Europe: Was (Is) It Worth The Trouble?

No for indexers. Yes for macro trend investors. Maybe (but probably not) for bottom-up stock pickers.

European stocks face a unique situation, which is that, outside of the rolling debt crises from Ireland to Iceland to Greece to Spain, their performance has been, and will continue to be, driven by macro factors emanating from outside the European Union.  This is mainly because Europe itself has the worst demographics of any region of the world with declining or stagnant populations in several countries and rising dependency ratios (dependents per worker) in all countries (see tables or, for more on demographics, see Demographic Megatrends of the 21st Century).  Therefore, except for the cyclical recovery which may or may not show up this year or next, the longer-term prognosis for domestic demand growth is far from encouraging for a large majority of European companies.

UN   Estimate Total Fertility Ratio Population (millions)
  2010 2030 2050 2100 2010 2030 2050 2100
 France 1.99 2.04 2.06 2.09 63 68 72 80
 Germany 1.46 1.74 1.9 2.05 82 79 75 70
 Italy 1.48 1.75 1.91 2.05 61 61 59 56
 UK 1.87 1.97 2.03 2.08 62 69 73 76
 Europe  1.59 1.82 1.93 2.06 738 741 719 675

These estimates are from the United Nations medium variant. Note how the dependency ratio declined for the past four decades and is now expected to rise in the next four.

 Dependency Ratio 
1950 1970 1990 2000 2010 2015 2020 2030 2050
 Europe 52 56 50 48 46 50 54 61 75
 USA 54 62 52 51 50 53 56 64 67

It is fortunate therefore that Europe has some tremendous companies, large and small, which are global leaders in their sectors and which can find growth outside of Europe’s borders.  A large number of these companies have had a very strong performance in recent years thanks to slow growth in the US and fast growth in emerging markets, in particular China. Good examples are iconic automaker BMW, luxury goods powerhouse LVMH, chemical giant BASF, retailer Hennes & Mauritz and many many others.

(Note: stock tickers not shown in the text are shown in the tables, using the Bloomberg convention)

Some of these winners have been smaller companies. Consider for example the Finnish tire company Nokian Tyres (NRE1V FH) spun off from Nokia (NOK1V FH) in 1995. Although Nokia has for years been followed obsessively by investors, it is Nokian Tyres which has outperformed Nokia proper by a stunning margin over the past seventeen years (except for 1998-2002 and 2008-09) logging in a nosebleed gain of nearly 4900% since the spinoff vs. Nokia’s decidedly paltry cumulative 11.3% (excluding dividends). Even if you exclude Nokia’s decline after 2007, the outperformance would still be very large. (Note to Apple AAPL watchers: it may be better to look elsewhere).

In the 1990s, there was much talk of the benefits to investors from geographic diversification. Academic research made a case that greater returns could be achieved with less volatility, a case which was then amplified in the financial media by large mutual fund companies. It is not within my scope to rebut this case from a theoretical perspective. For the next section however, I looked at the numbers empirically and they show that a multi-country European stock index would have underperformed the US or other global markets in the past ten and twenty years. In many periods, this underperformance was not accompanied by a correspondingly lower volatility. In fact, the volatility of European markets in 1996-98 and 2005-08 seems to have been higher. A European indexed fund or ETF (VGK, IEV), to put it plainly, was simply not worth it.

Because the vast majority of mutual funds underperform their benchmark index, you could also say that European mutual funds were not worth it.  In the event of a large deviation between a foreign stock fund and its benchmark, such deviation could usually be explained by currency moves rather than the fund managers’ skill at selecting a portfolio of superior stocks.  This was certainly the case in the 2003-07 bull market when US dollar weakness greatly helped all funds which were not fully currency-hedged. Here the financial media usually gave all the credit to the fund managers’ superior stock selection (often alleged) and not enough attention to the currency moves (always real).

A MEMO TO CLOSET INDEXERS

European stock indices usually move in step with the US market.  This is not true in every single year but it is true in most years and on a multi-year basis if not in magnitude, certainly in direction. Going back ten years, the European markets moved roughly in line with the S&P 500 except for 2005 when the European index outperformed by a wide margin, and 2010-2011 when the S&P 500 outperformed for two years in a row.

