2003 earnings forecasts, and 2.2 times invested equity, with a return on invested equity post tax of 18.7%, on our 2003 estimates, more than twice the group’s cost of equity.

Our price target is based on the average of five valuation metrics. We use a DCF valuation with a WACC of 8.1% and a six-year cycle to the group’s sales from the end of our detailed forecasts, which run to 2006 (our 10-year DCF valuation is 1,400p). Our P/E valuation, in which we use the 10-year average normalised P/E of 13.1 on 2003 earnings of 100.5p yields 1,312p. We have compared the 10-year average EBITA margin of 8.8% with our forecast 2003 EBITA margin of 10.8% and applied the 23% implied margin premium to the 10-year average sales multiple of 0.79 to arrive at an adjusted sales multiple of 0.97 (1,260p). We have compared our forecast 2003 return on invested equity with the 10-year average return, and the premium of this return has then been used as a multiplier to the 10-year average net invested equity multiple (1,275p). Finally, we have looked at the free cash flow yield generated by the group — on our 2003 FCF per share forecast of 89.5p, this suggests a FCF yield valuation of 1,129p.

Housing slowdown is not just an issue for Travis Perkins The key risk in the coming months would be a major slowdown or correction in the housing market, in our view. However, we would argue the following.

• Activity levels in the housing repair, maintenance and improvement market as well as the new build market remain well below their previous cyclical peaks.

• Increased housing transaction costs, particularly stamp duty costs, are likely to increase existing home improvement activity as homeowners choose to invest in their current property to create additional space rather than suffer the nil return costs of stamp duty incurred in moving house.

• A housing correction, should it occur, will have significant repercussions for the wider UK economy as well as the builders’ merchants. Arguably, other areas of discretionary spending are likely to suffer as much, if not more, than housing, which has not been a run-away market in volume terms.

Risks to our price target • A significant correction in UK house prices would affect UK homeowners’ propensity to spend on their homes. Housing repair, maintenance and improvement spending contributed 63% of Travis Perkins’ sales in 2002.

• A significant decline in UK consumer confidence is also likely to affect Travis Perkins adversely, in our view, and would likely lead to lower consumer spending, particularly major expenditure on housing amenities such as bathrooms, kitchens and other upgrades.

• If Travis Perkins were to see a 2.5% decline in volumes in 2003, followed in 2004 by a 7.5% decline in volumes and a 2.5% decline in product prices, we forecast the group’s earnings would fall by 11.9% in 2003 and 42.0% in 2004.

• A sudden increase in wage growth could also affect profitability in the absence of limited product price inflation.

• A period of general price deflation would also represent a risk to both the group’s profitability and our price target.

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Building & Construction April 11, 2003

Waiting for the Dragados Deal Outcome Alejandra Pereda ([email protected]) (+44 20 7513 5374) GICS SECTOR INDUSTRIALS

Strategists’ Recommended Weight 8.0%MSCI Europe Benchmark Weight 6.0% COMPANIES FEATURED

Company (Ticker, Price, Price Target) RatingACS (ACS.MC, €34.2, €40.0) Equal-weightDragados (DRC.MC, €17.3, €20.0) Underweight Waiting for additional good news to become more bullish. ACS and Dragados have outperformed the MSCI Europe index by 65% and 85% respectively in the past 12 months since ACS purchased its initial 23.5% stake in Dragados in April last year. We believe investors have already discounted the potential benefits of an ACS-Dragados merger for both companies despite ongoing earnings risks at Dragados. We would therefore need to see significant additional cost savings announced as a result of the merger before becoming more positive on the stocks.

Resuming coverage of Dragados with an Underweight rating and €20 price target. There are a number of reasons for our cautious stance on Dragados. In addition to its strong price performance, the stock has experienced deteriorating earnings over the past year, failing to meet its 2002 flat growth target and posting guidance for flat earnings in 2003 (excluding exceptionals). This is in contrast to the outlook for its main peers, which are expecting stable double-digit growth in 2003. Finally, we would stress the complexity of Dragados’ account disclosure. Several accounting changes and extraordinary charges over the past three years make year-on-year comparisons difficult, which is particularly relevant now as investors have a heightened sensitivity to accounting issues. We therefore think that investors are assuming greater earnings risk by investing in the shares.

Downgrading our rating on ACS from Overweight to Equal-weight. This change is prompted by the strong price performance of the past 15 months. During this period, ACS has benefited from Spain’s good economic and construction momentum and the positive effect of the market’s expectation of a potential merger with Dragados. Therefore, we think the market has already priced in the good news,

with the company’s record of strong earnings growth (ACS has achieved a compound annual growth rate of 20% in EPS in the past five years), which we think should continue — we forecast a CAGR of 12% in 2002-06. We would need to see additional good news before becoming more positive on the stock. Moreover, if there is a moderate market recovery, we believe Spanish contractors, which are perceived as a domestic and defensive group, will tend to underperform the market and our coverage universe.

We have an Attractive view of the European Building & Construction industry, within which we remain neutral on contractors, as we believe they are trading close to our fair value. Contractors are perceived as defensive and would lag in a market recovery, in our view.

ACS: 150% outperformance since January 2001 … The Spanish construction industry has delivered one of the strongest performances in European stock markets since the end of the TMT bubble. ACS outperformed MSCI Europe by 33% in 2001, 62% in 2002 and 11% so far this year. Since January 2001, it has outperformed the index by 150%.

… but we think the good news is already priced in. Although we are still expecting strong earnings growth for ACS — we forecast EPS growth of 15% in 2003 and 13% in 2004 — we believe that this is already in the share price. We think that the bulk of the strong price performance has been prompted by the market’s revised earnings estimates and the company’s ability to deliver on market expectations. However, the stock’s re-rating has been limited in terms of its earnings multiples. P/E and EV/EBITDA multiples for 2003 have risen from 10.1 and 5.2 a year ago to 10.5 and 5.6 now, on our estimates, which we view as still moderately attractive.

Potential merger of ACS with Dragados. Having acquired a 23.5% controlling stake in Dragados in April 2002, ACS has recently bid for and bought a further 10%. In the latest bid prospectus, management stated that it is studying a full merger with Dragados, which could be announced by the year-end or the beginning of 2004. We believe investors have already priced the potential merger into both stocks. However, we should highlight that, legally, ACS does not

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need to maintain the €22 price paid to acquire its 33.5% stake — it could offer less. Over the past year, the share price of ACS relative to that of Dragados has remained stable at 1.80 to 2.0 times, with the average being 1.88 and median 1.87. Recently, this has moved closer to 2.0, which was the ratio of Dragados to ACS before the original acquisition. This trading range was only interrupted during March 2003, when ACS bid for a further 10% stake in Dragados. The trading range was re-established after the offer closed on March 18. This ratio of 2.0 is consistent with our price targets of €40 for ACS and €20 for Dragados.

We are raising our price target on ACS from €38 to €40, which implies 17% upside potential. This is roughly in line with the 22% we expect for our industry. We employ a sum-of-the-parts method to value the company, based on a discounted cash flow analysis to value the construction business (assuming a WACC of 8.3% and terminal growth rate of 1%); multiples based on those for traded utilities companies with services operations; market value for the initial Dragados stake; and book value for other financial investments. We apply a 5% discount to account for the potential risk of ACS having to overpay in a potential bid for the rest of Dragados. The main risks to our valuation would be a deterioration in Spain’s national accounts and the potential effect of this on public construction, a material rise in interest rates and a material change in the Dragados share price.

We would become more positive on the stock if a merger and significant potential cost savings were announced. We estimate that cost savings from each 0.5% increase in sales would increase our fair value by 6-7% for both ACS and Dragados. Therefore, we would need to see cost reductions from at least a 1% rise in sales before increasing our fair value sufficiently to justify a change in rating.

However, we think the potential for cost savings is limited and that, all else being equal, savings would probably be concentrated on construction and central expenses. Therefore, we believe that it would be difficult to achieve more than 1% of pro-forma sales in savings, which would take the construction EBITDA margin to 8.8%, on our 2003 estimates.

