Momenta Partners - EQUITY RESEARCH Berenberg.pdf · 2018-01-20 · Business Services, Leisure &...

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EQUITY RESEARCH

RESEARCH Aerospace & DefenceRyan Booker +44 20 3753 3074 Andrew Gollan +44 20 3207 7891Charlotte Keyworth+44 20 3753 3013Ross Law +44 20 3465 2692

Automotives Alexandru-Cristian Dirpes +44 20 3465 2721 Alexander Haissl +44 20 3465 2749 Paul Kratz+44 20 3465 2678Fei Teng +44 20 3753 3049

Banks Adam Barrass+44 20 3207 7923Stephanie Carter +44 20 3207 3106James Chappell +44 20 3207 7844Andrew Lowe +44 20 3465 2743Andreas Markou +44 20 3753 3022Alexander Medhurst+44 20 3753 3047Eoin Mullany +44 20 3207 7854Peter Richardson +44 20 3465 2681

BeveragesJavier Gonzalez Lastra +44 20 3465 2719Matthew Reid +44 20 3753 3075

Business Services, Leisure & TransportRoberta Ciaccia +44 20 3207 7805Najet El Kassir +44 20 3207 7836Stuart Gordon +44 20 3207 7858Josh Puddle +44 20 3207 7881Katherine Somerville+44 20 3753 3081

Capital GoodsNicholas Housden +44 20 3753 3050 Sebastian Kuenne +44 20 3207 7856Philippe Lorrain+44 20 3207 7823Horace Tam +44 20 3465 2726Rizk Maidi+44 20 3207 7806Simon Toennessen+44 20 3207 7819

ChemicalsSebastian Bray+44 20 3753 3011Andrew Heap+44 20 3207 7918Rikin Patel +44 20 3753 3080

ConstructionSaravana Bala +44 20 3753 3043 Lush Mahendrarajah +44 20 3207 7896 Robert Muir +44 20 3207 7860 Olivia Peters +44 20 3465 2646

EnergyYuriy Kukhtanych (EM) +44 20 3465 2675

Food Manufacturing and HPCRosie Edwards+44 20 3207 7880 Yordana Mavrodieva +44 20 3207 7817Philip Patricha+44 20 3753 3039 Fintan Ryan +44 20 3465 2748 James Targett +44 20 3207 7873

Food RetailBatuhan Karabekir (EM) +44 20 3465 2631Dusan Milosavljevic +44 20 3753 3123

General Mid-Cap – DACHGunnar Cohrs +44 20 3207 7894Martin Comtesse+44 20 3207 7878Thomas Eble +44 20 3753 3014 Charlotte Friedrichs +44 20 3753 3077Gerhard Orgonas +44 20 3465 2635Benjamin Pfannes-Varrow+44 20 3465 2620Julia Scheufler+44 20 3753 3016

General Mid-Cap – EUFlavien Hias+44 20 3465 2693Aymeric Lang +44 20 3753 3037 Anna Patrice +44 20 3207 7863

General Mid-Cap – UKCalum Battersby +44 20 3753 3118 Robert Chantry +44 20 3207 7861 Samuel England+44 20 3465 2687Ned Hammond+44 20 3753 3017Omar Ismail +44 20 3753 3102Edward James +44 20 3207 7811Benjamin May+44 20 3465 2667Ian Osburn +44 20 3207 7814 Owen Shirley +44 20 3465 2731

General Retail Conrad Bartos+44 20 3753 3053Camilla Mazzolini+44 20 3753 3042 Michelle Wilson+44 20 3465 2663

HealthcareScott Bardo +44 20 3207 7869Jakob Berry +44 20 3465 2724Alistair Campbell +44 20 3207 7876Klara Fernandes +44 20 3465 2718Tom Jones +44 20 3207 7877Joseph Lockey+44 20 3465 2730Laura Sutcliffe +44 20 3465 2669

InsuranceCharles Bendit+44 20 3465 2729 Trevor Moss +44 20 3207 7893 Emmanuele Musio+44 20 3207 7916 Iain Pearce +44 20 3465 2665 Sami Taipalus+44 20 3207 7866

Luxury GoodsMariana Horn +44 20 3753 3044Zuzanna Pusz +44 20 3207 7812

MediaRobert Berg +44 20 3465 2680Laura Janssens +44 20 3465 2639Alastair Reid+44 20 3207 7841Sarah Simon +44 20 3207 7830

Metals & MiningAlessandro Abate +44 20 3753 3029Fawzi Hanano+44 20 3207 7910Yuriy Vlasov+44 20 3465 2674

Real EstateTina Munda+44 20 3465 2716Kai Klose +44 20 3207 7888

TechnologyJean Beaubois+44 20 3207 7835Josep Bori +44 20 3753 3058Georgios Kertsos +44 20 3465 2715Richard Odumosu+44 20 3207 7851 Tammy Qiu +44 20 3465 2673

Telecommunications Ondrej Cabejsek (EM)+44 20 3753 3071Nicolas Didio +44 20 3753 3091Usman Ghazi +44 20 3207 7824Siyi He +44 20 3465 2697Laura Janssens +44 20 3465 2639Paul Marsch +44 20 3207 7857

Thematic Research Nick Anderson +44 20 3207 7838Oyvind Bjerke +44 20 3753 3082Asad Farid+44 20 3207 7932Robert Lamb +44 20 3465 2623James Sherborne +44 20 3753 3073

Tobacco Jonathan Leinster +44 20 3465 2645

UtilitiesOliver Brown+44 20 3207 7922Andrew Fisher +44 20 3207 7937 Neha Saxena +44 20 3753 3048 Lawson Steele +44 20 3207 7887

ECONOMICS Florian Hense+44 20 3207 7859 Carsten Hesse (EM)+44 20 3753 3001Kallum Pickering+44 20 3465 2672Holger Schmieding +44 20 3207 7889

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A F I S C A L H O M E R U Npage 6

US Economics

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CONTENTS

All companies mentioned in this publication are covered by the equity research department of Joh. Berenberg, Gossler & Co. KG. Full research reports are available on our website at www.berenberg.de/en/crm.html.For disclosures, historical price targets and rating changes and recommendation keys pertaining to the companies included in this publication as well as for analyst certifications please visit our disclosure listing page at www.berenberg.de/eq-disclosures.html.In addition, the following internet link provides further information on Joh. Berenberg, Gossler & Co. KG’s financial analyses (e.g. valuation methodologies, analyst remuneration, sources of information etc.): www.berenberg.de/en/research.COMPETENT SUPERVISORY AUTHORITYBundesanstalt für Finanzdienstleistungsaufsicht -BaFin- (Federal Financial Supervisory Authority), Graurheindorfer Straße 108, 53117 Bonn and Marie-Curie-Str. 24-28, 60439 Frankfurt am MainLEGAL DISCLAIMERThis publication has been prepared by Joh. Berenberg, Gossler & Co. KG (hereinafter referred to as “the Bank”). This document does not claim completeness regarding all the information on the stocks, stock markets or developments referred to in it. On no account should the document be regarded as a substitute for the recipient procuring information for himself/herself or exercising his/her own judgements. The document has been produced for informational purposes. Private customers, into whose possession this document comes, should discuss possible investment decisions with their customer service officer as differing views and opinions may exist with regard to the stocks referred to in this document. This document is not a solicitation or an offer to buy or sell the mentioned stock. The document may include certain descriptions, statements, estimates, and conclusions underlining potential market and company developments. These reflect assumptions, which may turn out to be incorrect. The Bank and/or its employees accept no liability whatsoever for any direct or consequential loss or damages of any kind arising out of the use of this document or any part of its content. All views expressed in this publication by non-analysts reflect our equity research views and recommendations. The Bank and/or its employees may hold, buy or sell positions in any securities mentioned in this document, derivatives thereon or related financial products. The Bank and/or its employees may underwrite issues for any securities mentioned in this document, derivatives thereon or related financial products or seek to perform capital market or underwriting services.REMARKS REGARDING FOREIGN INVESTORSThe preparation of this document is subject to regulation by German law. The distribution of this document in other jurisdictions may be restricted by law, and persons into whose possession this document comes should inform themselves about, and observe, any such restrictions.UNITED STATES OF AMERICAThis publication has been prepared exclusively by Joh. Berenberg, Gossler & Co. KG. Although Berenberg Capital Markets LLC, an affiliate of the Bank and registered US broker-dealer, distributes this document to certain customers, Berenberg Capital Markets LLC provides limited input into its contents. This document does not constitute research of Berenberg Capital Markets LLC. In addition, this publication is meant exclusively for institutional investors and market professionals, but not for private customers. It is not for distribution to or the use of private investors or private customers. Please contact Berenberg Capital Markets LLC (+1 617.292.8200), if you require additional information.

COPYRIGHTThe Bank reserves all the rights in this document. No part of the document or its content may be rewritten, copied, photocopied or duplicated in any form by any means or redistributed without the Bank’s prior written consent.© May 2017 Joh. Berenberg, Gossler & Co. KG

DisclosuresWelcome 5

Economics Overview 6Dr Mickey Levy and Roiana Reid assess the likely impacts of Trump’s fiscal policies

Alpha Pub companies: cheers over fears 9

Ferrari: in pole position 12

Chocolate: liquid gold 14

Media: go West 18

In Conversation 20“Connected solutions” expert Ken Forster on navigating the industrial Internet of Things

Sector Focus 27Digital Healthcare: easing the pressures facing global healthcare systems

Thought Leadership HIV: a fight yet to be won 36

If Stocks Were Wine 40

Tobacco: the next generation 42

Software: tipping point 44

Access 47All the latest conferences and events

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Laura Janssens Head of European [email protected]

David Mortlock Head of Investment [email protected]

Berenberg Equities

EDITORIAL

Ahead of our third Tarrytown conference in New York in late May, we have given Issue 17 a US feel. When we decided three years ago to start covering US shares from London, we knew it would be a big undertaking. Now we cover almost 100 shares from London and 15 of our teams cover the US shares most relevant to their European coverage. For global investors, being able to talk to the same analyst about Airbus and Boeing or Estée Lauder and L’Oréal has obvious appeal. Even for those investors that are primarily interested in Europe, we are convinced that our global approach allows us to offer a deeper understanding of the industries we cover. • In this edition, our US economists Mickey Levy and Roiana Reid give some context to their above-consensus forecasts for US economic growth. We have an (entirely accidental) “vices” stream of updates on tobacco, chocolate and pubs companies. We also have a US edition of Emily Mouret’s regular If Stocks Were Wine feature and a chance to add to your own wine cellars in an American take on “spot the ball”. And to offset all the booze and candy, we have an overview of our Thematics team’s fascinating recent work on digital healthcare. • We are delighted to have Ken Forster of Momenta Partners as the external contributor for our In Conversation feature. Ken is an expert in the Internet of Things and the “connected” industry, with a variety of real-world experience at companies such as Coca-Cola, Philip Morris and Syngenta. • We have had a strong start to 2017, and we are excited about the pipeline of research, conferences and events we have scheduled for the summer. Thank you for your support, and if you have any questions or thoughts please don’t hesitate to contact us directly or at [email protected].

Welcome

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ECONOMIC OVERVIEW

To say the US economy and financial market performance and policymaking are in flux is an understatement. Amid all of the uncertainties, we maintain our above-consensus forecast for economic growth gaining momentum in 2018. This is based

in large part on the assessment that despite political obstacles, the Trump administration will enact some sort of tax and fiscal reform and stimulus later this year.

Since the election of President Trump, measures of business confidence and consumer sentiment have jumped dramatically. The economy has continued to chop along a moderate path, but this higher confidence has begun to lift business hiring and investment. International growth has also picked up, lifting US export orders and US profits from the rest of the world. Overall, corporate profits are rising. Meanwhile, Washington policymaking is turbulent and chaotic, reflecting the style of the Trump Presidency. Amid a flurry of proposals and initiatives, the failure of the Republican Congress to garner sufficient votes on its ACA repeal and replace healthcare legislation dealt a sizeable setback for the Trump administration. What does this imply for future

Treading carefully

Dr Mickey Levy is chief economist for the Americas and Asia for Berenberg Capital Markets in New York. He was previously chief economist of Bank of America from 1998-2013 and chief economist for Blenheim Capital Management from 2013-15. Mickey is an advisor to several US Federal Reserve banks and the US Congressional Budget Office.