As things stood last December 31st, Europe had returned 38% in a decade and the US 62%. Much of this underperformance can be attributed to the strengthening of the Euro which nearly doubled against the US dollar in 2001-2008. A strong Euro/weak dollar is detrimental to European indices which are heavily weighted with exporters. A dollar-based investor in Europe who did not hedge out the currency would have benefited from the stronger Euro and would have recorded, in the decade ending on December 31st 2012, a gain of 67% from European indices, marginally better than the S&P 500.  On a twenty year basis, the European index returned 162% for a currency-hedged investor and 196% for an unhedged investor, in both cases less than the S&P 500 which returned 227%. (These returns and the ones shown in the table do not include dividends).

Nonetheless, the overall European index (I use MSCI Europe) masks important differences between countries.  Although the EU has gone a long way to reduce these differences, they continue to be relevant because regulation, taxation, work ethic and basic business practices remain largely country-specific. It is trite to say that Germany is the uncontested leader in Europe, but it has emerged by now in early 2013 as the primary beneficiary of the Euro project.  I made a case here that Germany should in a strange way be thankful for Greece, because it is the presence of Greece (and Italy and Portugal) within the Euro sphere which has kept the Euro at a level that is weak enough to help German exports and to sustain the German economy on a growth path.  Without the Euro, the Deutsche Mark would have been stronger against other leading currencies and Germany’s economy would have probably fared worse than it did.

Twilight or sunrise?
Twilight or sunrise?

When you look at country indices going back two decades, a few things stand out quickly. First, the US, UK and Germany have recovered nearly all their losses of 2008-09, whereas France, Spain and Italy have not.  Second, Germany has outperformed the US by a wide margin in the past ten years and in the past twenty years. Spain has also outperformed the US in the past twenty years but that is mainly due to the first decade 1993-2002 when the Spanish stock market, along with Italy, was a huge beneficiary of the convergence trade preceding the adoption of the Euro.  The UK has lagged the US and Germany but has done better than France in the more recent decade.  All in, of the large markets, Germany stands out as a big winner, Spain a winner only in the first decade, Italy as a big laggard, and France and the UK somewhere in between.

The smaller Nordic markets have done exceedingly well over the past two decades.  Norway was greatly helped by its exposure to oil and oil services in the past decade.  Sweden and Denmark did very well in both decades thanks to stellar performers Hennes & Mauritz, Atlas Copco, Novo Nordisk (NOVOB DC) and TopDanmark (TOP DC). Finland’s index benefited from Nokia’s large market cap weighting in the 1990s and suffered from it in the last five years.  Ex-Nokia, the Finnish index would in fact show an impressive performance in recent years. On the two decades 1993-2002, Finland is still the best European performer by far. Like Germany, it has many world-class exporters.

 1993-02  2003-12 1993-12 2003-07 2008-12
 USA  S&P 500 101.9% 62.1% 227.3% 66.9% -2.9%
 Europe Local  MSCI 89.8% 38.2% 162.3% 85.9% -25.7%
 Europe USD  MSCI USD 77.9% 66.7% 196.4% 144.5% -31.8%
 UK  FTSE 100 38.4% 49.7% 107.2% 63.9% -8.7%
 Germany  DAX 30 87.2% 163.2% 392.7% 178.9% -5.6%
 France  CAC 40 64.9% 18.8% 96.0% 83.2% -35.1%
 Spain  IBEX 157.5% 35.3% 248.4% 151.5% -46.2%
 Italy  FTSE MIB 138.9% -30.8% 65.3% 62.8% -57.8%
 Switzerland  SMI 119.8% 47.3% 223.8% 83.2% -19.6%
 Netherlands  AEX 148.8% 6.2% 164.2% 59.8% -33.6%
 Sweden  OMX 174.6% 124.0% 515.0% 119.3% 2.2%
 Norway  OBX 320.0% 332.0% -2.8%
 Denmark  OMX 166.8% 148.7% 563.5% 132.7% 6.9%
 Finland  OMX 596.7% 0.5% 599.8% 100.8% -50.0%
 Brazil  Bovespa 166089.0% 440.9% 898832.0% 467.0% -4.6%
 Brazil USD 111.3% 836.5% 1879.1% 1030.2% -17.1%
 China  Shanghai 74.0% 67.1% 190.8% 287.6% -56.9%
 Hong Kong  Hang Seng 69.1% 143.1% 311.0% 198.4% -18.5%
 Japan  Nikkei 225 -49.3% 21.2% -38.6% 78.4% -32.1%

