Though insurers are preparing themselves better to withstand significant losses, an increasing probability of natural catastrophes due to growing global warming will continue to raise concerns. This is without mentioning the tornado devastation in Moore, Oklahoma this week, which, although nowhere near as concentrated as the East Coast, will nonetheless result in further losses for insurers.

The events outside the country such as continued debt crisis in the Eurozone will further limit the industry’s growth prospects.

However, the overall health of the industry has improved somewhat in the recent past riding on an economic recovery, after enduring pricing pressures and reduced insured exposure since the latest recession.

Rising premium rates should ultimately translate into margin expansion and mitigate the negative impact of the ongoing low interest rate environment on insurers’ investment income. Further, increasing awareness on the risk of catastrophe, strong underwriting discipline and favorable reserve development in the recent quarters should place the industry at least one step ahead.

That said, though the market condition doesn’t remain soft anymore, reasonable hardening is not expected at least until the end of 2013. Moreover, a stressed balance sheet, lack of real employment growth and legislative challenges are threatening insurers’ ability to rebound to the historical growth rate.

Also, limited organic growth opportunities and strict regulatory capital requirements will push the industry more toward consolidation. Insurers are seeking structural economies of scale through mergers and acquisitions to enhance market share. While this will help insurers stay afloat, inter-segment competition will alleviate. So, increasing profitability after complying with the regulatory requirements and coping with the challenges of climate change could prove difficult.

Zacks Industry Rank

Within the Zacks Industry classification, insurers are broadly grouped in the Finance sector (one of 16 Zacks sectors) and are further sub-divided into five industries at the expanded level: Insurance-Accident & Health, Insurance-Brokers, Insurance-Life, Insurance-Multiline and Insurance-Property & Casualty. The level of sensitivity and exposure to different stages of the economic cycle vary for each industry.

We rank all the 260 plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank.

As a guideline, the outlook for industries with Zacks Industry Rank of #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.'

The Zacks Industry Rank for Insurance-Property & Casualty is #6, Insurance-Multiline is #13, Insurance-Accident & Health is #50, Insurance-Brokers is #60 and Insurance-Life is #71. Looking at the Zacks Industry Rank of the five insurance industries, one could certainly say that the near-term outlook for the group is 'Positive.'

Life Insurers

A reduction in underwriting expenses and a modest increase in premiums have been helping life insurers increase net income in the last few quarters. But downward pressure on investment yields due to a low interest rates, higher hedging costs, lower income from the variable annuity business and more burdensome capital requirements will continue to mar profitability going forward. Also, low rates are spoiling life insurers’ efforts to grow fixed annuities and universal life insurance sales.

As the Federal Reserve plans to hold interest rates at low levels through mid-2015, life insurers will have to seek alternative asset classes to optimize return from investments. However, the addition of any risky asset class in their investment portfolios with hopes of better yield may lead to further losses.

As the industry’s statutory capital level fell sharply during the recession, life insurers will need to optimize their capital levels to address the ensuing challenges. In the short term, traditional sources of capital are expected to fulfill most of what life insurers need in order to stay in good shape. However, non-traditional sources of capital will take years to strengthen financials.

The underlying trends amid a recovering economy indicate stability in the sector over the medium term with respect to credit profile and financial prospects. However, higher-than-average asset losses, primarily resulting from their real estate exposure, will remain a major concern.

Further, the sluggish pace of economic recovery is making it difficult for life insurers to expand their customer base. In fact, insurers are struggling to even retain their existing clientele. Narrowed disposable income owing to high unemployment and huge credit card debt has made it difficult for Americans to invest in retirement products such as life insurance. Americans, primarily the youth, have significantly reduced expenditures on life insurance products, and are instead choosing alternative investments that promise better returns.

Though the carriers are transforming their products and businesses to make them attractive and profitable for customers, significant improvement in demand is not expected in the near term.

In December, Fitch Ratings has affirmed the credit outlook for the U.S. life insurance industry at stable for 2013. This action was primarily based on the expectation of insurers’ improved liquidity and balance sheet strength.

However, the rating agency expects statutory capital growth to be moderate in 2013 given subdued earnings growth due to the low interest rate environment. Also, the agency does not expect a significant improvement in portfolio credit quality due to the expected weakness in investment income.

Currently, the life insurers with favorable Zacks Ranks worth considering include Protective Life Corporation (PL) and StanCorp Financial Group Inc. (SFG) with a Zacks Rank #1 (Strong Buy), and China Life Insurance Co. Ltd. (LFC) with a Zacks Rank #2 (Buy).

Health Insurers

As U.S. health insurers are preparing themselves to comply with the mandates of the health care reform, their financials are expected to remain strong. Broad-based moderation in utilization has been primarily boosting the bottom line of health insurers. Also, increased access to capital and better retention opportunities are helping them grow consistently despite tardy economic growth.

Moreover, the carriers have been witnessing better credit quality in the recent quarters, reflecting a moderate industry risk.

In 2010, the historic health care reform legislation – The Patient Protection and Affordable Care Act (PPACA) – was passed by the Congress with the intension of making health care facilities more affordable, preventing private health insurers from continuing with the pre-existing condition clause and at the same time reducing the number of uninsured by bringing in 32 million more people under coverage by 2019.

The legislation had many detractors who contested several of its stated benefits and considered it another entitlement program that the country can ill afford. Finally, in Jun 2012, the U.S. Supreme Court ruled in favor of the reform, rejuvenating the industry by removing major uncertainties. Further, Obama's re-election in Nov 2012 essentially ensured a future to the law.

While the legislative overhaul brings more regulatory scrutiny for private insurers such as WellPoint Inc. (WLP) and UnitedHealth Group, Inc. (UNH), the net negative effect is expected to be far softer than was initially feared.

Although the full implementation of PPACA will be in 2014, the industry is expected to see gradual changes through the reminder of 2013. While bringing more people under coverage will add prospects for growth, the requirement to reduce health care costs will lead to margin compression.

Also, while the reform will provide more cross-selling opportunities for health insurers, their overall profitability will be limited over the long run as the negative impact of Medicare Advantage payment cuts, industry taxes and restrictions on underwriting practices will more than offset the benefits of bringing more people under the umbrella.

Consequently, substantial growth in industry revenue is not expected until 2015 as insurers will be forced to adjust the benefits to comply with the health care legislation. Among others, providing coverage to everyone regardless of an expensive pre-existing condition would put their top lines at stake.

(Want to know more about the future prospects of health insurers? Read our Health Insurance Stock Outlook)

Property & Casualty Insurers

Market hardening has been the key to improvement for property-casualty insurers in the recent quarters. After struggling with falling prices for years, insurers seem to finally reach a period of better premium rates. However, property-casualty insurers are still feeling the pressure on their investment portfolios due to the prevailing low interest rate environment. This has been continuously reducing the capital adequacy of most carriers.

Along with continually improving pricing power, better preparation to withstand catastrophe-related losses should help insurers perform better in the upcoming quarters despite the pressure on investment income.

As property-casualty insurers hold about two-thirds of the invested assets in the form of bonds, their capacity is highly sensitive to changes in credit market conditions. And with credit markets remaining weak plus bond prices hovering at low levels due to persisting concerns over defaults, insurers may incur significant realized and unrealized capital losses on their portfolios in the upcoming quarters. Moreover, catastrophe losses continue to keep the balance sheets of a number of carriers under pressure.

However, the ongoing recovery in the credit and equity markets is leading to a reduction in unrealized investment losses. Also, once the economic recovery gains momentum, insurance volume will grow rapidly. With growing employment in the private sector and recovery in the housing markets, a number of carriers have already started seeing growth in insurance sales.

The recent quarters have been increasingly witnessing a rebound in claims-paying capacity (as measured by policyholders’ surpluses), which reflects the industry’s resilience over the prior years. Conservative investment strategies and capital restructuring efforts will continue to help property-casualty insurers improve their financial footing in the upcoming quarters.

Currently, ProAssurance Corporation (PRA), XL Group plc (XL), Hilltop Holdings Inc. (HTH) and AXIS Capital Holdings Limited (AXS) with a Zacks Rank #1 are worth a look in the property-casualty industry.

OPPORTUNITIES

The industry has been undertaking several structural changes that will make underwriting and pricing schemes even more attractive to consumers. Also, improving financial fundamentals on the back of favorable macroeconomic trends make the stocks of a number of industry participants appear attractive.

We remain positive on Alleghany Corporation (Y), American Safety Insurance Holdings Ltd. (ASI), White Mountains Insurance Group, Ltd. (WTM), Assured Guaranty Ltd. (AGO) and Eastern Insurance Holdings, Inc. (EIHI) with a Zacks Rank #1.

Other insurers that we like with a Zacks Rank #2 (Buy) include The Chubb Corporation (CB), Cincinnati Financial Corp. (CINF), Everest Re Group Ltd. (RE), PartnerRe Ltd. (PRE), American International Group, Inc. (AIG), Cigna Corp. (CI), The Hartford Financial Services Group, Inc. (HIG), MetLife, Inc. (MET), Prudential Financial, Inc. (PRU) and Amerisafe, Inc. (AMSF).

WEAKNESSES

We expect continued pressure on investment yield and lower income from the variable annuity business to restrict the earnings growth rate of life insurers. Also, reduced financial flexibility and weak underwriting will hurt the earnings of many property-casualty insurers. Moreover, the overall industry is vulnerable to the ever-increasing threat of natural disasters.

Among the Zacks covered U.S. insurers, we prefer to stay away from the Zacks Rank #4 (Sell) stocks: ING Groep NV (ING), AFLAC Inc. (AFL), Loews Corporation (L), Meadowbrook Insurance Group Inc. (MIG) and Stewart Information Services Corporation (STC). Currently, there are no stocks with a Zacks Rank #5 (Strong Sell).
 
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Zacks Investment Research ]]> Fri, 17 May 2013 07:40:01 GMT OUTLOOK

Crude Oil

Record-high U.S. crude stocks, a struggling European economy, worries about China’s growth outlook, and the strong dollar have weakened oil prices to around mid-$90s a barrel. Partly offsetting this unfavorable view has been the improvement in domestic labor market conditions that points towards an improving economic growth backdrop.

The immediate outlook for oil, however, remains tepid given the commodity’s fairly positive supply picture. In particular, while Saudi Arabia is likely to cut back on its production, global oil output is expected to get a boost from sustained strength in North America, Iraq, Angola, Brazil and Colombia. On the other hand, the growth in global liquids fuel demand will be relatively soft in the absence of a strong global recovery.

According to the Energy Information Administration (EIA), which provides official energy statistics from the U.S. Government, world crude consumption grew by an estimated 0.7 million barrel per day in 2012 to a record-high level of 89.0 million barrels per day.

The agency, in its most recent Short-Term Energy Outlook, said that it expects global oil demand growth by another 0.9 million barrels per day in 2013 and by a further 1.2 million barrels per day in 2014. Importantly, EIA’s latest report assumes that world supply is likely to go up by 0.6 million barrels per day this year and by 1.8 million barrels per day in 2014.

In our view, crude oil prices in the second half of 2013 are likely to exhibit a sideways-to-bearish trend. With domestic demand relatively soft and the global economy still showing signs of weakness, the fact that supply will be outpacing consumption appears to be evident.

As long as sharp crude output growth from North America continues and the world demand is unable to keep up with that, we are likely to experience a pressure in the price of a barrel of oil. We assume that crude will trade in the $90-$95 per barrel range for the near future.

Natural Gas

Over the last few years, a quiet revolution has been reshaping the energy business in the U.S. The success of ‘shale gas’ -- natural gas trapped within dense sedimentary rock formations or shale formations -- has transformed domestic energy supply, with a potentially inexpensive and abundant new source of fuel for the world’s largest energy consumer.

With the advent of hydraulic fracturing (or fracking) -- a method used to extract natural gas by blasting underground rock formations with a mixture of water, sand and chemicals – shale gas production is now booming in the U.S. Coupled with sophisticated horizontal drilling equipment that can drill and extract gas from shale formations, the new technology is being hailed as a breakthrough in U.S. energy supplies, playing a key role in boosting domestic natural gas reserves.

As a result, once faced with a looming deficit, natural gas is now available in abundance.  In fact, natural gas inventories in underground storage hit an all-time high of 3.929 trillion cubic feet (Tcf) in 2012. The oversupply of natural gas pushed down prices to a 10-year low of $1.82 per million Btu (MMBtu) during late April 2012 (referring to spot prices at the Henry Hub, the benchmark supply point in Louisiana).

However, things have started to look up in recent times. This year, cold winter weather across most parts of the country boosted natural gas demand for space heating by residential/commercial consumers. This, coupled with flat production volumes, meant that the inventory overhang has now gone, thereby driving commodity prices to $4.38 per MMBtu – the highest since Sep 2011.

This, in turn, is expected to buoy natural gas producers. With the financial incentive to produce the commodity and the subsequent improvement in the companies’ ability to generate positive earnings surprises, the stocks are likely to move higher.

