The precious solidarity of the eurozone may be on the brink of collapsing. But even regular, scary headlines on the Greece debt crisis have so far been unable to halt the continent's steady return to economic prosperity. That's the view embedded in the latest purchasing managers' index (PMI), which smashed expectations by rising to 54.1 - its highest level in four years.
As a key barometer of economic health in the manufacturing sector and a future indicator of GDP levels, the steady rise of the euro-area factory and services index is encouraging - 54.1 is comfortably above the 50 mark dividing expansion from contraction and continues to suggest that the European Central Bank's (ECB) decision to expand its quantitative easing programme has been a major boon for the eurozone economy. Lower interest rates and a depreciated currency have had the desired effect of increasing spending power, boosted also by governments such as France pushing through legislation promoting greater economic flexibility and handy external events such as tumbling energy prices.
"The second-quarter upturn signalled by the PMI puts the region on course to expand by around 2 per cent this year," says Chris Williamson, chief economist at Markit, the data company that compiles the PMI. Mr Williamson's optimism is shared by numerous fund managers, too, who've reacted to a rosier outlook and depressed valuations by pumping more money into European shares, which are also benefiting from the weakened euro and the ECB's new quantitative easing programme.
Should we worry about Greece?
Despite the positivity surrounding this latest batch of economic numbers, risk-averse investors are still biting their nails over the prospect of Greece leaving the eurozone and further debt defaults following the country's 'no' vote in the referendum last weekend. That scenario has long been viewed as the recipe for a global stock market disaster, and more than capable of upsetting the ECB's own projections that GDP will grow by 1.5 percentage points this year and 1.9 percentage points next year.
Still, several experts argue that the moment everyone fears - a Grexit - would not actually be as damaging as first thought. Instead, the prospect of a Fed rate hike in September and further rate cuts in China are currently causing more of a stir in the Square Mile.
"Far from a tidal wave of economic destruction, as some doomsday economists have predicted, the prospect of a Greek exit from the euro has been on the cards for a number of years, and most European nations have been prepared and waiting for this possible eventuality," says Chris Williams, chief executive of online investment adviser Wealth Horizon. "Investors and investment managers have also heeded the same warnings. The protracted rollout of the Greek economic crisis has meant that only a small minority of investors are likely to be holding bonds or shares in the country."
Jupiter fund manager Ariel Bezalel was also quick to dismiss a repeat of the scenario that followed Lehman Brothers' collapse, primarily because the weak Greek economy now contributes far too little GDP to the union to create any major damage. "Our belief is that at less than 2 per cent of GDP, and with much of Greece's debt held by the public sector - circa 76 per cent - the fallout should be fairly well contained in the event of a Grexit."
Exporters' euro exposure
Those positive forecasts will come as welcome news to the UK's varied list of industrial companies, most of which export a great deal of their products to customers on the continent. Although many during the downturn sought to hone in on healthier regions such as the US and Asia, plenty still generate in excess of half their revenues from Britain's closest trading partner. That ultimately means that better trading conditions should start feeding into the top line, even if the double-edged sword of a weak euro succeeds in undoing some of this progress when translating back into sterling.
Industrial suppliers
Industrial suppliers certainly stand to benefit from an uptick in purchasing power on the continent. These distributors have been forced to cut costs in the face of the weak top-line growth generated from their core European neighbours. In a bid to boost profits, many of the sector's big names employed various self-help initiatives, with a key focus on making businesses more cost-effective and adaptable to stronger niche markets.
That's certainly been the case for Brammer (BRAM), which embarked on a mission to close its distribution centre in Coventry, install industrial tool vending machines and focus on key customer accounts. Those measures left the distributor of maintenance repair and overhaul products in better shape to weather the storm of weak trading markets, yet still wasn't enough to prevent a damaging profit warning in May.
Shares in Brammer plunged 10 per cent after the company warned that profits were to be hit by tough market conditions and strong currency headwinds. As it generates more than 60 per cent of revenues from the eurozone that shouldn't come as too much of a shock, yet as the economic picture improves some investors may now view Brammer as a potential value story. At 308p, shares trade on 14 times forecast earnings, which represents a 39 per cent discount to its average five-year rating of 23 times.