Among emerging markets, Brazil was a very strong performer.  The Brazilian Real’s devaluation against the US dollar in the 1990s explains much of this performance.  But Brazil has been one of the best global performers even on a dollar basis.  China has had a respectable performance, but perhaps one more muted than many would have guessed from the steady barrage of headlines about the rise of the Chinese superpower. And Japan as we know has been a dismal place to be an indexed investor, except for brief spurts in the mid-90s and in 2003-07.

Net net Europe has underperformed the US on both a one decade and a two decade basis whereas several emerging markets have performed in line or much better than the S&P 500.  All of this may be discouraging if a person worries about the indices too long. But for those who ignore the indices, Europe offers outstanding opportunities.

A MEMO TO THE REST OF US

After the closet indexers have left the room (or clicked away from this page), we can now talk about two incontestable reasons to invest in Europe: 1) an early warning system and 2) a leveraged play on other markets or trends.

Europe as an early warning system

The first reason is that early signs of an impending crisis often emerge in Europe before they do in the US. This is true not because Europeans are more prescient than Americans, but because their stock market is more fragmented into individual countries.  It would be the same here if each state of the United States had its own stock market.  In that case, we might have , for example in 2007, picked up on signs of distress in the subprime market through the Arizona, Nevada or Florida stock markets several months before they became visible in national indices temporarily held up by other, more buoyant sectors.

If a manager has some holdings in Europe, he is likely to pick up on signs of trouble before his competitors do and long before they appear in the major headlines. This was certainly true in 1997 and 1998 when European banks with large exposures to faltering Asian markets and to Russia telegraphed signals to the bullish markets in the late spring and early summer that all was not well. And it was also true in 2000, when stodgy companies like Alcatel (ALU FP) and the old state-owned telecom operators were trading at very inflated multiples normally reserved for hot new companies coming out of California.

This ‘Europe as an early warning system’ delivered again in the crash of 2008, in particular for people who were paying attention to Ireland. The S&P 500 recorded a small gain in 2007 but Ireland which had wholeheartedly embraced the housing bubble saw its index fall by 27%. Italy too was down in that same year, but by a less alarming 7%.

When the US subprime crisis erupted in 2007 and 2008, there was in Europe widespread belief and barely concealed schadenfreude that the Americans, already out of favor on the continent because of the Iraq war, were getting their comeuppance and that Europe, reinforced by a growing Euro sphere and a billion eager Chinese customers, could now promote its economic success as a new model for other countries. As we know, reality came back unsparingly when all Euro markets crashed in late 2008.

In 2011-12, the US market was to some degree driven by the daily news flow from Greece, Spain, Italy and other parts of Europe. For a while, exploding sovereign yield spreads threatened to throw in reverse the conversion trade of the late 1990s and to tear the Eurozone apart. And now Europe has combined bailouts and austerity and the US has combined bailouts and stimulus, with the net result that Europe is in recession and the US is growing modestly. In the coming years, it will still be a good idea for US investors to keep an eye on Europe, even if its importance has diminished in the global sales mix of American companies because of emerging markets.

I recognize that getting an early distress warning is by itself an insufficient reason to draw investors into Europe.  Insurance is a good idea but no one wants to overpay for it or feel that it has become a distraction. A larger and more positive reason to invest in European stocks is that they offer an excellent way to get exposure to other markets.

Europe as a leveraged play on other markets

Investing in Europe to get exposure to other, non-European, markets and trends can be exceptionally rewarding.  Most of the news that may push many large and midsize stocks higher or lower comes from outside of the European continent, chiefly from the US and China.

