Battered European energy stocks ripe for rebound

Fri Jan 24, 2014 6:53am EST

* Shares in oil majors left out of Europe's two-year rally

* Sector trades at a record price-to-book discount

* Sector may be past low point of investor pessimism -HSBC

* Trimmed capex, stronger cash flows, payouts to spur rebound

* Sector offers 4.5 pct dividend yield vs market's 3.2 pct

By Blaise Robinson and Atul Prakash

PARIS/LONDON, Jan 24 (Reuters) - Europe's energy stocks, shunned by investors for two years because of jitters over dividends and oil prices, are poised for a revival as companies start to cut investments and generate more cash.

The sector - trading at a record discount to the broad market even though it offers hefty payouts - is also set to benefit from rising prospects of an acceleration in global growth, which should support oil prices and boost profits.

That has prompted a growing number of asset managers, such as ING IM and Societe Generale Private Banking, to highlight energy stocks among their top picks for this year.

Shares of oil majors Royal Dutch Shell, BP, Total and ENI have barely budged in the past two years, falling behind a 36 percent surge in the broad MSCI Europe index due to worries over costly projects that have eaten into cash flows and threatened dividends.

In recent months, however, investors have been putting pressure on the oil firms to return more cash to shareholders and several major companies have started to respond positively, setting the scene for a rebound in the shares.

"Capital expenditure is going to start to tail off and as a result, you'll see a pick-up in the free cash flow. That's positive for potential returns to shareholders," HSBC equity strategist Robert Parkes said.

"You need a catalyst and we've got one in terms of improving cash profiles. Energy remains deeply out of favour among large international funds, but we are now starting to see some buying interest. This suggests that we may well be past the low point in terms of investor pessimism on the sector."

BP's shares have risen 9 percent since it raised its dividend, cut capital spending plans and ramped up its asset sales target in late October.

In a similar tone, France's Total boosted expectations of higher payouts after announcing a "soft landing" in capital expenditure to cut costs and generate greater cash flow. Its stock is up 8 percent since mid-December.

Shell, which has been seen as the least responsive to these shareholder demands, also seems to be listening and has promised that spending will be lower in future years.

"Capex was too ambitious in the oil patch lately, but companies are getting much more disciplined now," said Nicolas Simar, fund manager and head of the equity value team at ING IM, which manages 176 billion euros ($238 billion).

"The sector's discount to the broad market is set to disappear," said Simar, whose ING Euro High Dividend portfolio is 'overweight' energy stocks.

Chart on valuation ratios: link.reuters.com/tav26v

Chart on dividend yields: link.reuters.com/hed36v

RECORD DISCOUNT

Investors have shunned the sector so much in the past two years that it trades at a record discount to the market in terms of price-to-book and is the cheapest in a decade on price-to-earnings, offering a rare spot of value among European equities.

"When you look at their relative valuation levels versus the broad market, the oil sector trades at a near 10-year low," said Claudia Panseri, head of Societe Generale Private Banking, with 84 billion euros ($114 billion) in assets under management.

"The cheap valuation ratios in the sector, as well as attractive dividends which now look safer, should fuel a rebound. We're buyers of the energy sector," said Panseri, who has the oil and gas sector on her 'conviction list' for 2014.

The MSCI Europe energy index trades at 10.2 times expected earnings in the next 12 months, well below its 20-year average of 13.1 times, and representing a 25 percent discount to the broad MSCI Europe index.

The beaten-down sector looks even cheaper when looking at price-to-book ratios. It trades at 1.33 times book value, sharply below a 20-year average of 2.38 and still near a low of 1.17 hit last July, the lowest price-to-book ratio recorded since MSCI started to track the sector in 1995.

Relative to the broad market, the energy sector trades at a record discount of 27 percent in terms of price-to-book.

Even when looking at cash flows - which has been a sore point for the sector - energy stocks trade at 5.3 times cash flows expected in the next 12 months, among the lowest ratios for European sectors, according to Thomson Reuters Starmine.

With improving cash flows, fund managers said worries over the sustainability of payout ratios are fading, and yield hunters will soon rush into energy shares again.

The sector offers a lofty dividend yield of 4.5 percent, well above the broad market's 3.2 percent and about 240 basis points above German 10-year Bund yields.

"Earnings look set to improve, valuations and dividends are attractive and many companies are in good financial health," said James Butterfill, global equity strategist at Coutts, who is bullish on the sector. (Editing by Catherine Evans)

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