Another big European play in the sector is SIG (SHI). The insulation and roofing materials group generates about half its revenues from the continent and, like Brammer, has sought to clean up its affairs as trading conditions weakened. SIG has particularly struggled with weak construction markets in France and tepid sales in Poland, where regional business confidence has been shaken by the Ukraine crisis.
But investors appear to have already caught wind of SIG's recovery story as shares are up 6 per cent over the past year. That improving sentiment can be credited to the success of the group's cost-cutting measures and sale of three underperforming assets, including its German roofing business. Thanks to those measures, SIG widened its return on capital (ROCE) by 90 basis points to 10.3 per cent in the year to December 2014.
Electrocomponents (ECM), on the other hand, hasn't been so fortunate. Shares in the distributor of electronics and maintenance products nosedived 19 per cent throughout the year, as heavy investment to capture more business online and make three-quarters of products available to customers across the world failed to reverse slumping revenues.
That led chairman Peter Johnson to courageously admit that the group's financial performance had not been "good enough", yet interestingly one of the few areas of promise in the year to March 2015 came from the continent. After a sluggish start, 7 per cent revenue growth was generated from the 15 eurozone countries it serves in the second half, as regional e-commerce sales grew 8 per cent.
Improving search engine marketing and enhancing the website has been identified as a key strategy in boosting Electrocomponents' growth prospects because it makes the process of finding products clearer, faster and easier. In that area Europe has been a standout performer, with 71 per cent e-commerce penetration easily representing a better return than the other global markets it serves.
But even though the company is already benefiting somewhat from an improved economic backdrop on the continent, we're hesitant to turn bullish. That's because the positive potential effects from management's strategic initiatives appear to have been priced into the valuation - at 213p shares trade on 17 times forward earnings.
Electronic equipment
The continent's thirst for the latest gadgets also means the main players from the electronic equipment sector have pretty strong ties there. Stagnant global and European economies have been a notable headwind for the sector, yet shares in most have performed admirably due to surging demand for the latest technological trends. To some extent, it could be argued that this appetite is enough to weather any economic storm, although it's also worth noting that the successful players have been focusing more on healthier US and Asian markets.
Still, the likes of Spectris (SXS), Renishaw (RSW), Carclo (CAR), Oxford Instruments (OXIG) and e2v (E2V) each generate a reasonable chunk of revenues from the continent. TT Electronics (TTG) and XP Power (XPP), however, are the leaders in that regard, with both relying on eurozone customers for about half their sales. Yet aside from having this particular thing in common, their financial years have played out very differently.
Shares in TT Electronics plummeted 27 per cent in the past year, driven by weak demand in Europe and union-related disruptions which led to the relocation of production from Germany to the cheaper region of Romania. This lag in moving to low-cost sites has clearly been disappointing investors, as did an operating loss of £4.3m in the year to December 2014. Admittedly, £33.5m of losses stemmed from so-called exceptional costs, yet even after factoring this in underlying operating profits still slid 5 per cent.
>Whereas shares in packaging and chemical companies have proved resilient during the economic downturn, the industrial engineers have encountered more difficulties
But management hopes that investing in product development, appointing new executives, refocusing on key markets and slashing costs will eventually see a return to big profits. That, of course, could be helped by top-line growth from an improved European economy, which is why long-term investors may fancy taking a punt on this troubled company. We reckon it could take a good couple of years for these measures to filter through, and remain on the fence with shares trading on a forward multiple of 17 times.
By contrast, XP Power continues to look attractive. Shares may have weakened over fears of a Greek default, but still remain comfortably up on our buy tip in February (1,433p, 5 Feb 2015). That success is largely down to the power converter specialist's transformation from a distributor into a fully-fledged manufacturer. Products designed in-house now contribute record revenues, which together with new, cheaper factories in Asia is helping to boost margins. The only downside so far has been challenging trading conditions in some areas of Europe, although sales growth was still achieved in Germany and the south as XP Power gobbled up market share.
Considering how well it has fared on a continent plagued by recession, we are very excited by the extra uplift an improved European economy could provide. If that wasn't enough incentive, the shares - at 1,588p - continue to trade at a steep discount to international peers such as Cosel (JP:6905) and Emerson (GR:EMR) on 15 times forecast earnings.
Chemicals
A pick-up in eurozone consumer spending is also capable of driving reratings across an already resilient chemicals sector. Last year the majority of these speciality companies were boosted by strong exposure to niche end markets, smart management and bumper dividend payouts. A key strategy to offset weak consumer spending in Europe was to turn to Asia, where population growth, urbanisation and increasing wealth has been identified as a potential gold mine.