Exposure to the US dollar and US economy

Until China became a major source of export demand for European goods, the US economy was the most important driver of earnings growth for a large number of European firms. For this reason, the exchange rate of the dollar vs. European currencies was an important factor in the earnings of these companies. European stocks were a leveraged play on the US dollar. If the dollar moved 5%, some stocks would move 10 or 20%. It is true that you could instead invest directly in the currency markets but stocks gave you more leverage and also gave you the possibility of gaining from periodic efforts to create shareholder value. In the 1990s, for example, you had a wave of restructurings, followed by the tech boom. In the 2000s, you had the commodity boom and the rise of emerging markets.

Exposure to the Chinese economy and other emerging markets

Europe’s relationship to the US dollar and US economy still exists but it has been diluted by the rise of another very large client, the Asia-Pacific region. For a majority of large and midcap European companies, the Asia-Pacific region has replaced the US as the main source of sales growth. China and Japan are obviously the two main poles of demand, with China showing by far the fastest growth rate in the sales mix of European firms. One of the best ways to get exposure to the growing Chinese economy has been through a portfolio of European exporters which are global leaders in their industries.  In fact, such a portfolio would have handily outperformed the stock markets of China and Hong Kong in recent years. This may not be intuitive but investing in European exporters has been one of the best ways to invest in Chinese growth.

Nowhere is this more true than in luxury goods and prestige brand companies which have seen a growing percentage of their revenues coming from the Asia-Pacific Region. Luxury goods companies Hermès, Richemont and Swatch now have about 50% of their sales in that region.

 Luxury & Spirits     Market Cap   AsiaPac % 
     Billions USD   2011 Sales 
 Burberry  BRBY LN           9.49 34%
 Campari  CPR IM           4.44
 Diageo  DGE LN         74.33 10%
 Ferragamo  SFER IM           4.44 34%
 Heineken  HEIA NA         42.50
 Hermes  RMS FP         35.91 46%
 LVMH  MC FP         91.18 27%
 Pernod Ricard  RI FP         33.49 39%
 PPR  PP FP         27.16 24%
 Remy Cointreau  RCO FP           6.46 39%
 Richemont  CFR VX         46.74 51%
 SAB Miller  SAB LN         79.62
 Swatch Group  UHR VX         29.85 54%

European companies are by far the world leaders in luxury goods, and the French among them own some of the strongest brands. LVMH is the largest luxury goods company in the world, with an extensive portfolio of brands, including Louis Vuitton, Bulgari, Dom Perignon and Tag Heuer (see full list of LVMH brands here).  France also has Hermès and spirits companies Pernod Ricard and Remy Cointreau. Switzerland has the Swatch Group, the parent of Blancpain, Breguet, Omega, Glasshutte and, as of this year, Harry Winston (see Swatch Group brands here). Also in Switzerland is Richemont, the parent of Cartier, Montblanc and Vacheron Constantin (see Richemont brands here). Italy has Salvatore Ferragamo, spirits company Davide Campari, eyeglass leader Luxottica (LUX IM) and leather company Tod’s (TOD IM). Germany has automotive luxury with BMW, Porsche, Audi and Mercedes.  Porsche and Audi are part of Volkswagen, and Mercedes is part of Daimler (DAI GY). All of these countries also have many more luxury goods companies which are not publicly listed. I have also written about the luxury goods market in BMW, Louis Vuitton, Swatch: Can the Boom Continue?

The US is active in many of these sectors but has few dominant companies.  Coach (COH) and Tiffany (TIF) offer excellent products but cannot match the pricing power, brand supremacy, geographic footprint and cash flows of Hermès, LVMH or Swatch. US firms have also enjoyed better growth in their home market and have not felt the need to expand into the Asia-Pacific region as aggressively as the Europeans have.

Another sector which has benefited from the growth of emerging markets is industrials.  Here too, Europe has some global leaders in autos, chemicals, machinery, industrial gases, aircraft and heavy trucks. In the first nine months of 2012, for the first time ever, BMW sold more cars in China than it did in the United States.  BMW also owns Rolls Royce cars and the Mini brand. And Volkswagen in 2012 delivered nearly four times as many cars in the Asia-Pacific region as it did in North America. All three of BMW, Volkswagen and Daimler are present in both the luxury sector and the industrials sector: BMW through its own brand, Rolls Royce and Mini; Volkswagen through its own brand, Porsche, Bentley and Audi and its ownership stakes in Scania (SCVB SS, 46% of capital) and in MAN (75%); and Daimler through its Mercedes cars and trucks and Freightliner trucks.