Roiana Reid joined the US economics team in June 2016 and produces US macroeconomic commentary, analysis and forecasts. She holds a BA in Mathematics and Economics from Vassar College and is currently pursuing a Masters in Information and Data Science from the University of California, Berkeley.

+1 646 445 4842 [email protected]


DR MICKEY LEVYChief Economist, Americas and Asia

ROIANA REIDUS Economist

With US business confidence and consumer sentiment on the rise, the Trump administration seems to have so far avoided any unfortunate fiscal trip ups

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ECONOMIC OVERVIEW

Illustration by Matt Chase

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legislative initiatives, and what implications are in store for the economy and financial markets?

The fundamentals underlying sustained economic growth are positive, and despite the lengthy duration of the US expansion, there are no troublesome imbalances that would sidetrack growth. Both the demand and production sides of the economy seem firm. Consumer spending continues to expand (although Q1 2017 was very weak for temporary factors) driven by increases in employment and real wages that have lifted real disposable income. Housing activity is rising at a solid pace that is, if anything, inhibited by bottlenecks in the construction industry that have constrained inventories. In most industries, production has picked up to meet demand. Inflation has risen due to higher energy prices, a tight labour market and growing confidence from businesses to charge higher prices for their goods and services.

Against this backdrop, the prospects for policy changes are the biggest wildcard facing economic performance. Amid the potential positives and negatives, we tilt toward the positives. Initiatives to ease or reduce the regulatory burdens in a variety of industries – including oil drilling

and pipelines and motor vehicles – are expected to increase production efficiencies and boost output and contribute to increases in jobs and business investment. Tax and fiscal reform is potentially a large positive for sustainable potential growth.

The largest potential negative is the Trump administration’s tilt towards protectionism. But beyond the blustery rhetoric, it is difficult to assess which trade initiatives will actually be implemented, and our hunch is widespread and damaging barriers to trade like tariffs and quotas will not be erected. As widely anticipated, President Trump has walked away from the Trans-Pacific Partnership Trade Agreement, but the administration has also backed away from its proposal to designate China as a currency manipulator, and his earlier call to impose large tariffs on US imports has faded.

The failed effort to reform healthcare dealt a blow to the Republicans, and actually makes enactment of tax and fiscal reform this year imperative for Republican Members of Congress who face re-election in November 2018. However, the deliberations on healthcare did sidetrack attention from tax reform and delay its progress. We now expect the legislation will be developed, debated and modified during the summer and signed into law in the autumn, several months behind the original schedule. Washington insiders know that any legislation must occur in 2017, well before the 2018 mid-term elections.

The Republican leadership faces political opposition – from Democrats who will vote against any Trump proposal – as well as far-right-wing Republicans in the so-called Freedom Caucus who will insist that any fiscal package has an estimated neutral impact on the budget deficit. Moreover, Republicans had hoped to repeal the 3.8 percentage point tax on investment income imposed by Obamacare, which now adds an additional budget constraint on corporate tax reform proposals of significantly lower rates and expensing of all new investment.

The final legislation is expected to include a mix of fiscal reform aimed at lifting long-run potential growth, and some cyclical stimulus. Importantly, many of the tax reform initiatives have been under discussion for years, so unlike the insufficiently studied healthcare proposal, the debate on tax reform is much further along and detailed. Also, since the failure of healthcare reform, the Trump administration has played a more active lead in the tax policy deliberations, which should smooth out potential further delays.

The end result for the tax legislation likely will be a modified version of the House Republican Blueprint for corporate tax reform, including a lower corporate tax rate and expensing of all new equipment, the phasing out the deductibility of corporate interest costs and adoption of a territorial tax system. We also expect the legislation to include cuts in personal income taxes for middle and lower middle income households and base broadening for higher income tax filers. Many uncertainties about the details about the fiscal legislation remain – driven by factors such as the budget constraints that will shape the agenda.

The eventual fiscal reform and stimulus should boost economic growth, with momentum mounting in 2018. Business investment will be a major beneficiary, although we also expect the legislation will add jobs and wages.

We expect the Fed to raise its policy rate twice more this year – in June and September – and announce its plan to not reinvest all of its maturing assets which would result in a gradual reduction in its massive portfolio of Treasury securities and MBS. Interest rates may rise modestly, but not enough to adversely affect the economy. These steps could actually boost confidence and that may improve economic activity and bank lending. We expect the Fed to raise rates four times in 2018. Faster growth and a pick up inflation would mean a faster pace of rate normalisation. While the stronger growth and gradual reduction of the Fed’s monetary accommodation is likely to raise interest rates, its impact on the US dollar is uncertain. Responses to the Fed’s policies by the Bank of England and European Central Bank, which also face improving economies with growth exceeding expectations, will be very interesting indeed.

ECONOMIC OVERVIEW

‘The largest potential negative is the Trump administration’s tilt towards protectionism’

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ALPHA

Illustration by Bill Butcher

Pub companiesDespite reports of the imminent decline of UK pubs, there’s still life in the old Dog & Duck yet

Fuller’s BUYWe think Fuller’s, which owns a brewery and about 400 pubs in London, should be a cornerstone of any mid-cap portfolio. Its investment levels are ahead of the market’s and should continue to support strong like-for-like (which has averaged c5% over the past decade), while its premium positioning makes it best placed to both capitalise on market trends and offset cost pressures. Our valuation of its estate suggests the core pub operating business is valued on less than 3x EBITDA. This seems too cheap to us.

Marston’s BUYMarston’s operates about 1,550 pubs and brews beer such as Hobgoblin and Pedigree. Through disposals of its tail sites and the rollout of new-build managed pubs, it has materially improved the quality of its estate, but is yet to see a sustained re-rating of its shares valuation. We believe investors have been put off by optically high debt levels, but this ignores that Marston’s owns the freehold of 97% of its pubs. Meanwhile, with a growing dividend yield close to 6%, investors truly are being “paid to wait”.

M&B HOLDM&B manages about 1,800 pubs and restaurants. After years of bottom-of-the-class performance, M&B is reinvesting in its estate and shortening its capex cycle from 11 to six years. However, unfavourable currency moves, increased business rates, the higher national living wage and increased depreciation are more than offsetting any margin benefit from revenue growth. With the balance sheet stretched and the pension deficit growing, we see little reason to be excited.

Greene King HOLDGreene King is the UK’s largest managed pub operator with about 1,800 sites. Following its acquisition of Spirit in June 2015, Greene King is reducing its formats from more than 15 to just five “growth brands”, which should drive some like-for-like improvement. However, a line seems to have been drawn under the latest synergy targets, and cost pressures (currency, business rates and national living wage) are more than offsetting the incremental savings. As a result, we see few near-term catalysts.

JD Wetherspoon SELLJD Wetherspoon is a value-focused pub and hotel operator with more than 900 sites. It has long been a market favourite. However, we think its rollout is hitting the buffers and its low margin and value positioning put it at significant risk from upcoming cost pressures. With limited profitability growth ahead, debt can no longer be used to fund returns, meaning buybacks could become a thing of the past in our opinion.

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In recent times the UK pub market has seemingly drawn more media headlines than investor interest. We are often told that “pub numbers are declining”, “alcohol consumption is falling”, “pubs have too much debt” and “pubs are highly cyclical”. In our opinion, many of these views are at least partially misplaced. In this article we address some of these myths.

“The pubs are declining” – partial mythYes, pub numbers are declining, but this only tells part of the story for the listed operators. While the falling headline number of UK pubs is irrefutable – from about 70,000 in 1990 to about 50,000 today – we think the common-held view that the British pub is facing an inevitable demise is far from the truth. The managed sub-sector of the market (those directly operated by a larger corporate) where Greene King, Mitchells & Butlers (M&B), Marston’s, Fuller’s and JD Wetherspoon derive the majority of their earnings, represents fewer than one in five of the UK pub estate. These sites are typically larger pubs with higher levels of weekly turnover – in short, better-quality assets than the tail of underinvested, poorly located and largely drinks-focused pubs where the majority of closures have come. As a result, the managed pub sub-sector has been growing, and the five listed players have seen cumulative revenues grow from £4.5bn in 2007 to more than £7bn in 2016 (an annual growth of 5%) through a combination of organic growth and industry consolidation.

“Alcohol consumption is declining” – partial mythThe idea that we are boozing less is also (perhaps unfortunately) a partial myth. Yes, per capita alcohol consumption in volume terms is declining in the UK at about 2% a year. However, overall volumes are broadly flat and factoring in premiumisation trends driven by craft, UK on-trade alcohol is still a growing market (up about 3% a year) in value terms.

“The pubs are too levered” – mythWith headline 2016 net debt to EBITDA figures for the five pub companies ranging from 3.0x for Fuller’s to 4.8x for Marston’s, for many investors the pubs appear overly indebted. However, this overlooks the fact that the five listed pub companies own a significant amount of their properties, and hence have minimal off-balance-sheet liabilities. Marston’s owns the freehold of 97% of its pubs, while

Pub companies: cheers over fearsLeisure

Owen Shirley joined Berenberg in 2014 via the capital markets graduate programme before becoming an analyst in the UK Mid-Cap team. Prior to this, Owen gained an MSc with Distinction in International Business, and a first class degree in Politics from the University of Nottingham. He has passed CFA level II.


OWEN SHIRLEYUK Mid-Cap Analyst

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The Red Lion is the most common pub name in the UK, closely followed by The Crown and Royal Oak

The town of Rhayader in mid Wales claims to have the most pubs per person with 12 pubs for the 2,000 residents

The strongest beer is German, has an ABV of 57% and called Schorschbräu Schorschbock

The highest pub in the UK is the Tan Inn in the Yorkshire Dales, which is 1,700 feet above sea level

Pubs employ more than 600,000 people in the UK

Pub quiz

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that figure is 88% for Fuller’s, 83% for Greene King, 83% for M&B and 51% for JD Wetherspoon. We therefore would argue that fixed charge cover is a fairer metric to assess the ability to service the debt, which allows pub businesses to drive return on equity while owning freehold assets. On that basis, the five pubs as a whole had an average fixed charge cover of almost 3x at the end of last year – better than their UK mid-cap leisure peers, averaging 2.4x.

“The pubs are highly cyclical” – mythThe apparent acceleration in the decline of the headline number of pubs over 2008-09 has also led to the common belief that the listed pubs are highly cyclical. Indeed, it appears logical to assume so, given that the pubs essentially depend upon consumer discretionary spend. However, while there is undoubtedly an element of cyclicality, the managed businesses of Fuller’s, Marston’s, Greene King, M&B and JD Wetherspoon actually proved remarkably resilient in 2008-09. Like-for-like growth remained positive throughout for Fuller’s and M&B, while the worst figure seen across the five companies’ managed divisions was JD Wetherspoon’s 1.1% like-for-like decline in 2008. We believe the lower-than-expected level of cyclicality can, simply put, be attributed to the “experience” that a well-invested pub offers consumers at an affordable price. Hence, while some consumers opt not to visit the pub when confidence is low, that is to some extent offset by others substituting more-expensive leisure activities (such as weekends away) in favour of pub visits.

The recipe for successUK pub businesses do face a fierce competitor with a significant pricing advantage – the UK supermarket. As a result, we think it is crucial to cultivate venues that are differentiated to eating and drinking at home: characterful buildings, outstanding locations, interesting furniture and high-quality decoration. These are factors that in combination create the “ambience”, which pull consumers out of their homes. Our analysis suggests conservative balance sheets and the resultant higher propensity to invest are crucial drivers of pub success, with like-for-like growth, margin expansion and, ultimately, earnings growth all highly correlated to investment levels. We also think that pubs with premium positioning are likely to outperform given the current trends in alcohol premiumisation, the battle against supermarkets and the need to pass on cost inflation. Finally, we favour simplicity in terms of price positioning (fewer brands, less crossover) and provenance in terms of branding – ie the “pub as the local hero” approach, as opposed to chain branding.