But as the weather continues to turn milder and temperatures reach higher-than-normal levels, natural gas demand may suffer in the near future on account of above-average builds, thereby pulling down prices again.

OPPORTUNITIES

Considering the turbulent market dynamics of the energy industry, we always advocate the relatively low-risk conglomerate business structures of the large-cap integrateds, with their fortress-like balance sheets, ample free cash flows even in a low oil price environment and growing dividends.

Our preferred name in this group remains Chevron Corp. (CVX). Its current oil and gas development project pipeline is among the best in the industry, boasting large, multiyear projects. Additionally, Chevron possesses one of the healthiest balance sheets among peers, which helps it to capitalize on investment opportunities with the option to make strategic acquisitions.

Within the domestic exploration and production (E&P) group, we like SM Energy Co. (SM) and EPL Oil & Gas Inc. (EPL). Supported by attractive oil and gas investments, balanced and diverse portfolio of proved reserves, together with development drilling opportunities, we expect the companies to sustain their production growth and profitability over the foreseeable future.

Further, we remain optimistic on the near-term prospects of Halliburton Co. (HAL). The oilfield services behemoth -- among the top three players in each of its product/service categories -- is enjoying strong demand for its services in international markets and expects the trend to continue in the coming years. Additionally, the company remains in excellent financial health and has recently announced a 39% increase in its quarterly dividend.

China's CNOOC Ltd. (CEO) is also a top pick. CNOOC remains well-placed to benefit from the country's growing appetite for energy and the turnaround in commodity prices. In particular, the company enjoys a monopoly on exploration activities in China 's very prospective offshore region in addition to having a growing presence in the country's natural gas and liquefied natural gas (LNG) infrastructure. The recent acquisition of Canadian energy producer Nexen Inc. will further improve CNOOC’s growth profile by augmenting proven reserves by 30%, while helping it to vastly expand its holdings in Canada.

Finally, despite the uncertain natural gas fundamentals and the understandable reluctance on the investors’ part to dip their feet into these stocks, we would advocate to opt for Canada ’s biggest natural gas producer Encana Corp. (ECA). Encana has one of the largest natural gas resource portfolios in North America, which provides a diverse/high quality inventory of reserves. We see a solid long-term future for the company as demand for natural gas soars, spurred by its cost effectiveness and abundant supply in North America.

WEAKNESSES

We are bearish on Italian energy company Eni SpA (E). The integrated player -- with a large presence in Libya -- has seen its total production fluctuate in recent times, primarily due to operational disturbances at several fields in the North African nation.

Additionally, Eni's upstream portfolio carries greater political risk than its peers, since it has the highest exposure to the OPEC countries. The Rome-based company has also been mitigated by a weak macroeconomic scenario in Italy and Europe that is likely to affect its performances going forward.

Based upon the number of near-term challenges, we remain pessimistic on the near-term prospects of National Oilwell Varco Inc. (NOV). With markets remaining competitive and pricing likely to be soft, the energy equipment maker’s margins are expected to suffer in the next few quarters. Recent weakness in the North American onshore drilling environment has also been a negative. Furthermore, we expect shares to remain depressed until it increases its sub-par dividend yield.

Energy-focused engineering and construction firm McDermott International Inc. (MDR) is another company we would like to avoid for the time being, mainly due to its erratic earnings trend over the last few quarters and a disappointing outlook for 2013. Apart from having to deal with steeper operating costs, McDermott has already hinted that its top line will suffer next year due to uncertainty regarding the timing of big awards.

Near-term bookings also remain lumpy, as the current uncertain environment has hurt the economics of building new oil and gas infrastructure. Additionally, the transfer of the power generation and government operations has left McDermott with a less diversified business, thereby heightening its risk profile.

We are also skeptical on independent energy exploration firms Cabot Oil and Gas Corp. (COG) and Range Resources Corp. (RRC). Both of them have been among the better performing S&P stocks since the start of 2013, gaining 40% and 20% during the period, respectively. Most of the gains have been driven by their exposure to the high-return Marcellus Shale play, as well as their above-average production growth.

But given natural gas’ volatile fundamentals and the duo’s high exposure to the commodity, we do not believe that the stocks will be able to sustain the momentum in the near future. The companies’ steep valuations as well as miniscule payouts also worry us.
 
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Zacks Investment Research ]]> Wed, 15 May 2013 07:38:01 GMT Life Technologies Corporation (LIFE) came to an end last month with Thermo Fisher Scientific (TMO) emerging as the clear winner.

For most of the last seven years, Thermo Fisher has supported its business momentum by acquiring several entities. Nevertheless, the proposed acquisition of Life Technologies is the biggest-ever deal for the company since its inception in 2006. The takeover will inevitably strengthen Thermo Fisher’s global foothold and commercial reach.

It's a Buyer’s Market

Medical device M&As are not stopping there. Wary of an uncertain economy, MedTech companies have resorted to the acquisition route to harness their strength and diversify offerings.

Last month, in a bid to strengthen its contraceptive portfolio, Bayer (BAYRY) inked a deal to buy contraceptive device-maker Conceptus Inc. (CPTS) for approximately $1.1 billion in cash. This impending acquisition will add the Essure permanent (non-surgical) birth control system to Bayer’s product portfolio. The transaction is expected to close by mid-2013.

In Mar 2013, Becton, Dickinson and Company (BDX) acquired AustriA-based Cato Software Solutions, the manufacturer of “catoA? and chemocatoA?” software, a suite of comprehensive medication safety solutions for pharmacy intravenous medication preparation, physician therapy planning and nurse bedside documentation.

Low global penetration and demand outstripping supply provide a positive long-term thesis for investing in the blood processing and supply chain management industry. With the acquisition of the transfusion medicine business of Pall Corporation (PLL), Haemonetics (HAE) entered the $1.2 billion whole blood collection market. Moreover, in May 2013, Haemonetics acquired Hemerus Medical that develops technologies for the collection of whole blood, and processing and storage of blood components.

Also, Quest Diagnostics’ (DGX) acquisition of UMass Medical Lab in Jan 2013 is in sync with its goal to create a planned 'lab of the future.' According to the company, this will help boost its long-term growth opportunities in the faster-growing esoteric markets.

Additionally, earlier this month the company announced the acquisition of the outreach testing operations of Dignity Health in California and Nevada. Quest Diagnostics expects to complete additional fold-in acquisitions, consistent with its goal of generating 1–2% revenue growth per year through accretive acquisitions.

Apart from the abovementioned takeovers and/or acquisitions, at the end of last year, Baxter International (BAX) entered into a $4 billion deal to take over Gambro AB, a Sweden-based privately-owned renal products company. The deal which is expected to close in the second quarter of 2013, is going to strengthen the company’s role in the hemodialysis market.

Moreover, after the three successive acquisitions of Cameron Health, Rhythmia Medical and BridgePoint Medical last year, Boston Scientific (BSX) recently acquired Vessix Vascular, which has developed the percutaneous radiofrequency balloon catheter technology for the treatment of hypertension. The company expects commercial launch of this platform in Europe and other international markets in 2013.

Other major deals inked in recent times in the MedTech space include six successive acquisitions by healthcare products maker Covidien (COV) exceeding $1.2 billion. In Jan 2013, the company completed the acquisition of Fremont, California-based medical device company, CV Ingenuity. In Mar 2013, leading vendor of cloud-based services for physician practices Athenahealth (ATHN) took over Epocrates, a pioneer of mobile health workflows and POC health apps.

The past year also witnessed significant M&A deals, including the acquisition of Switzerland-based Synthes Inc. by Johnson & Johnson (JNJ) for a whopping $19.7 billion, and Gen-Probe Inc. by Hologic (HOLX) for $3.8 billion.

Trends over the recent past reflect focus on the diagnostics space. A prime example is that of Agilent Technologies (A) entering into the Diagnostics and Genomics space through the $2.2 billion acquisition of cancer diagnostic company Dako. The acquisition is intended to augment Agilent’s portfolio and build a global market share to better fight its major peers, especially Teradyne (TER), Thermo Fisher Scientific and Danaher Corp. (DHR) in this space.

In order to expand into the large and lucrative market for drug-coated balloons, C.R. Bard (BCR) purchased Lutonix Inc. in Dec 2012. The worldwide peripheral vascular market for drug-coated balloons is forecast to hit roughly $1 billion annually over the next ten years. Further, the acquisition of Neomend will allow Bard to expand into another $1 billion market for surgical specialties offerings.

In Nov 2012, the neurovascular division of Stryker Corporation (SYK) acquired Surpass Medical (for $135 million) to expand its Complete Stroke Care portfolio. Surpass’ mainstay, the CE-Marked NeuroEndoGraft family of flow diverters is an attractive addition to the company’s product line.

In the light of the discussion above, 2013 is going to be another big year for M&As in the MedTech space. We expect a significant pickup in in-licensing activities and collaborations for the development of pipeline candidates. Several MedTech majors struggling in their core businesses are looking to explore potential emerging therapies through collaborations and alliances.

Emerging Markets

The US still holds the leading position with almost one-third of the market share. However, emerging economies like Brazil, Russia, India and China -- collectively known as the BRICs -- are fast coming up in the medical devices space and are attracting a lot of attention.

These emerging economies are seeing an increasing uptake of medical devices due largely to growing medical awareness and economic prosperity. An aging population, increasing wealth, government focus on healthcare infrastructure and expansion of medical insurance coverage make these markets a happy hunting ground for global medical device players. Expansion in emerging markets, especially those with double-digit annual growth rates, represents one of the best potential avenues for growth in 2013 and beyond.

The focus on emerging markets is all the more significant given the saturation and uncertain growth in the developed markets of US, Europe and Japan. Companies like Medtronic Inc. (MDT), Boston Scientific, Thermo Fisher Scientific, Stryker and Smith and Nephew (SNN) are all vying to expand their presence in the BRICs and other emerging markets. These companies are also looking to establish their manufacturing facilities abroad.

According to a McKinsey & Co. report (Jul 2012), health-care spending in China has more than doubled from $156 billion in 2006 to $357 billion in 2011. It is expected to grow to $1 trillion by 2020. China is also setting up proper health insurance coverage that should boost the healthcare sector. It is expected that within the next decade, China will be the biggest healthcare market in the world, even outpacing the US.

Among the other BRIC members, Brazil is currently the largest health-care market in Latin America, covering almost one-fourth of the population. Though India has one of the largest and fastest growing health-care markets in the world, it is considered to have the least developed health-care infrastructure and spends relatively little on health care. In order to reverse the trend, during the 12th Plan (2012-2017), the Indian government planned to spend 2.5% of its GDP (up from 1.2% earlier) on healthcare and raise it to at least 3% by 2022.

Given the huge potential in these emerging regions, in Mar 2013, Stryker acquired China-based Trauson Holdings for $685 million. Trauson was a competitor in the Spine segment and a producer of Trauma products. The company sold as many as 120 offerings and maintained a decent pipeline.

Smith & Nephew, on the other hand, entered into two definitive agreements to expand in the BRIC regions. In Apr 2013, it contracted to purchase its Brazilian distributor, Pró Cirurgia Especializada (PCE). PCE has been associated with the company for the last 30 years and has distributed its sports medicine, orthopedic reconstruction and trauma offerings in Brazil.

In May 2013, the company announced another agreement, to take over Adler Mediequip Private Limited and with it the brands and assets of Sushrut Surgicals Private Limited, a leader in mid-tier, orthopedic trauma products for the Indian market.

Johnson & Johnson has already set up manufacturing and R&D centers in Brazil, China and India. While it has been doing business in China for more than 25 years, it established a new innovation center in the country in 2011. The Guangzhou Bioseal Biotech deal marked the company’s first MedTech acquisition in China. The company is expected to expand further in China on the back of the Synthes acquisition.

Medtronic is targeting 20% of its revenues from emerging markets by fiscal 2015−16. After setting up its Innovation Center in Shanghai, the first outside the US and Europe, last October the company acquired China Kanghui Holdings and formed a strategic alliance with China-based LifeTech Scientific Corporation (both in Oct 2012). The acquisition is expected to strengthen its orthopedic franchise in the country.

Boston Scientific is aiming to increase its below-average market share in the $700 million combined drug-eluting stent market in China and India, which is growing sharply at 20%. The company plans to invest $150 million in China over the next five years to build a local manufacturing operation.

Thermo Fisher is also expanding its presence in emerging markets. It expects to garner 25% of total revenues from the high-growth Asia-Pacific region and emerging markets by 2016, up from 19% in 2011 and 10% in 2006.

Divestments

Another trend that we have been observing of late is the divestment of non-core business segments. For example, in an effort to focus on its high-margin surgical product portfolio, healthcare products maker Covidien is spinning off its pharmaceuticals business Mallinckrodt plc, which is expected to take place by Jun 2013.

