U.S. Year Ahead 2012 2012.pdf · 2014-01-14 · for equities is generally muted (see Figure 15)...

North America Equity Research9 December 2011

U.S. Year Ahead 2012A Year of Gradual Healing

PortfolioStrategy

Thomas J Lee, CFA AC

(1-212) 622-6505

[email protected]

Director of U.S. Equity Research

Noelle V. Grainger

(1-212) 622-6504

[email protected]

J.P. Morgan Securities LLC

Bloomberg JPUS2012 <INDEX> <GO>

Bloomberg subscribers can use the ticker JPUS2012 to access tracking information on a basket created by the J.P. Morgan Delta One desk to leverage the theme discussed in this report. Over time, the performance of JPUS2012 could diverge from returns quoted in this report, because of differences in methodology. J.P. Morgan Research does not provide research coverage of this basket and investors should not expect continuous analysis or additional reports relating to it. For information on JPUS2012, please contact your J.P. Morgan salesperson or the Delta One Desk.

See page 152 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. In the United States, this information is available only to persons who have received the proper option risk disclosure documents. Please contact your J.P. Morgan representative or visit http://www.optionsclearing.com/publications/risks/riskstoc.pdf.

This document is being provided for the exclusive use of JOHN CULHANE at PENNANT MANAGEMENT, INC.

2

US Year Ahead 2012North America Equity ResearchDecember 2011

Table of Contents

Macro

Portfolio Strategy ............................................................................. 5

Economics..................................................................................... 50

Equity Strategy – Small Cap........................................................... 52

Equity Technical Strategy............................................................... 55

Equity Quantitative Strategy ........................................................... 63

Accounting & Valuation .................................................................. 67

Equity Derivatives .......................................................................... 70

Delta One Strategy ........................................................................ 74

Capital Goods/Industrials

Aerospace & Defense .................................................................... 81

Boeing Company (BA)

Airfreight & Surface Transportation................................................. 82

Union Pacific (UNP)

Electrical Equipment & Multi-Industry.............................................. 83

SPX Corp (SPW)

Engineering & Construction............................................................ 84

Chicago Bridge & Iron (CBI)

Environmental Services.................................................................. 85

Clean Harbors (CLH)

Waste Connections (WCN)

Machinery...................................................................................... 86

Deere & Co. (DE)

Consumer

Airlines .......................................................................................... 87

United Continental Holdings (UAL)

Autos & Auto Parts......................................................................... 88

Visteon (VC)

Beverages ..................................................................................... 89

PepsiCo (PEP)

Food Manufacturing ....................................................................... 90

J.M. Smucker Co. (SJM)

Food Retail .................................................................................... 91

The Fresh Market (TFM)

Gaming.......................................................................................... 92

Las Vegas Sands (LVS)

Homebuilding & Building Products.................................................. 93

Lennar (LEN)

Owens Corning (OC)

Household & Personal Care Products............................................. 94

Procter & Gamble (PG)

Consumer (Cont’d)

Lodging.......................................................................................... 95

Wyndham Worldwide (WYN)

Restaurants ................................................................................... 96

Brinker International (EAT)

Retailing – Broadlines, Apparel & Footwear .................................... 97

Macy’s (M)

Retailing – Hardlines/Discounters ................................................... 98

Costco (COST)

Retailing – Specialty....................................................................... 99

Ulta Salon, Cosmetics & Fragrance, Inc. (ULTA)

Tobacco....................................................................................... 100

Reynolds American (RAI)

Energy

Electric Utilities & Independent Power Producers .......................... 101

NRG Energy (NRG)

Energy MLPs ............................................................................... 102

Buckeye Partners (BPL)

North American Integrated Oils & Major Producers........................ 103

Nexen (NXY)

Oil & Gas Exploration & Production............................................... 104

Denbury Resources (DNR)

Pioneer Natural Resources (PXD)

Oilfield Services & Equipment....................................................... 105

Halliburton (HAL)

Financials

Asset Managers, Brokers, and Exchanges .................................... 107

Invesco Ltd. (IVZ)

Franklin Resources (BEN) – Avoid

Banks – Large Cap....................................................................... 108

Citigroup (C)

Banks – Mid- and Small Cap ........................................................ 109

First Horizon (FHN)

Insurance – Life ........................................................................... 110

Prudential Financial (PRU)

Insurance – Non-Life .................................................................... 111

Allstate Corp. (ALL)

REITs/Real Estate Services.......................................................... 112

Public Storage (PSA)

Specialty & Consumer Finance..................................................... 113

American Express (AXP)


3


Health Care

Biotechnology ...............................................................................115

Celgene (CELG)

SMid Biotechnology ......................................................................116

Onyx Pharmaceuticals (ONXX)

Healthcare Facilities......................................................................117

HCA Inc. (HCA)

Healthcare Information Technology ...............................................118

Accretive Health (AH)

Healthcare Technology & Distribution ............................................119

CVS Caremark (CVS)

Life Sciences Tools & Diagnostics .................................................120

Agilent (A)

Managed Care ..............................................................................121

UnitedHealth (UNH)

Medical Supplies & Devices ..........................................................122

St. Jude Medical (STJ)

Pharmaceuticals – Major...............................................................123

Pfizer (PFE)

Pharmaceuticals – Specialty..........................................................124

Mylan (MYL)

Materials

Chemicals – Specialty, Commodity & Agricultural...........................125

DuPont (DD)

Coal..............................................................................................126

Consol Energy (CNX)

Gold & Precious Metals.................................................................127

Goldcorp Inc. (GG)

Metals & Mining ............................................................................128

Freeport-McMoRan (FCX)

Paper & Packaging .......................................................................129

Crown Holdings (CCK)

Media & Telecom

Information Services/Radio & TV Broadcasting ..............................131

Verisk Analytics (VRSK)

Internet .........................................................................................132

Google (GOOG)

Media ...........................................................................................133

Viacom (VIAb)

Telecom, Cable & Satellite ............................................................134

Comcast (CMCSA)

Technology

Alternative Energy – LED ............................................................. 135

Cree (CREE)

Alternative Energy – Solar PV....................................................... 136

First Solar (FSLR) – Avoid

Applied & Emerging Technologies ................................................ 137

Zipcar (ZIP)

Business & Education Services .................................................... 138

Robert Half International (RHI)

Communications Equipment & Data Networking............................ 139

Riverbed (RVBD)

Computer Services & IT Consulting .............................................. 140

MasterCard (MA)

IT Hardware................................................................................. 141

Apple (AAPL)

Semiconductor Capital Equipment ................................................ 142

Lam Research (LRCX)

Semiconductors ........................................................................... 143

Texas Instruments (TXN)

SMid Semiconductors................................................................... 144

Broadcom (BRCM)

Software ...................................................................................... 145

Citrix Systems (CTXS) – Avoid

Red Hat (RHT) – Avoid

Software Technology.................................................................... 146

Equinix (EQIX)

Technology Supply Chain............................................................. 147

Jabil Circuit (JBL)

Disclosures .................................................................................. 152

Note: Unless otherwise noted, all stock prices and coverage lists in this report are as of the close on December 6, 2011, and target prices for December 2012.


4



5


Portfolio Strategy

Eight Reasons to Be Contrarian in 2012; YE Target 1430

Equities Rise Despite Uncertainty…

2011 is a year most investors would like to forget. Even though equity markets are essentially flat year to date, the S&P 500 saw a 300-point range (a 9% rally followed by a 22% drop, followed by a 20% rally). Multiple events contributed to this: Japan floods, Arab spring, Peripheral Europe, and U.S. AAA downgrade. However, despite this (Italian yields even broke above 8%), surprisingly U.S. equity markets are flat for the year.

We believe this is a testament to a combination of: 1) U.S. economic resilience; 2) U.S. corporate financial strength and pricing power; and 3) severe relative undervaluation of equities (supporting prices).

Eight Reasons to Be Contrarian (Optimistic) in 2012

The consensus view is that visibility remains murky with significant tail risks (European systemic crisis, China hard landing, U.S. fiscal tightening) and the outlook for equities is generally muted (see Figure 15) with only one strategist seeing equities in 2012 exceed the 1371 high of 3/11. However, we have eight reasons to be constructive, as shown below.

1. J.P. Morgan Fixed Income Strategists are constructive for 2012 on High Grade, High Yield, MBS, ABS, and CMBS. Given equities are the junior piece of the capital structure, this is positive for equities (Figure 14).

2. Consensus is cautious about 2012.

3. The J.P. Morgan base case is for the Euro crisis to abate by 2H12 with Europe potentially exiting recession by mid-year. Historically, equities have bottomed 6-9 months ahead of a return to growth.

4. EBIT margins should expand 100-150bps in 2012, bolstering net profit margins by 60-90bps to 10%, setting a new high for profit margins and driving 2012E/2013E EPS of $105/$110.

5. Corporates are likely to ramp up total cash return by as much as $250bn in 2012. For the past five years, corporates have represented 97% of the incremental inflows into equities.

6. U.S. housing should see a further advance in its recovery in 2012, driven by expanding household formation rates. Vacancies are at five-year lows and other factors are also supportive.

7. The 2012 U.S. election cycle should be positive for equities. Stocks have historically done well when an incumbent has had low approval ratings going into an election year (positive returns in seven of eight years).

8. China entering selective easing cycle sets the stage for a Cyclical upturn in EPS.

Thomas J Lee, CFA AC

(1-212) 622-6505

[email protected]

Daniel M McElligott

(1-212) 622-5598

[email protected]

Katherine C Khor

(1-212) 622-0934

[email protected]


Ma

cro


6


Establishing Year-End 2012 Target of 1430; Favor Cyclicalsand Financials

We believe the S&P 500 will reach 1430 by the end of 2012. This based on a target multiple of 13.0x estimated 2013 EPS of $110. From any historical lens, this P/E multiple appears conservative, representing an earnings yield of 7.7% (compared to JULI HG yield of 4.4%). We see Cyclicals and Financials outperforming, with Financials as our top pick for 2012.

65 Analyst Best Ideas

We have compiled J.P. Morgan’s 65 best long and 4 avoid ideas (Figure 9).


7


Valuation: See S&P 500 Trading to 13.0x 2013E EPS or 1430

2012 Price Target Reflects 13x 2013E EPS of $110

We believe the S&P 500 will reach 1430 by the end of 2012. This based on a target multiple of 13.0x estimated 2013 EPS of $110. From any historical lens, this P/E multiple appears conservative, representing an earnings yield of 7.7% (compared to JULI HG yield of 4.4%).

Similar to last year, we see greater variability in the P/E ratio, rather than in the EPS forecast. Over the course of 2011, top-down forecasts for 2011 EPS actually rose by $5.29 ($97.38 now vs. $92.09 in December 2010), but P/E ratios fell.

For 2012, we show our target P/E multiple and EPS forecast in Figure 1 below. We also highlight the upside and downside factors to the P/E multiple, namely macro factors that could weigh on P/E multiples.

As shown, if investors become comfortable with Europe and U.S. Congress, and gain conviction in a strong U.S. housing recovery, P/E multiples could expand further towards 14x. A P/E multiple of 14x, by the way, compares to a typical multiple of 13.9x in the fourth year of a bull market (Figure 2).

Figure 1: J.P. Morgan Year-End 2012 Price Target Scenarios for S&P 500

$ per share

Source: J.P. Morgan.

YE '12 P/E 2013 EPS Target

Upside 14.00X $115 1,600Europe recession ends

ECB bazooka

US housing recovers

Congress compromises

US govt ends attack on banks

Base 13.00X $110 1,430

China hard landing

Europe bank crisis

US enters recession

Obama gains in polls

Downside 12.00X $95 1,150


8


P/E Multiple of 13.0x In Line with Historical Average P/E 46 Months into a “Bull Market”…Thus, Target P/E Is Consistent

Our target multiple of 13.0x is in line with levels in prior bull markets. Take a look at the analysis in Figure 2 below which looks at P/E ratios 46 months into prior bull markets, even those that have become bear markets.

Our target multiple of 13.0x is in line with the historical average of 13.1x 46 months into prior bull markets (even those that ended a long time before that).

And for those that have remained bull markets, the P/E ratio was closer to 13.9x, or higher than our target P/E of 13.0x.

Also, since 1900, the average P/E multiple has expanded by 2.2x by month 46 if a bull market remained intact while multiple expansion was generally only 1.0x by month 46 across all bull markets examined. In contrast, the current bull markethas not seen any P/E multiple expansion and our target P/E of 13.0x represents no increase in multiple.

Figure 2: P/E Ratios During Fourth Year of a Bull Market

P/E ratio average for months 40-46 since 1900

Source: J.P. Morgan and FactSet.

Avg P/E: Months 40-46

11.8

x

12.9

x

14.7

x

7.9x

13.4

x

8.4x

13.2

x

14.0

x

15.1

x

9.7x

16.6

x

10.1

x

19.1

x

16.7

x

15.5

x

11.3

x

6.9x 9.

3x

15.1

x

19.4

x

13.9

x

14.3

x

13.0

x

13.1

x

13.9

x

0.0x

5.0x

10.0x

15.0x

20.0x

25.0x

1900

1903

1907

1914

1917

1921

1932

1933

1935

1938

1942

1949

1957

1962

1966

1970

1974

1978

1982

1987

1990

2002

2009

Avg

: all

Avg

: if

Bul

l int

act

DELTA (avg P/E for months 40-46 less avg P/E for months 0-6 of a bull market)

-1.9

x

0.4x 3.

5x

0.8x

5.9x

-2.1

x

-2.9

x

-5.9

x 3.5x

-4.8

x

8.4x

4.4x 5.4x

1.7x

-0.2

x

-3.6

x

-2.3

x

2.3x

5.5x

8.9x

-4.4

x

-1.8

x

0.0x

1.0x

2.2x

-8.0x

-4.0x

0.0x

4.0x

8.0x

12.0x

1900

1903

1907

1914

1917

1921

1932

1933

1935

1938

1942

1949

1957

1962

1966

1970

1974

1978

1982

1987

1990

2002

2009

Avg

: all

Avg

: if B

ull i

ntac

t


9


…And Equity Risk Premium Points to Equities Being Undervalued

Valuation for stocks continues to remain extremely attractive, in our view. We believe the most notable distortion is that the equity risk premium remains elevated. The figure below shows the equity risk premium is at a 50-year high.

The current equity risk premium is 6.27%, well above the 50-year average of 2.55% and the ten-year average of 3.55%. The current equity risk premium is also higher than at the major stock market lows of 1974, 1980, and 2009. It is even higher than the levels seen at the heights of the Asia and subprime crises. The equity risk premium is also virtually unchanged since the March 2009 low, despite substantial improvement in the economy.

This indicates that investors currently show little trust in equities and reflects a general fear of capital investment, both physical and financial. The implication, though, is the risk/reward for equities is attractive—that is, the margin of error is greater for equities when the equity risk premium is high.

While some may argue this is a result of extreme risk aversion, this again points to our argument that unless things worsen, this relationship is likely to narrow, thus favoring stocks.

Figure 3: Equity Risk Premium

Using a Dividend Discount Model to derive the real S&P 500 Equity Discount Rate implied by S&P 500 prices – This discount rate (EDR) is a risk-free rate.

The Equity Risk Premium is the difference between the Equity Discount Rate and the 10-yr real bond yield (10-yr nominal UST yield minus 10-yr Philly Fed

inflation expectations)

Source: J.P. Morgan Global Asset Allocation Team.

9/116.27

10yr Avg3.82

(2.0)

(1.0)

-

1.0

2.0

3.0

4.0

5.0

6.0

7.0

'57 '59 '62 '64 '67 '69 '72 '74 '77 '79 '82 '84 '87 '89 '92 '94 '97 '99 '02 '04 '07 '09 '12

Equity Risk Premia 10yr Avg Asia Crisis

Subprime Crisis

Euro Crisis

Market low Market lowMarket

low


10


2012 Expected to Look More Like 2009…

Fourth Year of Bull Markets Has Seen Less Variation in Performance…

We compiled the composite return of the eight bull markets (which lasted at least 34 months) below to highlight the typical return in the fourth year of a bull market.

The average was 15% and implies a YE level of 1448, which is slightly above the 1430 target we set for 2012.

This contrasts with 2010 and 2011, which saw major volatility in performance. Both 2010/2011 started with a 9% rally, followed by a double-digit decline, and ended with a rally.

Consensus sees a tough 1H12 and rally in 2H (similar to composite) which we believe is less likely to happen. Rather, we see either steady gains through 2012 or markets stronger in 1H. Either way, we think it makes sense to be long at the start of the year.

Figure 4: Price Performance of the S&P 500 in 2009-2012

2012 is a composite of Bull Markets that lasted at least 34 months

Source: J.P. Morgan and Bloomberg. Note: Composite is for bull markets that lasted at least 34 months.

2009 2010 2011 2012

Composite for Bull Markets that lasted at least 22 months Composite for Bull Markets that lasted at least 34 months

26% upside shown would be to reach 1350 YE target Assume 2012 starts the y ear at 1,255 (current lev el)

600

700

800

900

1,000

1,100

1,200

12/08 2/09 4/09 6/09 8/09 10/09 12/091,000

1,050

1,100

1,150

1,200

1,250

1,300

12/09 2/10 4/10 6/10 8/10 10/10 12/10

+9%

-17%

+24%+67%

1,050

1,150

1,250

1,350

1,450

1,550

1,650

1,750

12/11 2/12 4/12 6/12 8/12 10/12 12/12

Composite and High/Low range of Bull Mkts lasting at least 34 months

Avg gain of 15%-8%

51%

700

800

900

1,000

1,100

1,200

1,300

1,400

1,500

1,600

1,700

12/10 2/11 4/11 6/11 8/11 10/11 12/11

Actual S&P 500 Bull Mkt Composite

-22%

+9%

+17%(+26%)


11


No Fourth Year of a Bull Market Saw Declines…But Issue Today Is Risk of a Systemic Crisis…

We have detailed below the eight bull markets (which were entering their 34th month). Note that the markets fall into two categories.

Equity markets with modest gains (1952-53, 1965-66, 1993-94, and 2005-06) with 3-5% gains.

And those with strong gains (1924-25, 1945-46, 1960-61, and 1985-86).

Given the tepid 2011 performance, along with P/E of around 11.3x 2013E EPS, we expect returns to be stronger than single-digits.

Figure 5: Bull Markets Lasting at Least 34 Months

Since 1900

Source: J.P. Morgan and Bloomberg.

Bull Market Months 34-46 P/E

Start of Bull

Market

End of Bull

Market

Length of

Bull

Market

(months)

Date 34

Months

after Start

of Bull Mkt

Date 46

Months

after Start

of Bull Mkt

Perf

months 34-

46

P/E (NTM)

as of

Month 34

1 8/24/1921 9/3/1929 96.4 6/1924 6/1925 37% 7.9x

2 4/28/1942 5/29/1946 49.1 2/1945 2/1946 26% 15.2x

3 6/13/1949 7/12/1957 97.1 4/1952 4/1953 3% 9.8x

4 10/22/1957 12/12/1961 49.7 8/1960 8/1961 21% 18.4x

5 6/26/1962 2/9/1966 43.6 4/1965 4/1966 5% 16.4x

6 8/12/1982 8/25/1987 60.5 6/1985 6/1986 26% 12.6x

7 10/11/1990 3/24/2000 113.6 8/1993 8/1994 2% 15.4x

8 10/9/2002 10/9/2007 60.1 8/2005 8/2006 3% 14.9x

Average 71.3 15% 13.8x

% Times Up 100%

9 3/9/2009 12/31/2011 33.8 12/2011 1/2013 — 12.0x


12


Sectors: Overweight Cyclicals, FinancialsIn our view, the framework for 2012 may look a bit like 2009—emergence from a financial crisis and the potential for an acceleration of the business cycle (driven by Europe exiting recession and China easing). Thus, intuitively, we see Cyclicals and Financials outperforming.

Financials are arguably the most non-consensus call. After all, given the plethora of risks, investors are reluctant to own them. However, as shown in Figure 6below, note that Financials have done well in most past scenarios (post-Lehman, housing bottoms, election year).

This is also intuitive. If Europe’s crisis is resolved, the largest beneficiaries should be Financials. Housing is a major lever for Financials. And the prospect for Republican gains in the upcoming elections would likely also favor Financials.

In addition, Cyclicals broadly have outperformed under most scenarios.

Figure 6: Sector Rationale – Cyclicals and Financials Look Attractive

Cyclicals: Tech, Materials, Discretionary, Industrials; Near Cyclicals: Energy, Financials

Driver for 2012

Cyclical or

Defensives?

% Rel. Chg./

(Win Ratio) Best Sectors (12-Mo Relative Performance)

Post-financial crisis (a la ’08) Financials/

Cyclicals

1,400-7,700bp

(100%)

Financials (7,700bp), Discretionary (3,100bp), and Industrials (2,700bp)

Housing bottoms in 2012 Cyclicals/

Financials

1,200bp

(100%)

Discretionary (2,300bp), Technology/Materials/Staples (1,000bp), Financials

(700bp)

2012 Election year with Presidential approval

rating <50%

Cyclicals,

Financials

and Energy

200bp-700bp

(100%/75%)

Financials (700bp), Technology (500bp), Industrials (300bp), Energy (200bp)

Current P/E below 40-yr average Cyclicals N/A Technology (30% below LT trend), Materials (9%)

2011 Underperformers (“buy the losers”) Cyclicals,

Financials

and Energy

N/A Financials (1800bp underperformance in 2011), Materials (970bp), Industrials

(310bp)

Source: Bloomberg, FactSet, and Datastream.

Mac

ro-r

elat

edO

ther


13


Sector Earnings and Outlook

We think a Cyclical bent makes sense in 2012 given the characteristics/catalysts outlined in Figure 6 above. A summary of our sector views is shown in the following table. Not surprisingly, we recommend overweight positions in Cyclicals (Materials, Industrials, Discretionary, Technology) as well as Financials and Energy. We also continue to believe investors should overweight Health Care.

We are looking for 2012/2013 EPS slightly below bottom-up consensus (about $2/$10, respectively). Basically, we are slightly below consensus EPS for most sectors.

Financials are projected to have the fastest EPS growth (13%) of the ten sectors. For 2012, the next-fastest year-over-year EPS growth is expected for Basic Materials and Industrials.

As for anticipated upside, we see most groups offering double-digit returns with the exception of Utilities and Telecom. For Utilities, we see upside of around 8%—purely driven by P/E expansion. The group currently trades at a P/E multiple of 14x (124% relative P/E) and we look for that to reach 15.0x by YE 2012.

Figure 7:2011/2012/2013 Estimated EPS and Target P/E Multiples by Sector

$ per share

Source: J.P. Morgan, FactSet, and Datastream.

B/U consensus JPM Strategy EPS EPS % (JPM) 2013 P/E Relative 2013E P/E Point Contribution

JPM

Strategy

Rating 2012E 2013E 2011E 2012E 2013E

11E

vs.

'10

12E

vs.

'11E

13E

vs.

'12E Current Target Current Target

Long-

Term

Avg Cur

rent

Poi

nt

Ups

ide %

Upside

Cyclicals

Materials OW 4.02 4.59 3.55 3.95 4.20 32% 11% 6% 10.4x 12.0x 92% 92% 94% 44 7 15%

Industrials OW 10.78 12.27 9.40 10.40 11.30 21% 11% 9% 11.5x 13.0x 101% 100% 95% 129 17 13%

Discretionary OW 9.84 11.13 8.90 9.70 10.30 11% 9% 6% 12.9x 14.6x 114% 112% 101% 133 17 13%

Technology OW 21.22 24.11 19.55 21.50 22.50 17% 10% 5% 11.0x 13.0x 97% 100% 132% 247 46 19%

Near Cyclicals

Energy OW 14.72 16.37 14.30 14.75 15.15 39% 3% 3% 10.0x 11.4x 89% 88% 83% 152 21 14%

Financials OW 18.40 20.47 14.70 16.65 17.65 6% 13% 6% 9.3x 11.1x 83% 85% 75% 165 30 18%

Defensives

Staples UW 10.73 11.59 10.00 10.30 10.70 6% 3% 4% 14.1x 15.6x 125% 120% 103% 151 16 10%

HealthCare OW 12.67 13.58 12.15 12.30 12.55 6% 1% 2% 11.2x 13.1x 99% 101% 115% 141 24 17%

Telecom N 2.32 2.67 2.00 2.20 2.40 3% 10% 9% 15.6x 16.9x 138% 130% 91% 37 3 8%

Utilities UW 3.26 3.47 3.20 3.25 3.25 3% 2% 0% 14.0x 15.0x 124% 115% 71% 46 3 7%

S&P 500 107.95 120.26 97.75 105.00 110.00 15% 7% 5% 11.3x 13.0x — — — 1,244 185 15%

S&P ex-Fin 89.55 99.79 83.05 88.35 92.35 16% 6% 5% 11.7x 13.4x 103% 103% 98% 1,079 154 14%

Cyclicals 45.86 52.10 41.40 45.55 48.30 18% 10% 6% 11.4x 13.2x 101% 102% 105% 552 87 16%

Near Cyclicals 33.12 36.84 29.00 31.40 32.80 20% 8% 4% 9.7x 11.2x 85% 86% 79% 317 51 16%

Defensives 28.97 31.32 27.35 28.05 28.90 5% 3% 3% 13.0x 14.6x 115% 112% 95% 375 46 12%

Cyclicals vs. Defensives 16.89 20.78 14.05 17.50 19.40 13% 7% 3% -1.5x -1.3x -14% -10% 10% 178 41 353 bp


14


J.P. Morgan Industry Outlook by Analyst

We have summarized below the 2012 outlooks of J.P. Morgan’s U.S. fundamental equity analysts, based on our interpretation of their contributions to this report.

Figure 8: J.P. Morgan Fundamental Analyst Conviction Levels

HC = High Conviction, N = Neutral, LC = Low Conviction


Note: Analyst conviction levels are based on our interpretation of the analysts’ sector contributions to this report.

CYCLICALS

Materials — OW Industrials — OW Discretionary — OW Technology — OW

Gold & Precious Metals / Bridges HC Business & Education Svcs / Steinerman HC Gaming / Greff HC LED (Alt Energy) / Blansett HC

Metals & Mining / Gambardella HC Airlines / Baker N Info Svcs/Radio/TV Broadcasting / Meltz HC SMid Semiconductors / Sur HC

Chemicals / Zekauskas N Airfreight/Surface Transport / Wadewitz N Internet / Anmuth HC Semiconductors / Danely HC

Coal / Bridges LC Machinery / Duignan N Lodging / Greff N Technology Supply Chain / O'Brien HC

Paper & Packaging / Gresh LC Engineering & Construction / Levine N Restaurants / Ivankoe N Semiconductor Capital Equip / Blansett N

Env ironmental Serv ices / Levine N Autos & Auto Parts / Patel N Software Technology / Auty N

Aerospace & Defense / Nadol LC Media / Quadrani N Applied and Emerging Tech / Coster N

Electrical Equip & Multi-Industry / Tusa LC Homebuilders & Building Products / RehautLC Computer Svcs & IT Consulting / Huang N

Hardlines / Horvers LC Communications Equipment / Hall LC

Specialty Retail / Tunick LC Solar Alt Energy) / Blansett LC

Broadlines, Apparel & Footwear / Boss LC IT Hardware / Moskowitz LC

Software / DiFucci LC

NEAR-CYCLICALS

Energy — OW Financials — OW

Energy MLPs / Tonet HC Life Insurance / Bhullar HC

Oil Services & Equipment / Anderson N REITs / Michael Mueller & Anthony PaoloneHC

Integrated Oil & Gas / Minyard N Small/Mid Cap Banks / Alexopoulos HC

Oil & Gas E&P / Allman N Asset Managers / Worthington N

Large Cap Banks / Juneja N

Non-Life Insurance / Heimermann N

Exchanges / Worthington LC

Specialty & Consumer Finance / Shane LC

DEFENSIVES

HealthCare — OW Telecom — N Staples — UW Utilities — UW

Healthcare Tech & Distribution / Gill HC Telecom, Cable, & Satellite / Cusick N Tobacco / Maile N Utilities / Smith LC

SMid Biotechnology / Kasimov HC HH & Personal Care Products / Faucher LC

Pharmaceuticals (Major) / Schott HC Beverages / Faucher LC

Pharmaceuticals (Specialty) / Schott HC Food Manufacturing / Goldman LC

Managed Care / Rex N Food Retail / Goldman LC

Healthcare Information Tech / Rahim N

Biotechnology / Meacham N

Medical Supplies & Devices / Weinstein N

Life Sciences Tools / Peterson LC

Healthcare Facilities / Rex LC


15


J.P. Morgan Analysts’ Best Ideas for 201265 Long and 4 Avoid Stock Ideas

J.P. Morgan’s fundamental equity analysts have also provided 65 long stock picks that represent each analyst’s best idea for 2012 (Figure 10 through Figure 12). J.P. Morgan’s analysts have also provided 4 avoid stock picks as their best ideas for 2012.

Figure 9: 65 LONG and 4 AVOID Stock Ideas from J.P. Morgan Fundamental Equity Analysts

Sorted alphabetically within each sector


LONG STOCK IDEAS

CYCLICALS NEAR-CYCLICALS DEFENSIVES

Materials Discretionary Energy Staples

1 CCK 1 CMCSA 1 *NXY 1 COST

2 DD 2 EAT 2 BPL 2 CVS

3 FCX 3 LEN 3 CNX 3 PEP

4 GG 4 LVS 4 DNR 4 PG

5 M 5 HAL 5 RAI

6 ULTA 6 PXD 6 SJM

7 VC 7 TFM

8 VIAb Financials

9 WYN 1 ALL HealthCare

Industrials 2 AXP 1 A

1 BA Technology 3 C 2 AH

2 CBI 1 AAPL 4 FHN 3 CELG

3 CLH 2 BRCM 5 IVZ 4 HCA

4 DE 3 CREE 6 PRU 5 MYL

5 OC 4 EQIX 7 PSA 6 ONXX

6 RHI 5 GOOG 7 PFE

7 SPW 6 JBL 8 STJ

8 UAL 7 LRCX 9 UNH

9 UNP 8 MA

10 VRSK 9 RVBD Utilities

11 WCN 10 TXN 1 NRG

12 ZIP

AVOID STOCK IDEAS

CYCLICALS

Technology

1 CTXS

2 FSLR

3 RHT

NEAR-CYCLICALS

Financials

1 BEN


16


Figure 10: Top LONG Stock Ideas from J.P. Morgan Fundamental Analysts (1 of 3)

Priced as 12/6/2011; sorted by implied upside within each sector


JPM Coverage EPS and Valuation

Name Industry Ticker

Current

Price

Market

Cap

JPM

Rtg JPM Analyst

Target

Price

Implied

Upside

2012E

EPS

P/E

('12E) P/B

CYCLICALS: Materials, Industrials, Discretionary, Technology

Materials

1 Freeport-McMoRan Copper & Gold Inc.Metals & Mining FCX $40.54 $38,428 OW Michael F. Gambardella$61.00 50% $4.77 8.5x 2.50x

2 Crown Holdings Inc. Containers & Packaging CCK $33.14 $5,010 OW Phil Gresh, CFA $44.00 33% $3.16 10.5x

3 Goldcorp Inc. Metals & Mining GG $52.11 $42,195 OW John Bridges CFA, ACSM$63.00 21% $3.16 16.5x 2.02x

4 E.I. DuPont de Nemours & Co.Chemicals DD $47.94 $44,293 OW Jeffrey J. Zekauskas $57.00 19% $4.35 11.0x 3.92x

Industrials

5 United Continental Holdings Inc.Airlines UAL $20.13 $6,660 OW Jamie Baker $45.00 124% $5.32 3.8x 2.88x

6 Zipcar Inc. Road & Rail ZIP $14.43 $567 OW Paul Coster, CFA $30.50 111% $0.12 123.3x 2.63x

7 Robert Half International Inc.Professional Services RHI $27.48 $3,929 OW Andrew C. Steinerman$40.00 46% $1.44 19.1x 4.96x

8 Owens Corning Building Products OC $28.98 $3,503 OW Michael Rehaut, CFA$39.00 35% $2.69 10.8x 0.94x

9 Deere & Co. Machinery DE $78.38 $32,443 OW Ann Duignan $100.00 28% $7.78 10.1x 4.77x

10 Chicago Bridge & Iron Co. N.V.Construction & EngineeringCBI $39.47 $3,888 OW Scott Lev ine $50.00 27% $3.03 13.0x 3.33x

11 Waste Connections Inc. Commercial Services & SuppliesWCN $32.83 $3,673 OW Scott Lev ine $40.00 22% $1.65 19.9x 2.63x

12 Clean Harbors Inc. Commercial Services & SuppliesCLH $61.36 $3,256 OW Rodney C Clayton, CFA$73.50 20% $2.50 24.5x 3.87x

13 SPX Corp. Machinery SPW $62.82 $3,205 OW C. Stephen Tusa, Jr CFA$75.00 19% $5.24 12.0x 1.42x

14 Union Pacific Corp. Road & Rail UNP $102.84 $49,680 OW Thomas R. Wadewitz$119.00 16% $7.79 13.2x 2.68x

15 Boeing Co. Aerospace & Defense BA $70.87 $52,673 OW Joseph B. Nadol III $80.00 13% $4.95 14.3x 8.82x

16 Verisk Analytics Inc. Cl A Professional Services VRSK $38.06 $6,224 OW Michael A. Meltz, CFA$42.00 10% $1.91 19.9x

Discretionary

17 Las Vegas Sands Corp. Hotels Restaurants & LeisureLVS $45.58 $33,397 OW Joseph Greff $64.00 40% $2.57 17.7x 4.43x

18 Viacom Inc. Cl B Media VIAb $42.81 $21,439 OW Alexia S. Quadrani $56.00 31% $4.29 10.0x 2.77x

19 Brinker International Inc. Hotels Restaurants & LeisureEAT $23.78 $1,914 OW John Ivankoe $31.00 30% $1.84 12.9x 5.04x

20 Comcast Corp. Cl A Media CMCSA $23.19 $48,527 OW Philip Cusick, CFA $30.00 29% $1.86 12.5x 1.35x

21 Wyndham Worldwide Corp.Hotels Restaurants & LeisureWYN $35.84 $5,520 OW Joseph Greff $46.00 28% $2.86 12.5x 2.28x

22 Visteon Corp. Auto Components VC $56.30 $2,900 OW Himanshu Patel, CFA$68.00 21% $4.94 11.4x 2.11x

23 Macy's Inc. Multiline Retail M $32.95 $13,833 OW Matthew R. Boss, CPA$36.00 9% $3.17 10.4x 2.37x

24 Lennar Corp. Cl A Household Durables LEN $19.27 $3,000 OW Michael Rehaut, CFA$21.00 9% $0.81 23.9x 1.35x

25 Ulta Salon Cosmetics & Fragrance Inc.Specialty Retail ULTA $72.93 $4,514 OW Brian J. Tunick $80.00 10% $2.27 32.1x 8.51x


17







Current

Price

Market

Cap

JPM

Rtg JPM Analyst

Target

Price

Implied

Upside

2012E

EPS

P/E

('12E) P/B

Technology

26 Cree Inc. Semiconductors & Semiconductor EquipmentCREE $25.68 $2,977 OW Christopher Blansett $48.00 87% $1.18 21.8x 1.19x

27 Broadcom Corp. Semiconductors & Semiconductor EquipmentBRCM $30.10 $14,629 OW Harlan Sur $45.00 50% $2.68 11.2x 2.63x

28 Apple Inc. Computers & Peripherals AAPL $390.95 $363,352 OW Mark Moskowitz $525.00 34% $34.67 11.3x 4.74x

29 Lam Research Corp. Semiconductors & Semiconductor EquipmentLRCX $42.86 $5,124 OW Christopher Blansett $56.00 31% $1.87 23.0x 2.19x

30 MasterCard Inc. Cl A IT Serv ices MA $371.30 $45,062 OW Tien-tsin Huang, CFA$435.00 17% $21.69 17.1x 7.89x

31 Equinix Inc. Internet Software & Serv icesEQIX $102.48 $4,859 OW Sterling Auty, CFA $120.00 17% $2.68 38.2x 2.40x

32 Texas Instruments IncorporatedSemiconductors & Semiconductor EquipmentTXN $30.42 $34,759 OW Christopher Danely $35.00 15% $2.30 13.3x 3.15x

33 Google Inc. Cl A Internet Software & Serv icesGOOG $623.77 $159,686 OW Doug Anmuth $705.00 13% $43.86 14.2x 3.68x

34 Riverbed Technology Inc. Communications EquipmentRVBD $26.74 $4,145 OW Rod Hall, CFA $29.00 8% $1.13 23.6x 5.99x

35 Jabil Circuit Inc. Electronic Equipment Instruments & ComponentsJBL $20.86 $4,343 OW Steven J. O'Brien $22.00 5% $2.60 8.0x 2.27x

NEAR-CYCLICALS: Energy, Financials

Energy

36 Nexen Inc. Oil Gas & Consumable Fuels*NXY C$15.92 C$8,404 OW Katherine Lucas Minyard, CFAC$31.00 95% C$2.02 7.9x 1.00x

37 Consol Energy Inc. Oil Gas & Consumable FuelsCNX $40.80 $9,254 OW John Bridges CFA, ACSM$79.00 94% $3.73 10.9x 2.70x

38 Pioneer Natural Resources Co.Oil Gas & Consumable FuelsPXD $94.40 $11,503 OW Joseph Allman, CFA$167.50 77% $4.70 20.1x 2.17x

39 Denbury Resources Inc. Oil Gas & Consumable FuelsDNR $16.86 $6,603 OW Joseph Allman, CFA $28.50 69% $1.26 13.3x 1.38x

40 Halliburton Co. Energy Equipment & Serv icesHAL $35.57 $32,730 OW J. David Anderson, PE, CFA$58.00 63% $4.10 8.7x 2.65x

41 Buckeye Partners L.P. Oil Gas & Consumable FuelsBPL $63.40 $5,449 OW Jeremy Tonet $74.00 17% $3.49 18.2x 2.32x

Financials

42 Citigroup Inc. Diversified Financial Serv icesC $29.75 $86,808 OW Vivek Juneja $54.00 82% $4.42 6.7x 0.49x

43 Allstate Corp. Insurance ALL $27.12 $13,705 OW Matthew G Heimermann$40.00 47% $3.67 7.4x 0.76x

44 Prudential Financial Inc. Insurance PRU $51.41 $24,163 OW Jimmy S. Bhullar, CFA$66.00 28% $7.00 7.3x 0.66x

45 INVESCO Ltd. Capital Markets IVZ $20.67 $9,322 OW Kenneth B. Worthington, CFA$26.00 26% $1.78 11.6x 1.17x

46 First Horizon National Corp.Commercial Banks FHN $7.43 $1,959 OW Steven Alexopoulos, CFA$8.50 14% $0.66 11.3x 0.80x

47 American Express Co. Consumer Finance AXP $48.56 $56,402 OW Richard Shane $55.00 13% $4.15 11.7x 3.14x

48 Public Storage Real Estate Inv estment Trusts (REITs)PSA $129.12 $22,087 OW Michael W. Mueller, CFA$140.00 8% $3.84 33.7x 4.25x


18







Current

Price

Market

Cap

JPM

Rtg JPM Analyst

Target

Price

Implied

Upside

2012E

EPS

P/E

('12E) P/B

DEFENSIVES: Staples, HealthCare, Telecom, Utilities

Staples

49 Fresh Market Inc. Food & Staples Retailing TFM $40.55 $1,946 OW Ken Goldman $55.00 36% $1.32 30.7x 18.15x

50 CVS Caremark Corp. Food & Staples Retailing CVS $38.27 $49,813 OW Lisa C. Gill $50.00 31% $3.21 11.9x 1.34x

51 Procter & Gamble Co. Household Products PG $64.84 $178,396 OW John Faucher $75.00 16% $4.20 15.4x 2.73x

52 J.M. Smucker Co. Food Products SJM $76.67 $8,728 OW Ken Goldman $86.00 12% $5.55 13.8x 1.64x

53 PepsiCo Inc. Beverages PEP $64.65 $101,074 OW John Faucher $72.00 11% $4.63 14.0x 4.28x

54 Costco Wholesale Corp. Food & Staples Retailing COST $88.06 $38,162 OW Christopher Horvers, CFA$94.00 7% $3.87 22.8x 3.19x

55 Reynolds American Inc. Tobacco RAI $41.63 $24,267 OW Rae Maile $2.96 14.1x 3.61x

HealthCare

56 HCA Holdings Inc. Health Care Providers & Serv icesHCA $23.24 $10,146 OW John Rex $38.00 64% $3.46 6.7x

57 Accretive Health Inc. Health Care Providers & Serv icesAH $23.00 $2,259 OW Atif Rahim $35.00 52% $0.70 33.1x 10.83x

58 Agilent Technologies Inc. Life Sciences Tools & Serv icesA $36.98 $12,840 OW Tycho W. Peterson $53.00 43% $3.18 11.6x 2.98x

59 Mylan Inc. Pharmaceuticals MYL $19.81 $8,449 OW Chris Schott, CFA $28.00 41% $2.37 8.4x 2.43x

60 St. Jude Medical Inc. Health Care Equipment & SuppliesSTJ $36.95 $11,787 OW Michael Weinstein $48.00 30% $3.57 10.3x 2.66x

61 UnitedHealth Group Inc. Health Care Providers & Serv icesUNH $48.29 $51,478 OW John Rex $60.00 24% $4.77 10.1x 1.83x

62 Pfizer Inc. Pharmaceuticals PFE $20.23 $155,507 OW Chris Schott, CFA $25.00 24% $2.31 8.8x 1.73x

63 Celgene Corp. Biotechnology CELG $62.21 $27,617 OW Geoff Meacham $75.00 21% $4.50 13.8x 4.94x

64 Onyx Pharmaceuticals Inc.Biotechnology ONXX $42.40 $2,698 OW Cory Kasimov $48.00 13% -$1.05 4.55x

Utilities

65 NRG Energy Inc. Independent Power Producers & Energy TradersNRG $19.37 $4,454 OW Andrew Smith $33.00 70% $0.97 20.0x 0.59x

Average 34% 13.0x 2.64x


19


Figure 13: Top AVOID Stock Ideas from J.P. Morgan Fundamental Analysts



JPM Coverage


Current

Price

Market

Cap

JPM

Rtg JPM Analyst

Target

Price

Implied

Upside

CYCLICALS: Materials, Industrials, Discretionary, Technology

Technology

1 First Solar Inc. Semiconductors & Semiconductor EquipmentFSLR $46.11 $3,985 UW Christopher Blansett $40.00 -13%

2 Citrix Systems Inc. Software CTXS $73.23 $13,657 UW John DiFucci $53.00 -28%

3 Red Hat Inc. Software RHT $50.55 $9,748 UW John DiFucci $32.00 -37%

NEAR-CYCLICALS: Energy, Financials

Financials

4 Franklin Resources Inc. Capital Markets BEN $100.52 $22,168 UW Kenneth B. Worthington, CFA$111.00 10%

Average -17%


20


Risks: 4 Thesis Changers to Downside

What Would Negate Our Positive Thesis Beyond Valuation? Swing Factors Fairly Straightforward

Euro-area crisis morphs into a systemic bank crisis. Europe entering a recession is built into our base case, and a reason we see $105 in 2012 EPS (vs. trend of $110-115). But our view would be altered if Europe’s crisis spread beyond European banks and became a systemic global crisis. That is not the case; in fact, U.S. global banks are gaining market share as Euro banks delever.

China hard landing. Similarly, we do not see a hard landing in China in 2012. A hard landing is a level of growth too slow to prevent a significant rise in unemployment rates and social unrest. Our China team does not see significant risk of a hard landing. This partly stems from better inflation readings, but also supported by the major government measures such as Rmb 1.8tr hydraulic resource investment, subway projects, as well as affordable housing programs.

Oil at $150 from Middle East tension. In 2008, the surge in oil by itself was enough to cause a recession in the U.S. The catalyst for such a move in 2012 could follow any military action in the Middle East. While oil has been surprisingly stable, Colin Fentin, J.P. Morgan’s Global Commodity Strategist, does not see the risk of a surge in oil to these levels (he does see a 10% rise in S&P GSCI) given higher production, but of course the Middle East is the wildcard.

Jobless claims above 470k. Lastly, if U.S. labor markets deteriorate, this would undermine a U.S. recovery thesis. After all, if corporate profits continue to expand but labor remains weak, this would likely result in the U.S. slipping back into recession. Historically, a 20% rise in claims from a cycle low has been a good harbinger of a recession—the key level is 470k on the four-week average. Fortunately, four-week claims have been moving in the other direction, signaling strengthening of labor markets.


21


#1: Risky Markets Expected to Rally in ’12

Risky Assets Generally Have a Positive Outlook...

We have highlighted 2012 Outlook for risky assets based on targets established by J.P. Morgan Fixed Income and Equity Strategists and are summarized on Figure 14.

As a framework, we view equities as the junior piece of the capital structure and the resulting value is based on the residual of macroeconomic and credit outlooks.

Every strategist sees positive returns in their markets with the exception of Treasuries (10-year expected to rise to 2.5%). This bodes well for equities—think of it conversely, if credit was to have a negative outlook, how could equities necessarily rise?

Notably, U.S. High Yield strategist Peter Acciavatti sees HY spreads rallying to 700bp and U.S. High Grade strategist Eric Beinstein sees investment grade rallying to 175bp, both new cycle lows. These are particularly correlated to equities, and thus are bullish.

Figure 14: 2012 Outlook for Risky Assets

Spreads in Fixed Income; Index Targets for Equities

Risky Asset

J.P. Morgan

Strategist Current Target Delta Rationale

Equity

implication

Treasuries (10-year) Belton/

Ramaswamy

2.04 2.50 +0.46 Flight-to-quality rally in 1Q and trend higher Neutral

JULI Investment Grade Beinstein 246 175 -71bp Wide divergence between strong corporate metrics and

wide spreads lead to eventual rally

VERY

Positive

High Yield Acciavatti 776 700 -76bp Defaults remain historically low VERY

Positive

MBS (MBS L-OAS) Jozoff 56 35 -19bp Solid fundamentals and wildcard of QE3 for mortgages Positive

10Y AAA 30% CMBS (2007

Vintage)

Reardon 330 225 -105bp Cautiously optimistic due to cheap fundamental credit

risk

Positive

3Y AAA Credit Cards Sze 14 11 -3bp Fundamentals remain solid Positive

Emerging Markets Index (Fixed

Income)

Chang 442 350 -98bp 5%-10% total return in 2012, better fundamentals, low

financing risk

Positive

Corporate EM Index (Broad) Chang 476 400 -76bp Attractive yields against tail risks from Eurozone crisis Positive

Commodities (S&P GSCI) Fenton 10% Darker near-term outlook Mixed

EMEA (MSCI Europe) Matejka 1017 1150 13% Relative value Positive

Asia (MSCI EM) Mowat 969 1150 20% Supportive policy Positive


Surprisingly, despite the Eurozone uncertainty,

J.P. Morgan’s Fixed Income

teams see meaningful positive returns in their markets in 2012.

This is positive for equities.

Fix

ed In

com

e


22


#2: Consensus Is Cautious About 2012

In general, consensus is more cautious about 2012 compared to last year (when consensus was looking at 2011). There are many ways to illustrate this, but perhaps the simplest illustration is to look at top-down Strategists’ forecasts from Bloomberg (Figure 15, NI WGT <GO>). The mean year-end target is 1351. In some ways, this is a slightly bearish view. Why?

This is lower than the April 2011 high of 1363—given fixed income markets are forecasting spreads to be even tighter by YE 2012 vs. April, this implies even greater relative underperformance of equities.

This also implies a YE 2012 P/E ratio of 11.2x, which would be the lowest P/E since 1950 for any market into its 46th month (the age of the bull market by December 2012) (see Figure 2).

While not apparent from the figure below, the YE 2012 target is actually lower than the year-ago 2011 forecast of 1377 (as of December 2010).

Figure 15: Comparison of S&P 500 Targets for 2012

2012 based on those strategists that have established 2012 targets

Source: Bloomberg NI WGT <<GO>>.

Bottom Line—Consensus Is “Cautious” on 2012, a Contrast to a Year Earlier, When Consensus Was “Bullish” on 2011

Our takeaway is that the market is in a better position to be surprised on the upside given lowered expectations. A year ago, the Street was bullish on 2011 and perhaps, in retrospect, that was a very obvious caution sign.

Today, the confidence in the 2012 outlook is low, given the myriad macro issues. And, thus, the market is likely better positioned for an upside surprise.

1,19

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1,40

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9

1,000

1,100

1,200

1,300

1,400

1,500

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Broker 7 Broker 6 Broker 10 Broker 2 Broker 4 Broker 1 Broker 3 Broker 9 J.P. Morgan Thomas Lee

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23


#3: Euro Crisis to Abate by 2H12

J.P. Morgan Fixed Income Sees Euro-Crisis Abating by 2H12

Our Global Fixed Income team recently published its 2012 outlook. It sees 2012 as a bifurcated year—a worsening of the crisis in Europe, pushing spreads wider, followed by a coordinated response from ECB/EU/IMF that results in tightening of spreads. In the team’s words:

“In our view, the crisis is likely to worsen in 1H12, before the ECB feels compelled to step in and stabilize markets by monetizing debt . . . We expect that the eventual response from the ECB, IMF and EU will be on a scale sufficient to ultimately stabilise peripheral yields in 2H12.”

– Pavan Wadhwa, Global Fixed Income Strategist from “Global Fixed Income Markets 2012 Outlook” dated 11/24/11

Thus, the outlook for Europe in 2012 starts with the crisis worsening and then taking a turn for the positive. Granted, there is a lot of progress that needs to be made to get there. But consider that the pressure on markets today has resulted in the turnover of two governments (Greece and Italy) and, arguably, this pressure is working in favor of the core nations forcing change among the peripheral countries.

The obvious risk is that the crisis spreads to banks and beyond and, thus, the ultimate response is not able to contain this. However, this is not the base case of our Fixed Income strategists.

As for equities, a resolution of the crisis would be positive. And a rally in spreads should be positive for equities.

But the Current Situation Is a Negative Feedback Loop…

What had started as a “peripheral” debt crisis in Europe in early 2010 has spread and engulfed the entire region in a crisis that seems very difficult to extinguish. There is plenty of blame to spread around from slow reforms of policymakers, lagged responses by ECB, to reluctance of core countries to support weaker countries for fear of “socializing debt,” to Euro banks with excessive exposure to sovereign paper.

The fact is that cross-border capital allowed the weakness in the peripheral regions to quickly transmit through the rest of Europe. And as the feedback loop, produced by Pavan Wadhwa, J.P. Morgan Global Fixed Income Strategist, and his team shows, this has amplified the crisis (Figure 16).

The ECB Potentially the Cure: JPM Estimates €70Bn/Month Needed or Double Current Rate of Purchases...

J.P. Morgan’s Global Fixed Income team believes the crisis has spread so widely that the only institution that can end this crisis is the ECB—that is, it has the firepower to short circuit this feedback loop. However, there are multiple reasons it remains reluctant to intervene. Among the known reasons for its reluctance: 1) playing a larger role is deemed “socializing” the debt and provides a disincentive for structural reform; and 2) a larger role blurs the line between monetary and fiscal policy.


24


For a variety of reasons, Wadhwa believes that the current “official” resources (IMF, EFSF, etc.) are not sufficient to fund both Italy and Spain if they both lose market access (see pages 13-14 of “Global Fixed Income Markets 2012 Outlook” dated 11/24/11) and therefore the ECB eventually needs to step in.