We value Dragados using a sum of the parts to reach our price target of €20.0. We employ a discounted cash flow model for the construction business (assuming a WACC of 8.2% and terminal growth rate of 1%); multiples based on listed utilities companies for services operations; and market value (if available) or book value for financial investments. The main risks to our price target would be a deterioration in Spain’s national accounts and the knock-on effect this would have on public construction projects; a sharp rise in interest rates; or a significant change in the share price of Aurea, in which Dragados has a 10% stake.

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Transport April 9, 2003

Abertis — Use an Alternative Route Pablo Morales ([email protected]) (+44 20 7425 7495) Martin Borghetto ([email protected]) (+44 20 7425 6698) GICS SECTOR CONSUMER DISCRETIONARY

Strategists' Recommended Weight 12.5%MSCI Europe Benchmark Weight 9.3% COMPANIES FEATURED

Company (Ticker, Price, Price Target) RatingAutostrade (ACMI.MI, €11.59, €14.4) OverweightASF (ASF.PA, €24.7, €30.0) Overweight–VAcesa (ACE.MC, €12.03, €11.97, NA) Equal-weightAurea (AUM.MC, €26.75, €26.67, NA) Equal-weight This is an extract from a report (44 pp) dated April 9, 2003.

We view the European Surface Transport sub-industry as In-Line. We favour the quasi utility segment of motorways and airports from an earnings perspective, but believe that this is reflected in valuation. Freight and mail offer gearing to a recovery with more attractive valuations, in our view.

Resuming coverage of Aurea and Acesa We resume coverage of both Aurea and Acesa with an Equal-weight rating. On their own, however, the two stocks are of little interest as, in just over one month’s time when Abertis is constituted, they will no longer be listed individually. Abertis will be the product of the merger of Aurea and Acesa as well as the acquisition of Iberpistas in mid-2002. Therefore, from an investor’s standpoint, we think it is more fruitful to analyse the shape that the new company is likely to take.

As the merger terms have now been approved by all the parties involved and the deal finally seems set to proceed, the question is whether or not the market price reflects the exchange ratio — in short, whether there is a possibility of arbitrage. We assume that the market is efficient and does not offer this possibility.

We therefore focus on Abertis. We consider it a very attractive company within Europe’s motorway industry.

• Its new-found financial muscle will be similar to that of Autostrade and Autoroutes du Sud de la France (ASF), with the difference that Abertis will be able to increase its gearing since it has lower debt levels.

• It has more international experience in the industry than its peers, in our view.

• Its concessions portfolio mixes maturity and growth.

• It has a higher dividend yield than ASF and Autostrade. Its absolute free float should also be higher than theirs, on our estimates.

However, our estimates suggest that Abertis’ valuation is tight. We have attained a valuation of €7.0 billion for Abertis, implying 13% upside potential from current prices for Aurea and Acesa. This is not enough for us to give the company an Overweight rating since we see more attractive options elsewhere in the industry, such as ASF and Autostrade, which offer greater upside potential to their current prices, in our opinion.

In addition, we have two basic concerns about Abertis:

• the financial position of its subsidiaries in Argentina, particularly Ausol, whose revenues are denominated in peso, while its debt is denominated in dollars; and

• corporate governance — in this respect, we would like to have more visibility on the independence of the companies and their main shareholders, specifically La Caixa, Dragados and ACS.

The creation of Abertis is just a step away, in our view On April 8, at their respective shareholders’ meetings, Acesa and Aurea approved the merger of Aurea via Acesa’s absorption. The other parties involved (creditor banks, bondholders and suppliers, among others) now have one month to state their opposition.

In addition, while waiting for the formal procedure to be completed, the companies are required to present the merger prospectus to the Securities Markets Commission (CNMV)

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so that the new shares issued by Acesa to absorb Aurea can be listed for trading.

Once these steps have concluded, the company will be officially known as Abertis, and the new shares will automatically start to trade. No acceptance period is involved since the operation is a merger and not an offering, and therefore, after its approval at the meetings, shareholders no longer have the option to accept or reject the deal. We estimate that this listing could happen in late May.

Valuation We arrive at a value of €7.0 billion for Abertis, which implies 13% upside potential from the sum of the market capitalisation of Aurea and Acesa. We use a sum-of-the- parts method, first estimating the value of the company’s core businesses, then adding in its financial holdings. In this case, “core business” refers to what Acesa itself defines as its

core business; we would view the core business as motorways and car parks.

To value the new company’s motorway concessions, we use a DCF method with a different WACC each year. In addition, depending on their country risk and financial structure, we apply different costs of debt and equity risk premiums. For the Spanish motorways, these are 550-700 basis points and 350-500 basis points, respectively.

We value Abertis’ car park business at the price paid last week by Acesa for a 39.9% stake in Saba.

For the logistics and telecoms businesses, we use the book value, except for Xfera, to which we assign zero value.

Lastly, we apply a 10% discount to Abertis’ financial shareholdings since most of them are in listed companies.

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Centrica April 14, 2003

Hard Evidence Bobby Chada ([email protected]) (+44 20 7513 5238) David Lang, CFA STOCK RATING OVERWEIGHT

Price (April 8, 2003) 160pPrice Target 230p52-Week Range 235-130pStock ratings are relative to the analyst’s industry (or industry team’s) coverage universe.

GICS SECTOR UTILITIESStrategists' Recommended Weight 3.7%MSCI Europe Benchmark Weight 4.7% Currency = Sterling (p) Fiscal Year Ends Dec 31 2002 2003e 2004eEPS 15.2 18.2 19.7P/E 10.5 8.8 8.1Dividend 4.0 4.8 5.3Yield (%) 2.5 3.0 3.3

Market Cap (US$mn, £mn) 10,436, 6,689EPS Growth (02-07e) (%) 38.0Shares Outstanding (mn) 4,181

Reuters, Bloomberg CNA.L, CNA LN

Source: Company data, Morgan Stanley Research e = Morgan Stanley Research estimates


We have raised our EPS and DPS estimates Centrica’s shares have increased in value by some 17% over the past month, outperforming the FTSE AllShare index by 6.5% and the European Utility industry by 7%. However, overall performance in 2003 has so far been muted — the share price is only now back to its mid-February levels.

We believe that the stock continues to offer very attractive value and growth characteristics. We have raised our 2003-05 EPS estimates by 9% on average, and our dividend estimates by 4%. We believe that our increased dividend growth forecasts (20% growth in 2003 and 10% thereafter) could even be too conservative. Centrica could materially increase its dividend payout ratio, but our forecasts show just a small increase from 26% in 2002 to 28% in 2005. The scope for dividend growth should become clearer when the interim results are announced in July.

Relative valuations, even adjusted for the depleting upstream gas assets, are compelling, in our view. Centrica trades at a significant discount to the utility industry

average, but offers at least double the average rate of growth in earnings and cash flow. Even if we compare Centrica with the wider market, the relative valuation is equally compelling. Like for like, stripping out its upstream gas assets, we estimate that Centrica trades on a 2003 P/E multiple of 10 but offers an earnings CAGR of 16% (2002-07).

Also raising our price target Our sum-of-the-parts (SOP) valuation uses a number of different methodologies for each business segment to reflect their inherent differences. The methods we use include EBITDA multiples, P/E multiples, discounted cash flows and returns on invested capital (ROIC). For the largest part of the business, Residential Energy Supply, we assume annual revenue of £160 per single-product customer and £330 per double-product (‘dual-fuel’) customer. These revenue amounts are based on lifetime DCF valuations per customer using assumptions on the average bill, sustainable operating margin and churn rates. This implies a UK customer base value of £3,028 million, or 72p per share. Our recently revised SOP valuation has resulted in a small increase in our fair value from 225p to 230p, which we now set as our price target.


98 99 00 01 02

1.01.21.41.61.82.02.22.42.6

80100120140160180200220

Relative to MSCI The World Index / Utilities -IG (Right)Relative to FTSE - UK All-Share (GBP) (Right)Centrica (Left, British Pounds)

Data Source: FactSet Research Systems Inc. Company Description Centrica employs 28,000 people worldwide and was formed in 1997 from the demerger of British Gas. Its principal activity is the supply of gas and electricity to domestic, industrial and commercial customers. Since the demerger, the company has expanded its non-core ‘services’ business to include Home, Road and Financial Services. Centrica is building a presence in the North American and European energy markets. It also has telecoms interests and other small businesses.