In early January, Abbott Laboratories (ABT) separated its research-based pharmaceuticals business by creating a new company, AbbVie (ABBV), to allow the two separate entities to focus more on their operations.

Quest Diagnostics has also been focusing on areas with high potential such as gene-based esoteric testing for cancer, cardiovascular disease, infectious disease and neurological disorders. As a part of this strategy, in Apr 2013, the company completed the divestiture of the HemoCue diagnostics products business.

Last December, the company divested its OralDNA Labs salivary-diagnostics business in order to redirect its resources to core diagnostic information services. Johnson & Johnson, too, is currently looking for opportunities to sell or spin off its Ortho Clinical Diagnostics business.

In November last year, Becton, Dickinson and Company divested its Discovery Labware sub-segment (excluding Advanced Bioprocessing capability) to Corning (GLW) for $730 million. In May 2012, Smith & Nephew, through an agreement with Essex Woodlands, completed the disposal of its Clinical Therapies business, to the newly formed Bioventus LLC, in which it will retain a 49% investment.

Earnings Numbers

Challenging economic conditions, a competitive environment, pressure on core segments and a larger-than-expected currency headwind continue to remain as major causes of concern for medical device majors like Boston Scientific and St. Jude Medical (STJ). Both these companies barley managed to stay in line with the Zacks Consensus Estimate for earnings in the first quarter.

The still choppy U.S. defibrillator and global drug-eluting stents (“DES”) markets remain an overhang on these two stalwarts, and we expect the same to affect the performance of their peer Medtronic, which is slated to release its first quarter result on May 20, 2013.

While we are to some extent relieved with the signs of stability in Medtronic’s core spine markets, challenges remain in the Pacing and Spine business, which are expected to remain sluggish, in turn affecting the company’s overall performance. With the earnings Expected Surprise Prediction or ESP (Read: Zacks Earnings ESP: A Better Method http://www.zacks.com/stock/news/90676/Zacks-Earnings-ESP-A-Better-Method) of 0.0% and a Zacks Rank #3 (Hold) for the company, we are uncertain about a likely earnings beat in the first quarter.

Other major earnings reports by industry players include the first quarter earnings beat of Stryker Corporation. The austerity measures in Europe notwithstanding, which dampened sales growth at some of its segments, the recent stability in the company’s domestic recon market is encouraging.

However, there was a negative earnings surprise from Quest Diagnostics and its arch rival Laboratory Corporation of America (LH). We believe that the overall soft industry trends leading to challenging volume environment for testing laboratories and utilization weaknesses are looming headwinds. Moreover, their poor fiscal 2013 revenue guidance reflected the fact that the industry trend will not improve in the near future.

Notable in this regard, the implementation of the Medical Device Excise Tax (implemented in Jan 2013) will have an incrementally  negative impact on earnings per share of most of the medical device majors. This is also reflected in the conservative guidance posted by these companies.

OPPORTUNITIES

We continue to have a Neutral outlook on large-cap medical device stocks. While the companies will keep facing challenges like pricing pressures, declines in procedural volume from economic uncertainties and sluggish growth in the Cardiac Rhythm Management (CRM) business, increased M&A activities, focus on emerging markets and product approvals in latent areas could help reduce the impact. Better pipeline visibility and appropriate utilization of cash should increase confidence in the medical device sector.

With the announcement of its proposed acquisition by Bayer, shares of Conceptus reached a new high, leading to a Zacks Rank #1 (Strong Buy) for the stock. The Zacks Rank #2 (Buy) stocks in the MedTech sector include Becton, Dickinson and Company and The Cooper Companies Inc. (COO) among others.

In our universe, we see growth potential in companies dealing with promising technologies. In this respect, both these companies represent a value proposition. We are positive on Cooper based on factors such as margin expansion, acquisitions, product line expansion and geographical reach as well as share buybacks.

In spite of several core market challenges, the big three medical device players -- Medtronic, Boston Scientific and St. Jude Medical -- are striving to gain share in the implantable cardioverter-defibrillator (ICD) market through several new product launches. The big three are also exploring new avenues of growth beyond the mature pacemaker and ICD markets. With gradual stability in the ICD market, they should be able to revive their top line.

Beyond the MedTech majors, we are optimistic about the Zacks #3 Ranked orthopedic devices player Zimmer Holdings Inc. (ZMH). The percentage of population over age 65 in the US, Europe, Japan and other regions is expected to nearly double by the year 2030. In the US, the oldest baby boomers are now approaching retirement age. We believe the orthopedic giants will stand to benefit from this aging demography.

Among the scientific instrument makers, Thermo Fisher Scientific has been successfully expanding operating margins over the past few quarters on the back of operational efficiency. Given Life Technologies’ expansive line of consumables for genomic, and molecular and cell biology, the proposed buyout will complement Thermo Fisher’s market-leading portfolio of analytical technologies and specialty diagnostic.

CHALLENGES AND WEAKNESSES

On the flip side, the MedTech industry is currently hampered by several issues including the 2.3% medical device excise tax. Many of the nation’s medical devices players are currently bracing themselves for the impact of this tax.

The companies are either trying to relocate outside the US or reduce operations in order to weather the 2.3% tax burden. They are undertaking various restructuring initiatives to counter costs associated with the implementation of the new tax.

Other issues include pricing concerns, hospital admission and procedural volume pressures, Medicare reimbursement issues and regulatory overhang. While the debt crisis in Europe remains unresolved, economies throughout the world are trying to come to terms with myriad challenges. Consequently, procedural volumes in the US have been hit by a high unemployment rate, which has resulted in the expiry of health insurance as well as a decline in enrollment in private health plans.

Governments across several European countries have taken up measures to curb spending on devices, which is taking a toll on utilization. Volume headwind is likely to linger as unemployment continues to influence procedure deferrals.

Last but not least, the highly regulated US medical device industry is encumbered by stringent and complex procedures leading to approval delays. This sometimes demotivates companies, deterring them from investing in product development.

According to a report based on a survey of over 200 medical technology companies (FDA Impact on U.S. Medical Technology Innovation), the US FDA takes a significantly high time to review compared to its European counterpart.

Coming to the weakest link in the MedTech sector, we advise against names that offer little growth/opportunity over the near term. These include companies for which estimate revision trends for 2013 and 2014 reflect a bearish sentiment. Covidien currently retains a Zacks Rank #5 as doubts linger around its proposed divestiture of its pharmaceuticals business Mallinckrodt plc.

Another Zacks Rank #5 (Strong Sell) stock is Health Management Associates Inc. (HMA). Also, Edwards Lifescience Corp (EW), Orthofix International N.V. (OFIX), Vascular Solutions Inc. (VASC) and Symmetry Medical, Inc. (SMA) do not look inspiring and carry a Zacks Rank #4 (Sell).

Further, pricing compressions on hips, knees and spine products, which impaired the performances of several orthopedic companies, remain a key concern, at the macro level. We remain skeptical about companies including Wright Medical Group (WMGI) although the stock currently carries a Zacks Rank #3 (Hold).
 
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Zacks Investment Research ]]> Mon, 13 May 2013 07:33:01 GMT
According to the Association of American Railroads’ (AAR) rail traffic report, cumulative performance of the North American railroads (including U.S., Canadian and Mexican railroads) have fallen 1.5% year over year in the first quarter of the year. The biggest contributor to this decline was grain, which dropped 11%. Coal volumes followed closely, falling around 7%.

Going by the quarterly performance of the class 1 railroad, we see continued lower volumes from most of these carriers. One of the largest class 1 railroads in North America -- Union Pacific Corp. (UNP) -- registered first quarter volume decline of 2% year over year. Another major railroad CSX Corp. (CSX) also reported a similar level of decline in its volumes. Going forward, Canadian counterpart, Canadian Pacific Railway Ltd. (CP) also experienced lackluster growth trend with flat volume growth on a year-over-year basis.

However, railroad operators like Kansas City Southern (KSU), Norfolk Southern Corp. (NSC) and Canadian National Railway Company (CNI) have shown modest volume growth, mainly driven by the emerging automotive business and rising petrochemical shipments.

Notably, despite mixed carload results, these carriers have mostly generated positive earnings in the reported quarter. The primary catalyst to this bottom-line performance was operational efficiency even in times of low market demand. Rising employee productivity, deploying fuel-efficient locomotives and undertaking railroad safety measures are some of the key drivers of profitability even in adverse market conditions.

Rail carriers like Canadian Pacific recorded operating ratio improvement of 430 basis points year over year. Continued focus on maintaining asset efficiencies, safety measures and increased productivity have been the prime contributors to Canadian Pacific’s success in the first quarter. There are several other near-term growth catalysts in the railroad industry.

Rising Contribution of Petroleum Product Shipment

According to the AAR report, rail traffic from petroleum products has seen a whopping 46% growth in the three-month period ended Mar 30. According to the Energy Information Administration’s (EIA) reports, U.S. crude oil exceeded 7 million barrels per day production, representing record growth since the last two decades. Further, in 2013, long-term projections of EIA suggest that this growth may also go up to 10 million barrels per day over a period of 2020 to 2040.

As a result, this surge represents a potential opportunity for revenue accretion, which the railroads are trying to tap with infrastructural development. According to industry sources, the role of crude oil as a revenue contributor has grown by leaps and bounds in a four-year span from a mere 3% to 30% of the oil and petroleum products shipment by railroads.

Despite the fact that rail-based crude transportation costs five times more ($10–$15 per barrel), crude shippers are compelled to rely on rail-based transport. This is due to the lack of pipeline infrastructural support in key oil and gas fields like Bakken Shale Formation in North Dakota and Montana, Eagle Ford Shale, Barnett Shale and Permian basin in Texas, the Gulf of Mexico and Alberta oil sand fields in Canada.

In 2012, Canadian National Railway, which operates along the Western Canada (Alberta region) to the Gulf Coast, has shipped approximately 30,000 tank cars of volumes of crude oil, while its counterpart Canadian Pacific shipped 53,000 tank cars of crude during the same period. Another giant railroader, BNSF Railroad of Berkshire Hathaway Inc. (BRK-B), which serves the North Dakota region reportedly earned $272 million from crude shipments last year by shipping approximately 100 million barrels of oil.

In the coming days, we expect railroads to accelerate their investment in order to create adequate service capacity for the oil and gas markets. Canadian Pacific projects crude shipment to reach up to 70,000 oil-tank cars by the year-end and move to 140,000 by the end of 2015. This kind of exponential growth in crude oil shipments is taking place across the rail industry. Consequently, we expect petroleum shipments to remain favorable and emerge as a significant revenue contributor in the long term.

Automotive

Currently, Mexico is a growing market for automotive production and assembly given the lower cost of production there. As a result, markets sources predict that in the coming years, auto manufacturers are expected add capacity to accelerate manufacturing by 600,000 additional vehicles per annum. In the first three months of 2013, auto shipments by rail in Mexico increased 4.6% while in the U.S., auto shipment via rail rose about 2%. This counterbalanced the 1% drop in rail auto shipments in the Canadian market.

We believe upcoming plants by Honda Motor Co., Ltd. (HMC), Nissan Motor Co. (NSANY), Mazda and Audi would further boost auto production in Mexico. The facilities would also bode well for automotive shipments. Based on these proposed expansion plans, finished vehicle production in the Mexican market is expected to reach 3.5 million units in 2015, up about 35% from the 2012 production level.

The growth will provide carriers like Kansas City Southern, which operates across the Gulf of Mexico, ample opportunities to ship raw material into Mexico and return the finished products to the domestic market as well as to the U.S. and Canada. The increase in automotive production is also giving rise to new steel plants and processing centers across the company’s service networks. These steel plants are likely to bring opportunities for steel shipments and other related products.

However, in the coming year, the growth can be slightly muted by the onslaught of the fiscal cliff. According to market reports, auto sales may see single-digit growth due to a change in consumer behavior owing to the U.S. tax policy changes. If the situation improves on the macro front, there should not be a cyclical downturn in the way of automotives.

Intermodal

The railroad industry is gaining largely from the ongoing conversion of traffic from truckload to rail intermodal. Intermodal is gaining popularity among shippers given its cost effectiveness over truck. On average, railroads are considered 300% more fuel-efficient than trucks, and we believe that intermodal will play an important role in driving the rail industry based on the growing awareness among shippers about its benefits.

Currently, rail intermodal accounts for over 20% of the railroads’ revenue, second in line after coal. In the coming years, we expect this contribution to only rise given the growing dependence of shippers on intermodal services.

Apart from these positives, other factors likely to have a material impact on Railroads’ near-term, top and bottom line growth include:

Coal

Coal represents important commodities and accounts for over 40% of railroad tonnage. According to EIA reports, coal production hit lows of 9.9 million short tons (MMst) in first quarter 2013, representing a steep decline from 22.7 MMst in the year-ago quarter. As per AAR reports, coal shipments by rail also continued to decline 8% in the U.S. market. The decline was partially offset by 11% and 9% growth in rail shipments in the Mexican and Canadian markets, respectively.

