EUROPE ON SALE / BARRON´S COVER

Barron's Cover

SATURDAY, DECEMBER 22, 2012

Europe on Sale

By JONATHAN BUCK

European stocks could rally as much as 20% in 2013, helped by global growth and cheap valuations. Where to shop, what to buy.

 

Europe's sovereign-debt crisis is far from over, and economies on the periphery of the euro zone remain deeply troubled. Unrest has simmered in Greece and Spain as protesters have railed against government-imposed austerity, while economic growth, the desperately needed cure for the Continent's ills, seems a long way off.

So, is now a good time to buy European stocks? You bet. Despite lingering financial turmoil, doubts about the euro zone's sustainability effectively have been put to rest. European companies are awash in cash, and many are positioned to benefit from growth beyond their borders.



Not least, their shares are cheap, even though the Stoxx Europe 600 index has risen 15% this year, to a recent 280.95. Some investors think they could rally more than 10%, and perhaps as much as 20%, in the coming year.



The Stoxx Europe 600 index trades for 11.5 times 2013 estimated earnings, compared with a price/earnings multiple of 12.5 for the Standard & Poor's 500. European equities have sold at a discount to U.S. stocks since the 1980s, but the gap has widened in recent years because of heightened political and financial risk. Stoxx 600 constituents yield an average of 3.8%, nearly double the 2.2% yield on the S&P, and almost triple the coupon on 10-year German bunds.



This has been a winning year for many European companies. Take fashion retailer Inditex (ticker: ITX.Spain), whose shares have rocketed 67%, spurred by a unique business model that has delivered consistent earnings growth. The parent of the Zara chain trades for 27.5 times next year's expected earnings, which isn't cheap, but its earnings record makes it hard to bet against.



European stocks have done well, in part because companies are in excellent financial health. They took advantage of the recession to clean up their balance sheets, cut costs, trim capital expenditures, and hoard cash. Stoxx Europe 600 components boasted cash and equivalents of 596 billion euros ($790 billion) at the end of 2011, according to ThomsonReuters Eikon. That was up from about €540 billion in 2007. Corporate earnings are forecast to rise between 5% and 10% in 2013, aided by a weaker euro.



THE STOXX EUROPE 600 is dominated by banks, health-care, and industrial companies. Less than a third of index components have net debt, which means Europe's corporate finances are in far better shape than the finances of many European governments.



Shareholders are likely to ratchet up pressure on companies to put their cash to work, which could lead to more capital spending, an increase in merger activity, and more stock buybacks and dividend payments. Stepped-up spending, in turn, could help grease the wheels of Europe's economy.



But financial muscle alone isn't enough to unlock value. "If equity markets in Europe are going to give you a decent return next year, it is going to have to come from multiple expansion," says Dominic Rossi, global chief investment officer for equities at Fidelity.




Price/earnings multiples have improved since the summer, when the European Central Bank took action that finally persuaded investors it had the determination and ammunition to tackle the euro-zone sovereign-debt crisis. ECB President Mario Draghi pledged in July to do "whatever it takes" to save the euro. Those were the words that markets were longing to hear.



Europe's political risk has diminished but hasn't disappeared. Greece's economy is a shambles, but each time the country has gone to the brink of disaster, a face-saving resolution to ease its debt burden has been found. Spain continues to resist a rescue, even though the ECB has drawn up a suitable mechanism to provide support.

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France also is a cause for concern. Credit-rating agencies have stripped the country of its triple-A rating over worries about its competitiveness. The government urgently needs to reduce dependence on public spending. France's troubles are exemplified by the plight of car maker Peugeot (UG.France), which has been strong-armed by the government to keep open factories to preserve jobs, despite overcapacity in the European auto market. Peugeot disclosed earlier this year that it is losing €200 million a month. Its shares have fallen almost 50% in 2012.

