European Equities: Corporate strength abounds
The picture is complex, but in general low indebtedness and high return on equity will cause capital flows to CEE corporates, writes Juraj Kotian
The current crisis is providing a significant health check on public finances and corporate finance. While the former definitely needs a good dose of medicine, the latter will also need to make strides towards flexibility and efficiency in the sectors that make up the respective countries' economies (households, government, non-financial and financial corporations). It is clear that an economic rebound in the next couple of years will rely on the corporate sector and its ability to remain competitive, utilise capital efficiently and, importantly, create new jobs. Its strength and revival is core to economic recovery.
We looked into sector national accounts of EU countries and tried to figure out how the non-financial corporate sector has been doing, how big were the imbalances that built up during the credit boom, and whether the corporate sector is competitive and profitable enough to justify the level of debt and secure access to credit and capital markets in the future.
Our analysis showed that CEE corporates have fared well against their Western counterparts. They generate double the return on capital compared with Western Europe. Slovakia and the Czech Republic lead the way in CEE with the strongest performance in the non-financial corporate sector - the only challenge to this operating efficiency comes from Germany.
Leading the way in Europe
CEE companies are in general less indebted relative to the value-added they create or compared with their after-tax profits. This reduces the risk of being hit by any further deleveraging which has to occur in Europe's corporate sector. The least indebted are Czech, Slovak and Polish companies - with gross debt lower than the value-added they create in one year, or corresponding to 3-4 years' net after-tax profit.
In Western Europe, German companies are among the least indebted, with gross debt totalling about five years' net after-tax profits. At the other end of the scale are countries like Ireland, Belgium, Portugal and Spain, with the most indebted non-financial corporate sector in Europe, with gross debt totalling about 300-400% of the gross value-added they produce, corresponding to between nine and 20 years' net after-tax profit.
Looking at the enormous increase of net borrowing of the corporate sector until 2008, the central question is how efficiently was this capital utilised? How did it contribute to boosting the value-added and operating efficiency, and what was the return on capital?
The answers can indicate in which direction capital flows could move in the future.
CEE countries have been doing very well in this respect, as capital has been relatively efficiently allocated, generating about twice as high a return on capital compared with the euro-zone, which averages about 8%. The worst situation has been in Belgium, Spain and Portugal, where return on capital has ranged from about 4-6% over the last five years.
Among CEE countries, the least efficient or profitable corporate sector has been Hungary's (7% on average in 2005-09). In Western Europe, only the German corporate sector has been able to compete with CEE companies in terms of operating efficiency, with an average gross return on capital of about 15% and a return on equity close to 20% over the last five years. The most productive capital allocation in the non-financial corporate sector has been in Slovakia, generating about 26% gross return on capital and 19% net after-tax return on equity, even during the downturn.
Given its higher return on capital, CEE should stay attractive for capital inflows into the corporate sector much more than one have would thought during the economic slump. Many CEE companies rebounded strongly, especially in the manufacturing sector, which enabled them even to reduce the amount of debt.
CEE companies will also be able to efficiently compete for capital in highly indebted Europe because of the much bigger opportunities for cheaper production in CEE. For example, unit labour costs in the CEE area are about half of the EU average. Their lower indebtedness and high return will keep these companies competitive, unless barriers of capital flows are built either through increased regulation or support of national champions within the EU.
However, there are not so many stock exchange-listed companies in the CEE and many profitable companies are fully owned by their parent foreign company. The common way of benefiting from better operational efficiency in CEE is to invest directly into parent companies that have their operations in CEE. As higher economic growth is usually accompanied by appreciation of real exchange, the common way of benefiting from higher growth prospects is to take long positions in CEE currencies. The Polish zloty remains relatively undervalued while, given the low level of debt stock and high profitability, the Czech koruna should appreciate in the next couple of years.
Adjusting the corporate sector
The group of countries in which the corporate sector relied heavily on net borrowing during 2005-08 were the Baltic countries, Spain, Portugal and Slovenia, later joined by Romania (in 2007). Surprisingly, Ireland has not been in this group as, alongside their substantial increase of debt, Irish companies have also increased their financial assets. Dutch, Finnish, Swedish, German and UK companies were net exporters of their capital to other sectors (or the rest of the world). However, the global economic crisis had a big impact on capital flows, which almost stopped or even reversed.
The corporate sector had to adjust, mainly through a substantial cut in investments (as in the Baltics), retention of a cash buffer or even a reduction in overall debt. Labour productivity in manufacturing has increased in many CEE countries during the crisis, in order to preserve their competitiveness and profitability. Maintaining a higher return on capital and return on equity is positive news for CEE economies, as it partially justifies strong capital inflows into these economies and investments made in the past.
The largest reversal in net borrowing happened in the Baltic countries, Hungary, Romania and Slovakia, where non-financial corporations switched from net borrowing to net lending. A big reduction in net borrowing happened in Spain and Portugal, but their business models still relied on net borrowing (similar to the French and Italian models), and this can be difficult to sustain during times of high fiscal deficits. Sooner or later, both public and private sectors will compete for capital, which can result in yield increases and faster deleveraging (crowding out of the private sector). This is currently only counterbalanced by the generous liquidity supply from central banks.
So which countries and sectors present the most compelling opportunity for Western Europe's institutional asset owners?
Banks have already recovered quite nicely and, despite profitability, price levels are not very inviting anymore. However, in the financial sector insurance companies might be an interesting place to be. Depending on the situation, with euro-related worries calming down, we see this sector posting sound numbers with valuations that are still at appealing levels. As an early cycle industry, technology might be worth a look, as well.
Another option would be in markets where domestic demand is showing through in retail, in particular Turkey and maybe Romania in the second half of 2011. For conservative investors there are opportunities for co-financing infrastructure projects and earning some extra premium on top of sovereign yields.
Juraj Kotian is an analyst and co-head of CEE macro/fixed income research at Erste Bank Group