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We view Centrica as the most attractive utility in the UK Perhaps more importantly, we believe that, following the 2002 results, we can now present evidence to refute some of the concerns regarding the viability of Centrica’s business model and its reinvestment strategy. We therefore reiterate our Overweight rating as, in our view, Centrica is now the most attractive utility in the UK. We believe that the shares’ current discount to the pan-European average is unwarranted.

In short, we think that Centrica has generated a lot of cash since its demerger in 1997 and will continue to do so in the long term. Critically, this cash harvest has been invested sensibly and is already earning decent returns, in excess of its WACC. Apart from the small Goldfish Bank and Telecom businesses, we believe that Centrica’s newer businesses will generate an ROIC of 10-15% in 2003. These businesses already earned returns in excess of the company’s WACC in 2002, on an annualised basis. If Centrica is to meet its own internal targets, these returns will have to increase even further. At the same time, the company has maintained a strong balance sheet, with a single-A credit rating from Standard & Poor’s that looks to us very secure.

Sensible reinvestment that is already yielding returns means that Centrica should be able to increase earnings and cash-flow generation even as its upstream gas assets deplete. We forecast substantial growth in earnings and significant improvements in cash generation. We also expect that the company will continue to generate over £500 million of cash per annum on average. While Centrica does have some reinvestment plans, these are relatively modest. In the future, we think that investors are likely, therefore, to receive materially higher dividends as the company begins to reflect its strong cash generation in a higher payout ratio.

A rollercoaster ride in 2003 … Centrica’s share price has been on something of a rollercoaster ride in 2003. We believe that this reflects poor and inflexible communication of the company’s strategy by management. Assuming that poor communication of strategy and targets is a problem that should be relatively easy to resolve with a change in approach by management, would suggest that there is a way out of the recent woes for investors.

… as concerns gathered momentum We also think that a number of other problems have plagued the company, some of which have been exacerbated by the poor communication. We have sought to address these

concerns and evaluate whether they merit the significant discount to fair value at which Centrica’s shares now trade.

New analysis suggests concerns are overdone We have considered these concerns and assessed the investment case for Centrica in light of its 2003 performance to date. We conclude that such concerns are overdone and that the discount between Centrica’s share price and our estimate of fair value is similarly excessive. Put simply, our analysis reveals the following points.

• Upstream profits will decline, as we have always expected, but this is more than offset by increasing profits from other businesses.

• Investment in new gas assets should underpin annual upstream gas EBIT of around £150 million in the long term.

• For the most part, Centrica’s investment track-record is impressive. This goes against the received wisdom.

• Centrica’s energy supply business enjoys scale, brand and product mix advantages, and we think its operating profit margins are sustainable at 6%.

• Goldfish Bank and Telecom remain disappointments, but their prospects should become much clearer in 2003.

• Headline EPS growth is likely to decline slightly from past levels, on our forecasts, but should remain significantly above the industry average.

• We expect dividend growth to increase significantly, perhaps in excess of our forecasts

Risks to achieving our price target Lingering concerns regarding Centrica’s strategy and poor communication could mean that the stock continues to trade at a discount to our fair value. In addition, concerns regarding the UK Competition Commission inquiry into Centrica’s gas storage acquisition, Rough, or other regulatory risks in general could cause the risk premium to rise and instil a regulatory risk discount. On the financial front, Centrica has an FRS 17 pension deficit, which is equivalent to a liability of 15p per share. Lastly, the energy supply market is competitive; if the current market structure were to break down, triggering a price war, this could depress margins and reduce our valuation.

Our view of the European Utilities industry is Attractive We see 30% implied upside potential to our DCF-derived price targets.

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Reuters April 16, 2003

Obsolete Products Put Pressure on Second Half of 2003 Matthew Owen ([email protected]) (+44 20 7513 8605) STOCK RATING UNDERWEIGHT–V

Price (April 16, 2003) 122pPrice Target 130p52-Week Range 555-95pADR Price, Target US$11.26, US$12.00Stock ratings are relative to the analyst’s industry (or industry team’s) coverage universe.

GICS SECTOR CONSUMER DISCRETIONARYStrategists' Recommended Weight 12.5%MSCI Europe Benchmark Weight 9.3% Currency = Sterling (p) Fiscal Year Ends Dec 31 2002 2003e 2004eEPS 6.83 2.08 1.37P/E 17.9 58.6 89.1Dividend 10.00 7.00 7.00Yield (%) 8.2 5.7 5.7

Market Cap (US$mn, £mn) 2,618, 1,702 EPS Growth (03-07e) (%) 65.4Shares Outstanding (mn) 1,395.0

Reuters, Bloomberg, ADR RTR.L, RTR LN, RTRSY.O

ADR Data – US Dollars (US$) 2002 2003e 2004eEPADR 0.62 0.19 0.13P/E 18.1 59.3 86.6Dividend 0.91 0.64 0.64Yield (%) 8.1 5.7 5.7Exchange Rate (US$/£1) 1.52 1.52 1.52

Ordinary Shares per ADR 6.0

Note: Data are per our note Ahead of the Curve Except on Price (April 16, 2003) e = Morgan Stanley Research estimates Source: Company data, Morgan Stanley Research

Reviewing our estimates to reflect Reuters’ recent disclosures on volumes and pricing. We see the loss of revenues from obsolete products accelerating through 2003, so have reduced our 2003 and 2004 EPS forecasts. We have also analysed the consequences for valuation of existing company guidance and assumptions for the free cash flow of the core business. We reach four broad conclusions.

1. Mix is an even more important issue for Reuters than our pricing model suggested. The accelerating decline in revenues reflects weakness across the business, but the outmoded premium 2000 and 3000 (pre-Xtra) terminals are disproportionately responsible for the slide.

2. The erosion of obsolete premium subscriptions means that the revenue nadir is likely to occur in 2004 at the earliest, in our opinion. This is not a new assumption, but underlines our conviction that the second half of 2003 will be markedly worse than the first-half guidance of around a 10% fall in recurring revenues. This means that Reuters will have to front-load its latest round of cost savings into 2003 (we estimate that it needs to achieve some £260 million of savings this year of the £440 million targeted by 2005) if it is to reach even a margin of 11% for the core business, pre-restructuring; the company currently projects a margin of 13% for 2003.

3. The good news is that free cash flow and the debt pay-down are likely to surprise on the upside for 2003. Our previous fear that core cash flow was deteriorating even faster than the profit-and-loss performance now seems invalid. First, our concern that the collapse in capital expenditure since 2001 may have been related to an increase in exceptional restructuring charges has been allayed by the detail from the 2002 accounts, which demonstrate that property savings were largely responsible. Second, management’s stated willingness to explore options that will realise value in non-core stakes, such as GL Trade (in which Reuters owns a 34% stake) and TIBCO (50% stake), suggests that overall core net debt (£584 million at December


98 99 00 01 0202468

10121416

020406080100120140160180200

Relative to MSCI The World Index / Media -IG (Right)Relative to FTSE - UK All-Share (GBP) (Right)Reuters (Left, British Pounds)

Data Source: FactSet Research Systems Inc. Company Description Reuters is the leading provider of financial information globally. Its key markets are foreign exchange, equities, fixed income and risk. It has an important trading side to the business, especially foreign exchange.

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31, 2002 but now £700 million post the Multex acquisition) will be tackled sooner rather than later. Finally, the shrinkage of Instinet means that opportunities exist to reduce the required trading capital in the business, which represents £518 million of cash that is included in total net debt but is frustratingly out of Reuter’s grasp.

