TheChek News Flow

We add APPL to the Conviction Buy List. Shares are trading at a CY16 P/E of 11X (10.5X on GSe), a 30% discount to the S&P 500 multiple of 16X despite a 9% EPS CAGR in FY15-17 (GSe 14%) as the market views it as a “hardware” stock – a transactional model with limited recurring revenues and with visibility that extends only to the next product cycle. We expect that over the next year, the focus will shift from unit growth (which is slowing given a maturing smartphone market) to installed base monetization and recurring revenues (“Apple-as-a- Service”). Apple’s model has already tilted that way with its new iPhone 6s installment plans, and we see the upcoming TV service as a powerful next step.

With an estimated installed base of 500mn loyal iPhone users, we see a significant multi-year opportunity for Apple to increase monetization through  (1) increased attach of services such as TV, Music, and Pay, and  (2) increased attach of additional hardware such as Mac, iPad and Watch. The size and quality of the iPhone installed base is the glue behind this virtuous cycle, as it is very loyal (estimated churn <10%) and monetizable (80% higher app store sales than Google). In a recurring revenue framework, we have constructed an average revenue per user (ARPU) metric that captures the installment plan pricing of the iPhone ($32/month), assumed installment plans for the other hardware products, and services (e.g. Music at $10/mo, TV at $40/mo). We calculate a current ARPU of $42/mo per iPhone user, pro rata for the current adoption rates of Mac, iPad, Watch, and services. The theoretical ARPU (assuming every iPhone user has all other Apple hardware products and services) is $153/mo, implying significant growth as the adoption of Apple hardware and services increases within the user base.

Our 12-month $163 price target is based on 15X our CY16E EPS of $10.71.

Product cycle execution, end demand, and a slower pace of innovation.

- UK yield curve is too flat

- Gap between market and economists forcasts for rate rises tends to widen when risky assets do poorly

- Surveys can offer better guide to rate moves than BoE inflation forecasts

- Sees problem with focusing too obsessively on particular date for rate lift off

{http://bit.ly/1lu9v9I}

Add one more name to the chorus of doom. Earlier this week, Andrew Tyrie, the Conservative MP and chairman of the Treasury Select Committee, wrote to Mark Carney, the Governor of the Bank of England, to express his concern about bond market liquidity – or, more precisely, the lack thereof.

He’s far from the only worrier. In April, Jamie Dimon, the chief executive of JP Morgan Chase, devoted three pages of his annual shareholder letter to the subject, writing that dislocations in the US government bond and currency markets were a “warning shot across the bow”. These include the so-called “flash rally” in October last year when 10-year US Treasury yields fell by 29bps in just over an hour (it was a rally because prices rise as yields fall) and the Swiss franc spiking 28pc against the euro in 20 minutes at the beginning of this year.

In May, Nouriel Roubini, the US economist made famous for predicting the US housing problems that led to the financial crisis, wrote about “the liquidity timebomb”. In June, Stephen Schwarzman, the chief executive of private equity firm Blackstone, penned a comment piece for The Wall Street Journal on bond market liquidity entitled: “How the next financial crisis will happen”.

Why has what sounds like a pretty niche subject got so many knickers in such a collective twist?

Every market is a tug-of-war between buyers and sellers. Liquidity is a gauge of both the size of the market (the number of buyers and sellers) and its depth (the number of buyers and sellers of both small and large amounts of securities). Why is the depth of the market important? Because if you want to sell £10,000 of government bonds you’re sure to find plenty of willing buyers but if you want to sell £100m-worth, it might be a touch harder.

If there isn’t a buyer, supply could momentarily outweigh demand and the price will start to fall before you get a chance to execute the trade. This is called market impact. The less liquidity there is, the greater an impact large trades will have. If lots of people are all trying to sell lots of stuff at once, things could get very messy.

There are plenty of possible reasons why liquidity might be evaporating. For one thing, there has been a huge increase in the amount of bond trading being conducted electronically and this method of dealing is now responsible for about half of all turnover in the US. This has attracted the attention of high-frequency firms who help provide liquidity and lower transaction costs but only really for small trades, creating the illusion of liquidity, which, like a mirage, just isn't there when you reach for it.

Those looking to pull off a bigger trade require the services of a bank, which will, for a fee, act as a market maker – putting buyers together with sellers. If it can’t, the bank may buy the securities itself on the assumption that it will be able to find a buyer at a later date. In this way banks can smooth out any temporary mismatches in the market.