Domestic coal demand, of which utility coal accounts for approximately 93%, is witnessing persistent declines. Lower natural gas prices imply that gas is largely substituting the demand for utility coal. Additionally, higher stockpile levels have resulted in lower utility coal demand.  Besides, natural gas prices, another important factor that resulted in the decline of coal-powered plants are the environmental issues associated with coal burning.

However, in 2013, coal consumption in the domestic market is expected to grow 7% year over year to 948 MMst and reach up to 957 MMst in 2014 on the back of rising natural gas prices.

On the export front, the scenario remains entirely different. After reaching highs of coal export in 2012 (126MMst), EIA projects U.S. coal exports to decline 15% year over year to 107 MMst in 2013. However, 2014 may show modest improvement with exports of 109 MMst. Factors like an economic overhang in European markets, lower U.S. coal pricing, higher stockpile levels and increased exports from Indonesia as well as a recovery in the Australian mines are the primary reasons for the expected decline.

Grain Shipments

Since 2012, the Grain market has been experiencing lows due the drought in the Mid-West markets. The outlook for 2013 is also not encouraging enough to elevate rail freight shipment from its current lull.

According the rail traffic report of AAR, North American grain shipment registered a decline of almost 11% in the first three months of 2013, which was partially offset by 24.6% growth in Mexican grain shipment. In April, the U.S. Department of Agriculture (USDA) released the World Agricultural Supply and Demand Estimates (WASDE) report, which states that total U.S. corn demand, will go down by 11.1% from the year-ago level.

 U.S. corn exports will hit a low of 48.2% from last year with use of ethanol decreasing 9.2%. We believe that the impact of lowered estimates would be felt on railroad shipment as rail freight serves the majority of export shipment in the crop market.

Rail Investments

Investment in development and expansion plans remain critical when analyzing railroads prospects. These capital investments are a double-edged sword. While the investments put significant stress on margin performance, forgoing these would result in a loss of growth prospects.

Railway investments are paramount given the evolving supply chain management and increasing role of airfreight carriers in offering freight transportation services. These investments build the required infrastructure needed for railways to stay afloat in a competitive environment not only within the railroad industry but also with other modes like truck, barges and cargo airlines.

As a result, investments in infrastructural projects have been an integral part of railroads development. However, this sector, characterized by huge capital influx has been drawing funds primarily through private financing.

As a result, investment plans when undertaken can have a considerable impact on the liquidity position of the company and may lead to a highly leverage balance sheet. According to AAR reports, railroads invest approximately 17% of their annualized revenue, which compares with only 3% of average U.S. manufactures’ revenue on capital expenditures.

According to the Department of Transportation (DOT), the demand for rail freight transportation will increase approximately 88% by 2035. As a result, Class I carriers would have to expedite their investments to meet this growing demand.

It is estimated that railroads would require $149 billion to improve rail network infrastructure within this stipulated period. In respect of current investment requirements, railroads would invest about $24.5 billion in 2013 according to AAR. This figures project an escalating trend when compared with recorded investment of $23 billion in 2012 and $12 billion in 2011 as per AAR.

Given the growing demand and need to upgrade railroad infrastructure to meet new regulations, deployment of fuel-efficient locomotives, upcoming rules on track sharing, railroad safety and high-speed rail services make it mandatory for railroads to infuse more capital on development projects. According to DOT, almost 90% of the railway capacity needs to be upgraded to meet the expected rise in demand level by 2035.  Hence, for railroads it is important to balance profitability levels while investing in infrastructural development projects.

Currently, the U.S. railroad industry dominates less than 50% of total freight in America , indicating a huge opportunity for increasing market share. This opportunity can only be exploited by building railroad infrastructure that caters to the varied requirements of shippers.

OPPORTUNITIES

The railroad industry as a whole offers a number of opportunities that are difficult to ignore from the standpoint of investors.

Discretionary Pricing Power: The freight railroad operators function in a seller’s market and have enjoyed pricing power since 1980, when the U.S. government adopted the Staggers Rail Act. The idea was to allow rail transporters to hike prices on captive shippers like electric utilities, chemical and agricultural companies in order to improve profitability of the struggling railroad industry. As a result, of the Staggers Rail Act, railroads are hiking their freight rates by nearly 5% per annum on average, while maintaining a double-digit profit margin.

Duopolistic Market Structures: Railroads have by and large gained by practicing discretionary pricing in the freight market. In the prevailing duopolistic rail industry, railroad operators will be able to reap maximum benefits from rising prices when the overall demand grows.

This remains evident from the geographic distribution of markets between major railroads. Union Pacific and Burlington Northern Santa Fe control the western part of the U.S., while CSX Corp. and Norfolk Southern control the eastern part. On the other hand, Canadian Pacific and Canadian National control inter country rail shipment between the U.S. and Canada.

CHALLENGES

Despite the above mentioned positives, the freight railroad industry, like other industries, faces certain external and internal challenges. These are as follows:

Capital Intensive Nature: Railroad is a highly capital intensive industry that requires continued infrastructural improvements and acquisition of capital assets. Moreover, industry players access the credit markets for funds from time to time. Adverse conditions in credit markets could increase overhead costs associated with issuing debt, and may limit the companies’ ability to sell debt securities on favorable terms.

Positive Train Control Mandate: The Rail Safety Improvement Act 2008 (RSIA) has mandated the installation of PTC (Positive Train Control) by Dec 31, 2015 on main lines that carry certain hazardous materials and on lines that involve passenger operations. The Federal Railroad Administration (FRA) issued its final rule in Jan 2010, on the design, operational requirements and implementation of the new technology. The final rule is expected to impose significant new costs for the rail industry at large.

Price Regulations: The pricing practices of U.S. freight railroads are the major reasons of friction with captive shippers, who move their products through rail and do not have effective alternatives. According to the latest studies by the STB, approximately 35% of the annual freight rail is captive to a single railroad, allowing it monopoly pricing practices.

The unfair pricing power exhibited by the U.S. railroads has attracted congressional intervention for exercising stringent federal regulations on railroads. Congress has discussed railroad price regulation but has not passed any new rule so far.

U.S. Environmental Protection Agency: Railroads remain concerned about the proposed regulation by the U.S. Environmental Protection Agency (EPA) for power plants across 27 states. The proposed guideline –– Carbon Pollution Standard for New Power Plants –– aims at restricting emission of carbon dioxide by new power plants under Section 111 of the Clean Air Act. The standard proposes new power plants to limit their carbon-dioxide emission to 1,000 pounds per megawatt-hour.

Power plants fueled by natural gas have already met these standards but the majority of the units using conventional resources like coal are exceeding the set limit, as they emit an average of 1,800 pounds of carbon-dioxide per megawatt-hour. Railroads, which transport nearly two-thirds of the coal shipment, are most likely to be impacted by the implementation of the new regulation that could pose a significant threat to utility coal tonnage.
 
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Zacks Investment Research ]]> Wed, 08 May 2013 08:09:01 GMT
Changing consumer preferences and the advent of new and innovative technologies have been altering the way news is read and offered. Readers now have more choices to collect and read articles and news through devices such as netbooks, tablets or other hand-held devices.

These have been weighing upon the print newspaper industry, as advertisers now get low-cost avenues through which they can reach their target audience more effectively. Let’s have a look at what is happening in the publishing industry and how newspaper companies are adapting with the changing scenarios to keep themselves alive in the race for survival.

Circulation Falling Prey to Internet

Newspapers have fared far worse than magazines, as web-based news options have gotten the better hand in recent years. The two-decade-long erosion in newspaper circulation reinforced the decline in advertising revenue. Circulation has also fallen prey to budget cuts with newspaper companies reducing the number of print pages and newsroom staff to combat the downturn.

Despite the fall in newspaper circulation, some companies are reporting improved revenue from circulation due to the increase in subscription and newsstand prices. On the flip side, while the increase in prices for print editions is generating more circulation revenue, it is also resulting in subscriber losses due to the shift in preference for free online content.

Waning Newspaper Advertising Revenue

Advertising volumes are still under pressure as advertisers keep shying away from making any upfront commitments in an economy which is still not completely awoken from a state of hibernation.

According to the data released by the Newspaper Association of America, total advertising revenue for U.S. newspapers slipped 8.5% year over year in the fourth quarter of 2012 (October to December) to $6.26 billion, after falling 5.1% in the previous quarter, marking the 26th consecutive quarter of decline. The last time the Industry witnessed an increase in revenue was in the second quarter of 2006, when advertising revenue grew 1.1%.
 

                Data Source: Newspaper Association of America

Data compiled by the Newspaper Association of America suggested print advertising declined 10.8% to $5.29 billion in the fourth quarter of 2012, after declining 6.4%, 7.9% and 8.2% in the third, second and first quarters of 2012, and 8.0%, 10.8%, 8.9% and 9.5% in the fourth, third, second and first quarters of 2011, respectively. National advertising sales declined 16.2% to $874.9 million, retail dropped 10.0% to $3.11 billion and classified dipped 8.9% to $1.31 billion during the fourth quarter.

               Data Source: Newspaper Association of America

Print advertising revenue at The New York Times Company (NYT) dropped 13.3% in the first quarter of 2013. At Gannett Co. Inc. (GCI), publishing advertising revenue fell 4.5% in the first quarter.

Print advertising revenue tumbled 8.2% at The McClatchy Company (MNI) and 8.0% at The Washington Post Company (WPO) during the first quarter of 2013. Publishing advertising revenue dropped approximately 10.0% at Journal Communications, Inc. (JRN) during the quarter.

Efforts to Mitigate Losses

In an effort to offset declining revenue and shrinking market share, publishers are scrambling to slash costs. This has compelled many newspaper companies to undertake cost-cutting measures, such as trimming of headcount, pay cuts, furloughs, suspension of dividends, voluntary retirement program and closure of printing facilities.

Newspaper companies have now been remodeling and restructuring themselves to better align with the growing need of marketers, targeting younger people, affluent households and other demographic groups with multiple web and print publications. The publishing companies are adapting to the changing face of the multi-platform media universe, which currently includes Internet, mobile, tablet, social media networks and outdoor video advertising in its portfolio.

Publishing companies have been offloading assets that bear no direct relation with the core operations. The New York Times Company in May 2012 divested its remaining stake (210 Class B units) in the Fenway Sports Group, the owner of the Boston Red Sox and the Liverpool Football Club, for $63 million.

Another example of shedding the assets by the company is the sale of Regional Media Group in Dec 2011, which has long been grappling with shrinking advertising revenue.

Waning print advertising revenue, in an uncertain economy, compelled The New York Times Company to take this tough decision of divesting Regional Media Group, part of The New York Times Media Group. This would allow the company to re-focus on its core newspapers and pay more attention to its online activities. The decision to divest the division is also considered part of the cost containment efforts undertaken to stay afloat in this turbulent environment.

The New York Times Company on Sep 24, 2012 completed the sale of About Group, which it acquired in 2005, to InterActiveCorp (IACI) for a consideration of $300 million. In Oct 2012, the company sold its stake in Indeed.com, a job portal, for approximately $167 million.

The New York Times Company now intends to sell its New England Media Group, including The Boston Globe and its allied properties. Another diversified media conglomerate, The Washington Post Company offloaded its daily and Sunday newspaper, The Herald, to Black Press Ltd. and its subsidiary Sound Publishing. News Corporation (NWSA) is also on the verge of splitting into two separate publicly traded publishing and entertainment entities.

Online Advertising Gaining Traction

Advertisers are migrating to the Internet driven by increasing online readership and lower online advertising prices compared to print. Consumers are now spending more time online, and are searching news articles in the Internet.

Newspaper companies, who gauged this trend, have been trying to revamp themselves by increasing their digital applications. Digital advertising revenue remains a sole performer in the newspaper industry. McClatchy witnessed 1.5% rise in digital advertising revenue with national and classified advertising categories jumping 13.5% and 3.0%, respectively during the first quarter of 2013. Online publishing activities, principally washingtonpost.com and Slate, jumped 8% during the quarter.

Data released by the Newspaper Association of America suggested that online advertising revenue climbed 6.9% in the fourth quarter of 2012 to $968.1 million from $905.6 million in the prior-year quarter, reflecting  a twelfth consecutive quarter of growth. The rate of growth in online advertising improved over 3.6%, 2.9% and 1.0% witnessed in the third, second and first quarters of 2012, respectively.

 
              Data Source: Newspaper Association of America

Pay As You Access

”To read further please subscribe” is the new mantra that newspaper companies are fast adopting. To curb shrinking advertising revenue and improve market share battered by the recent economic downturn, some of the publishing companies are now considering charging readers for online content. We believe that this would mark an end to the free usage of online contents. Despite hiccups in the economy, the online subscription-based model still promises guaranteed revenue generation.