Wadhwa estimates there is about €1 trillion of funding (€350bn of primary plus €650-700bn of secondary selling less €135bn of private sector resources) or about €75bn per month of excess supply.

This implies the ECB would need to double its current rate of purchases (from €35bn/month) to eliminate this imbalance.

Figure 16: The Negative Feedback Loop in Europe . . . Negative Trifecta

From 2012 Global Fixed Income Outlook by Pavan Wadhwa


Doubling of Rate of Purchases Does Not Seem Unfathomable…But JPM Believes Markets Will Need to Force ECB’s Hand

At the moment, the view is that the ECB is not willing to commit to larger-scale purchases, based on self-imposed limits and the arguments noted above. However, there is no actual capacity constraint. In other words, there is no limit to how much the ECB would allow its balance to expand (beyond sterilization), but it does increasingly take on peripheral credit risk as it does so. And Germany and other parties have not been supportive of broadening commitment.

From an equity market perspective, this suggests that markets are likely to react very positively if the ECB finally succumbs to market pressure.

However, what will markets do in the interim? It is our view that, if the European situation stabilizes, equity markets will drift up—the reason being that global economic momentum remains and there still exists the positive option of an ECB intervention.

And, if the situation worsens, it simply pushes us closer to ECB intervention, in our view. The main risk, in this view, is if the situation deteriorates to the point that even the ECB cannot intervene. However, we do not think we are at that juncture.


25


While certainly a possibility, we believe those countries will see sufficient pressure from global policymakers to act prior to this.

But Europe’s Economy Is Slipping into Recession…

Europe’s economy continues to contract, a natural by-product of rising funding costs (both sovereign and corporate), de-leveraging by banks, lagged policy response, and deteriorating business confidence. While the region managed to post 0.8% growth in 3Q, J.P. Morgan economists expect 4Q GDP to show contraction of at least -1% and negative growth until 4Q12.

The weakening in the outlook is best seen in the downturn of the Euro-area PMIs. While the headline (Euro area) actually rose slightly in November, the country area data show that France is really the only country with an upturn in PMI and the rest of the region is likely weakening.

The ECB is also likely to cut rates, following the downturn in the PMIs.

J.P. Morgan forecasts a 25bp cut in December (2011) followed by moves in March 2012 and June 2012, resulting in its main policy rate falling to 0.50% and a similar narrowing of its interest rate corridor to +/- 25bp, resulting in a deposit facility rate of 0.25%.

Figure 17: Euro-Area PMIs Point to Recession . . .From “Global Data Watch” dated 11/25/11


Figure 18: . . . And Likely Further Cuts by ECBFrom “Global Data Watch” dated 11/25/11



26


What Outperformed After March 2009 Post-Lehman?

We compiled a list of the groups that outperformed following the lows established in 2009 (post-Lehman), as we think these groups should also be poised to outperform once the crisis in Europe reaches a resolution.

Financials appears to be the sector with the most upside potential, as it outperformed by 77% following the March 2009 low.

Cyclicals overall performed strongly, not surprisingly, outperforming by 22% on average.

On the downside, Defensives overall underperformed by -34% on average, with Telecom leading to the downside with -49% underperformance.

Figure 19: 2011 YTD Sector Performance

% change YTD


Figure 20: Sector Performance After 2009 Market Lows

Forward 12-mo performance


Rank Sector

Absolute

Perf

Relative

Perf

S&P 500 -1.1% —

1 Utilities 10.0% 11.1%

2 Staples 7.4% 8.4%

3 HealthCare 6.0% 7.0%

4 Discretionary 4.2% 5.2%

5 Energy 3.1% 4.1%

6 Technology 2.7% 3.8%

7 Telecom -3.2% -2.2%

8 Industrials -4.1% -3.1%

9 Materials -10.7% -9.7%

10 Financials -19.4% -18.3%

Cyclicals -2.0% -0.9%

Near-Cyclicals -8.2% -7.1%

Defensives 5.0% 6.1%

Rank Sector

Fwd 12-mo

Perf after

3/09 Low

S&P 500 69%

Relative Perf

1 Financials 77%

2 Discretionary 31%

3 Industrials 27%

4 Technology 15%

5 Materials 14%

6 HealthCare -23%

7 Staples -27%

8 Energy -30%

9 Utilities -36%

10 Telecom -49%

Cyclicals 22%

Near-Cyclicals 24%

Defensives -34%

Cyclicals and Near-Cyclicals underperformed sharply in 2011, and thus appear poised to outperform in 2012 once the European debt crisis is resolved.


27


#4: Corporate Profit Margin Expansion

Still See Upside to Our 2012E/2013E EPS of $105/$110

We remain comfortable with our EPS forecast for 2012 EPS of $105, which is above top-down consensus of $102 and below bottom-up consensus of $108. As shown in Figure 21 below, S&P 500 EPS in 2011 is expected to surpass the prior high of $88 in 2007.

The question for investors is whether to be thinking about a downturn in earningsgiven EPS is already at prior highs. Granted, we realize that with Europe in recession, there remains heightened risk of downside to earnings.

Figure 21: S&P 500 Annual EPS

Since 1990


But there are other reasons we see upside to profit margins. Specifically:

While net income margins are approaching the prior peak of 9% (Figure 22), S&P 500 EBIT margins at 15% are still below prior peak of 18%.

S&P 500 profit recovery is tracking slightly below that in prior earnings recovery cycles (Figure 24), suggesting that S&P 500 companies are not over-earning.

Finally, we believe quality of earnings is higher today as “inventory profits” are running at only 3% of overall earnings compared to 15% seen during the 1970s and 1980s.

EBIT Margins Have Room to Expand Further

We realize the pushback is that net income margins already exceed their prior peak at 9.2% compared 8.8% in 2007 (Figure 22). On the other hand, EBIT margins at 15% (as a percentage of sales) are still below the prior peak of 18% in 2007.

The reason for this is that interest expense and taxes (as a percentage of sales) are well below levels in 2007. We think such levels are somewhat sustainable given debt levels (as a percentage of sales) are lower than in 2007 and current low interest rates.

EBIT margins still appear set to expand. Intuitively, this should result from operating leverage as sales expand. Currently, only 78% of S&P 500 companies

$23.

42

$18.

49

$22.

77

$28.

07

$32.

68

$38.

74

$41.

02

$44.

85

$44.

33

$51.

02

$55.

12

$45.

16

$47.

94

$55.

44 $67.

10 $76.

28 $88.

18

$85.

12

$65.

47

$60.

80

$85.

28 $97.

75

$105

.00

$110

.00

$0.00

$20.00

$40.00

$60.00

$80.00

$100.00

$120.00

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

E

2012

E

2013

E

Prior peak EPS


28


have re-attained prior peak EBIT margins. And those 78% have already exceeded the prior peak by 6% (index 100 = prior peak).

At the sector level, 91% of Defensives are already operating at prior peak EBIT margins, compared to only 78% of Cyclicals and 66% of Near Cyclicals.

Figure 22: S&P 500 EBIT Margin and Net Income Margin

Since 2006


Those Companies that Have Reached Prior EBIT Margin Peak Have Seen EBIT Margins Continue to Surge…

Finally, consider Figure 23 below. We have plotted the composite EBIT margin of the 78% of companies that have exceeded prior peak EBIT margins.

As this figure shows, their EBIT margins are above the prior peak and are continuing to expand. In other words, the prior peak is not a constraint.

In the meantime, the 22% that have not exceeded the prior peak have seen EBIT margins continue to expand as well and at a faster pace.

Thus, we see no reason why EBIT margins cannot improve again in 2012, pointing to EPS growing faster than sales.

15.4%

9.2%

Prior Peak EBIT Margin, 17.5%

Prior Peak Net Income Margin, 8.8%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

12/06 4/07 8/07 12/07 4/08 8/08 12/08 4/09 8/09 12/09 4/10 8/10 12/10 4/11 8/11

EBIT Margin Net Income Margin

Prior Peak EBIT Margin Prior Peak Net Income Margin


29


Figure 23: Indexed S&P 500 EBIT Margin

Since 2006

Indexed at 100 at Prior Peak for S&P 500 EBIT Margin in 2Q07 EBIT Margin (% Sales)

Source: J.P. Morgan and FactSet. Note: S&P 500 pro forma assumes companies that had re-attained peak EBIT margin by 3Q11 have flat EBIT margin through YE2012, while companies that had

not re-attained peak EBIT margin by 3Q11 have re-attained peak EBIT margin by YE2012.

Current Profit Recovery In Line with Past Recoveries

Currently, our 2012 EPS forecast of $105 puts 2012 EPS at 118% of 2007’s peak EPS (see Figure 24). This recovery in profits is actually below what has typically been seen in EPS recoveries following the Great Depression.

We indexed earnings so that 100 was the prior peak in EPS (prior cycle).

The composite EPS recovery since the Great Depression has been for EPS to reach 123% of prior peak in 22 quarters (2012 equivalent).

Thus, the current recovery does not indicate an unprecedented surge in earnings.

Figure 24: S&P 500 EPS vs. Prior Peak

Indexed at 100 at prior peak EPS; since 1900

Source: J.P. Morgan, FactSet, and Shiller.

91

106

68

40

50

60

70

80

90

100

110

12/06 7/07 2/08 9/08 4/09 11/09 6/10 1/11 8/11 3/12 10/12

Ind

exed

LTM

EB

IT m

arg

in

S&P 50078% of cos that have Reattained Peak EBIT margin22% of cos that have NOT Reattained Peak EBIT marginS&P 500 Pro-forma

15%

17%

13%

7%

9%

11%

13%

15%

17%

19%

12/06 7/07 2/08 9/08 4/09 11/09 6/10 1/11 8/11 3/12 10/12

LT

M E

BIT

mar

gin

S&P 50078% of cos that have Reattained Peak EBIT margin22% of cos that have NOT Reattained Peak EBIT marginS&P 500 Pro-forma

117

106

118126

123

134141

40

60

80

100

120

140

-10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Ind

exed

S&

P 50

0 E

PS

Quarters since Peak EPS

Peak in EPS 6/2007 Composite Composite (post-Great Depression)

BU Consensus

YE 2012

YE 2013

YE 2014


30


#5: De-Equitization of Markets Taking Place

Expect 28% Increase, or $250Bn Upside in Total Cash Return…Looking at 2011 vs. 2007

We compared cash return statistics this year compared to 2007 (when S&P 500 profits were last near this level), and in our view the implication is that corporates are likely to vastly ramp up cash return activity.

Our current EPS estimate for 2011 of $97.75 compares to profits of $92.15 in 2007, or 6.1% higher. Profits are not forecast to peak until after 2013 (i.e., 2014-2015). Buybacks totaled $711bn in 2007 and are only $574bn currently. But to true up to the 2007 implied level, buybacks would need to increase by 31% to $754bn.

Dividends totaled $349bn in 2007 and are only $305bn currently. But to true up to the 2007 implied level, dividends would need to increase by 21% to $370bn. Total cash return totaled $1.1 trillion in 2007 and only totals $880bn currently. But to true up to the 2007 implied level, total cash return would need to increase by 28% to $1.1 trillion.

Figure 25: Dividends and Buybacks Likely Ramp Up . . .

2007 vs. 2011(annualized), $bn where applicable

EPS Buybacks Dividends Total Cash Return

Source: FactSet.

YTD 41% of Income Has Been Returned to Shareholders, Below 51% Long-Term Average and 78% in 2007…

As we are all aware, S&P 500 profits are at all-time highs, with expected 2011 EPS of $97.75 surpassing the prior record. Despite this record high, corporate cash return is not anywhere close to prior highs. We define corporate cash return as buybacks and dividends. We compiled all stock activity for all 15,000 U.S. companies that are publicly traded (even those no longer trading) and plotted the data in Figure 26below.

Corporate cash return as a percentage of profits (we used NIPA corporate profits for this exercise, which is a fairly comprehensive measure of corporate net income) is currently about 41% of profits—among the lowest levels since 1990 and well below the 20-year average of 51%.

$92

$98

2007 2011

$711

$574

$754

2007 2011 (annualized)

Implied level

$349

$305

$370


Implied level

$1,060

$880

$1,125


Implied level$245b implied increase in total return


31


As noted in Figure 26, during the later years of an expansion, this figure has tended to rise to 65-80%. In 2007, companies distributed 78% of profits via buybacks and dividends, and in 2000 distribution totaled 84%.

In dollar terms, this implies a buyback level in the range of $1.1-1.2 trillion, up substantially from $880bn currently.

An increase in corporate buybacks of $300-400bn is no different than a similar increase in the dollar amount of inflows from retail mutual funds. This would be equal to the largest single year of inflows into equities by mutual funds.

Figure 26: Year to Date 41% of Corporate Profits Have Been Used to Buy Back Stock or Pay Dividends . . . Below 20-Year Average of 51%

Since 1990

Source: FactSet. For % of profits, we compiled data on all companies since 1990 (~15,000 total securities). For profits, we used NIPA data from BEA.

Corporate Cash Return Likely to Dramatically Increase Buybacks and Dividends in Coming Quarters

Below we have compiled total cash return for the 15,000 companies since 1990 in Figure 27. The current figure is $880bn annualized with buybacks representing $574bn and dividends $305bn.

The prior record year for total cash return was 2007, with a total of $1.06 trillion returned to shareholders via buybacks and dividends. On an annualized basis, 2011 is tracking below that level, with a total of $880bn.

As for composition, we believe the delta in corporate cash return is likely to represent buybacks. Note that the current ratio of buybacks as a percentage of cash return is 65%.

There are also incentives for companies to buy back stock versus paying dividends—namely, the equity earnings yield is much higher than corporate bond yields. In other words, we do not see why corporates would want to accelerate buybacks given their equity is so cheap relative to credit.

37% 38%

43%

48%

43%46%

57%59%

65% 65%

84%

46%

32%

47%

52%54%

63%

78%

55%

37%

33%

41%

LT Avg51%

30%

40%

50%

60%

70%

80%

90%

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Recession Cash Return as a % of Corp Profits LT Avg

annualized

Mature stages… Mature stages…

Towards 70%-80%...


32


Figure 27: Buybacks and Dividends Are the Second Highest on Record . . .

Since 1990

Source: FactSet. For % of profits, we compiled data on all companies since 1990 (~15,000 total securities). For profits, we used NIPA data from BEA.

S&P 500 Shares Have Fallen to Levels Not Seen Since 2001…

The share count of the S&P 500 (ex-Financials) has declined since 2008, the first time this has occurred since 1990 (Figure 28). The share count has declined by 3% since 2006, highlighting the important role of corporates as the real incremental buyers of stocks (Figure 29).

Since 1990, shares outstanding have increased 3-4% annually, thus, the recent declines are a substantial change in trend.

As noted below, shares outstanding are currently at levels not seen since 2001. This is the first time since 1991 the share count is lower than it was a decade ago.

Figure 28: Share Count of S&P 500 Since 1991Ex-Financials; data are for 355 current constituents of S&P 500 with data

available since 1991

Source: FactSet.

Figure 29: Five-Year % Change in S&P 500 Share CountEx-Financials; data are for 355 current constituents of S&P 500 with data

available since 1991

Source: FactSet.

$45

$29

$37

$43

$49

$80

$107

$143

$190

$196

$186

$157

$153

$160

$266

$407

$556

$711

$450

$323

$365

$574

$101

$103

$107

$113

$121

$142

$148

$155

$173

$176

$167

$168

$176

$190

$225

$299

$302

$349

$311

$264

$287

$305

31%

22%26% 27% 29%

36%

42%

48%52% 53% 53%

48% 47% 46%

54%58%

65%67%

59%55% 56%

65%

$0

$200

$400

$600

$800

$1,000

$1,200

0%

10%

20%

30%

40%

50%

60%

70%

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Recession Buybacks Dividends Buybacks as a % of Cash Return

annualized

$145 $132 $144 $156 $170$222

$254$298

$363 $372 $353$324 $329 $350

$491

$706

$858

$1,060

$761

$587$652

$880

166 17

0 173 17

6 179 18

2 186 18

9

196

203 20

8 213 21

6

217

218

218

213

209 21

3

212

212

150

160

170

180

190

200

210

220

12/91 12/93 12/95 12/97 12/99 12/01 12/03 12/05 12/07 12/09 9/11

S&

P 5

00 s

har

es o

uts

tan

din

g (b

)

S&P 500 ex …

15.6 15.3 15.1

20.2

23.925.8

27.6 27.6

21.3

14.9

10.1

0.0

-6.9-4.4

-5.6 -6.3-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

30.0

12/96 12/98 12/00 12/02 12/04 12/06 12/08 12/10

5-ye

ar D

elta

in S

&P

500

sh

ares

out

stan

ding

(b

)

S&P 500 ex FinancialsShares are back to levels not seen since 2001


33


33% of S&P 500 Companies Have Bought Back at Least 10% of Shares in Past Five Years…

The reduction in shares outstanding for S&P 500 companies has also been widespread throughout the index, with 33% of S&P 500 companies (ex-Financials) reducing share count by 10% since 2006 (Figure 30).

The companies with the top 20 reductions in share count have seen shares outstanding fall by an average of 35% (Figure 31).

Figure 30: Distribution of Companies by Five-Year Change in Shares Outstanding% of companies in S&P 500 (ex-Financials) based on 5-year change in shares

outstanding

Source: FactSet.

Figure 31: 20 Largest Decline in Share Count (% Change) Since 2006% change in shares

Source: FactSet.

U.S. Corporate Buybacks 6x Larger than European Corporate Buybacks

U.S. corporates have been much more aggressive at buying back their shares than European companies. To get a better sense for this, take a look at Figure 32 and Figure 33.

Over the past five years U.S. corporates have executed buybacks equal to about 4% of market cap, a trend that has been steadily accelerating since 1995 when the level was closer to 1.5%.

In contrast, European corporates have bought back shares amounting to 0.7% of market cap and this level has been consistent for the past 15 years.

Thus, U.S. corporates have been buying shares at 6x the rate of European companies. This is obviously a significant difference and one reason we believe U.S. equities have outperformed European equities.

33%

11%

22%

15% 15%

11%

7%

20%

0%

5%

10%

15%

20%

25%

30%

35%

<-10% <-20% -20% to -10%

-10% to -5%

-5% to 0%

0% to 5%

5% to 10%

>10%

% o

f co

mp

anie

s

% chg in Shares Outstanding (Now vs. 5 years ago)

Shares Outstanding

Name Ticker

Sector

GICS 5yrs ago Current Delta % chg

1 Novellus Systems Inc. NVLS 45 124 67 -57 -46%

2 WellPoint Inc. WLP 35 621 349 -271 -44%

3 AutoZone Inc. AZO 25 71 40 -31 -44%

4 DIRECTV DTV 25 1,219 715 -503 -41%

5 Travelers Cos. Inc. TRV 40 690 413 -277 -40%

6 Big Lots Inc. BIG 25 109 67 -42 -38%

7 Compuware Corp. CPWR 45 352 218 -134 -38%

8 Gap Inc. GPS 25 822 527 -295 -36%

9 VeriSign Inc. VRSN 45 244 159 -85 -35%

10 Coca-Cola Enterprises Inc. CCE 30 478 312 -166 -35%

11 Medco Health Solutions Inc. MHS 35 589 387 -202 -34%

12 Chubb Corp. CB 40 412 278 -134 -32%

13 AutoNation Inc. AN 25 208 141 -66 -32%

14 AmerisourceBergen Corp. ABC 35 393 272 -121 -31%

15 Torchmark Corp. TMK 40 147 102 -45 -31%

16 Aetna Inc. AET 35 522 362 -160 -31%

17 Sears Holdings Corp. SHLD 25 154 107 -47 -30%

18 Loews Corp. L 40 556 397 -159 -29%

19 Biogen Idec Inc. BIIB 35 337 243 -94 -28%

20 Hewlett-Packard Co. HPQ 45 2,732 2,002 -730 -27%

Total -35%

33% of cos bought back at least 10% of shares


34


Figure 32: U.S. Corporate Buybacks vs. European Corporate BuybacksBuybacks as a % of Total Market Cap

Source: J.P. Morgan and DataStream.

Europe data is based on the Datastream Europe Total Market Index.

2011 data is annualized.

Figure 33: U.S. Corporate Buybacks vs. European Corporate BuybacksU.S. Corporate Buybacks/European Corporate Buybacks

Source: FactSet and Datastream.

Europe data is based on the Datastream Europe Total Market Index.

2011 data is annualized.

Corporates the Incremental Buyers of Equities: 83% of All Inflows to Equities Have Been from “Corporates”

This leads us to the next critical point. Corporates really have been the incremental buyers of stocks. Take at look at the chart below, showing that since 1990 buybacks and dividends have been the largest incremental source of market demand.

In total, there have been $11.5 trillion of total incremental flows into equities since 1990. Of this, mutual fund inflows totaled $1.9 trillion while $9.6 trillion came from corporates. We have not been able to obtain a similar figure for hedge funds, but it should be necessarily smaller.

Look at how this has evolved in the past five years. In 2005-2009, for instance, corporate buybacks represented 60% of the total. Think about that: the real incremental buyers for stocks have been corporates.

By the way, this figure, as we noted in the previous section, is likely to ramp up dramatically. Thus, we see the upside bid to equities continuing.

Figure 34: Corporates Have Been Incremental Buyers of StocksSince 1990; 2011 numbers are annualized

Source: FactSet and Investment Company Institute (ICI).

Figure 35: Corporates Have Been Incremental Buyers of StocksSince 1990; 2011 numbers are annualized

Source: FactSet and Investment Company Institute (ICI).

1.5%

2.0%

3.9%

2.6%

0.6% 0.5%0.7%

0.6%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

1996-2000 2001-2005 2006-2011 all Periods

US Corporate Buybacks as a % of Wilshire 5000 Market Cap

Europe Corporate Buybacks as a % of Europe Total Market Index

2.4x

3.8x

5.6x

4.1x

1.0x

1.5x

2.0x

2.5x

3.0x

3.5x

4.0x

4.5x

5.0x

5.5x

6.0x

1996-2000 2001-2005 2006-2011 all Periods

1996-2000 2001-2005 2006-2011 all Periods

$41 $143 $184

$489 $470 $5,227$109

$159 $185

$305 $296 $4,381

$75

$183 $127

$24

-$61

$1,920

$224

$484 $496

$818 $705

$11,528

-$150

$0

$150

$300

$450

$600

$750

$900

1990-1994 1995-1999 2000-2004 2005-2009 2010-2011 Total

$bil

lion

s

Buybacks Dividends Mutual Fund Flows into Equities

18%30% 37%

60% 67%45%

49% 33%37%

37% 42%38%

33% 38%26%

3%

-9%

17%

-25%

-5%

15%

35%

55%

75%

95%

1990-1994 1995-1999 2000-2004 2005-2009 2010-2011 Total

% o

f Flo

ws

Buybacks Dividends Mutual Fund Flows into Equities

83% of inflows are Corporates


35


#6: U.S. Housing Affirms Recovery in 2012

Our thesis has been that U.S. housing markets would stabilize in 2011, with shortages developing given the extremely low level of starts (see “Positive on Housing Food Chain,” “Positive on Housing Food Chain II,” and “Housing Food Chain: Part III”). While a bit slower to develop, evidence of a 2011 recovery is mounting:

Building permits hit a three-year high at 653k (October) (Figure 36).

NAHB Homebuilder sentiment hit a four-year high of 20 (November)(Figure 37).

Vacancy rate of homes fell to 2.4%, the lowest since mid-2006 (Figure 38).

Mortgage delinquencies (MBA) at 7.99% are the lowest since 3Q08 (Figure 39).

Figure 36: Building Permits Are Breaking Out of Prior Range . . . .NHSPATOT Index GP <GO>

Source: Bloomberg.

Figure 37: Homebuilder Sentiment Is the Best Since Early 2008USHBMIDX Index GP <GO>

Source: Bloomberg.

Figure 38: Vacancy Rate of HomesHVRAHOME Index GP <GO>

Source: Bloomberg.

Figure 39: % Mortgages Delinquent MBADLQTDLQT Index GP <GO> – MBA % mortgages delinquent

Source: Bloomberg.

Breakout to 4-yr high

3-yr range

Distortion from homebuyer tax credit

Fewest since 3Q08

Distortion from homebuyer tax credit

Breakout to 3-yr high

3-yr range

Lowest since 2006

Pre-Bubble


https://mm.jpmorgan.com/PubServlet?action=open&doc=GPS-574557-0.pdf





36


Excess Home Supply Declined from 1.4MM to 1.1MMRecently

We updated our analysis using current data (but using pre-2007 as target levels) and compared this to 3Q10. What is notable in Figure 40 is that the total excess units have declined from 1.4mm to 1.1mm.

We added another element of “vacancy” analysis called “vacant other.” This category of “other + temp occ by URE (Usual Residence Elsewhere)” could include homes held by banks and investors, and thus worth including in our view. As shown, this category is about 600k above the long-term trend.

Of the 316k drop in excess homes, 71% or 224k is attributable to a drop in excess rental vacancies—in other words, there was a 904k increase in occupied rental units and a 132k drop in “vacant” rental units, or a net increase in rented units of 1.2mm (rental formation).

The number of vacant homes declined slightly in the past year, by 87k, suggesting that the rise in rental demand was not all “migrations from homeowners to renters.”

Figure 40: Excess Inventory Has Declined from 1.4MM to 1.1MM

000s

Source: J.P. Morgan and US Census Bureau.

2011 data are the latest available data, as of 4Q10.

Homeowner: Calculating excess supply 3Q10 3Q11 Delta

+ Owner occupied home 75,511 75,250 (261)

+ Sold but awaiting occupancy 539 512

(a) + Vacant year-round for sale only 1,950 1,863 (87)

(b) Total homeowner units 78,000 77,625 (375)

Current vacancy rate 2.60% 2.40%

(c ) Target: 2005 Vacancy Rate 2.00% 2.00%

(d )=(b) * (c) Target homes vacant 1,560 1,553 (8)

(e) = (b) - (d) = Estimated excess housing units 390 311 (80)

Rentals: Calculating excess supply

+ Rental occuppied units 37,395 38,299 904

+ Rented but awaiting occupancy 467 652

(a) + Vacant year-round for rent only 4,371 4,239 (132)

(b) Total rental units 42,233 43,190 957

Current vacancy rate 10.30% 9.80%

(c ) Target: 2005 Vacancy Rate 9.60% 9.60%

(d )=(b) * (c) Target rentals vacant 4,054 4,146

(e) = (b) - (d) = Estimated excess rental units 317 93 (224)

Others: Vacant for "other supply"

(a) Other + Temp occ by URE 4,843 4,830 (13)

(b) Target: Other + Temp occ by URE 4,150 4,150

(c ) = (a) - (b) = Estimated excess rental units 693 680 (13)

Total excess units of housing 1,400 1,083 (316)

EXCESS HOUSING BASED ON

VACANCY RATE, NOT SHADOW

INVENTORY

Excess housing, in our view, is

best gauged by looking at vacancy rate, not shadow

inventory.

In 2010, we calculated estimated

excess homes using the notion

of vacancy rates. We used vacancy rates, rather than

“shadow inventory” or

foreclosure data, as the latter are better measures, in our view, of

pricing supply/demand, rather

than fundamental demand.

Why? The occupancy rate of

homes that are delinquent today is close to 100% (primary

residence); therefore, as these

homes move through the foreclosure process, the

occupant eventually needs to

find shelter.

Thus, while the home will be

liquidated, creating supply from a price perspective, the

occupant will need to find a new

shelter. In other words, this is not an excess home from a

fundamental supply/demand

perspective—the occupant simply moves to another shelter.

Large increase in occupied rentals


37


Household Formation Is Recovering as Well…

In order to reduce excess housing inventory of 1.1mm (and therefore establish a sustainable basis for a housing recovery), there needs to be a recovery in household formation.

However, this is still below the long-term average of 1.242mm (1959-2006) and reflects weak labor markets impairing household formation. A rise to the long-term average (Figure 41) would represent a doubling of household formation rates.

Figure 41: Household Formation Rates Are Slowly Recovering Are But Not at Normalized LevelsYoY change in household formation

Source: Bloomberg and Datastream.

Figure 42: Household Formation vs. Employment GrowthJobs and Households formed per net adult chg


Figure 43: Following Labor, HH Formation Households formed per net adult chg


This should bode well for household formation. As one can see, household formation varies with labor market conditions. The long-term average of households formed per net adult is 0.61, but in any year this ratio varies and has plunged during recessions but recorded similar bounces during labor recoveries. This ratio fell to cycle lows during the 2009 recession and has been slowly recovering.

9/11330

LT avg ('59-'06), 1,262

(500)

0

500

1,000

1,500

2,000

2,500

3,000

1/01 3/02 5/03 7/04 9/05 11/06 1/08 3/09 5/10 7/11 9/12

YoY

Hou

seho

ld F

orm

atio

n

YoY Household Formation LT avg ('59-'06)

1,50

0 2,

000

0.27

0.54 0.47

0.16 0.22

0.42

0.16 (6,000)

(4,000)

(2,000)

0

2,000

4,000

0.10

0.30

0.50

0.70

0.90

1.10

1.30

1/59 1/63 1/67 1/71 1/75 1/79 1/83 1/87 1/91 1/95 1/99 1/03 1/07 1/11

Incr

ease

in N

onf

arm

Pay

rolls

HH

form

atio

n p

er N

et A

dult

Chg

Recession Increase in Nonfarm PayrollsHH Formation per Net Adult chg

From trough HH Formed/ Net Adult chg

Year of Trough

in Ratio 0 1 2 3 4 5

1962 0.27 0.69 0.92 1.24 0.54 0.71

1966 0.54 0.71 0.82 0.53 0.54 0.55

1974 0.47 0.60 0.47 0.65 0.43 1.14

1982 0.16 0.50 0.70 0.69 0.48 0.87

1989 0.22 0.44 0.63 0.36 0.41 1.23

1995 0.42 0.67 0.84 0.67 0.55 0.67

b Avg All Years 0.35 0.60 0.73 0.69 0.49 0.86

2009 (today) 0.19 0.16 0.41 — — —

Implied HHs formed 2011e 2012e 2013e 2014e

a Incr. Adults 2.6mm 2.6mm 2.6mm 2.6mm

b HH/adult (see above) 0.73 0.69 0.49 0.86

a*b Implied HHs Formed 1.9mm 1.8mm 1.3mm 2.2mm

Trending higher…


38


By the third year into a recovery, this ratio has recovered to the long-term averageThe pace of that recovery is illustrated in Figure 43 on the right. As one can see, households formed per net adult change accelerate meaningfully as labor market conditions improve.

Rent/Own Affordability Ratio Shows Owning Is Cheaper

Houses are inexpensive when comparing the cost of ownership vs. the cost of renting, suggesting households are better off owning than renting at this point.

During the housing bubble of 2005-2007, the cost of owning greatly exceeded the cost of renting as housing prices became extremely elevated (see Figure 44).However, the sharp decline in home prices, combined with lower mortgage rates, has pushed the cost of owning well below the cost of renting again, with renting now 18% more expensive than owning.

Figure 44: Cost of Owning vs. Cost of Renting

Since 1990

Source: J.P. Morgan REITS Research.

Lending Standards Have Finally Started to Ease

One of the biggest obstacles to a housing recovery so far has been the difficulty for many households in obtaining a mortgage in order to purchase a home. In response to the lending practices that helped fuel the housing bubble, banks and mortgage lenders have been continuously tightening lending standards for the past few years.

As shown in Figure 45, bank mortgage loan standards have tightened in just about every quarter since the end of 2006. However, the net percentage of bank officers tightening standards has fallen sharply since late 2008.

2002

Cost of Owning, 3Q11, $858

1998

2000

Cost of Renting, 3Q11, $1,004

$550

$650

$750

$850

$950

$1,050

$1,150

$1,250

$1,350

12/90 8/93 4/96 12/98 8/01 4/04 12/06 8/09 4/12

Cost of Owning Cost of Renting

18% more expensive to rent


39


Figure 45: Bank Mortgage Loan Standards Easing

% of respondents tightening standards; Federal Reserve Senior Loan Officer Opinion Survey


Household Leverage Back to Level in Mid-1990s, Creating Room for Taking on Mortgage Debt

U.S. households have repaired their balance sheets substantially during this economic downturn, reducing debt leverage significantly since the beginning of 2008.

Figure 46 below shows the Household Total Financial Obligations Ratio. This ratio has fallen from 18.9 in 3Q07 to 16.1 as of 2Q11, bringing household debt leverage back to the best level since 4Q 1993.

Figure 46: Household Total Financial Obligations Ratio

Ratio of debt payments (payments on mortgage and consumer debt, auto lease payments, rental payments

on tenant-occupied property, homeowner insurance, and property tax payments) to disposable personal

income


-20.0%

0.0%

20.0%

40.0%

60.0%

80.0%

9/90 9/91 9/92 9/93 9/94 9/95 9/96 9/97 9/98 9/99 9/00 9/01 9/02 9/03 9/04 9/05 9/06 9/07 9/08 9/09 9/10 9/11

Net

% o

f Res

po

nde

nts

Tig

hte

nin

g S

tand

ards

Mortgage Loan Standards Prime Mortgage Loans Non-Traditional Mortgage Loans

Tightening lending standards

Easing lending standards

12/9316.1

9/0718.9

6/1116.1

Long-Term Avg17.2

15.0

15.5

16.0

16.5

17.0

17.5

18.0

18.5

19.0

3/80 3/82 3/84 3/86 3/88 3/90 3/92 3/94 3/96 3/98 3/00 3/02 3/04 3/06 3/08 3/10

Deb

t Rat

io

Household Total Financial Obligations Service Ratio Current Long-Term Avg 5yr Avg

Lo

wer

Deb

tH

igh

er D

ebt

At 16%, this ratio is comparable to levels seen during the early to mid-90s. Households have made rapid progress in deleveraging over the last few years.


40


What Groups Outperformed When U.S. Housing Starts Accelerated?

Following the trend of declining demand for housing, the supply of new housing has also dropped off significantly, as housing starts still remain near the lowest levels in the past 50 years.

Figure 47: Total U.S. Housing Starts

In 000s


U.S. housing starts have hit multi-decade troughs four times since 1959, as indicated in Figure 47 above. These troughs marked turning points in construction activity for U.S. housing and, along with it, U.S. economic activity.

In the table below we have highlighted those groups that have historically outperformed when U.S. housing activity picked up (since 1973). Cyclicals in general have outperformed by 12%, led by Discretionary which has outperformed by 23% with a 100% win ratio.

Figure 48: Sector Performance After Trough in Housing Starts

Forward 12-month performance

Source: J.P. Morgan and Datastream.

628

10/66843

2/75904

11/81837

1/91798

0

500

1,000

1,500

2,000

2,500

3,000

1/59 1/62 1/65 1/68 1/71 1/74 1/77 1/80 1/83 1/86 1/89 1/92 1/95 1/98 1/01 1/04 1/07 1/10

Ho

usi

ng

Sta

rts

Recession Housing Starts Current Trough

Rank Sector 2/1975 11/1981 1/1991 Avg

% Times

Outperform

S&P 500 22% 10% 19% 17% 100%

Relative Perf

1 Discretionary 17% 41% 11% 23% 100%

2 Technology -4% 39% -4% 10% 33%

3 Materials 29% -3% 3% 10% 67%

4 Staples -9% 23% 14% 10% 67%

5 Financials -10% 10% 22% 7% 67%

6 Industrials 7% 10% -2% 5% 67%

7 HealthCare -22% 16% 19% 4% 67%

8 Utilities -7% -1% -4% -4% 0%

9 Telecom -11% -6% -15% -10% 0%

10 Energy -13% -34% -18% -22% 0%

Cyclicals 12% 22% 2% 12% 100%

Near-Cyclicals -12% -12% 2% -7% 33%

Defensives -12% 8% 3% 0% 67%

Sector Strategy:

Buy Cyclicals, particularly

Discretionary

Discretionary has outperformed

by 23% on average with a 100%

win ratio following a trough in housing starts.

Energy has been the biggest laggard, underperforming by

-22% on average.


41


#7: U.S. Political Outlook Win-Win for Equities in Election Year…

2012 Likely to Be Win-Win: Either Electoral Change or Better Economy Keeping Incumbents in Office

Investors have grown frustrated with Washington, as contentiousness and indecision have weighed on the U.S. economy and equity markets. Moreover, programs like Health Care Reform and Dodd-Frank, among others, have added uncertainty to the outlook for certain sectors.

And, of course, the failure of the Super Committee speaks to the environment in Washington. However, as we look to 2012, we see an election year as a likely net positive going forward. Why? Our logic is simple:

Electoral change likely positive for equities. Given presidential and congressional approval ratings near historically low levels (see, for example, Figure 49), 2012 creates the potential for electoral change, with a good chance of change in the House and Senate and potentially in the White House. Markets could embrace such change as it might be interpreted as likely to result in an era of “deregulation/deinterference”—this should be good for equities.

Conversely, if the economy recovers with incumbents remaining in office, this would also help equities. An improving economy would be good for equities.

Historically equities have performed well when approval ratings leading into election year have been low. Currently, President Obama’s approval rating of 43 is below the long-term average (since 1940) at the start of an election year.

Figure 49: Presidential Approval Ratings into an Election Year: President Obama Below Long-Term Average

Approval rating as of 12/31 of year prior to election

Source: J.P. Morgan, Bloomberg, and Gallup.

64% 66%

53%

23%

76%

66%

77%

48% 49%46%

56%52%

49%46%

42%

63%60%

32%

43%

Avg53%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

FD

R (D

) —'4

0

FD

R (D

) —'4

4

Tru

man

(D) —

'48

Tru

man

(D) —

'52

Eis

enho

wer

(R) —

'56

Eis

enho

wer

(R) —

'60

John

son

(D) —

'64

John

son

(D) —

'68

Nix

on (R

) —'7

2

For

d (R

) —'7

6

Car

ter (

D) —

'80

Rea

gan

(R) —

'84

Rea

gan

(R) —

'88

Bus

h S

r (R

) —'9

2

Clin

ton

(D) —

'96

Clin

ton

(D) —

'00

Bus

h Jr

(R) —

'04

Bus

h Jr

(R) —

'08

Oba

ma

(D) —

'12

Pre

sid

ent A

ppro

val R

atin

g

Presidential Approving Rating at Start of Year Avg


42


Markets Have Rallied in Election Years When Presidential Approval Rating Was Below 50

In Figure 50 we have plotted the presidential approval rating at the start of an electrion year and equity returns for that same year:

There have been eight elections of 19 when approval ratings were below 50%. Of these eight instances, stock market returns were positive seven times in the election year. The sole exception was 2008. And we would argue that 2008 was likely an exception as that was the only time when the U.S. economy was in recession.

The other seven years are shown in Figure 51, and, as shown, the average gain for the S&P 500 in the election year was 13%.

We believe this reflects investor optimism that changes could take place in Washington during such an election year.

Bottom line: The disappointment from the Super Committee, in our view, is likely to solidify investor expectations that voter frustration could result in electoral changes.

Figure 50: Presidential Approval Ratings and Election Year Stock Market Returns



Figure 51: Expansion Years – Returns When Approval Rating Was Low in Election Year (<50%)



40

44

48

52

56

60

64

68

7276

80

84

88

92

96

00

04

08-40%

-30%

-20%

-10%

0%

10%

20%

30%

20% 30% 40% 50% 60% 70% 80%

S&

P 5

00 P

erf i

n th

at y

ear

Presidential Approval Rating at Start of Year

Approval rating below 50

Before Election After Election S&P 500 Perf

Year President Party President Party

S&P 500

Annual

Perf

1 1996 Clinton Democrat Clinton Democrat 20.3%

2 1976 Ford Republican Carter Democrat 19.1%

3 1972 Nixon Republican Nixon Republican 15.8%

4 1988 Reagan Republican Bush Sr Republican 12.4%

5 1952 Truman Democrat Eisenhower Republican 11.8%

6 1968 Johnson Democrat Nixon Republican 7.7%

7 1992 Bush Sr Republican Clinton Democrat 4.5%

Avg 13.1%

% times up 100%

Sole exception


43


Financials Have Consistently Outperformed During Election Years

We also looked at sector performance during Presidential election years in the midst of an expansion in which the President’s approval rating was low at the start of the year (<50%).

Financials was the clear beneficiary, outperforming by 7% on average with a 100% win ratio. This is likely due to low expectations for the economy at the start of the year (signified by a low approval rating) combined with investor optimism regarding potential changes as a result of the upcoming election.

Cyclicals overall also outperformed by 2%, again likely due to improving investor optimism during Presidential election years.

Figure 52: Sector Performance During Non-Recession Presidential Election Years When Presidential Approval Rating Was Low at Start of Year (<50%)

Since 1973


Rank Sector 1976 1988 1992 1996 Avg

% Times

Outperform

S&P 500 Abs Perf 19% 12% 4% 20% 14% 100%

Relative Perf

1 Financials 4% 1% 15% 8% 7% 100%

2 Technology 1% -13% 7% 23% 5% 75%

3 Industrials 6% -6% 4% 10% 3% 75%

4 Energy 8% 4% -5% 3% 2% 75%

5 Discretionary -5% 7% 14% -7% 2% 50%

6 Staples -10% 2% -2% 4% -1% 50%

7 Telecom 6% 3% 8% -23% -2% 75%

8 Materials -3% -6% 7% -4% -2% 25%

9 HealthCare -17% 1% -10% 1% -7% 50%

10 Utilities -2% -4% -2% -20% -7% 0%

Cyclicals 0% -5% 8% 5% 2% 50%

Near-Cyclicals 6% 2% 5% 5% 5% 100%

Defensives -6% 0% -2% -9% -4% 25%

Sector Strategy:

Buy Financials

Financials outperformed by 7% on average with a 100% win

ratio.

Cyclicals overall outperformed

by 2% and Near-Cyclicals

outperformed by 5%.

Defensives were big laggards,

however, underperforming by -4% on average with only a 25%

win ratio. The worst sectors on

average were Utilities and HealthCare, both

underperforming by 7%.


44


#8: China Entering Selective Easing Cycle

Debate continues on whether China can avoid a hard landing given growing imbalances in the economy (e.g., property prices, construction boom). Similarly, with headline inflation easing in China (5.5% vs. 6.1% prior month), our China strategists believe China is in a better position to begin easing interest rates (via RRR).

China’s economy becoming less dependent on exportsThe negative impact of external drags on China should be less severe than in past years, however, as China’s economy has transformed over the past few years, with exports contributing a much smaller amount to economic growth. Instead, Consumption and Capital Formation have become more important drivers (Figure 53).

Figure 53: China’s Economic Drivers

China’s GDP growth by expenditure, percentage points

Source: J.P. Morgan Research, from “China Amidst Softening Global Growth”, slide 2 from October 2011 by Jing Ulrich, Chairman of

Global Markets, China.

Inflation Cooling Off, Providing Support for Easing Monetary Policy

Inflation in China has begun to ease recently, with CPI rising only 5.5% yoy in October vs. 6.1% the month prior and the cycle high of 6.5% in July. Pipeline inflation pressure has also benefitted recently from the moderation in global commodity prices, according to Frank Li, J.P. Morgan’s Chief China Strategist.

-5.0

-3.0

-1.0

1.0

3.0

5.0

7.0

9.0

11.0

13.0

15.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1Q11 2Q11 3Q11

%p

oin

t co

ntri

butio

n to

Chi

na G

DP

Gro

wth

Final Consumption Gross Capital Formation Net Exports

Exports have become a much less significant driver of economic growth in China in recent years.


45


Figure 54: China Headline CPI, Food Prices, and Non-Food CPI Inflation

%oya

Source: J.P. Morgan Asia Pacific Equity Research, from "China Strategy: A Powerful rebound ahead", December 2011 by Frank Li,

J.P. Morgan Chief China Strategist.

China Likely to Avoid a Hard Landing

China will likely avoid a hard landing, according to Frank Li, J.P. Morgan’s Chief China Strategist. Li’s view is that “China’s economy has seen steady moderations in 2Q and 3Q, yet we see very little risk of hard landing, thanks to the economic housing projects and many 12th Five Year Plan related investment projects.”

Some examples of the government’s supportive measures that are likely to help engineer a soft landing, according to Frank Li, are:

China’s massive Rmb1.8 trillion hydraulic resource investments. On October 13, China Development quoted the senior officials from China’s Ministry of Hydraulic Resources as saying that China has planned Rmb1.8 trillion in investments for hydraulic resources.

The building of more subways in tier one cities such as Beijing and Shanghai, and the building of new subway projects in 30 provincial capital cities.

FAI projects from local governments, especially in western and central China.

Figure 55: China RRR Set to Move Down in 2012 as Inflation Cools

Since 1986

Source: J.P. Morgan Economics.

Figure 56: China One-Year Working Capital Rate Set to Be Flat/Up in 2012Since 1986

Source: J.P. Morgan Economics.

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

1/86 1/89 1/92 1/95 1/98 1/01 1/04 1/07 1/10 1/13

Ch

ina

CP

I Yo

Y %

ch

g

Ch

ina

Po

licy

Rat

e

Required Reserve Ratio CPI YoY % chg

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

1/86 9/88 5/91 1/94 9/96 5/99 1/02 9/04 5/07 1/10 9/12

Ch

ina

CP

I Yo

Y %

ch

g

Ch

ina

Po

licy

Rat

e

China - 1-year working capital rate CPI YoY % chg

Inflation is cooling off, both in CPI and PPI, which has benefitted from a moderation in global commodity prices.

JPM ForecastJPM Forecast


46


Sector and Style Analysis

Heading into 2012 with a bullish stance on equities overall, we continue to recommend a Cyclical/Financials tilt, as these groups look poised to outperform the overall market in 2012.

2011 Saw a Reversal of Outperformers of 2009-2010…

As mentioned earlier, 2011 is a year most investors would like to forget. At the sector level, there was a sharp reversal of leadership between the groups that had outperformed since the start of the bull market in March 2009 and the groups that led in 2011.

Since March 2009, Cyclicals and Financials were the clear leaders, with Cyclicals outperforming by 33%, led by Discretionary at 61% outperformance. Financials also performed strongly, outperforming by 23% since the March 2009 low.

So far in 2011, however, this trend has sharply reversed, with Defensives the clear leaders, outperforming by 6%, while Cyclicals and Near-Cyclicals have underperformed. Financials have had a particularly rough year, underperforming by 18%.

We expect this trend to reverse again in 2012, as the framework for 2012 is likely to look a bit like 2009—emergence from a financial crisis and the potential for an acceleration of the business cycle (driven by Europe exiting recession and China easing). Thus, intuitively, we see Cyclicals and Financials outperforming again in 2012.

Figure 57: Sector Relative Performance

YTD performance and performance since 3/9/2009 relative to S&P 500

Relative Performance Since 3/9/2009 YTD Relative Performance


83.9%

60.9%

33.4%

24.2%

22.8%

12.7%

-15.9%

-20.8%

-29.9%

-31.3%

-42.5%

32.8%

3.4%

-31.1%

-60%-40% -20% 0% 20% 40% 60% 80% 100%

S&P 500 Abs Perf

Discretionary

Industrials

Technology

Financials

Materials

Energy

Staples

Utilities

HealthCare

Telecom

Cyclicals

Near-Cyclicals

Defensives

-1.1%

11.1%

8.4%

7.0%

5.2%

4.1%

3.8%

-2.2%

-3.1%

-9.7%

-18.3%

-0.9%

-7.1%

6.1%

-25% -15% -5% 5% 15%

S&P 500 Abs Perf

Utilities

Staples

HealthCare

Discretionary

Energy

Technology

Telecom

Industrials

Materials

Financials

Cyclicals

Near-Cyclicals

Defensives

Sector leadership reversed sharply in 2011, with Cyclicals and Financials moving from leaders to laggards, but we expect this trend to reverse again to favor these groups in 2012.


47


Materials, Technology, and HealthCare Attractive on Relative P/E

Stocks look very attractively valued overall, as mentioned earlier, but valuations at the sector level vary significantly.

Technology is currently the most attractive sector on valuation, based on comparing the current relative P/E of the sector to the long-term average relative P/E. Materials and HealthCare are also attractively valued on this metric.

Utilities and Telecom are currently the most overvalued on relative P/E compared against the long-term average relative P/E. This likely reflects investor rotation into Defensives in 2011 to avoid some of the market volatility, thus driving up the relative valuation of Defensives in general.

Overall, valuation appears to favor Cyclical sectors, supporting our case for outperformance of Cyclicals in 2012.

Figure 58: Relative P/E Compared to Long-Term Average

Since 1973; P/E of each sector divided by S&P 500 P/E

Current and Long-Term Avg P/E Delta of Current Minus Long-Term Avg P/E


85%

106%

107%

102%

83%

79%

109%

112%

126%

107%

94%

95%

101%

132%

83%

75%

103%

115%

91%

71%

50% 70% 90% 110% 130% 150%

Materials

Industrials

Discretionary

Technology

Energy

Financials

Staples

HealthCare

Telecom

Utilities

Relative P/E

Current LT Avg

Cyc

lical

sD

efen

sive

sN

ear

Cyc

lical

s

-9%

11%

6%

-30%

1%

4%

6%

-3%

34%

36%

-40% -20% 0% 20% 40%

Materials

Industrials

Discretionary

Technology

Energy

Financials

Staples

HealthCare

Telecom

Utilities

Relative P/E

Delta

Cyc

lical

sD

efen

sive

sN

ear

Cyc

lical

s

Valuation of Defensives overall, particularly Utilities and Telecom, is currently less attractive, as investors rotated into Defensives in 2011…

Materials and Technology currently have attractive valuations.


48


Style Performance: Reversal of Style Leadership in 2011

Similar to the rotation in sector leadership in 2011 discussed earlier, 2011 also saw a sharp reversal in Style leadership. Riskier styles that have outperformed overall since the March 2009 low underperformed sharply in 2011.

The top eight styles since March 2009 are highlighted in dark blue on the left side of Figure 59 below. In general, these styles are “riskier” as they typically have more volatility and are less consensus stocks. These styles that outperformed the S&P 500 have hit extreme levels since March 2009, with five of the eight outperforming by 100% or more.

In 2011, however, these eight leading styles sharply underperformed. Only one of these eight styles (Citi Pure Growth) actually outperformed in 2011. Instead, less risky styles such as Defensives, Low Beta, High Quality, and Large Cap all outperformed.

Similar to our sector outlook, we expect this trend of style leadership to reverse again in 2012, thus favoring “riskier” styles in 2012.

Figure 59: Style Relative Performance

YTD performance and performance since 3/9/2009 relative to S&P 500; Performance since 3/9/09 assumes rebalancing of styles at each year-end (12/31/09

and 12/31/10); Top 8 Styles since 3/9/09 are highlighted in dark blue on both charts below

Performance Since 3/9/2009 YTD Performance


151.6%

151.4%

136.8%

125.7%

111.8%

85.5%

92.7%

86.6%

85.0%

63.5%

58.7%

53.5%

42.6%

35.4%

28.9%

20.5%

2.0%

-0.9%

0.0%

-0.9%

-13.8%

-12.8%

-50% 0% 50% 100% 150% 200%

Market Cap Smaller

Broken (low P/200d mavg)

Beta — Higher

Price Lower

P/B — cheaper

Citigroup Pure Growth

Less Liked

EV/EBITDA — cheaper

P/E — cheaper

Cyclical

Citigroup Pure Value

S&P Low Quality

P/E — more expensive

S&P High Quality

EV/EBITDA — more expensive

P/B — more expensive

Price Higher

Defensive

More Liked

Market Cap Larger

Beta — Lower

Momentum (high P/200d mavg)

6.4%

5.8%

4.2%

3.7%

3.7%

2.0%

0.4%

0.3%

-1.7%

-1.8%

-1.9%

-2.2%

-2.2%

-2.5%

-3.2%

-4.2%

-5.3%

-5.7%

-7.0%

-7.1%

-7.3%

-10.7%

-15% -10% -5% 0% 5% 10%

Defensive

Beta — Lower

P/B — more expensive

S&P High Quality

Price Higher

Citigroup Pure Growth

More Liked

Market Cap Larger

P/E — more expensive

EV/EBITDA — cheaper

Citigroup Pure Value

Cyclical

Broken (low P/200d mavg)

Market Cap Smaller

P/E — cheaper

Less Liked

S&P Low Quality

EV/EBITDA — more expensive

Momentum (high P/200d mavg)

P/B — cheaper

Price Lower

Beta — Higher

Style leadership reversed sharply in 2011, with “riskier” styles such as High Beta and Low Price changing from leaders to laggards, but we expect this trend to reverse again to favor these groups in 2012.