Croda (CRDA) is certainly benefiting from a drive to invest in high-growth, developing markets. A bid to expand its capabilities outside of Europe, together with some widespread takeover speculation, boosted its share price by more than a quarter over the past year. That came despite tepid euro-wide demand for its expensive consumer care products and weak commodity prices, which sent adjusted operating profit down 2 per cent to £260m in the year to December 2014.
Numerous reports have circulated indicating that customers on the continent have been sourcing cheaper ingredients. That's been hurting its European operations a great deal, spurring management to restructure operations in a bid to re-energise sales of high-margin additives. Should that strategy work, and European consumer spending rise as expected, Croda could really push on. As wealth in Asia increases, sales of its products there are rocketing, though, at 2,781p, shares do trade on 19 times forecast earnings. That premium rating suggests the added benefit of a eurozone economic recovery has already been factored into the valuation.
Likewise, shares in Synthomer (SYNT) have rallied throughout the past year as investors responded well to its targeted Asian expansion. That’s not bad considering that the supplier of emulsion polymers used in construction, textiles, latex gloves and paper posted a profit warning last autumn.
But despite struggling with weak trading in its core European market, the group has made a success of cost-saving, introducing new products and capitalising on lower raw material prices. Following the re-rating, shares look quite pricey on 16 times forecast earnings, which we believe adequately takes into account the Asian growth story and advantages of niche product innovation.
The same can be said for Zotefoams (ZTF). Just like its peers, shares in the manufacturer of foam products used in packaging, car wing mirrors and aeroplanes are enjoying a purple patch. Most of that prosperity has been driven by decent underlying growth in the UK and US, and an end to customers destocking in continental Europe. But despite the prospect of further capital appreciation, shares now trade on 23 times 2016 earnings.
Packaging
The sheer volume of deliveries made by online retailers such as Amazon also means that those specialising in packaging have weathered the eurozone economic storm rather well. The likes of DS Smith (SMDS), Mondi (MNDI) and RPC (RPC) all count on the continent for the lion's share of their revenues and, as a testament to their success, each posted strong profit growth in their most recent trading updates.
Business is going so well for kraft paper and industrial bag manufacturer Mondi that it is now pondering whether to invest hundreds of millions of euros in Slovakia or Poland. Aside from the profits being generated by years of capital investment, the paper and packaging specialist has also been taking advantage of low energy prices. That helped it to reduce transport and logistic costs and post high margins on modest top-line gains.
DS Smith's management team equally deserves some credit for growing adjusted, constant currency operating profit by 17 per cent in recession-stricken Europe. Surging profits for the packaging giant have been attributed to cost synergies from acquisitions, tight cash management and rolling out a wider range of services.
Proof of DS Smith gobbling up market share can be found in its corrugated box volumes increasing by 3.1 per cent, more than double wider European market growth of 1.5 per cent. Most of those gains were made in bustling central Europe and Italy, where management has been busy investing in new plants and businesses.
Plastics packaging specialist RPC has found similar success in cost-synergy-creating acquisitions. That was the story behind it posting adjusted operating profit growth of 30 per cent in the year to March 2015, although part of that fortune also stems from growing exposure to nations outside of the continent, such as Hong Kong.
Given the structural drivers in place across European packaging markets, we remain keen on each of the aforementioned. The rise of online retailers is likely to see demand for packaging solutions increase even more, especially as customers in the eurozone begin to enjoy the effects of moving out of recession.
Industrial engineers
But whereas shares in packaging and chemical companies have proved resilient during the economic downturn, the industrial engineers have encountered more difficulties. Plunging commodity prices have mainly been responsible for triggering substantial deratings across the sector, together with the factor that provoked it - weak global economic growth.
Valve maker IMI (IMI) has been particularly dogged by the low energy price that prompted the oil and gas sector to cut back on investment. But despite shares sliding a quarter over the past year, there have also been some grounds for optimism. That includes new boss Mark Selway's plans to double operating profits by developing new products and improving manufacturing facilities, and a decent performance from its European truck business. As mentioned in our feature on auto suppliers, IMI has capitalised on legislation to deliver fuel efficiency and reduce emissions.
