Rating Update – Construction & Engineering
In addition to eco-efficiency, community engagement, and other issues, Innovest’s most recent update of the Construction and Engineering (C&E) sector ratings reflect the strength of those construction and engineering companies that have adopted the life cycle business model, buoying their outlook even during the current economic downturn.
The life cycle business model generates revenue from the full life cycle of a project rather then its one-off sale. C&E companies traditionally have a cyclical economic performance intrinsically linked with the state of the national and world economy. In contrast, the life cycle business model enables the generation of extended revenues.
For example, a company that both builds a wind turbine and maintains ownership of it can then sell that energy to the grid. A company that builds an office and then manages those facilities can continue to generate revenues over the whole life cycle of that building. In both cases a company generates steady revenue over a longer period.
In good economic times, the traditional business model is highly profitable, as projects are in abundance and construction companies can build up a healthy order book. But during recession, project work declines, and the order book thins. The life cycle business model overcomes this volatility, producing long-term revenues for companies.
Four companies in the Innovest universe have adopted this life cycle model. They are Acciona, ACS, FCC and Carillion. All four have demonstrated the financial robustness of their life cycle business models as economies around the world have entered a period of recession.
Rating Update – Global Banks
The global banking sector is currently suffering through the most challenging and transformational financial crisis of a generation. ESG risks that few banks took seriously like irresponsible lending, energy efficiency, and volatile commodity costs have plunged the global economy into recession and have claimed the scalps of industry titans. The credit crisis has revealed that a bank which miscalculates how badly its assets will get hurt once good times turn to bad cannot be guaranteed to survive.
There are three core factors which structured our analysis of global banks this year:
· We expect global consumer loan losses to surpass USD 1 trillion by 2010. In the US, consumers will continue to default in droves. In addition the UK, Spain and many emerging market economies have experienced an unsustainable overextension of consumer credit which we predict will lead to additional defaults over the next 12-24 months. The banks which received the highest consumer finance ratings have either avoided these demographics or have only lended on responsible, sustainable terms. Consumer finance was the most heavily weighted component of each bank’s rating.
· A combination of collapsed consumer demand, volatile commodity costs, and high leverage will cause corporate credit defaults to double from 2008 levels. Through Innovest’s proprietary risk model we have identified USD 512 billion of high risk corporate loans made by the banks in this sector. The banks that have received the highest corporate finance ratings in the sector have either avoided these companies or have a credible, thoroughly-enforced strategy for managing this risk.
· Leverage will determine which banks can absorb losses. A bank which only finances sustainable companies but does not have a durable capital structure will still fail. An important difference in our rating methodology this year is that we looked carefully at banks’ capital adequacy and liquidity.
Our top quartile banks from this rating cycle have outperformed our bottom quartile banks by 22% since the onset of the credit crunch. But no bank is safe — the top quartile of the sector still dropped by 28%. The stock which performed the best since the last rating cycle, HSBC (then rated ‘A,’ now downgraded to ‘BBB’) still declined by 32%.
Key Upgrades and Downgrades:
JP Morgan Chase, Barclays, and Credit Suisse all moved up in the rankings since the last rating cycle.
RBS, Santander, BNP Paribas, Mizuho, HSBC and Citigroup were all downgraded since the last rating cycle.
Rating Update – Human Resources & Employment Services
The Human Resources and Employment Services (HRES) sector consists of companies offering a range of employment-related services and solutions, such as temporary and contract staffing, recruiting and permanent placement, outsourcing and outplacement, training, and human resource consulting.
The companies in the HRES sector have made significant improvements in endorsing environmentally friendly practices, and there has been an overall improvement in ESG activities undertaken by companies in this sector. Human capital development, environmental practices, emerging markets strategy, and the innovative ways in which the companies are responding to the demographic changes of an aging population and growing skill shortages form the key performance criteria of our analysis.
Michael Page International has been upgraded to ‘AA,’ taking into account its sector leading HR policies and eco-efficiency initiatives. Capita Group plc (‘AAA’) continues to lead in the sector with its strong focus on environmental management practices, supplier monitoring programs, and social improvement initiatives.
