Submitted by Peter Garnry of Saxo Bank
Summary: Netflix delivered its first positive free cash flow quarter but the Q2 guidance on net additions of subscribers was disappointing suggesting less positive impact on Netflix relative to the existing trajectory before the COVID-19 outbreak. The oil price collapse due to the lack of storage will cause bankruptcies and loan losses on energy loans and thus Q2 loan losses will be severe. We take a look at European banks and also highlight the banks with the highest exposure to the oil industry. Finally we present a fair value model on STOXX 50 based on dividend futures which shows that European equities have a potential 35% downside risk.
Yesterday we had one the worst equity sessions in several weeks as the oil market collapse likely caused some margin calls hitting several markets. Italian government bonds (BTPs) traded lower increasing the likelihood of a heated EUCO meeting tomorrow where Italy will once again push for joint euro bonds. The probability for a new severe euro area crisis is going up and BTPs (10YBTPJUN20) should be on anyone’s watchlist. While equities have stabilised a bit here in early European trading the nervousness has increased also evidenced by the moved yesterday in the VIX curve.
Last night after the close Netflix reported what was initially perceived as a good result but at later inspection it turned out to be disappointing on the guidance. Netflix reported its first positive free cash flow in Q1 as growth in expenses in content assets slowed dramatically. While the global subscriber base rose by 15.8mn the y/y growth was only 22.8% in line with previous quarters and the company guides with only 7.5mn new subscribers in Q2 which is outright disappointing given the share price developments leading up to the earnings release.
The majority of the net new subscribers came from EMEA and APAC showing that the US market is saturated for Netflix, even in a lockdown environment. With operating margins around 17-18% this source will also provide less tailwind going forward at it’s closer now to Disney’s and in general the competition is heating up from Amazon, Apple and Disney. With Netflix valuation still elevated at 1% FY23 forward free cash flow yield the company is priced for perfection and the only certain thing in investing is that high valuation on average compresses future returns.
Last week showed higher provisions for loan losses among US banks and this week the first European banks will report earnings. Today Svenska Handelsbanken reported a jump in credit losses to SEK 538mn SEK from SEK 288mn a year ago. Loan losses tend to go up over time as higher loan portfolios increases the provisions for loan losses which flows to the loan loss reserves. But Handelsbanken reported that SEK 400mn in additional provision requirements for expected credit losses. This is the direct impact from COVID-19 beyond what was set aside during normal times. The amount is still small and Handelsbanken is one of the best banks in Europe, but the loan loss reserve ratio is currently set to 0.2% against the peak of 0.21% in 2009. Given this crisis could become deeper, and especially for Sweden relative to the financial crisis of 2008, and thus a loan loss shock could come to Swedish banks.
Also today UniCredit reported €900mn in extra reserves as the bank is preparing for losses due to the extraordinary decline in economic activity from the lockdowns in Europe. Besides the general impact from the COVID-19 on loans the recent oil price collapse will have a significant impact on loans to the energy sector and according to Bloomberg the European banks with the highest exposure to oil companies are Natixis, Credit Agricole and DNB. European banks are flirting with the lows from March and our worry is whether the European banking sector is strong enough to weather the recession from COVID-19.
Clients have asked us to extend our dividend futures model on S&P 500 to European equities. Today we ran the model on STOXX 50 and we were a bit shocked about the result. STOXX 50 dividend futures for Dec 2021 trade future dividends at €64 against current dividends of €122.46. An almost 50% decline in dividends by 2021 and even more depressing the European dividend futures curve does not price in a rebound to the peak, so compressed profitability for many years.
Using the same methodology of historic dividend yields, earnings yields and payout ratios we can estimate the fair value of the STOXX 50 Index of the dividend futures. As the chart shows the current price in the STOXX 50 is significantly above the median (dotted line) and the mean at €1,800. In fact the fair value is 35% below the current price. Obviously the discrepancy could be a combination of both too positive sentiment in European equities and a mispricing in dividend futures. Nevertheless, it reinforces our negative on equities. Based on these number the STOXX 50 is valued at a 2.2% dividend yield against the average of 3.8% since 2004. Typically we observe a lower dividend yield when the economy is healthy and growing strongly.