U.S.Equity Strategy:Equity Strategy Navigator –December 201


Since the election, investors have focused on whether or not a tax bill wouldget through Congress. With successful votes in the House and Senate,attention is now shifting toward economic and market implications. Even afterthe President signs tax reform into law, company-level implications will remainunclear for quite some time. The only certainty is that investors will be left withgreater uncertainty on the trajectory of corporate earnings and cash flows for2018-19. As such, we believe the market will focus on four key issues over thenear term:

Potential tax changes would appear to benefit Steels most.

Laggards in, outperformers out The Hong Kong market rebounded slightly last weekon strength in the US market, which was supported by the Fed’s projection of furtherstrength in the US economy next year as well as market expectations of an imminentapproval of the US tax bill. Gaming, airlines, consumer staples, healthcare and banksoutperformed most, while the TMT, auto, insurance and materials sectorsunderperformed, showing a continued trend of picking laggards and switching out ofstrong performing sectors before the year-end. Among HSI constituent stocks, Tingyi (322HK, NR) and Galaxy Entertainment (27 HK, NR) rose the most, while Sunny Optical (2382HK, NR) and AAC Tech (2018 HK, NR) saw the biggest falls.

    1) Effective Tax Rate. While the current statutory rate is 35%, companiesare paying only 27% on average. While specifics are unclear, investors arepresuming the new effective rate will move toward 20%. If the changegoes into effect in 2018, consensus EPS would jump from $146 to $160.

    While early days, Trump's proposed tax reforms would tend to benefit capitalintensiveindustries due to potential expensing of capex, with companiespaying high effective rates and largely domestic operations, benefitting most.

    Southbound funds buy more, sell less; full-year net buying may exceed HK$350bnAverage daily southbound trading turnover decreased by 17% WoW to HK$12.1bn lastweek, falling below the Nov average of HK$14.6bn; as a result, southbound trading’smarket share in the Hong Kong market fell to just 9.2% last Friday. However, southboundfunds have further increased their net buying, as daily average net buying increasedfurther by 28% WoW last week to HK$2,609m, back to the Nov average (HK$2,651m),showing that mainland investors have regained interest in the Hong Kong market after atemporary cool down due to the volatile market the week before. In fact, as of Nov totalnet buying from southbound funds has already exceeded HK$309bn, and with the currenttrend, total net buying in 2017 is likely to exceed HK$350bn, up 42% YoY.

    2) Potential Upside. Historically, investors have rewarded revenues andEBIT margins more than taxes. As such, we would expect much—but notall—of the improvement in EPS to pass through to stock prices. Theexhibit below highlights that the tax benefit has not yet been fully realized.

    Within our M&M coverage, steel companies are most favorably positioned dueto the majority of their operations located within the US, followed byAluminum & Specialty Metals companies. With most Precious companies,within our coverage, operating outside the US (primarily Canada, SouthAmerica and Africa), they would be less impacted, followed by IndustrialMetals producers, who have the highest proportion of non-US operations.

    Banks back in favor In the Shanghai southbound connect, of the top-ten daily activestocks last week, ICBC (1398 HK, NR), Tencent (700 HK, NR), CCB (939 HK, NR) andChina Taiping (966 HK, NR) recorded net buying, indicating that banks are back in favor.

    3) Greatest Beneficiaries. Given that the full extent of tax reform is difficultto ascertain, we recommend that investors focus on relative beneficiaries.

    Steel mini-mills and Service Centers to be the largest beneficiary.

    In the Shenzhen southbound connect, Tencent, ZTE (763 HK, NR) and SMIC (981 HK,NR) recorded net buying, showing that Shenzhen investors continue to prefer tech stocks.

    Lists of potential winners and losers are highlighted on pages 59-66.

    Steel sub-sector Pre-tax Profit is expected at $5.5bn in 2018E to be taxed at aweighted tax rate of ~30%. With 93% exposure to US-based operations,lowering corporate tax rate to 20% would imply a $682m net income benefit.

    Tax policy in focus; large banks to benefit from higher interbank rates The CentralEconomic Work Conference, which usually sets the tone for economic policy in the comingyear, will be held this week. Given the short interval between the conference and the 19thCPC National Congress, we believe the conference will stick with the National Congress’sspirit, meaning indirect financing, controlling financial risk, tax cuts and housing systemreform should be among the key issues addressed. Given the imminent US tax reform,which may set a trend of lowering the tax burden for companies and individuals, news ofany tax reduction plan from the conference will be closely monitored. Meanwhile, marketliquidity continues to be tight given the year-end effect and the US interest rate hike, whilethe 1-month HIBOR/SHIBOR have risen for three/two weeks respectively. We believe thistrend will continue to favor large banks with strong deposit bases, helping to furtherimprove their NIM; hence, we continue to favor banks in the short term.

    4) Economic and Second Order Effects. The full impact of the new taxcode is impossible to calculate given yet unknown behavioral changes.

    Applying a 15x Price-Earnings multiple would translate to ~$10bn incrementalequity value or +25% vs current sector market capitalization of ~$41bn. SteelDynamics/Nucor are likely largest beneficiaries (2018E EPS upside of 23%),followed by Reliance/Ryerson (21% each) and Commercial Metals (15%, lowerdue to International ops). Integrated steelmakers (US Steel/AK Steel) lessimpacted as they do currently pay no Federal tax due to significant NetOperating Loss (NOL) carry-forwards, but expensing of capex a LT positive.

    Risks Market unrest driven by geopolitical events and hurdles in US tax reform.

    These include the use of repatriated assets for capex, buybacks, andM&A, as well as the stimulative benefits to consumer spending.

    Aluminum & Specialty Metals.

    2018E subsector Pre-tax Profit is $3.4bn @ ~34% tax rate. With 56% exposureto US operations, a cut to 20% rate implies a $240m. At 15x PE = ~$3.6bnincremental value or +12% vs current market cap of $30bn. Alcoa, Arconic andCarpenter Technology likely largest beneficiaries (2018E EPS upside of 15%),followed by Constellium at only 7% due to majority of operations ex-US.

    Allegheny, Century and Kaiser NOL’s limit near-term benefits.

    Precious Metals.

    Pre-Tax Profit 2018E at $4.3bn and ~32% tax rate. Precious Metals subsectorcould see EPS upside of 7% over the next two years at 20% tax rate. USexposure for Gold producers ~38%/34%, in 2018/19E (based on geographicalrevenue breakdown). Barrick has largest US presence at 45% (2018E EPSupside of 15%), while Goldcorp least-exposed, operating mainly in Canada andSouth America. Silver companies ~24% US-exposed, with Pan American andWheaton having none. EPS impact ~8% for Silvers.

    Industrial Metals.

    Within Industrial Metals, only Freeport-McMoRan and Teck have direct USoperations and we estimate overall EPS benefit of lower US tax rate at only~3%. Despite ~22% of Freeport’s 2018 pre-tax profit US-based, company has~$10bn of NOLs limiting near-term benefit of rate cut. For Teck, we calculate15% of pre-tax profit is US-derived via Red Dog and Pend Oreille mines.

    Valuation wrap.

    On average, our Price Targets are based on ~7.3x 2018E EV/EBITDA fordownstream companies or ~1.0x NPV for upstream miners. Risks includemetal price movements, raw material costs, end-market demand, operationaluncertainty, FX and M&A. This report does not change forecasts, ratings or PTs.