Rating Update – Metals & Mining – Precious
Precious Metals and Mining consists of companies that are engaged in exploring, mining, refining, smelting, production and sales of precious metals (e.g. gold, silver, and platinum) for industrial and other usage. The 26 companies analyzed have market capitalizations ranging from USD 376.83 million to USD 28,258 million. The sector is characterized by cyclicality; thus, production depends on demand, which can be driven by commercial demand or desire for a safe investment haven. In terms of ESG risks, providing basic raw materials, these companies are less motivated by (direct) consumer pressure and than by operating margin considerations.
Innovest predicts that energy and resource efficiency will differentiate companies in this sector. With energy prices soaring high in 2008, precious metals majors continued to seek energy security by adding energy assets to their portfolios. A significant example was Barrick Gold’s acquisition of Cadence Energy in 2008 to hedge its future energy needs.
Innovest also predicts a greater demand for the platinum group of metals (PGMs) due to its cleantech applications. We saw a substantial increase in PGM prices in 2008. Additionally, demand for platinum assets increased in the mining sector, with companies competing to acquire PGM assets. A major example was the USD 10-million hostile bid for Lonmin coming from Xstrata, a diversified major, though the bid fell through due to the credit crunch in the latter part of 2008. In South Africa, Impala Platinum acquired Northern Platinum and Mvele Resources.
Our analysis of the sector focuses on resource efficiency, health and safety, labor relations, and stakeholder relations that affect productivity and operating margins, in addition to opportunities in clean tech applications of PGMs. Lonmin and Anglo Platinum emerged as the sector leaders (‘AAA’). Hochschild Mining, St. Barbara Limited, Platinum Australia and Coeur D’Alene Mines were the laggards (‘CCC’). New additions to the sector are Gem Diamonds, St. Barbara Limited, Zijin Mining Group, Industrias Penoles Sab DV, and Platinum Australia. This update saw upgrades for Agnico-Eagle Mines (‘B’ to ‘BBB’) and Lihir Gold Limited (‘BB’ to ‘BBB’) and a downgrade for Aquarius Platinum Limited (‘BBB’ to ‘BB’).
Rating Update – Oil & Gas Exploration & Production
The analytical set of over 40 companies is characterized by OECD-based companies that either focus on indigenous reserves or have a wide international presence, primarily in emerging markets where national oil companies have a limited presence. A large number of the companies are focused on producing increasingly unconventional oil and gas assets in North America. The remote nature of these operations limit risks related to local communities; however, environmental risks are heightened by higher levels of environment regulations and new environmental risks posed by the challenges of producing unconventional assets, such as oil sands and coal-bed methane.
The majority of additions to Innovest’s coverage in this sector are Canadian energy trusts that are heavily invested in oil sands operations. These companies lag peers in the sector as they are generally more water- and energy-intensive, have a larger direct negative impact on the environment, incur greater remediation costs and are significantly exposed to incoming carbon regulations.
Also of note in this rating cycle, North American and Australian natural gas producers including EnCana (‘AAA’), Woodside (‘AAA’), Arrow Energy (‘AAA’) and Queensland Gas (‘AAA’) come in at the top of the competitive set. While it is true that a general trend of natural gas producers outperforming oil sands operators exists, this does not necessarily infer that all oil sands operators have poor environmental management practices, nor that natural gas operators carry no risks. Nexen has maintained its ‘AAA’ rating despite being one of the most diversified companies, exposed to the full spectrum of ESG risks. The opposite is true of XTO Energy (‘BB’), which is 85% gas weighted but does not meet the environmental and societal challenges of being a highly active driller in unconventional gas plays across North America. A handful of companies are leading peers with similar production and reserves portfolios, through investments in renewable energy and carbon capture and storage technologies. These include Woodside, Nexen, EnCana, Penn West (‘A’), Beach (‘A’), and Talisman (‘AA’).
Rating Update – Oil & Gas Refining & Marketing
The Oil and Gas Refining and Marketing environmental, social, and governance risks and opportunities are heavily weighted on both direct and indirect environmental impact factors, such as environmental liability and toxic emissions as well as strategic market opportunities associated with carbon management across the fuel supply chain. The 2009 update of R&M sector includes 13 companies. Geographically, the sector is heavily skewed to the Australasia region, where nine companies are headquartered.
