TheChek News Flow

We are delighted to host again Industry Veteran Gary Bull for a lunch to discuss the potential merger. The format will be Q&A. We hosted Gary in July earlier this year. We look forward to seeing you for the lunch.

ThursdayOctober 1st @1:00PM

Views on the Approach ahead of the PUSU deadline

Our Guest:

2013 – 2015 SABMiller Procurement GmbH (Switzerland)

2010 – 2013 SABMiller Procurement GmbH (Switzerland)

2000 – 2010 SABMiller Europe (Switzerland, Hungary, Czech Republic)

1996 – 2000 SAB Plc (Poland)

1987 – 1996 SAB Ltd (South Africa)

General Manager (Transkei and Eastern Cape)

1985 – 1987 SAB Ltd (South Africa)

deceives US regulators when measuring toxic nitrogen dioxide (N02) emissions. VW has

been using a "defeat device" to temporarily reduce N02 emissions during testing. When the

cars are on the road they emit as much as 40 times the level of N02 allowed under US

clean air rules. VW CEO Martin Winterkorn apologised and pledged full cooperation and an

external investigation. VW could face civil penalties of up to $37,500 ( €33,200) for each of

the 482,000 potentially non-compliant 4-cylinder VW and Audi diesel vehicles sold since

2008. This implies a worst case civil penalty of $18bn or €15.9bn/€32 per VW share. In past

cases where manufacturers have admitted providing misleading information, the penalties

have been below the potential maximum figure. The previous largest fine was the $300m

paid by Hyundai-Kia for overstating gas mileage. It also agreed to pay a further $400m to

settle a class action suit. But the VW case may break new legal ground.

* SG view As well as the potential financial issue, the biggest concerns are reputational

risk and potential criminal charges. VW has long lagged in the US, and clean diesel has

been a strategic pillar to differentiate itself and meet burgeoning emissions standards. This

has been deeply compromised. The search for the responsible parties could potentially

reach management board level (who knew what?) and lead to significant uncertainty and

volatility in the stock price beyond the inevitable initial sharp mark-down reaction. VW will

likely remain under pressure and in the penalty box for some time as the investigations and

litigation gather pace. Significant management changes may be a positive catalyst.

* How we value the stock TP reduced from €280 to €180 reflecting the unprecedented

financial and reputational destruction risk, concomitant reductions in valuations of the

operational divisions, risk of management distraction, and an increase in the overall SotP

discount factor from 10% to 25% (see page 2). With fundamentals undermined, we cut our

rating to Hold from Buy with 12m projected 14.6% TSR.

* Events, catalysts & risks 9M 15 results 28 Oct. Risks to TP: downside: unprecedented

criminal and civil penalties; further slowdown in China and Brazil; upside: US situation

proves less severe than we anticipate; management change.

A potential investigation into VW’s diesel engine technology in Europe could

trigger a wider and broader investigation in the industry, likely creating

uncertainty for car makers and translating into potentially more stringent Co2

emission controls in the auto industry. We see suppliers as clear beneficiaries

of this trend, supplying the badly needed products to make car makers reduce

CO2 emissions and improving its pricing power.

* Our take. We have read the newsflow on VW over the past few days and

received a broad variety of questions from investors. At the end of the day,

VW is producing around 2.6m diesel engines globally, around 160k units of

which are destined to NA and 2.4m units in Europe. We estimate VW’s

liability in NA is not as large as the share prices reflect about €14bn on the

back of yesterday’s closing. Our estimate for the potential liability in North

America is well below €3bn based on a calculation of the penalty VW would

have to pay the EPA, the cost of repairing the vehicles, and the settlement of

any legal claims (potentially this last one may be the largest hit).