Or they did. Since the financial crisis, global financial regulators have rightly been attempting to make banks safer. They have done this by, for example, banning proprietary trading, making it harder to lend government bonds in the repo market and, most importantly, forcing banks to deleverage.

One of the upshots is that it is now much more expensive for banks to hold securities on their own books and therefore provide liquidity in the market. Deutsche Bank recently noted that the amount of outstanding corporate bonds has doubled since 2001 but dealer inventories of these securities have fallen 90pc over the same period.

This could be a problem. The world is awash with debt. With central banks increasing their balance sheets through quantitative easing, simultaneously pushing down interest rates and taking huge chunks of the market out of circulation, investors have had to stray beyond developed market government bonds in search of yield.

Companies and emerging market countries have been happy to oblige. Since 2004, the stock of emerging market, non-financial corporate debt, for example, has more than quadrupled to $18 trillion, according to the International Monetary Fund. And this is increasingly being gobbled up by flighty retail investors – in 1990 mutual funds held around 4pc of all corporate bonds in circulation; today they hold more than 20pc.

This whole process could be about to go into reverse as central banks look to end the unprecedented period of loose monetary policy. As interest rates rise, the prices of many bonds will fall. How quickly is anyone’s guess. But, according to the worriers, a lack of liquidity could hasten the sell-off, turning a correction into a rout.

It is worth pausing here to ask whether there is a certain amount of self-interest behind the warning from banks. Is this just a more creative way for them to chafe against demands that they hold more capital? And would they really throw themselves in front of falling prices for the greater good when the crunch came? Liquidity had a habit of mysteriously disappearing during previous crises, even before the new rules were in place. Indeed, would we want banks to be making markets during a crash? If they bought bonds as prices fell, they’d end up sitting on huge losses.

That said, even though banks may have stood back for a while as markets fell in the past, they were usually the first buyers back in, ensuring that prices didn’t overshoot. That’s not to be sniffed at. Also worth noting: it’s not just banks that are issuing these warnings.

Regardless, there’s little appetite among regulators to row back on capital rules. So liquidity may need to come from somewhere else. One theory is that fund managers should try to trade directly with each other (although the fate of Bondcube, an online marketplace which tried to facilitate such transactions but went bust in July after only three months because investors couldn’t agree on prices without the involvement of a broker, doesn’t bode well).

Or perhaps the amount of liquidity available before the crisis was the aberration and we now need to reset our expectations. Banks have been made less risky. But, as Bill Gross, the famous bond investor, said earlier year, that risk hasn’t been eliminated – it’s just moved elsewhere in the system.

The question is: where? And the worry is that nobody appears to know for sure.

has asked financial advisors to look into a scenario that would allow Engie to

gain back control of Suez.

Engie currently owns 33.7% of Suez. The article says that Suez's activities

would fit well with Engie's strategy to focus on regulated markets and invest in

the energy transition, while selling thermal assets in the US. The companies

have not commented on this article – this corresponds to the policy of both

companies to never comment on press rumours.

On balance, we see a lack of obvious strategic rationale for such a deal. We

expect the focus at Engie to be more on streamlining its current portfolio

rather than extending it, and continue to believe that Suez could be a plausible

candidate for asset rotation (see our related Engie Insight note of Oct 13). The

announcement today by the Belgian Safety authority allowing the restart of

Doel 3 Tihange 2 helps de-risk the Engie equity story (1st Take: Restart of

Belgian reactors confirmed by safety authority). We can now focus on the

next important step: details on the new restructuring story in February,

including new cost cutting targets, more asset rotation and, possibly, more

return of cash to shareholders.

Our view: while we note the content of the article, the strategic

rationale mentioned for such a deal would be unclear to us, and so for 3

reasons.

1/ Water and Waste does not fit into the strategy of becoming a global

energy company: In our recent report on Engie dated 13/10/15, we

explained that Engie's strategy was to be a global energy company, focusing

on gas and electricity regulated assets, renewables, energy services, as well as

the gas value chain and power generation in growth geographies. It is not

obvious that Suez fits into this description, being a water and waste

management company (although a portion of its water activity is indeed

regulated). Energy production is only a small subset of the energy from waste

business.