 

GERMANY IS EUROPE'S standout economy, an economic engine firing on all cylinders, fueled by demand for exports. Industrial production is strong, and unemployment is low. Frankfurt's blue-chip DAX index is up 29.5% in 2012, the best-performing market in Europe. With no sign of demand for German goods slowing, the shares could have another good year. Chancellor Angela Merkel is almost certain to win a third term in office in September, another plus.




While many European economies stagnate, European companies could benefit in 2013 from accelerated global growth. The global economy is forecast to expand by 3% to 3.5%, driven by a broadening recovery in the U.S. and the resumption of turbocharged growth in China after this year's more sluggish performance. "If we don't get an improvement in the U.S. and Asia, European equities would be much more vulnerable," says Dorothee Deck, European strategist at Absolute Strategy Research in London. Failure by the U.S. to resolve fiscal-cliff issues also would be a blow.



Companies with substantial exposure to international markets, such as luxury-goods maker Richemont (CFR.Switzerland), drug maker Novo Nordisk (NOVO-B.Denmark), and chemicals producer Bayer (BAYN.Germany), all of which generate more than 60% of sales outside Europe, could outperform. They also could get a boost from a weaker euro, which would inflate earnings denominated in other currencies. The common currency could drop 10% in value against the dollar next year on Europe's likely recession.



Some domestically focused plays could do well, too. "On a bottom-up basis, there is still great value out there," says Dean Tenerelli, manager of T. Rowe Price's European Stock Fund in London. His picks include media companies Mediaset España Comunicacion (TL5.Spain) and M6-Metropole Television (MMT.France).



European cyclicals look more attractive than defensive issues, with sectors such as autos and auto parts, and media, likely to benefit from higher profit margins. Luxury goods, too, have promising prospects.



Telecommunications and oil and gas companies could face head winds, however. Opinions are divided on financials, although insurers are expected to outperform banks as bond yields start to rise.



Barron's recently combed the Continent for companies undervalued on a historical basis, with exposure to fast-growing international markets and minimal downside risk. We found 10 that fit these criteria and offer decent dividends that seem stable.




With the exception of Enagás (ENG.Spain), the Spanish utility, all are large-cap stocks. Here's a closer look at our 2013 picks.



Volkswagen (VOW3.Germany), the German auto maker, enjoyed a bumper year in 2012, and 2013 could be a repeat. The shares, which finished on Friday at €171, have rallied 48% since the start of the year, but still trade for only 7.2 times forecast 2013 earnings of €23.87 per share. Rival BMW (BMW.Germany), which also is in high gear, trades for nine times next year's estimates.

Volkswagen shares could advance at least 20% in the next 12 months, as demand for new cars is boosted by a broadening economic recovery in the U.S. and more growth in China. The company's global footprint helps mitigate the impact of a weak European market.

Volkswagen has 12.6% of the global auto market, selling one of every eight new cars, and its share is growing. Sales are forecast to top €200 billion in 2013. With a stable of brands including Lamborghini, Audi, and Skoda, Volkswagen is exposed to the more profitable premium-car sector, and trucks. Operating profit margins will slip this year due to write-downs related to the purchases of Porsche and truck maker MAN, but the company's scale gives it leverage to improve profitability in 2013.



Don't write off BMW, either. Since Barron's wrote a positive piece on the shares in the fall (see European Trader, Oct. 29), they have risen 19%, and could add 15% next year.



European Aeronautic Defence & Space (EAD.France) scared investors this year with its aborted attempt to merge with BAE Systems (BA.U.K.). But rich rewards could be on the horizon. Its Airbus unit has a huge backlog of orders, and EADS plans to remodel its governance and ownership structure in the first half of 2013, reducing the influence of the French and German governments. The stock's public float will increase to about 70% from a current 50%.



The company also plans to buy back up to 15% of its shares at a cost of about €3.35 billion, which can be funded from its cash pile of more than €11 billion. If the buyback were to take place before year end, 2013 estimated earnings per share would be enhanced by 15%, and 2014 earnings, by 16%, according to analysts at Société Générale. The bank has a price target of €38.



