Rating Update – Banks – Asia Pacific
The economic outlook for the Asia-Pacific region is becoming increasingly dire as the impact of the global financial crisis continues to exceed earlier expectations. Meanwhile, a period of rapid credit growth has left households more heavily indebted than ever. The combined effects of rising unemployment, a fall in house prices and a further contraction in credit will cause a much larger and swifter rise in defaults than most forecasts currently indicate. The credit cycle is about to turn for the worse, and the banks reliant on unsustainable lending will be badly hurt.
In the banking sector, we examine the environmental, social and governance (ESG) risk intensity of the individuals and companies that a bank has financed and evaluate how the bank manages that risk. In consumer finance, Innovest views a bank’s lending strategy as a key determinant of its ability to navigate the current global downturn. We examine (1) who a bank lends to, (2) how it approves, structures, and services those loans, and (3) what loans it finances indirectly through the capital markets to determine each bank’s exposure to high-risk household loans. In corporate finance, we examine the environmental and social risk intensity of the companies a bank finances. Above all, we seek to determine whether a bank’s ESG due diligence strategy is commensurate with its risk exposure.
Most of the weighting changes this cycle result from an increased emphasis on a bank’s consumer lending in our evaluation. In Japan, Shinsei was downgraded from ‘BBB’ to ‘CCC’ as a result of rising social risk exposure in its new consumer finance operations. The bank is severely under-provisioned in the face of rising loan losses. Commonwealth Bank of Australia was downgraded due to its recent acquisitions of non-bank mortgage lenders, which substantially increase its risk exposure at a time when mortgage stress is rising in the region.
Rating Update – Diversified Financials
The Diversified Financial Sector is currently going through a transformation which will have repercussions on the speed and substance of the economic recovery.
This competitive set is an outlier in Innovest’s financial sector coverage because it is comprised primarily of companies which do not lend or invest capital, but rather act as intermediaries and service providers for other investors and financial institutions. As a result the primary ESG risk confronting the companies rated in this sector stems from governance and regulatory behavior rather than from the ESG risk intensity of on-balance sheet assets. Put differently, the key question which underpins our analysis of the diversified financials sector is not where do they invest their capital, but do they process other investors’ orders in a manner which is fair, transparent and viable from a regulatory perspective?
There are a series of important trends which are reconfiguring the diversified financial sector:
· Counterparty Risk: Regulators and investors have argued that the decentralized system of clearing trades in the credit default swap market is destabilizing and no longer viable. There is no way to verify that the sellers of insurance contracts had adequate capital to cover claims in the event of default. All of the exchanges in this sector are quickly moving to establish viable central clearing platforms. Our analysis gave credit to the companies that have been early movers in shifting trades toward centralized clearings systems or have invested early in establishing central clearing platforms.
· Traditional Governance: During the credit bubble as trading volumes surged upward there was an inevitable increase in opportunistic behavior in exchanges and financial services companies. The most egregious example was Moody’s practice of awarding “prime” ratings to the highest bidders instead of offering an objective, fair assessment of credit quality. There was a commensurate increase in exchanges giving preferential treatment to their biggest clients rather than treating all investors equally. This behavior is especially rampant in the newer emerging market stock exchanges in Hong Kong and Singapore. We awarded strong ratings to the companies with the lowest incidence of client expropriation during the bull market. We also carefully evaluated the robustness of regulatory systems to catch and punish opportunistic behavior.
· Carbon Trading: As carbon regulation tightens, global exchanges are developing platforms to trade and clear carbon offsets and carbon emissions reduction futures.
This year’s top-rated companies, the London Stock Exchange (‘AAA’) and Deutsche Boerse (‘AA’), showed the least ESG risk concentration among constituent assets and the strongest corporate governance systems.
Rating Update – Electronic Equipment & Instruments
Innovest is releasing updated 2009 ratings for 30 companies in Electronic Equipment and Instruments. The widespread economic downturn has already led to reduce profits and a number of headcount reduction plans in this industry.