49


Valuation of Styles Suggests Cheap Stocks Even Cheaper than Usual

We also looked at the relative valuation of the Styles to identify those groups that have performed well since the March 2009 low but are still attractively valued. For valuation, we compared the current relative P/E of each style (vs. S&P 500) against the ten-year average relative P/E.

Low Momentum (Low Price/200-Day Moving Avg), Low Price, Cheap EV/EBITDA, and Cheap P/E are all currently attractive based on relative valuation (vs. ten-year average) and have all outperformed sharply since March 2009.

Smaller Market Cap and High Beta also look relatively attractively valued (only slightly more expensive on a relative basis than the ten-year average) and have been two of the top styles since March 2009. Thus, as the market sees a reversal again in 2012, these two groups, in particular, should be poised for outperformance, in our view.

Figure 60: Style Performance vs. Valuation

X-axis is performance relative to S&P 500 since 3/9/09; Y-axis is the # of standard deviations that current

relative P/E (2013E) is from the ten-year avg. relative P/E

Source: J.P. Morgan and FactSet. Note: Ten-year average relative P/E is calculated using the stocks that currently fall into each style

category and looking at those stocks’ relative P/E over the past ten years.

Low Price

High Price

Mkt Cap Smaller

Mkt Cap Larger

Cheap P/E

Expensive P/E

Cheap P/B

Expensive P/BLow Beta

High Beta

Low Momentum

High Momentum

Cheap EV/EBITDA

Expensive EV/EBITDA

More Liked

Less Liked

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S&P Low Quality

Pure GrowthPure Value

Cyclical

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-0.60

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0.90

1.40

-15% 5% 25% 45% 65% 85% 105% 125% 145%

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Relative Perf since 3/9/09

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Low Momentum, Cheap P/E, and Cheap EV/EBITDA are currently attractive on relative valuation despite having already outperformed the market strongly since March 2009.


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Economics

2012 U.S. Outlook: A Year of Gradual Healing

The economic recovery which began in the middle of 2009 has now entered its third year, and so far GDP growth in the first nine quarters of this expansion has averaged 2.4%. In both 2010 and 2011, the summertime produced a growth scare, which subsequently faded as the data stabilized, but not before the Federal Reserve was prompted to take additional actions to support the recovery. As was the case in 2010, as we come to the end of the year concerns about another recession have diminshed.

One important reason why the economy has been able to continue moving forward after the debt ceiling disruption of the summertime is the still-depressed levels of cyclically sensitive spending. The bouncback from low levels appears to be a central factor behind the strength in capital spending, which has been a major force behind the recovery thus far. While capital spending is now returning to more normal levels, investment in housing and other structures remains unsustainably low, and should be a ballast for growth going forward. Even so, two risks loom over the 2012 outlook.

The first risk relates to spillovers from the economic and financial crisis in Europe. Around 20% of U.S. exports are destined for Europe, and the economic contraction will surely impact demand from that market. If that were the only transmission channel the risks would appear to be contained. However, the potential financial spillovers could be larger. Thus far, most measures show only a modest impact of the European crisis on domestic credit availability. Nonetheless, if conditions in Europe worsen the U.S. economy would not be immune from a seizing up of global financial markets.

The second risk is tightening of domestic fiscal policy. The recession produced an unprecendented fiscal policy response, as the federal deficit increased to 10% of GDP. The political tolerance for such large deficits has lessened recently, and several temporary fiscal stimulus measures are set to fade in 2012, which could subtract one to two percentage points from GDP growth next year. There has been some talk about extending these measures, but so far nothing has been agreed upon. The anticipated drag from fiscal policy is the main reason behind our view that growth will be below potential in 2012, when we anticpate growth will average 1.75%.

This expected tightening of fiscal policy is likely to hit the economy where it is weakest: the household sector. Slack conditions in labor markets have eroded labor’s bargaining position, resulting in very tepid wage gains. This outcome has been positive for corporate profits—which have received significant lift from restrained unit labor costs—but has held back consumers’ purchasing power.

With wage inflation contained, the possibility of a wage-price spiral has been removed. The periodic episodes of higher headline inflation experienced in this expansion have not translated into lasting increases in underlying inflation. In the spring months of 2011, higher commodity prices, as well as temporarily higher prices of autos after the Japanese earthquake, gave a boost to core inflation. More recently, however, core inflation has eased back lower. With unemployment expected to remain elevated throughout 2012, we foresee more of the same on the inflation front: low wage inflation leading to low consumer price inflation.

Robert Mellman

(1-212) 834-5517

[email protected]

Michael Feroli

(1-212) 834-5523

[email protected]

JPMorgan Chase Bank NA


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The low rate of inflation has given the Fed leeway to be creative in supporting the recovery. The two experiments this year were the giving a specific date—mid-2013—for the zero rate funds guidance, and Operation Twist. We think the most likely next step for the Fed is to replace the mid-2013 rate guidance with language that is more explicitly dependent on a limited number of observable economic variables, particularly the unemployment rate. While we are not forecasting more asset purchases in 2012, the risk of this is high and rising (subjectively we’d put it at around 40%). Moreover, Fed officials have shown an increasing openess to considering returning to MBS purchases. A significant setback in Europe, or an unwelcome fall in inflation expectations, could be all that is required for QE3.


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Equity Strategy – Small Cap

A Year that Begins with Shattered Confidence Is Likely to End with Gains

The market was completely bipolar this year with the Russell 2000 seeing double-digit gains in 1H11 and a new record high, which quickly reversed into losses by 2H11. This period of high volatility is uncommon during the mid-cycle of an economic recovery, which is more characterized by yawnful up moves rather than recurring fears of a double dip. As we head into 2012, however, we believe the dark clouds will begin to lift as policymakers around the world are forced to action. Their actions are likely to inject hope and confidence that result in improving visibility, lower equity risk premia, and much higher equity prices. Overall, we remain constructive and believe U.S. small-cap companies will muddle through given the following backdrop and are likely to reach new all-time highs in 2012.

1) Negative real rates positive for the economy and risky assetsWith unemployment stubbornly high and inflation nowhere in the picture, the Fed should continue to keep policies favorable for the economy. This means real rates should remain negative, yield curve steep, and loan growth incrementally positive, which should support risky assets.

This economic recovery never got a fair chance to air its wings due to the number of confidence crises and exogenous shocks; however, the persistent cyclical tailwinds were clearly evident in 3Q GDP growth and corporate earnings. This stop-and-go recovery means that this cycle will likely be longer, but growth will be lower.

2) Fundamentals encouraging with growth above investors’ grave expectationsBased on consensus estimates, the median top-line growth for Russell 2000 is expected to be a healthy 7-9% in 2012 (Figure 61). This growth is not aggressive if nominal GDP growth comes in above 3%, as expected by J.P. Morgan Economists.

Revenue growth coupled with productivity gains and limited wage inflation is likely to drive further margin expansion in 2012. All told, Russell 2000 EPS growth is likely to come in near 20%.

Figure 61: Russell 2000 Revenue GrowthActual and Estimated Y/Y Growth

Source: Factset and J.P. Morgan.

Figure 62: Incremental Net Income MarginLast Ten Years


10%

8% 8% 7% 8%9%

-15%

-10%

-5%

0%

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3/04 6/05 9/06 12/07 3/09 6/10 9/11 12/12

Qu

arte

rly

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th (

Yo

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Estimates Russell 2000 R2K ex-Financials

4.9%

6/09, -2.5%

6/11, 3.7%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

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-400bp

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n (

bp

)

Incremental Net Income Margin (bp)

S&P 600 Net Income Margin

Bhupinder Singh AC

(1-212) 622-6406

[email protected]



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3) Rich in cash and unlevered by historical standardsOver the past two years, small caps have reduced credit risk substantially by extending maturities well into the future and/or paying off debt. In fact, the cash levels for small caps are near record level at around 10% of total assets while debt is near record low at 19% of total assets. If a slowdown were to materialize in 2012, these strong metrics should help to keep default rates low.

Figure 63: Cash as % of Total Assets – S&P 600Since 1996


Figure 64: Debt as % of Total Assets – S&P 600Since 1996


4) Technicals to become more favorable in 2012The increasing volatility and record equity risk premium resulted in outflows from small caps totaling -$13bn year to date and M&A activity remained relatively subdued. However, the increasing rate of stock repurchases was encouraging with a record number of companies participating in 3Q11. In total, Russell 2000 companies bought back $22bn of stock, higher than the outflows seen from the asset class YTD.

With improving visibility and declining volatility, we see: 1) M&A activity beingmore robust in 2012 with cash-rich U.S. corporates and underinvested PE firms; 2) flows reversing or stabilizing; 3) U.S. stocks likely to be seen as relative “safe havens,” especially with minimal international exposure by small caps; and 4) stock repurchase activity increasing with rising cash balances and high ROE.

Figure 65: Small-Cap Repurchases vs. Fund FlowsYTD


7.2%

7.5%7.7%

8.1%

7.8%

8.7%

9.1%

8.3%8.0%

8.4%

7.9%

7.6%7.6%

9.9%

11.0%

10.4%

7.0%

7.5%

8.0%

8.5%

9.0%

9.5%

10.0%

10.5%

11.0%

11.5%

1996

1997

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2006

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2008

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2010

Cur

rent

Cas

h as

% o

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s

The 15-yr average is 8.3%

23%

24%

27% 26%

24%25%

25%25%

21%

25%

21%

24% 24%

20%

19% 19%

17%

19%

21%

23%

25%

27%

1996

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Cur

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s

The 15-yr Average is 23.5%

Fund Flows, ($12,948)

Buybacks, $21,949

($25,000)

($15,000)

($5,000)

$5,000

$15,000

$25,000

1/11 2/11 3/11 4/11 5/11 6/11 7/11 8/11 9/11 10/11 11/11 12/11

Cu

mu

lativ

e ($

's in

mill

ion)

...while Funds Flows remain negative.

The rate of buyback activity is increasing...


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5) Valuation more attractive both on an absolute and relative basisRussell 2000 now trades at only 8.0x on an EV/EBITDA basis (2011E) compared to 8.5x at beginning of the year and the ten-year average of 11.9x (see Figure 66). On a P/E basis, the Russell 2000 trades at 14.8x NTM EPS (vs. 15.6x at beginning of the year).

Figure 66: Incremental EBITDA Margin – S&P 600Last Ten Years


Investment Strategy

If the nominal GDP growth is at least 2% in 2012, we believe small caps are likely to deliver strong cash flow driven by revenue growth and continued margin expansion. These positive fundamentals coupled with declining equity premium and improving technicals should push the Russell 2000 to all-time highs.

In this environment, we recommend investors overweight Small vs. Large, as smallcaps are likely to outperform large caps given the stronger growth and declining volatility from improving visibility, and overweight Growth vs. Value, as we are in the growth phase with investors chasing emerging ideas in this low-growth environment. We prefer Cyclicals over Defensives due to superior growth and lower valuation, especially after the sharp underperformance in 2011. At the sector level, we recommend Industrials and Technology over Consumer, given our view that U.S. Corporates are healthier than U.S. Consumers, and Materials over Energy with China’s soft landing but both sectors should outperform the Russell 2000 in 2012.

EV/EBITDA P/E

2011E 2012E 2011E 2012E

Cyclicals: 7.0x 3.9x 16.6x 12.8x

Technology 7.6x 1.9x 17.2x 14.7x

Industrials 7.0x 5.9x 15.9x 11.9x

Discretionary 7.0x 6.1x 18.0x 12.6x

Materials 5.8x 5.1x 12.9x 10.4x

Defensives: 9.6x 8.6x 54.1x 35.2x

Healthcare 13.4x 12.1x 258.8x 103.2x

Staples 8.6x 7.1x 24.6x 15.1x

Utilities 8.2x 7.5x 18.4x 16.9x

Telecom 5.3x 4.8x -75.2x 54.2x

Other: 9.7x 8.0x 21.0x 12.9x

Financials 15.4x 13.3x 19.1x 12.5x

Energy 6.4x 5.0x 29.5x 14.1x

Index 8.0x 5.2x 21.0x 14.8x


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Equity Technical Strategy

2012 Outlook: 1100-1350 Trading Range for S&P 500; 600-800 for the Russell 2000

Introduction

Our goal with this 2012 Outlook is to present a most probable “base case” and less probable extreme bullish and bearish “tail risks,” combined with likely Treasury and U.S. Equity targets under each scenario. As the financial markets are increasingly being driven by the gridlock of U.S. and European political and policy decisions, forecasting outcomes has become increasingly uncertain. Market participants in recent months have become increasingly neutral, retaining fewer risk positions, given the difficulty in anticipating global policy outcomes. Indeed, facts are changing almost daily in nearly manic-depressive fashion. Market whipsaws from “risk-on” to “risk-off” and back again have become commonplace from week to week, penalizing performance for many.

From the technical analysis side, we have often provided singular annual “roadmaps,” when our confidence levels were high. That is not the case for this 2012 Outlook. Rather, we will attempt to lay out our most confident targets/ranges, and then the less likely bullish and bearish extremes. The markets now are like ships caught in the treacherously stormy seas of headline risk. We shall try our best to help navigate these difficult markets with flexible technical analysis views, furthering the goal of getting to a safe harbor, while avoiding a shipwreck against the rocks.

“More than any time in history mankind faces a crossroads. One path leads to despair and utter hopelessness, the other to total extinction. Let us pray that we have the wisdom to choose correctly” – Woody Allen

S&P 500 Index Outlook

2011 Outlook Reviewed: S&P 500 IndexWhile our S&P 500 forecast for this year turned out to be more accurate than our ten-year yield forecast, looking back, it would have been better to have kept our S&P 500 scenario for the year from the 2011 Outlook, than to have made some subtle changes during March-April in our weekly U.S. Equity Technical Strategist report. Specifically, in the 2011 Outlook (written when the S&P 500 was at 1,175), we suggested that the SPX would peak for the year at 1,300-1,350 around mid-year, and then “see a substantial correction” down to a 1,100-1,130 yearly bottom in 2H (Figure 67). This “roadmap” was not far off, as the S&P 500 peaked for the year at 1,371 in May and bottomed at 1,075 in October.

Michael Krauss AC

(1-212) 834-5103

[email protected]

David Cohen, CFA

(1-212) 622-5338

[email protected]



56


Figure 67: SPX Roadmap Used in 2011 Outlook Last Year: A 1,350 “Best Case” Mid-Year Peak and a Down 2HS&P 500 Index – Monthly Bars

Source: CQG and J.P. Morgan.

Unfortunately, we somewhat changed our preferred scenario in March-April. We suggested a 1,350-1,370 “Sell in May and Go Away” peak, then a May-September correction that would hold 1,200-1,220 key 2010 range highs, which would be followed by 1,400-1,430 new highs by year-end. After properly suggesting “summer rally sales” at 1,340-1,360, we were forced to turn bearish below 1,200 in July, and eliminate the 1,400s year-end target. On a positive note, we suggested buying in lateSeptember/mid-October amid 1,060-1,080 targets, for a rally towards 1,275 by year-end. That bottom and subsequent rally was accomplished in just three weeks, leading to a more neutral bias into year-end.

2012 Outlook Targets: S&P 500 IndexFor this 2012 Outlook, our base case assumption is for the S&P 500 to form a 1,350to 1,100 trading range into December 2012 (Figure 68). It will be difficult for Equities to sustain back above the 1,300-1,350 trendlines, as long as the European sovereign debt crisis and recession lurk in the background. Similarly, it will be tough to move below strong 1,075-1,100 clustered support, as long as the U.S. avoids an economic recession, earnings stay elevated, and investors remain defensively positioned. We give this outcome a likelihood of 80%. Indeed, with this year’s range defined at the 1,371 May 2 peak and 1,075 October 4 low, it is reasonable for 2012 to form an inside range year, in our view.


57


Figure 68: We See a 1,350 to 1,100 Base Case Scenario for the S&P 500 in 2012 (80% Likelihood)S&P 500 Index – Monthly Bars


For next year, resistance near our anticipated 1,350 2012 range high includes: 1,300right shoulder channel symmetry with the July 2010 low/October 2011 low/April 2010 high (Figure 69), 1,325 May-July weekly downtrendline, 1,342 October 2007-May 2011 monthly downtrendline (Figure 68), 1,348 violated March 2009-July 2010 monthly uptrendline (Figure 68), 1,353 March 2009-July 2010 0.618 upside swing target, 1,355 parallel internal channel high on the quarterly bar chart off the 4Q02 low, 1Q09 low, and 1Q00 high (Figure 71). Just above, 1,371 is the May top, and 1,400 is the channel high off the July 2010 low/October 2011 low/May 2011 high (Figure 70).

Figure 69: S&P 500 Index Weekly Chart Parameters

S&P 500 Index – Weekly Bars


Figure 70: S&P 500 Index Monthly Momentum Gauges Are Currently in a Bearish SetupS&P 500 Index – Monthly Bars



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Figure 71: This Year’s 1,371 May Top in the S&P 500 Stopped Exactly on This 1Q00 Internal Channel HighS&P 500 Index – Quarterly Bars


On the downside, key supports near our anticipated 1,100 range low include: 1,121 is the October rally 78.6% retrace (Figure 69), 1,113 is the rising 200 month MA (Figure 68), 1,100 is the May-October 0.618 downswing measure, 1,106 is the declining 40-month MA (Figure 68), 1,101 is the March 2009 38.2% retrace, and 1,075 is both the October low and January 2009-July 2010 weekly internal trendline (Figure 68). We respect the fact that the S&P 500 has made higher annual lows in each of the past three years, 666 in March 2009, 1,011 in July 2010, and 1,075 in October 2011 (Figure 70).

S&P 500 Bullish versus Bearish AlternativesA more optimistic Equity case for 2012 would necessitate several of the following fundamental and policy outcomes: positive resolution of the European crisis, ECB quantitative easing, upward revisions to the J.P. Morgan U.S. Economic forecast, U.S. fiscal policy stimulus, Fed QE3, and a China soft landing. We estimate a likelihood of only 8% for this outcome.

Under the above global risk-on situation, the S&P 500 technically targets 1,500. Here: 1,473 is where the March 2009 bull market would equal the October 2002-October 2007 bull market, 1,510 March 2009-October 2011 0.618 upswing measure (Figure 72), 1,511 is the parallel internal channel high on the quarterly bar chart off the 4Q02 low, 1Q09 low, and 4Q07 top, and 1,564 March 2009-July 2010 equal upswing measure (Figure 72). Longer term, 1,600 is the trendline off the January 2000 and October 2007 peaks (Figure 72), 1,780 is the March 2009-October 2011 equal upswing (Figure 72), and 1,907 is the March 2009-July 2010 1.618 swing parameter (Figure 72).


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Figure 72: We See Potential Upside for the S&P 500 Near 1,500 in a “Global Risk-On” Scenario (Only 8% Likelihodd)S&P 500 Index – Monthly Bars


A more pessimistic Equity case for 2012 would arguably necessitate global contagion from an unraveling of the European debt crisis, if not a dissolution of the EU itself; a U.S. economic recession, zero U.S. fiscal policy stimulus given continued partisan rancor from Congress and the President, and a Chinese hardlanding. We ascribe this outcome a likelihood of only 12%, yet that is higher than the bull case.

The bear global risk-off case technically targets 950-1,000, and possibly 800(Figure 73): 1,025 is the quarterly chart internal trendline with four points of contact since October 1998 (Figure 71), 1,019 is the March 2009 50% retrace, 1,011 is the July 2010 bottom (Figure 72), 997 is the May-October equal downswing measure (Figure 73), 956 is the June 2009 high breakout, 936 is the March 2009 61.8% retrace (Figure 73), 814 is the May-October 1.618 downswing collapse measure (Figure 73), and 785 is a downside projection from a potentially developing two-year Head and Shoulders top pattern (Figure 73). Repeating the last sentence of both the 2010 and 2011 Outlooks, “We do not expect the 666 cycle low breaking, absent a global depression.”


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Figure 73: We See Downside to 950-1,000 (Maybe 800) in a “Global Risk-Off” Scenario (Only 12% Likelihood)S&P 500 Index – Weekly Bars


Absent a resolution to the European debt crisis, and a market-friendly outcome to the November 2012 presidential election, we believe it will be extremely difficult to exceed this May’s 1,371 S&P 500 peak during 2012. If our favored 1,100-1,350range proves incorrect, it is technically more likely that the downside support breaks, rather than the upside barrier. To that end, note that we did give slightly higher likelihood to the “bear case” than the “bull case.”

There are four main factors for this defensive rationale:

Monthly momentum retains a July sell signal (Figure 70). These signals have tended to last 7-9 months on average, which in this case would last into February-April 2012. If correct, then the typical Equity seasonality would not work in 2012, like it did in 2011. Equity seasonality typically sees a decline from May until October, and then a rally into May. Seasonality only “works” when the underlying technical, sentiment, and momentum conditions are supportive of the seasonal influence. This year, May peaked in our target zone of 1,350-1,370 by mid-year (U.S. Equity Technical Strategist), with distinct weekly momentum loss, and ebullient sentiment. Oppositely, the October seasonal bottom achieved our target low of 1,060-1,080 in late September/mid-October, with diverging weekly momentum, and alarming pessimism.

The 1,270 200-day moving average is falling with the major market averages trading below the moving average (Figure 69). To many technicians, that is the definition of a bear market. To us, the slope of the line is more important than the level, and changing the slope of the line can take months. A bull market would require the slope of the 200-day moving average to start rising, and for the market to sustain back above it.

The Elliott Wave pattern interpretation is bearishly concerning, as the May-to-October downtrend from 1,371 to 1,075 was an impulsive five-wave decline, and the subsequent rally to 1,293 has so far been a corrective three-step affair (Figure 73). Under Elliott, another five-wave decline is needed to either complete


61


a large corrective ABC decline from May (ultimately macro bullish), or start a very negative progression of a larger five-wave collapse (macro bearish). Either way, when subjectively interpreting Elliott Waves, sequences of five-wave declines and three-wave rallies are symptoms of bear markets that are incomplete. Note that at 997, equal downswings from the May and the October highs would measure in a large ABC decline (Figure 73).

There is a possibility that the S&P 500 has been forming a massive two-year “Head and Shoulders Top” pattern (Figure 73). The risk in this symmetrical pattern is that the April 2010 peak is the “left shoulder,” the May 2011 top is the “head,” and the October 2011 rally is the “right shoulder” (Figure 73). The 1,075July 2010-October 2011 uptrendline would be the “neckline” (Figure 73). A parallel channel off the neckline, touching the 1,220 April 2010 high provides interesting symmetry with the 1,293 October 2011 peak (Figure 73). Decisive weekly closes above 1,325-1,350 on superior advance-decline breadth would invalidate this foreboding pattern, which theoretically measures to 785 on a neckline breakdown (Figure 73).

Russell 2000 Index Outlook

The Russell 2000 small-cap index peaked at an 868 all-time high on May 2, with a bearish key reversal day rejecting the top end of a 1998-2009 annual chart channel high, after slightly exceeding the 856 July 2007 top (Figure 74). The RTY risks a 2011 downside reversal year with a December close below 2010’s 783.65 annual close (Figure 74). This would favor some additional weakness in 2012.

Figure 74: Russell 2000 Is Likely to Complete an 868 2011 Bearish Reversal Year at the End of DecemberRussell 2000 Index – Yearly Bars


Like the S&P 500, the Russell 2000 is most likely to trade within this year’s range in 2012. The 602 bottom on October 4 scored a bullish key reversal day, and substantially held major supports: 605 March 2009 50% retrace (Figure 75), 596150-month moving average (Figure 75), 596 May-August fifth-wave down target (Figure 76), 593 March 2000-April 2004 internal trendline (Figure 74), 588 July 2010 low (Figure 76), 547-553 August-November 2009 lows (Figure 76), and 543March 2009 61.8% retrace (Figure 75).


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Figure 75: Russell 2000 Index Monthly ParametersRussell 2000 Index – Monthly Bars


Figure 76: Russell Index Rejects 767-782 Key ResistanceRussell 2000 Index – Weekly Bars


The October 4-October 27 rally surged 27.9% to 769, in 17 trading days. Despite this strong showing, the RTY lifted in a corrective ABC fashion, and failed squarely in the 767-782 major resistance band, which shall be a major roadblock in 2012. This “barrier” includes: 765 “right-shoulder symmetry” with the possible April 2010 “left shoulder and May 2011 “head,” 766 May-October 61.8% retrace, 767 March-June Head and Shoulders Top neckline, 773 June low, 776 March low, 778 falling 40-week moving average, and 782 April 2010 internal trendline (Figure 75 and Figure 76).

Bulls need a weekly close above the 812 July 18 low breakdown/May 78.6% retracement to garner sufficient momentum to retest the 868 May peak, if not score new all-time highs towards the 910 1990-2009 monthly channel high, 927 March 2009-May 2011 0.618 swing projection, and 991 March 2009-July 2010 equal upswings (Figure 75).

Finally, the November 2012 Presidential election outcome should be a very important driver for the S&P 500 in the final two months of 2012. While we have no political aims in this Outlook, we can see the SPX index about 100 points higher on average through 2013 under a Republican victory than a President Obama reelection. Increasingly, many investors feel the current Democratic administration has been regulatory heavy and unwilling to cut entitlements. At the margin, one would expect a shift to the Republicans to be welcomed by the Equity investor class.


63


Quantitative Strategy

The Current Landscape and the Year Ahead

2011 has been a year when risk aversion has been the recurring theme. The market has essentially been oscillating back and forth between a “risk-on” and “risk-off”stance and has been very sensitive to headline news.

Given these market conditions, not surprisingly, among the various popular investment styles in the U.S., Quality and Price Reversal have been leading the pack with stock selection factors, such as Earnings Dispersion, Earnings Revisions, ROE, Dividend/Buyback Levels, 30-Day/14-Day Price-Reversal/RSI, being the dominantdrivers of returns (see figure Figure 77).

Figure 77: 2011 Cumulative L/S Factor Performance (Top Quintile – Bottom Quintile) – MSCI US

Source: Bloomberg, Compustat, I/B/E/S, MSCI, and J.P. Morgan.

Interestingly, Value as a style has continued its sideways-moving trend that began back in 2009. While it has yet again struggled to deliver this year, on a relative basis Value has held up a lot better in the U.S. than what we have seen in other global regions, such as Europe and Asia Pacific.

Going forward, while there certainly may be room for bottom-fishing, especially in periods like the beginning of 2012 due to year-end/rebalancing effects, it is equally compelling to say that the Value “pain” trade might be here to stay for some more time.

In fact, the level of dispersion in valuations across U.S. stocks—which can serve as a powerful barometer for style timing—does not seem to provide a strong case for value to outperform in the upcoming period. While the level in valuation dispersions has been ticking up, it is still not significantly above historical levels and it is far off 2008 highs (see Figure 78).

Dubravko Lakos-Bujas AC

(1-212) 622-3601

[email protected]



64


Figure 78: Level of Dispersion in Equity Valuations (Based on Stocks’ Fwd P/E) – MSCI US


With a lot of macro/tail risks still prevailing, we might quite likely continue to face a sideways-moving market environment in the months and quarters ahead. As a result, we think it is fair to say that a similar factor performance landscape to the one we saw this year may indeed continue to prevail, with Quality as a style likely to remain a dominant driver of future returns.

Moreover, Quality is not expensive from a valuation point of view relative to history and previous market crisis periods. The valuation spread between high- and low-Quality names has remained steady, suggesting there is room for the spread to expand and thus for higher-Quality names to outperform (see Figure 79).

Figure 79: Level of Dispersion in Equity Valuations (Based on Stocks’ Fwd P/E) Between High-and Low-ROE Names – MSCI US



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In addition, in the current market environment where systemic risk has been the main driver of returns and stock-specific news has taken more of a back seat, getting one’s systemic risk exposures right, such as Beta, has never been more important. The reason this matters to all stock pickers, whether quantitative or fundamental in nature, is because with stock return dispersions at historically low levels and stock return correlations simultaneously hitting record highs, the investor community has been presented with a very challenging stock picker’s environment (see Figure 80).

In fact, getting one’s systemic risk/style exposures wrong could be quite costly and could easily wipe out gains realized through pure stock selection and incur additional losses.

Figure 80: Stock Return Dispersion and Correlation Levels – MSCI US


A great example was the third quarter of this year which saw a relatively sharp unwinding of the beta trade—rotation from higher- to lower-beta names—with Beta underperforming by more than 25% in that time period (see Figure 81).

Figure 81: Cumulative L/S Performance for BETA (Top Quintile – Bottom Quintile) – MSCI US



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This has quite possibly been a painful ride for managers who did not have a tight grip on their portfolio’s Beta exposure (i.e., were long beta relative to market) and also possibly ones with a positive bias to value—thus implicitly capturing a positive Beta bias, as high-Beta names have been sold off and have become inexpensive on a relative basis.

Unless one has strong skill in timing the market, we urge managers to be very careful with respect to managing their portfolio’s systemic risk/style exposures in the upcoming quarters and especially in an environment like the current one.


67


Accounting & Valuation

Macro Uncertainty Takes Many Forms

We expect the key theme of macro uncertainty to continue to be an overhang on the markets into 2012. The actions or inactions of Congress and the Obama Administration, the U.S. Securities and Exchange Commission (SEC), the Federal Reserve, U.S. Financial Accounting Standards Board (FASB), the International Accounting Standards Board (IASB), and other key decision makers in 2012 will substantially influence the pace with which the macro uncertainty begins to abate.

Heightened tax policy uncertainty will continue through 2012Partisanship was a key political theme in 2011, and we expect it to be a dominant theme in 2012 as Congress and the Obama Administration focus on the November 2012 elections. We assign a very low probability to the potential for any substantive tax changes being enacted until after the elections. Our expectation is that extender legislation maintaining the status quo will likely be enacted to carry forward most expiring 2011 tax policies to the end of 2012. Based on history, there is a potential that many of the expiring 2011 tax provisions may not get extended until the first quarter of 2012.

Some of the high-profile tax code provisions that will expire at the end of 2011 unless they are extended are:

The temporary 4.2% Social Security payroll tax for employees (rather than the traditional 6.2% rate);

The research and development tax credit;

The state and local tax deduction for federal tax purposes;

The biodiesel and ethanol tax credits;

The Subpart F active financing exemption.

As we move further into 2012, the focus will shift to 2013 tax policy, and the November elections will have a lot of influence on defining the landscape of that environment. We are not likely to have clarity on the likelihood of the extension of the Bush-era tax cuts that expire in 2012 until the outcomes of the November elections are known. In addition, any hope for substantive legislative actions such as substantive tax system overhauls or economic stimulus in the form of special incentives for U.S. multinationals to repatriate foreign earnings will likely get pushed to 2013 at the earliest due to their controversial nature.

In December 2010, the Simpson-Bowles Deficit Commission called for substantial overhauls to the U.S. federal tax system. The “Gang of Six” made similar appeals. The drama related to the debt ceiling resulted in the creation of the 12-member Congressional Joint Select Committee on Deficit Reduction (the Super Committee) which was ultimately unsuccessful at agreeing on $1.5 trillion in spending cuts by its November 23 deadline; thus, automated federal spending cuts of $1.2 trillion are triggered that are to begin in 2013 and are to be spread evenly across defense and non-defense accounts.

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 provided companies with 100% bonus depreciation in 2011 and 50% bonus depreciation in 2012. There could be some consequences in 2012 of the reduced

Dane Mott, CFA, CPA AC

(1-415) 315-5905

[email protected]

Amy Schmidt

(1-415) 315-6705

[email protected]



68


bonus depreciation relative to 2011 levels since some activity that would have otherwise occurred in 2012 could have been accelerated into 2011 to take advantage of the tax benefit. If we approach the end of 2012 and it becomes likely that the 50% bonus depreciation will not be extended into 2013, some 2013 capital spending may be accelerated into 2012. Another ramification of the eventual end of accelerated depreciation periods will be that U.S. corporations will systematically have a historically low depreciation tax shield available to them in the initial period of a return to the traditional depreciation tax policy since depreciation from prior years’ capital expenditures will be largely exhausted.

Heightened accounting standard uncertainty will continue through 2012The U.S. Securities and Exchange Commission (SEC) had previously indicated that it would provide more guidance by year-end 2011 on the potential for the U.S. to move from U.S. GAAP to IFRS, but our sense is that this decision will likely get pushed out until 2012.

The process to converge U.S. GAAP standards issued by the FASB and IFRS issued by the IASB began during the early 2000s. While convergence initially appeared to be a “win-win” for all stakeholders when the process began in earnest, deeper investigation of the differences between U.S. GAAP and IFRS, two financial crises (one starting in the U.S. and one starting in Europe), and the inability for the boards to agree on some key areas of joint projects have all called into question the ambitiousness of the convergence plans. Based on our conversations with various U.S. stakeholders, our sense is that there is less support for a move to IFRS in the United States than there was prior to the financial crises of 2008 and 2011.

At this point, we think full adoption of IFRS by the U.S. is unlikely within the next five to ten years. Our sense is that the most likely arrangement will be a more explicit set of rules of engagement between the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). In our view, the most viable proposal detailing how the future relationship between FASB and IASB could be structured is laid out in a comment letter from the Financial Accounting Foundation (FAF) to the SEC. The FAF is the organization with responsibility for the oversight, administration, and finances of the FASB.

Currently, FASB and IASB are working on four key joint projects during 2012: 1) financial instruments, 2) insurance, 3) leases, and 4) revenue recognition. All four are controversial. We do not expect any of these proposals to be effective before 2015.

The IASB and FASB recently released a joint exposure draft on revenue recognition that would result in all companies following one broad revenue recognition model if the standard is finalized. As we outlined in our joint note with Peter Elwin, J.P. Morgan’s European accounting analyst, these proposals could radically affect the way some companies account for revenues with serious implications on valuation multiples.

Jointly issued exposure drafts for the insurance and leases projects are expected in the first half of 2012. The insurance proposal could dramatically change insurance accounting in the United States. The leases project looks to bring a portion of operating lease exposures onto companies’ balance sheets, thus making some balance sheets appear more leveraged.

While financial instruments was identified as an urgent joint project in reaction to the 2008 financial crisis, we do not expect an exposure draft on this project during 2012. The boards have come to different conclusions on a number of key issues on this




69


project, and the project takes on a multitude of complex issues. In addition, the boards must consider the effect of their decision on financial regulatory accounting since much of the regulatory accounting guidance references U.S. GAAP and IFRS measures. The success or failure of the boards to work together on the financial instrument project will likely have a large influence on the long-term viability of U.S. GAAP/IFRS convergence.

The dark side of low interest rates: increased pension riskWhile in theory low interest rates can be a form of stimulus if they ultimately induce companies and consumers to borrow and spend, an unintended consequence of a long-term period of low interest rates is that it results in higher pension obligations and can result in an increase in the cash costs of running a pension plan. As shown in the following figure, the Moody’s Aa rate is down approximately 400 basis points relative to its 8.14 level as of the end of May 2000. To the extent rate policy is reducing interest rates below where equilibrium levels would have been absent intervention, the implication is that rate policy may be exerting additional stress on companies with elevated pension risk and resulting in the need for incremental cash contributions being made to close funding gaps that would not have existed if interest rates had been higher.

Under pension funding rules in the United States, discount rates can be based off of a 24-month moving average of corporate rates. The risk-free rate has decreased substantially during 2011 and has taken U.S. corporate rates down with it. The smoothing in the funding discount rate mitigates temporary decreases in rates through its 24-month average; therefore, cash flow effects are not immediate. To the extent the decline in investment-grade corporate rates during 2011 persists into 2012 and beyond, material cash funding requirements could materialize and put liquidity strains on some companies beginning as early as 2013.

To identify companies with material levels of pension risk, see our October report.

Figure 82: Moody’s Aa Corporate Bond Index, Month-End, December 1998-November 2011

Source: Moody's and J.P. Morgan estimates.

Dane Mott is a member of the FASB’s Investor Technical Advisory Committee and two IASB advisory committees: the Capital Markets Advisory Council and the Employee Benefit Working Group. Dane Mott is also a former member of the IASB’s IFRS Advisory Council. Amy Schmidt is a former Technical Manager at the IASB.

JPMorgan Chase & Co. and its affiliates do not provide tax advice or advice on tax accounting matters. Accordingly, this material is not intended or written to be used, and cannot be used or relied upon, by any recipient in connection with promotion, marketing, or a recommendation for the purpose of avoiding U.S. tax-related penalties. Each client should consult his/her personal tax and/or legal advisor to learn about any potential tax or other implications that may result from acting on a particular recommendation.

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US Year Ahead 2012

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North America Equity ResearchDecember 2011

Equity Derivatives

2012 Global Volatility Outlook

During H1 2011, equities were in a low volatility regime with S&P 500 realized volatility reaching pre-Lehman low levels of ~12% (Figure 83). The low volatility regime of H1 was caused by a strong market performance in H2 2010 that triggered a record decline in equity correlations (Figure 84). Over the same time period, market liquidity reached new highs, and derivative hedging activity put downward pressure on realized volatility1. Given the positive macroeconomic sentiment and strong technicals (high liquidity, low correlation), even turmoil in the Middle East and the nuclear disaster in Japan in March did not result in a significant increase of equity volatility.

At the end of July, renewed concerns about European sovereign debt, the sustainability of U.S. growth and fears of another global recession caused rapid market deterioration. Large risk on/off flows between government bonds and risky assets such as equities, commodities, and currencies caused cross-asset correlations to reach all-time high levels (Figure 84). These macro risk on/off flows were transmitted to equities largely through index trading, giving rise to a record level of equity correlation (stock-to-stock correlation).

Figure 83: S&P 500 Realized Volatility and the VIX – Note distinct regimes of volatility in H1 and H2 2011, and different duration of 2010 and 2011 volatility spikes both related to European debt crisis

Source: J.P. Morgan Equity Derivatives Strategy.

Figure 84: Cross-asset and equity correlations recently reached all-time high levels. High correlations are the main driver of equity index volatility.


As most equity flows have been implemented with index instruments (e.g., futures and ETFs), equity volatility has been driven by risk on/off flows and the significantly reduced liquidity of equity index products. Figure 85 shows the liquidity of S&P 500 E-mini futures as measured by the number of contracts bid/offered within 5 futures ticks (1.25 index point). In August, liquidity dropped by more than 70% compared with the beginning of H1. It is interesting to note that the H2 changes in correlation (100% increase) and liquidity (70% decrease) were larger than changes in other equity risks, and were the key drivers of equity volatility, in our view.

1 See our H2 2011 Volatility Outlook for Discussion of Structural Pressure on Equity Volatility in H1 2011 due to long gamma positions.

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Nov, 01 May, 04 Nov, 06 May, 09 Nov, 11

1Y Average Correlation of Risky Assets at All-Time High

Equity Correlations at All-Time Highs

H2 '10

H2 '11

H2 '08

Marko Kolanovic AC

(1-212) 272-1438

[email protected]

Adam Rudd

(1-212) 272-1215

[email protected]

Amyn Bharwani

(1-212) 622-8030

[email protected]



US Year Ahead 2012

71


The drop in equity liquidity in H2 suggests that the current system has significantly reduced capacity to store equity risk. This may be related to regulations (e.g., elimination of proprietary desks, increased capital requirements) and changes in the structure of equity liquidity, i.e., the increased role of computerized trading in liquidity provision2. High levels of correlation and low liquidity further discouraged fundamental equity investors from trading stocks. For that reason, a significant amount of stock trading in H2 was the result of index and statistical arbitrage programs putting further upward pressure on correlations. This hostile risk on/off environment started undermining confidence in equities as an asset class, resulting in persistent outflows from U.S. equity mutual funds during H2 (Figure 85).

In addition to liquidity and correlations, the impact of index options hedging was another driver of equity volatility3. These products are used by asset managers, pension funds, and hedge funds to reduce their equity risk exposure. The other side of these hedging transactions is taken by dealers who replicate their liability by daily delta hedging. Based on dealers’ exposure, hedging activity can increase market volatility (hedging of short gamma positions) or decrease market volatility (hedging of long gamma positions)4. Our estimates show that dealers were net long gamma in H1 2011, thus reducing market volatility by ~2 points. After the sharp drop in the market in August, the gamma exposure of outstanding protection became significantly short, putting upward pressure of ~3-4 points on short-term realized volatility (Figure 86).

Figure 85: Cumulative US mutual fund flows in 2011 (left axis), market liquidity as measured by the depth of S&P 500 futures (right axis)


Figure 86: Estimated S&P 500 options gamma exposure (left axis), net futures speculative open interest (right axis)


Figure 87 shows an extreme example of the gamma hedging impact during the second week of August. As the amount of gamma exposure reached record levels, and liquidity fell to the lowest point for the year (Figure 85 and Figure 86), gamma hedging flows caused a significant portion of market volatility that week. Figure 88shows a more recent example from November 30th, when the market rallied on the coordinated action of central banks. A ~3% overnight move caused additional hedging flows that pushed the market another ~1% in the last hour of the trading day.

2 This liquidity can quickly disappear, such as during the flash crash in May 2010.3 Hedging of levered ETFs and other volatility products such as variance swaps and CPPI structures can also have an impact on market volatility.4 See our report “Impact of Derivatives Hedging,” as well as a series of Market commentaries from August and September 2011.

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US Year Ahead 2012

72


Figure 87: Impact of S&P 500 Gamma Hedging in Early August

Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg.

Figure 88: Impact of S&P 500 Gamma Hedging on November 30th

Source: J.P. Morgan Equity Derivatives Strategy, Bloomberg.

In addition to poor liquidity and gamma hedging flows, large short interest in index products also contributed to market instability and higher volatility. Figure 86 shows record levels of speculative short interest in S&P 500 futures built up during the month of August. Stop-loss covering of shorts caused several market squeezes and contributed to end-of-the-day moves such as the one illustrated in Figure 88.

Volatility in 2012 will largely depend on the pace with which the European sovereign debt crisis is addressed by policymakers, as well as changes in the outlookfor global growth. As it is not possible to forecast these developments with certainty, we build our forecast based on historical trends, our views on the structural drivers of correlation and volatility, and J.P. Morgan’s 2012 fundamental projections for the macroeconomy, equities, and credit.

Larger market crises and outbursts of equity volatility usually take a longer time to resolve. This gives rise to the familiar “triangular shape” of VIX spike patterns5. Comparing the current pattern of the VIX with the market crisis last summer (shown in Figure 83), one can notice that the current market crisis is taking a significantly longer time to abate6. This can be directly attributed to the lack of progress made by European policymakers, and in particular the reluctance of Germany to endorse employing ECB resources in removing the tail risk. While one could argue that volatility may persist and equities are entering a secular bear market, we believe a stabilizing solution in Europe will be agreed upon, eventually causing volatility to decline from current high levels.

The current record levels of cross-asset correlations and equity correlations are not sustainable in our view. A prolonged period of risk on/off trading in illiquid markets is likely to cause significant underperformance for proponents of this approach and create divergences in valuations that will invite relative value investors. While many of the structural drivers should persist, we believe that the correlations will either collapse (with removal of tail risk, cyclical or seasonal effects), or will gradually wear off from the current extreme levels, in either case contributing to a decline in volatility during 20127.

5More accurately, volatility tends to decay in an exponential, rather than linear, fashion.

6 This is also true when comparing the current outburst of volatility with volatility patterns over the past 20 years.7 See our report on the seasonality of equity correlations.



US Year Ahead 2012

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Our forecast is that the average realized volatility of the S&P 500 in 2012 will decline to ~18.5% with a most likely range of ~15-20%. This represents a decline from the current high volatility regime (6-month realized volatility at 30%) into amedium volatility regime8.

Another consideration in forecasting volatility is J.P. Morgan’s fundamental projections. While the outlook for the US economy (e.g., GDP, unemployment) points to the same level of volatility that we saw this year (12-month volatility of 23%), our credit and equity strategists argue for a significant reduction of credit risk and higher equity valuations in 2012, thus supporting our view of declining volatility (Figure 89). We believe that the premium of implied to realized volatility will stay elevated, due to reduced capacity of the system to store risk and high demand for downside and tail risk protection. Our forecast for the average spread of the VIX to realized volatility is 4.5 points.

Figure 89: S&P 500 Realized Volatility and Average VIX Forecast


8 Here we define medium volatility regime relative to the past 5 years. Over the past 100 years, an 18.5% target volatility would still be higher than about 75% of observations and could be classified as a high volatility regime.

Asset Current Target

Volatility

Impact

CDX Investment Grade 140 100 Lower

CDX High Yield 800 550 Lower

S&P 500 1245 1450 Lower

US GDP 1.68 1.75 Neutral

US Unemployment 8.6% 9.0% Neutral

S&P 500 Realized Volatility 23.2% 18.5% -4.7%

VIX 27.5 23 -4.5


US Year Ahead 2012

74


Risks of Common Option Strategies

Risks to Strategies: Not all option strategies are suitable for investors; certain strategies may expose investors to significant potential losses. We have summarized the risks of selected derivative strategies. For additional risk information, please call your sales representative for a copy of “Characteristics and Risks of Standardized Options.” We advise investors to consult their tax advisors and legal counsel about the tax implications of these strategies. Please also refer to option risk disclosure documents.

Put Sale. Investors who sell put options will own the underlying stock if the stock price falls below the strike price of the put option. Investors, therefore, will be exposed to any decline in the stock price below the strike potentially to zero, and they will not participate in any stock appreciation if the option expires unexercised.

Call Sale. Investors who sell uncovered call options have exposure on the upside that is theoretically unlimited.

Call Overwrite or Buywrite. Investors who sell call options against a long position in the underlying stock give up any appreciation in the stock price above the strike price of the call option, and they remain exposed to the downside of the underlying stock in the return for the receipt of the option premium.

Booster. In a sell-off, the maximum realised downside potential of a double-up booster is the net premium paid. In a rally, option losses are potentially unlimited as the investor is net short a call. When overlaid onto a long stock position, upside losses are capped (as for a covered call), but downside losses are not.

Collar. Locks in the amount that can be realized at maturity to a range defined by the put and call strike. If the collar is not costless, investors risk losing 100% of the premium paid. Since investors are selling a call option, they give up any stock appreciation above the strike price of the call option.

Call Purchase. Options are a decaying asset, and investors risk losing 100% of the premium paid if the stock is below the strike price of the call option.

Put Purchase. Options are a decaying asset, and investors risk losing 100% of the premium paid if the stock is above the strike price of the put option.

Straddle or Strangle. The seller of a straddle or strangle is exposed to stock increases above the call strike and stock price declines below the put strike. Since exposure on the upside is theoretically unlimited, investors who also own the stock would have limited losses should the stock rally. Covered writers are exposed to declines in the long stock position as well as any additional shares put to them should the stock decline below the strike price of the put option. Having sold a coveredcall option, the investor gives up all appreciation in the stock above the strike price of the call option.

Put Spread. The buyer of a put spread risks losing 100% of the premium paid. The buyer of higher ratio put spread has unlimited downside below the lower strike (down to zero), dependent on the number of lower struck puts sold. The maximum gain is limited to the spread between the two put strikes, when the underlying is at the lower strike. Investors who own the underlying stock will have downside protection between the higher strike put and the lower strike put. However, should the stock price fall below the strike price of the lower strike put, investors regain exposure to the underlying stock, and this exposure is multiplied by the number of puts sold.

Call Spread. The buyer risks losing 100% of the premium paid. The gain is limited to the spread between the two strike prices. The seller of a call spread risks losing an amount equal to the spread between the two call strikes less the net premium received. By selling a covered call spread, the investor remains exposed to the downside of the stock and gives up the spread between the two call strikes should the stock rally.

Butterfly Spread. A butterfly spread consists of two spreads established simultaneously. One a bull spread and the other a bear spread. The resulting position is neutral, that is, the investor will profit if the underlying is stable. Butterfly spreads are established at a net debit. The maximum profit will occur at the middle strike price, the maximum loss is the net debit.

Pricing Is Illustrative Only: Prices quoted in the above trade ideas are our estimate of current market levels, and are not indicative trading levels.


US Year Ahead 2012

75


Delta One Strategy

J.P. Morgan U.S. Top Picks for 2012 Basket <JPUS2012>

Introduction

The J.P. Morgan U.S. Top Picks for 2012 Basket (<JPUS2012> Index on Bloomberg) represents the portfolio of U.S. stocks that J.P. Morgan Equity Research Analysts have selected as their top ideas for 2012.

Basket Methodology and Composition

Each of the stocks in the basket has been selected as a key stock to own in 2012 that should outperform its sector, according to our analysts. The rationale for each stock’s selection is provided by the analysts in their individual sector notes. We have weighted the basket equally for all large-cap (>$5 billion market capitalization) and liquid (>$50 million average daily value traded) stocks. For smaller stocks with lower liquidity, we have used a sliding scale so that the amount of stock traded to enter the position should not be a substantial proportion of average daily volume. The basket is well diversified across sectors, with stocks selected by analysts covering a range of different industry groups. The charts below show the sector and industry group composition of the J.P. Morgan U.S. Top Picks for 2012 Basket. The constituents and their weights are shown in the table on the following page.

Figure 90: Sector and Industry Composition of the J.P. Morgan U.S. Top Picks for 2012 Basket

Source: J.P. Morgan Derivatives & Delta One Strategy, S&P, Bloomberg.

Information Technology

16%

Consumer Staples

10%

Health Care14%

Financials11%

Consumer Discretionary

14%

Industrials17%

Materials7%

Energy9%

Utilities2%

Software & Services5%

Household &

Personal Products

2%

Pharmaceuticals, Biotechnology

8%

Food Beverage & Tobacco

5%

Diversified

Financials5%

Media

3%

Capital Goods

8%

Health Care

Equipment & Servic5%

Food & Staples Retailing

4%

Transportation

4%

Materials

7%

Consumer Services

5%

Semiconductors & Semiconductor

7%

Energy

9%

Insurance

3%

Real Estate2%

Retailing

3%

Commercial &

Professional Serv6%

Utilities2%

Technology Hardware &

Equipmen5%

Consumer Durables & Apparel

2%

Automobiles &

Components

2%

Banks2%

Kapil Dhingra AC

(1-212) 272-7823

[email protected]

Marko Kolanovic

(1-212) 272-1438

[email protected]

Adam Rudd

(1-212) 272-1215

[email protected]


Basket Details

Bloomberg Ticker JPUS2012 <Index>

Benchmark SPX Index

Number of Components 65

Weighting Scheme Proprietary


Bloomberg subscribers can use the

ticker JPUS2012 to access tracking

information on a basket created by the

J.P. Morgan Delta One desk to

leverage the theme discussed in this

report. Over time, the performance of

JPUS2012 could diverge from returns

quoted in this report, because of

differences in methodology.

J.P. Morgan Research does not provide

research coverage of this basket and

investors should not expect continuous

analysis or additional reports relating to

it. For information on JPUS2012,

please contact your J.P. Morgan

salesperson or the Delta One Desk.