EADS shares closed on Friday at €29.99. The stock trades for 11.4 times forecast 2013 earnings of €2.62 a share, well below Boeing's (BA) P/E of 15.



Rio Tinto (RIO) is poised to benefit from China's increased appetite for natural resources, as its economy reaccelerates in the first half of 2013. With new Chinese leadership in place, stimulus measures could boost demand for iron ore, a key ingredient in the production of steel.
 

 

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In addition, the Anglo-Australian miner is on track to bring into production Mongolia's Oyu Tolgoi mine, which is expected to produce 450,000 metric tons (496,040 U.S. tons) of copper and 330,000 ounces of gold annually. Cost cuts and the finalization of asset sales in 2014 will help offset capital expenditures and aid free cash flow.



Rio Tinto is forecast to earn 3.44 pounds ($5.56) per share in 2013, up from an estimated £3.03 in 2012. At Friday's $56.54, the American depositary receipts trade for 10.2 times forward earnings, cheap versus rivals BHP Billiton (BLT.U.K.) and Anglo American (AAL.U.K). In the next 12 months, Rio Tinto's shares easily could add 20% in value.



Roche Holding (ROG.Switzerland) can outperform peers in 2013 as investor focus shifts to new products and away from macroeconomic troubles. The pharmaceutical company had positive results in 11 of 14 late-stage clinical drug trials this year. It also brought several new products to market, including Zelboraf and Erivedge, for skin cancer, and Perjeta, which strengthens its portfolio of breast-cancer medicines. Roche has a young product portfolio and the lowest patent-expiry risk among leading drug concerns, which augurs well for future growth. Nor is competition from biosimilars solidifying as quickly as expected.



Roche closed on Friday at 186.60 Swiss francs ($203.42). The stock trades for 12.4 times future earnings, below the sector average of more than 13 times. Roche is expected to earn CHF15.08 per share in 2013, up from a forecast CHF13.57 in 2012. Sales next year will be just shy of CHF48 billion.



Roche yields 3.6%, but analysts anticipate a special dividend in the next few years. The company, which paid specials in the past, is expected to move from a position of net debt to net cash in 2015. Credit Suisse rates the stock at Outperform with a price target of CHF223.



WPP (WPP.U.K.), the advertising and marketing giant, is growing steadily due to its geographic exposure and presence in digital channels. In the first nine months of 2012, revenue from digital businesses was up more than 7% year-to-year. Digital advertising is growing rapidly in mature markets such as North America, where more traditional forms of advertising are declining.

 

WPP, whose brands include Grey, JWT, and Ogilvy & Mather, also has market-leading positions in China and India. The company could earn 78 pence per share in 2013 on forecast revenue of £10.75 billion. Its shares, which closed on Friday at £8.90, trade for 11.4 times forecast earnings for 2013, well below a historical average of 15 to 16 times earnings.



The advertising industry traditionally has grown through acquisitions, but consolidation looks to be slowing. That is freeing up more money for dividends and share buybacks.



"This is a high-quality business with high returns and good growth prospects, trading [at an] attractive valuation compared to the long-term history and the potential of the business model," says Matthew Siddle, who manages the Fidelity European Growth Fund and owns shares. Bernstein Research rates WPP Outperform, with a price target of £10.50.



LVMH Moët Hennessy Louis Vuitton (MC.France) is a smart play on burgeoning demand for luxury goods. The industry has shown resilience in a difficult environment, and could continue to do well if the economic recovery in the U.S. broadens and fast-paced growth in China continues.



Through the first nine months of 2012, LVMH reported 22% growth in sales, including 10% organic growth, due to strength in Europe and Asia, and a pickup in the U.S. Its sought-after brands include Louis Vuitton, Donna Karan, Bulgari, Christian Dior, and TAG Heuer.



Sales are expected to reach €27.93 billion in 2012, up from €23.66 billion in 2011. Operating profit could approach €6 billion, and free cash flow, almost €3 billion.