While employee relations surrounding these reductions is an emergent issue, many of the issues facing the industry have been around for some time, specifically compliance with increasingly stringent environmental regulations and relations with emerging market suppliers. Environmental regulations include restrictions on the metals and chemicals used to make products, requirements for handling e-waste, and targets for energy consumption and greenhouse gas emissions.
Poor governance practices, however, have exacted heavy tolls in the most recent period. LG Display (034220-SE) was ordered to pay USD 400 million criminal fines by the US Department of Justice in November 2008 for its involvement in cartel practices for LCD panels. Tyco Electronics (TEL-N) and Xerox (XRX-N) agreed to pay USD 922 million in 2007 and USD 670 million in March 2008, respectively, to settle securities class action lawsuits. Customer dissatisfaction has also been an issue, as Hitachi (6501-TO) has been facing a JPY 41.8 billion (USD 398 million) lawsuit against Chubu Electric Power Company since October 2008 for turbine problems.
Last year’s leading companies, Agilent Technologies (A-N) and Ricoh (7752-TO), have remained as top-rated companies this year. Konica Minolta (4902-TO) and Omron (6645-TO) were both upgraded to ‘AAA’ thanks to steady progress in the environmental and social areas over the years, while Canon (7751-TO) was downgraded to ‘AA’ because of some continued concerns in the labor relation and workplace practice areas. AU Optronics (2409-TW) was upgraded to ‘A’ due to expanded disclosure of environmental and social issues in the latest CSR report and establishment of mid-term environmental goals, while another LCD panel manufacturer, LG Display, was downgraded to ‘BBB’ primarily due to huge criminal fines imposed by the US government as described above. Lastly, coverage was initiated for three new companies: Brother Industries (6448-TO) – ‘A,’ Rotork (ROR-LN) – ‘BBB,’ and Tyco Electronics – ‘BB.’
Rating Update – Household & Personal Products
Innovest is releasing updated ratings for 17 companies in Household & Personal Products. Increasingly, the environmental risks and opportunities in this sector are capturing the attention of financial analysts.
The top company in this year’s analytical set remained Natura, while the lowest score went to PZ Cussons, maintaining its ‘CCC’ rating. Upgrades went to Kimberly-Clark (‘A’ to ‘AA’) on the basis of improved supply chain and animal testing policies; Hindustan Unilever (‘B’ to ‘BB’) due to its improved focus on environmental management and further product development innovations; and Energizer Holdings (‘CCC’ to ‘B’) owing to its recycling initiatives and efforts to improve communication with customers. Avon’s was the only downgrade (‘AA’ to ‘A’), reflecting its intermittent environmental reporting and lagging management of product safety and human resources.
Rating Update – Retail – Asia Pacific
Our analysis of the Retail – Asia Pacific sector focuses on the key issues of product safety, product innovation, and energy, waste, and carbon risk assessments. Consumer demand for value as well as quality, healthy, and environmental-friendly products creates an opportunity for retailers to respond with innovative own-brand product lines, improving margins. Companies are also seeking growth in emerging markets such as China, as Japanese and Australian markets suffer from the economic downturn and harsh competition.
For the Japanese market, consensus favors convenience stores to outperform supermarket giants with their ready to eat food offers and other services. While we support a long-term positive performance for Seven & I and Lawson, we feel that FamilyMart (downgraded from ‘BBB’ to ‘BB’) will remain behind its competitors, in particular with food safety issues having an increasing impact on purchasing decisions.
Although sector leader Aeon (‘AAA’) will suffer lower growth in Japan during the downturn, its expansion strategy in China is expected to continue driving growth in the long run. The company’s improving environmental efficiency, product safety and product innovation indicate foresight on the key extra-financial risks that the company faces.
In Australia, Metcash’s food retailer IGA is likely to win market share over dominant rivals Woolworths and Coles (owned by Wesfarmer) in part due to its successful IGA Fresh campaign linked to its stronger local community support strategies. However, rising supply-side costs for Metcash, whose business model is heavily centered around distribution, and tough market conditions in general are likely to work against gains.