Rheinmetall: Business Separation Can Unlock Significant Value

| About: Rheinmetall AG (RNMBY)

Summary

Rheinmetall operates in two different business segments, namely automotive and defense, which don’t have much synergies between them.

This business profile makes its valuation more difficult to perform, leading to undervaluation compared to its peers.

I believe that a business separation is likely to be performed in the short to medium term, which could be an important catalyst to unlock significant value.

Rheinmetall (OTCPK:RNMBY) has a balanced business within the automotive and defense sectors. However, its defense segment has better growth prospects and a more solid business position than its automotive segment. This profile creates undervaluation because it is trickier to evaluate, leading to undervaluation compared to its closest peers. Moreover, given that synergies between the two segments don’t exist, a business separation makes sense, a move that could unlock significant value for shareholders.

Company Description

Rheinmetall is an automotive, electronics, defense, and engineering group. The company is based in Germany and was founded in 1889. It produces automotive pumps and components to supply air, reduce emissions, and supply fuel, bearings for engines, weapons, and ammunitions among other products. It has a market capitalization of about $5 billion and trades in the U.S. on the over-the-counter market, but investors should be aware that its primary listing on the German Stock Exchange has much more liquidity.

Despite its diversified product portfolio, Rheinmetall operates only two main business segments, namely automotive and defense. In its automobile division, it supplies mainly engine components, while its defense unit manufactures radar defense systems, weapons, and ammunition. Its closest competitors are therefore a mix of automotive supplier companies, such as Continental AG (OTCPK:CTTAY) or Valeo (OTCPK:VLEEY), and defense companies, like Leonardo SpA (OTCPK:FINMY) or Airbus (OTCPK:EADSY).

Business Overview

Rheinmetall’s sales are balanced between its automotive and defense businesses. Its defense unit is the largest one, accounting for about 53% of total sales, while the rest comes from its automotive unit. Geographically, it has a good diversification, given that sales generated outside its domestic market accounted for 76% of the total in 2016 and are spread across several countries.

Within its automotive division, 80% of sales are generated outside Germany with Europe being the largest market with a weight of 47%. By customer, it has a very good diversification with its three most important clients being Ford (F), Volkswagen (OTCPK:VLKAY), and Renault (OTCPK:RNLSY), accounting together for 34% of automotive sales with exposure to the biggest client only at 13%. In its defense segment, Europe (including Germany) accounts for about half of revenues, while Asia/Middle-East/Australia are responsible for almost all remaining sales.

The company’s strategy is based on organic growth in its two corporate sectors, where it expects favorable market developments in the coming years. In the automotive division, its growth prospects are supported by the global expansion of automotive production and mandatory regulations on emissions of pollutants. Additionally, it is pushing for growth in China and India, which have better long-term growth prospects than developed markets.

In the medium term, the combination of conventional and electric vehicles [EV] can also boost its growth, as the company already has several products for EV, such as electric pumps, and is therefore well prepared to adapt itself to technological change in the automotive industry. It expects moderate growth in this division in the medium term and a stable EBIT margin of about 8% in this segment.

In its defense business, Rheinmetall should benefit from increasing defense budgets across Europe. After several years of budget constraints, European countries seem to be much more willing to increase military spending. This is explained by the aggressive stance of Russia in more recent years and pressure from the U.S. for European countries to have a higher contribution to NATO.

Indeed, NATO countries agreed in 2014 to spend 2% of their GDP per year in defense until 2024, which means that defense spending is expected to remain robust in the next few years, given that most countries don’t achieve nowadays that level of defense spending.

Moreover, the company is pursuing new customers across high-growth regions, including Asia, Middle East, and Eastern Europe targeting countries to which it has not yet supplied military material, or only to a limited extent. Given this backdrop, Rheinmetall expects annual sales growth of between 5% and 10% in the medium term and an EBIT margin of 6% to 7%.

Financial Overview

Regarding its financial performance, Rheinmetall was negatively impacted by the economic slowdown in Europe a few years ago, which has led to deteriorating figures in 2013-14. However, positive automotive markets and increasing defense spending in the past couple of years have resulted in improved financial results more recently.

In 2016, its sales amounted to €5.6 billion ($6.5 billion), up by 8.1% from the previous year. Both its automotive and defense sectors posted rising sales, and the company was able to beat its own sales growth guidance. Nevertheless, its defense business posted stronger growth, with sales up by 14%, boosted by sales outside of Europe. Its group EBIT rose by 23% to €353 million ($413 million), leading to an EBIT margin of 6.3%. The automotive business had the highest margin at close to 8.4%, while the defense segment reported a margin of about 5%.

Rheinmetall’s net profit was up by 34% due to higher operating income and lower interest expense, as the company was able to improve even further its balance sheet and closed the year with an excess cash position. This means that its gearing is very low, making its strong balance sheet a strong support for future investments or to provide a more attractive shareholder remuneration policy.

This attractive financial position was possible by the steep rise on its cash flow generation, given that free cash flow jumped from only €29 million ($34 million) in 2015 to €161 million ($188 million) in the last year boosted by sales and profit growth. Rheinmetall used this cash generation mainly to reduce debt, even though its dividend was also increased substantially compared to the previous year.

Given that its business is somewhat cyclical and volatile, Rheinmetall has a dividend policy directly related to its earnings evolution. This has resulted on a significant dividend cut related to 2013 earnings, but more recently, it has delivered a growing dividend. In the past year, its dividend was set at €1.45 ($1.70) per share, an increase of 32% from the previous year. At its current share price, Rheinmetall offers a dividend yield of 1.5%.