LVMH shares ended last week at €140 and trade for 17.6 times forecast 2013 earnings of €7.97 per share. That multiple is in line with rivals like Richemont, which owns Cartier. LVMH yields 2.1%, having hiked its payout last year. Analysts at Nomura think shares could rally to €165.



Deutsche Post (DPW.Germany) could rack up substantial gains in the next 12 months due to the performance of its DHL parcel-delivery unit, the company's key profit driver. DHL controls more than a third of the Asia-Pacific market, where its revenue is growing at a double-digit pace. Progress was bumpy in the third quarter, but could be back on track in 2013, fueled by growth in China and the U.S. DHL also has a strong foothold in the logistics market in Europe and the Americas.




The company's mail business in Germany continues to generate healthy profits, despite declining volume. The shares, which closed on Friday at €16.62, trade for 12 times forecast 2013 earnings of €1.39 a share, up from an estimated €1.28 this year.



Competitors, meanwhile, have their hands full: Fedex (FDX) is restructuring its express operations, and United Parcel Service (UPS) is trying to complete the drawn-out purchase of Dutch rival TNT Express (TNT.Netherlands). Deutsche Post's stock could hit €20 in the next 12 months. The company yields 4.2%, another reason it could deliver for investors.



Vivendi (VIV.France): A strategic review of Vivendi's operations could unlock value in the next few quarters. The French media and telecommunications giant likely will sell Maroc Telecom, the Moroccan incumbent, or GVT, the alternative telecom operator in Brazil. GVT would fetch more -- up to an estimated €8 billion.



Proceeds could go toward reducing debt and buying back shares. A €4.4 billion buyback at €18 a share would make the stock worth €19.70 per share, according to Credit Suisse, which rates Vivendi Outperform with a €19.10 price target.



Vivendi is trading for €17.01, or 8.6 times forecast 2013 earnings of €1.98 per share, in line with rival Bouygues (EN.France) but more expensive than France Telecom (FTE.France). However, Vivendi, which owns French telecom SFR, has other business lines. It owns a large stake in Activision Blizzard (ATVI), which has launched some of the top-selling games in North America and Europe.



Its Universal Music Group is releasing albums from artists such as the Rolling Stones and Rihanna. Even if a share buyback doesn't materialize, Vivendi still offers good value after underperforming in 2012. Its 5.7% dividend looks secure.



AXA (CS.France) shares have climbed 33% in 2012, to €13.37, but at 6.8 times next year's expected earnings, they still look cheap. The large insurer is expected to earn €1.98 per share in 2013, up from an estimated €1.84 in 2012. Shares could rise to €16 or more in the next 12 months if the company can deliver on its strategy to be more selective about opportunities in mature markets.



AXA is looking to expand its more profitable life-protection business at the expense of traditional savings products, and is concentrating on margin instead of volume in property and casualty.



Operating in unfavorable markets has hurt its financial performance, but it looks to be better positioned now. Among insurance peers, AXA also offers the best dividend yield at more than 5%.



Enagás (ENG.Spain): There is nothing sexy about this Spanish gas utility, which generates just about all of its earnings domestically. Yet, despite the country's financial straits, Enagás profits rose 3.9% in the first nine months of 2012. Sales are expected to rise to €1.3 billion in 2013 from €1.2 billion this year. The company had €3.42 billion of debt as of Sept. 30, but its credit rating is higher than Spain's sovereign rating. Shares, at €16.20, trade for under 10 times forecast 2013 earnings of €1.67 per share. Enagás, which has a market value of €3.87 billion, offers a dividend yield of about 5%.



T. Rowe Price's Tenerelli says Enagás' business isn't economically sensitive. He reckons the stock could trade for 11 to 12 times future earnings, and be worth just shy of €20.



EUROPEAN POLITICS and poor economic news have unfairly depressed the prices and P/Es of some of the Continent's best companies. As Jim Moffett, chief international strategist at Scout Investments, says, "We are looking for good companies in bad places."





Europe obliges on both counts.



 

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