By David Sterman
In many third-quarter conference calls this earnings season, a key question kept popping up: "How are European sales holding up in light of the budding economic crisis?" A wide range of companies noted that sales are starting to slow and things could get worse in coming quarters. GM (NYSE: GM), for example, lost nearly $300 million during the third quarter in Europe -- a market that accounts for one-fifth of its sales.
With Europe possibly headed for a prolonged economic downturn, it's time to stress test your portfolio and re-think the merit of any holdings that have a high degree of exposure to the continent. To be sure, virtually every company in the S&P 500 (SPY) has some exposure to Europe. The key questions are: How big is the exposure? And how will profits in 2012 fare if Europe gets mired in a deep slump?
To help in that process, I've drawn up a list of American companies that count on Europe for a big chunk of sales and profits. This group, for example, gets more than 50% of annual sales from Europe.
The key is to differentiate which companies will be at risk of a big slowdown and which are likely to show more stable revenue trends. Take Philadelphia-based EResearch Technology (NYSE: ERT) as an example. The company provides contract research services to major European drug companies. Those drug companies are usually flush with cash and unlikely to sharply curtail research efforts in the face of temporary economic challenges. On the other hand, Clearwater, Fla.-based Tech Data (Nasdaq: TECD), which resells office equipment and tech and telecommunications hardware to IT departments, could suffer a sharp blow. IT spending could be severely curtailed in Europe in 2012 as companies avoid any discretionary spending.
There are many more companies with a heavy degree of European exposure. These companies, for example, derive between 40% and 50% of sales from Europe, and it's unclear whether they will even make any money on their European operations in 2012.
Make no mistake, European sales for some have held up well thus far. McDonald's Copr. (NYSE: MCD) recently noted that European same-store sales rose 4.8% in October compared with October 2010. That barely lagged the 5.2% growth rate seen in the United States, and the 6.1% growth in the APMEA (Asia, Pacific and the Middle East) region.
You'll also note Owen-Illinois (NYSE: OI), a manufacturer of glass containers, is on this table. The company was just singled out by Citigroup strategist Tobias Levkovich as an example of a company at risk to a struggling Europe. Speaking to investors in late October, management noted that "Macroeconomic news out of Europe has been volatile in the past few months due to uncertainty related to sovereign debt and the banking sector, and although our European shipment growth trends moderated compared to earlier this year, we have not seen any major decline in the consumer trends in the end markets that we serve."
Yet the company may be singing a different tune next quarter. After all, fast-rising Italian bond yields signal a potential systemic shock to the Europe. Italy's economy is far larger than the Greek economy, so the current quarter's economic activity could end up a whole lot more challenging than the prior quarter. Owens-Illinois stock may look quite cheap at around seven times projected 2012 EPS of $2.84, but doubts may start to rise about the reality of such a forecast. After all, the company's EPS slumped to $0.64 in 2009 when Western economies were last under duress. The stock doesn't look quite so cheap at 31 times that bottom-of-the-cycle forecast.
Looking for the bottom
If Europe's troubles deepen, then stocks that have a high degree of exposure can't help but buckle under. However, this also spells upside opportunity when the selling is done. As we saw in late 2008 and early 2009, a wide range of very good companies plunged to decade-long lows on fears of a long-term crippling economic crisis. Yet as we also saw, many of these same stocks went on to post massive rebounds once it became clear that economic problems were short-lived. How long will Europe's problems last? It's hard to know, but investors do tend to overdo it on the downside when pessimism reigns.
This chart shows how investors reacted to the heart of economic Europe.
The New Germany Fund (NYSE: GF) represents mid-sized manufacturers in Germany, a clear proxy for industrial activity across the continent. It would have been wise to dump this fund when problems were starting to brew in 2008, but it also would have been wise to jump in when bearishness was at a peak a year later.
Risks to Consider: Any analogies to 2008/2009 may prove imprecise simply because we're dealing with a different set of issues. A total economic meltdown was ultimately averted back then, but few have faith that today's global leaders can show and real competence when it comes to making the right choices.
It's axiomatic to note that stock prices reflect anticipated conditions six to 12 months into the future. If European operations at the U.S.-based multinationals steadily falter throughout 2012, then this is a fine time to lighten up your exposure to them. Yet any sort of sharp sell-off that brings these stocks drastically lower could then prove to be a buying opportunity, if history is any guide.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.