Return to the limelightInflation driven by sterling weakness, business rates revaluation and the national living wage all do pose sources of pressure for pubs. Yet with the UK population eating out more than ever, and craft alcohol driving a renewed boom in the UK on-trade drinks market, the British pub has plenty of opportunity left ahead. With misconceptions abundant and catalysts ahead plentiful, we believe the listed operators deserve a move back into the limelight.

‘The common-held view that the British pub is facing an inevitable decline is far from the truth’

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Best of British: Fuller’s pubs have proven resilient

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ALPHA

When Michael Schumacher’s red Ferrari galloped past the chequered flag under the scorching Budapest sun in first position in August 2004, it marked the culmination of the Italian team’s total dominance of Formula 1 with a record sixth successive Constructors’ Championship title. That title was

the Maranello team’s 14th, the latest addition to a glittering history of success that indisputably cemented its status at the pinnacle of motorsport – and as one of the most illustriously decorated franchises in the history of sport. Ferrari would add two further Championship titles to its collection and its 16 F1 Constructors’ titles remains a record. Even in spite of more modest recent performances, the famous prancing horse emblem remains utterly inseparable from the imagery that its history conjures: power, speed and victory.

Unmistakable auraThe company’s legendary founder, Enzo Ferrari, built the brand on a single philosophy: “You should always build one less car than the market demands.” For decades, the company simply sold road cars to wealthy customers to raise sufficient money to participate in racing. While that business model is (largely) no longer the case, the essence of Ferrari’s approach – to create an unmistakable aura around the product that captures the imagination of customers and admirers alike – continues to permeate the workspaces of its factory in northern Italy. So covetous is the demand for the exclusivity and symbolism of its cars that models are sold out before they are even revealed. Ferrari’s target customers are mostly high or ultra-high net worth individuals, whose sensitivity to price is limited, and often the reverse of what conventional supply-demand theory dictates. Academics even have a name for goods that generate this unusual and counter-intuitive type of behaviour – a “Veblen good” – where the more the price increases, the more customers demand the product. Needless to say, few goods can claim to exhibit this property, and even fewer to the extent that Ferrari cars do.

Enviable advantagesAs business models go, the ability to generate pricing power is an enviable advantage whose impact exceeds perhaps any other business model available to consumer companies. Thus, for Ferrari to grow, simply selling more cars is arguably less critical compared to selling the same cars for higher prices. This appears straightforward, yet the company has in reality only increased prices on its portfolio modestly – by an average of 2.5% per year since the mid-1990s. Meanwhile, over the same period, some high-end luxury products such as Louis Vuitton handbags or John Lobb shoes have seen inflation in excess of 6% per year. This gap in realised pricing power forms the cornerstone of our investment thesis – that the pricing power of Ferrari cars should be of a similar ilk to the strongest in the luxury goods industry. Even conservatively allowing for a margin of underperformance compared to bags and shoes, we view an acceleration of price increases to 4% each year as readily achievable. With full drop-though to profits, this in turn should translate into mid-teens earnings growth.

Ferrari: in pole positionAutomotive

Fei Teng joined the Berenberg Automotive research team in August 2016. Previously, he worked at Credit Suisse, which he joined in 2013 as a graduate. He holds an MEng in Chemical Engineering from the University of Cambridge.


FEI TENGAutomotive Analyst

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The Prancing Horse: a thoroughbred car company

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Why hasn’t Ferrari done this before?Perhaps, as a subsidiary of Fiat until 2015, there was less direct accountability to shareholders and thus less incentive to improve financial metrics. Now, as an independent company under the stewardship of the mercurial Sergio Marchionne, more evidence is beginning to emerge that the bottom line does matter. The recently launched 812 Superfast, a renewal of the flagship F12berlinetta, showed the company’s pricing strategy in full view – at an eye-watering €292,000, it was close to 6% more expensive than its predecessor and likely a significant contributor to profits from 2017.

Unparalleled resilienceBack in October 2015 when Ferrari’s listing was confirmed, sceptics immediately baulked at the company’s valuation: priced at $52 per share (€46), it valued the business at $9.8bn (€8.7bn), or 27 times expected forward earnings. The equity market grappled with a multiple well above conventional automakers’ – and failed to come to terms with it. From its peak, the stock fell close to 50% in the space of four months and languished at just $32 (€28) by mid-February 2016. However, we think the rationale for the market’s dismissal of Ferrari’s business credentials was flawed, and underappreciated the strength of the company’s fundamentals. Its order book, lasting up to 24 months in some cases, allows the company to demonstrate unparalleled resilience to economic downturns, vastly reducing the unpredictability that is normally a hallmark of the automotive industry, while simultaneously providing comfort to investors on the visibility of earnings for several quarters out. The market seems to agree, and the shares have subsequently more than doubled from those lows.

Worlds apartComparisons to automakers on the grounds of capital intensity also unfold as superficial, with free cash flow conversion averaging over 100% in the most recent five-year period, eclipsing even the most cash-generative automakers. In 2016, operating margins were already more than double that of its closest peer, Mercedes-Benz, and set to move even higher while the rest of the auto industry stagnates. In sum, Ferrari is a unique company with a business model that – other than building cars – sets it a world apart from any conventional carmaker. Fittingly then, after a string of surprisingly strong earnings reports, it returned to trading multiples more in line with the luxury goods industry, and its share price, like its red racing cars, returned to setting new records.

‘So covetous is the demand that models are sold out before they are even revealed’

363kmhfastest speed by a road Ferrari

$52m price paid by a private collector for a 250GTO, the most expensive Ferrari ever

F1: 16 Constructors’ Championships and 15 Drivers’ Championships

963BHP the LaFerrari is the most powerful road Ferrari

Ferrari’s F12berlinetta: 0-60 in 3.1 seconds and a top speed of 210mph.

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Despite the growth of “healthy” snacks, such as nuts, fruit and cereal bars, chocolate still dominates the market with a 25% share of sales

Food Manufacturing

Photography by Felicity McCabe14

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Food Retail & Manufacturing

Fintan Ryan joined the Consumer team at Berenberg in 2012 as a research analyst covering the pan-European Food Manufacturing sector. Prior to this, Fintan worked for two years in UK corporate finance at JPMorgan Cazenove in the execution of M&A and equity transactions across many sectors. He has a BA (Hons) first-class degree from Trinty College Dublin.


FINTAN RYANFood Retail Analyst

Snacking globally is a $400bn market – about 18% of packaged food spending. The segment has outperformed other food categories by approximately 70bp a year historically – an annual growth of 5.3% driven by the US, which makes up about a quarter of global snacking sales. Although our new vending machine at Berenberg is full

of seeds, organic coconut balls and courgette brownies, the global snacking market is still dominated by chocolate, which accounts for roughly a quarter of total sales. Billion-dollar brandsOur top pick in the snacking space is Mondelez, the global market leader with a 9% market share and leading positions in chocolate, confectionery and biscuits. Mondelez’s portfolio includes seven billion-dollar brands – Cadbury, Cadbury Dairy Milk, Milka, LU, Nabisco, Oreo biscuits and Trident gum – and another 44 brands that generate sales in excess of $100m. We think that after several years of underperformance, Mondelez is now in a position to accelerate growth in sales and operating profits. We expect this to translate into double-digit earnings growth in the next three years. Profitable product pipelineGrowth at Mondelez has been sluggish in recent years, albeit some of this has been self inflicted. Management has been focused on cost and productivity improvements in order to drive profitability, which has reduced growth as a consequence. Now, however, we expect to see a return to more healthy growth of around 4%, thanks to more innovation and a strong pipeline of product launches. As an example, the rollout of chocolate confectionery in China and the US in 2017 could add 300bp to group sales growth in the next three years on our estimates. Margin managementWe also expect margin improvement. Historically, Mondelez has delivered bottom quartile operating profit margins versus its peers, burdened by its complex structure and a relatively inefficient and underinvested production asset base. In 2014, management launched a massive $5.7bn restructuring plan, which should allow margins to continue to improve until 2018 at least. Management’s forecast operating margin of 18% would take it to the top quartile of its peers. Increased innovationAt the recent CAGNY conference, there was a clear “innovation” theme to Mondelez’s presentation. In particular, it said it will focus on “wellbeing” product launches into new categories and markets. Wellbeing snacks are about 33% of sales, but account for more than 70% of new launches and are accretive to organic growth. Management aims for about 50% of sales to come from these areas by 2020. One example is the launch of a new line of savoury snacks called Véa, which is being introduced in the US in July, with potential for further rollouts. This is being supported by an increased online focus. Online generates less than $500m of sales (or c2% of group sales) currently, and management targets $1bn by 2020, reporting 35% growth in 2016.

Chocolate: liquid gold

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Lindt & Sprüngli BUYLindt & Sprüngli (Lindt) has historically delivered best-in-class organic sales growth, screening well with its focus on innovations in premium and mass-premium chocolate confectionery. This has brought more potential consumers into the premium snacking space. As a result, Lindt has built up its chocolate confectionery market share organically in many developed markets that previously had been strongholds for the mass-market chocolate confectioners.

Going into 2017 we expect growth to accelerate as it uses the Russell Stover brand (which was acquired in 2014 for CHF1,475m and saw c10% decline in 2016 as Lindt rationalised its portfolio) as a vehicle for moving into faster-growth adjacent snacking categories in North America. Global growth rates will be supported by acceleration in the rollout of retail stores, which are a key feature of Lindt’s expansion plans into more nascent emerging markets.

Nestlé BUYNestlé’s snacking innovation activities have been relatively lacklustre in recent years, particularly in some of its larger markets such as China and the US (c10% sales each). Two of its other big markets, the UK and Brazil (30% combined) have also struggled due to increasing competition and macroeconomic weakness respectively. Across a diverse portfolio, Nestlé has few global confectionery brands (the exception being KitKat, except in the US where it is run by Hershey) and lacks a premium chocolate confectionery brand of scale (despite some more recent online launches of the Swiss Cailler brand). We believe that confectionery will continue to be a drag on group growth and margins, and could ultimately be wholly or partly sold or put into a joint venture – similar to the non-US ice cream business now called Froneri that was recently combined with R&R Ice Creams.

Hershey SELLHaving delivered strong growth and market share gains in the four years up to 2015, both domestically and internationally, Hershey is in a period of retrenchment in its core US market. Internationally, the Chinese business in particular has seen sales decline significantly in the past 18 months as Hershey failed to identify and react to changing channel shifts and local consumer demand. Although it does have a moderate pipeline of new platform innovations in the US business going into 2017 where it is the market leader, the market is getting considerably more competitive.

Given its over-reliance on the North American chocolate confectionery market (c70% of sales) and relatively small exposures elsewhere (although it has for example moved into meat snacks via acquisitions), we believe that growth will become more difficult to come by, although margin improvements on cost savings and strong cash generation will provide some support to earnings despite negative mix.

Our other picks

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ALPHA

RELX and Informa are two of the world’s leading professional publishers, creating, collating and delivering must-have information, data and services to a wide range of professional end-markets and users. With both companies set to present at our USA Conference 2017 at Tarrytown House in New York in May, we take the opportunity to

revisit the key trends in their main divisions. We conclude that both are well positioned to benefit from the strong US economy, where each generates more than half its earnings. We see both shares as good value given strong growth and cash generation. Given the cheaper valuation, we have a modest preference for Informa.

