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MS TOP RESEARCH PICKS FOR 2014

Based on the year ahead pieces, other recent notes and price action, we think these names are set to deliver strong outperformance this year…

Remains a top pick despite strong outperformance in 2013 (+87%). We see significant upside potential resulting from a pick-up in order flow, improving execution on new programs such as A380 and A350XWB and increasing production. We think the market is overlooking that EADS has proactively managed customers in the backlog to ensure limited cancellations. Key catalysts over the coming months include the Annual Press Conference in Jan 2014 where Management with outline its 2014 strategy including likely book to bill and FY13 results in March where Management will provide updates on 2015 and A350XWB flight testing progress.

The worst performing Autos stock in 2013 (along with BMW). We see this set to reverse in 2014, with MQB savings (driving €800m of savings by FY’14) and EU recovery set to drive positive earnings momentum. We think the market undestimates VOW’s gearing to the European car market, with a 25% market share and a ~400bps funding advantage over mass peers providing it with a dominant position in a market that can recover meaningfully. We also see upside surprise from Porsche which we think will contribute >€3bn EBIT in FY’14, incl. €1bn from the new Macan alone.

Having traded flat since March 2013, Wolseley is our top pick for 2014 within Building Materials. Three factors give us conviction in future outperformance: 1) Improving macro backdrop with 80% of the business based in the US and the UK. 2) Continued improvements in customer service and operational efficiencies driving market share gains and margin improvement. 3) Balance sheet deployment, with earnings enhancing bolt-on acquisitions. Stock trades on 15x PE Jul 15. With the stock at the top end of its recent trading range, we see scope for it to break out over the coming months.

One of our Special Sits team’s top picks as a potential breakup story. We believe Smiths’ prospects are not adequately discounted by the market with a reverse SOTP implying John Crane (the group’s main growth and profit driver) is trading on only 9.5x EBIT; peers trade on 13.4x. This discount appears steep, given its strong track record on earnings growth. In addition, the high quality Smiths Medical business makes the stock more resilient in a downturn and Management has confirmed that it received an approach for its Medical division in 2013 and that it will consider all options around the portfolio in the best interests of shareholders. CEO Philip Bowman has a strong trackrecord in delivering value for shareholders. A key play on an improving M&A environment in 2014.

Akzo is a clear restructuring story in European chemicals, with new management focusing more on returns and cash flow and we feel the earnings downgrade cycle has moderated. With the second highest operational leverage across European chemicals, Akzo should be a strong beneficiary from any sustainable European recovery. Additionally, the stock offers investors relative defensiveness, some benefit from a lack of raw material inflation, and cost cutting (ongoing >€500m EBITDA improvement programme).

An MS Best Idea, we see Lloyds are the best play on the UK help to Buy theme as it has both a better funding and capital position than other domestic banks. Our base case is that Lloyds’ earnings are ~10% ahead of consensus by 2015, largely from higher loan growth assumptions. With ~27% upside to our base case and scope for significant capital returns as Lloyds resumes its dividend, we see Lloyds as one of the most attractive banks in Europe.

We see successful restructuring at UBS from greater earnings from asset and wealth management, and believe non-core rundown can drive higher ROTE (>15%), leading to a re-rating and potential for higher capital returns. UBS offers leverage to potentially stronger markets through faster deleveraging, improved capital markets revenues, and higher private banking activity. Further, we believe strong capital leaves it with a sufficient buffer to meet stricter regulation and litigation, and potential for greater capital return. On ~1.6x 2013e TNAV, valuation looks undemanding for >15% ROTE and potential for payout of ~50%.

We see an intriguing self-help story at LSE. We anticipate that 2014 will see an acceleration in moves to improve profitability at the recently acquired LCH business. Our recent meeting with the company reinforced our conviction that LSE has ‘low-balled’ on cost efficiencies at LCH. The ~€25m cost-cutting commitment amounts to just ~8% of LCH’s cost base, compares to 25-35% cost savings from the target cost base in typical exchange M&A. We see significant upside to this number as LSE moves to a centralised service company model, reducing the complexity of multiple outsourced IT contacts. LSE trades on an undemanding 13x 2015 on cautious €25m cost savings. Factoring in more bullish cost savings of €100m with a bit of topline/cyclical recovery could see it trading on just 9x.

With strong FCF growth and substantial deployable capital we see the opportunity for Aegon to significantly de-risk its balance sheet and still increase its dividend by 50% over the next three years. Furthermore, AEGON is a compelling play on rising US rates, with 70% of its business in US and their current guidance on deployable capital based on just 2.5% 10yr yields. Given the trajectory from tapering, risks are clearly to the upside. Stock trades on just 8x 2014 PE vs US peers on 11x.

Nestle remains our key Overweight pick in EU large-cap Food on the back of accelerating top-line momentum, ‘self-help’ opportunities through more active portfolio management, and potential cash returns, driven by a significant improvement in cash generation. 3 reasons why the stock could re-rate, 1) improving momentum in organic (particularly volume) growth relative to peers. 2) We expect divestments to be a focus of management (as recently reflected by the sale of the Givaudan stake) which could enhance group organic growth and margins by 70-50bps and iii) growth in GCG from 1% in the last 5 years to 13% in the next 3 years.

