JPM_Europe Year Ahead 2019_watermark

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Mislav Matejka, CFA (44-20) 7134-9741

[e-mail]

Overweight

202p

23 November 2018

Price Target: 265p

End date: 31 Dec 19

Borja OlceseAC

(44-20) 7742-7170 [e-mail] JPMA OLCESE <GO>

Underweight

€0.80

23 November 2018

Price Target: €0.60

End date: 30 Jun 19

Borja OlceseAC

(44-20) 7742-7170 [e-mail] JPMA OLCESE <GO>

Europe Equity Research

03 December 2018

Top pick – Tesco

In March 2018, we turned positive on Tesco for the first time in five years as its cash flow, top line and balance sheet improved on a standalone basis, while Booker adds new addressable market potential and strong execution capabilities with Charles Wilson. We see Tesco as the most visible turnaround story in our food retail universe, one that has moving parts (new management, access to new markets, synergies, cost savings, legacy assets). Current valuation (12x FY19/20e PE and 9% FCF yield) looks attractive to us.

Capital return optionality. Over time, we believe the market will shift its approach of the Tesco story to one centered on capital return potential as opposed to a trading stock and the valuation approach to FCF from P/E. The building blocks of Tesco’s strategy (reinvigorating the Tesco brand, executing on cost savings, mix & property maximization) seem to have further to go. This should underpin further BS improvement, leading to higher cash flow and capital returns. As a result, in our view, Tesco could offer capital return optionality of up to £1.5bn in the next three years.

Main pushback. Investors seem to be concerned about the relative weak market share data from Kantar and the 1H miss. Our view is that the discrepancy between Kantar and actual LFL prints is widening (UK momentum has been beating expectations, whilst Thailand issues (ie, transition to front from back margins) should be temporary.

Least preferred – DIA

We believe the risk-reward remains unattractive given the risk of further ‘kitchen sinking’, the asset-light nature of the business and the lack of a high-profile management team with a credible strategy.

Risk of further ‘kitchen sinking’ ongoing. Given the number of ‘red flags’ observed over the years (eg, gross margin expansion, WC moves, trimming of financial disclosure, lack of disclosure on franchised operations, factoring/reverse factoring, etc), we are not in a position to discard further kitchen sinking (both at P&L & B/S level).

Strategic plan to impact P&L and CF further. In its strategic plan, DIA highlighted the areas of mismanagement and seems determined to finally address those, prioritizing the commercial proposition/customers/top line. The potential impact of the new strategy on the P&L and CF seems too far to be reflected in current market estimates. We think 2019 is likely to be a lower profitability point vs 2018 (JPMe c15% below cons) provided that the margin rebasing seen thus far is a function of operational deleverage/back margin dynamics, whilst we think DIA will need to cut prices. We separately see current capex levels as unsustainable.

Risk of capital raise. We see the B/S in capital raise territory (>5x LA ND/ EBITDAR, on the verge to break covenants). Its eventual magnitude depends on several factors (Mercadona, DIA strategy) and its timing unclear given potential lack of shareholder support in the current context of lack of clarity and strategic direction.

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Mislav Matejka, CFA (44-20) 7134-9741

[e-mail]

Overweight

€26.20

23 November 2018

Price Target: €35.00

End date: 31 Jan 19

Chiara BattistiniAC

(44-20) 7134-5417 [e-mail] JPMA BATTISTINI <GO>

Underweight

306p

23 November 2018

Price Target: 250p

End date: 03 Sep 19

Georgina Johanan, ACAAC

(44-20) 7134-5791 [e-mail] JPMA JOHANAN <GO>

Europe Equity Research

03 December 2018

Top pick – Inditex

Keeping up with the challenges, and very well so

Despite an increasingly challenging retail backdrop, Inditex has continued to outperform, with LFL running at MSD and operating profit margin expanding ex-FX (+120bps in H1). This is still a function, in our view, of a solid execution of a differentiated business model vs. peers, combining strong omni-channel capabilities to a nimble supply chain and pull model.

We believe this should continue into 2019, as we expect the overall environment to remain challenging and structural winners, such as Inditex, to continue to take market share. We expect sustained LFL growth in positive mid-single digits, another strong outperformance vs. the sector, with contribution not just from Zara, but from all concepts that are becoming increasingly sizeable and important growth drivers.

Importantly, in 2019, we would expect that, as forex headwinds fade through the year, Inditex should resume double-digit earnings growth, a key catalyst for Inditex shares, in our view. In addition, as Inditex continues to deliver strong free cash flow, we believe the likelihood of improving cash returns continues to increase.