ExhibitionistsInforma generates about 40% of group profits from exhibitions, which is roughly three times the proportion of RELX. We view this exposure as a positive – exhibitions overall generate above GDP growth, have low capex requirements, high barriers to entry and tend to also exhibit positive working capital dynamics. Exhibitions are also somewhat more geared to macro-economic cycles than other divisions, and so should help RELX and Informa capture the benefits of improving business confidence in the US in the coming quarters given the US represents more than half of global revenues (and a bit more than that for Informa given the US bias in its recent acquisitions). We also expect Informa to deliver synergies relating to its recent acquisitions in the US market both from a revenue perspective (for example, by targeting hotel commissions) and a cost perspective (reducing venue cost inflation across the portfolio). InformativeThe information publishing businesses of RELX and Informa should also benefit from a pick-up in US corporate activity. The legal division of RELX is about a fifth of revenues, and two-thirds of this is in the US. There should logically be improving demand from law firms for the information, tools and services RELX offers the legal industry as the economy picks up. However, this trickle-down impact could take some time to manifest. Contracts tends to be long (multi-year often) and the benefits of an upswing in the economy could be muted by industry indicators which show law firm productivity in the US is still weak. Informa’s business intelligence division serves a wide range of industries and we think it might be better positioned to capture an upswing quickly as it tends to have shorter subscriptions (as well as end customers showing better trends in productivity). AcademicBoth RELX and Informa generate more than a third of group profits from academic publishing. The US proportion of this (about 40% of the total) has been a source of investor concern, not least because of the repeated profit warnings from Pearson in its US higher education business. Proposals from President Trump to cut National Institute of Health (NIH) funding have added fuel to these worries. We think for RELX and Informa these concerns are misplaced. The NIH is a small proportion of revenues in reality, and actually trends through

Go WestMedia

Alastair Reid is currently an analyst in the media sector, having joined Berenberg in September 2015. Prior to this, he started his career as a graduate at ABN AMRO in 2004 and then in 2005 moved to UBS to cover the media sector, where he was most recently co-head of team. He has an MA in Natural Sciences from the University of Cambridge (Clare College).


ALASTAIR REIDMedia Analyst

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ALPHA

numerous recessions have demonstrated the resilience of spending on the must-have information the publishers provide, regardless of headline funding trends.

DifferentThese businesses are also structurally very different to Pearson. Both do have a small part (less than 10% of divisional revenues) focused on the sale of medical education textbooks to the US higher education market, where sales have been impacted by the counter-cyclical decline in college enrolments and structural shifts in purchasing habits by undergraduate students. However, for the vast bulk, the businesses sell high-end, constantly changing academic research and reference information to institutions, departmental libraries and academic professionals. This means they do not face the same threats from commoditisable open resources that Pearson does, and, as can be seen from US scientific research headcount trends in the non-farm payrolls, they benefit from much more resilience trends in customer numbers.

Buy InformaWhile we like both Informa and RELX, we think Informa is less well appreciated by the market and therefore offers more upside. The process of portfolio change (and improvement) is already well progressed, and this should mean growth picks up more quickly than most currently anticipate. The operational leverage related to this revenue growth could see earnings growth approach double digits in coming years.

‘Both RELX and Informa generate more than a third of group profits from academic publishing’

Illustration by Leillo

20

IN CONVERSATION

KEN FORSTER

The Internet of Things Just the opening act

Photographed in Los Angeles by Steve Schofield

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The industrial Internet of Things promises to reduce the capital intensity of many businesses’

ased on predictions that tens of billions of Internet of Things (IoT) devices are set to come online in the next few years, it’s easy to get the impression that the biggest impact will come from rolling out connected devices. Momenta Partners, which delivers advisory, executive search and ventures practices to drive growth in connected industry companies, believes that the Internet of Things is simply an enabler, or more correctly a catalyst, for profound digital transformation. Key technology drivers such as cloud computing have been taking shape for some time, and are poised to combine in powerful new ways to power business transformation and industry disruption. A tide is building, with tech tailwinds arrayed to create the perfect storm of disruption. IoT is a not a catalyst for an IT spending frenzy like Y2K; it’s more akin to a circulatory system for brand new ecosystems of value.

The concept of IoT refers to a combination of things/devices, connectivity and data analytics woven together into powerful systems. Many of the foundational concepts are familiar; they build on established technologies, processes and business practices. There is also a range of newer technology innovations at work. There’s a consumer dimension that encompasses wearables and smart home technologies, but the most consequential

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developments are happening in industrial sectors, such as transportation, manufacturing, agriculture, energy and public infrastructure. What’s not widely appreciated is that the most consequential impact of IoT adoption is not the technology itself – it’s the profound transformation in how goods and services will be produced, distributed, consumed and paid for across the economy. Businesses will be compelled to come to grips with potential changes, opportunities and risks at hand.

Building on familiar foundationsIndustrial IoT implementations build upon well-established technologies and paradigms – process controllers, M2M (machine to machine) connectivity, telemetry data, sensors and actuators at the edge. It’s nothing new to have a temperature gauge on a piece of industrial equipment that sounds an alarm above a set threshold, or having a GPS tracking device on a fleet of delivery vehicles, or an automatic pump shutoff triggered by vibration sensors. Automated industrial systems have evolved over decades. What’s different arises from applying information and communications technology (ICT) to industrial systems – the convergence of information technology with operational technology. This positions industrial systems to benefit from exponential technology cost curves that place ever more powerful capabilities into the hands of users.

Faster, cheaper, smarter: forces combine to accelerate changeThere are constant deflationary forces at work in ICT as hardware, software and connectivity get faster, cheaper, more powerful – and most importantly – easier to use over time. The trajectory of price/performance improvement in processing, connectivity and power efficiency is reflected in Moore’s Law (compute), Butters’ Law (bandwidth) and Koomey’s Law (battery power). There’s a plethora of free open-source software available (such as the Linux operating system, MySQL, MongoDB and Cassandra databases etc).

Cloud computing services pass cost savings along to users – Amazon Web Services has lowered pricing for on-demand compute and storage services more than 50 times since 2006. Enabling connectivity technologies include Wi-Fi, mesh networking standards like ZigBee and Z-Wave, 4G/LTE mobile networks and 5G is on the way.

Old wine in new bottles? Yes – and…There are common patterns in use cases from industrial scenarios that target established business outcomes through newer technologies. Much of what’s been popularised around industrial IoT is an update of existing technology. Traditional operational technology architectures that make use of centralised control units and distributed process controllers have been updated. In the prevailing cloud computing model, most data processing takes place in massive data centres connected to lightweight endpoints like smartphones. There’s an updated paradigm emerging for IoT with high-priority data processing, such as real-time analytics, occurring at the edge, and historical trend analysis taking place in the data centre. This approach parallels traditional industrial control systems, but with a few different twists becomes something new – “edge” or “fog computing”.

The promise of IoT lies in business transformationThe most significant impact from adoption of IoT solutions is not updating the technological aspects of existing business processes – it’s about realising new ways to solve problems and cultivate new types of business. Physical goods can be turned into services, capital purchases can be turned into subscriptions, and the nature of the relationship between those that make products and those that consumer them becomes aligned with mutual success. The industrial IoT involves instrumenting physical assets, generating data that can be harnessed for insights and actions to drive unprecedented optimisation and service-oriented business models.

What is a service-oriented business model? The promise of the industrial IoT lies in the ability to create new services business. The first type of IoT solution for many firms is offering predictive maintenance contracts that use the data from connected assets to be able to fix things before they break and avert downtime. Once a company is confident enough to guarantee service levels (like 99.99% availability) this sets the stage for “X as a service” where the function or utility of the asset can be delivered on a pay-per-use basis – so customers they don’t need to lease or purchase the asset itself.

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Cloud computing – template for IoT services businessesWe can look at the enterprise IT industry for precedent.In the 1990s the tech industry was dominated by companies like Sun, IBM and Hewlett-Packard that sold hardware servers and storage. Businesses made significant capital investments in discrete hardware systems, which had to be set up, maintained, supported and replaced on a regular cadence. Initially there was a lot of redundancy required to protect against failure, and there was a lot of unused capacity because of this. The introduction of virtualisation software from the likes of VMWare in the 2000s took advantage of the built-in instrumentation on servers. This improved average server utilisation from 15-20% often to 70-80%, and reduced the number of physical servers enterprises needed to purchase. A further generation of automation software gave rise to cloud computing from the likes of Amazon Web Services (AWS).

Cloud-scale data centres from AWS, Microsoft and Google are highly optimised, and they allow users to purchase as much or as little compute, storage and other services on a metered, per-use or subscription basis. The implications are profound: today small businesses have access to industrial scale compute power at a fraction of the cost, and AWS’s business is flourishing exceeding $12bn annually. Meanwhile, traditional hardware vendors including HP, IBM, Sun, Dell and others, have seen revenues decline, leading to consolidation, divestitures, and languishing stock prices.

Autos as a service as IoT-enabled future Look forward several years to when automobiles and trucks are fully autonomous and transportation can be delivered as service: for a trip to the grocery store you might summon a car from the Mercedes or BMW service – it arrives at your door, drops you off and another car picks up you and your groceries for the return trip. You pay by the minute – or the mile – while Mercedes, BMW (or another transport-as-a-service firm) keep track of their fleet through a network of onboard sensors, GPS and other data. Data provides visibility into assets and their performance that enables the fleet owners to guarantee service levels.

A consumption-based business model can be applied to transportation (autos as a service), capital goods (jet engine as a service), construction equipment, manufacturing equipment and other physical assets. For an idea of what this could look like just compare what cloud computing has done to the server market. Cloud computing providers build and maintain hyper-scale infrastructure that can be parceled out in chunks

of compute and storage, with users and billed on consumption. By some estimates, introduction of autos-as-a-service could reduce the number of automobiles sold every year by 85-90%. The automakers are doing their best to anticipate these changes, but there’s no doubt that the transition from car ownership to subscriptions will present significant challenges.

Managing transition risks to the industrial IoT eraThere are other issues that will need to be fleshed out, and there will be no one-size-fits-all approach. Who will own the data? It’s easy to envision the benefits of connected agriculture with soil, temperature and humidity sensors telling farmers the best time to plant, fertilise and water their crops. What’s not clear is who will exercise rights to the data in this situation – farmers, the equipment manufacturers, or the provider of analytic services?

Organisational and business model transitions are also a challenge. The shift from selling goods to selling subscriptions requires new ways of selling and servicing customers. Expertise in existing industrial systems needs to be bridged with expertise in data analytics, mobile technology and cloud computing. The traditional channel model of dealerships does not necessarily translate to selling subscriptions. Businesses that specialise in selling physical goods will need to think like software companies. Products will need to be designed with an eye toward enabling add-on subscriptions, and users will expect updates and enhancements and a more frequent cadence than in the past.

The opportunities are multifold and the implications are profound. At Momenta Partners, we work with a range of companies from early-stage startups to flagship industrial firms to help navigate the significant changes ahead. It’s still early days, and it’s difficult to quantify the market potential with precision, but it’s coming. The industrial IoT promises to reduce the capital intensity of many businesses, redefine the nature of customer-vendor relationships, and give rise to a new generation of stable subscription businesses built on technology-driven insights.

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Ken Forster is managing director of Momenta Partners. He is a connected industry veteran and has built “connected” products, services and businesses for more than 25 years with senior leadership roles at ThingWorx, Syngenta, Coca-Cola and Philip Morris.

Ken has co-founded three industrial automation companies and was an early leader in open architecture control systems. He lives in Switzerland and maintains an office in the “cloud”.

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Digital Healthcare

SECTOR FOCUS

D eveloped world healthcare systems are in crisis. Healthcare spending is rising faster than real GDP growth in most OECD economies. In the US, healthcare spending already represents 17% of GDP and healthcare spend per capita is approaching $10,000, more than double

the levels seen in the UK and France. With a rapidly ageing population, this trend is only going to get worse. Even among the general population, poor lifestyles and diets mean that about 40% of all Americans are classified as obese. Just taking this segment of the population, the cost of treating obese patients in the US is calculated at $150bn per year.

Living longerOver the past 15 years, the number of people above the age of 65 years old worldwide has risen by 183m. Over the next 15 years to 2030, this cohort will increase by another 370m people and account for about 12% of the global population versus approximately 8% in 2015. But while people are living for longer, healthy life expectancy is not rising as fast – in other words, elderly people are living for longer but in poor health. This is because the occurrence of chronic illnesses is rising disproportionally with age. Recent studies have shown that one-third of the population above the age of 70 develop

Digital Healthcare

Chris Armstrong has 20 years of experience on both the buy-side (as an analyst and portfolio manager) and on the sell-side, most recently as industrial specialist sales. Chris joined Berenberg as a Swiss equity salesman in 2006, before specialising in industrials in 2009. He has previously been a portfolio manager/analyst at Axa Framlington, Bank of Tokyo-Mitsubishi and NatWest, and holds a BA in Economics from Durham University.