Industrials   Market Cap AsiaPac %
    Billions USD 2011 Sales
Air Liquide AI FP          38.73 22%
Assa Abloy ASSAB SS          14.86 9%
Atlas Copco ATCOB SS          34.79 28%
BASF BAS GY          89.56 20%
Bayer BAYN GY          79.07 21%
BMW BMW GY          62.00 17%
Duerr DUE GY            1.75 39%
EADS EAD FP          39.13 29%
Henkel HEN GY          34.96 15%
KUKA KU2 GY            1.51 24%
MAN MAN GY          17.48
Rolls Royce RR/ LN          28.61
Volkswagen VOW GY        108.79 14%
Zodiac ZC FP            6.46

Because of its Airbus division which competes with Boeing, EADS may be of particular interest to US readers. Last year, I wrote about the epic battle between the two aircraft manufacturers in Boeing vs. Airbus: Orders and Profits. Since then, EADS has undergone some important changes in its shareholding structure. Its free float which is now 54% is expected to rise above 70% after large legacy shareholders reduce their stakes. Management has expressed a new commitment to transform the company from a conglomerate of state-owned or state-sponsored businesses into a more ‘normal’ company which is more responsive to shareholders.

Finally, Europe has some outstanding companies in the mass-market consumer and retail sector which expect to grow in emerging markets as well as in the United States.  Notable among them are Hennes & Mauritz and Inditex, the parents of retailers H&M and Zara, and cosmetics giant L’Oreal.

 Consumer/Retail     Market Cap   AsiaPac % 
     Billions USD   2011 Sales 
 Adidas  ADS GY           19.63 16%
 BAT  BATS LN         100.55 28%
 Beiersdorf  BEI GY           22.32
 Bic  BB FP             5.78
 Hennes & Mauritz  HMB SS           60.76
 Hugo Boss  BOSS GY             8.47
 Inditex  ITX SM           88.35
 L’Oreal  OR FP           91.98
 Nestle  NESN VX         226.60
 Unilever  UNA NA         118.07 41%

What Europe does not have

Outside of indexing and macro driven investing, what about simple bottom-up investing?  Ideally, we would like to invest in names which are insulated from the big macro questions of US and China growth.  However, it is difficult to imagine many large or midsized European stocks doing well in the event of a Chinese slowdown and US recession.  Under this scenario, it would be best to find a handful of smaller names with their own domestic growth dynamic.

Yet, if this seems like a desirable strategy, the US market is more fertile ground to find such small companies for two reasons: 1) the US has more new companies which go public and 2) these companies can grow domestically for longer because the size of the domestic market is many times larger. A good example is Whole Foods (WFM) which was still a small cap name in 2000 (and again briefly in late 2008). It now has over 300 stores in the United States (and 15 in Canada and the UK) and added ten new stores in the last quarter, eight of which were in the US. A similar European company would have hit the wall in its home market at a much earlier stage.  Outside of the large trends described above, there is, in my view, little reason for a US-based investor to put money in a small European company unless it is really a very unique and irresistible story with no US equivalent.

The clear Nordic air
The clear Nordic air

You might think that Nokian Tyres fits that profile. But even here, much of the company’s growth is directly linked to demand from Russia, which is itself tied to the rise in energy prices and ultimately, to the growth of the Chinese economy.  Should that economy slow down, the price of oil would decline which would dampen Russian demand for all sorts of goods, including tires.  Because European companies have a smaller domestic market than their US counterparts, it is more difficult to find good secular growth stories which are not dependent on the global growth picture.

If we redefine a company’s domestic market as the whole of Europe instead of just its home country, we find a handful of steady growth names. A notable pan-European success is the Swedish retailer Hennes & Mauritz which has 406 H&M stores in Germany, 226 in the UK, 182 in France, 177 in Sweden and hundreds of others elsewhere. It also has 269 in the US (from none in 1999) and 111 in China. H&M is among a handful of retailers that have gained market share in several markets (another is Inditex’s Zara). Today, the company’s growth is very much tied to globalization given that its cash flow (and ability to invest) is derived from a very high gross margin, the result of sourcing its products from 700 independent suppliers mostly in Asia. Hennes’ gross margin has expanded from 44.6% in 1998-99 to a blistering 59.5% in 2012 (it was over 60% in 2010-11). As a comparison, Gap’s gross margin in 2011 was 36.2%, down from 45.3% in 1999.