No company’s rating moved by more than one rank. Upgrades included Showa Shell (‘AA’ to ‘AAA’), Sunoco (‘A’ to ‘AA’), and Tonenegeneral Sekiyu (‘BB’ to ‘BBB’). Downgrades included Valero (‘BBB’ to ‘BB’). Idemitsu Kosan Co Ltd is new to the sector, rated ‘AA.’ The ranking movements are largely attributable to relative positioning across key performance indicators linked to the capacity to improve operational efficiency, reduce liabilities, and increase strategic profit opportunities in the clean energy space. Innovest benchmarks and analysis builds on available 2004-2007 data, absolute and relative metrics in the following categories:
1. Environmental impact management: SO2, NOx, VOC, and GHG emissions; waste generation; and water use.
2. Health and safety performance: lost time, recordable injury rates, and fatalities.
3. Climate change and innovation capacity: research and development (R&D) to sales ratios as well as investment in clean / renewable fuels and energy technologies.
The materiality of this focused ESG assessment resides in the fact that the refining business requires highly capital-intensive investments in order to meet fuel standards specifications and manage environmental impacts.
Leading companies are developing solid strategies and implementation mechanisms to deal with increasingly stringent regulations and enforcement avoiding penalties and litigations associated with permits breaches. They are also engaged in R&D and commercial activities targeting clean fuels (lead-free, sulfur-free, low-emission, high-efficiency), biofuels, fuel cell, and hydrogen-based technologies. These include Neste, Nippon Oil Co, and Showa Shell.
Laggard companies are failing to demonstrate strategy development and performance improvement (e.g. Valero), and are relying on low internalization of H&S and pollution control, particularly in the context of lower regulation and lax enforcement such is the case with companies in emerging markets (e.g. Formosa). Below average companies, while eventually required to meet tougher GHG emissions regulations across production and fuel specifications, fail to proactively focus on technology development and overlook growing opportunities in renewable fuels and high-efficiency energy systems. These include Valero, Caltex, and Formosa.
Rating Update – Pharmaceuticals
The Pharmaceutical industry includes companies that focus on the development and production of new drugs as well as companies who produce off-patent generic drugs. The analytical set consists of 36 companies, including two companies on which we are initiating coverage – Ono Pharmaceutical Co Ltd and Hisamitsu Pharmaceutical Co Inc. The set now includes 12 US companies, 12 Asian companies, 11 European companies, and one Israeli company. The industry encompasses two subsets – innovator pharmaceutical companies (31) and generic manufacturers (5). Intangible value issues in the innovator subset include access to medicine, ethical conduct of clinical trials, responsible marketing and advertising practices, product safety, bioethics, public policy influence and lobbying activities as well as environmental management. The generic subset is comprised of companies that by nature have a reduced environmental and social risk but play a significant role in the access to medicines debate, as the entry of a copycat drug drives prices down. Therefore many of the generic companies do not report on environmental strategies and social efforts to the same extent as innovator companies.
While Innovest’s findings this year have been in line with mainstream projections for top-performing ‘AAA’ and ‘AA’ rated companies, there is a divergence between Innovest’s outlook for many ‘B’ and ‘CCC’ rated companies and the opinion expressed by traditional equity analysts. Several companies rated ‘buy’ by mainstream analysts have been deemed below investment grade by Innovest. Teva Pharmaceutical Industries Limited, Hikma Pharmaceutical PLC and Hisamitsu Pharmaceutical Co have all been rated ‘B’ or lower, indicating that their performance on ESG factors is below sector average. Across the sector, interest in issues such as access to medicine, responsible marketing, the ethical management of clinical trials and pharmaceuticals in the environment, is broadening. Innovest’s analysis places particular emphasis on environmental and social risks associated within these realms. Overall leaders who are proactively managing these issues, Novo Nordisk A/S, Roche Holding Limited and GlaxoSmithKline PLC, are expected to outperform going forward.
As this year’s analytical set shifted slightly, removing six companies, adding two new ones (Ono Pharmaceutical Co Ltd and Hisamitsu Pharmaceutical Co Inc), there was an impact on relative scores. The top company, Novo Nordisk A/S, maintained last year’s ‘AAA’ rating; the lowest score fell to Hisamitsu Pharmaceutical Co Inc (‘CCC’). Sector leaders have long addressed ESG issues with a high level of sophistication and with consistency throughout their operations. They are committed to continuous improvement and have several commonalities in their ESG management. They extend responsibility for ESG matters to senior levels, including the board. They have established comprehensive access to medicine strategies, robust product safety and quality management systems, and transparent lobbying and bioethics policies. Sector leaders also comply with industry-specific responsible marketing standards and witness annual improvements in their environmental performance across all indices.
