Banks
U.S. Bank Earnings Follow Innovest Predictions, ESG Factors Key Driver of Performance
At a time when the world is reevaluating what a bank is worth, intangible drivers of performance, including risk management, quality of lending and the trust of depositors, are becoming the key determinants of a bank’s intrinsic value. In December, Innovest conducted thorough analysis of U.S. banks’ lending strategies and their exposure to high-risk consumers and loans. Despite departing from Wall Street consensus, Innovest’s analysis successfully predicted bank performance.
We benchmarked each bank’s high-risk loans and assets as a proportion of tangible book value, using this leading indicator along with our assessment of strategy to determine a bank’s rating. Since they were rated, the banks’ earnings and stock performance fell largely in line with Innovest’s assessment. Of the seven mid-sized banks analyzed, only two banks, BB&T (A) and M&T Bank (BBB), posted a profit in the fourth quarter, while the others, including Fifth Third (CCC) and SunTrust (B), recorded larger than expected losses. Although the entire financial sector took a dive in January, the divergence in the banks’ stock performance as earnings were released clearly reflects Innovest’s analysis:
Mid-sized US Banks, 1 month yield (January)
Bank by Innovest Rating Yield
BB&T (A) -27.9%
PNC (A) -32.2
M&T (BB) -33.6
Regions (B) -56.5
SunTrust (B) -58.5
Fifth Third (CCC) -71.1
Furthermore, our calls for the period went counter to Wall Street consensus – a clear indicator that conventional analysis has failed to factor in the intangible drivers of performance. This strengthens Innovest’s view that who a bank lends to and how it lends are pivotal factors that determine a bank’s ability to navigate the financial crisis. Another trend in Q4 earnings was that toxic consumer loans taken on in the recent round of acquisitions are generating heavier losses for the acquiring banks than anyone expected. This applies both to PNC’s acquisition of National City (CCC) and Wells Fargo’s acquisition of Wachovia (CCC). This is also a sign that Bank of America’s Countrywide acquisition, and to a lesser extent JP Morgan’s acquisition of Washington Mutual (CCC), present greater risks to the banks than once thought.
Healthcare
Obama’s Healthcare Reform: Risk or Opportunity for US Healthcare Firms?
In the face of the credit crisis and the resulting high unemployment rates in the US, the number of uninsured in the US is expected to significantly surpass the already high figure of 15.3%. Health care reform is high on Obama’s priority list.
Part of the government contribution will be in the form of tax rebates for businesses in order to encourage them to improve coverage, as well as providing tax credits for small businesses and uninsured individuals to encourage them to buy insurance.
The fundamental challenge that the Obama administration is facing is the unsustainably high cost of healthcare in the US. In 2008 the US spent 17% of its GDP on healthcare. This figure is the highest in the world, and has been growing at twice the inflation rate.
The Obama administration has outlined a two pronged attack on this problem: First, increase therapeutic care in order to reduce the high cost of acute care, and second, increase competition in the health insurance market in order to reduce administrative costs (which are estimated to be 5 times those of other OECD countries).
As a consequence, it is possible that price control measures will be introduced and healthcare firms will be required to provide more transparency on costs. Such measures will force managed care companies to be more competitive and will put downward pressure on their margins.
As profit margins thin under government scrutiny, healthcare companies will have to compensate by seeking new customers. The main growth driver in the near term will be a mad rush to capture market share among the 45 million uninsured Americans.
Most of the uninsured population are concentrated in the southern states including California (6.7 million uninsured), Texas (5.8 million uninsured), and Florida (3.7 million uninsured). These uninsured individuals are poorer (45.1% of them live under the federal poverty level); with Hispanics comprising the largest uninsured population all across the US (33.5% of them are uninsured).
We believe that managed care companies which are well-established in these key states and have already adopted initiatives to target the low-income uninsured population are well-positioned to benefit from the Obama healthcare policies.
Initiatives we are optimistic about include provision of comprehensive affordable health plans and outreach mechanisms such as educational campaigns for the uninsured and multilingual, and easy to understand and navigate service platforms.
