The Impact of Brexit on the Stocks We Cover
There's much to consider, but it's not all bad news.
The United Kingdom's June 23 vote to leave the European Union threw global markets into turmoil. According to Morningstar’s equity analysts, the effect of Britain's exit--or Brexit--on the stocks they cover will vary by sector and even by company. Here are some of their takes as of June 24.
The Brexit vote will have wide-reaching implications for our European financials coverage. We plan to lower our fair value estimates for several U.K. banks--including Barclays (BCS)/(BARC), Royal Bank of Scotland (RBS)/(RBS), and Lloyds (LYG)/(LLOY)--and we will review other valuations, such as that of Banco Santander (SAN)/(BNC)/(SANT)/(SAN), which has U.K. exposure. We expect the U.K. system and the European Union to experience substantial uncertainty and volatility as the U.K. seeks to renegotiate trade agreements with other countries, unwind other legal agreements with the EU over the next several years, and deal with the political aftermath of Prime Minister David Cameron’s resignation. We also now see the strong possibility of Scotland seeking independence, causing further turmoil to the overall system and particularly for Edinburgh-based banks Lloyds and Royal Bank of Scotland, which may need to redomicile. While the impact of Brexit is far-reaching, we do see an undervalued opportunity with HSBC (HSBC), primarily because of its relative lack of U.K. exposure and its pivot toward Asia.
There are several fairly immediate considerations for banks. We expect to see higher funding costs for U.K. banks, sharply lower loan growth as we expect anywhere between a 3%-6% impact to U.K. GDP, and a significant drop-off (potentially 40%-50%) in investment banking fees. Asset management and trading operations will be affected by the stock, bond, and currency volatility, and we expect trading losses as well as lower asset management fees. Foreign banks, such as JPMorgan Chase (JPM), are likely to incur millions of dollars in legal and personnel costs as they move employees to other countries from London to facilitate capital markets activity. We see particular risks for Barclays and Royal Bank of Scotland, as these banks have large investment banking operations and are wholesale funded. We expect to see lower scale and cross-firm synergies for banks in London and ultimately a negative impact on profitability.
We also see largely negative impacts over the longer term. We expect a lower level of normalized GDP growth for the U.K., which has been one of the strongest beneficiaries of GDP growth in the EU since it was formed. We believe the reorganizations that will take place at many U.K. banks will lower the overall importance of London as a key financial center, making it harder for banks to compete for talent and the relationships that drive fee income and help retain deposits. There are also renewed concerns regarding other countries in the European Union, such as Italy, France, and Spain, where citizens have expressed strong interest in holding in their own referendums to leave the European Union. Again, the impact for the banks we cover in those systems, such as UniCredit (UCG), Intesa Sanpaolo (ISNPY)/(ISP), and Societe Generale (SCGLY)/(GLE), would probably result in higher costs and slower growth, which combined with weak capital levels would be quite concerning.
Fears of the impact of Britain’s exit from the EU have pushed down the prices of most European communications stocks. We think this is an overreaction, as we view telecom as a sector somewhat immune to geopolitical changes. In our view, Brexit will have no effect on cross-border transfers of voice or data as mobile termination rates for voice have already been reduced to negligible levels, and for data they have been cut in half and will be down to local roaming rates by the end of 2017. While we expect the U.K. economy will slow as a result of Brexit, we don’t believe the event will have a material impact on the U.K. operators. We maintain our economic moat ratings for our entire European telecom coverage universe. We also maintain our fair value estimates in local currencies but may lower them for the ADRs, depending on currency moves versus the dollar. The exception is Vodafone (VOD)/(VOD); we plan to raise our valuation slightly, primarily from the time value of money and, to a lesser extent, slightly higher growth rates as the firm’s move to the euro as its functional currency reduces currency volatility. However, we are increasing our fair value uncertainty rating to high from medium, as results could be more volatile.
Within the U.K., we think BT Group (BT)/(BT.A) will probably be the most affected as the majority of its revenue is from the U.K. Its only non-U.K. revenue is from its global services division. However, we think what losses do accrue will be offset by stronger revenue from the global services division as revenue from other currencies is translated into a weaker pound.