US Year Ahead 2012

76


Figure 91: Composition of the J.P. Morgan Top Picks for 2012 Basket – JPUS2012 <Index>

Source: J.P. Morgan Derivatives & Delta One Strategy, Bloomberg.

Ticker Name Industry Group Analyst Wgt (% )Mkt Cap

($Bn)

ADV

($M)

AAPL Apple Inc Technology Hardware & Equipmen Mark A Moskowitz 1.625% 363.08$ 7,592$

GOOG Google Inc-Cl A Software & Services Douglas Anmuth 1.625% 199.53$ 2,147$

PG Procter & Gamble Co/The Household & Personal Products John A Faucher 1.625% 177.38$ 698$

PFE Pfizer Inc Pharmaceuticals , Biotechnology Christopher T Schott 1.625% 155.20$ 997$

PEP Pepsico Inc Food Beverage & Tobacco John A Faucher 1.625% 100.57$ 591$

C Citigroup Inc Diversified Financials Vivek Juneja 1.625% 81.13$ 1,461$

CMCSA Comcast Corp-Class A Media Philip Cusick 1.625% 61.10$ 459$

AXP American Express Co Diversified Financials Richard Shane Jr 1.625% 55.53$ 399$

BA Boeing Co/The Capital Goods Joseph B Nadol Iii 1.625% 52.15$ 432$

UNH Unitedhealth Group Inc Health Care Equipment & Servic John F Rex 1.625% 51.34$ 397$

CVS Cvs Caremark Corp Food & Staples Retailing Lisa C Gill 1.625% 49.07$ 379$

UNP Union Pacific Corp Transportation Thomas R Wadewitz 1.625% 48.49$ 329$

MA Mastercard Inc-Class A Software & Services Tien-Tsin Huang 1.625% 47.37$ 508$

DD Du Pont (E.I.) De Nemours Materials Jeffrey J Zekauskas 1.625% 42.98$ 380$

GG Goldcorp Inc Materials John Bridges 1.625% 42.42$ 336$

FCX Freeport-Mcmoran Copper Materials Michael F Gambardella 1.625% 36.34$ 805$

COST Costco Wholesale Corp Food & Staples Retailing Christopher Horvers 1.625% 37.17$ 226$

LVS Las Vegas Sands Corp Consumer Services Joseph R Greff 1.625% 35.46$ 734$

TXN Texas Instruments Inc Semiconductors & Semiconductor Christopher Danely 1.625% 34.19$ 380$

HAL Halliburton Co Energy J David Anderson 1.625% 30.49$ 562$

DE Deere & Co Capital Goods Ann Duignan 1.625% 31.82$ 420$

CELG Celgene Corp Pharmaceuticals , Biotechnology Geoffrey Meacham 1.625% 27.21$ 217$

PRU Prudential Financial Inc Insurance Jimmy S Bhullar 1.625% 24.00$ 261$

RAI Reynolds American Inc Food Beverage & Tobacco Rae Maile 1.625% 23.52$ 129$

VIAb Viacom Inc-Class B Media Alexia S Quadrani 1.625% 24.08$ 219$

PSA Public Storage Real Estate Michael W Mueller 1.625% 22.83$ 130$

BRCM Broadcom Corp-Cl A Semiconductors & Semiconductor Harlan Sur 1.625% 16.05$ 253$

M Macy'S Inc Retailing Matthew Boss 1.625% 13.56$ 284$

ALL Allstate Corp Insurance Matthew G Heimermann 1.625% 13.43$ 141$

A Agilent Technologies Inc Pharmaceuticals , Biotechnology Tycho W Peterson 1.625% 11.95$ 173$

STJ St Jude Medical Inc Health Care Equipment & Servic Michael N Weinstein 1.625% 11.43$ 136$

PXD Pioneer Natural Resources Co Energy Joseph D Allman 1.625% 10.78$ 171$

HCA Hca Holdings Inc Health Care Equipment & Servic John F Rex 1.625% 9.36$ 75$

IVZ Invesco Ltd Diversified Financials Kenneth B Worthington 1.625% 9.10$ 118$

CNX Consol Energy Inc Energy John Bridges 1.625% 8.73$ 154$

SJM Jm Smucker Co/The Food Beverage & Tobacco Kenneth Goldman 1.625% 8.67$ 62$

MYL Mylan Inc Pharmaceuticals , Biotechnology Christopher T Schott 1.625% 8.26$ 136$

NXY Nexen Inc Energy Katherine Lucas Minyard 1.625% 7.72$ 48$

DNR Denbury Resources Inc Energy Joseph D Allman 1.625% 6.28$ 94$

UAL United Continental Holdings Transportation Jamie N Baker 1.625% 6.52$ 133$

VRSK Verisk Analytics Inc-Class A Commercial & Professional Serv Michael A Meltz 1.500% 6.26$ 33$

WYN Wyndham Worldwide Corp Consumer Services Joseph R Greff 1.625% 5.38$ 96$

BPL Buckeye Partners Lp Energy Jeremy Tonet 0.625% 5.47$ 16$

LRCX Lam Research Corp Semiconductors & Semiconductor Christopher Blansett 1.625% 4.99$ 113$

CCK Crown Holdings Inc Materials Phil M Gresh 1.625% 4.94$ 47$

EQIX Equinix Inc Software & Services P Sterling Auty 1.625% 4.78$ 74$

ULTA Ulta Salon Cosmetics & Fragr Retailing Brian J Tunick 1.625% 4.46$ 73$

NRG Nrg Energy Inc Utilities Andrew L Smith 1.625% 4.28$ 55$

JBL Jabil Circuit Inc Technology Hardware & Equipmen Steven J O'Brien 1.625% 4.18$ 89$

RVBD Riverbed Technology Inc Technology Hardware & Equipmen Rod Hall 1.625% 4.01$ 129$

RHI Robert Half Intl Inc Commercial & Professional Serv Andrew C Steinerman 1.625% 3.92$ 53$

CBI Chicago Bridge & Iron-Ny Shr Capital Goods Scott Levine 1.625% 3.82$ 51$

WCN Waste Connections Inc Commercial & Professional Serv Scott Levine 1.250% 3.58$ 27$

OC Owens Corning Capital Goods Michael Rehaut 1.625% 3.33$ 49$

LEN Lennar Corp-A Consumer Durables & Apparel Michael Rehaut 1.625% 3.42$ 100$

CLH Clean Harbors Inc Commercial & Professional Serv Rodney C Clayton 1.250% 3.12$ 28$

SPW Spx Corp Capital Goods Charles Stephen Tusa 1.625% 3.07$ 40$

CREE Cree Inc Semiconductors & Semiconductor Christopher Blansett 1.625% 2.72$ 92$

VC Visteon Corp Automobiles & Components Himanshu A Patel 1.500% 2.82$ 34$

ONXX Onyx Pharmaceuticals Inc Pharmaceuticals , Biotechnology Cory William Kasimov 1.625% 2.55$ 45$

AH Accretive Health Inc Health Care Equipment & Servic Atif Rahim 0.500% 2.16$ 13$

TFM Fresh Market Inc/The Food & Staples Retailing Kenneth Goldman 0.625% 1.89$ 18$

FHN First Horizon National Corp Banks Steven Alexopoulos 1.625% 1.99$ 37$

EAT Brinker International Inc Consumer Services John W Ivankoe 1.500% 1.91$ 43$

ZIP Zipcar Inc Transportation Paul T Coster 0.250% 0.56$ 6$


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Basket Performance Statistics

The daily returns of the J.P. Morgan U.S. Top Picks for 2012 Basket would havebeen closely correlated to those of the S&P 500 Index9 (~98% correlation over the last year). The basket would have outperformed the S&P 500 since the beginning of 2009 by an annualized return of ~4%, and it would have underperformed the S&P 500 this year (since December 31, 2010) by an annualized return of ~5.9%. The figures below show the hypothetical performance of the J.P. Morgan U.S. Top Picks for 2012 Basket as well as that of the S&P 500 Index since beginning of 2009 and the beginning of 2011. The basket has a beta of ~1.2 versus the S&P 500. The realized volatility of the basket would have been ~28% since the beginning of 2011, compared to ~23% for the S&P 500. The J.P. Morgan U.S. Top Picks for 2012 Basket has a dividend yield well below that of the S&P 500, given the relatively high weighting of lower-yielding stocks. In addition, the charts below show a scatter plot of daily returns of the J.P.Morgan U.S. Top Picks for 2012 Basket and those of the S&P 500 Index. We also show the 3M rolling beta and the 3M rolling correlation for the basket against the S&P 500 Index.

Figure 92: Performance of the J.P. Morgan U.S. Top Picks for 2012 Basket Since the Beginning of 2008

Source: J.P. Morgan Derivatives & Delta One Strategy, Bloomberg. Note: All price performance

excludes commissions and fees. Past performance is not indicative of future returns.

Figure 93: YTD Performance of the J.P. Morgan U.S. Top Picks for 2012 Basket



9 Not all stocks in the basket have three years of price history (HCA, VRSK, VC, AH, TFM, ZIP). In such cases, we have substituted the basket with an equivalent quantity of cash for the purpose of the back test.

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J.P. Morgan U.S. Top Picks for 2012 Basket

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Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11

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J.P. Morgan U.S. Top Picks for 2012 Basket


US Year Ahead 2012

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Figure 94: 3M Realized Volatility of the J.P. Morgan U.S. Top Picks for 2012 Basket and the S&P 500 Index



Figure 95: 1Y Realized Dividend Yield of the J.P. Morgan U.S. Top Picks for 2012 Basket and the S&P 500 Index



Figure 96: Daily Returns of the J.P. Morgan U.S. Top Picks for 2012 Basket vs. Daily Returns of the S&P 500 Index



Figure 97: 3M Beta and 3M Correlation of the J.P. Morgan U.S. Top Picks for 2012 Basket vs. S&P 500 Index



0%

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3M Volatility of J.P. Morgan U.S. Top Picks for 2012 Basket

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Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11

Top Picks for 2012 Basket Dividend Yield

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Additional Basket Methodology

In order to keep the basket relevant to the investment theme, J.P. Morgan reserves the right to review the following at any time:

Basket methodology. This is to ensure the rules of the basket remain relevant following any structural changes to the theme. This may include ensuring that the sector exposure of the basket remains broadly consistent with the investment theme.

Basket change implementation. J.P. Morgan will consider extending the implementation of changes to the basket composition from one trading session to any period up to five trading sessions in the event that a material increase in the liquidity or capacity of the basket is required to minimize market impact.

Corporate actions may affect the J.P. Morgan U.S. Top Picks for 2012 Basket. The composition of a custom basket is typically adjusted in the following manner:

Cash merger. The divisor is adjusted, and we remove the merging company from the basket on the day of merger and redistribute gains into remaining companies according to recalculated market cap weights of surviving constituents in the basket.

Stock merger. If the acquirer is a member of the basket, then the weight allocated to the acquired will transfer to the surviving entity on the close of the last day it trades. If the acquirer is not a part of the basket, then proceeds (losses) from the acquired company will be redistributed to the surviving basket constituents based on the recalculated weighting on the close of its last trading day.

Spinoffs. The spinoff company and parent will be included in the basket, and both the spinoff and parent company weights will be readjusted according to new market capitalizations after the spinoff date.

Tender offers and share buybacks. The company remains in the basket and its weight is adjusted according to the impact the tender/buyback has on the stock’s market value.

Delisting/insolvency/bankruptcy. The company is removed from the basket as of the close of the last trading day, and the proceeds (losses) will be redistributed into remaining companies according to re-calculated weights of remaining companies in the basket. If a stock trades on “pink sheets” it will not be included in the basket.


US Year Ahead 2012

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US Year Ahead 2012

81


Aerospace & Defense

Commercial Aero Looks Solid Despite Uncertainty; Defense Down-Cycle Just Starting

Commercial aerospace fundamentals remain attractive, which should support stocks in 2012. Rate increases are scheduled to boost Boeing and Airbus deliveries by ~40% from 2011 to 2015, and demand driven by both air traffic growth, which has held upwell amid the macro turmoil of recent years, and replacement looks like it should support these production levels. A global economic downturn is a key risk, but we believe it would have to be especially severe and include the emerging markets, which account for 55-60% of traffic growth, to derail planned rate increases. Aircraft finance is another risk due to turmoil in the banking system, particularly in Europe, but we also see this as manageable. In the aftermarket, we see potential for continued double-digit growth in 2012 following the strong rebound in 2011, as aftermarket sales are just now surpassing the 2008 peak despite 10% higher airline capacity. The business jet market remains bifurcated, as large-jet demand is recovering nicely, aided by emerging market customers, particularly in China, while light-jet demand remains anemic and will probably require more activity from U.S. customers in order to bounce, which we think will take some time yet.

Defense fundamentals remain highly challenging, although the stocks appear to be heavily discounting a continued flow of bad news given their relatively strong performance in the wake of the Congressional Super Committee’s inability to reach an agreement. Nonetheless, we believe the stocks will be stagnant as earnings estimates sag, and the best hope for outperformance in 2012 appears to be poor market performance overall. Efforts to amend the automatic defense cuts are underway, but the timing and substance of any resolution are unclear. Regardless of the outcome, we expect 2012 sales to decline in line with a 4-5% decrease in the addressable market, and earnings to further suffer from ~60bps on average of margin pressure (excluding pension). Looking into 2013, we again expect a 5% decline in the addressable market and organic growth in line with that, and we could see ~2-3% upside or downside to that depending on the outcome of the effort to reverse or reduce the automatic cuts. Our average defense EPS forecasts are 4% and 6% below Consensus for 2012 and 2013, respectively. While defense stocks could outperform in 2012 in a poor market environment, we don’t believe the stocks will really start to work until the market gains confidence that the ~$1 trillion fiscal deficit will be cut to a more sustainable level, perhaps $300-400 billion, through entitlement reform and/or tax increases, and we see this as most likely at least a year away.

Best Idea – Boeing Company (BA)

Boeing (BA) is our top pick for 2012. We see two keys to performance: sustainment of aircraft demand despite the global economic turmoil and execution on the 787 program. Commercial aircraft orders should remain strong, driven by conversion of commitments for the 737 MAX into firm orders, the launch of the 787-10, and a resurgence of 777 demand driven by delays and customer concerns on the A350. We see potential for a major cash flow turnaround as 787 cash burn abates. Improving cash flows increase financial flexibility as well, and we believe 2012 could see Boeing’s first dividend increase since 2008.

Boeing Company (BA) – Overweight – Dec 12 Price Target: $80Price 52-Wk Range FY EPS P/E Mkt Cap

12/6/2011 High Low FY End Last (A) Cur (E) Next (E) Cur Next (mil.)

$70.87 $80.65 $56.01 Dec $4.45 $4.50 $4.85 15.7 14.6 $52,673 Valuation: Target reflects ~14x 2013E EPS, in line with commercial aero stocks historically. Risks: Incremental problems with 787 production ramp, higher-than-expected R&D, renewed recession or macro shock lowering production rates.

Joseph B. Nadol AC

(1-212) 622-6548

[email protected]

Seth M. Seifman, CFA

(1-212) 622-5597

[email protected]

Christopher Sands

(1-212) 622-9224

[email protected]


Joseph B. Nadol

Alliant Techsystems Inc. ATK N

Boeing Company BA OW

Bombardier BBDb.TO OW

CACI International Inc CACI N

Comtech Telecommunications CMTL OW

Embraer SA ERJ OW

Exelis Inc. XLS N

General Dynamics Corp. GD N

Goodrich GR (rs)

Harris Corporation HRS N

L-3 Communications LLL N

Lockheed Martin LMT OW

Northrop Grumman NOC N

Precision Castparts PCP OW

Raytheon RTN OW

Rockwell Collins COL OW

SAIC SAI N

Spirit AeroSystems SPR N

TransDigm Group Inc TDG N

United Technologies UTX (rs)

Wesco Aircraft Holdings, Inc. WAIR OW

Ca

pita

l Go

ods/In

dustria

lsThis document is being provided for the exclusive use of JOHN CULHANE at PENNANT MANAGEMENT, INC.

US Year Ahead 2012

82


Airfreight & Surface Transportation

Rail EPS Growth Should Persist Amid Modest Economy; UNP Story the Most Resilient

Against a backdrop of modest economic growth in 2012, we expect solid performance from the major railroad stocks as cost-side pressures from 2011 ease and solid pricing momentum continues. We anticipate only limited support for EPS performance from volume growth given a muted outlook for the economy. In our view, P/E valuation on our 2012 EPS estimates of 11.3-13.5x for the three major U.S. railroads (UNP, CSX, NSC) is attractive relative to a normal historical range of 11-15x and in light of our positive outlook for rail EPS performance in 2012. Among the other transports, we believe that the small package names FDX and UPS are attractive given a favorable domestic pricing story and operating costs that should remain muted. The small package names would likely be more interesting versus the railroads if economic growth surprises to the upside.

While we can identify a few truckload names with attractive company-specific stories such as WERN (cost side) and SWFT (valuation), and intermodal names (JBHT, HUBG) with attractive growth, we are generally cautious on the more cyclical industry groups within transportation including the less-than-truckload and truckload segments. In our view, sluggish economic growth in 2012 is a source of greater risk to the pricing stories in these less consolidated and more cyclical transport groups.

Best Idea – Union Pacific (UNP)

Union Pacific (UNP) should realize a significant tailwind in 2012 from repricing ~$1.05bn in revenue of old contracts (legacy intermodal and coal) for which pricing is likely to rise sharply. We estimate that the combined revenue increase resulting from repricing the legacy contracts is ~$490mm in 2012 or ~$0.63/share, which contributes about ten percentage points to earnings growth. In our view, UNP’s revenue mix is the most defensive of the rail group as 38% of the company’s revenues come from the less economically sensitive agriculture and coal segments. UNP’s exposure to PRB coal is likely to be more stable than the eastern rails’ due to moderate utility stockpile levels and little exposure to export coal demand. Risks to our earnings expectations and Overweight rating on UNP include increased price competition between the Western rails, which we believe is unlikely. Unfavorable regulatory and court rulings are also a risk to our positive view on UNP stock. A sharp slowing in the U.S. economy would be another risk to our volume and EPS growth forecasts and to our Overweight rating.

Union Pacific (UNP) – Overweight – Dec 12 Price Target: $119

Price 52-Wk Range FY EPS P/E Mkt Cap


$102.84 $107.89 $77.73 Dec $5.61 $6.52 $7.60 15.8 13.5 $49,680 Valuation: Target reflects 14x 2013E EPS, compared to long-term historical range of 11-15x and stronger range of 13-17x during the positive rail price story of 2004-2008.

Thomas R. Wadewitz AC

(1-212) 622-6461

[email protected]

Michael R. Weinz, CFA

(1-212) 622-6383

[email protected]

Alexander K. Johnson

(1-212) 622-6513

[email protected]


Thomas R. Wadewitz

Arkansas Best ABFS N

C.H. Robinson Worldwide CHRW UW

Canadian National Railway CNI N

Canadian Pacific Railway CP UW

Con-way CNW UW

CSX CSX OW

Expeditors EXPD N

FedEx Corp FDX OW

Genesee & Wyoming GWR OW

Heartland Express HTLD N

J.B. Hunt Transport Services JBHT OW

Kansas City Southern KSU OW

Knight Transportation, Inc. KNX N

Landstar LSTR OW

Norfolk Southern NSC OW

Old Dominion ODFL N

RailAmerica RA OW

Swift Transportation SWFT OW

Union Pacific UNP OW

United Parcel Service UPS OW

UTi Worldwide UTIW N

Werner Enterprises WERN OW

YRC Worldwide YRCWD N

Michael R. Weinz, CFA

Hub Group HUBG OW

Pacer International PACR N


US Year Ahead 2012

83


Electrical Equipment & Multi-Industry

Handoff to Late-Cycle Growth in Progress

The EE/MI group has underperformed in 2011, down 9% compared to a 5% decline for the S&P 500. Despite cyclical upside, weaker performance has been slantedtowards later-cycle stocks as the recovery for certain end markets was pushed to the right. The macro is still mixed, with uncertainties around developed market fiscal policy and a broader sovereign debt crisis leading to a lower-growth environment, which is reflected in our below-consensus estimates.

While the current 11x group multiple looks inexpensive on consensus (15x heading into 2011), with this backdrop of uncertainty, we remain cautious, as we see structural issues as a relevant drag on valuation. Within this dynamic, valuation disparity in a shifting growth landscape presents opportunities heading into next year. We continue to favor later-cycle stocks for which sales/earnings should begin to outperform in 2012. Coincidentally, most of these names trade a discount, or are being unfairly punished for what we believe to be universal macro uncertainty, providing an entry point.

Best Idea – SPX Corp. (SPW)

SPX Corp. (SPW) is one of the best ways to leverage the handoff from early- to late-cycle growth, in our view. The company’s sales should end 2011 about 10% below the 2008 peak, making this one of the last to fully recover on our coverage list, and leaving the whole earnings cycle ahead. The stock has unperformed this year (-17% vs. group -9%) as the recovery for power and T&D end markets (~50% of sales) remained tenuous for most of 2011, but we continue to get clarity on end-market and earnings momentum heading into 2012.

Specifically, we see several factors working in SPW’s favor in 2012 as end-market growth accelerates. First, the company’s transformer business, which is at trough, and represents a $2.00 swing in EPS through the peak, is starting to turn: lead times have stretched to peak levels (8-12 months), pricing has been up for two straight quarters, and the book-to-bill in 3Q11 was over 2x, setting up a ramp for the business in mid-2012. Timing the improvement here has been delicate, but order data from SPX and commentary from peer ABB (each ~34% NA market share) solidify that the turn is here. Outside of transformers, restructuring efforts, recent pricing action, and demand from process end markets should help show mid-cycle profit levels for Flow, now the company’s biggest business. The associated Clydeunion deal has moving parts (financing, revenue outlook), but is still expected to be accretive next year, padding EPS. Lastly, Thermal has been a risk given backlog degradation, but management has ring-fenced the issue, and mix is likely to act as a partial offset to sales pressure. In sum, we believe the turn in key end markets coupled with execution on Clydeunion/Thermal will help the shares’ multiple firm from what we view as an unwarranted 5% discount today.

SPX Corp. (SPW) – Overweight – Dec 12 Price Target: $75



$62.82 $87.13 $40.66 Dec $3.62 $4.40 $4.80 14.3 13.1 $3,205 Valuation: Target reflects ~13x 2013E EPS EPS, a 5% premium to the group vs. a ~10% discount historically, to account for a later-cycle business mix. Risks: Prolonged recovery in global infrastructure negatively affecting Thermal, muted recovery in short-cycle businesses like Flow, weak electricity demand leading a muted spending recovery on power transformers by utility customers.

C. Stephen Tusa, Jr CFA AC

(1-212) 622-6623

[email protected]

Paul Mammola, CFA

(1-212) 622-6382

[email protected]

Drew Pierson

(1-212) 622-6627

[email protected]


C. Stephen Tusa, Jr CFA

3M MMM N

Danaher DHR OW

Dover DOV UW

Emerson Electric Co. EMR N

Generac GNRC N

General Electric Co. GE OW

Honeywell HON OW

Hubbell Inc. HUBB OW

Ingersoll Rand IR OW

ITT Corp. ITT

Lennox International LII OW

Motorola Solutions MSI N

Rockwell Automation ROK N

Roper Industries ROP N

Sensata ST OW

SPX Corp. SPW OW

Textron TXT OW

Tyco International TYC OW

WABCO WBC N

Watsco WSO OW

Watts Water Technologies WTS N

Wesco WCC OW


US Year Ahead 2012

84


Engineering & Construction

An Unconventional Road to Recovery

Expecting an uneven global recovery; look for secular stories. The outlook for the global economy remains uneven and uncertain (with emerging markets expected to outgrow developed economies by 300-500bps), suggesting cyclical E&C stocks may not be viewed as particularly attractive in this environment. While the group indeed has cyclical qualities, several other factors influence spending on construction services, many of which (regulatory, budget, regional) may be unique to individual end markets (or E&Cs). Given this context, we favor E&Cs exposed to investment themes that we consider to be secular (i.e., non-cyclical) in nature, such as Natural Gas (particularly LNG) and Transmission & Distribution (T&D).

Q3 results signaled no disruption in industry bookings momentum. Q3 results suggested that the E&Cs experienced little (if any) disruption to bookings due to any recent slowing in global economic conditions. Composite E&C book-to-bill (BtB) was ~1.2x in Q3, reflecting continued improvement in order trends, and suggesting that the recovery in activity levels remains intact. BtB and backlog have traditionally been important drivers of E&C stock performance, though execution has been a greater factor in recent quarters, and may remain a focus for investors in 2012, as E&Cs ramp up on projects booked during the early phases of the cycle.

End-market variations could become more pronounced. We continue to favor E&Cs with exposure to private-sector markets, including commodity verticals such as Oil & Gas (particularly Upstream & Midstream) and Mining, given a still-favorable hydrocarbon market backdrop and expectations of continued recovery in global demand (supporting a favorable bias toward CBI, FLR, and JEC). Within public-sector markets, we maintain a cautious outlook for most Federal markets (including work for the DoD and DOE), though we’re more optimistic on the Infrastructure market, as new Highway legislation could benefit E&Cs, as well as the Materials companies (particularly aggregates-focused MLM and VMC).

Best Idea – Chicago Bridge & Iron (CBI)

Chicago Bridge & Iron (CBI) is our favorite name in E&C, due to its favorable business mix, including high exposure to attractive international energy markets (particularly global LNG) and limited exposure to domestic public-sector markets we view less favorably (given formidable budget and regulatory concerns). We consider CBI’s business model as uniquely attractive, as the company’s Lummus Technology and Steel Plate segments complement its more traditional EPC segment, enabling it to participate in projects in a greater variety of roles than many of its E&C peers. Although a competitive environment for contractors could limit further improvement in CBI’s margins, we think the company should be able to remain toward the top ofthe peer group (including high-single-digit EBIT margins), assuming execution remains strong, consistent with recent quarters.

Chicago Bridge & Iron (CBI) – Overweight – Dec 12 Price Target: $50



$39.47 $45.12 $23.88 Dec $2.04 $2.52 $3.00 15.7 13.2 $3,888 Valuation: Target reflects 14.5x 2013E EPS, slightly below historical average, but above peer group average, reflecting exposure to fast-growing international energy markets and improving execution. Risks: Slowdown in project flow, execution issues resulting in cost overruns on key projects, margin pressure in a more competitive environment, share issuance to support growth initiatives.

Scott Levine AC

(1-212) 622-5609

[email protected]

Rodney C Clayton, CFA

(1-212) 622-2873

[email protected]

Ankit Varmani

(1-212) 622-5654

[email protected]


Babcock & Wilcox Co. BWC N

Chicago Bridge & Iron Co. NV CBI OW

Eagle Materials EXP N

Fluor Corp FLR OW

Jacobs Engineering JEC OW

Martin Marietta Materials MLM OW

Mistras Group MG OW

Pike Electric PIKE N

Quanta Services, Inc. PWR OW

The Shaw Group, Inc SHAW N

TMS International TMS OW

URS Corporation URS N

Vulcan Materials VMC N


US Year Ahead 2012

85


Environmental Services

Focus on Fundamentals, Cash Flows in a Low-Growth Environment

Defensiveness appealing in a low-growth environment. Waste stocks have traditionally performed well during periods of uncertainty, suggesting a likely good fit for the low-growth environment our strategists/economists envision for 2012. Our forecast assumes stable volumes, and we don’t foresee much downside even in a recession, as the cyclical construction business is already at very low levels. Furthermore, cash flows tend to be resilient (often holding up better than earnings in downturns), suggesting this could be an appealing attribute if the recovery stalls.

Cash flow deployment initiatives could enhance shareholder returns. Waste companies can utilize their cash flows to increase shareholder value in a number of different ways, including share buybacks (BIN and RSG increased their authorizations over the past summer, while WCN, WM, and SRCL are also active in this area) and dividends (WM and RSG sport yields of 4.3% and 3.2%, respectively). M&A is another lever for waste companies to supplement organic growth, with BIN, CLH, WCN, and SRCL among the more active acquirors in the group.

Solid waste pricing is a risk worth monitoring. We view pricing as a risk for the group in 2012, as competition could intensify given the sluggish volume recovery. Signs of pricing pressure have become more evident in recent quarters (particularly in the municipal business), and easing inflation rates could limit index-based growth in 2012 (declines in diesel could also limit surcharge revenue). Also, recycled fiber prices (OCC, ONP) have fallen 25%+ in early Q4, suggesting the recycling business could turn from a tailwind to a headwind in 2012, unless trends reverse course.

Best Idea – Waste Connections (WCN)/Clean Harbors (CLH)

Solid Waste: We view Waste Connections (WCN) as an attractive stock for 2012, as its business model (which focuses on exclusive and secondary markets) provides comfort, as it insulates the company from any competitive headwinds that may emerge until volumes recover. Although WCN’s premium valuation could limit potential upside relative to other solid waste names, cash flows remain supportive (FCF margins are toward the top of the peer group), and new acquisitions (not included in our estimates) offer potential upside to our forecasts.

Waste Connections (WCN) – Overweight – Dec 12 Price Target: $40



$32.83 $35.95 $25.96 Dec $1.24 $1.48 $1.67 22.2 19.7 $3,673 Valuation: Target reflects 10x 2013E EBITDA, above historical average, reflecting potential for above-average M&A and defensive growth profile. Risks: Rising cost headwinds, decline in pace of acquisitions, weak macro conditions in Western and Southern markets.

Specialty Waste: We believe Clean Harbors (CLH) offers attractive long-term growth prospects, supported by its market-leadership position in hazardous waste and accelerating secular growth profile in energy and industrial services. Furthermore, the company has demonstrated the ability to augment organic growth with an aggressive but disciplined and accretive acquisition program, which offers potential upside to our estimates (we do not forecast future acquisitions).

Clean Harbors (CLH) – Overweight – Dec 12 Price Target: $73.50



$61.36 $61.84 $38.08 Dec $2.43 $2.14 $2.45 28.7 25.0 $3,256 Valuation: Target reflects 9x 2013E EBITDA, above historical avg. given strong balance sheet and increasing scale in higher-growth acquired businesses. Risks: Increased competition and pricing erosion, acquisition and integration risk, lower oil and gas prices.

Scott Levine AC

(1-212) 622-5609

[email protected]


(1-212) 622-2873

[email protected]

Ankit Varmani

(1-212) 622-5654

[email protected]


Scott Levine

Casella Waste Systems Inc. CWST N

EnergySolutions ES N

Progressive Waste Solutions BIN OW

Republic Services Inc RSG OW

Stericycle Inc. SRCL N

Waste Connections WCN OW

Waste Management WM N


Clean Harbors CLH OW


US Year Ahead 2012

86


Machinery

Agriculture Fundamentals Remain Strong; Overweight DE

The agriculture sector represents a decently defensive space, as agriculture commodity prices are less impacted by general macro trends and more influenced by strong global demand as well as supply-side volatility. Strong demand fundamentals are evidenced by the global food price index produced by the UN Food and Agriculture Organization (FAO) which reached a historic peak of 238 in February2011, well above the peak of 213.5 reached in 2008. According to FAO, prices have since eased and in October the index registered 216; however, this is still 16% higher than in October 2010. Supply-side fundamentals have improved in recent months on the back of decent harvests around the world, and this should result in lower price inflation in 2012. That said, farmers around the world are benefiting from the current balanced supply and demand conditions—a positive for equipment demand.

Best Idea – Deere & Co. (DE)

Globally, the fundamentals for farm cash receipts and thus farmer sentiment remain strong on the back of strong crop prices in North America, strong dairy and livestock prices in Western Europe, strong sugar and soybean prices in South America, and strong wheat prices in Eastern Europe. In North America, total cash receipts for 2012 are expected to be $374.2bn, down 2% y/y, but still at historically high levels; with the strong correlation between cash receipts and equipment sales, we expect North American farm equipment sales to remain elevated, though perhaps down slightly y/y. In Western Europe, equipment demand remains very strong—recovering after a significant decline in 2009 and 2010; in Brazil, equipment demand may be under some pressure due to the saturation of a program to support the sale of small-HP tractors to small farmers. That said, we believe that mix in Brazil will be positive as demand for large crop equipment, including sugarcane harvesting equipment, should remain solid.

Deere & Co. (DE) recently posted an upside earnings report for F4Q11 and introduced an outlook for FY12 that was well above consensus expectations. Management’s FY12 outlook included an expectation for equipment sales to be up 15% (implied sales of $33.9bn) vs. prior consensus of $31.6bn. Net income is expected to be $3.20bn vs. prior consensus of $2.96bn. Implied EPS for FY12 is $7.70 vs. prior consensus of $7.13—as a result, we anticipate a high probability of continued upside to earnings as we go through 2012.

We rate Deere Overweight and have a Dec-12 price target of $100, on solid end-market fundamentals as well as compelling valuation. Our $100 price target represents a ~13x multiple on our FY12 EPS estimate of $7.90, as the multiple compresses toward cycle peak. This is also higher than those of other ag equipment companies, given DE’s strong execution and share gains in key markets such as Brazil and Germany.

Deere & Co. (DE) – Overweight – Dec 12 Price Target: $100



$78.38 $99.80 $59.92 Oct $6.63 $7.90 $8.79 9.9 8.9 $32,443 Risks: Market share risk from aggressive competition, in Europe weather negatively impacting equipment spending and higher crop prices continuing to pressure the protein sector.

Ann Duignan AC

(1-212) 622-0381

[email protected]

Michael Shlisky

(1-212) 622-6656

[email protected]

Ingrid Aja, CFA

(1-212) 622-3730

[email protected]


Actuant Corp ATU N

AGCO Corp. AGCO N

Caterpillar Inc. CAT OW

CNH Global CNH N

Commercial Vehicle Group CVGI N

Cummins Inc CMI N

Deere & Co. DE OW

Eaton Corp. ETN OW

Illinois Tool Works ITW N

Joy Global JOY N

Kennametal Inc. KMT N

Manitowoc Co. MTW N

Modine Manufacturing Co. MOD N

Navistar Int'l NAV N

Oshkosh Corp. OSK N

PACCAR Inc. PCAR OW

Parker Hannifin PH N

Terex Corp TEX N

Westport Innovations Inc. WPRT N


http://www.fao.org/

US Year Ahead 2012

87


Airlines

2012: Modeling for a “Profitable Recession” with Opportunities Ahead

We continue to model for the unprecedented “profitable recession.” U.S. airlines have never produced profits in a U.S. recession. Call us stubborn, but we continue to model for just such an outcome in 2012, which lies at the root of our investment thesis. While it may appear unusual to stick with a recessionary outlook that differs from consensus GDP expectations, we believe there are good reasons to approach our modeling this way. For starters, in the post-war period, whenever U.S. GDP growth has been 1% or less for two consecutive quarters the economy was on the verge of entering a recession or already in one. More importantly, however, we believe if a strong value case can be made for airline equities when modeling for recessionary inputs, then upside equity potential in a firmer economic scenario should only bolster our thesis.

The market appears to be modeling for something much worse. Airline enterprise values continue to flirt with levels last seen in 1H09, a period in which the lights were quickly being dimmed on the U.S. airline industry, in our view. Frankly, we are running out of plausible explanations. Current profits, functioning markets, strong liquidity, and two recent acts of consolidation stand in stark contrast to what the industry then faced.

It’s different this time. We have opined for some time that the industry has undergone significant, structural improvement. Unfortunately, one differentiating facet is that not many seem to care—at least until AMR’s recent bankruptcy filing. We view AMR’s filing as a positive for the industry and believe continued profit production during a domestic downturn can help lift equities from their current funk. We also believe that the correlation between oil prices and GDP represents a “natural” hedge for airlines, and should reduce the historical operating margin range of -9% to +11% toward something closer to +6 to +9%. Ultimately, more stable and predictable profit streams should attract the types of longer-term investors that have shunned the space in the past, in our view.

Best Idea – United Continental Holdings (UAL)

United Continental Holdings (UAL) continues to offer a compelling valuation, in our view, and remains one of our best ideas. With AMR’s recent bankruptcy filing, we believe the benefits to UAL will prove most pronounced given UAL’s network overlap and a more favorable labor cost outcome. As such, we boosted our 2012 UAL estimates with additional revenue upside of ~$500mm and cost savings of $100mm leading to an EV/EBITDAR multiple valuation of 3.8x compared with the peer average of 5.1x. In addition, UAL is expected to generate roughly $10bn in unrestricted cash by year-end 2012 with forecasted net debt/LTM EBITDAR of 1.4x, the lowest leverage ratio among the legacies excluding Alaska. Lastly, while not immune to any unanticipated fuel or demand shocks, UAL’s liquidity profile is above average for similar airlines. We are maintaining our 2012 price target of $45.

United Continental Holdings (UAL) – Overweight – Dec 12 Price Target: $45



$20.13 $27.72 $15.51 Dec $4.31 $3.61 $6.97 5.6 2.9 $6,660 Valuation: Target reflects 50% weighting toward a P/E methodology using 7x multiple, at low end of United’s and Continental’s historical average range of 8-10x, in addition to 50% EV/EBITDAR weight using 4.5x, reflecting historical multiple associated with our level of forecast profitability. Risks: Fluctuations in demand for air travel, variations in energy prices and labor-related job actions, lower-than-expected capacity reduction, UAL/CAL merger proving more costly than expected.

Jamie Baker AC

(1-212) 622-6713

[email protected]

Scott Tan, CFA

(1-212) 622-5541

[email protected]

Joseph Abboud

(1-212) 622-7059

[email protected]


AerCap Holdings N.V. AER OW

Air Lease Corp. AL N

Aircastle Limited AYR OW

Alaska Air Group, Inc. ALK N

AMR Corp. AMR

Copa Holdings, S.A. CPA N

Delta Air Lines, Inc. DAL OW

FLY Leasing Ltd. FLY N

GOL Linhas Aereas Inteligentes S.A. GOL N

JetBlue Airways Corp. JBLU OW

Southwest Airlines Co. LUV N

TAM S.A. TAM (rs)

United Continental Holdings UAL OW

US Airways Group, Inc. LCC OW

Co

nsum

er


US Year Ahead 2012

88


Autos & Auto Parts

Global SAAR Signals Mixed as US-Europe Decoupling Evidence Builds

We believe the global auto sector continues to send mixed signals, but increasingly think 2012 expectations are near bottom. U.S. SAAR has generally trended up in recent months (November SAAR came in at 13.6mm vs. October’s 13.3mm andSeptember’s 13.1mm) and is broadly consistent with better-than-expected U.S.economic data points (we note JPM estimated 2012 SAAR is 13.2mm vs. 2011estimated SAAR of 12.7mm). The Western Europe PV SAAR, however, has been resilient (flattish in August through October) during the recent market swoon, despite steep regional confidence survey declines. It is not particularly farfetched, in our view, to fear a cliff-type event for European auto sales in the coming quarters, but the data flow in the past three months simply does not suggest such an event so far.

Our conversations with a handful of suppliers/OEMs suggest 2012 guidance commentary is likely to be more conservative than current consensus estimates, specifically for Europe-heavy players. Further, commodities are likely to be guided flattish as relief in base metals is offset by resins/rare earths, European auto production guidance may be down 8% at the more prudent suppliers (versus IHS’s-4% and JPM -5%), and Brazil has shown some signs of slowdown in recent months.

We continue to favor stories that are largely non-SAAR dependent (i.e., VC, HAR, TSLA) though the prospect of a plunge in Europe SAAR would suggest all could potentially be had for less. We also like the global tire space (Cooper Tire and Goodyear) going into 2012 as volumes have fallen but stabilized sequentially in many critical tire sub-segments (e.g., U.S. consumer replacement), and pricing is not likely to fall fast despite the recent lurch down in raw materials. We also think GM and particularly Ford have neared a bottom, though these stocks cannot escape a high degree of capital market sensitivity given their large pension plans.

Best Idea – Visteon Corp (VC)

We think Visteon’s timing on value-unlocking corporate actions may be accelerating. Visteon disclosed that it had retained Rothschild and Goldman as financial advisors, without any reference to their specific assignment, raising the question of why such an advisory assignment was disclosed at such a time. We believe VC made this disclosure primarily to signal to investors that it is serious about looking at portfolio restructuring actions. Also, the appointment of Harry Wilson (former U.S. Auto Task Force member with a workout/PE background) to the Board and Finance committee seems to suggest a similar theme on potential ways to unlock value and encourage management to accelerate portfolio optimization actions. We expect to hear of at least some actions in next six months.

We believe the most likely outcome of events could encompass two main transactions and one minor transaction (though potential sequence is unclear): 1) divestiture of Lighting (small deal); 2) purchase of remaining 30% stake in Halla Climate Control; and 3) divestiture of both interior trim assets (50% Yanfeng joint venture and consolidated Interiors).

Visteon Corp (VC) – Overweight – Dec 12 Price Target: $68



$56.30 $76.72 $38.32 Dec $0.52 $3.93 $4.50 14.3 12.5 $2,900 Valuation: Target reflects 3.5x EV/EBITDA multiple on pure (before equity income) 2013E EBITDA, with equity and minority stakes at 10x P/E. Risks: High customer concentration, FX transaction risk, atypical shareholder base, higher commodity costs, strategic actions.

Himanshu Patel, CFA AC

(1-212) 622-3906

[email protected]

Vivek Aalok

(1-212) 622-0798

[email protected]

Amy Carroll

(1-212) 622-1206

[email protected]

Michael Kimlat

(1-212) 622-0458

[email protected]


American Axle AXL OW

Autoliv ALV OW

AutoNation, Inc. AN N

Avis Budget Group, Inc. CAR

Borg Warner Inc. BWA OW

CarMax Inc. KMX N

Cooper Tire & Rubber CTB OW

Dana Holding Corporation DAN N

Dollar Thrifty Automotive DTG (rs)

Ford Motor Company F N

General Motors GM OW

Gentex Corporation GNTX N

Goodyear Tire & Rubber GT OW

Group 1 Automotive, Inc GPI OW

Harley-Davidson HOG N

Harman International HAR OW

Hertz Global Holdings, Inc. HTZ (rs)

Johnson Controls, Inc. JCI OW

KAR Auction Services, Inc. KAR N

Lear Corporation LEA N

Lithia Motors LAD N

Magna International, Inc. MGA OW

Meritor, Inc. MTOR N

Penske Automotive Group, Inc. PAG N

Sonic Automotive, Inc. SAH N

Tenneco Automotive TEN N

Tesla Motors TSLA OW

Tower International TOWR N

TRW Automotive TRW OW

Visteon Corp. VC OW


mailto:[email protected]



US Year Ahead 2012

89


Beverages

Another Tough Year Expected for Beverages

We remain unimpressed with the U.S. beverages sector. As we have stated all year, top-line growth remains fairly muted, and the profit outlook is even worse. We are below consensus for pretty much every name we cover, as we believe that raw materials and foreign exchange are not appropriately reflected. Consistent with our market strategist’s view, we recommend that investors underweight the sector, and would prefer HPC to beverages, although our enthusiasm for HPC is only slightly greater. If the economy does continue to improve, as our economic/strategy teams believe, this group should benefit, but likely not enough to meaningfully outperform.

Demand is likely to remain weak. The biggest problem for this group over the past several years has been the persistent weakness in the low-end U.S. consumer. Both the non-alcoholic and beer segments have been steady decliners over the past several years, as they have never truly seen a rebound following the recession. In non-alcoholic beverages, we think consumers have continued to move away from bottled water and CSDs, and pricing has dampened volume growth as well. For beer, we think the sustained high unemployment rate for young men (2x the rate before the recession) is the biggest negative impact, along with heightened competition from spirits and wine. We look for non-alcoholic volumes to be flat in 2012, with beer down slightly. For the wine and spirits categories, we expect low-single-digit volume growth along with muted pricing and a slight mix benefit as discounting continues at the higher end.

Raw materials are also likely worse than most think. While resins and aluminum may end up being favorable, we continue to be concerned about the overall raw material environment given very favorable hedges that most of these companies had in place for 2011. In particular, we think the CSD companies are likely to see strong inflation in corn costs. We expect juice costs to be flattish and PET costs are forecasted to also remain flattish with some potential relief in 2H.

With the group up a little over 2% YTD, yet still outperforming the market, sentiment is weak, as valuations have come down across the board. When we see reductions in consensus, potential stabilization of demand could provide a catalyst for the group.

Best Idea – PepsiCo (PEP)

With a lack of Overweight-rated stocks (only three in beverages), PepsiCo (PEP) is our top pick. The stock has underperformed the group YTD (-0.8%), after several rounds of negative revisions. While we are below consensus for 2012 ($4.48 versus consensus of $4.63), we think the buy-side is mostly aware that numbers need to come down. KO is trading at a 15% premium to PEP, and we are looking for that discount to close as investors regain some confidence in PEP management if they can finally deliver on (lowered) numbers for 2012. Recent reductions in corn futures prices leave us more optimistic that PEP will be able to continue to raise advertising/marketing support which should help keep top-line growth in the 4-5% range.

PepsiCo (PEP) – Overweight – Dec 12 Price Target: $72



$64.65 $71.89 $58.50 Dec $4.13 $4.39 $4.48 14.7 14.4 $101,075 Valuation: Target reflects 15x 2013E EPS, just under the five-year historical avg. multiple of 17x. Risks: Slowdown in international or Frito business, further increase in raw materials prices, namely energy and agricultural, more profound weakness in NA beverages.

John Faucher AC

(1-212) 622-6443

[email protected]

Neal Rudowitz

(1-212) 622-0094

[email protected]

Sofya Tsinis

(1-212) 622-6391

[email protected]

Peter K Grom

(1-212) 622-4876

[email protected]


John Faucher

Coca-Cola Co. KO N

Coca-Cola Enterprises CCE N

Dr Pepper Snapple Group DPS N

Hansen Natural Corp. HANS N

Molson Coors Brewing Company TAP N

PepsiCo PEP OW

Neal Rudowitz

Brown-Forman Corp BFb N

Constellation Brands STZ N

Cott Corp COT OW


US Year Ahead 2012

90


Food Manufacturing

Cost Inflation May Decelerate But Consumer Confidence Still Not Strong

We hold a mixed outlook for food manufacturing stocks in 2012. Tailwinds may include a less onerous level of cost inflation and corporate actions that could create a higher level of interest than normal in the group. Headwinds may include foreign exchange rates, less ability to take pricing, and consumers that are still cash strapped.

TailwindsWe believe that cost inflation should be significantly lower in 2012 than in 2011 for most food manufacturers. Based on current futures prices for corn, soybeans, hogs, etc., we expect spot prices to be up ~2-3% y/y on average, much less than the ~10% some companies have cited lately. We also believe that, while not fundamental in nature, some corporate actions may generate interest in the group. Three U.S.companies have announced their intention to split in two—Kraft, Sara Lee, and Ralcorp—and all three splits could possibly occur in 2012.

HeadwindsAssuming that foreign exchange rates remain flat between now and the end of next year, we would expect currency to be a headwind to sales and earnings growth for most international food companies we cover. We also assume that conditions for the average U.S. consumer will not improve much next year, which could be another headwind for the group. Although food is a staple, it can be victimized by trading down and/or less pantry loading. Government austerity programs will not help in this regard. Lastly, we remain concerned about the global retail environment—competitors in nations such as Australia are “playing hardball” with manufacturers on price and driving sales lower. We believe that the global retail environment will become even tougher in 2012, including in the United States, where retail comps may soften.

Best Idea – J.M. Smucker Co. (SJM)

J.M. Smucker Co. (SJM) is our top pick for 2012. After navigating one of the food industry’s most challenging cost-inflation periods in 2011, Smucker appears wellpositioned for strong growth in 2012. The company has a number of tailwinds next year, including decelerating raw material costs (vs. a COGS increase of 19% this year), benefits from the SLE coffee deal, accelerating savings from its restructuring program, and continued share repurchases. With over 60% of EBIT coming from SJM’s coffee business and our expectations for lower coffee costs next year, we see this margin tailwind outweighing continued challenges from rising peanut prices.

The company remains well positioned strategically as the branded leader in its categories and has proven its dedication to innovation and marketing, trends we believe should continue. With the stock currently trading at a P/E discount of 0.3x to the group median, we think the risk/reward profile is attractive given the company’s strong market share, clean balance sheet, and long list of tailwinds heading into next year.

J.M. Smucker Co. (SJM) – Overweight – Dec 12 Price Target: $86



$76.67 $80.26 $61.16 Apr $4.69 $5.00 $5.61 15.3 13.7 $8,728 Valuation: Target reflects 14.4x CY2013E EPS, in line with group. Risks: Rising coffee costs pressuring margins, SLE deal not as accretive as forecast, greater-than-feared peanut butter elasticity.

Ken Goldman AC

(1-212) 622-0359

[email protected]

Priscilla Tsai

(1-212) 622-5331

[email protected]

Jessica Schmidt

(1-212) 622-1205

[email protected]


Ken Goldman

Campbell Soup Company CPB N

ConAgra Foods CAG N

Dean Foods DF N

General Mills GIS OW

H.J. Heinz Co. HNZ OW

Hershey HSY OW

J.M. Smucker Co. SJM OW

Kellogg K OW

Kraft Foods KFT N

McCormick & Co., Inc. MKC N

Mead Johnson Nutrition MJN OW

Pilgrim's Pride PPC N

Sanderson Farms, Inc. SAFM N

Sara Lee SLE OW

Smithfield Foods, Inc. SFD N

TreeHouse Foods Inc. THS OW

Tyson Foods TSN OW

Jessica Schmidt

Dole Food Co. DOLE OW

Hain Celestial Group HAIN OW


US Year Ahead 2012

91


Food Retail

Beware the Comps

We expect input costs to come down significantly next year. Based on our JPM Raw Foodstuffs Index, we believe the worst of inflationary pressure is behind the grocers. By next year, we estimate food retailers may hit the “sweet spot” of low-single-digit cost inflation, which should create a favorable environment for margin expansion. Over the last 60 years, when the Food PPI declined month on month, the average food retail margin improved by 0.7% m/m. More importantly, price deceleration should help the bottom line. Historically, food retailers’ penny profits have been highest when inflation was in the low-single-digit range.

However, pricing deceleration should hurt ID sales. We believe the food retail industry is likely to experience a revenue slowdown next year, partially due to our expectations for a significantly weaker pricing tailwind vs. 2011. While there is an argument to be made that lower prices could lead to better volumes, history shows that the relationship has not been 1:1, meaning that volumes generally do not rise as much as prices fall, and vice versa.

The competitive environment remains a structural challenge for traditional grocers. We think traditional grocers will continue to lose share to alternative grocers. Club stores, discounters, dollar stores, niche grocers, etc., still have significant room for new store growth in the U.S. and continue to add more food to their mix, we believe. In addition, certain large supermarkets may accelerate their price investments, which could potentially pressure traffic at competitors. So on a relative basis, we see alternative retailers generally as better plays next year.

Best Idea – The Fresh Market (TFM)

The Fresh Market (TFM) is a true growth stock with strong fundamentals. In our opinion, The Fresh Market remains one of the best growth stories in the entire consumer space. Fundamentally, we think TFM is poised for significant growth and has found a niche—the higher-income consumer who is not as price sensitive and wants a quality shopping experience. We believe the company is likely to experience an EPS CAGR of ~28% over the next two years (FY12-13E), supported by its long runway for new store growth and margin expansion. We appreciate that other food retailers, namely Whole Foods (WFM – Neutral), offer better ID sales, but we note that the stores are rather different, with WFM more focused on health and wellness and TFM more committed to a pleasurable shopping experience. While we are not making an argument for significant multiple expansion (with TFM currently trading around 29x FY12E on a consensus basis and 1x below WFM’s ten-year average), we do not see it as inflated given the compelling case for continued earnings expansion.