Among the managed care companies, Humana (rated A) and Aetna (rated AA) are well established in the southern states. These two companies are expected to out-perform peers since they already have a strategy and operational platform to reach out to the uninsured population. For example, Aetna has set up educational campaigns and commercial platforms available in various languages while offering health plans with low premiums and adaptable policies. Humana has introduced lower premium health plans such as HumanaOne in many states to tap the uninsured market.
Another example of a company well-prepared to benefit from the current economic and political context is Wellpoint (rated AAA). Wellpoint which is the largest managed care company in the US in terms of number of members (34.8 million as of December 2007) is also the dominant healthcare coverage provider in California (the state with the highest number of uninsured in the US). The WellPoint Foundation is engaged in helping raise awareness about Medicaid and low-cost coverage options available to the uninsured, and simplifies public and private health insurance information while making it available in Spanish and Chinese, so that more people can access the health coverage to which they are entitled.
In contrast, we believe that companies such as Health Net (rated A) and Coventry Healthcare (rated BBB) will lag behind their competitors in terms of membership growth since such companies do not operate in many states with high rates of uninsured and consequently are not well-positioned or prepared to provide services to the uninsured population.
Integrated Oil & Gas
Intangible Value Opinion on Petro-Canada in the Wake of Ontario Teachers’ Investor Activism
On February 5, 2009, Ontario Teachers Pension Plan – Canada’s largest pension fund and Petro-Canada’s third largest shareholder – launched an activist investor’s monitoring of Petro-Canada by filing form 13F the U.S. Securities and Exchange Commission, where it disclosed an increased stake in the company in the amount of approximately 16 million common shares, or 3.3% of the company’s shares as of December 31, 2008.
Last time OTPP became an active shareholder was when the fund initiated the world’s largest, CAD$34.8 billion (USD$28.2 billion) leveraged buy-out of BCE Inc., a holder of Canada’s largest telecommunication company Bell Canada. The privatization saga continued for almost two years, including a landmark bondholders’ lawsuit dismissed in the Supreme Court of Canada. The deal collapsed abruptly at the end of 2008, when the KPMG auditor rendered an unfavorable solvency opinion, much to the relief of the bondholders, cash-strapped creditors who agreed to provide a $30- billion deal financing before the outbreak of the financial crisis, and most likely to the LBO consortium headed by OTPP that was on the hook for at least100% premium over BCE’s trading price on the deal’s deadline.
Innovest has tracked Petro-Canada’s sustainability capacity for over seven years, with the focus on the company’s performance on environmental, social and governance (ESG) risks. Today, we wish to reiterate our favorable evaluation of Petro-Canada’s intangible shareholder value in the context of the relative peer comparison, which covers the world’s 38 largest integrated oil & gas companies, including three other Canadian producers – Imperial, Husky, and Suncor.
We believe the Petro-Canada’s strategic governance provides a solid foundation for the company’s long-term performance. The company is strong in the areas of carbon and water risk management, stakeholder relations at home and abroad, and relatively clean environmental track record. While often criticized for its state-owned past, Petro-Canada’s business ethics translate into solid internal mechanisms to deliver long-term sustainable value to its stakeholders – shareholders, Canadian society, teachers of Ontario, and emerging markets communities in need of protected environment and human rights.
For example, to cement the positive working relationship with the host country, Petro-Canada carved out USD 100 million for sustainable development programs as part of its recently re-negotiated production sharing agreement (PSA) with the Libyan national oil company (NOC). The funds are intended to satisfy the requirements of the sensitive national political agendas and increasing expectation of the oil-producing, developing counties that the international oil companies contribute to the national economic and social progress. Petro-Canada’s relation with Colonel Gaddafi’s NOC promotes training of local Libyan staff, transfer of expertise, infrastructure improvements for the local communities; the funding excludes local content purchases, which are already mandated by the new Libyan PSA at 30% of total suppliers’ business.