The acquisitions of Sky Deutschland and Sky Italia look more prescient as Sky (SKYAY) /(SKY) now has a decent amount of euro-denominated revenue to bring back into the weaker pound to offset subscriber losses. Sky’s customer base held up better than we expected during the financial crisis, and while premium television services are more discretionary, we think losses will be minimal and offset by currency gains.
Allan C. Nichols, CFA
Capital markets-related companies’ earnings may be more affected by the knock-on macro effects of Brexit than the future operational disruption. Based on our current understanding, a relatively simple response to Brexit is for institutions to open a subsidiary in the EU to continue enjoying trade privileges similar to the ones in the U.K. Some additional capital may be locked up for regulatory requirements and duplicative expenses will be incurred, but overall we don’t expect it to be material.
More material to near- to intermediate-term earnings will be Brexit’s effects on macro factors. Global uncertainty shifts central bank policy to a more accommodative stance. Firms leveraged to rate hikes, such as retail brokerages, may have to wait longer to receive earnings boosts. Companies with material earnings denominated in European currencies will have earnings-depressing translation effects--25% of Goldman Sachs’ (GS) and 15% of Morgan Stanley’s (MS) revenue comes from Europe, the Middle East, and Africa. Wealth and asset management firms that bill based on client asset levels will have their fortunes affected by any decrease in asset prices and assets denominated in foreign currencies. Volatility will increase trading volume, definitely helping trading platforms like the financial exchanges, while having a somewhat mixed effect on brokerages, which will have higher trading volume potentially offset by valuation marks on their trading inventories. Continued capital market volatility will also damp underwriting and advisory revenue.
In the long run, if more countries split off the European Union, we believe brokerages, exchanges, and financial information providers stand to benefit. More countries with their own currencies and monetary authorities with disparate interest rate policies would lead to higher currency and rates trading volume. Information providers collecting and disseminating these new data points will also be more valuable.
Michael Wong, CFA, CPA
Brexit will have ramifications not only for the British pound but for the value of equity and fixed-income assets. While the U.S.-based asset managers we cover are not quite as exposed as firms based in the U.K. or Europe, there will be an impact on their levels of assets under management in the near term as global markets react negatively to the news. The longer-term problem for those doing business in the region will be the increased costs associated with operating in a less cohesive market.
While most of the asset managers we cover have exposure to the region by virtue of investing in the stocks and bonds of Europe-based firms, a handful also have exposure by way of clients being domiciled in the region--namely, BlackRock (BLK), Franklin Resources (BEN), Invesco (IVZ), Legg Mason (LM), AllianceBernstein (AB), and Affiliated Managers Group (AMG). Less exposed firms include T. Rowe Price (TROW), Federated Investors (FII), Eaton Vance (EV), Janus Capital Group (JNS), Waddell & Reed (WDR), and Cohen & Steers (CNS).
We expect all of these firms to be caught in the undertow of declining global markets in the near term. Although there is likely to be a fair amount of market and currency turmoil, primarily because most market participants were caught flat-footed by the vote to leave, we’re not anticipating making wholesale changes to the fair value estimates of the companies we cover.
Having reduced the valuations for most of the U.S.-based asset managers in mid-January, we held off on raising them after the global markets bounced off their mid-February lows, believing that the rally was unlikely to hold (with one of the potential downdrafts coming from the Brexit vote). In instances where a firm’s exposure to the European markets is heavier, we expect to revisit our model assumptions to ensure that we are adequately compensating for the increased risk.
Greggory Warren, CFA
Amid the fallout of the Brexit vote, we are reiterating narrow-moat Danone (DANOY)/(BN) as our top pick in pan-European consumer staples. Following the results of the referendum, we are shaving our near-term (through the end of 2017) organic growth rate assumption by around 10 basis points per year to reflect a weaker U.K. economy, but the weaker euro offsets the impact, and we are maintaining our EUR 71 fair value estimate. We are raising our valuation of the ADRs to $17.50 from $16.50, however, due to the depreciation in the euro. Though possible European Union referendums in other member countries present a new risk to our cash flow assumptions, we would regard any Brexit-driven weakness in the stock as a buying opportunity.
