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Pricey European industrials braced for headwinds

Source: Reuters - Tue 27th Apr 2010

European industrial stocks' lofty premium to the market is looking increasingly unwarranted as the sector readies itself for the end of government stimulus packages and the start of monetary tightening.

Companies such as Swedish engineer Sandvik, bearings maker SKF and Swiss electrical engineering giant ABB enjoyed a stellar performance in the last year, as companies began to ramp up their capital expenditure.

But facing only moderate economic growth, the sector - which trades at a one-year forward price-to-earnings of 16.2 times earnings, compared to the FTS Eurofirst's multiple of 12.5 times - may suffer a significant correction.

"The day the Federal Reserve changes its message on tightening and China starts to raise interest rates, the appetite for risk could reduce prompting a general correction in high-beta stocks, such as industrials" said Nicla Di Palma, equity analyst at Brewin Dolphin.

"The rise in interest rates could cause lending to slow and consumers and corporates to cut back spending causing downward revenues and earnings revisions. In an extreme case, the correction could be very significant."

China's central bank has already moved to drain further cash from the banking system and clamp down on lending, and analysts expect it to start raising rates this quarter. India has raised rates for the second straight month.

Analysts are starting to downgrade the sector. Bank of America Merrill Lynch said it is moving to a "neutral" stance on the capital goods sector as the U.S. and Chinese manufacturing leading indicators, which are highly correlated to the sector, are at or close to cyclical peak levels.

"Stock multiples are driven by lead indicator movements" said Bank of America Merrill Lynch in a note. "So we believe it is asking a bit much for multiples to move materially higher from here over coming months."

Among the stocks that are likely to be hurt by any weakness in the global economies are Finnish engineering firm Metso and Swedish engineer Sandvik, said David Hussey, head of pan-European equities at MFC Investment Management.


The euro zone's economic recovery looks like it is continuing, although growth is going to be moderate this year and inflation is likely to remain subdued in the medium-term, the European Central Bank said earlier this month.

Analysts argue that the sector has more than priced this in, as the STOXX Europe 600 Industrials sector rallied 95 percent since the market hit a low in March 2009 as companies have started to return to capital expenditure as earnings rose.

Industrials have been one of the best performers this year-to-date, with the STOXX Europe 600 Technology .SX8P and the STOXX Europe 600 Travel and Leisure the only other sectors to outpace it.

SKF, the world's biggest bearings maker, surprised investors on April 16 with strong first-quarter results. But some analysts are concerned the strength of the automotive business might not be durable as scrappage schemes end.

Meanwhile Swiss engineering group ABB has given a cautious outlook and posted a worse than expected 29 percent drop in quarterly net profit.

U.S. bellwether General Electric Co recently reported that new equipment orders which are the key indicator of future revenue growth were down 10 percent, while services orders were down 6 percent.

"It is a little bit early to talk about restocking" said Jeremy Batstone-Carr, strategist at Charles Stanley. "To some extent a recovery is coming through if you believe in government stimulus measures and also destocking ending."

"But we certainly think the industrial economies will disappoint and there will be a prolonged period of sub-trend growth as final demand is not there."

European lead indicators show that while industrial output is no longer falling, it has some way to go for a sharp recovery to take hold and for recovery to get back to pre-crisis levels.

"It is a fairly optimistic assumption about continued margin expansion in the industrial sector and growth rates returning to a pre-crisis level of growth" said MFC' Investment's Hussey.

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