We continue to see Inditex as a high-quality stock and one of the very few structural winners in this challenging space, and think this year’s stock weakness offers an attractive entry point.

Least preferred – Marks & Spencer

Few signs of improvement

Recent results provided us with little comfort on the near or medium term top-line outlook for either the Food or Clothing & Home division. We continue to see earnings risk and remain cautious despite the group’s high FCF yield (with consensus forecasts on this metric also possibly too high given management’s comments on capex moving higher from FY 20 onwards).

Food sales are now losing market share. Performance is suffering from a combination of reduced value and innovation being offered by MKS (not set to improve until Spring 2019), pressure from alternative convenience offerings (recall 40% of MKS food is still purchased for same day consumption) and improved premium ranges from competitors. The lack of an online offer is also a drag. In Clothing & Home, LFL performance remains negative (despite some support from sales transference from closed stores) and management has guided for little near term improvement (despite price investment and some range reviews already having taken place). Indeed improvements to ranges implemented by the new team won’t be visible to consumers until late 2019.

Furthermore, we are concerned that the group’s strategy to become more relevant to a family shopper in both divisions risks moving MKS away from its core brand equity and, instead, introduces product that is at greater threat from price competition from more value orientated players.

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Mislav Matejka, CFA (44-20) 7134-9741

[e-mail]

Overweight

1,695p

23 November 2018

Price Target: 1,730p

End date: 31 Dec 19

Estelle WeingrodAC

(44-20) 7742-8502 [e-mail] JPMA WEINGROD <GO>

Europe Equity Research

03 December 2018

Top pick – Compass Group

Attractive sector fundamentals. The food services market is structurally attractive, in our view, benefiting from low outsourcing share (<35%) in many regions including the US, Germany and Emerging markets. The total addressable food services market is estimated at c$270bn globally, with currently c25% operated by the larger players (Compass, Sodexo, Aramark & Elior), and c50% operated inhouse. The sector is separately supported by solid macro prospects in both the US and EM.

Bottom up, Compass best positioned. Already the undisputed market share winner, Compass is growing organically by >5% vs closest competitors at 1-3%. It benefits from its US GPO (c$23bn Group Purchasing Organization versus Sodexo’s c$18bn), bringing along buying efficiencies, which can be reinvested in the customer/ proposition/ price, a winning combination vis-à-vis tender offers, in our view.

Strong capital return profile. Compass separately scores best in terms of capital allocation, growing FCF by DD and returning excess cash to shareholders (£1bn special div. in 2014 and 2017 + £1.5bn buyback over 2012-16). We see c£1.3bn or c5% of market cap in excess cash versus the group’s 1.5x leverage target by FY20 and believe it could trigger an incremental capital return in the next couple of years, in the absence of significant M&A.

Underweight

€91.62

23 November 2018

Price Target: €79.00

End date: 31 Dec 19

Estelle WeingrodAC

(44-20) 7742-8502 [e-mail] JPMA WEINGROD <GO>

Least preferred – Sodexo

We find it difficult to be more constructive on Sodexo. While the shares have performed well since last warning in April, we are of the view that Sodexo’s recovery story is not exempt from execution risk. The risk-reward remains unappealing to us, especially in the early days of the turnaround and at a time of increasing margin pressure (i.e. labor cost inflation in the US/UK, which together represent about twothirds of EBIT).

Improved momentum, from a low base. While Sodexo seems to be picking up organic growth momentum across the board (albeit from a very low base), we remain cautious in the short term. Most of the improvement has come from Brazil (BRS c23% of group EBIT), but North America remains problematic (c45% of OSS revenue). All in all, margins will take time to recover and Compass (OW) still looks a safer play to us, outperforming Sodexo on all fronts (topline, margin, FCF).

Bull-case priced-in. We run two scenarios to assess the risks to our UW thesis. Our broad-based bull case scenario offers c11% upside potential to our base-case PT, hence we see the risk reward as unappealing in the context of the recent rally. In our Brazil blue sky scenario, we conclude that Edenred (N) offers much better upside than Sodexo (c15% vs c5%) and so is a good hedge to a Sodexo UW. For reference, Brazil accounts for 15-20% of Sodexo EBIT vs. c40% at Edenred.