The Fresh Market (TFM) – Overweight – Dec 12 Price Target: $55



$40.55 $46.85 $30.86 Jan $0.86 $1.07 $1.40 37.9 29.0 $1,946 Valuation: Target reflects 30x F2013E EPS, in line with WFM’s average over last ten years. Risks: Worsening economy, leaving consumers with less discretionary cash, other grocers lowering prices, widening gap with TFM, eventual venture into California proving unsuccessful.

Ken Goldman AC

(1-212) 622-0359

[email protected]

Priscilla Tsai

(1-212) 622-5331

[email protected]

Jessica Schmidt

(1-212) 622-1205

[email protected]


Ken Goldman

Kroger KR N

Safeway SWY N

SUPERVALU SVU OW

The Fresh Market TFM OW

Weight Watchers International WTW N

Whole Foods Market WFM N


US Year Ahead 2012

92


Gaming

Asia Outlook Remains Solid ─ LVS Positioned to Outperform in 2012

Within the Gaming sector, we believe the most attractive fundamentals continue to be in Macau and Singapore, where gaming growth continues to remain robust, while near- to mid-term competitive supply remains relatively low. Year to date through November, gaming revenue growth in Macau is up 44% over prior-year levels, despite a staunch +57% growth comparison. While market-wide gaming revenue growth is expected to show signs of deceleration in December due to a difficult year-over-year comparison, we believe the market can still grow 30-35%. Given the solid trends in the mass and VIP gaming segments, as well as the opening of Sands Cotai Central (sites 5 and 6) in late 1Q12, which should help to accelerate market-wide growth, we expect Macau GGR growth to trend in the 15-20% range in 2012, slightly higher than buy-side expectations, in our view.

The expected growth rate in Macau is significantly stronger than any gaming market in the U.S., where the mature nature of the business combined with high unemployment and a slow economic recovery continue to keep results muted. That being said, trends on the Las Vegas Strip continued to strengthen throughout 2011 and we believe this strength will accelerate in 2012, given solid convention and group business demand, as well as an increase in leisure travel. In addition, we remain very excited about the Singapore gaming market, which opened less than two years ago and consists of just two integrated resort casinos, one of which is owned by LVS. The initial growth of the Singapore market can be described as robust and going forward we believe the market-wide growth will remain solid given the depth of the Asian gaming customer base and limited capacity within the region. Recent trends point to continued strength in the mass and VIP gaming customer base, as well as increases in hotel and retail spend trends.

Best Idea – Las Vegas Sands (LVS)

We continue to maintain our Overweight rating on Las Vegas Sands (LVS) and view it as one of the best ideas within the gaming space for the year ahead. We believe LVS is a solid risk-reward proposition at current levels, offering an attractive combination of EBITDA and earnings growth, free cash flow generation (9% yield on 2013E), and reasonable valuation (17.4x 2012E EPS). In our view, LVS’s growth prospects are superior to those of any other company in our coverage universe, given its strong positioning in the growth markets of Macau (~47% of 2012E EBITDA) and Singapore (~42% of 2012E EBITDA), low exposure to the U.S. market (~11% of 2012E EBITDA), and no exposure to Europe. Furthermore, we believe there is potential for upside to estimates given Macau junket (VIP)–related market shares gains beginning in 4Q11, as well as a staggered 2012 (beginning in late 1Q12) Sands Cotai Central opening, for which we believe there are relatively low investor expectations.

Las Vegas Sands (LVS) – Overweight – Dec 12 Price Target: $64



$45.58 $51.05 $36.05 Dec $1.00 $2.04 $2.62 22.3 17.4 $37,386 Valuation: Target reflects multiples of 10.0x 2013E LV EBITDAR, 15.0x 2013E Macau EBITDAR (adjusted for 70.3% interest), 15.0x 2013E Singapore EBITDAR, 15.0x Sands China royalty fees, and 90% of 9.0x our 2013E PA EBITDAR, less 2013E year-end net debt, consistent with LV/Macau-centric peers. Risks: Additional regulatory investigations related to FCPA compliance, potential restrictions relating to Macau travel, volatility related to investor expectations on monthly Macau results, executing Singapore VIP ramp.

Joseph Greff AC

(1-212) 622-0548

[email protected]

James Omstrom, CFA

(1-212) 622-1306

[email protected]

Jonathan Mohraz

(1-212) 622-1111

[email protected]


Joseph Greff

Ameristar Casinos, Inc. ASCA N

Bally Technologies, Inc. BYI N

Boyd Gaming Group BYD N

International Game Technology IGT N

Las Vegas Sands Corp. LVS OW

Melco Crown Entertainment MPEL N

MGM Resorts International MGM OW

Penn National PENN OW

Pinnacle Entertainment PNK OW

Shuffle Master SHFL N

WMS Industries WMS N

Wynn Resorts WYNN OW

James Omstrom, CFA

Scientific Games Corporation SGMS N


US Year Ahead 2012

93


Homebuilding & Building Products

Selective Approach on Both Homebuilders and Building Products; Top Picks LEN and OC

HomebuildersWhile we estimate the builders are currently trading at 1.07x on an adjusted P/B basis, at the low end of their historical 1.0-2.0x range, given our outlook for the more challenged macro environment to persist at least over the next 6-9 months, as well asour more muted industry demand outlook for 2012, we believe valuations will likely remain depressed relative to historical averages over this period. As a result, we believe investors should use a fairly selective approach in terms of individual stock selection, given the more challenged macro and demand environments.

Best Idea – Lennar (LEN)

We continue to highlight Overweight-rated LEN as our top pick, as we believe the company’s near industry-leading margins, solidly positive EPS, and accretive Rialto segment should drive further multiple expansion relative to its peers. At 1.18x book value (ex-adj. FAS 109), LEN is currently trading at a 12% premium to its larger-cap peers, which we believe is reflective of LEN’s higher margins and profitability, as well as additional accretion coming from its Rialto segment. Moreover, given our outlook for continued outperformance by LEN’s homebuilding operations, as well as further positive results from Rialto, we believe further multiple expansion relative to peers is likely. We apply a 1.23x P/B multiple to our end-2012 book value estimate of $17.54 (ex-adj. FAS 109) to reach a December 2012 price target of $21.00.

Lennar (LEN) – Overweight – Dec 2012 Price Target: $21



$19.27 $21.54 $12.14 Nov $0.50 $0.52 $0.93 37.1 20.7 $3,464 Risks: Larger-than-expected impairment charges, weaker-than-expected growth, lower-than-expected Rialto earnings.

Building ProductsOur more selective approach to the Building Products sector is based on two factors. First, the Street is largely in line or ahead of our 2012E, leaving little room for upside. Second, while not expensive, the group’s P/E of 13.5x and 14.6x for 2011Eand 2012E, and current EV/EBITDA at 7.5x, is not compelling either, in our view.

Best Idea – Owens Corning (OC)

At only 6.3x 2011E EBITDA, an 8% discount to its ten-year average and a 15% discount to peer levels, OC’s valuation as attractive, in our view. We note that margins for one of its three main segments—Insulation—remain near trough levels and therefore represent a compelling upside opportunity, while we believe the Roofing segment’s margins can remain well above normalized levels at least through 2012. Lastly, OC’s third main segment, Composites, should show further margin expansion in 2012. In addition, there is upside potential, in our view, to the Street consensus for 2012, as our estimate of $2.85 is above the Street’s $2.69. Regarding our price target, we apply a 6.6x EV/EBITDA multiple to our 2012E EBITDA, resulting in a price target of $39.00. Our 6.6x multiple represents a 4% discount to its five-year average, which we believe is appropriate and reflects the recently more challenged visibility surrounding economic growth in both the U.S. and Europe.

Owens Corning (OC) – Overweight – Dec 2012 Price Target: $39



$28.98 $38.94 $18.67 Dec $1.57 $2.20 $2.85 13.2 10.2 $3,503 Risks: Greater-than-expected demand decline for composites, weaker-than-expected U.S. residential demand, higher raw materials costs.

Michael Rehaut, CFA AC

(1-212) 622-6696

[email protected]

Jason A. Marcus

(1-212) 622-4906

[email protected]

William W. Wong

(1-212) 622-1442

[email protected]


Beacon Roofing Supply BECN N

Beazer Homes BZH UW

D.R. Horton DHI N

Hovnanian Enterprises HOV UW

KB Home KBH N

Lennar LEN OW

Masco Corp. MAS UW

MDC Holdings MDC UW

Meritage Homes MTH N

Mohawk Industries MHK OW

NVR, Inc. NVR OW

Owens Corning OC OW

PulteGroup Inc. PHM N

Ryland Group RYL N

Standard Pacific SPF N

Stanley Black & Decker SWK N

Toll Brothers TOL OW

USG Corporation USG N

Whirlpool WHR N


US Year Ahead 2012

94


Household & Personal Care Products

Stay Picky as Numbers Come Down

As with the U.S. beverages sector, we remain unenthused with the state of the U.S. Household & Personal Care space, although with a slight preference to HPC. In the context of JPM’s macro call, we advise investors to underweight the group. We continue to believe that 2011 was a tougher year than investors realize, as our large-cap names (ex EL) will fail to deliver their long-term, Fx-neutral EPS algorithms. Top line has generally been at the low end of expectations given continued weakness in developed markets, only partially offset by strong emerging market growth. Raw materials have also been a big drag on results, with most of the companies using foreign exchange to substitute for pricing. We expect 2012 to be another difficult year, as organic top line is likely to remain sluggish as developed markets remain below our longer-term targets due to continued weakness with the low-end consumer. The turn in foreign exchange to negative for 2012 should lead to a slowdown in reported EPS growth. At this point, we are below consensus on most of our large-cap and SMid-cap names.

Our preference for HPC over beverages is due to pricing and raw materials. While not positive, the pricing and cost inflation outlooks are better for HPC than for beverages, in our view. On the pricing side, we generally see less risk despite some very competitive behavior on the part of most players, as the U.S. soft drink category still has more competitive pressure. In general, we are seeing pricing move up in the HPC categories. Pricing has turned positive on a reported basis for these companies, and should improve slightly on a sequential basis heading into calendar 2012. Raw materials should also be less of a drag as many oil-based raw materials are now projected to be just up slightly y/y, and could even be down in calendar Q2. We also would point out that productivity levels for HPC companies are generally higher, providing greater comfort surrounding the ability to drive some margin expansion.

On the SMid-cap side we are generally more positive, as many of the individual stories are less reliant on macro factors. In particular, names like Tupperware and NuSkin have greater-than-average exposure to emerging markets, which should lead to organic top-line growth at the high end of the group, although this will obviously come with greater foreign exchange risk.

Best Idea – Procter & Gamble (PG)

Our top pick for 2012 in HPC is Procter & Gamble (PG). While the more defensive nature of PG would seem to make it ill suited for this type of market, we think the underperformance in 2011 (-16% vs. the large-cap HPC group) leaves it well positioned to outperform its peers. We expect PG to accelerate core earnings growth from 4% in calendar 2011 to 14% in calendar 2012 through more pricing, better productivity, and SG&A leverage, as the ad-to-sales ratio has already been increased to above 11%. With the stock now trading at a 17% discount to the large-cap HPC group, we think there is room for the multiple to move up as well, as PG delivers four straight quarters of operating profit growth for the first time in four years.

Procter & Gamble (PG) – Overweight – Dec 12 Price Target: $75



$64.84 $67.72 $57.56 Jun $3.95 $4.15 $4.49 15.6 14.4 $178,396 Valuation: Target reflects approx. 16x CY13E EPS, similar to levels over past five years. Risks: Lower-than-anticipated benefit from cost-saving initiatives and/or investment levels, slowdown in top-line growth, deterioration in innovation pipeline, larger-than-anticipated hit from mix, inability to take pricing, input costs.

John Faucher AC

(1-212) 622-6443

[email protected]

Sofya Tsinis

(1-212) 622-6391

[email protected]

Neal Rudowitz

(1-212) 622-0094

[email protected]

Peter K Grom

(1-212) 622-4876

[email protected]


John Faucher

Church & Dwight CHD N

Clorox CLX N

Colgate-Palmolive CL N

Energizer Holdings ENR OW

Estee Lauder EL N

Kimberly-Clark KMB N

Newell Rubbermaid Inc. NWL OW

Nu Skin Enterprises NUS OW

Procter & Gamble PG OW

SodaStream International SODA OW

Sofya Tsinis

Tupperware Brands TUP OW





US Year Ahead 2012

95


Lodging

No Slowdown in Sight ─ WYN Positioned to Outperform in 2012

Current fundamentals in the lodging sector remain sound and in our view do not imply a slowdown despite recent soft macroeconomic data in the U.S. and Europe. That said, it is early for any impact given that lodging fundamentals have historically lagged economic cycles. Recent 3Q11 earnings conference calls suggest approximately mid-single-digit RevPAR growth in 2012, consistent with our estimates. We are generally positive on the longer-term demand-supply equation, given low supply growth in the U.S. for the next few years, room rate upside relative to rates in the prior cycle’s peak, and secular growth internationally (emerging markets like China, India, and Brazil, among others).

So far, no lodging operator that we know of has experienced cancellation increases, no-show increases, or increased attrition over the past month—things that lodging operators likely would experience at the beginning of a slowdown. We keep hearing words like “yet” when asked if the group has slowed or that it is still early (this is true, in our view) and that Fall will be a telling period on what impact, if any, there has been to business travel from potentially eroding business confidence. Our checks indicate that 2012 corporate rates should reflect mid-single-digit increases (likely slightly higher for markets like NYC, Hong Kong, Singapore, and London), though it is still early in the negotiations and we think that a mid-single-digit rate increase would be positive and better than what’s priced in the stocks currently.

Best Idea – Wyndham Worldwide (WYN)

Wyndham Worldwide (WYN) remains our top lodging pick given: (1) its substantial valuation discount to its peers, (2) its (still) underappreciated and improving free cash flow generation, (3) its solid balance sheet, and (4) not a lot of execution risk and high level of resiliency within its hospitality business model. We believe WYN’s valuation discount to its lodging peers is undeserved and, over time, the discount will narrow (current discount of ~4.0 multiple points on an EV/EBITDA basis to its C-Corp peers on our 2012 estimates). We believe the WYN investment story is one of the least appreciated in our gaming, lodging, and leisure coverage universe. In short, we believe WYN possesses a very resilient and underappreciatedset of hospitiality businesses with fairly low capital intensity that generate meaningful free cash flow ($600-700mm annually) which can be harvested to meaningfully shrink the share count (in a manner highly accretive to EPS given the shares’ low valuation) while maintaining investment-grade credit statistics.

Wyndham Worldwide (WYN) – Overweight – Dec 12 Price Target: $46



$35.84 $36.60 $24.76 Dec $2.00 $2.46 $2.80 14.6 12.8 $5,520 Valuation: Target reflects 11.0x 2012E Lodging EBITDA, 10.0x 2012E Vacation Exchange and Rentals EBITDA, 11.0x Property Management Fee EBITDA less corporate net debt plus value related to its timeshare receivables (100% of book value) and timeshare inventory value (100% of book value) less securitized timeshare debt (100% of book value). Risks: Greater-than-expected impact from slowing economy, greater-than-expected competition, timeshare development timing risk, timeshare financing issues.

Joseph Greff AC

(1-212) 622-0548

[email protected]

Kevin Milota

(1-212) 622-0987

[email protected]

Jonathan Mohraz

(1-212) 622-1111

[email protected]


Joseph Greff

Chesapeake Lodging Trust CHSP N

Choice Hotels International CHH N

FelCor Lodging Trust FCH N

Host Hotels & Resorts Inc. HST N

Hyatt Hotels Corporation H OW

LaSalle Hotel Properties LHO N

Marriott International MAR OW

Orient-Express Hotels OEH OW

Starwood Hotels & Resorts Worldwide HOT OW

Strategic Hotels & Resorts BEE N

Sunstone Hotel Investors Inc. SHO N

Wyndham Worldwide WYN OW

Kevin Milota

Carnival Corporation CCL OW

Gaylord Entertainment GET OW

Royal Caribbean Cruises RCL N



US Year Ahead 2012

96


Restaurants

Cost-Saving Initiatives and FCF Opportunity Make Brinker Our Top Pick in 2012

In 2012, we believe the story in the restaurant sector will be “much of the same” compared to 2011. Slow employment and wage growth should continue to limit traffic growth while 4-5% commodity inflation should test restaurant operators’ ability to manage margins as effective pass-through pricing power is limited. In such a period, we recommend that investors own a combination of defensiveness with respect to volatile sales/margins with opportunity for cyclical-driven upside resulting either from a forward-looking stock market or actually improved near-term results. Specifically, we believe investors should own Yum Brands for solid global development, particularly in emerging markets, and FCF generation which should allow for 10%+ EPS growth in F12 and beyond. We also believe investors looking for U.S. consumer acceleration should participate in casual dining’s cyclical upside potential but own Brinker specifically as the company provides highly visible cost-savings opportunity which we expect will enhance margins by 60bps in F12 (June) and 130bps in F13. In addition, a 6%+ FCF yield in F12E and 10%+ in F13E shouldprovide EPS support and potential for solid shareholder return, in our view.

Best Idea – Brinker International (EAT)

Our top pick for 2012 is Brinker International (EAT). We visited management at an onsite visit at a Chili’s in Raleigh in mid-November to showcase the new remodel package but more importantly Phase 2 of the “kitchen of the future.” We came away impressed with the company’s “better not bigger” focus with all operational initiatives geared toward—and succeeding in—driving improved employee/ customer satisfaction to improve shareholder returns.

We expect initiatives related to kitchen systems (to be completed by end-F12 for a 50bp impact) and kitchen equipment (500bps in F12, 300bps in 1H13 for a 100bp+ impact) to allow margin gains of 60bps for the year with further gains offset by a 3.5-4.5% commodity price increase offset by only 1-2 points of price. Further, comps of 2% in F12 should be driven by aforementioned pricing, a lapping of negative lunch-driven menu mix in January, and remodels. We expect the company to remodel 200 out of 800 units in F12 at a per-unit cost of $200-250k at an average 3-4%, or $100k, sales lift.

In addition, we expect F12 earnings to be driven by previously bought-back stock. The company had an average 83.6mm shares outstanding in 1Q12 vs. a F11 average of 92.3mm. For the full year F12, we expect an average of 82.6mm shares, an 11% reduction from the F11 level.

Valuation is also attractive—stock too inexpensive for 20%+ earnings growth in each of F12E and F13E and 12% thereafter. We believe sales, margin, and overall EPS visibility has increased and that the company’s C12E P/E multiple of 11.8x, the casual dining group low, has considerable opportunity for upside. Our $31 price target assumes EAT can trade at 14x F13E EPS, reflective of average earnings growth of ~20-25% over F12/13 and low-double-digit growth thereafter.

Brinker International (EAT) – Overweight – Dec 12 Price Target: $31



$23.78 $26.80 $19.50 Jun $1.52 $1.84 $2.25 12.9 10.6 $1,914 Risks: Reversal in SSS improvement at Chili’s, margin initiatives that fail to provide anticipated benefits, higher-than-expected commodity costs.

John Ivankoe AC

(1-212) 622-6487

[email protected]

Amod Gautam

(1-212) 622-6417

[email protected]

Shaurja Ray

(1-212) 622-2039

[email protected]


Arcos Dorados Holdings, Inc. ARCO N

Brinker International EAT OW

Chipotle Mexican Grill, Inc. CMG N

Darden Restaurants DRI OW

DineEquity Inc. DIN OW

Domino's Pizza Inc DPZ OW

Dunkin' Brands DNKN OW

McDonald's MCD OW

P.F. Chang's China Bistro PFCB N

Starbucks SBUX OW

Sysco Corporation SYY N

Texas Roadhouse Inc. TXRH OW

The Cheesecake Factory, Inc. CAKE N

The Wendy's Company WEN N

Tim Hortons Inc. THI.TO N

Yum Brands YUM OW



US Year Ahead 2012

97


Retailing – Broadlines, Apparel & Footwear

Balanced Approach to 2012 with Macy’s Our Top Idea

In the midst of today’s volatile macroeconomic backdrop, we recommend a balanced approach focusing on company-specific fundamentals, competitive forces, valuation, and investor sentiment.

Four notable themes out of 3Q EPS: 1) credit the primary upside P&L driver—all six retailers spoke to 3Q favorability (lower write-offs/bad debt); 2) gross margin pressure greater than expected with five of six department stores missing JPM projections (SKS the sole upside surprise), with headwinds including free shipping and increased promotions; 3) conservative Holiday/4Q tone with December (extra shopping day) expected to outpace November, with specific commentary related to need-based/event shopping and highly competitive/promotional backdrop; 4) tougher compares at high end to result in likely moderation—SKS and JWN cited tougher upcoming compares leading to likely top-line and gross margin moderation.

Balanced approach: Heading into 2012 we like OW-rated Macy’s (long-term core holding) and JCPenney (turnaround opportunity) on the long side and would use UW-rated Kohl’s (top-line inconsistency/peak gross margins) as a source of funds.

Department stores 2012 puts and takesFocus on top-line: We expect 2012 to remain promotional for the moderate department stores, as the battle for market share is likely to heat up given the reemergence of JCPenney under the direction of new management. From a macro perspective, elevated unemployment levels in 2012 should continue to pressure spending at the middle/low end. Europe’s financial turmoil (JPM Eurozone base case is mild recession ending mid-2012) could negatively impact high-end spending (i.e.,Saks), particularly given a potential slowdown in tourism (accounts for 25% of Saks’New York Flagship store). That said, the silver lining may be easing top-line compares as the year progresses with 2H12 ~270bps easier than 1H (two-year stack).

Eye on margins: On the cost side, while product cost inflation is expected to ease in 2H12, wage inflation in China could offset a portion of the upside opportunity. On the SG&A front, we anticipate continued spending around multi-channel online growth and believe the level of 2011 credit upside will be a tough act to follow.

Best Idea – Macy’s (M)

At 10.1x our 2012E EPS of $3.25 and 5.5x EBITDA, Macy’s (M) trades at some of the cheapest multiples in retail today. We believe top-line momentum is sustainable for the next 3-5 years given the following drivers: 1) Omni-channel initiative in first inning; 2) My Macy’s in third inning; and 3) Magic selling also in first inning. While the promotional environment continues to heat up, we believe Macy’s can and will continue to win through focusing on its own strategy (brand, price, quality trio). On the margin side, the roll-out of Omni-channel functionality and price optimization in 2012 should begin to bear P&L fruit in 2H12, particularly in the fourth quarter. With annual free cash flow generation in excess of $1.7 billion, the prospect of an increased share repurchase plan post December represents another upside catalyst.

Macy’s (M) – Overweight – Dec 12 Price Target: $36Price 52-Wk Range FY EPS P/E Mkt Cap


$32.95 $33.26 $21.69 Jan $2.11 $2.80 $3.25 11.8 10.1 $13,833 Valuation: Target reflects 11x 2012E EPS, 50bps above three-year average. Risks: Greater-than-expected downturn in household spending, change in competitive promotional landscape, excess clearance markdowns impacting gross margin more than expected.

Matthew R. Boss, CPA AC

(1-212) 622-2630

[email protected]

Anne McCormick

(1-212) 622-4163

[email protected]


Dillard's, Inc. DDS N

J.C. Penney Co., Inc. JCP OW

Kohl's Corp. KSS UW

Macy's, Inc. M OW

Nordstrom, Inc. JWN N

Saks, Inc. SKS N


US Year Ahead 2012

98


Retailing – Hardlines/Discounters

COST: Strong Port in the Storm

Years of aggressive store expansion drove outperformance for many retailers. In contrast, now only a handful of retailers are expanding significantly (and are generally crowded stocks). From a lifecycle perspective, hardlines/big-box retailersfall into the mature/macro-driven bucket with low domestic footage growth (which increases dependence on the economy for their success). Looking into 2012, our outlook for discretionary retail is challenged with the dominant bull or bear points being either 1) macro-related or 2) related to Congress and the EU. We believe the consumer is likely to remain conservative (and retrench after Christmas) given little need to shop (particularly in 1Q), a stretched savings rate, and likely mounting credit card bills. Furthermore, job creation remains lackluster with nonfarm payrolls posting an anemic 1% y/y growth rate since early 2011. While the worst of the de-leveraging process is likely past, it isn’t over and we don’t expect acceleration in spending trends, particularly for the low-end consumer, until more jobs are created. Overall, the uncertainties weighing on economic growth globally temper our outlook and we prefer to begin the year with a relatively defensive posture.

Best Idea – Costo (COST)

Given this backdrop, two of the most highly sought-after attributes a company can have include the ability to drive sales and visibility into earnings. COST continues to have strong sales momentum due to 3-4% store growth and ~4% traffic growth driving market share gains. The latter is a function of impressive merchandising, a value-oriented consumer, roughly half of the mix being consumable, and a higher-end customer base (household income of $96k per year). We forecast continued solid results with low- to mid-single-digit core comp growth expected for the foreseeable future. In addition to sales growth driving earnings, membership fees provide both stability and long-term visibility to EBIT margins, while the recently announced membership fee increase provides visibility into incremental earnings growth over the next eight quarters (~$0.08 in FY12E and ~$0.17 in FY13E or 3% and 4-5% incremental earnings growth, respectively).

Net-net, we believe these factors should support a high multiple and a “buy the dips”philosophy. We particularly favor COST in early 2012 when the consumer is likely to pause after what we expect to be a strong holiday period (when retail industry sales are expected to be up nearly 4%). Our Dec-12 price target of $94 is based on a multiple of ~21x our fiscal 2013 EPS forecast of $4.44 (equating to ~9x on an EV/EBITDA basis).

Costco Wholesale Corporation (COST) – Overweight – Dec 12 Price Target: $94



$88.06 $88.68 $68.53 Aug $3.30 $3.86 $4.44 22.8 19.8 $38,162 Risks: Consumers limiting spending on more discretionary product categories, rising product cost inflation and increased competitive pricing, decreased SG&A leverage, deterioration in membership renewal rates, missed or poorly executed store opening plans, high exposure to California.

Christopher Horvers, CFA AC

(1-212) 622-1316

[email protected]

Aaron Goldstein

(1-212) 622-1336

[email protected]

Rachel Stubins

(1-212) 622-4245

[email protected]

Mark Becks

(1-212) 622-5265

[email protected]


Christopher Horvers, CFA

Advance Auto Parts, Inc. AAP UW

AutoZone, Inc. AZO N

Bed Bath & Beyond BBBY N

Best Buy BBY N

Costco Wholesale Corporation COST OW

Dick's Sporting Goods DKS OW

Genuine Parts Company GPC N

GNC Holdings GNC OW

Lowe's Companies, Inc. LOW N

O'Reilly Automotive ORLY UW

Office Depot ODP OW

OfficeMax Inc. OMX N

PetSmart, Inc. PETM N

RadioShack RSH N

Staples SPLS OW

Target Corporation TGT N

The Home Depot HD OW

Tractor Supply TSCO N

Vitamin Shoppe, Inc VSI OW

Wal-Mart Stores, Inc. WMT OW

Williams-Sonoma, Inc. WSM N

Aaron Goldstein

Cabela's Inc. CAB UW

hhgregg HGG N


US Year Ahead 2012

99


Retailing – Specialty

Cotton May Offer Some Relief in 2H12, But Generally Expect More of the Same Trends

We believe that many of the same issues that impacted 2011 are set to continue to affect our coverage universe again in 2012. On the demand side, we still see a weak consumer confidence/employment backdrop for the lower-income demographics, a continuation of shopping closer to need, and uncertainty around fashion newness. On the supply side, the competitive landscape hasn’t seen much relief in the past year and there has actually been some new store growth from select international retailers looking for growth in the United States. This backdrop continues to set up a highly promotional environment in which softline apparel retailers in the missy, junior, and kids’ space could continue to be challenged to improve returns. Among our coverage universe, specialty retailers that cater to the underserved men’s/young men’s market, and those that sell accessories and handbags or other categories like cosmetics and intimates should be better positioned.

For the softline retailers as a group, some benefit should come in 2H12 as they start to feel the relief of lower cotton costs begin to hit their P&L. Labor costs are likely to remain elevated and freight costs are also unknown, but the fabric side of the equation could lead to high-single-digit declines in product costs versus 2H11. Beyond sourcing relief, the sector continues to look for growth to come from expansion into Europe, Asia, and Canada as those markets have so far shown to be higher-margin projects than additional openings in the saturated U.S. market. As U.S. growth continues to slow, the retailers are faced with the increasing burden of putting their volatile free cash flow to use. We also expect channel mix—growth of ecommerce and factory outlet—combined with the closing of some underperforming mall-based stores—to be another potential way for retailers to improve returns.

Best Idea – Ulta Salon, Cosmetics & Fragrance (ULTA)

We believe Ulta Salon, Cosmetics & Fragrance (ULTA) remains one of the few retailers that can more than double its 450-store base given favorable industry trends and a strong competitive position. ULTA should continue to benefit from market share shifts in the beauty industry away from traditional players and toward specialty stores, as the company offers one of the broadest product selections in beauty retail—a major competitive advantage, in our view—alongside its salon service offerings. The continued additions of new prestige brands, an improved loyalty program, and increased recognition of ULTA as a beauty destination (continued rollout of marketing events) should support comp growth going forward. Another positive in the ULTA story is the fact that new stores open at 30% lower volume than mature stores, giving the store base a natural “maturation curve” to help support 3-5% annual comp growth.

The company had stated that its long-term target is to achieve mid-teen operating margins over the next 3-4 years (vs. 8.0% in 2010) with the potential for $4.00-5.00 in EPS power over the next 3-4 years (~30% CAGR). As a result, ULTA remains one of the most compelling growth stories in retail, in our view.

Ulta Salon, Cosmetics & Fragrance (ULTA) – OW – Dec 12 Price Target: $80



$72.93 $75.70 $32.01 Jan $1.17 $1.80 $2.30 40.5 31.7 $4,514 Valuation: Target reflects 35x 2012E EPS, given company’s potential to generate 25-35% bottom-line growth for next several years. Risks: Ability to open new stores on timely basis, traffic levels, industry-wide level of promotions, departure of CEO having an impact on supply chain and relationships withspecific brand-name vendors.

Brian J. Tunick AC

(1-212) 622-6449

[email protected]

Ike Boruchow, Jr.

(1-212) 622-9758

[email protected]

Simeon Siegel, CFA

(1-212) 622-0149

[email protected]


Brian J. Tunick

Abercrombie & Fitch ANF N

Aeropostale ARO N

American Eagle Outfitters AEO N

Ann Taylor Stores ANN N

Ascena Retail Group Inc ASNA N

Chico's FAS, Inc. CHS OW

Citi Trends, Inc. CTRN N

Coach, Inc COH OW

Francesca's Holdings Corp FRAN N

JoS. A. Bank Clothiers Inc JOSB N

Limited Brands, Inc. LTD OW

Men's Wearhouse MW OW

Ross Stores ROST N

rue21, inc. RUE OW

The Buckle Inc. BKE N

The Children's Place PLCE N

The Gap, Inc. GPS N

The Wet Seal, Inc WTSLA OW

Tiffany & Co TIF N

TJX Companies TJX N

Ulta Salon, Cosmetics & Fragrance, Inc. ULTA OW

Urban Outfitters URBN OW

Ike Boruchow, Jr.

Fossil, Inc. FOSL OW

Signet Jewelers SIG OW

Vera Bradley VRA N


US Year Ahead 2012

100


Tobacco

Continuing to Deliver

The tobacco sector continues to offer scope for material, consistent profit growth over the medium term, we believe. As a result of consolidation in the global market there are just four major players, while in the U.S. the industry is dominated by just three players. Each of these companies has a stated target of consistently delivering medium-term profit growth to shareholders, driven by a focus on value growth rather than volume growth. In addition, each of the industry majors has an active share repurchase program, delivering further value to shareholders in addition to already generous dividends and ensuring that balance sheets do not strengthen further.

Pricing remains the key driver of industry profitability, with the industry benefiting from higher rates of tax and duty which mask underlying manufacturers’ pricing decisions. With duty approximating 65% of retail prices, a manufacturer’s price increase of 5% implies a retail price increase of only around 2%. With the major manufacturers focusing on product innovation—in packaging, filters, slims,superslims, blends, etc.—price has become a much reduced source of competition.

Although the sector has proven recession resilient it has not been wholly recession proof. As conditions improve we expect to see a lessening of downtrading pressures in developed markets and a stronger trend of uptrading in developing markets.

Philip Morris International (PM) should continue to deliver its stated target for constant-currency EPS growth of 10-12% in 2012, helped by its continuing share repurchase program but mainly as a result of the favorable industry dynamics discussed above.

In the U.S. domestic market we expect to see further evidence of a firm pricing agenda from the industry. For 2011 we estimate underlying tobacco consumption will have declined by only 2%, with a similar decline likely in 2012. With the benefit of pricing, the industry should be able to deliver mid-single-digit operating profit growth, and with the benefit of share repurchases (roughly $1bn per company) mid-to high-single-digit EPS growth.

Best Idea – Reynolds American (RAI)

Reynolds American (RAI) remains our top pick in the sector given the expectation of mid- to high-single-digit EPS growth over the medium term. This expectation is driven by our view that the company can deliver modest revenue growth from its portfolio of brands; leverage and reduce its cost base; and repurchase its equity (having announced a $2.5bn program in November 2011 to run over the next two and a half years). In addition, the company stands to benefit more than peers from a resolution to ongoing negotiations with respect to overpaid Master Settlement Agreement sums, offering further upside to estimates, we believe.

Reynolds American (RAI) – Overweight



$41.63 $42.18 $31.54 Dec $2.49 $2.66 $2.84 15.7 14.7 $24,267

Rae Maile AC

(44-20) 7155 6102

[email protected]

J.P. Morgan Securities Ltd.

Altria Group MO OW

Lorillard Inc LO N

Philip Morris International PM N

Reynolds American RAI OW


US Year Ahead 2012

101


Electric Utilities & Independent Power Producers

Electric Utilities Likely Underperform if Macro Call for Growth and Return to Equities Is Right

Growing economy likely pressures utility stocksElectric utility stocks were one of the best-performing sectors in 2011 as the UTY index gained 10.3% through 12/6/11 versus flat performance for the S&P 500 index. We believe the strong utility stock performance was driven by investors’ flight to the stable EPS profile of the regulated utility model along with attractive dividend yields. However, J.P. Morgan expects GDP growth to accelerate as 2012 progresses. If this happens, we expect investors to seek out stocks with greater leverage to the economic cycle, resulting in utility stocks underperforming.

Return to U.S. equities would also pressure utility stocksJ.P. Morgan’s U.S. Equity Strategist expects investors to return to U.S. equities in 2012. We believe utility stocks will also underperform if this occurs. Electric utility stocks have the second-highest fund flows of U.S. equities as a percentage of starting assets through November. We expect this trend to reverse if investors revisit U.S. equities more broadly as a return to U.S. equities likely signifies investor interest in stocks leveraged to an improving economic climate.

Valuations and fund flows might offset some pressureWe believe two factors might offset some of the pressure on utility stocks if J.P. Morgan’s economic outlook is accurate.

Yield spread versus the U.S. 10-year Treasury is attractiveElectric utility shares are near all-time-high valuations on a relative P/E multiple versus the S&P 500, trading at ~125% of the S&P 500 P/E multiple (the average is ~85%). However, the yield spread versus the U.S. 10-year Treasury is at historically attractive levels. We believe that the attractiveness of the yield spread may moderate some utility underperformance as declines in utility stock prices only amplify the attractiveness of the yield spread.

Fund flows may be slow to reverseElectric utilities have the second-highest fund inflows of U.S. equity sectors as a percentage of starting assets this year. Based on our conversations with dedicated utility fund managers, it appears that much of the fund flows are driven by retail investors seeking relative security and yield. We believe these investors may be slower to rotate out of utility funds, and thus moderate some of the pressure on utility stocks in the event that utility stocks start to come under pressure.

Best Idea – NRG Energy (NRG)

NRG Energy (NRG) matches a naturally short retail supply position with a naturally long power plant fleet. We project this drives stable EBITDA and FCF, which represents a FCF yield of ~20% today. The company should complete a balance sheet restructuring in 1Q12 that likely frees the company to buy back 20% or more of its shares outstanding. We also expect the stock to offer some upside if the macro environment discussed above occurs as NRG would benefit from higher power sales volumes.

NRG Energy (NRG) – Overweight – Dec 12 Price Target: $33



$19.37 $25.66 $18.22 Dec $1.84 $1.25 $1.75 15.5 11.1 $4,454 Valuation: Target reflects comparable asset transactions. Risks: Collapse in commodity costs or spike in fuel costs, failure to redeploy FCF in attractive investments or spending significant capital on pursuing construction of nuclear plant expansion, currently suspended.

Andrew Smith AC

(1-713) 216-7681

[email protected]

Christopher Turnure

(1-212) 622-5696

[email protected]

Michael Dandurand

(1-212) 622-6432

[email protected]


AGL Resources AGL (rs)

Ameren Corp AEE UW

American Electric Power AEP N

Black Hills Corp. BKH N

CenterPoint Energy CNP OW

CMS Energy Corp CMS OW

Consolidated Edison ED N

Constellation Energy Group CEG (rs)

Covanta Holding Corp. CVA OW

Dominion Resources D N

Duke Energy Corp. DUK (rs)

Dynegy, Inc. DYN N

Edison International EIX N

Entergy Corp. ETR (rs)

Exelon Corp. EXC (rs)

Great Plains Energy GXP N

Integrys Energy Group TEG

ITC Holdings ITC (rs)

NextEra Energy Inc. NEE OW

Northeast Utilities NU N

NRG Energy NRG OW

NV Energy Inc. NVE OW

Pepco Holdings POM N

PG&E Corp. PCG N

Portland General Electric Co. POR N

Progress Energy PGN (rs)

Sempra Energy SRE N

Southern Company SO N

UIL Holdings Corporation UIL N

Vectren Corp VVC UW

Westar Energy Inc WR N

Wisconsin Energy Corp WEC N

Xcel Energy XEL N

En

erg

yThis document is being provided for the exclusive use of JOHN CULHANE at PENNANT MANAGEMENT, INC.

US Year Ahead 2012

102


Energy MLPs

Low Interest Rates and Potential Market Turbulence Enhance MLP Value Proposition

The quest for yield is supporting MLP valuations. In this low interest rate environment, we believe MLPs offer an attractive value proposition on a relative basis. MLPs have historically traded at an average spread to the 10-year Treasury of ~300bps; the current 6.3% yield on the Alerian MLP Index represents a ~430bp spread over the 10-year Treasury’s 2.0% yield. While rising interest rates will be an issue at some point in the future, Michael Feroli (J.P. Morgan’s U.S. Economist) does not expect the Fed to increase rates during 2012 and Terry Belton(J.P. Morgan’s U.S. Fixed Income Strategist) forecasts a modest increase in the 10-year (exiting 2012 at 2.5%). Though we do not expect MLPs to fully converge towards the historical spread (which would drive ~22% price appreciation), we believe current yields of 6-7% combined with median distribution growth of ~6% could lead to low-double-digit total returns without any revaluation required. As we view energy infrastructure MLPs as a play on energy demand (which exhibits low elasticity), we view these returns as particularly attractive in a choppy market.

Secular trends in upstream development driving demand for new energy infrastructure. The secular trend towards liquids-rich production should continue to drive significant demand for new energy infrastructure. As producers focus on oil and liquids-rich production in the Eagle Ford, Bakken, Marcellus, and other emerging plays, new production likely will overwhelm existing infrastructure capacity and require new midstream buildout. MLPs appear well positioned to capitalize on such opportunities, allowing accelerating distribution growth in 2012.

Midstream consolidation is fueling distribution growth. With supportive capital markets and continued low interest rates, we expect to see elevated M&A activity in the midstream space next year. While we would not rule out more transactions whereby MLPs acquire C-Corp brethren in the quest for growth (KMP/EP and ETE/SUG), we think consolidation among MLPs is more likely. After multiple LP/GP mergers over the past few years, we believe the MLP space is ripe for consolidation as larger players acquire MLPs without a GP. Buckeye Partners, one of the two MLPs under coverage without a GP, screens cheaper than peers on 2013Emetrics, as BORCO expansions come online, and could provide asset diversification and strategic foothold in the northeast.

Best Idea – Buckeye Partners (BPL)

Our top pick is Buckeye Partners (BPL). Buckeye has undertaken several key initiatives to transform the partnership, such as increasing asset utilization (Farm and Home acquisition), lowering BPL’s cost of equity (acquiring the GP), and entering new complementary growth markets (BORCO acquisition). We believe that the market does not fully appreciate BPL’s transformation and that management is actively looking to capitalize on Buckeye’s lower cost of capital and new organic growth opportunity set. We expect projects coming on line will drive increasing distribution growth rates during 2H12, which we expect the market to reward with a higher valuation (lower yield), thereby driving attractive price appreciation.

Buckeye Partners L.P. (BPL) – Overweight – Dec 12 Price Target: $74Price 52-Wk Range FY EPS P/E Mkt Cap


$63.40 $68.92 $54.51 Dec $2.46 $2.79 $3.43 22.7 18.5 $5,449 Valuation: Target reflects DCF using 1.25% terminal growth rate and required rate of return of 8.75%. Risks: Execution risk at BORCO, capital indigestion weighing on near-term performance, acquisition risk.

Jeremy Tonet AC

(1-212) 622-4915

[email protected]

Alistair J Meadows

(1-212) 622-6442

[email protected]

Tim Fisher

(1-212) 622-5403

[email protected]


Buckeye Partners L.P. BPL OW

El Paso Pipeline Partners L.P. EPB OW

Enbridge Energy Partners, L.P. EEP OW

Energy Transfer Partners, L.P. ETP N

Enterprise Products Partners, L.P. EPD OW

Gibson Energy Inc. GEI.TO N

Kinder Morgan Energy Partners L.P. KMP N

Magellan Midstream Partners L.P. MMP N

Nustar Energy L.P. NS UW

Oiltanking Partners, L.P. OILT OW

ONEOK Partners, L.P. OKS N

Plains All American Pipeline, L.P. PAA OW

Williams Partners, L.P. WPZ N


US Year Ahead 2012

103


North American Integrated Oils & Major Producers

Will Value Work in 2012? Recommending OW-Rated Nexen as Top Pick (Again)

As we look ahead to 2012, we take a relatively longer view on investing in the sector, and maintain our stance that the better value lies in the higher-beta, riskier, and more volatile names within our coverage. Although uncertainty seems to dominate the overall investment mood, and we acknowledge a macroeconomic outlook shadowed by external (Europe) and internal (domestic fiscal policy) risks, an equity market outlook that suggests a wide range of potential outcomes, and a commodity outlook calling for near-term weakness in the energy and broader commodity space, we believe capital is best put to work over the course of 2012 in names offering a combination of strong potential upside, portfolio growth, oil price leverage, and catalysts, especially given our view that crude oil will hold between $110/bbl and $120/bbl in 2H12. At the risk of being repetitive, we are again selecting Overweight-rated NXY as our top pick for the year ahead.

Where to go when the defensive positioning has overstayed its welcome? As we have stated in recent research, we believe investors putting capital back to work in the sector will be more inclined to return to names offering a combination of attractive upside, expanding returns, and growing portfolios, but with some level of defensiveness and attractive dividend yield, and a handful of potentially favorable catalysts to focus investor attention on the underlying portfolios.

What happens when the buybacks stop? According to our Equity Strategy team, corporates themselves have been the incremental buyers of stocks, with $3 of buybacks for every $1 of mutual fund flows. In our view, the shares that have performed courtesy of a large boost from share repurchases may well be on an unsustainable share price trajectory; that is, if repurchases are a symptom of corporates’ reluctance to embark on large-scale capital investments in a period of economic uncertainty, then an improving economic outlook that reduces uncertainty and encourages investment may well do so at the expense of future buybacks, removing one of the elements of share price support.

Best Idea – Nexen (NXY)

We are again selecting Overweight-rated Nexen (NXY) as our top pick for the year ahead. We believe NXY offers a rich catalyst slate as new volumes from the Usan project come online in 1H12, delivering higher margins and loftier cash flows; exploration and appraisal activity continues, especially in the Gulf of Mexico and West Africa; production reliability improves at Long Lake and Buzzard; and investors move past the overhangs that have plagued NXY’s share price performance in the last 12 months (down 29% vs. S&P 500 +3% and WTI +13%). Although NXY’s below-market dividend yield (1.3%) is unlikely to attract capital alone, we believe the combination of upside, catalysts, and potentially changing investor sentiment underpin the outlook for 2012. With NXY shares offering >90% potential upside to our C$31/share price target, the highest in its peer group, we believe NXY is well positioned to outperform peers.

Nexen (NXY) – Overweight – Dec 12 Price Target: C$31



C$15.92 C$27.11 C$14.75 Dec C$1.16 C$1.83 C$2.79 8.7 5.7 C$8,396Valuation: Target reflects DCF, based on our estimate of segment-level cash flows discounted at a WACC of 7.8%. Risks: Continued challenges at Long Lake, oil price retreat, unsuccessful exploration, outside-operated project slate, currency exchange rate risk.

Katherine Lucas Minyard, CFA AC

(1-212) 622-6402

[email protected]

Igor Grinman

(1-212) 622-6596

[email protected]


Canadian Natural Resources CNQ.TO N

Cenovus Energy CVE.TO N

Chevron Corp CVX UW

ConocoPhillips COP (rs)

Exxon Mobil Corp XOM UW

Hess HES OW

Husky Energy HSE.TO UW

Lone Pine Resources LPR OW

Marathon Oil MRO N

Murphy Oil MUR N

Nexen NXY.TO OW

Occidental Petroleum OXY OW

Suncor Energy SU.TO N

Talisman Energy TLM.TO OW


US Year Ahead 2012

104


Oil & Gas Exploration & Production

Cautious Economic View Leads to Conservative E&P Investing

Consistent with our economics team, we are cautious on the U.S. and global economy and, therefore, would recommend investors position themselves conservatively. During the 2008-2009 financial crisis and the economic stresses of 2H11, the large-cap E&Ps outperformed the mid-caps, which outperformed the small caps. We think investors generally should orient their E&P investing towards the more defensive names: larger cap with good balance sheets and efficient cost structures.

Our favorite large cap is EOG Resources (Overweight rating, Dec 12 PT of $144.50), but two mid-caps appear to offer much more stock price upside potential and also have good balance sheets and efficient cost structures. Therefore, we highlight those names as our favorite stocks for 2012.

Best Idea – Pioneer Natural Resources (PXD)

Pioneer Natural Resources (PXD) is one of our best ideas for 2012. On a NYMEX NAV basis, the company offers over 70% upside from the current stock price. One operational catalyst stands out: drilling results from its new Horizontal Wolfcamp Shale play. If Pioneer can deliver strong well results, the stock likely will perform well. Overall, PXD is growing at ~20%. In recent years, PXD has been one of the most disciplined companies (i.e., shutting down operations when costs got out of hand) and the company’s balance sheet is strong.

Pioneer Natural Resources (PXD) – Overweight – Dec 12 Price Target: $167.50



$94.40 $106.07 $58.63 Dec $1.80 $3.98 $5.10 23.7 18.5 $11,503 Note: Target based on our estimate of NAV, which we calculate using a DCF model. Risks: Commodity price volatility, oilfield service cost inflation, oilfield leverage to crude, results from plays.

Best Idea – Denbury Resources (DNR)

Denbury Resources (DNR) is one of our best ideas for 2012. The company is among the oiliest in our coverage group (93% of current production is oil). Since trough E&P stock prices in March 2009, DNR is up only 52% versus the EPX which is up 151% (WTI oil was close to $40/Bbl in March 2009 vs. $100 today). Using NYMEX futures, the stock offers some of the best upside to NAV among all E&Ps. As the company also thinks it is undervalued, it recently instituted a share repurchase program and budgets around $250mm of buybacks for 2012. Despite revisions to the timing and/or the magnitude of production ramp at two of its EOR fields, the data suggest that DNR generally is on track in the development of its EOR projects. Operational catalysts include production response from its Hastings and Oyster Bayou EOR fields (commencing production in the next few months) and the performance of its other EOR fields.

Denbury Resources (DNR) – Overweight – Dec 12 Price Target: $28.50



$16.86 $26.03 $10.20 Dec $0.61 $1.28 $1.33 13.2 12.7 $6,603 Note: Target based on our estimate of NAV, which we calculate using a DCF model. Risks: Commodity price volatility, oilfield service cost inflation, leverage to crude, performance of CO2 fields and EOR fields.

Joseph Allman, CFA AC

(1-212) 622-4864

[email protected]

Jeanine Wai

(1-212) 622-6489

[email protected]

Jessica Lee

(1-212) 622-9812

[email protected]


Anadarko Petroleum APC OW

Apache Corporation APA OW

Approach Resources AREX N

ATP Oil & Gas ATPG UW

Berry Petroleum BRY OW

Brigham Exploration Company BEXP N

Cabot Oil & Gas COG N

Carrizo Oil & Gas Inc. CRZO N

Chesapeake Energy CHK N

Cimarex Energy Co. XEC OW

Cobalt International Energy CIE OW

Concho Resources, Inc. CXO N

Continental Resources, Inc. CLR N

Delta Petroleum Corporation DPTR UW

Denbury Resources Inc. DNR OW

Devon Energy DVN OW

El Paso Corp. EP OW

EOG Resources, Inc. EOG OW

EQT Corporation EQT OW

EXCO Resources, Inc. XCO N

Goodrich Petroleum GDP OW

McMoRan Exploration Company MMR OW

Newfield Exploration Company NFX OW

Noble Energy NBL OW

PDC Energy PETD OW

Penn Virginia Corporation PVA OW

PetroQuest Energy, Inc. PQ OW

Pioneer Natural Resources PXD OW

Plains Exploration & Production PXP OW

QEP Resources QEP N

Quicksilver Resources Inc KWK N

Range Resources Corp RRC OW

SandRidge Energy Inc. SD N

SM Energy SM N

Southwestern Energy Company SWN OW

Swift Energy Company SFY N

Ultra Petroleum Corp UPL N

Venoco, Inc. VQ UW

Whiting Petroleum Corporation WLL N

Williams Companies WMB (rs)


US Year Ahead 2012

105


Oilfield Services & Equipment

North America Is Stronger Than You Think

The Oilfield Services & Equipment sector is unlikely to outperform the broader market until two things occur: global macro issues abate and international upstream markets start growing again . . . both of which should happen by mid-2012. Beyond the next few quarters, we remain incredibly bullish on the fundamentals of the group, and continue to believe this group will outperform through the cycle based on asimple premise: each barrel of oil produced in the foreseeable future will cost more than the last. Global oil production is becoming increasingly service intensive, requiring ever-greater scale and the latest technology, often applied in harsh environments. Whether exploring and developing from oil and gas fields in 10,000ft of water or unlocking the potential of unconventional resources in shales, service companies should reap the benefits of increased spending with improving pricing.

We take a portfolio approach to our sector, viewing large-cap services, offshore drillers, and capital equipment companies separately, as each has its own set of drivers and trades distinctly. We believe large-cap service companies are most attractive on valuation, trading about 40% below estimated fair value on normalized EPS and about $20/bbl below WTI oil prices using historical regressions. Our concern is whether this valuation gap can close with the overriding macro issues and the persistently weak international markets. We don’t think so, instead favoring those names with the greatest potential for upside to earnings. That leads us to the North American land market, which has once again been left for dead . . . we couldn’t disagree more.

