* 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 (Reuters) - 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 Paribas.
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 Pitchford)