Why You Should Be Cautious On Daimler's Stock Following Its Rally

| About: Daimler AG (DDAIF)

The shares of Daimler AG (OTCPK:DDAIF) have rallied about 20% in the last month on strong American and Chinese sales. The cars and vans sold under the Mercedes brand contribute almost 70% to the stock price, as per our estimates.

We expect the automaker to perform better in the second half of the year than the first half due to a slew of model refreshments and new introductions that are lined up. However, due to ongoing weakness within the company and uncertainty in the macroeconomic environment, the level of improvement might not be as significant as the market might be hoping. The low profitability remains an issue for the automaker, and management's guidance is based on optimistic assumptions on which the company could have difficulty delivering.

Low Profitability

Operating margins have been declining sequentially with each quarter and fell to 3.4% in the first quarter. On the other hand, the margins of Audi and BMW have been consistently clocking 10%. This means the company has to see a huge improvement if it wants to match the profits of its German rivals.

Right now, margins are also being hurt due to some one-time investments associated with the model makeovers. Moreover, the automaker will be keen to clear its inventory to pave the way for the revamped products. This generally hurts profits in the short term since the automakers offer greater discounts to sell off the stockpile of the soon-to-be-replaced models.

In absence of these one-time costs, margins should naturally improve in the second half of the year. But, as you can see, the gap is too wide at the moment. Moreover, the next wave of growth could come from some of the lower-priced, high-volume cars such as the CLA in the U.S. and the A-Class in China. Generally, the high-volume cars have thinner margins compared to the more expensive models such as the S-Class or the GL-Class. Generating higher unit sales is obviously good for the automaker, but that could fail to achieve the desired level of margin improvement. The automaker may find it difficult to achieve historical levels of its long-term margin range due to a shift in product mix toward lower-priced models.

Failing to Deliver

Company management has recently had trouble delivering on its guidance as the 2012 numbers were below management's initial forecast. The profit guidance for 2013 was revised lower after first-quarter results. This is not to say that the company is entirely to blame. The macroeconomic conditions in some of the European nations are so weak that the entire automobile industry is suffering, not just Mercedes. That said, blindly following management's guidance wouldn't be wise since it is generally based on the assumption that market conditions will improve.

For example, during the earnings call, the company stated that it expects the German auto industry to rebound this year after it showed weakness in the second half of 2012. But the data for the first five months of 2013 shows that the German auto market has only worsened this year, and that it might not have bottomed out yet. Car sales in Germany fell 9.9% last month and are down 8.8% through May. Germany accounts for about a fifth of the automaker's sales.

Western Europe, in general, continues to remain weak. Daimler depends on about half of its sales from the region. Thus, although we expect the second half of the year to be better than the first, there are issues that need to be addressed. Therefore, the level of improvement might not match the expectations.

We have a price estimate of $58 for Daimler's stock, which is about 10% below the current market price.

Disclosure: No positions.