Best Idea – Halliburton (HAL)

Halliburton (HAL) is our top pick within the large-cap service sector, heavily discounted because of its high exposure to North America (60% of ’12E revenue). Yes, this market is more cyclical than the others, but is by no means poised to turn down, in our view. North America is an oil market now, for which 60% of rigs are now drilling, compared to 83% drilling for natural gas at the last peak in 2008. We are forecasting the U.S. land rig count to grow 10% in 2012, with service intensity considerably higher than in 2008 (monthly revenue/rig). All the growth will be coming from horizontal oil and liquids plays that should be largely insensitive to oil prices above $70/bbl, while 50% of operators are major oil companies or large-cap E&Ps (i.e., steady spenders). We expect 2012 EPS estimates to have upside risk as the Street becomes convinced in the strength of the North American market, along with multiple expansion as the offshore and international land markets contribute more materially as the year progresses.

Halliburton (HAL) – Overweight – Dec 12 Price Target: $58



$35.57 $57.77 $27.21 Dec $2.06 $3.34 $4.45 10.6 8.0 $32,730 Valuation: Target reflects 13x 2012E EPS and assumes stock trades at a smaller discount to the group average due to its commanding position in North America and progress in its international operations. Risks: Potential and uncertain liability from involvement in Macondo blowout, sustainability of North American onshore recovery, biggest consensus long on Street, market consolidation putting HAL’s advantage in unconventional resources at risk, possibility of a large acquisition pressuring shares.

J. David Anderson, PE, CFA AC

(1-212) 622-6684

[email protected]

Samantha Hoh, CFA

(1-212) 622-5248

[email protected]

William S Thompson

(1-212) 622-9978

[email protected]


Baker Hughes BHI OW

C&J Energy Services CJES OW

Cameron Int'l CAM OW

Complete Production Services CPX (rs)

Diamond Offshore DO UW

Dresser-Rand DRC OW

Dril-Quip DRQ N

Ensco plc ESV N

Exterran Holdings EXH N

FMC Technologies FTI OW

Halliburton HAL OW

National Oilwell Varco NOV OW

Noble Corp. NE OW

Rowan Companies RDC OW

Schlumberger SLB OW

Transocean RIG N

Weatherford International WFT N


US Year Ahead 2012

106



US Year Ahead 2012

107


Asset Managers, Brokers & Exchanges

Asset Managers Offer Opportunities; Exchanges Could Underperform in 2012

Asset Managers: The 2012 outlook is for modestly increasing earnings on what are still uncertain equity market conditions. Weak markets in 2H11 depressed asset levels and volatility acted as a deterrent to retail and institutional sales. As a result, asset managers experienced meaningful multiple contraction in 2011. However, we believe that valuations are especially inexpensive and are poised to bounce back if fundamentals improve slightly. As an investor, we recommend being positioned in asset managers that are especially inexpensive and are generating positive sales and good relative performance. Invesco (IVZ) fits these criteria. Franklin Resources (BEN) is the one to avoid, in our view, as its flagship Templeton Global Bond fund goes out of favor due to poor currency investments and negative returns.

Exchanges: Exchanges posted record volume levels and earnings in 3Q and are expected to report better-than-usual earnings in 4Q, as uncertainty continues to plague the equity markets. Record volume levels and consolidation among the exchanges helped them outperform their financial sector peers in 2011. However, 2011 saw a number of macro events that are not expected to repeat in 2012 and, as a result, volumes are likely headed lower in 2012. While exchanges still act as defensive stocks in an uncertain market, we believe they will underperform the financial sector in 2012. Our top picks for 2012 are Intercontinental Exchange (ICE) and FXCM.

Best Ideas – Invesco Ltd. (IVZ)/Franklin Resources (BEN)

For the short to medium term, the relative value pair Invesco Ltd. (IVZ) and Franklin Resources (BEN) is our favorite idea. Invesco remains on the road to a sales recovery after acquiring and merging Van Kampen funds. With its relativelyinexpensive valuation, improvement in fund performance, outstanding performance of its UK- and Canada-based funds, and potential for added distribution to drive incremental sales in the coming quarters, we continue to see the stock as attractive.

On the other hand, Franklin’s leading asset-gathering funds, led by the Templeton Global Bond fund, continue to meaningfully underperform peers as currency investments (both long and short) are working against the funds. We are concerned that the Global Bond fund will experience flat sales or redemptions as the one-year Lipper performance has now dipped to bottom quartile. Even if the Global Bond fund does not wind up posting significant redemptions, a slowdown in global fixed-income fund sales could result in overall net outflows for Franklin, something that was not expected when Global Bond fund was gathering about $10bn of sales per quarter over the last few quarters.

Invesco Ltd. (IVZ) – Overweight – Dec 12 Price Target: $26



$20.67 $27.50 $14.52 Dec $1.38 $1.64 $1.76 12.6 11.7 $9,322 Valuation: Target reflects 13x 2013E EPS, as valuation should recover as asset managers recuperate after a particularly weak 3Q. Risks: Market downturn, fee rate falling, meaningful appreciation of USD.

Franklin Resources (BEN) – Underweight – Dec 12 Price Target: $111



$100.52 $137.56 $87.71 Sep $8.64 $8.92 $9.30 11.3 10.8 $21,853 Valuation: Target reflects 12x C2013E EPS, a continued discount as sales continue to slow down. Risks: Aggressive deployment of cash on balance sheet, tax repatriation legislation, positive turn in sales of global equity funds and global fixed income funds.

Kenneth B. Worthington, CFA AC

(1-212) 622-6613

[email protected]

Rahul Nevatia

(1-212) 622-6454

[email protected]


Apollo Global Management APO OW

Artio Global Investors ART N

BM&F Bovespa BVMF3.SA OW

CBOE Holdings CBOE N

Charles Schwab SCHW OW

CME Group Inc. CME OW

Eaton Vance Corp EV N

Evercore Partners Inc. EVR N

Federated Investors, Inc. FII UW

Franklin Resources BEN UW

FXCM FXCM OW

Invesco Ltd. IVZ OW

Investment Technology Group ITG OW

Janus Capital Group JNS UW

Knight Capital Group KCG N

LPL Investment Holdings LPLA N

NASDAQ Stock Market NDAQ

NYSE Euronext NYX (rs)

Och-Ziff Capital Management OZM OW

Penson Worldwide PNSN N

Pzena Investment Management PZN N

T. Rowe Price Group, Inc TROW OW

The Intercontinental Exchange ICE OW

Fin

ancia


US Year Ahead 2012

108


Banks – Large Cap

Several Headwinds Near Term; Capital Return, Continued Recovery to Help Later in 2012

We expect a slow recovery in the United States and continued economic slowdown in Europe to create some headwinds for bank stocks early in 2012. However, positive results under a very harsh stress test and continued recovery in the U.S. combined with attractive valuations should provide a lift to bank stocks later in the year. Regulatory/political risk will likely remain high because it is an election year. We expect bank earnings to be driven by continued recovery in loan growth, continued but slower-paced improvement in credit costs, and some expense reduction plus benefit to EPS for some banks from share repurchases. These should offset net interest margin pressure, the biggest headwind to banks. We also expect benefit to some U.S. banks from divestitures of U.S. assets by European banks and de novo growth of business lines. Consolidation activity remains sluggish and large deals are unlikely in this environment, in our view. However, continued slow recovery in the U.S. could drive some small bank deals.

The bank sector has lagged recently due to fears about multiple headwinds—U.S.economy, Eurozone, and regulatory/political risk. As a result, the sector remains underowned. Given the uncertainty in the environment, we remain defensively positioned near term and recommend names such as US Bancorp and Wells Fargo due to relatively lower risk, good capital including continued capital return, and some drivers for revenue growth (portfolio acquisitions and growth/expansion of relatively newer businesses). We also expect Citigroup to recover in 2012 as it gets approval to return some capital despite the harsh stress tests. Citi has among the highest capital ratios in our universe. Even under the Fed’s harsh stress test, emerging markets are expected to recover sooner which should be a positive for Citigroup.

Trust and processors: attractive valuations, but some headwinds. We expect trust bank stocks to remain under pressure near term due to pressure on revenues from weak markets and still-high expenses. Absolute low interest rates and legal/regulatory challenges are added headwinds and expense savings are further out.

Best Idea – Citigroup (C)

On a full-year 2012 basis, we recommend Citigroup (C) because it has been overly beaten down due to concerns about weak markets and fallout from the Eurozone including in the emerging markets. However, emerging markets should have a lesser impact and likely quicker recovery from a slowdown. In addition, despite the harsh stress test scenario, we expect C to begin returning capital via share repurchases in 2012 due to its strong capital position. Near term, C stock may remain under some pressure especially due to Eurozone issues. C continues to grow revenues and improve profitability of international revenues, with Asia consumer business reporting positive operating leverage in 3Q11 and Latin America business expected to do so in 4Q11. While growth in emerging markets will lead to higher credit losses, C has improved its risk management over the last few years and we believe losses should be manageable. Valuation remains attractive with C trading at 0.6x tangible book (near low of 0.3x during last recession) and 6.4x 2012E EPS.

Citigroup (C) – Overweight – Dec 12 Price Target: $54Price 52-Wk Range FY EPS P/E Mkt Cap


$29.75 $51.50 $21.40 Dec $3.58 $4.17 $4.65 7.1 6.4 $86,980 Valuation: Target reflects 1x YE12E TBV, a discount to expected peer group multiple of 1.5x. Risks: Regulatory risk, slowdown in global economic growth, risks from government interference, deterioration in credit risk profile, changes in capital structure/adequacy, rating agency actions, performance of equity and fixed income markets.

Vivek Juneja AC

(1-212) 622-6465

[email protected]

John P Grassano

(1-212) 622-5605

[email protected]

Chris K Baydar

(1-212) 622-8115

[email protected]


Bank of America BAC OW

Bank of New York Mellon Corp. BK N

BB&T Corporation BBT N

Citigroup Inc. C OW

Fifth Third Bancorp FITB N

Northern Trust NTRS N

PNC Financial PNC (rs)

Regions Financial RF N

State Street STT N

SunTrust Banks, Inc. STI N

U.S. Bancorp USB OW

Wells Fargo WFC OW


US Year Ahead 2012

109


Banks – Mid- and Small Cap

Risk/Reward Favors Going Long This Crisis; 15% Sector Upside with Many Attractive Plays

With mostly indirect risk from Eurozone, we see 15% upside through 2012. Global markets have seen considerable selling pressure since mid-July largely in response to the Euro debt crisis. While most U.S. mid- and small-cap banks don’t have direct exposure to either Eurozone countries or companies, a global risk-off trade has resulted in a flight to U.S. Treasuries, resulting in a flattening of the yield curve. Coupled with absent loan growth and more banks investing free cash flow into securities, the flattened curve is having a pronounced negative effect on net interest margins. With that said, however, with our average stock down 19% YTD, we believe the coming NIM storm is largely captured in valuations, particularly with the group trading at only 1.37x TBV. Contrasted to the financial crisis of 2008/2009 when many banks were forced to issue stock at historical lows, permanently diluting shareholders, given the indirect risk of the current crisis at hand, many mid- and small-cap banks are now actually buying back small amounts of stock at historical lows—even a small buyback has the potential to materially reduce the share count. Although the fiscal drag is expected to meaningfully detract from U.S. GDP growth in 2012 (could be -150 bps should current benefits expire), through 2012 we see a tremendous amount of uncertainty being lessened in regards to both the Euro debt crisis as well as the U.S. economic outlook. We believe this will open a window for investors to reduce underweight positions in mid- and small-cap banks through 2012.

A shopping list of buying opportunities. With regional bank stocks trading off recent lows, we believe investors will now need to tolerate increased downside risk to position for this longer-term upside potential. Consequently, we believe investors should consider utilizing a buy-on-dips strategy. Given the anticipated fiscal drag in 2012, we suggest a portfolio of niche banks that can capture growth despite tepid macro conditions. In this group, we suggest FRC, SBNY, and SIVB. In the value bucket, we see many attractive values and point o a portfolio of CMA, FHN, KEY, PVTB, and ZION, with FHN our top pick owing to a very inexpensive valuation and multiple earnings levers. For income funds, we suggest FMER given the 4.5% yield.

Best Idea – First Horizon (FHN)

Although we see many attractive values within the mid- and small-cap bank sector, First Horizon (FHN) moves to the top of our list of attractive bank stocks, for the first time. In addition to an inexpensive valuation, with FHN’s stock trading below TBV at 0.85x, we like the multiple earnings levers. While we’ve known about these for some time, we needed to get comfortable on the risk profile at the bank given a sizeable home equity portfolio as well as mortgage putback risk. While credit has now improved for several quarters, in terms of the risk of mortgage putback, we believe the $100mm buyback plan announced in tandem with 3Q earnings was a milestone, given a conservative management team that feels comfortable reducing its strong capital position. In terms of earnings levers, while the stock is inexpensive on “normalized” 2015E EPS of $1.05, excluding mortgage repurchase provisions for 2015E, normalized EPS move to $1.35 (puts stock at 5.7x), and looking to long-term profitability targets could put the stock in the 3.5-4.0x range.

First Horizon (FHN) – Overweight – Dec 12 Price Target: $8.50Price 52-Wk Range FY EPS P/E Mkt Cap


$7.43 $12.67 $5.38 Dec $(0.14) $0.49 $0.40 15.2 18.6 $1,959 Valuation: Target reflects 0.9x TBV, maintaining current discount to peers. Risks: Failure to deliver on previously outlined results, adverse scenario for private label, using excess capital to pay a sharp premium on an acquisition.

Steven Alexopoulos, CFA AC

(1-212) 622-6041

[email protected]

Preeti S Dixit

(1-212) 622-9864

[email protected]


Astoria Financial AF N

BancorpSouth BXS UW

CapitalSource CSE N

City National Corp CYN OW

Comerica Incorporated CMA OW

Cullen/Frost Bankers Inc. CFR N

First Horizon National FHN OW

First Republic FRC OW

FirstMerit Corporation FMER OW

KeyCorp KEY OW

M&T Bank MTB N

MB Financial MBFI N

New York Community Bank NYB N

People's United Financial PBCT N

PrivateBancorp, Inc. PVTB OW

Signature Bank SBNY OW

Susquehanna Bancshares SUSQ (rs)

SVB Financial SIVB OW

Synovus Financial Corp. SNV N

TCF Financial Corporation TCB

Trustmark Corporation TRMK N

Umpqua Holdings Corporation UMPQ OW

Valley National Bancorp VLY N

Washington Federal, Inc. WFSL N

Webster Financial Corporation WBS N

Zions Bancorporation ZION OW


US Year Ahead 2012

110


Insurance – Life

Macro Factors to Drive Near-Term Performance, But Long-Term Risk-Reward Is Favorable

Our outlook for the life insurance sector is positive. While near-term stock performance is likely to be heavily dependent on moves in interest rates and the equity market, operating fundamentals are relatively healthy. Even if the current rate environment persists, we expect the group to generate a 10%+ ROE for the foreseeable future, and sales and net flows in most products are recovering. In addition, most companies have excess capital, and we expect management teams to continue repurchasing shares and raising dividends despite the macro uncertainty.

Insurers’ balance sheets are better positioned to withstand poor equity and credit markets than in 2008-2009. Capital levels have steadily risen over the past few years (RBC 422% at YE10 vs. 370% at YE07). Also, insurers have increased holding company cash and reduced reliance on short-term funding. Investment portfolio risk seems manageable with reduced exposure to structured securities and minimal European holdings. Insurers also have more extensive hedging programs, although prevalence of equity market and interest rate guarantees remains a concern.

Sales outlook mixed by product, but pricing trends are generally improving. We expect individual life sales to continue recovering, helped by new products and stable pricing. Sales of variable and indexed annuities should also rise at a healthy rate despite the weak market. On the other hand, top-line growth in group benefits (group life and disability) and retirement plans remains pressured by tepid employment growth. Fixed annuity sales are also likely to be pressured by low interest rates. Competition in most products appears rational, and we believe insurers should be able to raise rates to help offset lower investment portfolio yields.

Sustained low interest rates are our primary fundamental concern. While declining yields will pressure investment income, insurers have several levers to offset the drag on earnings, including raising prices and reducing crediting rates. In addition, we do not anticipate significant near-term balance sheet charges (reserve increases or DAC and goodwill impairments) for most insurers related to low rates.

Risk-reward appears attractive given current valuations. The life group is currently trading at roughly 0.8x BV (ex. AOCI), well below what we consider to be fair value based on our projected returns. In our view, if the sector can earn a 10% ROE, the group should trade close to book value. As a result, we expect multiples to expand as fears about insurers’ ability to withstand low interest rates dissipate.

Best Idea – Prudential Financial (PRU)

PRU is our top pick as we project an improving ROE, above-average EPS growth, and healthy operating trends will drive upside in the stock. We project returns to improve from 10.1% in 2011 to 11.5% in 2012 and 12.4% in 2013 as a result of organic growth, capital deployment, and accretion from the Star/Edison acquisition. In addition, PRU is generating robust sales and flows in its international insurance, annuities, and asset management businesses, which should enable the company to generate double-digit EPS growth for the next few years.

Prudential Financial (PRU) – Overweight – Dec 12 Price Target: $66Price 52-Wk Range FY EPS P/E Mkt Cap


$51.41 $67.52 $42.45 Dec $6.90 $6.20 $6.95 8.3 7.4 $24,985 Valuation: Target reflects 1.1x YE2012E BV ex. AOCI (50% weight), 0.9x YE2012E total BV (25% weight), 8.0x 2013E EPS (25% weight). Risks: Accretion from Star/Edison below guidance, sizable variable annuity heding loss, further deterioration in disability margins.

Jimmy S. Bhullar, CFA AC

(1-212) 622-6397

[email protected]

Erik J. Bass, CFA

(1-212) 622-2295

[email protected]

Matthew P. Byrnes, CFA

(1-212) 622-0695

[email protected]


Jimmy S. Bhullar, CFA

AFLAC, Inc. AFL OW

American International Group AIG N

Assurant, Inc. AIZ N

Genworth Financial, Inc. GNW N

Hartford Financial Services HIG OW

Lincoln National LNC N

MetLife, Inc. MET OW

National Financial Partners NFP N

Phoenix Companies PNX UW

Principal Financial Group PFG UW

Protective Life PL N

Prudential Financial PRU OW

Reinsurance Group of America RGA OW

Symetra Financial SYA N

Torchmark Corp TMK N

Unum Group UNM N

Erik J Bass, CFA

American Equity Investment Life AEL OW

CNO Financial Group CNO N


US Year Ahead 2012

111


Insurance – Non-Life

Pricing Showing Signs of Life, But Need More to Expect Outperformance

Commercial insurance prices in the United States, which were bottoming at mid-year2011, now appear to be improving with positive rate gains being reported in a number of product and market segments. While this is clearly a positive development, rates need to rise further over a sustained period of time to significantly improve earnings prospects across the group, in our view. The market also seems to be lacking one of the convincing catalysts that has marked other periods of material pricing power—reserve inadequacies, asset pressures, low executive compensation, etc. As a result, we are skeptical that we are witnessing a traditional cycle turn. Rather, the industry appears to be in an environment in which incremental pressures—falling investment yields, weak economic growth, catastrophe losses, and, more recently, normalizing loss cost trends—have finally resulted in underwriters pushing through small price increases. We believe the implications of this incrementalism are much less positive than past periods of commercial pricing power. Meanwhile, pricing trends in personal lines remain positive as do trends in a number of property reinsurance markets. Despite more constructive pricing trends, we believe it is premature to move from neutral to overweight the group.

We believe the following factors are important to consider in the group today: 1) relative earnings prospects given continued ROE headwinds from low interest rates; 2) growth prospects, whether organic or via M&A given weak organic prospects; 3) capital flexibility for either capital management or acquisitions; 4) ROE leverage to the extent that pricing fundamentals improve further; and 5) valuation relative to current, intermediate, and normalized ROE levels.

Best Idea – Allstate Corp. (ALL)

We believe Allstate Corp. (ALL) offers investors the best risk-reward opportunity in our sector, especially for those with medium time horizons. It is one of the only stocks we cover that is likely to generate significant bottom-line growth over the next few years given current pricing fundamentals. In addition, valuation appears to be discounting further EPS deterioration rather than improvement. We believe the stock and valuation can expand with earnings over time. In terms of EPS, we believe that EPS could reach a run rate of $5.00-plus exiting 2013 assuming normal catastrophes. We have identified three areas that should help ALL achieve this normalized EPSgoal, including 1) returning homeowners’ margins, excluding catastrophes, to the levels of 2003-2007; 2) achieving underwriting profitability in Florida and New York auto, while holding margins stable in the rest of the country; and 3) growing life earnings in areas with high margins and low capital intensity. While the stock is still a show-me story, we see limited downside given the stock is trading at 6.8x 2012EEPS (versus its long-run average of 10.5x) and 0.77x tangible book (excluding AOCI) despite a 2012E ROE of close to 11%. The risk to our call is that commercial pricing trends accelerate creating margin expansion opportunities in other parts of the sector.

Allstate Corp. (ALL) – Overweight – Dec 12 Price Target: $40



$27.12 $34.40 $22.27 Dec $2.84 $0.75 $3.96 36.2 6.8 $13,705 Valuation: Target reflects residual income analysis based on prospective ROE (as defined by book value change adding back dividends) adjusted for operating and financial risks as well as historical valuation multiples and historical risk-adjusted returns. Risks: Expectations for stabilizing to improving EPS and capital levels prove optimistic, improved industry pricing may not continue, increased period of high-frequency/low-severity events continuing to pressure earnings, pressure on investment yields.

Matthew G. Heimermann AC

(1-212) 622-6545

[email protected]

Donald H. Chen

(1-212) 622-2875

[email protected]

Mei Feng A. Zhang

(1-212) 622-6445

[email protected]


ACE Limited ACE OW

Allied World Assurance Company Holdings, Ltd. AWH OW

Allstate Corp. ALL OW

Aon Corporation AON OW

Arch Capital Group, Ltd. ACGL UW

Axis Capital Holdings, Ltd. AXS N

Brown & Brown, Inc BRO N

Chubb Corp. CB UW

Endurance Specialty Holdings ENH OW

Everest Re Group, Ltd. RE N

Marsh & McLennan Cos., Inc. MMC N

PartnerRe Ltd. PRE N

Platinum Underwriter Holdings, Ltd. PTP N

The Progressive Corp. PGR N

Transatlantic Holdings TRH (rs)

Travelers TRV N

Validus Holdings VR (rs)

Willis Group Holdings plc WSH N

XL Group PLC XL N


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112


REITs/Real Estate Services

Earnings Visibility, High Yields, and Good Total Return Prospects

We think REIT stocks should deliver mid-teens total returns in 2012 with a combination of 4% dividend yields, 7% earnings growth in 2013, and about 3% valuation expansion from current levels. We believe there is some room for valuations to expand since 1) the pullback in stocks starting in July has been greater than the roughly 1% decline in 2012 FFO estimates stemming mostly from a weaker macro backdrop; 2) REIT stocks now trade at a slight NAV discount; and 3) the RMZ sits about 3% below our shorter-term tactical fair value of 790.

Fundamentally, REIT portfolios should see occupancy increase at a slow clip (up 0-100bps) and market rents should move up modestly (3-5%) in 2012. To the extent job growth picks up in 2H or trends higher than 100-150k/month, there could be upside to our core growth estimates. On the transaction side, we expect REITs to be active buyers as they continue to have better balance sheets than most private market counterparts. However, if equity prices remain under pressure, it will be more difficult for REITs to drive external growth initiatives as most will not want to increase leverage to do deals.

From a capital flows point of view, REIT stocks should benefit from capital seeking relatively visible earnings streams and high cash dividends while the U.S. economy continues to face drags on growth and financial markets face global uncertainty. Some key risks we see to the group are: 1) capital rotation out of REIT stocks if the economy and financial uncertainties surprise on the upside; 2) Japanese investors reverse course and redeem massive investments in REIT stocks made over the last 12-18 months; and 3) commercial real estate debt markets widening out.

Best Idea – Public Storage (PSA)

Public Storage (PSA) continues to be one of our top ideas in the REIT sector based on both our fundamental outlook for the company and its relative valuation. Our 2012 FFO estimate of $6.51 is $0.19 higher than the Bloomberg consensus as we believe that the combination of stronger-than-expected comp NOI growth and the deployment of retained cash flow should drive bottom-line earnings growth, higher than what the Street currently expects. From a valuation perspective, two things stand out to us. First, the stock trades at 22x our 2012 AFFO estimate which is less than a 10% premium despite being a blue chip with financial leverage that is just one-third of the overall REIT sector average. Second, in contrast to prior to the downturn, PSA offers a competitive dividend yield today (just 90bps below the group average) due to three dividend increases over the past 24 months that were driven by a rebound in earnings.

Public Storage (PSA) – Overweight – Dec 12 Price Target: $140

Price 52-Wk Range FY FFO P/FFO Mkt Cap

12/6/2011 High Low FY End 2010 (A) 2011 (E) 2012 (E) Cur Next (mil.)

$129.12 $132.20 $97.04 Dec $4.72 $5.81 $6.51 22.2 19.8 $23,118 Valuation: Target reflects DCF model based on our normalized dividends driven by our AFFO estimates, assuming 8.5% discount rate and long-term growth rate of about 5%. Risks: Continued economic weakness taking a toll on occupancy or pricing power, inability to deploy capital into new investments.

Michael W. Mueller, CFA AC

(1-212) 622-6689

[email protected]

Anthony Paolone, CFA AC

(1-212) 622-6682

[email protected]

Joseph Dazio, CFA

(1-212) 622-6416

[email protected]

Cindy True

(1-212) 622-6748

[email protected]

Molly McCartin

(1-212) 622-6615

[email protected]


Michael W. Mueller, CFAAcadia Realty Trust AKR NCBL & Associates Properties CBL NDCT Industrial Trust DCT NDDR Corp DDR NEquity One Inc. EQY NFederal Realty Investment Trust FRT OWFirst Industrial Realty Trust FR UWGeneral Growth Properties GGP NHCP, Inc. HCP NHealth Care REIT HCN OWHealthcare Realty Trust HR NJones Lang LaSalle Inc JLL NKimco Realty Corporation KIM NMacerich MAC OWMedical Properties Trust MPW UWPennsylvania REIT PEI UWProLogis PLD NPS Business Parks PSB NPublic Storage PSA OWRamco-Gershenson Properties Trust RPT UWRegency Centers REG NSimon Property Group SPG OWSTAG Industrial, Inc. STAG NTanger Factory Outlet Centers SKT NTaubman Centers TCO OWWeingarten Realty Investors WRI OW

Anthony Paolone, CFAAIMCO AIV UWAlexandria Real Estate Equities ARE OWAmerican Campus Communities ACC NAvalonBay Communities AVB NBoston Properties BXP OWBrandywine Realty Trust BDN NBrookfield Office Properties BPO NCamden Property Trust CPT NCBRE Group, Inc CBG OWCorporate Office Properties OFC UWCousins Properties CUZ NDouglas Emmett, Inc. DEI OWDuke Realty DRE NEducation Realty Trust EDR NEntertainment Properties Trust EPR OWEquity Residential EQR OWEssex Property Trust ESS OWGetty Realty GTY UWKilroy Realty KRC OWLexington Realty Trust LXP OWLiberty Property Trust LRY NMack-Cali Realty CLI NMission West Properties MSW NPiedmont Office Realty Trust PDM OWPost Properties PPS NRealty Income O NSL Green Realty Corp. SLG OWUDR, Inc. UDR OWVornado Realty Trust VNO NWashington Real Estate Investment Trust WRE N


US Year Ahead 2012

113


Specialty & Consumer Finance

The New Normal

A new normal for credit quality and growthFollowing two years of improvement, we believe credit performance has reached a cyclical peak (DQs and NCOs are likely to increase in 2012). We believe this will occur across asset classes (consumer, commercial, secured, and unsecured, with the possible exception of residential mortgage). As the credit tailwind begins to subside, we expect our coverage universe will encounter periods of data point–driven volatility. Ultimately, we see long-term value in the group as normalized loss rates are likely to remain below historical levels. In order to maximize returns over the next 12 months, investors will need to be willing to embrace tactical entry points created by credit data. We also note that loan growth is likely to remain below historical norms as the supply/demand equilibrium for credit remains constrained.

Best Idea – American Express (AXP)

Our best idea for 2012 is American Express (AXP). We believe the company is well positioned for an environment of normalizing credit and slow portfolio growth. This is based upon our thesis that high-end consumers are generally less sensitive to cyclical trends in terms of credit and spending. On the credit side, losses and delinquencies on the company’s portfolio are 200bps and 140bps below the industry averages, respectively. We note that current loss levels are approximately 220bps below the company’s historical average. Over the past year, domestic billed business has grown approximately 13% y/y, versus the industry average of approximately 9%. Finally, we note that in 2012, we expect the company to demonstrate additional operating leverage as credit tailwinds subside and Visa/MasterCard settlement payments expire. We are modeling operating expenses to fall to 71% of net revenues (versus 74% in 2011).

American Express (AXP) – Overweight – Dec 12 Price Target: $55



$48.56 $53.80 $41.25 Dec $3.38 $4.04 $4.12 12.0 11.8 $56,402 Valuation: Target reflects 11.9x our 2013 EPS estimate of $4.63, a discount to historical multiple of 17.5x (excluding 2009), in light of increased economic uncertainty. Risks: Economic backdrop remains fragile, Department of Justice lawsuit, sluggish growth outlook for credit card portfolio.

Richard Shane AC

(1-415) 315-6701

[email protected]

Jonathan Philpot

(1-415) 315-6725

[email protected]

Daniel Kim

(1-212) 622-6557

[email protected]


American Capital ACAS OW

American Express AXP OW

Annaly Capital NLY OW

Apollo Investment AINV N

Apollo Residential Mortgage AMTG N

Ares Capital ARCC OW

BlackRock Kelso Capital BKCC N

Capital One COF (rs)

Discover Financial DFS N

MFA Financial MFA N

PennantPark Investment PNNT N

SeaCube Container Leasing BOX OW

Solar Capital SLRC N

TAL International TAL N


US Year Ahead 2012

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US Year Ahead 2012

115


Biotechnology

Fundamentals Intact, But Volatile Times Call for Selective Measures: Celgene Top Pick

Biotech fundamentals are intact, in our view, which is underscored by solid top-lineperformance in 2011 despite a challenging macro environment. Despite this performance, generalist interest overall in the sector is quite low. Looking to 2012, headlines regarding macro and biotech industry–specific concerns (EU sales exposure, U.S. biosimilars legislation, and pricing pressure on Medicare/Medicaid duel-eligible patients) could keep generalists on the sidelines. Given this, our overall view on the sector is to take a selective approach. We do believe there are names in biotech that retain the sector’s inherent defensive nature—which should garner interest from both generalists and specialists alike. These names have good underlying fundamentals, with potential meaningful clinical/regulatory catalysts (Alexion, Celgene, Gilead, and Viropharma).

Best Idea – Celgene (CELG)

Our favored names in biotech are ones with solid underlying fundamentals and/or ones with meaningful potential catalysts. Indeed, our top pick for 2012, Celgene(CELG), has both. The demand trends for flagship drug Revlimid were impressive in 2011, particularly in the face of concerns regarding second primary malignancies (SPMs) associated with the drug in 1H11 (concerns that we had always felt were overdone). In 2012, we expect increased market penetration and share duration gains to continue to fuel Revlimid growth. Regarding clinical/regulatory catalysts, 2011 was a quiet year, but 2012 will be different. Our focus in early 2012 will be on the first-line maintenance filing in the EU, a substantial market opportunity. We do expect ultimate approval. Other meaningful potential catalysts for Celgene to monitor will be potential accelerated approval of pomalidomide in relapse/refractory multiple myeloma and Phase 3 data from apremilast in psoriasis/psoriatic arthritis. We do not currently include either of these opportunities in our model.

Celgene (CELG) – Overweight – Dec 12 Price Target: $75



$62.21 $68.25 $48.92 Dec $2.80 $3.79 $4.20 16.4 14.8 $27,617 Valuation: Target reflects 18x 2012E EPS, above large-cap group average of 13x, as we expect Celgene to continue to outperform its biotech peers. Risks: Vidaza or Abraxane sales fluctuating from quarter to quarter, additional data from clinical trials could come in below expectations, any negative developments with the IP for Revlimid.

Geoff Meacham AC

(1-212) 622-6531

[email protected]

Anupam Rama

(1-212) 622-0105

[email protected]

Michael E Ulz

(1-212) 622-0900

[email protected]


Acorda Therapeutics Inc. ACOR OW

Alexion Pharmaceuticals ALXN OW

Allos Therapeutics ALTH OW

AMAG Pharmaceuticals AMAG N

Amgen Inc AMGN OW

Amicus Therapeutics FOLD N

AVEO Pharmaceuticals, Inc. AVEO OW

Biogen Idec BIIB N

Celgene CELG OW

Gilead Sciences GILD OW

Idenix Pharmaceuticals IDIX OW

InterMune ITMN OW

Ironwood Pharmaceuticals IRWD OW

Medivation MDVN OW

PDL BioPharma PDLI N

Pharmasset VRUS N

Regeneron Pharmaceuticals REGN N

United Therapeutics UTHR N

Vertex Pharmaceuticals VRTX N

ViroPharma Incorporated VPHM OW

He

alth

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reThis document is being provided for the exclusive use of JOHN CULHANE at PENNANT MANAGEMENT, INC.

US Year Ahead 2012

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SMid Biotechnology

Will 2012 Finally Be the Year for Resurgence in M&A Activity? ONXX Remains Top Pick

We have a generally optimistic outlook for the small/mid-cap biotech group going into 2012. To date in 2011, the Nasdaq Biotechnology Index (NBI) has outperformedthe broader market (NBI +8.6% vs. S&P 500 +0.3%), and we would note that SMid biotechs are not as reliant as most industries on the performance of the overall economy so long as they have access to capital. With that backdrop, we still expect investor risk appetite for the SMid biotechs to continue to be driven by high-profile clinical and regulatory catalysts, commercial performance, and the potential for M&A activity. The anticipated uptick in M&A once again failed to live up to expectations in 2011, although the recent proposed acquisition of Pharmasset (VRUS) by Gilead Sciences (GILD) could reignite investor optimism. Ultimately, we do believe there’s a reasonable chance that biotech M&A activity could pick up in 2012 for the same reasons that have been tossed around for the last couple of years (patent cliffs for large pharma combined with plush pharma balance sheets and more mature biotech pipelines).

Beyond a possible acceleration in M&A, attractive valuations and a potentially more robust IPO market could also facilitate increased investor interest. However, on the negative side, persistent investor skepticism surrounding “launch stories” could continue to be a theme next year. We believe it will be important for the overall performance of the sector that at least some of these commercial companies make strides in 2012. Within our universe alone, key launches to monitor include DNDN’s Provenge, HGSI’s Benlysta, SGEN’s Adcetris, INCY’s Jakafi, and potentially AMLN’s Bydureon (late January PDUFA date).

Best Idea – Onyx Pharmaceuticals (ONXX)

Among our mid-cap companies, we continue to prefer ONXX and BMRN. However, when choosing between the two, we lean towards ONXX at this point as it is the more controversial name (at least in the near term) while BMRN has become more of a “consensus long.” ONXX shares have posted solid performance YTD in 2011 (up 12.5%) but 2012 could be a transformative year with the potential approval of wholly owned asset carfilzomib (CFZ) for multiple myeloma. Potential approval in 1H12 would be the major positive catalyst though we also believe that any regulatory setbacks could be met with money coming in from the sidelines (given long-term optimism). CFZ’s efficacy and safety profile has resonated well with doctors and we believe, based on early data, that there is a good chance the drug will be eventually be used across the entire spectrum of disease, boosting its value to ONXX.

We’ve also stressed that ONXX is about much more than just CFZ despite investors’ overwhelming focus on that product. Key to this view are the eight ongoing or recently completed studies evaluating Nexavar and regorafenib in six different tumor types. So far ONXX is 2-for-2 (positive Nexavar SPACE data and positive rego CRC data). We expect the next updates will be in 1Q for Nexavar in lung cancer (see our MISSION preview) and rego in GIST with the remaining four studies reporting out at varying times over the subsequent 12 months.

Onyx Pharmaceuticals (ONXX) – Overweight – Dec 12 Price Target: $48



$42.40 $46.07 $27.17 Dec $0.13 $0.72 $(0.34) 58.9 N/M $2,698 Valuation: Target reflects P/E analysis, real options scenario analysis, and risk-adjusted NPV analysis. Risks: Slower- and lower-than-projected uptake of Nexavar in HCC setting, faster- and greater-than-expected erosion in RCC, failure of label expansion trials, greater-than-expected competition in RCC and HCC markets, regulatory and/or commercial failure of carfilzomib in multiple myeloma.

Cory W Kasimov AC

(1-212) 622-5266

[email protected]

Matthew J Lowe, Ph.D.

(1-212) 622-0848

[email protected]

Karen E Jay, Ph.D.

(1-212) 622-4668

[email protected]


Alkermes, Inc. ALKS OW

Amylin Pharmaceuticals AMLN N

Arena Pharmaceuticals, Inc. ARNA N

Ariad Pharmaceuticals ARIA OW

Array BioPharma ARRY OW

Biodel Inc. BIOD N

BioMarin Pharmaceuticals BMRN OW

Dendreon DNDN OW

Emergent BioSolutions EBS OW

Exelixis, Inc EXEL N

Geron Corp GERN N

Human Genome Sciences HGSI OW

ImmunoGen IMGN N

Incyte Corporation INCY OW

Lexicon Pharmaceuticals LXRX OW

MannKind Corporation MNKD UW

Nektar Therapeutics NKTR OW

Onyx Pharmaceuticals ONXX OW

Orexigen Therapeutics OREX N

Rigel Pharmaceuticals RIGL OW

Savient Pharmaceuticals SVNT N

Seattle Genetics SGEN N

The Medicines Company MDCO N

VIVUS, Inc VVUS OW


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Healthcare Facilities

Economic Stability and Expansion Assist Long Term, While Budget Issues First

Among the most levered in healthcare to economic stability/recovery, while that not the nearest-term event. Healthcare facilities stocks have been challenged this year, in part as the group has been under pressure with still persistently weak payor mix, light medical consumption patterns, and the threat (and reality) of budget cuts for government program business. However, with a cost structure much more heavily biased to semi-fixed costs than most of healthcare, facilities will ultimately be among those most levered to economic stabilization/recovery. Here in particular, and especially as we consider acute care, it is about payor mix. That is the potential, as more individuals gain employer-based coverage, to swap some of the current disproportionate mix of (low-paying) self-pay and/or government-support program business out for (much higher-paying) commercial. With virtually no cost-of-care differential, the leverage to earnings from such a shift is meaningful. It’s the longer-term play in acute care, and while economic recovery is likely not viewed by most as a near-term event, our hospital volume work does show stabilization in mix.

Beyond mix improvement, coverage expansion extends longer-term view. While likely to be much in focus in 1H12 as the Supreme Court takes up its review, we believe that ultimately most of the 2014 coverage expansion envisioned under the health reform law will occur. Recall that 34 million individuals are expected to gain coverage, and even if this trimmed somewhat, the benefit to lowering uncompensated care costs will be meaningful.

Nearer term though, replaying the deficit talks is a potential headwind. At the end of November, the Super Committee announced that it had not found a compromise in the deficit reduction talks and technically (under sequestration at least) for now this means Medicare will take just a 2% cut beginning in 2013 and Medicaid will see no reductions at the federal level. Of course that’s the technicalprognosis, while the reality is probably more biased to the fact that Congress and the Administration will have to restart the discussion in 2012, an element that that we believe could factor again as a renewed visibility constraint. With the largely non-profit acute-care sector running extremely slim margins, we believe it will ultimately be difficult to enact anything much more significant than 2%, but we see how the entire story may have to be revisited, and that potentially a nearer-term constraint on the stocks.

Best Idea – HCA Inc. (HCA)

We currently rate HCA Inc. (HCA) Overweight, with a year-end 2012 price targetof $38. HCA is the largest U.S. hospital system by a considerable margin, operating over 160 hospitals with nearly 39,000 beds, about 5% of the market. The company’s facilities—with a portfolio biased toward higher quality-ranked properties—are mostly situated in urban markets with faster population growth, and often have one of the leading shares in those regions. Broadly, we favor such scale and urban market positioning, particularly as we look further ahead and consider leverage to a recovering job market and, out in 2014, coverage expansion.

HCA Inc. (HCA) – Overweight – Dec 12 Price Target: $38



$23.24 $35.37 $17.03 Dec $2.93 $2.67 $3.60 8.7 6.5 $10,146 Valuation: Target reflects 7x EV/EBITDA using our 2013E EBITDA, in line with our group average objective. Risks: Pressures on operating margins as currently running well above peer group, health reform coverage expansion getting derailed or scaled back, potential supply of shares from private equity investors.

John Rex AC

(1-212) 622 6600

[email protected]


Community Health Systems Inc. CYH N

HCA Inc. HCA OW

Health Management Associates Inc. HMA N

HealthSouth Corp HLS N

Kindred Healthcare, Inc. KND OW

LifePoint Hospitals Inc. LPNT N

Select Medical Corp. SEM N

Skilled Healthcare Group SKH N

Tenet Healthcare Corp. THC OW

Universal Health Services Inc. UHS N

Vanguard Health Systems VHS OW


US Year Ahead 2012

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Healthcare Information Technology

What’s the Next Growth Driver Beyond Stimulus?

The electronic health record (EHR) companies in our coverage universe (ATHN, CERN, MDRX, and QSII) have benefitted from the 2009 Stimulus Bill, which incentivizes healthcare providers to purchase EHRs and demonstrate “meaningful use.” Investors generally view stimulus-driven demand as priced into the shares at current levels, but we continue to believe there is upside to the names because Stage 2 requirements which are due to be finalized by mid-2012 point to sustained demand for the next 2-4 years, longer than many investors believe to be the case (we published a detailed report on this on June 16, 2011, titled “Stage 2 Criteria Point to Sustained Demand; EHR Market Update”).

For investors that are looking for the next driver of growth, we believe initiatives under the Patient Protection and Affordable Care Act (aka Health Reform) will provide the next growth driver. Specifically, we believe health information exchanges (HIEs) and technology to allow development of accountable care models, as well as revenue cycle management (to offset reimbursement pressure) are the products and services that will experience increased demand. It is still early to quantify precisely how much demand will be generated given the dynamic nature of Health Reform and the fact that a number of rules have yet to be published. However, we intend to focus on this in the coming year as that is where the puck is moving.

Best Idea – Accretive Health (AH)

Accretive Health (AH) is the best long idea in our coverage universe. At a high level, we like Accretive for its unique business model which requires no upfront or incremental investment from a hospital and yet delivers revenue gains to the hospital by bringing efficiency to the collection process. The recently announced Intermountain Healthcare deal is likely to go a long way in terms of generating brand recognition for the company. From a numbers standpoint, Accretive has the best top-and bottom-line growth prospects in our coverage universe and trades at a 43% discount to our projected 55% earnings growth rate for the company through 2013. Also, for investors wary of the risk of multiple compression as the effect of the Stimulus wanes, we believe Accretive is an attractive option as the company has not experienced any material benefit from the Stimulus.

Accretive Health (AH) – OW – Dec 12 Price Target: $35



$23.00 $32.82 $13.20 Dec $0.24 $0.43 $0.73 53.5 31.5 $2,259 Valuation: Target reflects 34x 2013E EPS, as we expect the company’s steady-state EPS growth in the 2014-2017 timeframe to be around 30-40%. Risks: Loss of key customers, competitive pressure from new entrants, regulatory changes, delays in signing on new customers, multiple contraction from execution missteps.

Atif Rahim AC

(1-212) 622-6671

[email protected]


Accretive Health AH OW

Allscripts Healthcare Solutions MDRX OW

athenahealth ATHN UW

Cerner Corp CERN OW

Epocrates EPOC N

MedAssets MDAS N

Quality Systems QSII OW


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Healthcare Technology & Distribution

The Generics Wave Is Here: Expect Positive Benefit Across the Pharma Supply Channel

Underlying earnings visibility remains strong, while a cyclical lift could drive incremental prescription usage and earnings upside. We remain positive on the pharmaceutical supply channel in general, based on favorable demographic trends and the near-term generics opportunity. The aging population should continue to help drive prescription utilization as the elderly utilize a significantly higher number of scripts per year than the overall average. In addition, generic launches are expected to ramp significantly in 2012, and we note that generics are generally more profitable across the pharmaceutical supply channel. While the weak economy and high unemployment rate have contributed to slower prescription growth over the past few years, a cyclical recovery could provide a potential source of upside to the companies across the pharmaceutical channel. Finally, we expect the PBMs, distributors, and retail pharmacies to continue to use strong free cash flows to repurchase shares, which could provide a cushion to earnings should a weak economy persist.

The PBMs continue to be our favorite subsector, based on a sizeable expected benefit from the generics wave. The outlook for the PBMs remains strong, based on two key drivers: generics and specialty pharmacy. We believe the weak economy has led to plan designs that promote utilization of mail and generics, which are more profitable for PBMs. Further, the number of new generic launches will ramp over 2012, although due to the timing of launches and exclusivity periods, much of the benefit will be felt in 2H12. Finally, the specialty pharmacy opportunity remains strong, based on a robust biotech pipeline and ongoing demand from plan sponsors looking to rein in rising specialty drug costs. For pharmaceutical distributors, the longer-term trend remains favorable as well, especially if there is incremental prescription growth from a gradual recovery in the labor market. The drug distributors have highly fixed cost bases and incremental scripts are very accretive to the model, while the upcoming generics wave will also be an incremental positive. For the retail pharmacies, while top-line growth slowed with the economy, increasing prescription utilization and consumer spending driven by a cyclical recovery could drive near-term upside. In addition, generic utilization (based on new launches expected in 2012) and private-label sales should continue to benefit margins. Finally, we note that the weak economy has created consolidation opportunities for the large chains, as small chains and independents find it increasingly difficult to compete.

Best Idea – CVS Caremark (CVS)

Our best idea for 2012 is CVS Caremark. We believe healthy PBM operating income growth (driven by generic launches, new business, and streamlining benefits) coupled with stability in the retail pharmacy and ongoing share buybacks should lead to accelerating earnings growth in 2012, which should lead to improved investor sentiment and multiple expansion. Further, based on marketplace developments, we believe the company is well positioned for share gains on the retail side and also a strong 2013 PBM selling season. In our view, valuation remains attractive, withshares currently trading at 12.1x our 2012 EPS estimate of $3.16, below the average historical forward P/E multiple, and also below our longer-term EPS growth forecast.

CVS Caremark (CVS) – Overweight – Dec 12 Price Target: $50Price 52-Wk Range FY EPS P/E Mkt Cap


$38.27 $39.50 $31.30 Dec $2.68 $2.80 $3.16 13.7 12.1 $49,813 Valuation: Target reflects 14x blended multiple on 2013E EPS. Risks: Weak core productivity, slowdown in front-end sales, retail pharmacy reimbursement pressure, slowdown in prescription drug utilization, competitive pressure on PBM profitability, acquisition integration.

Lisa C. Gill AC

(1-212) 622-6466

[email protected]

Michael Minchak, CFA

(1-212) 622-6506

[email protected]

Gavin S. Weiss

(1-212) 622-5451

[email protected]


Lisa C. Gill

AmerisourceBergen ABC N

Cardinal Health CAH OW

CVS Caremark Corp. CVS OW

Express Scripts, Inc. ESRX (rs)

Henry Schein Inc HSIC N

LabCorp LH N

McKesson Corporation MCK OW

Medco Health Solutions, Inc. MHS (rs)

Omnicare Inc. OCR OW

Owens & Minor, Inc. OMI N

Patterson Companies PDCO N

PSS World Medical, Inc. PSSI N

Quest Diagnostics DGX N

Rite Aid RAD N

Walgreen Company WAG N

Michael Minchak, CFA

Catalyst Health Solutions, Inc. CHSI OW

SXC Health Solutions SXCI OW


US Year Ahead 2012

120


Life Sciences Tools & Diagnostics

Seeking Favorable Risk-Reward After the Storm

With two of the three core growth drivers (academic, pharma) for life science tool companies facing a secular shift to lower growth in the next several years, and the industrial market set for a mid-cycle slowdown (at best), we are taking a more cautious stance for our 2012 outlook. While we see opportunities to selectively own names in the group based on valuation and exposure to emerging markets, the life science tools industry is undergoing a secular change that could have meaningful impacts to sector multiples longer term. We continue to selectively favor stocks that appear to be discounting severe macro scenarios in the near term, despite company fundamentals remaining well positioned to benefit longer term from emerging market growth, operational excellence, and prudent capital deployment.

Best Idea – Agilent (A)

We are Overweight on Agilent (A) due to the company’s above-peer organic growth (e.g., 14% and 15% organic growth in FY2010 and FY2011, respectively), favorable geographic exposure (~30% exposure to Asia/ROW (ex-Japan)), credible management, operational excellence (targeting >30% incremental operating margins, >20% ROIC), and disciplined capital deployment. Importantly, we think the stock is fully discounting a serious downturn and believe risk/reward is favorable.

Spun out of Hewlett-Packard in 1999, Agilent endured significant challenges during the 2000 tech bust, which led to restructuring and divestitures over the subsequent decade, including a further restructuring during the 2008/2009 financial crisis. We believe the company is now more profitable and less cyclical.

After a strong FY2011 and given the difficult and highly uncertain macro environment, the company expects a more challenging FY2012 (~6% organicgrowth), although this is still above our expectations for peer growth next year. Given management’s history of disciplined capital deployment, we expect the company to utilize its strong balance sheet (now ~$1.4bn net cash, though the vast majority trapped overseas) and robust cash flow toward favorable long-term opportunities in 2012.

Agilent (A) – Overweight – Dec 12 Price Target: $53



$36.98 $55.33 $28.67 Oct $2.95 $3.13 $3.44 11.8 10.8 $12,840 Valuation: Target reflects DCF analysis, assuming 2% terminal growth and WACC of 13.5%. Risks: Macro conditions, secular trends in electronic test and LS/CA instrumentation, competitive dynamics, Varian integration.

Tycho Peterson AC

(1-212) 622-6568

[email protected]

Evan Lodes

(1-212) 622-5650

[email protected]

Ramesh C Donthamsetty

(1-212) 622-6580

[email protected]


Accuray ARAY N

Affymetrix AFFX UW

Agilent Technologies A OW

Bruker Corporation BRKR OW

Charles River Laboratories CRL N

Covance CVD OW

Gen-Probe GPRO N

Genomic Health GHDX N

Hologic HOLX OW

ICON Plc ICLR N

Illumina, Inc. ILMN OW

Intuitive Surgical, Inc. ISRG N

Life Technologies Corporation LIFE OW

Luminex LMNX N

Mettler-Toledo MTD N

Myriad Genetics Inc. MYGN N

Pacific Biosciences Inc. PACB UW

Qiagen N.V. QGEN N

Quidel QDEL N

ShangPharma Corp. SHP OW

Sigma Aldrich SIAL OW

Sirona Dental Systems Inc SIRO OW

SonoSite SONO OW

Thermo Fisher Scientific TMO N

Varian Medical VAR N

Waters WAT N

WuXi PharmaTech WX OW


US Year Ahead 2012

121


Managed Care

Operating Themes Familiar, Regulatory Backdrop Likely Gets Some Focus

For 2012, operating themes are familiar, while regulatory considerations persist. For managed care, the underwriting margin outlook often dominates the stocks, while for the past couple of years this component has been quite favorable, on slack medical consumption against a stable commercial pricing environment. As a result, earnings upside for the group was significant again in 2011 and, at current consumption levels, we would expect favorable spread and resulting earnings upside again for 2012. To be sure, the question of competitive pricing pressures remains, with not-for-profit insurers (40%+ of the market) continuing to have record surplus capital levels and, as a result, pricing yields in some markets have moderated. However, in the context of these high surplus levels, the pricing actions are far more contained than one would normally expect and we credit continued uncertainty around 2014 health reform changes as having inserted a high degree of caution among such operators, a factor we expect to persist as a braking factor. As a result, we look for more of the same on the operating front (earnings upside), while for the stocks the first half 2012 will be somewhat crowded with regulatory events that could temper the response.