* What about Europe? Our understanding is that the testing of vehicles is

done through independent testing firms which conduct tests at the premises

of the car makers. According to Bild Zeitung, the German Transport

Minister wants to investigate all diesel engines of VW through third party

investigators. A representative of ADAC (the German Automobile club) also

highlights to Bild Zeitung that the differences between their CO2 emissions

tests and the official tests from the OEMs don’t match. The critics are piling

on but, in our view, this could be a wider industry issue rather than a specific

standalone VW problem. We will find out over the coming months.

* Who is most exposed to Diesel in Europe? If a potential investigation into

other car makers will be launched through the diesel investigation in Europe,

we estimate that globally BMW and Daimler have 35% and 45% of engines

exposed to diesel technology, respectively; PSA 40%; Renault Nissan group

25%; VW group 25%; Ford 20%; and GM 10%. Within that diesel exposure

on average Europe takes 77% share across all regions, making it the

predominant region to use this fuel.

* What does this mean for investors? A month ago the largest worry

investors had was the Chinese car market slowdown; now at least

temporarily it could be CO2 emissions in Europe and a possible

investigation in Germany which could have ripple effects across the auto

industry. We don’t expect multibillion payouts in Europe if comments from

ADAC or various other consultants in the automotive world were discovered

to be true. We would rather expect more stringent control over emissions in

Europe through independent checks to ensure car makers comply with the

rules if they are not already doing so. From a different point of view, we find

suppliers more in need than ever to help OEMs meet CO2 regulations which

the consumer ultimately is not willing to pay up for, thus creating an even

larger OW trend of suppliers vs OEMs. Within this strategy, we are OW

Valeo and Faurecia.

Midway into the Renzi Journey

* The Jury is Still Out — While Matteo Renzi promised to change Italy in a thousand days, midway into the journey the jury is still out: Italy may be heading in the right direction but reversing decades of poor government might require a much longer period of time than PM Renzi and investors factor. We believe that the pending reform of the Senato is likely to be the turning point; if approved, the government might accelerate the reform pace while strengthening the economy.

* Tepid Tailwinds, Structural Headwinds — Citi economists believe that with GDP growth expected to be around 0.7% in 2015 and 1.3% in 2016, Italy’s underperformance is likely to persist. While we appreciate that Italy has been able to take advantage of macro tailwinds (so often missed over the past decades), we are nonetheless concerned that a tepid and uneven recovery might be empowering structural headwinds (i.e., vested interests) that are, in turn, preventing Italy from achieving the strong growth that Renzi will need to convince Italians this time is different.

* Can Italy Return to 3% plus Growth? — Italy needs stability, visibility, credibility; these conditions can be achieved only via an overhaul of the country architecture alongside legal certainties. While we see Renzi as possibly the last opportunity for a turnaround of Italy, his failure might push back Italy into being the chaotic country that disappointed for so long.

* Remain long on Italy — Sharing our strategists’ view that we are in an “old but not dead” bull market, we maintain a positive stance on Italian equities. While we can’t exclude volatility should Renzi fail to modernize the country, corporate finance might provide an interesting angle for long-term investors. Italy is full of first-class companies that are extremely

attractive for overseas investors. And the seeds for an improved economic environment might have been planted.

* What we Like — Among SMID caps, we favour Autogrill, Prysmian and Yoox – not least for possible M&A. While

Luxottica and Geox are Neutral-rated, we could turn more positive on share-price weaknesses. Among asset gatherers, our preference goes for Banca Generali and Mediolanum while we like Unicredit (focus list) and Intesa SanPaolo among traditional banks. UBI and BPER are our preferred means to take advantage of Popolari reform. Finally, A2A and Snam remain attractive in the utility industry — set to benefit from a more favorable environment in years.

* What we Like Less — Mediaset, ENEL, ENEL GreenPower and (Swiss-listed) Dufry, which is taking over WDF.