Rupert Murdoch, the Chief Executive Officer of News Corporation, has long been pushing for the online subscription model for all general news websites. But newspaper companies have been reluctant in doing so, as they feared losing readership and, in turn, advertisers.

News Corporation has taken a leap towards an online subscription-based model for general news content. News International, a subsidiary of News Corporation, began charging readers for online content for The Times of London and Sunday Times of London, effective June 2010.

Business newspapers such as The Financial Times and The Wall Street Journal (owned by News Corporation) have long been following an online pay model. But levying access charges on readers for online access to general news content was a first for any news publication.

Another media giant, The New York Times Company, on March 28, 2011 launched a pricing system for NYTimes.com similar to that of the Financial Times' metered system, whereby after browsing a certain number of free articles, readers will be asked to subscribe for complete access to its articles on phones, tablet computers and the Internet.

The New York Times Company fixed monthly charges of $15 for access to more than the restricted number of articles on its website and on a smartphone application; $20 for unlimited access online and on Apple Inc.'s (AAPL) iPad tablet computer application; and $35 for online, smartphone and iPad application. Moreover, in order to woo subscribers, the company introduced a plan of 99 cents under which one will be able to enjoy all digital offerings for one month.

The company also indicated that the users of NYTimes.com will be able to read 10 articles per month without spending a penny. However, readers visiting The New York Times Company’s website via blog links or social-media sites such as Facebook, Inc. (FB) or Twitter will be able to access an unlimited number of articles.

But traffic reaching the company’s website through search engines such as Google Inc. (GOOG), Microsoft Corporation's (MSFT) Bing and Yahoo Inc. (YHOO) will be able to view five articles per day before being asked for a subscription.

We believe the success of the pay model depends on the accessibility of new articles across the web. Potential customers will be reluctant to shell out a penny if content is available free of cost elsewhere. However, The New York Times Company notified that the number of paid digital subscribers for The Times and the International Herald Tribune reached 676,000 at the end of the first quarter of 2012, reflecting a year-over-year jump of about 45%.

The company also launched a pay-and-read model for BostonGlobe.com for a weekly subscription of $3.99. The number of paid digital subscribers reached 32,000 at the end of the quarter, representing a year-over-year increase of 50%.

The New York Times Company intends to transform itself and lessen its reliance on traditional advertising. In doing so, the company wishes to launch lower-priced as well as premium subscription based model to target different masses according to their appetite, and emphasize on online video production and brand extension.

The company will also christen International Herald Tribune as the International New York Times to represent itself as a single brand identity in order to attract international digital subscribers. These initiatives will come into play in the fourth quarter of 2013 and into 2014.

OPPORTUNITIES

Despite the tough times faced by the publishing industry, there are a number of defensive names in the group that can hold their ground. Companies are radically changing their business models to get in line with industry trends.

Gannett Co. Inc. (GCI) is diversifying its business by adding new revenue streams to make it less susceptible to economic uncertainties. The company is also streamlining its cost structure, strengthening its balance sheet and rebalancing its portfolio. Gannett remains well positioned to harness the opportunities of rapidly changing business model such as digitalization in order to keep itself on the growth path.

Gannett posted stronger-than-anticipated first-quarter 2013 results, benefiting largely from its all access content subscription model coupled with sturdy performance of its Broadcasting and Digital segments. The adjusted quarterly earnings came in at 37 cents a share that surpassed the Zacks Consensus Estimate of 34 cents, and rose 8.8% year over year.

Gannett currently holds Zacks Rank #3 (Hold). Another stock in the publishing sector that looks promising is Tribune Company (TRBAA), which holds a Zacks Rank #1 (Strong Buy).

WEAKNESSES

The newspaper industry continues its struggle with plummeting advertising revenue amid the economic headwinds. Although murmurs about advertisers returning to the market are gaining ground as the economy recovers, the positive effects have yet to be realized.

The current economic upheaval is taking a toll on publishing companies, and The New York Times Company (NYT) is no exception. During first-quarter 2013, total advertising revenue slid 11.2%, whereas print advertising fell 13.3%. Total classified advertising dropped 10.9%.

The company’s high dependence on advertising revenue, a derivative of the health of the economy, remains a potential threat. However, the company is repositioning itself for improvement in print and digital media through a new subscription based model. The New York Times Company currently carries a Zacks Rank #4 (Sell).

Let’s Conclude

The newspaper companies are transforming their business models to better position themselves in a multi-platform media universe. Although the U.S. economy is witnessing a sluggish improvement in the advertising environment, we believe 2013 will not likely mark the resurrection of the publishing industry.  

With a strategic and steady newspaper budget, we could see fewer layoffs, increased focus on web and local content, improved subscription and concentration on profitable circulation.
 
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Zacks Investment Research ]]> Thu, 02 May 2013 08:56:01 GMT

Moderate job growth and slowly increasing consumer confidence are also contributing to a rise in demand for new homes. Inventory of foreclosed homes and short-sale homes are declining, thus stabilizing prices of new homes. Home prices have started moving up with market demand gathering momentum.

As the housing market returns to its pre-downturn level, it will drive employment upward and build consumer confidence, thus providing stimulus to the overall economy. In fact, the health of the housing market is often an indicator of the health of an economy at large.

Homebuilders are thus witnessing increasing traffic levels due to heightened consumer demand. Most homebuilding companies are witnessing significant growth in both volumes and average selling prices (ASP). New home orders, backlogs (number of homes under sales contracts at the end of the year) and homes delivered are climbing year over year.

Moreover, improving homebuilding revenues combined with tight cost control and better overhead leverage (as volumes improve) are boosting margins for most homebuilders. The large discounts and incentives offered in response to declining demand during the housing downturn have mostly been called back.

Overall, the U.S. housing market has seen significant upside in new home sales volume for 2012 with industry-wide sales increasing roughly 25% from prior-year levels. New home construction activity improved 25% in 2012. Faced with the fiscal cliff at 2012 end, and the threat of sequestration and a mounting national debt, the recovery of the housing market was one bright spot on the U.S. economic horizon.

Increased Investments in Land Positions

With sales and profitability improving, most housing companies have strategically focused on acquiring new home sites in high demand areas, which will further improve revenues and profits. In addition to purchasing finished home sites, companies like Lennar Corporation (LEN), KB Home (KBH) and D.R. Horton, Inc. (DHI) also acquire early stage raw lands in A-plus locations, on which finished home sites can be built faster at a relatively lower cost.

D.R. Horton has indeed stepped up investments in homes under construction, land development and finished lots on the strength of its improved liquidity position from solid sales growth in 2012. The company's land and lot position is now the strongest in its 35-year history.

PulteGroup, Inc. (PHM) spent $925 million on land and land development in 2012 and plans to spend another $1.2 billion on land and related development in fiscal 2013 and 2014. While the company is disciplined in adding land positions, it is also divesting lower-margin projects and exiting underperforming communities and lower-margin land lots which no longer fit into their operating strategy. This would free up cash to invest in other potential opportunities, generating higher returns.

KB Home has also exited underperforming markets like South Carolina, downsized operations in Arizona and Charlotte, disposed of unnecessary land and reduced exposure to risky joint ventures.

Focus on High-End Communities

Most homebuilders are shifting their focus on high-end communities. The average selling prices (ASPs) are improving for most large-cap homebuilders due to changes in the community/product mix. ASPs have gained from increased sales in high-end communities of California, Arizona, Colorado and Florida, where home prices are generally higher.

Given the scenario, large builders are eating into the share of other undercapitalized/small/medium-sized private builders on the back of overall housing demand, stronger capital and better land positions.

Lennar strategically focuses on acquiring new home sites that would boost margins and percolate down to the bottom line. The company focuses on high-margin, well-positioned communities and avoids fringe or tertiary markets where price is the only driver. The company's focus on quality instead of quantity is benefiting margins and boosting new sales orders.

Pulte is also shifting its focus towards high-priced Pulte-branded move-up homes, which improve the overall ASP. A better mix of sales, particularly Pulte-branded move-up homes, as well as addition of new higher margin communities, is consistently boosting the company's margins.

Small homebuilders like KB Home has started rolling out communities in highly desirable submarkets primarily in the Central and West Coast regions, which allow it to sell larger, higher-priced homes, driving up the ASP. KB Home in the fourth quarter 2012 has been able to drive up ASPs for 10 consecutive quarters. KB Home is also targeting higher income, first-time and move-up buyers -- all of whom are more inclined toward buying a new home rather than buying a foreclosed one.

Another small homebuilder, Meritage Homes Corp. (MTH) is also seeing improving selling prices from a mix shift towards move-up homes in higher-priced communities and states. Luxury home-builder Toll Brothers (TOL) is focused on raising the quality and the luxury quotient of its homes, thus giving it a competitive advantage.

Ancillary Companies also Stand to Gain

Construction material companies, Vulcan Materials Company (VMC) and Eagle Materials Inc. (EXP), and building product makers Masco Corporation (MAS) and Louisiana-Pacific Corporation (LPX) are also slowly gaining momentum from improving new home demand. These companies are also seeing a concomitant rise in demand and volume.

With both residential housing starts as well as non-residential contract awards showing a steady improvement, Vulcan is seeing some improvement in demand for its aggregates as well as non-aggregates businesses. Its aggregates business, which was sluggish in 2012, is expected to see solid demand growth in 2013 as private construction demand rises.

Masco is seeing improving North American sales on the back of increasing new home construction activity, which is driving demand for its home improvement products.

Strategic Restructuring & Cost Saving Initiatives

Most housing companies are striving to improve their operating and financial performance. The initiatives taken include steps to expand margins, improve overhead leverage, manage inventory tightly and implement new pricing strategies.

As part of its cost reduction program, Pulte has made significant workforce reductions and is also aggressively working to reduce overhead costs. In addition, the company had effectively managed its business during the downturn that led to positive cash flows, which in turn could be used to pay back outstanding debt. The company is also adjusting contents of its homes and building smaller floor plans to curtail construction costs.

Masco's strategic initiatives include improvement of underperforming businesses like Installation and Cabinet, solidifying its market position and leveraging its brands, new product introductions and product innovation, reducing costs, paying off debt and strengthening its balance sheet. The company's cost-saving initiatives included business consolidations, system implementations, plant closures, branch closures, improvement in the global supply chain and headcount reductions.

Over the last 4-5 years, Masco has reduced its gross fixed costs by approximately $600 million by closing around 33 facilities and reducing headcount by more than 30,000.

Construction aggregates maker Vulcan's aggressive cost saving actions resulted in improved per-ton margins in 2012. In addition, the company re-organized its structure (consolidated eight divisions into four regions) in 2012, which lowered its selling, general & administration costs by 11% in 2012.

The company also has two other ongoing initiatives -- a Profit Enhancement Plan and planned asset sales -- in order to improve earnings and cash flows, pay off debts and thereby strengthen its overall credit profile.

The Profit Enhancement Plan is designed to reduce costs as well as enhance profitability by streamlining the management structure. Under the planned asset sale, Vulcan plans to divest its non-core assets in order to focus on the higher-growth Aggregates business. These sales will improve the company's liquidity position and earnings.

KB Home is improving and refining its products, activating communities (which were held for future development) in stabilizing markets, increasing revenues per community with intense focus on sales performance, and strengthening management teams with additional resources to improve its operating performance while carefully managing costs.

Most homebuilders expect these cost reduction and operating efficiency improvement plans combined with reinvigorated housing demand to boost profitability in 2013.

How Will the Big Players Perform this Quarter?

A look at the Earnings ESP (Expected Surprise Prediction - Zacks' proprietary methodology for determining which stocks have the best chance to surprise with their next earnings announcement) in the table below shows that Louisiana-Pacific could beat the Zacks Consensus Estimate in its first quarter 2013. The company is expected to outperform on the back of solid performance in its Oriental Strand Board (OSB) and Sliding segments driven by the housing market recovery. Masco is also expected to beat earnings this quarter driven by continued improving trends in the North American and the company's turnaround efforts and profit improvement initiatives.

Among those which have already reported their results for this quarter, Lennar beat the Zacks Consensus Estimates for both revenue and earnings; KB Home beat on revenues and incurred a narrower loss; and Fastenal Company (FAST) delivered in line earnings and missed on revenues. While Lennar and KB Home gained from improving housing fundamentals, Fastenal continues to see sluggish sales of its fasteners product line (hurt by end-market slowdown and a broader economic uncertainty). Fastenal is a national distributor of industrial and construction supplies.

In terms of composite growth expectations (combining the reports that have come out with those still to come), total earnings for companies in the construction sector are expected to increase 80.5% (year over year) in the first quarter after the +90.3% gain in the fourth quarter of 2012, thus continuing its positive momentum. This reflects 10.9% increase in revenue and a modest margin contraction.



Note: DHI's fiscal year ends in September while that of all other companies end in December.

Will the Housing Momentum Continue?

Notwithstanding the improving trend, the U.S. new home demand remains at historically low levels due to the currently weak U.S. economic conditions and tight mortgage lending standards. Sustainable increases in housing and housing demand for the long term will require the overall economy to strengthen, including further job growth.