CHRIS ARMSTRONGSpecialist Sales

As the population ages, the crisis in world healthcare systems is only set to worsen

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Illustration by Mike Lemanski

multiple chronic illnesses. This makes the elderly cohort the biggest users of prescription medication. Indeed, in some developed countries the elderly accounts for more than 60% of medication expenses. At the same time as ageing affects long-term care needs, the rising dependency ratio will also have a negative impact on tax receipts due to shrinkage in working-age populations.

To compound the fact that spending on healthcare is certain to increase, the supply of medically trained staff able to administer care is falling significantly short of what is needed. Part of this problem is the retirement of qualified doctors and nurses, who are at the end of their careers – 30% of US physicians are aged over 60. In total, the WHO estimates that the shortage of health workers in the OECD will increase from about 7m in 2013 to 13m by 2035. As if this wasn’t a big enough challenge, public sector budget cuts also mean many countries don’t have enough long-term care facilities or beds. With such pressures on the system, it is easy to see how medical error is the third-biggest killer in the US.

As it stands, these trends are unsustainable. If we want to care for an increasingly aged population we need to find new ways of both preventing chronic disease and, just as importantly, dramatically reducing the cost of treating it. Our latest thematics research is focused on the latter. Putting people into hospital is expensive – whether it is a chronically ill patient in a long-term care facility or a mother taking their feverish daughter to an emergency room because the primary care facility is closed, both are a significant cost to the healthcare system.

Digital healthcare technologies enable systems to shift care from hospital to home. We estimate such solutions could

save up to $260bn a year across the OECD region. This could significantly reduce some of the stress on many developed market healthcare systems. Digital healthcare is not new –many of these technologies have been around for more than 10 years. So why are we likely to see significantly higher adoption than we have in recent years? There are three key reasons.

First, and most importantly, many healthcare systems are moving away from traditional “fee for service” models, where hospitals and doctors get paid on a per-procedure or treatment basis with little regard for the success of the procedure or treatment. New “value-based care” models are rapidly emerging in markets such as the US and the UK, whereby hospitals are reimbursed on a “per patient” basis. In order to make treatment profitable, healthcare providers need to find ways to keep that patient out of hospital with new technology, more integrated care and a more holistic approaches to prevention rather than just cure. From zero penetration a few years ago, 8% of all patients in the US are now covered by value-based care. Insurers are driving adoption higher and many are planning 70-80% penetration of this approach in the next few years. Medicare is also following this trend.

Second, we have the democratisation of healthcare due to the high levels of smartphone and internet penetration, which allows individuals to benefit from better digital infrastructure and also use that infrastructure to access the data already stored on electronic health records (EHRs). Penetration of EHRs is now 98% in the US and 75% in Europe.

Finally, in order to implement these changes, we are seeing the rise of integrated care organisations. These are groups of hospitals, primary care groups and social and mental care organisations who are collaborating on finding integrated solutions for caring for patients, with an over-riding aim of keeping people well and out of hospitals whenever possible. These are known as accountable care organisations in the US (and there are now more than 800 covering over 28m patients) and the UK is setting up similar vanguard sites (27 of them).

Emerging technologiesSo with an increasing need for digital healthcare and now finally a framework that looks set for increased adoption, which technologies are we likely to see emerging? We see five key enabling technologies that will provide significant cost savings ($260bn) and which could grow to a combined $140bn addressable market by 2026 – a seven-fold increase from current levels and a roughly 20% CAGR. This is an exciting opportunity for both health sector participants and also investors in this space.

1 TelemedicineThis is using online technology, increasingly video based, to allow patients with minor ailments such as colds, rashes, sinus problems to have a remote consultation

with a qualified doctor via smartphone, tablet or internet. The key opportunity to reduce costs is to reduce the amount of M

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The elderly are the biggest users of prescription medicine and in some developed countries account for more than 60% of medication expenses

By making access to doctors 24 hours, it can solve the problem of where to go when primary care is not available

Cost saving ($bn)

Market size ($bn)2016-2026

Digital health can deliver at least $260bn in cost savings

TELEMEDICINE (0.7 / 2016)TELEHEALTH (0.6)POPULATION HEALTH MANAGEMENT (0.8)MOBILE HEALTH (3)EHR (18)

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Remote care is drastically cheaper than hospital care

Healthcare data doubling every 18 monthsAn ageing population in 2030: over-65s will make up 12% of the global population compared to 8% in 2015

Global shortage of health professionals7.2m in 2013 to 12.9m in 2035

Helathcare in the US

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athenahealth provides US physicians and hospitals with a cloud-based software platform that outsources collection of payments from health insurers and documents patient visits. It is paid a percentage of its customers’ revenue (4-5%), therefore it has a vested interest in the success of its clients. As the US healthcare market increasingly moves towards a value-based system, we believe athenahealth is very well positioned and is our top pick in digital healthcare. Disruptive hospital strategyathenahealth currently targets small US hospitals with fewer than 50 beds, which we view as potentially disruptive as this market is under-served by the bigger software providers. Its technology can also be used by the growing number of “hospital-like” surgery centres. To contain healthcare costs, we expect more care to be delivered outside large hospitals and in these smaller settings. athenahealth has signed approximately 100 small hospital contracts and hopes to double this in the near term. Well-placed for population health management Population health management uses analytical tools to

accumulate patient data and make valuable clinical recommendations to healthcare providers – it is essential for delivering value-based healthcare. With only about 2m of the 47m patients (2015: 39m) in athenahealth’s network currently covered by its population health software this is a material growth opportunity. Beneficiary of consolidation: Government financial incentives in the US (2011-2015) prompted a rush by physicians to move from pen and paper to software, leading to a fragmented market today. In our view, athenahealth will benefit from market consolidation as it enjoys very high “mind share”, with physicians more likely to choose it over competitors. Margin accretive revenue growth: Given the above opportunities, by 2020 we expect athenahealth to double current revenues to more than $2bn, driving operating margins up 300-400bp to more than 17%. athenahealth is not a “value” stock, but we believe the combination of continued sales growth and margin expansion will support current multiples and investors can ride the growth story.

athenahealth: A hospital Trojan horse

Cost saving ($bn)

Market size ($bn)2016-2026

Digital health can deliver at least $260bn in cost savings

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non-urgent patient visits to both their doctor and also the emergency room in a hospital. Estimates suggest that more than 40% of OECD emergency visits are non-urgent and hence making remote consultations available could lead to significant improvements in over-utilisation of emergency services. This could also save about $70bn driven by the fact it costs $40 per telemedicine consultation versus $1,000 for an emergency department visit. By making access to doctors 24 hours, it can also solve the problem of where to go when primary care is not available. We believe the number of online consultations can grow from 5m per year currently, to about 350m by 2026, driving a $15bn market. Leading companies in this area are Teladoc in the US, Medgate in Switzerland and Babylon in the UK.

2 Remote patient monitoring This is an even more exciting area, which we see growing from 300,000 covered patients globally today to 28m by 2026 and a $36bn opportunity.

With an increasingly accurate and sophisticated offering in terms of medical-grade sensors combined with internet-connected smartphones and tablets, chronically ill patients can be monitored in their own homes, 24 hours a day. Their vital readings, be it glucose, blood pressure, heart rate, can be monitored in a data centre and if there are any irregularities the patient and/or the hospital can be notified. The key benefits for this technology are both cost ($1,500 per year versus unto $80,000 per year for full-time nursing home care) and patient satisfaction, as most would prefer to be looked after in their own home than in a care home or hospital. A European Commission survey suggests 10% of all hospital M

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admissions in Europe are preventable, with the number as high as 20% in Germany alone. Philips is the world leader in patient monitoring and looks set to benefit as more and more countries and in the US states allow reimbursement for cost and performance reasons.

3 Mobile health and wearablesMobile health and wearables is concerned with the hardware needed to accurately monitor patients. While currently this market is largely a consumer

market-focused on fitness tracking, we believe a lot of companies such as Fitbit, Nokia, Garmin and Apple will continue to develop medical-grade wearables, which can collect data for monitoring services in the chronic care markets. The 28m patients mentioned above in the monitoring market, will need a number of wearable devices leading to an estimated $20bn market by 2026.

4 Electronic health records Electronic health records (EHRs) is a well-established market with most hospitals and primary care organisations having some form of digital records

system. However, many of these have had problems in terms of interoperability and performance. With the amount of healthcare data doubling every 18 months, EHRs are crucial for digital healthcare and without them, adoption is impossible. Lack of co-ordination and data sharing can result in duplicate medical tests, long waiting times and higher incidence of medical errors – making working EHRs indispensable. We still see growth potential in areas such as cloud-based platforms, which can then provide broad data for population health services. There are also opportunities in markets such as small hospitals in the US as we move to value-based care and in geographies such as the Nordics and the UK – where large-scale IT upgrades are starting. While overall the market growth is less exciting than those areas identified above (5% annual growth on our estimates), we still see this as a $30bn market by 2026. Key players in this area would be athenahealth and Cerner in the US as well as Servelec in the UK and Nexus in Germany.

5 Population health managementFinally, and perhaps most exciting, is the market for population health management (PHM). PHM allows data providers to analyse the aggregated data of the

patient population and then analyse it to provide targeted and proactive care based on the conclusions and trends seen from the data. With increased data sharing between EHRs, the ability to analyse huge amounts of patient data should lead to significant advancement in diagnosis and prevention. This data can also be used by pharmaceutical companies to accelerate the development personalised medication. Companies such as BenefitFocus, Evolent Health, Inovalon, athenahealth and Cerner in the US along with Philips and IBM are providing services on top of the software in a market we think can grow from sub-$1bn currently to about $40bn by 2026.

We believe the number of online consultations can grow from 5m per year currently, to about 350m by 2026, driving a $15bn market

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SECTOR FOCUS

USA Aerospace & Defence

The Boeing CompanyLockheed Martin Corp

Automotive

BorgWarnerDelphi AutomotiveFord Motor CompanyGeneral Motors CompanyGoodyear Tire & Rubber CoLear CorporationMobileyeTesla Motors

Banking

Bank of America CorporationCitigroupGoldman Sachs GroupJPMorgan Chase & CoMorgan StanleyWells Fargo & Co

Beverages

Boston Beer CompanyBrown-Forman Corporation

Capital Goods & Industrial Engineering

AGCO CorporationAllegion Deere & CompanyEmerson Electric CoHyster-Yale Materials HandlingRockwell Automation

Food Manufacturing

The Hershey CompanyInternational Flavors & FragrancesMead Johnson NutritionMondelez International

Household & Personal Care

Colgate Palmolive CoCotyEstée Lauder Companies

Leisure

AramarkCarnival CorporationHilton Worldwide HoldingsHyatt Hotels CorporationMarriott InternationalNorwegian Cruise Line HoldingsRoyal Caribbean Cruises

Med. Tech/Services

athenahealth LivaNova

Metals & Mining

Alcoa CorporationAllegheny TechnologiesBarrick Gold CorpFreeport-McMoRanGoldcorpKinross Gold CorpNucor CorporationSouthern Copper CorporationSteel Dynamics IncTernium

Pharmaceuticals

Bristol-Myers Squibb CompanyEli Lilly and CompanyGilead SciencesMerck & Co PfizerTeva Pharmaceutical Industries

Software & IT Services

AccentureAnsysAutodeskBenefitfocusCognizant Technology Solutions CorpEPAM SystemsLuxoft HoldingOracle CorpPayPal HoldingsPTC

Sporting Goods

Under Armour

Technology Hardware

Applied MaterialsCisco SystemsCitrix SystemsHewlett Packard Enterprise CoInternational Business Machines CorpJuniper NetworksKLA Tencor CorporationLAM Research CorporationVeeco InstrumentsVMware

Tobacco

Altria GroupPhilip Morris InternationalReynolds American

Our growing US stock coverage

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THOUGHT LEADERSHIP

The developing world continues to bear the majority of the burden of this devastating disease, where drugs are frequently given away for little or nothing in an effort to eradicate the epidemic. In western markets, by contrast, sales of the most effective products represent multi-billion dollar opportunities. The gold standard offerings

are “triple combination” products, which contain the most modern class of molecules, integrase inhibitors, alongside two other drugs from another class. These are formulated into a single once-daily tablet. Gilead and ViiV (majority-owned by GSK) both make products in the space – Genvoya and Triumeq respectively – which are comfortably blockbusters.