On the downside, Petro-Canada’s management of industrial relations, resource efficiency, and oil sands risks is weak. In 2007, the company recorded one of its worst industrial actions at one of its two refineries. The dispute over the national bargaining program resulted in a 14-month long lock-out of the union workers at the Montréal refinery. Representatives of the Communications, Energy and Paperworkers union (CEP) alleged that Petro-Canada attempted to discriminate against the Montréal refinery staff by offering lower pay, substandard working and health and safety conditions, reduced seniority rights and training budgets, and a longer term of unfavorable agreement of six years compared to the three-year agreement with the staff at the Edmonton refinery. CEP, which has seen unionization rates at Petro-Canada decline over the last several years from 24% in 2004 to 20% in 2007, also expressed concern that during the lock-out period, the management operated the refinery on a skeleton staff with deteriorated safety conditions.
An agreement was finally reached in December 2008, when the company offered a settlement retroactive to January 2007; however, this significant industrial dispute will continue to be associated with the damage to Petro-Canada’s human capital value, as it has negatively effected employee satisfaction and motivation to perform. Meantime, cash flow from operating activities in Petro-Canada’s downstream segment declined 41% in 2008. The company’s decision to go ahead with the expansion of the cooker at the Montréal refinery and the associated heavy crude capacity expansion have been delayed indefinitely since the start of the dispute in Q4’07.
Relative to peers, Petro-Canada’s environmental, health and safety (HSE) performance was below average in the analytical set. On an intensity basis (as measured by tons of emissions per USD million of operating sales), in 2007 and 2006 Petro-Canada’s relative performance was lackluster – SOx (0.74 tons/USD mm sales), NOx (0.99 t) and energy (5.8 TJ) intensities were high, and GHG (353 t) and VOC (0.74 t) intensities were average. The company has recently spent a significant amount – downstream environmental budget peaked in 2005 at CAD 690 mm (USD 570 mm), or approximately a fifth of total capital expenditures – to comply with environmental regulations; however, we are yet to see the optimized performance of the resource efficiency team established in 2005.
Finally, Petro-Canada’s oil sands risks are most acute. The 48% oil sands portion in Petro-Canada’s proved reserve portfolio is the third-highest in the analytical set after Imperial Oil and Suncor Energy; plus, the company’s production profile will shift substantially in the 2010ties, once Fort Hills project comes on-stream. Following partial nationalization of its assets in Venezuela, Petro-Canada boosted investment in the oil sands sector in June 2007 on top of its existing 12% interest in the Syncrude mining and its 100% ownership of the MacKay River in-situ projects. Petro-Canada committed CAD 24 billion (USD 22.3 bn), or approximately five years of the company’s annual capex budget, to the Fort Hills mining and upgrading project, where the company’s operations constitute 60% along with partners UTS (20%) and Tech Cominco (20%). Innovest’s analysis of the looming federal carbon regulation that requires carbon sequestration beginning 2018, indicates that Petro-Canada’s estimated discounted annual carbon compliance costs from the three key oil sands projects will amount to USD 203 million, or 2.83% of YE2007 EBITDA.
Innovest considers the oil sands development in Canada to be unsustainable in its current state, as it is associated with acute environmental and social risks, including carbon compliance costs, shortage of water and non-quantified site remediation liabilities. The substantial scale and fast pace of the Canadian oil sands development has had a negative impact on the health and well-being of local Aboriginal communities resulting in the calls for a moratorium on further development. It has also put a substantial inflationary pressure on the economy of Alberta, including ballooning costs of materials and labor. In addition to the ESG risks, the industry faces substantial market risks in the form of Section 526 of the US Energy Independence and Security Act of 2007 and subsequent implementation by the climate change – proactive Obama administration, introduction of low-carbon fuel standards (LCFS) led by the state of California, the US Mayors’ resolution –all calling for the ban on the use of gasoline produced from oil sands-based synthetic crude oil, which is on average three times more carbon-intensive than conventional oil. Despite Petro-Canada’s solutions to carbon, water and soil remediation risks, its unconventional oil strategy remains its largest risk to sustainable value creation.
