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RWE – Recovery Postponed, Indefinitely?

RWE has warned earnings will not as expected bottom out in 2015. It will also struggle with its debt target. The announced strategic moves are not enough short term relief. Political risk is high with major pieces of legislation in a controversial debate, namely capacity markets and climate legislation. RWE is the most exposed within the peer group. As power markets in Europe get taken over by new structures, volatility and earnings risk, energy system infrastructure is a better investment proposition. RWE’s ( OTCPK:RWEOY ) earnings warning weighs stronger short term than its strategic moves. The company will continue to struggle with weak commodities and high leverage in 2015, despite the DEA sale. It may embark onto some rescuing of value through power plant sales, but it does not have the potential to deliver a similar strategic boost to E.ON. RWE is at the heat of the political storm that still has high potential to deliver more unpleasant surprises. Infrastructure and the private sector, conversely, might be beneficiaries. There are signs that private investors with longer strategic horizon are circling around distressed assets. They will gain a more important part in a decentralized energy market. Asset rotation will be a feature. My view of increasing M&A activity remains underpinned. RWE is not out of the woods yet; investors who were hoping for earnings stabilization as indicated by the company in April 2014 may be disappointed. Management has warned on earnings , saying that the earnings trough may not occur in 2015 yet. Consensus has not bottomed out for 2015 yet and it may still come down. Power prices are the unsurprising cause of the problem. Futures are pointing nowhere to a meaningful enough recovery, and the broader commodities environment is not any more supportive. RWE more than any of its peers, needs significant commodity recovery. In tandem with the above comes relentless balance sheet stress. I find little chance of material decrease of leverage. The Urenco sale will not come through short term. The CEO has further confirmed that leverage falling to 3x net debt/Ebitda by 2016 will be “extremely difficult to achieve”. I estimate just short of 4x for 2016. Attention will swiftly return to risk to the dividend. RWE may rescue some value through selling its power stations that are unprofitable abroad as announced this week. That is clearly a strategy to mitigate cash losses. It would bring minor debt reduction. Some of the company’s plant is new and competitive technology. The bulk of the RWE’s mothballing and closure programme is less than 20 years old, some plants are not even three years from commissioning. That concerns particularly gas. It is sensible that management looks to maximise value of otherwise potentially stranded assets. But, a power plant cannot be displaced and sold into another location like other capital assets. High quality and well performing equipment may still find a market value in locations with tighter reserve margins and new build demand. The CEE region comes to mind. There is also an active secondary plant market also in Asia. There will clearly be a loss of value for RWE. Investors should not hold up high hopes of significant earnings contributions from the process. Signaling power to the political powers may be stronger than actual earnings impact. Infrastructure investors have begun to look at power generation with a view of power price recovery over the long term. The prospect for capacity payments may underpin that kind of activity. Germany is uncertain on that note, but plenty of European countries putting into place capacity markets could keep M&A activity up. All of RWE’s strategic moves could in the end amount to a similar outcome to E.ON’s corporate split. The company has been vocal about reducing the share of generation to 5% of earnings. Most recently, the CFO has now said it no longer rules out a similar move even though management decided against it in 2012. RWE is in a different situation to E.ON ( OTCQX:EONGY ), in that it cannot bring as diversified a generation park into any potential new co. Merging renewables into a “genco” may remedy to a point. But in that case management would have to have a clear strategy about how it would pursue downstream brand equity and service/product packing for which renewables exposure is important. A split co will also not have the same upstream and oil and gas diversification as E.ON. That would make a genco or “upstreamco” resemble much more of a bad bank than in the case of E.ON. Importantly, it would in my view have to raise capital in order to fund the nuclear liabilities that the genco would inherit. RWE might embark onto greater strategic change beyond its already announced transformational steps. That would be a positive. But with the chances increasing that more steps are taken, so does the probability of a capital increase. I see significant potential for large parts of RWE’s business going private. Meanwhile, the debate over capacity payments rages on. The Economy Minister’s has again repeated he is opposed to capacity payments , which is out of line with market expectations. The political debate bears high potential for disappointment. My preferred exposure in all of this is infrastructure, engineering and market backbone. Editor’s Note: This article discusses one or more securities that do not trade on a major exchange. Please be aware of the risks associated with these stocks.

