* Margins a fifth below 10-year average, in contrast to U.S.
* Rising PMIs signal profitability recovery into next year
* Spain, Italy, banks, retailers to benefit
By Toni Vorobyova
LONDON, Sept 13 Two years of falling
profitability are nearing an end in Europe and companies'
margins will track a rebound in purchasing managers' indices,
data analysis suggests, sustaining the equity market rally.
The euro zone's recovery from recession should ease pressure
on companies - from banks to retailers - to cut prices to keep
customers, or to eat up revenues with provisions.
Over the past decade, corporate margin moves have lagged the
euro zone economy by around 10 to 18 months, pointing to an
imminent recovery in profitability given that the region's
composite PMIs started to move higher around a year ago and now
signal expansion in activity. (r.reuters.com/vat92v)
That, in turn, should give equity markets fresh momentum to
continue a rally so far driven largely by central bank stimulus.
Calculating an aggregate for global growth, weighted by how
much revenue European companies earn in each region, Morgan
Stanley models predict next year's economic outlook should
enable margins to recover.
"Our own margin lead indicator is suggesting that 2014 will
be the first year of margin expansion in Europe for three years
- next year we could see a 25 basis point expansion," said
Graham Secker, equity strategist at Morgan Stanley.
"The top line is improving, margins are going to pick up.
Broadly, if we think earnings are going to go up 9 percent next
year, then the market can go up 9 percent next year."
Exane BNP Paribas' margin indicator is also moving into
positive territory while JP Morgan research suggests margin
expansion starts once real gross domestic product growth reaches
1 percent, which they expect in the final quarter of 2013.
Consensus analyst forecasts also point to higher margins,
with European earnings seen rising 14.3 percent next year even
as revenues increase only 3.6 percent, according to StarMine.
Historically, a pick up in margins has been accompanied by
continued share price gains. For example, in 2009, margins
lagged the equity market pick up by around nine months, but
stocks then continued the broad upward trend, adding a further
10 percent in the following year. (r.reuters.com/tat92v)
Overall, at around 4.9 percent, net margins in Europe are
running around a fifth below their 10-year average, according to
Datastream, with the economies hardest hit by the euro debt
crisis - such as Italy and Spain - showing the biggest gaps. In
contrast, in the United States, profitability is already above
its historic average. (r.reuters.com/sat92v)
"In Europe, up to this point, whatever earnings growth you
have seen has been driven by cost cutting. Going forward you've
got a combination of the top line driving earnings and the
margin effect," said Graham Bishop, strategist at Exane BNP
Margins should be helped by still low interest rates and
subdued labour costs against a recovery in demand.
Companies which have fixed assets can thus increase sales
while keeping costs relatively stable - retailers selling more
goods from the same number of shops with the same number of
staff, or manufacturers producing more from the same factories.
"Retail is the purest (margins) play," said Exane's Bishop.
On an individual stock level, though, Exane recommends
screening for companies with high staffing costs and below
average margins, including airport shop operator Autogrill
and holiday lets firm Pierre & Vacances.
The sectors with the lowest margins relative to history are
banks, basic resources, technology, oil and gas
, and travel and leisure and utilities.
However, investors must also consider issues such as
regulation and politics capping utilities' pricing power.
"Sector dynamics can change from one cycle to the next and
the next cycle looks more structurally challenged for basic
resources, oil and gas and utilities," analysts at S&P Capital
IQ said in a note, rating those sectors 'underweight'.
Among those left, banks combine still relatively low
profitability with fixed assets, a high exposure to the economic
cycle and cheap valuations.
"For investors who believe the macro environment is
improving and you are going to get margin expansion next year,
the bigger picture story is to buy financials in the UK and
Europe," said Secker at Morgan Stanley.
"They are one of the very few value sectors where return on
equity and profitability are low, and should rise."
(Additional Reporting by Atul Prakash; Editing by Ruth