Over the weekend, it was reported by several media outlets (WSJ) that Volkswagen

AG (not covered by Citi) has stopped sale on U.S. diesel-powered cars after

allegedly evading U.S. diesel emissions testing using software. The software that

was allegedly used on about 482k U.S. VW diesel vehicles and made the cars

appear cleaner than they were during testing. The automaker has reportedly issued

an apology and is investigating. Our initial thoughts with respect to the read-through

to our U.S. covered auto stocks is as follows:

– (1) If this issue is contained to VW U.S. – VW commands a small ~2% U.S.

market share. Previous major recalls have not led to noticeably lasting market

share shifts though each recall situation is obviously different.

– (2) If this issue somehow spreads to VW on a Global Scale – Then we may

see some shift in global OEM share as VW group commands a strong ~25%

share in the EU market and a double-digit share in China. Note that at this point

we have no information to suggest that this issue goes beyond the U.S. For

information purposes, suppliers who are exposed to VW globally include

BorgWarner (~17%), Tower (~15%), Magna (~11%), Delphi (~10%), Lear (we est.

8-9%), Autoliv (~8%), Visteon (~3%) and Johnson Controls (listed as a Top 5

largest OEM customer). While exposed suppliers could be hurt on any global VW

market share shift (again, this scenario assumes the situation escalates to a

global scale, for which we have currently no information to suggest it will), these

suppliers would presumably gain some or all back with other OEMs they are

exposed to as most of these companies are well-diversified.

– (3) If this somehow hurts diesel demand – If any impact to diesel demand is

contained to the U.S., the impact to our covered companies would likely be fairly

small given modest diesel penetration in the U.S. If there’s somehow an impact

to diesel demand on a global scale, companies we cover with material exposure

to diesel engines include Delphi (~15% of revenue, though a good portion is

commercial vehicle/some aftermarket and light vehicle content likely made up

partially/wholly by other powertrains) and BorgWarner (diesel turbos = 15% of

backlog). Again, we have no information to suggest that industry diesel demand

is at risk from these unfolding events.

Head to Head: Unicredit vs Societe Generale

* Head to Head — In the latest edition of the series we compare Unicredit and

Societe Generale. Both banks are unloved by the market and trade at discount to

book. This is possibly due to the groups business complexity, as well as market

skepticism on capital level and future profitability. We have run sensitivity analysis

on capital, looked at profitability and balance sheet. We believe the market will rerate

the stocks on the back of evidence of delivery on capital rebuild and profitability

recovery (in Italy for UCI and internationally for SOGN). We rate both banks Buy,

but prefer UCI (on Citi Focus List Europe), given higher ROTE growth, gearing to

Italian business recovery, higher cost cutting opportunities, and upcoming plan.

* Transforming into Swans via Capital Rebuilding — UCI and SOGN are at the

lower end of the peer group on capital. We have run 2 simulations on CET1: on the

current framework we simulate a c50bp gap for UCI and c60bp for SOGN; 2) on a

more conservative scenario (e.g. B4 RWAs) the gap widens to c130bp. Our base

case is no need for capital increases, given banks’ ability to generate capital

organically (we estimate the banks to generate each c170bp of capital in the next 3

year) via higher profitability, RWAs optimization, disposals and actions on dividend.

* Western Europe vs International Recovery — UCI ROTE is depressed by high

loan loss provisions in Italy and low profitability in Austria and Germany. The Italian

cost of risk should benefit from Italian NPLs/macro recovery and we expect higher

cost cutting/restructuring in Austria, Germany and Italy. SOGN has a proven track

record on costs, its domestic business shows stable and high return, the CIB is

profitable, and only the international business is running below target. We expect

ROTE to reach c9% for UCI and c11% for SOGN in 2018E.

* Discount Too Wide — Both banks trade at discount to the European sector (UCI at

0.7x 16E P/TBV; SOGN at 0.8x, vs sector at c1.0x), are unloved vs the main

domestic peer (especially UCI) and we expect no need for external capital and

positive profit development; all of these should support the stocks re-rating. Key

risks are regulatory development and macroeconomic trends.