Other interesting growth companies include food caterers Compass (CPG LN) and Sodexho (SW FP), eye lens maker Essilor (EF FP), lock manufacturer Assa Abloy (ASSAB SS), diabetes care leader Novo Nordisk (NOVOB DC), health product suppliers Coloplast (COLOB DC) and Getinge (GETIB SS) and oil services companies Technip (TEC FP), TGS Nopec (TGS NO) and Seadrill (SDRL NO).  Yet they all seem in varying degrees to have grown to their current size because of demand from outside Europe. I maintain that the odds of finding several small or mid cap stocks which will grow year after year from domestic demand alone are significantly lower than in the US.

Europe also does not have a large investable technology sector. Among larger companies, there are SAP (SAP GY) and ASML (ASML NA). Every country has a smattering of smaller companies which operate in services or in manufacturing niches.  What some Europeans call technology tends to be larger scale and sometimes state-sponsored, an R&D effort which may very well be on the cutting edge but which has more to do with machinery and engineering than with computers, data processing or the internet. This includes high speed trains and nuclear plants where the French are leaders. Perhaps there will be another new technology where European companies will take a lead, but if the history of mobile phones is an indication, this leadership will probably be short-lived.

The conclusion is two-fold:  1) the main reason to invest in Europe has in recent years been non-European demand for some superior products and 2) Europe has been the first place to see early signs of an emerging crisis. One has to approach European investing with a macro perspective developed elsewhere, by analyzing demand in the US and China, and then choose the global leaders which are best leveraged to that macro perspective. Obviously, this could work in reverse with a vengeance.  Any evidence of a prolonged Chinese slowdown would tumble some luxury goods and industrial stocks by 20%, 30% or more.

Because Europe is now in recession, a recovery would certainly result in a cyclical upturn in earnings for many companies. Value investors today should be sifting through the long list of beaten down names, among them the long suffering French volume auto producers Peugeot (UG FP) and Renault (RNO FP). But European demographics are poor and cannot contribute a sustained source of demand.  This means that, beyond the cyclical recovery, the longer term growth driver for most European equities will still have to come from outside Europe.

Boeing vs. Airbus: Orders and Profits

Boeing has a better product lineup and is more profitable but Airbus has more room for improvement.

The rising tide of globalization has boosted growth prospects for the airline industry all over the world, and in particular in emerging markets such as China and India.  As air travel has become more accessible to hundreds of millions of people, airplane orders and deliveries have boomed. We examine the evolution of orders and profits at Boeing and Airbus.

Airbus Market Share Strategy

Given the Boeing – Airbus duopoly and buoyant demand markets, both manufacturers should now be highly profitable but this is only true of Boeing.  Airbus made some strategic decisions in the late 1990s and early 2000s that continue to depress its profitability, namely the development of the super jumbo A380 which is still loss-making, and the sale of planes below cost or at razor-thin margins in the early 2000s in a drive for market share.

If Airbus’s main mission has been to gain market share, one has to recognize that this mission has so far been highly successful.  In the year 2000, Airbus delivered 311 planes to airlines and Boeing delivered 489.  Eleven years later in 2011, Airbus delivered 534 planes and Boeing 477.  As important, the backlog at EADS (European Aeronautic Defence and Space Company, the parent of Airbus), including non-Airbus divisions, grew from €132 billion in 2000, the equivalent of 5 years of revenues, to €541 billion in 2011, the equivalent of 11 years of revenues.  Boeing’s comparable backlog grew from $153 billion in 2000, 3 years of revenues, to $355 billion in 2011, 5 years of revenues.  Because the Euro has appreciated against the dollar in that decade, these figures actually underestimate the scale of the shift in favor of EADS/Airbus.  In dollar terms, EADS’s backlog has grown from $124 billion in 2000 to $700 billion in 2011, a near six-fold increase.