Tech ETFs With Global Footprints At Risk

The U.S. dollar continues to appreciate against other overseas currencies. Large-cap companies with heavy overseas exposure could see revenue slow due to currency risks. Tech sector at risk of overseas exposure. As foreign central banks enact loose monetary policies, a strong U.S. dollar will negatively affect prominent technology stocks, along with related-sector exchange traded funds, that have significant overseas exposure. The Technology Select Sector SPDR ETF (NYSEARCA: XLK ) has been outperforming the broader markets, but a strong dollar could crimp the sector’s performance. XLK has declined 1.5% year-to-date and increased 16.0% over the past year. Meanwhile, the S&P 500 has dipped 1.7% year-to-date and risen 12.3% over the past year. A “strong dollar is negative for any company with significant overseas business,” James Kelleher, director of research at Argus, said in a CNBC article. “Companies like IBM and HP can’t totally avoid a currency headwind at the cost of being a global company.” According to Kensho quantitative analytic data, when the U.S. dollar appreciated 5% or more over 60 trading days on 10 separate occasions since January 1, 2005, tech companies were among the worst performers over the following three months. For instance, Hewlett-Packard (NYSE: HPQ ) traded in the red 70% of the time, with a negative median return of 4.51%. Intel (NASDAQ: INTC ) traded negative 70% of the time, with a median return of 2.97%. Adobe (NASDAQ: ADBE ) was negative 60% of the time, with a median negative return of 5.19%. IBM Corp. (NYSE: IBM ) also blamed the strong currency Tuesday for erasing any chance of a revenue increase this year, following its earnings report. XLK includes a 3.8% tilt toward INTC, 3.7% in IBM, 1.5% in HPQ and 0.9% in ADBE. Semiconductor ETFs, like the Market Vectors Semiconductor ETF (NYSEARCA: SMH ) and iShares PHLX SOX Semiconductor Sector Index ETF (NASDAQ: SOXX ) , also have significant exposure to INTC, which makes up 19.8% of SMH and 8.0% of SOXX. Additionally, the increasingly popular tech dividend ETF, First Trust NASDAQ Technology Dividend Index ETF (NASDAQ: TDIV ) , holds large positions in these large and stable tech names, including INTC 8.0%, IBM 8.0% and HPQ 3.0%. FX headwinds were “really the difference between growing pretax income and not growing pretax income in the fourth quarter for us,” CFO Martin J. Schroeter said. “Now, in this currency environment, and with the divestitures we’ve completed, our total revenue as reported will not grow in 2015.” An appreciating U.S. dollar makes U.S. products relatively more expensive in overseas markets. Sales in foreign currencies will translate to a lower U.S. dollar-denominated return in a strong U.S. dollar, or weak overseas currency, environment. Fueling the continued strength in the U.S. dollar, major central banks have been implementing loose monetary policies and enacting quantitative easing. For instance, all eyes were on the eurozone as the European Central Bank contemplated a Federal Reserve-styled bond purchasing program. “Policy diversion is driving this rally,” Win Thin, global head of emerging markets at Brown Brothers Harriman, said in the CNBC article. “The divergence is U.S. raising rates and the ECB, BOJ expected to do more easing, which typically weighs on a currency. Everyone’s very bullish on the dollar. The fundamental backdrop still favors the dollar.”

Is Retail In Retreat?