With the euro falling slightly against most major currencies, Danone could benefit from a sustained currency tailwind. We estimate that just over 70% of Danone’s sales are denominated in currencies other than the euro, meaning a depreciation in the euro will provide a boost to Danone’s reported numbers. Only 6% of the firm’s sales are generated in the U.K., so the firm would be relatively insulated against a recession in that market.
Danone recently raised its 2016 guidance, indicating full-year margin expansion of 50-60 basis points, entirely in line with our investment thesis. Danone possesses strong secular growth drivers that should allow it to grow at a rate above packaged food competitors. Danone’s infant formula business is a growing, profitable business in which brand loyalty is fairly high, but acquisitions and a more capital-intensive process weigh significantly on returns on invested capital. Economic development is a strong secular growth driver in this category, and if historical operating leverage ratios hold, we believe Danone can expand its divisional EBIT margin by 400 basis points, a factor that is not appreciated by the market, in our view, and the source of the valuation upside.
Philip Gorham, CFA, FRM
We estimate that the U.K. is around 15% of Priceline’s (PCLN) total bookings, and should the pound remain at current levels of GBP 1.37 to the U.S. dollar, it would represent around a 1-percentage-point headwind to total bookings growth this year. Forecasting the economic impact of Brexit is challenging, but we note that both Priceline and European travel bookings remained fairly resilient in 2011-13 despite the uncertainty regarding sovereign debt and financial unity that existed in the eurozone and drove lower overall GDP growth at that time. We have lowered our fair value estimate to $1,770 from $1,800 to account for sterling currency headwinds that mostly affect this year and for some slowdown in European GDP growth due to the uncertainty that might be created by Brexit. We maintain our narrow moat rating, which is driven by an increasingly powerful network, and recommend that investors take advantage of pullbacks in the stock price.
According to Phocuswright, the U.K. represents 27% of the total European online travel booking market. We estimate Priceline gets around 55% of its total bookings from European customers, so assuming that the mix to the U.K. is similar to the overall market results in the company having around 15% of its total bookings from the country.
Although slowing to some degree, European travel and Priceline bookings were fairly resilient during the European GDP slowdown in 2012 and 2013. European GDP was roughly flat then, declining from around 2% growth the prior two years. Despite that economic slowdown, Europe travel bookings growth (based in euros) was 1.8% in 2011, 6.1% in 2012, and 1.2% in 2013. Meanwhile, Priceline’s total bookings growth was 59% in 2011, 31% in 2012, and 38% in 2013. European revenue per available room was up high single digits in both 2011 and 2012 before dropping to low-single-digit growth in 2013.
Deutsche Boerse and London Stock Exchange
Brexit has several immediate implications for the Deutsche Boerse (DB1) and the London Stock Exchange (LSE). Unless the merger is restructured, we think it is less likely to go through, and we are dropping our assumed chance of the deal happening to 25% from 50%. While management teams from both companies have said they are moving ahead with the deal and presumably had considered the Brexit possibility in behind-the-scenes negotiations, we think it will be more difficult to obtain regulatory approval for the deal from Germany and the EU. We also think increased uncertainty tends to decrease shareholder enthusiasm, and the latest turn of events is likely to be no exception.
An increase in volatility should increase trading volume, which will benefit the exchanges. Additionally, weakness in the pound has traditionally been an earnings tailwind for LSE, which has earnings exposure to the U.S. dollar and euro but reports in pounds. This could boost earnings in the short term, but the benefits will probably be modest and not meaningfully alter our fair value estimate. Deutsche Boerse has less exposure to currency fluctuations, probably less than 3% of total revenue; therefore, this should not be a meaningful event.
To account for the decreased possibility of a deal, as well as the decreased value of LSE shares in terms of pounds/euros, we are lowering our fair value estimates to GBX 3,000 from GBX 3,100 GBX for LSE and to EUR 81 from EUR 85 for Deutsche Boerse. Our narrow moat ratings are unchanged.