We expect SCA to remain one of the best EPS growth stories in staples in the medium-term, with the coming quarters set to offer continued evidence of the group delivering on the benefits of the strategic changes in the last years. SCA offers sector-leading earnings growth for 2013-15 (18% CAGR), driven by defensive categories, providing stable top-line growth, and a self-help story that should transform profitability in the next few years. At 17.4x 2014 PE (12.5x EV/EBITDA) SCA remains attractive, in our view.

We expect Jeromino Martins to outperform the rest of European food retail over the next 12 months as it remains exposed to the two most powerful trends in food retail globally: the shift away from big box stores to proximity formats, and the shift to discount. Additionally we believe high margins are sustainable given its superior unit economics, its exposure to the proximity and discount channels, its ability to continue to expand the size of its network in the foreseeable future

We believe that negative earnings revisions have troughed and with a new product cycle in Knees, Smith & Nephew is set to outperform in 2014. Valn is relatively attractive on 14.5x 2015 with 7% FCF yield for c9% earnings growth.

We see scope for significant outperformance in 2014 as FCF improves on back of peaking capex. Volume growth is set to accelerate on project rap up driving strong earnings growth. With a strong record of capital discipline, we expect Boliden to increase cash returns, delivering 5% div yield. Stock trades on just 6.5x 2015 PE with a 18% FCF yield.

SSAB has been a meaningful laggard vs US and European Steel peers after a poor performance in its EMEA division. We see scope for this unit to turn around by pursuing a volume focused strategy and enter a JV with a local player in APAC. Furthermore, SSAB is set to be a key beneficiary of the improving US steel market, with 1/3 of sales coming from its high quality US business. Stock trades on 14x 2015 with a 3.4% div yield and 13.7% FCF yield.

Total offers a unique combination of best in class FCF growth and undemanding valuation. After a period of high investment in both upstream and downstream, Total is set to deliver significant growth in operating CF in the coming years. Total trades on a 5.5% div yield vs sector on 5%. Given superior coverage, we believe this should coverage towards the peer group average.

We believe that TF1 is set to benefit from improving audience and advertising trends. With high operational gearing and low expectations of ad growth in 2014, we see significant upside risks to forecasts in 2014. TF1 trades on just 7x EV/EBITDA vs peers on 10x with an 8.7% FCF yield (vs peers on 5.9%).

We believe Ericsson is set to deliver significant margin improvement in 2014 driven by lower “investment” in market share, faster software upgrades to LTE in Europe and higher capacity utilisation in the US. Further capex announcements by carriers in Europe should help drive the stock.

SAP traded sideways in 2013 as lacklustre licence growth, FX downgrades and cloud concerns weighed on the shares. We think momentum is set to accelerate, with cyclical headwinds dissipating and growth in HANA and Cloud subs improving.

We believe that SAP’s transition towards Software as a Service (SaaS) in 2014 will be a positive for the shares as the negative short term impact on EPS is offset by the higher multiple on the back higher recurring revenues. Expect positive 2017 guidance with clear cloud stratey on 21 Jan.

We think earnings revisions are toughing and continued headlines around pricing in 4G are already in the price. Scope for upside surprise in 2014 from further cost cutting as well as upside from Fibre roll out and potential IPO/sale of EE. One of the cheapest telcos in Europe, trading on 4.2x EV/EBITDA with a 14.5% FCF yield and trading near all time relative lows vs the sector.

Compelling self help and economy recovery. We expect asset sales and cost cutting to make Veolia a smaller, leaner company with leadership positions in structurally attractive Water and Waste businesses. After years of negative FCF, we expect Veolio to be able to self fund growth from 2015. Stock is trading on 12x 2015 with a 5.7% div yield, materially below historic levels and peer Suez Environnement .

We believe continued execution on biomass conversion is likely to drive significant LT FCF, especially as they convert further plans. The UK government continues to demonstrate good support for Drax. Even on a bear case scenario, we belive that Drax can deliver a 8% unlevered FCF yield.

Go Ahead is our top pick in Bus & Rail. We expect GOG to get to £102m of Bus EBITA by F2016. This plus a low capex and the recent pull-back in the shares means GOG is on a highly attractive ex-rail FCF yield of 13% on average for F2015e & 16e. The shares trade close to our fair value for Bus, suggesting Rail is for free.

Hays is our top pick in Business Services. Hays has the most attractive geographic exposure, which should drive strong levels of growth and conversion rates of gross profit into EBIT. In addition, a decreasing tax rate will help drive similar levels of EPS growth to Michael Page, we think, but at a far lower multiple. A 2015e EV/Sales multiple of 0.48x and a P/E of 12.8x are commensurate with the Temp staffers and do not reflect its superior margin potential due to mix, in our view.

Thomas Cook is one of the most attractive turnaround stocks in the market. New CEO Harriet Green is executing well on her plans to drive £440m of savings by 2015. Importantly cost savings should continue beyond 15 as it implements wave 2 (similar size to wave 1). TCG trades on an attractive 10x 2015 PE and 10% FCF yield, with risks to the upside for both.

Our top pick in infrastructure, we believe the market is too pessimistic around the risk of EC enforced cuts to access charged, with both UK and French states providing support. Operational momentum is strong, with regulation likely to impact ferry competitiveness and new routes in 2015 to provide growth. Eurotunnel also offers exposure to an improving European economy, with its high operational and financial (in particular given its strong exposure to the UK).