4. Price target of 130p still realistic, in our view, but our Underweight–V rating reflects breadth of potential downside. Despite our reduction in near-term EPS estimates, we are maintaining our price target of 130p, as we have more faith in the value of Reuters’ non-core assets and accept that a steeper decline in revenues will be accompanied by a cost reduction in line with management’s guidance of £440 million. We base our valuation on a cash-flow scenario analysis in which revenues decline by 20% from their 2002 base. We then tie the FCF output (which we place on a multiple of 12, a discount to the peer group) in with the rest of the Reuters portfolio at current market valuations. Risks to our price target would be a larger decline in revenue than we are forecasting and an even further deepening of the extreme overcapacity in the financial services industry, coupled with a falling client base. We continue to believe that a dividend cut is imminent (we assume to 7p), but recognise that this provides yield support. To become more still positive, we would wish to see a rapid debt pay-down or firm evidence that Xtra or Bridge 7 terminal sales are more than offsetting the loss of obsolete subscriptions. Anatomy of a revenue contraction The disclosure of the business’ core drivers is improving and information regarding volume and price composition of recurring revenues is certainly welcome. The disclosure also provides a basis from which to evaluate the present revenue malaise and reinforces our assumption that average pricing is a bigger issue than terminal volumes. The increasingly obsolete 2000 and 3000 (pre-Xtra) products that represented Reuter’s premium desktop offering during the 1990s are no longer competitive at historical prices and are slowly, but surely, disappearing. In 2002, revenues from these products fell by 26%; we think that, in 2003, the decline could exceed 41%. As such, the challenge is for Reuters to convert these lost subscriptions into, ideally, Xtra or Bridge 7 users or, at least Market Monitor.

Revenue problems are not new to Reuters. What is more interesting, in our view, is what this continued decline might mean for the stock beyond 2004. In the past, we have used

intrinsic valuations, normalised earnings and a DCF to gauge

value. We now feel that the uncertainties are such that it makes sense to stick to just one variable. Therefore, we focus on one question — how far core revenues will fall from their 2002 levels — and analyse the consequences of different scenarios for free cash flow.

The fair values we reach from this analysis (for full details, see our note Obsolete Products Put Pressure on 2H03, April 14, 2003) point to considerable upside potential if management delivers on its promises and we make no change to our assumptions. Although this implies significant upside to our price target, we would still reiterate our Underweight–V rating, given the considerable downside risk that a 30% drop in revenues would imply.

It is not difficult to construct a rationale for why we think such a worst-case scenario is extremely unlikely, given the stability (albeit stagnant) of the dealing revenues. We believe, however, that signs of a turnaround at Reuters are unlikely to be apparent before 2004 at the earliest and that, even if investment banks start to rally, the structural overhang from the 2000/3000 obsolescence will blunt Reuters’ leverage. Issues such as the elimination of soft commission purchases of Reuters by the Financial Services Authority (FSA), while specious, illustrate how easily misunderstood news flow can hit the stock. This was demonstrated by the recent negative share price reaction to the FSA report, Bundled Brokerage and Soft Commission Arrangements (April 2003), despite the fact that the limited number of market data terminals purchased by UK equity managers through soft commission are essential tools that would be required even after any reform of commission arrangements. We would therefore be positive on the stock below 90p, given the scope for management to realise value from non-core stakes and maintain free cash flow from dealing and news revenues.

Our view of the European Media & Internet industry is Cautious. We see limited opportunities for earnings upgrades, and a re-rating is unlikely, in our view, for the broad group, given the premium at which the stocks currently trade.

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Vivendi Universal April 14, 2003

Breaking Up Is Hard To Do Sarah Simon ([email protected]) (+44 20 7513 6064) Matthew Owen ([email protected]) (+44 20 7513 8605) Javier Marin, CFA ([email protected]) (+44 20 7513 3503) STOCK RATING UNDERWEIGHT

Price (April 7, 2003) €13.95Price Target €14.552-Week Range €40.85-8.62ADR Price, Target US$14.9, US$15.5Stock ratings are relative to the analyst’s industry (or industry team’s) coverage universe.

GICS SECTOR CONSUMER DISCRETIONARYStrategists' Recommended Weight 12.5%MSCI Europe Benchmark Weight 9.3% Currency = Euro (€) Fiscal Year Ends Dec 31 2002 2003e 2004eEPS (0.47) 0.37 0.66P/E NM 37.7 21.1Dividend 0.0 0.0 0.0Yield (%) NA NA NA

Market Cap (US$mn, €mn) 16,061, 15,010EPS Growth (03-06e) (%) 43Shares Outstanding (mn) 1,076

Reuters, Bloomberg, ADR EAUG.PA, EX FP, V.N

ADR Data – US Dollars (US$) 2002 2003e 2004eEPADR (0.50) 0.40 0.71P/E NM 36.0 20.3Dividend 0.0 0.0 0.0Yield (%) NA NA NAExchange Rate (US$/€1) 1.07 1.07 1.07

Ordinary Shares per ADR 1.0

e = Morgan Stanley Research estimates Source: Company data, Morgan Stanley Research


Cutting our price target following management guidance In our last report on Vivendi Universal* (VU) (Clear as Mud, March 10, 2003), we noted various issues that lay behind our Underweight rating, including insufficient financial disclosure, liquidity and lack of visibility on strategy. Since then, two out of three have been addressed. VU has now given out some detailed financial information, which has allowed more precise divisional analysis. It has also gone a considerable way to addressing liquidity, through the issuance of a high-yield bond, the refinancing of the VUE bridge loan and the arrangement of a new term loan facility.

While this is good news, we now need to lower our estimates. The more detailed financial information leads us to lower our 2003 revenue forecast by 4%, EBIT by 15% and operating free cash flow by 6%. We are consequently cutting our price target from €15.8 to €14.5. Our rating on the stock remains Underweight for the following reasons.

VU still depends on future disposals in the medium term (after the end of 2003), even though the refinancing has improved short-term liquidity. We believe that execution of disposals will be difficult, given current economic and geopolitical uncertainties.

The cost of refinancing is high. While VU’s 2002 average cost of debt was 4.1%, the group paid 9.25-9.75% for the recent high-yield offering. The securitisation was at less than 200 basis points over LIBOR, but is likely to have required substantial over-collateralisation.

Operational strategy is still unclear. Management’s stated strategy is to return the company to investment-grade status. While this is a reasonable aim in the short term, it will be hard to form a long-term view of VU until the company indicates which assets will be core for the group in the future.

VU will remain a holding company for some years, even after making the necessary disposals, since various liabilities make it inefficient for the company to sell certain of its assets. The longer VU takes to sell assets, the greater the likelihood


98 99 00 01 020

20406080

100120140

020406080100120140160

Relative to MSCI The World Index / Media -IG (Right)Relative to France CAC 40 (Right)Vivendi Universal (Left, Euro)

Data Source: FactSet Research Systems Inc. Company Description Vivendi Universal is a global media and communications group with interests in music, pay TV, filmed entertainment, recreation, fixed and mobile telephony, and games. It owns 20% of Vivendi Environnement, which it plans to sell as part of its restructuring.

Company Analysis



Page 42

that the market will look at P/E or price/FCF multiples. In our view, VU is not compelling on either measure at the current price.

Valuation: is sum of the parts the right approach? We continue to believe that valuing VU on a sum of the parts basis is right, but note the following.

• The company faces a number of potential tax liabilities should it sell some of its assets.

• Because management cannot dispose of all the assets in the company, it may be that investors continue to see VU as a conglomerate and assign a discount to valuation to reflect this.

• Although VU has reaffirmed its commitment to sell €7 billion of assets in 2003, the recent refinancing does take the pressure off the company. If this results in slower execution of disposals, we would need to pay increasing attention to earnings and cash flow multiples

We value Universal Music Group (UMG) on 15 times 2003 FCF, versus EMI’s multiple of 10. We believe that this premium reflects the fact that UMG has been more successful than EMI on a global basis.

We value the Publishing division (Games) at 26 times 2003 FCF. This is the fastest growing division within VU, and the premium multiple reflects this, in our view.

We value Vivendi Universal Entertainment at 27 times 2003 FCF. This is an average of the multiples we estimate for Viacom (22), Disney (34) and News Corp (22).

We value Cegetel at the price implied by VU’s purchase of BT’s 26% stake. Our €10.8 billion valuation of VU’s interests in the Fixed Line and Mobile divisions implies a

multiple of 18.8 times our estimate of 2003 proportionate FCF for those businesses. This compares with a multiple of 17.2 for the European large-cap peer group. For international telecoms, we assign a value of €2 billion.