But Boeing has been more profitable.  In 2011, its EBIT margin in commercial planes was 9.7% vs. 1.7% at Airbus. This dichotomy between one party’s push for market share gains and the other’s focus on profitable orders has defined the relationship between the two competitors for over a decade.

In a decade of astounding revenue and order growth, Airbus has not improved its profitability.  In fact, its operating income (EBIT) was negative in three of the last six years (2006-2011) despite healthy revenues and deliveries.  Boeing has remained profitable but its commercial airplane sales and operating income have been range-bound for a decade.  From 2000 to 2011, Boeing sales grew at a small 1.4% annualized rate and EBIT at only 2.3%.  At Airbus, sales have grown at a 7.6% annual rate (11% in dollar terms) but EBIT has nosedived into the red for the past six years.  Boeing’s commercial plane division accounted for 66% of its group sales in 1999 and now accounts for 52%.  Airbus sales have remained consistently above 60% of EADS group sales and reached a new high of 67% in 2011.  Airbus’s drive for market share at the expense of profits has had a very measurable impact: its revenues are up, its profits are down, and Boeing’s airplane sales and earnings have flatlined.

EADS went public in July 2000 at €19 per share and ended 2011 near €24, a subdued performance for an 11-year period in which sales more than doubled. In January 2012, Airbus promised better returns for its shareholders for the years ahead and the share responded by rising to €31 in March (it recently traded at €28.8). EADS’s reasons for optimism are a decline of the Euro vs. the US dollar and a long-awaited improvement in operating margins for its superjumbo A380.

Prospects

Long-term headline prospects look nominally encouraging. Airbus and Boeing estimate that 25,000 to 33,500 new planes (including both passenger and cargo) will be delivered to airlines in the next twenty years.  However, according to Boeing, single-aisle aircraft (the A320 for Airbus, the 737 for Boeing, and their successors) will account for two thirds of units sold and for half of the value.  And as many as one third of new planes will be sold in the Asia-Pacific region.

As a market segment, ‘single-aisle in Asia-Pacific’ is not the ideal sweet spot for profit growth because smaller planes have lower margins and because Airbus and Boeing face new entrants in the single-aisle category, notably from China’s COMAC C919 and from Russia’s Sukhoi Superjet 100. The COMAC C919 seats 165 to 190 passengers and is therefore directly positioned against the larger versions of the A320 and the 737. It already has 175 orders, nearly all from Chinese airlines, and it plans to start deliveries in 2016.  Note in passing that Airbus is now assembling some of its own A320s in Tianjin, China, with a target production rate of four per month in 2012. It says on its web page Airbus in China that it “has several major technology transfer programmes underway” some of which have ostensibly already been filtered to COMAC.

The Superjet 100 is smaller than the C919 at 75 to 95 passengers and is positioned against the smallest versions of the A320 and 737 and against Brazil’s Embraer and Canada’s Bombardier. Although it has 240 orders, there are only eight in service now, seven of them with the Russian carrier Aeroflot. Last week’s tragic crash in Indonesia raises fresh safety concerns about Russian aviation just as it tries to rebound from its accident-prone Soviet legacy.

Turning to recent orders, we see that as of the end of April, Boeing had received 415 new plane orders in 2012 and Airbus 95. This huge lead in favor of the American is a temporary anomaly because most of it comes from orders for the new Boeing 737MAX which came on line about 12 months after the competing Airbus 320NEO.  If 2012 is the year of the MAX, 2011 was the year of the NEO with Airbus logging a commanding 1419 total orders (of which 1226 for the NEO) against 805 at Boeing (of which 150 for the MAX).

Wide-bodies

Looking at wide-body categories, the Airbus lineup includes the A330, the A340, the perennially loss-making superjumbo A380, and the A350 still under development.  Boeing’s competing lineup includes the aging but ever-updated 747, the 767, the new 787 ‘Dreamliner’, and most importantly today, the hugely successful 777. Stripping out single-aisle aircraft from 2011 orders, we see that Boeing secured 254 orders for wide-bodies and Airbus 193.