By Robert Goldsborough As fourth-quarter earnings reports have started coming across the wire, several themes already have begun emerging. One of the biggest themes, however, has been not company-specific, but rather a government report showing surprisingly weak retail sales numbers for December and a downward revision for November’s numbers. According to United States Commerce Department data, retail sales fell nearly 1% in December on a month-to-month basis (and were down fully 1% month-to-month excluding autos), while consumer core sales (retail sales less autos, gasoline, building materials, and food services) were down 0.4% month-to-month. The news surprised both the markets and economists, who had forecast basically flat retail sales in aggregate and a 0.4% rise in consumer core sales on a month-to-month basis. And it indicated that consumers enjoying lower gasoline prices did not take that extra cash in their pockets and spend it at other retailers. Some economists contend that the retail weakness simply is a matter of the calendar and timing differences involved in making seasonal adjustments to economic data. By other measures, they suggest, such as the Federal Reserve’s Beige Book or the National Retail Federation’s data, retail spending is solid. My colleague Robert Johnson, Morningstar’s director of economic analysis, acknowledges that on a headline basis, the retail sales numbers didn’t look great, but he notes that on a year-over-year basis, retail sales growth continues to be strong, exceeding 4% on a nominal basis and growing close to 3.5% on an inflation-adjusted basis. Going forward, he doesn’t see dramatic improvement ahead in retail sales, but he does anticipate generally solid data. Although the retail sector has outperformed the broader market over the past few months, the most recent news in the retail space has pressured the share prices of many retailers a bit. For investors who see this as a buying opportunity in a generally well-valued broader market, there are several exchange-traded funds that investors can consider. An Overview of Retail ETFs There are three passively managed, unleveraged ETFs devoted to the retail industry: SPDR S&P Retail ETF (NYSEARCA: XRT ) , Market Vectors Retail ETF (NYSEARCA: RTH ) , and PowerShares Dynamic Retail ETF (NYSEARCA: PMR ) . Easily the largest and most liquid retail ETF, XRT also offers broad exposure, tracking an equally weighted index of 102 U.S. retail firms. Because XRT’s index is equally weighted, heavyweights like Wal-Mart (NYSE: WMT ) sit shoulder to shoulder in the fund with relative pipsqueaks like women’s fashion specialty retailer Cato Corp. (NYSE: CATO ) . As a result, large-cap companies make up just 15% of assets, while mid-cap firms comprise 30.5% of the fund. Small- and micro-cap companies make up 35.5% and 16% of assets, respectively. XRT holds both defensive retailers, such as Wal-Mart, Costco (NASDAQ: COST ) , and Walgreens Boots Alliance (NASDAQ: WBA ) , and nondefensive retailers, such as specialty retailers and apparel stores. XRT also holds Amazon (NASDAQ: AMZN ) , but it does not hold home-improvement retailers such as Home Depot (NYSE: HD ) and Lowe’s (NYSE: LOW ) . The fund’s 0.35% price tag is appealing, but given the exposure to smaller firms, would-be investors should expect higher beta exposure relative to a more traditional, market-cap-weighted ETF that tilts toward larger firms. RTH tracks a market-cap-weighted benchmark of 25 retail companies. That means that the largest firms, such as Wal-Mart, CVS Health (NYSE: CVS ) , Amazon, and Walgreens Boots Alliance, hold the most sway. RTH is devoted almost entirely to large-cap names, with mega-cap retailers making up 35% of the fund and large-cap companies comprising another 59% of assets. Unlike XRT, RTH holds home-improvement retailers, which gives the fund more exposure to the housing market than XRT. RTH charges 0.35%. Finally, PMR is a small, thinly traded strategic beta ETF that tracks an enhanced index of 30 retailers. The index evaluates firms based on price momentum, earnings momentum, quality, and value, among other factors. The index rebalances and reconstitutes quarterly, ensuring higher turnover. In addition, PMR has a pronounced small-cap tilt, devoting almost 27% of assets to small-cap firms, 11% to micro-cap companies, and another 21.5% to mid-cap retailers. PMR’s performance has lagged that of RTH in the trailing one- and three-year periods ending Jan. 16, 2015 (RTH has not traded for five years), and while it has nicely outperformed XRT in the trailing one-year period, it’s underperformed XRT in the trailing three- and five-year periods. It’s not clear whether investors can count on outperformance from this fund going forward. PMR charges a relatively high expense ratio of 0.63%. What the Economic Outlook for 2015 Means for Retail ETFs In general, Morningstar’s analysts anticipate a healthier and stronger U.S. consumer in 2015 and beyond, which portends well for retail ETFs. A strengthening consumer in particular would favor ETFs with small- and mid-cap tilts, as they hold fewer defensive names and more discretionary, higher-beta firms. So that dynamic could make XRT and PMR more appealing options. At the same time, investors should pay close attention to some retail trends that are less favorable for smaller players. Some of these include the need for retailers to have both a brick-and-mortar business and an e-commerce presence–a requirement that in general requires firms to be larger and have more scale–and a broader trend of the millennial generation spending less money on high-priced items found at specialty retailers offering apparel or luxury goods and instead spending more on experiential items and more expensive places to live. Although any generational shift plays out over a much longer-term time horizon, it’s worth watching closely. E-Commerce Growth Continuing Unabated In addition to disappointing December results, traditional bricks-and-mortar retailers continue to face challenges from online shopping. Many traditional retailers have struggled to keep up with Amazon’s strong fulfillment capabilities and price competition. Although Amazon continues to grow and take share from traditional retailers, it also has problems of its own, as it continues to search for ways to grow its business profitably. In the first few weeks of 2015, the firm’s share price is down sharply. Over the longer term, we have some concerns about smaller retailers’ ability to compete with Amazon from a fulfillment standpoint. Morningstar’s equity analysts note that a variety of retailers have increased their emphasis on logistics and delivery speeds, but even so, only a few retailers at this time can match Amazon’s capacity and geographic reach. The transition to e-commerce is continuing slowly for bricks-and-mortar retailers, as many of their fulfillment centers were not designed for e-commerce. For investors, what this means is that smaller-cap retail names–which are found more in XRT and PMR–may well find themselves more susceptible to the growth in online shopping. So while broader macroeconomic trends–a stronger consumer with more disposable income–could benefit those funds, e-commerce growth could come at the expense of some, if not many, of the smaller firms in those ETFs. Other Options Because retail makes up a large chunk of the consumer discretionary industry, investors seeking broad exposure to the retail space also could consider a consumer discretionary ETF. Consumer Discretionary Select Sector SPDR (NYSEARCA: XLY ) , which charges 0.16% and holds about 85 companies, is a large and liquid fund that devotes about one third of its assets to retailers. Similarly, Vanguard Consumer Discretionary ETF (NYSEARCA: VCR ) costs just 0.12%, holds a broader portfolio of 382 firms, and also invests about a third of its assets in retail firms. Investors interested in ETFs with meaningful exposures to Amazon can consider one of two Internet ETFs, both of which devote between 7% and 8% of assets to Amazon: First Trust Dow Jones Internet (NYSEARCA: FDN ) (0.60% expense ratio) and PowerShares NASDAQ Internet (NASDAQ: PNQI ) (0.60% expense ratio). Internet and catalog retailers like Amazon make up between 20% and 25% of the assets of each ETF. Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.