Quarterly Outlook
Equity outlook: The high cost of global fragmentation for US portfolios
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Governments bailouts are coming to Europe
Peter Garnry
Chief Investment Strategist
Summary: In today's equity update we focus on Europe's utility sector which is running into profitability issues over Europe's gas crisis with the German utility Uniper asking for a bailout of EUR 9bn due to higher costs for gas as Gazprom has cut its gas supplies to Europe. In the travel sector, European airliners are experiencing a horrible summer with labour shortages and SAS has recently failed to strike a deal with around 1,000 pilots pushing the airliner into Chapter 11 to negotiate a restructuring in order to get better unit costs. Bailouts are back in Europe.
Uniper and potential nationalisations of the utility sector
Europe’s gas situation was already deteriorating rapidly before Russia’s invasion of Ukraine but after the war it has gone from bad to worse. The 1-month forward natural gas future has galloped to 170 EUR/MWh zooming in on the highs from when the war broke out. These punitive natural gas prices are having a demand destruction in Europe already with emergency plans being enacted in many countries in our to ration gas supplies for the industry if the gas supply from Russia is cut even further. Many industrial stocks in Europe are down recently as the outlook is gloomy.
Gas storage in Europe is still trending well within the past 10 years seasonality pattern suggesting that despite lower supply of gas storage is still rebuilding at the same pace suggesting demand is lower at these high prices. Another recent casualty of Europe’s gas crisis is the German utility company Uniper, which is 75% owned by Finnish Fortum, which is no longer receiving the gas volume from Gazprom that it has contracted (only 40% of its previous gas volume) and as a result the utility is forced to acquire the gap in the spot market at punitively high prices.
Uniper has recent issued a profit warning and cancelled its outlook while seeking a government bailout of as much as €9bn to cover the extra costs. Both E.ON and RWE have less exposure to Russian gas than Uniper but other utilities in Europe could face same issues as Uniper and thus more government bailouts could be on the table in Europe’s utility sector. To preserve gas for its industry, Germany has declared gas emergency level 2 (out of 3) and will allow extending coal fired electricity generation to lower gas intake in its electricity generation.
The pandemic is catching up with the travel sector
SAS failed yesterday to strike a deal with around 1,000 pilots to cut costs and as a consequence the airliner has filed for Chapter 11 bankruptcy in the US which allow SAS to continue to operate while it discusses with its creditors a plan to restructure the business. The European airlines industry was already underperforming before the pandemic, but from an operations point of view SAS had actually got its house in order.
In its fiscal year before the pandemic that ended in October 2019 the airliner generated SEK 3.1bn in operating income down from SEK 4bn the year before and had only SEK 2bn in net debt while modernizing its fleet. The pandemic hit the travel sector hard and SAS went from SEK 46bn in revenue in fiscal year before the pandemic to SEK 20.5bn in the fiscal year ending October 2020 and down to only SEK 14bn in the fiscal year ending October 2021. SAS is expected to generate SEK 32.1bn in revenue in the fiscal year ending October 2022. While this is an impressive rebound relative to other airliners such as Norwegian it is still a shortfall of SEK 14bn in revenue and as a result the airliners economics of scale have been lowered requiring lower operating costs on a unit basis. In addition the increased net debt is reducing overall cash flow generation allowing less cash for investments to upgrade its fleet to make the company more cost competitive.
SAS has only one way out of the dark and that is to drastically cut costs, convert a large part of its debt to equity wiping out existing shareholders, and then raise additional equity with the help of the Scandinavian governments to reduce the net debt situation and invest in newer planes to reduce unit costs. Overall, the SAS story is the story of the European airliner industry that is structurally unhealthy and does not deliver return on invested capital above the cost of capital. With many airports having reached a physical limit, Schiphol in Amsterdam will cut its capacity next year to reduce noise pollution and NOx emissions, and interest rates going higher we expect ticket prices to continue to go up in Europe and many the airport capacity constraint is exactly what the industry needs to become more profitable going forward. Latest Market Insights
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