For Groupe Canal+, our DCF suggests a midpoint value of €5.9 billion. This use a WACC of 9% and terminal growth rate of 4%.

To these, we add various other assets and liabilities, including the market value of listed investments, disposals that have been announced but not closed, taxes due, the VU pension deficit, and net debt. Finally, we deduct the value of VU overheads, which we capitalise at 14 times our estimate of 2003 taxed EBIT loss. The sum of the above gives us an equity value range of €13.7-16.7 billion. This equates to a value per share of €11.8-14.5.

Risks to our price target We think there are a number of fundamental issues that are likely to hold back the stock relative to its peers, including:

• lack of cash flow generation in the group of assets to which VU has full cash-flow access;

• heavy indebtedness and reliance on disposals to reduce this burden and thus avoid another liquidity problem in 2004; and

• lack of clear strategy, other than to return to investment-grade status;

Our view of the European Media & Internet industry is Cautious. We see limited opportunities for earnings upgrades, and a re-rating is unlikely, in our view, for the broad group, given the premium at which the stocks currently trade.

Price for other stocks mentioned: Disney US$18.31, EMI 106p, News Corp US$27.35, Viacom US$41.30


Company Analysis



Page 43

Xstrata April 9, 2003

MIM — Right Deal at the Right Price, But Not Without Risk Paul McTaggart ([email protected]) (+44 20 7513 6948) Marcus Lun ([email protected]) (+44 20 7513 5354) STOCK RATING OVERWEIGHT

Price (April 9, 2003) 560p Price Target 650p52-Week Range 1,015-451pADR Price, Target US$8.85, US$10.20Stock ratings are relative to the analyst’s industry (or industry team’s) coverage universe.

GICS SECTOR MATERIALSStrategists' Recommended Weight 6.8%MSCI Europe Benchmark Weight 5.3% Currency = US Dollar ($) Fiscal Year Ends Dec 31 2002 2003e 2004eEPS 0.90 0.74 0.82P/E 9.8 11.9 10.8Dividend 0.20 0.22 0.25Yield (%) 2.3 2.5 2.8

Market Cap (US$mn) 2,221EPS Growth (02-06e) (%) 3.8Shares Outstanding (mn) 253

Reuters, Bloomberg XTA.L, XTA LNe = Morgan Stanley Research estimates Source: Company data, Morgan Stanley Research


Background to the acquisition Xstrata has agreed to acquire the entire issued share capital of MIM Holdings for a total acquisition value of US$2,959 million. This includes assumed MIM debt, estimated by Xstrata to be US$894 million at the potential completion date in late June 2003. The acquisition is recommended by the MIM board of directors but is subject to approval by 75% of the common shareholders.

A premium paid; we believe A$1.72 will be enough The Xstrata offer represents a premium of 38% to the closing share price on November 20, 2002 and a 10% premium to our standalone DCF valuation of MIM. The MIM board said it sought offers from other companies, but none have arisen.

We believe this is the right ‘company-transforming’ deal Our initial pro-forma analysis of a merged Xstrata-MIM assumes a successful offer at A$1.72 per share and the proposed 3-for-2 rights issue. We estimate that the deal is earnings accretive by 6% and 8% in 2004 and 2005 and cash flow accretive by 12% and 15% in these years. We do note some dilution (19%) in 2003, on our estimates; however, we have assumed a pro-forma full year of MIM/Xstrata, whereas in reality only six months of MIM earnings would be included, as the deal is complete at the end of June 2003. We estimate that ROE in 2004 and 2005 will be boosted from our current forecasts of 5.2% and 5.7% to 7.2% and 8.2%, respectively. We believe this is the right ‘company-transforming’ deal for Xstrata, struck at about the right price.

However, the acquisition is not without risks, in our view. On our estimates, the deal would be EPS dilutive in 2003 even if only six months of earnings were taken into consideration, given our forecast for depressed MIM earnings (although we estimate it to be accretive to cash flow in 2003). We reiterate that the success of this deal hinges on an earnings recovery at MIM.


MayJun Jul AugSepOctNovDecJanFebMar

5

6

7

8

9

10

65707580859095100

Relative to FTSE - UK All-Share (GBP) (Right)Xstrata PLC (Left, British Pounds)

Data Source: FactSet Research Systems Inc. Company Description Xstrata is an international resources group based in Switzerland with sales of over US$2 billion in 2002. The company comprises three major businesses: Coal, which has interests in operating coal mines in Australia and South Africa; Zinc, with a zinc mining and smelting operation in Europe; and an integrated ferrochrome and vanadium business with operations in South Africa and Australia.

Company Analysis



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Price target and risks We rate Xstrata Overweight. Based on the company’s current asset base, our DCF valuation is 695p per share. We use a WACC of 9% and a terminal growth rate of 3%. Our price target of 650p represents a 7% discount to our DCF valuation. We believe this is appropriate given Xstrata’s high level of exposure to South Africa and the uncertain outlook for near-term coal prices. We note that the other London-listed mining stocks with substantial South African exposure are trading at discounts to our DCF valuation that range from 5% to 17%. The key risks to our price target would be a protracted ‘double dip’ economic downturn; unforeseen political events in Southern Africa; European and Australian geotechnical mining and development risks; and commodity prices or exchange rates that are worse than we expect.

The Xstrata perspective We recently argued that the attractions of an acquisition of MIM for Xstrata included earnings accretion, improved balance sheet efficiency, tax synergies, geographic diversity and broader commodity mix. Now that the company has announced acquisition terms, we can revisit our financial analysis.

Ex-rights price. We calculate a theoretical ex-rights price of 337p and a bonus adjustment factor of 1.41 (this is similar but not quite the same as the Xstrata derived numbers). Our calculated value of shares post the rights issue is 476p compared with a pre-deal price of 487p (the difference reflects issue costs).

Valuation impact. We estimate that the deal is earnings accretive by 6% and 8% in 2004 and 2005 and cash flow accretive by 12% and 15% in those years, assuming the proposed rights issue and a A$1.72 price for MIM shares. Furthermore, we estimate that ROE in 2004 and 2005 will be boosted from our current estimates of 5.2% and 5.7% to 7.2% and 8.2%, respectively. (Note that we have grossed up post-deal EPS and cash flow per share so that we can make like-for-like comparisons.)

At the current price of 560p, Xstrata is trading at a P/E of 10.8 and price/cash flow of 4.9, on our 2004 estimates. After the deal, we estimate that the 2004 P/E will fall to 10.2 and price/cash flow to 4.4. This compares with a P/E of 16.6 and price/cash flow of 10.5 for Rio Tinto, on our 2004 estimates.

Our calculations imply gearing is manageable Assuming the deal goes ahead, we estimate that group cash flow will be robust, and we expect gearing (net debt:net debt + equity) to fall to a modest 28% by the end of 2003. In our opinion, this should enable the merged group to achieve an investment grade rating. MIM debt is rated BBB- with a positive outlook by S&P.

Potential for another bid While it cannot be ruled out completely, the possibility of another bidder emerging is low, in our view. There is a break fee of A$51 million payable by MIM, and only the Swiss-based Xstrata is able to realise the lower tax rate (16- 18%) compared with its UK peers. As noted above, MIM’s board has said that it had solicited bids from other companies unsuccessfully, while, unlike a traditional on-market takeover bid for a company, the negotiation process between Xstrata and MIM has been ongoing since November 2002. We believe this is likely to mean the offer of A$1.72 per share reflects the end of negotiations between the companies on price, hence the agreement of MIM’s non-executive directors to the bid. Since the negotiations began in November 2002, the global economic outlook has deteriorated and the A$/US$ exchange rate has appreciated sharply.

What if the offer from Xstrata was unsuccessful? Given the weak economic environment, cyclically low base metal prices, the poor outlook for thermal coal prices, and the recent appreciation of the A$/US$, if the Xstrata offer for the company did not succeed, then we believe that the MIM share price could fall significantly below current levels.

