Earnings Outlook Tough Times for Europe’s Blue Chips

Brexit and slowing global growth have darkened the outlook for Europe’s top 500 companies, which are already chronically under profitable. Handelsblatt research shows net earnings fell 20 percent on average in the first half of this year.
Not a bull market anymore.

Just a few months ago, economists, equity analysts and chief executives were confidently predicting a bumper 2016 and busily revising up their earnings forecasts, waxing lyrical about the improving outlook for the German and European economy.

That euphoria is gone. Sluggish global growth, the end of the boom in emerging economies including China and above all Britain’s vote to leave the European Union have dampened the outlook for most companies. In fact, Handelsblatt calculations show that Europe’s companies are in a worse position than during the global financial and economic crisis of 2009.

And the outlook is darkening. “We must brace for a lean period with lower sales and earnings growth,” said Hubert Barth, Germany chief of auditing group Ernst & Young.

5,000 European companies polled by financial information company Markit viewed their business situation as worse than at any time since January 2015. Markit chief economist Chris Williamson said there were “no indications whatsoever of an uptrend.”

An analysis of company results for the first quarter and the forecasts for the half-year reports about to be released don’t bode well for European companies. The net earnings of the 500 biggest European companies are expected to have fallen 20 percent year-on-year in the first six months of 2016.

German companies are particularly vulnerable because they generate just under 70 percent of their revenues abroad, making them more dependent on unrestricted world trade than their European competitors

French media giant Vivendi, Swiss drugs group Novartis and British oil group BP are set to post earnings declines of 30 percent or more. The European outlook would be even gloomier if it weren’t for the predicted 7 percent increase in German companies listed in the DAX and MDax indices that include reliable money-spinners like consumer goods firm Henkel, auto components supplier Continental and healthcare group Fresenius.

Handelsblatt research shows that Europe’s companies posted earnings drops for the fourth year in a row last year. Net earnings totaled €312 billion, or $343 billion, in 2015, 17.4 percent down from the previous year, and almost 40 percent less than in 2011.

All industries are affected. Swiss construction group Lafarge posted a net loss of €1.4 billion after writedowns in countries including Syria and Iraq. British mobile phone company Vodafone lost €5.2 billion due to writedowns and German utility E.ON confronted its shareholders with a net loss of €7 billion following massive writedowns on its coal and gas-fired power stations as electricity prices fell. Rivals like French power and gas producer Engie didn’t fare much better with a net loss of €4.6 billion.

Europe’s problem is that despite falling profits, its companies are steadily increasing their output and their revenues. Italian automaker Fiat Chrysler, Swiss food group Nestlé, French retailer Carrefour and Deutsche Post are prime examples. Compared to the record year 2007, when the companies on average earned over 70 percent more than in 2015, the combined revenues of the top 500 were up by a quarter at €7.9 trillion.

This combination of rising revenues and falling profits has dramatic consequences, because it cuts the all-important return on sales. Europe’s companies on average earned just 3.9 cents on every euro of revenue in 2015. That’s even less than during the 2009 crisis when companies were still earning 4.9 cents per euro.

A comparison with U.S. competitors exposes Europe’s weakness. The 500 biggest U.S. companies last year earned €560 billion, almost twice as much as the Europeans, on revenue that wasn’t much higher. It’s quality rather than quantity — U.S. companies on average chalked up a net return on sales of 6 percent, over 50 percent more than the Europeans.

America’s big three firms in terms of revenues, retailer Walmart, oil group Exxon and iPhone maker Apple, last year earned €74.5 billion which was more than all 30 Dax-listed German companies put together. And that came despite Exxon sustaining a 40 percent slump in earnings due to the oil price slump.

America's superiority is evident in almost all sectors. Harley-Davidson is the most profitable automaker, Gilead is the highest-margin pharmaceutical company and Oracle the most successful software company. Its German competitor SAP may be Germany's "margin king,’ but Oracle with a net return on sales of 26 percent is almost twice as profitable.

The Americans weren't always ahead. In 2007 and even in 2010, the year after the financial crisis, Europe's companies were more profitable. But the real estate and property crisis, from which the U.S. economy emerged leaner, meaner and stronger, put the Americans consistently ahead. Europe, meanwhile, descended into a government debt crisis with fewer public contracts and investments -- and less purchasing power for many consumers. As a result, firms kept on earning less.