Like many European companies, Rheinmetall only distributes one dividend payment per year, and the German dividend withholding tax rate is 25%, making its income attractiveness quite low for U.S. investors. On the other hand, its dividend payout ratio was only 31% in 2016, a low level that gives some room for an increasing dividend in the next few years.

During the first six months of 2017, Rheinmetall maintained a good operating momentum with sales and profits up at moderate levels in both its business segments. This also led to improved margins and cash flows, which led to an upward revision of its annual guidance. The company now expects to grow group sales by about 6% in the year and its operating margin is expected to be at about 6.5%.

This means that Rheinmetall is not a high-growth company but should continue to report growing sales and improved profitability in the next few years. Indeed, according to analysts’ estimates, its sales should increase by about 6.6% annually in the next years, while its operating profit is expected to increase 12% per year during this period, implying a higher operating margin that should be close to 7.3% by 2019.

Most of this improvement should come from its defense segment, given that in its automotive business its margin is expected to stabilize in the next few years. Additionally, its order backlog in defense is very strong, representing more than two years of annual revenues of this segment, providing very good visibility for its growth prospects in the next 2-3 years.

Business Separation

Rheinmetall operates in two highly diverse markets, with different competition and customer structures, market mechanisms and cycles. This means that its business models are very different, and synergies among its two businesses are scarce, related to both costs and sales.

Its defense business is more project driven with long product life cycles of up to 20 years, while its automotive business is linked to engine and model policy of carmakers. Rheinmetall is the largest defense company in Germany, but ranks only among the 15 biggest automotive suppliers in its domestic country.

Therefore, its current group structure doesn’t seem to provide the best profile for shareholders because the company is a mix of two complete industries. A separation of its businesses would much probably lead to a higher valuation due to several reasons.

Firstly, investors who want exposure to automotive or defense have other options, particularly through companies that operate strictly in those industries. This means that an investor has to be bullish on both the automotive sector and defense to consider an investment in Rheinmetall, something that may not happen all the time and can create some undervaluation.

Secondly, the company is part of the auto sector indexes in Europe and is probably overlooked by ‘defense’ investors. As this last sector usually trades at higher multiples than automotive companies, this may also create undervaluation for Rheinmetall.

Thirdly, a relative valuation is more difficult to perform because its ‘peer group’ is composed of two completely different groups, one for its automotive unit and another for defense. Moreover, given that there isn’t any other company with a similar profile, there isn’t a direct peer to compare making its valuation more difficult to do on a relative basis. This may also result on undervaluation because investors will certainly use different weights for the two segments, creating some valuation distortions.

Lastly, investors usually perform a sum-of-the-parts [SOTP] valuation for companies with a holding structure similar to Rheinmetall. The listed entity is usually a holding company, while its operating units appear below on the corporate structure. This means that investors evaluate its two units separately and then use an SOTP valuation to arrive at a holding company value. Usually, investors apply a holding discount to this type of structure of about 20%, creating an undervaluation that can be eliminated by the separation of the business and elimination of the holding company.

Therefore, there are several reasons that justify a separation of Rheinmetall’s business segments into two separated listed companies. This would eliminate some valuation distortions that lead to undervaluation, even though most of them are difficult to quantify. Nevertheless, as synergies between the two businesses are practically non-existent, a separation would certainly be beneficial for shareholders, because it most likely would result on a higher valuation of the two businesses separately compared to its current group structure.

This type of spin-off is not uncommon among German companies, as they streamline their portfolios to focus on the where they have more competitive advantages in the long term. For instance, in the recent past, Siemens (OTCPK:SIEGY) has split out Osram (OTC:OSAGY) and Bayer (OTCPK:BAYRY) has performed the spin-off of Covestro (OTCPK:CVXTY), something that Rheinmetall is likely to do in the near future because its auto unit has reached peak margins, and therefore this is the best time to spin-off the business.

Conclusion

Rheinmetall is an interesting company with good growth prospects, especially within its defense segment. However, it can have even more upside in the short-term from a possible business separation, as this would lead much likely to a higher valuation.

Rheinmetall is currently trading at 15.7x forward earnings and 2.5x book value, a valuation that is closer to its automotive suppliers’ peers. Compared to its defense peers, its valuation is clearly cheap, as shown in the next table. This shows that Rheinmetall is usually benchmarked against its auto peers, even though 53% of its sales and 41% of operating income have come from its defense unit in the past year.

P/E P/BV
Rheinmetall 15.7 2.5
Continental AG 12.4 2.9
Valeo 13.1 3.6
Brembo (OTC:BRBOF) 17.0 5.2
Leoni (OTC:LNNNY) 13.2 1.9
Auto Peers Average 14.3 3.2
Airbus 24.0 6.8
Leonardo 16.8 2.0
BAE Systems (OTCPK:BAESY) 18.5 5.7
Thales (OTCPK:THLEY) 22.4 4.3
Defense Sector Average 19.2 4.4

Source: Bloomberg

Thus, Rheinmetall seems to be undervalued, considering its current business profile, assuming a weight of 60% for its automotive business (its weight on the group’s operating income) and 40% for defense. Taking into account the average valuation multiples of the two peer groups, Rheinmetall is undervalued by about 25%. Additionally, if the company decides to separate its businesses, it could eventually lead to higher upside, as the holding discount would be eliminated.

A possible catalyst may be its capital markets day, expected in next November. The company should make some announcements regarding its capital allocation, and I believe, probably it can announce a spin-off of its automotive businesses into a different company. This makes Rheinmetall an interesting play both due to its organic growth prospects and attractive valuation and the possible event of a business separation that would unlock significant value for shareholders.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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