The acquisition of Bopp & Reuther, a power-generation valve specialist brought in to strengthen IMI's exposure to emerging regions and more resilient after-market sales, is also promising. But the group, which generates just shy of 40 per cent of revenues on the continent, continues to be hampered by weaker European construction markets.
A turnaround here, and in the oil price, can only benefit this struggling company, whose margins are also expected to be hit in the coming years by Mr Selway's restructuring efforts. Once these issues pass we see upside potential, although – at 1,255p – we are not convinced that shares are worth buying yet on 15 times 2016 earnings.
Melrose Industries (MRO) is another company with big European exposure that's been struggling with tepid industrial and oil markets. The company famed for its unique buy-improve-sell business model has encountered plenty of pitfalls in its electricity-generator-making Brush unit. As the oil industry is a big customer, sliding demand for the black stuff is largely responsible for weaker order intake in this segment.
Nevertheless, investors may be buoyed by the success of its other division, Elster, and growing speculation that the next deal is on the horizon. Acquisitions historically have a close correlation with share upside for Melrose, although for now they continue to look priced in at 252p.
But it has not been all doom and gloom for the industrial engineers serving continental markets. Thanks to the implementation of some countercyclical drivers, Bodycote (BOY) has been able to expertly ride the wave of a European downturn. The supplier of heat treatment, metal joining, hot isostatic pressing and coating services has counteracted pricing pressures by focusing on product innovation, resulting in widening margins and strong cash generation.
The low oil price isn't too much of an issue either, as a large chunk of its energy operations is based on specialist technologies with strong pricing power. Factor in a forward rating of 14 times and we reckon shares in Bodycote may be worth a punt.
Five european companies in pole position
Air Liquide (fr:AI), the French supplier of industrial gases and services to medical, chemical and electronic manufacturers, has an estimated 22 per cent share of the €60bn global industrial gases oligopoly, making it the largest player in Europe, number three in the US and co-leader in China. Industrial gases are sometimes referred to as a defensive investor's dream, particularly as contracts can last for decades and offer regular revenue streams. But as the sector caters to several megatrends there are also some decent growth prospects in store. For example, nitrogen is used in fracking and food freezing, oxygen to provide relief for elderly bronchitis and cancer sufferers and hydrogen to treat increasingly sour and heavy crude oil.
As global demand for luxury cars swells and the European economy springs back into life, Daimler (de:DIAX) looks in pole position to benefit. Record sales of its Mercedes-Benz cars saw the German automaker beat first-quarter earnings forecasts and close its profitability gap with rivals BMW and Audi. Daimler has a foothold in two major growth markets. Aside from building a big presence in electric autos, it has also been investing about €1bn to further develop the next generation of compact cars. As there's been a shift to smaller vehicles across the world, that certainly appears to be a smart move.
Legrand (fr:LR), a world leader in electrical and digital building infrastructures, provides more than 215,000 products in relatively strong growth areas such as cable management, smart meters, switches and sockets. Given that it generates about 62 per cent of revenues on the continent, including 28 per cent in France and 18 per cent from Italy, a resurgent eurozone economy is a big plus point. Another attraction is the group's strong pricing power and cash generation, which it has used to make small acquisitions. Legrand can be described as a consolidator in a very fragmented market, a factor that's greatly enhanced its defensive characteristics.
Dutch giant Philips (nl:PHIA) is excellently positioned to capitalise on the North American medical technology equipment recovery story. The group, which generates about a quarter of revenues from Western Europe and 30 per cent from the US, is a market leader in this field, as well as boasting a strong presence in other emerging areas such as male grooming and oral healthcare. Investors will also be relieved to hear that Philips has addressed the difficulties faced by its lighting arm. The diversified technology company is in the process of spinning off this business to focus on stronger healthcare and consumer segments. That could unlock some value, while cost-cutting measures should boost profits.
Engine, aerospace-component and security company Safran (fr:SAF) is reaping the benefits from its leading positions in the commercial aerospace propulsion market. As demand for parts rockets - Airbus and Boeing hold a combined order book of 12,000-plus aircraft - shares in the French behemoth look poised to continue rising. What's more, solid air traffic growth and a low oil price have sparked a surge in lucrative after-market orders, which were up 17.8 per cent in the first quarter. Like its European exporting peers a weak euro has also been a boon, while Safran has similarly been finding joy from an increase in narrow-body plane production.
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