Investors should be prepared for market and currency turmoil as the ramifications of Britain leaving the EU are complex and without precedent, and this is just the beginning of a drama that could take years to play out. In the long run, however, the EU and the UK both need functioning financial markets and the exchanges that enable this.
Michael Wong, CFA, CPA
We do not expect a large change to our $47 fair value estimate for no-moat Hain Celestial (HAIN), though we do plan to reduce our fiscal 2017 and 2018 forecasts for the company’s U.K. operations. The U.K. segment accounted for 27% of Hain’s fiscal 2015 revenue, and we anticipate reducing our fiscal 2017 and 2018 sales growth expectations to a mid-single-digit decline and a low-single-digit uptick, respectively, from a prior 6% increase assumed for both years. However, we predict these revisions to our expectations will affect our 10.7% 2016-20 compound average revenue growth forecast by less than 100 basis points and our 12.4% average operating margin estimate for the same period by less than 25 basis points.
While we expect Brexit to modestly reduce demand for Hain’s lineup of premium-priced products as the economy slows (leading to slight expense deleveraging), we anticipate the bulk of the impact on the firm’s results will come from currency movements’ impact on translated sterling-denominated U.K. profits. Hain’s natural and organic ethos necessitates relatively local sourcing for many of its products as it eschews many commercial pesticides and preservatives; therefore, we expect the company does not have a large currency mismatch between revenue and costs in the U.K. segment. We believe the U.K. unit’s plans to expand its Tilda and Terra lineups, broaden distribution for its beverage offerings (even after concessions to secure antitrust approval for its Orchard House acquisition), and achieve back-office efficiencies should help offset the less attractive macroeconomic picture. Furthermore, Britain’s exit from the EU should take place over time, with replacement trade agreements negotiated in the interim and ample opportunity for the company to use its extensive sourcing network to secure alternative supplies, should imports from the continent for various ingredients become costly.
Hain may stand to benefit from Brexit’s economic volatility in its ongoing merger and acquisition efforts, as small natural and health-oriented foods makers in the U.K. may respond to the new, more volatile macroeconomic landscape by seeking acquisition partners more aggressively. This could result in Hain sourcing attractive assets at lower multiples than recent precedents. While we do not plan to change our $160 million average M&A expenditure forecast and 1.2 times sales average multiple expectation for 2017-20 at this time, we anticipate a larger share of the company’s efforts may be focused on adding to its British operations, offsetting a slower U.S. acquisition cadence as the company refocuses on reigniting organic growth in its home market.
Penske Automotive Group
Most of the public auto dealerships have zero exposure outside the United States, but the major exception relevant to the Brexit vote is Penske Automotive Group (PAG), which in 2015 got 34% of its total revenue from the U.K. We think the market sold off auto stocks too harshly after the vote, and although we have reduced our forecast for Penske’s annual revenue as a result of translation headwinds from the stronger dollar against the pound, we are not changing our moat rating or fair value estimate.
We think Penske’s focus on premium and luxury brands is the best brand positioning possible in light of the U.K.’s vote to leave the EU. Penske has said in Securities and Exchange Commission filings that 95% of its U.K. revenue is through the service of premium brands, which include Audi, BMW, Jaguar, Land Rover, Mercedes, and Porsche but also high-end luxury brands such as Bentley, Ferrari, and Lamborghini. We do not see the buyers of these vehicles opting to buy a volume (that is, mass market) brand just because of a possible tariff in the future. We think someone who wants a Ferrari or a Mercedes S550, for example, will buy one regardless of the price. The company’s U.K. stores buy and sell their inventory in pounds, so the biggest risk to profits, in our view, comes from translation risk of revenue back to a stronger dollar rather than transactional risk. Store expenses are in pounds, so there is a favorable translation impact on U.K. expenses into dollars partially offsetting the negative translation impact of U.K. revenue into dollars.
David Whiston, CFA, CPA, CFE
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