2nd July 2015
Tim Crockford, co-manager of the Hermes Sourcecap Europe ex-UK Fund, believes revitalised European companies can defy the pervading Greek gloom…
Europe’s private sector exposure to Greece has been reduced significantly since the last Greek drama in 2012, with European banks, in particular, reducing their holdings of Greek government debt to immaterial levels. The contagion threat is that fear spreads to the periphery of Europe, pushing up yields and potentially de-railing the recovery that is underway in the region.
We expect that the European Central Bank will continue to stand behind markets, and while European yields have climbed since their trough, they continue to remain well below historic levels.
Revitalised European corporates
Since the onset of the crisis, European corporates have diversified their revenue bases at a domestic European level and internationally. We continue to like those firms that have reinvented their product lines and are reducing their fixed costs – which has driven profitability ahead of improving revenue growth.
These companies offer flexibility if the European recovery stagnates and exposure to the improving macro via increased operational leverage if it continues. We have been using the recent volatility to increase our exposure to these companies.
Renault is a great example of these companies. Owned across all three of our strategies, the French automaker is driving earnings and freeing up cashflow for investors from the cost side, as it migrates production to its new Common Module Family platform and increases the commonality of parts shared between different models. Naturally, a continuation of European auto sales gains following a recent pause would benefit Renault to a greater extent than German car manufacturers, which have also been reliant of China for sales growth. A healthy new model pipeline will also help Renault’s relative sales gains.
Legrand has actively cut out low-profit margin product lines, increasing its margins in the process, while expanding into the US organically and in the Far East by acquisition. As the company increases its market share in these regions, so too is its pricing power increased, as retraining acts as a barrier to their electrician customers switching to other brands. However, Legrand still generates more than half of its revenues in Europe, and margins are significantly higher in these regions due to their dominant market shares. Following 14 consecutive quarters of declines in Italy and 13 in France, a turnaround in these countries will therefore have a disproportionately positive effect on profits, when these markets do eventually turn. In the meantime, the company continues to grow revenue by increasing prices in markets where they see relative strength.
Europe is not all about restructuring, however, and there are still some high-growth areas that particular European companies are exposed to, such as healthcare companies that are in the biological drug space. Although only about a quarter of treatments currently available are biologics, this emerging class of drugs accounts for over half of the global pharmaceutical pipeline. We expect Sartorius to continue to benefit from this shift towards increased manufacture of biologics, as one of the leading manufacturers of equipment that is used in the manufacturing process. In addition to enjoying double-digit sales growth, the company also benefits from high visibility towards future sales growth, since once a particular piece of equipment that makes up one of the stages of biologic manufacturing is approved at inception, it is extremely difficult for the manufacturer to change supplier. Hence, Sartorius will enjoy an annuity stream from consumable products that are sold to drug manufacturers using their equipment.
Dutch semiconductor equipment manufacturer ASM International remains a core holding with its prospects tied into a number of trends that are driving adoption of its key technology, Atomic Layer Deposition, or ALD. We expect the ALD market to be more than double the size it was at the end of 2014 by 2017. With a clear technology advantage after a 20 years research and development head-start, ASM has a market share of over 75% in the leading-edge ALD space, which will drive an acceleration of revenue growth at the company as chipmakers continue to miniaturise. However, on a 13x 2016 earnings valuation and a 6% free cashflow yield, ASM International’s valuation is hardly pricing in this structural growth opportunity, and it remains at a significant discount to many of its closest peers, despite the company’s dominant market position.
Cerved Information Solutions
Our latest addition to the portfolio is Cerved, the leading credit information supplier in the Italy, selling credit data analyses reports to financial institutions and increasingly, corporate customers. The business model is hugely attractive; with a primarily fixed cost base, the company’s credit information division makes 85c on every euro of additional sales, and sales volumes are just starting to pick-up, thanks to Italian loan growth moving into positive territory. Their scalability is matched with impressive free cashflow generation, with conversion rates of over 80%, putting them on a free cashflow yield of 6%. At an unstretched valuation, investors are “paid to wait” for volumes to pick-up in the credit information market as lending increases in the country. In the meantime, reforms to the Italian bankruptcy law will have a positive effect on their credit management business, and we expect that increasing improvement in Italian lending will drive more investors to focus on this highly consolidated market.