Global Growth | International | April 2015
Potential operating leverage opportunities in Europe
Sources: Thomson Reuters Datastream, FactSet, Bloomberg. As of February 28, 2015.
Europe is showing signs of improvement, despite unaddressed structural issues. But many companies domiciled in the region continue to trade at a discount to U.S. peers due to lower operating margins (EBIT). Margins remain low because of some high fixed costs, including labor, and anemic revenue growth emanating from the region. But larger fixed costs mean that operating leverage tends to be higher in Europe than in other regions.
EBIT margins of the STOXX Europe 600 Index have yet to surpass prior period peaks, while the EBIT margins of the S&P 500 continue to expand, reaching new highs in 2014. The difference in EBIT margins between the two indexes is near its widest level in the last 10 years. There is also a disparity between the valuation of S&P 500 companies and those in the STOXX Europe 600 Index.
Operating leverage can be powerful when an economic environment is improving and can result in rapid earnings estimate revisions as well as multiple expansion. The European Central Bank’s quantitative easing program, a pickup in business activity in the euro zone, or any positive news out of Greece or the Ukraine could produce meaningful sales growth for many companies that have large business exposure within the EU. As potential European sales growth occurs, investors could quickly close the valuation gap between European and U.S.-domiciled companies.
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