GSK’s integrase inhibitor, dolutegravir, offers the best protection in the class against the development of drug resistance by the virus. It is sold both as part of Triumeq and alone as Tivicay, to offer physicians flexibility. On a volume basis, dolutegravir leads the market in the US, although Gilead is fast catching up with Genvoya. We expect the market for combination single-tablet integrase inhibitor products

LAURA SUTCLIFFEHealthcare Analyst

HIV treatment has come a long way since the discovery of the virus in the early 1980s, but there is plenty of work still to be done

HIV: a fight yet to be won

Laura Sutcliffe joined Berenberg in 2014. Prior to this she spent four years in strategy consulting working with healthcare and banking clients. She holds a PhD in Engineering, an MPhil in Bioscience Enterprise and a BA in Zoology from the University of Cambridge.


37Illustration by Matt Chase

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to grow strongly over the next few years. They are the best choice for most new patients and those on older treatments can benefit from switching.

Control but no cureDespite occasional hopeful headlines, the scientific community has not yet found a cure for HIV. However, better treatments mean that patients can live for much longer than previously. Those in developed nations taking the latest treatments can now expect a near-normal lifespan, and this is driving growth of the patient pool, who as things stand, must remain on therapy for life. On top of this, infection rates are still not fully under control. Current estimates put the total population in the US living with HIV at 1.2m and rising.

New priorities emergingEven the likes of Genvoya and Triumeq, are not perfect. Genvoya contains an extra ingredient necessary to make the integrase inhibitor work as a once-daily treatment. This is known as a “booster” and can cause side effects. Triumeq has a different problem – the integrase inhibitor works well without a booster, but one of the other two ingredients, abacavir, can cause reactions in some patients, and has been linked to cardiovascular issues. This has meant giving up some ground to Gilead. As patients live longer, long-term side effect profiles and the maintenance of virologic suppression without the emergence of drug resistance will become more pressing issues. Gilead and GSK are both looking to optimise future treatments with these considerations in mind, but are taking very different approaches.

Three drugs or two?GSK is experimenting with having patients take two drugs, rather than the usual three, on the grounds that this might present a better toxicity picture. Gilead, on the other hand, believes in sticking with a safety-optimised three-drug approach and is developing a replacement, bictegravir, for the integrase inhibitor in its existing combination tablet, which will not need a booster. Both companies have demonstrated in clinical trials that their chosen strategies can be made to work. Gilead is still waiting for data from phase III trials, which are due in the middle of 2017, but has the benefit of the weight of a large body of scientific evidence supporting the use of three-drug regimens. GSK has the advantage of a best-in-class integrase inhibitor from a resistance perspective already, leaving Gilead to show that bictegravir can be just as good, but faces an uphill battle to persuade physicians to accept two-drug solutions in a three-drug world.

Additional nichesHIV drugs will be crucial for the top line at both GSK and Gilead over the next few years, and both companies have new treatment options outside of oral integrase inhibitors which can incrementally boost sales. In 2012, Gilead won a label expansion for one of its older HIV drugs, Truvada, to include use by at-risk but uninfected individuals to reduce the chance of catching the disease. Taking Truvada in this setting is known as pre-exposure prophylaxis or PrEP. PrEP is seen

THOUGHT LEADERSHIP

‘HIV will be crucial for the top line at both GSK and Gilead over the next few years’

Truvada: one of Gilead’s older HIV drugs, which can be taken prophylactically to reduce the chance of catching the disease.

Healthcare

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IMA

GES

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controversial in some circles and Gilead originally did not envisage a major commercial opportunity here. However, uptake has recently taken off and anecdotal evidence suggests that major centres have started to report a drop in infection rates since its introduction. The company is now promoting PrEP use more aggressively, and at the end of 2016 an estimated 110,000 patients in the US were taking Truvada for this purpose. The US PrEP market, in which Gilead is alone in addressing for the next few years, was annualising at $1.4bn at the end of 2016.

Something differentGSK is trying something completely different – an injectable therapy. It is fairly unusual to see a situation where injections are preferred over tablets, so enthusiasm for this option came as something of a surprise to us during the course of our research. In conjunction with partner J&J, GSK is developing a monthly treatment that would be administered in a doctor’s surgery. There are two groups of patients who could potentially benefit from this arrangement – first, those who struggle to comply with daily tablet taking and where the development of viral resistance is therefore a concern, and second those who worry about the stigma that is still associated with HIV if a bottle of medication is discovered by family, friends or colleagues. Although it will not be for everyone, we think this could be a meaningful opportunity for GSK to take around 10% of first-line market share in a few years’ time.

For Gilead, bictegravir is crucialIf the phase III data for the bictegravir single tablet regimen lives up to expectations, it will be a very attractive option for physicians to prescribe for both new patients and those switching from older options. The company has a long history in HIV and an extensive portfolio of combination drugs elsewhere in the space, but the vast majority of growth will come from the integrase inhibitors. Gilead’s ability to overtake ViiV and become the market leader in integrase inhibitors will depend upon showing that bictegravir’s resistance profile can compete with dolutegravir’s.

GSK will have to defend dolutegravir’s position Dolutegravir’s position as front runner will likely be challenged so GSK will have to work hard to ensure that its longer data set remains in the field of view for doctors. Sales growth may slow as bictegravir launches so the development of new options such as the injectable will become important areas to watch. Nevertheless, Triumeq will remain a big drug – physicians are unlikely to switch patients who are already taking it and doing well – and sales at ViiV will continue to be an important driver of growth for GSK at group level.

Cure likely still far awayOur understanding of the long-term trajectory of HIV infection is still incomplete and as such, the most appropriate way to eliminate it from the body has yet to be determined. In any case, very long-term data will be needed before a cure can be declared. As such the best and safest drugs we have today are crucial for the continued health of those living with this potentially fatal condition.

HIV timeline

1981 The US Centers for Disease Control and Prevention (CDC) reports that five gay men in Los Angeles have developed a rare lung infection called pneumocystis carinii pneumonia as well as an array of other diseases consistent with a collapsing immune system.

1982 As the disease begins to spread, the CDC introduces the term AIDS (acquired immune deficiency syndrome).

1986 The International Committee on the Taxonomy of Viruses issues a statement in which it is agreed that the virus that causes AIDS will officially be named HIV (human immunodeficiency virus).

1987 The FDA approves AZT (zidovudine) as the first antiretroviral drug for the treatment of HIV.

1992 AIDS becomes the number one leading cause of death for American men aged 24 to 45.

1995The use of protease inhibitors ushers in the era of HAART (high active antiretroviral therapy) in which a combination of three or more drugs is used to treat HIV.

2015According to the WHO, 36.7m people are infected with HIV and nearly 35m people have died since the beginning of the epidemic.

THOUGHT LEADERSHIP

Emily Mouret has been in equities for more than 15 years. She joined Berenberg in 2012 and previously worked for Goldman Sachs and Exane BNP Paribas. Emily has been based in our San Francisco office since 2014. Born out of her love of stocks and passion for wine, If Stocks Were Wine is Emily’s weekly sales publication.


The stock Eli LillyDrug pricing in the US is subject to increasing scrutiny, so innovation and improved patient outcomes remain crucial to pipeline success. Importantly for Lilly, new products are the major contributors to volume growth, as we saw during the last quarter of 2016. Within the new-product bucket, GLP-1 Trulicity (for diabetes) has been the star performer and we now forecast $2.4bn of sales by 2020. Lilly is also leading the competition with SGLT2 Jardiance. The pipeline looks equally impressive, helped by the recent acquisition of CoLucid. While Lilly’s shares continue to trade at a premium to the sector on 19x next year’s earnings, at 15% annual core earnings growth for 2016-20, the stock offers the highest growth in our large-cap pharma coverage universe. The wine 2010 Robert Mondavi “Reserve” Cabernet Sauvignon, Napa ValleyAs an early pioneer in the diabetes space that suffered from the impact of a more competitive landscape, Lilly reminded me in many ways of Robert Mondavi, a legend who shaped the California wine industry. Mondavi sought to produce wines that would compete with the finest in Europe, applying old world techniques to accomplish his goal. From its very first vintage in 1966, Mondavi stood for everything Napa Valley hoped to become and this was a true turning point for the region. To this day, the Robert Mondavi Reserve Cabernet remains the wine that shaped the Napa Valley landscape. The 2010 vintage does not disappoint with just the right balance of tannins and a lingering fruitiness.

The stock PTCAfter years of restructuring, PTC is now a changed company. Its once-troubled Solutions division is growing at above the market rate and the top-line contribution from the Internet of Things business is becoming more important. Furthermore, we see the end of perpetual licensing in sight. PTC is also something of a self-help story – recent investments in CAD have started yielding results and increased growth in the core is sustainable. Finally, PTC could potentially be an attractive acquisition target for a number of companies (especially in the capital goods space) and might be a good fit for the likes of GE or Siemens. While the stock has done well, we see further incremental value coming from maintenance conversion, which would provide upside. The wine 2012 Spring Mountain Estate Cabernet Sauvignon, Napa ValleySubscription models (or “clubs”) in the wine industry have been around for a very long time. This reminded me of my very first wine club membership – Spring Mountain Winery in Napa. I first discovered it back in 2005, when I purchased a bottle of the 1999 Reserve to try. It was, in a word, phenomenal. When I went to buy some more, I discovered that they were already sold out and distribution at the time was still quite limited. So I joined the Spring Mountain wine club. The 2012 Cabernet is full of ripe fruit, blackberries and a lingering hint of chocolate with just the slightest hint of vanilla. And like PTC, the 2012 vintage has the potential to continue to exceed long-term expectations.

2010 Robert Mondavi “Reserve” Cabernet Sauvignon, Napa Valley

2012 Spring Mountain Estate Cabernet Sauvignon, Napa Valley

EMILY MOURETEquity Sales, Berenberg Capital Markets, San Francisco office

If StocksWere Wine

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The stock BoeingOver the past three years Boeing has returned a staggering $33bn to shareholders. Looking ahead, it should be able to sustain $7bn of buybacks per annum, in addition to a healthy dividend growth of 18% through to 2020. Furthermore, potential corporate tax cuts and margin upside could mean almost 50% upside to 2020 earnings in a blue-sky scenario. Overall commercial aircraft programme trends are favourable – the outlook for the 737 is and the 787 has finally turned profitable. The defence outlook is also positive – as the second-largest supplier to the US DoD. While Boeing shares trade at a 15% premium to its 20-year average, the stock is set to become a serial earnings compounder, which, combined with significant cash returns, make it the perfect stock to “tuck away” in your portfolio. The wine 2012 Cadence Bel Canto Cara Mia Vineyard, Red Mountain, ColumbiaBoeing founded a wine club in 1971 so employees could make their own wine. One such employee was Ben Smith, who made his first wine in 1992. It quickly became apparent that he had a natural gift for winemaking, and Smith eventually left Boeing in 2000 to make wine full time. The Cara Mia Vineyard was established in 2004 and is located in the Red Mountain district of Washington state. While it has many Washington wine characteristics (echoes of plum, spice, black cherry), there is something almost “Bordeaux-esque” about this wine. And while it is drinking really well now, this is definitely one that you could easily cellar for 15-plus years.

The stock Estée LauderEstée Lauder has consistently outperformed its peers on top-line growth and this should continue. 2017 should be a transition year, especially in the US as the group shifts away from department stores and faces cyclical headwinds (tourism flows). Going into 2018, the US business will be strengthened, given recent M&A and distribution expansion, and an improving brand mix, as faster-growing brands become a larger proportion of revenue. Estée also has the most developed online business in health and personal care, accounting for 10% of group revenue – and importantly, over half is direct to consumer. The stock trades on just 22x next year’s earnings, in line with the sector, despite sector-leading top-line and earnings growth. The wine Bollinger “Special Cuvee” Brut NV ChampagneEstée Lauder was one of the most influential women in the 20th century, building a small business from scratch and transforming it into an iconic brand. As such, I thought it would pair well with a similarly feminine-inspired wine. Lilly Bollinger – who became head of the House of Bollinger after the premature death of her husband in 1941 – came to mind. Like Estée, Lilly was also linked to many innovations during her tenure – mainly aimed at improving the winemaking process and grape quality. One of the qualities of the Bollinger NV is the vintagesque aftertaste that you find lingering on the palate. This is a fabulous wine, with hints of pear, apple, citrus and a certain nuttiness.