In contrast, Innovest believes there are strategic profit opportunities Petro-Canada can pursue in the natural gas markets. Carbon-constrained economy will place a premium on the cleaner-combusting natural gas relative to oil – natural gas emits on average 30% less carbon dioxide than oil and 40% less than coal, and is a minimal source of air emissions compared to the latter two options. Petro-Canada remains an oil-weighted company, with only 21% of reserves and 29% of production portfolios composed of natural gas. The company’s 2004-2007 natural gas net proved reserve replacement ratio of 84% was below industry average of 130%. Nevertheless, an approval for construction of the CAD 1 billion (USD 980 million) Gros Cacouna LNG regasification facility in northern Quebec presents an opportunity to enter the LNG market. Following Gazprom’s decision in February 2008 not to accept Petro-Canada’s bid for construction of the Baltic Sea liquefaction plant, Petro-Canada’s positioning in natural gas markets will improve from the potential LNG supply opportunities in Trinidad and the Arctic.
Metals & Mining
Barrick Dumped Over its Waste: Allegations of Environmental Damage
After a recommendation from the Council on Ethics, Norway excluded Barrick Gold from its USD 300 billion sovereign wealth fund. The company was blacklisted over harmful environmental pollution allegations regarding the Porgera Mine in Papua New Guinea (PNG). Innovest rates mining companies in terms of environmental, social and governance (ESG) management capacity, operating efficiency, environmental impact, ESG strategy and governance, human capital and stakeholder capital. Norway’s ruling represents a reputational setback for Barrick and its ESG efforts.
Norway’s Ministry of Finance has alleged that Barrick is involved in “extensive environmental damage in several countries”, based on the findings of the Council of Ethics. The Council of Ethics has accused Barrick of breaching international environmental standards by dumping waste and propagating water pollution and heavy metal accumulation which may have serious effects on the ecosystem. The Council has also accused Barrick of “lack of openness and transparency” regarding its environmental reporting.
In 2006, Barrick Gold (rated A by Innovest), the world’s largest gold producer, acquired Placer Dome and inherited and integrated the Porgera mine among its mining interests. The mine is operated by Porgera Joint Venture (PVJ) in which Barrick has a 95% interest, the remaining 5% belongs to Mineral Resources Enga Ltd. The Porgera mine is located in the mountainous regions of Enga Province, PNG and uses both open pit and underground mining methods of ore extraction.
At present, Barrick treats tailings and soft waste rock by riverine disposal. The company has stated that the Porgera mine follows a PNG government approved environmental management and monitoring program. Due to the rugged terrain and seismic activity of the region, tailings dam construction might not be a viable alternative as there is a high risk of engineering failure and drastic alterations to watersheds may be required. Nevertheless, Barrick and PJV are assessing other mitigation and treatment methods to its present riverine disposal and are working towards cyanide code certification.
In the past, the Porgera mine has been fraught with ESG issues, besides alleged environmental pollution and questionable riverine tailings disposal methods, it had stakeholder issues regarding private security concerns, lethal force and deaths, community land settlement and relocation, mine invasion and vandalism. Innovest has highlighted legacy mines as a risk area that may affect Barrick’s competitive advantage.
The Council of Ethics may have conducted a thorough analysis regarding the Porgera mine and this may be sufficient for meeting the exclusionary criteria for the Norwegian government. However, these findings may be skewed for other investors; as a complete ESG investigation was not done for all of Barrick’s operations, or even operating regions.
Barrick’s action in Porgera is of concern; although, the company appears to have followed local government standards; it may not be enough regarding the standards of the international community. Innovest views the company’s overall strategy as sufficient is managing its ESG risks. However, the exclusion of Barrick in the fund may be a reputational issue. The company will need to bolster its ESG strategy; emphasis will need to be placed in its stakeholder communication strategy, as well as in its environmental transparency and certification. The sovereign wealth fund has banned other mining companies, including Rio Tinto, Vedanta Resources, and Freeport McMorRan. Blacklisting is based on concerns ranging from environmental, labor and human rights issues. Innovest will continue to monitor these developments.