Cheaper Euro and Oil Set to End Europe's Years of Earnings Downgrades

Posted by Michelle Howard October 8, 2014

More analyst downgrades than upgrades for 42 months in a row
High correlation between euro and earnings revisions
Deutsche Bank sees the euro falling to $0.95 by 2017
Jet fuel accounts for a third of airlines' operating costs

The recent sharp slide in the euro and commodity prices is set to provide tailwind for European companies struggling against economic weakness, and soon break a streak of earnings downgrades that has already lasted 3-1/2 years.

After two years of declining profits, European firms have struggled to turn the corner as the euro zone economy flat-lined; data on Tuesday even showed a sharp drop in Germany industrial production.

Every month since early 2011, equity analysts have revised more profit forecasts downward than upward for European firms, a trend exacerbated by a sharp rise in the euro that hit exporters hard in the early part of this year.

"On average, we have had nearly 100 downgrades every single working day since March 2011," Nick Nelson, European equity strategist at UBS, wrote in a recent research note.

However, the euro's 10 percent drop in the past five months, and steep falls in the prices of commodities ranging from crude oil to iron ore, look set to break the spell by boosting the revenues and margins of companies including Airbus, Siemens (SIEMENS.NS), Air France-KLM, BASF and Daimler.

Strategists and fund managers said the euro's fall and oil's 20 percent plunge since mid-June would not be felt in the third-quarter earnings season that starts next week, but had already prompted analysts to stop trimming their forecasts.

"There's a very high correlation between the euro exchange rate and the trend in earnings revisions," said Joerg De Vries Hippen, co-chief investment officer for European equities at Allianz Global Investors, which has 373 billion euros ($472 billion) under management.

Restoring Competitveness
"From 2012 to early 2014, the euro rose steadily while earnings forecasts were slashed. Now it's the other way round. About 25 percent of euro zone GDP comes from outside the region, and most of this comes in dollars. Companies like Airbus will be much more competitive," De Vries Hippen said.

For Airbus, one of Europe's most dollar-sensitive companies, a 10 cent move in the euro against the dollar translates into a 1 billion euro swing in annual profits at the operating level.

Although September was the 42nd consecutive month of net downgrades, according to UBS strategists, it had the fewest negative reviews since June 2012, in part due to the lower euro.

In most European countries, the pace of downgrades has slowed significantly since April, data from Thomson Reuters Datastream show.

On average, 12-month forward earnings per share (EPS) estimates for companies in the Europe-wide STOXX 600 index were cut by 2.1 percent in the past three months, down from an average of minus 4.9 percent in the three months to April.

On Tuesday, Morgan Stanley (MS) upgraded its recommendation on European cyclical firms, citing a significant improvement in the sector's earnings revisions since the euro started to weaken. Exporters such as BMW and BASF feature among the broker's top European picks.

"The currency is moving from being a huge headwind to being a tailwind," said Tim Stevenson, fund manager at Henderson Global Investors, which has 93.3 billion euros ($117.8 billion) in assets under management.

"The advantage of that for European companies cannot be underestimated. All the firms we met in the first half of this year have mentioned it as a major factor. At current levels, the euro is making life much easier for exporters. But the market is ignoring it for now."

Despite the drop in the euro since May, the blue-chip Euro STOXX 50 index is down 4 percent over the same period.

Euro Down, Profits Up
According to analysts and fund managers, a 10 percent drop in the euro translates into a boost to European firms' earnings of between 3 and 6 percent.

With a majority of economists predicting further falls in the euro as the monetary policies of the European Central Bank and the U.S. Federal Reserve move apart, the lift to European earnings could be even bigger.

Deutsche Bank analysts see the euro's exchange rate against the dollar falling to $0.95 by 2017, which would translate into a 10 to 19 percent rise in companies' earnings.

The call by Germany's biggest bank, the world's second largest currency trader, is the most aggressive yet from a major investment house, most of which have already turned overwhelmingly bearish on the euro.

"The drop in the euro will be a boost for companies, both in terms of improved competitiveness and in terms of mechanical rise in revenues from abroad," said Matthieu Groues, chief investment officer at Lazard (LAZ) Freres Gestion.

"Profit forecasts are still being trimmed, but if you look in absolute terms, it's in the euro zone that forecasts for the next two years are the strongest."

Analysts and fund managers said the effect of the lower currency and commodity prices would more than offset the effect of slow economic growth on fourth-quarter earnings.

"The currency impact is going to be a major theme in the fourth quarter," UniCredit strategist Christian Stocker said.

"Healthcare, food and beverages, and personal household sectors are better placed than others in terms of earnings performance, because we have stable consumer demand in the Asia-Pacific region and in the developed world," he said.

The industrials, chemicals and construction sectors should also benefit from lower commodity prices as oil, metals and electricity represent 20 to 45 percent of their input costs.

With Brent futures sinking towards $90 a barrel - dragged down more than 20 percent in the past four months by a combination of ample supply and sluggish demand - energy-hungry sectors will see a significant drop in their costs.

Jet fuel, derived from crude, accounts for around a third of the operating costs of airlines such as Air France-KLM , Ryanair and Lufthansa, which means the oil price drop should be a boon for the sector's earnings.