On earnings, mostly about medical consumption. So while the commercial pricing environment is a bit softer, it’s still holding up comparably well and the focus for the 2012 margin outlook should really be mostly about medical consumption, this against the highly constrained current level, and we believe heavily tied to the economy and consumer confidence. As we write this, neither of these looks particularly prone to surge in the coming year and, moreover, we see an incremental mitigating element as employers once again adapt even greater levels of high-engagement offerings, these featuring increased out-of-pocket exposure for employees. Taking a look at government program books, while there was resurgence in cost ratios in the first half across the industry, the most recent reports exhibited more stability.

First half of 2012 about the Supreme Court and the deficit. On the latter, even with the failed Super Committee efforts, we expect this to be in focus for much of 2012. Ultimately, though, we do not see a significant negative outcome for managed care, while such considerations seem to at least insert some overhang across healthcare stocks broadly. The first-half 2012 Supreme Court review of the health reform law, however, could appear somewhat binary, having the potential to act as a stalling factor, similar to the 2010 overhang as the regulations were being written, and the stocks unable to react to even quite meaningful earnings upside until that outcome was 100% assured.

Best Idea – UnitedHealth (UNH)

We rate UnitedHealth (UNH) Overweight, with a year-end 2012 price target of $60. UNH is the most diversified name within the benefits business having well-established, market-dominant positions that span both employer/commercial and higher-growth government program lines. In addition, the company has a large and rapidly growing business in less regulated health-related services (non-insurance) business, now approaching 20% of earnings and with a target 30-40% composition.

UnitedHealth (UNH) – Overweight – Dec 12 Price Target: $60



$48.29 $53.50 $34.94 Dec $4.10 $4.56 $4.65 10.6 10.4 $51,478 Valuation: Target reflects 11.5x 2013E EPS, in line with group average objective. Risks: Implementation of regulations that will govern health reform law, potential for medical utilization to reaccelerate ahead of pricing yields, greater exposure to Medicare Advantage.

John Rex AC

(1-212) 622 6600

[email protected]


Aetna Inc. AET OW

AmeriGroup Corp. AGP N

Centene Corp. CNC N

Cigna Corp. CI OW

Coventry Health Care Inc. CVH N

Health Net Inc. HNT N

Humana Inc. HUM N

Molina Healthcare Inc. MOH N

Sun Healthcare Group, Inc. SUNH N

UnitedHealth Group UNH OW

WellCare Health Plans Inc. WCG N

WellPoint Inc. WLP OW


US Year Ahead 2012

122


Medical Supplies & Devices

Outlook for 2012

MedTech stocks struggled in 2011. A combination of structural and cyclical pressures has resulted in weakening end markets and a slowing of industry growth rates. In 2012, we expect these pressures to continue, resulting in low- to mid-single-digit industry revenue growth and mid- to high-single-digit EPS growth.

Absent a pickup in U.S. demand, 2012 is likely to bring incremental pricing pressure and make Europe the incremental risk to the industry’s 2012 outlook. To date, Europe has been weak, but relatively stable. Downside demand risk from new austerity measures and a weaker Euro are both worth watching, with the potential to pressure 2012 earnings across the space.

MedTech stocks are, of course, inexpensive, trading at 10.5x 2012E EPS and a 10.1% FCF yield. Moreover, the companies are generating ample cash and, in manycases, returning that cash to shareholders. Yet, with two-thirds of S&P healthcare stocks trading at less than 12x anticipated 2012 earnings, valuation and capital allocation alone aren’t likely to be enough to improve sector performance. In our view, either fundamentals will need to improve, or there will need to be an increased level of interest from strategic or financial sponsors.

Best Idea – St. Jude Medical (STJ)

Our top pick as we enter 2012 is St. Jude Medical (STJ). St. Jude struggled in 2011 from a >10% contraction in the U.S. ICD market. This led to a series of downward revisions to Street estimates, which as we approach 2012 is still playing out,particularly on the heels of the unfavorable CardioMEMS panel. Yet, St. Jude still has, by our estimation, one of the best pipelines in large-cap MedTech. Over the next 12 months new product approvals should pave St. Jude’s entry into two major new markets: transcatheter aortic valve replacement and renal denervation for drug-resistant hypertension. St. Jude is also at the front of entering or developing several other markets, including deep brain stimulation for Parkinsons and occipital nerve stimulation for chronic migraines.

Because of the ongoing contraction of the ICD market and the timing of key approvals, St. Jude is looking more and more like a 2013 growth acceleration story, which, as visibility on new products increases, is likely to get increasing Street attention over the course of 2012. Near-term risks remain: 1) the ICD market has yet to bottom; 2) St. Jude’s ICD leads are undergoing increasing scrutiny, causing near-term share loss; and 3) the St. Jude story is dependent upon EU and FDA approvals.

Yet, with the stock trading at 10x 2012 estimates, the potential for a 2013 acceleration is far from reflected in the name, making the 12-month risk/reward in our view meaningfully skewed to the upside.

St. Jude Medical (STJ) – Overweight – Dec 12 Price Target: $48*



$36.95 $54.18 $33.54 Dec $3.02 $3.27 $3.45 11.3 10.7 $11,787 * Target and estimates as of December 9, 2011. Valuation: Target reflects 13x 2013E EPS, a premium to the large-cap MedTech average due to STJ’s superior top- and bottom-line growth prospects. Risks: Further weakening in the U.S. ICD market, pipeline delays for Portico or renal denervation program, increased pricing and reimbursement pressures in the U.S. and Europe.

Michael Weinstein AC

(1-212) 622-6635

[email protected]

Christopher Pasquale

(1-212) 622-6590

[email protected]

Kimberly Gailun

(1-617) 310-0740

[email protected]

Ross Comeaux

(1-212) 622-1895

[email protected]


Michael Weinstein

Abbott Laboratories ABT N

Baxter Intl BAX OW

Becton, Dickinson & Co BDX N

BioMimetic Therapeutics BMTI N

Boston Scientific Corporation BSX N

C.R. Bard Inc. BCR N

CareFusion CFN OW

Covidien COV OW

Edwards Lifesciences EW UW

Heartware International HTWR OW

Johnson & Johnson JNJ N

Medtronic MDT N

St Jude Medical STJ OW

Stryker Corp SYK OW

Tornier TRNX N

Zimmer Holdings ZMH N

Kimberly Gailun

Insulet Corp PODD OW

Mako Surgical MAKO N

NxStage Medical, Inc. NXTM OW

The Cooper Companies, Inc. COO N

Wright Medical Group WMGI N

Christopher Pasquale

Hansen Medical HNSN N

Integra LifeSciences IART N

NuVasive, Inc. NUVA N

Thoratec Corp. THOR N

Volcano Corporation VOLC OW


US Year Ahead 2012

123


Pharmaceuticals – Major

Increasing Clarity on Trough Earnings Positive for Pharma in 2012

We see the major pharma group as well positioned in 2012 based on what we expect will be increasing clarity on trough EPS as we move through a wave of significant patent expirations (Zyprexa, Lipitor, Singulair) as well as increased visibility on post–patent cliff earnings growth based on continued pipeline newsflow/businessdevelopment activity. Following several rounds of cost-cutting, we now expect the sector to maintain operating margins through its patent cycle. In addition, major pipeline data releases or new product launches across the group should increase the Street’s confidence in the longer-term earnings power for the sector. Finally, we see capital deployment as an underappreciated catalyst with a notable increasing focus on returning cash to shareholders following a period of M&A digestion. We continue to see nearly all capital redeployment options (business development, share repurchase, dividend increases) as more attractive than the scenario that we (and the Street) currently have modeled—namely significant growth of cash on the balance sheet. With valuation (particularly for Pfizer and Merck) continuing to reflect ongoing earnings erosion for the sector, we see an opportunity for multiple expansion across the sector.

Best Idea – Pfizer (PFE)

Pfizer (PFE) offers an attractive mix of 1) inexpensive valuation (8.8x ’12E EPS), 2) an approaching near-term new product cycle, 3) a high FCF/dividend yield, and 4) limited earnings risk, in our view. Along these lines, we continue to see an attractive entry point in PFE shares and reiterate our Overweight rating.

Strong new launch cycle ahead. We believe the positive results from the ARISTOTLE study for Eliquis (atrial fibrillation) coupled with the recent approval of Xalkori (ALK-positive lung cancer) and positive Phase III data for tofacitinib (RA) at ACR represent the start of a significant new product cycle for Pfizer including four $1bn-plus product opportunities. Beyond these assets, we anticipate approval of Prevnar 13 in adults (January 2012) will represent an incremental positive catalyst for the shares. This core portfolio of pipeline assets will enable Pfizer to return to modest top-line growth beyond the company’s 2012 patent expiration cycle, by our estimates.

Beyond pipeline catalysts, we see the company’s business unit divestitures as unlocking significant value and believe a December 2011 dividend increase represents another potential catalyst on the horizon.

Pfizer (PFE) – Overweight – Dec 12 Price Target: $25



$20.23 $21.45 $16.59 Dec $2.23 $2.28 $2.32 8.9 8.7 $155,507 Valuation: Target reflects DCF assuming 0% sector terminal growth and WACC of 9%. Risks: Failure to effectively integrate the Wyeth acquisition, potential for pipeline setbacks to put pressure on margins, challenges PFE’s size presents to longer-term growth/management.

Chris Schott, CFA AC

(1-212) 622-5676

[email protected]

Jessica Fye

(1-212) 622-4165

[email protected]

Dewey Steadman, CFA

(1-212) 622-5350

[email protected]


Bristol-Myers Squibb Company BMY N

Eli Lilly & Company LLY UW

Merck & Co., Inc. MRK OW

Pfizer Inc. PFE OW


US Year Ahead 2012

124


Pharmaceuticals – Specialty

Generics Offering an Increasingly Favorable Risk/Reward

Generics: Heading into a record year of new product launches and with valuations near an all-time low, we see a number of opportunities in the generics group in 2012. We are anticipating accelerating U.S. growth for the group in 2012 driven by a combination of significant new product introductions and ongoing favorable pricing. In addition, we see Europe as less of an overhang on the sector as expectations have reset and volume growth is expected to accelerate as major products such as Lipitor, Zyprexa, and Diovan lose patent protection.

While we anticipate strong results across the generic group, our Overweight-rated names in the sector include Mylan (MYL), Teva (TEVA), Watson (WPI), and Hospira (HSP), for which we see broadly improving news flow throughout the year.

Specialty Pharmaceuticals: Merger activity represented a significant catalyst for the group over the past two years and we anticipate the same to be true in 2012 as the sector continues to consolidate in-market assets. We expect names such as Valeant (VRX) and Warner Chilcott (WCRX) to remain active on this front while merger integration will be a focus for Endo (ENDP), Medicis (MRX), as well as Valeant (VRX). In addition, new product launches from Endo (Opana TR) and Forest (linaclotide, aclidinium) represent potential catalysts within the sector.

Best Idea – Mylan (MYL)

We see a very strong 2012 ahead for Mylan (MYL) driven primarily by the company’s core U.S. business, which is poised for an extremely strong new product cycle next year. While we acknowledge that Mylan’s European business has been an ongoing overhang for the stock, expectations have generally moderated and we believe the impact from a downside scenario in Europe would have only a muted impact on Mylan’s bottom line, as was seen in 2011. With a highly diversified business that we believe is capable of delivering mid-teens EPS growth over the next several years, we remain Overweight MYL shares heading into 2012.

Mylan (MYL) – Overweight – Dec 12 Price Target: $28



$19.81 $25.46 $15.49 Dec $1.62 $1.99 $2.46 10.0 8.1 $8,449 Valuation: Target reflects 11.5x 2012E EPS, closer to our target sector multiple of roughly 12.5x 2012E EPS, reflecting ongoing core business strength and solid execution on cost-synergy objectives from the Merck KgaA/Matrix integration. Risks: Greater-than-expected generic competition for Mylan’s core base products, greater-than-expected European price erosion, generic competition for Epipen.

Chris Schott, CFA AC

(1-212) 622-5676

[email protected]

Dewey Steadman, CFA

(1-212) 622-5350

[email protected]

Jessica Fye

(1-212) 622-4165

[email protected]


Allergan AGN N

Endo Pharmaceuticals ENDP OW

Forest Laboratories, Inc FRX OW

Hospira, Inc. HSP OW

Impax Laboratories IPXL N

Medicis Pharmaceutical Corp. MRX OW

Mylan Inc. MYL OW

Perrigo Company PRGO N

Sagent Pharmaceuticals SGNT N

Teva Pharmaceuticals TEVA OW

Valeant Pharmaceuticals VRX OW

Warner Chilcott WCRX OW

Watson Pharmaceuticals WPI OW

Jessica Fye

MAP Pharmaceuticals MAPP OW


US Year Ahead 2012

125


Chemicals – Specialty, Commodity & Agricultural

Gathering Strength

2012 Outlook: The agricultural markets are likely to be strong in the year-ahead period. Current drivers of domestic agriculture are low stocks-to-use ratios, high crop prices, and excellent farmer profitability. Moreover, ethanol consumption absorbs 40% of the domestic corn market. We believe that year-ahead agricultural fundamentals are likely to be more resilient when encountering economic volatility due to the long-cycled nature of agricultural balances.

We believe that 2012 is likely to be a year of rebuilding profitability for North American chemical producers (commodity and specialty). Commodity chemical margins sharply weakened late in 2011 from peak-like levels in 2Q and 3Q. Broader commodity chemicals demand is currently weak due to seasonal factors, lower export demand, inventory destocking, and falling product prices. We expect commodity chemical margins to recover gradually in 2012 as supply and demand rebalance. We expect a healthy and improving multi-year earnings profile for Dow Chemical, LyondellBasell, and Westlake Chemical given the advantaged feedstock position of North American producers. This regional raw material advantage may become more apparent later in 2012 and beyond, as advantages accrue from the development of North American shale gas. We rate DOW, LYB, and WLK Overweight.

Specialty chemical volume growth has stepped down with the economy since the end of August. We do not expect a robust earnings year for these companies generally in 2012 given contracting European export markets, a slower rate of domestic volume growth, and a slower rate of emerging market demand expansion. We rate ASH, APD, ECL, and IFF Overweight.

Best Idea – DuPont (DD)

DuPont’s large Agricultural and Performance Chemical (TiO2 and Refrigerants) segments, which account for about 70% of consolidated operating income, should perform well in an economic environment of little growth. Volume growth for agricultural seeds in 2012 is supported by a likely corn planting acre increase in the U.S. to 94 million versus 91.9 million in 2011. DuPont forecasts seed prices to grow ~5% in 2012 with additional benefits from a better product mix. DuPont is reinvesting with free cash from TiO2 and Agriculture, and is purchasing regional seed companies.

DuPont’s construction and auto-related operations in 2012 should compare well versus 2011 performance. DD has increased its exposure to growth markets in China, India, and Brazil and is executing well. We believe a $130mn cost saving target (2013) from the acquisition of Danisco could prove conservative. DuPont has made a successful transition to a new CEO and her team, which has an enhanced technology and operational focus. DuPont currently trades at 7.2x 2012E EBITDA, which compares to its Specialty Chemical peer range of 7.2-10.9x EBITDA for 2012E. The company trades at an 11.7x P/E multiple for 2012E compared to the peer group at 11.7-20.4x. DuPont should generate 7-8% of its share price in free cash flow in 2011 and about 6-7% in 2012. The dividend yield is 3.4%.

DuPont (DD) – Overweight – Dec 12 Price Target: $57



$47.94 $57.00 $37.10 Dec $3.30 $4.00 $4.10 12.0 11.7 $45,291 Valuation: Target relects 8.5x EV/EBITDA on 2012E, implying 14x EPS, consistent with Specialty Chemicals peers. Risks: Cyclical company, customer inventory rebalancing, pension expense.

Jeffrey J. Zekauskas AC

(1-212) 622-6644

[email protected]

Silke Kueck

(1-212) 622-6503

[email protected]

Olga Guteneva

(1-212) 622-6488

[email protected]

Ben Richardson

(1-212) 622-6455

[email protected]

Youyou Yan

(1-212) 622-4951

[email protected]


Jeffrey J. Zekauskas

Agrium AGU OW

Air Products and Chemicals APD OW

Albemarle Corporation ALB OW

Amyris, Inc. AMRS N

Ashland Inc. ASH OW

Avery Dennison AVY N

Cabot Corporation CBT (rs)

CF Industries Holdings, Inc. CF N

Compass Minerals International, Inc. CMP N

Dow Chemical DOW OW

DuPont DD OW

Eastman Chemical Company EMN N

Ecolab Inc. ECL OW

Ferro Corp FOE N

Georgia Gulf GGC OW

H.B. Fuller FUL N

Huntsman Corporation HUN N

International Flavors & Fragrances IFF OW

LyondellBasell Industries LYB OW

Minerals Technologies MTX OW

Monsanto MON OW

Novozymes NZYMb.CO N

Pall Corporation PLL N

Polypore International PPO N

Potash Corp. POT OW

Praxair PX N

RPM International Inc. RPM N

Scotts Miracle-Gro Co. SMG N

Sherwin-Williams SHW N

The Mosaic Company MOS OW

Valspar Corp VAL N

WD-40 Company WDFC N

Westlake Chemical Corp. WLK OW

Silke Kueck

Rockwood Holdings, Inc. ROC OW

Ma

teria


US Year Ahead 2012

126


Coal

Sector to Remain Choppy . . . We Like the Quality Names

The U.S. coal sector has been lifted by the international coking coal markets. We could see some pressure on coal prices in the near term unless Australian floods again interrupt supplies. J.P. Morgan’s commodity group recognizes the pullback in steel prices as a worry and something that must be watched. On a positive note, coking coal hasn’t fallen as much as the scrap steel and iron ore prices. The thermal coal prices have also come under pressure, but the demand from China and India remains a wildcard. With international coal prices trading below Chinese domestic coal prices, we believe there could be some lift in China’s imports once colder weather increases demand.

Our economists highlight two major risks: 1) spillovers from the economic and financial crisis in Europe and 2) tightening of domestic fiscal policy. We believe under the prolonged negative sentiment scenario the coal sector could remain under pressure for longer. Reduced crossover coal demand will affect CAPP producers’ margins significantly and, with the region already facing regulatory pressures and high inflation, this could create a difficult situation for some of the miners. However, we feel the better-quality names will gain market share.

Best Idea – CONSOL Energy (CNX)

We believe CONSOL Energy (CNX) is a special situation within the coal sector with some of the best remaining coal assets in Appalachia and a rapidly growing gas business. With its low-cost coal operations, the company is better placed than other miners in the region to take market share in a weaker market, in our view.

The company also has large gas reserves in the Marcellus, Utica, and other shales. It has been doing deals to monetize these assets. CNX has completed joint ventures with Noble Energy to develop its Marcellus acreage and with Hess Corporation to develop its Utica acreage. The accelerated development of the gas properties helped by its JV partners is de-risking these properties. We believe the market has still not been able to value the coal/gas hybrid correctly and the company is trading at a discount to its actual value.

Consol Energy (CNX) – Overweight – Dec 12 Price Target: $79



$40.80 $56.32 $30.56 Dec $1.98 $2.90 $4.08 14.1 10.0 $9,254 Valuation: Target reflects sum-of-the-parts analysis using DCF values for coal and gas assets. Risks: Delay in expected global and U.S. recovery, continued oversupply of natural gas, high medical inflation or lower forecast rate of return on pension plan assets.

John Bridges CFA, ACSM AC

(1-212) 622-6430

[email protected]

Sadhak Bindal

(1-212) 622-2684

[email protected]


Alliance Resource Partners ARLP OW

Alpha Natural Resources ANR N

Arch Coal, Inc. ACI OW

CONSOL Energy CNX OW

Peabody Energy BTU


US Year Ahead 2012

127


Gold & Precious Metals

We Continue to Recommend “Golden Insurance”

The gold price is up roughly 30% since the start of 2011 (currently $1,729/oz); it touched the $1,900/oz level during September. We believe the precious metal will remain attractive relative to most other assets in the current uncertain environment and expect the metal to outperform other industrial metals and its “basier” sister metal, silver.

While the absolute value of gold could be depressed by money flows into the U.S.dollar, we see no change in the positive trend shown by the gold equities’outperformance of the S&P 500 in the relative chart shown below.

Figure 98: HUI/SPX – A Decade of Outperformance

Source: Bloomberg.

European problems could also prompt more stimulus. Our economists say “a significant setback in Europe, or an unwelcome fall in inflation expectations, could be all that is required for QE3.” If there is a QE3, gold prices and gold equities could benefit from the new money supply as the risk of inflation increases.

Best Idea – Goldcorp Inc. (GG)

Goldcorp (GG) offers our favorite mix of solid production growth and lower-than-average geopolitical risk; GG is forecasting 60% growth in its production profile by 2015. The company has one of the best growth profiles with new ounces coming from the Cerro Negro, Pueblo Viejo, and Éléonore projects. The company has apparently resolved the issues at its flagship mine, Penasquito, and expects to ramp up to nameplate throughput in early 2012. We believe the company is well positioned to grow ounces per share and we continue to see value in the stock.

Goldcorp Inc. (GG) – Overweight – Dec 12 Price Target: $63



$52.11 $56.31 $39.04 Dec $1.36 $2.17 $2.75 24.0 18.9 $42,355 Valuation: Target reflects Black-Scholes call option value based on aplying a probability-weighted average gold price of $1,300/oz to the gold forward curve and our estimates of gold sales over the life of the known assets and the forecast cost structure. Risks: Further difficulties with high-pressure rolls at Penasquito, significant capital or cost overruns at joint development project (Pueblo Viejo), sharp fall in silver and base metals prices that affects economics of Penasquito.

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John Bridges CFA, ACSM AC

(1-212) 622-6430

[email protected]

Sadhak Bindal

(1-212) 622-2684

[email protected]


Agnico-Eagle Mines AEM N

Barrick Gold ABX OW

Coeur d'Alene CDE N

Compania de Minas Buenaventura BVN N

Gold Reserve GRZ N

Hecla Mining HL N

Jaguar Mining JAG N

Kinross Gold KGC OW

Newmont Mining NEM OW

NovaGold Resources NG (rs)

Pan American Silver PAAS UW

Silver Wheaton SLW OW

Stillwater Mining SWC N


US Year Ahead 2012

128


Metals & Mining

Stocks Discounting Significant Further Deterioration in Macro Fundamentals

In general, most stocks in our coverage universe appear to be pricing in a recession for Europe, a stall/mild recession in the U.S., and a slowdown in Chinese growth, with the metal/mining stocks more levered to China/global growth and the steel stocks to U.S. growth. In contrast to what equities are discounting, our economists and strategists are looking for a more positive scenario for 2012. U.S. GDP growth is expected to remain positive, Europe should start to grow again by mid-2012, and easing inflation in China should allow for a more accommodative monetary policy.

If the growth follows J.P. Morgan’s forecasts rather than the signals from equities, we would expect our stocks to rally strongly on the stronger-than-expected demand, especially as the lessening in uncertainty would likely cause purchasers to move away from their current cautious buying patterns. More specifically, companies with high levels of fixed costs should outperform those with more variable cost structures. On the steel side, we would expect integrated producers (such as X, MT, and AKS) to outperform the more variable-cost minimills and distributors. For the metal producers, miners with low (and more fixed) costs such as FCX in copper should do better than aluminum producers as their cost profiles also adjust to a greater extent with underlying commodity prices.

Best Idea – Freeport-McMoRan (FCX)

Since July 15th, the LME copper price is down 19% to $3.54/lb, while FCX is down 27% to $40.54. We believe, however, that FCX’s stock price is pricing in too negative an outlook for copper prices and not fully valuing the financial strength and flexibility of the company. FCX’s stock now appears to be pricing in a copper price for 2012 of $3.10/lb, as this number (assuming current gold and moly prices of $1,728/oz and $13.40/lb, respectively) would have the stock trading at its historical forward EV/EBITDA multiple of 5.5x. In addition, assuming current metal prices for all of 2012 would have FCX trading at a 2012E EV/EBITDA multiple of 4.5x and a FCF yield of 8%, by our estimates. We also don’t believe FCX’s current stock price is fully reflecting the company’s strong balance sheet. As of 3Q11, the company’s net cash position stood at $1.6bn, which (excluding the potential impact of the strike in Indonesia) we estimate would grow to roughly $2.7bn by the end of 2012 if current metal prices hold flat for the remainder of this year and next. With its regular quarterly dividend of $0.25/share, FCX has a dividend yield of 2.5%. However, if we were to include the supplemental dividend of $0.50/share that FCX paid on both December 30, 2010 and June 1, 2011 as regular payments going forward, FCX’s dividend yield would increase to 4.9%. Finally, given the company’s track record of shareholder-friendly actions (dividend increases, special dividends, and share repurchases), we would not be surprised to see the company take additional actions if the stock remains near these levels.

Freeport-McMoRan (FCX) – Overweight – Dec 12 Price Target: $61



$40.54 $60.75 $28.85 Dec $4.65 $5.01 $5.08 8.1 8.0 $38,428 Valuation: Target reflects 5.5x EV/EBITDA using 2012E, in line with FCX’s long-term avg. forward multiple. Risks: Pullback in copper purchases by China, further deterioration in global economy, inability of company to cut costs quickly enough to preserve cash, increased copper supply, rise in U.S. dollar.

Michael F. Gambardella AC

(1-212) 622-6446

[email protected]

Tyler J. Langton

(1-212) 622-5234

[email protected]

Brian P. Ossenbeck, CFA

(1-212) 622-1023

[email protected]


Michael F. Gambardella

AK Steel AKS OW

Alcoa AA OW

Allegheny Technologies ATI OW

Arcelor Mittal MT OW

Carpenter Technology CRS (rs)

Century Aluminum Company CENX N

Cliffs Natural Resources CLF OW

Commercial Metals CMC N

Dynamic Materials BOOM N

Freeport-McMoRan Copper & Gold FCX OW

Globe Specialty Metals GSM OW

GrafTech International GTI OW

Haynes International HAYN OW

Metals USA MUSA OW

Molycorp MCP N

Nucor Corp. NUE OW

Reliance Steel & Aluminum RS OW

Steel Dynamics, Inc. STLD OW

Teck Resources TCKb.TO OW

Thompson Creek Metals TC N

U.S. Steel Corp X OW

Worthington Industries WOR N

Tyler J. Langton

Inmet Mining IMN.TO OW


US Year Ahead 2012

129


Paper & Packaging

Stick with Relative Security at a Discount in a Volatile Market: CCK Top Pick

In a macro environment in which our economists are forecasting <2% GDP growth in 2012, our overall view on the paper and packaging space is fairly cautious. As a reminder, the paper sector tends to exhibit “GDP minus” growth, even in containerboard, therefore we do not expect much in the way of pricing in 2012 (we currently assume flat pricing for containerboard, with some declines in pulp and paper). Packaging, on the other hand, tends to hold up better in a slow-growth environment, particularly since it has some exposure to faster-growing emerging markets with opportunities to improve penetration rates in beverage cans that could lead to end-market outperformance. Therefore, we would recommend investing in these higher-quality stocks that are likely to show lower earnings volatility, in particular CCK. On the paper side, if one wanted to invest here around the theme of potential consolidation in containerboard, we would recommend RKT, given that we see synergy upside over the next several quarters from its acquisition of SSCC.

Best Idea – Crown Holdings (CCK)

Crown Holdings (CCK) is our top pick in the paper & packaging sector. While CCK is a consensus long (91% buys), it is hard to ignore the combination of its potential mid- to high-single-digit organic growth through 2013 and shareholder-friendly capital allocation. By 2013, CCK should be on track to gain 5-10 points of market share in key emerging markets such as Brazil and China, along with its dominant share in the Middle East and SE Asia, all of which should drive higher long-term earnings power and FCF generation once volumes are fully ramped.

From a valuation perspective, CCK shares currently trade at 6.8x 2012E EBITDA, a discount to its recent average of closer to 7.5x forward EBITDA. While some of this reflects the overall discount in the market today, we think CCK shares look fairly inexpensive on a relative basis to the packaging group overall as well. Our December 2012 price target of $44 (33% upside, group 20% upside) represents a ~7.1x multiple on 2013E EBITDA, or an 8% premium to the group’s 6.6x target multiple (discount to more recent group average multiple of 7x).

Crown Holdings (CCK) – Overweight – Dec 12 Price Target: $44



$33.14 $41.58 $28.68 Dec $2.24 $2.80 $3.10 11.8 10.7 $5,010 Risks: Overexpansion into emerging markets could lead to overcapacity, particularly if global economy slows, pricing risks in Western Europe, a function of increased competition due to Can-Pack’s entry into the United Kingdom, overcapacity resulting from weaker CSD trends and the end of can exports from North America to Brazil leading to pricing compression, shift from can to glass packaging in North America and Brazil as brewers focus on price over volume.

Phil M. Gresh, CFA AC

(1-212) 622-4861

[email protected]

Ariel Avila

(1-212) 622-8021

[email protected]


Ball BLL N

Boise BZ N

Crown Holdings CCK OW

Domtar UFS N

Graphic Packaging GPK N

Greif GEF N

International Paper Co. IP N

MeadWestvaco MWV OW

O-I OI N

Packaging Corp of America PKG OW

Rock-Tenn RKT OW

Silgan Holdings SLGN N

Sonoco SON N

Temple-Inland TIN N


US Year Ahead 2012

130



US Year Ahead 2012

131


Information Services/TV & Radio Broadcasting

Remain Positive on Info Services Names in 2012; Auto & Political Ads Could Lift TV Names

Information Services stocks should outperform in a sluggish economic recovery given rising secular demand, nice operating leverage, and market expansion opportunities. These companies provide “need-to-have” information for professionals, thus typically enjoy good pricing flexibility and high renewal rates. The group has limited exposure to the anticipated fiscal drag on households in 2012. A few educational/book publishers (e.g., McGraw-Hill, John Wiley) are exposed to state budget pressures—although both operators are diversified and benefiting from share gains. High diesel gas prices and European unemployment could limit Solera’s near-term upside. In a financial spillover, the rating agencies would likely see the most estimate downside, depending on the duration. On the positive side, a modest improvement in housing investment could imply estimate upside for many of these stocks (VRSK, EFX)—with improving revenue growth bolstered by highly fixed cost bases. We remain positive on the credit bureaus (Experian, Equifax), and also like a handful of esoteric research/database/analytics providers (Verisk, Gartner).

Comparison for TV & Radio Broadcasters and Magazines will ease in 2012. We expect most operators to benefit from a rebound in auto advertising and strong political spending. For TV, we expect industry ad revenues to jump >10% due to Olympics and heavy political spending—with a boost from the Presidential Election and the Supreme Court Citizen’s United campaign finance ruling. We assume 2-3% growth in underlying core TV advertising. We’re keeping a close eye on Washington newsflow regarding spectrum incentive auctions, retransmission consent, and the FCC 2010 quadrennial review of media ownership laws. For Magazines, secular trends remain challenging and we expect modest advertising growth industrywide.

Best Idea – Verisk Analytics (VRSK)

Verisk is a leading provider of risk management solutions and analytics to the insurance, mortgage, supply chain, and healthcare industries. Its databases and tools are used by customers to measure risk, predict losses, and prevent and detect fraud. The company’s ISO brand dominates in its niche, with “need-to-have” databases, software, and tools for P&C insurers. A clearinghouse model results in high barriers to entry and above-average pricing power. VRSK has performed well year to date (+9% v. the S&P 500’s -5%) and we see more room for upside in 2012. We find valuation attractive (17.8x 2013E EPS and 10.9x 2013E EBITDA).

Subscription nature of business implies relatively less inherent leverage to an economic slowdown. Verisk generates nearly 70% of revenues from a subscription model—this could limit downside if market volatility persists. Verisk’s key vertical, P&C customers (~58% of revenues), is steadily recovering. The company drives strong cash flow and maintains a healthy balance sheet (1.7x net debt/EBITDA).

Diversifying with acquisitions of faster-growing Decision Analytics properties.Analytics (59% of revenues) lifted 12% in Q3. Verisk is rapidly expanding its addressable market into data solutions and analytics for emerging verticals including mortgage (~17% of revenues), healthcare (~15% of revenues), and supply chain.

Verisk Analytics (VRSK) – Overweight – Dec 12 Price Target: $42



$38.06 $39.75 $30.76 Dec $1.40 $1.70 $1.90 22.4 20.0 $6,273 Valuation: Target reflects 19-20x 2013E adj. EPS. Risks: Subscription-oriented revenue mix is late cycle and weighted to P&C insurance sector, acquisitions remain major part of growth strategy, insurance companies could trim business relationships with VRSK.

Michael A. Meltz, CFA AC

(1-212) 622-0416

[email protected]

David Lewis, CPA

(1-212) 622-6435

[email protected]

Nadia Lovell

(1-212) 622-4885

[email protected]


Michael A. Meltz, CFA

Arbitron ARB OW

Belo Corp. BLC N

CBS Corporation CBS OW

D&B DNB N

Equifax EFX OW

Experian plc EXPN.L OW

IHS Inc. IHS N

Meredith Corporation MDP N

Moody's Corp. MCO OW

Nielsen Holdings N.V. NLSN OW

Sinclair Broadcast Group SBGI N

The McGraw-Hill Companies MHP OW

Thomson Reuters TRI N

Verisk Analytics VRSK OW

David Lewis, CPA

FactSet Research Systems FDS N

Gartner Inc. IT OW

John Wiley & Sons JWa OW

Solera Holdings SLH OW

Nadia Lovell

Clear Channel Outdoor CCO N

Lamar Advertising Co. LAMR N

XO Group Inc XOXO N

Me

dia

& T

ele

com



US Year Ahead 2012

132


Internet

Positive Outlook Given Strong Secular Growth and Emerging Trends

Our positive view on the U.S. Internet sector into 2012 is driven by strong secular growth, increased online accessibility via mobile devices and tablets, and strengthening of key trends including social, local, and video. While most Internet names in our coverage universe have high levels of exposure to discretionary consumer spending and are subject to the broader macro pullback, we believe the Internet economy is quite healthy and supported by the shift to online channels in both advertising and eCommerce.

Strong secular growth to continue. With online advertising at ~18% of total ad spending and eCommerce at ~9% of total retail (in the U.S.), we believe these segments should continue to have many years of double-digit growth ahead on a global basis. The Internet economy will also likely be bolstered by monetization of online video content, virtual goods, applications, and cloud-based services.

Platform/ecosystem competition to intensify. We believe Amazon, Apple, Google, and Facebook are emerging as primary platforms on which increasing amounts of online/mobile communications, advertising, and commerce are likely to be conducted. Notable characteristics of these major platforms include global reach, large and developing ecosystems, strong network effects, and revenue-generating,toll-booth capabilities. Looking ahead, we expect these platforms to continue to grow stronger as the rest of the Internet increasingly relies on them.

Mobile devices leading confluence of key trends. We believe smartphone and tablet adoption has played a critical role in accelerating key industry trends including social, local, and mobile search. As smartphone penetration moves beyond the current ~30% global penetration rate and tablets approach mainstream adoption, we expect mobile devices to have an even bigger impact on Internet business models and eCommerce trends.

Best Idea – Google (GOOG)

Google is our top pick on the strength of its core business fundamentals. We believe core search growth remains healthy—in the high teens in 2012—while Google’s mobile and display businesses are taking significant share in higher-growth segments. Margin concerns and the MMI acquisition have been recent overhangs on the stock. However, we think the spending is appropriate given new management’s focus on product and innovation, and strong mobile revenue numbers highlight the importance of Android and support the rationale for the MMI deal. We continue to believe Google shares represent strong large-cap growth at a compelling valuation.

Google (GOOG) – Overweight – Dec 12 Price Target: $705



$623.77 $642.96 $473.02 Dec $29.61 $36.65 $42.20 17.0 14.8 $202,031 Valuation: Target reflects 14x 2013E PF EPS, or 0.8x PEG on 2010-13E EPS CAGR of 19%. Risks: Potential for continued heavy investment spending, increasing competition from Facebook as source of traffic across Internet, continued competition for engineering talent, “appification” of mobile Internet, increased regulatory scrutiny.

Doug Anmuth AC

(1-212) 622-6571

[email protected]

Kaizad Gotla, CFA

(1-212) 622-6436

[email protected]

Bo Nam

(1-212) 622-5032

[email protected]

Shelby Taffer

(1-212) 622-6518

[email protected]


Amazon.com AMZN OW

Bankrate Inc RATE N

eBay, Inc EBAY N

Google GOOG OW

HomeAway Inc AWAY OW

LinkedIn Corp LNKD OW

Netflix Inc NFLX N

Pandora Media Inc P OW

Priceline.com PCLN OW

QuinStreet, Inc. QNST N

ReachLocal RLOC OW

Yahoo Inc YHOO N


US Year Ahead 2012

133


Media

Economic Uncertainty Continues, But Advertising Holding In and Valuations Appear Attractive

Economic concerns continue to weigh on the Media sector as investors remain skittish and look for any signs of an advertising slowdown. Ad spending is highly correlated to GDP and generally lags movements in economic data by a quarter or two, so a modest deceleration in growth is expected heading into 2012. We currently expect global ad growth to approximate 4% in 2012, down slightly from 5% growth anticipated in 2011. Recent comments from top executives at some of the largest ad agencies indicate that budgets for 2012 look relatively healthy so far and advertisers are not meaningfully changing spending patterns heading into next year. While local will benefit from a boost in political spending in 2012 (possibly upwards of $4bn), core national advertising levels appear to be much healthier. As such, we favor those stocks in our universe with greater national ad exposure and particularly like cable assets given their growing share of ad spend and additional revenue stream of steady affiliate fees.

Best Idea – Viacom (VIAb)

We find Viacom (VIAb) shares compelling heading into 2012 given the company’s leading cable assets, discounted valuation, and substantial share buyback.

In a healthy but sensitive macro environment, cable networks stand out as attractive earnings generators given their dual revenue streams of advertising and high-visibility affiliate fees. Viacom’s leading cable assets—including Nickelodeon and MTV—represent more than 90% of the company’s earnings vs. its Filmed Entertainment division. Management has guided to high-single- to double-digit affiliate fee growth driven in part by meaningful digital content deals. On theadvertising side, industry trends remain healthy heading into 2012 and while scatter has softened a bit recently, it continues to sell at nice premiums to a strong Upfront base. Viacom’s network ratings have been weak which may put a lid on near-term ad growth but we believe this fact is well digested and anticipated. Finally, we expect profitability in the Cable business to expand nicely in the year ahead, boosted by the strong affiliate revenue growth and ongoing structural improvements internationally.

Viacom plans to buy back at least $2.5bn in shares during F2012 (we estimate $2.8bn), representing over 10% of shares outstanding—the highest among its peers. Repurchases will be funded by robust free cash flow at over $2.5bn in F2012E, more than $1bn of cash, and a planned increase in leverage through debt issuance.

We believe VIAb shares offer great value at just 10x our F2012E EPS, more than a 20% discount to its peers (DIS, TWX, CBS, SNI, and DISCA) and well below its own historical averages, for a high-teens EPS growth profile. Viacom also pays a nice dividend, yielding 2.3%. We look to a healthy ad market into 2012, continued aggressive buybacks, and improved ratings as catalysts to shares ahead.

Viacom (VIAb) – Overweight – Dec 12 Price Target: $56

Price 52-wk range FY EPS P/E Mkt Cap


$42.81 $52.67 $35.13 Sep $3.61 $4.35 $5.11 9.8 8.4 $24,013Valuation: Target reflects VIAb’s three-year historical forward P/E of 11x applied to forward EPS. Risks: Weaker-than-expected advertising revenue, change in cable provider structure to tiering or a la carte, studio business tends to be volatile, concentration of ownership.

Alexia Quadrani AC

(1-212) 622-1896

[email protected]

Townsend Buckles, CFA, CPA

(1-212) 622-0461

[email protected]

Monica DiCenso, CPA

(1-212) 622-0473

[email protected]

Caroline Anastasi

(1-212) 622-0138

[email protected]


Cinemark CNK OW

Discovery Communications DISCA N

Disney DIS OW

Gannett Company GCI N

Harte-Hanks, Inc HHS N

Interpublic Group of Companies IPG OW

National CineMedia, Inc. NCMI N

New York Times Company NYT N

Omnicom Group OMC OW

Regal Entertainment RGC OW

Scripps Networks Interactive SNI N

The E.W. Scripps Company SSP OW

The McClatchy Company MNI N

Time Warner TWX OW

Valassis Communications VCI OW

Viacom VIAb OW

WPP Group WPP.L N


US Year Ahead 2012

134


Telecom, Cable & Satellite

Slowing Growth But Strong Capital Return Potential: Top Pick CMCSA

WirelessFor 2012, we expect to see slower subscriber growth but continued strength in wireless data revenue growth from increased penetration of smartphones, sales of tablets, and higher ARPU driven by data. Smartphone penetration could exceed 75%at some carriers, up from 40-60% today, which should drive growth in ARPU. In addition, there could be incremental wireless data growth from tablets with the iPad continuing to be the dominant tablet, but new Android and Windows tablets gaining some traction. LTE data cards and MiFi devices could also drive 2012 growth mainly from Verizon, but also from AT&T as it launches markets.

WirelineOn the wireline side, we believe the biggest upside could come from a continued recovery in enterprise telecom spending. While we do not reflect a significant macroeconomic recovery in our estimates, we are seeing increased activity from enterprises for data, IP, and cloud services and slower declines in legacy services. We also expect cell tower backhaul revenues to continue to increase as wireless carriers ramp up their 4G network build and require higher throughput for handling the increase in data usage. However, government-related revenue could be at risk.

TowersWe expect tower companies to continue to benefit from the 4G network buildout by wireless carriers in 2012. 2011 business trends were strong and we expect that 2012 could be even better. AT&T and Verizon continue to rapidly build out LTE. Sprint has become more active after years of minimal leasing activity, and applications for amendments are rolling out for Network Vision upgrades.

Cable and SatelliteWe maintain a positive view on the cable and satellite sector, as we find the over-the-top threat limited and believe that broadband growth will offset softness in the video market. Cash generation in the space is high, with free cash flow yields of 6.9% to 20.2% in 2012E and aggregate U.S. revenue and EBITDA growth of 4.1% and 2.5%, respectively, as expected. We also think the commercial business offers incremental growth potential vs. the slowing residential business.

Best Idea – Comcast (CMCSA)

Comcast is our top pick in the telecom, cable, and satellite space with an Overweight rating and year-end 2012 price target of $30, implying 33.4% upside from current levels including an estimated 2.2% dividend yield. In our view, the company’s solid cable segment growth combined with steady improvements at NBCU make for a strong and well-diversified cash flow stream. We expect that most of 2012E cash flow—an 10.9% yield at current levels—will be available to capital-return projects including ramping the company’s 2.2% dividend yield and 3.5% buyback, while maintaining leverage, currently 2.1x versus Comcast’s target range of 2-2.5x.

Comcast (CMCSA) – Overweight – Dec 12 Price Target: $30



$23.19 $27.16 $19.19 Dec $1.18 $1.41 $1.64 16.4 14.1 $63,045 Valuation: Target reflects DCF analysis assuming WACC of 7.5% and perpetual growth rate of 0.5%, and doesn’t give CMCSA any credit for value of its 50% carried interest in NBCU. Risks: Heavy telecom video competition continues to increase, over-the-top video creates potential for customers to cut basic video packages, NBC requires investment for further improvements, NBCU increases ad exposure, Roberts family voting control.

Philip Cusick, CFA AC

(1-212) 622-1444

[email protected]

Richard Choe

(1-212) 622-6708

[email protected]

Derya Erdemli, CFA

(1-212) 622-8529

[email protected]


American Tower AMT OW

AT&T T (rs)

Cablevision CVC N

CenturyLink CTL OW

Charter CHTR OW

Clearwire CLWR N

Comcast CMCSA OW

Crown Castle CCI OW

DIRECTV DTV OW

DISH Network DISH N

Frontier FTR N

Leap Wireless LEAP OW

MetroPCS PCS OW

NTELOS NTLS OW

SBA Communications SBAC OW

Sprint Nextel S N

Telephone & Data Systems TDS N

Time Warner Cable TWC N

US Cellular USM UW

Verizon Communications VZ N

Windstream WIN


US Year Ahead 2012

135


Alternative Energy – LED

LED Fundamentals Troughing, Lighting-Related Demand Growth to Lead the Way in 2012

We believe the LED industry will trough in C4Q11/C1Q12 and improve throughout 2012. However, we believe demand for LEDs for consumer electronics (CE) will recover slowly due to a significant structural oversupply and weak macro outlook for CE product demand while demand for LEDs for lighting will accelerate aggressively throughout the year as third-generation LED lighting products come to market, which further reduce product cost and have lower relative payback periods vs. prior product generations. In general, we recommend investors invest as far downstream towardLED-based lighting as possible as we believe LED-related companies with higher exposure to lighting will outperform LED companies that are more CE-centric.

In general, the combination of third-gen LED lighting products, a greater number of utility-based energy efficiency subsidies, and legislative mandates for conventional lighting technologies in various countries should drive the long-awaited inflection in demand for LED-based lighting in 2012. Unsubsidized payback periods for third-gen LED lights vs. conventional incandescent and outdoor lighting technologies are very attractive and we think associated usage of these products will greatly increase, especially if there is an energy efficiency subsidy available. In addition, legislative drivers in numerous countries are limiting the availability of incandescent bulbs, which should only help to drive increased adoption of LED-based lighting products.

Best Idea – Cree (CREE)

Cree is our top pick in the LED sector as roughly 75% of its revenue already comes directly from sales related to LED-based lighting. We expect this to increase further in 2012. Cree recently acquired Ruud Lighting, a lighting product manufacturerwhich we believe has the largest share of North America’s LED-based outdoor lighting market with its Beta LED product line. We expect the combination of Ruud Lighting and Cree’s internally developed, indoor LED-based lights will be the fastest-growing business for the company with a 50%+ CAGR over the next fiveyears. In addition, Cree is a leading supplier of high-performance LED components used extensively by LED lighting product manufacturers. As these companies bring to market their own third-gen LED lighting products over the next six months, we expect demand for Cree’s LED components to accelerate significantly through 2012.

We believe there is significant GM leverage in Cree’s business model due to a very high level of fixed costs in both COGS and Opex. We do not believe the Street understands the strong correlation between Cree’s utilization rates and its margins and, as a result, believe the Street is underestimating the improvement in margins and earnings that is likely to occur should Cree return to 90%+ utililization rates. In addition, Cree will begin to ramp production on 6” wafers at the beginning of C12, which will help to reduce its product cost basis at an accelerated rate.

We also believe the need for very high performance LEDs to provide LED-based lighting products with a short payback period will limit competition for the next few years. Thus, we expect less pricing pressure for LEDs sold into LED lighting vs. those that are sold into traditional consumer electronics applications.

Cree (CREE) – Overweight – Dec 12 Price Target: $48



$25.68 $72.85 $23.03 Jun $1.37 $0.86 N/A 29.9 N/A $2,977 Valuation: Target reflects 29x C12E EPS, given expected revenue growth opp. of >30% over next few years. Risks: Weaker-than-expected demand for high-brightness LEDs, slower-than-expected penetration of LED-based lighting, stronger-than-expected competitive environment.

Christopher Blansett AC

(1-415) 315-6708

[email protected]

William Peterson

(1-415) 315-6711

[email protected]


Cree CREE OW

Rubicon Technology RBCN OW

Veeco Instruments VECO OW

Te

chn

olo

gy


US Year Ahead 2012

136


Alternative Energy – Solar PV

Long Investors Should Stay Away, 2012 Will Be Even More Difficult Than 2011

We continue to recommend long investors avoid the solar sector heading into 2012 as further subsidy reductions in major markets will continue to drive down returns on solar project investments, causing meaningful demand destruction in our view. Germany, Italy, and the U.S., which represent more than 50% of global solar demand, will all reduce their solar subsidies at the beginning of 2012. These subsidy cuts will cause a significant impairment in solar economics requiring a reduced capital cost to offset the lower subsidy levels. Given the already poor financials of most solar PV companies which are in the red or operating near breakeven, we do not believe the industry is in a position to reduce pricing further, in line with subsidy cuts, resulting in less demand in 2012 vs. prior years. We also believe financing costs will be higher in 2012 vs. 2011, also placing additional downward pressure on solar system returns and further inhibiting demand.

The solar industry continues to be driven by subsidies and its outlook has little to do with the outlook for the global economy. Thus, as the subsidies go, so does the solar sector. In addition, the force behind the creation of the subsidies in the first place, rising electricity prices due to rising natural gas prices, is no longer a factor to help maintain the political willpower to keep them intact. In fact, the growing realization that we are at the beginning of a new era in global natural gas production enabled by the combination of horizontal drilling/fracking is likely to be a negative factor toward the subsidization of solar and all forms of renewable energy, as many governments around the world are now looking at the potential to produce significant amounts of natural gas domestically at rates significantly lower than current market prices.

We also believe 2012 will be a year known for significant consolidation of the solar PV industry with companies with high product costs and/or poor balance sheets likely to disappear through bankruptcy or through acquisition by stronger players. Unfortunately, a weaning out of weak players is not likely to resolve the industry’s woes as the problems are not simply due to overcapacity, but primarily due to the structural lowering of subsidy levels.

Best Idea – First Solar (FSLR)

We rate First Solar Underweight and continue to believe the stock will remain under pressure as pricing conditions in the solar sector become even more difficult in 2012. Although the company has a strong U.S. pipeline of projects, a large percentage of its revenue comes from the sale of modules. We believe First Solar will see significant margin compression in its module business in 2012 as subsidies are reduced and as silicon wafer–based peers see significantly lower polysilicon prices. We also believe First Solar will need to structurally raise its R&D spend in order to try and accelerate product improvement to keep pace with falling subsidies. This, in conjunction with significantly lower module margins, is likely to reset operating margins lower than most investors currently expect. We think long-only investors will continue to avoid FSLR and other solar stocks until uncertainty on subsidies and overcapacity is resolved. We think multiple contraction, due to a deteriorating growth outlook for the company, is likely to be the primary reason for stock price underperformance.

First Solar Inc. (FSLR) – Underweight – Dec 12 Price Target: $40



$46.11 $175.45 $40.05 Dec $7.71 $7.24 $5.13 6.4 9.0 $3,985 Valuation: Target reflects 0.9x C12E revenue. Risks: Faster-than-expected reduction in product cost, strong B/S assists project financing.


(1-415) 315-6708

[email protected]

William Peterson

(1-415) 315-6711

[email protected]


Broadwind Energy BWEN N

First Solar, Inc. FSLR UW

MEMC Electronic Materials WFR UW

SunPower SPWR UW


US Year Ahead 2012

137


Applied & Emerging Technologies

Hip to Be Zip

Best Idea – Zipcar (ZIP)

Auto-sharing is a secular growth market. The flexibility of auto-sharing yields consumers the benefits of auto ownership without the high cost and hassle, and engenders sustainable consumption in an urbanized, resource-constrained world. Frost & Sullivan forecasts tenfold growth in car-sharing members through 2016 and a revenue CAGR of 44% to $3.3 billion in the United States alone.