Consumers will remain cautious until the employment scenario improves, home prices appreciate further and access to the credit markets ease. A sustainable housing recovery in the long term can be achieved only through a broad-based recovery in the overall economy, which we believe will take time.

Rising input costs are also a concern due to increasing costs of building material and labor. As housing starts accelerate, both labor and construction material costs would continue to experience upward pricing pressure, impeding margins in the future.

The National Association of Home Builders/Wells Fargo Housing Market Index (HMI), known as the homebuilder sentiment index, dropped by 2 points to 45 in April due to rising building materials costs and shortage of developed lots and labor supply. Moreover, difficulty in obtaining construction loans and tightened lending standards are making it tough for homebuilders, especially the smaller ones to effectively respond to increasing demand.

OPPORTUNITIES

That said, the earnings momentum for homebuilders has remained positive for the near term, resulting in a Zacks #1 Rank (Strong Buy) for D.R. Horton, Louisiana-Pacific and The Ryland Group, Inc. (RYL), and a Zacks #2 Rank (Buy) for Pulte, Masco, Lennar, KB Home and Hovnanian Enterprises, Inc. (HOV).

D.R. Horton has beaten Zacks earnings estimates in all the quarters of fiscal 2012 (ended Sep 2012) as well as in the first quarter of fiscal 2013 driven by growth in net sales orders, homes closed and sales order backlog. The company is expected to see continuous improvement in profitability on the back of geographic diversity, solid cost discipline, sound balance sheet, improved liquidity position, better pricing power, and rising home inventories and land position.

Lennar has witnessed solid year-over-year growth in new home orders, average selling prices and home closings in all quarters of 2012. Margins have also been above average, despite rising costs, driven by strong operating leverage. The company expects to continue to achieve further profitability in fiscal 2013 on the back of rising home prices, strong liquidity positions, solid backlog, strategic land acquisitions and new community openings.

Pulte has beaten Zacks earnings estimates in the last three quarters of 2012. Improving homebuilding revenues combined with the company's cost control initiatives and solid operating leverage to boost margins. We believe that homebuilders like Pulte, who have significant land positions, broad geographic and product diversity, and better capital positions, are expected to benefit the most as market conditions recover.

Masco's had a solid fourth quarter as both top and bottom line results surpassed the Zacks Consensus Estimate. The strong quarterly results were driven by strong performance in North America and Masco's profit improvement initiatives. We are encouraged by Masco's continued focus on product innovation and cost improvements. In general, management expects improved profitability in 2013 as both the new home construction and repair and remodel activities continue to recover.

WEAKNESSES

With the housing market on a recovery path, we are not generally bearish on any housing company. However, we advise investors to avoid Fastenal. Fastenal's daily sales growth rates in the last three quarters of 2012 were lower than the first quarter as well as the year-ago comparable periods. Daily sales growth rates to manufacturing customers have declined sharply due to lower sales of fasteners. We believe that the shift of resources to vending may also be hurting fastener sales. The stock carries a Zacks #3 Rank (Hold).
 
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Zacks Investment Research ]]> Tue, 30 Apr 2013 09:02:01 GMT
While the situation is not expected to change radically in the current quarter given the continued Eurozone problems, the industry is expected to fare relatively better this year, aided by the gradual healing in the U.S. economy and hopes of a rebound in Chinese demand. The industry is expected to benefit from strength across emerging markets and a rise in shale gas production in the U.S. The fledgling recovery in the housing market also augurs well for the chemical industry in the second half of 2013 and beyond.

Industry Fact File

Chemicals are used to make consumer goods and are also used in the agriculture, manufacturing, construction and service industries. In fact, the chemical industry itself consumes 26% of its own output. Major industrial consumers include rubber and plastic, textiles, apparel, petroleum refining, pulp and paper and primary metals.

The chemical industry, a nearly $3 trillion global business, has grown at a brisk pace for more than five decades. The fastest-growing areas have involved the manufacture of synthetic organic polymers used as plastics, fibers and elastomers. The chemical industry is mainly concentrated in three areas of the world: Western Europe, North America and Japan. Europe is the largest producer, followed by the U.S. and Japan.

The U.S. chemical industry represents more than 15% of the global chemical output and employs nearly 800,000 people. It constitutes roughly 12% of the nation's exports, aggregating $187 billion annually. Roughly 5.5 million additional jobs are backed by the purchasing activity of the chemical industry. The U.S. chemical industry supports roughly 25% of the nation's gross domestic product (GDP).

The chemical industry is cyclical by nature and heavily linked to the overall condition of the U.S. and world economy. The Chemical industry also touches 96% of manufactured goods, making the manufacturing industry the biggest consumer of chemical products.

There are 170 major chemical companies in the U.S. operating internationally, with more than 2,800 facilities abroad. The chemical industry is among the biggest industries in the U.S., a roughly $760 billion enterprise. It has been consistently leading the U.S. economy's business cycles due to its early position in the supply chain.

According to chemical powerhouse BASF SE (BASFY), global chemical production (excluding pharmaceuticals) rose 2.6% in 2012, down from a 3.8% rise registered a year ago. The deceleration resulted from slower demand for chemical products compared with 2011, hindered by weak economic environment and subdued growth across a number of emerging markets.

Industry Rank

Within the Zacks Industry classification, the chemical industry falls under the broader Basic Materials sector (one of 16 Zacks sectors). We rank all of the more than 260 industries in the 16 Zacks sectors based on the earnings outlook for the constituent companies in each industry. This ranking is available in the Zacks Industry Rank page.

The way to look at the complete list of 260+ industries is that the outlook for the top one-third of the list (Zacks Industry Rank of #87 and lower) is positive, while the outlook for the bottom one-third (Zacks Industry Rank #174 and higher) is negative.

We have four chemicals related industries: Chemical Plastics, Chemical Specialty, Chemical Diversified and Chemical Fibers. The Chemical Plastics industry currently retains a Zacks Industry Rank #9, placing it in the top 1/3rd of the 260+ industry groups. The Chemical Diversified industry is featuring in the bottom one-third of all Zacks industries with a Zacks Industry Rank #187, followed by the Chemical Specialty industry with a Zacks Industry Rank #228 and the Chemical Fibers industry with a Zacks Industry Rank #257.

Looking at the exact location of these chemical industries, one could say that the general outlook for the chemicals space as a whole to towards the 'Negative' side.

Please note that the Zacks Rank for stocks, which is at the core of our Industry Rank, has an impressive track record going back years, verified by outside auditors, to foretell stock prices, particularly over the short-term (1 to 3 months). The rank along with Expected Surprise Prediction (ESP) (Read: Zacks Earnings ESP: A Better Method) helps in predicting the probability of earnings surprises.

Key Raw Material Trends

The chemical industry uses oil, naphtha and natural gas as energy and feedstock inputs. BASF report states that the price of Brent crude oil averaged $112 a barrel in 2012 compared with $110 a barrel a year ago. Price rose sharply at the beginning of 2012 stirred by the combined impact of higher demand and political unrest in the Middle East.

Brent crude, which hit a four-year high of $128 a barrel in Mar 2012, reached a nine-month high of $119 in Feb 2013, triggered by strong Chinese crude oil import data and geopolitical tension in the Middle East, exacerbated by Iran's nuclear program.

However, in a recent development, Brent crude prices eased to below $100 for the first time since July 2012 as reports of slowing Chinese economic growth coupled with weak U.S. economic data (disappointing New York manufacturing data coupled with a drop in retail sales) dampened the demand outlook for oil. However, a possible intervention by OPEC through a potential production cut may keep prices from sliding further.

The price of the other key raw material, naphtha, which is produced from oil, averaged $937 per metric ton in 2012 compared with $930 per metric ton in 2011. High crude prices kept the cost of naphtha elevated. Natural gas remains a bright spot on the feedstock front. The average annual price of natural gas in the U.S. dropped to $3 per million British thermal units (mmbtu) in 2012 from $4 mmbtu in 2011.

Over the last five years, the U.S. natural gas markets have seen a dynamic shift due to the emergence of a new source of energy, shale gas, which exists in large quantities with sources close to many big energy-intensive cities. Shale gas is not only desirable for environmental reasons given its low carbon footprint relative to oil or coal, but is at the same time cost effective.

Chemical Industry on the Recovery Trail

The European debt crisis, weak U.S. manufacturing along with sluggish activity in China and other key emerging markets led to weak demand for chemical products in 2012. While the U.S. is not headed toward another recession, the lingering debt issue in Europe coupled with other economic uncertainties pose downside risks to the nation's economic outlook.

The American Chemistry Council (ACC) foresees national chemical output (excluding pharma) to rise 1.9% in 2013 (following a 1.5% gain in 2012) and 2.3% in 2014. Strength across light vehicle and aerospace markets bodes well for the industry. U.S. chemical exports are expected to rise 4.7% this year (up from 1.8% in 2012) and 6.6% in 2014, leading to an expansion in trade surplus.

The trade group expects global chemical industry output to grow 4.3% in 2013 and 4.7% in 2014. Chemical makers in the emerging economies are expected to deliver a 7.5% production gain in 2013.

The ACC expects strong rise in capital spending in the coming years, stemming from new investments in petrochemicals and derivatives. Domestic chemical investment jumped 15.5% to around $38.1 billion in 2012. The ACC envisions capital spending to reach $64.5 billion by 2017. The shale gas boom is expected to drive investment on plants and equipment in the U.S. A rebound across emerging markets is expected to contribute to accelerated rise over the next several years.

BASF expects global chemical production to recover this year on the back of healthy gains in the emerging markets. It expects the U.S. chemical industry to benefit from lower gas prices. Asia is expected to show strong rise riding on strength across construction, electronics and automotive industries. However, output in Europe is expected to rise narrowly due to marginal gain in industrial production.

According to the European Chemical Industry Council (CEFIC), European chemical output is expected to show a modest increase of 0.5% in 2013 following a 1.5% decline in 2012. The expectation for a slim gain this year stems from the anticipated modest gain in every quarter, partly driven by export markets.

OPPORTUNITIES

According to the American Chemistry Council (ACC), an industry trade group, emerging market growth and abundant shale gas should help drive U.S. chemical exports. A string of factors are driving growth in the export markets including favorable energy costs stemming from the abundance of shale gas and strong demand from the emerging markets.

Affordable natural gas and ethane (derived from shale gas) offer U.S. producers a compelling cost advantage over their global counterparts who use a more expensive, oil-based feedstock. New methods of extraction such as horizontal drilling and hydraulic fracturing are boosting shale production, bringing down prices of ethane in the process.

Leveraging the abundant natural gas supply and cost advantage, chemical companies are investing billions of dollars for setting up facilities (crackers) that produce ethylene from ethane. ACC report indicated that over 50 projects have been announced by the U.S. chemical makers (representing capital investment of more than $40 billion) to take advantage of ample natural gas supplies. Such investments are expected to boost capacity and export over the next several years.

Further, cost-cutting measures implemented by chemical companies including plant closures and headcount reduction should yield industry-wide margin improvements. Cash flows derived through these actions can be used for growth.

Mergers and acquisitions offer chemical companies another means to shore up growth in this difficult scenario. These companies remain focused on exploring growth opportunities in the fast-growing emerging markets, particularly in the lucrative regions of Asia-Pacific and Latin (especially China and Brazil).

China is expected to see a recovery this year following a somewhat soft 2012. Government stimulus actions coupled with efforts to staunch inflation appears to bear fruit and exports to the U.S. and other key markets are regaining momentum. An improved demand outlook for China bodes well for the chemical industry in 2013.

We feel that chemical companies with strong earnings quality, healthy growth trajectories and liquidity profiles are better placed in the current rickety market environment. In particular, this is considering their ability to leverage strong balance sheets and cash flows in maximizing shareholder value in the form of dividends and share repurchases, or use them for value acquisitions.

We have a bullish view on Eastman Chemical Company (EMN), which is well placed to benefit from its Solutia acquisition. The company's diversified chemical portfolio and integrated and diverse downstream businesses represent the pillars of strength. It also benefits from business restructuring, cost-cutting measures and increased capacity additions.

Chemical titan E.I. DuPont de Nemours & Co. (DD) is witnessing strength in its agriculture and food businesses. Its Agriculture segment delivered healthy sales in the December quarter boosted by higher volume and strong performance of the crop protection business. The company expects continued strong gain in crop protection in 2013 driven by new products. Moreover, DuPont should continue to benefit from the synergies of Danisco acquisition and its aggressive restructuring actions.

We are also optimistic about Celanese Corp. (CE), despite the challenges it faces in Europe. We like the company's initiatives to improve margins and profits by running its plants better and controlling expenses. The company's strong presence in emerging markets, especially in China, will enable it to deliver incremental earnings in 2013. We are also upbeat about the prospect of its TCX ethanol process technology.