2/ Potential synergies around joint marketing to industrial customers

are not obvious to us: SEV increasingly focuses on industrial clients (for

instance for Industrial Water treatment and Hazardous Waste treatment), and

these clients could also be interested in energy saving services. After all, this is

Veolia’s business model, combining Water, Waste and Energy Services. Yet we

remain unconvinced about the value derived from combining Energy with

Water and Waste – for proof, Engie has been able to make strong progress and

become the world leader in energy services that it is today without the help of SEV.

3/ Recent rebranding sets Suez apart from Engie: the rebranding was

aimed at aligning the old GDF Suez name to the group strategy focusing on

Energy. The new Suez corporate identity ensures that confusion with Engie is

now pretty much impossible. We view the rebranding of the 2 groups earlier

this year as an indication that the paths of the 2 companies have been

gradually moving in different directions.

•Why do we believe Suez could be a plausible candidate for asset

rotation, rather than a target for control? Suez is posting strong growth at

the bottom line (+13% EPS CAGR 2015-18e), but the SEV businesses of water

and waste management are not aligned with Engie’s ambition to become a

global leader in energy. We also note that Engie only has a 33.6% stake in SEV.

As a principle, Engie would rather own controlling stakes in its core businesses,

as is the case for all its energy holdings whether listed businesses (eg

Tractebel, Glow) or non listed fully consolidated entities (E&P division). We

note however that Engie CEO G Mestrallet has repeatedly said that Suez

remains core to Engie, with the latest example being during the 1Q15

conference call on 27/04/15. The 2 groups remain close, sharing selected

industrial projects together.

•A gradual path of reduction of Engie’s influence over Suez: since 2008,

Engie has demonstrated a gradual yet clear path to reduce its influence over

Suez, with the listing of Suez allowing Engie to reduce its economic stake from

100% to 34%. The full consolidation was maintained due to the shareholders’

pact. But its non–renewal in 2013 means that the entity is now only

consolidated as an associate.

•The valuation argument: given Suez's current level (trading at 19.7x PE16e)

relative to Engie (at 14.2x PE16e) a deal would be dilutive, even before

considering the level of premium that Engie would have to attach to an offer

for control.

On balance, we see a lack of obvious strategic rationale for such a deal

and continue to believe that Suez could be a plausible candidate for

asset rotation.

What form of asset rotation ? As we wrote recently, a disposal could be

structured via a sale to an industrial partner or a market placement. History

provides good examples, with the listing of Suez orchestrated by Engie in

2008, or the various conversation between Suez/Engie and other groups. Over

the past decade, VIE and GSZ/SEV have held talks with Vinci and Air Liquide,

respectively (although these talks were very brief and did not lead to any form

of agreement), latest evidence being in October 2012 for an aborted business

combination between the 2 competing companies (see our report dated

22/10/2012).

SEV shares are up strongly today on speculation that Engie may be considering taking back control (from 33.5%

currently). Given Engie management has stated that SEV is non-core, this has come as a surprise: the stake was

widely seen until now as a candidate for disposal. In the absence of a denial from Engie (which has chosen not

to comment so far) we expect the speculation to sustain SEV shares at or above current levels, almost regardless

of valuation/fundamentals. A full takeover would be required under French law if Engie was to raise its stake

above 50% and given recent performance of SEV shares, this would not be immaterial from a leverage

perspective (we estimate +0.6x on ND/EBITDA if the deal was financed with debt). We expect Engie to

announce a substantial disposal programme at its CMD in Q2 2016, which could help free up capital for

reinvestment in focus areas (energy services, PPA generation and networks in growth markets). Buying out SEV

at a significant premium to the current price is unlikely to qualify as a priority for long term Engie shareholders,

and we see scope for disappointment if this was confirmed.

* Claims that Engie is looking at taking back control of SEV are surprising. La Lettre de l'Expansion

reported yesterday in a very brief article that Engie is looking to take back control of Suez Environnement,

which was partially spun off in 2009 as a pre-condition of the GDF/Suez merger. We see the source as

relatively credible and so far Engie has not formally denied the claim; as such we expect today’s share price

gains to be sustained and speculation to persist. That being said, the report comes as a real surprise – Engie

and Suez Environnement spent money and time splitting their operations and establishing separate brand

names; Engie management has publicly stated for a number of years that the SEV stake was non-core, as a

result this was widely seen as a disposal candidate. We would also note that Engie is accustomed to executing

complex M&A transactions; a leak on a transaction of such magnitude would also be quite surprising.

