European Capital Goods: A good quarter but will it last?

At -0.4%, Q2 showed modest improvement in core sector organic growth from -1.2% for 1Q. Europe saw some short-cycle demand growth, and whilst China improved from Q1, it remained weak.

The US deteriorated. Even on good execution, core margins declined by 10bps YoY, beating expectations for a 40bps decline. In all, the Q2 results were therefore not as bad as some had feared. However, looking ahead at H2, neither companies nor lead indicators point to meaningful improvement. Sliding oil and copper and rising steel prices pose risks as do plateauing automotive volumes.
But above all, geopolitical risk looms large as a potential disruptor to Europe’s status as the sector’s growth driver. Post the recent rally, valuations are now at all time highs of 12x EV/EBITA and 17x P/E again, leaving the sector vulnerable, in our view. We prefer quality and tangible self-help and remain bullish on Wind’s secular prospects.

Q2 – not as bad as feared. Organic growth was once again led by the Electricals, which posted +1.6%, whilst the mechanicals declined by 1.1%. Siemens stood at the high end with organic of 7% while Alfa saw the largest decline at -9.7%. Heading into Q2, we were concerned about short-cycle demand. China – whilst still weak – wasn’t as bad as we feared. But the US weakened, particularly so for SKF. Core sector margins reached 14.0% (-10bps YoY), but beat expectations by an average of 2.5%. Six companies raised guidance, whilst only Alfa and SKF lowered the FY16 outlook. Core sector Bloomberg FY17 EPS estimates nudged up but a smidgeon over the Q2’16 season.

End-markets remain mixed. During Q2, the construction market continued to show encouraging signs, both in mature markets, such as France and the US, and further afield, e.g. India. The energy revolution is still driving demand for both Renewables and T&D. Gas turbines demonstrated persistent growth in a competitive pricing environment. Mining equipment showed signs of stabilization whilst consumables were mixed. Outside of automotive, discrete automation was mixed at best, whilst process was weighed down by O&G. China remained mixed with automotive and T&D standing out positively, construction mixed and non-auto automation and resources poor.

Sector positioning – quality, tangible self-help and Wind. The sector has re-ratedsignificantly in the post-Brexit yield-search rally and is now trading on 12x EV/EBITA and 17x P/E (2017E). The Mechanicals are now on 14x EV/EBITA, whilst the Electricals are at a more modest 11x. In that light, we still struggle to see buying opportunities in the former group with only one OW rating (Atlas Copco) and UWs on Alfa Laval and Sandvik.
We recently upgraded Legrand to an OW on expected flight to quality and saw confirmation in Q2 results. ABB remains our preferred large electrical with a clear catalyst in the upcoming CMD whilst we rate Schneider as UW. Elsewhere among the Electricals, we like Alstom on a margin improvement story whilst we moved Osram to an UW as earnings momentum has turned and valuation is elevated. Our Sector Top Pick is Vestas, which benefits from secular growth, quality management and a strong balance sheet.
Amongst the other wind names, we also like Nordex and Senvion.

Barclays Equity Research