We have a favorable view on Air Products and Chemicals Inc. (APD). Impressive results from its core Merchant Gases segment coupled with Indura and DA NanoMaterials acquisitions helped it to rake in better-than-expected results in the December quarter. Air Products plans to take a number of steps including cost-control measures, restructuring actions, price improvements and volume gains. Its recent strategic moves will position it for future growth and profitability despite the soft economic backdrop.

In the specialty chemical space, PPG Industries Inc. (PPG) represents an attractive play. The company witnessed strong growth in its North American automotive OEM coatings business in the December quarter. Continued momentum across automotive OEM and aerospace markets helped it to post better-than-expected sales in the quarter. It has a diversified base of products and markets, and looks to grow its businesses strategically along with controlling costs.

WEAKNESSES

Given the industry's sensitivity to the global economy, any negative current in the macro economy would be reflected in the prospects of the chemical companies. The turmoil in Europe and its impact on global growth remain sources of near-term uncertainty. Western Europe continues to pose challenges on chemical stocks due to weak demand and the nagging impact of debt crisis.

The U.S. housing sector, a key consumer of chemicals, has shown signs of recovery lately, manifested by rising housing starts, increase in building permits and a steady pick-up in home prices. However, demand from this industry remains way below the historic levels. In addition, weakness still persists in commercial construction and electronics, which are among the key end-markets.

Chemical companies generate a considerable amount of revenues outside the U.S., and therefore are exposed to foreign exchange fluctuations. Currency exchange translation remains a headwind for these companies.

Chemical makers may also face greater regulatory challenges in 2013. Environmentalists as well as different consumer and industry groups long argued that the existing Toxic Substances Control Act (TSCA), administered by the U.S. Environmental Protection Agency (EPA), is outdated and needs an overhaul.

Recently, Sen. Frank Lautenberg and Sen. Kirsten Gillibrand along with other co-sponsors introduced the Safe Chemicals Act of 2013, which is geared to limit the use of toxic chemicals linked to a broad range of diseases and place the burden on chemical makers to prove that their chemicals are safe.

Commodity prices, though subsiding lately, still remain a concern for many of the U.S. chemical producers. Their ability to pass these costs on to end consumers is not always easy, given the competitive pressures at play. As a result, margins for a number of producers may continue to be under pressure.

U.S. chemical kingpin The Dow Chemical Company (DOW) slipped into a bigger loss in the December quarter, clobbered by weakness across end-markets, especially in China, and weak pricing. Dow still faces challenges in Western Europe and is exposed to significant pension headwinds. Moreover, weakness in the electronics and construction end-markets may continue in first-quarter 2013 and currency headwinds are expected to persist given the weak euro.

Specialty chemical company Valspar Corporation (VAL) is grappling with the difficult market conditions. Persistent weakness in its Paints segment hurt its sales in the most recent quarter. Weakness in the residential housing market in Australia may continue to hurt paint sales moving ahead. The company cut its earnings forecast for full year citing a soft demand environment across some overseas markets.

Methanex Corp. (MEOH) put up a lackluster fourth quarter with both revenues and earnings missing expectations. Restricted supply of natural gas affected its operations in Chile, Trinidad and Egypt in the quarter. Methanex may continue to face headwinds due to curtailment of gas supply and constrained spending across its end markets.

In the agricultural chemical space, Potash Corporation (POT) is contending with macroeconomic uncertainties and a challenging demand scenario outside North America. Reduced contributions from all three nutrients arising from slack global fertilizer markets and lower demand hurt its sales in the December quarter. The company remains exposed to volatility in potash and phosphate pricing and currency exchange fluctuation.

Also, agricultural chemical company Agrium Inc. (AGU) is exposed to a soft pricing environment and somewhat weak overseas demand for potash and phosphate. The pricing environment for phosphate is expected to remain soft in the March quarter. Moreover, the global phosphate market is expected to remain weak in the near term, partly due to lower demand from India (a major phosphate import market).
 
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Zacks Investment Research ]]> Wed, 24 Apr 2013 10:07:01 GMT Overview

The aerospace and defense industry found its largest base in the U.S. with a military budget fittingly impressive. The country's global leadership position requires it to maintain the capacity to respond to the ever-changing national security environment. But unlike many other countries, the U.S. relies on the private sector to meet its defense needs.

The U.S. Army, Air, and Naval forces enter into long-term contracts with aerospace and defense companies to meet their various needs for systems and equipment. As such, the outlook for the industry is closely tied to the outlook for defense spending by the U.S. government.

Earlier this month, the Obama administration proposed defense budget for FY14 of $526.6 billion, down $0.9 billion from the FY13 annualized continuing resolution level of $527.5 billion. However, the FY14 request does not yet include a detailed budget for Overseas Contingency Operations ("OCO"), which is essentially government-speak for foreign wars and war on terror operations. The government is preparing a separate OCO request that is expected to be released soon.

Under the continuing resolution, OCO funding for FY13 is $88 billion. This is lower than the $115 billion enacted for FY12 OCO activities as a result of reduced operations in Afghanistan and conclusion of operations in Iraq. Going forward, OCO funding is expected to continue to decline as troops redeploy out of Afghanistan. In fact, the request for future OCO funding will likely be closely correlated to the amount of troops required for each operation.

Budget Issues - the Sequester

The budget sequester that went into effect at the start of March 2013 and that has a direct bearing on the U.S. government's defense spending is a function of the country's fiscal and economic challenges.

As a background, Congress passed the Budget Control Act of 2011 in order to resolve the debt-ceiling crisis. The Act provided for a Joint Select Committee on Deficit Reduction known as the super committee to produce legislation by late Nov 2012 that would decrease deficit by $1.2 trillion over ten years.

However, Congress failed to reach an agreement. This would have led to automatic cuts known as sequestrations, split evenly between defense and domestic spending, beginning on Jan 2, 2013. However, the 'Fiscal Cliff' was averted at the last moment and the date was postponed by two months by the American Taxpayer Relief Act of 2012.

But it finally took effect last month. The cuts as a result of the budget sequester are evenly between the defense and non-defense categories. The spending reductions are approximately $85.4 billion during fiscal year 2013, with similar cuts for years 2014 through 2021.

Some major programs like Social Security, Medicaid and federal pay (including military pay and pensions and veterans' benefits), however, have been exempted from these cuts. Over the 2014-2023 period, sequester would reduce planned spending outlays by $995 billion with interest savings of $228 billion leading to approximately $1.2 billion in debt reduction.

Zacks Rank

The Zacks Industry Rank, which relies on the same estimate revisions methodology that drives the Zacks Rank for stocks. The way to look at the complete list of 260+ industries is that the outlook for industries with Zacks Industry Rank of #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.' Zacks Industry Rank for the Aerospace industry is at #93 out of 261 industries, which puts it in the Neutral zone.

Please note that the Zacks Rank for stocks, which is at the core of our Industry Outlook, has an impressive track record going back years, verified by outside auditors, to foretell stock prices, particularly over the short term (1 to 3 months).

Only one of the 11 companies in the industry has a Zacks Rank #1 (Strong Buy). While 2 carry a Zacks Rank #2 (Buy), seven hold a Zacks Rank #3 (Hold). Only one company has a Zacks Rank #4 (Sell).

MTU Aero Engines Holding AG (MTUAY) boasts a Zacks Rank #1 (Strong Buy). Safran SA (SAFRY) and Wesco Aircraft Holdings, Inc. (WAIR) carry a Zacks Rank #2 (Buy).

The Boeing Company (BA), Lockheed Martin Corp. (LMT), Northrop Grumman Corp. (NOC), Huntington Ingalls Industries, Inc. (HII), Erickson Air-Crane Inc. (EAC) and Embraer SA (ERJ) carry a Zacks Rank #3 (Hold). General Dynamics Corp. (GD) is a Zacks Rank #4 (Sell).

Earnings Outlook

A few companies have started reporting March ending numbers. Boeing came out with a solid Q1 results, as did Northrop Grumman, Rockwell Collins (COL), Lockheed Martin and General Dynamics, though Textron came up short. The Q1 results don't show much impact from the budget sequester, though it will be interesting to see how these companies cope in the coming quarters. The expectation is for Aerospace sector's earnings this year to be up 6.8% after declining 4.5% in 2012.

Going forward, a number of contracts, sizeable acquisitions, beneficial spin-offs and restructuring of the companies are expected to counter the budgetary uncertainty. This leads us to keep a keep a Neutral outlook on the aerospace and defense sector.

TAILWINDS

Mergers & Acquisitions, Spin-offs and Strategic Alliances

The big defense operators armed with strong balance sheets are expanding their operations through acquisitions. The U.S. Defense department also endorses mergers among U.S. defense companies, provided they don't involve the top five or six suppliers acquiring each other. For that matter, the industry encourages acquisitions as the highest-priority investment area for a company with a sizeable cash balance looking for growth amid significant defense budget cuts.

In fact, the four main strategies to stimulate growth are joint ventures, foreign military sales, international expansion and mergers and alliances. Among important mergers and acquisitions, we begin with The Boeing Company which acquired CPU Technology Inc.'s Acalis business in February this year. The acquisition would address the need of Boeing's global customers to protect warfighters from information-assurance attacks.

Acalis provides security-on-a-chip that can help defend manned and unmanned aircrafts. This acquisition will help the company to better differentiate its offerings and provide long-term value for its global aerospace and defense customers.

Last month, Triumph Group, Inc. (TGI) completed the acquisition of Goodrich Corporation (Goodrich Pump & Engine Control Systems) from United Technologies Corporation (UTX). We also saw last month Erickson Air-Crane acquire Evergreen Helicopters, Inc.

Sometimes, instead of acquiring a particular firm, defense companies enter into contracts to purchase certain assets in order to acquire capabilities that enhance their ability to expand into attractive adjacent market opportunities. For instance, in January this year, Lockheed Martin entered into an agreement with Aveos Fleet Performance, Inc. to purchase certain assets of the engine maintenance, repair and overhaul ("MRO") business.

Meanwhile, SAIC Inc. (SAI) is progressing well on its plan to split SAIC into two independent, publicly traded companies. In its announcement, SAIC said it intends one company to focus on government technical services and enterprise information technology. The other will focus on science and technology solutions in national security, engineering and health. The split is expected to occur in the second half of fiscal year 2014.

Overall, these acquisitions and even spin-offs help the defense pros in fulfilling task orders and contracts.

Agreements and Contracts

International Orders

Currently, the world's five largest military spenders are the U.S., China, Russia, U.K. and France. Following suit are Saudi Arabia, India, Germany, Italy, Brazil, South Korea, Australia, Canada and Turkey.

The aerospace and defense companies generate revenue from international orders and foreign military sales ("FMS"). Since the domestic defense sector is faced by budget cuts and a constrained spending environment from the U.S. government, the industry is looking for growth from international orders.

In January this year, General Dynamics received a contract for the procurement and production of 69 Saudi M1A2 Abrams tanks for the Kingdom of Saudi Arabia. The Foreign Military Sales contract was awarded by the U.S. Army TACOM Life Cycle Management Command for the Royal Saudi Land Forces. Again, in Jan 2013, Alliant Techsystems Inc. (ATK) entered into a contract with Israel Aerospace Industries under which it will provide the solar array to power the flagship Israeli company's 5-ton Earth satellite AMOS-6.

In February, under another FMS sales program, Alliant Techsystems received a contract for the production of rocket motors for AIM-9P Sidewinder customers.

The rapidly evolving security challenges and the need for countries to modernize aging inventories keep demand alive in international markets. However, in Europe, the continuous financial crisis is forcing governments to institute austerity measures that will negatively impact defense spending in the near term. The initiatives taken up would constrain their defense budgets and fiscal priorities in current and future periods.

Over the next few years, demand for U.S. military exports is expected to remain strong. A truculent Iran, with increasing potential for nuclear capacity and relatively strong oil prices, has of late spurred the demand for U.S. military aerospace products by Gulf countries.

Similarly, increasing Chinese defense budgets have led to significant new U.S. sales in South and East Asia. Going forward, these sales would more than offset diminishing sales to European countries that have significantly cut their defense budgets.

DARPA Contracts

A trend very much noticeable among recent contract wins is that most of these awards come from the Defense Advanced Research Projects Agency (DARPA). DARPA is an agency of the United States Department of Defense responsible for the development of new technologies for use by the military.

In March this year, Lockheed received a Long Range Anti-Ship Missile modification contract from DARPA to conduct air- and surface-launched flight tests and other risk reduction activities. Again in the same month, Northrop Grumman received a contract for the DARPA ASPN phase 2 project that develops algorithms and a prototype sensor-fusion system to enable low-cost navigation for military users on any operational platform and in any environment.