* Full takeover would be compulsory under French law. The French commercial code stipulates that a full

takeover is rendered compulsory if a company that owns between 30% and 50% of a listed entity increases its

stake by more than 1% over a period of 12 months (article 234-2). The Autorite des Marches Financiers

(AMF) may grant an exemption where a company that already owns between 30-50% increases its stake if it

intends to keep it as a long-term holding and doe not exceed the 50% threshold (article 234-5). As such, our

understanding is that Engie would not be able to increase its holding in SEV above 50% without launching a

full takeover offer.

* Running the numbers. Assuming Engie was to launch a full takeover offer for SEV funded with debt and

assuming a 20% premium to yesterday’s close (cash out €7.4bn), we estimate EPS accretion of 5-7% in 2016-

18E (based on a pre-tax cost of debt of 2.5%). The impact on leverage would be significant in our view, with

2016E ND/EBITDA increasing to 3.1x (Engie definition) versus 2.5x pre-acquisition which is also the

maximum leverage the company has long targeted. As such, should Engie decide to make a takeover for SEV

quickly (i.e. before significant disposals can be executed), we would not exclude a mixed offer (shares and

cash) or a partial rights issue to fund a cash offer, as was the case for International Power.

* We expect SEV shares to be sustained; on balance the read is negative read for Engie. If not denied, we

expect the speculation of a potential take over by parent Engie will sustain SEV shares at or above the current

level (almost regardless of fundamentals and valuation). That being said, the AMF may require a statement

from Engie at some point if the impact on SEV shares continues to be obvious. As for Engie, one could argue

the benefits of integrating SEV’s engineering business (Degremont), but we doubt investors will be won over

by the concept of returning to the early 2000s model of a “multi utility” offering. We believe investor interest

in Engie has been growing as the obvious remaining restructuring story among large European utilities,

For once, the result of the French 700MHz auction was more benign than expected, with

the price per block coming below our expectations, and more importantly no “nuclear”

scenario that would have been an Iliad without spectrum. Although a disciplined auction

made sense with both NUM-SFR and Bouygues downplaying the need for 700MHz

spectrum, the outcome was always uncertain. We don’t see direct short-term

implications for potential consolidation, with all players well equipped with low-band

spectrum. However, the “no-talk” period on spectrum ends, and both NUM-SFR and

Orange continue to see rationale for consolidation talks to re-open.

• Auction over after two days and 10 rounds. Total cost: €2.8bn (12% above reserve

price of €2.5bn).

• Orange and Iliad granted with 2 blocks for €932m each, SFR and Bouygues got 1

block for €466m each.

• Secondary auction to determine block allocation by Nov 19th, limited cash outlays

expected

• Coverage obligations (France metro): 98% pop 17 Jan 2017, 99.6% T+15 years.

Coverage obligations in each “department”: 90% pop by 17 Jan 2027, 95% T+15

years. Coverage obligations in less dense areas: 50% 17 Jan 2011, 92% 2027,

97.7% T+15 years

• Payment terms: 4 yearly payments (25% each of total amount), first payment at

attribution of spectrum, and 12 month intervals. 1% of revenues, 20 year period

• Orange (Buy): starting to build a differentiated spectrum portfolio versus SFR and

Bouygues Tel, with more spectrum in both 700MHz and 2.6GHz. We remain

constructive on Buy-rated Orange on revenue recovery, efficiency and valuation

support

• Iliad (Buy): the auction outcome is a clear positive for Buy-rated Iliad, avoiding a

potential squeeze by competitors. Q3 were solid and pave the way for further

revenue and EBITDA delivery, but higher capex drain mid-term FCF generation

• Bouygues (Neutral): spectrum position remains very solid post auction, with the

same holding as NUM-SFR despite a much smaller subs base, and a total of 25% of

spectrum holding in the market vs a 14% market share.

• NUM (Neutral): we were not expecting an aggressive bidding from NUM-SFR post

the increase in leverage to fund the Vivendi stake payment. NUM-SFR will have to

continue to invest to match the quality gap with leaders, and appears open to

relaunch consolidation discussions in the medium term. We see long term value on

delivery, but revenue improvement required.