October 7, 2008: Morning Call

October 7, 2008: Morning Call

Fair Value: SP500 – 1060.46; NDX: 1421.86; DOW – 9975


Technical Levels:


SPX: 998 -1005 support/1090, 1142, 1250, 1298-1300 resistance

NASDAQ: 1783, 1838 support /1890, 2020 resistance

Events:

11:00: Fed’s Stern speaks on financial shock
11:00: KBR presents at Johnson Rice Energy Infrastructure Conference
13:15: Bernanke speaks on the economy and financial markets
14:00: FOMC Minutes from the September 16 Meeting
15:00: Consumer Credit (August): 5.9B
17:00: ABC Consumer Confidence
17:00: AA Earnings call
Post-market EPS: YUM (.54/2.78B); AA (.61/7.38B)


Foreign Market Summary/Key Macro News/Commentary:

“This crisis doesn’t wear you down over time. It hits you over the head with a two-by-four. On a daily basis.” Joe Nocera – New York Times (A23).

SP and NASDAQ futures are trading flat with fair value at 7:30am ET as the extraordinary volatility continued in the overnight session; the overnight range has been 30 points (1045-1075). BAC is trading down 10% after pre-announcing Q3 earnings (BAC announced a 50% cut in the dividend and 10 billion capital raise. The most ominous aspect of the report was the meaningful erosion in credit quality. The rate of change is more alarming than the absolute losses; NPAs were up 37% in just the last 3 months). European markets are rallying (+1.5%) on speculation that the UK government is going to inject 45 billion pounds into the 3 largest banks to bolster their balance sheets. UK banks (RBS, BCS, HBOS, LLOY) are trading sharply lower on fears about dilution and rumors about balance sheet problems; BCS denied requesting capital from the government. Separately, there is also rampant speculation that the ECB and BOE are going to cut interest rates (chatter circulating that ECB may cut rates 200 basis points) and that the Fed is going to backstop unsecured commercial paper. Asian markets closed mostly lower but the declines were more modest than many US market participants expected. Australia reversed early declines after the central bank cut rates by 100 basis points vs the expected 50-point cut. India closed modestly lower despite a surprise 50-basis-point cut in the cash reserve ratio. Exporters were broadly lower in Japan. Sharp (6753.JP) plunged after cutting its profit forecast. Hong Kong was closed for Chung Yeung Festival. The yen is trading at ¥101.81 to the US dollar.

Although I want to get more constructive on the markets because of the vicious sell-off, I continue to be bearish primarily because Q4 and 2009 earnings guidance is going to be awful. The street is starting to aggressively cut numbers across the board and I have no idea if these revisions are already discounted in the market. But, I can afford to miss the turn given my bearish posture this year. I would rather watch how the market reacts to the much weaker earnings guidance than taking a lot of long risk in front of the EPS reports. Perhaps more important is the fact that hedge funds are caught in a vicious cycle: many hedge funds have been forced to sell assets to meet redemptions which causes even worse performance and more redemptions. Trying to game an end to the forced selling is practically impossible because this is an invisible catalyst and nobody knows the extent of the damage. A break below 1000 on the S&P 500 appears likely. Mark down October 23 as a key trading day – the auction to settle the credit default swaps related to the Lehman bankruptcy is supposed to occur on October 23.


Impact Research Calls/Market Moving News:

BAC (32.22): Deutsche Bank analyst Mike Mayo comments on the BAC pre-announcement. “3Q08 Earnings Review: Core EPS - Bank of America reported GAAP EPS of 15 cents and we estimate operating EPS of 45 cents after excluding one-time revenue and expense items identified by the company and detailed in Figure 1. Operating EPS could be adjusted by up to another 329 cents depending upon the treatment of credit reserve builds during the quarter ($2.1 bil.). Operating Leverage- Reported revenues were down 4% linked quarter (to $19.6B), and we estimate core revenues down 25% sequentially (ex-capital markets one-timers in both quarters, gains on sales in 2Q08, and the impact of Countrywide). Revenues were negative impacted by lower cards (economic pressure and the lack of 2Q08 tax stimulus hurts consumer spending), poor investment banking results (weak activity levels globally, esp. fixed income; reduced risk taking, seasonal trends, and in part the lack of prime brokerage revenues), and asset management (lower global asset values). Spread revenues were up 4% linked, driven primarily by higher core margin (up 12 bps to 3.53%; down 5 bps to 3.36% incl. Countrywide), mitigated by lower earnings assets (down 3% linked) as the company reduced $45 bil. Of market-related earning assets (reflects more efficiency and
divestiture of prime brokerage). Key Capital Markets Exposures- Bank of America reported $2.5 bil. of total capital markets charges during 3Q08, up from $1.0 bil. last quarter At quarter-end, BofA had $6.6 bil. of total leveraged loan commitments, down $3.7 bil. from 2Q08-end. BofA $8.2 bil. in CMBS commitments at 3Q-end, down about $1 bil. Also, the company had about $7.4 bil. in super senior CDO and other subprime-backed structured product exposures, down about $1 bil. Credit- Reported net charge-offs increased 17 bps to 1.84% (but up 34 bps excl. Countrywide due to amount of write downs/charge-offs of acquired assets incurred at merger close), and nonperformers were up 37%. Core non-performing loans (ex-Countrywide noise) were up 25%. Highlights incl. total managed credit card loss rates of 6.40% (up 44 bps), and management indicated that as the U.S. unemployment rate may surpass 7% next year, so could card charge-offs. Ex-Countrywide, home equity was up 6 bps to 3.15% (though much lower than the 137 bps increase last quarter). Residential mortgage was up 17 bps to 0.41% ex-Countrywide. Capital- Bank of America's Tier 1 ratio at 1Q-end was 7.5%, down from 8.3% last quarter, owing to the timing of the Countrywide merger (closed July 1). Owing to challenging operating environment in addition to the recently closed Countrywide and pending Merrill Lynch mergers, BofA announced it was cutting the dividend by 50% to 32 cents/share (quarterly) and intends on raising $10 bil. in common equity. The firm's Tier 1 target remains 8.0%, and it expects to surpass this following the capital raise (to est. 8.3%). Earnings Outlook- We lowered our 4Q08 by est. 24 cents to 30 cents/share, reflecting higher expected charge-offs (esp. cards and home equity) and weak capital markets results (little deal and underwriting activity and lower global asset values). We lowered our 2009 est. by 50 cents to $2.50/share, reflecting much higher charge-offs than previously projected in cards, mortgage, and commercial real estate as management has indicated that problem loans and charge-offs will remain at elevated levels through 2009. We lowered our 2010 est. by 25 cents to $3.25/share as the company is expected to benefit from improving credit quality (lower charge-offs and modest reserve releases), improving revenues and expense controls within investment banking as BofA proceeds with the integration of Merrill Lynch. Valuation: We believe the valuation of Bank of America reflects merger integration risks associated with the recently announced Merrill Lynch acquisition (announced Sept. 15, 2008 early 1Q09 expected close) and the recent completed Countrywide deal (closed July 1, 2008) along with macroeconomic and industry headwinds, such as a slowing U.S. economy, higher unemployment, ongoing declines in U.S. home values, and potential ongoing disruptions in global capital markets esp. U.S. fixed income). These headwinds are partially offset by the company's leadership in U.S. consumer banking (#1 in deposits, mortgage, and
cards) as well as top tier positioning in global investment banking and wealth management (upon close of Merrill Lynch deal). For these reasons, we believe a projected P/E multiple of 9.3x is warranted (slightly below the 5-year average), which implies a price target of $26 given our '09 est. The historical ratios for P/E (5-yr. avg. of 10.0x) implies a price target of $25. Our dividend discount model produces a price target of $24, assuming 8% long-term growth, 13% cost of capital, and a 50% payout ratio. Our P/E-to-growth price ratio model yields a price target of $29 and assumes -3% core EPS growth from (2006 to 2011) and market PEG ratio of 1.1x on 2010E EPS of $3.25.”