Our European Metals and Mining industry view is In-Line We believe over-production and slowing demand could create substantial inventories in palladium, aluminium and zinc.

Prices of companies mentioned: MIM Holdings, Equal-weight with an Attractive view of the Australian Metals and Mining industry, A$1.60, price target A$1.7; Rio Tinto, Equal-weight, 1258p, price target 1300p

European Industry Valuations and Economic Forecasts



Page 45

European Industry Valuations Price/Earnings Price/Sales EV/EBITDA Dividend Yield (%) Updated as of 11/04/03 Close 2003e 2004e 2003e 2004e 2003e 2004e 2003e 2004e Automobiles & Components 7.2 5.8 0.19 0.18 5.4 4.9 4.3 4.9 Banks 12.5 10.5 – – – – 4.5 4.9 Capital Goods 12.8 10.2 0.33 0.32 4.8 4.4 6.9 7.6 Commercial Services & Supplies 18.2 14.2 0.44 0.41 6.4 5.7 3.2 3.6 Consumer Durables & Apparel 13.4 11.8 0.75 0.72 6.9 6.1 4.5 5.0 Diversified Financials 10.2 8.9 – – – – 6.0 6.4 Energy 12.6 12.8 0.61 0.63 4.3 4.4 4.2 4.3 Food & Drug Retailing 14.7 12.9 0.34 0.32 5.5 5.1 5.5 6.0 Food Beverage & Tobacco 15.8 14.1 1.10 1.04 7.7 7.2 4.6 4.9 Health Care Equipment & Services 18.1 15.6 0.66 0.62 7.4 6.7 2.0 2.2 Hotels Restaurants & Leisure 13.3 11.4 0.72 0.67 6.4 6.2 10.3 10.5 Household & Personal Products 24.8 22.0 1.78 1.68 12.2 11.2 1.4 1.5 Insurance 10.1 8.3 – – – – 3.8 4.3 Materials 12.4 10.2 0.53 0.51 4.9 4.5 8.3 5.3 Media 28.8 21.3 0.87 0.84 7.5 6.8 3.8 4.1 Pharmaceuticals & Biotechnology 17.0 15.3 2.80 2.62 9.6 8.8 2.3 2.5 Real Estate 13.9 13.3 – – 12.1 11.3 8.1 8.5 Retailing 12.5 11.1 0.34 0.32 6.6 5.5 6.7 7.1 Software & Services 42.5 27.0 1.68 1.56 11.2 9.3 0.9 1.1 Technology Hardware & Equipment 35.1 17.5 1.39 1.28 8.0 6.1 1.8 1.9 Telecommunication Services 36.3 22.8 1.23 1.18 5.3 4.9 3.0 3.3 Transportation 12.8 10.3 0.43 0.41 8.5 7.8 5.3 5.8 Utilities 13.3 11.9 0.57 0.54 5.6 5.4 7.2 7.3 MSCI Europe (Coverage) 14.6 12.3 0.70 0.67 6.0 5.6 4.3 4.5

e = IBES estimates Source: IBES, MSCI, Morgan Stanley Research Economic Forecasts GDP Growth (%) CPI Inflation (%) 3-Month Euro Rates (%) (e) 10-Year Bond Yields (%) (e) Exchange Rates1 (e) 01 02e 03e 04e 01 02 03e 04e 15-Apr2 Jun 03 Sep 03 Dec 03 15-Apr2 Jun 03 Sep 03 Dec 03 15-Apr2 Jun 03 Sep 03 Dec 03 North America US 0.3 2.4 2.0 4.0 2.8 1.6 2.3 1.9 1.3 1.6 1.8 2.0 4.0 4.3 4.4 4.5 - - - - Canada 1.5 3.4 3.1 3.9 2.5 2.2 3.1 2.5 3.4 3.7 4.2 4.7 5.1 5.6 5.9 6.1 1.45 1.48 1.45 1.42 Europe 1.5 1.0 0.8 2.3 2.2 2.1 2.1 1.7 - - - - - - - 1.08 1.05 1.10 1.12 EMU 1.4 0.8 0.6 2.3 2.3 2.3 2.0 1.5 2.5 1.9 2.5 2.8 4.3 3.6 4.0 4.5 - - - - Austria 1.0 0.9 0.6 1.9 2.7 1.8 2.0 1.5 2.5 1.9 2.5 2.8 4.2 3.9 4.3 4.8 13.76 - - - Belgium 0.8 0.7 0.8 2.3 2.5 1.6 2.2 1.6 2.5 1.9 2.5 2.8 4.2 3.7 4.1 4.6 40.3 - - - Denmark 1.4 1.6 1.1 2.4 2.2 2.3 1.8 2.2 2.6 2.2 2.7 3.0 4.5 3.9 4.3 4.8 7.43 7.46 7.46 7.46 Finland 0.6 1.6 1.9 2.6 2.7 2.0 1.9 2.0 2.5 1.9 2.5 2.8 4.3 3.8 4.2 4.7 5.95 - - - France 1.8 1.2 0.9 2.4 1.6 1.9 1.8 1.5 2.5 1.9 2.5 2.8 4.2 3.7 4.1 4.6 6.56 - - - Germany 0.6 0.2 0.0 2.0 2.0 1.4 1.2 1.0 2.5 1.9 2.5 2.8 4.3 3.6 4.0 4.5 1.96 - - - Greece 4.1 3.6 3.5 3.8 3.4 3.6 3.1 2.8 2.5 1.9 2.5 2.8 4.4 3.9 4.3 4.8 340.8 - - - Ireland 5.9 3.6 3.0 4.5 4.7 4.3 3.2 3.8 2.5 1.9 2.5 2.8 4.2 3.8 4.2 4.7 0.79 - - - Italy 1.8 0.4 0.7 2.0 2.8 2.5 2.1 1.6 2.5 1.9 2.5 2.8 4.4 3.9 4.3 4.8 1,936 - - - Netherlands 1.3 0.2 0.0 2.0 4.2 3.4 2.8 2.2 2.5 1.9 2.5 2.8 4.3 3.7 4.1 4.6 2.20 - - - Norway 1.4 1.4 1.8 2.3 3.0 1.3 1.9 2.5 5.2 6.7 6.7 6.7 5.4 5.1 5.3 5.8 7.84 7.60 7.70 7.80 Portugal 1.6 0.5 0.4 2.3 4.4 3.6 2.9 2.5 2.5 1.9 2.5 2.8 4.3 3.7 4.1 4.6 200.5 - - - Spain 2.7 2.0 1.7 2.6 3.7 3.5 2.6 2.1 2.5 1.9 2.5 2.8 4.2 3.7 4.1 4.6 166.4 - - - Sweden 1.5 1.9 1.4 2.4 2.8 2.6 2.7 1.5 3.6 3.5 3.8 4.1 4.8 4.2 4.5 4.9 9.16 8.95 8.80 8.80 Switzerland 0.9 0.1 0.7 2.1 1.0 0.6 0.7 0.9 0.2 0.2 0.5 1.0 2.6 2.0 2.4 2.8 1.50 1.48 1.47 1.49 UK 2.1 1.8 1.7 2.4 1.8 1.6 2.8 2.6 3.6 3.3 3.4 3.6 4.5 3.9 4.2 4.6 0.69 0.65 0.66 0.67 US$/GBP 1.57 1.62 1.67 1.67 Japan 0.4 0.3 0.7 0.5 -0.9 -0.8 -0.7 -0.8 0.02 0.06 0.06 0.06 0.7 0.9 0.7 0.6 120 124 119 117 Asia 4.0 5.8 4.6 5.8 2.2 1.3 1.7 1.9 - - - - - - - - - - - Latin America 0.5 -0.3 1.5 3.9 5.4 12.9 11.3 7.6 - - - - - - - - - -

1. European exchange rates are against the euro, except where noted 2. Actual data e = Morgan Stanley Research estimates Source: National Statistics Offices, Morgan Stanley Research

European Model Portfolio



Page 46

Total Portfolio: 65 Stocks Portfolio Portfolio Price Benchmark Over- (+) / Price Benchmark Over- (+) / 11/04/03 Weight (%) Under- (-) weight 11/04/03 Weight (%) Under- (-) weight Note: Industries ranked from greatest Overweight to greatest Underweight