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Mislav Matejka, CFA (44-20) 7134-9741

[e-mail]

Overweight

6,647p

23 November 2018

Price Target: 9,000p

End date: 31 Dec 19

Celine Pannuti, CFAAC

(44-20) 7134-7123 [e-mail] JPMA PANNUTI <GO>

Underweight

€18.41

23 November 2018

Price Target: €17.00

End date: 31 Dec 19

Celine Pannuti, CFAAC

(44-20) 7134-7123 [e-mail] JPMA PANNUTI <GO>

Europe Equity Research

03 December 2018

Top pick – Reckitt Benckiser

Even as the visibility remains low into the year-end, we view 2019 as an inflection point in Reckitt’s earnings trajectory and top-line momentum and reacceleration in margin delivery should lead to HSD earnings growth. Moreover, we would expect the market to increasingly focus on the SOTP valuation as Reckitt builds portfolio optionality with the potential split of its HyHo division. We see JPMe upside to £110-125 on a potential split of HygieneHome, along with reinvestment into Global Consumer Health - a fast growing industry ripe for consolidation, in our view.

2019 set to be an inflection point on earnings delivery. After two years of negative momentum, RB earnings are at an inflection point (JPMe FY19 Adj. EPS growth of c9%). Improving top-line (3.7% LFL) rests on 1) accelerating Health (improving end markets; comping of past issues; with upside to Mead as we conservatively factor in a knock-on effect from production disruptions) and 2) continued operational benefits of a HyHo standalone, with positive risks from share stabilization and upside from pricing. We see +100bps margin (Mead synergies to support) driving one of the highest European HPC earnings deliveries at 9% (Adj. EPS).

Reckitt currently trades on 18x PE (vs EU HPC on 21x) and 14x EV/EBITDA (vs EU HPC on 14x), which we find attractive at a time of earnings re-acceleration and valuation upside on balance sheet optionality.

Least preferred – Ontex

We remain cautious on Ontex into 2019 with low visibility on margin delivery given the magnitude of raw material cost inflation, while top line could see pressure on volumes from pricing. Further, we believe execution risk remains on a slower than expected turnaround in Brazil. Overall, we continue to see negative risk-reward while we do not expect management’s strategic review (after PAI failed bid) to yield meaningful upside.

2019 should see some recovery for Ontex though risk remains on the downside. Our FY19 LFL estimate of 3.4% assumes a strong recovery in Americas as growth in Brazil should normalize, with continued momentum in Growth Market. Mature Markets are likely to remain a drag with soft growth in Healthcare. Having recently cut FY18E/19E estimates by 4%/7% respectively on lower margin expectations, we forecast 6% Adj. EPS growth in 2019 (one of the lowest within our sector coverage) - though low visibility on raw material headwinds and pricing power adds downside risk to earnings.

Ontex trades on 12x PE19 and 9x EV/EBITDA19 compared with global Hygiene peers Essity and KMB on a blended PE19 of 17x and EV/EBITDA 11x, a valuation discount we find justified given low visibility/high volatility on earnings (unfavorable RM environment, progressive pricing in Europe leading to pressure on volumes).

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Mislav Matejka, CFA (44-20) 7134-9741

[e-mail]

Overweight

€258.45

23 November 2018

Price Target: €360.00

End date: 31 Dec 19

Melanie Flouquet, ACAAC

(39-02) 8895-2133 [e-mail] JPMA FLOUQUET <GO>

Europe Equity Research

03 December 2018

Top pick – LVMH

LVMH is the global leader in Luxury Fashion & Leather Goods with Louis Vuitton

(‘LV’), the leader in premium Champagne & Spirits and the leader in Perfume & Cosmetics selective distribution with Sephora. LVMH is also the most ‘staplised' company in our coverage and it provides a rare combination of luxury momentum and better resilience on the downside.

LV (50% of profit) is the high quality brand in Luxury in our view. LV bears the fruit of a favourable product mix (LG is the highest sales density and margin category in luxury), a balanced growth approach (several pillars, carefully managed innovation), strong creative momentum, deeply engrained retail excellence (100% retail, best sales densities in the sector), higher pricing power, and marketing firepower. On the EBIT margin, after running opex up LSD-MSD in FY16 and 17, LV saw opex back up more meaningfully in H1 18 leading to some risk of operational deleverage if sales were to decelerate. But those should be relatively short lived: c40% of LV’s opex base is variable in our view, some opex are more easily cut than in the past (eg pop up stores) and mgmt. has a strong financial discipline track record.

C35% of its NAV in staple activities: Over recent years, LVMH has gained significant mkt share in W&S (where it is the leading player in premium champagne and spirits worldwide), and in HPC (where CDior has become a firmly established top 3 brand and is fast building a sound portfolio of up and coming brands).

LVMH stands out in our view as a high quality asset that is only trading broadly inline with the Luxury sector, despite operationally outperforming, and at a discount to staple peers, with further upside on a SoTP-basis.

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