Missing Boom in Europe Profit Margins Flouts Strategists' Callby
Margins are declining, halting two years of expansion
Most industries see margin drops, led by commodity producers
At the end of last year, strategists predicted that cheap oil and a weak euro would send European profit margins to a five-year high. That didn’t happen.
Dragged down by energy firms and miners, profit margins for companies in the Stoxx Europe 600 Index have slid since last year, halting two years of expansion. Analysts have been slashing their earnings and sales growth projections to keep up. While some industries have posted wider margins, most of them saw declines as the European Central Bank’s unprecedented stimulus didn’t give the push that was expected.
“It’s been one of the most stupefying things this year,” said Pierre-Yves Gauthier, head of strategy at AlphaValue SAS, an equity research firm in Paris. “We’ve had cheap oil, a weaker euro, and yet earnings forecasts have become downgraded.”
The possible culprits, he says, were two-fold: companies were spooked by a potential economic slowdown in China and Brazil; and prices at European gas pumps didn’t fall as fiercely as oil did, meaning consumers were frugal with excess cash. That led to corporate incomes getting crimped, Gauthier said. It is also still unclear, he said, whether ECB stimulus is translating into business activity.
Profit margins, or the ratio of profits versus revenue, for Stoxx 600 companies have slid to 5.5 percent from 6.4 percent at end of last year, according to data compiled by Bloomberg. Analysts estimated they would climb to 7.7 percent at the start of 2015, which would have been the most since 2010.
Of the 19 industry groups in the Stoxx 600, 11 have seen profit margins shrink this year, data compiled by Bloomberg show. Besides commodity companies, retail, telecommunication and utility firms were among those that experienced declines. Domestically focused lenders, health and travel companies saw their margins increase.
As concern grew that the global economy would slow, estimates for 2015 revenue gains by Stoxx 600 companies fell to 3.1 percent from 4.3 percent three months ago. Earnings-growth projections dropped to 4.2 percent from 6.5 percent in August.
One factor that investors monitor to gauge profit margins is salaries, which have been steadily rising. Wage pressure could crimp company margins even more in 2016, according to Peter Garnry, head of equity strategy at Saxo Bank A/S.
Companies have lacked confidence in the economic rebound, making them hesitant to invest, according to Alex Dryden of JPMorgan Asset Management. Capital spending by Stoxx 600 firms shrank by 3.6 percent in the first half of this year, compared with the second of half of 2014, and was 14 percent lower than at its 2008 peak, data compiled by Bloomberg show. The Ifo Eurozone Business Climate Index, which is derived by surveying the sentiment of executives at manufacturing, construction and retail corporations, has fallen for two consecutive quarters.
“This has been one of the most unloved recoveries from a corporate standpoint -- there have been many false dawns,” said Dryden, a global market strategist at JPMorgan Asset. “Companies have held off on making the big investments like a new factory that could boost productivity. You’re not going to make those investments when you’re not sure the recovery has legs to it.”
The Stoxx 600 has lost 8.3 percent since its April peak.
While European profit margins have dropped in 2015, they’ve narrowed the gap relative to their U.S. peers, climbing in September to the highest level compared with Standard & Poor’s 500 Index members in almost four years. S&P 500 margins have tumbled after peaking in December, and analysts estimate earnings and sales will slip in 2015.
“Margins in Europe still look quite reasonable,” said Maya Bhandari, the London-based director for multi-asset at Columbia Threadneedle Investments. “From a global regional perspective, Europe looks relatively good.”
With profit margins for S&P 500 members at 8.3 percent, those at European firms will need to widen to help justify current valuations versus U.S. companies, Saxo Bank’s Garnry said. The Stoxx 600 trades at 15.9 times estimated earnings, up 15 percent since January.
“Revenue growth by European companies is much better than for their U.S. counterparts; now more of that revenue needs to reach the bottom line,” Garnry said. “If we don’t see that profit-margin growth in the fourth quarter, it would be a red flag.”