The stock AllegionAllegion is a global provider of security access products, in what is a highly fragmented industry. The company is undergoing a multi-year transformation phase that will ultimately lead it to shift from a pure mechanical component supplier towards a digital access control solutions provider. The US retrofit and electromechanical businesses account for about 45% of revenues and are growing at a double-digit rate. Since its spin-off from Ingersoll Rand three years ago, Allegion has been able to improve margins significantly, but there is still plenty of headroom to do more. On 18x next year’s earnings, Allegion trades at a 10% discount to closest peer Assa Abloy despite stronger growth, which seems unjustified.

The wine 2011 Domaine du Vieux Telegraphe “La Crau”, Châteauneuf-du-PapeIn thinking about locks, Allegion reminded me of Châteauneuf-du-Pape, famous for having two crossed keys etched into the front of the bottle, in reference to the papal coat of arms. The origin of this historic wine goes back to the 14th century, when Pope Clement V, relocated the papacy to the town of Avignon. Vieux Telegraphe was founded in 1898 by Hippolyte Brunier, a modest fruit and vegetable farmer who had cultivated a small hectare of land to make wine. Today, Vieux Telegraphe boasts 242 acres in the Châteauneuf-du-Pape AOC area. The 2011 vintage has powerful aromas of cherry and blackberry and a hint of spice. It is actually drinking really well now, but certainly it will keep for at least another five to six years.

2012 Cadence Bel Canto Cara Mia Vineyard, Red Mountain, Columbia

2011 Domaine du Vieux Telegraphe “La Crau”, Châteauneuf-du-Pape

Bollinger “Special Cuvee” Brut NV Champagne

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THOUGHT LEADERSHIP

Next-generation products (NGPs) are likely to be the single largest change in the world tobacco market since the move to the standard filtered cigarette during the 1950-60s. NGPs potentially offer a much “lower risk” solution for people who want to consume nicotine, which are understandably proving popular with consumers.

However the existing industry will also face a significant change in its business model , a model that has proved hugely value creative for shareholders over the past 15 years, and governments, too, will have to look again at their tax and regulatory policies as markets become more dynamic.

CompoundersDespite consistent volume declines, the tobacco sector has delivered consistent earnings growth and valuation multiple re-rating in recent years. This apparent contradiction is to a large degree due to the industry’s ability to more than offset the volume declines with consistent price/mix increases. In addition, because volumes are shrinking, capital expenditure spending requirements have tended to be limited, and the resulting strong cash flow has been available for mergers and acquisitions (resulting in industry consolidation) and for shareholder returns.

DisciplinePrice increases are possible because, unsurprisingly given their addictive nature, cigarettes exhibit a low price elasticity of demand (we estimate in the region of -0.35). Add to that the fact that high levels of taxation mean price-based competition is not especially effective, and with four players controlling 70% of the market outside China and the US, and you have an industry with price discipline, able to grow even in the face of declining volumes.

VolatilityInnovation and improvements in the technology associated with NGPs should result in them becoming ever more effective substitutes for smoking over time, and logically this should result in an increase in the level of sensitivity to price changes. For the time being, there are largely two types of NGP – vaping (which contains nicotine, but not tobacco) and heat not burn, which is a non-combustible tobacco product that tries to recreate the taste and consumer experience of a traditional combustible cigarette. The industry players vary in their exposure to these new technologies, with Philip Morris International (PMI) leading the heat not burn segment whereas British American Tobacco (BAT) leads the vaping segment. For now, none of the players seem entirely sure at what price level the new products will be consumer acceptable in different markets, and over time technologies may be introduced that make previous ones less comparatively attractive or even obsolete. Therefore market shares are likely to be far more volatile in the future than historically, and this combined with far lower tax rates for some of the new products may mean that price-based competition becomes a more significant factor.

The next generationTobacco

Jonathan Leinster joined Berenberg in November 2015. He has more than 24 years’ experience in the consumer sector – initially for three years on the buy-side and then on the sell-side, including 20 years at SG Warburg/UBS investment bank. Jonathan was consistently top three-rated in the Extel and II surveys for the tobacco sector during his time at SGW/UBS and was named in Institutional Investor’s “Most Team Leader Appearances 1986-2015” for the All-Europe Research Team.


JONATHAN LEINSTERTobacco Analyst

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THOUGHT LEADERSHIP

ChallengesThe changing face of the industry also presents challenges to governments and regulators. Should the ban of “characterising flavours” that will come into force within the EU be applicable to heat not burn or even vaping products? Does indoor smoking bans cover vaping and tobacco vaping? Should the ban on tobacco advertising be extended to the new products? And how should new products be taxed given their perceived “lower risk of harm” versus traditional products?

So far, few countries have levied duties on vaping, and tax rates on heat not burn are much lower than traditional products. However, a question remains over whether governments will allow the overall market for tobacco products to grow in volumes terms (possible if they believe there is little harm from the new products), or whether governments are willing to accept lower tax revenues as consumption switches from highly taxed combustible cigarettes to more lowly taxed heat not burn products.

ScienceFuture government actions ought to be determined partly on a scientific determination of the levels of harm and risk involved with the new products. The tobacco industry is already working on this, but “proving” that the new products are “lower harm” or “largely safe” is likely to prove difficult in the face of health scepticism from the strong anti-tobacco lobby and also differences of opinion as to exactly what the “problem” is.

For example, the World Health Organisation’s stated objectives include the reduction in the levels of nicotine addiction as well as smoking and smoking-related diseases. The industry has produced emission and exposure tests to prove that the emissions from NGPs include significantly lower levels of toxicants than combustible cigarettes.

However the longer-term “harm” tests, which attempt to determine at what point the level of toxicants build up will actually increase the chances of disease, have yet to be completed since they often takes years.

Conclusion The industry has begun to see a significant shift in product demand and with other technologies likely to be launched such as carbon tipped cigarettes, third generation vaping and hybrids that include tobacco vaping and other vaporisers and nicotine sprays then this trend looks set to continue. Currently the low tax rates attracted to these products makes them a net win for the industry, but at the expense of the governments unless they are prepared to allow a larger “nicotine use” market place. However, in the short term the replacement of a highly stable, high return industry which has generated significant cash flow with a more technology driven industry will create higher uncertainty. This means investors will have to pick potential winners and losers far more so than in the past.

‘Market shares are likely to be far more volatile in the future and price-based competition may become a more significant factor’Illustration by Christopher De Lorenzo

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THOUGHT LEADERSHIP

S oftware content and its increasing importance is not only changing the business models of industrial companies, but also how investors think about valuing these firms. Despite a revenue contribution today from digitalisation that is still materially below hardware sales, the investment community is at the tipping point of

believing in a big game changer that will unravel over the coming years and will unmask the winners from the losers.

Two approachesWe recognise two main distinctions when analysing the software expansion strategy of industrial companies. First, investment into design and/or simulation software capabilities. An example would be Siemens expanding its position in the value chain to industrial automation before the actual engineering process. Second, investment into asset or operations management software. An example of this would be GE’s Predix, which helps to improve the efficiency and productivity of, for example, a factory or equipment. Interestingly, Siemens has so far been the only company to proactively invest in design and simulation expertise resulting in head-to-head competition with pure-play software businesses such as French company Dassault Systemes or US-based PTC. While Siemens also offers operations management software to clients, we see this approach more at risk of commoditisation in the long term.

Early days With the exception of sales into weak process industries such as oil and gas, software markets are enjoying healthy growth rates ranging on average between about 4-8% depending on the subsector. However, some of our companies, such as Siemens, are benefiting from stronger, often double-digit, growth as a low revenue base

Simon Toennessen joined Berenberg in May 2015 to head the global Capital Goods team and to cover the large-cap electricals stocks within Capital Goods & Industrial Engineering. Before joining Berenberg, he worked six years at Credit Suisse, covering the electricals and business services sector. Prior to this, he worked at Dresdner Kleinwort and WestLB in equity research and ECM roles in Frankfurt, Zurich and London. Simon has a Diploma degree in Business Economics from the University of Cologne.


SIMON TOENNESSENCapital Goods Analyst

Examining the huge shift facing the software industry – and investors

Tipping point

45Illustration by Denis Carrier

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and better market positioning is allowing market share gains. Given the profitability level of software businesses are above that of average hardware products, this faster growth improves revenue mix and should enhance the margin profile of those industrials that have a high enough exposure.

Acquisition frenzySiemens alone has spent about €12bn on software acquisitions over the past 10 years, boosting revenues in this area to a staggering €5bn. Similarly, GE is targeting $15bn from software sales by 2020 from about $5bn a year ago. Now, some will say that this constitutes only a small part of each conglomerate’s revenue base today (on average less than 10%). However in a few years, a combination of strong organic growth and acquisitions will result in a more material contribution Indeed, the revenue base is likely to exceed that of pure-play software companies. In addition, software M&A will remain a focus of industrial companies for the foreseeable future, thus fuelling ongoing takeover speculation.

Valuation implicationsGiven the increasing importance and transition of business models towards software, we expect the debate to lead more and more towards the valuation of software businesses within industrial companies, but also a valuation impact for the sector overall. We are just at the starting point of this discussion, but we are fairly convinced it will have favourable implications for companies with exposure.

China boostOver the past few years, the industrial software market in China has grown from roughly CNY50bn in 2010 to CNY110bn (c.$16bn) in 2015 (a 17% annual growth) and industry research suggests the market will almost double (again) over the next five years. We expect particularly strong demand from manufacturing execution systems (MES) and product lifecycle management (PLM) software. This trend is in line with recent comments by Siemens that its software business in China has grown at a double-digit rate. We expect western companies to have a competitive advantage in industrial software with Chinese companies focusing on more hardware quality as their software expertise still lags behind those of western players.

Pricing transitionThe software industry is currently undergoing a huge shift from a perpetual licence-based system of payment to a subscription model. Traditionally, companies purchase software through perpetual licensing, in which they pay a one-time fee, plus annual costs for maintenance. These annual costs are sometimes compulsory, in particular for more specialised software. Although the traditional model works well for stable enterprise software with high switching costs, companies can end up being stuck with costly licensing contracts for software they are not using, thus hampering their cost structure and flexibility of usage. It will be critical for industrials to manage this transition given the tendency to use licences and pure-play software companies switching fast.

Top picks Capital Goods: tipping point

THOUGHT LEADERSHIP

Siemens The perception of Siemens is transforming from a complex conglomerate to a company that consistently improves margins. We think it has the best automation business in our coverage with the strongest software portfolio. It is also the only company in our coverage that has lifted guidance in three out of the last five quarters and we see further scope from here. Management has successfully repositioned its businesses towards growth, while de-risking the portfolio and improving underperforming divisions. Although Siemens reported five out of eight divisions at or above the top end of the mid-term guidance range last quarter, we don’t think the market is giving it the re-rating it deserves (we estimate about 60% of recent share performance has been driven by upwards earnings revisions). We see a fair value of €140, while our blue-sky scenario suggests a fair value of €154.

Schneider Schneider is the second best-positioned industrial company in relation to software, in our opinion. We favour the combination of discrete versus process automation in its Industry business coupled with a strong position in manufacturing execution systems and controls, in addition to offering some simulation capabilities. We believe investors are underestimating the potential for stronger margin delivery based on better net pricing, cost savings and favourable currency movements. In addition, strong exposure to improving markets in North America and China, and the potential for portfolio pricing look under-appreciated at current share price levels.

Convertible Bonds Conference

Berenberg SRI Conference

Berenberg UK Corporate Conference

30 March 2017

28 March 2017

25-27 April 2017

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Berenberg UK Corporate Conference London, 25-27 April

ROB CHANTRYUK Mid-Caps Analyst

We recently welcomed 40 UK corporates from a diverse set of industries and a wide range of market caps to our 60 Threadneedle Street offices for our second annual UK Corporate Conference. More than 150 investors attended with over 300 one-on-ones and small group meetings taking place.