The second reason is that Europe has a greater proportion of "old economy" industrial firms active in sectors teeming with competition: firms like ABB and Siemens in plant construction and electrical engineering, Nestle and Danone in the solid but slow-growth food industry with intense price competition, and oil giants like Royal Dutch Shell, BP and Total which are victims of the oil price slump. Around half of Europe’s 500 biggest firms, including all automakers and components suppliers, belong to these low-growth sectors. They account for a combined share of almost 60 percent of total revenues. In the U.S., the old economy share is far lower at just a third. Technology companies are dominant, and that industry has been generating the highest growth rates since 2011.

"Digitization is developing into the all-dominating trend and is calling the business models of companies and entire industries into question," warned Mr. Barth of EY, referring to Europe. German premium automakers like Daimler will have to revamp their business models if they want to stop Google and Tesla overtaking them in the race to develop self-driving cars, for example.

Industrial group Thyssen-Krupp is a further example. It recently presented an elevator system hooked up to the Internet to tackle technical faults. It used Microsoft's platform Azure. Why an American firm? "In Germany we don't have a company that can do that," said Chief Executive Heinrich Hiesinger.

Europe's weakness is evident in most countries. Swiss corporate earnings fell 11 percent on average last year, French firms were down 13 percent, Spanish companies dropped 18 percent and the 89 British firms among the top 500 were down as much as 31 percent. Italy's top companies even slumped to an aggregate loss and the 62 German firms among the top 500 sustained an average earnings decline of 16.5 percent. Intriguingly, Russian companies increased their profits by 12 percent despite Western sanctions imposed in the Ukraine conflict and falling raw materials prices that hit the country's important oil and gas sector. But that was due to the massive depreciation of the rouble which lost almost half of its value from 2014, which led to a surge in rouble-denominated profits. As soon as the currency appreciates, Russian corporate profits will fall commensurately.

Currency weaknesses helped Europe's companies as well last year. The 17.4 percent fall in their profits would have been even higher if the euro hadn't declined by 15 percent against the dollar last year. The weaker euro boosted the foreign income of exporting firms because their dollar revenues became worth more when converted to euros. 80 percent of European firms are export-reliant.

Commerzbank calculated the extent to which firms profit from the currency effect. If the dollar appreciates 10 percent against the euro, the DAX 30 companies earn an additional €12 billion in profit before tax, interest rates and writedowns. That amounts to a exceptional profit boost of around 8 percent. Applied to the whole of Europe, and taking into account that average dollar earnings are less in the whole of Europe than in Germany, it still amounts to a 5 percent boost. The problem this year is that the weak euro is not fueling revenues and profits because it hasn’t declined significantly, depriving companies of the year-on-year earnings impact. Instead, the weakening global economy, the unresolved government debt crisis in many southern European countries and the impact of the Brexit vote are cooling down sentiment and hitting business.

“The decision by the British not to remain in the European Union is a dampener for the economic outlook in Germany and the whole of Europe,” said Clemens Fuest, head of Germany’s Ifo institute.

The International Monetary Fund cut its euro zone growth forecast for 2017 to 1.4 percent from 1.6 percent after the June 23 referendum. It described the risk that the slowdown could be even worse as “high.”

German companies are particularly vulnerable because they generate just under 70 percent of their revenues abroad, making them more dependent on unrestricted world trade than their European competitors.

“New borders, protectionism, isolation and nationalism harbour greater risks for Germany and its top companies than most other countries,” warned Mr. Barth of EY.

Much is at stake for the German economy because Britain is one of its biggest export markets. It was even the biggest single market for German automakers in the first quarter. If the British economy weakens after the Brexit vote, German industry and especially German automakers will be hit hard.

Handelsblatt research shows Germany’s 30 DAX companies generate just under 9 percent of their revenues in Britain. That is almost as much as their sales in China.

“German economic growth will suffer noticeably under the impact of falling demand from Britain,” warned Stefan Bielmeier, an economist at DZ Bank. Analysts have recently lowered their earnings forecasts for 22 of the 30 DAX companies.

For Europe as a whole, the position is even worse. Earnings forecasts have been cut for 40 of Europe’s biggest companies.

“We’re in an environment with quite weak growth,” warned Commerzbank economist Peter Dixon, “and companies are noticing that they’re not in a position to deliver the profit increases they had expected.”

If stock markets live up to their reputation of being bellwethers of the economy, they do not bode well. Europe’s biggest bourse-listed companies included in the Euro Stoxx 600 index have lost 15 percent in value over the last 12 months.


Ulf Sommer reports for Handelsblatt on companies and financial markets. To contact the author: [email protected]