The recovery opportunities in overlooked Europe

The recovery opportunities in overlooked Europe

Stuart Mitchell (pictured) is manager of the SWMC European Fund at SW Mitchell Capital.

While it only been a few months since the surprise UK referendum vote, European economies encouragingly appear to be largely unaffected by the Brexit result.

A fact often overlooked is that the UK accounts for just 6% of eurozone exports – so the direct economic impact on companies in the eurozone is, on average, likely to be limited. Of course, averages are only averages, and investors need to be alert to potentially more adverse impacts for individual companies.

While there is a chance Brexit could threaten, by a sort of contagion, the whole European ‘project’ – but for the moment there is scant parliamentary backing for referenda in other member states. In any event, to borrow a celebrated phrase, do not underestimate the willingness of the ECB and the Bank of England to ‘do whatever it takes’ to calm financial markets should we witness another bout of instability.

While many investors remain sceptical on the prospects for Europe, we continue to identify a number of attractively valued underappreciated companies on offer on the recovering Continent. Here are two recent additions to our portfolio:

We have purchased a significant new position in the French semiconductor group STMicroelectronics, a company strategically focused on ‘smart driving’ and ‘the internet of things’. The group is geographically diversified, with roughly a third of sales coming from each of the Americas, EMEA and Asia Pacific.

The company is working hard to restructure its set top box business, which has overshadowed the group for a number of years. Sales have fallen by some 50% since 2013, depressed by a number of weak new product introductions – as well as intensified competition from the developing world.

The company’s overall digital business, which includes set top boxes, is losing roughly $100m per annum – but management is in the process of redeploying 600 related developers to the more successful automotive and microcontroller areas of the group. The restructuring programme will also include 1,400 redundancies. Overall, the project should yield about $170m of annualised cost savings per annum from the end of 2017.

We have been impressed by the quality of the remainder of the business. Approximately half of revenues are derived from the microcontroller and automotive divisions, where they are positioned second and third in the world respectively. The microcontroller business, in particular, generates an impressive 17% EBIT margin and has managed to double its market position over the last five years. STM were, notably, the first manufacturer to adopt 32-bit ARM processors.

While the automotive business is currently less profitable, at a 9% EBIT margin, the business is growing by more than 10% per annum and is expected to generate significantly higher returns in the future.

With a very broad range of different technologies, STM also appears to be well positioned to benefit from the rapid development of the ‘internet of things’. The emergence of areas such as autonomous vehicles, home automation, health and even drones are presenting dynamic growth opportunities.

STMicroelectronics’ Q2 results were very encouraging, with the company achieving 6% quarter-on-quarter growth. The group should be able to return to year-on-year growth by the second half of this year. The shares could be trading on some seven times 2018 earnings, which appears to good value relative to other semiconductor manufacturers.

Another recent addition to the portfolio is Vallourec, one of the leading manufacturers of specialist tubes for the oil and gas industry – as well as for the electrical, petrochemical and automotive industries.

The company is restructuring in the face of a sharp slowdown in the oil and gas industry. In particular, management is working hard to improve productivity in Europe. It is planning 5,000 redundancies across the group, including 1,000 job cuts in France.

In Brazil, furthermore, two blast furnaces are to be closed and manufacturing refocused on one key site.

The combination of €750m cost savings and a recent €1bn capital increase should allow the group to weather further volume declines this year. With prices already starting to firm up in the US, we imagine its shares could be trading on 1.5x earnings as we approach the next peak in the cycle.