First Solar (FSLR), SunPower (SPWRA) downgraded at Goldman Sachs: “The risk of oversupply in the solar market will soon become a reality as considerably less generous demand subsidies take hold just as a wave of supply and tight financing hit the market. We believe that liberal subsidies of the past in markets like Germany and Spain are unlikely to be replicated in the future given fears of their ultimate cost in a bad world economy. As supply continues to come online in a less favorable subsidy environment, pricing will have to adjust strongly downward to generate demand. In our view, these price drops—at levels likely more than most people expect — will lead to below-consensus earnings for module manufacturers and compressed valuations over the next 6 months in our view. We now have a cautious coverage view on the US solar sector and downgrade First Solar to Conviction Sell (from Buy) and SunPower to Sell (from Buy). For FSLR, we are changing EPS estimates to $3.62, $5.92, and $8.02 from $3.75, $7.13, $9.50 and reduce the price target to $103 from $365. For SPWRA, we are changing GAAP EPS estimates to $1.22, $2.47, and $3.18 from $1.27, $2.63, $3.51 and cut our price target to $43 from $100. Our 6-month price targets are based on P/E analysis on 2009 earnings, as well as PEG and DCF analyses

IBM (100.62): IBM downgraded to equal-weight from overweight at Barclays Capital: Firm notes risks from the weakening economy and checks that indicate large exposure to financial services.

GOOG (371.21); YHOO (15.31): Google (GOOG) and Yahoo! (YHOO) estimates reduced at Stifel: The firm reduces estimate for the shares citing the global slowdown. Target for buy rated GOOG is reduced to $525 from $600.

MER (24.20): Merrill Lynch estimates lowered at Wachovia: Firm lowers Q3 and full year '08 estimates below consensus. Firm believes losses in FICC should overwhelm decent results in underwriting and the gain from the sale of the Bloomberg stake. Firm also expects another round of asset marks in the quarter. Rating is market perform.

FCX (43.71): Freeport-McMoRan upgraded to outperform from market perform at Friedman Billings Ramsey

Citi reduces its PC growth outlook to +13% vs prior +15% for 2008 and to +5% vs prior +10-12% for 2009: Firm says HPQ is the most defensive name in its large cap hardware universe, though IBM and AAPL valuations appear to discount potential consensus cuts. Firm reduced its 2H:08, f09 and f10 estimates on DELL, HPQ, IBM, and JAVA to reflect credit crisis and f/x moves.

WB (5.78): CNBC's Charlie Gasparino says the most likely outcome for Wachovia is a carve-up and split between WFC and C, according to his source: Gasparino says the information is coming from his sources inside both WFC and C, with the WB's branches being carved up between the two.

MSFT (24.91); Microsoft (MSFT), VMware (VMW) estimates and target lowered at Barclays Capital: MSFT estimates for FY'09/'10 are lowered given various end market exposures, which the firm believes are vulnerable to estimate cuts in the near-term. Target is lowered by $1 to $29. VMW estimates for FY'08/'09 are lowered due to weakening macro conditions. Target is lowered to $22 from $30.

Bush administration may have to do something drastic - WSJIn a "Heard on the Street" column, the Journal argues that if the panic selling in the market continues unabated, the Bush administration may have to take drastic measures, such as placing a temporary guarantee on more of the banking system's liabilities. The paper adds that in an effort to get banks to start lending to each other, the Fed and other central banks may need to step in as a clearinghouse for such unsecured bank-to-bank loans. However, the Journal concedes that such interventionist measures are only likely to go so far, and need to be accompanied by radical market-based solutions designed to fix the root of the crisis, a massively overleveraged global financial system. The column goes on to note that the government needs to do a much better job of fostering consolidation in the beleaguered banking sector.