Although the European debt crisis is raging on halfway across the world – out of sight of most Americans – the impact could hit home. And in a big way.
As my colleague, Karim Rahemtulla, pointed out in September 2011, “The reality is that a European crash – even a slowdown – would have a devastating impact on U.S. growth.”
Newsflash: A European slowdown, even an all-out recession, appears imminent.
In the last year, manufacturing PMI readings for almost every European country went from solidly above 50 (signaling expansion) to below 50 (signaling contraction).
So how much of an impact can we expect in the United States?
Let’s take a closer look today to find out. And in the process, I’ll share two stocks you should avoid buying.
The Truth About a European Recession
What few Americans realize is that the S&P 500 companies rely heavily on sales to foreign countries, particularly Europe.
Foreign sales accounted for 46% of total sales in the last year, according to Standard & Poor’s Howard Silverblatt. Of that, 29% came from Europe.
Do the math and it turns out that S&P 500 companies rely on Europe for $0.14 of every $1 in sales. So any slowdown in Europe is certain to create a ripple effect in the United States.
We’re not talking about a tiny ripple, either.
Diane Swonk, Chief Economist at Mesirow Financial, predicts that the European turmoil could shave at least half a percentage point off of U.S. GDP growth this year.
At first glance, half a percentage point might not seem like a lot. Until you realize that the U.S. economy is only expected to grow by approximately 2.5% this year.
In actuality, we’re talking about U.S. GDP growth getting a haircut of 20% (or more) thanks to Europe.
That’s on the macro level. If we move onto the micro level – to companies with the heaviest exposure to Europe – it stands to reason that the impact will be even more significant. Especially since the euro’s getting hammered.
In the last year, the currency’s down about 15%. Thanks to currency translation, that means any profits earned by U.S. companies in Europe will be worth less when they’re converted into dollars.
Here are two companies that are particularly vulnerable:
~ Electronic Arts (Nasdaq: EA): This leading developer of video games derived 45.8% of sales from Europe last quarter. That’s up from 41.5% a year ago. At those levels, a double-digit slowdown in Europe could easily undermine the firm’s overall growth. (Analysts only expect the company to increase sales by 7% in fiscal 2013.)
But an increasingly heavy reliance on Europe isn’t the only red flag for the stock.
The company operates in an intensely competitive industry. Plus, demand might be waning, as video game sales unexpectedly dipped in the fourth quarter, based on the latest industry numbers from NPD Group.
On top of that, as I revealed in a recent interview with CNBC, Electronic Arts is trading at a premium to the S&P 500 based on its forward price-to-earnings (P/E) ratio.
~ Red Hat (NYSE: RHT): This leading provider of cloud-computing services doesn’t break out sales by Europe separately. Like many companies, it lumps European sales in with sales to the Middle East and Africa (EMEA). But Europe accounts for the majority of EMEA segment sales. And in the last quarter, Red Hat EMEA sales accounted for 36.9% of total sales. That’s up from only 22.7% a year ago.
Further, the company, like Electronic Arts, operates in an intensely competitive industry. Plus, the open-source nature of its products makes it hard for Red Hat to differentiate itself from competitors.
Here, too, shares are trading at a premium. At current prices, the stock carries a P/E ratio of 59.2, compared to an industry average of just 27.9. And its forward P/E ratio of 37.7 is roughly triple that of the S&P 500 Index.
Bottom line: Look out below! A European slowdown could send shares of heavily exposed U.S. companies south, and in a hurry. Electronic Arts and Red Hat appear particularly vulnerable because they’re both ramping up reliance on Europe for sales at precisely the wrong time.
Ahead of the tape,