FRANKFURT (Reuters) - European companies in industries with low growth prospects such as airlines, retailers and utilities are set to seek more cost cuts to sustain profits and reassure investors in the absence of a strong economic recovery.
They will have to walk a fine line between making further savings and damaging their businesses by cutting too deeply, having already slashed expenditure during the downturn last year.
But many will not have any choice.
While equity strategists predict European share prices will rise this year the index for Europe’s 50 biggest stocks .STOXXE is so far down more than 9 percent this year while the Stoxx Europe 600 index is down 3.5 percent and indicators show increasing risks to the positive outlook.
Valuations of companies have dropped as if an economic downturn was imminent, Thomas Teetz, equity strategist at HSBC said, and companies will have to attend to that greater nervousness amongst investors.
The OECD composite leading indicator is pointing to a slower pace of growth and the Economic Cycle Research Institute (ECRI) sees an increasing risk of a cyclical downturn.
“We are far from seeing a stable recovery,” said Markus Steinbeis, who helps manage some 180 billion euros for Pioneer Investments.
“As growth falters companies in several sectors will have to turn to cost cuts again because they cannot rely on the economy for their profits.”
Moreover, companies struggling already will get a particularly hard ride in any second downturn and will therefore need to take extra steps to protect profits.
The return on equity for utilities is running at 7 percent below the nine-year average, according to Commerzbank analysts, while for health care it is 14 percent below and for the travel and leisure sector it is 31 percent.
But companies already slashed expenditure last year more aggressively than in past downturns so that the average operating margin only dropped to 6 percent, compared with 4 percent in past recessions, according to Jutta Weidenbach, who helps manage some 280 billion euros for Deutsche Bank’s DWS unit.
“The risk is that you save too much, for example on service, and then your sales suffer,” said fund manager Uwe Zweigler from Panthera Investment in Frankfurt.
However, cutting employment costs is one way companies can go on reducing overheads and European airlines still have scope for savings, with both British Airways BAY.L and Germany’s Lufthansa (LHAG.DE) currently locked in disputes over pay and contracts with their staff.
And they need to. The industry, which buys fuel in dollars, suffers from a weak euro as well as from reduced demand for business travel and the International Air Transport Association (IATA) in June raised its forecast loss for European airlines this year to $2.8 billion.
In addition Lufthansa’s earnings at its core airlines business are set to take another hit this year from losses at carriers it has recently bought.
Meanwhile public spending cuts by European states seeking to rein in their deficits is set to hit consumer spending and expenditure on health care.
“Earnings trends for the (healthcare) sector are poor. Analysts forecast less than 10 percent earnings growth for both 2010 and 2011,” equity strategists from Citigroup said.
Pharmaceutical companies throughout the world are cutting expenditure on developing new drugs but do not have nearly enough new drugs in the pipeline to replace all those they are about to lose.
They try to make up for that loss by buying promising products from smaller laboratories, a move that according to analysts from Morgan Stanley in fact helps them to raise profitability at least in the short term.
But problems might arise if companies lose the ability to properly assess promising medication. Profits come under more pressure as fiscal measures squeeze European drug prices, with GlaxoSmithKline (GSK.L) expecting an annual cut of 3 percent every year throughout Europe.
Austerity measures are also hitting consumers and consequently retailers.
“They are earning less than other sectors and will have to tighten costs further with measures such as cutting working hours and closing less profitable branches,” said Commerzbank strategist Markus Wallner.
Last month Swedish fashion chain Hennes & Mauritz (HMb.ST) cited tight cost management as a reason for its profitability being higher than markets expected in its fiscal second quarter.
Some companies such as Kingfisher (KGF.L), Europe’s biggest operator of home improvement stores, are driving up their profitability by increasing a push to buy more products directly from cheaper manufacturing centers like Asia.
Companies might have to shift to suppliers in countries such as Bangladesh or Vietnam as China’s decision to allow its currency to appreciate as well as rising wages there make the country a more costly producer, analysts say.
In the utility sector power and gas companies are having to cope with a drop in industrial demand to levels last seen 10 years ago and regulatory moves on pricing in countries such as Germany and Britain that put added pressure on profits.
Many companies are expected to look at job cuts as a result. Typically, UK regional water and sewage treatment company Severn Trent (SVT.L) recently said savings helped the company to beat expectations last year but it will shed more jobs after the water regulator imposed a tougher cap on investment returns.
Another way to lower expenditures is to simplify structures of energy companies, that were often created by merging smaller entities and still maintain some of those old structures.
E.ON (EONGn.DE), the world’s largest utility, had already announced annual cost cuts of 1.5 billion euros and plans to combine some of the company’s divisions in what might be the first step to more cost cuts.
“Utilities such as E.ON and RWE are forced to cut more costs (and) most of them will jack up profitability by selling less profitable units,” Sebastian Kauffmann from Credit Agricole’s CA Cheuvreux unit said.
The problem with that strategy is that buyers are elusive in the current environment. E.ON had to cancel the sale of a gas pipeline in Italy as bids were too low and Sweden’s Vattenfall VATN.UL took more than two years to sell its German power grid.
Editing by Greg Mahlich