Zipcar is the global leader in auto-sharing, with over 75% share of the market and competitive advantages through scale and reach, size of balance sheet, unrivaled transactional and customer data, differentiated technology infrastructure, and branded self-service experience. Zipcar plans to deploy in two new U.S. cities each year, and through the recent Streetcar acquisition has a beachhead to pursue the European market in 2012.

ZIP should reach sustainable profitability in 2012. We expect ZIP to grow pro forma EBITDA ~90% in FY12E on revenue growth of ~24%, continuing the positive trajectory from FY11E which, at the midpoint of guidance, calls for pro forma EBITDA and revenue growth of ~125% and ~30%, respecitvely. We also expect ZIP to record net income of ~$5mm, compared to an estimated loss of ~$11mm in FY11. ZIP’s established markets have grown ~23% year to date and pre-tax margins have increased by ~80bps to 20.9%.We expect this favorable trend in ZIP’s established markets to continue with additional growth and leverage experienced as other existing markets mature.

Macro resistant. ZIP was able to add members, grow revenue, and lower acquisition cost per new member during the 2008/2009 downturn. While it is certainly not completely immune from another downturn, we believe ZIP’s experience during the last downturn compares favorably to those of traditional rental car companies, which experienced revenue declines on average during that timeframe.

Zipcar (ZIP) – Overweight – Dec 12 Price Target: $30.50

Price 52-Wk Range FY PF EPS P/E Mkt Cap


$14.43 $31.50 $14.00 Dec $(0.68) $0.05 $0.34 N/M 42.4 $567 Valuation: Target reflects 30x multiple assigned to 2014E PF EPS discounted back one year at WACC of 12%. Risks: Probable price-based competition from rental car companies, deteriorating unit economics as company enters new markets or existing markets approach saturation, auto-resale value introducing profit risk, execution challenges.

Paul Coster, CFA AC

(1-212) 622-6425

[email protected]

Mark Strouse, CFA

(1-212) 622-8244

[email protected]

Marija Krgovic

(1-212) 622-5552

[email protected]


Acacia Research Corp. ACTG OW

Avid Technology AVID N

Coinstar Inc. CSTR OW

Comverge, Inc. COMV N

Cubic Corp CUB N

Diebold, Incorporated DBD UW

DigitalGlobe, Inc. DGI OW

Dolby Laboratories, Inc. DLB OW

DTS, Inc. DTSI UW

Echelon Corporation ELON N

Elster Group SE ELT OW

EnerNOC Inc. ENOC N

ESCO Technologies Inc. ESE N

FLIR Systems Inc FLIR UW

Garmin Ltd. GRMN UW

GeoEye, Inc. GEOY N

iRobot Corporation IRBT N

Itron, Inc ITRI OW

Ituran Location and Control ITRN UW

Logitech International LOGI N

LoJack Corp LOJN N

NCR Corporation NCR OW

Nice Systems NICE OW

Novatel Wireless NVTL N

OmniVision Technologies OVTI OW

Plantronics Inc PLT N

Rambus Inc. RMBS N

RealD Inc. RLD OW

Sierra Wireless Inc. SWIR UW

Synaptics Inc. SYNA N

TASER International Inc. TASR UW

TeleCommunication Systems, Inc. TSYS N

TeleNav, Inc. TNAV N

Trimble Navigation TRMB OW

Verint Systems, Inc. VRNT OW

Zebra Technologies ZBRA OW

Zipcar ZIP OW


US Year Ahead 2012

138


Business & Education Services

Business Services/Staffing to Outperform in Decent Recovery; Education Finding Traction

U.S. flexible staffing growth is solid amid low GDP. U.S. flex staffing growth has remained healthy throughout 2011, despite rather lackluster GDP. We sense that the threshold level of real GDP needed to generate favorable flex-staffing growth has dropped due to the enhanced secular attraction of flex staffing following the Great Recession. Still, we recognize that flex staffing in key European markets has slowed remarkably in late 2011, but is still modestly growing. Eurozone real GDP is more of a risk in those geographies. We have long maintained that flex staffing is concurrent with the economy and a leading read on the labor market. We continue to see solid prospects in staffing fundamentals, especially in the U.S. marketplace.

Domestic demand continues to be strong in IT and other professional staffing, and commercial staffing is enjoying some solid seasonal lift in late 2011. Encouragingly, the labor supply is tightening within professional staffing, allowing staffers to push for higher bill rates in those areas. We also see operating leverage prospects tied to revenue growth. We sense margins of many staffing firms (e.g., MAN, RHI) could be 50%+ higher over the next couple of years, assuming a permissive economy.

Staffing stocks more than discounting a normal recession. For example, U.S.-centric RHI is currently trading at its normal recessionary EV/S multiple (based on valuation lows around the 2011 recession), while more European-exposed MAN is trading at an almost 30% discount to its normal recessionary level. So, assuming a conducive economy in 2012, staffers should see a powerful combination of expanding multiples, better margins, and revenue growth.

DC storm for Education stocks has passed; the key is the trajectory of new enrollments. With new 2011 regulations finalized and Congress in gridlock, we do not expect much higher education change in DC during 2012, other than current uncertainty around Pell Grant funding. For-profit education institutions are eager to return their focus to operations and students. New enrollments (starts) are the leading indicator of the sector and have been pulled down by the exhausted consumer and negative media during 2011. Start declines have narrowed in Fall 2011 for the sector,and Apollo has already seen starts return to growth. We expect sector starts to rebound by mid-year 2012 and total enrollments to follow with a lag. We maintain that for-profit education institutions will reachieve healthy mid-term growth due in part to public sector supply constraints. We note that Education stocks now trade at 11x NTM EPS, still near the lowest level in a decade. We favor APOL and STRA.

Best Idea – Robert Half International (RHI)

Robert Half International (RHI) is the King Kong of accounting staffing with ~20% market share in the U.S. and should benefit from much faster growth and higher profitability than most staffing companies through the cycle. In addition, Robert Half primarily addresses mid-market companies, enabling it to command better pricing power. RHI is still trading at a normal recessionary multiple. Assuming a permissive economy, RHI should see expanding multiples, better margins, and strong revenue growth into 2012.

Robert Half International (RHI) – Overweight – Dec 12 Price Target: $40



$27.48 $34.26 $19.69 Dec $0.44 $1.05 $1.48 26.2 18.6 $3,929 Valuation: Target reflects 1.4x EV/S using 2012E revenues, below historical expansionary cycle multiple of 1.7x. Risks: Economic slowdowns and accounting staffing volatility, extended labor recovery causing continued stock volatility.

Andrew C. Steinerman AC

(1-212) 622-2527

[email protected]

Jeffrey Y. Volshteyn

(1-212) 622-2940

[email protected]

Molly R. McGarrett

(1-212) 622-5841

[email protected]


Andrew C. Steinerman

American Reprographics Company ARC N

Apollo Group APOL OW

Bridgepoint Education BPI N

Capella Education CPLA N

CDI Corp. CDI N

Cintas CTAS N

DeVry DV N

Education Management EDMC N

G&K Services GKSR N

Iron Mountain IRM OW

ITT Educational Services Inc ESI N

ManpowerGroup MAN OW

Resources Global Professionals RECN N

Robert Half International RHI OW

Strayer Education STRA OW

UniFirst UNF N

Jeffrey Y. Volshteyn

Towers Watson TW OW


US Year Ahead 2012

139


Communications Equipment & Data Networking

Riverbed Our Top Pick in a Slowing World

Telecom InfrastructureNormally, telecom carriers would be the last to see the effects of a downturn since their customers typically reduce spending on everything else before they get to the telephone. However, we believe European carriers have been reducing capex ahead of the cycle. Of ten large carriers that we track in Europe six were already running below expectations on capex as of Q211 and this trend continued into Q3. Large builds like Sprint and AT&T (LTE) in the U.S. should help to partially offset this European effect but not completely, in our view. This adds up to a tough start to 2012 for equipment manufacturers and then an uncertain H2 given the continued threat of economic slowdown. As a result, we are cautious on most infrastructure names in early 2012 with the exception of Cisco (diversified into data networking). We also believe that optical networking companies like CIEN and INFN may see a pulse of investment with the advent of less-expensive 100G technology beginning in mid-2012.

Data NetworkingWe believe data-center virtualization will continue to be a major driver of growth in 2012. However, we see direct data center–oriented companies like FFIV as increasingly predictable in terms of their growth profile and so less attractive from a momentum point of view. We believe that key trends in 2012 will be increased spending on WAN optimization products like those of Riverbed as data centers consolidate. We also see the increasing complexity of various data center management/security/monitoring products as a key opportunity.

HandsetsWe believe that handset demand will shift with the macroeconomy. However, smartphones should continue to become a larger proportion of overall handset demand in 2012. We see this trend as positive for Qualcomm’s chipset business and potentially also helpful to royalties as smartphones cause a temporary shift upward in overall market ASPs for 3G devices. RIM and Nokia are also making a run at the so-called “3rd OS” position though we aren’t sure there is room for such in the market as Apple and Android continue to power ahead.

Best Idea – Riverbed (RVBD)

We continue to like Riverbed (RVBD) against a backdrop of slowing growth. We believe the WAN optimization market which Riverbed leads will continue to experience rapid growth even in a slow economy. We see ongoing data-center consolidation driven by virtualization as the key driver for this growth. We also believe that WANOP benefits from the move of businesses toward cloud-based services and away from owned infrastructure. Both the consolidation trend and the migration to cloud-based services should, if anything, strengthen as companies look for more ways to reduce costs.

Riverbed (RVBD) – Overweight – Dec 12 Price Target: $29



$26.74 $44.70 $18.33 Dec $0.58 $0.89 $1.26 30.0 21.2 $4,145Valuation: Target reflects 23x 2012E EPS, 34% premium to SMid-cap peers. Risks: Data-center consolidation does not drive uptake of WAN optimization as expected, macro risks to enterprise spending, increased competition from Cisco.

Rod Hall, CFA AC

(1-415) 315-6713

[email protected]

Joseph Park

(1-415) 315-6760

[email protected]

Ashwin Kesireddy

(1-415) 315-6756

[email protected]


Rajat Gupta

(91-22) 6157-3347

[email protected]

J.P. Morgan India Private Limited

Ciena Corp. CIEN N

Cisco Systems CSCO N

Corning GLW UW

F5 Networks FFIV N

Infinera INFN UW

Juniper Networks JNPR N

Motorola Mobility MMI N

QUALCOMM QCOM OW

Research in Motion RIMM N

Riverbed RVBD OW

Tellabs TLAB UW


US Year Ahead 2012

140


Computer Services & IT Consulting

Expecting Better Performance as Regulation Uncertainty Shifts to Execution

The Computer Services and IT Consulting coverage universe encompasses IT consulting, data processing, and payment processing and services companies. The payment processing space is characterized by recurring revenues that are generally insensitive to minor fluctuations in output and consumer spending (due to ongoing secular tailwinds). Payment processing companies have historically been a relative safe haven for investors during times of economic slowdowns or uncertainty, and we believe that theme will hold in 2012, should domestic fiscal policy tighten and growth moderate, as J.P. Morgan Economists predict. Regulation will continue to be the focus for the FinTech names, as financial institutions are likely to seek better economics in the coming year as regulatory pressures impact FI revenue streams. Slower growth and a continuation of elevated unemployment levels will likely be neutral to slightly negative for the HR and payroll providers, with innovation and strong sales execution serving as potential offsets to the tough macro backdrop. Finally, IT services stocks should benefit from a rising stock market, and an improving economic growth outlook throughout 2012. The potential for a mild recession in Europe is a risk but is likely priced in many IT services stocks.

Best Idea – MasterCard (MA)

MasterCard (MA) is the number two credit and debit network worldwide and benefits from the ongoing global secular shift towards card-based and electronic payments. MasterCard’s business is highly defensable and characterized by recurring revenues, high incremental margins, low capital expenditures, and high free cash flow. Amid a backdrop of potentially slowing domestic GDP growth and European uncertainty, we believe MasterCard is the most compelling large-cap growth idea in our payment processing coverage universe due to its 1) reasonable valuation (shares trade in line with our multi-year earnings growth rate) and 2) attractive business model which is both defensive (MA can reduce discretionary operating expenses in the face of slowing volume growth) and offensive (the company benefits from improved consumer confidence and spending). Unlike Visa, MasterCard has limited exposure to debit-card regulation, and recently announced several new processing and issuer wins that provide built-in growth next year.

MasterCard (MA) – Overweight – Dec 12 Price Target: $435



$371.30 $384.99 $215.00 Dec $14.05 $18.58 $21.75 20.0 17.1 $47,628 Target reflects 17x 2013E EPS, in line with our multiyear EPS growth forecast, representing a slight discount to MA’s historical PEG ratio. Risks: Material adverse impact from pending debit interchange regulation, unforeseen payment processing regulation in non-U.S. markets, increased competition from alternative payment processing providers, deceleration in GDV growth, increased pricing pressure, major issuer defection, larger-thananticipated legal settlements for pending legal/regulatory cases.

Tien-tsin Huang, CFA AC

(1-212) 622-6632

[email protected]

Reginald L. Smith, CFA

(1-212) 622-6743

[email protected]

Stephanie Davis

(1-212) 622-6591

[email protected]


Tien-tsin Huang, CFA

Accenture plc ACN OW

Automatic Data Processing ADP N

Broadridge BR OW

Cognizant CTSH OW

Computer Sciences CSC UW

ExlService Holdings Inc. EXLS OW

FIS FIS UW

Fiserv, Inc. FISV N

FleetCor FLT N

Genpact G N

Global Payments GPN OW

Green Dot GDOT OW

Heartland Payment Systems HPY N

MasterCard MA OW

MoneyGram MGI N

Paychex Inc PAYX UW

VeriFone PAY (rs)

Visa Inc. V OW

Western Union WU OW

WNS Holdings Ltd. WNS UW

Wright Express WXS N

Reginald L. Smith, CFA

Alliance Data ADS N

Cardtronics, Inc CATM OW

Puneet Jain

Syntel, Inc. SYNT OW

Virtusa Corp. VRTU N


US Year Ahead 2012

141


IT Hardware

Macro Challenges May Worsen, But Apple Offers Partial Buffer to Weather the Storm

We first called out the increasing risk of macroeconomic pressures in our April 18 Quarterly Crossroads industry report, and we think that the duration and severity of the macroeconomic slowdown could be worse than investors anticipate. In our view, it is this disconnect that could drive many stock valuations lower in the near to mid-term. Our view is based on 1) continued macroeconomic uncertainty, 2) our recent CIO survey, and 3) inputs from our primary research contacts.

The J.P. Morgan Global Manufacturing PMI declined in November and remains at a depressed level. In our view, the recent reading does not provide a good setup for a year-end IT spending push or for the start to 2012. As austerity measures in the U.S. and EMEA likely usher in more fiscally disciplined spending and government infrastructure decreases, we expect all industry verticals, including technology, to be negatively affected in the next 12 months. We expect this dynamic to be compounded by any moderation in growth out of Asia-Pacific, especially China.

Similarly, the J.P. Morgan CIO Survey published on September 29 pointed to tough times ahead. Spending cuts have begun, and the items that stand to be affected the most in a protracted downturn include hardware and services. Our latest research indicates that CIO budgets remain under pressure, including high-priority items, which points to a tepid spending environment exiting 2011. As a result, we prefer market share gainers, such as Apple, that stand to post above-peer revenue and earnings growth in spite of challenging times.

Best Idea – Apple (AAPL)

Overweight-rated Apple (AAPL) remains one of our top picks in IT Hardware. We recommend that investors take advantage of the recent cooling-off period in the stock. Apple navigated the prior global downturn in 2008-09 better than most tech companies, and we think that Apple’s current model is even stronger. Breakout revenue growth, upward-trending margins, and incremental market penetration opportunities are offsets at Apple that most tech companies do not possess.

Our current estimates point to above-peer revenue and earnings growth, despite current macroeconomic challenges and a large revenue base. Key drivers include increasing sales momentum for iPhone and iPad, as well as sustainable market penetration with the Mac, particularly MacBook Air. Geographically, Asia and Latin America also offer significant, multi-year growth opportunities. Add in iTunes and iCloud, and we think that Apple’s digital “way of life” underpins a formidable moat to fend off competitive and economic challenges.

In our view, Apple is trading as a “value stock” and not as the high-growth story in large-cap equities. At 10.9x our C2012 EPS estimate, Apple is trading well below its three-year average of 16.2x.Our Dec-12 price target of $525 implies 34% upside from current levels. Apple is the only stock in our coverage list for which we expect both revenue and EPS estimates to have upside potential in the next 6-12 months.

Apple (AAPL) – Overweight – Dec 12 Price Target: $525



$390.95 $426.70 $310.50 Sep $27.68 $35.17 $39.53 11.1 9.9 $363,353 Valuation: Target reflects a weighted blend of EV/EBITDA and P/E scenarios utilizing historical peak/trough multiples. Risks: Incremental macroe weakness or slowing expansion, disruption in competitive dynamics, gross margin pressure, slower rate of new product refreshes.

Mark Moskowitz AC

(1-415) 315-6704

[email protected]

Anthony Luscri

(1-415) 315-6702

[email protected]

Mike Kim

(1-415) 315-6755

[email protected]


Mark Moskowitz

Aeroflex ARX N

Apple Inc. AAPL OW

Brocade BRCD UW

Dell Inc. DELL UW

EMC EMC N

Emulex Corp. ELX UW

Fusion-io FIO N

Hewlett-Packard HPQ UW

IBM IBM OW

Lexmark International LXK UW

NetApp NTAP OW

Orbotech ORBK N

QLogic Corporation QLGC UW

Seagate Technology STX N

STEC STEC UW

Western Digital WDC N

Xerox Corporation XRX UW

Anthony Luscri

National Instruments NATI OW


US Year Ahead 2012

142


Semiconductor Capital Equipment

Look for Fundamentals to Trough in C1Q12; It’s Time to Load Up for the Next Cycle

We believe C1Q12 will be the fundamental trough quarter for the SemiCap sector and expect fundamentals to improve throughout the remainder of the year. We think it’s the right time in the cycle to get long SemiCap stocks.

We expect C12 Wafer Fab Equipment (WFE) spending to return to C10 levels, likely troughing in C1Q12. Overall, for the year we estimate semi capex will decline 15-20% from C11 levels. With weaker macro demand as a backdrop, Foundry and Intel capex should decline meaningfully in C12 after a relatively large spend in C11. We expect NAND capex to be flat to modestly down given secular growth in end demand, and DRAM capex, which has been weak for a number of quarters, to remain relatively flat at low levels. Overall, we expect Foundry capex will decline the most of all segments y/y as factory utilization rates remain low exiting C11. That being said, SemiCap stocks generally discount fundamentals 3-6 months ahead and we think it is the right time in the cycle to take long positions in the sector. As it becomes more apparent that semi fundamentals have troughed in C4Q11/C1Q12, we believe investors will get more positive on the outlook for semi capex and SemiCap stocks.

Best Idea – Lam Research (LRCX)

Our top pick in Semiconductor Capital Equipment is Lam Research (LRCX) with its higher-than-average exposure to memory which we expect to outperform in terms of capex in 2012. Lam Research is poised to capitalize on share gain momentum in its core Etch equipment business as well as benefit from Single Wafer Wet and Bevel Clean, two equipment segments that are relatively small but have significantly outgrown the WFE market over the past ten years. In addition, with over $2bn in cash and short-term investments, Lam Research has been very vocal in regards to share repurchase; as of the end of C3Q11, LRCX had $575mn set aside for this activity. We expect aggressive share repurchase would increase EPS meaningfully in C12. Our Dec-12 price target of $56.00 for LRCX is based on 3.0x our C12 revenue estimate of $2.4bn. We believe 3.0x represents a forward-looking, cross-cycle average P/S multiple for LRCX. At this time, LRCX is trading at 2.2x our C12 revenue estimate.

Lam Research (LRCX) – Overweight – Dec 12 Price Target: $56



$42.86 $59.10 $34.92 Jun $5.86 $1.54 N/A 27.8 N/A $5,124 Risks: Protracted semi capex down cycle exacerbated by weak consumer demand, high exposure to Foundry & Memory and high level of volatility in memory pricing and associated capital spending of these customers, increased competition in Clean.


(1-415) 315-6708

[email protected]

William Peterson

(1-415) 315-6711

[email protected]


Applied Materials, Inc. AMAT N

KLA-Tencor KLAC N

Lam Research LRCX OW

MEMC Electronic Materials WFR UW

Novellus Systems NVLS OW

Photronics PLAB N

Veeco Instruments VECO OW


US Year Ahead 2012

143


Semiconductors

Semiconductor Fundamentals Bottoming, Driving Upside in 2012: Hop in the Minivan!

As we approach 2012, we continue to see evidence of a bottom in semiconductor fundamentals, as multiple semiconductor companies and distributors have indicated orders remain stable and book-to-bill for 1Q12 appears to be close to parity. We believe we are in Phase II of the semiconductor upturn as companies have stopped lowering estimates, and we expect upside to Consensus estimates in 1Q12 as orders and fundamentals improve. As a result, we reiterate our positive stance on the sector and continue to recommend buying stocks ahead of the recovery.

Phase I of the Upturn: Stabilizing orders—already happened. Multiple semiconductor companies and distributors such as Intel, Texas Instruments, Microchip, ON Semi, Arrow, and Avnet have recently stated order rates continue to be stable, as they have been over the previous six weeks. Avnet stated its book-to-bill for 1Q12 is approaching parity, the first time in almost a year.

Phase II: Companies stop lowering estimates—happening now. We believe we are now in Phase II of the upturn—semiconductor companies stop lowering estimates. We expect this to continue through the end of the year.

Phase III: Orders improve—expected early 1Q12. We believe Phase III of the upturn will occur when several semiconductor companies report improving order rates as demand stabilizes and inventory needs to be replenished.

Phase IV: Estimates start to move up—likely late 1Q12. We believe Phase IV of the upturn will be when semiconductor companies raise expectations on the back of a continued improvement in order rates. We expect Consensus estimates to rise in late 1Q12 as semiconductor companies raise guidance.

Semis under-shipping end demand by at least 10%. The SIA data combined with 4Q11 guidance indicate semiconductor units should decline 6% during 2H11, far below the 5% unit growth for PCs and 8% unit growth for handsets. We believe this is hard evidence that semiconductors are under-shipping end demand, and should lead to a bounce in order rates during 1Q12 due to inventory replenishment.

Same thing happened during last upturn in 2009. During the previous upturn in 2009, INTC and TXN orders stabilized in late 4Q08. In early 1Q09 both INTC and TXN lowered guidance, but neither stock traded down, and in late 1Q09 both companies’ orders improved. Subsequently, INTC and TXN raised guidance in 2Q09on stronger demand and Consensus estimates rose.

Best Idea – Texas Instruments (TXN)

Texas Instruments (TXN) is our top pick due to a bottom in fundamentals and upside potential to Consensus estimates throughout 2012. We also expect roughly 10% EPS accretion in C12 from its recent acquisition of National Semiconductor.

Texas Instruments (TXN) – Overweight – Dec 12 Price Target: $33*



$30.42 $36.71 $24.34 Dec $2.63 $1.83 $1.75 16.6 17.4 $34,759 * Target and estimates as of December 9, 2011. Valuation: Target reflects average of P/S and P/E based on historical trends. Risks: Sudden economic decline in a particular country or geographic region, weaker-than-expected global economic recovery.

Chris Danely AC

(1-415) 315-6774

[email protected]

Shaon Baqui

(1-415) 315-6766

[email protected]

Venk Nathamuni

(1-415) 315-6783

[email protected]


Christopher Danely

Advanced Micro Devices AMD N

Altera ALTR N

Analog Devices ADI OW

Avago Technologies AVGO N

Cypress Semiconductor CY UW

Intel INTC OW

Linear Technology LLTC N

Maxim Integrated Products MXIM UW

Microchip Technology MCHP N

ON Semiconductor Corporation ONNN OW

RF Micro Devices RFMD UW

Texas Instruments TXN OW

Xilinx XLNX OW

Venk Nathamuni

Fairchild Semiconductor FCS OW

Intersil Corporation ISIL N


US Year Ahead 2012

144


SMid Semiconductors

Signs of Bottoming in Demand and Market Segment Recovery Set Up a Positive 2012

Despite some near-term challenges for our universe of SMid semiconductor companies, we believe that the same market segments (comm. infrastructure, enterprise server/storage, smartphones/tablets) that drove strong growth over the past couple of years will continue to provide attractive expansion opportunities in 2012,particularly for product cycle–driven stocks like BRCM and CAVM.

Looking back on 2011, the global macroeconomic uncertainty has resulted in pushouts of wireless infrastructure projects by carriers as well as more conservative deployment of enterprise IT capex by corporations. Also, the recent flooding in Thailand has placed a severe constraint on near-term HDD growth. However, we believe the market has already baked in these developments and is discounting a larger-than-warranted impact to 2012 revenues and earnings, setting the stage for a move up in SMid semi stocks.

As 2011 draws to a close, we see positive indications that SMid semi companies could see a modest recovery in 1H12 and a stronger snapback in 2H12. In particular, commentary from several semi companies and distributors (CAVM, MRVL, TXN, FCS, MCHP, ARW) during the last earnings season suggests a bottoming in order rates and a return to more normal patterns.

In terms of market segments, carriers likely will have better clarity regarding wireless network requirements in the New Year and should resume 3G and 4G network deployments in earnest during 1H. We also believe that IT spending will recover in 2012 as corporations take stock of the increasing demand on data processing/storage infrastructure. As for HDDs, we anticipate a modest recovery through the 1H, as getting capacity back online will likely be a protracted process lasting several quarters. We believe the 2H will exhibit a larger snapback in HDD shipments, given the pent-up demand over the course of the manufacturing recovery. The one market vertical that bucked the trend and remained strong through the macro sluggishness was smartphones/tablets, and we believe that it will continue to drive robust growth in 2012.

Best Idea – Broadcom Corporation (BRCM)

Broadcom Corporation (BRCM) has a solid track record of significantly outgrowing the overall semiconductor market. Over the last five years, BRCM’s revenues have grown 15% per year while the semi industry has grown only 4% per year, and BRCM’s earnings have grown by 16% per year over the same period. In 2011, we estimate BRCM’s revenues will grow nearly 8% compared to forecast growth of 1% for overall semi revenues by J.P. Morgan’s Large-Cap Semiconductor analyst, Chris Danely. We believe BRCM continues to exhibit solid fundamentals that will enable it to keep outperforming the market for the foreseeable future. In 2012, we anticipate the company will experience multiple new customer program ramps utilizing its combo connectivity, Ethernet controller and switch, microwave backhaul, and settop-box solutions.

Broadcom Corporation (BRCM) – Overweight – Dec 12 Price Target: $45



$30.10 $46.89 $29.17 Dec $2.70 $2.84 $2.80 10.6 10.8 $16,224 Valuation: Target reflects 13.5x run-rate 2H12E non-GAAP EPS, consistent with estimated 12-15% revenue and earnings growth for the foreseeable future. Risks: Ultra-competitive environment in WLAN & combo solutions, slower or delayed Nokia & Samsung 2.5G & 3G ramp.

Harlan Sur AC

(1-415) 315-6700

[email protected]

John S. Ahn

(1-415) 315-6758

[email protected]

Saqib Jalil

(1-415) 315-6761

[email protected]


Broadcom Corporation BRCM OW

Cavium Networks CAVM OW

Entropic Communications ENTR N

Freescale Semiconductor FSL OW

LSI Corporation LSI N

Marvell Technology Group MRVL OW

Mellanox Technologies MLNX N

Micron Technology MU N

NVIDIA Corporation NVDA N

NXP Semiconductors NXPI N

PMC-Sierra PMCS N

SanDisk Corp SNDK N


US Year Ahead 2012

145


Software

Likely to Get Worse Before It Gets Better

We agree with our economist’s view of the U.S. economy, but have a more pessimistic view of what the fallout of European, U.S. Federal government, and potential Financial Services weakness will mean for IT spending worldwide. While we agree with our strategist’s anticipation of a volatile 2012, we believe deep global macro forces will hamper progress. Therefore, we believe investors should position defensively to offset any potential downward market forces. This likely will dilute constructive moves, but in our view is worth the cost in such an uncertain time.

We believe that almost half of worldwide IT and Software spending will see a net negative impact due to pressure from these macro forces, as we estimate that European governments account for 10-15%, the U.S. government for about 10%, and Financial Services (including Insurance) for about 20% of worldwide IT and Software spending. We have written extensively on this subject, with the most recent note, “As Nero Fiddled . . .” published October 24.

Best Ideas – Avoid Citrix Systems, Inc. (CTXS)/Red Hat Inc (RHT)

In this context, our best ideas are to underweight CTXS and RHT. For CTXS, we believe the opportunity for Desktop Virtualization is much more cannibalistic than incremental, and is unlikely to be adopted by the masses of corporations given such an elusive ROI. In addition, some highly regulated industries that are most likely to adopt Desktop Virtualization for security, compliance, and control reasons are likely to see incremental pressure (Government, Financial Services, and Health Care). We believe RHT is misunderstood by investors, as the real business momentum of the company is exaggerated with a simple calculation of billings proxy. An annualized billings analysis is more appropriate, in our view. In addition, we believe Red Hat will not see leverage in the most important expense line of a software company—Sales & Marketing—since it has to pay its sales force high commissions on subscription renewals.

For investors that are more optimistic on the market, we like Overweight-rated ORCL. ORCL is likely to experience a positive secular trend of its own making related to its Exadata product line. See our note, “All That Remains Is . . . Exacution” dated November 17.

Citrix Systems, Inc. (CTXS) – Underweight – Dec 12 Price Target: $53



$73.23 $88.49 $50.21 Dec $2.08 $2.46 $2.63 29.8 27.8 $13,657 Valuation: Target reflects DCF analysis incorporating our Base Case scenario for XenDesktop revenue. Risks: Embedded XenDesktopfunctionality could spur upgrade cycle, customers moving to reduce dependence on VMware, leverage to economic recovery.

Red Hat Inc (RHT) – Underweight – Dec 12 Price Target: $32*



$50.55 $53.42 $31.77 Feb $0.83 $1.05 $1.11 48.1 45.5 $9,748 * Target as of December 9, 2011. Valuation: Target reflects DCF scenario analysis. Risks: Emerging as one of a few server virtualization players, stops paying sales commission on subscription renewals, share gains in Linux market.

John DiFucci AC

(1-212) 622-2341

[email protected]

Darren Jue

(1-212) 622-4071

[email protected]

Sandeep Madhur

(1-212) 622-6516

[email protected]

Kenneth R Talanian Jr.

(1-212) 622-1303

[email protected]

Marc P Griffin

(1-212) 622-5615

[email protected]


BMC Software, Inc. BMC UW

CA Technologies CA OW

Carbonite Inc. CARB OW

Citrix Systems, Inc. CTXS UW

LogMeIn LOGM OW

Microsoft MSFT N

Oracle Corp. ORCL OW

PROS Holdings PRO N

Qlik Technologies Inc. QLIK OW

Quest Software QSFT OW

Red Hat Inc RHT UW

salesforce.com CRM N

SolarWinds SWI OW

Symantec SYMC OW

Taleo TLEO OW

TIBCO Software Inc TIBX OW

VMware VMW N


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Software Technology

Waiting for Macro Clarity So Investors Can Focus on Company Fundamentals

After a very big 2010 when our software technology coverage outperformed the market by almost a factor of three times, 2011 has been almost a mirror image of the overall market with performance roughly flat year to date vs. the S&P 500 up 0.1% year to date. Looking to 2012, it appears that at least the first part will be much more about the macro backdrop than company fundamentals in terms of stock price performance, because if investors are highly confident in forward estimates we would expect share prices to be much higher than current levels. For those that believe a resolution of the European financial and economic situation can be achieved in the near term, we would point to high-quality cyclical names like Autodesk and Rovi. But for investors that are in the camp of believing another potential economic meltdown is imminent our most defensive name remains Neustar. For our favorite pick we are going with a stock we believe offers considerable upside in more favorable economic times, but provides some stability with its recurring revenue during choppy environments.

Best Idea – Equinix (EQIX)

Sometimes having your head in the cloud is a good thingEquinix (EQIX) has established itself as the clear leader in the collocation segment of the data-center industry, and with several large trends providing a tailwind to growth, a stable recurring revenue model, and high margins, we believe this makes for an attractive investment opportunity.

Our expectation for the data-center industry, which we currently estimate at $12bn of annual revenue, is growth of 15-20% for the next five years. Within that, we expect Equinix to continue to be the number one provider of collocation, one of the three main segments in the data-center industry.

Demand for Equinix data-center solutions is being spurred by several large trends including enterprises moving more solutions to both private and public clouds and users digesting more content over the Internet given the rapidly increasing use of mobile devices like smartphones for Internet access (mobile data).

Roughly 95% of revenue is recurring in nature and there is only approximately 8% customer churn each year; combine this with 45%+ EBITDA margins and this is a very attractive business model with high visibility and cash flow generation.

Our Dec-12 price target of $120 is based on an EV/EBITDA multiple of 8.9x versus the average of 9.8x for the last three years.

Equinix (EQIX) – Overweight – Dec 12 Price Target: $120



$102.48 $107.00 $78.78 Dec $2.78 $2.98 $3.48 34.4 29.4 $4,859 Risks: More customers opting for in-house or generic wholesale data-center capacity, recurring revenue leveling out, capital-intensity of business could have some expansion drag on incremental margin.

Sterling Auty, CFA AC

(1-212) 622-6389

[email protected]

Lauren Choi

(1-212) 622-6102

[email protected]

Saket Kalia, CFA

(1-212) 622-6477

[email protected]


Sterling Auty, CFA

Advent Software ADVS UW

Akamai Technologies, Inc. AKAM N

Amdocs DOX N

ANSYS, Inc. ANSS N

Aspen Technology AZPN OW

Autodesk ADSK OW

Blackbaud Inc BLKB N

Cadence Design Systems CDNS OW

Check Point Software CHKP N

Comverse Technology CMVT N

CSG Systems CSGS N

Equinix EQIX OW

Fortinet, Inc FTNT N

Intuit INTU OW

Motricity, Inc MOTR OW

Neustar NSR N

Parametric Technology Corp. PMTC OW

Rovi ROVI OW

SS&C Technologies SSNC OW

Synopsys Inc SNPS OW

VeriSign VRSN N

Websense WBSN UW

Lauren Choi

Ariba, Inc ARBA OW

Synchronoss Technologies SNCR N

Saket Kalia, CFA

Mentor Graphics MENT N

Monotype Imaging TYPE OW


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Technology Supply Chain

We Favor Jabil’s Clear Growth and Margin Improvement Plan Amid the Uncertain Macro

We believe the EMS industry may be underappreciated with near-trough valuations over fears of a cyclical downturn and concerns aggressive competition could arise as new business pipelines slow. However, we expect EMS to see a growing addressable market driven by increased outsourcing from nontraditional sources such as the medical, industrial, and energy industries. We believe a weak macro environment could provide incentive for OEMs in these industries to move to variable cost structures and capture manufacturing and procurement savings. Also, we do not expect EMS competitors to chase growth via price as high margins and ROIC, not growth, are rewarded with premium valuations. Hence, we believe an investment strategy based on timing cyclical upturns may forego a compelling opportunity at current attractive valuations. We recognize that moderately high inventory levels for communications and networking, from which EMS companies still derive the majority of revenues (although not necessarily profits), could have a dampening effect during 1H12. But we see a trend toward supply chain consolidation in these industries benefiting larger EMS companies, such as Jabil Circuit and Flextronics.

We expect electronic connector demand to reflect global GDP plus a small margin derived from content growth. While admittedly not exciting from a growth perspective, we believe connectors could be relatively stable during an uncertain 2012 due to diverse geographic revenue streams, low customer concentration risks, declining materials costs, and an early move toward supply chain inventory reduction which began in June. However, we remain concerned with Amphenol’s ~18% exposure to defense and Molex’s 19% exposure to consumer electronics.

We maintain our cautious view toward General Cable due to its 30% exposure to Europe and North Africa. A first-half 2012 recession could depress both demand and prices. We estimate nearly 75% of General Cable’s business is tied directly or indirectly to construction spending which may be finally nearing a bottom.

While enterprise voice vendors’ VoIP call control systems provide compelling value through efficiency improvement and expense savings, we continue to believe risingemployment is the primary catalyst for system upgrades. Hence, with J.P. Morgan’s expectation for elevated unemployment levels in 2012, ShoreTel and Mitel could face a challenging year. The government and education verticals represent over 10% of industry demand and tightening public sector spending may also be a headwind.

Best Idea – Jabil Circuit (JBL)

We continue to believe Jabil Circuit (JBL) is positioned to deliver multi-year margin improvement while outgrowing peers. We expect above-peer growth to be driven by the burgeoning materials business, the after-market services business, as well as the increasing opportunities from industrial, medical, and cleantech industries where outsourced manufacturing penetration is low. These growth opportunities now represent 40% of JBL’s revenue and carry margins substantially above the corporate average. Despite having a clear revenue growth and margin improvement strategy and delivering consistent results, Jabil trades at a discount to peers.

Jabil Circuit (JBL) – Overweight – Dec 12 Price Target: $22

Price 52-wk range FY EPS P/E Mkt Cap


$20.86 $23.09 $13.94 Aug $2.34 $2.55 $2.83 8.2 7.4 $4,343 Valuation: Target reflects peer average 4.5x EV/EBITDA on 2012E. Risks: Slowing product demand resulting in fewer new outsourced manufacturing projects, OEMs choosing to manufacture more products in house.

Steven O’Brien AC

(1-212) 622-6554

[email protected]


Amphenol APH N

Fabrinet FN OW

Flextronics FLEX OW

General Cable BGC N

Jabil Circuit JBL OW

Mitel Networks MITL N

Molex MOLX N

Powerwave Technologies PWAV N

ShoreTel SHOR OW

TE Connectivity TEL (rs)


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Stock Ratings and Prices of Companies Discussed in This Report

Ratings and prices for analysts’ second half “best ideas” appear on the corresponding sector page. Stock prices and ratings are as of the close on December 6, 2011.

Company Name Ticker Rating Price Company Name Ticker Rating Price

Autodesk ADSK OW $34.78 The Intercontinental Exchange ICE OW $123.28

AK Steel AKS OW $8.68 International Flavors & Fragrances IFF OW $54.02

Altera ALTR N $36.84 Incyte Corporation INCY OW $13.50

Alexion Pharmaceuticals ALXN OW $65.05 Infinera INFN UW $7.01

Amylin Pharmaceuticals AMLN N $10.79 Intel INTC OW $25.35

Amazon.com AMZN OW $191.99 Gartner Inc. IT OW $37.20

Air Products and Chemicals APD OW $82.82 J.B. Hunt Transport Services, Inc. JBHT OW $45.53

Amphenol APH N $45.50 J.C. Penney Co., Inc. JCP OW $33.30

Apollo Group APOL OW $50.14 Jacobs Engineering JEC OW $42.61

Ashland Inc. ASH OW $57.11 John Wiley & Sons JWa OW $47.48

athenahealth ATHN UW $61.00 Nordstrom, Inc. JWN N $47.36

General Cable BGC N $26.73 KeyCorp KEY OW $7.33

Progressive Waste Solutions Ltd. BIN OW $20.38 Kraft Foods KFT N $36.51

BioMarin Pharmaceuticals BMRN OW $33.59 Kinder Morgan Energy Partners L.P. KMP N $78.72

Cavium Networks CAVM OW $32.46 Coca-Cola Co. KO N $66.68

Cerner Corp CERN OW $61.06 Kohl's Corp. KSS UW $50.73

Ciena Corp. CIEN N $11.50 LyondellBasell Industries LYB OW $33.70

Comerica Incorporated CMA OW $25.89 ManpowerGroup MAN OW $37.77

Cisco Systems CSCO N $18.73 Microchip Technology MCHP N $34.90

CSX CSX OW $21.83 Allscripts Healthcare Solutions MDRX OW $19.36

Cooper Tire & Rubber CTB OW $13.77 The McGraw-Hill Companies MHP OW $42.75

Dendreon DNDN OW $8.66 Mitel Networks MITL N $3.13

Dow Chemical DOW OW $28.05 Martin Marietta Materials MLM OW $75.84

Ecolab Inc. ECL OW $55.58 Motorola Mobility MMI N $38.85

Equifax EFX OW $37.75 Molex MOLX N $24.72

Estee Lauder EL N $112.22 Merck & Co., Inc. MRK OW $35.40

Endo Pharmaceuticals ENDP OW $33.99 Marvell Technology Group MRVL OW $14.10

EOG Resources, Inc. EOG OW $104.89 Medicis Pharmaceutical Corp. MRX OW $33.50

El Paso Corp. EP OW $25.13 Arcelor Mittal MT OW $19.30

Experian plc EXPN.L OW GBp834 Noble Energy NBL OW $98.38

Ford Motor Company F N $11.05 Nokia ADR NOK UW $5.41

FedEx Corp FDX OW $82.67 Norfolk Southern NSC OW $74.86

F5 Networks FFIV N $114.32 Neustar NSR N $33.66

Flextronics FLEX OW $5.98 Nu Skin Enterprises NUS OW $49.15

Fluor Corp FLR OW $54.64 ON Semiconductor Corporation ONNN OW $8.20

FirstMerit Corporation FMER OW $14.49 Oracle Corp. ORCL OW $31.73

First Republic FRC OW $29.15 Philip Morris International PM N $75.58

Forest Laboratories, Inc FRX OW $30.05 PrivateBancorp, Inc. PVTB OW $9.76

FXCM FXCM OW $10.44 QUALCOMM QCOM OW $54.83

Gilead Sciences GILD OW $39.80 Quality Systems QSII OW $36.63

General Motors GM OW $21.68 Research in Motion RIMM N $17.03

Goodyear Tire & Rubber GT OW $14.27 Rock-Tenn RKT OW $57.06

Harman International HAR OW $40.68 Rovi ROVI OW $27.06

Hess HES OW $60.42 Republic Services Inc RSG OW $27.15

Human Genome Sciences HGSI OW $7.34 Sprint Nextel S N $2.61

Hospira, Inc. HSP OW $28.14 Signature Bank SBNY OW $59.36

Hub Group HUBG OW $31.24 Seattle Genetics SGEN N $17.20


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Company Name Ticker Rating Price Company Name Ticker Rating Price

ShoreTel SHOR OW $6.10 Vulcan Materials VMC N $33.90

SVB Financial SIVB OW $46.96 ViroPharma Incorporated VPHM OW $23.59

Saks, Inc. SKS N $9.73 Pharmasset VRUS N $128.13

Sara Lee SLE OW $18.94 Valeant Pharmaceuticals VRX OW $46.56

Solera Holdings SLH OW $45.90 Verizon Communications VZ N $38.32

Stericycle Inc. SRCL N $80.24 Warner Chilcott WCRX OW $16.35

Strayer Education STRA OW $98.73 Werner Enterprises WERN OW $24.27

Swift Transportation SWFT OW $9.36 Wells Fargo WFC OW $26.65

AT&T T (rs) $29.17 Whole Foods Market WFM N $69.83

Teva Pharmaceuticals TEVA OW $40.05 Westlake Chemical Corp. WLK OW $42.63

Tesla Motors TSLA OW $34.87 Waste Management WM N $31.61

Tupperware Brands TUP OW $56.23 Watson Pharmaceuticals WPI OW $62.39

United Parcel Service UPS OW $71.80 U.S. Steel Corp X OW $28.27

U.S. Bancorp USB OW $26.21 Yum Brands YUM OW $57.33

Visa Inc. V OW $95.37 Zions Bancorporation ZION OW $16.32

Varian Medical VAR N $64.43


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Disclosures

Disclosures

A portion of this report is a product of the research department's Global Equity Derivatives and Delta One Strategy group. Views expressed may differ from the views of the research analysts covering stocks or sectors mentioned in this report. Structured securities, options, futures and other derivatives are complex instruments, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Because of the importance of tax considerations to many option transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated option transactions.

Analyst Certification: The research analyst(s) denoted by an “AC” on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an “AC” on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst's compensation was, is, or will be directly or indirectly related to the specific recommendations or viewsexpressed by the research analyst(s) in this report.

Important Disclosures

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Explanation of Equity Research Ratings and Analyst(s) Coverage Universe: J.P. Morgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analyst's (or the analyst's team's) coverage universe.] In our Asia (ex-Australia) and UK small- and mid-cap equity research, each stock’s expected total return is compared to the expected total return of a benchmark country market index, not to those analysts’ coverage universe. If it does not appear in the Important Disclosures section of this report, the certifying analyst’s coverage universe can be found on J.P. Morgan’s research website, www.morganmarkets.com.


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J.P. Morgan Equity Research Ratings Distribution, as of September 30, 2011

Overweight(buy)

Neutral(hold)

Underweight(sell)

J.P. Morgan Global Equity Research Coverage 47% 42% 11%IB clients* 51% 44% 33%

JPMS Equity Research Coverage 45% 47% 7%IB clients* 70% 60% 52%

*Percentage of investment banking clients in each rating category.For purposes only of FINRA/NYSE ratings distribution rules, our Overweight rating falls into a buy rating category; our Neutral rating falls into a hold rating category; and our Underweight rating falls into a sell rating category.

Equity Valuation and Risks: For valuation methodology and risks associated with covered companies or price targets for covered companies, please see the most recent company-specific research report at http://www.morganmarkets.com , contact the primary analyst or your J.P. Morgan representative, or email [email protected] .

Equity Analysts' Compensation: The equity research analysts responsible for the preparation of this report receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factors, and overall firm revenues, which include revenues from, among other business units, Institutional Equities and Investment Banking.

Registration of non-US Analysts: Unless otherwise noted, the non-US analysts listed on the front of this report are employees of non-US affiliates of JPMS, are not registered/qualified as research analysts under NASD/NYSE rules, may not be associated persons of JPMS, and may not be subject to FINRA Rule 2711 and NYSE Rule 472 restrictions on communications with covered companies, public appearances, and trading securities held by a research analyst account.

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"Other Disclosures" last revised September 30, 2011.

Copyright 2011 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of J.P. Morgan. #$J&098$#*P


US Year Ahead 2012

156


Equity Research – AmericasMacroPortfolio Strategy Thomas J. Lee, CFA (1-212) 622-6505 [email protected] Strategy – Small Cap Bhupinder Singh (1-212) 622-6406 [email protected] Technical Strategy Michael Krauss (1-212) 834-5103 [email protected] Quantitative Strategy Dubravko Lakos-Bujas (1-212) 622-3601 [email protected] & Valuation Dane Mott, CPA (1-415) 315-5905 [email protected] Derivatives & Delta One Strategy Marko Kolanovic (1-212) 272-1438 [email protected]

Capital Goods/IndustrialsAerospace & Defense Joseph B. Nadol III (1-212) 622-6548 [email protected] & Surface Transportation Thomas R. Wadewitz (1-212) 622-6461 [email protected] Equipment & Multi-Industry C. Stephen Tusa, Jr., CFA (1-212) 622-6623 [email protected] & Construction/Environmental Services Scott Levine (1-212) 622-5609 [email protected] Ann Duignan (1-212) 622-0381 [email protected] Jamie Baker (1-212) 622-6713 [email protected] & Auto Parts Himanshu Patel, CFA (1-212) 622-3906 [email protected] Manufacturing and Retail Kenneth Goldman (1-212) 622-0359 [email protected] & Lodging / Leisure Joseph Greff (1-212) 622-0548 [email protected] Building & Building Products Michael Rehaut, CFA (1-212) 622-6696 [email protected] & Personal Care Products/Beverages John Faucher (1-212) 622-6443 [email protected] John Ivankoe (1-212) 622-6487 [email protected] – Broadlines, Apparel & Footwear Matthew R. Boss, CPA (1-212) 622-5260 [email protected] – Hardlines/Discounters Christopher Horvers, CFA (1-212) 622-1316 [email protected] – Specialty Brian J. Tunick (1-212) 622-6449 [email protected] Utilities & Independent Power Producers Andrew Smith (1-713) 216-7681 [email protected] MLPs Jeremy Tonet (1-212) 622-4915 [email protected] & Gas Exploration & Production Joseph Allman, CFA (1-212) 622-4864 [email protected] Services & Equipment David Anderson, PE, CFA (1-212) 622-6684 [email protected] American Integrated Oils & Major Producers Katherine Lucas Minyard (1-212) 622-6402 [email protected]

Asset Managers, Brokers, and Exchanges Kenneth B. Worthington, CFA (1-212) 622-6613 [email protected] – Large Cap Vivek Juneja (1-212) 622-6465 [email protected] – Mid- and Small Cap Steven Alexopoulos, CFA (1-212) 622-6041 [email protected] – Life Jimmy S. Bhullar, CFA (1-212) 622-6397 [email protected] – Non-Life Matthew G. Heimermann (1-212) 622-6545 [email protected]/Real Estate Services Michael W. Mueller, CFA (1-212) 622-6689 [email protected]/Real Estate Services Anthony Paolone, CFA (1-212) 622-6682 [email protected] & Consumer Finance Richard Shane (1-415) 315-6701 [email protected] Geoffrey Meacham (1-212) 622-6531 [email protected] – SMid Cap Cory Kasimov (1-212) 622-5266 [email protected] Information Technology Atif Rahim (1-212) 622-6671 [email protected] Techonology & Distribution Lisa C. Gill (1-212) 622-6466 [email protected] Sciences Tools & Diagnostics Tycho W. Peterson (1-212) 622-6568 [email protected] Care/Health Care Services John Rex (1-212) 622-6600 [email protected] Technology & Devices Michael Weinstein (1-212) 622-6635 [email protected] – Major/Specialty Chris Schott, CFA (1-212) 622-5676 [email protected] – Specialty, Commodity & Agricultural Jeffrey J. Zekauskas (1-212) 622-6644 [email protected] &Precious Metals John Bridges CFA, ACSM (1-212) 622-6430 [email protected] & Mining Michael F. Gambardella (1-212) 622-6446 [email protected] & Packaging Phil Gresh (1-212) 622-4861 [email protected]/TelecomInformation Services/TV & Radio Broadcasting Michael Meltz, CFA (1-212) 622-0416 [email protected] Doug Anmuth (1-212) 622-6571 [email protected]

Media Alexia Quadrani (1-212) 622-1896 [email protected], Cable, and Satellite Services Philip Cusick (1-212) 622-1444 [email protected] Energy & Semiconductor Capital Equipment Christopher Blansett (1-415) 315-6708 [email protected] and Emerging Technologies Paul Coster, CFA (1-212) 622-6425 [email protected] & Education & Services Andrew Steinerman (1-212) 622-2527 [email protected] Equipment Rod Hall, CFA (1-415) 315-6713 [email protected] Services & IT Consulting Tien-Tsin Huang, CFA (1-212) 622-6632 [email protected] Hardware Mark Moskowitz (1-415) 315-6704 [email protected] Christopher Danely (1-415) 315-6774 [email protected] – SMid Cap Harlan Sur (1-415) 315-6700 [email protected] John DiFucci (1-212) 622-2341 [email protected] – SMid Cap Sterling Auty, CFA (1-212) 622-6389 [email protected] Supply Chain – SMid Cap Steven J. O'Brien (1-212) 622-6554 [email protected]



U.S. Year Ahead 2012 2012.pdf · 2014-01-14 · for equities is generally muted (see Figure 15)...

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Transcript of U.S. Year Ahead 2012 2012.pdf · 2014-01-14 · for equities is generally muted (see Figure 15)...