The UK has been a key focus for us in recent years. Of the close to 700 stocks we cover, more than 170 are in the UK, the most of any market,

ACCESS

and there is more expansion to come. By the end of 2017, we expect to cover in the region of 250 stocks in the UK, and in excess of 800 shares in total. The UK Small and Mid-Cap team has played a part in this growth. In the past six months, we have doubled the team to 12 analysts and plan to double our stock coverage again to 120 by the end of 2017.

The remit of the team remains to find interesting, uncovered companies in the UK market with a market cap below £4bn. Three of the more recent initiations were present at the conference and stood out for us: 1) value gym operator Gym Group, which we feel has a substantial roll-out ahead; 2) events business Ascential, whose smaller, more focused portfolio arguably gives it an advantage over some peers; and 3) outsourcing video game developer Keyword Studios, which gives unique exposure to the structural changes taking place in the video gaming sector.

We are planning to increase the scale of the conference again for 2018.

ACCESS

One-to-one meetings

149Investors attended

Photography by Scott Wishart 51

Companies in attendance Ascential, Benchmark Holdings, Cineworld Group, Connect Group, Cranswick, Dalata Hotel Group, DS Smith, Fuller, Smith & Turner, Intertek Group, John Menzies, Keyword Studios, Laird, Legal & General Group, Lookers, Low & Bonar, MJ Gleeson, Next 15 Communications Group, Nichols, Pendragon, Polymetal International, Polypipe Group, Provident Financial, Prudential, Restore, Safestore Holdings, Servelec Group, Sirius Real Estate, Softcat, St James’s Place, Staffline Group, Standard Life, Taptica International, TBC Bank Group, Telit Communications, The Gym Group, Victoria, Xeros Technology Group, XLMedia, Zegona Communications

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Held at the Le Bristol Hotel in Paris, Berenberg’s second Convertible Bonds Conference – organised by the Fixed Income Team – brought together nine companies with 42 investors from 30 different institutions. Investors experienced a broad spectrum of European issuers across different sectors from real estate to food and nutrition production.

The presentations were well received with interesting Q&A afterwards. Investors also had the opportunity to meet the management in one-to-ones. Unsurprisingly, most are focusing on their operations while already preparing for their upcoming maturities. There have

Convertible Bonds Conference Paris, 30 March

ALEXANDER KRETZLERFixed Income Team

ACCESS

42Investors attended

Companies in attendance Aroundtown Property Holdings, Cofinimmo, Franz Haniel & Cie, Glanbia, Grand City Properties, Greenyard, Maire Tecnimont, SGL Carbon and TAG Immobilien.

been a variety of plans to tackle these maturities.

Franz Haniel & Cie, for example, is still weighing up its options with regards to the exchangeable bond maturing in 2020 – a buy-back would be a possibility. On the other side, SGL Carbon is likely to use disposal proceeds for deleveraging, in other words calling its high-yield bond maturing in January 2021 and repaying its convertible bond which matures in 2018.

28One-to-one meetings

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Forty investors attended our first SRI Conference at Le Bristol Hotel in Paris on 28 March. Investors had the opportunity to meet 18 European companies including Banco Santander, GlaxoSmithKline, Nestlé and Volvo. The conference hosted SRI/CSR representatives and was a great opportunity for investors to discuss various topics from corporate governance to environmental issues.

Berenberg SRI Conference Paris, 28 March

DALILA FARIGOULEHead of Berenberg Paris

Top: Berenberg’s Kai Klose. Above: TAG Immobilien CFO Martin Thiel. Left: Grand City Properties CEO Christian Windfuhr.

ACCESS

Companies in attendance Ahold Delhaize, Banco Santander, BASF, Centrica, Compagnie Financière Richemont, CRH, Deutsche Bank, Glanbia, GlaxoSmithKline, Iberdrola, Jeronimo Martins SGPS, Lenzing, Nestle, Pernod Ricard, SAP, Skanska, Swiss Re, Volvo Group

97One-to-one meetings

30Different institutions

Photography by Antoine Doyen

COMPETITION

5

4

3

2

1

Win a case of US wineThis issue’s Spot The Ball heads Stateside to Superbowl 51 between the New England Patriots and the Atlanta Falcons. To win a case of excellent US wine, look at the picture above and use your skill and judgement to determine which numbered circle our panel of judges believes best represents the position of the ball. Our resident wine (and Thematics) expert Nick Anderson has selected a case of either Ridge Vineyards Estate Cabernet Sauvignon or Chateau Montelena Chardonnay for one lucky winner, who will be chosen at random from the correct entries. For your chance to win, email [email protected] with your guess, name, contact details and whether you would prefer the case of red or white wine, and let us know where you read our magazine. The closing date for entries is 31 July 2017.

T&Cs 1. Prize draw is open to entrants aged 18 and over, with the exception of employees of Berenberg, c-ll-ct-v-ly or any associated parties. 2. Only one entry per person. Proof of identity may be required before prize is awarded. 3. Responsibility cannot be accepted for entries that are incomplete, delayed, damaged or wrongly delivered or not received for any reason. Proof of entering is not proof of receipt of entry. 4. Prize is non-transferable and must be accepted as offered. No cash or alternative prize will be offered. 5. The winner will be notified within 14 days of the closing date. 6. The winner will be the first correct entry selected at random after the closing date. 7. The judges’ decision is final. No correspondence will be entered into. 8. Closing date for entries is 31 July 2017.

54

Spot the ball

EYEV

INE

EQUITY SALES



US SALES

SALES Enrico DeMatt +1 646 445 4845Kelleigh Faldi+1 617 292 8288Isabella Fantini +1 646 445 4861Shawna Giust +1 646 445 7216Richard Harb +1 617 292 8228 Zubin Hubner +1 646 445 5572Michael Lesser +1 646 445 5575

Jessica London +1 646 445 7218Anthony Massucci +1 617 292 8282Ryan McDonnell +1 646 445 7214 Emily Mouret+1 415 802 2525Peter Nichols +1 646 445 7204 Rodrigo Ortigao +1 646 445 7202 Kieran O’Sullivan+1 617 292 8292Ramnique Sroa +1 415 802 2523

Matt Waddell+1 646 445 5562

SALES TRADING Isaac Carp +1 646 445 4866 Michael Haughey +1 646 445 4821 Chris Kanian+1 646 445 5576Lars Schwartau +1 646 445 5571Brett Smith +1 646 445 4873Bob Spillane+1 646 445 5574

CRMMonica Kwok+1 646 445 4863

CORPORATE ACCESSOlivia Lee +1 646 445 7212Tiffany Smith +1 646 445 4874

ECONOMICSMickey Levy +1 646 445 4842Roiana Reid +1 646 445 4865

SPECIALIST SALESAerospace & Defence and Capital Goods Bruna Zugliani +44 20 3207 7818 Automotive & Thematic Research Chris Armstrong +44 20 3207 7809Banks, Diversified Financials & Insurance Calum Marris +44 20 3753 3040 Iro Papadopoulou +44 20 3207 7924Business Services, Leisure & Transport Rebecca Langley +44 20 3207 7930Consumer DiscretionaryVictoria Maigrot +44 20 3753 3010Consumer Staples Rupert Trotter +44 20 3207 7815HealthcareAbigail James +44 20 3753 3078MaterialsJames Williamson +44 20 3207 7842Special SituationsJeremy Grant +44 20 3207 7890Telecommunications & MediaJulia Thannheiser +44 20 3465 2676

SALESBeneluxMiel Bakker +44 20 3207 7808Martin de Laet +44 20 3207 7804Alexander Wace +44 20 3465 2670Emerging MarketsPeter Kaineder +44 20 3753 3062 GermanyMichael Brauburger +49 69 91 30 90 741 Nina Buechs +49 69 91 30 90 735

André Grosskurth +49 69 91 30 90 734 Florian Peter +44 69 91 30 90 740 Joerg Wenzel +49 69 91 30 90 743UK Alexandra Clement +44 20 3753 3018Fabian de Smet +44 20 3465 7810Karl Hancock +44 20 3207 7803 Sean Heath +44 20 3465 2742David Hogg +44 20 3465 2628Gursumeet Jhaj+44 20 3753 3041James Matthews +44 20 3207 7807James McRae+44 20 3753 3036David Mortlock +44 20 3207 7850Eleni Papoula+44 20 3465 2741Bhavin Patel +44 20 3207 7926Kushal Patel +44 20 3753 3087Richard Payman +44 20 3207 7825Chris Pyle +44 20 3753 3076 Joanna Sanders +44 20 3207 7925Mark Sheridan +44 20 3207 7802George Smibert +44 20 3207 7911Paul Walker +44 20 3465 2632FranceThibault Bourgeat+33 1 5844 9505Alexandre Chevassus +33 1 5844 9512 Dalila Farigoule +33 1 5844 9510 Clémence Peyraud +33 1 5844 9521Benjamin Voisin +33 1 5844 9505

ScandinaviaFredrik Angel +44 20 3753 3055 Marco Weiss +49 40 350 60 719Switzerland, Austria & ItalyAndrea Ferrari +41 44 283 2020 Carsten Kinder +41 44 283 2024Gianni Lavigna +41 44 283 2038Jamie Nettleton +41 44 283 2026 Yeannie Rath+41 44 283 2029 Benjamin Stillfried +41 44 283 2033

EQUITY TRADING HamburgDavid Hohn +49 40 350 60 761Gregor Labahn +49 40 350 60 571Lennart Pleus +49 40 350 60 596Marvin Schweden +49 40 350 60 576Omar Sharif +49 40 350 60 563Tim Storm +49 40 350 60 415Philipp Wiechmann +49 40 350 60 346Christoffer Winter+49 40 350 60 559LondonAssia Adanouj +44 20 3753 3087 Mike Berry +44 20 3465 2755Ed Burlison-Rush +44 20 3753 3005Stewart Cook +44 20 3465 2752Mark Edwards +44 20 3753 3004 Tom Floyd +44 20 3753 3136Tristan Hedley +44 20 3753 3006Richard Kenny+44 20 3753 3083Peter King +44 20 3765 3139

Christoph Kleinsasser +44 20 3753 3063Chris McKeand +44 20 3207 7938Simon Messman +44 20 3465 2754 Adrian Pulleyn +44 20 3465 2756Matthew Regan+44 20 3465 2750Asbjoern Rogge +44 20 3753 3051Michael Schumacher +44 20 3753 3006 Paul Somers +44 20 3465 2753ParisVincent Klein +33 1 5844 9509Antonio Scuotto+33 1 5844 9503

CRMLaura Cooper +44 20 3753 3065 Jessica Jarmyn +44 20 3465 2696 Greg Swallow +44 20 3207 7833

CORPORATE ACCESSLindsay Arnold +44 20 3207 7821 Stella Siggins +44 20 3465 2630Jennie Jiricny +44 20 3207 7886

EVENTSLaura Hawes +44 20 3753 3008Suzy Khan +44 20 3207 7915Charlotte Kilby +44 20 3207 7832Natalie Meech +44 20 3207 7831Rebecca Mikowski +44 20 3207 7822Ellen Parker +44 20 3465 2684 Sarah Weyman +44 20 3207 7801

BERENBERG CAPITAL MARKETS LLC Member FINRA & SIPC

Berenberg 60 Threadneedle St, London EC2R 8HP +44 20 3207 7800 www.berenberg.com [email protected]

For Berenberg Laura Janssens, Head of European Research David Mortlock, Head of Investment Banking Jennie Jiricny, Corporate Access Laura Cooper, Client Relationship Management Rachel Whitehead, Research Co-ordinator Darren Barrett, Research Editor

Designed by Creative Director: Mark Leeds Picture Research: Alice Mansbridge

The contents of this publication are subject to worldwide copyright protection and reproduction in whole or in part, whether mechanical or electronic, is expressly forbidden without the prior consent of Berenberg.

© Berenberg All Rights reserved.

ISSUE 17 • MAY 2017

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