Media 2.8 +3.5 Publicis (PUBP.PA) €16.96 Vivendi Universal (EAUG.PA) €12.70 Wolters Kluwer (WLSNc.AS) €11.70 VNU (VNUN.AS) €24.35 TPI (TPI.MC) €3.67 Commercial Services & Supplies 0.9 +2.0 ISS (ISS.CO) DKr 225.0 Securitas (SECUb.ST) SKr 88.5 Vedior (VDOR.AS) €4.75 Materials 5.3 +1.5 Acerinox (ACX.MC) €34.29 BASF (BASF.DE) €38.69 Lafarge (LAFP.PA) €56.90 Pechiney (PECH.PA) €23.09 UPM-Kymmene (UPM1V.HE) €12.23 Consumer Durables & Apparel 1.9 +1.0 Philips (PHG.AS) €16.30 Richemont (RIFZ.VX) SFr 18.8 Thomson Multimedia (TMM.PA) 1 €11.13 Diversified Financials 1.8 +1.0 Fortis (FOR.BR) €14.75 ING (ING.AS) €13.25 Health Care Equipment & Services 0.9 +1.0 Amersham (AHM.L) 412p Fresenius Medical Care (FMEG.DE) 1 €49.07 Hotels Restaurants & Leisure 1.2 +1.0 Kuoni (KUNZn.S) SFr 300.0 Sodexho (EXHO.PA) €19.94 Six Continents (SXC.L) 592p Technology Hardware & Equipment 3.1 +1.0 Ericsson (ERICb.ST) SKr 5.7 Nokia (NOK1V.HE) €13.45 Banks 18.5 +0.5 Allied Irish Banks (ALBK.I) €13.05 BNP Paribas (BNPP.PA) €39.66 Credit Suisse Group (CSGZn.VX) SFr 27.4 HSBC (HSBA.L) 674p Intesa (BIN.MI) €2.19 Lloyds TSB (LLOY.L) 373p Nordea (NDA.ST) SKr 41.6 Svenska Handelsbanken (SHBa.ST) SKr 131.0 UBS (UBSZn.VX) SFr 65.2 Energy 12.7 +0.5 Eni (ENI.MI) €13.35 Statoil (STL.OL) NKr 56.0 Technip-Coflexip (TECF.PA) €69.85 TotalFinaElf (TOTF.PA) €122.60 Capital Goods 3.8 +0.0 Acciona (ANA.MC) €44.30 Alstom (ALSO.PA) €1.57

BAE SYSTEMS (BA.L) 1 122p Sandvik (SAND.ST) SKr 199.5 Food & Drug Retailing 1.9 +0.0 Boots (BOOT.L) 526p Sainsbury (SBRY.L) 2 232p Insurance 4.3 +0.0 Aegon (AEGN.AS) €8.10 Allianz (ALVG.DE) €56.95 Legal and General (LGEN.L) 74p Swiss Re (RUKZn.VX) SFr 82.5 Transportation 1.3 +0.0 FirstGroup (FGP.L) 220p Fraport (FRAG.DE) €17.50 UNDERWEIGHTS Automobiles & Components 1.8 -0.5 BMW (BMWG.DE) €28.95 Real Estate 0.6 -0.6 Software & Services 1.0 -1.0 Telecommunication Services 9.5 -1.0 OTE (OTEr.AT) €8.82 Portugal Telecom (PTCO.IN) €6.71 Telefónica (TEF.MC) €9.64 Vodafone Group (VOD.L) 121p Utilities 4.8 -1.0 ENDESA (ELE.MC) €12.84 ScottishPower (SPW.L) 388p Suez (LYOE.PA) €12.80 Household & Personal Products 1.2 -1.2 Retailing 1.7 -1.7 Food Beverage & Tobacco 7.7 -2.5 BAT (BATS.L) 587p Danisco (DEMC.CO) 1 DKr 238.0 Diageo (DGE.L) 676p Pharmaceuticals & Biotechnology 11.4 -3.5 Aventis (AVEP.PA) €41.69 Celltech (CCH.L) 279p Novartis (NOVZn.VX) SFr 53.1 Schering (SCHG.DE) 1 €39.83 Totals 100 0 Benchmark Over- (+) / SUMMARY Weight (%) Under- (-) weight Industrial Cyclicals/Oil 22.8 +4.0 TMT 16.3 +2.5 Financials 25.2 +0.9 Consumer Cyclicals 7.8 -0.1 Defensive 27.9 -7.2 Asset Allocation (%) 3 Equities Bonds Cash Recommended Allocation 65 33 2 Benchmarks 50 40 10

1. This stock is not covered currently in Europe by a Morgan Stanley industry analyst. 2. Although the shares of this company remain on the model portfolio, Morgan Stanley & Co. International Limited policy precludes the exercise of investment management discretion or the rendering of investment advice on the shares at this time by the strategist and/or the Morgan Stanley analyst who follows the shares. 3. The equity position is allocated as the European Equity Model Portfolio. Bonds are allocated equally between France, Germany, the Netherlands and the UK. The bond position is invested in ten-year paper of these countries. Source: MSCI/Exshare, Morgan Stanley Research



Page 49

Analyst Certification

The following analysts hereby certify that their views about the companies and their securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this report: Sarah Simon, Javier Marin, Martin Borghetto, Pablo Morales De Labra, Luis Prota, Bobby Chada, John Messenger, Paul McTaggart, Alejandra Pereda, Matthew Owen, Richard Davidson.

Important US Regulatory Disclosures on Subject Companies The information and opinions in this report were prepared by Morgan Stanley & Co. International Limited and its affiliates (collectively, "Morgan Stanley").

The following analyst, strategist, or research associate (or a household member) owns securities in a company that he or she covers or recommends in this report: Richard Davidson - ISS (common stock), Lafarge (common stock), Amersham (common stock), Publicis Groupe (common stock), AEGON (common stock), Boots (common stock), TOTALFINA-Elf (common stock), Allied Irish Bank (common stock).. Morgan Stanley policy prohibits research analysts, strategists and research associates from investing in securities in their sub industry as defined by the Global Industry Classification Standard ("GICS," which was developed by and is the exclusive property of MSCI and S&P). Analysts may nevertheless own such securities to the extent acquired under a prior policy or in a merger, fund distribution or other involuntary acquisition.

As of March 31, 2003, Morgan Stanley beneficially owned 1% or more of a class of common equity securities of the following companies covered in this report: Autostrade, Aurea, News Corp., Vivendi Universal, Walt Disney, MIM Holdings Ltd., UPM-Kymmene OY, Pechiney, VNU, Lafarge, Nokia, Ericsson, ING, Technip Coflexip, TOTALFINA-Elf, Nordea, UBS, Credit Suisse Group, Banca Intesa - BCI, Eni SpA, BNP Paribas, BAE SYSTEMS PLC, BAE SYSTEMS PLC ORD, Aventis, Novartis, Schering-Plough, BAT Plc, Suez, Vodafone Group, OTE (Hellenic Telecoms), DANISCO DANISH ORD.

Within the last 12 months, Morgan Stanley managed or co-managed a public offering of securities of Thomson, Fortis (B), ING, llied Irish Bank, Svenska Handelsbanken, HSBC, Lloyds TSB, AEGON, Nordea, UBS, Credit Suisse Group, Banca Intesa - BCI, Eni SpA, BNP Paribas, ENDESA, Diageo, Telefonica, OTE (Hellenic Telecoms), Wanadoo, Walt Disney, Rio Tinto.

Within the last 12 months, Morgan Stanley has received compensation for investment banking services from T-Online International AG, Terra Lycos, Acesa, Viacom, Walt Disney, Portugal Telecom, Centrica, Rio Tinto, TPI, BASF, Thomson, Fortis (B), Amersham, Vivendi Universal, VNU, Lafarge, Nokia, Ericsson, ING, Statoil, Allianz, Fraport, Swiss Re, HSBC, Lloyds TSB, AEGON, Credit Suisse Group, Banca Intesa - BCI, Eni SpA, BNP Paribas, ScottishPower, ENDESA, Diageo, Telefonica, Suez, Vodafone Group, OTE (Hellenic Telecoms), Schering AG, Reuters.