Rating Update – Publishing
The Publishing sector consists of companies that publish information or entertainment via print or electronic media. The publishing activity can be broken into five categories — development, acquisition, copy editing, graphic design, and production via print and electronic media. The publishing industry is split into many industry verticals, consisting of publishers who engage in marketing and distribution of newspapers, magazines, books, literary works, software, commercial printing, musical works and other works dealing with information, in both print and electronic formats. Innovest’s analytical universe also includes companies that have ancillary businesses in TV and radio broadcasting, event management, and employment websites. Our coverage includes major publishing companies across the world from the US, Canada, the UK, Europe, Singapore, and Australia.
This year’s rating is more or less in tune with the previous year’s ratings. The relative scores and ratings of several companies like Daily Mail and General Trust, Lagardere, New York Times, and Gannett have been displaced by a level as competitors have moved up on the rating scale. Reed Elsevier and Pearson remain sector leaders. This year also witnessed a strategic takeover of Reuters Group by Thomson Corp in April 2008. The new entity has yet to completely merge the CSR approaches of the two previous companies, and our next update will reflect the result of this process.
Rating Update – Real Estate Investment Trusts (REITs) – Europe
Innovest has released updated ratings for 13 companies in the Real Estate Investment Trusts (REITs) – Europe sector. Due to the addition of a number of new companies this year, the previous REITs sector was divided by geography into three new sectors – Asia Pacific, Europe and North America. The European set includes REITs from the UK, France and the Netherlands active in various property sub-sectors: Retail (5); Office (2); Industrial (2); Investment (1); and Diversified (3).
After several years of outperformance, most of the REITs’ stock prices underperformed the overall financial markets during 2008. Consensus investment research views nearly all European REIT stocks as high risk; mostly because of the weakened credit markets and global recession. REITs own properties — the assets most associated with the excessive leverage and stellar investment returns of 2003-2006, and the subsequent collapse of the credit markets and equity valuations. For 2009 and 2010, REITs are facing sharply reduced earnings estimates, little development of new properties, higher borrowing costs, debt renewal risk, and increasing vacancy rates. The retail sector is suffering due to building oversupply, a lack of new tenants and a decline in consumer discretionary spending. Office property is experiencing increased vacancies and declining rents as companies resist expansion. Furthermore, the weakened credit markets make sourcing capital for development projects extremely difficult. In this environment of increased supply and tenant choice, operating efficiency is a key differentiator and figures in the center of Innovest’s analysis of these companies. Top-performers British Land and Land Securities have lowered operating costs significantly through the reduction of energy use throughout their portfolios (21% over 2005 levels, 9% over 2006 levels respectively). Growing energy regulation and mandatory disclosure of energy use is further increasing the relevance of these non-traditional risks for all companies within the competitive set.
As a result of the credit crisis and recession, the investment community favors REITs with less debt, longer term leases, and a small development pipeline – the reverse of two years ago. Corio NV, for instance, meets much of this criteria and now has a slight buy rating from the investment community. Yet, Innovest rated the retail REIT Corio NV ‘BB,’ since it has done little to improve the environmental efficiency and carbon intensity of its properties. Liberty International plc, also a retail REIT, performed slightly worse over 2008 than Corio in terms of stock price, yet it is rated ‘AA’ by Innovest for its extensive improvements of the environmental efficiency of its properties. Thus, Corio risks costly environmental efficiency upgrades, regulatory compliance and tenants seeking lower utility costs; while Liberty International stands to attract and retain tenants for having managed these risks well.
Rating Update – Specialty Chemicals
The economic crisis of 2008 saw a sharp decline in global growth. End markets such as fertilizers and explosives are expected to continue to grow, fuelled by an increasing population and demand for energy. However, large chemical companies are expecting a slowdown in demand for chemicals in 2009.
Our analysis of the Specialty Chemicals sector focuses on innovation and new product development. Of particular interest is the race for second generation biofuels, with a focus on Novozymes’ progress. Additionally, we continue to monitor the adoption of Green Chemistry in mainstream chemical manufacturing, as companies struggle to increase efficiency, develop high-margin offerings, and grow the bottom line despite the current economic challenges.
The Specialty Chemicals sector saw few major rating changes. Due to ICL-Israel Chemicals’ significant exposure to REACH Authorization, the lack of an overarching REACH management mechanism, and minimal focus on innovation and new product development, the company was downgraded to a CCC.