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Summary

  • Stock down at least 15% year to date (in USD terms).
  • Normalized P/E below 12x.
  • Market capitalization greater than $20 billion.

Turmoil in the Ukraine and disappointing economic reports have created some interesting opportunities for investors willing to look across the pond. Today I will highlight three European stocks which I expect to outperform the broader market over the next three years. My criteria are as follows:

  1. Stock at least 15% below 52 week high
  2. Normalized P/E below 12x
  3. Market capitalization greater than $20 billion

Leading UK grocer Tesco (OTCPK:TSCDY) shares have performed terribly over the past several years and are down 26% year to date. Shares have fallen due to 1) increased competition causing a decline in Like-for-Like sales and operating margin compression (2) general weakness in the UK economy. While current operating trends are difficult, investors are overlooking several positives including: 1) low valuation - even after several earnings downgrades, Tesco sells at less than 11x 2014 expected earnings and (2) strong balance sheet with net debt of less than 2x EBITDA and over L34 billion worth of owned real estate. The combination of a low valuation and strong balance sheet mean that Tesco could be ripe for either an activist hedge fund or could be an appealing LBO target (given Tesco's large size, this would have to be a club deal involving 2-3 private equity firms). Recent LBO activity in the US involving Albertsons and Safeway (NYSE:SWY) lend credibility to the possibility of an LBO. Further, with a dividend yield greater than 5%, Tesco investors are being paid to wait.

Arcelor Mittal (NYSE:MT) shares have been pummeled in the past two weeks are now down 23% year to date. Investors are concerned about 1) continued weakness in Europe suppressing steel demand and pricing (2) delayed recovery in US commercial construction again leading to lower demand for steel. This caused the company to downgrade 2014 EBITDA guidance when it reported first half results last week. While the near term picture is not pretty, Mittal has de-levered its balance sheet over the past three years (through external capital raises and free cash flow generation). Net debt is now below 3x EBITDA and I do not expect Mittal will have to dilute shareholders in the future. While current results are depressed, assuming Mittal could earn just $120 of EBITDA per ton (just below 10 year average), the company would earn $4 per share. Assuming an 8x P/E multiple, this implies 140% upside. Note that in a cyclical upturn, Mittal could earn upwards of $175 per ton or nearly $7 per share (so at today's price, Mittal trades at less than 2x estimated peak earnings).

Volkswagen (OTCQX:VLKAY) shares have suffered this year falling 19%. Continued weakness among European consumers is hurting the mass market segment while the commercial vehicle manufacturing business remains mired in a cyclical downturn. Shares are selling at less than 90% of book value and below 8x 2014 expected earnings. This is a 20-25% discount to comparable German automakers Daimler (OTCPK:DDAIF) and BMW. While corporate governance at Volkswagen (involvement of township and inexplicable share issuance earlier this year) argue for a discount to comparables, there are reasons to believe Volkswagen should actually trade at a premium including: 1) ownership of the Porsche brand (Porsche represents just 2% of auto volumes but 25% of auto division operating profit) which is both high margin and fast growing - Porsche has grown revenues at about 10% over the past decade while earning 15-20% operating margins. One could argue that Porsche should be valued more like a luxury goods company and trade closer to 20x earnings (2) potential to improve the profitability of the Volkswagen brand. Today the VW brand earns just 3% operating margins. The company has a Euro 5 billion cost cutting program in place. While I don't think the full amount is achievable looking at comparable automakers, I think a 5-7% operating margin is very reasonable (3) rebound in the commercial vehicle business. Assuming continued growth in Porsche, achievement of a 5% operating margins at Volkswagen, and a return to normality in the commercial vehicle business, I think Volkswagen could earn $7 per ADR share. Applying a 10x multiple (in-line with peers), Volkswagen would trade at $70, or 55% higher than current levels.

Though currently out of favor, I believe patient investors will be rewarded and expect the aforementioned shares to outperform the broader market (i.e. S&P 500) over the next 3-5 years.

Disclosure: The author is long TSCDY, VLKAY, MT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Source: 3 Cheap European Large Cap Stocks