Yellow Flags on Germany's Prospects

The country's economy has shown signs of slipping. S&P is becoming more cautious on a number of companies, but still likes SAP

From Standard & Poor's Equity Research

It looks as if Europe's strongest economy may be heading for a downturn. The DAX, Germany's blue-chip index, peaked on May 9 just as high hopes of a big boost from World Cup events were making headlines. But new figures released Aug. 10 show that Germany's industrial output unexpectedly declined in June as the tournament played out.

German business confidence has also slipped from a 15-year high. The latest euro-zone survey shows that although current conditions are good, expectations about future conditions have dropped off sharply. Now companies in some industries that call the top euro-zone country home have become more cautious, a sentiment reflected in the outlook by S&P economists, strategists, and equity analysts.

Europe's largest telecommunication company, Deutsche Telekom (DT; ranked 3 STARS, hold) recently reported disappointing quarterly figures. It slashed profit and sales forecasts, which were already revised downward in May, after posting a 14% drop in second-quarter net income on a 2.6% rise in sales.


  The company has been trying to grow market share in other European countries, admitting that its strategy of generating clear growth on the back of increased investments in the German market has reached a limit. "We have to acknowledge the group is no longer growing in Germany," Chief Executive Officer Kai-Uwe Ricke said at a press conference on Aug. 10.

The German market remains the main contributor of consolidated revenues for Deutsche Telekom, representing about two-thirds of total revenues over the last couple of years. Germany, the strongest euro-zone economy, has experienced robust consumer spending and industry consolidation combined with fiscal reforms. That formula had been sustaining earnings growth and higher revenue, and was a catalyst for higher stock prices.

In terms of appreciation, utilities continue to be the best-performing sector among ordinary shares of German stocks since equities peaked May 9. S&P thinks that's due to their defensive appeal in the face of a potential economic slowdown and rising interest rates. Although second-quarter financial results in the utilities sector have been mixed to date, S&P believes investors have overlooked actual earnings growth.


  RWE trimmed its profit estimate earlier this month despite beating forecasts, as uncertainty over German regulation and the price the utility could charge for its water business continued. Last month, Centrica posted a loss on higher energy-producing costs, while SNAM Rete Gas posted a 16% drop in profits due to the Italian energy authority cutting its rate of return.

E.ON (EON; 3 STARS, hold), a utility that trades U.S. Depository Receipts on the New York Stock Exchange, posted an 84% increase in first-half net income, on gains in the Latin American and European markets. S&P forecasts continued gains for the rest of the year.

On Aug. 15, S&P downgraded its opinion to hold from strong buy, saying the uncertainty of Spanish regulators approving E.ON's all-cash offer for power company Endesa (ELE) for about $34.3 billion remains a risk. Still, S&P says the shares are worth holding, with about a 5% dividend yield.


  The future for German companies appears to be in opportunities outside their home turf. The prospect of higher inflation and interest rates, combined with the looming increase in German value added tax in 2007, had been accelerating consumer demand as shoppers sought to avoid higher prices in the future, explains Alec Young, S&P equity market strategist.

Now, however, S&P's European economists expect the third quarter of 2006 to mark the peak of euro-zone growth. The country's July IFO Survey, Germany's version of the U.S. purchasing managers' index, posted its first drop in the last seven months.

In banking, Deutsche Bank (DB; 2 STARS, sell) is not sufficiently diversified, says S&P analyst Derek Chambers, who notes that Germany accounted for 27% of the bank's 2005 revenues. For its second quarter, profits were up 29%, slightly lower than the S&P forecast. Revenues also missed the forecast.


  The acquisition of Berliner Bank's operating businesses, employees, and banking outlets from Landesbank Berlin for a provisional sum of €680.5 million ($860 million) in June gave Deutsche Bank the third-largest branch network in Berlin.

At the time of the latest acquisition, Deutsche Bank's CEO, who has been criticized in the past for not investing enough in Germany, stated, "The purchase of Berliner Bank is an unambiguous signal that we are continuing on our path of successful growth. To this end, it is important we invest and grow in Germany, and particularly in the capital, Berlin."

S&P equity research sees limited opportunity among Germany's information-technology companies. Infineon Technologies (IFX; 3 STARS, hold), a Munich-based semiconductor company, lost more money than expected in its June quarter while revenues rose 23%. S&P expects a return to profitability in the September quarter.


  June-quarter earnings rose at Siemens (SI; 3 STARS, hold), which supplies electronic components to the telecommunications sector, but the higher profits were still below S&P's expectations, while revenue grew 14%. S&P sees 10% minimum sales growth in fiscal year 2007 (ending September).

On the bright side, the world's largest business software maker doesn't rely only on German or European clients for its profits. Well-diversified SAP (SAP; 4 STARS, buy) should report 13% higher revenues for 2006 and a wider gross margin, according to S&P forecasts. In 2007, earnings should rise 15%. The company increased operating earnings by 42% in the second quarter, which was in line with S&P expectations.

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