In the next 3 months, Morgan Stanley expects to receive or intends to seek compensation for investment banking services from Seat Pagine Gialle, EMI, Wanadoo, T-Online International AG, Terra Lycos, Acesa, Viacom, Autostrade, Aurea, News Corp., Walt Disney, CS, Dragados, Centrica, Rio Tinto, MIM Holdings Ltd., Publicis Groupe, Wolters Kluwer, ISS, Securitas, Vedior, Acerinox, Richemont, Kuoni, Sodexho Alliance, BASF, Thomson, Fortis (B), Amersham, UPM-Kymmene OY, Pechiney, Vivendi Universal, VNU, Lafarge, Nokia, Ericsson, ING, Acciona, Alstom, Boots, Legal and General, FirstGroup, Sandvik, Allied Irish Bank, Svenska Handelsbanken, Statoil, Allianz, Fraport, Swiss Re, HSBC, Lloyds TSB, AEGON, Technip Coflexip, TOTALFINA-Elf, Nordea, UBS, Credit Suisse Group, Banca Intesa - BCI, Eni SpA, BNP Paribas, Thomson Multimedia, Sainsbury Bros Ltd., Celltech Group, Portugal Telecom, ScottishPower, ENDESA, Diageo, Telefonica, Aventis, Novartis, Schering-Plough, BAT Plc, Suez, Vodafone Group, OTE (Hellenic Telecoms.), Danisco, Schering AG, Reuters.

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

Morgan Stanley & Co. Incorporated makes a market in the securities of Viacom, News Corp., Centrica, Rio Tinto, Fortis (B), Pechiney, Ericsson, ING, Sandvik, Swiss Re, HSBC, Lloyds TSB, AEGON, UBS, BNP Paribas, SAINSBURY(J) PLC ORD25P ENGLISH REG, ScottishPower, Telefonica, BAT Plc, Vodafone Group, OTE (Hellenic Telecoms), Reuters.

An employee or director of Morgan Stanley & Co. Incorporated and/or Morgan Stanley DW Inc. is a director of BAE SYSTEMS.

Morgan Stanley & Co. International Ltd. is a corporate broker to Amersham.



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Global Stock Ratings Distribution (as of March 31, 2003)

Coverage Universe Investment Banking Clients (IBC)

Stock Rating Category Count % of Total Count

% ofTotal IBC

% of Rating Category

Overweight 593 32% 237 39% 40%Equal-weight 861 47% 270 44% 31%Underweight 395 21% 108 18% 27%Total 1,849 615

Data include common stock and ADRs currently assigned ratings. For disclosure purposes (in accordance with NASD and NYSE requirements), we note that Overweight, our most positive stock rating, most closely corresponds to a buy recommendation; Equal-weight and Underweight most closely correspond to neutral and sell recommendations, respectively. However, Overweight, Equal-weight, and Underweight are not the equivalent of buy, neutral, and sell but represent recommended relative weightings (see definitions below). An investor’s decision to buy or sell a stock should depend on individual circumstances (such as the investor’s existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan Stanley or an affiliate received investment banking compensation in the last 12 months.

Analyst Stock Ratings * Overweight (O). The stock’s total return is expected to exceed the average total return of the analyst’s industry (or industry team’s) coverage universe, on a risk-adjusted basis, over the next 12–18 months. Equal-weight (E). The stock’s total return is expected to be in line with the average total return of the analyst’s industry (or industry team’s) coverage universe, on a risk-adjusted basis, over the next 12–18 months. Underweight (U). The stock’s total return is expected to be below the average total return of the analyst’s industry (or industry team’s) coverage universe, on a risk-adjusted basis, over the next 12–18 months. More volatile (V). We estimate that this stock has more than a 25% chance of a price move (up or down) of more than 25% in a month, based on a quantitative assessment of historical data, or in the analyst’s view, it is likely to become materially more volatile over the next 1–12 months compared with the past three years. Stocks with less than one year of trading history are automatically rated as more volatile (unless otherwise noted). We note that securities that we do not currently consider "more volatile" can still perform in that manner. *For Asia/Pacific and Latin America, total return and thus stock ratings are relative to the relevant MSCI country index (rather than the analyst’s coverage universe). Unless otherwise specified, the time frame for price targets included in this report is 12–18 months. Ratings prior to March 18, 2002: SB=Strong Buy; OP=Outperform; N=Neutral; UP=Underperform. For definitions, please go to www.morganstanley.com/companycharts.

Analyst Industry Views Attractive (A). The analyst expects the performance of his or her industry coverage universe to be attractive vs. the relevant broad market benchmark over the next 12–18 months. In-Line (I). The analyst expects the performance of his or her industry coverage universe to be in line with the relevant broad market benchmark over the next 12–18 months. Cautious (C). The analyst views the performance of his or her industry coverage universe with caution vs. the relevant broad market benchmark over the next 12–18 months.

Stock price charts and rating histories for companies discussed in this report are also available at www.morganstanley.com/companycharts. You may also request this information by writing to Morgan Stanley at 1585 Broadway, 14th Floor (Attention: Research Disclosures), New York, NY, 10036 USA.



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Other Important Disclosures For a discussion, if applicable, of the valuation methods used to determine the price targets included in this summary and the risks related to achieving these targets, please refer to the latest relevant published research on these stocks. Research is available through your sales representative or on Client Link at www.morganstanley.com and other electronic systems. This report does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The securities discussed in this report may not be suitable for all investors. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial adviser. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. This report is not an offer to buy or sell any security or to participate in any trading strategy. In addition to any holdings disclosed in the section entitled "Important US Regulatory Disclosures on Subject Companies", Morgan Stanley and/or its employees not involved in the preparation of this report may have investments in securities or derivatives of securities of companies mentioned in this report, and may trade them in ways different from those discussed in this report. Derivatives may be issued by Morgan Stanley or associated persons. Morgan Stanley is involved in many businesses that may relate to companies mentioned in this report. These businesses include specialized trading, risk arbitrage and other proprietary trading, fund management, investment services and investment banking. Morgan Stanley makes every effort to use reliable, comprehensive information, but we make no representation that it is accurate or complete. We have no obligation to tell you when opinions or information in this report change apart from when we intend to discontinue research coverage of a subject company. Reports prepared by Morgan Stanley research personnel are based on public information. Facts and views presented in this report have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel. LVMH has sued Morgan Stanley in the Paris Commercial Court in connection with Morgan Stanley’s research coverage of LVMH. LVMH is unhappy with Morgan Stanley’s research and alleges unfair treatment. Morgan Stanley categorically rejects LVMH’s claim and stands by the integrity of its research. Morgan Stanley intends to defend this suit vigorously. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. There may be time limitations on the exercise of options or other rights in your securities transactions. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. This publication is disseminated in Japan by Morgan Stanley Japan Limited; in Hong Kong by Morgan Stanley Dean Witter Asia Limited; in Singapore by Morgan Stanley Dean Witter Asia (Singapore) Pte., regulated by the Monetary Authority of Singapore; in Australia by Morgan Stanley Dean Witter Australia Limited A.B.N. 67 003 734 576, a licensed dealer, which accepts responsibility for its contents; in certain provinces of Canada by Morgan Stanley Canada Limited, which has approved of, and has agreed to take responsibility for, the contents of this publication in Canada; in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, which is supervised by the Spanish Securities Markets Commission (CNMV) and states that this document has been written and distributed in accordance with the rules of conduct applicable to financial research as established under Spanish regulations; in the United States by Morgan Stanley & Co. Incorporated and Morgan Stanley DW Inc., which accept responsibility for its contents. Private U.K. investors should obtain the advice of their Morgan Stanley & Co. International Limited representative about the investments concerned. In Australia, this report, and any access to it, is intended only for “wholesale clients” within the meaning of the Australian Corporations Act. The trademarks and service marks contained herein are the property of their respective owners. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. The Global Industry Classification Standard ("GICS") was developed by and is the exclusive property of MSCI and S&P. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. 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