The 777 in particular now enjoys a quasi-monopoly in some segments, vindicating Boeing’s decision to develop this plane while Airbus exhausted itself on the prestige-minded A380 double-decker. Boeing delivered its 1,000th 777 to Emirates in March.  Airbus has positioned different versions of the upcoming A350 against both the 777 and the 787 Dreamliner. The A350 is years away from service but it now has a total of 548 orders. Recent cancellations by Abu Dhabi-based Etihad Airways have slowed down the momentum for the largest version A350-1000 which competes with the 777-300ER.

Airbus still loses an estimated €30+ million on each A380 that it builds but it expects the program to break even in 2014-15 on an EBIT pre R&D level, which is break-even on an operating level, ignoring much of the upfront investment.  That would place the EBIT break-even point somewhere between 200 and 250 unit deliveries (so far 72 A380s have been delivered).  In 2005, Airbus estimated the program would break even on an IRR basis at 270 units.  But in 2006, it revised the break-even point to at least 420 units.  The A380 now has 253 orders, two thirds of which have come from airlines based in emerging markets. And one airline, Dubai-based Emirates, accounts for 90 orders.

Airbus sees a total market of over 1,200 units for the A380 (all versions) in the next 20 years, but Boeing believes the potential market is only 325 units. Depending on where one stands on either end of this range, the A380 will either be handsomely profitable in a few years or one of the most visible financial failures in modern industry. For context, consider that in the 42 years since the introduction of the Boeing 747 in 1970, Boeing has sold nearly 1,500 versions of the plane.  With its A380 projections, Airbus is hoping to sell 80% as many units in as few as 20 to 25 years. It is true that the overall market is much bigger today but it is also true that airlines seem more interested in smaller planes. Rising world demographics do not necessarily create a correspondingly large demand for jumbo planes, as much as they do for a larger number of destinations and higher frequency of flights serviced by smaller aircraft.

It would be beneficial for both manufacturers if the A380 turned a profit (at least at EBIT level).  The plane has a list price of $375 million but list prices are generally above contracted prices.  Boeing’s revamped 747, the 747-8 Intercontinental, has a list price of $318 million. If the A380 stays in the red, the question becomes how long will Airbus continue to build it at a loss? Thousands of European jobs depend on the plane and Airbus will probably keep the program for as long as possible. Selling the A380 at a loss for an indefinite period would be detrimental to the Boeing 747-8’s own profitability if Airbus has to offer greater and greater discounts in order to keep the program alive.

It is still early in 2012 but both manufacturers have had difficulty selling wide-body aircraft this year.  Of Boeing’s 415 net orders, only 2 were for wide-bodies (there were 8 new orders and 6 cancellations). Of Airbus’ 95 net orders, only 6 were for wide-bodies (there were 22 new orders and 16 cancellations). The A350 has lost a net 7 orders in 2012. Boeing’s newest plane, the 787 Dreamliner lost a net 6 orders. However, both manufacturers have large backlogs, equivalent to 5 years of 2011 revenues at Boeing and to 11 years at Airbus, which should keep their factories humming in any downturn, barring large cancellations.

Profitability

Airbus is trying to improve its poor profitability.  Its EBIT margin in 2011 was a dismal 1.7% vs. 9.7% at Boeing’s Commercial Airplanes division. Airbus management is targeting an EBIT margin of 10% for 2015, a level last reached in 2005. The margin is expected to start expanding in 2012 as A380 losses subside and low-margin orders from the early 2000s are finally phased out.

By contrast, there may not be a lot of room for margin improvement at Boeing. Its group EBIT margin was 8.5% in 2011 and its margin in commercial planes was 9.7%.

Long-term expectations remain high and both manufacturers are likely to add more capacity in coming years. Because these expectations are predicated on continued growth in emerging markets, a cyclical downturn in these markets will depress utilization rates and put pressure on pricing at the same time that new competitors enter the lower end of the market. On the other hand, continued expansion of emerging market airlines and operational improvements at Airbus could result in better pricing power unless COMAC manages to gain significant market share.

In conclusion, both companies stand to benefit or suffer from emerging market developments. Operationally, Airbus has more room to improve. If it can narrow the margin gap with Boeing, EADS’s EV/Sales and stock should rise correspondingly. But its manufacturing location in Europe may make it difficult to reach its stated margin targets.