Modification Contracts

Modification contracts are extended contracts that increase the value of original contracts. In fact, they demonstrate the ability of these defense companies of performing the contracts well in time. In April this year, Northrop Grumman received a modification contract from the U.S. Air Force for its Global Hawk unmanned aircraft system. Recently, L-3 Communications (LLL) also received a firm-fixed-price modification to a previously awarded contract for the production of 16 universal modular masts for Virginia-class nuclear fast-attack submarines.

Busy Repositioning

The aerospace and defense industry is experiencing continued consolidation. The companies are also busy restructuring in order to streamline their operations. A few days back, Raytheon Company (RTN) decided to reorganize its business through segment realignment, announcement of key executive roles and job cuts. The restructuring would aim to streamline operations, increase productivity and achieve stronger alignment with customer preferences.

The other way out for U.S. weapon makers who are under pressure to cut costs and preserve profit margins amid dwindling defense spending in the U.S is layoffs. In January this year, Boeing announced that it will consolidate its El Paso facilities and reduce the workforce there by the end of 2014.

The move again comes on the heels of the company's strategy to increase affordability for government customers and become more competitive in an increasingly global marketplace. Boeing intends to reduce occupied square footage 50% by moving from three buildings into one, and will reduce employment by up to 160 positions.

Cutting-Edge Innovation and New Products

At the macro level, a gradual shift in defense spending patterns can be discerned. In response to asymmetric terrorist threats, the emphasis appears to have shifted to high-tech intelligence equipment, replacing demand for conventional big guns and heavy armor. The major industry players have, in response, resorted to bolt-on acquisitions to plug gaps in their product offerings.

Among state-of-the-art products, the latest radar and telecommunication systems, new ballistic missiles, unmanned warplanes, development of fighter jets and sophisticated surveillance equipment are on the priority list of most countries. These help enhance the preparedness of a nation to detect, preempt and counter hostile situations.

Contemporary warfare has seen a paradigm shift from traditional forms of waging a war. There is high demand for new defense products that help the military in locating and eliminating terrorists before they strike. Moreover, the success of these defense companies depend on the ability to develop, market and produce products and services at a cost which is consistent with the defense budget.

Indeed, the defense pros can barely survive in this competitive industry without these innovations. In March this year, Northrop launched its Fourth Generation Tracking Adjunct Sensor (4G TAS), the latest upgrade to the company's range of high-resolution electro-optical/infrared (EO/IR) sensors for the Hawk air defense system. In March again, Raytheon announced the release of SureView Version 6.7 aimed at implementing an insider threat detection program to address national security threats while protecting privacy rights.

HEADWINDS

Global Downturn

The global economic downturn that started in late 2008 has significantly weakened the financial profiles of all major industrialized countries. The growth and development of the aerospace and defense industry is tied to the defense budgets of the different nations around the globe, especially the U.S. The general trend in this context is to cut national defense expenditures.

Austerity Drive

Needless to say, the major defense spenders throughout the world are on an austerity drive. They are gradually lowering their defense budgets and concentrating on other avenues to fix their ailing economies. The U.S. defense department has reduced the defense budget significantly. These cutbacks will impact the big contractors, as the lion's share of their revenues comes from domestic defense spending.

Acquisition and Program Risk

Taking into account the huge number of acquisition deals in progress, the industry faces risks associated with the completion, integration, and financing of these acquisitions. Then with the majority of revenue coming from government contracts, the industry could be adversely affected by the cancellation and delay of major government contracts.

Intense Competition

The aerospace and defense companies compete amongst themselves in the information and services markets for a number of small and large programs. The major defense players are Boeing, Raytheon, General Dynamics, L-3 Communications, BAE Systems plc, European Aeronautic Defense and Space Company, Finmeccanica SpA, Airbus, Embraer SA and Bombardier Inc. Therefore, with new competitors coming in, it has become important for the U.S. pros to stay ahead in technology.

Our Take

The aerospace & defense industry has been a keystone of the U.S. economy for decades and has provided well paying jobs for a variety of skill levels. The U.S. aerospace industry continues to contribute significantly to the country's economy and provides capabilities vital for national security. It generates new technology in fields such as advanced materials, sensors, information processing and sharing. Finally, aerospace continues to generate the largest positive trade balance of any U.S. manufacturing sector.

The U.S. is the leader in global defense spending. The major super power also has strategic alliances in place with other foreign nations with considerable military strengths. The country shares its military technology and supplies sophisticated weapons to its allies. These activities, in turn, boost the revenue of the defense operators.

However, on the flip side, the industry's position is now challenged by global competition, changes in technology, national and worldwide economic conditions, and global policies affecting defense, civilian and commercial aviation.

However, the costs incurred by aerospace and defense companies for executing projects due to order delays would increase leading to an imbalance between the cost and revenue structure. This would not only hurt profitability but also lead to delays and even cancellations of orders and/or programs.

Moreover, in the forthcoming years, the industry will face challenges, particularly in the defense sector, as the federal government looks for solutions to an ongoing budget crisis. In addition to budgetary constraints, including the Budget Control Act, defense spending will come down due to the draw-down of U.S. forces from major overseas deployments.

Sequestration still remains an overhang both in the civil and military sectors. The companies that have little diversification outside the U.S. are highly susceptible to spending cuts from sequestration. On the other hand, those with an international order book would find it less difficult to face the brunt of sequestration.

Despite the uncertainty related to sequestration, huge defense budget cuts and cancellation of big-ticket programs, we have a mixed outlook for the sector based on product progress, opportunities, acquisition benefits and cost-cutting efforts of individual companies.
 
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Zacks Investment Research ]]> Mon, 15 Apr 2013 07:05:01 GMT
Yet top-line growth remains uncertain due to continued sluggishness in loan growth, pressure on net interest margins from the sustained low rate environment and less flexible business models owing to stringent risk-weighted capital requirements (Basel III standard). However, banks have been gradually easing their lending standards and trending toward higher fees to dodge the pressure on the top line.

Moreover, U.S. banks are actively responding to legal and regulatory pressures, indicating competence to encounter impending challenges. But the potency of the sector is not expected to return to its pre-recession peak anytime soon. Economic intricacies, both domestic and overseas, may even result in some more disappointments in the upcoming quarters.

Overall, structural changes in the sector will continue to impair business expansion and investor confidence. Several dampening factors -- asset-quality troubles, mortgage liabilities and tighter regulations -- will decide the fate of the U.S. banks in the quarters ahead. But entering the new capital regime will ensure long-term stability and security for the industry.

Zacks Industry Rank

Within the Zacks Industry classification, U.S. banks are broadly grouped in the Finance sector (one of 16 Zacks sectors) and are further sub-divided into six industries at the expanded level: Banks-Major Regional, Banks-Midwest, Banks-Southeast, Banks-West, Banks-Southwest and
Banks-Northeast. The level of sensitivity and exposure to different stages of the economic cycle vary for each industry.

We rank all the 260 plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank.

As a guideline, the outlook for industries with Zacks Industry Rank of #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.'

The Zacks Industry Rank for Banks-Southeast and Banks-West is #60, Banks-Northeast is #84, Banks-Major Regional is #90, Banks-Southwest is #99 and Banks-Midwest is #213. Considering the Zacks Industry Rank of the six banking industries, one could safely say that the near-term outlook for the group is leaning towards 'Positive.'

Signs of Improvement

Only a few banks have reported first-quarter 2013 results so far. Among these, the stupendous performances of a couple of mammoth players -- JPMorgan Chase & Co. (JPM) and Wells Fargo & Company (WFC) -- indicate the improved health of the sector, as these two banks command a significant portion of the U.S. banking market.

Results of these two mega banks show that top line still needs to improve for assured strength in performance. In addition to their fundamental strength, the positive developments of the sector and better macroeconomic elements helped most of the business segments of these two banks report improved results. Most importantly, similar to the last couple of quarters, these two banks did not have to majorly depend on accounting tricks to increase their earnings.

Moreover, progress seen in 2012 gives a clear growth indication. Federal Deposit Insurance Corporation (FDIC)-insured commercial banks and savings institutions earned $141.3 billion in the year, up 19.3% from 2011. This is the second-highest level since reporting earnings of $145.2 billion in 2006.

Besides contraction in provisions for credit losses and cost containment, marked recovery in the bond and equity markets and consequent revenue growth helped most of the banks report higher-than-expected earnings. Expanding consumer credit and overall improvement in lending activity made it easy for banks to show steady growth.

In the final quarter of 2012, the industry witnessed substantial improvement with the institutions reporting 36.9% year-over-year growth in earnings to $34.7 billion. This marked the 14th straight quarter of year-over-year earnings increase.

Around 60% of all institutions witnessed year-over-year improvements in net income during the quarter. Also, the share of institutions reporting loss slumped to 14.0% from 20.2% a year ago. Given the solid start by a few mega-banks, the improvement should further gain ground in the first quarter of 2013.

Fewer Bank Failures and Problem Institutions

During the first quarter of 2013, bank failures have almost bottomed out with the failure of only 5 FDIC-insured banks. This is the lowest quarterly tally since the recession started four years ago (only 2 insured institutions failed in the second quarter of 2008). This compares with 8 bank failures in the fourth quarter of 2012.

Moreover, as of Dec 30, 2012, the number of FDIC's "problem institutions" declined from 694 to 651. As the overall sector continues to recover, the list of "problem institutions" is expected to shorten when the FDIC releases the final list for the first quarter of 2013.

Maintaining Profitability Won't Be Easy

We don't expect reduction in provisions for credit losses to significantly help earnings growth in the upcoming quarters as the difference between loss provisions and charge-offs is gradually decreasing.

Banks will definitely try to look at other areas -- interest income, non-interest income and operating costs -- to maintain earnings growth, but there will be limited opportunities given regulatory restrictions and sluggish economic recovery.

Efforts to cut interest expenses and take additional risks to improve net interest margins could be marred by a flattening yield curve. Further, shifting assets to longer maturities for net interest margin strength could backfire once interest rates start rising.

Conversely, increasing revenues through non-interest sources -- prepaid cards, new fees, higher minimum balance requirement on deposit accounts and pushing credit cards -- could be hampered by regulatory actions, economic volatility and soaring overhead. However, with a rebound in capital market activity, the propensity to invest in the market increased, which may lead to more non-interest revenue sources. So, non-interest income can marginally contribute to the total revenue.

Eventually, banks will have to resort to cost containment through job cuts and reduced size of operations to stay afloat. So, any cost-cutting measure will act as a defense. The last four and a half years saw over half a million banking layoffs, and the story continues.

Balance Sheet Improvement to Take Time

Steady deposit growth from lack of low-risk investment opportunities post-financial turmoil is quite possible, but high charge-offs and delinquency rates plus weak demand could keep loan growth under pressure through the remainder of the year. Though banks are easing lending standards to accelerate loan growth, credit quality concerns are likely to mar the effort.

Banks are also trying to address asset-quality troubles by divesting nonperforming assets, but we don't expect balance-sheet strength to return anytime soon.

Basel III: A Major Concern

The implementation of Basel III requirements from this year will boost minimum capital standards. But adjusting liquidity management processes will cause a short-term negative impact on the financials of U.S. banks.

This will ultimately make credit costlier and reduce employment. But a greater capital cushion will help larger banks withstand internal and external shocks over the long run.

Macro Backdrop Still Uncertain

Though improved economic data such as higher consumer spending and gross domestic product (GDP), improving housing market and declining unemployment rate point towards optimism, a paltry interest-rate environment is disturbing.

The European debt crisis should exacerbate the situation. Though U.S. commercial banks appear to have significant direct and indirect exposure to Europe, potential costs are expected to be manageable. But if the crisis continues, worldwide capital markets will face a big blow, and the U.S. will not go unscathed.

OPPORTUNITIES

Though the improving performances by banks seem already priced in and there remain significant concerns, the sector's performance in the upcoming quarters is not expected to disappoint investors.

Specific banks that we like with a Zacks Rank #1 (Strong Buy) include BNC Bancorp (BNCN), Capital City Bank Group Inc. (CCBG), Crescent Financial Bancshares, Inc. (CRFN), SCBT Financial Corporation (SCBT), Columbia Banking System Inc. (COLB), Western Alliance Bancorporation (WAL) and The Bancorp Inc. (TBBK).

Stocks in the U.S. banking universe with a Zacks Rank #2 (Buy) currently include JPMorgan (JPM), State Street Corporation (STT), Regions Financial Corporation (RF), Bank of the Ozarks, Inc. (OZRK), American River Bankshares (AMRB), First Commonwealth Financial Corp. (FCF), Washington Trust Bancorp Inc. (WASH), BOK Financial Corporation (BOKF) and QCR Holdings Inc. (QCRH).

WEAKNESSES

The profitability metrics (like returns on equity and return on assets) are expected to be under pressure. Further, difficulty in liquidity management due to regulatory restrictions will restrict top-line growth.

Specific banks that we don't like with a Zacks Rank #5 (Strong Sell) include Seacoast Banking Corp. of Florida (SBCF), Synovus Financial Corporation (SNV) and Sun Bancorp Inc. (SNBC).
 
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